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username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 10 2009 number 1 the new oecd approach on profit allocation: a step forward towards neutral treatment of permanent establishments and subsidiaries by professor dr. irene j.j. burgers* i. introduction ................................................ 52 ii. historical background .............................. 54 iii. the new oecd approach to allocation of profits to permanent establishment ......................... ...... 59 a. the 2008 commentary............................61 b. the proposal for a new article 7 oced ................. 64 iv. does the new oecd approach result in deeming the permanent establishment as subsidiary? . . .. . . . .. . . .. . .. . . 70 v. justification grounds for not deeming a permanent establishment as subsidiary .................................... 72 vi. conclusion.... ............................................... 74 * professor of international tax law and professor of economics of taxation, university of groningen, the netherlands. 51 florida tax review i. introduction one of the vexing questions in tax law is whether or not the legal form should make a difference in taxing companies. this question arises amongst others when companies do business outside their country of residence. companies may set up a subsidiary. the subsidiary, being a separate legal person, will in most countries be taxed as a resident company in the state of incorporation and/or in the state in which it has its effective management.' it will be taxed as if it acts on an arm's length basis with the parent company and other associated companies.2 in case the taxpayer performs its foreign activities without setting up a subsidiary the income derived from these foreign activities may also be taxed in the country where the activity is performed. most countries tax non-residents on income derived from sources in their country including income derived from permanent establishments situated in that country.' these countries generally use the concept of permanent establishment both in their domestic law and in tax treaties. a permanent establishment generally is defined as a fixed place of business through which the business of an enterprise is wholly or partly carried on. pe-profits are determined on the basis of the separate enterprise theory for allocating profits to permanent establishments:4 the pe-state taxes the profits which the permanent establishment might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. important exception is the united states. in its tax treaties the united states 1. some countries use incorporation for determining residency, others use effective place of management. 2. for a historical overview of the u.s. approach to intercompany pricing see lawrence m. axelrod, intercompany transactions, practicing law institute, tax law and estate planning course handbook series tax law and practice pli order no. 11569, october-november, 2007, tax strategies for corporate acquisitions, dispositions, spin-offs, joint ventures, financings, reorganizations & restructurings 2007; and wayne r. strasbaugh, intercompany transaction regulations, practicing law institute, october-december, 2008. 3. for a description of the fundamentals of source-based and residencebased taxation see yoram keinan, the case for residency-based taxation of financial transactions in developing countries, 9 florida tax review 1, (2008). 4. for an overview see the country chapters in i.j.j. burgers and a. bakker (ed.), the taxation of permanent establishments, ibfd, amsterdam, loose-leaf [vol.10:152 the new oecd approach on profit allocation uses the pe-concept.s however, in its domestic law the united states uses the fixed place of business concept in combination with the "income effectively connected with a trade of business" rule. this article focuses on the question of whether or not, and if so to what extent, differences in profit allocation may influence a taxpayer's choice between permanent establishment and subsidiary in case the peconcept is used. contrary to the historical reasons for adopting the separate enterprise theory as leading doctrine for allocating business profits permanent establishment and subsidiary are not treated neutral. recent developments in respect of profit allocation for tax treaty purposes presumably will make the differences smaller as the oecd in 2008 adopted a new approach to the separate enterprise theory and revised the commentary to article 7 oecd in as far as the changes required to incorporate the new approach are in line with the text of the present article 7 oecd. moreover the oecd published a proposal for a new article 7 oecd and commentary on 7 july 2008 which was revised on 24 november 2009. this new approach takes a functional and factual analysis followed by a comparability analysis as starting point for allocating profits to a permanent establishment. in paragraph 224 of the report on the attribution of profits to permanent establishments of 17 july 2008 the oecd states that the transfer pricing guidelines drafted for determining the arm's length price in intercompany relations will be applied by analogy to dealings between the permanent establishment and the other parts of the enterprise of which it is a part. this article raises the issue of which justification grounds for these differences in treatment can be pointed out and whether the arguments raised by the oecd are solid. the structure of this article is as follows: in part ii, the historical background of the separate enterprise theory is described. part iii focuses on the recent changes in the oecd approach to this theory and sets out the changes in consequences of the new approach compared to the old approach for the allocation of profits in respect of: 5. for an in-depth discussion see diane ring, the taxation of permanent establishments in the united states, 1 1.1.2 in i.j.j. burgers and a. bakker (ed.), the taxation of permanent establishments, ibfd, amsterdam, loose-leaf. 6. the u.s. income tax system is based on the principle of origin instead of the principle of source. the principle of origin, as introduced in the u.s. by von schanz, requires economic allegiance. more factors are decisive than in respect of the principle of source, requiring that there is a close connection of the income to the soil of a country (e.g. a factory (pe-income) or physical presence of a worker (labour income). k. vogel, worldwide vs. source taxation of income a review and reevaluation of arguments, intertax 1088, part 1, pp. 216 229, part ii, pp. 310 320 and part iii, pp. 393 402. 2009] s3 florida tax review 1. transfer of goods; 2. internal services 3. management activities 4. transfer of material assets 5. transfer of immaterial assets 6. financing. both the view laid down in the 2008 commentary and the proposal for a new article 7 oecd will be dealt with. part iv shows the new oecd approach still results in a different allocation of profits to permanent establishment then to subsidiaries. part v addresses the question if there is a justification ground for treating permanent establishments and subsidiaries differently. part vi contains the conclusion. ii.historical background the history of this theory can be traced back to the early decades of the previous century. in 1933, m.b. carroll did a survey of the income tax legislation in 27 countries, and concluded that most countries used what carroll called the separate accounting method, but which is nowadays generally referred to as the separate enterprise theory in their domestic law for determining the amount of taxable profits derived by non-resident countries. carroll suggested to include in tax treaties a provision reflecting the way these countries determined this source income:' "if an enterprise with its fiscal domicile in one contracting state has permanent establishments in other contracting states, there shall be attributed to each permanent establishment the net business income which it might be expected to derive if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions." he also proposed that such net income should, in principle, be determined on the basis of the separate accounts pertaining to such establishment. carroll formulated the following reasons why this separate accounting method should be regarded as superior to other methods used in those days, such as fractional apportionment where tax is assessed on the part of the total net income of the enterprise that corresponds to the relative economic importance of the local establishment: 7. m.b. carroll, league of nations, geneva, 1933, c.425(b). m.217(a).1933.h.a. 54 [vol10:1 2009] the new oecd approach on profit allocation 55 1. the method avoids the taxation of unrealized profits; 2. the information necessary for tax purposes can be derived from sources which were within the jurisdiction of the permanent establishment; 3. in practice separate accounts are kept for branches; 4. the method prevents tax evasion; 5. the method does not interfere with the actual business organization; 6. resident and non-resident enterprises will be treated similarly. the separate accounting method, as proposed by carroll, formed the basis for the "business profits articles" in the league of nations conventions and the oecd conventions on double taxation. carroll did not formulate any detailed rules concerning the profit allocation. he advised that there is 'apparently no theoretically perfect rule for determining exactly how much of the income is attributable to each establishment any more than there is an accurate way for apportioning the compensation of an individual workman to his hand and feet, and to his brain which has coordinated all his efforts.' 8 this lack of guidance both between countries and within countries resulted in many different interpretations of the separate enterprise theory. in my dissertation9 published in 1991 1 made a detailed analysis of these different interpretations of the separate enterprise theory in germany, the netherlands, the united kingdom and the united states. i concluded that these interpretations could be categorized into the following five approaches: 1.the legalistic functional approach: no fictitious agreements may be assumed for purposes of determining profits attributable to the permanent establishment. no agreements may be concluded between the different parts of a worldwide enterprise. thus assets, income and expenses related to the pe-activities should be allocated to the pe but internal transactions should not be taken into account; 2.the narrow functional approach: this approach does take into account internal transactions but only in as far as identical or in case similar activities are rendered to or received from third parties (for instance internal interest derived by branches of banking enterprises); 8. league of nations document c.425(b).m.217(b).1933.ii.a, pp. 189 190. 9. i.j.j. burgers, taxation and supervision of branches of international banks, a comparative study of banks and other enterprises, ibfd, amsterdam, 1991. florida tax review 3.the broad functional approach-based on the premise that the various parts of an international enterprise must be remunerated for their function within the enterprise. all internal transactions should be remunerated at arm's length prices. 4.the narrow territorial approach: in case this theory is applied profits are allocated to the permanent establishment as if it was a subsidiary. arm's length fees are charged for most transactions. no fees are charged for activities that would in the case of a subsidiary be referred to as shareholder activities. the permanent establishment is deemed to have its own management and to fulfill all legal obligations that have to be fulfilled by a subsidiary, including a minimum endowment capital 5.the broad territorial approach: this theory fully reflects the wording of article 7(2) oecd. it implies that the permanent establishment is treated as a completely separate enterprise. contrary to the narrow territorial approach the shareholder relationship is deemed not to exist. the research showed that each of these five approaches had been applied or advocated in the four countries researched and that the wording of article 7(2) oecd seems to refer to the broad territorial approach and that of article 7(3) oecd to the logistic functional approach. my conclusion therefore was and still is that revision of the text of article 7 oecd would be necessary to create clarity on the issue of which approach should be adopted. in the same year c. van raad also made a proposal for a redraft of article 7 oecd.'0 in 1995, the oecd revised the oecd commentary by making clear that internal contracts between the permanent establishment and other parts of the enterprise should be taken into account at arm's length and that the arm's length price would equal actual expenses made: -if a particular property or service would not have been obtainable from an independent enterprise; -in case a particular property or service is obtainable from an independent enterprise but independent enterprises would agree to share costs. in order to facilitate the distinction the committee formulated the following question (hereafter the "borderline question"): 10. c. van raad: the 1977 oecd model convention and commentary: selected suggestions for amendment of the articles 7 and 5, intertax, 1991, no. 11; pp. 497-502. [vol.10:156 the new oecd approach on profit allocation is the internal transfer of goods or services (whether temporary or final) one of the same type which the enterprise might in the ordinary course of its activity be likely to have offered to or be requested to supply by an independent third party at an arm's length price (paragraph 31 of the 1994 report). in 2000, 2003 and 2005, new versions of the commentary were published. the only changes in respect of article 7 were the inclusion of paragraph 10.1 in 2003 stating that the purpose of article 7 (1) oecd is to provide limits to the right of a contracting state to tax the business profits of enterprises that are residents of the other contracting state, as well as some more reservations and observations to the article. the following internal transactions should be remunerated at arm's length basis according to the commentaries 1995-2005: internal delivery of goods for resale in a finished state or as raw materials or semi-finished goods. in case of a time lag it is up to the head office country to seek on a case by case basis a bilateral solution with the outward country where there is serious risk of overtaxation (paragraphs 15 and 17.3 of the 1995-2005 commentary); internal delivery of services, provided " the trade of the enterprise, or part of it, consists of the provision of such services and therefore there is a standard charge for their provision (paragraph 17.5 of the 1995-2005 commentary); or " the main activity of the permanent establishment is to provide specific services to the enterprise to which it belongs and these services provide a real advantage to the enterprise and their costs represent a significant part of the expenses of the enterprise (paragraph 17.6 of the 1995/2005 commentary); internal transfer of tangibles, (paragraphs 15 and 17.3 of the 19952005 commentary) in case: o the transfer is not temporary (paragraph 17.3 of the 19952005 commentary) and; " the pe-state's domestic law taxes the profits deemed to arise in connection with such a transfer. in case of double taxation the head office country should seek a solution (paragraph 15.1 of the 1995 2005 commentary); payments of interest made by different parts of a financial enterprise to each other on advances etc. (paragraph 19 of the 1995-2005 commentary). 2009] 57 florida tax review a mere deduction of costs takes place in respect of: good management (for practical reasons: paragraph 21 of the 19952005 commentary); general administrative expenses, such as for a common system of training (paragraph 17.7 of the 1995-2005 commentary) internal transfer of tangibles in case the domestic law of the state does not allow an arm's length transfer (paragraph 15 of the 19952005 commentary) or in case deduction of costs might be appropriate, i.e. in case of temporary use of the asset (paragraph 17.3 of the 1995-2005 commentary); internal transfer of intangible rights as it is difficult to allocate ownership (paragraph 17.4 of the 1995-2005 commentary) external interest paid by a company other than a financial company to finance the activities of the permanent establishment. payments in the name of interest made to a head office by its permanent establishment are not allowed as: o "from the legal standpoint, the transfer of capital against payment of interest and an undertaking to repay in full at the due date is really a formal act incompatible with the true legal nature of a permanent establishment;" and o "from the economic standpoint, internal debts and receivables may prove to be non-existent, since if an enterprise is solely or predominantly equity-funded it ought not to be allowed to deduct interest charges that it has manifestly not had to pay." (paragraph 18.3 of the 19952005 commentary). a mutual agreement procedure was suggested for preventing double taxation in attributing profits to a permanent establishment in the case of internal disposals of technology and trade-marks, internal services, questions of underor overcapitalization of a permanent establishment and in all other cases where a clear distinction between "expenses" and "prices including an element of profit" actually leads to results compatible with the underlying principles of double taxation agreements, i.e. the avoidance of economic double taxation and a fair allocation of taxation rights between countries which hold differing views. to some extent this revision created more clarity. however, numerous vexing questions still remained unanswered. in 2001, the oecd started with a new project concerning the change of the commentary of article 7 oecd. practice was asked to give comments on the proposals published on the website of the oecd. at the time of writing this article (august 2009) the project was partly finalized. the oecd published the final report on the attribution of profits to permanent 58 [vol. 10: 1 the new oecd approach on profit allocation establishments on 17 july 2008. part of the ideas on allocation of profits to permanent establishments laid down in this report have been included in the update 2008 of the oecd commentary. other proposals were not included as these were not in line with the present article 7 oecd. a proposal for a new article 7 oecd and commentary were published on 7 july 2008. a revised text was published on 24 november 2009. the intention is to include this article in the 2010 update of the model. iii.the new oecd approach to allocation of profits to permanent establishments at the start of the discussions on a new approach to the attribution of profits to permanent establishments in 2001 some states advocated an approach referred to by oecd as the relevant business approach, others the what is referred to by the oecd as functionally separate entity approach. the relevant business approach implies that due to the wording of article 7(1) oecd the attributed profits cannot exceed the profits that the worldwide enterprise earns from the relevant business activity. the relevant business activity is determined either by reference to the profit of the enterprise as a whole or to a particular business activity in which the pe has participated. such limitation does not occur in the functionally separate entity approach. the functionally separate entity approach implies that a functional and factual analysis must identify the economically significant activities and responsibilities undertaken by the permanent establishment. it should be determined which functions are significant people functions or in respect of financial institutions key entrepreneurial functions and which functions are routine functions. on the basis of this determination of functions assets and risks should be allocated. next a comparative analysis should determine remuneration of any dealings between the hypothesized enterprises. consensus was reached that preference should be given to the functionally separate entity approach. in its (draft) reports the oecd stresses that this approach should be preferred for the following reasons: 1. the approach is consistent with the arm's length principle as it does not impose any limitation on the profits attributable to the permanent establishment that might affect the determination of the profits attributable to the permanent establishment in accordance with the arm's length principle; 2. it is easier to apply than the relevant business approach as it does not require the host country to determine the enterprise's worldwide profits from the relevant business activity and is thus from an administrative point of view preferable; 2009] 59 florida tax review 3. it is preferred from the perspective of consistency as a similar type of analysis should be undertaken as the one that should take place in case the permanent establishment were a legally distinct and separate enterprise (paragraphs 72 79 of the 2008 report on the attribution of profits to permanent establishments). the starting point for the evaluation of potential "dealings" will normally be the accounting records and internal documentation of the permanent establishment. conditions are as follows: * the documentation is consistent with the economic substance of the activities taking place within the enterprise as revealed by the functional and factual analysis; * the arrangements documented in relation to the dealing, viewed in their entirety, do not differ from those which would have been adopted by comparable independent enterprises behaving in a commercially rational manner or, if they do so differ, the structure as presented in the taxpayer's documentation does not practically impede the tax administration from determining an appropriate transfer price; and * the dealing presented in the taxpayer's documentation does not violate the principles of the authorized oecd approach" (hereafter: aoa approach) "by, for example, purporting to transfer risks in a way that segregates them from functions" (paragraph 39 of the 2008 report on the attribution of profits to permanent establishments). documentation is not decisive in case booking practices are inconsistent with the functional and factual analysis. the documentation requirements imposed in connection with intra-enterprise dealings are not intended to be more burdensome than in case of intercompany dealings. moreover documentation requirements should not impose disproportionate costs and burdens on taxpayers both in respect of permanent establishments and subsidiaries (paragraph 40 of the 2008 report on the attribution of profits to permanent establishments). as to paragraph 39 of the 2008 report accounting records and contemporaneous documentation that meet the requirements of symmetry constitute a useful starting point for the purpose of attributing profits to a permanent establishment. in respect of the comparability analysis by analogy the same factors should be taken into account as applied in respect of intercompany dealings: -functional analysis -characteristics of property or services; -contractual terms; -economic circumstances; and -business strategies (paragraph 92 of the 2008 report on the attribution of profits to permanent establishments). 60 [vol10:1 the new oecd approach on profit allocation a. the 2008 commentary the conduct of parties is used as proof for the allocation of risks. economic principles that govern relationships between independent enterprises should be applied (paragraph 98 of the 2008 report on the attribution of profits to permanent establishments). paragraphs 17 and 18 of the 2008 commentary explain the functionally separate entity approach. however, only those conclusions that do not conflict with the 2005 version have been incorporated in this commentary (paragraph 7 of the 2008 commentary). similar to the 1995-2005 commentaries the 2008 version of the commentary remunerates the following internal transactions at arm's length basis: internal delivery of goods by the permanent establishment to other parts of the company. like the 1995-2005 commentary the 2008 commentary recommends the time lag problem should be solved on the initiative of the head office state (paragraph 21 of the 2008 commentary). minor change to the 1995-2005 commentary is the change in wording of parts of the paragraph: o "many states consider that there is a realization of a taxable profit" has been changed into "there may be a realization of a taxable profit;" and " "business property of a permanent establishment situated within their territory" has been changed into "within a state's territory." this change in wording no doubt has not been intended to have practical consequences, but only to bring the wording of the treaty in line with the actual situation that the tax law of some countries does not identify a realization of a taxable profit upon a transfer of an asset from a permanent establishment to other parts of the enterprise; internal delivery of services, provided a the trade of the enterprise, or part of it, consists of the provision of such services and therefore there is a standard charge for their provision (paragraph 35 of the 2008 commentary); or o the main activity of the permanent establishment is to provide specific services to the enterprise to which it belongs and these services provide a real advantage to the enterprise and their costs represent a significant part of the expenses of the enterprise (paragraph 36 of the 2008 commentary).; internal transfer of tangible assets from a permanent establishment to another part of the enterprise, in case: 2009] 61 florida tax review 0 the transfer is not temporary and; " the pe-state's domestic law taxes the profits deemed to arise in connection with such a transfer. in case of double taxation the head office country should seek a solution. (paragraphs 21 and 22 of the 2008 commentary); payments of interest made by different parts of a financial enterprise to each other on advances etc. (paragraph 37 of the 2008 commentary). as regards deduction of costs changes concern internal transfer of intangible rights and interest deduction. a mere deduction of costs takes place in respect of: good management (for practical reasons: paragraph 38 of the 2008 commentary); internal transfer of tangible assets in case the domestic law of the state does not allow an arm's length transfer (paragraph 21 of the 2008 commentary) or in case deduction of costs might be appropriate, i.e. in case of temporary use of the asset (paragraph 33 of the 2008 commentary); general administrative expenses, such as for a common system of training (paragraph 32 of the 2008 commentary); internal transfer of intangible rights as it is difficult to allocate ownership (paragraph 34 of the 2008 commentary). the wording has been slightly changed compared to the 1995-2005 commentary: "in such circumstances it would be appropriate to allocate between the various parts of the enterprise the actual costs of the creation or acquisition of such intangible rights, as well as the costs subsequently incurred with respect to these intangible rights, any mark-up for profit or royalty" (bold parts added in 2008 and made bold by this author); external interest paid by the company to finance the activities of the permanent establishment. the argument for denying internal interest payments remained similar to that raised in the 1995-2005 commentary (paragraph 41 of the 2008 commentary). in new paragraphs 43 48 of the 2008 commentary it is explained that interest expenses actually incurred by an enterprise relating to the activities of the permanent establishment are deductible. however, the permanent establishment should have sufficient capital to support the functions it undertakes, the assets it economically owns and the risks it assumes. the oecd allows the following approaches for attributing free capital: 62 [vol.10:1 the new oecd approach on profit allocation othe capital allocation approach. this approach allocates free capital on the basis of the proportion of assets and risks attributed to the permanent establishment. if on the basis of a functional analysis 10% of the enterprise's assets and/or risks is attributed to the permanent establishment, 10% of the enterprise's free capital should be attributed; othe economic capital allocation approach. this approach has as starting point that all types of risk should be taken into account (including e.g. developmental risk), instead of e.g. in the banking field only the risks taken into account by the regulators; and othe thin capitalization approach. this approach should not be confused with the thin capitalization approaches applied in the domestic law of several states as an anti-abuse measure (requiring a minimum debt-to-equity ratio). the thin capitalization approach that is considered to be an aoa approach requires that the permanent establishment has the same amount of free capital as an independent enterprise carrying on the same or similar activities under the same or similar conditions in the host country of the permanent establishment by undertaking a comparability analysis of such independent enterprises. as practical solution to prevent double taxation in case states use different methods the oecd member states agreed the state of residence must adopt the same approach as the pe state in case: othe difference in capital attribution between the two states results from conflicting domestic law choices of capital attribution methods; and ostates agree that the state in which the permanent establishment is located has used an authorized approach to the attribution of capital, producing a result consistent with the arm's length principle in the particular case. compared to the 1995-2005 commentary the 2008 commentary contains new remarks on: -services performed by the other parts of the enterprise or a related party in connection with the building site or construction or installation project. paragraph 24 stresses that close attention must be paid to the general principle that income is attributable to a permanent establishment only when it results from activities carried on by the enterprise through that permanent establishment; -dependent agents: paragraph 25 of the 2008 commentary stresses that the dependent agent and the enterprise on behalf of which it is acting 2009] 63 florida tax review constitute two separate potential taxpayers; -documentation: paragraph 20 of the 2008 commentary explicitly mentions that accounting records and contemporaneous documentation that are prepared symmetrically on the basis of internal agreements and reflecting the functions performed by the different parts of the enterprise constitute a useful starting point for the purposes of attributing profits to a permanent establishment. summarizing, with a few minor exceptions, the 2008 commentary reads similar to the 1995-2005 commentary. it merely contains some clarifications to the previous version. thus the application of this version of the treaty does not necessarily result in a different allocation than the application of the 2005 commentary. b. the proposal for a new article 7 oecd in line with the dynamic approach of interpretation advocated by the oecd in paragraphs 33 36 of the introduction to the 2008 commentary the oecd stressed that a redraft of article 7 oecd is required in order to provide maximum certainty and remove the potential for different interpretations based on the commentary and practices in the member states. the new oecd approach to the attribution of profits to a permanent establishment, as laid down in the 17 july 2008 allocation report, is reflected in all aspects in the new article 7 oecd. this proposed article no longer includes provisions similar to the present article 7(3), 7(4) and 7(5) oecd." the 2008 version contained a new proposed article 7(3) 11. the 2008 proposed article reads as follows: 1. profits of an enterprise of a contracting state shall be taxable only in that state unless the enterprise carries on business in the other contracting state through a permanent establishment situated therein. if the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that state. 2. for the purposes of this article and article (23 a)(23 b) the profits that are attributable in each contracting state to the permanent establishment referred to in paragraph i are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise. 3. where 64 [vol. 10: 1 the new oecd approach on profit allocation concerning the attribution of "free" capital. this proposal is not included in the 2009 version. alternatively a corresponding adjustment provision, which in the 2008 version was included in the commentary, is provided for in the 2009 article 7(3). the 2009 proposed article reads as follows: 1. "profits of an enterprise of a contracting state shall be taxable only in that state unless the enterprise carries on business in the other contracting state through a permanent establishment situated therein. if the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that state. 2. for the purposes of this article and article (23 a)(23 b) the profits that are attributable in each contracting state to the permanent establishment referred to in paragraph i are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks a) in one contracting state, the amount of "free" capital that is used for determining the interest that is deducted in computing the profits that are attributable to a permanent establishment situated in that state of an enterprise of the other contracting state is determined using a method of attributing capital to the permanent establishment that is provided by the domestic law of the first-mentioned state and both states agree that the application of that method produces an arm's length result in conformity with paragraph 2 in that case; and b) that method is different from the method provided by the domestic law of the other state and used by that state to attribute capital to the permanent establishment and, as a result of this difference, part of the profits of the enterprise are charged to tax in both contracting states, and, in the absence of this paragraph, article 23 would not apply to eliminate the double taxation of these profits, the other state shall, in determining the profits attributable to the permanent establishment for the purposes of article 23, use the amount of "free" capital derived from the application of the capital attribution approach used by the first-mentioned state. for the purposes of this paragraph, "free" capital means capital that does not give rise to a return in the nature of interest that is deductible in the first-mentioned state. 4. where profits include items of income which are dealt with separately in other articles of this convention, then the provisions of those articles shall not be affected by the provisions of this article." 2009] 65 florida tax review assumed by the enterprise through the permanent establishment and through the other parts of the enterprise. 3. where, in accordance with paragraph 2, a contracting state adjusts the profits that are attributable to a permanent establishment of an enterprise of one of the contracting states and taxes accordingly profits of the enterprise that have been charged to tax in the other state, the other state shall, to the extent necessary to eliminate double taxation on these profits, make an appropriate adjustment to the amount of the tax charged on those profits. in determining such adjustment, the competent authorities of the contracting states shall if necessary consult each other. 4. where profits include items of income which are dealt with separately in other articles of this convention, then the provision of those articles shall not be affected by the provisions of this article." paragraph 19 of the 2009 commentary to the proposed article 7 oecd explains that the functional and factual analysis will lead to: -the attribution to the permanent establishment of the rights and obligations arising out of transactions between the enterprise of which the permanent establishment is a part and separate enterprises; -the identification of significant people functions relevant to the attribution of economic ownership of assets and the attribution of economic ownership of assets to the permanent establishment; -the identification of significant people functions relevant to the assumption of risks and the attribution of risks to the permanent establishment; -the recognition and determination of the nature of those dealings between the permanent establishment and other parts of the same enterprise that can appropriately be recognized; -the attribution of capital based on the assets and risks attributed to the permanent establishment. paragraph 20 sets out that for the comparative analysis the 1995 transfer pricing guidelines should be used by analogy to dealings between the permanent establishment and the other parts of the enterprise. paragraph 24 stresses that documentation requirements may not be more burdensome than in connection with such dealings that apply to transactions between associated enterprises and should not be applied in such a way as to impose on taxpayer's costs and burdens disproportionate to the circumstances. paragraph 26 explains that the separate enterprise fiction does not change the nature of the income derived by the enterprise: for instance notional interest may be taken into account for the application of articles 7 66 [vol. 10: 1 the new oecd approach on profit allocation and 23 oecd, but should not be regarded as income from immovable property, unless states adopted in their tax treaties provisions according to which such charges be recognized for the purpose of article 6 oecd, thus putting the permanent establishment at a par with the subsidiary. paragraph 28 points out that the issue of whether expenses are deductible is a matter of the domestic law of the contracting states. paragraph 30 explains a time lag might be inevitable. paragraph 33 clarifies that in respect of building sites or construction or installation projects "it is necessary to pay close attention to the general principle that income is attributable to a permanent establishment only when it results from activities carried on by the enterprise through that permanent establishment. paragraph 53 of the 2008 proposal introduced the corresponding adjustment mechanism for pe-situations as a provision that states might include in their bilateral treaties. in the 2009 revised draft, such provision is included in the revised article 7 (3). contrary to previous versions of the commentary to article 7 oecd neither the 2008 nor the 2009 version of the proposed commentary to a new article 7 oecd provide an overview of the most important consequences of applying the functionally separate enterprise approach, but simply refer to the 2008 report that "provides a detailed guide as to how the profits attributable to a permanent establishment should be determined" (paragraph 17 of the commentary). it is submitted such an overview would make the (proposed) commentary more user friendly and transparent, as without such overview the user has to search in extensive 2008 report. 12 as the overview provided below shows, in this report the most important remarks on attribution of the different assets, risks and functions are widespread. according to the 2008 report: -assets will be attributed to the part of the enterprise which performs the significant people functions relevant to the determination of economic ownership: ofor financial assets the creation and management of such assets and their attendant risks is the significant people function relevant to determining the initial economic ownership of the assets (paragraph 23 of the 2008 report); ofor tangible assets use is decisive (paragraph 104 of the 2008 report) ofor intangible assets the extent to which the intended user performed the significant people functions relevant to the determination of economic ownership of the intangible asset, i.e. by taking the initial decision to develop the intangible or 12. the general part i contains 73 pages. 2009] 67 florida tax review undertaking the active management of the r&d programme is decisive. this is further specified as follows: *in respect of internally developed trade intangibles the part of the enterprise that undertakes the active decision-making with regard to the taking on and active management of the risks related to the creation of the new intangible performs the significant people function is decisive (paragraph 122 of the 2008 report) *in respect of acquired intangibles should be traced where within the enterprise the significant people functions related to active decision-making relating to the taking on and management of risks are undertaken (paragraph 125 of the 2008 report); *in respect of marketing intangibles the functions associated with the initial assumption and subsequent management of risks of these assets should be traced (paragraph 128 of the 2008 report); -the significant people functions relevant to the assumption of risks (including inventory risk, credit risk, currency risk, interest rate risk, market risks, product liability and warranty risks, regulatory risk, etc.) are those which require active decision-making with regard to the acceptance and/or management of those risks (paragraphs 27, 97 and 98 of the 2008 report). the division of risks and responsibilities within the enterprise will have to be deduced from the parties' conduct and the economic principles that govern relationships between independent enterprises (paragraph 1.28 of the transfer pricing guidelines): ofor excess inventory risk initial assumption by the part of the enterprise which makes the active decisions related to inventory levels determines the allocation; ocredit risk initially is allocated to the part of the enterprise which initially decides to conclude a sale to a particular customer after having reviewed the creditworthiness of the customer. -capital follows risk. capital must be allocated to the part of the enterprise that performs the significant people functions relevant to the assumption of risks would be attributed the capital necessary to support these risks. it should be determined on the basis of the capital allocation approach, the economic capital allocation approach or the thin capitalization approach or though not an aoa approach on the basis of a safe harbour approach such as quasi thin capitalization/regulatory minimum capital approach (paragraphs 28, [vol10: 168 the new oecd approach on profit allocation 122 and 155 172 of the 2008 report); -the permanent establishment should have sufficient capital to support the functions it undertakes (paragraph 31 of the 2008 report); -the transfer pricing guidelines' comparability factors will be applied: odirectly (characteristics of property or services, economic circumstances and business strategies) or oby analogy (functional analysis, contractual terms) (paragraph 47 of the 2008 report); -accounting records and contemporaneous documentation showing a dealing that transfers economically significant risks, responsibilities and benefits would be a useful starting point for the purposes of attributing profits (paragraph 39 of the report). the following transactions will be remunerated at arm's length in case the treaty parties apply the approach laid down in the proposed article 7 oecd and the commentary to this article: any dealings through which one part of the enterprise performs functions for the rest of the enterprise including assistance in day-today management (paragraph 36 of the commentary to the proposed article 7 oecd); internal delivery of goods by the permanent establishment to other parts of the company (paragraph 220 of the 2008 report); internal delivery of services (paragraphs 222 and 251 256 of the 2008 report). first it should be determined whether or not both parties would have contracted for the provision of the service. next an arm's length price should be determined. similar techniques can be used as for associated enterprises. costs may be charged in case a cost-benefit analysis does not justify the costs and administrative burdens of determining an appropriate arm's length price. however an arm's length price should be determined in case the provision of the service is a principal activity of the associated enterprise, the profit element is relatively significant or direct charging is possible; internal transfer of tangible assets: at fair market value or if that is arm's length because the dealing reflects a cost contribution arrangement at cost (paragraphs 229 234 of the 2008 report); internal transfer of intangible assets (paragraph 221 of the 2008 report). again fair market value or a dealing reflecting a cost contribution arrangement should be taken into account. the notional royalty is only relevant for attributing profits, not for other articles in the treaty (paragraph 238 of the 2008 report); payments of interest made: 0 by different parts of a financial enterprise or 2009] 69 florida tax review o by another enterprise for the purpose of rewarding a treasury function being the function of determining economic ownership of the cash or financial asset (paragraphs 187 and 188 of the 2008 report). a mere deduction of costs takes place in respect of: internal services in case a cost-benefit analysis does not justify the costs of determining arm's length prices (paragraphs 251 256 of the 2008 report); internal services comparable to services provided b a parent or centralized service provider of a mne group (paragraph 255 of the 2008 report); internal transfer of tangible or intangible assets in case cost reflects an arm's length amount (paragraphs 232 and 246 of the 2008 commentary); general administrative expenses, such as for a common system of training (paragraph 32 of the 2008 commentary); external interest paid by the company to finance activities of the permanent establishment in the absence of treasury dealings. it proved not possible to develop a single approach for determining the amount of attributable interest expense. therefore the oecd allows: o the tracing approach: internal movements of funds provided to a permanent establishment are traced back to the original provision of funds by third parties; o the fungibility approach: each permanent establishment is allocated a portion of the whole enterprise's actual interest expense paid to third parties on a pre-determined basis; o the big ticket approach: tracing for big tickets and fungibility for the rest of the assets (paragraphs 189 191 of the 2008 report). iv. does the new oecd approach result in deeming the permanent establishment as subsidiary? summarizing, the new approach remunerates more "dealings" at arm's length then the present approach. the new oecd approach allows an arm's length remuneration for the following transactions for which the present approach only allows deduction of costs: internal delivery of services not comparable to services provided in the trade of the enterprise or part of it nor being part of the main activity of the permanent establishment; internal transfer of intangible assets; 70 [vol10: 1 the new oecd approach on profit allocation payments of interest made by a part of a non-financial enterprise fulfilling the treasury function to another part of the enterprise; assistance in day-to-day management (not including head office services similar to those provided by a parent or centralized service provider of a mne group). thus for each of the dealings that may take place between a permanent establishment and a subsidiary a similar analysis is made as for transactions between subsidiaries and the other members of the group of which it is part, no matter what is their nature, and whether or not similar dealings take place with third parties. for the allocation of capital and allocation of funding costs it is not possible to make a similar analysis. therefore, a practical solution had to be found for the lack of a contract, thus that economic substance is reflected and abuse prevented. in order to provide more certainty on this issue a new article 7(3) oecd was proposed in the 2008 draft. in the comments received by oecd practice expressed their concerns about this provision. during the ifa-congress in vancouver, september 2009 the panel for seminar f, something old, something new: redrafting article 7 suggested to replace this proposal by a much wider provision providing for corresponding adjustment so that all cases of double taxation will be solved. this proposal was accepted. though the functional analysis to be made is the same for permanent establishment as for a subsidiary and the mechanism chosen for solving cases of double taxation is also similar the oecd stresses in the 2008 report that a permanent establishment is not the same as a subsidiary as it is not in fact legally or economically separate from the rest of the enterprise. besides the difference mentioned above in respect of determining the amount of capital the oecd mentions the following differences: unlike in the case of parent-subsidiary relations, in pricing dealings between a permanent establishment and the rest of the enterprise the same creditworthiness should be taken into account for the permanent establishment as for the rest of the enterprise (paragraphs 36 and 132 of the 2008 report); there is no scope for a guarantee fee (paragraphs 36, 134 and 135 of the 2008 report); greater scrutiny of documentation is necessary (paragraphs 37 of the 2008 oecd report). remarkably considering the importance of this explanation for providing transparency on this issue neither the 2008 nor the 2009 version of the discussion draft of a new article 7 of the oecd model tax convention contain these remarks. 2009] 71 florida tax review v. justification grounds for not deeming a permanent establishment as subsidiary in paragraphs 36, 132, 134 and 135 of the 2008 report the following justification grounds for not deeming a permanent establishment as subsidiary are mentioned: the permanent establishment shares the creditworthiness of the worldwide enterprise (paragraphs 36 and 132 of the 2008 report); as the permanent establishment is part of the worldwide enterprise the rest of the enterprise cannot enter into a legally binding agreement to guarantee the creditworthiness of the permanent establishment nor can the permanent establishment enter into an agreement to guarantee the creditworthiness of the rest of the enterprise (paragraphs 36, 134 and 135 of the 2008 report); dealings between a permanent establishment and the rest of the enterprise have no legal consequences for the worldwide enterprise and therefore to prevent abuse a threshold needs to be passed before a dealing is taken into account on the same basis as a transaction between third parties (paragraph 36 of the 2008 report). these arguments were also raised in the 2004 and the 2006 draft. in previous drafts more arguments were raised, which have not been included in the 2008 report, to wit: the legal form chosen, permanent establishment or subsidiary, may have some economic effects that should be reflected in the determination of taxable profits. thus, it might be expected that business done through pes is actually more profitable because of the possibilities of efficient capital utilization, risk diversification, economies of scale etc. (paragraph 55 of the 2004 draft report); capital and risks are not segregated from each other within a single legal enterprise and therefore there is no basis for guarantee fees (paragraph 96 of the 2004 draft report); if the same functions were carried on through a subsidiary in the host country, the subsidiary may be required by thin capitalization rules to have some equity or "free capital." therefore the permanent establishment needs a certain amount of free capital (paragraph 149 of the 2006 draft report). it is submitted other arguments can be raised why the permanent establishment should not be deemed as subsidiary for profit allocation purposes such as the following arguments that i raised in my dissertation: 72 [vol10:1 the new oecd approach on profit allocation minimum endowment capital requirements or solvency requirements are not posed separately for permanent establishments; a permanent establishment does not have its own shareholders and should not be deemed to organize its own meeting of shareholders. these arguments were the reason why in my dissertation i gave preference to what i called the broad functional approach to the separate enterprise theory and what the oecd calls the functionally separate enterprise theory.13 all arguments mentioned above can be summarized into one broad argument: legal requirements posed to subsidiaries that have nothing to do with people functions should not be deemed to apply to permanent establishments. due to these differences in legal requirements the determination of the tax base for permanent establishments differs from that of subsidiaries. the most important other legal difference, to wit the fact that a contract is not available for internal delivery of goods, services and assets, should not result in a different determination of the tax base as this difference concerns the performance of people functions. the people functions performed, associated risks and capital required to perform these people functions are the same whether performed by a permanent establishment or by a subsidiary. like the oecd advocates functions should be analyzed and internal dealings should be remunerated at arm's length. moreover a certain amount of capital should be allocated to the permanent establishment, not because legal reality requires so but because economic reality is that functions cannot be performed and risks cannot be taken without capital. thus the answer to the research question of whether or not the choice between permanent establishment and subsidiary may be influenced by differences in taxation of profits is affirmative. differences in legal requirements caused by differences in legal form may result in a different economic reality that is not the result of people functions and therefore should not be neutralized. the functionally separate enterprise theory only requires similar treatment of permanent establishments and subsidiaries in respect of people functions and the risks inherent to significant people functions, as well as the allocation of assets used for fulfilling the functions. it does not require to deem legal requirements that apply to subsidiaries and 13. i.jj. burgers, taxation and supervision of internationally operating banks, a comparative study of banks and other enterprises, ibfd, amsterdam, 1991, chapter 22. 2009] 73 florida tax review not to permanent establishments and that have nothing to do with people functions to apply to permanent establishments. this argument, however, is not the only argument why -it is submitted that the research question should be answered in the affirmative. there is another argument, which was raised in the 2004 draft report, but for reasons not clear to me, was not included in later (draft) reports. paragraph 55 of the 2004 draft report reads: "it might be expected that business done through pes is actually more profitable because of the possibilities of efficient capital utilization, risk diversification, economies of scale, etc." perhaps the oecd decided not to include this argument in later versions because of lack of proof. the fact is that if this argument is true it will result in differences in tax base in case similar activities are performed by a permanent establishment or by a subsidiary. vi. conclusion as the analysis above shows the answer to the research question is that it may make a difference for tax payers to perform their activities through a permanent establishment instead of through a subsidiary. in case the functionally separate entity theory as advocated by oecd will be applied permanent establishments and subsidiaries will be treated neutral as far as the functional analysis and comparability analysis is concerned. people functions are remunerated in a similar way. the oecd however does not deem the permanent establishment as subsidiary for two reasons: legal requirements for permanent establishments differ from those for subsidiaries, a difference that is not directly related to people functions performed by permanent establishments or subsidiaries and the assets and capital needed to perform these functions and therefore should not be neutralized in applying the functionally separate enterprise theory; a permanent establishment may be more profitable because of possibilities of efficient capital utilization, risk diversification, economies of scale, etc. and therefore the comparability analysis may result in differences in prices to be taken into account for similar functions performed by permanent establishments and subsidiaries. the oecd summarizes the reasons why they did not choose for deeming the permanent establishment as subsidiary in paragraph 84 of the 2008 report as follows: 74 [vol.10:1 the new oecd approach on profit allocation "it should be noted that the aim of the aoa approach is not to achieve equality of outcome between a pe and a subsidiary in terms of profits but rather to apply to dealings among separate parts of a single enterprise the same transfer pricing principles that apply to transactions between associated enterprises. there are generally economic differences between using a subsidiary and pes. application of the authorized oecd approach will not achieve equality of outcome between subsidiaries and pes where there are economic differences between them. the legal form chosen, pe or subsidiary, may have some economic effects that should be reflected in the determination of taxable profits" (bold added by this author). it is submitted this explanation is not precise enough. the sentences made bold above ("there are generally economic differences ... taxable profits") should in my view be rephrased along the lines formulated above: "it should be noted that the aim of the aoa approach is not to achieve equality of outcome between a pe and a subsidiary in terms of profits but rather to apply to dealings among separate parts of a single enterprise the same transfer pricing principles that apply to transactions between associated enterprises. legal requirements for permanent establishments differ from those for subsidiaries, a difference that is not directly related to people functions performed by permanent establishments or subsidiaries and the assets and capital needed to perform these functions and therefore should not be neutralized in applying the functionally separate enterprise theory. moreover, a permanent establishment may be more profitable because of possibilities of efficient capital utilization, risk diversification, economies of scale, etc. and therefore the comparability analysis may result in differences in prices to be taken into account for similar functions performed by permanent establishments and subsidiaries." it is recommended that this clarification to the difference in treatment of a pe and a subsidiary will be included in the final version of the commentary to the new article 7 of the oecd model tax convention. moreover it is recommended that in order to improve the transparency of the consequences of the functionally separate entity approach 2009] 75 76 florida tax review [vol.10:1 the commentary to the new article 7 oecd would not only include a reference to the 2008 report for a detailed guide as to how the profits attributable to a permanent establishment should be determined under the provisions of (the proposed) article 7 (2) oecd (see paragraph 17 of the 2009 draft), but would also provide for an overview of the most important consequences of applying the functionally separate enterprise such as the overview provided in paragraph 4 above. florida tax review florida tax review volume 14 2013 number 2 45 structural impediments to tax reform: the environment as case study by leo p. martinez* “things shouldn’t be so hard.”1 abstract while the goal of any system of taxation is to be fair, however elusive the concept of fairness, there are two kinds of obstacles that impede or affect our ability to be fair. i categorize these two kinds of obstacles as those that resound in politics and those that are structural. this article deals with the structural aspects of how we go about taxing ourselves. the politics of taxation i leave for another day. because the united states internal revenue code (the code) is vast and complicated, i examine the structural problems of taxation in the single context of the code — the environment — as the vehicle to evaluate the prospects for reform. this focus on a single area is undertaken with two underlying observations. first, the code is necessarily complex. a focus on a *.albert abramson professor of law, university of california, hastings college of the law. special thanks to professor roberta mann whose guidance and expertise influenced the shape of this piece. i am grateful to professor lawrence zelenak and to my colleague professor darien shanske for their constructive criticisms of early drafts. thanks are also due for the insights provided by the participants in the april 2011 critical tax conference hosted at the santa clara university school of law by professors pat cain and david hasen. i am finally grateful to andrey gabets and katelyn keegan whose diligent and able research made this paper a better product. early versions of this paper were presented at the 12th global conference on environmental taxation in october 2011 in madrid and at the university of southern california 2012 conference of the international society for new institutional economics in june 2012 in los angeles. i am not a close student of environmental law. at the same time, even a cursory review of the subject reveals that the title of this paper could be reversed without changing the substance. that is, it could be entitled the structural impediments to environmental policy: tax reform as case study. 1. kay ryan, things shouldn’t be so hard, the new yorker, june 4, 2001, at 48 [hereinafter ryan, things shouldn’t be so hard]. 46 florida tax review [vol. 14:2 single area is manageable and serves as a useful case study. second, the problems we all face from a degraded environment allow for the possibility that attention will be paid. the paper will move from the general to the specific, first highlighting the strengths and the weaknesses of the code, and second, highlighting structural problems that affect tax policy. the aim will be to guide legislators and policymakers toward a sane tax policy. i. introduction ............................................................................... 46 ii. background ................................................................................. 49 a. taxation and the environment — an overview ........................ 49 b. taxation and taxpayer behavior .............................................. 49 iii. the tax legislative process .................................................. 51 a. the sanitized version of the legislative process ...................... 51 b. alternative processes for the creation of tax law: treasury regulations ................................................................. 53 c. a misplaced focus .................................................................... 54 d. tax legislation and the environment ........................................ 55 iv. making sense of it all ............................................................. 57 a. lobbying influence .................................................................... 57 b. parochial interests .................................................................... 59 c. inertia ........................................................................................ 63 d. unintended consequences......................................................... 68 e. external considerations ............................................................ 70 v. conclusion ................................................................................... 72 i. introduction our constitutional democracy can be defined by the way in which we tax ourselves in order to fund the essential functions of government. in kenneth r. feinberg’s recent book, he recounts his experiences in connection with determining suitable compensation to victims and their survivors of this country’s most spectacular events, ranging from the terrorist attacks of september 11, 2001, to the british petroleum oil spill disaster to the vietnam veterans who were exposed to agent orange.2 he muses about the knotty problems of distributing compensation to those who are similarly situated, at least in the sense that they have endured the same experience, but who, for various and justified reasons, are nonetheless compensated 2. kenneth r. feinberg, who gets what: fair compensation after tragedy and financial upheaval (2012). 2013] structural impediments to tax reform 47 differently.3 in the very same way, the way we tax ourselves presents exactly the same sort of knotty problems. while the goal of any system of taxation is fairness, however elusive the concept,4 there are two kinds of obstacles that impede or affect fairness in taxation. i categorize these two kinds of obstacles as those that resound in politics and those that are structural.5 this article deals with the structural aspects of how we go about taxing ourselves. the politics of taxation — a not-so-trivial aspect of how we go about taxing ourselves and the grim prospects for meaningful tax reform — i leave for another day. however it is worth briefly mentioning the underlying political issues. since 1986, americans for tax reform, a conservative tax lobby, has sponsored the “taxpayer protection pledge,” in which lawmakers and candidates promise to oppose any and all tax increases.6 in the 112th congress, serving from 2011-2012, all but 6 of the 242 republican members of the u.s. house of representatives, as well as all but 7 of the 47 republican members of the u.s. senate have signed the pledge.7 the pledge, and the lobby’s president grover norquist, are often blamed for the stalemate in congressional efforts to reduce the deficit. then senator john kerry, a member of the congressional super committee charged with deficit reduction, stated: “[the] most significant block to our doing something right now, tomorrow, is [republicans’] insistence, insistence, insistence on the grover norquist pledge and extending the bush tax cuts.”8 some republicans similarly acknowledge the pressure added by norquist’s pledge and its contribution to the challenges in tax reform. representative frank 3. id. at xix–xx. 4. see leo p. martinez, the trouble with taxes: fairness, tax policy, and the constitution, 31 hastings const. l.q. 413 (2004). 5. in making this distinction, it is not my intent to suggest that the two categories are mutually exclusive, and i recognize that there is likely a significant overlap between the two. 6. about americans for tax reform, americans for tax reform, http://atr.org/about (last visited feb. 10, 2013). the text of the pledge for the house of representatives reads: “one, oppose any and all efforts to increase the marginal income tax rates for individuals and/or businesses; and two, oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates.” see taxpayer protection pledge, americans for tax reform, http://www. atr.org/userfiles/congressional_pledge(1).pdf (last visited february 10, 2013). 7. current list of taxpayer protection pledge signers for the 112th congress, americans for tax reform, http://atr.org/current-list-taxpayerprotection-pledge-signers-a5597 (last visited feb. 10, 2013) (listing 238 representatives and 41 senators as signatories of the pledge). 8. senator john kerry, meet the press, (nbc television broadcast nov. 20, 2011) (transcript http://www.msnbc.msn.com/id/45355107/ns/meet_the_presstranscripts/t/meet-press-transcript-november/#.ueytkqrss_y). 48 florida tax review [vol. 14:2 wolf, a republican from virginia, noted in a speech before the house: “i believe how the pledge is interpreted and enforced by mr. norquist is a roadblock to realistically reforming our tax code.”9 professor edward mccaffery makes the perceptive and perhaps perverse observation that despite this deadlock exemplified in tax reform, such inaction is actually in congressional members’ interests.10 he uses tax reform to illustrate this point: “congress has shown an appetite for keeping the issue of estate tax repeal alive through a never-ending series of brinksmanship votes; it never does anything fundamental or, for that matter, principled, but rakes in cash year in and year out for just considering the matter.”11 professor mccaffery explains that in our capitalist democracy, wealthy minorities rule over big groups with smaller stakes, that is, the majority of american taxpayers.12 congress maintains this power through what professor mccaffery calls the “shakedown” game, which consists of: (1) an issue of high stakes to small groups . . . ; (2) two or more sides, to prevent congress from coalescing (lord forbid) on one side and actually doing something permanent; (3) plausible action, for rational actors will not pay for extreme improbabilities; and (4) action that would be longlived or at least valuable enough to be worth paying for.13 accordingly, it is the american public that ultimately loses because “they cannot even get a seat at the table.”14 moreover, the prospects for any substantial change in tax policy remain bleak.15 politics, exemplified by both norquist’s pledge and the “shakedown” game theory, undoubtedly affect (and largely inhibit) governmental action to reform tax policy. however, this article deliberately focuses on other aspects of tax policy to assess the outlook. sad to say, the conclusion may very well be the same — the prospects for tax reform that improve the current situation are dim. 9. congressman frank r. wolf, grover norquist’s relationships should give people pause, (c-span television broadcast, floor speech, house of representatives, oct. 4, 2011) (http://wolf.house.gov/index.cfm?sectionid=34& itemid=1805). 10. edward j. mccaffery, the dirty little secret of (estate) tax reform, 65 stan. l. rev. online 21, 21 (2012). 11. id. 12. id. at 22. 13. id. at 22–23. 14. id. at 22. 15. mccaffery, supra note 10, at 26. 2013] structural impediments to tax reform 49 ii. background a. taxation and the environment — an overview the united states internal revenue code (the “code”) is vast, complicated, and often internally inconsistent. this inconsistency plagues tax policy and does little to further legitimate government objectives or inspire confidence in the code. the code is also an instrument, at times crude and blunt, by which public policy is implemented. the effect of the code’s inconsistency is thus doubly lamentable. nowhere is the code’s inconsistency and crudity more apparent than in its application to the environment. many code provisions are explicitly environmentally flavored, but many other code provisions are at odds with a sound environmental policy. this results in a code that incentivizes the use of hybrid and electronic plug-in vehicles and encourages commuters to use public transportation and bicycles, while simultaneously promoting the use of motor vehicles with internal combustion engines, rewarding oil exploration and depletion of natural resources, and indirectly promoting urban sprawl. the reality is that the code is a complex stew of sound and unsound public policy, special interests, and situational pressures. this paper uses the environment as a case study to explore the reasons for the code’s schizophrenia and seeks to highlight the areas that impede legislators and policymakers in achieving a cohesive policy. my modest hope is to affect change in an arena where it might do some good. b. taxation and taxpayer behavior through the power to tax, governments are able to collect revenue for necessary government functions.16 taxation’s core function is to raise revenue, but it is also used as a tool to influence taxpayer behavior.17 governments are able to affect behavior through the tax system by subsidizing activities they wish to promote and penalizing activities they wish to discourage. 16. reuven s. avi-yonah, the three goals of taxation, 60 tax l. rev. 1, 3 (2007) [hereinafter avi-yonah, three goals]. (“what are taxes for? the obvious answer is that taxes are needed to raise revenue for necessary governmental functions, such as the provision of public goods.”) 17. see samuel a. donaldson, the easy case against tax simplification, 22 va. tax rev. 645, 654–57 (203) (explaining the ways in which tax laws shape behavior); david a. weisbach & jacob nussim, the integration of tax and spending programs, 113 yale l.j. 955, 972–82, 1027 (2004) [hereinafter weisbach & nussim, the integration of tax and spending programs] (arguing that program implementation ought to be done by the agency with the necessary expertise and not through the tax system). 50 florida tax review [vol. 14:2 this “carrot and stick” approach permeates the code. for example, in order to discourage activities, the government imposes targeted taxes, like those imposed on the purchase (and presumably consumption and use) of alcohol18 and tobacco.19 conversely, in order to promote social goals, the government provides tax incentives that favor certain industries, activities, or persons.20 tax incentives reward taxpayers by reducing their tax liability. these types of provisions, commonly referred to as “tax expenditures,” can take many forms, including exclusions, deductions, credits, preferential tax rates, exemptions, and deferrals of tax.21 whatever their form, they are a type of government spending because the government takes in less revenue to the benefit of the taxpayer who owes less in taxes.22 in a sense, tax expenditures diverge from the primary revenue collection goal of the code and instead act as spending provisions designed to achieve various social and economic objectives.23 18. i.r.c. § 5051 (imposing an excise tax on “all beer brewed or produced, and removed for consumption or sale, within the united states, or imported into the united states”). 19. i.r.c. § 5701 (imposing an excise tax on cigars, cigarettes, and other tobacco products). 20. ariz. christian sch. tuition org. v. winn, 131 s. ct. 1436, 1452 n.1 (2011) (kagan, j., dissenting) (defining tax expenditures); yair listokin, equity, efficiency, and stability: the importance of macroeconomics for evaluating income tax policy, 29 yale j. on reg. 45, 60 (2012) [hereinafter listokin, equity, efficiency, and stability] (“tax expenditures represent reductions for the revenue that would be collected from a comprehensive income tax”); stanley s. surrey, the tax expenditure concept and the budget reform act of 1974, 17 b.c. indus. & com. l. rev. 679, 680 (1976) [hereinafter surrey, the tax expenditure concept] (“these special preferences, often called tax incentives or tax subsidies, are departures from the normal tax structure and are designed to favor a particular industry, activity, or class of persons.”). 21. surrey, the tax expenditure concept, supra note 20, at 680 (“they [capital expenditures] partake of many forms, such as permanent exclusions from income, deductions, deferrals of tax liabilities, credits against tax, or special rates.”). 22. see generally gregory mankiw, the blur between spending and taxes, n.y. times, nov. 21, 2010, at b5. 23. stanley s. surrey, tax incentives as a device for implementing government policy: a comparison with direct government expenditures, 83 harv. l. rev. 705, 706 (1970) (“the term ‘tax expenditure’ has been used to describe those special provisions of the federal income tax system which represent government expenditures made through that system to achieve various social and economic objectives.”); surrey, the tax expenditure concept, supra note 20, at 680 (“whatever their form, these departures from the ‘normative’ income tax structure essentially represent government spending for the favored activities or groups made through the tax system.”); see weisbach & nussim, the integration of tax and spending programs, supra note 17, at 972–82. 2013] structural impediments to tax reform 51 iii. the tax legislative process an overview of the process by which tax legislation is enacted is instructive in order to better understand the relationship between tax provisions and their effect on behavior. i begin with a high-minded overview of the process by which tax legislation is enacted. i then continue the discussion with a précis of the related regulatory process. a. the sanitized version of the legislative process the constitution provides that “congress shall have power to lay and collect taxes, duties, imposts and excises.”24 to further that goal, the constitution directs that tax legislation must begin in the house of representatives.25 the committee on ways and means has jurisdiction over tax legislation in the house, while a parallel committee on finance has jurisdiction in the senate.26 after the house ways and means committee proposes a tax law, it goes to the house floor where it is reviewed, debated, possibly rewritten, and eventually approved or disapproved.27 the tax bill then undergoes a similar process in the senate — first referred to the committee on finance and then debated on the senate floor. if the house and senate pass differing versions of the legislation, it is referred to a joint committee consisting of both house and senate members who try to negotiate a uniform version of the tax bill.28 only after the final version is 24. u.s. const. art. i, § 8, cl. 1. 25. u.s. const. art. i, § 7, cl. 1 (“all bills for raising revenue shall originate in the house of representatives; but the senate may propose or concur with amendments as on other bills.”). 26. h.r. comm. on rules, rule x: organization of committees, http://www.rules.house.gov/singlepages.aspx?newsid=131&rsbd=165 (last visited february 10, 2013); s. comm. on rules and admin., rules of the senate, rule xxv: standing committees, http://rules.senate.gov/public/index.cfm?p=rule xxv (last visited february 10, 2013). 27. for an understanding of how our tax legislative process works, see internal revenue service, understanding taxes – activity 2: formal tax legislative process, http://apps.irs.gov/app/understandingtaxes/whys/thm01/les02/ media/is1_thm01_les02.pdf (illustrating the fundamental process for how a tax bill becomes law). see also john v. sullivan, how our laws are made, h.r. doc. no. 110–49 (2007), http://www.gpo.gov/fdsys/pkg/cdoc-110hdoc49/pdf/cdoc110hdoc49.pdf [hereinafter sullivan, how our laws are made); michael j. graetz, reflections on the tax legislative process, 58 va. l. rev. 1389, 1395–97 (1972). 28. stephen w. mazza & tracy a. kaye, restricting the legislative power to tax in the united states, 54 am. j. comp. l. 641, 645 (2006). 52 florida tax review [vol. 14:2 separately approved by both the house and the senate, and the president thereafter signs the bill, does a tax bill finally become law.29 many tax experts participate in the tax legislative process.30 both the house committee on ways and means and the senate committee on finance have an expert staff at hand.31 the joint committee on taxation (“jct”), with their professional staff of attorneys, accountants, and economists, also works to assist members of congress on tax legislation.32 the jct is a nonpartisan congressional committee established under the 1926 revenue act that alternates chairmanship between the house ways and means committee and senate finance committee.33 the jct prepares revenue estimates for all tax legislation considered in congress, analyzes (and sometimes even drafts the statutory language) of tax proposals, investigates relevant issues in the federal tax system, and reports back to each committee the results of their findings.34 additionally, congressional committees can seek input from relevant departments and agencies, including the government accountability office, who can provide a report on the efficiency or desirability of enacting a given tax bill into law.35 despite the input of all the legislators, tax experts, and governmental agencies, “nowhere in the system does a particular official, committee, or other entity have the assignment to evaluate tax legislation from an environmental perspective.”36 while a comprehensive analysis should incorporate environmental implications, it is telling that the word “environment” and related terms are not found in any source materials. moreover, as is made plain below, the unsanitized version of the tax legislative process relegates the lack of environmental input to a minor role in the incoherence of the process. 29. as with all other legislation, if the president vetoes the tax law, congress can override it with a two-thirds vote in both the house and the senate. 30. richard a. westin & sanford e. gaines, the relationship of federal income taxes to toxic wastes: a selective study, 16 b.c. envtl. aff. l. rev. 753, 758 (1989) [hereinafter westin & gaines, a selective study] (“an army of experts interacts with any tax legislation.”). 31. id. 32. the joint committee on taxation, overview, http://www.jct.gov/ about-us/overview.html (last visited feb. 10, 2013). 33. id. 34. the joint committee on taxation, joint committee role in the tax legislative process, http://www.jct.gov/about-us/role-of-jct.html (last visited feb. 10, 2013); the joint committee on taxation, statutory basis for the joint committee on taxation, http://www.jct.gov/about-us/statutory-basis.html (last visited feb. 10, 2013). 35. sullivan, how our laws are made, supra note 27, at 11. 36. westin & gaines, a selective study, supra note 30, at 758. 2013] structural impediments to tax reform 53 b. alternative processes for the creation of tax law: treasury regulations law is sometimes derived from sources beyond congressional enactments. one alternative source of binding legal authority is administrative agency regulation under the executive branch. the department of the treasury creates regulations that guide the tax code’s interpretation, enforcement, and litigation.37 there is recognition, however, that regulation has the potential to be inconsistent. accordingly, beginning with executive order 12,291 issued by president reagan in 1981, executive agencies were required to engage in a cost-benefit analysis for all proposed regulations.38 major regulations had to be submitted with a “regulatory impact analysis” to the office of information and regulatory affairs (“oira”) for review and approval before they were to take effect.39 with reagan’s executive order 12,498, administrative agencies also had to submit an “annual regulatory plan” to oira, seeking approval for all their proposals in the following year.40 these executive orders were enacted to effect improvement on perceived inefficiencies in the expanding regulatory framework.41 while the cost-benefit monitoring function of oira was deemphasized by the clinton administration,42 the obama administration has recently affirmed this general arrangement in executive order 13,563.43 oira oversight operates to coordinate all proposed regulations to avoid redundancy, economic burdens, and inefficiency.44 notwithstanding the salutary purpose of oira, it is not the environmental protection 37. section 7805(a) delegates to the treasury department the task of “prescrib[ing] all needful rules and regulations for the enforcement of . . . law in relation to internal revenue.” i.r.c. § 7805(a). 38. exec. order no. 12,291, 3 c.f.r. 127 (1981). 39. id. 40. exec. order no. 12,498, 3 c.f.r. 323 (1985). 41. see generally richard h. pildes & cass r. sunstein, reinventing the regulatory state, 62 u. chi. l. rev. 1, 3–6 (1995) [hereinafter pildes & sunstein, reinventing the regulatory state] (discussing the developments of administrative law in the 1980s). 42. timur kuran & cass r. sunstein, availability cascades and risk regulation, 51 stan. l. rev. 683, 757 (1999). 43. exec. order no. 13,563, 76 fed. reg. 3821 (jan. 18, 2011); see also memorandum from cass r. sunstein, adm’r office of info. & regulatory affairs, to the heads of exec. dep’t & agencies, & of indep. regulatory agencies (feb. 2, 2011) (“executive order 13563 is designed to affirm and to supplement executive order 12866.”) http://www.va.gov/orpm/docs/eo_oira_guidance_m11-10.pdf (last visited feb. 10, 2013). 44. see pildes & sunstein, reinventing the regulatory state, supra note 41, at 3–6. 54 florida tax review [vol. 14:2 agency.45 rather than focus on environmental concerns, oira has a larger charge of the national interest.46 moreover, executive order 12,866, issued by president clinton in 1993, limited oira’s centralized review of regulation to those that were “significant.”47 while such limitation is undoubtedly necessary to manage the workload,48 it also makes clear that oira review is neither comprehensive nor is it the sole answer to environmental concerns that may be raised by tax regulation. c. a misplaced focus in 1972, christopher stone famously asked, “should trees have standing?” and he suggested that it was time to assign legal rights to nature.49 he argued that by granting trees and other “natural objects” legal standing, lawsuits could be initiated on their behalf whenever a wrong was committed against the environment.50 that same year, justice douglas argued the same point in his dissent in the environmental hallmark case, sierra club v. morton: inanimate objects are sometimes parties in litigation. a ship has a legal personality, a fiction found useful for maritime purposes. the corporation sole — a creature of ecclesiastical law — is an acceptable adversary and large fortunes ride on its cases . . . . so it should be as respects valleys, alpine meadows, rivers, lakes, estuaries, beaches, ridges, groves of trees, swampland, or even air that feels the destructive pressures of modern technology and modern life. the river, for example, is the living symbol of all the life it sustains or nourishes — fish, aquatic insects, water ouzels, otter, fisher, deer, elk, bear, and all other animals, including man, who are dependent on it or who enjoy it for its sight, its sound, or its 45. while the consideration of environmental concerns is one of the goals of the oira oversight process, greater emphasis is placed on more traditional economic factors. roberta s. karmel, the controversy over systemic risk regulation, 35 brook j. int’l l. 823, 840 (2010). 46. sally katzen, a reality check on an empirical study: comments on “inside the administrative state,” 105 mich. l. rev. 1497, 1505 (2007). 47. id. at 1509. 48. wendy e. wagner, administrative law, filter failure, and information capture, 59 duke l.j. 1321, 1325 (2010) (discussing the problem of information capture — “the excessive use of information and related information costs as a means of gaining control over regulatory decisionmaking in informal rulemakings.”). 49. christopher d. stone, should trees have standing? toward legal rights for natural objects, 45 s. cal. l. rev. 450 (1972). 50. id. 2013] structural impediments to tax reform 55 life. the river as plaintiff speaks for the ecological unit of life that is part of it.51 the preceding is based on the tacit assumption that litigation and resort to the courts is the solution to environmental problems. as is shown below, inattention to the legislative process can effectively undermine and render inconsequential the use of impact litigation as a tool to solve environmental concerns. d. tax legislation and the environment with the foregoing, we can analyze environmentally flavored tax legislation — a task simplified by professor roberta mann who has well catalogued these provisions.52 congress has for a long time attempted to influence taxpayers to be more environmentally minded with code provisions that encourage conservation and renewable energy. tax credits are available for the purchase of solar energy systems, fuel cells, geothermal heat pumps, and small wind-energy systems.53 to promote energy efficiency, tax credits are allocated for the installation of energy-efficient doors, roofs, windows, as well as for cooling and heating equipment.54 automobile industry incentives are also provided by way of credits available for the purchase of hybrid, plug-in, and other alternative fuel vehicles.55 commuting is endorsed with benefits available for those who take public transportation or ride bicycles to work.56 tax benefits are available for forest landowners who preserve their private forest land rather than develop it.57 the congressional message seems to be clear — “green” is good. however, the code also rewards behaviors that are at apparent odds with these environmentally flavored provisions. while the tax system provides incentives for renewable energy, fossil fuels remain heavily 51. sierra club v. morton, 405 u.s. 727, 742–43 (1972) (douglas, j., dissenting). 52. see roberta f. mann, back to the future: recommendations and predictions for greener tax policy, 88 or. l. rev. 355 (2009) [hereinafter mann, back to the future]. 53. i.r.c. § 25d. 54. i.r.c. § 25c. 55. see i.r.c. §§ 30, 30b, 30c, 30d. 56. mann, back to the future, supra note 52, at 366–79 (discussing the federal tax system’s stance on transportation and the resulting environmental effect). 57. see francine j. lipman, no more parking lots: how the tax code keeps trees out of a tree museum and paradise unpaved, 27 harv. envtl. l. rev. 471, 476–507 (2003) (describing the tax benefits available to forest landowners). 56 florida tax review [vol. 14:2 subsidized. one study revealed that from 2002 to 2008, the federal government provided $72 billion in subsidies to fossil fuels and only $29 billion for renewable energy.58 more recently, largely because of the enactment of the energy policy act of 2005, it has been found that the available subsidies for fossil fuels have decreased to less than 50 percent, and the available subsidies for renewable energy and conservation have increased to more than 50 percent.59 while that might suggest a victory for the environment, renewable energy still represents a tiny share of the country’s energy consumption. in 2009, renewable energy provided only 7.7 percent of our country’s energy supply.60 by contrast, petroleum (35.3 percent), natural gas (23.4 percent), and coal (19.7 percent) dominated the energy sector.61 if the goal is to reverse the trend in favor of non-renewable energy using the tax system, then providing balanced incentives to both fossil fuels and renewable energy is not the prudent solution.62 the code’s subsidy to fossil fuels is extensive.63 there is a tax credit available under code section 45k for producing unconventional fuels like oil from shale, gas from depressurized brine, and coal-based fuels.64 code section 263(c) allows intangible drilling costs to be deducted as business expenses rather than be subject to amortization.65 under section 613, independent producers and royalty owners can deduct percentage-depletion equal to 15 percent of gross income from the property with respect to oil and 58. estimating u.s. gov’t subsidies to energy sources: 2002-2008, envtl. law inst., at 3 (2009), http://www.elistore.org/data/products/d19_07.pdf (last visited feb. 10, 2013). 59. gilbert e. metcalf, energy policy & the environment report no. 13, taxing energy in the united states: which fuels does the tax code favor?, manhattan inst. for policy research, at 13 (2009), http://www.manhattaninstitute.org/html/eper_04.htm (last visited feb. 10, 2013). 60. annual energy review 2008, u.s. energy info. admin., u.s. dep’t of energy, at 37 (2009), http://www.eia.doe.gov/emeu/aer/pdf/aer.pdf (last visited february 10, 2013). 61. id. 62. mann, back to the future, supra note 52, at 376 (“repealing these subsidies would raise about $26 billion over the next decade, as well as help stimulate use of renewable energy sources.”). however, professor john bogdanski questions “whether an increase in income taxes on production would have the salutary effect of increasing investor interest in greener energy or decreasing consumer demand for petroleum-related products.” john a. bogdanski, reflections on the environmental impacts of federal tax subsidies for oil, gas, and timber production, 15 lewis & clark l. rev. 323, 332 (2011) [hereinafter bogdanski, reflections]. 63. see bogdanski, reflections, supra note 62, at 325–28 (describing the major subsidies given to the gas and oil industry). 64. i.r.c. § 45k. 65. i.r.c. § 263(c); regs. § 1.612-4; see also i.r.c. § 263a(c)(3). 2013] structural impediments to tax reform 57 gas deposits.66 (section 613a denies percentage-depletion to large producers, including all major oil companies).67 under code section 631(c), royalty payments from coal sales are characterized as capital gains rather than ordinary income.68 these examples illustrate that the code may not necessarily be purely green. iv. making sense of it all legislation should be reasoned and consistent with governmental goals. while the preceding version of the legislative process describes a rational and dispassionate approach, the reality is often incoherent and full of contradiction. we find ourselves with a structural tendency toward incoherence within the tax system. at least five factors drive this tendency. these include (1) the influence of lobbying; (2) the effect of parochial interests; (3) simple inertia; (4) external considerations; and (5) the universal problem of unintended consequences. (each is discussed in turn below). the inescapable conclusion is that the legislative process is more sordid, lowerminded, and intensely political than the sanitized version of the process would lead us to believe. a. lobbying influence first, perhaps being an obvious point, lobbying influences legislation. corporations and individuals spend billions of dollars every year to get their voices heard. joseph pechman, the late dean of american tax policy once stated: “tax law is always a compromise among the view of powerful individuals and groups.”69 although the environmental lobby and the alternative energy lobby have been picking up steam the last decade, the energy lobby overshadows them. pechman’s unstated assumption is that compromise involves parties of near equal power. where one party is vastly more powerful than the other, compromise means little. legislation is skewed in favor of the powerful even if it detracts from an efficient or green government. as an industry, the energy sector is uncommonly effective at influencing government policy through lobbying.70 coincidentally, the top 66. i.r.c. §§ 613, 613(a)(c). 67. i.r.c. § 613a. 68. i.r.c. § 631(c). 69. joseph a. pechman, federal tax policy 38 (5th ed. 1987). 70. fossil fuels and electric utilities are some of the biggest spenders across all industries. in 2010, for example, the top ten 10 lobbying spenders included pg&e corp., general electric, and conocophillips. top spenders: lobbying, 2010, 58 florida tax review [vol. 14:2 contributors in the energy sector are often the biggest polluters.71 in 2010, the electric utilities industry spent $191 million on lobbying; pacific gas & electric (pg&e) led the way ($45 million).72 the gas and oil industry spent $145 million: conocophillips ($19 million), chevron ($12 million), and exxonmobil ($12 million).73 these corporations are just a few of the many energy companies with the capacity to contribute millions of dollars every year to the energy lobby. despite the pro-environmental rhetoric in politics, the energy lobby severely outmatches environmental groups.74 environmental groups as a whole spent only $20 million,75 and alternative energy groups spent only $31 million.76 when all the dust settles, earmarks, campaign contributions, and lobbying all work to influence government decision-making. in the context of environmental policy, the salient inquiry becomes whether the natural ctr. for responsive politics, http://www.opensecrets.org/lobby/top.php?show year=2010&indextype=s (last visited feb. 10, 2013). 71. according to the political economy research institute, the top twenty corporate polluters in the united states include prominent corporations from the energy sector, such as conocophillips, general electric, koch industries, duke energy, valero energy, and exxonmobil. press release, toxic 100 names top corporate air polluters, political econ. research inst. (mar. 31, 2010), http://www.peri.umass.edu/toxic_index/ (last visited feb. 10, 2013). 72. electric utilities: lobbying spending database, open secrets, 2010, ctr. for responsive politics, http://www.opensecrets.org/lobby/ indusclient.php?id=e08&year=2010 (last visited feb. 10, 2013). 73. oil & gas: lobbying, 2010, open secrets, ctr. for responsive politics, http://www.opensecrets.org/industries/lobbying.php?cycle=2010&ind=e01 (last visited feb. 10, 2013). 74. similarly, records from the 2008 election cycle demonstrate that $78 million worth of campaign contributions came from the energy and natural resources sector. totals by sector over time, open secrets, election cycle 2008, ctr. for responsive politics, http://www.opensecrets.org/bigpicture/sectors.php?cycle= 2008 (last visited feb. 10, 2013). specifically, the oil and gas industry donated $36 million. top industries, open secrets, election cycle 2008, ctr. for responsive politics, http://www. opensecrets.org/bigpicture/industries.php?cycle=2008 (last visited feb. 10, 2013). 75. environment: lobbying, 2010, open secrets, ctr. for responsive politics, http://www.opensecrets.org/industries/lobbying.php?cycle=2010&ind= (last visited feb. 10, 2013). 76. alternative energy production & services: lobbying, 2010, open secrets, ctr. for responsive politics, http://www.opensecrets.org/industries/ lobbying.php?cycle=2010&ind=e1500 (last visited feb. 10, 2013). http://www.opensecrets.org/industries/ 2013] structural impediments to tax reform 59 treasures described by justice douglas realistically have effective lobbyists working on their behalf.77 b. parochial interests the parochial interests of individual members of congress matter. the infamous “bridge to nowhere” and the sunrail commuter train both highlight the influence that individual legislators can exert over legislation. the gravina island “bridge to nowhere” is a prime example of how easily legislation goes awry. the proposed $398 million-dollar bridge was supposed to connect the alaskan town of ketchikan (population 8,900) to gravina island (population 50).78 even though a fifteen-minute ferry route existed between the ports, the project contemplated the construction of a structure “[eighty] feet higher than the brooklyn bridge and just [twenty] feet short of the golden gate bridge.”79 the local reasons behind the project were to advance the infrastructure and improve transportation to the airport. the obvious question was whether solving these problems by building a monumental bridge between two remote areas made any common sense. the support for the legislation can be better explained by the political phenomenon of “earmarking.” although definitions vary, merriam-webster defines an earmark as a “provision in congressional legislation that allocates a specified amount of money for a specific project, program or organization.”80 earmarks are often slipped into unrelated pieces of legislation allowing lawmakers to pass specific spending allocations without attracting attention from the public or media. the term is synonymous with “pork spending,” to refer to representatives’ pet projects that may be approved without debate or hearing.81 in the gravina island example, it was senator ted stevens and representative don young, both from alaska, who pushed for the project.82 fortunately, congress rescinded the money after the project’s exposure 77. one is reminded of the need for dr. seuss’ fabled “lorax,” who proclaims he “speak[s] for the trees, for the trees have no tongues . . . .” dr. seuss, the lorax 23 (1971). 78. see erika hayasaki, palin said yes to a road to nowhere, l.a. times, sept. 19, 2008, at a1 (hereinafter hayasaki, palin said yes). 79. timothy egan, built with steel, perhaps, but greased with pork, n.y. times, apr. 10, 2004, at a1. 80. earmark definition, merriam-webster online dictionary, http://www.merriam-webster.com/dictionary/earmark (last visited june 18, 2011). 81. see andrew woellner, spending on an empty wallet: a critique of tax expenditures and the current fiscal policy, 7 hous. bus. & tax l.j. 201 (2006); richard simon, earmark, n., gets an updated definition, l.a. times, july 18, 2009, at a11. 82. see hayasaki, palin said yes, supra note 78. 60 florida tax review [vol. 14:2 generated national public outcry.83 the failed project nevertheless became a symbol for wasteful spending and excessive earmarking. the problem with earmarks is that they leave little room for analysis of legislation. some recent examples of earmark controversies include a $500,000 grant for a teapot museum,84 over $200 million for a highway running through a representative’s own property,85 and former congressman duke cunningham who was sentenced to prison after accepting $2.4 million in bribes to insert earmarks for military spending.86 rather than passing these enactments based on the merits and public policy, our representatives often base their decisions on ulterior motives including profit, re-election, and political advancement. tax legislation is not immune from earmarking. however, instead of allocating funds to specific groups, tax earmarks allocate tax benefits. for example, the emergency economic stabilization act (eesa),87 enacted in 2008 to “bailout” the u.s. financial system from the mortgage crisis, contained numerous tax sweeteners, including a rebate of excise taxes for the rum industry in puerto rico and virgin islands worth $192 million, tax relief to plaintiffs involved in the exxon valdez oil spill litigation worth $49 million, tax credits for corporations operating in american samoa worth $33 million, and fringe benefits related to bicycle commuting worth $10 million.88 (the last example shows that even earmarks can be green). the difficulty is parsing through legislation to identify lobbying and earmarking to ensure that the purposes of new enactments are meritorious in their own right and further national public policy instead of personal or political gain for a small few. for example, the florida department of 83. id. 84. in 2006, $500,000 was allocated for a sparta teapot museum in north carolina in order to “expose its visitors to an unexpected art form — the teapot.” citizens against gov’t waste, 2006 congressional pig book summary 47 (2006), http://www.cagw.org/assets/pig-book-files/2006/2006pigbooksummary.pdf. 85. matthew mosk, lawmakers cashing in on real estate, financial reports reveal, wash. post, june 15, 2007, at a4. 86. colbert i. king, from the hill, lessons in high-stepping hypocrisy, wash. post, dec. 17, 2005, at a23. 87. see emergency economic stabilization act of 2008, h.r. 1424, 110th cong. (2008). 88. these numbers must be kept in perspective. first, some of these earmarks extended tax benefits rather than creating new ones. second, the monetary value of the enactments span multiple years for the length of time that the particular legislation is enacted. top 10 tax sweeteners in the bailout bill, taxpayers for common sense, http://www.taxpayer.net/library/article/top-10-tax-sweeteners-inthe-bailout-bill (last visited july 2, 2011); zachary coile, billions in earmarks in senate’s bailout bill, sfgate (oct. 3, 2008), http://www.sfgate.com/politics/ article/billions-in-earmarks-in-senate-s-bailout-bill-3192435.php. http://www.cagw.org/assets/pig-book-files/2006/2006pigbooksummary.pdf http://www.taxpayer.net/library/article/top-10-tax-sweeteners-in-the-bailout-bill http://www.taxpayer.net/library/article/top-10-tax-sweeteners-in-the-bailout-bill http://ww/ 2013] structural impediments to tax reform 61 transportation is on course to build a sunrail commuter train in central florida that is 50 percent funded with federal dollars.89 although commuter trains are synonymous with green policy and energy conservation, this project is the perfect combination of pork, rewarding political contributors, and providing false green rhetoric. with a $1.2 billion price tag, the 61-mile rail is expected to benefit only 2,125 commuters per day when it begins operating.90 it might well be more cost-effective to buy each of the commuters a fleet of hybrid vehicles. 91 the sunrail system was actually a pet project of representative john l. mica and ranked as “one of the least cost-effective mass transit efforts in the nation.”92 according to the new york times, mica “has spent years badgering federal agencies, bullying state officials, blocking amtrak naysayers and trying to bypass federal restrictions to build support and squash opposition to the commuter line.”93 financial records show that many of mica’s campaign contributors would benefit from the deal, including csx, a florida rail corporation that stands to gain $432 million.94 although such evidence does not establish a causal link between campaign contributors and their influence on decision-making, one cannot help but suspect the relationship in our political system. tax legislation, as the examples illustrate, is not always rational and reasoned. aside from governmental policy goals, external forces are at play. legislators act to further their self-interest and the interests of their constituents. to be sure, a legislator’s agenda is often the byproduct of personal commitment to a specific tax policy.95 at other times, their actions 89. see faq, sunrail, http://sunrail.com/faqs (follow “how much will sunrail cost to build?” hyperlink). 90. eric lipton, a congressman’s pet project; a railroad’s boon, n.y. times, june 28, 2011, at a1 (hereinafter lipton, congressman’s pet project). 91. the math is simple — spending $1.2 billion on slightly more than 2000 daily commuters works out to about $600,000 for each commuter. to be fair, such a solution would not solve the problem of congestion, which is often cited as the major reason for backing the sunrail. according to the sunrail website, “traffic congestion is a growing concern for those who live, work and visit central florida . . . that’s why the florida department of transportation (fdot) . . . is advancing sunrail.” about sunrail, sunrail, http://www.sunrail.com/welcome/page /aboutsunrail (last visited mar. 4, 2013). 92. lipton, congressman’s pet project, supra note 90; see lloyd dunkelberger, scott approves orland’s sunrail system, theledger.com (july 1, 2011), http://www.theledger.com/article/20110701/news/110709988?p=1&tc=pg. 93. id. 94. id. 95. michael doran, legislative compromise and tax transition policy, 74 u. chi. l. rev. 545, 567 (2007) [hereinafter doran, legislative compromise] (“many legislators--probably most of those who serve on the ways and means committee (the tax writing committee in the house) or the finance committee (the 62 florida tax review [vol. 14:2 are merely attempting to win votes or campaign contributions. wellorganized interests groups attempt to influence the tax legislative process by lobbying, and legislators often help advance those very interests.96 legislation can often be the final result of representatives’ attempt to win votes, receive campaign contributions, get reelected, advance their political careers, or even make a profit in some cases.97 these motivations, whether legitimate or not, tend to undermine the ability of the congress to act in a focused and cohesive fashion. the final tax legislation that takes effect is often a compromise between “competing ideologies, competing interests, and competing groups.”98 this often results in tax policy full of contradiction and incoherence, disconnected from reason and utility. it does not help that tax expenditures are relatively easy to create. professor roberta mann notes that “[t]ax incentives do not require specific appropriation of funds, and tend to be less politically contentious.”99 the result is that parochial interests cannot help but trump national policy. it then comes as little surprise that at least one member of congress has observed that the code’s tax expenditures now approach total federal discretionary spending.100 it is estimated that tax expenditures amount to about $1 trillion and account for approximately a quarter of total expenditures.101 in 2010, discretionary spending accounted for 39 percent of total government spending.102 the united states government accountability office stated: “on an outlay-equivalent basis, the sum of tax expenditures estimates exceeded discretionary spending for most years in the last decade.”103 this tax writing committee in the senate)--and many presidents have strong commitments to a particular vision of tax policy.”). 96. id. at 567–68 (discussing the influence of interest group politics in the tax legislative process). 97. see generally ron nixon, cost-cutters, except when the spending is back home, n.y. times, july 20, 2011, at a16. 98. doran, legislative compromise, supra note 95, at 570 (citing michael j. graetz, the u.s. income tax: what it is, how it got that way, and where we go from here 184 (norton 1999)). 99. roberta f. mann, federal, state, and local tax policies for climate change: coordination or cross-purpose?, 15 lewis & clark l. rev. 369, 391 (2011) [hereinafter mann, federal, state, and local tax policies]. 100. earl blumenauer, business law forum taxation and the environment: introduction, 15 lewis & clark l. rev. 315, 319 (2011). 101. thomas l. hungerford, cong. research serv., rl 34622, tax expenditures and the federal budget 2 (2011); listokin, equity, efficiency, and stability, supra note 20, at 89. 102. thomas l. hungerford, cong. research serv., rl 34622, tax expenditures and the federal budget 2 (2011). 103. u.s. gov’t accountability office, gao-05-690, government performance and accountability: tax expenditures represent a 2013] structural impediments to tax reform 63 seemingly uncontrollable increase of tax expenditures presents yet another issue for the prospects for tax reform: the challenge of stopping or changing long-standing policies and practices. c. inertia third, the inertia of existing code provisions makes environmental reform more difficult. this phenomenon is well illustrated by the code’s treatment of the production of ethanol. in 1826, samuel morey created an engine that was powered by ethanol and turpentine.104 ethanol is an alternative fuel made from starch grains, generally corn, which is then turned into alcohol.105 nearly a century later, in 1908, henry ford manufactured his world famous model t that ran on both ethanol and gasoline.106 although ethanol has been available as an energy source since before the model t, oil was the favored fuel because of its relatively lower price.107 the united states only began subsidizing ethanol after domestic oil production began to decline in the 1970s.108 perhaps the threshold for tolerance was reached when the oil-producing nations in the middle east imposed an oil embargo on the united states after which there was a policy shift to support alternative fuel sources.109 president nixon expressed this sentiment when he declared that “[o]ur independence will depend on maintaining and achieving self-sufficiency in energy.”110 substantial federal commitment and need to be reexamined highlights (2005). 104. ethanol fuel history, fuel-testers, http://www.fuel-testers.com/ ethanol_fuel_history.html (last visited july 14, 2011) [hereinafter ethanol fuel history]. 105. see ethanol, st. energy conservation off., http://seco.cpa.state. tx.us/ energy-sources/biomass/ethanol.php (last visited july 14, 2011). 106. ethanol fuel history, supra note 104. 107. zachary m. wallen, far from a can of corn: a case for reforming ethanol policy, 52 ariz. l. rev. 129, 134 (2010). 108. id. for a more comprehensive overview about the history of ethanol and the development of energy policy in the united states, see michael j. graetz, the end of energy: the unmaking of america’s environment, security, and independence (2011). while professor graetz’s book is not tax-centered, it is a useful background for understanding energy politics as it traces back the history of u.s. energy policy since the 1970s. 109. brian r. farrell, fill ‘er up with corn: the future of ethanol legislation in america, 23 j. corp. l. 373, 375 (1998) [hereinafter farrell, fill ‘er up with corn]. 110. ctr. for pub. integrity, foreign oil dependence has grown (dec. 10, 2008, 12:00 am), http://www.publicintegrity.org/2008/12/10/6211/foreign-oildependence-has-grown. http://www.fuel-testers/ 64 florida tax review [vol. 14:2 in line with that goal, president carter promoted ethanol as an alternative to foreign fossil fuels when he became president.111 as foreign oil dependency grew,112 he made a promise that “this nation will never use more foreign oil than we did in 1977 — never.”113 ethanol was an option to help foster that energy independence. as we have witnessed, the road to energy independence is not an easy one. part of the difficulty is that, in the beginning, ethanol production was less efficient than the production of established fossil fuels.114 to help ethanol compete in the free market, congress decided to subsidize the industry.115 with the passage of the energy tax act of 1978, ethanol alcohol fuels were allowed an exemption from the motors fuel excise tax in the amount of forty cents per gallon.116 the purpose of the act was “to provide tax incentives for the production and conservation of energy.”117 congress better summarized its policy goals with respect to ethanol fuel when it reconsidered the legislative act in 1987: congress finds that — (1) the united states is dependent for a large and growing share of its energy needs on the middle east at a time when world petroleum reserves are dwindling; (2) the burning of gasoline causes pollution; (3) ethanol can be blended with gasoline to produce a cleaner source of fuel; (4) ethanol can be produced from grain, a renewable resource that is in considerable surplus in the united states; (5) the conversion of grain into ethanol would reduce farm program costs and grain surpluses; and (6) increasing the quantity of motor fuels that contain at least 10 percent ethanol from current levels to 50 percent by 1992 would create thousands of new jobs in ethanol production facilities.118 111. farrell, fill ‘er up with corn, supra note 109, at 375. 112. in 1977, foreign oil accounted for 48 percent of the united states oil supply. robert d. hershey, jr., u.s. urges cut in dependence on foreign oil, n.y. times, mar. 16, 1987, at a1. 113. jimmy carter, president, crisis of confidence (july 15, 1979) (transcript http://www.cartercenter.org/news/editorials_speeches/crisis_of_confidence.html). 114. farrell, fill ‘er up with corn, supra note 109, at 375. 115. id. 116. energy tax act of 1978, pub. l. no. 95-618, 92 stat. 3174 (1978). 117. id. 118. omnibus budget reconciliation act of 1987, pub. l. no. 100-203, § 1508(a), 101 stat. 1330-29 (1987). 2013] structural impediments to tax reform 65 the favorable policy goals articulated by congress made it difficult to oppose the legislation for political reasons.119 no legislator wanted to be seen as opposing energy independence, agricultural production, and environmental policy. as a result, ethanol subsidies originally received bipartisan political support.120 between 1978 and 2004, the amount of the ethanol subsidy ranged from 40 to 60 cents per gallon.121 with the passage of the energy act of 2005,122 the ethanol subsidies were restructured so that the alcohol fuel tax credit under code section 40 was enacted to include: (1) the alcohol mixture credit (also known as the blender’s credit), (2) the alcohol credit, and (3) the small ethanol producer credit.123 the three income tax credits were to be part of the general business credit under code section 38.124 additionally, code section 30c was enacted for taxpayers investing in vehicles that dispensed at least 85 percent ethanol.125 these statutes are modern-day codifications of the ethanol subsidies.126 while ethanol subsidies enjoyed political support in its early years, the political game has changed. first, ethanol subsidies no longer appear necessary to help ethanol to compete with oil in the free market. in 2009, for example, the ethanol industry increased the nation’s gross domestic product by $53.3 billion and produced 10.6 billion gallons of ethanol.127 with oil prices sky high, the ethanol industry is healthy enough to operate without government assistance.128 second, new data has since come out undermining ethanol as a viable alternative to oil; ethanol has been linked to higher food prices, inefficient energy use, and smog production.129 even with a new 119. farrell, fill ‘er up with corn, supra note 109, at 377. 120. id. 121. wallace e. tyner, u.s. ethanol policy — possibilities for the future, purdue u. 1 (2007), http://www.extension.purdue.edu/extmedia/id/id342-w.pdf [hereinafter tyner, u.s. ethanol policy). 122. energy policy act of 2005, pub. l. no. 109-58, 119 stat 594 (2005). 123. i.r.c. § 40(a); see roberta f. mann & mona l. hymel, moonshine to motorfuel: tax incentives for fuel ethanol, 19 duke envtl. l. & pol’y f. 43, 47– 51 (2008). 124. i.r.c. § 38(b)(3). 125. i.r.c. § 30c. 126. in 2006, it was estimated that ethanol subsidies varied between $1.05 and $1.38 per gallon of ethanol and between $1.42 and $1.87 per gallon of gasoline equivalent. tyner, u.s. ethanol policy, supra note 121, at 2. 127. renewable fuels ass’n, climate of opportunity: 2010 ethanol industry outlook 2, http://ethanolrfa.3cdn.net/32b7ed69bd366321cb_r1m626lb0.pdf. 128. see clifford krauss, ethanol subsidies besieged, n.y. times, july 8, 2011, at b1 [hereinafter krauss, subsidies besieged]. 129. steve ratner, the great corn con, n.y. times, jan. 25, 2011, at a19 [hereinafter ratner, corn con]. moreover, the congressional budget office has 66 florida tax review [vol. 14:2 political climate where ethanol subsidies create little political support,130 the ethanol industry has continued to receive hefty government subsidies. this situation leaves us with an interesting inquiry. lobbying by itself cannot explain this development. biofuel companies spent $7.3 million on lobbying in 2009 alone,131 and ethanol has been actively opposed by the oil industry, livestock interests, and environmental groups.132 to put it into context, the american petroleum institute spent $7.3 million in 2009, as much as the whole biofuel industry combined.133 the environmental lobby nearly tripled the amount spent by the biofuel lobby that same year.134 the lobbying differential between ethanol supporters and their opposition suggests that the success of the ethanol industry cannot be wholly explained by monetary influence. perhaps that is because ethanol interests cleverly, and somewhat deceitfully, stand behind a political platform of environmental concern and the movement toward cleaner alternative fuels, making it easier for a politician to support ethanol subsidies.135 found that reducing co2 emissions with ethanol cost at least $750 per ton of co2, much more than by other methods. id. 130. see id. (describing the ethanol subsidy as “government policy run amok”). 131. kate mcmahon, friends of the earth, buying bills: how the biofuels industry influences congress to waste your taxpayer dollars 6 (2010). 132. see dan eggen, the influence industry: ethanol lobby running low on fuel in washington, wash. post (june 14, 2011), http://www.washingtonpost.com/politics/the-influence-industry-ethanol-lobbyrunning-low-on-fuel-in-washington/2011/06/14/ag7srpwh_story.html; see farrell, fill ‘er up with corn, supra note 109, at 377–80. 133. oil & gas: lobbying, 2009, open secrets, ctr. for responsive politics, http://www.opensecrets.org/lobby/indusclient.php?id=e01&year=2009 (last visited july 16, 2011). 134. see environment: lobbying, 2009, open secrets, ctr. for responsive politics, http://www.opensecrets.org/industries/lobbying.php?cycle=2009&ind=q11 (last visited july 16, 2011). 135. a complementary explanation is that politicians — presidential candidates in particular — support ethanol because they want the votes of iowans, one of the primary beneficiaries of ethanol subsidies. krauss, subsidies besieged, supra note 128, at b1 (“federal subsidies for corn ethanol have long been considered untouchable in washington — not least because politicians want the votes of iowans, who have traditionally held the first nominating caucuses in the contest for the presidency.”); ratner, corn con, supra note 129, at a19 (“almost since iowa — our biggest corn-producing state — grabbed the lead position in the presidential sweepstakes four decades ago, support for the biofuel has been nearly a prerequisite for politicians seeking the presidency.”). 2013] structural impediments to tax reform 67 moving away from this cynical view of our political system, the support for ethanol can be alternatively explained based on public policy concerns outside of the environmental realm. behind all the shortcomings of ethanol, there are legitimate policy goals (for example, energy independence) that are supposedly being carried out. while it is easy to criticize the code by isolating environmental problems, those concerns should be weighed against other governmental goals that are at stake. the pros and cons of ethanol are difficult to measure against each other but as one prominent commentator notes, “we have incurred — and will incur — far greater costs than benefits by continuing to subsidize ethanol.”136 recently, professor lawrence zelenak undertook a comprehensive analysis of one of the most anti-environmental provisions in the code — the so called “suv loophole” or “hummer deduction.”137 with the government subsidizing hybrid, electric, and other alternative fuel vehicles, it is remarkable that taxpayers are currently allowed a deduction of up to $25,000 for the purchase of a sport utility vehicle (“suv”).138 tracing the deduction to its roots reveals that the purpose of the original provision was not to subsidize suvs.139 when enacting the provision back in 1984, congress assumed that the “use of a vehicle weighing more than 6,000 pounds would be based on business needs, rather than on personal preferences.”140 the american driving culture has since changed; the heavy suv is now a popular alternative to regular cars. thus, while the original provision did not intend for suv consumers to benefit, societal effects have since emerged to provide that very benefit for the business use of suvs. even though the shortcomings of the ethanol tax break and the “suv loophole” have long been exposed, they still find their respective places in the code. just this past summer, however, the senate overwhelmingly approved a bill amendment to repeal the volumetric ethanol energy tax credit (veetc), which is supposed to have the effect of eliminating tax 136. michael j. graetz, the end of energy: the unmaking of america’s environment, security, and independence 131 (2011). 137. see lawrence zelenak, the loophole that would not die: a case study in the difficulty of greening the internal revenue code, 15 lewis & clark l. rev. 469 (2011) [hereinafter zelenak, loophole that would not die] (presenting the “suv loophole” as a case study in order to show the difficulty of greening the code). 138. i.r.c. § 179. 139. congress assumed that “taxpayer’s choice of a vehicle weighing more than three tons would be based solely on business concerns; no one would derive personal consumption benefits from such a behemoth.” zelenak, loophole that would not die, supra note 137, at 473. 140. id. 68 florida tax review [vol. 14:2 credits for ethanol.141 the vote was viewed as largely symbolic for two reasons. first, it was part of the economic development and revitalization act, which was given little chance of winning final approval.142 second, even without the tax credits, the 2005 federal mandate requiring corn-ethanol producers to blend their ethanol with conventional gasoline would remain.143 because the senators in favor of ethanol tend to be from high-volume corn producing states, the vote represented a triumph of geography over ideology.144 nonetheless, the negative vote represents progress of sorts. still, as professor lawrence zelenak observes, it is difficult to hope for progress when even the hidden tax subsidy for large suvs — which he describes as “the most transparent and the most outrageous [of tax loopholes]” — still exists despite almost universal condemnation.145 the point is that the ethanol subsidy and the suv subsidy despite explicit recognition that each is deeply flawed nonetheless persist. the inertia possessed by existing legislation is very difficult to overcome. d. unintended consequences fourth, the environmental effects of various code provisions can come about unintentionally, and the policy inconsistencies that plague the code are not readily apparent upon enactment. over a decade ago, professor christine klein observed that tax policy does not always consider the whole picture when enacting legislation.146 she suggested that the now-repealed capital gain rollover rule in code section 1034 had a negative unintended 141. the bill was ethanol subsidy and tariff repeal act, s. 871, 112th cong. (2011). the final vote was 73 votes in favor of repeal with 27 against. lauren gardner & niels lesniewski, house, senate show some support for ending federal ethanol subsidies, cq today, june 16, 2011. the “carried interest” tax benefit has shown similar inertia in the face of criticism. see generally victor fleischer, the missing preferred return, 31 j. corp. l. 77 (2005); laura sanders, “carried interest” in the crosshairs, the wall street j. aug. 6-7, 2011, at b9. 142. stephen mufson & lori montgomery, senate votes to end ethanol tax credits, wash. post, june 17, 2011, at a15 [hereinafter mufson & montgomery, senate votes to end ethanol]. 143. david shaffer, ethanol-subsidy fight affects towns: an era of nearly unwavering federal support for the industry is ending, l.a. times, june 25, 2011, at b3. 144. mufson & montgomery, senate votes to end ethanol, supra note 142 (“among ethanol supporters, geography trumped party.”). 145. zelenak, loophole that would not die, supra note 137, at 471. 146. see generally christine a. klein, a requiem for the rollover rule: capital gains, farmland loss, and the law of unintended consequences, 55 wash. & lee l. rev. 403 (1998). 2013] structural impediments to tax reform 69 consequence of promoting the purchase of more expensive housing.147 by deferring capital gain on the sale of a personal residence when a subsequent home was of equal or greater value, the section effectively discouraged investment in older residences and encouraged the purchase of more expensive housing.148 this illustrates that while tax legislation generally shapes taxpayer behavior in its intended manner, sometimes the full effect is not evident until its application. similarly, the current home mortgage interest deduction, in its promotion of home ownership, indirectly encourages energy use. by allowing a deduction for interest paid on the mortgages of up to $1 million,149 the provision encourages unnecessary borrowing to purchase expensive homes.150 instead of encouraging home ownership, the deduction gives an incentive for the already wealthy to acquire larger, grander, and more expensive housing.151 this effectively encourages low-density development in the suburbs and increases dependence on automobiles.152 both of these examples, in light of professor klein’s observation, show that tax policy is not always pointed and calculated. adverse environmental effects are often the result of unforeseen circumstances. while this can potentially explain some of the inconsistencies in the code regarding the environment, it does not ultimately explain why those very same code provisions remain unaltered even after its negative environmental effects are unveiled. inaction can be partially explained by the influence gap between the energy sector and environmental interests in the tax legislative process. as the home mortgage interest deduction has encouraged urban sprawl and as the “suv loophole” has encouraged the purchase of gasguzzling behemoths, we can plainly see how environmentally harmful effects can be the byproduct of unforeseeable consequences. in some situations, the environmental dichotomy can be explained, in part, by unexpected developments, societal changes, or pure chance. 147. id. at 434–37. 148. see i.r.c. § 1034 (1994) (repealed 1997). 149. i.r.c. § 163(h)(3) (describing qualified residence interest). 150. mann, back to the future, supra note 52, at 363. 151. id. at 364–65. 152. see id. at 361–66 (discussing the process by which the home mortgage interest deductions encourages sprawl and excess energy use); see generally roberta f. mann, the (not so) little house on the prairie: the hidden costs of the home mortgage interest deduction, 32 ariz. st. l.j. 1347 (2000) (arguing for a repeal of the home mortgage interest deduction by focusing on the hidden effects of the provision). 70 florida tax review [vol. 14:2 e. external considerations finally, the ethanol case study introduces yet another variable — policy concerns other than the environment that can influence environmental legislation. in the case of ethanol, the external policy goal was energy independence to be achieved by reducing fossil fuel consumption. although the environmental benefits might be negligible, the provisions nevertheless helped the nation move away from oil consumption. isolating environmental concerns may not always reveal a complete picture. tax legislation is often a mesh of different policy goals that must be kept in perspective before a proper environmental analysis can be made. a variety of policy concerns influence legislation that ultimately benefits environmental causes. indeed, “[t]he most common purpose of state environmental legislation is to protect public health.”153 aligning the goals of public health and environmental legislation can “create market-based, regulatory incentives that promote sustainable commerce initiatives, and in doing so, position the u.s. local and state economy to aggressively compete against global competitors in global markets.”154 the international trend toward sustainable business has served external national purposes including reducing reliance on foreign energy sources and expanding markets for u.s. goods while having incidental benefits to the environment through reducing the impacts of american industrial operations and accelerating the use of sustainable technologies and practices.155 the new york times recently reported that americans are pumping significantly less gasoline, partly as a result of the recession and higher gasoline prices, but also because more americans are driving fewer miles and replacing older cars with hybrid or fuel-efficient vehicles.156 while there is some environmental benefit to the decreased consumption of fossil fuel, the main effect of this trend is increased independence from foreign energy, which relates directly to the policy considerations of foreign policy, national security, and the economy.157 the policies, including domestic drilling on federal lands and waters, leading to this state of independence were often 153. norman j. singer and j.d. shambie singer, conservation laws — environmental protection in the states, 3b sutherland statutory construction § 77:6 (7th ed.). 154. t. rick irvin and peter a. appel, sustainable commerce: public health law and environmental law provide tools for industry and government to construct globally-competitive green economies, 33 s. ill. u. l.j. 367, 368 (2009). 155. id. at 372. 156. clifford krauss and eric lipton, u.s. inches toward goal of energy independence, n.y. times, mar. 23, 2012, at a1. 157. id. 2013] structural impediments to tax reform 71 “industry-friendly” pieces of legislation fought by environmental groups.158 unfortunately, although these conditions could provide an opportunity to incentivize the decreased use of gasoline, instead the government is passing more legislation to expand drilling and similar technologies to develop domestic oil sources.159 in the future, it has been suggested that u.s. energy policies will need to continue to address the political and economic security threat posed by a dependence on oil, as well as the issue of poverty and the gap between the rich and the poor in access to energy.160 further, the global demand and market for energy could provide a venue for the government to further economic, national security, and environmental goals.161 as one article articulated: “energy is a common thread weaving through the fabric of critical american interests and global challenges.”162 all of this is emblematic of a much larger concern. the traditional goals of tax policy are “equity, efficiency, and simplicity.”163 as one commentator has suggested, these goals may be too myopic by not accounting for economic stability.164 if tax policy does not account for fiscal concerns, there is less hope that it would account for environmental concerns. extrapolating still further, the prospects for accounting for external considerations — a “big picture” sort of analysis is truly missing. the sum is that when all of these five points — lobbying influence, parochial interests, inertia, unintended consequences, and external considerations — are taken together, we are left with the inconsistent approach to environmental concerns that we have today. using the environment as a microcosm of what plagues tax policy today, the inescapable observation is that more, not less, incoherence and inconsistency is in our future. 158. id. 159. id. (noting that in march 2012, president obama opened 38 million more acres in the gulf for oil and gas exploration. “if there is a loser in this boom, it is the environment.”) 160. timothy e. wirth, c. boyden gray & john d. podesta, the future of energy policy, foreign affairs, vol. 82, no. 4 at 133 (2003) (“the lack of access by the world’s poor to modern energy services, agricultural opportunities, and other basics needed for economic advancement is a deep concern”). 161. id. (“market mechanisms can help address the various economic, environmental, and security interests at stake.”). 162. id. at 139. 163. listokin, equity, efficiency, and stability, supra note 20, at 47; see generally avi-yonah, three goals, supra note 16 (discussing the merits of a tax in terms of equity, efficiency, and simplicity); joseph t. sneed, the criteria of federal income tax policy, 17 stan. l. rev. 567, 568 (1965). 164. see listokin, equity, efficiency, and stability, supra note 20, at 48; richard musgrave, the theory of public finance: a study in political economy 5 (1959). 72 florida tax review [vol. 14:2 v. conclusion inconsistent environmental legislation is a public policy problem that we in the united states cannot ignore. the code, in its attempt to shape taxpayer behavior within the environmental realm, is often at cross-purposes. such conflicts cannot be overlooked as they lead astray tax legislation from governmental goals. not only does this undermine the execution of a cohesive public policy, it wastes government resources. if the federal government is foregoing revenue with the enactment of tax expenditures, whose effects are being undermined by its own doing, taxpayer money is wasted. in such circumstances, a better tax policy is needed, first, to formulate consistent goals and second, to ensure that the effects following the application of the enactments are in sync with the original objectives. one is tempted to suggest that independent commissions or advisory bodies can inject reason into the equation. however, history has shown that this approach may very well represent the triumph of hope over reality. a few examples illustrate the problem. president obama created the national commission on fiscal responsibility and reform via an executive order in 2010.165 the purpose of the commission was to provide recommendations to the president on how to balance the budget and how to best improve the long-term fiscal outlook of the united states.166 when the co-chairs, former republican senator simpson and former clinton chief-of-staff bowles, proposed overhauling the code by cutting $100 billion per year in popular tax breaks,167 they faced heavy opposition and eventually fell short.168 it is difficult to enact change when the approval of a final report requires a supermajority — the vote of at least fourteen of the eighteen bipartisan members of the commission.169 although supporters of the commission had hoped that president obama would nevertheless back the recommendations, the president offered no support.170 165. exec. order no. 13,531, 75 fed. reg. 7927 (feb. 18, 2010). 166. about the national commission on fiscal responsibility and reform, fiscalcommission.gov, http://www.fiscalcommission.gov/about (last visited july 21, 2011). 167. for the final version of the proposal see nat’l comm’n on fiscal responsibility and reform, the moment of truth: report of the national commission on fiscal responsibility and reform (2010), http://www. fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/themomentoftru th12_1_2010.pdf. 168. see lori montgomery, deficit panelists offer bold moves on taxes, outlays, wash. post, nov. 11, 2010, at a1; lori montgomery, budget panel’s unsteady balancing act, wash. post, nov. 17, 2010, at a12. 169. see exec. order no. 13,531, 75 fed. reg. 7927 (feb. 18, 2010). 170. david brooks, moment of truth, n.y. times, apr. 5, 2011, at a23 (“the polls suggested that voters were still unwilling to accept tax increases or 2013] structural impediments to tax reform 73 congress has fared no better in this regard. in 2010, congress ordered the national academy of sciences (nas) to “undertake a comprehensive review of the internal revenue code of 1986 to identify the types of and specific tax provisions that have the largest effects on carbon and other greenhouse gas emissions and to estimate the magnitude of those effects.”171 the hope was that congress would begin “greening” the code once the carbon footprint of the various code provisions were identified.172 the nas report, when issued, will suffer from a fundamental flaw — the approach will be retrospective. because nas will only analyze the code provisions already in existence, the possibility of new code provisions will not be part of the report. consequently, highlighting the anti-environmental provisions will not necessarily lead to beneficial reform without first pointing out viable alternatives. although affecting future provisions is not the point of the nas study, a prospective approach could forestall future environmentally unsound code provisions. while the nas has yet to issue its report, its review may well follow the fate of the advisory commission on intergovernmental relations (“acir”) established by congress in 1959 and created to provide technical assistance to legislators and to promote efficiency with respect to resources, notably revenue.173 while the idea was sound and the acir issued a number of worthy papers, there is little to show for the effort. indeed, acir was disbanded in 1995.174 even if the nas report is issued, it may very well get lost in the wrangle over the debt limit or suffer the fate of the simpsonbowles commission. ultimately the solution has to be a call for responsible government that is the result of competent legislators who are single-minded about the good of the nation. professor lawrence zelenak recently expressed pessimism over this possibility, but he is not the first to have such reservations.175 over two hundred years ago, james madison’s concern about benefit cuts. smart washington insiders like mitch mcconnell and president obama decided that any party that actually tried to implement these ideas would be committing political suicide. the president walked away from the simpsonbowles package. far from addressing the fiscal problems, the president’s budget would double the nation’s debt over the next decade, according to the congressional budget office.”). 171. energy improvement and extension act of 2008, pub. l. no. 110-343, §117, 122 stat. 3807, 3831 (2008). 172. zelenak, loophole that would not die, supra note 137, at 469–70. 173. mann, federal, state, and local tax policies, supra note 99, at 389– 901. 174. id. at 391. 175. professor lawrence zelenak uses the long-established “suv loophole” of section 179 in order to illustrate the difficulty of enacting environmental change in the code. zelenak, loophole that would not die, supra 74 florida tax review [vol. 14:2 the domination by the majority over the minority led him to observe that men were not angels. he wrote: but what is government itself, but the greatest of all reflections on human nature? if men were angels, no government would be necessary. if angels were to govern men, neither external nor internal controls on government would be necessary. in framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. a dependence on the people is, no doubt, the primary control on the government; but experience has taught mankind the necessity of auxiliary precautions.176 my own hope notwithstanding, i fear that zelenak and madison may be right. the mechanisms viewed as necessary by madison are not in place or do not exist to inject environmentally flavored reason into the code. this is not surprising. partisan dispute and not harmony is what has characterized the legislative and political process throughout our history.177 indeed, one of madison’s first observations of politics in this country was “two fixed and violent parties” standing “invariably contrasted on the opposite columns,” governed by “passion, not reason.”178 despite the partisan challenges facing the government throughout america’s past, in the end, the result has been accomplishment. the golden gate bridge exists, hoover dam was built, and the transcontinental railroad united the country from coast to coast — all done in spite of partisan bickering.179 in that sense there is some hope. at the same time there is probably a significant difference between large infrastructure projects, which can attract support because of their tangible nature, and the more elusive and less tangible, but just as important notions of economic stability and big picture analysis. we as responsible citizens must make sure legislators and policymakers understand this simple proposition. until such occurs or until angels are elected to congress, we in the united states are faced with the prospect of a code that is hostile to or at note 137. he concludes his analysis by exclaiming that “the prospects for the greening of the internal revenue code are not good.” id. at 481. 176. the federalist no. 51 (james madison). 177. adam goodheart & peter manseau, american history hits the campaign trail, ny times, july 8, 2012, at 5 [hereinafter goodheart & manseau, american history]. 178. the federalist no. 50 (james madison) (emphasis in original). 179. see goodheart & manseau, american history, supra note 177, at 5. 2013] structural impediments to tax reform 75 least indifferent to environmental concerns. by extension we are faced with the prospect of a code that is hostile to or at least indifferent to larger social concerns. as kay ryan might say, “things shouldn’t be so hard.”180 180. ryan, things shouldn’t be so hard, supra note 1, at 48. i. introduction ii. background a. taxation and the environment — an overview iii. the tax legislative process a. the sanitized version of the legislative process b. alternative processes for the creation of tax law: treasury regulations d. tax legislation and the environment iv. making sense of it all a. lobbying influence b. parochial interests c. inertia d. unintended consequences fourth, the environmental effects of various code provisions can come about unintentionally, and the policy inconsistencies that plague the code are not readily apparent upon enactment. over a decade ago, professor christine klein observed that tax ... similarly, the current home mortgage interest deduction, in its promotion of home ownership, indirectly encourages energy use. by allowing a deduction for interest paid on the mortgages of up to $1 million,148f the provision encourages unnecessary ... e. external considerations v. conclusion florida tax review florida tax review volume 15 2014 number 2 the unruly world of tax: a proposal for an international tax cooperation forum by h. david rosenbloom * noam noked ** mohamed s. helal *** abstract international cooperation in tax policy is deeply fractured. inconsistencies, loopholes, and ineffective mechanisms—which could be avoided if real collaboration among countries existed—have created significant inefficiency losses for decades. this article focuses on the institutional infrastructure underlying international cooperation in tax issues and argues that the current forums in which such cooperation is encouraged do not provide an adequate platform in which countries with similar interests can effectively make a collaborative effort. to facilitate cooperation, this article proposes to create a new institution currently missing from the international tax policy-setting arena: an informal forum for coordination among countries that share similar interests in tax policy, inspired by the model of “like minded groups” in international organizations. this forum will enable countries that share similar interests to cooperate and reach understandings about necessary policy adaptations. we identify two major projects that this forum could promote—efforts to curtail tax evasion and efforts to harmonize various aspects of tax policy. we argue that this model might have significant *member, caplin & drysdale, chartered, washington, d.c.; director of the international tax program, new york university school of law. **terence m. considine fellow in law and economics; fellow of the program on corporate governance; candidate for s.j.d., harvard law school. ***teaching fellow, john f. kennedy school of government; candidate for s.j.d., harvard law school. 58 florida tax review [vol. 15:2 advantages in promoting cooperation, reducing the “competitiveness” threat, advocating coordinated policies, and overcoming external and domestic pressures. in light of the current challenges in the field of tax policy, and the difficulties in forming international cooperation within the current institutional framework, the proposed model is worth serious discussion and consideration. i. introduction ............................................................................. 58 ii. current international tax policy forums ...................... 61 a. the oecd ........................................................................... 61 b. g20 ...................................................................................... 66 c. other forums ...................................................................... 69 iii. proposal: tax cooperation forum ...................................... 77 a. applying the “like-minded group” model to tax policy setting ...................................................................... 77 b. where can the tcf make a difference? ............................ 83 c. rationale and advantages ................................................... 85 iv. conclusion ................................................................................... 87 i. introduction international cooperation in the making of tax policy is inadequate. inconsistencies, loopholes, and ineffective mechanisms—which could be avoided if real collaboration between countries existed—have created significant inefficiency losses for decades. there are various reforms that might be suggested to improve existing mechanisms of global tax governance, but in this article we focus on the institutional infrastructure underlying international cooperation on tax issues. we argue that the current forums in which international tax cooperation is intended to occur do not provide an adequate platform for countries with similar interests to engage in a true collaborative effort. we propose a new institution currently missing from the international tax policy-setting arena: an informal forum for coordination between countries sharing similar interests. this forum would enable such countries that share similar interests to cooperate and reach understandings about necessary policy changes. the proposal is inspired by the model of “like minded groups,” widely practiced in international organizations, where states whose interests converge establish a group to coordinate policies and create a negotiating bloc enabling them to achieve greater gains 2014] the unruly world of tax 59 in negotiations with other parties. this article emphasizes the maximization of national welfare, but it is possible that the cooperation envisioned would increase worldwide welfare as well. current international institutions and forums specializing in the field of international taxation do not provide an effective platform for cooperation. the organisation for economic cooperation and development [hereinafter “oecd”], which is based on consensual decision-making, consists of countries with divergent and, in some cases, conflicting interests, which limits the ability of the organization to make progress on contentious issues and achieve significant changes to the status quo. the g20, a forum for heads of state with differing interests and no institutional support, cannot permanently play the role of initiator and leader of international tax policy changes. additionally, the other bodies discussed in this article do not effectively facilitate cooperation in tax policy matters. we call our proposed institution the “tax cooperation forum” [hereinafter “tcf”]. different groups of countries can form different tcfs to promote their shared interests. one group of countries with similar tax interests that might establish such a forum could be the united states, the united kingdom, germany, france, japan, and a few other developed countries that share similar interests. the tcf would be informal in nature and without any legal authority over members. this would allow members to opt in or out of the discussions in accordance with the policies under consideration and create ad hoc coalitions. as we explain further below, the use of an informal body would reduce political pressure and sensitivities regarding the inclusion or exclusion of different countries. if the changes agreed upon in a tcf only required actions by the member countries, no further international cooperation would be needed, and the countries in the tcf would adopt the changes through domestic laws, or encourage their adoption in bilateral or multilateral agreements. if the changes affected other parties or needed the cooperation of other countries, the tcf could submit the proposed changes to the oecd (and possibly to the g20 or the wto for issues that affect trade), in order to allow negotiation and the formation of a broader consensus. the tcf may indicate where its core principles are non-negotiable and where there is room for concessions in order to obtain broader acceptance by non-tcf states. if a broad consensus is not achieved, the tcf countries would adopt the proposed changes (though some might opt not to do so) and may set other mechanisms to incentivize cooperation and mitigate problems with lack of cooperation between other parties. what kind of tax issues could be on the agenda of such a group or could be addressed differently if this forum existed? at least two major projects could be promoted by the tcf—efforts to curtail tax evasion and to 60 florida tax review [vol. 15:2 harmonize different aspects of tax policy. there may be measures to fight tax evasion that are not being taken now due to the lack of cooperation among countries. 1 the implementation of automatic information exchange by the united states, which is inconsistent with the adoption of anonymous crossborder tax withholding in the uk-swiss confederation taxation cooperation agreement, makes one wonder whether a different outcome would have resulted if these countries had first attempted collaboration on this matter. 2 the tcf could also promote multilateral harmonization efforts. many commentators have suggested ideas for improving international tax policy, but these ideas must be adopted multilaterally: a multilateral tax treaty; 3 formulaic apportionment system 4 and reforms in the current transfer pricing rules; 5 standardization of anti-avoidance rules, such as the rules regarding cfcs; 6 uniform minimal tax rate on capital income; 7 coordinated policy regarding taxation of intellectual property, 8 and so on. other, more modest initiatives that would be beneficial include harmonization of reporting rules so as to make compliance less costly for taxpayers; 1. see infra note 29. 2. see itai grinberg, taxing capital income in emerging countries: will fatca open the door? georgetown public law research paper no. 13-031, (2013), http://scholarship.law.georgetown.edu/facpub/1227/ [hereinafter grinberg, capital income in emerging countries]. 3. see victor thuronyi, international tax cooperation and a multilateral treaty, 26 brook. j. int’l l. 1641 (2001) [hereinafter thuronyi, international tax cooperation]. 4. see kimberly a. clausing & reuven s. avi-yonah, reforming taxation in a global economy: a proposal to adopt formulary apportionment, the hamilton project, policy brief no. 2007-08 (2007) [hereinafter clausing & aviyonah, reforming taxation] (discussing one proposal for a formulaic apportionment), http://www.brookings.edu/~/media/research/files/paper/2007/6/corp oratetaxes%20clausing/200706clausing_aviyonah_pb.pdf. 5. david spencer, transfer pricing: will the oecd adjust to reality?, j. int’l tax’n 35 (2012) [hereinafter spencer, transfer pricing]. 6. see chloe a. burnett, replacing cfc regimes with a collective attribution system, 38 tax notes int’l 1109 (2005) [hereinafter burnett, cfc regimes]. 7. see peter birch sørensen, the case for international tax coordination reconsidered, 15:31 economic policy 429 (2000) (analyzing the harmonization of tax rates on capital income) [hereinafter sørensen, the case for coordination]. 8. see michael j. graetz & rachael doud, technological innovation, international competition, and the challenges of international income taxation, 113 colum. l. rev. 347 (2013) (discussing coordination of intellectual property taxation and its policy alternatives) [hereinafter graetz & doud, technological innovation]. 2014] the unruly world of tax 61 standardizing source and transfer pricing rules; improving mechanisms for dispute resolution and administrative cooperation, and other initiatives that would improve efficiency. what would be the advantages of the tcf? first, cooperation among countries that share similar interests is beneficial because it reduces the “competitiveness” threat—a fear that investors will withdraw or that domestic companies will be unable to compete against foreign companies. second, cooperation among influential countries may be utilized to further tax policies and achieve consensus, and in the event consensus is not possible, to set a coordinated policy that may be preferable to either the status quo or acting unilaterally. third, this proposed model would permit different groups of states that share similar interests to set their own tax policy agenda and cooperate on issues that may not have broad interest. fourth, cooperation within a group of countries may help policymakers overcome domestic political pressures and lobbies against policy changes. fifth, the proposed model is practical, feasible, and within the current framework of international institutions. the structure of this article is as follows: part ii discusses the current international tax organizations and demonstrates how they fail to foster cooperation efficiently. part iii discusses the proposed model for international tax policy leadership. part iv offers concluding remarks. ii. current international tax policy organizations assume that a group of countries sharing similar interests seek to collaborate on tax policy matters. what current international forum could facilitate such cooperation? what difficulties would this forum likely encounter? a. the oecd the oecd claims to have performed a central role in developing and promoting tax policies that are implemented globally, 9 a contention that is accepted by several commentators. 10 the most successful oecd standard 9. see, e.g., organisation for economic co-operation and development, current tax agenda 9 (2012), http://www.oecd.org/ctp/oecdcurrenttax agenda2012.pdf, [hereinafter oecd tax agenda]. 10. jan wouters & karien meuwissen, global tax governance: work in progress?, leuven center for global governance studies, working paper no. 59, (2011) [hereinafter wouters & meuwissen, global tax governance], http://papers. ssrn.com/sol3/papers.cfm?abstract_id=1766436; allison christians, taxation in a 62 florida tax review [vol. 15:2 setting instrument in the field of tax policy is the oecd model tax convention on income and on capital, which essentially provided the foundation for over 1,500 current bilateral tax treaties. 11 another similarly successful example of oecd standard-setting are the 1995 transfer pricing guidelines, which have been used as the basis for legislation in participating oecd countries and an increasing number of non-oecd countries. the oecd also took the lead in developing the widely adopted standards regarding e-commerce. 12 the oecd guidelines for multinational enterprises (2008, updated 2011) include a chapter on taxation, in which the oecd outlines the proper standard of behavior in the field of tax. 13 however, the oecd has faced setbacks in its efforts to achieve greater coordination among its members in the area of tax policy. for example, some observers have noted that by 2006 the oecd’s harmful tax competition agenda, originating from a 1998 oecd report, had largely failed in achieving its objective of combating the role of offshore countries in international tax avoidance and evasion. 14 other commentators, such as professor avi-yonah of the university of michigan college of law, contend the oecd agenda has had limited success. 15 overall, oecd activities in the field of tax policy are based on the principle of fiscal sovereignty, which favors enhancing cooperation rather than tax harmonization among member states. 16 time of crisis: policy leadership from the oecd to the g-20, 5 nw. j. l. & soc. pol’y 19, 19–40 (2010) [hereinafter christians, taxation in a time of crisis]; yariv brauner, an international tax regime in crystallization, 56 tax l. rev. 259 (2003) [hereinafter brauner, tax regime in crystallization]; arthur j. cockfield, the rise of the oecd as informal “world taxation organization” through national responses to e-commerce tax challenges, 8 yale j.l. & tech. 136 (2006) [hereinafter cockfield, rise of the oecd. 11. see thuronyi, international tax cooperation, supra note 3, at 1641. 12. see cockfield, rise of the oecd, supra note 10, at 136. 13. organisation for economic co-operation and development, oecd guidelines for multinational enterprises (may 25, 2011), http://www.oecd. org/daf/inv/mne/oecdguidelinesformultinationalenterprises.htm. 14. richard eccleston, peter carroll & aynsley kellow, handmaiden to the g20? the oecd’s evolving role in global economic governance, australian political studies association conference, working paper (2010) [hereinafter eccleston etal., handmaiden to the g20], http://apsa2010.com.au/full-papers/pdf/ apsa2010_0228.pdf; wouters & meuwissen, global tax governance, supra note 10, at 12. 15. reuven s. avi-yonah, the oecd harmful tax competition report: a retrospective after a decade, 34 brook. j. int’l l. 783 (2009). 16. see oecd tax agenda, supra note 9, at 111. 2014] the unruly world of tax 63 the recent financial crisis increased international interest, particularly among g20 member states, in augmenting government revenues by effectively combating tax havens. implementing g20 decisions in this regard is largely dependent on the effectiveness of the oecd. 17 indeed, the relationship between these two bodies is symbiotic: the g20 elevates some of the oecd’s tax policies to the top of the international policy-making agenda, while the oecd provides supportive functions for the g20, the latter of which lacks the capacity to develop standards or implement and oversee its decisions. 18 the global forum on transparency and exchange of information for tax purposes [hereinafter “global forum”] provides an interesting example of this relationship between the oecd and the g20. the global forum was established in 2001 under the auspices of the oecd to set a multilateral framework within which progress in the areas of transparency and exchange of information might be made by both oecd and non-oecd economies. from its early years, the global forum achieved the development of standards of transparency and exchange of information through the publication of the model agreement on exchange of information for tax purposes in 2002 and the publication of a paper setting out the standards for the maintenance of accounting records. additionally, the global forum has, since 2006, produced annually an assessment of the legal and administrative frameworks for transparency and exchange of information in over eighty jurisdictions. 19 in 2009, the global forum was restructured and strengthened as a result of the g20’s pressure to implement standards of transparency and exchange of information. 20 the oecd’s tax transparency agenda, adopted 17. see wouters & meuwissen, global tax governance, supra note 10, at 10. see also christians, taxation in a time of crisis, supra note 10, at 29. 18. id. see also eccleston, handmaiden to the g20, supra note 14, at 4. the paper contends that there are potential benefits to closer coordination between the oecd and the g20 on international tax issues: the latter’s high profile support of the oecd’s agenda represents a stronger political commitment, thus making it less likely that oecd member states will veto the g20’s agenda in the face of domestic political pressures. furthermore, this strong commitment would probably result in specific funding to the oecd to support the agenda and fund its implementation and enforcement. 19. see about the global forum, oecd.org (august 10, 2013), http://www.oecd.ort/document/33/0,3746,en_2151361_4384757_44200609_1_1_1 _1,00.html. 20. see organisation for economic co-operation and development, oecd’s current tax agenda, 102–104 (2010), http://www.uscib.org/docs/ctpa_ brochure_june_2010.pdf: 64 florida tax review [vol. 15:2 through the global forum, had little effect prior to the g20’s involvement. as of 2006 only eleven tax information exchange agreements [hereinafter “tie agreements”] were signed, whereas by 2012 more than 800 tie agreements were signed. 21 in order to strengthen the implementation of these standards, in 2010, the global forum launched a peer review process including a review of each jurisdiction’s legal and regulatory framework for transparency and the exchange of information for tax purposes and a survey concerning the practical implementation of those standards. 22 this demonstrates that while the oecd can set the agenda on issues so long as they are not very contentious, it lacks the ability to effectively promote its policy proposals, whereas the g20 has been much more effective in promoting the oecd’s agenda. however, the g20 depended on the oecd to ensure implementation of the agenda and monitor each jurisdiction’s compliance with it. 23 at its mexico meeting on 1-2 september 2009, 178 delegates from over 70 jurisdictions and international organizations met to discuss progress made in implementing the international standards of transparency and exchange of information for tax purposes, and how to respond to the g20 call to strengthen the work of the global forum. the membership of the global forum was expanded to include more than 90 jurisdictions, including all oecd and g20 countries. its governance and financing were restructured to ensure that all members participate on an equal footing. they agreed to a threeyear mandate, which includes: carrying out an in-depth monitoring and peer review of the implementation of the standards of transparency and exchange of information for tax purposes; developing multilateral instruments to speed up negotiations; and ensuring that developing countries benefit from the new environment of transparency. 21. see organisation for economic co-operation and development, global forum on transparency and exchange of information for tax purposes: tax transparency 2012 report on progress, 16 (2012), http://www.oecd.org/tax/ transparency/tax%20transparency%202012_jm%20mb%20corrections%20final.p df). see also tax information exchange agreements (tieas), oecd.org (august 10, 2013), http://www.oecd.org/tax/exchange-of-tax-information/taxinformation exchangeagreementstieas.htm (providing a list of tie agreements by date). 22. see global forum on transparency and exchange of information for tax purposes, frequently asked questions, oecd.org (august 10, 2013) http://www.oecd.org/dataoecd/35/16/46615395.pdf. 23. it may be argued that the g20 and the oecd could be tougher in their current efforts, as they do not require imposing automatic information exchange or closing down tax havens, but only seek “information exchange upon request,” 2014] the unruly world of tax 65 the oecd recently presented to the g20 an action plan on base erosion and profit shifting [hereinafter “action plan”]—a plan to reformulate international tax standards in order to reduce tax avoidance opportunities for multinational corporations. 24 the action plan identifies weaknesses in the current framework and sets a timeline for the development of new standards for each recommended plan of action. this is an ambitious plan, both with regard to its scope and its goal of achieving consensus on many sensitive issues. the oecd notes that “[i]naction in this area would likely result in some governments losing corporate tax revenue, the emergence of competing sets of international standards, and the replacement of the current consensus-based framework by unilateral measures, which could lead to global tax chaos marked by the massive re-emergence of double taxation. “in fact, if the action plan fails to develop effective solutions in a timely manner, some countries may be persuaded to take unilateral action for protecting their tax base, resulting in avoidable uncertainty and unrelieved double taxation. it is therefore critical that governments achieve consensus on actions that would deal with the above weaknesses.” 25 although it remains the most significant international forum in the field of tax policy coordination, the oecd suffers from substantial limitations in its efforts to lead international reforms in this field. first, oecd decision-making is based on consensus among thirty-four member states. naturally, these countries have different interests, different economic characteristics, and different tax systems. as is the case in other multilateral forums, oecd decisions and policies tend to reflect the lowest common denominator that its members can agree upon. although it is desirable to achieve policy goals by broad acceptance, partial cooperation among some members may be better than a stalemate. however, oecd rules of procedure do not provide for partial cooperation among these members that share similar interests. it is possible that in order to resolve the weaknesses identified in the action plan through broad consensus, the oecd will have to dilute the suggested reforms, thus undermining the goal of this ambitious project. allowing tax havens to be taken from the oecd’s blacklist by nominally complying with information exchange requirements. exchange of information, oecd.org (october 14, 2013), http://www.oecd.org/ctp/exchange-of-tax-information/. 24. organisation for economic co-operation and development, action plan on base erosion and profit shifting, (august 10, 2013), http://www.oecd.org/ctp/ bepsactionplan.pdf. 25. see id. at 10–11. 66 florida tax review [vol. 15:2 second, the oecd lacks the political and diplomatic influence to advance the policies it endorses, as evident from the oecd’s efforts on tax transparency and harmful tax competition. therefore, although the oecd remains the forum best suited for forging a broad consensus on proposed international tax policies, there may be a need for an additional mechanism to achieve coordination among a group of countries that share similar interests. sustained high-level political support provided by the g20 to the reforms suggested by the oecd may resolve this problem. however, the g20’s interest in tax issues became significant only after the financial crisis of 2008, and it is undetermined if and for how long the political support of the g20 to the oecd will continue. finally, as a forum aiming to address global tax issues, the oecd is probably not the most suitable body to discuss issues of interest to only a portion of its membership. for example, some countries may have a keen interest in collaborating to suppress tax competition harmful to them. this form of coordination would not be feasible through the oecd, which is not a forum that is conducive to cooperation among only some of its members. b. g20 from its inception in 1999 until the financial crisis that arose in late 2008, the group of twenty finance ministers and central bank governors [hereinafter “g20”] played a limited role in setting tax policy. 26 the g20 is 26. the g20 was established in 1999 as a forum for both industrialized and developing nations to discuss key issues relating to the global economy, economic growth, and economic stability. the g7 created the g20 as a response both to the financial crises of the late 1990s and to a growing recognition that key emerging economies were not being adequately integrated in debates on global economic governance. the body of the g20 is composed of the finance ministers and central bank governors of nineteen countries and the european union. there are no formal criteria for membership in the g20 and the composition of the group has remained unchanged since it was established. the original members of the g7 are canada, france, germany, italy, japan, the united kingdom and the united states, who were later joined by argentina, australia, brazil, china, india, indonesia, mexico, russia, saudi arabia, south africa, republic of korea and turkey. in light of the objectives of the g20, it was seen as important that the g20 include countries wielding considerable influence within the international financial system. aspects such as geographical balance and population representation also played a major part in determining membership. the g20 usually meets annually at the level of the g20 finance ministers and central bank governors. this meeting is usually preceded by two meetings between deputies of the g20, as well as technical work to provide the financial 2014] the unruly world of tax 67 an informal forum with no founding legal instrument or voting mechanisms. its decisions are reached by consensus and are not legally binding. moreover, the g20 does not have a permanent secretariat to assist it. the member state holding the rotating position of president hosts the annual meeting of the g20 and provides secretarial and logistical support. 27 in 2004, the g20 released a “statement on transparency and exchange of information for tax purposes,” in which it made a commitment “to the high standards of transparency and exchange of information for tax purposes that have been reflected in the model agreement on exchange of information on tax matters as released by the oecd in april 2002” and a call to “all countries to adopt these standards.” 28 however, as noted above, the 2004 statement had little effect on the signing of tie agreements. in the aftermath of the emerging financial crisis in 2008, the role of the g20 in the field of international tax policy became more significant. the primary indication of the g20’s interest in this field came from its fight against tax havens through the improvement of transparency and exchange of information. 29 these statements were backed with political and diplomatic ministers and bank governors with a foundation to better inform their consideration of policy options. see what is the g20, g20.org (august 10, 2013), http://www.g20.org/docs/about/about_g20.html. 27. see id. 28. the g20 stated that it “strongly support[s] the efforts of the oecd global forum on taxation to promote high standards of transparency and exchange of information for tax purposes and to provide a cooperative forum in which all countries can work towards the establishment of a level playing field based on these standards.” see g20, statement on transparency and exchange of information for tax purposes (november 21, 2004), http://www.g20.utoronto.ca/2004/2004 transparency.html. 29. in a statement issued after the g20 london summit in 2009, the g20 expressed the need to “take action against non-cooperative jurisdictions, including tax havens. we stand ready to deploy sanctions to protect our public finances and financial systems. the era of banking secrecy is over. we note that the oecd has today published a list of countries assessed by the global forum against the international standard for exchange of tax information.” see g20, london summit – leaders’ statement, 4 (april 2, 2009), http://www.imf.org/external/np/sec/pr/2009/ pdf/g20_040209.pdf. later, during the pittsburgh summit in 2009, a statement by the g20 was issued: “we welcome the expansion of the global forum on transparency and exchange of information, including the participation of developing countries, and welcome the agreement to deliver an effective program of peer review. the main focus of the [global] forum’s work will be to improve tax transparency and exchange of information so that countries can fully enforce their tax laws to protect their tax base. we stand ready to use countermeasures against tax havens from march 2010.” see g20, pittsburgh summit – leaders’ statement, 10 68 florida tax review [vol. 15:2 commitments. thereafter, the number of signed tie agreements by key countries substantially increased. furthermore, the global forum was granted additional funding. nonetheless, the g20’s ability to affect international tax policy is limited because of several impediments. first, the g20 depends on the oecd in a way that limits its ability to originate tax policy. as described above, the relationship between the g20 and the oecd is symbiotic: the g20 provides high-level political backing, while the oecd develops technical standards and monitors implementation. 30 therefore, as one commentator has noted, the primary role of the g20 is to “syndicate, rather than originate, tax policy.” 31 moreover, since the g20 depends on the oecd for implementation, if tax policies adopted by the g20 are not in accord with oecd standards, the latter organization is not likely to implement them. (september 24–25, 2009). the g20 has not yet stated what countermeasures are being considered against tax havens. see wouters & meuwissen, global tax governance, supra note 10 at 5–7. 30. see wouters & meuwissen, global tax governance, supra note 17. see also christians, taxation in a time of crisis, supra note 10; ecceleston, handmaiden to the g20, supra note 14. 31. see christians, taxation in a time of crisis, supra note 10 at 29. for example, see the g20 statement from february 2013, noting that: [w]e welcome the oecd report on addressing base erosion and profit shifting and acknowledge that an important part of fiscal sustainability is securing our revenue bases. we are determined to develop measures to address base erosion and profit shifting, take necessary collective actions[,] and look forward to the comprehensive action plan the oecd will present to us in july [2013]. we strongly encourage all jurisdictions to sign the multilateral convention on mutual administrative assistance. we encourage the global forum on transparency and exchange of information to continue to make rapid progress in assessing and monitoring on a continuous basis the implementation of the international standard on information exchange and look forward to the progress report by april 2013. we reiterate our commitment to extending the practice of automatic exchange of information, as appropriate, and commend the progress made recently in this area. we support the oecd analysis for multilateral implementation in that domain. g20, final communiqué of finance ministers and central bank governors 5 (february 15–16, 2013). this statement demonstrates how the oecd originates the action plans and norms while the g20 provides high-level political support in order to effectuate those plans. 2014] the unruly world of tax 69 second, since the g20 is an executive-level forum based on consensual decision-making, it tends to avoid taking stances on issues that are politically sensitive. this could explain why the g20 refrained from taking a tougher stance in the fight against tax havens. conflicting interests among g20 members who accommodate tax havens within their borders, such as hong kong and macau in the case of china and the isle of man, guernsey, and jersey in the case of the united kingdom may also explain the g20’s choice not to endorse harsher measures in combating tax havens. 32 the g8, which is less active in tax policy issues in the last few years, suffers from similar problems. nevertheless, the advantage of the g20 is that it enables cooperation in regard to fiscal issues within a relatively small group of influential countries. this cooperation may lead to significant advances in proposed tax standards, which could not be achieved by the oecd alone. c. other forums other bodies and international organizations do not provide an effective platform for countries to collaborate on tax policy matters. some of these organizations—the united nations, the european union, the world trade organization, the international monetary fund, the world bank, and regional and administrative forums—are discussed below. the united nations [hereinafter “un”] has not been a leading forum for international tax policy setting, 33 although it has made contributions by advancing some proposals that affect the tax policy of developing countries. 34 there are a few reasons for the surprising lack of involvement of 32. see wouters & meuwissen, global tax governance, supra note 10, at 7. 33. the lack of un leadership in tax issues became apparent at the international conferences on financing for development in monterrey during 2002 and doha during 2008, where tax-related issues received limited attention. 34. overall, un activity in this area sought to support developing countries’ tax policy, due to the universal membership of the organization. see wouters & meuwissen, global tax governance, supra note 10 at 16. one major development relevant to tax policy that took place at the un was the adoption of the model double taxation convention between developed and developing countries (hereinafter “un model”). work on this instrument began in 1967 as a response by developing countries to the success of the draft of the oecd model treaty from 1963, and its main goal was to eliminate the double taxation impeding the flow of investments to developing countries. the un model was published in 1980, and revised in 2001. see michael j. mcintyre, developing countries and international cooperation on income tax matters: an historical review 70 florida tax review [vol. 15:2 the un in tax policy issues. one is that the respective ministries of finance in developed countries are ambivalent toward the prospect of the un becoming a major player in fiscal policy, whereas the respective ministries of foreign affairs, which are the departments most involved in un affairs, are usually unqualified to deal with tax issues. these institutional and bureaucratic realities have in part prevented the un from being at the forefront of international tax policy. 35 similarly, as an inclusive forum, the un usually adopts the lowest common denominator acceptable to all participating states. this effectively means that no real change in the status quo is achieved by the un. dries lesage, david mcnair, and mattias vermeiren argue that the negotiating blocs, such as the g7, the rio group, and the eu that are divided internally, come to negotiations with only their respective group’s lowest common denominator, prejudicing discussions before a conference is convened. 36 some commentators argue that the un is inferior to the oecd with regard to the un’s institutional capacity to develop and implement tax policy standards. 37 although the un has a permanent committee on international cooperation in tax matters, consisting of twenty five experts with a mandate to discuss all relevant global tax issues, 38 most of the committee’s work is focused mainly on updating the un model income tax convention. 39 4–7 (tax policy for developing and transitional countries in the global economy, working paper, 2005) www.michielse.com/files/mcintyre_intl_cooperation.pdf‎. while the un model mirrored many aspects of the oecd model, it departed from the latter on some major issues in a manner more favorable to developing countries. specifically, it modified the definition of a ‘permanent establishment’ to allow additional taxation of business income by the source country and provided that any reduction in a country’s statutory withholding rates would be done through bilateral negotiations. additionally, no specific target withholding rates were established in the un model, and the expectation was that treaties based on the un model would have higher withholding tax rates on royalties, dividends, and interest than those recommended in the oecd model. the un model has been effective in influencing tax treaties between developed and developing countries— virtually all of which have a positive withholding rate on royalty income, and the proposed “permanent establishment” article was widely adopted. 35. see dries lesage, david mcnair & mattias vermeiren, from monterrey to doha: taxation and financing for development, 28:2 dev. pol’y rev. 155, 162–64 (2010). 36. see id. 37. see id. see also wouters & meuwissen, global tax governance, supra note 10, at 17. 38. the mandate of the un committee on international cooperation in tax matters, is: 2014] the unruly world of tax 71 although the european union [hereinafter “eu”] has the legal authority to coordinate indirect tax issues among its member states, it remains limited in its ability to promote other kinds of cooperation. the eu has legislative authority over indirect taxes, since these taxes affect the free movement of goods and the freedom to provide services. therefore, the eu has set common rules for the operation of value added tax [hereinafter “vat”], and has lowered the limit on vat rates that can be charged, yet has allowed considerable leeway for national differences in vat rates. excise taxes are also subject to some common rules, but the eu leaves a great deal of room for national differences. 40 in the case of direct taxes, unanimous consent of the member states is needed for eu legislation. 41 this policy is based on respect for the principle of fiscal sovereignty. however, the european court of justice [hereinafter “ecj”] can strike down domestic legislation dealing with direct taxation of a member 1. keep under review and update as necessary the united nations model double taxation convention between developed and developing countries and the manual for the negotiation of bilateral tax treaties between developed and developing countries; 2. provide a framework for dialogue with a view to enhancing and promoting international tax cooperation among national tax authorities; 3. consider how new and emerging issues could affect international cooperation in tax matters and develop assessments, commentaries[,] and appropriate recommendations; 4. make recommendations on capacity-building and the provision of technical assistance to developing countries and countries with economies in transition; 5. give special attention to developing countries and countries with economies in transition in dealing with all the above issues. see united nations economic and social council, res. 2004/69 on committee of experts on international cooperation in tax matters, e/2004/inf/2/add.3, at 14, (november 11, 2004), http://www.un.org/esa/ffd/tax/overview.htm. 39. dries lesage, taxation and the 2008 un follow-up conference on financing for development: policy recommendations, 5 (2008), www.taxjustice.net /cms/upload/pdf/doha_and_tax_0806_dries_lesage.pdf. see also tax justice network, the un is failing on international tax — so the oecd calls the shots (june 20, 2008), http://taxjustice.blogspot.com/2008/06/un-is-failing-on-in international-tax-so.html. 40. see european union, taxation (august 10, 2013), http://europa.eu/ legislation_summaries/taxation/index_en.htm (detailing the relevant eu legislation). 41. lilian v. faulhaber, sovereignty, integration and tax avoidance in the european union: striking the proper balance, 48 colum. j. transnat’l. l. 177, 181 (2010) [hereinafter faulhaber, tax avoidance in the eu]. 72 florida tax review [vol. 15:2 state if it violates “community law,” 42 that is, the legislation creates an unjustified and disproportionate obstacle to the free movement of goods, services, and capital throughout the eu’s single market. 43 the ecj, in a series of cases, struck down anti-avoidance legislation of various member states as inconsistent with the “wholly artificial arrangement” doctrine endorsed by the court. 44 still, the lack of legislative authority in the eu and the legislative vacuum induced by the ecj are problematic. 45 initiatives to harmonize the direct tax treatment of eu tax on corporations have been unsuccessful so far, mainly because legislation requires a consensus among all eu members while some have conflicting interests. it is, in fact, debatable whether any harmonization agreement would be accepted by all eu members. 46 moreover, eu rules apply only (or at least mainly) to relations among eu member states. therefore, this body in its current form is not well structured to facilitate cooperation among other countries sharing similar interests in regard to tax policy issues. the world trade organization [hereinafter “wto”] has an indirect effect on its members’ tax policies, as the agreement on subsidies and countervailing measures forbids distortive measures, including government revenue foregone or not collected (for example, fiscal incentives such as tax credits). 47 some possible tax reforms (such as implementing subtractionmethod vat with border adjustments) might contradict and be barred under the wto rules. 48 although some commentators have called for further 42. see id. at 188. 43. see id. at 189–92. 44. see id. at 193–200 (providing a detailed description and analysis of the court’s decision). these judicial decisions are limited to the relations between eu members—the legislation is valid with regard to relations between an eu member and a non-eu member. 45. see id. 46. see id. at 226–28. 47. see wouters & meuwissen, global tax governance, supra note 10, at 25–26. see also world trade organization, subsidies and countervailing measures: overview, (august 10, 2013), http://www.wto.org/english/tratop_e/scm_e/subs_ e.htm. the case law of the wto on this issue, banning the use of some fiscal policies, has an influence on current and potential domestic tax law of the member countries. some exemptions were banned as “subsidies” by the wto’s adjudicating bodies. see wouters & meuwissen, global tax governance, supra note 10, at 25– 29. 48. see itai grinberg, where credit is due: advantages of the creditinvoice method for a partial replacement vat, 63 tax l. rev. 309, 347–349 (2010). 2014] the unruly world of tax 73 intervention of the wto in tax policy matters, 49 the wto currently does not foster collaboration—it only sets constraints on tax policies adopted by member states. political conditions make it unlikely that countries would agree to allow the wto to assume some of their sovereignty in tax matters. 50 both the world bank and the international monetary fund [hereinafter “imf”] operate as economic advisors, presenting policy options and recommendations, as opposed to forums for negotiation and cooperation. the imf provides technical advice as well as policy advice to member states. 51 the g20 occasionally assigns tasks to the imf, as it is one of the “organizational instruments” of the g7/8 and the g20. 52 similarly, the world bank occasionally makes specific recommendations for particular 49. reuven avi-yonah and joel slemrod, (how) should trade agreements deal with income tax issues? 55 tax l. rev. 533–54 (2002). avi-yonah and slemrod argue that trade agreements should cover more income tax issues that are relevant to enabling free trade with no “predatory tax protectionism.” id. at 544. they also note that the multilateral nature of the trade agreement is more effective than the bilateral nature the tax treaties in addressing some problems, such as tradedistorting and “investment-distorting tax competition.” id. at 534. 50. see brauner, tax regime in crystallization, supra note 10. 51. see wouters & meuwissen, global tax governance, supra note 10, at 20. for example, tax expenditures and the need to eliminate them are discussed in the 2011 edition of the imf fiscal monitor. see international monetary fund, fiscal monitor 99-106 (april 2011), www.imf.org/external/pubs/ft/fm/2011/01/pdf/ fm1101.pdf. “ideally, revenue increases would be achieved by widening tax bases and removing distortions, rather than by raising tax rates. in many countries, the elimination of tax expenditures can contribute to this objective.” id. at 62. in the 2010 edition, the imf recommended increasing revenues efficiently by strengthening broad-based taxes on relatively immobile bases, increasing externalityreducing taxes, and strengthening tax compliance, including through better international cooperation. see imf, fiscal monitor 45-47, 4 (may 2011), www.imf.org/external/pubs/ft/fm/2010/fm1001.pdf. see also imf fiscal affairs department, the fiscal implications of climate change 12 (march 2008), www.imf.org/external/np/pp/eng/2008/022208.pdf (providing recommendations on carbon tax issues). 52. see wouters & meuwissen, global tax governance, supra note 10 at 20. for example, the statement issued by the pittsburgh summit called on the imf to prepare a report regarding the “options countries have adopted or are considering as to how the financial sector could make a fair and substantial contribution toward paying for any burdens as associated with government interventions to repair the banking system.” see supra note 29, at ¶ 16. the imf report responsive to this statement presented and discussed several tax options. see international monetary fund, a fair and substantial contribution by the financial sector 6 (june 2010), www.imf.org/external/np/g20/pdf/062710b.pdf. 74 florida tax review [vol. 15:2 developing countries, 53 and it can condition loans or grants on the adoption of its recommendations. additionally, the world bank publishes tax policy recommendations in different fields, such as carbon taxes, 54 improving tax compliance and administration, and other global or developing-countriesrelated issues. 55 neither body is a forum dedicated to achieving cooperation among countries. the international tax dialogue, which was initiated in 2002 by the imf, the oecd, and the world bank, serves as a platform for comparative data and analysis of tax issues, but not as a forum for negotiation and cooperation. 56 regional tax organizations—such as ciat, 57 cata, 58 pata, 59 iota, 60 credaf, 61 and ataf 62 —also have limited capacity to promote 53. see fred ojambo, world bank calls on uganda to widen tax base, reduce dependency, bloomberg (april 7, 2011), http://www.bloomberg.com/news /2011-04-07/world-bank-calls-on-uganda-to-widen-tax-base-reduce-dependency.html. see also judith balea, world bank: no-new-taxes plan won’t cut deficit, abscbnnews.com (december 8, 2010), http://www.abs-cbnnews.com/business/11/06/ 10/world-bank-no-new-taxes-plan-wont-cut-deficit. 54. gerard wynn, world bank to suggest global carbon tax on airline, shipping fuel (paid by you), reuters (june 5, 2011), http://www. prisonplanet.com/world-bank-to-suggest-global-carbon-tax-on-airline-shipping-fuelpaid-by-you.html. 55. see generally search for world bank group, international tax dialogue (august 10, 2013), http://www.itdweb.org/pages/search.aspx?st= 6&sort=2&c=246. 56. the international tax dialogue, or itd, was initiated in april 2002 by the imf, the oecd, and the world bank, partly in response to the call issued by the monterrey conference for enhancing international dialogue on tax matters. it is a joint initiative intended to encourage and facilitate the discussion of tax matters among national tax officials, regional tax organizations, and international organizations. the itd’s goal is to provide reliable information on all international tax matters at the global level, with an emphasis on the publication of professional, comparative, or research studies in the field. the itd’s website is a platform for countries to share documents, knowledge, and experience, in order to improve the sharing of useful information and avoid duplication of effort. all countries can use this website and make contributions. see about us, international tax dialogue (august 10, 2013), http://www.itdweb.org/pages/aboutus.aspx. 57. the inter-american center of tax administrations, or ciat, was founded in 1967. the ciat is based in panama city and has forty member and associate countries: thirty-one countries of the americas, six european countries, two african countries, and one asian country. the organization supports the efforts of national governments by promoting the evolution, social acceptance, and institutional strengthening of tax administrations, encouraging international cooperation, and exchanging of experiences and best practices. 2014] the unruly world of tax 75 58. the commonwealth association of tax administrators, or cata, was founded in 1977-1978 and has forty-eight member countries, most of which are developing countries. cata’s mission is to promote the improvement of tax administration of its members in all aspects. to this end, its activities include: “holding meetings of technical and administrative personnel in tax administration for the exchange of ideas and experiences; organi[z]ing seminars, workshops[,] and training courses on aspects of tax administration; collecting, analy[z]ing[,] and disseminating information on tax administration; providing directly or, collaborating with, and generally facilitating, the work of bilateral and multilateral agencies providing technical assistance and research facilities in the field of tax administration; generally carrying out functions related to the overall improvement of the capabilities of tax administrations through functional co-operation between and among commonwealth countries.” see commonwealth association of tax administrators const. of 1978, art. ii (2004), http://www.catatax.org/resources/ our-mission. 59. the pacific association of tax administrators, or pata, was established in 1980. the countries comprising this intergovernmental tax group consist of australia, canada, japan, and the united states, respectively represented by tax officials from their tax authorities. pata was formed in response to the increased use of certain strategies and techniques by transnational corporations to evade taxes, including transfer pricing and tax havens. its members meet at least annually to exchange information and identify specific deterrents to tax evasion activities. the main products of pata were exchange of information mechanisms, transfer pricing policies, and mutual agreement procedures between pata members. see susan c. borkowski, the history of pata and its effect on advance pricing arrangements and mutual agreement procedures, 17 j. int’l acc., auditing & tax’n 31–60 (2008). for example, pata provides principles under which taxpayers can create uniform transfer pricing documentation called a “pata documentation package” so that one set of documentation can meet each pata members’ transfer pricing documentation provisions. use of this pata documentation package by taxpayers is voluntary and does not impose any legal requirements greater than those imposed under the local laws of a pata member. this way a taxpayer can reduce compliance costs of duplicative administrative requirements in order to meet the transfer pricing documentation standards of the different jurisdictions. id. 60. the intra-european organization of tax administrations, or iota, is a non-profit organization, founded in 1996-1997, which provides a forum to assist member european countries in improving their tax administration. see what is iota, intra-european organization of tax administrations (august 10, 2013), http://www.iota-tax.org/about-iota/what-is-iota.html. iota’s mission is “to provide a forum for discussion of practical tax administration issues, to promote co-operation between tax administrations in the european region and to support their development according to their individual needs.” id. 61. the general assembly of the meeting and studies center of tax administration directors, or credaf, first met in 1972 and currently includes 76 florida tax review [vol. 15:2 collaboration among countries that share similar interests. the major focus of these organizations is on tax administration and not broader tax policy issues. moreover, the membership of most of these organizations is generally based on geography and not on shared interests in tax policy. one current forum that might serve as an example for cooperation in tax matters among a small number of countries sharing similar interests is the joint international tax shelter information centre [hereinafter “jitsic”]. jitsic was established in 2004 by the tax administrations of the united states, the united kingdom, australia, canada, and later japan, south korea, and china to supplement the ongoing work of tax authorities in these countries in identifying and curbing tax avoidance, tax shelters, and those who promote them and invest in them. 63 according to the jitsic memorandum of understanding, the member countries each appoint tax experts as officials to the jitsic. the member countries create an executive steering group to coordinate, oversee, and evaluate the work of the jitsic, with meetings held periodically in different locations. 64 although the jitsic is an interesting example of cooperation among a small number of countries, it has a narrow focus and does not deal significantly with policy issues. thirty french speaking countries, with a secretariat located in paris. see general assembly of the meeting and studies center of tax administration directors, credaf (august 10, 2013), http://www.credaf.org. 62. the african tax administration forum, or ataf, was founded in 2009 and has thirty-nine member countries. it is a platform to promote and facilitate mutual cooperation among african tax administrations (and other relevant and interested stakeholders) with the aim of improving the efficacy of their tax legislation and administrations. see african tax administration forum, ataf (august 10, 2013), http://www.ataftax.net/. its goals are similar to the aforementioned organizations. 63. see joint international tax shelter information centre, memorandum of understanding (august 10, 2013), www.irs.gov/pub/irs-utl/jitsic-finalmou.pdf [hereinafter jitsic memorandum]. jitsic’s purposes are to: provide support to the parties through the identification and understanding of abusive tax schemes and those who promote them[;] share expertise, best practices[,] and experience in tax administration to combat abusive tax schemes[;] exchange information on abusive tax schemes, in general, and on specific schemes, their promoters, and investors consistent with the provisions of bilateral tax conventions[;] enable the parties to better address abusive tax schemes promoted by firms and individuals who operate without regard to national borders. id. 64. see id. 2014] the unruly world of tax 77 iii. proposal: tax cooperation forum a. applying the “like-minded group” model to tax policy setting the most salient feature of international affairs is the absence of a global government capable of regulating activity on the international plane. this is why scholars of international relations describe the world order as anarchic. 65 however, this does not mean that the world is chaotic—far from it. as the world became increasingly globalized, it also became necessary to regulate the multitude of global activities of every type and form absent the intervention of a centralized authority. 66 this has led various actors, including states, businesses, international organizations, and civil society institutions to engage in a dynamic process involving many of the functions of governance that traditionally fall to governments. this process, called global governance, includes norm creation, standard-setting, and even the enforcement of laws and regulations. 67 it is by nature a decentralized, and at times fragmented, process that takes various forms in various fields of international affairs. the lack of international cooperation and coordination in the field of tax policy is, in many respects, a global governance problem. a large group of actors, primarily states, have a stake in harmonizing, or at least coordinating, tax policies as the actions and decisions taken by any particular state might affect the interests of other states. this means that ensuring the full effectiveness of national tax policies requires a degree of international cooperation to ensure that the measures adopted externally do not undermine national policy. moreover, tax policy affects many other areas of public policy, such as monetary and general economic policy. tax policies adopted in foreign countries impact the flow of international investments and affect 65. see generally kenneth waltz, theory of international politics (mcgraw-hill, inc., 1st. ed. 1979) (presenting an authoritative statement of this claim). 66. see david held & anthony mcgrew, globalization/antiglobalization, 1–12 (polity press, 2d ed. 2003). 67. according to one scholar, “global governance is governing, without sovereign authority, relationships that transcend national frontiers. global governance is doing internationally what governments do at home.” lawrence finkelstein, what is global governance? 1 global governance 367, 369 (1995). see also james rosenau, governance in the twenty-first century, 1 global governance 1 (1995); klaus dingwerth & philipp pattberg, global governance as a perspective on world politics, 12 global governance 185–203 (2006); thomas weiss, governance, good governance, and global governance: conceptual and actual challenges 21:5 third world quarterly 795–814 (2000). 78 florida tax review [vol. 15:2 business transitional decisions. the multiplicity of actors of varying types and disparate interests and the absence of a central body to determine and enforce policy necessitate the creation of global governance forums that bring various stakeholders together to coordinate policies. 68 this is the essence of the proposal advanced by this paper. the creation of the tcf would fill a gap in the scheme of international tax policy-making by providing a setting in which similarly minded stakeholders could coordinate their policies. 69 this proposed tcf would be modeled around, but not identical to, what is known as a ‘like minded group’ [hereinafter “lmg”] of states, which is a common practice in many international organizations, especially the un. an lmg is a noninstitutionalized, informal gathering of states sharing similar interests regarding a specific matter. 70 the practice in many international organizations is that delegations of the member countries meet to agree on common positions that satisfy their interests in order to create a negotiating bloc in international meetings or conferences. the un has established such lmgs in numerous settings, including the six main committees of the un general assembly in new york, 71 the un human rights council in geneva, 72 un specialized agencies, the wto, 73 international environmental law and policy forums, 74 and even within the osce. 75 68. see john g. ruggie, reconstituting the global public domain—issues, actors, and practices, 10:4 euro. j. int’l rel. 499–531 (2004). 69. see h. david rosenbloom, international tax policy: a current view from the united states, 41:3 australian tax rev. 133–35 (2012). 70. see generally antony j. dolman, the like-minded countries and the new international order: past, present and future prospects, 14 cooperation and conflict 57 (1979). 71. the six main committees are first committee: disarmament and international security committee; second committee: economic and financial committee; third committee: social, humanitarian, and cultural committee; fourth committee: special political and decolonization committee; fifth committee: administrative and budgetary committee; sixth committee: legal committee. see generally m. j. peterson, the un general assembly 80 (thomas g. weiss & rorden wilkinson eds., 1st. ed. 2006). 72. see philip alston, reconceiving the un human rights regime: challenges confronting the new un human rights council, center for human rights and global justice, working paper no. 4, (2006), http://www.chrgj. http://www.chrgj.org/publications/docs/wp/wps_nyu%20_chrgj_alston_final. pdf. 73. see john s. odell, introduction, in negotiating trade: developing countries in the wto and nafta 1, 17 (john s. odell ed., cambridge university press, 1st ed. 2006) [hereinafter negotiating trade]. 2014] the unruly world of tax 79 an lmg has no permanent premises, no secretariat or staff, and is not established pursuant to a treaty or a legally binding instrument. in most cases, the presidency of an lmg rotates among member states. in cases where the lmg does not fall within the framework of an international organization such as the un, the presiding state would provide secretarial services and background papers for the group’s meetings, lead discussions, facilitate debates, and speak and negotiate on behalf of the group in other forums. the principal advantage of an lmg lies in its flexibility. it allows states with different views on policy areas generally to cooperate on specific matters on which their interests converge. this means that an lmg offers countries the opportunity to achieve policy objectives without having to overcome the hurdles created by their differences in views on distinct policy areas. for example, india and pakistan, hardly political allies, were members of an influential lmg during the uruguay round of negotiations that led to the establishment of the wto. 76 furthermore, the lmg model does not require permanent membership. 77 whenever a state concludes that its interests are no longer served by membership in the lmg, it may simply terminate its participation. this presents a much lower political cost than formally withdrawing from an international organization. membership in lmgs is usually open to states that believe their interests are identical to those of other participating 74. see fen osler hampson, climate change: building international coalitions of the like-minded, 45 int’l j. 36 (1989). see also john s. odell & amrita narlikar, the strict distributive strategy for a bargaining coalition: the like minded group in the world trade organization, 1998-2001 in negotiating trade, supra note 73, at 115–144 (prepared for the conference on developing countries and the trace negotiation process, unctad, geneva). 75. see generally maria-pia kothbauer-liechtenstein & mette kongshem, the group of like-minded countries within the osce, osce yearbook 2005 at 89 (2005), http://www.core-hamburgde/documents/yearbook/english/05/kothbauerkon gshem-en.pdf. 76. see amrita narlikar & diana tussie, the g20 at the cancun ministerial: developing countries and their evolving coalitions in the wto, 27:7 the world economy 947 (2004). 77. for example, during the 2001 doha round of wto negotiations a likeminded group of countries was created that included twelve countries and two observers. the members included india and cuba. the fact that the former is the world’s largest democracy, while the latter is a communist state, demonstrates the flexibility a like-minded group offers. see amrita narlikar, bargaining over the doha development agenda: coalitions in the world trade organization, series latin american trade network papers no. 34 (2005). 80 florida tax review [vol. 15:2 countries. the latter may invite a new member to attend meetings. thus, participation is a low-key matter and very flexible. additionally, lmgs do not have formal procedures and protocols similar to those in institutionalized forums, meaning that meetings can be more efficient and focus sharply on matters of interest to participants. meetings of the lmg can be periodic, can be convened whenever the need arises, or can be held on the margins of other events. the fact that these are informal forums means there is no obligation for any particular member country to meet. this is distinguishable from other institutions that require members to meet regularly, even if there is no urgent need. finally, lmgs are essentially a negotiating bloc. members of these groups may agree on a joint position that reflects their common interests and present a common policy during meetings of international organizations. as numbers bring influence, an lmg provides a useful mechanism to increase the bargaining power of all members. meetings of lmgs are usually preceded by informal consultations between member countries about the agenda and any desired outcomes. in many global governance settings, these preparatory consultations are undertaken by technical experts and government functionaries. once the lmg concludes these meetings and reaches agreement on what items will be discussed and proposed outcomes, the lmg reviews the matters and makes the necessary decisions at the policy executive level. most lmgs have been established within the framework of a broader international organization, such as the un or the wto. the members of these lmgs coordinate positions and participate in meetings of international organizations as a bloc. the proposal advanced in this article is to create a body that is similar, but not identical, to an lmg. as indicated from the above survey of global tax policy forums, there is no central or leading international organization that oversees matters relating to taxation. therefore, the proposed tcf would not be established as a negotiating bloc within any particular forum. rather, the tcf would act independently as a coordinating forum for states whose interests within the field of taxation are similar in at least some matters. those countries would meet in the same manner as an lmg, agree on common positions and policies, and then jointly promote those common positions in the various organizations that are active in the field of international taxation, such as the oecd. in other words, the tcf could become a vehicle through which some, but not necessarily all, countries could cooperate and agree on positions regarding global tax policy. a model that might serve as a guide to the establishment of the proposed tcf is the basel committee on banking supervision [hereinafter “bcbs”], which deals with a global governance problem similar to the 2014] the unruly world of tax 81 regulation of international taxation. 78 this committee was established in 1974 to provide a forum for cooperation and coordination between central bank governors of the main world economies. 79 similar to the tcf that we propose, the presidency of the bcbs rotates among central bank governors of the participating states. in addition, the bcbs does not “possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force.” 80 rather, the bcbs has been described as “one of the central organs of global economic governance, being both the locus of financial decisionmaking and a facilitator for coordinating the actions of other international financial institutions.” 81 this is similar to the functions that the proposed tcf could perform, namely to act as a coordinating mechanism among players in the field of international taxation who have similar interests, and to enable these countries to reach common understandings and agree on joint positions that could be adopted in each participating country and advanced through other international organizations. one group of like-minded countries that could establish a tcf would include major developed economies having comparable tax systems and interests, such as the united states, the united kingdom, germany, france, and japan. other groups of countries that share similar interests could form a tcf as well. like other lmgs, the tcf would be informal and 78. like tax policies, fiscal and monetary policies are decided by national agencies. however, in an increasingly interconnected world, it is no longer tenable for states to set fiscal and monetary policies without considering the international ramifications of their domestic decisions. this change created the need for forums and mechanisms designed for the global governance of fiscal and monetary affairs. it was for this purpose the bcbs was established. indeed, as one scholar notes, “questions concerning the interface between the international nature of banking and the domestic character of financial regulation/supervision otherwise faced a political/economic/legal vacuum at this time. it was this vacuum that the bcbs filled. . . .” charles goodhart, the basel committee on banking supervision 6 (2011). 79. the membership of the bcbs currently includes the following states: argentina, australia, belgium, brazil, canada, china, france, germany, hong kong sar, india, indonesia, italy, japan, korea, luxembourg, mexico, the netherlands, russia, saudi arabia, singapore, south africa, spain, sweden, switzerland, turkey, the united kingdom, and the united states. 80. avijit chatterjee & cameron mills, risk management, in fifth gloal conference of actuaries, 161 (august 10, 2013), http://www.actuaries.org/ events/seminars/new_delhi/chapters/page-161to179.pdf . 81. duncan wood, governing global banking: the basel committee and the politics of financial globalisation (ashgate publishing limited 2005). 82 florida tax review [vol. 15:2 would not exercise legal authority over its members. its decisions and recommendations would not be binding, and it would not require an international legal instrument for its establishment. comparatively, a joint statement or communiqué by representatives of the participating states would suffice to announce that the tcf would hold regular meetings to coordinate tax policies. one design question would be whether the tcf should have a permanent staff. as noted, lmgs generally do not have a permanent secretariat or staff. if the tcf follows that model, a staff would not be costly to create. in addition, the agenda of its meetings would not be predetermined, but would be agreed upon by members depending on international developments currently requiring attention and consideration. however, the utilization of a lean staff to facilitate regular communication, prepare meetings, and shape the agenda might be beneficial. costs would still be quite low, as demonstrated by the jitsic experience. members of the jitsic each appoint tax experts as representatives; there is an executive steering group who coordinates, oversees, and evaluates the work of the tax experts. meetings of the jitsic are held periodically in different locations. 82 the implementation of decisions made by a tcf would depend on the nature of the issues considered and the understandings amongst its members. for example, if participating states decided to adopt certain measures that affected only their interests, then each respective state would oversee the implementation of those measures domestically. however, if the tcf reached an agreement that required further consultation with other states, the matter could be brought before the pertinent international forum, such as the oecd. the members of the tcf would then submit their proposals on the specific matter to these forums. like any negotiating party, the members of the tcf could agree on what they will consider to be their non-negotiable bottom lines, in which they might compromise to garner greater international agreement. in addition, the tcf could invite leading tax scholars and experts to attend meetings and express their views on the matters being discussed. representatives from participating governments would benefit from the knowledge and expertise of tax scholars who could give their opinions either as written submissions or during informal meetings, such as roundtable discussions or interactive dialogues. the tcf could also extend invitations to its meetings to representatives of international organizations that are relevant to the matter being considered by the tcf. 82. see jitsic memorandum, supra note 63. 2014] the unruly world of tax 83 b. where can the tcf make a difference? tcfs could deal with a wide range of topics. for example, a tcf could undertake to promote measures to curtail tax evasion and avoidance. as noted in part ii.a, the oecd’s efforts to fight tax evasion have only had limited success. despite the g20’s decisive 2010 statement that it is “ready to use countermeasures against tax havens,” no countermeasures were further discussed among countries that might benefit from putting pressure on tax havens. 83 the jitsic focuses on cooperation among tax administrators from the united states, the united kingdom, australia, canada, and japan in combating tax avoidance and shelters and focuses less on policy issues. a tcf could deal with broader policy issues that the jitsic does not address and could also set goals for tax administrations, instruct them on priorities, and promote other collaborative efforts to reduce tax evasion. a current example of the lack of cooperation in combating tax evasion concerns the choice between automatic information exchange (adopted unilaterally by the united states in the foreign account tax compliance act (fatca)) or anonymous cross-border tax withholding (adopted by the united kingdom in a treaty signed with switzerland in 2011 84 ). it is unclear whether the different policies are beneficial to these countries, and one may wonder whether a different result would have been achieved if the aforementioned countries tried to collaborate on those issues in advance. a tcf could also promote multilateral harmonization efforts. many commentators have suggested ideas that could improve international tax policy, but adoption of those ideas must be multilateral: promoting a multilateral tax treaty to address inconsistencies among other treaties and multilateral issues that cannot be addressed through a bilateral treaty system; 85 implementing formulaic apportionment of multinational companies’ income in a manner that would reduce incentives for income shifting through the use of transfer pricing and other planning tools 86 or other alternatives to the current transfer pricing system; 87 standardizing anti 83. g20, toronto summit declaration, (june 26-27, 2010), http://www. whitehouse.gov/the-press-office/g-20-toronto-summit-declaration. 84. see grinberg, capital income in emerging countries, supra note 2. 85. see thuronyi, international tax cooperation, supra note 3. 86. see clausing & avi-yonah, reforming taxation, supra note 4 (proposing a formulaic apportionment approach). 87. see spencer, transfer pricing, supra note 5 (discussing the flaws of the current transfer pricing system). 84 florida tax review [vol. 15:2 avoidance rules, such as the rules regarding cfcs; 88 addressing situations in which an entity is not taxed in any jurisdiction because of differences in tax laws; adopting a minimal corporate and capital income tax rate to reduce tax competition between countries that have similar economies and tax structures; 89 changing the taxation of intellectual property to limit companies’ ability to lower tax liability by use of planning tools, and reducing incentives to change location of research and development because of differences in tax systems. 90 other initiatives that might be beneficial include harmonization of reporting rules so as to make compliance less costly for taxpayers, standardizing source and transfer pricing rules, improving mechanisms for dispute resolution and administrative cooperation, and other means of making cooperation in tax administration more efficient. the lack of cooperation today can likely be explained in several ways. powerful lobbies, influential multinational companies, and other countries can put significant pressure on countries that share similar interests to prevent them from cooperating to improve their ability to tax income that is currently being evaded or avoided. these forces might limit the ability to attain effective cooperation even if the proposed tcf existed. however, while there may be inherent reasons why countries do not cooperate, the lack of a forum to facilitate collaboration between countries definitely does not help the situation. as noted earlier, the lack of coordination in the international setting is not unique to tax policy—other international institutions face similar difficulties and pressures. learning from other institutional frameworks that are used for cooperation-building can be useful for the tax policy setting as well. to the extent institutional factors have influence on policy decisions—and we believe they do— establishing a forum or a process in which countries with similar interests will better cooperate can make an actual difference in regard to tax policy issues. c. rationale and advantages the rationale for this proposal is clear: to enhance cooperation among countries that have similar interests in matters of taxation in order to 88. see burnett, cfc regimes, supra note 6. 89. see sørensen, case for coordination, supra note 7 (analyzing the harmonization of tax rates on capital income). 90. see graetz & doud, technological innovation, supra note 8 (discussing this topic and its policy alternatives). 2014] the unruly world of tax 85 maximize the national welfare of those countries. 91 greater cooperation in tax matters may, in turn, reduce current inefficiencies stemming from a lack of cooperation so as to increase global welfare as well. thus, although the reduction in sheltering opportunities may hurt some countries that benefit from providing tax shelters, it may increase worldwide welfare due to efficiency gains. 92 the potential cooperation gains are clear. first, countries today face a “competitiveness” threat: if a country adopts a strict tax policy that is not adopted by competitors, investors may shift their capital and, even if that does not occur, local businesses may be placed in an inferior competitive position. thus, even if current tax policy is inefficient and causes social waste, a lack of coordination leads countries to stick with it. cooperation among countries having similar policy interests may enable them to suppress undesired competition in an effective way. second, cooperation may provide a countermeasure to domestic political pressures and lobbies. for example, assume that tcf members reach an agreement on a particular anti-tax abuse policy. this policy could be undermined by domestic lobbies within individual member countries. however, the dynamics of the domestic legislative process may change when the policy is a result of collaboration among comparable countries—no one country may wish to stand out as rejecting the anti-abuse measures adopted by other countries. this may boost local pressure to adopt the proposal. third, cooperation among countries with similar interests increases their ability to advance their agenda and reach a broader consensus (such as within the g20). even if broad consensus is not feasible, cooperation in adopting a policy change may effectively mitigate the problem of less than full cooperation by incentivizing other countries to comply with the policy change. 93 thus, it may be advantageous for countries to cooperate even if 91. see michael j. graetz & itai grinberg, taxing international portfolio income, 56 tax l. rev. 537 (2003) (discussing alternative implementations of the national welfare approach). see also mihir a. desai & dhammika dharmapala, investor taxation in open economics international tax policy forum working paper no. 3, (2009), http://www.law.northwestern.edu/colloquium/tax/documents/ dharmapala.pdf. 92. in terms of distribution, very rich countries such as switzerland and luxemburg are some of the states that will suffer the most from reduction of sheltering opportunities. while some impoverished countries who rely on tax shelters will suffer as well, it is unclear if the inefficiency they cause justifies the distributive gain and whether there are other ways to improve distributive goals and simultaneously stimulate economic growth in these countries. 93. one example of efficiency gains from a collaboration between several states is the streamlined sales and use tax agreement, which is a multilateral 86 florida tax review [vol. 15:2 there is no global or oecd consensus. since the forum is informal, flexible, and does not infringe on members’ sovereignty, a potential member may achieve cooperation benefits with no significant risk, except in the unlikely event that a tcf forms a consensus that is contrary to the policy preference of that member. fourth, as reflected in the survey of international organizations active in the field of tax policy, negotiations in these bodies are burdened by the need to achieve consensus. this inevitably leads to the lowest common denominator, which in many cases is not the most efficient and effective policy choice. cooperation within a smaller group would provide an alternative to the lowest-common-denominator result. the existence of this alternative may increase the leverage of tcf members trying to achieve a broader consensus. fifth, when tax issues are discussed within a broader international organization, such as the oecd or g20, they naturally must compete for the attention of policy makers with other non-tax matters and issues. for example, the ministers of finance at the g20 have a long list of topics that need to be discussed and agreed upon, meaning that international tax policy may not receive the requisite attention and consideration. having a forum focused on tax policy would be desirable. moreover, establishing the forum would be practical, inexpensive, and politically feasible. the forum should complement the current international institutions and thus should not give rise to strong opposition in its formation. the proposed model does not impugn the role of the oecd in negotiating for a broad consensus, developing standards regarding global issues, and providing data and analysis for policy-making. the proposed model may even increase the importance of the oecd as a negotiator and consensus achiever. in addition, since this forum is informal, flexible, and resembles other forums in the international sphere, it would probably be readily accepted without opposition. an informal body should not offend sensitivities regarding the inclusion or exclusion of different countries. iv. conclusion this article proposes the implemenation of tax cooperation forums, informal forums for coordination among countries that share similar agreement between several states in the united states to harmonize their sales tax systems (after attempts by states to prevent buyers from avoiding sales wax were struck down by the supreme court of the united states as a violation of the commerce clause of the u.s. constitution). see faulhaber, tax avoidance in the eu, supra note 41, at 228–29. 2014] the unruly world of tax 87 interests in tax policy, an institution that is currently missing in international tax policy-setting. the ability of existing institutions and forums that affect tax policy today to achieve effective cooperation in international tax matters is both limited and problematic. the proposed model would maximize national welfare for cooperating countries, and possibly promote global welfare by reducing current inefficiencies. any group of countries that share similar interests in tax policy could establish such a forum. all that would be needed for creating the forum is a joint or parallel statement or communiqué by the ministers of finance of participating states announcing that they would hold regular meetings to coordinate their tax policies. we mention two major projects this forum could promote—efforts to curtail tax evasion and efforts to harmonize different aspects of tax policy. the advantages of this model are significant. cooperation among countries sharing similar interests would benefit them by reducing the “competitiveness” threat. such cooperation might be utilized to advance policies and achieve consensus in tax matters and, if consensus is not in reach, to set a coordinated policy which may be preferable to the status quo or acting unilaterally. this model would allow different groups of states sharing similar interests to set their own tax policy agendas and cooperate on issues that are not of broad interest, which appears practical and feasible. for all of these reasons, we believe the proposed model deserves serious consideration. florida tax review volume 10 2010 number 3 investment income withholding in the united states and germany by professor lily kahng* i. introduction .................................... ...... 316 ii. the taxation of income from labor and income from capital in the united states...........................316 iii. disparate tax enforcement in the united states ......... 321 a. in general ................................ 321 b. withholding..................... .......... 322 iv. germany's withholding experience ......................... 327 a. constitutional limits on tax legislation: background ....327 b. constitutional mandate for withholding on interest income ................................. 329 c. luxembourg.. ............................... 332 d. liechtenstein .......................... ..... 334 e. the court that started it all................. ........ 336 v. the case for investment income withholding .............. 337 a. equality in enforcement........................337 b. practical and political considerations ........ ........ 338 associate professor, seattle university school of law. i am grateful to karen brown, henry ordower, and the participants of the 2009 international tax symposium at the university of florida fredric g. levin college of law for their helpful comments. i also thank seattle university law librarian kelly kunsch and research assistants james beebe, thomas chang, and cory lizarraga. 315 florida tax review investment income withholding in the united states and germany by professor lily kahng i. introduction in a reversal from its historical roots, the united states income tax system now taxes income from labor significantly more heavily than income from capital. it does so not only facially, through explicit preferences for income from capital, but also more subtly, through more hidden features of the tax system specifically, enforcement strategies. this article focuses on a prominent disparity in enforcement between the two forms of income: wage income is subject to withholding while investment income is not. in its critical examination of this disparity, the article first offers a brief history of withholding in the united states, in which withholding on wage income was eagerly embraced as a part of a patriotic war effort, while withholding on investment income was rejected again and again. the article then contrasts the united states experience with that of germany. under germany's remarkably robust constitutional principle of equality in taxation, the failure to withhold on interest income was held unconstitutional, and the german legislature was required to enact it. however, instead of leading to greater equality in tax enforcement, the new withholding law led to widespread evasion. the german experience is cited as a cautionary tale on the dangers of international tax competition. yet, ultimately, it may prove to have been the tipping point for countries to engage in the cooperative behavior needed to overcome undesirable tax competition. the last part of the article draws upon lessons learned from past u.s. and german experiences to make the normative and practical case that now is the time to adopt investment income withholding in the united states. ii. the taxation of income from labor and income from capital in the united states the united states tax system has almost always differentiated between income from capital, on the one hand, and income from labor, on the other. when originally adopted in 1913, the income tax was targeted to wealthy taxpayers' income from capital, which, until then, had largely escaped taxation under the scheme of consumption taxes that funded the 316 [vol. 10:3 2010] investment income withholding in the united states and germany 317 federal government.' lawmakers intended the upper classes to pay the lion's share of the income tax, in part to balance out the regressive effects of consumption taxes, 2 while lower income wage earners paid little or no income tax.3 not until world war ii did the income tax begin to have a significant impact on wage earners, shifting from "class tax to mass tax," as professor carolyn jones so aptly phrases it.4 philosophically, income from labor was thought to be morally superior to income from capital. according to professor marjorie kornhauser, the heightened moral status of income from labor is grounded in two important value systems the protestant equation of work with godliness and the republican conception of equality: only by earning money can one do god's work and thus display signs of grace. unearned income does not display the same grace. moreover, since work is a calling through which one enhances the public good, one is only a trustee or steward of the wealth one has.... [t]he heir has no moral right to the wealth primarily because he did not earn it.... republican equality also affects attitudes about the source of wealth: it is acceptable to receive money as a result of one's own talent and industry because that is what america is about equal opportunity for achievement based on merit. it is quite another thing to acquire money through inheritance, because that practice continues the influence of heredity, the "dead hand" of property.s considerations of fairness and distributive justice also favored taxing income from labor more lightly than income from capital. john stuart mill 1. see john witte, the politics and development of the federal income tax 77 (1985). 2. see generally erik m. jensen, the taxing power, the 16th amendment, and the meaning of "incomes," 33 ariz. st. l.j. 1057 (2001) (detailing lawmakers' concern, in adopting the income tax, that the tax burden be distributed appropriately across all classes, including the wealthy). 3. fewer than 2% of workers filed income tax returns between 1913 and 1915. see witte, supra note 1, at 78. 4. carolyn c. jones, class tax to mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685 (1989). as compellingly documented by professor jones, the transformation of the income tax took place quickly and completely. in 1942, 42 million taxpayers paid income taxes in 1945, compared to 7 million in 1940. id. at 686. by 1943, 68.9% of americans were subject to the income tax, compared to just 2.6% in 1933. id. at 695. 5. marjorie e. komhauser, the morality of money: american attitudes toward wealth and the income tax, 70 ind. l.j. 119, 128-29 (1994). florida tax review argued that those who work for a living have less ability to pay taxes than those who live off accumulated capital because they have only a finite period of time in which they can work and must save for retirement and illness.6 a related argument is that those who earn income from labor must sacrifice leisure, and therefore are less well off than those whose income is derived from capital.' in a remarkable reversal from its historic and philosophical roots, today's tax system strongly prefers income from capital over income from labor. this is most prominently evidenced by the differing rates of tax imposed on the two categories of income a maximum effective rate of 35% on earned income and generally 15% on long term capital gains and dividends.! the recent controversy surrounding huge payouts to private equity and hedge fund managers illustrates the stakes. in 2006, the top 25 hedge fund managers were reportedly paid an average of $570 million, with the high payout at $1.7 billion. if characterized as compensation from labor, the payouts would be subject to tax at 35%; if, on the other hand, treated as investment returns, they would be taxed at a mere 15%.9 6. 2 john stuart mill, principles of political economy 315 (the colonial press 1899) (bk. v, ch ii). mill ideally would have exempted all savings from tax, but short of that, supported a lighter tax on income from labor than income from capital. see marjorie e. kornhauser, equality, liberty, and a fair income tax, 23 fordham urb. l.j. 607, 658-59 (1996); edward j. mccaffery, a new understanding of tax, 103 mich. l. rev. 807, 809-12 (2005). 7. this argument is advanced by the british mead committee in its report recommending the adoption of a gratuitous wealth transfer tax. see j. e. meade, institute for fiscal studies, the structure and reform of direct taxation 350 (1978) [hereinafter meade report]. though describing the meade report as "distinguished," professor eric rakowski dismisses this argument as "not worth lingering over." eric rakowski, can wealth taxes be justified, 53 tax l. rev. 263, 334, 358 (2000). 8. irc § 1. some forms of income from capital, such as interest, rents and royalties, are taxed at the same rates as earned income. in addition, the 15% tax rate on dividends is scheduled to expire on dec. 31, 2010. economic growth and tax relieve reconciliation act of 2001, p.l. 107-16, § 901(a)-(b), 115 stat. 38 (2002). 9. see lee a. sheppard, blackstone proves carried interests can be valued, 115 tax notes 1236 (june 25, 2007). ms. sheppard reports that the top 25 hedge fund managers were paid an average of $570 million in 2006, with the high payout at $1.7 billion, and argues that the payouts ought to be taxed at ordinary income rates as compensation, rather than at capital gains rates as a "carried interest" (a speculative profits interest in a partnership). she notes that former treasury secretary robert rubin, and even the "notoriously antitax" economist magazine, endorse this view. see victor fleischer, two and twenty: taxing partnership profits in private equity funds, 83 n.y.u. l. rev. 1 (2008) (arguing against capital gain treatment of carried interests); david a. weisbach, professor says carried interest 318 [vol. 10:3 2010] investment income withholding in the united states and germany 319 the other most prominent difference in the treatment of income from capital and income from labor is that the latter is subject to additional taxes under the federal insurance contribution act.o these payroll taxes, intended to fund social security and medicare, have been called the "neglected stepchild of policy analysis," often ignored because academics and policymakers find them conceptually uninteresting or dislikeably regressive." however, it is becoming increasingly hard to ignore their impact. in 2008, payroll taxes accounted for 36% of total federal receipts, 2 and, as of 1999, almost two-thirds of families paid more in payroll taxes than in income taxes. payroll taxes contribute significantly to the heavy tax burden on income from labor. income from capital is treated favorably in a variety of other ways.14 for example, the tax on capital gains is deferred until the occurrence of a realization event, further lowering the effective rate of tax. if an appreciated asset is held until death, the tax is entirely eliminated. 5 gains realized on legislation is misguided, 116 tax notes 505 (aug. 6, 2007) (arguing for capital gain treatment of carried interests). 10. federal insurance contributions act, irc §§ 3101-3128 [hereinafter, fica]. fica imposes a tax of 6.2% on wages up to $102,000 (in 2008) and an additional 1.45% with no cap. irc §§3101, 3111. see generally, deborah a. geier, integrating the tax burdens of the federal income and payroll taxes on labor income, 22 va. tax rev. 1 (2002). 11. patricia e. dilley, breaking the glass slipper reflections on the selfemployment tax, 54 tax law. 65, 65 (2000). 12. congressional budget office, budget and economic outlook: fiscal years 2009 to 2019, at 16, table 5 (2009). 13. andrew mitrusi & james poterba, the changing importance of income and payroll taxes on u.s. families, 15 tax pol'y & econ. 95, 101 (2001). 14. see generally william j. turnier, theory meets reality: the case of the double tax on material capital, 27 va. tax rev. 83 (2007) (detailing comprehensively ways in which income from capital and income from labor are treated differently). professor tumier begins with proposition that a pure income tax actually taxes income from capital more heavily than income from labor. id. at 8993. however, once he examines specifics of our actual system, he states that, particularly in light of payroll taxes, "most reasonable observers [would] conclude that, under the code, human capital bears at least, and likely more than, its fair share of the tax burden." id. at 125. 15. in general, gains of property held at death are free from income tax because the transferee of the property takes a basis equal to the property's fair market value on the date of the decedent's death. irc §1014. of course, the transferred property may be subject to the estate tax, if the decedent's taxable estate is large enough and if the decedent neglects to engage in the wealth of planning opportunities that allow him to minimize the estate tax. professor mccaffery has formulated a memorable summary of all a taxpayer needs to do to avoid income and estate tax on financial capital: "buy, borrow, die." mccaffery, supra note 6, at 890. florida tax review "like-kind exchanges" are deferred,16 and gains realized on the sale of a principal residence are exempt.' 7 to be sure, income from capital is not always treated more favorably than income from labor. it is easy to come up with examples to the contrary. thus, for example, dividend income is nominally taxed twice under our classical system of corporate taxation, first at the corporate level when earned, and then at the shareholder level when distributed. 8 and while income from labor is taxed at more than double the rate of capital gains and dividends (at the maximum rates), and is subject to additional, significant payroll taxes, it receives favorable treatment in other respects. for example, imputed income from services performed for oneself or one's family is untaxed.' 9 at low income levels, the earned income tax credit arguably produces a negative tax rate.20 nonetheless, it is clear that the balance has shifted in favor of income from capital over income from labor.21 the next part examines the more hidden ways in which income from capital is preferred in particular, through enforcement strategies. 16. irc § 1031. 17. irc § 121. 18. see generally jennifer arlen & deborah m. weiss, a political theory of corporate taxation, 105 yale l.j. 325 (1995); terrence r. chorvat, apologia for the double taxation of corporate income, 38 wake forest l. rev. 239 (2008). 19. see generally nancy c. staudt, taxing housework, 84 geo. l.j. 1571 (1996). 20. i say "arguably" because when viewed in conjunction with payroll taxes, the earned income credit does not result in a negative tax rate. see generally anne l. alstott, the earned income tax credit and the oversimplified case for tax-based welfare reform, 108 harv. l. rev. 533 (1995). 21. see john buckley, tax changes since woodworth's time: implications for future tax reform, 34 ohio n.u. l. rev. 1, 7-8 (2008); turnier, supra note 14, at 125; stewart karlinsky & hughlene burton, america's inexorable move to a consumption-based tax system, or, why warren buffett is winning the class tax war, 105 tax notes 699, 699-700 (nov. 1, 2004). as professor kornhauser observes, the shift has not been linear. tax law changes have sometimes favored income from labor and sometimes favored income from capital, reflecting americans' ambivalent attitudes about wealth. kornhauser, supra note 5, at 168-70. see also, dennis j. ventry jr., equity versus efficiency and the u.s. tax system in historical perspective, in tax justice (eds. joseph j. thorndike & dennis j. ventry jr. 2002) at 25-70. though professor komhauser believes that the current system is a sincere reflection of our conflicting attitudes about wealth, i am more cynical than she, and believe it increasingly promotes the interests of the powerful and wealthy. [vol. 10:3320 2010] investment income withholding in the united states and germany 321 iii. disparate tax enforcement in the united states a. in general the preceding part describes explicit aspects of the preferential tax treatment of income from capital. this preference for income from capital is also discernible in more subtle ways. in particular, enforcement strategies with respect to income from capital and income from labor diverge quite dramatically. the recently enacted "tax holiday" of section 965 as a response to the "deferral problem"2 2 exemplifies the ineffectual enforcement effort often undertaken with respect to income from capital. in 1998, the treasury department and internal revenue service sought, through regulatory action, to limit a major cause of the deferral problem. 23 faced with a firestorm of objections by corporate taxpayers and their lobbyists, 24 and under pressure from congress, the irs retreated. untaxed profits continued to accumulate offshore. then, in 2004, congress enacted section 965, under which the multinationals were able to repatriate earnings at a tax cost hundreds of billions of dollars less than they would ordinarily have incurred.25 the tax holiday was purportedly a quid pro quo, under which, in exchange for the low rate of tax on repatriated earnings, the multinationals were supposed to invest the earnings domestically. however, critics of the holiday characterize it as a pure windfall to the multinationals. 26 the proliferation of tax shelters in the last decade provides another example of the ineffectual enforcement efforts on income from capital. this recent generation of shelters was largely designed to reduce corporate tax liabilities, ultimately benefiting the return on corporate investment.27 another 22. "deferral problem" refers to the ability of multinational corporations to defer offshore profits that probably ought to have been taxed currently under subpart f principles. see generally keith engel, tax neutrality to the left, international competitiveness to the right, stuck in the middle with subpart f, 79 tex. l. rev. 1525 (2001); lawrence lokken, whatever happened to subpart f? u.s. cfc legislation after the check-the-box regulations, 7 fla. tax rev. 185 (2005). 23. see notice 98-11, 1998-1 c.b. 433. 24. see engel, supra note 22, at 1552-57. 25. see martin a sullivan & lee a. sheppard, multinationals accumulate to repatriate, 122 tax notes 295 (jan. 19, 2009); robert goulder, if in doubt, blame check the box, 119 tax notes 1061 (june 9, 2008). 26. see lynnley browning, a one-time tax break saved 843 corporations $265 billion, n. y. times, june 24, 2008 ("it basically worked out to be one big giveaway," quoting robert willens, a tax and accounting authority in new york); see also, lisa m. nadal, repatriation gluttony was it worth it? 119 tax notes 1228 (june 23, 2008). 27. see generally joseph bankman, the new market in corporate tax shelters, 83 tax notes 1775 (june 21, 1999). florida tax review major area of enforcement failure is in the collection of taxes on capital gains, where no meaningful efforts are made to prevent taxpayers from overstating basis.28 this is not to say that enforcement efforts do not also fall short in collecting tax on income from labor. notably, sole proprietors of unincorporated businesses, who presumably derive a significant proportion of their income from their labor, are among the least compliant taxpayers, and, in 2001, accounted for an estimated $68 billion of the $345 billion tax gap.29 but when it comes to collecting tax on wages paid to employees, one enforcement mechanism has been devastatingly effective: wage withholding. 30 b. withholding withholding is a simple concept. the payor holds back a portion of a payment and remits it to the tax authorities, to be applied against the payee's tax liability. modem wage withholding came in during the world war ii, and the tax system has never looked back.3 1 withholding was particularly useful during wartime, when revenue needs were high, immediate, and volatile.32 in addition, it was an attractive way to ensure collection from the expanded rolls of new taxpayers, who had no experience filing a tax return or putting funds aside for the payment of taxes. withholding first gained a toehold in 1942, as the means for collecting the "victory tax," a special 5% 28. see joseph m. dodge & jay a. soled, inflated tax basis and the quarter-trillion-dollar revenue question, 106 tax notes 453, 454-61 (jan. 24, 2005) (taxpayers overstate tax basis with impunity because there are no serious deterrents from doing so, underpaying taxes by an estimated $250 billion over 10 years). 29. see irs tax gap facts and figures, 11 available at http://www.irs.gov/pub/irs-utl/taxgap facts-figures.pdf; u.s. gov't accountability office report to the committee on finance, u.s. senate, tax gap: a strategy for reducing the gap should include options for addressing sole proprietor noncompliance (july 2007), available at http://www.gao.gov/new.items/d071014. pdf. 30. irc § 3402. 31. for a history of withholding, see generally, richard l. doemberg, the case against withholding, 61 tex. l. rev. 595, 599-603 (1982); jones, supra note 4, at 695-99; charlotte twight, evolution of federal income tax withholding: the machinery of institutional change, 14 cato j. 359, 367-90 (1995). the united states' first experience with income tax withholding on wages and interest actually occurred from 1913 to 1917. it was extremely unpopular, and it was replaced in 1917 by an information reporting system. see doemberg at 600. 32. see doemberg, supra note 31, at 601; jones, supra note 4, at 697. 33. see doemberg, supra note 31, at 601-02; jones, supra note 4, at 695-96. 322 [vol. 10:3 2010] investment income withholding in the united states and germany 323 gross income tax on wages and salaries.3 4 just one year later in 1943, extolling taxpayer convenience and patriotic sacrifice, congress enacted comprehensive wage withholding.35 withholding has proven to be the single most effective enforcement mechanism for collecting taxes on income from labor. 36 the "tax gap" for wage income the amount by which taxpayers fail to file their returns and pay the tax due on time has consistently been measured at less than 1%.31 (by way of comparison, the overall tax gap is estimated to be 15% 16%.)38 withholding could easily be adopted for dividends, interest and other investment income, which are currently subject to information reporting. 34. see doemberg, supra note 31, at 601; jones, supra note 4, at 695. 35. see doernberg, supra note 31, at 602-03; twight, supra note 31, at 38285. 36. see generally, leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stan. l. rev. 695, 698, 731-33 (2007) (withholding uses both employee and employer as third party enforcer of their respective obligations); edward k. cheng, structural laws and the puzzle of regulating behavior, 100 nw. u. l. rev. 655, 675-81 (citing withholding as an example of effective "structural" enforcement mechanism); piroska soos, selfemployed evasion and tax withholding: a comparative study and analysis of the issues, 24 u.c. davis l. rev. 107, 126-130 (1990) (withholding is an efficient, reliable way to collect tax; it improves compliance in payment and reporting); but see doemberg, supra note 31, at 603-31 (analyzing the shortcoming of withholding as an enforcement mechanism). 37. irs, u.s. dep't of the treasury, federal tax compliance research: individual income tax gap estimates for 1985, 1988, and 1992 [hereinafter tax gap estimates], at 8 tbl. 3, 15 tbl. 7 (rev. ed. 1996) (tax gap information for 1992, 1988, and 1985). this data was collected by the irs under its taxpayer compliance management program (tcmp). the tcmp was discontinued in 1994, so comparable data from more recent years is not available. the program was revived by former irs commissioner charles rossotti in 2002, and renamed the national research program (nrp). see irs new release, irs moves to ensure fairness of tax system; research program works to increase compliance program effectiveness, reduce burdens on taxpayers, rel. no. ir-2002-05 (jan. 16, 2002). the nrp has compiled and published tax gap data for 2001, and the tax gap for income subject to withholding appears to be in a similar range. irs tax gap facts and figures, at 11 (reporting a tax gap of 1.2% 1.4% for wages, salaries, tips, etc.). see eric toder, what is the tax gap?, 117 tax notes 367 (oct. 22, 2007) (describing the preliminary findings of the nrp and ways in which its methodology differs from the tcmp). 38. see tax gap estimates, at 8 tbl.3, 15 tbl. 7. 39. compliance rates for income subject to information reporting are better than for all sorts of income, but not as high as for income subject to withholding. see michael brostek, tax gap: multiple strategies, better compliance data, and long-term goals are needed to improve taxpayer compliance, gao, oct. 25, 2005, available at http://www.gao.gov/new.items/d06208t.pdf (putting the rate of florida tax review indeed, many other industrialized countries do impose withholding on investment income.40 it is therefore mystifying that the united states has not availed itself of this powerful enforcement tool to collect taxes on investment income. perhaps our reluctance is not mystifying, but rather, all too predictable, in light of the interests opposed to investment income withholding. in 1942 and 1943, wage withholding was embraced in the throes of a patriotic fever that inspired such slogans as "taxes to beat the axis."41 withholding on dividends and interest, on the other hand, was proposed, but withdrawn in the face of objections by banks and corporate 42interests. in the years that followed, many legislators and policymakers continued to be intrigued by the idea of deploying the powerful enforcement mechanism of withholding to collect taxes on investment income as well as wages. just as clearly, banks continued to resist the idea. in 1950, the house noncompliance for income subject to some information reporting at 7.1% and for income subject to substantial information reporting at 4.2%). see also, james b. mackey, narrowing the tax gap, at slide 7, available at http://www.irs.gov/pub/irssoi/07researchtaxgapmackie.ppt (putting the tax gap for information reporting at 4.5%). however, the compliance rates for all investment income including unreported income from hidden offshore accounts is likely dramatically lower than this. see joseph guttentag & reuven avi-yonah, closing the international tax gap, in bridging the tax gap: addressing the crisis in federal tax administration (max b. sawicky, ed., 2006) (estimating offshore tax evasion by individuals at $40-$70 billion annually in lost u.s. tax revenues). 40. for withholding in australia, see, 951-3rd foreign income portfolios (bna) at xii-a (withholding on interest); for withholding in germany, see, jorgdietrich kramer, germany, 3 tax notes int'l 853, 854-855 (aug. 1991) (interest withholding); for withholding in israel, see, 967-4th foreign income portfolios (bna) at xi-e (interest, dividend, and miscellaneous other withholding provisions); for withholding in italy, see, 968-3rd foreign income portfolios (bna) at x-h(1) (withholding on select dividend and interest income); for withholding in new zealand, see, 975-2nd foreign income portfolios (bna) at xi-d (withholding on most dividends); for withholding in the netherlands, see, 973-2nd foreign income portfolios (bna) at ix-a and vii-b(2) (withholding on dividends); for withholding in puerto rico, see, 980-1st foreign income portfolios (bna) at x-e (withholding on dividends from certain, mostly resident corporations); for withholding in switzerland, see, 986-3rd foreign income portfolios (bna) at xii-e (withholding on most interest, dividends, and investment income); for withholding in the uk, see, hmrc, revenue and customs brief 47/08, available at http://www.hmrc.gov.uk/briefs/company-tax/brief4708.htm (withholding on interest). 41. jones, supra note 4, at 723 (describing a treasury commissioned pro-tax film starring donald duck, filling out a tax return). 42. see doemberg, supra note 31, at 600-01. 324 [vol. 10:3 2010] investment income withholding in the united states and germany 325 of representatives passed legislation imposing withholding on dividends, interest, and royalties.4 3 the senate rejected the provision in the final bill." in 1951, the house tried again;45 again, the senate refused.4 the kennedy administration put forth a dividend and interest withholding proposal again, in 1962. the house approved a bill providing for withholding at a rate of 20% on interest and dividends,47 and again, the financial services industry managed to beat it back.48 congress instead expanded and strengthened the information reporting scheme for interest and dividends, persuaded by the banks that this would work equally well in improving compliance. 49 this has not proven to be the case.50 in 1980, the carter administration proposed a 15% withholding tax on interest and dividend payments5' as part of a package of anti-inflationary measures.5 2 the proposal of the unpopular president was given a chilly reception by the house. only one congressman expressed support for the new tax, and the proposal died quickly and quietly.5 3 finally, mirabile dictu, congress succeeded in enacting dividend and interest withholding, as part of the tax equity and fiscal responsibility act of 1982.54 the law was enacted over the objections of the financial services industry (and many lawmakers) as a result of "astute parliamentary leadership"" and strong support from the charismatic and popular president reagan. 56 the financial services industry protested that withholding would 43. h.r. 8920, 81st cong. (1950). 44. revenue act of 1950, s. rep. no. 2375, 81st cong., 2d sess. (1950). 45. h.r. rep. no. 586, 82nd cong., (1951). 46. revenue act of 1951, s. rep. no. 781, 82nd cong., (1951). 47. h.r. rep. no. 1447, 87th cong., 2d sess. (1962). 48. see john t. scholz, compliance research and the political context of tax administration, in 2 taxpayer compliance: social science perspectives (jeffrey a. roth & john t. scholz eds., 1989) at 22). 49. see doemberg, supra note 31, at 632-41 (setting forth history of information reporting and its inadequacies compared to withholding). 50. see doemberg, supra note 31, at 632-41 (setting forth history of information reporting and its inadequacies compared to withholding). 51. see judith miller, withholding on interest, dividends to be asked, n.y. times, mar. 14, 1980. 52. see edward cowan, taxes withholding plan on interest, n.y. times, apr. 28, 1980. 53. president's proposal for withholding on interest and dividends: hearing before the house comm. on ways and means, 96th cong., 96-92 (1980); see also edward cowan, committee is cool to dividend withholding tax, n.y. times, apr. 30, 1980. 54. the tax equity and fiscal responsibility act of 1982 [hereinafter tefra] § 301, pub. l. no. 97-248, 96 stat. 324. 55. see scholz, supra note 48, at 22. 56. see twight, supra note 31, at 389. florida tax review impose undue hardship on elderly or low income individuals, and small savers; congress responded by exempting these payments from the new law. banks and corporations also complained that withholding would unfairly shift the cost of .collecting the tax from the government to them; again, congress accommodated them by allowing them to invest the withheld amounts for 30 days before remittance to the government.5 8 finally, in desperation, the financial services industry managed to procure a six month delay in the start of the new law, until july 1, 1983, pleading that they needed more time to implement withholding. instead, they used the extra time to launch a national campaign for the repeal of the law. according to a report prepared by the u.s. house of representatives democratic study group, banks included inserts in the year-end statements mailed to millions of depositors, telling them that "10% of your savings is going to disappear" because of the withholding law, and that "the government is going to loot your savings." bank statements also included form letters and postcards for customers to mail to members of congress urging repeal of the law. measured by the amount of "protest mail" congress received, interest and dividend withholding was more unpopular than the vietnam war.59 the financial services industry prevailed, and in 1983, dividend and interest withholding was repealed retroactively without ever having taken effect.60 the industry's victory was decried by treasury officials, members of the tax bar, and commentators as a historic low point in the precedence of special interests over the common good. withholding, used continuously and highly successfully to collect taxes on income from labor since 1942, has never been used to collect taxes on income from capital.62 57. tefra § 301. see michael h. hoeflich, withholding at source on non-wage income: a brief historical excursus, 19 tax notes 678, 679 (may 23, 1982). 58. id. 59. see h.r. rep. no. 98-7, special report, u.s. house of representatives democratic study group (1983). 60. interest and dividend tax compliance act of 1983 § 102(a), pub. l. no. 98-67, 97 stat. 369. see generally hoeflich, supra note 57 (noting the parallels between the tefra and the 1917 repeal of withholding). 61. see federal bar association's section of taxation, the condition of the tax legislative process, 39 tax notes 1581, 1590 (june 27, 1988) ('grassroots' lobbying regarding tefra interest and dividend withholding provision was inappropriate). 62. dividends and interest and security sale proceeds are subject to backup withholding in cases where taxpayers fail to provide taxpayer identification information. irc § 3406. however, unlike wage withholding, backup withholding can be avoided by providing the required information. 326 [vol. 10:3 2010] investment income withholding in the united states and germany 327 iv. germany's withholding experience a. constitutional limits on tax legislation: background germany's experience with disparate enforcement of its tax laws presents a vivid contrast to that of the united states, most importantly because of the german federal constitutional court's interpretation of germany's basic law. as professor ordower demonstrates in his authoritative article, the constitutional court is much more inclined than the u.s. supreme court to invoke constitutional equality principles to limit and shape tax laws.63 thus, for example, the constitutional court has interpreted the general equality clause of the basic law," in conjunction with the constitutional protection of the family,6s to require that a subsistence 63. see henry ordower, horizontal and vertical equity in taxation as constitutional principles: germany and the united states contrasted, 7 fla. tax rev. 259, 259-335 (2006); see also hugh j. ault & brian j. arnold, comparative income taxation: a structural analysis 54 (2d ed. 2004); david p. currie, the constitution of the federal republic of germany 52-60 (1994); gerald l. neuman, constitutional equality: equal protection, "general equality" and economic discrimination from a u.s. perspective, 5 colum. j. eur. l. 281, 308-09 (1999) (noting that the constitutional court has applied equality principles particularly vigorously in the context of tax laws). cf stephen w. mazza & tracy a. kaye, restricting the legislative power to tax in the united states, 54 am. j. comp. l. 641, 641-670 (2006) (describing potential constitutional challenges on the legislative power to tax, but concluding that most challenges fail due to courts' extreme deference to the legislature on tax matters). 64. article 3 (equality before the law) (1) all persons shall be equal before the law. (2) men and women shall have equal rights. the state shall promote the actual implementation of equal rights for women and men and take steps to eliminate disadvantages that now exist. (3) no person shall be favored or disfavored because of sex, parentage, race, language, homeland and origin, faith, or religious or political opinions. no person shall be disfavored because of disability. 65. id. at art. 6 (marriage and the family; children born outside of marriage) (1) marriage and the family shall enjoy the special protection of the state. (2) the care and upbringing of children is the natural right of parents and a duty primarily incumbent upon them. the state shall watch over them in the performance of this duty. (3) children may be separated from their families against the will of their parents or guardians only pursuant to a law, and only if the parents or guardians fail in their duties or the children are otherwise in danger of serious neglect. florida tax review minimum be exempt from tax, and further, that the exempt amount be adjusted to take into account dependent children.6 similarly, the court has held that mandatory joint filing by married couples is constitutionally prohibited where it would result in a marriage penalty (that is, a greater tax liability for the married couple than for two unmarried individuals with comparable income). the court has also flexed its constitutional muscle in tax areas outside of family and personal expenses. it invalidated the inheritance tax and the wealth tax because their valuation methods undervalued real property, which resulted in a disproportionately low tax burden on taxpayers owning real property relative to taxpayers owning other sorts of property. (4) every mother shall be entitled to the protection and care of the community. (5) children born outside of marriage shall be provided by legislation with the same opportunities for physical and mental development and for their position in society as are enjoyed by those born within marriage. 66. see ordower, supra note 63, at 308-16; neuman, supra note 63, at 309; rainer prokisch & michael rodi, german constitutional court rules amount of basic allowance for income tax purposes is unconstitutional, 6 tax notes int'l 137 (jan. 18, 1993); willi leibfritz, wolfgang buttner & ulrich van essen, the tax system of germany, 10 tax notes int'l 465, 481-82 (feb. 6, 1995). see also johannes frey & axel mielke, german courts issue landmark decision on family tax benefits, 18 tax notes int'l 839 (mar. 1, 1999); ralph atkins, german court says tax breaks must extend to married couples, 18 tax notes int'l 453 (feb. 1, 1999) (tax allowances for single parents constitutionally required for married couples with children). as professor ordower points out, the notion that deductions for basic living expenses are constitutionally mandated would be considered outlandish under united states law, where such deductions are allowed only as a matter of legislative grace. see ordower, supra note 63, at 308. as a policy matter, though, the idea of exempting subsistence amounts is an appealing one. see deborah a. geier, the taxation of income available for discretionary use, 25 va. tax rev. 765 (2006). 67. see ordower, supra note 63, at 318-23. as a result of the court's decision, the legislature adopted an elective joint filing system for married couples. id. 68. see ordower, supra note 63, at 327-28; jens blumenberg, german taxation of real estate based on assesses unit values held unconstitutional, 11 tax notes int'l 703 (sept. 11, 1995). the wealth tax has not been in effect since 1997. the valuation rules for the inheritance tax were amended to cure the constitutional deficiencies and allow the inheritance tax to continue. however, in 2007, the court found other valuation rules under the inheritance tax to be unconstitutional. see darryl tait, court declare inheritance tax unconstitutional, 45 tax notes int'l 552 (feb. 12, 2007); clemens phillip schindler & sima maria qamar, inheritance taxes in austria and germany, 46 tax notes int'l 1221 (june 18, 2007). the court required the tax to be amended by dec. 31, 2008, which the 328 [vol. 10:3 2010] investment income withholding in the united states and germany 329 in the area of business taxes, the court struck down a turnover tax exemption for laboratory medical services because it was available only to unionized labs, thereby discriminating against independent labs.69 the court has not shied away from scrutinizing the finer details of the tax law. for example, the court invalidated on the grounds that it violated the constitutional equality principle and the family protection principle a two-year limit on the deductibility of duplicate household expenses.7 0 the court also recently struck down a provision eliminating a commuting tax allowance for commutes of 20 kilometers or less.7 ' in view of the court's assertive approach with respect to tax matters, it is perhaps not surprising that tax enforcement measures would also be tested under the constitutional equality principle. specifically, with respect to taxes imposed on investment income, the court has on two occasions found that inadequate enforcement in the collection of the taxes violated the equality principle. the following section describes the german experience with withholding on investment income. b. constitutional mandate for withholding on interest income under german law, interest and dividends are included in the income, but collection efforts have historically been minimal, particularly with respect to interest.72 prior to 1988, banks and other interest payors were not required to withhold or make information reports with respect to interest payments. moreover, bank secrecy laws prohibited tax auditors of banks german legislature managed to do by the skin of its teeth. see wolfgang kessler & rolf eicke, the new german inheritance and gift tax act, 53 tax notes int'l 233 (jan. 19, 2009). 69. see ordower, supra note 63, at 328; neuman, supra note 63, at 309. in several other cases challenging turnover tax provisions, however, the court has declined to act. see ordower, supra note 63, at 328-29. 70. see ordower, supra note 63, at 303-308. the court considered the situation of a worker in a single location, away from home who ended up being employed there for more than two years through the repeated extension of a shortterm assignment to that of a worker who is away from home for more than two years as a result of short-term assignments to multiple locations. comparing the two, the court found that the two-year rule unfairly limited the ability of the singlelocation worker to deduct duplicate living expenses. the court also found the twoyear rule to be invalid as it applied to two-earner married couples, because it could result in a heavier tax burden on such couples as compared to single-earner couples, who could more easily relocate to eliminate duplicate living expenses. id. 71. see niko harig, commuter tax allowance cutback unconstitutional, court says, 52 tax notes int'l 853 (dec. 15, 2008); niko harig, germany's constitutional court to rule on cutback of commuter tax allowance, 51 tax notes int'l 978 (sept. 22, 2008). 72. see ault & arnold, supra note 63, at 67. florida tax review from gaining access to account holder information to ensure that the account holders were reporting the interest income.73 the compliance rate was very low.74 in 1989, a new withholding tax was put into place, at the relatively modest rate of 10%, with respect to interest paid by banks. it caused a massive capital flight as depositors moved their funds from german banks to the luxembourg banks' subsidiaries, and six months later, the tax was repealed.n predictably, the low compliance rate with respect to interest income returned. in 1991, the constitutional court found that the tax on interest income violated the constitutional equality principle. the case was brought by a taxpayer who had reported his interest income and then challenged the legality of the tax on the grounds that it unfairly burdened voluntarily compliant taxpayers. 79 the court interpreted the equality principle to require the tax burden to fall equally on all taxpayers both as a legal and a factual matter.80 because the tax on interest was not enforced, and had high levels of noncompliance, it disproportionately burdened taxpayers who voluntarily reported and paid taxes on their interest income.8 ' the court did not 73. see id. jorg-dietrich kramer, germany, 3 tax notes int'l 853, 855 (aug. 1991). richard minor, german parliament committee compromises on new interest withholding tax bill, 5 tax notes int'l 63, 63 (july 13, 1992). 74. see ault & arnold, supra note 63, at 67. 75. see leif muten, international experience of how taxes influence the movement of private capital, 8 tax notes int'l 743, 746 (mar. 14, 1994). at the same time, it appears that bank secrecy laws were strengthened. see kramer, supra note 73, at 855. 76. an estimated 120 billion marks flowed out of west germany in 1988, in part out of concern about the imposition of withholding taxes. see ferdinand protzman, 10% withholding tax abolished in germany, n.y. times, apr. 28, 1989. see also h. schlesinger, capital outflow and taxation the case of the federal republic of germany, in reforming capital income taxation (h. siebert ed., 1990) 101-09. 77. see muten, supra note 75, at 746. the heightened secrecy laws protecting banks, enacted at the time of withholding, remained in place even after withholding was repealed. 78. in 1991, an estimated dm 5.3 to 15 billion of revenue was lost as a result of nonpayment of taxes on interest income. see kramer, supra note 73, at 855. according to estimates accepted by the federal constitutional court in 1991, between 60% and 70% of domestic interest received by private investors was not reported. see ault & arnold, supra note 63, at 67. 79. see kramer, supra note 73, at 855. 80. see kramer, supra note 73, at 855; richard g. minor, pending legislation: german parliament committee compromises on new interest withholding tax bill, 5 tax notes int'l 63, 63-64 (july 13, 1992). 81. see kramer, supra note 73, at 855; neuman, supra note 63, at 309. 330 [vol. 10:3 2010] investment income withholding in the united states and germany 331 invalidate the tax, but rather directed the legislature to cure the defect by enacting compliance measures by january 1, 1993, in order to prevent the tax from being struck down.82 the court prescribed two alternative enforcement approaches for the legislature to consider: information reporting and withholding. the administration initially proposed a withholding tax of 25%, along with significant exemptions and exceptions that would have resulted in only about 20% of german interest recipients being subject to withholding.8 the administration's proposal was approved by one parliamentary chamber but the other, controlled by the opposition party the social democrats rejected it.85 the social democrats took the position that the proposal was constitutionally inadequate, and that only a reporting requirement would be sufficient.86 they proposed to amend the bank secrecy laws to allow tax authorities access to bank records of german taxpayers.87 the compromise ultimately agreed upon by the joint legislative conference committee was a somewhat more rigorous withholding tax. as part of its compromise with the opposition party, the ruling coalition made a commitment to re-examine its interpretation of bank secrecy laws restricting the tax authorities' access to account information by the end of the year. effective january 1, 1993, the new withholding tax, at a rate of 30%, was introduced. the tax incorporates many of the exceptions and limitations of the originally proposed tax: the tax applies to interest received by german residents, but those who have interest income below a threshold exemption amount can have the withholding requirement waived.90 nonresidents are not subject to withholding. in addition, foreign branches of 82. see kramer, supra note 73, at 855. 83. see minor, supra note 80, at 64. 84. id. 85. id. 86. id. 87. id. 88. id. at 63. 89. see id. it appears that the promised ruling was never issued. 90. as under the administration's original proposal, the exempt amount was increased 10-fold from the prior law amount, to dm 6,000 for an individual, and dm 12,000 for a married couple filing jointly. see id. at 64. as of 2004, the exemption amount was e 1,370. see ault & arnold, supra note 63, at 67. german taxpayers with interest income below the exemption amount are not subject to withholding if they provide an exemption form to the withholding agent. the tax authorities are authorized to gain access to account information to ensure that a taxpayer does not claim multiple exemptions for multiple bank accounts. see minor, supra note 80, at 64. florida tax review german banks are not required to withhold on interest payments made to german account holders.9 ' c luxembourg despite the limited scope of the withholding tax, taxpayers were concerned that in the future, the exemption amount might be increased or that german bank secrecy laws might be eroded.92 as a result, there occurred again a capital outflow reminiscent of the 1989 experience, with an estimated dm 500 billion ($333 billion) moving from germany primarily to branches of german banks in luxembourg and switzerland. amid reports of german citizens skulking around the streets of luxembourg's banking district carrying plastic bags stuffed with deutschemarks, lured by full page ads proclaiming, "luxembourg, the holiday home for your money,"94 and "it's only a cat's leap away," 9 5 setting up accounts using false names such as helmut kohl and pinocchio,96 the german government lost an estimated $15 billion in tax revenues during 1993 and 1994.97 in the ensuing years, the situation deteriorated further. the german government tried, unsuccessfully, through diplomatic channels to persuade luxembourg to introduce a withholding tax and called for a europe-wide withholding tax.98 luxembourg declined to act, pointing out that even if all european union countries agreed to cooperate, germans would continue to evade taxes by moving their money to non-eu countries such as switzerland or monaco, or to territories exempt from eu rules such as the channel 91. see minor, supra note 80, at 64. 92. see nathaniel c. nash, germans in tax revolt embrace luxembourg, n.y. times, nov. 25, 1994. 93. see ault & arnold, supra note 63, at 67. 94. see john eisenhammer, view from frankfurt: finding unification in luxembourg's safe haven, the independent, apr. 3, 1993. 95. see greg steinmetz, german tax collectors rile country's banks with aggressive raids, wall st. j. dec. 4., 1996, at al. 96. john eisenhammer, dresdner denies hand in clients' fraud, the independent, nov. 12, 1994. 97. see nash, supra note 92. estimates of capital moved and tax revenues lost vary, due to the evasive nature of the capital movement. see, e.g., steinmetz, supra note 95 (citing an estimated $200 billion per year in capital moving out of germany, and an estimated revenue loss of $15 billion per year); greg steinmetz, tax raids tarnish luxembourg's luster as jewel of international banking set, wall st. j., june 14, 1996 (citing an estimated revenue loss or $10 billion per year). 98. see john eisenhammer, dresdner protests against "bullying" inspectors, the independent, jan. 26, 1994; nash, supra note 92. (the german finance ministry also proposed that european countries require banks to share information about accounts holders with tax authorities.). 332 [vol. 10:3 2010] investment income withholding in the united states and germany 333 islands or gibraltar." the remark of luxembourg's minister of finance, budget and labor, jean-claude juncker, captures the essence of the classic tax competition problem: "the money would leave within weeks [of an euwide agreement]. you would have to get european-wide cooperation, which is next to impossible."' 00 desperate to stem the revenue loss, german tax authorities resorted to more aggressive tactics, staging about 50 raids against most major banks during 1995 and 1996.10 in one raid, prosecutors sent 40 tax inspectors and finance experts to search the offices of dresdner, germany's second largest bank, for evidence of illegal money transfers, reportedly seizing incoming mail from luxembourg and threatening to arrest uncooperative bank employees. 102 in another, 250 tax inspectors raided the frankfurt headquarters of germany's fourth largest bank, commerzbank, seizing files and computer disks.103 ultimately, in 1998, even deutsche bank became a target, with 300 investigators swarming its headquarters and branches to search for evidence that bank executives collaborated with clients in illegal tax evasion.10 the banks fired back, claiming they were being "unjustifiably criminalized" in scare tactics aimed at german account holders.'0o dresdner accused the government of leaking confidential information about investigations to the press. 06 juergen sarrazin, the chairman of dresdner, went so far as to play the 'fascist card,' declaring "these are no longer the methods of a democratic state." 07 in 1998, the german police made their first arrests in the investigations. 08 ultimately, bank executives and clients were convicted of tax evasion.'" luxembourg's status as a premier international financial 99. see nash, supra note 92. 100. see eisenhammer, supra note 96. 101. see steinmetz, supra note 95. 102. see eisenhammer, supra note 96. 103. see steinmetz, supra note 95. 104. see edmund l. andrews, big german bank is raided in a search for tax cheats, n.y. times, june 16, 1998. 105. see steinmetz, supra note 95. 106. see id. 107. see id. 108. see a. fisher, german bank staff held in tax evasion inquiry, fin. times, jan. 4, 1996; d. crossland, police make first arrests in dresdner tax probe, reuters eur. bus. rep., jan. 3, 1996. 109. see e.g., dresdner tax case fines, fin. times, aug. 14, 1996 (director of branch bank sentenced to dm 500,000 ($338,000) fine or four months in jail, and head of foreign department sentenced to dm 300,000 fine or one year in jail for helping a client evade taxes by transferring funds to luxembourg); w. munchau, dresdner client jailed for tax evasion, fin. times, feb. 13, 1996 (bank client, a florida tax review center suffered a decline."l0 but german taxpayers did not lose their taste for tax evasion, and german tax authorities did not lose their taste for aggressive investigations. the pattern of german evasion and enforcement established in luxembourg played out even more sensationally in liechtenstein, and the repercussions are still being felt."' d. liechtenstein as is now widely known, liechtenstein is a tiny principality (population: 35,000), located between austria and switzerland, that was famed for its bank secrecy laws. liechtenstein has been at the center of a worldwide tax scandal that began in 2006, when the german foreign intelligence service, bundesnachrichtendienst (bnd), purchased secret customer information from a former employee of liechtenstein global trust (lgt), a liechtenstein bank.1 2 the former employee, heinrich kieber, had first tried to blackmail liechtenstein governmental authorities, demanding passports and free passage in exchange for keeping the information secret. (he was trying to evade criminal fraud charges in spain.) kieber then offered the information to tax authorities around the world, and the bnd paid him $7.4 million. the bnd turned the information over to german tax authorities, who used it to investigate hundreds of wealthy german citizens for failing to report income on deposits in liechtenstein. prosecutors raided homes and businesses of high-profile executives and celebrities, and investigated german banks who may have aided in the evasion. one prominent executive, klaus zumwinkel, the former ceo of deutsche post, has been convicted of tax evasion." many others came forward and confessed, and paid back taxes and fines, rather than face prosecution."14 55-year old dealer in sausage skins, sentenced to 45 months in jail and dm 1.3 million ($885,000) fine for evading dm 6.3 million in taxes using luxembourg account). 110. see suzanne mcgee, tax inquiry turns banking grayer in luxembourg, wall st. j., july 20, 1999; steinmetz, supra note 97. 111. see infra notes 115-120 and accompanying text (describing the worldwide crackdown on tax evasion). 112. this account is drawn primarily from randall jackson's story summarizing major news developments in the liechtenstein scandal. see randall jackson, the mouse that roared: liechtenstein's tax mess, 49 tax notes int'l 707 (mar. 3, 2008). see also, lynnley browning, banking scandal unfolds like a thriller, n.y. times, aug. 15, 2008; carter dougherty & mark landler, tax scandal in germany fans complaints of inequity, n.y. times, feb. 18, 2008. 113. see randall jackson, former deutsche post ceo convicted of tax evasion, 53 tax notes int'l 393 (feb. 2, 2009). 114. derek scally, german authorities to tell revenue of evaders, irish times, feb. 27, 2008 (within two weeks of beginning investigation, german 334 [vol 10:3 2010] investment income withholding in the united states and germany 335 german tax authorities shared the information they had received from kieber freely with tax authorities elsewhere, prompting investigations in countries including the united kingdom, italy, france, the united states, canada, sweden, new zealand, and australia.15 in many cases, the investigations expanded to include massive numbers of taxpayers.'16 in the united states, the senate permanent subcommittee on investigations held hearings and released a 115-page report on tax haven banks in july 2008, detailing offshore tax evasion by u.s. taxpayers in liechtenstein and switzerland."'7 in february 2009, swiss bank ubs agreed to pay $780 million in fines and admitted that its employees had participated in a scheme to defraud the united states by helping u.s. taxpayers to set up offshore accounts."8 in august 2009, the justice department's investigation of ubs resulted in a historic agreement by ubs to disclose the identity of 4,450 of its u.s. customers to the internal revenue service." 9 by november 2009, nearly 15,000 additional u.s. taxpayers had come forward to disclose hidden offshore accounts pursuant to an amnesty program initiated by the irs.120 authorities raided 120 homes, 91 people confessed to tax evasion, and 72 people turned themselves in voluntarily). 115. christian retzlaff & kim murphy, irs searches for hidden u.s. assets in liechtenstein banks, l.a. times, feb. 27, 2008. 116. see randall jackson, government cracks down on tax cheat, 55 tax notes int'l 804 (sept. 7, 2009) (french government investigating 3,000 french taxpayers with undeclared assets in swiss bank accounts); kristen a. parillo, tax authorities investigating offshore account holders, 55 tax notes int'l 612 (aug. 24, 2009) (italian government investigating up to 170,000 italians with offshore accounts); helen power, hrmc targets 60,000 more britons in offshore account probe, the daily telegraph, july 23, 2008 (british tax authorities investigating 400,000 british accountholders, discovering 100,000 suspected of tax evasion, with 40,000 voluntarily stepping forward and the remaining 60,000 under further investigation). 117. staff of s. comm. on homeland sec. & gov. aff., perm. subcomm. on investigations, 110th cong., report on tax haven banks and u.s. tax compliance (2008), available at http://hsgac.senate.gov/public/_files/071708psi report.pdf [hereinafter tax haven report]. 118. see lynnley browning, a swiss bank is set to open its secret files, n.y. times, feb. 18, 2009. 119. see james quinn, ubs provides customers' names in us tax inquiry, the daily telegraph, aug. 20, 2009. 120. see lynnley browning, 14,700 americans tell i.r.s. of foreign accounts, n.y. times (nov. 18, 2009). britain, france, italy and canada have instituted similar amnesty programs. see coming clean: amnesty offered for tax dodgers, the globe and mail (canada), oct. 29, 2009. florida tax review e. the court that started it all despite the shockwaves caused by its decision on interest withholding, the constitutional court does not appear to have been deterred from aggressive constitutional review of tax laws. in 2004, the court again invalidated an inadequately enforced tax on investment income this time a capital gains tax imposed on short-term gains from securities trading.121 the statute did not provide for withholding or information reporting in collecting the tax, and for the years in question (1997 and 1998), the tax authorities had done little to enforce the tax through audits or other means.12 2 the taxpayer challenging the tax, retired tax law professor klaus tipke, argued that because the tax was not enforced, it had the effect of imposing a greater tax burden on honest taxpayers, thereby violating the equality principle.123 the court agreed, and invalidated the tax for the years in question.12 4 the unconstitutionality of the tax turned on both its lack of facial enforcement mechanisms, such as withholding or information reporting, and the lack of other meaningful enforcement activity. the court's limited ruling implied that the tax's facial defects could have been cured by adequate enforcement efforts.12 5 in its decision, the court sought to anticipate, and forestall, other challenges based on "unequal enforcement." it suggested that the capital gains tax, as applied to real estate, was less susceptible to avoidance and therefore valid. it also opined that even though independent contractor income is not subject to withholding (while wages paid to employees are), collection of the tax from independent contractors was adequately enforced through other means.126 in addition, there continues to be lingering concerns that the withholding tax on interest does not satisfy the equality in enforcement principle because its rate of 30% is less than the marginal rate of most taxpayers. 12 7 121. see sirena j. scales, high court holds capital gains taxes unconstitutional, 33 tax notes int'l 963 (mar. 15, 2004); ordower, supra note 63, at 323-26. under german law, longer-term gains from capital appreciation are generally not subject to tax. see ault & arnold, supra note 63, at 59. 122. see ordower, supra note 63, at 324. 123. see scales, supra note 121; ordower, supra note 63, at 324-25. 124. see ordower, supra note 63, at 325-26. 125. see id. 126. see id. 127. see ault & arnold, supra note 63, at 67. 336 [vol 10:3 2010] investment income withholding in the united states and germany 337 v. the case for investment income withholding the u.s. and german experiences with investment income withholding provide both normative and practical support for adopting investment income withholding in the united states. a. equality in enforcement germany's "equality in tax enforcement" principle suggests that differences in enforcement effort are inherently unfair. this is not to say that the united states ought to import such a principle into its constitutional jurisprudence, and require withholding as a constitutional matter. the united states constitutional tradition is so different from germany's that this is almost unimaginable.128 add to this the united states' ambivalence about consulting foreign law at all in constitutional matters,129 and it becomes even clearer that a constitutionally-based argument for u.s. withholding would be futile. rather, germany's equality in enforcement principle legitimizes the fairness and equality as fundamental policy goals in designing and evaluating the enforcement mechanisms of any tax system. this article began with the claim that the u.s. system has tilted in favor of income from capital through explicit provisions of the tax law, and further, through differences in enforcement strategies. withholding is the embodiment of this claim. our failure to withhold from investment income proven by our experience with wages to be highly effective magnifies the explicit tax rate preference and other preferences enjoyed by investment income. whether investment income ought to be taxed more lightly than wage income is a contentious issue, and this article does not attempt to reach a conclusion in that fraught debate.130 rather, it makes the more modest 128. as comparative constitutional law scholar professor gerald neuman observes, in discussing the german decision requiring withholding as a constitutional matter, "it would difficult even to articulate this successful argument as an equal protection claim in the united states." see neuman, supra note 63, at 309. see generally edward j. eberle, equality in germany and the united states, 10 san diego int'l l. j. 63 (2008); peter e. quint, the most extraordinarily powerful court of law in the world? judicial review in the united states and germany, 65 md. l. rev. 152 (2006). 129. see generally, daniel a. farber, the supreme court, the law of nations, and citations of foreign law: the lessons of history, 95 cal. l. rev. 1335 (2007). 130. compare turnier, supra note 14, at 132-33 (income from capital and income from labor ought to be treated comparably), and leslie snyder, taxation with an attitude: can we rationalize the distinction between "earned" and "unearned" income?, 18 va. tax rev. 241, 298-99 (1998) (differing treatment of florida tax review argument legitimized by the german equality in enforcement principle that, whatever rate of tax is imposed, fairness demands that we use proven and effective tools to collect that tax. b. practical and political considerations the u.s. past experience with dividend and interest withholding is instructive on two fronts. first, the 1982 legislation, along with the withholding laws of many other countries, can provide some basic design parameters for a new withholding proposal. second, the 1982 experience gives us valuable predictive information about the resistance to be encountered the groups who will likely lead the opposition and those likely to be enlisted, and the sorts of objections that will be made.' 3 ' donald c. alexander, who served as irs commissioner in the nixon administration (from 1973 to 1977), recently predicted (perhaps based on his personal experience with the 1982 law) there would be "ferocious resistance" by the financial services sector to any investment withholding proposal.132 but forewarned is forearmed. we know that the principal argument historically made against investment income withholding was that it would be too costly and difficult to administer. this argument has become increasingly obsolete, to the point that it seems almost quaint. the same technological advances that made global tax evasion possible also make withholding cheap and easy to implement. perhaps the best evidence of this can be found in the evolution earned income and investment income should be eliminated) with eric m. zolt, the uneasy case for uniform taxation, 16 va. tax rev. 39, 77-80 (1996) (there may be efficiency and administrative reasons for taxing income from labor differently than income from capital). the question of how to treat income from labor and income from capital is closely related to the even more contentious debate about whether it is better to tax income or consumption, which is beyond the scope of this article. see, e.g., joseph bankman & david a. weisbach, the superiority of an ideal consumption tax over an ideal income tax, 58 stan. l. rev. 1413, 1420-1422 (2006) (summarizing three arguments in favor of taxing income); daniel shaviro, beyond the pro-consumption tax consensus, 60 stan. l. rev. 745 (2007) (identifying a widespread consensus that consumption is the superior tax base, taking into account both efficiency and fairness, but arguing that when certain assumptions fail, there may be strong arguments for taxing savings). 131. clearly, one major objection will be that investment income is subject to extensive information reporting requirements, which, theoretically, provides all the information the irs needs to collect the tax on such income. however, it is well established that information reporting is less effective than withholding. see, e.g., george k. yin, jct chief discusses the tax gap, 107 tax notes 1449, 1452 (june 13, 2005). 132. dustin stamper, budget strain may lead to attack on tax gap, former irs chiefs say, 115 tax notes, 898, 898 (june 4, 2007). 338 [vol. 10:3 2010] investment income withholding in the united states and germany 339 of the payroll industry. when wage withholding was introduced in 1943, many employers used handwritten ledgers to keep track of employees' hours and wages, and paid their workers in cash.'3 3 the "cutting edge" technology of the time consisted of punch card machines and printed (as opposed to handwritten) data entries.134 a major innovation was an i.b.m. machine that could prepare payrolls "in five copies, interleaved with one-time carbon paper.'s 35 computers did not enter the scene until the late 1950s, with roomsized machines that read data key punch cards, and giant reels of magnetic storage tape.136 today, in contrast, complete payroll programs that calculate state and federal tax withholding, prepare w-2 and other forms, print checks or perform direct deposits-are available for $200 or less.'37 any small business owner with a home computer can withhold accurately and cheaply. the german experience is a predictor of the new forms of objection the "ferocious resistance" is likely to take, and a training ground for critical evaluation of these objections. there will be howls of protest about capital flight, and its adverse impact on the domestic economy. but the german experience shows us that that capital flight was illusory most of the funds moved into luxembourg were reinvested in mark-denominated moneymarket mutual funds, thus immediately returning to the german economy.'38 if capital flight is not the problem, then protests will focus on evasion, again pointing to germany's dramatic drop in tax revenues upon the introduction of withholding. opponents of withholding will sound like luxembourg's finance minister explaining why his country's cooperation with germany to stem evasion would be pointless: as long as there is a single country willing to exempt some u.s. investors and provide secrecy, they will argue, withholding taxes will be virtually impossible to collect, given the ever-increasing mobility of capital, combined with the avoidance genius of tax and finance experts. 133. see leonard a. haug, the history of payroll in the united states: the evolution of the profession and the process from colonial america through the end of the 20th century 108-12 (2000). ford motor company did not stop its practice of paying its 106,000 workers in cash until 1950. see id. at 141. 134. see id. at 129-30. 135. see id. at 133. 136. see id. at 145-48. 137. galt buying guides, "payroll software reviews and buying guide," available at http://www.galttech.com/research/software/payroll-software.php. 138. see nash, supra note 92. given united states' investors penchant for investing domestically even with today's globalized markets, even if the investors moved funds offshore, they would most like return to the u.s. economy, as happened in germany in the 1990s. see andrew swiston, a global view of the u.s. investment position, imf working paper (2005) available at http://papers.ssrn.com/sol3/papers.cfm?abstract-id=888050. florida tax review this coordination problem is the essence of the tax competition problem,'39 and indeed, the german experience with withholding is sometimes cited by academics as a cautionary tale about the dangers of tax competition. 140 whether this proves true in the long run, however, remains to be seen. the german experience may instead turn out to be a tale about reaching the tipping point that led countries to engage in the cooperative behavior needed to overcome undesirable tax competition. at the time of the events in luxembourg described above, the luxembourg finance minister's warning about the futility of cracking down on tax evasion seemed to ring true. evasion had become widespread, as wealth holders from all over the world moved their money to tax havens to avoid home country taxes.141 however, at the same time, countries began to undertake concerted efforts to combat tax evasion. in 1998, the organization for economic cooperation and development (the "oecd") issued a report identifying international tax evasion as a global problem, and proposing steps designed to rein it in.142 the oecd has since made sustained effort to combat the tax haven problem.' 4 in addition, in 2003, the european union 139. see generally reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573 (2000); julie roin, competition and evasion: another perspective on international tax competition, 89 geo. l. j. 543 (2001). 140. see muten, supra note 75, at 745-46; avi-yonah, supra note 139, at 1583-84; arthur j. cockfield, transforming the internet into a taxable forum: a case study in e-commerce taxation, 85 minn. l. rev. 1171, 1240 n. 244 (2001). 141. estimates of the amounts held in offshore accounts have ranged from $5 to $11 trillion. see tax haven report, supra note 117, n. 2. offshore tax evasion had existed in the past, but the technological advances of the new millennium-by facilitating global mobility of capital enabled it to run rampant. see cynthia blum, sharing bank deposit information with other countries: should tax compliance or privacy claims prevail?, 6 fla. tax rev. 579, 590-92 (2004). 142 oecd, harmful tax competition: an emerging global issue (1998), available at http://www.oecd.org/dataoecd/33/0/1904176.pdf. 143. oecd, toward global tax cooperation: progress in identifying and eliminating harmful tax practices (2000); oecd, improving access to bank for information for tax purposes (2000); oecd, the 2001 progress report by the oecd's project on harmful tax practices (2001); oecd, improving access to bank information for tax purposes the 2003 progress report (2003); oecd centre for tax policy and administration, the oecd's project on harmful tax practices: the 2004 progress report; oecd centre for tax policy and administration, overview of the oecd's work on countering international tax evasion (2009). the oecd's initiatives have received mixed reviews. see, e.g., avi-yonah, supra note 139; karen b. brown, harmful tax competition: the oecd view, 32 gw j. int'l l. & econ. 311 (1999); steven a. dean, philosopher kings and 340 [vol. 10:3 2010] investment income withholding in the united states and germany 341 (the "eu") adopted the eu savings directive, under which interest paid within the eu to individual residing in the eu is subject either to information exchange or withholding by the source country.1" several other information sharing and enforcement initiatives were also undertaken around the same time.145 the events of liechtenstein have yet to play out in their entirety, but they have already prompted further progress in international cooperation, mostly in the form of increased information exchange.146 while some commentators are skeptical about whether these efforts will deter evasion in the long run,14 7 others are more sanguine. 14 8 the ultimate lesson from the german experience may be that part of the solution to the international tax evasion problem lies at home that a country must make a serious commitment to collect taxes from its own residents in order to elicit cooperation from other countries. by adopting withholding on domestic investment income, the united states could make just such a commitment. international tax: a new approach to tax havens, tax flight, and international tax cooperation, 58 hastings l.j. 911 (2007); j.c. sharman, havens in a storm: the struggle for global tax regulation (2006). 144. council directive 2003/48/ec of june 3, 2003. 145. see blum, supra note 141, at 597-603; reuven s. avi-yonah, the oecd harmful tax competition report: a retrospective after a decade, 34 brooklyn j. int'l law 783, 784-87 (2009). 146. see david jolly, 2 nations agree to ease bank secrecy rules, n.y. times, mar. 13, 2009 (andorra and liechtenstein agree to loosen bank secrecy rules); graham bowley, a privileged world begins to give up its secrets, n.y. times, aug. 23, 2009; charles gnaedinger, oecd empties blacklist, 42 countries remain on gray list, 54 tax notes int'l 803 (june 8, 2009) (andorra, liechtenstein, monaco removed from list of uncooperative tax havens); financial secrecy jurisdictions pledge tax cooperation, 2009 worldwide tax daily 48-1 (mar. 16, 2009) (jurisdictions including switzerland, luxembourg, belgium, andorra and austria pledge to share information with foreign tax authorities). 147. see lee a. sheppard, don't ask don't tell part 4: ineffectual information sharing, 53 tax notes int'l 1139 (mar. 30, 2009). 148. see avi-yonah, supra note 145, at 783 (oecd effort against tax havens "a success"). tcharity really does begin at home: florida tax review volume 11 2011 number 2 97 in defense of college savings plans: using 529 plans to increase the impact of direct federal grants for higher education to lowand moderate-income students by caroline waldner introduction ............................................................................................ 98 i. federal financial aid scheme ....................................................... 101 a. background .................................................................................... 101 b. current 529 plans ......................................................................... 105 1. structure ............................................................................. 105 2. previous evaluations of effectiveness ................................ 107 ii. college savings as a useful element of federal financial aid .................................................................................. 110 a. lower-income students under-invest in higher education ........... 111 1. lowand moderate-income students may have lower returns from higher education ......................................... 117 2. hyperbolic discounting ...................................................... 118 3. debt aversion ..................................................................... 118 b. lower-income students respond more to grants than other types of aid ................................................................................ 120 c. 529 plans have the same effect as grants ..................................... 121 iii. policy proposals to maximize the impact of 529 plans ..... 122 a. structure plans to induce savings .................................................. 122 b. reduce regressivity ........................................................................ 125 c. reduce uncertainty ......................................................................... 127 iv. an illustration ............................................................................... 129 conclusion .............................................................................................. 135 98 florida tax review [vol. 11:2 introduction a high school graduate with no college education can expect to earn on average $638 per week. those holding a bachelor’s degree earn almost twice as much at an average of $1,121 per week.1 this will amount to almost $1 million more in earnings over a lifetime. these abstract numbers, however, do not tell the entire story. consider that at $638 a week, a person with only a high school diploma will earn on average $33,176 per year. this falls below the average annual family budget by almost $7,000 per year when including only necessities.2 in fact, this annual salary is lower than average family budgets in seven of the eight cities sampled.3 in addition to these individual monetary benefits, higher education also has significant non-monetary benefits as well. college graduates overwhelming report being happier and healthier than those who only attended high school, and most often reported being in “excellent” or “very good health.”4 this disparity increased with age — for those over the age of 65, 70 percent of college graduates identified themselves as being in good health compared to “only 45 [percent] of high school graduates.”5 these benefits can be seen in society as a whole as well. some of the societal benefits of increased enrollment in higher education include reductions in unemployment, poverty, dependence on social welfare programs, and crime. college graduates also have healthier lifestyles, more positive perceptions of personal health, and lower smoking rates than nongraduates.6 completing post-secondary education is also correlated with higher rates of civic participation, including volunteer work, blood donation, 1. u.s. bureau of labor statistics, usual weekly earnings of wage and salary workers news release (jan. 21, 2010), http://www.bls.gov/ news.release/archives/wkyeng_01212010.htm. this difference means that a typical bachelor’s degree holder will earn approximately 61 percent more over his or her working life than someone holding only a high school diploma. see generally sandy baum & jennifer ma, college board, education pays: the benefits of higher education for individuals and society, 11 (2007), http://www.collegeboard.com/ prod_downloads/about/news_info/cbsenior/yr2007/ed-pays-2007.pdf. 2. sylvia a. allegretto, economic policy institute, basic family budgets: working families’ incomes often fail to meet living expenses around the u.s. (aug. 30, 2005), available at http://www.epi.org/publications/entry/bp165/. “necessities” in the study included food, housing, transportation, taxes, child care, and healthcare. 3. id. the only city to have a family budget below this amount was casper, wyoming, the most rural city in the study. 4. inside higher ed, the (non-monetary) value of a college degree (sept. 13, 2007), http://www.insidehighered.com/news/2007/09/13/collegeboard (summarizing a survey conducted by the national center for health statistics). 5. id. 6. baum & ma, supra note 1, at 2. 2011] in defense of college savings plans 99 voting, and openness to the opinions of others. there is even evidence that the earnings of workers with lower education levels are positively affected by increased numbers of college graduates in the workforce.7 recognizing the numerous positive externalities and internalities associated with higher education, the federal government has chosen to heavily subsidize this area in order to increase enrollment. the government currently spends roughly $180 billion dollars per year subsidizing higher education costs through a variety of educational incentives ranging from direct grants to deductions for interest paid on student loans.8 despite this tremendous effort, there has been little increased enrollment in higher education in recent years. the federal government began financing higher education in the 1960s.9 this support came first in the provision of direct financial aid, primarily targeted at lower-income students and families. more recently, the government has expanded its role by delving into the world of tax incentives. while some of these incentives may still reach those in lowerand middleincome households (specifically the hope and lifetime learning credits), they also include broader tax incentives and advantages that reach even those in the highest income ranges. none of these incentives can reach the lowincome taxpayers who are generally in the zero bracket, and thus are not influenced by deductions, exclusions, and non-refundable credits, which are the forms current tax incentives take.10 7. id. 8. see college board, trends in student aid 2009, at 6 (2009), http://inpathways.net/2009_trends_student_aid.pdf. further, federal tax expenditures are currently estimated at $35 billion annually. staff of the joint comm. on tax’n, estimates of federal tax expenditures for fiscal years 20072011, at 31 tbl.1 (comm. print 2007), available at http://www.jct.gov/s-3-07.pdf. this estimate includes tuition tax credits, the deductions for tuition and interest on education loans, and education savings accounts. the stafford loan program, including subsidized, unsubsidized, and consolidated loans, currently costs roughly $7.05 billion annually. the pell grant program is funded with $18.2 billion annually. see memorandum from deborah kalcevic & justin humphrey on cbo march 2007 baseline projections for the student loan and grant programs (mar. 2, 2007), available at http://www.cbo.gov/budget/ factsheets/2007b/studentloans.pdf; see also sima j. gandhi, viewing education loans through a myopic lens 11 (brookings inst., the hamilton project discussion paper 2008-05, 2008), available at http://ssrn.com/abstract=1607774. 9. see higher education act of 1965, pub. l. no. 89-329, § 401, 79 stat. 1219, 1232 (1965). 10. as part of the american recovery and reinvestment act of 2009, the american opportunity tax credit replaced and revised the hope credit for tax years 2009 and 2010. this credit is partially refundable (40 percent of the maximum of $2,500 credit, or $1,000) and thus can reach those with little or no tax liability. 100 florida tax review [vol. 11:2 this paper will focus on one such tax incentive — the tax preferred college savings plan, or 529 plan — and its current and potential impact on higher-education participation rates among lowand moderate-income students. this article will synthesize and describe the existing literature attempting to explain the low participation in higher education among lowto-moderate-income students, despite economic models that indicate that participation should be equivalent across income levels. building on the recommendations stemming from the literature, which suggests that grants are the best way to increase those participations rates, i will argue that 529 college savings plans can, with important changes from their current structure, be a similar but more powerful tool than direct grants. in conclusion, the paper will attempt to illustrate one possible revenue-neutral plan for the federal government making use of 529 plans. the example will show that a 529 plan with an initial contribution from the government offered to every lowand moderate-income child, and matching grants annually, can increase enrollment among this group of students by almost five percentage points. this increase would far outpace any seen over the previous two decades, and yet is obtained using a very small portion of the total federal financial aid program. such an increase would have positive impacts on social equality and mobility and offer substantial monetary benefits to those affected. the increased enrollment would also have widespread societal benefits like raising all wages, reducing healthcare costs, and increasing volunteerism and civic participation.11 this article offers a revenue-neutral proposal for amending 529 plans simply to show the additional impact that the same amount of money could have if targeted differently. this paper argues, however, that these 529 plans are the most efficient way to offer financial aid incentives because they lead to the largest effective grant. i would therefore advocate for an increased amount of federal funding to be directed at these plans, either as increased spending on educational incentives or redirected from other programs. however, it is beyond the scope of this paper to analyze all of the financial aid programs and whether or how much of that funding would be better allocated to 529 plans.12 president obama has proposed making this tax credit permanent but as of this writing it applies only for these two years. 11. baum & ma, supra note 1, at 1-2. 12. it would be too simplistic to say that all federal funding for education could or should be distributed through these 529 plans. it may be that no amount of incentive can entice those of very low-income to save for education or otherwise. after all, it is impossible to save money that you do not have. the best incentive to enroll in education for these households would therefore be an upfront grant at the time of enrollment, like the pell grant. it would therefore not be wise to redirect all 2011] in defense of college savings plans 101 part i will offer a brief description of the federal financial aid scheme as it exists today, including an overview of 529 plans as currently structured. part ii explains why grants are the most effective form of financial aid for increasing enrollment in higher education, and how 529 plans operate in largely the same manner. part iii offers a number of proposals for maximizing the impact that 529 plans can have on higher education attainment. part iv provides an illustration of how a 529 plan might be structured around these proposals and demonstrates the impact that such a remodeled 529 plan could have on enrollment rates. i. federal financial aid scheme a. background the federal financial aid scheme was adopted in response to the widely held beliefs that (1) the high cost of higher education was acting as a barrier to entry, (2) higher education produces a number of positive externalities, and (3) a failure to equalize opportunity perpetuates income inequality because of the associated market rewards.13 all three of these beliefs led to the aim of decreasing the cost in order to increase enrollment. the initial push of federal financial aid focused on direct aid targeted at lower-income students under the rationale that moderateand high-income students could afford to attend college without help from the federal government. this remained true for roughly twenty years through the pell grant and stafford loans systems, both of which are need-based and primarily awarded to students from families with income below $40,000.14 the formula for determining eligibility for these types of aid is highly progressive.15 of that type of funding into a 529 matching program. a similar argument could be made for student loans; one aspect of human capital theory, discussed infra, is that there is no liquidity problem for obtaining college education. this is largely true because of the availability of student loans. eliminating government support of student loans could therefore change that entire calculus. again, in-depth analysis into such issues is beyond the scope of this paper. suffice it to say that there are certainly existing government expenditures that would be more effective if spent on matching grant 529 plans. 13. see deborah h. schenk & andrew l. grossman, failure of tax incentives for education, 61 tax l. rev. 295, 296-97 (2008). 14. susan dynarski, hope for whom? financial aid for the middle class and its impact on college attendance 1 (nat’l bureau of econ. research, working paper no. 7756), available at http://www.nber.org/papers/w7756.pdf. 15. see id. progressive as used here indicates that these types of aid are given more heavily to students of lower income and less to students of relatively moderate income, and generally not at all to students of high-income households. 102 florida tax review [vol. 11:2 over the past twenty years, however, there has been a substantial increase in the cost of both public and private higher education. this rise in price has outpaced increases in both inflation and family income and has priced many more families out of higher education obtainment.16 in inflation-adjusted dollars, the price of a four-year private education rose by $5,500 over the past decade, while four-year public universities have increased by $2,200.17 to counter this trend, many of the new federal financial aid programs have been targeted less toward lower-income students and instead more toward moderate-to-high-income families. many of the incentives directed toward these classes of students are tax incentives such as the deduction for interest on student loans, tax preferred savings vehicles, and more recently, higher education tax credits. at the same time, those programs targeted at lower-income families have lost much of their power. the maximum pell grant, when established in the 1970s, covered approximately 77 percent of the cost of a four-year public education for those who received it. it now covers only 30 percent of that cost.18 these changes, combined with the fact that low-to-moderateincome students are much more price-sensitive to college tuition, means that there are far less of these students obtaining higher education than high this thus results in a redistribution of wealth from higher-income students and households to lower-income students and households. a progressive tax system is one where average rates go up as income increases, so that those with a higher income are paying a larger percentage of that income towards taxes. this is contrasted with a proportional system where the tax rate remains constant for every level of income. for example, in a proportional system a taxpayer with $50,000 of income would pay $5,000 (10 percent) of taxes and someone with income of $100,000 would pay $10,000 (10 percent still) of taxes. in contrast, under a progressive system, someone with income of $50,000 might pay $5,000 (10 percent) of taxes while a taxpayer with income of $100,000 might pay $20,000 (20 percent) of taxes. because the many complex features of the tax code that affect the effective tax rate that people pay, some scholars have advocated thinking of a progressive tax system more simply as one where after-tax income is more equally distributed than before-tax income. see, e.g., thomas piketty & emmanuel saez, how progressive is the u.s. federal tax system? a historical and international perspective, 21 j. econ. persp. 3, 5 (2007). 16. see college board, trends in college pricing 2006, at 7 (2006), http://www.collegeboard.com/prod_downloads/press/cost06/trends_college_pricing_ 06.pdf 17. college board, trends in college pricing 2008, at 9 (2008), http://professionals.collegeboard.com/profdownload/trends-in-college-pricing-2008. pdf. 18. francine knowles, durbin, roosevelt students tout hike in pell grants, chicago sun-times (mar. 30, 2010), http://www.suntimes.com/business/ 2129674,cst-nws-pell30.article. 2011] in defense of college savings plans 103 income students. the rate of enrollment among those from households with income below $18,000 per year has never been above 30 percent, while the rate for students from households with annual income of $60,000 (still considered moderate income) is consistently above 50 percent.19 further, the percentage of high school graduates enrolling in college in the lowest quintile stayed roughly the same from the 70s to the 90s, at about 43 percent. at the same time, however, the percent of those in the highest quintile rose by approximately ten percentage points, from about 70 percent to about 80 percent.20 a number of commentators have called these recent tax incentives for higher education complete failures — they cost the federal government billions of dollars annually but incentivize essentially no one to obtain a higher education.21 in fact, after these tax incentives took effect in 1998, there was no increase in the percentage of high school graduates enrolled in post-secondary education (table 1). table 1 population age 18-24 enrolled in post-secondary schools 22 year percent of high school graduates 1992 41.9 1993 41.4 1994 42.4 1995 42.4 1996 43.5 1997 45.2 1998 45.3 1999 43.8 2000 43.3 2001 44.1 2002 45.0 this is true not only of the population as a whole, but for lowerand middle-income students as well (table 2). enrollment rates for these students showed fluctuations over the time period but no clear increase over previous rates of enrollment (table 2). 19. see infra table 2. 20. charles f. manski, income and higher education, 14 focus 14, 17 (1992), http://www.irp.wisc.edu/publications /focus/pdfs/foc143c.pdf. 21. see schenk & grossman, supra note 13, at 298-99. 22. u.s. census bureau, current population survey tbl.a-5, the population 14 to 24 years old by high school graduate status, college enrollment, attainment, sex, race, and hispanic origin: october 1967 to 2002 (jan. 4, 2004), available at http://www.census.gov/population/ socdemo/school/taba-5.pdf. 104 florida tax review [vol. 11:2 table 2 percentage of population, age 18-24, enrolled in college by family income23 year/income $18,000 $35,000 $60,000 1992 29.4 38.2 52.6 1997 26.1 40.1 58.4 2002 29.2 32.8 52.6 2005 29.9 40.2 53.8 the problem is that these tax incentives are too opaque and targeted at the wrong people. one incentive that has been particularly criticized is the 529 college savings plan. these plans are: regressive, in that the benefit is tied to the taxpayer’s tax bracket; expensive, costing the federal government approximately $1 billion annually; and used almost entirely by high-income households.24 since high-income students are presumed to need no incentive to obtain higher education, many believe that these plans are an entirely misdirected use of federal funds.25 despite the fact that many believe that high-income families need no incentive to save money or to enroll in higher education, almost 60 percent of the funds in 529 accounts are held by those in the top 5 percent of household income.26 in contrast, virtually none of the balance of these accounts is held by those in the first quartile.27 23. data from 1992-2002 from schenk & grossman, supra note 13, at 362, slightly modified to reflect changes in reporting in the 2005 reported data. 2005 data compiled from u.s. census bureau, current population survey tbl.14, enrollment status of dependent primary family members 18 to 24 years old, by family income, level of enrollment, attendance status, type of school, sex, race, and hispanic origin: october 2005, available at http://www.census.gov/population/ www/socdemo/school/cps2005.html. the income listed on the table represents the median of the range used by the census bureau. 24. staff of the joint comm. on tax’n, supra note 8. one billion dollars is the estimate provided for 2010. 25. see william g. bowen, martin a. kurzweil & eugene m. tobin, equity and excellence in american higher education 97 (2005) (“children from families [in the highest income brackets] almost surely would go to college in any case.”); see also schenk & grossman, supra note 13, at 351 (“higher income taxpayers, []have a strong propensity to save, especially for college, and need no incentive to do so . . . .”). 26. see schenk & grossman, supra note 13, at 351; infra figure 1. 27. see infra figure 1. 2011] in defense of college savings plans 105 b. current 529 plans 1. structure qualified tuition plans, commonly referred to as “529 plans” for the code section which authorizes them, were first introduced into the tax code in 1996.28 section 529 allows all fifty states and the district of columbia to administer such plans and provides rules that the plans must follow in order to receive favorable tax treatment.29 the plans are then administered by the states. forty-three of the states allow investment by out-of-state residents while five make them available only for in-state residents.30 most states contract out management and record-keeping functions, and all states contract out investment services to third-party financial services companies.31 these plans can, but do not always, come with fees attached for enrollment, maintenance, and administration.32 the state tax benefits can vary widely but are generally more favorable than federal tax treatment. most are both deductible when money is contributed and excludable upon withdrawal under state income taxes.33 28. irc § 529. there are actually two different types of plan authorized under § 529 of the code: college savings plans and prepaid tuition plans. in 2008, 88 percent of assets were in college savings plans with only 12 percent in prepaid tuition plans. there has been a steady shift away from prepaid tuition plans (which pre-date college savings plans) to college savings plans. while the tax treatment of the two types of plans are highly similar, this paper will only specifically discuss college savings plan and this is what is meant by 529 plans. 29. the only rule of real consequence here is that each plan must have one and only one “designated beneficiary” at all times. 30. the plans are available in the district of columbia and every state except wyoming. in addition, tennessee and washington offer only prepaid tuition plans and not savings plans. dep’t of treas., an analysis of section 529 college savings and prepaid tuition plans: a report prepared by the department of treasury for the white house task force on middle class working families 1 (sept. 9, 2009), http://www.treasury.gov/resource-center/economic-policy/ documents/09092009treasuryreportsection529.pdf 31. id. at 2. 32. plans with no fees attached are offered in arizona, california, connecticut, florida, georgia, idaho, illinois, iowa, kentucky, louisiana, michigan, minnesota, oklahoma, tennessee, and vermont. see generally your guide to saving for college, http://www.savingforcollege.com (last visited jan. 26, 2011). 33. a total of thirty-two states offer a full or partial income tax deduction for contributions to the state’s 529 plan or have no income tax. of those, five states offer a full income tax deduction, twenty states a partial income tax deduction, and seven states have no income tax. those states that offer a partial income tax deduction often allow a carry forward of excess contributions for up to five years. see saving for college, compare 529 plans, compare by features, http://www.savingforcollege.com/compare_529_plans/index.php?plan_question_ids[ 106 florida tax review [vol. 11:2 investors in these accounts cannot fully control how the funds are invested, but generally are able to choose between several options. this choice usually allows variations based on the time until college enrollment for the beneficiary and personal preferences for risk.34 some states offer investment options that are guaranteed to grow with the rate of tuition for instate colleges.35 the primary federal tax benefit stems from the exclusion from federal income tax of withdrawals from a qualified account used for qualified higher education expenses. the earnings accrued on the accounts are also tax-free. contributions are made from after-tax income for federal tax purposes.36 529 plans grew significantly after 2001 when they were revised to make distributions tax-free at a federal level as long as used for qualified expenses.37 prior to that time, the benefit of such plans was that contributions could grow tax-deferred; the earnings on such accounts were only taxable once distributed. after the benefit changed from deferral to exemption, the assets in 529 plans grew from $14 billion to $130 billion within six years.38 section 529 plans also allow for beneficial gift tax treatment.39 up to five years of tax-exempt giving can be compressed into a one-year period. as of 2010, the § 2503(h) gift tax exclusion was $13,000 annually.40 based on this amount, a donor could deposit up to $65,000 into the account in one year without being subject to the gift tax. the donor could then not take advantage of the annual exclusion as to that beneficiary for the next four years, but this allows a larger lump sum and therefore a larger accumulation of interest over that time. ]=437&plan_question_ids[]=85&mode=compare&page=compare_plan_questions& plan_type_id=; http://www.finaid.org/savings/529plans.phtml (last visited jan. 26, 2011). 34. schenk & grossman, supra note 13, at 303-04. 35. see, e.g., montana family education savings program, collegesure® cd, http://montana.collegesavings.com/montana/collegesure_cd.asp (last visited jan. 26, 2011). 36. see generally what is a 529 plan?, http://savingforcollege.com/ intro_to_529s/what-is-a-529-plan.php (last visited jan. 26, 2011). 37. irc § 529(e)(3)(b); economic growth and tax relief reconciliation act, pub. l. no. 107-16, 115 stat. 38, (2001); see also christopher e. houston, section 529 plans: opportunities and uncertainties, 2002 a.l.i.-a.b.a. sophisticated est. plan. techs. 63, 65. 38. dep’t of treas., analysis of section 529, supra note 30, at 3. for comparison, there are an estimated $2 trillion in assets in 401(k) accounts. 39. irc § 529(c)(2)(b). this result is achieved through an election that allows the taxpayer to treat a contribution as if it was made over a five-year period rather than in one year. 40. rev. proc. 2009-50, 2009-45 i.r.b. 617. 2011] in defense of college savings plans 107 2. previous evaluations of effectiveness 529 plans have been largely criticized as being both ineffective and highly regressive. because the primary benefit from 529 plans is the exclusion from income, the benefit from these plans is tied to the taxpayer’s tax bracket and is thus worth more for high-income (high-bracket) taxpayers. the regressivity of the program is compounded by the fact that high-income taxpayers generally are willing and able save more than middleand lowerincome taxpayers. the plans can also offer no (federal) incentive to the significant number of taxpayers in the zero bracket who can make no use of an exclusion (or deduction).41 there are a number of additional elements of 529 plans that make them particularly attractive for high-income taxpayers. first, the limits on such plans are quite high, generally allowing enough investment to cover four years of private higher education plus additional years of graduate study, varying by state. further, while each beneficiary can have only one account in his or her name in each state, there is no limit to the number of total accounts in each beneficiary’s name. therefore a family could potentially hold one account in each state open to non-residents for each beneficiary up to the limit of approximately $300,000.42 this would result in a total investment of roughly $12.9 million per beneficiary.43 the benefit of investing more than could possibly be spent on qualified higher education expenses is that when a non-qualified distribution from the account is made (i.e., not for higher education expenses), it can be included in the beneficiary’s income and thus is taxed at a lower rate than would apply to the account owner. non-qualified withdrawals have also still benefited from 41. it has been estimated that 43.4 million individuals paid no income tax in 2006, amounting to 32 percent of the returns filed. scott a. hodge, number of americans paying zero federal income tax grows to 43.4 million, tax found. 1, 2 (2006), http://www.taxfoundation.org/files/ff54.pdf. the number of those individuals actually in the zero bracket is no doubt lower than that number given that some of these people eliminated their tax liability through the use of credits, and the number of these individuals making use of the educational credits is not known. it is clear that the percentage of people who cannot make use of these tax incentives is not insignificant. 42. the limit currently ranges from $224,465 to $368,600 and exceeds or equals $300,000 in a majority of states. there are forty-three states offering plans that are open to non-residents. see dep’t of treas., analysis of section 529, supra note 30, at 2. 43. calculations derived using the estimate of a $300,000 limit in fortythree plans. note that a resident in one of the five states with accounts open only to residents could have plans in forty-four states — all forty-three open to non-residents plus in his or her resident state. 108 florida tax review [vol. 11:2 deferral. the 10 percent penalty is often not sufficient to offset the benefit of tax deferral and eventual taxation at this lower rate.44 besides the fact that it appears that high-income tax payers can use 529 plans as a tax shelter, reaping tax benefits even when not used for educational savings, it also seems that they provide no actual incentive to higher-income individuals. high-income individuals tend to save for education without any tax incentive to do so.45 those in the highest tax brackets also generally have enough current income to pay for education such that they do not need a financial incentive to encourage enrollment.46 there is also an element of uncertainty surrounding 529 plans that reduce any incentive that these plans might have for middleand lowerincome families.47 families, especially at lower levels of income, are often uncertain whether their children will attend college, what type of college they will attend, the amount of tuition that will need to be paid, and the amount of financial aid that they will receive. there is further uncertainty and complexity surrounding the interaction of 529 plans with other benefits, particularly availability of need-based federal financial aid. this uncertainty arises because assets of both the parents and the child are counted in determining the amount of aid the student is otherwise eligible to receive, and a 529 plan is an asset that is considered in the determination. these ambiguities might well keep an interested taxpayer from taking advantage of 529 plans.48 44. assume the withdrawal is $10,000. also assume that the account owner is in the 35 percent bracket and the beneficiary, son of the account owner, is in the 15 percent bracket. without even considering the benefit of deferral, the account owner would owe taxes of $3,500 ($10,000 * .35) on a taxable account, while the beneficiary would owe taxes of only $2,500 [($10,000*.15) + ($10,000 * .10)] when withdrawing from a 529 plan with a penalty. 45. schenk & grossman, supra note 13, at 350. (“[i]nvestment decisions [of taxpayers in the 33 percent and 35 percent tax brackets] with respect to education will not be affected by the availability of a 529.”) 46. bowen, kurzweil & tobin, supra note 25, at 197 (“children from families who elect to participate in the savings plan almost surely would go to college in any case.”); see also salliemae, how america pays for college, at 6 (2009), available at http://www.salliemae.com/nr/rdonlyres/52d9fb57-d14a46ea-a6d9-ecb284d13fd/11499/gcr1979_2009_pays_survey_final_091609.pdf, (finding that families of higher-income students cover, on average, over two-thirds of costs out of current income as compared to only 19 percent for lower-income families). 47. see schenk & grossman, supra note 13, at 346 (arguing that “it is . . . extremely unlikely that taxpayers in either [the 10 percent bracket] or the 15 percent bracket will be able to overcome the ambiguities associated with 529 accounts”). 48. id. 2011] in defense of college savings plans 109 assuming that this incentive then is aimed almost entirely at those who do not need to be incentivized, this is an extremely inefficient use of government funds if the goal is to increase college enrollment. empirical data relating 529 participation rates to income, while limited, confirms this expected pattern of contribution. as illustrated in table 3 and figure 1, data from the survey of consumer finances shows that participation rises rapidly with income; less than 1 percent of those in the lower half of the income distribution participate while over 30 percent participate in the top 5 percent of the income distribution.49 the asset balance in 529 plans also follows this trend; for the taxpayers with income in the first three quartiles, the average account balance is about $8,000. the average balance rises to over $100,000 for those in the 95-100 percentiles (table 3 and figure 1). table 3 education savings plans account balances held by income group50 49. the survey suffers from a number of problems. first, it has a relatively small sample size. second, both income and assets were self-reported and thus subject to measurement error. while the survey asked about 529s and coverdells separately, the public data does not distinguish between the two. this is likely to skew the data somewhat because high-income individuals are more likely to invest in 529s than coverdells because of coverdells low contribution limits. 50. dep’t of treas, analysis of section 529, supra note 30, at 30 tbl.7. section 529 and coverdell esa account balances by income group item income percentile range 0-25 25-50 50-75 75-90 90-95 95-100 with children observations 1,439 1,479 1,428 966 440 1,808 percent w/ 529/csa 0.4 1.2 8.6 15.0 27.8 31.4 with children & 529 observations 1 20 112 148 117 352 average for: income $27,766 $47,827 $80,005 $120,177 $176,284 $548,077 529/csa balance $ 3,000 $ 8,794 $ 8,111 $ 15,482 $ 30,674 $106,250 balance as % of income 10.8 20.0 10.2 13.4 18.0 24.5 number of children 1.0 1.3 1.9 1.8 2.4 2.0 age oldest child 17.0 13.0 12.7 11.9 12.0 12.8 percent of total: 529/csa balance 0.0 1.1 7.0 13.9 18.5 59.4 income 0.0 1.0 11.6 18.1 17.9 51.3 110 florida tax review [vol. 11:2 figure 1 education savings plans account balances held by income group51 ii. college savings as a useful element of federal financial aid there is no question that qualified tuition plans can be structured in a way that would make them less regressive, and thus a more tailored tool for lowering the cost of higher education for those most in need of the incentive. the question, though, is not how these plans can be structured to maximize the effectiveness of saving for college. instead, the correct inquiry is whether a savings plan can ever be the most effective and efficient way for the government to spend a given amount of money to incentivize enrollment in higher education. this part argues that students should decide whether to obtain higher education based on a fairly simple evaluation of the costs of education and the expected returns. empirical evidence suggests that the returns from higher education are always greater than the costs and thus everyone, regardless of income, should make the decision to invest in higher education. this does not hold true, however, because low-to-moderate-income students systematically misestimate these values for a number of reasons, making them believe that higher education is not a worthwhile investment. the best 51. id. 59.4%18.5% 13.9% 7.0% 1.1% 0% 529 account balance held by each income percentile range 95-100 90-95 75-90 50-75 25-50 0-25 2011] in defense of college savings plans 111 way to change that calculus and incentivize these students to enroll in higher education is to lower the upfront cost (or net price) of higher education by providing them with grants. a properly structured college savings plan can provide the same incentive as a grant but be of greater financial value at the time the college decision is made. a. lower-income students under-invest in higher education the prevailing theory on the provision of financial aid generally stems from gary becker’s human capital theory (hct). this theory simply states that people use the same cost and return analysis in making decisions about training and education as they do in other areas of economic decisionmaking. as applied to higher education, this means that so long as the investment in higher education will lead to more future income than it will cost, rational people will invest in higher education. in terms of the below graph, as long as area a (future income) is larger than areas b (forgone income) and c (tuition) then a rational person will make the investment. figure 2 standard human capital theory52 52. alex usher, grants for students: what they do, why they work, educ. policy inst. 16 (2006), http://www.educationalpolicy.org/pdf/grantsforstudents .pdf. 112 florida tax review [vol. 11:2 the most recent estimates show that college graduates earn roughly $900,000 more over a lifetime than those with only a high school diploma, have a far more stable work life, and enjoy a much more stable working career (figure 4). the college board estimates the present value of this amount to be around $450,000, well over the amount of loans the average person incurs to attend college.53 this number also exceeds the cost of borrowing to pay for four years of private education, including all living expenses.54 53. see sandy baum & kathleen payea, college board, education pays: the benefits of higher education for individuals and society, 11 (2004), http://www.collegeboard.com/prod_downloads/press/cost04/educationpays2004.pdf. 54. the most expensive college for this school year was sarah lawrence college with tuition plus room and board costing $54,410. see campus grotto, most expensive colleges for 2009-2010, http://www.campusgrotto.com /most-expensivecolleges-for-2009-2010.html (last visited apr. 25, 2009). even factoring in an additional $10,000 of living expenses, the entire four years would cost $257,640. the college board estimates that average cost of a four-year private education will cost $244,571 in 2019, including tuition, fees, room, and board. see minnesota higher educ. servs. office, start today. invest in a child’s tomorrow, at 1 (2003), http://529professor.com/pdfs/mn_eb.pdf. 2011] in defense of college savings plans 113 figure 3 earnings for full-time workers by education attainment over 40-year work life 55 55. u.s. census bureau, the big payoff: educational attainment and synthetic estimates of work-life earnings, at 4 (2002), http://www.census.gov/ prod/2002pubs/p23-210.pdf $1 1.2 1.6 2.1 2.5 3.4 4.4 $0.0 $1.0 $2.0 $3.0 $4.0 $5.0 work life earnings (in millions of dollars) 114 florida tax review [vol. 11:2 figure 4 unemployment rate of the populaton 25 years and over by educational attainment56 the college board further estimates that the average college graduate has earned enough to compensate for borrowing for full tuition and forgone income by the age of 33, as shown in figure 5 below.57 56. u.s. bureau of labor statistics, education pays 2009, available at http://www.bls.gov/emp/ep_chart_001.htm. 57. see baum & ma, supra note 1, at 11. 7.1% 4.4% 3.0% 2.2% 1.8% 1.4% 1.3% 0% 10% 20% unemployment rate 2011] in defense of college savings plans 115 figure 5 cumulative earnings relative to costs of education, including loan repayment and foregone income 58 based on this data, it seems empirically clear that the return from investment in higher education (area c on the hct graph) is larger than the cost of obtaining that education (areas a and b). the only hindrance from obtaining higher education thus ought to arise from cash-flow shortages; even if a person realizes that higher education is a good investment (and empirical evidence has clearly shown that it is in almost all cases), not everyone can afford to pay for it. this cashflow problem is most cheaply and easily solved through the availability of student loans.59 in other words, if student loans are readily available then there can be no cash-flow problem and thus no barrier to obtaining higher education.60 58. id. 59. this theory does not suggest that these loans should be subsidized through below-market interest rates or deductions for interest paid, only that they should be readily available. 60. in theory, student loans are universally available because of the robust market for private student loans. private student loans do not have caps on the interest that can be charged and also are not dischargeable in bankruptcy, leading to very high approval rates for student borrowers. see, e.g., deanne loonin & alys cohen, nat’l consumer l. ctr., paying the price: the high cost of private student loans and the dangers for student borrowers 12-14 (mar. 2008), www.studentloanborrowerassistance.org/uploads/file/report_privateloans.pdf. analyzing how this affects the returns to education as illustrated in figure 2 is beyond the scope of this paper and should not have a dramatic impact given that only 14 percent of undergraduate students use private loans, and many of them could be using federal loan programs. the project on student debt, private loans: facts and trends (aug. 2009), http://projectonstudentdebt.org/files/pub/private_loan_ facts_trends_09.pdf. 116 florida tax review [vol. 11:2 human capital theory and the estimated returns from higher education thus suggest that financial aid incentives should not be needed to induce students to obtain a higher education; this should apply equally to students of all income levels.61 this theory though does not square with reality. in fact, lowerand middle-income students attend college at much lower rates than high-income students: 90 percent of graduates from families earning $80,000 or more are attending college compared to only 60 percent of other graduates, and around 30 percent of those at the lowest income levels.62 even among only high-achieving students, virtually all students from the top quarter of families in terms of income enroll in post-secondary education compared to only 75 percent of those in the lowest quartile.63 empirical evidence further shows that reducing the upfront costs of college has a dramatic impact on enrollment in lower-income students.64 this evidence thus suggests that lower-income students are systematically undervaluing the return from education and are not making the rational decision to invest in higher education.65 the behavioral economic theories of myopia and debt aversion appear to be the best explanations for this phenomenon. 61. increasing the number or percentage of students obtaining a higher education should have no impact on the returns to college education, although early proponents of this theory suspected that it would. see herbert l. smith, overeducation and underemployment: an agnostic review, 59 soc. educ. 85, 97 (1986) (quoting finis welch, an early proponent of human capital theory, as saying that “one of the most important phenomena of our time is that rates of return to investments in schooling have failed to decline under the pressure of rapidly rising educational levels” and noting that “this observation is still relevant today”). 62. lawrence gladieux, low-income students and the affordability of higher education, in america’s untapped resource: low-income students in higher education 17, 20 (richard d. kahlenberg ed., 2004). 63. high-achievement is measured based on high (“top”) standardized test scores. baum & ma, supra note 1, at 2. 64. see usher, supra note 52, at 23 (reviewing the research on price elasticity to changes in net price and finding that “[o]ne constant across all research findings is that grants/reductions in net price are much more effective among lowincome students than among middleor high-income students”). 65. see supra note 12. one other explanation is that lower-income people are more prone to over-estimating the costs of higher education, something that has been proven through empirical evidence. however, it seems that to the extent that that is the problem, the most efficient solution would be an information approach, not lowering the cost. for that reason, i have left this explanation out of the analysis. 2011] in defense of college savings plans 117 1. lowand moderate-income students may have lower returns from higher education there is some evidence that those coming from lower-income families cannot expect to have these same high returns from investment in education. one study in canada actually found that the rate of return to education was approximately 30 percent for the top quintile of university graduates, but was negative for the bottom quintile.66 if this is true, the returns to higher education for lower-income students might look more like the following: figure 6 human capital theory – lower returns67 however, this picture does not seem to hold in the u.s. the college board found that higher education provides more than adequate returns to cover costs for all income levels, racial and ethnic groups, and both genders.68 even assuming that the returns from education are lower for lower-income students (but still positive), the solution would be the same as 66. see daniel boothby & geoff rowe, rate of return to education: a distributional analysis using the lifepaths model (human resources development canada, working paper no. w-02-8e, 2002), available at http://www.s3ri.soton.ac. uk/qmss/documents/rateofreturn_to_education-distributionalanalysisusing_life paths.pdf. 67. author’s illustration. 68. baum & ma, supra note 1, at 12. 118 florida tax review [vol. 11:2 if those returns were simply misevaluated — lower the upfront costs in order to make the investment worthwhile and encourage enrollment.69 2. hyperbolic discounting in calculating rates of return, each person must use his or her own discount rate — the rate at which he or she values money in the present more than money in the future. a higher discount rate makes one less likely to make an investment — someone with a higher discount rate values the returns on the investment less than someone with a lower discount rate, even if both accurately estimate what that return will be. a number of empirical studies have shown that myopia, or the tendency to have a high discount rate, increases as income decreases.70 this outlook makes lowand moderate-income people less likely to make any investment where the returns come only in the future. a high discount rate is also related to the amount of uncertainty related to an investment. since low and middle-income students are far less likely to attend and complete college than higher-income students, this uncertainty means that the discount rate as related to education returns may be even higher than the already hyperbolic discount rate of lower-income people in general.71 a degree in higher education takes a substantial amount of time to acquire. further, the college board estimates that it takes on average until the age of 33 for that particular investment to begin showing positive returns. that long time horizon, combined with the uncertainty of obtaining the degree and the returns from that degree once obtained, makes those with shorter temporal preferences less likely to pursue a degree in higher education. 3. debt aversion empirical evidence also suggests that lower-income students are more averse to debt than are higher-income students. this tendency is 69. another issue with this line of argument is whether lower-income students could possibly know that their expected return may be lower than that of higher-income students. while some argue that lower-income students would not know this information and thus not include it in their calculus, others argue that lower-income students are well aware that their performance levels tend to be lower than those of more affluent students. lower-income students could thus assume from that knowledge that they would experience lower returns because of lesser performance. see supra figure 2. either way, the answer must be the same — lower the upfront costs to make the investment worthy. 70. see, e.g., gary s. becker & casey b. mulligan, the endogenous determination of time preference, 112 q.j. econ. 729 (1997). 71. id. at 745 (income), 742 (certainty). 2011] in defense of college savings plans 119 generally tied to the behavioral economic theory of loss aversion. loss aversion means that a loss generates more disutility than a gain generates utility. some studies have shown that a loss can generate twice the disutility that a gain can generate utility — in other words, the pain someone incurs from a $100 loss is more than the pleasure he gets from a $100 gain, and equal to the pleasure from a $200 gain.72 loss aversion then is presumed to manifest itself as debt aversion because taking on debt is a constructive outof-pocket expense equivalent to a loss.73 since this myopic loss aversion is most commonly associated with low-income people, many presume that lowincome students are also debt averse and thus under-invest in higher education because of a reluctance to take on debt in order to finance that education. the most sophisticated study on debt aversion stems from england and used multivariate analysis to attempt to disaggregate the view on debt from actual decisions. the study found a very significant relationship between debt and social class.74 empirical evidence suggests that this debt aversion can be seen in lower-income students but is not entirely conclusive. in one study tom mortensen analyzed federal reserve data on perceptions about borrowing for higher education and found that low-income individuals were less inclined to borrow and concluded that loans were not a viable option for increasing participation of these students in higher education.75 more recent studies have found that the significant factor is not income, but race and ethnicity, determining that minority students are less likely to borrow to finance unmet need for all income levels.76 there is still a strong correlation between minority status and low-income status such that most of those averse to borrowing are low-income. 72. gandhi, supra note 8, at 14. 73. id. 74. see claire callender, access to higher education in britain: the impact of tuition fees and financial assistance, in cost-sharing and accessibility in higher education: a fairer deal? 105, 126 (2005). 75. see the project on student debt, the student debt dilemma: debt aversion as a barrier to college access 4, available at http://projectonstudentdebt. org/files/pub/debtdilemma.pdf; tom mortensen, attitudes of americans toward borrowing to finance educational expenses 1959-1983 14, 22 (act student financial aid research report series no. 88-2, 1988). 76. alisa f. cunningham & deborah a. santiago, the inst. for higher educ. policy & exelencia in educ., student aversion to borrowing: who borrows and who doesn’t 17, http://www.ihep.org/assets/files/publications/s-z/student aversiontoborrowing.pdf. 120 florida tax review [vol. 11:2 b. lower-income students respond more to grants than other types of aid the failure of lower-income students to properly evaluate the cost of and returns from higher education suggests a particular role for grants in the financial aid system. there are two aspects of grants that distinguish them from other modes of financial aid: first, they are paid directly to the student (or to the institution on behalf of the student); second, they do not require repayment. the unique aspect of grants in the financial aid system is that they reduce both out-of-pocket costs and “net price,” two factors that bear most heavily on the cost-benefit ratio when making the higher education decision. “net price” or “net tuition” is the idea that the price of a year of higher education to the student is not the full price of tuition or the amount of money that will be paid by the student over time for tuition, but is actually the amount of tuition reduced by guaranteed payments made to, or on behalf of, the individual student. grants are the only type of federally sponsored financial aid that immediately reduces both net price and out-of-pocket expenses. tax incentives (such as deductions and credits) and subsidized loans both reduce the cost of higher education, but only in the future, thus not changing the immediate calculus. tax incentives generally have a time lag because they are administered through the tax system rather than concurrently with provision of financial aid or the payment of tuition. further, the credits are often taken by the parents of dependent students while it is the student making the cost and returns evaluation.77 in these instances, the credit cannot change that ratio. grants alone can make what is perceived as an otherwise unworthy investment worthy by lowering the “net price” of higher education (areas a plus b in figure 2) to less than the return (area c in figure 2). this reduction in net price essentially offsets the hyperbolic discount rate or debt aversion so that even lower-income students subject to these behavioral economic biases will perceive the returns from higher education as exceeding these reduced costs. empirical evidence supports the theory that grants most effectively correct for the irrational failure to invest in higher education. studies into this phenomenon largely began after taking note of changes in patterns of financial aid and enrollment in the 1970s and 1980s. the 1970s were marked 77. see jeffrey taylor, marcia b. harris & susan taylor, nat’l ass’n of colleges & employers, parents have their say . . . about their college-age children’s career decisions (2004) (finding that 91.8 percent of parents felt that they should be either neutral or have very little influence on their children’s college and career decisions). 2011] in defense of college savings plans 121 by high amounts of direct government aid to low-income and minority students and were also a period of relatively high participation rates for those groups. the 1980s saw a marked decline in both indicators.78 the important findings from these studies are that grants (or reductions in net price) increase enrollment, particularly for lower-income students, and that loan subsidization does not have the same effect.79 the fact that low-to-moderate-income students seem to have systematically higher discount rates and may be subject to debt aversion suggests that these students are less likely to attend higher education even when not credit-constrained. these biases influence these students to subjectively value higher education at less than its objective value. therefore low-to-moderate-income students will under-invest in higher education unless they are given a subsidy — a grant — which increases this subjective rate of return. in other words, grants can have a much larger effect on the higher education choice of low-to-moderate-income students than on highincome students who already perceive higher education to be a good investment.80 c. 529 plans have the same effect as grants recall from above that the salient features of grants are that they do not require repayment and that they be paid directly to the student for educational purposes or to the institution on behalf of the student. the important point in time at which to look is when the college decision is made, the time when the costs of higher education are compared to the returns. at that time, the 529 plan must be paid toward education expenses and must be used for the particular designated beneficiary.81 this means that the 529 acts to reduce the net tuition on that day — it is an available amount of money that is guaranteed to be paid to the student to reduce the amount of tuition that needs to be funded from elsewhere. for example, imagine two students, anna and ben, both deciding whether to attend school x. school x has tuition of $20,000 and both students receive a grant of $5,000. anna, however, is the designated beneficiary of a 529 account worth $5,000. on the day that the college decision is made, the net price to ben is $15,000 but the 78. edward p. st. john, refinancing the college dream: access, equal opportunity, and justice for taxpayers 100, 113 (johns hopkins university press 1997). 79. gandhi, supra note 8, at 23. 80. see usher, supra note 52, at 23 (making this same argument, but finding no debt aversion and relying largely on lower returns for lower-income students). 81. this is what distinguishes 529 plans from general savings or income — the latter may or may not be used toward education and thus are not earmarked in the same way as 529 plans. 122 florida tax review [vol. 11:2 net price to anna is only $10,000 because the 529 account must be paid toward the tuition (or else the penalties will be incurred). the 529 plan then has the same effect of reducing net price as a grant and therefore offers the same efficient incentive to low-income taxpayers. iii. policy proposals to maximize the impact of 529 plans a. structure plans to induce savings in order for 529 plans to be a more efficient incentive than outright grants, they must induce those taxpayers who can save for college to do so in order to increase the “grant” at the time the enrollment decision is made. for example, say the government has $500 to use toward each student to incentivize his or her college decision. the above analysis shows that the most efficient use of that $500 is to give it directly to the student to reduce net price at the time of enrollment. however, this sum of money would be a better incentive if the government could use it to encourage the family to pledge an additional $500 toward the student’s education. if that can be done, the amount of the grant received by the student is no longer the $500 of federal aid, but instead is $1,000. there are ways to structure 529 plans to increase participation and the amount of savings, especially by lower-income families. on this point it is best to look at different ways that the states have experimented with increasing participation and the effectiveness of those programs.82 one successful program involves opening an account in the name of all children with an initial contribution by the government to the fund. maine currently offers such a program, the harold alfond college challenge. the program, now in its initial phases, was funded by a large grant from a maine philanthropist and provides a one-time grant (“scholarship”) into a maine 529 account in the name of any newborn resident of maine. the paperwork required to open the account and receive the grant is reviewed with the mother along with other hospital paperwork before discharge after giving birth. it is also available on the internet and in government offices and the program is widely advertised on tv, radio, and in newspapers. in the first two months of the program roughly 1,000 people began the process to open the account.83 given that there are around 14,000 births in maine per year, this would indicate that almost half of the newborns in maine will open an 82. see appendix b for a summary of the state programs offering some sort of initial grant or matching grant for contributions. 83. press release, western maine health, over 1,000 families have requested harold alfond college challenge grant information, http://www.wmhcc. org/wmh_body.cfm?id=5439. 2011] in defense of college savings plans 123 account and receive the grant.84 in the national study only roughly 10 percent of respondents with children indicated having a 529 account.85 this is also a significant increase over previous participation; only 8,000 accounts had previously been opened in maine since the program began in 1999. those administering the program expect that number to increase as the program becomes more widely known. the program has not yet released information on effects by income level, but is a clear indication that this upfront grant can greatly increase participation. a more ideal program along these lines would open an account in the name of every child with this initial contribution, but only make the program available to children in families below a certain income threshold. this presents two administrative difficulties: first, determining the appropriate income level where the cut-off should be, and second, dealing with changing levels of income over the life of the child. the first has been given much attention by states experimenting with incentives that target only lowand moderate-income families. while none of these involve income limits for an initial contribution, most of the states offering a matching grant program have an income limit that attempts to track the line between moderate-income households in need of an incentive to save, and highincome households without need for such an incentive. this income limit is generally between $50,000 and $80,000.86 there is also evidence stemming from a number of programs that offering a matching grant increases both participation and the amount of saving by participants. increased savings is the variable that makes these plans more effective than a traditional grant. one study focused on the maine nextgen matching grant program (before the introduction of the initial contribution, discussed above). the program was available to lower-income households, defined as those with income below $50,000 adjusted gross income (indexed to cpi). of the 6,414,529 nexgen accounts in the state, 1,335 had received at least one matching grant, meaning that they met this income threshold. this indicates that at least 20 percent of the accounts were held by those with household agi below $50,000. this is a stark improvement over the national data discussed previously where those in the lower half of the income distribution held only 2.8 percent of the 529 84. press release, fin. auth. of maine, harold alfond college challenge celebrates six months of awards (aug. 1, 2008), http://www.famemaine.com/ blog/post/harold_alfond_college_challeng.aspx. 85. there were 7,560 total respondents and 750 indicated having a 529 plan. see supra table 3. 86. see margaret clancy, lisa reyes mason & soda lo, ctr. for soc. dev., wash. univ. st. louis, state 529 matching grant program summary (2008), available at http://csd.wustl.edu/publications/documents /529_summary.pdf. 124 florida tax review [vol. 11:2 accounts;87 $50,000 is roughly the 55th percentile in terms of income distribution.88 the data further shows that at least 2 percent of the participants have household agi of less than $20,000 compared to around .1 percent in the national survey.89 the results of the study on maine’s matching grant program also support the fact that lowerand moderate-income people are incentivized to save by the program. the report states that “the most important results of this study are the simple facts that low-to-moderate income individuals save in nextgen, and save through the matching grant program,” and that “income level is not statistically associated with saving performance.”90 the study further finds that about 80 percent of those who receive a matching grant go on to receive continued matching contributions. the “very positive impact on lowand moderate-income families” eventually formed the basis for a proposal of a similar matching grant program in missouri.91 the fact that a matching grant program encourages participation as compared to deductions is also evidenced by a comparison of the kansas and louisiana 529 programs. the programs are similar in most respects, but at the time of the study louisiana offered a progressive matching grant system (increasing the amount of the match as income decreased) while kansas offered only the deduction. in louisiana, participants in the 0-50 income percentiles held almost 23 percent of the total accounts. participants of the same income level in kansas held only about 8 percent of the total 529 accounts. both of these studies compare the use of matching grants to the use of deductions and find significantly increased participation among low-tomoderate-income households with use of matching grants. while a refundable credit provides an economically equivalent benefit to a matching grant, empirical evidence has shown that people are more incentivized by the matching grant than the equivalent credit. the main study in this area found that participants gave around 20 percent more to charities when the incentive 87. of the 750 accounts in the survey, twenty-one were held by those in the 0-50 percentiles. see supra table 3. 88. dep’t treas., analysis of section 529, supra note 30, at 11 (noting less than 1 percent participation); margaret clancy, chang-keun han, lisa reyes mason & michael sherraden, ctr. for soc. dev., wash. univ. st. louis, inclusion in college savings plans: participation and saving in maine’s matching grant program 5 (2006), http://csd.wustl.edu/publications/documents/rp06-03.pdf. 89. only one of the 750 survey participants was in the 0-25 percentile, which corresponds to a maximum income of roughly $22,500. 90. clancy, han, mason & sherraden, supra note 88, at 40. 91. press release, george warren brown sch. of soc. work, wash. univ. st. louis, center for social development’s research informs missouri’s legacy initiative (jan. 22, 2007), http://gwbweb.wustl.edu/newsroom/pressrelease/pages/ missouritreasurersarahsteelman.aspx. 2011] in defense of college savings plans 125 was structured as a matching grant rather than a subsidy rebate.92 for this reason, the ideal program should use a matching grant in order to induce the most savings.93 b. reduce regressivity the role of federal financial aid is to increase enrollment in higher education. lowerand middle-income students are most responsive to and in need of such an incentive, and grants are most effectively and efficiently targeted at those groups. in order to achieve that goal through 529 plans, the plans need to be made not regressive but progressive means of federal financial aid. there are a number of simple changes that can and should be made to 529 plans to achieve such progressivity. many of these proposals have been experimented with for state tax purposes but should be implemented for federal tax purposes as that is the primary benefit of the 529 plans. first, there should be an overall contribution limit. this is probably most easily implemented by allowing only one account total (as opposed to one per state) per designated beneficiary. it may also be that the contribution limit, which now hovers around $300,000, should be lowered. further, there should be an income limit which an account owner must fall below in order to participate in a 529 plan.94 empirical evidence shows that low-income families are most incentivized by direct financial aid, but middle-income families can be responsive to such incentives as well. middle-income families are also more able to save for higher education and take advantage of this particular incentive. thus it is probably the case that direct financial aid, pell grants in particular, should remain focused on the lowest-income families while 529 plans may be a better vehicle for those who are somewhat better off but not high-income. 529 plans can still be 92. catherine c. eckel & philip j. grossman, rebate versus matching: does how we subsidize charitable contributions matter? 87 j. pub. econ. 681 (2003). 93. see infra note 96 for a discussion of the terminology of match vs. refund. 94. consistent with the existing 529 matching programs targeted at lower and middle-income families, the eligibility should be means-tested based on the agi of the child’s family for the previous one to three years. note that the relevant income is that of the child’s family and not that of the owner/donor of the account. this is a more accurate measure of the financial resources available to the child. eligibility must be re-established every year. 126 florida tax review [vol. 11:2 available to even the very lowest-income families but with recognition that they likely will not be able to make much use of them.95 the most important change is that the contributions should be structured as a matching grant.96 either a matching grant or a refundable credit must be used in order to prevent the tax incentive aspect of 529 plans from being regressive. an exclusion is always regressive because it is tied to the taxpayer’s tax bracket. excluding an item of income of $1,000 is worth $350 to a wealthier taxpayer in the 35 percent tax bracket, but worth only $150 to a lower-income taxpayer in the 15 percent tax bracket. a non-refundable credit is not necessarily regressive but is limited by a taxpayer’s tax liability. if two taxpayers are both entitled to a $1,000 deduction and one has tax liability of $3,000 while the other’s is only $800 then the non-refundable credit will be worth the full $1,000 for the first (probably higher-income) taxpayer but worth only $800 to the second (probably lower-income) taxpayer, making the credit regressive. a refundable credit is not limited in this way. as to the $800 taxpayer, he or she would be entitled to a $200 payment, or refund. the refundable credit is therefore worth $1,000 to both of the taxpayers. a matching grant would be a payment into the account equal to some percentage of the payments made by the taxpayer.97 therefore both the refundable credit and the matching grant would solve the regressivity problem of the current exclusion. given the tax-neutral choice between a matching grant and refundable credit, empirical evidence suggests that people will contribute more money when the incentive is a matching grant rather than a refundable credit, even where the economic impact is exactly the same. a credit would be implemented as follows: the taxpayer would pay $2 into the account and the government would remit $1 to the taxpayer. the account would have a $2 balance and the government and taxpayer would each have $1 less. a matching grant would have the following effect: the taxpayer would pay $1 into the account and the government would match that with a $1 payment 95. it is probably also the case that we do not want to force these taxpayers to use 529s because we do not want to force the very limited funds of these families into one particular use. 96. match here is used to mean that the funds are deposited directly into the account (or linked account in the beneficiary’s name) even though theoretically either a refundable tax credit or a spending grant program could be structured either way (to be paid to the donor or the account). for purposes of this paper, a “match” or “matching grant” is payment made to the account while a “refund” is a payment to the donor. 97. in actuality, the matching grants, or contributions by the government, are almost universally held in a separate but linked account. this allows the state or the plan to be the legal owner of the funds and eases administration and return in the event that the funds are not used for qualified expenses. 2011] in defense of college savings plans 127 (depending on the match ratio). the account balance is again $2 and both the government and taxpayer have $1 less, the exact economic equivalent. despite this equivalence, empirical evidence is replete with studies showing that taxpayers respond more to matching grants than credits, though these are not in the educational context.98 c. reduce uncertainty middleand lower-income families may be dissuaded from taking advantage of the benefits of 529 plans, even as restructured, if the uncertainty surrounding the child’s college choice and financial aid remain too high. there are a number of changes that can be made that would reduce this uncertainty and allow these families to use these accounts in the event that their children do attend college. first, there needs to be a mechanism by which the family is not fully penalized if the student fails to attend college. such a penalty could be an overriding deterrent for families where even high-achieving students are attending college only 75 percent of the time.99 given that most of this decision is made well before the family knows anything about the child’s performance or desires (imagine the maine program where the mother is asked to enroll in the program at the time she gives birth), this is a huge level of uncertainty. current 529 plans do not deal with this uncertainty at all — the only way to withdraw funds in that scenario is to incur the penalty.100 the portion of the maine plans contributed by the state, which makes the initial contribution, simply reverts back to the state if the child does not 98. a real but easily corrected problem with a matching grant is churning. churning results when a deposit is made into an account just long enough to receive the match and then both the grant and the match are immediately withdrawn. the problem of churning is generally dealt with in one of two ways: either the grant is recaptured upon early withdrawal, or matches are disallowed during the calendar year (or two, etc.) in which a withdrawal is made from the account. see, e.g., notice of hearing on proposed administrative rulemaking, state of kan., state treasurer’s office (2009), http://www.kansasstatetreasurer.com/prodweb/pdfs/hearing_notice_ 09.pdf (including a discussion of this proposed change to the regulations). this is also the approach used with the saver’s credit. irc § 25b(d)(2)(a). since this latter anti-churning rule only extends the time period during which churning can occur, the recapture of the match option is the better one and should be adopted. this rule would essentially require that should the expenses be withdrawn for any non-qualified reason, the matches that had been deposited into the account would be reclaimed by the government. 99. supra note 63. 100. as noted earlier, while it is possible that a high-income taxpayer may still be better off in this scenario than if they had saved in a taxable account, this is unlikely to ever be true for the lower-income taxpayers who will be eligible to use these 529 plans. 128 florida tax review [vol. 11:2 enroll in higher education or to the extent not used for that purpose. it probably would not work to allow the family to withdraw and reclaim the funds with no penalty like the state can do. the problem would be that this could be used against the student — essentially the family could pressure the student not to attend college in order to regain use of those funds. in other words, in order for the family’s portion of the contribution to act as a grant, it must be earmarked for education. the loss of the state funds alone would not act as a deterrence or penalty as to the family’s portion. an option would be to allow the 529 plans to be rolled over into another such account for a different beneficiary, to the extent that that account was below the limit. in the case where there is no such account or all such accounts are at the contribution limits, the family could have the choice to withdraw the fund with penalty, or to roll it into another tax-preferred account such as a 401(k) or ida. another major cause of uncertainty that leads marginal taxpayers to avoid use of 529 plans is the effect that these assets will have on financial aid. most low-to-moderate-income students will be eligible for federal financial aid, and accumulating assets can act to reduce that financial aid. as it currently stands, 529 plans count as an asset of the parent for purposes of determining the financial aid eligibility of the student. this means that roughly 5.6 percent of the value of the account is treated as being available to pay for college.101 in order to eliminate this disincentive to save, these plans should be excluded from consideration when determining need-based financial aid. the last change that ought to be made to reduce the uncertainty is that withdrawals should be allowed without penalty to the extent that the student receives financial aid, either government or institutional, and does 101. the calculation of the 5.6 percent is a bit complicated. all federal financial aid programs use the free application for federal student aid (fafsa). the fafsa operates by calculating the “expected family contribution,” or the amount that the family should reasonably be expected to pay toward the student’s college education. this in turn indicates to both the government and the institution the amount of need the student has (essentially the tuition at the institution minus the efc). in calculating the efc, the fafsa determines the family’s adjusted available income, which is the family income plus 12 percent of the “unprotected” assets (i.e., those that are not specifically protected like the family home and retirement accounts), of which a 529 plan is one. once the aai is calculated, the efc is 47 percent of that amount. thus in the end 47 percent of 12 percent of the 529 is included in the efc, or 5.6 percent. the fafsa must be filled out each year and so this calculation will be repeated each year based on the value of whatever amount remains in the 529 plan. note that these are maximum amounts, but they begin to apply at low levels of income, generally below $30,000. see u.s. dep’t of educ., info. for fin. aid profs., the efc formula, 2010-2011 19, http://www.ifap. ed.gov/efcformulaguide/attachments/111609efcformulaguide20102011.pdf. 2011] in defense of college savings plans 129 not need to use the funds from the 529 account. this would be only a slight expansion from the current rules which allow withdrawal without penalty when the student receives a scholarship and thus does not need to use the 529 plan. the withdrawal would be subject to taxation but not the 10 percent penalty. one possibility would be that the amount no longer needed for education expenses would be returned to the state and withdrawn by the family penalty-free in proportion to overall contributions to the plan. alternatively, the state may want its own contributions to be returned before the family withdrew any funds without penalty. iv. an illustration building on the evidence taken from state experimentation and studies about matching grants, it seems that the best way to structure a 529 plan to encourage participation is with an initial contribution by the government with no initial contribution requirement on the individual’s behalf. in order to induce additional contributions by the owner, the matching grant is the most effective option. empirical evidence is fairly clear that a matching grant encourages greater contribution than a refundable credit.102 this empirical evidence further shows that at least a one-to-one match encourages more contribution than any lower level of match.103 therefore, the lowest level of match should be one-to-one. it is crucial that the program address the fact that low-income households are less likely to save (or save as much) in response to savings incentives, but are more likely to respond to any program that lowers the net price of higher education because they have the lowest enrollment rates. in order to compensate for those facts, the match should be higher for lowincome families and then reduced to one-to-one for higher-income families. similarly, the initial contribution by the government should be higher for lower-income families and reduced as income increases until it is phased out.104 the federal tax benefits of 529 plans currently cost the government around $1 billion annually.105 given this ideal structure of an initial contribution and at least one-to-one matching grant, this section will make a number of assumptions and attempt to estimate the impact that 529 plans 102. eckel & grossman, supra note 92. 103. id. 104. this design is essentially a compromise between increasing the size of grants to the lowest-income students and offering a savings incentive that would be used more often by middle-income students’ families. this phasing out also prevents the cliff effect and impact on marginal rates when the taxpayer first becomes ineligible. 105. staff of the joint comm. on tax’n, supra note 8. 130 florida tax review [vol. 11:2 could have on college enrollment among lowand moderate-income groups given a reasonable scenario. according to the u.s. census bureau, in 2006 there were approximately 4.2 million births in the u.s.106 additional data (see appendix a) shows that about 52 percent of these births were in households with an income below $50,000 per year.107 that means that around 2.2 million children were born into households below that level of income in 2006; approximately 550,000 to households with income between $35,000 and $50,000 and 1.63 million to households with an income below $34,999. consistent with the federal financial aid plan and the existing matching programs for 529 plans, this illustration will treat a household with income below $35,000 as low-income, and those with income between $35,000 and $50,000 as moderate-income. in order to offer the best incentive and increase enrollment rates the most, an initial contribution of $300 and a later match with a three-to-one ratio will be given to students from households of low-income.108 for those households of moderate income, the beneficiary will receive an initial grant of $100 and one-to-one matches for later contributions.109 looking at the existing plans and participation rates suggests that participation might be somewhere in the 30 percent range. recall that the louisiana matching grant program had about 20 percent participation for these income ranges, without an initial contribution from the government. the maine plan may have had up to a 50 percent participation rate, but that was not controlled for income. it makes sense then to assume that the participation rate when limited to this income would be above that seen in louisiana (with no initial grant) but below that observed in maine. if the participation rate were around 30 percent, and assuming it is equal for households of lowand moderate-income, then participation could be expected for about 489,000 children of low-income and 165,000 of 106. u.s. census bureau, statistical abstract of the united states: 2011 tbl. 78, live births, deaths, marriages, and divorces: 1960 to 2007, available at http://www.census.gov/compendia/statab/2011/tables/11s0078.pdf. 107. jane lawler dye, u.s. census bureau, fertility of american women: 2006, 6 tbl. 3, available at http://www. census.gov/prod/2008pubs/p20-558.pdf. 108. there should be no requirement of initial (or any) contribution by the family. the earlier maine program as well as the ok seed program both saw large increases in participation when this requirement was eliminated and in interviews most account owners indicated that the lack of upfront requirement was a decisive factor in opening an account. see lisa reyes mason, margaret clancy, margaret sherraden & chang-keun han, ctr. for soc. dev., wash. univ. st. louis, saving for college in maine’s matching grant program: account owner experiences 13 (2006), http://csd.wustl.edu/ publications/documents/rp06-04.pdf. 109. as discussed above, the determination of eligibility should be based on the average agi of the previous three years of the family of the beneficiary. 2011] in defense of college savings plans 131 moderate income. given these participation numbers, the $1 billion could fund almost $1,530 per plan initially if it were all used for these upfront grants. some of the funds, however, should be reserved for matching grants to encourage additional investment by the owner of the plan. recall that in a study of maine’s matching grant program, 80 percent of participants who received a first match continued to make contributions to receive subsequent matches; this data was using only low-to-middle-income taxpayers.110 assuming that this rate would be somewhat lower for those only of lowincome, because of the difficulty of saving any money, it seems reasonable to estimate roughly 60 percent of low-income households will continue to participate. the 80 percent observed in the maine program will be assumed to be the continued participation rate among moderate-income households. this would mean that 18 percent of low-income families (60 percent of the original 30 percent) and 24 percent of moderate-income families (80 percent of the original 30 percent) of those in the targeted income group could be expected to maximize the matching portion of the account. assuming these participation rates, a roughly $1 billion budget, and initial grants of $300 and $100 respectively, the government could offer the following (very basic) program: low-income households would receive the $300 initial grant and a three-to-one match of up to $150 per year; moderate-income families would receive the $100 initial grant and a one-to-one match of up to $50 per year.111 if the account owner (or friends, family, etc.) contributed the full matching amount of $50 per year, and the account grew at a rate of 6 percent annually and had earnings 110. the matching amount for that program was $100 per year at the beginning of the study and $200 per year by the end. mason, clancy, sherraden & han, supra note 108, at 2. 111. creating and incentivizing the use of these accounts will certainly raise a number of administrative issues, many of which have already been dealt with by the states experimenting in this area or discussed previously in this paper. as noted several times, the contributions from the family/donor and the matches from the state will almost certainly be kept in different accounts to allow for separate ownership until the point of distribution. the funds can then be paid directly to the institution or paid as reimbursement upon proof of spending for qualified expenses. the fact that all of these 529 accounts are held as part of a larger plan of the state allows for administration of even the smallest accounts. providers therefore do not need to avoid small, unprofitable accounts because these have been shown to be adequately supported by the larger accounts of the plan. see margaret clancy, peter orszag & michael sherraden, ctr. for soc. dev., wash. univ. st louis, college savings plans: a platform for inclusive savings policy? (2004), http://www.cfsinnovation. com/system/files/imported/managed_documents/clancy_et_al_2004.pdf. 132 florida tax review [vol. 11:2 taxed at a 20 percent rate, then on the day the child made his or her college decision, the plan for each household would look as follows:112 table 4 account for full participating account for full participating moderate-income household low-income household family family gov contriaccount gov contriaccount year match bution balance year match bution balance 0 $100 $100 0 $300 $300 1 $50 $50 $205 1 $150 $50 $514 2 $50 $50 $315 2 $150 $50 $739 3 $50 $50 $430 3 $150 $50 $975 4 $50 $50 $550 4 $150 $50 $1,221 5 $50 $50 $677 5 $150 $50 $1,480 6 $50 $50 $809 6 $150 $50 $1,751 7 $50 $50 $948 7 $150 $50 $2,035 8 $50 $50 $1,094 8 $150 $50 $2,333 9 $50 $50 $1,246 9 $150 $50 $2,645 10 $50 $50 $1,406 10 $150 $50 $2,972 11 $50 $50 $1,573 11 $150 $50 $3,314 12 $50 $50 $1,749 12 $150 $50 $3,673 13 $50 $50 $1,933 13 $150 $50 $4,050 14 $50 $50 $2,126 14 $150 $50 $4,444 15 $50 $50 $2,328 15 $150 $50 $4,857 16 $50 $50 $2,539 16 $150 $50 $5,291 17 $50 $50 $2,761 17 $150 $50 $5,745 112. this does not assume the current benefit of deferral but instead the account balance reflects a tax on the earning of 20 percent. the benefit of the accounts as presented here is not deferral but instead is the match. thus, an account’s earnings should be taxable to the owner of the account, which in most cases is the parent. the tax (as assumed here) should be able to be paid out of the account balance in order to ease what might otherwise be a liquidity problem. note too that many of these taxpayers will almost certainly be in the zero bracket. also, recall from above that the contributions from the state and federal government likely should and would be kept in a separate but linked account, in the beneficiary’s name but technically owned by the plan or the state. 2011] in defense of college savings plans 133 while the balance of these accounts is not insignificant, the impact is greatly increased if the account also gets the benefit of a state matching program as well. as an illustration, assume that this is a plan in arkansas which provides a two-to-one match for low-income households and a one-toone match for moderate-income households, with a maximum $500 match per year.113 table 5 account for full participating account for full participating moderate-income household, low-income household, including state match including state match year gov match state match family contribution account balance year gov match state match family contribution account balance 0 $100 $100 0 $300 $300 1 $50 $50 $50 $255 1 $150 $100 $50 $614 2 $50 $50 $50 $417 2 $150 $100 $50 $944 3 $50 $50 $50 $587 3 $150 $100 $50 $1,289 4 $50 $50 $50 $765 4 $150 $100 $50 $1,651 5 $50 $50 $50 $952 5 $150 $100 $50 $2,030 6 $50 $50 $50 $1,148 6 $150 $100 $50 $2,428 7 $50 $50 $50 $1,353 7 $150 $100 $50 $2,844 8 $50 $50 $50 $1,568 8 $150 $100 $50 $3,281 9 $50 $50 $50 $1,793 9 $150 $100 $50 $3,738 10 $50 $50 $50 $2,029 10 $150 $100 $50 $4,218 11 $50 $50 $50 $2,276 11 $150 $100 $50 $4,720 12 $50 $50 $50 $2,536 12 $150 $100 $50 $5,247 13 $50 $50 $50 $2,807 13 $150 $100 $50 $5,799 14 $50 $50 $50 $3,092 14 $150 $100 $50 $6,377 15 $50 $50 $50 $3,391 15 $150 $100 $50 $6,983 16 $50 $50 $50 $3,703 16 $150 $100 $50 $7,618 17 $50 $50 $50 $4,031 17 $150 $100 $50 $8,284 113. assume for the time being that the account owner still only contributes up to the level of the federal match. 134 florida tax review [vol. 11:2 a significant number of studies have found that an increase in direct aid leads to an increased enrollment of roughly 3.6 to 4 percentage points, or correspondingly, that an increase in net price leads to decreased enrollment of the same level.114 one such study looked at the elimination of the social security student benefits program, which provided aid to students who had suffered the death of a parent. this study found, consistent with previous studies, that $1,000 in grant aid leads to an increase in enrollment of 3.6 percentage points.115 since the aid provided by these 529 accounts will be almost entirely redirected from higher-income students to these lowand moderate-income students, almost all, if not all, of this amount should be treated as an increase in aid. even assuming that only $7,500 (low-income) and $3,500 (moderateincome) represent additional aid, and assuming the 18 percent (low-income) and 24 percent (moderate-income) participation rates, this basic scenario could lead to an increase in enrollment of up to 4.8 percentage points (low) and 3 percentage points for these income classes, increasing participation from around 40 percent to as high as 44 percent.116 there is also reason to believe that these classes of students are more price-elastic than higher-income students, and the dynarski study on the impact of aid did not address differential impact based on income. to the extent that that is true, the increase in enrollment may be toward the higher end of the spectrum (4 percent) since it is targeted only toward lowand moderate-income students. this would represent increased enrollment of 3.6 114. susan dynarski, does aid matter? measuring the effect of student aid on college attendance and completion 16 (john f. kennedy sch. of gov’t, faculty research working paper series, no. rwp01-034, 2001), available at http://web.hks.harvard.edu/publications/getfile.aspx?id=21. see also larry l. leslie & paul t. brinkman, the economic value of higher education 124-25, 155 (1988) (stating that a $1,000 increase in net price decreases attendance by 3-5 percent); charles f. manski & david a. wise, college choice in america 119-28, 123 tbl.7.4 (1983) ($1,000 in aid increases enrollment by 3.8 percent); thomas j. kane, college entry by blacks since 1970: the role of college costs, family background, and the returns to education, 102 j. pol. econ. 878, 892-93 tbls.3 & 4 (1994) (finding that a $1,000 increase in price decreases enrollment by 3.7 percent). 115. dynarski, supra note 114, at 16. 116. this assumes a linear impact of the aid such that the third $1,000 has the same impact as the first, an assumption also made in these studies. thus, this number is calculated as 3.6 percent (7.5) = 27 percent (.18) = 4.86 percent, and for moderate-income students 3.6 percent (3.5) = 12.6 percent (.24) = 3.02 percent. note also that this should not have an impact on college prices — when pell grants were introduced many argued that the increase in aid would just be directly offset with an increase in tuition. this never materialized and is not suspected to be problem. see id. 2011] in defense of college savings plans 135 percentage points for low-income students and 2.7 percentage points for moderate-income students. conclusion federal financial aid has recently moved away from focusing on giving direct aid to lowand moderate-income students and at the same time has seen a stalling of enrollment rates. there is also a continued and wide gap between the enrollment rates of lower-income students and higherincome students. this paper has shown that the most effective way to increase the enrollment rates among low-to-moderate-income students is to decrease net price by offering a grant at the time of enrollment. a 529 plan can not only affect this same decrease in net price and thus have the same incentive, but it can also induce families to save on their own — thus giving the student a grant in the amount not only of the government’s share, but of the family’s contributed share as well. this can be accomplished in a revenue-neutral manner by eliminating the current tax benefits on 529 accounts, thus giving the government $1 billion annually for the program. the government can thus offer an initial grant into a 529 account for each child born into a family with low-to-moderate income, as well as annual matching grants, both dependent on income. based on evaluations of similar current programs, this could lead to an increase in enrollment among these students of almost 5 percentage points, a number which could be much larger if expanded beyond this revenue-neutral analysis. this increase would be more than any seen in the previous two decades and was achieved using only $1 billion of federal funds already allocated to 529 plans — a paltry sum compared to either the $180 billion of total federal financial aid or the $35 billion of tax incentives for education. 136 florida tax review [vol. 11:2 appendix a ― births by income for 2006 income minimum income maximum number of women births per 1,000 women births % 0 $10,000 15,889,965 33.2 527,547 12.61% $10,000 $14,999 2,308,705 89.5 206,629 4.94% $15,000 $24,999 5,324,892 85.2 453,681 10.85% $25,000 $34,999 5,864,945 74.7 438,111 10.47% $35,000 $49,999 8,599,979 64.2 552,119 13.20% $50,000 $74,999 13,215,740 58.9 778,407 18.61% $75,000 $99,999 9,647,862 51.9 500,724 11.97% $100,000 $149,999 9,444,088 48.1 454,261 10.86% $150,000 $199,999 3,105,652 46.7 145,034 3.47% $200,000+ 2,770,679 45.7 126,620 3.03% total 76,172,507 4,183,133 100.00% source: jane lawler dye, u.s. census bureau, fertility of american women: 2006, 6, available at http://www.census.gov/ prod/2008pubs/p20-558.pdf. source: jane lawler dye, u.s. census bureau, fertility of american women: 2006, 6, available at http://www.census.gov/ prod/2008pubs/p20-558.pdf. 28.4 23.6718.61 22.83 6.5 births by income 0-$24,999 $25,000-$49,999 $50,000-$74,999 $75,000-$149,999 $150,000+ 2011] in defense of college savings plans 137 appendix b ― state plans state name of plan eligibility match criteria funding procedure for granting match distribution arkansas gift college investing plan household income below $60,000 for income below $30,000, the match is 2 to 1. for income between $30,000 and $60,000 the match is 1 to 1. both are capped at $500 per year. state appropriation of $250,000 for a pilot program. match contributed to account opened by the owner. colorado direct portfolio college savings plan, scholars choice college savings program, stable value plus college savings program household income up to 200% of the federal poverty line, and beneficiary under the age of 13 at the time of application. 1 to 1 match for contributions up to $500 per year and limited to 5 years of matches. annual budgeting by the state. match goes into separate account in the beneficiary's name that is owned by collegeinve st (the investment managemen t company). paid directly to institution, matches revoked if no qualified withdrawals by age 22. kansas learning quest household income below 200% of the federal poverty level and available to first 300 applicants in each of the four congressional districts. 1 to 1 match for contributions above $100 and up to $600 per year. pilot program funded for three years by the state. match goes into separate account in the beneficiary's name but tied to the same investment portfolio. paid directly to institution or to beneficiary with proof for reimburseme nt of qualified expenses. louisiana start saving program all residents are eligible but the match is progressive based on household progressive match based on income which ranges from 2% to 14%. subject to yearly appropriation s. credited directly to the accounthold er. state recovers match and earnings accrued if withdrawal for non138 florida tax review [vol. 11:2 income, with the highest match (14%) available to those with income up to $29,999. qualified purpose. maine nextgen college investing plan families with agi of $75,000 or less. state provides a $200 initial grant on accounts funded with at least $50. the harold alfond foundation makes available a $500 initial grant to all babies to open such an account, regardless of income. (the annual contribution match was not renewed for 2010). funded by the user fees that are paid by nonresident accountholde rs. matches go to separate account in beneficiary’ s name but owned and invested by fame. application process to apply for use of the funds. michigan discontinued for 2009-2010 michigan educaiton savings program available to those with agi up to $80,000 and beneficiary under the age of seven. one time matching grant of $1 for every $3 contributed, capped at a total match of $200. state appropriation from tobacco settlement fund. matches go to separate account owned by the savings program and invested in institutional bonds. paid directly to the institution and recovered by the state if not used by the age of 30 or if no longer needed by beneficiary. minnesota minnesota college savings plan agi up to $80,000 and must contribute $200 per year. 15% match for those with income up to $50,000, 10 % match for those with income between $50,000 and $80,000. both funded by annual appropriation s where matches reduced proportionatel y when not sufficient to cover all. matches go to separate account owned by the state and invested in guaranteed return fund. no distributions can be made until the account has been open for 3 years. 2011] in defense of college savings plans 139 are capped at $400 per year. nebraska college savings plan of nebraska available to residents and non-residents attending a nebraska university. can apply for additional contribution from a private fund. privatelyfunded endowment. matches go to the account. nevada the upromise college fund prior-year agi of $61,950 or less and nevada resident. $300 annual matching contribution with a $1,500 lifetime limit. new jersey any nj college savings plan eligible to anyone with a nj college savings plan with contributions requirements (not yet set). $1,500 scholarship at nj college for first semester if have met the contribution requirements. state appropriation s. directly to institution. north dakota college save nd residents with incomes below $80,000 (joint) or $40,000 (single) and beneficiary under the age of 12. one time 1 to 1 match of up to $300. funded by user fees. matches go to separate account owned by bank of north dakota. payment sent directly to institution. oklahoma oklahoma college savings plan randomly selected children born in the state in 2007. received an initial $1,000 contribution and are eligible for a .5 to 1 ($125 total) or 1 to 1 ($250 total) match based on income. part of a study called seed ok funded by the ford foundation. matches and initial contribution go to beneficiary's account. rhode island collegebou ndfund eligibility based on previous-year agi but income limits not yet set. 1 to 1 match up to $500 annually. funded by national user fees (and reduced proportionall y preserving 1 to 1 match where necessary). matches go to separate account in beneficiary's name and owned and invested by collegebou nd. sent directly to institution and will be revoked if not used within "reasonable" time of becoming eligible to withdraw. 140 florida tax review [vol. 11:2 sources: savingforcollege.com, compare 529 plans, http://www.savingforcollege. com/compare_529_plans/index.php?plan_question_ids[]=438&mode=compare&pa ge=compare_plan_questions&plan_type_id= (last visited jan. 24, 2011). margaret clancy, lisa reyes mason, & soda lo, ctr. for soc. dev., wash. univ. st. louis, state 529 matching grant program summary (2008), available at http://csd.wustl.edu/publications/documents/529_summary.pdf. utah utah education savings plan up to 200% of federal poverty level or eligible for tanf, and must commit to saving $25 per month in account. 1 to 1 match up to $300 per year for a maximum of four years. pilot program funded by the state. matches go to separate account owned by the plan and in the beneficiary's name. paid directly to instution. introduction i. federal financial aid scheme a. background b. current 529 plans 1. structure 2. previous evaluations of effectiveness ii. college savings as a useful element of federal financial aid a. lower-income students under-invest in higher education 1. lowand moderate-income students may have lower returns from higher education 2. hyperbolic discounting 3. debt aversion b. lower-income students respond more to grants than other types of aid c. 529 plans have the same effect as grants iii. policy proposals to maximize the impact of 529 plans iv. an illustration conclusion microsoft word 1st 5 pages.doc florida tax review volume 10 2010 number 4 411 the coming(?) inflation and the income tax: lessons from the past, lessons for the future by david gliksberg* abstract the concerns about inflation as a result of the current financial crisis and the u.s. budget deficit challenge the social order, including taxation. based on the historical u.s. experience and discourse on this issue, the article focuses on the relationships between adjusting the tax system for inflation and the general attitude towards adjustment for inflation in the social order. the article offers a new insight which is very different from the current research. the nominalism/adjustism culture that dominates the social order is placed at the center of the analysis. there is “equilibrium” between the scope of adjustment in the social order and in the tax regime. advancing adjustment of the tax regime requires that it also be promoted in the general social order. this cultural paradigm plays a significant role in the tax response to inflation, including the scope and character of that adjustment regime. this approach erodes the literature’s conservative approach arguing that classical tax policy consideration like cost-benefit analysis is the most effective factor on the adjustment issue. the article argues that adopting an adjusted tax regime is largely dependent on the existence and extent of a general culture towards the concept of “money”: is the prevailing culture one of nominalism or adjustism? this paradigm explains the reality in the u.s. in the past with regards to adjustment for inflation. the sophisticated american discourse on adjusting the income tax regime for inflation, which first took place in the late nineteen seventies and early nineteen eighties, was unproductive from * satinover professor of tax law, faculty of law, hebrew university. i would like to extend my thanks to ilan benshalom and victor thuronyi for their helpful comments on a previous draft. i would also like to thank the harvard law school and alvin c. warren jr. for their gracious hospitality while i was writing the main part of this article. 412 florida tax review [vol. 10:4 the start, and was doomed to failure because the u.s. culture of adjustism was not sufficiently ripe for justifying or permitting a “legitimate” social decision on adjusting the tax regime. the lessons from the past are that advancing adjustment of the tax regime requires promoting adjustment of the general social order. adjusting the income tax regime without adjusting the general social order would be, culturally, a tough mission and even impossible. 2010] the coming(?) inflation and the income tax 413 introduction .......................................................................................... 414 i. fundamental principles of adjusting the income tax regime for inflation ..................................................................................... 417 a. general ........................................................................................... 417 b. comprehensive adjustment ............................................................ 423 c. explicit partial adjustment and implicit partial adjustment ......... 425 ii. general tax policy considerations .......................................... 427 a. general ........................................................................................... 427 b. cost-benefit analysis ..................................................................... 428 c. the general culture paradigm: nominalism or adjustism ........... 428 d. nominalism as a stabilizer ............................................................. 438 e. tax collection considerations ....................................................... 440 f. political and social considerations ............................................... 441 g. inflation levels and tax rates ....................................................... 448 conclusions ............................................................................................ 449 414 florida tax review [vol. 10:4 introduction the concerns of facing inflation under the current economic crisis and the tremendous u.s. budget deficit challenge the current social order, including taxation. will the issue of adjusting the income tax regime to inflation be on the tax agenda?1 based on the historical u.s. experience and discourse on this issue, the article focuses on the relationships between adjusting the tax system for inflation and the general attitude towards adjustment for inflation in the social order. tax adjustment for inflation must be examined in the framework of an integrative, cohesive and coherent review of nominalism (valorism)\adjustism present in the social order.2 it attempts to establish the strategic boundaries of the various inflationary adjustment regimes and the means for choosing among them. the issue of adjusting the tax regime to inflation is challenging due to its complexity, and that tends to create an imbalance between the attention given to the particulars of adjustment for inflation and the concern for broader issues such as the general attitude towards adjustment for inflation in the social order. a proper balance must be struck between those particulars and the broader issues. the tax discourse must therefore adopt a coherent approach that attaches proper weight to the role of tax law in society by emphasizing the reciprocity between tax law and other components of the social order. the fundamental underpinnings of the tax regime cannot be examined autonomously, but rather must be viewed as part of the general social order reflected in the legal system. most countries3 either do not adjust for inflation (nominalist regimes), or do so only partially.4 such adjustment may be either explicit or 1. the scholarly literature uses the terms ‘adjustment’ and ‘indexation’ in regard to converting nominal-value tax regimes to real-value tax regimes. see, e.g., victor thuronyi, tax law design & drafting 434 (victor thuronyi ed., kluwar law international 2000); reed shuldiner, indexing the tax code, 48 tax l. rev. 537 (1993); brookings inst. inflation and the income tax (henry j. aaron ed., 1976) [hereinafter inflation and the income tax]. this article uses the term ‘adjustment’ rather than ‘indexation,’ inasmuch as several adjustment regimes do not employ indexation but use other means of adjustment. 2. for historical developments, see, e.g., keith. s. rosenn, law and inflation 57-59 (univ. of penn. press 1982); eliyahu hirshberg, the impact of inflation law and inflation, (1982); eliyahu hirschberg, the impact of inflation and devaluation on private legal obligations (1976); frederick a. mann, the legal aspects of money, 5th ed. (oxford univ. press 1992); shirley renner, inflation and the enforcement of contracts (edward elgar 1999); aaron yoran, the effect of inflation on civil and tax liability (springer 1983). 3. to the best of my knowledge, only nine countries have adopted a comprehensive adjustment model: argentina, brazil, chile, colombia, israel, mexico, peru, romania, and venezuela. see thuronyi, supra n. 1, at 447 n.37; vito 2010] the coming(?) inflation and the income tax 415 implicit.5 this article proceeds from the assumption that a tax regime should be adjusted for inflation, and the absence of such adjustment results in a distorted tax regime.6 the classical approach7 adopts the view that the issue of adjustment for inflation should be weighed in accordance with the normal tax-policy considerations, i.e., cost-benefit considerations.8 the primary benefit is taxation of real income, thus preventing a distortion of distributive justice9 and promoting economic efficiency. the cost is the compliance costs. the dominant view is that comprehensive adjustment for inflation, which is preferable to nominalism or partial adjustment,10 is conceptually and technically complex and involves high compliance costs. thus, in terms of a cost-benefit analysis, it should not be adopted despite the inflationary damage to the tax regime. as inflation rates rise, the benefit of adjustment increases, while compliance costs generally remain fixed. thus, under the classical approach, the tendency toward adjustment will grow as the rate of inflation increases. since the inflation rates in the democratic countries are not high, the classical tax discourse involves finding the optimal partial adjustment regime as the second best option, due to its relatively low cost compared to a comprehensive adjustment. at the core of this article is the erosion or elimination of the literature’s conservative approach arguing that classical tax policy consideration like cost-benefit analysis is the most effective factor on the tanzi, inflation and the personal income tax: an international perspective (cambridge univ. press 1980); keith s. rosenn, adjusting taxation of business income for inflation: lesson from brazil and chile, 13 texas int’l l.j. 165 (19771978); int’l fiscal ass’n, adjustments for tax purposes in highly inflationary economies (kluwer law international 1985); yishai beer, taxation under conditions of inflation: the israeli experience, 5 tax notes int’l 299 (1992); daniel halperin & eugene steuerle, indexing the tax system for inflation, in uneasy compromise: problems of a hybrid income-consumption tax 347 (aaron et al. eds., brookings inst. press 1988). 4. see part iii c. 5. see halperin & steuerle, supra note 3, 353-57. 6. see text accompanying note 14 et seq. 7. see, e.g., the literature cited in notes 1 and 3; richard a. musgrave, comments, in uneasy compromise: problems of a hybrid income-consumption tax 376 (aaron et al. eds., brookings inst. press 1988). 8. in this article cost-benefit considerations include all social costs, unless otherwise stated. 9. see, e.g., cong. budget office, indexing the individual income tax for inflation, at 5-10 (1980); oecd comm. on fiscal affairs, the adjustment of personal income tax systems for inflation, at 19-22 (oecd publications center 1976) [hereinafter the oecd report]. for example, the effect of non-adjustment for capital gains is greater for the middle class than for the wealthy. see bruce bartlett, inflation and capital gains, 75 tax note 1263 (1997). 10. id. 416 florida tax review [vol. 10:4 adjustment issue. the article argues that adopting an adjusted tax regime is largely dependent on the existence and extent of a general social culture of adjustment, which i refer to as ‘adjustism’ (the opposite of nominalism). the more a society and its economy are characterized by adjustment for inflation in non-tax areas,11 the more likely it is that the tax system will also adjust for inflation. adjustisim derives from the way a society relates to the value of “money”: is the society committed to nominalism or adjustism? is the prevailing culture one of nominalism or adjustism?12 according to the proposed paradigm, the integration of the tax system into the surrounding socio-economic culture includes the adjustment for inflation. in the face of substantial change in the socio-economic environment, the tax system will not be the first to react due to its complicated and conservative nature, but it is not to say that the tax system will be the last to adjust. the general cultural paradigm of adjustment affects the decision of whether to adopt a partial adjustment regime or a comprehensive adjustment regime. this paradigm explains the reality in the united states with regards to adjustment for inflation in general and its tax regime in particular. the american discourse on adjusting the income tax regime for inflation, which first took place in the late nineteen seventies and early nineteen eighties, was unproductive from the start and was doomed to failure because the u.s. culture of adjustism was not sufficiently ripe for justifying or permitting a “legitimate” social decision on adjusting the tax system for inflation. part i will present the fundamental principles regarding the adjustment of the income tax regime, focusing on the two basic models of adjustment for inflation – comprehensive adjustment and partial adjustment – and the subcategories of partial adjustment: explicit partial adjustment and implicit partial adjustment. this part provides the necessary background for part ii, which will review the various considerations that influence the transition from a nominalistic model to a model that adjusts for inflation, and the scope of that adjustment. at the center of this discussion is the general culture paradigm of adjustment for inflation, and the relationship between the general culture paradigm and other policy considerations. 11. for a legal analysis of inflation, see rosenn, supra note 2; hirschberg, supra note 2; mann, supra note 2. 12. only few areas of the social order are unaffected by inflation. see, e.g., jim chen, the price of macroeconomic imprecision: how should the law measure inflation? 54 hastings l.j. 1375, 1376 (2003). 2010] the coming(?) inflation and the income tax 417 i. fundamental principles of adjusting the income tax regime for inflation a. general inflation erodes the effectiveness of various normative regimes by distorting distributive justice13 and economic efficiency.14 this erosion continues as long as the legal system employs nominal values of money between points in time. when inflation occurs, this nominal nominal approach creates a variety of distortions, and many legal regimes are rendered ridiculous in the absence of adjustment for inflation.15 inflation undermines the primary goal of the tax system: collection of just and efficient taxes.16 this distortion occurs even at relatively low rates of inflation.17 distributive justice suffers when inflation affects ability to pay,18 both in terms of horizontal and vertical justice. it also causes substantial harm to the economic effectiveness of the tax system. inflation gives preference to debt over equity due to the deduction of the inflationary 13. for an analysis of the impact of inflation on distributive justice, see, e.g., stanley fischer, indexing, inflation, and economic policy 19-27 (mit press 1986). fischer argues that inflation harms distributive justice because it introduces discrimination between creditors and debtors, risk takers and risk seekers, and between short-term and long-term contracts, while also exacerbating the intergeneration issue. unlike the economic costs of inflation, the social costs of inflation have not been explored in depth. see, e.g., stanley fischer, why are central banks pursuing long-run price stability?, in achieving price stability, federal reserve bank of kansas city symposium series (1996). 14. for the economic harm caused by inflation, see, e.g., stanley fischer, modern central banking, in the future of central banking (forrest capie et al. eds., 1994); stanley fischer, towards an understanding of the costs of inflation: ii, in the cost and consequences of inflation (karl brunner and allen h. meltzer eds., 1981). 15. guido calabresi, a common law for the age of statutes 66 (lawbook exchange 2000). calabresi emphasizes that inflation often leads to serious results that prevent the achieving of legislative purpose. for example, legislation intended to benefit a particular group may end up harming that group. 16. see, e.g., richard goode, government finance in developing countries 128-29 (brookings inst. press 1984). 17. halperin & steuerle, supra note 3, at 348. 18. see, e.g., martin j. baily, inflationary distortions and taxes, in inflation and the income tax, supra note 1, at 291, 296 et seq. on this principle and critique of it in the framework of the traditional view of tax justice, see, e.g., liam murphy & thomas nagel, the myth of ownership: taxes and justice 12-39 (oxford univ. press 2002). 418 florida tax review [vol. 10:4 element of debt19 and the choice among different assets will be affected by the inflationary effect caused by tax law. failure to neutralize inflation effectively levies an additional tax burden. this burden can be positive or negative (constituting a subsidy) and its scope may be influenced by arbitrary variables (e.g., the inflation rate, equity v. debt, the length of asset possession) that are inappropriate or irrelevant to a desirable tax policy. such arbitrariness harms both distributive justice and economic efficiency. inflation not only adversely affects the accurate measurement of income, but also the collection of taxes after tax liability has been established. what suffers from inflation can be analyzed from several perspectives. for our analysis, i will use the classic view of the effects of inflation on the tax system,20 which identifies three primary normative levels that have to be adjusted. each of the levels erodes the distributive justice and efficiency of the tax regime, since each has unjustifiable and inefficient tax consequences that change the effective tax burden, as compared to the effective tax burden that would apply in an inflation-free world. the first level is the collection lag. tax liability must be adjusted after the occurrence of a tax event. even if the tax base is entirely adjusted for inflation, the tax liability must also be adjusted to the date of payment. in the absence of such adjustment the effective tax burden will not coincide with what is normatively required. the collection lag applies to two subperiods: the period between the occurrence of the tax event and the date the taxpayer is required to pay the tax21 and the period between the date the taxpayer is required to pay and the date of actual payment.22 the second subperiod is not inherently connected to tax law. hence, it must be treated the same way that society treats other debts’ collection lag. in the absence of a general legal arrangement for adjusting debts for inflation, there is no justification for only adjusting tax debts. the second level concerns the effect inflation has on nominal elements in the tax system. for example, in the case of income tax, the required adjustment comprises, first and foremost, personal exemption, 19. for the difficulty in distinguishing equity capital and debt capital in the context of adjustment for inflation, see, e.g., halperin & steuerle, supra note 3, at 366. 20. see, e.g., thuronyi, supra note 1, at 435. 21. the first sub-period is of particular relevance to income tax rather than to value added tax. see, e.g., thuronyi, supra note 1, at 437. 22. for increasing the collection efficiency, see, e.g., goode, supra note 16, at 132, 225. a substantive reaction to the erosion is the collection tools that operate over the course of the taxable period, such as withholding tax and tax advances. these vehicles were not originally intended to serve as adjustment mechanisms, but rather to increase the effectiveness of collection. these mechanisms thus serve a dual function: collection and adjustment. the latter is of greater importance during periods of high inflation. 2010] the coming(?) inflation and the income tax 419 standard deduction, earned income credit, and the tax brackets, in order to prevent the phenomenon of bracket creep.23 these elements are essential, primarily from the distributive justice perspective. addressing inflation in this level is relatively simple, and can be achieved by adjusting nominal values to inflation.24 the third level deals with the inflation effect on the tax base. this level is the one most ‘infected’ by inflationary distortions, and curing it is most difficult.25 inflation potentially affects the tax base of other tax regimes, as well, but the income tax regime is the most susceptible.26 the simplest explanation of how inflation affects the tax regime is provided by the s.h.s. (schanz-haig-simons) model,27 according to which taxable income is composed of the addition to wealth between the two end points of the measurement period, with the addition of consumption over that period. these variables are measured at different times (beginning, end and inbetween of the period). thus, the inflationary reality distorts the accuracy of the measurement.28 23. in the united states, the adjustment of these elements began in 1984. see irc §§ 1(f), 63(c)(4), and 151(d)(4); joel slemrod & jon bakja, taxing ourselves 238 (mit press 1996); indexing the individual income tax for inflation, supra note 9, at 5; the oecd report, supra note 9, at 9. for comparative aspects, see goode, supra note 16, at 128, 140. for the political aspects of bracket creep, see s. steinmo, taxation and democracy: swedish, british and american approaches to financing the modern state 19 (yale univ. press 1993). it should be noted that not all the elements of the u.s. income tax regime were indexed, as for example, the alternative minimum tax. see, e.g., gabriel aistebaomo, the individual alternative minimum tax and the intersection of bush tax cuts: a proposal for permanent reform, 23 akron tax j. 109, 138 (2008); joint comm. on tax’n, present law and background relating to the individual alternative minimum tax, at 110 (comm. print 2007). 24. slemrod & bakja, supra note 23, at 28, 237-38; emil m. sunley, jr. & joseph pechman, inflation adjustment for the individual income tax, in inflation and the income tax, supra note 1, at 153-54; george vukelich, the effect of inflation on real tax rates, 20 canad. tax j. 243 (1972). 25. these three areas form a dynamic process of adjustment. for example, if adjustment is adopted in the second area, this adjustment influences the effective tax burden, and motivates adjustment of the entire tax system, including the third area, based on the argument that from the effective tax point of view, there is no substantive distinction between adjusting the second area and adjusting the third area. 26. see thuronyi, supra note 1, at 440. 27. for attributing the haig-simons model to the german economist george von schanz, see, e.g., stanley. s. surrey & paul. r. mcdaniel, tax expenditures 4 (harvard univ. press 1985). 28. robert m. haig, the concept of income – economic and legal aspects, in the federal income tax 1, 7 (robert m. haig ed., 1921) (reprinted in 420 florida tax review [vol. 10:4 five fundamental issues arise when adjusting the income tax base:29 first, the capital gains tax regime imposes tax on nominal capital gain, including the inflationary component.30 such taxation represents the taxation of the capital itself,31 rather than taxation of the capital gain.32 second, inflation distorts income and expense in relation to debt.33 conceptually, the inflationary component of nominal interest does not constitute real interest, but rather is part of the principal and this component does not create income or expense.34 incorporating the inflationary component distorts the income tax regime by erasing the distinction between capital and the return on the am. econ. ass’n, readings in the economics of taxation 54 (richard a. musgrave & carl s. shoup eds., richard d. irwin 1959); henry c. simons, personal income taxation: the definition of income as a problem of fiscal policy 50 (1938). 29. dale chua, inflation adjustment, in tax policy handbook 142 (parthasarathi shome ed., int’l monetary fund 1995). 30. thus, for example, between the years 1946 and 1977, there was no real capital gain, yet capital gains were taxed. see robert eisner, capital gains and income: real changes in the value of capital in the united states, 1946-1977, in the measurement of capital 447 (dan usher ed., univ. of chicago press 1980). the proposal to index capital gains was first raised by the us treasury in department of treasury, blueprint for basic tax reform (gpo, washington d.c: 1977). 31. see shuldiner, supra note 1, at 549; halperin & steuerle, supra note 3, at 352. it should be noted that the longer the asset is held, the smaller the effect of taxing the inflationary component of the capital gain, for two reasons: first, the longer the said period, the smaller the inflationary component in the overall capital gain. second, the longer the period, the greater the benefit of the tax deferral. however, when we are concerned with losses, the longer the asset is held, the greater the need for adjustment, due to the same considerations. see shuldiner, supra note 1, at 552-557; halperin & steuerle, supra note 3, at 3. 32. the adjustment of capital gains tax for inflation is strongly tied to the realization requirement and eliminating this requirement by building the tax regime on an accrual basis would substantially reduce the need to address adjustment. see halperin & steuerle, supra note 3, at 379; shuldiner, supra note 1, at 550-57. this article proceeds from the premise of the realization requirement which stands at the core of the current income tax regime. 33. yoram margalioth, the case for tax indexation of debt, 15 am. j. tax pol’y 205 (1998). 34. the same tax treatment that applies to the principal applies to the inflationary component of the nominal interest. for analyzing the proposal of an arbitrary distinction between the two components, see halperin & steuerle, supra note 3, at 353-54; richard a. musgrave, supra note 3, at 378; eugene steuerle, tax arbitrage, inflation, and the taxation of interest payments and receipts, 30 wayne l. rev. 991, 991-1013 (1984). for the effect of inflationary taxation on the interest rates, see, e.g., int’l monetary fund, taxation, inflation, and interest rates (vito tanzi ed., 1984). 2010] the coming(?) inflation and the income tax 421 capital,35 both conceptually and functionally. such incorporation provides a wide space for creating arbitrages and under relatively high inflation rates, the nominal income tax regime collapses.36 third, the institution of depreciation is based upon the historical purchase cost of an asset. in a period of inflation, the historical cost is of little significance. fourth, evaluating inventory according to its nominal value distorts the measure of income by including the inflationary profits.37 fifth, losses carried forward suffer a reduction in real value due to inflation. the article will focus on the third level, i.e., adjustment of the tax base which is the most challenging.38 in theory, the issue of adjustment for inflation could be rendered entirely superfluous if we were to exchange our local coinage for virtual currency that would reflect inflationary changes daily (or any other time period chosen), and tax liability would be calculated by that virtual currency. such a system would not require adjustment for inflation. effectively, a “virtual” currency could be “foreign currency,” assuming that the change in its exchange rate at any given time (day, month, or year) would be identical to the inflationary change over that period.39 this method would be equivalent to periodically adjusting the tax base. however, a cost-benefit analysis illustrates that this approach is very costly since it is based on a daily measurement of price variations.40 although selecting a longer period would lower the cost, benefits would also drop,41 and a trade 35. for negating the distinction between capital gain and interest in a broader context, see joseph stiglitz, the general theory of tax avoidance, 38 nat. tax j. 325, 328-29 (1985). 36. the tax rates on the various categories of capital income are not necessarily identical. from distributive justice and efficiency perspectives, this lack of uniformity increases the distortion during an inflation period. see halperin & steuerle, supra note 3, at 352. 37. this issue can be mitigated to some extent by adopting the lifo rather than the fifo. for the arbitrary nature of lifo, see, e.g., strnad, supra note 15, at 257-58. 38. therefore, when this article addresses an unadjusted income tax regime, it does not imply that the first two levels are not adjusted, but only that the tax base is unadjusted. hence, an unadjusted regime can also refer to a regime that adjusts tax payments, tax brackets, fixed elements etc., (the first two areas), while the third area – the tax base – is unadjusted. 39. see, e.g., thuronyi, supra note 1, at 454. 40. in terms of neutralizing the inflationary effect, the results of this approach are identical to those produced by comprehensive adjustment of net worth (which will be further examined). however, the latter is far cheaper than a daily, weekly or monthly adjustment. see also thuronyi, supra note 1, at 454-55. 41. thus, for example, in the case of income tax regime, the taxpayer would be required to file a semi-annual, quarterly or monthly return. the income tax regime does not carry out multi-period (multi-year) measurements in order to ascertain the 422 florida tax review [vol. 10:4 off would have to be reached.42 the article proceeds from the classical view that the purpose of adjustment for inflation is neutralizing the effects of inflation so that the effective real tax rate will be unaffected by inflation. in other words, the effective tax rate during periods of inflation will be identical to the effective tax rates during periods that are inflation-free.43 there are two archetypical adjustment regimes: partial adjustment44 and comprehensive adjustment. academic literature on adjusting tax systems discusses a broad spectrum of adjustment regimes (hereinafter – the adjustment spectrum), beginning with non-adjustment – which effectively is an adjustment regime for zero inflation rate – through various forms of partial adjustment regimes and ending with comprehensive adjustment. the end points of the adjustment spectrum are clearly defined: non-adjustment and comprehensive adjustment. between those two points, there are many varied models of partial adjustment. a non-adjustment regime is the simplest of the existing tax regimes along the spectrum, inasmuch as it ignores inflation, and the tax burden is levied in purely nominalistic terms. as we move along the adjustment spectrum from non-adjustment to comprehensive adjustment, the discussion becomes increasingly complex. one of the basic structural decisions that must be addressed in the adjustment discourse is whether adjustment will be performed automatically45 or whether an administrative authority will be required to exercise discretion. eroding the automatic adjustment mechanism by subordinating it to administrative discretion provides, first and foremost, flexibility to react to changing circumstances. in addition, some have viewed automatic adjustment as a costly tool because it denies the government flexibility in times of inflation crisis.46 on the other hand, discretion can average income. in general, income is measured over a period of a taxable year. shortening the taxable period can increase the detrimental effects of a lack of multiperiod measurement, due to the fluctuations among the various periods (which are shorter than a tax year). thus, for example, replacing the classical taxable year with a taxable “half-year” will lessen the inflationary gap, but it will also increase the distortion derived from the lack of a multi-period measurement in regard to the year (which is composed of two semi-annual tax periods). the issue of adjusting value added tax is of limited scope for few factors such as the shorter taxable period. 42. shortening the periods for measuring the tax base provides an implicit partial adjustment. for this adjustment model see part iii c. 43. for the various objectives of adjusting tax regimes for inflation, see, e.g., shuldiner, supra note 1, at 566-69. 44. sometimes referred to as ad hoc adjustment. see halperin & steuerle, supra note 3, at 347; thuronyi, supra note 1, at 443. 45. see, e.g., edward m. gramlich, the economic and budgetary effects of indexing the tax system, in inflation and the income tax, supra note 1, at 271, 279. 46. see, e.g., musgrave, supra note 7, at 379. 2010] the coming(?) inflation and the income tax 423 serve improper political interests, and lacks the certainty and stability that automatic adjusting provides.47 the less comprehensive and more partial the adjustment, the easier it may be to justify subjecting it to administrative discretion. b. comprehensive adjustment comprehensive adjustment (ca) for inflation means adjusting all the relevant components of the tax regime in order to neutralize the inflationary element.48 i will present the basic aspects of ca, inasmuch as it is important for the appraisal of the merits of the central argument against adopting a ca, according to which such a regime is overly complex and, therefore, unjustifiable. the classical approach to ca is that of net worth,49 which focuses on the opening and closing balance, including all assets and liabilities, the changes (increase/decrease) in equity capital over the course of the year, and income and expenses that are not recognized for income tax purposes. ca is comprised of many issues.50 accounting is of cardinal importance in a ca,51 since it is entirely based on balance sheet values and general accounting principles as reflected in financial reports.52 thus this adjustment regime transfers the tax discourse on adjustment for inflation from a classical legal arena to an accounting arena, which bears significant consequences.53 47. denying discretion in an adjustment regime is consistent with a general tax policy that views the exercise of discretion in the tax regime to be undesirable except in extraordinary circumstances. 48. see thuronyi, supra note 1, at 446; arnold c. harberger, comments, in uneasy compromise: problems of a hybrid income-consumption tax 381, table 3 (aaron et al. eds., brookings inst. press 1988). some countries have adopted significant adjustment regimes that are not ca regimes due to the argument of complexity. however, these achieve similar results, see, e.g., francisco gil-dias & wayne thirsk, mexico’s protracted tax reform, in tax reform in developing countries 287, 304-09 (wayne thirsk ed., oxford univ. press 1998). 49. for a more detailed explanation of the net worth method, see thuronyi, supra note 1, at 446. 50. for example, what is the status of foreign currency in the adjustment regime? see, e.g., herberger, supra note 60, at 383; r.j. vann & d.a. dixon, measuring income under inflation 70-71 (1990); thuronyi, supra note 1, at 453, 460. 51. see, e.g., thuronyi, supra note 1, at 453. 52. double-entry bookkeeping is a basic precondition for introducing a ca regime that is based upon financial records. 53. transferring a significant part of the tax discourse from the legal arena to the accounting arena bears substantial implications in three spheres: in legal education; in the participants in the tax discourse (particularly in practice); and in designing the development of the tax discourse. the tax law education must pay 424 florida tax review [vol. 10:4 grounding tax adjustment in accounting theory requires a suitable foundation of appropriate enforceable accounting standards.54 adjustment in a ca regime, like the net-worth method, and an explicit partial adjustment regime,55 are generally achieved through indexing to the cpi,56 by measuring the change in cpi over the course of the current tax year.57 there are two alternatives for transitioning to a ca regime. the first is the “extreme” alternative, transitioning from a non-adjustment regime directly to a ca regime with no intermediate steps of implicit or explicit partial adjustment.58 the second alternative is that of gradual transitioning; going step by step through the adjustment components without jumping directly from a non-adjustment regime to a ca regime. the nw method is not the product of a process by which an additional adjustment component is added to a pre-existing partial-adjustment regime in reaction to growing inflation, so that at the end of the process, the regime evolves into a ca regime. rather, the nw method facilitates a direct transition from a nonadjustment regime to a ca regime without intermediate steps.59 increased attention to the role of accounting. the participants in the tax discourse also change as a greater role is given to accountants as opposed to lawyers. increasing accounting education and the role of accountants also affects the way tax law develops. one can expect erosion in the status of general legal insights, together with an increase in the importance of accounting insights. moreover, one can expect a decrease in the scope of dialectic discourse in the tax law discourse, which stems from the substantial dialectical character of the legal education – and which is seen as one of the pinnacles of legal culture – in comparison to the relatively limited dialectic discourse in accounting thought. 54. a proper comparative study of adjustment regimes must also consider the level of the accounting infrastructure in the various countries, due to its importance in a ca regime. 55. for the explicit partial adjustment see part iii c. 56. for a discussion of the appropriate index for adjusting tax regimes to inflation, see indexing the individual income tax for inflation, supra note 9, at 3034; oecd report, supra note 9, at 27-30. for a discussion of this issue in regard to the general law, see, e.g., rosenn, supra note 2, at 27-30; chen, supra note 12, at 1403-29. for a comparative analysis, see supra note 3, at 30. 57. the method measures the change in cpi over the course of the current tax year and not over the course of the previous tax year, since there is no justification for indexing adjustment using the change in the previous year. an identical position must be taken in regard to the elements comprising the second level affected by inflation, i.e., tax brackets. 58. for implicit partial adjustment, see part iii c. 59. following a decision to adopt ca, several issues, generally of secondary importance, arise. if the income tax regime operated on an accrual basis, switching to an indexing system is not particularly complex. however, since the current classic income tax regime uses the realization requirement, a decision has to be made as to the timing of indexation. should it be continuous, or performed only 2010] the coming(?) inflation and the income tax 425 c. explicit partial adjustment and implicit partial adjustment partial adjustment can be achieved using one of two models: explicit partial adjustment (epa) and implicit partial adjustment (ipa).60 the difference is that epa relies on indexation for the purpose of adjustment, but not comprehensively, whereas ipa uses other tools in order to neutralize the effects of inflation. the extent of epa includes three types: the first type applies partial indexation of some of the elements of economic activity. for example, the partial indexation of some capital gains, so that capital gain tax will not be entirely applied to inflation, but only to part, in accordance with the scope of indexation. the second type includes full indexation of some of the elements of economic activity. for example, full indexation will apply only to capital assets so that no capital gain tax will be levied on its inflationary component. the last type applies partial indexing of all the elements of economic activity (e.g., adoption of the nw comprehensive adjustment regime and using only partial indexation instead of full indexation). these patterns of epa include certain arbitrariness in the rate of indexation or scope of economic elements indexed. it is hard to determine whether the arbitrariness expressed by a partial rate of indexation is greater than that expressed in a partial scope of the indexed economic activities, or vice versa.61 it should be noted that in terms of compliance costs, there is no difference, regarding the indexation of all components of economic activity between 100% indexation and partial indexation. the inherent arbitrariness of the epa, based on the scope of the adjustment’s partialness creates infringing affects on distributive justice and economic efficiency.62 however, there are additional aspects which make the analysis more complicated. for example, macro-economic considerations of an anti-inflation policy63 argue for reducing the scope of adjustment for inflation as part of the battle against inflation. granting significant weight to this policy leads to adjustment models that reduce adjustment to a minimum and diminish the use of indexation. such a policy often prefers employing implicit adjustment methods in order to “hide” adjustment and remove it upon realization? the common approach is that capital assets are adjusted upon realization under a ca regime. see, e.g., halperin & steuerle, supra note 3, at 363. 60. see halperin & steuerle, supra note 3, at 347. 61. sometimes it is justified to limit the scope of assets subject to indexation for a variety of reasons, primarily that of compliance costs. 62. see, e.g., goode, supra note 16, at 133. thus, for example, indexing only capital gains creates distortions. see, e.g., slemrod & bakja, supra note 23, at 328. the distortions in partial adjustment create new areas for tax planning and tax arbitrage. see, e.g., charles e. mclure, jr., demographic shark in the fiscal water, in tax policy in the twentieth-first century 33, 43 (herbert stein ed., jon wiley & sons 1988). 63. see part iv d. 426 florida tax review [vol. 10:4 from the public agenda. granting significant weight to political considerations64 that support a tax policy utilizing adjustment, as a means for granting tax benefits, will lead to the scope of indexation being dictated by the desirable scope of the benefit, and by the areas of economic activity that the tax policy seeks to promote. ipa is an adjustment model that does not use indexation at all, but rather uses other tools as a proxy for indexation. ipa is also characterized by an element of arbitrariness, in the sense that its partial nature infringes distributive justice and economic efficiency.65 the consequences of the arbitrariness of epa are all the more applicable to ipa.66 in terms of the desirable tax policy, even if there are considerations that support partial, rather than comprehensive adjustment, epa is preferable to ipa. like any implicit normative regime, an ipa regime lacks transparency, and is more susceptible to arbitrariness in comparison to an epa regime. in terms of achieving the goal of neutralizing the inflationary element, ipa is inferior not only to ca, but also to epa.67 ipa can be achieved by various, and at times odd, means including, for example, reduced capital gain tax burdens,68 accelerated depreciation,69 reduced tax on dividends,70 adopting the lifo method for inventory,71 and indexation to the exchange rate of a foreign currency that is of particular importance for the local market. ipa can also be “hidden” in the tax treatment of the interest expense, by imposing arbitrary limitations on the deductibility of the expense, while completely ignoring the actual rate of 64 . see part iv f. 65. thuronyi, supra note 1, at 443-45; shuldiner, supra note 1, at 563-66. 66. on the distortions of a lower capital gains rate as a mean for ipa, see martin feldstein & joel slemrod, inflation and the excess taxation of capital gains on corporate stock, 31 nat. tax j. 107 (1978). 67. see halperin & steuerle, supra note 3, at 348. 68. see shuldiner, supra note 1, at 563-64; halperin & steuerle, supra note 3, at 353-55; joint comm. on tax’n, general explanation of the revenue act of 1978, at 252 (united states printing office, 1979). for a discussion of whether reduced capital gain tax burden constitutes partial adjustment, see musgrave, supra note 7, at 379; walter j. blum, a handy summary of the capital gains arguments, 35 taxes 247 (1957); noel b. cunningham & deborah h. schenk, the case for a capital gains preference, 48 tax l. rev. 319 (1993); alvin c. warren, jr., the individual income tax, in the promise of tax reform 37, 54-55 (joseph a. peachman ed., prentice hall 1985). 69. see halperin & steuerle, supra note 3, at 355; david f. bradford, untangling the income tax 52-53 (harvard univ. press 1986). 70. see halperin & steuerle, supra note 3, at 356; shuldiner, supra note 1, at 569-74. 71. see shuldiner, supra note 1, at 613-617; halperin & steuerle, supra note 3, at 356; strnad, supra note 15, at 258. 2010] the coming(?) inflation and the income tax 427 inflation.72 the same is applying on interest income, e.g., by recognizing only part of interest income as taxable income, or by applying a reduced tax rate to a nominal interest income. the realization requirement may also constitute ipa, inasmuch as the effective tax liability that stems from nominal measurement, is set off, partially or fully, by the tax benefit inherent to tax deferrals.73 it should be emphasized that there are tax arrangements that inherently create ipa, although it is not their original function or purpose, and, therefore, they do not require adjustment for inflation. setting off financial expenses against financial income makes an adjustment of these tax items. this is also the case with tax-exempt income, such as capital gains74 or interest income produced by tax-exempt organizations.75 shortening the taxable period of the tax base is also a technique for achieving ipa.76 ii. general tax policy considerations a. general what are the considerations in choosing among na, epa, ipa and ca? the cornerstone for this analysis discussion is that ca is preferable to epa or ipa, or na, inasmuch as ca completely neutralizes the inflationary component and therefore increases distributive justice and economic efficiency.77 in other words, inflation’s substantive effect on the central goal of the tax system – just and efficient collection of just and efficient taxes – lessens as adjustment increases, and adopting ca completely eliminates that effect.78 inflation rates and tax rates79 also appear to exert an influence over the choice of adjustment regime. the higher the inflation rate, the greater the tendency to increase the adjustment component in the tax regime. tax rates 72. see halperin & steuerle, supra note 3, at 368. the partial method creates difficulties for financial institutions. see halperin & steuerle, supra note 3, at 369-70. 73. for a critique of this model of ipa, see, e.g., strnad, supra note 15, at 252. 74. for example, the tax exemption of capital gains due to the “step-up in basis” doctrine applying on death. 75. see halperin & steuerle, supra note 3, at 353; see also note 11. 76. see also text accompanying note 25 et seq. 77. see halperin & steuerle, supra note 3, at 372. 78. when inflation is not steady but exists at a fluctuating rate, ca is particularly preferable in terms of the neutrality of the tax system. see mark perlis, comments, in uneasy compromise: problems of a hybrid income-consumption tax 373 (aaron et al. eds., brookings inst. press 1988). 79. see, e.g., halperin & steuerle, supra note 3, at 349. 428 florida tax review [vol. 10:4 operate in a similar manner. the higher the tax rates, the greater the tendency to increase the scope of adjustment (although this variable exerts less influence than the inflation rate variable). nevertheless, i argue that the effect of these two variables must be considered in the broader context of the various tax policy considerations, analyzed below. under an extreme level of inflation, the inflation rate will have greater, if not decisive, influence. in an environment of triple-digit inflation, for example, we may expect the tax system to introduce a ca regime. in contrast, at a very low inflation rate we may reasonably expect the tax system to opt for non-adjustment or “soft” partial adjustment. however, we should bear in mind that the discussion of the appropriate adjustment regime does not, in general, address inflation rates at the extreme ends of the spectrum, but rather “moderate” inflation rates. the variables of inflation rate and tax rate are also built into the various tax policy considerations that will be addressed below. b. cost-benefit analysis the cost-benefit analysis examines the cost of adopting an adjustment regime, of one model or another, compared to the benefit it provides. among the social benefits sought are distributive justice and economic efficiency of the tax regime. the more comprehensive the adjustment regime, the more successful it will be at attaining these goals. the same is true for the choice between ipa and epa. generally speaking, the more explicit the adjustment, the more just and efficient it will be.80 opposite the benefits stand the compliance costs,81 which can be divided into two groups: first, the initial costs of introducing the comprehensive or partial adjustment to the tax administration and the taxpayers. these costs are fixed. the second group comprises the variable 80. see the discussion regarding the weaknesses of an implicit adjustment regime which are reflected in the capital gain tax regime through reduced capital gain tax rates. shuldiner, supra note 1, at 563-64. 81. see, e.g., indexing the individual income tax for inflation, supra note 9, at 43. this analysis considers the difficulties in adjusting fixed amounts (the second level). of course, indexing the tax basis creates more complexity and compliance costs. see also the adjustment of personal income tax systems for inflation, supra note 9, at 12 (recommending retaining the nominal adjustment regime in the case of, for example, a low inflation rate or when revenue from income tax represents a small part of the budget. the reason for this is cost-benefit considerations). the compliance costs also include the difficulty in enforcement that derives from non-adjustment of criminal penalties in the tax law. for this issue see report to the comm. on finance, tax compliance: inflation has significantly decreased the real value of some penalties (united states accountability office 2007). 2010] the coming(?) inflation and the income tax 429 annual costs of operating and maintaining the adjustment regime. the costs of adopting and operating a comprehensive adjustment regime are higher than those of epa,82 and certainly higher than those of ipa.83 the classical discourse on adjustment for inflation employs arguments regarding the complexity of adjustment regimes, reflected on the compliance costs side, in order to reject or adopt them; this is particularly so in regard to ca.84 c. the general culture paradigm: nominalism or adjustism the most influential factor affecting adjustment for inflation of a tax system is the general cultural of adjustment, in which adjustment for inflation in the tax arena is but one element of a broader cultural phenomenon referred to in this article as “the general culture of adjustment for inflation.” in other words: what is the cultural character of the social order: a culture of adjustism or a culture of nominalism? addressing adjustment of the tax regime divorced from the other elements of social order is mistaken and undesirable. effort should be made to match the scope of adjustment of the tax regime to a society’s general culture of adjustment for inflation. the phenomenon of inflation affect a substantial fraction of human activity and it greatly influences the entire social order, and not just taxes. the extent of a tax regime’s adjustment, whether comprehensive or partial, should be set up in accordance with the general culture of adjustment as reflected in the social order. the tax system’s approach to inflation must be consistent with the way that society contends with inflation in general. focusing exclusively on the issue of adjusting the tax system for inflation, while ignoring or discounting the issue of adjustment in other branches of the social order, creates an internal imbalance in the social order. this imbalance is created because risk 82. from the compliance cost perspective, it is irrational to support the introduction of explicit partial adjustment that includes the entire economic activity, but adopts partial indexation. there are generally no marginal compliance costs in transferring from less than 100% indexation to 100% indexation. 83. implicit adjustment is generally of an arbitrary nature, so the compliance costs involved tend to be relatively low compared to the scope of such costs in an explicit adjustment regime. 84. see, e.g., slemrod & bakja, supra note 23, at 35. the complexity argument has also been employed to reject partial adjustment. thus, for example, the rejection of the recommendation for partial-adjustment by full indexing of capital gains was based upon complexity, along with the argument of tax arbitrage, see, e.g., bartlett, supra note 9, at 16-17. it should be emphasized that, often, among the costs of maintaining a nominal regime is the harm to the tax system as a result of the intensive preoccupation with the issue of whether or not to adjust for inflation. focusing on this issue may deviate attention from other tax issues. introducing adjustment into the tax regime “frees” the society to address the other tax issues. 430 florida tax review [vol. 10:4 management’s policy towards the risks of inflation in the tax arena will differ from the risk management’s policy towards inflation in other areas of the social order.85 introducing an adjustment regime only in the tax arena shows that society is unwilling to expose itself to inflationary risks in regard to tax, while it tolerates leaving other social components open to inflationary risk. the proposed paradigm reflects a broader approach according to which the tax discourse should not be viewed as an autonomous cultural discipline that is separate from the general discourse of the social order as a whole, which captures society’s dominant cultural attitudes.86 the tax system should not be analyzed independently of the general social order regarding the cultural issue of nominalism or adjustism. adjustment for inflation is social, legal, economic and political insight purposed to cope with the phenomenon of inflation. in general, every social institution must attain normative, legal or social recognition in the social order before it is recognized by the tax system, and this approach has to apply on the adjustment for inflation as a social institution as well. the tax regime, in general, is a normative system that “hovers above” human activity, gathers “select” elements (“tax events”), and taxes them. in fulfilling its role, the tax regime develops a dialogue with that human activity in terms of language (concepts, etc.) and discourse that derives from its legal institutions. this is the cornerstone of any analysis of desirable tax policy, and it changes only if there are weighty arguments that require deviation. the social order conducts a broad and ongoing, sometimes painful, dialogue with the phenomenon of inflation. one of the important variables in this dialogue is the institution of adjustment for inflation. this institution is not unique to tax regimes, but is both relevant and necessary to every field of law. if a society has a culture of adjustism, that culture will be reflected across the entire spectrum of the social order. normative recognition of the institution of adjusting for inflation must, first and foremost, find expression in the social order as a whole and not in its tax regimes alone. tax regime recognition of the adjustment institution will not precede its general acceptance of the social order. is it conceivable, for example, that changes in family structure – like the “new family” – will be recognized by the tax regime before first achieving recognition in the social order, i.e., in family law? i have chosen an example from the family arena in order to emphasize that the difference between a nominalistic perspective and an adjusted perspective is no different in our context than the said change in the context of family law. one cannot a priori discount the possibility of circumstances 85. see, e.g., chen, supra note 12, at 1430. 86. thus, for example, the issue of fairness in the tax arena should be addressed from a broader perspective, so that it focuses not merely on tax fairness, but on social fairness. see liam murphy & thomas nagel, supra note 18, at 173. 2010] the coming(?) inflation and the income tax 431 that might lead to incoherence between the social order and the tax regime, but such a situation would be exceptional. the adjustment for inflation cannot be categorized as such an exception. introducing a ca regime into a tax system requires the existence of a broad culture of adjustism, founded upon a valoristic perspective at the various levels of the social order, particularly the economic level. thus, it would be unreasonable that the concept of “profit,” in the income tax regime, will be based upon real values (adjustism), while, for example, the same concept will be based upon nominalistic values in the corporate law. it would not be undesirable to adjust the tax system for inflation, while accounting practice, for example, remains unadjusted. a culture of adjustment for inflation in the economic sphere means that the economic and commercial discourse – not just in the tax arena – be conducted in real terms. hence, for example, a firm’s profitability will be established in real terms, and investment strategies will be based upon a real analysis. the measurement of taxable income (“tax accounting”) may differ from economic or financial accounting measurements. such differences derive, primarily, from taxpolicy aspects according to which income tax law must deviate from accounting or economic measurement practices in appropriate circumstances. but it would be difficult to present tax policy considerations that would justify a substantive difference among these disciplines in regard to adjusting for inflation. moreover, inasmuch as ca regime is based upon accounting, it would be unreasonable to adjust the tax system for inflation while leaving accounting practices unadjusted. to put it differently, the inflationary phenomenon presents a challenge to a broad cross section of the social order regarding the adjustment.87 the general culture of adjusting to inflation is developed through the contending with this challenge, and an adjustment means thus enter into various areas of the social order. the adjustment culture contains a wide variety of adjustment mechanisms and the issue of adjusting the tax regime for inflation does not stray from the general discourse, in the sense that adopting a regime for adjusting the tax system for inflation cannot be described as audacious, extraordinary, too complex or “strange” to the general public discourse. adjustment for inflation is not an exclusively technical issue of computations, so that the discussion is limited to technical issues. it is not just an economic or accounting technique, as one might imagine from looking at the classical tax literature. adjustment of the tax system is an inseparable component of an economic, social and political culture that adopted the fundamental insight regarding the meaning of money. the adjustment insight denies a nominalist approach to money based on nominal 87. see, e.g., oecd report, supra note 9. 432 florida tax review [vol. 10:4 terms and prefers a valoristic system that focuses on the value of money in terms of purchasing power. converting nominalist values with valoristic values as a culture involves far-reaching consequences for the social order, of which the tax system is not the primary focus. when a society faces significant inflation and its democratic structure and social and economic institutions are preserved and continue to function, it is a reflection of the existence of the culture of adjustism.88 in the absence of such a culture, the foundations of the economic and social structure will be damaged, perhaps beyond repair, as a result of inflation’s effects on distributive justice and economic efficiency.89 the proposed paradigm is not based solely on a coherent normative or doctrinal approach, but also and mainly on distributive justice and utilitarian considerations. thus, for example, as the number of non-tax adjustment regimes increases, the compliance costs associated with adopting and maintaining adjustment regimes for tax will be decreased. this paradigm does not argue that the tax regime must “wait” until all other components of the social order adjust for inflation. the tax regime requires the social order’s substantive recognition of adjustment, and this usually comes about as a result of its absorption of a critical mass of non-tax adjustment arrangements in the social order. this critical mass provides the platform for the adoption of an adjustment arrangement in the tax arena. generally speaking, the tax regime reacts to social and economic changes, but does not initiate them. it is an inseparable part of the legal system, which, as a rule, responds to social change. not only will the tax regime not lead the way, it will usually lag behind other institutions, because it tends to be one of the more conservative branches of the social order.90 therefore, the tax discourse will not address the issue of adjustment immediately upon the onset of inflation, but will require an “introductory” period for the development of a public discourse on adopting strategies for adjustment for inflation in the various branches of social order. a similar process will take 88. on the constitutional implications of adjustment for inflation, see, e.g., chen, supra note 12, at 1388-95; fred wertheimer & susan weiss manes, campaign finance reform: a key to restoring the health of our democracy, 94 colum. l. rev. 1126, 1142 (1994): rosenn, supra note 1 (analyzing the effect of inflation on the various branches of law); united states v. soderna, 82 f.3d 1370 (7th cir. 1996). 89. on the political economics of inflation, see, e.g., the political economy of inflation, (fred hirsh & john goldthorpe eds., harvard univ. press 1978). 90. there are several reasons for this. the tax system is technically complex, cumbersome and conservative in the sense that it does not take risks and demands a relatively high degree of certainty of success; the tax system often serves as an arena for political grappling in regard to political approaches of considerable economic and social importance that are ultimately decided through a long process. lastly, there are often powerful elements of society that support preserving the status quo. 2010] the coming(?) inflation and the income tax 433 place when the rate of inflation decreases, and the social agenda addresses the issue of rescinding adjustment regimes. here, too, the tax regime will respond only after the crystallization of a culture of nominalism in the primary levels of the social order. this characteristic of the tax system means that it will neither be the first to adopt nor the first to repeal adjustment mechanisms. this approach clarifies the united states environment regarding adjustment for inflation, including the tax regime.91 the american discourse on adjusting the income tax regime for inflation, which first took place in the late nineteen seventies and early nineteen eighties, was unproductive from the start, and was doomed to failure because the u.s. culture of adjustism was not sufficiently ripe for justifying or permitting a “legitimate” social decision on adjusting the tax system for inflation. it would have been entirely unreasonable to expect the tax system to adopt adjustment regime when the american social order did not comprise the requisite normative adjustment infrastructure within which tax adjustment could develop. there was little academic writing on adjusting the social order for inflation of its non-tax components, despite the impact of inflation on the american economy and society.92 american legal discourse did not perceive the issue of adjustment for inflation to be the kind of fundamental cultural issue that would warrant in-depth theoretical research from a broad perspective. this discourse reflected a deeply rooted and pure nominalistic culture. although the american theoretical tax research laid the appropriate groundwork for adopting an adjustment regime,93 that groundwork did not achieve statutory expression. political discussions highlighted the complexity behind adjustism in order to reject its adoption.94 the complexity argument 91. see, e.g., advisory comm. on intergovernmental relations, inflation and federal and state income taxes: a commission report (1976). 92. chen, supra note 12, at 1378-79. 93. differences in adjustment culture are also reflected in attitudes towards changes in the monetary currency itself. thus, for example, in regard to replacing bills with coins, which reflects the diminished importance of the sum formerly represented by the bill now represented by the coin, a country with a pure culture of nominalism will be more resistant to changing its currency than a country with a culture of adjustism. despite the aggregate inflation in the u.s. over the years, the currency has not been replaced, and, for a very long time, there was no substantial attempt to exchange bills for coins. the recent move of introducing a one-dollar coin alongside the dollar bill does not seem to have been met with success. in this issue, nominalism is reflected in symbolic and psychological manifestations that ascribe significant importance to the status quo. 94. in 1984, the u.s. treasury recommended an adjustment regime based on indexing the tax system, but the recommendation failed to garner support, primarily due to the complexity argument. see treasury dep’t, tax reform for fairness simplicity and economic growth, at 97 (1984); david a. weisbach, the 434 florida tax review [vol. 10:4 was largely rhetorical, since the primary reason for rejecting adjustment for inflation was the pervasive nominalistic culture of the american society. while there are some isolated instances of adjustment for inflation, they are inconsequential compared to the overall nominalistic approach, and do not affect the general nominal character of the american culture.95 therefore, it is reasonable to predict that even if the rate of inflation were to rise, it is doubtful that the tax system will adopt ca or even epa regime in the absence of parallel developments in other levels of the social order. the prevailing american culture of nominalism leaves little room for any kind of adjustment for inflation other than ipa.96 the foregoing leads to the conclusion that there must be general equilibrium in the overall culture of adjustism97 between the social order as a whole and in the tax regime. this equilibrium is twofold. first, it would be hard to justify an economic, social and legal system characterized by adjustment regimes in the central levels of the social order, but lacking a parallel adjustment regime for its tax regime. second, it would be hard to justify the opposite situation of adjustment of the tax regime when such adjustment is lacking in other central levels of the social order. this is true particularly in the case of ca regime. the upshot is that increasing the level of adjustment for inflation in the other levels of the social order is crucial for promoting the adjustment of the tax regime, especially in regard to ca (non) taxation of risk, 58 tax l. rev. 1, 13-14 (2004); slemrod & bakja, supra note 31, at 238; david f. bradford and the u.s. treasury tax policy staff, blueprints for basic tax reform 75 (2nd revised ed., 1984); henry j. aaron, inflation and the income tax: an introduction, in inflation and the income tax, supra note 1, at 29. 95. see, e.g., david leonhardt, some rain on the parade on wall st., n.y. times, july 18, 2007, business day, at c1; calabresi, supra note 15, at 66-68, tried to explain america’s nominalistic laws, but with only limited success. in my opinion, the answer lies in the general nominalistic culture that pervades the american experience as a whole, and that is reflected in the social order and legal discourse. for a detailed description of the depth of the nominalism in the american laws, see chen, supra note 12. 96. for example, reduced capital gain tax rate, based on the perspective that it is an ipa regime. 97. two types of equilibrium must be distinguished in regard to adjustment for inflation. the first is “external” equilibrium that characterizes the various elements of the social order – i.e., if and to what extent the social order has adopted a culture of adjustism/nominalism. the second is the “internal” tax equilibrium that treats of the equilibrium among the various elements of the tax regime itself. for example, adjustment for inflation only of capital assets without a parallel adjustment of liabilities creates an imbalance. there is a certain relationship between the two, in the sense that the greater the general external equilibrium, the greater the tax internal equilibrium. 2010] the coming(?) inflation and the income tax 435 regime. only an increased culture of adjustism in the social order will enable the appropriate, parallel adjustment for inflation of the tax regime. it appears that the deciding factor behind adjusting for inflation is the existence of a general culture of adjustment to inflation. this view differs from the classical approach that imputes far greater importance to costbenefit considerations, in particular with ca regime. complexity, which has served as a primary defense against the adoption of adjustment regimes, is a concept found in the cost-benefit lexicon. the classical approach98 utterly disregards the general culture of adjustment for inflation. it does not address the relationship between the scope of the general adjustment culture and the extent to which the tax regime adjusts. thus, the tax discourse on the issue of adjustment does not see itself as part of the general discourse on adjustment, whether in theory or in politics, and addresses adjustment from a technical perspective. the compliance costs are relatively unimportant in the debate over adoption of adjustment for inflation in modern tax systems that operate in a developed and sophisticated technological environment. in such an operating environment, the introduction and the maintenance of even a ca regime do not involve substantial compliance costs that might deter its adoption. in the area of compliance, tax systems contending with substantive and technical issues are no less complex, and often considerably more complex, than adjusting for inflation. for example, the prevailing regime of international tax requires comprehensive treatment of international economic activity, or the complicated issue of taxation of financial instruments.99 the complexity of these two issues is certainly no less than that of adjustment for inflation. it should be emphasized that this approach does not deny the influence of all of the other considerations mentioned in this chapter on the decision-making process regarding the introduction of an adjustment regime. however, their relative weight is not significant compared to the substantial importance of the paradigm of the general culture of adjustment. 98. see the literature cited in notes 1, 3 and 9. 99. see, e.g., alvin c. warren, jr., u.s. income taxation of new financial products, 88 j. of public econ. 899 (2004); alvin c. warren, jr., financial contract innovation and income tax policy, 107 harvard l. rev. 460 (1993); david. p. hariton, the taxation of complex financial instruments, 43 tax l. rev. 731 (1988); j. p. simon, selected federal income tax aspects of securitizing debt obligations, 66 taxes 897 (1988); reed shuldiner, a general approach to the taxation of financial instruments, 71 tex. l. rev. 243 (1992); reed shuldiner, consistency and the taxation of financial products, 70 taxes 781 (1992); jeff strand, choosing a tax treatment for new financial products, 46 stan. l. rev. (1994); george c. howell, iii & cameron n. cosby, exotic coupon stripped: a voyage to the frontier between debt and options, 12 va. tax rev. 531 (1993). an analysis of these articles reveals a theoretical complexity greater than what is argued in regard to adjusting tax regime for inflation. 436 florida tax review [vol. 10:4 there are two arguments for the exclusive focus on cost-benefit considerations, which ignore the perspective of the general culture of adjustment. the first is that cost-benefit considerations exist in every decision-making process. the second is that when we address tax issues like the one before us, there is a tendency to adopt a utilitarian view that focuses on cost-benefit considerations to the exclusion of other factors such as cultural influences. this tendency is consistent with the broader tendency to view tax law as one of the most, if not the most, “utilitarian” areas of the social order in terms of excluding cultural arguments. in my view, in the tax law arena, as in every other normative sphere, the cost-benefit analysis is not the only player. the discourse has to adopt a broader and richer analysis based also on cultural infrastructure as well.100 the general culture of adjustment for inflation provides a good example, as it provides a broader perspective on society’s monetary culture, including its psychological and sociological aspects.101 there are powerful forces in society that are not interested in adjustism. for example, in certain circumstances, it is worthwhile for the financial sector to continue to communicate in nominal rather than real terms (as would be required by a general adjustment culture). this is primarily true in regards to the discourse between this sector and the common household. it prefers nominal discourse to real discourse since nominal measurements tend to show higher levels of profitability than real measurements.102 the choice between a ca regime and an ipa or epa regime is also influenced by the general culture of adjustment. the level to which this culture has taken root in the social order will be expressed in the scope of adjustment chosen. when the adjustment culture is not pervasive, but there is an awareness of the substantial need for adjustment in tax law, a regime of ipa will be adopted. ipa is a device for bridging the gap between the tax discourse and the general discourse in the social order on the adjustment issue. epa is premised on a limited general adjustment culture, and will be adopted when the social order is primarily nominalistic, with “adjustment islands.” this is especially true when the cultural reality is one of a dynamic character, where nominalism is in the process of erosion due to an increasing public discourse on adopting an adjustment regime. from this perspective, it is reasonable to conclude that the general adjustment culture in the u.s. had not even reached the level that enables epa of the tax regime. the american 100. this issue requires a separate and more comprehensive analysis than can be provided in the confines of this article. 101. see, e.g., nigel dodd, the sociology of money: economics, reason & contemporary society (continuum int’l 1994) (especially chapter 3: “cultural aspects of the mature money economy,” beginning on pg. 41). 102. regarding deflation, see strnad, supra note 15, at 247-50. 2010] the coming(?) inflation and the income tax 437 social order is characterized by a purely nominalistic culture,103 and whatever adjustment islands exist are insufficient to justify the introduction of epa into the tax regime. as noted, the general adjustment cultural paradigm is of crucial importance in deciding between a nominalistic regime, a regime of partial adjustment or of comprehensive adjustment. it also influences the choice between ipa and epa. however, it does not help in making the choice between various ipas or various epas.104 in this regard, the suggested paradigm is of little influence in relation to the relative weight of other considerations. the general adjustment culture may be dynamic and can respond to the scope and challenges of inflation faced by society. the more nominalism is culturally ingrained, the greater the inflationary challenge needed to spur change. the tax regime may adopt ipa or epa, but as the non-tax environment takes on an increasingly adjusting character over time, the partial adjustment regime will gradually fall out of step with the general adjustment culture. this will be the case, for example, with a tax system that adopts an ipa without any indexing component. if, over time, indexing becomes increasingly common in other areas of the social order, the absence of even partial indexing in the tax system will be perceived as unjustified. the influence of the general culture paradigm on adjustment for inflation is not limited to such fundamental tax issues as the model and scope of adjustment of the tax regime. it is also manifested in areas of secondary importance, such as whether the adjustment regime will operate automatically or whether it will require the exercise of discretion of administrative agency.105 the more pervasive the adjustment culture, the greater the tendency toward automatic adjustment without an exercise of discretion. one can argue that the ultimate proof of the primacy of a costbenefit analysis is that it can reasonably be assumed that at particularly high rates of inflation, tax regimes will adopt ca. this is because in a highly inflationary environment, the benefit to be gained from adjustment outweighs the cost. this argument is incorrect. in reality, at high rates of inflation we can expect to find a developed general adjustment culture that has introduced adjustment mechanisms across the social order, such that ca of the tax regime is consistent with the society’s general adjustment culture. 103. for a general description on the united states legal approach to adjustment to inflation, see, chen, supra note 12. 104. cost-benefit considerations are of particular importance in these decisions. 105. see text accompanying note 46. 438 florida tax review [vol. 10:4 there are countries, like the united states106 and others,107 in which tax brackets are adjusted, as are various fixed sums set by the tax system,108 even though there is no general adjustment culture. this kind of adjustment represents the outer limit of the tax system’s ability to include elements of adjustment in a social order dominated by nominalism. such adjustment is possible only because it does not clash with other areas of the social order, inasmuch as these variables are unique to the tax system. this is different from the fundamental tax concepts of “profit” or “income,” which stand at the center of the social order’s economic activity (corporate law, accounting, etc.). the proposed paradigm is tied to a broader issue. two tax culture approaches can be distinguished in the tax discourse. the first is the isolationist approach, which views the tax culture as set apart from other areas of the social order. this approach is reflected in classical legal discourse, which does not always include tax law as its normative participant. another approach is the coherent approach, according to which the tax discourse forms an integral part of the general social order. the proposed paradigm in this study is premised on the coherent, rather than the isolationist approach. d. nominalism as a stabilizer from an economics perspective, nominalism contributes to price level stability, and thus works against inflation. under a macro-economic theory, according to which comprehensive adjustment of the social order to inflation may cause society to become “reconciled” to inflation, makes the marketplace indifferent to inflation. the “reconciliation” will perpetuate and even intensify inflation.109 according to the rational expectations 106. see text accompanying note 23. 107. for example, in canada, france and the u.k., tax brackets are adjusted for inflation. see, e.g., brian j. arnold, genaral description: canada, in hugh j. ault, comparative income taxation, a structural analysis 25, 26 (kluwer law int’l 1997); guy gest , genaral description: france, in hugh j. ault, comparative income taxation, a structural analysis 39, 41 (kluwer law int’l 1997); john tiley, genaral description: united kingdom, in hugh j. ault, comparative income taxation, a structural analysis 109, 117 (kluwer law int’l 1997); see also note 23. 108. for this component of adjustment regime, see text accompanying note 23. 109. bannock et al., the penguin dictionary of economics, 7th ed. 183 (penguin books 2004) (“‘indexation’…while indexation reduces the cost of inflation, some economists believe it entrenches inflationary expectations and makes it harder to get inflation down….”); fisher, supra note 14, at 193 (“the main reason governments are reluctant to adopt price indexation in their own transactions and 2010] the coming(?) inflation and the income tax 439 theory,110 the inflation includes fundamental psychological aspects, making it important to restrict the scope of economic regimes that introduce ca. institutionalizing adjustment as part of the social order sends a clear message to the public that inflation will continue.111 this argument has been the subject of criticism.112 in addition, non-adjustment of the tax system can be encourage its use in the private sector is that indexing is thought to be inflationary. the argument is that an indexed economy inflates more, and more rapidly, in response to an inflationary shock than does a nonindexed economy, given the monetary and fiscal policies being followed. it is also argued that the will to fight inflation is weakened when the costs of inflation are reduced by indexing – equivalently, that the adoption of indexing affects the choice of policies.”) see shuldiner, supra note 1, at 546; the implication for economic stability of indexing the individual income tax, in inflation and the income tax, supra note 1, at 173-74, 187-88 (1976); hirschberg, supra note 2, at 151-52. for a discussion of this argument and the counterarguments, see milton friedman, monetary correction: a proposal for escalator clauses to reduce the costs of ending inflation 29-32 (inst. of econ. affairs 1974). tax regimes function as a stabilizer as well and the nominal character of the tax regime could be viewed as a stabilizer. for the stabilization function, see, e.g., yair j. listokin, stabilizing the economy through the income tax code, 123 tax notes 1575 (2009). 110. see, e.g., thomas sargent, the ends of the four big inflations, in inflation: causes and effects 41 (robert e. hall, ed., univ. of chicago press 1982). this study looks at inflation in germany, austria, poland and hungary between the two world wars and the effects of rational expectations theory on inflation rates. 111. oecd report, supra note 9, at 17. 112. for criticism of these macro concerns, see, e.g., fisher, supra note 14, at 215 (“the theoretical development of section . . . implied that indexation does put potential destabilizing mechanisms in place that will worsen the impact of an inflationary shock, given monetary and fiscal policies that link money growth to the budget deficit. but it was also emphasized that the link between inflation and indexation is not inevitable, and that appropriate policies can prevent the inflationary shock-cum-indexing effect on the budget deficit that is responsible for the result. the empirical evidence, presented in table…, is that the inflationary response to the oil shock in countries with indexation was not significantly larger than in other countries. this suggests that the indexed countries followed policies that mitigated the inflationary impact of the oil shock, or those other countries’ policies permitted the oil shock to affect prices as much as it did in indexed countries. evidence that money growth rates responded more to the oil price shock in nonindexed countries supports this view.”). 440 florida tax review [vol. 10:4 seen as a tool for price stabilization.113 this position is controversial as well.114 under the above theories, even if a cost-benefit analysis supports ca of the tax regime, it should be rejected in order to attain the anti-inflationary goal of price stability. in the general fight against inflation, we must bear the cost of maintaining a non-adjusting tax system. however, there is an advantage to ipa since it “conceals” adjustment from the public. this explains why tax systems adopt ipa despite its inherent substantive distortions. this macro-economic consideration creates a hierarchy among adjustment regimes, giving high preference to a non-adjusting regime, followed by ipa, epa, and finally, ca.115 e. tax collection considerations in general, tax collection is greater in a non-adjusting tax system as compared to a comprehensively adjusted tax system (hereafter: “the basic tax collection insight”).116 thus, converting a non-adjustment regime to that of partial or comprehensive adjustment, or increasing the scope of adjustment, leads to a decline in tax collection.117 these changes in the adjustment regime are, therefore, not characterized by tax collection neutrality, and may, therefore, be rejected or delayed due to budgetary constraints. in this regard, these changes are no different than any other structural reforms in the tax system whose adoption, scope and timing may be affected by concern over tax collection. these collection considerations are such that the decision to adopt an adjustment regime is not solely contingent upon the tax-inflation discourse, but is also affected by the general tax discourse, inasmuch as there may be other tax areas that require reform and that involve tax collection 113. james l. pierce & jared j. enzler. the implication for economic stability of indexing the individual income tax, in inflation and the income tax, supra note 1, at 141, 173; indexing the individual income tax for inflation, supra note 9, at 21-22. 114. shuldiner, supra note 1, at 546. 115. for a discussion of the issue whether the tax system should be employed to contend with macro-economic issues, see, e.g., strnad, supra note 15, at 249-50. 116. see, e.g., henry j. aaron, inflation and the income tax: an introduction, in inflation and the income tax, supra note 1, at 16-17; indexing the individual income tax for inflation, supra note 9, at 10-11; margalioth, supra note 41, at 209. see also w. elliot brownlee, federal taxation in america: a short history, 135-36 (cambridge univ. press 2004) (the historical public debate in the u.s. regarding the adjustment of tax brackets and fixed amounts, where collection considerations weighed against those adjustments). 117. collection considerations can support making adjustment subject to discretion. see, e.g., oecd report, supra note 9, at 30. 2010] the coming(?) inflation and the income tax 441 declines. budgetary constraints thus impose trade-offs among the various tax issues, including that of adjustment for inflation. the existence of a nominalistic culture versus a culture of adjustism is of particular importance in this regard, because the greater the extent of the latter, the greater the tendency toward adjustment despite concerns over tax collection.118 f. political and social considerations introducing the adjustment tax regime constitutes a change in the economic, social and political status quo and it may face considerable political opposition. during a period of inflation, a non-adjusting tax regime increases the tax burden. it allows an increase in the effective tax without increasing the tax rate,119 and politicians are fond of hidden taxes.120 furthermore, there are taxpayers who benefit from non-adjustment,121 and will join the politicians and supporting the nominalistic status quo by opposing the adjustment, based on a variety of arguments mentioned above.122 118. it should be noted that sometimes part of the discussion devoted to tax collection decline in deciding the character of the adjustment regime focuses also on the difficulty that will be caused in regard to the budget, both in terms of planning and in terms of execution. this issue reflects, inter alia, a political argument according to which adjustment limits political maneuverability compared to its scope in an environment of nominalism (on the political aspects of the adjustment issue, see part iv f below). part of the debate on budgetary issues focuses on the lack of equilibrium in the budgetary process because some of the elements of the budget are adjusted for inflation, while others are not. it should be pointed out that this argument should be seen as part of the culture of adjustism/nominalism of the social order which comprises the budgetary process as well. for an analysis of the various arguments concerning the relationship between inflation, adjustment for inflation and the budgetary process in both its components, see, e.g., indexing the individual income tax for inflation, supra note 9, at 14-25. 119. indexing the individual income tax for inflation, supra note 9, at 15. see also w. elliot brownlee, supra note 116 at 126-28, 133) (historical analysis of this phenomenon in the united states in the course of various inflationary periods, particularly following the two world wars, and in the course of the nineteen seventies (primarily in the second half of the decade)). 120. see, e.g., sven steinmo, taxation and democracy: swedish, british and american approaches to financing the modern state 19 (yale univ. press 2004); milton friedman, supra note 119, at 13-15. 121. as a result of the nature of their economic activity or as a result of their tax arbitrage. 122. one of the central variables in the cost-benefit debate is the high operating cost of an adjusting regime. thus, for example, supporters of the nonadjusting status quo have argued in the past that adjusting tax brackets and fixed 442 florida tax review [vol. 10:4 political powers prefer arrangements that involve political decisions or administrative discretion123 so they have the potential to be used or even abused in various alternatives, based on the political arena. one of the main arguments raised in the u.s. against adopting adjustment regimes is that a comprehensive and automatic adjustment regime would prevent the political echelon from annually reexamining the tax system in its entirety in order to uncover tax arrangements that should be redesigned. this argument is wrong for four reasons: first, it would be exceedingly difficult to produce tax cuts that could precisely offset excess taxes, both in terms of scope and entitled taxpayers, resulting from non-adjustment. second, this practical difficulty infringes economic efficiency. third, it is possible that the distortion created by non-adjustment is more substantive than the other distortions that may be discovered. fourth, this argument undermines any possibility of tax reform intended to correct distortions. moreover, such an argument124 allows the political echelon to retain tremendous power to “correct” inflationary damage by means of tax reductions in other areas, while not addressing them in the primary area of adjustment for inflation. adopting a ca regime sets aside political considerations, since this regime comprises an all-inclusive, precise, automatic mechanism that, by its nature, neither requires nor is subject to purely political decisions. it is an independent normative regime that is not directly or indirectly dependent on the ongoing political discourse. in contrast, ipa and epa regimes do involve the political discourse, which may explain their greater appeal,125 as well as the continued widespread use of ipa, despite its general inferiority to amounts in the income tax regime presents a difficult and complex challenge; see, e.g., w. elliot brownlee, supra note 116, at 135 -6 . 123. the primary argument for adopting automatic mechanisms is that of distributive justice. for the issue of automatic adjustment and discretionary adjustment, see richard goode, government finance in developing countries 128 (the brookings inst. 1984); oecd report, supra note 9, at 17-18, 30. for comparative aspects of this issue, see the adjustment of personal income tax systems for inflation, supra note 9, at 13-16. 124. the argument is not limited to adjustment of the tax regime, but also applies to other areas of the social order in which a political effort can be made to neutralize the effects of inflation by means of correcting other distortions, while leaving inflation itself unaffected. 125. a ca proposal put forward in the u.s. in 1984 failed, inter alia, because political interests eroded its pure adjustment objectives by introducing tax arrangements that contradicted the adjustive purpose of the proposal. for example, the proposal made it possible to deduct mortgage interest, including the inflationary element, even though the proposed adjustment regime ruled out deducting the inflationary component of interest expenses. see slemrod & bakja, supra note 23, at 238 n.9. 2010] the coming(?) inflation and the income tax 443 epa.126 using ipa allows for political use, and abuse, of the adjustment regime. partial adjustment arrangements, particularly implicit ones, can be used to accomplish unrelated political goals without a public debate. for example, consider the debate over the appropriate tax burden on capital gains.127 one argument for the reduced tax rate for capital gains is the issue of taxing inflationary profits, even though those gains enjoy deferral.128 from a political perspective, implicit adjustment has, in general, the dual function in the sense that it can be justified on the basis of inflationary function or on the basis of a non-inflationary function. this leads to political maneuvering that can maximize the advantages of this dualistic dimension.129 this duality may facilitate the enactment of controversial tax arrangements by emphasizing the adjustment aspects while eroding contentious non-adjustment aspects. there can also be situations in which political considerations will operate in the opposite direction, emphasizing the non-adjustment feature while playing down adjustment.130 the range of uses to which the duality of the tax arrangement can be used is a product of the general social order regarding adjustism/nominalism. in the discourse of a culture of nominalism, the debate over the appropriate capital gain tax rate will emphasize the non-adjusting function of the reduced tax rate, whereas in the discourse of a culture of adjustism, the adjusting function will be more prominent. there are political advantages to an epa regime as well. creating tax regimes that adjust only certain economic components or activities can provide new areas for political maneuvering. rather than apply ca to all taxpayers as part of the normative equality-based tax regime, the epa regime would be seen as a medium for granting tax benefits. the basic requirements of the normative tax regime (e.g., taxing real income) would be 126. for the political conceptions that influence the scope of adjustment for inflation in the tax arena, see shuldiner, supra note 1, at 641. shuldiner argued that american politics assigns greater importance to adjustment of capital assets than to liabilities, although he believes that the adjustment of liabilities is more important. 127. this represents a concealed partial adjustment regime. for this issue, see part iii c. 128. see, e.g., shuldiner, supra note 1, at 552-57; halperin & steuerle, supra note 3, at 354. 129. thuronyi, supra note 1, at 445, argues that ipa is explained on a nonadjustment function. in my opinion, ipa can also be explained on the adjustment function when the culture of nominalism is common and it reflects the “maximum” adjustment that can be introduced into this culture. 130. imagine a ca tax regime in which there is also a reduced capital gain tax rate. in such circumstances, strong emphasis would be placed on the nonadjustment aspects of the reduced capital gain tax rate, while the adjustment aspect would be muted in order to preserve the reduced capital gain tax rate together with the comprehensively adjusted tax regime. 444 florida tax review [vol. 10:4 politically transformed into tax benefits (tax expenditures).131 this transformation is of public importance because such epa can divert the public discourse from a debate on the normative nature of the adjustment regime to a debate of tax expenditures. it enlarges the political involvement in the redesigning of the partial adjustment tax regime and, in turn, increases the potential for arbitrariness and abuse. here the culture of adjustism/nominalism of the social order plays a very important role: the strength of political considerations wanes the more a society employs adjustism. the ability of political groups to adopt/prevent the ca or ipa/epa regime diminishes as the culture of adjustism/nominalism increases in the social order. the public debate on adjustment in the tax arena comprises of political tension among different groups of taxpayers. for the purpose of this discussion, i will refer to each of the concepts as follows: atc the total tax collected under a ca regime (adjusted tax collection). ntc the total tax collected under a non-adjusted tax regime (nominal tax collection). euit the difference between the ntc and the atc is the excess tax, positive or negative, caused by inflation (excessive unadjusted inflationary tax; ntc – act = euit).132 the taxpayer population is comprised of three groups when looked at from the perspective of the effect of non-adjustment/adjustment on tax 131. on the relationship between the adjustment regime and tax expenditures, see w. elliot brownlee, supra note 116, at 132-33. 132. since euit is created as a result of inflation, it would seem appropriate to call it inflation tax, but that concept has a completely different meaning, according to which inflation itself constitutes a tax in the sense that it transfers real resources from the public to the government. it is the government that imposes the tax (inflation) due to its monopolistic power over money supply. a distinction should be drawn between inflation tax and seigniorage. the state’s revenue from issuing currency, in its sovereign and monopolistic role, unrelated to inflation, is referred to as “seigniorage.” however, if the government wishes to increase its revenues, and induces inflation, its revenues in excess of seigniorage constitute “inflation tax.” john maynard keynes, tract on monetary reform 41 (1935) (keynes referred to inflation (as a tax) as: “…the form of taxation which the public find hardest to evade and even the weakest government can enforce.”); milton friedman, supra note 119, at 13 (from a political point of view, governments are particularly fond of taxation in the form of inflation: “inflation has been irresistibly attractive to sovereigns because it is a hidden tax that at first appears painless or even pleasant, and above all, because it is a tax that can be imposed without specific legislation. it is truly taxation without representation.”). 2010] the coming(?) inflation and the income tax 445 liabilities: the first group consists of the taxpayers whose tax liability decreases as a result of adjustment. this group is thus “fined” as a result of non-adjustment (hereafter: the fined taxpayer group). the second group comprises of taxpayers who are not affected by the adjustment/nonadjustment arrangements (hereafter: the indifferent taxpayer group).133 there is a third group of taxpayers, who benefit from a decrease in the scope of adjustment, in the sense that as the scope of adjustment increases, their tax liability increases (hereafter: the benefited taxpayer group). the benefited taxpayer group exists as a result of the gap between theory and the effective tax reality, one which includes loopholes and enables tax planning and arbitrage. this reality occurs in a non-adjustment regime or in a partial adjustment regime, due to the absence of comprehensive adjustment.134 there are thus three possible scenarios: if the euit on the fined taxpayer group is greater than the (negative) euit of the benefited taxpayer group, then euit > 0. in this situation, a ca decreases the total collection revenue, which is in accordance with “the basic tax collection insight.”135 in contrast, if the euit imposed on the fined taxpayer group is less than the (negative) euit of the benefited taxpayer group, then euit < 0. in this situation, a ca will increase the total collection revenue. if the euit imposed on the fined taxpayer group is equal to the (negative) euit enjoyed by the benefited taxpayer group, then euit = 0. in this scenario, it is also important to carry out ca, because such adjustment increases the distributive justice and economic efficiency of the tax regime by eliminating the excess tax and the negative tax, leaving the taxpayers with tax burdens equal to the tax burdens in a tax regime in an inflation-free environment. these conclusions apply to an introduction of a ca, but only partially apply to epa or ipa. the conflict between the benefited taxpayer group and the fined taxpayer group creates political, economic and social tension in the public discourse about adjustment. the more realistic “the basic tax collection insight” – in the sense that it accurately reflects reality – the smaller the benefited taxpayer group, and the lesser the tension between the two groups. when “the basic tax collection insight” is accurate, the benefited taxpayer 133. employees are generally members of this group. 134. thus, for example, in terms of tax collection, the tax system may find itself in a position in which the total tax collection under a partial adjustment regime is lower than under a ca regime, due to inefficient introduction of partial adjustment components that enables tax arbitrage. 135. this is not to say that the benefited taxpayer group is empty, but rather that the extent of their benefit is smaller than the extent of tax imposed upon the fined taxpayer group. 446 florida tax review [vol. 10:4 group is empty and the only player left on the field is the fined taxpayer group that desires the elimination of the unjust tax imposed on it.136 the indifferent taxpayer group may take part in this public debate, and either support or resist adjustment, despite its indifference, as long as its relative portion of the tax collection changes as a result of increased adjustment. for example, when the benefited taxpayers are an empty group, then increasing the scope of adjustment reduces the tax burden on the fined taxpayer group, to which the indifferent taxpayer group may object in light of the increase in its relative contribution to overall tax revenues. such an objection should be rejected because while the adjustment indeed increases the relative tax burden of the indifferent taxpayer group, the original tax burden imposed on the fined taxpayer group was unjust and therefore had to be changed. 137 assuming euit > 0, which is most likely, proceeding from a lesser adjustment to a greater adjustment will cause an erosion of the euit. such a process has two tax consequences: first, transitions that increase adjustment create a “negative tax” that may be unjustly distributed. thus, for example, if the partial adjustment regime chooses only to index capital gains, then the owners of capital assets will enjoy a negative tax while those who do not possess capital assets will continue to bear the burden of non-adjustment, i.e., the remainder of euit after its reduction through indexing capital gains. second, partial adjustment may create new opportunities for tax arbitrage due to the fact that the adjustment mechanisms of the tax regime are not coherent. such tax arbitrage causes the euit to decrease not only due to the increase of adjustment, but by a greater amount due to the tax arbitrage.138 moving along the spectrum of adjustment regimes toward increased adjustment includes converting from one adjustment regime to another where the difference between them is in the content of the various adjustment components. every partial adjustment regime changes the scope and composition of the benefited taxpayer group, the fined taxpayer group, and the indifferent taxpayer group, and the euit imposed. an adjustment 136. the third group of taxpayers unaffected by adjustment/non-adjustment is not relevant to this discussion. 137. for collective action’s aspects regarding inflation, see mancur olson, the logic of collective action 166 (harvard univ. press 1971). 138. a single process of increasing adjustment can meet – although not entirely – the condition of distributive justice if the only variable related to adjustment is the extent of indexation, i.e., gradually increasing the percentage of indexation. thus, for example, at the beginning of the adjustment process, all of the relevant elements of the tax system are linked to a certain percentage of the index, and progress along the spectrum of adjustment regimes is carried out by means of gradually increasing the level of linkage to the index up to 100% linkage, which constitutes ca. in general such an adjustment process would be atypical. see also text accompanying note 61. 2010] the coming(?) inflation and the income tax 447 component added to the adjustment regime changes the composition of the three groups and their euit burden. this conclusion will be correct even if euit < 0, because every increase in the extent of adjustment leads to changes in the relative tax burdens of the three groups. even if euit = 0, the composition and tax burdens of the three taxpayer groups may change in either direction. a parallel issue concerns economic efficiency. adopting a gradually adjusting approach leads to changes in modes of economic behavior, and causes changes in the composition of the three taxpayer groups and their share in the euit. the primary goal for economic efficiency is finding the optimal “imposition” of the euit during the adjustment process. to summarize, when a tax system progresses along a spectrum of adjustment regimes, each step will encounter a political confrontation from the taxpayer groups due to the concrete components of adjustment. this will be the case because those components will influence the manner in which the positive and negative elements of the euit will be distributed among the different groups, as well as the scope and composition of the indifferent taxpayer group. the political discourse will focus both on distributive justice and economic efficiency. the wide range of considerations in this regard may result in a political decision that will create discontinuous and distorted movement along the spectrum not grounded in a tax policy appropriate for confronting inflation. intense political involvement in the design of partial adjustment regimes can lead to distortions of distributive justice and economic efficiency and may serve as a strong incentive to adopt a ca regime. the tension among the various taxpayer groups plays out against the background of society’s culture of nominalism or adjustism. in a culture of adjustism, the fined taxpayer group is more likely to support further adjustment of the tax regime. if society is dominated by a culture of nominalism, then the benefited taxpayer group will find support for its desire to maintain the nominalistic status quo. inasmuch as nominalism is the typically dominant culture, one may expect the fined taxpayer group to play the most active role in advocating the adjustment of the tax system for inflation, as well as for increasing the adjustment in other areas. moreover, the same paradigm will lead the benefited taxpayer group to oppose not only the adjustment of the tax system, but any attempt to introduce adjustment for inflation in any part of the social order, due to the influence that adjustment of non-tax areas will have on adjustment of the tax system.139 139. see oecd report, supra note 9, in regard to the influence of other areas of the social order. 448 florida tax review [vol. 10:4 g. inflation levels and tax rates as noted,140 the inflation levels and tax rates are built into the arguments and considerations discussed above. for example, a cost-benefit analysis demonstrates that the higher the inflation rate and tax rates, the greater the benefit of adjustment.141 the same applies for the general culture paradigm of inflation.142 the higher the inflation rate, the more likely it is that adjustment regimes are rooted in non-tax areas of the social order. however, it is possible that a society will have a culture of adjustism even when inflation rates are not high. this may result from past experience with high inflation143 that engendered social and economic sensitivity. under these circumstances the effect of the general culture paradigm will be opposite to the effect of cost-benefit analysis. under the general culture paradigm, tax rates have relatively little influence over the scope of adjustment. this greatly contrasts the importance of tax rates to cost-benefit considerations. what about the macro-economic considerations combating inflation by means of nominalism?144 the influence of the inflation rate on the weight of these considerations is the reverse: the higher the inflation rate, the more important it becomes to eliminate it by means of non-adjustment. tax rates do not affect the macro-economic considerations favoring nonadjustment for inflation. the inflation level and tax rates also influence tax collection considerations.145 the higher the inflation level and the tax rates, the higher the budgetary cost of introducing adjustment mechanisms into the tax system. therefore, tax collection considerations will lean in the opposite direction of costbenefit considerations and the effect of the general culture paradigm. the political considerations follow the direction of collection considerations, in the sense that the higher the inflation level and tax rates, the more valuable the “political assets” that result from the absence of comprehensive or partial adjustment. nevertheless, as inflation and tax rates rise, the relative importance of tax collection and of the political considerations lessen in comparison to that of general culture paradigm of inflation and the cost-benefit considerations. under such circumstances, adjustment for inflation will increase. 140. see text accompanying note 1 et seq. 141 . however, the analysis becomes complicated when inflation is not high, since the compliance costs are not strongly affected by the inflation rate’s increase. 142. see part iv c. 143. on the expression of an inflationary culture in the context of the role of the central bank in stabilizing prices, see, e.g., bernd hayo, inflation culture, central bank independence and price stability, 14 eur. j. of pol. econ. 241 (1998). 144. see part iv d. 145. see part iv e. 2010] the coming(?) inflation and the income tax 449 conclusions this article analyzes fundamental aspects of adjusting the tax regime to inflation. the cultures of nominalism and adjustism are placed at the center of the analysis due to the reciprocal relationship between the tax adjustment debate and the unadjustment/adjustment culture that dominates the social order. in these relationships, there is “equilibrium” between the scope of adjustment in the social order and in the tax regime. advancing adjustment of the tax regime requires that it also be promoted in the general social order. adjustment to inflation demands the tax discourse to be integrated within the general social order. this cultural paradigm plays a central role in the tax response to inflation, both in terms of the adoption of an adjustment regime, and in regard to the scope and character of that regime. according to this approach, the academic orientation that sees the complexity of comprehensive and partial (implicit and explicit) adjustment as the primary cause for adopting nominalism is largely rhetorical in that it ignores the following: first, the current tax regime comprises elements that are far more complex than the alleged “complexity” of adjustment for inflation. second, greater weight should be given to the cultural nature of adjustment to inflation, and less emphasis should be placed on its technical aspects. adjustment for inflation is a cultural phenomenon and not a technical issue. this article takes the view that tax regimes should be analyzed and critiqued on the basis of an integrative-cultural approach which is reflected in the social order, rather than an isolated phenomenon not playing a major role in the social order. tcharity really does begin at home: florida tax review volume 12 2012 number 10 827 trading one danger for another: creating u.s. tax residency while fleeing violence at home by mark s. hoose* abstract recent levels of violence in mexico have caused certain of its citizens who do not hold permanent u.s. residency status (and who may not intend to reside in the united states permanently) to spend more time in the united states. by doing so, these individuals create the risk that they will become u.s. residents for u.s. tax purposes, thereby subjecting their income to worldwide taxation by the united states (as well as creating potential u.s. estate and gift tax issues). this paper explores whether there is relief available to such individuals under u.s. domestic law (the “substantial presence” test and its various exceptions). it also explores whether mexican nationals can obtain relief from u.s. residency under the terms of the united states-mexico income tax treaty. the paper concludes that it is less than clear whether relief is available; in particular, it is not clear whether the tax authorities or the courts may consider violence in the person’s home country in determining whether the individual is a u.s. tax resident. the paper then goes on to propose various statutory changes to the law to allow the tax authorities to provide relief and certainty on the question of u.s. tax residency to individuals who are present in the united states merely to avoid violence at home. the paper argues for such relief on the basis that imposing worldwide u.s. taxation and tax reporting obligations on mexican nationals present in the united states merely to avoid danger at home is inequitable given the contributions of u.s. policy to the violence in mexico. i. introduction ............................................................................. 829 ii. u.s. tax residency under statutory law .................... 83131 a. consequences of the u.s. residency determination ............. 8322 1. consequences of u.s. residency ................................... 8322 2. consequences of u.s. nonresidency ............................. 8333 * assistant professor of law, university of san diego school of law. the author would like to thank richard doernberg, mike difronzo, jorge vargas, jordan barry, and the participants of the usd-procopio international tax conference for helpful input and guidance. any errors are the sole responsibility of the author. 828 florida tax review [vol.12:10 3. the difference between residency and nonresidency ................................................................. 8344 b. u.s. residency under the internal revenue code ................ 8355 1. the current law definition .......................................... 8355 2. some historical background ........................................ 8366 3. the war cases .............................................................. 8377 4. 1984 – the substantial presence test ........................... 8399 c. the substantial presence test in detail .............................. 84040 1. the test ....................................................................... 84040 a. meaning of “present” ......................................... 84141 b. exception for certain days of presence ............. 84141 c. exception for exempt individuals ....................... 84242 d. the “closer connection” exception ...................................... 844 1. definition of “tax home” ............................................. 8444 2. definition of “closer connection” ............................... 8455 e. conclusion – residency under domestic law...................... 8466 1. summary of exceptions ................................................. 8466 a. more than 183 days ............................................... 8466 b. less than 183 days ................................................ 8477 2. is danger at home relevant? ....................................... 8488 3. conclusion individual fleeing danger....................... 8488 iii. u.s. tax residency under u.s. tax treaties ................... 8499 a. the u.s.-mexico tax treaty in general ............................. 85050 b. residency under the treaty ................................................ 85050 1. the test for residency ................................................ 85050 2. first tie-breaker – “center of vital interests” ............ 8522 a. “permanent home” .............................................. 8533 b. “center of vital interests” .................................... 8533 3. second tie-breaker – “habitual abode” ..................... 8544 4. third tie-breaker – national status ............................. 8555 5. fourth tie-breaker – competent authority .................. 8555 c. analysis – u.s. residency under the treaty ......................... 8555 iv. proposals for change ........................................................... 8566 a. rationales for change ........................................................... 8577 b. overview of proposals .......................................................... 8599 c. substantial presence exception for those fleeing danger ...................................................................... 8599 1. exempt individual – refugee from violence? ............. 86060 2. exception from days of “presence” ........................... 86060 3. a “facts and circumstances” exception ................... 86161 d. repeal the substantial presence test .................................. 86161 1. repeal of substantial presence test ............................. 8622 2. repeal for nationals of mexico ..................................... 8633 e. the nafta taxpayer ............................................................ 8633 2012] one danger for another 829 1. joint tax rulings ........................................................... 8644 2. income apportionment .................................................. 8644 3. conclusion nafta ..................................................... 8655 v. conclusion .......................................................................................... 8666 i. introduction it is fairly well known, at least within tax circles, that the united states is unique in its approach to taxation of its citizens.1 the united states is unique because it taxes its citizens on their worldwide income.2 this means that income of a u.s. citizen is taxed by the united states regardless of where the income is earned and where the individual resides.3 in addition to u.s. citizens (whether born or naturalized), this system also applies to lawful permanent residents (“green card” holders) of the united states, who are considered to be u.s. residents for u.s. federal income tax purposes.4 what is less well-known is that individuals who are neither citizens nor lawful permanent residents of the united states can also be considered to be u.s. residents for purposes of the u.s. federal income tax, and hence subject to u.s. tax on their worldwide income.5 these individuals can create u.s. tax residency by satisfying the “substantial presence test,” which essentially provides that an individual who is “present” in the united states for a certain number of days over a given period can create u.s. tax residency by means of this “substantial presence.”6 accordingly, an individual who is not a citizen or permanent resident can nonetheless create u.s. tax residency merely by being present in the united states for a certain number of days over a given period.7 1. see, e.g., edward a. zelinsky, citizenship and worldwide taxation: citizenship as an administrable proxy for domicile, 96 iowa l. rev. 1289, 1291 (2011). 2. reg. § 1.1-1(b) (“[a]ll citizens of the united states, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the code whether the income is received from sources within or without the united states.”). 3. id.; see also i.r.c. § 1. 4. i.r.c. § 7701(b)(1)(a)(i). 5. residency may also create u.s. estate and gift tax consequences. see i.r.c. § 2001(a). 6. i.r.c. §§ 7701(b)(1)(a)(ii), 7701(b)(3). other nations also tax individuals based on residency, which is a difficult determination to make and has vexed numerous policymakers. see, e.g., adrian j. sawyer, the mire of tax residency determination in new zealand, tax notes int’l 737 (dec. 5, 2011). 7. this is a different issue than the “accidental american” issue, where a long-term resident of a foreign country (such as mexico or canada) discovers later in life that she was born in the united states and hence has been a u.s. citizen (subject to u.s. worldwide taxation) since birth. relief is now available in these situations. 830 florida tax review [vol.12:10 this can be the case even if the individual is physically present in the united states merely to avoid either political or other dangers in the person’s home country of citizenship or residency.8 there is some evidence that this has become a substantial problem for certain citizens of the border regions of mexico, who may currently find it difficult to remain in their home country due to increasing levels of violence.9 take as an example an individual who is a citizen of mexico but has family members (including perhaps a spouse) who reside in the united states. the individual may live in a border town such as cuidad juárez or tijuana, where there has been a significant increase in violence since 2007.10 the individual may have significant business interests in mexico, but also business interests and other connections to the united states.11 she may have her usual home in mexico, but also a residence available to her in the united states, given that she has family in the united states. due to the increase in violence in her hometown, she may feel that it is necessary to spend more time in the united states.12 the u.s. tax question arises if she comes to the united states13 in 2011, and due to conditions at home, she is required to stay in the united states for more than 183 days in 2011. the specific issue is whether she has inadvertently become a “resident alien” individual14 for see kristen a. parillo, irs to minimize penalties on dual u.s.-canadian citizens, tax notes int’l 798 (dec. 12, 2011). 8. see staff of the joint comm. on taxation, 98th cong., gen. explanation of the revenue provisions of the deficit reduction act of 1984 464 (joint comm. print 1984) [hereinafter jct, general explanation]. 9. see a “green zone” for firms in ciudad juárez: business on the bloody border, economist, nov. 26, 2011, at 76 (noting how cuidad juárez considered implementing a well-protected “green zone,” in order to protect local entrepreneurs and reassure visitors). 10. see, e.g., mexico’s changing drug war: shifting sands, economist, nov. 26, 2011, at 48 (summarizing the “drug war” and the significant increases in violence in certain parts of mexico during 2011). 11. the economic relationship between the united states and mexico is the most important relationship, by a significant margin, for mexico and its citizens. see m. angeles villarreal, cong. research serv., rl 32934, u.s.-mexico economic relations: trends, issues, and implications (2005), http://fpc.stat. gov/documents/organization/50161.pdf [hereinafter villarreal, u.s.-mexico relations]. 12. see, e.g., mary beth sheridan, drug war sparks exodus of affluent mexicans, wash. post, aug. 26, 2011, http://www.washingtonpost.com/world/ national-security/drug-war-sparks-exodus-of-affluent-mexicans/2011/ 08/19/giqa6or1gj_story.html. 13. she may hold an “e-1” or “e-2” investment visa, which allows her to enter the united states. the number of such visas has increased by 73% from 2006 to 2010. id. 14. i.r.c. § 7701(b). 2012] one danger for another 831 u.s. tax purposes, and thus is subject to worldwide u.s. taxation on her income,15 notwithstanding the fact that she remains a citizen of mexico16 and does not hold lawful permanent resident status17 in the united states. the remainder of this article will explore this problem further.18 part ii will take an in-depth look at the “substantial presence” test and discuss the consequences of a u.s. residency determination under that test. part iii will then analyze whether relief may be available to such individuals under a u.s. tax treaty (for example, in the case of mexico, the united states-mexico income tax treaty). part iv will then make the argument for an exception to the “substantial presence” test for individuals who can show that they are only present in the united states to avoid political or other dangers in their home countries. that part will emphasize that the united states should particularly make such an exception with respect to nationals from mexico, given the contributions of u.s. policy to the recently increased levels of violence in that country. this part will also suggest that policymakers consider other alternatives (such as a joint ruling process) to give mexican nationals more certainty as to whether their presence in the united states creates u.s. tax residency. ii. u.s. tax residency under statutory law to determine whether an individual is a u.s. resident, one must first consult the u.s. internal revenue code for the relevant rules.19 however, if the individual is found to be a resident under these rules, this is not the end of the analysis. if an individual is a foreign person who is also entitled to benefit from the provisions of a u.s. tax treaty, then the treaty must be consulted to determine whether the individual is truly a u.s. resident, or is a 15. reg. § 1.1-1(b). 16. as a citizen of mexico, with a home in that country, she is likely to be considered a mexican resident for mexican income tax purposes. see infra note 178. 17. as noted, it may be that she entered the united states on either a “tourist” or “investor” visa. it will be seen that a person’s immigration status (short of lawful permanent residency) is generally not determinative in the analysis of whether the individual is a u.s. tax resident subject to worldwide taxation. see i.r.s. tech. adv. mem. 75-08-291120a (aug. 29, 1975) (finding that an individual who was in the united states illegally was nonetheless a resident of the united states for tax purposes (under the test for residency that appeared in the law prior to 1984’s introduction of the “substantial presence test”)). 18. similar issues can arise for other individuals fleeing violence at home, such as salvadorans fleeing violence in el salvador. see, e.g., drew combs, nixon peabody lawyer wins asylum for salvadoran teen tormented by gangs, am. law, dec. 13, 2011, http://www.law.com/jsp/article.jsp?id=1202535303729. the focus of this article, however, will be on mexico, given its proximity to the united states. 19. see i.r.c. § 1. 832 florida tax review [vol.12:10 resident of the other country, for (at least some) purposes of u.s. taxation.20 these rules are now discussed in turn (the treaty rules are discussed in part iii). a. consequences of the u.s. residency determination before proceeding to discuss u.s. residency rules in detail, it is worth evaluating the consequences of a u.s. residency determination. also, it is useful to explore the differing tax treatment accorded to individuals who are not residents of the united states. each will be discussed in turn. 1. consequences of u.s. residency if an individual is determined to be a u.s. resident (specifically, a “resident alien individual”), then such individual is taxed by the united states on his or her worldwide income, no matter where earned.21 likewise, there may be gift and estate tax consequences to the determination.22 lastly, depending on the type of resident, there may be u.s. tax consequences upon the termination of u.s. residency status.23 in addition, there are numerous reporting requirements that are triggered by u.s. residency, including an obligation to report most foreign bank accounts,24certain ownership interests in foreign corporations and partnerships, and25 interests in foreign trusts.26 further, as a u.s. resident, an 20. see i.r.c. § 894(a), which states that u.s. domestic law shall be applied with “due regard” to any treaty obligation of the united states. the u.s. supreme court has generally stated that the “last expression of the sovereign will” shall prevail when a treaty (including a tax treaty) conflicts with u.s. domestic law, and hence a tax treaty may override a determination under domestic tax law. chae chan ping v. united states, 130 u.s. 581, 600 (1889). for a general discussion of the treaty override issue, see sung-soo han, the harmonization of tax treaties and domestic law, 7 byu int'l l. & mgmt. rev. 29 (2011). 21. reg. § 1.1-1(b). worldwide taxation will result even if a foreign government also considers the individual to be a foreign resident and thus subject to foreign income taxation as well. in these situations, u.s. residents typically can take a credit against u.s. tax liability for any income taxes paid to a foreign government in order to mitigate the likelihood of double taxation. see i.r.c. § 901. 22. see, e.g., i.r.c. § 2001. 23. i.r.c. §§ 877, 7701(b)(10). 24. transfer and reorganization of bank secrecy act regulations, 75 fed. reg. 65806-01 (proposed oct. 26, 2010) (to be codified at 31 c.f.r. § 103.24). this obligation is due to become more onerous once the new rules of the foreign account tax compliance act (fatca) come into effect in 2013 and 2014. see i.r.c. §§ 1471-1474 (effective for payments made after december 31, 2012). 25. see, e.g., i.r.c. § 6038. 2012] one danger for another 833 individual is subject to the “subpart f” regime, under which the income of certain foreign corporations that are “controlled” by the individual is subject to current u.s. taxation.27 however, there also may be taxpayer-positive effects to a determination of u.s. residency. for example, a u.s. resident taxpayer may be entitled to tax deductions (such as the deduction for mortgage interest paid) that are not available to nonresidents.28 further, a u.s. resident can be a shareholder in a subchapter s corporation, while nonresidents cannot.29 in general, subchapter s treatment is a positive result for the entity and its shareholders, as it generally permits pass-through taxation and hence avoids the double taxation imposed on regular corporations under u.s. law.30 2. consequences of u.s. nonresidency if, instead, an individual is determined to be a nonresident alien individual for the calendar year in question, then a different u.s. tax regime applies to the person.31 this regime can be described as a form of a territorial regime, under which only income that bears some connection to the united states is subject to u.s. federal income taxation.32 in particular, there is a thirty percent tax imposed on income “not connected with [a] united states business,” but only if such income is considered, in general, to be “fixed or determinable annual or periodical” (fdap) income from sources within the united states.33 under these rules, capital gains (such as gains earned from 26. i.r.c. § 6048. 27. i.r.c. §§ 951-965. 28. generally, nonresidents are only permitted deductions that are connected with income that is “effectively connected” to a u.s. trade or business. i.r.c. § 873. 29. i.r.c. § 1361(b)(1)(c). 30. i.r.c. § 1368. double taxation is imposed on subchapter c corporations by treating the corporate entity itself as taxable, and by treating dividends paid by such corporations as taxable to their shareholders but not deductible by the paying corporation. see generally i.r.c. §§ 11, 301, 316. by contrast, an s corporation is generally not taxable on its income, and distributions by the s corporation are not taxable when received by shareholders. see i.r.c. § 1368. 31. see i.r.c. §§ 871-879. 32. joseph isenbergh, international taxation 81–83 (3rd ed. 2010). 33. i.r.c. § 871(a). such income, often referred to by the acronym “fdap,” includes dividends and interest from u.s. sources (generally dividends paid by u.s. corporations or interest paid by u.s. persons). the thirty percent tax imposed by this section is collected via the mechanism of a withholding obligation imposed on the payors of such income. see i.r.c. §§ 1441–1445. however, gain from the disposition of property (such as corporate stock) is generally not taxable to foreign persons. see i.r.c. § 871(a)(2). 834 florida tax review [vol.12:10 the disposition of corporate stock) earned by nonresidents are generally not subject to u.s. taxation.34 the other type of income taxable to nonresident aliens is any income that is “effectively connected” with a u.s. trade or business carried on by the nonresident alien.35 as an extension of this rule, any gain or loss from the disposition of a “united states real property interest” by a nonresident alien is subject to u.s. taxation as though it were connected with a u.s. business.36 these real estate rules are effectively exceptions to the general rule that gains earned by a nonresident alien are not subject to u.s. taxation and reflect a policy decision that real estate gains of foreign persons should be subject to u.s. taxation.37 lastly, the impact of u.s. taxation on a nonresident alien can be altered and minimized by the application of a u.s. tax treaty with the alien’s country of residency.38 for example, under the u.s.-mexico income tax treaty, the u.s. tax imposed on u.s.-source interest and royalties (as well as certain dividends) is reduced from thirty percent to zero.39 likewise, the graduated tax imposed on business profits will only be imposed if the mexican resident has a “permanent establishment” in the united states; not all u.s. businesses of a foreign person will rise to the level of a permanent establishment.40 3. the difference between residency and nonresidency from these rules, it can be seen that the primary difference between u.s. residency and u.s. nonresidency is the taxation of income earned outside the united states. if an individual is a resident alien (i.e., a u.s. 34. see i.r.c. § 871(a)(2), which imposes taxation upon the capital gains of nonresident aliens who are present in the united states 183 days or more in the year of disposition. 35. i.r.c. § 871(b). this income is taxed at the graduated rates applicable to u.s. residents. also, business income that is taxable under this rule can include income earned by a partnership in which the nonresident alien is a partner, if the partnership is engaged in a u.s. trade or business. see i.r.c. § 875(1). 36. i.r.c. § 897(a). thus, under this rule, any gain on the sale of u.s. real estate by a foreign person will be subject to taxation at the graduated rates applicable to u.s. residents. 37. see joel d. kuntz & robert j. peroni, u.s. international taxation ¶ c1.06[1] (2011) [hereinafter kuntz & peroni, u.s. int’l taxation]. 38. see, e.g., convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, u.s.-mex., sept. 18, 1992, s. treaty doc. no. 103-07, http://www.irs.gov/businesses/international/ article/0,,id=169680,00.html [hereinafter u.s.-mexico treaty]. 39. id. art. 10, 11, 12. 40. id. art. 7. 2012] one danger for another 835 resident), then all income is subject to taxation, no matter where earned.41 nonresidents, by contrast, are generally taxed only on u.s.-connected income, which will include sales of u.s. real property.42 thus, the practical difference will be u.s. taxation on non-u.s. income if the individual is found to be a u.s. resident. in other words, if the individual is a u.s. resident, the united states will impose income tax (with a provision of a credit for any foreign income taxes paid) on both the u.s. and non-u.s. income of the individual.43 however, due to the application of a u.s. tax treaty to nonresidents only, u.s. residency status can also lead to u.s. taxation of u.s.-source passive income (such as interest and dividends) that would otherwise be exempt from u.s. taxation under the treaty, had the person been a u.s. nonresident and, instead, a resident of the other treaty country (e.g., mexico).44 further, u.s. residency brings with it substantial tax reporting obligations, as described above.45 b. u.s. residency under the internal revenue code 1. the current law definition the term “resident alien individual” is defined by section 7701(b) of the internal revenue code.46 under this provision, an individual who is not a u.s. citizen can be a resident alien for a particular calendar year in one of three ways. first, an individual will be a resident alien if the person is a “lawful permanent resident” of the united states at any time during the calendar year.47 a person is a lawful permanent resident if such person has been “lawfully accorded the privilege of residing permanently in the united states as an immigrant in accordance with the immigration laws,” and such status has not been revoked or abandoned.48 this is commonly referred to 41. however, as noted, a u.s. resident is also entitled to more deductions than are typically available to a nonresident. further, the u.s. resident should be entitled to a foreign tax credit for income taxes paid to foreign countries. see i.r.c. § 901. 42. i.r.c. § 897. 43. reg. § 1.1-1(b). see i.r.c. § 901 for rules allowing u.s. residents a credit against u.s. tax liability for foreign income taxes paid. 44. see u.s.-mexico treaty, supra note 38, art. 10 (exempting from u.s. tax certain dividends received from u.s. sources by residents of mexico). 45. see discussion supra note 24. 46. this paper will use the term “u.s. resident” interchangeably with “resident alien individual”; the meaning is the same. a person who is a u.s. citizen is automatically a u.s. resident for u.s. federal income tax purposes; hence, this discussion assumes that the individual in question is not a u.s. citizen. 47. i.r.c. § 7701(b)(1)(a)(i). 48. i.r.c. § 7701(b)(6). 836 florida tax review [vol.12:10 as the “green card” test for establishing resident alien status (and hence becoming a u.s. tax resident).49 second, an individual can be a resident alien by meeting the “substantial presence” test set forth in the statute.50 the substantial presence test is described in greater detail below. lastly, an individual can become a resident alien by making the first year election provided in the statute.51 for this election to be available, the individual must not have been a u.s. resident in either the current or the preceding tax year (either lawfully or under the substantial presence test).52 the individual must also meet the substantial presence test in the subsequent calendar year.53 further, the individual must be present in the united states for a certain number of days during the election year.54 accordingly, it can be seen from these rules that the only way a nonresident can “accidentally” create u.s. residency is by satisfying the substantial presence test, which is discussed below.55 2. some historical background u.s. law has long had to grapple with the issue of whether a foreign national is a “u.s. resident” for u.s. income tax purposes.56 prior to 1984, the u.s. residency of a foreign national was determined under a facts and circumstances analysis, which created a fairly substantial body of case law determining which factors were dispositive or important in determining the u.s. tax residency of a foreign national.57 in particular, the relevant treasury regulation at the time stated that if an individual was a mere sojourner in the 49. even the internal revenue service (irs) refers to this test as the “green card” test on its website. http://www.irs.gov/businesses/small/international/ article/0,,id=96314,00.html. 50. i.r.c. § 7701(b)(1)(a)(ii). 51. i.r.c. § 7701(b)(1)(a)(iii). 52. i.r.c. § 7701(b)(4)(a)(i)–(ii). 53. i.r.c. § 7701(b)(4)(a)(iii). 54. i.r.c. § 7701(b)(4)(a)(iv). individuals who are going to be subject to u.s. taxation in subsequent years may wish to make this election for the current year in order to avail themselves of the additional u.s. tax deductions available only to u.s. residents. 55. as noted previously, there are individuals who “accidentally” became u.s. citizens (due to birth in the united states). supra note 7. these people are automatically u.s. residents for u.s. tax purposes (even if they are unaware of their u.s. citizenry), and hence the substantial presence test is not relevant to their cases (and they will not be discussed in this paper). 56. joseph isenbergh, international taxation: u.s. taxation of foreign persons and foreign income ¶ 6.6 (4th ed. 2011) [hereinafter isenbergh, u.s. taxation]. 57. id. 2012] one danger for another 837 united states (i.e., had no intention to stay), then such person was not a u.s. tax resident.58 likewise, if the individual’s stay in the united states was “limited to a definite period by the immigration laws,” then such person was not a u.s. tax resident.59 other factors considered by the courts included the individual’s immigration status; whether (and to what extent) the foreign individual was actually present in the united states; and whether the foreign individual planned to stay in the united states either permanently or for an extended period.60 hence, the intentions of the individual (as to whether to stay in the united states or to return), as well as the situation in the individual’s country of citizenship or prior residency, were considered important. 3. the war cases a relevant example of this analysis can be found in the case of nubar v. commissioner.61 in that case, an egyptian citizen found himself in the united states at the outbreak of world war ii. the tax court described nubar as a “man of great wealth” (whose grandfather was the prime minister of egypt) who resided in egypt until 1915, but then took an apartment in paris, which he maintained continuously from 1915 to 1944.62 nubar arrived in the united states on august 1, 1939, on a three-month visitor’s visa, evidently with the intention of seeing the new york world’s fair and also meeting with albert einstein.63 however, the war broke out on september 1, 1939, making it difficult for him to return to egypt. he sought an extension of his visa, which was eventually denied, and he was arrested by immigration authorities. eventually, he was ordered to be deported, but the order was stayed until ninety days after termination of the war in europe. once the war ended, nubar did indeed return to europe, first to switzerland, and then eventually to paris.64 the tax court found that nubar was not a u.s. resident because he had no intention to stay in the united states.65 the tax court emphasized that nubar came to the united states with minimal possessions and stayed in a hotel, all of his household goods and family remained in europe, and he had a home in switzerland to which he could return.66 he also expressed an 58. reg. § 1.871-2(b) (1984). 59. id. 60. isenbergh, u.s. taxation, supra note 56, at ¶ 6.6. 61. 13 t.c. 566 (1949), rev’d, 185 f.2d 584 (4th cir. 1950). 62. id. at 568. 63. id. at 569. 64. id. 65. id. at 576. 66. id. 838 florida tax review [vol.12:10 intention to return to europe, and then he indeed did return once the war ended. however, on appeal, the fourth circuit reversed the tax court and held that nubar was a u.s. tax resident.67 the fourth circuit panel agreed that nubar may have entered the united states with intentions to stay only temporarily, but the court emphasized that nubar made significant profits trading on u.s. exchanges while under the protection of the laws of the united states.68 in other similar cases, the tax court found individuals to be nonresidents in very similar situations. in molnar v. commissioner, the taxpayer was a citizen of hungary who was present in the united states from january 1940 through october 1943, on a series of visitor’s visas that were extended periodically.69 the tax court noted that the individual was only in the country for a definite and temporary period, in that he traveled on a round trip ticket, stayed in hotels, and did not engage in any business activity in the united states. also, his only family and similar connections remained in europe. hence, he was found to be a nonresident of the united states for tax purposes.70 in constantinescu v. commissioner, the facts were similar to the situation in nubar.71 the taxpayer in this case, a citizen of romania who resided in paris, gained admission to the united states in 1939 on a temporary visitor’s visa. after a few renewals of her visa, such renewal was finally denied in 1942, and the taxpayer was arrested in 1943 and ordered deported in 1944. her deportation orders were eventually stayed, and she ultimately left the united states for europe in late 1945.72 the irs asserted that she was a u.s. tax resident from 1944-1945, a time during which she was actually under arrest in the united states. the tax court did not agree, and held that the taxpayer was not a u.s. tax resident, applying the “facts and circumstances” test called for by the regulations in force at that time.73 in the post-war years, other transitory individuals (in one case, a flight attendant, and in another, an actor) succeeded in defeating u.s. 67. commissioner v. nubar, 185 f.2d 584, 589 (4th cir. 1950). 68. id. at 586. this can be thought of as a “benefit” test, which is an oftstated theoretical foundation for taxing non-citizens. see jct, general explanation, supra note 8. under this benefit test, taxation by the united states is deemed appropriate because the non-citizen is benefitting from the laws and protections of the united states. 69. 4 t.c.m. (cch) 951 (1945). 70. id. 71. 11 t.c. 37 (1948). 72. id. at 38–39. 73. id. at 42–44. 2012] one danger for another 839 tax residency in court.74 in addition, in the 1970’s, the irs dealt with this issue in tax rulings with inconsistent results.75 it can be seen from these cases and rulings that the “facts and circumstances” analysis of the prior regulations led to inconsistent application of the u.s. residency test to similarly situated taxpayers. in particular, there appears to be very little difference between the fact pattern in nubar and the fact pattern in constantinescu — in both cases, the taxpayer was forced to stay in the united states due to war conditions in europe. yet, in one case, the taxpayer was found (on appeal) to be a u.s. resident, while in the other, the taxpayer did not create u.s. tax residency. these fact patterns are also very similar to the fact pattern of the mexican national mentioned in the introduction to this paper. it was this inconsistent application of a vague standard, which focused primarily on the person’s intention in creating u.s. residency, that led congress to enact the substantial presence test in 1984, as described below. 4. 1984 – the substantial presence test it was in an effort to bring objectivity to this area that congress amended section 7701(b) in 1984.76 first, as noted above, congress implemented the “green card” test — if a person is a lawful permanent resident of the united states, then such person is a u.s. resident for tax purposes.77 additionally, congress tried to bring further objectivity to the analysis through application of the mechanical “substantial presence” test.78 however, due to the number of exceptions,79 it is highly questionable whether this test is truly objective. the test, and its various exceptions, are discussed in detail below. 74. see sanford v. commissioner, 27 t.c.m. (cch) 266 (1968) (holding that a honduran flight attendant who maintained some living quarters in new orleans was not a u.s. tax resident); jellinek v. commissioner, 36 t.c. 826 (1961) (“stateless” actor who worked periodically in hollywood was not a u.s. tax resident). 75. see i.r.s. tech. adv. mem. 77-40-002 (apr. 27, 1977) (employee of international organization who was present in the united states was a u.s. tax resident); i.r.s. tech adv. mem. 77-40-001 (apr. 27, 1977) (student who became an employee of an international organization in the united states was held to be a u.s. resident). 76. see h.r. rep. no. 98-861, at 181 (1984) (conf. rep.). 77. i.r.c. §§ 7701(b)(1)(a)(i), (b)(6). 78. i.r.c. § 7701(b)(3). 79. see i.r.c. §§ 7701(b)(5), (b)(7). 840 florida tax review [vol.12:10 it is an interesting query as to whether congress intended to overrule or abandon the prior case law when implementing the substantial presence test. thus, the question is whether these old cases, relating to “intention” and danger in the individual’s home country, still have any relevance under either statute or treaty. the legislative history to the 1984 tax reform act (which brought section 7701(b) into the code) is silent on this topic.80 however, the staff of the joint committee on taxation’s general explanation of the 1984 act [hereinafter 1984 act jct explanation] gives some indication that the old case law may no longer be relevant.81in particular, the 1984 act jct explanation states that congress intended to create only limited exceptions for people in the united states to “teach or learn,”82 as opposed to people in the united states merely to enjoy “political stability.”83 this is evidence that the old “facts and circumstances” analysis was truly made irrelevant by the 1984 legislative change. c. the substantial presence test in detail this section describes the substantial presence test in detail. the next subsection describes a major potential exception to u.s. tax residency under the code, often called the “closer connection” exception. 1. the test in order for an individual to be substantially present in the united states for a calendar year, and hence a u.s. tax resident for that year, the person must initially be physically present in the united states for at least thirty-one days in the calendar year in question.84 then, assuming this condition is met, the individual’s presence in the united states must be determined for each of the two preceding years.85 the sum of the days present in the current year, plus the days present during the preceding two years (multiplied by a “multiplier”) must equal or exceed 183 days.86 the “multiplier” for the first preceding year is one-third (i.e., the days actually 80. see h.r. rep. no. 98-861, supra note 76. 81. see jct, general explanation, supra note 8, at 464. 82. id. this is a reference to the statutory exceptions in i.r.c. § 7701(b)(5) for individuals in the united states merely as students or teachers, as discussed infra part ii.c.1.c. 83. jct, general explanation, supra note 8, at 464. 84. i.r.c. § 7701(b)(3)(a)(i). 85. i.r.c. § 7701(b)(3)(a)(ii). 86. id. 2012] one danger for another 841 present in such preceding year are multiplied by one-third), and the multiplier for the second preceding year is one-sixth.87 by way of example, consider the following (taken from the treasury regulations): example 1. b, an alien individual, is present in the united states for 122 days in the current year. he was present in the united states for 122 days in the first preceding calendar year and for 122 days in the second preceding calendar year. in determining his status for the current year, b counts all 122 days in the united states in the current year plus 1/3 of the 122 days in the united states in the first preceding calendar year (40 2/3 days) and 1/6 of the 122 days in the united states during the second preceding calendar year (20 1/3 days). the total of 122 + 40 2/3 + 20 1/3 equals 183 days. b meets the substantial presence test and is a resident alien for the current year.88 a. meaning of “present” in general, the term “present” encompasses any day that the individual is “physically present” in the united states any at time during such day.89 thus, whether the individual is in the united states legally or not is irrelevant for this purpose.90 however, there are certain exceptions to the definition of “present” for certain days of actual presence and for certain individuals, as described below. b. exception for certain days of presence the statute makes certain exceptions for days of actual presence within the united states that will not count as days “present” for purposes of the substantial presence test. there are three types of days that will not count as presence. the first exception is for days during which an individual commutes from a residence in canada or mexico to a place of employment (or self-employment) within the united states.91 any day so commuting will not be considered a day of “presence” for purposes of the test. 87. id. 88. reg. § 301.7701(b)-1(e), ex. 1. 89. i.r.c. § 7701(b)(7)(a). 90. see i.r.s. tech. adv. mem. 75-08-291120a (aug. 29, 1975). 91. i.r.c. § 7701(b)(7)(b). 842 florida tax review [vol.12:10 the second exception is for individuals who are in transit between two foreign points.92 in order for this exception to apply, the individual must be present for less than twenty-four hours in the united states.93 this exception is evidently intended for situations in which individuals are merely changing planes, for example, in new york while in transit between mexico and paris. the third exception is for members of a crew of a “foreign vessel,” provided such individual is a regular member of such crew and is present in the united states solely as part of the crew of the vessel engaged in transportation between the united states and a foreign country (or u.s. possession).94 any days present in this capacity will not count as “presence” so long as the individual does not engage in any other u.s. business on such a day.95 interestingly, there is no explicit exception for days of presence in the united states due solely to exigencies in the individual’s home country. as noted above, under the “facts and circumstances” analysis undertaken by the courts and the tax authority prior to 1984, there was some consideration given to this issue.96 c. exception for exempt individuals in addition to making exceptions for certain days of presence, the statute also makes exceptions for certain types of individuals who are actually present in the united states. if any person is an “exempt individual” on a particular day of presence in the united states, then such day shall not count as a day of “presence” for purposes of the test.97 the statute provides four categories of “exempt individuals” and one exception for certain medical conditions: (1) a foreign government-related individual; (2) a teacher or trainee; (3) a student; (4) a professional athlete temporarily in the united states to compete in a charitable sports event; or (5) a person unable to leave the united states due to a medical condition that arose while the individual was present in the united states.98 each of these will now be discussed in turn. a foreign government-related individual includes a person who is temporarily in the united states under diplomatic status that is full time or 92. i.r.c. § 7701(b)(7)(c). 93. id. 94. i.r.c. § 7701(b)(7)(d). 95. id. 96. see, e.g., nubar, 13 t.c. at 579. 97. i.r.c. § 7701(b)(3)(d). 98. id.; i.r.c. § 7701(b)(5)(a)-(e). 2012] one danger for another 843 consular (under u.s. state department rules).99 this definition also includes an individual who is a full-time employee of an “international organization.”100 any immediate family members of either a diplomat or employee of an international organization also are included.101 the “teacher or trainee” category includes only individuals who hold a “j” visa or a “q” visa and are in the united states in compliance with the requirements of those visa statuses (as potentially determined independently by the irs).102 there is, however, a time limit imposed on the teacher or trainee exception — if an individual qualified as an exempt teacher or trainee in any two of the preceding six calendar years, then the individual cannot so qualify for the current calendar year.103 a student is exempt if she is temporarily present in the united states under either an “f,” “m,” “j,” or “q” visa and complies with the requirements of these visa statuses.104 similar to teachers and trainees, students are subject to a time limit — a student cannot qualify for exempt status in any year after the fifth calendar year in which the student first qualified, unless the student can establish that she does not intend to permanently reside in the united states.105 professional athletes who are present in the united states merely to compete in a “charitable sports event” will not be counted as present in the united states for purposes of the test.106 likewise, individuals who are unable to leave the united states due to a “medical condition” that arose 99. i.r.c. § 7701(b)(5)(b). here, “temporarily” means a person who holds diplomatic status or works for an international organization (or is a family member) and does not have a “green card,” no matter how long the person has been in the united states. reg. § 301.7701(b)-3(b)(2)(i). 100. i.r.c. § 7701(b)(5)(b)(ii). “international organization” means any organization that qualifies for benefits under the international organizations act, which should include the united nations, world bank, and international monetary fund. reg. § 301.7701(b)-3(b)(2)(ii). 101. i.r.c. § 7701(b)(5)(b)(iii). under the regulations, “immediate family” includes a spouse and unmarried children under the age of twenty-one, but not personal assistants. reg. § 301.7701(b)-3(b)(8). 102. i.r.c. § 7701(b)(5)(c). 103. i.r.c. § 7701(b)(5)(e). this time limit effectively means that a teacher or trainee can only qualify as an exempt individual in two years out of any sevenyear period. 104. i.r.c. § 7701(b)(5)(d). 105. i.r.c. § 7701(b)(5)(e). 106. i.r.c. § 7701(b)(5)(a)(iv). a “charitable sports event” is defined as an event for the benefit of a tax-exempt organization, where all the proceeds from the event go to the organization, and the event is staffed substantially by volunteers. see i.r.c. § 274(l)(1)(b). 844 florida tax review [vol.12:10 while they were in the united states are not counted as “present” in the united states on any such day.107 there are a variety of disclosure requirements imposed by the irs on the ability to utilize these exclusions (for example, the requirement to file form 8843 with the irs).108 d. the “closer connection” exception in addition to the exceptions for certain days of presence and certain exempt individuals (as described above), the statute also provides a separate exception for an individual who is present (after considering the exceptions noted above) in the united states for fewer than 183 days in the year in question, if such individual can establish that she has a “tax home” in a foreign country and a “closer connection” to such foreign country than to the united states.109 further, in order for this exception to apply, the individual must not have an application for “adjustment of status” pending during the year in question, and the individual must not have taken any other steps during the year to apply for status as a lawful permanent resident of the united states.110 lastly, certain reporting requirements will apply in order for an individual to qualify under this exception.111 1. definition of “tax home” section 911 provides the definition of a “tax home”;112 that section, in turn, refers to section 162(a)(2) for the definition.113 under section 162, the term “tax home” has a long history.114the term effectively refers to an individual’s main location or main place of employment or selfemployment.115 under this case law, an individual who is transient may be 107. i.r.c. § 7701(b)(3)(d)(ii). the exception will not apply if the medical condition arose prior to the individual’s arrival in the united states. likewise, the exception will not apply if it is shown that the individual would have stayed in the united states had the medical condition not occurred. reg. § 301.7701(b)-3(c). 108. see generally reg. § 301.7701(b)-8. 109. i.r.c. § 7701(b)(3)(b). 110. i.r.c. § 7701(b)(3)(c)(i)–(ii). the regulations list the types of forms that constitute an “application for adjustment of status.” see reg. § 301.7701(b)-2(f). 111. i.r.c. § 7701(b)(8). 112. i.r.c. § 911(d)(3). 113. id. see also kuntz & peroni, u.s. int’l taxation, supra note 37, at ¶ b1.04[2][b][iii]. 114. see generally james j. freeland et al., fundamentals of federal income taxation: cases and materials 374 (16th ed. 2011). 115. see, e.g., rosenspan v. united states, 438 f.2d 905, 912 (2d cir. 1971). 2012] one danger for another 845 considered to have no “tax home” at all.116 once an individual spends more than one year away from this main location of employment, she is deemed to have a new “tax home.”117 the regulations under section 7701 clarify that if an individual has no regular place of business (e.g., if the individual is retired), the individual’s “tax home” is her “regular place of abode in a real and substantial sense.”118 also, the regulations make clear that the “tax home” must be maintained, in the same foreign country, for the entire current year.119 thus, an alien who changes her home during a calendar year, even if moving from one foreign location to another, may not be eligible for the “closer connection” exception.120 it can be seen from this analysis that the determination of an individual’s “tax home” is fairly subjective and depends on the specific facts and circumstances of the individual’s case. it may be particularly difficult for a mexican national who is fleeing violence to show that her “tax home” is in mexico, as the violence may make it impossible for her to show that mexico is her main place of employment or regular place of abode, as required by the rules discussed above. 2. definition of “closer connection” assuming an individual can prove that she has a “tax home” in another country, she must also prove that she has a “closer connection” to such home.121 the regulations provide a list of factors to consider in determining whether an individual has a closer connection to a tax home in a foreign country.122 the list of factors include the individual’s “permanent home,”123 the location of the person’s family, banking activities, driver’s license, voting activity, and personal effects, among other criteria.124 it is clear that this list is subjective, yet it is less than clear whether danger in the person’s home country, or even the person’s intentions as to residency, may be considered. thus, the relevancy of the pre-1984 case law, discussed 116. id. 117. rev. rul. 99-7, 1999-1 c.b. 361. 118. reg. § 301.7701(b)-2(c)(1). 119. reg. § 301.7701(b)-2(c)(2). 120. isenbergh, u.s. taxation, supra note 56, at ¶ 6.19. 121. i.r.c. § 7701(b)(3)(b)(ii). 122. reg. § 301.7701(b)-2(d)(1). 123. reg. § 301.7701(b)-2(d)(1)(i). the concept of an individual’s “permanent home” may differ from her “tax home.” the regulations make clear that a “permanent home” must be a residence of some sort that is available to the individually continuously. reg. § 301.7701(b)-2(d)(2). 124. reg. § 301.7701(b)-2(d)(1)(i)–(x). 846 florida tax review [vol.12:10 above,125 is also in question. even if such case law, with its emphasis on intention, is relevant, this “closer connection” exception only applies if the individual in question is present in the united states for fewer than 183 days in the year in question.126 e. conclusion – residency under domestic law as can be seen from the analysis above, the determination of u.s. residency under the “substantial presence” test involves significant subjective analysis of various factors, despite a pretense of objectivity arising from the numerical requirements of the section.127 as noted, creating u.s. residency under the test, initially, is not subjective — the test is based on the number of days present in the united states during the current year and the two preceding calendar years.128 however, the large number of exceptions,129 and their nature, creates what is in effect, in many situations, a subjective analysis to determine whether a foreign person is a u.s. resident under this test. 1. summary of exceptions in summary, even if a foreign person is present the requisite number of days, the individual may be able to avoid u.s. residency in the ways described below.130 these various exceptions undermine the objectivity of the substantial presence test, and yet none of the exceptions seems to provide explicit relief for individuals who are in the united states merely to avoid dangers in their home country. the exceptions can be categorized based on whether they require 183 days or fewer of presence in the united states in the year in question and are summarized below. a. more than 183 days if an individual is actually present in the united states for more than 183 days131 in the year in question, the only way to avoid a u.s. residency determination under the substantial presence test is to fall under one of the following exceptions: 125. see supra part ii.b.3. 126. i.r.c. § 7701(b)(3)(b)(i). 127. i.r.c. § 7701(b)(3)(a). 128. id. 129. i.r.c. §§ 7701(b)(3)(b), (5), (7). 130. id. 131. i.r.c. § 7701(b)(3)(a)(ii). 2012] one danger for another 847 i. commuter – days spent commuting from mexico or canada to a job in the united states do not count;132 ii. transit – a day spent in the united states in transit between two foreign locations does not count;133 iii. foreign vessel – days spent in the united states as a member of a crew of a foreign vessel do not count;134 iv. government – days spent in the united states as a foreign government official do not count;135 v. student – in certain limited circumstances, days spent in the united states under a student visa do not count;136 vi. teacher – likewise, in limited circumstances, days spent in the united states as a teacher or trainee do not count;137 vii. professional athlete – days spent as a professional athlete participating in a charity event in the united states do not count;138 and viii. medical condition – days spent in the united states due to a medical condition that prevents the individual from leaving the united states do not count.139 b. less than 183 days if the individual is in the united states less than 183 days (once the above-mentioned exceptions are taken into account),140 then the individual can also avoid u.s. residency under the “closer connection” test described above.141 under this exception, the individual must effectively have business interests (or at least a regular place of abode) outside the united states, and must prove a closer connection to this particular place, under a subjective analysis.142 132. i.r.c. § 7701(b)(7)(b). 133. i.r.c. § 7701(b)(7)(c). 134. i.r.c. § 7701(b)(7)(d). 135. i.r.c. § 7701(b)(5)(b). 136. i.r.c. § 7701(b)(5)(d). 137. i.r.c. § 7701(b)(5)(c). 138. i.r.c. § 7701(b)(5)(a)(iv). 139. i.r.c. § 7701(b)(3)(d)(ii). 140. see i.r.c. § 7701(b)(3)(b)(i). the closer connection exception only applies if an individual is “present” in the united states fewer than 183 days during the current year. by using the term “present,” presumably all the exceptions to days of presence (as well as the exempt individual rules) apply in determining whether an individual is present in the united states for fewer than 183 days in the current year in question. 141. supra part i.d. 142. reg. § 301.7701(b)-2(d)(1). 848 florida tax review [vol.12:10 2. is danger at home relevant? what is not clear under this test is whether the authorities or courts may consider the situation in the individual’s home country when determining whether an individual satisfies the substantial presence test and hence is a u.s. tax resident. under the authorities from the period prior to 1984, it was clear that courts did consider dangers at home in making the u.s. tax residency determination.143 however, under the mechanical test described above and its very specific statutory exceptions,144 it appears that the authorities may not consider dangers in the person’s home country in the analysis of whether an individual is an “exempt individual,” or whether certain days of presence do not count for purposes of the test. as to the “closer connection” exception, it is also not clear whether danger at home may be considered. it could be possible to satisfy the “closer connection” exception in the context of an individual who is in the united states merely to avoid danger at home, but the person would have to show a “tax home” (i.e., a place of business activity, or regular abode), in a foreign country, and also the person would have to show a “closer connection” to such home. however, in such a situation, danger at home may work against the foreign person, in that a dangerous situation in the home country may make it difficult for the person to prove that she has a “closer connection” to such country.145 also, as noted, this exception is only available to the person if she is “present” in the united states for fewer than 183 days in the year in question.146 3. conclusion – individual fleeing danger accordingly, with respect to a foreign national in the united states merely to avoid dangers in her home country (such as the mexican national described in the introduction), it is clear that the only likely exception that 143. nubar, 13 t.c. 566 (1948), rev’d, 185 f.2d 584 (4th cir. 1950). 144. the only exception that may apply is the “medical condition” exception, but this would be unlikely — essentially, the individual would have to argue that she was in the united states to prevent a medical condition from arising (due to violence) should she return home. 145. the dangers at home may make it difficult to show that such place is the location of her “cultural and social” activities if the situation there is so difficult as to make such activities nearly impossible. however, the analysis could cut the other way — but clearly danger at home is not explicitly a factor in making the closer connection determination. 146. i.r.c. § 7701(b)(3)(b)(i). 2012] one danger for another 849 would apply here is the “closer connection” exception.147 the problems with this exception are two-fold: first, an individual must be “present” in the united states for fewer than 183 days during the year in question for the exception to apply.148 the second major issue is its subjectivity — unlike many of the other exceptions, there are no objective definitions of “tax home”149 or “closer connection” upon which such a person may rely.150 accordingly, an individual who is in the united states merely to avoid dangers at home may not be able to obtain much comfort151 that she can avoid u.s. tax residency under the substantial presence test. in particular, it should be noted that the taxpayers in nubar and constantinescu, in which the fact patterns are similar to the mexican national mentioned in the introduction to this paper, would be considered to be u.s. residents under the substantial presence test had such test been in force during the world war ii years. both taxpayers were present for much longer than 183 days in the united states, and hence could not utilize the closer connection exception. likewise, none of the other exceptions seems to apply to their cases. hence, the substantial presence test would change the tax court result in each of those cases (in nubar’s case, the court of appeals found him to be a u.s. tax resident even under the old standard). iii. u.s. tax residency under u.s. tax treaties if an individual is deemed to be a u.s. tax resident under the internal revenue code, the analysis does not necessarily end at this point.152 if the individual is entitled to the benefits of a tax treaty between her home country and the united states, then the person may be able to avoid u.s. tax residency status.153 147. as noted, the other exceptions (for days of presence and for exempt individuals) do not seem to apply to an individual in the united states merely to avoid danger at home. see i.r.c. §§ 7701(b)(5), (7). 148. i.r.c. § 7701(b)(3)(b)(i). 149. see supra note 112–17 and accompanying text. 150. see reg. § 301.7701(b)-2(d)(1) for the list of subjective factors to be considered in making the closer connection determination. 151. advance comfort is probably impossible to obtain, as it is the policy of the irs to not provide an advance ruling on whether an individual is or is not a u.s. resident (and in any event, given the time constraints, such a ruling would not be possible in time to be useful). see rev. proc. 2012-7, 2012-1 i.r.b. 232, § 3.01(6). 152. see i.r.c. §§ 894(a), 7852(d). 153. id. see also supra text accompanying note 20. in addition, the legislative history to the 1984 act made it clear that the “substantial presence” test was not intended to override u.s. tax treaty determination of residency. see h.r. rep. no. 98-861, supra note 76, at 182. 850 florida tax review [vol.12:10 the united states has entered into a number of income tax treaties with foreign countries,154 the terms of which vary from treaty to treaty.155 however, certain terms and provisions are fairly consistent across treaties, as reflected in the u.s. treasury department’s u.s. model income tax convention of 2006,156 which itself is based heavily on the model tax convention developed by the organization for economic cooperation and development (oecd).157 for purposes of the remainder of the paper, the u.s. tax treaty with mexico will be analyzed, given that the issue identified (i.e., accidentally triggering u.s. tax residency due to being present in the united states to avoid dangers in another country) is likely most applicable to citizens of mexico.158 a. the u.s.-mexico tax treaty in general the current u.s.-mexico tax treaty was signed in 1992,159 and follows (in broad form) the u.s. model tax treaty and the oecd model convention.160 under the treaty, the two “contracting states” (i.e., the united states and mexico) agree to alter their domestic tax laws as such laws are applied to residents of the other contracting state;161 in effect, the provisions of the treaty override the then-existing relevant domestic law on the topic.162 accordingly, the provisions of the u.s.-mexico treaty have the potential to override a determination of u.s. tax residency under the substantial presence test, which is a u.s. domestic law provision.163 b. residency under the treaty 1. the test for residency the definition of residency under the u.s.-mexico treaty looks first to the domestic law of each contracting state to determine an individual’s 154. the irs website contains a list of u.s. tax treaties, which can be found online at: http://www.irs.gov/businesses/international/article/0,,id=96739,00.html. 155. richard e. andersen, analysis of united states income tax treaties, ¶ 1.02[2] (2012) [hereinafter andersen tax treaties]. 156. id. at ¶ 1.02[4]. 157. id. at ¶ 1.02[2]. 158. see supra note 8–9 and accompanying text. 159. see u.s.-mexico treaty, supra note 38, preamble. 160. for example, many of the basic provisions of the mexico treaty, such as art. 4 (residency) are virtually identical to the provisions of the 2006 u.s. model treaty and the oecd model tax convention. 161. see u.s.-mexico treaty, supra note 38, art. 1. 162. see i.r.c. § 894(a). 163. id. see also reg. § 301.7701(b)-7. 2012] one danger for another 851 residency.164 thus, utilizing standard rules of treaty interpretation, the rules of the internal revenue code (described in part i above) will be applied to determine whether an individual is a u.s. resident. likewise, mexican tax law will be used to determine if an individual is a resident of mexico. thus, due to this reliance on domestic law in the first instance to determine residency, there will be situations (perhaps often) where an individual is determined to be a resident of both the united states and mexico. the treaty anticipates this potential result, and provides for a series of “tie-breakers” to determine the residency, for purposes of the treaty, of a particular individual.165 the tie-breakers are to be applied in the order they appear; once a tie-breaker is satisfied, the analysis is stopped, and the residency of the individual is determined under that particular rule.166 it should be emphasized that the tie-breaker rules are applicable only for determining residency for purposes of applying the particular income tax treaty in question.167 for years, there was some question as to the exact u.s. tax treatment of an individual who is a u.s. resident under u.s. domestic law but is considered to be a resident of a foreign country under the applicable tax treaty.168 possible interpretations included treating the individual as a nonresident for all u.s. tax purposes, or instead treating the person as a u.s. resident for most tax purposes, but allowing treaty benefits for specified types of income (such as dividends) called for by the treaty.169 this uncertainty was ultimately resolved by treasury regulations. under these regulations, for all other u.s. tax purposes, an individual’s residency is still determined under non-treaty u.s. rules (as discussed above).170 however, the irs has determined that a person, who is a u.s. resident under u.s. domestic law, but a non-resident under a treaty, will be treated as a non-resident for purposes of determining her u.s. income tax liability only.171 for other purposes (such as determining whether a corporation is “controlled” by u.s. shareholders172), the individual is still treated as a u.s. person.173 thus the person is basically a “half-resident” — 164. see u.s.-mexico treaty, supra note 38, art. 4(1). 165. see u.s.-mexico treaty, supra note 38, art. 4(2). 166. id. 167. u.s.-mexico treaty, supra note 38, art. 4(1), makes it clear that article 4 determines residency only “for purposes of this convention.” 168. isenbergh, u.s. taxation, supra note 56, at ¶ 102.10.1 169. id. 170. id. at ¶ 102.10.2. such other purposes include determination of whether a foreign corporation is a controlled foreign corporation under section 957. see reg. § 301.7701(b)-7(a)(3). 171. reg. § 301.7701(b)-7. 172. see i.r.c. § 957. 173. one prominent commentator has called these individuals “half resident aliens” because they are treated as u.s. residents for certain purposes, but as foreign 852 florida tax review [vol.12:10 she is treated as a nonresident for determining her tax liability (and thus she is not subject to worldwide u.s. taxation), but for other u.s. purposes (particularly information reporting), she continues to be treated as a u.s. resident.174 this is an odd combination, and though it provides relief from worldwide u.s. taxation, it still requires the person to report substantial information to the u.s. government.175 lastly, before turning to the tie-breaker rules in detail, it should be noted that u.s. courts, as reflected in the tax court’s decision in podd v. commissioner,176 require proof that the individual in question is indeed a resident under the tax laws of the foreign country. without such proof (the burden of which falls on the taxpayer), the courts will generally not consider the applicability of the treaty tie-breakers in determining residency.177 in the case of mexico, an individual will generally be considered to be a resident of mexico for tax purposes if she has established an “abode” in mexico.178 if the individual has an abode in more than one country (including mexico), then the mexican authorities will generally use the “center of vital interests” criteria (described immediately below) to determine the individual’s residency.179 given the subjective nature of this test, there is a substantial risk that an individual with connections to both the united states and mexico will be considered a resident of both countries prior to application of the treaty “tie-breakers” described below. 2. first tie-breaker – “center of vital interests” assuming an individual is a resident of both the united states and mexico under the domestic laws of the respective countries, then the “tiebreaker” provisions of the treaty will become applicable. residents for determination of u.s. tax liability. isenbergh, u.s. taxation, supra note 56, at ¶ 102.10. one interesting question that arises is whether these “half resident aliens” are eligible shareholders in an s corporation, which can only have domestic shareholders. id. at ¶ 102.11 174. isenbergh, u.s. taxation, supra note 56, at ¶ 102.10.2. 175. see, e.g., i.r.c. § 6038 (requiring u.s. shareholders to report information regarding foreign corporations in which they own at least a 10% interest). 176. 76 t.c. memo. (cch) 906, 908 (1998). 177. id. 178. nicasio del castillo, manuel f. solano, & terri l. grosselin, “business operations in mexico,” 972-4th tax mgmt. (bna) foreign income, at vii.b (2011). 179. id. 2012] one danger for another 853 a. “permanent home” the treaty’s first tie-breaker looks to the country in which the individual has a “permanent home.”180 thus, under the ordering rules contained in this residency section, if the individual has only one permanent home, then the country where such permanent home is located will be the person’s country of residence for purposes of the u.s.-mexico treaty. there is little guidance under the treaty as to what constitutes a “permanent home.” the technical explanation to the u.s.-mexico treaty is silent on this topic, and makes reference to the model treaty put forth by the oecd.181 the commentary to the oecd model treaty includes language similar to the definition of “permanent home” contained in the u.s. tax regulations.182 under that definition, a permanent home is one that is continuously available to the person; it does not matter whether such home is owned or rented, or whether it is a house or apartment.183 this guidance is vague, and in the context of a mexican citizen with connections to both countries (i.e., a home in mexico, but family and available space to stay in the united states), it is possible that the person will be considered to have a permanent home in both countries. accordingly, this first tie-breaker may not settle residency, and the next tie-breaker must be considered. b. “center of vital interests” if the person has a permanent home available to her in both mexico and the united states, then the treaty will grant residency to the country where her “personal and economic relations” are closer. the treaty, parenthetically, calls this the “center of vital interests” test.184 according to the oecd commentary and other relevant authority, the center of vital interests test requires a weighing of various factors to determine where such center lies for the particular individual.185 factors to be considered include location of family and other social interests; location 180. see u.s.-mexico treaty, supra note 38, art. 4(2)(a). 181. treasury department technical explanation of the convention and protocol between the government of the united states of america and the government of the united mexican states for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, art. 4. 182. oecd: technical explanation (2005 income tax treaty), art. 4 [hereinafter oecd: technical explanation]. 183. reg. § 301.7701(b)-2(d)(2). 184. see u.s.-mexico treaty, supra note 38, art. 4(2)(a). 185. oecd: technical explanation, supra note 182. 854 florida tax review [vol.12:10 of business activities; location of cultural activities; and place of administration of property.186 one prominent commentator has asserted that applicability of the center of vital interests test should consider u.s. law as it existed prior to introduction of the substantial presence test in 1984. if this is indeed the case, then perhaps the authorities can consider the situation in the person’s home country when making the determination of the location of “center of vital interests.”187 authorities would also be able to consider the person’s intentions regarding residency, as well as many other relevant factors. however, there is very little actual direct authority regarding how the irs or u.s. courts would apply this test.188 the only relevant case decided by a u.s. court appears to be a tax court memorandum decision from 1998.189 in that case, the tax court held that there was “doubt” as to the taxpayer’s center of vital interests, and hence did not draw a conclusion as to the location of such interests; instead, it moved on to the second tie-breaker (habitual abode) described below.190 it can be seen from this test (and the tax court’s conclusion) that it is easy for an individual to have either no “center of vital interest” or for the question to be unclear.191 in such a case, the person would be required to move on to the next tie-breaker. 3. second tie-breaker – “habitual abode” this tie-breaker looks to the location of the person’s “habitual abode.”192 this term must mean something different than “permanent home,” given that this term is also used in article 4 of the u.s.-mexico treaty, though the exact meaning of habitual abode is unclear. in the one relevant case, the tax court determined that habitual abode effectively means the country in which the individual stays most frequently during the year in question.193 in making this determination, the court counted the number of days the individual was present in each country, 186. id. 187. isenbergh, u.s. taxation, supra note 56, at ¶ 102.8.2. 188. andersen, tax treaties, supra note 155, at ¶ 2.01[4][b][i] (commenting that the term “center of vital interests” is not a well-developed concept under u.s. law). 189. podd, 76 t.c. memo. (cch) 906 (1998). 190. id. at 910. 191. other countries have grappled with this language with some success. see, e.g., wolf. v. the queen, 2000 canlii 178 (can. tax ct.) (a canadian court determined an individual to have his “center of vital interests” in the united states due to his lack of intention to remain in canada). 192. see u.s.-mexico treaty, supra note 38, art. 4(2)(b). 193. podd, t. c. memo. (cch) 906 at 910. 2012] one danger for another 855 even if the individual did not stay at a “permanent home” in such country.194 in the case, the court found that the individual spent more days in the united states than in canada during the year in question, and hence was a u.s. resident for that particular year.195 it is questionable whether this is the right way to look at the “habitual abode” test. the treaty clearly contemplates a situation where a person has a “habitual abode” in both countries (otherwise, there is no reason to provide for a third tie-breaker). however, under the court’s interpretation, a person could only have a habitual abode in two countries in a situation where there was an exact tie in number of days spent in each country. 4. third tie-breaker – national status if the individual has a habitual abode in both countries, or does not have a habitual abode in either country, then the person’s residency is determined by reference to her nationality.196 5. fourth tie-breaker – competent authority if national status does not break the tie (either because the individual is a citizen of both countries, or a citizen of neither), then the competent authorities of the united states and mexico must decide the individual’s residency under the mutual agreement provisions of the u.s.-mexico treaty.197 c. analysis – u.s. residency under the treaty based on the podd case, if an individual has a permanent home in both countries and her center of vital interests cannot be determined, residency may effectively come down to the country in which she spends more days during the year in question.198 it is not clear that this is the real intended meaning of the treaty tie-breakers, but this case appears to be the only valid interpretation of a “close call” situation where permanent home and center of vital interests are too close to determine. 194. id. 195. id. 196. see u.s.-mexico treaty, supra note 38, art. 4(2)(c). 197. u.s.-mexico treaty, supra note 38, art. 4(2)(d). in the situation being considered (that of a mexican citizen in the united states merely to avoid violence in mexico), this particular mechanism would not be invoked, as the individual’s residency would be settled by the third tie-breaker (nationality). 198. podd, t.c. memo. (cch) 906 at 910. 856 florida tax review [vol.12:10 it is evidently an open question as to whether a court similar to podd may consider the violence in the individual’s home country in making the residency determination. as noted above, the substantial presence test does not seem to permit consideration of the dangers in the individual’s home country.199 likewise, it is not completely clear whether the series of tests under the treaty may permit consideration of violence at home, either. however, it should be noted that one prominent commentator believes that the authorities may consider the intentions of the individual (which obviously may be impacted by the situation in the individual’s home country, as in nubar),200 using the pre-1984 caselaw, in making the “center of vital interests” determination.201 accordingly, there may be situations where a mexican national can show that her “center of vital interests” is indeed in mexico and hence avoid u.s. worldwide taxation on her income, utilizing the u.s.-mexico treaty. however, even in this situation, the individual will face significant u.s. tax reporting obligations.202 even though situations can be envisioned where the individual will prevail under the “center of vital interests” test, it is clear that the analysis is very subjective and cannot give much comfort to a mexican citizen facing this situation. accordingly, legislative or regulatory change should be considered. some suggested changes are now offered in the following section. iv. proposals for change as can be seen from the analysis above, the determination of u.s. residency is very subjective under either the substantial presence test203 or the u.s.-mexico treaty.204 under the substantial presence test, presence of 183 days or more in the current year will almost ensure u.s. residency, unless an individual is “exempt,” or certain of the days of residency are excepted.205 under the u.s.-mexico treaty, an individual who is otherwise present more than 183 days can avoid u.s. residency (at least for purposes of the person’s u.s. tax liability) under one of the “tie-breakers” described above.206 however, these mechanisms are also subjective. 199. supra part ii.e.2. 200. nubar, 13 t.c. 566 (1949), rev’d, 185 f.2d 584 (4th cir. 1950). 201. isenbergh, u.s. taxation, supra note 56, at ¶ 6.6. 202. reg. § 301.7701(b)-7. 203. supra part ii. 204. supra part iii. 205. i.r.c. § 7701(b)(3). 206. u.s.-mexico treaty, supra note 38, art. 4(2). 2012] one danger for another 857 accordingly, mexican citizens who are not u.s. citizens and do not hold “green cards”207 are left with significant uncertainty in determining their u.s. tax status, if they are indeed present in the united states for periods during a particular calendar year. this is particularly the case for mexican nationals who are in the united states only to avoid violence at home — it is obviously difficult for such individuals to return to mexico (where they face potential harm), and it can also be difficult (and uncertain) for such individuals to avoid u.s. residency treatment because of their prolonged presence in the united states. the following sections will first describe some rationales for changing the current approach in determining u.s. residency (at the very least, for mexican nationals), and then will move on to summarize and then discuss in detail various proposals for change. a. rationales for change as noted, the substantial presence test was originally added to the code in 1984 in order to bring objectivity to the analysis of whether a foreign national is a u.s. tax resident.208 however, with its myriad of exceptions,209 the test no longer fulfills this hope. this is particularly the case given the complexity added to the analysis by application of a u.s. tax treaty, and the potential for an individual to be a “half resident” for u.s. tax purposes.210 objectivity has failed, and the attempt at objectivity reflected in the substantial presence test also has the potential impact of creating inequitable situations, such as the one under consideration here. application of an objective test can create inequity when it is not clear whether the irs and the courts are permitted to consider extenuating circumstances (other than those provided by the statute) in determining the u.s. tax residency of a foreign national.211 this inequity is particularly sharp in the case of mexican nationals who are present in the united states only because of increased violence in mexico, when such violence is, in large part, caused by drug cartels whose primary customers may reside in the united states.212 the u.s. government, under president obama, has gone some distance in acknowledging u.s. 207. as noted, such individuals are automatically u.s. residents for tax purposes. i.r.c. § 7701(b)(1)(a)(i). 208. supra part ii.b.4. 209. i.r.c. §§ 7701(b)(5), (7). 210. reg. § 301.7701(b)-7. 211. supra parts i & ii. 212. aimee rawlins, mexico’s drug war, council on foreign relations (december 13, 2011), http://www.cfr.org/mexico/mexicos-drug-war/p13689. 858 florida tax review [vol.12:10 contributions to the problem of violence in mexico.213 this acknowledgement should lead u.s. tax officials and rulemakers to the conclusion that some change needs to be made to the substantial presence test to relieve mexican nationals of the risk of inadvertently creating u.s. tax residency while in the united states due to violence in mexico. this inequity is further illuminated when one looks to the purpose of treating individuals who are present in the united states as u.s. tax residents. the primary justification for treating such persons as u.s. residents is that they benefit from the laws of the united states while in the country.214 for individuals who are present in the united states to avoid violence at home, one can argue that such individuals are indeed enjoying the benefits of protection of u.s. law. however, such arguments are significantly weakened when one considers the situation of mexican nationals who are present in the united states only to avoid drug-related violence in mexico, given the acknowledged contributions of u.s. policy to the violence in mexico.215 additionally, there is some rationale for treating mexican nationals differently than nationals of other countries, due to the physical proximity of mexico to the united states, the membership of mexico in the north american free trade agreement (“nafta”),216 and the close economic ties between the united states and mexico.217 mexico may also come in for special treatment given the history between the two nations.218 accordingly, there is some rationale for abandoning the attempt at objectivity in determining u.s. tax residency, particularly when objectivity can lead to inequity, as in the case of mexican nationals in the united states merely to avoid violence at home. thus, consideration should be given to abandoning objectivity, at least with respect to mexican nationals. various proposals to accomplish this goal are summarized immediately below and then described in the following sections. 213. partnership, and its obstacles, economist, sept. 3, 2011, at 35 [hereinafter economist]. 214. see, e.g., nubar, 13 t.c. at 586. 215. economist, supra note 213. 216. north american free trade agreement, u.s.-can.-mex., dec. 17, 1992, 32 i.l.m. 289 (1993). 217. see villareal, u.s. -mexico relations, supra note 11. 218. treaty of peace, friendship, limits and settlement between the united states of america and the mexican republic, u.s.-mex., (feb. 2, 1848), 9 stat. 922 (ending the mexican-american war and requiring a substantial concession of territory to the united states by the republic of mexico). 2012] one danger for another 859 b. overview of proposals thus, some proposals to change the u.s. residency determination rules, at least with respect to mexican citizens, should be considered. the remainder of this paper will analyze proposals to change the residency determination rules in order to mitigate their impact on mexican nationals fleeing violence at home. these proposals call for specific statutory changes. it is certainly possible that the irs, using its “prosecutorial discretion,”219 could provide relief to mexican nationals who are in the united states merely due to violence at home. however, in order to provide greater certainty in this area, statutory change should be considered. as described in detail below, statutory change could be implemented by changing the substantial presence test to provide an exception for individuals fleeing danger. conversely, the test could be modified to provide a “facts and circumstances” exception, to explicitly allow the irs and the courts to consider an individual’s circumstances, as was the case prior to 1984, in determining residency. a different change would be to repeal the substantial presence test, either entirely, or just with respect to nationals of mexico (and perhaps also canada, given its proximity to the united states). lastly, the united states could consider a joint tax ruling approach, under which the tax authorities of the united states and mexico, upon application of a taxpayer, jointly determine the residency of the individual, which would then be binding for both u.s. and mexican tax purposes. the ruling could be binding for a number of years, so long as the underlying factual situation did not change. each of these proposals is now discussed in turn in the following sections. c. substantial presence exception for those fleeing danger one proposal would be to provide another exception to the substantial presence test for individuals who are fleeing danger in their home countries. as described above, the substantial presence test already includes numerous exceptions, such as those for commuters from mexico and canada, and also teachers and students (among others).220 this proposal would be to add another category of exception. the exception could be legislatively added to section 7701(b) as either an exception for individuals 219. see, e.g., notice 2012-12, 2012-6 i.r.b. 365 (human trafficking restitution payments do not constitute gross income for income tax purposes, without citation to any direct legislative or regulatory authority). 220. i.r.c. §§ 7701(b)(5), (7). 860 florida tax review [vol.12:10 (an expansion of the “exempt individual” definition), or the exception could be added as an expansion of the exceptions to the definition of “presence” in the united states. 1. exempt individual – refugee from violence? currently, section 7701(b)(5) exempts certain individuals from u.s. residency determination under the substantial presence test.221 this category of individuals could be expanded to include individuals from any country who were present in the united states, temporarily, only because of violence in their home countries. obvious interpretive issues arise in determining whether a particular foreign individual is present in the united states merely to avoid violence in his or her home country. one approach would be for the irs to develop a list of countries, similar to the list described below in the context of section 911(d)(4), as noted below. 2. exception from days of “presence” a different, and perhaps better, approach could be to provide an exception to the definition of “presence” for any days spent in the united states by a foreign national while she was reasonably in fear of danger in her home country. this exception could be based on the waiver contained in section 911(d)(4). section 911 is applicable to u.s. citizens and residents who earn income outside the united states. section 911 excludes certain foreign earned income from u.s. taxation, but only if the individual in question can show that he or she was resident in a foreign country during the year in question.222 however, the statute provides an exception to this residency requirement in situations where the individual in question is forced to leave a foreign country due to war or civil unrest.223 the irs provides a list of such countries periodically.224 the proposed rule could provide an exception, for purpose of the substantial presence test, for days of presence in the united states if the individual in question were present in the united states solely because she was unable to return to one of the countries on the section 911(d)(4) list due to war or civil unrest in such country. the problem with this approach is that 221. as described in part ii, these individuals include foreign governmentrelated individuals, teachers, trainees, students, and certain professional athletes. see i.r.c. § 7701(b)(5). 222. i.r.c. § 911(d)(1). 223. i.r.c. § 911(d)(4). 224. see, e.g., rev. proc. 2012-21, 2012-11 i.r.b 484. 2012] one danger for another 861 the number of countries on this list is very small, and it does not currently include mexico.225 it is not clear why there are not more countries on this list; it may be that it is not politically possible for this list to cover a larger number of countries, particularly countries such as mexico, which have close relations with the united states.226 accordingly, an exception to the substantial presence test for either individuals fleeing danger, or for days spent in the united states fleeing danger, may be administratively and politically unworkable. hence, other possible solutions should be considered. 3. a “facts and circumstances” exception another approach would be for congress to amend section 7701(b)(3) to explicitly allow the irs and courts to consider the facts and circumstances, including the security situation in the person’s home country, in determining whether a person meets the substantial presence test. in this way, the substantial presence test could become merely a presumption of u.s. residency, which could be rebutted by the individual in question through a showing of equity or other factors. this would effectively return the determination of u.s. residency to its former form, but would retain the certainty contained in the “green card” test. another way to effectively achieve a “facts and circumstances” analysis for all foreign nationals would be to repeal the 183 day requirement contained in the “closer connection” exception.227 the “closer connection” exception, which does take into account, to some degree, an individual’s intentions and the situation in the country of the “tax home” of the individual, would then be available to all foreign nationals no matter how many days actually present in the united states, thus expanding availability of this exception. d. repeal the substantial presence test other options could involve either a complete or partial repeal of the substantial presence test. complete repeal would be removal of section 7701(b)(3), while partial repeal could include the exclusion of mexican citizens (or citizens of certain other countries) from the list of individuals 225. id. the current list includes just four countries: egypt, libya, syria, and yemen. 226. there may be reluctance to add mexico to such a list given its cooperation in the “drug war” and the u.s. state department’s evaluation of all countries on their efforts in combating illegal drugs. see united states department of state, international narcotics control strategy report (march 1, 2010), http://www.state.gov/documents/organization/137411.pdf. 227. i.r.c. § 7701(b)(3)(b)(i). 862 florida tax review [vol.12:10 who are subject to the substantial presence test. this latter change could be made by adding mexican citizens and nationals to the list of “exempt individuals” contained in section 7701(b)(5). 1. repeal of substantial presence test one solution to the problem is to repeal the substantial presence test as it currently stands. in this case, both u.s. citizens and “green card” holders would continue to be considered u.s. residents subject to worldwide taxation.228 however, all other individuals would only be u.s. residents under the “facts and circumstances” analysis that most other countries utilize to determine residency, which was the test utilized in the united states prior to 1984.229 one possible objection to this approach is that it is less objective than the current substantial presence test. however, the current test is full of exceptions, some of them subjective,230 which undermine its objective nature. and, as applied to individuals such as those fleeing danger at home, it is too rigid. prior law (as exemplified in the world war ii cases)231 allowed for flexibility and equity in making the u.s. residency determination. repealing the substantial presence test would again introduce such equitable considerations into the analysis. repeal could be done in such a way as to indicate that the current exceptions (such as for students and teachers, as well as the “closer connection” exception, for example) should still be considered by the irs and the courts when determining residency, even though such exceptions would no longer be contained in statutory law.232 further, if desired, repeal could be accompanied by a rule that presumes a foreign person to be a u.s. resident if the person is present in the united states for more than 183 days in the year in question.233 it should be noted that retaining these concepts (perhaps in regulations) makes repeal of the substantial presence test very 228. i.r.c. § 7701(b)(1)(a). 229. isenbergh, u.s. taxation, supra note 56, at ¶ 6.4. 230. see, e.g., i.r.c. § 7701(b)(3)(b), the “closer connection” exception, which as noted above, is quite subjective. see supra part ii.d. 231. see, e.g., nubar, 13 t.c. 506 (1949), rev’d, 185 f.2d 584 (4th cir 1950). 232. these current exceptions could be encapsulated in regulations supporting the new “facts and circumstances” analysis. 233. some foreign countries view 183 days as setting a standard for residency. see hugh j. ault & brian j. arnold, comparative income taxation: a structural analysis 431–34 (3d ed. 2010) [hereinafter ault & arnold, comparative income taxation]. 2012] one danger for another 863 similar to the suggestion above to introduce a “facts and circumstances” exception to the current substantial presence test.234 2. repeal for nationals of mexico a different approach would be to repeal the substantial presence test for nationals of mexico, and perhaps the other contiguous country, canada, as well. this could be accomplished by excluding mexican citizens from the test by adding them to the list of exempt individuals in section 7701(b)(5). under such an approach, mexican citizens would become u.s. tax residents only by obtaining lawful permanent residence (or by becoming u.s. citizens). otherwise, they would remain residents of mexico, and would not become u.s. tax residents, no matter how often they were present in the united states.235 the rationale for such an approach would be to further objectivity,236 provide fairness in the case of mexican nationals, reflect the free-trade concepts of nafta, and further promote cross-border trade. there would likely be objections to the special treatment granted to mexican nationals (from nationals of other nations) under such an approach. e. the nafta taxpayer another reform proposal would be to take a holistic approach to the taxation of the citizens of the three countries that signed the north american free trade agreement (nafta), which include the united states, mexico, and canada.237 in the spirit of nafta, the authorities could take two possible approaches. one would be to develop a joint ruling process whereby the tax authorities of the member countries determine an individual’s tax residency in a joint ruling, similar conceptually to an advanced pricing agreement (“apa”)238 now available in the transfer pricing area. another — more radical — approach is to move towards an apportionment tax regime for the income earned by individuals within nafta that has a significant cross-border element. each is now discussed in some detail. 234. supra part iv.c.3. 235. this new exception would be contingent on such individuals retaining and certifying tax residency in their country of citizenship, in order to avoid situations where mexicans or canadians use this rule to avoid residency in both the united states and their home country. 236. under this approach, mexican nationals would only create u.s. tax residency by obtaining u.s. legal residence (or becoming u.s. citizens), thus tying tax residency to immigration status. hence the approach is more objective. 237. north american free trade agreement, supra note 216. 238. rev. proc. 2006-9, 2006-1 c.b. 278. 864 florida tax review [vol.12:10 1. joint tax rulings currently, in the transfer pricing context, u.s. taxpayers (typically corporations) can obtain an apa from the irs.239 such apas can also arise in a bilateral manner, where the u.s. “competent authority” agrees with the tax authority of the other relevant nation (which has a tax treaty with the united states) as to the allocation of profits arising from intercompany transactions between related parties in the two countries.240 apas are typically arrived at after much negotiation (and time) and provision of documents to the relevant tax authorities.241 the apa is typically then valid for a number of years, assuming that the underlying facts and assumptions do not change.242 a similar concept could be envisioned for the determination of tax residency for individuals with significant cross-border activities. a set of facts or assumptions could be provided, and the tax authorities, working jointly, could determine the residency of the individual. then, the country of residence would tax the entire income of the individual, and the other country would treat the individual as a nonresident, eligible for benefits under the tax treaty between the two nations. once residency is determined, it would remain for the term of the agreement, unless facts and assumptions change. this concept has the benefit of enhancing further joint workings between the u.s., mexican, and canadian tax authorities, which is has long been a goal of the u.s. tax authorities.243 it should also be noted that such a concept is essentially already contemplated as the final “tie-breaker” under the existing u.s.-mexico treaty, as discussed above.244 2. income apportionment it has often by noted by scholars that the current international tax system, under which the allocation of cross-border taxable income between nations is determined by residency, “arm’s length transfer pricing,” and 239. rev. proc. 2008-31, 2008-1 c.b. 1133. 240. see, e.g., u.s.-mexico treaty, supra note 38, art. 26. 241. david d. stewart, new director seeks to improve transfer pricing practice, 131 tax notes 1136, (jun. 13, 2011). 242. rev. proc. 2006-9, supra note 238, at § 4.07. 243. anne o’connell et al., gw conference highlights many hot international issues, 1405 tax notes (dec. 16, 1996) (reporting on a conference where the tax authorities of the united states, mexico, and canada stressed the importance of cooperation between their nations in tax enforcement). 244. u.s.-mexico treaty, supra note 38, art. 4(2)(d). 2012] one danger for another 865 allowance of foreign tax credits, is less than ideal.245 many commentators instead have argued that nations should apportion a cross-border taxpayer’s taxable income among nations based on some formula.246 many u.s. states already do this by apportioning an entity’s total taxable income to the state based on the relative percentage of the entity’s payroll, sales, and property located in such state (often referred to as “3 factor” apportionment).247 this approach could be extended to taxpayers with significant crossborder income attributable to the united states, mexico or canada (canada being included here due to its proximity to the united states and the significant amount of cross-border trade between the two nations). at a taxpayer’s election, taxpayers could elect to have their income apportioned between the two or three countries, based perhaps on the “3 factors” or other factors that states currently use to apportion income of corporations in the united states. evidently, no other foreign countries do this, not even within the european union, which still bases taxation on residence, notwithstanding the ability of people to move across national borders.248 further, this concept is typically applied, even at the u.s. state level, to corporations, rather than individuals.249 however, apportionment is an idea whose time may be coming, and perhaps within nafta, the united states and mexico could be on the vanguard of this movement. 3. conclusion – nafta consideration should be given, at the very least, to a joint ruling process, whereby taxpayers can obtain certainty from the tax authorities, for a number of years, as to which country will treat them as a resident for tax purposes. this joint ruling process will enhance cooperation among tax authorities and pave the way for increased cross-border commerce in the u.s.-mexico context. 245. see, e.g., rueven avi-yonah, kimberly clausing, & michael durst, allocating business profits for tax purposes: a proposal to adopt a formulary profit split, 9 fla. tax rev. 497 (2009). 246. see, e.g., susan c. morse, revisiting global formulary apportionment, 29 va. tax rev. 593 (2010). 247. see, e.g., california revenue and taxation code, § 25128(c). see generally hellerstein & hellerstein, state taxation, ¶ 8.14 (2011). 248. ault & arnold, comparative income taxation, supra note 233, at 431. 249. california revenue and taxation code, § 17014. 866 florida tax review [vol.12:10 v. conclusion citizens of mexico face substantial uncertainty when they are present in the united states merely to avoid increasing violence and danger in their home country. they run the risk of creating u.s. tax residency, and the accompanying u.s. taxation of worldwide income (plus various and onerous tax return filing requirements), unless they can fit under an exception to the “substantial presence” test or utilize the u.s.-mexico tax treaty to show that their true residency is in mexico.250 however, as demonstrated, it is unclear whether the situation in an individual’s home country can be taken into consideration when applying either the exceptions to the “substantial presence” test, or when applying the “tie-breaker” provisions of the u.s.-mexico treaty. this uncertainty, coupled with the general inability to obtain a tax ruling from u.s. tax authorities on this issue, creates problems for mexicans who are present in the united states merely to avoid violence at home. hence, congress should consider clarifications to the substantial presence test to allow the irs and the courts to consider dangers in a person’s home country when determining whether the person is a u.s. tax resident. this can be done through clarifications or further exceptions to the substantial presence test, or by repealing it altogether, and thus returning the analysis to the “facts and circumstances” test that was the law before 1984. the simplest, best approach would be to provide by statute that the tax authorities may consider other facts and circumstances when determining whether an individual has indeed satisfied the substantial presence test. conversely, if the authorities desire to go further, the irs and the mexican (and perhaps canadian) tax authorities could consider implementation of a joint ruling program, to allow individuals who often cross the u.s. border to have their tax residency determined by a joint ruling of the tax authorities, as described above. 250. even in this case, they will retain certain u.s. filing requirements, as they will be considered u.s. residents for u.s. tax purposes other than determination of their u.s. tax liability. see reg. § 301.7701(b)-7. i. introduction a. consequences of the u.s. residency determination 1. consequences of u.s. residency 2. consequences of u.s. nonresidency 3. the difference between residency and nonresidency b. u.s. residency under the internal revenue code 1. the current law definition 2. some historical background 3. the war cases 4. 1984 – the substantial presence test c. the substantial presence test in detail 1. the test a. meaning of “present” b. exception for certain days of presence c. exception for exempt individuals d. the “closer connection” exception 1. definition of “tax home” 2. definition of “closer connection” e. conclusion – residency under domestic law 1. summary of exceptions a. more than 183 days b. less than 183 days 2. is danger at home relevant? 3. conclusion – individual fleeing danger iii. u.s. tax residency under u.s. tax treaties a. the u.s.-mexico tax treaty in general b. residency under the treaty 1. the test for residency 2. first tie-breaker – “center of vital interests” a. “permanent home” b. “center of vital interests” 3. second tie-breaker – “habitual abode” 4. third tie-breaker – national status 5. fourth tie-breaker – competent authority c. analysis – u.s. residency under the treaty iv. proposals for change a. rationales for change b. overview of proposals c. substantial presence exception for those fleeing danger 1. exempt individual – refugee from violence? 2. exception from days of “presence” 3. a “facts and circumstances” exception d. repeal the substantial presence test 1. repeal of substantial presence test 2. repeal for nationals of mexico e. the nafta taxpayer 1. joint tax rulings 2. income apportionment 3. conclusion – nafta v. conclusion tcharity really does begin at home: florida tax review volume 10 2010 number 7 461 just enough: substantial performance, ministerial acts and the all events tests for income and expense accruals by glenn walberg i. introduction ............................................................................. 462 ii. constructive conditions and their satisfaction through substantial performance ................................... 464 a. constructive conditions to performance obligations ...... 465 b. the satisfaction of constructive conditions through substantial performance ................................................... 470 iii. the role for substantial performance in determining taxable income ........................................................................ 474 a. the all events anomaly for ministerial acts .................... 475 b. substantial performance as a justification for the ministerial acts anomaly .................................................. 483 c. the broader role for substantial performance in accrual methods of accounting ........................................ 492 iv. should the all events tests account for substantial performance ................................................................................... 499 v. conclusion ................................................................................. 503 462 florida tax review [vol. 10:7 just enough: substantial performance, ministerial acts, and the all events tests for income and expense accruals by glenn walberg* i. introduction the tax law sets unrealistic expectations for accruing many income and expense items arising out of bilateral contracts. under an accrual method, a taxpayer generally takes an income item into account when the taxpayer has a fixed right to receive it and takes an expense item into account when the taxpayer has a fixed liability to pay it.1 the tax law thus expects the taxpayer to determine when all events have occurred to make the right or liability unconditional.2 the taxpayer might find this determination easy if it were to exchange only one promise for one promise (e.g., seller only promises to perform services and buyer only promises to pay), use words establishing conditional relationships (e.g., the buyer promises to pay if and only if the seller performs the services), and experience nothing short of complete performance (e.g., the seller never provides nonconforming services). but the taxpayer probably doesn’t engage in those transactions very often. for most transactions, the taxpayer will find it difficult to determine whether all events have occurred to fix rights and liabilities from bilateral contracts. for example, consider a contract that contains a typical explicit requirement that a service provider submit an invoice to a client to receive payment for rendered services. once the services have been performed, the accrual method rules contemplate that the parties will determine whether the submission of the invoice represents an event that must occur to fix the service provider’s right to income and the client’s liability to pay under the contract. that determination might prove difficult because some authorities and guidance have disregarded requirements to submit documentation3 ∗ assistant professor of accounting and business law, university of north carolina wilmington. 1. see reg. § 1.446-1(c)(1)(ii)(a) (as amended in 2006). 2. see id. 3. see, e.g., dally v. commissioner, 227 f.2d 724, 726 (9th cir. 1955) (“this mere mechanical act of making out the necessary voucher did not operate to postpone the accrual of the sum which had been earned.”) (citing commissioner v. dumari textile co., 142 f.2d 897, 899-900 (2d cir. 1944)); frank’s casing crew & rental tools, inc. v. commissioner, t.c. memo 1996-413, 72 t.c.m. (cch) 611, 612-13 (1996) (“petitioner must accrue income from the goods and services in the taxable year in which performance occurs, and it cannot wait until the year in which 2010] just enough: substantial performance, ministerial acts 463 whereas others have treated the satisfaction of such requirements as a prerequisite to any finding of fixed rights and liabilities.4 aside from raising questions about how to reconcile the authorities and guidance, the differences in treatment highlight a larger issue that tax accounting rules occasionally require, but do not always permit—accruals prior to the full performance of all promises contained in bilateral contracts. as a consequence, taxpayers need to consider whether the occurrence of substantial performance, rather than full performance, represents the last event that must occur to fix rights and liabilities for tax purposes. this article explores the role of substantial performance under the all events tests of sections 451 and 461 by placing particular emphasis on its application to ministerial acts. because these code sections focus on unconditional rights and liabilities, part ii starts with a discussion of conditions constructed by courts to preserve expectations and avoid forfeitures in accordance with promises contained in bilateral contracts. this discussion of contract law then describes why, in response to additional concerns about fairness, courts treat the substantial performance of certain promises as satisfying the conditions that the courts construct. the discussion illustrates how a party’s substantial performance, rather than full performance, can establish unconditional rights and obligations under a contract. it invoices its customer.”); rev. rul. 98-39, 1998-2 c.b. 198 (“y’s submission of a claim form and proofs of performance . . . is merely the mechanism by which y requests payment for advertising services already performed. thus, similar to dally and frank’s casing, y’s submission of the claim form and proofs of performance is a ministerial act, much like the submission of an invoice[, and] . . . not a condition precedent that is necessary to establish x’s liability for § 461 purposes.”). 4. see, e.g., united states v. general dynamics corp., 481 u.s. 239, 244 (1987) (“[the taxpayer was] liable to pay for covered medical services only if properly documented claims forms were filed . . . . such filing is not a mere technicality. it is crucial to the establishment of liability on the part of the taxpayer.”); challenge publ’ns, inc. v. commissioner, 845 f.2d 1541, 1544 (9th cir. 1988) (“it seems plain that under the agreement, challenge was under no obligation to reimburse pdc without these evidences of unsold copies. therefore, it cannot be said its liability to pdc was fixed, absolute, and unconditional at the time of shipment, but only at the time of the returned documents.”); tech. adv. mem. 9416-004 (dec. 23, 1993) (“thus, the contract term is controlling in determining what events fix the dealer’s right to income and taxpayer’s obligation to reimburse for advertising expenses. the contract . . . provides that a dealer association will be reimbursed if its expenditures are properly substantiated and it fulfills certain other requirements. since this requirement appears to delineate the performance required by the contract, it is no less an element of performance than any other requirement . . . . the parties determined the provisions of the contract and there is no indication that the parties did not intend for all terms and conditions to be met.”). 464 florida tax review [vol. 10:7 the remainder of the article discusses substantial performance in the context of the tax law. part iii considers how substantial performance, as developed under contract law, might and should impact income and expense accruals under the all events tests. this consideration begins by examining a poorly-explained anomaly under the all events tests that disregards unfulfilled requirements to perform ministerial acts in determining when to accrue income and expense items. that part then explains that the all events tests could better justify such accruals, despite the unfulfilled requirements, by treating a party’s substantial performance under the contract as being sufficient to fix certain rights and liabilities. finally, that part of the article suggests that the all events tests cannot confine considerations of substantial performance to ministerial acts. accordingly, that part argues that a party’s substantial performance—rather than full performance—of primary contractual obligations would similarly require accruals for those obligations. finally, part iv describes the desirability of taking substantial performance into account in applying the all events tests, despite the difficulty of the resulting analyses, to the extent such applications also reflect any constructive conditions to the parties’ contractual obligations. ii. constructive conditions and their satisfaction through substantial performance although parties exchange promises as their requisite consideration in forming a bilateral contract,5 the valid formation of the contract does not assure that the parties will or must perform as promised. instead, conditions can affect a party’s obligation to perform. a condition precedent makes the maturity of a performance obligation depend on the occurrence of an event, which is not guaranteed to occur.6 in other words, a promisor might lack an obligation to do x as promised unless and until the condition of y occurs. prior to the occurrence of y, the unexcused condition precedent would foreclose both a definite obligation to perform x as promised7 and any allegation of breach attributable to the promisor’s nonperformance.8 5. see johnson enters. of jacksonville, inc. v. fpl group, inc., 162 f.3d 1290, 1311 (11th cir. 1998) (noting that a contractual promise is not enforceable unless supported by consideration and, in a bilateral contract, “the exchange of promises by both parties constitutes consideration”). 6. see restatement (second) of contracts § 224 (1981). an event certain to occur, such as a mere passage of time, cannot serve as a condition because the certainty establishes a definite performance obligation. see id. § 224 cmt. b. 7. see id. § 225(1). 8. see id. § 235 cmt. b (“non-performance is not a breach unless performance is due.”). 2010] just enough: substantial performance, ministerial acts 465 a. constructive conditions to performance obligations conditions precedent originate from several sources. express and implied conditions originate from the intentions of contracting parties to make an obligation to perform contingent on the occurrence of a specific event.9 express conditions appear in the oral and written language used to describe an agreement in terms of a conditional obligation.10 implied conditions (occasionally called implied in fact conditions) reflect the parties’ understandings of a conditional obligation as evidenced, for example, by prior course of dealings, trade usage, or the general nature of the agreement.11 express and implied conditions, therefore, regulate the maturity of a performance obligation in accordance with the contracting parties’ intentions. in contrast, courts use their equitable powers to fashion constructive conditions for otherwise unconditional promises of future performance. a court would read a constructive condition (occasionally called an implied in law condition) into a contract where the parties have omitted a term that the court considers essential for determining their rights and obligations.12 rather than interpreting the parties’ intentions as reflected in express and implied conditions, a court might impose a constructive condition on a promise where necessary to address circumstances beyond those originally contemplated by the parties.13 for example, a court might make the performance of promised work, in accordance with industry standards, a condition to a promise to make progress payments for such work. such a condition would permit the payor to stop making payments if the work quality were to become unacceptable.14 a construction would thus condition the payment obligation on the rendering of acceptable work to meet a need identified by the court irrespective of the seemingly unconditional relationship established by the parties. 9. see id. § 226 cmt. a. 10. see id. § 226 cmt. c. 11. see id. 12. see id. § 226 cmts. a, c. 13. see edwin w. patterson, constructive conditions in contracts, 42 colum. l. rev. 903, 913 (1942) (describing constructive conditions as “gap fillers”). 14. see k & g constr. co. v. harris, 164 a.2d 451, 455-56 (md. app. 1960) (“it would, indeed, present an unusual situation if we were to hold that a building contractor, who has obtained someone to do work for him and has agreed to pay each month for the work performed in the previous month, has to continue the monthly payments, irrespective of the degree of skill and care displayed in the performance of work, and his only recourse is by way of suit for ill-performance.”). 466 florida tax review [vol. 10:7 constructive conditions of exchange15 often become necessary to avoid hardship and achieve justice16 where parties to a bilateral contract fail to specify whether the promised performance of one party depends on performance by the other party.17 early court decisions had routinely found the absence of express and implied conditions indicative of independent relationships between promises.18 in dealing with independent promises, a court would have held a defendant to its facially unconditional promises in a contract even if the plaintiff had neither fulfilled nor offered to fulfill its promises in that contract.19 courts simply enforced each promise as made by contracting parties. the judicial approach changed by the landmark decision kingston v. preston,20 which used constructive conditions to establish dependent relationships between promises of performance.21 kingston involved a contract wherein a buyer promised to put up adequate security for the buyer’s obligation to make installment payments for property acquired from a seller.22 the court found that the receipt of security for future payments was so fundamental to the contemplated installment sale that the court made the buyer’s delivery of (or offer to deliver) adequate security a necessary condition precedent to the seller’s promise to convey the underlying property.23 in short, despite the absence of express and implied conditions, the court refused to compel a conveyance of the property because the court 15. this article focuses on constructive conditions of exchange, which reflect a “mutual dependency of promises,” patterson, supra note 13, at 907, without addressing other possible constructive conditions, such as conditions of cooperation and frustration. see generally id. at 928-54 (describing various constructive conditions). 16. see dorn v. stanhope steel, inc., 534 a.2d 798, 805 (pa. super. ct. 1987). 17. see restatement (second) of contracts § 232 (1981). 18. see, e.g., nichols v. raynbred, 80 eng. rep. 238 (k.b. 1615). 19. see damien nyer, withholding performance for breach in international transactions: an exercise in equations, proportions or coercion?, 18 pace int’l l. rev. 29, 53 (2006) (“[i]t was thought that a party confronted with the other party’s non-performance remained obligated to perform his part of the deal.”). 20. 98 eng. rep. 606 (k.b. 1773), discussed in jones v. barkley, 99 eng. rep. 434, 436-37 (1781). courts arguably recognized dependent relationships between promises prior to kingston. see generally william m. mcgovern, jr., dependent promises in the history of leases and other contracts, 52 tul. l. rev. 659 (1978) (arguing against a commonly-held notion that the law developed from treating promises as independent to treating them as dependent). 21. see kingston v. preston, 98 eng. rep. 606 (k.b. 1773), discussed in jones v. barkley, 99 eng. rep. 434, 436-37 (1781). 22. see id. 23. see id.; see also restatement (second) of contracts § 234 cmt. b (1981). 2010] just enough: substantial performance, ministerial acts 467 could not construe the seller’s promise to convey as being wholly independent of the buyer’s willingness to provide security for the future payments.24 kingston thus began a trend of finding dependent relationships between promises of performance in recognition of the fact that, although parties exchange promises in forming bilateral contracts, they ultimately expect to exchange performances.25 today, absent a clear showing of contrary intention, a presumption exists that parties expect to exchange all performances as promised in a contract.26 constructive conditions help protect these expectations by allowing a party to defer performance—thereby minimizing a risk of forfeiture—until receiving some assurance that the other party will also perform as promised.27 24. see kingston v. preston, 98 eng. rep. 606 (k.b. 1773), discussed in jones v. barkley, 99 eng. rep. 434, 436-37 (1781). 25. see restatement (second) of contracts § 232 cmt. a (1981); see also id. § 231 cmt. a (“ordinarily when parties make such an agreement [by exchanging promises], they not only regard the promises themselves as the subject of an exchange, but they also intend that the performances of those promises shall subsequently be exchanged for each other.”) (citation omitted). 26. see id. § 232; see also id. § 232 cmt. a (“when the parties have exchanged promises, there is ordinarily every reason to suppose that they contracted on the basis of such an expectation since the exchange of promises would otherwise have little purpose.”). the presumption avoids the task of deciding what relationships exist between various contractual promises, including those of purportedly minor importance, due to the expectation that each party will exchange all of its promised performances for all of the promised performances of the other party. see id. § 232 cmt. b. instead, the relative importance of any failure of promised performance comes into question in determining the materiality of such failure. see infra notes 58-64 and accompanying text. 27. see id. § 234 cmt. a. professor andersen aptly explained the holding in kingston v. preston: the buyer was correct, of course, that the seller might have brought a separate action seeking damages for breach. but that remedy would have fallen far short of protecting the seller’s position under the contract. it probably was precisely because the seller doubted the likelihood of collecting damages in the event of default in payment of the purchase price that the buyer’s promise to provide security had been included in the agreement in the first place. the only safe way to protect the seller’s interest was to permit him to withhold his own performance if the security were not forthcoming. it was exactly that remedy that was made available by the “dependency” or constructive condition relationship declared by lord mansfield. eric g. andersen, a new look at material breach in the law of contracts, 21 u.c. davis l. rev. 1073, 1079 (1988) (footnote omitted). 468 florida tax review [vol. 10:7 however, the resulting doctrine of constructive conditions does not purport to establish dependent relationships between all promises in bilateral contracts. instead, it anticipates that courts will supply constructive conditions only as needed to avoid hardship and achieve justice in enforcing the orderings of performance as determined from supplemental timing rules and contracting parties’ agreements/intentions. the supplemental timing rules generally presume that promised acts capable of simultaneous performance will become due concurrently.28 for example, promises to convey and to pay for property in a sale would generally become due at the same time. in contrast, the timing rules treat promised acts requiring time to complete, like a promise to render personal services, as becoming due before promised acts that do not, like a promise to pay for such services.29 the timing rules thereby set a default ordering for promised performances, which the parties may modify as they deem appropriate.30 a sense of fairness then suggests that a party should not be asked to perform as promised unless any performance due earlier has already occurred or any performance due simultaneously will occur.31 constructive conditions achieve this desired fairness by establishing dependent relationships among promises consistent with the ordering of performances. with respect to concurrently due obligations, constructive conditions generally make each obligation to perform depend on the other party’s simultaneous performance or offer to perform.32 consequently, neither party would need to perform without reasonable assurance of simultaneous performance by the other party.33 with respect to sequentially due obligations, performance of the earlier due obligation (e.g., rendering services) generally serves as a constructive condition for the later due obligation (e.g., a promise to pay for the services) whereas the earlier due obligation exists without any constructive conditions (i.e., an independent promise).34 fairness keeps a party from having to perform if an earlier due obligation has not been fulfilled. but no injustice occurs by treating the earlier due obligation as unconditional because the parties would have 28. see restatement (second) of contracts § 234(1) (1981). 29. see id. § 234(2); see also id. § 234 cmt. f (noting the typical application of the timing rule to contracts involving services). 30. see id. §§ 234, 234 cmt. a (“even absent an express provision, a contrary intention may be shown by circumstances including usage of trade and course of dealing.”) (citations omitted). for example, parties might explicitly state a date on which promised performances become due. 31. see id. § 237 cmt. a. 32. see id. § 238. 33. see id. § 238 cmt. a. 34. see id. § 237. 2010] just enough: substantial performance, ministerial acts 469 anticipated its fulfillment prior to the performance of other promised acts.35 constructive conditions thus help secure expectations about exchanges of performance and minimize risks of forfeiture36 where contracting parties have not addressed those concerns themselves.37 constructive conditions become particularly relevant upon a material failure of promised performance, including any defective performance or an absence of performance.38 the nonoccurrence of performance prevents any obligation, which was constructively conditioned on that performance, from falling due.39 a party with an obligation subject to such an unsatisfied condition could accordingly withhold performance of that party’s own promise without breaching the contract.40 therefore, in a lawsuit, a court must evaluate constructive conditions to determine which party, if any, to charge with the first material failure of performance.41 that initial failure would then justify the nonperformance of all remaining promises that never became due as a result of unsatisfied constructive conditions.42 accordingly, in frequent contractual disputes where both parties fail to complete their promised performances, the identification of a first material failure of 35. see id. § 234 cmt. e (“since one of the parties must perform first, he must forego the security that a requirement of simultaneous performance affords against disappointment of his expectation of an exchange of performances, and he must bear the burden of financing the other party before the latter has performed.”); see also patterson, supra note 13, at 918 (noting that students extend credit by paying tuition in advance of receiving instruction). 36. see restatement (second) of contracts § 234 cmt. a (1981); see also robert h. jerry, ii, insurance, contract, and the doctrine of reasonable expectations, 5 conn. ins. l.j. 21, 45 (1998) (“this doctrine rewrites text in the sense that it adds terms to the contract that are simply not there; but no one seriously argues that courts, at least with respect to the doctrine of constructive conditions, should abstain from rewriting text to enable the reasonable expectations of the parties to be protected.”). 37. see restatement (second) of contracts § 234(1) (1981) (prescribing an order for performances “unless the language or the circumstances indicate the contrary”); id. § 234(2) (same); id. § 239(2) (describing an assumed risk of having to perform a promised obligation despite the absence of a forthcoming exchange due to the nonoccurrence of a condition). 38. see id. § 237 cmt. a. 39. see id. §§ 225(1), 237. 40. see id. § 235 cmt. b. 41. see id. § 237 cmt. b. 42. see id. §§ 225(2), 237. the failure would initially justify a suspension of any obligation for future performance before resulting in a discharge of the obligation. see id. § 242. 470 florida tax review [vol. 10:7 performance helps resolve whether one party’s failure to perform justified the other party’s nonperformance.43 b. the satisfaction of constructive conditions through substantial performance the use of a materiality standard in assessing failures of performance has meant that something less than full performance can satisfy constructive conditions. full performance generally must occur before an obligation becomes due under an agreement that makes such performance an express or implied condition of the obligation.44 if a court were to otherwise accept less than full performance of an express or implied condition, then the court would frustrate the contracting parties’ clear intentions to have such condition applied strictly. so contracting parties can expect that a court will demand full performance of any promised acts that function as triggering events for conditional obligations, even if such demand produces harsh consequences, where the parties intended that result.45 conversely, contracting parties might reasonably expect less exacting standards for satisfying judicially constructed conditions, which were designed to meet needs identified by a court rather than outcomes intended by the parties.46 consistent with that expectation, the less demanding standard of substantial performance has been applied to constructive conditions. under that standard, no material failure of performance occurs as long as a party has substantially performed or offered to perform as promised.47 accordingly, any remaining obligation constructively conditioned on the performance of a promised act becomes due upon substantial performance of that act even though a claim for damages might arise from the failure to perform fully as promised.48 43. see id. § 237 cmt. b. 44. see id. § 226 cmt. c. 45. see id.; id. § 237 cmt. d (“if . . . the parties have made an event a condition of their agreement, there is no mitigating standard of materiality or substantiality applicable to the nonoccurrence of that event. if, therefore, the agreement makes full performance a condition, substantial performance is not sufficient . . . .”). 46. see id. § 226 cmt. c. 47. see id. §§ 237 cmt b, 238 cmt. a. 48. see id. §§ 235(2), 235 cmt. b (“when performance is due, . . . anything short of full performance is a breach, even if the party who does not fully perform was not at fault and even if the defect in his performance was not substantial.”), 236 cmt. a (“every breach gives rise to a claim for damages . . . .”), 241 cmt. a (“even if not material, the failure may be a breach and give rise to a claim for damages for partial breach.”). 2010] just enough: substantial performance, ministerial acts 471 the willingness of courts to accept substantial performance as satisfying constructive conditions seems compelled by the same notion of fairness used to justify the construction of those conditions. in supporting mutual expectations about an exchange of performances, constructive conditions avoid hardship and achieve justice by shielding a party from demands that it fulfill its later-due obligations where an earlier due performance has not occurred.49 as a shield, these conditions minimize the risk that the party would forfeit its later-due performance if the benefit of return performance were not forthcoming. for example, a constructive condition minimizes the risk of having to pay for work that will never be performed by generally permitting an employer to avoid paying an employee until after the employee has provided services.50 these concerns about a risk of forfeiture shift once a party has substantially performed. fairness then suggests that the performing party should expect to receive the benefit of return performance rather than to forfeit its own performance (albeit deficient).51 so fairness suggests that the employee in the above example should receive payment, less any damages, for providing services even if the employee’s work were to deviate somewhat from the original promise of performance. courts achieve such fairness by accepting substantial performance as the satisfaction of a constructive condition to other performance obligations. this acceptance thereby prevents the defensive shield provided by a constructive condition from morphing into a weapon that a party might otherwise use to threaten nonperformance of its promises as a result of immaterial nonconforming performance of other requirements in a contract.52 substantial performance thus significantly affects performance obligations. as a long-standing complement to constructive conditions,52 substantial performance mitigates the harshness that demands for full 49. see supra text accompanying notes 20-27. 50. see restatement (second) of contracts § 234 cmt. e (1981) (“centuries ago, the principle became settled that where work is to be done by one party and payment is to be made by the other, the performance of the work must precede payment, in the absence of a showing of contrary intention . . . . [m]ost parties today contract with reference to the principle . . . .”). 51. see id. § 241 cmt. d. the performing party should also expect to be held accountable for damages attributable to the failure to perform fully. see supra note 48 and accompanying text. 52. see patterson, supra note 13, at 925-26 (describing how a constructive condition gives a party with a conditional obligation “a method of coercing performance” from the other party). 52. see boone v. eyre, 126 eng. rep. 160 (k.b. 1777) (recognizing the need for substantial performance four years after kingston v. preston established constructive conditions). 472 florida tax review [vol. 10:7 performance might otherwise inflict.53 for example, in its classic application to construction contracts,54 the doctrine of substantial performance permits a contractor to receive compensation (less an allowance for damages) for building a house despite having installed the wrong brand of pipe during construction.55 although the obligation to pay for the house would normally depend on completion of its promised construction, the obligation would become due even with the deviation. such a trivial and insignificant deviation from the promised act—arguably within a margin of error expected for sizable projects—simply cannot defeat the contractor’s expectation to receive some compensation under notions of equity and fairness.56 thus one party’s promise, which was otherwise considered dependent under a judicial construction, becomes equivalent to an unconditional promise to perform upon the occurrence of substantial performance.57 considerations of substantial performance and its corollary of a material failure of performance58 impose a considerable burden in assessing when performances become due under a contract. the burden results from the need to decide whether a particular instance of deficient performance is sufficient to satisfy a constructive condition.59 the decision, reflecting considerations of justice and relative hardships, necessarily must occur 53. see celia r. taylor, self-help in contract law: an exploration and proposal, 33 wake forest l. rev. 839, 862 (1998). 54. the substantial performance doctrine applies to contracts of all types, even though the doctrine is most frequently described in the context of construction contracts. see restatement (second) of contracts § 241 cmt. a (1981); patterson, supra note 13, at 927 n.116. 55. see jacob & youngs, inc. v. kent, 129 n.e. 889, 891 (n.y. 1921); see also restatement (second) of contracts § 237 cmt. d (1981) (describing a typical application of the substantial performance doctrine to construction contracts). 56. see jacob & youngs, 129 n.e. at 890-91. 57. see id. at 890; see also id. at 891 (“this is not to say that the parties are not free by apt and certain words to effectuate a purpose that performance of every term shall be a condition of recovery . . . . this is merely to say that the law will be slow to impute the purpose, in the silence of the parties, where the significance of the default is grievously out of proportion to the oppression of the failure.”). 58. see restatement (second) of contracts § 237 cmt. d (1981) (noting that the substance of an issue remains the same regardless if one asks whether a material failure of performance has occurred or whether substantial performance as occurred); amy b. cohen, reviving jacob and youngs, inc. v. kent: material breach doctrine reconsidered, 42 vill. l. rev. 65, 79 n.51 (1997) (characterizing the substantial performance doctrine as a parallel doctrine to the material breach doctrine). 59. see taylor, supra note 53, at 879 (commenting that the circumstances used to determine whether a material failure has occurred “place[ ] the burden on the ‘innocent’ (presently non-breaching party) to make a critical determination about contractual status”). 2010] just enough: substantial performance, ministerial acts 473 without the assistance of well-defined guidance.60 imprecise, yet flexible, standards remain vital in assessing the substantiality of performance or the materiality of failure under notions of fairness.61 in that regard, circumstances impacting the decision might include: (1) the extent to which a breach denies an expected benefit, (2) the extent to which adequate compensation exists for the denied benefit, (3) the extent to which the breaching party will suffer forfeiture, (4) the likelihood of cure, and (5) the extent to which the breaching party acted in accordance with expectations of good faith and fair dealing.62 unfortunately, courts inconsistently account for these circumstances in their decisions and occasionally abandon them in favor of other vague approaches, such as making determinations based on the mere “essence” of agreements.63 considerations of substantial performance thereby theoretically advance the objective of achieving fairness. but these considerations also impose uncertainty on the practical process of identifying unconditional performance obligations in bilateral contracts.64 60. see restatement (second) of contracts § 241 cmt. a (1981) (“[c]ircumstances, not rules, . . . are to be considered in determining whether a particular failure is material.”). 61. see id.; jacob & youngs, 129 n.e. at 891 (“we must weigh the purpose to be served, the desire to be gratified, the excuse for deviation from the letter, the cruelty of enforced adherence. then only can we tell whether literal fulfillment is to be implied by law as a condition.”). 62. see restatement (second) of contracts § 241 (1981). 63. andersen, supra note 27, at 1089-92; see also cohen, supra note 58, at 83-90 (highlighting “the arbitrariness and uncertainty of the material breach doctrine” as applied by courts). 64. see cohen, supra note 58, at 67 (describing a determination about whether a material breach has occurred as “often seem[ingly] either completely without logic or precision, or self-evident and conclusory”); taylor, supra note 53, at 863 (“what then is ‘substantial’ performance? this is clearly a critical question as it determines the life or death of the contract . . . . although the concept of substantial performance is simple to state in general terms, it is difficult to nail down.”); andersen, supra note 27, at 1083-84 (“fairness and justice are not empty concepts, but unaided by a more specific theory of materiality they cannot provide anything close to the sense of certainty or predictably that is important to both the formation of agreements and the resolution of contract disputes.”); stewart macaulay, the reliance interest and the world outside the law school’s doors, 1991 wis. l. rev. 247, 251 (mentioning material failures of performance and substantial performance in observing that “[t]he law often states contracts doctrine in hard-to-apply qualitative standards”); see also arthur i. rosett, contract performances: promises, conditions and the obligation to communicate, 22 ucla l. rev. 1083, 1087 (1975) (“[the traditional approach for analyzing contracts] assumes that the crucial need is to advise judges and lawyers how to dispose of litigation. this assumption is misguided, for at the time of litigation courts are engaged in salvage operations at best, seeking to raise the hulk or to apportion blame for the sinking. at worst, courts 474 florida tax review [vol. 10:7 iii. the role for substantial performance in determining taxable income under an accrual method of accounting, a taxpayer must identify unconditional performance obligations to determine taxable income. similar “all events” tests focus on a taxpayer’s unconditional rights to receive income and unconditional liabilities to pay expenses in taking such items into account.65 one all events test generally requires that a taxpayer include an item of income in gross income when all the events have occurred that fix the right to receive such item and its amount is determinable with reasonable accuracy.66 the other test generally treats a taxpayer as having incurred a liability for an expense item when all of the events have occurred that establish the fact of liability and its amount is determinable with reasonable accuracy.67 both tests accordingly call for inquiries into whether every necessary event has happened, including the occurrence of any prerequisite performance, to establish a fixed right or liability.68 the existence of the right or liability thus establishes the time to account for the item rather than the date when a taxpayer receives income or pays an expense.69 in the context of a bilateral contract, these tests naturally suggest a need to examine when a taxpayer has an unconditional right to receive another party’s promised performances and when the taxpayer becomes unconditional obligated to perform as promised. serve a function analogous to that of the men with brooms who follow the passage of the circus parade.”). 65. see reg. § 1.446-1(c)(1)(ii)(a) (as amended in 2006). the all events test applicable to liabilities extends to any items allowable as a deduction, cost, or expense. see reg. § 1.446-1(c)(1)(ii)(b). for clarity, the text discusses the all events test in the context of a liability to pay an expense. 66. see reg. § 1.451-1(a) (as amended in 1999). 67. see reg. § 1.461-1(a)(2)(i) (as amended in 1999). a taxpayer cannot treat the all events test as being satisfied for any liability prior to the taxable year during which economic performance occurs with respect to the liability. see irc § 461(h)(1). this article focuses on how performance under a contract might fix a liability for purposes of the all events test without addressing the impact of the economic performance requirement in taking the liability into account. 68. see united states v. anderson, 269 u.s. 422, 441 (1926). 69. see spring city foundry co. v. commissioner, 292 u.s. 182, 184-85 (1934) (“keeping accounts and making returns on the accrual basis . . . import that it is the right to receive and not the actual receipt that determines the inclusion of the amount in gross income. when the right to receive an amount becomes fixed, the right accrues.”); united states v. hughes properties, inc., 476 u.s. 593, 604 (1986) (“[t]he accrual method itself makes irrelevant the timing factor [of payment] that controls when a taxpayer uses the cash receipts and disbursements method.”). 2010] just enough: substantial performance, ministerial acts 475 a. the “all events” anomaly for ministerial acts as fundamental tax principles,70 the all events tests put forth exacting requirements to have a definite, unconditional right or established liability to justify an accrual.71 as a result, a taxpayer cannot accrue an item without having a fixed right to receive or liability to pay irrespective of the probability of receipt or payment.72 an unsatisfied condition precedent to a right or liability simply precludes the accrual.73 each test seeks a seemingly clear-cut answer to a simple question: does an unconditional right or liability exist or not?74 but, while the all events tests ascended to touchstone status,75 an anomaly developed to account for rights and liabilities conditioned on ostensibly insubstantial events. the anomaly permits a finding of fixed rights to income or fixed liabilities to pay under the all events tests despite the nonoccurrence of ministerial, procedural, or mechanical acts required by contracts (collectively, “ministerial acts”).76 courts still regarded the 70. see united states v. consolidated edison co., 366 u.s. 380, 385 (1961). 71. see thor power tool co. v. commissioner, 439 u.s. 522, 543 (1979) (“[t]he tax law, with its mandate to preserve the revenue, can give no quarter to uncertainty. this is as it should be.”). 72. see brown v. helvering, 291 u.s. 193, 201 (1934). 73. see hughes properties, 476 u.s. at 600-01. with respect to accruing a deduction for a liability, the court noted: the court’s cases have emphasized that “a liability does not accrue as long as it remains contingent.” brown v. helvering, 291 u.s. 193, 200 (1934); accord, dixie pine products co. v. commissioner, 320 u.s. 516, 519 (1944). thus, to satisfy the allevents test, a liability must be “final and definite in amount,” security flour mills co. v. commissioner, 321 u.s. 281, 287 (1944), must be “fixed and absolute,” brown v. helvering, 291 u.s., at 201, and must be “unconditional,” lucas v. north texas lumber co., 281 u.s. 11, 13 (1930). and one may say that “the tax law requires that a deduction be deferred until ‘all the events’ have occurred that will make it fixed and certain.” thor power tool co. v. commissioner, 439 u.s. 522, 543 (1979). id. 74. see hallmark cards, inc. v. commissioner, 90 t.c. 26, 34 (1988) (“the all-events test is based on the existence or nonexistence of legal rights or obligations at the close of a particular accounting period, not on the probability—or even absolute certainty—that such right or obligation will arise at some point in the future.”) (citing united states v. general dynamics corp., 481 u.s. 239 (1987), and brown v. helvering, 291 u.s. 193 (1934)). 75. see consolidated edison, 366 u.s. at 385. 76. see exxon mobile corp. v. commissioner, 114 t.c. 293, 314 (2000). 476 florida tax review [vol. 10:7 ministerial acts, such as certain required approvals or computations, as conditions.77 however the courts have considered the nonperformance of the required acts too insubstantial to prevent the fixing of rights or liabilities under the all events tests.78 the reference to “all events” in the tests thus essentially became understood to mean all events other than the performance of ministerial acts. courts have accommodated the nonperformance of ministerial acts in applying the all events tests with little explanation. their opinions occasionally mentioned that the ministerial acts did not go to the substance of the agreements and, as such, their nonperformance apparently could not preclude a finding of fixed rights or liabilities.79 in some instances, courts summarily concluded that the acts were associated with collection procedures rather than events that fixed the rights or liabilities for the amounts subject to collection.80 but the courts did not disclose why the otherwise exacting tests accepted something less than the occurrence of all events. dally v. commissioner81 provides a good example of this unexplained accommodation for ministerial acts. the dally court considered a seller’s right to income under a single contract clause that provided for payment of 90 percent of a purchase price “upon submission of properly 77. see dally v. commissioner, 227 f.2d 724, 727 (9th cir. 1955) (describing acts as “necessary in order to make the collection”); charles schwab corp. v. commissioner, 107 t.c. 282, 293-94 (1996) (indicating that ministerial acts might function as conditions subsequent), aff’d without opinion, 161 f.3d 1231 (9th cir. 1998); cf. h.j. heinz co. v. granger, 147 f. supp. 664, 670 (w.d. penn. 1956) (“payment was expressly made ‘subject to the terms and conditions’ applicable to the contracts and it is evident that those terms and conditions included more than the making of eligible sales.”); irs priv. ltr. rul. 81-29-114 (apr. 27, 1981) (noting that “[m]inisterial functions are not substantial conditions”). 78. see, e.g., charles baloian co. v. commissioner, 68 t.c. 620, 627 (1977) (distinguishing the subsequent approval of a claim from the prior “primary substantive considerations and decisions” that fixed a right to payment), nonacq., 1978-2 c.b. 3. 79. see hallmark cards, 90 t.c. at 33 (“far from being a ministerial act, the passage of title and risk of loss to the buyer constitutes the very heart of the transaction and is the sine qua non to petitioner’s right to receive payment.”); see also charles schwab, 107 t.c. at 295 (“[w]e cannot agree that ministerial acts . . . are converted to conditions precedent merely because they may comprise a significant percentage of the overall activities conducted by the broker.”). 80. see continental tie & lumber co. v. united states, 286 u.s. 290, 295 (1932) (characterizing an award by a government agency as a “mere administrative procedure to ascertain the amount to be paid,” which did not delay the fixing of the right to payment, despite acknowledging that the taxpayer had no vested right to any amount and could not compel payment prior to the award). 81. 227 f.2d 724 (9th cir. 1955). 2010] just enough: substantial performance, ministerial acts 477 certified invoices” for delivered articles and 10 percent of the purchase price upon final acceptance of all articles by the buyer.82 although the court did not question that the seller lacked a fixed right to 10 percent of the purchase price before final acceptance, the court found that the seller had a fixed right to 90 percent of the purchase price in the year of delivery despite the fact that the required certification was not submitted before year end.83 the opinion summarily concluded that the seller must accrue 90 percent of the payment as income because it was earned, even if the amount was uncollectible due to the nonoccurrence of the mechanical act of certifying performance.84 neither the dally opinion nor other court decisions following dally gave any meaningful explanation about why the certification, as required by the contract, was not a condition precedent to the right to receive 90 percent of the purchase price whereas the required final approval was a condition precedent to the right to receive the remaining amount. because courts have readily accepted this anomaly without explanation, the only real insight about it comes from discussions about whether to characterize certain acts as ministerial in applying the all events tests. for example, the supreme court found the submissions of medical claim forms to represent nonministerial acts in united states v. general dynamics corp.85 the taxpayer in general dynamics self insured its medical plans for employees and attempted to deduct the cost of covered medical services provided to its employees by year end but for which the employees had not filed the required forms by year end.86 such costs are frequently described as being incurred but not reported (“ibnr”) by year end. the taxpayer asserted that the provision of covered medical services was the final event that established the taxpayer’s unconditional liability for the ibnr costs.87 but the court disagreed and noted that the filing of a claim was “not a mere technicality” but a condition precedent to the taxpayer’s liability.88 because the medical plans stated that payment would occur only after the filing of a claim form, the court concluded that, “as a matter of law, the filing of a claim was necessary to create liability.”89 the court expressed concern that, as a result of oversight, procrastination, confusion, or fear of disclosure, employees might not file claims for covered costs; therefore, the 82. id. at 725. 83. see id. at 726-27. 84. see id. at 727. 85. 481 u.s. 239 (1987). 86. see id. 241-42. 87. see id. 88. id. at 244-45. 89. id. at 244 n.4. 478 florida tax review [vol. 10:7 court refused to treat the requirement to file claims as an ignorable ministerial act in applying the all events test.90 in contrast to general dynamics, the submission of claim forms and documentation has constituted ministerial acts in other situations. for instance, the internal revenue service (“service”) concluded that a medical practice, conducted in a professional corporation, had a fixed liability for ibnr costs subject to direct billing by outside physicians.91 under a contract with a health maintenance organization, the corporation agreed to pay for services rendered by outside physicians for the benefit of the corporation’s patients.92 the corporation then required the physicians to submit claims directly to the corporation in order to receive payment for the rendered services.93 the service could not find a reason why a physician might render services without making a claim.94 because the physicians were commercially motivated to file claims, the service found this situation distinguishable from general dynamics insofar as the submission of a claim represented a mere technical obligation to verify that the services were rendered and therefore constituted a ministerial act.95 the service thus concluded that the liability for the ibnr costs became fixed when the physicians rendered the services irrespective of when the claims were filed.96 accordingly, one might surmise that an economic interest in filing claims or a fiduciary duty to file claims would minimize concerns that claims could go unfiled, as had so troubled the court in general dynamics.97 those diminished concerns suggest the insignificance of filing a claim and 90. see id. at 244-45. 91. see irs field serv. adv. 2001-04-011 (oct. 19, 2000). 92. see id. 93. see id. 94. see id. 95. see id. 96. see id.; see also irs field serv. adv. 2000-36-009 (may 4, 2000) (concluding that ibnr costs of a taxpayer engaged in network management becomes fixed when an affiliated physician renders services because the physician’s submission of a claim form to the taxpayer constitutes a ministerial act). 97. see irs priv. ltr. rul. 2004-09-010 (nov. 13, 2003); irs field serv. adv. 2001-04-011 (oct. 19, 2000) (“in general, we believe that the rule of law of general dynamics should be confined to analogous facts involving consumers or patients. where a claim for payment in which processing is ministerial is required from a business in a commercial transaction, the fixing of the liability is not delayed until the claim is filed.”) (footnote omitted). but see coordinated issue pharmaceutical industry medicaid rebates (apr. 17, 1997) (concluding that a pharmacist might not submit a claim to a state for dispensing a drug to a medicaid beneficiary, which would prevent the drug manufacturer from having a fixed obligation to pay the state under the medicaid program), reprinted in irs releases isp paper on medicaid rebates, 97 tax notes today 75-19 (apr. 18, 1997). 2010] just enough: substantial performance, ministerial acts 479 apparently support characterizing the filing as a ministerial act. the ministerial nature of an act therefore occasionally seems to depend on factors external to the contract, such as the parties’ interests in having the act performed. in other situations, the relative importance of an act in comparison to other required performances appears to determine whether the nonoccurrence of the act has any impact under the all events tests. for example, the tax court held that the preparation and sending of invoices constituted a ministerial act under a contract that required a taxpayer to send customers invoices with all supporting documentation.98 although the taxpayer had delayed its invoicing because it had not yet received documentation for thirdparty charges, the court concluded that the taxpayer nevertheless had a fixed right to income because it had performed the sales and services, for which it would send the invoices, for its customers.99 pursuant to the court’s rationale, the performance of the primary objectives of a contract would appear to establish a fixed right or liability, whereas any required billing would operate merely as a secondary administrative function.100 accordingly, acts of billing or sending invoices to customers101 as well as acts of having customers accept invoices,102 even where such acts are required by contract, would often be considered ministerial acts. so ministerial acts also seem to consist of required performances of secondary importance in contracts. but the ministerial nature of an act could also be derived from its purpose in a contract. for example, after having issued a series of rulings with conflicting conclusions,103 the service generally addressed the 98. see frank’s casing crew & rental tools, inc. v. commissioner, t.c. memo 1996-413, 72 t.c.m. (cch) 611 (1996). 99. see id. at 613; cf. cox v. commissioner, 43 t.c. 448, 458 (1965) (noting that a billing delay attributable to independent auditors did not affect the taxpayer’s right to income), acq., 1965-2 c.b. 4, nonacq., 1965-2 c.b. 7. 100. see irs field serv. adv. 1999 fsa lexis 382 (june 25, 1999). 101. see jerry lipps, inc. v. commissioner, t.c. memo 1990-293, 59 t.c.m. (cch) 849, 866 (1990). 102. see irs tech. adv. mem. 2009-03-079 (oct. 8, 2008) (noting that a buyer’s acceptance of an invoice might act as a condition precedent to the seller’s right to payment but not to the seller’s right to bill); cf. irs tech. adv. mem. 200310-003 (oct. 30, 2002) (“even if the terms of the sales agreement made acceptance of the system a condition precedent to the right to receive income, … [t]he return of an acceptance form by the customer is merely a ministerial act, and is not required to establish taxpayer’s right to the income under the all-events test.”). 103. see irs field serv. adv. 1997 fsa lexis 350 (feb. 10, 1997) (noting that, by “dictating the form and documentary requirements for reimbursement” in a cooperative advertising agreement, the taxpayer “made the submission of certain documents a condition precedent to its own” liability to pay 480 florida tax review [vol. 10:7 ministerial nature of submission requirements under a cooperative advertising agreement.104 the agreement obligated a manufacturer to pay a retailer a promotional allowance for products purchased from the manufacturer and advertised by the retailer in a prescribed time and manner, provided the retailer submitted a claim form and proof of the advertising.105 drawing a comparison to submitting an invoice, the service found that the retailer’s claim and proof submission only functioned as the means to request payment insofar as it merely evidenced that the advertising services were performed as required under the agreement.106 the comparison led the service to conclude that the filing constituted a ministerial act that would not serve as a condition precedent to the manufacturer’s liability to make the payments.107 thus, the service derived the submission’s ministerial nature from its purpose to substantiate the other performances required by the contract. the unpredictable approaches taken in these cases and rulings show that ministerial acts lack readily identifiable characteristics and any willingness to disregard the nonoccurrence of required performance depends largely on context. cases and rulings broadly suggest that a nonministerial act, which can preclude a taxpayer from having a fixed right or liability, often signifies more than just a technical requirement,108 provides some the cooperative advertising expenses); irs tech. adv. mem. 94-16-004 (dec. 23, 1993) (concluding that a liability for cooperative advertising expenses did not become fixed prior to the submission of a claim form, absent proof that substantial performance would establish liability under state law); irs tech. adv. mem. 93-43006 (july 13, 1993) (holding, in reconsideration of irs tech. adv. mem. 92-04-003, that a liability did not become fixed prior to compliance with a contractual requirement to submit a claim); irs tech. adv. mem. 93-20-001 (dec. 17, 1992) (holding that a liability became fixed only upon compliance with a claim submission requirement in a contract); irs tech. adv. mem. 92-04-003 (oct. 2, 1991) (finding that a liability for cooperative advertising expenses became fixed upon the performance of the required advertising); irs tech. adv. mem. 91-43-083 (aug. 1, 1991) (concluding that a right to receive payment for cooperative advertising services became fixed upon the placement of advertising despite the requirement to submit a claim form). the service apparently faced an internal disagreement between the field, which thought satisfaction of the all events tests depended on compliance with all contractual terms, and the national office, which believed performance of the services (for which the parties had contracted) satisfied the all events tests. see irs field ser. adv. 1999-1134 (undated). 104. see rev. rul. 98-39, 1998-2 c.b. 198. 105. see id. 106. see id. at 199. 107. see id. 108. see united states v. general dynamics corp., 481 u.s. 239, 244 (1987); challenge publ’ns, inc. v. commissioner, 845 f.2d 1541, 1544 (9th cir. 1988) (characterizing compliance with a requirement to submit suitable 2010] just enough: substantial performance, ministerial acts 481 significant benefit to contracting parties,109 represents consideration exchanged for something else,110 calls for performance of a complex nature or in a manner subject to interpretation or judgment,111 or constitutes something crucial in a contract.112 on the other hand, they also suggest that a ministerial act often functions as a mere mechanism to substantiate other performances,113 appears minor or insubstantial in comparison to other documentation under the terms of an agreement as a “legally significant moment” for a taxpayer’s obligation); irs chief couns. adv. 2008-34-019 (may 7, 2008) (finding that the mailing of a rebate form is “necessary” to fix the liability to pay a rebate, whereas the processing and issuing of a rebate cannot be “anything other than a ministerial act”); compare orange & rockland utils., inc. v. commissioner, 86 t.c. 199, 214 (1986) (finding a utility company’s inability to bill customers prior to a meter reading date, pursuant to industry regulations, distinguishable from a ministerial act of billing) with announcement 86-65, 1986-19 i.r.b. 19 (concluding that a right to income becomes fixed when earned “irrespective of the time when billing is permitted”). 109. see irs tech. adv. mem. 77-42-002 (june 27, 1977) (manufacturer benefits when customers return defective products). 110. see ertegun v. commissioner, 531 f.2d 1156, 1159 (2d cir. 1976) (remarking that the finding of a quid pro quo precludes a ministerial act characterization); l.e. thompson v. commissioner, 489 f.2d 288, 292 (4th cir. 1974) (“[i]t is doubtful that delivery of three rocket launcher track assemblies, each 3,000 feet in length, from parkersburg, west virginia, to dahlgren, virginia, could be construed as an insignificant part of the consideration bargained for and a mere ministerial duty.”). 111. see h.j. heinz co. v. granger, 147 f. supp. 664, 672 (w.d. penn. 1956) (“[t]he receipt of subsidies was subject to the making of a factual determination by the party controlling the payment of satisfactory performance of applicable conditions.”); irs field serv. adv. 2000-36-009 (may 4, 2000); irs field ser. adv. 1999-1134 (undated); irs field serv. adv. 992 (apr. 30, 1992) (“triggers a substantive verification process”); cf. yapp corp. v. commissioner, t.c. memo 1992-348, 63 t.c.m. (cch) 3155, 3157 (1992) (rejecting an argument that an examination of a refund claim by a state tax commissioner constitutes a ministerial act); rev. rul. 2003-3, 2003-1 cb 252 (concluding that approvals of tax refunds by state tax authorities “involves substantive review”). 112. see hallmark cards, inc. v. commissioner, 90 t.c. 26, 33 (1988) (a nonministerial act is “the sine qua non to petitioner’s right to receive payment”); irs field serv. adv. 1994 fsa lexis 283 (mar. 23, 1994) (“a necessary identifying event in taxpayer’s … procedures”); irs field ser. adv. 1999-1134 (undated) (“contracts with its providers still must be evaluated to determine whether the claim represents a crucial element of taxpayer’s liability or is merely a bill”). 113. see rev. rul. 98-39, 1998-2 c.b. 198, 199 (“substantiating that it has performed”); rev. rul. 74-372, 1974-2 c.b. 147, 147 (trade confirmation); irs tech. adv. mem. 2000-37-004 (may 11, 2000) (“merely verification”); in re doyle, dane, bernbach, inc. v. commissioner, action on decision 1988-014 (june 27, 1988) (used to ascertain accuracy). 482 florida tax review [vol. 10:7 contractual requirements,114 contemplates mere steps necessary to effectuate a transaction,115 or denotes something nonessential to a contract.116 unfortunately, these suggestions are not particularly helpful. they might seem like obvious ways to distinguish between nonministerial and ministerial acts in hindsight. but they hold little predictive value. where a taxpayer encounters a contractual requirement to submit paperwork, for example, these suggestions to consider aspects such as contractual technicalities, significance, and essence provide poor guidance for determining whether the submission is critical like the requirement in general dynamics or ministerial like the requirement in the cooperative advertising guidance. as a result, accrual-method taxpayers lack both a solid justification for disregarding ministerial acts and a reasonable means for identifying them. perhaps the ministerial acts anomaly under the all events tests represents a practical accommodation for insignificant events. but the anomaly seems hard to reconcile with the notion that, with respect to assessing fixed rights and liabilities, “the tax law … can give no quarter to uncertainty.”117 moreover, the anomaly provides little guidance but awkwardly forces taxpayers to decide what contractual requirements, which were important enough to include in the contract, are too insubstantial to take into account in applying the all events tests. 114. see exxon mobile corp. v. commissioner, 114 t.c. 293, 319 (2000) (“perfunctory”); charles baloian co. v. commissioner, 68 t.c. 620, 627 (1977) (distinguishing the remaining ministerial acts from the prior “primary substantive considerations and decisions”), nonacq., 1978-2 c.b. 3; schneider v. commissioner, 65 t.c. 18, 28 (1975) (“only the ministerial act of computation remained to be done”), acq., 1976-2 c.b. 2; irs tech. adv. mem. 2009-03-079 (oct. 8, 2008); irs priv. ltr. rul. 81-29-114 (apr. 27, 1981) (“not substantial conditions”); irs field serv. adv. 1992 fsa lexis 69 (mar. 14, 1992) (“no substantive contingency remains”); cf. dumari textile co. v. commissioner, 47 b.t.a. 639, 645 (1942) (finding a ministerial act where the remaining required function was “purely a matter of computation under the express direction of the statute”), aff’d, 142 f.2d 897 (2d cir. 1944). 115. see charles schwab corp. v. commissioner, 107 t.c. 282, 293-94 (1996) (functions that “effectuate the mechanics of the [securities] transfer and confirm the trade executed”), aff’d without opinion, 161 f.3d 1231 (9th cir. 1998); rev. rul. 74-372, 1974-2 c.b. 147, 147 (same); cf. gold coast hotel & casino v. united states, 158 f.3d 484, 490 (9th cir. 1998) (“here, a slot club member’s demand for payment (redemption of points) is a technicality. it is nothing more than making a demand for payment of an uncontested liability.”). 116. see irs field serv. adv. 2001-04-011 (oct. 19, 2000); irs field serv. adv. 992 (apr. 30, 1992). 117. thor power tool co. v. commissioner, 439 u.s. 522, 543 (1979). 2010] just enough: substantial performance, ministerial acts 483 b. substantial performance as a justification for the ministerial acts anomaly the substantial performance doctrine, as established under contract law, can explain and provide structure for the accommodation of ministerial acts under the all events tests. the general willingness of courts to ignore ministerial acts, based on aspects like contractual technicalities and significance, in accruing items of income and expense resembles the willingness of courts to accept substantial performance in determining which party, if any, to charge with the first material breach of performance under a contract. in each instance, promised performance under a contract can become due despite the nonperformance of other required acts. under the tax law, a right to receive or liability to pay is deemed fixed and its accrual is not delayed where the unfulfilled acts appear ministerial in nature.118 under contract law, a right to receive or obligation to pay is deemed unconditional where fairness dictates that a party should not have to forfeit its performance due to immaterial noncompliance with a contractual requirement.119 both approaches basically ask whether the performances occurring to date have sufficiently met the parties’ expectations, in accordance with the “essence” of their agreement, such that one could justify holding the parties to their remaining promises.120 the recognition of constructive conditions and their satisfaction through substantial performance would accord with current applications of the all events tests to items not otherwise subject to express or implied conditions. the service, for example, asserts that a right to income becomes fixed upon the earliest of when performance occurs, payment becomes due, or payment is made.121 similarly, the service takes a position that a liability becomes fixed upon the earliest of when certain events occur, such as a rendering of performance, or payment becomes due.122 under these standards, where a corporation promises to render services and a customer promises to pay for those services under a bilateral contract, the corporation generally would have a fixed right to income only after performing the services and the customer would not have a fixed liability to pay for the services prior to such performance.123 the service would focus on when the 118. see supra part iii.a. 119. see supra part ii.b. 120. see supra notes 63, 116 and accompanying text. 121. see rev. rul. 74-607, 1974-2 c.b. 149, 149-50. 122. see rev. rul. 2007-3, 2007-1 c.b. 350, 350. 123. see, e.g., charles schwab, 107 t.c. at 282, 292-96 (reciting that a right to income becomes fixed upon the earliest of being due, paid, or earned and determining when the taxpayer earned its income by performing services), aff’d without opinion, 161 f.3d 1231 (9th cir. 1998); irs priv. ltr. rul. 2008-28-011 484 florida tax review [vol. 10:7 corporation performed the services because it generally believes the performance constitutes an event that must occur to fix the right and liability despite the absence of express and implied conditions to the promise to pay. although the service has not articulated this reason for its standards, the performance of the services plays such a critical role under the all events tests because a court, following a well-accepted principle that work precedes payment,124 would treat the performance as a constructive condition to the promise to pay.125 notions of fairness and justice would simply preclude a finding that the corporation has a right to demand and the customer has an obligation to make payment before the services are rendered.126 consistent with this judicial approach and as discussed elsewhere, the all events tests accordingly must account for constructive conditions in determining fixed rights and liabilities for seemingly unconditional promises in bilateral contracts.127 in accounting for these and other conditional obligations, the all events tests must address the impact of unfulfilled requirements to perform ministerial acts. ministerial acts only become relevant under the all events tests where their completion functions as a condition to a right or obligation; if no such condition exists, the right or obligation is fixed. where parties to a contract make purportedly ministerial acts express or implied conditions to other promises, only the full performance of the ministerial acts could fix a right or liability.128 in that situation, the all events tests would appropriately deny any related accruals prior to such performance. (apr. 15, 2008) (“with regard to services, the event fixing the liability generally is the performance of services, unless payment is due prior to the services being performed.”). although the corporation and customer could agree to have the payment due in advance, most service contracts reflect a principle that the performance of services should occur before payment becomes due. see restatement (second) of contracts § 234 cmt. e (1981) (“it is sometimes supposed, that this principle grew out of employment contracts, and reflects a conviction that employers as a class are more likely to be responsible than are workmen paid in advance. whether or not the explanation is correct, most parties today contract with reference to the principle, and unless they have evidenced a contrary intention it is at least as fair as the opposite rule would be.”). 124. see restatement (second) of contracts § 234 cmt. e (1981) (“centuries ago, the principle became settled that where work is to be done by one party and payment is to be made by the other, the performance of the work must precede payment, in the absence of a showing of contrary intention.”). 125. see supra text accompanying note 34. 126. see supra notes 31-37 and accompanying text. 127. see glenn walberg, constructive conditions and the all events test, 62 tax law. 433, 463-68 (2009) (describing the implications of constructive conditions for the standards applied by the service under sections 451 and 461). 128. see supra notes 44-45 and accompanying text. 2010] just enough: substantial performance, ministerial acts 485 but where parties exchange a promise to perform a ministerial act along with other promises of future performance without an intention to establish a conditional relationship, a court might treat the ministerial act as a constructive condition to another promise. the constructive condition would thereby reflect the basic presumption that contracting parties expect to exchange all promised performances.129 so, in the example above, assuming the corporation promised to provide services and send an invoice, and the customer agreed to pay for those services, the promise to pay might be conditioned on the performance of the services and the sending of an invoice. one must then ask if the all events tests, which otherwise would treat the corporation’s right and customer’s liability as becoming fixed upon the performance of the services, should require a different result if the corporation were to perform the services without sending an invoice by year end. the doctrine of substantial performance could help answer that question by showing how to account for the nonperformance of certain requirements, such as ministerial acts, under the all events tests. the doctrine would recognize that the desires to achieve justice and avoid forfeitures, which motivated the construction of the condition for the customer’s promise to pay,130 would not let the customer avoid paying for its receipt of services if the corporation failed to send an invoice.131 the corporation’s substantial compliance with its promises would result in the deemed satisfaction of the condition to the customer’s promise to pay. accordingly, the payment would become unconditionally due. irrespective of whether the act of sending an invoice appears “ministerial” in nature,132 the all events tests would justifiably treat the rendering of services as fixing the corporation’s right and the customer’s liability because the occurrence of substantial performance satisfied the condition to such right and liability. an acknowledgement of this role for substantial performance would appropriately recognize that the all events tests do not ask if all requirements in a contract have been fulfilled. instead, the tests more narrowly focus on whether all events have occurred to fix a right or liability.133 if an event of 129. see supra note 26 and accompanying text. 130. see supra notes 49-50 and accompanying text. 131. see supra notes 51-52 and accompanying text. 132. see supra note 26. 133. see regs. §§ 1.451-1(a) (“under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.”), 1.461-1(a)(2)(i) (“under an accrual method of accounting, a liability … is incurred … in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined 486 florida tax review [vol. 10:7 either full or substantial performance satisfies a condition to a right or liability, then such right or liability becomes fixed irrespective of whether the contract requires either party to complete other performances, including any ministerial acts. therefore, the substantial performance doctrine provides a strong justification for a new and different treatment of ministerial acts under the all events tests. unlike cases and rulings that have essentially chosen to disregard requirements to perform ministerial acts in applying the all events tests,134 the doctrine takes into account the ideas that: (1) parties exchange multiple promises to form bilateral contracts, (2) the performance of certain promises might act as constructive conditions to other promises, and (3) the occurrence of substantial performance can satisfy a constructive condition to establish an unconditional obligation under a contract. the doctrine thus articulates a well-reasoned approach for addressing contractual requirements to perform ministerial acts. the all events tests should accordingly embrace this approach as its principled explanation about how to account for ministerial acts under accrual methods of accounting. curiously, the service brought the doctrine of substantial performance to the forefront while struggling to resolve whether it should classify submission requirements under cooperative advertising agreements as ministerial acts. in recognizing that the terms of a written cooperative advertising agreement would determine a taxpayer’s obligation to pay promotional allowances, the service had noted that documentation requirements could operate as conditions to payment.135 however, in accordance with case law and administrative rulings dealing with documentation requirements, the service acknowledged at one point that “the all events test was met when substantial performance required under the contract had occurred, notwithstanding the requirement for documentation.”136 the service thereby reasoned—at least during the early part of its struggle to resolve how to treat payments under cooperative advertising agreements—that the liability became fixed for tax purposes upon substantial performance and that the submission requirements were properly disregarded as ministerial acts under the agreements.137 with reasonable accuracy, and economic performance has occurred with respect to the liability.”). 134. see supra part iii.a. 135. see irs tech. adv. mem. 92-04-003 (oct. 2, 1991), reconsidered in irs tech. adv. mem. 93-43-006 (july 13, 1993) (finding that a liability did not become fixed prior to full compliance with documentation requirements). 136. id. (citing continental tie & lumber co. v. united states, 286 u.s. 290 (1932), and dally v. commissioner, 227 f.2d 724 (9th cir. 1955)). 137. see id; irs tech. adv. mem. 91-43-083 (aug. 1, 1991). 2010] just enough: substantial performance, ministerial acts 487 the service clearly contemplated that substantial performance, as determined under contract law, played a critical role in determining ministerial acts for tax purposes. the service specifically acknowledged that slight nonperformance, such as noncompliance with a requirement to submit documentation, would not bar legal recovery by a person who had substantially complied with the terms of a contract.138 for purposes of determining substantial performance in accordance with the “spirit” of a cooperative advertising agreement, the service recognized that a taxpayer would bargain to receive the performance of promotional services rather than to receive the verification of performance.139 accordingly, the service found that the performance of the services would establish the taxpayer’s contractual obligation to pay despite any failure to submit the documentation that could verify such performance.140 the service thereby effectively equated a liability established, as a matter of law, through substantial performance to a liability considered fixed for purposes of the all events test.141 under that reasoning, the obligation to pay was constructively conditioned on the rendering of services and submission of documentation. such payment then became due upon the occurrence of substantial performance—when the advertising was performed—because the lack of documentation did not represent a material failure of performance, and only a material failure could have excused noncompliance with the promise to pay. the service further used the substantial performance doctrine to explain and differentiate a conclusion stated in a footnote of general dynamics and its impact on the all events tests. in characterizing the filing of a claim as a condition precedent, the supreme court had “conclude[d] that, as a matter of law, the filing of a claim was necessary to create liability.”142 the court, however, never explained the rationale for its conclusion. given that the court stated its conclusion in contrast to the factual findings of the lower court143 and in light of the undisputed fact that a claim had not been 138. see irs tech. adv. mem. 92-04-003 (oct. 2, 1991) (citing woodruff v. hough, 91 u.s. 596, 602 (1875), which had accepted jury instructions that described how parties were not entitled to recover under a contract unless they “had complied substantially with [the contract’s] specifications”). 139. see id. 140. see id. 141. see generally irs tech. adv. mem. 94-16-004 (dec. 23, 1993) (“[i]f the taxpayer is able to clearly demonstrate that under applicable state law a specific term of the contract which is not satisfied by year-end would be ignored by the courts and all other terms of the contract would be enforced despite noncompliance with that term, the liability under the contract will be fixed by year-end.”). 142. united states v. general dynamics corp., 481 u.s. 239, 244 n.4 (1987). 143. see id. 488 florida tax review [vol. 10:7 filed in that case, it seems reasonable to attribute the “as a matter of law” reference to the conditional nature of the obligation arising from a judicial construction rather than from an interpretation of the parties’ intentions.144 if the court could have relied on an express or implied condition as a reflection of their intentions, then the case would have been easily resolved by requiring nothing less than full performance to establish liability. but the court’s willingness to weigh factors, including reasons why a claim might go unfiled, suggests that the court instead contemplated a need to construct a condition for the promise to pay. yet the court’s consideration of those reasons also indicates how, without a filed claim, the liability remained conditional insofar as considerations of equity made the court unwilling to find that substantial performance had occurred to satisfy the condition. in contrast, the service found a cooperative advertising liability enforceable as a matter of law—due to substantial performance of an underlying condition as a result of the occurrence of advertising services, which fixed the liability for purposes of the all events test—and thereby distinguishable from the liability in general dynamics.145 unfortunately, within a few years, the service became unwilling to accept substantial performance as being capable of fixing liabilities under cooperative advertising arrangements.146 in reconsidering its prior guidance, the service expressed its belief that the contract terms themselves formed the basis for the supreme court’s holding that the filing of a claim, as a matter of law, was necessary to establish the liability in general dynamics.147 the 144. see generally jacob & youngs, inc. v. kent, 129 n.e. 889, 891 (n.y. 1921) (“the question [of substantial performance] is one of degree, to be answered, . . . if the inferences are certain, by the judges of the law.”); verdi constr., inc. v. central ohio cmty. improvement corp., no. 2:07-cv-972, 2008 u.s. dist. lexis 91551, at *18 (“when the facts are undisputed, . . . whether a party’s conduct constitutes substantial performance is a question of law for the court.”). 145. see irs tech. adv. mem. 92-04-003 (oct. 2, 1991), reconsidered in irs tech. adv. mem. 93-43-006 (july 13, 1993); cf. irs tech. adv. mem. 91-43083 (aug. 1, 1991) (recognizing that a taxpayer can satisfy the all events tests through substantial performance under a contract but concluding that, after performing advertising services and prior to the submission of documentation, a taxpayer had a right to receive “partial” payment under a cooperative advertising agreement). 146. see, e.g., irs field serv. adv. 1997 fsa lexis 350 (feb. 10, 1997) (“although substantial performance under contract law in some states may establish a legal basis for recovery . . ., it does not meet the all events test for tax purposes, as defined in general dynamics. the legal theories are different.”). 147. see irs tech. adv. mem. 93-43-006 (july 13, 1993); see also irs field serv. adv. 1997 fsa lexis 350 (feb. 10, 1997) (“as ‘a matter of law,’ the supreme court was referring to the contract. the contract required the filing of a 2010] just enough: substantial performance, ministerial acts 489 service then relied on that belief to conclude that the submission of documentation was a prerequisite to fixing a liability under a cooperative advertising agreement where the terms of a written contract require the submission.148 the service thus generally took the position that contract terms for required submissions impose express or implied conditions, which courts may interpret in accordance with the intentions of contracting parties, but may not deem as being satisfied with anything less than full performance.149 insofar as such contracts contain unambiguous documentation requirements, the service envisioned few opportunities for constructing conditions and thereby foreclosed the possibility of applying the corresponding substantial performance doctrine.150 basically, under the service’s position, a right to receive, or liability to pay an amount could not become fixed if a party had not fulfilled its obligation to submit documentation as required by a contract. the service accepted the resulting implications for the all events tests as natural consequences flowing from the parties’ mutual agreement about the need for documentation, as they chose to establish pursuant to their freedom to contract.151 claim . . . . the supreme court was not allowing for the possibility of ‘substantial performance’ as creating the obligation.”). 148. see id. (“[p]ursuant to the contract between taxpayer and its customers, it is improper to accrue promotional allowances … prior to the receipt of a claim.”). 149. see irs tech. adv. mem. 94-16-004 (dec. 23, 1993) (“[t]he terms of that contract as interpreted under state law determines when the taxpayer’s liability is fixed for tax purposes . . . . consequently, the specific contract language which sets forth the parties’ rights and obligations determines the taxpayer’s liability.”). 150. see id. 151. see irs field serv. adv. 1997 fsa lexis 350 (feb. 10, 1997) (“[o]perating under its freedom of contract, [the taxpayer] set the terms of the cooperative advertising plans with retailers and that it was, in effect, the master of its offer, dictating the form and documentary requirements for reimbursement. by doing so, [the taxpayer] made the submission of certain documents a condition precedent to its own duty to perform.”). for example, the service concluded: in the instant case, taxpayer’s obligation to reimburse for advertising expenses is set forth under the terms of its contract. thus, the contract term is controlling in determining what events fix the dealer’s right to income and taxpayer’s obligation to reimburse for advertising expenses. the contract . . . provides . . . [for] reimburse[ment] if its expenditures are properly substantiated and it fulfills certain other requirements. since this requirement appears to delineate the performance required by the contract, it is no less an element of performance than any other requirement such as the mandate that the advertising fulfill the program requirements. the parties determined the provisions of the contract 490 florida tax review [vol. 10:7 but the service later changed its position again and ultimately concluded in a revenue ruling that under a cooperative advertising arrangement a liability could become fixed by the performance of required advertising services without the fulfillment of a required ministerial act, such as the submission of documentation.152 the ruling reached that conclusion without referencing the substantial performance doctrine. instead, the ruling noted the relevancy of written contract terms under the all events tests and how the performance of services, such as the promised advertising, can fix liabilities153 in accordance with the service’s general standard for applying the all events test of section 461.154 however, the ruling did not describe any conditional relationships that might exist between the promises of performance contained in a contract. the service’s changing positions on cooperative advertising resulted in an untoward departure from using the substantial performance doctrine to justify the anomaly for ministerial acts under the all events tests. when the service began asking if there had been full compliance with each requirement in determining whether a taxpayer had an unconditional right or obligation, the service appeared to reject substantial performance under a mistaken impression about the conditional relationships among the promises. the impression that the performance of each required act (e.g., a requirement to submit advertising documentation) must occur before a right or liability (e.g., an obligation to pay for advertising services) becomes fixed assumed that such performance (i.e., submission) acted as an express or implied condition of another promise (i.e., promise to pay). but that assumption is appropriate only where the parties intended that result, which is not the case where the parties merely exchanged several promises to perform as consideration in forming a bilateral contract. if the parties exchanged such promises without intending to make the performance of one promise a condition for another promise, then a court would construct a condition for the latter promise only where necessary to preserve their expectations about an exchange of performances. with respect to a cooperating advertising agreement, a court would likely consider that the parties expected to exchange the advertising services and documentation submission for the payment. to preserve that expectation and avoid a potential forfeiture of the payment, the court would likely treat the performance of services and submission of documentation as conditions to the obligation to pay, unless and there is no indication that the parties did not intend for all terms and conditions to be met. irs tech. adv. mem. 94-16-004 (dec. 23, 1993). 152. see rev. rul. 98-39, 1998-2 c.b. 198. 153. see id. at 199. 154. see supra note 122 and accompanying text. 2010] just enough: substantial performance, ministerial acts 491 the parties called for a different ordering of events. thus a constructive condition would affect the relationship between express terms of a contract. in dealing with a relationship based on a constructive condition, the service’s earlier consideration of the substantial performance doctrine supported a better reasoned analysis of those cooperative advertising arrangements. as noted above, a constructive condition would avoid a risk of forfeiture by preventing a party from having to pay for advertising services before the services and documentation are provided. the risk of forfeiture shifts, however, once the services are rendered. at that time, substantial performance of the obligations occurs and the party rendering services faces a risk of not receiving payment due to noncompliance with a submission requirement. the same notions of justice and fairness, which initially shielded one party from the risk of having to pay for services it might not receive, should then shield the other party from the risk of not being paid for the services it actually rendered. accordingly, substantial performance of the contractual obligations would be deemed to satisfy the constructive condition to the obligation to pay, and the liability to pay would become fixed despite the nonoccurrence of the ministerial act. by relying on the doctrine of substantial performance to explain the special treatment of ministerial acts, taxpayers benefit from a stronger justification for disregarding noncompliance with requirements to perform those acts in applying the all events tests. the doctrine more fully accounts for all promises in contracts and for any performance or nonperformance of those promises in determining fixed rights and liabilities for tax purposes. in accordance with the objective of the all events tests to accrue unconditional rights to receive income and liabilities to make payments, the doctrine simply recognizes that substantial performance can fix an obligation under a bilateral contract, which had been constructively conditioned on such performance. this ability to recognize substantial performance as the last event that must occur to fix rights and liabilities for purposes of the all events tests makes reliance on the doctrine more justifiable in accruing income and expense items than simply disregarding ministerial acts because they are supposedly too insignificant or too technical to affect such accruals. although the doctrine requires assessments of substantial performance through imprecise and flexible standards,155 the framework for analysis seems more structured than the current approach taken with respect to ministerial acts. the structure partially results from the more cohesive explanation provided for the relationship between substantial performance and the conditional promises, as described above, in comparison to the seemingly unexplained acceptance of the ministerial acts anomaly in the case law and the service’s rulings. applying these imprecise standards seems easier than trying to deal with the uncertainty of identifying ministerial acts 155. see supra notes 59-61 and accompanying text. 492 florida tax review [vol. 10:7 because the reasons and objectives for applying the doctrine are more clearly stated and logical. the enhanced structure also results from the more established circumstances evaluated under contract law to assess the substantiality of performance or the materiality of failure.156 the applicable standards are neither perfect nor unambiguous under the doctrine of substantial performance. however, they provide more meaningful guidance than simply asking taxpayers to distinguish something of a technical, significant, or crucial nature from items of a minor, insubstantial, or nonessential importance in bilateral contracts.157 even though the doctrine has been invoked infrequently under contract law with respect to seemingly ministerial acts158—presumably due to the high cost of litigating a claim compared to the cost of completing the required act—the general principles underlying the doctrine provide a suitable framework for determining unconditional contractual obligations relative to these acts and provide adequate support for making accruals under the all events tests. c. the broader role for substantial performance in accrual methods of accounting the substantial performance doctrine arguably impacts the all events tests more broadly than merely justifying the ministerial acts anomaly. as an initial matter, it is noteworthy that acceptance of the idea that substantial performance can fix rights and liabilities under a contract for tax purposes— such as using the doctrine to justify the anomaly for ministerial acts— 156. see supra note 62 and accompanying text. 157. see supra notes 108-16 and accompanying text. 158. see, e.g., beard family p’ship v. commercial indem. ins. co., 116 s.w.3d 839, 846-47 (tex. app. 2003) (refusing to excuse an appellant’s nonpayment, in light of the appellee’s substantial performance, where the appellant promised to make payment after the presentation of an all-bills-paid affidavit, which had not been provided); vowels v. witt, 149 cal. app. 2d 257, 262 (cal. ct. app. 1957) (holding that a contractor would be deemed to have substantially performed under a contract despite having delayed in its submission of subcontractor bills); b.f. schlesinger & sons v. kohler & chase, 103 cal. app. 195, 199-200 (cal. ct. app. 1930) (concluding that a failure to give notice did not constitute a material failure of performance); chas. t. main, inc. v. mass. tpk. auth., 196 n.e.2d 821, 829-30 (mass. 1964) (holding that a service company had a right to receive payment for services despite the failure of a utility company to submit a bill, which affected the company’s payment by $12.61 out of more than $1,180,000 of total earned compensation); in re sandman assocs., l.l.c., 251 b.r. 473, 482-83 (bankr. w.d. va. 2000) (deeming a failure to sign an operating agreement, as required by a contract to acquire a membership interest in a limited liability company, as an immaterial breach of the contract under which substantial performance occurred). 2010] just enough: substantial performance, ministerial acts 493 provides indirect support for a conclusion that the all events tests must account for constructive conditions.159 that support results from the fact that substantial performance can only excuse the nonoccurrence of an event that serves as a constructive condition to a performance obligation.160 but more importantly with respect to the discussion in this article, nothing in the tax law suggests that considerations of the substantial performance doctrine must be confined to the nonessential, noncritical, or technical requirements of contracts. instead, the doctrine seems equally relevant in accruing income and expense items as a result of the substantial performance of primary contractual obligations (e.g., substantial performance of a promise to render services under a contract for services or a promise to deliver goods under a contract for a sale of goods). the need to recognize the doctrine, outside the ministerial acts context, seems partially compelled by references in existing authorities and guidance to substantial performance relative to income and expense accruals for primary contractual obligations. for example, courts and the service have often determined when sales of property have taken place for tax purposes by considering various factors, including whether substantial performance has occurred with respect to any conditions precedent.161 such determinations are important under an accrual method of accounting because the identification of when a sale takes place establishes when a seller secures a fixed right to receive payment under the sales contract for purposes of the all 159. see supra note 127 and accompanying text. 160. see supra notes 44-47 and accompanying text. 161. see, e.g., commissioner v. segall, 114 f.2d 706, 710 (6th cir. 1940) (noting that substantial performance constitutes a factor taken into account in determining when a sale is consummated for tax purposes); bradford v. united states, 444 f.2d 1133, 1143 (ct. cl. 1971) (describing how the substantial performance of conditions precedent, where payment of the purchase price was the only unfulfilled promise under a contract, created an unconditional obligation on a buyer to purchase property and permitted the buyer to acquire the benefits and burdens of ownership); int’l paper co. v. united states, 33 fed. cl. 384, 394 (1995) (citing bradford with approval in distinguishing a “contract of sale” from a “contract for sale”); harmston v. commissioner, 61 t.c. 216, 228 (1973) (quoting the description about the relevance of substantial performance from segall); irs tech. adv. mem. 80-40-015 (june 27, 1980) (same); irs priv. ltr. rul. 87-18-003 (jan. 7, 1987) (highlighting the occurrence of substantial performance of conditions precedent as a relevant factor in determining whether a purchaser has an unconditional obligation to pay in a sale transaction); irs field serv. adv. 1997 fsa lexis 713 (dec. 16, 1997) (same); see also irs gen. couns. mem. 33,966 (nov. 13, 1968) (concluding that substantial performance of conditions precedent could make a stock subscription contract absolute and establish a documentary stamp tax liability). 494 florida tax review [vol. 10:7 events test of section 451.162 although neither the courts nor the service has elaborated about the connection between substantial performance and the occurrence of a sale, they have emphasized that substantial performance constitutes just one factor considered as part of the analysis.163 these references at least acknowledge the general relevancy of substantial performance in determining when to recognize income (and presumably expenses) under the all events tests. more significantly, in a few instances, the tax court and the service have directly focused on substantial performance of primary contractual obligations in applying the all events tests. for example, the substantial performance doctrine most prominently impacted the decision in levert v. commissioner.164 in that case, the taxpayers entered into contracts to receive services, which were performed in years after years during which the taxpayers entered into the contracts.165 the taxpayers, using an accrual method of accounting, attempted to deduct the costs of the services for the taxable year during which the taxpayers entered into the contracts whereas the service argued that the costs were not deductible until the years during which the services were completed.166 the tax court, relying on a constructive condition, agreed with the service and held that the taxpayers lacked fixed liabilities to pay for the services when they entered into the contracts.167 but in describing when the obligations became fixed, the court noticeably contemplated applying the all events tests with due regard for substantial performance and material failures of performance: 162. see hallmark cards, inc. v. commissioner, 90 t.c. 26, 32 (1988) (“the objective is to determine at what point in time the seller acquired an unconditional right to receive payment under the contract.”). 163. see id. (noting that no one factor controls in determining when a sale takes place). but cf. steiner v. commissioner, t.c. memo 1995-122, 69 t.c.m. (cch) 2176, 2194 (1995) (“what may be fairly regarded as ministerial when an accrual basis taxpayer is required to determine—or to estimate—how much income to recognize, often well in advance of any right to present possession of the income, may be far different from what is ministerial when a small shift in amount of corporate income affects whether or not the taxpayer becomes the owner of stock.”). 164. t.c. memo 1989-333, 57 t.c.m. (cch) 910 (1989), aff’d by court order, 956 f.2d 264 (5th cir. 1992). 165. see id. at 916. 166. see id. 167. see id. 916-17. in support of its holding, the court relied on a quote from levin v. commissioner, 219 f.2d 588 (3d cir. 1955), about the conditional nature of performance obligations due to unsatisfied constructive conditions. see levert, 57 t.c.m. (cch) at 917 (quoting levin, 219 f.2d at 589). the service later relied on the lower court opinion in levin to support its denial of deductions for costs attributable to bilateral contractual arrangements prior to an obligee’s performance of the promised services. see rev. rul. 2007-3, 2007-1 c.b. 350. 2010] just enough: substantial performance, ministerial acts 495 [the taxpayers] did not become unconditionally liable for the full amounts of the contract prices until the contractor[s] completed, at least in substantial part, [their] duties under the contracts. until that time, the possibility remained that a “material failure” of performance would excuse [the taxpayers’] refusal to pay. . . . we find that the parties contemplated significant performance by the contractor[s] prior to the time [the taxpayers] were required to make full payment of the contract prices. . . . . . . while there is some evidence that minimal [required services] may have occurred . . . later . . ., we find that [the required services] were completed in the years following [the] execution [of the contracts] and that the contractor[s] substantially performed [their] obligations under both contracts in those years.168 with respect to the cost of the acquired services, the court accordingly found a deduction appropriate for the year during which the contractors had substantially performed the promised services.169 levert clearly expresses the idea that substantial performance of a primary contractual obligation is sufficient to establish an unconditional right to receive and liability to make payment for that performance under the all events tests. the idea is not surprising insofar as one might expect the means for distinguishing between conditional and unconditional rights and liabilities for tax purposes to correspond with the role of substantial performance in distinguishing between legally enforceable and unenforceable obligations for contact law purposes. accordingly, the service has relied on levert to deny deductions for the cost of unperformed services due to the possibility that a “‘material failure’ of performance could excuse the taxpayer from fulfilling its obligations [to pay] under the terms of the contract”170 and the tax court has relied on levert to deny a deduction for the cost of moving services under an agreement with “c.o.d.” payment terms due to the legally contingent nature of the obligation prior to delivery 168. levert, 57 t.c.m. (cch) at 917. 169. see id. 170. irs field serv. adv., 1997 fsa lexis 577 (apr. 3, 1997). asking whether a material failure of performance has occurred involves the same considerations as asking whether substantial performance has occurred. see supra note 58 and accompanying text. 496 florida tax review [vol. 10:7 of the goods.171 although these few instances in which levert has been followed only involved situations where substantial performance had not occurred by year end, their approach strongly suggests that the occurrence of substantial performance would simultaneously establish enforceable obligations under contract law and fixed rights/liabilities under the tax law. thus, a taxpayer would properly accrue an expense item under a contract for services, for example, when notions of equity shift from creating a constructive condition—as protection for the taxpayer against a risk of having to pay if the services were not forthcoming—to expecting the taxpayer to perform as promised—as a result of the other party’s substantial performance of the services.172 the prospect of accruing items upon the substantial performance of primary contractual obligations would also nicely complement a rationale used to reject tax deductions for promises to pay in executory contracts, despite any potential liability for breach. generally, a loss deduction cannot be claimed for anticipated damages that might arise from a breach of contract claim because the loss is not certain to occur even if the events that caused the breach have already happened.173 nevertheless, taxpayers have occasionally asserted that deductions were proper for the amounts they promised to pay under executory contracts, for the years during which they entered into those contracts, in anticipation that the taxpayers could be held liable for breach if they fail to make the payments.174 the courts have rejected those deductions because any liability for damages remains contingent until a breach occurs.175 the courts further explained that no such breach could occur for a promise to pay that remains subject to an unsatisfied condition precedent, and that the unfulfilled performances contemplated by executory contracts usually represent the unsatisfied constructive conditions to those promises to pay.176 for example, a constructive condition would generally keep a promise to pay for future services from becoming due as long as the contract remained executory.177 so no breach could occur with 171. see halle v. commissioner, t.c. memo 1996-116, 71 t.c.m. (cch) 2377, 2385-86 (1996). 172. see supra notes 49-52 and accompanying text. 173. see lucas v. am. code co., 280 u.s. 445, 450 (1930) (noting the lack of certainty insofar as a harmed party might forgive the breach or refrain from prosecuting a claim or a taxpayer’s possible success in defending against a claim of breach). 174. see, e.g., hallack & howard lumber co. v. commissioner, 18 b.t.a. 954, 957-58 (1930). 175. see, e.g., levin v. commissioner, 219 f.2d 588, 589 (3d cir. 1955). 176. see, e.g., id. 177. see supra note 29 and accompanying text. 2010] just enough: substantial performance, ministerial acts 497 respect to the promise to pay,178 and consistent with the courts’ rationale, no deduction could be claimed for the payment before the rendering of the promised services.179 an accrual resulting from substantial performance would logically follow from this rationale expressed by the courts in denying deductions for amounts payable under executory contracts. upon substantial performance of the services in the above example, the promise to pay would become unconditional and—although a claim of breach might arise for nonpayment—the liability to pay the promised amount would become fixed for tax purposes.180 accruals triggered by substantial performance would accordingly complement the denials of deductions for anticipated damages. in particular, if unsatisfied conditions served as the basis for keeping taxpayers from claiming deductions for amounts payable under executory contracts, then the satisfaction of those conditions through substantial performance must logically trigger accruals for the promised payments that had been subject to those conditions. these considerations of substantial performance suggest that fixed rights and liabilities align rather closely with legally enforceable obligations. in the past, courts have refused to equate fixed rights/liabilities with legally enforceable obligations in order to require accruals for certain legally unenforceable obligations.181 their refusals, however, do not mean that the all events tests cannot require recognition of legally unconditional obligations. to the contrary, the concept of recognizing legally unconditional obligations appears very consistent with the objectives of the all events tests. in fact, it would be hard to construe the all events tests in a way that would deny the establishment of a right to receive or the fact of liability under a contract in which such right or liability is legally unconditional as a result of substantial performance. nevertheless, despite the theoretical soundness of accounting for substantial performance, these considerations might create considerable practical issues in applying the all events tests. in particular, substantial performance could result from any deficient performance, regardless of 178. see supra note 8 and accompanying text. 179. see hallack & howard lumber, 18 b.t.a. at 958 (“we think no liability was incurred by the petitioner under its contract [for services] with allen until . . . allen commenced his performance.”). 180. note that any damages payable under a breach of contract claim might differ from the amount payable under the terms of the contract. see levin, 219 f.2d at 589; hallack & howard lumber, 18 b.t.a. at 958. 181. see, e.g., flamingo resorts, inc. v. united states, 664 f.2d 1387, 1390 (9th cir. 1982) (concluding that an inability to enforce the collection of gambling markers in court did not prevent a casino from having a fixed right to receive income). 498 florida tax review [vol. 10:7 whether it is nonconforming or incomplete.182 therefore, a taxpayer would need to ask if sufficient performance had occurred to justify treating contractual rights and obligations as unconditional irrespective of the likelihood of any cure of the deficient performance or the simple completion of the promise after year end. as a result, the all events tests would call for assessments at year end of whether enough performance has occurred to make any primary contractual obligations legally unconditional and to require corresponding accruals for income and expense items. with respect to a typical contract for services, for example, a taxpayer might then expect to accrue any income and expense items at some point—determined under equitable notions—after the execution of the contract but before the completion of the promised services. despite the impracticality of making this determination, it seems necessary under a method that focuses on fixed rights and liabilities unless one could somehow conclude that only full performance could represent an event that could fix a right or liability. the all events tests therefore seem to require accruals for certain primary contractual obligations prior to the completion of performance even though determinations of taxable income would depend on fluid concepts like fairness. the tests would otherwise: (1) lose meaning if they disregarded substantial performance, which makes obligations legally enforceable, as an event that could fix rights and liabilities, (2) struggle to justify the ministerial act anomaly without relying on substantial performance,183 and (3) create an 182. see houchin v. commissioner, t.c. memo 2006-118, 91 t.c.m. (cch) 1248, 1251 (2006) (concluding that a right to income became fixed upon the effective date of a settlement agreement despite the contemplated later delivery of a payment in exchange for the compromise and satisfaction of the taxpayers’ counterclaims in a lawsuit). 183. without explaining its understanding of the all events tests in terms of constructive conditions and substantial performance, the service appears to have relied on these contract law doctrines in applying the tests: where the [t]axpayer’s liability is set forth in a written contract, the terms of that contract as interpreted under state law determine when the taxpayer’s liability is fixed for tax purposes. consequently, the specific contract language which sets forth the parties’ rights and obligations determines the taxpayer’s liability. however, if the taxpayer is able to clearly demonstrate that under applicable state law a specific term of the contract which is not satisfied by year-end would be ignored by the courts and all other terms of the contract would be enforced despite noncompliance with that term, the liability under the contract will be fixed by year-end. irs tech. adv. mem. 95-22-003 (june 2, 1995) (citations omitted). the service supported the last sentence of this quote by citing, without explanation, micromanagers, inc. v. gregory, 434 n.w.2d 97 (wis. ct. app. 1988), which applied the 2010] just enough: substantial performance, ministerial acts 499 inconsistency to the extent that the tests have relied on constructive conditions, developed through concepts of fairness, to defer income and expense recognition under executory contracts.184 accordingly, the all events tests appear to require accruals for a contractual obligation, which had been subject to a constructive condition, when the occurrence of substantial performance has made it “fair” to expect the obligation to be fulfilled as promised. i. should the all events tests account for substantial performance? irrespective of how well the doctrine of substantial performance justifies the treatment of ministerial acts and how well the doctrine fits with the all events tests generally, a fundamental question arises about whether the all events tests should account for substantial performance. the doctrine, which originated to resolve contractual disputes, brings complexity and uncertainty to the tax system insofar as it relies on flexible and imprecise standards to determine unconditional contractual obligations. despite these undesirable traits, it nevertheless seems preferable—if not necessary—to account for substantial performance in applying the all events tests to the extent those tests also take constructive conditions into account.185 the difficulty of applying uncertain standards in assessing the substantiality of performance definitely weighs against incorporating the doctrine into the all events tests. one could attribute the difficulty, which such factually-intensive assessments would bring to the all events tests, to the fact that the doctrine originated to resolve disputes under contract law. the doctrine, which a court would invoke to determine the fairness of enforcing a promise in a single contract, might appear ill-suited for the task of routinely assessing all of a taxpayer’s fixed rights and liabilities at year end.186 thus, the reasonableness of making an inquiry relative to a single substantial performance doctrine in upholding a defendant’s liability to pay for services rendered by a plaintiff in developing computer software. 184. see supra note 127. 185. see walberg, supra note 127, at 468-73 (expressing a preference for making only express and implied conditions relevant in applying the all events tests). 186. see, e.g., travis v. commissioner, 406 f.2d 987, 989-90 (6th cir. 1969) (rejecting an argument that a fixed “right to receive income” was “intended to equate that phrase in all respects with ‘a legally enforceable right to receive income’” due, in part, to “so many practical problems which would be engendered in tax cases” with such an interpretation); cf. e.e. black, ltd. v. alsup, 211 f.2d 879, 880 (9th cir. 1954) (applying a plain meaning to a “finally completed and accepted” reference in prior regulations governing the completed contract method and rejecting the tax court’s interpretation of the reference, which had accounted for substantial 500 florida tax review [vol. 10:7 dispute might not readily extend to a comprehensive analysis of all outstanding promises of performance at year end. in addition, the use of a doctrine designed to identify which party to charge with the first material failure of performance conceptually seems at odds with the objective of accruing income and expense items for promises that contracting parties presumably intend to keep. the all events tests accordingly would require difficult analyses if they asked a taxpayer to determine, based on performance occurring by year end, the legal enforceability of individual obligations in a contract that the taxpayer might reasonably expect to see eventually satisfied through full performance. however, the difficulty of applying the doctrine in accruing income and expense items cannot overcome its usefulness in providing a coherent explanation about what items to accrue. the tax system benefits from operating with clearly articulated principles and avoiding seemingly arbitrary approaches. the doctrine of substantial performance, although possibly difficult to apply, supplies a reasonable and consistent explanation about when tax accruals are appropriate for items about which the tax treatment might otherwise appear unjustifiable or haphazard. for example, as discussed above, a general willingness to disregard ministerial acts seems like a true anomaly in applying the all events tests187 unless one considers the substantiality of other performances under a contract.188 similarly, one might question what principles should apply in determining whether a taxpayer has a fixed right to income from a sale of goods if the taxpayer unknowingly delivers defective goods (e.g., a taxpayer promises to convey 100 widgets, but delivers 99 operable units and 1 damaged unit to fulfill its promise).189 it becomes difficult to explain how the all events test could apply to that sale, given that the taxpayer failed to perform fully as promised, without considerations of substantial performance. finally, if a taxpayer were to identify an obligation that became legally enforceable as a result of substantial performance, the tax system would appear fairly arbitrary unless that unconditional obligation was also regarded as fixed for tax purposes. the doctrine of substantial performance thus provides a useful explanation about how the tax system can consistently account for many items, like those mentioned in these examples. the difficult task of assessing the substantiality of performance arguably would merely replace existing problems in dealing with uncertain completion, as “import[ing] into the tax law an unwarranted and undesirable uncertainty”). 187. see supra part iii.a. 188. see supra part iii.b. 189. see rev. rul. 2003-10, 2003-1 c.b. 288 (requesting comments on the application of the all events test of § 451 to accrue income from shipments of defective goods where a customer discovers the defect in a later taxable year). 2010] just enough: substantial performance, ministerial acts 501 tax accruals without adding complexity to the tax system. existing authority and guidance create uncertainty about how a taxpayer should account for ministerial acts and defective performance, for example, which fosters confusion and controversy and makes the tax system difficult to administer. for instance, in applying existing case law and service guidance, a taxpayer would face considerable uncertainty in simply deciding what acts to deem as being ministerial in nature for purposes of the all events tests.190 considerations of substantial performance could minimize this uncertainty and make the tax system easier to administer by offering a single doctrine that could consistently apply to many tax accruals. the application of the doctrine, however, requires some effort and creates its own uncertainty by relying on imprecise standards. it seems reasonable to conclude therefore that the burdens of applying the doctrine under the all events tests would offset the benefits realized in the tax system from having a consistent and meaningful justification for tax accruals. in any case, the all events tests might already require considerations of substantial performance even though courts have refused to equate fixed rights and liabilities with legally enforceable obligations and the doctrine has not been formally incorporated into the tests. in rejecting legal enforceability as the standard for accruing income and expense items, the courts have determined fixed rights and liabilities by making inquiries about a “reasonable expectancy” of performance191 through a pragmatic approach192 of viewing a transaction “as a whole and in the light of realism and practicality.”193 it becomes difficult to conceive of how one might apply the all events tests without having a party’s substantial performance of contractual obligations influence any reasonable expectations about future performance. the realistic and practical implications of an immaterial failure of performance presumably would not preclude the deemed satisfaction of a condition precedent for tax purposes, particularly in light of the general willingness of courts to disregard the nonperformance of ministerial acts. 190. see, e.g., united states v. general dynamics corp., 481 u.s. 239, 244 n.4 (1987) (refusing to challenge the characterization of processing a claim form as a ministerial act but concluding that the filing of the claim did not represent a ministerial act). 191. see flamingo resort, inc. v. united states, 664 f.2d 1387, 1389 (9th cir. 1982) (requiring an accrual for income from pit markers despite “certain speculative and potential legal objections to payment” that gamblers could make because courts would not enforce those gambling debts); barker v. magruder, 95 f.2d 122, 124-25 (d.c. cir. 1938) (applying similar reasoning to usurious interest). 192. see general dynamics, 481 u.s. at 251 (o’connor, j., dissenting) (recognizing the pragmatic origin of determining fixed liabilities under the all events test of § 461). 193. travis, 406 f.2d at 990 (6th cir. 1969) (quoting commissioner v. segall, 114 f.2d 706, 709 (6th cir. 1940)). 502 florida tax review [vol. 10:7 these calls for pragmatic considerations thus appear to contemplate a role for the doctrine in applying the all events tests. moreover, the doctrine could assume a more formal role if these pragmatic considerations were reframed in terms of equitable notions of fairness and justice. those equitable notions already appear to impact applications of the all events tests through the recognition of constructive conditions to otherwise seemingly unconditional obligations in bilateral contracts. as argued elsewhere, the standards applied by the service for determining fixed rights and liabilities under the all events tests depend on constructive conditions.194 for example, the service generally takes a position that an obligation to pay for services does not become fixed before such services are rendered,195 which reflects the idea that the obligation is constructively conditioned on the performance of the service consistent with the commonlyheld understanding that work precedes payment.196 because courts use the same notions of fairness and justice to determine whether substantial performance has occurred as they use to impose constructive conditions, considerations of the substantial performance doctrine would impose no greater burdens on taxpayers in determining fixed rights and liabilities than they currently face in accounting for constructive conditions. more importantly, the complementary relationship between the doctrine and constructive conditions makes such recognition seem necessary to the extent that the all events tests already take constructive conditions into account. considerations of substantial performance therefore seem desirable for accruing income and expense items in a manner consistent with the principles of the all events tests. if the theoretical desirability of assessing substantial performance were to conflict too severely with the practical difficulty of making the assessment, then the service should provide simplified means for identifying fixed rights and liabilities. the service might consider issuing guidance as an exercise of administrative grace that provides simplifying conventions or safe-harbor methods, which comprehensively address constructive conditions and substantial performance, to ease tax compliance efforts, particularly through automated systems. however, the doctrine of substantial performance justifies accruals of income and expense items so well that courts and the service should not reject the doctrine as being incompatible with the all events tests. 194. see walberg, supra note 127, at 463-68. 195. see, e.g., rev. rul. 2007-3, 2007-1 c.b. 350, 351; irs chief couns. adv. 2007-26-023 (may 25, 2007). 196. see supra 124-27 and accompanying text. 2010] just enough: substantial performance, ministerial acts 503 v. conclusions the doctrine of substantial performance can fill a gap in the tax law to explain why taxpayers accrue income and expense items under bilateral contracts prior to the full performance of all promises. in particular, the doctrine facilitates a determination of taxable income without having to resort to a practice of disregarding certain unfulfilled contractual requirements, such the nonperformance of ministerial acts, in assessing whether all events have occurred to fix rights and liabilities. accruals for such rights and liabilities are often deferred because the rights and liabilities remain subject to unsatisfied constructive conditions. but the substantial performance of contractual promises results in the deemed satisfaction of those conditions, which justifies accruals insofar as such performance represents the last event necessary to fix those rights and liabilities. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 15 2014 number 3 optional basis adjustments under subchapter k: trap for the unwary, tax planning tool, or both? should they be mandatory? by philip f. postlewaite* i. introduction ........................................... 106 ii. optional adjustment to basis of partnership property on transfer of a partnership interest section 743(b).... 108 a. outlining the problem section 743...... ........... 108 b. legislative history of the bases adjustments ...... ..... 113 c. election under section 754......... ................. 115 d. operation ofadjustment to basis ofpartnership properties in general.......................... 116 e. effect of partnership liabilities .................... 117 f. section 704(c) allocation for contributed property.............. 118 g. operation ofadjustment to basis ofpartnership properties.... 120 1. calculation in determining items ofincome, gain, or loss .............................. 120 2. depreciation ................................... 121 3. amortization ............................... 122 h. other transfers of a partnership interest ....... ......... 122 i. on death of partner. ...................... ...... 124 j. mandatory adjustment to basis under section 743(b).......... 125 iii. allocating optional basis adjustment under section 743(b) to specific partnership properties ...... ........ 126 a. allocating the optional adjustment amount section 755...... 126 b. the regulations. ......................... ...... 127 * professor of law and director of the tax program at northwestern university. a special thank you is due the chattanooga tax practitioners group that in october 2012 requested a presentation on the §§ 743(b) and 734(b) basis adjustments. that opportunity and a number of drafts led to this article. i also thank gabriela olteanu for her research assistance and david cameron, jeff kwall, and bob wootton for their insightful comments. any errors, of course, are exclusively those of the author. finally, the support from the northwestern university school of law faculty research program is thankfully acknowledged. 105 florida tax review 1. allocation between two classes ofproperty.................. 128 2. allocation to property within a class.... ......... 129 iv. optional adjustment to basis of undistributed partnership property section 734(b) . ............. 130 a. reason for optional adjustment to basis ofpartnership property following certain distributions ..... ........ 130 b. analysis of section 734(b)................... ..... 1 32 1. recognition of gain or loss......................... 133 2. basis ofdistributed property........... ......... 133 3. illustration ....................... ......... ......... 134 4. depreciation and amortization .................. 135 c. some difficulties in the operation of section 734(b) ............ 135 d. mandatory application of section 734(b).... .............. 138 v. allocation of section 734(b) basis adjustment among undistributed partnership properties ....... ......... 140 vi. section 732(d) safety valve for transferee partner if no section 754 election to adjust basis......143 a. the conditions and method of section 732(d)....................... 143 b. basis of the distributed property........... .............. 145 c. distribution of unadjusted property .................... 146 d. application ofsection 732(d) by requirement of commissioner. ................................ 146 vii. traps for the unwary and tax planning opportunities ........................................... 147 viii. analysis of arguments supporting the elective aspect of the basis adjustments of sections 734(b) and 743(b) .................................. ............. 149 ix. reasons for making the sections 734(b) and 743(b) basis adjustments mandatory. ............... ............... 151 x. conclusion ...................................... ....... 154 i. introduction the optional basis adjustments of subchapter k have occupied a prominent position in tax planning and partnership operations for the past 60 years. in the dispositional context, the general approach of the code to the taxation of partnerships and their partners treats the partnership as an entity, separate and distinct from its partners. thus, if a partner disposes of his partnership interest by sale to a third party, no adjustment or modification of the bases of the assets of the partnership occurs. such is the case even though ownership of the partnership has been altered and the purchase price for the interest reflects the fair market value of the partner's underlying share of the partnership assets. similarly, if a partner's interest is liquidated by the 106 [vol. 15:3 optional basis adjustments under subchapter k partnership, although the value of the distributed assets equals that of the relinquished partnership interest, the bases of the partnership's remaining assets are unaffected. thus, in the case of a disposition by sale or liquidation for cash of an appreciated partnership interest, although the seller/distributee is taxed on the gain, without a basis adjustment, the purchaser or the remaining partners will be taxed on the same gain when realized by the partnership. in a similar fashion, for a depreciated partnership interest, a "duplication of loss" will arise, i.e., at both the partner and the partnership level. by affording the purchaser and/or the remaining partners an elective basis adjustment in such settings, congress has permitted the impacted parties to switch to an aggregate treatment of the enterprise and generate basis adjustments for the assets of the partnership. through the adjustment, the aggregate inside basis of the partnership's assets generally will equal the aggregate outside basis for the partnership interests. as a consequence, the duplication of gains and losses from a tax policy standpoint is minimized, if not eliminated. as with all elective provisions, the basis adjustment option, to some extent, permits taxpayers with full information to effectuate win-win situations. if the adjustment produces beneficial results, i.e., elimination of additional income recognition and possible increased depreciation and amortization deductions, the election will be made and "double taxation" avoided. should an election prove disadvantageous, i.e., the elimination of additional loss availability and possible decreased depreciation and amortization deductions, the parties will refrain from doing so and loss duplication will ensue. after 60 years, the rationale for the continuation of the election should be scrutinized and assessed from a tax policy standpoint. whatever the wisdom behind such elective provisions when enacted in 1954, their existence should be revisited in the modern context and a determination made as to whether that rationale continues today. in light of the recent regulatory and legislative tinkering with the election, the question presented is whether the basis adjustment provisions should be mandatory in all cases involving the disposition of a partnership interest by sale or exchange as well as by partial or complete liquidation. this article is divided into ten parts. in part ii, the purpose and application of the section 743(b) basis adjustment is examined. the adjustment, if elected, generally applies to the transfer of a partnership interest by sale or exchange or by death. part iii discusses the rules governing the allocation of the overall section 743(b) adjustment to the transferee's share of the assets of the partnership. in part iv, the purpose and application of the section 734(b) basis adjustment is considered. such adjustments generally arise on the distribution of partnership assets to a partner in the process of reducing his or 2014] 107 florida tax review her interest in the enterprise. part v explores the rules governing the allocation of such an adjustment to the retained assets of the partnership. part vi examines the elective basis adjustment of section 732(d). that provision attempts, under specified circumstances, to afford a distributee partner the same results which the section 743(b) basis adjustment would have provided had the partnership elected under section 754. part vii assesses the tax planning possibilities as well as the traps for the unwary in making or failing to make the election for basis adjustments. in certain settings, "double taxation" may ensue if the partnership does not elect. in others, duplicate losses may arise. parts viii and ix consider the case for and the case against continuing the elective aspects of these basis adjustments. the article concludes that the elective aspect of basis adjustments conflicts with sound tax policy principles and calls for legislative amendments eliminating the election and mandating such adjustments in all cases. ii. optional adjustment to basis of partnership property on transfer of a partnership interest section 743(b) a. outlining the problem section 743 the equivalence of inside basis (the overall basis of the partnership's assets) and outside basis (the overall basis for the partners' partnership interests) in subchapter k is fundamental to its structure. it ensures that income earned through a partnership is taxed once, and only once. for 1. the scope of the proposal is focused exclusively on a statutory amendment to mandate the sections 734(b) and 743(b) basis adjustments in all cases (accompanied by the repeal of section 732(d)). a similar proposal was advanced almost 30 years ago as part of a comprehensive response to the ali subchapter k study. see philip f. postlewaite, thomas e. dutton, & kurt r. magette, a critique of the ali's federal income tax project subchapter k: proposals on the taxation of partners, 75 geo. l.j. 423 (1986). given the snail's pace of tax reform, that call for the mandatory application of sections 734(b) and 743(b) is renewed. there has been commentary about section 734(b) adjustments and their imperfections. see howard e. abrams, the section 734(b) basis adjustment needs repair, 57 tax law. 343 (2004); karen c. burke, repairing inside basis adjustments, 58 tax law. 639 (2005). however, many of those problems stem from another defect in the current regime of partnership taxation, i.e., the allowance of non-recognition for property distributions by a partnership (another topic which was addressed previously and which would not arise if that proposal were adopted and the non-recognition rules for property distributions modified). see postlewaite et al., supra at 470. the non-recognition issue on property distributions and the imperfections of the allocation rules for section 734(b) basis adjustments is left for another day. 108 [vol. 15:3 optional basis adjustments under subchapter k example, assume that a, b, and c are equal partners and in year i each contributes $6,000 to partnership abc, which purchases inventory and capital asset for $9,000 and $6,000 respectively. the tax balance sheet documents the equivalence of inside and outside basis: assets: basis capital: basis cash $ 3,000 a $ 6,000 inventory 9,000 b 6,000 capital asset 6,000 c 6,000 total $18,000 total $18,000 this equivalence continues even with an appreciation or depreciation in value of the assets over time. for example, assume in year 2 that the assets increase in value to $18,000 for inventory and $12,000 for capital asset. the tax balance sheet appears as follows: assets: adjusted fair market capital: adjusted fair market basis value basis value cash $ 3,000 $ 3,000 a $ 6,000 $11,000 inventory 9,000 18,000 b 6,000 11,000 capital asset _,000 _1200 c 6000 _11,000 total $18,000 $33,000 total $18,000 $33,000 additionally, the equivalence continues even though the partnership's activity generates income or loss. assume in year 3 that the assets are sold, yielding income to the partnership of $9,000 attributable to inventory and $6,000 attributable to capital asset, which is allocated to the partners equally, i.e., $5,000 per partner. under subchapter k, each partner is taxed on his share of the income, and the basis for each partner in his partnership interest increases accordingly. at the end of year 3, the tax balance sheet reveals the equivalence of inside and outside basis: assets: adjusted fair capital: adjusted fair basis market basis market value value cash $3300 $330_00 a $11,000 $11,000 total $33,000 $33,000 b 11,000 11,000 c 1100 11000 total $33,000 $33,000 in contrast to much of subchapter k, which maintains basis equivalence, the general rule for sales or exchanges of partnership interests results in an imbalance. under section 743(a), the basis for the partnership's assets is unaffected by the sale or exchange of a partnership interest. thus, if at the end of year 2 c sells her interest to d for $11,000, a gain of $5,000 2014] 109 florida tax review will be recognized by c, i.e., the increased value of her partnership interest attributable to her share of the assets' appreciation. however, due to the failure of section 743(a) to adjust the basis of the partnership's assets (as shown in the balance sheet for the close of year 2 above), inside and outside basis will differ. assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 3,000 $ 3,000 a $ 6,000 $11,000 inventory 9,000 18,000 b 6,000 11,000 capital asset 6 1 d _ll_00 11000 total $18,000 $33,000 total $23,000 $33,000 as a result of the failure to adjust, not only does c recognize $5,000 of income on the sale of her partnership interest, but d will have similar treatment upon the sale of the assets due to his reporting of his share of the partnership's income as earned, resulting in what appears to be "double taxation." when sold in year 3, the assets generate $15,000 of gain, allocable equally, i.e., $5,000, to each partner, a, b, and d. thereafter, the partnership's tax balance sheet will reflect a disparity between inside and outside basis. assets: adjusted fair capital: adjusted fair basis market basis market value value cash $330 $;3000 a $11,000 $11,000 total $33,000 $33,000 b 11,000 11,000 d 16_00 1100 total $38,000 $33,000 thus, the imbalance remains even after the sale of the assets, and d will be made "whole" at best upon the sale or liquidation of her interest, which would generate an offsetting $5,000 loss. fortunately, the code provides for adjustments to the basis of partnership property as the result of a sale or exchange of such an interest or the transfer of a partnership interest on the death of a partner if an election is in effect.2 without such an election, the purchaser typically has a basis for that interest which differs from the purchasing partner's share of the bases of the partnership's assets. as illustrated above, such-disparities can lead to income tax consequences for the acquiring partner with respect to the pre2. i.r.c. §§ 754 and 743(b); reg. § 1.743-1(a). see generally 1 arthur b. willis & philip f. postlewaite, partnership taxation, 1 12 (7th ed. 2011) [hereinafter willis & postlewaite, partnership taxation]. 110 [vol. 15:3 optional basis adjustments under subchapter k acquisition appreciation or depreciation of the partnership's assets. with an election in effect, the basis adjustment is intended to eliminate most, if not all, of these consequences. consider again the sale to d of c's interest in partnership abc for $11,000. on the date of the sale, the balance sheet of the partnership is as follows: assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 3,000 $ 3,000 a $ 6,000 $11,000 inventory 9,000 18,000 b 6,000 11,000 capital asset 6,000 10 c _6,)( 11,00 total $18,000 $33,000 total $18,000 $33,000 c's one-third interest in the partnership's assets at the date of sale is: assets: adjusted fair market basis value cash $1,000 $ 1,000 inventory 3,000 6,000 capital asset 2 4,000 total $6,000 $11,000 if the basis of the partnership property is not adjusted to reflect the sale to d, partnership bcd will have $9,000 of income if it sells inventory and a $6,000 gain if it sells capital asset. d's distributive share of the income from the sale of the inventory will be $3,000, and her distributive share of the gain from capital asset will be $2,000. this treatment will be unfair to d, because she purchased a partnership interest based on one-third of the market values of inventory and capital asset. she should not recognize taxable gain on the partnership's sale of those items at the values upon which she determined the purchase price for her interest. furthermore, c already paid tax on the gain attributable to those assets when she sold her interest to d, i.e., amount realized ($11,000) decreased by adjusted basis ($6,000) for a resulting gain of $5,000. to tax the gain again suggests that the fisc has extracted two pounds of flesh rather than one.4 3. i.r.c. § 743(b). 4. importantly, the absence of the section 743(b) adjustment will not lead to actual "double taxation." in the example, assuming no subsequent appreciation or depreciation in value, d ultimately would offset her distributive share of the partnership's income attributable to pre-acquisition appreciation with the tax loss she would have on the subsequent sale or liquidation of the partnership interest. under section 705(a)(1)(a), the basis for d's interest increases to $16,000 ($11,000 purchase price plus $5,000 of income) as partnership bcd recognizes income on the 111 florida tax review similarly, an adjustment to basis would be required to avoid unfairness if c died and her partnership interest passed to d. the basis of the partnership interest in d's hands would be its fair market value at the date of c's death (or at the optional valuation date), i.e., $11,000. if d's basis of $11,000 for the interest acquired from the decedent were not reflected in the basis of the partnership's assets, an unfair result similar to that in the purchase context would ensue, again invoking the specter of double taxation. the basis adjustment seeks to avoid unfairness to d in either situation by permitting an adjustment to the basis of the partnership property to reflect the purchase price of the interest if acquired by sale or exchange or the estate tax basis if acquired by inheritance.' while unfairness to the transferee partner results in the case of a transfer of an appreciated partnership interest, a tax planning opportunity arises in the case of a transfer of a depreciated partnership interest. the transferor partner recognizes a loss on the transfer and the transferee will duplicate that loss when the assets are sold by the partnership. given the unsound tax consequences of a failure to elect the optional basis adjustments, i.e., double taxation, loss duplication, and a disparity between inside and outside basis, the question arises as to why they are elective. as illustrated, tax policy concerns warrant such ameliorative treatment. as discussed in the next section, congress recognized the soundness of such an approach. nevertheless, it refrained from mandating basis adjustments even though its failure to do so permits a disparity between inside and outside basis and imposes collateral damage on the sound tax policy operation of subchapter k. disposition of the assets. on the sale or liquidation of her interest for cash, d would recognize a $ 5,000 capital loss, her $16,000 basis less the sales proceeds of $11,000. while the dollar amount of income and loss will offset, time value considerations and characterization issues (possible ordinary income on some of the partnership's dispositions of assets and capital loss on sale) may prove disadvantageous. 5. the adjustment to the basis of partnership property affects only the acquiring partner and is available only if the partnership has made an election. reg. § 1.743-1(j)(1). in certain settings, the adjustment is mandatory. see discussion infra at part ii, j. the other partners are unaffected by the adjustment; however, subsequent distributions may precipitate consequences under section 734(b) and subsequent transfers will be subject to section 743(b). see discussion infra at part iv. the other partners' subsequent transferees or successors may be affected, because the election is ongoing and may be revoked only with the consent of the commissioner. 112 [vol. 15:3 optional basis adjustments under subchapter k b. legislative history of the bases adjustments section 754, which authorizes basis adjustments under section 743 and section 734, was enacted as part of the 1954 codification of subchapter 6 k, the first comprehensive statutory treatment of partnerships and partners. prior to 1954, the tax treatment of such enterprises and their members was regarded as "perhaps the most complicated and confused area of the tax law."7 the necessity for fundamental reform proved evident as partnership transactions became increasingly important from a revenue perspective while the judicial and statutory authority addressing them remained chaotic and inconsistent.! the principal objectives of the codification were comprehensive simplification and reformulation9 to achieve consistent and predictable tax results. section 754 owes its origin to the proposal drafted by the american bar association (aba) and american law institute (ali), which was the result of a collaborative study spanning several years.' 0 among the major problem areas identified by the proposal were current distributions, liquidations, and transfers of partnership interests by sale or by death of a partner." such events could lead to discrepancies between the basis of partnership property and the basis of partners in their partnership interests. the 1939 code did not provide for basis adjustments upon the transfer of a partnership interest or distributions of partnership assets. 12 6. s. rep. no. 83-1622, at 89 (1954). 7. comm. on taxation of partnerships, aba tax sec., program and comm. rep. 55 (1952) [hereinafter 1952 aba report]. 8. h.r. rep. no. 83-1337, at 65 (1954) ("the present statutory provisions are wholly inadequate. the published regulations, rulings, and court decisions are incomplete and frequently contradictory."). for a survey of the partnership tax rules of the 1939 code, see jacob rabkin & mark h. johnson, the partnership under the federal tax laws, 55 harv. l. rev. 909 (1942). 9. forty topics pertaining to the general revision of the internal revenue code topic 29 partnerships: hearing before the h. comm. on ways & means, 83d cong. 1369 (1953) (statement of mark h. johnson, american bar association) [hereinafter hearing, 83d cong.] ("[i]t is more important to have some set of clearlydefined rules than to have any one particular set of rules, because this is one area where clarity and certainty are more important than the end result."). see also s. rep. no. 83-1622, supra note 6. 10. the aba's 1949 recommendations initiated the ali's subsequent study on partnership taxation, which was an integral part of the massive ali project advocating the complete revision of the federal tax code. in 1952, the aba tax section adopted the ali's recommendations which were approved "in principle" at the ali's 1952 annual meeting. see 1952 aba report, supra note 7, at 55-56. 11. see 1952 aba report, supra note 7, at 56. 12. see h.r. rep. no. 83-1337, supra note 8, at 70. 2014] 113 florida tax review the aba/ali proposal generally adopted an aggregate approach by recognizing the desirability of basis adjustments in the context of distributions of partnership assets and transfers of partnership interests and recommended basis adjustments as a general rule.' 3 such adjustments would minimize the amount and timing of distortions of income and loss. however, in the interest of simplicity and flexibility and the acknowledgement that basis adjustments could lead to burdensome administrative costs, especially for large partnerships, the proposal allowed partnerships the option of electing out. 14 accordingly, upon a distribution of partnership assets or a transfer of a partnership interest, a partnership could elect to refrain from making basis adjustments. under the house bill, this approach to basis adjustments was reversed. basis for the partnership assets remained unchanged; however, if the partnership desired, it could elect to the contrary.' 5 the election for basis adjustments addressed transfers of partnership interests only, not distributions of partnership assets. 16 the house bill was highly criticized by the tax bar. the senate finance committee redrafted the partnership provisions almost in their entirety, 17 adopting the concept of elective basis adjustments both in the case of distributions of partnership property as well as in the case of transfers of partnership interests.18 in the end, congress adopted basis adjustments, but 13. see 1952 aba report, supra note 7, at 56. 14. see hearing, 83d cong., supra note 9, at 1370 (statement of mark h. johnson on behalf of the aba: "[w]e provide a series of elections based upon an 'entity' approach, which we assume would be exercised generally by the larger and more complex partnerships."). 15. see h. r. rep. no. 83-1337, supra note 8, at 70. the committee on ways and means stated in its report that "[i]t is anticipated that many partnerships will prefer not to make an election which entails the adjustment to the basis of partnership assets each time a transfer of an interest in a partnership takes place. the possible tax advantages of such an adjustment may be outweighed by the bookkeeping expenses and inconvenience." id. 16. see h. rep. no. 83-1337 supra note 8, at 68-69. 17. see paul jackson et al., the internal revenue code of 1954: partnerships, 54 colum. l. rev. 1183 (1954). 18. see s. rep. no. 83-1622, supra note 6, at 406. the committee stated that, in the context of transfers of partnership interests, "assigning this special basis largely to the transferee partner is desirable because it is more accurate than the house bill in reflecting the increase (or decrease) in basis to the partner to whom it is attributable. id. at 97. in addition, unlike the house bill which made the election irrevocable until the termination of the partnership, the senate bill "permitted the partnership to revoke the election, subject to the regulations to be prescribed by the secretary." such a case would arise where a partnership could demonstrate that the benefits of the election were outweighed by increased administrative burdens. 114 [vol. 15:3 optional basis adjustments under subchapter k concluded that basis should not be adjusted unless the partnership elects affirmatively to do so. 19 the basis adjustment provisions remained virtually unchanged for 50 years. however, dramatic changes to the section 734 and section 743 basis adjustments that impacted their electivity were enacted by congress in 2004. prior to that time, a partnership had an unconstrained right to elect, or not to elect, under section 754. a section 754 election was not required, even in cases where the resulting adjustment under section 734(b) and section 743(b) would cause a decrease to the basis of the partnership property. concerned about the potential for loss duplication, congress significantly modified section 734 and section 743 by making certain basis adjustments mandatory.20 those changes reduce the elective scope of section 754 and call into question the efficacy of continuing its electivity in all other cases. as the basis adjustments are mandatory in some cases, regardless of size or administrative burden, why not make them mandatory in all cases? c. election under section 754 the basis adjustment is specifically conditioned on the filing of an election by the partnership. the election is a prerequisite to a basis adjustment. although only the acquiring partner is affected by a section 743(b) basis adjustment, the election must be made by the partnership, not by the acquiring partner. the regulations provide that the election is "filed with the partnership return for the taxable year during which the distribution or transfer occurs."2 ' once made, it requires the application of the adjustment to all current and future transfers of partnership interests by sale, exchange, or death as well as distributions of assets in certain settings. only upon a revocation of the election, which is conditioned upon the approval of the service, can these consequences be avoided.22 however, the revocation would not be permitted when designed to avoid stepping down the basis of the partnership assets upon a transfer or a distribution. 19. h. r. rep. no. 83-1337, supra note 8, at 70. 20. as amended in 2004, section 734(b) requires a partnership without a section 754 election in effect to adjust the basis of partnership property for distributions to partners with respect to which there is a substantial basis reduction. also, section 743(b) requires a partnership without a section 754 election to adjust basis to partnership property in the event of a transfer of a partnership interest with respect to which there is a substantial built-in-loss. congress carved out an exception to mandatory basis adjustments under section 743(b) for electing investment partnerships. 21. reg. § 1.754-l(b)(1). 22. the regulations list examples of situations where a sufficient reason for revocation may exist: a change in the nature of the partnership business; a substantial 2014] 115 florida tax review d. operation of adjustment to basis of partnership properties in general returning to the balance sheet of equal partnership abc, assume in year 3 that c sells his partnership interest to d for $11,000 and recognizes gain of $5,000.23 assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 3,000 $ 3,000 a $ 6,000 $11,000 inventory 9,000 18,000 b 6,000 11,000 capital asset _6,00 1 c _6,00 110 total $18,000 $33,000 total $18,000 $33,000 the code permits an elective adjustment to the bases of the partnership's properties. this adjustment in essence reflects the difference between the purchasing partner's basis in the transferred partnership interest and his share of the partnership's adjusted bases for those properties. such a comparison may result in an overall increase in basis or an overall decrease in basis.24 in the example, c sells a one-third interest in the partnership to d for $11,000. accordingly, d's basis in the transferred partnership interest is $11,000.25 under the regulations, her section 743(b) basis adjustment equals the difference between her basis for the partnership interest and her interest in previously taxed capital increased by her share of partnership liabilities.2 6 previously taxed capital equals her share of the liquidation proceeds if all of the partnership assets were sold at fair market value ($11,000) decreased by her share of gain arising from the sale ($5,000) and increased by her share of loss ($0).27 there are no liabilities in the example. thus, d is entitled to a positive adjustment of $5,000 ($11,000 $6,000).28 increase in the assets of the partnership; a change in the character of partnership assets; and an increased frequency of retirements or shifts of partnership interests so that an increased administrative burden would result to the partnership from continuing under the election. an application for revocation will not be approved if the purpose is to avoid reducing the basis of partnership assets. see reg. § 1.754l(c)(1). 23. i.r.c. §§ 741, 75 1(a). 24. reg. § 1.743-1(b). 25. reg. § 1.743-1(c). 26. reg. § 1.743-1(d)(1). 27. reg. § 1.743-l(d)(2). 28. reg. § 1.743-1(d)(1)(i)-(iii). see also reg. § 1.743-l(d)(3), exs. (1), (2). 116 [ vol. i15: 3 optional basis adjustments under subchapter k the further allocation of the overall positive adjustment to the assets of the partnership is dependent upon another provision. 2 9 however, without more, the remedial effect of the adjustment is obvious. upon a subsequent sale of the partnership's assets generating $5,000 of gain attributable to d, the $5,000 positive adjustment would offset her share of the gain.30 e. effect of partnership liabilities a factor in determining the total basis adjustment under section 743(b) is the role of partnership liabilities. the regulations provide that the adjustment is determined by comparing the purchaser's basis for his partnership interest with his share of previously taxed capital increased by his share of the partnership's liabilities.3 1 liabilities play a double role in the determination: (1) in the calculation of the basis for the transferee partner's partnership interest and (2) as an addition to the transferee partner's share of previously taxed capital in arriving at the transferee partner's share of inside basis.32 the differential between amount (1) and amount (2) constitutes the amount of the basis adjustment. while the section 752 regulations govern liability allocations, the determination of a transferee's share of previously taxed capital utilizes a fictional sale of all of the partnership's assets for cash. 3 the formula thereunder backs out the gain or loss from such a sale and the amount remaining is the partner's share of previously taxed capital. previously taxed capital is increased by the transferee's share of the partnership's liabilities to determine the transferee's share of inside basis.34 the resulting amount is compared with the transferee's basis for his acquired partnership interest. the difference is the overall section 743(b) adjustment, which may be positive or negative. for example, assume the following balance sheet for partnership abc with $3,000 of recourse liabilities: 35 29. i.r.c. § 755; reg. §§ 1.743-1(e), 1.755-1. 30. gain or loss is determined under section 702 for all partners. thereafter, the effects for the transferee partner are offset by the section 743(b) adjustment. see reg. § 1.743-1(j). 31. reg. § 1.743-1(d)(1). 32. see reg. § 1.743-1(d)(3), ex. (1). a partner's share of liabilities is determined under section 752 and its attendant regulations. 33. reg. § 1.743-l(d)(2). 34. as the focus is on the transferee's share of income or loss, allocable amounts under section 704(b) special allocations and section 704(c) allocations of pre-contribution gain or loss are taken into account. 35. reg. §§ 1.743-1(d)(3), ex. (1), 1.743-1(d)(1)(i)-(iii). 2014] 117 florida tax review assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 3,000 $ 3,000 a $ 6,000 $11,000 inventory 9,000 18,000 b 6,000 11,000 other assets _6,00 1 c _6,00 1 total $18,000 $33,000 total $18,000 $33,000 assume that a sells her interest to d for $11,000, i.e., $10,000 plus of her share of partnership liabilities, $1,000.36 d's basis for the acquired partnership interest is his $11,000 purchase price ($10,000 cash and $1,000 share of liabilities). d's share of previously taxed capital is cash on liquidation after taking liabilities into account ($10,000) decreased by his share of gain ($5,000) which totals $5,000, further increased by his share of the partnership's liabilities ($1,000), i.e, $6,000. the comparison yields a positive section 743(b) basis adjustment of $5,000. f. section 704(c) allocation for contributed property income, gain, loss, and deduction with respect to contributed property must be allocated in such a manner as to attribute to the contributing partner the tax consequences of any pre-contribution appreciation or depreciation in the property.3 ' the regulations provide that section 704(c), including remedial allocations, is to be taken into account in determining a transferee partner's share of previously taxed capital.38 in determining the section 743(b) basis adjustment, if an election is in effect, the focus is on a determination of the transferee partner's interest in previously taxed capital, which equals the liquidation value of the interest increased by the taxable loss and decreased by the taxable gain attributable to that interest upon a hypothetical sale of the partnership's assets. the gain attributable to an interest is determined by taking section 704(c) into account.39 once determined, assuming the absence of partnership liabilities, 36. see i.r.c. § 752(d). 37. i.r.c. § 704(c). 38. reg. §§ 1.743-1(d)(1)(ii), 1.743-l(d)(1)(iii). see also reg. §§ 1.7043(a)(6)(ii), 1.704-3(a)(7). 39. the example assumes that the traditional method for taking section 704(c) into account is employed. if curative or remedial section 704(c) allocations are in effect, they must be taken into account. loss attributable to section 704(c) property is not taken into account because section 704(c)(1)(c) treats the property with regard to any partner other than the contributor as having a basis equal to fair market value. thus, upon the purchase, with regard to the transferee partner and the partnership, there is no section 704(c) allocation because basis and value on the date of the property's original contribution are deemed to be the same. 118 [vol. 15:3 optional basis adjustments under subchapter k the adjustment can be computed by comparing that figure with the adjusted basis for the acquired partnership interest. for example, assume that partnership klm has a balance sheet as follows and that an election is in effect: assets: adjusted book fair capital: adjusted book fair basis market basis market value value cash $ 5,000 $ 5,000 $ 5,000 k $13,000 $13,000 $16,000 inventory 21,000 21,000 24,000 l 13,000 13,000 16,000 land _0. 0 _13000 1,000 m 7,000 _1300 _16,qq total $33,000 $39,000 $48,000 total $33,000 $39,000 $48,000 m has a lower adjusted basis for her partnership interest than either k or l, because m contributed unimproved land to the partnership at an agreed valuation of $13,000, for which she had an adjusted basis of $7,000. if the land contributed by m is sold by the partnership for $13,000 or more, the first $6,000 of gain is allocated to m. the balance of the gain is allocated equally among the three partners. m has a capital account balance of $13,000, as do k and l. since all three partners have the same economic interest in the partnership, a purchaser would pay the same price for the interest of any of the three partners provided that a section 754 election were in effect. the only differences between m on the one hand and k and l on the other are their adjusted bases for their partnership interests and their respective shares of previously taxed capital. the amount of the adjustment varies, depending on whether the purchaser transacts with k or l (their situations are identical) or with m. where the purchase is from a partner who is subject to section 704(c), the determination of taxable gain from the hypothetical sale transaction will be affected. the following chart illustrates the calculations which must be made in such a situation. the selling partner is: korl m purchaser's adjustment basis of the partnership interest acquired: amount paid $16000 $i,000 purchaser's share of previous taxed capital: cash on liquidation $16,000 $16,000 decreased by taxable gain 3 9,00 $13,90 $2700 amount of the § 743(b) adjustment $ 3,000 $ 9,000 if either k or l sells his partnership interest, the section 704(c) allocation remains a problem to be solved in the future when the property is 2014] 119 florida tax review sold.40 if m sells her partnership interest, the effect of the section 704(c) allocation on the purchase of m's interest disappears through the adjustment. the allocation is subsumed by the basis adjustment.4 1 on selling her partnership interest, m recognizes taxable gain from the pre-contribution appreciation of the contributed property as well as her share of any postcontribution appreciation in value of the partnership property. as a result of the adjustment, the purchaser of m's interest, while technically allocated the gain resulting from the pre-contribution appreciation attributable to m, will offset that amount with the section 743(b) basis adjustment. g. operation ofadjustment to basis ofpartnership properties 1. calculation in determining items ofincome, gain, or loss the regulations provide that the adjustment is personal to the transferee.4 2 it is generally irrelevant and disregarded in the partnership's determination of its financial results.43 instead, after making these determinations, the adjustment is integrated into the transferee's distributive share; however, it has no impact on the transferee's capital account.44 for example, the sale of an asset by equal partnership abd for a gain of $9,000 would generate $3,000 of income for each partner. however, if d had a positive adjustment of $3,000 attributable to that asset, he would not be taxable on any of that gain.45 40. reg. § 1.743-1(d)(3), ex.(1). 41. reg. § 1.743-1(d)(3), ex.(2). 42. reg. § 1.743-1(j)(1). 43. reg. § 1.743-1(j)(2). 44. id. 45. reg. § 1-743-1(j)(3). as discussed above, of particular concern is the integration of section 704(c) with the adjustment. importantly, the adjustment takes section 704(c) into account. for operational purposes, a basis adjustment does not merely reduce or eliminate a partner's share of gain recognized on the subsequent disposition of the property by the partnership. in some cases, the adjustment may produce the opposite effect. in other words, a positive adjustment may produce a loss or vice versa. while the likelihood of this effect may be greater regarding section 704(c) property, it is not limited to that category. assume that equal partnership abc purchased its sole asset for $3,000 which appreciated in value to $12,000. a sells her partnership interest to d for $4,000 and the partnership elects. d has a positive adjustment of $3,000. the partnership subsequently sells the property in an arm's-length transaction for $6,000, allocable $2,000 to each partner. d's $2,000 share of gain is reduced by the $3,000 positive adjustment producing a $1,000 loss. 120 [vol. 15:3 optional basis adjustments under subchapter k 2. depreciation the regulations address the effect of a section 743(b) basis adjustment on the determination of depreciation deductions.4 6 additional deductions may arise through positive basis adjustments to depreciable property, which are added to the transferee's distributive share of such item. 4 7 regarding the recovery period for the allocation, the increased basis is treated as arising from newly purchased recovery property.48 for example, assume that a sells her one-third interest in partnership abc to d for $5,000. the partnership has depreciable property with an adjusted basis of $9,000 and a fair market value of $15,000. partner d has an adjustment to the depreciable property in the amount of $2,000 ($5,000 purchase price less his previously taxed capital of $3,000). if the property were depreciable under a straight-line method with a cost recovery period of five years and a's one-third share of the partnership's depreciation were $1,000, the depreciation for the year on the $2,000 adjustment would be $400, and he would have a $400 offset against his distributive share of 49partnership income for the year. regarding negative adjustments which result in a decrease of the determined depreciation deduction, the regulations provide similarly.o reduced deductions are required. however, if the decreased basis adjustment exceeds the amount of the transferee's depreciation, other allocable items of depreciation of the transferee are reduced by the differential.' if a portion of the basis adjustment remains after applying the specified order of offset, ordinary income is recognized to the extent of the excess. the recovery period for the negative adjustment is the remaining cost recovery period of the underlying property.52 46. reg. § 1.743-1(j)(4). 47. reg. § 1.743-1(j)(4)(i)(a). 48. reg. § 1.743-1(j)(4)(i)(b)(1). 49. reg. § 1.743-1(j)(4)(i)(c), ex. (1). if the partnership is utilizing the remedial allocation method for previously contributed property, the portion of the adjustment allocable to the section 704(c) built-in gain is recovered over the partnership's recovery period. any excess amount may be recovered pursuant to the method and period of the transferee's choice. see reg. § 1.743-1(j)(4)(i)(c), ex. (2). 50. reg. § 1.743-1(j)(4)(ii). 51. reg. § 1.743-1(j)(4)(ii)(a). 52. reg. § 1.743-1(j)(4)(ii)(b). examples are provided in the regulations illustrating the application of these principles. the first example is a straightforward reduction of the transferee's share of depreciation by his negative adjustment. the second example illustrates that the recovery period for the negative adjustment is identical to the remaining recovery period of the partnership for the property. the third example generates ordinary income since the negative adjustment exceeds the transferee's depreciation from the asset for the year. 2014] 121 florida tax review 3. amortization the use of an election may result in amortization benefits as well. a taxpayer acquires an interest in an intangible asset held by a partnership "only if, and to the extent that, the acquiring taxpayer obtains, as a result of the transaction, an increased basis for such intangible." thus, amortization is available for transactions producing basis adjustments to certain intangible assets. a qualifying intangible asset may be amortized over a 15-year period.54 the regulations specifically address the issue of the amortization consequences attributable to partnership basis adjustments. any increased portion of the basis thereunder "is treated as a separate section 197 intangible and the intangible is treated as having been acquired at the time of the ",55transaction that causes the basis increase... for example, assume that partnership abc, to which each partner contributed $9,000 for his interest, purchases an intangible asset for $18,000.56 after three years of amortization, the asset has a basis of $14,400 and each partner has a basis for his partnership interest of $7,800. the asset has increased in value to $54,000, the value of the partnership's total assets is $90,000, and c sells his partnership interest to d for $30,000. without an election, d receives only his share, $400 per year, of the amortization even though he paid full value for his partnership interest. however, with the election, his interest in the asset is bifurcated, i.e., he continues to have a one-third interest ($4,800) in the partnership's common basis ($14,400) that generates $400 of amortization per partner per year over its remaining life of 12 years. in addition, he is considered to have a basis in the intangible asset equal to the basis adjustment of $23,333, which is amortizable over a new 15-year period, thereby generating a deductible expense of approximately $1,620 per year. h. other transfers ofa partnership interest in light of the legislative purpose of keeping inside and outside basis in sync, not every transfer of a partnership interest is a sale or exchange for 53. staff of the joint comm. on tax'n; technical explanation of the tax simplification act of 1993, 103d cong., 161 (comm. print. 1993). 54. i.r.c. § 197. see generally philip f. postlewaite, david l. cameron, and tom kittle-kamp, taxation of intellectual property and intangible assets (warren, gorham, & lamont 1997) [hereinafter postlewaite et al., intellectual property]. 55. reg. § 1.197-2(g)(3). 56. see also reg. § 1.197-2(k), ex. (13) (16). 57. reg. § 1.197-2(k), ex. (14). 122 [vol. 15:3 optional basis adjustments under subchapter k purposes of the basis adjustment. thus, not all transfers or dispositions give rise to a section 743(b) adjustment. the controlling issue is whether a particular mode of transferring the partnership interest falls within the purview of the statute. for example, if a partner makes a gift of an interest in a partnership that has no liabilities, the gift is not a sale or exchange. the subsection is not applicable to that transfer. on the other hand, the transfer of a partnership interest as a gift constitutes a sale or exchange to the extent that the transferor's share of partnership liabilities exceeds the adjusted basis of the partnership interest. accordingly, section 743(b) is applicable to the extent of any gain in that circumstance, because a basis adjustment in such a case would comport with the policy rationale of maintaining harmony between inside and outside bases.ss other types of transfers of a partnership interest raise similar issues. for example, a contribution of a partnership interest to a corporation in a non-recognition transaction is an exchange. however, except where gain is recognized to the transferor,59 the transferor's basis for the partnership interest carries over to the transferee. thus, there is no adjustment to the basis of partnership property, even if an election were in effect. a similar issue arises with respect to the transfer of a partnership interest to another partnership. a companion issue is whether such transfers, although not generating basis adjustments themselves, carry over pre-existing adjustments of the transferor. the regulations address the treatment of special basis adjustments in such cases.60 following a gift of a partnership interest in which the donor has a basis adjustment, the donee is entitled to continue the treatment available to the donor regarding his basis adjustment. 6 1 thus, if a is entitled to a $4,000 basis adjustment and gives his partnership interest to d, his child, d is entitled to similar treatment.6 2 58. if there is no gain to the transferor partner, the transferee's adjusted basis for the partnership interest acquired generally will be the same as the transferor's adjusted basis under section 1015. however, if the transferor paid a gift tax on the transfer, section 1015(d) provides that the donee's basis for the property is adjusted by a portion of the federal gift tax paid, which increases the basis of the partnership interest in the hands of the donee. nevertheless, as there has not been a sale or exchange of a partnership interest, this increase cannot constitute an adjustment under section 743(b). 59. i.r.c. §§ 351, 357. 60. see reg. § 1.743-1(h). 61. reg. § 1.743-1(f). 62. reg. § 1.743-1(f), ex. (iii). apparently this treatment is available even if the donee takes a dual basis for the partnership interest because its fair market value on the date of the gift was less than its adjusted basis. see reg. § 1.10151(a)(1). 2014] 123 florida tax review while the basis adjustment continues with the transferred property in the partnership context, the contributor partnership, as it receives the benefits of the adjustment, must segregate the items and ensure that they are allocated to the partner to whom the adjustment is attributable. assume that a possesses an adjustment of $1,000 in partnership abc regarding capital asset x which has a common partnership basis of $6,000. if partnership abc transfers capital asset x to partnership abcde for a one-third interest therein, capital asset x will have a $7,000 basis and partnership abc will have a $7,000 basis for its interest in the partnership abcde. however, any tax consequences flowing from the $1,000 adjustment to partnership abcde must be allocated exclusively to the partner, i.e., partnership abc, responsible for it. furthermore, consequences from the adjustment allocable to partnership abc must be allocated exclusively to a.63 i. on death ofpartner the basis adjustment of section 743(b) is not restricted to a sale or exchange of a partnership interest where valuable consideration is received for the transferred interest. the adjustment also is available in the case of a transfer of a partnership interest upon the death of a partner. 4 for example, assume that the balance sheet of equal partnership abc at the date of c's death is as follows: assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 5,000 $ 5,000 a $11,000 $16,000 inventory 16,000 19,000 b 11,000 16,000 capital asset 10 24,0(0 c _16,000 total $33,000 $48,000 total $33,000 $48,000 c's partnership interest is valued at $16,000 for estate tax purposes. if the partnership files the election, the adjustment is $5,000 determined as follows: 63. reg. § 1.743-1(h)(1). 64. i.r.c. § 743(b). 124 [vol. 15:3 optional basis adjustments under subchapter k adjusted basis for partnership interest acquired: estate tax value $16,000 proportionate share of adjusted basis of partnership: previously taxed capital cash on liquidation pursuant to hypothetical $16,000 decreased by share of gain on sale (5,000) 11,000 section 743(b) adjustment to basis of partnership property: $ 5,000 this treatment is consistent with the rationale for the adjustment, since the property owned by a decedent receives a basis equal to its fair market value at the date of death or at the optional valuation date.65 thus, the same adjustments are made to the basis of partnership property when a partner dies as when a partnership interest is sold or exchanged. 1 mandatory adjustment to basis under section 743(b) while the section 743(b) adjustment prevents unfair results to the purchaser of a partnership interest where the assets are appreciated, a failure to adjust arguably may produce a double benefit to the transferor and the transferee if the assets are depreciated. in 2004, congress evidenced its concern with loss duplication in the partnership context. previously, the partnership had the unfettered ability to determine whether it desired a basis adjustment for a transferee partner. thus, without an election, it was possible for the seller and the purchaser to take a similar loss into account once the partnership assets were sold. while the loss would ultimately be offset by a corresponding amount of gain on the transferee's liquidation or sale of the interest, tax benefits, i.e., loss duplication, arose through the failure to elect. notwithstanding the general anti-abuse regulation, which asserted its applicability in such settings, 6 congress felt compelled to legislate, possibly due to serious doubt that the failure to elect under an optional statutory provision could constitute abuse. since 2004, an adjustment to the basis of the partnership's assets with regard to the transferee is mandatory, regardless of election, if a "substantial built-in loss" exists. section 743(d) defines substantial built-in loss as existing when the bases of the partnership assets exceed the fair market values of those assets by more than $250,000 in the aggregate. in such cases, the adjustment is required. regulations address the need for aggregating related partnerships and the need for disregarding property 65. i.r.c. § 1014(a). 66. reg. § 1.701-2(d), ex. (8). 67. i.r.c. § 743 (b), (d) as amended by the american jobs creation act of 2004, pub. l. no. 108-357, § 833(b), 118 stat. 1418. 2014] 125 florida tax review acquired with the purpose of eliminating a substantial built-in loss. the adjustment appears to be mandatory regardless of the absence of any tax saving motivation, e.g., in the case of death. for example, assume that m, n, and p form partnership mnp with equal contributions of $500,000. the partnership purchases capital asset x for $700,000 and capital asset y for $800,000. in year 3, when the value of capital asset x remains $700,000 but the value of capital asset y declines to $200,000, m transfers his partnership interest to q for $300,000. on the date of the transfer, the balance sheet of partnership mnp is as follows: assets: adjusted fair capital: adjusted fair basis market basis market value value capital asset x $ 700,000 $700,000 m $ 500,000 $300,000 capital asset y 800,000 200,000 n 500,000 300,000 p 500,000 300,000 total $1,500,000 $900,000 total $1,500,000 $900,000 m recognizes a loss on the transfer of $200,000. prior to 2004, if the partnership did not make the election, a subsequent sale of capital asset y for $200,000 would have resulted in a $600,000 loss, allocated equally to n, p, and q. thus, the partnership's failure to elect would have resulted in a duplication of the $200,000 loss m recognized on the transfer of his interest. under amended section 743(b), however, because the difference between the fair market value of the partnership's property ($900,000) and the partnership's adjusted basis for its property ($1,500,000) is more than the statutory threshold of $250,000, a substantial built-in-loss in the partnership's property exists. consequently, a negative basis adjustment of $200,000 with respect to q is required for the adjusted basis of the partnership property. iii. allocating optional basis adjustment under section 743(b) to specific partnership properties a. allocating the optional adjustment amount section 755 section 743(b) addresses only the determination of the total amount of the aggregate optional adjustment to basis for all partnership property. it does not provide for its allocation to specific partnership properties. instead, the allocation of the adjustment is governed by section 755. 68. section 743(e) provides that specifically described enterprises, i.e., investment partnerships and securities partnerships, are exempt from the mandatory application of section 743(b). 126 [vol. 15:3 optional basis adjustments under subchapter k that provision establishes two rules for allocating the total amount of the optional adjustment to basis. the general rule allocates the adjustment "(1) in a manner which has the effect of reducing the difference between the fair market value and the adjusted basis of partnership properties, or (2) in any other manner permitted by regulations prescribed by the secretary."69 in applying the general allocation rule, the provision adds a special rule which specifies that the increase or decrease to the basis of partnership property arising from a transfer of an interest is allocable to "(1) capital assets and property described in section 1231(b) or (2) any other property of the partnership," depending on which of the two specified classes of property generated the adjustment to basis under the regulations.o the regulations expand upon this approach by noting that the allocation is made first between the two classes and thereafter among the assets within each class.7' thus, in allocating an adjustment, the amount of the adjustment is allocated first between the two classes of property, capital assets and other property.n thereafter, the amount allocated to each class is allocated to specific properties within that class.73 b. the regulations the regulations employ a hypothetical sale approach for allocating the adjustment by focusing on the tax consequences to the distributee in a fully taxable transaction at fair market value.74 through use of this approach, the income or loss that would be incurred by the transferee, including allocations under section 704(c), is offset. the focus applies both for allocations between classes as well as those within a class. thus, whether the overall adjustment or class adjustment is positive or negative is generally irrelevant since the process ties the adjustment for each individual asset to the transferee's share of its inherent gain or loss.75 the regulations authorize two-way adjustments, i.e., positive or negative, both between the classes of capital assets and other property as well as permitting them within a class. by so doing, in the case of a partnership holding both appreciated and depreciated assets, the regulations permit 69. i.r.c. § 755(a); reg. § 1.755-1. 70. i.r.c. § 755(b). for ease of reference, the two classes are referred to simply as "capital assets" and "other property." 71. reg. § 1.755-1(a). the § 743(b) adjustment is addressed separately from the § 734(b) adjustment. see reg. § 1.755-1(b); donnell m. rini-swyers, allocating basis adjustments after the section 755 final regulations, 99 j. tax'n 211 (2003). 72. i.r.c. § 755(b); reg. § 1.755-1(b)(2). 73. i.r.c. § 755(a); reg. § 1.755-1(b)(3). 74. reg. § 1.755-1(b)(1)(ii). 75. reg. § 1.755-1(b)(1). 2014] 127 florida tax review adjustments increasing the basis of some assets while reducing the basis of others. 1. allocation between two classes ofproperty regarding the allocation of the basis adjustment between classes, the regulations prioritize allocations by mandating the allocation to other property first.76 thereafter, the amount of the adjustment allocable to capital assets is determined and equals the difference between the total basis adjustment and that attributable to other property. however, a decrease in basis to capital assets cannot exceed the partnership's basis for that property. once exhausted, the excess is applied to reduce the basis for other property.7 the rule attempts to ensure that there is no disappearing or suspended basis adjustment. assume equal partnership abc with the following tax balance sheet: assets: adjusted fair excess of fair d's share of basis market market value income/loss on value over basis hypothetical transaction capital assets land investment $30,000 $ 60,000 $ 30,000 $10,000 securities 10 90,000 7 0 total $45,000 $150,000 $105,000 other property inventory $21,000 $ 66,000 $ 45,000 $15,000 accounts receivable 0 15,00 10050 total $21,.000 $ 81,00 $ 60,000 total $66,000 $231,000 $165,000 $55,000 capital: a $22,000 $ 77,000 $ 55,000 b 22,000 77,000 55,000 c 22000 77,009 5 total $66,000 $231,000 $165,000 if c sells her partnership interest to d for $77,000, the total adjustment available to d is $55,000, the excess of the basis for d's partnership interest ($77,000) over his share of previously taxed capital ($22,000). 76. reg. § 1.755-l(b)(2)(i). 77. reg. §§ 1.755-1(b)(2)(i)(a), 1.755-1(b)(2)(i)(b). many of the complex allocation rules appearing in these regulations are not generally necessary. as they deal with deep discount purchase price situations, their applicability is limited. even in such cases, there are theoretical concerns with such an approach, i.e., how can the value of the assets not equate with the purchase price in an arm's length transaction. 128 [ vol. i15: 3 optional basis adjustments under subchapter k as the starting point, the regulations ensure that the $55,000 adjustment is allocated between the classes based upon the hypothetical sale of assets, with priority given to other property. thus, the portion of the $55,000 adjustment attributable to other property is the $20,000 of income that would arise upon a sale of such assets. the calculation for the capital assets involves a comparison between the overall adjustment ($55,000) and the amount allocated to the class of other property ($20,000), which results in a $35,000 adjustment to d's share of those assets. 2. allocation to property within a class the regulations address allocations of the adjustment to assets within a class, in essence, following a procedure similar to the overall adjustment. furthermore, the regulations prioritize the adjustment to ordinary income property and focus on the income or loss that would be generated by each asset through the hypothetical sale. as a consequence, both positive and negative adjustments can arise simultaneously within a single class.79 if the value of the land were instead $123,000, i.e., an increase in prior value by $63,000, and the inventory value were $3,000, i.e., a decrease in prior value by $63,000, the altered tax balance sheet would appear as follows: assets: adjusted fair excess of d's share of basis market fair market income/loss value value over hypothetical basis transaction capital assets land $30,000 $123,000 $ 93,000 $31,000 investment 0 90 securities total $45,000 $2 13000 $16,000 $56,000 other property inventory $21,000 $ 3,000 ($ 18,000) ($6,000) accounts receivable 0 1l5o 1500 5,000 total $21,000 $ 18,000 ($ 3,000) ($ 1000) total $66,000 $231,000 $165,000 $55,000 capital: a $22,000 $ 77,000 $ 55,000 b 22,000 77,000 55,000 c _22,000 25q 0 total $66,000 $231,000 $165,000 1.755-1(b)(3)(ii). 78. reg. § 1.755-1(b)(3). 79. reg. §§ 1.755-1(b)(3)(i), 2014] 129 florida tax review if c sells her partnership interest to d for $77,000, the total adjustment available to d is $55,000, the excess of the basis for d's partnership interest ($77,000) over his share of previously taxed capital ($22,000). as its starting point, the regulations ensure that the $55,000 adjustment is allocated between the classes with priority given to other property. furthermore, the adjustment to both classes is not capped at $55,000. thus, the portion of the adjustment attributable to the class of other property is a decrease of $1,000, i.e., a $6,000 decrease attributable to the inventory offset by a $5,000 increase attributable to the accounts receivable. the adjustment attributable to d's share of the capital assets equals the overall adjustment of $55,000 increased by the $1,000 negative adjustment to other property. thus, the adjustment to d's share of the capital assets is a positive adjustment of $56,000.80 iv. optional adjustment to basis of undistributed partnership property section 734(b) a. reason for optional adjustment to basis of partnership property following certain distributions with property distributions in complete or partial liquidation of a partner's interest in the partnership, disparities between the inside basis of the partnership's assets and the outside basis of the partners' interests will frequently arise. similar to the basis adjustments available on the transfer of a partnership interest, congress adopted an elective approach to basis adjustments for partnership distributions of cash and/or property. section 734(a) provides that a distribution of partnership property to a partner has no effect on the basis of property retained by the partnership. this is so notwithstanding the appreciation or depreciation in the value of the asset(s) distributed and the partial or complete liquidation of the distributee. as with the section 743(b) adjustment, the primary purpose of the section 734(b) adjustment is to keep inside and outside basis in sync to prevent distortions of income or loss that can occur under the general rule. for example, assume that the balance sheet of partnership abc is as follows: assets: adjusted fair capital: adjusted fair basis market basis market value value cash $12,000 $12,000 a $ 8,000 $11,000 capital asset x 3,000 11,000 b 8,000 11,000 capital asset y 900 10,000 c 8,000 _10_00 total $24,000 $33,000 total $24,000 $33,000 80. reg. § 1.755-1(b)(2)(ii), exs. (1), (2). [vol. 15:3130 optional basis adjustments under subchapter k if c receives $11,000 in cash in liquidation of her interest, she realizes taxable gain of $3,000, i.e., $11,000 received minus her $8,000 basis. this gain is one-third of the total potential gain of $9,000 on capital asset x and capital asset y. under the general rule, which provides no adjustment to the basis of the partnership property, the partnership will realize the full $9,000 of gain when capital asset x and capital asset y are sold. since $3,000 of gain has been recognized by and taxed to c, a portion of the gain will be double taxed. the situation is similar to a purchase of c's partnership interest by a and b without an adjustment to basis. as in a section 743 situation, this inequity will be corrected when a and b dispose of their partnership interests, but, because of timing and the character of the gain and loss, they may not be made whole. if a full aggregate theory were used, c would be treated as if she had sold her pro rata share of each partnership asset to a and b for its fair market value and that portion of those assets would have a basis equal to the purchase price. similar to the section 743(b) basis adjustment, the section 734(b) adjustment is intended to accomplish such a result following a distribution to a partner resulting in gain or loss recognition. the distributee partner has recognized a portion of the partnership gain or loss, and the adjustment is intended to prevent the remaining partners from recognizing it again. a similar rationale exists for the application of section 734(b) to the distribution of property other than money in reduction of a partner's interest or withdrawal of a partner from the partnership. where such property is appreciated or depreciated, its distribution carries out of the partnership gain or loss, which, if the property had been sold by the partnership, generally would have been attributable to all of the partners, not merely the distributee. in the above example, instead of distributing cash for the partnership interest upon c's withdrawal, the partnership might distribute capital asset x, with an adjusted basis to the partnership of $3,000 and a fair market value of $11,000. partners a and b have, in effect, acquired c's interest in the partnership in exchange for their two-thirds interest in capital asset x. in essence, a and b have acquired c's one-third interest in other partnership assets. c's one-third share of the partnership's adjusted bases for the assets in which she relinquished an interest in exchange for the two-thirds interest of a and b in capital asset x is as follows: cash $4,000 capital asset y 3 total $7,000 no gain or loss is recognized by the partnership on the distribution of capital asset x to c. the general rule in a non-taxable exchange of properties is that the property acquired takes the adjusted basis of the 2014] 131 florida tax review property exchanged. a distribution of property in reduction of a partner's interest or withdrawal of the partner from the partnership technically is not an exchange, and the properties exchanged are not necessarily like-kind properties, but the rationale of section 734(b) generally applies that principle. the transaction is summarized as follows: 1. the partnership, as constituted after c's retirement, acquired an interest in the undistributed partnership property. c's proportionate share of the partnership's basis for that undistributed partnership property (cash and capital asset y) was $7,000. 2. the partnership distributed to c capital asset x having an adjusted basis to the partnership of $3,000. partners a and b exchanged their two-thirds share of capital asset x, which had an adjusted basis to the partnership of $2,000. 3. the property acquired from c should take the same basis as the adjusted basis of the property exchanged. consequently, there should be a decrease in the partnership's basis of its undistributed property generally in the amount of $5,000. the mechanics of section 734(b) are intended to approximate an aggregate approach, to equalize inside basis and outside basis, and to prevent an increase or decrease in the aggregate basis for the partnership's assets (both those distributed and those retained). if the assets distributed to the distributee partner lose basis, the assets retained by the partnership generally gain basis, and vice versa. b. analysis ofsection 734(b) the basis adjustment, if elected by the partnership, is available in the case of a distribution of property by the partnership to a partner. although the above example involved a distribution in liquidation of a partner's interest, a complete liquidation is not necessary to make the provision applicable. a distribution of property, including money, which merely reduces a partner's proportionate interest can precipitate adjustments. current distributions of property, including money, to all partners in proportion to their interests, leaving their proportionate interests unchanged, also may invoke adjustments. section 734(b) generally is an elective provision which applies if the partnership has a section 754 election in effect for the year of the distribution.8 1 the adjusted basis of undistributed partnership property is increased by the taxable gain recognized to the distributee and the excess of 81. but see sections 732(d) and 734(a) for settings in which the adjustment is mandatory. 132 [vol. 15:3 optional basis adjustments under subchapter k the partnership's adjusted basis of the distributed property over the basis of the distributed property in the hands of the distributee. the adjusted basis of undistributed property is decreased by the loss recognized to the distributee and the excess of the basis of the distributed property in the hands of the distributee over the partnership's adjusted basis of the distributed property. another, and perhaps easier, way to state the adjustment rules is that the partnership's adjusted basis for its undistributed property is increased by the amount of taxable gain recognized to the distributee, decreased by the amount of deductible loss recognized to the distributee, increased by the amount of the basis decrease for the distributed property when it passes from the partnership to the partner (the lost basis), and decreased by the amount of the basis increase for the distributed property when it passes from the partnership to the partner (the gained basis). 1. recognition of gain or loss gain is recognized in either a current or a liquidating distribution only to the extent that cash distributed (or deemed to have been distributed under section 752(b)) exceeds the basis for the distributee partner's partnership interest. if property other than cash is distributed in either a current distribution or a liquidating distribution, gain still is limited to the excess of cash over the distributee's partnership basis, even though some of the other property distributed is unrealized receivables or inventory. loss is recognized only in a liquidating distribution and only if the property distributed is cash, unrealized receivables, inventory, or a combination of the three. 2. basis ofdistributed property if property, other than or in addition to cash, unrealized receivables, or inventory, is distributed, the rules of section 732 determine whether its basis to the distributee partner after the distribution is more or less than its basis to the partnership before the distribution. if the distribution is a current distribution, the general rule is that the property has the same basis to the distributee that it had to the partnership immediately before the distribution. in that event, the distribution will not create a section 734(b) adjustment. however, the transferred basis of the distributed property in the aggregate cannot exceed the basis for the distributee partner's partnership interest, reduced by any money distributed in the same transaction. if that limitation applies, the aggregate basis of the distributed property to the distributee will be less than the aggregate basis of that property to the partnership. in that event, and assuming that an election is in effect, the decrease in basis of the property will cause an increase in basis for the remaining partnership property. 2014] 133 florida tax review if the distribution is a liquidating distribution, there is no transferred basis with respect to the distributed property. there is an exchanged basis because the distributed property always takes a basis, in the aggregate, equal to the basis for the distributee's partnership interest, reduced by any money distributed.82 the basis of the distributed property can either increase or decrease by reason of the distribution. therefore, it can create either a downward or an upward adjustment to the basis of the remaining partnership property. 3. illustration the regulations 84 illustrate an adjustment when the liquidation of a partner's interest results in a decrease in the basis of an asset distributed and an increase in the basis of the remaining partnership property. in that example, d has a $10,000 basis for his one-third interest in partnership def, which has the following tax balance sheet: assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 4,000 $ 4,000 d $10,000 $11,000 capital asset x 11,000 11,000 e 10,000 11,000 capital asset y 15 0 _18,000 f 10,000 11,000 total $30,000 $33,000 total $30,000 $33,000 if d receives capital asset x in complete liquidation of his interest, it will have a basis to him of $10,000, which is the basis of d's partnership interest. there has been a decrease of $1,000 in the basis of that asset, which will result in a $1,000 increase in the basis of the remaining partnership assets if the election is in effect. this increase is applied to the basis of capital asset y, the only remaining partnership property other than money.85 the new balance sheet of partnership ef is as follows: 82. this is so on an aggregate basis. however, the distributee's basis in unrealized receivables and inventory items cannot exceed the basis of such property to the partnership prior to the distribution under section 732(c)(1). 83. the only circumstance in which a distribution of property in liquidation will not result in an increase or decrease of its basis is when the basis of the distributee's partnership interest equals the basis of the distributed property. 84. reg. § 1.734-1(b)(1). 85. the allocation is made under the rules of section 755, discussed below. [vol. 15:3134 optional basis adjustments under subchapter k assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 4,000 $ 4,000 e $10,000 $11,000 capital asset y 16000 _18,000 f _10,000 1100 total $20,000 $22,000 total $20,000 $22,000 the effect of the adjustment is to prevent an overall increase or decrease in the basis of the total partnership assets, including those distributed, solely by reason of the distribution. the adjustment also preserves the equality of the total of the inside and outside basis of the partnership and the partners. 4. depreciation and amortization as in the previous discussion of the impact of the section 743(b) adjustment on the depreciation or amortization amounts available to the transferee partner if an election is in effect, unsurprisingly, similar additional calculations are required in the case of a section 734(b) adjustment. the adjustments produce increases or decreases in the basis of the assets for the partnership. accordingly, if the adjusted assets are depreciable or amortizable, additional tax consequences will arise for the continuing partners. c some difficulties in the operation of section 734(b) in contrast to the section 743(b) basis adjustment, the section 734(b) adjustment does not operate as well in certain situations. this is particularly so where there is a disparity between inside and outside basis existing at the time of a distribution. for example, assume that the tax balance sheet of partnership bcd is as follows: 86. see david l. cameron & philip f. postlewaite, amortization of intangible assets under the improved final regulations, 93 j. tax'n 150 (2000). see generally postlewaite et al., intellectual property, supra note 54. 87. although the treasury in 2004 markedly improved the operation of the section 743(b) basis adjustment through the issuance of new regulations, its efforts in section 734(b) context were not as impressive. 2014] 135 florida tax review assets: cash capital asset x capital asset y total adjusted fair basis market value $45,000 $ 45,000 15,000 40,000 12,000 35,000 $72,000 $120,000 capital: adjusted fair basis market value b $24,000 $ 40,000 c 24,000 40,000 d _24,00 40,000 total $72,000 $120,000 b sells her partnership interest to e for $40,000. the election is not in effect so there is no section 743(b) adjustment to the basis of partnership property. thus, an imbalance is created between the inside basis of the partnership property and the outside basis of the partnership interests. the total inside basis of partnership property remains at $72,000. however, by virtue of the sale, the total of the outside basis of the partnership interests is increased to $88,000 ($24,000 for c, $24,000 for d, and $40,000 for e). the tax balance sheet would appear as follows: assets: cash capital asset x capital asset y total adjusted fair basis market value $45,000 $ 45,000 15,000 40,000 12000 35,000 $72.000 $120.000 capital: adjusted fair basis market value b $24,000 $ 40,000 c 24,000 40,000 e a 40,000 total $88.000 $120.000 the intended result of section 734(b) is reached, if at all, only in situations where the inside basis and the outside basis are the same when the partner's withdrawal occurs. for example, in the above example, when e acquired his interest, if a $16,000 adjustment had been made to capital asset x and capital asset y (for e's benefit), section 734(b) would work properly.88 however, section 734(b) cannot remedy the matter when there is a disparity between the inside basis and the outside basis due to a failure to elect. if e's interest is liquidated for $40,000 of cash and a section 754 88. even if on the liquidation of e's interest none of the four events required for a section 734(b) adjustment occurred, e.g., because only cash was received by e and no gain or loss was recognized by him, order is restored to the partnership under regulation section 1.734-2(b)(1). the regulation provides that if a transferee partner (e) in a complete liquidation of his interest receives property (cash in the example) to which no basis adjustment previously has been made, his "unused special basis adjustment" attributable to his interest in other property which he has relinquished ($16,000) is applied to the retained partnership property. after the adjustment, inside basis of $48,000 ($72,000 minus $40,000 distributed plus $16,000) would equal the outside basis of the total basis of the interests of c and d ($24,000 each). 136 [vol. 15:3 optional basis adjustments under subchapter k election is made by the partnership, section 734(b) will not work properly. there will be no recognized gain or loss on the distribution, which is one of the prerequisites to its application. after the distribution to e, the tax balance sheet of partnership cd would be unbalanced and would reflect this disparity: assets: adjusted capital: adjusted basis basis cash $ 5,000 c $24,000 capital asset x 15,000 d 24,0 capital asset y 1 total $32,000 total $48,000 if the provision functioned perfectly, the basis of the remaining partnership property would be adjusted upward so that the partnership's basis of its assets equaled $48,000, the adjusted basis of the interests of c and d in the partnership. other difficulties arise in the section 734(b) context which preclude it from functioning as well as the section 743(b) adjustment. the regulations require that when a distribution of property results in an adjustment to the basis of undistributed property, the adjustment is allocated to remaining property of a similar character. thus, adjustments attributable to cash and capital assets (including section 1231 property, but not section 1245 recapture) must be allocated to capital assets. adjustments attributable to other property must be allocated to other property. the difficulty is that the allocation is based on the character of the distributed asset instead of the character of the asset responsible for the appreciation or depreciation of the partnership assets. for example, assume that equal partnership abc, with the following tax balance sheet, distributes $60,000 to a in a liquidating distribution. assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 70,000 $ 70,000 a $ 50,000 $ 60,000 inventory 60,000 65,000 b 50,000 60,000 capital asset x 20,000 45,000 c 50,000 60,000 total $150,000 $ 180,000 total $150,000 $180,000 89. regulation section 1.734-2(b) may appear to redress this problem, but without success. it addresses a circumstance where a partner receives in liquidation of his interest property (including money) in which he has no special adjustment in exchange for his interest in property in which he has a special adjustment, whereas the problem exists when the property relinquished is property in which he should have a special adjustment but does not. 2014] 137 florida tax review a will recognize a gain of $10,000, and the basis adjustment will be allocable to the class of capital assets only.90 thus, while inside and outside basis will be equal, the adjustment does not function properly. the tax balance sheet after the transaction would appear as follows: assets: cash inventory capital asset x total adjusted fair basis market value $ 10,000 $ 10,000 60,000 65,000 30,000 4 $100,000 $120,000 capital: adjusted fair basis market value b $ 50,000 $ 60,000 c 50,000 60,000 total $100,000 $120,000 proper functioning of the adjustment would have allocated the overall basis adjustment between inventory and capital asset x, i.e., $1,666 to inventory and $8,333 to capital asset x. finally, section 734(b) does not allow for positive and negative adjustments from a single transaction. allocations between classes and within classes are only one-directional. assume in the following case that a's partnership interest is liquidated for cash of $9,000. assets: cash capital asset x capital asset y total adjusted fair basis market value $10,000 $10,000 5,000 14,000 600 3 $21,000 $27,000 capital: adjusted fair basis market value a $ 7,000 $ 9,000 b 7,000 9,000 c _7,00 9,000 total $21,000 $27,000 while this generates a basis increase of $2,000, the regulations dictate that the adjustment is made solely to capital asset x ($5,000 + $2,000 = $7,000). upon its sale, the remaining partnership bc will recognize $7,000 of gain ($14,000 $7,000 = $7,000), $3,500 each. from a tax policy standpoint, the basis adjustment should have been a $3,000 increase to capital asset x and a $1,000 decrease to capital asset y, as is the case with the revised regulations under section 755, which deal with the allocation of basis adjustments under section 743(b). d. mandatory application of section 734(b) in 2004, congress evidenced its concern with loss duplication in the partnership context. given the ability of a partnership to determine whether 90. had the inventory been substantially appreciated, section 751(b) would have come into play and resulted in a basis adjustment for the inventory. 138 [vol. 15:3 optional basis adjustments under subchapter k to elect the adjustment for the partnership, it is possible to duplicate losses through a failure to elect, i.e., the distributee partner recognizes loss on the distribution of cash and the partnership takes a similar loss into account if the remaining assets are sold subsequently. while the loss would ultimately be offset by a corresponding amount of income on the liquidation or sale of the remaining partnership interests, tax benefits through such efforts are possible. section 734(b) was amended to provide that an adjustment to the basis of the partnership's assets is mandatory, regardless of election, if a substantial basis reduction to the basis of the partnership's assets would occur. a substantial basis reduction is defined as a basis decrease in excess of $250,000. regulations to effectuate the legislation are specially authorized.9 ' for example, assume that equal partnership def does not have an election in effect. its tax balance sheet is as follows: assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 800,000 $ 800,000 d $1,000,000 $ 700,000 capital asset x 1,000,000 600,000 e 1,000,000 700,000 capital asset y 1,200,000 700,000 f 1,000,000 700,000 total $3,000,000 $2,100,000 total $3,000,000 $2,100,000 if f receives $700,000 cash in complete liquidation of his interest, he will recognize a $300,000 loss. prior to 2004, absent an election, this distribution would have created a disparity between the inside and outside bases of partnership de, which would allow d and e to duplicate the $300,000 loss that f recognized on his liquidating distribution. under amended section 734, however, partnership de is required to make a basis adjustment because the distribution would create a basis reduction greater than $250,000 if an election had been in effect. accordingly, the partnership is required to decrease the basis of the remaining partnership assets. the decrease is applied to both capital asset x and capital asset y proportionally according to their decrease in value. the basis of capital asset x is reduced by $133,333 ($400,000/$900,000 x $300,000) and the basis of capital asset y is reduced by $166,667 ($500,000/$900,000 x $300,000).92 the new tax balance sheet is as follows: 91. i.r.c. §§ 734(d)(2), 743(d)(2). 92. see discussion supra at part iv, regarding the allocation of section 734(b) adjustments among the remaining assets of the partnership. see also section 704(c)(1)(c), discussed at part ii, f., which is similarly intended to prevent loss duplication. 2014] 139 florida tax review assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 100,000 $ 100,000 d $1,000,000 $ 700,000 capital asset x 866,667 600,000 e 1,000,000 700,000 capital asset y 1,033,333 700,000 total $2,000,000 $1,400,000 total $2,000,000 $1,400,000 v. allocation of section 734(b) basis adjustment among undistributed partnership properties the adjustment determined under section 743(b) is a total adjustment to the basis of all partnership property. the allocation of that total adjustment among the various undistributed properties is determined according to section 755,93 which, as in the case of the allocation of a section 743(b) adjustment, requires a segregation of the total basis adjustment between two classes of property-capital assets and other property. the allocation of a section 755(b) adjustment raises a question of grammatical interpretation. the statute provides that: "increases or decreases in the adjusted basis of partnership property arising from a distribution of, or a transfer of an interest attributable to, property consisting of-(1) capital assets and property described in section 1231(b), or (2) any other property of the partnership, shall be allocated to partnership property of a like character...." whether the adjustment is allocated to the same class of property as the property distributed or to the class of property to which the increase or decrease is attributable is unclear from the peculiar sentence construction of the provision. allocation to the same class as the property distributed produces distortions. allocation to the class of property to which the adjustment is attributable produces an apparently logical result. this latter interpretation, however, is contrary to the grammatical construction of the sentence by the treasury. the treasury has issued brief regulations setting forth rules for the allocation of section 734(b) basis adjustments.94 the rules provide that the basis adjustment is first allocated between the two classes of propertycapital assets and other property. where there is a distribution of partnership property resulting in an adjustment to the basis of undistributed partnership property, the adjustment must be allocated to remaining partnership property of a character similar to that of the distributed property with respect to which the adjustment arose. thus, when the partnership's adjusted basis of distributed capital gain property immediately prior to distribution exceeds the basis for the property to the distributee partner (as determined under section 93. see rini-swyers, supra note 71; abrams, supra note 1; and burke, supra note 1. 94. reg. § 1.755-1(c). 140 [vol. 15:3 optional basis adjustments under subchapter k 732), the basis for the remaining capital assets is increased by an amount equal to the excess. conversely, when the basis to the distributee partner (as determined under section 732) of distributed capital gain property exceeds the partnership's adjusted basis for such property immediately prior to the distribution, the basis of the remaining capital assets in the partnership is decreased by an amount equal to such excess. similar adjustments would be made with respect to any distribution of other property, i.e., the adjustment would be made only to property of the same class. however, where there is a distribution resulting in an adjustment to the basis of undistributed partnership property (due to gain or loss recognized by the distributee partner), the adjustment is allocated only to capital gain property. the practical effect of this rule is to treat distributions that result in capital gain as giving rise to an increase in the basis of assets the income from which would be capital in nature. 9 nevertheless, focusing upon the nature of the property distributed rather than the property responsible for the appreciation or deprecation may cause basis distortion. if there is an increase in basis to be allocated within a class of property, the section 755 regulations provide that it must be allocated first to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation before such increase (but only to the extent of each property's unrealized appreciation). any remaining increase must be allocated among the properties within the class in proportion to their fair market values. if there is a decrease in basis to be allocated within a class, it must be allocated first to properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation before such decrease (but only to the extent of each property's unrealized depreciation). any remaining decrease must be allocated among the properties within the class in proportion to their adjusted bases. however, the basis of partnership property of the required character cannot be reduced below zero. the regulations contain a helpful example. assume that a, b, and c form equal partnership abc to which a contributes $50,000 of cash and asset 1, capital gain property with a fair market value of $50,000 and an adjusted tax basis of $25,000. b and c each contribute $100,000 of cash to the partnership, which uses the cash to purchase assets 2, 3, 4, 5, and 6. the latter three assets are ordinary income property. after seven years, the 95. presumably, the treasury was concerned that taxpayers would be able to arbitrage tax rates by obtaining capital gains for the distributee partner and a decrease in ordinary income for the remaining partners in the partnership. this concern should have been reduced by the existence of section 751(b) which would apply in many of such settings, forcing a basis increase or decrease because it treats some or all of the transaction as a sale. 96. reg. § 1.755-l(c)(6), ex. 2014] 141 florida tax review adjusted basis and fair market value of the partnership's assets are as follows: capital assets: adjusted basis fair market value asset 1 $ 25,000 $ 75,000 asset 2 100,000 117,500 asset 3 50,000 60,000 other property asset 4 40,000 45,000 asset 5 50,000 60,000 asset 6 10,000 2.500 total $275,000 $360,000 assume that the partnership distributes assets 3 and 5 (worth $120,000) to a in complete liquidation of his interest in the partnership. a's basis in the partnership interest was $75,000, whereas the partnership's basis in the distributed assets was $50,000 each. a will have a basis of $25,000 in asset 3 (capital gain property) and a basis of $50,000 in asset 5 (ordinary income property) because, under section 732(c), basis must first be allocated to the ordinary income property in an amount equal to the partnership's adjusted basis for such property. in other words, a's basis of $75,000 in the distributed assets is first allocated to ordinary income property, which results in a reduction of $25,000 in the basis of the capital gain property distributed to him. this results in a basis increase to the partnership of a like amount. the basis increase must be allocated to the remaining partnership assets of a similar character (capital gain assets) in proportion to their relative appreciation. the fair market value of asset 1 exceeds its tax basis by $50,000, whereas the fair market value of asset 2 exceeds its tax basis by $17,500. therefore, the basis of asset i will be increased by $18,519 ($50,000/$67,500 x $25,000), whereas the basis of asset 2 will be increased by $6,481 ($17,500/ $67,500 x $25,000).97 a partnership may not have sufficient basis in its remaining property of the requisite character. this could arise if the partnership does not have sufficient basis in its property (in the case of a basis decrease) or if the partnership lacks property of the character whose basis could be increased. in that event, the adjustment is made when the partnership subsequently acquires property of a like character to which an adjustment can be made. such situations, of course, result in a disparity between inside and outside basis, thereby failing to achieve the overall legislative purpose for the adjustment. 97. see generally monte a. jackel & shari r. fessler, the mysterious case ofpartnership inside basis adjustments, 89 tax notes 529 (october 23, 2000). [vol. 15:3142 optional basis adjustments under subchapter k vi. section 732(d) safety valve for transferee partner if no section 754 election to adjust basis in certain cases, the code permits a basis adjustment for certain partnership assets as a result of a transfer of a partnership interest even if the partnership has not made a section 754 election. the use of the provision is typically elective with the transferee partner, although in some circumstances the adjustment is mandatory. the purpose of the statute is to afford, to the degree possible, a distributee partner who acquired his interest by transfer the same result that he would have had if an election had been in effect at the time of the transfer generating a section 743(b) adjustment. however, the basis of the distributed property under such an adjustment will not necessarily be the same as if there had been such a section 743(b) adjustment. a. the conditions and method of section 732(d) the provision is available on an elective basis to a partner who (1) acquires his partnership interest by purchase or inheritance from another partner when the partnership did not have an election in effect and (2) receives a distribution of property other than money within two years thereafter. in that circumstance, the partner may elect to treat the basis that the property would have had if the adjustment were made when the partner acquired his interest as the basis for the distributed property. the election is made by the distributee partner, and the consent of the partnership is not needed.98 although the election adjusts the basis as though a section 743(b) had been made at the time of the transfer, the adjustment is effective only at the time of the distribution. the amount of the adjustment, therefore, is not affected by any potential depreciation, depletion, or amortization on the portion of the basis resulting from the adjustment because such depreciation, depletion, or amortization has not in fact been taken.99 generally such a distribution becomes important only if the partnership is about to sell the property (frequently ordinary income property) and the distributee wants to reduce the gain he will recognize if the 98. one advantage of a section 732(d) election is that its use by the transferee/distributee partner imposes no obligation on the partnership to make adjustments for future transactions. it appears that the distributee need not be uniform in his election pattern, e.g., the election might be made in one year and not another. with respect to multiple distributions in the same year, the issue is even more clouded since some authority suggests that all such non-liquidating distributions are treated as occurring on the last day of the year. see reg. § 1.731 1(a)(1)(ii). 99. reg. § 1.732-l(d)(1)(iv). 2014] 143 florida tax review partnership makes the sale. in that case, the coordination between the partnership and the partner may be so close in consummating the sale that the service takes the position that, in substance, the sale was made by the partnership followed by a distribution of the proceeds.0 o because the provision is intended to be a relief provision and its election does not give the distributee an unwarranted tax advantage, such a position may not be justified. the primary importance of the elective method of allocating basis to specific partnership properties is where the partnership has a significant amount of unrealized receivables and inventory items. if the allocation of basis to distributed properties is made under the general rule, no amount can be allocated to the distributed unrealized receivables and inventory items in excess of the adjusted basis of such items to the partnership. for example, assume that partnership abc's balance sheet is as follows: assets: adjusted fair capital: adjusted fair basis market basis market value value cash $ 3,000 $ 3,000 a $ 4,000 $ 6,000 inventory 6,000 12,000 b 4,000 6,000 capital asset x 3,0 3,000 c 4,000 6,000 total $12,000 $18,000 total $12,000 $18,000 partner c dies, and the partnership shortly thereafter distributes his pro rata share of cash of $1,000, inventory valued at $4,000, and capital asset x valued at $1,000 in liquidation of his partnership interest.'01 if the general rule for allocation of the adjusted basis of c's interest (increased to $6,000 by reason of his death) were in effect, c's one-third share of the partnership's $6,000 adjusted basis for inventory would transfer to the distributee. thus, c's successor in interest would have a $2,000 basis for inventory. that amount plus the cash of $1,000 distributed to c's successor in interest would be deducted from the basis of $6,000 for c's partnership interest on his death, leaving $3,000 as the adjusted basis of capital asset x with a fair market value of $1,000. if c's successor in interest sold inventory, there would be $2,000 of ordinary income. if he sold capital asset x, there would be a $2,000 capital loss. however, if because the partnership had not made a section 754 election c's successor in interest made an election under section 732(d), the adjusted basis of the distributed assets would be the same as though the 100. see commissioner v. court holding, co., 324 u.s. 331 (1945). 101. given the pro rata distribution, the rigors of section 751(b) are avoided. 144 [vol. 15:3 optional basis adjustments under subchapter k adjustment to basis of partnership property under section 743(b) had been made on c's death. the assets would have bases of cash at $1,000, inventory at $4,000, and capital asset x at $1,000. no gain or loss would be realized on the sale of the assets. clearly, under the facts given, it would be beneficial for c's successor to elect such treatment. the amount of the adjustment is determined as though the election was in effect and an adjustment made upon the transfer of the partnership interest. after the amount of the adjustment is determined, it is allocated to specific properties pursuant to section 755 in an identical manner to that of a normal section 743(b) adjustment. the purpose of the adjustment is to determine the basis of property distributed to the transferee partner. therefore, the adjustment has no effect on property not so distributed. the section 732(d) adjustment is taken into account, however, as part of the partnership's basis for the property in determining the basis of distributed property. 102 b. basis of the distributed property the basis of distributed property is determined under the general rules. under these provisions, basis is derived from the partnership's basis for the distributed property immediately prior to the distribution. the section 732(d) adjustment affects the pre-distribution basis, which in turn affects the basis after the distribution by virtue of its effect on the pre-distribution basis. if the distribution is a current distribution and the basis to the partnership of the distributed property is less than the basis of the distributee's partnership interest, the basis of the distributed property after the distribution is the same as the basis the property had to the partnership.' 0 3 because the section 732(d) adjustment is part of the partnership's basis, it has a direct effect on the basis of the property to the distributee. however, the adjustment does not directly affect the basis of distributed property in all cases. if the basis of the distributed property is limited to the basis of the distributee partner's partnership interest, under section 732(a)(2) in a current distribution or under section 732(b) in a liquidating distribution, the adjustment only indirectly affects the basis to the distributee of the property through the allocation of the distributee's basis for his partnership interest under section 732(c).104 102. reg. § 1.732-1(e). 103. i.r.c. § 732(a)(1). 104. see id. §§ 732(c)(1)(b)(ii), 732(c)(2)(a), 732(c)(2)(b). 2014] 145 florida tax review c. distribution of unadjusted property the property distributed to a partner making the election may not be the property to which the adjustment applies. in that case, the special basis adjustment will apply instead to any like-kind property received by the distributee, provided he has relinquished his interest in the property with respect to which the special basis adjustment applies.'os the property distributed need not have been on hand when the distributee acquired his partnership interest as long as it is similar property to which the section 743(b) adjustment would have applied. 106 such shifting may be very detailed and complicated.10 7 d. application ofsection 732(d) by requirement of commissioner section 732(d) requires a mandatory adjustment to distributed property in certain circumstances. a partner who acquired his interest by a transfer to which the section 754 election was not in effect is required to apply the adjustment to a distribution made to him at any time (not only within two years) if at the time the interest was acquired the following conditions are met: 1. the fair market value of all partnership property (other than money) exceeds 110 percent of its adjusted basis to the partnership; 2. an allocation of basis under section 732(c) (if the interest had been liquidated immediately after the transfer) would have shifted basis from property not subject to an allowance for depreciation, depletion, or amortization to property subject to such allowance; and 3. a special basis adjustment under section 743(b) would change the basis to the distributee of the property actually distributed.'0o the purpose of the requirement is to prevent distortions beneficial to the taxpayer resulting from shifting increases in the value of non-depreciable property to the basis of depreciable property. the impact of section 732(d) was narrowed by the amendments to section 732(c) affecting basis determinations for distributed property as well as by the enactment of section 197, which allows for the amortization of intangible assets. section 732(d) applies on a mandatory basis only if an 105. reg. § 1.732-l(d)(1)(v). 106. id. § 1.732-l(d)(1)(vi), ex. 107. id. § 1.743-1(g)(2)(ii). 108. id. § 1.732-1(d)(4). 146 [vol. 15:3 optional basis adjustments under subchapter k allocation of basis under section 732(c) would have resulted in a shift of basis from property not subject to an allowance for depreciation, depletion, or amortization to property subject to such an allowance. prior to its amendment, section 732(c) focused on the distributed property's basis in allocating unused basis of the partnership interest to the distributed assets. it now focuses on relative appreciation, thereby minimizing such shifts. prior to the enactment of section 197, a partnership frequently would own both depreciable and non-depreciable property. the enactment of section 197 means, however, that some intangible assets owned by a partnership are now subject to an allowance for amortization. thus, although basis shifting may occur (and basis may be shifted from assets with longer lives to those with shorter lives), section 732(d) would not be applicable because the assets still would be depreciable or amortizable. section 732(d) can apply with respect to a partnership that owns land or other non-depreciable property; however, the impact of this provision has been narrowed. vii. traps for the unwary and tax planning opportunities as illustrated in the prior discussion, the basis adjustments of subchapter k afford planning opportunities for those with a working knowledge of their application and the results that they can generate. on the tax planning side for section 743(b), the transferee with a willing partnership should elect the adjustment where the partnership holds appreciated assets and thereby avoid double taxation provided the parties are "comfortable" about future events, i.e., the foreseeable future will continue to involve an appreciation of the partnership's assets. furthermore, the transferee will be entitled to additional amortization and depreciation deductions if the partnership holds such property. the difficulty with the election, even where it is certain that it will avoid double taxation by the transferee or afford additional deductions, is that the election is binding into the future, not only with respect to future transferees under section 743(b), but also to future distributions of property subject to section 734(b) adjustments. thus, if the partnership subsequently experiences economic reversals, the benefits of failing to elect, i.e., "duplication of loss," are foreclosed. in the depreciated assets setting, the parties should not elect where there is a loss in the partnership's assets that is not a substantial built-in loss, i.e., less than $250,000 for the partnership as a whole. the failure to elect will generate beneficial results, as it will produce duplicate losses. 1 09 109. given the imprecision in sections 734(b) and 755 adjustment allocations, not all loss duplication will be eliminated depending upon the mix of the partnership's assets, bases, and fair market values. see generally jeffrey i. 2014] 147 florida tax review with respect to tax traps involving the section 743(b) adjustment, failure to elect a basis adjustment, whether due to ignorance of the provision's existence or the failure to understand its operation, in an appreciated assets setting will result in double taxation and the loss of additional amortization and depreciation deductions for the transferee partner. thus, the purchasing partner is at the mercy of the partnership unless he or she conditions the purchase on a section 754 election by the partnership. even if the initial setting suggests utilizing the election, it is easy to forget that the election has consequences for the future. it will impact future transferees as well as the partnership on future distributions of assets. thus, the election requires foresight and an ability to accurately forecast the future. finally, the tax savings for the parties must be weighed against the administrative costs and record keeping involved in tracking the effect of the election, particularly as it is for the benefit of the transferee, not the partnership. the section 732(d) election, while made exclusively by the partner, provides similar opportunities and traps. while it requires a distribution of property by the partnership, the basis adjustment permits favorable results. for example, in the case of distribution of inventory, the adjustment, if positive, would reduce the amount of ordinary income. if the property were depreciable or amortizable by the distributee, additional deductions would arise. on the trap for the unwary side, few practitioners, if any, consider the potential mandatory application of section 732(d) on a partnership distribution. on the tax planning side for section 734(b), a willing partnership should elect the basis adjustment where the partnership holds appreciated assets in order to avoid "double taxation" provided the parties are "comfortable" about future events, i.e., the foreseeable future will continue to involve an appreciation of the partnership's assets. in the depreciated assets setting, the parties should not elect where there is a loss in the partnership's assets that is not a "substantial built-in basis reduction," i.e., less than $250,000, which generates beneficial results as it will produce duplicate losses. with respect to tax traps involving the section 734(b) adjustment, failure to elect a basis adjustment, whether due to ignorance of the provision's existence or the failure to understand its operation, in an appreciated assets setting will result in double taxation and the loss of additional amortization and depreciation deductions for the partnership. even if the initial setting suggests utilizing the election, it is easy to forget that the election has consequences for the future. it will impact future transferees as rosenberg, ajca imposes new burdens for partnership basis adjustments under sections 734 and 743, 101 j. tax'n 334 (2004). thus, tax planning opportunities through the failure to elect remain. 148 [vol. 15:3 optional basis adjustments under subchapter k well as the partnership on future distributions of assets. thus, the election requires foresight and an ability to accurately forecast the future. finally, the tax savings for the parties must be weighed against the administrative costs and record keeping involved in tracking the effect of the election. a further difficulty with the section 734(b) adjustment is its failure to operate properly in all cases. as previously discussed, if there is a preexisting disparity between inside and outside basis, the section 734(b) adjustment will not restore equilibrium. additionally, the adjustment is typically one dimensional in contrast to the two dimensional approach of section 743(b). given its operational dictates, it is far from certain that the assets responsible for the appreciation or depreciation in the value of the partnership will receive the appropriate amount of the adjustment. viii. analysis of arguments supporting the elective aspect of the basis adjustments of sections 734(b) and 743(b) the founding values for the enactment of subchapter k in 1954simplicity and flexibility-have been the strongest arguments in favor of maintaining the electivity of the basis adjustment provisions of section 743(b) and section 734(b). those values influenced the congressional decision to minimize the administrative burdens and costs incurred by the operation of a partnership."o while the crafting of subchapter k was intended to bring order out of the chaos surrounding the taxation of partners and partnership, the electivity of the basis adjustments was but one of the numerous issues being considered. however, with the passage of 60 years, accompanied by the entry into the computer and electronic world, such an argument loses much of its persuasive force when basis adjustments are considered as a single tax policy issue. in the age of computers, the administrative burdens and costs of such determination are not what they once were. in fact, the present complexity of the code defies these arguments. even before the 1999 amendments to the regulations, partnerships, especially large ones, were faced with complex recording and computational problems in numerous areas. the pervasive use of special allocations 110. see h.r. rep. no. 83-1337, supra note 8. see also hearing, 83d cong., supra note 9, at 1370 ("in the interest of simplicity and flexibility, however, we provide a series of elections based upon the 'entity' approach, which we assume would be exercised generally by larger and more complex partnerships."). interestingly, the ali/aba proposal embraced the concept that basis adjustments would occur unless the partnership elected out. in the final statutory version adopted by congress, basis adjustments do not occur unless the partnership elects to do so. 2014] 149 florida tax review evidences the fact that sophisticated tax counsel and accountants are invariably confronted with complex calculations.' furthermore, the amendments to section 743(b) and section 734(b) making the adjustments mandatory in certain loss settings not only added more complexity to the code but also ensured that numerous partnerships will be required to make such calculations in order to determine whether the provision applies. these required calculations and determinations are contrary to tax simplicity." 2 while having theoretical merit, these amended rules require sophisticated accounting practices and thus confront partnerships with tremendous record-keeping burdens. furthermore, the amendments signaled a new attitude by congress, the service, and treasury favoring accuracy and efficiency as opposed to simplicity and flexibility." 3 in those few cases where the administrative and record keeping burden is genuine, congress has provided exceptions from the calculations and determinations.'14 the 2004 amendments to section 734(b) and section 743(b) underscore the increasing ambivalence regarding the elevation of flexibility and simplicity over consistency, efficiency, and overall sound tax policy." 5 the mandatory application of the provisions in such settings marks a partial victory against partnerships' ability to manipulate basis disparities. the changes to the basis adjustment provisions are sweeping in scope because they apply to most partnerships, regardless of size. administrative burdens and costs imposed are irrelevant. thus, the transfer of a one percent interest or less in a partnership could trigger the mandatory application of the basis adjustment rule as long as the built-in-loss threshold is met. the mandatory basis adjustment rules also apply even in the case of a transfer due to the death of a partner, a situation in which an intention to duplicate losses should be lacking. the mandatory application of the provisions would not only simplify partnership taxation by rendering obsolete section 732(d) and section 754, but it would also greatly facilitate the accuracy, uniformity, and efficiency of 111. see willis & postlewaite, partnership taxation, supra note 2, at 619. 112. see reg. §§ 1.734-1, 1.755-1. 113. see willis & postlewaite, partnership taxation, supra note 2, at tt 12.03[l] and 13.05[l]. 114. see sections 743(e) and 743(f) regarding the inapplicability of the mandatory adjustment for electing investment partnerships and securitization partnerships. interestingly, only securitization partnerships are exempt from section 734(b). see i.r.c. § 734(e). 115. the mandatory application of section 732(d) in certain settings was an earlier indication of this concern. given that most practitioners are not aware of its existence, it has not received much attention in the literature. 150 [vol. 15:3 2014] optional basis adjustments under subchapter k 151 partnership transactions.116 most importantly, it would rebalance equity considerations not only horizontally, between similarly situated partners, but also vertically, between partners with greatly varied tax characteristics, thereby curtailing or preventing abusive tax sheltering. notwithstanding the 2004 amendments requiring mandatory application, transactions under section 734(b) and section 743(b) falling short of the $250,000 threshold remain untouched. mandatory application of the basis adjustments in all cases would ensure vertical and horizontal equity in all cases.' 17 ix. reasons for making the sections 734(b) and 743(b) basis adjustments mandatory the legislative history of subchapter k links its origin to the excessive use of taxmotivated family partnerships of the 1940s."'8 the legal and historic context surrounding its enactment, in which both the united states supreme court and congress sanctioned the use of tax-motivated entities,' stressed the "vital need" for "clarification," "simplicity," and "flexibility."1 20 the accurate reflection of the economic aspect of partnership transactions was not a high priority for the drafters of subchapter k; rather, their overriding objectives were certainty and the elimination of confusion. 121 those principles led to the enactment of rules designed to facilitate 116. however, the mandatory application of the basis adjustment provisions would not cure the inherent problems with section 734(b) or the flawed allocation rules under sections 734(b) and 755, and the regulations. while the 1999 amendments relating to optional basis adjustments greatly clarified the methodology of the allocation rules under sections 743(b) and 755, they failed to provide similar improvement to the corresponding rules under section 734(b). 117. an interesting aspect of the threshold is that congress did not do similarly in section 704(c)(1)(c), where a mere loss potential of but a single dollar will trigger its application. 118. see discussion supra at part ii, b. 119. the economic and historic activity throughout the late 1940s and 1950s, where the top marginal tax rate was typically above 90 percent and the necessity for economic growth following world war ii was stringent, offers a contextual basis for the prevailing policies embraced by the legislature and judiciary. see superior oil co. v. mississippi, 280 u.s. 390, 395-396 (1930), where justice holmes stated that "[t]he only purpose of the [taxpayer] was to escape taxation.... the fact that it desired to evade the law, as it is called, is immaterial, because the very meaning of a line in the law is that you intentionally may go as close to it as you can if you do not pass it." 120. see s. rep. no. 83-1622, supra note 6, at 89 (1954). equity among partners was another important concern for the drafters of the 1954 code. 121. h.r. rep. no. 83-1337, supra note 8, at 66 (1954). "this general treatment was adopted because of its extreme simplicity as contrasted with any other alternative and because it conforms to the usual expectations of partners." florida tax review partnership transactions expected to comply with the economics of the transaction. basis manipulation through the exploitative tax planning of the discrepancies between outside and inside partnership basis has emerged as a central concern of the treasury and internal revenue service. this indicates that the policies of simplicity and flexibility have largely failed and should give way to more significant concerns such as equity, accuracy, and efficiency. the recent major legislative changes to the adjustment of basis provisions, specifically the 2004 amendments to section 734(b) and section 743(b), partially addressed the problem of their electivity. partnerships play a major and ever-increasing role in the field of federal taxation from a revenue perspective; therefore, policies promoting the tax policy goals of subchapter k are required. the drafters of subchapter k in 1954 recognized the potential for shifting tax attributes through the manipulation of basis discrepancies. 12 2 nevertheless, starting from the premise that the cost of complexity through the harmonization of inside and outside basis outweighed the benefits of accuracy, the drafters opted for a laissez faire approach, an optional election, for resolving the problem. it is apparent that the elective nature of the provisions springs from a preference for simplicity and compromise and demonstrates a general commitment to avoid complex or burdensome solutions for both taxpayers and agents in the field. 12 3 such preference could be explained, at least partially, by the fact that the drafters (1) were not as appreciative as congress is currently of the timing issue and (2) were not confronted regularly with situations where partners had different tax profiles and were ready to exploit their differences to the detriment of the treasury. as the tax sheltering activity of the 1990s and 2000s demonstrated, the attitudes and behavior of taxpayers shift and policies do not have immutable properties, regardless of their scope and desirability. 12 4 consequently, as the application of competing policies compromises the functionality of partnership taxation, they must be challenged and re-evaluated. the treasury launched a subjective attack on abusive partnership transactions and published the final anti-abuse regulation under section 701 in 1995.125 examples (10) and (11) of regulation section 1.701-2(d) recognize the potential abusive exploitation of the basis adjustment 122. see generally jackson et al., a proposed revision of the federal income tax treatment of partnership and partners-american law institute draft, 9 tax l. rev. 109 (1953); see also jackson et al., supra note 17. 123. see generally, william s. mckee, partnership allocations in real estate ventures: crane, kresser and orrisch, 30 tax l. rev. 1 (1974). 124. see notices 2002-50, 2008-34. 125. reg. § 1.701-2, t.d. 8588, 60 fed. reg. 23 (jan. 3, 1995). 152 [vol. 15:3 optional basis adjustments under subchapter k provisions along with the treasury's determination to curtail them. in addition to the concern that the anti-abuse regulations were erroneous with regard to the failure to elect under section 754, the legislative change imposing mandatory basis adjustment provisions demonstrates that congress has grown increasingly dissatisfied with the operation of the basis adjustment provisions and sought sound tax policy results. the senate's version of the 2004 amendments regarded the electivity of the basis adjustments rules as "anachronistic" and rejected them almost in their entirety. it proposed mandatory basis adjustments in both "gain or loss situations," except for transfers of a partnership interest by reason of death, "which may involve unsophisticated taxpayers."1 2 6 although the senate's 2004 proposal for mandatory basis adjustments was regarded by its opponents as "misguided" and "overbroad"l 2 7 and received only partial recognition, it highlighted the awareness of a conceptual truth of partnership taxation-namely that the aggregate basis of a partnership's assets should equal the aggregate basis of its partners' interests in the partnership. this congruence of bases ensures that each partner recognizes income or loss attributable to his partnership interest only once. ample scholarly arguments have been raised to support the necessity of inside and outside basis equality in the face of taxpayers' astute exploitation of the difference. some propose the mandatory application of section 734(b).128 almost 30 years ago, a commentator, in a critical assessment of the 1984 american law institute six-year study of the taxation 126. s. rep. no. 108-192, at 190 (2004). the senate also proposed the repeal of section 732(d). 127. see monte a. jackel & robert g. honigman, the proposed abusive tax shelter shutdown act of 2001: the mandatory code secs. 743 and 734 adjustment provisions are misguided, overbroad and just plain poor tax policy, 4 j. passthrough entities 5, 9 (2001) (arguing that the section 701 anti-abuse regulations offered a satisfactory method in dealing with partnership transactions inconsistent with the intent of subchapter k, including the shifting of loss or gain through inside-outside basis manipulation). 128. see generally william d. andrews, colloquium on partnership taxation: inside basis adjustments and hot asset exchanges in partnership distributions, 47 tax l. rev. 3, 8 (1991). professor andrews stressed the "urgent need to make [§ 734(b)] mandatory [at least for in-kind distributions] because the failure to adjust is much more subject to systematic exploitation than in the cases of transfers and cash distributions." see also noel b. cunningham, "needed reform: tending the sick rose," 47 tax l. rev. 77 (1991). professor cunningham endorsed the proposal emphasizing that "many of the rules of subchapter k are designed to preserve [the] equality" between the partnership's aggregate inside basis and the partners' aggregate outside basis. 2014] 153 florida tax review of partners and partnerships, 12 9 advocated the mandatory application of both section 734(b) and section 743(b). 13 0 responding to the ali study, the commentator proposed that (1) following "the transfer of a partnership interest by sale or death, the transferee's share of the partnership basis for its assets [should] equal the adjusted basis of his partnership interest, with resulting adjustments made in accordance with the assets' fair market values" and that (2) following distributions in complete or partial liquidation, the "partnership [should be required] to adjust its basis for assets relinquished by the distributee to reflect their 'cost' to the partnership."l 3' the major arguments supporting mandatory basis adjustments are that these rules: (1) would protect the purchaser from recognizing gains attributable to pre-entry appreciation and prevent the recognition of pre-entry losses, (2) would prevent the partnership from exploiting the electivity of basis adjustment provisions for the sole purpose of achieving favorable tax results, (3) would assure horizontal and vertical equity through the uniform treatment of all partners, regardless of their interest in the partnership, (4) would enhance the taxpayer's understanding by basing the adjustments on the assets' fair market value, which should provide "a coherent and consistent system" for determining tax consequences upon transfers, and (5) would prevent the provisions from being a trap for the unwary or a tax planning tool.132 x. conclusion for the past 60 years, the basis adjustment provisions have been shaped by, and representative of, the temporal context in which they were employed. upon codification in 1954, the provisions highlighted broad congressional goals such as economic stimulation through various forms of enterprises, many of which constituted partnerships for tax purposes. they also reflected the modest congressional appraisal of the revenue to be generated under subchapter k. at that time, flexible and simple rules, unburdened by stringent equity considerations, were viewed not only as desirable but necessary. logic and accuracy were often sacrificed for the sake of simplicity. consequently, it was not surprising that the complex rules 129. american law inst., federal income tax project, subchapter k: proposals on the taxation of partners 2-5 (1984). 130. see postlewaite et al., supra note 1, at 621. 131. id. at 622. 132. some may criticize the proposal by asserting that it will be burdensome on small partnerships, non-compliance and erroneous results will ensue, and faith in the system will be undermined. however, in such settings, transfers of interests occur infrequently. furthermore, while some additional record keeping will be required in such settings, that burden will be more than offset by the benefits noted in the text. [vol. 15:3154 optional basis adjustments under subchapter k required to correct basis discrepancies following distributions and transfers of partnership interests were avoided. instead, their use was left to taxpayers by the adoption of elective treatment. the conflict with the sound tax policy goals of vertical and horizontal equity as well as the inequality imposed on the fisc or taxpayers were ignored. confronted with the exploitation of basis discrepancies by everincreasing partnership structures intended to generate significant revenue loss, congress, treasury, and the service adopted several synthetic solutions against tax arbitrage, marking a radical shift in the war against abusive partnership transactions. equity, accuracy, and efficiency became integral elements in the design of partnership taxation. the road for major reform remains open and widening. 33 basis discrepancies following distributions or transfers of partnership interests are conceptually incoherent and unjustifiable. mandatory adjustments are not simple but necessary. those who favor accuracy, equity, and efficiency should embrace them; those who do not have the freedom to choose a different or simpler modality of taxation for their business enterprises. there is no reason that section 734(b) and section 743(b) should not have uniform mandatory application to prevent basis manipulation in partnership transactions. it is time for congress to act! 133. on march 12, 2013, house ways and means committee chair, dave camp, released a discussion draft of his small business tax reform comprised of two option plans. dave camp, ways and means discussion draft, committee on ways and means (march 12, 2013), http://waysandmeans.house.gov/ uploadedfiles/final sm buspassthroughlegislative text_03.12.13.pdf. in option 1, he proposed mandatory basis adjustments under sections 734(b) and 743(b) as well as the striking of sections 754 and 755. id. option 2 would repeal subchapter k in its entirety and replace it with a new subchapter devoted to passthrough entities. id. 2014] 155 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 12 2012 number 4 sunshine and shadows on charity governance: public disclosure as a regulatory tool evelyn brody* abstract as legislatures turn to disclosure as the primary tool of nonprofit regulation, we should ask some basic questions: why isn't it enough that charities report information to the authorities why further require those filings to be disclosed to the public? is information collected by regulators who worry primarily about financial self-dealing useful to a public worried about charity effectiveness? ideally, the prospect of disclosure should improve not just the accuracy of filings, but also board monitoring and governance: boards will become sensitive not only to how operations look, but how well the charity is really doing. if mandated disclosures focus on the wrong questions or paint an incomplete picture, engaged boards can ensure that charities tell their stories through additional, voluntary forms of disclosure. at the same time, increased public disclosure of the irs's professor law, chicago-kent college of law, illinois institute of technology. this article grew out of my norman a. sugarman lecture, "governing in a fishbowl: the effects of sunlight on nonprofit accountability," mandel center for nonprofit organizations, case western reserve university (cleveland, november 11, 2004). i appreciate comments received from laura brown chisolm, paul feinberg, and students and other attendees, elizabeth boris and discussant joseph cordes at the 2011 irs-tpc research conference (urban institute, washington, d.c., june 22, 2011). i am grateful for opportunities to present drafts at the internal revenue service's 2011 research conference; the chicago bar association committee for trade and professional associations law (chicago, january 11, 2011), the 38th annual conference of the association for research on nonprofit organizations and voluntary action (alexandria, virginia, nov. 18, 2010), and the advanced topics in taxation colloquium series, northwestern university school of law (chicago, april 19, 2010). this article will also appear (in substantially identical form) in the proceedings of the 2011 irs-tax policy research conference, and i thank alan plumley for permission to publish it in the florida tax review. this article cites portions of draft chapters i prepared for the american law institute as reporter of its project on principles of the law of nonprofit organizations. while tentative draft no. 1 (2007 and 2008) and tentative draft no. 3 (2011) (through § 660) were approved by council and the membership, they are subject to further revisions and final approval. 183 florida tax review exemption determinations and revocations reveals the need for formal guidance from the tax regulator about acceptable governance structures and practices. i. introduction ............................................. 185 h. sound governance and internal disclosure ............. 191 111. regulatory registration and reporting . ................. 195 a. state registries: constitutional limits on state regulation offundraising .......................... 195 b. federal tax filings: governance focus of redesigned form 990 ............................ 197 c. what's not publically available from federal tax filings........ 201 iv. public disclosure of regulatory filings and determinations ................................ ...... 203 a. privacy interests of charities and their supporters .................. 204 b. what filings are subject to public disclosure? ...... ...... 205 c. rationales for governmentally mandated disclosure to the public ................................. 210 d. disclosure of state and federal enforcement activity...............214 e. congressional oversight. ........................... 224 v. voluntary disclosure by the organization and disclosure by private parties ........................... 226 a. voluntary disclosure by the organization itself ...... ..... 226 b. media ................................... ..... 227 c. peer regulators and charity "watchdogs" ................... 228 vi. conclusion ..................................................... 230 appendix: summary and governance pages of core form of redesigned form 990 ........................................233 [vol. 12:4184 charity governance i. introduction the federal tax treatment of tax-exempt organizations, as i once wrote, is a photo-negative of congress's treatment of those who pay taxes.' as a substantive matter, this.favors charities. the higher the tax rate on forprofit corporations, the higher the relative value of the charity's income-tax exemption; the higher the individual income-tax rates, the lower the price of charitable giving (and the greater the interest-rate savings to charities from issuing tax-exempt bonds); and charities are big defenders of the estate tax, under which donations are fully deductible. by contrast, exempt organizations might lament the reversal of the presumption of privacy. in stark contrast to the strict protections enjoyed by taxpayers under internal revenue code section 6103, exempt-organization filings are publicly available under code section 6104. indeed, in the last twenty years, the annual information return filed by federally tax-exempt organizations the form 990 has become not only the public face of individual charities, but also the most readily available data source for potential donors, state regulators, the media, and researchers, as well as the charity's governing board, staff, and volunteers. this filing is so important that in 2008 the internal revenue service (irs) took into account the interests of these various stakeholders in radically redesigning the form 990, which now makes available, among other information, a detailed picture of the organization's governing structure, policies, and related-party transactions. moreover, simply by asking questions about the existence of perceived "best practices," the irs sends a strong signal of their desirability. meanwhile, the emergence of the thirdparty online database of forms 990 maintained by guidestar itself a private, nonprofit organization completes the goal of transparency. aside from any oversight actions of regulators, any member of the public (including competitors, nonprofit and for-profit) can scrutinize filings without the charity's knowledge of who is looking, when, or why.2 sunlight, of course, creates both clarity and shadows. knowing that detailed information about charity structure and practices will be available to the public can as no doubt intended influence charity behavior. however, requiring charities to disclose information to the irs is a separate question from requiring charities to disclose their irs filings to the public. since 1987 .exempt organizations have operated under a statutory obligation to provide their forms 990 to members of the public upon demand. that 1. evelyn brody, charities in tax reform: threats to subsidies overt and covert, 66 tenn. l. rev. 687, 694 (1999). 2. see guidestar, http://www.guidestar.org. 3. see pub. l. no. 100-203, § 10702(a), 101 stat. 1330 (1987) adding subsection (e) to internal revenue code § 6104. in 1998 congress replaced 1852012] florida tax review significant development has long made me wonder about the effect on the nonprofit sector from mandated public disclosure of tax filings.4 in a march 2010 letter, then-ranking member (and former chair) of the senate finance committee, charles grassley, praised the 2008 redesign of the form 990 in declaring: "the best way i know to increase voluntary compliance is to inject "5transparency." meanwhile, pursuant of its obligation to administer and enforce the requirements for federal tax exemption, the irs has long kept its hand in issues of sound charity governance. in the 1990s, the public was treated to peeks at the irs's view of appropriate governance through the release of a few otherwise confidential "closing agreements" that the irs entered into on the condition that the organization agree to publish them.6 more systematically, in 1996, congress involved the irs in charity governance by adopting the "intermediate sanctions" statute designed to deter charity insiders from engaging in "excess benefit transactions" with charities.7 the subsections (d) and (e) with the current subsection (d). 4. as i wrote in 1996: the wealth of data demanded by the irs inspired the following exchange between a member of the american bar association and the irs's special assistant for exempt organization matters: mr. gallagher: howard, what does the irs do with all this stuff? mr. schoenfeld: it's not so much what the irs does with all this stuff. it's also what the public does with all this stuff. that's an equal part, i think, of what the question should be. but what, then, is the public to do with all this stuff? evelyn brody, institutional dissonance in the nonprofit sector, 41 vill. l. rev. 433, 501 (1996) (citing the exchange in edited transcript ofthe morning sessions of the august aba eo committee meeting in new orleans, panel iii, the role of the irs in promoting public accountability of exempt organizations, 10 exempt org. tax rev. 805 (oct. 1994)). 5. charles grassley, letter to the editor, increasing irs enforcement remains a 'slippery slope, 'chronicle of higher educ., mar. 7, 2010. 6. the closing agreements with jimmy swaggart ministries, pat robertson's christian broadcasting network, and jerry falwell's old time gospel hour not only required the payment of taxes, but also required the organizations to make changes in corporate governance and to publicize the general terms of the closing agreements. see streckfus, paul, swaggart settlement drawing comments (dec. 17, 1991), 5 exempt org. tax rev. 205 (feb. 1992); statement of jerry falwell regarding closing agreement (feb. 17, 1993), 7 exempt org. tax rev. 876 (may 1993). see also closing agreement on final determination covering specific matters (oct. 1, 1993), 97 tnt 251-24 (dec. 1, 1997) available in lexis, fedtax library, tnt file (purporting to be between the irs and the church of scientology, but never acknowledged by either party). 7. evelyn brody, a taxing time for the bishop estate: what is the i.r.s. role in charity governance?, 21 u. haw. l. rev. 537 (1999) (bishop estate symposium issue). for the august 18, 1999 closing agreement between the internal [vol. 12:4186 charity governance legislative history of code section 4958 suggests that administrative guidance could protect financial transactions entered into between charities and their insiders if the approval process assured independent decisionmaking, obtained comparable data, and maintained documentation. treasury regulations issued under section 4958 detail the process for qualifying for such a "rebuttable presumption of reasonableness." 9 more recently, charity governance writ broadly has emerged as a fundamental focus in the regulation of federally tax-exempt organizations. in 2004, the staff of the senate finance committee produced a white paper proposing a broader role for the irs in charity governance; the nonprofit sector responded with studies and proposals to improve nonprofit governance, including recommendations for self-regulation.10 both when chair, and subsequently as ranking member, of the senate finance committee, grassley demanded and posted online massive amounts of information (including emails and correspondence, some labeled "privileged and confidential") from specific organizations whose governance practices he questioned." relying on public disclosure, however, puts pressure on the irs to ensure that the form asks the "right" questions and allows the filer to present complete and accurate answers. the irs itself benefited from a transparent process in its form 990 redesign, having posted online drafts of the form (and schedules) and the thousands of comments it received, all still available on the irs website.12 that exposure process allowed the irs not just to revenue service and the kamehameha schools/bishop estate (ksbe), see department of the treasury, internal revenue service, estate of bernice pauahi bishop, also known as, kamehameha schools bishop estate closing agreement on final determination covering .specific matters (aug. 18, 1999), www.ksbe.edu/newsroom/filings/final-vo21029.pdf this closing agreement required in addition to a payment from ksbe to the irs of $9 million plus interest (for a total of about $14 million) significant governance reforms, as well as the internet posting of the final closing agreement. the closing agreement did not cover any personal tax liability of the trustees. 8. see h.r. rep. no. 104-506 (1996). 9. reg. § 53.4958-6. 10. see infra text at notes 159-60, 177. 11. see infra part iv.e. see also senator charles grassley, press releases, http://grassley.senate.gov/news/press-releases.cfi. 12. for the 2007 draft form 990 and related schedules, the draft instructions, and the comments on these drafts, along with educational material, see internal revenue service, chronological history: redesign of the 2008 form 990 and corresponding instructions, http://www.irs.gov/charities/charitable/article/ 0,,id=185892,00.html. see also the urban institute's center on nonprofits and philanthropy and harvard university's hauser center for nonprofit organizations, 17th emerging issues in philanthropy seminar, irs form 990 redesign (washington, d.c., sept. 10, 2007) (on file with author), where over sixty attendees, 1872012] florida tax review rework misleading questions but also to recast the questions both to produce a better picture of the organization and to steer the sector to good governance structures and practices. notably, the irs acceded to a storm of pleas to remove the most "prejudicial" (and uninformative) lines from the allimportant new summary page (part i). (compare the 2007 draft, on the first page of the appendix, below, with the final version, on the third page.) line 6 of draft part i had asked: "enter the number of individuals receiving compensation in excess of $100,000 (part ii, line 2);" while this line, like all the others in the summary page, draws from a question elsewhere on the form, what valid information does it convey by including it on the front of the form? similarly, the irs removed the three "efficiency ratio" questions, which, while used by some charity watchdog groups and rating agencies, have long been criticized as oversimplified and unhelpful metrics. to give another example, consider the 2007 draft form 990's question in part iii (statements regarding governance, management, and financial reporting) on conflict of interest transactions (see the second page of the appendix, below): 3a does the organization have a written conflict of interest policy? b if "yes," how many transactions did the organization review under this policy and related procedures during the year? what is the preferred answer to question 3b? if the organization answers "zero," is this good (because there were no conflict of interest transactions to review) or bad (because the organization was blind to the interested transactions that occurred)? commentators pointed out the problems with this and other governance questions of the draft. substantially revised (and renumbered) part vi not only addresses the suggestions (see the last page of the appendix), but also states at the outset: "governance, management and disclosure (sections a, b, and c request information about policies not required by the internal revenue code.)" (on the 2010 version of the form 990, this disclaimer has been moved to the beginning of part b (policies).) moreover, the 2007 draft did not provide an opportunity for the organization to provide attachments to the form. in response to complaints including the argument that it is unconstitutional to deny a filer subject to mandatory disclosure the opportunity to explain yes/no and other short answers the final form includes a schedule 0 for extensions of responses and supplemental narration. the final conflict of interest questions read: 12a does the organization have a written conflict of interest policy? if "no, " go to line 13. b are officers, directors or trustees, and key employees including representatives from the internal revenue service and congressional staff, as well as from sector organizations, practitioners, and scholars, discussed the draft form 990. 188 [vol. 12:4 charity governance required to disclose annually interests that could give rise to conflicts? c does the organization regularly and consistently monitor and enforce compliance with the policy? if "yes, " describe in schedule 0 how this is done. (incidentally, contrary to the suggestion in line 12a, an organization could have a conflicts-of-interest policy, and engage in effective monitoring, without reducing the policy to writing.) separately, since 2003, the irs has become subject to public disclosure obligations of its own. as a result of freedom of information act suits brought against the irs, the agency's views on a range of issues can, at least informally, be gleaned through the release of rulings denying or revoking exemption. (by law, the irs redacts these rulings to hide the names of and other identifying information about the charities and other taxpayers.)14 most helpful for the nonprofit sector would be for the irs to take the now-substantial database of denial and revocation letters and develop from it formal guidance on which indicators of governance structure and policies the irs would like to impose as conditions for exemption. the simultaneous developments of substance and process of increased federal interest in charity governance and in the tool of disclosure threaten to conflate an examination of the relative merits of each. it might be appropriate, for example, to require reporting of certain information to state regulators or to the irs without also requiring that information to be made publicly available. it is important to recognize, however, that a large percentage of exempt organizations file forms other than the form 990, or do not even make a substantive filing at all. 15 because of statutory exemptions, it can be difficult, if not impossible, to obtain much information on churches and on smaller charities. moreover, hundreds of thousands of charities will fall below the governance radar when the cutoff between charities required to file the form 990 and the simplified form 990-ez is fully phased in beginning in 2010: the definition of "small" doubled from $25,000 or less in gross receipts to $50,000 or less. finally, arguably the most important disclosures take place internally within the organization. to explore these thoughts, part i begins with the desirability of information flow to key decision makers in the organization, including the board, and considers the possible dilatory as well as salutary effects of public disclosure on governance practices. part ii covers reporting to the states and to the irs as regulator of the federal tax-exemption regime. part iii, the longest of this article, compares disclosure of filings with the regulators (the charities' transparency) and disclosure of enforcement activities (the 13. see infra part iv.d.2. 14. id. 15. see infra part iil.b.15. 1892012] florida tax review regulators' transparency). part iv looks at voluntary public disclosure by the organization, as well as disclosure by third parties, notably the media and third-party "watchdogs." throughout, i not only describe criticisms of required disclosure, but also suggest areas in which the current levels or types of disclosure are not enough. now we turn to the dark side of sunshine. the greatest practical impediment to relying on public disclosure is the unfortunately widespread assumption that providing charity is a free good and so general overhead, much less fund raising expenses, should be zero or close to it.,6 one of the great lost opportunities of the september 11th experience was the failure of charities to defend the costs of wisely allocating charitable resources. more broadly, charities resist increased standardized disclosures because they worry that the public will misunderstand or misinterpret the information. a public that does not understand cost constraints cannot perform effective oversight. a public whose oversight focuses on the wrong considerations induces charities to adopt inefficient and ineffective behaviors. in this climate, the solution to the problem of a misinformed public is more disclosure nothing prevents an organization from providing a more positive narrative of its goals and accomplishments. while the competing demands of the various stakeholders cannot always be reconciled, all involved will better appreciate the challenges faced by a charity that reveals rather than hides its costs of fund raising and administration, explains why its executives merit their pay and why its reserves are necessary, and describes its limits as well as its potential in delivering services and addressing social needs. finally, the sector as a whole should also weigh in, denouncing unacceptable practices. consider a recent u.k. report addressing whether public confidence in charities would be affected by increased mandatory disclosure of expense reimbursements. the report opposed expanding mandated disclosure beyond current requirements, arguing, in part: greater disclosure might risk being at best, of little interest or, at worst, of misinterpretation and even suspicion, possibly leading to damage to public trust and confidence. this might risk elevating expenses to become an inappropriate measure of charity effectiveness and distract attention away from more appropriate measures, namely those relating to a charity's overall outcomes and impact. it 16. for example, a survey conducted by the charity watchdog bbb-wise giving alliance suggested that the public does not accept fund raising costs over 15 percent, an unrealistically low number. see grant williams, watchdog group proposes changes in evaluating charity operations, chron. of philanthropy, jan. 24, 2002. [vol. 12:4190 charity governance might even lead to pressure to inappropriately drive down certain costs.1 7 moreover, the report continued, focusing only on expenses ignores issues of greater accountability for "good governance" and sound systems of internal control.' 8 rather, the lengthy report which was based partially on a survey to which 575 registered charities responded urged trustees to consider additional, appropriate voluntary public disclosure, in addition to ensuring the adoption, internal communication of, and compliance with an expense reimbursement policy.' 9 indeed, the voluntary disclosure of information also serves charities that do not solicit donations. all nonprofits remain politically vulnerable not just to the removal of subsidies, but also to the danger of unwise legislation and regulation.20 regrettably, the most important information that both regulators and the public might want will continue to be unavailable simply because performance measurement is an unsolved metric. as a society, we would want to be able to assess whether and which charities are producing favorable outcomes, but often we cannot even measure outputs because quality can be subjective. at the same time, while focusing on outputs (such as patient stays or unemployed trained) can lead to de facto quotas, focusing on outcomes (such as good health or jobs) holds nonprofits responsible for factors beyond their control. thus, the ultimate disclosure question how do we challenge an organization that says it "does good"? is beyond the scope of this paper. h. sound governance and internal disclosure as described in the american law institute's project on principles of the law of nonprofit organizations, for which i am the reporter, a charity's governing board is responsible for "establishing appropriate procedures for internal controls, including financial controls, legal compliance, and information flow to the board."2 ' thus, as a matter of good governance, the board needs accurate and timely information from 17. report of the independent expert group on expenses 9, 16-17 (feb. 2010), http://www.ncvo-vol.org.uk/sites/default/files/expensesreportfinal.pdf the study was prompted by a scandal that erupted in the united kingdom over expense reimbursements claimed by members of parliament. 18. id. 19. id. at 50-51. 20. see generally evelyn brody, accountability and public trust, in the state of nonprofit america 479 (lester m. salamon ed., 2002). 21. a.l.i., principles of the law of nonprofit organizations § 320(b)(8) (tentative draft no. 1, 2007 & 2008) [hereinafter a.l.i., principles]. 1912012] florida tax review management, including financial reports, and accurate and timely information from board members themselves, such as when a transaction might present a conflict of interest for a particular fiduciary. i am often asked if there are any limits on the information to which a board member is entitled, and the answer is almost always no.22 more fundamentally, it seems that we cannot be too basic in explaining to nonprofit board members what information they should be seeking. a comment in the ali project sets forth the documents which should be provided to every board member. 23 the availability of forms 990 from guidestar's website (discussed below), of course, means that board members and prospective board members can learn a great deal about the organization even if management is not forthcoming organization formation and operations generally are private affairs. if the organization is itself a quasi-public entity, it might be subject to sunshine laws. tax-exemption alone, however, does not convert a nonprofit organization into a public entity.24 (separately, the government as grantmaker might impose transparency as a condition of funding; state laws vary.) nevertheless, a great deal of internal information becomes public information because it must be set forth on regulatory reports, as explained in part iii. nonprofit governance practices have long remained a mystery. in 2007, the first comprehensive survey was published by the urban institute's francie ostrower.25 notably, she found that charities commonly enter into 22. see id at § 340. the most common exceptions are for some personnel issues. 23. id. at § 320, comment g(6), suggests a list of documents that every board member should receive, including the current (and dated) versions of the charity's trust instrument or articles of incorporation; bylaws; board policies applicable to board members (e.g., conflicts of interest, travel and expense reimbursement, confidentiality, and any general ethical policy); a directory (with contact information) of board members and officers; charters of any board committees and committee assignments; an organizational chart and contact information for senior staff; the current budget and recent financial statements, including the outside's auditor's management letter; recent forms 990; minutes of recent board meetings and, if applicable, of executive committee meetings; the charity's mission or vision statement, if prepared; and a schedule of dates and locations of upcoming meetings of the board and of the membership (if any). 24. see exploration of this issue in evelyn brody & john tyler, how public is private philanthropy?: separating reality from myth (philanthropy roundtable monograph, 2d ed. 2012), www.philanthropyroundtable.org/files/public private%20monograph high%20res final.pdf, and as respecting foundation and charity autonomy: how public is private philanthropy?, 85 chi.-kent l. rev. 571 (2010) [hereinafter brody & tyler, philanthropy]. 25. francie ostrower, nonprofit governance in the united states: findings on performance and accountability from the first national representative study, 192 [vol. 12:4 charity governance transactions for goods and service (beyond board services) with members of the governing body, and that these transactions grew with charity size; but she further found that it was not even always known to a particular organization whether a fiduciary was on the other side of a transaction.26 she further found a serious lack of internal disclosure: "[a]mong those nonprofits that say they did not engage in transactions with board members or affiliated companies, however, fully 75 percent also say they do not require board members to disclose their financial interests in entities doing business with the organization, and thus, respondents may have been unaware of transactions that do exist."27 how has nonprofit governance been and how will it be affected by the knowledge that internal information is public due to its presence on the form 990 and other filings? (this topic is explored at length in part iv; specifically, see part il for more discussion of the governance questions in the redesigned form 990.) will organizations change their decisions or pay more attention to documenting their decisions, providing additional explanation? will organizations try harder to skew the information to what it perceives the public wants to see? there is a difference between perceived wrongdoing and actual wrongdoing. if the public misinterprets or demands the wrong "answers," charities can suffer a loss of trust. to give a personal example, early in the internet age, as i was about to write our family's charitable contribution checks, i realized that i could and should consult the organizations' forms 990 from my home computer. back then and, sadly, still too often today you could not expect to find this information on most charities' own websites, but rather you would have to sneak, feeling somewhat guilty, to guidestar. there i discovered that two organizations to which we had generously contributed reported high executive compensation and high retained surpluses. then i tried to get a grip on myself: "hold on," i muttered. "you're a professional! surely you urban institute, http://www.urban.org1uploadedpdf/411479_nonprofit_ governance.pdf [hereinafter ostrower, nonprofit governance]. 26. id. importantly, the subset of charities dubbed "private foundations" by federal tax law are prohibited from entering into transactions with insiders other than the payment of reasonable compensation for services rendered. i.r.c. § 4941 (taxes on self-dealing). for a full discussion of interested transactions, see a.l.i., principals, supra note 21, at § 303. 27. ostrower, nonprofit governance, supra note 24, at 8 (footnote omitted). that study found: "[almong nonprofits engaged in financial transactions, most obtained goods at market value (74 percent), but a majority (51 percent) did report that they obtained goods below market cost. under 2 percent reported paying above market cost. keep in mind, too, that these are self-reports, and thus, if anything, the figures are likely to underreport transactions resulting in obtaining goods at above market value or at market value costs and overreport transactions resulting in obtaining goods below market cost." id. (footnote omitted). 2012] 193 florida tax review appreciate why these important, well-run organizations need to pay the executive salaries and maintain the reserves they do." but if that was the reaction of "a professional," it's easy to see why charities are loath to report to the public at large. even before the 2008 redesign of the form 990, advisors focused on the importance of having the board know what will appear in the organization's federal tax filing.2 8 attention to executive compensation, interested transactions, and relationships among fiduciaries will be even more important as exempt organizations file the redesigned form 990. as described in part [11, below, the new version of the form contains numerous questions about organizational structure and governance practices.29 despite the disclaimer, described above, that this portion of the form "requests information about policies not required by the internal revenue code,"3 0 the expectation is that most organizations will want to answer "yes" to the questions. it will be interesting to see, as the next few years pass, the rise in adoption of the policies and practices asked about on the return. more basically, if board members have not routinely been provided with the organization's forms 990, they likely will now. one question reads: "was a copy of the form 990 provided to the organization's governing body before it was filed? all organizations must describe in schedule 0 the process, if any, the organization uses to review the form 990.",31 not only will the typical board's role in preparing or reviewing the form 990 change, but also the relationship between the board and management could change as 28. see, e.g., michael w. peregrine, ralph e. dejong & timothy j. cotter, transparency: what the eo board needs to know about executive compensation, 46 exempt org. tax rev. 23 (oct 2004). 29. refer also to the last page of the appendix, which reproduces the governance part of the form. 30. in contrast to questions asking whether the organization has written policies addressing conflicts of interest, whistleblowers, document retention and destruction, and about participation joint ventures, the question relating to the process for determining the compensation of top management, officers, and key employees is rooted in statutory and regulatory requirements. see i.r.c. § 4958 (excess benefit transactions engaged in by section 501(c)(3) and (c)(4) organizations). reg. § 53.4958-6 sets forth a rebuttable presumption that a compensation arrangement or other transaction is reasonable if it is (1) approved in advance by an independent body acting for the organization (2) that obtained and relied on appropriate comparability data, and (3) that the body adequately documented its determination. reg. § 53.4958-6. 31. form 990 (2008), core form, part vi (governance, management, and disclosure), line 10. it is unfortunate that this question does not allow for the alternative of review prior to filing by a board committee, as recommended in comments submitted on the draft redesign. regrettably, many time-pressed charities will likely prefer to file under an extension than answer "no." [vol. 12:4194 charity governance the board focuses on reported structures and events as it might not have in the past. at the extreme, a nonprofit even might be willing to forgo taxexempt status in part to preserve the confidentiality of its activities, given that corporate income tax returns are not subject to public disclosure." more likely, a nonprofit might use a for-profit affiliate to carry out charitable activities for which tax exemption would be available,34 especially when taxable profits are expected to be nonexistent or low. while an organization might sacrifice some support (from employees, donors, or others) in forgoing exemption, other advantages of the for-profit form include the ability to raise equity capital, avoid an irs inquiry into whether the nonprofit has sufficient charitable purposes, and gain some flexibility in providing levels and types of compensation.35 i. regulatory registration and reporting this part examines filings received by nonprofit regulators. the discussion in part iv of public disclosure includes the transparency of enforcement actions by the regulators. a. state registries: constitutional limits on state regulation of fundraising a nonprofit corporation typically obtains its certificate of incorporation from the state secretary of state and makes annual filings with that office. outside the well-regulated area of charitable solicitation, described below, marion fremont-smith's comprehensive survey chronicles 32. a charity might be expected to have to ensure that it preserves its tax exemption, but a charity may relinquish tax exemption "so long as the charitable organization's fiduciaries can demonstrate that they made a good faith determination that loss of exemption was in the best interests of the organization." marion r. fremont-smith, relinquishing tax exemption: state and federal constraints, presented at the nonprofit forum, new york city (oct. 16, 1991). 33. compare the new requirement that forms 990-t, on which an exempt organization reports its unrelated business taxable income, are now subject to public disclosure. see infra part ill. 34. this topic was the subject of an emerging issues in philanthropy seminar, sponsored jointly by the urban institute's center on nonprofits and philanthropy and by harvard university's hauser center for. nonprofit organizations (cambridge, mass., nov. 30, 2000). 35. see c. eugene steuerle, when nonprofits conduct exempt activities as taxable enterprises, emerging issues in philanthropy seminar no. 4, the urban institute and the hauser center for nonprofit organizations, http://www.urban.org/url.cfm?id=310254. 1952012] florida tax review the development but lamentably limited extent of attorney general registration and annual filing (seven states).36 (fremont-smith separately found that in four states the attorney general must be notified when the nonprofit seeks tax-exemption.37 ) in 2011, the uniform law commission adopted a "model protection of charitable assets act;" the project addresses the authority of state attorneys general to protect charitable assets, to require annual filing and notice of specified "life-events," and to cooperate in interstate and multi-state cases and with the irs.3 8 most state oversight of charity deals with the solicitation of contributions. by the mid-1960s and 1970s, the desire to protect charities from "wasting" resources on fundraising led a total of twenty-six states and countless municipalities to regulate fundraising; some even imposed ceilings on the percentage of annual revenues that could be spent on fundraising expenses.39 in the 1980s, however, a trio of supreme court decisions blocked these restrictions on first amendment free-speech grounds. 40 to the court, procrustean percentage limits on fundraising disproportionately impact new charities (with low name recognition and no established donor base) and unpopular causes (which require a greater expenditure to raise a dollar). states may punish fraudulent fundraising speech after the fact, but, as the court more recently confirmed, regulatory approaches seeking to equate fraud with fundraising efficiency are invalid.4 1 conceding their inability to mandate fundraising limits, the states have concentrated their efforts on requiring charities to increase public disclosure using standardized forms. almost all the states require registration; a charity soliciting in many states will welcome the uniform registration statement accepted in most states requiring registration.42 36. fremont-smith identifies new york, california, massachusetts, ohio, illinois, minnesota, and new hampshire. marion r. fremont-smith, governing nonprofit organizations: federal and state law and regulation 315-17 (2004) [hereinafter freemont-smith, governing]. 37. id. at 317 (identifying california, mississippi, minnesota and oregon). 38. see uniform law commission, http://www.uniformlaws.org/ committee.aspx?title=protection%200fo2ocharitable%2assets%2oact. 39. see fremont-smith, governing, supra note 36, at 370. 40. riley v. national federation of the blind of north carolina, inc., 487 u.s. 781 (1988); maryland v. joseph h. munson co., 467 u.s. 947 (1984); village of schaumburg v. citizens for a better environment, 444 u.s. 620 (1980). 41. madigan v. telemarketing associates, inc., 538 u.s. 600 (2003). 42. version 4.01 (may 2010) supports 37 jurisdictions (36 states and the district of columbia), and includes supplemental forms required by 14 jurisdictions. the united registration statement, the multi-state filer project, http://www.multistatefiling.org. this charitable-solicitation registration form resulted from a joint project of the national association of state charities officials, the national association of attorneys general, and the multi-state filer program, a [vol. 12:4196 charity governance addition, thirty-five states require annual filings, usually with the attorney general, for charitable trusts and nonprofit corporations that solicit charitable contributions; those states either require or accept the form 990 in partial or complete satisfaction of that filing. statutes, though, commonly exempt small entities, educational institutions, hospitals, and churches and membership organizations but variations abound. some localities also regulate fundraising. b. federal tax filings: governance focus ofredesigned form 990 because of legislation enacted in 2006, the irs will be able to clean up its business master file to weed out those nonfiling small charities that have simply ceased to exist. effective for tax years beginning in 2007, small organizations that fail to file an annual notice of their continued existence (and minimal other information) for three consecutive years will have their exemption revoked.43 as of 2009, the irs records showed a total of 1,912,695 exempt organizations (1,238,201 million of which were exempt under section 501(c)(3)).44 as of mid-2011, the irs announced that the net total of automatic revocations had exceeded 330,000.45 to ascertain whether consortium of nonprofits. 43. churches (and their integrated auxiliaries) and small public charities (normally, $5,000 or less in gross receipts) are exempt from having to apply for recognition of tax exemption under 1.r.c. § 501(c)(3), and churches and most small public charities (normally, after a phase-in period for tax years ending in 2010, $50,000 or less in gross receipts) do not have to file the annual form 990 or form 990-ez. the requirement to file an "e-postcard" form 990-n can be filed only online applies to small charities, but not to churches. the new legislation additionally requires notification to the irs when an exempt organization terminates its existence. see i.r.c. §§ 6033, 6652, and 7428, as amended by the pension protection act of 2006, pub. l. no. 109-280, § 1223, 120 stat. 170 (2006). 44. internal revenue service data book, 2009 (march 2010), http://www. irs.gov/pub/irs-soi/09databk.pdf. 45. the number of section 501 (c)(3) exempt organizations appearing in the irs business master file grew 289 percent from 1976 to 2004, and, as of 2004, stood at 1,010,365. see joint comm. on taxation, 109th congress, historical development and present law of the federal tax exemption for charities and other tax-exempt organizations (jcx-29-05, april 19, 2005) (comm print 2005) (citing to irs statistics of income division reports and the business master file). the 2010 irs data book reports almost 1.28 million section 501(c)(3) organizations. see internal revenue service data book 2010, tbl. 25 (march 2011), http://www.irs.gov/pub/irs-soi/l0databk.pdf. (all private foundations, regardless of revenue level, must file, and the pension protection act of 2006 requires supporting organizations and organizations with controlled entities to file form 990 even if their gross receipts are less than $25,000.) pension protection act of 2006, pub. l. no. 109-280, § 1223, 120 stat 170 (2006). 1972012] florida tax review these organizations were "in fact defunct or just uninformed and/or confused about irs regulations,"46 researchers who had previously reached out to vulnerable indiana organizations concluded that 27 percent of organizations "that we have reason to believe are still active" lost their exemption for failure to file.47 with the overhaul of the form 990 effective for tax years beginning in 2008, we will finally have up-to-date information about organizational form for most large public charities.48 line k near the beginning of form asks the filer to identify the type of organization, with boxes provided for corporation, trust, association, and other (with space to describe). in a comment letter on the 2007 draft of the redesigned form, i suggested adding such a question.49 46. to publicize the new filing requirement for small charities, the irs identified and contacted 640,000 potential e-postcard filers in its database; based on survey results and historical filing patterns, it expected 166,000 e-postcard filers. internal revenue serv. tax exempt and government entities, eo 2008 annual report and 2009 work plan 12 (nov. 2008), http://www.irs.gov/pub/irstege/finalannualrptworkplan1 l25 08.pdf. evidently, filings came in from organizations too small to have had to file an exemption application (and thus do not appear on the business master file). a 2010 national study found that the largest categories of nonfilers were human service organizations (29 percent), public and societal benefit organizations (22 percent), and education organizations (15 percent); volunteer-run organizations, often with changing addresses, predominated. amy blackwood and katie l. roeger, national center for charitable statistics, here today, gone tomorrow: a look at organizations that may have their tax-exempt status revoked 2-3 (july 8, 2010), http://www.urban.org/publications/412135.html. for information identifying those organizations that automatically lost their exemption for failure to file and providing a one-time opportunity for retroactive reinstatement see internal revenue service, automatic revocation of exemption, http://www.irs.gov/charities/article/0,,id=239696,00.html. 47. kirsten a. granbjerg, kellie mcgiverin-bohan, kristen dmytryk, & jason simons, irs exempt status initiative: indiana nonprofits and compliance with the pension protection act of 2006, at p. 18, indiana nonprofits: scope & community dimensions briefing 2011: no. 1 (july 1, 2011 (revised oct. 10, 2011), http://www.indiana.edu/-nonprof/results/database/irsrevocation.html. this report found that suffering the highest rates of revocation were cemeteries, advocacy organizations, and nonprofit business associations, while fraternal organizations, veterans groups and other organizations with close connections to national groups were most successful in avoiding having their tax-exempt status revoked, suggesting that communications networks helped such groups comply with the law. id. at 3. 48. the exemption application, form 1023, asked about organizational form and changes in organizational form should have been reported on the form 990, but this process was unreliable. note that the irs did not redesign the simplified form 990-ez or the private foundation form, 990-pf. 49. see evelyn brody, professor comments on form 990 redesign, 24-28, tax notes today 181-13 (sept. 18, 2007) [hereinafter brody, professor 198 [vol. 12:4 charity governance not surprisingly, the form 990 focuses largely on financial reporting and transactions the irs's core competency is, after all, tax collection, which is measured in dollars. the form 990 is not limited to financial results, though, because it also has to reflect specific requirements and prohibitions in the tax laws. thus, we find many questions about relationships among fiduciaries and conflict-of-interest transactions, as well as questions about two additional concerns of federal tax exemption for charities: unrelated business activity and lobbying and political activity. the most striking feature of the 2008 redesigned form 990 is the new first page that highlights key information set forth elsewhere on the form. this summary page will make the form more accessible to donors, the press, and state regulators not to mention to board members themselves. the form also adds a full page of questions about organizational structure and governance practices. 0 (see the appendix for the 2007 exposure draft and the 2008 final versions of those two pages.) i strongly supported this focus on governance in my comment letter on the draft redesign. indeed, i proposed replacing the draft half-page of questions with a full page of my own. as i explained: it seems to me that most useful for the service, potential donors, the press, and anyone else who reviews the form 990 would be a series of questions that describe the governance structure of the organization and that determine whether the organization has in place procedures to support good governance. at the same time, it is important to recognize that these organizations are private entities, whose obligation to make public disclosures must be based on the requirements of the code. i agree with those who have urged you make clear on the form itself and not just in the instructions which of these items are legally required, so that readers do not draw inappropriate adverse inferences. 52 tracking many of my suggestions, part vi as finalized requires the disclosure of whether the organization has a voting membership; the identity of voting board members (and which ones are independent); whether and how certain documents, including the organization's form 1023, forms 990, and 990-t, financial statements, governing documents, and conflict of comments]. 50. see generally elaine waterhouse wilson, more than you ever wanted to know (or tell!): heightened compensation disclosure on the new form 990, 60 exempt org. tax rev. 273 (june 2008). 51. brody, professor comments, supra note 49. 52. id. 2012] 199 florida tax review interest policies, are made available to the general public; and whether the organization became aware during the year of an embezzlement or other material diversion of the organization's assets. but the governance-focused part of the form 990, which steve miller, then-commissioner for the tax exempt and government entities division (te/ge), characterized as "the crown jewel" of the irs's recent activity in the nonprofit governance area, has proven somewhat controversial. the advisory committee on tax exempt and government entities (the "act"), a high-level advisory body to te/ge, issued a lengthy report in june 2008 focusing on the irs role in charity governance.54 the 2008 act report comments: we believe in large part the governance questions on the redesigned form 990 for 2008 are appropriate and formulated in a relatively neutral manner, recognizing that true neutrality is an unattainable goal. the inclusion of the questions, however, inherently (and intentionally) suggests that the irs supports adoption of specific governance policies and practices. the danger then is that organizations will take the path of least resistance and adopt the policies and practices whether or not they are appropriate for them, or effective in their context. the act concludes that the public availability of the form 990 will induce organizations to adopt practices that they might not need, as discussed in part ii, above: "thus, while disclosure and transparency play a valid role in promoting compliance with the tax laws and in encouraging appropriate nonprofit governance, they also can impact behavior in a manner that can be harmful to the sector, and inappropriately suggest to the public and watchdog groups that the absence of specific governance policies or practices is in effect misgovernance. accordingly, the irs should carefully consider the public disclosures it requires." 53. remarks of steven t. miller, western conference on tax exempt organizations (nov. 20, 2008), http://www.irs.gov/pub/irs-tege/stm-loyloa agovemancei 1208.pdf. 54. advisory committee on tax exempt and government entities (act), the appropriate role of the internal revenue service with respect to tax-exempt organization good governance issues 3, page 89 of the pdf (june 11, 2008), http:/www.irs.gov/pub/irs-tege/tegeact rpt7.pdf [hereinafter act, appropriate role]. 55. id. 56. id. at 29 (pdf at 115). the report cites to dana brakman reiser, there ought to be a law: the disclosure focus of recent legislative proposals for nonprofit reform, 80 chi.-kent l. rev. 559 (2005). [vol. 12:4200 charity governance c. what's not publically available from federal tax filings as thorough as the redesigned form 990 appears, there still are reporting holes. 1. filing exceptions separate from the filing exemption for churches, as mentioned above, the irs phased in the requirement to use the new form 990 or the simpler form 990-ez by the size of the organization. the irs doubled the annual revenue threshold for filing form 990 or form 990-ez from $25,000 to $50,000 beginning in 2010.58 thus many "small" organizations will shift to filing either the short form 990-ez or the bare-bones e-postcard form 990-n (which requires only such basic information as employee identification number, the name of a principal officer, a mailing address, and affirmation that gross receipts total less than the threshold). although i am sympathetic to saving costs for small organizations as well as the irs, both regulators and the public stand to lose valuable information on hundreds of thousands of small organizations. this latter issue is of particular concern to state regulators who accept the series form 990 as its annual filing document. 2. data on form 990 that are unclear or not collected some of the ambiguities on the prior form 990 will be cleared up by the redesigned form 990. consider the fundamental example of determining who is in charge of the organization particularly who actually has power in those arts and cultural or educational institutions with multiple advisory positions (the proliferation of titles, like "life trustee," are uniformative). while the draft redesigned form 990 asked simply for a listing of trustees or directors, the final form makes clear that it is looking only for those with voting rights. 57. for tax years beginning in 2008, an exempt organization with annual revenue of more than $25,000 and less than $1 million and assets of less than $2.5 million could file the simpler form 990-ez. for the 2009 year, the cutoff dropped to less than $500,000 of revenue and less than $1.25 million of assets. for 2010 and later, the lower end of the revenue breakpoint rises to more than $50,000 and the upper end drops to less than $200,000 (see supra note 43, for the form 990-n "epostcard") and less than $500,000 in assets. internal revenue service, overview of form 990 redesign for tax year 2008, at 2 (dec. 20, 2007), http://www.irs.gov/pub/irs-tege/overviewform_990_redesign.pdf. 58. rev. proc. 2011-15, 2011-3 i.r.b. 322. 2012012] florida tax review as another example, my comment letter to the irs noted the tendency of too many expenses winding up on the "other" line, which allows for the itemization of specific categories not listed above.59 in the redesigned form 990, line 24 of part ix (statement of functional expenses) of the core form cautions: "expenses grouped together and labeled miscellaneous may not exceed 5% of total expenses .... " problems of inaccurate or incomplete filings will continue. the push to electronic filing will help with the latter problem if the system will not accept a return unless the fields are properly filled in. as to the former problem, floyd perkins, former illinois charities bureau chief, commented, "we should tell our citizens that nobody in illinois is looking at this stuff. if you want to give to a charity, you're on your own." 60 the significance of this problem is magnified by the pressures to "fudge numbers," as discussed in part i.61 is there a duty to amend a return discovered to contain a material misrepresentation? the tax system imposes no statutory duty to amend tax returns, although filing an amended return stops the accumulation of penalties and interest (but for an exempt organization, interest on what?). by contrast, the federal securities laws require amendment of a filing if failure to amend would be materially misleading.62 the possibility of state-level enforcement of an inaccurate return, where the form 990 satisfies the state filing requirement, can provide an incentive to file an amended form 990 at both the federal and state levels. 6 3 59. brody, professor comments, supra note 49. 60. robert franklin, critics say charity watchdogs are nearly toothless many state agencies have inadequate staff resources, minneapolis star tribune, sept. 28, 1992, at al. 61. see also urban institute studies showing that a high percentage of forms 990 are filled out by professionals. fremont-smith, governing, supra note 36, at 457-58. thus this is not a question of amateurs not knowing what they're doing. 62. form 8-k, to be filed under section 13 of the securities exchange act of 1934, requires "current" disclosures; the "real time issuer disclosure" amendments provided by section 409 of the sarbanes-oxley act of 2002 are intended to provide investors with improved and more timely disclosure of important corporate events. see sec final rule, 17 c.f.r. §§ 228, 229, et. al. (2011). additional form 8-k disclosure requirements and acceleration of filing date, 69 fed. reg. 15594 (march 25, 2004), http//:www.sec.gov/rules/final/33-8400.pdf. 63. for example, in 2004, the pennsylvania secretary of state filed suit against nonprofits and their officers for 1,200 false forms 990s, which were also filed with the state. the 2007 settlements called for four national charities to pay $150,000 and to stop fund raising in pennsylvania; the charities acknowledged that they did not report, among other things, h.r. wilkinson as a key employee; relatedparty transactions; and relationships among officers, employees, directors or members. pennsylvania dep't of st., charities, consent agreements and [vol. 12:4202 charity governance 3. group returns the tax rules provide not only for umbrella recognition of multiple 64 related exempt organizations, but also permit the filing of group returns. by contrast, the irs does not permit members of an affiliated group to file a consolidated return, as that term is understood in corporate tax. group returns thus can be uniquely uninformative and nontransparent: the return includes all members of the group except the "parent," in contrast to a corporate consolidated return (and any member of the group can elect to file its own return); the transactions within the group are not netted, as they would be in a corporate consolidated return; and it is impossible to determine the finances and operations of any particular member of the group.66 the topic was the subject of the 2011 irs act report, which urged the irs to strengthen the group exemption requirements but disallow the filing of group returns.67 iv. public disclosure of regulatory filings and determinations the discussion in this part iv examines the privacy interests of charities and relevant third parties; reviews what types of state and federal filings are made public; analyzes the possible rationales for public disclosure; and addresses the transparency (or not) of charity regulators. in the federal tax system as a whole, congress's overarching lodestar with regard to tax return information is confidentiality. while individuals and businesses are compelled to report their activities to the irs, the irs may not release taxpayer identifying information to the public or even, except as specifically permitted by statute, to other governmental agencies.68 indeed, a taxpayer may recover damages from the government for unauthorized disclosure, and severe penalties apply to irs employees who improperly disclose return information.69 this presumption of confidentiality, however, adjudications, http://www.portal.state.pa.us/portal/server.pt/community/charities/ 12444/consent agreements andadjudications/571848 (last modified aug. 6, 2011, 7:48 am). 64. advisory committee on tax exempt and government entities (act), exempt organizations: group exemptions-creating a higher degree of transparency, accountability, and responsibility (june 15, 2011) at 291 of the pdf http://www.irs.gov/pub/irs-tege/tege-actrptl0.pdf. 65. id. 66. id. 67. id. 68. see generally i.r.c. § 6103. 69. see internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, §§3102 (damages), 1203 (listing ten infractions, commonly 2032012] florida tax review is reversed for tax-exempt organizations.o why does congress only in the nonprofit view context view sunlight as an important disinfectant? a. privacy interests of charities and their supporters by longstanding law and practice a charity's governance activities and operations are generally private affairs. requiring regulatory filings and other information to be disclosed to the public intrudes even more than does reporting to regulators on the associational and operational autonomy of charities, and might even make board service or employment less attractive. indeed, the most controversial portion of the irs form 990 and the primary reason for initial resistance by exempt organizations to requests for public disclosure is the section reporting board member and executive compensation. (often, the organization's own employees and volunteers are the most curious!) as discussed below, policy makers and observers have identified a variety of justifications for state and federally required public disclosures by charities, the levels and types of which seem only to increase. importantly, the summary cover page of the redesigned form 990 highlights certain information of particular importance to donors, the press, and state regulators not to mention to the organization's board members. privacy interests are broader than the charity's, of course, and in certain situations public disclosure can lead to harm for the charity or to its donors, members, or those it serves. one category of sensitive information includes the types of trade secrets and personnel information protected from disclosure, as described below, by freedom of information laws. narrower examples of sensitive information protected from disclosure include the address of a battered women's shelter (so that abusers cannot find clients) and the countries of operation of human rights organizations (note that schedule f of the new form 990 was revised to address this concern). public disclosure of membership lists also can be sensitive, particularly for groups advocating on socially contentious issues; usually, membership lists are not even required to be filed with regulators. churches receive special protection by their exclusion from the requirement to file an application for recognition of federal tax exemption and forms 990.71 the identity of donors is an area of particular focus. the names of contributors to private foundations are not redacted from the form 990-pf, which is required to be made publicly available in full. donors to statereferred to as the "ten deadly sins," requiring termination of irs exmployment), 112 stat. 685 (1998). 70. see generally i.r.c. § 6104. 71. however, a 2011 staff memorandum to senator (and ranking member) of the senate finance committee) charles grassley discussed possible modification of this special treatment of churches. see infra part iv.e. [vol. 12:4204 charity governance related nonprofit institutions, such as alumni-created foundations affiliated with state universities, are often unprotected as well.72 by contrast, congress exempts from public disclosure the names of donors reported on the list of major donors (schedule b) to the form 990 filed with the irs by exempt organizations other than private foundations. as one result, only the irs can fully review a charity's claim to be publicly supported, and thus not a private foundation.7 3 b. what filings are subject to public disclosure? the states typically make available often online corporate annual reports filed with the secretary of state, and annual reports filed with the attorney general in those states rejuiring reports, generally from those who solicit charitable contributions. confidential information can be protected from public disclosure. uniquely, as far as i know, new jersey requires that the audit submitted to the attorney general be accompanied by the auditor's management letter, if one was prepared, although the management letter will not be released to the general public. material supplied in the course of, or subsequent to, a state investigation remains confidential except as might be required under a state freedom of information law. specifically, sections 6104 and 6110 provide for disclosing applications for tax exemption, including supporting documents, and determination letters and rulings. all of these items are available from the irs upon request. moreover, the organization must make its exemption application, supporting documents, and determination letter or ruling available for public inspection without charge. separately, the law 72. see brody & tyler, philanthropy, supra note 24, at 597 nn.61 & 62 and accompanying text. 73. under federal election laws, because of the enhanced public interest in open and fair elections, generally all but the smallest donors and amounts contributed to federal political campaigns must be identified (some states have similar "clean government" rules); this result leads some strategists to advise conducting issue-related advocacy through section 501(c)(4) organizations. issues relating to political activity and election law and regulation, including tax-law rules and filing requirements, are generally beyond the scope of this article. 74. see supra part iii. the states typically make available often online corporate annual reports filed with the secretary of state, and annual reports filed with the attorney general in those states requiring reports, generally from those who solicit charitable contributions. 75. n.j. rev. stat. § 45:17a-24(f) (2011). 76. i.r.c. §§ 6104, 6110. 77. see regulations promulgated under i.r.c. §§ 6104, 6110. 78. id. 2012] 205 florida tax review obligates a charity to produce any of its last three tax returns upon request.79 posting the form 990 on the charity's website satisfies this obligation but the posted return must be complete. evidently, the salaries and other compensation paid to the top executives and independent contractors are of greatest interest to the press, the public, competitors, and even other workers in the organization, and a return rovided without this information does not satisfy the disclosure obligation. even though the filings with the irs are available from the regulator (the same is true for some of the states), private groups have revolutionized charity transparency. the searchable databases on guidestar and the national center for charitable statistics at the urban institute themselves privately funded charities that work with each other and with the irs make this whole system work. 82 the irs itself offers for sale (at no cost to the media and other government agencies) scanned copies of the last seven years of filed forms 990 on dvd or cd-rom.83 it would be most helpful if the irs provided usable data from these forms promptly to researchers. training program materials for the irs exempt organizations division explain some of the advantages of instantaneous, online disclosure: "obtaining information from an organization had potential drawbacks if a requestor and the organization were not on friendly terms. despite the requirements of the law, some organizations simply refused to allow access to their returns."84 those materials provide "a discussion of the more common errors that are made and an explanation of the reasons for some of the information requested."8 (regrettably, in 2005, the eo division discontinued drafting these training materials, which has been a great loss to practitioners as well as to the exempt organization staff.)86 79. id. 80. id. 81. id. 82. guidestar, http://www.guidestar.org. see also the urban institute's national center for charitable statistics' website for filed forms 990, along with statistical analysis, http://nccs.urban.org. 83. internal revenue service, copies of scanned eo returns available, http://www.irs.gov/charities/article/0,,id=150268,00.html. 84. see cheryl chasin, debra kawecki & david jones, form 990, chapter g of fy2002 irs eo continuing professional education text, www.irs.gov/pub/irstege/eotopicg02.pdf. 85. id. 86. for eo tax continuing profession education technical instruction program from fy 1979 through fy 2004, see internal revenue service, http://www.irs.gov/charities/article/0,,id=161088,00.html. these training materials are also available through a topical index, http://www.irs.gov/pub/irstege/cpeindexbytopic.pdf. [vol. 12:4206 charity governance some information still remains private between the organization and the tax collector. the statute excludes from public disclosure the customary fola exceptions for "a trade secret, patent, process, style of work, or apparatus if the service determines that the disclosure of the information would adversely affect the organization."8 7 in addition, as mentioned above, schedule b to the form 990, on which public charities report the identities of their large donors, is protected from mandatory disclosure. 8 exemption applications are not public until exemption is granted; nor must withdrawn applications for exemption be disclosed. finally, the pension protection act of 2006 requires an exempt organization to make public its form 990-t, on which it reports and pays any tax due on unrelated business taxable income.89 however, congress did not impose a parallel requirement on the corporate returns of an exempt organization's taxable affiliates (business tax returns, like the returns of individuals, are not public documents), giving charities one more reason to spin off unrelated businesses into a separate for-profit corporation. unfortunately, because of a glitch in the statute, the irs cannot provide the forms 990-t to guidestar, so anyone curious about unrelated business activity of a particular charity will have to ask the organization for the form, and they will not be available in a searchable database of these forms. 1. applications for exemption form 1023. the application form for filing for recognition of federal tax exemption under section 501(c)(3) was significantly revised in 2004.90 the 2008 act report on the irs role in charity governance described the evolution of the irs's approach to governance during the exemption application process: "while the form 1023 prior to the current version asked 87. i.r.c. §§ 6104(a)(1)(d), 6110(c); see regs. §§ 301.6104(a)-5 & 301.6110-3. 88. the non-disclosure of the identity and contributions of donors to exempt organizations has made section 501(c)(4) organizations, which can engage in political speech so long as it is not their primary activity, a tempting vehicle for avoiding the disclosure requirements of federal election law. see infra note 101 and accompanying text. 89. staff of the joint comm. on taxation, 109th cong., 2nd session, general explanation of tax legislation enacted in the 109th congress, (comm. print 2007), http://www.house.gov/jct/s-i-07.pdf. 90. the current version, revised in 2010, is available at department of the treasury, internal revenue service, notice 1382, http://www.irs.gov/pub/irspdf/fl023.pdf. it would be great if guidestar could collect and post these once exemption is granted. the forms 1023 (especially the ones filed electronically, when the irs makes this process available) would provide an interesting database for study. 2012] 207 florida tax review questions regarding organization structure and governance, it principally focused on the charitable activities of the organization. in contrast, the 2004 (the most current) version places an increased emphasis on an organization's governance by focusing on board and management relationships (independence) as well as compensation and other potential opportunities for inurement."91 commentator jack siegel praised the irs for "attempting to identify those organizations that are likely to violate the rules governing section 501 (c)(3) organizations before granting tax-exempt status rather than relying on an audit process that is currently underfunded and spotty."92 however, siegel cautioned future applicants who seek to abuse tax-exempt status to take care in filling out the application: in the past, questions covering compensation, grant making, affiliations, and activities were very open-ended, permitting people who wanted to game the system to conveniently omit information without significant risk. the 2004 revised form 1023 touches on all the same topics, but with very specific questions which will make it much more difficult to hide abusive arrangements without risking penalties of perjury. "we also suspect that certain answers to questions may not cost an organization its requested exempt status, but may place the organization in a special queue for subsequent audits focused on potential violations under the intermediate sanctions.9 3 of course, failure to make full disclosure on the prior versions of the application form which, like the form 990, is filed under penalties of perjury still had consequences. in an unusual case, the united states recently won criminal convictions relating to a muslim group that had failed to disclose on its form 1023 what the justice department asserted were such terrorist activities as publishing newsletters and raising funds forjihad.94 91. act, appropriate role, supra note 54, at 32-33 (pages 118-19 of the pdf) (footnotes omitted). 92. jack siegel, re-engineering form 1023 to identify problem organizations before exemption is granted: watch out for the "penalties of perjury" statement (november 3, 2004), http://charitygovernance.blogs.com/ charitygovernance/2004/1 i /reengineering f.html. 93. id. 94. see united states v. mubayyid, 658 f.3d 35 (1st cir. 2011) upholding mubayyid's convictions for filing false forms 990 for a putative charity known as care international. the court explained that question 76 on the form 990 for tax years 1997, 1999, and 2000 asked the following question: "did the organization engage in any activity not previously reported to the irs? if 'yes,' attach a detailed 208 [vol. 12:4 charity governance 2. forms 990: problems ofaccuracy and timeliness like other federal tax returns, the forms 990 are self-reported. as filed, many contain errors, some materially misleading. hopefully, compliance will improve as boards and top management become more involved in preparing the form. even with the redesign, though, this document cannot provide much insight into the nature and quality of charity activities. moreover, many forms 990 are filed under an automatic six-month extension. the blame for this commonly falls on the accountants, who can barely recover from having to prepare tax returns for individuals (due april 15) before gearing up to file forms 990 (due may 15, for calendar-year organizations). no reputational sanction seems to follow from filing late, so many calendar-year exempt organizations file close to november 15. (you can set your calendar by all the news stories on nonprofit compensation that appear around thanksgiving.) this means that events that occur in, say, january 2011 will likely not be disclosed to the public until november 2012, almost two years later.95 the irs highlights the value of disclosure in describing its e-filing initiative: e-filing reduces normal processing time and makes compliance with reporting and disclosure requirements easier. 96 indeed, e-filing is mandatory for large charities: "for tax years ending on or after december 31, 2006, exempt organizations with $10 million or more in total assets may be required to e-file if the organization files at least 250 returns in a calendar year, including income, excise, employment tax and information returns .... private foundations and non-exempt charitable trusts are required to file forms 990-pf electronically regardless of their asset size, if they file at least description of each activity." the court ruled that "[i]t was well within the jury's capability to find that mubayyid in fact understood that the obligation imposed by question 76 required reporting of care's activities not disclosed on the form 1023, regardless of the year in which those activities began, because had not previously reported them. "specifically," the court concluded, "the record supports a finding that mubayyid answered question 76 falsely by failing to disclose three distinct activities: the publication of the 'al-hussam' newsletter in 1997; the operation of care's website in 1999 and 2000; and, in all three years, an orphan sponsorship program that targeted the families of martyred mujahideen." id. at 60, 63-64 (footnote omitted). 95. in an oral comment at the senate finance committee staff roundtable held in washington, d.c., on july 22, 2004 (which this author attended), attorney douglas mancino recommended that exempt organizations be required to report compensation on a more current basis, citing as precedent the quarterly filings required by the sec of public companies. 96. internal revenue service, e-file for charities and nonprofits, http://www.irs.gov/efile/article/o,,id=108211,00.html. 2012] 209 florida tax review 250 returns annually." 97 beginning in 2006, the irs started a federal/state filing system, and has begun working with individual states to test their systems. 98 in 2008, the irs processed 901,000 exempt-organization tax returns (mostly forms 990, 990-ez, and 990-pf); in 2009 the irs processed 132,000 returns, an increase of 25.6 percent; and in 2010 the irs processed 1,343,000 returns (an increase of 18.6 percent); presumably these rapid increases were due to the filings of the e-postcard, form 990-n.99 of these returns, many were filed electronically: in 2008, exempt organizations filed 57,975 forms 990; 44,362 forms 990-ez; and 292,002 forms 990-n (which can only be filed electronically).'o c. rationales for governmentally mandated disclosure to the public this subpart considers four possible rationales for mandating public disclosure of charity finances and other activities. 1. disclosure without judgment: "disclose or abstain" while, as mentioned above, congress provides for the confidentiality of tax returns, in regulating the securities issued by publicly traded companies, congress has generally adopted a "disclose or abstain" model in lieu of prescriptive regulation. under that approach, if the issuer makes honest (i.e., not materially misleading) public disclosures, we essentially leave investment decisions to the market. if a similar public disclosure rationale is chosen for charity regulation, what are nondisclosing nonprofits supposed to abstain from? soliciting the public for contributions (state registration model)? something else? after all, the typical private foundation or government-funded agency is not seeking or expecting contributions from the public. interestingly, congress required private foundations to make their forms 990-pf available on request in 1969, but did not obligate publicly supported charities to make their forms 990 available until 1987. incidentally, a disclosure model based on this rationale might be the only constitutional regulation permitted of corporate political speech after the 97. id. 98. see also guidestar's service: gov@guidestar offers a suite of tools designed specifically for government users of guidestar data. these research and reporting tools enable government decision makers to perform critical tasks with greater ease and confidence. 99. 2009 irs data book, supra note 44, at 4, tbl. 2; 2010 irs data book, supra note 45. 100. internal revenue service exempt organizations, fy 2010 annual report and fy 2011 work plan, (dec. 15, 2010) at 13, http://www.irs.gov/pub/irs-tege/fy20 11_eoworkplan.pdf. [vol. 12:4210 charity governance supreme court's decision in citizens united, a topic beyond the scope of this article."o' 2. condition of tax subsidies is the rationale for public disclosure instead that the "public" benefits through providing support for tax subsidies, and therefore tax filings should be made public? (generally, imposing requirements conditioned on tax-exempt status does not give rise to the argument of "unconstitutional conditions," because exemption is not a constitutional right. 102) in 2000, the staff of the joint committee on taxation released a congressionallymandated study of the disclosure rules in the tax system, devoting a full volume to those that apply to exemption organizations. 103 the report called for increased public disclosure of exempt-organization information, including the release of (1) complete private letter rulings and technical advice memoranda, without redaction of information identifying the entity and its transaction, (2) the results of all audits of tax-exempt organizations, also without redaction, (3) applications for exemption, not just exemptions once issued, (4) forms 990-t (unrelated business income tax) and the returns of taxable affiliates, and (5) a description of lobbying activities, and amounts spent on self-defense lobbying and on nonpartisan research and analysis that includes a limited "call to action."1 04 many of the recommendations attracted strong criticism.105 as mentioned above, congress now requires disclosure of forms 990-t (but not the returns of taxable affiliates);' 0 and as discussed 101. see citizens united v. fed. election comm'n, 130 s. ct. 876 (2010); the proposed d.i.s.c.l.o.s.e. act, h.r. 5175, 111th cong. (2010); and papers presented at "nonprofit speech in the 21st century: time for a change?," the annual conference of the national center on philanthropy and the law, new york university school of law (new york city, oct. 28-29, 2010) (on file with author). 102. compare the constitutional limits on mandated speech as set forth in the riley v. nat'l fed'n of the blind, inc. trilogy. see cases cited supra note 40. see generally evelyn brody, entrance, voice, and exit: the constitutional bounds of the right ofassociation, 35 u.c. davis l. rev. 821 (2002). 103. staff of the joint comm. on taxation, 106th cong., study of present-law taxpayer confidentiality and disclosure provisions as required by section 3802 of the internal revenue service restructuring and reform act of 1998, volume ii: study of disclosure provisions relating to tax-exempt organizations 3 (comm. print 2000), http://www.house.gov/jct/s-1-00vol2.pdf. the report provides a background to form 990 public disclosure. id at 89-90. 104. id. at 7-9. 105. see grant williams, tax report shakes up charities, chron. of philanthropy, mar. 9, 2000, at 27. 106. see supra note 89 and accompanying text. 21i2012] florida tax review below, the irs must release determination letters denying or revoking exemption, although in redacted form.10 7 the joint committee asserted the following rationale for public disclosure: "disclosure of information regarding tax-exempt organizations also allows the public to determine whether the organizations should be supported either through continued tax benefits and contributions of donors and whether changes in the laws regarding such organizations are needed."' 0 8 that is, informing potential donors is one aspect, but only one, of this rationale. just as important to the joint committee is allowing the public to judge the legitimacy of tax-exemption, and whether it should be altered. 3. condition of nonprofit (specifically, charitable) status the independent sector, a leading trade association of charities, proposed an alternative rationale for transparency. in commenting on the joint committee's 2000 report, the independent sector declared: "is believes that charities' public disclosure obligations derive from charities' fundamental nature as voluntary associations formed by private citizens to advance the public good not from charities' receipt of favorable tax treatment." 09 after all, the independent sector observed: "charities were recognized as separate entities with legal rights and responsibilities long before there was a federal income tax code. the need for disclosure stems from charities' unique social role. a charity must be transparent enough to make donors, volunteers, and partners confident that the charity will, in fact, advance public rather than private interests." 10 107. see infra notes 135-138 and accompanying text. 108. staff of the joint comm. on taxation, 106th cong., study of disclosure provisions relating to tax-exempt organizations, supra note 103, at 5. 109. staff of s. comm. on ways and means, 106th cong., written comments on joint committee on taxation disclosure study 50 (comm. print 2000), http://www.gpo.gov/fdsys/pkg/cprt-106wprt1 l/pdf/cprt-106 wprt 1 l.pdf. i10. id. separately, the independent sector "[took] issue with the jct report's characterization of tax exemption and the charitable deduction as government subsidies and the report's view that the receipt of those subsidies creates a strong presumption in favor of increased disclosure." id. the independent sector pointed to "years of serious academic debate over whether the charitable exemption and deduction are appropriately viewed as special benefits or as structural necessities of a properly calculated income tax." id. [vol. 12:4212 charity governance as a general comment, the independent sector challenged the utility of counting on the form 990, as it existed then, as the vehicle for informing the public: "without an understandable user's guide and no such guide exists the public derives little benefit from much of the information already reported by charities. thus, there is a deep need for tools to help the public understand the information that is already disclosed.""' independent sector urged the irs to revise the form 990 "so that it highlights critical information and facilitates the reader's understanding of the significance of the information being presented. a top priority for the irs in this regard should be providing, either directly or through non-governmental intermediaries, on-line access to all forms 990." 1l2 4. we cannot think of a better alternative finally, we have to admit the possibility that we rely on public disclosure because we do not know what else to do (or who should do it). betsy adler nicely summarized the current regulatory approach with the acronym "fed": "funding, enforcement, disclosure." 1 3 in our laissez-faire system, we don't want government telling charities what to do and how to do it.1 14 the absence of shareholders goes to why we disclose to regulators; by contrast, public disclosure seems driven by regulators' lack of resources, expertise, or inclination. nor should we discount the ceremonial value of sunshine. public disclosure even in the absence of enforcement action is useful because knowing that information will be disclosed induces the fiduciaries to pay more (and better) attention not just to how they report, but also to what they do. at the same time, this leads to the possibility of fudging the reporting due to the pressures described in part ii. as the 2002 cpe text commented: 111. id. at 54. a few years later, the irs included in its 2003 exempt organization continuing professional education text a helpful set of q&a's on how to fill out (and therefore read) the form 990. cheryl chasin, susan l. paul & david w. jones, exempt organizations-technical instruction program for fy 2003, form 990, schedule a and schedule b, at h-2 to -23 (2003), http://www.irs.gov/pub/irs-tege/eotopich03.pdf. 112. staff of s. comm. on ways and means, 106th cong., comments on disclosure study, supra note 109, at 54. 113. betsy adler, former chair of the exempt organizations committee of the american bar association tax section, remarks at the senate finance committee staff roundtable in washington, d.c. (jul. 22, 2004) (on file with author). 114. evelyn brody, agents without principals: the economic convergence of the nonprofit and for-profit organizational forms, 40 n.y.l. sch. l. rev. 457, 527-28 (1996). 2012] 213 florida tax review several things must happen in order for this increased disclosure of form 990 to be of maximum benefit to the public. first, the information entered on form 990 must become more standardized and reliable. second, potential users of the data must become more familiar with the requirements for proper completion of the return so that they will understand the data they are viewing.115 d. disclosure of state and federal enforcement activity 1. what are the states doing? it is not easy to figure out how to spur nonprofit board members into performing better. increasing monetary sanctions might make things worse: indeed, we might improve nonprofit governance by reducing what's at stake. in large part regulators are so timid (at least publicly) because they don't want to discourage volunteers acting in good faith. as a result they don't send a sufficient signal (at least publicly) of the problems they encounter on nonprofit boards."16 but lack of transparency in their regulation of charities makes it impossible to assess the effectiveness of regulators in improving charity governance or even whether they are acting at all. few cases involving nonprofit fiduciary issues have reached the courts. reform rather than punishment is generally the goal of the charity regulator, and charities as well prefer a chance to improve their behavior while avoiding embarrassment and personal liability. most settlements are kept confidential. finally, state attorneys general can act or not act out of parochial and political motives."' regulators have limited (financial and political) resources.' 18 in that case, we might expect attorneys general to publicize their enforcement 115. chasin, kawecki & jones, form 990, supra note 84, at 227. 116. for draft principles relating to enforcement see principles of the law of nonprofit organizations §§ 610, 620 (tentative draft no. 3, 2011) (approved through section 660). 117. see evelyn brody, whose public? parochialism and paternalism in state charity law enforcement, 79 ind. l.j. 937, 975 (2004). 118. id. at 951-52. garry jenkins conducted a survey, to which all but one of the states responded, finding that 74 percent of the states had one or fewer fulltime-equivalent attorneys devoted to charitable oversight, and that 17 states assigned no attorneys to that function. garry w. jenkins, incorporation choice, uniformity, and the reform ofnonprofit state law, 41 ga. l. rev. 1113, 1128-29 (2007). legal staffs exceeding 2.5 fte's are found in california (12), connecticut (5), illinois (7), indiana (4), massachusetts (6), minnesota (5), new york (20.5), ohio (10), pennsylvania (12), and texas (6). id. at 1129. [vol. 12:4214 charity governance actions in order to benefit from the leveraging effect miscreants in a similar position would recognize themselves in the press release, and voluntarily straighten out.1 19 indeed, attorneys general do trumpet cases in which they catch someone violating the law. in other cases, where there is no real "bad guy" but rather well-meaning fiduciaries caught in governance failures states could usefully issue aggregate annual reports on the types of enforcement activities they undertook and outcomes achieved.120 regrettably though, even the limited official reporting of enforcement activity tends to have a frustratingly short shelf-life. press releases often vanish from attorney general websites when a new attorney general comes into office, thus undercutting the educational and deterrent value of publicizing enforcement actions. 121 private-sector solutions, while promising, have their own limitations. notably, in 2008, the charities law project at columbia law school began developing a website to assist attorneys general in fulfilling their responsibilities over charitable assets. 12 2 although a separate intranet just for attorneys general might be created, so far most of the posted material is available to the public. the clearinghouse contains links to state and irs websites (and specifically to state best practice guides) and summaries of law review articles. 23 no enforcement materials have been posted yet, but a few recent settlements from around the country are available through links to materials for a panel on remedies presented at the march 2008 conference. 124 119. recall dr. strangelove's complaint: "deterrence is the art of producing, in the mind of the enemy, the fear to attack. the whole point of the doomsday machine is lost if you keep it a secret! why didn't you tell the world, ch?!" see the doomsday machine in dr. strangelove, youtube (nov. 24, 2008), http://www.youtube.com/watch?v-cmckji3ckge. 120. see pennsylvania dep't of st., charities, consent agreements and adjudications, http://www.portal.state.pa.us/portal/server.pt/community/charities/ 12444/consent-agreements_ and adjudications/571848 (last modified aug. 6, 2011, 7:48 am), for an example of pennsylvania's database of consent agreements and adjudications relating to charities, solicitors, and fundraising counsel. 121. for example, the massachusetts attorney's general's website no longer carries the very useful "final judgment database" of legal actions, with links to the specific cases. see mass. gov., the official website of the attorney general ofmassachusetts, http://www.mass.gov/?pageld=cagohomepage&l=lo=home& sid=cago (last visited oct. 10, 2011). 122. nat'l states attorneys gen. program, charities law project, colum. l. sch., http://www.law.columbia.edu/centerprogram/ag/policy/charitiesproj/ (last visited oct. 10, 2011). 123. nat'l states attorneys gen. program, charities resources & publications, colum. l. sch., http://www.law.columbia.edu/centerjrogram/ag/ policy/charitiesproj/resources (last visited oct. 10, 2011). 124. nat'l states attorneys gen. program, charities conference march 2008, colum. l. sch. (mar. 28-29, 2008), http://www.law.columbia.edu/ 2012] 215 florida tax review as of october 2011, the most recent conference shown on the project's website was held in march 2011;125 the page containing summaries of "ags and the charitable sector; in the news" is current through september 2011.126 2. irs determination letters denying or revoking exemption as a threshold matter, despite the irs's fearsome reputation, it is as resource-constrained as the states. hopefully, we will soon have better data available about the irs exempt organizations division.127 as of 2011, this irs division employed only 889 people: 332 in rulings and agreements, 531 in examinations, twelve in customer education and outreach, and fourteen in the eo director's office.128 total employment peaked at 910 in 2009.129 the eo division must oversee 1.8 million registered tax-exempt center_program/ag/policy/charitiesproj/events/conference/conferencemar08.www.1 aw.columbia.edulcenterprogram/ag/policy/charitiesproj/events/conference/confere ncemar08. 125. nat'l states attorneys gen. program, conferences, colum. l. sch., http://www.law.columbia.edu/centerjprogram/ag/policy/charitiesproj/events/confer ence (last visited oct. 10, 2011). 126. nat'1 states attorneys gen. program, ags and the charitable sector: in the news, colum. l. sch., http://www.law.columbia.edu/center program/ag/policy/charitiesproj/resources/charitiespubl/charitiesnews (last visited oct. 10, 2011). 127. see infra part iv.e. 128. internal revenue service, exempt organizations fy 2011 annual report and fy 2012 work plan, http://www.irs.gov/pub/irstege/fy2012_eo work plan_2011_annrpt.pdf, at 2. 129. id. see also u.s. gov't accountability office, gao-05-561t, tax-exempt sector: governance, transparency, and oversight are critical for maintaining public trust 17 (2005) ("[fjrom fiscal year 2000 through 2004, irs staffing for overseeing tax-exempt entities stayed relatively flat as measured by the number of fte staff assigned to oversee tax-exempt entities."). despite its mind-boggling potential workload, te/ge's enforcement activities reach only a small fraction. eo tax journal editor paul streckfus commented on the compliance data reported on page 2 of eo's fy 2010 annual report: "the graph tells us that in fy 2009 of 16,960 returns examined 6,773 pertained to compliance checks and 10,187 pertained to traditional examinations." paul streckfus, eo tax j. 2010-185 (dec. 16, 2010, 8:05 am), http://eotaxjoumal.com/ eotj/?m=201012&paged=2. he adds: [o]f those 10,187 returns examined, only 3,445 were forms 990 and 990-ez. the rest were mostly employment tax returns (4,582) and 990-ts (962).... [m]ost audits involve more than one year, so an audit of one organization may involve multiple 990s. my best guess was that this translated to 1,723 organizations being subject 216 [vol. 12:4 charity governance entities, including almost 1.2 million registered charities. 13 0 thus, the development of published guidance (as well as examinations) suffers, putting pressure on practitioners to grasp at any type of informal guidance they can find. throughout the tax-practice world, practitioners and their clients have long benefited from the public availability of (redacted) versions of private letter rulings, audit memoranda, and other taxpayer-specific agency positions.13 1 marion fremont-smith explains how this type of informal transparency can improve tax administration in general: "members of the bar were also able to identify issues needing study or revision, and call these to the attention of the service as a group and not as partisans of individual clients."1 3 2 the irs, however, had long refused to release redacted determination letters relating to denial or revocation of tax exemption. in a milestone decision issued in 2003, however, the district of columbia circuit held "that the portions of treasury regulations sections 301.6110-1(a) and 301.6104(a)-1(i) that include denials and revocations 'within the ambit of section 6104' and prevent their disclosure violate section 6110's plain language."l 33 in annual revenue procedures, the irs sets forth the process for issuing determination letters and rulings on exempt status, both in response to applications for recognition of exemption and in cases of revocation or to a traditional audit in fy 2009. . . . regardless, we are talking a .002 audit rate, not 2%, but .2 %, pretty close to infinitesimal, especially when you exclude targeted audits [of colleges and hospitals]. . . id. 130. tax-exempt organizations registered with the irs in 2009, qhron. of philanthropy (mar. 21, 2010), http://philanthropy.com/article/tax-exemptorganizations/64785/. 131. it took a series of freedom of information act lawsuits by tax analysts, publisher of tax notes magazine and the exempt organization tax review, to compel the irs to release these items. 132. fremont-smith, governing, supra note 36, at xiv. 133. tax analysts v. internal revenue serv., 350 f.3d 100, 104-05 (d.c. cir. 2003). the court described the legislative history: congress passed the tax reform act [of 1976] to protect taxpayer privacy while requiring the irs to disclose written determinations. our holding advances that purpose: the irs must disclose determinations denying or revoking tax exemptions, but do so in redacted form, thus protecting the privacy of the organizations involved. the treasury regulations, in contrast, keep denials and revocations completely secret, preventing the very monitoring of the irs that the tax reform act was designed to facilitate. id. at 104. 2012] 217 florida tax review modification of determination letters or rulings. section 8 of the revenue procedure describes the rules for disclosure. notably, "[u]pon issuance of the final adverse determination letter or ruling to an organization, both the proposed adverse determination letter or ruling and the final adverse determination letter or ruling will be released under section 6110 ... after the deletion of names, addresses, and any other information that might identify the taxpayer."1 3 4 importantly, section 6104 applies only to material furnished by the organization or issued by the irs,135 and not to settlement agreements (termed "closing agreements") between the irs and the organization unless the organization consents.136 these redacted denial and revocation letters began to appear in 2004. an early redacted denial letter was issued to a recreation center in which the irs found an inbred governance structure not likely to ensure public benefit; specifically, the irs wrote: "since all three members of your original board were related and receiving compensation, we asked you to expand your board of directors by three to four non-related members of the community. [you added three new members.]"'137 however, the irs continued: "[a] full copy of your approved bylaws have not been received by the service. the limited information provided indicates that the * * * may appoint and remove the directors. the * * * appear to be the three related directors."l 3 8 incidentally, when faced with the prospect of a denial, why doesn't the applicant simply withdraw the application (this would not be a disclosable event)? evidently, the denial letters are for groups that want 134. rev. proc. 2012-9, § 8.02, 2012-2 i.r.b. 261. 135. because a closing agreement is a "bilateral agreement signed by both the service and the taxpayer," it was "not issued by the irs," and thus was not subject to the clause of section 6104(a)(1)(a) making "disclosable information 'issued' by irs 'with respect to' an organization's application for tax exempt status." tax analysts v. internal revenue serv., 2004 u.s. dist. lexis 28032, 93 a.f.t.r.2d (ria) 2004-1251, 2004-1252 n.2 (d.d.c. 2004) (citing tax analysts v. internal revenue serv., 53 f. supp. 2d 449, 452-53 (d.d.c. 1999), aff'd, 410 f.3d 715 (d.c. cir. 2005). this litigation ended when the d.c. circuit upheld the district court's refusal to compel the irs to disclose the closing agreement referred to in a press release issued by the christian broadcasting network. tax analysts v. internal revenue serv., 410 f.3d 715, 716 (d.c. cir. 2005). 136. the irs chief counsel's office notified its attorneys of the procedures to follow "when advising internal revenue service employees concerning a determination that publicizing a closing agreement between a taxpayer and the internal revenue service advances tax administration." chief counsel notice cc2008-014 (apr. 14, 2008). when the parties agree that "public disclosure of a closing agreement (or any of its terms)" is warranted, in general, it "would be through an irs news release, or a jointly authored statement, which would be released at the time the closing agreement is executed." id. 137. i.r.s. determination letter 20044033e (apr. 5, 2004). 13 8. id. 218 [vol. 12:4 charity governance judicial review, and the determination letter is the ticket to court. alternatively, the irs might back down and flag the file for examination after a period of operations. with the continued issuance of denial and revocation letters, there has been a flood of up to a dozen a week, adding up to hundreds a year. 139 an adverse ruling generally falls into one (or more) of three categories: private benefit, "commerciality," with, most recently, the return of the ground that the charity failed to conduct a charitable program "commensurate-in-scope" with its resources. the irs has denied exemption to nonprofits engaged in a variety of activities including adoption, insurance, financial services, religious publishing, conference centers, low-income housing, and retreats for caretakers generally on the basis of their resemblance to similar for-profit businesses. examples of recent determination letters with governance implications include the following, as summarized in the 2008 act report: plr 200736031 (dec. 7, 2006) (noting that married couple were sole officers and directors, there was no conflict of interest policy and couple did not recuse themselves when causing organization to contract for management services with for-profit company of which husband was sole shareholder); plr 200535029 (june 9, 2005) ("finally, despite the expansion of your governing board from three (3) to five (5) members, and the enactment of a conflict of interest policy, we still have some concern that your actual operations will be controlled and directed by b and his daughter c. we acknowledge that there is no evidence of any inurement to the benefit of these individuals, but then there has been no financial activity on your part to date.["]); plr 200514021 (jan. 13, 2005) ("there seems to be great likelihood of inurement to these individuals in that they all 139. author's estimate. the fy 2010 annual report makes no mention of either revocation or denial numbers, nor of closing agreements. in earlier years, the irs finalized 78 closing agreements with section 501(c) organizations in fiscal year 1999; 72 in fiscal year 1998; and 65 in fiscal year 1997. see staff of the joint comm. on taxation, 106th cong., study of disclosure provisions relating to tax-exempt organizations, supra note 103, at 38 n.97 (citing the irs exempt organization return inventory and classification system). in fiscal year 1999, the irs revoked the exempt status of 97 organizations, of which 20 were exempt under section 501(c)(3); in fiscal year 1998, the irs revoked the exemption of 97 organizations, 38 of which were described in section 501(c)(3); and in fiscal year 1997, the irs revoked the exemption of 89 organizations, 17 described in section 501(c)(3). id. at 27 n.56 (citing the irs audit information management system, tables 41 and 42). 2012] 219 florida tax review serve on the board of directors, and have a vote on compensation arrangements, leasing arrangements, and other financial matters that would affect the organization's financial interests as well as their own. thissituation gives rise to an inherent conflict of interests that would potentially, adversely impact the financial well being of the organization. thus, you have failed to show that b, c, d and e, through their positions on the board, would not benefit from inurement....["]); plr 200510031 (nov. 15, 2004) ("there is not even one outside, disinterested board member to speak for the community. we must conclude that you violate the second fundamental rule for exempt organizations, and operate for private, not public benefit.[",])140 unfortunately, the irs website makes these exempt-organization determination letters available only as part of its general release of all determination letters.14 1 given how many of these determination letters we now have, and how cumbersome the process is of reviewing them, the irs or another institution, with either public or private funding could usefully collect and sort these documents.14 2 the easiest way to find specific issues in these letters is to search a commercial electronic database, such as lexis or westlaw. even when one can find a particular determination letter, the redactions are simple elisions. as with all private rulings and memoranda, the redactorsl 43 make no effort to give a sense of the substance underlying 140. act, appropriate role, supra note 54, at 34 n. 116. 141. internal revenue service, irs written determinations, http://www.irs.gov/app/picklist/list/writtendeterminations.html (last visited oct. 11, 2011). while the website makes it possible to sort determination letters by something called the uilc number, the letters are coded in obscure and unhelpful ways. for example, uilc 501.06-02 begins helpfully, under code section 501, but "06-02" means "conduct of business for profit." this category is to be distinguished from "501.06-02 conduct of business for profit." and what to make of "501.03-30 organizational and operational tests" and "profit vs. not for profit"? moreover, categorical assignments do not seem to be made with great care. for example, i.r.s. determination letter 200634046 (aug. 25, 2006), which involves a nonprofit corporation that lost its exemption on grounds of private inurement, is filed under "501.03-04 unincorporated associations." of course, no single category is going to be helpful when the reasons for revocation are manifold. 142. for example, leading practitioner and author bruce hopkins maintains a collection of citations. see bruce r. hopkins, resource center, nonprofit l. center, http://www.nonprofitlawcenter.com/resources.php (last visited oct. 11, 2011). 143. in the case of private rulings, the redactors, in the first instance, are the [vol. 12:4220 charity governance the facts. 144 thus, we get such baffling indications as "$j" or "$ * * * " rather than, say, orders of magnitude, percentages, or relationships that would give a sense of the materiality of the problem; one recent revocation letter dealing with a complex structure referred to all names, places, and banks accounts by an undifferentiated "xx." 145 the steady stream of denial and revocation letters has allowed the irs informally to stake out positions on basic substantive issues, such as whether a particular activity is eligible for exemption.14 6 for example, it is understood that the irs demands a minimum of three unrelated board members, although, because such a requirement does not appear in the statute or regulations, the irs cannot deny exemption on this basis alone. the 2008 act report comments: we were not able to find guidance as to how the irs takes governance issues into account in the determination process, except in limited instances in the health care and low-income housing joint venture areas. we certainly appreciate that governance can bear on the operational test, among other issues. our personal experience and research for this report suggest, however, that the irs may require specific governance practices on an ad hoc and inconsistent basis.147 requesting taxpayers themselves. 144. in comments on the joint committee's 2000 disclosure study, the independent sector "strongly oppose[d]," among other jct recommendations, those that would require the service to make unredacted disclosure of written determinations and related file documents, closing agreements and audit results, exemption applications at the time of filing, and forms 990-t (for its unrelated business taxable income) and 1120 (of any affiliated organizations of tax-exempt organizations). staff of s. comm. on ways and means, 106th cong., comments on disclosure study, supra note 109, at 54. the independent sector supported, assuming technical refinement, giving greater flexibility for irs information sharing with state charity regulators, a proposal enacted in the pension protection act, as described below. id. at 56. 145. i.r.s. determination letter 201052022 (oct. 5, 2010). 146. for example, see i.r.s. priv. ltr. rul. 2008-27-041 (apr. 10, 2008), denying recognition of tax-exempt status under section 501(c)(3) and setting forth "12 specific conditions" for recognizing an llc under the organizational test of section 501(c)(3); while the letter cited no authority for these conditions, they appear in richard a. mccray & ward l. thomas, limited liability companies as exempt organizations update 29-32 (2001), http://www.irs.gov/pub/irstege/eotopicb01.pdf. 147. act, appropriate role, supra note 54, at 3. 2012] 221 florida tax review the report cites two illustrations: [d]etermination specialists may require organizations seeking exemption to have independent boards or at least some independent board members. similarly, despite the fact that the form 1023 specifically states that a conflict of interest policy is recommended but not required, our experience and interviews suggest that determination specialists often require adoption of such a policy, and occasionally require adoption of the sample form of policy included with the form 1023 instructions. 14 8 notably, as the 2008 act report, adds: "there typically is no public record where taxpayers agree to make the changes required, strongly urged, or recommended by the irs in the determination process and receive an exemption; or where an application is withdrawn."l the 2008 act report concludes that while we have only anecdotal evidence regarding governance issues in the determination process. . . [t]he 'when' and 'what' . . . [seem] unclear and not uniformly applied. we are concerned about the irs having this level of discretion in cajoling or requiring specific governance process, particularly in the determination phase, where there usually is no track record evidencing operational failures.150 now, six years on, the irs should use this substantial database of published denial and revocation letters to develop formal guidance. as with the revenue ruling on housing down-payment assistance organizations,"' and in light of congressional endorsement of the irs's position on credit-counseling agencies, 152 the sector is entitled to revenue rulings or even regulations setting forth the agency's positions on organizational and operational issues, including nonprofit governance, that jeopardize exempt status. an excellent place to start would be to adopt the approach of benjamin leff, who found that the irs actually and appropriately follows a "middle way" of requiring the addition of independent board members only in specific narrow circumstances when the organization "has the potential to advance a 148. id. 149. id. at 33. 150. id. at 35. 151. rev. rul. 2006-27, 2006-1 c.b. 915. 152. i.r.c. § 501(q) (added by the pension protection act of 2006 pub. l. no. 109-280, 120 stat. 780 (2006)). [vol. 12:4222 charity governance substantial private purpose."l53 such guidance would also allow the irs to provide examples that show specific or relative dollar amounts and other facts masked by the redaction process. 3. information sharing: disclosure from irs to state attorneys general amendments to code section 6104 in the pension protection act of 2006 (ppa) broadened the irs's authority to provide certain information to state charity regulators, especially regarding exemption applications and denials. 154 the ppa extends to those state charity officials the section 6103(a) obligation to protect the confidentiality of the taxpayer information it receives. in march 2011, the irs proposed regulations under amended section 6104(c).156 the preamble emphasizes: "all disclosures authorized under section 6104(c) may be made only if the state receiving the 153. benjamin moses leff, federal regulation of nonprofit board independence: focus on independent stakeholders as a "middle way," 99 ky. l. j. 731, 780 (2011) [hereinafter leff, federal regulations]. specifically, the irs has been asking for independent board members for charities (other than private foundations, which are subject to other rules) "(i) whose governing boards are dominated by their founders, and (ii) who intend to engage in ongoing financial transactions with those founders/directors;" and (iii) "when other independent stakeholders are absent." id. professor leff concludes that congress could grant the irs the authority to impose this requirement as a condition of section 501(c)(3) status. id. at 781. 154. pension protection act of 2006, pub. l. no. 109-280, § 1224, 120 stat. 780, 1091-93 (2006). see also rev. proc. 2011-9, 2011-2 i.r.b. 283 (emphasis added) (citations omitted) ("the service may notify the appropriate state officials of a refusal to recognize an organization as tax-exempt under § 501(c)(3). the notice to the state officials may include a copy of a proposed or final adverse determination letter or ruling the service issued to the organization. in addition, upon request by the appropriate state official, the service may make available for inspection and copying the exemption application and other information relating to the service's determination on exempt status."). separately, the irs may disclose to appropriate state officials "the name, address, and identification number of any organization that has applied for recognition of exemption under § 501(c)(3)." id. in calendar year 2009, the irs made 334 disclosures to state officials under section 6104(c). internal revenue service, disclosure report for public inspection pursuant to internal revenue code section 6103(p)(3)(c), at 3(2010), www.jct.gov/publications.html?func=startdown&id=3680. 155. pension protection act of 2006, pub. l. no. 109-280, § 1224, 120 stat. 780, 1093 (2006). 156. notice of proposed rulemaking and notice of public hearing, disclosure of information to state officials regarding tax-exempt organizations, reg-140108-08, 2011-11 i.r.b. 591. 2012] 223 florida tax review information is following applicable disclosure, recordkeeping and safeguard procedures."'17 the national association of state charity officials (nasco) has commented, though, that in part because of the "cumbersome nature of the safeguard requirements and the resources needed to adhere to them," just three states (california, hawaii, and new york) have reached information-sharing agreements with the irs.' indeed, nasco asserted, the situation is now worse: "the ppa actually decreased disclosure of information to the states since the non-participating states no longer receive the pre-ppa notifications of final denials, revocations and notices of tax deficiencies."1 59 e. congressional oversight the congressional tax-writing committees have oversight responsibility for the performance of the internal revenue service. in october 2011, the chairman of the oversight subcommittee of the house ways and means committee sent a five-page letter to the irs commissioner requesting a wide variety of information about exempt-organization resources, exempt-organization activities, and enforcement actions. in a class by itself, and generally beyond the scope of this article, was the devotion by senator charles grassley while he served as chair and ranking member of the senate finance committee to publicizing abuses in the charitable sector. his most systematic effort began with a 2004 hearing and staff white paper on nonprofit governance,161 followed by 157. id. 158. letter from the nat'l ass'n of state charity officials to the internal revenue service (jun. 13, 2011), http://www.charitableplanning.com/cpc_1827385i.pdf. moreover, the comment letter states: those states that have entered into such agreements have limited their receipt of information to paper documents to avoid the substantial burdens of maintaining safeguards required for the maintenance of electronic data, since an audit of the statewide data center would be required. it is truly regrettable that [appropriate state officers] find themselves having to forego the efficiencies and other benefits of electronic information technology, especially as they strive to modernize their own systems. id 159. id. 160. see letter from charles boustany, jr., chairman, oversight subcommittee of the house ways & means comm., to douglas h. shulman, commissioner, internal revenue service (oct. 6, 2011), http://waysandmeans.house.gov/uploadedfiles/tax-exempt.oct6.11_redacted.pdf. 161. staff of sen. comm. on finance, 108th cong., tax exempt governance proposals: staff discussion draft (jun. 22, 2004), http://finance.senate.gov/imo/media/doc/062204stfdis.pdf. [vol. 12:4224 charity governance senator grassley's invitation to the independent sector to convene a blueribbon panel on the nonprofit sector, which produced three influential reports.162 senator grassley also issued a series of "love letters" to specific nonprofit organizations inquiring about their practices. this latter group included the american red cross, american university, the nature conservancy, and the smithsonian institution.163 industry-wide inquiries, often joined by finance committee chair max baucus, asked extensive questions about nonprofit hospitals' charity-care practices, higher educations' endowment spending, and, most recently, a group of televangelists of the "prosperity gospel" bent. these investigations had greater legitimacy when they covered nonprofit subsectors (rather than individual nonprofits) and the oversight of the irs's performance in administering the laws. indeed, senator grassley deserves much of the credit for the extensive exempt-organization reforms in the pension protection act of 2006.164 however, the irs, as part of the executive branch, has the enforcement responsibility and expertise to prosecute individual cases; moreover, as described above, the irs must function under confidentially constraints by which senator grassley seemingly felt unencumbered. perhaps not surprisingly, the first sign of public resistance to providing the information "requested" came from some of the televangelists. 65 162. reports and recommendations, panel on the nonprofit sector, http://www.nonprofitpanel.org/report/index.html (last visited oct. 12, 2011). see also infra part v. 163. these letters and, often, the responses, can be found in the press releases pages at grassley press releases, senator charles grassley, http://www.grassley.senate.gov/news/press releases.cfmt (last visited oct. 12, 2011). 164. see generally dean a. zerbe, former tax counsel to senator grassley, remarks at the georgetown law center cle, representing & managing taxexempt organizations (apr. 24, 2008), in 13 eo tax j. 38 (2008) (setting forth reflections on the congressional oversight process and goals by a former key tax aide to senator grassley). 165. see memorandum from theresa pattara and sean barnett on review of media-based ministries to senator charles grassley 16-32 (jan. 6, 2011), http://grassley.senate.gov/news/article.cfn?customeldatapageld_1502=30359. attorney marcus owens, on behalf of one of the target churches, wrote to senators baucus and grassley on november 27, 2007: "if a [senate] subpoena were issued, the church and its members could be afforded certain confidentiality protections, which, like the privacy protections of section 6103, would reduce the likelihood of any public discourse regarding its religious beliefs." letter from marcus s. owens, esq., caplin & drysdale, chartered, to max baucus, chairman of the committee on finance, u.s. senate, and charles d. grassley, ranking member of the committee on finance, u.s. senate (nov. 27, 2007), 2007 tax notes today 235-29. 2012] 225 florida tax review v. voluntary disclosure by the organization and disclosure by private parties a. voluntary disclosure by the organization itself charities often make disclosures to various constituencies without the compulsion of law. prospective donors and grantmakers might condition funds on the production of satisfactory financial or other information. for example, before making grants to charities, many community foundations insist on being advised of such information as the names and relationships of board members and officers, the compensation of officers and relevant relationships, the identities of beneficiaries, audit data, and basic performance metrics. government contracting rules, too, might demand reporting and audited financial statements. beyond statutory requirements, the bylaws of membership organizations might require certain disclosures to the members. as discussed in part iii, charities have no excuse for refusing to provide basic information to members of the governing board, who should not be compelled to bring litigation to obtain that information on a timely basis. while, as mentioned in part iv, the affairs of a nonprofit, nongovernmental entity are private, and generally not subject to public disclosure, many of the reported troubles that have befallen charities in recent years could have been avoided had there been routine, timely and consistent public disclosure of basic information. some of this information is already available through the regulatory and tax filings described in part iii, but usually only much after the fact (even when timely filed) and in a form that can be difficult for laymen to parse. the panel on the nonprofit sector's principles for good governance and ethical practices recommends: "a charitable organization should make information about its operations, including its governance, finances, programs and activities, widely available to the public. charitable organizations also should consider making information available on the methods they use to evaluate the outcomes of their work and sharing the results of those evaluations."l 66 charities should consider making clear in their bylaws or policies that transparency with the public is to be the norm, and deviations from that norm ought to require board consideration. the fact that transparency is the norm itself would deter many of the abuses made public. 166. panel on the nonprofit sector, principles for good governance and ethical practice: a guide for charities and foundations 12 (2007), http://www.independentsector.org/uploads/accountabilitydocuments/ principles forgoodgovernance-andethical practice.pdf. see generally john tyler, philanthropic transparency: the good, the bad, and the useful (forthcoming). [vol. 12:4226 charity governance for the benefit of the general public, nonprofits commonly post annual reports to their websites, but it is not so common to see forms 990 and financial statements.16 7 in a crisis, whether as a matter of damage control or sincerely to get ahead of the story, nonprofits should make timely disclosure. spinning is a problem, though. for example, prior to the 2008 settlement, the dueling websites of the litigants over the robertson gift to princeton university to fund the woodrow wilson school represented an attempt to influence the court of public opinion.1 6 8 other recent scandals include the smithsonian institution 69 and the j. paul getty foundation (discussed in part v.c, below)."o b. media spurred by the perceived fundraising abuses by charities in response to the attacks on september 11, 2001, mainstream as well as specialty media interest in nonprofit governance has exploded. for those trying to keep up, important resources include the chronicle of philanthropy's daily posting of summaries (with links) of news stories published around the country,"' as 167. for a laudable example of transparency, see the ford foundation's site, which provides its articles of incorporation; bylaws; committee charters and membership; standards of independence; trustee code of ethics; staff code of conduct and ethics; procedures for approving affiliated grants; and procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls and auditing matters. governance, fordfoundation, http://www. fordfoundation.org/about-us/govemance (last visited oct. 12, 2011). see annual reports, fordfoundation, http://www.fordfoundation.org/about-us/annual-reports (last visited oct. 11, 2011) for copies of the ford foundation's annual reports, and see financial statements, fordfoundation, http://www.fordfoundation.org/aboutus/financial-statements (last visited oct. 11, 2011) for copies of the ford foundation's financial statements. 168. only princeton's webpage survives. see robertson lawsuit overview, princeton univ., http://www.princeton.edu/robertson/about/ (last updated dec. 16, 2008). 169. see the governance material posted at the board of regents, smithsonian inst., http://www.si.edu/govemance/ (last visited oct. 12, 2011). 170. see governance, the getty trust, http://www.getty.edu/about/ governance/ (last visited oct. 12, 2011). the posted material includes the getty's mission statement, trust indenture, bylaws, board of trustees, board committees, trust officers and program directors, policies, financial information, annual and other reports, and the california attorney general's 2006 investigative report and the 2008 closure of the state's monitoring process. id. 171. today's news, chron. of philanthropy, http://philanthropy.com/ section/todays-news/284/ (last visited oct. 12, 2011). 2012] 227 florida tax review well as such legal nonprofit blogs as don kramer's nonprofit issues,7 a group of legal academics' nonprofit law prof blog, 73 and jack siegel's charity governance blog.17 4 reporters often dwell on "fraud and abuse" in the nonprofit sector. we run the risk, however, of over-reaction to anecdotal information since we don't know the denominator, is the fact that we're seeing more stories an indication of increasing problems, or of increasing observation? in general, the increased availability of information on nonprofit operations increases the public expectation for more transparency. c. peer regulators and charity "watchdogs" peer regulation in the nonprofit sector comes in two flavors the third-party watchdogs and the trade associations. the watchdogs are donorfocused, and they typically provide assessments (sometimes using a star system or letter grades) regardless of whether the charity knows about the review or supplies information. however, the bbb wise giving alliance which assesses whether a given charity meets or does not meet its standards for charity accountability relies on information from the charity and states cases in which the organization failed to respond.' 6 172. don kramer's nonprofit issues, http://www.nonprofitissues.com/ (last visited oct. 12, 2011). 173. nonprofit law prof blog, http://lawprofessors.typepad.com/ http://lawprofessors.typepad.com/nonprofit/ (last visited oct. 12, 2011). 174. charity governance, http://www.charitygovemance.com./ (last visited oct. 12, 2011). 175. see marion r. fremont-smith & andras kosaras, wrongdoing by officers and directors of charities: a survey of press reports 1995-2002, 42 exempt org. tax rev. 25 (oct. 2003); marion r. fremont-smith, pillaging of charitable assets: embezzlement and fraud, 46 exempt org. tax rev. 334 (dec. 2004). 176. see implementation guide to bbb wise giving alliance standards for charity accountability, bbb, http://www.bbb.org/us/charity-evaluation/ (last visited oct. 13, 2011). as explained in the preface to the standards: the overarching principle of the bbb wise giving alliance standards for charity accountability is full disclosure to donors and potential donors at the time of solicitation and thereafter. however, where indicated, the standards recommend ethical practices beyond the act of disclosure in order to ensure public confidence and encourage giving. as voluntary standards, they also go beyond the requirements of local, state and federal laws and regulations. standards for charity accountability, bbb, http://www.bbb.org/us/charitystandards/ (last visited oct. 13, 2011). note that i have served on the board of the bbb wise giving alliance since 2006. 228 [vol. 12:4 charity governance by contrast, membership in the trade associations is voluntary, with the organizational member submitting both to the groups' standards17 7 and to any disciplinary process for violation. most groups are not as open as the evangelical council for financial accountability, which posts a chart of former members, indicating the reason voluntary resignation or termination.7 8 for example, brian gallagher, head of the united way of america (uwa), said at the july 22, 2004, senate finance committee roundtable that the uwa has decertified 30 uw's around the country in the previous two years. this information should have been more widely known i couldn't even find it on the uwa's website. peer organizations generally seem loathe to publicly discipline noncompliant members. while still an anomaly, compare the council on foundation's brief suspension of the j. paul getty trust's membership, ending when the trust adopted reforms including new training and evaluation tools for board members, strengthened conflict-of-interest provisions, increased board oversight of real estate deals, and increased transparency of staff compensation and performance reviews. 179 finally, there is the behavior of nonprofit groups speaking out or, more likely not about specific misbehaving organizations or unacceptable practices as they occur. is not protection of the sector's reputation a duty of nonprofits themselves? the independent sector's panel on the nonprofit sector energetic response to senator grassley's 2004 staff white paper culminated in a report containing 33 principles of self-regulation.o some 177. see, e.g., evangelical council for financial accountability, ecfa's seven standards of responsible stewardship, http://www.ecfa.org/ pdf/ecfasevenstandardsof responsible stewardship.pdf. standard 5, titled transparency, reads: every member shall provide a copy of its current financial statements upon written request and provide other disclosures as the law may require. the financial statements required to comply with standard 3 must be disclosed under this standard. a member must provide a report, upon written request, including financial information on any specific project for which it has sought or is seeking gifts. id. 178. former members, ecfa, http://www.ecfa.org/formermembers.aspx (last visited oct. 12, 2011). the most common reason for termination was failure to submit renewal information. id. 179. j. paul getty trust membership status in council on foundations restored council on foundations lifts probation, the getty trust (apr. 17, 2006), http://www.getty.edu/news/press/center/council on foundations release 041706.html. note that the press release is no longer posed on the council's website! see council on foundations, www.cof.org/council/newsletter.cfn? itemnumber4285&navltemnumber-2499 (last visited oct. 12, 2011). 180. panel on the nonprofit sector, principles for good 2012] 229 florida tax review members of the working group, however, were disappointed that the principles are precatory only, and that the nonprofit panel could not achieve consensus around adopting a mechanism for certification and discipline. deciding how to bell the cat is never easy. vi. conclusion the internal revenue service does not have the resources to verify all tax exemptions on a routine basis. rather, the irs conducts a relatively small number of examinations (including targeted correspondence audits) of specific charities, either as part of a system of examining forms 990 or pursuant to a particular compliance initiative (such as on political campaign activities, hospitals, and institutions of higher education).18 1 in 2009, the irs's exempt organizations division released a governance check sheetl8 2 and a governance project guide sheet for completing the project check sheet 83 to be used by agents in examining code section 501(c)(3) exempt organizations. the public can access these guidelines from a new webpage that explains: a check sheet will be used by irs' exempt organizations examination agents to capture data about governance practices and the related internal controls of organizations being examined. the data will be included in a long-term study to gain a better understanding of the intersection between governance practices and tax compliance. 8 4 the webpage links to the check sheet, guide sheet, and other governance materials on the website,'85 notably an article entitled governance of governance and ethical practice, supra note 166, at 8-37. 181. see douglas shulman, commissioner of internal revenue service, remarks before independent sector (nov. 10, 2008) (transcript http://www.irs.gov/newsroom/article/0,,id=188567,00.html) ("we're . . . taking other proactive action like starting to check up on young exempt organizations to ensure that after a few years in operation they are in fact fulfilling an exempt purpose."). 182. i.r.s. form 14114, governance check sheet (2009), http://www.irs.gov/pub/irs-tege/governance check sheet.pdf. 183. internal revenue service, governance project guide sheet for completing the project check sheet, http://www.irs.gov/pub/irs-tege/govemance guide sheet.pdf. 184. internal revenue service, governance and tax-exempt organizations examination materials, http://www.irs.gov/charities/article/0,,id=216068,00.html (last updated feb. 11, 2011). 185. id. 230 [vol. 12:4 charity governance charitable organizations and related topics18 6 included in the life cycle on-line educational tool for charities. the irs's recent focus on exempt-organization governance has attracted thoughtful commentary on both sides of the issue. thomas silk supports this endeavor of the irs: it is not far-fetched to imagine a national scandal featuring a prominent charity in violation of standards of charitable governance but incorporated in a state with inadequate charitable enforcement. in the congressional hearings that might follow, the irs would surely be in a far more defensible position if it had already gone forward to educate the charitable sector about the importance of good governance practices. later legislation introduced by a supportive congress may easily resolve any jurisdictional ambiguities about governance of charitable organizations and enforcement.' on the other hand, bonnie brier (lead author of the 2008 act report quoted above) expressed skepticism that the described governance practices actually lead to good governance, and worries that charities will adopt them just to satisfy the irs regardless of whether they are appropriate for the organization.'8 marcus owens, former top exempt organization official at the irs, questions the irs's authority to include governance questions on the form 990. senator grassley responded to such objections by proposing legislation to provide statutory authority for the irs to assert an interest in charity governance as an indicator of compliance with the federal taxexemption regime. 186. internal revenue service, governance and related topics 501(c)(3) organizations (2008), http://www.irs.gov/pub/irs-tege/govemance_ practices.pdf. 187. thomas silk, good governance practices for 501(c)(3) organizations: should the irs become further involved?, 57 exempt org. tax. rev. 183 (aug. 2007). for different audiences, see his articles at 107 j. tax'n 45, 45-46 (2007) and 10 int'l j.not-for-profitl. 30, 31 (2007). 188. bonnie brier, the new governance project of the exempt organizations division of the internal revenue service (feb. 20, 2010 draft) (on file with author) (presented at the nonprofit forum in new york city on feb. 24, 2010); see also james. j. fishman, stealth preemption: the irs's nonprofit corporate governance initiative, 29 va. tax. rev. 545, 586-89 (2010). for specific criticism of the irs's focus on the perceived benefits of independent board members, see dana brakman reiser, director independence in the independent sector, 76 fordham l. rev. 795 (2007); see also leff, federal regulation, supra note 153. 2012] 231 florida tax review i generally disagree with those critical of a role for the irs in charity governance, at least to the extent these criticisms apply to the governance questions on the redesigned form 990. indeed, as described above, i submitted comments to the irs on the 2007 draft of the redesigned form 990, proposing for inclusion a series of questions on organizational structure and governance practices1 many of which were added in the final version. at that time, i had in mind the usefulness of the form 990 to the governing board itself and to state regulators, to donors, to the media, and, yes, to researchers, even aside from what uses the irs might make of the data. while recognizing the values of privacy discussed above, on balance, i believe these interests do not outweigh the benefits from transparency of the organization's governance structure to these outside constituencies. if a particular "best" practice is inappropriate in a particular case, the charity can and should provide an explanation on the form 990. thoughtful additional disclosure is an opportunity for the organization to demonstrate if it can how its structure and policies appropriately safeguard charitable assets. 189. brody, professor comments, supra note 49, at 3-5. 232 [vol. 12:4 charity governance appendix: summary and governance pages of core form of redesigned form 990 (2007 draft and 2008 final versions) return of organization exempt from income tax fuder section 501 i 57. ri 49474ati i ofi tihe internal revenue code leaept blet kmg entetfit trust or private foundtit 1 the opizaten ay ha0e e use 0c1y of tio relumn to staty state freart i a for the 2oxx calendar voar or tax ya, belinning btec:ifapplit : c name o rganzaion e rne retun el eteiiioli i liq f 5 11d 10t1 o n1 n rnt.= w flintol ff1050001110211100111 f bitt hinuhi-ini 000010110 0140 i nnoriirennm{ornio 0 cit 01 teen, 21010111 lniooa 0110 zip 0 11010 i.] o re-anwn romr f namnr 10 addr0r rai0 i ooo n rtnatd inc -lof alocted 1t h enter arnourit el te ega s o acs ol k oranization lyp-e (iekedfi orej -~oi ao sort oidc:,ino a 014 p-ippion.-le l year of f:omation: nm stt of legal brinmil l-m summary, i briefly descrnbe the organization misiot .. l. -2 ust the organizationo threa most significant oativties and the actiity ctodes part lx): a ------... -ocd--------b ------------code ......--...od-i enter the num ber of n ttbers of the govem ing to y (part iil. line 1 i -)4 enter the number of indepndent rembers of the governing body (part ill. fini bt 4 5 enter the total numle of grnploes (part vll. line pa) . . . ._._.._._._... 5 6 entw the num-i of indiordual ieiving compenstin oess of $1000if (part 11 line 2. . 6 7 enter the highetn ompenation amount riported on part iis sction a tsum of columns d and q 7 oa enter officer, dire ctoru -tr e nd ther key eopoyee compensation (pori v. line 5, column (mi sa i divide line sa by li n 17 _ go enter total gions unrelated businss rhvenue from part iv, line 14, column 1-) . 9n b enter net unrelated business taxable incom frm ferm 9o0-t, hri 34 b 10 chet thito o] ifthe attntration dm0stttiiniod its oerain or diosend o-ffrolethan1 25% of its as0ks ard attach fschide i ainutit 0total 11 contibutions and grants (part iv, line 1. column . 12 program service revenue ipart v,. line 2g, column (ae) 13 memiership, due, and assoessmonts (part iv, lire 3. column (a) .a 14 investmnlt itorn. (part iv lines 4, 5, 6. s. 10d) . . . 15 other revetnu (part iv, lines, 3. , 11c, 12c, and 13a, column ai f6 total ravniue add lines 11 through 15 iniut equl part iv. line 14. clunin io _ 1o% --t f7 program nervice expensnel (partv, litno 24, clumn 2)). 18 management and general expenoses part v fine 24, column (.t10a fundraising exopensesipart v. line 24, column (d i. .. . . 19b poerentage of contributions (divide line 19a ty line 11 % 20 total expensmust equal part v, litre 24, column ia. . . . 21 not inom qie diia 1 rinus line 20i 22 total asset4 ipart v line 17) 23 total liablities (part vi, line 271 a . . 24a fntassets or fund blances line 22 minus line 23 94h total axmensoe line 20, as areontace of net nasseto ll i 24d) i ot s re snlue 01) expenses (fll(# net to melanization im dwide clmn (lh tycolurrriii 25 nr t ca 100101r 14i cieu foplinen me s 01 gsw pior atfl, 71 00 chaarn 26 ftnirrab (01tel ischeduj 1. pat on int wib0 ornil) ikellid g. pal 1. ine lbed~rmi iv (schelile q pan t ine tb calmitn iii ia nert tent for privacy act and pape-work reduction act ntice, see the eparate instructions, ca. no. li2 for 490 -oxq 2012] 233 on 990 t 110 xx florida tax review foi me mxxs la enter the number of inanitas af th governing body . . b enter the number of independent em bers of the goeming body ------2 did the olganizatioti make un aijojiiant changito to its orgalcing or go iningdxumenta? if "-e briefly describ these changes. 32 does the organbation have a written conflict of intrest poiv -...................... b if "s how mary transactions lid the organizatinis ravie under tin' plir and rliated procedures dating the year? . . .-------4 does the organation have a written whmtl-blovst polic-6 dos the or anization have a wntten dciminent ret-ntinn and detruction policy . s des the organization c:ntrnporaneousy document the meetings of the gening bode and related committsthrough the preparation of mtinites or other sinl adocumetaion 0 . ta dothe organization have local chaptle. brnt hc or uffilites. . . b it eoc dose itgunitio have written poliie and pr.cedures goverming the activities of such chapter nftfiltes and brandies ho ensure their ophn-rcon se-tent with the orianizations 8 deall officer, dir:1tr, trusteeinpl-a orvotuntr prtir-the ugaonzatki s finanell statements ldicatewhetherarn independent aountant poidea any of the tollowing setiw.es compilation 5 review o auit l 9 does the organization have an audit uomm-itee . . . . . . . . . 10 did th organcation's governing body revte. thi fom gon before it was fied? . ...... 11 how do you make the following available to the publr check all that apply drganiingciverninu document o o o wqbsile o onhei neboute o office [ other conflict of interest policy 0 rva c wbsi ti her rebite o office e other foim an re c webse c other .ebslte o office 0 other foam aoo-t o rea 0 website o other website c office o other financial statements o oea c weebsite c other website o office o other audit report 0 rsa 0 website o other webslte [ office o other 12 list the states with which a copy of this retum is filed: 234 [vol 12:4 page 4 ys i no 2 2i tb pome 990 rmati pon 9go -,qxk, 11h= bo11i en n egrnes gv v ., evvensanae n, -1-,sess tcharity really does begin at home: florida tax review volume 12 2012 number 3 125 understanding consolidated returns by martin j. mcmahon, jr.* abstract section 1501 allows all of the members of an affiliated group of corporations to elect to file a consolidated return. a consolidated return permits the includible members of an affiliated group of corporations to combine their incomes into a single return. the detailed rules for filing consolidated returns are found in regulations promulgated pursuant to a broad delegation of authority in section 1502 of the internal revenue code. in general, the regulations reflect a “single entity” approach that attempts to treat the several members of a consolidated group in the same manner as divisions of a single corporation. this article explains the most important general principles governing consolidated returns and is intended to provide an overview of the consolidated return regulations for lawyers who are generally unfamiliar with the detailed rules. among other topics, the article explains (1) the rules governing eligibility to file a consolidated return, (2) the computation of consolidated taxable income, including relevant limitations on the use of net operating losses, (3) intercompany * stephen c. o’connell professor of law, university of florida college of law. portions of this article are adapted from various chapters of paul r. mcdaniel, martin j. mcmahon, jr. & daniel l. simmons, federal income taxation of corporations, 3d ed. (foundation press, 2006). a somewhat different version of this article was published under the title consolidated corporate income tax returns in the united states, in svensk skattetidning (no. 8, 2011) 597. i am deeply indebted to professor daniel l. simmons for his contributions. i also thank professor don leatherman and jack cummings for their insightful comments and suggestions. all errors that remain are my own. this article is up-todate as of january 31, 2012. 126 florida tax review [vol. 12:3 transactions and distributions, (4) stock basis adjustments, and (5) earnings and profits calculations. it explains both the rules in the consolidated return regulations and the differences from the rules that otherwise would govern had the corporations not elected to file a consolidated return. i. introduction ............................................................................. 127 ii. overview .................................................................................... 128 iii. eligibility and includible corporations......................... 133 a. stock ownership ...................................................................... 133 b. includible corporations .......................................................... 135 iv. consolidated taxable income............................................. 136 v. formation of a corporate subsidiary .............................. 137 a. generally ................................................................................. 137 b. receipt of other property ....................................................... 138 c. assumption of transferor’s debts ........................................... 139 d. transfers to foreign corporations ......................................... 140 vi. dividend distributions: fundamental rules ................... 141 a. generally ................................................................................. 141 b. dividends in kind .................................................................... 143 vii. investment adjustments ........................................................ 144 a. stock basis ............................................................................... 144 b. section 357(c) situations ......................................................... 147 c. unified loss rules ................................................................... 147 1. generally .......................................................................... 147 2. the basis redetermination rule ....................................... 148 3. the basis reduction rule ................................................. 149 4. the attribute reduction rule ............................................ 150 5. worthlessness .................................................................... 152 viii. earnings and profits .............................................................. 152 ix. intercompany transactions ................................................. 154 a. transactions between members of a consolidated group ..... 154 1. generally .......................................................................... 154 2. matching intercompany items related to deferred gains and losses .............................................................. 155 3. acceleration of deferred gains and losses ..................... 159 b. distributions with respect to the stock of a member ............. 160 1. section 301 distributions .................................................. 160 2. intercompany distributions of appreciated and depreciated property........................................................ 160 3. liquidation of a subsidiary ............................................... 162 2012] understanding consolidated returns 127 c. transactions in which a member acquires stock of another member ...................................................................... 166 d. transactions in which a member acquires its own stock ..... 166 e. transactions in which a member acquires debt of another member ...................................................................... 167 f. anti-abuse rules ..................................................................... 168 x. net operating loss carryovers ......................................... 168 a. generally ................................................................................. 168 b. application of section 382 to consolidated groups ............... 170 c. separate return limitation year ............................................. 172 1. generally .......................................................................... 172 2. reverse acquisition ........................................................... 173 3. built-in deductions ........................................................... 175 4. post acquisition losses of an acquired member .............. 175 xi. foreign subsidiaries................................................................ 176 a. generally ................................................................................. 176 b. anti-inversion rules ................................................................ 178 c. foreign tax credit .................................................................. 179 1. direct credit ..................................................................... 179 2. indirect credit ................................................................... 180 d. dual consolidated losses ....................................................... 180 xii. conclusion ................................................................................. 181 i. introduction virtually all publicly owned united states corporations, as well as the handful of large privately owned corporations that cannot (or chose not to) make an election under subchapter s, as well as the domestic subsidiaries of foreign corporations, elect to report their income for federal tax purposes as part of a consolidated group rather than as separate entities.1 in one form or another, the consolidated return regime dates back to 1917,2 although the current regime is far more sophisticated than its early forerunners. the modern consolidated return regime is highly complex and articulated by voluminous regulations. nevertheless, judging by the paucity of litigation in the area, one must conclude that the regime works surprisingly well. indeed it works so well that practitioners frequently assume they know what the regulations provide without actually looking at them. that can be dangerous. this article aims to acquaint the uninitiated student or practitioner, and 1. for 2008, over 42,000 consolidated returns were filed. 30 soi bulletin no. 4, 339, tbl. 13 (spring 2011). 2. see jasper l. cummings, consolidating foreign affiliates, 11 fla. tax rev. 143, 163-195 (2011) (describing the history and evolution of the early consolidated return regulations). 128 florida tax review [vol. 12:3 perhaps even remind the seasoned practitioner who has been relying too much on memory, with the principal features of the consolidated corporate income tax return regime. ii. overview election to file a consolidated return — section 1501 of the internal revenue code provides that all members of an affiliated group of corporations may elect to file a consolidated income tax return.3 a consolidated return permits the includible corporations (as defined in section 1504(b)) that are members of an affiliated group of corporations to combine their incomes, net operating losses, credits, and other items into a single return. section 1502 authorizes the treasury to promulgate regulations4 as necessary in order “that the tax liability of any affiliated group of corporations making a consolidated return and of each corporation in the group . . . may be returned, determined, computed, assessed, collected, and adjusted, in such manner as clearly to reflect the income tax liability and the various factors necessary for the determination of such liability, and in order to prevent avoidance of such tax liability.” as amended in 2004, section 1502 specifically provides that the consolidated return regulations may contain “rules that are different from the provisions ... that would apply if such corporations filed separate returns.” the detailed rules for filing consolidated returns are found in regulations promulgated pursuant to this broad delegation of authority. broadly speaking, the regulations reflect a “single entity” approach to dealings within the group, which attempts to treat the several members of a consolidated group in the same manner as divisions of a single corporation. however, in certain instances a separate-corporation approach applies to coordinate separate-return and consolidated-return years and to properly associate certain tax attributes with particular members of the group. the members of an affiliated group includible in a consolidated return are identified under section 1504(a) as the common parent corporation and one or more corporations affiliated through a chain (or chains) of corporations connected by ownership of stock representing 80 percent of the voting power and value of each affiliated member.5 unless otherwise excluded by statutory provision, any corporation that is connected to the 3. all references and citations sections in this article are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. 4. all references and citations in this article to regulations are to the current treasury regulations under the sections of the internal revenue code of 1986, as amended, unless otherwise indicated. 5. the value determination is made without regard to certain non-voting, non-convertible preferred stock. i.r.c. § 1504(a)(4). 2012] understanding consolidated returns 129 common parent or another member of an affiliated group by meeting this ownership requirement is treated as an “includible corporation” and must be included on the consolidated return.6 foreign subsidiaries are specifically excluded from the definition of “includible corporation” and thus are almost never included in a consolidated return.7 advantages of filing a consolidated return: net operating losses — the principal advantage of filing consolidated returns is the ability to combine the income and loss of each member of an affiliated group into a single taxable income.8 thus, net operating losses of one member of the group can be used to offset the taxable income of another member. this ability to offset losses of one member of the group against income of another member of the group does not extend to affiliated corporations that do not file a consolidated return. in addition, net operating losses of a member of the group incurred during consolidated return years of the group in which the group as a whole operates at a loss contribute to the overall net operating loss of the group, which may be carried back or forward to other consolidated return years, offsetting income of any member of the group. there are, however, limitations on carryovers of losses incurred by a corporation in separate return years before the corporation became a member of the affiliated group.9 filing a consolidated return also permits the members of the affiliated group to exclude intercompany dividends from gross income in computing taxable income and to defer recognition of gain or loss on intercompany transactions. the basis of stock of one member of a consolidated group held by another member is adjusted to reflect taxable income, loss and the other items of the lower-tier member. intercompany distributions and contributions also affect the basis of stock of a member of an affiliated group that is held by the common parent or other members, thereby increasing or decreasing gain or loss on disposition of the stock. in addition, deferred intercompany gains and losses may be taken into account in the event that a member leaves the consolidated group, even if the transaction otherwise would be accorded nonrecognition treatment as a taxfree reorganization. filing consolidated returns requires that all members of the consolidated group use the taxable year of the common parent, but, subject to an anti-abuse rule, the individual members may use different accounting methods.10 6. i.r.c. § 1501. 7. i.r.c. § 1504(b)(3). however, section 1504(d) provides a very limited special exception to this rule. 8. reg. § 1.1502–11(a). 9. reg. § 1.1502–21(c). 10. regs. §§ 1.1502–76(a), –17. 130 florida tax review [vol. 12:3 advantages of filing a consolidated return: intercompany transactions — the treatment of intercompany transactions within members of a consolidated group also offers significant advantages in many instances. in general, the tax consequences of intercompany transactions between members of the same consolidated group are accounted for in consolidated taxable income as transactions between divisions of a single corporation.11 in the case of payment for services or a sale or exchange of property, gain or loss that is recognized by the selling member under its method of accounting is deferred until the item can be matched with the buying member’s accounting of its corresponding item in the form of a deduction or a recovery of basis when the expenditure is capitalized.12 thus, in the case of an intercompany sale of property, the selling member defers accounting for its recognized gain or loss until the date on which the buying member sells the property outside of the consolidated group or an analogous event occurs requiring acceleration. in this manner, the gain or loss is deferred until the property is disposed of outside of the consolidated group, as would be the case with respect to an exchange of property between divisions of a single corporation. the character of the selling member’s deferred gain and the buying member’s recognized gain on sale outside of the group also will be determined by single entity principles. the activities of each, therefore, may affect the character of the other’s gain.13 for example, assume that s corporation and b corporation are members of an affiliated group filing a consolidated return. s corporation sells appreciated investment real estate to b corporation. subsequently, b corporation develops the land as residential real estate for sale to customers in the ordinary course of b corporation’s trade or business. when b corporation disposes of the land, s corporation must recognize its deferred gain. even though s corporation held the land for investment at the time of its sale to b corporation, both s corporation and b corporation’s gain will be treated as ordinary income.14 in the case of a sale of depreciable property, the selling member will defer its gain or loss to the time when the buying member claims increased capital cost recovery deductions.15 for example, under the single entity approach of the regulations, if the selling member sells depreciable property at a gain, the increased capital recovery deductions that result from the buying member’s cost basis will be offset by the corresponding gain taken into account by the selling member. in this fashion, these transactions have no net effect on the overall taxable income of the group, which is the same result that would have occurred if the selling and buying members had been 11. reg. § 1.1502–13(a)(2). 12. reg. § 1.1502–13(c)(2). 13. reg. § 1.1502–13(c)(1)(i). 14. reg. § 1.1502–13(c)(7)(ii), ex. (2). 15. reg. § 1.1502–13(c)(7)(ii), ex. (4). 2012] understanding consolidated returns 131 divisions of a single corporation, rather than separate corporations filing a consolidated return. any increased deduction or basis recovery by the buying member will be offset on the consolidated return by an equivalent recognition of deferred gain by the selling member. deferred gain or loss from intercompany transactions is accelerated into a year in which it becomes no longer possible to match the buying member’s corresponding item with the selling member’s deferred gain or loss.16 thus, gain or loss deferred by the selling member will be accounted for if either the buying member or the selling member ceases to be a member of the consolidated group before the buying member accounts for its matching item corresponding to the selling member’s deferred gain or loss. distributions — distributions from one member of an affiliated group to another are also treated under the single entity principle. distributions are not included in the income of the recipient, but only so long as there is a matching reduction in the basis of the stock of the distributing member held by the recipient member under the investment adjustment rules of treasury regulation section 1.1502–32.17 gain recognized by the distributing member under section 311(b) is deferred under the matching principle until the property is sold outside the group, the property is depreciated by the distributee member, or either the distributing or distributee corporation leaves the group.18 aggregate versus entity theory — even though the federal tax liability of an affiliated group filing a consolidated return is based on the combined taxable incomes of the members of the affiliated group, the separate tax identity of each member of the group is respected through maintenance of individual earnings and profits accounts and basis adjustments with respect to the stock of each member.19 as a result, while accounting for certain intercompany transactions is deferred for purposes of computing taxable income of the group under the consolidated return rules, those transactions will affect the earnings and profits and stock basis of the component members. accounting for the separate tax identity of each member is required to determine tax consequences in the event that an includible corporation enters or leaves the affiliated group. investment adjustment accounts — the regulations require a series of “investment adjustments” to the basis of stock of subsidiaries held by 16. reg. § 1.1502–13(d). 17. reg. § 1.1502–13(f)(2)(ii). 18. reg. § 1.1502–13(f)(2). 19. regs. §§ 1.1502–19, –31, –32, and –33. 132 florida tax review [vol. 12:3 other members of an affiliated group.20 these adjustments are intended to eliminate potential double tax consequences as the separate taxable income or loss of each member of the consolidated group is reflected on the consolidated return.21 investment adjustments begin with the stock of the lowest-tier subsidiary in a chain and work their way up to stock of includible corporations held by the common parent.22 positive adjustments increase the basis of the stock of a subsidiary member of the group held by another member, and negative adjustments decrease basis.23 adjustments are made for the net amount of the subsidiary’s taxable income or loss, expired loss carryover, tax-exempt income, non-deductible non-capital expenses (e.g. fines and disallowed losses), and distributions with respect to the stock of the subsidiary. losses of a subsidiary and/or distributions may exceed the uppertier corporation’s basis in the stock of the subsidiary. in that case, the regulations provide for the creation of an “excess loss account”, which is the equivalent of a negative basis in the subsidiary’s stock.24 the amount of an excess loss account attributable to the stock of an includible subsidiary is recognized as income (1) on a sale of the stock, (2) whenever either the subsidiary or the includible corporation holding the stock ceases to be a member of the consolidated group, or (3) if the subsidiary’s stock becomes worthless (as defined in the regulations).25 the gain is generally treated as gain from the disposition of stock, and is thus capital gain. however, to the extent that the subsidiary is insolvent (or deemed to be insolvent), gain is ordinary except to the extent that the excess loss account is attributable to distributions.26 elections —in the first year that a group files a consolidated return, each member of the affiliated group for any part of that year must consent to filing the return; generally that consent must be demonstrated by the member filing a form 1122 with the first return.27 the common parent consents to the return by filing the return. after the first year, each member is deemed to consent to the return, even if it joins the group after that first year.28 an election to file a consolidated return may not be revoked without the consent of the commissioner. permission to discontinue filing a 20. reg. § 1.1502–32. 21. reg. § 1.1502–32(a)(1). 22. reg. § 1.1502–32(a)(3)(iii). 23. reg. § 1.1502–32(b)(2). 24. reg. § 1.1502–32(a)(3)(ii). reg. § 1.1502–19(a)(2)(b)(ii) refers to the amount of an excess loss account as “basis that is negative in amount.” 25. reg. § 1.1502–19(a)(1), (b). 26. reg. § 1.1502–19(b)(4). 27. reg. § 1.1502–75(a)(1), (b)(2). 28. reg. § 1.1502–75(a)(2). 2012] understanding consolidated returns 133 consolidated return will be granted only on a showing of good cause.29 the regulations describe “good cause” as including a change in the code, regulations, or other law which has a “substantial adverse effect” on the tax liability of an affiliated group relative to the aggregate tax liability of the members of the group filing separate returns.30 the commissioner has additional authority to grant blanket permission to discontinue filing consolidated returns to all groups, or to a class of groups, in the event of a change in the law of the type that will have a “substantial adverse effect on the filing of consolidated returns.”31 the election to file a consolidated return will, therefore, affect the tax liability of an affiliated group for the current and future tax years, and a proposal to file a consolidated return must be carefully analyzed. iii. eligibility and includible corporations a. stock ownership an affiliated group consists of the common parent and one or more chains of corporations connected through stock ownership with the common parent.32 the common parent must own stock of at least one other corporation that represents at least 80 percent of the total voting power of the stock of that corporation and has value equal to at least 80 percent of the total value of the stock of that corporation.33 in addition, each includible corporation must be connected to the common parent or to one or more corporations owned by the common parent with the requisite 80 percent of voting power and value. thus, a single chain of connected corporations or parallel brother-sister corporations connected to a common parent corporation can qualify as an affiliated group. all shares of stock within a class are treated as having the same value. control premiums, minority discounts and blockage discounts are not taken into account.34 generally, voting power relates to the right to elect members of the board of directors, although other factors may be considered for complicated voting arrangements. in alumax inc. v. commissioner,35 the court was required to interpret the 80 percent voting power requirement of section 29. reg. § 1.1502–75(c). 30. reg. § 1.1502–75(c)(1)(ii). 31. reg. § 1.1502–75(c)(2). the irs typically allows consolidated groups the option to cease filing consolidated returns when it promulgates any significant change to the overall consolidated return regime. 32. i.r.c. § 1504(a)(1). 33. i.r.c. § 1504(a)(1), (2). 34. reg. § 1.1504–4(b)(2)(iv). 35. 109 t.c. 133 (1997), aff’d, 165 f.3d 822 (11th cir. 1999). 134 florida tax review [vol. 12:3 1502(a)(2) in the face of a complicated voting arrangement. alumax had two classes of stock outstanding. the class c stock, which was owned by an affiliated group claiming control, was entitled to elect four of six voting members of the alumax board. the class b stock was entitled to elect two of six voting members. the class b and class c directors, in the aggregate and not voting by class, elected one of two special non-voting directors. by agreement between the two classes of stockholders, the class b directors were permitted to name this special director. the other special non-voting director was the ceo of alumax. each of the two class b directors had one vote. each of the four class c directors had two votes. however, a majority of the directors of each of the two classes was required to approve certain corporate actions. likewise, with respect to shareholder votes, each share of class c stock had four votes while each share of class b stock had one vote. a majority vote of each class of stock was required with respect to a number of restricted stockholder matters. the court rejected the taxpayer’s assertion that a mechanical application of these voting formulae represented 80 percent voting control. the court held that the impact of various restrictions on the actions of elected directors must be taken into account in assessing the existence of voting power under section 1502(a)(2). accordingly, the control test was not met and alumax was not part of the affiliated group. certain stock that possesses more “debt-like” features than equity features is not included for purposes of determining whether the voting power and value tests of section 1504(a)(2) are satisfied. section 1504(a)(4) provides that “stock” does not include non-voting stock that is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, if its liquidation and redemption rights do not exceed its issue price (except for a reasonable liquidation or redemption premium), and it is not convertible into another class of stock. in addition, section 1504(a)(5) authorizes regulations that treat certain convertible instruments as not constituting stock. the regulations provide in general that options will not be treated as stock, or as deemed exercised, unless it can be reasonably anticipated that the issue or transfer of the underlying stock will result in a substantial federal income tax saving, and it is reasonably certain that the option will be exercised.36 the regulations broadly define options as including any instrument that provides for the transfer of stock.37 this definition, therefore, includes convertible stock. the inquiry is undertaken at the time of issue or transfer of an option, the “measurement date,” with some exceptions.38 if an 36. reg. § 1.1504–4(b)(1), (2)(i). 37. reg. § 1.1504–4(d)(1). 38. reg. § 1.1504–4(c)(4). a “measurement date” does not include a transfer between spouses that is covered by § 1041, or a transfer between persons 2012] understanding consolidated returns 135 option is treated as exercised, it will be taken into account in determining the percentage of the value of stock held by the option holder relative to other parties, but not for purposes of determining the option holder’s voting power.39 b. includible corporations an includible corporation is any domestic corporation that is a member of the affiliated group at any time during the taxable year under the stock ownership tests of section 1504(b). includible corporations do not include, among others, tax-exempt corporations, insurance companies,40 possessions corporations under section 936 (certain u.s. owned corporations doing business in puerto rico), regulated investment companies (mutual funds) and real estate investment trusts. an includible corporation must be included in the consolidated return of an affiliated group for the part of any year during which the includible corporation meets the stock ownership tests.41 if a corporation ceases to be a member of an affiliated group, absent the consent of the commissioner, the corporation may not again be included within the consolidated return of the affiliated group for five years after the close of the taxable year in which the corporation ceased to be a member of the group.42 in elko realty co. v. commissioner,43 the court held that two subsidiaries acquired for the purpose of using losses to offset income of the profitable acquiring corporation were not includible on a consolidated return. the court indicated that if ownership of a subsidiary’s stock serves no business purpose other than a tax reduction purpose, the subsidiary is not an affiliate for purposes of the consolidated return provisions. the court also disallowed loss deductions under the predecessor to section 269. none of whom is a member (or related to a member) of an affiliated group that includes the issuing corporation. reg. § 1.1504–4(c)(4)(ii). 39. reg. § 1.1504–4(b)(2)(iii). 40. section 1504(c) permits insurance companies to form a consolidated group that includes only affiliated insurance companies. in addition, the common parent of an affiliated group can elect to include an insurance company on the consolidated return of the group after the insurance company has been a member of the affiliated group for five consecutive years. 41. i.r.c. § 1501. 42. i.r.c. § 1504(a)(3). but see rev. proc. 2002–32, 2002–1 c.b. 959 (permitting certain qualifying corporations to obtain a waiver of the § 1504(a)(3) bar). 43. 29 t.c. 1012 (1958), aff’d per curiam, 260 f.2d 949 (3d cir.1958). 136 florida tax review [vol. 12:3 iv. consolidated taxable income the consolidated group computes its regular federal income tax liability on the basis of its combined consolidated taxable income. the computation of consolidated taxable income begins with the determination of the separate taxable incomes of each member of the consolidated group.44 in general, each member of the consolidated group computes its separate taxable income as a separate corporation.45 in determining separate taxable income, with limited exceptions all of the generally applicable rules of the code apply, except as modified by the consolidated return regulations themselves.46 however, separate taxable income excludes distributions with respect to the stock of other members of the group, deferred gains and losses from intercompany transactions, capital gains and losses, section 1231 gains and losses, and charitable contributions. items excluded from the taxable income of members are separately consolidated and accounted for in consolidated taxable income as provided in specific regulations.47 tax liability for the consolidated group is determined by applying the rates of section 11, and other relevant provisions of the code, to the consolidated taxable income of the group. tax liability is reduced by consolidated credits attributable to members of the group. each member of a consolidated group is severally liable for the tax on consolidated taxable income.48 in some instances, it may be important to determine whether a particular item is characterized separately by a member corporation, whose net taxable income or loss is then separately calculated based on that characterization and aggregated with the net taxable income or loss of other member corporations, or whether the item must be characterized with reference to the overall income and expense items of the consolidated group viewed as a single entity without regard to how it would separately be taken into account by a member in computing the member’s separately taxable income. in other words, it can be important whether the consolidated group computes its income with respect to certain items on a “single entity” basis in which all such items are consolidated, or whether the different impact of an item on the taxable income of separate entities is taken into account. the consolidated net operating loss of a consolidated group generally includes the consolidated net operating loss carrybacks and carryovers of the consolidated group.49 in addition, the net operating losses of a member of a consolidated group can be carried over from a pre 44. reg. § 1.1502–11(a)(1). 45. reg. § 1.1502–12(a). 46. reg. § 1.1502–80. 47. reg. § 1.1502–11(a)(2) – (8). 48. reg. § 1.1502–6(a). 49. reg. § 1.1502–21(a). 2012] understanding consolidated returns 137 consolidation return period against the consolidated income of the group.50 this general rule, is, however, subject to two limitations: (1) if the loss year was a “separate return limitation year” (srly), then the loss may be carried over only against the income of the member of the group that generated the loss,51 or (2) if section 382 is applicable, then the carryovers are limited accordingly.52 the srly rule does not apply in the case of an acquisition of a new member of a consolidated group if the net operating loss limitation of section 382 applies to the losses of the new member.53 v. formation of a corporate subsidiary a. generally wholly apart from whether consolidated return regulations apply, section 351 permits the tax-free creation of a corporation, including the formation of a subsidiary corporation by another corporation, if the transferor or transferors or property own at least 80 percent of the combined voting power and at least 80 percent of each class of nonvoting stock of the transferee corporation immediately after the transaction.54 section 351 also permits the transfer of property to an existing corporation without the recognition of gain where the contributing shareholder has, or as a result of receiving additional stock in consideration for the transferred property acquires, control. under section 351 losses are not recognized on the transfer of property to a controlled corporation in exchange for stock of the corporation. like many other code provisions, section 351 applies within consolidated returns. for purposes of determining subsequent taxable gain or loss on a sale, section 358 provides that the basis of stock received in exchange for property contributed to the corporation in a nonrecognition transaction under section 351 will be the same as the basis of property transferred to the corporation. the stockholder’s basis in the stock must be allocated among stock of different classes in proportion to the fair market values of the stock in each class.55 regardless of whether or not section 351 provides nonrecognition of gain or loss to the shareholder, section 1032 and the regulations 50. reg. § 1.1502–21(b). 51. reg. § 1.1502–21(c); see also reg. § 1.1502–22(c) (applicable to capital loss carryovers). 52. reg. § 1.1502–91. 53. reg. § 1.1502–21(g). 54. see rev. rul. 59–259, 1959–2 c.b. 115. 55. i.r.c. § 358(b)(1); reg. § 1.358–2(b)(2). 138 florida tax review [vol. 12:3 thereunder56 provide that the corporation does not recognize gain or loss on the issuance of stock in exchange for cash, property, or services. if section 351 applies to a transferor-shareholder, section 362(a) generally provides the corporation with a basis in the property equal to the transferor’s basis for purposes of determining the corporation’s (1) gain or loss on a subsequent sale, and (2) depreciation and amortization deductions. outside of a consolidated return context, section 362(e)(2) prevents taxpayers from transmuting a single economic loss into two (or more) tax losses by taking advantage of the dual application of the substituted basis rules in section 358 for stock received in a section 351 transaction and in section 362 for assets transferred to a corporation in a section 351 transaction. if the aggregate basis of the property transferred to a corporation by any particular transferor in a section 351 transaction exceeds the aggregate fair market value of the property, the aggregate basis of the property must be reduced to its fair market value. when both depreciated property and appreciated property is transferred to the corporation, section 362(e)(2) does not necessarily result in the basis of every item of loss property being reduced to its fair market value. section 362(e)(2)(a) requires that the aggregate basis of the transferred property be reduced by the excess of the aggregate basis over the aggregate fair market value, and section 362(e)(2)(b) requires that the aggregate basis reduction be allocated among the transferred properties in proportion to the built-in losses in the properties before taking into account section 362(e)(2). section 362(e)(2) generally does not apply to transfers to a controlled subsidiary that is a member of the transferor’s consolidated group.57 it is not necessary to apply section 362(e)(2) within consolidated returns because within consolidated groups, the problem otherwise addressed by section 362(e)(2) is addressed by the investment adjustment rules in treasury regulation section 1.1504–32. b. receipt of other property if the transferor receives money or other property (“boot”) in addition to stock as the consideration for the transfer of property to a controlled corporation, under section 351(b) the transferor’s realized gain is recognized to the extent of money and the fair market value of property received. loss, however, is never recognized even though boot may be received.58 under section 358(a), the transferor’s basis in stock received is adjusted to reflect receipt and taxation of the boot. generally speaking, the 56. reg. § 1.1032–1. 57. reg. § 1.1502–80(h). 58. i.r.c. § 351(b)(2). 2012] understanding consolidated returns 139 adjustment increases the amount of the stock’s basis by the amount of gain recognized and decreases the amount of the stock’s basis by the amount of boot received. the corporation’s basis in property received is increased by gain recognized to the transferor.59 c. assumption of transferor’s debts section 357 provides that the assumption of a liability or the acquisition of property subject to a liability does not constitute boot for the purpose of section 351, unless a tax avoidance scheme is involved or unless the liabilities assumed exceed the basis of the property transferred. outside of the consolidated return regime, section 357(c)(1) provides that if the amount of liabilities assumed exceeds the basis of the property transferred, gain results to the extent of such excess, regardless of the purpose of the debt or the assumption.60 however, under the regulations, section 357(c) does not apply to transfers with an affiliated group of corporations filing a consolidated return.61 instead the transferor takes a negative basis in the stock of the transferee corporation equal to the amount by which the debt(s) exceeds the aggregate basis of the transferred property. for purposes of determining the transferor’s basis in nonrecognition property received in the exchange, section 358(d) treats the assumption of a liability of the transferor or a transfer of property subject to a liability as the receipt of cash by the transferor, without regard to how the debt is treated under section 357. the result is a reduction in the transferor’s basis to the extent of the liability. however, if the shareholder’s basis for stock received in a section 351 transaction otherwise would exceed its fair market value, section 358(h) requires that the basis of the stock be reduced (but not below the fair market value) by the amount (determined as of the date of the exchange) of any section 357(c)(3) liability that was assumed by the corporation. for this purpose, “liability” is broadly defined to include “any fixed or contingent obligation to make payment, without regard to whether the obligation is otherwise taken into account for purposes of [the income tax].” under this definition, a liability that is not cognizable under section 357 — for example, a cash method account payable, a contingent liability, or an obligation of an accrual method taxpayer that is not yet deductible because of the operation of the economic performance rules of section 461(h) — nevertheless will be taken into account under 59. i.r.c. § 362(a). 60. for purposes of applying the exception in section 357(c)(1), section 357(c)(3)(a) provides that a liability the payment of which would give rise to a deduction is excluded. 61. reg. § 1.1502–80(d). 140 florida tax review [vol. 12:3 section 358(h) to reduce the transferor shareholder’s stock basis. section 358(h) does not apply in all instances, however. section 358(h)(3) provides that, except as provided in regulations, section 358(h) does not apply if, as part of the exchange (1) “the trade or business with which the liability is associated is transferred to the person assuming the liability,” or (2) “substantially all of the assets with which the liability is associated are transferred to the person assuming the liability.” as permitted by the statute, the regulations narrow this exception by providing that the exception for a transfer of “substantially all of the assets with which the liability is associated” to the corporation assuming the liability is inoperative.62 the exception in section 358(h)(3) does not apply to selective transfers of assets that may bear some relationship to the liability, but do not represent the full scope of the trade or business (or substantially all the assets) with which the liability is associated. d. transfers to foreign corporations section 367(a) denies nonrecognition under section 351 for transfers to foreign corporations. however, section 367(a)(3) generally restores the nonrecognition rule of section 351 with respect to a transfer of property to be used in the active conduct of a foreign trade or business.63 this exception is in fact of limited use. although, for example, the transfer of machinery and equipment to a foreign subsidiary to be used in manufacturing abroad initially appears to be tax-free, that gain must be recognized to the extent that depreciation deductions have been taken on the property while the asset was used in the u.s.64 furthermore, the active trade or business exception does not apply to transfers of inventory, foreign currency, installment obligations, or property leased to third persons.65 section 367(d) provides a special rule for intangible property (other than goodwill and going concern value) that makes most transfers of 62. reg. § 1.358–5. 63. temp. reg. § 1.367(a)–2t. the active trade or business exception does not apply to the incorporation of a foreign branch to the extent that the branch has been operating at a loss in prior years. in effect the prior losses that have been deducted for u.s. tax purposes must be “recaptured” on the incorporation of the branch. i.r.c. § 367(a)(3)(c); temp. reg. § 1.367(a)–6t. section 367(a)(5) provides that the active trade or business exception does not apply to the transfer of business assets to a foreign corporation in a type (c), (d), or (f) reorganization, unless five or fewer corporations own at least 80 percent of the transferee foreign corporation and certain conditions are met that are designed to insure that gain inherent in the assets remains subject to u.s. taxation. 64. temp. reg. § 1.367(a)–4t(b). 65. temp. regs. §§ 1.367(a)–4t and –5t(c) provide detailed rules governing these exceptions to the trade or business exception. 2012] understanding consolidated returns 141 intangible assets taxable, regardless of whether or not the intangibles are to be used in an active foreign business. the income deemed to be realized on the intangible transfer is calculated as if the intangible had been transferred for a royalty. the deemed royalty is for the lesser of the intangible’s useful life or twenty years,66 and is treated as foreign source income. the amount is determined with reference to the transfer pricing rules under section 482.67 if the u.s. person receiving the stock of the foreign corporation in exchange for the intangible property disposes of the stock to any person, other than certain related parties, before the end of the useful life of the intangible property, the transferor must immediately recognize the gain (but may not recognize loss) inherent in the intangible property (reduced by any gain on the transfer of the stock that was subject to u.s. tax).68 vi. dividend distributions: fundamental rules a. generally section 301(c) requires the inclusion in gross income (under section 61(a)(7)) of distributions received as dividends. section 316(a) defines a dividend as any distribution to a shareholder if it is out of either (1) earnings and profits accumulated after february 28, 1913, or (2) earnings and profits of the current year regardless of a lack of, or deficit in, accumulated earnings and profits. earnings and profits differ substantially from taxable income, being more akin to net income in a financial accounting sense. but, because some significant adjustments to earned surplus in the corporate sense are not taken into account in computing earnings and profits, it is not entirely accurate to say that the taxability of the shareholder depends essentially on the earned surplus account of the corporation. the earnings and profits of parent and subsidiary corporations that do not file consolidated returns are generally not consolidated for purposes of determining whether distributions by the parent corporation to its shareholders are out of earnings and profits and hence taxable as dividends. as a result, in the non-consolidated return context, it is possible for the parent corporation to make distributions to its shareholders that will not be treated as dividends despite the existence of earnings and profits in the 66. reg. § 1.367(d)–1t(c)(3). 67. reg. § 1.367(d)–1t(c)(1). 68. reg. § 1.367(d)–1t(d), (h). the amount of the gain subject to tax is the excess of the fair market value of the intangible at the time of the stock transfer over the original transferor’s basis in the intangible at the time of the original transfer, reduced, as noted in the text, by any gain on the subsequent transfer of the stock that was subject to u.s. tax. reg. § 1.367(d)–1t(d). 142 florida tax review [vol. 12:3 subsidiary corporation. members of an affiliated group of corporations filing consolidated returns do combine the earnings and profits of the group.69 if affiliated corporations file a consolidated return, dividends received from another member of the group are not included in gross income by the recipient in computing taxable income.70 however, the corporation receiving the dividend must reduce its basis in the stock of the dividendpaying corporation, and the resulting basis may be negative.71 outside of the consolidated return context, section 243(a)(1) provides a u.s. corporation that is a shareholder in another corporation with a deduction equal to 70 percent of intercorporate dividends received; section 243(c) increases the deduction to 80 percent if the shareholder corporation owns at least twenty percent of the stock of the payor corporation;72 and section 243(a)(3) extends this deduction to 100 percent for affiliated corporations that so elect.73 (the test for affiliation in section 1504(a)(2) requires the parent corporation to own both (1) 80 percent or more of the voting stock, and (2) 80 percent or more of the total value of all stock of the subsidiary corporation, except that pursuant to section 1504(a)(4), nonparticipating, nonconvertible, nonvoting preferred stock is not counted in determining control.) the recipient corporation is not required to reduce its basis in the stock of the distributing corporation unless the dividend is an “extraordinary dividend” as defined in section 1059.74 69. reg. § 1.1502–33. 70. reg. § 1.1502–13(f)(2)(ii). 71. reg. § 1.1502–32. 72. section 246a reduces the intercorporate dividend received deduction under § 243 by the percentage of the corporation’s portfolio stock that was debt financed during the applicable measuring period. 73. section 246(c) disallows the dividends received deduction with respect to any dividends on any share of stock that is held for less than 45 days during the 91 day period beginning on the date that is 45 days before the date on which the stock becomes ex-dividend. for preferred stock, if the dividends received are attributable to a period in excess of 366 days, the holding period is extended to 91 days during the 181 day period beginning on the date that is 90 days before the date on which the stock becomes ex-dividend. 74. generally speaking, section1059 requires that a corporate shareholder that receives an “extraordinary dividend” on stock that it has not held for more than two years before the dividend announcement date must reduce the basis of the stock (but not below zero) by the amount of the untaxed portion of the dividend, i.e., the amount of the section 243 dividends received deduction. if the untaxed portion of any extraordinary dividend exceeds the shareholder’s basis for the stock, the excess is taxed as gain on the sale of the stock in the taxable year in which the extraordinary dividend is received. section 1059(c) defines an extraordinary dividend in terms of the size of the dividend in relation to the shareholder's adjusted basis in its stock, subject to an alternative test using fair market value instead of basis at the taxpayer's 2012] understanding consolidated returns 143 b. dividends in kind if a dividend is paid in property (other than the corporation’s own stock or promissory note), the distributing corporation must recognize gain under section 311(b) as if it sold the property to the shareholder at fair market value. loss may not be recognized.75 the amount of the distribution, and thus potential dividend, received by the shareholder is the fair market value of the property. if the shareholder assumes any liabilities of the corporation in connection with the distribution, section 301(b) provides that the amount of the distribution is reduced by the amount of the liabilities. the shareholder’s basis for the property is its fair market value, unreduced by any liabilities.76 within consolidated returns, dividends in kind, and the accompanying gain or loss recognition, are governed by the intercompany matching rules of treasury regulation section 1.1502-13, resulting in deferral of gain or loss recognition, as discussed below.77 election. a dividend is extraordinary if aggregate dividends received in any 85-day period exceed 10 percent of the basis of common stock, or 5 percent of the basis of preferred stock, with respect to which the dividends were paid. furthermore, if aggregate dividends paid with respect to stock in any one year period exceed 20 percent of the corporate shareholder's basis for the stock, then all such dividends are aggregated and considered to be an extraordinary dividend. certain distributions are treated as per se extraordinary dividends. distributions to a corporate shareholder that has held the stock of the distributing corporation for the entire period the distributing corporation has been in existence are exempt. i.r.c. § 1059(d)(6). the basis reduction rules do not apply to distributions between members of an affiliated group filing consolidated returns or to distributions that constitute qualifying dividends within the meaning of section 243(b)(1), except to the extent the dividends are attributable to pre-affiliation earnings or appreciation of the payor corporation. i.r.c. § 1059(e)(2). any distribution (without regard to the holding period for the stock or the relative magnitude of the distribution) to a corporate shareholder (1) in partial liquidation of the distributing corporation (as defined in section 302(e)), or (2) that is a non-pro rata redemption is treated as an extraordinary distribution. i.r.c. § 1059(e)(1). the section 1059(d)(6) and section 1059(e)(2) exceptions do not apply to distributions in partial liquidations or non pro rata redemptions treated as extraordinary dividends under section 1059(e)(1). reg. § 1.1059(e)–1. 75. i.r.c. § 311(a). 76. i.r.c. § 301(d). 77. see infra part ix.b. 144 florida tax review [vol. 12:3 vii. investment adjustments a. stock basis each member of the group owning stock in another member of the group must adjust its basis for that stock to account for income, losses and other items attributable to the subsidiary that are reflected in consolidated taxable income.78 the purpose of the investment adjustment rule is to prevent gain or loss which has been recognized by the subsidiary from being recognized a second time as investment gain or loss by the parent upon disposition of the subsidiary’s stock. these rules treat the consolidated group as a single entity by accounting for gains and losses within the consolidated group only once. a parent corporation’s basis in the stock of its consolidated subsidiary is increased or decreased annually by the net amount of the subsidiary’s taxable income or loss, tax exempt income, nondeductible noncapital expenses, and distributions to the parent corporation.79 (this rule applies with respect to both the common parent and subsidiaries that are in turn parents of lower-tier subsidiaries.) a positive adjustment increases basis, while a negative adjustment decreases basis. these items cause an adjustment to the parent’s basis in subsidiary stock in the taxable year in which the item is taken into account in determining consolidated taxable income. thus, items of income and loss, and distributions, will result in adjustments to the parent’s basis in the stock of a consolidated subsidiary. adjustments to the basis of a member’s stock are taken into account in determining the basis adjustments of higher-tier members; the adjustments are applied in the order of the tiers, from lowest to highest. the basis adjustment is made at the end of the year unless an interim basis adjustment is necessary to determine a tax liability, for example, as a result of the sale of some of the stock.80 basis adjustments attributable to distributions are allocated to the shares on which the distribution was made.81 negative adjustments are allocated only to common stock and then among the shares to reflect the manner in which the shares suffer the economic loss. positive adjustments are allocated first to preferred stock to reflect distributions and dividend arrearages accrued during the period the subsidiary was a member of the group,82 and then to the common stock.83 adjustments to the common stock 78. reg. § 1.1502–32. 79. reg. § 1.1502–32(a) and (b). 80. reg. § 1.1504–32(b)(1). 81. reg. § 1.1504–32(c)(1)(i). 82. reg. § 1.1504–32(c)(1)(ii), (c)(3). 83. reg. § 1.1504–32(c)(2). 2012] understanding consolidated returns 145 generally are made equally to each share, but if any shares have an excess loss account, the adjustments are first allocated among the shares with an excess loss account to equalize and then to eliminate the excess loss accounts.84 for purposes of the investment adjustment rules, a member’s taxable income or loss includes items of income or loss attributable to the member that are included in the consolidated taxable income of the group.85 operating losses are included in the investment adjustment in the year the loss is absorbed into consolidated taxable income. thus, a net operating loss carryforward is reflected in a basis adjustment for the year to which the loss is carried. a carryback loss is reflected as an adjustment in the year in which it arose.86 the amount of gain on the sale resulting from the excess loss account is treated as capital gain. arguably, the gain attributable to the excess loss account should be treated as ordinary income when it represents deductions previously taken against ordinary income. however, the regulations allow capital gain treatment, apparently on the theory that, had the subsidiary realized the appreciation in its assets prior to the disposition, the earnings and profits so generated would have eliminated the excess loss account and this is in effect what is happening when the parent sells the stock at a gain. if the subsidiary is insolvent at the time of the disposition, however, then ordinary income results from the transaction to the extent of the insolvency.87 the amount treated as ordinary income is limited to the amount of the excess loss account redetermined to exclude distributions to the parent.88 the existence of an excess loss account also can affect transactions that otherwise would be tax-free. for example, the disposition of stock in a reorganization involving an unrelated corporation will trigger recognition of gain if the subsidiary involved had generated an excess loss account.89 on the other hand, tax-free reorganizations within the group generally do not 84. id. 85. reg. § 1.1502–32(b)(3)(i). 86. reg. § 1.1502–32(b)(3)(i)(a) and (b). 87. reg. § 1.1502–19(b)(4)(i) (specially defining “insolvency”). covil insulation co. v. commissioner, 65 t.c. 364 (1975), upheld the validity of reg. § 1.1502–19, and required the parent corporation to include as ordinary income the excess loss account with respect to a subsidiary whose stock had become worthless. both the treatment of the stock’s worthlessness as an income generating event with respect to the excess loss account and characterization of the gain as ordinary were “permissible exercise[s] of the rulemaking power granted by section 1502.” id. at 374. 88. reg. § 1.1502–19(b)(4)(ii). 89. reg. § 1.1502–19(b)(2)(ii) and (c)(1)(ii). 146 florida tax review [vol. 12:3 require the inclusion of the excess loss account in income; instead the excess loss account is applied to the stock received without recognition of gain or loss under section 354, either reducing basis or adding to the excess loss account of that stock.90 a liquidation to which sections 332 and 334(b) apply eliminates the excess loss account. the transaction is in effect treated as if the parent had owned the subsidiary’s assets directly from the beginning; triggering the excess loss account in this situation could lead to duplication of gain. other events, such as the discontinuation of filing consolidated returns or the worthlessness of the stock of the subsidiary, also can require the inclusion in income of the amount of the excess loss account.91 recognition of gain attributable to an excess loss account of a worthless subsidiary is deferred from the date the stock becomes worthless under the normal facts and circumstances test of section 165(g) to the date on which substantially all of the subsidiary’s assets are disposed of or abandoned or the date on which the subsidiary realizes cancellation of indebtedness income that is accorded nonrecognition under section 108(a) by virtue of insolvency or in a bankruptcy proceeding.92 in garvey, inc. v. united states,93 the parent corporation acquired stock of a subsidiary in a tax-free type (b) reorganization (an exchange of stock for stock under section 368(a)(1)(b) pursuant to which under section 354 no gain or loss is recognized) that resulted in a $250,000 basis in the subsidiary stock for the common parent under section 358. subsequent to acquisition, the subsidiary distributed $4.9 million in dividends out of preaffiliation earnings and profits. under the predecessor of treasury regulations sections 1.1502–32(b)(2)(iv) and 1.1502–19(a)(2), the dividend distribution created an excess loss account of $4.65 million which was required to be recognized as income when the group disaffiliated. the court rejected the taxpayer’s argument that application of the regulations unfairly created phantom income that would not have existed had the group filed separate tax returns. the court pointed out that in electing consolidated treatment the taxpayer “must now take the bitter with the sweet.”94 90. reg. § 1.1502–19(b)(2)(i). 91. reg. § 1.1502–19(c)(1)(iii) and (2). 92. reg. § 1.1502–19(c)(1)(iii). 93. 726 f.2d 1569 (fed. cir. 1984). 94. id. at 1571. 2012] understanding consolidated returns 147 b. section 357(c) situations in the consolidated return context, the regulations provide that section 357(c) does not apply to an intercompany transaction.95 instead, section 358 applies, sometimes resulting in a negative basis (i.e., excess loss account), due to investment adjustments. suppose that p corporation, the parent of a consolidated group, forms s corporation, which immediately becomes a member of the p corporation consolidated group. in exchange for all of the stock of s corporation p contributes to s an asset with a basis of $100, subject to a liability of $130, which s corporation assumes. apart from the consolidated return rules, section 357(c) would require p to recognize gain of $30—an amount equal to the excess of the liabilities assumed over the basis of the property transferred. but p corporation takes a basis of negative $30 in the stock of s corporation, and s corporation’s basis in the asset remains $100.96 c. unified loss rules 1. generally in some cases, application of the investment adjustment rules conflicts with the principles of sections 311 and 336, which require recognition of gain on the distribution by a corporation of appreciated property, and permit the recognition of loss on the distribution of depreciated property by a liquidating corporation, because it permits assets that are sold out of the consolidated group to obtain a step up in basis without the payment of a current corporate level tax. suppose, for example, that s corporation holds a single asset with a basis of $100 and a fair market value of $300. p corporation purchases all of the stock of s corporation for $300, p and s do not make a section 338 election, and p and s corporations elect to file a consolidated return. s corporation then sells the asset for $300. s corporation recognizes a $200 gain, and p corporation increases its basis in the s corporation stock from $300 to $500. p corporation then sells the stock of s corporation for $300, realizing a $200 loss, which offsets the $200 gain. absent a limitation on the recognition of this loss, tax on the gain realized from the sale of the assets effectively would be eliminated by p corporation’s loss on the sale of the stock of s. p corporation’s tax loss is artificial; it does not reflect an economic loss. the same problem arises if the asset is a depreciable asset which is consumed in the course of s corporation’s business. 95. reg. § 1.1502–80(d). 96. id. 148 florida tax review [vol. 12:3 to deal with this issue, treasury regulation section 1.1502–36 provides unified rules for loss on subsidiary stock transferred by a member of an affiliated group filing a consolidated return. a transfer of a loss share of stock (defined as a share of stock of an affiliate having a basis in excess of fair market value) includes any event in which (1) gain or loss would be recognized (apart from the rules in the regulations), (2) the holder of a share and the subsidiary cease to be members of the same group, (3) a nonmember acquires an outstanding share from a member, or (4) the share is treated as worthless. the purpose of these rules is twofold, to prevent the consolidated return provisions from creating non–economic losses on the sale of subsidiary stock and to prevent members of the affiliated group filing the consolidated return from claiming more than one tax benefit from a single economic loss. under the regulations, any transfer of a loss share requires the application in sequence of three basis rules. first, under treasury regulation section 1.1502–32, a basis redetermination rule is applied to deal with tax losses attributable to investment adjustment account allocations among different shares of stock that result in disproportionate reflection of gain or loss in shares’ basis.97 second, if any share is a loss share after application of the basis redetermination rule, a basis reduction rule is applied under treasury regulation section 1.1502–36(c) to deal with artificial loss attributable to investment adjustment account adjustments, but this reduction does not exceed the share’s “disconformity amount.” third, if any duplicated losses remain after application of the basis reduction rule, under treasury regulation section 1.1502–36(d) an attribute reduction rule is applied to the corporation the stock of which was sold to prevent the duplication of a loss recognized on the transfer or preserved in the basis of the stock. if a chain of subsidiaries is transferred (rather than a single subsidiary) the order in which the rules are applied is modified. in this case, the basis redetermination rule and the basis reduction rule are applied sequentially, working down the chain, and the attribute reduction rule is then applied working up the chain, starting with the lowest tier subsidiary. 2. the basis redetermination rule the basis redetermination rule in treasury regulation section 1.1502–36(b) does not apply when all of the stock of the subsidiary has been transferred in a taxable transaction; thus it typically does not apply. when the basis redetermination rule does apply, investment adjustments (exclusive of distributions) that were previously applied to members’ bases in subsidiary stock are reallocated in a manner that, to the greatest extent possible, first eliminates loss on preferred shares and then eliminates basis disparity on all 97. reg. § 1.1502–36(b). 2012] understanding consolidated returns 149 shares. this rule affects both positive and negative adjustments, and thus addresses both noneconomic and duplicated losses. first, the basis of any transferred loss share is reduced by any positive investment adjustments, but the basis will not be reduced to less than the value of the loss share. second, to the extent of any remaining loss on the transferred shares, negative investment adjustments are removed from shares that are not transferred loss shares and are applied to reduce the loss on transferred loss shares. third, the positive adjustments removed from the transferred loss shares are allocated to increase basis of other shares only after the negative adjustments have been reallocated. this rule does not affect the aggregate basis of the shares, and thus does not apply if all of the shares of a subsidiary are sold or become worthless; it is important only when some, but not all, shares are sold. a number of special limitations on basis reallocation also must be considered in various specific circumstances. 3. the basis reduction rule if, after applying the basis redetermination rule in step one, any transferred share is a loss share (even if the share only became a loss share as a result of the application of the basis redetermination rule), the basis of that share is subject to reduction. the basis reduction rule in treasury regulation section 1.1502–36(c) eliminates noneconomic losses that arise from the operation of the investment adjustment account rules. under this rule, the basis of each transferred loss share is reduced (but not below its value) by the lesser of (1) the share’s disconformity amount, or (2) the share’s net positive adjustment. the “disconformity amount” with respect to a subsidiary’s share is the excess of its basis over the share’s allocable portion of the subsidiary’s inside tax attributes (determined at the time of the transfer). every share within a single class of stock has an identical allocable portion. between shares of different classes of stock, allocable portions are determined by taking into account the economic arrangements represented by the terms of the stock. “net inside attributes” is the sum of the subsidiary’s loss carryovers, deferred deductions, cash, and asset bases, minus the subsidiary’s liabilities. the disconformity amount identifies the net amount of unrealized appreciation reflected in the basis of the share. a share’s net positive adjustment is computed as the greater of (1) zero, or (2) the sum of all investment adjustments (excluding distributions) applied to the basis of the transferred loss share, including investment adjustments attributable to prior basis reallocations under the basis reallocation rule. the net positive adjustment identifies the extent to which a share’s basis has been increased by the investment adjustment provisions for items of income, gain, deduction and loss (whether taxable or not) that have been taken into account by the group. special rules apply when the 150 florida tax review [vol. 12:3 subsidiary the stock of which is transferred itself holds stock of a lower–tier subsidiary. 4. the attribute reduction rule if any transferred share remains a loss share after application of the basis reallocation and basis reduction rules, any loss recognized with respect to the transferred share is allowed. however, in this instance, the subsidiary’s tax attributes (including the consolidated attributes, e.g., loss carryovers, attributable to the subsidiary) are reduced pursuant to treasury regulation section 1.1502–36(d). the attribute reduction rule addresses the duplication of loss by members of consolidated groups, and is designed to prevent the group from recognizing more than one tax loss with respect to a single economic loss, regardless of whether the group disposes of the subsidiary stock before or after the subsidiary recognizes the loss with respect to its assets or operations. however, under a type of de minimis rule, unless the group so elects, the attribute reduction rule does not apply if the aggregate attribute reduction amount in the transaction is less than five percent of the total value of the shares transferred by members in the transaction.98 under the attribute reduction rule, the subsidiary’s attributes are reduced by the “attribute reduction amount,” which equals the lesser of (1) the net stock loss, or (2) the aggregate inside loss. the “attribute reduction amount” reflects the total amount of unrecognized loss that is reflected in both the basis of the subsidiary stock and the subsidiary’s attributes. “net stock loss” is the amount by which the sum of the bases (after application of the basis reduction rule) of all of the shares in the subsidiary transferred by members of the group in the same transaction exceeds the aggregate value of those shares.99 the subsidiary’s “aggregate inside loss” is the excess of its net inside attributes over the aggregate value of all of the shares in the subsidiary.100 (net inside attributes generally has the same meaning as in the basis reduction rule, subject to special rules for lower-tier subsidiaries.) the attribute reduction amount is first applied to reduce or eliminate items that represent actual realized losses, such as operating loss carryovers (category a), capital loss carryovers (category b), and deferred deductions (category c) in that order unless the taxpayer elects to make a different allocation. if the subsidiary does not hold stock of any lower-tier subsidiaries, any excess attribute reduction amount is then applied to reduce the basis of assets (category d) in the asset classes specified in treasury regulation section 1.338–6(b) other than class i (cash and general deposit accounts, other than certificates of deposit held in depository institutions), 98. reg. § 1.1502–36(d)(2)(ii). 99. reg. § 1.1502–36(d)(3)(ii). 100. reg. § 1.1502–36(d)(3)(iii). 2012] understanding consolidated returns 151 but in the reverse order from the order specified in that section. thus, the basis in any purchased goodwill is the first item reduced. if the subsidiary holds stock of one or more lower-tier subsidiaries, the category d attribute reduction is first allocated between the subsidiary’s basis in any stock of lower-tier subsidiaries and the subsidiary’s other assets (treating the nonstock category d assets as one asset) in proportion to the subsidiary’s basis in the stock of each lower-tier subsidiary and its basis in the category d assets other than subsidiary stock. only the portion of the attribute reduction amount not allocated to lower-tier subsidiary stock is applied under the reverse residual method. (additional special rules apply to prevent excessive reduction of attributes when the subsidiary itself holds stock of a lower-tier subsidiary.101) if the attribute reduction amount exceeds all of the attributes available for reduction, that excess amount generally has no effect. if, however, cash or other liquid assets are held to fund payment of a liability that has not yet been deducted but will be deductible in the future (e.g., a liability the deduction for which is subject to the economic performance rules of section 461(h)), loss could be duplicated later, when the liability is taken into account. to prevent such loss duplication, the excess attribute reduction amount will be held in suspense and applied to prevent the deduction or capitalization of later payments with respect to the liability.102 additional special rules apply to prevent excessive reduction of attributes when the subsidiary itself holds stock of a lower-tier subsidiary. in cases where as a result of the stock transfer the subsidiary ceases to be a member of the group, an election may be made to reattribute attributes (other than asset basis) and/or to reduce stock basis (and thereby reduce stock loss) in order to avoid attribute reduction.103 if an election is made and it is ultimately determined that the subsidiary has no attribute reduction amount the election will have no effect (or if the election is made for an amount that exceeds the finally determined attribute reduction amount, the election will have no effect to the extent of that excess). in addition, taxpayers may elect to reduce (or not reduce) stock basis, or to reattribute (or not reattribute) attributes, or some combination thereof, in any amount that does not exceed the subsidiary’s attribute reduction amount.104 finally, if the subsidiary ceases to be a member of the consolidated group as a result of the transfer, the common parent of the group can elect to reduce stock basis (thereby reducing an otherwise allowable loss on the sale of the stock), reattribute attributes, or apply some combination of basis 101. reg. § 1.1502–36(d)(4)(ii). 102. reg. § 1.1502–36(d)(4)(ii)(c). 103. reg. § 1.1502–36(d)(4). 104. the reattribution election may be made only if the subsidiary ceases to be a group member. 152 florida tax review [vol. 12:3 reduction and attribute reattribution after the otherwise required attribute reduction. 5. worthlessness if a member treats stock of the subsidiary as worthless under section 165(g) and the subsidiary continues as a member, or if a member recognizes a loss on subsidiary stock and on the following day the subsidiary is not a member and does not have a separate return year following the recognition of the loss, all category a, category b, and category c attributes (i.e., capital loss carryovers, net operating loss carryovers, and deferred deductions) that have not otherwise been eliminated or reattributed, as well as any credit carryovers, are eliminated.105 viii. earnings and profits earnings and profits are one of those categories of tax attributes that are tracked on a separate member basis because it is necessary to know when each member pays a dividend. section 301(a) generally covers all distributions of property by a corporation to its shareholders in their capacity as shareholders unless displaced by another rule. there are important exceptions: (1) the distribution of stock or rights to stock of the corporation is not considered a distribution of “property” for this purpose, and (2) distributions in redemption of stock under certain circumstances and complete liquidations are not considered section 301 distributions. section 301(c) classifies distributions between dividends, which are included directly in gross income (section 301(c)(1)), and distributions that are not dividends, which are first treated as a return of capital applied against the stock basis (section 301(c)(2)), with amounts in excess of that basis being treated as gain from the sale or exchange of property (section 301(c)(3)), thus bringing the capital gain provisions into play. section 61(a)(7) also requires that dividends in the tax sense be included in gross income. section 316(a) defines a dividend as any distribution to a shareholder if it is out of either (1) earnings and profits accumulated after february 28, 1913, or (2) earnings and profits of the current year regardless of a lack of, or deficit in, accumulated earnings and profits. earnings and profits differ substantially from taxable income, being more akin to net income in a financial accounting sense. special adjustments are required in the earnings and profits accounts of the parent corporation in a consolidated group to reflect the consolidated situation. if the parent of the group were not required to include in its 105. reg. § 1.1502–36(d)(7). a worthlessness determination must take into account the rules in reg. § 1.1502–80(c), as well as under section 165. 2012] understanding consolidated returns 153 earnings and profits the earnings and profits of subsidiaries in the group, under section 301 a parent corporation with profitable subsidiaries and no earnings and profits of its own could make tax-free distributions to its stockholders despite the group as a whole having current or accumulated earnings. the earnings and profits of a consolidated subsidiary are determined under the applicable provisions of the code and passed up through higher-tier entities to be consolidated in the earnings and profits of the common parent.106 if the common parent, or any other member of the group, owns less than all of the common stock of a lower-tier member of the group, only a proportional amount of the earnings and profits is tiered-up.107 a separate determination of the parent’s basis in the stock of a consolidated subsidiary is required for purposes of determining the increase or decrease in earnings and profits resulting from the sale of the subsidiary’s stock.108 gain or loss on the disposition of the stock of a member of the consolidated group is determined from the basis of the stock as adjusted by the investment adjustment rules of treasury regulation section 1.1502–32, which are based on the subsidiary’s contribution to taxable income. there are differences in the computation of earnings and profits and taxable income, however, primarily because sections 312(k) and (n) require adjustments to earnings and profits for a number of items including depreciation, inventory amounts, and installment sales, which differ from the amounts taken into account in computing taxable income or loss. to account for these differences in determining the effect on the parent’s earnings and profits of the sale of stock in a subsidiary, the basis of a subsidiary’s stock must be determined using earnings and profits as the basis for investment adjustments. thus, the basis of stock of a subsidiary for earnings and profits purposes is increased by the earnings and profits of the subsidiary and decreased by a deficit in earnings and profits.109 under section 1552, tax liability of the consolidated group is apportioned against the earnings and profits of each of the members in proportion to the member’s contribution to consolidated taxable income, as a percentage of the total tax attributable to the member if the tax of each member were computed on a separate return basis, on the basis of each member’s actual contribution to consolidated taxable income including reductions in income, or by any other method selected by the group and approved by the commissioner. section 1552 does not provide a device to account for the effect of the absorption of one member’s tax attributes by another member, e.g., one member’s income may be absorbed by another member’s losses. the regulations provide rules to account for the impact of 106. reg. § 1.1502–33(a) and (b). 107. reg. § 1.1502–33(b)(3)(ii), ex. 3. 108. reg. § 1.1502–33(c). 109. reg. § 1.1502–33(c)(1). 154 florida tax review [vol. 12:3 the absorption of tax attributes which are intended to reflect in earnings and profits the reduction of one member’s tax liability by attributes of another that would have reduced the latter member’s earnings and profits in a different year if not used by the first member.110 finally, to the extent a lower-tier member of the group’s earnings and profits were taken into account by a higher-tier member of the group under the tiering-up rules, upon deconsolidation the lower-tier member’s earnings and profits are eliminated.111 ix. intercompany transactions a. transactions between members of a consolidated group 1. generally treasury regulation section 1.1502–13 provides rules for transactions between members of the same consolidated group involving the sale or exchange of property, the provision of services by one member of the group to another, the licensing or rental of tangible and intangible property, and the lending of money. the regulation also controls the treatment of intercompany distributions with respect to the stock of a member.112 the intercompany transaction rules are treated as a method of accounting that is applied in addition to the member’s other methods of accounting.113 the timing rules of the intercompany transaction regulations control over other accounting methods, however.114 the regulations treat members engaging in an intercompany transaction in some ways like a separate corporations and in other ways like divisions of a single corporation. in determining the amount and location of items related to those transactions, the members are treated as separate corporations. for example, if one member sells an asset to another member, the seller recognizes gain or loss under section 1001, while the buyer takes a cost basis in the asset under section 1012. however, to determine the timing, character, and other attributes of the transaction, the members are treated as divisions of a single corporation. thus, in the example above, the seller does not take its gain or loss on asset sale into account until the buyer takes its basis into account, and the character of the seller’s gain or loss may depend 110. reg. § 1.1502–33(d). 111. reg. § 1.1502–33(e). 112. reg. § 1.1502–13(f). 113. reg. § 1.1502–13(a)(3). 114. see also reg. § 1.446–1(c)(2)(iii), which provides that the consolidated return rules are a method of accounting under section 446(e). 2012] understanding consolidated returns 155 on the buyer’s and seller’s collective activity. the regulations accomplish these results with two rules, the matching rule and the acceleration rule. 2. matching intercompany items related to deferred gains and losses gain or loss recognized by the selling member in an intercompany transaction is accounted for by the selling member under its method of accounting, but is not accounted for in consolidated taxable income until the “corresponding item” resulting from the transaction is taken into account by the buying member under its method of accounting.115 for example, on a sale of property, the selling member’s gain or loss is not accounted for in consolidated taxable income until the buying member disposes of the property outside of the consolidated group, or otherwise recovers its corresponding basis in the acquired property. in this fashion, items resulting from an intercompany transaction are taken into account in a manner that produces the same net result in terms of consolidated taxable income as if the transaction occurred between divisions of a single entity. if a member sells an asset at a gain to another member and the purchasing member later sells that asset outside the consolidated group, the purchasing member’s reduced gain or increased loss attributable to the purchase price paid to the selling member is offset in consolidated taxable income by the selling member’s deferred gain. under this single entity principle, the character, source, and other attributes of intercompany transactions are determined with reference to the activities of both the selling and buying members of the consolidated group.116 however, for purposes of identifying the amount and location of 115. reg. § 1.1502–13(c)(2); see also reg. § 1.1502–13(b)(3). note that even outside of the consolidated return context, losses (but not gains) on sales of property between members of a “controlled group” of corporations are deferred using consolidated return matching principles. i.r.c. § 267(f); see reg. § 1.267(f)-1. a parent-subsidiary controlled group is one or more chains of corporations connected through stock ownership with a common parent if 50 percent of the voting power or value of each corporation (except the common parent) is owned by another member of the group, and the common parent owns at least 50 percent of the voting power or value of all classes of stock of at least one of the other corporations (determined by excluding stock of any member of the group held directly by another member of the group). i.r.c. §§ 267(f), 1563(a)(1). a brothersister controlled group means two or more corporations if five or fewer persons who are individuals, estates, or trusts own (or constructively own) stock possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote, or more than 50 percent of the total value of all stock, taking into account the stock ownership of each person only to the extent the stock ownership is identical with respect to each corporation. i.r.c. §§ 267(f),1563(a)(2). 116. reg. § 1.1502–13(c)(1). 156 florida tax review [vol. 12:3 specific items, each party to an intercompany transaction is treated as a separate entity.117 the regulations illustrate the single entity approach with the following example.118 in year one, s corporation sells property for $100 that it has held for investment with a basis of $70 to b corporation, which is a member of the consolidated group that includes s corporation. the accounting in consolidated taxable income for s corporation’s recognized gain on the sale is deferred. as a separate entity, b corporation holds the property with an adjusted basis of $100 and s corporation will be required to recognize its deferred gain when b corporation takes advantage of the $30 basis increase.119 in year three b corporation resells the property for $90 to a customer in the ordinary course of b corporation’s business. if s corporation and b corporation were divisions of a single entity, b corporation would succeed to s corporation’s $70 basis in the land and realize $20 of gain. under the matching principle of treasury regulation section 1.1502–13(c), in the year of b corporation’s sale, s corporation must take into income an amount that reflects the difference for the year between the “corresponding item,” which is the amount actually taken into account by b corporation as a separate entity ($10 loss),120 and the “recomputed corresponding item,” which is the amount that b corporation would take into account if s corporation and b corporation were divisions of a single entity ($20 gain).121 thus, in year three, s corporation is required to recognize $30 ($20 – ($10) = $30).122 b corporation recognizes its $10 loss in year three.123 the net effect on consolidated taxable income is $20 gain. the character of s corporation’s and b corporation’s gain (or loss) is also determined as if s corporation and b corporation were divisions of a single entity. thus, if b corporation’s activities with respect to the property convert the property from investment property into property described in section 1221(a)(1), both s corporation’s and b corporation’s gain or loss will be ordinary.124 the gain and loss taken into account by s corporation and b corporation will be preserved on a separate entity basis for purposes of stock basis and earnings and profits adjustments as required by treasury regulation sections 1.1502–32 and –33.125 117. reg. § 1.1502–13(a)(2). 118. reg. § 1.1502–13(c)(7)(ii), ex. 1(f). 119. reg. § 1.1502–13(a)(2). 120. reg. § 1.1502–13(b)(3). 121. reg. § 1.1502–13(b)(4); see also reg. § 1.1502–13(c)(7)(ii), ex. 1(d). 122. reg. § 1.1502–13(c)(2)(ii). 123. reg. § 1.1502–13(c)(2)(i). 124. reg. § 1.1502–13(c)(1) and (7)(ii), ex. 2. 125. reg. § 1.1502–13(a)(2). 2012] understanding consolidated returns 157 the matching principle of the regulations also requires an accounting for the selling member’s deferred gain as the buying member claims capital recovery deductions on its purchase price basis of depreciable property in an intercompany transaction. assume for example, that s corporation and b corporation are members of the same consolidated group. in 2008, s corporation acquires depreciable five year property for $150 and properly claims capital recovery deductions of $30 in 2008 and $48 in 2009. on the first day of its 2010 taxable year, s corporation sells the property to b corporation for $110. at the time of sale, s corporation’s basis in the property is $72 ($150 – [$30 + 48]). s corporation recognizes $38 of gain, which is deferred. under section 168(i)(7), b corporation must use the same depreciation rate as s corporation with respect to so much of the adjusted basis of the property in b corporation’s hands as does not exceed s corporation’s adjusted basis at the time of the transfer. thus, in taxable year 2010, b corporation deducts $28.80, which is the depreciation deduction that would have been available to s corporation under section 168. in addition, b corporation is permitted to recover its remaining basis as if the property were new five-year property. thus, in 2010 b corporation claims an additional $7.60 depreciation deduction (20 percent of adjusted basis of $38, applying the half-year convention as if the property were new five-year property). the additional depreciation deduction claimed by b corporation requires that s corporation take into account $7.60 of its deferred intercompany gain in 2010. in 2011, b corporation deducts $17.28 of depreciation with respect to the basis that would have been its basis had it taken a transferred basis from s corporation, plus $12.16 of depreciation based on its $28 basis increase from the intercompany transaction. s corporation is required to take into account $12.16 of its deferred intercompany gain in 2011.126 under the single entity principle, which treats s corporation and b corporation as divisions of a single corporation, the character of s corporation’s recognized gain will reflect the tax consequence of b corporation’s depreciation.127 thus, because s corporation’s deferred gain offsets b corporation’s increased depreciation, s corporation’s gain is treated as ordinary income.128 in this fashion, the regulations recognize separate entity aspects of the transaction as reflected in b corporation’s increased basis and depreciation, but treat the overall consequence to consolidated taxable income as though the property were transferred between divisions of a single entity through the matching of b corporation’s increased depreciation deductions with restoration of s corporation’s deferred intercompany gain. 126. reg. § 1.1502–13(c)(7)(ii), ex.(4). 127. reg. § 1.1502–13(c)(1)(i) and (c)(4)(i). 128. see also reg. § 1.1502–13(c)(7)(ii), ex.(4)(d). 158 florida tax review [vol. 12:3 if, on the first day of its 2012 taxable year, b corporation sells the property to x corporation, which is not a member of the s–b consolidated group, for $120 payable in two annual installments with adequate interest, both b corporation and s corporation must account for recognized gain. b corporation recognizes gain of $75.84 ($120 − $44.16).129 as a consequence of b corporation’s sale, s corporation must also recognize recapture gain. if s and b corporations were divisions of a single entity, on its 2012 sale of the property the corporation would have realized $94.08 of gain, determined by subtracting from the $120 amount realized an adjusted basis of $25.92 computed without regard to b corporation’s purchase from s corporation ($150 original cost less four year’s capital recovery deductions totaling $94.08). the difference between the gain recognized on a single entity basis and the gain recognized by b corporation as a separate entity, $18.24 ($94.08 – $75.84), is b corporation’s “recomputed corresponding item,” which must be accounted for by s corporation at the time of b corporation’s disposition.130 as a consequence, the consolidated taxable income of the group reflects the tax consequence of the sale of the property on a single entity basis; s corporation’s gain of $18.24 plus b corporation’s gain of $75.84 is the equivalent of the gain that would have been recognized on the sale of the property outside of the group without the intervention of the intercompany sale from s corporation to b corporation. continuing with the single entity model, because all of the gain recognized on disposition of the property would have been recaptured as ordinary income under section 1245, the gain recognized by both s corporation and b corporation is treated as ordinary gain.131 under section 453(i) none of the gain is eligible for installment reporting. if b corporation had sold the property to x for $160, an amount that would have produced $10 of section 1231 gain in addition to depreciation recapture, b corporation would have been eligible to report $5 of its gain under the section 453 installment method in each of the two years payments are received from x. s corporation’s deferred gain accounted for in the year of sale would not have been eligible for installment reporting, however, because all of s corporation’s deferred gain on its intercompany sale to b corporation is section 1245 ordinary income recapture gain.132 129. b corporation’s adjusted basis is its $110 purchase price minus $65.84 of depreciation for 2010 and 2011. 130. the recomputed corresponding item is equivalent to s’s deferred gain of $38 less gain recognized by s corporation in 2010 and 2011 as b corporation claimed increased capital recovery deductions. 131. reg. § 1.1502–13(c)(1)(i). 132. reg. § 1.1502–13(c)(7)(ii), ex. 5(f). in the case of an installment sale reported under section 453, the regulation also provides that b and s must account for the interest charge of section 453a on gains deferred under the installment 2012] understanding consolidated returns 159 3. acceleration of deferred gains and losses under the acceleration rule, the presence of deferred intercompany gain or loss within the consolidated group will also affect transactions involving the stock of subsidiaries. the regulations address stock transactions by requiring “acceleration” of deferred intercompany items in the case of an event that prevents accounting for an item under the matching rules.133 for example, if either the selling or buying member leaves the consolidated group, it is no longer possible to match the selling member’s deferred gain or loss with the buying member’s subsequent accounting for its corresponding item. thus, if either member ceases to be a member of the consolidated group, the selling member generally is required to account for its deferred gain or loss.134 in the first example above, where s corporation sold investment property with a $70 basis to b corporation for $100, if b corporation should cease being a member of the consolidated group in year two before selling the property, s corporation would be required to account for its deferred $30 gain in that year.135 as a separate entity, or as a member of a different consolidated group, b corporation would continue to hold the property with a $100 basis. the character of s corporation’s gain would be determined under the matching principles of treasury regulation section 1.1502–13(c) as if s corporation and b corporation were divisions of the same entity.136 thus, b corporation’s activities with respect to the property could convert s corporation’s deferred investment gain into ordinary gain. the common parent of a consolidated group may request that the irs consents to the group accounting for intercompany transactions on a separate entity basis.137 this consent may be granted for all items or a class of items of the consolidated group. method if the aggregate tax installment obligations of the group outstanding at the end of the taxable year exceed $5 million. reg. § 1.1502–13(c)(7)(ii), ex. 5(b). 133. reg. § 1.1502–13(d)(1). 134. the deferred gain or loss is not accelerated when the group is acquired in a reverse acquisition defined in section 368(a)(2)(e), another group acquires the common parent’s stock, or another group acquires the common parent’s assets in a section 381(a)(2) transaction. reg. § 1.1502–13(j)(5). 135. see reg. § 1.1502–13(d)(3), ex. 1. 136. reg. § 1.1502–13(d)(1)(ii). 137. reg. § 1.1502–13(e)(3). 160 florida tax review [vol. 12:3 b. distributions with respect to the stock of a member 1. section 301 distributions the single entity approach to intercompany transactions involving the stock of the members of a consolidated group applies to distributions on the stock of one group member made to another group member.138 intercompany distributions with respect to the stock of a member of the consolidated group that are subject to section 301 are excluded from the gross income of the distributee member, but only to the extent that the distributee reflects a corresponding negative adjustment to the basis of the stock of the distributing member.139 thus an intercompany distribution will increase recognized gain, or decrease loss, on a disposition of the stock of the distributing member. under the investment adjustment rules of treasury regulation section 1.1502–32, if the distribution exceeds the recipient member’s basis in the stock of the distributing member, the recipient’s negative basis creates an excess loss account. the existence of an excess loss account will trigger recognition of gain if either the distributing or recipient member ceases to be a member of the consolidated group.140 2. intercompany distributions of appreciated and depreciated property both gain and loss on intercompany distributions of appreciated or depreciated property with respect to the stock of the distributing member are recognized under the principles of section 311(b) but are accounted for as deferred intercompany gain or loss under the matching rule if the property is sold to a non-member.141 if either member leaves the consolidated group, it will no longer be possible to match accounting for the distributing corporation’s deferred item with the recipient’s corresponding item, and the acceleration rule will require the distributing corporation to account for deferred gain or loss recognized on the distribution.142 however, while deferred section 311(b) gain always is included in consolidated taxable income, loss is allowed if the property subsequently is sold to a nonmember; the deferred loss in excess of the transferee’s gain is permanently disallowed if the property is distributed to a nonmember shareholder.143 the deferred 138. reg. § 1.1502–13(f). 139. reg. § 1.1502–13(f)(2)(ii). 140. reg. § 1.1502–19. 141. reg. § 1.1502–13(f)(2)(iii). 142. reg. § 1.1502–13(d)(1). 143. reg. § 1.1502–13(c)(6) and (f)(7), ex. 4(d). 2012] understanding consolidated returns 161 loss would also typically be allowed under the acceleration rule if either the distributing or distributee member ceases to be a member of the group. the application of these rules in the context of a transaction that creates an excess loss account is illustrated by an example in the regulations. (a) facts. s owns all of t’s only class of stock with a $10 basis and $100 value. s has substantial earnings and profits, and t has $10 of earnings and profits. on january 1 of year 1, s declares and distributes a dividend of all of the t stock to p. under section 311(b), s has a $90 gain. under section 301(d), p’s basis in the t stock is $100. during year 3, t borrows $90 and declares and makes a $90 distribution to p to which section 301 applies, and p’s basis in the t stock is reduced under § 1.1502–32 from $100 to $10. during year 6, t has $5 of earnings that increase p’s basis in the t stock under § 1.1502–32 from $10 to $15. on december 1 of year 9, t issues additional stock to x and, as a result, t becomes a nonmember. (b) dividend exclusion. under paragraph (f)(2)(ii) of this section, p’s $100 of dividend income from s’s distribution of the t stock, and its $10 of dividend income from t’s $90 distribution, are not included in gross income. (c) matching and acceleration rules. under § 1.1502– 19(b)(1), when t becomes a nonmember p must include in income the amount of its excess loss account (if any) in t stock. p has no excess loss account in the t stock. therefore p’s corresponding item from the deconsolidation of t is $0. treating s and p as divisions of a single corporation, the t stock would continue to have a $10 basis after the distribution, and the adjustments under § 1.1502–32 for t’s $90 distribution [which decrease basis] and $5 of earnings [which increase basis] would result in a $75 excess loss account [$10 – $90 + $5]. thus, the recomputed corresponding item from the deconsolidation is $75. under the matching rule, s takes $75 of its $90 gain into account in year 9 as a result of t becoming a nonmember, to reflect the difference between p’s $0 gain taken into account and the $75 recomputed gain. s’s remaining $15 of gain is taken into account under the matching and acceleration rules based on subsequent events (for example, under the matching rule if p 162 florida tax review [vol. 12:3 subsequently sells its t stock, or under the acceleration rule if s becomes a nonmember). 144 in the example, if the basis of the t stock had not been adjusted as a result of s’s distribution of the t stock to p, the $90 distribution to p would have resulted in an excess loss account with respect to the t stock. on a single entity basis, the excess loss account would have been $75, the original $10 of basis, increased by $5 of earnings and profits and decreased by the $90 distribution. accordingly, s is required to take into account $75 of deferred gain when t ceases to be a member of the consolidated group. the remaining $15 of s’s deferred gain remains a deferred item for s, which can be matched with p’s disposition of its remaining t stock, or accelerated if either s or p ceases to be members of the same consolidated group.145 3. liquidation of a subsidiary where a parent corporation completely liquidates a subsidiary corporation that it controls, under section 332 no gain or loss is recognized to the parent. this provision also applies if a controlled subsidiary merges into its parent corporation.146 section 332 is another one of the basic code provisions that operates with the consolidated return regime as well as without the consolidated return regime. “control” is defined in section 332(b)(1), through a cross reference to section 1504(a)(2), as holding both (1) 80 percent or more of the voting power, and (2) 80 percent or more of the total value of all stock of the corporation, except that pursuant to section 1504(a)(4), nonparticipating, nonconvertible, nonvoting preferred stock is not taken into account. when section 332 applies to the parent of a liquidating corporation, section 337 provides a general exception to the basic rule of section 336 that a liquidating corporation recognizes gain or loss on liquidating distributions.147 under section 337(a), no gain or loss is recognized on a distribution to an “80 percent distributee”, defined in section 337(c) as a 144. reg. § 1.1502–13(f)(7), ex. 2. 145. reg. § 1.1502–19. the deferred gain or loss is not accelerated when the group is acquired in a reverse acquisition, another group acquires the common parent’s stock, or another group acquires the common parent’s assets in a section 381(a)(2) transaction. reg. § 1.1502–19(c)(3). 146. reg. § 1.332–2(d). 147. to prevent the complete avoidance of tax on appreciation in the subsidiary’s assets, subject to certain exceptions, section 337 does not apply to a liquidation of a subsidiary of a tax-exempt organization. i.r.c. § 337(b)(2). this provision is necessary because notwithstanding a carryover basis under section 334(b), a subsequent sale of the former subsidiary’s assets generally would not be taxable. 2012] understanding consolidated returns 163 corporation that meets the stock ownership requirements of section 332(b). the final sentence of section 337(c) requires that a single corporation must meet the 80 percent requirement: it is not sufficient for two or more affiliated corporations to have aggregate holdings meeting the 80 percent test. section 337 does not apply to a liquidating subsidiary if the 80 percent controlling parent is a foreign corporation (which, in any event, cannot be included in a consolidated return with an affiliated group of u.s. subsidiaries).148 both gains and losses are recognized. however, capital losses may not exceed capital gains and ordinary losses may not exceed ordinary gains. excess losses in either category are disallowed. the gain recognition rule does not apply if the property remains within u.s. jurisdiction, for example, u.s. real property interests or u.s. real property holding company holding companies, or assets used in a u.s. trade or business, if certain conditions are met.149 under section 334(b) the basis of the assets in the parent corporation’s hands remains the same as the basis of the assets to the subsidiary corporation, except that if gain or loss is recognized on a distribution of property, its basis is its fair market value. section 332(d) treats a liquidating distribution by a u.s. holding company to a foreign corporation as a section 301 distribution, which is a dividend to the extent of earnings and profits, thereby invoking the 30 percent withholding tax under sections 861 and 1441, if the holding company has not been in existence for five years. section 332 applies to provide nonrecognition upon the liquidation of a subsidiary within a consolidated group. consequently, the parent corporation receiving the distribution takes a transferred basis under section 334(b). furthermore, in determining whether one member of the group holds sufficient stock to qualify for nonrecognition under section 332, stock owned by other members of the group shall be taken into account.150 assume, for example, that y corporation and z corporation, which are members of the same consolidated group, owned 60 percent and 40 percent, respectively, of the stock of s corporation, and s corporation liquidates by distributing 60 percent of its assets to y corporation and 40 percent of its assets to z. section 332 accords nonrecognition to each of y corporation and z corporation. however, section 337(c) provides that the determination of whether a corporation receiving a liquidating distribution is an “80–percent distributee,” distributions to which do not result in recognition the liquidating corporation under section 337(a), is to be made without regard to any consolidated return regulation. thus, for purposes of section 337, neither y corporation nor z corporation meets the 80–percent stock ownership 148. i.r.c. § 367(e)(2). 149. reg. § 1.367(e)–2(b)(2). 150. reg. § 1.1502–34. 164 florida tax review [vol. 12:3 requirement of section 332(b) and s corporation must recognize gain, but not loss.151 however, the gain is deferred, and y and z succeed to s’s deferred gain.152 but the manner in which that deferred gain is allocated between the distributee corporations in unclear. there are some exceptions to the matching principle that will result in certain intercompany items being redetermined to be treated as excluded or as a nondeductible, noncapital amount.153 however, this rule does not apply to gain on the sale of stock to another group member, followed by a section 332 liquidation in which the purchaser does not recognize gain.154 an intercompany sale of the stock of a member of the consolidated group, followed by a liquidation of the subsidiary creates an interesting problem under the single entity approach. the problem is illustrated by the following example.155 b corporation, s corporation and t corporation are members of the same consolidated group. s corporation owns all of the t corporation stock, which has a fair market value of $100. s corporation’s basis in the t corporation stock is $70. the fair market value of t corporation’s assets is $100 and the assets have a basis of $10. on july 1 of year 1, b corporation purchases the t corporation stock from s corporation for $100. s corporation’s $30 gain on the intercompany sale to b corporation in year 1 is deferred in determining consolidated taxable income in that year. on july 1 of year 3, when t corporation’s assets are still worth $100, t corporation distributes all of its assets to b corporation in a complete liquidation governed by section 332. b corporation’s basis in the t corporation stock is $100. on liquidation of t corporation, b corporation receives a $100 distribution and thus has zero realized gain. in addition, b corporation recognizes no gain or loss on the liquidation under section 332. if the transfer of t corporation stock from s corporation to b corporation had been between divisions of a single entity, b corporation’s realized gain on liquidation of t corporation would have been $30, but the gain would not have been recognized under section 332. thus, b corporation’s recomputed corresponding item is $30 of unrecognized gain, which must be taken into account by s corporation in year 3. although the attributes of s corporation and b corporation’s gain, including its status as a nonrecognition item, are determined as if s corporation and b corporation were divisions of a single entity,156 gain subject to a nonrecognition provision that is not permanently and explicitly disallowed is not treated as having the attribute of an item 151. i.r.c. § 336(d)(3). 152. reg. § 1.1502–13(j)(2)(ii); reg. § 1.1502–13(j)(9), ex. 7. 153. reg. § 1.1502–13(c)(6). 154. reg. §§ 1.1502–13(c)(6)(ii), 1.1502–13(f)(5), and 1.1502–13(f)(7), ex. 6(c). 155. the example is based on reg. § 1.1502–13(f)(7), ex. 6(c). 156. reg. § 1.1502–13(c)(1)(i). 2012] understanding consolidated returns 165 excluded from income.157 thus, s corporation’s $30 of deferred gain is taken into account as capital gain in year 3. this result seems to be necessary because b corporation inherits t corporation’s asset basis and the t corporation stock is no longer available as a corresponding item to match s corporation’s deferred gain from the sale of the t corporation stock to b corporation. however, the regulations allow elective relief from s corporation’s accounting for its deferred gain.158 deferred loss on an intercompany sale of stock of a subsidiary followed by a section 332 liquidation of the subsidiary is treated as a nondeductible, noncapital item,159 and thus is not taken into account by the selling member. however, the regulations allow elective relief from s corporation’s treating its deferred loss as a nondeductible, noncapital item.160 section 381(a) provides that the tax attributes of the subsidiary carry over to the parent. the most notable of these attributes are net operating loss carryovers, capital loss carryovers, and the earnings and profits accumulations or deficits. if either the parent or the subsidiary has a deficit in its earnings and profits accounts after a section 332 liquidation, the parent must maintain separate earnings and profits accounts; the deficit of one corporation cannot be used to offset the surplus in the earnings and profits account of the other.161 earnings and profits accumulated by the parent after the liquidation are used to exhaust the deficit account before the accumulated earnings and profits account of the parent is increased.162 section 332 generally applies to the liquidation of a controlled subsidiary whether the subsidiary is a u.s. corporation or a foreign corporation. (an exception to nonrecognition with respect to certain foreign holding companies is provided in section 332(d)). if the controlled subsidiary is a foreign corporation, however, section 334(b)(1)(b) limits the u.s. parent’s basis in properties received in the liquidation to the properties’ fair market values if the subsidiary’s aggregate basis in the transferred properties exceeds their aggregate fair market value. the rule thus prevents the importation of assets with built-in losses into the u.s. tax system. 157. reg. § 1.1502–13(c)(6)(ii). 158. reg. §§ 1.1502–13(f)(5)(ii) and 1.1502–13(f)(7), ex. 6(b). 159. reg. §§ 1.1502–13(f)(7), ex.(6)(c). 160. reg. §§ 1.1502–13(f)(5)(ii) and 1.1502–13(f)(7), ex. 6(c). 161. i.r.c. § 381(c)(2). 162. reg. § 1.312–11(b)(2) and (c). 166 florida tax review [vol. 12:3 c. transactions in which a member acquires stock of another member outside of the consolidated return context, if one affiliated corporation purchases the stock of another affiliated corporation, section 304 applies to determine whether the transaction will, generally speaking, be respected as a sale and purchase or instead recharacterized as a dividend distribution from the purchaser to its controlling shareholder. however, the regulations provide that section 304 does not apply in the consolidated return context.163 thus, the transaction is respected as a stock sale and purchase. the selling member of the group has a deferred intercompany transaction subject to the rules of treasury regulations section 1.1502-13,164 and the purchasing member of the group takes a section 1012 cost basis in the stock. special rules apply to transactions involving the intra-group sale of stock of the common parent.165 d. transactions in which a member acquires its own stock when a corporation acquires its own stock, as a consequence of the nonrecognition rules of section 1032, there will be no subsequent transaction in which the basis of the acquired stock is accounted for. to deal with this situation, the regulations provide, in effect, that if a member of a consolidated group acquires its own stock in an intercompany transaction, gain or loss recognized by the selling member must be accounted for at the time of the transaction under the acceleration rule.166 the gain or loss is accelerated to the date of the intercompany transaction under the acceleration rule because there is no corresponding item with which to match deferred gain.167 if a corporation acquires its own stock in a redemption subject to section 302(a), the selling member must account for its gain. if a corporation acquires its own stock in a section 301 distribution from another member, the distributing member must account for gain recognized under section 311(b).168 if the selling or distributing corporation realizes a loss on the transaction, the loss is accounted for as a noncapital, nondeductible amount.169 163. reg. § 1.1502–80(b). 164. see reg. § 1.1502–13(f)(7), ex. 6. 165. reg. § 1.1502–13(f)(6). 166. reg. § 1.1502–13(f)(4). 167. see reg. § 1.1502–13(f)(7), ex. 4. 168 reg. § 1.1502–13(f)(7), ex. 5(c). 169. reg. § 1.1502–13(c)(6) and (f)(7), ex. 5(d). 2012] understanding consolidated returns 167 e. transactions in which a member acquires debt of another member the regulations address the treatment of debt obligations between members of the same consolidated group, an “intercompany obligation.”170 the rules apply to three types of transactions: (1) transactions in which an obligation between a group member and a nonmember becomes an intercompany obligation, for example, the purchase by a consolidated group member of another member’s debt from a nonmember creditor or the acquisition by a consolidated group member of stock of a nonmember creditor or debtor (inbound transactions); (2) transactions in which an intercompany obligation ceases to be an intercompany obligation, for example, the sale by a creditor member of another member’s debt to a nonmember or the deconsolidation of either the debtor or creditor member (outbound transactions); and (3) transactions in which an intercompany obligation is assigned or extinguished within the consolidated group (intragroup transactions).171 in each of these circumstances the following sequence of events is deemed to occur immediately before, and independently of, the actual transaction: (1) the debtor is deemed to satisfy the obligation for a cash amount equal to the obligation’s fair market value, and (2) the debtor is deemed to immediately reissue the obligation to the original creditor for that same cash amount. the parties are then treated as engaging in the actual transaction but with the new obligation.172 as a result, in the year of the purchase, the debtor recognizes cancellation of debt income under section 61(a)(12) unless one of the exceptions in section 108 applies, and the deemed reissuance of the obligation for an amount equal to its fair market value causes it to be an original issue discount (oid) obligation. under the oid rules,173 over the life of the obligation, the purchasing member (the creditor) recognizes interest income and the debtor member recognizes interest deductions. the regulations contain a number of exceptions to the application of the deemed-satisfaction-reissuance model where it is determined that application of the model is not necessary to achieve its purposes or that burdens associated with valuing the obligation or applying the mechanics of the deemed satisfaction-reissuance model outweigh the benefits achieved by its application. to avoid misuse of the exceptions to the satisfaction-reissuance model, the regulations provide two anti-abuse rules. the material tax benefit rule applies to an intragroup assignment or extinguishment of an obligation if the transaction is undertaken with a view to shifting built-in items among 170. reg. § 1.1502–13(g). 171. reg. § 1.1502–13(g)(3)(i)(b). 172. reg. § 1.1502–13(g)(3)(ii). 173. i.r.c. §§ 1272–1274, and the regulations thereunder. 168 florida tax review [vol. 12:3 members to achieve a material tax benefit.174 the off-market issuance rule applies if an intercompany obligation is issued at a materially off-market interest rate with a view to shifting of built-in items from the obligation to secure a material tax benefit. in such cases, the intercompany obligation will be treated as originally issued for its fair market value, and any difference between the amount loaned and the fair market value of the obligation will be treated as transferred between the creditor member and the debtor member, as appropriate (for example, as a distribution or a contribution to capital).175 f. anti–abuse rules treasury regulation section 1.1502–13(h)(1) provides that, “if a transaction is structured with a principal purpose to avoid the purposes of this section, (including, for example, by avoiding treatment as an intercompany transaction), adjustments must be made to carry out the purposes of this section.” specific examples of abusive transactions described in the regulation include the transfer of property to a partnership to avoid the srly limitation, the use of corporations formed under section 351 or partnerships to mix assets for the purpose of avoiding gain on disposition of appreciated property, and the use of a sale-leaseback transaction to create gain for the purpose of absorbing losses subject to the srly limitation.176 similar anti-abuse language is attached to other consolidated return regulations.177 x. net operating loss carryovers a. generally if corporations are members of an affiliated group of corporations filing a consolidated return, the consolidated net operating loss of a consolidated group generally includes the consolidated net operating loss (nol) carrybacks and carryovers of the group.178 furthermore, the regulations allow the net operating losses of a member of an affiliated group to be carried over from a pre-consolidation return period against the consolidated income of the group.179 this general rule, is, however, subject to two generally mutually exclusive limitations. if after a change of 174. reg. § 1.1502–13(g)(3)(i)(c). 175. reg. § 1.1502–13(g)(4)(iii). 176. reg. § 1.1502–13(h)(2). 177. see e.g., regs. §§ 1.1502–19(e), –32(e), and –33(g). 178. reg. § 1.1502–21(a). 179. reg. § 1.1502–21(b). 2012] understanding consolidated returns 169 ownership, the corporation is a member of an affiliated group of corporations filing a consolidated return and section 382 is applicable, then the carryovers are limited accordingly.180 alternatively, if there was not a change of control within the meaning of section 382, but the loss year was a “separate return limitation year” (srly), then the loss may be carried over only against the income of the member of the group that generated the loss.181 the srly rules allow the use of losses from a separate return year of a member of the group only to the extent of income produced by that member. the srly rule does not apply if a corporation becomes a member of a consolidated group within six months of the change date of an ownership change.182 thus, in cases of overlap, generally only the section 382 limitation is applicable.183 as noted above, in united dominion industries, inc. v. united states,184 the supreme court adopted the single entity approach regarding consolidated net operating losses, making it clear that there is only a consolidated net operating loss, not a collection of the separate members’ losses, although separate member losses must be identified when members enter and leave a group. united dominion industries was the parent of an affiliated group that reported a consolidated net operating loss in each of three years. the consolidated net operating losses included losses attributable to so-called product liability expenses that gave rise to product liability losses. product liability losses can be carried back under section 172(b)(1)(i) for ten years, rather than the much shorter carryback allowed under section 172(b)(1)(a). five of the corporate members of the affiliated group, which collectively generated $3.1 million of product liability expenses over three years, had sufficient income to offset their product liability expenses, thereby producing positive separate taxable income in each entity. the government argued that the consolidated group could not carry back product liability expenses incurred by a profitable member because the product liability expenses that were offset with positive income did not enter into the 180. reg. § 1.1502–91. 181. regs. §§ 1.1502–21(c) (nols) and –22(c) (capital loss carryovers). 182. reg. § 1.1502–21(g). 183. in limited cases generally beyond the scope of this article, both the srly rule and § 382 may apply. this generally occurs when there are two different acquisitions. for example, if x corporation, which is the common parent of a consolidated group, owns 50 percent of y corporation and acquires an additional 30 percent of the y corporation stock at a time when y corporation has net operating loss carryovers, the srly rules apply to y corporation’s net operating loss carryovers. if p corporation, which is the common parent of a consolidated group, subsequently acquires 80 percent of x corporation, resulting in both x corporation and y corporation becoming members of p corporation’s consolidated group, § 382 applies to the p corporation subgroup’s net operating loss carryovers, while the srly rules continue to apply to y corporation’s net operating loss carryovers. 184. 532 u.s. 822 (2001). 170 florida tax review [vol. 12:3 consolidated net operating loss of the group. the supreme court reasoned that there is only a single definition of consolidated net operating loss in treasury regulation section 1.1502–21(f) and no definition in the regulations of a separate nol for a single member of the consolidated group. the subsidiary’s specified liability loss deduction items reduced the subsidiary’s separate taxable income dollar-for-dollar and thereby contributed to the overall consolidated net operating loss of the affiliated group. a product liability loss subject to the special ten year carryback is the lesser of product liability expenses or the taxpayer’s nol for the taxable year.185 identifying the product liability loss first requires calculation of the consolidated group’s consolidated net operating loss, the only nol available under the consolidated return regulations, then determining product liability loss from all of the product liability expenses within the consolidated group. thus, a portion of the consolidated nol could be carried back ten years. b. application of section 382 to consolidated groups the ability to use the target acquired corporation’s net operating loss carryovers following an acquisition, whether taxable or a tax-free reorganization, is substantially restricted by section 382. section 382 applies whenever there is a greater than 50 percentage point increase in the ownership of the stock of a corporation with a net operating loss carryover by one or more five percent stockholders over a three year testing period. the annual limitation on post-acquisition income that can be offset by net operating loss carryovers following an ownership change is computed by multiplying the value of the loss corporation by the “federal long-term taxexempt rate”, a number that is published by the irs monthly. the regulations provide detailed rules applying the section 382 limitation in the consolidated return context.186 the regulations generally treat the members of a consolidated group as a single entity for purposes of determining whether an ownership change has occurred with respect to a loss corporation and ascertaining the value of the loss corporation stock. before an ownership change, a consolidated group of corporations is able to absorb net operating losses of some members against the income of other members as a single entity. following an ownership change, the consolidated taxable income of a group that may be offset by pre-ownership change losses and built-in losses of the group is limited by the section 382 consolidated limitation applied to the group as a whole.187 a consolidated loss group has an ownership change for purposes of section 382188 if there has been an 185. i.r.c. § 172(j)(1). 186. regs. §§ 1.1502–90 through 1.1502–99. 187. reg. § 1.1502–91(a)(1). 188. temp. reg. § 1.382–2t. 2012] understanding consolidated returns 171 ownership change of the common parent.189 in determining whether an ownership change has occurred, losses of the group are treated as the losses of the common parent, and the testing period is measured by losses of members of the loss group.190 the regulations provide for the identification of loss subgroups within a consolidated group for the purpose of applying the section 382 limitation on the basis of a loss subgroup.191 there is an ownership change with respect to a loss subgroup if there is an ownership change of the common parent of the loss subgroup.192 the regulations also treat brothersister corporations as a loss subgroup if two or more corporations that become members of a consolidated group at the same time were affiliated with each other immediately before becoming members of the new group and the common parent of the acquiring group elects to treat the new members as a loss subgroup.193 the section 382 limitation, which under section 382(b)(1) is based on the value of the stock of the loss corporation multiplied by the applicable long-term tax-exempt rate, is determined from the value of the stock of the consolidated loss group or subgroup as a single entity.194 the value of the consolidated loss group immediately before an ownership change is the value of the stock of each member of the group, other than the value of stock of a member of the group that is held directly or indirectly by another member of the group.195 in some circumstances, a subsidiary will be required to recognize an ownership change on a separate corporation basis with respect to its portion of the consolidated return net operating loss of the group.196 a separate set of rules apply section 382 to carryover losses of a new member of a consolidated group that were incurred by the new member in a separate return limitation year with respect to the current consolidated group.197 in general, a new loss member of a consolidated group is treated as a separate entity for purposes of applying the section 382 limitation. thus, the amount of consolidated taxable income of the group that may be offset with losses of the new member is limited by a section 382 limitation that is computed with respect to the value of the new member corporation’s stock at 189. reg. § 1.1502–92(b)(1). 190. reg. § 1.1502–92(b)(1)(ii)(a) and (b). 191. reg. § 1.1502–91(d). 192. reg. § 1.1502–92(b)(1)(ii). 193. reg. § 1.1502–91(d)(4). 194. reg. § 1.1502–93(a). 195. reg. § 1.1502–93(b)(1). 196. reg. § 1.1502–96(b)(1) and (2). 197. reg. § 1.1502–94. 172 florida tax review [vol. 12:3 the time of its ownership change.198 if the section 382 limitation does not apply, under the srly limitation, the amount of the new member’s losses that may be absorbed by the consolidated group is also limited to the new member’s aggregate contribution to the consolidated taxable income of the group.199 as explained previously, a consolidated loss group subject to the section 382 limitation is treated as a single entity subject to the limitation on the basis of the stock value of the entire group. if a loss corporation leaves a consolidated loss group or subgroup that has had an ownership change while the departing corporation was a member of the group, a portion of the consolidated net operating loss carryover is apportioned to the departing loss corporation,200 and those losses remain subject to the section 382 limitation. the section 382 limitation applicable to the departing loss corporation will be zero unless the common parent (not a loss subgroup parent) elects to apportion part of the section 382 limitation of the consolidated loss group to the departing loss corporation.201 the section 382 limitation apportioned to the departing member will reduce the section 382 limitation of the remaining consolidated loss group.202 the regulations also permit an election to apportion part of the net unrealized built-in gain of the loss group, which increases the section 382 limitation, to the departing member.203 a pro-rata portion of the group’s net unrealized built-in loss must be allocated to the departing member of a consolidated group.204 c. separate return limitation year 1. generally generally, the definition for “separate return limitation year” is a year in which any member of the consolidated group filed a separate return.205 but there are exceptions. the parent is excepted from the general rule.206 this exception permits a loss corporation to acquire a profitable subsidiary and apply its own loss carryovers against the profits of the newly acquired subsidiary. acquisition of a corporation with built-in gain, however, is subject to the limitations of section 384, which restricts the use of 198. reg. § 1.1502–94(b)(1). 199. regs. §§ 1.1502–21(c) and 1.1502–94(b)(4), ex. 1(iii). 200. reg. § 1.1502–21(b)(2). 201. reg. § 1.1502–95(c)(2). 202. reg. § 1.1502–95(c)(3). 203. reg. § 1.1502–95(c)(2)(ii). 204. reg. § 1.1502–95(e). 205. reg. § 1.1502–1(f). 206. reg. § 1.1502–1(f)(2)(i). 2012] understanding consolidated returns 173 preacquisition losses against recognized built-in gain of either the acquired or acquiring corporation. in addition, a srly does not include a separate return year for a subsidiary that was a member of the affiliated group at the time the loss was incurred but which was not included in a consolidated return for that year.207 the deduction of a srly loss by the consolidated group in any taxable year is limited to the taxable income contributed to the group by the member with the srly loss.208 the member’s contribution to consolidated taxable income is measured on a cumulative basis over the entire period during which the srly corporation is a member of the group. thus, a member’s srly losses may be absorbed in any consolidated return year to the extent of the member’s cumulative net contribution to consolidated taxable income in prior consolidated return years of the group, even though the member may not have taxable income in the year the loss is absorbed. similar rules apply on the basis of a srly subgroup, rather than fragmenting the limitation on a corporation-by-corporation basis.209 a srly subgroup consists of corporations affiliated with the loss corporation continuously from the year in which the loss was incurred to the year into which the loss is carried. 2. reverse acquisition since the srly limitation does not apply in the case of a change of ownership of the common parent, there remains a possibility that the common parent of the loss group might acquire a profitable corporation in a transaction that results in the acquired corporation’s shareholders owning more than 50 percent of the stock of the common parent of the loss group.210 for example, assume that a profitable p corporation merges into l corporation, which is the common parent of a consolidated group of corporations, and as a result of the merger the persons who were shareholders of former p corporation immediately before the merger end up owning more than 50 percent of the stock of l corporation. srly does not limit the losses of the l corporation consolidated group none of which were incurred in a separate return limitation year. however, the regulations 207. reg. § 1.1502–1(f)(2)(ii). 208. reg. § 1.1502–21(c)(1). 209. reg. § 1.1502–21(c)(2). 210. the section 382 limitation applies where there is a more than 50 percent change in ownership of the loss corporation, but the section 382 limitation would not apply, for example, if the profitable corporation’s shareholders already owned 10 percent of the loss corporation stock and by virtue of the transaction increased their ownership interest to 52 percent, which is an increase of only 42 percent. 174 florida tax review [vol. 12:3 recognize that while in form the loss corporation acquired the profitable corporation, in substance the profitable corporation acquired the loss group and treat this transaction as a “reverse acquisition” to deny the net operating loss carryover against the profits of the profitable “acquired corporation.”211 wolter construction co., inc. v. united states,212 upheld the validity of the srly regulations. the taxpayer argued that the common parent exception to the srly limitation and the reverse acquisition exception to the exception were intended to insure that loss carryovers were available only to the stockholders who owned the corporation when the losses were incurred, and that this policy should be applied to allow use of losses by the common parent affiliated with its former sister corporation. the court rejected the argument and described the reverse acquisition rule as follows: in a typical reverse acquisition in the loss carryover context, substantially all the assets or stock of a profit corporation are nominally acquired by a loss corporation in exchange for more than 50 percent of the latter’s stock, so that control of the loss corporation has shifted to the stockholders of the profit corporation as they existed prior to the acquisition. the regulations essentially treat the loss corporation as having been acquired, and under section 1.1502–1(f)(3) of the treasury regulations, all taxable years of the loss corporation prior to the reverse acquisition are treated as separate return limitation years, notwithstanding its status as the common parent corporation of the new affiliated group consisting of it and the profit corporation. conversely, the separate return years of the profit corporation prior to the acquisition are not treated, in general, as the separate return limitation years. accordingly, the net operating losses sustained by the loss corporation, but not the profit corporation, in its separate return years are subject to the carryover limitation contained in section 1.1502–21(c). the purpose and effect of the reverse acquisition rules is to prevent trafficking in loss corporations. this is accomplished by redirecting the srly limitation to the ostensibly acquiring corporation. this “simple technical rule thwarts the attempts of those who would seek to present that the ailing david is trying to improve its financial strength by 211. regs. §§ 1.1502–1(f)(3) and 1.1502–75(d)(3). 212. 634 f.2d 1029 (6th cir. 1980). 2012] understanding consolidated returns 175 drawing on the earning power of goliath.” gans [a practical guide to consolidated returns (1976)], at 828.2.213 3. built-in deductions if losses are economically incurred in a prior separate return year but recognized for tax purposes in a consolidated year, the losses are treated as arising in a separate return limitation year and thus may not be applied against consolidated income but may be used only to offset the income of the corporation which realized the loss.214 net unrealized built-in losses are thus subject to the srly limitations. the regulations adopt the definitions of built-in loss contained in section 382(h)(3), which refers to the excess of adjusted basis of assets over their fair market value.215 the srly limitation applies to the recognition of “net unrealized built-in losses” of a new member of a consolidated group (as determined under section 382(h)(3)) but only during a five year recognition period after the new member joins the group.216 however, the srly limitation on built-in-loss does not apply if the losses are also subject to the built-in-loss limitation of section 382.217 4. post acquisition losses of an acquired member consolidated net operating losses of the group are subject to being carried back and carried forward the under the general principles of section 172(b)(two year carryback and twenty year carryforward).218 however, the consolidated net operating loss does not include losses apportioned under to a separate return year of a member of the consolidated group.219 in amorient, inc. v. commissioner,220 the taxpayer incurred a consolidated net operating loss that was allocable in part to separate return years of a corporation that had been a subchapter s corporation prior to acquisition by the consolidated group. the tax court held that the portion of the taxpayer’s consolidated net operating loss allocable to separate return years of the former s corporation was to be carried back to the s corporation’s separate return year even though deduction of net operating losses by an s corporation is barred by 213. id. at 1035-36. 214. reg. § 1.1502–15. 215. built-in loss under section 382(h) includes deduction items that are attributable to a srly but which are accounted for in a consolidated return year. i.r.c. § 382(h)(6)(b). 216. reg. § 1.1502–15. 217. reg. § 1.1502–15(g). 218. reg. § 1.1502–21(b)(1). 219. reg. § 1.1502–21(b)(2). 220. 103 t.c. 161 (1994). 176 florida tax review [vol. 12:3 section 1373(d). the tax court justified its result in part on its conclusion that losses that are not deductible in carryback separate return years of the s corporation are to be carried forward to a year when either the former s corporation or the consolidated group can utilize the loss. the regulations partially addresses the issues raised in amorient by providing that the portion of a consolidated net operating loss that is apportioned to a member and carried back to a separate return year of the member may not be carried back to an equivalent or earlier year of the consolidated group.221 likewise, if a consolidated net operating loss is carried forward to a separate return year of a member of the group, that carryforward loss may not be used in an equivalent or later consolidated return year of the group.222 xi. foreign subsidiaries a. generally foreign affiliates of a u.s consolidated group are not included in the consolidated return.223 the income of a foreign corporation with u.s. shareholders generally is not taxed to the shareholder(s) until it is repatriated, either as a dividend or a liquidation distribution. because of the foreign tax credit, this treatment is of major significance only when the foreign corporation is in a country with tax rates lower than the u.s. rates. if the country of the foreign corporation has tax rates lower than the u.s., the deferral effected by the general rule is limited by the “subpart f” rules.224 a u.s. shareholder (including individuals as well as corporations) that owns ten percent or more of the total combined voting power of all classes of voting stock of a controlled foreign corporation (cfc) must include in income each year its pro rata share of the cfc’s “subpart f income.”225 a cfc is a foreign corporation in which more than 50 percent of either (1) the total combined voting power of all classes of voting stock or (2) the total value of all stock, is owned by u.s. shareholders on any day during the taxable year of the cfc.226 a u.s. corporate shareholder is entitled to a foreign tax credit for the foreign income taxes it is deemed to 221. reg. § 1.1502–21(b)(2)(i). 222. reg. § 1.1502–21(b)(2)(i). 223. i.r.c. § 1504(a)(1)(a) and (b). 224. i.r.c. §§ 951 – 964. 225. i.r.c. §§ 951(a) and (b). section 958(a) requires that indirect ownership be taken into account and reg. § 1.958(b) applies constructive ownership rules for determining the amount of stock owned by a u.s. shareholder. 226. i.r.c. § 957(a). section 958(a) requires that indirect ownership be taken into account, and reg. § 1.958(b) applies constructive ownership rules for determining the amount of stock owned by a u.s. shareholder. 2012] understanding consolidated returns 177 have paid on the subpart f income (and must include the amount of the deemed foreign tax credit in income). the u.s. shareholder’s basis in the cfc’s stock is increased by the amount of income taxed under subpart f and decreased by subsequent distributions of such previously taxed income. the primary category of income taxed under subpart f is “foreign base company income.”227 speaking very generally, subject to a variety of special rules and limitations, foreign base company income includes income, reduced by properly allocable deductions, in the following five categories: (1) foreign personal holding company income (fphci). this income consists of (i) dividends, interest, rents and royalties;228 (ii) net gains from the sale or exchange of property that produces dividends, interest, rents and royalties or that does not produce any income; (iii) gains from certain commodities transactions; (iv) gains from certain foreign currency transactions; and (v) income that is the equivalent of interest. (2) foreign base company sales income. this category encompasses income from property purchased from or sold to a related person if the property is manufactured outside and sold for use outside the cfc’s country of incorporation. if, however, the cfc purchases property from a related party but sufficiently transforms the property to constitute “manufacturing” by it, the income from the sale of the property is not foreign base company sales income.229 (3) foreign base company services income, which is income derived from performing services outside the cfc’s country of incorporation for or on behalf of a related person. (4) personal services contract income.230 (5) foreign base company oil related income. if the gross foreign base company income of a cfc for the taxable year is less than the lesser of 5 percent of its total gross income or $1 million, the cfc is treated as having no foreign base company income. conversely, if the gross foreign base company income for the taxable year exceeds 70 percent of the cfc’s gross income, then all of its gross income, less allocable deductions, is considered foreign base company income. if a taxpayer (generally the u.s. parent) establishes that the income was subject to an effective tax rate in a foreign country that exceeded 90 percent of the 227. i.r.c. §§ 952(a) and 954. 228. reg. § 1.954–2. 229. reg. § 1.954–3(a)(4). 230. reg. § 1.954–4. 178 florida tax review [vol. 12:3 maximum marginal u.s. corporate tax rate — which currently calculates to 31.5 percent — the income is not foreign base company income. section 951(a)(1) also currently taxes u.s. shareholders on the amount determined under section 956, which generally speaking is the earnings and profits of the cfc invested in u.s. assets. this prevents a cfc that had no subpart f income to avoid u.s. taxation on its income but nevertheless makes that income available to its u.s. shareholders. the subpart f regime has been significantly undermined by the “check-the-box” entity classification rules.231 b. anti-inversion rules section 7874, enacted in 2004, is intended to combat “inversion” transactions, which are designed to escape subpart f by moving a widelyheld u.s. multinational corporation’s place of incorporation abroad. (the u.s. applies a place of incorporation test to determine corporate residency.) if 80 percent or more of the interests in the new foreign parent created in the inversion are owned by former shareholders of the u.s. corporation, the foreign parent (statutorily termed a “surrogate foreign corporation”) continues to be treated as a u.s. corporation. treaty provisions that would prevent this treatment are expressly overridden. as a result, subpart f continues to apply to the group and the parent is taxed on any foreign source income it earns directly. if the former u.s. shareholders own at least 60 percent but less than 80 percent of the new foreign parent, its status as a foreign corporation will be respected but the inverted u.s. corporation cannot use any of its tax attributes, such as net operating loss carryforwards or foreign tax credits, to offset the corporate level “inversion gain” realized on the inversion transaction.232 inversion gain includes any gain realized on the inversion or any gain realized on the transfer of assets to a related foreign inversion, including royalties on licensed intangibles, for a ten-year period after the inversion transfer. neither of these rules applies, however, if the foreign corporation has substantial business activities in the country of its incorporation. 231. see lawrence lokken, whatever happened to subpart f u.s. cfc legislation after the check-the-box regulations, 7 fla. tax rev. 185 (2005). 232. i.r.c. § 7874(a). 2012] understanding consolidated returns 179 c. foreign tax credit 1. direct credit u.s. citizens and corporations can either deduct foreign income taxes under section 164 or claim a foreign tax credit (ftc) against their u.s. income tax liability under section 27, calculated under the rules in sections 901 through 908 and 960.233 the amount of the ftc is limited to the amount of u.s. tax imposed on the income.234 if the foreign tax is imposed at a higher rate than the u.s. rate, the ftc is based on the tax at the u.s. rate. the ceiling on the amount of the ftc can be expressed by the following formula: u.s. tax liability x foreign source taxable income worldwide taxable income excess ftcs above the ceiling can be carried back one year and forward ten years.235 the ftc is limited to the amount of u.s. tax imposed on foreign source income. the limitation on the ftc is imposed separately on two categories of foreign source income — (1) the general income category, and (2) the passive income category. the passive income category includes dividends from foreign corporations in which a u.s. corporate shareholder owns less than ten percent of the stock,236 interest, annuities, certain rents and royalties and net gains from sales of assets that produce passive income. the general income category includes all income that is not passive category income.237 dividends, interest, rents and royalties from a corporation in which a u.s. corporate shareholder owns at least ten percent of the stock or from a controlled foreign corporation (cfc) are assigned to the proper basket by “looking through” to the character of the underlying income of the foreign corporation from which the payment was made. 233. the credit applies only to foreign income, war profits, and excess profits taxes. i.r.c. § 901(b)(1). special limitations apply to the credit with respect to foreign mineral income. i.r.c. § 901(e). 234. i.r.c. § 904. 235. i.r.c. § 904(c). 236. section 901(k) disallows the foreign tax credit for withholding taxes on dividends if the stock is held for 15 days or less. 237. special rules are provided for high-taxed income (i.r.c. § 904(d)(2)(f)) and financial services income (i.r.c. § 904(d)(2)(c)) 180 florida tax review [vol. 12:3 2. indirect credit foreign income taxes paid by a foreign corporation are not normally creditable by a u.s. shareholder of the foreign corporation. however, if a u.s. corporation directly owns at least 10 percent of the voting stock of a foreign corporation from which it receives a dividend, the u.s. corporation is deemed to have paid the foreign income taxes paid by the subsidiary attributable to the dividend.238 as a result, the u.s. corporation is entitled to a foreign tax credit under section 901 for those taxes. to treat repatriated subsidiary profits in the same manner as profits from direct foreign branch operations for purposes of the foreign tax credit, section 78 requires the u.s. parent to include the amount of the credit in its income. the indirect credit also applies with respect to dividends paid by second, third, fourth, fifth and sixth tier foreign corporations if each respective parent meets the 10 percent voting stock requirement, provided the u.s. parent has indirect ownership in each subsidiary of at least five percent. for foreign corporations below the third tier, the corporation must be a cfc for the indirect credit to be available. d. dual consolidated losses section 1503(d) denies the use of the losses of one u.s. corporation by another affiliated u.s. corporation where the loss corporation is also subject to the income tax of a foreign country. section 1503(d) was enacted to prevent the double counting of net operating losses resulting from a member of a consolidated group being a u.s. corporation for u.s. tax purposes and simultaneously being a domestic corporation of another country for purposes of that country’s tax laws (i.e., a dual resident corporation). if the consolidation regime of a foreign country generally allows losses of a dual resident corporation to be offset against income of affiliated corporations, a net operating loss of the corporation is a dual consolidated loss, even if the foreign country’s equivalent of the dual consolidated loss rule disallows the loss. however, the regulations permit a method by which the loss can be allowed pursuant to an agreement with the other country that permits the loss to be deducted in only one country.239 a “separate unit” of a u.s. corporation is treated as a dual resident corporation. separate entities include foreign branches, partnership interests and trust interests, as well as hybrid entities. a hybrid entity separate unit is an entity that is treated as a disregarded entity or partnership for u.s. tax 238. i.r.c. § 902. 239. reg. § 1.1503–2(g)(1). 2012] understanding consolidated returns 181 purposes but under the laws of a foreign country is taxed as a corporation either on its worldwide income or on a residence basis.240 foreign entities that are per se corporations are listed in the treasury regulations.241 the following are among the many others included as per se corporations: belgium, societe anonyme; france, societe anonyme; germany, aktiengesellschaft; italy, societa per azioni; ireland, public limited company; luxembourg, societe anonyme; netherlands, naamloze vennootschap; norway, allment aksjeselskap; spain, sociedad anonima; sweden, publica aktiebolog; switzerland, aktiengesellschaft; united kingdom, public limited company. for foreign entities with limited liability that are not per se corporations, the default rule is that the entity is a corporation unless it elects to be a partnership or disregarded entity.242 for u.s. tax purposes a foreign entity lacking in limited liability is treated as a partnership if it has two of more members or as disregarded if it has only one owner, unless the foreign entity elects to be treated as a corporation.243 xii. conclusion the u.s. consolidated return rules are fearsomely complex, but they need to be that complex to so thoroughly implement the “single entity” approach to dealings within the group, which attempts to treat the several members of a consolidated group in the same manner as divisions of a single corporation. it has been critical to the successful implementation of the “single entity” approach that congress has left the development of the rules, other the definition of an “affiliated group” eligible to elect to file a consolidated return, entirely to the treasury department and internal revenue service. moreover, the one instance in which a court held a consolidated return regulation to be invalid on the grounds that it was inconsistent with a provision of the internal revenue code244 prompted congress to amend section 1502 specifically to provide that the consolidated return regulations may contain “rules that are different from the provisions . . . that would apply if such corporations filed separate returns.” there is, however, one glaring statutory weakness in the consolidated return regime. that weakness is the exclusion of foreign affiliates in section 1504(b)(3) from the consolidated return. the exclusion of foreign affiliates form the consolidated return appears to have been as much an accident of the early history of the development of various code 240. reg. § 1.1503–2(c)(3) and (4). 241. reg. § 301.7701–2(b)(8)(i). 242. reg. § 301.7701–3(b). 243. reg. § 301.7701–3(b). 244. rite-aid corp. v. united states, 255 f.3d 1357 (fed. cir. 2001) (invalidating former reg. § 1.1502-120 as manifestly contrary to section 165). 182 florida tax review [vol. 12:3 provisions dealing with related corporations as it was a carefully considered policy decision. from a policy perspective, it would be much better to included foreign affiliates in the consolidated group.245 that issue, however, has become part of the much larger debate on whether the united states should move from its quasi-world-wide-taxation / semi-territorial tax system to either a robust world-wide-taxation regime or to a purely territorial regime.246 subject to legal constraints on the ability of the revenue department in other countries to promulgate detailed regulations, the u.s. consolidated return regulations should be examined carefully by any country seeking to implement or improve a consolidated corporate tax return regime. of course, for a country that provides a participation exemption for gains on the sale of stock of a subsidiary, rules analogous to many of the stock basis adjustment rules in the u.s. consolidate corporate tax return regulations would be unnecessary.247 conversely, for a country seeking to deal with the proposed eu directive on the common consolidated corporate tax base (ccctb),248 the omission from u.s. consolidated corporate tax returns of foreign affiliates leaves a hole in the u.s. regime as a model. 245. see jasper l. cummings, consolidating foreign affilaites, 11 fla. tax rev. 143 (2011). 246. see clifton fleming, robert j. peroni & stephen e. shay, worse than exemption, 59 emory l.j. 79 (2009). 247. for discussion of participation exemptions, see hugh j. ault & brian j. arnold, comparative income taxation, 372-75 (2d ed. 2004); arturo requenez ii & timothy shuman, u.s. private equity funds making cross-border investments, 1152-53 (practicing law institute 2008). 248. see european commission, proposal for a council directive on a common consolidated corporate tax base (ccctb), http://ec.europa.eu/taxation_ customs/resources/documents/taxation/company_tax/common_tax_base/com_2011_ 121_en.pdf; eurpoean commission, taxation and customs union, http://ec.europa. eu/taxation_customs/taxation/company_tax/common_tax_base/index_en.htm. understanding consolidated returns martin j. mcmahon, jr.0f* iii. eligibility and includible corporations a. stock ownership b. includible corporations iv. consolidated taxable income v. formation of a corporate subsidiary a. generally b. receipt of other property c. assumption of transferor’s debts d. transfers to foreign corporations vi. dividend distributions: fundamental rules a. generally b. dividends in kind vii. investment adjustments a. stock basis b. section 357(c) situations c. unified loss rules 1. generally 2. the basis redetermination rule 3. the basis reduction rule 4. the attribute reduction rule 5. worthlessness viii. earnings and profits ix. intercompany transactions a. transactions between members of a consolidated group 1. generally 2. matching intercompany items related to deferred gains and losses 3. acceleration of deferred gains and losses b. distributions with respect to the stock of a member 1. section 301 distributions 2. intercompany distributions of appreciated and depreciated property 3. liquidation of a subsidiary c. transactions in which a member acquires stock of another member d. transactions in which a member acquires its own stock e. transactions in which a member acquires debt of another member f. anti–abuse rules x. net operating loss carryovers a. generally b. application of section 382 to consolidated groups c. separate return limitation year 1. generally 2. reverse acquisition 3. built-in deductions 4. post acquisition losses of an acquired member xi. foreign subsidiaries a. generally b. anti-inversion rules c. foreign tax credit 1. direct credit excess ftcs above the ceiling can be carried back one year and forward ten years.235f 2. indirect credit d. dual consolidated losses xii. conclusion subject to legal constraints on the ability of the revenue department in other countries to promulgate detailed regulations, the u.s. consolidated return regulations should be examined carefully by any country seeking to implement or improve a consol... login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 11 2011 number 5 defining income by alice g. abreu* richard k. greenstein i. defining income that is taxed...................... ....... 300 a. the definition expands .......................... 301 b. the definition contracts ......................... 307 c. the definition fragments ................................ 312 ii. definitions: a jurisprudential detour ................... 321 a. the quest for scientific precision ................... 321 b. aptness ..................................... 325 1. controversial vs. easy applications of the law.........327 2. the aptness of a legal definition... ................ 329 3. rules and standards ....................... 330 iii. aptness in the tax law...................................333 a. values in the tax law................... ........ 334 b. the importance ofrules ................... ....... 336 c. aptness and glenshaw glass............... ............ 339 iv. conclusion ................................................ 348 * alice g. abreu is james e. beasley professor of law and richard k. greenstein is professor of law at temple university's beasley school of law. we want to express our deep appreciation to professor john prebble of the victoria university of wellington, new zealand and dr. marco greggi, of the universita di ferrara, ferrara, italy, for organizing the grapperhaus colloquium on jurisprudential perspectives on taxation law in ferrara, italy in september, 2010 and inviting us to present a draft of this article there. the colloquium inspired our collaboration and the reactions and comments of the participants in the colloquium contributed meaningfully to the development of the article. we are also grateful for the suggestions and challenging questions posed by our temple colleagues at two workshops. we refined our analysis as a result of extensive discussions with our temple colleagues mark anderson, jane baron, scott burris, jeffrey dunoff, david hoffman, nancy knauer, andrea monroe, muriel morisey, and bill woodward, as well as with steve cohen, cliff fleming, kristin hickman, and marty mcmahon. finally, it is impossible to overstate the contribution of our students and research assistants, albert antonelli, allie misner, lane schiff, and ryan trifelitti, from whose insights and dedication we benefitted incalculably. all errors, omissions, and deficiencies remain ours. 295 florida tax review more than half a century ago in commissioner v. glenshaw glass, the supreme court defined "income," as used in section 61 of the internal revenue code, as "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion."' the code narrows the scope of income by providing for specific exclusions but, outside of those exclusions, the code's own, self-referential definition-"gross income means income from whatever source derived" 2 seems to confirm the broad scope of the definition.3 the breadth of the glenshaw glass definition appears to be nearly co-extensive with the haig-simons definition of income, which is widely accepted as providing the theoretical foundation for the income tax.4 accordingly, many tax professionals interpret the language in section 61 and glenshaw glass solely in light of the economic principles reflected in the haig-simons definition.5 the analytical structure for determining what is 1. comm'r v. glenshaw glass, 348 u.s. 426, 431 (1955). professor joseph dodge has observed that the court in glenshaw glass "does not purport to 'define' the term 'income.' it only 'translates' the facts of glenshaw-goldman into the legally relevant form of 'realized economic gain of the taxpayer."' joseph m. dodge, the story of glenshaw glass: towards a modern concept of gross income, in tax stories 18 (paul l. caron ed., 2d ed. 2009) [hereinafter glenshaw glass story]. although professor dodge is correct that the court in glenshaw glass does not adopt a formulation that says "we define income as . . . ," courts and scholars following glenshaw glass have uniformly taken the formulation announced in glenshaw glass to be the definition of income and we do likewise here. the title of professor dodge's chapter in tax stories, and indeed, its placement as the first chapter in that book, suggests that we are not alone. 2. section 61 provides: "except as otherwise provided in this subtitle, gross income means income from whatever source derived, including (but not limited to) the following items . . . ." i.r.c. § 61. the list of specific inclusions contains principally receipts that are fairly obviously income, such as compensation for services. this formulation is not tautological if gross income is viewed as "merely a phrase indicating a step in the mathematical computation" for which the term "statutory base" could well be substituted. stanley s. surrey & william c. warren, the income tax project of the american law institute: gross income, deductions, accounting, gains and losses, cancellation ofindebtedness, 66 harv. l. rev. 761, 771 (1953). 3. the regulations shed a bit of light by including additional specific items, such as some fringe benefits and treasure trove, treas. reg. § 1.61-14, but despite the tremendous and increasing girth of the code, the glenshaw glass formulation remains the starting point for defining income. 4. henry c. simons, personal income taxation 50 (1938). the glenshaw glass definition differs from haig-simons because glenshaw glass requires realization, but its inclusion of all accessions makes it otherwise just as broad as haig-simons. see infra notes 45-46 and accompanying text. 5. in addition, as zoe and john prebble have noted, "[t]here is a strong tradition of construing tax statutes literally," zoc prebble & john prebble, the 296 [vol. 11:5 defining income income appears clear and is generally treated as immutable. the analysis begins with the broad mandate of section 61 and glenshaw glass. as long as there is a realized accession in the economic sense within the taxpayer's dominion, glenshaw glass would seem to provide that there is income unless, pursuant to the very first words of section 61, there is an exclusion in the statute. from the time they are introduced to the tax law, students are taught this analytical structure, and by the time they become practitioners and then judges or scholars, it is second nature. the apparent breadth of the glenshaw glass formulation seems to give the internal revenue service (irs) wide authority to tax accessions to wealth. nevertheless, the irs has sometimes taken the position that a particular accession is income, only to be rebuffed by a trial or appellate court and then abandon its position.7 other times the irs has chosen not to take the position that a particular accession is income at all.8 for example, courts and the irs have concluded that "imputed" income is not income even though nothing in the glenshaw glass definition specifically excludes it. 9 similarly, courts have held that neither meals and lodging provided by an morality of tax avoidance, 20 creighton l. rev. 101, 123 (2010), and in this context there would seem to be scant reason to do otherwise because the statutory language seems to further the policies that underlie the tax law. for an important dissenting view, which will be discussed at greater length below, see lawrence a. zelenak & martin j. mcmahon, jr., taxing baseballs and other found property, 84 tax notes 1299 (1999). 6. even the suggestion of a different approach to defining income is so anathema to tax scholars that it was described as an "untenable position" that would result in "bittker's quagmire" during the late 1960s when a (ctb) was offered as the foundation for tax reform. boris i. bittker, comprehensive income taxation: a response, 81 harv. l. rev. 1032, 1041 (1968) [hereinafter bittker's ctb response]; see infra part ii. more recently it has been labeled "incoherent." joseph m. dodge, accessions to wealth, realization of gross income, and dominion and control: applying the "claim of right doctrine" to found objects, including record-setting baseballs, 5 fla. tax rev. 685, 691 (2000) [hereinafter dodge, claim of right]. indeed, professors zelenak and mcmahon, whose suggestion that the analysis of what is income should begin with cash, bringing in property in kind only as necessary to prevent avoidance, prompted the charge of incoherence, acknowledge their own late-coming to that position. zelenak & mcmahon, supra note 5, at 1301 n.13. 7. see benaglia v. comm'r, 36 b.t.a. 838 (1937); gotcher v. united states, 401 f.2d 118 (5th cir. 1968). 8. for example, the irs has not tried to tax support, the value of an expensive lunch provided by a lawyer to a client, or the value of record breaking baseballs caught by fans. see infra notes 48, 52, 90-94 and accompanying text. 9. even professor dodge, who asserts the incoherence of the zelenak and mcmahon approach, acknowledges that psychic benefits and what he refers to as "hypothetical" or imputed income are not income. see dodge, claim of right, supra 2011] 297 florida tax review employer on the employer's business premises for the convenience of the employer'o nor an expense-paid trip to germany to inspect vw facilities provided to a vw dealer to induce him to make an additional investment in the dealership" were income, and the irs acknowledges that cash welfare payments are not income either.12 sometimes, as in the case of "swag bags" given to nominees and presenters at the academy awards, the irs has taken a position consistent with the apparent breadth of glenshaw glass,13 but other times, as in the case of less valuable free samples received by ordinary people, child support, government transfer payments, government-funded benefits (such as public education and medical care), or even record-breaking baseballs caught by baseball fans, it has not.14 while such instances reflect the irs's and the courts' reluctance to attempt to implement the full apparent breadth of the glenshaw glass definition of income, neither the courts, nor tax scholars, nor the irs have articulated a comprehensive theory that explains all of these specific outcomes.' 5 perhaps in reaching these conclusions the courts and the irs are being lawless, deliberately ignoring the apparent mandate of glenshaw glass. or maybe they simply do not understand the breadth of the glenshaw glass definition and are therefore incompetently failing to effectuate it. note 6, at 692-93. professors zelenak and mcmahon agree and indeed make the non-inclusion of imputed income the centerpiece of their claim for non-inclusion of found property. zelenak & mcmahon, supra note 5, at 1304-05. every major tax casebook and treatise acknowledges that imputed income is not income for tax purposes. see, e.g., dodge et al., federal income tax: doctrine, structure and policy 226, 228-31 (3d ed. 2004); michael j. graetz & deborah h. schenk, federal income taxation, principles and policies 130-33 (6th ed. 2009); klein et al., federal income taxation 63-69 (14th ed. 2006); paul r. mcdaniel et al., federal income taxation 83-86 (6th ed. 2008); richard schmalbeck & lawrence zelenak, federal income taxation 121-27 (2d ed. 2007). for an analysis of one possible exception to this-income from interest free loans-see infra notes 73-77. 10. benaglia, 36 b.t.a. 838. 11. gotcher, 401 f.2d 118. 12. notice 99-3, 1999-1 c.b. 271 (tanf payments are not gross income); rev. rul. 71-425, 1971-2 c.b. 76 (state welfare payments are not gross income). see infra note 50 and accompanying text. 13. see infra note 82 and accompanying text. 14. see infra notes 48, 50, 90-94 and accompanying text. 15. professors zelenak and mcmahon come close to articulating such a theory when they propose that the analysis of what is income should "start with the observation that basically what the income tax is about is the inclusion of the receipt of cash in gross income, and then describe the ways in which section 61 extends beyond cash receipts." zelenak & mcmahon, supra note 5, at 1304 (footnotes omitted). 298 [vol. 11:5 defining income we believe that neither lawlessness nor incompetence explains the apparent inconsistency between the breadth of the glenshaw glass definition and the narrower interpretation adopted by the courts and the irs. we subscribe, rather, to a third explanation: that the rulings of the courts and the irs reflect a widespread uncertainty and disagreement about what counts as the kind of "accession to wealth" that should be taxed-that is, widespread uncertainty and disagreement about what the language in the internal revenue code and glenshaw glass means. our thesis is that what explains the inconsistency and the uncertainty and disagreement is that economics-at least haig-simons economics-is not everything. although the glenshaw glass definition of income is largely consistent with the haig-simons definition,16 and thus with economics, it fails to take into account other values that count for the people who are subject to the tax and must buy into it, at least to some degree, for the tax to be administrable.17 the irs, the agency charged with administering the tax law, sometimes understands this. while the irs rarely acknowledges these noneconomic values explicitly-perhaps for fear of unmooring tax from economics and being left rudderless on a turbulent sea-it does give itself some slack, taking into account competing, non-economic values, and finding no income when glenshaw glass could be read to suggest otherwise. and in those instances when the irs misunderstands the competing values, courts or congress provide the slack, rebuffing the irs without explicitly recognizing the departure from strict economic values and thereby retaining an anchor to prevent excessive drift. the task before us in this article, therefore, is to demonstrate that we can make theoretical sense of what is actually treated as income by taking into account both economic and noneconomic values. we begin in part i by exploring the difficulty of articulating a definition of income that describes with precision the universe of accessions which are actually subject to tax. we trace the expansion of the positive definition of income, culminating in glenshaw glass, and then show the difference between the apparent breadth of that definition and what the irs and sometimes congress and the courts are actually willing to tax. in part ii we consider possible explanations for this incongruity, focusing on the idea of "aptness." the aptness of a legal definition describes the extent to which it reflects the values that are important in the relevant field, which in turn minimizes the number of controversial applications of the definition. 16. see supra note 4 and accompanying text. 17. for discussion of the importance of congruence between the values of those subject to laws and the values reflected in those laws, see, e.g., john h. robinson & paul m. darley, the utility ofdesert, 91 nw. u. rev. 453, 456 (1997). 2011] 299 florida tax review armed with this concept, we return in part iii to the glenshaw glass definition and ask whether it is apt. since an apt definition should reflect the values that define a field, we attempt to identify the important values in tax and determine whether those values converge in the glenshaw glass definition. here we encounter a difficulty because outside of a few categories of accessions, such as the receipt of cash salary, there is little society-wide consensus about what ought to be subject to tax, reflecting, in turn, a lack of consensus about what values ought to determine what is taxed. hence, the glenshaw glass definition proves not to be apt in the expected sense, for it fails to reflect tax values directly. nonetheless, this apparent defect in the definition is its virtue. its very breadth makes it possible for a variety of values-including noneconomic values-to compete. and the irs, with its vast authority to administer the tax law, is left free to explore what values are relevant, as well as their relative importance, on a case-by-case basis. in the absence of legislative action, the irs substitutes its view for the non-existent consensus and then awaits the judicial, congressional, or popular response. the irs serves as the taste tester for society's views." accordingly, we conclude that the glenshaw glass definition of income is apt after all, but in a highly unusual way. instead of reflecting by its own terms tax law's defining values, it gives the irs the flexibility to navigate the shoals of social opinion regarding income taxation, thereby both providing stability in the administration of the income tax and permitting the evolution of a concept of income that serves the important values in taxation. the candidates for these values, as we will show, include economic values, but also include a variety of noneconomic values. and if the irs (with occasional assistance from the courts and congress) does its job well-if its ongoing determination of what is income meets with general political and social approval-then glenshaw glass turns out to be apt, after all. i. defining income that is taxed in this part we explore the dramatic expansion of the definition of income in 1955's glenshaw glass decision, in contrast to the narrow approach taken by the court in eisner v. macomber over 30 years earlier. but in the more than half century since glenshaw glass, the irs has treated many accessions to wealth, clearly realized and under the taxpayer's dominion, as nontaxable. we describe this contraction of the glenshaw glass definition to show that the definition of income as administered by the irs is neither as broad nor as straightforward as glenshaw glass appeared to promise. 18. of course, if the irs gets it wrong, it is subject to correction by the courts or the legislature. 300 [vol. 11:5 defining income a. the definition expands that the glenshaw glass definition of income seems so broad is not surprising. its apparent breadth likely reflects its source (a supreme court opinion interpreting a vacuously worded text), its place in the history of the income tax (after the income tax evolved from a class tax to a mass tax during world war ii), and perhaps even the scholarly acceptance of what is now commonly referred to as the haig-simons definition of income following the publication of henry simons' book in 1938.19 the glenshaw glass definition stands in marked contrast to the much narrower definition the court had announced in eisner v. macomber.20 in macomber the court had to decide whether a pro-rata stock dividend was income. in holding that it was not, the court defined income as "the gain derived from capital, from labor, or from both combined," and emphasized that the gain be "derived," or severed, from the property.2' by requiring severance the court gave birth to the realization requirement, which remains part of the definition of income today.22 despite the longevity of the realization requirement, the first part of the macomber definition, which limited income to the "product of labor or capital or both combined" was destined for a different fate. more than three decades after it decided macomber the court in glenshaw glass had to decide whether punitive damages were income. unlike compensatory damages, punitive damages bear no relationship to the labor or capital of the plaintiff but are paid solely to punish the defendant. hence, as to the plaintiff, they are a windfall. because windfalls do not proceed from the recipient's labor or capital or both combined, the punitive damages received by glenshaw glass could not be income under the macomber definition, and the lower courts had consistently so held.23 to treat them as income the court needed to redefine the term. the court's decision in glenshaw glass must have come as quite a surprise to the lower federal courts, whose opinions betrayed little doubt that they were reaching the correct result in concluding that windfalls generally, 19. see supra text accompanying note 4. 20. eisner v. macomber, 252 u.s. 189 (1920). 21. id. at 193. (citing earlier cases for its definition). 22. see infra part iii.b. 23. the taxpayer had won not only in the third circuit, which decided both glenshaw glass and william goldman theatres together, comm'r v. glenshaw glass co., 211 f.2d 928 (3d cir. 1954), rev'd, 348 u.s. 426, (1955) but in the tax court as well. see glenshaw glass co. v. comm'r, 18 t.c. 860 (1952), aff'd, 211 f.2d 928; william goldman theatres, inc. v. comm'r, 19 t.c. 637 (1953). 2011] 301 florida tax review and punitive damages specifically, were not income.24 the third circuit reasoned that the court had "never expressly departed from the definition of income of eisner v. macomber," had "reiterated it fairly recently" and had even "expressly declined to overrule" it.25 indeed, the third circuit seemed shocked that the "government in substance asserts that any money or property coming into the hands of any person is taxable as income unless specifically exempted."2 despite the court's apparent attraction to the symmetry that taxing punitive damages would produce (it would remove the difference in the taxation of compensatory and punitive damages), it was unwilling to depart from existing case law. it concluded that "if such a result is to be achieved after nearly two decades it should be effected by the supreme court and not by this tribunal."27 in holding for the taxpayer the third circuit did as the court had done in macomber and supported its reading of existing case law by considering the ordinary meaning of the term. as it explained, we concede that no definition is too helpful, and that the decisions relating to income tax law contain charts rather than definitions . . . . but it should be borne in mind that in eisner v. macomber, albeit where severability was the primary issue, the supreme court said, that "only a clear definition of the term 'income,' as used in common speech" was required. we do believe that a "windfall"-and the payments at bar were "windfalls"-would not be regarded as "income" within the terms of common speech. certainly the payments to the taxpayers cannot fairly be regarded as products of capital or labor. we believe that the ordinary man regards income as something which comes to him from what he has done, not from something which is done to him. this is perhaps an over-simplification but we are of the opinion that the ordinary man using terms of common speech would not regard punitive damages as "income. 24. professor dodge, who has thoroughly studied the court's glenshaw glass decision, notes that the court's opinion in glenshaw glass does not seem to have been perceived as seismic at the time. dodge et al., supra note 9, at 31-32. 25. glenshaw glass, 211 f.2d at 933. 26. id. at 932. 27. id. at 934. 28. id. at 933. [vol. 11:5302 defining income the third circuit thus followed macomber not only by applying its definition of income but also by hewing to its methodology: reference to common understanding of what should be taxed.29 the tax court, which had also held for the taxpayer in both glenshaw glass and its companion case, had seemed even more certain of its conclusion. 30 nevertheless, not only did the court reverse the judgments of the tax court and the third circuit, but it adopted a definition of income that went far beyond that which courts had applied in the three decades following macomber. with the benefit of hindsight, it is not surprising that the court in glenshaw glass defined income as it did. the glenshaw glass definition preserves the realization requirement but is broad enough to encompass windfall gains of the sort at issue in that case. that it may have been excessively broad might not have concerned the court because the statutory formulation it was construing was also very broad. indeed, in quoting the statutory formulation the court emphasized that income included "gains or profits and income from any source whatever" by italicizing that specific language, 31 and explaining that "the court has given a liberal construction to this broad phraseology in recognition of the intention of congress to tax all gains except those specifically exempted." 3 2 that the glenshaw glass court took its cue from the breadth of the statutory definition of income seems reasonable in light of the evolution of the tax law from the time of macomber in 1920 to glenshaw glass in 1955. at the time of macomber, the constitutional income tax was barely seven years old and tax laws were contained in yearly enactments. although there was a brief period of growth in the income tax occasioned by the need to fund world war i, the income tax that the macomber court faced was still a class tax of relatively narrow application." by the time the court decided glenshaw glass in 1955, congress had not only enacted the 1939 code, but in the time during and after world war ii the income tax had grown so much that a second codification project was necessary, culminating in the 1954 29. the macomber definition of income came from dictionaries. eisner v. macomber, 252 u.s. 189, 207 (1920). 30. see glenshaw glass co. v. comm'r, 18 t.c. 860, 868 (1952), affd, 211 f.2d 928 (3d cir 1954), rev'd, 348 u.s. 426 (1955); see also william goldman theatres, inc. v. comm'r, 19 t.c. 637 (1953) (with identical case history). 31. comm'r v. glenshaw glass co., supra note 1, at 429 (1955). 32. id. at 430. 33. see carolyn c. jones, class tax to mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685 (1988) (describing the growth in the income tax from a levy that affected only those at the very top of the income distribution at its inception to a levy of general application as a result of the need to fund world war ii). 2011] 303 florida tax review code, the structure and organization of which persist to this day.34 during the 1940s marginal tax rates skyrocketed, wage withholding was instituted, and the income tax grew from a levy on the few (a class tax) to a substantial exaction on the many (a mass tax). in that context, expanding the definition of income to correspond with the expanding importance of income taxation was sensible. there was only one dissent from the court's decision: justice 35 douglas, dissenting without opinion. the definition adopted by the court in glenshaw glass would also have seemed reasonable to tax scholars. tax theory derives from public finance economics, so a definition of income grounded in economics would seem natural. by the early 1950s, when glenshaw glass was making its way through the courts, the haig-simons definition of income had become the centerpiece of the scholarly lexicon, following henry simons's 1938 publication of the famous book in which he refined robert haig's definition of income.36 simons wrote that "[p]ersonal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question."37 this is an exceedingly broad definition, bringing within its grasp all accessions, whether consumed or saved. its breadth allows it to serve the goal of raising maximum revenue while also being maximally equitable and efficient and therefore serving two important tax policy objectives. if all accessions are subject to tax then taxpayers who are similarly situated economically will be taxed similarly and the level of taxation can be adjusted to correspond to relative positions. this serves both horizontal and vertical equity. in addition, because such a definition does not distinguish between sources of income, it does not privilege income from certain activities, which is efficient. 34. although the current code is the internal revenue code of 1986, the change in appellation marks the importance of the tax reform act of 1986 rather than the creation of a new codification. 35. see, bernard wolfman et. al., dissent without opinion: the behavior of justice william 0. douglas in federal tax cases, 41-42 (1975); dodge et al., supra note 9, at 31 n.43. 36. simons, supra note 4. simons's work is generally acknowledged to be refinement and elaboration of "the basic concept advanced in robert m haig, the concept of income economic and legal aspects, in the federal income tax (robert m. haig ed. 1921)" and previously advanced by the german theorist georg von schanz. dodge, glenshaw glass story, supra note 1, at 36 n.65. the haigsimons definition was discussed in a number of scholarly pieces published in the early 1950s, including comment, taxation of found property and other windfalls, 20 u. chi. l. rev. 748, 753 n.23 (1953); surrey & warren, supra note 2, at 770. 37. simons, supra note 4, at 50. [vol. 11:5304 defining income even simons understood that his definition could not describe a workable tax base. one significant limitation on it comes from the absence of a realization requirement. absent a realization requirement a taxpayer's property would have to be valued periodically and the difference between the beginning and ending values would have to be computed in order to determine the amount of a taxpayer's income. even if the valuation were easy, as in the case of public traded securities, treating a positive difference as income would create persistent liquidity problems in the absence of cash. the realization requirement solves these problems. the glenshaw glass definition, which is the haig-simons definition limited by realization, is faithful to all three major tax policy objectives: equity, efficiency, and administrability. 40 it is neither too broad, as haigsimons alone would be, nor too narrow, as the macomber definition was. by retaining realization while moving to embrace haig-simons, the court may have gotten it just right. this probably did not happen by accident. unlike the macomber court, whose 1920 opinion predated even the publication of haig's work, the glenshaw glass court had reason to know of the haig-simons definition and of its importance as the theoretical underpinning of the modem income tax. although the court did not cite simons or refer to the haig-simons definition in its opinion, there is strong 38. id at 103-07. 39. see helvering v. horst, 311 u.s. 112, 116 (1940); cottage say. ass'n v. comm'r, 499 u.s. 554, 565 (1991); graetz & schenk, supra note 9, at 154; mcdaniel et al., supra note 9, at 70-71; fred b. brown, proposal to reform the like kind and involuntary conversion rule in light offundamental tax policies: a simpler, more rational, and more unified approach, 67 mo. l. rev. 705, 713 (2002); edward a. zelinsky, for realization: income taxation, sectoral accretionism, and the virtue of attainable virtues, 19 cardozo l. rev. 861, 863, 961 (1997); marjorie e. komhauser, the constitutional meaning of income and the income taxation of gifts, 25 conn. l. rev. 1, 20 (1992); but see david m. schizer, realization as subsidy, 73 n.y.u. l. rev. 1549, 1551 (1998) (suggesting that the realization requirement provides an important subsidy to savings); deborah h. schenk, a positive account of the realization rule, 57 tax l. rev. 355, 355-56 (2004) (noting "[t]here is a strong consensus in the literature that a normative income tax would tax changes in wealth as they accrue rather than as realized, but a realization requirement is nevertheless necessary due to the liquidity and valuation constraints of accrual taxation" but that the realization requirement is necessary not because of liquidity and valuation concerns, but because it is politically impossible to repeal since it aligns with a taxpayer belief that "paper gains" should not be taxed); see generally marjorie e. komhauser, the story of macomber: the continuing legacy ofrealization, in tax stories 93, 115 (paul l. caron ed., 2d ed. 2009). 40. see supra note 4. even professor dodge admits the closeness of the two definitions, as do other scholars. see, e.g., bankman et al., federal income tax: examples and explanations 40 (4th ed. 2005). 2011] 305 florida tax review reason to believe that simons's work and the central place of the haigsimons definition in economic theory were known to it. significantly, the government's brief in glenshaw glass cited two pieces of scholarship that make explicit reference to simons's work and to the haig-simons definition of income.41 one is a student note in the chicago law review that begins by quoting justice douglas, proclaiming in dissent that "eisner v. macomber dies a slow death," and goes on to advocate a broad definition of income, citing simons's work.4 2 the other is more significant. it is the report of the ali income tax project, for which stanley surrey and william warren served as reporters and which was published in an issue of the harvard law review in 1953.43 given the pedigree of the contributors to that project," not to mention the scholarly stature of the reporters,45 it is inconceivable that the justices and law clerks who read the government's brief would not have read the documents the government was citing in support of its position.46 the ali report criticized the macomber definition, classifying it as a "generalization rather than a definition," and then looked to the economists' definitions-specifically, to haig-simons-for assistance. we think that the similarity between the glenshaw glass definition and the haig-simons formulation is not coincidental and that similarity accounts for the continuing appeal of glenshaw glass. by being rooted in haig-simons the glenshaw glass definition ensures promotion of the important tax policy objectives of equity and efficiency, while the constraint of realization makes 41. brief for the petitioner at v, 14, 23, 25., comm'r v. glenshaw glass co., 348 u.s. 426, no. 199 (dec, 27, 1954). 42. comment, supra note 36, at 753. 43. surrey & warren, supra note 2. 44. the project was under the direction of the tax policy committee of the ali; that committee was composed of seven members, including two renowned tax scholars: dean erwin griswold of the harvard law school, and randolph e. paul of washington, d.c. see id at 766. 45. stanley surrey, the chief reporter, was then a professor at the harvard law school and william warren, the associate reporter, was then acting dean and professor of law at columbia law school. id. at 761. 46. professor dodge acknowledges that "'accession to wealth' sounds very much like 'increase in net wealth,' and to that extent, the statement from glenshawgoldman is congruent with the haig-simons concept of income." dodge, glenshaw glass story, supra note 1, at 36. nevertheless he asserts that "there is no evidence from the record that the court and counsel were particularly aware of the haigsimons concept." id. the government's citation of scholarly pieces that refer to the concept in its brief, and in the case of the ali project, discuss in detail its relationship to a legal definition of income, lead us to a different conclusion. given that both lower courts in glenshaw glass held for the taxpayer, it stands to reason that the court was aware of the scholarship that supported the government's position and that was cited to it, including the scholarship that advocated a broad concept of income consistent with emerging economic theory. 306 [vol. 11:5 defining income it administrable. in developing the glenshaw glass definition the court played goldilocks, trying the narrow definition (macomber), almost certainly considering the broader one (haig-simons), but developing a formulation that retained the best of both. the problem is that the definition cannot apply as written. b. the definition contracts as the third circuit had observed in its opinion in glenshaw glass, the breadth of the government's position, which prevailed in the supreme court, was such that any receipt could be income unless excluded. 47 because congress did not act to increase the specific exclusions in the code after glenshaw glass, it was possible for an amount that would not have been treated as income before glenshaw glass and that would not generally be thought to constitute the type of receipt that should be taxed to be treated as income and to remain in the tax base because no exclusion would rescue it from that fate. child support provides an example of such a receipt. a check for support wrung by a court from a recalcitrant father is an accession to the child's, or her mother's, wealth, and is clearly realized and within their dominion. hence, although it would not have been income under the macomber definition because it does not proceed from either the mother's or child's labor or capital, it fits the glenshaw glass definition.48 nothing in the statute excludes it. if it were true that the statutory pattern is that gross income is income, as defined by glenshaw glass, unless an exclusion applies, support would be income. yet, support other than alimony is not taxed.49 millions of dollars constituting support doubtless change hands every day and the irs has never 47. comm'r v. glenshaw glass co., 211 f.2d 928, 932 (3d cir. 1954), rev'd, 348 u.s. 426 (1955). 48. in gould v. gould, 245 u.s. 151 (1917), the court held that alimony was neither deductible to the ex-husband paying it nor includible in the income of the ex-wife receiving it. unlike the definition contained in the statute at the time of glenshaw glass, the definition of income at issue in gould was closer to the macomber definition in listing the kinds of items that were income. with respect to alimony § 71 now provides for a specific inclusion, but the very existence of the specific inclusion when the payor gets a deduction proves that the general rule would be exclusion. 49. section 71(c) provides that § 71(a), which includes alimony in the recipient's income, will not apply to child support, but that does not exclude child support from income-it only provides that it will not be included as alimony. nothing in § 71(c) precludes the inclusion of child support in income under § 61 in the absence of a specific exclusion. while some child and other support, such as spousal support, could be excluded from income as a gift, that rationale would not apply to support which is provided as a result of a legal obligation, not detached and 2011] 307 florida tax review asserted that such amounts are income. apparently, the irs does not interpret income as broadly as glenshaw glass seems to permit. the gap between the apparent breadth of the glenshaw glass definition of income and what is taxed grows if we consider other items. consider government transfer payments, such as those provided by the temporary aid to needy families (tanf) program, medical services, including hospitalization, provided by medicaid and medicare, and public education. such benefits, particularly those for medical care, could reach substantial amounts and, like support, appear to come within the glenshaw glass definition of income. in this case, as in the case of support, the statute is silent, but unlike the case of support the irs has provided some guidance by developing a so-called general welfare exclusion pursuant to which payments from the government that meet certain criteria are not treated as income.50 although the exclusion is sensible, it is inconsistent with the apparent breadth of glenshaw glass. the irs's failure to tax child support and its administrative exclusion of government benefits complicate the articulation of a definition of income that reflects what is actually subject to tax. in light of the administratively defined general welfare exclusion such a definition would go something like this: "gross income is all accessions to wealth, clearly realized, over which the taxpayer has dominion unless excluded by statute, or by the irs's never having attempted to tax them, or by the irs's having announced an administratively created exclusion pursuant to no specific authority whatsoever." such a definition might not merit being labeled lawless but it does reveal the existence of an apparent incongruence 1 disinterested generosity, which is required for classification as a gift. duberstein v. comm'r, 363 u.s. 278 (1960). indeed, if support were income, there would be no need for § 71(a). 50. for a comprehensive history and description of the general welfare exclusion, see robert w. wood & richard c. morris, the general welfare exception to gross income, 109 tax notes 203 (2005); robert w. wood, updating general welfare exception authorities, 123 tax notes 1443 (2009). for a recent application see notice 2011-14, 2011-14 i.r.b. 544. 51. in the morality of law professor lon fuller discusses "the most complex of all the desiderata that make up the internal morality of law: congruence between official action and law." lon fuller, the morality of law 81 (rev. ed. 1969). insofar as the actual practices of the irs reflect an interpretation of the term "income" that seems inconsistent with § 61 as interpreted by glenshaw glass, its administration of income tax law appears to lack this "congruence." as professor fuller explains: the most subtle element in the task of maintaining congruence between law and official action lies, of course, in the problem of interpretation. legality requires that judges and other officials apply statutory law, not according to their fancy or with crabbed [vol. 11:5308 defining income between what the positive law (statute and regulations) says and what the irs actually attempts to tax. that apparent incongruence is an unexplained contraction of the positive law. the apparent incongruence between the positive law definition of income and what the irs actually attempts to tax, which we refer to as the administered definition of income, is not limited to accessions that take place in non-commercial transactions. the wheels of commerce are often oiled by the transfer of valuable property or services and such transfers undoubtedly enhance the wealth of those who receive, realize, and have dominion over them. lawyers take clients to lunch or dinner and invite them to sporting events every day. some businesses provide unsolicited samples of their wares at no charge in hopes of inducing additional purchases thereof. still others court potential investors or candidates for employment by covering the cost of travel designed to induce the investor or candidate to invest or accept an offer of employment. all such transactions would appear to fit within the glenshaw glass definition of income. yet, the irs does not currently treat them as generating income. in these cases the existence of the apparent incongruence is especially troublesome because of the near absence of any administrative pronouncement.52 the only authority that supports the proposition that such realized accessions are not income is one fifth circuit opinion which the irs only partially lost and in which it has not announced 53its acquiescense. in united states v. gotcher,54 the taxpayer, who had an interest in a vw dealership, and his wife went on a trip to germany arranged and paid for by vw. it was a group trip, in which 60 of the participants were vw dealers literalness, but in accordance with principles of interpretation that are appropriate to their position in the whole legal order. id. at 83. however, as we will develop in part iii, in interpreting the word "accession" in glenshaw glass more narrowly than its apparent breadth would seem to allow, the irs is neither acting according to its fancy nor with crabbed literalness. rather, it is choosing among competing values, which, in the absence of a wide consensus, is what it should do. 52. rev. proc. 2000-30, 2000-2 c.b. 13 provides that de minimis in-kind payments (the proverbial toaster offered by a bank to new depositors) will not be treated as original issue discount, or income, but such pronouncements are rare in light of the multiplicity of situations that raise similar issues. 53. gotcher v. united states, 401 f.2d 118 (5th cir. 1968). by acquiescence we do not necessarily mean formal acquiescence, but the irs can indicate its agreement with a decision that it lost by other means. it hasn't chosen to do that in this case. 54. id. 2011] 309 florida tax review and their wives, and the other participants were vw employees." as the court of appeals explained: the trip was made in 1959 when vw was attempting to expand its local dealerships in the united states. the "buy american" campaign and the fact that the vw people felt they had a "very ugly product" prompted them to offer these tours of germany to prospective dealers. . . . it was believed that once the dealer saw the manufacturing facilities and the stability of the "new germany" he would be convinced that vw was for him.5 6 the government took the position that the cost of the trip was income to mr. and mrs. gotcher. that position followed from a straightforward application of positive law, based on section 61 and the glenshaw glass definition. nevertheless, the district court agreed with the taxpayers, holding that the trip was neither compensation for services rendered nor a prize or reward for past services, thus distinguishing other cases but arguably disregarding the expansive language of section 61 and glenshaw glass, neither of which confine income to compensation or prizes. the government appealed, but the fifth circuit also agreed with the taxpayers, at least with respect to mr. gotcher's trip. its rationale, like that of the district court, was that taxation to the recipient should be determined by the motive of the payor. it found an analogy in the judicially created "convenience of the employer" doctrine because the trip served a purpose of the payor and was not intended to compensate or reward the payee, and concluded that there was no income to mr. gotcher.5 7 although the district court had found that mrs. gotcher's attendance had also furthered vw's purpose because of the communal nature of investment in a significant business venture such as a vw dealership, the appellate court panel, over the objection of the chief judge, reversed, finding that for mrs. gotcher the trip was a vacation. gotcher may reach the correct result with respect to mr. gotcher for reasons we develop in part iv, but it seems puzzling in light of the language of the positive law. the only possibly applicable exclusion, section 119 (which codified the judicially-created convenience of the employer doctrine) was clearly inapplicable because vw was not mr. gotcher's employer. indeed, the very codification of that doctrine in a statutory provision by its terms applicable only to employees (and even then only to meals and lodging 55. gotcher v. united states, 259 f. supp. 340, 343 (e.d. tex. 1966); aff'd in part and rev'd in part, 401 f.2d 118 (5th cir. 1968). 56. gotcher, 401 f.2d at 121. 57. beraglia v. comm'r, 36 b.t.a. 838 (1937). 310 [vol 11:5 defining income provided on the employer's business premises) should have allowed the irs to prevail. that it didn't was certainly good news for mr. gotcher, but the case nevertheless had the potential for creating substantial uncertainty. the uncertainty would have come from the irs's having taken the position that the trip was income at all, not losing completely, and not announcing its agreement with the fifth circuit majority. taxpayers might have drawn comfort from a tightly reasoned opinion, but not only does the gotcher court apply a judicial doctrine that has been codified to a situation clearly not covered by the codification, but the doctrine itself does not withstand rigorous analysis. the court's rationale, which focuses on the motives of the payor, proves too much. to say that an amount is paid because it furthers an important objective of the payor is to describe salary, which is clearly income. the desire to induce specific behavior on the part of the payee does not distinguish from salary the payment of amounts such as vw's payment of mr. gotcher's trip to germany, not only because salary is also paid to induce particular behavior (work) but also because if vw thought that it could get the potential dealers to go to germany without the inducement of covered expenses, it would have done so, just as an employer who can get desired services without the payment of compensation, or with the payment of less compensation, would do so. in both cases the payor is paying because paying serves an important interest of the payor. the fifth circuit's decision in gotcher also provides scant comfort to taxpayers because it is internally inconsistent. surely vw's motivation for paying mr. gotcher's expenses was the same as its motivation for paying mrs. gotcher's expenses: it wanted to induce the investment in the dealership. the district court recognized this and found no income with respect to either taxpayer. two of the three judges on the fifth circuit panel, however, distinguished between mr. and mrs. gotcher; mrs. gotcher's purpose was personal but mr. gotcher's was business. putting aside the implicit sexism in this view, it underscores the internal inconsistency of the court's stated rationale. if it is the payor's purpose that is determinative, then the payee's purpose ought not matter. what the internal inconsistencies of the gotcher opinion reveal is the tension between the glenshaw glass definition and the apparent legal structure of which it is a part (in which all realized accessions are income unless specifically excluded), and the difficulties of administering a tax system consistent with that structure. the tension is evident in the irs's litigation of gotcher even though in 1963 it had issued a ruling in which it reached a conclusion apparently at odds with its litigating position in gotcher. the ruling held that amounts paid by a potential employer in one state to reimburse individuals who incurred expenses in travelling from another state to undergo interviews for potential employment were neither 2011] 311 florida tax review wages nor income." the conclusion that the amounts are not wages is obvious, but the conclusion that they are not income is not. perhaps the irs didn't think there was an element of enjoyment (personal consumption) in the situation in the ruling but suspected the existence of such an element in gotcher, but we do not know because the ruling limits itself to describing the situation and providing a conclusion. no rationale is given. to us, the ruling and the litigation of gotcher within the same time frame reveal an agency trying to find its way.59 the irs apparently resolved the tension by deciding to make the gotcher argument only in very public situations involving relatively large amounts.60 after gotcher the administered definition of income would seem to be something like: "gross income is all accessions to wealth, clearly realized, over which the taxpayer has dominion, unless excluded by statute, or by the irs's not ever having attempted to tax it, or by the irs's having announced an administratively created exclusion pursuant to no specific authority whatsoever or by the irs's having taken the position that it is income but having a court, albeit not the supreme court, disagree in part, on grounds that cannot withstand rigorous analysis, which therefore allows the irs to take a contrary position in a case in which the amounts are larger." c the definition fragments another way of attacking the gotcher problem of non-taxable consumption is to deny a business expense deduction to the payor in any situation that contains a significant element of consumption.61 this technique assumes that the statutory limitation will restrict the deduction to the cases that have the smallest possibility of representing consumption to the recipient and that, in the absence of a deduction, payors would only incur the expenses when the benefits to them exceeded any consumption element to the payee, thus creating an equilibrium and relative ease of administration provided by the visibility of the deduction. in the employment context, congress attempted to provide certainty on the definition of income by codifying specific rules after the irs 58. rev. rul. 63-77, 1963-1 c.b. 177. 59. the year at issue in gotcher was 1960. the district court decided gotcher in 1966, and the court of appeals in 1968. 60. there are no cases after gotcher, and the irs has raised the income issue only in situations that draw significant public attention, as will be discussed later. the absence of additional cases is surely not due to the absence of situations that present gotcher issues. 61. section 274 provides the clearest example of this approach. for example, § 274 limits the deduction for many meals or entertainment that would otherwise be deductible business expenses to 50 percent of the amount spent. i.r.c. § 274(n). 312 [vol. 11:5 defining income suggested that fringe benefits common in many workplaces were actually income, prompting howls of protest from business and industry groups.62 a similarly vitriolic public reaction led the irs to abandon the possibility of taking the position that frequent flyer miles accumulated while on business travel paid for by an employer (and properly excluded from income under section 132 as a working condition fringe) produced income to employees when used to obtain free personal travel. the difficulty of reconciling the positive law definition of incomethe statutory structure in which the apparently broad glenshaw glass definition is followed by specific exclusions-with the need to administer the tax law, is nicely illustrated by the quandary into which an elementary school principal put the irs in the late 1960s. in 1967 and 1968, the elementary school principal, mr. haverly, received unsolicited textbooks from publishers, as all of us in academia still do. 4 in 1968 mr. haverly not only gave the books to his school's library but also took a charitable contribution deduction therefor. apparently flummoxed by this action the irs in 1970 issued a revenue ruling in which it took the position that unsolicited books received by a book reviewer were income to the reviewer, reasoning that they were an accession to the reviewer's wealth not excluded by any statutory provision.6 ' later that same year, it superseded that ruling with another one which held that receiving such unsolicited books and then donating them to charity resulted in income.66 the irs challenged mr. haverly's deduction, but in 1974 the district court handed the taxpayer a complete victory. the irs was clearly bothered by the apparent double benefit of receiving property free of tax and then being allowed a deduction for giving 62. testimony before the senate finance committee by treasury assistant secretary for tax policy john e. chapoton in 1983 succinctly summarizes the irs action and public and congressional reaction. treasury, joint tax committee discuss taxation of fringe benefits, 19 tax notes 1191 (1983). in 1984 congress enacted § 132. see kenneth j. kies, analysis of the new rules on the taxation of fringe benefits, 24 tax notes 981 (1984). 63. announcement 2002-18, 2002-1 c.b. 621; irs tech. adv. mem 9547001 (july 11, 1995), see also irs wrestles with frequent flyer miles; clinton and hill fight over budget, 69 tax notes 1157 (1995); sheryl stratton & ryan j. donmoyer, don't ask, don't tell: the irs's frequent flier policy, 69 tax notes 1159 (1995). 64. haverly v. united states, 513 f.2d 224 (7th cir. 1975), cert. denied, 423 u.s. 912 (1975). 65. rev. rul. 70-330, 1970-1 c.b. 14. 66. rev. rul. 70-498, 1970-2 c.b. 6. by superseding the previously issued ruling the irs seemed fairly clearly to be saying that it would not treat mere receipt of the books as income. the books would be income only if received and donated. 67. haverly v. united states, 374 f. supp. 1041 (n.d. ill. 1974), rev'd, 513 f.2d 224 (7th cir. 1975). 2011] 313 florida tax review it away. but the amount of the charitable contribution deduction is determined by the value of the property donated and does not depend on that value having been taxed. 8 because there was no question of the taxpayer's entitlement to the deduction, the irs had to litigate the issue from the income side. as to the income issue, the district court was unable to distinguish the receipt of books which were later donated to charity by a taxpayer who took a charitable contribution deduction therefor from the receipt of books donated to charity by a taxpayer who took no such deduction, or from the many situations in which taxpayers receive unsolicited samples which they use, exercising dominion in ways more private than the taking of a tax deduction but exercising dominion nonetheless.69 it reasoned that all such situations were the same with respect to the exercise of dominion and that "a distinction based on the value of the sample, or on the particular way in which a recipient converts it to his or her own use, is not acceptable as a matter of law based on any applicable tax provision, precedent or logic."70 the second circuit reversed. although that court acknowledged the unassailable logic of the district court's analysis, it concluded, in archetypical common law fashion, that only mr. harverly's case was before it, and mr. haverly, having realized an accession to wealth over which he exercised dominion by making the donation and taking the ensuing deduction, had income. any resulting lack of symmetry was acceptable because [t]he internal revenue service has apparently made an administrative decision to be concerned with the taxation of unsolicited samples only when failure to tax those samples would provide taxpayers with double tax benefits. it is not for the courts to quarrel with an agency's rational allocation of its administrative resources.n the opinions in haverly illustrate the difficulty of defining income in a coherent, administrable way not only by their inability to do so but because the existence of the case itself confirms the inadequacy bordering on irrelevance of the "intent of the payor" or "convenience of the employer" talismans. there can be no doubt that the publisher of the books sent to mr. 68. i.r.c. § 170. 69. haverly, 374 f. supp. at 1045. 70. id. 71. haverly, 513 f.2d at 227. the charitable contribution provisions clearly allow a deduction for the fair market value of property, not its basis, so denial of the deduction could not reasonably be pursued. inclusion in income was the only way of preventing a double benefit. 314 [vol. 11:5 defining income haverly wanted mr. haverly to adopt them in his school, which would lead to substantial sales. its motives were no more compensatory than those of vw in paying for the gotchers' trips to germany. the existence of a significant non-compensatory purpose by the payor sufficed to save mr. gotcher from having income but failed to provide a similar fate for mr. haverly (and mrs. gotcher).7 2 the post-gotcher legacy renders any attempt at a definition of administered income nearly incoherent. it would seem to go something like this: "gross income is all accessions to wealth, clearly realized, over which the taxpayer has dominion unless excluded by statute, or by the irs's not ever having attempted to tax it, or by the irs's having announced an administratively created exclusion pursuant to no specific authority whatsoever or by the irs's having taken the position that it is income but having a court, albeit not the supreme court, disagree in part, on grounds that cannot withstand rigorous analysis, which therefore allows the irs to take a contrary position in a case in which the amounts are larger, or adopting without explanation a position driven by administrative convenience, of uncertain application beyond the specific facts provided, or otherwise having indicated that it doesn't know whether it can or should tax it but for the moment it won't." to add to the uncertainty, the irs can, and sometimes does, change its position. even though the irs had never taken the position that imputed income is income and had issued a revenue ruling stating that interest-free loans did not result in income to the recipient as a result of the forgone interest,73 it subsequently took the position that an interest-free loan from a corporation to a shareholder resulted in the receipt of interest by the shareholder.74 there followed nearly two decades of litigation in which the courts stubbornly refused to agree, until one court finally adopted the irs's analysis in the gift tax context.7s the resulting split in the circuits landed the 72. as the district court in haverly pointed out, and as the court of appeals seemed to acknowledge, the contribution of the items received is logically distinct from their inclusion in income. the two events can be tied in the service of administrative convenience, as the court of appeals acknowledged, but it is one thing to say the receipt of the property is income which the irs is going to choose not to tax for reasons of administrability, and another to say that the receipt is just not income at all. 73. rev. rul. 55-173, 1955-2 c.b. 23. 74. dean v. comm'r, 35 t.c. 1083 (1961), non-acq, 1973-2 c.b. 4. for another example of the irs's change in position on interest free loans see favorable ruling on interest-free loans is revoked, 22 tax notes 285 (1984). 75. for a detailed explanation of the judicial and administrative events that preceded the enactment of § 7872, see staff of the joint comm. on tax'n, general explanation of the revenue provisions of the deficit reduction act of 1984, jcs 412011] 315 florida tax review gift tax issue before the supreme court, which agreed with the irs.7 6 chaos then threatened to ensue because of the virtual impossibility of administering such a conclusion uniformly.77 the irs tried to calm the waters by issuing guidance, and congress stepped in by enacting section 7872, which treats as income (or gift) the forgone interest in below market loans under some, though not all, circumstances. despite such arguably happy endings, the difficulties persist. members of oprah's studio audience in september 2004 were probably delighted to hear that they would all receive pontiac g6 automobiles, until someone pointed out that the cars, whether solicited or not, were realized accessions to wealth within the audience members' dominion and hence income." of course, in many ways, the audience members were like mr. haverly or even mr. gotcher-beneficiaries of a seller's desire to hawk its wares-but their situation was too public, the value of what they received-a car-too clear, and they looked too much like prize winners. 9 they did not ask for the cars, may not have wanted them, and it seems to us that they received the cars only because it was in pontiac's and oprah's interest that they do so,80 but that was not the only possible characterization. perhaps the 84, at 524-26 (1984). for thoughtful commentary on § 7872, see nancy j. knauer, legal fictions and juristic truths, 23 st. thomas l. rev. 70, 113-14 (2010). 76. dickman v. comm'r, 456 u.s. 330 (1984). 77. the irs was keenly aware of these problems and promptly after winning dickman issued published guidance to resolve them both retroactively and prospectively and in the income and gift tax contexts. see irs explains valuation of pre-1984 interest-free demand loans, 23 tax notes 851 (1984). 78. surprise! oprah gives entire audience new cars, today television, sept. 13, 2004, http://today.msnbc.msn.com/id/5989964/ns/today-entertainment/. 79. some news accounts underscored the prize aspects. see, e.g., oprah car winners hit with hefty tax, cnnmoney.com, sept. 22, 2004, http://money.cnn.com/2004/09/22/news/newsmakers/oprahcartax/, but others praised the marketing aspects, tara burghart, oprah's car giveaway hailed as marketing coup, pontiac confident in its multimillion investment, cincinnati.com, sept. 15, 2004, http://www.enquirer.com/editions/2004/09/15/bizbizlyoprha.html. 80. the move indeed added to oprah's luster; not only did she repeat the event, most recently with vw beetles and trips to australia, but the 2004 original stunt was recently voted "tv's greatest surprise." michael langston, oprah's free car giveaway voted no.1 as "tv's greatest surprise," examiner.com, june 6, 2010, www.examiner.com/african-american-entertainment-in-nationalloprah-s-freecar-giveaway-voted-no-i -as-tv-s-greatest-surprise. for descriptions of the beetle and australia trip giveaways, on which oprah agreed to pay the resulting tax liability for her audience members, see tax consequences of oprah's latest car giveaway, taxprof blog, nov. 29, 2010, http://taxprof.typepad.com/taxprof blog/1910/11/ tax-consequences.html; michael cohn, oprah to pay taxes for audience's australia trip, accounting today.com, sept. 24, 2010, http//www.accountingtoday.com/ debitscredits/oprah-pay-taxes-audience-australia-trip-55711-1 .html. 316 [vol. 11:5 defining income cars were a prize for being in the audience that day, like the person who receives money for being the millionth customer of an establishment. that quickly became the prevailing public view.81 like oprah's audience, for years award show presenters and nominees enjoyed the samples of luxury items contained in the "swag bags" they received. such items were provided for the same reasons vw paid for the gotchers' trip to germany and the publishers of textbooks sent the books to mr. haverly: sellers wanted to increase sales of their products by generating publicity for them. their motives were as non-compensatory as those of vw or the textbook publishers; oscar presenters do not need swag bags to be induced to serve as presenters (many would almost certainly pay for the opportunity if they could), and no behavior whatsoever was required from the nominees who also received the bags. as with other free samples, it would be nearly impossible to determine whether the taxpayer exercised dominion by using the product. nevertheless, as the value of the bags and the resulting publicity surrounding them grew, the irs felt compelled to act, and in 2006 it took the position that the value of the swag in the bags was income to the recipient.82 while that position clearly follows from the glenshaw glass definition of income, and those of us who champion progressive taxation might not quarrel with its effect, it is completely inconsistent with the irs's published position on unsolicited samples, as well as with the intent of the payor and convenience of the employer talismans approved by the courts in gotcher and other cases. all of the arguments made by the district court in haverly would apply to the swag bags, and in the absence 81. there were even some reports that oprah had agreed to cover the resulting tax liability, see, e.g., zachariah boren, great tax lesson of oprah's "free" cars, szone.com, sept. 22, 2004, http://www.szone.us/f65/great-tax-lessonoprahs-free-cars-7034/ (referring to a cnn story reporting that oprah would pay), although most reports suggest that she did not do so in that instance. chuck sudo, "and then the irs asked for their cut, and the screaming stopped." chicagoist.com, nov. 22, 2010, http://chicagoist.com/2010/11/22/andthenthe_ irs asked for their cu.php (noting that oprah's studio had said the recipients of the cars would have to pay). in subsequent giveaways oprah has agreed to cover the resulting tax liability. see cohn, supra note 80; see also anosheh azarmsa, note, award shows, gifts, and taxes: a criticism of the tax treatment of celebrity gift bags, 28 loy. l.a. ent. l. rev. 27, 43 (2007/2008); brian hirsch, the extreme home renovation giveaway: constructive justification for tax-free home improvements on abc's extreme makeover: home edition, 73 u. cinn. l. rev. 1665, 1669 (2005). 82. the irs did this not by issuing a ruling or similar document, but by having then-commissioner everson issue a press release. i.r. 2006-128, 2006 tnt 160-6 (aug. 17, 2006); see robert j. wells, there are no free goody bags, 112 tax notes 621 (2006); allen kenney, irs reaches out to celebrities to soothe anxiety over tax on swag, 112 tax notes 636 (2006); azarmsa, supra note 81, at 43. 2011] 317 florida tax review of a deduction taken by the recipients, the distinction which the second circuit found determinative in that case would not apply.83 the distinction, if any, has to be one of degree and not of kind unless the bags are regarded as prizes, which is unlikely.8 4 nevertheless, we may never know how a court would rule. in response to the irs's asserted position, the academy reached an agreement with the irs for past years, agreed to issue information returns to recipients in 2006, and thereafter discontinued the practice. still, the practice of bestowing swag on celebrities has not so much died as evolved. at the 2010 academy awards (oscars) public relations companies organized "gifting suites" filled with expensive items free to celebrities, as well as consolation gift bags to be given to losing nominees. in the confusion, the beat goes on. whatever comfort the average taxpayer may take from the taxpayer victory in gotcher and the irs's apparent decision not to tax free samples unless the taxpayer takes a charitable contribution deduction," its position on oscar swag bags shows that it does not in fact believe that free samples are categorically not income. it knows glenshaw glass. what it appears to be doing is applying an unarticulated de minimis rule, seeking to make the glenshaw glass definition of income coextensive with the administered definition only when it can do so because the public nature of the receipts, the limited number of recipients and the size of the amounts involved make them identifiable and worth taxing. although, as the second circuit observed in haverly, the irs is probably making a perfectly rational decision on how to deploy its administrative resources, nothing in glenshaw glass or in section 61 defines income as "accessions to wealth, clearly realized, over which the taxpayer has dominion, and which are big enough and public 83. commissioner everson acknowledged that the motivation for the bags was the same as for other free samples: "this has become big business for companies promoting their products. these things aren't given without pride and prejudice." i.r. 2006-128, 2006 tnt 160-6. 84. the prize characterization is most fitting in the case of the bags delivered to the nominees who do not win the oscar, as they are sometimes referred to as "consolation prizes," but to say that angelina jolie receives a swag bag because she has won the role of presenter seems fanciful given that the bag is not paid for by the academy but rather by the manufacturers of the products in it. in any event, if the irs uniformly applied the gotcher rationale and looked to the motive of the payor, the bags would not be income because the motives of the swag bag providers are indistinguishable from those of vw-increased sales. 85. kenney, supra note 82. 86. see cheryl wischhover, oscars swag 2010: it gets weird, fashionista.com, http://fashionista.com/2010/03/oscar-swag-2010-it-gets-weird/. but see, i.r. 2006-128, 2006 tnt 160-6 (items taken from gifting suites are income). 87. see rev. rul. 70-498, supra note 66 and accompanying text. 318 [vol. 11:5 defining income enough for the irs to find." in any event, it is clear that the irs attempts to tax some accessions (swag bags) but not others (free books to book reviewers), and no theory for distinguishing one situation from the other exists. two final examples suffice to show the array of situations in which the administrative application of the positive definition of income seems confused. the first involves the iconic american game of baseball. when contemporary players began to threaten long established home run records, it was clear that any ball that broke such a record would become a collector's item worth substantial amounts of money. when the records began to be broken and a fan caught the record-breaking ball, the tax controversy erupted. practitioners, academics, and former irs commissioners all agreed that catching the ball, like finding old currency in a used piano, which was held to be income in a case known to virtually every student of taxation, 8 resulted in the realization of income.89 but the public and congressional outcry at such a prospect was fierce.90 how could the joy of catching the record breaking-ball be marred by the prospect of the rapacious irs pursuing the fan for a cut of the good fortune? legislation to ensure non-taxation was introduced.91 one irs commissioner, not a lawyer, dissembled.92 years later, the chief. counsel of the irs, not only a lawyer but a tax lawyer, reportedly covered his head with his hands and captured the difficult position the agency was in when he responded to the question whether the fan who caught and kept the ball had income by saying, "please don't ask me that." 93 scholarly articles were written and the question was debated,94 but the irs's position remains unknown. 88. cesarini v. united states, 296 f. supp. 3 (n.d. ohio 1969), aff'd, 428 f 2d 812 (6th cir. 1970). 89. see zelenak & mcmahon, supra note 5, at 1300 (1999) (reporting former irs commissioner donald alexander's opinion that a record-breaking baseball is income when caught by a fan, documenting that alexander's opinion was "universally shared among tax experts," and attributing the "unanimity of expert opinion" to its reliance on the literal language of treas. reg. § 1.61-14.). see also claim of right, supra note 6, at 688 (2000). 90. see zelenak & mcmahon, supra note 5, at 1299. 9 1. id. 92. id.; charles 0. rossotri, many unhappy returns 95 (2005). this was possible because the commissioner responded to a hypothetical question involving a fan who caught the ball and then gave it to the player, which could be analogized to a disclaimer. i.r. 98-56, 98 tnt 174-14. 93. tom herman, the big catch could have a big catch, wall st. j., july 25, 2007, at di. 94. zelenak & mcmahon, supra note 5; dodge, claim of right, supra note 6; andrew d. appleby, ball busters: how the irs should tax recordsetting baseballs and other found property under the treasure trove regulation, 33 vt. l. rev. 43 (2008). 2011] 319 florida tax review the second example involves fish. found money and found property are income under the regulations, but how about caught fish? the expenses incurred by the recreational fish catcher may exceed the value of the fish caught,95 but in most cases expenses incurred by commercial fishing operations will not. catching fish produces a realized accession to the taxpayer's wealth, within the taxpayer's dominion. yet the irs has taken the position that caught fish are not income until sold. despite opportunities to do so and arguable provocation, the irs has also declined to assert that the value of big game trophies is income to the hunters, or that minerals are income when removed from the ground.97 these discrepancies between the positive law, including the dictates of the treasury's own regulation, and the irs's administration thereof may be sound from the standpoint of tax administration, but they have caused at least two prominent tax scholars to call for the withdrawal of the regulation and the adoption of a position generally treating only cash as income, except when equity strongly demands otherwise to prevent abuse.98 that position has been resisted99 and the irs has shown no inclination to adopt it, but our objective here is not to debate the merits of the competing positions. we use the controversy to illustrate the difficulty of articulating an accurate and clear definition of the income that is actually subject to tax. the irs has not done it yet. we have tried to demonstrate that although the glenshaw glass definition of income appears clear and straightforward, its application has not always been likewise. some realized accessions over which the taxpayer has dominion are income, others are not taxed despite the absence of a statutory or even administratively stated exclusion, and still others are not taxed based on administrative practice or pronouncement. most significantly, we have tried to demonstrate that a theory that satisfactorily explains the various results has yet to be articulated. we now proceed to explore the source of the difficulty. 95. this could still result in residual income because the expenses, even if they could offset any income in theory under § 183(b), would be miscellaneous itemized deductions not fully deductible in most cases. 96. tax highlights for commercial fishermen, irs pub. 595, 9 (1998). like professors zelenak and mcmahon, supra note 5, to whom we are thankful for the example, we do not question the wisdom of this position as a sensible recognition of the likelihood that in all but the most unusual cases the catching and the selling will take place during the same taxable year, and accounting for fish caught but unsold would be administratively burdensome. like them, however, we recognize that such a position would not follow from a technically accurate application of the treasury's regulation. 97. zelenak & mcmahon, supra note 5, at 1302. 98. id. at 1304-08. 99. dodge, claim ofright, supra note 6, at 688. 320 [vol. 11:5 defining income ii. definitions: a jurisprudential detour why is it so difficult to define what income is actually subject to tax? we now explore this question and offer as an answer the concept of aptness. in part iii we will apply the idea of aptness to the problem of defining income. a. the quest for scientific precision from the time the court decided glenshaw glass, scholars have struggled with the definition of income. this struggle is arguably an iteration of the more general struggle between those who see law as science and those comfortable with a less definitive account. the struggle was manifest in the debate over the search for a "comprehensive tax base" (a tax system free of loopholes and base erosions), which raged during the late 1960s and continues to this day with the claim that tax law suffers from a dislocation from real world events, dubbed an ectopia, that dooms it to doctrinal incoherence. the first salvo in the battle over the search for a comprehensive tax base ("ctb") was fired by no less an iconic tax scholar than professor boris bittker, who asserted that a "neutral, scientific definition of . . . income is a mirage,"'oo and that efforts to use the haig-simons definition of income as the point of departure for the development of a ctb that would serve as the touchstone for developing a pristine tax system were doomed to failure.'o prominent public finance economists and legal tax scholars promptly attacked professor bittker's apparent heresy, accusing him of misunderstanding haig-simons, adopting an "untenable position" and even doing no more than "suggesting ad hoc settlements."' 0 2 in response, professor bittker remained undaunted, sardonically expressing the hope that the search for a ctb, which he derided as "an encompassing verity" would not lead its proponents into that "dank, miasmic, myxomycetous sump" that his detractors would probably like to call "bittker's quagmire."' 03 100. boris i. bittker, a "comprehensive tax base" as a goal of tax reform, 80 harv. l. rev. 925 (1967) (hereinafter bittker, ctb as goal). 101. id. at 925. 102. see joseph a. pechman, comprehensive income taxation: a comment, 81 harv. l. rev. 63 (1967) (accusing professor bittker of misunderstanding haig-simons); r.a. musgrave, in defense of an income concept, 81 harv. l. rev. 44 (1967) (accusing professor bittker of adopting an "untenable position"); and charles 0. galvin, more on boris bittker's comprehensive tax base: the practicalities of reform, the aba's cstr, 81 harv. l. rev. 1018, 1019 (1968) (accusing professor bittker of doing no more than suggesting "ad hoc settlements"). 103. bittker's ctb response, supra note 6, at 1041. 2011] 321 florida tax review although the current income tax system is far from the ctb, the desire for scientific precision continues. recently, it has taken the form of professor john prebble's claim that tax law suffers from ectopia, which he describes as a regime of legal doctrines that have no relationship to real world events and which are therefore doomed to doctrinal incoherence. the oddity of income tax law, in professor prebble's view, is that, unlike other fields of law, tax law necessarily relies on artificial concepts and definitions that do not answer to an underlying economic reality, and the pervasive indeterminacy that results from this ectopia is, therefore, ineradicable from the law of taxation. at the heart of this problem is the concept of income, which professor prebble believes "is not something that ultimately can be defined by law because it is not something that exists either as a physical fact or as an abstract thought."'0 we offer a critique of ectopia because we see it as an iteration, albeit an extreme one, of the yearning for scientific precision in tax law, which we, like professor bittker, believe is doomed to failure, like obtaining hydration from a mirage. our critique, and our development of the concept of aptness, shows that abandoning the search for scientific precision need not lead to a "dank, miasmic, myxomycetous sump," but can instead provide space for articulation of a multiplicity of values. these values include but are not limited to economic values. in this way, tax is no different from other areas of law, where multiple values inform the development of doctrine. os 104. john prebble, ectopia, tax law and international taxation, 1997 british tax rev. 301, 310 (2002). 105. many judges, lawyers, and tax scholars view tax as a self-contained body of law that differs from other areas of law and believe that tax lawyers are somehow different from other "normal" lawyers. furthermore, the complexity of tax statutes has led some to advocate approaching statutory construction differently in the context of tax statutes. see paul l. caron, tax myopia, or mamas don't let your babies grow up to be tax lawyers, 13 va. tax rev. 517, 519-32 (1994) (discussing the "myth" that tax law and tax lawyers are different); leo p. martinez, the summons power and the limits of theory: a reply to professor hyman, 71 tul. l. rev. 1705, 1714-16 (1997) (suggesting that courts afford tax legislation a greater than normal level of deference due to the special importance of tax laws for the functioning of the government). but see kristin e. hickman, the need for mead: rejecting tax exceptionalism in judicial deference, 90 minn. l. rev. 1537 (2006) (urging that tax regulations deserve the same level of judicial deference as any other regulations). david a. hyman, procedural intersection and special pleading: is tax different?, 71 tul. l. rev. 1729, 1744 (1997) (criticizing the view the tax laws are different and advocating a less self-contained approach to tax); joshua d. rosenberg & dominic l. daher, the law of federal income taxation, § 1.02, at 4-5 (2008) (stating that "tax laws are not so different from any other laws," despite the fact that tax laws are judged primarily based on their economic impact, which differs from the manner in which many other laws are evaluated, and that equity standards applied to tax and nontax laws tend to be different). in deciding that 322 [vol. 11:5 defining income the prebble position echoes one offered by professor john miller in 1993, when he argued that the internal revenue code comprises a set of "creational" rules. his idea was that "the income tax has no counterpart in reality antedating its enactment in the same sense that a murder statute may be antedated by the act of killing someone and the societal disapproval that act may engender."1 0 6 professor miller analogized tax law to a game, of which "the rules are an inseparable and definitional part."1,o if tax law is a game, created by the legislature, it has the possibility of being pristine because it can be created that way. if the definition of income tracks haigsimons (except when it has to depart to accommodate the administrative necessity for realization), 0 8 then it can be precise, because economic accessions can be counted in dollars and added up with mathematical accuracy. but we do not believe that such precision is attainable. professors miller and prebble invoke a pre-law world-an "underlying reality" 1 09-that, much like classical economics, appears to have an identifiable nature independent of human interpretation and thus independent of any constitutive effects produced by rules devised by humans. for example, in professor prebble's view, the rules of criminal law or torts (to take two of his examples) map reasonably well onto this antecedent "natural world.""10 by contrast, although there is a "natural world" of economic transactions that income tax law regulates, professor prebble argues that tax law does so with definitions that do not reflect that world, which leads to a legal regime full of incongruities, indeterminacies, and consequent instability. is this contrast between criminal law and tort law, on the one hand, and income tax law, on the other hand, correct? for example, does a tax regulations are entitled to the same level of deference as other regulations, the supreme court has recently cast its lot with the non-exceptional view. mayo foundation v. united states, 131 s. ct. 704 (2011). 106. john a. miller, indeterminacy, complexity, and fairness: justifying rule simphfication in the law of taxation, 68 wash. l. rev. 1, 68 (1993). 107. id. at 62. professor miller explicitly connects this idea to john rawls's concept of a "practice." id. at 62 n.288, 68 n.319. rawls defines a practice as "any form of activity specified by a system of rules which defines offices, roles, moves, penalties, defenses, and so on, and which gives the activity its structure. as examples one may think of games and rituals, trials and parliaments." john rawls, two concepts ofrules, 64 the philosophical review 3, 3 n. 1(1955). 108. see simons, supra note 4. 109. john prebble, fictions of income tax 13 (victoria university of wellington centre for accounting, governance, and taxation research, working paper series, paper no. 7 2002), centre for accounting, governance, and taxation research, at http://www.victoria.ac.nz/sacl/cagtr/working-papers/wpo7.pdf. 110. john prebble, income taxation: a structure built on sand, 24 sydney l. rev. 301, 310 (2002). 2011] 323 florida tax review homicide statute, as professor miller suggests, map onto an antecedent reality: the killing of a human being? clearly not. there are substantial categories of killings that are not homicides, such as killings by state executioners, and killings by the insane, killings in self-defense and in defense of others. conversely, there are homicides such as felony murder and various accomplice and conspiracy-based homicides that do not involve the killing of a human being by the accused. nothing in the "natural world" accounts for these distinctions. the willful, deliberate, and premeditated killing of a convicted murderer by the state executioner differs from the willful, deliberate, and premeditated killing of an organized-crime rival only by social and legal convention and the values that inform them. without denying any "natural occurring phenomena," we could treat both the same, just as english law used to treat killing in self-defense as a criminal homicide,"' without running afoul of the "physical facts." the reason that no underlying scientific reality answers to legal claims about homicide or income becomes apparent when we examine professor prebble's proffered example of a claim that straightforwardly maps onto things that "exist in the natural world,"'12 namely, the claim that "kilimanjaro is in tanzania."ll 3 let us begin with tanzania. as professor prebble acknowledges, national entities are "defined by the actions and agreements of people, not by nature.""14 nonetheless, he insists that "the definitions that we employ are definitions (borders) that themselves are defined by reference to natural, physical features of the landscape." accordingly, there is a "required logical connection between a country and a mountain or a river in that country."115 but, of course, there is no logical connection between a country's borders and topographic features. that relationship is entirely contingent, and the world is full of counter-examples. (consider the border between the koreas or between canada and the united states.) thus, whether kilimanjaro is in tanzania (as opposed to some other country) is entirely dependent on "actions and agreements of people." it is not just science. what about kilimanjaro? is it logically connected to a physical, scientific reality? not at all. do foothills count as part of a mountain? if the answer is no, then kilimanjaro is currently in tanzania; if the answer is yes, then part of kilimanjaro is in kenya. the answer to the status of the foothills cannot be determined by reference to an underlying physical reality. the decision whether to include the foothills in the definition of "mountain" is, again, conventional, not scientific: it depends on the "actions and agreements 111. george p. fletcher, rethinking criminal law 344, 352 (1978). 112. id. at 310. 113. prebble, supra note 104, at 388. 114. id. 115. id. [vol. 11:5324 defining income of people." and these actions and agreements are informed by the values of those who enter into them. the point, of course, is that there is no antecedent reality that is presented to us without being "always, already" conceptualized. this bears emphasizing: it is not that there is no real world independent of human thought, but that that real world is never present to us free of conceptualization-conceptualization that represents the world with a particular form and order. and those concepts, and the form and order they engender, are necessarily conventional and, therefore, contingent and provisional. this is true of "tanzania," of "kilimanjaro," and of "income." an individual can receive a $100 bill that is hers to keep, or she may show great happiness when seeing a loved one, but whether either of those observable events are income requires more than observing them. it requires defining income, and reference to scientific, observable phenomena is not enough. as with tanzania or kilimanjaro, the success of the definition of income is a function of its "aptness." it is to this notion of aptness that we now turn. b. aptness we develop the idea of aptness by focusing on the relationship between the definition and the goals and values it is meant to serve. in this view, legal definitions are instruments that are designed to promote particular ends. the aptness of a definition, then, is a measure of its success in realizing those ends.' 16 those ends or purposes, of course, are contingent. as society changes over time, the ends that a given legal definition furthers can 116. for earlier views that goals and values are fundamental to understanding law, see, e.g., william n. eskridge, jr. & philip p. frickey, an historical and critical introduction to the legal proces, in henry m. hart, jr. & albert m. sacks, the legal process: basic problems in the making and application of law xci-xcii (william n. eskridge, jr. & philip p. frickey eds. 1994) (legal process movement); l.l. fuller & william r. perdue, jr., the reliance interest in contract damages, 46 yale l.j. 52, 52 (1936) ("[l]egal rules can be understood only with reference to the purposes they serve."); thomas c. gray, freestanding pragmatism, in the revival of pragmatism: new essays on social thought, law, and culture 256 (morris dickstein ed. 1998) ("pragmatist jurisprudence" understands "legal thought" to be both "contextual" and "instrumental"); kenneth heinar himma, natural law, in internet encyclopedia of philosophy (james fieser & bradley dowden eds., 2005), http://www.iep.utm.edu/natlaw/. ("according to natural law theory of law, there is no clean division between the notion of law and the notion of morality."). 2011] 325 florida tax review change." 7 moreover, in a complex society, the ends are multiple. thus, for instance, tort law and the concepts that constitute it are shaped by a collection of goals and values that include compensation of innocent victims, imposition of liability on individuals whose conduct is blameworthy, and imposition of liability on individuals who cause harm to others." to take another example, criminal law is defined by goals and values that include retribution, utility, and autonomy. a quick examination of these two examples shows that the goals and values that define a legal field are not only multiple, but heterogeneous. compensation, fault, and causation cannot be reduced to one another, nor can they be subsumed under a single, broader rubric. the same is true of retribution, utility, and autonomy. being heterogeneous, these goals and values are potentially in tension and even conflict. indeed, at the risk of anthropomorphism, we can think of the multiple, heterogeneous goals and values that constitute a field of law as competing with one another for attention through the formulation of the various concepts that give legal content to the field.119 in this part we use these characteristics of multiplicity, heterogeneity, tension, conflict, and competition to develop a number of ideas that will be important for addressing the problem of defining income. we first seek to explain why some applications of the law are easy while others are controversial, and that distinction will help clarify what determines the aptness of a legal definition. an apt definition, we will argue, tends to generate a preponderance of easy applications. we will then examine the important difference between a rule and a standard and discuss how each can be apt. finally, we will focus on a particular goal/value that plays a dominant role in determining the aptness of definitions in public law fields, including 117. even more fundamentally, the very existence of a coherent set of ends furthered by a given legal definition is generally contingent on the existence of a high degree of social consensus. the significance of this dependency for the definition of income will become apparent later in part iii. 118. the division in tort law between blameworthiness (fault) and causation is illustrated by sindell v. abbott laboratories, which adopted the theory of market share liability. see infra notes 120-24 and accompanying text. in sindell each defendant could be shown to have behaved in a blameworthy manner (as described by the court), but could not be shown to have caused harm to anyone in particular. conversely, a person can cause harm to someone without acting in a blameworthy manner (a careful driver who kills a child who dashes out from between two parked cars, for example). 119. e.g., sindell v. abbott labs., 607 p.2d 924 (cal. 1980) (market share liability in torts); mapp v. ohio, 367 u.s. 643, 659-60 (1961) (discussing tension among goals and values of law enforcement, judicial integrity, and individual liberties). 326 [vol. 11:5 defining income income taxation: administrability. finally, we will see how administrability pushes public law definitions to prefer rules over standards. 1. controversial vs. easy applications of the law if we imagine the various goals and values comprised by a particular field of law as having directional vectors, we can think of an easy case as one in which those vectors point in roughly the same direction: toward the same outcome. conversely, in a controversial case the vectors point in significantly different directions and, therefore, toward different outcomes. consider, for instance, the market share liability rule developed in sindell v. abbott laboratories. 1 20 this litigation concerned cancer suffered by daughters of mothers who had ingested diethylstilbestrol (des) during their pregnancies. the defendants in the suit were various companies that had manufactured and marketed des as an anti-miscarriage drug. although the culpability of the companies was established, 12 ' not one of the injured parties could prove which company had manufactured the specific drug that her mother had taken during pregnancy. thus each of these victims was asking the court to hold various drug companies liable for her injuries although she could not establish a causal connection between her injuries and the conduct of any particular company. indeed, since the defendants accounted for ninety percent of the des that was placed on the market, there was a ten percent chance that none of the defendants had caused any particular injury. the california supreme court resolved the case by requiring each drug company to pay a share of the plaintiffs' injuries equal to the company's share of the des market. a company could avoid this liability only by showing that it could not have caused the injuries. thus, the california court allowed the injured parties to recover damages from the defendants without having to establish a causal connection between the injuries and the conduct of any particular defendant. the court was clearly aware of the tension in this case among the goals and values of compensation, culpability, and causation, and of its denigration of causation in favor of the other two. although the three dissenting justices were unwilling to jettison the requirement of causation, 12 2 the majority emphasized the innocence of the plaintiff and the culpability of the defendants, who were the only parties in a position to have prevented the harm caused by their product.123 120. snidell, 607 p.2d at 924. 121. id. at 925-926. 122. id. at 938. 123. id. at 936. 3272011] florida tax review when goals and values collide, as they did in sindell, the court could have resolved the matter if it had been able to identify some applicable metaprinciple. but no such legal metaprinciple exists. the precedents that inform the law of torts express doctrines that permit imposition of liability in the absence of culpability (e.g., a manufacturer's strict liability for injuries caused by a defective product), in the absence of causation (e.g., an employer's liability under the doctrine of respondeat superior for torts committed by employees), and in the absence of injury (e.g., the imposition of so-called "nominal" damages for the mere invasion of a legal right). thus, none of the principles under consideration expresses a necessary condition for liability as a general matter, nor do the precedents indicate a fixed hierarchical or lexicographical relationship among the principles. faced with a controversial case in which important goals and values clashed, in the absence of guiding metaprinciples the sindell court was required to choose which goals or values to vindicate and which to sacrifice. the majority chose to vindicate compensation and culpability and to sacrifice causation. the dissent would have subordinated compensation and, to some extent,124 culpability, to causation. by contrast, in an easy tort case (such as a two-car automobile accident caused by the careless inattention of one of the drivers), the compensation, culpability, and causation principles all point toward the same conclusion. accordingly, no matter how the court prioritizes the various goals and values that comprise the field, the outcome of the easy case remains the same. it is important to keep in mind that the ends served by a field of law are contingent and can change over time. that means not only that the goals and values themselves can change, but also that the way in which they are understood can change. that, in turn, means that what is an easy or controversial case at one point in time can become its opposite at another point. for example, when the united states supreme court held that the constitution permitted racially segregated railroad cars in plessy v. ferguson,12 5 it bolstered its conclusion with the apparently uncontroversial example of "the establishment of separate schools for white and colored children." 26 accordingly, in 1896 the supreme court would have regarded the constitutionality of racially segregated public schools as an easy case. however, a series of supreme court decisions and an altered social climate 124. the implication of the dissent is to clearly subordinate culpability to causation. however, the dissenters conflate causation and culpability, in that they appear to believe that the drug companies are not really culpable since they can't be shown to have caused harm. for this reason we use the hedging language "to some extent." 125. plessy v. ferguson, 163 u.s. 537 (1896). 126. id. at 544. 328 [vol. 11:5 defining income transformed that easy case into a hard case, culminating in brown v. board of education,'27 which held segregated public schools unconstitutional.128 2. the aptness of a legal definition we can now define the aptness of the definition of a legal concept like income as its tendency to further the goals or values that constitute a field of law. by so doing, an apt definition will generate a preponderance of easy applications, in which the goals and values served by the definition point toward the same conclusion. it bears emphasizing that "preponderance" is, as the word suggests, a relative measure. some apt definitions will generate more controversial applications than others, as the discussion of rules and standards in the next section will illustrate. however, when a definition is apt easy applications preponderate. as an example of an apt definition, consider "cause" in criminal law. the model penal code provides that "[c]onduct is the cause of a result when it is an antecedent but for which the result in question would not have occurred." 2 9 this definition is notoriously underand over-inclusive. nonetheless, the but-for definition of cause works terrifically well in reliably identifying causal behavior that we wish to punish as criminal, and it works well because it is apt. it succeeds in both of the senses identified above: first, the definition can be demonstrated to serve effectively all of the core values of criminal law: retribution, utility, and autonomy. second, because it furthers the core values of criminal law so well, those values all point toward the same conclusion regarding causation in the great run of situations, while holding controversial applications (where the core values point toward different conclusions regarding causation) to an acceptable level. we can contrast the aptness of but-for causation by comparing it to a famously inapt definition: the specification of the crime of "vagrancy" in a jacksonville, florida ordinance struck down as unconstitutionally vague in the 1972 case papachristou v. city of jacksonville.13 0 the language of the ordinance was so vague that it failed "to give notice of conduct to be avoided"' 3' and thereby placed "unfettered discretion ... in the hands of the . . . police," 3 2 transmuting all sorts of ordinary conduct into potential violations of the law, depending on whether the police wished to respect the autonomy of the individual or saw the individual as a threat to the social 127. brown v. board of education, 347 u.s. 483 (1954). 128. see generally richard kluger. simple justice: the history of brown v. board of education and black america's struggle for equality (1975). 129. model penal code § 2.03(1)(a) (proposed official draft 1961). 130. papachristou v. city of jacksonville, 405 u.s. 156 (1972). 131. id. at 166. 132. id. at 168. 2011] 329 florida tax review order. consequently, there were virtually no easy applications. and the reason for the defect is found in a single paragraph early in the court's opinion, where it notes that the statute was "derived from early english law" designed to address "labor shortages" caused by the "breakup of feudal estates," and subsequently "became criminal aspects of the poor laws."1 33 thus, however apt the language might have been given the historical goals and values promoted by the english vagrancy statutes, those specific goals and values no longer obtained in late twentieth-century florida. 3. rules and standards our claim that an apt legal definition generates predominantly easy applications requires some further clarification. specifically, we need to attend to two types of formulations: rules and standards. a rule can be likened to an on-off light switch: it is formal, and in the great majority of circumstances the rule either clearly applies or clearly does not. a statute of limitations is a familiar example. by contrast, a standard acts like a dimmer switch for a light: it allows for infinite gradation between on and off. application of a standard tends to be contextual and fact-sensitive. examples include negligence (lack of reasonable care) in tort law. if a field of law is constituted by a particular set of goals and values, then we can understand the difference between rules and standards from that perspective. insofar as a definition within the field promotes fewer than all the goals and values or rests on a particular priority among the values, it will seem rule-like. this is because only those facts necessary to determine whether the favored goal or value is satisfied need be determined and because other goals and values are not in play to point the analysis in different directions. conversely, insofar as the definition promotes many or all of the goals and values simultaneously and without preference, it will seem standard-like. the increased number of values in play will push the analysis in different directions and will require many more facts to be determined. the analysis will therefore be much more contextual and complex. 13 4 because the goals and values that constitute a field are heterogeneous-because they cannot be reduced to one another or collectively subsumed under another goal or value-they will, as suggested earlier, compete for attention in the formulation of a legal definition. accordingly, we can understand professor carol rose's analysis of the rule133. id. at 161-62 (citations omitted). 134. see, e.g., popov v. hayashi, no. 400545 (san francisco super. ct. dec. 18, 2002) ("using a contextual" analysis to resolve dispute over "possession" of barry bonds's seventy-third home run baseball). 330 [vol 11:5 defining income standard dialectic1 3 5 as follows. at any given moment in the development of the field, certain goals and values will gain ascendency and generate definitions that use rule-like formulations to promote them over the other goals and values. however, the demoted goals and values may continue to compete for attention and over time generate changes in the definition that muddy it up and move it more in the direction of a standard. but the competition doesn't stop, and we can expect at some point in time that once again certain goals and values will contingently gain ascendency and generate more rule-like definitions. and the cycle continues. both rules and standards can be apt. because a rule generally reflects a prioritization of the core values of the field, promoting certain values and sacrificing others, there should be very few instances in which values point in different directions when the rule is applied, and the ratio of easy to controversial applications should, consequently, be very high. for instance, we would expect a very small proportion of statute of limitations issues to be controversial. 36 in contrast to rules, standards generally require for their application that virtually all the core values be considered in the context of the particular case. and for this very reason standards can generate many controversies. nonetheless, a standard can be apt as long as the ratio of easy applications (where all the relevant values point toward the same conclusion) to controversial applications (where the values point to different conclusions) is high. negligence illustrates this. while this dimmer-switch-like standard, with its focus on nuance and context, generates many more disputes than does an on-off rule like a statute of limitations, the easy applications still predominate. if we consider the countless everyday physical encounters (pedestrian bumps, fender-benders, etc.) that are quickly resolved by means of an apology or informal compensation, we quickly realize that as a practical matter the question whether behavior constitutes reasonable care is easily resolved in the vast majority of situations.137 how does that happen? how is it that the all-things-considered judgments required by a standard can generate predominately easy applications? the answer appears to lie in a contingent social fact: if there is 135. carol m. rose, crystals and mud in property law, 40 stan. l. rev. 577 (1988). 136. however, for a rule to be apt, two conditions must usually be met. the first is that the rule must reflect values that define the field. the second condition is that the prioritization of core values reflected in a rule must be politically and socially acceptable. a failure to meet either or both of these conditions would generate noncompliance or legal challenges. 137. of course, an additional reason for a lack of formal controversy is that the injury is too trivial to litigate. the significance of this factor will become apparent in the consideration of the distinction between public and private law. infra notes 138-40 and accompanying text. 2011] 331 florida tax review a widely shared understanding of the goals and values that underlie the field, then a standard that reflects those values will be apt. the significance of social consensus becomes clearer as we consider the distinction between private and public law and the important public law value of administrability. two particular features distinguish public from private law. the first of these is institutional. governmental institutions monopolize the enforcement of public law, while enforcement of private law is primarily in the hands of individuals, with the government serving as enforcer of last resort. again, the vast majority of issues involving questions of negligencea private law question-are resolved privately. easy applications routinely stay in the hands of private individuals (people do not litigate accidental bumps in a crowd), and many controversial applications are similarly resolved privately without litigation (by negotiating compensation or ignoring the matter). indeed, individuals are free to invent the standards governing their relationships, as long as such standards do not violate legally enforced social policies.138 the government, largely through the judiciary, is invoked only when these private negotiations fail and the stakes are sufficiently high. by contrast, individuals cannot decide for themselves whether a particular accession to wealth is taxable or whether particular behavior is criminal. 3 9 income tax law and criminal law, two paradigmatic examples of public law, are binding on all and are principally interpreted, applied, and enforced by agencies of the government. a second feature that distinguishes public from private law is, in some ways, the flip side of the first. because public law is enforced by the government and potentially applicable to everyone, administrability should be a centrally important value. a legal definition is administrable to the extent that it can be applied easily and without excessive controversy by the governmental agency charged with its enforcement. in the competition 138. see robert c. ellickson, order without law: how neighbors settle disputes pt. 1 (1991) (describing how cattle ranchers in shasta county, california resolve disputes using informal norms rather than law); see generally id. pt. ii (setting out a "theory of how people manage to interact to mutual advantage without the help of a state or other hierarchical coordinator"); and stewart macaulay, non-contractual relations in business: a preliminary study, 28 am. sociological rev. 1 (1960) (study of use of informal norms rather than contract law to structure business relationships). 139. the problem of triviality is more complicated. minor accessions to wealth or instances of criminal behavior may be overlooked because private individuals fail to bring them to the attention of the government. however, while private law permits private individuals to resolve such issues among themselves; public law does not. law enforcement officials may decide that a particular offense is not worth the expenditure of resources to prosecute; however, the law does not delegate that kind of determination to private persons. 332 [vol. 11:5 defining income among the congeries of values that constitute a given field of public law, the importance of administrability will tend to push definitions in that field toward rule-like formulations for two reasons. first, the central importance of administrability will cause it to dominate in the competition among goals and values, and definitions that reflect the domination of a single goal or value will tend to be rule-like. second, administrability itself suggests rulelike definitions since the on-off nature of rules tends to support many of the qualities associated with administrability: clarity, simplicity, dependence on discoverable information, and predictabilityand, not coincidentally, few controversial applications.14 0 the dimmer-switch quality of standards, on the other hand, tends to defeat administrability with its insistence on highly nuanced, contextual application of multiple, heterogeneous values. that is, because of the all-things-considered requirement of a standard, its application is less efficient and simple than the more limited considerations required by a rule. of course, administrability is a value in all fields of law because some governmental institution will have the responsibility for policing (i.e., administering) the law's implementation. but in private law this responsibility falls to the courts, which are called upon only as a last resort; following the law is largely in the hands of private individuals. accordingly, administrability isn't a powerfully important value, and in the ongoing competition it will not consistently dominate the formulation of definitions. hence, private law makes frequent and successful use of standards (e.g., the negligence standard in torts). but tax is public law, and administrability is crucially important, so we would expect the definition of a key concept like income to be a rule or be inapt. we will now show that it is neither. iii. aptness in the tax law individuals have tax responsibilities even if they do not do anything wrong and do not want to pay taxes, and these responsibilities are triggered by the receipt of gross income.14' the definition of income is therefore of central and foundational importance. yet, as we demonstrated in part i, a definition that accurately describes what is subject to tax does not exist. although glenshaw glass purports to provide a definition of income in the 140. the qualities that constitute administrability have an affinity with the qualities identified by lon fuller as constituting the "internal morality of law"qualities he regarded as necessary to fulfill law's function as "the enterprise of subjecting human conduct to the governance of rules." see fuller, supra note 51, ch. 2. 141. not all gross income will become taxable income because of the existence of deductions, and even the existence of taxable income may not result in positive tax liability because of the existence of credits, but the receipt of gross income raises the possibility of the existence of ultimate tax liability. 2011] 333 florida tax review tax law, there is an apparent incongruence between the arguable reach of that definition and the income that is actually subject to tax. in our discussion of aptness in part ii we saw that a definition that generates many contestable cases may be inapt. accordingly, we now turn to determining whether the glenshaw glass definition of income is inapt for this reason. a. values in the tax law the first step in determining aptness is an identification of the goals and values in the tax law. identifying the principal goal of the income tax system is easy: the tax system exists to raise revenue. redistribution of wealth and shaping behavior are secondary objectives, and whether they are proper objectives at all is debatable, but there can be little disagreement that the primary goal of the income tax system is to raise revenue.14 2 important policies determine how the revenue is raised. those policies are usually described as a trinity: equity,14 3 efficiency,1" and simplicity,14' but that listing is misleading for two reasons. first, it does not capture the degree to which each of the items is valued. in most discussions of tax policy, equity and efficiency take center stage.14 6 not only is simplicity always third, but it is a very distant third. often it is not discussed at all, and when it is, it appears in the role of an intruder crashing the theoretical party. although simplicity is often touted as 142. our analysis is deliberately confined to the income tax. other taxes, such as wealth transfer taxes (estate, gift, and generation skipping) have other principal objectives. 143. equity takes two forms. horizontal equity refers to the taxation of similarly situated taxpayers similarly. vertical equity refers to taxing in proportion to ability to pay so that tax burdens rise as ability to pay raises. both forms are contested, as it is often difficult to determine the way in which the similarity of situations should be determined and the proposition that tax the rate of tax should rise as ability to pay rises is hotly debated. although scholars, policy makers, and the public differ on how they define equity, there is general agreement that equity is an important goal of the tax system. 144. efficiency is generally defined in economic terms, in which an efficient system is one that does not interfere with the actions of participants in the marketplace. the more a system interferes with economic activity, such as by providing more favorable tax consequences for one activity than another, the more inefficient it is. sometimes the inefficiency is deliberate, as in the case of tax expenditures. 145. see, e.g., graetz & schenk, supra note 9, at 28. 146. see samuel a. donaldson, the easy case against tax simplification, 22 va. tax rev. 645, 652-53 (2003); david a. weisbach, line drawing, doctrine, and efficiency in the tax law, 84 cornell l. rev. 1627, 1649 (1999); deborah l. paul, the sources of tax complexity: how much simplicity can fundamental tax reform achieve?, 76 n.c. l. rev. 151, 157 (1997). [vol. 11:5334 defining income desiratum, it seems to have little actual traction since the tax laws get more complicated every year and the trend shows no sign of abating. simplicity is lauded as an objective, but in the end it usually gets left on the cutting room floor. 147 second, simplicity is not the whole story. simplicity can be important in producing an equitable and efficient system, but it does not necessarily do so,145 and we believe it is more appropriately thought of as a part of what makes the tax law administrable. as we argued in part ii, administrability is a centrally important value in any field of public law, and having an administrable tax law is what makes it possible for the system to raise the revenue which is its raison d'etre. an unadministrable system will almost certainly be inequitable and inefficient because it will affect taxpayers arbitrarily, resulting in inequity and inefficiency. simplicity enhances administrability and administrability is necessary so that the system can raise revenue in an equitable and efficient way. administrability requires simplicity, but it requires other things as well. administrability includes transparency, as well as the procedures and practices necessary for the collection of revenue, such as designing and printing forms and instructions and providing mechanisms for audit, assessment, and enforcement.14 9 because the concept of administrability captures the reason for including simplicity as a tax policy value but is more comprehensive, we believe that it is more descriptively appropriate and we adopt it in our analysis. we consider administrability to consist of the interaction between simplicity, transparency, and the operational mechanics that makes a system work to achieve its objective of collection of revenue in an equitable and efficient manner. 147. graetz & schenk, supra note 9, at 31, see steven a. dean, attractive complexity: tax deregulation, the check-the-box election, and the future of tax simplification, 34 hofstra l. rev. 405 (2005); steve r. johnson, the e.l. wiegand lecture: administrability-based tax simplification, 4 nev. l.j. 573, 583 (2004); donaldson, supra note 146, at 647. 148. for example, a head, or per capita tax, is simple, but very inequitable, and a tax on wages, but nothing else, is also simple, but it is not only inequitable but also very inefficient as taxpayers have every incentive to receive compensation in non-wage forms. 149. graetz & schenk, supra note 9, at 71-74, 78-80; gao, understanding the tax reform debate: background, criteria, & questions 45-52 (2005); mcdaniel et al., supra note 9, at 27-32; see anthony c. infanti, tax equity, 55 buffalo l. rev. 1191, 1202 (2008) ("[a]n 'administrable' tax is one that minimizes the burdens on taxpayers in complying with it and reduces the costs to the government of enforcing it."); see johnson, supra note 147, at 580; william g. gale & janet holtzblatt, the role of administrative issues in tax reform: simplicity, compliance, and administration, in george r. zodrow & peter mieszkowski, united states tax reform in the twentyfirst century 9-13 (cambridge univ. press 2000). 2011] 335 florida tax review conceptualizing simplicity as part of the larger concept of administrability does not rescue it from the back of the policy pack, however. in most tax policy discussions, when issues of administrability are discussed at all, they are portrayed as near-afterthoughts, as considerations that must be tolerated, but not embraced. administrability is the housework of tax policy.s 0 b. the importance ofrules not coincidentally, the realization requirement, so crucial to the administrability of the income tax system, is a rule. realization requires an event that changes a taxpayer's legal relationship to property. in helvering v. bruun the court held that a landlord whose tenant built a building upon leased land and then abandoned the lease had income in the amount of the value of the new building.' 5 ' the landlord's legal relationship to the building changed upon the tenant's abandonment of the lease because as a result of 150. administrability played a role in the debate over the proper treatment of caught record breaking baseballs, but its role was controversial and illustrates its uncertain status as a policy value. professors zelenak and mcmahon asserted that one reason to embrace their view that "income is cash except when it can't be to prevent avoidance" is that it has the "attainable virtues" of ease of valuation and of liquidity, zelenak & mcmahon, supra note 5, at 1304, but professor dodge was unpersuaded, opining instead as follows. [t]he income tax base has been, and perhaps should be, modified to take into account practical concerns such as difficulty or impossibility of valuation and nonliquidity is commonplace. but practical concerns do not automatically trump other norms. nevertheless, insofar as zelenak and mcmahon are arguing that practical concerns should be taken seriously, i would not only concur but advance the point a step further: accommodation to practical considerations should not be viewed as a 'retreat' from 'principle,' but rather as a 'shift' to a different kind of principle, namely, a 'legal' (as opposed to 'economic' or 'fairness') principle. legal issues that are relevant to the present discussion include: (1) whether or not rules that can rarely be enforced, or which are enforced at the whim of officials, are 'rules' worth having, and (2) whether various distinctions among tax categories are coherent and intelligible. admitting legal norms into tax policy debates should not be a cause for embarrassment. dodge, claim of right, supra note 6, at 693 (footnotes omitted). professor dodge's characterization of administrability as proceeding from a "different" principle consigns it to second class status. 151. helvering v. bruun, 309 u.s. 461 (1940). 336 [vol. 11:5 defining income the abandonment the landlord acquired rights, such as the right to take possession of or re-lease the building, which it did not have before.15 2 in bruun the court found realization despite the absence of the severance which it had considered determinative in macomber, looking to the more subtle change in legal relationship rather than the more crass severance. similarly, in cottage savings v. commissioner the court found that a taxpayer who exchanged a pool of mortgages with a fair market value of $4.5 million for another pool with the identical fair market value had a realization event despite the equivalence of the market values because the underlying mortgages in each pool were different.15 3 in the court's view the difference in the identity of the properties and obligors in the underlying mortgages sufficed to create realization.15 4 realization has all of the hallmarks of an apt concept. it provides a rule in an area of public law and it is an on/off switch which tracks an identifiable event. the rule is easy to apply in most situations, and those in which it is not tend to be relatively few. in realization the vectors of important tax values point in the same direction. the vector of equity, treating similarly situated taxpayers similarly, is satisfied because all taxpayers who experience a change in their legal relationships with property will have realization events. the vector of efficiency, having the tax system interfere as little as possible with what taxpayers feel it is economically favorable to do, is satisfied because tax consequences are determined by reference to the change in legal relationships, which has economic significance in most cases. the vector of administrability points to realization because the occurrence of an event makes the definition administrable insofar as the event can be identified. the wrinkle in this analysis is that the change in legal relationships is not the only occurrence that has economic significance. the increase or decrease in value has economic significance as well, and that is one reason cottage savings has been controversial.155 arguably, a system in which 152. although the enactment of § 109 changes the specific result reached in bruun, it does not affect the validity of the holding on the realization question or its effect on other fact patterns not covered by § 109. 153. cottage savings v. comm'r, 499 u.s. 554 (1991). 154. as the court explained, "[b]ecause the participation interests exchanged by cottage savings and the other s & l's derived from loans that were made to different obligors and secured by different homes, the exchanged interests did embody legally distinct entitlements. consequently, we conclude that cottage savings realized its losses at the point of the exchange." id. at 566. 155. the absence of a change in economic position has led many to regard cottage savings as a tax shelter case. see, e.g., david weisbach, business purpose, economic substance, and corporate tax shelters: the failure of disclosure as an approach to shelters, 54 smu l. rev. 73, 75 (2001); joseph bankman, the economic substance doctrine, 74 s. cal. l. rev. 5 (2000). indeed, taxpayers often 2011] 337 florida tax review taxation followed fluctuations in market values would be more equitable and efficient than one which requires realization, as all taxpayers with equivalent changes in their wealth would be treated alike. an accrual (non-realization based) system would also be less susceptible to manipulation through the creation of events with legal but little economic significance and would therefore be more efficient than a realization based system.1 57 but, as we have seen, it would also be nearly impossible to administer. factoring in the change in values makes the equity and efficiency vectors favor accrual rather than realization but causes significant administrability problems in many cases. the administrability vector therefore points in favor of realization (rather than accrual) and in this case its strength is determinative because an unadministrable tax system is no tax system at all. the strength of administrability therefore suffices to overcome the strength of the values of equity and efficiency. over seventy years earlier the court grappled with these clashing values when it embraced the concept of realization by failing to find that it existed. in macomber a majority of the court, over the vigorous dissent of justice brandeis (as well as a less vigorous dissent by justice holmes), held that a pro-rata stock dividend was not income because any increase in the value of the taxpayer's capital (the underlying stock) represented by the issuance of the stock dividend had not be severed from the capital. in requiring severance before being willing to find that receiving the additional shares of stock created income, the court allowed administrability to moderate the pull of equity and efficiency, for equity and efficiency are precisely what the taxpayer, and justice brandeis in dissent, championed.158 cite cottage savings in support of their position in corporate tax shelter cases. see, e.g., acm pship v. comm'r, 157 f.3d 231, 251 (3d cir. 1998). 156. jeffrey kwall, when should asset appreciation be taxed?; the case for a disposition standard of realization, 86 indiana l. rev. 77 (2011); clarissa potter, mark-to-market taxation as the way to save the income tax-a former administrator's view, 33 val. u. l. rev. 897 (1999); david a. weisbach, a partial mark-to-market tax system, 53 tax l. rev. 95, 103-05 (1999); daniel halperin, saving the income tax: an agenda for research, 77 tax notes 967 (1997); fred b. brown, "complete" accrual taxation, 33 san diego l. rev. 1559 (1996); reed shuldiner, a general approach to the taxation offinancial instruments, 71 tex. l. rev. 243 (1992); jeff strnad, periodicity and accretion taxation: norms and implementation, 99 yale l.j. 1817, 1879 (1990); david shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. 1111 (1986). 157. the code requires mark-to-market (accrual) taxation in a few situation in which it is feasible, such as in the case of certain financial instruments, as described in § 1256. see generally henry ordower, revisiting realization: accretion taxation, the constitution, macomber, and mark to market, 13 va. tax. rev. 1 (1993). 158. the two values converge in this case, as they do in many cases. treating economically similarly situated taxpayers similarly is equitable, and making [vol. 11:5338 defining income although the government lost both macomber and cottage savings, the allure of grounding decisions on changes in economic relationshipseconomic substance-has remained strong.15 9 we think that the glenshaw glass definition of income has endured because it is grounded in economics; it is nearly coextensive with the haig-simons definition. the question we must now answer is whether the glenshaw glass definition of income is apt. c. aptness and glenshaw glass preliminary analysis would suggest that the answer to that question is yes. the definition of income in the tax law is a part of public law, and a public law of intended application to the entire population. in such cases definitions ought generally to be promulgated as rules to maximize administrability, and the glenshaw glass definition looks like a rule. it has the on/off quality of rules. applying the glenshaw glass definition, a taxpayer either has a clearly realized accession under her dominion or she does not. defining income should be like turning on a light-the light is either on or off. but that binary paradigm is illusory. the glenshaw glass definition of income has the appearance of a rule but is actually a standard. as interpreted and administered by the irs, the definition of income is a standard because it does not operate like an on-off switch. as we demonstrated in part i, there are numerous items that fit the glenshaw glass definition of income and are not excluded by statute but which are nevertheless not income that is taxed. the reason for this is not that the irs is lawlessly refusing to follow the dictates of glenshaw glass; the reason is that glenshaw glass does not indicate what metrics ought to be applied in making the determination of what is and what is not within the definition. that is, glenshaw glass fails to specify what counts as an "accession to wealth." does psychic wealth count? on the one hand, much of the market value of mark mcgwire's seventieth home run ball derives from the psychic benefits its ownership can provide; on the other hand, a foul ball hit by a taxpayer's favorite baseball player might hold as much or more psychic value for her as the more famous record-breaking ball. is that taxpayer's increase in psychic wealth income when she catches her favorite player's foul ball? the answer is no, but not because glenshaw glass explicitly says that an accession is not to be determined by a psychic metric. we do, in economic position, rather than form, determinative makes it futile for taxpayers to engage in transactions purely for formalistic reasons, which is efficient. 159. most recently congress codified the economic substance doctrine, to the dismay of much of the tax bar. see generally martin j. mcmahon, jr., living with the codfied economic substance doctrine, 128 tax notes 731 (2010). 2011] 339 florida tax review effect, tax psychic value when it can be translated into market value.16 0 when the goals and values of income taxation are all taken into account, the reasonable conclusion is that the kind of wealth we are concerned with in taxation excludes psychic wealth, unless it enhances market value, just as it excludes imputed income from services, the material support that parents give to children, or, sensibly, welfare payments or education provided by the government. these exclusions, resulting from an all-things-considered understanding of the meaning of "accessions to wealth," are typical of how standards operate.161 recall that an apt definition reflects the goals and values of the field and thereby generates predominately easy applications. rules accomplish this by privileging certain values over others. standards, by contrast, typically achieve aptness despite their all-things-considered approach through widely shared consensus. an example is the standard of "reasonable care" in the law of torts. by contrast, we expect a standard lacking widely shared consensus as to its applications to generate a large "borderland"-a predominance of controversial cases. so is the glenshaw glass definition of income an apt standard like reasonable care in torts? we conclude that the glenshaw glass standard is apt, but for a surprising reason. although there is probably wide agreement with respect to whether some items, such as salary, are income, there is wide disagreement generally as to many other items. the disagreement is deep, ranging from fundamental issues, such as whether capital gains should be income, to the more peripheral, such as the treatment of caught record breaking baseballs. while positive law resolves the disagreement in some cases, in part by providing a compromise, such as the reduced rate of tax applicable to realized capital gains in the united states, deep divisions remain. as professor bittker observed more than four decades ago, "[w]hen we turn to the field of income taxation, however, we do not begin with a consensus on the meaning of income, but with a myriad of arguments about what should be taxed, when, and to whom." 62 the arguments have not abated in the intervening years-if anything they are now more intense. the clash of values in taxation is so deep that it encompasses not only what ought to be taxed but whether there ought to be a tax system at all or, if so, how extensive it should be. taxation not only played a pivotal (if 160. see william a. klein, timing in personal taxation, 6 j. legal stud. 461,479 (1977). 161. the transformation of the glenshaw glass rule-like definition into the standard-like administered definition of income is neatly explained by professor carol rose's analysis of the rule-standard dialectic. supra notes 135-37 and accompanying text. 162. bittker, ctb as goal, supra note100, at 985. 340 [vol. 11:5 defining income symbolic) role in the founding of the united states, but debate about its role and extent continues today and exposes deep divisions regarding values. issues of the reach of the tort law or some aspects of the criminal law are debated in the context of the political debates that are part of the democratic process, but it is difficult to say that any other area of law is as visible a part of political debate at the highest levels as the tax system. presidential candidates are rarely asked about their positions on matters of torts, contracts, or property, and with respect to criminal law they may be asked about the death penalty. but a presidential candidate without a position on taxes is unimaginable. the candidates are almost certain to differ, and differ substantially. that those differences constitute a central part of their platforms illustrates the deep societal divisions on taxation. if there is little agreement on whether we should be taxed and the extent to which we should be taxed, it is hardly surprising that there will be little agreement on what the tax base should be. even individuals who agree on the essential need for taxation will differ on what ought to be subject to tax, and those differences are not only deep but are often unexplored. tax may be different from other areas of the law in at least two ways. first, self interest can affect tax values in ways that are less evident in other areas of law. ex ante, an individual might not know what kind of contract or tort rules she might favor because she would not know whether she would be likely to be a breaching promissor or a disappointed promisee, or the driver of the vehicle or the pedestrian who was hit. in tax, however, self interest will almost always move an individual toward a conclusion of no income. sides are more easily taken, even in the abstract. second, putting self-interest to one side, while socialization produces in most individuals a shared morality and sense of right and wrong, socialization does not typically produce in individuals a sense of what ought, or ought not, be taxed. those who teach tax know that until students take the introductory income tax course, few have given much thought to the subject. they may know that there is an obligation to pay tax, as do most people, but like most people, they expect the tax law to consist of a set of mechanical rules unmoored from values. students expect that the subject will be artificial, unlike, for example, constitutional law, which they know will involve the clash of deeply felt values. that perceived artificiality complicates the clash of values. people who have not thought much about the values of equity and efficiency in taxation but care about baseball may well think that a caught record breaking baseball ought to bring nothing but joy to its catcher. there is almost certainly a greater national consensus about baseball than about what ought to be taxed and it is likely that most baseball fans would agree with former 2011] 341 florida tax review irs commissioner rossotti that the lucky fan who catches the record breaking ball deserves "a round of applause, not a tax bill."l 63 commissioner rossotti's account of his reaction to the caught baseball tax controversy, which we discussed briefly in part i.c, is worth detailing because it illustrates perfectly the clash of values we have identified. commissioner rossotti was the first commissioner in a very long time who was not a tax professional.16 he had founded and run a large information technology corporation and was brought in to head the irs at a time when the agency was in great turmoil and the approach of y2k raised the specter of the possible collapse of its computer systems.165 that he was not a lawyer, much less a tax lawyer, is important because it means he brought to the position of commissioner the reactions and sensibilities of a member of the public, not of someone whose professional training began at the knee of section 61 and glenshaw glass. in his reflections on his time as commissioner he recounted the events that began the baseball tax controversy: a new york times reporter asked "a hypothetical question about gift tax due from a fan who might catch [mark mcgwire's] record breaking baseball and give it back to mcgwire.166 when an irs spokesperson answered the question by saying that tax would be due, a firestorm of controversy erupted. as rossotti explains, more than innocent-spouse cases, more than small-business owners losing their businesses, more than its modernization failures, the prospect of the irs taxing this hypothetical good-hearted fan unleashed the fury of the american people, not to mention their representatives in congress. this was what people thought of when they talked about a faceless bureaucracy..16 the firestorm of controversy erupted because even if most people had not thought much about what ought to be taxed, it seemed obvious to them that a ball caught at a park should not be. in the words of white house spokesman mike mccurry, taxing the baseball was "about the dumbest thing i've ever heard in my life." 68 it is telling that tax professionals, those who had been inculcated with the structure that begins with section 61 and proceeds to glenshaw 163. ir 98-56, 98 tnt 174-14. see rossorri, supra note 92, at 223. 164. ryan j. donmoyer, next irs commissioner should be outsider, grassley says, 74 tax notes 993 (1997); see, unofficial transcript of finance hearing on irs commissioner-nominee rossotti, 77 tax notes 583 (1997). 165. rossotti, supra note 92, at 1-25. 166. id. at 94. 167. id. at 95. 168. id. [vol. 11:5342 defining income glass, were unanimous in their view that catching the baseball and keeping it produces income.169 commissioner rossotti was fortunate in not having to answer that question. the irs chief counsel was able to respond to the catch-and-return hypothetical by analogy to disclaimers and thus conclude that there would be no tax.170 a subsequent irs chief counsel, himself a baseball fan, had no such easy out. when asked the income question directly, he covered his head with his hands and declined to respond.171 commissioner rossotti is justifiably proud of his handling of the situation, reporting that the press grudgingly gave us credit for not being so pinheaded after all. i was told one of the television commentators read my quote "sometimes pieces of the tax code can be as hard to understand as the infield fly rule. all i know is that the fan who gives back the home run ball deserves a round of applause, not a big tax bill" to the national audience at the beginning of the game in which mcgwire hit his sixty-second homer. by the skin of our teeth, we had turned a potential public relations disaster into something that made it seem as if real people worked at the irs, even people who knew what the infield fly rule was.172 commissioner rossotti's account of the irs response to the controversy captures the importance of the irs's role in resolving clashes of values in defining income. it is significant that, in commissioner rossotti's words, "real people work at the irs." commissioner rossotti's reaction to the baseball controversy illustrates another way in which values clash over what should be taxed-the clash between tax professionals and the tax laity. there was unanimity of opinion on the part of tax professionals, for whom it was clear that the baseball was income when caught, but members of the general public, including members of congress and the irs commissioner himself (who as a non-tax professional had not been privy to the inculcation of values that begins when a student takes her first tax course), considered such a result preposterous. as the casebooks and other student materials show, the study of tax begins with what is income, and that in turn begins with haig-simons and leads directly to section 61 and glenshaw glass. 1 tax students are 169. zelenak & mcmahon, supra note 5, at 1300. 170. rossorri, supra note 92, at 95; ir 98-56, supra note 163. 171. herman, supra note 93, at dl. 172. rossorri, supra note 92, at 95. 173. see supra notes 5-6 and accompanying text; see also casebooks cited supra note 9. 2011] 343 florida tax review taught that the definition of income is rooted in haig-simons and that tax should follow economics, in large part because doing so will effectuate the core values of equity and efficiency. the approach does not admit other, non-economic values, and that sets up an inevitable clash between the views of the professionals, who have absorbed this training, and the laity, which has not. practicing tax lawyers may not consciously experience the full force of the clash because their duty to represent their client's interest will usually cause them to want to find no income and they will attribute any irs desire to find income to rapaciousness born of the duty to collect revenue. law trains us to think in adversarial terms. but tax lawyers who work for the irs, particularly those in its office of chief counsel, have a more difficult task. those tax lawyers would probably agree that equity and efficiency point toward taxing the value of the baseball (because it is an accession to wealth clearly realized within the taxpayer's dominion if she keeps it), and the chief counsel who covered his head with his hands and pleaded not be asked the question probably reflects that. 174 but as lawyers working for the irs they understand the difficulty of administering such a conclusion, not only because of the difficulty of valuation but also because it necessarily implies taxing all caught baseballs, including those of relatively little value. such a result, while equitable and efficient,' 75 is unadministrable, not only because people would rebel but also because it would be impossible for the irs to enforce it. administrability encompasses non-economic values, which affect the irs's ability to enforce the law, as well. equity, efficiency, and administrability thus clash in this case as they do in those involving free samples, because the free sample of shampoo mailed to an individual's house is logically indistinguishable from the one included in the oscar swag bag. a rule based on administrability could be an invitation to circumvention] and would lack the flexibility to address similar but unforeseen iterations of the same issue by weighing non-economic values that affect public perception and enforceability. in the case of income, a standard is therefore most apt.17 7 174. see supra note 93 and accompanying text. 175. it is efficient because it doesn't privilege one type of accession over another and hence does not induce taxpayers to engage in a particular type of behavior over another. 176. rules can invite behavior that might be regarded as circumvention because they create bright lines that allow taxpayers to choose whether to go to, but not over, the line, or to cross the line. see, e.g., granite trust co. v. united states, 238 f.2d 670 (1st cir. 1956); rev. rul. 78-285, 1978-2 c.b. 287. this is not a new problem, and it is one that may be informed by the concept of aptness that we have tried to develop here, but further discussion of it is beyond the scope of this first attempt. 177. treasury has used rules effectively when its overriding objective has been to promote administrability. two prominent examples are implementing the 344 [vol. 11:5 defining income but if we cannot rely on a shared consensus regarding tax values to render the glenshaw glass standard apt, what is the substitute? the answer is ad hoc intervention by the irs. the irs has specified on a case-by-case basis what counts as an accession to wealth for purposes of income taxation, and it has generally done so in a manner that respects the values of equity and efficiency, along with the equally important value of administrability. the glenshaw glass standard will produce the right result in those cases where the values align, so salary will be income because treating it as such promotes both equity and efficiency and is highly administrable. but in cases where the values point in different directions, such as the case of the client who is taken to lunch by her lawyer, the irs can weigh equity and efficiency, both of which would point to income, but allow administrability to outweigh them, leaving itself open to argue income when it senses abuse, either because the value of the lunch is excessive or because it suspects some non-business motivation on the part of the lawyer. moreover, with a standard the irs can take into account non-economic values that are not central to tax law but emerge as important in specific situations-like reverence for the game of baseball. 78 the use of a standard, as exists in the administered definition of income, respects equity and efficiency. at the same time, the standard allows for the crucial value of administrability by giving the agency charged with administering the tax law, the irs, the ability to weigh the relative values, including non-economic values, and make decisions that reflect current circumstances. the very cloudiness of the definition thus becomes its strength. it was justice benjamin cardozo, writing for a unanimous court trying to define "ordinary and necessary" in welch v. helvering,179 who perhaps captured the wisdom of the structure: "the standard set up by the statute is not a rule of law; it is rather a way of life. life in all its fullness must supply the answer to the riddle."8 o supreme court's decision in indopco, inc. v. comm'r, 503 u.s. 79 (1991), by issuing regulations that contained numerous safe harbors and de minimis rules, treas. reg. § 1.263(a), and making entity classification elective in many cases through the promulgation of the check-the-box regulations, treas. reg. § 301.77013. 178. in his 1992 h.l.a. hart lecture at oxford university, professor tony honor6 offered a political justification for substituting the will of officials for social consensus in defining our legal obligations. tony honor6, the dependence of morality on law, 13 oxford j. legal stud. 1 (1993). 179. welch v. helvering, 290 u.s. 111 (1933). 180. id. at 115. the deep irony of our conclusion does not escape us. not only do we know that the welch opinion is not generally regarded with admiration by tax lawyers and scholars, but for decades at least one of us shared the deep derision in which it is held. see, e.g., joel s. newman, the story of welch: the use (and misuse) of the "ordinary and necessary" test for deducting business 2011] 345 florida tax review what we propose, that the definition of income be acknowledged to be a standard that should be interpreted in light of the values-including noneconomic values-that animate the field of income taxation, may sound heretical or even incoherent to the contemporary scholarly ear, but it is not revolutionary when viewed in historical context. it has a long and distinguished pedigree that dates to the period shortly before the court's decision in glenshaw glass and that was contained in scholarship that was cited by the government to the court in that case.181 professors surrey and warren understood that even the macomber formulation was "a generalization rather than a definition"' 82 that failed to answer questions such as whether the "act of picking up found money [was] 'labor"'"83 which would be captured by the macomber formulation of income as "gain derived from capital, from labor, or from both combined." 84 they acknowledged that the haig-simons definition was too broad to be administrable and concluded instead that the concept of income is a flexible one, with the result in a particular case being determined by the interplay of common usage, accounting concepts, administrative goals, and finally judicial reaction to these forces. each force and judicial reaction in turn reflects an underlying judgment as to what types of receipts should be subject to a tax imposed on )1185"income. they advocated "a simple reference to 'all gains, profits, and income,"" 86 because they "believed that this combination of wide expenses, in tax stories 197, 205 (2d ed. 2009) (characterizing what justice cardozo was doing as "whining"). although we agree with professor newman that the opinion "long ago should have been consigned to the judicial scrap heap" for its extreme obfuscation of the capitalization doctrine, which should have served as the sole basis for deciding the case, id, at 223, we are constrained to conclude that despite the "archaic, verbose style," id. (quoting brady coleman, lord denning & justice cardozo: the judge as poet-philosopher, 32 rutgers l.j. 485 (2001)), and the charge that justice cardozo "sometimes substitutes rhetorical flourish for analysis," william powers, jr., thaumatrope, 77 tex. l. rev. 1319 (1999) (quoted in newman, supra, at 223), justice cardozo nevertheless captured the tension and the clash of values it has taken us an entire article to untangle. that deserves some credit. 181. see supra notes 36-46 and accompanying text. 182. surrey & warren, supra note 2, at 770. 183. id. 184. eisner v. macomber, 252 u.s. 189, 207 (1920). 185. surrey & warren, supra note 2, at 771. 186. id. 346 [vol. 11:5 defining income inclusiveness and elasticity" offered "reasonable certainty for almost all of the area and a workable standard for the application of judicial and administrative common sense in dealing with the infrequent but intriguing problems at the periphery."187 after reviewing some of what were then novel questions, such as whether the recovery of damages for insider trading under section 16(b) of the securities exchange act were income, they explained that [t]he question is thus whether it is more sensible to have these unforeseen borderline questions depend upon the construction of the phrase "gains, profits, and income" or upon a judicial dissection of various subsidiary items of income. it is likely that the former would produce a more satisfactory and coherent result, since the court's attention would be focused directly on the basic issue of the desirability of including these borderline items within a statute taxing "income." in the income tax, as in other complex legislation, the need is for a standard which will project our present aims into the future and serve as the vehicle for solving the unforeseen cases as they arise. the legislative function is not denied or thwarted when other branches of the government are relied upon by congress to perform substantial tasks in the application of statutes. administration and judicial interpretation are necessary parts of the overall process of legislation. the income tax is no exception."' we couldn't agree more. because the surrey and warren article was cited in the government's brief in glenshaw glass and because its discussion of the definition of income implicated precisely the issue facing the courtexpansion of the macomber definition-and was prominent, having been placed at the very beginning of the piece, we believe that it is likely that the court considered it, and took it to heart in the formulation it adopted in that case.'8 9 we think that history has proven professors surrey and warren, and later bittker, right. while a definition of income that is acknowledged to be a standard does not fit the desire for technical precision that seems to be the hallmark of so much tax legislation, it is not for that reason inapt. 187. id. at 772. 188. id. at 773-75. 189. see supra text accompanying notes 43-46. 2011] 347 florida tax review acknowledging that the glenshaw glass formulation is not a rule but a standard will not land the tax system in a quagmire but will instead, like professor bittker's rejection of the ctb as a goal of tax reform, allow a deliberate examination of whether a particular item ought to be included in the tax base. iv. conclusion in law, as in baseball, there are rules and there are standards. the infield fly rule is a rule, but the strike zone is a standard. in law, apparently crystalline rules can turn into muddy standards as they are applied to situations in which competing values clash. the glenshaw glass definition of income may seem to provide a rule, but it is actually a standard, and the irs is its umpire. unlike the umpire, the irs generally does not have the last word. however, the irs does call the balls and strikes within the zone. in doing so it weighs numbers of factors and tries to reach the right result: a tax system that is equitable, efficient, and administrable. by exploring the irs's role in defining income and by dissecting the factors that make it so difficult to articulate a clear, precise, and accurate definition of the income that is taxed, we have tried to illuminate the penumbral area where income becomes no-income. in that area, economics are important, but non-economic values also count. economics is not everything. [vol 11:5348 tcharity really does begin at home: florida tax review volume 12 2012 number 6 453 relighting the charitable deduction: a proposed public benefit exception kristin balding gutting∗ let no man’s ghost say his training ever let him down.1 i. introduction .................................................................................... 454 ii. overview of the charitable deduction ................................. 460 a. the history and purposes of the charitable deduction ......... 460 b. the mechanics of the charitable deduction ........................... 462 iii. the quid pro quo test .................................................................. 464 a. the evolution of the quid pro quo test ................................. 465 1. the pre-quid pro quo test approaches .......................... 466 a. the intent of the donor approach.............................. 466 b. the substantial benefit received approach ............... 470 c. the benefit received approach.................................. 472 2. the quid pro quo test ..................................................... 475 a. the supreme court weighs in .................................... 475 b. the service speaks out — treasury regulation section 1.170a-1(h) .................................................... 480 b. exceptions to the quid pro quo test ...................................... 483 iv. the live burn donation................................................................ 486 a. an overview of live burn training ........................................ 487 b. the deductibility of the live burn donation .......................... 490 1. scharf — allowing the live burn donation ..................... 490 2. hendrix — lack of a qualified appraisal ........................ 494 c. rolfs — the tax court extinguishes the live burn donation 497 ∗ assistant professor of law, charleston school of law. ll.m. in taxation, university of florida fredric g. levin college of law; j.d., st. louis university school of law; b.s. in accounting, valparaiso university. i express my deepest gratitude to j. abraham gutting for his review of earlier drafts. i thank the participants at the southeastern association of law schools (seals) annual meeting, new scholar workshop, and at the southeastern law scholars conference for helpful comments on and ideas for this article. i also thank my research assistants corey smith and aaron scheuer for their tireless efforts. moreover, i dedicate this article to all the firefighters that so bravely risk their lives on a daily basis to keep the public safe. thank you. 1. firematic quotes and prayers, pa fire, http://www.eriepafire.com/ quotes.html (last visited sept. 18, 2011). 454 florida tax review [vol. 12:6 v. the public benefit exception ..................................................... 504 a. the application of the benefit exception ................................ 506 1. the scope of the beneficial group factor........................ 508 2. the type and use of property being donated factor ..... 508 3. the potential underfunding of the donation factor ........ 509 b. the live burn donation amendment ...................................... 511 1. the maximum amount of the deduction allowed ............ 511 2. the time limitation .......................................................... 513 3. the proposed live burn donation amendment ............... 513 iv. conclusion ....................................................................................... 515 i. introduction throughout the country, firefighters risk their lives on a daily basis to keep the public safe. it is, therefore, imperative they receive the best possible training. one invaluable training method is live burn training, in which a structure is set on fire providing firefighters with “a level of realism that is unsurpassed.”2 fire departments, both career and volunteer, as well as numerous municipal departments conduct various training exercises, including roof ventilation, domestic violence exercises, simulated meth lab explosions, room-to-room fire practice, firefighter survival techniques, arson investigation training, rescue techniques, and/or firefighter down techniques, through the donation of homes that are finally burned to the ground as part of live burn training.3 for over thirty-five years, relying on a united states tax court case,4 many believed a taxpayer could claim a charitable deduction for the donation of the taxpayer’s home to the local municipality for live burn training, while still retaining ownership of the underlying land (live burn donation).5 in 2004, however, the internal revenue service (the service) 2. national fire fighter near-miss reporting system: live burn training, fire engineering, http://www.fireengineering.com/articles/2011/01/near-miss-liveburn.html (last visited aug. 3, 2011). see also infra note 179 and accompanying text. 3. robert sullivan, training fire a valuable tool for rfd, paladiumitem (richmond, in), mar. 16, 2011, available at 2011 wlnr 5157123 [hereinafter sullivan, training fire]. 4. scharf v. commissioner, 32 t.c.m. (cch) 1247 (1973), action on dec., 1974-36031 (mar. 20, 1974). 5. see, e.g., sheldon i. banoff & richard m. lipton, tax deductions for clunker homes, without congressional bailouts, 112 j. tax’n 63, 63 (2010) (“experience tells us that charitable deductions for [live burn donations] have been claimed for decades.”); bernard leibtag, tax aspects of contributing a house to a fire department, 39 tax adviser 723 (2008) (“taxpayers can obtain 2012] relighting the charitable deductions 455 established a task force, charged with the sole purpose of extinguishing live burn donations, and requested that local municipalities not cooperate with taxpayers in executing the requisite paperwork in claiming a charitable deduction for a live burn donation.6 in 2009, the deductibility of a live burn donation was thrust into the public spotlight as the media publicized the service’s attack on the charitable deduction claimed by kirk herbstreit, an espn commentator and former ohio state quarterback, for the donation of a charitable contribution deduction for the fair market value of property (i.e., land improvements) donated to a fire department to be burned down.”); bruce w. mcclain & paul j. lee, structuring charitable gifts of property in lieu of demolition or condemnation, taxes: the tax mag., oct. 2000, at 31 (“[a] taxpayer who plans to have a home demolished . . . might instead make a contribution of the property to the local city fire department to be burned for live fire practice. . . . result[ing] in a tax deduction . . . .”); gregory a. thompson & karen s. muraskin, charitable contribution deductions – an alternative to capitalization of demolition costs, 24 tax adviser 421 (1994) (“as a planning alternative, taxpayers should consider making a charitable contribution of the structure to a local fire department for use in training drills.”); discussion: donation of house to fire department, tax almanac, http://www.taxalmanac.org/index/php/discussion: donation_of_house_to_fire_department (last visited mar. 3, 2011) (discussion board). but see paul caron, irs denies deduction for homes donated to fire department and burned down, taxprof blog (sept. 26, 2009), http://taxprof.typepad.com/taxprof_blog/2009/09/irs-challenges.html [hereinafter caron, taxprof blog]. steven willis, a professor at the university of florida who studies income tax law, said a charitable deduction can be no greater than the value of whatever was donated, and a house given to a fire department has negative value, since the owner was going to have to pay somebody to get rid of it. id. 6. sheldon i. banoff & richard m. lipton, more on tax deductions for clunker homes, 112 j. tax’n 189, 190 (2010); combustible tax deductions: will this charitable contribution go up in smoke?, accountingweb (july 27, 2009), http://www.accountingweb.com/topic/tax/combustible-tax-deductions-will-charit able-contribution-go-smoke (“[i]n 2004, which was the year of their donation, the irs began taking a different view of these donations.”). 456 florida tax review [vol. 12:6 his home to the local fire department.7 soon after, in 2010, the live burn donation was back in the headlines as it was exposed that oregon 7. caron, taxprof blog, supra note 5 (“the story has been picked up by over 100 media outlets and newspapers, including abc, atlanta journal constitution, cbs, chicago tribune, cleveland plain dealer, cnbc, forbes, houston chronicle, los angeles times, miami herald, new york times, newsday, npr, philadelphia inquirer, san diego union-tribune, seattle times, and washington times.”). see, e.g., meghan barr, burning down the house? irs nixes tax deductions, newsday.com, (sept. 25, 2009), http://www.newsday.com/ business/burning-down-the-house-irs-nixes-tax-deductions-1.1476952 [hereinafter barr, irs nixes tax deductions], reprinted in burning down the house? irs nixes tax deductions, san diego union-trib., (sept. 25, 2009, 1:32 pm), http://www. signonsandiego.com/news/2009/sep/25/us-burning-down-house-092509/; irs: no tax deduction for burning down house, cnbc.com (sept. 25, 2009, 4:02 pm), http://www.cnbc.com/id/33023329; burning down the house? irs nixes tax deductions, ajc.com (sept. 25, 2009 5:11 pm), http://www.ajc.com/news/nationworld/burning-down-the-house-146954.html; irs nixes tax deductions, wash. times (sept. 26, 2009), http://washingtontimes.com/news/2009/sep/26/irs-nixes-taxdeductions/; irs feeling burned by house deductions, seattle times (sept. 26, 2009, 8:35 pm), http://seattletimes.nwsourse.com/html/nationworld/2009943541_ apusburningdownthehouse.html; burning down the house? irs nixes tax deductions, cbsnews (sept. 25, 2009), http://www.cbsnews.com/stories/2009/09/ 09/25/ap/national/main5340252.shtml; burning down the house? irs nixes tax deductions, abc news (sept. 25, 2009), http://abcnews.go.com/us/wirestory?id= 8674343; burning down the house? irs nixes tax deductions, miami herald (sept. 25, 2009), http://www.miamiherald.com/news/nation/ap/story/1251852.html; burning down the house? irs nixes tax deductions, philly.com (sept. 25, 2009), http://www.printthis.clickability.com/pt/cpt?action=cpt&title=burning...925_ap_bur ningdownthehouseirsniestaxdeductions.html&partnerid=193672; burning down the house: irs nixes tax deductions for those who donate their homes to fire dept, l.a. times (sept. 25, 2009, 2:09 pm), http://latimes.com/news/nationworld/nation/ wire/sns-ap-us-burning-down-the-house,0,2553997; burning down the house? irs nixes tax deductions, nat’l pub. radio (sept. 25, 2009), http://www.npr.org/ templates/story/story.php?storyid=113212594; burning down the house? irs nixes tax deductions, cleveland.com (sept. 25, 2009, 3:30 pm), http://www.cleveland. com/newsflash/index.ssf?/base/national-23/1253911593255590.xml&storylist= cleveland; burning down the house? irs nixes tax deductions, forbes.com (sept. 25, 2009, 3:31 pm), http://www.forbes.com/feeds/ap/2009/09/25/business-financialimpact-us-burning-down-the-house_6933091; burning down the house: irs nixes tax deductions for those who donate their homes to fire dept, chi. trib. (sept. 25, 2009, 4:09 pm), http://www.chicagotribune.com/news/nationworld/sns-ap-usburning-down-the-house,0,5359520.story; burning down the house? irs nixes tax deductions, n.y. times (sept. 25, 2009, 4:50 pm), http://www.nytimes.com/ aponline/2009/09/25/us/ap-us-burning-down-the-house.html?_r=1; a home donation flare-up, it’s a win-win situation — firefighters get practice, residents clear property — but irs says it doesn’t earn any deduction, hous. chron. (sept. 26, 2009, 7:55 am), http://chron.com/disp/story.mpl/nation/6638041.html. 2012] relighting the charitable deductions 457 gubernatorial candidate, chris dudley, claimed a deduction on his 2004 federal income tax return for a live burn donation so he could build a new residence on the land.8 consequently, in recent years, there has been much confusion and debate on whether live burn donations qualify for charitable deductions. in rolfs v. commissioner,9 the united states tax court recently overruled its earlier opinion10 holding a live burn donation was a quid pro quo transaction because the taxpayers received demolition services in exchange for the live burn donation.11 in early 2012, the united states court of appeals for the seventh circuit affirmed the tax court’s decision.12 because the live burn donation is a quid pro quo transaction, the taxpayers must pass a two-part quid pro quo test originally laid out by the united states supreme court in united states v. american bar endowment.13 under the quid pro quo test, a taxpayer must demonstrate (1) the fair market value of the payment to the charitable organization exceeded the fair market value of the benefit received by the taxpayer and (2) if there is an excess payment, the taxpayer intended such portion of the payment to be a gift.14 in applying the first prong of the quid pro quo test, the tax court held the demolition benefit received by the rolfs outweighed the fair market value of the live burn donation, as the home had a restricted use.15 accordingly, the charitable deduction for the rolfs’ live burn donation was disallowed.16 because the tax court determined there was no excess contribution, the court did not examine the intent prong of the quid pro quo test. 8. jack bogdanski, dudley pushed another envelope on taxes, jack bog’s blog (oct. 6, 2010), http://bojack.org/2010/10/dudley_pushed_another_envelope. html (stating that the deduction was $350,000). 9. 135 t.c. 471 (2010), aff’d 668 f.3d 888 (7th cir. 2012). 10. scharf v. commissioner, 32 t.c.m. (cch) 1247 (1973), action on dec. 1974-36031 (mar. 10, 1974). 11. rolfs v. commissioner, 135 t.c. at 486, aff’d 668 f.3d 888, 888 (7th cir. 2012). 12. rolfs v. commissioner, 668 f.3d 888, 888 (7th cir. 2012) (the seventh circuit held, inpart, that “[t]o support the deduction, the rolfs needed to show a value for their donation that exceeded the substantial benefit they received in return. the tax court found that they had not done so. we agree and therefore affirm.”). essentially, the seventh circuit affirmed the tax court’s holding that the live burn donation was not deductible. thus, this article will primarily focus on the tax court’s opinion. 13. united states v. am. bar endowment, 477 u.s. 105 (1986). in 1997, the american bar endowment two-part test was incorporated into treasury regulation section 1.170a-1(h). 14. id. at 117. 15. rolfs, 135 t.c. at 494. 16. id. 458 florida tax review [vol. 12:6 under the current state of the law, the tax court and the seventh circuit were correct in subjecting the donation to the quid pro quo test as the taxpayer did receive a benefit in return for the donation to the local fire department. after a careful review of the rolfs opinion, however, neither the tax court nor the seventh circuit held that a charitable deduction was disallowed for all live burn donations. arguably, if a taxpayer demonstrates and substantiates that the value of the structure donated is higher than the demolition benefit received, the taxpayer could successfully deduct the excess amount.17 both, tax court’s and the seventh circuit’s holdings, however, effectively extinguished the live burn donation by adopting a valuation approach that makes it nearly impossible for a taxpayer to claim a charitable deduction for a live burn donation.18 in determining the value of the live burn donation, the tax court found the home to be of minimal value due to underlying restrictions and conditions of the donation.19 the tax court focused mainly on the impact of the severance of the house from the underlying land and determined such fact made the live burn donation “virtually worthless.”20 after considering the condition of the house and the restrictions placed thereupon, the tax court held the fair market value was de minimis as no one would purchase the house for more than a nominal amount.21 accordingly, the tax court determined the fair market value of the house was an amount between $100 and $1,000, which is necessary to ensure sufficient consideration exists for a sales contract to be enforceable.22 17. for example, if the taxpayer demonstrated that the fair market value of the live burn donation was $100,000 and the demolition benefit received was $10,000, then the taxpayer would be able to claim a $90,000 charitable contribution. this assumes, however, that the taxpayer was able to demonstrate that he intended to make a gift of the excess amount of $90,000 to the fire department. additionally, the live burn donation would also have to survive the service’s other two arguments asserted in rolfs: (1) the charitable deduction should be disallowed for the live burn donation as the taxpayers “transferred to the vfd less than their entire interest in the lake house” and (2) the “lake house as donated to the vfd was worthless.” rolfs, 135 t.c. at 481. see also infra notes 233–234 and accompanying text (discussing the service’s alternative arguments). 18. rolfs, 668 f.3d 888, (emphasis added) (“[p]roper consideration of the economic effect of the condition that the house be destroyed reduces the fair market value of the gift so much that no net value is ever likely to be available for a deduction, and certainly not here.”) 19. rolfs, 135 t.c. at 493. 20. id. at 494. 21. id. at 479, 495. 22. id. while beyond the scope of this article, the tax court arguably incorrectly valued the live burn donation. clearly, the house material alone was worth more than the $100 to $1,000 value that the tax court assigned to the live burn donation. for arguments that the tax court improperly valued the live burn 2012] relighting the charitable deductions 459 the seventh circuit affirmed the tax court’s approach, but added that “[n]one of the value of the house, as a house, was actually given away,” “[t]he taxpayers . . . gave away only the right to come onto their property and demolish their house.”23 thus, under the either approach, it is hard to imagine a live burn donation where the value would be greater than the demolition benefit received. while it appears that the service has won the fight in the courts, this article proposes the live burn donation not be extinguished. instead, congress should consider exceptions to the application of the quid pro quo test when the benefit of the donation to the public substantially outweighs the benefit received by the taxpayer (the public benefit exception). ultimately, this will encourage donations that otherwise would be underfunded, as is the case in live burn donations. in reaching this conclusion, part ii of this article provides a brief overview of the charitable deduction, including a discussion of its purpose and legislative history.24 part iii explores the evolution of and current exceptions to the quid pro quo test, which concludes the quid pro quo test is the most workable approach in determining whether a quid pro quo contribution to a charitable organization is deductible.25 part iv provides a brief overview of live burn training and the development of the law regarding the live burn donation.26 part v argues that in certain circumstances exceptions should be made to the quid pro quo test — the public benefit exception — and discusses the public benefit exception using the live burn donation as the lens to examine the application of the proposed exception.27 in conclusion, part v proposes an amendment to the charitable deduction, thereby allowing a charitable deduction for live burn donations, while recognizing the need for limitations given the perceived abuse and donation see willis w. hagen ii, the tax court’s capricious nature in ascertaining the value of donated property, 114 j. tax’n 301 (2011) [hereinafter hagen, capricious nature]; brief and required short appendix of petitioners-appellants, theodore r. rolfs, et al. at 15-30, rolfs v. commissioner, no. 11-2078 (7th cir. july 26, 2011). furthermore, the seventh circuit stated that “[p]erhaps the best ‘comparable sales’ comparison might have been the price paid by the fire department to rent a burn tower for the length of time the department conducted exercises in and around the lake house.” arguably, this was incorrect as the court overlooked the stark difference between tower training and live burn training. see infra part iv.a (discussing the benefits of live burn training). 23. rolfs, 668 f.3d 888. 24. see infra text at notes 30–45. 25. see infra text at notes 53–166. 26. see infra text at notes 177–254. 27. see infra text at notes 255–72. 460 florida tax review [vol. 12:6 valuation difficulties of the live burn donation.28 part vi provides closing remarks.29 ii. overview of the charitable deduction a. the history and purposes of the charitable deduction it was not until 1917, four years after the united states first income tax law,30 that individual taxpayers were allowed to deduct “charitable contributions or gifts”31 to qualified charitable organizations (the charitable deduction).32 the congressional intent behind the charitable deduction was to 28. see infra text at notes 273–78. 29. see infra part vi. 30. tariff act of 1913, ch. 16, 38 stat. 114. see also jacob l. todres, internal revenue code section 170: does the receipt by a donor of an intangible religious benefit reduce the amount of the charitable contribution deduction? only the lord knows for sure, 64 tenn. l. rev. 91, 97 (1996) [hereinafter todres, intangible religious benefit] (stating that “the omission was deliberate.”) for a detailed review of the history of code section 170 see generally vada waters lindsey, the charitable contribution deduction: a historical review and a look to the future, 81 neb. l. rev. 1056 (2003). 31. see 65 cong. rec. 6728 (1917). (remarks of senator hollis). senator hollis stated that: we are now talking about the income tax on individuals, however; and the point i wish to emphasize is this: by agreement of the committee we are now going to exempt from taxation gifts to charitable, educational, and scientific institutions not to exceed 15 per cent of the donor’s income. id. at 6730. see also seed v. commissioner, 57 t.c. 265, 275 (1971) (“[t]he term ‘charitable contributions’ as it is used generally in section 170 and the regulations is synonymous with the word ‘gift.”’). hereinafter, the words “contribution” and “gift” when referencing the charitable deduction will be used interchangeably. 32. war revenue act of 1917, ch. 63, § 1201(2), 40 stat. 300, 330. the original charitable deduction provision read as follows: contributions or gifts actually made within the year to corporations or associations organized and operated exclusively for religious, charitable, scientific, or educational purposes, or to societies for the prevention of cruelty to children or animals, no part of the net income of which inures to the benefit of any private stockholder or individual, to an amount not in excess of fifteen per centum of the taxpayer’s taxable net income as computed without the benefit of this paragraph. such contributions or gifts shall be allowable as deductions only if verified under rules and regulations prescribed by the commissioner of internal revenue, with the approval of the secretary of the treasury. 2012] relighting the charitable deductions 461 ensure taxpayers would have money available to support charities, despite the necessary tax increase to fund world war i.33 generally, the government appropriates public funds to charitable organizations, as well as state and local governments which often provide funding to local fire departments. the charitable deduction, however, relieves the government of this financial burden. [t]he exemption from taxation of money or property devoted to charitable and other purposes is based upon the theory that the government is compensated for the loss of revenue by its relief from financial burden which would otherwise have to be met by appropriations from public funds, and by the benefits resulting from the promotion of the general welfare.34 id. for a discussion of the history of the charitable deduction, see generally boris i. bittker & lawrence lokken, federal taxation of income, estates, and gifts ¶ 35.1 (2011) [hereinafter bittker & lokken, federal taxation]; boris i. bittker, martin j. mcmahon, jr. & lawrence a. zelenak, federal income taxation of individuals ¶ 25.01 (2002) [hereinafter mcmahon & zelenak, income taxation]. but see todres, intangible religious benefit, supra note 30, at 97 n.39 (stating that prior to the modern income tax law, there was a charitable deduction allowed for corporations under the pre-1913 corporate income tax). 33. 65 cong. rec. 6728 (1917). (remarks of senator hollis). senator hollis commented that: usually people contribute to charities and educational objects out of their surplus. after they have done everything else they want to do, after they have educated their children and traveled and spent their money on everything they really want or think they want, then, if they have something left over, they will contribute it to a college or to the red cross or for some scientific purposes. now, when war comes and we impose these very heavy taxes on incomes that will be the first place where the wealthy men will be tempted to economize, namely, in donations to charity. they will say, “charity begins at home.” id. 34. h.r. rep. no. 75-1860, at 19 (1938), reprinted in 1939-1 c.b. 728, 742. see also mcmahon & zelenak, income tax, supra note 32 quoting regan v. tax’n with representation of wash., 461 u.s. 540, 544 (1983)) (“more recently, the supreme court has remarked that ‘[d]eductible contributions are similar to cash grants [from the government to the charity] of the amount of a portion of the individual’s contributions.’”); brinley v. commissioner, 782 f.2d 1326, 1336 (5th cir. 1986) (hill, j., dissenting) (providing that the charitable deduction is meant to help “aid in the accomplishment of many social goals which our federal and local governments otherwise cannot or will not accomplish”). for arguments against the original purpose of the charitable deduction see mcmahon & zelenak, income tax, supra note 32. mcmahon and zelenak propose a better rationale for the charitable deduction stating that: 462 florida tax review [vol. 12:6 thus, through the enactment of the charitable deduction, which is codified in code section 170,35 congress sought to encourage taxpayers to provide private support for a wide range of activities and organizations that aid in the accomplishment of social objectives that otherwise would not or could not be sustained by the federal and local governments. essentially, this allows the american people to decide which charity to support, whether public or private, while allowing the federal government to subsidize a portion of such charitable enterprise. b. the mechanics of the charitable deduction over the years, the charitable deduction has been subject to endless scrutiny, given its frequent use as a vehicle for tax abuse.36 consequently, the charitable deduction, which originally started out as two sentences in 1917,37 has morphed into a maze of complexity. this congressional incentive to donate a portion of one’s income to charity is subject to significant exceptions and limitations, some of which are statutorily proscribed while others are judicially and administratively created.38 for purposes of this article, however, the key language is still the same — a taxpayer is allowed the charitable deduction for a “contribution or gift to or for the use of” a qualified organization.39 if money one gives to charity is the equivalent of money one never had, in terms of its effect on one’s ability to pay tax, then allowing a deduction for charitable contributions makes perfect sense. the premise of this argument is debatable, both because the taxpayer had the choice whether or not to give money to charity, and because the taxpayer may bask in the warm glow of having made a contribution. if the premise is accepted, however, § 170 logically follows. id. 35. unless, otherwise indicated, all references to the internal revenue code in this article are to the internal revenue code of 1986, as amended. 36. pension protection act of 2006, pub. l. no. 109-280, 120 stat. 780 [hereinafter pension protection act of 2006]. 37. see supra note 32 (providing the original charitable deduction language). 38. for an in-depth discussion of i.r.c. § 170 see generally bittker & lokken, federal taxation, supra note 32, ¶ 35.1; mcmahon & zelenak, income tax, supra note 32, ¶ 25.01. 39. see i.r.c. § 170(a) (“there shall be allowed as a deduction any charitable contribution (as defined in subsection (c)) payment of which is made within the taxable year.”); i.r.c. § 170(c) (“for purposes of this section, the term ‘charitable contribution’ means a contribution or gift to or for the use of….”). 2012] relighting the charitable deductions 463 generally, for a taxpayer to claim the charitable deduction,40 the donation must (1) be made to or for the use of a qualified recipient,41 (2) be a “contribution or gift” rather than a payment for goods or services,42 and (3) meet the relevant substantiation requirements.43 additionally, the taxpayer must navigate through a complex web of rules that provide income-based percentage limitations on the dollar amount a taxpayer can deduct based on both the type of property donated and the type of qualified organization receiving the property.44 however, while the charitable deduction is a vast 40. i.r.c. § 63 (providing that the charitable deduction is a below-the-line itemized deduction). 41. i.r.c. § 170(c)(1) (providing that the charitable deduction is allowed for a charitable donation to or for the use of wide-ranging list of entities). i.r.c. § 170(c)(1), as it pertains to this article, states that the charitable contribution can be “made to or for the use of (1) a state, a possession of the united states, or any political subdivision of any of the foregoing, or the united states or the district of columbia, but only if the contribution or gift is made for exclusively public purposes.” id. see also rev. rul. 71-47, 1971-1 c.b. 92 (discussing that fire volunteer departments are qualified charities); search for charities, online version of publication 78, internal revenue service, http://www.irs.gov/app/pub-78/ (last visited sept. 5, 2011) (a web-searchable list of organizations that are “eligible to receive tax-deductible charitable contributions”). 42. see infra part iii (discussing the definition of “contribution or gift”). 43. in order for a taxpayer to claim the charitable deduction, some form of written receipt has always been required. however, due to the increase in fraudulent claims of the charitable deduction, congress enacted stricter substantiation standards. see pension protection act of 2006, supra note 36. now, every donation of cash requires that the taxpayer maintain a bank record or a written statement from the charitable organization, which includes the name of the charitable organization, the date of the charitable contribution, and the amount of the charitable contribution. i.r.c. § 170(f)(17). however, when the contribution is in a form other than money, additional levels of substantiation are required depending on the value of the nonmonetary donation. see infra notes 217–19 and accompanying text (discussing the relevant substantiation requirements). 44. reg. § 1.170a-1(c)(1). in determining the amount of the charitable deduction that a taxpayer can claim in a given year for the taxpayer’s charitable donation, the taxpayer first must determine the value of the charitable contribution. generally, the value of the charitable contribution is equal to its fair market value. thus, the amount of the deduction for cash charitable contributions is straight forward; the amount of cash donated to the charitable organization. charitable contributions made with property other than money, however, are much more challenging. generally, the amount of non-monetary contributions is the fair market value of the property at the time of the contribution. reg. § 1.170a-1(c)(2) (providing that for charitable contribution purposes, fair market value is defined as the “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts”). special rules, however, exist which 464 florida tax review [vol. 12:6 and complex deduction, the core of the current deduction, insofar as this article is concerned, is the definition of “contribution or gift” and the quid pro quo test that flows therefrom. accordingly, this article will focus on the meaning of the term “contribution or gift” in the context of the quid pro quo test.45 iii. the quid pro quo test a taxpayer’s eligibility to claim a charitable deduction requires the charitable donation be a “contribution or gift.”46 in 1954, congress described “gifts” as payments “made with no expectation of a financial return commensurate with the amount of the gift.”47 thirty years later, the supreme court, in american bar endowment, stated “the sine qua non of a charitable contribution is a transfer of money or property without adequate consideration.”48 the words “contribution or gift,” according to the supreme court, are “intended to differentiate between unrequited payments to qualified recipients and payments made to such recipients in return for goods or services.”49 accordingly, the contribution cannot be a payment for goods reduce the value of some charitable contributions, such as contributions of certain types of appreciated property. i.r.c. § 170(e). for example, in the case of appreciated property, the amount of such charitable contributions is reduced by any gain from a hypothetical sale which would not have been long-term capital gain. i.r.c. § 170(e)(1)(a) (resulting in the taxpayer typically valuing the charitable contribution equals to the property’s adjusted basis). however, the amount of the charitable deduction is not unlimited. i.r.c. § 170(b) (providing limits on the overall amount that a taxpayer can deduct). the limitations are very complex, as the limitation applicable to the charitable contribution is based on the type of taxpayer, the type of the property contributed, and the type of the charitable organization. generally, an individual taxpayer is allowed to deduct the aggregate amount of his annual contributions to a public charity, including a governmental unit, to the extent such contributions do not exceed fifty percent of his contribution base. i.r.c. § 170(b)(1)(a)(v). i.r.c. § 170(b)(1)(g) (defining “contribution base” as a taxpayer’s adjusted gross income for the taxable year without regard to any net operating loss carrybacks under code section 172.) but see i.r.c. § 170(b)(1)(b) (providing a thirty percent ceiling rule for certain donations to private charities); i.r.c. § 170(b)(1)(c) (providing that certain capital gain property is subject to additional limitations). a more in-depth examination of these limitations is beyond the scope of this article. 45. see infra part iii (discussing the evolution of the quid pro quo test). 46. i.r.c. § 170(c). 47. s.rep. no. 83-1622, at 196 (1954); h.r.rep. no. 83-1337, at a44 (1954) 48. united states v. am. bar endowment, 477 u.s. 105, 118 (1986). 49. hernandez v. commissioner, 490 u.s. 680, 690 (1989). 2012] relighting the charitable deductions 465 or services.50 ultimately, the quid pro quo test was developed for determining whether any portion of a payment that was part of a quid pro quo transaction (i.e., when a taxpayer receives a financial benefit in return, whether it be in the form of goods or services) was a “contribution or gift.”51 for various reasons, congress and the service, however, have enacted and promulgated exceptions to the application of quid pro quo test.52 a. the evolution of the quid pro quo test for many years, courts have struggled with articulating a standard for determining whether a payment to a charity qualifies as “contribution or gift” within the context of the charitable deduction, thereby resulting in three different tests: (1) the intent of the donor approach, (2) the substantial benefit received approach, and (3) the benefit received test.53 under the intent of the donor approach, the allowance of the charitable deduction depends on the subjective intent of the donor, allowing a deduction only if the donor’s motivation for the payment was a “detached and disinterested generosity . . . out of affection, respect, admiration, charity or like impulse.”54 however, under the substantial benefit received approach, the donor’s motivation is irrelevant. instead, the charitable deduction is allowed only if the payment is made without the taxpayer receiving or expecting any substantial benefit in return for such payment.55 finally, under the benefit received approach, the court considered whether the donor received a benefit in return for his payment.56 assuming the donor receives a benefit, the donor is only allowed a deduction for the amount which the payment exceeds the value of the benefit he received.57 in 1986, in american bar endowment, the supreme court provided guidance on the proper approach to use in determining whether a donation to 50. i.r.c. § 170(c). 51. see infra part iii.a (discussing the evolution of the quid pro quo test). 52. see infra part iii.b (discussing the exceptions to the quid pro quo test). 53. see generally todres, intangible religious benefit, supra note 30, at 101–14; joseph v. sliskovich, charitable contributions or gifts: a contemporaneous look back to the future, 57 u. mo. kan. city l. rev. 437, 457– 80 (1989) [hereinafter sliskovich, charitable contributions or gifts]; james w. colliton, the meaning of “contribution or gift” for charitable contribution deduction purposes, 41 ohio st. l.j. 973, 973–73 (1980) [hereinafter colliton, meaning of contribution]; richard d. hobbet, charitable contributions — how charitable must they be?, 11 seton hall l. rev. 1 (1980) [hereinafter hobbet, charitable contributions]. 54. dejong v. commissioner, 309 f.2d 373, 379 (9th cir. 1962). 55. singer co. v. united states, 196 ct. cl. 90, 106 (1971). 56. oppewal v. commissioner, 468 f.2d 1000, 1001-02 (1st cir. 1972). 57. id. 466 florida tax review [vol. 12:6 a charity qualified as a “contribution or gift.”58 the court adopted the quid pro quo test, a two-part test in which the taxpayer must demonstrate (1) the fair market value of the payment to the charitable organization exceeded the fair market value of the benefit the taxpayer received in return and (2) if there is an excess payment, the taxpayer intended the excess payment to be a gift.59 soon after, in hernandez v. commissioner,60 the court reexamined the quid pro quo transaction issue in the context of religious benefits and provided insight into the application of the quid pro quo test.61 eleven years later, in 1997, the service promulgated regulations to determine the deductibility of a quid pro quo donation, thereby codifying the quid pro quo test.62 1. the pre-quid pro quo test approaches a. the intent of the donor approach the first attempt of a federal appeals court to define “contribution or gift” within the context of the charitable deduction was in 1962, by the united states court of appeals for the ninth circuit in dejong v. commissioner.63 the ninth circuit was confronted with deciding whether a donation to a non-profit religious-based school, the society for christian instruction (the society), which was attended by the donors’ two children, qualified for the charitable deduction.64 the society was a tuition-free school funded through various means, including the solicitation of donations from the students’ parents.65 “approximately [seventy] percent of the [society’s] 58. united states v. am. bar endowment, 477 u.s. 105, 117 (1986). 59. id. 60. 490 u.s. 680 (1989). 61. id. at 690. 62. reg. § 1.170a-1(h). 63. 309 f.2d 373 (9th cir. 1962). see id. at 377 (citing commissioner v. duberstein, 363 u.s. 278, 284 (1960)) (“the meaning of the term ‘gift’ as applied to particular transfers has always been a matter of contention. specific and illuminating legislative history on the point does not appear to exist. analogies and inferences drawn from other revenue provisions, such as the estate and gift taxes, are dubious.”). 64. id. at 375 (“the sole question presented to us is whether . . . the $400.00 paid by [the donor] to the society was in the nature of a tuition fee paid for the education which the society was expected to furnish the petitioner’s children, and therefore not deductible as a charitable contribution.”). 65. id. in the late summer or early fall of each year, enrollment committees appointed by the board of trustees of the society meet with parents of prospective students. at these meetings the parents 2012] relighting the charitable deductions 467 total income [was] derived from contributions from parents of enrolled students,” as all parents contributed to the society.66 even if a student’s parents did not financially contribute to the society, the student was still allowed to attend.67 the court began its analysis by recognizing the terms “contribution” and “gift” have been used interchangeably.68 unfortunately, without any analysis regarding the purpose of the charitable deduction, the court adopted the definition given by the supreme court, in commissioner v. duberstein,69 to the term “gift” within the meaning of code section 102.70 the duberstein court defined the term “gift” as “detached and disinterested generosity71 . . . out of affection, respect, admiration, charity or like impulses.”72 furthermore, the court stated the subjective intent of the transferor is the most significant factor in determining whether a transfer is a “gift.”73 in relying on duberstein, the ninth circuit recognized: the value of a gift may be excluded from gross income only if the gift proceeds from a “detached and disinterested generosity” or “out of affection, admiration, charity or like impulses,” and must be included if the claimed gift proceeds are given “a broad picture of what the cost will be in the operating budget for the coming year” and they are asked to contribute to the best of their ability and to try to carry as much “of the load as they feel they can.” when a parent is known to be “pretty well-to-do” it is suggested that he contribute the full amount of the estimated cost per student for the coming year times the number of students he is enrolling. all of the parents interviewed are given an enrollment card to sign and are asked to indicate thereon the number of students they wish to enroll and the amount of the contribution they intend to make toward the operation of the school or schools. with the exception of a few parents who have reservations against signing a card of this nature, signed cards are received from all parents. id. 66. dejong, 309 f.2d at 375. (“[a]ll parents of prospective students do pledge a certain amount of money, although in some cases that amount is ‘very nominal.’”). 67. id. (“all facilities of the schools are available to all students irrespective of the amounts pledged or contributed by their parents.”). 68. id. at 376 69. 363 u.s. 278 (1960). 70. dejong, 309 f.2d at 379. 71. duberstein, 363 u.s. at 285. 72. id. 73. id. 468 florida tax review [vol. 12:6 primarily from “the constraining force of any moral or legal duty,” or from “the incentive of anticipated benefit of an economic nature.”74 ultimately, the ninth circuit adopted the intent of the donor approach articulated in duberstein, for determining whether a payment was a “contribution or gift” within the meaning of the charitable deduction by “conclud[ing] that such criteria are clearly applicable to a charitable deduction under § 170.”75 accordingly, the court in dejong held that $40076 of the $1,075 donation “was in the nature of tuition fees for the education which the society was expected to furnish to [the donor’s] children,” and thus “[t]he payment of such sum is not a charitable gift.”77 the charitable deduction was allowed for the remaining $675. the intent of the donor approach is difficult to apply because it requires a subjective look into the mind of a donor to determine whether the payment is “detached and disinterested generosity.”78 the court’s opinion 74. dejong, 309 f.2d at 379. for other courts adopting the intent of the donor approach see for example dowell v. united states, 553 f.2d 1233 (10th cir. 1977); burwell v. commissioner, 89 t.c. 580 (1987); mclaughlin v. commissioner, 51 t.c. 233 (1968). see also winters v. commissioner, 468 f.2d 778 (2d cir. 1972) (in determining that a charitable deduction was not allowed, the court decided not to chose between the intent of the donor approach and the benefit received approach; and, instead, tested the payment under both approaches). 75. dejong, 309 f.2d at 379. see also hobbet, charitable contributions, supra note 53 (“as, precedent, however, dejong was clouded in that the [service] has clearly presented the issue to the court on the basis of an objective determination.”). but see united states v. transamerica corp., 392 f.2d 522, 524 (9th cir. 1968) (refusing to apply the intent of the donor approach in determining if a charitable deduction was allowed for a payment by a corporation to a charitable organization ). 76. dejong, 309 f.2d at 379 (stipulating that $400 was the approximate cost of an education for two children at the society). 77. id. see also channing v. united states, 4 f. supp. 33 (d. mass 1933), aff’d, 67 f.2d 986 (1st cir. 1933) (holding that the payment of a child’s school tuition is a family expense, not a charitable contribution to the educating institution). 78. see douglas a. kahn & jeffrey h. kahn, “gifts, gafts, and gefts” the income tax definition and treatment of private and charitable “gifts” and a principled policy justification for the exclusion of gifts from income, 78 notre dame l. rev. 441, 503–12 (2003) [hereinafter kahn & kahn, “gifts, gafts, and gefts”] (“despite a number of decisions to the contrary, it appears reasonably certain that the duberstein standard of ‘detached and disinterested generosity’ does not and should not apply to the determination of whether a transfer to a charity is a gift.”). the application of the “detached and disinterested generosity” standard also has a long standing history of being problematic in its application to i.r.c. § 102. see oppewal v. commissioner, 468 f.2d 1000, 1002 (1st cir. 1972); steven j. willis & 2012] relighting the charitable deductions 469 lacked an explanation regarding its application of the “detached and disinterested generosity” standard. although the ninth circuit did not discuss this division of the contribution amount, in order to make the analysis and conclusion consistent with duberstein,79 the only rational interpretation is that the court viewed the donation as being two separate transactions.80 the first transaction, the nondeductible $400, was viewed by the court as a payment to the society for the tuition, which lacked the requisite “detached and disinterested generosity” motive as the taxpayers anticipated the return benefit of their childrens’ education. the second transaction, being a charitable donation of the remaining $675, which the court deemed deductible, must have been motivated by “detached and disinterested generosity.”81 the court arguably allowed the $675 deduction for the amount of the payment exceeding the value of the educational benefit received by the taxpayer because a person would only pay more for a good or service out of “detached and disinterested generosity.” this approach is similar to the quid pro quo test later adopted by the supreme court because under the quid pro quo test only the amount of the payment exceeding the amount of the benefit received is deductible and then only to the extent it was intended to be a gift. michael s. hawley, i.r.c. section 247(b) and duberstein resurface: the emperor still has no clothes, 25 ariz. l. rev. 907, 921 (1984) (explaining courts’ inconsistent results when applying the duberstein test and attributing the inconsistency to the test’s uncompromising “all-or-nothing” requirement). but see hobbet, charitable contributions, supra note 53, at 13–30 (discussing that the best standard to determine if a payment is a “contribution or gift” is the intent of the donor approach). 79. see also collman v. commissioner, 511 f.2d 1263 (9th cir. 1975) (treating the donation of land to a government agency as two transactions and thus holding it was only partially deductable as the amount of the charitable deduction was reduced by the value of the construction work performed by the county for the donor). but see for the inconsistent application of the transaction splitting approach, allen v. united states, 541 f.2d 786 (9th cir. 1976) (treating the donation of land to a county in order to secure the necessary permission to build a housing development as one transaction and allowing a deduction for the full value of land donated); stubbs v. united states, 428 f.2d 885 (9th cir. 1970) (disallowing in its entirety the charitable deduction for the donation of land, even though the value of the donation exceeded the value of the benefit the donor received in return). in allen and stubbs, the ninth circuit applied a modified version of the intent of the donor approach stating that the approach was to “expose the true nature of the transaction.” allen, 541 f.2d at 788; stubbs, 428 f.2d at 887. 80. colliton, meaning of contribution, supra note 53, at 983 (“it is difficult to escape the feeling that the court first decided that $675 more was given to the society than the value of the education received in return and that, therefore, the transfer of $675 was made because of “ʻdetached and disinterested generosity.’”). 81. dejong, 309 f.2d at 379 (providing that the service has already conceded the issue that the excess payment amount of $675 was deductible). 470 florida tax review [vol. 12:6 b. the substantial benefit received approach in 1971, nine years after dejong, in singer co. v. united states,82 the united states court of claims established an alternative approach to the intent of the donor approach. in singer, the singer company sold its sewing machines to schools and other charities at a rate83 below fair market value.84 accordingly, the claims court considered whether the singer company, a manufacture of sewing machines, was entitled to the charitable deduction for “contributions made in the form of discounted sales of its . . . sewing machines.”85 in doing so, the court explored the definition of the term “contribution or gift.”86 recognizing the flaws of the intent of the donor approach, the court began its analysis by stating “[i]f we were to accept [dejong’s] definition of gift . . . it would then be necessary for us to look to the subjective intent of the plaintiff when awarding discounts to organizations. this would not be an impossible task, but it would indeed be a very difficult one.”87 accordingly, the court proposed an alternative objective approach based on the benefit received by the donor. [i]f the benefits received, or expected to be received, are substantial, and meaning by that, benefits greater than those that inure to the general public from transfers for charitable purposes (which benefits are merely incidental to the transfer), then in such case we feel the transferor has received, or expects to receive, a quid pro quo sufficient to remove the transfer from the realm of [the charitable deduction]. with this standard, we feel that the subjective approach of “disinterested generosity” need not be wrestled with.88 82. 196 ct. cl. 90 (1971). see also i.r.s. chief couns. adv. 2004-35-001 (aug. 27, 2004) (stating that singer is “[a] leading authority” in the area of charitable intent). 83. singer co., 196 ct. cl. at 94 (providing that the discounts ranged from twenty-five percent for “[c]hurches and charitable organizations (other than governments, schools, hospitals, and red cross)” to forty-five percent for “[g]overnments, schools, hospitals, and red cross”). 84. id. (stating that the sales “were made at break even prices and resulted in no over-all immediate net profit or loss to [the singer company]”). 85. id. at 93. 86. id. at 97 (stipulating that the sales where bargain sales). 87. id. at 99–100. 88. singer co., 196 ct. cl. at 106. see also id. at 104 (noting that “[o]ne of the most persuasive arguments plaintiff makes in the case against ‘disinterested generosity’ is that those provisions which allow exclusions from gross income are matters of ‘legislative grace’ and subject to narrow construction.”). but see hobbet, 2012] relighting the charitable deductions 471 in applying the substantial benefit received approach, however, the court appeared to divert to a subjective intent approach. the court looked to, and determined that, the singer company’s “predominant purpose” for providing the discounted machines to the schools was to obtain goodwill and to increase the possibility of future sales.89 the predominant purpose analysis resulted in the court holding that the discounted sales to the school provided potential benefits that “were substantial enough to supply the plaintiff with a quid pro quo for the discount which, in turn, effectively destroyed the discounts’ charitable nature.”90 although the court never placed a value on the expected return benefit, in order for the substantial benefit received approach to disallow the deduction, the court determined the expected return benefit of goodwill and future sales to the singer company was greater than the benefit to the general public receiving discounted sewing machines. alternatively, once again the court, diverting to a subjective intent approach, found the purpose of the discounted sales to charities other than schools “was to assist the recipient organizations in the performance of the charitable, religious or public services that they were currently providing. the incidental effect of this policy was the development and maintenance of a favorable public image [(goodwill)] for plaintiff in the eyes of those organizations and their members.”91 the court held “that the benefits derived from such discounts were merely incidental to the making of the transfer and not substantial enough to destroy the charitable contribution characterization.”92 clearly, the court determined that the benefit to the charities receiving a discount on sewing machines was greater than the expected return benefit of goodwill and future sales to the singer company. after careful examination of singer, the true question under the substantial benefit received approach is not the intent of the donor, but instead, whether a substantial benefit was received. while the court stated the charitable contributions, supra note 53, at 6 (calling the singer approach a “hybrid objective-subjective analysis”). 89. singer co., 196 ct. cl. at 108 (stating that the purpose of the discounts was to “encourag[e] those institutions to interest and train young women in the art of machine sewing; thereby enlarging the future potential market by developing prospective purchasers of home sewing machines and, more particularly, singer machines-the brand on which the future buyers learned to sew”) (emphasis omitted). 90. id. at 93. 91. id. at 108. 92. id. at 93 (1972); see also id. at 109 (“such a finding, together with our agreement therewith, makes it difficult to see how the plaintiff could derive substantial benefits from such discounts in the way of increased sales.”). but see colliton, meaning of contribution, supra note 53, at 989–90 (providing an alternative viewpoint that the singer holding was inconsistent with the substantial benefit received approach). 472 florida tax review [vol. 12:6 intent of the donor approach was a difficult approach to administer,93 the substantial benefit received approach is also flawed in both the court’s quasisubjective application of the test, as discussed above, and the test itself. in determining whether a substantial benefit was received, the court proposed a balancing test between the benefit to the general public and the direct benefit to the taxpayer. assuming the benefit to the public was greater than the return benefit to the taxpayer, the return benefit to the taxpayer was merely incidental and a deduction for the full amount of the payment to the charitable organization was allowed. while the substantial benefit received approach conforms to the purpose of the charitable deduction, acting as a subsidy to those organizations the government feels provides a community benefit, it creates difficulty for the courts in determining a value of the benefit to the charitable organization. additionally, it potentially allows the taxpayer a deduction for an amount, which encompasses in part, a payment for goods or services.94 c. the benefit received approach in 1967, five years after dejong, in crosby valve & gage co.v. commissioner,95 the united states court of appeals for the first circuit expressed dissatisfaction with the intent of the donor approach.96 the court, however, did not provide an alternative test. instead, the court agreed with the ultimate holding of the united stated tax court below, but made a point of disagreeing with the tax court’s use of dejong’s intent of the donor approach.97 the court stated: 93. see supra note 87 and accompanying text. 94. for example, under the substantial benefit received approach, if a taxpayer makes a $100 payment to a charitable organization and in return receives a benefit valued at $10, but under the balancing test, the court views that benefit to the general public to be greater than those that the taxpayer received, the benefit would be considered an incidental benefit. as a result, the taxpayer would be able to deduct the full amount of the payment, $100. 95. 380 f.2d 146 (1st cir. 1967). 96. id. at 146 (the issue before the court was whether “a business corporation, wholly owned by a charitable foundation, [is] entitled to a charitable deduction for property (in this case equity in bonds) turned over without consideration to its parent[.]”). 97. id. at 146. the tax court held that the transfers to the foundation were not deductible. it placed primary emphasis on its syllogism that (1) “charitable contribution” is synonymous with “gift;” (2) a gift proceeds from a “detached and disinterested generosity;” and (3) since the transfers in this case were the result of the foundation’s control over the corporation they were motivated by legal duty to 2012] relighting the charitable deductions 473 were the [charitable deduction] to depend on “detached and disinterested generosity,” an important area of tax law would become a mare’s nest of uncertainty woven of judicial value judgments irrelevant to eleemosynary reality. community good will, the desire to avoid community bad will, public pressures of other kinds, tax avoidance, prestige, consciencesalving, a vindictive desire to prevent relatives from inheriting family wealth — these are only some of the motives which may lie close to the heart, or so-called heart, of one who gives to a charity. if the policy of the income tax laws favoring charitable contributions is to be effectively carried out, there is good reason to avoid unnecessary intrusions of subjective judgments as to what prompts the financial support of the organized but non-governmental good works of society.98 five years later, in oppewal v. commissioner,99 the first circuit formulated an alternative test. in oppewal, under facts very similar to dejong, the court was confronted with deciding whether a donation to a nonprofit religious-based school, the whitinsville society for christian instruction (the whitinsville society), which was attended by the donors’ two children, qualified for the charitable deduction.100 as in dejong, the court ultimately held the amount of the payment in excess of the cost of the educational benefit the donors received for their children was deductible.101 its sole stockholder, and not by disinterested generosity. while agreeing with the holding of the tax court, we think it necessary to register our disagreement with the majority’s emphasis upon a purely charitable motive as a prerequisite for a deductible charitable contribution. id. 98. id. at 146–47. 99. 468 f.2d 1000 (1st cir. 1972). 100. id. at 1001. 101. id. at 1002. applying that test here, the conclusion is inescapable that six hundred and forty dollars of taxpayers’ payment to the society was non-deductible tuition. the taxpayers’ two children obtained a year of education in the society’s religiously-oriented school, as desired by taxpayers. the cost to the society of providing that service was at least six hundred and forty dollars. in effect, if not in form or by design, taxpayers paid this cost. id. 474 florida tax review [vol. 12:6 in reaching this conclusion, the court developed an objective test for determining when a payment is a “contribution or gift.”102 the court stated: the more fundamental objective test is — however the payment was designated, and whatever motives the taxpayers had in making it, was it, to any substantial extent, offset by the cost of services rendered to taxpayers in the nature of tuition? if so, the payment, to the extent of the offset, should be regarded as tuition for, in substance, it served the same function as tuition.103 under the benefit received approach, the court simply looked to see whether a donor received a benefit without regard for his motivation at the time of the payment. assuming a benefit was received, the donor could not claim the charitable deduction for the full amount of the payment, but rather the donor could only deduct the amount by which the payment exceeded the value of the benefit received. the benefit received approach was thus the easiest to administer of all three approaches, as it eliminated the need for the court to inquire into the subjective intent of the taxpayer or to value the benefit received by the public. moreover, unlike the substantial benefit received approach, it reduces the amount of the charitable deduction by the value of the benefit received.104 102. id. (“the objective test taxpayers would apply is whether there was certainty as to the beneficiaries of their payment.”). 103. oppewal v. commissioner, 468 f.2d 1000, 1002 (1st cir. 1972). under this test, the fact that the taxpayers might have made the payment even had their children not been enrolled in the society’s school, or that the society would have enrolled the children even had no payment been made, or that taxpayers’ children would have received an education of the same academic quality (although not religiously oriented) in a public school without additional expense to taxpayers, become irrelevant considerations. id. at 1002 n.2. 104. for example, under the benefit received approach, if a taxpayer makes a $100 payment to a charitable organization and in return receives a benefit valued at $10, the taxpayer would be able to deduct only $90, the difference between the amount of the payment and the benefit received. 2012] relighting the charitable deductions 475 2. the quid pro quo test a. the supreme court weighs in united states v. american bar endowment.105 in 1986, over twenty years after the confusion began as to the meaning of “contribution or gift,” the supreme court provided guidance.106 the american bar endowment (the endowment), which was the fundraising branch of the american bar association, sold various group insurance policies to its members to raise funds for charity.107 the endowment purchased a group policy for its members from an insurance company at a negotiated premium. because the insurance company’s actual cost of providing coverage to the group was lower than the premium paid by the endowment, the insurance company paid a dividend to the endowment.108 the endowment, however, required its members participating in the group insurance program to permit the endowment to retain all of the dividends paid by the insurance company because such funds were critical to its fundraising efforts. despite its ability to negotiate a lower premium for its members, the endowment competitively priced its policies with other insurance policies offered to the public and its members thereby allowing the endowment “to generate large dividends to be used for its charitable purposes.”109 accordingly, the endowment advised its insured members that their respective share of the dividends, less any administrative costs incurred by the endowment, constituted a charitable deduction for such member. it was this after-tax cost to its members that resulted in the endowment group insurance program being less than the cost of an identical commercial policy. accordingly, the supreme court was faced with the issue as to “whether the [endowment’s] members [could] 105. 477 u.s. 105 (1986). for a more in-depth review of the facts in american bar endowment see sliskovich, charitable contributions or gifts, supra note 53, at 480–87. 106. see colliton, meaning of contribution, supra note 53, at 998. [b]oth the courts and the internal revenue service have adopted three different lines of reasoning in deciding charitable contribution deduction cases. circuit courts have adopted one or another of the tests. the tax court has been inconsistent as to what test to use. moreover, the internal revenue service has enthusiastically adopted all three tests. the law, therefore, [was] in a state of great confusion. id. 107. am. bar endowment, 477 u.s. at 107 (noting that approximately twenty percent of the endowment’s members purchased the insurance). 108. id. at 108. 109. id. 476 florida tax review [vol. 12:6 claim a charitable deduction for the portion of their premium payments that exceed[ed] the actual cost to the organization of providing insurance.”110 in examining the meaning of “contribution or gift,” the court stated if a donor expects a substantial benefit in return for their payment to a charity, the general rule is it cannot be a “contribution or gift.”111 assuming the donor, however, only receives an incidental benefit, “[w]here the size of the payment is clearly out of proportion to the benefit received,” the charitable deduction should not be denied in its entirety.112 consequently, a donor may claim the charitable deduction equal to the excess of the payment to the charitable organization over the value of the benefit the donor received in return because the payment had a “dual character.”113 but the deduction is allowed only if the donor can demonstrate he intended to contribute “money or property in excess of the value of any benefit he received in return.”114 in applying this two-part quid pro quo test, the court determined the endowment members’ cost for participating in the group insurance program was not more than what they could have paid for a similar group policy. the endowment’s “members [were] never faced with the hard choice of supporting a worthwhile charitable endeavor or reducing their own insurance costs.”115 accordingly, the endowment members failed to demonstrate that they paid more for the endowment insurance policy than it was worth or that they intended to pay in excess in order to benefit the endowment. therefore, the court held that the members were not allowed a charitable deduction because the court could not construe that there was a charitable motive behind the endowment members’ purchases of the insurance policies. the quid pro quo test can be viewed as combining all three prior approaches and their underlying flaws. thus, after american bar endowment, the confusion regarding the meaning of “contribution or gift” did not completely disappear. first, the court stated if the benefit received is substantial, then no charitable deduction should be allowed. assuming, however, the benefit is merely incidental, the two-prong quid pro quo test should be applied. yet, the court did not explicitly provide a manner for determining whether the benefit received was incidental or substantial. the court, however, cited to singer for the notion that if a substantial benefit was 110. id. at 106–07. 111. id. at 116–17. 112. am. bar endowment, 477 u.s. at 117. 113. id. (citing rev. rul. 67-246, 1967-2 c.b. 104) (formulating a two-part test in determining that the price of a ticket to a charity ball deductible to extent it exceeds the market value of admission); rev. rul. 68-432, 1968-2 c.b. 104, 105 (noting the possibility that a payment to a charitable organization may have “dual character”). 114. am. bar endowment, 477 u.s. at 118. 115. id. at 116. 2012] relighting the charitable deductions 477 received, the contribution was not deductible. logically, the court effectively adopted singer’s balancing test requiring a court to determine whether the “benefits [received are] greater than those that inure to the general public from transfers for charitable purposes. . . .”116 secondly, the court did not expressly discuss the dejong intent of the donor approach, which required a “detached and disinterested” motive. instead, the court reached its holding, in part, based on the members’ lack of intent to make a payment to the endowment in excess of the benefit the members received. the court stated a taxpayer “must at a minimum demonstrate that he purposely contributed money or property in excess of the value of any benefit he received in return.”117 the court reasoned that since the endowment member did not know “he could [have] purchase[d] comparable insurance for less money,” the member could not have “intentionally [given] away more than he received.”118 “[t]he [court’s] emphasis appears to be on a more sterile measurement of ‘intent’ or ‘purpose.’”119 therefore, the court seems to have changed the intent element into a more administrable knowledge standard. however, the court’s focus on knowledge can also be viewed as applying a “detached and disinterested” standard. if a person intentionally makes a payment greater than the value of the benefit he receives, arguably, this excess payment is “detached and disinterested.”120 thus, confusion still exists. hernandez v. commissioner.121 almost three years later, in hernandez, the court was confronted with applying the quid pro quo test in the religious context. in hernandez, the taxpayers paid the church of 116. see singer co. v. united states, 196 ct. cl. 90 (1971); see also supra part iii.a.1.b. (discussing singer). 117. am. bar endowment, 477 u.s. at 118. 118. id. see also kahn & kahn, “gifts, gafts, and gefts,” supra note 78, at 503–05. 119. sliskovich, charitable contributions or gifts, supra note 53, at 486. 120. see, e.g., id. however, as developed by the court, the notion of intentional or purposeful transfer of excess value necessarily embraces the sort of unselfish beneficence generally associated with charity and generosity. indeed, it is difficult to imagine a situation in which a transfer of excess value (with no anticipation or expectation of any measurable or identifiable return benefit), intentionally made to an organization ostensibly performing a charitable function, would not reflect “generosity” in the colloquial sense, as well as for purposes of section 170. id. 121. 490 u.s. 680 (1989). for a more in-depth view of hernandez see todres, intangible religious benefit, supra note 30. 478 florida tax review [vol. 12:6 scientology (the church) for various “auditing”122 and “training”123 sessions. the church believed “any time a person receives something he must pay something back.”124 accordingly, the church charged fixed prices for the auditing and training sessions based on the length and sophistication of the auditing or training.125 the church offered a five percent discount for advance payments.126 moreover, the church refunded any person’s “unused portion of prepaid auditing or training fees, less an administrative charge.”127 the court stated payments for auditing and/or training were the “quintessential quid pro quo exchange.”128 therefore, the payments were not a “contribution or gift” because “[e]ach of these practices reveals the inherently reciprocal nature of the exchange.”129 additionally, since the court found no support that congress intended to distinguish religious benefits from other benefits in the application of the quid pro quo test, the court disagreed with the taxpayer’s assertion that the quid pro quo test does not apply if the benefit is purely religious.130 the court also found that a purely religious benefits exclusion “might raise problems of entanglement between church and state” because 122. hernandez, 490 u.s. at 684-85. the court described auditing as: [i]nvolv[ing] a one-to-one encounter between a participant (known as a “preclear”) and a church official (known as an “auditor”). an electronic device, the e-meter, helps the auditor identify the preclear’s areas of spiritual difficulty by measuring skin responses during a question and answer session. although auditing sessions are conducted one on one, the content of each session is not individually tailored. the preclear gains spiritual awareness by progressing through sequential levels of auditing, provided in short blocks of time known as “intensives.” id. 123. id. at 685 (“participants in these sessions study the tenets of scientology and seek to attain the qualifications necessary to serve as auditors. training courses, like auditing sessions, are provided in sequential levels. scientologists are taught that spiritual gains result from participation in such courses.”). 124. id. 125. id. 126. hernandez, 490 u.s. at 686. 127. id. 128. id. at 691. 129. id. at 692. the court also held that denying the charitable deduction violated neither the establishment clause nor the free exercise clause of the first amendment. id. at 695–98, 700–03. 130. hernandez, 490 u.s. at 693. 2012] relighting the charitable deductions 479 the service and the judiciary would be forced to distinguish “‘religious’ services from ‘secular’ ones.”131 the taxpayers also asserted selective prosecution, arguing the denial of the charitable deduction for payments to the church for auditing or training was inconsistent with the service’s “longstanding practice of permitting taxpayers to deduct payments made to other religious institutions in connection with certain religious practices.”132 due to a lack of an evidentiary record in the lower court, however, the court stated it could not decide this issue: [the service’s] application of the “contribution or gift” standard may be right or wrong with respect to these other faiths, or it may be right with respect to some religious practices and wrong with respect to others. it may also be that some of these payments are appropriately classified as partially deductible “dual payments.”. . . only upon a proper factual record could we make these determinations. absent such a record, we must reject petitioners’ administrative consistency argument.133 thus, in hernandez, the court did not clarify all the confusion looming with regards to the quid pro quo test. however, the court clarified the second-prong of the quid pro quo test by requiring the examination of intent based on an objective standard. essentially, the court considered “the external features of the transaction in question” and rejected “conduct[ing] imprecise inquiries into the motivations of individual taxpayers.”134 the court then went on to discuss american bar endowment and focused on the external factors demonstrating the donor had no knowledge he was paying in excess for the insurance policy.135 thus, under the quid pro quo test, the 131. id. at 694. 132. id. 133. id. at 702–03; see also id. at 704 (o’connor, j., dissenting). the court today acquiesces in the decision of the [service] to manufacture a singular exception to its 70-year practice of allowing fixed payments indistinguishable from those made by petitioners to be deducted as charitable contributions. because the irs cannot constitutionally be allowed to select which religions will receive the benefit of its past rulings, i respectfully dissent. hernandez, 490 u.s. at 704. 134. id. at 690–91 (“in ascertaining whether a given payment was made with ‘the expectation of any quid pro quo,’ . . . the irs has customarily examined the external features of the transaction in question . . . . obviating the need for the irs to conduct imprecise inquiries into the motivations of individual taxpayers.”). 135. id. at 691. 480 florida tax review [vol. 12:6 second prong is arguably met by merely showing the donor knew he made a payment in excess of the benefit received.136 the court also held that the benefit received included religious services.137 in 1993, however, the service issued revenue ruling 93-73,138 which simply read “revenue ruling 78-189, 1978-1 c.b. 68, is obsoleted.”139 revenue ruling 93-73 caused much confusion, since it purportally overruled hernandez,140 as revenue ruling 78-189141 provided a charitable deduction was not allowed for the payment to the church for auditing or training.142 thus, such payments are now deductible.143 b. the service speaks out — treasury regulation section 1.170a-1(h) in december of 1996, ten years after the supreme court weighed-in, the service promulgated a regulation adopting the quid pro quo test for determining whether the charitable deduction is allowed for a payment made as part of a quid pro quo transaction (the quid pro quo regulation).144 the quid pro quo regulation provides a facts and circumstances test, in which: 136. see also id. at 690 (noting that american bar endowment cited singer, but adding that this citation was because singer “embraced this [external factor] analysis.”). but see supra note 115 and accompanying text (providing an alternative viewpoint as to the reason american bar endowment cited singer). 137. hernandez, 490 u.s. at 691. 138. 1993-2 c.b. 75. 139. id. 140. see generally gregg d. polsky, can treasury overrule the supreme court?, 84 b.u. l. rev. 185, 244 (2004) (stating that revenue ruling 93-73 is invalid, as it overrules hernandez); alison h. eaton, comment, can the irs overrule the supreme court?, 45 emory l.j. 987, 991 (1996) [hereinafter eaton, irs overrule] (arguing that “the irs exceeded its authority, and therefore, revenue ruling 93-73 is invalid.”). 141. 1978-1 c.b. 68. 142. id. 143. eaton, irs overrule, supra note 140, at 1012–13 (discussing that revenue ruling 93-73 was issued within weeks after a settlement was reached with the church involving the exempt status of the church). see also elizabeth macdonald, scientologists and irs settle for $12.5 million, wall st. j., dec. 30, 1997, at a12 (discussing the unauthorized disclosure of the settlement agreement and stating that “[t]he settlement, which lets scientologists deduct on their individual tax returns “auditing” fees as donations, supersedes the [service’s] earlier rule denying such deductions — a position that was backed by the u.s. supreme court.”). 144. t.d. 8690, 1997-1 c.b. 68 (providing that the quid pro quo regulation “incorporates the two-part test adopted by the supreme court in [american bar endowment]”); reg. § 1.170a-1(h). 2012] relighting the charitable deductions 481 no part of a payment that a taxpayer makes to or for the use of an organization . . . that is in consideration for . . . goods or services . . . is a contribution or gift . . . unless the taxpayer - (i) intends to make a payment in an amount that exceeds the fair market value of the goods or services; and (ii) makes a payment in an amount that exceeds the fair market value of the goods or services.145 as in american bar endowment, the amount of the charitable deduction is limited to the amount in which the fair market value of the payment to a charitable organization exceeds the fair market value of the goods or services received by the taxpayer.146 a charitable organization is deemed to provide goods or services in return for a payment if, at the time of the payment, the donor receives or “expects to receive” goods or services in return for the payment, whether in the year of payment or thereafter.147 the preamble to the quid pro quo regulation provides insight into what is meant 145. reg. § 1.170a-1(h); see t.d. 8690, 1997-1 c.b. 68. the preamble states that the quid pro quo regulation provides that: a deduction is not allowed for a payment to charity in consideration for goods or services except to the extent the amount of the payment exceeds the fair market value of the goods or services. in addition, a deduction is not allowed unless the taxpayer intends to make a payment in excess of the fair market value of the goods or services. id. 146. reg. § 1.170a-1(h)(2) (providing that the charitable deduction is limited to “the excess of — (a) the amount of any cash paid and the fair market value of any property (other than cash) transferred by the taxpayer to [a charitable] organization . . .; over (b) the fair market value of the goods or services the organization provides in return.”). 147. t.d. 8690, 1997-1 c.b. 68; reg. § 1.170a-13(f)(6). a donee organization provides goods or services in consideration for a taxpayer’s payment if, at the time the taxpayer makes the payment to the donee organization, the taxpayer receives or expects to receive goods or services in exchange for that payment. goods or services a donee organization provides in consideration for a payment by a taxpayer include goods or services provided in a year other than the year in which the taxpayer makes the payment to the donee organization. id. 482 florida tax review [vol. 12:6 by the “expects to receive” goods or services standard, providing it is a facts and circumstance test and includes payments that are either made: (1) “in response to an express promise of a benefit,” (2) “with knowledge that the charitable donee has conferred a benefit on other donors making comparable contributions,” or (3) with the expectation, “at the time of his or her payment to charity, that there would be a quid pro quo, even though there was no explicit promise of one.”148 the quid pro quo regulation, however, does not provide a standard for determining whether the donor intended to make a payment in excess of the benefit received. because the preamble states that the quid pro quo regulation is a codification of the quid pro quo test, it is reasonably concluded the intent required to claim a charitable deduction for the excess payment amount can be easily satisfied by showing the donor knew he paid in excess of the benefit received. in recent informal guidance, the service defined the term “gift” for purposes of a charitable deduction stating it is “a transfer of money or property without receipt of adequate consideration, made with charitable intent.”149 the guidance further stated “[a] transfer is not made with charitable intent if the transferor expects a direct or indirect return benefit commensurate with the amount of the transfer.”150 arguably, this guidance has adopted the knowledge standard. furthermore, the quid pro quo regulation does not discuss the rule that a charitable deduction shall be denied if a substantial benefit is received. thus, the only logical conclusion is that a substantial benefit is one in which the quid is less than or equal to the quo (i.e., the payment to the charitable organization is less than or equal to the value of the benefit received).151 the 148. t.d. 8690, 1997-1 c.b. 68. for example, if a charity has a history of sponsoring a dinnerdance for donors making substantial contributions, a donor making a substantial contribution may have an expectation of receiving an invitation to such an event. the expectation of a quid pro quo may exist even though the donor is not aware of the exact nature of the quid pro quo (e.g., a donation to a charity that sponsors a donor appreciation event of a different type every year). id. 149. i.r.s. chief couns. adv. 2004-35-001 (aug. 27, 2004). 150. id. 151. but see kahn & kahn, “gifts, gafts, and gefts,” supra note 78, at 515. what, then, is the standard for determining whether a transfer to a charity is a gift? the standard rests on whether the transferor received a substantial benefit in return for, or as a consequence of, making the transfer. a benefit that accrues to the general public is not “substantial” for this purpose. a substantial benefit will not deny the transferor a deduction to the extent that the amount transferred to the charity exceeds the value of the benefit obtained, 2012] relighting the charitable deductions 483 quid pro quo regulation, however, provides certain goods or services, of an insubstantial value, received by the taxpayer are not to be considered in applying the quid pro quo test.152 various other exceptions to the quid pro quo test also exist, which are discussed herein. b. exceptions to the quid pro quo test when applying the quid pro quo test, various congressional and administrative exceptions do not require taxpayers to reduce their donation by a benefit received, but, instead, allow taxpayers to deduct the full amount of the payment to a charitable organization. for example, the service has provided that certain items of insubstantial value and annual membership benefits are not considered when applying the quid pro quo test.153 thus, a token item bearing the charity’s name or logo, such as a key chain or teeshirt, given to a taxpayer in the context of a fundraising campaign is not considered when applying the quid pro quo test, so long as payment to the charitable organization is of, or exceeds, a certain amount ($48.50 in 2011)154 and the cost of the item does not exceed the yearly low-cost item amount ($9.70 in 2011).155 additionally, the quid pro quo test does not consider any annual membership benefits offered to a taxpayer in exchange for a yearly $75 payment or less consisting of either (1) any rights or privileges the donor can exercise frequently during the membership period, such as free or discounted admission to the organization’s facility, and/or (2) admission to member-only events during the membership period, as long as provided that the donation of the excess value was intentional (i.e., a dual payment). id. 152. reg. § 1.170a-1(h)(3). 153. reg. § 1.170a-1(h)(3) (providing that for purposes of the quid pro quo test “goods or services described in § 1.170a-13(f)(8)(i) or § 1.170a-13(f)(9)(i) are disregarded”); reg. § 1.170a-13(f)(8)(i)(a) (refers to “[g]oods or services that have insubstantial value under the guidelines provided in revenue procedures 90-12, 1990-1 c.b. 471, 92-49, 1992-1 c.b. 987, and any successor documents” and certain “[a]nnual membership benefits offered to a taxpayer in exchange for a payment of $75 or less per year”); reg. § 1.170a-13(f)(9) (providing an additional exception for certain goods or services provided by a charitable organization to the employees of a corporation or the partners of a partnership in return for a donation from the corporation or partnership to the charitable organization). 154. the monetary values are indexed for inflation. see rev. proc. 2010-40, 2010-46 i.r.b. 663 (providing the indexed limitations for 2011). 155. id. additionally, in 2011, low-cost items include the fair market value of all benefits received for a contribution, if the benefits are not more than the lesser of two percent for the payment or $97. see id. (citing rev. proc. 90-12, 1990-1 c.b. 471). 484 florida tax review [vol. 12:6 the charitable organization reasonably projects the cost per person is under a threshold amount ($9.70 in 2011).156 most scholars and practitioners are comfortable with these administrative exceptions because the exceptions allow practical administration of the quid pro quo test, given the valuation difficulties and nominal value. however, a more controversial exception157 to the quid pro quo test is the congressionally mandated exception providing for a charitable deduction equal to eighty percent of a payment to a university or college in return for the right to purchase tickets for seating at an athletic event in the respective university’s or college’s athletic stadium (the season ticket exception).158 thus, for example, if a university requires a minimum 156. reg. § 1.170a-1(h)(3); reg. § 1.170a-13(f)(8)(i)(b); rev. proc. 201040, 2010-46 i.r.b. 663. for example, if a taxpayer purchases an annual zoo membership for $75, which provides free parking, free admission, and a discount on items sold in the zoo’s gift shop, such benefits would be disregarded in the application of the quid pro quo test. additionally, if the minimum membership payment does not exceed $75, the membership benefits are also excluded for those who contribute more than $75. if the organization offers additional benefits to members paying more than $75, such as a calendar for those contributing $100, only the additional benefits are taken into account in applying the quid pro quo test. 157. see, e.g., mcmahon & zelenak, income taxation, supra note 32, ¶ 25.01[2] (calling code section 170(l) “[a] notable exception to the quid pro quo bar, reflecting the exalted position accorded to college athletics”); kahn & kahn, “gifts, gafts, and gefts,” supra note 78, at 515 (suggesting that the congress actually reduced the deduction stating that “[i]f congress wished to reduce a charitable gift for the receipt of benefits of that nature, as it did in the case of a contribution to a university for which the donor receives a right to purchase tickets to an athletic event, congress can establish an arbitrary figure or percentage of the donation to be disallowed.”). 158. i.r.c. § 170(l). code section 170(l) provides that a charitable deduction equal to eighty percent of the amount paid to or for the benefit of college or university if: such amount would be allowable as a deduction under this section but for the fact that the taxpayer receives (directly or indirectly) as a result of paying such amount the right to purchase tickets for seating at an athletic event in an athletic stadium of such institution. if any portion of a payment is for the purchase of such tickets, such portion and the remaining portion (if any) of such payment shall be treated as separate amounts for purposes of this subsection. id. see also tech. adv. mem. 2000-04-001 (jan. 28, 2000) (providing that code section 170(l) applied even when the donation entitled the taxpayer to purchase skybox seating). for an in-depth history of the deductibility of payments for the right to purchase collegiate athletic season tickets see nina r. murphy, revenue ruling 84-132: sidelined, but not forgotten, 19 u. rich. l. rev. 301 (1985) [hereinafter murphy, revenue ruling]. 2012] relighting the charitable deductions 485 donation of $10,000 to obtain the right to purchase season tickets to the university’s football games (or sometimes the right to be placed in a lottery to potentially be able to purchase season tickets), the donor would be able to claim a charitable deduction for $8,000.159 the season ticket exception arose out of political pressure from universities and colleges fearing they would lose an additional source of revenue.160 in july 1984, the service issued revenue ruling 84-132,161 denying the deduction for a payment to a university scholarship program to obtain the right to purchase preferred seating for university home football games. due to scrutiny from universities and colleges, one month later, revenue ruling 84-132 was withdrawn until a public hearing was held.162 in response to revenue ruling 84-132, the national collegiate athletic association (ncaa) criticized revenue ruling 84-132 stating it would “lead to enormous confusion and ultimately to serious erosion in [universities’ and colleges’] fund-raising capacities.”163 subsequently, in early 1986, revenue ruling 84-132 was replaced by revenue ruling 8663,164 thereby allowing for a deduction equal to the difference between the payment and the value of the preferred seating. the donor, however, bore the burden of establishing the value of the preferred seating.165 universities and college were once again in uproar. thus, in 1988, congress promulgated the season ticket exception stating it was intended “to eliminate otherwise unavoidable valuation controversies.”166 159. it is not out of the realm that a university requires a $10,000 minimum donation. in 2008, the university of georgia required a $10,651 minimum donation to obtain the right purchase season tickets. also, the minimum donation at many schools varies depending on the location of the desired seat. furthermore, the donation in some cases is more than the price of the season tickets. 160. murphy, revenue ruling, supra note 158, at 301 n.7 (noting that, in a 1985 statement, the ncaa stated that, “the results of [a] survey of its member schools [concluded] that 77% of the schools responding had preferential seating as a benefit of membership.”). 161. 1984-2 c.b. 55. 162. announcement 84-101, 1984-45 i.r.b. 21 (stating that “based on news release ir-84-111, dated october 19, 1984” that the revenue ruling 84-132 was “suspended pending a public session on the implications of rev. rul. 84-132 upon the varied athletic scholarship programs in existence throughout the country.”). 163. toner testifies at irs hearing on contribution ruling, the ncaa news, jan. 9, 1985, at 16 (citing statement of john l. toner, president, national collegiate athletic association, to the internal revenue service on the implications of revenue ruling 84-132 (jan. 7, 1985)). 164. 1986-1 c.b. 88. 165. id. 166. h.r. rep. no. 100-795, at 523–24 (1988). 486 florida tax review [vol. 12:6 iv. the live burn donation for decades, relying on the tax court’s pre-american bar endowment decision in scharf v. commissioner,167 many believed a taxpayer could claim a charitable deduction for a live burn donation.168 in 2004, however, the service began targeting live burn donations.169 the debate over the deductibility of a live burn donation began to garner national recognition as the media publicized the service’s attack on the charitable deduction claimed by kirk herbstreit, an espn commentator and former ohio state quarterback, for the contribution of his home to the local fire department.170 soon after, the fire surrounding live burn donations was ignited again, when it was revealed that oregon gubernatorial candidate, chris dudley, took a large deduction on his 2004 federal income tax return for a live burn donation so he could build a new residence on the land.171 recently, several cases involving live burn donations were filed in the tax court and the united states district court for the southern district of ohio.172 but, it was not until 2010 that the courts finally provided their view on the live burn donation in light of american bar endowment. 167. 32 t.c.m. (cch) 1247 (1973). 168. see supra note 5 and accompanying text. 169. see supra note 6 and accompanying text. 170. see supra note 7 and accompanying text. 171. see supra note 8 and accompanying text. it appears that dudley’s deduction was never challenged by the service, since the deduction was discovered after the three year time period the service typically has to make adjustments to a taxpayer’s return. i.r.c. § 6501 (providing the statute of limitations for the service to assess additional taxes to a taxpayer). for a discussion of how dudley’s live burn donation might have affected the outcome in the gubernatorial election see generally oregon: democrat wins historic 3rd term as governor, usa today (nov. 4, 2010, 12:19 pm), http://www.usatoday.com/news/politics/2010-11-02-or-fullelection-results_n.htm (noting how dudley’s opposition used his house donation deduction against him in the 2010 oregon gubernatorial election); oregon 2010 election results, oregonlive.com, http://gov.oregonlive.com/election/ (last visited nov. 20, 2011) (providing that dudley received forty-eight percent of the vote; his opponent received forty-nine percent); nigel duara, dudley gave house for fire training, got tax break, bloomberg busn. wk. (oct. 8, 2010, 8:58 am), http://www.businessweek.com/ap/financialnews/d9inhb3o2.htm (discussing oregon democrats’ accusation that dudley took a fraudulent tax deduction). 172. see rolfs v. commissioner, 135 t.c. 471 (2010), aff’d 668 f.3d 888 (7th cir. 2012). (rolfs was filed on june 7, 2004); petition, hendrix v. united states, 106 a.f.t.r.2d (ria) 2010-5373 (s.d. ohio 2010) (no. 2:09-cv-132) (hendrix was filed on february, 24, 2009); petition, vassos v. commissioner, no. 2097-10 (t.c. jan. 19, 2010) (vassos was filed on january 19, 2010); complaint, herbstreit v. united states, no. 2:09-cv-216 (s.d. ohio mar. 19, 2009) (dismissed without prejudice july 15, 2009). 2012] relighting the charitable deductions 487 consequently, in recent years, there has been much confusion and debate over whether live burn donations qualify for charitable deductions. in early 2010, the united states district court for the southern district of ohio, in hendrix v. united states,173 issued the first opinion in over thirty-five years disallowing a live burn donation. however, the court’s opinion was not helpful because ultimately the court disallowed the live burn donation on a technicality — the lack of a qualified appraisal and “contemporaneous written acknowledgement.”174 then, nine months later, in rolfs, the tax court, which was affirmed by the seventh circuit, overruled scharf and held that a live burn donation was a quid pro quo transaction.175 in applying the quid pro quo test, the tax court stated that the demolition benefit received in exchange for the live burn donation outweighed the fair market value of the house donated because the house had a restricted use.176 accordingly, the taxpayer was unable to claim a charitable deduction for its live burn donation. prior to exploring the relevant case law regarding the deductibility of the live burn donation, a brief overview of the relevance of live burn training is necessary. a. an overview of live burn training “live burn training is the best, most comprehensive, realistic training that firefighters can take part in, as burn towers with propane fires do not have the same effect or realistic or authenticity as burn training with donated structures.”177 throughout the country, both career and volunteer fire 173. 106 a.f.t.r.2d (ria) 2010-5373 (s.d. ohio 2010). 174. see id. at 2010-5373. see also martin j. mcmahon, jr., ira b. shepard & daniel l. summons, recent developments in federal income taxation: the year 2010, 10 fla. tax. rev. 565, 701–02 (2011) (“both their house and their claimed charitable contribution deduction went up in smoke. district court denies deduction for about-to-be-demolished house to local fire department on ‘qualified appraisal’ and ‘contemporaneous written acknowledgment’ grounds, but ducks the issue of whether taxpayers could claim a deduction for this type of donation.”). 175. rolfs, 135 t.c. at 487–89 aff’d 668 f.3d 888 (7th cir. 2012). 176. id. at 495. 177. interview with jeff m. balding, driver eng’g, springfield fire dep’t (sept. 11, 2011) [hereinafter balding interview]. see also rolfs, 135 t.c. at 475 (“chief wieczorek believed the firefighter training exercises conducted at the lake house were superior to the training exercises otherwise available to the [fire department].”); bruce vielmetti, decision awaited on denial of tax break for burning house, jsonline, (april 3, 2011), http://www.jsonline.com/news/ wisconsin/89850962.html [hereinafter vielmetti, decision awaited] (“[live burn training is] the best training [firefighters] get all year. . . . is it worth the write-off? yes . . . .”); thomas j. burmeister, jr., comment, burnin’ down the house – and deducting it too: charitable contributions of building to fire departments under 488 florida tax review [vol. 12:6 departments use donated houses to conduct various training exercises, including roof ventilation, domestic violence exercises, simulated meth lab explosions, room-to-room fire practice, firefighter survival techniques, arson investigation training, rescue techniques, and/or firefighter down techniques, resulting in the home being burned to the ground as part of live burn training.178 we can do things in an actual house that we can’t do at our training facility. one of the big things was putting a firefighter in a room as if he were trapped and then having i.r.c. § 170, 94 marq. l. rev. 1013, 1046 (2011) [hereinafter burmeister, burnin’ down the house] (discussing the value of live burn training); sullivan, training fire, supra note 3 (“the experience is invaluable”); kriss garcia & reinhad kauffmann, realistic live-burn training you can afford, fire engineering, http://www.fireengineering.com/articles/print/volume-162/issue-5/features/realisticlive-burn-training-you-can-afford.html (last visited nov. 12, 2011) (“on the fireground, when all else fails and success or survival is measured in seconds and inches, we all fall back on our experience and what we learned in training to pull us through. not much in today’s fire service pays bigger dividends than intense, realistic fire training.”); national fire fighter near-miss reporting system: live burn training, fire engineering, http://www.fireengineering.com/articles/ 2011/01/near-miss-live-burn.html (last visited nov. 12, 2011) (“[live burn training] exercises are much sought after and provide valuable experience.”). 178. sullivan, training fire, supra note 3 (discussing the donation of a home by a resident of richmond, virginia to the local richmond fire department “instead of having it leveled as they prepare to build a new home on the property”). see also burmeister, burnin’ down the house, supra note 177, at 1047–48. [c]ontrolled burning exercises serve as training opportunities for arson investigators, who come to the scene after the burn and work through standard protocol to determine the origin of the fire, which is unknown to the investigators at the time. while the rate of building donations to small fire departments can vary from year to year, each donation represents added value to the expertise of the responding fire departments. unlike burn towers, a commercially available practice facility that can cost hundreds of thousands of dollars, the uniqueness of each donated structure provides unpredictability common to normal household fires. additionally, the use of a donated structure can stretch beyond the controlled burn itself. often times, the use of a donated structure can extend beyond a week’s time, consisting of several smoke drills, flashover simulations, and rescue technique training exercises. depending on the size of the structure, local fire departments may invite departments from neighboring towns to practice the coordination process that takes place when more than one department is called to a fire. id. 2012] relighting the charitable deductions 489 them break through the wall and find a space between the studs so that they could get out. we also had a chance to practice breaking out windows and breaking through walls to get to someone who was down and then carry them out of the home. it provides great training for us.179 additionally, in some cases, the donated house is also used for training by the local police department, swat teams, and rescue crews.180 in some rural areas, this is the only training firefighters receive since fire training centers are costly and many departments have limited budgets.181 “live burns supply invaluable training for volunteer departments, which make up a bulk of the nation’s firefighters.”182 unfortunately, not every house qualifies for live burn training because there are certain structural and environmental requirements.183 once 179. sullivan, training fire, supra note 3; burmeister, burnin’ down the house, supra note 177, at 1047 (“for small communities, donated structures in some cases represent the only true exposure to live fire training for new firefighters.”). 180. barr, irs nixes tax deductions, supra note 7. the [donated house] was put to good use before the fire department burned it to the ground. swat teams barged through the front door in an exercise on dealing with domestic violence. rescue crews scattered mannequins around the house and blew smoke through the halls to simulate a meth lab explosion. firefighters set fires in one room after another and practiced putting them out. then, in one last drill, the [fire department] torched the place. id. see also michael j. karter, jr. & gary p. stein, nat’l fire prot. ass’n, u.s. fire department profile through 2010, (2010), http://www.nfpa.org/ assets/files/pdf/os.fdprofile.pdf (providing that there are 1,103,300 firefighters in the united states, of which twenty-nine percent are career firefighters and the remaining seventy-one percent are volunteer firefighters). 181. chris shay, training rural fire departments, fire engineering, http://www.fireengineering.com/articles/print/volume-163/issue10/departments/volunteers-corner/training-rural-departments.html (last visited aug. 3, 2011) (“like any rural fire department in the united states, we do our best to get by training with limited personnel and limited budgets.”). see also scharf v. commissioner, 32 t.c.m. (cch) 1247, 1251 (1973), action on dec. 1974-36031 (mar. 20, 1974) (“the testimony of the municipal fire chief indicated it is only by similar donations of buildings for use in fire drills that the volunteers in this rural area are able to test their new equipment and train new staff members under controlled conditions.”) 182. barr, irs nixes tax deductions, supra note 7 (“[s]ome fear that the tax disputes will discourage donors from coming forward.”). 183. balding interview, supra note 177. see also rolfs v. commissioner, 135 t.c. 471, 474 (2010) aff’d 668 f.3d 888 (7th cir. 2012) (discussing the taxpayer 490 florida tax review [vol. 12:6 a home is accepted, a tremendous amount of work goes into preparing the house for the live burn because each live burn must follow the standards of the national fire protection association (nfpa) 1403.184 the cost associated with preparing the building for the live burn is typically incurred by the donor.185 additionally, when all is said and done and the house has been burnt down, the donor is responsible for the cost of clearing the debris.186 thus, while the donor of a live burn donation does get the benefit of the home being demolished, there is an economic cost associated with this type of donation. most importantly, a live burn donation serves as an invaluable training opportunity to firefighters and other public service agencies. b. the deductibility of the live burn donation 1. scharf — allowing the live burn donation in 1973, the tax court allowed the taxpayers to claim a charitable deduction for their live burn donation.187 in scharf, the taxpayers contributed a fire damaged building to the local fire department for fire training purposes and claimed a charitable deduction.188 the building donated by the taxpayers was purchased for investment purposes, but was partially destroyed by a fire thereby resulting in the taxpayers receiving insurance proceeds. because the building was so badly damaged and the underlying land had increased in value to the extent it was worth more than the building, the taxpayers obtaining the “the necessary approval for the burn from the wisconsin department of natural resources”). 184. gregory havel, construction concerns: acquired structures for live fire training, fire engineering, http://www.fireengineering.com/articles/ 2010/04/cc-live-fire.html (last visited nov. 12, 2011) (discussing structural concerns when acquiring a donated property for live burn training). see also balding interview, supra note 177 (providing that various permits must be obtained); national fire fighter near-miss reporting system: live burn training, fire engineering, http://www.fireengineering.com/articles/2011/01/near-miss-liveburn.html (last visited nov. 12, 2011) (“today’s live burn requires an extensive investment of time. . . . the acquired structure burn, following nfpa 1403 live fire training evolutions, lays out a comprehensive plan for conducting an exercise in the safest manner possible.”). 185. balding interview, supra note 177; rolfs, 135 t.c. at 475. 186. barr, irs nixes tax deductions, supra note 7. 187. scharf v. commissioner, 32 t.c.m. (cch) 1247 (1973), action on dec., 1974-36031 (mar. 20, 1974). 188. id. at 1249. 2012] relighting the charitable deductions 491 decided it was not “economically feasible to restore the existing building.”189 thus, the taxpayers decided to donate the building to the local volunteer fire department for live burn training.190 the fire department used the building for three subsequent fire training exercises resulting in the building being completely burnt down.191 on their 1968 federal income tax return, the taxpayers claimed a charitable deduction of $13,131.65 for the fair market value of the contributed building.192 however, the service disallowed the charitable deduction arguing the taxpayers were not entitled to such deduction due to “the impending condemnation of the building, the [taxpayers] had no desire to rebuild and therefore donated it with the expectation that its demolition would increase the value of the land and make the property easier to convert to a more productive use.”193 based on the taxpayer’s motivation, the service argued the deduction should be disallowed under the intent of the donor approach because it was not donated out of “detached and disinterested generosity.”194 alternatively, the service argued that a charitable deduction should be disallowed under the substantial benefit test as the live burn donation was “made with the expectation of receiving something in return as a quid pro quo for the transfer.”195 thus, in a case of first impression, the tax court was confronted with deciding 189. id. see also id. at 1248 (noting that the mr. scharf was an attorney, real estate broker, and a magistrate judge for over 30 years). 190. id. at 1249 (“with the encouragement of municipal authorities, the petitioner arranged for the mahwah volunteer fire department to use the building to conduct fire drills and test the use of its new fire equipment.”). 191. scharf, 32 t.c.m. (cch) at 1249 (noting that the some debris was left which the taxpayer covered up and “the rest of the foundation and the chimney pushed over to avoid injury to persons nearby”). 192. id. (“by an amendment to their petition filed february 15, 1973, the petitioners alleged that the value of their charitable contribution is $28,500 rather than the $13,131.65 originally claimed on their federal income tax return for 1968, and that they are entitled to an increased charitable contribution carryover to 1969 and subsequent years.”). see u.s. inflation calculator http://www.usinflation calculator.com/ (last visited sept. 13, 2011) (providing that, in 2011, a $13,131.65 charitable deduction would be equivalent to the taxpayer claiming a $85,250.82 charitable deduction). 193. scharf, 32 t.c.m. (cch) at 1251. 194. id. (“[w]here evidence indicates that the primary motive for a contribution is to obtain a direct or indirect benefit by enhancing the value of his remaining property, then a charitable deduction for such a contribution should be denied.”). 195. id. 492 florida tax review [vol. 12:6 “whether [the taxpayers were] entitled to a charitable contribution deduction for a building donated to a volunteer fire department for use in fire drills.”196 the tax court began its analysis by discussing the motivation and benefit the taxpayer received stating: there is no doubt that [taxpayer’s] donation of the firedamaged . . . building resulted in a clearer tract of valuable land which he could market far more easily than before the demolition. there is also no doubt that [taxpayer] was somewhat motivated in his donation by a desire to have the building burned to the ground by the volunteer fire department.197 the tax court recognized that, even though the requisite intent for a claimed charitable deduction “is frequently difficult to determine,” it has used the intent of the donor approach in the past.198 however, the tax court reasoned that often when a charitable deduction has been disallowed under the intent of the donor approach “a quid pro quo flowed back to the donor from the exempt organization donee which certainly exceeded the satisfaction which flows from the performance of a generous act.”199 thus, without much explanation, the tax court decided to use the substantial benefit approach, stating: [t]here are situations where the benefits of a charitable contribution inuring to the donor are incidental to the much greater benefits inuring to the general public from the donation. when this occurs, the small benefit to the donor does not destroy his right to a charitable contribution deduction. . . . thus, where the primary benefit inures to the general public with only lesser and incidental benefits flowing back to the donor, then a charitable deduction will be allowed.200 196. id. at 1248 (“alternatively, whether petitioners are entitled to an abandonment or demolition loss as a result of its use by the fire department.”). 197. id. at 1251. 198. scharf, 32 t.c.m. (cch) at 1252 (“this court has often held that a charitable gift must proceed from affection, respect, admiration, charity or like impulses, rather than from either the incentive of anticipated benefit beyond the satisfaction flowing from the performance of a generous act, or the constraining force of any moral or legal duty.”). 199. id. 200. id. 2012] relighting the charitable deductions 493 accordingly, the tax court held that while it was a close call, “the benefit flowing back to [the taxpayer], consisting of clearer land, was far less than the greater benefit flowing to the volunteer fire department’s training and equipment testing operations.”201 the tax court, thus, determined that while the taxpayer did receive the return benefit of clearer land, the taxpayer still had to remove debris and prepare the property before he could place it on the market. in balancing this benefit with the benefit to the general public, the tax court found the live burn donation primarily benefited the community “in its fire control and prevention operations.”202 accordingly, the benefit to the taxpayer was an incidental benefit and, therefore, the taxpayer was entitled to a charitable deduction for the live burn donation. having held the live burn donation was deductible, the tax court then faced the issue of determining the fair market value of the live burn donation. the taxpayer asserted that the live burn donation consisted of a donation of the entire building and, therefore, the fair market value should be based on the reproduction cost of the building. the service asserted that the taxpayer only donated the use of the building, and the taxpayer did not establish “a marketable value for the privilege of using the building for fire drills.”203 alternatively, the service argued reproduction cost should not be used as the building was already damaged by fire at the time of the donation. based on the facts and circumstances,204 the tax court held that the best method for valuation was the fair market value of the building for insurance loss purposes less the amount of any insurance proceeds recovered. furthermore, the tax court stated: “we need not choose here between the value of the donated use of the building and its fair market value in its damaged condition because in these circumstances we find they are the same.”205 three months after the tax court decided scharf, the service issued an action on decision (the scharf aod) agreeing with the holding in scharf.206 in the scharf aod, the service stated: the court found as a fact that the benefits flowing back to petitioners, consisting of clearer land, were far less than the greater benefit flowing to the fire department and that petitioners benefited only incidentally. there was evidence 201. id. 202. id. 203. scharf, 32 t.c.m. (cch) at 1252. 204. id. (“all factors bearing on value are relevant, including the cost, selling price, sales of comparable properties, the present condition of the property, opinion evidence and market conditions.”). 205. id. 206. in re scharf, 1974 wl 36031 (i.r.s. aod mar. 20, 1974). 494 florida tax review [vol. 12:6 in the record to support this factual finding and such finding is not clearly erroneous. in view of the court’s finding that the benefits received by petitioners were incidental, the mere fact that petitioners were benefited is not sufficient to deny the deduction.207 additionally, the service agreed, based on the facts in scharf, that the tax court was correct in holding a “donation of the right to destroy a building is the same as donation of the building itself. such finding is correct.”208 moreover, the service stated it would no longer use the intent of the donor approach, requiring a donor’s intent in making a donation to be out of “detached and disinterested generosity,” stating “[n]otwithstanding that the court in dicta appeared to approve this position, the service will no longer make this argument.”209 2. hendrix — lack of a qualified appraisal in july 2010, in hendrix v. united states,210 the united states district court for the southern district of ohio, was the first federal court in over thirty-five years to examine the deductibility of a live burn donation.211 in 2000, hendrix purchased a house located in the prominent historic neighborhood of upper arlington in the columbus, ohio area. four years later, the taxpayers decided to demolish the house sitting on the lot and build 207. id. at *1. 208. id. 209. id. in the scharf aod, the service also provided that “[i]n cases involving the donation of the use of property, for transfers in taxable years beginning before january 1, 1970, a contribution of the right to use property is allowable as a charitable contributions deduction if, under local law, a legally enforceable present interest has been conveyed.” id. at *2. cleary, this is the service preserving its position that code section 170(f)(3) applies to live burn donations. 210. 106 a.f.t.r.2d (ria) 2010-5373 (s.d. ohio 2010). 211. id. but see wells v. dep’t of revenue, no. tc-md 030449b, 2003 wl 22905250, at *1 (or. tax magis. div. dec. 8, 2003). in wells, the oregon department of revenue argued that a charitable deduction was not allowed for a live burn donation, as the volunteer fire department was not a qualified organization. id. the court held based on scharf and revenue ruling 71-47, 1971-1 c.b. 92, that the volunteer fire department was a qualified organization, as it was a “political subdivision” as “the volunteer fire department relieves a political subdivision of a function which it would normally perform.” id. furthermore, in dicta, the court, relying on scharf, stated “although it may be argued that the donor is in fact receiving a benefit through the destruction of an unwanted building, it has been reasoned that the incidental benefit to the donor is outweighed by the much greater benefit inuring to the general public.” id. 2012] relighting the charitable deductions 495 a new home. accordingly, the taxpayers obtained two bids for demolition services.212 after declining to accept either of the demolition bids from private companies, the taxpayers decided to donate their personal residence to the upper arlington fire department for various training purposes. thus, the taxpayers obtained an appraisal of the house, which valued the house at $520,000. additionally, the taxpayers consulted the accounting firm of deloitte & touche for tax advice. despite receiving adverse advice from deloitte & touche, the taxpayers entered into a contract with the fire department.213 the agreement provided the taxpayers would grant the city sole discretion to burn and/or demolish the house. from june 29, 2004 to october 29, 2004, the city used the house for various training exercises and ultimately demolished the house. the taxpayers subsequently claimed a $287,400 charitable deduction.214 in deciding whether the live burn donation was deductible, the district court first examined the substantiation requirements for a charitable deduction.215 in particular, the court looked at the “qualified appraisal”216 212. hendrix, 106 a.f.t.r.2d (ria) at 2010-5374 (providing that the price to demolish the home was approximately $10,000). 213. id. (the advice from deloitte & touche stated that a live burn donation “is aggressive and not explicitly sanctioned by the internal revenue code.”). 214. id. 215. id. at 2010-5375. 216. i.r.c. § 170(f)(11)(e)(i) (defining qualified appraisal). a qualified appraisal is an appraisal of property which — (i) is treated for purposes of this paragraph as a qualified appraisal under regulations or other guidance prescribed by the secretary, and (ii) is conducted by a qualified appraiser in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed under subclause (i). (ii) qualified appraiser. except as provided in clause (iii), the term “qualified appraiser” means an individual who — (i) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations prescribed by the secretary, (ii) regularly performs appraisals for which the individual receives compensation, and 496 florida tax review [vol. 12:6 and “contemporaneous acknowledgment” requirements.217 ultimately, the court held these two requirements were not met, and thus granted the service’s motion for summary judgment thereby ending the litigation.218 (iii) meets such other requirements as may be prescribed by the secretary in regulations or other guidance. (iii) specific appraisals. an individual shall not be treated as a qualified appraiser with respect to any specific appraisal unless — (i) the individual demonstrates verifiable education and experience in valuing the type of property subject to the appraisal, and (ii) the individual has not been prohibited from practicing before the internal revenue service by the secretary under section 330(c) of title 31, united states code, at any time during the 3-year period ending on the date of the appraisal. id. see also reg. § 1.170a-13(c)(3) (explaining the requirements of the qualified appraisal); reg. § 1.170a-13(c)(4) (explaining the requirement of the summary appraisal); reg. § 1.170a-13(c)(5) (defining qualified appraiser). 217. see i.r.c. § 170(f)(8) (providing the contemporaneous acknowledgment requirement). i.r.c. § 170(f)(8) states that: “no deduction shall be allowed under subsection (a) for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgment of the contribution by the donee organization. . . .” the written acknowledgement must contain the following information: (i) the amount of cash and a description (but not value) of any property other than cash contributed. (ii) whether the donee organization provided any goods or services in consideration, in whole or in part, for any property described in clause (i). (iii) a description and good faith estimate of the value of any goods or services referred to in clause (ii) or, if such goods or services consist solely of intangible religious benefits, a statement to that effect. id. 218. hendrix, 106 a.f.t.r.2d (ria) at 2010-5375. the appraisal submitted by taxpayers failed to contain: [t]he expected date of contribution, the terms of the agreement between [the taxpayers] and the city, the qualification of [the taxpayers’] appraiser . . . and the required statement that the 2012] relighting the charitable deductions 497 unfortunately, the court did not reach the looming issue of whether a charitable deduction is allowed for live burn donation, stating: either of the foregoing grounds ends this litigation. thus, as noted, the court declines to reach the remaining moot issues involved in the parties’ dispute. the consequent result of the foregoing analysis is that, regardless of whether taxpayers may be able to claim a deduction for the type of donation involved in this case — a question this court need not ultimately answer today — the deficient manner in which [the taxpayers] pursued such a donation here proves dispositive.219 even though the court did not decide the issue of whether a charitable deduction is allowed for a live burn donation, it was evident from the tone of the hendrix opinion that the court did not agree with the deductibility of the live burn donation. c. rolfs — the tax court extinguishes the live burn donation in october 2004, thirty-five years after the tax court held that a charitable deduction was allowed for a live burn donation, the court was once again confronted with the same issue.220 this time, however, there was a different landscape in which to view this issue in light of american bar endowment and hernandez. due to the chief judge requiring an en banc review of the rolfs opinion, it was not until november 2010 that the tax court issued the rolfs opinion disallowing the live burn donation as a appraisal was prepared for income tax purposes. . . . in fact, in addition to failing to contain any of the identified, specifically required information, one provision of the appraisal arguably disavows by omission that the appraisal was prepared for income tax purposes. the appraisal indicates its “purpose and scope” by providing that “[t]he intended use of this appraisal is to assist the owner in estimating the fair market value of the subject property.” id. at 2010–5376 (emphasis in original). 219. id. at 2010–5379. 220. internet docket inquiry in the matter of rolfs v. commissioner, u.s. tax ct., https://ustaxcourt.gov/ustcdockinq/docketdisplay.aspx?docketno = 04009377 (last visited sept. 13, 2011) (showing that on october 24, 2005, the trial for the rolfs’ case took place before the united states tax court. however, it was not until six years later, on november 4, 2010, the tax court issued an opinion). 498 florida tax review [vol. 12:6 charitable deduction.221 in early 2012, the seventh circuit affirmed that tax court’s decision.222 in 1996, the rolfs purchased a 1900s lake house located on 3-acres, at which time they were unsure whether they would remodel the home or demolish it.223 finally, in late 1997, the taxpayers decided to tear down the house and build a new one.224 around the same time that the taxpayers learned that demolition and debris removal of the lake house would cost between $10,000 and $15,000, the taxpayers became aware of an individual who claimed a charitable deduction for a live burn donation. as a result, the taxpayers decided to donate the lake house to the local volunteer fire department for training purposes and claim a charitable deduction for their live burn donation. the taxpayers did not enter into a written contractual agreement with the fire department for the contribution of the house, but rather communicated orally with the fire department their desire to donate the property. on february 10, 1998, the taxpayers memorialized their previous conversations with the fire chief and expressed their desire to donate their lake house “to the fire and police departments of the village for [the sole use of] training and eventually demolition.”225 the letter purported to “serve as an acknowledgment that it is [the taxpayers’] intention to donate the house for such purposes” and that “[t]he house is available immediately.”226 according to testimony of the local fire department chief, there was a mutual understanding between the taxpayers and him that “the lake house would be destroyed within ‘the first part of [1998].’”227 additionally, the taxpayers donated $1,000 to the fire department to defray the costs associated with the live burn training.228 within the following eleven days after the letter was 221. see vielmetti, decision awaited, supra note 177 (rolfs’ attorney of record, michael goller, stated that while the presiding judge is studious and academic, he believes that “the whole tax court may be reviewing this.” such belief is shared by others, as one tax scholar believes that “[the rolfs’ case] does have larger significance” and that if the irs does not prevail congress would be expected to enact a law specifically addressing the deductibility of such donations.). 222. rolfs v. commissioner, 668 f.3d (7th cir. 2012), aff’g 135 t.c. 471 (2010). 223. id. at 473 (stating that the taxpayers paid $600,000 for the lake house). 224. id. (stating that as the mother of “julia a. gallagher’s mother, beatrice gallagher (mrs. gallagher)” proposed that the taxpayer “build a new house to her specifications as her residence in its place, and then exchange the lake property for her existing residence”). 225. id. at 474. 226. id. 227. rolfs, 135 t.c. at 474. 228. id. at 475. “the record does not include an itemization of this amount, and it is unclear whether [taxpayers] claimed a deduction for the $1,000 remitted to 2012] relighting the charitable deductions 499 sent, the fire and police departments used the lake house for training, ending with the fire department burning and demolishing the house. soon after, on march 30, 1998, the taxpayers entered into a construction contract for a new residence on the lake property.229 the taxpayers claimed a charitable deduction for $76,000230 on their 1998 federal income tax return, which the service denied.231 the service asserted that a charitable deduction was not allowed for the live burn donation based on three alternative legal arguments. relying on american bar endowment and the quid pro quo regulation, the service asserted that the taxpayers received the substantial benefit of demolition services in return for their live burn donation. thus, because the fair market value of the benefit received, the demolition services, was greater than the fair market value of the live burn donation, there was no “contribution or gift” (the quid pro quo argument).232 alternatively, the service argued a charitable deduction was disallowed for the live burn donation because the taxpayers “transferred to the [fire department] less than their entire interest in the lake house.”233 the service’s final argument was that the “lake house as the [fire department] to defray the costs incurred in connection with the use of the lake house for training exercises.” id. at 476 n.3. 229. id. at 475 (stating the cost of the new house was $383,000). 230. but see id. at 472 (stating that the taxpayers amended their petition claiming valuing the land based on its reconstruction value of $235,350, “rather than the $76,000 claimed on their return . . . resulting in an overpayment of $39,672 for 1998”). 231. rolfs, 135 t.c. at 476. see also id. at 477 (stating that the taxpayers “subsequently filed an amended petition in which they averred that they were entitled to a charitable contribution deduction for their donation of the lake house of at least $235,350, the reproduction cost of the house”). 232. id. at 480–81. 233. id. at 481 (relying on code section 170(f)(3)(a)). see i.r.c. § 170(f)(3)(a) (providing that a charitable deduction is not allowed for certain contributions of partial interests in property). section 170(f)(3) reads as follows: (a) in general. in the case of a contribution (not made by a transfer in trust) of an interest in property which consists of less than the taxpayer’s entire interest in such property, a deduction shall be allowed under this section only to the extent that the value of the interest contributed would be allowable as a deduction under this section if such interest had been transferred in trust. for purposes of this subparagraph, a contribution by a taxpayer of the right to use property shall be treated as a contribution of less than the taxpayer’s entire interest in such property. (b) exceptions. subparagraph (a) shall not apply to (i) a contribution of a remainder interest in a personal residence or farm, 500 florida tax review [vol. 12:6 donated to the [fire department] was worthless.”234 on the other hand, the taxpayers argued235 that, in accordance with a qualified appraisal, the value of the lake house was $76,000; thus it was not worthless. additionally, the taxpayers, relying on scharf, argued they only received an incidental benefit; as a result, they should be able to deduct the entire fair market value of the house. finally, the taxpayers asserted that “because [they transferred] the lake house to the [fire department] with the right to demolish it, they transferred their entire interest in the property.”236 in reaching its decision to disallow the charitable deduction for the live burn donation, the tax court only addressed the quid pro quo argument. essentially, the tax court found the taxpayers did, indeed, receive a substantial benefit in excess of the value of their live burn donation and, ultimately, disposed of the case.237 in reaching this conclusion, the tax court began its analysis by citing the definition given by the supreme court in hernandez to the term “contribution or gift,” stating: the legislative history of the “contribution or gift” limitation [of the charitable deduction], though sparse, reveals that congress intended to differentiate between unrequited payments to qualified recipients and payments made to such recipients in return for goods or services. only the former were deemed deductible. the house and senate reports on the 1954 tax bill, for example, both define “gifts” (ii) a contribution of an undivided portion of the taxpayer’s entire interest in property, and (iii) a qualified conservation contribution. id. see also infra note 246 (arguing that code section 170(f)(3)(a) does apply to the live burn donation). 234. rolfs, 135 t.c. at 481. 235. id. (providing that the taxpayers also argued that the under code section 7491(a) the burden of proof shifted to the service and that the service’s quid pro argument that the taxpayer’s received a benefit in return should not be heard as “this argument constitutes new matter that respondent raised for the first time in his opening brief”). the tax court held against both of these assertions. for the tax court’s analysis of these issues see rolfs, 135 t.c. at 482–86. 236. id. at 482. 237. id. at 495 n.19 (stating that the tax court “need not decide [the service’s] alternate contentions that the deduction is disallowed pursuant to sec. 170(f)(3) or on account of the worthlessness of the lake property at the time of the donation”). see also rolfs, 668 f.3d, n.3 (“the irs offered an alternate theory for denying the rolf’s deduction: that the gift transferred only a limited right to use (i.e., burn down) a house and therefore was not a qualifying contribution under 26 u.s.c. § 170(f)(3), which denies deductions for gifts of most partial interests in property. . . . the tax court did not reach this question, and we affirm without reaching it.”). 2012] relighting the charitable deductions 501 as payments “made with no expectation of a financial return commensurate with the amount of the gift.”238 accordingly, the tax court concluded that “[a] payment of money generally cannot constitute a charitable contribution if the contributor expects a substantial benefit in return.”239 in determining whether a payment was made with the expectation of a return benefit, “the external, structural features of the transaction, which obviates the need for imprecise inquiries into the motivations of individual taxpayers” must be examined.240 the tax court, agreeing with the service, found the taxpayers did receive a benefit, since the taxpayers contacted the fire department to burn down the lake house after deciding they wanted to build a new home on the lakefront property and, thus, needed the lake house demolished. accordingly, the external features of the transaction showed that the taxpayers anticipated a demolition benefit in exchange for their live burn donation. the tax court rejected the taxpayers’ reliance on the scharf test on the grounds that american bar endowment rendered scharf moot, stating: the test applied in scharf, which examines whether the value of the public benefit of the donation exceeded the value of the benefit received by the donor, differs from the supreme court’s test announced 13 years later in united states v. am. bar endowment. the am. bar endowment test examines whether the fair market value of the contributed property exceeded the fair market value of the benefit received by the donor. the test applied in scharf has no vitality after am. bar endowment. 241 accordingly, the transaction was a quid pro quo transaction and was required to be examined under the two-prong quid pro quo test announced in american bar endowment: (1) “the payment is deductible only if and to the extent it exceeds the market value of the benefit received,” and (2) “the 238. id. at 480 (quoting hernandez v. commissioner, 490 u.s. 680, 690 (1989)). 239. id. (quoting united states v. am. bar endowment, 477 u.s. 105, 116 (1986)). the tax court also interestingly cited singer co. v. united states, 196 ct. cl. 90 (1971). 240. rolfs, 135 t.c. at 480, (relying on hernandez, 490 u.s. at 690–91). 241. id. at 487 (internal citations omitted). see also rolfs, 668 f.3d 888 (“the tax court ruled correctly in this case that the scharf test “has no vitality” after american bar endowment.”). but see hagen, capricious nature, supra note 20, at 302–04 (arguing that american bar endowment did not render scharf moot). 502 florida tax review [vol. 12:6 excess payment must be made with the intention of making a gift.”242 consequently, the tax court turned to the issue of determining the values of the demolition benefit and the lake house.243 the tax court held the value of the demolition benefit received by the taxpayers was $10,000. the taxpayers asserted they did not receive a benefit because the contract for the construction of the new house included a fee of “‘$10,000 to $15,000’ in excavation charges for clearing the remnants of the burn and concrete foundation of the lake house.”244 the tax court, however, rejected this assertion because the construction contract did not include a line item specifically allocating any portion of the total contract price to excavation and debris removal.245 instead, the tax court based its finding on the fact that both the taxpayers’ and the service’s experts found the cost to have the lake house demolished to be in the range of $10,000. thus, the tax court turned to the harder issue of valuing the donation of the lake house. in valuing the lake house, the tax court focused on the rule of law requiring that any restrictions and/or conditions limiting the marketability of contributed property on the date of the contribution, including those imposed by the donor, must be considered when determining the fair market value of the contributed property. the tax court agreed with the taxpayers that the lake house could be separately valued from the underlying land as the “donation of the lake house to the [fire department], without [the taxpayers’] conveyance of the underlying land on which it was sited, effected a ‘constructive severance’ of the structure from the land, recognized under wisconsin law, even though the structure remained affixed to the land.”246 242. rolfs, 135 t.c. at 486. 243. see generally reg. § 1.170a-1(c)(1)) (“if a charitable contribution is made in property other than money, the amount of the contribution is the fair market value of the property at the time of the contribution . . . .”); reg. § 1.170a-1(c)(2) (“the fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”). 244. rolfs, 135 t.c. at 488 (“[taxpayers] argue on brief that these additional excavation costs demonstrate that [taxpayers] did not save anything from the demolition resulting from the burning and therefore received no benefit from their donation of the lake house to the vfd.”) 245. id. (stating that “[m]oreover, a preprinted portion of the contract covering ‘building site conditions’ has been lined through by the parties to the contract, creating an inference that the contract price did not cover any significant debris or foundation removal services”). 246. id. at 489–90. arguably, based on the tax court’s holding that the home was severed from the underlying land, one could foresee that if the tax court would have addressed the service’s alternative partial interest argument, that the tax court would have held that land and the house were two distinct pieces of property. 2012] relighting the charitable deductions 503 however, because the taxpayers transferred the lake house and not the underlying land, the tax court determined that a restriction or condition was created on the marketability of the donation because the lake house could not remain in its current location. the tax court determined there were two additional restrictions or conditions on the lake house: (1) restricting the use to fire and police training and (2) requiring the house to be burnt down within a short period of time after the donation.247 consequently, the tax court did not accept the taxpayers’ qualified appraisal in the amount of $76,000 because it used the “before and after” approach which did not consider the restrictions placed on the lake house.248 furthermore, the tax court determined there was no authority for using the “before and after” approach in situations where the property was severed from the underlying land and laden with restrictions on use.249 instead, the tax court relied on the service’s experts and held that the property was of minimal value due to the underlying restrictions and conditions of the donated lake house. the tax court examined the impact of the severance of the lake house from the underlying land and determined this fact “rendered the lake house virtually worthless.”250 the court subsequently examined the impact of the restriction on the use of the lake house and determined that although there was insufficient evidence to determine the dollar impact, the court was convinced the impact would be adverse.251 thus, the court held, thus, by giving the lake house to the fire department for live burn training, the taxpayers gave the entire house. 247. id. at 490 (providing the chief of the fire department “testified that he understood he could not use the lake house for any other purpose and that the burndown was to take place during the first part of 1998”). 248. id. at 490–92. under the “before and after” approach, the appraiser determined the value of the lake house and underlying land and then determined and subtracted the value of the lake property without the lake house. the appraiser determined that the $76,000 difference was the value of the lake house when donated to the fire department. 249. rolfs, 135 t.c. at 492–93. [a]lternatively [the taxpayers] contend that the fair market value of the lake house as contributed to the [fire department] was $235,350, its reproduction cost as estimated by [the appraiser] . . . [but] offer no expert testimony in support of this proposition . . . [taxpayers] merely borrow [the appraiser’s] estimate of reproduction cost and assert on brief . . . that because the lake house was “unique” and was “special use” property in the hands of the donee, reproduction cost is the appropriate measure of its value. id. at 492. 250. id. at 494. 251. id. (stating that “the lake house’s salvage value was zero”). 504 florida tax review [vol. 12:6 after considering all the conditions and restrictions to ensure sufficient consideration existed to render the contract enforceable, the fair market value of the lake house was de minimis because no one would purchase the lake house for more than a nominal amount, which was between $100 and $1,000.252 as a result, the tax court held for the service on its quid pro quo argument because the live burn donation failed the first prong of the quid pro quo test. meaning, the taxpayers failed to show the fair market value of the lake house exceeded the value of the demolition benefit received by the taxpayers. accordingly, the taxpayers were not entitled to a charitable deduction for their live burn donation.253 thus, the tax court was not confronted with examining the second prong of the quid pro quo test— “whether the excess of the value of the donation over the value of the benefit received was transferred with the intention of making a gift.”254 had the court determined the fair market value of the live burn donation exceeded the fair market value of return benefit, the tax court would have been forced to examine the second prong of the quid pro quo test. surely the tax court would have concluded that the second prong was met as the taxpayers clearly knew they were making a donation in excess of the return benefit. v. the public benefit exception while it appears the service has won the live burn donation fight in the courts,255 the deductibility of the live burn donation remains an issue of 252. id. at 479, 495. 253. rolfs, 135 t.c. at 495. see also id. at 495–96 (holding that the taxpayers were not subject to code section 6662 accuracy-related penalties, as the taxpayers “given all the facts and circumstances, including the uncertain state of the law . . . acted with reasonable cause and in good faith”). 254. id. at 488 n.13. 255. in rolfs, the tax court was correct in applying the quid pro quo test to the live burn donation. arguably, however, the court incorrectly valued the amount of the contribution. see supra note 20 (discussing the improper valuation). as a result of undervaluing the donation at $100 to $1,000, the court’s analysis stopped at the first prong of the quid pro quo test. while i will not speculate to the actual value of the donation, i would assert that the value of the live burn donation clearly exceeded the value of the demolition services. consequently, the court would have had to examine the live burn donation under the second prong of the quid pro quo test — whether the excess donation was transferred with the intention of making a gift. surely, the tax court would have concluded that the second prong was met, as the taxpayers clearly knew they were making a donation in excess of the return benefit. as for the services’s alternative arguments, the house was clearly not worthless, because it had some value, regardless of whether the taxpayers intended to demolish the house or not. assuming a donation is deemed worthless because a 2012] relighting the charitable deductions 505 contention primarily due to the issue of valuation. those who opposed the deduction did so mainly because of the large dollar figures associated with the deductions; this is commonly referred to as “wealthfare.”256 due to the perceived abuse of the live burn donation, it is believed that congress might enact legislation specifically disallowing live burn donations.257 this article proposes congress should not extinguish the live burn donation. rather, exceptions to the application of the quid pro quo test should be made when the benefit of the donation to the public substantially outweighs the benefit received by the donor (the public benefit exception). the public benefit exception should be used to encourage donations that otherwise would be underfunded, as is the case in live burn donations. this section will first discuss the public benefit exception using the live burn donation as the lens to examine the application of the proposed exception. ultimately, this section proposes an amendment to the charitable deduction, thereby allowing a charitable deduction for live burn donations, while recognizing the need for limitations given the perceived abuse and valuation difficulties of the live burn donation. taxpayer is done using the item, then most, if not all, charitable deductions would be worthless. see also supra 246 (arguing that the taxpayer transferred their entire interest in the house). 256. marie rohde, asbestos could stop fox point firefighting drill village officials demand review of policy allowing residents to donate homes, milwaukee j. & sentinel, mar. 3, 1999, at b1, available at 1999 wlnr 2868170. see also editorial, burned-down house can’t be used again, columbus dispatch (ohio), aug. 2, 2009, at 04g, available at 2009 wlnr 14917592. 257. see, e.g., vielmetti, decision awaited, supra note 177 (quoting professor lloyd mayer of notre dame school of law stating that the rolfs case “does have larger significance…. usually, when you give to charity, you can deduct the fair market value. but in a number of cases, including [rolfs] people, including congress, were getting uncomfortable.”). congress has promulgated similar laws to target abuse in the area of taxidermy and vehicle donations. see, e.g., kathy m. kristof, charitable donations get stricter tax rules, l.a. times (aug. 27, 2006), http://articles.latimes.com/2006/aug/27/business/fi-perfin27 (“rules governing donations of automobiles, another area in which legislators believed there was widespread cheating, were tightened under a 2004 tax law. now, if a charity sells — rather than uses — a donated car, the donor can write off only the amount the charity received for the car.”); press release, united states senate comm. on fin. summary of senator grassley’s non-profit oversight to date (nov. 20, 2007), http://finance.senate/gov/newsroom/ranking/release/?id=83f6b20e-3327-4619-8b9236ce643ef5fe (tax breaks for taxidermy. this shuts down a practice in which a donor received big tax breaks for the cost of his african safari while a museum received a nearly worthless, dusty boar’s head sitting in a railway car.”). 506 florida tax review [vol. 12:6 a. the application of the public benefit exception as discussed above, exceptions have been made to the application of the quid pro quo test by the service in situations where it would be administratively inconvenient to account for a taxpayer receiving a nominal return benefit, such as a coffee mug or a keychain bearing the logo of the charitable organization. the service has also made exceptions when the value of a return benefit is difficult to determine, such as intangible religious benefits. moreover, congress enacted the season ticket exception, which is one of the most controversial exceptions. the season ticket exception was promulgated to eliminate potential valuation controversies based on the argument that the return benefit of the right to purchase season tickets would be difficult to value. with that said, congressional consideration of other exceptions to the quid pro quo test is warranted when the benefit of the donation to the public substantially outweighs the benefit received by the donor. the balancing concept behind the public benefit exception was first discussed in singer as part of the substantial benefit received approach. the court proposed a balancing test whereby “the benefits received, or expected to be received,” were balanced against the benefits “inur[ing] to the general public from transfers for charitable purposes.”258 due to the lack of guidance from the court, it was unclear how to apply such a balancing test. it has been argued the test could be interpreted in two different ways because “it is not readily apparent whether the court intended that the transferor’s benefit be measured against those benefits received by the general public, or whether the benefits received by the transferor [were to be measured against] those that would incidentally inure to it as a member of the general public.”259 the better interpretation is to balance the return benefit inuring to the taxpayer with the benefits received by the general public as such conforms to the purpose of the charitable deduction —acting as a subsidy to those organizations the government recognizes as providing a community benefit. under the substantial benefit approach, the balancing test was troubling due to the immense ramifications. if the return benefit was deemed 258. singer co. v. united states, 196 ct. cl. 90, 106 (1971). 259. hobbet, charitable contributions, supra note 53, at 7. the better view would be to first determine whether the taxpayer has received a direct benefit from the recipient organization, disregarding whether it may also happen to benefit incidentally as a member of the general public. once it [has been] determined that a direct benefit has been received, an objective test could focus upon the value of the direct benefit, measuring it against the benefit received by the public by virtue of the contribution, and not against any incidental benefit received by the taxpayer. id. 2012] relighting the charitable deductions 507 incidental, the substantial benefit approach allowed a charitable deduction for the entire amount of the payment to the charitable organization without a reduction for the value of the return benefit. consequently, substantial weight was placed on a test that could potentially pose difficulty to the courts in assessing the value of the benefit to the charitable organization. this fear is alleviated under the public benefit exception because the balancing test would only be used to determine whether an exception to the application of the quid pro quo test for a particular donation should be considered. it is not the intended purpose of this article to suggest that if the benefit flowing to the public outweighs the benefit flowing back to the taxpayer the entire payment should be deductible. instead, whether the public benefit exception applies, congress should enact specific legislation for the donation at hand recognizing the need for limitations given any currently recognized or potentially perceived abuses, as well as any valuation issues. in applying the public benefit exception, congress must first determine the fair market value of the benefit taxpayers are receiving from the particular type of donation. the benefit that a taxpayer receives from a specific type of donation will vary among taxpayers based on various factors. nevertheless, for administrative convenience, this article suggests that the average benefit received be used when determining whether the public benefit exception applies. although the return benefit of demolition services received by taxpayers from the live burn donation will vary depending on the size and location of the home, if the nationwide average of the value of the demolition services received is, for example, $10,000, then the value of the benefit received for purposes of testing the live burn donation under the public benefit exception should simply be $10,000. most likely, the more difficult benefit to value is the benefit received by the general public.260 while it is highly unlikely that an exact monetary value can be placed on such benefit, congress must determine whether the perceived value of the benefit to the general public outweighs the benefit inuring to the taxpayer. in determining the value of the benefit flowing to the general public congress must look at all the facts and circumstances of the donation, including, but not limited to, the following three factors: (1) the scope of the benefitted group, (2) the type and use of property being donated, and (3) the potential underfunding of the donation. 260. see rolfs, 668 f.3d 888 (stating the “scharf court did not actually calculate a dollar value for the public benefit, and if it had tried, it probably would have found the task exceedingly difficult.”). 508 florida tax review [vol. 12:6 1. the scope of the benefitted group factor the general public ultimately bears the cost of the charitable deduction; and accordingly, any exception to the quid pro quo test should be for the benefit of the greatest number of people.261 the value of the benefit to the general public, thus, should increase as the scope of the benefitted group widens. if the benefit flowing from a donation only benefits a small segment of society, more likely than not the value of the donation being reviewed is low and the public benefit exception should not apply. for example, live burn donations are used by firefighters and other public servants to train and enhance public safety. the live burn donation thus affects a broad segment of the population. alternatively, the season ticket exception only benefits universities or colleges, and perhaps, primarily only the athletic departments. the season ticket exception thus benefits a much narrower group of society. therefore, in the case of the live burn donation, the benefit to the general public should be viewed by congress as being more valuable than the right to purchase season tickets to one’s favorite collegiate sport. 2. the type and use of property being donated factor the type and use of property being donated to the charitable organization must be considered in valuing the benefit to the general public. if donated property is unique or not commonly available to the charitable organization, the value of the benefit to the general public should increase. on the other hand, if the property being donated is money, the benefit to the general public should be deemed to have zero value as money is the most common type of property. however, if the return benefit inuring to the taxpayer is difficult to value, making the quid pro quo test difficult to apply and causing potential valuation controversy, monetary donations should not render the public benefit exception inapplicable. instead, this factor should be viewed as neutral. otherwise, the public benefit exception should not apply in the case of monetary donations. for example, the property being donated in a live burn donation is unique property because the home must meet specific structural and environmental requirements.262 moreover, the property is not commonly available to local fire departments resulting in fire training typically taking 261. shannon weeks mccormack, too close to home: limiting the organizations subsidized by the charitable deduction to those in economic need, 63 fla. l. rev. 857, 866 (2011) [hereinafter mccormack, too close to home] (“because the cost of the charitable deduction is spread among all taxpayers, the benefit should also be somewhat dispersed.”). 262. see supra notes 183–84 and accompanying text. 2012] relighting the charitable deductions 509 place in burn towers, if such training is affordable. live burn donations allow for firefighters to conduct live burn training, which provides a realism not seen in controlled tower burns.263 in some situations, the local fire departments do not have access to fire towers, so the only training after the academy takes place in one of these donated houses.264 not to mention, the donated structures are utilized by other municipal departments, including swat teams, rescue crews, and fire investigators, prior to being burned to the ground. thus, congress should view the benefit to the general public as being extremely valuable in the case of the live burn donation. alternatively, the season ticket exception involves the donation of money. thus, generally, the public benefit would not apply because the season ticket exception involves a monetary donation. however, the congressional intent of the season ticket exception was to eliminate any valuation issues regarding the return benefit (i.e., the value of the right to purchase season tickets). accordingly, in the case of the season ticket exception, this factor should be viewed as neutral. 3. the potential underfunding of the donation factor congress should use the public benefit exception sparingly. it should be applied only to encourage donations that otherwise would be underfunded. a charitable organization is underfunded when the donations it receives do not meet the organization’s needs. while this definition of underfunding of a charitable organization has been discussed by various scholars,265 no scholar has yet presented a clearly measurable standard for determining to what extent, if any, a charity would be underfunded without the charitable deduction.266 in light of the difficulty in determining whether a charitable organization is underfunded, congress’s application of the public benefit exception must take into consideration whether the taxpayer would still donate the property despite the deduction being denied or limited by the quid pro quo test. in assessing the potential underfunding, consideration 263. vielmetti, decision awaited, supra note 177 (moreover, live burns “offer a more realistic, and cheaper, training opportunity than going to dedicated, and familiar, fire towers at area technical colleges.”). 264. kathy l. gray, herbstreit ‘fire’ puts focus on irs dispute, columbus dispatch (july 24, 2009, 3:46 pm), http://www.dispatch.com/content/stories/local/2009/07/23/irsburn.art_art_0723-09_a1_ddeib64.html [hereinafter gray, herbstreit ‘fire’]. 265. see, e.g., mccormack, too close to home, supra note 261, at 872– 910; mark p. gergen, the case for a charitable contributions deduction, 74 va. l. rev. 1393, 1396–1406 (1988). 266. for a leading article on defining a clear standard for determining if an organization is underfunded see mccormack, too close to home, supra note 261, at 884–908. 510 florida tax review [vol. 12:6 should be given to the taxpayer’s alternatives, if any, for otherwise obtaining the return benefit. for example, it is unclear whether a taxpayer would make a live burn donation if there was not a corresponding charitable deduction.267 currently, there is an alternative to the live burn donation, which is known as deconstruction, whereby taxpayers pay a company to deconstruct their home piece-by-piece, salvaging everything, including bathroom fixtures, windows, doors, flooring, wires, pipes, nails, and wood.268 a charitable organization, such as habitat for humanity, provides the deconstruction services at no cost to the taxpayer.269 essentially, the taxpayer donates all the deconstructed salvageable pieces to the charitable organization.270 thus, deconstruction results in removal of the home from the land, minimum debris to clean up, and, more importantly, a charitable deduction.271 another alternative method is to sever the structure from the underlying land and claim a charitable deduction by donating the home to a charitable organization, which relocates the home to another site. assuming a charitable deduction is disallowed for a live burn donation, taxpayers will either pay to have their home demolished and avoid the hassle of dealing with the fire department or have their home deconstructed or relocated. accordingly, the live burn donation will clearly be underfunded if the corresponding charitable deduction is disallowed. on the other hand, unlike the live burn donation, there is minimal to no potential for the underfunding of a monetary donation in return for the right to purchase season tickets. while the ncaa argued taxpayers would less likely make donations if the season ticket exception did not exist, it is highly unlikely universities and colleges, in particular their athletic programs, would not receive cash donations. assume congress chose to deny all charitable deductions for donations for the right to purchase season tickets; taxpayers would still give money to their favorite universities and colleges. taxpayers would still purchase tickets and support collegiate 267. see, e.g., gray, herbstreit ‘fire,’ supra note 264 (providing that a fire chief in upper arlington, ohio stated that the number of house donations dropped off since 2005; after the herbstreit and hendrix families had donated their homes previously in 2004 and were denied charitable deductions); stacie zoe berg, homes go to blazes for public safety, private savings, wash. post, july 5, 1997, at e1, available at 1997 wlnr 7204221 (suggesting tax deductions have motivated homeowners to donate houses to fire departments for live burn trainings rather than hiring contractors for demolitions). 268. deconstruction, reuse people, http://thereusepeople.org/ deconstruction (last visited sept. 20, 2011) [hereinafter, reuse people] (providing the tax benefits to and guidance on deconstruction). 269. see, e.g., habitat ready to help ‘deconstruct,’ recycle, island packet (hilton head island, s.c.), mar. 21, 2011, available at 2011 wlnr 5485607. 270. reuse people, supra note 268. 271. id. 2012] relighting the charitable deductions 511 athletics. currently, the minimum donation required at some universities varies depending on where the seat is located.272 a right to purchase a season ticket on the 50-yard line might cost $1,000 and the underlying season ticket only $400.273 arguably, since there is no alternative means to obtaining the 50-yard line ticket, a taxpayer wanting season tickets would pay $1,400 for the ticket, whether the season ticket exception existed or not. in applying the public benefit exception to the live burn donation, the benefit to the public substantially outweighs the benefit received by the donor. thus, congress should enact an amendment to the charitable deduction specifically allowing for a charitable deduction for live burn donations while recognizing the need for limitations given the perceived abuse and valuation difficulties of the live burn donation. yet, in light of the public benefit exception analysis, the season ticket exception likely should have not been enacted. the goal of the public benefit exception is for congress to enact needed exceptions to the quid pro quo test for donations that have a broad general public purpose and which might otherwise be underfunded. the goal is not to provide politically motivated exceptions, like the season ticket exception, which prove difficult in justifying the general public bearing the burden of the donation. subsidizing another taxpayer’s collegiate football season ticket purchase is not the intended purpose of the public benefit exception. b. the live burn donation amendment in drafting the live burn donation amendment, which would expressly allow for a charitable deduction for live burn donations, congress should consider the need for limitations given the perceived abuse and valuation difficulties of the live burn donation. specifically, congress should limit (1) the maximum amount of the deduction allowed and (2) the length of time the taxpayer must allow the fire department and other municipal departments to train at the house. 1. the maximum amount of the deduction allowed due to the public perception of the live burn donation being another form of “wealthfare,” congress should consider limiting the amount of the charitable deduction allowed for a live burn donation.274 in doing so, 272. chart: cheapest seat in the house, rivals.com, http://collegefootball. rivals.com/content.asp?cid=1094191 (last visited sept. 22, 2011). 273. arguably, the donation is part of the season ticket price. 274. the amounts of the claimed charitable deduction were as follows: rolfs ($76,000), hendrix ($287,400), vassos ($622,825), herbstreit ($330,000), dudley ($350,000). see also, e.g., nigel jaquiss, burning down the house, 512 florida tax review [vol. 12:6 congress must find a balance between providing taxpayers with an incentive to donate their homes and limiting the deduction to the fire department’s cost to purchase or construct a structure to conduct live-burn training.275 two main approaches are (1) a percentage cap, similar to the season ticket exception, or (2) a specific dollar figure cap.276 in light of the valuation controversy that has arisen in determining the fair market value of the live burn donation structure the latter approach is easily administered and more effective. assume congress opts to limit the maximum amount of a charitable deduction for a live burn donation to $50,000. despite a qualified appraisal establishing the fair market value of the home as $200,000, the amount of the live burn donation would be $50,000. in establishing the ceiling, congress will be confronted the difficult task of determining the amount that will cost taxpayers the least, but still promote live burn donations. any limitation must take into consideration the amount allowed as a deduction for deconstruction and relocation donations. in 2010, the median and average square feet of floor area in a singlefamily home was 2,169 and 2,392 respectively.277 based on a 2,200 square foot home, the total materials salvageable from the deconstruction of the home generally appraise for $77,000 to $112,000. 278 thus, in order to adequately compete with the major alternative of deconstruction, a cap of $100,000 will most likely accomplish these goals. williamette wk. (oct. 6, 2010), http://www.wweek.com/portland/article-12555burning_down_the_house.html (law professor and former irs attorney posit there may be some justifiable deduction for home donations, but the $350,000 deduction former gubernatorial candidate chris dudley took was too much); jeff mapes, dudley defends $350,000 tax deduction for allowing lake oswego fire department to burn down a house he owned, oregonlive.com (oct. 6, 2010, 6:43 pm), http://www.oregonlive.com/politics/index.ssf/2010/10/dudley_defends_ 350000_tax_dedu.html (service’s attorneys argued taking the full market value of a donated home as a deduction is too much). 275. see wendy c. gerzog, from the greedy to the needy, 87 or. l. rev. 1133, 1133 (2008) (providing that when a taxpayer makes a charitable donation, “the loss of revenue to the government, and the corresponding gain to the taxpayer,” should be less than “the benefit to the charity”). 276. however, a different view is to have no cap at all asking oneself — should there be a different tax treatment for a taxpayer who donates $350,000 in cash to a local municipality for the sole purpose of acquiring a structure for training purposes versus a taxpayer who donates a structure with an appraised fair market value of $350,000 to the same local municipality for the sole purpose of being used in various trainings? 277. u.s. census bureau, median and average square feet of floor area in new single-family houses completed by location (2010), http://www.census.gov/const/c25ann/sftotalmedavgsqft.pdf. 278. reuse people, supra note 268. 2012] relighting the charitable deductions 513 finally, as part of the cap approach, in the example above, the fair market value of the live burn donation was used as the starting point. but considering the valuation controversy, using the taxpayer’s adjusted basis in the home is more appropriate. essentially, this will eliminate any valuation issue and ensure a taxpayer does not receive a deduction for more than his investment in the home. under these guidelines, a taxpayer with an adjusted basis of $300,000 would result in the value of live burn donation for purposes of the charitable deduction being $100,000. conversely, if the taxpayer’s adjusted basis in the home was $90,000, the value of live burn donation for purposes of the charitable deduction would be $90,000. 2. the time limitation in order for the live burn donation to provide the greatest benefit, it is essential for the fire departments and municipal departments to have an adequate amount of time to use the home for training. in rolfs, the fire department had limited access to the house as the agreed upon turnaround time was a total of eleven days. while the fire department and numerous municipal departments did obtain a substantial benefit from the rolfs’ donation, arguably the benefit would have been greater had the home been made available for a longer period of time. in determining the amount of time, there must be a balance between providing the fire department with adequate time to fully benefit from the live burn donation and avoiding any discouragement of live burn donations. while any length of time congress ultimately chooses will be arbitrary, as there is no formula for determining this, a period in the range of three to six months is recommended. for purposes of this article, three months will be used, because the shorter the period, the more likely a taxpayer will be encouraged to consider a live burn donation as an option. thus, in order for the taxpayer to claim a charitable deduction there must be a written contract allowing the fire department, and any other municipal department, to use the home for a minimum of three months before the home is to be burnt down. with that said, however, the fire department should have the option of using the home for a lesser period. 3. the proposed live burn donation amendment thus, the following proposed legislation is recommended: special rule for certain real property transferred to or for the use of a fire department 514 florida tax review [vol. 12:6 (1) in general. for the purposes of this section, in the case of a live burn donation the amount described in paragraph (2) shall be treated as a charitable contribution. (2) amount described. for purposes of paragraph (1), the amount of the charitable contribution for a live burn donation is the lesser of: (a) the taxpayer’s adjusted basis (as described in section 1011) in the property described in paragraph (3)(a) donated as part of the live burn donation, or (b) $100,000. (3) live burn donation. for purposes of this paragraph, the term “live burn donation” means a: (a) donation of any home, dwelling, building, or structure without donating the underlying land; (b) to or for the use of an organization described in subsection (c)(1); (c) for which, there is a written contract granting permission to a fire department and any other municipal departments (as described in subsection (c)(1)) to use the home, dwelling, building, or structure described in paragraph (3)(a) for a minimum period of three months (regardless of whether the organization uses the home, dwelling, building, or structure for a lesser period); (d) resulting in the home, dwelling, building, or structure being demolished by fire; and (e) such amount would be allowable as a deduction under this section but for the fact that the taxpayer receives (directly or indirectly) as a result of donating the home, dwelling, building, or structure (described in paragraph (3)(a)) demolition services. although not included in the suggested statutory language, an inflation adjustment might be appropriate. ultimately, the government helps subsidize 2012] relighting the charitable deductions 515 invaluable training to a fire department at a cost less279 than the government could have purchased or constructed a similar structure. thus, the live burn donation amendment acts as a subsidy to fire departments and other municipal departments resulting in a public benefit. vi. conclusion the quid pro quo test serves a valuable purpose of making sure the government only subsidizes payments to charitable organizations that are truly donations and not situations where the taxpayer is merely purchasing good or services. it does so by only allowing a deduction for the excess of the payment to the charitable organization minus the benefit the taxpayer receives. it also requires the taxpayer to have knowledge he actually gave more to the charity than the fair market value of his return benefit. however, exceptions to the application of the quid pro quo test should be made when the benefit of the donation to the public substantially outweighs the benefit received by the donor. the public benefit exception should be used to encourage donations that otherwise would be underfunded, as is the case in live burn donations. accordingly, congress should enact legislation specifically allowing live burn donations, while recognizing the need for limitations given the perceived abuse and valuation difficulties of the live burn donation. 279. if a taxpayer was able to claim a charitable deduction for $100,000, based on a twenty-eight percent tax rate, the maximum tax savings to the taxpayer (and thus the foregone revenue (cost) to government) would be $28,000. the quid pro quo test serves a valuable purpose of making sure the government only subsidizes payments to charitable organizations that are truly donations and not situations where the taxpayer is merely purchasing good or services. it does so by onl... login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review florida tax review volume 14 2013 number 9 361 utopian visions toward a grand unified global income tax by henry ordower* i. introduction ............................................................................. 361 ii. what is a gugit and how would it work? .................... 370 iii. centralization, sovereignty, and privacy ..................... 375 iv. some technical details of a gugit .................................. 384 a. the distribution formula ................................................. 384 1. the sales factor .................................................. 385 2. the property factor ............................................ 386 3. the payroll factor ............................................... 387 4. the beneficial ownership factor ........................ 388 5. individuals ........................................................... 390 6. investment income ............................................... 396 b. enterprise and related taxpayer definitions ................... 397 c. residence change and expatriation ................................. 404 d. language and currency translation ................................ 406 v. toward uniform tax rules .................................................. 411 vi. economic displacement from the new gugit ............... 414 vii. conclusion ................................................................................. 417 i. introduction a grand unified global income tax (gugit) may prove as elusive as the grand unified theory (gut) that physicists have sought for many years.1 * professor of law, saint louis university school of law. a.b., washington university; m.a., j.d., at the university of chicago. the author wishes to thank the organizers of the ifa international tax research symposium, boston, 2012 for inviting me to prepare and present an early draft of this article, and diane ring for having the patience to read that draft and observe that i was designing a tax system and not describing a tax base. thanks also to my good friend and former colleague bill natbony for facilitating work on this project; my spouse, ilene ordower, for plodding through drafts of the text; and to the teaching taxation committee of the aba tax section (adam chodorow and tracy kaye) for the opportunity to present this paper and receive comments on it at the winter meeting in 2013. 362 florida tax review [vol. 14:9 yet, just as recent discoveries bring physicists closer to a gut,2 developments in the international financial and tax worlds may move a gugit into imaginable reach. since the discussions of a global unified corporate tax base in the early 1990s,3 significant and often surprising 1. a grand unified theory (gut) refers to attempts to explain electromagnetic, strong, and weak forces under a single theory. to date, physicists have not accounted successfully for the three forces in a single theory. see dan hooper, nature’s blueprint: supersymmetry and the search for a unified theory of matter and force 130–38 (e-book ed. 2008). the search for a gut began long before construction of the cern large hadron collider (lhc) began. cern is the acronym for conseil européen pour la recherche nucléaire, the european organization for nuclear research. cern built the lhc on the switzerland-france border. the collider became operational in 2008 but cern does not plan to operate it for significant research until 2014. for more information about cern and the lhc, see about cern, cern (2013), http://public.web.cern.ch/public/en/about/about-en.html. when fully operational, the collider should provide experimental evidence that will confirm or refute many theoretical positions concerning the nature and interaction of subatomic particles. the failure to produce conclusive experimental evidence that a gut exists does not deter particle physicists from continuing to strive for a theory, conduct particle collision experiments, and develop applications for the data from the particle accelerators. 2. recently, cern scientists announced a breakthrough as they discovered a particle that may be the higgs boson. on wednesday, july 4, 2012, scientists at cern announced the possible discovery of the higgs boson particle, which would be critical to the gut, at the lhc. dennis overbye, physicists find elusive particle seen as key to universe, n.y. times (july 5, 2012), http://www.nytimes.com/ 2012/07/05/science/cern-physicists-may-have-discovered-higgs-boson-particle.html ?_r=0. according to an explanation on the cern website, the higgs boson is the — possibly no longer hypothetical — particle that gave mass to the massless particles the big bang created. see the search for the higgs boson, cern (2013), http://public.web.cern.ch/public/en/science/higgs-en.html. 3. see, e.g., reuven s. avi-yonah, slicing the shadow: a proposal for updating u.s. international taxation, 58 tax notes 1511 (mar. 15, 1993); eric j. coffill & prentiss wilson jr., federal formulary apportionment as an alternative to arm’s length pricing: from the frying pan to the fire?, 59 tax notes 1103 (may 24, 1993); william j. wilkins & kenneth w. gideon, memorandum to congress: you wouldn’t like worldwide formula apportionment, 65 tax notes 1259 (dec. 5, 1994) (marshaling arguments against worldwide formulary apportionment of corporate business income and labeling the concept a “design for disagreement”); paul r. mcdaniel, formulary taxation in the north american free trade zone, 49 tax l. rev. 691 (1994) (describing unitary taxation for north america). more recent discussion of worldwide taxation and cross-border formulary apportionment appears in the literature on reform of u.s. taxation, including julie roin, can the income tax be saved? the promises and pitfalls of adopting worldwide formulary apportionment, 61 tax l. rev. 169 (2008); reuven s. avi-yonah, kimberly a. clausing & michael c. durst, allocating business profits for tax purposes: a 2013] utopian visions toward a grand unified global income tax 363 changes have taken place in the financial and tax worlds. several of those changes include: (1) the european union (eu) expanded eastward to include many of the former soviet satellite countries;4 (2) seventeen member states of the eu,5 including several from the eastward expansion,6 eliminated their national currencies in favor of a single common currency;7 (3) the organization for economic cooperation and development (oecd) shamed and coerced many tax havens into cooperating in the exchange of information in tax matters;8 (4) switzerland and liechtenstein began to negotiate limitations on the protection they offered to foreign investors under their financial institution secrecy laws;9 (5) russia’s suspension of payments on its sovereign debt in 1998 driving the failure of major investment pools and their managers10 and the subprime crisis in the united states in 2007 proposal to adopt a formulary profit split, 9 fla. tax. rev. 497 (2009); and susan c. morse, revisiting global formulary apportionment, 29 va. tax. rev. 593 (2010). 4. in 2004, the czech republic, estonia, latvia, lithuania, hungary, poland, slovakia and slovenia joined the eu, as well as non-soviet satellite countries cyprus and malta. romania and bulgaria joined the eu in 2007. from 6 to 28 members, eur. commission, http://ec.europa.eu/enlargement/policy/from-6to-28-members/index_en.htm (last updated june 27, 2013). 5. the euro, eur. commission, http://ec.europa.eu/economy_finance/ euro/index_en.htm (last updated june 13, 2013) (showing belgium, germany, ireland, spain, france, italy, luxembourg, the netherlands, austria, portugal, finland, greece, slovenia, cyprus, malta, slovakia, and estonia as euro zone countries). 6. id. (slovenia, slovakia, and estonia). 7. the euro became available for financial transactions in 1999 with banknotes and coins appearing in 2002. eleven eu states adopted the euro in 1999 with an additional six joining the currency union at various times later. countries using the euro retain control over their own economies but “they undertake to adhere to commonly agreed rules on public finances known as the stability and growth pact.” id. 8. the initial step was the issuance of a report on tax havens, org. for econ. co-operation & dev. [oecd], harmful tax competition: an emerging global issue (1998), www.oecd.org/tax/transparency/44430243.pdf [hereinafter oecd, harmful tax competition]. 9. eu tax chief urges swiss to end bank secrecy, voice of am. (june 17, 2013), http://www.voanews.com/content/eu-tax-chief-swiss-bank-secrecy/1683707. html. 10. for example, the well-known u.s. hedge fund long-term capital management. see kevin dowd, too big to fail? long-term capital management and the federal reserve (1999), http://www.cato.org/pubs/ briefs/bp52.pdf. 364 florida tax review [vol. 14:9 leading to the financial crisis in 200811 threatened to undermine the world economy and brought the concept of systemic risk to prominence; (6) in the united states, the 2008 financial crisis led to enactment of systemic risk– focused regulation of the economy;12 (7) the securities and exchange commission (sec) adopted a proposed rule to converge and convert financial reporting in the united states13 from generally accepted accounting principles14 to international financial reporting standards;15 and (8) the european commission (ec) took the first definitive step toward cross-border combined income tax reporting in the eu. while barriers to development of a working gugit may be just as formidable as barriers to discovery of a gut, this paper argues that each step toward a gugit is a step toward tax transparency, distributional fairness, and public acceptance of the legitimacy of the income tax system. amidst the clamor in recent decades to abandon historically progressive taxation16 in favor of proportional and regressive taxation,17 the 11. for a discussion of the events leading to the financial crisis, see nat’l comm’n on the causes of the fin. & econ. crisis in the u.s., the financial crisis inquiry report (2011), http://fcic-static.law.stanford.edu/cdn_media/fcicreports/fcic_final_report_full.pdf. 12. see, e.g., dodd-frank wall street reform and consumer protection act, pub. l. no. 111-203, 124 stat. 1376 (2010). 13. see roadmap for the potential use of financial statements prepared in accordance with international financial reporting standards by u.s. issuers, 73 fed. reg. 70816 (proposed nov. 21, 2008) (to be codified at 17 c.f.r. pts. 210, 229, 230, 240, 244, 249). more recently, however, the sec’s support for a u.s. transition to ifrs has wavered. see sec. & exch. comm’n, final staff report, work plan for the consideration of incorporating international financial reporting standards into the financial reporting system for u.s. issuers (2012), http://www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-final -report.pdf [hereinafter sec, final staff report] (not recommending adoption of ifrs, but recommending further work toward convergence of gaap and ifrs). see also infra note 218 and accompanying text. 14. referred to as gaap and including fairly detailed rules for financial reporting. 15. referred to as ifrs and based upon general principles of reporting rather than specific rules. 16. the classic work cataloging arguments for progressive taxation is walter j. blum and harry kalven, jr., the uneasy case for progressive taxation (1953). the german constitutional court, in holding that taxpayers whose jobs and family structure required them to maintain two residences permanently must be treated the same as taxpayers whose secondary residence was purportedly temporary but who might have a series of temporary placements, observed with respect to horizontal and vertical equity that “taxpayers who have the same ability to pay should be taxed equally (horizontal tax equity), while (in the vertical direction) taxation of higher incomes should be measured against the 2013] utopian visions toward a grand unified global income tax 365 hum of progressive taxation remains faintly audible.18 tax competition and mobility of capital have led many countries to decrease the tax burden on capital and capital income and increase the burden on the less mobile tax bases of labor19 and consumption.20 some commentators argue that taxing taxation of lower incomes.” bundesverfassungsgericht [bverfg] [federal constitutional court] dec. 4, 2002, 107 entscheidungen des bundesverfassungsgerichts [bverfge] 27 (46–47) (author’s translation) (emphasis added). the german reads: “steuerpflichtige bei gleicher leistungsfähigkeit auch gleich hoch zu besteuern (horizontale steuergerechtigkeit), während (in vertikaler richtung) die besteuerung höherer einkommen im vergleich mit der steuerbelastung niedriger einkommen angemessen sein muss.” for further discussion of the decision, see henry ordower, horizontal and vertical equity in taxation as constitutional principles: germany and the united states contrasted, 7 fla. tax rev. 259, 303–05 (2006). but see james repetti & diane ring, horizontal equity revisited, 13 fla. tax rev. 135 (2012) (reviewing the literature and arguing that horizontal equity has no normative content and most likely is only part of the vertical equity concept). 17. see, e.g., oecd, tax policy studies, fundamental reform of personal income tax, at 7 (2006) (identifying trends in tax rates in oecd countries); gregg a. esenwein & jane g. gravelle, cong. research serv., rl 32603, the flat tax, value-added tax, and national retail sales tax: overview of the issues (2008) (identifying issues and distributional concerns in tax restructuring); robert e. hall and alvin rabushka, the flat tax (2d ed. 1995) (arguing for a flat rate of tax with an exemption at the lower end); michael j. graetz, 100 million unnecessary returns: a simple, fair, and competitive tax plan for the united states 197–202 (2008) (proposing a value-added tax and exempting all but the highest income individuals from any income tax in order to preserve minimal progressivity). 18. see warren e. buffett, stop coddling the super-rich, n.y. times (aug. 14, 2011), http://www.nytimes.com/2011/08/15/opinion/stop-coddling-the-superrich.html?_r=0 (editorial arguing that very wealthy individuals are undertaxed, especially on their income from capital). 19. see roger h. gordon, taxation of capital income vs. labour income: an overview, in taxing capital income in the european union: issues and options for reform 15, 24 (sijbren cnossen ed., 2000). 20. for example, the share of governmental revenues that the value-added tax produced in sweden from the year 2000 to 2010 increased gradually from 16.88 percent to 21.28 percent. vat, eur. commission, http://ec.europa.eu/taxation_ customs/tedb/taxdetail.html?id=531/1330473600&taxtype=vat (last visited sept. 25, 2013). during the same period, the personal income tax in sweden accounted for a decreasing percentage of tax revenue, declining from 29.86 percent to 25.26 percent. personal income tax—national and local income tax, eur. commission, http://ec.europa.eu/taxation_customs/tedb/taxdetail.html?id=1701/1330905600&tax type=pit (last visited sept. 25, 2013). taxes on capital decreased even more with the elimination of both the wealth tax and the estate tax. in addition, recent financial crises and risks that governments like greece and spain will default on sovereign 366 florida tax review [vol. 14:9 capital at all is inefficient, as it causes taxpayers to engage in tax arbitrage,21 shifting capital income to low tax jurisdictions often through favorable transfer prices.22 transfer pricing has proven particularly problematic for tax collectors. transfer pricing refers to the price that one member of a group of related entities (or individuals and entities) charges another member of the group for goods or services where the group members are in different jurisdictions. since the parties to the transaction are related, they do not negotiate at an arm’s length in determining the correct price for the goods or services but may select a price that places the income from the transaction in the jurisdiction extracting the lowest tax.23 most high-tax jurisdictions require that the taxpayer establish that its transfer prices are the prices that it would pay or receive, as the case may be, in an arm’s length negotiation.24 satisfactorily combatting artificiality in transfer prices often has proven challenging and costly for tax collectors. taxpayers having significant income from exploitation of their intellectual and other intangible properties, including goodwill, have been particularly adept at establishing transfer prices that place that income in low-tax jurisdictions.25 in addition to the efficiency argument and the impact of tax competition are arguments against taxing capital income because much capital income is not real income since it is attributable to the effect of inflation and because taxing capital is taxing labor a second time since taxes on capital are taxes on savings of the income from labor.26 the arguments for not taxing income from capital are unpersuasive. if the tax reached only the debt suggest that governments are relying more heavily on sovereign debt to offset shortfalls in tax revenue. 21. tax arbitrage refers to the practice of consciously exploiting differences in tax rules from one taxing jurisdiction to another by constructing transactions to capture taxpayer-beneficial elements of differing tax rules. see generally gene steuerle, defining tax shelters and tax arbitrage, 95 tax notes 1249 (may 20, 2002) (explaining tax arbitrage and its leveraging effect). 22. see reuven s. avi-yonah, diane m. ring & yariv brauner, u.s. international taxation: cases and materials 192 (3d ed. 2011). 23. id. 24. see oecd, oecd transfer pricing guidelines for multinational enterprises and tax administrations (july 22, 2010). 25. the oecd recently announced a discussion draft of transfer pricing guidelines for intangibles. oecd working party no. 6 releases a discussion draft on the transfer pricing aspects of intangibles, oecd (june 6, 2012), http://www.oecd.org/document/41/0,3746,en_2649_33753_50509929_1_1_1_1,00.h tml. the final report from the working group would supplement the oecd transfer pricing guidelines cited in note 25 above. 26. see gordon, supra note 19, at 17–21 (surveying the academic literature arguing against taxing income from capital). 2013] utopian visions toward a grand unified global income tax 367 current portion of capital income, interest for the use of capital, for example, only that part of the interest in excess of the nominal rate for the use of capital would be attributable to inflation. that same excess manifests itself in wages and living costs, however, as well as the return on capital. the argument not to tax the inflation portion of yield on capital is equally an argument not to tax part of wage increases. the inflation argument with respect to capital appreciation is also flawed since the simple fix to bring that in line with wage increases is elimination of the realization requirement for taxing gains on property and substituting a broad mark-to-market regime for all assets.27 the argument that capital represents savings from labor income, so that taxing capital income is taxing frugal wage earners a second time,28 also is weak. most wage earners have little opportunity to save, so that savings and investment take place primarily in the higher income groups, and much is from reinvested capital income.29 moreover, the higher earning groups sometimes even find ways to convert income from their services into preferred capital income.30 transfer pricing and other tax arbitrage opportunities would diminish substantially if there were no income tax on capital but only at the cost of increased value-added taxes on consumption and increased taxes on labor tax sufficient to replace the lost revenue from elimination of the tax on capital. the presence of the high value-added taxes in turn would generate incentives to purchase and consume outside the high-tax jurisdiction whenever possible. high taxes on wages create incentives at all levels to evade taxes by not reporting cash and barter income,31 and, at high wage 27. cf. i.r.c. § 1256 (marking to market and including in income (or loss) the annual appreciation or depreciation in the value of certain commodities and other gains). 28. see gordon, supra note 19, at 19. 29. see consumer expenditure survey, bureau of lab. stat., http://www.bls.gov/cex/tables.htm (last modified may 22, 2013) (providing data on expenditures in various income groups in the u.s.). 30. consider the recent discussion of carried interests that found its way into the 2012 presidential campaign. see victor fleischer, two and twenty: taxing partnership profits in private equity funds, 83 n.y.u. l. rev. 1, 57–58 (2008) (arguing that some or all the profits a partnership allocates to service provider partners is ordinary income from services rather than a distributive share of the partnership’s income). 31. the underground or shadow economy refers to payments that do not use the national or international banking system in order to avoid detection and taxation. see friedrich schneider & dominik enste, hiding in the shadows: the growth of the underground economy 1–5 (2002) (explaining the concept of the shadow economy, estimating the underground economy around the world, estimating the underground economy at ten percent of gross domestic product in the united states during the 1999-2001 period, and identifying steep growth from 19702000). 368 florida tax review [vol. 14:9 levels, to convert income from services into income from capital wherever possible.32 individuals whose provision of services is not tied to the specific physical location also may relocate physically to a lower tax jurisdiction.33 individuals with the ability to relocate in that manner are likely to come from the high-income or wealth segments of the society. this paper will argue that a gugit likewise solves the problem of tax arbitrage and transfer pricing without sacrificing the progressive income tax. a gugit would diminish opportunities to engage in tax arbitrage because tax rules would be uniform across jurisdictions. a gugit also would eliminate most opportunities to exploit transfer pricing since the gugit would use a robust taxpayer-group concept34 and exclude all intragroup transactions from the tax base and the formula for distributing the base among nations. members of a taxpayer group would have a group tax base that the gugit would apportion among the members of the group.35 seeking a gugit in the 2012 world is a far different matter from seeking a gugit in 1994. in 2012, the concept, if not all the details, of a common consolidated corporate tax base (ccctb) has embedded itself in the world’s largest aggregate economy, the eu.36 the ec proposed the ccctb working group’s (ccctb wg) recommendations for an elective ccctb,37 and the european parliament (ep) modified and adopted the 32. see fleischer, supra note 30. 33. see discussion infra part iv.c. 34. see infra part iv.b. 35. see infra part iv.a–b. 36. the combined member states of the eu have the largest aggregate gross domestic product in the world, constituting nearly twenty percent of the worldwide gdp. the world fact book, cent. intelligence agency, http://www.cia.gov/ library/publications/the-world-factbook/geos/xx.html (updated weekly) (estimating the world purchasing power gdp at approximately $79 trillion in 2011 and the eu gdp at $15.4 trillion, with the u.s. a close second at $15 trillion). 37. see commission proposal for a council directive on a common consolidated corporate tax base (ccctb), com (2011) 121/4 final (mar. 16, 2011), http://ec.europa.eu/taxation_customs/resources/documents/taxation/company _tax/common_tax_base/com_2011_121_en.pdf [hereinafter ccctb proposal]. the ec describes the proposal on its website as follows: the european commission on 16 march 2011 proposed a common system for calculating the tax base of businesses operating in the eu. the proposed common consolidated corporate tax base (ccctb), would mean that companies would benefit from a “onestop-shop” system for filing their tax returns and would be able to consolidate all the profits and losses they incur across the eu. member states would maintain their full sovereign right to set their own corporate tax rate. 2013] utopian visions toward a grand unified global income tax 369 proposal for the enactment of a mandatory — rather than the ec’s proposed voluntary — ccctb with a five-year phase-in.38 unlike the 1994 world that was nearly devoid of international cooperation on tax transparency and information sharing, ever-increasing international cooperation on tax information sharing characterizes the 2012 world.39 yet, despite advances in information sharing, tax competition and tax avoidance have rendered the need for better assessment and collection methods compelling. the primary goals of those improved methods are to prevent wealthier taxpayers from avoiding tax and to restore public confidence that the distribution of tax burden is fair. without some fundamental change in the income tax system, the public perception of the tax system as favoring the wealthy and powerful is likely to continue to grow,40 as will the shadow economy and its accompanying loss of tax revenue.41 a gugit just might offer the solution as it diminishes concealment of income and limits cross-border tax arbitrage. to the extent people who participate extensively in the underground economy do so to level the playing field with wealthier people who are able to capture favorable tax treatment within existing tax systems, the gugit may diminish the underground economy as well. this paper offers an overview of many of the issues that a gugit raises and explains why current global trends suggest that most of those issues no longer are a barrier to adoption of a gugit. the paper does not provide a detailed gugit proposal but builds on the work of the ccctb wg and its detailed proposal for a ccctb.42 part ii of this paper defines the gugit concept and describes its contours and limitations. part iii confronts common tax base, eur. commission, http://ec.europa.eu/taxation_customs/ taxation/company_tax/common_tax_base/index_en.htm (last updated aug. 13, 2013). 38. see european parliament legislative resolution of 19 april 2012 on the proposal for a council directive on a common consolidated corporate tax base (ccctb) (com (2011) 0121–c7-0092/2011–2011/0058 (cns)), eur. parliament, http://www.europarl.europa.eu/sides/getdoc.do?type=ta&reference= p7-ta-2012-0135&language=en&ring=a7-2012-0080 (last updated july 25, 2013) [hereinafter ep ccctb resolution]. 39. oecd, progress report to the g20 (june 2012), in tax transparency 2012: report on progress 31 (2012), http://www.oecd.org/tax/ transparency/ [hereinafter oecd, progress report] (identifying a significant increase in tax transparency and automatic information exchange, including jurisdictions that formerly were non-cooperative tax havens). 40. see generally henry ordower, the culture of tax avoidance, 55 st. louis u. l.j. 47, 115–125 (2010) (discussing public perceptions of tax rates and fairness and expressing general willingness to avoid and often evade taxes). 41. see schneider & enste, supra note 31 (discussing the underground economy). 42. see ccctb proposal, supra note 37. 370 florida tax review [vol. 14:9 the critical issue of national sovereignty under a centralized reporting and collection system. part iii also addresses incentivizing countries to accommodate a gugit as well as the more general considerations of the relinquishment of personal freedom that would be essential to the successful operation of the gugit. part iv reviews several of the technical objections to a gugit including the methodology for allocating and apportioning income among jurisdictions, currency conversions, and accounting and language translation matters. part v argues that international agreement to a uniform set of tax rules is not quite so unattainable as it might seem because national tax laws tend to converge internationally in any event. nations increasingly borrow successful elements from the tax laws of other countries and follow the models that other nations establish.43 part vi concerns itself with the economic displacements and revenue losses that are likely to arise from transition to a gugit. part vii concludes that economic globalization has created the conditions essential to development of a global tax system. converging income tax rules internationally make it possible to negotiate uniform rules, while acceptance of international cooperation on information sharing in tax matters has become sufficiently established and essential to preventing tax avoidance, so national sovereignty as a barrier to a gugit quickly is weakening. a gugit, while utopian (or dystopian if the gugit would limit the taxpayer’s planning opportunities), also may be possible so that development of a model and commencement of negotiations lies in the near, not distant, future. ii. what is a gugit and how would it work? a gugit provides rules to identify the taxpayer, rules to compute the taxpayer’s income, and rules to distribute the power to tax the taxpayer’s income among the jurisdictions in which the taxpayer receives or accrues income. first, the gugit must determine the identity of the taxpayer. the taxpayer might be a single individual or entity or a more complex combination of multiple individuals or entities. once the gugit identifies the taxpayer, it determines the tax base that it will distribute under a comprehensive set of uniform rules of inclusion in and exclusion from income as well as rules for characterization of special types of income — capital income, for example.44 in addition, a gugit uniformly sorts a 43. compare the proliferation of general anti-avoidance rules during the most recent year tax history. see generally ordower, supra note 40, at 94–103. 44. many income tax systems distinguish income from capital from income from labor, and tax the different types of income at different rates. the us, for example, taxes gain from the sale or exchange of capital assets that a taxpayer has held for more than a year and certain dividends at a lower rate of tax than it taxes income from labor. i.r.c. § 1(h). germany also taxes capital gain at a favorable rate 2013] utopian visions toward a grand unified global income tax 371 taxpayer’s expenditures among currently deductible expenses, capital expenditures, and expenditures unrelated to income production. with respect to capital expenditures, the gugit governs when the taxpayer may recover those expenditures for tax purposes by: (1) allowing a gradual recovery under uniform rules for depreciation and amortization; (2) absorbing the expenditures into inventory cost recoverable as part of the cost of goods the taxpayer sells; or (3) including the expenditure in the tax cost of property that the taxpayer recovers for tax purposes when the taxpayer disposes of the property. with respect to those expenditures that do not relate to the production of income, the gugit reserves those items for national or local decisions on deductibility. after determining the taxpayer’s income and reducing it by the deductible and currently recoverable amounts of expenditures, the gugit distributes the tax base under a uniform set of rules among all countries in which the taxpayer produces income.45 each country might provide additional deductions for the taxpayer’s non-income-producing expenditures (e.g., charitable contribution deductions) and possibly other adjustments unrelated to the production of income, including personal deductions, a subsistence minimum free of tax with respect to its share of the taxpayer’s tax base.46 each country would impose its income tax on the net amount remaining after those deductions. current differences among countries in defining expenditures as personal and most likely nondeductible, or related to income production and deductible or capitalizable, might result in difficult negotiations toward a uniform rule, but once settled, there would be a rule applicable universally.47 relative to labor income but taxes other income from capital, including interest, royalties, and dividends, at the same favored rate. einkommensteuergesetz [estg] [income tax law], oct. 8, 2009, bgbl. i at 3366, 3862, § 2(1), no. 5, last amended by gesetz [g], july 15, 2013, bgbl. i at 2397, art. 1, http://www.gesetze-iminternet.de/bundesrecht/estg/gesamt.pdf (capital as a tax class); § 20 (defining capital wealth); § 32d (imposing a twenty-five percent preferential rate on income from capital). 45. part v below will provide more detail on the structure of the uniform tax base and its shares. 46. where a taxpayer is subject to tax in multiple jurisdictions, status deductions or exemptions like personal exemptions and standard deductions assure that each taxpayer retains an amount of income free from tax. in order to prevent duplication of those items in multiple jurisdictions, countries would allocate the items in proportion to their respective shares of the tax base. most states of the united states currently do that type of allocation with their personal exemption amounts, for example, illinois under 35 ill. comp. stat. ann. 5/204. 47. for example, commuting expenses in the united states are personal and not deductible as business expenses, i.r.c. § 262 (although when the employer pays them, i.r.c. § 132(a)(5), the employer may deduct the payment, but the employee does not have to include them in her income), while in germany commuting expenses are deductible business expenses subject to a statutory limit, estg, supra 372 florida tax review [vol. 14:9 under stabile global rules, the economic displacements that have accompanied the frequent changes in national tax laws stop.48 the tax future becomes predictable, so those pricing property and services need no longer anticipate tax regulatory changes. individuals and entities may adjust their operations to accommodate those stabile rules. predictable outcomes — even if dystopian to some or many participants in the world economy — seem preferable to uncertainty. governments need only adjust their tax rates to raise necessary revenue as changes in tax rules become a function of worldwide negotiation rather than local political considerations. a uniform base should diminish much tax competition among nations. cross-border tax arbitrage to exploit characterization differences would disappear. while the gugit would not regulate the rate of tax that a country might impose on capital income, for example, it would fix the definition of capital income applicable in all jurisdictions.49 without regard to location, expensing and rules of capital recovery through amortization and depreciation would be identical as would rules governing capitalization of expenditures. no country would be able to use favorable rates of depreciation, current expensing, or income exclusion from specific activities in order to attract investment. taxpayers may continue to shift portions of their tax base to lower tax jurisdictions in order to diminish their tax burdens. however, the gugit distributes income among jurisdictions on the basis of measurable factors, so shifting income means shifting those factors to the lower rate jurisdiction.50 in apportioning business income among jurisdictions, both the states of the united states and the ccctb proposal rely on factors that include sales and, in most instances, property and payroll.51 a taxpayer wishing to shift income note 44, § 9(1), no. 4. similarly, considerable variations of the treatment of childcare expenses exist, sometimes in a single tax system. in the united states, there is a partial tax credit and also an exclusion if the employee pays for the child care with cafeteria plan funds under i.r.c. § 125. two-thirds of childcare costs (not to exceed 4000 € per child) for childcare to age fourteen are deductible in germany. estg § 10(1), no. 5. 48. see discussion of economic displacement in part vi below. 49. many jurisdictions tax capital income at a preferential rate, but the jurisdictions currently do not define capital income uniformly from jurisdiction to jurisdiction. see sources cited supra note 44. 50. apportionment of income under any formula still may give rise to disputes. see, e.g., peter l. faber, letter to the editor, international formulary apportionment is not a panacea, 136 tax notes 615 (july 30, 2012) (arguing based on experience with formulary apportionment among the states of the u.s. that disputes on transfer pricing will continue despite formulary apportionment). 51. while the states of the u.s. use differing apportionment factors for business income, all include sales as a factor, and those using multiple factors use property and payroll as well. the ccctb proposal, supra note 37, apportions 2013] utopian visions toward a grand unified global income tax 373 to a lower rate jurisdiction would have to shift the taxpayer’s production or relinquish sales opportunities in higher tax jurisdictions in order to do so. if, as several commentators recommend,52 the gugit adopted a destinationsales-factor-only apportionment formula, income shifting becomes impractical without loss of revenue. preventing income shifting with a single destination sales factor disadvantages poorer countries as they tend to be producing but not consuming countries. those producing countries might lose their tax base to consuming countries.53 in any event, an income distribution formula that is a function of real factors such as payroll, property, and sales would make the decision to shift income less artificial than it is currently. a gugit also would impact income shifting among members of enterprise groups insofar as the gugit consolidates the incomes of all members of an enterprise group.54 by eliminating intragroup transactions, the gugit restricts tax-planning opportunities that rely on intragroup transfer prices. formulary apportionment of income of the enterprise group’s aggregate income replaces arm’s length determinations of transfer prices. payments from one group member to another, whether as sales, interest, dividends, or royalties similarly would not impact the distribution of income among jurisdictions. instead, the income would follow the apportionment factors of the group as a whole. groups would be free to require intragroup payments in order to redistribute the tax burden, but those payments would not impact the tax base distribution. since the distribution methodology renders it difficult to manipulate the geographic placement of income, tax competition might continue but would link closely to real investment in the taxing jurisdiction. when lowincome countries deliver incentives to foreign direct investment with tax incentives, they no longer risk losing the intended effect of the benefit to the home country’s credit-based foreign tax regime. tax-sparing treaty provisions become unnecessary to protect the low-income country’s incentives.55 yet, some leveling of tax rates is likely to follow. countries business income by equally weighted property, sales, and employment factors, but in order to level the effect of wage differentials among member states, the employment factor is a combination of payroll and numbers of employees. 52. see, e.g., avi-yonah, clausing & durst, supra note 3; morse, supra note 3. 53. see discussion infra part iv.a. 54. defining the taxpayer for purposes of the gugit is likely to require analysis of the group members’ community of interests. see discussion infra part iv.b. 55. see kim brooks, tax sparing: a needed incentive for foreign investment in low-income countries or an unnecessary revenue sacrifice?, 34 queen’s l.j. 505 (2009) (arguing that tax sparing treaty provisions do not work efficiently and give rise to abuse). 374 florida tax review [vol. 14:9 losing investment may conform their rates more closely to those of countries gaining investment, so that cross-border competition becomes a function primarily of factors such as labor costs and direct subsidies rather than tax rates. in its discussion of the ccctb proposal, the ep saw the harmonization of rates within a range as a natural complement to the ccctb.56 in addition, higher tax jurisdictions may encourage or pressure lower tax jurisdictions to harmonize their rates with those of the higher tax jurisdictions, as high tax jurisdictions recently coerced tax havens to provide greater transparency, information reporting, and other features necessary to prevent “harmful tax competition.”57 by limiting the value of subsidies through the tax system, the common tax base encourages jurisdictions to return to and increase use of transparent, direct subsidies. public scrutiny of those direct subsidies brings the additional benefit of discouraging economically inefficient subsidies like those that the united states commonly has delivered through its income tax system.58 for most taxpayers, the gugit would change little from today. although the rules of inclusion might differ from current rules, the bulk of taxpayers in any country do not engage in any cross-border activity or investing. those taxpayers would report their incomes in much the same manner as they do today. for remaining taxpayers that engage in transactions or invest across national borders, the gugit diminishes compliance costs by 56. the ep tends to view the next logical step to be the harmonization of tax rates. see the further study recommendations of the ep ccctb resolution, supra note 38, amend. 37, and the rapporteur’s explanatory statement to accompany the ep enactment (follow “a7-0080/2012” hyperlink; then select “explanatory statement”). 57. see oecd, harmful tax competition, supra note 8 (reporting on the features of harmful tax competition); oecd, towards global tax co-operation: report to the 2000 ministerial council meeting and recommendations by the committee on fiscal affairs, progress in identifying and eliminating harmful tax practices, at 16–26 (2000), http://www.oecd.org/tax/transparency/44430257.pdf (identifying uncooperative tax haven jurisdictions and reporting on progress toward cooperation). since 2009, the oecd no longer lists any country as an uncooperative tax haven. list of unco-operative tax havens, oecd, http://www.oedc.org/ countries/monaco/listofunco-operativetaxhavens.htm (last visited sept. 25, 2013). 58. i.r.c. § 103, for example (exempting interest on state and local bonds). marketing of tax exempt bonds often requires an interest rate greater than that which would attract the highest-tax-rate investors as bond purchasers. since the rate is uniform on all bonds in an issue, the highest-tax-rate investor captures a higher than necessary rate when he purchases those bonds that have to be marketable to investors taxable at a lower rate, thereby redirecting part of the subsidy intended to benefit the state or local governmental unit to the high-rate investor. 2013] utopian visions toward a grand unified global income tax 375 requiring familiarity with and reporting under a single set of rules.59 the compliance-cost savings would ameliorate somewhat the negative cost that loss of flexibility in tax planning would entail, as might the diminution of deadweight loss accompanying reduced diversion of resources from business activity to tax planning and inefficient, but tax-advantaged, investment.60 iii. centralization, sovereignty, and privacy the gugit would have centralized reporting and auditing. this central global taxing authority just may be the most utopian of the gugit visions.61 the agency responsible for enforcement would be transnational. each country would participate in the selection of the executives of the agency and assigning revenue agents at all levels of the agency. the agency would have the authority to require both taxpayers and third parties to report information under uniform international standards. the gugit legislation similarly would require local courts to support the taxing authority’s demand for information. most, possibly all, taxpayers would submit their tax data electronically under uniform electronic forms. the creation of identical 59. the ec estimated a seven-percent reduction in compliance costs for multinational enterprises that selected the ccctb. ccctb proposal, supra note 37, at 5. 60. see david m. schizer, sticks and snakes: derivatives and curtailing aggressive tax planning, 73 s. cal. l. rev. 1339, 1349 (2000) (“if the tax savings is less than the cost of changing behavior (‘standard deadweight loss’) and paying experts (‘avoidance costs’), the issuer will use the more tax expensive form.” (footnote omitted)). klaus-dieter drüen, unternehmerfreiheit und steuerumgehung [entrepreneurial freedom and tax avoidance], 2/2008 steuer und wirtschaft [stuw] 154, 158, observes: “steuerumgehung volkswirtschaftlich betrachtet den wettbewerb und führt zur ineffizienten allokation von ressourcen, weil beträchtliches personal in unternehmen, steuerberatung und staat fern von wirtschaftlicher nutzenmaximierung gebunden wird.” (“[f]rom an economic perspective, tax avoidance disrupts competition and leads to inefficient allocation of resources as considerable personnel in business, tax planning industries, and the state remain far from economic production maximization activity.”) (author’s translation) (citation omitted). 61. the agency would be gargantuan. at the end of 2011, the irs had approximately 91,000 employees. dep’t of the treasury, internal revenue serv., internal revenue service data book 2011, at 67. if the central taxing agency were the exclusive agency and employee numbers were to increase in proportion to the increase in the gross domestic product of the area administered, the agency would need perhaps one-half million employees. the u.s. gdp in 2011 was approximately $15 trillion, while world gdp was approximately $79 trillion. the world fact book, cent. intelligence agency, http://www.cia.gov/library/ publicications/the-world-factbook/geos/xx.html (updated weekly). 376 florida tax review [vol. 14:9 forms in hundreds of languages is in and of itself a formidable task, but it is a task no different from that confronting current international bodies.62 information submission would include data necessary to enable the central authority to distribute the taxpayer’s income among the jurisdictions that would share the taxpayer’s tax base. comprehensive third-party information reporting and robust data matching would provide much of the information that the centralized agency would need to determine the tax base. ideally, third parties would withhold and deposit part of any payment with the international tax agency. where the nature of the income-production activity is inconvenient for or precludes withholding, the taxpayer would have to make periodic estimated tax payments. the agency would retain the deposited funds in the currency deposited, but the taxpayer would have the minimal control over the funds to convert them into the taxpayer’s currency of choice.63 with extensive withholding, national tax authorities would determine the amount of tax payable in their respective jurisdictions and recover all or part of the tax from withheld funds and estimated tax deposits. withheld funds and estimated deposits are likely to be available to meet most tax obligations in the currency of the country requiring payment. each country imposing a tax would receive payments from the taxpayer’s withheld funds and estimated deposits first before looking to the taxpayer for payment. enhanced withholding and information reporting to facilitate the gugit may eliminate the need for many, perhaps most, taxpayers to selfreport at all. withholding and information reporting from third parties would provide both the information to determine the taxpayer’s tax liability and the funds with which to pay the taxpayer’s tax liability.64 except in rare circumstances in which, for example, the taxpayer might claim non-incomeproduction-related deductions other than a standard deduction, there would be little need to involve the taxpayer in that process.65 an organization sufficiently vast to administer taxation worldwide is likely to become unwieldy. reliance on automated, nondiscretionary 62. see discussion infra part iv.d. 63. a gugit is likely to stabilize currency conversion in many instances. id. 64. in fact, the united states may be the outlier in requiring its taxpaying public to file returns of their income and assess their own tax. many jurisdictions, germany for example, require self-reporting and payment only from those taxpayers who receive substantial amounts of income from sources other than their salaries. see roman seer, besteuerungsverfahren: rechtsvergleich usadeutschland [methods of taxation: a legal comparison between the usa and germany] (2002) (recommending self-assessment for germany). 65. see urban inst. & brookings inst., tax policy ctr., the tax policy briefing book, at iii-5-1 (2008) (using withholding and information reporting to eliminate filing for most taxpayers). 2013] utopian visions toward a grand unified global income tax 377 operations with centralized data processing limits the need for discretionary administrative interventions, which are the most cumbersome aspect of tax administration. like any large administrative body, local or regional offices would have to carry out most day-to-day functions of tax administration that require direct taxpayer contact or the exercise of discretion. the challenge is enforcing worldwide uniformity and evenhandedness in tax administration. while the taxing authority would have to deal with taxpayers in their own languages (so local administration would be essential to operating efficiency), preventing taxpayers from “gaming the system” by choosing one specific national taxing authority over others is indispensable to building public confidence.66 underlying the eu’s ccctb is an implicit assumption that neither favoritism nor corruption is problematic in any eu member state. there the taxpayer continues to file and communicate primarily with its national taxing authority, and the local authority shares the information with the other jurisdictions in which the taxpayer operates.67 a global base does not lend itself as readily to similar no-favoritism, no-corruption assumptions. since the perception of even-handed treatment of all taxpayers under a central and apolitical taxing authority encourages tax compliance, oversight centralization is a key feature of the gugit. in order to protect its legitimacy as an independent and multinational administrative agency, it must manage interpretations and applications of rules as uniformly and impartially as the rules themselves. centralization and independence of the agency controls the risk of local favoritism and corruption and overcomes the negative public perception that local authorities might favor local residents in application of the tax laws. a functional central agency also must have the power to assemble tax information and coerce compliance without regard to national borders. nations must be willing to cede their national sovereignty to instill the necessary administrative and enforcement powers in the agency and provide policing support of the agency’s tax assessment and collection. while relinquishment of sovereignty historically has been a matter of coercion through military conquest, following world war ii, limited surrenders of sovereignty for the purposes of maintaining peaceful relations and supporting trade and economic development across borders has become commonplace. prime among those twentieth-century compromises of national sovereignty is the formation of the eu68 in which the member states yielded autonomy, 66. local favoritism is a longstanding concern in the u.s. the effort to control favoritism underlies the constitutionally protected diversity jurisdiction of the federal courts. u.s. const. art. iii, § 2, cl. 1. 67. see ccctb proposal, supra note 37, art. 109, at 57–58 (providing for tax return filing with the principal tax authority where the group parent is a resident). 68. the treaty of rome, mar. 25, 1957, http://ec.europa.eu/ economy_finance/emu_history/documents/treaties/rometreaty2.pdf, created the 378 florida tax review [vol. 14:9 subject to the principles of subsidiarity69 and proportionality,70 in order to preserve peace in a region and capture the economic advantages of a common market for goods and services.71 nevertheless, sovereignty often has proven a barrier to the creation of effective international agencies,72 even though proliferation of international decision-making agencies acknowledges an ever-increasing need for those bodies.73 even the international agreement that introduced the common euro currency in the eu protected national sovereignty on budgetary matters.74 that protection of sovereignty probably european economic community that ultimately became the eu. the treaty of rome emphasized the removal of trade barriers in order to stabilize the region. 69. “under the principle of subsidiarity, in areas which do not fall within its exclusive competence, the union shall act only if and in so far as the objectives of the proposed action cannot be sufficiently achieved by the member states, either at central level or at regional and local level, but can rather, by reason of the scale or effects of the proposed action, be better achieved at union level.” consolidated version of the treaty on european union, art. 5(3), mar. 30, 2010, c83 o.j. 15, http://eur-lex.europa.eu/lexuriserv/lexuriserv.do?uri=oj:c:2010:083:0013:0046: en:pdf. 70. “under the principle of proportionality, the content and form of union action shall not exceed what is necessary to achieve the objectives of the treaties.” id. art. 5(4). 71. for the first half of the twentieth century and much of the preceding centuries, one or another war plagued the european region and alliances constantly shifted. despite the temporary loss of national sovereignty twice in the twentieth century to germany, member states submitted voluntarily to germany’s economic hegemony in order to build that market. 72. the united nations, for example, suffers from insufficient power to enforce actions of its body, although “peacekeeping troops” under un control do serve an important function in maintaining separation of hostile nations. the un’s primary authority comes in the form of unenforceable resolutions and agreements to cooperate voluntarily in matters such as iran sanctions. see s.c. res. 1737, u.n. doc. s/res/1737 (dec. 23, 2006). 73. in addition to the un, there are regional organizations including the north atlantic treaty organization, the organization of american states, the association of southeast asian nations; worldwide financial organizations including the world bank, organization for economic cooperation and development, the international monetary fund, the world trade association; and tribunals including the international court of justice and the international court of human rights, all of which exercise governmental-like functions across national borders. 74. the euro, eur. commission, http://ec.europa.eu/economy_ finance/euro/index_en.htm (last updated june 13, 2013). for links to the various texts making up the stability and growth pact, see the ec’s website for the legal texts at relevant legal texts and guidelines, eur. commission, http://ec.europa.eu/economy_finance/economic_governance/sgp/legal_texts/index_e n.htm (last updated july 12, 2013), and see the more recent conclusions of the ec on maintaining growth and stability in the eu and protecting the euro, council 2013] utopian visions toward a grand unified global income tax 379 has contributed to the difficulties that the common currency is having in 2012–201375 and could result in the ultimate collapse of the currency union.76 yielding sovereignty on tax matters may be easier than on matters of international borders, human rights, wealth distribution, control of the military,77 and prevention of war. tax collection is indispensable to maintenance of governmental functions and the preservation of existing power concentrations. technology and economic globalization have rendered it easier for taxpayers to shift revenue away from their home jurisdictions to diminish their tax burdens by way of transfer prices; by investments through bank secrecy jurisdictions using trusts, foundations, or local corporate entities; and by expatriation. increased international cooperation on tax matters becomes increasingly important to protecting the tax base. shortcomings in the effectiveness of international cooperation provide impetus for a gugit. thus, while the ec’s recent proposal on a ccctb treads lightly on the issue of sovereignty,78 the ep’s election to make the ccctb mandatory is more realistic in its recognition that only mandatory tax harmonization will generate the needed predictability and commonality of taxation within the eu and prevent taxpayers from choosing the ccctb when it is beneficial to them but rejecting it when it is not.79 since the oecd issued its initial report on harmful tax competition,80 there has been considerable and steady progress toward global tax information transparency.81 the global forum on transparency and conclusions (ec) no. 76/12 of 28/29 june 2012, http://www.consilium. europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131388.pdf. 75. global financial stability report: mounting risks, euro area worries fuel financial instability, int’l monetary fund (oct. 10, 2012), http://www.imf.org/external/pubs/ft/survey/so/2012/new100912a.htm. 76. greece and spain have called on the european central bank for assistance with their national debt. in greece, serious political discussion of possible withdrawal from the euro currency and return to the drachma ensued, but elections resulted in greece’s decision to remain in the currency union. see rachel donadio, supporters of bailout claim victory in greek election, n.y. times (june 17, 2012), http://www.nytimes.com/2012/06/18/world/europe/greekelections.html?pagewanted=all. 77. with some regularity, nations even put their troops under the control of foreign military commanders through various alliances including nato and un peacekeeping missions. 78. see ccctb proposal, supra note 37, explanatory memorandum, pt. 3, at 9–10 (addressing subsidiarity and proportionality in the context of voluntary participation in the ccctb). 79. see ep ccctb resolution, supra note 38. 80. oecd, harmful tax competition, supra note 8. 81. or, from the information-sharing opponents’ perspective, considerable erosion of their privacy. 380 florida tax review [vol. 14:9 exchange of information for tax purposes (the global forum) currently has 118 member jurisdictions,82 including bank privacy jurisdictions such as switzerland, liechtenstein,83 and luxembourg, plus the eu and twelve observers.84 among the observers are international fiscal institutions such as the world bank, the international monetary fund, and the asian development bank, but the united nations also is an observer. the global forum has conducted more than seventy-nine peer reviews of various jurisdictions for transparency and exchange of tax information.85 the reviews have multiple stages. the 2012 report describes the review process: the peer review process examines the legal and regulatory framework of member jurisdictions (phase 1 reviews) and the actual implementation of the international standard of transparency and exchange of information in practice (phase 2 reviews). the review outputs include determinations regarding the availability of any relevant information in tax matters (ownership, accounting or bank information), the appropriate power of the administration to access the information and the administration’s capacity to deliver this information to any partner which requests it.86 underlying the progress report is an assumption that tax transparency and exchange of information has become an internationally accepted objective. members of the global forum strive to overcome internal barriers to transparency and exchange of information and no longer view transparency and exchange of information to be unacceptable compromises of national sovereignty. needless to say, implementation of information sharing lags well behind execution of information sharing and transparency agreements.87 82. the global forum on tax transparency welcomes romania as new member, oecd (jan. 23, 2013), http://www.oecd.org/tax/transparency/ theglobalforumontaxtransparencywelcomesromaniaasnewmember.htm. 83. see, e.g., larry r. kemm, william m. sharp sr. & william t. harrison iii, liechtenstein and the u.s.: the long road to full disclosure, 67 tax notes int’l 355 (july 23, 2012) (discussing the tiea between liechtenstein and the u.s. and the change in liechtenstein law expanding the scope of information available under tieas). 84. oecd, progress report, supra note 39, at 32 (the report uses the number 109). the list of members appears in annex 4 to the report at 61–64. 85. id. at 32. 86. id. at 32–33. the report further refers to ten criteria of transparency and information exchange and lists them in annex 1 at 50. 87. id. at 51–56 (annex 2, especially column c5 assessing timeliness of exchange of information). annex 2 displays in columnar form the results of the phase 1 assessments of transparency and exchange of information. the report does 2013] utopian visions toward a grand unified global income tax 381 a recent (and politically charged report) pegs the amount of net financial assets that wealthy individuals secrete in tax havens at twenty-one to thirtytwo trillion dollars, yielding a loss in tax revenue of 190 to 280 billion dollars each year.88 tax information exchange agreements (tieas) allow the taxing authorities in one country to access information that another country has collected or has the power to collect in the administration of its domestic tax laws.89 tieas generally govern information concerning taxpayers and transactions that may impact the assessment and collection of taxes in a second country but to which the second country lacks direct access.90 need for the exchange may be a matter of a taxpayer failing to report information to a second country when the taxpayer is obliged to do so or may stem from the lack of the second country’s jurisdiction over the record-keeper. sometimes the existence of a tiea may make the task of securing taxpayer cooperation on disclosing financial and related information more difficult. whenever one country transfers information that individuals or entities must provide to another country, taxpayers and third-party record keepers may raise concerns as to whether or not the requesting country will protect confidential information it receives through the exchange.91 those concerns in some instances may be valid and the oecd model agreements not display the results of the phase 2 implementation review but does observe that “[t]he main finding so far in several cases has been that information exchange is too slow and jurisdictions need to take steps to expedite the process.” id. at 46. 88. william hoffman, world’s wealthy hide more than $20 trillion in offshore havens, study says, 2012 tnt 142–5 (july 24, 2012) (describing a report that the tax justice network released). the report is: james s. henry, the price of offshore revisited: new estimates for “missing” global private wealth, income, inequality, and lost taxes 5 (2012), http://www.taxjustice. net/cms/upload/pdf/price_of_offshore_revisited_120722.pdf (estimating $21–32 trillion in hidden private wealth). 89. in 2002, the oecd global forum working group on effective exchange of information developed bilateral and multilateral variants for a model tiea to combat harmful tax competition by making it more difficult for taxpayers to hide assets and transactions in low-tax jurisdictions. see oecd, agreement on exchange of information on tax matters, www.oecd.org/ctp/exchange-of-taxinformation/2082215.pdf [hereinafter oecd model agreement]. 90. id. 91. the united states provides statutory protection of taxpayer information under i.r.c. § 6103 prohibiting disclosure of returns and return information. i.r.c. § 6103 has an exception for disclosure of information for tax administration purposes, including “the administration, management, conduct, direction, and supervision of the execution and application of . . . tax conventions to which the united states is a party.” i.r.c. § 6103(b)(4)(a)(i); i.r.c. § 6103(k)(4) (permitting disclosure to foreign competent authority pursuant to treaty or convention). 382 florida tax review [vol. 14:9 seek to guarantee confidentiality of information.92 however, concerns also may stem from the taxpayers having sought to avoid or evade taxes in the country that is requesting the information. for those reasons, taxpayers may resist providing information voluntarily that they might have provided to the country having direct access to the taxpayer and record keepers if the information were not subject to sharing. practical concerns like those aside, national law has begun to yield to international law and treaties to give taxing agencies from one country authority to reach into another country for tax information. a country, under appropriate tieas, may collect information concerning its own residents, citizens, and businesses having their base in that country with respect to financial and tax information from operations and activities in the country into which it is reaching. many information exchange conventions require taxpayers to make information about themselves and third parties with whom they deal available to the foreign government’s agencies. yielding sovereignty becomes increasingly commonplace in the tax realm as information exchange agreements proliferate.93 many countries have come to accept that sound international tax administration demands the relinquishment of sovereignty. given growing acceptance of transnational information sharing, it becomes easier to envision a gugit that a central and international authority administers. with a gugit, taxpayers’ concerns about differing rules protecting confidential information become less cogent. confidentiality protection rules are uniform throughout the gugit area. a central authority renders most historical competent-authority functions obsolete and, accordingly, limits inquiry on matters that are internal to an enterprise, such as transfer pricing, since the gugit distributes the uniform tax base among the countries in which the taxpayer produces income. risk of exposure of trade secrets often accompanies inquiry into the construction of the taxpayer’s transfer price within an enterprise group. taxpayers may continue to worry that enforcement of privacy protection will not be uniform, but the taxing authority’s vital independence from the control of national governments ultimately should dispel those worries — although not necessarily taxpayers’ claims of concern. extensive third-party reporting of information is an indispensable supporting pillar of a gugit. it simplifies data collection and verification. the arm’s length relationship between the information provider and the 92. see oecd model agreement, supra note 89, art. 8 (protecting the confidentiality of the exchanged information). 93. from 2008 through 2011, more than 800 tieas and dual-tax conventions were signed. each of those agreements requires some surrender of a nation’s sovereign control over financial information of its residents or institutions and some level of international cooperation on tax reporting and collection. oecd, progress report, supra note 39, at 46. 2013] utopian visions toward a grand unified global income tax 383 taxpayer diminishes the likelihood of deception insofar as the third party has no incentive to risk civil and criminal penalties in order to protect an unrelated person’s tax information. certainly, the taxpayer could compensate the third party for withholding or falsifying information. historically, tax professionals and financial institutions readily accepted compensation to withhold or even falsify information for taxpayers,94 but in light of broadbased information reporting that must accompany the gugit, the risk of detection because yet another party must report the same transaction might deter such practices. the gugit agency will have to overcome collateral concerns relating to personal privacy and protection of individual liberty. between a taxpayer and the national tax collector, no country protects the individual’s privacy. the tax collector has the authority to access all the taxpayer’s business and personal records that relate in any way to the determination and assessment of tax. the taxpayer has only the right to protection from dissemination of private information beyond the tax collection agency and outside the scope of tax collection. the success of a gugit depends upon international recognition that the central taxing authority simply steps into the shoes and assumes all the authority of domestic taxing agencies. while it may be difficult to accept a foreigner asking questions about one’s personal finances, most people readily relinquish information in order to cross national borders or engage in business activities outside their home countries. athletes and entertainers frequently must address claims of foreign taxing authorities against a portion of their earnings. for those who do not cross national borders, or do so only for the purposes of tourism, their tax reporting and information disclosures will not differ significantly from what they do now. the agency to which they report may be different, but no country only their country of residence will claim any portion of their taxes. their personal information will be no more vulnerable than it is today. in fact, privacy protection is likely to be more vigilant under the gugit because the very size of the taxing authority makes security a primary structural concern. 94. consider the role of professional advisors in tax shelter design, ordower, culture of tax avoidance, supra note 40, at 87–94, and the recent criminal conviction of tax shelter attorney paul daugerdas and others, jenkens & gilchrist attorneys, former bdo seidman ceo and deutsche bank broker found guilty in new york of multi-billion dollar criminal tax fraud scheme, u.s. dep’t of just. (may 24, 2011), http://www.justice.gov/opa/pr/2011/may/11-tax-676.html. daugerdas and denis field, however, have a new trial pending, while donna guerin pleaded guilty and will not have a new trial. ameet sachdev, chicago lawyer pleads guilty in ny in tax fraud, chi. trib. (sept. 13, 2012), http://articles. chicagotribune.com/2012-09-13/business/chi-chicago-lawyer-pleads-guilty-in-ny-intax-fraud-20120913_1_paul-daugerdas-donna-guerin-count-of-tax-evasion. 384 florida tax review [vol. 14:9 iv. some technical details of a gugit a successful gugit design95 will limit opportunities for taxpayers to diminish their taxes through transaction structures that lack a compelling nontax purpose. economically sound choices independent of tax avoidance should determine business and investment decisions.96 the tax base involves at least four discrete design areas that the gugit project must and this article will address: (a) the formula for distributing the tax base among jurisdictions in which the taxpayer is active, (b) the definition of the taxpayer for purposes of the gugit, (c) expatriation prevention, and (d) language and currency translation. part v addresses components of the base, including matters of accounting and specific inclusionary and exclusionary rules. a. the distribution formula the ccctb proposal apportions business income among the jurisdictions in which the taxpayer is active according to a formula that gives equal weight to the three components of labor, property, and sales.97 the ep ccctb resolution would decrease the sales factor to ten percent and increase each of the other factors to forty-five percent.98 although the states of the united states use a combination of the property, payroll, and sales factors to apportion the income of corporations operating in more than one state, the states have not agreed on a single formula.99 some states use only 95. building consensus for a gugit will require long-term gradual development that will include opportunities for all interested parties to participate. at best, this paper provides a point of departure for the discussion and does not aspire to completeness. 96. ordower, supra note 40, at 70–72. the ccctb wg recognized the continuing risk of tax avoidance in the ccctb and included an anti-avoidance rule in the proposal. see ccctb proposal, supra note 37, art. 80, at 46. 97. ccctb proposal, supra note 37, art. 86, at 49. 98. ep ccctb resolution, supra note 38. 99. while article iv of the multistate tax commission (mtc), model multistate tax compact (available on mtc’s website at http://www.mtc.gov/ about.aspx?id=76) uses an equally weighted three-factor formula like that of the ccctb proposal, only sixteen states and the district of columbia have adopted the compact. member states, mtc, http://www.mtc.gov/aboutstatemap.aspx (last visited sept. 25, 2013). other states use a variety of formulae, including sixteen states that use only sales, some transitioning to only sales, and others using double or triple-weighting of the sales factor. see fed’n of tax adm’rs, state apportionment of corporate income (formulas for tax year 2013—as of january 1, 2013), http://www.taxadmin. org/fta/rate/apport.pdf. 2013] utopian visions toward a grand unified global income tax 385 destination sales.100 in the course of collecting comments on the project, several commentators recommended to the ccctb wg that destination sales should be the only factor because it is the most difficult factor to move from one taxing jurisdiction to another without the move impacting negatively the profitability of the taxpayer.101 in any event, support for formulary apportionment for multinational corporations’ international income is growing but not yet solid,102 and the apportionment formula is likely to include destination sales, property, and payroll. 1. the sales factor sales might be a reasonable choice as a single factor where the taxpayer is active only in countries having substantially equal tax rates and having populations with substantially equal abilities to consume. the eu might be just such a region, but even there, significant differences in wage levels and the ability to consume inhere. the ep rapporteur attempted to “reconcile the various points of view about the factor ‘turnover,’”103 by reducing the weighting of sales and increasing the weighting of the other factors.104 in the presence of large wealth disparities from country to country or region to region, destination sales is a far less compelling factor. the sales factor apportions income to consuming countries even when production is in nonconsuming countries. while it is difficult to manipulate the destination of sales without sacrificing profit, concentration of sales in wealthier jurisdictions deprives producing — but not consuming — jurisdictions of their shares of the tax base. 100. id. 101. see, e.g., avi-yonah, clausing & durst, supra note 3 (arguing that relinquishing sales opportunities in order to move income to another jurisdiction hardly makes economic sense). 102. see eric kroh, formulary apportionment could resolve problems with international taxation system, 2012 tnt 139-3 (july 19, 2012) (summarizing comments made by lee sheppard of tax analysts and paul oosterhuis of skadden, arps, slate, meagher & flom llp concerning formulary apportionment at an international tax institute forum). 103. ep ccctb resolution, supra note 38 (follow “a7-0080/2012” hyperlink; then select “explanatory statement”). 104. id. part of the objection lay in the universal presence in the eu of a destination sales–based value-added tax, so the proposed formula would give significant weight to sales under both primary tax systems in the eu, the income tax and the value-added tax. 386 florida tax review [vol. 14:9 2. the property factor taxpayers locate their physical property where production or management activity takes place. heavy industry (both manufacturing and extraction) uses substantial amounts of physical property. while location of productive activity generally correlates with location of physical property, so that some labor-based measure of productive activity might substitute for that property in an apportionment formula, direct inclusion of a property factor in the apportionment formula seems appropriate. moreover, form of ownership should make no difference to formulary inclusion. leased property should be part of the apportionment formula of the lessee during the term of its use of the property. while the payment of business rent would be a deductible expense under the gugit, the present value of the rental payments should constitute property for purposes of the allocation formula. the independence of the lessor from the lessee assures that the rental price reflects fair market rental value. where the lessor and lessee are not dealing at arm’s length, the gugit would disregard the lease and include the owned property as property of the taxpaying enterprise that includes both the lessor and the lessee. the property factor will apportion income to the location of the productive activity, whether the productive activity is the actual manufacturing or extraction or, in the case of management offices, the management of activity occurs. to the contrary, the location of intangible property frequently bears little relationship to productive activity. excluding intangible property from the apportionment formula prevents enterprises that generate income from intangible property from shifting the income artificially to lower tax jurisdictions. one may store the formula for a process or a pharmaceutical anywhere without adversely affecting the production from use of the intangible elsewhere. the ccctb proposal excludes intangible assets from the property factor of the apportionment formula because relocation of those assets requires no significant cost.105 since the creation of the intangible property will manifest itself in the payroll factor during its creation and development and in the sales factor as it generates saleable goods or services, the gugit apportionment formula should disregard intangible property completely. location of intangible intellectual property has been central to the aggressive use of transfer pricing to shift income to low-tax jurisdictions.106 similarly, other intangible property like goodwill follows the location of the enterprise headquarters and 105. see ccctb proposal, supra note 37, art. 92(1), at 51. 106. intangibles have proven to be particularly problematic from a transferpricing perspective. see oecd, transfer pricing and intangibles: scope of the oecd project (jan. 25, 2011), http://www.oecd.org/ctp/transfer-pricing/ 46987988.pdf. 2013] utopian visions toward a grand unified global income tax 387 management. several major corporations moved their nominal headquarters outside the united states107 in order to avoid the united states residual tax on income from lower tax jurisdictions.108 the costs associated with the headquarters moves generally were not significant and did not require top management to relocate to those jurisdictions. those costs increased materially when the united states began to impose a continuing tax on the income of expatriate corporations.109 disregarding intangibles in the property factor of the apportionment formula eliminates major complexities of the income tax and removes a principal incentive to establishing a presence in low-tax jurisdictions to receive and own intellectual property and other intangible property. 3. the payroll factor outsourcing, whether contractual or by shifting one’s own operations to a low-wage and low-cost jurisdiction, became common in the last decades of the twentieth century. costs, not taxes, generally drove decisions to shift manufacturing, call centers, and other operations to those low cost jurisdictions, but one could envision taxes under an apportionment formula providing sufficient additional incentive to managers to relocate operations but not top management.110 a payroll factor that takes only gross wages (and, presumably, also payments to independent contractors) into account may slant the weight of the factor to high wage jurisdictions where highly compensated managers are located or, in the case of development of 107. the literature refers to the transaction as a corporate inversion. see, e.g., rachelle y. holmes, deconstructing the rules of corporate tax, 25 akron tax j. 1, 17–20 (2010) (discussing the reasons for corporate inversions). 108. the inversion trend arose in part from the u.s.’s worldwide taxation of its citizens, permanent residents, and domestic corporations. the u.s. cedes primary taxing jurisdiction to the country in which the taxpayer earns income by giving the taxpayer a credit against the u.s. tax on that foreign income (but not exceeding the amount the u.s. tax would be on that income). i.r.c. § 901 (providing a tax credit for foreign taxes paid); i.r.c. § 164(a)(3) (allowing a deduction for foreign taxes if the taxpayer does not elect a credit). thus, a person subject to u.s. worldwide taxing jurisdiction pays tax at a combined rate no lower than the u.s. rate. 109. see i.r.c. § 7874 (imposing a tax on the income of a corporation that expatriates as if it continued to be a domestic corporation and taxing certain controlled expatriated corporations as domestic corporations). a number of countries that have a territorial system of taxation continue to impose a tax on the investment incomes of expatriates for a period as much as ten years following expatriation. see, e.g., 3 ch. 19 § inkomstskattelag (svensk fӧrfattningssamling [sfs] 1999:1229) [hereinafter income tax law of sweden] (taxing swedish citizens and permanent residents who leave sweden on income from capital). 110. see kroh, supra note 102 (summarizing oosterhuis’s objections to formulary apportionment). 388 florida tax review [vol. 14:9 intellectual property, including drugs, for example, where the research and experimentation takes place.111 the ccctb wg was mindful of wage differentials from country to country and tried to address the disparities by dividing the labor factor in its formula into two equally weighted components: payroll and number of employees.112 rather than balancing wage differentials with an employee number feature, the formula could employ a cost of living or wage differential factor to adjust wages to a common value for purposes of applying the distribution formula. alternatively, the formula could measure part of the payroll factor by taking person-hours of work into account, rather than a simple count of the number of employees, since longer hours for low wages may characterize the working conditions in those outsourcing target jurisdictions. 4. the beneficial ownership factor while none of the existing apportionment formulae take underlying ownership into account, increasingly tax administrators probe beneficial ownership of entities in bank secrecy jurisdictions in order to determine whether taxpayers are concealing income on which they are subject to tax in the investigating jurisdiction. the united states long has required its taxpayers to report their investment accounts outside the united states. more recently, the irs has begun to demand extensive information on beneficial ownership of accounts in switzerland. tax administrators in germany and elsewhere in europe purchased stolen secret bank records in order to identify german taxpayers who were using liechtenstein foundations to avoid or evade taxes in germany.113 the united states enacted legislation designed to ferret out additional information in order to tax united states citizens and residents on their offshore investment activities.114 111. short of intermediary entities such as personal service corporations established in low-tax jurisdictions to provide the services of their otherwise highly compensated owner/employees, the labor portion of the formula is predominantly residence-based. 112. ccctb proposal, supra note 37, art. 86(1), at 49. 113. gerson trüg und jörg habetha, die “liechtensteiner steueraffäre”— strafverfolgung durch begehung von straftaten? [the liechtenstein tax matter— criminal pursuit through commission of criminal offenses?], 61 neue juristische wochenschrift [njw] 887 (2008) (describing the purchase of a cd-rom with secret accountholder information for a price of some 4.2 million euros). 114. congress enacted the foreign account tax compliance act (fatca) of 2010 as part of the hiring incentives to restore employment (hire) act of 2010, pub. l. no. 111-147, 124 stat. 71 (requiring taxpayers to report foreign financial holdings and requiring foreign financial institutions to identify u.s. taxpayers among their direct and indirect accountholders; imposing penalties for failure to comply with reporting requirements). 2013] utopian visions toward a grand unified global income tax 389 with growing emphasis on beneficial ownership to prevent taxpayers from concealing assets and income,115 declining corporate tax rates, integration of corporate and shareholder taxes, and the increasing use of tax transparent entities,116 including a beneficial ownership factor in the apportionment formula would make sense. an entity’s income inures directly through distributions and indirectly by way of capital appreciation to the entity’s owners. opponents of the corporate income tax often characterize tax on corporate distributions following a tax on the corporate income as double taxation. in identifying where income should be taxed, a beneficial ownership factor in the formula directs the income to where it provides its final economic benefit. one even might argue that income should be taxable only where the benefit accrues so that the single factor of beneficial ownership should be the only apportionment factor. applying a single factor beneficial ownership formula concentrates income in wealthy jurisdictions even if sales and production occur in less-wealthy jurisdictions. accordingly, beneficial ownership of income (or the income-producing entity) should be one of the several apportionment factors but probably should not be the only factor in the distribution formula. requiring identification of the underlying ownership, subject to protection of the identity of the owners where they desire that protection, should not be a barrier to that apportionment factor. use of beneficial ownership as a factor also might lead to simplification of unnecessarily complex entity structures when the owners no longer may hide behind layers of entities. moreover, technology for tracking changes in ownership is readily available to enable entities to identify actual ownership and changes in ownership on a daily basis. the statutes would require beneficial ownership disclosure to the entity in order to enable it to comply with its statutory obligation to apply the apportionment formula. supported by robust anti-avoidance provisions, apportionment of business income under a formula composed of sales, property, payroll, and beneficial ownership would strike a sound and fair balance for income distribution of enterprises. sales and beneficial ownership would tend — 115. see, e.g., oecd model agreement, supra note 89, art. 5 (emphasizing in various places identification of beneficial, rather than legal, ownership as a criterion for exchange). 116. partnerships (including limited liability companies in the united states) and limited partnerships, and trusts in common law jurisdictions generally are transparent so that the income of the entity is taxable to the owners of the entity and not to the entity itself. see i.r.c. §§ 651–52, 661–62 (allowing trusts to deduct income distributed to beneficiaries and including the distributions in beneficiaries’ gross income); i.r.c. § 701 (providing that partnerships as such are not subject to income tax and that “[p]ersons carrying on business as partners shall be liable for income tax only in their separate or individual capacities”). 390 florida tax review [vol. 14:9 although not identically — to place income in wealthier consuming countries while property and payroll would apportion income to producing and manufacturing countries. the bifurcated payroll factor of employee numbers, work hours, or adjusted wages for cost of living differentials would balance in part the high wages in the formula that favor top management in the wealthier countries. similarly, the property factor could use an adjustment factor to eliminate the distortion that very low and very high cost locations bring to the formula. investment (capital) income of operating enterprises would follow income from production under an assumption that investment return is a function of the underlying income production and accompanying retention and investment. for investment entities not part of a larger enterprise engaged in the active conduct of business, income should follow a single factor of beneficial ownership except where the investment is inextricably linked to specific countries. income from direct investment in real property, natural resources, and personal property used in a specific country and the investment return from a pooled investment vehicle that invests in such property117 probably should be taxable in the country of permanent location, extraction, or use. 5. individuals to this point the discussion has focused on enterprises composed of any combination of entities (or a single entity) and individual sole proprietorships118 having property, payroll, sales of goods or services, or beneficial ownership in more than one jurisdiction. a comprehensive gugit addresses taxation of individuals as well and contemplates a uniform set of rules that determine the tax base that includes income from individuals’ services and from their investments. as noted above,119 while the gugit may alter specific rules of inclusion, exclusion, or deduction in the course of harmonizing those rules worldwide, the changes may appear no different from tax law changes that national legislatures make regularly. the gugit will change little else for most individuals, as it will allocate income 117. especially if it is tax-transparent like a reit, for example. see i.r.c. §§ 856–59. 118. the oecd model tax convention on income and on capital (2010), deleted article 14, “independent personal services” in the year 2000 because of overlap with article 7, “business profits,” so that article 14 was unnecessary. see oecd model tax convention on income and on capital, art. 14 (commentary) (june 22, 2010) (hereinafter “oecd model convention). independent personal services constitute a trade of business so that income from that trade or business is article 7 business profits. id., art. 7 (allocating business profits to the residence jurisdiction unless the taxpayer produces the profits from a permanent establishment in the other country — subject to an embedded transfer pricing rule). 119. see supra note 59 and accompanying text. 2013] utopian visions toward a grand unified global income tax 391 from services an individual performs in the single jurisdiction where the individual lives and works to that jurisdiction. similarly, investment income from domestic financial accounts and stocks will be taxable in the jurisdiction in which the individual lives and works. such individuals will continue to report income locally and, if necessary, deal with local tax offices. in the presence of extensive third party information reporting and withholding,120 self-reporting and self-assessment will become obsolete. this section suggests several models for apportionment of income from services so that individuals working in more than one jurisdiction or individuals working in a jurisdiction different from that in which they live may find the gugit affecting them more profoundly. one model, however, may require no major changes from the taxation of individuals under current double tax convention practice. consistent with the oecd model convention,121 under many double taxation treaties, countries in which a nonresident works often cede the authority to tax income from services under the countries’ general income tax, but not under wage taxes for retirement and insurance programs,122 to the jurisdiction in which the individual resides.123 exceptions to this cession of taxing power under the treaties exist for certain types of services, including athletic and entertainment activities, which are taxable in both the resident country and the country in which the individual engages in the activity.124 other than those exceptions, only when the individual does not live most of the year in her country of residence do the treaties give the jurisdiction in which the individual performs services as an employee the authority to tax the individual’s wages.125 in those instances, 120. see supra note 65 and accompanying text. 121. see supra note 59. 122. oecd model convention, supra note 118, article 2; c.f. convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital and to certain other taxes, aug. 29, 1989, u.s.-f.r.g., s. treaty doc. no. 101-10 (1990) (entered into force aug. 21, 1991) (hereinafter germany-us double tax treaty). 123. see, e.g., article 7 “business profits” and article 14 “independent personal services” (repealed in the oecd model convention, supra note 118, favoring the jurisdiction of residence unless the taxpayer works from a fixed place in the other country) and article 15 “dependent personal services” (favoring the residence jurisdiction but permitting the other country to tax income from services performed there if the taxpayer is not present in her resident jurisdiction more than half the year) of the germany-us double tax treaty. see germany-us double tax treaty, supra note 122. likewise, see oecd model convention, supra note 118, article 15 “dependent personal services” (favoring resident jurisdiction unless taxpayer works in the other country and is not present in resident country more than half the year). 124. see germany-us double tax treaty, supra note 122, at article 17. 125. see germany-us double tax treaty, supra note 122 at article 15. 392 florida tax review [vol. 14:9 jurisdictions with territorial tax systems cede the authority to tax the taxpayer’s income from personal services to the jurisdiction in which the individual performs services.126 and only when the taxpayer performs services as an independent contractor and not an employee from a permanent establishment may the work location tax the service provider.127 under its global income taxation system,128 however, the united states continues to tax even if the individual properly becomes taxable on her wages in another country. to prevent double taxation of the income, the united states applies any properly-imposed foreign income taxes as a credit against the united states income tax otherwise payable.129 the income from services of a united states citizen or permanent resident will be subject to a tax rate lower than the united states’ tax rate on that income only when the individual qualifies for the limited exclusion for united states persons who live and work outside the united states.130 otherwise the individual is taxable in the united states on the foreign earned income, and all united states individuals also are taxable on their foreign earned income in excess of the limitation.131 foreign taxes payable on the income from services are creditable in the united states but not to the extent the foreign taxes exceed the united states income tax on that income.132 the residence-based allocation rule of modern treaties has much to recommend for the gugit. the rule is simple to apply. a residence rule enables most taxpayers to participate in a single country’s array of social welfare programs and retirement systems. choice of one’s place of residence under a more than half-year rule would seem a sufficiently important personal decision that, for most taxpayers, remains free from tax planning 126. sweden, for example, exempts its citizens and residents from swedish income tax if they reside and work outside sweden for at least six months and are taxable on the personal services income in the other country, and, without regard to taxation in the country where they work if the period is at least one year. see income tax law of sweden, supra note 109, 3. kap. § 9. 127. see oecd model convention, supra note 118, article 7 “business profits.” 128. i.r.c. § 61 (including in the individual’s gross income “all income from whatever source derived” without regard to where the individual earns the income). 129. i.r.c. § 901. 130. i.r.c. § 911 (excluding an inflation adjusted amount of income in the case of u.s. citizens who are bona fide foreign resident living outside the u.s. for the full tax year or u.s. citizens or residents residing outside the u.s. 330 days in any 12 month period). 131. i.r.c. § 61. 132. i.r.c. § 901 (providing a credit for foreign taxes); i.r.c. § 904 (limiting the credit under i.r.c. § 901 to a proportional amount of the u.s. tax on the foreign income). 2013] utopian visions toward a grand unified global income tax 393 motivations.133 nevertheless, expatriation to avoid taxes remains a recurrent theme in the united states134 and other countries and may require antiavoidance rules to prevent taxpayers from changing primary residence without relinquishing the collateral characteristics of their previous residence.135 other configurations of the allocation rule might make expatriation less dependent upon anti-avoidance rules and might distribute revenue more equitably among the states in which the taxpayer is active. a residence-based rule also is problematic because it is likely to result in considerable mismatching of income and deduction whenever the service recipient is taxable in one country and the service provider is taxable in another. treaties recognize that, for certain taxpayers, the performance jurisdiction should have the right to tax the income.136 determining how much of the taxpayer’s income is attributable to the place of performance may be no easy matter. for example, an athlete may train in one country, perhaps the country of her residence, but receive payment for competing in another. if the athlete would receive no payment without a successful outcome, place of performance is arguably the place of the competition only, even if the time the athlete spends there is small relative to the time in training. on the other hand, without the training, the athlete would be unlikely to compete successfully so the income belongs primarily to the place of training. an athlete who receives a salary from an employer based in the country where she trains but who competes in another country should be taxable in both. allocation might follow an absolute measure of time spent in each location, the measure of time that the athlete engages in the athletic activity in each jurisdiction, both training and competition, or perhaps heavier weighting of the time in competition in an allocation based on the proportional amount of weighted time she devotes to the athletic activity in each.137 the issues for entertainers are the same. in both the case of the 133. compare, doctrine of acts of independent significance referring to acts that are unlikely to be within a taxpayer’s control or which the taxpayer is unlikely to engage in for tax avoidance purposes. 134. marie sapirie, facebook expat is latest billionaire without borders, 66 tax notes int’l 709 (may 21, 2012) (discussing expatriation to avoid u.s. taxes). for a list of first quarter 2012 expatriates (including long term, non-citizens who relinquished permanent residency), see quarterly publication of individuals who have chosen to expatriate as required by section 6039g,” 77 fed. reg. 25538, 25544 (april 30, 2012). 135. see infra discussion in part iv.c. 136. see oecd model convention, supra note 118, article 17 “artistes and sportsmen” (allowing the country of performance to tax). 137. cf. oecd model convention, supra note 118, article 17 (commentary) (not providing a method for determining what portion of the athlete’s or entertainer’s income is attributable to the place of performance). 394 florida tax review [vol. 14:9 athlete and the entertainer, the individual is selling into and performing some part of her services in a jurisdiction in which she does not reside. with or without a gugit, the issue of place of performance often is ambiguous. even more perplexing is where to allocate the service income of an individual who performs services remotely from a fixed location for customers located in other jurisdictions. by analogy to destination salesbased apportionment,138 it might be appropriate to tax the services where the customer receives delivery and consumes them rather than where the service provider performs them. for example, a customer might commission an artist139 who lives and works in country a to create artwork for the customer’s office building in country b. simplifying the issue, assume the artist never enters country b, and the customer sends a representative to country a to collect the completed work and transport it to country b. should the result differ if the artist ships the completed work to the customer in country b, or if the artist makes a single trip to country b in order to oversee the installation of the work?140 remote performance of technology services is still more bewildering. with technology services, a technician in country a, all of whose clients are in country b, may reach into country b through cyberspace in order to alter, create, repair, or destroy an item that the customer or target uses in country b or elsewhere and which may have no physical manifestation at all. the data may be stored in country b or anywhere else in the world, including a satellite or under an arctic or antarctic ice sheet. yet a residence rule that allocates all of a taxpayer’s service income to the single jurisdiction in which the taxpayer resides without regard to the identity of the employer or other payer is somewhat unsatisfying. the rule might be better if, for a taxpayer who regularly splits her residence time between or among jurisdictions, the rule allocated all income from services according to those relative periods of time. temporary presence and work in another jurisdiction for an aggregate period during the year that does not exceed a minimal period, ten days, for example, the rule would disregard. for most taxpayers, the rule corresponds to their activities and simplifies reporting for when they spend short periods in another jurisdiction. for the 138. see supra note 104 and accompanying text. 139. implicit in the commentary to article 17 of the oecd model convention, supra note 118, is that the term “artiste” does not contemplate a sculptor or painter but may include a performance artist because of the performance element of the art. 140. see ccctb proposal, supra note 37, article 96 at 52–53 (using destination sales as the sales factor but having alternative rules to deal with the complexity of the issue for goods and especially services). on the other hand, for the labor factor in the apportionment formula, an employee is allocated to the member of the enterprise group from which the employee receives payment. id., article 91-1 at 50. 2013] utopian visions toward a grand unified global income tax 395 athletes and artists in the example above, a special rule of allocation still might be necessary if the principal source of income for the taxpayer is a competition or two in a country where the taxpayer spends little time. a payer rule, on the other hand, allocates income to the country in which the payer takes the expenditure into account, whether by way of deduction or capitalization. a payer rule is appealing because it avoids mismatching of income and deduction. for each deduction, there is an inclusion in the same country. a payer rule may provide the fewest opportunities for tax planning since the business decision that drives the employment places the payer and the recipient at arm’s length to one another. a payer rule, however, may complicate reporting for the individual service provider and subject her to taxation in other countries even if she does not perform any services in those countries.141 while the mechanics of a single tax administrative agency may simplify the reporting, the outcome may seem unfair to a taxpayer who does not leave her residence jurisdiction to perform services but works for a foreign employer. the taxpayer even may be unaware that the employer is foreign.142 finally, rather than a place of performance rule, a rule that allocates income based upon the intended impact of the performance of services would allocate income to the jurisdiction where the individual’s services have their impact. while athletes might be taxable under that rule only where they compete and not where they train, in most cases their performance would carry recognition and intended impact through endorsements, for example, in their home country as well as the performance country. remote services are taxable not at the location of the taxpayer, but where those services have the intended impact. such an impact rule is also likely to allocate a larger proportional share of the income of highly compensated individuals to poorer countries where those individuals may be responsible for the business decisions concerning operations and activities in those countries including manufacturing and natural resource production. this impact rule might distribute taxable income more fairly between rich and poor countries, although a modified residence rule might accomplish the same result as top managers are likely to visit facilities in poorer countries regularly, even if the managers are not based in those countries. problems of mismatching income and deduction might inhere under such a rule but, in many cases, the distribution formula for business income would apportion more of the income to the producing countries so that the impact rule would match the income and deduction. undoubtedly, an impact rule would be at least 141. cf. ccctb proposal, supra note 37, art. 91-1, at 50 (including employees in the labor factor of the group member from whom they receive compensation). 142. id. at art 91-2. (including employees in the labor factor of a group member for which they work if different from the payer). 396 florida tax review [vol. 14:9 somewhat unwieldy as place of impact is likely to be uncertain in many instances, and services may have an intended impact in multiple jurisdictions. 6. investment income an individual’s income from investment raises questions different from her income from personal services. most investments do not have a place of performance and often do not present any risk of mismatching inclusion of income and deduction of payment in-so-far as investment gains, as opposed to periodic payments of interest, dividend, or royalty, give rise to no deduction. under current law, an individual taxpayer is taxable in her country of residence and on periodic payments frequently is also taxable in the country of the investment as well.143 since the taxpayer may have no other contact with the investment jurisdiction, withholding taxes at the source of the payment of an investment return substitute for tax returns for the foreign investors.144 treaties frequently reduce the rate or eliminate the withholding tax and cede the jurisdiction to tax to the investor’s home country.145 subject to tax avoidance expatriation rules,146 countries with territorial income tax systems do not tax their citizens who live abroad on investment income even if they retain their citizenship.147 the united states differs in this respect as well by conditioning exemption from united states income taxes on relinquishment of citizenship.148 143. see oecd model convention, supra note 118, at article 10 “dividends” and article 11 “interest” (taxable in country of residence but also by limited withholding tax in country of source); c.f. article 12 “royalties” (taxable only in residence country unless from a permanent establishment in the source country). 144. i.r.c. §§ 871 and 881 (providing a withholding tax on periodic income on non-resident individuals and corporations respectively) are representative of withholding at the source. 145. see germany-us double tax treaty, supra note 122, article 10 (reducing the withholding rate on dividends from thirty percent (i.r.c. § 871) to five or fifteen percent), articles 11 and 12 (empowering only the country of residence to tax interest and royalties respectively). 146. sweden, for example, see income tax law of sweden, supra note 109; see also part iv.c. infra. 147. individuals resident in or having certain connections to and previously resident sweden are taxable on their income from all sources in sweden. income tax law of sweden, supra note 109, 3. kap. § 3. non-residents, whether or not swedish citizens, are taxable only on income from swedish sources. id. 3. kap. § 18. 148. treas. reg. § 1.1-1(a) (imposing “an income tax on the income of every individual who is a citizen or resident of the united states. . .”); i.r.c. § 61 (including all income from whatever source derived in gross income). 2013] utopian visions toward a grand unified global income tax 397 investment income in the case of an enterprise derives from the investment of retained revenue. apportioning the investment income in the same manner as the active income of the enterprise approximates attributing the investment income to the source of the funds for investment. investment income for individuals might similarly follow the allocation of the individual’s personal service income as the source of funds for the individual to invest. such a rule is far less compelling for individuals than it is for enterprises. after retirement, for example, the individual will no longer have service income to follow, although the formula might take the individual’s lifelong work record or, in order to simplify the process, an average of some number of years of the individual’s work record into account and allocate investment income according to that determination. that generalization, however, fails to account for the wealth many individuals inherit or receive as gifts. to be consistent with the production rule for the investment income from that wealth, one must look to the donor’s work history rather than the donee’s whose taxes are at issue. that might prove a formidable task over several generations of gifts. principal residence-based allocation, subject to a few special rules for investments in tangible productive property149 having a direct geographical link to a specific country, including rental personal and real property, natural resource production, farming properties, might work more smoothly than allocation following service income. it is a less appealing rule when an individual lives in one country but works in a neighboring country, or when an individual stops working and moves to another country from that in which she worked thereby depriving the country in which she earned her wealth of the tax on the income from the investment of that earned wealth. in the latter case, investment income should be taxable in the jurisdiction of residence but subject to expatriation limitations.150 in the former instance, even though a portion or all the investment income results from investment of the income from the individual’s services in another jurisdiction, simplicity and adherence to existing prevailing rules should take precedence. in any event, if the trend of preferential rates of tax on capital income continues, taxing investment income that is not part of a trade or business but primarily capital income may represent a smaller loss of revenue than loss of the tax on income from personal services. b. enterprise and related taxpayer definitions most income tax systems examine transactions between related taxpayers under various arm’s-length-pricing standards. rules that permit the 149. in many instances, the u.s. tax law might view such investments as income from the conduct of a trade or business as opposed to investment income. 150. see part iv.c. infra. 398 florida tax review [vol. 14:9 tax collector to adjust the price for tax purposes between such taxpayers to an appropriate arm’s-length price151 without regard to actual payment amounts152 recognize that taxpayers may not set their prices at arm’s length because of their close relationship. even when the price may be arm’s length, the allocation of asset ownership among members of a taxpayer’s interest group may shift income from that asset to low tax jurisdictions artificially. chief among the assets that taxpayers have used within a group to shift income has been intangible property, especially intellectual property. by shifting ownership to a related entity in a low-tax offshore jurisdiction, the domestic taxpayer that may own the offshore group member defers domestic taxes until they repatriate the income from the offshore group member in those jurisdictions that tax domestic persons on their worldwide income153 and may eliminate domestic taxation of the income where the jurisdiction only taxes domestic persons on their income from domestic sources and not on distributions from foreign group members. even when pricing is correct, taxpayers may manipulate the timing of income or loss under a realization-based tax system without relinquishing interest group control of the property. statutory rules in the united states, for example, deter some timing shifts by denying losses on sales between related taxpayers.154 under the gugit’s concept of taxpayer group, timing of inclusion and deduction would correspond in most instances with the group’s actual relinquishment of ownership or control of the asset sold. essential to limiting taxpayers’ opportunities to shift income to lowtax jurisdictions under the gugit is a robust mechanism that apportions a single tax base among taxpayers that act or tend to act in concert. determining which taxpayers are sufficiently closely related to share a common tax base informs two basic issues: (i) income-splitting to shift income to a taxpayer subject to a lower rate of tax in the same or another taxing jurisdiction and (ii) the privilege to use losses from one person to offset another person’s income. while these issues frequently manifest themselves in enterprise groups, tax administrators have struggled with them in family settings as well. for example, the united states supreme court determined that one spouse may not contractually shift income from his personal services to the other spouse even though the binding contractual 151. i.r.c. § 482, for example (giving the irs the power to redetermine prices in transactions between related taxpayers). 152. the tax collector may not require the taxpayers to change their actual prices but may require taxpayers to determine income and deduction based upon an adjusted price. 153. the united states, for example. see treas. reg. § 1.1-1(a) (taxing resident and nonresident u.s. citizens on their worldwide incomes). 154. for example, i.r.c. § 267 (disallowing the deduction of losses on sales of property between related taxpayers). 2013] utopian visions toward a grand unified global income tax 399 obligation arose before the taxpayer performed the services and gave the other spouse the legal right to that income.155 the united states ultimately resolved the marital unit issue by permitting spouses to file a joint return of income. the issue inheres for non-marital relationships. despite the court decisions barring direct shifting of income from services, opportunities to shift income indirectly abide. a taxpayer may interpose an entity, including a tax transparent entity like a partnership, s corporation, or limited liability company, and perform services on behalf of the entity. the service provider effectively shifts income to the entity in exchange for a smaller amount of compensation and shares the income with other owners who might be related to the service provider. taxpayers also may shift income from services by transforming their services into property. for example, painters, composers, and builders may shift income by giving the finished product to a family member who sells the product and includes the taxable income from the sale. tax rules often combat artificial shifts of income with anti-avoidance rules. in the united states, several statutes allow the irs to reallocate income among related taxpayers to prevent tax avoidance.156 income splitting includes a wide range of permutations. as noted above,157 for enterprise groups, the problem in the international context takes the form of transfer pricing158 and placement of ownership of intangible assets in low-tax countries. if the related taxpayers together are a single taxpayer under a gugit, the gugit’s formula for distribution of the tax base disregards transactions between members of the single taxpayer group, so that the transfer price would be of no concern for tax purposes. a major source of contention between taxpayers and their national tax collectors would disappear with transfer pricing.159 and the gugit apportions the 155. lucas v. earl, 281 u.s. 111, 50 s. ct. 241 (1930) (holding that a binding contract between spouses under which the working spouse assigns half his income from services to the other spouse does not prevent the working spouse from having to include the full amount of his service income for tax purposes). however, if the assignment of income is by operation of law in a community property jurisdiction, the working spouse is taxed on only half the income. poe v. seaborn, 282 u.s. 101, 51 s. ct. 58 (1930). community property laws applicable to married individuals split income between spouses so that each spouse is entitled to one-half the income of the marital unit. 156. i.r.c. §§ 482 (permitting the irs to reallocate tax items among taxpayers in order to prevent tax avoidance); 704(e) (reallocating income in family partnerships to prevent understatement of income to the service provider). 157. supra note 154 and accompanying text. 158. see supra note 25. 159. presumably the transfer pricing issue is only a related taxpayer problem. unrelated taxpayers are likely to set prices that do not result in artificial shifting of income from one taxpayer to another in order to exploit lower tax rates 400 florida tax review [vol. 14:9 group income without regard to the location of intangible assets so that positioning those assets in low tax jurisdictions does not shift the income from those assets to that jurisdiction.160 with respect to enterprise groups, the ccctb proposal identifies the taxpayer by means of a dual test of ownership and voting control. it requires ownership of more than fifty percent voting rights and more than seventyfive percent equity for consolidation.161 the united states always has used a much higher common ownership rule in permitting domestic corporations to become a single taxpayer. domestic corporations in the united states may consolidate their returns under an affiliated group concept of eighty percent or more common control and ownership. 162 the consolidated return statute precludes foreign corporations from consolidating with domestic corporations.163 subject to limitations that prevent taxpayers from trafficking in carryovers of losses,164 consolidation enables the consolidated taxpayer to offset income from one member of the group with losses from another member of the group. under ccctb consolidation, but not united states consolidation because transfer-pricing is a cross-border concern and the united states does not permit foreign corporations to consolidate with domestic corporations, the consolidation eliminates those intra-group transactions that generate transfer-pricing concerns. both the united states consolidated return rules and the ccctb proposal address only entity groups, but a gugit should include a common enterprise concept for individuals and entities and individuals together as well as entities. in the united states, only in the cases of married individuals,165 where joint tax filing may be beneficial, and minors and their for one taxpayer although in instances in which rates of tax differ with the type of income for one taxpayer but not the other, even unrelated taxpayers may try to shift income types to arbitrage the rate differentials. i.r.c. § 704(c) recognizes this unrelated taxpayer problem and prohibits the shifting of gain and loss on contributed property among partners in a partnership by taxing built-in gains and losses to the contributing partner when the partnership disposes of the contributed property. 160. see discussion of intangible property in the apportionment formula supra in part iv.a.2. 161. ccctb proposal, supra note 37, at 13. 162. i.r.c. §§ 1501 (permitting affiliated groups to file consolidated return), 1504 (defining includible corporation in an affiliated group as 80 percent voting and value). 163. i.r.c. § 1504(b)(3) (excluding foreign corporations from the definition of includible corporation). 164. i.r.c. §§ 382, 383(b), for example, that limit deductibility of net operating losses and capital losses on change of ownership of a corporation. 165. married individuals may elect to file a joint return of their combined income. i.r.c. § 6013. whether or not married individuals elect to file jointly, their marital status affects the rates of tax applicable to each spouse. see i.r.c. § 1(d). 2013] utopian visions toward a grand unified global income tax 401 parents,166 where the community would suffer the tax detriment of a higher rate, do the taxable income, tax rates, and losses of one individual impact the taxable income, tax rates, and losses of any other individual expressly. nevertheless, many other communities of interest among individuals exist, including cohabiting, but unmarried, individuals, some related, some unrelated, who may share expenses and income, but the code does not take them into account. taxpayers in the united states may elect to split income and deductions of various types through a variety of tax transparent or semitransparent entities when splitting may be beneficial to them and avoid tax transparency when splitting might be detrimental. other provisions prevent members of a family from deducting losses on sales of property from certain family members to others,167 but those provisions do not encompass other communities of interest and other transactions. the gugit may afford an opportunity to revisit those underlying tax law assumptions about relationships and define the community in a broader and possibly more contemporary manner including cohabitation, income and expense sharing, common economic plans and goals, or even acting in concert as the securities laws view shareholder groups, 168 for example. while a high common ownership threshold might prevent taxpayers from using the gugit to their advantage,169 the high threshold also limits the gugit’s ability to prevent taxpayers’ manipulation of transactions within a non-consolidated interest group. in the united states, it is more difficult for taxpayers to elect to combine as a single taxpayer than it is for the taxing agency to combine taxpayers in order to disregard transactions or structures that are beneficial to the taxpayer. varying lower thresholds for determining relatedness and disallowing losses on transactions between related taxpayers permeate the united states tax law.170 and because the united states has had a graduated rate scale applicable to corporations, it the marital status also prevents spouses from making different elections on itemization of deductions. i.r.c. § 63(c)(6). 166. i.r.c. § 1(g) (tacking the investment income of minors to their parents’ (or highest earning parent’s) income for purposes of determining the rate of tax applicable to the minor. 167. i.r.c. § 267 (disallowing losses on sales between certain family members among other transactions). 168. section 14(d)(2) of the securities exchange act of 1934, 15 u.s.c. §§ 78a-78kk, § 78n(d)(2) (1982) (originally enacted as securities exchange act of 1934, ch. 404, 48 stat. 881 (1934)) (hereinafter, the “exchange act”) (defining person to include various people acting in concert in the acquisition of securities, whether or not they form a formal partnership or other entity). 169. see supra notes 164–166 and accompanying text. 170. section 267, for example, denies losses to taxpayers who bear, directly or indirectly, a more than fifty-percent ownership relationship to one another. https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1000546&cite=15uscas78a&originatingdoc=ied643e6164f011db8a54a698991202fa&reftype=lq&originationcontext=document&transitiontype=documentitem&contextdata=%28sc.search%29 https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1000546&cite=15uscas78a&originatingdoc=ied643e6164f011db8a54a698991202fa&reftype=lq&originationcontext=document&transitiontype=documentitem&contextdata=%28sc.search%29 https://1.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1000546&cite=15uscas78kk&originatingdoc=ied643e6164f011db8a54a698991202fa&reftype=lq&originationcontext=document&transitiontype=documentitem&contextdata=%28sc.search%29 402 florida tax review [vol. 14:9 also has an anti-abuse rule to prevent the proliferation of unconsolidated corporate taxpayers to capture multiple sets of graduated rates.171 regarding multiple taxpayers as a single taxpayer sometimes benefits the taxpayers by allowing them to use the losses of one to offset the income of another. on other occasions, the conflation of taxpayers prevents them from controlling the placement of income with their transfer prices and the timing of the deductions that otherwise might arise from transactions between them. careful planning sometimes permits taxpayers to seize the economic benefits but avoid the economic detriments of their relationships. in choosing a threshold of common ownership or relatedness, designers of the gugit must consider whether the gugit should follow the pattern of requiring a higher threshold for the benefits of consolidation than the threshold for disregarding separateness to prevent artificial diminution of tax liability.172 in the united states, the use of differing thresholds to combat various tax-planning opportunities has led to a cacophony of anti-avoidance type rules.173 those loss disallowances and other anti-avoidance rules target communities of interests that taxpayers exploit to diminish their tax liability. the ccctb proposal enhances its enterprise concept by embedding a transfer pricing anti-avoidance concept for transactions between enterprises that have overlapping control but are not members of the same group.174 the “community of interest” or “acting in concert” test that this paper recommends would provide the tax agency flexibility in identifying and 171. i.r.c. § 1561(a)(1) (denying multiple sets of rate brackets to component members of a controlled group of corporations defined in section 1563 as eighty-percent parent-subsidiary ownership or when five or fewer persons (not including most entities) own a fifty-percent overlapping voting ownership or value ownership). 172. with the term “artificial” this paper refers to a tax structure that produces a tax benefit without affecting the underlying economic transaction. see ccctb proposal, supra note 37, article 80, at 46 (using the “artificial” terminology in its anti-abuse rule). 173. some use a more than fifty percent test (i.r.c. § 267 for losses on sales between related entities); others an unspecified common control test (i.r.c. § 482 for transfer prices between commonly controlled entities and individuals). many of the anti-avoidance rules include a series of complex constructive ownership rules. section 318, applicable to section 302 redemptions of shares uses one set of rules, but section 544 uses different constructive ownership rules for determining the number of shareholders for personal holding company tax rules. 174. ccctb proposal, supra note 37, articles 78 & 79 (defining associated enterprises and forcing accrual of income in transactions between associated enterprises where the transaction has conditions that differ from those that would have arisen in between unrelated taxpayers). 2013] utopian visions toward a grand unified global income tax 403 preventing tax-planning opportunities that inflexible numerical standards provide.175 other approaches to the problem suggest themselves as well. rather than relying on thresholds of overlapping ownership to prevent tax manipulation, the united states treasury regulations, interpreting and supplementing the substantial economic effect partnership tax statute,176 turned to a present value analysis of the impact of allocations that did not correspond to the taxpayers’ interests in the partnership. under that regulation: the economic effect of an allocation (or allocations) is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement. 177 similarly, recognizing that tax planners are likely to find weaknesses in the ccctb, the ccctb proposal embeds a general anti-abuse rule providing: “[a]rtificial transactions carried out for the sole purpose of avoiding taxation shall be ignored for the purposes of calculating the tax base.”178 this anti 175. taxpayers may assert, as they have with general anti-avoidance rules (“gaars”), infra note 179 and accompanying text, that flexible standards leave uncertainty in the application of the tax laws in violation of constitutional standards. as with gaars, such flexibility is essential to combatting the technically correct application of rigid tax rules for aggressive tax planning that has plagued the united states for many years. ordower, supra note 40, at 92. 176. i.r.c. § 704(b) (requiring that partnership allocations of income and deduction among the partners in a partnership have substantial economic effect). the statute requires that allocations not having substantial economic effect be disregarded and the items of income and deduction be allocated according to the partners’ interests in the partnership. the statute leaves to the department of the treasury the task of defining substantial economic effect. reg. § 1.704-1 and 2 seek to define substantial economic effect and provide a safe harbor of permissible allocation structures. 177. reg. § 1.704-1(b)(2)(iii)(a) (providing rules on the substantiality of allocations). 178. see ccctb proposal, supra note 37, article 80 at 46 (ignoring artificial transactions carried out to avoid tax but not transactions representing 404 florida tax review [vol. 14:9 abuse rule is a member of the growing family of general anti-avoidance rules (gaars) to which many jurisdictions have turned to help curb aggressive tax planning.179 a gaar enables the taxing agency to look beyond the express statutory language to ascertain whether the economic substance of a transaction corresponds to its form and the intention of the statute itself. it is probable that even if the gugit includes differing thresholds for combining taxpayers and disregarding tax avoidance transactions, the gugit will nevertheless need some kind of more general anti-avoidance provisions, whether broad language like that of a gaar,180 present value analysis like that of the united states partnership allocation rule, or the “acting in concert” standard. without a gaar, technical compliance with the gugit’s rules will yield opportunities to structure around the purpose of the gugit. rather than attempting to anticipate tax avoidance opportunities with detailed statutory rules, differing relationship thresholds for income and loss and special mechanical rules, a principles-based approach like a gaar would provide the greatest flexibility to combat unforeseeable tax planning opportunities. insofar as the gugit redesigns thinking about taxes along global lines, traditional arguments against a gaar181 should give way to the need for a unified and effective approach to protect the integrity and fairness of this new taxing system. c. residence change and expatriation to the extent that the gugit uses a residence concept in distributing income among jurisdictions and tax rates differ materially from one jurisdiction to another, taxpayers will try to avoid the higher tax jurisdiction by shifting residence. for corporations, where corporate residence is a function of place of incorporation and nominal headquarters, rather than actual place of management, change of the country of incorporation to reduce taxes is a sensible decision. if the residence test is a matter of the place of actual management, a decision to relocate the alternative structures, one of which generates a more favorable tax outcome than another). 179. for example, in germany, § 42 abgabeordnung, in sweden skatteflyktslagen; in the united states, i.r.c. § 7701(o) (codifying an economic substance concept). 180. id. for the present value test, see supra note 177 and accompanying text. 181. supra note 175. ambiguities of any statutory language creating uncertainty in application of a statute aside, most, perhaps all, taxpayers who structure to avoid the application of a specific statute know that they are avoiding taxes rather than altering the economic substance of their transactions. ordower, supra note 40, at 98. 2013] utopian visions toward a grand unified global income tax 405 corporation for tax purposes affects the physical location of the principal managers and becomes a far more difficult move. in the case of an individual taxpayer, changing one’s residence may have little significance if one may retain the national citizenship to which one has an emotional and linguistic bond. in fact, the change of residence might have independent significance182 like a retirement to a country with a more pleasant climate or a lower cost of living, rather than a tax avoidance purpose.183 countries with territorial tax systems historically permit citizens and taxable residents to emigrate and free themselves from the home country’s income taxes, although increasingly countries have turned to continuation taxes to prevent tax emigration.184 with its tax on worldwide income of citizens and permanent residents, the united states, on the other hand, requires that the citizen renounce her citizenship and emigrate in order to become free from the united states’ income tax.185 relinquishing one’s citizenship would seem a much higher emotional price to pay to avoid taxes than simply changing one’s residence while retaining citizenship. nevertheless, some americans do renounce.186 in order to combat change of residence to avoid taxes, countries have adopted two basic approaches: exit taxes and continuation taxes. an exit tax requires the taxpayer to, at the time of expatriation, include in income all the net gain the taxpayer would have included in income if she had sold her assets at their respective fair market values on the date of residence change or expatriation.187 under a continuation tax, the departing or expatriating taxpayer, corporate or individual, remains subject to the income tax of the country from which she or it departed or expatriated for several years following the expatriation.188 182. supra note 133 and accompanying text on acts of independent significance. 183. many canadians move to florida for much of the winter (but tend to keep their period of residence under 183 days to avoid becoming u.s. residents for tax purposes). many americans retire to border areas of mexico to capture the lower mexican cost of living. scandinavians, germans, dutch, and british select winter or all year residence in spain and mediterranean islands to avoid their harsh northern climates. 184. see infra note 188 and accompanying text. 185. reg. §1.1-1(a) (taxing resident and nonresident u.s. citizens on their worldwide incomes). 186. supra note 134. 187. i.r.c. § 877a (imposing a tax on individual expatriations). 188. i.r.c. §§ 7874 (taxing in the u.s. the inversion gain of an entity and defining inversion gain as gain from the sale of assets or income from licensing property to a related party for 10 years following expatriation); 877 (taxing an expatriating individual on effectively connected income for 10 years following 406 florida tax review [vol. 14:9 the proposed formula for apportionment of trade or business income under the gugit removes most of the incentives for expatriating since it apportions income based upon some factors that remain unchanged following expatriation — destination sales and beneficial ownership.189 the underlying enterprise owners themselves would have to change residence or expatriate to shift the beneficial ownership factor to another country. as a practical matter, relocation of property and payroll to a low tax jurisdiction is likely to be a matter of business economics, such as lower wages and property costs, rather than tax avoidance. similarly, if the gugit allocates an individual’s income based on intended impact or relative periods of residence,190 change of residence or expatriation may have little effect on the taxpayer’s tax rate on personal services income since both factors are independent of the taxpayer’s permanent residence. investment income follows residence more closely and is likely to shift with residence. given the centralization of tax reporting and collection, a continuation tax may be more administrable than an exit tax to counter tax departures and expatriations. a continuation tax does not require immediate asset valuations with their uncertainties for all but the most liquid assets. a continuation tax also requires taxpayers to cut ties with the home country if they wish to become free from the continuation tax.191 ultimately, change of residence and expatriation will cease to be an issue if tax rates harmonize as one would expect them to do under a gugit. d. language and currency translation there are six official languages of the united nations: arabic, chinese, english, french, russian, and spanish,192 but the eu operates expatriation); see income tax law of sweden, supra note 109, 3. kap. 3 § 3., 7 § (taxing expatriates on their income from all sources if they continue to have substantial connection with sweden presumptively for five years following expatriation). 189. supra part iv.a.1. and a.4. 190. supra part iv.a.5., especially text accompanying and following note 139. 191. the u.s. continuation tax under section 877(c)(2)(b) excepts dual nationals from the continuation tax only if they maintain no substantial contacts with the u.s. similarly, the swedish continuation tax holds expatriates to taxability in sweden on their income from all sources for the five-year continuation if they maintain significant contacts with sweden, including, for example, continuing conduct of a trade or business, possession of a year round residence, family, and so forth. see income tax law of sweden, supra note 109, 3. kap. 7 § inkomstskattelag (sweden). 192. un official languages, united nations, http://www.un.org/en/ aboutun/languages.shtml/ (last updated august 29, 2013). 2013] utopian visions toward a grand unified global income tax 407 currently in twenty-three official languages. however, the eu does not translate documents automatically into all twenty-three but relies primarily on english, french, and german as its procedural languages.193 the irs provides some documents in spanish, chinese, korean, vietnamese, and russian.194 the quality of computerized translation is imperfect but improving,195 and there is no reason to assume that the quality will not continue to improve over the next several years. the model of working in a handful of languages having wide usage and providing translation into other languages when needed seems a reasonable approach for the gugit. english tends to predominate in international business transactions and has become an unofficial worldwide common language.196 invariably, tieas have an english language official text based upon the oecd model.197 while this article does not suggest that the gugit use only english, as a practical matter, the group that will design the gugit is likely to conduct negotiations primarily in english198 and generate a single language text for the gugit initially before translating it into other languages. while translations into many languages may become necessary for users, the gugit presumably will have one or at most a handful of official primary texts to which other language users may refer if the translations into their languages are ambiguous or erroneous. selection of the official language is politically charged but historical negotiations to create an artificial international language always failed and people who have had to 193. official eu languages, european commission, http://ec.europa.eu/languages/languages-of-europe/eu-languages_en.htm (last updated august 29, 2013) (“[d]ue to time and budgetary constraints, relatively few working documents are translated into all languages. the european commission employs english, french and german in general as procedural languages, whereas the european parliament provides translation into different languages according to the needs of its members”). 194. irs multilingual gateway offers online help in other langauges, internal revenue service, http://www.irs/gov/individuals/article/0,,id=224594, 00.html?navmenu=menu3 (last updated august 29, 2013). 195. google translate currently offers translation between sixty-four languages, including several substantially obsolete languages, such as yiddish. see about google translate, google, http://translate.google.com/about/ (last updated august 29, 2013). 196. seth mydans, across cultures, english is the word, new york times online, http://www.nytimes.com/2007/04/09/world/asia/09iht-englede.1.5198685. html?pagewanted=all&_r=0 (last updated april 9, 2007); the triumph of english: a world empire by other means, the economist (december 20, 2001), http://www.economist.com/node/883997?story_id=883997 (last updated august 29, 2013). 197. supra note 90. 198. as the ccctb wg conducted its negotiations. 408 florida tax review [vol. 14:9 communicate in international settings generally have turned to french or english except when they had a closer common second language.199 despite the existence of multiple numeral systems,200 most countries use the common european system of so-called arabic numerals alongside any national system. moreover, the gugit will rely on electronic numerals. data processing translates data input (without regard to the numeral system appearing at the data entry point) into a common electronic data representation that can be translated into any numeral system without the uncertainties and ambiguities of language translation. taxpayers and thirdparty reporters will transmit primarily numerical data electronically in certain sequences or positions in order to comply with their obligations under a gugit. the electronic data entry protocols will reject data that does not sensibly fit the data entry field so that, in most instances, language will be necessary only to the explanatory material to instruct the person entering the data how to use the data entry fields. undoubtedly, there will be disagreements on interpretation of obligations that the taxing statutes create, as there always are with tax statutes, but translation of the statutes from one language to another seems unlikely to become a principal source of those disagreements. there probably will not be so much more interpretational uncertainty created by translation errors and ambiguities than there is today with the language of single country laws and regulations. currency translation may be a more serious concern than language translation, since relative currency values fluctuate from day to day while the meaning of words does not. for most taxpayers, currency translation will be unnecessary. most will not engage in international commerce so their income will be in their local currency, as will be withholding, and the currency of the tax payment obligation. computation of the tax base where income and expense involve multiple currencies is more problematic. the ccctb proposal requires translation into the euro of all transactions on the last day of the taxable year at the average rate of exchange that the european central bank determines for the year, unless the company or enterprise is located in a single member state that does not use the euro.201 within the eu, the decision to use an average rate of exchange over a year’s time makes sense because the other european currencies 199. for example, the second language in the soviet republics historically was russian; however, since the 1990 change in the economic systems, those former soviet republics increasingly have used english in business dealings if not governmental functions. 200. numerals in many different writing systems, omniglot, http://www.omniglot.com/language/numerals.htm (last updated september 3, 2013) (listing twenty-three different numeral systems). 201. see ccctb proposal, supra note 37, article 22, 2 at 26. 2013] utopian visions toward a grand unified global income tax 409 fluctuate within a narrow band relative to the euro. 202 the region is monetarily stabile. a worldwide tax base will be more complicated since currency translation goes to both the distribution of the base and the use of withheld and estimated tax payments. instability of currencies and lack of convertibility are both problematic. the problem of convertibility no longer is insurmountable. all major currencies are currently either convertible or on the way to full convertibility.203 while a common international currency ultimately might follow from a gugit, until that happens, it will be necessary to convert all transactions into a single measure in order to facilitate distribution of the tax base. the taxpayer may select a functional currency for reporting revenue and expenditures. regular use of an artificial currency pegged to a major world currency, usually the united states dollar or the euro has become commonplace.204 several countries use the united states dollar for their currency in order to control exchange rate fluctuations that historically plagued their own currencies.205 frequently, businesses in countries with unstable currencies state prices in a major, stable currency but then convert at the rate of exchange at the moment of sale.206 taxpayers also might choose their home jurisdiction’s currency because the taxpayer maintains books and records in that currency. 202. what is erm ii?, european commission, economic and financial affairs, http://ec.europa.eu/economy_finance/euro/adoption/erm2/index_en.htm (last updated september 3, 2013). members of erm ii, most of which joined the euro zone, agreed to a maximum fluctuation within fifteen percent. denmark maintains the range at 2.25 percent and latvia at one percent. the uk and sweden are not part of erm ii, but the swedish krona generally fluctuates relative to the euro within the fifteen percent range from the base rate, but the uk pound sterling has fluctuated more widely from its base rate. 203. yuan will be fully convertible by 2015, chinese officials tell eu chamber, bloomberg news (september 8, 2011), http://www.bloombert.com/ news/2011-09-08/yuan-to-be-fully-convertible-by-2015-eu-chamber.html (last up dated september 3, 2013) (announcing a target for full yuan convertibility); reserve bank of india, annual report, development and regulation of financial markets http://www.rbi.org.in/scripts/annualreportpublications.aspx?id=984 (last updated september 3, 2013) (see the capital account portion of the report, discussing liberalization of the capital markets and convertibility). 204. for example, the asian clearing union permits clearance of transactions either in acu dollars or euros. see generally, asian clearing union, http://www.asianclearingunion.org/introduction.aspx_ (last updated september 3, 2013). 205. most recently, ecuador. see generally hale e. sheppard, dollarization of ecuador: sound policy dictates u.s. assistance to this economic guinea pig of latin america, 11 ind. int’l & comp. l. rev. 79, 81 (2000). 206. zambia, for example. 410 florida tax review [vol. 14:9 formulary distribution of income among taxing jurisdictions requires relative currency stability unless the taxpayer never actually uses money earned in one jurisdiction to pay expenses in another. in the absence of cross-border payments, translation of income and expenditure at an average rate should result in a correct distribution of income and tax burden.207 in the presence of cross border expenditures, however, use of an average rate of exchange over a full annual accounting period works well only in the context of narrow band currency fluctuation such as that present in the eu and its member states.208 average exchange rates work less well when a currency lacks a ready foreign exchange market because the country has a high rate of inflation or the economy and, accordingly, the currency otherwise is unstable. in those instances, where a taxpayer uses one currency to pay an expense in another currency, the tax base distribution works correctly if the taxpayer uses a cash basis of accounting and the actual exchange rates of currency conversion. government restrictions on outbound convertibility further complicate distribution of income and payment of taxes outside the restricted country.209 fixed exchange rates would permit the gugit to distribute income among jurisdictions seamlessly and fairly, but those fixed exchange rates must be a function of stabile economies rather than artificial controls that depart from economic reality. a single worldwide currency is the best choice in light of increasing interconnectedness of national economies. 207. to illustrate: taxpayer elects currency a as its functional currency. taxpayer earns 1000 units of net income in currency a, and 100 units of net income in currency b as well. on the first day of the year, currencies a and b traded at one to one, on the last day of the year a and b trade at ten to one and the average for the year is eight to one. taxpayer earned the 100 units of b on the first day of the year and 1000 units of income in currency a on the last day of the year. the average exchange rate for the year is the eight to one. assume countries a and b have a fiftypercent tax rate. using the average exchange rate and the taxpayer’s functional currency, the taxpayer earned 800 units of a in country b, and 1000 units of a in country a, even though when earned the amounts were identical in value. the gugit would allocate 5/9 of the tax base of 1800, 1000 units to country a for a 500 unit tax (the correct amount), and 800 to b translated at the average rate of 8 to 100 b units for a tax of 50 b units (also correct). 208. supra note 202. 209. governments do not restrict inbound movement of foreign exchange although many have prohibited their citizens from holding foreign exchange, thus requiring conversion into the local currency for legal receipts of foreign exchange, for example, all the soviet bloc countries before 1990. 2013] utopian visions toward a grand unified global income tax 411 v. toward uniform tax rules a gugit requires uniform rules of inclusion and deduction in the income producing portion of the taxpayer’s world.210 variations in those rules from jurisdiction to jurisdiction frustrate the gugit’s objective of eliminating the possibility of both multiple inclusions of the same income and no inclusion of income in any jurisdiction. the gugit must construct a single tax base to distribute among the jurisdictions in which the taxpayer is active. a simple example might be that commuting expenses be uniformly deductible or non-deductible as business expenses.211 if the gugit design makes commuting expenses non-deductible, a country would remain free to allow such deductions against that country’s share of the uniform tax base but could not take them into account in determining the distributable tax base itself. the states of the united states have used formulary apportionment for many years. they have employed the federal income tax base as a uniform point of departure for apportionment212 but have failed to achieve complete uniformity of base and apportionment formula.213 each state adjusts the federal base in state specific ways to construct its own tax base to apportion according to its apportionment formula. the ccctb proposal, on the other hand, lays down principles for the computation of a single uniform tax base without country specific variations.214 while the concept of a multinational uniform tax base might have seemed unimaginable in the past, broad 210. countries may provide additional deductions for the non-income producing part of the taxpayer’s world. these deductions in u.s. tax parlance would fit into the current group of itemized (or below the line) deductions under section 63 and might include such items as a deduction for the interest on a home mortgage. 211. u.s. tax law considers commuting expenses to be personal, living, and family expenses that under i.r.c. § 262 are non-deductible. german tax law views commuting costs as necessary to the taxpayer’s income production and, accordingly, deductible. see, e.g., art. 3 g v. 8.5.2012 i 1030, einkommensteuergesetz (neugefasst durch bek. v. 8.10.2009 i 3366, 3862; zuletzt geändert durch) (german income tax law) § 9, ¶ 1, nr. 4 (permitting a deduction for commuting costs as trade or business expenses). 212. the state of missouri, for example, commences the computation of the corporate tax with federal taxable income and then makes modifications applicable to missouri before apportioning the income. form mo-1120, line 1-4 (federal taxable income and modifications), line 10 (apportioned missouri taxable income), http://dor.mo.gov/forms/mo-1120_fillable_2011.pdf (last updated september 3, 2013). 213. supra note 99 and accompanying text. 214. supra note 378, chapter iv at 22–24. 412 florida tax review [vol. 14:9 acceptance of the ccctb proposal, albeit with modifications,215 brings the concept into the imaginable. both accounting principles and substantive tax rules now tend to converge across national borders. while the united states applies generally accepted accounting principles, a rule-based system of financial reporting, to public disclosure, european and other countries use the principles based system of the international financial reporting standards. whenever a united states issuer of securities included financial results from a european affiliate in its financial statements or a non-united states issuer wished to list its securities on a united states exchange, it had to translate the accounting results from ifrs to gaap. the converse also was true for issuers based in the united states and using gaap but wishing to list in europe. in 2008, however, the sec announced and published a “roadmap” for use of ifrs by united states issuers possibly as early as 2014.216 in the roadmap the sec acknowledged that increasing integration of international financial markets and international acceptance of ifrs made it necessary for the united states to consider seriously whether adoption of ifrs would be in the best interests of united states issuers and their shareholders.217 although the sec’s final staff report on ifrs did not conclude that ifrs would be in the best interests of united states issuers and shareholders, neither did it reject continuing convergence and future possible transition to ifrs. the report recommends continuing sec involvement with development of ifrs.218 convergence and integration of financial reporting standards worldwide certainly is in process but possibly at a slower pace than earlier sec statements suggested. the last several decades have also seen an increase in borrowing of substantive tax rules and convergence of tax concepts. while the ccctb proposal is perhaps the most immediately visible of the developments, the decade of the 1990s saw the construction of income tax systems in the formerly centrally planned economies of the soviet republics and satellite states. tax experts from free market economic systems assisted in the development of the new tax systems and modeled them from their own experience.219 similarly, the ccctb wg solicited the views of experts from many countries in constructing the ccctb. inevitably, neither the tax 215. see ep ccctb resolution, supra note 38. 216. sec, final staff report supra note 133. 217. id. 218. see sec, final staff report, supra note 13. 219. jorge martinez-vazquez and robert m. mcnab, the tax reform experiment in transitional countries, 53 nat’l tax journal 273 (2000) (describing tax reform approaches and international assistance in tax reform in the formerly centrally planned economies); yolanda k. kodrzycki and eric m. zolt, tax issues arising from privatization in the formerly socialist countries, 25 law & pol’y int’l bus. 609 (1994) (discussing the development of tax systems and the importance of taxation to stable economies). 2013] utopian visions toward a grand unified global income tax 413 systems in the former soviet republic’s sphere of influence nor the ccctb copied any single existing tax system. rather both projects were convergence projects that selected elements from several systems. in many instances, systems and concepts converge as countries experience similar problems or concerns with their systems and look to other countries for possible solutions. legislatures and courts have examined debates and decisions in other countries for guidance on and solutions to problems that confront them as well as the legislatures and courts of the other countries. among striking examples of this phenomenon are gaars220 and controlled foreign corporation (cfc) rules.221 neither gaars nor cfc rules are identical in all jurisdictions but all have fundamental similarities. gaars empower the tax administrator to disregard the form of a transaction having a tax avoidance purpose and substitute a different tax outcome than that the taxpayer wanted;222 cfc rules prevent some shifting of income to low tax jurisdictions where a compelling business reason for the placement of the income is absent. the income has no immediate relationship with the jurisdiction in which it arises. similarly, the oecd has taken on several antitax avoidance projects that tend to make rules across national borders more uniform, including transfer pricing methodologies223 and exchanges of tax information.224 in addition, the stark historic differences between schedular and global tax systems have tended to converge into hybrid systems,225 while rate competition has reduced corporate and often individual income tax rates throughout most of the economically, developed world. 220. supra note 175 and accompanying text. 221. see generally, controlled foreign company taxation regimes in selected countries: report prepared for the advisory panel on canada’s system of international taxation, kpmg llp, (april 2008), http://www.apcsit-gcrcfi.ca/06/rrre/rr5%20-%20kpmg%20-%20en%20-%20final%20-%20090608.pdf (describing the controlled foreign corporation rules in 10 countries, which either attribute the controlled foreign corporation’s income to domestic shareholders or impose a domestic tax on the corporation to reflect its domestic ownership). 222. ordower, note 40, at 94–103 (discussing the growth of gaars internationally). 223. see oecd transfer pricing guidelines, supra note 24 (providing guidelines for transfer pricing restraints). the oecd has also announced its intention to publish a white paper on standardization and simplification of transfer pricing documentation. see julie martin, oecd to tackle transfer pricing documentation, 2012 tnt 149–4 (august 2, 2012). 224. see oecd, harmful tax competition, supra note 8 and model tiea, supra note 89. 225. see sylvain r.f. plasschaert, schedular, global and dualistic patterns of income taxation, 17–24 (1988) (discussing schedular tax systems); eric m. zolt, the uneasy case for uniform taxation, 16 va. tax rev. 39, 49–50 (1996). 414 florida tax review [vol. 14:9 while nations continue to enact and maintain tax rules that differ from those of other nations, most of those rules exist as a matter of internal political compromise rather than as reflections of deeply embedded, fundamental national principles that render them unalterable. even when exhibiting clear policy choices, the rules are details, not basic structural elements of an income tax system. resistance to enactment of a gugit will come as no surprise, but that resistance is likely, at best, to reflect principled differences of opinion with the gugit design group’s negotiated compromises on specific tax rules and at worst political posturing alongside some fear of sacrificing national autonomy. thus, if local enactment of an internationally designed gugit leaves nations the choice of accepting or rejecting the gugit as a whole only,226 leaving no opportunity to reject or modify specific items of the gugit, countries are less likely to isolate themselves by refusing to join if their neighboring states and major economic powers join. vi. economic displacement from the new gugit in 1981 when the united states enacted favorable new tax rules for depreciation, the average price of depreciable real property increased,227 and depreciable real property similarly lost value when the depreciation rules became less favorable again.228 when the rules became more favorable, owners of depreciable real property received a windfall gain if they sold the property insofar as they bought their property when rules were less favorable and, accordingly, commanded a lower price. when the depreciation rules became less favorable, owners of depreciable real property suffered a loss in value of their properties. that loss in value was probably particularly noticeable to those who acquired property during the period of more favorable rules when there was a spike in value. at the time of each change in depreciation rules, there were economic displacements. changing rules causes those displacements, although well-functioning markets anticipate changes and take them into account gradually or sooner than the change event so that the displacements are less remarkable. changes require other changes to compensate for the first changes. when the united states tax depreciation rules became more favorable, 226. a problem with uniform laws is that jurisdictions often modify features of those laws so that they are not truly uniform from jurisdiction to jurisdiction. 227. 30 year look back, marcus & millichap, research review trends report: commercial real estate review, http://vitorinogroup.com/wp-content/ uploads/2012/02/commercialrereview.pdf (last updated august 27, 2013) (discussing impact of tax law changes on commercial real estate). 228. id. 2013] utopian visions toward a grand unified global income tax 415 income tax revenues from the operation of real estate declined. on the other hand, initially there may have been more sales of real estate at taxable gains because a purchase would enable the purchaser to use the new, favorable depreciation rules and the seller to capture the spike in value that the rule change created. if the tax from gain did not offset the loss of revenue from favorable depreciation rules, other rule changes or rate changes would become necessary to make up for the lost tax revenue so that the government could continue to provide services. from time to time, the rules for budgeting tax changes that diminish revenue in the united states require revenue offsets. under those rules a legislator may not introduce legislation to increase an existing or create a new tax benefit without complementary legislation to offset the revenue loss.229 revenue neutrality for tax changes does not mean revenue neutrality for taxpayers. changes create winners and losers, even if on a governmental revenue measure no change occurred. stabile rules do not. economic displacements will accompany the shift to a gugit. economic displacements also accompany any change in substantive tax laws (and probably procedural tax laws as well).230 taxpayers that have exploited tax-planning opportunities such as transfer pricing to shift income to low tax jurisdictions will lose that tax avoidance opportunity and probably pay more taxes. those taxpayers should arguably not have had the opportunity to shift income in the first instance. in addition, the diminished deadweight loss of tax planning and tax administration to prevent such tax planning offsets some or all the economic displacement, although the beneficiaries of the economic benefit may not be identical with those losing the tax-planning benefit. like all tax changes, adoption of the gugit will produce winners and losers. for the average taxpayer, little will change. enhanced withholding under the centralized collection system may deprive some taxpayers of the financial float they enjoyed by waiting until tax payment time to pay.231 exclusions and inclusions in income may not be identical to what they are currently, but most of the changes will not have a recurrent effect on any specific taxpayer. if there is a strong policy reason for a specific exclusion — subsidization at national level for local governments through the interest 229. the budget enforcement act of 1990 was title 13 of the omnibus budget reconciliation act of 1990 (including pay-as-you-go rules (paygo) requiring tax legislation that reduced revenue to include an offsetting revenue increase). 230. supra note 227 and accompanying text. 231. with current interest rate levels, it is difficult to imagine any significant value to the float from short term tax deferral. 416 florida tax review [vol. 14:9 exclusion,232 for example — a direct subsidy would work equally well possibly without as much deadweight loss.233 changes in the cost recovery rules, depreciation and amortization, may cause more significant economic displacement as they alter the underlying value of property. yet, if the united states is representative of the frequency with which the legislature alters those rules, the resulting economic displacement is far from unusual. more significant for countries that tax on worldwide income, like the united states, might be the implicit shift to territoriality. those countries will receive their share of the taxpayer’s uniform tax base but not the bonus over the tax rate that other countries may charge on their shares of that base.234 on the other hand, the united states is likely to be on the receiving end of tax base on the destination sales and beneficial ownership factors in the formula. disruption of taxpayer’s opportunity to shift income through transfer pricing is also likely to increase the share of the tax base allocated to the united states, so that the “deferral” opportunity diminishes235 and temporary tax reductions to encourage repatriation of earnings become unnecessary. 236 232. i.r.c. § 103. 233. if, in order to sell local government tax exempt bonds, the interest rate must target an income group not subject to the highest marginal rate of tax, investment in the bonds by a taxpayer subject to the highest rate of tax results in deadweight loss because it shifts part of the subsidy value to the high bracket taxpayer and away from the subsidized local government. 234. the united states computes the tax liability of its citizens and residents on their worldwide income. see i.r.c. § 61 (including income from all sources worldwide) and allows a credit for taxes paid to foreign countries under i.r.c. § 901. whenever the u.s. rate exceeds the foreign rate of tax, the united states retains the excess of the u.s. tax on the foreign income over the creditable foreign tax. 235. since a corporation’s earnings from the active conduct of business generally are not taxable to its shareholders until distributed, unless an antiavoidance rule like the passive foreign investment company, see i.r.c. § 1291 et seq., or controlled foreign corporation, see i.r.c. § 951 et seq., rules apply, corporate taxpayers seek to defer u.s. taxes by shifting income offshore, especially through transfer pricing arrangements. 236. in 2004, u.s. legislation effectively reduced the u.s. tax rate repatriated earnings of a controlled foreign corporation to a maximum of 5.25 percent temporarily for a single tax year to encourage investment in the united states and increase employment in the united states. the rate reduction resulted from a dividends received deduction of eighty-five percent of the amount of the dividend if the recipient invested the funds in the u.s. under a domestic reinvestment plan. i.r.c. § 965, added by the american jobs creation act of 2004, pub. l. no. 108-357, 118 stat. 1418 (2004) (codified as amended in scattered section of 26 u.s.c.). proposed legislation in 2011 would repeat the decreased rate on repatriation even though the earlier effort seems to have accomplished little to 2013] utopian visions toward a grand unified global income tax 417 vii. conclusion transfer-pricing regulation has failed to prevent taxpayers from shifting income to low tax jurisdictions, as tax administrators have struggled to challenge those prices. gaars have proliferated worldwide suggesting that existing tax laws are inadequate to staunch loss of revenue through sophisticated tax planning. commerce has become increasing global and business ownership no longer national. with growing regularity, enterprises reach across national borders to acquire other enterprises, even very large ones. against the backdrop of internationalization of commerce, taxation only on a national level seems strangely anachronistic. while not pushing for a global tax regime, tax administrators and national legislatures have increased international access to the domestic tax information gathering power. treaties and tieas require transmission of large quantities of taxpayer data from national tax administrations to tax administrations in other countries. oecd projects on harmful tax competition237 and transfer pricing,238 the united states’ and other countries’ prosecutions for concealment of assets and income abroad, negotiations with various jurisdictions for changes in bank secrecy laws, enactment of fatca, tax administrators’ purchase of stolen secret financial information, and the ccctb proposal239 all emphasize the critical importance of international cooperation on tax matters. jurisdictions have become less protective of their national sovereignty on tax matters.240 the ccctb proposal opens the door to cross border tax administration. the momentum to replace obsolescent domestic taxation with global taxation reflecting global commerce is growing. a progressive income tax remains conceptually fair and desirable, but the international trend is toward more administrable, and regressive, consumption and labor taxes. a gugit might protect the progressive income tax and contribute to long term development of global markets with uniform tax rules free from the deadweight loss of resources to tax planning. the limited purpose of this paper has been to identify many of the global conditions that lend themselves to and to present a framework for gugit development. the paper’s recommendations are utopian or stimulate the u.s. economy. the concept, however, is that deferral traps the revenues offshore and only a rate reduction would free them for u.s. use. 237. supra note 8. 238. supra notes 25–26. 239. supra note 377. 240. see generally, roman seer & isabel gabert, mutual assistance and information exchange (amsterdam, 2010) (assembling and compiling national reports on exchange of information and mutual assistance in tax matters from various european jurisdictions and the united states for the 2009 meeting of the european association of tax law professors). 418 florida tax review [vol. 14:9 dystopian depending upon the impact that a gugit might have on the individual reader. florida tax review volume 12 2012 number 7 citizens united, tax policy, and corporate governance by michael a. behrens* i. introduction ................................... ....... 590 ii. why tax-motivated campaign interventions pose a special threat to corporate governance.........594 a. background: citizens united and corporate governance ................................ 594 b. the dangers to corporate governance of tax-motivated corporate political speech ............... ...... 597 1. why tax is particularly divisive among corporate constituents ............. ..... 597 2. why corporations are likely to pursue corporate political interventions ..... ...... 605 3. what an increase in tax-motivated corporate campaign interventions means for corporate governance .......................... 611 iii. how the market can solve the problem of taxmotivated corporate campaign interventions but only with strengthened campaign finance disclosure laws ...................................... ........ ........... 617 a. potential legislative and regulatory responses .............. 617 b. how the market can solve the problem: proxy advisory firms.................. ....... 621 c. the need for adequate disclosure laws .......................... 626 iv. conclusion .............................................. 628 * law clerk, the hon. kim mclane wardlaw of the united states court of appeals for the ninth circuit, 2011-2012; b.a., uc berkeley; j.d., ucla school of law. starting in fall 2012, the author will be an associate at irell & manella in los angeles. thanks to professor steven a. bank of the ucla school of law for his insight and invaluable comments on this article, and to my wife, amy atchison, and my daughters keiko and charlotte, for their love and support. 589 florida tax review i. introduction in the wake of the supreme court's recent, controversial decision in citizens united v. federal election commission,l consider the following scenarios involving corporate tax policy and elections: 1. two political candidates face off in an election. candidate #1 wants to cut the corporate dividend tax rate.2 candidate #2 opposes the dividend tax cut, but has privately promised the managers of corporation a, which is in his district, his support for firm-specific business tax subsidies. the managers support candidate #2, who wins. the subsidies effectively lower corporation a's corporate tax rate, swelling the corporation's treasury. the managers use the high dividend tax rate as an excuse not to distribute these earnings. they end up squandering the retained earnings on costly, self-interested corporate projects that misfire. 2. in the same election, candidate #1 wants to slash or eliminate the dividend tax. the firm's managers, founding family, and a private equity group hold large amounts of stock in corporation b. the majority shareholders, however, are institutional investors such as mutual funds and pension plans that desire high share value. the corporation supports candidate #1, who wins and votes to lower the dividend tax rate. the managers, founding family, and private equity investors proceed to bleed the company dry with large dividends. the company's share price plummets, lowering the value of the other shareholders' investments. 3. in the same election, candidate #2, who opposes the dividend rate cut, is also pro-union. the managers of corporation c wish to undertake a corporate asset sale that requires shareholder approval. a tax-exempt union pension plan wants the corporation to support candidate #2. the pension plan colludes with other tax-exempt institutional investors, such as a university investment fund, to trade votes for the asset sale for the?corporate managers' intervention in 1. 130 s. ct. 876 (2010). 2. or, in a nod to current events, to keep the dividend rate at the 2003 bush tax cut levels beyond the current extension to december 31, 2012. see infra note 32. 3. in this scenario, the shareholders lose out in three ways: (1) the specific dividends that this firm might otherwise have paid; (2) a tax reduction on all of their dividend-paying shares held; and (3) their investment in this particular firm after the managers have run it into the ground. [vol. 12:7590 citizens united & tax policy the campaign in favor of candidate #2.4 candidate #2 wins and votes to keep the dividend tax rate high. corporation c's majority shareholders are taxed on their dividends at a higher rate than they 4therwise would have been. these scenarios illustrate the ways in which the citizens united decision might enable corporations to stage tax-motivated campaign interventions that benefit certain corporate stakeholders at the expense of others. 5 the court's holding that certain restrictions upon corporate political speech violate the first amendment, while representing an incremental change to existing law, essentially removed limitations upon the exercise of political speech by corporations.6 the court's decision drew immediate criticism from those concerned that corporate discourse would come to dominate the political process. other observers were offended by the supreme court's basic premise in reachin§ its holding that corporations, like individuals, possess free speech rights. it is this premise that gives rise to the subject of this paper, but in a slightly different context. after all, a key difference separates corporations and individuals. an individual speaks only for himself or herself when exercising the right to free speech. in contrast, a corporation is a legal construct that apportions power among shareholders, the board of directors, 4. the university fund might support the pro-union candidate for political reasons, or might be willing to horse-trade with the union pension fund in return for a special benefit e.g., a favorable position in upcoming negotiations with its unionized workers. in any case, the university fund's costs in such a transaction are nil since it too is tax-exempt. 5. professor theodore seto uses the phrase "campaign intervention" to describe corporate political speech undertaken during a political campaign in favor of a particular candidate. see theodore seto, keeping tax-subsidized corporate money out of politics, 127 tax notes 1476, june 28, 2010 [hereinafter seto, corporate money]. 6. citizens united v. fed. election comm'n, 130 s. ct. 876, 885 (2010). 7. see floyd abrams, citizens united and its critics, 120 yale l.j. online 77, 78 (2010), http://www.yalelawjournal.org/the-yale-law-journal-pocketpart/constitutional-law/citizens-united-and-its-critics/ (quoting legal philosopher and scholar ronald dworkin as blaming the citizens united decision on the court's "instinctive favoritism of corporate interests"). 8. see editorial, unbound: the supreme court undermines convoluted campaign-finance rules, the economist, jan. 30, 2010, at 39, 39. ("another criticism. [of the decision] is that the supreme court is treating corporations like people."). 2012] 591 florida tax review and corporate managers in the process known as corporate governance.9 thus, a corporate campaign intervention, inasmuch as it involves the corporation "speaking" with one voice, cannot help but involve corporate governance issues. these issues encompass, but are not limited to, the well-known "agency cost" problem. the -most vexing issues in corporate law result from the separation between ownership and control of large corporations.10 traditionally, an agency cost problem arises when the goals of the corporation's managers (the agents) diverge from those of the shareholder owners (the principals) because of managerial self-interest and opportunism.11 on this view, the corporate governance fear raised by citizens united-enabled corporate campaign interventions is that the managers might conduct interventions that serve their own interests, not those of the shareholders who "own" the company. indeed, the dissent in a prior decision regarding corporate political speech, first nat'1 bank of boston v. bellotti, discussed corporate governance problems at some length in arguing that the state has a strong interest in assuring that shareholders are not forced to choose between their investment and their political views.12 thus, the dissent in bellotti averred that corporate governance issues arose only when the corporation engaged in speech on political and social issues, suggesting that speech intended to merely improve the corporation's economic position would not trigger such problems. while not denying the seriousness of concerns regarding the political agency cost of such speech, this paper chooses to focus on a separate issue. it examines whether corporate political speech intended to further economic gain poses a special and potent threat to corporate governance within the "speaking" corporation. in so doing, i have chosen to examine this issue through the lens of a particular economic issue: tax. this is for two reasons. 9. see iman anabtawi & lynn stout, fiduciary duties for activist shareholders, 60 stan. l. rev. 1255, 1257 (2008) [hereinafter anabtawi, fiduciary duties]. 10. see jennifer arlen & deborah m. weiss, a political theory of corporate taxation, 105 yale l. j. 325, 327 (1995) [hereinafter arlen, political theory]. 11. see steven a. bank, tax, corporate governance, and norms, 61 wash. & lee l. rev. 1159, 1165 (2004); mihir a. desai & dhammika dharmapala, tax and corporate governance: an economic approach, in tax and corporate governance 13, 14 (wolfgang schben, ed., 2008) [hereinafter desai, an economic approach]. 12. see first nat'1 bank of boston v. bellotti, 435 u.s. 765, 812 (1978) (white, j., dissenting). 13. id. 592 [vol. 12:7 citizens united & tax policy first, as this paper will show, tax issues are particularly divisive between managers and shareholders, thus providing fertile ground for potential agency cost issues. additionally, the connection between tax and corporate governance has a distinguished history. adolfe berle and gardiner means were motivated to study the separation of ownership and control in the modern corporation because of the role of tax in changing the ownership patterns of corporations.14 tax considerations continue to lurk as a primary motivation behind many corporate decisions. the wall street journal recently reported that tax considerations lay behind a "divide" on wall street between private equity-controlled corporations and publicly traded companies regarding the payout of dividends to investors.15 moreover, in the wake of citizens united, corporations are likely to engage in political speech. empirical data from the 2010 midterm elections show firms beginning to exercise their newfound speech rights.16 moreover the promise (or threat) of campaign interventions on behalf of incumbents also presents corporations with a powerful new tool in lobbying efforts. in addition, this paper predicts that due to the risks and rewards inherent therein, corporate managers will be most likely to engage in corporate political speech in support of corporate tax breaks a tax reduction strategy that at least in theory poses a particular risk of agency costs. therefore, this paper will endeavor to show not only that corporate political speech is indeed likely to occur in the wake of citizens united, but that the tax initiatives corporate managers will be likely to pursue through such political speech increases the risk of agency costs and by extension the probability of corporate governance problems at our nation's firms. to address such a problem, this paper proposes a solution with both legal and extralegal components: (1) state and perhaps federal regulation requiring disclosure of corporate speech, including contributions to intermediary groups that participate in political speech, which will in turn enable (2) monitoring of corporate political speech by third-party gatekeepers such as proxy advisory firms. in response to a robust investordriven market for information, such third-party monitors already scrutinize corporations for symptoms of weak governance, and could easily expand their role to monitor the corporate governance implications of tax-motivated campaign interventions. moreover, the holistic approach taken by proxy advisory firms, which attempts to analyze corporate action in the context of 14. see desai, an economic approach, supra note 11, at 13. 15. carrick mollenkamp, et al., dividend rock: firms reward buyout bosses, wall st. j., oct. 14, 2012, at cl. 16. see infra part ii.b.2. media reports on the 2012 presidential primary campaign, primarily focusing on the rise of so-called "super pacs," also support this conclusion. see infra note 77. 2012] 593 florida tax review each particular firm, is superior to an outright ban on corporate tax benefits received as a result of campaign intervention, which will be over-inclusive since not all exercises of corporate political speech will necessarily reflect a corporate governance problem. the stakes have never been higher for corporate governance. the 2007 financial crisis, which nearly destroyed the u.s. financial system, has been widely attributed to a runaway culture of greed and self-interest among corporate officers, particularly ceos.n now, citizens united has given corporations a powerful new tool corporate political speech with which to pursue matters "of special interest" to them.1 8 should exercise of this newfound constitutional right exacerbate corporate governance problems as this paper argues, a pernicious cycle could be created in which the corporate money flooding public discourse reflects an ever-more self-interested minority. as the financial crisis of 2007 warns us, the consequences of such a development could be disastrous. part ii of this paper will examine both why tax issues are particularly divisive as among corporate stakeholders, and why corporations are likely to intervene in political elections in order to gain favorable tax treatment. part iii will argue why the market, through external monitoring by gatekeepers such as proxy advisory firms, possesses the capability to address this problem but only if campaign finance disclosure laws are bolstered. in the process, it will examine and reject several other possible responses to the problem. part iv will conclude. ii. why tax-motivated campaign interventions pose a special threat to corporate governance a. background: citizens united and corporate governance in its decision in citizens united v. federal election commission,19 the supreme court held that independent expenditures by corporations were protected political speech, reversing prior court precedent.20 specifically, the 17. see kathyrn j. kennedy, excessive executive compensation: prior federal attempts to curb perceived abuses, 10 hous. bus. & tax l. j. 196, 242 (2010) (quoting then-senator barack obama on the campaign trail in 2008: "[w]hat we need to do is restore balance to our economy . .. [and] hold ceos accountable, and make sure they're acting in a way that's good for their company, good for our economy, and good for america, not just good for themselves.") [hereinafter kennedy, excessive executive compensation]. 18. seto, corporate money, supra note 5, at 1476-82. 19. 130 s. ct. 876 (2010). 20. see, e.g., austin v. mich. state chamber of commerce, 494 u.s. 652, 655 (1990) (upholding restrictions on corporate campaign expenditures in state [vol. 12:7594 citizens united & tax policy decision appeared to ease two significant restrictions on corporate political speech under federal law. before citizens united, the federal elections campaign act had prevented corporations and unions from using general treasury funds to spend money to influence federal elections.21 following the decision, corporations and unions may now make such expenditures, including funding express advocacy messages those calling for the election or defeat of a particular candidate so long as those expenditures are independent, meaning that they are not coordinated with the candidate's -22campaign. citizens united also invalidated restrictions under the 2002 bipartisan campaign reform act that prevented corporations from using general treasury funds either to pay for messages calling for the "election or defeat of candidates [that is, express advocacy] or to broadcast electioneering communications within thirty days of a primary election and sixty days of a general election." 23 "electioneering communications" are messages that specifically identify a candidate for federal office but do not necessarily call for defeat or election of that candidate.24 thus, under citizens united, corporate and union treasuries may now fund express advocacy and electioneering communications throughout the election process. the effect of the court's decision was to remove "effective limits on corporate participation in politics.' 25 in first nat'1 bank of boston v. bellotti, a previous supreme court decision on the subject of corporate political speech, justice white's dissent had acknowledged the corporate governance issues inherent in corporate campaign interventions, primarily in the context of forcing shareholders to choose between their investment and their political views. this appeared to reflect the recognition that corporations, unlike individuals, are legal entities composed of several constituencies, and that any corporate action by its elections), overruled by citizen united v. fed. election comm'n, 130 s. ct. 876 (2010). 21. see r. sam garrett, campaign finance policy after citizens united v. federal election commission: issues and options for congress, congressional research service 2 (2010) [hereinafter garrett, campaign finance policy]. 22. id. 23. citizens united, 130 s. ct. 876, 897 (2010). 24. see garrett, campaign finance policy, supra note 21, at 1. 25. seto, corporate money, supra note 5, at 1476-82. it should be noted that the ban on direct contributions by corporations and unions to candidate committees, party committees, and political action committees remains in place. 2 u.s.c. § 441(b) (2002). 26. see first nat'l bank of boston v. bellotti, 435 u.s. 765, 812 (1978) (white, j., dissenting). 5952012] florida tax review nature therefore involves governance issues. even justice white, however, appeared to assume that those concerns would not apply to corporate political speech that pursued the purported economic self-interest of the corporation itself.27 such a point of view appears to assume that corporate economic interest is monolithic. however, nearly from the beginning, corporate legal scholarship has been preoccupied with the possibility of divergent economic interests among corporate constituents. specifically, corporate scholars have recognized the potential "agency costs" inherent in ownership's delegation of authority to corporate managers.28 in their seminal book adolf berle and gardiner means were the first to note the growing separation of ownership and control.29 berle and means worried that when dispersed shareholders delegated control of the corporation to managers, the resulting agencyprincipal relationship might result in managers using their authority to pursue their own interests rather than those of ownership. for example, managers might seek benefits not shared by shareholders, such as executive compensation or job security. 30 the costs to ownership of these benefits would be considered agency costs, representing inefficiency to the overall corporate entity. since corporate political speech does not require shareholder approval, the question then becomes whether corporate managers' use of corporate political speech could result in economic agency costs. that is, just as the dissent in bellotti worried that unrestricted corporate political speech could pose an agency cost to shareholders by allowing managers to convey political or ideological messages that were not necessarily those of shareholders, does citizens united-enabled corporate political speech also raise the risk that managers might pursue economic interests not shared by ownership? this paper argues that it likely will, at least where one specific issue is concerned:'corporate tax policy. 27. id (arguing that "overriding" interest in restricting corporate political expenditures is "assuring that shareholders are not compelled to support and financially further beliefs with which they disagree where, as is the case here, the issue involved does not materially affect the business, property, or other affairs of the corporation." (emphasis added)). 28. see, e.g., steven a. bank, corporate managers, agency costs, and the rise of double taxation, 44 wm. & mary l. rev. 167, 188 (2002) [hereinafter bank, corporate managers] (paraphrasing the observations of berle and means in this area). 29. see generally adolf a. berle, jr. & gardiner c. means, the modern corporation and private property (1932). 30. see bank, corporate managers, supra note 28, at 188 (summarizing berle and means' specific concerns regarding what came to be known as agency costs). 596 [vol. 12:7 citizens united & tax policy b. the dangers to corporate governance of tax-motivated corporate political speech tax-motivated corporate campaign interventions pose an increased risk of agency cost problems for two, and perhaps three, reasons. first, due to the peculiar structure of corporate tax, notably the corporate "double tax," tax issues are particularly divisive as between corporate constituents. second, even if corporate-funded campaign ads remain a relatively rare scenario and the empirical evidence from the 2010 midterm elections suggests otherwise campaign interventions provide a powerful new source of leverage with which corporations can supplement their extensive lobbying efforts for tax advantages. finally, this paper argues that the types of tax advantages corporations are most likely to pursue through campaign interventions those in pursuit of corporate tax breaks pose particular risks of agency costs to shareholders and other corporate stakeholders. 1. why tax is particularly divisive among corporate constituents understanding the different interests between managers and shareholders when it comes to tax begins with the nature of the corporate "double" tax. corporate income is subject to two layers of tax. first, it is taxed at the corporate income level, with a maximum rate of 35 percent for income over $10 million.31 second, upon distribution as a dividend, corporate income is taxed again at the individual level currently, at the capital gains rate through december 31, 2012.32 hence, a "double tax" because corporate income is taxed both at the entity and shareholder levels. corporate tax scholars and policymakers have long been interested in the intersection of corporate governance and tax. one line of thought concerns itself with the risk of managerial opportunism posed by tax reduction or avoidance at the entity level. of course, such reduction or avoidance increases profits, and not every case of tax avoidance represents a corporate governance issue if the tax savings pass directly from the government to shareholders. however, to some observers these increased profits pose a corporate governance concern. specifically, a key worry is that lower corporate rates.or deductions and credits at the entity level could also allow large reservoirs of retained earnings to accumulate in the corporation. 31. i.r.c. § 11(b)(1)(d). 32. i.r.c. § 1(h)( 1); see also the tax relief, unemployment insurance reauthorization, and job creation act of 2010, pub. l. no. 111-312 § 101(a), 124 stat. 3296 (2010) (extending the sunset of section 901 of the economic growth and tax relief reconciliation act of 2001 for two years by replacing "december 31, 2010" with "december 31, 2012").2012] 597 florida tax review this could tempt managers to retain some measure of increased profits due to reduced taxes for themselves or to shunt them into nonproductive uses, which may itself represent a certain type of rent-seeking. such concerns increased in the 1930s after the stock market crash of 1929 and the ensuing. great depression, as the federal government focused on patrolling corporate governance through the tax code.34 more recently, the bush dividend tax cut of 2003 was justified publicly as a way to police corporate governance by encouraging the distribution of dividends, which would "promote a more efficient allocation of capital and give shareholders, rather than executives, a greater degree of control over how a company's resources are used." 35 as suggested by the preceding paragraph, a second level of taxation at the shareholder level therefore may give rise to a divergence between manager and shareholder interests in maintaining such a tax. scholars have noted that the second level of taxation may provide "a disincentive for shareholders to demand higher dividends or to investigate further a board's decision to reinvest profits in the business," 36 because individual shareholders will not wish to pay a significant tax on their dividends. thus, because they wish to retain profits or to avoid a certain level of monitoring, managers might have an interest in allowing the shareholder tax to persist, 33. see desai, an economic approach, supra note 11, at 1; steven a. bank, from sword to shield: the transformation of the corporate income tax, 1861 to present xxvi (2010) [hereinafter bank, sword to shield]. a nonproductive use of profits may benefit managers if they derive a personal benefit from the project for instance, if it allows them to solidify and expand their power and authority. see also reuven avi-yonah, the story of the separate corporate income tax: a vehicle for regulating corporate managers, in business tax stories 11, 12 (steven a. bank & kirk j. stark, eds., 2005) ("imposing a corporate tax that reduces the economic resources available to corpbrate managers also reduces the power of corporate management.") [hereinafter avi-yonah, the separate corporate tax]. 34. see bank, sword to shield, supra note 33, at xxvii. 35 joint economic committee, dividend tax relief and capped exclusions 1 (2003), http://www.jec.senate.gov/republicans/public/?a=files.serve &file_id=c5aac286-ad96-4e04-bcdb-6ba3970231a9 (commenting on the bush proposal); cf dep't of the treas., general explanations of the administration's fiscal year 2004 revenue proposals 4 (jan. 2003), http:// www.treasury.gov/resource-center/tax-policy/documents/bluebk03.pdf (advocating eliminating the double tax on corporate earnings on the basis that "[tihe bias in the current system against paying dividends can result in a reduced pressure on corporate managers to make the most efficient use of retained earnings, because corporate investments funded by retained earnings may receive less scrutiny than investments funded by new, outside sources of capital.") . 36. bank, sword to shield, supra note 33, at xxvi. 598 [vol. 12:7 citizens united & tax policy and correspondingly little motivation to pursue an "integration"3 7 of the entity and shareholder level taxes. indeed, in exploring the "puzzling" persistence of the double tax despite widespread support for integration from academics, policymakers, and the public, jennifer arlen and deborah weiss argue that this lack of incentive amounts to an agency cost problem.39 in their seminal article, arlen and weiss posited two diver ences in interest between managers and shareholders regarding integration. the first is that while both shareholders and managers gain from new investments, only shareholders gain from increased gains on old investments. since the current dividend tax at the time of purchase is "baked in" to the price that a shareholder paid for shares, any reduction or elimination of the dividend tax represents a windfall on existing investment.41 thus, shareholders should support integration. managers, meanwhile, benefit more from policies that increase aftertax profits on new investment, such as accelerated depreciation or investment tax credits.42 this is because the greater profitability of projects allows them to expand the corporation, thus increasing their power and authority. the second reason for managerial bias against integration posited by arlen and weiss was the previously discussed theory that the double tax traps retained earnings in the corporation. this allows managers greater freedom to pursue investment, which may afford them benefits not necessarily shared by ownership if the investments they pursue are nonproductive and selfserving. for example, more recent observers have elaborated on this point by noting that managers prefer to fund investment with retained earnings rather than debt or equity because of the increased monitoring and expense that commonly accompanies the latter forms of financing.44 37. arlen, political theory, supra note 10, at 326 ("congress regularly considers legislation to eliminate the double tax by integrating the personal and corporate taxes into a single system."). 38. id at 327. 39. see generally arlen, political theory, supra note 10. 40. id at 327. 41. id. at 338. 42. arlen and weiss suggest that holders of existing equity are actually hurt by new investment, in part because a firm's increased investment can lower share value. see id. at 339-40. for an example of this dynamic at play in today's economy, see geoffrey a. fowler, costly sales growth for amazon, wall st. j., oct. 22, 2010, at bi (noting that the online retail giant's expansion has "spooked" some investors and share prices fell 3.8 percent in after-hours trading after the release of financial reports reflecting increased spending). 43. arlen, political theory, supra note 10, at 327. 44. see bank, corporate managers, supra note 30, at 199 n.182 ("financing projects internally avoids [external financing] monitoring and the possibility the funds will be unavailable or available only at high explicit prices." 2012] 599 florida tax review since arlen and weiss wrote in 1985, the recognized heterogeneity of tax interests applicable to various corporate constituents has only increased, complicating arlen and weiss' classic agency-cost theory of the politics behind integration proposals.45 observers have noted that the agency cost model fails to account for differences among managers or among shareholders when it comes to tax positions.46 for example, consider the differing tax positions of managers who hold large amounts of their firm's stock and those whose compensation is primarily in stock options. managers who own significant amounts of their own firm's stock would benefit personally from a reduction or elimination of the dividend tax (assuming dividends were paid). however, managers with stock options would not benefit and would in fact be harmed by such a reduction (if accompanied by a corresponding increase in distributions) because their options would now be worth less.47 studies on the effect of the 2003 bush dividend rate on firm dividend policies confirmed the intuition that managers might act on these personal tax preferences. the studies found a correlation between high dividend payouts at a firm and executive or director ownership of stock in that firm. conversely, firms where executives were paid in stock options were less likely to distribute dividends, even after the dividend rate cut.4 9 one could easily imagine managers acting upon these same personal tax preferences in confronting the question of whether to support integration. as integration commonly involves a reduction or elimination of the dividend rate, managers with significant personal holdings of stock will stand to benefit personally from integration. those paid primarily in options will (quoting michael c. jensen, agency costs of free cash flow, corporate finance, and takeovers, 76 am. econ. rev. 323, 323 (1986))). 45. see generally michael doran, managers, shareholders, and the corporate double tax, 95 va. l. rev. 517 (2009) [hereinafter doran, corporate double tax]. doran uses this heterogeneity of tax positions to argue against arlen and weiss's classic agency cost theory regarding the persistence of the double tax in favor of a more "nuanced" view of the problem with managers on either side of the integration issue. id. at 523. 46. id. at 523. 47. this is due to the fact "that the option is now worth less because the company's stock value per share has declined by the amount of the dividend distributed." steven a. bank, dividends and tax policy in the long run, 2007 u. ill. l. rev. 533, 551 n.125 (2007) [hereinafter bank, dividends and tax policy]. 48. id. at 552 (citing raj chetty & emmanuel saez, dividend taxes and corporate behavior: evidence from the 2003 dividend tax cut, 120 q.j. econ. 791 (2005)). 49. id. at 551. 600 [vol. 12:7 citizens united & tax policy not.50 these differing tax positions among managers points out the fact that managerial interests are not as monolithic as classic agency cost theory might assume. it could, of course, be pointed out that differing tax positions among managers doesn't pose a corporate governance issue if those managers are at different firms. for example, if controlling managers at corporation a are paid in stock and those at corporation b are paid in options, this differential in tax positions has no effect on the tax-related internal corporate governance issues at each firm. moreover, since the managers at corporation a at least theoretically now share the same tax position as their shareholders regarding integration, corporate governance concerns have lessened in the aggregate, since there will be at least one less corporation with agency cost issues in this specific tax area. however, it is possible that managers at the same firm may hold differing personal tax positions. to continue with the example of stock versus option-based compensation, some managers at corporation a might be compensated largely in cash and stock, while others are compensated largely in cash and stock options. these differing tax positions (at least regarding the reduction or elimination of the dividend tax) could give rise to what at least one corporate scholar has called "squabbling costs." 51 originally envisioned in terms of divergent interests among shareholders, squabbling costs occur when corporate constituents with different preferences seek to influence management to adopt a course of action that benefits their particular position. in the context of shareholders, squabbling "consumes resources that have a positive opportunity cost elsewhere in the economy simply by attempting to shuffle wealth." 52 the concept of squabbling costs can be applied to corporate managers as well. just as activist shareholders can consume resources by attempting to influence management, managers can consume firm resources by "squabbling" over a particular course of action, such as support for integration. such conflict-could take place either among executives or board 50. in the wake of the 2007 financial crisis, executive compensation reform efforts seem to be focusing on converting the bulk of performance-based executive compensation from stock options back to restricted stock, on the theory that stock encourages more long-term thinking and better aligns managerial incentives with those of shareholders. see, e.g., sanjai bhagat & roberta romano, reforming executive compensation: focusing and committing to the long-term, 26 yale j. on reg. 359, 360-61 (2009) (arguing that altering the form of executive compensation to restricted stock would "better align [managerial] incentives with investor interest"). 51. iman anabtawi, some skepticism about increasing shareholder power, 53 ucla l. rev. 561, 577 (2006) [hereinafter anabtawi, increasing shareholder power]. 52.id. 2012] 601 florida tax review members who hold varying tax positions, or conceivably between executives and the board if each group holds a different tax position. in either case, such "squabbling" could consume resources and result in opportunity costs. thus, squabbling represents a corporate governance problem. the heterogeneity of tax positions among corporate constituents is not limited to divergences between the' interests of managers and shareholders, and among managers. the divisiveness of tax issues among shareholders may pose an even greater threat to corporate governance. in general, the power of activist or institutional shareholders to effect corporate policy has been increasing. 53 as corporate ownership has been increasingly concentrated in institutional shareholders such as corporate and union pension funds, mutual funds, and hedge funds, 54 these institutional or "activist" shareholders have become increasingly emboldened to directly or indirectly influence management. 55 an example of indirect influence is the rise of proxy advisory firms that advise institutional shareholders on corporate governance issues. through their monitoring of corporations, firms such as riskmetrics group have become important corporate governance players in their own right.56 this paper will explore one implication of this fact below. more perniciously, evidence exists that management will sometimes negotiate directly with powerful institutional shareholders, engaging in a quid pro 51uo arrangement in order to win approval for management initiatives. such an arrangement, sometimes referred to as "greenmail," undercuts the usual shareholder "majority rule" standard of corporate governance. this evidence of coercion or collusion between powerful, institutional or activist shareholders and management shows that divergent interests between shareholders may indeed pose a significant threat to corporate governance. to understand how interests between types of shareholders may diverge according to their tax positions, it is first helpful to understand how shareholder interests may differ generally. observers have identified a 53. see anabtawi, increasing shareholder power, supra note 51, at 583 (discussing former corporate raider carl icahn's use of a hedge fund coalition to "pressure companies to make dramatic structural changes"). 54. see id. at 579 ("continuing growth in mutual fund and hedge fund holdings has generated a significant focus on short-term stock prices."). 55. id. at 598. 56. kennedy, excessive executive compensation, supra note 17, at 203 (noting that in the wake of the financial crisis of 2007, shareholder scrutiny of executive compensation has increased, and "[a]s a result, more companies pay greater attention to the [riskmetrics group] guidelines regarding shareholder votes"). 57. anabtawi, increased shareholder power, supra note 51, at 596-97. [vol. 12:7602 citizens united & tax policy number of such ways in which shareholder interests may diverge. for instance, shareholders may be short-term or long-term holders of stock. a short-term shareholder endeavors to profit from a stock's increase in value over quarterly or annual periods, while a long-term shareholder is more concerned with the classic goal of maximizing long-term shareholder value over years.59 a hedge fund investor provides an example of a short-term shareholder, while pension funds and insurance companies are generally longer-term shareholders. 60 another major difference between shareholders involves the degree to which they are diversified. corporate scholars have noted that the "institutionalization" of u.s. shareholdings means that most stock market investors possess widely diversified portfolios.61 these diversified shareholders can be contrasted with shareholders such as managers or firm founders who have large proportions of their stock bound up in a specific firm.62 generally, the interests of diversified and undiversified shareholders are likely to diverge in the area of risk preference.63 observers have pointed out that diversified shareholders will prefer projects that pose a higher risk but a greater expected return, because they are insulated against the risk of the project's failure by their other holdings. in contrast, undiversified shareholders will be more likely to pursue less risky projects with a comparatively lower expected return, because they cannot offset the risk.6 this difference in risk preferences will be explored at greater length below. a third difference between shareholders involves whether they hold political or institutional affiliations that may provide them with noneconomic motivations. union pension funds and public pension funds are examples of such shareholders. observers have noted that public pension funds are under pressure to engage in investments that promote in-state economic development.6 5 labor union pension funds pose an even greater concern in this arena. in a much remarked-upon instance early in the 2000s, the california public employees' retirement system (calpers) intervened in a labor dispute between safeway, inc., and the united food and commercial workers union (ufcw).66 calpers, which owned $75 million in safeway stock, pressured safeway to give in to the ufcw's demands, and after the 58. id. at 579. 59. id. 60. id. at 580. 61. id. at 583. 62. id. at 584. 63. id. at 585. 64. id. 65. id. at 589. 66. id. at 590. 2012] 603 florida tax review strike campaigned against the re-election of safeway's ceo.67 as this example shows, noneconomic motivations can lead powerful shareholders to support actions that need not necessarily bolster firm value. tax issues are likely to exacerbate these general divergences of interest between shareholders. for instance, a state pension fund might seek to foster economic development within their particular state. states often seek to foster economic development with tax breaks to businesses.68 state pension funds are also exempt from income tax.69 therefore, a state pension fund could push for corporate action to bring about greater business tax breaks in its state, while remaining indifferent to corporate action that might bring about integration (or a lower dividend tax rate). similarly, union pension funds could push for corporate action that favors organized labor. as in the safeway case mentioned above, such action might not serve the economic interests of other corporate stakeholders. however, the addition of tax considerations deepens the conflict. for example, union pension funds are tax-exempt. because it stands to suffer no adverse tax consequences, a union fund might be more likely to push for a corporation to support a prounion political candidate who has also taken a political stand against a dividend rate cut. 70 67. id. 68. see, e.g., todd wallack, jobs program lost its way-and tax money, boston globe, mar. 14, 2010, at al ("over the past 16 years, massachusetts has given away hundreds of millions of dollars in state and local tax breaks for more than 1,300 development projects under its economic development incentive program, which aims to encourage companies to invest [in the state] and create jobs."); greg leroy et al., protecting public education from tax giveaways to corporations, 27 st. tax notes 975, 978 (2003) ("for some time, corporations have been persuading state legislatures, county boards, and city councils to lower businesses' taxes to foster a better 'business climate."'). 69. bank, dividends and tax policy, supra note 47, at 550 ("[b]oth pension funds and nonprofits are tax-exempt and therefore subject to zero rate taxes on both dividends and capital gains."). 70. this scenario, while hypothetical, may be likely because pro-union candidates tend to be toward the left end of the political spectrum, a position also associated with antagonism toward "tax breaks" for the wealthy. notwithstanding the rise of institutional shareholders such as mutual funds, shareholders of corporations are still often perceived to be wealthy individuals. see daniel n. shaviro, decoding the u.s. corporate tax 62 (2009) ("[m]any of the people who support [the corporate income tax] . . . do so on the view that it is an indirect way of increasing how the overall tax burden falls on rich people, such as those with extensive shareholdings.") [hereinafter shaviro, u.s. corporate tax]; bank, sword to shield, supra note 33, at xv ("some have countered [criticisms of the corporate tax] by suggesting that the corporate income tax supplements the progressivity of the individual tax system by targeting wealthy shareholders."). [vol. 12:7604 citizens united & tax policy while the heterogeneity of shareholders and their individual tax positions precludes drawing categorical conclusions about such potential conflicts, the larger point remains that the rise of institutional shareholders, with its concentration of power in fewer parties holding larger blocks of stock, increases the likelihood of conflict between such shareholders to the extent that they hold, and seek to advance, different interests. 1 as discussed above, these differing interests can include dissimilar tax positions. 2. why corporations are likely to pursue corporate political interventions this article has thus far examined the reasons for the particular divisiveness of tax issues among corporate constituents. therefore, it follows that tax-motivated corporate campaign interventions, if they occur, may be particularly likely to involve agency costs or other corporate governance issues. but will such corporate campaign interventions occur? this is ultimately an empirical question the answer to which may reveal itself more fully to corporate scholars in the wake of citizens united; below this paper will discuss some data from recent elections, including the midterm elections of 2010 and the republican presidential primaries of 2011-2012. however, even without a full range of empirical data, it seems reasonable to predict that corporate managers will consider corporate political speech a viable complement to lobbying in pursuing legislative goals. in a sense, corporate campaign interventions undertaken to reduce a firm's tax burden are analogous to tax avoidance strategies, and cost/benefit analysis from the literature dealing with such strategies may be helpful here. before introducing the concept of divergent risk/reward profiles among managers and shareholders, it might be useful to inquire whether corporations would pursue political speech in a world where no such divergences existed that is, in a world where the interests of managers and shareholders were perfectly aligned. in this world, our inquiry premises itself upon the notion that a tax avoidance strategy benefits a corporation if the return from the strategy outweighs its cost not just in dollars, but other factors such as loss of goodwill and risk of economic sanctions such as politically-motivated boycotts.72 71. cf anabtawi, increasing shareholder power, supra note 51, at 573-74 (noting how increasing shareholder power "might encourage [institutional] shareholders to use their greater voice to advance their private interests at the expense of their common shareholder interests"). 72. see nicola sartori, effects of strategic tax behaviors on corporate governance 15-20 (2008) (unpublished manuscript) http://papers.ssrn.com/sol3/ papers.cfi?abstract-id=1358930 [hereinafter sartori, strategic tax behaviors]. 2012] 605 florida tax review in seeking to examine whether corporate political speech will appeal to corporate economic self-interest in general, we can start with some general observations about the exercise of corporate political speech. in terms of the potential costs associated with tax-avoidance strategies, 73 corporate campaign interventions pose little risk of the classic direct sanctions (such as internal revenue service audit) associated with such strategies. direct cost (the dollar amount of the intervention) may be significant to some corporations, but given the wealth of most large corporations, it is unlikely to be a significant factor. the fact that single pieces of advertising may often play an outsized role in political campaigns the infamous "willie horton" spot, for instance indicate that corporations may be able to influence elections with relatively little outlay (the cost of a single campaign ad, while substantial to all but the wealthiest individuals, is assumed to represent a de minimis expense to the average large publicly traded corporation). 74 however, corporate political speech does pose risks of other kinds to the corporate speaker. under current campaign finance law, corporations must disclose to the federal election commission (fec) funds in excess of $10,000 spent on express advocacy and electioneering communications. 75 also under current campaign finance law, corporations or any other "person" engaging in express advocacy (calling for the election or defeat of a specific candidate) must "disclaim," or identify, themselves in the advertisement. 76 the 2010 midterm elections saw a number of intermediary groups such as the u.s. chamber of commerce, which is treated as a corporation under federal campaig finance law, funding political electioneering communications. since such groups may not have to disclose their donors 73. nicolas sartori identifies a number of costs associated with tax avoidance strategies, including direct costs, risk of sanctions or blowback, implicit tax costs, compliance costs, and agency costs. id. at 16-17. 74. the "willie horton" ad of the 1988 presidential election campaign was an independent spot showing a mug shot of an african-american convict named william horton who attacked a couple while free on a prison furlough program overseen by the democractic nominee, massachuetts governor michael dukakis. the ad helped to cement the image that dukakis was soft on crime, and the republican nominee, vice-president george h.w. bush, ended up winning the presidency. see paul farhi, two political ads share more than fame and controversy, the wash. post, sept. 7, 2004, at a2. 75. see garrett, campaign finance policy, supra note 21, at 10 (citing 2 u.s.c. § 441d(a)(3) (2003)). 76. id. at 6-7. 77. such intermediary groups are also associated with "super pacs," political groups that rose to prominence during the 2012 republican primary campaign in the wake of the citizens united decision and subsequent court rulings that allowed unlimited corporate and union contributions. super pacs may not coordinate directly with candidates but may spend for advertising and other activities [vol. 12:7606 citizens united & tax policy if they meet certain qualifications under the u.s. tax code, this presents a potential loophole for corporations to fund political speech anonymously.7 8 however, state laws may still require disclosure. 79 as target corporation found out in the last election cycle, such disclosure might provoke a negative reaction from consumers, activist groups, and shareholders, who disagree with either the notion of corporate political speech, or the particular candidate whom the corporation is supporting through its speech. target came under intense criticism and threat of boycott from activist groups after a state-law mandated disclosure of its contribution to a political nonprofit group that supported an anti-gay marriage gubernatorial candidate. the fact that the company's ceo later apologized publicly for the contribution and pledged to re-examine the corporation's campaign contribution policies demonstrates the seriousness with which large corporations treat any potential threats to their goodwill arising from such negative publicity.81 moreover, corporations might similarly fear shareholder unrest prompted by corporate political speech. shareholders could potentially object to a given campaign intervention on an issue at hand or to the general principle of corporate campaign interventions for instance, on grounds that at some point they might be forced to choose between their political that support them. morever, they must disclose their donors. this may be the reason why the new york times in february 2012 noted that "much of the money" raised by republican and democratic independent groups to that point in the republican primary season had flowed into intermediary groups affiliated with the super pacs, which are not subject to the same disclosure requirements. nicholas confessore and michael luo, secrecy shrouds 'super pac' funds in latest filings, new york times, feb. 1, 2012 at al (noting that many super pacs have "affiliates that are organized as nonprofit organizations known as 501(c)(4) groups, which can raise unlimited money but do not have to reveal their donors.") 78. garrett, campaign finance policy, supra note 21, at 7. 79. state disclosure laws, applicable to elections for state office, are often more stringent than federal disclosure laws. it was such a state law in minnesota that revealed target corp.'s donation to minnesota forward, a pro-business group. jeremy herb, minnesota a model in disclosure law, startribune, oct. 11, 2010, at 01a http://www.startribune.com/politics/104747019.html [hereinafter herb, minnesota model]. 80. see bill de blasio & wendy greuel, corporations hide election spending from the public eye, the nation, oct. 18, 2010, http://www.thenation.com/article/155432/corporations-hide-election-spendingpublic-eye [hereinafter blasio, corporations hide spending]. 81. see tom scheck, target ceo apologizes for donation to mn forward, mprnews, aug. 5, 2012, http://minnesota.publicradio.org/collections/special/ columns/polinaut/archive/2010/08/target ceoapol.shtml (posting the full text of target ceo's letter to target employees regarding the controversial donation). 2012] 607 florida tax review beliefs and their investment. some shareholders might have their own ideas about the political agenda the corporation should pursue. legal scholars have noted the rise of the corporate social responsibility movement among shareholders who wish the corporation to behave ethically as part of a larger duty to society.82 in either case, one of two things could happen, neither desirable to managers. displeased shareholders could sell their shares, although the effect of such a reaction upon overall share value might be difficult to predict. from a managerial perspective, however, an even greater problem might be posed if disgruntled shareholders engaged in proxy challenges or other forms of pressure on management, particularly if the displeased shareholders were powerful institutional or activist shareholders. the bottomline is that all corporate political speech, due to its public and controversial nature, poses some economic risk to the corporation engaging in that speech. given this, we might ask, why should corporations risk campaign interventions at all, particularly when an alternative means of influencing policy namely lobbying exists? corporations currently lobby intensely for beneficial legislation, spending over $3 billion on lobbying expenditures in 2008 alone.83 ninety-three corporations spent over $282.7 million lobbying for a single tax provision the "repatriation amnesty" of 2004.84 the reasons for such massive expenditures are obvious. unlike visible and public campaign interventions, lobbying takes place behind the scenes, in state capitols and washington, d.c., removed from local constituents who might look askance at hobnobbing between their representatives and wealthy corporations. lobbying is also highly effective in terms of its profitability. the ninety-three corporations that spent $282.7 million lobbying for the repatriation amnesty received a total of $62.5 billion in tax savings when the provision passed a return of $220 in tax savings for every dollar spent.85 moreover, legislators may already be highly motivated to parcel out business tax breaks in order to make their communities attractive to businesses and therefore attract jobs and investment a "race to the bottom" undertaken with the ultimate goal of reaping political rewards from local constituents. by this logic, lawmakers might need barely a nudge to support tax policies beneficial to corporations. moreover, lobbying on 82. see, e.g., sartori, strategic tax behaviors, supra note 72, at 10; see generally reuven s. avi-yonah, corporate social responsibility and strategic tax behavior, in tax and corporate governance 183 (wolfgang schon ed., 2008). 83. see raquel alexander et al., measuring rates of return on lobbying expenditures: an empirical case study of tax breaks for multinational corporations, 25 j.l. & pol. 401, 402 (2009) [hereinafter alexander, measuring rates]. 84. seto, corporate money, supra note 5, at 1476. 85. id. 608 [vol. 12:7 citizens united & tax policy specific issues reduces the need to secure a blanket promise from a politician ("i will lower corporate taxes") that the politician might find difficult to keep after the election. for these reasons, lobbying would seem to present a less risky and more attractive alternative to campaign interventions. while no one is asserting that campaign interventions will replace lobbying as the primary means by which corporations will seek to advance their interests in the political realm, we should still be concerned about corporate campaign interventions, for several reasons. first, the empirical evidence from the 2010 midterm elections suggests that in the wake of citizens united, corporations have indeed increased their exercise of political speech. as of october 18, 2010, independent political groups had spent $80 million in the midterm elections more than five times the amount such groups spent in the previous mid-term elections.86 other sources have put the amount far higher.8 7 due to disclosure limitations, it cannot be conclusively affirmed that these donors were corporate. however, anecdotal evidence suggests that much of the money did come from corporations or unions for instance, the target revelation (prompted by a state disclosure law) and the disclosure in the new york times that the ceo of one of the country's leading ethanol companies was a major funder behind an independent group spending heavily in races where candidates had seats on legislative committees dealing with ethanol policy. progressive media sources such as the new york times and the nation have charged that many of the dollars came from corporations, a claim that more conservative commentators do not dispute.89 thus, the evidence from the 2010 midterm elections seems to indicate that in the wake of the supreme court's decision, corporations have indeed increased campaign interventions. second, while many large corporations may indeed be deterred by possible disclosure of campaign contributions that alienates shareholders and consumers such as occurred with target, other corporations may not be as concerned with consumer and shareholder relations. a corporation may not manufacture products for the consumer sector and so may be less concerned 86. see blasio, corporations hide spending, supra note 80. 87. see, eg., editorial, drowning in campaign cash, n.y. times, oct. 30, 2010, http://www.nytimes.com/2010/10/31/opinion/31suni.html (claiming that as of october 30, 2010, independent groups had spent $280 million in the 2010 midterms as compared with $51.6 million in the 2006 midterms). 88. id. 89. id; blasio, corporations hide spending, supra note 80; editorial, campaign finance-reform, rip, wall st. j., nov. 2, 2010, at a20 (noting that pelosi's comments regarding "secret money" were likely directed at the "businesses whose first amendment rights to engage in political speech were restored by the supreme court in january's citizens united v. fec"). 2012] 609 florida tax review with the opinion of the "person on the street." as one commentator noted, graco incorporated, a company that manufactures "fluid handling systems," contributed $50,000 to the same independent group as did target, yet received no backlash, perhaps because it is more difficult for progressive organizations to organize against a corporation that operates "out of the public eye."90 moreover, a corporation may conclude that investors and consumers will welcome a particular exercise of political speech, perhaps because it has calculated that it will appeal to their economic and political interests. for instance, perhaps the ceo of the ethanol company mentioned above believes that his shareholders and consumers will support any political campaign intervention that works to reduce the country's dependence on fossil fuels. it could also be the case that corporate officers, for a variety of reasons, might be willing to undertake the campaign intervention no matter what the potential consequences. an example of this willingness may be seen in the notorious massey coal affair, which spawned a supreme court case of its own. in 2004, the ceo of massey energy spent $3 million to help elect a candidate to the west virginia supreme court of appeals, knowing that the supreme court of appeals was set to hear the appeal of a $50 million business tort damage judgment against massey.91 the $3 million in contributions was more than the total amount spent by all other contributors to the candidate's campaign and was three times as much as was spent by the candidate himself.92 the candidate won the election and then voted to overturn the award against massey. the entire affair received national media coverage, inspired a best-selling john grisham novel, and eventually resulted in a 2009 u.s. supreme court ruling that the due process clause, incorporating common law rules of judicial ethics, required the justice's recusal. 93 while the massey coal affair may be an outlier, it demonstrates that under certain circumstances some corporate managers may not be deterred by even the most potentially controversial campaign interventions. moreover, in the first national election after citizens united, unions showed great willingness to engage in campaign interventions. by late october 2010, the american federation of state, county, and municipal employees (afscme) was the biggest independent spender in the 2010 90. patrick caldwell, citizens united frees corporations to spend on elections, but increases scrutiny, minn. indep., aug. 12, 2010, http://minnesotaindependent.com/63514/citizens-united-frees-corporations-to-spendon-elections-but-increases-scrutiny. 91. caperton v. a.t. massey coal co., inc., 129 s. ct. 2252, 2257 (2009). 92. id. 93. id. at 2265 ("our decision today addresses an extraordinary situation where the constitution requires recusal."). [vol. 12:7610 citizens united & tax policy midterm elections, with a total of $87.5 million.94 as discussed in the previous section, union pension funds can act as activist shareholders, pressuring corporate managers to act in their interests. 95 as reflected in the third hypothetical presented in this paper's introduction, given both the willingness of unions to intervene in political campaigns and the willingness of union-affiliated institutional investors to exert pressure on corporate managers, it is plausible that union pension funds or other union-affiliated institutional investors could place pressure on corporate managers to undertake campaign interventions even in situations where the managers might prefer to do otherwise. 96 however, perhaps the primary reason to think that citizens unitedenabled campaign interventions will indeed change the equation of corporate influence upon lawmaking involves the potential synergy between lobbying and corporate political speech. simply put, campaign interventions give corporations another tool with which to lobby lawmakers. as commentators have observed, citizens united allows corporations to implicitly threaten legislators with campaign interventions against them in future elections should they fail to act as the company wishes. 97 moreover, this might develop into a two-way street in return for voting for beneficial policies, the incumbent politician may demand a quid pro quo of corporate political spending on the politician's behalf in upcoming elections. indeed, some corporations may curse citizens united for giving the incumbent lawmaker something tangible to request campaign intervention in the form of express advocacy or electioneering communications, which as we have seen, poses more risk than lobbying in return for the lawmaker's support of 98 policies beneficial to the corporation. 3. what an increase in tax-motivated corporate campaign interventions means for corporate governance as the previous section showed, we can expect in the wake of citizens united that at least some corporations will engage in corporate 94. brody mullins & john d. mckinnon, campaign's big spender, wall st. j., oct. 22, 2010, at al. 95. see supra part ii.b.l. 96. these campaign interventions would not be tax-motivated per se, but as discussed in part ii.b.1, supra, the different tax positions of tax-exempt union pension funds could lead to them placing pressure on corporate management to undertake actions that are not optimal tax-wise for taxable shareholders. 97. see, e.g., steve bickerstaff, opinion, the real effects of corporate spending in elections, know, feb. 3, 2010, http://www.utexas.edulknow/2010/ 02/03/steve bickerstaff opinion/ [hereinafter bickerstaff, real effects]. 98. id 6112012] florida tax review political speech in order to pursue economic self-interest. in the context of tax-motivated interventions, what does this mean for corporate governance? we might wish to begin to answer this question with the understanding that although, under current law, managers will initiate campaign interventions on the corporation's behalf,99 not every tax-motivated campaign intervention will result in an agency cost. as has been noted in the literature regarding aggressive tax sheltering, if manager and shareholder interests are aligned, a reduction in tax either at the entity or shareholder level simply means a transfer of resources from the state to shareholders. 100 yet, as alluded to in this paper's first section, this rosy picture is complicated by a number of factors, beginning with the double tax and the resulting variety of policy changes that managers might undertake to bring about through corporate speech. at least three tax policy options exist that managers can pursue through interventions: integration, corporate rate reduction, and business tax breaks.' 0 ' that is, managers could seek to reduce or eliminate the dividend tax, they could seek to reduce the statutory rate paid by corporations on profits, or they could seek firm, industry-specific, or economy-wide tax subsidies and credits. as with any tax reduction strategy, when deciding whether to attempt to influence tax policy through a campaign intervention, managers will likely engage in a cost-benefit analysis. that is, whatever intervention offers the least possibility of risk while posing the greatest possible reward will likely be most attractive to managers. this raises the question, however: whose risk and whose reward is being considered? corporate managers possess different risk preferences than shareholders. this is due to the fact that managers have significant capital invested in their specific firms, both in the sense of human capital and often, as mentioned previously, in the form of incentive-based compensation, such as firm stock or stock options.102 this firm-specific capital investment on the part of managers makes them risk-averse as to corporate actions that pose a 103 chance of harming the firm. in contrast, shareholders, because they are diversified across the economy, are not *as heavily invested in the firm as managers. thus, they are risk-neutral when it comes to the chance of firm harm and will expect the managers to take actions that increase firm value 99. under state corporate law, campaign interventions are considered part of the daily management of the corporation's operations and therefore a responsibility of managers. several measures that would require shareholder approval for campaign expenditures by corporations are currently pending in congress. garrett, campaign finance policy, supra note 21, at 6. 100. see, e.g., desai, an economic approach, supra note 11, at 1. 101. see notes 36-39, supra, and accompanying text. 102. see arlen, political theory, supra note 10, at 336-37. 103. id. 612 [vol. 12:7 citizens united & tax policy (or, in the example at hand, undertake a tax avoidance strategy) regardless of risk. 1 in terms of policies that pose the greatest "reward" for managers, both a reduction in the corporate rate and corporate tax subsidies work to reduce the overall tax paid by the firm and, therefore, to increase corporate income. an increase in corporate income offers managers greater retained earnings with which to fund projects (assuming moderate to minimal distributions to shareholders), with a corresponding increase in power and authority. increased income also means managers are more likely to meet earnings and cash flow goals, which will allow them to further entrench their power and attract investment. in contrast, integration, by offering a windfall to existing investment, benefits managers less than it does shareholders (with the notable exception of a scenario in which managers also own significant amounts of stock). moreover, a higher dividend tax rate may encourage "lock-in" of capital, allowing managers to use retained earnings to fund projects as opposed to debt or equity, with an associated reduction in oversight. however, tax subsidies offer managers additional benefits that a reduction in the corporate rate cannot. as arlen and weiss have pointed out, tax subsidies, such as investment tax credits and research and development tax subsidies, specifically target new investment, which benefits managers because it increases the after-tax profitability of such investment and increases their power and authority. in contrast, a reduction in the corporate rate could swell corporate coffers and place pressure on managers to distribute dividends. moreover, tax credits often target specific industries or specific firms.los as we have seen, managers are more likely to favor subsidies that benefit their particular firm or industry.106 therefore, corporate tax subsidies seem to offer managers the greatest "reward." corporate tax subsidies .also seem to offer less risk than other tax policies managers might pursue. both integration and the corporate tax rate remain controversial proposals with a long history of public debate.10 7 as proposals, both cutting the corporate rate and integration provoke differing but related strains of populist sentiment. one theory to explain the enduring hold of the entity-level corporate tax posits that the political problems associated with exempting corporations from tax in favor of individuals 104. id. at 336; see sartori, strategic tax behaviors, supra note 72, at 10. 105. see t. j. rodgers & lissa fried, silicon valley execs slam 'corporate welfare, '98 tax notes today 189-251, (may 5, 1998) (noting subsidies intended to benefit american high-technology industries and comparing them to the historical subsidies given to the u.s. airline industry in the 1970s). 106. see arlen, political theory, supra note 10, at 341. 107. see bank, sword to shield, supra note 33, at ix-x. 2012] 613 florida tax review render an elimination of the corporate tax unfeasible. 0 8 as a result, proposals for corporate tax rate cuts remain politically controversial. 109 moreover, reducing or eliminating the dividend tax a common feature of integration proposals is often seen as cutting taxes for wealthy holders of capital (despite the fact that stock ownership among middle-class americans has grown faster than among any other income class). 110 as a result, integration proposals that include a dividend rate cut could also spark progressive opposition to "tax cuts for the rich." therefore, these national tax proposals will likely draw the type of attention from the media and political activists that could pose firm-specific risk to a corporation engaging in political speech 11 on the issue. in contrast, corporate tax subsidies, even economy-wide ones that represent large dollar amounts, tend to be relatively invisible.112 even economy-wide corporate tax breaks worth billions of dollars rarely penetrate the national consciousness. as professor theodore seto pointed out in a recent article, the repatriation amnesty of 2004 a tax break worth $62.5 billion dollars to the corporations that received it received hardly any public debate and is not widely known to non-tax insiders.113 moreover, many corporate tax breaks are firm or industry-specific and, therefore, lowerprofile than national proposals. additionally, legislators often present corporate tax breaks to companies from their home states as initiatives to stimulate jobs and investment for their local communities. 114 thus, in the 108. see avi-yonah, the separate corporate tax, supra note 33, at 11-12. 109. see shaviro, u.s. corporate tax, supra note 70, at 146 (noting that stronger political party-line voting may cause the future of u.s. corporate taxation including the corporate rate to become less stable in the near future). 110. see joy sabino mullane, incidence and accidents: regulation of executive compensation through the tax code, 13 lewis & clark l. rev. 485, 537 (2009) ("[rjank-and-file americans, through institutional mediators, are now investing indirectly in public companies in ever-greater numbers and amounts."). 111. while the term "political speech" seems ironic in this context (who would "speak" if they wished to shun the spotlight?), it should be remembered that under the supreme court's decision in buckley v. valeo spending money is considered speech, and so this paper's use of the term "political speech" encompasses monetary support to candidates. buckley v. valeo, 424 u.s. 1, 16 (1976). 112. see seto, corporate money, supra note 5, at 1476 (noting that the repatriation amnesty of 2004, which corporations spent $282.7 million.to lobby for in return for $62.5 billion of tax savings, is not widely known to the public). 113. id. 114. see daniel shaviro, beyond public choice and public interest: a study of the legislative process as illustrated by tax legislation in the 1980s, 139 u. pa. l. rev. 1, 26-27 (1990) (describing house members tasked with tax reform instead passing special breaks for "'productivity property,' which more or less meant [vol. 12:7614 citizens united & tax policy court of public opinion, concern for strengthening the local economy may offset more generalized concern over "corporate welfare." therefore, pursuit of corporate tax subsidies seems to pose more personal reward, and less personal risk, to corporate managers considering tax-motivated campaign interventions. this raises the possibility that managers, acting as agents for shareholders, may be influenced by their own personal risk-reward preferences in the types of tax policy changes they pursue. this, of course, is an extension of arlen and weiss's argument regarding the persistence of the double tax. professor michael doran, in arguing for a more "nuanced" vision of managerial self-bias rather than a monolithic preference for subsidies, has presented evidence showing that corporate lobbying was essentially split on the bush dividend exclusion proposal. professor doran argues that some managers even indicated in their testimony to congress on the proposal that they supported integration over targeted tax preferences (in other words, subsidies). yet the larger implication of professor doran's empirical findings seems to support arlen and weiss's thesis doran's findings show that corporate managers essentially deadlocked on the bush integration proposal (perhaps contributing to the compromise nature of the final plan that reduced, but did not eliminate, the dividend rate), while, as we have seen, corporations on the whole have shown no such ambivalence at least not in any meaningful way in their furious lobbying for "targeted tax preferences" such as the repatriation measure of 2004. however, as we have seen, any tax reduction strategy undertaken by managers via campaign interventions poses a risk of agency costs only if managers will reap a benefit from it not shared by shareholders. after all, divergence in preferences between managers and shareholders, such as those investigated by arlen and weiss, do not necessarily translate into agency costs. for example, if a tax subsidy procured for a corporation by managers through corporate political speech increases its after-tax profit and therefore its share value, shareholders have benefitted even if they do not cash out their shares. as illustrated by the first hypothetical in this paper's property of a sort manufactured in the home state of a finance committee member"). 115. see doran, corporate double tax, supra note 45, at 569-75 (noting that while the business roundtable group, an association of chief executive officers, as well as the u.s. chamber of commerce, supported the proposal to integrate the corporate entity and shareholder tax, other managers expressed concerns that the proposal would interfere with their discretion to retain or distribute earnings, and some managers in particular industries expressed concerns about the effects of the proposal on corporate tax preferences). 2012] 615 florida tax review introduction,ll6 in which managers intervened in favor of a firm-specific tax subsidy and then squandered the proceeds on self-serving projects, an.extra step is needed managers must extract a benefit from the subsidy not shared by ownership. the first hypothetical offers such a scenario. in that case, managers plowed the tax savings back into unsuccessful projects that increased their own power and authority but ultimately either failed to raise share value or lowered it. the third hypothetical in the introduction,117 in which a union pension plan colludes with management to support a certain candidate who opposes dividend rate reduction, while featuring the additional factor of an institutional investor, operates using the same calculus: if the managerial project enabled by the managerial collusion with the union pension fund benefits shareholders less than the lost savings from the dividend reduction that did not take place, then an agency cost has resulted. the picture is complicated somewhat by the heterogeneity of positions, tax and otherwise, held by any corporate constituents at a given company. for example, short-term shareholders may be more likely to share in benefits from tax subsidies that swell corporate coffers since they will "cash in" on the increased share value within a shorter time frame. in contrast, buy-and-hold investors may be more susceptible to agency costs caused by managers' misuse of tax savings. however, despite the difficulty of drawing firm conclusions about the exact manner in which agency costs might result at individual firms from corporate tax subsidies, the larger truth remains that tax breaks received by a corporation work to reduce the rate at which that corporation is taxed, and in general the corporate tax has long been seen as a constraint on managerial abuse of power. in his 1909 address to congress, president taft identified restricting "managerial abuses of power" as the primary reason for enacting a corporate tax, and the same theme predominated in the congressional debate over the tax that ensued.118 as we have seen, a related notion underlies dividend rate reform the idea that pressuring managers to pay dividends and therefore distribute retained earnings serves as a constraint on managerial power.119 therefore, it seems reasonable to postulate that giving managers a powerful new tool with which to pursue corporate tax subsidies that reduce corporate tax, without countervailing measures to ensure that shareholder interests are protected as well, will increase the likelihood of agency costs. citizens united, by providing managers with such a tool, is therefore likely to weaken corporate governance overall. 116. see supra part i. 117. id. 118. avi-yonah, the separate corporate tax, supra note 33, at 18. 119. see generally id. 616 [vol. 12:7 citizens united & tax policy iii. how the market can solve the problem of taxmotivated corporate campaign interventions but only with strengthened campaign finance disclosure laws this paper has thus far argued that citizens united-enabled taxmotivated corporate political speech is likely to exacerbate corporate governance problems for the corporation in question, both because tax issues may be particularly divisive among corporate constituents and because managers are most likely to use campaign interventions to pursue corporate tax subsidies, a method of tax reduction that possesses particular potential for agency costs. what, if anything, can be done to address this problem? this part analyzes possible legislative or regulatory responses from the ex ante and ex post perspective, concluding that at this point in time no response represents a "magic bullet" solution. however, institutional investors and third-party monitors such as proxy advisory firms have established a robust market for information about corporations and their governance practices. the answer to the problem of agency costs created by corporate political speech may therefore lay in strengthened campaign finance disclosure laws that will enable existing market forces such as proxy advisory firms to monitor corporate actions in this area. a. potential legislative and regulatory responses in examining possible legislative or regulatory responses to the issue of tax-motivated corporate campaign interventions, it is important to keep in mind that this paper's concern with citizens united-enabled corporate political speech is limited to economic agency costs to shareholders and other corporate stakeholders. this is not to deny that corporate political speech raises other concerns as well, such as the worry about political agency costs raised by justice white in his bellotti dissent.120 more recently, professor theodore seto pointed out that citizens united enables taxpayersubsidized corporate political speech if corporations (illicitly) use savings from existing corporate tax subsidies to seek further subsidies through campaign interventions.121 while not wishing to deny these other, arguably broader, concerns, at this time this paper wishes to remain focused on an analysis of the particular tax-related corporate governance issues raised by citizens united. for these purposes, professor seto's solution to the problem posed by citizens united-enabled corporate political speech is inappropriate. professor seto proposes that the internal revenue code be revised to provide 120. 435 u.s. at 810-12 (white, j., dissenting). 121. see seto, corporate money, supra note -5, at 1476. 2012] 617 florida tax review that any corporation that incurs meaningful political expenditures be prohibited from claiming certain tax benefits (all of professor seto's examples are business tax subsidies) for that tax period and some years after. 22 however, from a corporate governance standpoint, such a denial of tax benefits could be over-inclusive since, as we have seen, under certain conditions, tax-motivated corporate political speech will not pose corporate governance concerns (namely, if corporate managers do not siphon off the resulting tax savings for their own benefit). professor seto's solution would prevent the corporation from realizing benefit from the intervention in question regardless of whether it raises a corporate governance problem. such a result would likely chill corporate political speech and raises a collective action problem since no given corporation would have incentive to pursue such speech. while the managers at the refraining corporation would lose the benefit of the tax subsidy to their particular firm, the shareholders would lose the economywide benefit to their diversified portfolios. thus, professor seto's solution would prevent both corporate managers and owners from benefitting from tax-motivated corporate political speech. from a corporate governance standpoint, a better solution would be one that more effectively targets only those exercises of tax-motivated corporate political speech that result in agency costs. in envisioning possible legislative or regulatory measures to prevent such campaign interventions, we could use either an ex ante or ex post approach. an example of an ex ante approach would be requiring either board approval or shareholder approval for corporate campaign interventions. board approval would subject decisions by corporate officers to an extra layer of oversight from supposedly impartial directors. however, serious questions have been raised about board "capture" by executives in the context of executive compensation, raising questions as to whether board approval can prevent self-serving managerial action.123 moreover, it is not clear how boards could gather sufficient information about the tax positions of various parties in order to make an informed decision, particularly under the peculiar time constraints of a political election. to many observers, shareholder approval by majority vote would presumably help to ensure that managerial action is consistent with overall shareholder benefit. campaign finance reform activists as well as members of congress have called for legislation requiring shareholder approval for exercises of corporate political speech; various measures are reportedly 122. id. at 1476. 123. see generally lucian bebchuk & jesse fried, pay without performance: the unfulfilled promise of executive compensation (2004). 618 [vol. 12:7 citizens united & tax policy already under development, and some have already been introduced.124 examples of these measures include requiring shareholder approval for any political spending or requiring firms to provide advance notice of political spending, either generally or with respect to particular issues or political campaigns.125 however, both at the general level and specific (tactical) level, these approaches fail to adequately address the particular issue of agency cost. at the general level, shareholders may be able to approve or disapprove political spending on the whole, but will have little way to distinguish between specific instances of political spending particularly spending that might present the danger of agency cost as opposed to spending that might maximize the value of their shares. and at the specific (or tactical) level, shareholder approval suffers from logistic and efficacy problems. usually, shareholder meetings either take place annually or must be specially called by the board.126 given the fast-moving, tactical nature of a political campaign, calling shareholder meetings to approve interventions would likely prove impractical. of course, opponents of tax-motivated corporate political speech might support shareholder approval for exactly this reason. they will see the requirement's impracticality as a natural check on corporate political speech because it will forestall most tactical exercises of the speech (for example, to bolster the campaign of a candidate who is suddenly sagging in the polls), which, due to their exigent nature, will need to be carried out by the managers entrusted with the daily operations of the firm. thus, by its very nature shareholder approval will act as a check on management. however, as discussed above, some (if not many) managerial actions will genuinely maximize shareholder value and will not present an agency problem. thus, the chilling of specific exercises of corporate political speech through the impracticality of shareholder approval falls into the same trap as general shareholder approval campaign interventions that will increase shareholder value will be thrown out along with those that will result in agency cost. furthermore, shareholder approval as a concept rests on the premise that shareholder empowerment will result in managerial action more beneficial to shareholders. however, as many corporate legal scholars have pointed out, the nature of shareholder votes conducted by proxy in large publicly traded corporations stacks the deck in favor of management 124. see garrett, campaign finance policy, supra note 21, at 6 (referencing h.r. 4487 (rep. alan grayson) and h.r. 4537 (rep. michael capuano)). 125. id. 126. see, e.g., del. code ann. tit. 8, §§ 211 (a)-(b), 222 (providing that shareholder meetings must take place annually or by special meetings called by the board with not less than ten days and not more than sixty days notice). 2012] 619 florida tax review proposals.127 thus, even if logistically workable, proposals involving shareholder empowerment fail to entirely eliminate the specter of agency costs. moreover, as was discussed at length in part h, given the rise of institutional and activist shareholders with disparate tax interests, serious doubts have been raised about whether "shareholder empowerment" really empowers all shareholders or only a vocal and motivated minority.128 thus, shareholder approval of campaign interventions ultimately cannot escape the corporate governance concerns that afflict all corporate action. alternatively, an ex post approach could be taken. for instance, in response to a questionable tax-motivated corporate campaign intervention, a shareholder could bring a derivative suit subjecting the action to judicial review under state fiduciary duty laws. if successful (and even if not), such lawsuits could serve to deter managers at the corporation in question and other corporations from future self-serving exercises of corporate political speech. however, corporate fiduciary duty laws have set a relatively high bar for showing malfeasance. under the business judgment rule, to be liable for a breach of their fiduciary duty of care to shareholders, managers must have engaged in blatant shirking. 9 to be liable for a breach of loyalty due to self-interest, directors or officers must have received a personal financial benefit not available to shareholders.1 30 while an exploration of the applicability of duty of loyalty doctrine to tax-motivated managerial action is beyond the scope of this paper, on the whole such actions are less than likely 127. see, e.g., lee harris, shareholder campaign funds: a campaign subsidy scheme for corporate elections, 58 ucla l. rev. 167, 168-69 (2010). the dodd-frank wall street reform and consumer protection act of 2010 included shareholder empowerment provisions. however, these provisions were primarily aimed at granting shareholders greater access to the proxy voting process for nominees to the board of directors. see dodd-frank wall street reform and consumer protection act of 2010, pub. l. no. 111-203, 124 stat. 1376 (2010). thus, as currently written, they would not influence the dynamics behind shareholder voting for corporate actions outside the director election process. 128. see supra notes 53-71 and associated text; see generally anabtawi, increasing shareholder power, supra note 51. 129. see, e.g., smith v. van gorkom, 488 a.2d 858 (del. 1985) (holding that where the board took only two hours to decide to sell the corporation in a hastily called meeting, the business judgment rule presumption was overcome, and the directors were liable for a duty of care breach) overruled on other grounds by gantler v. stephens, 965 a.2d. 695 (del. 2009). 130. in re walt disney co. derivative litig., 731 a.2d 342, 355 (1998) ("in order to create a reasonable doubt that a director is disinterested, a derivative plaintiff must plead particular facts to demonstrate that a director 'will receive a personal financial benefit from a transaction that is not equally shared by the stockholders'. . . .") (quoting rales v. blasband, 634 a.2d 927, 936 (1993)) rev'd in part by brehm v. eisner, 746 a.2d 244 (del. 2000). 620 [vol. 12:7 citizens united & tax policy to succeed. 131 put simply, many agency cost scenarios fail to rise to the level of fiduciary breach. relying on shareholder derivative suits also raises collective action issues. as corporate scholars have pointed out, the average shareholder of a large corporation is "rationally apathetic."l32 individual shareholders also face daunting information challenges. the tax positions of various corporate constituents may be difficult to discern. without the benefit of expert analysis, tax advantages conferred by any given managerial action may take years to reveal themselves. it is true that institutional or activist shareholders are more likely to possess the resources for such information gathering and analysis, as well as the will to monitor the corporations in which they invest, since these types of investors have become increasingly concerned with corporate governance issues as evidenced by the rise of proxy advisory firms. 133 however, institutional investors may have too little invested in a given company to have incentive to monitor it effectively.134 moreover, as discussed in part ii, institutional or activist shareholders may themselves pose part of the problem by seeking to obtain "personal" benefits from taxmotivated political speech. in this sense, relying in any systematic way upon institutional or activist investors to monitor corporations in order to constrain tax-motivated corporate political speech that poses agency costs may be like asking the fox to guard the hen house. b. how the market can solve the problem: proxy advisory firms the robust market for proxy advisory firms that advise these same institutional shareholders may provide the strongest reason for why legislative and regulatory solutions are not yet necessary to solve the 131. it is not clear whether the examples of managerial rent extraction discussed above might be susceptible to a breach of loyalty action. for instance, courts have held that an officer's bare desire to maintain corporate control does not constitute self-interest. see, e.g., gantler, 965 a.2d at 707. however, an officer's desire to keep his or her position can be self-interested if other examples of disloyalty are found. id as for hypothetical interventions by stock-holding managers to reduce the dividend tax rate, it is difficult to see how a court could find that this benefit was not shared by other shareholders, since they would all receive the same tax rate on their dividends. 132. anabatwi, fiduciary duties, supra note 9, at 1257. 133. see surpa note 56. 134. omari scott simmons, taking the blue pill: the imponderable impact of executive compensation reform, 62 smu l. rev. 299, 354 (2009) ("institutional investors, despite having greater capacity to monitor and gather information, may have too small a stake in a company or too limited industry expertise to monitor it actively."). 6212012] florida tax review problem of tax-motivated corporate campaign speech.135 proxy advisory firms, such as riskmetrics group, have become important players in corporate governance, providing institutional investors advice on how to vote at annual meetings, but even more importantly, regularly rating companies on their corporate governance practices.136 assuming for the moment that corporate campaign expenditures are adequately disclosed, these firms are therefore positioned to monitor campaign interventions that could reflect weak corporate governance at a given firm because they possess the information-gathering resources and analytical ability to detect improper tax motivations behind managerial actions such as the exercise of corporate political speech. such capabilities can be seen in proxy advisory firms' treatment of the perennial corporate governance conundrum: executive compensation. in this field, proxy advisory firms such as riskmetrics have developed elaborate best practices guidelines and tout their ability to evaluate executive compensation practices on a case-by-case basis.137 according to riskmetrics, its compensation monitoring includes analysis of tax issues excise tax gross-ups and tax reimbursements related to executive perquisites.138 riskmetrics further maintains that it can monitor director independence through an analysis of the materiality of transactional relationships held by the director or by an organization with which the director is affiliated.139 riskmetrics undertakes such monitoring and reporting primarily for its usual clientele large institutional investors. this market-driven relationship may seem counter-intuitive, since as asserted above, institutional investors may be part of the corporate governance "problem" in that they often possess interests not shared by other investors and may seek to coerce managers to pursue those interests. moreover, as also noted above, institutional investors lack the incentives to care that much about the corporate governance practices at any given company in which they are 135.id. 136. id.; see riskmetrics group, proxy research services for institutional investors worldwide i in today's complex and highly scrutinized environment, institutional investors need a corporate governance partner that can provide proxy voting policies and research that allow them to meet their fiduciary and compliance needs. . . . [riskmetrics group] offers both recommendation-based proxy research as well as nonrecommendation corporate governance research on a global scope with local market expertise. 137. riskmetrics group, u.s. corporate governance policy 2010: updates 23-24 (2009). 138. id at 26. 139. see id. at 8. [vol. 12:7622 citizens united & tax policy invested. however, while institutional investors may act selfishly on a caseby-case basis, this does not impact in any meaningful way the generalized desire of such institutional investors to invest in companies that feature strong corporate governance practices. in other words, because proxy advisory firms serve institutional investors in the aggregate, these gatekeepers should be able to maintain their analytical neutrality even if certain institutional investors are occasionally implicated in an instance of weak corporate governance. such a situation exists with corporate pension funds that utilize proxy advisory services; the fact that many of their clients are themselves affiliated with corporations has not prevented proxy advisory firms from becoming a primary third-party gatekeeper of corporate governance practices in general. moreover, the aggregate nature of the service provided by proxy advisory firms ensures that the same institutional investors that lack incentive to individually investigate the corporate governance at any given firm with which they are invested will pay for third-party monitoring on an economy-wide basis because such monitoring becomes sufficiently valuable to them when applied to their investment portfolios as a whole. proxy advisory firm monitoring would be most effective where managers' self-interest is easily apparent. for example, if a corporation where the top managers all hold large amounts of the corporation's dividendpaying stock makes a large campaign expenditure in favor of a reduction in the dividend rate, advisory firms could make the connection and red-flag the intervention as a possible symptom of weak corporate governance. if the problem is due to an activist shareholder teaming with management or coercing management to gain a tax advantage not shared by other stakeholders, the advisory firm could still suss out the indirect connection. the proxy firm's information regarding the tax positions of various parties would be to some degree limited, but its value would be primarily in its ability to synthesize and analyze what information was available (for example, sec required disclosures of the compensation of the top five managers at the corporation). a possible objection to the assertion that proxy advisory firms may represent a solution to corporate political speech that causes agency costs, however, is that in other instances such costs will take too long to develop for third-party monitoring to do its job. for instance, say that at a certain firm corporate managers exercise the corporation's political speech rights in pursuit of corporate tax subsidies that will increase after-tax profit and swell retained earnings. unlike executive compensation contracts that can be immediately analyzed for certain "red flags" that ultimately point to weak corporate governance at the firm in question, the governance implications of this particular instance of corporate political speech may not be immediately apparent. the managers might use the retained earnings to undertake productive projects that increase shareholder value. or they might squander 6232012] florida tax review the earnings on self-serving, unproductive projects that lower shareholder value; only time will tell. since the intervention only gains meaning in connection with further managerial abuses, the bare fact of such intervention would mean little to gatekeepers. as corporations pursue campaign interventions in successive election cycles, however, a correlation between interventions and managerial abuses will develop that may allow gatekeepers to "red-flag" the campaign intervention. an analogy can be made to performance-based pay in the executive compensation context. historically, performance-based compensation (such as stock options) became an indicator of corporate governance problems only after such pay ended up being far more lucrative than initially anticipated. o thus, just as stock option compensation became correlated with weak corporate governance after executive pay underwent an economy-wide boom, campaign interventions may become correlated with problematic governance practices if widespread managerial abuses take place at the intervening corporations. what about the demand side of the equation? will third-party monitors such as proxy advisory firms have adequate incentive to monitor this information that is, will institutional investors be willing to pay for it? good reasons exist to think that they will. first, such monitoring is likely to be relatively inexpensive compared to the services already provided by such firms. with the existence of sufficient disclosure laws (as discussed below), information about exercises of corporate political speech will become public information that is as easily accessible as sec filings and other mandated disclosures. thus, the marginal cost of compiling and analyzing this information should be minimal given the sorts of information gathering and analysis in which proxy advisory firms already engage, and so gatekeepers would be able to supply this information at little extra cost to customers. of course, a more in-depth analysis of the corporate governance implications of a given corporation's political speech will require more digging. however, if heavy corporate intervention in political campaigns results in a widespread perception of managerial abuse, a correlation will develop of which third-party monitors can take notice in their "best practice" policies and other advisory services. much as in the executive compensation context, this correlation will allow monitors to treat large amounts of political spending at a given corporation as a warning of a possible, but not inevitable, problem. subscribers to the monitors' services can then either pay 140. see mark a. sargent, lawyers in the perfect storm, 43 washburn l.j. 1, 8-9 (2003) (describing how stock option compensation, once conceived as a "brilliant, non-regulatory solution" to aligning managerial and shareholder interests, ended up causing executive compensation to "balloon wildly" and created "perverse incentives for abusing shareholders," with the result that it is now "obvious" that the experiment was a failure). [vol. 12:7624 citizens united & tax policy for a deeper analysis or do their own research. such service tiers will allow the flexibility for an efficient market in information between advisory firms and their customers. as for the investors themselves, most rational holders of shares will likely wish to know about the political speech of the corporations in which they invest. first, as evidenced by the public reaction to the citizens united decision, corporate political speech remains highly controversial. as target corporation found out, corporations that engage in political speech risk provoking a backlash from activist groups, and such negative responses, if intense enough, could conceivably hurt shareholder value. therefore, insofar as corporate political speech presents a risk, investors would presumably want to know about a corporation's exercise of political speech just as they would wish to know about any risky action taken by the firm. moreover, as discussed in part ii, many investors, particularly institutional ones, often have their own political agendas (for example, a public union pension fund may favor candidates that support organized labor). thus, investors may have unique political reasons for wishing to know about political campaign interventions undertaken by the corporations in which they invest. and of course, any developing correlation between corporate campaign interventions and managerial abuse will likely be noted and reported not only by proxy advisory firms but by other third-party monitors, such as the media and activist watchdog groups. this additional third-party monitoring, which may be more political in nature, will work to alert institutional investors to the correlation, and thereby create demand for a service that provides the information the investor needs to determine whether a problem indeed exists. statements by institutional investors tend to support the notion that such investors would be willing to pay for information about corporate political expenditures. the council for institutional investors, an organization of public, employee, and corporate pension funds representing assets of more than $3 trillion,141 has expressed concern that corporate managers have unfettered authority to make political expenditures and notes that this authority is concerning because, inter alia, studies have shown a correlation between high levels of political expenditures and lower share values.142 the council states that its policy is to encourage boards to monitor 141. about the council, council of institutional investors, http://www.cii.org/about (last visited jan. 24, 2012). 142. political giving, council of institutional investors, http://www.cii.org/politicalgiving (last visited january 24, 2012) [hereinafter political giving] (citing rajesh k aggarwal et al., corporate political contributions: investment or agency? (nov. 24, 2007) (unpublished manuscript), http://www.cii. org/userfiles/file/corporate%2opolitical%20contributions%20-%20lnvestment% 20or/o20agency%20--%2onovember/ 202007.pdf. 2012] 625 florida tax review "all charitable and political contributions (including trade association contributions) made by their companies," to develop and disclose guidelines for contributions, and to disclose all contributions made. 143 in the wake of the citizens united decision, the council released a statement reaffirming these policies.144 these sentiments show that institutional investors consider information about corporate political speech important. therefore, these investors would likely be willing to pay for monitoring, thereby creating a market that will incentivize gatekeepers to do so. c. the need for adequate disclosure laws for the above reasons, hope exists that the market may in large part address the problem of tax-motivated corporate political speech and therefore forestall the need for legislative or regulatory solutions. however, a major caveat exists to this predicted scenario: it is predicated on adequate disclosure of corporate campaign expenditures. as discussed earlier, under current federal law, corporations are required to disclose only significant campaign expenditures made directly by the corporation. intermediate organizations that receive corporate funding to engage in political speech are not required to disclose their donors under federal and most state law. 145 such intermediate groups have developed into major players in campaign expenditures,146 and there is every reason to expect this will continue in future elections.147 so long as corporations can launder their expenditures through an intermediary organization, the ability of third-party gatekeepers to monitor corporate campaign interventions will be severely curtailed. therefore, this proposal depends on revising current state and perhaps federal law to mandate such disclosure of such organizations' donors. 143. political giving, supra note 142. 144. see good governance is key to policing corporate political activities, the council governance alert, counci of institutional investors: the voice of corporate governance 1 (2010), http://www.cii.org/userfiles/file/resource%20center/council%20governance% 2 0aler t/2010%20archive/2010%20alert%203.pdf (last visited jan. 24, 2012). 145. see supra part ii.b.2. 146. chisun lee, higher corporate spending on election ads could be all but invisible, propublica, (mar. 10, 2010, 9:04 am) http://www.propublica.org/article/higher-corporate-spending-on-election-ads-couldbe-all-but-invisible (reporting that the u.s. chamber of commerce spent $144.5 million on "advertising, lobbying and grass-roots activism" in 2009, more than either the democratic or republican party spent over the. same time frame). 147. see bickerstaff, real effects, supra note 97 ("based on the 2002 experience in texas, it is various associations of businesses (for example, the chamber of commerce, texas association of business, texans for a republican majority) that will use media to influence voters."). [vol. 12:7626 citizens united & tax policy currently, only a handful of states possess such laws, although more are rushing to enact them in the wake of citizens united.148 should such measures fail to pass in a majority of states, however, amendment of current federal disclosure law may be necessary. such disclosure is consistent both with supreme court campaign finance doctrine and congress's disclosure requirements of lobbyists. in buckley v. valeo, the supreme court held that disclosure of the sources of campaign expenditures was fully consistent with the view that such expenditures were speech; disclosure that revealed the speaker's identity facilitated political discourse by allowing the public to more fully weigh the message being conveyed.149 moreover, under current federal law, lobbyists are required to disclose their clients. 50 since intermediate organizations function much like lobbyists in the corporate political speech context in the manner described above, the same policy objectives are served by requiring such organizations to disclose their donors. of course, it might be argued that this is a caveat that swallows the proposal that is, if changes to current federal or state laws enable disclosure of campaign expenditures, no need exists for third party gatekeeper monitoring of corporate political speech since shareholders and media will have access to this information and will presumably act upon it. on this theory, the resulting threat of adverse reaction to any given exercise of political speech could then serve as sufficient deterrent in itself to corporations considering campaign interventions. however, as mentioned previously, many companies not in the public eye will "fly under the radar" and their campaign expenditures will therefore fail to draw media attention. 151 moreover, many if not most shareholders are either rationally apathetic or (if institutional) insufficiently invested in any given company to police its political speech via federally mandatory disclosures.152 an analogy can be drawn here to executive compensation disclosures required in securities filings by the securities and exchange commission. while such disclosures are accessible to the public, the fact that third party gatekeepers, such as proxy advisory firms, have successfully established a market for the gathering and analysis of this information shows that mandatory corporate 148. see herb, minnesota model, supra note 79. 149. 424 u.s. 1, 66-67 (1976) (finding that compelled disclosure of the identities of groups making campaign expenditures is justified by the compelling governmental interest in providing the electorate with information needed in order to aid the voters in evaluating candidates for federal office). 150. 2 u.s.c. § 1603(b) (2012). 151. see supra note 90, and accompanying text. 152. see supra notes 132 & 134, and accompanying text. 2012] 627 florida tax review disclosures still may require fatekeeper information-gathering and analysis to be at their most effective. iv. conclusion in the wake of citizens united, many have worried that corporations may come to dominate political discourse. others have focused on corporate governance concerns involving political beliefs at the corporations exercising their constitutional speech rights. in contrast, this paper focuses on the economic agency costs at stake. in so doing, it discusses tax issues which have a historic but underappreciated association with corporate governance issues. it argues that citizens united-enabled tax-motivated corporate political speech is likely to exacerbate corporate governance problems. first, tax issues are particularly divisive among corporate constituents. second, tax-motivated corporate political speech is most likely to be in pursuit of corporate tax subsidies, which are more likely to involve agency costs than other tax initiatives. to address this potential problem, this paper argues for bolstering campaign finance disclosure laws to require intermediary groups to disclose their corporate contributors. such disclosure measures, which are already in effect in a handful of states, will enable existing third-party corporate governance gatekeepers such as proxy advisory firms to monitor and therefore discourage any exercises of tax-motivated corporate political speech that results in agency costs to shareholders. 153. see supra note 134, and accompanying text. [vol. 12:7628 florida tax review florida tax review volume 14 2013 number 3 77 taxing anxiety by morgan l. holcomb* i. introduction ............................................................................... 77 ii. a long (but not so winding) road: section 104(a)(2) ...... 81 iii. confusion in the courts: section 104(a)(2) in action ...... 89 a. what is “physical injury” for section 104(a)(2) purposes? ............................................................................ 90 b. when is an award “on account of” physical injury or sickness? .............................................................. 93 c. allocation anguish .............................................................. 98 iv. section 104(a)(2) needs reform .............................................. 99 a. allocation arbitrage ......................................................... 101 b. gendered component ....................................................... 102 c. additional rationales for eliminating the exclusion ....... 106 v. the better solution: full inclusion with jury awareness .................................................................................. 108 a. the full inclusion with jury awareness proposal is more likely to lead to tax certainty and uniformity ............... 109 b. the full inclusion with jury awareness proposal reduces incentives for specious claims of mental anguish, and reduces incentives for allocation arbitrage .................... 109 c. additional benefits of the full inclusion with jury awareness proposal.......................................................... 112 d. responding to objections ................................................. 112 vi. conclusion ................................................................................. 114 i. introduction a truism of tax policy is that a good taxing regime treats similarly situated taxpayers similarly. this truism, which i concede that i have espoused in class a time or two, really does not tell us much, though.1 *associate professor of law, hamline university school of law. thanks to gregg d. polsky for his suggestion to explore this topic, and for his generous and thoughtful reviews of the piece. excellent feedback was provided by participants at 78 florida tax review [vol. 14:3 consider the taxation of damages. under the current statute, many taxpayers do not pay taxes on the damages they receive either through jury awards or settlements. other taxpayers, however, do pay taxes on such damages. the dividing line, right now, is whether the damages were received “on account of physical injury.” if so, no taxes; if not, taxes. here is how it works, via an admittedly simplified example. anne and bob both work for bigautoco as assembly line workers. bob’s surly boss has a particularly bad day and punches bob in the nose. 2 the punch in the nose leads to several days of missed work, some medical bills, and a few weeks of headaches. for several weeks, bob suffers from insomnia as a result of the stress stemming from the pain and stress. bob sues, and bigautoco wisely settles with bob; the settlement includes lost wages, additional sums for pain and suffering, and even more money to compensate bob for the indignity and reputational harm surrounding the boss’s actions. because bob was punched in the nose, no portion of his settlement is taxable.3 the 11th annual junior tax workshop, held at the university of california-hastings school of law, as well as participants at the arizona state university scholars conference including jordan m. barry, andy grewal, mark s. hoose, james m. puckett, and urska velikonja. valuable input was also provided by participants at a hamline university school of law colloquium, and hamline law students jessica stoekman, chad thomas, and daniel jones provided excellent research assistance. 1. this concept is referred to in tax literature as “horizontal equity.” as scholar louis kaplow observes, the command of horizontal equity is “that equals be treated equally,” but it remains “to determine who are the equals who should be treated equally.” louis kaplow, a fundamental objection to tax equity norms: a call for utilitarianism, 48 nat'l tax j. 497, 498, 508 (1995). 2. there is some disagreement about the interpretation of section 104(a) in the context of minor physical injury. see, e.g., douglas a. kahn & jeffrey h. kahn, federal income tax: a student’s guide to the internal revenue code 101-02 (6th ed. 2011). for the purposes of simplification, let us assume that the boss is a former welter-weight boxer, and there is no question that getting punched by him is a significant physical injury. see id. at 99 (stating “the scope of the § 104(a)(2) exclusion from income is very broad. once that provision applies, even amounts compensating for lost wages are excludable from gross income.”). 3. commissoner v. schleier, 515 u.s. 323, 329 (1995) (note that although schleier pre-dates the addition of “physical” to section 104(a)(2), its reasoning regarding the scope of the exclusion remains good law); see also i.r.s. priv. ltr. rul. 199952080 (jan. 1, 2000) (citing favorably the schleier hypo). the conference committee report indicates that congress did not intend to change this result with its 1996 amendment. see h.r. rep. no. 104-737, at 301 (1996) (conf. rep.), reprinted in 1996 u.s.c.c.a.n. 1677, 1793 (explaining that “if an action has its origin in a physical injury or physical sickness, then all damages (other than punitive) that flow therefrom are treated as payments received on account of physical injury”). 2013] taxing anxiety 79 anne has the same boss. on the same day that the boss punches bob, he calls anne a few horrible names and tells her that he will punch her, too, if she shows up to work again. even though anne is a tough cookie, she decides to take her boss at his word and not show up to work for a few days (unpaid leave). furthermore, the stress of the boss’s actions causes anne to suffer headaches and insomnia. anne also sues, and bigautoco wisely reaches a settlement with her as well. bigautoco provides anne with a nearly identical settlement: she receives money to compensate for the pain and suffering relating to the headaches and insomnia, reimbursement for lost wages, and an additional sum for the indignity and reputational harm surrounding these events. anne’s award, however, is entirely taxable. the take-away is that bob walks home with about 30 percent more cash than anne. anne and bob are, at least in some ways, “similarly situated” taxpayers. and yet under the current rules relating to taxing damages, the internal revenue code (the code) treats them very differently. anne will take home about one-third less than bob; this is because anne will have to pay income taxes on her settlement, while bob will not. anne might well have preferred a punch in the nose. the disparity i have outlined above has led to calls for the elimination of the “physical” requirement in section 104(a)(2). thoughtful suggestions for reform have been made by the national taxpayer advocate (nta),4 as well as the american bar association (aba).5 the nta argues that settlement payments for mental anguish and emotional distress ought to be excluded just as payments on account of physical injury are currently excluded from gross income. similarly, the aba is lobbying for legislative 4. see nat’l taxpayer advocate, 2009 annual report to congress 351-57 (2009) [hereinafter 2009 annual report], http://www.irs.gov/pub/irsutl/2_09_tas_arc_vol_1_lr.pdf; see also nat’l taxpayer advocate, 2008 annual report to congress 472 (2008) [hereinafter 2008 annual report], http://www.irs.gov/pub/irs-utl/08_tas_arc_mli.pdf (“taxation of damage awards spurs litigation every year.”). 5. the american bar association’s position is summarized in the june 2010 issue of the aba journal. rhonda mcmillion, rite of spring, a.b.a. j., june 2010, at 65, 65 [hereinafter mcmillion, rite of spring]. others have called for reform as well. e.g., vivian berger, end the inequity: taxation of damages, nat’l l.j., sept. 17, 2007 (calling for reform similar to that called for by the nta); habib hanna, comment, heads i win, tails you lose: the disparate treatment of similarly situated taxpayers under the personal injury income tax exclusion, 13 chap. l. rev. 161, 163 (2009) (arguing “that those who suffer real, verifiable physical manifestations of emotional distress injuries should receive the same favorable tax treatment received by those who suffer purely physical injuries”). 80 florida tax review [vol. 14:3 changes that would exclude noneconomic damages from taxable income.6 the aba argues that current law penalizes taxpayers who are victims of discrimination by requiring them to pay taxes on the damages they receive.7 in this article, i too argue for a statutory change, though a quite different change than the nta/aba suggestions. i submit that nearly all damages, including damages received on account of physical injury, ought to be taxable, and that juries must be apprised of tax consequences so that they can make proper adjustments to take account of these tax consequences.8 i will refer to this as the full inclusion proposal with jury awareness — for ease, the full inclusion proposal. my proposed change is the more sound solution for several reasons. full inclusion creates certainty and avoids wasteful tax gamesmanship. furthermore, assuming informed parties, counsel, and juries, full inclusion need not harm individual taxpayers.9 this proposal works because under it, 6. mcmillion, rite of spring, supra note 5, at 65. the aba journal describes the position as follows: “victims of discrimination are penalized by current tax laws requiring them to pay taxes on settlements and awards of noneconomic damages, and to pay taxes at one time on income awards that might cover many years. the proposed legislation would exclude noneconomic damages from taxable income and allow income averaging for income awards covering multiple years that are paid in a lump sum.” id. 7. id. 8. juror tax awareness varies depending on the precise issue. for example, although juries are often informed of the non-taxability of plaintiffs’ damages awards, jurors are rarely, if ever, informed that defendants can deduct punitive damage payments. see 1 borris i. bittker & lawrence lokken, federal taxation of income, estates and gifts 13.1.4 (3d ed. 1999) (“the exclusion of recoveries for personal injuries and wrongful death is deeply entrenched in private tort law, and juries are often instructed that plaintiffs are not taxed on their awards.”); gregg d. polsky & dan markel, taxing punitive damages, 96 va. l. rev. 1295, 1345–46 (2010) [hereinafter polsky & markel, punitive damages] (noting that few courts instruct jurors that defendants can deduct punitive damage payments, and arguing for jury-awareness, rather than non-deductibility of punitive damage awards, as the preferred solution to the perceived problems created by the lack of jury awareness). 9. jury awareness is critical to this proposal not only for those few cases that actually go to the jury, but for the influence on parties’ settlement negotiations. see, e.g., david benjamin oppenheimer, verdicts matter: an empirical study of california employment discrimination and wrongful discharge jury verdicts reveals low success rates for women and minorities, 37 u.c. davis l. rev. 511, 513 (2003) [hereinafter oppenheimer, verdicts matter] (“verdicts matter . . . not only to the parties and their counsel in those few cases where verdicts are rendered, but also to public policy makers and lawyers evaluating that vast majority of cases that never go to trial. . . . stories about jury verdicts can have a profound effect on public opinion and public policy.”). 2013] taxing anxiety 81 all settlement components are taxed the same. jury tax awareness is critical to the proposal because it permits the jury to provide the intended (after-tax) compensation, and also because only by assuming an informed jury will parties be on equal footing for settlement negotiations. and because my policy, unlike the aba and nta suggestions, provides no incentive to make specious claims of emotional distress, it does not risk increasing societal skepticism of mental illness. finally, and not of least importance, the tax preference for physical injuries has a gendered component: men, more than women, recover damages from physical injury, and therefore men, more than women, benefit from the tax rule in its current form.10 by taxing damages for physical injury just as we tax damages for nonphysical injury, we lessen the significance of this gendered distinction. part ii of this article sets the stage by describing the evolution of section 104(a) and the taxation of damages. in part iii, the article turns to a comprehensive, to-date discussion of how courts are treating disputes about damages. parts iv and v discuss the possible solutions: part iv explains the nta and the aba position — achieving parity by expanding the exclusion; and part v explains the full inclusion proposal — achieving parity by eliminating the exclusion — and explains why full inclusion is the better solution. part vi concludes. ii. a long (but not so winding) road: section 104(a) section 104 provides an exclusion from gross income.11 the exclusion is best understood in the context of what is included in income in the first instance. early in our income tax evolution, the construction of income was narrow — income was thought of as gains derived from capital or labor, or both combined.12 workers were taxed on their salaries, and capitalists were taxed on the gains they made from their capital. that early construction proved too narrow, and over time gave way to our current understanding of “income” — a broad and flexible concept.13 income is any accession to wealth, clearly realized, over which the taxpayer has complete dominion.14 this very broad understanding of income encompasses salaries and gains from the use of capital, of course, but it also includes things like 10. it is true that the nta/aba proposals also lessen this gendered component. for the reasons discussed in this article, however, i think my solution is more sound. 11. i.r.c. § 104(a)(2). 12. eisner v. macomber, 252 u.s. 189, 193 (1920). 13. e.g., joseph j. thorndike, the fiscal revolution and taxation: the rise of compensatory taxation, 1929-1938, 73 law & contemp. probs. 95, 96 (2010) (referring to the modern income tax as a “broad-based, flexible revenue instrument”). 14. commissioner v. glenshaw glass co., 348 u.s. 426, 429, 431 (1955). 82 florida tax review [vol. 14:3 prizes, lottery winnings, and even the value of record-breaking home run baseballs caught by fans.15 this understanding of income amplifies the code’s cursory definition: “gross income means all income from whatever source derived.”16 despite the brevity, the court frequently tells us that by this definition, congress intended to exercise the full extent of its constitutional authority to tax income.17 in short, it is taxable unless congress says it is not.18 monetary recoveries from lawsuits and settlements that do not relate to physical injury are sometimes included in this expansive definition of income, and sometimes not. the uneasy, but seemingly settled, rule is that the recovery will be taxable if the recovery was “in lieu of” a taxable receipt.19 under this “in lieu of” rule, recoveries for lost profits are taxable, and recoveries representing a return of capital are not taxable.20 for example, 15. e.g., andrew d. appleby, ball busters: how the irs should tax record-setting baseballs and other found property under the treasure trove regulation, 33 vt. l. rev. 43, 44 (2008) (discussing the public debate surrounding the taxation of record-setting homerun baseballs, and ultimately proposing that we “tax the catcher of the record-setting ball immediately on the retail price of the baseball, then treat the increase in value as unrealized gain, and tax the catcher on that gain if the catcher sells the ball”); joseph m. dodge, accessions to wealth, realization of gross income, and dominion and control: applying the “claim of right doctrine” to found objects, including record-setting baseballs, 4 fla. tax rev. 685, 729 (2000) (arguing that found items, such as record-setting baseballs are well within the definition of “income” and therefore create tax liability). but see lawrence a. zelenak & martin j. mcmahon, jr., taxing baseballs and other found property, 84 tax notes 1299, 1308 (aug. 30, 1999) (arguing that found objects are not within the “residual” category of taxable income and therefore should not create tax liability). 16. i.r.c. § 61(a). 17. glenshaw glass co., 348 u.s. at 429 (noting that “[t]his court has frequently stated that this language was used by congress to exert in this field ‘the full measure of its taxing power.’” (citations omitted)) 18. commissioner v. banks, 543 u.s. 426, 433 (2005) (noting that “[t]he definition [in section 61] extends broadly to all economic gains not otherwise exempted”); commissioner v. kowalski, 434 u.s. 77, 82-83 (1977) (holding the “starting point in the determination of the scope of ‘gross income’ is the cardinal principle that congress in creating the income tax intended to use the full measure of its taxing power” and “‘to tax all gains except those specifically exempted’” (internal quotations omitted). 19. raytheon prod. corp. v. commissioner, 144 f.2d 110, 113 (1st cir. 1944). see also joseph m. dodge, murphy and the sixteenth amendment in relation to the taxation of non-excludable personal injury awards, 8 fla. tax rev. 369, 424 (2007) [hereinafter dodge, murphy and the sixteenth amendment] (discussing the limited but appropriate application of the “in lieu of” test). 20. raytheon prod. corp., 144 f.2d at 113-14. recoveries are taxable only to the extent that the recovery causes the taxpayer to realize a gain on the capital. 2013] taxing anxiety 83 if a party to a contract dispute recovers damages for lost profits, the award will be taxable, because profits are taxable. in contrast, if the recovery instead is for damage to property — say a punk-kid smashed a delivery truck — the award is presumably not taxable, since it is merely putting the truck back to its pre-tort position — the victim is not richer, in the income-tax sense of the word. when the recovery is for personal physical injury, however, congress has seen fit to enact a special rule. section 104(a) excludes from gross income recoveries for personal physical injuries.21 the current version of section 104(a) provides that “gross income does not include . . . (2) the amount of any damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness[.] . . . for the purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness.”22 until recently, damages received for physical injuries also had to satisfy an additional explicit requirement to be excluded: they must have been received on account of “tort or tort type rights.”23 final regulations were issued recently removing the “tort” or “tort-like” requirement, but the removal was not intended to open the floodgates of exclusion.24 as the treasury explained, the “tort” or “tort-like” requirement was no longer necessary because following the 1995 case of commissioner v. schleier,25 the supreme court has interpreted the statutory “on account of” test to exclude only damages directly linked to “personal” injuries or sickness,26 and under the 1996 act, only damages for personal physical injuries or physical sickness are excludable. in other words, the treasury regarded the “tort” or “tort-like” requirement as redundant; the change was in no way intended to permit individuals with no physical injury to recover tax-free. finally, one type of damages is never excluded: receipts are income to the extent they represent punitive damages.27 importantly, emotional distress is 21. i.r.c. § 104(a). 22. id. 23. regs. § 1.104-1(c) (2011). 24. see t.d. 9573, 77 fed. reg. 3106 (jan. 23, 2012). 25. 515 u.s. 323 (1995). 26. t.d. 9573, 77 fed. reg. 3106, 3107 (jan. 23, 2012). 27. i.r.c. § 104(a)(2) (the parenthetical language of section 104(a) provides as such). as a rule, punitive damages are taxable with possible minor exceptions not relevant here. see glenda g. cochran & john s. campbell, taxability of punitive damages, 58 ala. law. 96, 96 (1997) (explaining that the 1996 amendment to section 104(a) clarifies that most punitive damages are taxable, though noting one minor exception — punitive damages awarded for wrongful death are exempt from taxation if awarded in a state in which state law regarding wrongful death provides for no remedy other than punitive damages). see also notice 2012-12, 2012-6 i.r.b. 84 florida tax review [vol. 14:3 specifically excluded from the definition of physical injury or sickness, even if the emotional distress leads to physical injury.28 the anomalous result is that damages for emotional distress arising from a physical injury or sickness are excluded from gross income, while damages for physical manifestations of emotional distress are included in gross income.29 the section 104 exclusion has a long history in our code. its predecessor was first enacted as part of the revenue act of 1918, which excluded from gross income “[a]mounts received . . . as compensation for personal injuries or sickness,” as well as “any damages received . . . on account of such injuries and sickness.”30 although the legislative history does not offer a definitive rationale for the adoption of the exclusion, the exception was enacted just as the court was struggling with the understanding of the breadth of “income” for federal tax purposes. congress created the exception on the heels of a series of supreme court decisions holding that restoration of capital was not income; it is quite possible that these decisions influenced the congressional understanding of income and that the 1918 congress understood damages from physical injury as similarly 365 (advising that restitution payments to victims of human trafficking, which arguably have a punitive component, are not taxable). 28. i.r.c. § 104(a). 29. see, e.g., stadnyk v. commissioner, 96 t.c.m. (cch) 475, 476, t.c.m. (ria) ¶ 2008-289 at 1576 (2008), aff’d, 367 f. app’x 586 (6th cir. 2010) (“for purposes of section 104(a)(2), emotional distress is not treated as a physical injury or physical sickness, except for damages not in excess of the cost of medical care attributable to emotional distress.) note the minor exception explained by the court: taxpayers may exclude damages received for physical manifestations of emotional distress, but only to the extent those damages offset unreimbursed medical expenses that were not deducted. id. this exception is likely to become less important if the patient protection and affordable care act results in fewer individuals lacking health care coverage. 30. revenue act of 1918, pub. l. no. 254, § 213(b)(6), 40 stat. 1066 (1919). recall that the sixteenth amendment passed in 1913, so the exclusion has been part of the income tax almost as long as we have had an income tax. dodge, murphy and the sixteenth amendment, supra note 19, at 372 (noting that congress proposed the sixteenth amendment in 1909, and it was ratified in 1913). “in the early years of this tax (1918-31), only 5.6 percent of the united states population filed income-tax returns with a tax due.” sergio pareja, taxation without liquidation: rethinking “ability to pay,” 2008 wis. l. rev. 841, 851 (2008) (citing michael j. graetz, 100 million unnecessary returns: a simple fair, and competitive tax plan for the united states 86 (2008)). it was not until world war i that the income tax became a tax “on the masses.” dodge, murphy and the sixteenth amendment, supra note 19, at 385. 2013] taxing anxiety 85 falling outside the definition of ‘income’ upon which they could lawfully impose a tax.31 these early cases, and the commentary from the executive and legislative branches, suggest that the exception for damages was carved out in part because the conception of “income” was quite narrow: congress was unsure that damages could in fact be taxed. this early understanding of the scope of permissible taxable income, as evidenced in the cases from the 1910s, has evolved. most modern scholars and the court have abandoned the notion that income is limited to receipts from capital or labor or both combined. an oft-cited turning point in the evolution of our understanding of income and of what is constitutionally subject to tax is found in commissioner v. glenshaw glass.32 although the court in glenshaw glass noted that damages for personal injury would not be included in income, the court articulated a more expansive understanding of income when it held that punitive damages were well within congress’s constitutional taxing power.33 despite the long-standing nature of the exclusion, congress has never articulated the policy reason for the section 104(a)(2) exclusion, and commentators presume that the exception rests at least in part on compassion.34 in casting about for theoretical justifications for the exclusion, courts have surmised that the exclusion serves to make the taxpayer whole for the “loss of personal rights:”35 these awards, as one court noted “in effect . . . restore a loss to capital.”36 however, the argument that damages for personal injury are simply a return of capital and thus not taxable has been 31. see o’gilvie v. united states, 519 u.s. 79, 84 (1996) (explaining that just prior to the enactment of section 104’s predecessor, “this court had recently decided several cases based on the principle that a restoration of capital was not income; hence it fell outside the definition of ‘income’ upon which the law imposed a tax.” (citing doyle v. mitchell brothers co., 247 u.s. 179, 187 (1918); s. pacific co. v. lowe, 247 u.s. 330, 335 (1918))). the house of representatives, the attorney general, and the department of the treasury made similar findings. o’gilvie, 519 u.s. at 85–86 (quoting h.r. rep. no. 767, at 9–10 (1918); 31 op. atty. gen. 304, 308 (1918); t.d. 2747, 20 treas. dec. int. rev. 457 (1918)). 32. 348 u.s. 426, 432, n.8. see also dodge, murphy and the sixteenth amendment, supra note 19, at 383 (discussing glenshaw glass, and discussing that the supreme court reversed the lower court’s reliance on macomber because although “the macomber definition may have been useful in earlier days in order to distinguish capital from income, [it] did not constitute a comprehensive definition of income”). 33. 348 u.s. 426, 432–33. 34. j. martin burke & michael k. friel, taxation of individual income 183 (9th ed. 2010) [hereinafter burke & friel, taxation]. 35. starrels v. commissioner, 304 f.2d 574, 576 (9th cir. 1962). 36. id. 86 florida tax review [vol. 14:3 recently, and firmly, rejected.37 scholar joseph dodge explains the “bankruptcy” of the theory that damages for personal injury must be excluded from gross income because such damages are not “gain” but are a replacement of capital.38 as dodge summarizes: the embarrassing truth is that there has never been a “replacement” requirement under section 104 or any of the non-statutory authority for excluding personal injury damages. shorn of any relevance to facts or even broad (non-tax) notions of capital, the replacement-of-capital theory appears to be nothing more than a new cover draped over the “no (economic) gain” theory.39 the “no (economic) gain” theory fares no better under dodge’s withering gaze, however. he carefully dismantles the notion that damages for physical or emotional injury must be excluded because they do not result in economic gain.40 this lack of theoretical justification does not change the fact of the exclusion. and for decades, courts read the exclusion in section 104(a)(2) to mean that “personal injuries” for section 104 purposes included nonphysical injuries.41in 1989, congress toyed with an amendment that would have required a physical injury before damages were excluded from income,42 but the conference committee rejected the amendment. instead, in 1989 congress added its imprimatur to the expansive reading of the exclusion by amending section 104(a) to exclude from the provision “punitive damages in connection with a case not involving physical injury or physical sickness.”43 37. murphy v. united states, 493 f.3d 170 (d.c. cir. 2007), reversing, murphy v. united states, 460 f.3d 79 (d.c. cir. 2006). for a full discussion of the murphy case and the controversy surrounding the first panel decision, see dodge, murphy and the sixteenth amendment, supra note 19, at 426–27. 38. dodge, murphy and the sixteenth amendment, supra note 19, at 391, 417. 39. id. at 417. 40. id. at 418–23. 41. hawkins v. commissioner, 6 b.t.a. 1023, 1024–25, (1927). but see burke & friel, taxation, supra note 34, at 184 (noting that “congress likely intended to exclude only those damages received on account of physical injuries.”). 42. h.r. rep. no. 101-247, at 1354–55 (1989), reprinted in 1989 u.s.c.c.a.n. 1906, 2824–25. 43. omnibus budget reconciliation act of 1989, pub. l. no. 101-239, § 7641(a), 103 stat. 2106, 2379 (1989). in other words, this amendment clarified that punitive damages were included in income. see patrick e. hobbs, the personal injury exclusion: congress gets physical but leaves the exclusion emotionally 2013] taxing anxiety 87 by clarifying that punitive damages for personal injuries not involving physical injury or sickness were included in taxable income, congress implied that compensatory damages for such injuries were excluded through section 104(a).44 following this amendment, then, it was settled law that section 104(a)(2) excluded from income damages for personal injuries, as defined by the regulations, regardless of whether those damages stemmed from physical or emotional injuries.45 congress took up the issue again in 1996, and this time, the change was radical. as part of the small business job protection act, congress added the current requirements — that excluded damages be a result of physical injury. at the same time, congress clarified that damages arising from emotional distress are not excludable from gross income under section 104(a).46 the legislative history for the 1996 amendment is scant but indicates an intent to exclude from the exclusion — in other words, to include in income — “damages received . . . based on a claim of employment discrimination or injury to reputation accompanied by a claim of emotional distress.”47 although the legislative history is not revealing, the amendment might be seen as a codification of the holdings in two cases, commissioner v. schleier48 and united states v. burke,49 in which the court held that damages received in age discrimination in employment act (“adea”) and title vii cases, respectively, were not excluded from gross income under section 104(a)(2). in burke, the court held that the words “on account of personal injuries” in section 102(a)(2) required that damages be received due to an underlying tort to be excluded.50 the court reasoned the remedies associated with a tort were meant to compensate a victim for a personal injury; distressed, 76 neb. law rev. 51, 74 (1997) [hereinafter hobbs, congress gets physical] (calling the 1989 amendment “an unusual imprimatur”). 44. hobbs, congress gets physical, supra note 43, at 75. 45. united states v. burke, 504 u.s. 229, 236 n.6 (1992) (noting congressional “support for the notion that ‘personal injuries’ includes physical as well as nonphysical injuries”). 46. small business job protection act of 1996, pub. l. no. 104-188, § 1605, 110 stat. 1755, 1838-39 (1996). 47. h.r. rep. no. 104-737, at 300–01 (1996) (conf. rep.), reprinted in 1996 u.s.c.c.a.n. 1474, 1792–93. 48. 515 u.s. 323, 336–37 (1995) (cited in h.r. rep. no. 104-737, supra note 47, at 300 n.55, reprinted in 1996 u.s.c.c.a.n. at 1792). 49. 504 u.s. 229, 237 (1992). 50. burke, 504 u.s. at 242. employees of the tennessee valley authority filed a title vii action alleging wage discrimination on the basis of sex. id. at 230– 31. a settlement was reached in which employment taxes were withheld. id. the taxpayers commenced an action claiming the settlement was on account of personal injury or sickness and, therefore, should be excluded from gross income. id. at 232. 88 florida tax review [vol. 14:3 however, remedies available in cases such as burke under title vii did not compensate for a personal injury, but were exclusively for back wages.51 the court added another layer in schleier, an adea case, when the court held that to be excluded, the taxpayer must not only demonstrate that his or her claim was premised on tort, or tort-like injury (as required by burke) but must in addition “show that the damages were received ‘on account of personal injuries or sickness.’”52 even assuming the taxpayer in schleier met the “tort” requirement, the court reasoned that damages awarded to a victim of age discrimination do not meet the statutory “personal injury or sickness” requirement because, the court explained, “[w]hether one treats respondent’s attaining the age of 60 or his being laid off on account of his age as the proximate cause of respondent’s loss of income, neither the birthday nor the discharge can fairly be described as a ‘personal injury or ‘sickness.’”53 the court distinguished victims of age discrimination with a hypothetical victim of a motor vehicle accident who recovered $30,000 for her medical expenses, lost wages and pain, suffering and emotional distress.54 in the case of the car accident victim the court explained that the entire $30,000 would be excludable under section 104(a)(2) because in that instance, all the damages received were “on account of personal injuries.”55 the critical point this hypothetical illustrates is that each element of the settlement is recoverable not simply because the taxpayer received a tort settlement, but rather because each element of the settlement satisfies the requirement set forth in § 104(a)(2) . . . that the damages were received “on account of personal injuries or sickness.”56 one final supreme court case merits discussion. in its 1996 decision in o’gilvie v. united states57 the court held that punitive damages received by the surviving spouse and the children of a victim of toxic shock syndrome were not excluded from income by section 104(a). the o’gilvie court focused its attention on the meaning of the phrase “on account of” and held that the phrase requires more than simply “but for” causation. it was not enough, the court reasoned, that “but for the personal injury there would be 51. id. at 235, 238. 52. schleier, 515 u.s. at 337. 53. id. at 330. 54. id. at 329. 55. id. at 329–30. 56. id. at 330. 57. 519 u.s. 79 (1996). in 1996, congress modified section 104(a) and clarified that punitive damages are not excluded from income by the section. small business job protection act of 1996, pub. l. no. 104-188, § 1605, 110 stat. 1755, 1838–39 (1996). the o’gilvie court was addressing the 1989 version of section 104(a), which provided in relevant part that “(2) the amount of any damages received . . . on account of personal injuries or sickness” are excluded from income. i.r.c. § 104(a)(2) (1989). 2013] taxing anxiety 89 no lawsuit, and but for the lawsuit, there would be no damages.”58 to be excluded, the court continued, the damages must have been awarded “by reason of, or because of, the personal injuries.”59 the damages awarded to the victim’s family in this case did not fit the exception, since they were given to punish the defendant’s reprehensible conduct.60 although each of these cases was decided under the pre-1996 section 104(a)(2), the cases are important not only as precursors to the 1996 amendment — congress amended the section in the shadow of the court’s various interpretations — but also because the 1996 amendment was not a rejection of any of these cases. the amendment instead provided some clarification, but, as the discussion below makes clear, left much up to courts. as the courts have struggled with interpreting the scope of the modified exception, the trilogy of cases — burke, schleier,61 and o’gilvie — provide some guidance. iii. confusion in the courts: section 104(a)(2) in action despite the amendments to section 104(a), and the guidance provided by the cases discussed above, litigation and uncertainty persist.62 58. o’gilvie, 519 u.s. at 82. 59. id. at 83. 60. id. 61. the two-part schleier test has since been extended to apply to the amended version of section 104, although the second prong now requires proof that the personal injuries or sickness for which the damages were received were physical in nature. see, e.g., venable v. commissioner, 86 t.c.m. (cch) 254, t.c.m. (ria) ¶ 2003-240 (2003), (citing relevant cases) and cases cited therein; oyelola v. commissioner, t.c. summ. op. 2004-28, 9 (mar. 12, 2004). 62. this uncertainly is not surprising, given congress’s “hedging” on several important aspects of section 104(a)(2). see hobbs, congress gets physical, supra note 43, at 83 (complaining that “the new provision raises both interpretive and theoretical questions” such as how to draw the line between physical and nonphysical, and what to do with mixed awards). as will be shown below, the litigation following section 104(a)(2) proves professor hobbs prescient. this confusion is not new, and i am certainly not the first scholar to recognize it. see, e.g., frank j. doti, personal injury income tax exclusion: an analysis and update, 75 denv. u. l. rev. 61, 79 (1997) (“for nearly eighty years, taxpayers, their advisors, and the government have wrestled with the scope of the personal injury exclusion.”); f. philip manns jr., restoring tortiously damaged human capital tax-free under internal revenue code section 104(a)(2)’s new physical injury requirement, 46 buff. l. rev. 347, 351 (1998) [hereinafter manns, restoring human capital] (complaining that the section 104(a)(2) “cases can be described only in an ad hoc manner”). it is not only academics who raise the issue. the nta has flagged it on at least two occasions. 2009 annual report, supra note 4, at 351–54; 2008 annual 90 florida tax review [vol. 14:3 this section focuses on significant problems revealed through close examination of the section 104(a) cases. first, a fundamental definitional problem: the understanding of “physical injury” in the section 104(a) context has courts flummoxed. second and closely related, despite the court’s discussion in o’gilvie, litigants and courts face continuing challenges applying the statutory language “on account of.” and finally, this section examines the differing approaches the courts have taken with respect to allocation of settlement proceeds. a. what is “physical injury” for section 104(a)(2) purposes? congress has decreed, and the courts consistently hold, that to be excluded from income, the settlement or award must be on account of a physical injury or sickness. but congress provided no guidance as to what constitutes a physical injury. sometimes, the answer is easy, as it was for example in chappell v. international steel group.63 in that case, the taxpayer suffered a low-back injury following a motor vehicle accident, and through settlement he received compensation for previously paid medical bills, lost wages, and pain and suffering as well as future medical bills and pain.64 the court readily held that this claim fit exactly under section 104(a)(2) as amplified by schleier: the underlying claim was tort, and further, each element of the settlement was awarded because of that physical injury, not to punish the tortfeasor or deter further tortious conduct.65 few reported cases are as easy as chappell, and courts have struggled at the margins of “physical injury.”66 some courts have determined that a physical injury requires more than a mere involvement of the taxpayer’s physical body. an interesting recent example is the sixth circuit report, supra note 4, at 471 (“taxation of damage awards spurs litigation every year.”). 63. 105 a.f.t.r.2d (ria) 2010-1229, 1230 (n.d. ind. 2010) (deeming the settlement was excludable as it was based upon the taxpayer’s lower back injury and no relief was sought for nonphysical type). 64. id. 65. id. 66. in only a few cases have the courts provided a definite decision on what is not a physical injury in a particular instance. for example, in bond v. commissioner, the tax court deemed that depression is not a physical injury. 90 t.c.m. (cch) 445, 446-47, t.c.m. (ria) ¶ 2005-25 at 1860 (2005). this appears to be a legal, not a medical, conclusion. in wells v. commissioner, the court rejected a taxpayer’s argument that since depression is not specifically listed in the tax code as an emotional injury damages awarded in relation to that depression should be excluded from gross income. 99 t.c.m. (cch) 1032, 1034, t.c.m. (ria) ¶ 2005-5 at 47 (2010). 2013] taxing anxiety 91 decision in stadnvk v. commissioner,67 in which the taxpayer recovered damages after being wrongly accused of writing a bad check and being falsely imprisoned. while the false imprisonment certainly impacted the taxpayer’s physical body (she was arrested and handcuffed, and confined to a cell), the court determined that the arrest did not constitute a physical injury for section 104(a) purposes because there was no causal connection between the physicality and the damages.68 similarly, in shelton v. commissioner, 69 the tax court held a physical injury must include more than an effect on one’s physical body. in shelton, the taxpayer argued that her settlement ought to be excluded from gross income since “after being harassed she was not the same person physically.”70 although current brain science suggests she might well be correct,71 the court rejected this argument.72 even taxpayers who show manifest physical injury, such as bruising, do not always succeed in excluding damages. in some cases, the courts dismiss minor physical injuries, implicitly holding that “physical injury” has an unwritten requirement that the injury be major or significant. in hansen v. commissioner,73 for example, the tax court held that a taxpayer who recovered damages after being physically assaulted twice by his supervisor did not qualify for the exclusion. in the first assault, the supervisor pushed the taxpayer, a mineworker, to the ground, and then rubbed the taxpayer’s 67. 367 f. app’x 586, 587–89 (6th cir. 2010). 68. id. at 594. 69. 97 t.c.m. (cch) 1592, 1593-94, t.c.m. (ria) ¶ 2009-116 at 849 (2009). 70. 97 t.c.m. (cch) at 1594, t.c.m (ria) ¶ 2009-116 at 849. 71. diane ackerman, the brain on love, new york times opinionator (march 24, 2012, 4:28 pm), http://opinionator.blogs.nytimes.com/2012/03/24/thebrain-on-love/ (noting that imaging studies of brains done by ucla neuroscientist naomi eisenberg show that the same areas of the brain that register physical pain are active when someone feels socially rejected, and the same area of the brain registers both rejection and physical assault. ackerman continues, “that’s why being spurned by a lover hurts all over the body, but in no place you can point to. or rather, you’d need to point to the dorsal anterior cingulated cortex in the brain, the front of a collar wrapped around the corpus callosum, the bundle of nerve fibers zinging messages between the hemispheres that register both rejection and physical assault.”). see also david depianto, the hedonic impact of “stand-alone” emotional harms — an analysis of survey data, 36 law & psychol. rev. 115, 117 (2012) [hereinafter depianto, the hedonic impact] (noting that “this negative view of ‘mental’ and ‘emotional’ health — which covers anxiety, inability to concentrate, depression, anguish, grief, psychosis, humiliation, fright, shock and other negative emotions distinct from physical pain — is a legal concept, not a medical one”). 72. shelton, 97 t.c.m. (cch) at 1594, t.c.m (ria) ¶ 2009-116 at 849. 73. 97 t.c.m. (cch) 1447, 1450-51, t.c.m. (ria) ¶ 2009-87 at 644–45 (2009). 92 florida tax review [vol. 14:3 face in the limestone with sufficient force to cause bruising.74 on a different date, the same supervisor again assaulted the taxpayer; this second assault resulted in a cut on the taxpayer’s foot.75 the taxpayer successfully negotiated a settlement after suing on an employment discrimination theory.76 despite the undisputed physical injury, the tax court held the settlement was not excluded from gross income because the complaint and agreement did not specify that the settlement was on account of the physical injuries.77 similarly, in another case the tax court held that when a supervisor bumped his elbow into the employee-taxpayer’s breast, the resulting bruise did not constitute a physical injury for section 104(a)(2) exclusion purposes.78 a kick to the groin, however, might be another story. in an earlier case, amos v. commissioner,79 the court excluded a portion of the taxpayer’s settlement proceeds, despite questionable evidence of physical injury. the taxpayer suffered a kick to the groin; he sought medical care twice, but no evidence of an injury was found, no treatment was prescribed, and the taxpayer declined pain medication.80 the court nonetheless attributed $120,000 of the $200,000 settlement to the physical injury.81 as amos demonstrates, taxpayers are not always on the losing end of this “physical injury” confusion. in fact, in at least two recent cases, discussed in the next section, taxpayers have successfully excluded portions of their recovery of damages even in the total absence of physical contact.82 74. 97 t.c.m. (cch) at 1447, t.c.m. (ria) ¶ 2009-87 at 639–40. 75. 97 t.c.m. (cch) at 1447, t.c.m. (ria) ¶ 2009-87 at 640. 76. 97 t.c.m. (cch) at 1448, t.c.m. (ria) ¶ 2009-87 at 641. 77. 97 t.c.m. (cch) at 1450-51, t.c.m. (ria) ¶ 2009-87 at 644–45. 78. nield v. commissioner, t.c. summ. op. 2002-12, 2, 19-20 (aug. 27, 2002). accord mumy v. commissioner, t.c. summ. op. 2005-122, 2-3, 14-15 (aug. 24, 2005) (denying section 104(a)(2) exclusion to taxpayer who recovered for claim of sexual harassment despite the fact that the taxpayer’s claim that she suffered a physical assault was not refuted, and reasoning that because the taxpayer did not seek medical treatment and did not suffer any long-term physical manifestation, she did not qualify for the section 104(a) exclusion). 79. 86 t.c.m. (cch) 663, 667, t.c.m. (ria) ¶ 2003-329 at 1899–1900 (2003). the amos case is relatively well known, because the tortfeasor was nba star dennis rodman. mr. amos, a professional photographer, was working the game. rodman became frustrated with an aspect of the game and took his frustration out on the nearest person — who happened to be mr. amos sitting courtside. 86 t.c.m. (cch) at 663, t.c.m. (ria) ¶ 2003-329 at 1894. video of the kick is readily found on youtube, and makes a great tax i teaching tool. 80. 86 t.c.m. (cch) at 663–64, t.c.m. (ria) ¶ 2003-329 at 1894–95. 81. 86 t.c.m. (cch) at 667, t.c.m. (ria) ¶ 2003-329 at 1899. 82. see domeny v. commissoner, 99 t.c.m. (cch) 1047, t.c.m. (ria) ¶ 2010-009 (2010); parkinson v. commissioner, 99 t.c.m. (cch) 1583, t.c.m. (ria) ¶ 2010-142 (2010) see also infra part ii.b. 2013] taxing anxiety 93 b. when is an award “on account of” physical injury or sickness just as congress declined to delineate the scope of “physical injury,” section 104(a)(2) does not define the relationship between the physical injury and the tort that is required for exclusion of a damages award. the statutory language provides simply that to exclude damages under section 104(a)(2), those damages must be “received . . . on account of personal injuries or physical sickness.”83 while all courts begin with this language, they vary in their discussions of how the physical injury and the underlying cause of action must interrelate to satisfy the “on account of” language. those differing discussions have led to frequent taxpayer error in excluding from income awards that the courts later hold must be included. the lack of clear guidance has also led, however, to a handful of taxpayers succeeding in excluding damage awards in cases that are nearly indistinguishable from cases in which the irs has prevailed. two recent tax court decisions in which the taxpayer successfully excluded damages merit attention: domeny v. commissioner84 and parkinson v. commissioner.85 in both cases, sympathetic plaintiffs succeeded in excluding portions of their damage awards under section 104(a)(2) after negotiating successful settlements of particularly egregious conduct by their respective employers. in domeny, the taxpayer worked for a nonprofit dedicated to helping children with autism.86 the taxpayer became aware that her new supervisor was embezzling funds, and approached the board of directors with that information. several months later, the supervisor was still on the job, and the escalating tension that taxpayer felt following her whistle-blowing exacerbated her pre-existing multiple sclerosis.87 eventually the symptoms of her ms became debilitating and she was forced to take a leave from her job.88 during that leave, her supervisor telephoned her and informed her that she was fired.89 petitioner contacted an attorney, who agreed she had a cause of action, and the attorney successfully negotiated a settlement.90 the settlement agreement recited that the taxpayer was releasing eight possible rights or causes of action: the first seven comprised a variety of employment claims, such as americans with disabilities act (“ada”), adea and family and medical leave act (“fmla”) claims.91 the final 83. i.r.c. § 104(a)(2); regs. § 1.104-1(c). 84. 99 t.c.m. (cch) 1047, t.c.m. (ria) ¶ 2010-009 (2010). 85. 99 t.c.m. (cch) 1583, t.c.m. (ria) ¶ 2010-142 (2010). 86. domeny, 99 t.c.m. (cch) at 1048, t.c.m. (ria) ¶ 2010-009 at 67. 87. id. 88. id. 89. id. 90. id. 91. specifically, the first seven claims released included the following: 94 florida tax review [vol. 14:3 cause of action released was that for “any and all claims for breach of contract, breach of the covenant of good faith and fair dealing, invasion of privacy, infliction of emotional distress, defamation and misrepresentation.”92 the settlement was for about $33,000, of that amount around $8,000 was wages due, and an additional $8,000 went to the plaintiff’s attorney.93 the tax treatment of those first two amounts was not in dispute; instead, the dispute centered on whether the remaining amount — about $16,000 — was properly excluded under section 104(a)(2).94 the settlement agreement was silent as to the purpose of the payment.95 such silence is often fatal to the exclusion of damages under section 104(a)(2),96 (a) any and all rights and claims relating to or in any manner arising from the * * * [petitioner’s] employment or the termination of her employment; (b) any and all rights and claims arising under the california fair employment and housing act * * *; (c) any and all claims arising under the civil rights act of 1964 * * *; (d) any and all rights and claims arising under the americans with disabilities act; (e) any and all rights and claims arising [sic] the age discrimination in employment act of 1967 * * *; (f) any and all rights and claims arising under the family and medical leave act or the california family rights act; (g) any and all claims for violation of the fair labor standards act, the california labor code, or the california wage orders. 99 t.c.m. (cch) at 1048, t.c.m. (ria) ¶ 2010-009 at 68. 92. id. 93. id. 94. 99 t.c.m. (cch) at 1049, t.c.m. (ria) ¶ 2010-009 at 68. 95. domeny, 99 t.c.m. (cch) at 1049, t.c.m. (ria) ¶ 2010-009 at 68 (noting that “[i]n all respects, the settlement agreement is ambiguous regarding any specific reason for the payment”). 96. see e.g., hellesen v. commissioner, 97 t.c.m. (cch) 1810, 1813, t.c.m. (ria) ¶ 2009-143 at 1170 (2009) (noting that “[w]ithout such an allocation, no amount of the settlement may be excluded from income”). even with a specific allocation in a settlement agreement, damage awards might nonetheless be included in income. e.g., goode v. commissioner, 91 t.c.m. (cch) 901, 903-05, t.c.m. (ria) ¶ 2006-048 at 378–81 (2006), appeal dismissed per stipulation, no. 06-1219, 2008 wl 435520 (d.c. cir. 2008) (including the award and upholding the penalty despite express allocations in settlement agreements because although express identification of payment amounts deemed eligible for “compensation for injuries or sickness” exclusion from income are generally upheld, allocations that do not arise from arm’s length negotiations are not conclusive); vincent v. commissioner, 89 t.c.m. (cch) 1119, t.c.m. (ria) ¶ 2005-095 at 667 (2005) (“we are not bound by a settlement agreement’s characterization or division of settlement amounts, particularly where it appears that one party may not have had a strong motivation to negotiate at arm’s length as to the characterization and/or division of the settlement amounts.”). 2013] taxing anxiety 95 but in this case, the court permitted exclusion from income, reasoning that the payment was “on account of” the physical injuries — in particular, the exacerbated multiple sclerosis.97 domeny is not unique. in a similar case, parkinson v. commissioner,98 the taxpayer successfully excluded a portion of his settlement from income on the basis of a physical injury. in parkinson, just like domeny, the taxpayer’s pre-existing health condition was exacerbated due to stress brought on by a hostile work environment. mr. parkinson was a hospital-based ultrasound technician who had supervisory responsibilities. harassment by colleagues and stressful conditions at work contributed to an initial heart attack. upon his return to work not only did his employer fail to provide reasonable accommodations but in fact permitted the harassment to escalate such that mr. parkinson suffered a second heart attack.99 he eventually filed suit in state court, alleging claims of intentional infliction of severe emotional distress and invasion of privacy. a day after the jury trial began, the parties reached a $350,000 settlement for “noneconomic damages and not as wages or other income.”100 mr. parkinson received a portion of the settlement and did not report any as income. the court ultimately agreed the payment was properly excluded, and in so doing, rejected the irs’s argument that the payment was on account of emotional distress, and not physical injury.101 citing legislative history, the court distinguished between subjective physical symptoms resulting from emotional distress — such as “insomnia, headaches, stomach disorders” and objective signs of physical injury manifesting from emotional distress.102 damages received on account of the subjective symptoms are includable in income, while damages received on account of objective signs of physical injury are properly excluded pursuant to section 104(a)(2). the court concluded that mr. parkinson’s settlement was properly excluded because “a heart attack and its physical aftereffects constitute physical injury 97. 99 t.c.m. (cch) at 1049–50, t.c.m. (ria) ¶ 2010-009 at 68–70. 98. 99 t.c.m. (cch) 1583, t.c.m. (ria) ¶ 2010-142 (2010). 99. 99 t.c.m. (cch) at 1584, t.c.m (ria) ¶ 2010-142 at 853. the alleged harassment was indeed extreme. for example, the taxpayer suffered a second heart attack at work; he was taken to the emergency room, but he could not escape harassment even there. as the taxpayer was “receiving treatment in the emergency room, one of [his co-workers] reached him by telephone and demanded that he return to work or [else] face disciplinary action.” id. at 1584, t.c.m. (ria) ¶ 2010142 at 853. 100. 99 t.c.m. (cch) at 1584–85, t.c.m (ria) ¶ 2010-142 at 853. 101. 99 t.c.m. (cch) at 1587, t.c.m (ria) ¶ 2010-142 at 857 102. parkinson, 99 t.c.m. (cch) at 1586, t.c.m (ria) ¶ 2010-142 at 855–56 (citing and quoting h.r. rep. no. 104-737, supra note 47, reprinted in 1996 u.s.c.c.a.n. 1677). 96 florida tax review [vol. 14:3 or sickness rather than mere subjective sensations or symptoms of emotional distress.”103 few taxpayers fare so well with similar claims.104 for example, in pettit v. commissioner,105 the taxpayer’s pre-existing condition, irritable bowel syndrome,106 was exacerbated by a wrongful discharge. however, unlike the courts in domeny and parkinson, the pettit court held that the settlement was not “on account of” a physical injury or sickness as required for the section 104(a)(2) exclusion.107 another difficult to distinguish case is hellesen v. commissioner.108 in hellesen, the taxpayer and his wife worked as claims attorneys for the same company. the couple recovered about $500,000 in settlement of their claims for discrimination. the taxpayer husband alleged various physical ailments, including chest pains, stomach 103. 99 t.c.m. (cch) at 1586, t.c.m (ria) ¶ 2010-142 at 856. the “symptom versus sign” distinction can be found throughout the tax cases, with taxpayers’ bids to exclude damages more frequently being rejected because the courts interpret certain injuries as “symptoms” rather than “signs.” e.g., lindsey v. commissioner, 422 f.3d 684, 688–89 (8th cir. 2005) (taxpayer suffered hypertension and periodic impotency, insomnia, fatigue, occasional indigestion and urinary incontinence, but the award was taxable because these were symptoms rather than a physical injury or sickness); sanford v. commissioner, 95 t.c.m. (cch) 1618, 1620, t.c.m. (ria) ¶ 2008-158 at 870 (2008) (physical injuries of “asthma, sleep deprivation, skin irritation, appetite loss, severe headaches, and depression” were symptoms related to the underlying sexual harassment and discrimination and therefore the award was taxable). see also prinster v. commissioner, t.c. summ. op. 2009-99, 8 (june 30, 2009) (taxpayer suffered exacerbation of hyperlipidemia and hypertension caused by his wrongful termination; the court held these were “symptoms related to emotional distress rather than physical sickness”). 104. for example, in prasil v. commissioner, the taxpayer claimed that the sexual harassment for which she recovered damages had exacerbated her condition of sweet’s syndrome, but the court determined that because her medical records did not sufficiently document her claim, her entire settlement was taxed. 85 t.c.m. (cch) 1124, t.c.m. (ria) ¶ 2003-100 (2003). “sweet’s syndrome . . . is a rare skin condition marked by fever and painful skin lesions that appear mainly on your arms, neck, face and back.” health information, mayo clinic, http://www.mayoclinic. com/health/sweets-syndrome/ds00752 (last visited jan. 27, 2013). 105. 95 t.c.m. (cch) 1341, t.c.m. (ria) ¶ 2008-087 (2008). 106. “irritable bowel syndrome or ibs affects up to 55 million americans, mostly women. ibs causes are unknown. ibs symptoms include diarrhea, constipation, and abdominal cramps. there are ibs treatments such as diet and lifestyle changes and medications that can help.” webmd, http://www.webmd.com/ ibs/default.htm (last visited jan. 27, 2013). 107. pettit, 95 t.c.m. (cch) 1341, 1344, t.c.m. (ria) ¶ 2008-087 at 475–76 (noting that no medical records tied the physical injury to the cause of action). 108. 97 t.c.m. (cch) 1810, t.c.m. (ria) ¶ 2009-143 (2009). http://www.mayoclinic.com/health/sweets-syndrome/ds00752 2013] taxing anxiety 97 problems, and significant weight loss.109 the court reasoned, though, that the settlement must be fully included in income since none of the seven causes of action claimed in the lawsuit alleged physical injury or sickness, even though the settlement agreement was broad and encompassed physical injuries.110 the court hinted that the taxpayer might have salvaged his argument, had the settlement made a specific allocation as compensation for physical injuries or physical sickness, but “[w]ithout such an allocation, no amount of the settlement may be excluded from income.”111 the proper interpretation of the “on account of” requirement is not the only challenge facing taxpayers and the courts in their efforts to divine the proper parameters of section 104(a)(2). in particular, courts vary in what the requirements of the taxpayer’s underlying claim must be — for example, denying the exclusion even where there is undisputed evidence of physical injury because the underlying cause of action was not sufficiently “tortlike.”112 and yet another outstanding issue is whether the taxpayer must allege some physical contact by the payor that leads to the physical injury, regardless of the underlying claim, before the exception will apply.113 109. 97 t.c.m. (cch) at 1811, t.c.m. (ria) ¶ 2009-143 at 1168. 110. 97 t.c.m. (cch) at 1813, t.c.m. (ria) ¶ 2009-143 at 1170. 111. 97 t.c.m. 9cch) at 1813, t.c.m. (ria) ¶ 2009-143 at 1170. numerous cases reason similarly. see, e.g., hawkins v. commissioner, 386 fed. app’x 697 (9th cir. 2010) (holding the settlement fully included in income because the taxpayer’s claim was for wage and hour discrimination, not personal injury, even though she alleged physical and mental distress); tamberella v. commissioner, 139 fed. app’x 319 (2d cir. 2005) (whether damages are excludable under section 104(a)(2) turns on the nature of the claim underlying the award of damages); longoria v. commissioner, 98 t.c.m. (cch) 11, 15, t.c.m. (ria) ¶ 2009-162 at 1279 (2009) (reasoning that first a court should examine the nature of the claim based upon the claims asserted in the lawsuit and then should look to the intent of the payor as to why the settlement amounts were actually paid); green v. commissioner, 93 t.c.m. (cch) 917, 919-20, t.c.m. (ria) ¶ 2007-039 at 387–88 (2007) (holding that since the complaint did not allege any physical injury and the award did not reference a physical injury or sickness, the award for retaliation for filing a discrimination suit could not have been on account any physical injuries); peck v. commissioner, t.c. summ. op. 2006-86, 6 (may 23, 2006) (holding that “[t]here is nothing in the record linking the settlement proceeds to petitioner’s diabetes or other physical injuries,” the settlement was consequently not excludable under section 104(a)(2)); medina v. commissioner, t.c. summ. op. 2003-148 (oct. 7, 2003). 112. see cases in note 111, supra. 113. e.g., gibson v. commissioner, 94 t.c.m. (cch) 164, t.c.m. (ria) ¶ 2007-224 (2007). in gibson, the taxpayer and his family inherited a house in sun city, california. at the time, sun city’s housing code permitted only senior citizens to reside in the district. the taxpayer and his family members were subject to significant harassment from their neighbors, and they eventually sued various 98 florida tax review [vol. 14:3 furthermore, in some but not all cases, the court has required that particular language appear in the settlement agreement for the exclusion to apply. in longoria v. commissioner,114 for example, the taxpayer, a former state trooper, suffered from several physical injuries related to the racial discrimination for which he ultimately recovered damages. the taxpayer’s physical injuries were a subject of the negotiation, but mention of those physical injuries did not appear in the complaint or ultimate settlement agreement.115 this absence, according to the court, was fatal to the exclusion of any of the award.116 in contrast, as discussed above, the court did not apply such a requirement in the domeny case.117 c. allocation anguish finally, the courts have added to the confusion by differing in their approaches to allocating recoveries. as described below, treatments range from cases in which the court summarily accepts the taxpayer’s allocation, to the tax court inventing its own allocation.118 in the majority of reported decisions, if no allocation is indicated, the court will consider the entire settlement or award taxable.119 a characteristic remark is that “[i]n the absence of a basis for allocation, we presume the entire amount is not excludable.”120 even in cases in which the allocation between physical and nonphysical damages is specific, the courts may not respect the allocation. in defendants under a theory of housing discrimination. the taxpayer claimed headaches, stomachaches, and breathing problems, and eventually recovered $350,000. 94 t.c.m. (cch) at 165–66, t.c.m. (ria) ¶ 2007-22.4 at 1397–98. the court did not question the taxpayer’s veracity but held the entire recovery nonetheless includable because the taxpayer failed to show that any of the payors actually caused his physical injury. 94 t.c.m. (cch) at 167, t.c.m. (ria) ¶ 200722.4 at 1399–1400. 114. 98 t.c.m. (cch) 11, t.c.m. (ria) ¶ 2009-162. mr. longoria suffered injuries during his trooper training and additional injuries during his tenure as a trooper. as one example, “mr. longoria’s locker was top-loaded by a group of renegade troopers. . . . the arrangement had its intended effect when mr. longoria opened the locker, it fell on him, and he injured his back.” 98 t.m.c. (cch) at 11, 12, t.c.m. (ria) ¶ 2009-162 at 1275. 115. 98 t.c.m. (cch) at 15, t.c.m. (ria) ¶ 2009-162 at 1279. 116. 98 t.c.m. (cch) at 15–17, t.c.m. (ria) ¶ 2009-162 at 1279–81. 117. domeny v. commissioner, 99 t.c.m. (cch) 1047, t.c.m. (ria) ¶ 2010-009 (2010). 118. this of course sets aside those cases in which the court summarily includes an award in its entirety. 119. see cases in note 111, supra. 120. prinster v. commissioner, t.c. summ. op. 2009-99, 9 (2009). 2013] taxing anxiety 99 burditt v. commissioner,121 for example, a settlement agreement allocated a portion of the settlement to physical damages. however, the allocation came about after the taxpayer asked his attorney to insert “the proper personal injury language” and hence his attorney included boilerplate language.122 the court held that because of this the allocation was tax-motivated and did not reflect the realities of the settlement, the entire award was taxable.123 finally, in a handful of reported cases, the courts have taken it upon themselves to allocate or re-allocate. in parkinson, discussed above, the parties did not make a specific allocation.124 in this instance, the absence did not automatically dictate inclusion. instead, the court surmised that half of the settlement was for physical injuries and thus excludable from gross income.125 similarly in amos v. commissioner,126 the court allocated the settlement on its own, in the absence of a specific allocation. though the settlement agreement used generic language of “to resolve any potential claims,” the court imputed the taxpayer’s dominant reasons for making the settlement based upon the settlement agreement, a declaration by dennis rodman (the tortfeasor), the payor, and the taxpayer’s testimony. ultimately, the court excluded $120,000 of the $200,000 settlement under section 104(a)(2).127 iv. section 104(a)(2) needs reform the nta128 has urged a modification to section 104(a),129 and the aba has added its significant voice to the call for reform. the nta would reform section 104(a)(2) to eliminate the “physical” requirements. presumably, any damages received on account of physical or emotional 121. 77 t.c.m. (cch) 1767, t.c.m. (ria) ¶ 1999-117 (1999). 122. 77 t.c.m. (cch) at 1772, t.c.m. (ria) ¶ 1999-117 at 99–714 (1999). 123. 77 t.c.m. (cch) at 1772-73, t.c.m. (ria) ¶ 1999-117 at 99–714. 124. parkinson v. commissioner, 99 t.c.m. (cch) 1583, 1586, t.c.m. (ria) ¶ 2010-142 at 855 (2010). 125. 99 t.c.m. (cch) at 1587, t.c.m. (ria) ¶ 2010-142 at 857. 126. 86 t.c.m. (cch) 663, 667, t.c.m. (ria) ¶ 2003-329 at 1899 (2003). 127. 87 t.c.m. (cch) at 667, t.c.m. (ria) ¶ 2003-329 at 1899 (2003). 128. according to the taxpayer advocate services’ (tas) website, nina e. olson, the national taxpayer advocate, leads an office which “serves as an advocate for taxpayers to the irs and congress.” see about tas: tas leadership, taxpayer advocate services, http://www.taxpayeradvocate.irs.gov/abouttas/tas-leadership (last visited jan. 27, 2013). the tas is “a nationwide organization of approximately 2,000 taxpayer advocates who help u.s. taxpayers resolve problems and work with the irs to correct systemic and procedural problems.” id. 129. 2009 annual report, supra note 4. 100 florida tax review [vol. 14:3 injury would be non-taxable. the aba sketches out a possibly more ambitious exclusion. the aba would modify section 104(a)(2) so as to exclude from income not only those monies received on account of injury, but all “noneconomic damages.”130 as i discuss below, it is unclear how these reforms would eliminate the significant problems plaguing the taxation of damages. first, however, i will amplify the nta/aba discussion of the problems of the current regime. the 2008 and 2009 nta annual reports detailed some of the problems with the current treatment of damages.131 for example, the nta’s 2008 annual report noted that continuous litigation plagues section 104(a).132 since the nta reports, that litigation has not let up.133 that continuous litigation is a drawback need not be belabored. litigation is stressful to taxpayers; it is expensive not only to the taxpayers, but also to the irs and the courts.134 though some taxpayers represent themselves pro se in tax court, all taxpayers sink a significant amount of time and energy into their representation. further, some taxpayers secure representation in tax court, and no doubt incur additional costs for that representation. although not expressly mentioned by the nta, in section 102(a)(2) cases, the irs frequently seeks penalties.135 in the sample of cases examined, penalties are 130. mcmillion, rite of spring, supra note 5, at 65 (explaining the aba position regarding the civil rights tax relief act as follows: “victims of discrimination are penalized by current tax laws requiring them to pay taxes on settlements and awards of noneconomic damages, and to pay taxes at one time on income awards that might cover many years. the proposed legislation would exclude noneconomic damages from taxable income and allow income averaging for income awards covering multiple years that are paid in a lump sum.”). 131. see 2009 annual report, supra note 4, at 351–56; 2008 annual report, supra note 4, at 472–74. 132. 2008 annual report, supra note 4, at 472. 133. see supra part iii and the cases discussed therein. 134. the majority of the cases were in tax court, rather than federal district court; many of the taxpayers were pro se. see 2008 annual report, supra note 4, at apps. tbl. 3, http://www.irs.gov/pub/irs-utl/08_tas_arc_apps.pdf. although foregoing representation saves attorney fees, it creates additional stresses for taxpayers, who often spend a great deal of time and money representing themselves. 135. see, e.g., parkinson v. commissioner, 99 t.c.m. (cch) 1583, t.c.m. (ria) ¶ 2010-142 (2010) (holding taxpayer not liable for accuracy-related penalty); longoria v. commissioner, 98 t.c.m. (cch) 11, t.c.m. (ria) ¶ 2009-162 (2009) (rejecting the commissioner’s request for an accuracy-related penalty); pettit v. commissioner, 95 t.c.m. (cch) 1341, t.c.m. (ria) ¶ 2008-087 (2008) (rejecting the commissioner’s request for accuracy-related penalties); prinster v. commissioner, t.c. summ. op. 2009-99 (june 30, 2009); smith v. commissioner, t.c. summ. op. 2007-106 (june 25, 2007) (rejecting the commissioner’s request for accuracy-related penalties); medina v. commissioner, t.c. summ. op. 2003-148 (oct. 7, 2003) (rejecting the commissioner’s request for accuracy-related penalties). 2013] taxing anxiety 101 rarely upheld, but they nonetheless sometimes are upheld,136 and the threat of penalties is an added stress to taxpayers who have already been victimized or injured. finally, even those taxpayers who avoid penalties must pay the statutory rate of interest on any income they failed to include.137 the frequency of litigation pointed out by the nta is likely the tip of an iceberg. the ongoing confusion surrounding the issue no doubt influences parties’ settlement negotiations. in cases in which taxpayers are wrongly advised that their damage award will not be taxable, the taxpayer demands insufficient monies to make her whole. mistakes going the other way no doubt occur — it is almost certain that taxpayers and tortfeasors on occasion mistakenly include damages in taxable income that properly would be excluded pursuant to section 104(a)(2). such mistakes are difficult to quantify, since it is highly unlikely that the irs will have any way of finding an overpayment of this sort and has no incentive to do so. a. allocation arbitrage i agree with these drawbacks of the present regime, as i make clear in the above discussion, which significantly expands on the preliminary remarks offered in the nta’s reports. another pressing concern not identified by the nta reports is that the exclusion of damages on account of physical injury provides an incentive for taxpayers and the parties against whom they are negotiating to engage in creative structuring of settlement agreements to “share” the tax savings that results by exclusion. as it stands, section 104(a)(2) provides a significant tax incentive for plaintiffs to settle, especially in cases where there is a probability of punitive damages. this incentive exists because the parties can engage in what i have termed “allocation arbitrage” — they can agree that the damages awarded to the plaintiff are not punitive and are instead awarded on account of physical injury so that the plaintiff will not be taxed on the award. the resulting tax savings can then be shared between the parties. it is difficult to establish the extent of such allocation arbitrage, but it no doubt exists. for example, consider a negotiation surrounding an employment discrimination dispute — assume that the plaintiff suffered a minor physical injury and that physical injury was related to the illegal discrimination. also assume that the plaintiff and plaintiff’s counsel were 136. see, e.g., sanford v. commissioner, 95 t.c.m. (cch) 1618, t.c.m. (ria) ¶ 2008-158 (2008) (upholding an accuracy-related penalty). 137. i.r.c. § 6601(a) (“if any amount of tax imposed by this title (whether required to be shown on a return, or to be paid by stamp or by some other method) is not paid on or before the last date prescribed for payment, interest on such amount at the underpayment rate established under section 6621 shall be paid for the period from such last date to the date paid.”). 102 florida tax review [vol. 14:3 able to find some sort of “smoking gun” that would be damning to the company’s reputation if revealed in trial. counsel, and no doubt the parties, are keenly aware that if the case went to trial the “smoking gun” would present a huge risk that the jury would award punitive damages. in such a situation, our hypothetical plaintiff will be able to negotiate a very favorable settlement, some of which ought to be attributable to punitive damages. there is absolutely no incentive though, to allocate even one dollar of the settlement agreement to punitive damages. rather the plaintiff has an incentive not to do so, since the damages would be taxable. the tortfeasor has no incentive to do so,138 since they would then be admitting wrongful conduct and since the plaintiff is likely to demand some additional sum to make up for the tax cost.139 b. gendered component in addition, yet another significant drawback to the current treatment of the taxation of damages is its gendered component: women, more than men, recover damages attributable to “noneconomic” injury,140 and therefore, men, more than women, benefit from this tax rule. by taxing damages for physical injury just as we tax damages for nonphysical injury, we lessen the significance of this gendered distinction. 138. at present, punitive damages are deductible by business taxpayers. polsky & markel, punitive damages, supra note 8, at 1296. the deductibility of punitive damages would provide an incentive to characterize damages as punitive only if a different characterization would render the damages non-deductible. that is not a risk here — the damages would be deductible to the business tortfeasor whether characterized as compensatory or punitive. 139. in conversation with members of the employment bar, i have not been able to find even a single instance of a settlement agreement that includes punitive damages. notes from interviews between members of the employment bar and the author, minneappolis and st. paul, minn (2012) (on file with author). see also robert w. wood, tax aspects of settlements and judgments, 522-3d tax mgmt. (bna) a-33 (2006) (“it would be highly atypical for a settlement agreement to acknowledge that any portion of the settlement was being paid on account of punitive damages” since “[v]irtually no defendant would agree to such a characterization”) (cited in polksy & markel, punitive damages, supra note 8, at 1334 n. 98). 140. lucinda m. finley, the hidden victims of tort reform: women, children, and the elderly, 53 emory l.j. 1263, 1265-66 (2004) [hereinafter finley, hidden victims]; see also joanna m. shepherd, tort reforms’ winners and losers: the competing effects of care and activity levels, 55 ucla l. rev. 905, 946-47 (2008) [hereinafter shepherd, winners and losers] (finding that women suffer injuries more commonly compensated through noneconomic damages than men). 2013] taxing anxiety 103 empirical work done by scholar lucinda finley141 and others in the context of tort reform142 establishes that when women recover damages, a much higher percentage of those damage awards are for “mental-type” injury than is the case when men recover damages.143 finley’s data establishes the strong tendency of juries to allocate a much higher portion of women’s awards to noneconomic damages.144 finley is not the only scholar to find evidence of the gendered nature of damage awards. joanna m. shepherd, for 141. finley does not address the tax consequences of the awards; instead she focuses on the impact of tort reform on women and children. see finley, hidden victims, supra note 140. nonetheless, her valuable work documents the gendered nature of damages, and as such is valuable to my thesis. see id. at 1266 (collecting data from “several states on how juries in medical malpractice and other tort suits allocate their damage awards between economic loss damages and noneconomic loss damages”). 142. this section utilizes research done in the field of tort reform. as noted above, section 104(a)(2) is no longer explicitly tied to the presence of a tort; nonetheless, section 104(a)(2) applies principally in the tort context. see supra notes 23–26 and accompanying text. further, it is possible that the relevant trends the tort reform studies have revealed of women recovering more for nonphysical harms (which are taxable) than physical harms (nontaxable) are not exclusive to tort actions. for example, scholars have also found evidence of gendered disparities in employment discrimination actions. see infra note 145. 143. in the group of california cases finley studied, an eye-popping 76.35 percent of the damages women recovered were attributable to noneconomic damages. finley, hidden victims, supra note 140, at 1285. to take another example, in the eighty-eight cases finley collected from maryland, the average noneconomic award to women was $714,881, while the average noneconomic award to men was $495,457. id. at 1307. when further broken down into medical malpractice and automobile cases, the trend held: in medical malpractice cases, women’s noneconomic damages averaged $839,341 and men’s awards averaged $544,429; in auto cases, noneconomic awards to women totaled $669,474, while men’s averaged $450,354. id. at 1308. the work of other scholars shows similar results. e.g., thomas koenig & michael rustad, his and her tort reform: gender injustice in disguise, 70 wash. l. rev. 1 (1995) [hereinafter koenig & rustad, gender injustice] (noting that in the context of medical malpractice, punitive damages are more often awarded to women, and make up a higher percentage of women’s awards). recall that punitive damages are taxable even if the underlying action is for physical injury. i.r.c. § 104(a)(2); see supra note 27 and accompanying text. 144. because finley examines primarily medical malpractice awards, some of these awards nonetheless qualify for the section 104(a)(2) exclusion because the underlying medical malpractice satisfies the “physical injury” requirement, and therefore the broad exclusion applies. see also koenig & rustad, gender injustice, supra note 143, at 1 (finding that “proposed restrictions on non-economic damages and the food and drug administration defense to punitive damages will have a disparate impact on women’s mass tort remedies” because of the gendered nature of damages awards). 104 florida tax review [vol. 14:3 example, has examined tort reform, and she found not only that tort reform disproportionately reduces women’s overall tort judgments, but distressingly, that the reforms are associated with increases in women’s death rates.145 the reforms envisioned by nta and aba seem to be driven in part by a focus on victims of employment and other forms of discrimination, and not just tort victims.146 just like in the more traditional tort context, however, the limited available empirical data suggest that in cases of employment discrimination, there is a gendered component to recovery.147 one scholar who studied a large sample of california verdicts concluded that “[t]he most significant finding is that women and minorities are substantially disadvantaged in bringing certain kinds of employment discrimination claims, as compared with the success rates of all plaintiffs in all employment law jury trials.”148 this conclusion suggests that the gendered nature of recoveries ought to be considered when contemplating a reform of the tax treatment of those recoveries. based on this data, exempting monies received by victims of employment discrimination will benefit men more than women. if that is the case, the gendered nature of the current tax treatment of damages will only be exacerbated. in sum, reform of section 104(a)(2) is appropriate because in its current form, the preference of awards for physical injury imports into tax law the longstanding and well-documented gender bias in our tort system.149 the exclusion of awards for physical, but not emotional damages disadvantages women in two ways: first (and ignoring “types” of awards) since “[i]n the aggregate, women’s tort damage awards are lower than their 145. shepherd, winners and losers, supra note 140, at 908–09; see also lisa m. ruda, caps on noneconomic damages and the female plaintiff: heeding the warning signs, 44 case w. res. l. rev. 197, 231 (1993) (arguing in the context of tort reform that “[t]he impact of caps on noneconomic damages will impact women disproportionately since women currently are awarded lower overall damages in comparison to their male counterparts”). 146. the aba specifically mentioned discrimination victims in its call for reform. mcmillion, rite of spring, supra note 5, at 65 (specifically mentioning victims of discrimination in describing the aba position). 147. oppenheimer, verdicts matter, supra note 9, at 514. see also charles a. brown, employment discrimination plaintiffs in the district of maryland, 96 cornell l. rev. 1247, 1271 (2011) (noting the limitation of the empirical studies of employment discrimination litigation, which usually do not distinguish among the types of discrimination alleged or the types of plaintiffs involved). 148. oppenheimer, verdicts matter, supra note 9, at 514. 149. see generally martha chamallas & jennifer b. wriggins, the measure of injury: race, gender, and tort law 1 (2010) [hereinafter chamallas & wriggins measure of injury] (explaining “how the shape of contemporary u.s. tort law — from the types of injuries recognized, to judgments about causation, to the valuation of injuries — has been affected by the social identity of the parties and cultural views on gender and race”). 2013] taxing anxiety 105 male counterparts,”150 the total dollar amount of tax savings is higher for men than for women under the current regime. the current tax treatment of damages disadvantages women in a second way because the empirical data establishes that men, more than women, recover the types of damages, (specifically, damages on account of physical injury) that qualify for the section 104(a)(2) exclusion.151 by exempting from taxation only those dollars recovered for physical injury, while taxing dollars received on account of mental or emotional distress and punitive damages, we give a systematic tax advantage to men. this tax preference might be defensible if there were a legitimate or compelling reason for the preference, but the exclusion of awards for physical injury is longstanding, but not long on reason. neither tax policy, nor tort theory, nor the two together, supports the exclusion in its current form. tax scholar joseph dodge has examined the theoretical justifications for the exclusion in his exhaustive discussion of section 104(a)(2).152 dodge concludes that there is no compelling policy justification for the exception, at least in its current form and in its entirety.153 dodge is not the only scholar to reach this conclusion.154 the difficulty courts and tax scholars have had finding a tort theory justifying the exclusion might be in part explained by the argument that tort theory itself is muddled, as argued by leading tort theorists, such as john c.p. goldberg and others, who suggest that tort theory itself has lost its way.155 though goldberg does not appear to have addressed the intersection of torts and taxes,156 he argues persuasively that tort theory has missed the mark by 150. rebecca korzec, maryland tort damages: a form of sex-based discrimination, 37 u. balt. l.f. 97, 99 (2007). 151. see sources cited in notes 143–44, supra. 152. joseph m. dodge, taxes and torts, 77 cornell l. rev. 143, 144 (1992) (setting out as the “main purpose . . . to examine whether tax policy, alone or in conjunction with policies of tort law, justifies the exclusion of any component of a personal injury recovery”). 153. id. at 188. 154. see, e.g., manns, restoring human capital, supra note 62, at 349 (complaining of a “lack of focus on the [section104(a)(2)] exclusion and a resultant failure to develop a coherent theory or policy underlying it”). 155. john c.p. goldberg & benjamin c. zipursky, torts as wrongs, 88 tex. l. rev. 917, 918 (2010) [hereinafter goldberg & zipursky, torts as wrongs] (lamenting that “law professors have lost their grip” on the subject matter of torts and setting out their goal to “put us back on track, not just pedagogically but theoretically”). 156. goldberg is a prolific scholar, and several of his articles mention taxes to illustrate another point, but his published work does not appear to have taken up the question of the intersection of tort theory and tax policy or theory. e.g., john c.p. goldberg, twentieth-century tort theory, 91 geo. l.j. 513, 544, 574 (2003) (mentioning taxes in the following rhetorical: “if mandatory insurance schemes are 106 florida tax review [vol. 14:3 disassociating “wrongs” from tort.157 the significant scholarly focus of tort theory, which goldberg traces with co-author benjamin c. zipursky from holmes to present day scholars, has been on making torts about shifting losses regardless of fault. goldberg and zipursky demonstrate the pitfalls of such an approach and offer their solution — returning to torts as a law of wrongs.158 goldberg’s critique, however, demonstrates the danger of relying on tort theory as justification for the rule set out by section 104(a)(2): if tort theory itself is disjointed, it is unlikely to suffice to justify a tax rule. c. additional rationales for eliminating the exclusion another reason to eliminate the exclusion is that it is difficult to justify an exclusion for one sort of damages when other taxpayers who are equally or more sympathetic do not get the benefit of a similar exclusion for money damages. for example, in some states, individuals who have been exonerated after being wrongfully convicted and incarcerated are entitled to significant monetary awards.159 although academics have argued that such awards ought to be nontaxable, no code provision provides for such.160 as another example, victims of human trafficking are entitled to mandatory statutory restitution payments from convicted offenders.161 in particular, courts must order convicted defendants to pay restitution including: [a]ny costs incurred by the victim for — (a) medical services relating to physical, psychiatric, or psychological care; (b) physical and occupational therapy or rehabilitation; (c) necessary transportation, temporary housing, and child care expenses; (d) lost income; (e) attorneys’ fees, as well the preferred solution to the social dislocation caused by accidents, does not fairness require that they be funded by generally applicable taxes and be available not only to the victims of human-generated accidents, but to victims of all disasters?”). 157. goldberg & zipursky, torts as wrongs, supra note 155, at 918–19. 158. id. 159. erin tyler brewster, comment, when have they paid enough? the taxability of compensation payments made to wrongfully incarcerated individuals, 64 smu l. rev. 1405, 1407 (2011) [hereinafter brewster, compensation payments] (noting that in texas, wrongly incarcerated individuals are entitled to significant damages upon exoneration, and exploring in the article “how the classification of payments made to wrongfully incarcerated individuals directly dictates their taxability,” and arguing that “such payments should not be subject to federal income taxation”). 160. see generally, brewster, compensation payments, supra note 159. although ms. brewster argues for exclusion, she is forthcoming in noting that there is no guidance on point. id. at 1429. 161. 18 u.s.c. § 1593. 2013] taxing anxiety 107 as other costs incurred; and (f) any other losses suffered by the victim as a proximate result of the offense.162 under section 104(a)(2), as well as the “in lieu of what” approach to damages, some of these damages would be excluded (unreimbursed medical services, unless previously deducted), and some would not (lost income). the irs, however, advised recently that these restitution payments are not taxable in their entirety.163 i do not mean to take up the arguments surrounding the particular tax treatment of either of these examples. what i do mean to point out, though, is that these examples highlight a central problem of the current tax treatment of damages — its unpredictability. lack of clarity in the code, combined with the absence of a theoretical justification for the exclusion in section 104(a)(2) has forced the irs to take a piece-meal approach, which is what we see reflected in the recent guidance to trafficking victims. although there are no doubt good reasons why congress might choose to exclude these mandatory restitution payments from income,164 the fact of the matter is that they did not,165 and left the irs holding the bag.166 162. 18 u.s.c. § 2259(b)(3); see § 1593 (providing that “full amount of the victim’s losses” has the same definition of the term as that found in section 2259). 163. notice 2012–12, 2012-6 i.r.b. 365 (“this notice advises taxpayers that mandatory restitution payments awarded to victims of human trafficking under 18 u.s.c. section 1593 are excluded from gross income under section 61 of the code for federal income tax purposes.”). 164. without purporting to be exhaustive, congress might be persuaded that the exception is justified because the criminal court’s involvement mitigates any concern about allocation arbitrage or other tax gamesmanship. furthermore, this statute addresses a defined, specific, and limited group of potential recipients of the exclusion. given that specificity, and the remoteness that any large number of victims will recover significant damages, congress could reasonably decide to forego the revenue so that the irs could go after higher dollar disputes. yet another possibility is that because some of the award appears taxable, and some not, congress could opt for ease in administration, so as not to burden the u.s. attorneys prosecuting the cases. 165. the exclusion could very readily have gone into section 1593 of title 18 itself by simply adding the phrase, “restitution awarded under this section shall be excluded from income under 26 u.s.c. 61.” 166. this question likely is largely academic. despite the criminal law beginning to “assume the same compensatory role as the large private lawsuit,” few crime victims ever recover damages from perpetrators. adam s. zimmerman & david m. jaros, the criminal class action, 159 u. pa. l. rev. 1385, 1390, 1455 n.41 (2011) (internal citations omitted). though there is little available data on sex trafficking victims in the united states, it is unlikely that trafficking victims will recover significant amounts through criminal prosecution. donna m. hughes, combating sex trafficking: a perpetrator-focused approach, 6 u. st. thomas l.j. 108 florida tax review [vol. 14:3 v. the better solution: full inclusion with jury awareness i agree with the call for reform of section 104(a)(2): many reasons support reform, not the least of which is that there is simply no persuasive reason to tax the awards of those victims whose injuries are mental or emotional, but at the same time, exempt awards of those victims whose injuries are physical.167 furthermore, i agree with the litany of defects in the current tax treatment of damages as identified by the nta/aba in their respective reports.168 in addition to amplifying those defects noted by the nta/aba, i have identified and discussed additional problems plaguing the tax treatment of damages. i differ with the nta/aba, however, regarding the proposed solution. the nta/aba proposed changes are unlikely to eliminate the problems plaguing section 104(a). neither the nta nor the aba proposes a sufficiently bright-line rule; the aba proposal simply shifts the pressure from one line that can be gamed (physical versus non-physical) to another that can similarly be gamed (economic versus non-economic). simply put, when the problem is line drawing, changing the lines rarely solves the problem. in some respects, the nta proposal provides a bright line, but the nta proposal gives away the store, and it creates a tantalizing opportunity for tax gamesmanship, or what i have termed, allocation arbitrage, as well as encouraging specious claims of mental injury. the nta proposal fails to acknowledge the floodgates that will open if damages on account of nonphysical injury become non-taxable. in this section, i discuss why the full inclusion with jury awareness proposal is the better solution. 28, 40 (2008) (lamenting that as of 2008 “[t]here are no studies of the legal or illegal sex industry in the united states” and noting that one such study was funded in 2005, but never carried out). there has been at least one high profile conviction under the anti-trafficking law that seems to have resulted in victim restitution. united states v. sabhnani, 599 f.3d 215, 224 (2d cir. 2010) (millionaire international perfume maker and his wife were convicted of trafficking and ordered to pay nearly one-million dollars in restitution to two victims; the restitution award was remanded for recalculation to exclude overtime pay, but generally upheld on appeal). 167. see generally g. christopher wright, taxation of personal injury awards: addressing the mind/body dualism that plagues § 104(a)(2) of the tax code, 60 cath. u. l. rev. 211, 242 (2010) [hereinafter wright, mind/body dualism] (discussing the inequity and unsoundness of the distinction). 168. see supra notes 128–34 and accompanying text (discussing the nta and aba reports). 2013] taxing anxiety 109 a. the full inclusion with jury awareness proposal is more likely to lead to tax certainty and uniformity as the cases discussed above demonstrate, the level of litigation surrounding the tax treatment of damages suggests that taxpayers and their advisors are not certain about when to include damages and when to properly exclude them. this uncertainly creates unnecessary expense. the expense of litigation is a burden to individual taxpayers and a strain on the irs. litigation is unlikely to be stemmed by the nta proposal because the nta solution is not sufficiently tax-neutral, and it will lead to aggressive allocations that are likely to be challenged by the irs. in contrast, with full inclusion and jury awareness, there should be no derivative litigation between the irs and taxpayers following a damages recovery. in the usual course, individual taxpayers will be taxed on all damages they receive. furthermore, the taxability of awards will not depend on the state’s tort regime, which is a result that respects state tort policy and provides no tax incentive for parties to forum shop. the nta proposal contains a possible hidden distinction based on geography. in particular, depending on how courts treat the change in the regulations regarding “tort or tort-type damages,”169 it is possible that victims of employment discrimination in states that permit “tag-along” claims sounding in tort will benefit but discrimination victims in other states will not.170 for example, in some states, plaintiffs claiming employment discrimination can also bring a claim for intentional infliction of severe emotional distress. those plaintiffs, under the nta proposal, would presumably recover tax-free because they would satisfy the requirement of “tort or tort-like,” and they would have a claim for emotional injury. these plaintiffs would thus satisfy the section 104(a)(2) requirements, as modified by the nta proposal. on the other hand, victims of employment discrimination in states that do not permit such “tag-along” torts would presumably be taxed on their awards in their entirety. b. the full inclusion with jury awareness proposal reduces incentives for specious claims of mental anguish, and reduces incentives for allocation arbitrage i agree with the nta/aba and other critics of the current system: treating victims of physical injury differently than victims of non-physical 169. see supra notes 23–26. 170. chamallas & wriggins, measure of injury, supra note 149, at 78 (2010) (noting the geographic distinctions in permitting tag-along claims). 110 florida tax review [vol. 14:3 injury is unsound.171 i suggest that by excluding non-physical damages, however, we throw open the door to significant tax avoidance and perhaps more damning, to specious claims of mental anguish. specifically, if we make the nta/aba change, every settlement of every wrongful discharge claim will have a provision remarking that the dismissed employee has a nonphysical injury, so that the parties can, by a bit of tax thaumaturgy, render all such awards non-taxable. there is no tax or public policy reason to permit the exclusion of all such settlements. there is no compelling argument that victims of wrongful discharge ought to be taxed at a lower effective rate than other taxpayers (of course they should not be taxed at a higher effective rate, either). not only would such a proposition give away tax revenue, but by inviting specious claims of mental anguish (or inviting an exaggeration of the value of such claims), we risk undermining the legitimacy of taxpayers who truly do suffer from mental illness. skepticism of mental illness is already all too common.172 the nta/aba proposal inadvertently risks increasing this skepticism by providing an economic incentive to invent or exaggerate claims of mental injury. the possibility of specious or exaggerated claims of emotional injury is especially pernicious given the number of americans who suffer from mental disorder. in the united states, “mental disorders are the leading cause of disability”173 and a quarter of americans “suffer from a diagnosable mental disorder in a given year.”174 in many disputes, therefore, the plaintiff will have a mental or emotional injury; that does not necessarily mean, 171. e.g., wright, mind/body dualism, supra note 167, at 242 (discussing the inequity and unsoundness of the distinction). 172. see, e.g., scott a. moss & peter h. huang, how the new economics can improve employment discrimination law, and how economics can survive the demise of the “rational actor,” 51 wm. & mary l. rev. 183, 221 (2009) (noting the difficulty in sustaining damages for emotional distress absent a professional psychiatric diagnosis); depianto, the hedonic impact, supra 71, at 117 (2012) (noting the “enduring suspicion” of the importance of emotional tranquility); camillas & wriggins, measure of injury, supra note 149, at 2 (noting the “privileged status of physical harm over emotional and relational injury” which is “sustained by dubious assumptions about the greater seriousness and importance of this type of injury in the lives of ordinary people”). 173. the numbers count: mental disorders in america, nat’l inst. of mental health, (citing world health organization, the global burden of disease: 2004 update, annex a, tbl. a2: burden of disease in dalys by cause, sex and income group in who regions, estimates for 2004 (2008), http://www.who.int/healthinfo/global_burden_disease/gbd_report_2004update_an nexa.pdf.), http://www.nimh.nih.gov/health/publications/the-numbers-count-mentaldisorders-in-america/index.shtml (last visited jan. 27, 2013). 174. id. (citing ronald c. kessler, et. al., prevalence, severity, and comorbidity of 12-month dsm-iv disorders in the national comorbidity survey replication, 62 archives gen. psychiatry, 617 (2005)). 2013] taxing anxiety 111 however, that the mental or emotional injury was caused or exacerbated by the defendant’s acts. given the potential for shared tax savings and lower out-of-pocket costs, few defendants will have an incentive to challenge the causation or the claim of mental or emotional injury. even if the defendant wanted to do so, it is difficult to determine causation in the context of mental illness or injury. furthermore, strong privacy concerns are implicated. we do not want individuals with mental illness or emotional injury to have to offer up their psychiatrist’s notes to satisfy a tax requirement, especially where that tax requirement is not based in sound theory.175 just as the parties do not have incentive to police each other’s claims of emotional distress, they are rarely adversarial with respect to the issue of allocation (though they almost always are adversarial until that point).176 most settlements have no reason to allocate, and to the extent that they do so, the allocation is likely tax-motivated and subject to irs scrutiny. indeed, the irs successfully challenges allocations in many instances.177 it is unclear, though, that the allocation improves when courts reallocate. as respected commentators have quipped, “[t]he precise dollar amounts allocated to each claim, as is often true in cases such as this, were an arbitrary guess by the court.”178 despite some re-allocations, it is almost certain that in other instances, parties have succeeded in their allocation arbitrage, and successfully worked the tax system to their mutual advantage. if we implement the nta/aba proposal, there will be almost no way for the irs to catch instances of allocation arbitrage. there would simply be too great of an incentive to engage in such gamesmanship, and it would be increasingly expensive for the irs to police it. the full inclusion proposal, in contrast, reduces the incentive to engage in allocation arbitrage. allocation arbitrage creates a tax-incentive to settle, and to the extent opportunities for allocation arbitrage increase, so too does the incentive to settle. the nta and aba proposals exacerbate the tax-incentive to settle by 175. see, e.g., kenneth s. broun, the medical privilege in the federal courts — should it matter whether your ego or your elbow hurts?, 38 loy. l.a. l. rev. 657, 659 (2004) (discussing the important policy animating the physicianpatient, and psychologist-patient privilege, and specifically discussing the “protection of basic privacy rights” afforded by recognizing the privilege). a significant scholarship discusses privacy interests in the context of mental health. see, e.g., jennifer l. hebert, mental health records in sexual assault cases: striking a balance to ensure a fair trial for victims and defendants, 83 tex. l. rev. 1453 (2005). 176. preston r. burch & james h. fowles iii, traversing the swamp: understanding the tax implications of settlements and awards in employmentrelated litigation, 17 jan. s.c. law. 28 (2006). 177. see supra notes 118–27. 178. boris i. bittker, martin j. mcmahon, jr. & lawrence a. zelenak, federal income taxation of individuals ¶ 7.03 (3d ed. 2012). 112 florida tax review [vol. 14:3 increasing significantly the group of disputes with the possibility for allocation arbitrage. absent the nta/aba proposal, only plaintiffs with colorable claims of physical injury face the allocation incentive. with the nta/aba proposal, added to that group will be any plaintiff with a colorable claim of mental injury. the full inclusion proposal does not have an artificial settlement incentive. c. additional benefits of the full inclusion with jury awareness proposal the full inclusion with jury awareness proposal takes a small step toward more equal tax treatment of men and women. admittedly, so would the nta/aba proposals. but the full inclusion proposal comes without the problems of the nta/aba proposals. an additional benefit of the full inclusion proposal is that it mitigates a potential conflict between attorneys and clients that exists under the current regime and would be exacerbated under either alternative proposal. in most personal injury disputes, attorneys have a significant incentive to maximize the pre-tax dollars. in contrast, clients care less about pre-tax dollars and simply desire to maximize after-tax dollars. the fee structures of most personal injury retention agreements create these incentives. my proposal avoids this attorney-client tension, by more closely aligning the interests of lawyers with those of their clients. since under the full inclusion proposal the entire award is taxable regardless of whether the parties settle or try the case, the distinction between pre-tax and after-tax dollars is eliminated. in contrast, the nta proposal will result in attorneys having incentives to try cases, while their clients, all else being equal, would prefer to settle so they can take aggressive valuations on the tax-free versus taxable component issue. d. responding to objections the task of grossing up plaintiffs’ awards adds an administrative burden.179 specifically, in those cases that go to trial, there likely will be expert costs associated with educating the court or jury about the mechanics of a gross up.180 this added burden and complexity is a potential weakness of the full inclusion proposal. in other words, it might simply be too hard for the jury to deal with the tax issue. i offer two responses to this objection. the first is to attack the underlying proposition: gross-ups might be a bit 179. see polsky & markel, punitive damages, supra note 8, at 1345–46 (discussing the administrative burden of gross ups in the context of punitive damages). 180. id. 2013] taxing anxiety 113 complicated, but juries face difficult questions every day.181 some of those difficult questions even involve math.182 properly instructed, juries ought to be trusted to calculate a gross-up. as the supreme court remarked decades ago, “the practical wisdom of the trial bar and the trial bench has developed effective methods of presenting the essential elements of an expert calculation in a form that is understandable by juries that are increasingly familiar with the complexities of modern life.”183 in that case, the court “reject[ed] the notion that the introduction of evidence describing a decedent’s estimated after-tax earnings is too speculative or complex for a jury.”184 and i suggest the argument that a gross-up is too complex for a jury should be rejected as well. should the reader remain skeptical, i offer an alternative approach. if we are not convinced the task of gross-ups should be left to juries, this alternative approach would be to instruct the jury to disregard taxes, and instead permit or require the trial judge to calculate the gross-up following the jury’s verdict. this is not a novel concept: many courts currently are tasked with calculating interest in certain instances.185 no doubt some costs still will be incurred under this alternative approach, such as additional briefing to the court on the proper gross-up calculations. these minimal costs are unlikely to outweigh the significant benefits of the full inclusion with jury awareness rule discussed above. in those disputes that do not go to trial, it is likely that some minimal additional costs also will be incurred, as the parties will have one more detail (the gross-up) to negotiate. but at the same time, the parties will not have to negotiate, or even discuss, the appropriate tax treatment; there will be no need or potential for allocation arbitrage. the more serious potential drawback is that the additional monetary demand necessitated by the tax due on the damage award will put the parties further apart, dollar-wise, and make the settlement negotiations more difficult. absent jury awareness, this critique would have even more force. however, with jury awareness, plaintiffs need not absorb the entirety of the tax cost of the settlement. jury 181. after all, we trust juries to decide certain aspects of patent disputes, antitrust cases, and complex white-collar crime prosecutions. see generally joe s. cecil, valarie p. hans & elizabeth c. wiggins, citizen comprehension of difficult issues: lessons from civil jury trials, 40 am. u. l. rev. 727, 729 (1991) (reviewing the literature on jury competence to, among other things, “establish that, although the civil jury has some areas of vulnerability, its ability to render a reasoned and principled decision is far greater than typically acknowledged”). 182. id. 183. norfolk & w. ry. co. v. liepelt, 444 u.s. 490, 494 (1980). 184. id. 185. e.g., city of milwaukee v. cement div., nat’l gypsum co., 515 u.s. 189, 190 (1995) (discussing calculation of prejudgment interest in admiralty case in which the plaintiff’s loss was primarily attributable to its own negligence). 114 florida tax review [vol. 14:3 awareness provides the requisite incentives to defendants to settle for appropriate amounts to make plaintiffs whole (or as close to it as the tort regime contemplates) “since settlements are reached in the shadow of what a jury would be expected to award.”186 for this reason, jury awareness is a critical component of my proposal because absent jury awareness, defendants would not have the necessary incentive to gross-up a damages award to an injured plaintiff. related to the previous objection, another is that under my proposal, plaintiffs will not be made whole. in a typical personal injury or employment contingency case, about one-third of any award will go to the taxpayer’s attorney. if we tax the remaining amount, the plaintiff could end up with too few dollars to be made whole. but even under the current regime, there is no certainty that plaintiffs ever are being made whole. in addition, employment discrimination plaintiffs already face this predicament. finally, the certainty is really useful. my proposal need not result in harm to tort-victim taxpayers assuming jury awareness, and the gross-up component. injured taxpayers will know prior to making their settlement demand that any damages received will be taxable; injured taxpayers can simply demand sufficient damages to be made whole, while taking the tax payment into account. vi. conclusion in this piece, i have called for including in gross income damages received on account of physical injury. there is no tax reason for the continued exclusion. the exclusion breeds uncertainty, encourages tax arbitrage, and perpetuates disparate treatment of taxpayers that has a gendered result. given these bad outcomes, two solutions are obvious: do not tax any damages awards, or tax all of them. for the reasons set out above, the better solution is to tax all of them. anne should not have to ask for a punch in the nose to achieve tax parity. 186. polsky & markel, punitive damages, supra note 8, at 1307. see also, oppenheimer, verdicts matter, supra note 9, at 513 (“verdicts matter . . . not only to the parties and their counsel in those few cases where verdicts are rendered, but also to public policy makers and lawyers evaluating that vast majority of cases that never go to trial. . . . stories about jury verdicts can have a profound effect on public opinion and public policy.”). a. the full inclusion with jury awareness proposal is more likely to lead to tax certainty and uniformity 109 b. the full inclusion with jury awareness proposal reduces incentives for specious claims of mental anguish, and reduces incentives for allocation arbitrage 109 c. additional benefits of the full inclusion with jury awareness proposal 112 d. responding to objections 112 florida tax review 775 florida tax review volume 11 2012 number 10 a proposal for taking the complexities out of taxing u.s. retirement distributions to foreign nationals by cynthia blum * paula n. singer ** abstract as the global mobility of workers increases, more and more foreign nationals participate in u.s. retirement plans and eventually receive payments from these plans. the current system for u.s. taxation of these payments is exceedingly complex and uncertain. an elderly recipient of these payments living outside the u.s. finds it difficult and expensive to obtain the tax advice necessary for filing an accurate nonresident form 1040nr. as a result, many do not file the return, and few are likely to be contacted by the irs. whatever tax, if any, was withheld by the payer becomes by default the final tax, even though it is unlikely to correspond with the actual tax liability prescribed by congress and the applicable u.s. treaty. moreover, foreign recipients are often able to avoid disclosure of their payments to tax authorities in their home countries. we recommend a new system for taxing retirement payments to foreign nationals that would alleviate these serious administrative burdens. under our proposal, congress would establish two withholding rates for these distributions: a low rate of 15% for periodic distributions or minimum required distributions; and a 30 percent rate for other lump sum distributions, which are most conducive to avoiding home country tax and depleting retirement savings. the 30 percent withholding rate would also apply whenever a payee fails to provide documentation of his u.s. or foreign * professor of law & robert knowlton scholar, rutgers school of lawnewark. ** partner in tax law firm of vacovec, mayotte & singer llp, newton, ma., co-founder of windstar technologies, inc., norwood, ma., a tax and immigration software company, now part of the tax & accounting business of thomson reuters. 776 florida tax review [vol.11:10 status. these rates would be, by design, the final u.s. tax liability for foreign nationals, who would generally have no need to file a nonresident form 1040nr. in addition, the treasury would provide more detailed guidance to payers regarding the types of distributions that qualify for treaty relief; and a recipient’s request for treaty relief would always trigger notification to the home country so as to permit it to collect its own tax. our proposal would greatly reduce administrative burdens for the irs, for payers and for payees, and would provide greater assurance that the tax prescribed by congress and by our treaty partners is accurately collected. i. introduction ............................................................................. 777 ii. taxation of distributions from u.s. retirement plans in a domestic context ............................................................ 778 a. substantive rules ....................................................................... 778 b. withholding by payer ............................................................... 782 iii. typical situations in which foreign nationals receive distributions from u.s. retirement plans ...... 785 a. foreign national classified as resident alien while working and in retirement ...................................................... 785 b. foreign national classified as resident alien while working but later changing to nonresident alien status ...... 786 c. foreign national who maintains nonresident alien status while contributing to a u.s. retirement plan and while receiving distributions ................................................. 787 d. foreign national who is beneficiary of participant in u.s. retirement plan ............................................................... 788 iv. tax rules governing taxation of retirement distributions made to nonresident aliens ..................... 788 a. determination of recipient’s tax liability ............................... 788 b. withholding or other payment of tax ...................................... 796 v. problems caused by current rules ................................... 800 a. need for many nonresident alien payees to file form 1040nr if correct amount of u.s. tax to be collected ............................................................................ 800 b. flawed presumption rule ....................................................... 804 c. inadequate treaty guidance and inappropriate treaty claims .......................................................................... 805 vi. proposed solution: a new system for taxing nonresident alien recipients of u.s. retirement distributions ............................................................................. 807 2012] retirement distributions to foreign nationals 777 a. brief description ..................................................................... 807 b. further explanation of our proposal ..................................... 809 1. substituting a flat rate tax liability; rejection of “effectively connected” treatment ........................................ 809 2. clarifying treaty rules ....................................................... 811 3. possible implications for future treaties ........................... 813 vii. conclusion ................................................................................. 814 appendix a ............................................................................................... 815 appendix b ................................................................................................ 817 i. introduction the federal income taxation of pension distributions and the rules for tax withholding and reporting by the pension administrator are quite complex. however, the level of complexity, uncertainty, and administrative difficulty is much greater when the recipient of the pension distribution is a foreign national. in part, this is due to a lack of adequate guidance provided by the internal revenue service to payers and recipients of these distributions. 1 however, a large part of the confusion and difficulty stems from rules adopted by congress in the internal revenue code and the ambiguity of treaties negotiated by the treasury department. in part ii of this article, we describe the rules governing the taxation of distributions from tax-qualified retirement vehicles in a fully domestic context. in part iii, we briefly describe the common situations in which a foreign national receives distributions from a u.s. qualified retirement vehicle. in part iv, we discuss the complex rules that govern retirement distributions to a foreign national who is not a u.s. resident alien. in part v, we discuss the shortcomings and disadvantages of these existing rules. in part vi, we propose a new system for withholding on, and taxation of, distributions to foreign nationals that will greatly reduce administrative complications for the withholding agent, the recipient, and the internal revenue service. part vii is our conclusion. 1. see letter from paula n. singer, esq., vacovec, mayotte & singer llp, to internal revenue serv. (may 16, 2008), http://services.taxanalysts. com/taxbase/eps_pdf2008.nsf/docnolookup/10719/$file/2008-710719-1. pdf, suggesting that the “irs issue comprehensive published guidance relating to cross-border pension and other retirement payments made to nonresident aliens.” [hereinafter singer letter]. 778 florida tax review [vol. 11:10 ii. taxation of distributions from u.s. retirement plans in a domestic context a. substantive rules congress has authorized employers to establish various types of taxadvantaged retirement plans for their employees. if a retirement plan meets the requirements established in the internal revenue code, 2 the plan may be funded with contributions that are not currently taxed to the employee and yet are currently deductible by the contributing employer. 3 the retirement plan itself is not taxed on the income from its investments. 4 the employee is taxable only when he or she receives a distribution from the plan. 5 loans from a plan are classified as distributions if they do not meet certain requirements. 6 the rules of section 72 of the code (allowing recovery of basis, if any) are applicable. 7 the taxable portion of the distribution is 2. section 401(a) refers to ―a trust created or organized in the united states and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries.‖ i.r.c. § 401(a) (first clause). qualification further depends on meeting ―[m]inimum participation standards . . . [a] prohibition against contributions and benefits discriminating in favor of highly compensated employees . . . [m]inimum vesting standards . . . [l]imits on the benefits and contributions accruing to certain participants . . . [a] prohibition of assignments or alienation of benefits . . .‖ and various other requirements. boris i. bittker & lawrence lokken, federal taxation of income, estates, and gifts, ¶ 61.2, at 61–45 to 46 (rev. 3d ed. 2005) [hereinafter bittker & lokken, federal taxation]. 3. see bittker & lokken, federal taxation, supra note 2, ¶ 61.1.1 at 61-5, ¶ 61.14.1, at 61–311 to 12. of course, governmental units and tax-exempt organizations do not claim deductions. 4. see id. ¶ 61.1.1, at 61–5. 5. see id., at ¶ 61.14.1, at 61–311 to 61–312. 6. i.r.c. § 72(p)(1)-(2); bittker & lokken, federal taxation, supra note 2, ¶ 61.14.2 at 61–315 to 61–316; i.r.s., publication 575, pension and annuity income, 17–18, http://www.irs.gov/pub/irs-pdf/p575.pdf. 7. i.r.c. § 402(a) (providing that amounts distributed from employer trust shall be taxable to the distributee under section 72); bittker & lokken, federal taxation, supra note 2, ¶ 61.14.1 (discussing taxation of distributions from an employer trust); i.r.c. § 408(d) (providing that ira distributions shall be taxable to the distributee under section 72); bittker & lokken, federal taxation, supra note 2, ¶ 62.3.5 (discussing taxation of distributions from an ira). for discussion of basis recovery, see i.r.s., publication 575, supra note 6, at 10–17. see also i.r.s., publication 939, general rule for pensions and annuities, http://www.irs.gov/pub/irs-pdf/p939.pdf, providing rules for nonqualified plans and for qualified plans in certain limited circumstances. for distributions from a 2012] retirement distributions to foreign nationals 779 classified as ordinary income; the character of the income earned by the plan (e.g., dividends or capital gains) does not pass through to the payee 8 (except in the case of distributions of stock 9 ). a ten percent penalty tax applies to certain premature distributions not used for retirement. 10 on the other hand, beginning at age 70 1/2, a retired employee must receive at least a ―minimum required distribution.‖ 11 in some cases, payments occur in the form of a commercial annuity purchased by the plan or employee from an insurance company. 12 one type of qualified plan is a pension plan, i.e., a plan ―established and maintained by an employer primarily to provide systematically for the traditional ira, see i.r.s., publication 590, individual retirement arrangements (iras), 40–41, http.www.irs.gov/pub/irs-pdf/p590.pdf . 8. see, e.g., rev. rul. 72-99, 1972-1 c.b. 115, cited in clayton v. united states, 33 fed. cl. 628 (fed. cl. 1995), aff’d without published opinion, 91 f.3d 170 (fed. cir. 1996), cert. denied, 519 u.s. 1040 (1996). see also i.r.s. priv. ltr. rul. 87-21-006 (jan. 30, 1987) (distribution to nonresident alien beneficiary of decedent‟s rollover ira did not retain its character as savings bank deposit so that interest on deposit after decedent‟s death did not qualify for treatment as foreign-source under section 861(c)(2)). 9. see i.r.c. § 402(e)(4); regs. § 1.402(a)-1(b)(1)(i); i.r.s., publication 575, supra note 6, at 15. 10. i.r.c. § 72(t); bittker & lokken, federal taxation, supra note 2, ¶ 61.13.2, at 61–256; see also i.r.s., publication 575, supra note 6, at 30–32. a distribution made before the taxpayer attains age 59 1/2 is generally subject to the penalty unless it is made after the death of the employee, is attributable to the employee‟s being disabled, is part of a series of substantially equal periodic payments made for the life or life expectancy of the employee (or the employee and his designated beneficiary), or made after separation from service after attainment of age 55. there are exceptions for certain medical expenses, and, in the case of an individual retirement plan, for certain expenses for health insurance premiums while unemployed, higher education expenses, and first-time home purchases. i.r.c. § 72(t)(b), (d)-(f). 11. i.r.c. § § 401(a)(9), 408(a)(6) (ira); i.r.s., publication 575, supra note 6, at 32-34; bittker & lokken, federal taxation of income, estates, and gifts, supra note 2, ¶¶ 61.13.4, 62.3.4. bittker and lokken explain that “[t]he purpose . . . is to limit the extent to which employees and their beneficiaries may use qualified plans as tax shelters longer than is reasonably necessary to accomplish the objective of providing retirement income.” id. ¶ 61.13.4, at 61-267. 12. regs. § 1.401(a)(9)-5(e) (defined contribution plan); regs. § 1.401(a)(9)-6 a-4 (defined benefit plan); regs. § 1.401(a)(9)-8 a-2(a)(3) (purchase by employee); regs. § 1.402(a)-1(a)(2) (distribution to an employee of a nontransferable annuity contract by a qualified plan will not be considered income). a commercial annuity contract would also be a section 403(a) plan or tax-sheltered annuity plan under section 403(b). see infra notes 14, 30. in addition, the owner of a traditional ira can instruct the trustee or custodian to purchase an annuity contract for him. i.r.s., publication 590, supra note 7, at 41. 780 florida tax review [vol. 11:10 payment of definitely determinable benefits to his employees over a period of years, usually for life, after retirement.‖ 13 a pension plan may take the form of a trust or of an employee annuity plan pursuant to section 403(a). 14 under a traditional pension plan, benefits are determined under a formula based on factors such as years of service and rate of compensation. 15 a pension plan may also take the form of a cash balance plan. 16 pension plans are defined benefit plans. 17 another type of qualified plan is a profit-sharing 18 or stock bonus plan, 19 such as a section 401(k) plan. these plans are defined contribution plans: 20 each participant has a separate account, which reflects contributions, trust income and expense, or gains and losses, and the account balance is the basis for determining the participant‘s benefits. in 1974, congress first authorized an individual earning compensation to establish his own tax-favored ―individual retirement account (ira).‖ 21 an ira is defined as a trust or custodial account ―created or organized in the united states for the exclusive benefit of an individual or 13. regs. § 1.401-1(b)(1)(i); see also bittker & lokken, federal taxation, supra note 2, ¶ 61.2, at 61–35, ¶ 61.13.2, at 61–254. 14. see i.r.c. §§ 403(a), 404(a)(2); regs. § 1.404(a)-3(a) (“an „annuity plan‟ means a pension plan under which retirement benefits are provided under annuity or insurance contracts without a trust.”); see bittker & lokken, federal taxation, supra note 2, ¶ 61.2, at 61–39 (noting that “[a]nnuity plans must satisfy all the requirements of section 401(a) except those that are inapplicable because of the absence of a trust.”); see also id. ¶ 61.1.2, at 61–10 (“essentially a pension plan”). 15. see bittker & lokken, federal taxation, supra note 2, ¶ 61.1.2, at 61–10. 16. id. at 61–12 to 14. bittker and lokken describe a cash balance plan as “a defined benefit plan that functions somewhat like a defined contribution plan.” id. at 61–12. benefits are defined by reference to a hypothetical account for each employee. id 17. a “defined benefit plan” by definition lacks separate accounts for individual employees. i.r.c. § 414(i)-(j). see bittker & lokken, federal taxation, supra note 2, ¶ 61.1.2, at 61–12 n.28. bittker and lokken note that “benefits to be received by employees . . . are prescribed by the plan or determined by a formula stated in the plan.” id. at 61–12. 18. see reg. § 1.401-1(b)(1)(ii); bittker & lokken, federal taxation, supra note 2, ¶ 61.1.2, at 61–10. 19. see reg. § 1.401-1(b)(1)(iii); bittker & lokken, federal taxation, supra note 2, ¶ 61.1.2, at 61–11. 20. i.r.c. § 414(i); bittker & lokken, federal taxation, supra note 2, ¶ 61.1.2, at 61–11. 21. see bittker & lokken, federal taxation, supra note 2, ¶ 62.3.1, at 62–49 to 50. see generally i.r.s., publication 590, supra note 7. 2012] retirement distributions to foreign nationals 781 his beneficiaries.‖ 22 in a traditional ira, the employee‘s (or self-employed individual‘s) contribution is deductible up a specified dollar limit, which may be reduced for an individual who is an active participant in an employer sponsored plan. 23 the ira is not taxable on its earnings, and the individual is taxed only upon receipt of distributions (and without any pass-thru of the character of the ira‘s earnings). 24 an alternative to the traditional ira is the roth ira. in this type of account, deductions are not allowed for contributions; however, qualified distributions are nontaxable. 25 yet another type of qualified plan is a ―simplified employee pension,‖ an employer-sponsored plan consisting of an ira for each individual employee. 26 the employer may make deductible contributions to these iras (subject to dollar limitations and nondiscrimination rules). 27 these are referred to as sep iras and are subject to the rules for distributions from traditional iras. 28 a self-employed individual may establish a sep ira, section 401(k) plan, or defined benefit plan, and contribute based on his earned income. 29 additional types of retirement plans are available for certain employers. a public school or section 501(c)(3) organization may create a tax-sheltered annuity plan for its employees pursuant to section 403(b). 30 a 22. i.r.c. § 408(a), (h); bittker & lokken, federal taxation, supra note 2, ¶ 62.3.3, at 62–60. 23. i.r.c. § 219; bittker & lokken, federal taxation, supra note 2, ¶ 61.1.1, at 61–9, ¶62.3.1, at 62–48; i.r.s., publication 590, supra note 7, at 12–16. 24. bittker & lokken, federal taxation, supra note 2, ¶ 62.3.1, at 62– 49. basis recovery is allowed when nondeductible contributions have been made. see i.r.s., publication 590, supra note 7, at 38–44. 25. bittker & lokken, federal taxation, supra note 2, ¶ 62.4.1, at 62– 83; i.r.c. § 408a; i.r.s., publication 590, supra note 7, at 54–66. see generally natalie b. choate, life and death planning for retirement benefits 316 (7th ed. 2011). she notes that roth iras offer other advantages over traditional ira‟s, i.e., “no minimum required distributions during the participant‟s life . . . no maximum age for making contributions . . . and the ability to withdraw the participant‟s own contributions, separately from the earnings thereon, income taxfree at any time.” id. at 316–17. 26. i.r.c. § 408(k); bittker & lokken, federal taxation, supra note 2, ¶ 62.6.1; i.r.s., publication 560, retirement plans for small business (sep, simple, and qualified plans), at 5–8, http://www.irs.gov/ pub/irs-pdf/p560.pdf. 27. bittker & lokken, federal taxation, supra note 2, ¶ 62.6.1. 28. i.r.c. § 402(h)(3); bittker & lokken, federal taxation, supra note 2, ¶ 62.6.1, at 62–97 & n.18. in addition, an employer with no more than 100 employees may establish “simple retirement accounts” for employees. i.r.c. § 408(p). 29. i.r.c. §§ 401(c), 408(k)(7). 30. see generally bittker & lokken, federal taxation, supra note 2, ¶ 62.8; i.r.s., publication 571, tax-sheltered annuity plans (403(b) plans), 782 florida tax review [vol. 11:10 state or local government, or a tax-exempt organization, may create a deferred compensation plan for its employees pursuant to section 457. 31 after an employee‘s death, a spouse or other beneficiary may be entitled to receive distributions from a qualified plan or ira. a distribution to a beneficiary (at least to the extent that the pension accrued before death) may be characterized as ―income in respect of a decedent,‖ and therefore the characterization of the payment is the same for the beneficiary as it would be for the employee if he were alive to receive it. 32 b. withholding by payer the withholding and reporting obligations of a payer of a retirement distribution depend on whether the distribution is a ―periodic payment‖ or a ―nonperiodic payment.‖ in the case of a ―periodic payment,‖ 33 the payer is required to withhold tax in the same manner 34 as for wage payments. 35 the http://www.irs.gov/pub/irs-pdf/p571.pdf; irving s. schloss & deborah v. abildsoe, understanding tiaa-cref: how to plan for a secure and comfortable retirement 14 (2000). such a plan may provide either for individual annuity contracts or for individual custodial accounts for regulated investment company stock. see i.r.c. § 403(b)(1), (7). 31. a section 457 plan is not a qualified plan. however, in the case of an “eligible deferred compensation plan,” as defined in section 457(b), the recipient is taxed only at the time of distribution. i.r.c. § 457(a). this treatment is, in effect, an exception to the rule that compensation deferred by a governmental unit or taxexempt organization outside of a qualified plan is taxable to the employee as soon as there is no substantial risk of forfeiture. i.r.c. § 457(f). see discussion in bittker & lokken, federal taxation, supra note 2, ¶ 62.9. 32. i.r.c. § 691(a)(1), (3); rev. rul. 69-297, 1969-1 c.b. 131 (distribution from qualified profit-sharing trust to employee‟s estate); rev. rul. 92-47, 1992-1 c.b. 198 (distribution from ira treated as “income in respect of a decedent” to extent of balance in ira at owner‟s death). see discussion of payments to beneficiaries in publication 575, supra note 6, at 34. 33. under section 3405, the payor of a “periodic payment” is required to withhold “the amount which would be required to be withheld from such payment if such payment were a payment of wages by an employer to an employee for the appropriate payroll period.” i.r.c. § 3405(a)(1). a “periodic payment” is defined as a “designated distribution which is an annuity or [other] similar periodic payment.” i.r.c. § 3405(e)(2). a designated distribution is generally any distribution or payment from an employer deferred compensation plan, an individual retirement plan, or a commercial annuity. see generally publication 575, supra note 6, at 8–9. 34. see i.r.s., publication 15-a, employer‟s supplemental tax guide (supplement to publication 15 (circular e), employer‟s tax guide), at 22, http://www.irs.gov/pub/irs-pdf/p15a.pdf, stating that: withholding from periodic payments of a pension . . . is figured in the same manner as withholding from wages. . . . if the recipient 2012] retirement distributions to foreign nationals 783 recipient may waive withholding unless the payment is delivered outside the united states. 36 the payer is required to report the tax withheld on form 945 and report the distribution on form 1099-r. 37 nonperiodic (or lump sum) distributions from a qualified plan that do not exceed the ―required minimum distribution‖ or that are made pursuant to a hardship exception are subject to withholding at a flat 10 percent rate, wants income tax withheld, he or she must designate the number of withholding allowances on line 2 of form w-4p and can designate an additional amount to be withheld on line 3. if the recipient does not want any federal income tax withheld . . . , he or she can check the box on line 1 of form w-4p. . . . if the recipient does not submit form w-4p, you must withhold on periodic payments as if the recipient were married claiming three withholding allowances. . . . if you receive a form w-4p that does not contain the recipient‟s correct taxpayer identification number (tin), you must withhold as if the recipient were single claiming zero withholding allowances even if the recipient chooses not to have income tax withheld. see also regs. § 35.3405-1t b-4. 35. wage withholding is governed by sections 3401 and 3401 of the code. section 3402(a)(1) imposes on an employer making a payment of wages a requirement of withholding tax. under section 3401(a), wages are defined as “all remuneration . . . for services performed by an employee for his employer. . . .;” see regs. § 31.3401(a)-1(a)(2) (pensions treated as compensation for services). however, under section 3401(a)(12), the term “wages” does not include a payment to an employee under a trust described in section 401(a) which is exempt from tax under section 501(a), under an annuity plan described in section 403(a), or under an arrangement to which section 408(p) applies, i.e., a “simple retirement account” involving a qualified salary reduction arrangement. 36. a recipient filing form w-4p, with a valid taxpayer identification number, may waive withholding. i.r.c. § 3405(a)(2) (individual may elect not to have withholding under section 3405(a)(1) apply with respect to periodic payments made to such individual). however, if the payment is delivered outside of the united states, no election may be made. i.r.c. § 3405(e)(13)(a). an exception applies if the recipient certifies to the payer that such person is not a united states citizen or a resident alien and is not an individual to whom section 877 applies. i.r.c. § 3405(e)(13)(b). see also i.r.s., publication 15-a, supra note 34, at 22; russell e. hall, international pension planning, 320 tax mgmt. (bna) a-67 (stating that under i.r.s. notice 87-7, 1987-1 c.b. 420 “the irs has made the place of delivery irrelevant to the application of this rule. instead, mandatory withholding will be required in any case where the participant has furnished a residence address outside the united states or has not provided any residence address to the payor.”). under the notice, “a payee who has provided the payor with an address for the payee‟s nominee, trustee or agent . . .” is not considered to have thereby provided a residence address. notice 87-7, 1987-1 c.b. 420. 37. i.r.s. publication 15-a, supra note 34, at 22–23. 784 florida tax review [vol. 11:10 unless withholding is waived by the recipient. 38 this same treatment applies to distributions from an ira (other than a roth ira). 39 other lump sum distributions are classified as ―eligible rollover distributions‖ because they are eligible to be rolled over 40 to another qualified plan or an ira within sixty days without triggering income tax to the recipient. 41 these distributions (except when made directly to the trustee of the receiving plan) are subject to withholding at a flat rate of 20 percent, and this withholding may not be waived. 42 38. in the case of a nonperiodic payment that is not an eligible rollover distribution, withholding is at a flat rate of 10 percent, but can be waived on a form w-4p, with a valid taxpayer identification number, if delivery is not made outside the united states. id. at 22; i.r.c. § 3405(b)(1) (the payer “of any nonperiodic distribution . . . shall withhold an amount equal to 10 percent of such distribution.”); i.r.c. § 3405(b)(2)(a) (an individual may elect not to have such withholding apply to any nonperiodic distribution); i.r.c. § 3405(e)(3) (a “nonperiodic distribution means any designated distribution which is not a periodic payment.”); i.r.c. § 3405(e)(13) (no election allowed if delivery is outside the u.s.). 39. irs instructions state that ―[t]he 20 percent withholding does not apply to distributions from any ira, but withholding does apply to iras under the rules for periodic payments and nonperiodic distributions.‖ i.r.s. 2011 instructions for forms 1099-r and 5498, at 11, http://irs.gov/pub/irs-pdf/f1099r.pdf. the irs further explains that ―[i]n most cases, designated distributions from any ira are treated as nonperiodic distributions subject to withholding at the 10 percent rate even if the distributions are paid over a periodic basis.‖ id. see also regs. § 35.3405-1t, f-15 (―[d]istributions from iras that are payable on demand are not periodic payments‖). twenty percent withholding does not apply to an ira distribution because 20 percent withholding applies only to an ―eligible rollover distribution,‖ and this term does not include a distribution from an ira. see infra notes 40–42 for definition of ―eligible rollover distribution.‖ 40. distributions from an ira that exceed the required minimum distribution may also be rolled over. i.r.c. § 408(d)(3). 41. i.r.c. § 402(f)(2)(a) (“eligible rollover distribution” has same meaning as when used in sections 402(c), 403(a)(4), 403(b)(8)(a)); i.r.c. § 402(c)(4) (“„eligible rollover distribution‟ means any distribution to an employee of all or any portion of the balance to the credit of the employee in a qualified trust”, but with exceptions for certain substantially equal periodic payments, certain required distributions, or hardship distributions). 42. i.r.c. § 3405(c) (“in the case of a designated distribution which is an eligible rollover distribution,” as defined in section 402(f)(2)(a), withholding under section 3405(a) or (b) does not apply and the payer is required to withhold an amount equal to 20 percent of the distribution). a direct rollover is exempt from withholding pursuant to section 3405(c)(2). see publication 15-a, supra note 34, at 22. 2012] retirement distributions to foreign nationals 785 iii. typical situations in which foreign nationals receive distributions from u.s. retirement plans a. foreign national classified as resident alien while working and in retirement a foreign national who is a u.s. lawful permanent resident (i.e., ―green card‖ holder) or who meets the substantial presence test for ―resident alien‖ classification under section 7701(b) is taxed in the same manner as a u.s. citizen. by contrast, nonresident aliens are taxed under a special tax and withholding scheme. 43 some foreign nationals who are classified as resident aliens while they are working and participating in a qualified u.s. retirement plan (or are contributing to an ira) continue in this status if they are green card holders (or become u.s. citizens) for the rest of their lives. 44 in fact, an individual may manage to maintain green card status even though spending most of his time abroad. distributions from u.s. retirement plans to these individuals would be taxed in the same way as distributions to u.s. citizens. 45 resident aliens (and u.s. citizens) are generally not eligible for tax treaty benefits because u.s. treaties generally include a ―saving clause‖ preserving the right of the u.s. to tax its citizens and residents as if the treaty had not come into effect. 46 43. see i.r.c. §§ 2(d), 871-874, 1441. 44. moreover, some foreign nationals may remain in the united states, upon retirement, despite lack of authorization under the immigration laws. because they meet the “substantial presence” test, they are classified as resident aliens for u.s. tax purposes. i.r.c. § 7701(b)(3). 45. resident aliens may receive, and be subject to tax on, distributions from foreign retirement plans as well. paula n. singer, international aspects of individual u.s. tax returns 68 (2010). whether such foreign plan distributions result in u.s. tax depends on their basis in the distribution as determined under section 72(w). see id.; i.r.s., publication 519, u.s. tax guide for aliens, at 27, http://www.irs.gov/ pub/irs-pdf/p519.pdf. 46. see united states model income tax convention of november 15, 2006, art. 1, para 4, (u.s. dep‟t of the treasury 2006) [hereinafter 2006 u.s. model treaty], http://www.treasury.gov/resource-center/tax-policy/treaties/documents/ model006.pdf. exceptions are typically provided for specified treaty articles for “individuals who are neither citizens of, nor have been admitted for permanent residence . . . .” id. at art. 1, para. 5(b). double taxation is avoided by offsetting u.s. federal (but not state) taxes on foreign pension benefits with foreign tax credits. tax treaties with most countries cede taxation of social security benefits to the government paying the benefits, however. under most treaties, the article providing exemption from tax on “payments . . . under provisions of the social security or similar legislation” of the treaty country overrides the saving clause. id. art. 17, para. 2. a few treaties cede taxation of social security benefits to the residence country. 786 florida tax review [vol. 11:10 b. foreign national classified as resident alien while working but later changing to nonresident alien status in many cases, a foreign national who is classified as a resident alien while contributing to a qualified u.s. retirement plan subsequently becomes a nonresident alien before receiving some or all of his distributions from the plan. in these cases, the individual‘s status as resident or nonresident at the time that the distribution is received is determinative of the tax regime applicable to the distribution. 47 moreover, if the distributee is resident in a country that has a tax treaty with the united states, u.s. taxation of the distribution may be limited or eliminated by the treaty. a foreign national who loses or abandons long–held green card status on or after june 17, 2008, may be taxed under a special regime 48 for ―covered expatriates.‖ 49 this regime is applicable only if the individual‘s convention between the government of the united states of america and the government of the united kingdom of great britain and northern ireland for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, jul. 24, 2001, art. 17, para. 3, 2224 u.n.t.s. 247 [hereinafter 2001 u.s.–uk convention], http://www.irs.gov/pub/irs-trty/uk.pdf (recipients of both u.s. and foreign social security benefits will generally have their u.s. benefits reduced under the windfall elimination provision). 47. in some cases, an individual‟s status changes in the middle of a calendar year, so that the year is divided into a resident portion and a nonresident portion (a “dual status” year). see i.r.c. § 7701(b)(1)-(2); i.r.s., publication 519, supra note 45, at 8. 48. see i.r.c. § 877a; see generally henry p. alden ii & thomas s. bissell, the increased cost of expatriation: is this the final chapter?, 38 tax mgm‟t int‟l j. 429 (2009). expatriation must occur after june 16, 2008. see heroes earning assistance and relief tax act of 2008, pub. l. no. 110-245, § 301(g), 122 stat. 1624, 1642-44 (codified as amended at i.r.c. § 877a(g)). 49. for this purpose an ―expatriate‖ includes ―any long-term resident of the united states who ceases to be a lawful permanent resident of the united states (within the meaning of section 7701(b)(6)).‖ i.r.c. § 877a(g)(2). a long-term resident is defined as any individual (other than a citizen of the united states) who is a lawful permanent resident of the united states in at least 8 taxable years during the period of 15 taxable years ending with the taxable year during which [he ceases to be a lawful permanent resident]. . . . for purposes of the preceding sentence, an individual shall not be treated as a lawful permanent resident for any taxable year if such individual is treated as a resident of a foreign country for the taxable year under the provisions of a tax treaty between the united states and the foreign country and does not waive the benefits of such treaty applicable to residents of the foreign country. 2012] retirement distributions to foreign nationals 787 average annual net income tax for the period of five taxable years ending before the expatriation date is greater than $124,000 (as adjusted for inflation), his net worth as of such date is at least $2 million, or he has failed to make a certification of u.s. tax compliance for the five preceding years. 50 c. foreign national who maintains nonresident alien status while contributing to a u.s. retirement plan and while receiving distributions in some situations, a foreign national classified as a nonresident alien may nevertheless participate in a u.s. qualified plan or contribute to an ira. for example, an individual living throughout the year in the united states may nevertheless be classified as a nonresident alien because he is present in certain immigration categories, typically as a student, trainee, or teacher, researcher or cultural visitor, in which case his days of presence for certain (but not necessarily all) calendar years are not counted toward the ―substantial presence‖ test for resident status. 51 a nonresident alien employee of a u.s. company may be covered by a u.s. retirement plan even if most or all of his services are performed abroad. a self-employed nonresident alien who derives earned income that is effectively connected with a u.s. trade or business may be eligible to establish a sep ira or other qualified retirement plan. 52 if an individual in this situation simply maintains his nonresident alien status, then distributions from the u.s. retirement plan are governed by the taxing regime for nonresident aliens, subject to treaty provisions. i.r.c. § 877(e)(2); see i.r.c. § 877a(g)(5) (referring to section 877(e)(2)); i.r.c. § 7701(b)(6) (last sentence). see alden & bissell, supra note 48, at 432, noting that ―[t]he 2008 law provides in effect that if a green card holder is classified as a resident of a treaty country under the ‗tie-breaker‘ rule of an income tax treaty, he is treated as if he had ceased to be a lawful permanent resident . . . .‖ for a review of expatriation rules prior to the 2008 law, see id. at 429–30. former long-term residents who expatriated after june 3, 2004, and before june 17, 2008, are subject to a different regime described below at text accompanying infra notes 84–85. see also i.r.s., publication 519, supra note 45, at 23. 50. i.r.c. § 877a(g)(1)(a) (referring to section 877(a)(2)); i.r.c. § 877(a)(2). exceptions to coverage are contained in section 877a(g)(1)(b). certification is made on a form 8854. 51. see i.r.c. § 7701(b)(3)(d), (5). immigration status in which u.s. days do not count for some, but not necessarily all calendar years of presence are “f”, “j”, “m” and “q.” i.r.c. § 7701(b)(5)(d). tax rules for determining when a calendar year‟s days do not count apply to principal and dependent aliens individually. see i.r.c. § 7701(b)(3). 52. see singer, international aspects of individual income tax returns, supra note 45, at 93; i.r.s., publication 519, supra note 45, at 27. 788 florida tax review [vol. 11:10 d. foreign national who is beneficiary of participant in u.s. retirement plan a foreign national may receive distributions from a u.s. retirement plan by reason of being designated as a beneficiary by the plan participant in the event of death or pursuant to a qualified domestic relations order (qdro). 53 the distributee‘s status as resident or nonresident (or as entitled to treaty protection) will determine the u.s. tax treatment of the distribution. 54 iv. tax rules governing taxation of retirement distributions made to nonresident aliens a. determination of recipient’s tax liability if the distributee of a retirement distribution is a nonresident alien, determination of the proper amount of tax depends upon additional variables not relevant in a purely domestic context: (1) whether the distribution constitutes income from u.s. or from foreign sources; (2) whether the u.s. source income, if any, is considered to be ―effectively connected with the conduct of a trade or business within the united states;‖ and (3) whether an income tax treaty entered into by the united states with the country of the individual‘s tax residence allows an election to reduce or eliminate u.s. tax. 55 apart from any treaty, a nonresident alien usually is not taxed on foreign-source income 56 and is taxed at a flat rate of 30 percent on u.s. 53. see i.r.c. §§ 402(e)(1), 414(p). 54. see, e.g., i.r.s. priv. ltr. rul. 98-06-012 (nov. 10, 1997) (nonresident alien beneficiary of u.s. citizen‟s estate, stating that: “the united states tax treatment of distributions to a nonresident alien individual characterized for u.s. tax purposes as originating from a u.s. pension fund or an annuity depends on both the statutory and regulatory rules of withholding and taxation and, where the recipient is a citizen or resident of a country with which the united states has an income tax treaty, the application of that treaty.”); i.r.s. priv. ltr. rul. 2000-04-030 (nov. 2, 1999) (distributions from an estate of interest on series e bonds to nonresident alien); i.r.s. priv. ltr. rul. 87-28-048 (apr. 15, 1987) (pension article of treaty exempted pension distributions to beneficiaries of u.s. estate who were residents of ireland). note that i.r.s. priv. ltr. rul. 98-06-012, supra, is misleading in suggesting that treaty benefits are based on citizenship. see infra note 66. 55. i.r.s., publication 519, supra note 45. treaties became elective rather than mandatory with the introduction of the current section 894(a) by the technical and miscellaneous revenue act of 1988. h.r. conf. rep. no. 100-1104, pt. 1, at 12–13 (1988), reprinted in 1988 u.s.c.c.a.n. 5048, 5072–73. 56. i.r.c. §§ 871(a)–(b), 864(c)(4)–(5). 2012] retirement distributions to foreign nationals 789 source income that is not ―effectively connected with the conduct of a trade or business within the united states.‖ 57 however, ―effectively connected‖ u.s. source income is taxed at the progressive rates of section 1 (applicable to u.s. citizens and residents), with the allowance of a personal exemption and certain other deductions. 58 application of these rules requires characterization of a retirement distribution. for this purpose, the irs treats a retirement distribution as consisting of two separate parts: (1) the portion attributable to employer contributions and tax-advantaged employee contributions to the plan, characterized as personal services income, and (2) the portion attribution to ―earnings and accretions‖ thereon. 59 the ―earnings and accretions‖ portion is apparently viewed as u.s. source, but not ―effectively connected,‖ income, in the case of a u.s. retirement plan; as such, it is taxed to a nonresident alien at a flat rate of 30 percent. 60 the ―contributions‖ portion is classified as either u.s. source or foreign source depending on where the services were performed. 61 the foreign source portion is not subject to u.s. tax. the u.s. source portion is treated as ―effectively connected income‖ to the extent that the services were performed after 1986 and, therefore, taxed at graduated rates. 62 an exclusion from u.s. tax is provided in section 871(f) for 57. i.r.c. § 871(a)(1). 58. i.r.c. §§ 871(b)(1), 873(a)-(b). 59. rev. rul. 79-388, 1979-2 c.b. 270; see also clayton v. united states, 33 fed. cl. 628 (fed. cl. 1995), aff’d without published opinion, 91 f.3d 170 (fed. cir. 1996), cert. denied, 519 u.s. 1040 (1996) (earnings and accretions portion of cash distribution from qualified stock bonus plan was from u.s. sources). prior to the issuance of this ruling, irs chief counsel had argued that the entire distribution from a qualified pension plan should be viewed as compensation income. see discussion in cynthia blum, u.s. income taxation of cross-border pensions, 3 fla. tax rev. 259, 304 (1996). 60. similarly, the irs treats the income of a nonresident alien from a commercial annuity contract issued by a foreign branch of a u.s. life insurance company as from u.s. sources and as fixed and determinable income subject to 30 percent withholding. rev. rul. 2004-75, 2004-2 c.b. 109. 61. the source of income from compensation is determined under section 861(a)(3). david w. ellis, covering expatriate employees in qualified plans (both inbound and outbound), sp039 a.l.i.-a.b.a. 577, 591 (2009); see also supra note 52. 62. see i.r.s. priv. ltr. rul. 90-41-041 (july 13, 1990); i.r.s. priv. ltr. rul. 89-04-035 (oct. 31, 1988); blum, supra note 59, at 279 n.101. see also t.d. 8288, 1990-1 c.b. 163, 164 (explaining that section 864(c)(6) applies to pensions, because “[p]ensions are treated as compensation for services under section 31.3401(a)-1(a)(2).”). see also i.r.s., publication 519, supra note 45, at 19, stating that “[i]f you were a nonresident alien engaged in a u.s. trade or business after 1986 because you performed personal services in the united states, and you later receive a pension or retirement pay attributable to these services, such payments are 790 florida tax review [vol. 11:10 distributions from a qualified plan if the employee performed all his services outside of the united states as a nonresident alien and 90 percent of the covered employees are u.s. citizens or residents. 63 the treatment of the ―contributions‖ portion of the retirement distribution as ―effectively connected income‖ to the extent that the services were performed in the united states after 1986 results from the application of section 864(c)(6) of the code. although a recipient of a retirement distribution may not be currently engaged in a u.s. trade or business, for example, by current performance of services in the u.s., 64 section 864(c)(6) provides that income from deferred compensation is characterized as if the income were taken into account in the year that the services were performed. 65 a final consideration is whether the recipient is protected by a u.s. treaty with his country of residence. 66 most treaties 67 entered into by the effectively connected income in each year you receive them.” this statement suggests that the irs views the provision as not applying to services performed before 1986. see ellis, supra note 61, at 591 n.55. but see advisory comm. on tax-exempt and gov‟t entities, internal revenue serv., international pension issues in a global economy: a survey and assessment of irs‟ role in breaking down the barriers 32 (2009) [hereinafter act] (indicating that guidance is needed on this “effective date” issue). 63. i.r.c. § 871(f). a limited amount of united states services (the section 864(b) short-term business travel exception) is also permitted. id. in addition the requirement that 90 percent of employees be u.s. persons is eliminated when there is a reciprocal exclusion in the residence country or it is a developing country under the trade act of 1974. see i.r.s., publication 515 withholding of tax on nonresident aliens and foreign entities, at 20–21, http://www.irs.gov/pub/irs-pdf/p515.pdf; bittker & lokken, federal taxation, supra note 2, ¶ 67.2.5, at 67–34. 64. a taxpayer who receives compensation for services currently performed in the u.s. (when the amount does not qualify under the “de minimis” business traveler rule of sections 861(a)(3) and 864(b)(1)) is considered to be engaged in the conduct of a u.s. trade or business and receives income from compensation that is effectively connected with that business. i.r.c. § 864(b), (c)(2); regs. §§ 1.864-2(a), 1.864-4(c)(6)(ii). 65. i.r.c. § 864(c)(6), added by pub. l. 99-514, sec. 1242(a), 100 stat. 2085, and amended in pub. l. 100-647, sec. 1012(r), 102 stat. 3342, 3525 (codified as amended at section 864(c)). 66. although the resident article of most u.s. treaties includes citizenship in the definition of “resident of a contracting state,” eligibility for treaty benefits is based on tax residence in the treaty country, not citizenship. see 2006 u.s. model treaty, supra note 46, at art. 4, para. 1 & art. 1, para. 1. u.s. treaty partners generally include a provision denying treaty benefits for individuals claiming u.s. residence under the treaty solely on the basis of citizenship or green card status. see, e.g., 2001 u.s.–uk convention, supra note 46, at art. 4, para. 2. 2012] retirement distributions to foreign nationals 791 united states either eliminate or reduce the rate of u.s. tax imposed on private 68 pension distributions made to a treaty resident. whether a payment is a ―pension distribution‖ depends upon the terms of the particular treaty. 69 a separate treaty exemption may be provided for annuities (paid in return for consideration other than for services rendered). 70 67. see i.r.s., publication 515, supra note 63, at 38–41 (table 1). see generally thomas st.g. bissell, u.s. income taxation of nonresident alien individuals, 907 tax mgmt. (bna); david s. foster, treaty issues in cross–border retirement benefits, 56 n.y. u. ann. inst. on fed. tax‟n 14, § 14.05 (1998); hall, supra note 36, at a-81 to a-93; ellis, supra note 61. 68. under the 2006 u.s. model treaty ―any pension and other similar remuneration paid by, or out of funds created by, a contracting state or a political subdivision or a local authority thereof to an individual in respect of services rendered to that state or subdivision or authority . . .‖ is taxable only by that state, except that source country taxation is not allowed if the ―individual is a resident of, and a national of, [the other] state.‖ 2006 u.s. model treaty, supra note 46, at art. 19, para. 2. however, article 17 (private pensions) applies to a pension in respect of services rendered in connection with a business carried on by a contracting state or a political subdivision or a local authority thereof. see i.r.s., publication 901, u.s. tax treaties, at 34–35, http://www.irs.gov/pub/irs-pdf/p901.pdf (table 1, indicating with the letter ―d‖ the countries that permit full taxation by the source country of u.s. government (federal, state, or local) pensions and annuities). footnote ―d‖ also lists countries that bar u.s. taxation if the individual is a resident of, and a national of (or in some cases, a citizen of), that country. id. at 37. 69. as reported by lee sheppard, the treasury deputy international tax counsel for treaty affairs explained, at a june 19, 2007, meeting, that the technical explanation of the 2006 u.s. model treaty was “meant for use by treaty negotiators,” and “is not meant as guidance for taxpayers.” lee a. sheppard, treasury official explains new model treaty, 115 tax notes 1249, 1249 (june 25, 2007). sheppard states that “a treasury technical explanation is not legally binding, though, as the nysba pointed out, the irs sometimes cites it in interpreting treaties.” id; see also n.y. state bar ass‟n tax section, report on the model income tax convention released by the treasury on november 15, 2006, at 3 nn.7–8 (2007) [hereinafter nysba report]. 70. see infra note 72 for 2006 u.s. model treaty; see also i.r.s. priv. ltr. rul. 87-17-046 (jan. 27, 1987) (annuity option distributions from a qualified employee trust were pensions under the old u.s.-u.k. treaty.) for example, under the u.s.–south africa treaty whereas a pension is taxable at the reduced rate of 15 percent, a separate rule is provided for annuities (obtained for consideration other than for services rendered). convention between the government of the united states of america and the republic of south africa for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, feb. 17, 1997, art. 18, para. 1–3 [hereinafter 1997 u.s.-south africa convention], http://www.irs.gov/pub/irs-trty/safrica.pdf. these are exempt from source country tax, but are fully taxable if purchased in the source country while the individual was a resident of that country. id. art. 18, para. 3. under the treaty with 792 florida tax review [vol. 11:10 the 2006 u.s. model treaty exempts pensions 71 as well as annuities 72 from source country taxation. the technical explanation defines pensions as including both periodic and single sum payments from qualified private retirement plans. 73 by contrast, some u.s. treaties allow source the philippines, annuities (obtained for consideration other than for services rendered) are exempt from source country tax, but pensions are not exempt from tax in the country where services were rendered. convention between the government of the united states of america and the government of the republic of the philippines with respect to taxes on income, oct. 1, 1976, art. 18, para. 1, 4, 5 [hereinafter 1976 u.s.-philippines convention], http://www.irs.gov/pub/irstrty/philip.pdf. under the treaty with indonesia, pensions may be taxed by the source country at a rate of 15 percent, but annuities (other than for services rendered) are exempt. convention between the government of the united states of america and the government of the republic of indonesia for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, july 11, 1988, art. 21, para. 1–2, 4–5 [hereinafter 1988 u.s.-indonesia convention], http://www.irs.gov/pub/irs-trty/indo.pdf. in the u.s.-denmark treaty, pensions are taxable by the source country; however, annuities (other than for services rendered) are exempt. convention between the government of the united states of america and the government of the kingdom of denmark for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, aug. 19, 1999, art. 18, para. 1, 3 [hereinafter 1999 u.s.-denmark convention], http://www.irs.gov/pub/irs-trty/denmark2.pdf. 71. see 2006 u.s. model treaty, supra note 46, at art. 17, para. 1, providing that “[p]ensions and other similar remuneration beneficially owned by a resident of a contracting state shall be taxable only in that state.” 72. under the 2006 u.s. model treaty, annuities are exempted from source country taxation. 2006 u.s. model treaty, supra note 46, at art. 17, para. 3. an annuity is defined as “a stated sum paid periodically at stated times during a specified number of years, or for life, under an obligation to make the payments in return for adequate and full consideration (other than services rendered).” id. the technical explanation states that, “[a]n annuity received in consideration for services rendered would be treated as either deferred compensation that is taxable in accordance with article 14 . . . or a pension that is subject to the rules of article 17.” u.s. dep‟t of the treasury, technical explanation to the united states model income tax convention, nov. 15, 2006, at 54, http://www.treasury.gov/presscenter/press-releases/documents/hp16802.pdf. see i.r.s. priv. ltr. rul. 87-17-046, supra note 70 (old u.s.-u.k. treaty). 73. in the technical explanation, the treasury states that article 17 refers to “distributions from pensions and other similar remuneration . . . in consideration of past employment . . . .” technical explanation to the 2006 u.s. model treaty, supra note 72, at 54. it states that “[t]he term „pensions and other similar remuneration‟ includes both periodic and single sum payments.” id. it further explains that the term is intended to encompass payments made by qualified private retirement plans. in the united states, the plans encompassed by paragraph 1 include: qualified plans under section 401(a), 2012] retirement distributions to foreign nationals 793 country taxation of pensions, 74 and some provide for source country taxation of all (or certain) lump sum payments. 75 individual retirement plans (including individual retirement plans that are part of a simplified employee pension plan that satisfies section 408(k), individual retirement accounts and section 408(p) accounts), section 403(a) qualified annuity plans, and section 403(b) plans. distributions under section 457 plans may also fall under paragraph 1 if they are not paid with respect to government services covered by article 19. id. 74. under the 2004 protocol to the u.s.–france treaty, pension distributions are taxed exclusively by the source country. u.s. dep‟t of the treasury, technical explanation of the protocol between the united states of america and the french republic, dec. 8, 2004, art. iii, http://www.treasury.gov/resourcecenter/tax-policy/treaties/documents/tefranceprot09.pdf. under the u.s.–denmark treaty, pension distributions are taxable solely in the source country unless the distributee was already receiving distributions on march 31, 2000. 1999 u.s.– denmark convention, supra note 70, art. 18, para 1. under the u.s.–south africa treaty, the u.s. may tax a distribution from a u.s. pension, but the rate of tax may not exceed 15 percent; the reduced rate is inapplicable if the distribution is subject to the early withdrawal penalty. 1997 u.s.-south africa convention, supra note 70, at art.18, para. 1. under the u.s.–philippines treaty, pensions may be taxed by the country in which the services were rendered. 1976 u.s.–philippines convention, supra note 70, at art. 18, para. 1, 4. under the treaty with indonesia, the source country may tax pensions at a rate of 15 percent. 1988 u.s.–indonesia convention, supra note 70, art. 21, para. 1. the u.s.–poland treaty does not contain a pension provision. convention between the government of the united states of america and the government of the polish people‟s republic for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, oct. 8, 1974, 28 u.s.t. 891, http://www.irs.gov/pub/irs-trty/poland.pdf. 75. under the u.s.–u.k. treaty, pensions and other similar remuneration are taxable only in the residence country; however, only source country taxation is allowed for a “lump-sum payment.” see 2001 u.s.-uk convention, supra note 46, at art. 17, para. 1–2. the treasury‟s technical explanation states that this treatment of lump sum distributions is designed to avoid “double non-taxation” in that “the united kingdom does not tax lump-sum distributions from pension funds.” u.s. dep‟t of the treasury, technical explanation of the convention between the government of the united states of america and the government of the united kingdom of great britain and northern ireland for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, march 5, 2003, at 63, http://www.treasury.gov/resource-center/taxpolicy/treaties/documents/teus-uk.pdf. under the u.s.-italy treaty, pensions are taxable only in the residence state; however, if a lump sum payment is received after a change of residence from the country where the employment was exercised to the other country, the payment is taxable only in the source country. convention between the government of the united states of america and the government of the italian republic for the avoidance of double taxation with respect to taxes on 794 florida tax review [vol. 11:10 a special tax regime applies, however, if a foreign national participating in a u.s. retirement plan 76 is a ―covered expatriate.‖ 77 the employee has the option of notifying the payer under the plan of his ―covered expatriate‖ status and making an irrevocable waiver of any right to claim a treaty reduction in withholding on any distribution from the plan; in that case, any distributions under the plan will be subject to 30 percent withholding by the payer. 78 presumably, the distributee may then file a form 1040nr claiming the benefits of a treaty or graduated rates on effectively income and the prevention of fraud or fiscal evasion, aug. 25, 1999, art. 18, para. 1, 3, http://www.treasury.gov/resource-center/tax-policy/treaties/documents/italy. pdf policy/treaties/documents/italy.pdf. see u.s. dep‟t of the treasury, technical explanation of the convention between the government of the united states of america and the government of the italian republic for the avoidance of double taxation with respect to taxes on income and the prevention of fraud or fiscal evasion, oct. 27, 1999, at 61–62, http://www.treasury.gov/resource-center/taxpolicy/treaties/documents/teitaly.pdf, explaining that this provision “prevents a u.s. resident who anticipates receiving a lump–sum distribution from a u.s. pension plan with respect to employment in the united states from establishing residence in italy in order to obtain more favorable italian tax treatment under paragraph 1.” under the u.s.–canada treaty, the source country may tax a periodic pension distribution at a rate not exceeding 15 percent and is not limited in taxing a lump sum distribution. convention between the united states of america and canada with respect to taxes on income and on capital, sept. 26, 1980, art. xvii, para. 1–2, 1469 u.n.t.s. 189, http://www.irs.gov/pub/irs-trty/canada.pdf. see memorandum from m. grace fleeman, senior technical reviewer, internal revenue serv., on united states– canada income tax treaty and the united nations joint staff pension fund to andrew zuckerman and tony montanaro (july, 11, 2007), http://services.taxanalysts.com/taxbase/eps_pdf2009.nsf/docnolookup/2413/$file /2009-2413-1.pdf. see ellis, supra note 61, at 594 nn.65–66 and accompanying text. under the u.s.-netherlands tax treaty, a lump sum payment may be taxed by the source country if the recipient has been a resident of the source country within the previous five years. convention between the united states of america and the kingdom of the netherlands for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, apr. 29, 1948, art. 19, para. 2, http://www.irs.gov/pub/irs-trty/nether.pdf. see i.r.s. priv. ltr. rul. 9626-055 (apr. 11, 1996) (applying this rule to a spouse of the employee receiving a distribution from a pure-rollover ira pursuant to a qdro). 76. the rule applies to any “deferred compensation item,” defined in section 877a(d)(4), and includes “any interest in a plan or arrangement described in section 219(g)(5).” alden & bissell note that that provision “embraces most u.s. tax qualified plans. . . .” alden & bissell, supra note 48, at 437–38. 77. see supra notes 48–49 and accompanying text. 78. in this case, the deferred compensation is classified as an “eligible deferred compensation item.” i.r.c. § 877a(d)(3). 2012] retirement distributions to foreign nationals 795 connected income, 79 but this is not 80 clear. 81 if the employee does not choose this option, he is treated as receiving a constructive distribution of the present 79. the statute states that ―[a]ny item subject to the withholding tax imposed under paragraph (1) [of section 877a(d)] shall be subject to tax under section 871.‖ section 877a(d)(6)(b) entitled ―application of tax.‖ section 877a(d)(6)(a) states: ―rules similar to the rules of subchapter b of chapter 3 [i.e., sections 1461 et seq.] shall apply for purposes of this subsection.‖ subparagraph (c) states that: ―any item subject to withholding under paragraph (1) shall not be subject to withholding under section 1441 or chapter 24 [26 uscs §§ 3401 et seq.].‖ thus far, irs has not provided clear guidance. it has stated that ―[b]ecause the expatriate must waive his or her right to claim treaty benefits with respect to an eligible deferred compensation item, the 30 percent withholding tax cannot be reduced or eliminated by treaty.‖ notice 2009-85, sec. 5.c. however, the notice further provides that ―section 877a(d)(6) provides that the tax that is imposed on taxable payments from eligible deferred compensation items by section 877a(d)(1) is imposed under section 871, but that the payment is subject to withholding under section 877a(d)(1) and not under section 1441 or chapter 24. any amount due under section 871 that is not paid by means of withholding must be reported on the income tax return filed by the covered expatriate for the relevant taxable year.‖ id. at sec. 5.f. 80. see bittker & lokken, federal taxation of income, estates, and gifts, supra note 2, at ¶ 66.1a.5 (concluding that ―it is a final tax‖); compare alden & bissell, supra note 48, at 438–39, suggesting treaty relief may be available; see mark a. spielman, service issues guidance on section 877a exit tax, news quarterly, vol. 29, no. 2, pp. 11–13, winter 2010, ―several important interpretative questions remain unanswered by [notice 2009-85], including the relationship and application of section 871 to section 877a.‖ see also thomas st. g. bissell, an ―exit tax‖ enters the u.s. tax lexicon — section 877a and guidance under notice 2009-85, tax management memorandum, april 12, 2010, stating that ―the expatriate's actual tax must be calculated under the provisions governing payments to nonresident aliens under section 871, and the 30 percent withholding tax is then credited against the expatriate's substantive federal income tax liability.‖ (footnotes omitted.) he further states that ―it should be possible for him to claim treaty relief in the final determination of tax under section 871.‖ he argues that both the instructions to form 8854 and notice 2009-85 are ―silent on the issue — possibly a tacit admission on the part of the irs either that it agrees with this conclusion but does not wish to concede this point as yet, or else that it is still studying the issue.‖ id. see also edward tanenbaum, more on individual expatriation — notice 200985, 39 tax mgmt. int‘l j. 94 (2010), noting that ―[t]his withholding requirement applies in lieu of any other withholding requirements under current law, but items that are subject to the withholding requirement are nevertheless subject to tax under section 871.‖ id. 81. apparently the treasury does not intend to take the position that treaty protection would be barred by provisions in a treaty‟s savings clause extending it for ten years to long-term residents who have expatriated. (for such provisions, see infra note 85) this is suggested by the fact that the treaty signed with hungary on feb, 4, 2010 contains this type of extension of the savings clause, but the technical http://www.lexis.com/research/buttontflink?_m=3dd0d0e37c21c9816d0ebd5717e211a8&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b26%20uscs%20%a7%20877a%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=12&_butinline=1&_butinfo=26%20usc%203401&_fmtstr=full&docnum=1&_startdoc=1&wchp=dglzvlz-zskaz&_md5=8029897a10bdad62e5549f31973614e8 796 florida tax review [vol. 11:10 value of the accrued retirement benefit on the day before the expatriation date. 82 moreover, without regard to any election, a covered expatriate is generally deemed to receive a distribution of his entire interest in an individual retirement account on the day before the expatriation date (when no treaty protection would be available). 83 a former long-term resident who expatriated after june 3, 2004 and before june 17, 2008, is not subject to the rules for covered expatriates. however, the u.s. source portion of any distributions received within ten years after expatriation is taxed at graduated rates 84 and is excluded from treaty protection in many cases. 85 b. withholding or other payment of tax if the recipient of a distribution from a u.s. qualified retirement plan is a nonresident alien, a distinct set of withholding rules apply. 86 except when a treaty applies, a distribution to a nonresident alien retiree or explanation provides that it refers to the application of section 877 to long-term residents or citizens who expatriated before june 17, 2008. convention between the united states and hungary for the avoidance of double taxation and prevention of fiscal evasion with respect to taxes on income, u.s.–hungary, feb. 4, 2010, treaty doc. 111–7. 82. i.r.c. § 877a(d)((2)(a). see discussion in alden & bissell, supra note 48, at 438 (noting the unavailability of the $600,000 exemption of section 877a(a)(3)(a) or the deferral election of section 877a(b)). 83. see i.r.c. § 877a(e). this rule does not apply to simplified pensions or retirement accounts described in section 408(k) or (p). no early distribution tax applies. i.r.c. § 877(e)(1)(b). see notice 2009-85, 2009–2 c.b. 598, sec. 6. see discussion in alden & bissell, supra note 48, at p. 431. 84. see i.r.c. § 877(a), (b). 85. as explained by alden & bissell, the 1996 act, which first applied section 877 to former long-term residents, contained a treaty override, expiring in 2006. many treaties that were negotiated or amended after 1996 contain a provision extending the savings clause to long-term residents who have expatriated. see alden & bissell, supra note 48, at text accompanying notes 16–18, (citing 2006 u.s. model income tax convention, art.1 (4); 1997 u.s.–south africa tax treaty, art. 1(4).) see also protocol to u.s.–mexico treaty, september 8, 1994, article 1, t.i.a.s. 1404; protocol to 2001 us–uk convention, supra note 46, at art. 6. 86. regs. § 1.1441-4(b)(1). see i.r.c. § 1441(a), (b) (30 percent withholding required on payments to nonresident alien individuals of wages, annuities, compensations or other fixed or determinable annual or periodical income); i.r.c. § 1441(c) (no withholding required in the case of any item, other than compensation for personal services, which is effectively connected with the conduct of a u.s. trade or business and is included in gross income of the recipient under 871(b)(2) for the taxable year). 2012] retirement distributions to foreign nationals 797 beneficiary is subject to 30 percent withholding under section 1441 87 (and not under the rules provided for distributions to u.s. citizens). 88 the payer is required to provide the foreign person with form 1042-s and report the tax withheld on form 1042. 89 an irs publication states that the nonresident has the option to request that the payer instead implement wage withholding; however, this treatment appears inconsistent with the treasury regulations. 90 87. regs. § 1.1441-4(b)(1)(ii),(iv). prior to 1987, section 1441 withholding was required. however, after the enactment of section 864(c)(6), withholding under section 3405 was permitted for pensions with respect to services performed in the u.s. after 1986. see discussion in t.d. 8288, 1990-1 c.b. 163 (adopting temp. reg. § 1.1441-4t(b)(ii), which required withholding under section 1441 if the recipient elected out of section 3405 withholding); act, supra note 62, at e–14, n.118 (prior to 2001, regulations allowed nonresident alien to elect withholding at graduated rates on a pension distribution to avoid 30 percent withholding tax, even though only a portion of the distribution was effectively connected income). however, when proposed regulations under section 1441 were issued in 1996 (in a major revision of the withholding regulations), see 61 fr 17614-01, 1996-1 c.b. 773, april 22, 1996, the treasury stated that ―a new paragraph (b)(1)(ii) is added to require that withholding on distributions from certain qualified pension plans and annuities occur under section 1441 rather than under section 3405 as was required under section 1.1441-4t(b)(ii) (which expired on february, 1993).‖ see also discussion in blum, supra note 59, at n.231. in 2000, the regulation was modified to add a reference to individual retirement accounts under section 408; the preamble stated that the result of the regulation was ―that section 1441, rather than section 3405, applies to retirement distributions. this rule considerably eases the burdens that would otherwise apply to retirement distributions. commentators noted that the regulations did not provide the same rule for distributions from individual retirement accounts and annuities described in section 408. the regulation has been amended so that those distributions will be subject to section 1441 as well.‖ t.d. 8881, 2001-1 c.b. 1158. 88. however, an eligible rollover distribution can be rolled over into an ira to avoid withholding. see act, supra note 62, at e–15, citing i.r.s. priv. ltr. rul. 92-06-015 (nov. 7, 1991). the ruling explains: “the primary reason for imposing withholding tax at the source on distributions to nras . . . is that it may be difficult or impossible to collect the tax once the income is out of the united states. this concern is addressed, however, if a qualified plan distribution is rolled over to an ira.” i.r.s. priv. ltr. rul. 92-06-015 (nov. 7, 1991), quoted in act, supra note 62, at e–15. 89. i.r.s., publication 15-a, supra note 34, at 23. 90. see i.r.s., publication 15-a, supra note 34, at 22; i.r.s., publication 519, supra note 45, at 50 (―if you receive a pension as a result of personal services performed in the united states, the pension income is subject to the 30 percent (or lower treaty) rate of withholding. you may, however, have tax withheld at graduated rates on the portion of the pension that arises from the performance of services in the united states after december 31, 1986. you must fill out form w-8ben and give it to the withholding agent or payor before the income is paid or credited to you.‖); 798 florida tax review [vol. 11:10 a payer who receives a form w-8ben (or 8233) 91 from the payee claiming a treaty exemption would not withhold u.s. tax on the distribution. in that case, the payer is required to file form 1042-s, showing the treaty exemption, with the irs. 92 the irs automatically sends this information to the treaty country, which puts it in a position to seek tax from its resident. 93 although the irs instructs a nonresident alien to file a form w8ben with the payer before receiving any payment from a qualified u.s. retirement plan, 94 some nonresident alien payees fail to file the form. in that i.r.s., publication 515, supra note 63, at 20. this appears to be inconsistent with the current version of regulation 1.1441-4(b) described in supra note 87; see also act, supra note 62, at e-14 & n.119 (noting that the section 1441 regulations ―explicitly state that [section] 3405 does not apply to any distribution subject to [section 1441] withholding‖). see also hall, supra note 36, at a-68, stating that under the current regulations, which came into effect in 2001, ―the withholding rules of [section] 1441 now entirely supplant the domestic rules when payments are made to a nonresident alien from a qualified plan or annuity, a [section] 403(b) arrangement or an ira,‖ and citing section 3405(e)(1)(b)(iii) and regs. section 1.1441-4(b)(1)(ii). the authors further note that ―it is not possible for a nonresident alien to elect a lower rate of withholding in a situation where the individual‘s substantive u.s. tax liability is expected to be lower than the amount required to be withheld,‖ (citing regs. § 1.1441-1(b)(3)(iii)(c)). id. 91. according to act, supra note 62, at e–15, a nonresident alien claiming treaty relief for a pension distribution should file form 8233, or instead w-8ben “when a distribution is subject to u.s. income tax solely because of the investment earnings (i.e., no portion of the distribution is attributable to employer contributions for services within the united states).” form 8233, (rev. june 2011), states that it should be used to claim treaty exemption in respect of compensation for dependent services performed in the u.s. the form indicates that a nonresident alien receiving such compensation and not claiming treaty exemption should file form w-4. however, the form 8233 instructions state that a ssn, and not an itin, must be included on line 2 of the w-4. no specific mention of pension income is made in form 8233 or the instructions. form w-8ben appears to be the more appropriate form since form 8233 requires information relevant to foreign nationals engaged in activities in the united states such as visa and immigration status, which are not relevant for foreign nationals residing abroad who are receiving retirement distributions. see i.r.s. form 8233, (rev. june 2011). 92. on form 1042-s, in box 1 “income code,” the withholding agent would use “14,” the code for pensions, annuities, alimony and/or insurance premiums. see i.r.s. form 1042-s (2011) explanation of codes. 93. see i.r.c. § 6103(k)(4) (return may be disclosed to competent authority of a foreign government pursuant to the terms of an income tax treaty). 94. see i.r.s. form w-4p (2011), p. 4 (“a foreign person should submit form w-8ben, certificate of foreign status of beneficial owner for united states tax withholding, to the payer before receiving any payments” and it “must contain the foreign person‟s tin.”). the current form w-8ben requiring certification that the income is not “effectively connected income” (unless exempted by treaty) might 2012] retirement distributions to foreign nationals 799 case, a payer without actual knowledge of the payee‘s u.s. or foreign status may rely on a presumption provided in section 1.1441-1(b)(3)(iii)(c) of the treasury regulations: if the payer has a social security number for the payee and the payer relies on a mailing address in the united states or in a treaty country, the payee is presumed to be a u.s. person; otherwise, the payee is presumed to be a foreign person. 95 in many cases, a taxpayer who has worked for a significant period in the united states will have a social security number, which is on file with the payer; if payment is made to a u.s. address or to an address in a treaty country, the payer should then be withholding in the same manner as for a u.s. person who has not filed a form w-4p, i.e., by wage withholding on periodic distributions (as if the recipient were married claiming three withholding allowances), or at a flat 10 percent or 20 percent rate on other distributions. 96 as noted above, if the payer has received a notification that the taxpayer is a covered expatriate and is waiving treaty benefits, the payer should withhold from distributions at a 30 percent rate. cause confusion for foreign recipients who know the taxation rules for such retirement payments. see i.r.s. form w-8ben (rev. february 2006), part iv. 95. under this regulation, “a payment from a trust described in section 401(a), an annuity plan described in section 403(a), a payment with respect to any annuity . . . or retirement income account described in section 403(b), or a payment from an individual retirement account . . . described in section 408 that a withholding agent cannot reliably associate with documentation is presumed to be made to a u.s. person only if the withholding agent has a record of a social security number for the payee and relies on a mailing address [of the following sort, i.e.,] an address used for purposes of information reporting or otherwise communicating with the payee that is an address in the united states or in a foreign country with which the united states has an income tax treaty in effect and the treaty provides that the payee, if an individual resident in that country, would be entitled to an exemption from u.s. tax on amounts described in this paragraph (b)(3)(iii)(c).” in the absence of a ssn and treaty address, this type of payment “is presumed to be made to a foreign person.” id. this is an exception to the general rule that a payment that the withholding agent cannot reliably associate with documentation is presumed to be made to a u.s. person. reg. §1.1441-1(b). however, these presumptions will not protect a payer to the extent that he has actual knowledge or reason to know the actual status of the payee if such status would require withholding of a higher amount. reg. § 1.14411(b)(3)(ix)(b). see also reg. § 1.1441-1(b)(3)(x) example 4. 96. see supra notes 33–42 and accompanying text. 800 florida tax review [vol. 11:10 v. problems caused by current rules a. need for many nonresident alien payees to file form 1040nr if correct amount of u.s. tax is to be collected a key defect of the current rules regarding distributions from a u.s. qualified plan is the frequent discrepancy between the amount of tax withheld from the distribution by the payer and the actual tax liability of the nonresident alien receiving the distribution. 97 the tax withheld (absent a treaty claim and assuming the recipient files a form w-8ben or form 8233, indicating foreign status) is 30 percent of the amount distributed; however, the actual liability will often differ because any portion of the distribution attributable to contributions for u.s. services performed after 1986 is classified as effectively connected income and therefore taxable at section 1 rates with allowance of a personal exemption. moreover, any portion attributable to contributions for services performed outside the united states 98 is exempt from u.s. tax; but there is no requirement that the payer determine this portion and exempt it from withholding. 97. see act, supra note 62, at 33, noting the “mismatch between amounts withheld and the tax actually owed by a nonresident alien receiving a distribution from a qualified plan, 403(b) plan or ira that is attributable to effectively– connected income.” the report concludes that “[t]his results in the recipient either having to file and pay estimated taxes if the flat 30 percent rate (or treaty rate) is too little or having to file for a refund if the 30 percent rate is too high.” id. see also hall, supra note 36, at a-68 noting the “disconnect between the flat 30 percent rate of withholding . . . and the substantive u.s. income tax liability related to these retirement payments.” 98. see i.r.s., publication 519, supra note 45, at 14 (“if you receive a pension from a domestic trust for services performed both in and outside the united states, part of the pension payment is from u.s. sources. that part is the amount attributable to earnings of the pension plan and the employer contributions made for services performed in the united states.”); see rev. proc. 2004-37, 2004-1 c.b. 1099, providing “a method for determining the source of a pension payment to a nonresident alien individual from a defined benefit plan” involving a trust qualified under section 401(a). the revenue procedure provides a formula for determining “the portion of each payment that is deemed to be attributable to contributions for services rendered outside the united states, and thus treated as income from sources without the united states.” it notes that “the remainder of the payment, which represents the sum of deemed contributions for services rendered within the united states plus earnings on all contributions, is treated as income from sources within the united states.” id. at § 4; see also bissell, t.m. portfolio, supra note 67, at a72, noting that the rule provided may not lead to correct results “because over a 30year career an employee‟s salary would typically be increased each year,” but concluding that “[t]he rule, nevertheless, provides for administrative convenience, 2012] retirement distributions to foreign nationals 801 as a result of the discrepancy, the taxpayer would be required to file a u.s. tax return on form 1040nr 99 if additional tax is due; 100 moreover, if withholding is more than the actual tax liability, the taxpayer would need to file form 1040nr to claim the refund to which he is entitled. yet the nonresident alien may be unaware of any requirement of, or potential benefit from, filing the form 1040nr. in addition, a retiree who lives outside the united states is not in a good position to obtain accurate, reasonably priced u.s. tax advice. the retiree may be elderly (and thus less likely to use irs.gov or other internet because it may be difficult to reconstruct the employee‟s annual salary information over the course of his entire career.” id. 99. irs instructions for form 1040nr state that the part of the pension payment attributable to contributions in respect of services performed in the u.s. after 1986 is reported as effectively connected income on page 1, line 17, of the form and that, generally, the remaining amount is reported on page 4, schedule nec, line 7. instructions for i.r.s. form 1040 (2010), at pp. 14–15. as noted by act, supra note 62, estimated tax may also be due. see supra note 97. 100. reg. § 1.6012-1(b)(1)(i) (form 1040nr required of any nonresident alien individual who is engaged in a u.s. trade or business during the taxable year or who has income which is subject to taxation under subtitle a of the code, sections 1 through 1563). there is an exception in section 1.6012-1(b)(2)(i) for cases where tax liability is fully satisfied by section 1441 withholding, but it would not apply if tax is due. see hall et al., supra note 36, at a-68, stating that “if the effectively connected income is subject to substantive income tax at a rate greater than 30 percent, it is contemplated that the nonresident alien recipient would file a form 1040nr to pay the additional u.s. tax.” even if the tax liability is fully satisfied by withholding, the exception from return filing is not available if the retiree is engaged in a u.s. trade or business at any time during the taxable year or if he has income treated as effectively connected under section 871(c) or (d) or by reason of section 897. reg. § 1,6012-1(b)(2)(i). it is not clear whether the failure to mention income treated as effectively connected income by reason of section 864(c)(6) was intentional. see singer letter, supra note 1, concluding that “[r]etirees receiving payment, from defined contribution plans have [effectively connected income] which results in a tax return requirement even if the income is treaty–exempt.” the 2010 instructions for form 1040nr, at 3, simply state that a nonresident alien is required to file if either “you were . . . engaged in a trade or business in the united states during 2010” or, if not, “you received income from u.s. sources that is reportable on schedule nec, lines 1 through 12 [and n]ot all of the u.s. tax that you owe was withheld from that income.” the items reportable on schedule nec are items of income not effectively connected with a u.s. business. see bissell, t.m. portfolio, supra note 67, at a49–50, suggesting that if any tax has not been fully paid by withholding then a tax return is required, but if not, then “the regulations and the instructions imply that” no return is required. bissell further points out that “if no actual tax were due and the irs took that position that this type of income required the filing of a return, there is no civil penalty on the income recipient.” id. at a-50. see i.r.c. § 6651(a). 802 florida tax review [vol. 11:10 sources) 101 and may not be financially sophisticated. there is no commercial software such as turbotax that could be used by the retiree to complete a form 1040nr. 102 there is little walk-in help from the irs in foreign countries, 103 and limited access to tax return preparers with sufficient familiarity with u.s. tax issues to prepare the form 1040nr accurately. 104 moreover, the plan administrator may not have provided the retiree with information about the composition of the distribution that would be required for an accurate determination on the form 1040nr. 105 the retiree 101. see treasury inspector general for tax administration, memorandum for commissioner, wage and investment division, reference number 2009-30-076, may 28, 2009, at 2009 tnt 113-37, noting that a 2008 gallop organization survey indicated that “more than half of all americans have visited a government web site” but that “those americans aged 65 or older comprised the smallest group of internet users.” the memorandum concluded that “it is likely that taxpayers aged 65 or older are not utilizing irs.gov.” id. 102. the gao notes in a recent report that “irs does not engage in outreach to tax software providers on nonresident alien tax issues, primarily because form 1040nr currently cannot be filed electronically. . . .” the form 1040nr “contains fields that cannot easily be transcribed into an electronic format,” although irs “redesigned form 1040nr for tax year 2009, in part to address this problem.” the irs “does not plan to accommodate electronic filing of the form until at least 2014.” united states government accountability office, irs may be able to improve compliance for nonresident aliens and updating requirements could reduce their compliance burden, report to the chairman, subcommittee on select revenue measures, committee on ways & means, april 2010, at 2010 tnt 94-56 [“hereinafter gao report”]. 103. the gao notes, in a recent report, that “irs employees at foreign posts are available to provide guidance to nonresidents, although these posts generally are staffed by few employees, making outreach difficult.” gao report, supra note 102. publication 901, supra note 68, notes that taxpayer assistance is available in beijing, frankfurt, london or paris; it also provides a telephone number for use by those outside the u.s., but the number is not toll-free. id. at 56. 104. a recent report by the gao noted, however, that “a greater proportion of forms 1040nr than forms 1040 were prepared by a paid tax return preparer, a disparity which may be due to several factors, such as the complexity of the nonresident tax law and that some employers with employees traveling internationally may hire tax professionals to assist in preparing employees‟ returns.” gao report, supra note 102. 105. the advisory committee on tax exempt and government entities notes that “[c]onspicuous by its absence from [rev. proc. 2004-37, supra note 98, dealing with defined benefit plans,] is guidance for determining the portion of a distribution that is effectively connected with the united states.” it concludes: “by failing to provide this guidance, the irs is effectively requiring withholding at the 30 percent flat rate for both employer contributions for services performed within the united states and the investment earnings, rather than allowing withholding at the graduated income tax rates for the portion of the distribution constituting effectively 2012] retirement distributions to foreign nationals 803 (particularly in the case of a defined benefit plan) may not be in a position to obtain and apply the information herself. for example, there is no regulation requiring an employer to track contributions to a retirement plan based on whether services were performed inside or outside the united states. a resident alien employee, who may not currently anticipate that he will retire as a nonresident alien, would also have no reason to keep track of days spent working abroad unless the information is needed for claiming a section 911 exclusion or foreign tax credit on his current return. even if the retiree has sufficient information about the distribution, she still faces the need to resolve significant uncertainties in the proper application of the u.s. rules. for example, it is unclear whether ―effectively connected‖ treatment applies to employer contributions to a retirement plan if made on behalf of a resident alien individual or u.s. citizen (rather than a nonresident alien) performing services in the united states. 106 it is also unclear whether distributions from an ira account attributable to deductible employee contributions or from a sep ira attributable to contributions determined by reference to earnings from self-employment are viewed as ―effectively connected‖ income. finally, it is not clear whether in cases where a portion of a distribution is treated as effectively connected income (because attributable to contributions in respect of post-1986 u.s. services), this treatment also extends to the ―earnings and accretions‖ portion of the distribution. 107 in summary, many retirees will not be aware that filing a form 1040nr is required or would be beneficial, and those who are aware may decide that it is too difficult (or expensive) to prepare and file the return. it is connected income because it is attributable to employer contributions for service within the united states.” act, supra note 62, at e-13. 106. see act, supra note 62, at 31–32, explaining that a literal reading of section 864(c)(6) would preclude its application in such cases. cf. field service advice memoranda, may 31, 1996, 1996 fsa lexis 183, stating that “[s]ection 864(c)(6) does not apply to foreign source option income that would not have been effectively connected income to a nonresident, which is earned by a taxpayer, as a resident, in one year but that is received by the taxpayer, as a nonresident, in another year.” 107. bissell, t.m. portfolio, supra note 67, at text accompanying n.417, citing instructions to 2009 form 1040nr, at 13–14, to the effect that, in this case, the entire u.s. portion is treated as effectively connected. bissell states that “[a]lthough the irs rule may not be technically correct, it has the advantage of administrative convenience . . . [and] is also a „taxpayer-friendly‟ rule.” id.; see also instructions to 2010 form 1040nr at 15. the advisory committee also recommends that there be further guidance as to “[w]hether the earnings and accretions portion of the distribution from a u.s. pension plan would always be fixed, determinable, annual, periodic (fdap) income or whether they would be eci if the contributions are eci.” act, supra note 62, at 32. 804 florida tax review [vol. 11:10 not clear how likely it is for irs to request filing of a form 1040nr. 108 the result is that the correct amount of tax will not be paid (and either the irs or the taxpayer will be shortchanged). on the other hand, those nonresident aliens who do file the form 1040nr will be subject to considerable expense and inconvenience and may file incorrectly. 109 b. flawed presumption rule another defect of the current system is that the presumption rule prescribed for use by withholding agents will often cause them to treat a nonresident alien (with a u.s. ssn and a treaty address) as a u.s. citizen for purposes of withholding. as a result, the payer withholds u.s. tax at wage withholding rates for periodic payments or at a flat 10 percent (or 20 percent) rate on nonperiodic payments. since no form 1042-s is filed by the payer, the residence country is not informed of the payment, unless the payee reports it, and thus the residence country may not collect any tax. the nonresident alien may not file a form 1040nr with a treaty claim to obtain a refund of the u.s. tax, either to avoid the possibility of disclosure to the treaty country 110 or simply out of ignorance of his treaty claim. this outcome is inconsistent with the expectations under most u.s. treaties that the united states would surrender its source–based tax, while the resident country would obtain the information needed to impose its own tax on the payment received by its resident. moreover, the united states is not collecting the correct amount of tax from the nonresident alien even if one assumes that the treaty resident has the right not to press his treaty claim. 108. according to the gao, “irs has not developed estimates for three types of nonresident alien tax noncompliance: (1) failing to file a tax return . . . (2) underreporting income on filed returns, and (3) filing form 1040 instead of form 1040nr.” gao report, supra note 102. 109. the treasury inspector general recently audited the processing of forms 1040nr by the irs and concluded that “inaccurate and fraudulent forms 1040nr are not being detected during processing,” and that “[a]s long as proper controls are not in place, the risk of fraudulent returns and refunds is substantial.” treasury inspector general for tax administration, improvements are needed to verify refunds to nonresident aliens before the refunds are sent outside of the united states, reference no. 2010-40-121, sept. 15, 2010. as a result, the irs is tightening its procedures for allowing treaty claims resulting in tax refunds when no form 1042-s indicating a treaty exemption from withholding (exemption code 04) is included with the return. 110. filing a claim for refund on form 1040nr currently does not result in disclosure to the treaty country. the form 1042-s information exchange is pursuant to section 6103(k)(4). this section allows for disclosure of treaty claims made on a tax return as well but such disclosures will not be feasible until form 1040nr can be filed electronically. see i.r.c. § 6103(k)(4). 2012] retirement distributions to foreign nationals 805 one might speculate that the intended purpose of the presumption rule provided in the regulations is to thwart the operation of treaty rules requiring the united states to completely surrender source-based taxation. in fact, it might be more appropriate for the united states to agree to a reduced rate of tax on u.s. source pension distributions, rather than complete exemption under a treaty. however, that goal should be achieved by modification of the treaty itself, not by undermining its application. c. inadequate treaty guidance and inappropriate treaty claims a third defect of the current rules is that the payer and payee are often unable to determine whether a particular treaty will apply to the type of retirement distribution being made. irs guidance is limited. the treasury‘s technical explanation of the 2006 u.s. model tax convention specifies the types of retirement plans eligible to make payments that are exempt under the convention and also specifies that both periodic and single sum payments are covered. 111 however, the technical explanation is not authority for interpreting actual treaties entered into by the united states with other countries. 112 for example, in the case of older treaties, it is unclear whether the pension article covers iras, 113 401(k) plans, or other pension products that were not available when the treaty was signed. 114 it is often 111. see supra note 73. 112. see supra note 69. the technical explanation of the 2006 model treaty does not indicate that it is intended as an interpretation of existing treaties. by contrast, the technical explanation of the 1996 model stated that the pension article of the model included “both periodic and single sum payments” and that “[t]he same result is understood to apply in u.s. treaties that do not make this point explicitly.” at the same time, the 1996 model imposed certain limitations, i.e., “the employee must have been either employed by the same employer for five years or be at least 62 years old at the time of the distribution. in addition, the distribution must be made either (a) on account of death or disability, (b) as part of a series of substantially equal payments over the employee‟s life expectancy (or over the joint life expectancy of the employee and a beneficiary), or (c) after the employee attained the age of 55. finally, the distribution must be made either after separation from service or on or after attainment of age 65.” as described by bissell, t.m. portfolio, supra note 67, these limitations had been previously mentioned in a series of private letter rulings. id. at n.420. 113. see act, supra note 62, at b-5, noting that “lower treaty rates are not automatic for iras,” and that if a treaty does not specify that a distribution from an ira is pension income “most ira payers default to the 30 percent withholding rate.” 114. more than 20 treaties became effective in the mid-1980‟s or before. private letter rulings issued in the 1980‟s or 1990‟s cannot be cited as precedent. moreover, these rulings are not necessarily consistent with newer treaties or the 806 florida tax review [vol. 11:10 unclear whether a treaty article that refers to ―periodic payments‖ would also apply to lump sum payments. 115 in some cases, there is a possibility that the ―other income‖ article of a treaty might cover payments not covered by the pension article. 116 it is also unclear whether a treaty exemption for a pension also prevents application of the 10 percent early withdrawal penalty. 117 finally, the treatment of annuities under qualified plans is uncertain. this ambiguity in the treaty rules leads payers to withhold at the statutory rate, rather than take a risk that the treaty claim is not valid. the result is that a form 1040nr must be filed in order for a treaty claim to be made, a burdensome process, as noted above. a further problem is that some nonresident aliens may make inappropriate treaty claims based merely on the fact that their address is in a treaty country. they may not appreciate the requirement that they actually be a resident in the treaty country for tax purposes and that they be subject to tax on their retirement distributions in that country. 118 or they may be resident of a treaty country that requires that, for their type of tax residency technical explanation of the u.s. model. singer letter, supra note 1. see supra notes 73 and 112. 115. see bissell, t.m. portfolio, supra note 67, at a-73, discussing uncertainty regarding classification of lump sum payments. see foster, supra note 67, at §§ 14.05, 14.07, and 14.14 (treaties with australia, cyprus, egypt, greece, iceland, india, korea (south), morocco, norway, philippines, romania, and trinidad and tobago refer to “periodic payments”) id. and, further the “technical explanation to the treaty with india states that „the definition excludes from the pension definition a single lump-sum payment.‟” id. 116. for example, since iras are “not dealt with” in the pension articles of various treaties, such as finland, france, russia, and germany, they are arguably covered under the other income article. 117. see i.r.s priv. ltr. rul. 92-53-049 (oct. 6, 1992), stating that under the u.k. treaty, a distribution from a rollover ira before age 59 1/2 is treated as exempt from u.s. tax as “other income” under art. 22(1), and that therefore section 72(t) penalty tax does not apply. section 72(t) imposes a 10 percent additional tax only on “the portion of [the amount received] which is includible in gross income.” the ruling reasons that since the amount distributed “is excluded from the taxpayer‟s united states gross income under . . . the treaty, the ten percent additional tax . . . does not apply.” id. by contrast, the ruling concludes that the treaty would not “prevent the application of” the 15 percent penalty on excess distributions under section 4980a “because the tax imposed is an excise tax.” id. 118. the form 1040nr does require a taxpayer claiming a treaty exemption to enter the exempt income and answer “yes or no” whether he is subject to tax on “any of the income” entered. 2010 i.r.s. form 1040nr, p. 5, schedule oi, part l, question 2. 2012] retirement distributions to foreign nationals 807 status in the treaty country, income must be remitted to the treaty country in order to be accorded treaty exemption from tax. 119 vi. proposed solution: a new system for taxing nonresident alien recipients of u.s. retirement distributions a. brief description we propose a new simpler and more administrable system for taxing nonresident alien payees of u.s. retirement distributions. under our proposal, payers would withhold a flat 15 percent tax on (1) periodic distributions from a qualified retirement plan, (2) distributions to the extent not exceeding the required minimum payments from a defined contribution plan or ira, and (3) hardship distributions (that are not early distributions). 120 for other distributions from u.s. qualified retirement plans (hereinafter referred to as ―lump sum distributions‖), withholding would be at a 30 percent flat rate. most significantly, these withholding taxes would also be the final tax liability of the nonresident alien recipient, so that there would generally be no need for the recipient to file a form 1040nr. these 119. convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, march 19, 1984, art. 4, para. 6, u.s.– cyprus, 35 u.s.t. 4737; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, july 28, 1997, art. 24, para. 6, u.s.–ireland, 2141 u.n.t.s. 167; convention between the government of the united states of america and the government of the state of israel with respect to taxes on income, nov. 20, 1975, art. 6, para. 6, u.s.–israel, http://www.irs.gov/pub/irs-trty/israel.pdf; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, nov. 6, 2003, art. 4, para. 5, u.s-japan, http://www.treasury.gov/resource-center/taxpolicy/treaties/documents/japantreaty. pdf; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, may 21, 1980, art. 4, para. 5, u.s.–jamaica, 33 u.s.t. 2865; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, aug. 1, 1977, art. 20, para. 7, u.s.–morocco, 33 u.s.t. 2545; 2001 us-uk convention, supra note 46, at art. 1, para. 7. 120. hardship distributions are excluded from the category of ―eligible rollover distributions‖ under section 402(c)(4). hardship distributions are defined in reg. sections 1.401(k)-1(d)(3). we use the term ―early distributions‖ to refer to distributions that are described in section 72(t)(2)(a), i.e., distributions made before the employee attains age 59 1/2 unless: (i) on or after the death of the employee, (ii) attributable to the employee being disabled, or (iii) after separation from service after attainment of age 55. the payer indicates these early distributions with code 1 in box 7 on form 1099. these early distributions may include distributions avoiding 72(t) penalty tax under exceptions in subparagraphs (b),(d),(e) and (f) of section 72(t). 808 florida tax review [vol. 11:10 taxes would not apply to the portion of a distribution attributable to contributions in respect of services performed outside the united states. however, this exception would have limited application because services performed by an employee while a u.s. citizen or resident would be treated as performed in the united states. by filing a form w-8ben with the payer, a treaty resident would be able to claim an exemption or reduced rate of withholding provided for in his residence country‘s treaty with the united states. this form requires that the taxpayer certify under penalties of perjury that he or she is a resident of the treaty county. as under current rules, the payer would file a form 1042-s, and information about the payment would be shared automatically with the treaty country. alternatively, a treaty resident could seek a refund of withheld tax by making a treaty claim on form 1040nr, p. 4, which would include the same certification; this filing should also trigger notification of the treaty country (if at all feasible). 121 the individual would have to provide an address on the form w-8ben or 1040nr that is in the claimed treaty country. in addition, in either case, the individual would certify on the form that the distribution is actually subject to tax in the treaty country. thus, for example, this certification could not be made if the distribution was made after an individual had established residency in the treaty country but is subject only to tax on income sourced in the treaty country for a specified period of time following becoming a treaty country resident. 122 under our proposal, if a distribution is sent outside the united states, or the payer is instructed to send the payment to a financial institution (whether u.s. or foreign), and the payee fails either to file a form w-9 (or a w-4p with a u.s. address and a u.s. ssn) or to file a w-8ben (as a certificate of foreign status), the payer would treat the distribution as made to a nonresident alien. moreover, the 30 percent withholding rate would apply to all distributions (even if periodic or if not in excess of minimum required distributions or if on account of hardship). (the higher rates for undocumented distributees would provide an incentive for them to submit the proper withholding certificates to the pension administrator.) there would be no presumption of u.s. status by reason of the payee having a u.s. ssn and an address in a treaty county. 121. we recognize that automatic notification of the treaty country may not be feasible unless the form 1040nr is filed electronically, but we believe that providing this notification, especially for lump sum distributions, is an important goal. with the elimination of the “u.s. person” presumption rule and greater treaty guidance for payers under our proposal, the number of filings of form 1040nr should decrease significantly. 122. for example, australia provides a three-year period during which income from sources outside the country are not taxed. 2012] retirement distributions to foreign nationals 809 finally, under our proposal, the treasury would publish guidance as to the types of retirements distributions covered by pension articles (or ―other income‖ articles) in all existing treaties. 123 both withholding agents and distributees would be able to easily determine the status (at least in the treasury‘s view) of all types of distributions. in addition, the irs would revise the form 1042-s income codes to provide greater reporting guidance to those distributees who still find it necessary to file a form 1040nr. b. further explanation of our proposal the objective of our proposal is to reduce the administrative burden for the irs, plan administrators, and nonresident aliens receiving distributions from u.s. qualified pension plans and to assure that the united states and its treaty partners actually collect the amount of tax imposed by law, as modified by treaties. 1. substituting a flat rate tax liability; rejection of “effectively connected” treatment the complications and administrative burden of the current regime are largely due to the treatment of the portion of a retirement distribution attributable to contributions in respect of post-1986 u.s. services as ―effectively connected income‖ after enactment of section 864(c)(6). however, we do not believe that the policy justification for applying section 864(c)(6) to qualified retirement distributions is strong. ―effectively connected‖ treatment of a nonresident alien‘s income is generally reserved for situations in which the nonresident alien is engaged in a trade or business, including performance of services, in the united states, during the current taxable year. in this way, the need for filing a form 1040nr is generally limited to taxpayers with a current business connection to the united states. congress made an exception when it adopted section 864(c)(6), which treats compensation paid for u.s. services as effectively connected income even though the taxpayer is not engaged in a u.s. trade or business in the year of receipt. in the legislative history, congress expressed concern that ―foreign persons should not be able to avoid u.s. tax on their income from the performance of services in the united states where payment 123. the guidance should cover various categories of retirement arrangements, such as private pensions and annuities, individual retirement agreements, roth iras, money-purchase annuities, social security, and government plans and annuities, and should include footnotes explaining which types of distributions are covered in each category (i.e., periodic, lump sum, hardship, premature, etc.). 810 florida tax review [vol. 11:10 of the income is deferred until a subsequent year in which the individual is not present in the united states.‖ 124 it was logical for the irs to apply this new rule not only to unfunded deferred compensation, but to the ―contribution‖ portion of distributions from a u.s. qualified retirement plan. however, in a qualified retirement plan, different considerations apply because deferral of tax for contributions to a qualified retirement plan is deliberately sanctioned by congress to encourage a worker‘s savings for retirement. moreover, a withheld tax computed at a flat 30 percent rate would often not be lower (and may be higher) than a tax at graduated rates (with a 35 percent maximum) and one personal exemption. therefore, we do not believe ―effectively connected‖ treatment is required to prevent tax avoidance. in fact, a better justification for ―effectively connected‖ treatment may be that the resulting graduated rates and personal exemption often result in a lower effective tax than the 30 percent rate and may serve to prevent hardship to a taxpayer who has no other source of income. but in light of the administrative burden from the filing of a form 1040nr, we believe that a better way to address this concern would be for congress to provide a flat 15 percent rate of withholding for the entire amount of a qualified retirement distribution to a nonresident alien. 125 our proposal does not apply this reduced rate of 15 percent to lump sum distributions. a less favorable treatment of lump sum payments is appropriate because, outside of a treaty context, these payments carry a greater risk that the recipient will be able to arrange for the payment to escape the notice of tax authorities in his residence country. 126 moreover, a lump sum payment often results in depletion of savings without assuring income throughout retirement; this undermines congress‘s goal to encourage retirement savings. therefore, it seems fair for the united states to recoup a portion of the tax benefits previously enjoyed through imposition of tax on the distribution. however, it would be possible for an individual receiving a lump sum retirement distribution to roll over the distribution into an ira account within sixty days, and to receive periodic payments from the ira 124. staff of joint comm. on taxation, 99th cong., general explanation of the tax reform act 1048 (comm. print 1987). 125. see act, supra note 62, at 4, recommending that there be an evaluation of the current withholding rates “to determine if another rate or series of rates would more closely relate the rate to the actual tax owed by the nonresident alien.” id. 126. we apply the 15 percent rate to required minimum distributions in that these distributions are encouraged by congress as part of its retirement policy. similarly, we consider it appropriate to apply the 15 percent rate to hardship distributions because of their involuntary nature; however, if the distribution is an early distribution, it is hard to view it as made “on account of retirement.” 2012] retirement distributions to foreign nationals 811 account (not in excess of the required minimum distribution) that are eligible for the reduced 15 percent rate. this could be explained to the recipient in the notice that is required to be provided to lump sum recipients. 127 if our proposal is adopted, we believe that it should also apply to a long-term u.s. resident who is a ―covered expatriate‖ provided that he makes timely notification of his status to the payer under the retirement plan. 128 we also recommend that such a taxpayer be able to claim treaty benefits (if not at the point of withholding, at least by filing a form 1040nr). 2. clarifying treaty rules with our proposed elimination of the ―u.s. person presumption rule,‖ payers of retirement distributions would have more need to focus on treaty rules that would exempt distributions from tax or would reduce the applicable rate. we believe that the treasury has the responsibility to provide clear guidance regarding the circumstances in which existing treaties apply to exempt or to reduce the rate of tax on retirement distributions of various sorts. it should not be necessary for each payer or each recipient of a distribution to independently interpret an ambiguous treaty provision (for example, by deciding whether to apply an ―ambulatory‖ or ―static‖ approach). 129 moreover, if the rules were clear to the payer so that the payer would allow a treaty exemption when warranted, there would less need for the filing of a form 1040nr by the recipient. even if the irs itself is uncertain about the proper treatment of a type of distribution under a particular treaty, it should stake out a clear position. it could, for example, create a new chart detailing the application of each treaty to each type of distribution. this would greatly simplify the task of withholding agents. it would also be simpler for recipients. for example, if the irs chart were to indicate that a lump sum distribution from a traditional ira is not exempt under a particular treaty, the recipient would have a clear choice. he could either accept the irs position, thus avoiding 127. see notice 2009-68, 2009-2 c.b. 423, providing “safe harbor explanations that may be provided to recipients of eligible rollover distributions from an employer plan in order to satisfy section 402(f).” the safe harbor explanation states that “[i]f you are a nonresident alien and you do not do a direct rollover to a u.s. ira or u.s. employer plan, instead of withholding 20 percent, the plan is generally required to withhold 30 percent of the payment for federal income taxes. if the amount withheld exceeds the amount of tax you owe (as may happen if you do a 60-day rollover), you may request an income tax refund by filing a form 1040nr and attaching your form 1042-s.” 128. such notification is made on form w-8ce, covered expatriate. 129. see act, supra note 62, at 49, recommending that the irs consider updating publication 515 “to specifically address whether or not treaties cover iras.” 812 florida tax review [vol. 11:10 the need for filing form1040nr; or he could file form 1040nr claiming the treaty exemption, with the knowledge that the irs would reject his claim and that he would be required to challenge the irs position in a refund suit in a u.s. district court or the u.s. claims court. moreover, if the irs position regarding a particular treaty is unfavorable to some retirees, they might put pressure on the tax authorities of the residence country to renegotiate that aspect of the treaty. an example of the level of detail required in such a chart is shown in appendix a. specifically, payors and retirees need to know: (1) the treaty rate of u.s. withholding applicable to private pensions, (2) whether or not this treaty rate applies to distributions from each of the following plans: qualified plans under section 401(a), including 401(k) plans, section 403(a) qualified annuity plans, section 403(b) plans, pure rollover ira‘s, traditional iras, roth ira‘s, sep ira‘s (under section 408(k), or a section 408(p) account, and whether covered plans include plans created by the selfemployed; 130 (3) whether the treaty rate for pensions applies to a nonperiodic payment, including a premature distribution 131 subject to the 10 percent penalty tax under section 72(t) or an ―eligible rollover distribution;‖ (4) whether amounts not treated as ―pensions‖ will be covered by the ―other income‖ article of the treaty, 132 (5) whether a distribution from a pure rollover ira is treated differently from a distribution from other types of iras, 133 (6) whether the treaty bars imposition of the 10 percent penalty tax 130. see supra notes 13–31, relating to such plans. if a treaty covers distributions from roth iras, there is still a question as to whether a nonqualified distribution would be covered. 131. see e.g., i.r.s. priv. ltr. rul. 84-22-069 (feb. 28, 1984) (premature distribution from ira to uk resident was not a pension under article 18(1), but was “other income” under article 22(1); see also i.r.s. priv. ltr. rul. 92-53-049 (oct. 6, 1992). 132. we do not believe that a distribution from a qualified retirement plan that fails to meet the definition of a “pension” in the treaty should be eligible to be treated as “other income” under the treaty. the application of the “other income” article should be limited to income when the treaty lacks an applicable provision such as for money purchase annuities (e.g., art. 17 of the u.s.–russia treaty). 133. see i.r.s. priv. ltr. rul. 96-26-055 (apr. 11, 1996) (lump sum distribution paid to divorced spouse, pursuant to qdro, from rollover ira, was pension under article 19(2) of the u.s.–netherlands treaty); i.r.s. priv. ltr. rul. 8904-036 (oct. 31, 1988) (distribution from rollover ira was exempt as a pension under art. 18(1) of the old u.s.–italy treaty); i.r.s. priv. ltr. rul. 95-41-043 (july 6, 1998) (distribution from pure rollover ira was pension under art. 20 of u.s.– india treaty; recipient was over 55, and distributions were made after his separation from service); i.r.s. priv. ltr. rul. 98-06-012 (nov. 10, 1997) (distributions from a rollover ira and from an ira funded by decedent‟s tax–deductible contributions 2012] retirement distributions to foreign nationals 813 under section 72(t), and (7) the treatment of pensions for government services. the rules established to cover the various types of distributions should be rules that can be easily applied by the payer with information in his possession. for example, it might be sensible to interpret treaties to apply to nonperiodic distributions from a traditional ira only to the extent of a minimum required distribution. 134 other distributions from a traditional ira could be classified as not eligible for treaty protection (including under the other income article). 135 to facilitate a taxpayer‘s correct application of the rules in preparing his return, the irs should assign additional income codes for use by the payer on form 1042-s. 3. possible implications for future treaties if our proposal (summarized in appendix b) were to be adopted, the u.s. taxation of retirement distributions made to nonresident aliens would be much simpler for both withholding agents and retirees; in addition, the rate of tax for nontreaty taxpayers would be relatively modest, provided that periodic payments are made. these two factors might lead to a rethinking of the treasury‘s current policy in the 2006 u.s. model treaty of providing complete exemption from source country tax, for both periodic and lump sum payments. from the u.s. standpoint, it might be preferable for the source country to take a share of the revenues from taxing retirement distributions made to nonresidents. (as noted above, this could be the treasury‘s motivation behind the ―u.s. person presumption‖ rule of current law since this rule allows the united states to collect a u.s. tax in situations where a treaty exemption could potentially be claimed.) under our proposal, it might make sense to consider adoption of the reduced rate approach in our treaties with canada, south africa and indonesia. 136 moreover, as in the treaties with canada, italy, the u.k., and the netherlands, the source country could be given greater leeway to tax lump sum distributions. 137 at the same time, the treaty could allow a tax–free were treated as pension payments to his beneficiary under article 18(1) of the u.s.– germany treaty). 134. compare i.r.s. priv. ltr. rul. 2010-09-012 (mar. 5, 2010), (ruling that a payment from a traditional ira is a pension under article xviii(3) of the u.s.–canada treaty, and that a required minimum distribution amount that is distributed in accordance with section 408(a)(6) is a “periodic pension” for purposes of article xvii(2)(a), eligible for the 15 percent reduced treaty rate). 135. see supra note 132. 136. see supra note 74–75. 137. see supra note 75. 814 florida tax review [vol. 11:10 rollover from a qualified retirement plan of the source country to a qualified plan of the residence country. 138 we also recommend that treasury reconsider the provision of the model treaty requiring the residence country to exempt from tax any portion of a distribution that would be exempt in the source country if paid to a resident of that country, such as a qualified distribution from a roth ira. 139 in order for a treaty resident to take advantage of this provision, he would need to consult a tax professional familiar with the source country‘s tax law; this seems unduly burdensome, particularly, if the treaty provides for exclusive residence country taxation. in addition, we question the wisdom of applying the treaty exemption for pensions to a distribution from a roth ira, which often is not used for retirement. 140 however, the treaty should bar the residence country from taxing a rollover between qualified plans within the source country. vii. conclusion current tax rules regarding taxation of u.s. retirement distributions to foreign nationals impose serious administrative burdens on payers, recipients and the irs. we propose that congress eliminate ―effectively connected‖ treatment for any part of a qualified retirement distribution, that the irs revise its regulations to end the flawed ―u.s. person‖ presumption rule applicable to such distributions, and finally that the irs issue more specific guidance regarding the treatment of such distributions under individual treaties. our proposed changes would greatly alleviate administrative burden, provide an appropriate level of u.s. taxation for such retirees, and assure that the tax articulated in the statute, and allowed by treaties, is actually collected. 138. see discussion in letter of david powell, groom law group, july 13, 2009, comments on certain pension aspects of the united states model tax treaty, at 2009 wtd 134-24. 139. 2006 u.s. model treaty, supra note 46, at article 17.1.b. see discussion in nysba report, supra note 69. that report explains that this clause is meant to cover “roth iras, rollovers and distributions that are a return of nondeductible contributions.” 140. the absence of a minimum distribution requirement before the death of the participant and of a maximum age for making contributions is inconsistent with the goal of saving for retirement (versus accumulating savings for heirs). we see no reason why the u.s. decision to provide an income exclusion for a qualified distribution from a roth ira should require the residence country to forgo taxation. if the roth distribution is nonqualified, it will bear even less resemblance to a retirement distribution; in that case, there seems to be little reason for the u.s. to renounce source–based taxation under the pension article. 2012] retirement distributions to foreign nationals 815 appendix a belgium code category of income payer beneficial owner 1 tax rate treaty article 14 private pensions (and annuities) 2 qualified plan under sec. 401(a) 3 qualified plan under sec. 403(a) qualified plan under sec. 403(b) 3 individual retirement plan under section 408(k) section 408(p) accounts section 457 plans 3 any 0 17(1)(a) new individual retirement agreements traditional ira 4 nondeductible ira 4 any 0 17(1)(a) new roth ira 4 any 0 17(1)(a) new money-purchase annuities 5 any 0 17(3) new social security us gov‘t 30 17(2) new gov‘t pension or annuity 6 us gov‘t resident and national 0 18(2)(b) 1. the beneficial owner must be a treaty country resident not eligible for an exemption from tax by the treaty country on the distribution. 2. defined by the treaty as qualified retirement plan distributions whether paid periodically or in a lump sum; includes annuities purchased using plan assets. 3. to the extent not covered under the provisions for government pensions and annuities. 816 florida tax review [vol. 11:10 4. included in the applicable treaty definition of a private pension. 5. sums paid periodically under an obligation to make payments in return for adequate and full consideration (other than services rendered). 6. pensions for government services generally include sections 457, 401(a), and 403(b) plans established for government employees and thrift savings plans under section 7701(j). government services include services for the united states, a political subdivision, or local authority thereof, or a corporation performing services of a governmental nature which is owned by one of these governmental authorities. 2012] retirement distributions to foreign nationals 817 appendix b withholding on retirement distributions under our proposal type of distribution usc or ra inside us (current law) usc or ra outside us (current law) nra (documented) our proposal undocumented outside u.s. our proposal treaty exemption1 our proposal periodic payments gr2 or 03 gr 15% 30% yes nonperiodic payments 1. amounts not in excess of required minimum distribution 10% or 03 10% 15% 30% yes 2. distributions made upon hardship of employee4 that are not early distributions5 10% or 03 10% 15% 30% yes 3. other distributions6 20% or 07 if from ira, 10% or 03,7 20% if from ira, 10% 30% or 07 30% yes; perhaps no for early distributions, unless rolled over into treaty country plan 1. must be tax resident in the treaty country and distribution must be subject to tax by the treaty country. 2. graduated rates. 3. if withholding waived by recipient. 4. hardship as used in section 402(c)(4); defined in regulation section 1.401(k)-1(d)(3). 5. early distributions are those described in section 72(t)(2)(a), i.e., distributions made before age 59 1/2 (unless (i) on or after death of employee, (ii) attributable to employee being disabled, or (iii) after separation from service after attainment of age 55). the payor indicates these early distributions with code 1 in box 7 on form 1099-r. these early distributions may include distributions avoiding section 72(t) penalty tax under exceptions in subparagraphs (b),(d),(e) and (f) of section 72(t). 818 florida tax review [vol. 11:10 6. these are eligible for rollover (apart from early distributions for hardship). see sections 402(c)(4), 408(d)(3). 7. no withholding on direct rollovers. florida tax review florida tax review volume 15 2013 number 1 tax abuse according to whom? by shannon weeks mccormack * abstract before 1996, the internal revenue code presumed that tax regulations applied to transactions executed before their enactment, giving the treasury department broad authority to regulate retroactively. in 1996, however, congress reversed this presumption, requiring regulations relating to code sections enacted after 1996 to operate prospectively. congress also provided an important exception in section 7805(b)(3), allowing tax regulations to apply retroactively “to prevent abuse.” congress did not, however, explicitly define abuse; nor did it designate to any specific actor the power to do so. this article provides a comprehensive look at the level of deference reviewing courts owe a treasury regulation’s interpretation of section 7805(b)(3)’s abuse exception. generally, an agency’s statutory interpretation is entitled to receive either the strong standard of deference articulated in chevron v. natural resource defense council, or the lesser degree of deference articulated in skidmore v. swift & co. to date, the courts reviewing retroactive tax regulations enacted to prevent abuse have declined to apply chevron deference, relying on administrative law principles recently rejected by the supreme court in mayo foundation v. united states. this article, therefore, provides a needed guide to future courts by applying the post-mayo deference framework to treasury regulations that interpret section 7805(b)(3). this * associate professor of law, university of washington school of law. i especially thank professors kathryn watts and kristin hickman for their comments on this project. i also thank professors dorothy brown, ted seto, and the participants of the 2012 critical tax workshop held at the university of washington school of law, the pittsburgh tax conference at the pittsburgh school of law in march 2013, and the critical tax conference at the university of california hastings college of the law in april 2013 for their comments at various stages of this project. 2 florida tax review vol. 15:1 article concludes that, under this framework, a treasury regulation’s interpretation of section 7805(b)(3)’s abuse exception should receive strong chevron deference so long as it is promulgated under proper administrative procedures. this analysis provides a significant contribution. through the issuance of retroactive regulations, treasury promotes the efficient enforcement of the tax laws and deters egregious abuse. but case law suggests that the courts and treasury department have very different interpretations of the code’s abuse exception. therefore, the ability of treasury to respond to and prevent aggressive tax behavior through retroactive tax regulation may turn largely on which actor possesses primary authority to define tax abuse. i. introduction ................................................................................. 3 ii. putting retroactive treasury regulations in context ...................................................................................... 8 a. the significance of retroactive tax regulations ............... 8 b. retroactive tax regulations: pre-1996 law .................... 10 c. retroactive tax regulations: post-1996 law ................... 13 iii. the new retroactivity cases ................................................ 14 a. background information: retroactive regulation 1.752-6 ................................................................................ 15 b. murfam farms and stobie creek ....................................... 19 c. sala v. united states ........................................................... 23 d. where’s the deference?...................................................... 25 iv. who should interpret tax abuse? ....................................... 27 a. the relevant deference doctrines .................................... 27 1. skidmore v. swift & co.: an intermediate, sliding-scale standard of review ................................ 28 2. chevron v. natural resources defense council: a strong standard of review ....................................... 29 3. step zero: united states v. mead corporation ............ 30 b. are treasury interpretations of section 7805(b)(3) chevron-eligible? .............................................................. 32 1. mead step 1: did congress delegate to treasury the power to interpret tax abuse with the force of law? ................................................ 32 2. mead step 2: how does treasury exercise its authority to interpret section 7805(b)(3) ................ 33 2013] tax abuse according to whom? 3 v. applying chevron to treasuryʼs interpretations of tax abuse ...................................................................................... 34 a. chevron 1: did congress intend for treasury to interpret tax abuse?........................................................... 35 1. section 7805(b)(3)ʼs role in the code ....................... 35 2. legislative history ..................................................... 35 3. agency expertise ......................................................... 44 4. even if congress intended treasury to interpret tax abuse, did congress unambiguously foreclose and particular interpretation of that term? ................................................................... 46 a. how does the interpretation fit within the statutory scheme? ....................................... 47 b. the importance of the question presented ....... 49 b. applying chevron step 2 to treasuryʼs interpretation of section 7805(b)(3) .......................................................... 51 1. is treasuryʼs interpretation of tax abuse within the range of permissible choices? ............................ 51 2. chevron step 2 as “hard lookˮ review .................... 53 vi. conclusion...................................................................................... 55 i. introduction if one were to tell an average taxpayer that the treasury department possesses some power to issue tax laws that might affect the tax treatment of transactions completed before those rules existed, one might expect that taxpayer to act with a mixture of surprise and horror. 1 however, the treasury department has long used retroactive regulations to prevent and respond to 1. see, e.g., louis kaplow, an economic analysis of legal transitions, 99 harv. l. rev. 509 (1986) [hereinafter kaplow, economic analysis of transitions] (acknowledging that there is “hostility towards retroactivity”); michael j. graetz, legal transitions: the case for retroactivity in tax revisions, 126 u. pa. l. rev. 47, 49 (1977) [hereinafter graetz, legal transitions] (explaining that “retroactivity in tax legislation has been widely criticized”). see also saul levmore, the case for retroactive taxation, 22 j. legal stud. 265, 265 (1993) [hereinafter levmore, retroactive taxation] (“retroactive taxation is generally regarded as unwise, abhorrent or even illegal”); david w. ball, retroactive application of treasury rules and regulations, 17 n.m. l. rev. 139, 139 (1987) [hereinafter ball, retroactive application] (describing retroactive lawmaking as “shocking” to “notions of due process and fundamental fairness”). 4 florida tax review vol. 15:1 egregious tax behavior 2 and to foster the efficient 3 and uniform administration of the tax laws. 4 before 1996, the internal revenue code presumed that tax regulations applied to transactions executed before their enactment, giving the treasury department broad authority to regulate retroactively. 5 in 1996, congress reversed this presumption in code section 7805(b), requiring regulations relating to code sections enacted after 1996 to operate prospectively. 6 congress also provided an exception to this general requirement in section 7805(b)(3), allowing regulations to apply retroactively “to prevent abuse.” 7 congress did not, however, explicitly define abuse; nor did it designate to any specific actor the power to do so. it, therefore, left open essential questions upon which this article focuses: when the treasury department issues a retroactive regulation under section 7805(b)(3), is that regulation’s interpretation of tax abuse entitled to deference? if so, what level of deference should these interpretations receive? the importance of these questions should not be underestimated. granting treasury some power to issue retroactive regulations allows it to police and prevent the most aggressive tax transactions. but case law suggests that the courts and the treasury department have very different interpretations of the code’s abuse exception. therefore, the treasury’s 2. as argued by then-irs commissioner fred goldberg in hearings discussed in section iii, infra: “if the irs is precluded from asserting positions retroactively in cases where taxpayers have taken questionable positions, the tax system will lose an implicit restraint.” see taxpayer bill of rights 2: hearings on s. 2239 before the subcommittee on private retirement plans and oversight of the internal revenue service of the committee on finance, 102nd cong. (1992) [hereinafter 1992 tbor 2 hearings]. 3. scholars have eloquently argued that retroactive regulation may be more efficient (or at least as efficient) as prospective rulemaking. see kaplow, economic analysis of transitions, supra note 1, at 512 (“generally, transitional relief is inefficient because it insulates investors from the real effects of their decisions, and thus distorts their behavior.”); graetz, legal transitions, supra note 1, at 73 (finding that an analysis of “various efficiency criteria demonstrates that grandfathered rules are not necessarily to be preferred in tax reform legislation.”); levmore, retroactive taxation, supra note 1; but see generally kyle d. logue, tax transitions, opportunistic retroactivity, and the benefits of government precommitment, 94 mich. l. rev. 1129 (1996) (suggesting limits to the graetz-kaplow theory by identifying a category of tax provisions that should not be modified retroactively). 4. as argued by irs commissioner shirley petersen in hearings discussed in section ii infra, a ban on retroactive regulations would “absolutely abolish uniformity between the date of enactment of the statute and the date the regulations are issued.” 1992 tbor 2 hearings, supra note 2. 5. i.r.c. § 7805(b). 6. i.r.c. § 7805(b). 7. i.r.c. § 7805(b)(3). 2013] tax abuse according to whom? 5 ability to respond to and deter egregious tax behavior through retroactive tax regulation may turn largely on which actor possesses primary authority to define tax abuse. to date, cases that have reviewed the validity of retroactive tax regulations enacted to prevent abuse under section 7805(b)(3)’s abuse exception have resulted in government defeat. 8 the courts reviewing these regulations have declined to apply strong chevron deference, relying on administrative law principles recently rejected by the supreme court in mayo foundation v. united states. 9 in doing so, each court rejected the government’s arguments that “abuse” should be defined expansively for purposes of section 7805(b)(3) in favor of its own narrow construction of the term. this article, therefore, provides a needed guide to future courts by applying the post-mayo deference framework to treasury regulations that interpret section 7805(b)(3). generally, an agency’s statutory interpretation (such as treasury’s interpretation of the internal revenue code), is entitled either to the strong standard of deference articulated in chevron v. natural resource defense council 10 or the lesser degree of deference articulated in skidmore v. swift & co. 11 after mayo, treasury’s interpretations of the internal revenue code are entitled to chevron deference, if they meet the two-step test articulated in united states v. mead corp. 12 (and are otherwise entitled to deference under skidmore). mead instructs courts to first ask whether congress “delegated authority to the agency . . . to make rules carrying the force of the law.” 13 in its 2013 decision, city of arlington v. federal communications commission, 14 the supreme court held that when congress delegates to an agency general authority to administer a particular statute, it, has vested that agency with authority to make legally binding rules. 15 because section 7805(a) authorizes treasury to provide “all needful rules and regulations” 16 necessary to enforce the internal revenue code, interpretations found in treasury regulations, including interpretations of 8. see infra section iii. 9. 131 s. ct. 704 (2011). 10. 467 u.s. 837 (1984). 11. 323 u.s. 134 (1944). 12. 533 u.s. 218 (2001). 13. id. at 226–27. the “agency interpretation claiming deference” must also be “promulgated in the exercise of that authority.” id. at 227. 14. 133 s. ct. 1863 (2013). 15. id. at 16 (“it suffices to decide this case that the preconditions to deference under chevron are satisfied because congress has unambiguously vests the fcc with general authority to administer the communications act through rulemaking and adjudication, and the agency interpretation at issue was promulgated in the exercise of that authority.”). 16. i.r.c. § 7805(a). 6 florida tax review vol. 15:1 section 7805(b)(3)’s abuse exception, would seem easily to pass mead’s first hurdle. 17 a treasury regulation’s interpretation of section 7805(b)(3) will therefore be eligible for strong chevron deference so long as it is “promulgated in the exercise of th[e] authority” granted in section 7805(a), 18 mead’s second step. it is not entirely clear that treasury’s current method of interpreting section 7805(b)(3) satisfies this requirement. when treasury interprets a provision of the internal revenue code by issuing a regulation pursuant to notice and comment or other formal adjudication procedures, it is clear that treasury has acted within the exercise of the general authority granted in section 7805(a), and chevron deference is warranted. 19 however, to date, treasury has explained its reasons for making a particular regulation retroactive under section 7805(b)(3)’s abuse exception in the preamble of that regulation. when treasury interprets a code section in a preamble, is that action exercising the general authority granted by congress? while there is no direct authority on this point, it would seem logical that these interpretations would be chevron eligible so long as they appear in the preamble for the entire notice and comment period. nevertheless, treasury might wish to avoid the ambiguity in the future by interpreting section 7805(b)(3) in separate regulations. having reached this conclusion, this article illustrates how chevron deference should be applied to a treasury regulation’s interpretation of section 7805(b)(3). chevron instructs courts to first ask whether “congress had spoken to the precise question at issue” 20 or whether congress left an ambiguity that it intended an agency to resolve (chevron step 1). 21 in the latter case, according to chevron, a court should uphold that agency’s interpretation so long as it is a “permissible construction” 22 that is not “arbitrary, capricious or manifestly contrary to the statute” 23 (chevron step 2). clearly, treasury’s power to issue retroactive regulations to “prevent abuse” is an ambiguous one and when terms in a statute are ambiguous, 17. united states v. mead corp., 533 u.s. 218, 226–27 (2001). 18. id. at 227. 19. mayo found. v. united states, 131 s. ct. 704, 704 (2011). 20. id. at 842. 21. id. see also united states v. home concrete & supply, llc, 132 s. ct. 1836 (2012). the supreme court made clear that chevron’s first step seeks to solve the “underlying interpretive problem of deciding whether or when a particular statute in effect delegates to an agency the power to fill a gap, thereby implicitly taking from a court the power to void a reasonable gap-filling interpretation.” when a statute is silent or ambiguous about the question addressed by the agency interpretation, it is likely that congress intended the agency to fill the statutory gap. 22. id. at 844. 23. id. 2013] tax abuse according to whom? 7 courts generally conclude that congress intended the relevant agency to provide clarification. however, the powers granted in section 7805(b) are purposefully limited and prohibit retroactive regulation unless certain exceptions apply. it is therefore not clear whether congress intended treasury to interpret the meaning of these exceptions, including section 7805(b)(3)’s abuse exception, or expected courts to play this role. to answer this question, this article considers the way in which section 7805(b)(3) fits within the internal revenue code, the legislative history of section 7805(b)(3), and the special expertise of the treasury and internal revenue service, and ultimately concludes that congress intended treasury to interpret section 7805(b)(3)’s abuse exception. as a result, a treasury regulation’s interpretation of section 7805(b)(3) will generally satisfy chevron step 1. 24 if it does, that interpretation will be upheld so long as it is not an “arbitrary or capricious” construction of section 7805(b)(3) (chevron step 2). 25 while this standard is high, it is not necessarily “insurmountable.” 26 for instance, this article argues that courts should invalidate interpretations that enact too great an alteration to current tax laws. 27 this article proceeds in four parts. section ii explains the significant role retroactive regulations play in curbing tax abuse and describes past and current laws regarding retroactive tax regulations. section iii summarizes the cases that have applied section 7805(b)(3) to review retroactive treasury regulations. section iv applies relevant deference doctrines to conclude that a treasury regulation’s interpretation of section 7805(b)(3)’s abuse exception should be eligible to receive strong chevron deference, so long as it is enacted under proper procedures. section v shows the way in which chevron’s two-step test should be applied to regulations made retroactive to “prevent abuse” under section 7805(b)(3). 24. as discussed in section iii, some courts might also look at whether congress unambiguously foreclosed a particular interpretation of section 7805(b)(3) at chevron step 1. other courts might reserve this inquiry for chevron step 2. 25. chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837, 844 (1984). 26. leandra lederman, the fight over “fighting regs” and judicial deference in tax litigation, 92 b.u. l. rev. 643, 697 (2012) [hereinafter lederman, fighting regs] (citing judulang v. holder, 132 s. ct. 476, 479 (2011)). 27. as discussed, this inquiry may fall either at chevron step 1 or 2, depending on the court. see infra section iii. 8 florida tax review vol. 15:1 ii. putting retroactive treasury regulations in context a. the significance of retroactive tax regulations although the scope of this authority has changed over time, the treasury department has long possessed some power to issue retroactive regulations.28 even before one becomes acquainted with the specific laws governing this power, one might wonder whether treasury should possess any ability to issue regulations that apply to transactions completed prior to their enactment. scholars and lawmakers have engaged in considerable debate about how to define the ideal boundaries of this power.29 far less controversial, however, is the need for treasury to have some ability to use retroactive regulations to respond to and deter egregious tax behavior. sophisticated taxpayers and their advisors are constantly engaged in efforts to devise transactions that produce tax savings within the literal meaning of the internal revenue code but that are clearly not intended by the tax laws.30 these transactions are extremely sophisticated and varied, making it impossible to predict their occurrence ex ante.31 it is, therefore, well understood that the tax laws cannot be adequately enforced through traditional, forward-looking legislation alone.32 in response to this reality, courts have developed several anti-abuse doctrines. for instance, under the 28. see i.r.c. § 7805(b) (creating presumption that treasury regulations operate prospectively); compare i.r.c. § 7805(b) (creating opposite presumption). 29. see supra note 3. 30. see, e.g. joseph bankman, the new market in corporate tax shelters, 83 tax notes 1775, 1777 (june 21, 1999) (“the tax shelter, while supported by a literal reading of the statute, regulation or case law produces a result that is inconsistent with the commonly understood tax principles and is not supported by clearly defined legislative intent”). 31. see e.g. marvin a. chirelstein & lawrence a. zelenak, essay, tax shelters and the search for a silver bullet, 105 colum. l. rev. 1939, 1951–52 (2005) (“contemporary tax shelters are considerably more varied in design — and in the code provision they exploit — than were their predecessors.”); shannon weeks mccormack, tax shelters and statutory interpretation: a much needed purposive approach, 2009 u. ill. l. rev. 697, 705 (2009) [hereinafter weeks mccormack, tax shelters and statutory interpretation] (“lawmakers… cannot be expected to predict today’s abusive transactions before they occur because the complexity and diversity of today’s shelters prevents lawmakers from foreseeing the transactions”). 32. james s. eustice, abusive corporate tax shelters, old “brine” in new bottles, 55 tax l. rev. 135, 141 (2002) [hereinafter eustice, old “brine” in new bottles] (“even when congress attempts to close down a perceived abuse, it frequently comes late to the rescue, reacts with excessive overkill, and then repents at leisure, if ever, only rarely returning to the scene of the accident.”); weeks mccormack, tax shelters and statutory interpretation, supra note 31, at 704–8 (discussing how lawmakers cannot handle the tax shelter problem alone). 2013] tax abuse according to whom? 9 so-called economic substance doctrine, the tax savings associated with a transaction will be disallowed if that transaction is not motivated by a substantial non-tax purpose and did not meaningfully change the taxpayer’s economic position aside from the tax benefits claimed.33 these doctrines operate retroactively by stripping taxpayers of the tax savings associated with transactions completed prior to litigation. but once a tax shelter scheme is devised, numerous taxpayers will rush to mimic it, driven by the promise of large tax savings. if forced to rely solely on the judicial anti-abuse doctrines, the internal revenue service would be required to litigate each of these transactions on a case-by-casebasis. in addition to being extremely costly and time-consuming, each court will have its own opinion about whether and to what extent the tax savings associated with a particular transaction should be disallowed.34 retroactive regulation, by contrast, can efficiently and uniformly respond to transactions the treasury believes to subvert the purposes of the tax laws. in addition to policing tax abuse, providing treasury the ability to regulate retroactively can deter taxpayers from engaging in abusive transactions in the first place by creating uncertainty and lowering the expected profitability of these structures. 35 thus, retroactive regulation can play an important role in the administration of the tax laws. with this in mind, this article now turns to the past and present laws governing the ability of the treasury department to enact retroactive tax regulations. 33. the economic substance doctrine has recently been codified but is still entrusted to the courts to administer. i.r.c. § 7701(o)(1): “in the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if — (a) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (b) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.” 34. for instance, numerous courts have considered similar versions of the so-called “son-of-boss” transactions discussed in section iii, infra. see, e.g., stobie creek inv., llc v. united states, 82 fed. cl. 636 (2008) (analyzing “son-of-bosstransaction”); see also murfam farms, llc v. united states, 88 fed. cl. 516 (2009); sala v. united states, 552 f. supp. 2d 1167 (d. colo. 2008); klamath strategic inv. fund, llc v. united states, 440 f. supp. 2d 608 (e.d. tex. 2006), aff’d 568 f.3d 537 (5th cir. 2009); cemco investors, llc v. united states, 515 f.3d 749 (7th cir. 2008); maguire partners — master invs., llc v. united states, 2009 wl 4907033 (c.d. cal. 2009). 35. david a. weisbach, ten truths about tax shelters, 55 tax l. rev. 215, 249 (2002) (discussing the role uncertainty may play in deterring tax shelters); eustice, old “brine” in new bottles, supra note 32, at 147 (“. . . there highly abusive transactions somehow have to be stopped, or at least seriously impeded and if menacing ambiguity is the only way to do it, then do it we must.”). 10 florida tax review vol. 15:1 b. retroactive tax regulations: pre-1996 law before 1996, section 7805(b) created a presumption that treasury regulations would operate retroactively, 36 allowing the secretary of the treasury to use her discretion to determine whether a regulation should apply prospectively, or also apply to previously executed transactions. 37 while this accorded the treasury department, of which the internal revenue service (the irs) is part, rather wide latitude to choose the effective date of issued regulations, there were some limits on the way in which this discretion could be exercised. by 1996, the predominant standard 38 used to review the treasury’s “failure to limit a regulation to prospective application. . .” 39 was an “abuse of discretion” standard. 40 36. see i.r.c. § 7805(b). “the secretary may prescribe the extent, if any, to which any ruling or regulation, relating to the internal revenue laws, shall be applied without retroactive effect.” 37. id. 38. see toni robinson, retroactivity: the case for better regulations of federal tax regulations, 48 ohio st. l. j. 773, 784–93 (1987) (reviewing “older” theories used to analyze whether regulations could properly be applied retroactively). professor robinson writes: “burdened by section 7805’s approval of retroactivity, the courts fashioned several other avenues for non-retroactivity, including the doctrines of discrimination, legislative reenactment, and reliance.” id. at 784–85. she, however, later writes that the fifth circuit’s multi-factored test for “abuse of discretion,” discussed at note 46 infra, shows that “each of these other standards . . . is really part of abuse of discretion.” id. at 791. see also ball, retroactive application, supra note 1, at 147–48 discussing alternative “equitable estoppel” arguments used to analyze retroactive regulations. this article focuses on the “abuse of discretion” standard because it is the standard most often used by courts considering post-1996 cases under the pre-1996 version of § 7805(b). see, e.g., amergen energy co., llc ex rel. exelon generation co., llc v. united states, 94 fed. cl. 413 (2010) (using abuse of discretion standard); see also ford motor co. v. united states, 94 fed. cl. 211 (2010); meserve drilling partners v. commissioner, 1996-72, 71 t.c.m. (cch) 2146 (1996), aff’d per curiam, 98-2 u.s.t.c. ¶ 50,663 (9th cir 1998); democratic leadership council, inc. v. united states, 542 f. supp. 2d 63 (d.d.c. 2008); grapevine imports, ltd. v. united states, 636 f.3d 1368 (fed. circ. 2012); csx corp. inc. v. united states, 58 fed. cl. 341 (2003); rice v. commissioner, 77 t.c.m. (cch) 1488 (1999); variety club tent no. 6 charities, inc. v. commissioner, 74 t.c.m. (cch) 1485 (1997); salmon ranch, ltd. v. commissioner, 647 f.3d 929 (10th cir. 2011); tate & lyle, inc. v. commissioner, 87 f.3d 99 (3d cir. 1996). but see atchinson, topeka & santa fe ry., co. v. united states, 61 fed. cl. 501 (2004) (analyzing whether the retroactive application of the regulation violated due process); howard e. clenenden, inc. v. commissioner, 207 f.3d 1071 (8th cir. 2000). 39. snap-drape, inc. v. commissioner, 98 f.3d 194, 202 (5th cir. 1996) (“although we have noted that regulations generally will have retroactive effect, the 2013] tax abuse according to whom? 11 to apply this standard, a variety of factors were considered. for instance, courts asked whether the retroactive application of the rule or regulation would produce “inordinately harsh result[s]” 41 and/or raise concerns of horizontal equity. 42 courts also inquired whether the taxpayer was entitled to rely upon settled law reversed by the retroactive regulation, 43 whether congress implicitly acquiesced to that settled law through reenactment 44 and/or whether the process of deciding to make the regulation failure to limit a regulation to prospective application only is nevertheless reviewable for abuse of discretion.”). 40. see, e.g., id.; anderson, clayton & co. v. united states, 562 f.2d 972 (5th cir. 1977); wendland v. commissioner, 739 f.2d 580, 581 (11th cir. 1984) (“the decision to make a ruling or regulation retroactive will stand unless it constitutes an abuse of discretion.”); auto. club of mich. v. commissioner, 353 u.s. 180, 185 (1957) (using “abuse of discretion” standard); see also lecroy research systems corp. v. commissioner, 751 f.2d 1465 (11th cir. 1984); baker v. united states, 748 f.2d 1465 (11th cir. 1984); elkins v. commissioner, 81 t.c. 669 (1983). see also benjamin j. cohen & catherine a. harrington, is the internal revenue service bound by its own regulations and rulings?, 51 tax law. 675 (1998) (discussing abuse of discretion standard). 41. snap-drape, 98 f.3d at 202; anderson, clayton & co., 562 f.2d at 981; lesavoy found. v. commissioner, 238 f.2d 589 (3d cir. 1956); cwt farms v. commissioner, 755 f.2d 790, 802 (7th cir. 1986) (asking whether “change causes the taxpayer to suffer inordinate harm.”). 42. snap-drape, 98 f.3d at 202; anderson, clayton & co., 562 f.2d at 981; elkins v. commissioner, 81 t.c. 669 (1983) (rejecting taxpayer’s assertion that the retroactive amendments would “spawn unequal treatments among taxpayers.”); ibm corp. v. united states, 170 ct. cl. 357 (1965); baker v. commissioner, no. 912822, 1992 wl 104812 (7th cir. 1992). 43. chock full o’ nuts corp. v. commissioner, 453 f.2d 300, 303 (2d cir. 1971) (“a taxpayer, when acting in an area of unsettled law, has ‘no vested interest in a hypothetical decision in his favor prior to the advent of the regulations.’”) (citing helvering v. reynolds, 313 u.s. 428 (1971)); redhouse v. commissioner, 728 f.2d 1249 (9th cir. 1984) (inquiring whether “taxpayer was. . .relying to his detriment on settled law); wedland v. commissioner, 739 f. 2d 580 (11th cir.1984) (finding that there was no abuse of discretion because “taxpayers had notice of the impending amendment [to the law]” and that amendment “did not change settled law.”); anderson, clayton & co., 562 f.2d at 981 (asking “whether or to what extent the taxpayer justifiably relied on settled prior law or policy and whether or to what extent the putatively retroactive regulation alters the law.”). see also snap-drape, 98 f.3d at 381; cwt farms, 755 f.2d at 802 (“[a]n abuse of discretion maybe found where retroactive regulation alters settled prior law or policy upon which the taxpayer justifiably relied and if the change causes the taxpayer to suffer inordinate harm”). 44. anderson, clayton & co., 562 f.2d at 981. the anderson, clayton court also asked “the extent, if any, to which the prior law or policy has been implicitly approved by congress, as by legislative reenactment of the pertinent code 12 florida tax review vol. 15:1 operate retroactively was flawed. 45 in 1977, the fifth circuit adopted a fivefactored test that essentially incorporated all of these elements. 46 the test has since been applied by other courts, though it is by no means universally accepted. 47 regardless of how a particular court formulates the “abuse of discretion” standard, it has generally been applied in a way that is deferential to agency determinations, 48 making it “… a difficult threshold for taxpayers to surmount.” 49 in 1996, however, the treasury’s ability to regulate retroactively was dramatically altered. provisions.” id. see also helvering v. r.j. reynolds tobacco co., 306 u.s. 110 (1939), which pre-dated the abuse of discretion test, and held that retroactive repeal of law that congress had implicitly authorized through reenactment was improper. 45. see, e.g., chock full o’ nuts corp., 453 f.2d at 302 (stating that “the internal revenue service does not have carte blanche [to issue retroactive regulations]. its choice must be a rational one supported by relevant considerations.”) (citing ibm corp., 170 ct. cl. 357). pac. first fed. sav. bank v. commissioner, 101 t.c. 117, 128 (1993) (considering factors considered in establishing retroactive effective date). 46. the fifth circuit proposed a multi-factored test to determine whether retroactive application constitutes an abuse of discretion, first articulated in anderson, clayton & co. 562 f.2d at 981, and later used by other fifth circuit courts, including snap-drape, inc. v. commissioner, 98 f.3d 194, 202 (5th cir. 1996) and klamath strategic inv. fund, llc v. united states, 568 f.3d 537 (5th c. 2009). 47. see supra note 39 and accompanying text. 48. see, e.g., ball, retroactive application, supra note 1, at 142 (noting generally “…courts have historically accorded extraordinary deference to the discretion of the commissioner under [the post-1996 version of] section 7805(b)”). 49. kristin e. hickman, a problem of remedy: responding to treasury’s (lack of) compliance with administrative procedure act rulemaking requirements, 76 geo. wash. l. rev. 1153, 1193 (2008). for instance, in the often-cited case snap-drape v. commissioner, the court explicitly found that the “retroactive application of [the] regulation [at issue]...produced inordinately harsh results” but held that the secretary had not abused his discretion because these results were not “totally unforeseeab[le].” 98 f.3d at 203. this is not, of course, to imply that taxpayers cannot be successful on their claims of abuse of discretion. see, e.g., gehl co. v. commissioner, 795 f.2d 1324 (7th cir. 1986) (holding that it was an abuse of discretion to apply a regulation retroactively when treasury handbook had “promised” to not change the law without further notice); see also ibm corp. v. united states, 170 ct. cl. 357 (1965) (holding that there was an abuse of discretion when commissioner failed to retroactively apply favorable treatment provided in competitor’s private letter ruling). 2013] tax abuse according to whom? 13 c. retroactive tax regulations: post-1996 law as part of the taxpayer bill of rights 2, section 7805(b) was changed to reverse the presumption that regulations would operate retroactively. 50 specifically, the post-1996 version of section 7805(b) provides that regulations relating to sections of the internal revenue code enacted after 1996 51 may not apply earlier than: (a) the date on which [the] regulation was filed with the federal register; (b) in the case of a final regulation, the date on which any proposed or temporary regulation to which such final regulation related was filed with the federal register; or (c) the date on which any notice substantially describing the expected contents of any temporary, proposed or final regulation is issued to the public. 52 “new section 7805(b)” carves out several exceptions to this general prohibition against retroactivity. most of these exceptions are concretely defined. for instance, the prohibition will not apply to “promptly issued regulations,” 53 defined as those “regulations filed or issued within 18 months of the date…the statutory provision to which the regulation relates” 54 was enacted ; or “when congress has specifically authorized the secretary to prescribe the effective date … [of a regulation];” 55 nor will the prohibition apply to “internal regulations” 56 or regulations enacted to “prevent a procedural defect.” 57 new section 7805(b)(3) includes a less defined exception, allowing regulations to apply retroactively “to prevent abuse.” 58 section 7805(b)(3) 50. see pub. l. 104-168, § 1101, 110 stat. 1452, 1468 (codified in i.r.c. § 7805(b)). 51. see id. (stating “the amendment[s]… shall apply with respect to regulations which relate to statutory provisions enacted on or after the date of the enactment of this act.”). 52. i.r.c. § 7805(b)(1) (2006). this section does not apply to rulings under i.r.c. § 7805(b)(8) (2006), stating “the secretary may prescribe the extent, if any, to which any ruling (including any judicial decision or any administrative determination other than by regulation) relating to the internal revenue laws shall be applied without retroactive effect.” 53. i.r.c. § 7805(b)(2). 54. id. 55. i.r.c. § 7805(b)(6). 56. i.r.c. § 7805(b)(5). 57. i.r.c. § 7805(b)(4). 58. i.r.c. § 7805(b)(3). 14 florida tax review vol. 15:1 does not provide a definition of abuse and its legislative history does not elaborate further. 59 the joint committee report adds little, stating only that the “abuse” to which section 7805(b)(3) refers is “abuse of the statute.” 60 by failing to expressly define abuse or designate to a specific actor the power to do so, congress left open essential questions regarding the administration of new section 7805(b). as discussed below, the cases which have reviewed the validity of retroactive tax regulations enacted to prevent abuse under section 7805(b)(3)’s abuse exception have resulted in government defeat. iii. the new retroactivity cases since july 30, 1996, there are six cases which resolve the issue of whether a regulation can be applied retroactively under new section 7805(b) 61 and only three of these cases engage in any substantial discussion 59. see, e.g., murfam farms, llc v. united states, 88 fed. cl. 516, 526 (2009) (“unfortunately, ‘abuse’ is not defined by the statute.”). see united states supplemental memorandum of law in opposition to plaintiff’s motion for partial summary judgment as to the validity of treasury regulation 1.752-6 referring to “court order dated september 25, 2008, murfam farms, 2010 wl 3260167 (fed.cl. aug 16, 2010), no. 1:06-cv-00245-ejd” at 14 [hereinafter united states supplemental memorandum responding to court order] (“neither section 7805(b)(3) or it legislative history define the word abuse.”). see sala v. united states, 552 f. supp. 2d 1167, 1201 (d. colo. 2008) (“the question of what constitutes “abuse” is not clarified by the statute.”) (citing edward a. morse, reflections on the rule of law and “clear reflection of income:” what constrains discretion?, 8 cornell j.l. & pub. pol’y 445, 488 (1999) (“the scope of this exception is unclear and it remains to be seen whether it will be exercised independently of congress’ power to authorize retroactive regulations.”)). 60. staff of joint comm. on taxation, 104th cong., background and information relating to the taxpayer bill of rights 22 (comm. print 1995). 61. in order to reach this conclusion, six searches were run, using westlaw databases: sct, cta, dct, allfeds. the searches were as follows: search 1: “26 u.s.c. s 7805” & dates between 19952013; search 2: “26 u.s.c.a. s 7805” & dates between 1995-2013; search 3: “26 u.s.c. s 7805(b)” & dates between 19952013; search 4: “26 u.s.c.a. s 7805(b)” & dates between 1995-2013; search 5: “internal revenue code” & “7805(b)” & dates between 1995-2013; search 6: “tax!” & “7805(b)” & dates between 1995-2013. out of 193 cases produced in this search, 30 cases were coded as resolving the issue of whether a regulation could operate retroactively. retroactivity was considered a resolved issue only if both a) the court found that the challenged regulation or ruling operated retroactively to affect the taxpayer and b) the court made a specific holding as to whether such retroactive application was valid. twenty-three of these cases resolved the issue 2013] tax abuse according to whom? 15 of section 7805(b)(3)’s abuse exception. 62 these cases deal with the more specific issue of whether treasury regulation section 1.752-6 (“regulation section 1.752-6”) can be applied retroactively to disallow the tax savings claimed by taxpayers engaged in various versions of the notorious son-ofboss tax shelter transactions. 63 the fact that so few cases discuss section 7805(b)(3) underscores rather than minimizes that section’s importance. as discussed in section i.a., granting treasury the ability to regulate retroactively can serve to police and prevent the most aggressive tax planning. the relative scarcity of cases suggests that the treasury department uses this power sparingly. but as the facts of these cases also suggest, when that power is exercised, it is used to respond to extremely egregious transactions that seek to subvert the purposes of the tax laws. in the absence of retroactive regulation, each of these transactions must be litigated on a case-by-case basis, resulting in (sometimes extreme) judicial inefficiency. a. background information: retroactive regulation 1.752-6 in order to understand regulation 1.752-6, it is helpful to first understand the transaction that led to its enactment. the transaction at issue in coltec industries, inc. v. united states 64 provides a useful example. in that case, coltec, through its subsidiaries, created a new corporation (“newco”) to which it transferred non-business assets worth $379.2 million. 65 coltec did not transfer any business assets to newco. newco, however, did assume $375 million worth of contingent asbestos liabilities (i.e. liabilities whose amount had not yet been determined) associated with products that coltec had previously manufactured. 66 in other words, coltec transferred “naked using the pre-1996 version of section 7805(b) and six resolved the issue using the post-1996 version. (search last run 7/18/13). 62. see infra note 88. 63. these cases are: stobie creek inv., llc v. united states, 82 fed. cl. 636 (2008); murfam farms, llc, 88 fed. cl. 516; sala, 552 f. supp. 2d 1167; klamath strategic inv. fund, llc v. united states, 440 f. supp. 2d 608 (e.d. tex. 2006); 568 f.3d 537 (5th cir. 2009); cemco investors, llc v. united states, 515 f. 3d 749 (7th cir. 2008); maguire partners — master inv., llc v. united states, 2009 wl 4907033 (c.d. cal. 2009). 64. 454 f.3d 1340 (fed. cir. 2006). for a similar transaction, see black & decker v. commissioner, 436 f.3d 431 (4th cir. 2006). 65. specifically, the assets consisted of $375m notes and $4.2m nonbusiness property. coltec, 436 f.3d at 1342. 66. id. at 1343. coltec also transferred employees to newco to “manage” these liabilities. 16 florida tax review vol. 15:1 liabilities” 67 to newco — business liabilities severed from the business assets with which they were associated. 68 in exchange for these transfers, coltec received newco stock. this transaction had no tax consequence because it qualified under section 351 of the code. 69 soon afterwards and as always planned, coltec sold the stock for $500,000. 70 under general tax principles, coltec would have reduced its basis in the newco stock by the amount of liabilities assumed by newco, claiming a basis of $4 million. 71 however, under then-existing law, a taxpayer was not required to reduce its basis in the transferee-corporate stock (here, newco) if the assumed liability would have been deductible by the transferor (here, coltec). 72 coltec qualified for this exception and thus claimed a basis equal to $379.2 million, allowing it to claim large losses upon the sale of the newco stock for $500,000 (the stock’s value). there are several reasons why this result was deemed troubling. some argued that coltec’s liability deduction was artificially accelerated, 73 violating the general rule that liabilities may not be deducted until the liability amount can be determined with reasonable certainty. 74 under this general rule, coltec would not have been able to deduct the contingent asbestos liabilities. however, by transferring the naked liabilities to newco and not reducing its basis in the newco stock by the liability amount, coltec deducted that liability amount when calculating the losses associated with the newco stock sale. 67. see weeks mccormack, tax shelters and statutory interpretation, supra note 31, at 745–46 (“the taxpayers . . . transferred over liabilities severed from their businesses (naked liabilities) to generate capital losses from the sale of the newco stocks.”). 68. id. 69. i.r.c. § 351. 70. coltec, 454 f.3d at 1344. 71. see i.r.c. § 358(d)(1) (providing that the assumption of a liability is treated as money received, so that the transferor (here coltec) would have to reduce its basis by the amount of that liability). see also i.r.c. § 358(a)(1) (providing general basis calculation for section 351 transfers). 72. i.r.c. § 358(d)(1). 73. see, e.g., lee a. sheppard, a more intelligent economic substance doctrine, 112 tax notes 325, 330 (2006) (“the tax law is dead set against premature recognition of expense and loss, as indicated by section 461(h) and the all-events requirement.”). see also 70 fed. reg. 37414, 17415 (explaining that in transactions such as that involved in coltec “taxpayers attempted to duplicate a loss in corporate stock and to accelerate deduction that typically are allowed only on the economic performance of these obligations.”). 74. i.r.c. § 461(h). this requirement is known as the all events requirement. 2013] tax abuse according to whom? 17 others argued that the coltec transaction violated the general principle that a deduction may only be claimed once. 75 coltec deducted the liability amount in calculating its loss on the sale of the newco stock. the liability deduction, some argued, might then be duplicated if newco were later entitled to deduct the liability amount because it became fixed. 76 in 2000, after these transactions were identified, congress enacted section 358(h), which applied to future section 351 transactions. section 358(h) generally requires the transferor of property to reduce its basis in the corporate stock acquired by the amount of contingent liabilities assumed by the transferee corporation. 77 thus, had section 358 been in effect at the time of coltec’s transaction, coltec would have been required to reduce its basis by the contingent asbestos liabilities assumed by newco and would not have been able to claim large losses upon the sale of the newco stock. 78 congress, however, realized that section 358 only applied to corporate transfers and that similar abuse could still occur at the partnership level. 79 thus, in section 309(c) of the 2000 tax act, congress authorized the secretary of the treasury to prescribe rules that were “comparable” to those in section 358 and to “provide appropriate adjustments to [the partnership tax laws] to prevent the acceleration or duplication of losses through the assumption of . . . liabilities described in section 358(h)(3) of the code.” 80 section 358(h)(3) makes clear that liabilities include both fixed and contingent obligations. 81 section 309(c) of the 2000 act also provided that 75. see weeks mccormack, tax shelters and statutory interpretation, supra note 31, at 751 (summarizing these arguments). 76. id. 77. i.r.c. § 358(h). section 358(h)(1) provides that when the basis of the partnership interest exceeds its fair market value, the basis will be reduced the basis in that interest will be reduced (but not below its fair market value) by liabilities assumed by the partnership. section 358(h) makes clear that contingent liability should be treated as other liabilities. certain exceptions are found in section 358(h)(2). a basis reduction is not required if the assumed liability is part of “the amount (determined as of the date of the exchange) of any liability “the trade or business with which the liability is associated is transferred to the person assuming the liability as part of the exchange, or substantially all of the assets with which the liability is associated are transferred to the person assuming the liability as part of the exchange.” coltec would not have qualified for these exceptions. 78. the difference between the $4.2 million basis and $500,000 sales price might have been considered genuine loss. 79. 68 fed. reg. 36414, 37415 (“congress recognizes that taxpayers were attempting to use partnerships to carry out the same types of abuses that section 358(h) was designed to deter.”). 80. community renewal tax relief act of 2000, pub. l. no. 106-554 (app. g), § 309, 114 stat. 2763a-587, 2763a-638 (codified at 26 u.s.c. § 358 note) [hereinafter section 309, 2000 tax act]. 81. i.r.c. § 358(h)(3). 18 florida tax review vol. 15:1 regulations issued under its grant of authority could be made retroactive to october 18, 1999. 82 treasury then promulgated regulation section 1.752-6, issued in temporary version on june 24, 2003 and finalized on may 26, 2005. 83 under regulation section 1.752-6, when a taxpayer contributes property to a partnership and that partnership also assumes contingent liabilities that qualify under section 358(h), the partner must generally reduce its basis in the partnership interest by the amount of the liability. 84 the regulation was intended to “adopt the approach of section 358(h), with some modifications…made to…conform the application of section 358(h) to partnerships.” 85 treasury regulation section 1.752-6 applies retroactively to transactions occurring after october 18, 1999 and before june 24, 2003.” 86 the treasury claimed that the regulation could operate retroactively because it was expressly authorized by congress in section 309(c) of the 2000 tax act 87 and prevented abuse under section 7805(b)(3). 88 treasury explained that “[t]hese … regulations are necessary to prevent abusive transactions of the type described in notice 2000-44.” 89 that earlier notice identified certain partnership transactions that generated non-economic losses and alerted taxpayers engaged in these transactions that these losses would be disallowed. one of these transactions was virtually identical to the transactions involved in the cases discussed below. 90 in its explanation of notice 2000-44 in the federal register, treasury explained: [i]n a transaction addressed in notice 2000-44, a taxpayer purchases and writes economically offsetting options and then purports to create substantial positive basis by transferring those option positions to a partnership. on the disposition of the partnership interest, the liquidation of the partner’s interest in the partnership or the taxpayer’s sale or depreciation 82. section 309, 2000 tax act, supra note 80. 83. 70 fed. reg. 37414, 37414. 84. reg. § 1.752-6. 85. t.d. 9207, assumption of partner liabilities, 70 fed. reg. 30334, 30335 (may 26, 2005). one of these modifications was that exception found in i.r.c. § 358(h)(2) would not apply to transactions described in notice 2000-44, 2000-2 c.b. 255, and at issue in the cases described, infra. thus, regulation section 1.752-6 created an exception to section 358(h)(2)’s exception. 86. reg. § 1.752-6(d); t.d. 9207, assumption of partner liabilities, 70 fed. reg. 30334, 30335 (may, 26 2005). 87. see 70 fed. reg. 30334, 30335. 88. id. 89. id. 90. see infra sections iii.b. and iv.c. http://web2.westlaw.com/find/default.wl?mt=208&db=1037&docname=70fr30335&rp=%2ffind%2fdefault.wl&findtype=y&ordoc=2015883817&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=s&pbc=9810399f&referenceposition=30335&rs=wlw12.04 http://web2.westlaw.com/find/default.wl?mt=208&db=1037&docname=70fr30335&rp=%2ffind%2fdefault.wl&findtype=y&ordoc=2015883817&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=s&pbc=9810399f&referenceposition=30335&rs=wlw12.04 http://web2.westlaw.com/find/default.wl?mt=208&db=1037&docname=70fr30335&rp=%2ffind%2fdefault.wl&findtype=y&ordoc=2015883817&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=s&pbc=9810399f&referenceposition=30335&rs=wlw12.04 http://web2.westlaw.com/find/default.wl?mt=208&db=1037&docname=70fr30335&rp=%2ffind%2fdefault.wl&findtype=y&ordoc=2015883817&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=s&pbc=9810399f&referenceposition=30335&rs=wlw12.04 http://web2.westlaw.com/find/default.wl?mt=208&db=1037&docname=70fr30335&rp=%2ffind%2fdefault.wl&findtype=y&ordoc=2015883817&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=s&pbc=9810399f&referenceposition=30335&rs=wlw12.04 2013] tax abuse according to whom? 19 of distributed partnership assets, the taxpayer claims a tax loss, even though the taxpayer has incurred no corresponding economic loss. 91 three cases clearly discuss whether regulation 1.752-6 could operate retroactively under section 7805(b)(3)’s abuse exception: 92 murfam farms, llc v. united states 93 and stobie creek investments, llc v. united states, 94 decided by the court of federal claims and sala v. united states, 95 decided by the united states district court for the district of colorado. b. murfam farms and stobie creek the transactions in murfam farms, 96 stobie creek 97 and sala 98 (discussed below) are extremely similar to the transaction in coltec, except that the former transactions involved partnerships rather than corporations. in murfam farms, for instance, the taxpayers employed a version of the son-ofboss shelter known as cobra (currency options bring rewards). 99 the individual taxpayers — members of the murphy family — purchased and sold long and short “put” currency options, and then contributed these offsetting options to a partnership in exchange for partnership interests. 100 the taxpayers claimed a high basis in these partnership interests equal to the value of the long options but unreduced by the value of the short options. 101 91. 70 fed. reg. 30334, 30335. see also notice 2000-44, supra note 85. 92. in cemco investors, llc v. united states, 515 f.3d 749 (7th cir. 2008), judge easterbrook quickly found that the regulation fell within the express grant of section 309(c). he did not appear to reach the issue of whether the regulation was necessary to prevent tax abuse and deference was not discussed. in maguire partners—master invs., llc v. united states, 2009 wl 4907033 (c.d. cal. 2009), the court found that the regulation could be applied retroactively but did not directly address new section 7805(b). it instead appears to have found that the regulation was valid because it did not depart from prior law. in klamath strategic inv. fund, llc v. united states, 440 f. supp. 2d 608 (e.d. tex. 2006), the court failed to recognize a distinction between old and new section 7805(b), applying the old abuse of discretion framework discussed in section i to analyze the retroactivity issue. this is odd and incorrect unless one is to assume that there is no difference between the way one analyzes retroactive effect under the postand pre-1996 versions of section 7805(b). 93. 88 fed. cl. 516 (2009). 94. 82 fed. cl. 636 (2008). 95. 552 f. supp. 2d 1167 (d. colo. 2008), rev’d 613 f.3d 1249 (10th cir. 2010). 96. murfam farms, 88 fed. cl. at 516. 97. stobie creek, 82 fed. cl. at 636. 98. sala, 552 f. supp. 2d 1167. 99. murfam farms, llc v. united states, 88 fed. cl. 516, 519 (2009). 100. id.at 520. 101. id. 20 florida tax review vol. 15:1 generally, in an exchange like that described, taxpayers must reduce their basis in acquired partnership interests by the amount of liabilities assumed by that partnership. however, under the then-existing helmer doctrine, partners did not have to reduce their bases by assumed contingent liability amounts, including short options. 102 the offsetting options expired according to their terms, at which time the partnership acquired municipal bonds. 103 as was always planned, the partnership interests were then transferred to an s corporation and the partnership was liquidated. 104 as was also planned, the s corporation then sold the municipal bonds. 105 because the corporation claimed that the high basis in the partnership interests attached to the bonds, the sale generated a large tax loss that was then allocated to the partners — the members of the murphy family. 106 the government argued, inter alia, that regulation 1.7526 applied retroactively to the taxpayer’s transactions which would require the taxpayers to reduce their bases in the bonds by the short option amount, resulting in a disallowance of the large losses claimed. 107 the court of federal claims in murfam farms first found that section 309(c) of the 2000 act did not expressly authorize the retroactive application of regulation section 1.752-6 because the regulation did not “prevent the acceleration or duplication of losses” as required. 108 in arguing to the contrary, the government explained the similarity of the cobra transaction to the coltec transaction, to which congress had already responded in code section 358, and argued that, like that transaction, the murfam farms transaction resulted in duplicative losses. 109 the first loss, the government argued, was claimed by the partnership when the options expired worthless. 110 because most or all of the options expired “out of the money” the partnership claimed losses that were then allocated to the individual 102. id. at 521. 103. id. at 520. 104. murfam farms, llc v. united states, 88 fed. cl. 516, 520 (2009). 105. id. 106. id. 107. id. at 521–2. 108. id. at 523–26. 109. see united states supplemental memorandum responding to court order, supra note 59. it did not argue that the loss was accelerated, see united states; supplemental memorandum of law in opposition to plaintiff’s motion for partial summary judgment as to the validity of treasury regulation 1.752-6, murfam farms, 2010 wl 3260167 (fed.cl. aug 16, 2010), no. 1:06-cv-00245-ejd at 2-10 [hereinafter united states supplemental memorandum regarding validity of treasury regulation 1.752-6]. 110. united states supplemental memorandum regarding validity of treasury regulation 1.752-6, supra note 109, at 4–10. 2013] tax abuse according to whom? 21 members of the murphy family, as partners. 111 a second duplicative loss, the government argued, was claimed when the municipal bonds were sold by the s corporation, because the s corporation “claimed that the artificially inflated bases in their partnership interests then carried over and attached to the [bonds].” 112 by doing so, the s corporation claimed a large non-economic loss of $61,543,012 from this sale, and the individual members of the murphy family then reported their alleged pro-rata share of losses. 113 the court, however, rejected this argument. it agreed that the taxpayers had artificially inflated their basis, which may have resulted in their claiming non-economic losses. the court found, however, that because s corporations are pass-through entities — i.e. entities that do not themselves pay taxes and instead pass their taxable income to their owners — that the losses were not duplicative as required by section 309(c). 114 the court also found that regulation section 1.752-6 did not prevent abuse within the meaning of section 7805(b)(3). the government argued that prevention of abuse should be defined expansively. 115 while abuse is not defined in section 7805(b)(3), the government explained, it is defined elsewhere in the internal revenue code. 116 for instance, it explained that section 357(b)(1) provides an anti-abuse rule preventing taxpayers from claiming that an exchange is tax free when the transferee assumes liabilities “principally for tax avoidance purposes [that] lack a bona fide business purpose.” 117 the government also cited the broad anti-abuse rules of treasury regulation 1.701-2, which require that partnerships “be bona fide and [that] each partnership transaction or series of transactions…be entered into for a substantial business purpose.” 118 the government argued that abuse 111. id. at 4–10. 112. id. at 4. 113. id. 114. id. the court found that the government’s argument amounted to “a cosmetic reframing of [the government’s previously asserted] argument that [the taxpayer’s] transaction created ‘artificially inflated basis in the s corporation.’” however, the court held, “[t]he mandate of congress to the treasury in section 309(c)(1) …was not to combat inflation of basis – artificial or otherwise – rather, to preclude the acceleration and/or duplication of losses.” murfam farms, llc v. united states, 88 fed. cl. 516, 525–26 (2009). 115. to help it determine whether the retroactive application of regulation 1.752-6 would “prevent abuse” within the meaning of section 7805(b)(3), the court ordered the government to explain “how… ‘prevention of abuse’ under 26 u.s.c. 7805(b) [should] be defined?” see united states supplemental memorandum responding to court order, supra note 59, at 14. 116. id. 117. id. 118. see united states supplemental memorandum responding to court order, supra note 59, at 14. 22 florida tax review vol. 15:1 should be defined in a similarly broad manner for purposes of section 7805(b)(3) and that regulation section 1.752-6 would prevent abuses that also fell within these other anti-abuse provisions. 119 the court, however, rejected these arguments, essentially finding that a transaction was abusive within the meaning of section 7805(b)(3) only if it lacked economic substance. in general, the economic substance doctrine is used by courts to disallow the tax savings associated with transactions that are not motivated by any substantial non-tax purpose or that fail to meaningfully change the taxpayer’s economic position aside from the tax benefits claimed. 120 the government argued that abuse should be defined to include transactions lacking economic substance but should not be confined only to those transactions. 121 “various statutes can be manipulated to produce an array of different types of abuse … [so that] … the u.s. treasury is engaged in a perpetual game of catch up with the innovative geniuses who seek to subvert the tax system and congressional intent.” 122 in light of this known environment, the government argued, congress intended abuse to be defined expansively when enacting section 7805(b)(3). 123 however, the united states court of federal claims granted the taxpayer’s motion for summary judgment, invalidating retroactive regulation section 1.752-6, stating: the question of whether the transaction at the heart of this case lacked economic substance has yet to be determined…[i]t is possible, at least in theory that the transactions in which a partnership assumes the liabilities of a partner without a corresponding reduction in the partnership’s outside basis could likewise have economic substance. 124 119. id. 120. i.r.c. § 7701(o)(1): “in the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—(a) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (b) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.” 121. united states supplemental memorandum responding to court order, supra note 59, at 17. 122. id. at 15 (citing irs v. cm holdings, inc., 254 b.r. 578, 624 (d. del. 2000), aff’d, 301 f.3d 96 (3d cir. 2002)). 123. id. 124. murfam farms, llc v. united states, 88 fed. cl. 516, 526 (2009). 2013] tax abuse according to whom? 23 the court, therefore, decided that “abuse” was synonymous with transactions lacking economic substance, rejecting the government’s contrary arguments. the court of federal claims also invalidated regulation section 1.752-6 in stobie creek, 125 employing extremely similar reasoning. 126 c. sala v. united states in sala, 127 the taxpayer, carlos sala participated in a cobra transaction similar to the transactions conducted by the murfam family, described above. mr. sala purchased long and short options which “essentially offset one another” 128 and contributed them along with $8 million in cash to a partnership. 129 rather than claiming a basis of $8 million in the partnership interests, mr. sala included only the value of the long options and claimed a basis of $69 million. 130 like the taxpayers in murfam farms, mr. sala did not reduce his basis by the short option amount, claiming that it was a contingent liability falling under the previously discussed helmer doctrine. 131 one month later, as was always planned, the partnership sold the options “resulting in a profit of between $90,000 and $110,000” 132 and 125. stobie creek inv., llc v. united states, 82 fed. cl. 636, 636–38 (2008). 126. id. at 667–71. 127. sala v. united states, 552 f. supp. 2d 1167 (d. colo. 2008), rev’d 613 f.3d 1249 (10th cir. 2010). 128. id. at 1251. on october 23, 2000, sala deposited an initial sum of $500,000 into a personal account with refco capital markets, which was managed by krieger through deerhurst management. opting to participate beyond the “test period,” sala contributed another $8,425,000 to his refco account on november 21, 2000. krieger used the funds in this account to acquire a combination of twenty-four long and short foreign currency options on sala’s behalf, resulting in a net cost to sala of $728,297.85. the options had a total sales price of $60,259,568.94 for the short options, if exercised, and a total purchase price of $60,987,866.79 for the long options, if exercised. in other words, the long and short options essentially offset one another. id. 129. id. 130. id. applying the rule in helmer, solid calculated its adjusted basis in deerhurst gp by disregarding the short options. thus, only the value of the long options, approximately $61 million, plus $8 million in cash solid contributed to the partnership were used to calculate solid’s basis in its partnership interest. see 26 u.s.c. §§ 705, 722 (2006). 131. see supra text at note 102. 132. sala, 552 f. supp. 2d at 1186. http://web2.westlaw.com/find/default.wl?serialnum=1975002207&tc=-1&rp=%2ffind%2fdefault.wl&sv=split&rs=wlw11.07&tf=-1&findtype=y&fn=_top&mt=208&vr=2.0&pbc=b6f97a73&ordoc=2022597592 http://web2.westlaw.com/find/default.wl?tc=-1&docname=26uscas705&rp=%2ffind%2fdefault.wl&sv=split&rs=wlw11.07&db=1000546&tf=-1&findtype=l&fn=_top&mt=208&vr=2.0&pbc=b6f97a73&ordoc=2022597592 http://web2.westlaw.com/find/default.wl?tc=-1&docname=26uscas705&rp=%2ffind%2fdefault.wl&sv=split&rs=wlw11.07&db=1000546&tf=-1&findtype=l&fn=_top&mt=208&vr=2.0&pbc=b6f97a73&ordoc=2022597592 http://web2.westlaw.com/find/default.wl?tc=-1&docname=26uscas722&rp=%2ffind%2fdefault.wl&sv=split&rs=wlw11.07&db=1000546&tf=-1&findtype=l&fn=_top&mt=208&vr=2.0&pbc=b6f97a73&ordoc=2022597592 24 florida tax review vol. 15:1 liquidated. 133 mr. sala received $8 million in cash and two foreign currency contracts. mr. sala claimed a $61 million basis in these contracts, a value far in excess of their $1 million fair market value. 134 mr. sala sold the options for this value and claimed a large loss. like the court of federal claims in murfam farms and stobie creek, the united states district court for the district of colorado held that retroactive regulation 1.752-6 was neither authorized by section 309(c) nor properly enacted to prevent abuse under section 7805(b)(3). as in murfam farms, the government explained how the cobra transaction in sala was similar to the coltec transaction. 135 it also argued that “[t]he promulgation of treas. reg. § 1.752-6 was necessary to prevent certain taxpayers who – prevented from abusing the corporate form by the new i.r.c. § 358 – would undoubtedly ‘go down the street’ to the partnership form in order to avoid paying their fair share of taxes,” 136 rendering code section 358(h) “impotent.” 137 the district court, however, rejected these arguments, explaining: …the facts show sala’s participation in the deerhurst program was a genuine investment transaction that possessed economic substance and was entered into for the purposes of realizing profits above and beyond the tax losses. because sala’s investment in the deerhurst program was not abusive, it is immaterial whether other transactions of the general type he entered into were abusive. 138 thus, like the court of federal claims, the district court decided that the term abuse was synonymous with transactions that lack economic substance and independently defined section 7805(b)(3)’s abuse exception narrowly. 133. sala v. united states, 552 f. supp. 2d 1167 (d. colo. 2008), rev’d 613 f.3d 1249 (10th cir. 2010). 134. id. at 1200. 135. the government again did so in claiming that reg. 1.752-6 was authorized under section 309. “treas. reg. 1.752-6 goes to the very heart of the harm referred to by congress in section 309 of the 2000 act – abusive transactions designed to inflate basis artificially in a way that creates an artificial tax loss.” united states’ supplemental brief at 9, sala v. united states, 552 f. supp. 2d 1167 (d. colo. 2008) (no. 1:05-cv-00636-ltb-ktm) [hereinafter united states’ sala supplemental brief]. the colorado district court in sala held that regulation 1.752-6 exceeded the statutory authority. sala, 552 f. supp. 2d at 1200. 136. united states’ sala supplemental brief, supra note 135, at 9. 137. id. 138. sala, 552 f. supp. 2d at 1202. 2013] tax abuse according to whom? 25 d. where’s the deference? generally, an agency’s interpretation of a statute it is entrusted to administer is entitled to some level of deference. in order to determine the level of deference owed to treasury regulation section 1.752-6, the courts in each of the described cases used administrative law principles now rejected by the supreme court in mayo foundation v. united states. 139 as discussed in greater detail below, generally courts apply the twopart test set forth in united states v. mead corp. 140 to determine whether an agency’s statutory interpretation is owed the strong deference articulated in chevron v. natural resource defense council 141 or the lesser standard of deference articulated in skidmore v. swift & co. 142 before mayo, 143 however, it was not clear whether the mead test applied to tax regulations or whether the standards articulated in rowan cos. v. united states 144 and united states v. vogel fertilizer co. 145 controlled. 146 while rowan and vogel pre-dated chevron and mead, the latter two cases were not tax-specific. thus, some argued that rowan and vogel, which involved tax regulations, still applied to treasury interpretations. 147 under these two cases, tax regulations issued under specific congressional grants of authority were entitled to strong chevron deference. however, some believed that treasury regulations issued under general grants of authority — such as that provided in section 7805(a), authorizing treasury to provide “all needful rules and regulations” 148 — should be scrutinized under the multi-factored approach articulated in national muffler dealers ass’n, inc. v. united states, 149 which 139. 131 s. ct. 704, 704 (2011). 140. 533 u.s. 218, 218 (2001). 141. 467 u.s. 837, 837 (1984). 142. 323 u.s. 134, 134 (1944). 143. mayo, 131 s. ct. at 704. 144. 452 u.s. 247 (1981). 145. 455 u.s. 16 (1982). 146. kristin hickman, the need for mead: rejecting tax exceptionalism in judicial deference, 90 minn. l. rev. 1537, 1549 (2006) [hereinafter hickman, the need for mead] (explaining the post-mayo framework). 147. id. 148. i.r.c. § 7805(a) (2006). 149. 440 u.s. 472, 477 (1979). (“in determining whether a particular regulation carries out the congressional mandate in a proper manner, we look to see whether the regulation harmonizes with the plain language of the statute, its origin and its purpose. a regulation may have particular force if it is a substantially contemporaneous construction of the statute by those presumed to have been aware of congressional intent. if the regulation dates from a later period the manner in which it evolved merits inquiry. other relevant considerations are the length of time the regulation has been in effect, the reliance place on it, the consistency of the 26 florida tax review vol. 15:1 involved the interpretation of a treasury regulation. 150 the mayo court rejected the distinction between general and specific authority regulations and held that the mead test should be applied to determine the deference owed to tax regulations. 151 mayo also made clear that all tax regulations that cleared mead’s two-part test were chevron eligible, regardless of whether they were issued under a specific or general grant of authority. 152 the cases analyzing regulation section 1.752-6 predated mayo. as a result, those cases utilized the now-rejected distinction between regulations promulgated under general versus specific grants of authority. specifically, in each of the cases discussed above, the courts believed strong deference should apply only if regulation section 1.752-6 was promulgated pursuant to section 309(c)’s express authorization. after finding that the regulation was not expressly authorized, each of these cases suggested that while a lesser standard of deference might apply, regulation 1.752-6 must be invalidated. 153 commissioner’s interpretation, and the degree of scrutiny congress has devoted to the regulation during subsequent re-enactments of the statute.”). 150. in national muffler, a trade organization representing muffler dealers sued for an income tax refund, claiming that they were entitled to the so-called “business league” exception and that the treasury regulation defining “business league” (a definition which would exclude muffler dealers) was not a valid interpretation of the statute granting the exemption. see hickman, the need for mead, supra note 146. see also ellen aprill, irvin salem & linda galler, aba section of taxation report of the task force on judicial deference, 57 tax lawyer 717, 740 (2004) (“this report reviews post-chevron tax cases through the end of 2003, and concludes that although chevron’s two-step process has been affirmed for tax cases, the supreme court nonetheless has consistently applied the national muffler test to determine if a general authority regulation is reasonable.”); thomas w. merrill & kathryn tongue watts, agency rules with the force of law: the original convention, 116 harv. l. rev. 467, 570–75 (2002) (discussing tax exceptionalism in administrative law); paul caron, tax myopia, or mamas don’t let your babies grow up to be tax lawyers, 13 va. tax. rev. 517 (1994). 151. mayo found. v. united states, 131 s. ct. 704, 713–14 (2011) (“we have held that chevron deference is appropriate ‘when it appears that congress has delegated authority to the agency generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the exercise of that authority…our inquiry in that regard does not turn on whether congress’ delegation was general or specific.”). 152. id. at 714 (“we believe chevron and mead, rather than national muffler and rowan, provide the appropriate framework for evaluating [the tax regulation at issue.]) 153. the courts also appeared to believe that once the regulation fell outside the congressional grant of section 309(c), treasury could not invoke section 7805(b)(3) at all. for instance, in stobie creek the court of federal claims stated: 2013] tax abuse according to whom? 27 mayo, however, clearly rejected the “tax exceptionalist” 154 methodology used by these courts, holding that the level of deference courts owe treasury regulations depends on the same general framework applied to all other agency regulations. thus, neither courts nor scholars have had the opportunity to speak to the questions upon which the remainder of this article focuses: 155 when the treasury department issues a retroactive regulation pursuant to section 7805(b)(3), is that regulation’s interpretation of tax abuse entitled to deference? if so, what level of deference should these interpretations receive? to address these questions, this article now turns to the general administrative law framework that is, after mayo, clearly applicable to treasury regulations. iv. who should interpret tax abuse? a. the relevant deference doctrines when determining whether an agency regulation is a valid interpretation of the statute to which it relates, there are two predominant [the government] alternatively argues that the retroactive application of treasury regulation § 1.752–6 is appropriate pursuant to i.r.c. § 7805(b)(3) in order ‘to prevent abuse.’ … it would be an incongruous result to defer to treasury’s determination that a particular regulation must apply retroactively in order to prevent abuse, when congress saw fit to decree the end of one named abuse on a retroactive basis (acceleration and duplication of losses), but not all potential abuses related to transfers of partnership assets. because treasury regulation § 1.752–6 exceeds the congressional mandate to address transactions that accelerate and duplicate losses, this broad ‘abuse prevention’ authority cannot serve as an alternate ground for validating retroactive application. stobie creek inv., llc v. united states, 82 fed. cl. 636, 671 (2008). 154. see supra note 139 and accompanying text. 155. the circuit courts to which these cases were appealable did not address issues regarding section 7805(b). in 2009, the taxpayers and the internal revenue service reached a settlement in murfam farms, so that the issue will not be considered by the federal circuit, to which it was appealable. murfam farms, llc ex rel. murphy v. united states, 2010 wl 3260167 (fed. cl. aug 16, 2010) (referring to settlement agreement). on appeal in sala, the tenth circuit did not address the issue of retroactivity, finding it unnecessary because the taxpayer was not entitled to the claimed losses on other grounds. sala v. united states, 613 f.3d 1249 (10th cir. 2010). in stobie creek, the government did not appeal the issue of retroactivity. stobie creek inv. llc v. united states, 608 f.3d 1366, 1374 (n.4) (fed. cir. 2010). http://web2.westlaw.com/find/default.wl?mt=208&db=1016188&docname=26cfrs1.752-6&rp=%2ffind%2fdefault.wl&findtype=l&ordoc=2016685240&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&pbc=afd47426&rs=wlw13.01 http://web2.westlaw.com/find/default.wl?mt=208&db=1012823&docname=26uscas7805&rp=%2ffind%2fdefault.wl&findtype=l&ordoc=2016685240&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=t&pbc=afd47426&referenceposition=sp%3bd801000002763&rs=wlw13.01 http://web2.westlaw.com/find/default.wl?mt=208&db=1016188&docname=26cfrs1.752-6&rp=%2ffind%2fdefault.wl&findtype=l&ordoc=2016685240&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&pbc=afd47426&rs=wlw13.01 http://web2.westlaw.com/find/default.wl?mt=208&db=1016188&docname=26cfrs1.752-6&rp=%2ffind%2fdefault.wl&findtype=l&ordoc=2016685240&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&pbc=afd47426&rs=wlw13.01 28 florida tax review vol. 15:1 standards of deference that a court might apply. a regulation might receive the strong level of deference articulated in chevron v. natural resource defense council. 156 if a regulation is not chevron-eligible, courts will generally apply the multi-factored “sliding-scale” approach articulated in skidmore v. swift & co. 157 1. skidmore v. swift & co.: an intermediate, sliding-scale standard of review in the 1944 supreme court case skidmore v. swift & co., 158 the supreme court held that the weight to be accorded to an agency’s judgment should “depend upon the thoroughness evident in its consideration, the validity of its reasoning, its consistency with earlier and later pronouncements and all those factors which give it power to persuade, if lacking power to control.” 159 the approach advocated in skidmore is often referred to as “sliding-scale deference” since a court may, after considering the various factors discussed above, view the agency interpretation with “great respect,” “near indifference,” or something anywhere between the two. 160 for about four decades after skidmore was decided, this standard “enjoyed prominence as perhaps the supreme court’s best expression of its policy of judicial deference toward many if not most agency interpretations of law.” 161 in 1984, however, chevron v. natural resources defense council 162 dramatically shifted the administrative law landscape. 156. 467 u.s. 837, 837 (1984). 157. 323 u.s. 134, 134 (1944). 158. id. 159. id. at 140. 160. see. e.g. kristin e. hickman & matthew d. krueger, in search of a modern skidmore standard, 107 colum. l. rev. 1235, 1242 (2007) [hereinafter hickman & krueger, modern skidmore standard] (positing that skidmore’s sliding scale encompasses three zones or “moods” reflecting strong, intermediate, and weak or no deference). see also amy j. wildermuth, solving the puzzle of mead and christensen: what would justice stevens do? 74 fordham l. rev. 1877 at 1887 (2006) (discussing skidmore deference). 161. see. e.g., hickman & krueger, modern skidmore standard, supra note 160, at 1242. 162. 467 u.s. 837 (1984). 2013] tax abuse according to whom? 29 2. chevron v. natural resources defense council: a strong standard of review in chevron v. natural resources defense council 163 the supreme court articulated a two-part deference standard for reviewing an agency’s interpretation of the statute it is entrusted to administer. under chevron, a court must first ask whether “congress had spoken to the precise question at issue” 164 (chevron step 1). if congress has done so, courts must “give effect to the unambiguous expressed intent of congress.” 165 if, however, congress has left a gap or ambiguity that it intended an agency to fill or clarify, 166 a court should uphold the agency interpretation so long as it is a “permissible construction of the statute” 167 that is not “arbitrary, capricious or manifestly contrary” to the law (chevron step 2). 168 immediately after chevron, it appeared that all statutory ambiguities might be viewed as implicit delegations, making agency interpretations of those ambiguities eligible for chevron deference. 169 with this sweeping scope, it was unclear whether the skidmore approach was rendered “an anachronism” 170 or whether there remained situations to which skidmore could apply. in 2001, the supreme court spoke to these issues in united 163. id. at 838. 164. id. at 842. 165. id.at 843. 166. chevron is premised on the notion that courts should defer to agency interpretations when and only when congress intended that agency to interpret its laws. christensen v. harris county, 529 u.s. 576 (2000); united states v. mead corp., 533 u.s. 218 (2001). in its recent decision, united states v. home concrete & supply, llc, 132 s. ct. 1836 (2012), the supreme court emphasized that chevron’s first step seeks to solve the “underlying interpretive problem … of deciding whether, or when a particular statute in effect delegates to an agency the power to fill a gap, thereby implicitly taking from a court the power to void a reasonable gap-filling interpretation.” id. at 1843. 167. chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837, 844 (1984). 168. id. 169. adrian vermeule, introduction: mead in the trenches, 71 geo. wash. l. rev. 347, 348 (2003) [hereinafter vermeule, mead in the trenches] (“[t]he key innovation of chevron is to create a global interpretive presumption: ambiguities are, without more, taken to signify implicit delegations of interpretive authority to the administering agency.”). 170. hickman & krueger, modern skidmore standard, supra note 160, at 1242–43 (“chevron did not make clear when exactly courts should presume that congress delegated interpretive authority to the agency, or concomitantly, when chevron’s framework of controlling deference was appropriate.”). 30 florida tax review vol. 15:1 states v. mead corporation, 171 narrowing the set of situations to which chevron deference applies 172 and making clear that skidmore retained a place in the administrative law landscape. 173 because mead sets forth a two-part test to determine whether an agency’s statutory interpretation is eligible for chevron deference, mead is often referred to as creating a “step zero” test. 174 3. step zero: united states v. mead corporation 175 in united states v. mead corporation, 176 the supreme court found that an agency’s statutory interpretation is entitled to chevron deference if two criteria are satisfied: first, “congress [must have] delegated authority to 171. 533 u.s. 218 (2001). mead built upon christensen v. harris county, 529 u.s. 576 (2000). see e.g. hickman, the need for mead, supra note 146, at 1550–51 (“mead and its foreshadowing predecessor, christensen v. harris county, clearly establish that the choice for the courts is not between chevron or no deference at all by revitalizing the classic, pre-chevron deference case of skidmore v. swift & co. as an intermediate deferential alternative.”). id. the supreme court also spoke to step zero issues in barnhart v. walton, 535 u.s. 212 (2002). however, mead represents the predominant method for determining whether an agency interpretation is chevron eligible. for discussion of the confusion initially created by barnhart, see generally lisa schultz bressman, how mead has muddled judicial review of agency action, 58 vand. l. rev. 1443 (2005) [hereinafter bressman, mead has muddled judicial review]. 172. vermeule, mead in the trenches, supra note 169, at 348 (“mead reverses this global presumption. rather than taking ambiguity to signify delegation, mead establishes that the default rule runs against delegation.”). 173. hickman, the need for mead, supra note 146, at 1550–51 (“mead and its foreshadowing predecessor, christensen v. harris county, clearly establish that the choice for the courts is not between chevron or no deference at all by revitalizing the classic, pre-chevron deference case of skidmore v. swift & co. as an intermediate deferential alternative.”). 174. see, e.g., cass sunstein, chevron step zero, 92 va. l. rev. 187, 211 (2006) [hereinafter sunstein, chevron step zero] (referring to mead, christensen, and barnhart as a “step zero trilogy” in which “the court ha[d] attempted to sort out the applicability of the chevron framework.”). see also hickman & krueger, modern skidmore standard, supra note 160, at 1247 (“some have described mead’s inquiry as a ‘step zero’ in the overall analytical framework, coming before the application of either chevron’s two steps or skidmore’s multiple factors. others view mead as ‘sort of a chevron step one-and-one-half,’ relevant only if the reviewing court first concludes that the statute’s meaning is ambiguous.”) id. this article will refer to the questions dictating whether chevron applies to a particular regulation as “step zero” questions with recognition that “both conceptualizations are technically correct.” 175. 533 u.s. 218 (2001). 176. id. 2013] tax abuse according to whom? 31 the agency generally to make rules carrying the force of the law.” 177 (mead step 1). second, “the agency interpretation claiming deference [must have been] promulgated in the exercise of that authority.” 178 (mead step 2). in mead, the court found that agency interpretations issued pursuant to congress’ express authorization “to engage in the process of rulemaking or adjudication that produce[d] regulations or rulings,” 179 were likely to satisfy mead’s first step. 180 thus, the requisite “force of law” delegation required by mead step 1 is almost certain to exist where congress has authorized the agency to issue rules through notice-and-comment rulemaking or formal adjudication, creating what some have called a procedural safe harbor. 181 the mead court, however, was clear that an agency interpretation would not be rendered ineligible for chevron deference solely for “want of procedure.” 182 thus, the customs ruling in mead was not barred from receiving chevron deference solely because it was not subject to notice-andcomment rulemaking, but also because the court could find nothing “suggesting that congress ever thought of classification rulings as deserving” that deference. 183 however, the court did not make clear what criteria an agency interpretation “wanting procedure” could possess to make it eligible for chevron deference. having articulated this important two-part test for determining the scope of chevron deference, the mead court also reaffirmed skidmore’s continuing vitality. according to the court, if an interpretation fails either of mead’s two steps (as did the ruling at issue), a reviewing court should apply skidmore’s sliding scale approach to determine whether, and to what extent, courts should defer to the agency’s interpretation. 184 177. id. at 226–27. 178. id. at 239. 179. id. at 240 (referring to this express authorization as a “good indicator” that the requisite delegation had been made). id. at 219. 180. united states v. mead corp., 533 u.s. 218 (2001). “it is fair to assume generally that congress contemplates administrative action with the effect of law when it provides for a relatively formal administrative procedure tending to foster the fairness and deliberation that should underlie a pronouncement of such force.” id. at 230. 181. id. at 246. 182. id. at 251. 183. id. at 231. 184. id. at 234. “chevron did nothing to eliminate skidmore’s holding that an agency’s interpretation may merit some deference whatever its form, given the ‘specialized experience and broader investigations and information’ available to the agency, and given the value of uniformity in its administrative and judicial understandings of what a national law requires.” id. at 235. the court continued, “there is room at least to raise a skidmore claim here, where the regulatory scheme 32 florida tax review vol. 15:1 as discussed, the cases which have assessed the validity of retroactive regulations under new section 7805(b)(3)’s abuse exception used the now-rejected distinction between general authority and specific authority regulations to analyze the level of deference owed to treasury’s interpretation of section 7805(b)(3). this article will now focus on the level of deference a reviewing court owes a treasury regulation’s interpretation of section 7805(b)(3) under the now-applicable framework sanctioned in mayo. b. are treasury’s interpretations of section 7805(b)(3) chevron eligible? as discussed above, an agency’s statutory interpretation is eligible for chevron deference if it satisfies each of the two steps articulated in united states v. mead corp. 185 in determining whether a treasury regulation issued under to section 7805(b)(3) satisfies mead’s first step, a court must ask whether congress delegated authority to treasury to interpret section 7805(b)(3)’s abuse exception with binding legal effect. 186 1. mead step 1: did congress delegate to treasury the power to interpret tax abuse with the force of the law? in its 2013 decision, city of arlington v. federal communications, 187 the supreme court held that when congress delegates to an agency general authority to administer a particular statute it has vested that agency with authority to make legally binding rules. 188 as section 7805(a) authorizes treasury to provide “all needful rules and regulations” 189 necessary to is highly detailed, and customs can bring the benefit of specialized experience to bear on the subtle questions in this case. . . .” id. see also kristin e. hickman, unpacking force of law, 66 vand. l. rev. 465, 485 (2013) (“in mead, the court held that chevron applies only if congress has given the agency in question the authority to bind regulated parties with ‘the force of law’ and if the agency has ‘in fact acted in the exercise of that authority.’ if either of these conditions is lacking, then skidmore provides the appropriate evaluative standard.”). 185. 533 u.s. 218 (2001). 186. id. at 226–27 (requiring a court to ask whether “congress delegated authority to the agency generally to make rules carrying the force of the law.”). 187. 133 s. ct. 1863 (2013). 188. id. at 1874 (“it suffices to decide this case that the preconditions to deference under chevron are satisfied because congress has unambiguously vested the fcc with general authority to administer the communications act through rulemaking and adjudication, and the agency interpretation at issue was promulgated in the exercise of that authority.”). 189. i.r.c. § 7805(a). 2013] tax abuse according to whom? 33 enforce the code, interpretations found in treasury regulations, including interpretations of section 7805(b)(3)’s abuse exception would seem to easily pass mead’s first hurdle. 190 therefore, these interpretations will be eligible for chevron deference so long as they are “promulgated in the exercise of th[e] authority” granted in section 7805(a), 191 mead’s second hurdle. 2. mead step 2: how does treasury exercise its authority to interpret section 7805(b)(3)? when treasury interprets a provision of the code by issuing a regulation pursuant to notice-and-comment or other formal adjudication procedures, it is clear that treasury has acted within the exercise of the general authority granted in section 7805(a), and chevron deference is warranted. 192 however, as explained in section iii, when promulgating regulation section 1.752-6, treasury explained its reasons for making that regulation retroactive under section 7805(b)(3)’s abuse exception in the preamble. treasury has not, however, issued any stand-alone regulations that define “abuse” for purposes of section 7805(b)(3). when treasury interprets section 7805(b)(3) in the preamble of a regulation it intends to apply retroactively, is that interpretation “in the exercise” of the general authority granted by congress? 193 the authority on this question appears to be scant. 194 however, since a treasury regulation issued pursuant to notice-and-comment carries the force of the law under mayo’s procedural safe harbor, there seems a strong argument that treasury’s explanation of why that regulation prevents abuse within the meaning of section 7805(b)(3), made in the preamble to that regulation, should carry the same force so long as that explanation is subject to review during the entire notice-and-comment period. if this were not so, each time treasury wished to respond to a tax transaction by invoking its power under section 7805(b)(3) (e.g. by issuing 190. mead, 533 u.s. at 226–27. 191. united states v. mead corp., 533 u.s. 218, 227 (2001). 192. mayo found. v. united states, 131 s. ct. 704, 710 (2011). 193. mead, 533 u.s. at 226–27. 194. there are various cases which address the question whether to accord deference to a declaration in the preamble of a regulation that the regulation will preempt state law, but the holdings of these cases are overwhelmed by the special nature of preemption and the problems of allowing a federal agency to declare that federal law trumps state law. see, e.g., wyeth v. levine, 555 u.s. 555, 577 (2006) (discussing the deference accorded to “an agency’s explanation [here, made in a regulatory preamble] of how state law affects the regulatory scheme. . . .”); fidelity federal savings & loan association v. de la cuesta, 458 u.s. 141, 154. see generally catherine m. sharkey, preemption by preamble: federal agencies and the federalization of tort law, 56 depaul l. rev. 227 (2007). 34 florida tax review vol. 15:1 regulation section 1.752-6) it would have to write a separate regulation declaring that the transaction to which it responded (e.g. the cobra transaction) was abusive within the meaning of section 7805(b)(3). requiring treasury to take this additional action seems redundant, though treasury might wish to avoid this ambiguity in the future by issuing separate regulations interpreting tax abuse. 195 v. applying chevron to treasury’s interpretations of tax abuse if it is determined that treasury’s interpretation of section 7805(b)(3) passes mead’s hurdles, that interpretation will be analyzed under chevron’s two-part framework. thus, a court must first apply chevron’s first step (discussed supra) to determine whether congress intended treasury to interpret section 7805(b)(3). clearly, treasury’s power to issue retroactive regulations to “prevent abuse” is an ambiguous one. when terms in a statute possess ambiguities courts generally infer that congress intended a relevant agency to clarify them. however, the powers granted in section 7805(b) are purposefully limited and prohibit retroactive regulation unless certain exceptions apply. it is therefore not clear whether congress intended treasury to interpret the meaning of these exceptions, including section 7805(b)(3)’s abuse exception, or expected courts to play this role. to answer this question, this article considers the way in which section 7805(b)(3) fits within the internal revenue code, the legislative history of section 7805(b)(3), and the special expertise of the treasury and internal revenue service. 195. in barnhart v. walton, the supreme court found that in cases where the agency interpretation did not fall within mead’s procedural safe harbor, courts should determine the proper level of deference by considering “the interstitial nature of the legal question, the related expertise of the agency, the importance of the question to administration of the statute, the complexity of that administration, and the careful consideration the agency has given the question over a long period of time.” 535 u.s. 212, 222 (2002). how barnhart and mead fit together — if they do so at all — is the subject of some debate. see generally bressman, mead has muddled judicial review, supra note 171. however, it seems the barnhart factors could help in determining when an interpretation found in a preamble merits chevron deference. 2013] tax abuse according to whom? 35 a. chevron 1: did congress intend for treasury to interpret tax abuse? 1. section 7805(b)(3)’s role in the code in addition to section 7805(b)(3), there are multiple other provisions in the code that grant treasury open-ended power to police tax abuse. for example, the code allows the treasury secretary to reapportion “gross income, deductions, credits, or allowances . . . among [commonly controlled] organizations . . . if he determines that . . . [it] . . .is necessary . . . to prevent evasion of taxes . . . . ” 196 the code also allows the treasury secretary to require taxpayers to provide information about transactions determined to “hav[e] a potential for tax avoidance or evasion.” 197 in this way, section 7805(b)(3) is one of many instances where congress sought to give broad power to treasury to prevent abuse of the tax laws, at least suggesting that congress intended treasury to interpret what it means to “prevent abuse.” this conclusion is greatly bolstered by the legislative history of section 7805(b)(3). 198 2. legislative history as discussed previously, section 7805(b) does not explicitly define “abuse” and its legislative history does not elaborate further. 199 the joint committee report adds little, stating only that the “abuse” to which section 196. i.r.c. § 482. 197. i.r.c. § 6707a. 198. chevron instructs courts to determine “whether congress has directly spoken to the precise question at issue,” applying the “traditional tools of statutory construction.” chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837, 842, n. 9 (1984). this article therefore assumes that legislative history may be used in determining whether an agency interpretation satisfies chevron’s first step. for an interesting discussion on this matter, see e.g. lisa schultz bressman, chevron’s mistake, 58 duke l. j. 549 (2009). 199. see, e.g., murfam farms, llc v. united states, 88 fed. cl. 516, 526 (2009) (“unfortunately, ‘abuse’ is not defined by the statute.”). see also sala v. united states, 552 f. supp. 2d 1167, 1201 (d. colo. 2008) (“the question of what constitutes ‘abuse’ is not clarified by the statute.”) (citing edward a. morse, reflections on the rule of law and “clear reflection of income:” what constrains discretion?, 8 cornell j.l. & pub. pol’y 445, 488 (1999) (“the scope of this exception is unclear and it remains to be seen whether it will be exercised independently of congress’ power to authorize retroactive regulations.”)). 36 florida tax review vol. 15:1 7805(b)(3) refers is “abuse of the statute.” 200 nonetheless, the legislative history of section 7805(b) provides useful information about congress’ intent in enacting section 7805(b)(3)’s “abuse exception.” section 7805(b) is part of the taxpayer bill of rights 2 [hereinafter “tbor 2”]. the idea for the original taxpayer bill of rights [hereinafter “tbor 1”] appears to have emanated from the first speech then-democratic representative harry reid 201 delivered to the house of representatives. 202 in his “maiden address,” 203 representative reid expressed the need for legislation that would “give the average taxpayer . . . additional rights in dealing with the internal revenue service.” 204 immediately after hearing reid’s speech, republican senator david pryor communicated to reid his desire to partner in the effort to write and pass this legislation. 205 the final version of tbor 1 was signed into law by president ronald regan in 1988 206 and enumerated certain rights of american taxpayers. 207 tbor 1 required the treasury secretary to issue a “simple and nontechnical” 208 statement describing the taxpayer’s rights, as well as an explanation of the audit process, the method of appeal available to the taxpayer, and the methods by which the irs may collect unpaid tax 200. staff of joint comm. on taxation, 104th cong., background and information relating to the taxpayer bill of rights 22 (comm. print 1995). 201. harry reid first became senator of nevada in 1986. 202. 138 cong. rec. 2831 (1992) (statement of sen. harry reid, recounting that “the first speech [he] gave on the house floor…related to the taxpayer bill of rights.”). 203. id. at 2822 (statement of sen. david pryor, referring to reid’s “maiden address”). 204. id. see also irs implementation of the taxpayers’ bill of rights: hearing before the subcomm. on private retirement plans and oversight of the internal revenue service of the s. comm. on finance, 101st cong., 2d sess., 3 (1990) (statement of harry reid). 205. this event is recounted several times by senators pryor and reid. see, e.g., 138 cong. rec. 2822, 2831 (1992) where senators pryor and reid recount the formation of their partnership. for instance, pryor recounts: “i will never forget at the conclusion of [reid’s maiden address] i sent the distinguished senator a note saying i want to be your partner, i want to join with you because we need to give the average taxpayer in our country additional rights in dealing with the internal revenue service.” id. at 2822. 206. pub. l. 100-647, 102 stat. 3342, 3730–52 (1988). 207. the taxpayer bill of rights was enacted in sections 6226 through 6247 of the technical and miscellaneous revenue act of 1988 (tamra), pub. l. 100-647, 102 stat. 3342, 3730–52 (1988). 208. pub. l. 100-647, §§ 6247-51, 102 stat. 3342, 3730–52 (1988). 2013] tax abuse according to whom? 37 liabilities. 209 tbor 1 also expanded the rights of taxpayers by, for instance, allowing a taxpayer to recover previously unrecoverable administrative and litigation costs from the irs, 210 creating “the right of the taxpayer to rely on the written advice of the internal revenue service,” 211 by abating penalties under certain circumstances when the relied-upon advice was erroneous, 212 creating new causes of action against the irs for negligently failing to release a taxpayer lien, 213 and for recklessly or negligently disregarding provisions of the code and/or regulations. 214 in 1996, the taxpayer bill of rights 2, of which new section 7805(b) is part, was enacted to improve upon and increase the taxpayer protections provided by tbor 1. 215 senator pryor and now-senator reid were again at the forefront in advocating this legislation. 216 the issue of retroactive regulation was not discussed in the first hearing relating to tbor 2. this first hearing, held by the senate finance committee in april 1990, was held to evaluate whether the irs was implementing tbor 1 in a manner which set “the individual rights of the 209. for the full document explaining these items, see internal revenue service, declaration of taxpayer rights, publication 1, http://www.irs.gov/pub/irspdf/p1.pdf. as explained at the beginning of this publication “[t]he first part . . . explains some of [the] taxpayer’s most important rights . . . . the second part explains the examination, appeal, collection, and refund processes.” id. 210. i.r.c. § 7430 (2006). see also 142 cong. rec. 17371 (1996) (senator pryor explains tbor 1 and states that it provided “the right of the taxpayer to recover, for the first time, civil damages and attorney’s fees from the internal revenue service.”). 211. id. 212. pub. l. 100-647, § 6229, 102 stat. 3342, 3733 (1988) (amending i.r.c. § 6404(f)(1) which reads: “the secretary shall abate any portion of any penalty or addition to tax attributable to erroneous advice furnished to the taxpayer in writing by an officer or employee of the internal revenue service, acting in such officer’s or employee’s official capacity.”) 213. i.r.c. § 7432 (2006). 214. i.r.c. § 7433 (2006). 215. see, e.g., reforms to establish taxpayer safeguards and protect the rights of taxpayers under the internal revenue code: hearings before the subcomm. on oversight of the h.r. comm. on ways and means, 102d cong. [hereinafter 1991 house hearings] (press release july 12, 1991) (“the honorable j. j. pickle (d. texas) chairman of the subcommittee on oversight, committee on ways and means, u.s. house of representatives announced today that the subcommittee will conduct hearings to review reforms to establish taxpayers safeguards in dealing with the internal revenue service (irs) and to protect the rights of taxpayers under the internal revenue code (irc).”) 216. see generally irs implementation of the taxpayers’ bill of rights: hearing before the subcomm. on private retirement plans and oversight of the internal revenue service of the s. comm. on finance, 101st cong., 2d sess. (1990). 38 florida tax review vol. 15:1 american taxpayer [as] a high priority,” 217 and whether tbor 1 was itself providing adequate protections to taxpayers. 218 following senator david pryor’s brief opening statement, senator reid recited a poem based on t.s. elliot’s “the wasteland:” april is the cruelest month, sending 1040’s [sic] across the land . . . and as the irs was churlish, crafting new abuses, congress, it passed a bill of rights. the agency’s leash was tightened. they had to say, taxpayers you have rights. the irs must follow rules. in the meantime, all citizens are free to inquire about their rights and keep their legal wage. 219 after this recital, reid encouraged the committee to “keep [sic] the pressure on” the irs to ensure it took “both the spirit and the letter of the taxpayers’ bill of rights seriously and [was] incorporat[ing tbor’s] philosophy into all its activities.” 220 the hearings commenced with statements by and the questioning of various employees of the irs who testified generally as to the measures taken to comply with tbor 1. the committee also heard statements by public witnesses who had been mistreated by the irs. 221 some of these statements were extremely emotional, including for instance, a statement by an individual taxpayer whose husband’s experience with the irs had allegedly caused him to commit suicide. 222 this initial hearing, therefore, seemed to be devoted to information collection. in july 1991, the subcommittee on oversight of the house on ways and means announced in a press release its intention to hold two more substantive hearings that would “review reforms to establish taxpayer safeguards in dealing with the internal revenue service (irs) and to protect the rights of taxpayers under the internal revenue code (irc).” 223 this press release invited interested parties to participate either through the filing of written statements or by testifying at the scheduled hearings. 217. id. 218. id. at 2 (statement of sen. pryor, chairman of the subcommittee): “this brings me to the second subject of today’s hearing, a look at the legislation itself to see if it is providing the necessary protections for the taxpayers.” id. 219. id. at 3–4. 220. id. at 5. 221. id. at 18–21. 222. id. at 18–19. 223. press release, subcomm. on oversight of the h.r. comm. on ways and means house of representatives, hearings on reforms to establish taxpayer safeguards (july 12, 1991) (on file with author). 2013] tax abuse according to whom? 39 chairman jake pickle identified thirteen reforms that would be discussed at the two hearings. most of these reforms seemed to be an extension of the reforms made in tbor 1. for instance, the press release stated that the subcommittee would consider reforms that would require the irs to formalize its appeals procedures, 224 allow the taxpayer to appeal court decisions regarding certain penalties, 225 and shift the burden of proof to the irs on certain issues. 226 the press release also stated that the subcommittee would consider reforms that would “provide protections for taxpayers who make ‘good faith’ efforts to comply with the tax laws during the period between enactment of the law and issuance of clear guidelines and final regulations.” 227 it is to this category of “good faith reforms” that the issue of retroactive regulation would be linked. while there seemed ample opportunity to discuss the issue of retroactive regulation at the two hearings that followed, the subject was discussed only at the second by representatives of two professional organizations both of whom supported a flat prohibition on retroactive rulemaking. at the first hearing in july 1991, damon holmes, then-irs taxpayer ombudsman was invited to “share his views on the problems affecting taxpayers and the possible remedies for those problems.” 228 the office of the taxpayer ombudsman was originally created by the irs and later codified in tbor 1 229 “to serve as the primary advocate, within the irs, for taxpayers,” 230 and “to issue taxpayer assistance orders (taos) when taxpayers were suffering or about to suffer significant hardships because of the way the internal revenue laws were being administered.” 231 at these july 1991 hearings, mr. holmes laid out various ways to reduce the burdens on taxpayers, focusing on simplification, communication, modernization, and 224. id. 225. id. 226. id. 227. id.: “the [other] reforms under consideration would: (a) require [the] irs to establish formal taxpayer appeal procedures covering the irs collection process; (b) allow taxpayers to challenge in tax court [the] assessment [sic] of additional interest that are [sic] based on irs determinations that underpayments were tax-motivated; (c) shift the burden of proof from taxpayers to [the] irs in certain situations [and] (d) improve taxpayers’ access to reimbursements for attorneys’ fees . . . .” 228. 1991 house hearings, supra note 215, at 11. 229. pub. l. 100-647, §§ 6247–51, 102 stat. 3342, 3730–52 (1988). 230. internal revenue manual, part 13, http://www.irs.gov/irm/part13/ index.html. 231. id. 40 florida tax review vol. 15:1 other procedural improvements. 232 the issue of retroactive regulation was not discussed in these hearings, perhaps because substantive tax matters might have been seen as falling outside of the taxpayer ombudsman’s role. however, at the second hearing in september 1991, kenneth gideon, assistant secretary of tax policy at the u.s. department of treasury, and fred goldberg, commissioner of the irs, both testified and answered questions. 233 the subcommittee questioned neither gideon nor goldberg on his views regarding a ban on retroactive regulation, despite the clear substantive tax expertise of each. retroactivity was mentioned in the later testimony of the chairman for the american institute of certified public accountants 234 who indicated the aicpa’s “strong support” 235 for a reform that would protect taxpayers from retroactive rulemaking. 236 the tax executives institute, a professional association who, at the time of the hearings, consisted of 4,700 individuals who work primarily in large corporations, 237 submitted comments to the subcommittee suggesting that the goals underlying the “good faith reforms” listed in the press release would be advanced if congress made statutes effective only after regulations had been finalized, particularly in instances “when [sic] broad grants of authority are given to the treasury department to promulgate [these] regulations.” 238 thus, as of july 1991, it appeared that representatives of the u.s. government — e.g. the administration and irs — had not expressed their views on banning retroactive regulation. nonetheless, in november 1991, senator pryor announced that “in the coming month [he] plan[ned] to 232. 1991 house hearings, supra note 215, at 11. 233. id. at 311–17, 323–54. 234. id. at 441 (statement of aicpa chairman). 235. id. “this is a very important issue which the aicpa strongly supports.” id. 236. “we commend the subcommittee for its consideration of a reform that would provide protection for taxpayers who make “good faith efforts” to comply with the tax laws during the period between of enactment of the law and issuance of clear guidelines and final regulations. such a reform would recognize taxpayers’ [sic] needs for early guidance in complex areas of the tax law, while at the same time stimulate the irs and treasury to accelerate for the issuance of such guidance.” id. 237. see id. at 584 (statement of timothy j. mccormally, tax counsel, tax executives institute). for more information about the tax executives institute tei, see: http://www.tei.org/pages/default.aspx. 238. 1991 house hearings, supra note 215, at 587. the institute referenced and supported the majority tax staff of the ways and means committee’s 1990 proposal to “make all rules and regulation[s] implementing broad guidelines effective on a prospective-only basis,” id. at 587–88. this 1990 proposal was part of a much larger proposal to simplify the tax system. the results of that effort were published as staff of house comm. on ways and means, 101st cong., written proposals on tax simplification (comm. print 1990). 2013] tax abuse according to whom? 41 introduce the taxpayer bill of rights 2 . . . .” 239 as one of eight examples of reforms to be addressed, senator pryor stated that “all regulations issued by the treasury department [should] be prospective unless expressly provided otherwise by congress,” 240 and conveyed a strong belief that this was “one of the critical elements of the taxpayer bill of rights 2.” 241 on february 20, 1992, 242 senator pryor officially introduced tbor 2. 243 the first version of what would become new section 7805(b) provided that all regulations would “apply prospectively from the date of publication of such regulation in the federal register.” 244 the only exception to this prohibition on retroactivity was that congress could expressly authorize the secretary to issue certain regulations retroactively. 245 on the following day, hearings were held before the senate finance committee subcommittee on private retirement plans and oversight of the irs. 246 the u.s. government finally expressed its opinions about reforms that would ban retroactive regulation in the absence of express congressional 239. 137 cong. rec. 30,415 (1991) (statement of sen. pryor). 240. id. 241. 138 cong. rec. 2822–23 (1992). he continued: “it is almost unimaginable . . . that we have an agency of the u.s. government, the internal revenue service, that has the authority and the power to issue regulations that apply retroactively. but the internal revenue service does it all the time. we are going to eliminate that authority.” id. the summary description of the proposals (hereinafter summary proposal) for the taxpayer bill of rights 2 stated that: t2 will generally require that all regulations issued by the treasury department to implement broad legislative guidelines be effective prospectively from the date of issuance in final, temporary or proposed form. to keep such a presumption from providing shelter for abusive transaction, and to provide for administration of tax laws in the interim between the effective date of a statute and the effective date of the associated regulations, taxpayers would be deemed to have satisfied the necessary requirements if they made a good-faith effort to utilize a reasonable interpretation of the statute that resulted in substantial compliance. this general rule requiring that regulations be prospective could be superseded by a specific legislative grant authorizing the treasury department to prescribe the effective date of regulations with respect to statutory provision. 137 cong. rec. at 30,417. 242. see generally 1992 tbor 2 hearings, supra note 2. 243. 138 cong. rec. 2822 (1992). 244. id. at 2828 (1992). 245. id. the material introduced by senator pryor restated the language of the summary proposal verbatim. see 138 cong. rec., supra note 241, at 1910. 246. see 1992 tbor 2 hearings, supra note 2. 42 florida tax review vol. 15:1 authorization. the administration and the irs both opposed the prohibition. 247 fred t. goldberg, jr., now-assistant secretary for tax policy for the department of the treasury explained that “there are numerous situations where the retroactive application of regulations is a substantial benefit to taxpayers.” 248 for instance, retroactive regulations promote consistency 249 and can operate to “protect the taxpayer” 250 rather than leaving her “to the mercy of individual revenue agent[s] or irs employee[s],” 251 each of whom might have different interpretations of the law. yet, mr. goldberg seemed most gravely concerned that the ban would greatly weaken the irs’s power to respond to aggressive taxpayer behavior: if the irs is precluded from asserting positions retroactively in cases where taxpayers have taken questionable positions, the tax system will lose an implicit restraint. as a consequence, sophisticated taxpayers will tend to take more aggressive positions and revenue will be lost . . . .[t]he government should not be foreclosed from issuing retroactive regulations in situations in which sophisticated taxpayers have engaged in questionable transactions with the knowledge that they are subverting the congressional purpose in enacting a statutory provision. 252 in her prepared statement, shirley d. peterson, then-commissioner of the irs, succinctly explained the irs’s reasons for opposing the 247. see id. at 121 (“the administration opposes this provision on revenue and policy grounds.”). see also id. at 212 (“we [the internal revenue service] oppose this provision. we believe current procedures already address this concern. also, the provision would deny [the] irs the ability to address attempted abuses of the statutory provision by sophisticated taxpayers.”). 248. id. at 58. 249. “i would point out that there are situations where regulations by their nature require choices. some taxpayers may be benefitted[;] others may be harmed. a consistent rule is in the system’s best interest.” commissioner peterson also commented on uniformity, stating ‘[b]etween the time the statute is enacted and the regulations are issued, one taxpayer will interpret the law one way, another taxpayer will interpret it another way, and you may have 15 different approaches to the application of that statute. you absolutely abolish uniformity between the date of enactment of the statute and the date the regulations are issued if you go forward with this provision.” id. at 59. 250. id. 251. id. 252. id. at 122. 2013] tax abuse according to whom? 43 prohibition of retroactive regulations, also focusing on how the ban would “deny [the] irs the ability to address attempted abuses of the statutory provision by sophisticated taxpayers.” 253 representatives of the taxpayer executive institute, 254 the american supply association (“the not-for-profit national organization serving wholesale distributors and their suppliers in the plumbing, heating, cooling and industrial and mechanical pipe, valves and fittings industries”), 255 and the national association of enrolled agents (a professional organization consisting of members sanctioned by congress to represent taxpayers) 256 filed statements expressing their support of the prohibition on retroactive regulation. 257 in march 1992, a conference agreement was reached which included an exception to the presumption of retroactivity, permitting the treasury to “issue retroactive temporary or proposed regulations to prevent abuse of the statute.” 258 two versions of tbor 2 incorporating the amended section 7805(b) passed both houses of congress in 1992, but each bill was vetoed by president george h. w. bush for reasons unrelated to the legislation. 259 from 1992 until 1996, when tbor 2 was signed into law, the house of representatives and senate proposed various versions of what would become new section 7805(b). each of these proposals generally prohibited retroactive regulation, but included an exception that allowed regulations to “apply retroactively to prevent abuse of the statute to which the regulation relates.” 260 in 1996, the final version of tbor 2 passed unanimously through both the house of representatives and the senate. 261 president bill clinton 253. id. at 212 254. see 1992 tbor 2 hearings, supra note 2, at 244 (statement of timothy j. mccormally, tax counsel, tax executives institute). 255. http://www.asa.net//about-asa.aspx. 256. http://www.naea.org/. 257. other professional organizations filed statements but did not discuss the retroactive prohibition. 258. see h.r. rep. no. 102-460, 102d. cong., 2d. sess. (1992) (accompanying h.r. 4210). 259. 142 cong. rec. 17,371 (1996) (statement of sen. pryor, explaining that tbor 2 “passed congress twice that year, [but] . . . was ultimately vetoed because it was included as part of two large tax bills with which president bush did not agree.”). 260. see, e.g. revenue act of 1992, 102 h.r. 11, § 5803 (1992) (containing language alluded to in h.r. rep. no. 102–460, at 380); 104 s. 258, § 903 (1996). 261. 142 cong. rec. 17,371 (1996) (statement of sen. pryor) (“in making its way to the senate, [tbor 2] passed the house of representatives by a unanimous 425 to 0 vote. i applaud the action of the house of representatives, and i 44 florida tax review vol. 15:1 signed tbor 2 into law on july 30, 1996. 262 this final version of section 7805(b) contained an abuse exception that allowed the treasury secretary to “provide that any regulation may take effect or apply retroactively to prevent abuse.” 263 it is therefore clear that section 7805(b)(3)’s abuse exception was a direct response to the concerns expressed by the administration and irs that a flat ban on retroactive regulation would compromise the treasury and irs’s ability to adequately respond to egregious tax positions, especially those taken by sophisticated taxpayers seeking to subvert the purposes of the code. this history strongly suggests that congress intended to grant treasury substantial leeway to interpret this exception. this argument becomes even stronger once one considers the specialized expertise possessed by the employees of treasury and the irs. 3. agency expertise when determining whether congress intended to delegate a certain power to an agency, courts have considered whether that agency possesses special expertise to exercise that authority. 264 as justice marshall wrote in martin v. occupational safety and health review commission, 265 “because historical familiarity and policymaking expertise account in the first instance for the presumption that congress delegates interpretive lawmaking power to the am proud that this thursday, because of a strong bipartisan coalition, the senate has now followed suit by unanimously passing taxpayer bill of rights 2.”). 262. taxpayer bill of rights 2, pub. l. no. 104-168, 110 stat. 1452 (1996). 263. id. at 1468, § 1101, codified at i.r.c. § 7805(b)(3). 264. see, e.g., cass sunstein, agencies as common law courts, 47 duke l.j. 1013, 1056 (1998) [hereinafter sunstein, agencies as common law courts] (“the central idea behind chevron is that where underlying statutes are ambiguous, congress should be taken to have decided that agencies are in a better position to make judgments about their meaning than are courts.”). see also rafael i. pardo & kathryn a. watts, the structural exceptionalism of bankruptcy administration, 60 ucla l. rev. 384, 423 (2012) (“administrative law teaches that broad delegations of policymaking power to agencies may well be desirable--and, hence, will generally be tolerated as a constitutional matter--because of a variety of functional considerations relating to agencies’ institutional structures and capacities. these functional considerations include the expertise that many agencies enjoy in specialized areas of the law . . . .”). 265. 499 u.s. 144 (1991). see also gonzales v. oregon, 546 u.s. 243, 266– 67 (2006) (quoting the best actor rule articulated in martin). 2013] tax abuse according to whom? 45 agency rather than to the reviewing court . . . ” 266 we presume here that congress intended to invest interpretive power in the administrative actor in the best position to develop these attributes. 267 there are a large number of cases that have considered this factor. 268 for instance, in babbitt v. sweet home chapter of communities for a great oregon, 269 the court held that it “owe[d] some degree of deference” 270 to the secretary of the interior’s “reasonable interpretation” 271 of the endangered species act pointing, inter alia, to the “degree of regulatory expertise necessary to” enforce that act. 272 by contrast, in gonzales v. oregon 273 the attorney general interpreted the controlled substance act to prohibit physicians from prescribing legal medicine to terminally ill patients for the purpose of committing suicide. the supreme court declined to apply deference to this interpretation, believing it to be extremely unlikely that congress would have granted to the attorney general the authority to make “quintessentially medical judgments.” 274 aside from the united states tax court, lower courts may hear at most several tax cases a year. on the other hand, employees of treasury and the irs possess tax-specific expertise and devote their daily attention to issues of federal taxation law. “the irs is engaged in extensive efforts to 266. martin, 499 u.s. at 153 (citing mullins coal co. v. director, office of workers’ comp. programs, 484 u.s. 135, 159, 108 s. ct. 427, 440, 98 l. ed.2d 450 (1987); ford motor credit co. v. milhollin, 444 u.s. 555, 566, 100 s. ct. 790, 797; ins v. stanisic, 395 u.s. 62, 72, 89 s. ct. 1519, 1525, 23 l. ed.2d 101 (1969)). 267. id. 268. in addition to the cases discussed, see, e.g., nat’l cable & telecomm. ass’n v. brand x internet services et al., 545 u.s. 967, 1002−03 (2005) (breyer, j., concurring) (“the questions the commission resolved in the order under review involve a ‘subject matter [that] is technical, complex, and dynamic.’ the commission is in a far better position to address these questions than we are. nothing in the communications act or the administrative procedure act makes unlawful the commission’s use of its expert policy judgment to resolve these difficult questions.” (citing nat’l cable & telecomm. ass’n, inc. v. gulf power co., 534 u.s. 327, 339 (2002))). 269. 515 u.s. 687 (1995). 270. id. at 703–04. 271. id. 272. id. “the latitude the esa gives the secretary in enforcing the statute, together with the degree of regulatory expertise necessary to its enforcement, establishes that we owe some degree of deference to the secretary’s reasonable interpretation.” id. 273. 546 u.s. 243 (2006). 274. id. at 267. https://1.next.westlaw.com/link/document/fulltext?findtype=y&sernum=1969132986&pubnum=708&originationcontext=document&transitiontype=documentitem&contextdata=%28sc.userenteredcitation%29#co_pp_sp_708_1525 46 florida tax review vol. 15:1 curb abusive tax shelter schemes and transactions,” 275 and to identify and respond to “tax avoidance” transactions as quickly as possible. 276 thus, employees of treasury (of which the irs is part) are generally in the best position to determine whether a transaction constitutes abuse of the code — for instance, whether transactions, such as the cobra transaction, result in duplicated losses or produce other results that run against fundamental principles of the tax law. congress, in enacting section 7805(b)(3), was certainly aware of these facts, creating further evidence that congress intended to trust treasury (and not courts) with the authority to interpret tax abuse under section 7805(b)(3). because it seems clear that congress intended to grant treasury substantial leeway to interpret tax abuse, a treasury regulation’s interpretation of section 7805(b)(3) will generally satisfy chevron’s first step. before turning to chevron’s second step, however, this part will discuss cases which seem to analyze chevron step 1 in a different manner. 4. even if congress intended treasury to interpret tax abuse, did congress unambiguously foreclose any particular interpretation of that term? in food and drug administration v. brown & williamson tobacco corporation, 277 the supreme court held that the fda’s interpretation of an ambiguous statutory term could not clear chevron’s first step. while congress intended to delegate interpretive authority to the fda to interpret the ambiguous language at issue, the court found that congress clearly did not intend the fda to adopt the particular interpretation it had. under this line of analysis, if a court were to find that congress unambiguously foreclosed treasury’s interpretation of section 7805(b)(3)’s abuse exception — e.g. if a court found that congress clearly did not intend treasury to interpret cobra transactions as an abuse of the code — then that interpretation would fail chevron step 1, and regulations enacted 275. ep abusive tax transactions, http://www.irs.gov/retirementplans/ep-abusive-tax-transactions. 276. id. “the parties who participate in listed transactions may be required to disclose the transaction as required by the regulations, register the transaction with the irs, or maintain lists of investors in the transactions and provide the list to the irs on request.” id. 277. 529 u.s. 120 (2000). for further discussion of this case, see generally sunstein, agencies as common law courts, supra note 264. see also sunstein, chevron step zero, supra note 174, at 240–42. 2013] tax abuse according to whom? 47 retroactively in reliance on that interpretation could only apply prospectively. 278 because congress failed to define “abuse,” one might naturally wonder how a court could find that congress unambiguously foreclosed any particular interpretation of tax abuse. this part identifies two factors to guide this inquiry. a. how does the interpretation fit within the statutory scheme? in food and drug administration v. brown & williamson tobacco corporation, 279 the supreme court assessed the food and drug administration’s (fda’s) interpretation of the food, drug, and cosmetic act. the food, drug, and cosmetic act grants the fda “the authority to regulate, among other items, ‘drugs’ and ‘devices.’” 280 the food and drug administration had long maintained that it did not have jurisdiction to regulate tobacco products. years later, however, it changed this position and issued regulations related to those goods. in the federal register, the food and drug administration claimed authority to do so by interpreting nicotine to be a “drug” and cigarettes and smokeless tobacco to constitute “drug delivery devices.” 281 the court found this regulation could not pass chevron’s first step because congress clearly did not intend the fda to interpret these ambiguous terms (i.e. “drug” and “drug delivery device”) in this way. in so finding, the court parsed through the legislative history of the food, drug, and cosmetic act as well as “the tobacco related legislation that congress ha[d] enacted over . . . the 35 years” 282 preceding the decision. reaching as far back as 1929, the court chronicled the various instances in which congress declined to grant the fda jurisdiction over tobacco products. 283 it also discussed the various pieces of tobacco-related legislation that congress enacted “against the backdrop of the fda’s consistent and repeated statements that it lacked authority under the fdca to regulate tobacco. . . .” 284 278. chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837, 843 (1984). 279. 529 u.s. 120 (2000). for further discussion of this case, see generally sunstein, agencies as common law courts, supra note 264. see also sunstein, chevron step zero, supra note 174, at 240–42. 280. 529 u.s. at 126. 281. id. at 127 (citing 61 fed. reg. 44418 (1996)). 282. id. at 143. 283. id. at 137–40. 284. food and drug admin. v. brown & williamson tobacco corp., 529 u.s. 120, 144 (2000). 48 florida tax review vol. 15:1 the court also emphasized the importance of a contextual analysis of the food, drug, and cosmetic act, 285 examining not just the provision of the food, drug, and cosmetic act that defined the fda’s authority, but “viewing the fdca as a whole.” 286 the court found that if the fda were to have jurisdiction to regulate cigarettes, other provisions of the food, drug, and cosmetic act would require that cigarettes be removed from the market. 287 because congress had “foreclosed the removal of tobacco products from the market” in other legislation, 288 the court concluded that congress could not have intended the fda to interpret their jurisdiction in a way that overrode that result. 289 in the 2001 decision, whitman v. american trucking associations inc., 290 the supreme court used similar tools of statutory construction to determine whether the environmental protection agency’s (epa’s) interpretation of the clean air act (caa) satisfied chevron step 1. 291 the caa required the administrator of the epa to set air quality standards at a level that was “requisite to protect the public health.” 292 in making these air quality calculations, the epa claimed it could consider the costs that industries would incur in complying with the applicable standards. the court looked at the caa as a whole and found that air quality standards were “the engine that [drove] nearly all of . . . the caa.” 293 the court therefore found it unlikely that congress intended to delegate to the epa the authority to interpret these standards in the way it had. “congress,” the court wrote “does not alter the fundamental details of a regulatory scheme in vague terms or ancillary provisions.” 294 thus, when determining whether congress clearly foreclosed treasury’s interpretation of section 7805(b)(3), courts should look holistically at how that interpretation fits within the code. to illustrate, 285. id. at 132 (“the meaning—or ambiguity—of certain words or phrases may only become evident when placed in context.”). 286. id. at 133. 287. id. at 137. 288. id. 289. food and drug admin. v. brown & williamson tobacco corp., 529 u.s. 120, 137 (2000). 290. 531 u.s. 457 (2001). 291. whitman, 531 u.s. at 481. “we cannot agree with the court of appeals that subpart 2 clearly controls the implementation of revised ozone naaqs . . . because we find the statute to some extent ambiguous. we conclude, however, that the [epa]’s interpretation goes beyond the limits of what is ambiguous and contradicts what in our view is quite clear. we therefore hold the implementation policy unlawful.” id. (citations omitted). 292. id. at 465 (quoting 42 u.s.c. § 7409(b)(1)). 293. id. at 458. 294. id. at 468. 2013] tax abuse according to whom? 49 regulation section 1.752-6 held that transactions such as the cobra transaction abused the code. as the government argued in the cases discussed in section iii, this interpretation is consistent with other anti-abuse provisions of the code. the cobra transactions were similar to the coltec transaction to which congress responded in section 358. further, the cobra transactions would likely have been deemed abusive under other sections of the code. finally, section 358(h) might have been rendered “impotent” 295 without regulation 1.752-6. thus, far from “alter[ing] the fundamental details” 296 of the code, it appears that regulation section 1.7526’s interpretation of section 7805(b)(3) actually complemented and enforced other provisions of the tax laws. b. the importance of the question presented in a seminal article, justice breyer suggests that courts “[a]sk whether the legal question [an agency interpretation addresses] is an important one” 297 [since] “congress is more likely to have focused upon, and answered, major questions, while leaving interstitial matters to answer themselves in the course of the statute’s daily administration.” 298 thus, in brown & williamson, 299 discussed above, the court found that a decision to prohibit the marketing of tobacco products (the result of granting the fda the jurisdiction it claimed) was one of great “economic and political significance.” 300 the court, therefore, felt “confident that congress could not have intended to delegate [this decision] to an agency in so cryptic a fashion.” 301 the court also looked at the importance of the questions presented in other cases, such as mci telecommunications corp. v. american telephone & telegraph company 302 (mci) and gonzales v. oregon. 303 in mci, the federal communications commission (fcc) claimed that because the communications act of 1934 gave it authority to “modify any requirement” of that act, the fcc could completely eliminate the 295. united states v. sala, united states’ supplemental brief. supra note 138, at 9. 296. whitman v. american trucking ass’n inc., 531 u.s. 457, 468 (2001). 297. stephen breyer, judicial review of questions of law and policy, 38 admin. l. rev. 363, 370 (1986). 298. id. (cited in food and drug admin. v. brown & williamson tobacco corp., 529 u.s. 120, 159 (2000)). 299. 529 u.s. 120. 300. id. at 147. 301. id. at 160. 302. 512 u.s. 218 (1994). 303. 546 u.s. 243 (2006). 50 florida tax review vol. 15:1 requirement that long distance carriers file their rates. 304 the court found it “highly unlikely that congress would leave the determination of whether an industry will be entirely, or even substantially, rate-regulated to agency discretion—and even more unlikely that it would achieve that through such a subtle device as permission to ‘modify’ rate-filing requirements.” 305 in gonzales, 306 the supreme court held that the attorney general did not have the authority to interpret the controlled substance act to prohibit physicians from prescribing legal medicine to terminally ill patients for the purpose of committing suicide. the court found the “issue of physicianassisted suicide [to be] the subject of an ‘earnest and profound debate’ across the country.” 307 the court therefore found it unlikely that congress would have delegated to the attorney general the authority to resolve that issue. 308 thus, when determining whether congress foreclosed treasury’s interpretation of section 7805(b)(3), courts might also look at the importance of the question that the interpretation would purport to resolve. it is unlikely that many of the questions addressed by treasury would have the same “economic and political significance” 309 as the questions presented in brown & williamson and gonzales. nonetheless, there certainly may be situations in which treasury’s retroactive application of a regulation implicates a “major” issue of taxation law. in fact, with respect to regulation section 1.752-6, had congress not already decided through its enactment of section 358 that contingent liabilities reduced a transferee’s basis in the transferor-corporate stock received in a section 351 exchange, regulation section 1.752-6, which provided for the same adjustments in partnership exchanges, may have been seen to resolve a “major” question of taxation law. as it were, however, regulation section 1.752-6 simply extended section 358’s requirements, which applied to certain section 351 corporate transactions to analogous partnership transactions. thus, the questions resolved in regulation section 1.752-6 seem far closer to the interstitial questions that congress generally intends agencies to answer. in sum, by considering how the treasury department’s interpretation of “abuse” fits (or fails to fit) with the other provisions of the code and the importance of the question the interpretation purports to resolve, courts can come to an informed conclusion about whether congress foreclosed treasury’s interpretation of section 7805(b)(3)’s abuse exception (and thus 304. mci, 512 u.s. at 221. 305. id. at 231. 306. gonzales, 546 u.s. 243. 307. id. at 267. 308. id. 309. food and drug admin. v. brown & williamson tobacco corp., 529 u.s. 120, 147 (2000) 2013] tax abuse according to whom? 51 whether that interpretation can withstand scrutiny under brown & williamson’s formulation of chevron step 1). b. applying chevron step 2 to treasury’s interpretations of section 7805(b)(3) if treasury’s interpretation of section 7805(b)(3)’s abuse exception clears chevron’s first step, it should be upheld so long as it is a “permissible construction” 310 of section 7805(b)(3) that is not “arbitrary, capricious or manifestly contrary to” 311 the plain language of the statute. 1. is treasury’s interpretation of tax abuse within the range of permissible choices? in applying chevron step 2, the supreme court asks whether the interpretation chosen by the agency issuing the regulation is in the range of permissible alternatives. 312 while this standard is high, it is “not necessarily insurmountable.” 313 for instance, in raponos v. united states 314 the supreme court considered the validity of the u.s. army corps of engineers’ (corps) interpretation of the clean water act (cwa), which prohibits pollution of “navigable waters.” 315 “navigable waters” is defined in the cwa to include “the waters of the united states, including the territorial seas.” 316 while the corps initially interpreted “waters of the united states” to include only those waters that are “‘navigable in fact’ or readily susceptible of being rendered so,” 317 it later adopted a far more expansive definition which included “[a]ll 310. chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837, 843 (1984). 311. id. at 844. 312. see, e.g., raponos v. united states, 547 u.s. 715, 731–32 (2006). “we need not decide the precise extent to which the qualifiers ‘navigable’ and ‘of the united states’ restrict the coverage of the [clean water] act. whatever the scope of these qualifiers, the [clean water act] authorizes federal jurisdiction only over ‘waters.’ 33 u.s.c. § 1362(7). the only natural definition of the term ‘waters,’ our prior and subsequent judicial constructions of it, clear evidence from other provisions of the statute, and this court’s canons of construction all confirm that ‘the waters of the united states’ in § 1362(7) cannot bear the expansive meaning that the [u.s. army corps of engineers] would give it.” id. 313. lederman, fighting regs, supra note 26, at 697 (citing judulang v. holder, 132 s. ct. 476, 479 (2011)). 314. 547 u.s. 715 (2006). 315. id. at 723. 316. id. 317. raponos v. united states, 547 u.s. 715, 723 (2006). http://web2.westlaw.com/find/default.wl?mt=208&db=1000546&docname=33uscas1362&rp=%2ffind%2fdefault.wl&findtype=l&ordoc=2009382759&tc=-1&vr=2.0&fn=_top&sv=split&tf=-1&referencepositiontype=t&pbc=0f45878f&referenceposition=sp%3b794b00004e3d1&rs=wlw13.04 52 florida tax review vol. 15:1 interstate waters including interstate wetlands.” 318 the supreme court found that, [t]he only natural definition of the term ‘waters,’ our prior and subsequent judicial constructions of it, clear evidence from other provisions of the [cwa], and this court’s canons of construction all confirm that ‘the waters of the united states’ cannot bear the expansive meaning that the corps would give it. 319 instead, the court found that the term “waters of the united states” could only be interpreted to include “relatively permanent, standing or continuously flowing bodies of water” and did not include “channels through which water flows intermittently or ephemerally, or channels that periodically provide drainage for rainfall.” 320 as a result, the court held that interpreting “waters of the united states” to include wetlands was not “based on a permissible construction of the statute.” 321 thus, in determining whether treasury had adopted a “permissible construction” of section 7805(b)(3)’s abuse exception, courts would apply a very similar analysis as the one described in section iv(a)(4), asking whether congress had unambiguously foreclosed any particular interpretation of “tax abuse.” in other words, the analysis at chevron step 2 might be seen to “fold in” on the inquiry used by the brown & williamson court at chevron step 1, an effect observed by prominent administrative law scholars. 322 regardless of whether the inquiry falls at chevron step 1 or 2, if treasury enacts a retroactive regulation which interprets section 7805(b)(3)’s abuse exception in a way which permits too great an alteration to current tax laws, courts should not hesitate to invalidate that regulation. the 318. id. at 724. 319. id. at 731–32. 320. id. at 739. 321. id. 322. see matthew c. stephenson & adrian vermeule, chevron has only one step, 95 va. l. rev 597, 599 (2009) “step one is therefore nothing more than a special case of step two, which implies that all step one opinions could be written in the language of step two. consider, as an example, fda v. brown & williamson tobacco, in which the supreme court struck down the fda’s assertion of statutory jurisdiction over tobacco products. the court reached this conclusion under step one, asserting that congress had expressed an intention on the ‘precise question’ of whether the fda could regulate tobacco. it would have been equally easy, however, for the court to find under step one that the full scope of the fda’s statutory jurisdiction is ambiguous . . . but to declare that the fda’s assertion of jurisdiction over tobacco products was unreasonable under chevron step two, for precisely the same reasons the court advanced in the actual opinion.” id. at 599–600. 2013] tax abuse according to whom? 53 interpretation of abuse found in the preamble of regulation 1.752-6, however, would not seem to come close to doing so. 2. chevron step 2 as “hard look” review when reviewing agency rules under the administrative procedure act (apa), courts must determine whether the agency action was “arbitrary or capricious. . . .” 323 in this context, a court reviews the process by which the agency arrived at the rule, sometimes referred to as “hard look” review. 324 this review process was articulated in motor vehicle manufacturers association of united states, inc. v. state farm mutual automobile insurance company: 325 the agency must examine the relevant data and articulate a satisfactory explanation for its action including a “rational connection between the facts found and the choice made.” . . . in reviewing that explanation, we must consider whether the decision was based on a “consideration of the relevant factors and whether there has been a clear error of judgment.” . . . normally, an agency rule would be arbitrary and capricious if the agency has relied on factors which congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation for its decision that runs counter to the evidence before the agency, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise.” 326 although the supreme court has not formally adopted this processfocused formulation in determining whether an agency interpretation is “arbitrary and capricious” under chevron step 2, it seems to have equated 323. 5 u.s.c. § 706(2)(a) (2000). 324. see kathryn a. watts, proposing a place for politics in arbitrary and capricious review, 119 yale l.j. 2, n.1 (2009). (“the term ‘hard look’ review developed in the d.c. circuit as a judicial gloss on the meaning of the apa’s arbitrary and capricious test.”) (citing matthew warren, active judging: judicial philosophy and the development of the hard look doctrine in the d.c. circuit, 90 geo. l.j. 2599 (2002)). 325. 463 u.s. 29 (1983). 326. id. at 43 (citing burlington truck lines v. united states, 371 u.s. 156, 83 s. ct. 239, 9 l. ed.2d 207 (1962); bowman transportation, inc. v. arkansas-best freight system, 419 u.s. 281, 285, 95 s. ct. 438, 442 (1974); citizens to preserve overton park v. volpe, 401 u.s. 402, 416, 91 s. ct. 814, 823 (1971)). 54 florida tax review vol. 15:1 the two inquiries in dicta. 327 furthermore, the federal circuit recently found that a treasury regulation was an impermissible interpretation of the code under chevron’s second step because, inter alia, it “violate[d] the state farm requirement that treasury provide a reasoned explanation for adopting a regulation.” 328 for treasury’s interpretation of the abuse exception within section 7805(b)(3) to survive this alternative formulation of chevron step 2, treasury must engage in deliberate efforts to distinguish “abusive” from “non-abusive” transactions and show this analysis in the federal register, explaining its rationale for concluding that a particular transaction (or set of transactions) constitutes abuse. to illustrate, treasury might have bolstered its analysis in the preamble of regulation section 1.752-6 by incorporating the strong arguments advanced by the department of justice in the son-ofboss litigation described in section iv. treasury might have, for example, stated that regulation section 1.752-6 was necessary to prevent abuse for the following reasons:  the transaction addressed by regulation section 1.752-6 is the partnership analogue to the coltec transaction to which code section 358 responds, and without it, section 358 would be rendered “impotent.” 329  “abuse” should be interpreted broadly like the other anti-abuse provisions found in the code and regulations. in fact, it is likely that cobra transactions also violate some of these rules. 330  “abuse” is not synonymous with a lack of economic substance. “statutes can be operated so as to produce various types of abuse” to the point where the 327. but see judulang v. holder, 132 s. ct. 476, 476 n.7 (2011). (“the government urges us instead to analyze this case under the second step of the test we announced in chevron u.s.a. inc. v. natural resources defense council, inc., . . . to govern judicial review of an agency’s statutory interpretations. . . . were we to do so, our analysis would be the same, because under chevron step two, we ask whether an agency interpretation is “arbitrary or capricious in substance.’”) (citing chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837, 104 s. ct. 2778, 81 l. ed.2d 694 (1984)). 328. dominion resources inc. v. united states, 681 f.3d 1313, 1319 (2012). 329. united states v. sala, united states’ supplemental brief. supra note 138, at 9. 330. see generally in re cobra tax shelters litigation, m.d.l. docket no. 1727, united states supplemental memorandum of law in opposition to plaintiff’s motion for partial summary judgment as to the validity of treasury regulation 1.752-6 (s.d. ind.) (apr. 21, 2008). http://scholar.google.com/scholar_case?case=14437597860792759765&hl=en&as_sdt=2,48&as_vis=1 2013] tax abuse according to whom? 55 treasury is “engaged in a perpetual game of catch up with the innovative geniuses” who seek to subvert the tax system and congressional intent. 331 in light of this known environment, congress intended “abuse” to be defined expansively when enacting section 7805(b)(3). in addition to looking at treasury’s analytical process, courts applying this “hard look” version of chevron’s second step might look at the circumstances under which the retroactive regulation has been promulgated. for instance, professor leandra lederman has suggested that if a regulation is promulgated in the course of (or in anticipation of) litigation — as retroactive regulations may relatively often be — courts should consider whether this timing “reflect[s] opportunism rather than careful application of the agency’s expertise.” 332 vi. conclusion before 1996, treasury had broad authority to regulate retroactively. in 1996, however, this authority was dramatically curtailed. as part of the taxpayer bill of rights 2, section 7805(b) prohibited treasury from issuing retroactive regulations unless certain exceptions were met. section 7805(b)(3) allows a regulation issued by treasury to operate retroactively “to prevent abuse.” 333 but congress failed to explicitly define “abuse” or designate to any specific actor the power to do so. generally, when an agency interprets the statute it is entrusted to administer — such as when treasury interprets section 7805(b)(3) of the code — that interpretation is entitled to some level of deference. however, courts that have analyzed whether a treasury regulation may operate retroactively to prevent abuse used administrative law principles recently rejected by the supreme court in mayo foundation v. united states. 334 this article provides the first comprehensive look at the level of deference owed treasury’s interpretation of section 7805(b)(3)’s abuse exception after mayo. this analysis offers a significant contribution. granting treasury some power to issue retroactive regulations can help police and prevent the most egregious tax transactions. however, case law suggests that the courts and treasury have very different interpretations of the code’s abuse exception. the fate of future retroactive tax regulations may, therefore, turn largely on which actor possesses the primary authority to define tax abuse. 331. internal revenue service v. cm holdings, inc., 254 b.r. 578, 624 (d. del. 2000), aff’d, 301 f.3d 96 (3d cir. 2002). 332. lederman, fighting regs, supra note 26, at 698. 333. i.r.c. § 7805(b)(3) (2006). 334. 131 s. ct. 704 (2011). login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe tcharity really does begin at home: florida tax review volume 12 2012 number 1 1 legal ethics and federal taxes, 1945-1965: patriotism, duties, and advice by michael hatfield* i. introduction ................................................................................. 1 ii. legal ethics for tax layers: a review of the 1945-1965 literature ................................................................... 5 a. the literature’s authors ............................................................. 5 b. philosophical professionalism .................................................... 8 c. patriotism .................................................................................. 11 d. duty to the system ..................................................................... 15 e. duty of disclosure ..................................................................... 28 f. practical advice for tax lawyers ............................................. 32 g. reform agenda .......................................................................... 44 iii. reflections.................................................................................. 46 we are professional men not mere hired hands.1 i. introduction in 2013 we will celebrate (or, at least, commemorate) the centurymark of the sixteenth amendment and the federal income tax.2 we should anticipate a flow of historical reflections on this first century of income * j.d., new york university school of law (1996); professor of law, texas tech university school of law; of counsel, schoenbaum, curphy & scanlan, p.c., san antonio, texas. this article was made possible through the support of the glenn d. west research professorship. 1. edmond n. cahn et al., ethical problems of tax practitioners: transcript of the tax law review’s 1952 banquet, 8 tax l. rev. 1, 9 (1952) [hereinafter cahn et al., ethical problems] (statements by jerome hellerstein). 2. u.s. const. amend. xvi. for an introduction to the politics of the sixteen amendment ratification and the 1913 revenue act adoption, see w. elliot brownlee, federal taxation in america: a short history 49–57 (2d ed. 2005) [hereinafter brownlee, taxation in america]. 2 florida tax review [vol. 12:1 taxation.3 these historical reflections on the income tax should develop our understanding of what has changed in the past century, and just as importantly, what has not changed, and will give us some idea of why one change occurred rather than another in any given case. it is likely that these reflections will focus on acts of congress, nearly acts of congress, and acts urged on congress by enthusiastic supporters of one persuasion or another; the ebb and flow of economic theories and fiscal policies; responses to political, business, and technological changes; and, of course, important court cases that went this way and that way and, sometimes, the right way. yet the history of the income tax is, in large part, also the history of tax lawyers. without these lawyers working to interpret the tax code, to advise clients on planning with the tax code, and to advocate for the rights of clients under the tax code, the income tax system would not be what it has become. the role of these lawyers, especially their own sense of right and wrong, is rarely the subject of legal histories. economics, politics, and financial innovations may make better reading, and may be better at explaining legal histories, but legal history includes legal ethics. this article is devoted to exploring the legal ethics writings by tax lawyers in a pivotal period of income tax history: 1945-1965,4 the first two decades of the federal income tax as we now know it. although the income tax began in 1913, it was world war ii that created the modern mass income tax: in 1939 there were 3.9 million individual income tax taxpayers but by 3. such reflection has already begun as a recent symposium was held at duke to examine the history of the federal income tax. the duke symposium included several particularly interesting pieces on “some lesser-known aspects of the history of the federal income tax.” lawrence a. zelenak, foreword: the fabulous invalid nears 100, 73 law & contemp. probs. i, iii (2010). this symposium focused in large part on what professor zelenak described as “losers’ tax history,” — that is “tax roads considered by congress but not taken, or taken briefly and then abandoned” — is particularly obscure. id. at i. one particularly interesting article describes the period in which the government disclosed the tax return information of certain high-income taxpayers, while another explains how close the 1940s proponents of replacing the mass income tax with a sales tax came to victory. marjorie e. kornhuaser, shaping public opinion and the law: how a “common man” campaign ended a rich man’s law, 73 law & contemp. probs. 123 (2010); lawrence a. zelenak, the federal retail sales tax that wasn’t: an actual history and an alternative history, 73 law & contemp. probs. 149 (2010). 4. i have focused on the ethics literatures in the tax law review, the nyu institute on federal income taxation, the usc institute for major tax planning, and taxes, but also reviewed some often-cited pieces from outside these periodicals, such as randolph e. paul, the lawyer as a tax adviser, 25 rocky mntn. l. rev. 412 (1952) [hereinafter paul, tax adviser] (this journal became the university of colorado law review in 1963). 2012] legal ethics and federal taxes 3 1945 there were 42.6 million.5 this period was also one of significant progress in the administration of the income tax: the internal revenue code was re-organized in 1954 and, following widespread corruption scandals, the bureau of internal revenue was re-organized as the internal revenue service.6 thus, the tax lawyers writing on ethics issues during this period were the first generation to be considering the role of the tax lawyer in the modern tax system. perhaps the most importance difference between the income tax system then and now is that the system then enjoyed broad-based and bi-partisan support while imposing an extremely high top-end marginal rate of taxation (91-94 percent for most of this period).7 this income tax system and these writers should also be placed in their even broader social, political, and legal context. these writers belonged to the generation that had confronted totalitarianism, the holocaust, and the 5. though the richest 1 percent accounted for 32 percent of the income tax revenue, by the end of the war, almost 90 percent of the labor force filed income tax returns and 60 percent paid income taxes. the marginal rates of taxation ranged from 50 percent to more than 90 percent during the war. in 1940, the income tax accounted for only 16 percent of all taxes collected at all levels of government, but by 1950 it accounted for more than 51 percent. the implementation of the new mass tax regime “succeeded because of the popularity of the war effort.” the two were connected in the public mind in some part due to a walt disney-produced propaganda cartoon starring donald duck and watched by more than 32,000,000 theatre-going americans in 1942. brownlee, taxation in america, supra note 2, at 115–17. 6. in the early 1950s, a string of corruption scandals prompted congress to investigate the bureau of internal revenue, where it discovered the consequences of political patronage and substantial corruption. more than 200 then-current and former tax officials resigned, were removed, and/or were indicted. in 1952, truman released a plan that reorganized the bureau, and the reorganization carried over into the eisenhower administration. joseph j. thorndike, reforming the internal revenue service: a comparative history, 53 admin. l. rev. 717, 755–59, 761–64 (2001) [hereinafter thorndike, reforming]. 7. “the winning of world war ii and a postwar surge of economic prosperity, which followed so closely on the heels of the great depression, all helped produce a popular, bipartisan consensus of support for sustaining the basic [tax] policy shifts undertaken during the roosevelt administration.” brownlee, taxation in america, supra note 2, at 100–01. this national optimism is reflected not only in the tax policy of the time but also in the baby boom, of course. the highest marginal tax rates during this period were: 94 percent in 1945; 91 percent in 1946-1951; 92 percent in 1952-1953; 91 percent in 1954-1963; 77 percent in 1964; and 70 percent in 1965. the history of federal individual income tax rates is available from the tax foundation. the tax foundation, http://www.taxfoundation.org/publications/show/151.html (last visited jan. 15, 2011) [hereinafter tax foundation]. 4 florida tax review [vol. 12:1 great depression.8 during the time they were writing, the united states engaged in nuclear warfare to end world war ii,9 the cold war began, and the cuban revolution both began and ended.10 senator mccarthy conducted a witch-hunt for communists.11 the rosenbergs were executed for conspiring to commit espionage.12 the soviet union admitted supplying arms to the north vietnamese and demonstrations against the war in vietnam spread.13 the civil rights movement emerged: rosa parks and the students at the lunch counters refused to leave their respective seats, brown v. board of education was handed down, federal troops were sent into arkansas and mississippi, and the voting rights act was passed.14 there were massive labor strikes.15 the president of the united states was assassinated.16 these events should be kept in mind as the literature of the period was read, as these events make clear that the period in which this literature was produced was certainly not simpler, fairer, or more moral than our own. this article is divided into two primary sections. part ii is a description of literature of the era, and part iii is a reflection on the literature. part ii has several parts. it introduces the writers (ii.a) and describes their philosophical professionalism (ii.b) and the patriotic tone of their writings (ii.c). it then describes their debates over a special duty to the system (ii.d) and disclosing arguable points in a tax return (ii.e). it concludes with their practical advice for tax lawyers (ii.f) and their policy suggestions for the tax system (ii.g). the reflective part ii provides historical context and connections between topics that may not otherwise be evident. 8. bernard grun, the timetables of history 522 (3d ed. 1991) [hereinafter grun, timetables]. 9. id. at 524. 10. id. at 528, 542–44. 11. id. at 536. 12. id. 13. grun, timetables, supra note 8, at 554. 14. id. at 538, 550–54. 15. id. at 528. 16. id. at 552. 2012] legal ethics and federal taxes 5 ii. legal ethics for tax lawyers: a review of the 1945-1965 literature a. the literature’s authors the men (and they were all men)17 writing on legal ethics and federal taxes between 1945 and 1965 were professional heavyweights. among them were preeminent tax lawyers who were founders of preeminent law firms. randolph e. paul was a founder of paul, weiss, rifkind, wharton & garrison.18 mortimer m. caplin was a founder of caplin & drysdale.19 merle h. miller was a founder of (the firm now known as) ice miller.20 17. throughout these essays, i have intentionally followed these writers’ use of masculine pronouns and references to lawyers exclusively as male. this underscores what a different world it was in which these men wrote, as well as underscoring how that different world was not long ago or in a place far away. 18. after graduating from new york law school, mr. paul began his law career as a switchboard operator at a new york firm. five years into his career, he accepted a job from a tax attorney — and eventually would become an architect of the modern income tax system. he was one of the most influential tax advisors to president roosevelt, arguing the adoption of a keynesian approach to regulating the economy through tax policy. in his private practice, his clients included henry ford, standard oil co., and general motors. he was also a prolific writer. he died while testifying before a congressional committee — complaining about president eisenhower’s tax policies. tax history project, historical perspectives, profiles in tax history: randolph e. paul, http://www.taxhistory.org/thp/readings. nsf/cf7c9c870b600b9585256df80075b9dd/afd2a67073f6b87085256f8600681f74?o pendocument (last visited jan. 16, 2011) [hereinafter tax history project]. 19. see, e.g., mortimer m. caplin, what is good tax practice: a statement of the problem and the issues involved, 21 n.y.u. ann. inst. on fed. tax’n. 9 (1963) [hereinafter caplin, good tax practice]. mortimer m. caplin practiced law in new york city from 1941 to 1950 (except for his time in military service) and then begin teaching at the university of virginia school of law in 1950. in 1961, he was appointed u.s. commissioner of internal revenue where he served until july 1964, when he resigned to form the law firm caplin & drysdale. on leaving the u. s. government, he received the alexander hamilton award, the highest award conferred by the secretary of the treasury, for his “distinguished leadership.” he is also the recipient of the achievement award from the tax society of new york university; judge learned hand human relations award, american jewish committee; tax executives institute distinguished service award; veterans of foreign wars public service award; and the virginia state bar and virginia society of certified public accountants award. he has received honorary degrees from the university of south carolina, washington college, and st. michael’s college. virginia law, mortimer m. caplin, http://www.law.virginia.edu/lawweb/ faculty.nsf/fhpbi/mcaplin (last visited mar. 28, 2011) [hereinafter virginia law]. 20. see merle h. miller, morality in tax planning, 10 n.y.u. ann. inst. on fed. tax’n. 1067 (1952) [hereinafter miller, morality]. merle h. miller was 6 florida tax review [vol. 12:1 others were tax partners in prestigious firms. norris darrell was a partner in sullivan & cromwell.21 adrian w. dewind was a partner in paul, weiss, rifkind, wharton & garrison.22 thomas n. tarleau was a partner in willkie farr & gallagher.23 and, of course, some of the writers were well known with the office of chief counsel of the bureau of internal revenue prior to joining ice miller as a partner in 1940 and beginning the firm’s federal tax practice. jerry crimmins, ice, miller celebrates its 100th anniversary, ice miller law bulletin, (apr. 12, 2010) http://www.icemiller.com/enewsletter/ice.news/im_100_law_ bulletin.htm. he was instrumental in founding the indianapolis affiliate of the american civil liberties union (aclu) — some in the indianapolis legal community believed that the aclu was connected to communism, but mr. miller and his firm believed that the aclu was good for the law profession and the community they served. ice miller, l.l.p., firm history, http://www.icemiller. com/firm_history.aspx (last visited jan. 17, 2011). mr. miller and his firm partner harry ice were both eagle scouts, and they founded the i and m firesets company to manufacture and sell flint and steel fire starting kits to boy scouts. the company was later passed down through the hands of various scouts and troop leaders in indianapolis. ice miller, l.l.p., firm fact sheet for 100 year celebration, http://www.icemiller.com/news/100yearfacts.htm (last visited jan. 17, 2011). 21. norris darrell, some responsibilities of the tax adviser in regard to tax minimization devices, 8 n.y.u. ann. inst. on fed. tax’n 983 (1950) [hereinafter darrell, tax minimization devices]. “mr. darrell was a partner of sullivan & cromwell for 42 years and president of the american law institute for 15 years. he represented the law firm in paris and berlin from 1928 to 1930 and was made a partner in 1934. he was elected to the council of the american law institute in 1947 and headed a project that laid the groundwork for the internal revenue code of 1954. he retired in 1976, n.y. times, norris darrell, lawyer and tax expert, 90, (aug. 15, 1989), http://www.nytimes.com/1989/08/15/obituaries/norris-darrelllawyer-and-tax-expert-90.html [hereinafter, n.y. times]. mr. darrell was the son-inlaw of legal legend learned hand and, as the executor of his estate, was instrumental in assisting hand’s former clerk and stanford law school professor gerald gunther write a biography of the famed jurist. see gerald gunther, ‘contracted’ biographies and other obstacles to ‘truth,’ 70 n.y.u. l. rev. 697 (1995). 22. in addition to serving as the head of the tax department at paul, weiss, rifkind, wharton & garrison, working at the treasury department drafting legislation to fund the war, and advising presidents john f. kennedy and lyndon b. johnson, mr. dewind became a founder of human rights watch and served on the boards of the naacp legal defense and educational fund, the national coalition against censorship and the lawyers alliance for nuclear arms control. dennis hevesi, adrian dewind, tax expert and human rights watch founder, dies at 95, n.y. times, (aug. 19, 2009), http://www.nytimes.com/2009/08/19/nyregion/ 19dewind.html. 23. boris i. bittker, professional responsibility in federal tax practice xi (1965) [hereinafter bittker, professional responsibility]. 2012] legal ethics and federal taxes 7 law professors: professor john m. maguire (harvard),24 professor john potts barnes (virginia),25 professor edmond cahn (new york university),26 professor jerome hellerstein (new york university),27 dean erwin n. griswold (harvard),28 and professor boris bittker (yale), who authored more than 15 books and whose name is a contemporary synonym for tax treatises.29 many of these writers were also significantly involved in government, politics, and the social and legal movements of the day. randolph e. paul was one of the most influential tax advisors to president roosevelt, arguing the adoption of a keynesian approach to regulating the economy through tax policy.30 norris darrell was president of the american law institute for 15 years and also worked on the groundwork for the internal revenue code of 1954.31 mortimer m. caplin was the commissioner of the internal revenue service under john f. kennedy, during a time of significant tax reform.32 dean erwin n. griswold joined the lyndon b. johnson administration as solicitor general, and then continued as solicitor general in the richard m. nixon administration, eventually arguing over 100 cases before the supreme court (including the pentagon 24. john m. maguire, conscience and propriety in lawyer’s tax practice, 13 tax l. rev. 27 (1957) [hereinafter maguire, conscience and propriety]. 25. john potts barnes, the lawyer and the voluntary assessment system, 40 taxes 1034 (1962) [hereinafter barnes, voluntary assessment system]. 26. see cahn et al., ethical problems, supra note 1. see also edmond n. cahn et al., what makes a successful tax lawyer? a tax law review symposium, 7 tax l. rev. 1 (1951) [hereinafter cahn et al., successful tax lawyer]. 27. see cahn et al., ethical problems, supra note 1, at 4. (mr. hellerstein contributed a paper entitled “ethical problems in office counseling” at the symposium banquet). 28. see erwin n. griswold, the blessings of taxation: recent trends in the law of federal taxation, a.b.a. j., dec. 1950, at 999 [hereinafter griswold, blessings of taxation]. 29. bittker, professional responsibility, supra note 23. for tax lawyers, professor bittker needs no footnoted introduction. he wrote over 100 articles and at least 15 books. however, his focus was always on his students. at one point he even told the shah of iran that he could not work on his tax case, no matter what the pay, until after the current semester. he began his teaching career at yale law school only four years after graduating from the school. professor bittker was also an environmentalist who served many years as a trustee with the natural resources defense council, an avid adventurer, and tremendous photographer. see yale law report, boris i. bittker 1916 – 2005, http://www.law.yale.edu/ ylr/pdfs/v53-1/531bittker.pdf (last visited jan. 16, 2011). 30. see tax history project, supra note 18. 31. see n.y. times, supra note 21. 32. see virginia law, supra note 19. 8 florida tax review [vol. 12:1 papers case).33 merle h. miller was a founder of the american civil liberties union in indianapolis.34 adrian dewind was a founder of human rights watch and served on the boards of the naacp legal defense and educational fund, the national coalition against censorship and the lawyers alliance for nuclear arms control.35 professor boris bittker was a trustee with the natural resources defense council36 and professor edmond cahn wrote broadly, authoring books such as the sense of injustice — an anthropocentric view of the law (new york university press, 1949), the moral decision — right and wrong in light of american law (indiana university press, 1955), and the predicament of democratic men (macmillan company, 1961). b. philosophical professionalism the tax bar of this time evidenced a remarkable philosophical sensitivity. in 1949, for example, the committee on state and federal taxation of real property, probate and trust law of the american bar association issued a report on the importance of natural law for tax jurisprudence.37 the report began: [t]axation both in its purpose and its method, is at once a function of government, and, under a philosophy of government by law rather than by men, a process of law. as a function of government, taxation, therefore, of necessity finds roots and justification in the philosophy of government. as a process of law by which it, as a function of government, is exercised, it of necessity finds its roots and justification in the philosophy of law.38 having framed taxation between philosophy of government and philosophy of law, the report continued that “tax laws must of necessity be subject to, and limited by, certain basic underlying moral principles by virtue of our 33. associated press, erwin n. griswold; former solicitor general, l.a. times (nov. 21, 1994) http://articles.latimes.com/1994-11-21/news/mn-65525_25_ 1_solicitor-general. 34. see darrell, tax minimization devices, supra note 21. 35. see supra note 22. 36. see bittker, professional responsibility, supra note 23. 37. joseph f. mccloy et al., the moral issue, 27 taxes 9 (1949) [hereinafter mccloy et al., moral issue] (this was a portion of a report mr. mccloy, chairman of the committee on state and federal taxation, section of real property, probate and trust section, presented to the committee at a prior meeting). 38. id. 2012] legal ethics and federal taxes 9 american philosophy of government and law,” which the report identified as “the unchanging principles of the natural law.”39 the report then explains implications of these moral principles, such as taxes being rightfully imposed only to secure material, spiritual, and social rights of the governed, and that “in imposing taxes, a due proportion to the wealth of each citizen must be observed, as distributive justice demands, so that the burden will not exceed the resources of the individual and he will be proportionately compensated by the services which come to the people from the tax money.”40 the impetus for this report appears to have been concern about the influences of legal realism, which “conceives the law to be the rule of conduct imposed in specific situations by our courts and based upon the court’s interpretation of the feelings, morals and other standards of conduct currently prevailing in the community.”41 the committee warned that legal realism was contrary to natural law, and that it elevated the authority of courts at the expense of the authority of “the supreme lawgiver, man’s creator.”42 the tax bar’s philosophical orientation was broader than philosophy of law. this broad interest was on full display at the 1952 tax law review banquet, which was dedicated to discussing ethical problems of tax practitioners. the discussion began with topics such as preparing corporate records to justify accumulating earnings to expand the business (when the purpose for accumulation may have been more the lawyer’s idea than the client’s) but developed into an argument over “whether our generation is worse or better than previous generations have been.”43 thomas n. tarleau maintained that americans were not “in a degenerate age” but merely “a more self-conscious age,” while professor edmond cahn maintained that americans of the day were too “outer-directed,” insufficiently “innerdirected,” and generally too conformists with “the obsessive need to be like everyone else.”44 in good law professor style, dean miguel a. de capriles (new york university) framed another argument of the evening as “the problem of obedience to the unjust law,” questioning the tax lawyers — without explanation or follow-up — with “it seems to me that we are taking for granted, are we not, that the socratic answer is still the right one?”45 that there would be a banquet discussion on the ethical problems of tax practitioners evidences the concern these men had for the state of their 39. id. 40. id. at 10–11. 41. id. at 10. 42. mccloy et al., moral issue, supra note 37, at 10. 43. cahn et al., ethical problems, supra note 1, at 15 (remarks of bruno schachner). 44. id. at 2, 10, 14. 45. id. at 23 (statement of miguel a. de capriles, dean at new york university school of law). 10 florida tax review [vol. 12:1 profession in 1952. if “civic and moral obligations were being fulfilled currently to even a reasonably satisfactory extent, they would not have played so significant a part in the discussion” at the banquet.46 on the one hand, there was concern regarding widespread ethical failures among tax lawyers47 but, on the other hand, there was comfort in the progressing ethical sensitivity of lawyers — or at least an increase in their discussions of ethics.48 professor john potts barnes characterized the increase as a “sudden burst of interest in the tax lawyer’s ethics.”49 he wondered if this burst was a passing fad of the sort that often makes the rounds of lawyers meetings,50 a reflection of great failings among tax lawyers, or a reflection of a more general “awakening of lawyers generally to the need . . . for shoring up the ethical foundations of the profession.”51 he decided, however, that this burst of interest was due to “the realization . . . of the special significance of the tax lawyer’s ethical standard,” especially in a voluntary assessment system.52 there was a chorus of calls for greater definition of the tax lawyer’s ethical standard. mortimer caplin described the need for “authoritative guidance in prelitigation tax practice,” including an identification of “practices which, though not necessarily in technical violation of an ethical code, are, in the words of mr. justice stone . . . looked upon . . . as ‘things that are not done.’”53 norris darrell was comforted by the increase in legal ethics discussions at conferences and by committees, and hoped the tax bar would become more involved.54 professor john m. maguire had a more specific hope: for the full connotations of the tax lawyer’s special obligations 46. cahn et al., successful tax lawyer, supra note 26, at 18. 47. cahn et al., ethical problems, supra note 1, at 32 (statements of jerome r. hellerstein). 48. norris darrell, the tax practitioner’s duty to his client and his government, 7 prac. law. 23, 39 (1961) [hereinafter darrell, tax practitioner’s duty] (this article was based on various addresses, including the n.y.u. institute on federal taxation in 1958 where it was subsequently published). see darrell, conscience and propriety in tax practice, infra note 82; paul, tax adviser, supra note 4, at 412. 49. barnes, voluntary assessment system, supra note 25, at 1034. 50. describing fads in subjects discussed at legal conferences, he wrote “i have observed that a subject considered a lively one for discussion at one tax conference is not unlikely to appear on the program of another and another and to be written about until it has lost the appeal of both novelty and timeliness.” id. i suppose this is as true today as then. 51. id. 52. id. 53. mortimer m. caplin, responsibilities of the tax adviser — a perspective, 40 taxes 1030, 1031 (1962) [hereinafter caplin, perspective]. 54. darrell, tax practitioner’s duty, supra note 48, at 39–40. 2012] legal ethics and federal taxes 11 to be “spelled out” by a bar committee;55 that is, for the tax bar to be given “marching orders” in “a number of commonplace situations produced by tax practice.”56 the concern for the ethical well-being of the tax bar was not limited to committee-crafted solutions to commonplace situations, however. there was a concern that deeper problems were eroding the profession. sensitive to the increasing time and energy required to be expanded by tax lawyers, professor cahn bemoaned the “steady-flowing river of texts, services, and articles” about taxation that “any tax expert, who is unfortunately required to earn his living while trying to maintain his expertness” must read in order to keep up-to-date.57 worse, he feared that lawyers were becoming the “jackals of the bourgeoisie,” desiring only to “live the same lives, obtain for their wives the same type of coats, and ride around in the same automobiles” as their “mercantile neighbors.”58 when arguing that “we may be fast losing our status as a profession and becoming nothing more than skilled merchantclerks,”59 he thought this loss followed the loss of the sense of “moral responsibility” and “civic nobility.”60 he described the deeper problem as lawyers succumbing to an emerging “obsessive need” in american culture to “be like everyone else, to have the same possessions as everyone else, to follow the same pattern in the pursuit of material goods.”61 the result was that as lawyers gave into this consumerism, its mentality would transform them into being “what the communists have always said the lawyers were in a capitalist society . . . jackals of the bourgeoisie.”62 c. patriotism nineteen fifty-two was the year of the philosophically reflective tax law review banquet, and also a year in which the cold war was heated. there were large scale bombings in korea (the armistice came in 1953) and 55. maguire, conscience and propriety, supra note 24, at 48. 56. id. at 45. 57. cahn et al., successful tax lawyer, supra note 26, at 2–3. randolph e. paul described the “wearisome quota of suggestion and criticism and dogma” that “constantly pour[s] out” from tax magazines and journals. randolph e. paul, the responsibilities of the tax adviser, 63 harv. l. rev. 377, 378 (1950) [hereinafter paul, responsibilities] (this article is an adaptation, with minor revisions, of an address before the 1949 second annual institute on federal taxation, university of southern california school of law). he even footnotes to an “inventory of the growing mass of tax materials.” id. at n.8. 58. cahn et al., ethical problems, supra note 1, at 2. 59. id. 60. id. at 3. 61. id. at 2. 62. id. 12 florida tax review [vol. 12:1 the communistic threat was on the minds of americans. in professor cahn’s mind, individuality, moral responsibility, and civic nobility buttressed lawyer professionalism against the potentially accurate criticisms of the communists. merle h. miller sounded a very similar tone, praising an intentional and international movement of “moral re-armament” as perhaps “the most potent challenge to communism in the struggle for men’s minds,” and framed moral appeals to fidelity to the tax law in this context.63 to mr. miller, the time was one in which there was a “great battle between the west and east” in which good tax lawyers contributed “greatly to the well being of the country at large” by “kill[ing] off a bad tax scheme.”64 in this time of great battle, he did not think any tax lawyer wanted to be known for drafting minutes giving “reasons for not paying out dividends” or writing “long instruments setting up tricky trusts.”65 for mr. miller, the risk that american capitalism might fail in this great battle was real, and it was the touchstone for developing sound tax law ethics: we are engaged in a most challenging economic struggle. before too many years will be answered the question as to which economic system is more efficient, that in which the properties are owned by the government and operated by government employees, or that in which the people own the sources of production, the factories, the distribution facilities, and from these sources of wealth chip in their share toward assembling resources to be used for the common defense and general welfare of the people. it is the system of taxation which supplies the very life blood of the government operating under the latter system . . . .66 mr. miller characterized the situation as “the present emergency,” and thought a tax lawyer ought to “do his best to maintain in his fellow citizens a proper respect for the methods we have set up under a democratic system for the collection of each citizen’s share” of the burden of responding to the 63. miller, morality, supra note 20, at 1068. the reference to “moral rearmament” appears to be to the group begun by american lutheran minister frank buchman, which is now known as the initiatives of change international. mr. buchman’s philosophy of moral awakening was very influential at this time. though not much discussed today, the organization was very active at the end of world war ii, but may be best known today for its connections with the founding of alcoholics anonymous. see initiatives of change international, http://www.iofc.org/history (last visited jan. 15, 2011). 64. miller, morality, supra note 20, at 1076. 65. id. at 1075. 66. id. at 1082–83. 2012] legal ethics and federal taxes 13 emergency.67 merle h. miller believed that despite feeling that he was personally “carrying the full brunt of our defense effort” by paying large tax liabilities, “i can pay the full liability as shown, with even some concessions in the knowledge that a great deal more would not be an overpayment for the privilege of american citizenship.”68 (anecdotal evidence suggests that some clients may have felt similarly69). dean griswold compared the need for increased revenue during the cold war to the need for increased revenue during the “past ten years . . . devoted to protecting us against the nazi aggression,” concluding that there were no expenditures americans could make that would “benefit us more than that we pay to the government in taxes [.]”70 indeed, he wrote that “taxation is a benefit, not a curse” in that it finances our organized society, and that rather than “groaning about the burden of taxes” on our money we should remember that we would not have had money, had it not been for what taxes finance.71 during this threat to national security, it was important to remember the benefits of taxation he argued, because “the present state of the world, and the need for protecting ourselves from the threats directed at our society,” meant an increased tax burden, and the prospect of keeping the war (and communism) localized meant that it would be cheaper to pay “its cost currently, and we will be better off in the long run if we do.”72 he was worried that in the “midst of a real shooting war” in korea, the unfairness of the tax law would be increased through “loopholes and special privileges” and “handouts,” such as those for the “oil and gas interests.”73 the need for a high tax burden and the unfairness of its distribution prompted dean griswold to argue that tax lawyers had a “public responsibility” to work to ensure that the tax burden was distributed fairly.74 he lamented the tax bar’s failures with this responsibility during this threat to the national security.75 67. id. at 1083. 68. merle h. miller, a taxpayer’s duty to his fellow taxpayers, 19 n.y.u. ann. inst. on fed. tax’n. 1, 9 (1961) [hereinafter miller, taxpayer’s duty]. given the tax rates of the day, one wonders the effective tax rate under which mr. miller did labor — he may have good reason to feel as if he were personally carrying a great share of the defense burden. 69. bittker, professional responsibility, supra note 23, at 104–05. 70. griswold, blessings of taxation, supra note 28, at 1002. in reflecting on the supreme court’s tax jurisprudence during the war against nazi aggression, it is interesting that he concluded the court favored the government in those in some part “because there was a war on.” id. at 1000. 71. id. at 1002. 72. id. 73. id. at 1057. 74. id. 75. griswold, blessings of taxation, supra note 28, at 1057. 14 florida tax review [vol. 12:1 other writers also referenced the cold war in the tax ethics context. mortimer caplin pointed out that “our strength as a nation is dependent upon our ability, year after year, to raise many billions of dollars,” much of which was specifically for the sound financing of “our defense programs” and “missile and space programs.”76 according to dean griswold, the privileges of american citizenship were not limited to personal safety but, included effectively financing collective improvements to society,77 and by another writer more specifically included financing “social security, unemployment insurance, four-lane highways and other blessings of modern government.”78 merle h. miller directly connected the efforts of revenue agents with those who work on “the assembly lines where are built the rockets and missiles to provide our security” and “those in the armed forces,” writing that it is the revenue agents who are responsible for securing the funds to pay the assembly workers and armed forces members.79 robert n. miller echoed this characterization, writing that the agents were “patriotic” and “sustained in their work by a justifiable pride in their organization.”80 he pointed out that it was a “vital duty of the treasury . . . to maintain dignity and self-respect in this body of men on whom the government must rely for every dollar of the government’s revenue.”81 on the one hand there was a theme of characterizing the revenue agents as important enlistees in the cold war, since it was their work collecting the funds that made the government’s spending possible, but, on the other hand, the need to police a mass tax touched concerns especially acute during the cold war. both robert n. miller and norris darrell thought it was very important that tax administration be conducted without descent into a “terrorizing” or “police state” mentality on behalf of the revenue agents, further reflecting cold war distinctions between the u.s. and communist regimes.82 mortimer caplin expressed concern that “the huge sums needed to finance our government” be raised without violating our “democratic traditions.”83 and professor boris bittker raised the fear of “big brother,” warning that too close a sympathy for the revenue-collecting 76. caplin, good tax practice, supra note 19, at 9. 77. griswold, blessings of taxation, supra note 28, at 1002. 78. peter james wikel, grandfather paid taxes too, 37 taxes 329 (1959). 79. miller, taxpayer’s duty, supra note 68, at 8. 80. robert n. miller, human elements in the federal tax system, 10 n.y.u. ann. inst. on fed. tax’n 1049, 1050 (1952). 81. id. 82. id.; norris darrell, conscience and propriety in tax practice, 17 n.y.u. ann. inst. on fed. tax’n. 1, 23 (1959) [hereinafter darrell, propriety in tax practice]. both robert miller and mr. darrell tied this concern with the honesty of taxpayers. 83. caplin, good tax practice, supra note 19, at 13. 2012] legal ethics and federal taxes 15 necessities may lead to the belief that the treasury department “represents ‘all of us’ and hence embodies a virtue superior to that of any of us.”84 d. duty to the system is the tax lawyer a special species of lawyer, one with special duties not shared by other lawyers? the legal ethics writers in this time wrote of tax lawyers’ “duties,” “roles,” “relationships,” “responsibilities,” “loyalties,” and “obligations”85 owed to clients, as well as those owed to the “government,” the “treasury,” “our government and its agents,” the “public interest,” the “country,” “society,” the “state,” “other taxpayers,” “professional responsibility,” “public responsibility,” and the “united states.”86 some writers described the tax lawyer as having a “double” or “dual” sets of duties (e.g., “dual responsibility to his client and the 84. bittker, professional responsibility, supra note 23, at 268. professor bittker’s allusion suggests a study of references to contemporary literature in tax literature might be interesting. 85. e.g., cahn et al., ethical problems, supra note 1, at 9 (“duty” was used by professor hellerstein); miller, morality, supra note 20, at 1081, (“duty” was used by mr. m. miller); miller, taxpayer’s duty, supra note 68, at 5 (“role” was used by mr. m. miller); h. brian holland et al., what is good tax practice: a panel discussion, 21 n.y.u. ann. inst. on fed. tax’n.23, 25 (1963) [hereinafter holland et al., panel discussion] (“obligation,” “loyalty,” “responsibility,” and “relationship” were used by in the headings and in the text of seymour s. mintz’s remarks); bittker, professional responsibility, supra note 23, at 241 (“responsibility” was used by professor bittker). 86. e.g., mark h. johnson, does the tax practitioner owe a dual responsibility to his client and to the government? — the theory, 15 u.s.c. l. sch. inst. on major tax planning 25 (1963) [hereinafter johnson, theory] (using the term “government”); milton young, does the tax practitioner owe a dual responsibility to his client and to the government? — the practice, 15 u.s.c. l. sch. inst. on major tax planning 39 (1963) (using the term “government”); barnes, voluntary assessment system, supra note 25, at 1036 (using the term “government”); cahn et al., ethical problems, supra note 1, at 10 (“treasury” was used in the statements by thomas tarleau); miller, morality, supra note 20, at 1081, 1083 (using the term “our government and its agents” and “country”); maguire, conscience and propriety, supra note 24, at 44 (using the term “public interest”); darrell, propriety in tax practice, supra note 82, at 2 (using the term “society”); caplin, good tax practice, supra note 19, at 25 (using the term “society”); holland et al., panel discussion, supra note 85, at 25 (mr. mintz used the term “state” and hugh f. culverhouse used the term “other taxpayers”); bittker, professional responsibility, supra note 23, at 95 (statement by norris darrell using the term “professional responsibility”); bittker, professional responsibility, supra note 23, at 241 (professor bittker used the term “united states”); and caplin, perspective, supra note 53, at 1032 (using the term “public responsibility”). 16 florida tax review [vol. 12:1 government,”) and at least one described a “triple” set of responsibilities.87 while the discussion was generally limited to “our” government, a question was raised as to whether or not the same duty owed to “our” government was also owed to other governments.88 professor jerome hellerstein premised his description of a tax lawyer’s duty to the system on denying that the citizen’s relationship to his government was comparable to a plaintiff’s adversarial relationship with a defendant.89 professor hellerstein argued that a citizen owes “his government and his neighbors the duty of paying his share of taxes,” even though doing so may get him labeled as a “sucker” in the business community.90 he argued that tax lawyers “owe to our government and to ourselves” the use of “our skill and experience and the great confidence which our clients repose in us . . . to improve the tax morality of the community.”91 professor hellerstein’s objective for tax lawyers was to develop a sense in the general community and in clients specifically that citizens should pay their share of taxes. specifically, he argued for developing “generally ethical standards which require full and fair disclosure by the taxpayer, [and] which abhor fraud, whether obvious or cloaked in elegantly drawn documents or befuddled by the stretching of judgments or the magnifying of doubts.”92 he described this duty as the need to “curb the excesses of the businessmen whom we represent.”93 he suggested these ethical standards were necessary to avoid “moral schizophrenia or chaos.”94 he thought that accomplishing this goal would require tax lawyers to change their sense of duty, at least in some particulars, but that doing so would lead to tax lawyers living “happier lives,” as well as to a “fairer distribution of the tax results.”95 professor hellerstein’s references to disclosure and fraud, as well as his desire to enlist tax lawyers to improve tax morale, indicated that his 87. holland et al., panel discussion, supra note 85, at 29 (mr. crane c. hauser included a duty to one’s self (i.e., professional reputation)). 88. maguire, conscience and propriety, supra note 24, at 36; darrell, propriety in tax practice, supra note 82, at 2; bittker, professional responsibility, supra note 23, at 97. 89. cahn et al., ethical problems, supra note 1, at 9 (statements of jerome r. hellerstein). 90. id. 91. id. 92. id. 93. cahn et al., successful tax lawyer, supra note 26, at 14. 94. see cahn et al., ethical problems, supra note 1, at 9 n.4 (citing m.r. cohen & f.s. cohen, readings in jurisprudence and legal philosophy 595 (1951)). 95. id. at 32. 2012] legal ethics and federal taxes 17 understanding of the duty to the system was oriented primarily on the duty to undermine abuses and evasion. the duty to the system, in his mind, was the duty to refrain from acts such as backdating documents or advising clients to take unauthorized deductions96 — activities that he thought were “widespread.”97 thus, while he argued for a duty to the system, other than the duty to improve tax morale, the duties he had in mind were not clearly beyond those applicable to all lawyers. professor john m. maguire separated the tax lawyer’s duties into two categories. the first category consisted of duties applicable to tax controversies handled by the courts. when tax controversies reached the courts, tax lawyers had “few if any ethical problems differing from those encountered by trial lawyers generally.”98 the second category consisted of tax controversies prior to their submission to the courts. with these matters, tax lawyers had a “double responsibility,” one to the client and one to the public interest.99 professor maguire did not attempt to explicate the details of these “additional obligations” on tax lawyers, but instead called for the full connotations of these obligations to be “spelled out,” perhaps, by a committee of the american bar association section of taxation.100 he did not consider this to be a speculative matter, but instead a specific derivation of guidance from the general standards of circular 230.101 while he was mostly concerned for a “systematic” approach to be articulated by a bar committee, he also thought individuals and firms should consider framing their own code for navigating their obligations.102 professor maguire premised the defense of tax lawyers’ special obligations on the idea that the revenue system simply required “a high degree of acquiescence and cooperation from taxpayers and their experts.”103 in other words, in his view, the need to have a “proper pattern” for tax lawyer conduct was related to the income tax being “a system of voluntary compliance”104 with the details of these duties being grounded in the treasury department’s regulation of tax lawyers.105 professor maguire’s concern with the duty to the system was not related to philosophical reflections on tax lawyering, but instead related to the tax bar’s need for 96. id. at 5, 7. 97. id. at 5. 98. maguire, conscience and propriety, supra note 24, at 30. 99. id. at 44–45. 100. id. at 48. 101. id. 102. id. at 46. 103. maguire, conscience and propriety, supra note 24, at 45. 104. id. at 28. 105. id. at 45. 18 florida tax review [vol. 12:1 “marching orders” in “a number of commonplace situations produced by tax practice.”106 thomas n. tarleau characterized the ethical problems encountered by tax lawyers as “largely the same as those of any lawyer dealing with an adversary.”107 he wrote that no lawyer, including a tax lawyer, is entitled to engage in “trickery” or make false statements or misrepresentations.108 every adversarial conflict in the legal system brings into tension the lawyer’s responsibility to his client and “his ethical responsibilities as a member of the bar,” and so, in large part, the same responsibilities that are generally applicable to lawyers cover the ethical problems raised in tax practice. 109 however, mr. tarleau argued that tax lawyers are special in two ways. first, tax lawyers always have the same party on the other side: the treasury department.110 second, tax lawyers are also enrolled members of the treasury department’s bar.111 one of the most striking consequences of this distinctiveness is that unlike other lawyers who are “free to furnish his adversary facts or refuse to furnish them,” mr. tarleau believed that the treasury department is entitled to all pertinent information and the tax lawyer is obligated to provide it.112 there is no tactical choice available on providing information. this means, he thought, that the tax lawyer always has “an obligation to engage in open-handed dealing with the representatives of the department” when it came to the facts.113 he believed such an obligation was sensible because the taxpayer has sole “control of the facts.”114 there are limits and complications to disclosure, of course. mr. tarleau considered the limits of disclosure provided by the attorney-client privilege, but also situations in which he argued the privilege is not available, such as return preparation.115 he also emphasized the threshold issue of determining whether or not particular facts are “material” and must be 106. id. 107. cahn et al., ethical problems, supra note 1, at 10. 108. id. 109. id. 110. id. at 13. 111. id. at 10. 112. maguire, conscience and propriety, supra note 24, at 11. 113. id. at 12. 114. id. he also argued that a lawyer taking care to deliver the pertinent facts and vouch for their accuracy “insures and protects his own most available asset — his good reputation.” id. at 13. query the relevance of the professional reputation of the attorney. this is his goodwill. it benefits all of his clients. however, there may be a conflict between his clients. by disclosing unfavorable facts in one client’s situation, the lawyer may thereby purchase a greater goodwill with the agent who may help with other clients but the disclosure will hurt this one. 115. id. at 14. 2012] legal ethics and federal taxes 19 disclosed or “merely evidentiary” and accordingly need not be disclosed.116 thus, while mr. tarleau argued that a general obligation to disclose facts to the treasury department makes the practice of tax law inherently distinctive, he did not conclude this was a blanket obligation. merle h. miller premised the tax lawyer’s duty to the system on patriotism. he wrote that a tax lawyer owes a great duty the country that has educated him, and made possible his present success. he must do his best to maintain in his fellow citizens a proper respect for the methods we have set up under a democratic system for the collection of each citizen’s share to meet the present emergency [i.e., the cold war.] he must inculcate in each citizen a respect for the system, and a proper respect for the part which honesty plays in that system. it is an awesome responsibility. pray god that we may have the moral caliber to meet it.117 mr. miller waxed eloquently about the duty to avoid “aiding and abetting taxpayers in their suspicion, distrust[,] and even animosity toward those who are writing and enforcing our tax laws.”118 he understood why a “layman” might interpret particular applications of the tax law as arbitrary, and thus the tax lawyer “who should be seeing the overall picture with its many insolvable problems” ought to increase the layman’s respect for the system.119 he thought that a lawyer in another field may be permitted to “indulge himself in the luxury of agreeing with his client as to everything the client said about the opposing party,” but this indulgence is not available to the tax lawyer.120 instead, the tax lawyer is obligated to correct his client’s misconceptions of the system, urging on the client not only respect for the system but an appreciation of the importance of honesty in their compliance with the system.121 mr. miller described the american system as “an honor system,” that was necessary to supply the “very life blood of the government” as it engaged in the struggle against communism.122 for mr. miller, the tax lawyer’s duty to “our government and its agents” was the duty 116. id. at 11. 117. miller, morality, supra note 20, at 1083. 118. id. at 1081. 119. id. 120. id. at 1081–82. 121. id. at 1083. 122. miller, morality, supra note 20, at 1083. 20 florida tax review [vol. 12:1 to encourage honesty and compliance in taxpayers, a duty which was especially important given the cold war’s demands.123 mr. miller’s philosophy of tax lawyering did not merely emphasize the duty of tax lawyers and taxpayers to the government, but also highlighted the “moral obligations owing by taxpayers one to another, because of their reciprocal positions as taxpayers.”124 stressing that “no taxpayer lives alone,” he noted that “most of us recognize a duty, whether or not enacted into law, to govern our acts with due regard to the effect which our conduct may have on others.”125 mr. miller was especially concerned with how the acts of taxpayers “affect other taxpayers favorably or adversely.”126 he described the consequences of these acts in several situations, such as how a taxpayer’s experience with a revenue agent may in large part reflect that revenue agent’s experience with other taxpayers.127 if a revenue agent has been dealing with a very resistant taxpayer, he will have one sort of attitude, but if the revenue agent has been dealing with a “victim” who gave up some “absurd concession,” he will have quite another attitude.128 another example noted by mr. miller was how taxpayers affect one another by using overworked gimmicks.129 the effect of these acts is such that we should realize that “most of our woes are brought upon us not by the original voluntary acts of congress or the dyspepsia of the revenue agent, but as the inevitable result of fellow taxpayers who took a good thing too far . . . .”130 mr. miller emphasized that when it comes to “pick[ing] up any part of the tab,” the “government” is not a taxpayer.131 there are no cases in which the government is one side with all the taxpayers in different situations on the other.132 rather, in any case, there is one taxpayer on one side and all the other taxpayers on the other.133 a “victory” for “the taxpayers” is one in which the tax burden is to be shared equitably; a defeat is one in which “one class [of taxpayers] is going to get by for less.”134 norris darrell phrased his conception of the special duties of a tax lawyer in terms of “certain social responsibilities,” including “the duty, putting it baldly, to help make our self-assessing income tax system work; 123. id. at 1081. 124. miller, taxpayer’s duty, supra note 68, at 2. 125. id. 126. id. 127. id. 128. id. 129. miller, taxpayer’s duty, supra note 68, at 3. 130. id. at 5. 131. id. at 7. 132. id. at 6–7. 133. id. 134. miller, taxpayer’s duty, supra note 68, at 7. 2012] legal ethics and federal taxes 21 and the duty . . . to lend . . . one’s special talents and experiences to . . . improving that system in the public interest.”135 he believed a tax lawyer has a duty to his client and “a duty to live up to his professional responsibility.”136 echoing merle h. miller, mr. darrell considered a large part of this duty to be educating and influencing clients to conduct their tax affairs “as honorably and ethically as the adviser would himself act under similar circumstances.”137 he believed this was necessary to the success of the voluntary compliance system, and thus necessary to avoid “police state methods” in tax collection.138 he encouraged tax lawyers to help their clients understand the “public policy reasons underlying the tax rules affecting them.”139 he thought this encouragement would help clients “understand the moral implications of what they do,” and develop more farsighted judgments on tax matters.140 he argued that “ethical propriety and legal effectiveness in tax planning often shade into each another,” frequently resulting in the ethically questionable plan being also practically questionable.141 mr. darrell charged each tax lawyer with “a further duty, namely, a duty to do what he can to help make the tax law more fair, practical and equitable and to improve its administration.”142 he encouraged each tax lawyer to “speak out as a citizen,” using his expertise to improve the tax system, “whatever the immediate effect upon his client’s pocketbook may be.”143 while emphasizing that the lawyer advocating for change in the system was not working on behalf of a client, he pointed out that “clients usually understand this” and respect it.144 he did not consider the duty to work to improve the system (even with a cost to the client) to be inconsistent with the duty to give “full devotion” to his client.145 even as mr. darrell affirmed that a tax client facing the treasury department as his adversary is entitled to expect the same from his lawyer as 135. darrell, propriety in tax practice, supra note 82, at 2. 136. bittker, professional responsibility, supra note 23, at 95. this chapter of professor bittker’s book was a transcription of the first in a series of five talks on “lawyers’ problems of conscience,” sponsored by the harvard student bar association, in which mr. darrell gave a talk entitled “responsibilities of the lawyer in tax practice.” id. at 87. 137. darrell, propriety in tax practice, supra note 82, at 23. 138. id. 139. bittker, professional responsibility, supra note 23, at 101. 140. id. 141. id. 142. darrell, propriety in tax practice, supra note 82, at 24. 143. bittker, professional responsibility, supra note 23, at 102. 144. id. at 102, 103. 145. darrell, propriety in tax practice, supra note 82, at 22. 22 florida tax review [vol. 12:1 a criminal defendant facing prosecution, he expressed uncertainty about “everyday administrative tax practice.”146 he described this situation as “perplexing, and one the area is especially in need of further study and clarification,” specifically the question of whether the tax lawyer owed greater or lesser duties to the treasury department than he would a court.147 mr. darrell expressed doubts about the possibilities of a neat and categorical resolution of this particular issue, but had no doubts that tax lawyers had social responsibilities to educate their clients on the importance of ethics in the voluntary compliance system, as well as being involved in other ways to improve the system. even among those writers who did not directly address the theoretical aspects of a general duty to the system, there were several who, like merle h. miller and norris darrell, insisted on the duty to educate clients on the ethics of tax compliance and the duty to avoid characterizing the irs as an unreasonable adversary applying arbitrary rules. agreement on this specific duty to the system was voiced by boston tax lawyer h. brian holland (ropes and gray),148 regional commissioner of revenue dean j. barron,149 mortimer m. caplin,150 and robert n. miller.151 like mr. darrell, professor boris i. bittker made clear that he considered a tax client and a criminal defense client to be in the same situation — having the government as an adversary and a lawyer who should be devoted to him.152 he did not think that tax practice was special as a consequence of the government being on the other side. nor did he think that being a member of the treasury bar should dilute a lawyer’s obligation to his client.153 on the contrary, he suggested it was all the more important to be independent. he wrote “[t]here is a shadow of big brother . . . in these suggestions that the lawyer has special obligations to the treasury because it regulates his admission to practice or because it represents ‘all of us’ and hence embodies a virtue superior to that of any of us.”154 he insisted that while “[t]he adversary system of administering governmental rules and regulation unquestionably has its drawbacks[,]” the right of citizens to deal with the government at arm’s length had such important advantages that it should not be abandoned.155 146. id. 147. id. at 22–23. 148. caplin, good tax practice, supra note 19, at 23. 149. id. 150. id. at 23, 35. 151. cahn et al., successful tax lawyer, supra note 26, at 9. 152. bittker, professional responsibility, supra note 23, at 267. 153. id. at 267–68. 154. id. 155. id. at 270. 2012] legal ethics and federal taxes 23 professor bittker did not think tax practice was a special kind of legal practice.156 he considered the debate over a special duty to the system to be academic, arguing that those who stress the lawyer’s duty to the client still believe the lawyer cannot engage in fraud, and those who stress the lawyer’s duty to the government do not believe the lawyer must completely open his files to the government.157 he thought that agreement on the issues was to be found in specific situations, not general propositions.158 personally, he believed that the ethics rules common to all lawyers, and statutory requirements such as a tax return “being verified under the penalties of perjury,” were sufficient to guide ethical tax practice and therefore there was no need to conjure special duties in an attempt to do so.159 randolph e. paul staked-out a position similar to that taken by professor bittker. he framed the question in terms of whether or not circular 230 provides “a standard of conduct different from that which binds the general practitioner representing clients in private litigations,”160 much like professor maguire had framed it.161 although at one time mr. paul had claimed there were special obligations on the tax lawyer, he later was content to claim that it “is far from clear.”162 by this, he did not intend to “deprecate the need of a high standard of ethics in the practice of tax law[,]”163 but instead considered it debatable whether the high standard of ethics applicable to tax lawyers was meaningfully distinguishable from the high standard applicable to all lawyers.164 mr. paul also seemed to doubt the usefulness of settling these types of questions in the abstract, preferring instead to discuss the ethical demands in concrete cases.165 after considering several such cases, he concluded that 156. id. at 274. 157. bittker, professional responsibility, supra note 23, at 268. 158. id. 159. e.g., id. at 241, 269. 160. paul, tax adviser, supra note 4, at 425. 161. see maguire, conscience and propriety, supra note 24. 162. paul, tax adviser, supra note 4, at 425. mr. paul is the one who mentions his own conversion on this point. id. at 425 n.58 (citing his “responsibilities of the tax adviser.”). both his rocky mountain law review and harvard law review articles are tremendously insightful and nicely written, though the latter rocky mountain law review article presumably is more reflective of his later thought. in the earlier harvard law review article, he explicitly championed the idea that the tax lawyer must not treat the sovereign government as a mere adversary, as well as going to lengths in other ways to emphasize the uniqueness of tax practice vis-à-vis other legal fields. see paul, responsibilities, supra note 57. 163. paul, tax adviser, supra note 4, at 425. 164. id. 165. id. 24 florida tax review [vol. 12:1 he had no definitive answer but doubted whether a tax attorney had any special responsibility.166 while he countenanced the possibility that there are special rules that may apply to tax lawyers prior to a case entering litigation, he found it “clear enough that they cease to apply when a civil tax case reaches the litigation stage . . . .”167 he concluded his analysis with one point on which he was certain: a tax lawyer ought to use his special expertise and experience to improve the tax law — and that he ought to do so regardless of potential client objections to the position he takes.168 new york city tax lawyer and treatise author mark h. johnson argued against any special tax lawyer duty to the system by focusing on the effects of suggesting to clients that their tax lawyers have dual responsibilities. mr. johnson’s argument begins with distinguishing between “the people collectively as a citizenry” and “individual citizens as separate taxpayers.”169 a collective citizenry may trust its government and understand the need for its government to be funded.170 however, an individual taxpaying citizen also knows that in a tax case he will either prevail and pay less or the government will prevail and he will pay more.171 thus, the individual taxpayer does have an interest adverse to the government’s interest, even if the collective citizenry does not.172 mr. johnson emphasized that the individual taxpayer wants advice from a lawyer who is “worried about him . . . .”173 mr. johnson argued that it is very important that each individual taxpayer is satisfied that his personal tax lawyer has an undivided duty to him, subsequently giving him the benefit of “all doubts and of all choices.”174 only if this duty is satisfied will the individual taxpayer rely on his tax lawyer.175 if he believes his tax lawyer is not worried exclusively about him, he will resort to self-help.176 the longterm consequence of tax clients being told their lawyers are not worried exclusively about them would be “wholesale tax evasion . . . by a skeptical and unadvised citizenry.”177 whereas others argued that the voluntary compliance system justifies special duties on tax lawyers, mr. johnson argued that imposing 166. id. at 430. 167. id. 168. paul, tax adviser, supra note 4, at 434. 169. johnson, theory, supra note 86, at 28. 170. id. 171. id. 172. id. 173. id. at 29. 174. johnson, theory, supra note 86, at 30. 175. id. 176. id. 177. id. 2012] legal ethics and federal taxes 25 special duties on tax lawyers would undermine the voluntary compliance system: [s]ince the absolute condition to a taxpayer’s compliance is his confidence in his expert’s advice, the whole community has a stake in instilling that confidence . . . we must assure the taxpayer that the advice he gets is being directed to his own best interest. he must feel sure that he is not getting the advice of a conscientious revenue agent, nor even the advice of a conscientious tax court judge. he must know he is getting the advice of his own counselor and advocate. he must know, in other words, that his adviser is in his own corner, and is not in the middle of the ring as a referee. only then can the taxpayer be expected to be trustful enough to throw away his tip sheets and stifle his own protective instincts.178 mr. johnson offered another argument against imposing special obligations on tax lawyers. he attributed the “remarkably coherent, uniform, and equitable body of law” enjoyed by americans to the adversarial process with tax lawyers on one side and government lawyers on the other.179 tax lawyers provided a tremendous and necessary benefit to the system, not because of any special duty incumbent upon them, but by merely acting as lawyers.180 in addition to serving this essential role, mr. johnson encouraged tax lawyers to engage in “disinterested public service,” such as work in bar associations where, he insisted, the lawyers were not to bring their client’s cases to bear.181 like professor bittker, mr. johnson believed that the ethics rules applicable to all lawyers were sufficient for tax lawyers.182 he argued that the recognition of boundaries on a tax lawyer’s behavior was not recognition of a special responsibility to the government.183 rather, lawyering within boundaries —such as avoiding fraudulent representations — was simply “a matter of my dignity and pride as a lawyer.”184 mr. johnson emphasized this point stating: “i would hate to think that this is considered some special obligation of the tax lawyer.”185 178. id. at 30–31. 179. johnson, theory, supra note 86, at 27. 180. id. at 35–36. 181. id. at 36. 182. id. at 32. 183. id. 184. johnson, theory, supra note 86, at 33. 185. id. 26 florida tax review [vol. 12:1 professor john potts barnes denied that it was the tax lawyer’s role to be “the keeper of the taxpayer’s conscience or an instrument for the implementation of the voluntary assessment system . . . .”186 much like professor bittker and mr. johnson, he believed that the general ethical obligations of all lawyers to “act fairly and honestly” and “be law-abiding” and “to advise compliance with the law” was sufficient to guide tax lawyers, as well.187 professor barnes did not hesitate to characterize the client and the treasury department’s relationship as adversarial, writing that this does not reflect any particular view of the government, but simply reflects that the individual taxpayer, regardless of political orientation, “carries on a running battle” to minimize his income tax liabilities.188 similar to the arguments made by mr. johnson, professor barnes insisted that a lawyer advising his client on how to lawfully minimize taxes was not “thwarting or defeating the system” but, on the contrary, was “assisting in its proper working, because the taxpayer is as much entitled to the benefits of the law as he is obligated by its burdens.”189 professor john potts barnes believed that the tax lawyer’s ethics did have special significance in the voluntary assessment system.190 however, it did not involve the tax lawyer taking on a special role of any sort. much like mr. johnson, professor barnes argued that the tax lawyer, simply by lawyering, “contributes to the effective operation” of the tax system.191 however, this is neither because the tax lawyer is motivated by some special duty to the system nor because he sets out with the intention of improving the system. rather, it is because he is merely “motivated by the impulse to give the advice that is for the best interest of the client” and within the general limits of legal ethics.192 any duty that would limit the effectiveness of the tax lawyer’s devotion to the client is one that, perhaps paradoxically, would undermine the benefits to the system provided by the tax lawyer. much like mr. darrell, washington d.c. tax attorney seymour s. mintz (hogan & hartson) was unable to define a strictly adversarial relationship between tax clients and the government prior to the two entering the courtroom.193 with respect to tax advice, he pondered the question of whether or not tax lawyers had “some greater degree of responsibility to be objective” than lawyers giving advice in other fields.194 “the answer to the 186. barnes, voluntary assessment system, supra note 25, at 1039. 187. id. at 1037–36, 1039. 188. id. at 1037. 189. id. at 1035. 190. id. 191. barnes, voluntary assessment system, supra note 25, at 1035. 192. id. 193. holland et al., panel discussion, supra note 85, at 23, 58. 194. id. at 24. 2012] legal ethics and federal taxes 27 question is not easy,” he said.195 mr. mintz identified three possible answers, each of which had some support in the tax bar.196 first, he said there was a “sizeable segment” of the tax bar which believes the ethical considerations applicable to tax lawyers are merely those applicable in other fields.197 circular 230, according to this view, is nothing but a detailed “implementation or an elaboration” of how those considerations are to be applied in the tax field.198 second, he said there was a “larger group” who believed that there was “something special and peculiar about practicing in the tax field . . . .”199 this position could be justified by any one or a number of considerations: the self-assessment system “cannot work in a purely adversary context;” the sovereign is simply not the same as a “purely civil adversary;” the taxpayer has control of all the facts; or tax lawyers are members of the treasury bar and, at the minimum, that membership “demands a higher duty of disclosure . . . .”200 finally, he said there was a “midway” position unconcerned with theoretical resolutions and grounded pragmatically: [y]ou are never really up against the gun to determine whether the practitioner does have dual responsibilities, that is, one set of responsibilities to his client and another set to the government, but that it is just good business for you, for the client and for the government to try to minimize adversary aspects just as much as possible, and to increase the disclosure aspects just as much as possible, and thereby to improve relationships among the three of you as much as possible.201 for mr. mintz, practicing tax law at the borderline was “just not good tax practice or good tax business . . . .”202 with this fact of practice in mind, he concluded it was a “mere academic exercise when we discuss the degree to which there is this dual relationship . . . .”203 in his mind, “it is in our best interest to act as if there were a dual responsibility,” regardless of the academic conclusion.204 195. id. 196. id. at 24–26. 197. id. at 24–25. 198. holland et al., panel discussion, supra note 85, at 25. 199. id. 200. id. at 25–26. 201. id. at 26. 202. id. 203. holland et al., panel discussion, supra note 85, at 27. 204. id. 28 florida tax review [vol. 12:1 others shared mr. mintz’s conviction that the difference between good tax ethics and a good tax practice may be merely academic, at least in many circumstances. irs chief counsel crane c. hauser argued the tax lawyer’s professional reputation within the irs offices was not “simply a matter of ethics” but “a matter of dollars and cents to the practitioner.”205 indeed, mr. hauser suggested that rather than speaking of dual responsibilities to client and government, it would be useful to invoke a third responsibility: the lawyer as to himself, that is, to preserve his professional reputation.206 mortimer caplin and mr. holland agreed that “we will find ourselves pretty good tax advisers” by avoiding advice that raises ethical concerns within us.207 new york city tax lawyer milton young (young, kaplan & edelstein) followed this sentiment as well, writing that a moral reaction is “often a correct forecast of the effectiveness of the plan itself.”208 for mr. young, it was reasonable to speak of a dual duty to the client and government, but he emphasized that a “dual responsibility” is not necessarily a conflicting one.209 it is good for both the government and the client to avoid bad tax planning, he thought. e. duty of disclosure alongside the debate on the general duty to the system was the more specific debate on whether or not there was a duty to disclose “doubtful but arguable points in a tax return.”210 norris darrell argued there was.211 for mr. darrell, the relevant issue was not his own professional judgment on the taxability of the issue but rather his professional judgment as to whether “the government would probably seek to tax it.”212 although he argued for a general rule to disclose any item that “might be considered taxable by the tax authorities,” he also argued for an exception.213 the exception would be those situations in which “there were many courts decisions uniformly in his client’s favor but as to which the government bullheadedly simply hadn’t yet 205. id. at 29. 206. id. 207. id. at 38. mortimer caplin believed that tax lawyers should “accept their special responsibilities,” and that they should be “willing to work cooperatively for stronger and better tax administration not only for their own interest, but in the interest of the nation, as well.” caplin, good tax practice, supra note 19, at 21. 208. johnson, theory, supra note 86, at 39–40. 209. id. at 39. 210. bittker, professional responsibility, supra note 23, at 92 (quoting norris darrell). 211. id. 212. id. 213. id. 2012] legal ethics and federal taxes 29 given up.”214 and into the calculations of the government’s probable interest — and whether or not the interest was merely bullheaded — mr. darrell also cited the need to consider potential penalties (e.g., for disregarding regulations) and potential tactical decisions (e.g., making and reporting gifts in a year in which the need to file a gift return was debatable — so as to start the statute of limitations).215 despite his unambiguous argument for a duty to disclose, it was, ultimately, merely a presumptive duty. he recognized the “difficulty of generalizing,” and wrote that the decision “depends upon your best judgment as to the law, the merits of any claim of taxability and the government’s probable attitude.”216 mr. darrell asserted a presumptive general duty to disclose, and shared his thoughts on what factors might overcome the presumption, but he did not argue for it from specific theoretical premises. professor jerome hellerstein, in contrast, deduced a disclosure duty from his theoretical conviction that the taxpayer and the government were not in an adversarial relationship in the way a plaintiff and defendant would be.217 professor hellerstein thought that the prevailing norm of the tax bar was “perfectly clear” that the there was no duty to “recommend full and fair disclosure” in situations in which the lawyer is “reasonably clear” that the bureau would decide the issue adversely, but “not as clear as to what the results will be in the courts.”218 and he believed this would be appropriate were the taxpayer and the government in a typical adversarial relationship.219 denying that to be the relationship, and desiring that tax lawyers would work to improve “tax morality,” he urged tax lawyers to bring their influence “to bear in order to develop in the community generally ethical standards which require full and fair disclosure by the taxpayer.”220 professor hellerstein did not elaborate on what “full and fair disclosure” meant, nor when it should be provided or what counter-considerations there might be. he lamented the current ethical comfort with the lack of disclosure, urging a higher standard, but not considering the practicalities, at least not in the way mr. darrell did.221 214. id. 215. darrell, propriety in tax practice, supra note 82, at 10–11. 216. id. at 11. 217. cahn et al., ethical problems, supra note 1, at 9 (statements of jerome r. hellerstein). 218. id. at 8. 219. id at 9. 220. id. 221. due to his rhetorical style, professor hellerstein’s thoughts on the subject are arguably ambiguous. he describes the prevailing norm with specificity but his own assessment of it is rather general. professor john maguire concluded that professor hellerstein did not argue for a higher duty of disclosure. maguire, conscience and propriety, supra note 24, at 42 n.60. randolph paul concluded that he did. paul, tax adviser, supra note 4, at 427. while professor hellerstein’s 30 florida tax review [vol. 12:1 randolph paul did not analyze the duty to disclose in light of an abstract relationship between the taxpayer and the government, nor did he lament the current practice. instead, he described the current practice as more nuanced than professor hellerstein took it to be. in situations where the legal issues are in a “thicket of obscurity” or lack a “yardstick for the measurement,” such as the ones professor hellerstein considered specifically, mr. paul was at ease with the prevailing norm not to disclose.222 nor did he think disclosure should be warranted when an issue has been “repeatedly decided favorably to taxpayers” but the bureau continues a “policy of persistent litigation.”223 however, he believed that most tax lawyers would insist the client disclose in order to make substantially debatable issues “automatically come to the attention of the revenue agent.”224 in general, mr. paul characterized the disclosure territory as one in which “many borderline problems constantly arise.”225 while he did not stake-out a theoretical position, given his focus on the merits of the underlying issue, and whether or not the bureau was unreasonably litigating an issue, in practical terms it seems quite likely that mr. paul’s and mr. darrell’s positions would reach similar results. professor boris bittker provided the most thorough analysis of the issue. though professor bittker thought the issue would be better discussed at the taxpayer-level (as did professor barnes),226 he left the discussion at the professional-level as this was where it usually occurred. professor bittker focused on whether or not there was a “professional obligation” to disclose debatable items, contrasting this from more practical considerations, such as disclosing to avoid the possibility of a penalty or an extended statute of limitations or disclosing for “a tactical advantage vis-a-vis other debatable items in the return . . . .”227 professor bittker identified two arguments for a general professional obligation of disclosure. first, the practitioner may be wrong about the taxability of the item, and disclosure permits the orderly resolution of it.228 second, a taxpayer ought not to benefit from the mere volume of returns, rhetoric obscures his reasoning in some places, i believe mr. paul provided the more sensitive reading, characterizing professor hellerstein as having “regretfully concluded” that the prevailing norm was against disclosure whereas professor maguire restated professor hellerstein’s description of the prevailing norm without catching the fairly clear sense of his regret as to it. id. 222. id. 223. id. at 428. 224. id. 225. id. 226. barnes, voluntary assessment system, supra note 25, at 1038. 227. bittker, professional responsibility, supra note 23, at 251. 228. id. at 252. 2012] legal ethics and federal taxes 31 which, without disclosure, might often mean the taxpayer receives a tax benefit to which he is not truly entitled.229 in contrast, professor bittker argued, first, while disclosure is already required in certain specific situations (e.g., receipt of stock in allegedly tax-free reorganizations), neither the regulations nor the service imposes a general obligation of disclosure.230 second, if there were a general obligation, the burden on the service would be increased tremendously as there would be “hundreds of thousands of riders” filed annually.231 third, if there a general obligation of disclosure, it should extend to matters not usually reflected on returns (e.g., exclusions) and should not be limited to matters that are (e.g., deductions).232 fourth, there are often complex issues underlying the relevant tax issue (e.g., allocation of costs of goods sold), and if there were an obligation of disclosure related to the relevant tax issue, it would need to extend to the underlying issues. 233 professor bittker argued that the fundamental issue was the purpose of the tax return. on the one hand, the purpose of the return might be considered to present the taxpayer’s opinion as to his tax liability — his and his tax advisor’s honest beliefs about the liability.234 on the other hand, the purpose of the return might be considered to present to the government all it “ought to know to make the most efficient use of its auditing facilities . . . .”235 if one has the “honest-belief approach to the tax return,” then honestly presenting one’s opinion as to the liability is required but flagging an issue on which the service is expected to disagree is not. however, if one has the “audit-assistance concept,” then flagging the issue for the service should be required. professor bittker held the honest-belief approach. he thought requiring taxpayers to engage in audit-assistance would be counterproductive. “[a] vague concept of taxpayer disclosure for debatable items” would not be an efficient assistance to the service, and it would impose significant “moral wear and tear” on the taxpayers (e.g., it would encourage “hypocritical” claims that certain issues were not really debatable).236 if the service determines to seek more specific information in certain situations, then it should do what it has already done which is to specify what information it wants in which situations.237 specificity — backed with potential penalties — would be an efficient and clear approach, while an 229. id. 230. id. at 252–53. 231. id. at 253. 232. bittker, professional responsibility, supra note 23, at 253–54. 233. id. 234. id. at 254. 235. id. 236. id. at 255. 237. bittker, professional responsibility, supra note 23, at 255. 32 florida tax review [vol. 12:1 overarching duty to disclose whatever the practitioner thought the service might want to review would not. professor boris bittker admitted the “full-disclosure” approach carried a loftier “vision of taxpayer cooperation with the government in a common search of truth” than did his own approach.238 but professor bittker (who suspected the full-disclosure approach reflected the influence of securities disclosure law on legal practice)239 was not alone in rejecting it. he was joined by professor john m. maguire, who suspected considerable hypocrisy on the disclosure issue, writing, “[t]here are more words of conscientious subservience to the idea of open returns openly arrived at than unpublicized practice justifies in fact.”240 gerald wallace believed that so long as the “attorney is of the position that the bureau’s position is wrong,” there is no duty to disclose simply “for the purpose inviting close examination.”241 mark h. johnson believed that having “a reasonable basis for an advantageous position” is what counts, and there is no reason to “provoke controversy by advertising the grounds on which it might be attacked.”242 mortimer m. caplin also did not argue for a general disclosure obligation, focusing instead on what is specifically required under circular 230 or as a result of signing a return,243 urging the american bar association and the american institute of certified public accountants to provide guidance.244 f. practical advice for tax lawyers the tax lawyers writing on ethics between 1945 and 1965 gave considerable practical advice on becoming a good tax lawyer. the 1951 tax law review dedicated its annual banquet to discussing the making of a successful tax lawyer. the symposium’s speakers included robert n. miller, mark johnson, and professor harry j. rudick (new york university and lord, day & lord) who each presented prepared remarks on specific themes. randolph e. paul, norris darrell, and merle h. miller were not featured 238. id. 239. id. at 271. professor bittker was not the only writer connecting issues of tax return disclosure with those of securities disclosures. mortimer caplin also connected the two, simply by questioning if tax disclosure standards should be the same as what “the sec requires in a prospectus.” caplin, good tax practice, supra note 19, at 19. 240. maguire, conscience and propriety, supra note 24, at 42. 241. cahn et al., ethical problems, supra note 1, at 31 (statements by gerald wallace). 242. johnson, theory, supra note 86, at 32. 243. caplin, good tax practice, supra note 19, at 17; caplin, perspective, supra note 53, at 1033. 244. id. 2012] legal ethics and federal taxes 33 speakers at the 1951 symposium, but they did provide advice on advising in other venues. mark h. johnson emphasized education as the foundation to being a good tax lawyer. he believed that given the variety of non-tax legal issues with which tax lawyers must be familiar, a tax lawyer “probably must place more reliance than most lawyers upon the adequacy of his law school education.”245 the importance of a broad legal education for the tax lawyer was not, however, mr. johnson’s exclusive focus. he indicated the importance of studying “the great literature of the world.”246 without a tax lawyer having done so, even “the surface of his speech and writing will reflect the narrowness of his learning and make his judgment suspect.” 247 mr. johnson also argued that a tax lawyer must be knowledgeable in world history, as he believed that such knowledge gave “perspective for the immediate eddies and currents of the law” and “data for long-term appraisal and predictions.”248 mr. johnson believed that the cultural taste for this type of learning is “pretty well developed by the time a young man arrives at law school” and so only if he arrives at law school with such a “desirable background and habits” does he have much of a chance of not “retrogressing.”249 in addition to knowing the humanities, mr. johnson also argued that a good tax lawyer must know calculus (for understanding life expectancy curves); economics and statistics (for understanding supply and demand curves, and especially useful for dealing with the excess profits tax); government; public finance; and accounting (for the tax lawyer, a “balance sheet or income statement must be read as easily a baseball box score.”)250 the tax lawyer, mr. johnson argued, must understand that he is “a lawyer who knows something about taxes” and never a “‘tax expert’ who happens to be a lawyer.”251 he must “know as much law as any other lawyer,” beginning with “contracts, sales, property, equity, wills, corporations, partnerships, agency, and negotiable instruments,” and, in addition, he must know “the principles of administrative law . . . tax court practice, and the federal rules . . . [and] all the law of evidence.”252 most of all, he must know the internal revenue code “at least as well as a minister knows his bible,” and keep an “orderly mental catalogue” of regulations, 245. cahn et al., successful tax lawyer, supra note 26, at 4 (statements by merle h. miller). 246. id. at 5. 247. id. 248. id. 249. id. 250. cahn et al., successful tax lawyer, supra note 26, at 5 (statements by mark h. johnson). 251. id. at 2. 252. id. at 3–4. 34 florida tax review [vol. 12:1 rulings, and cases (specifically including obsolete authorities as “[t]he obsolete is . . . key to the current.”).253 in order to succeed, a tax lawyer must be reconciled to the fact that he always needs to do “more research on specific problems than is required of his brethren in general practice,” and that the “economic justification is that he will spend less additional time for his client on those phases of his work than the general practitioner will spend in finding the tax law.”254 finally, mr. johnson underscored the importance of the tax knowledge one gains only by “experience.”255 the tax lawyer learns “the workings of the bureau” by experience.256 the tax lawyer develops a reliable predictive intuition as to “a tax official’s reaction” by experience.257 the tax lawyer acquires a reliable clairvoyance in his “guesswork as to long term ‘trends’” by experience.258 and it is only by experience the tax lawyer learns to recognize “patterns in tax problems and solutions.”259 professor harry j. rudick addressed the symposium on the skills necessary for being a successful tax lawyer. he thought these skills were “pretty much the same as the skills required for success in the practice of other fields . . . .”260 some of these skills, he argued, could “only be acquired by experience,” however, he added that others “are inherent” and “[t]he latter may be nurtured and developed but unlike cultured pearls, their seeds cannot be implanted.”261 whether acquired by experience or birth, he believed that “the great majority of the tax practitioners who have achieved success” have, “in significant measure,” the skills identified.262 professor rudick’s list of skills was varied. he considered a “good memory” as among the most indispensible skills for a successful tax lawyer.263 for example, “when a client telephones and wants the answer to an answerable question,” since “[i]n the vast majority of cases the question is one which the practitioner has looked up before,” the quality of the practitioner’s memory can save the client “time and expense.”264 of course, 253. id. at 2. 254. id. at 4. 255. cahn et al., successful tax lawyer, supra note 26, at 2 (statements by mark h. johnson). 256. id. 257. id. 258. id. 259. id. 260. cahn et al., successful tax lawyer, supra note 26, at 5 (statements by harry j. rudick). 261. id. at 6. 262. id. at 8. 263. id. at 6. 264. id. 2012] legal ethics and federal taxes 35 not every tax question is readily answerable, but if it is, memory likely will be the resource that provides the answer. along with a good memory, a successful tax lawyer needs to be able to write well and speak well, being careful to avoid “verbosity and pomposity.”265 the successful tax lawyer also needs the ability to administer the law office: “to select and train assistants, delegate work to them, and appraise that work.”266 the tax lawyer who tries to do it all himself eventually suffers professionally, and his “usefulness to business world and the bar are circumscribed.”267 finally, the successful tax lawyer must also have good judgment and be decisive.268 good judgment, being “a compound of experience, knowledge, and talent,” is [t]he ability to look at a case “in the round” and not merely from a single viewpoint; to approach a problem objectively and without bias; to evaluate the importance of the separate issues of a case in relation to the entire case; to weigh the chances of success in litigation; and to foresee the probable consequences of success or failure in relation to the whole enterprise . . . . judgment includes knowing when to listen, when to argue, and when to stop listening and arguing. it includes an ability to change one’s mind . . . .269 when it comes time to make a judgment, the tax lawyer must do so decisively rather than in an “equivocal or wishy-washy” way.270 it is the “problems which do not permit . . . categorical solution” that are most likely to be submitted to the successful tax lawyer, and even where the “suggested answer is no more than an informed guess, the practitioner is not excused from stating his position — with an appropriate caveat, of course.”271 265. cahn et al., successful tax lawyer, supra note 26, at 7 (statements by harry j. rudick). as an aside, professor rudick notes that “the lower schools” ought to work harder to remedy writing defects in their students, as his law students were making “[m]istakes in grammar and spelling” and sentence structure in their “examination papers.” id. given the regularity with which this complaint is heard among law professors today, there is some odd comfort in his expression of concern, even though i fear he would indict my own lower schools. 266. id. at 8. 267. id. 268. id. at 7–8. 269. id. at 8. 270. cahn et al., successful tax lawyer, supra note 26, at 7 (statements by harry j. rudick). 271. id. at 7. 36 florida tax review [vol. 12:1 robert n. miller addressed the symposium on “the successful tax lawyer’s character and personal relationships.”272 he thought a tax lawyer must have a “youthful and daring spirit” because “a peculiar quality of tax controversies is that each one is likely to present at least some unique features” and so the tax lawyer “will often be called on to enter territory which is relatively unexplored . . . .”273 this “daring spirit” is different from the spirit of a lawyer who “never knows when he is licked.”274 the successful tax lawyer must “recognize the real weaknesses of a situation” and, more importantly, must be able “to induce the client to recognize them — even the client who would rather not.”275 a good tax lawyer must have “in a special degree the quality of patience,” especially when “dealing with government conferees,” and must be able to foresee “each possible difficulty . . . the bureau men” may discover.276 additionally, a successful tax lawyer must be able “to use effectively in his work a number of partners and assistants, as well as experts in the field of accounting, engineering, and economics.”277 perhaps the most interesting highlight of mr. miller’s very practical advice is that he subjects it all to the following preface: [a] truly successful lawyer’s career must be consistent with the lawyer’s own achievement of a well-balanced life as an individual and as a member of the bar . . . . a professional man who gets the details of his own life into a tangle is not likely to exhibit broad intelligence in guiding the affairs of other people; the tax field, particularly, calls for exercise of general wisdom, because there are very large areas in which the adviser can get no decisive help from established precedents.278 according to mr. miller, a good tax lawyer must have a well-ordered life in order to advise well another — that is, if a lawyer’s wisdom is not sufficient to govern his own life, how could it be useful to his clients? as mr. miller put it, the successful practice of tax law may rely more on practical wisdom than technical analysis.279 272. id. at 1 (statements by robert n. miller). 273. id. at 9. 274. id. at 10. 275. cahn et al., successful tax lawyer, supra note 26, at 10 (statements by robert n. miller). 276. id. at 10–11. 277. id. at 10. 278. id. at 9. 279. id. at 12. 2012] legal ethics and federal taxes 37 although not part of the 1951 symposium, norris darrell took time to provide very specific advice on tax advising. mr. darrell described a typical tax client as someone who wants “to keep his taxes down . . . taking advantage of every possible loophole in the law” but who “seldom comprehends the difference between sound and border-line transactions.”280 the tax lawyer has to make a judgment as to the “elusive line between what may be done and what dare not be done with reasonable tax safety.”281 he described the common situation in which a tax lawyer finds himself: we have oftentimes found ourselves in the uncomfortable position of having to cast a wet blanket over tax minimization schemes developed by overly enthusiastic planners, with the attendant risk that we may appear in the eyes of our clients, who too often confuse cleverness for competence, to be more negative than constructive minded.282 mr. darrell wrote that “cleverness is not competence” and “the tooclever, overly-enthusiastic tax planner is likely to be either a limited or an irresponsible man.”283 but it is “inexcusable to frustrate appropriate and desirable action because of a lurking fear, born of confusion; only the incompetent will do that.”284 while the good tax lawyer “must only too often disappoint clients and only too often turn down the fashionable tax device of the moment,” he need not always “take a line so conservative that his clients drop off to more daring advisers.”285 being either unduly clever or unduly fearful is incompetent and irresponsible.286 mr. darrell sketches out the steps for competent tax advice — infused not only with “care and caution,” but also “constructive imagination and ingenuity . . . .”287 280. darrell, tax minimization devices, supra note 21, at 983. 281. id. 282. id. other ethics writers identified the common need to throw a wet blanket on tax advice with the risk of appearing too negative-minded. often times, the alleged advice comes not from another lawyer or an accountant but the neighbor “joe,” whose lawyers “dreamed up a wonderful scheme whereby he could save thousands of dollars in taxes without risking anything.” holland et al., panel discussion, supra note 85, at 35–36. of course, joe, having advised his neighbor of the wonders of his tax lawyers, prompts the neighbor to ask his own lawyer, “why don’t you consider setting up a scheme like that for me?” id. 283. bittker, professional responsibility, supra note 23, at 100. 284. darrell, tax minimization devices, supra note 21, at 988. 285. id. 286. id. 287. id. 38 florida tax review [vol. 12:1 to give good tax advice, a tax lawyer must first “make that ‘most inordinate expenditure of time’” in understanding the statute, regulations, and rulings.288 the “second tool” the lawyer should acquire is “a thorough knowledge of [the] so-called tax common law . . . .”289 third, the tax lawyer “should be thoroughly acquainted with administrative procedure.”290 fourth, the tax lawyer must “know how to investigate the ultimate reality” of the relevant facts, including the “client’s real desires and best interests,” bearing in mind that a client is sometimes “influenced too greatly by saving taxes” and influenced too little by “what he would really want to do” if he “considered the matter more carefully in the light of his own best interests and those of his family.”291 the lawyer must also remember the difference between “facts as related orally by the client and facts which can be proved to a court.”292 he must be ready to dig up the facts like “a miner who digs up mounts of earth to reach the ore.”293 mr. darrell emphasized that being a good tax lawyer “requires training, experience and real work” in order to “marshal and analyze facts effectively, and to be able to identify a transaction by its right name . . . .”294 having taken these steps, the tax lawyer has not finished his job but has just begun the most important part of it. he must realize that the steps “function only to make judgments informed, and cannot . . . take the place of judgment.”295 he must recognize that the “the line is not a static but a shifting one.”296 he must ponder the relevant history and likely changes, being careful to interpret “the overriding congressional purpose” involved.297 he must realize that a good tax plan should be “adapted to survive amid the interplay of living social forces” and never “simply jig-saw cut . . . .”298 it is with these issues that mr. darrell believed “that considerations of moral and ethical propriety and legal effectiveness . . . often shade into each other” insofar as a “foul-smelling” plan is “likely to be adjudged ineffective” eventually.299 in this realm of professional judgment, 288. id. at 984. 289. darrell, tax minimization devices, supra note 21, at 984. 290. id. 291. id. at 983, 985. 292. id. at 985. 293. id. 294. darrell, tax minimization devices, supra note 21, at 985. 295. id. 296. id. at 989. 297. id. 298. id. at 988. 299. bittker, professional responsibility, supra note 23, at 101. 2012] legal ethics and federal taxes 39 mr. darrell compares the tax lawyer with “the perfume smeller or the wine taster.” 300 finally, in arriving at his final judgment, the good tax lawyer never loses “sight of the fact that the tax consideration is only one of the many factors that should be taken into account,” and that “[i]ll-considered action to escape taxes may prove . . . tragic . . . .”301 he must then have “a character, and a breadth of background, training and experience in business and personal affairs” that will enable him “to put all aspects of the matter before his client in their proper light so that the client may be guided toward a wise decision.”302 much as mr. darrell characterized clients as apt to confuse technical cleverness for practical judgment, merle h. miller believed they were likely to have “more faith in technicalities” than their lawyers do.303 they think tax lawyers must have “a bag of tricks that greatly reduces our clients’ taxes and probably get us out altogether on our own.”304 or so they may think, “until they call on upon us in a professional way and usually leave in amazement after being told that they really owe more than they thought they did when they came to see us.”305 rather than finding tax lawyers to be technical magicians with secrets for sale, mr. miller thought the client was more likely to find a professional who considers his primary job to be preventing his clients “from going off on screwy tantrums, diverting their energies into non-productive tax avoidance activities, to the great detriment of our productive system and our tax collecting system.”306 whereas mr. darrell wrote that tax lawyers often have to throw a “wet blanket” on such tantrums,307 mr. miller provided a more graphic description, writing that a tax lawyer spends nine-tenths of his time killing schemes believed by the proponents to be new, but which were actually dead and buried many revenue acts and many decisions ago. as we grow old in the practice, this mortality rate bothers us less and less, and we come to suspect that the scheme is bad even 300. id. the tax lawyer’s use of the “smell test” was mentioned in holland et al., panel discussion, supra note 85, at 23, 38, 43. the image of the nose as a useful guide to the tax lawyer appears to have been in circulation among tax lawyers for quite some time. 301. darrell, tax minimization devices, supra note 21, at 988. 302. id. 303. miller, morality, supra note 20, at 1075. 304. id. at 1074. 305. id. at 1074–75. 306. id. at 1076. 307. darrell, tax minimization devices, supra note 21, at 983. 40 florida tax review [vol. 12:1 before we have heard it. once a man has become reconciled to the proposition that there is little new under the sun, this job of decimating someone else’s brain child becomes rather perfunctory, and even loses some of its zest.308 mr. miller concluded by writing, “the man who can kill off a bad tax scheme at its inception is contributing greatly to the well being of the country at large.”309 unfortunately, as he put it, “infanticide is as abhorrent in the intellectual, as in the physical realm,” and so while “[i]t is easy to kill off someone else’s scheme,” it is “most difficult to maintain that critical attitude with respect to one’s own creations.”310 and thus, the challenge for a good tax lawyer is to maintain that critical attitude with respect to his own advice.311 mr. miller pointed out that we must guard ourselves against becoming too “enmeshed in the same wishes which motivate our clients” for when this happens we are “rendered easier to please with our own answers” and “are most apt to fit together the letter of the statute and the court decisions” in coming up with “an answer that will satisfy everyone” — except the “moral sense of the revenue agent and the court that will test it.”312 those lawyers, he continued, who may have “been able to invoke righteous indignation” when killing off some other advisor’s “flagrant tax scheme” may often “fall victim to a lack of moral sensibilities in testing their own brain creations.”313 thus, mr. miller urged that tax lawyers “should be as zealous in developing a sense of moral fairness as in acquiring a technical working knowledge of the code.”314 the good tax lawyer needs both technical knowledge and the sense of moral fairness which is necessary for testing his own tax advice. mr. miller put great emphasis on this moral sense.315 he argued that applying this moral sense to interpreting the tax code was what courts did when settling cases.316 citing cases like gregory, clifford, and court holding co. as evidence, mr. miller wrote, “we have witnessed during the past twenty years the growth of court-made law which is to our tax law what equity was to the old common law.”317 the moral sense of the tax lawyer was similar to this equitable sense of the courts, and it was an essential 308. miller, morality, supra note 20, at 1075. 309. id. at 1076. 310. id. 311. id. 312. id. 313. miller, morality, supra note 20, at 1076. 314. id. at 1077. 315. id. at 1070. 316. id. at 1068. 317. id. at 1070–72. 2012] legal ethics and federal taxes 41 qualification of the good tax lawyer because it had become an essential aspect of evolving tax law. as part of this evolution, statutory formalities were often “completely or partially disregarded” by the courts “to the extent necessary to achieve a ‘right’ result.”318 and what was the source of the sense of a right result? it was nothing other than “the moral sensibilities of the courts today.”319 this sense of “morality in our courts is the only known factor accountable” for the decisions cited, he argued.320 mr. miller wrote, “there is a sense of morality rampant in our courts today, ready to take care of any omission of congress, or any brilliant scheme of the most brilliant genius” if such an omission or scheme would “result in an unfair dislocation” of tax burden.321 the practical tax lawyer considers the long term when eyeing “a loophole which long research fails to discount . . . .”322 the practical tax lawyer “will not hesitate to condemn a plan merely on the ground that it offends his own moral sensibilities” because such a plan is “apt to be found deficient by a court that would have less desire to find the plan effective than would the tax counselor.”323 lawyers assuming their “own moral sensibilities were irrelevant as guides” in interpreting the tax law was the reason that “[m]any clients are in trouble today.”324 “[n]ow that morality is part of our tax laws,” a taxpayer cannot “afford to have a tax advisor whose sense of morality is less acute than that of the courts.”325 randolph e. paul emphasized the importance of tax lawyers beginning with a coherent “philosophy on the subject of tax avoidance.”326 mr. paul urged tax lawyers to accept that because “[d]ifferent tax consequences may flow from the different methods of accomplishing the same ultimate economic result,” it follows that taxpayers “are plainly entitled to select the method which results in the lower tax liability.”327 he believed that there was no reason to “hesitate to advise the client fully and frankly in choosing among ‘the oddities in tax consequences’ that emerge from the different methods of accomplishing the same economic result.”328 the tax lawyer’s personal, ethical, or policy concerns are not relevant to this task; his task is simply “to help the client reduce his tax liability to the lowest possible 318. miller, morality, supra note 20, at 1070–72. 319. id. 320. id. at 1072. 321. id. at 1073–74. 322. id. at 1074. 323. miller, morality, supra note 20, at 1074. 324. id. at 1076. 325. id. at 1076–77. 326. paul, tax adviser, supra note 4, at 414. 327. id. at 416. 328. id. at 418–19. 42 florida tax review [vol. 12:1 legal level or save him from a greater tax liability than his transactions need to carry.”329 unlike mr. johnson, professor rudick, and mr. robert n. miller, mr. paul warned that “too many qualifications in other areas of the law may be a handicap to the tax lawyer.”330 he thought it important that a tax lawyer not have too much “vested intellectual interest” in other areas of the law,” as it might make him “overanxious to apply in tax territory principles which will not be welcome there.”331 income taxation is distinctive in considerable part due to its being a young field of law, starting only “a little more than a quarter of a century ago.”332 in comparison with other fields of law, mr. paul considered tax law to be less concerned with “form and technicality,” and more oriented towards a “search for underlying substance and basic realities.”333 in one article, mr. paul emphasized the differences between tax lawyers and other lawyers, but then, having undergone a philosophical conversion on the specialness of tax lawyering, he later emphasized the similarities, at least for certain ethics purposes.334 but even that change in his own thinking, his practical caution of too much interest in non-tax fields was presumably unconnected with his more abstract shift in ethical philosophy. he wrote that when the tax client comes in, that client “may have a specific plan in mind or he may have a general objective,” and he has come to check with the tax lawyer “whether a given course of conduct will produce unforeseen tax liability or whether a foreseen liability may be minimized.”335 unlike mr. darrell or mr. miller, mr. paul’s criticism of clients was not that they had too much faith in technicalities but rather their “ingenuity and uncanny cunning at concealing and suppressing facts,” which, he continued, “pass my poor powers of description.”336 in order to get at the facts, he 329. id. 330. see paul, responsibilities, supra note 57, at 380. 331. id. 332. id. at 381. 333. id. 334. id. in this article, mr. paul also distinguished tax law from other fields by citing that its controversies were between the taxpayers and their government rather than a private adversary. he asserted this “puts the public interest into the equation and enormously complicates the responsibilities of the tax adviser.” in his later article in the rocky mountain law review, he instead argued that the tax field was not as distinctive from other legal fields, at least not sufficiently distinctive to necessarily require different ethical norms. he is explicit about his change of mind on this point. paul, tax adviser, supra note 4, at 425, n.58 (citing his harvard law review article). for his earlier point of view, see paul, supra note 162. 335. paul, tax adviser, supra note 4, at 414. 336. paul, responsibilities, supra note 57, at 382. 2012] legal ethics and federal taxes 43 suggested that the lawyer prepare for the “client in writing exactly what he has told the lawyer orally.”337 this technique works because the client “will hardly be able to resist the temptation to demonstrate the mistakes his lawyer has made,” which “may be humiliating to the lawyer” but, he added, “a little mortification is a small price for the discovery of the essential facts.”338 he also criticized clients who “come to a lawyer to cover their own tracks.”339 these clients, he wrote, “want to follow a given course of action” and want “the lawyer to share blame if results are disappointing.”340 he cautioned lawyers in these situations, especially if they are tempted “to give an immediate opinion.”341 mr. paul continued with a reminder that even though competition for the client pressures the tax lawyer to give in and “slant opinions in the direction of a client’s desires,”342 a lawyer should always recall that “[i]n tax law the day of reckoning is often on earth and not in heaven.”343 or, as he otherwise puts this sobering thought: “[t]he tax adviser’s failure will be measurable in dollars and cents, the client’s dollars and cents — and the tax adviser’s, as well.”344 like mr. darrell and mr. miller, mr. paul was careful to make clear that the tax lawyer should not “put undue trust in the letter of the law.”345 he argued it is important that the tax lawyer consider “interstitial judicial legislation,” as well as understanding that “the policy of tax statutes is not always to be found in the literal meaning” used in the statutes, because the statutes “derive vitality from the obvious purpose as which they are aimed.”346 the tax lawyer, he elaborated, must consider not only what the law is, but also what it “will become” when giving advice.347 continuing, mr. paul indicated that the tax lawyer must know the statute, the regulations, the rulings, the courts decisions, and the “suggestion and criticism and dogma” of the “[m]agazines, law reviews, [and] periodicals.”348 mr. paul added the tax lawyer must also have the “gift of controlled intuition,” the ability to think “with his profound intestines” when giving his systematized predictions.349 337. id. at 383. 338. id. 339. id. 340. id. 341. paul, responsibilities, supra note 57, at 383–84. 342. id. at 385. 343. id. 344. id. at 379. 345. paul, tax adviser, supra note 4, at 417. 346. id. 347. id. 348. paul, responsibilities, supra note 57, at 378. 349. id. at 379. 44 florida tax review [vol. 12:1 in writing what may well be the best single paragraph on tax advising, mr. paul warned: above all things, a tax attorney must be an indefatigable skeptic; he must discount everything he hears and reads. the market place abounds with unsound avoidance schemes which will not stand the test of objective analysis and litigation. the escaped tax, a favorite topic of conversation at the best clubs and the most sumptuous pleasure resorts, expands with repetition into fantastic legends. but clients want opinions with happy endings, and he smiles best who smiles last. it is wiser to state misgivings at the beginning than to have to acknowledge them ungracefully at the end. the tax adviser has, therefore, to spend a large part of his time advising against schemes of this character. i sometimes think the most important word in his vocabulary is “no;” certainly he must frequently use this word most emphatically when it will be an unwelcome answer to a valuable client, and even when he knows that the client may shop for a more welcome answer in other offices which are more interested in pleasing clients than they are in rendering sound opinions.350 g. reform agenda in the articles and essays devoted to professional ethics, some of the tax lawyers also expressed opinions on certain tax reform needs. professor bittker, for example, encouraged the treasury department to license or to enroll all return preparers in order to reduce the abuses of the system, such as a preparer’s wholesale manufacturing of tax deductions and credits.351 both mortimer caplin and he mentioned the possibility of moving to a britishstyled system in which returns certified by accountants or lawyers would be subject to less scrutiny.352 new york city tax lawyer and treatise-author jacob rabkin complained about the complexity of the tax law, writing, “[n]o society developed on so fine-spun a statute or set of laws can help from failing from its sheer weight.”353 mr. merle h. miller thought the solution to the problem 350. paul, tax adviser, supra note 4, at 416. 351. bittker, professional responsibility, supra note 23, at 237–38. 352. caplin, good tax practice, supra note 19, at 20–21; 15 u.s.c. § 33 (repealed 1970); bittker, professional responsibility, supra note 23, at 249. 353. cahn et al., successful tax lawyer, supra note 26, at 17 (statements by jacob rabkin). 2012] legal ethics and federal taxes 45 of complexity in the code was to accept imperfections in the code. he warned against ever pursuing the improvement of the code, “for the perfect code would be so complex that its inherent complexities would make it imperfect.”354 tax expenditures and tax lobbying were also indicted.355 contrasting the importance of funding the cold war with the growth of tax expenditures, mr. merle h. miller complained of a congress using the tax code “not only to raise the vast sums we need to maintain . . . a garrison state” but also to address economic and social issues.356 he argued that special provisions for one group of taxpayers “may well prove a trap . . . for some other unsuspecting taxpayers.”357 he also argued that such special provisions have negative effects on economic competition: “[a] tax advantage obtained by some scheme, may more than offset the greater production efficiency of a competitor.”358 similarly, new york city tax lawyer and treatise-author richard kilcullen complained of the complications that arise when congress grants “special tax privilege[s] . . . in favor of a particular group,”359 and adrian w. dewind worried about the dangers that tax planning has for business when it distorts activities merely for tax savings.360 dean griswold lamented the increase of “loopholes and special privileges” and “handouts” in the tax codes, specifically identifying those for the oil and gas industry.361 354. miller, taxpayer’s duty, supra note 68, at 7. 355. the protest against tax expenditures and other reform rhetoric organized around the concept of a “comprehensive tax base” was analyzed by professor bittker, in “comprehensive tax base” as a goal of income tax reform, 80 harv. l. rev. 925 (1967). 356. miller, taxpayer’s duty, supra note 68, at 7. 357. cahn et al., ethical problems, supra note 1, at 22 (statements by merle h. miller). 358. miller, morality, supra note 20, at 1069. it is notable that mr. miller phrased the struggle between capitalism and communism in terms of efficiency. remembering that mr. miller was focused on establishing the efficiency of capitalist economy over a communist economy his point is not only about business efficiency, like mr. dewind’s, but also about national security. id. at 1083. 359. cahn et al., successful tax lawyer, supra note 26, at 15 (statements by richard kilcullen (mcguigan & kilcullen, new york city)); joyce stanley and richard kilcullen, the federal income tax: a guide to the income tax provisions of the internal revenue code, (tax club press 1948). 360. cahn et al., successful tax lawyer, supra note 26, at 14 (statements by richard kilcullen discussing remarks by mr. dewind). mr. dewind had in mind plans such as “trying to channel otherwise ordinary business income, otherwise individual surtax income into the ‘dreamland’ of capital gains rates.” id. 361. griswold, blessings of taxation, supra note 28, at 1057. dean griswold’s reference to “the gross inequities of the law in favor of the oil and gas interests” prompted mr. rex g. baker, general counsel of the humble oil and 46 florida tax review [vol. 12:1 mark h. johnson had a list of problems in the tax system. he said that there were certain pressures that would continue to prevent the development of a “sound system of law and a sound system of administration,” including: “lawyers who are economically or spiritually marginal . . . confiscatory tax rates, silly tax laws, . . . revenue agents who have to come up with a deficiency, [and] a silly court holding company rule where, if you take one rule, you come out one way and another, another.”362 he said that “unless you eliminate” these pressures, you are always going to have an unsound tax system.363 iii. reflections when reviewing the tax ethics literature of this era, it is useful to keep in mind that the authors were practical, professionally accomplished men. remembering the law firms to which many of these belonged reminds us these were not idealists concerned with abstract notions of professionalism, but men whose practice and clientele were as demanding as any today.364 several of the writers mention the client-related pressures in which tax lawyers work. norris darrell wrote that the good tax lawyer “must only too often disappoint clients and only too often turn down the fashionable device of the moment,” acknowledging the risk that his disappointed clients may “drop off to more daring advisers.”365 merle h. miller described the tax lawyer’s job, in large part, as routinely decimating some other tax advisor’s “brain child,” leaving clients disappointed with the lack of a bag of technical tricks for sale.366 randolph e. paul warned that competitive pressures may tempt the lawyer to “slant opinions in the direction of a client’s desires” and away from good judgment.367 mr. paul emphasized the importance of the word “no,” and acknowledged that “the client may shop for a more welcome answer in other offices.”368 there is also mention of the importance of office management skills, the importance refining co. to write dean griswold, and thus began a correspondence between the two eventually published in baker and griswold, percentage depletion — a correspondence, 64 harv. l. rev. 361 (1951). 362. cahn et al., ethical problems, supra note 1, at 27–28 (statements by mark h. johnson). 363. id. at 28. 364. see supra part ii.a. and text at notes 18–23. 365. darrell, tax minimization devices, supra note 21, at 988. 366. miller, morality, supra note 20, at 1075. 367. paul, responsibilities, supra note 57, at 385. 368. see supra text at note 350. 2012] legal ethics and federal taxes 47 of being able to work with partners and assistants,369 and an articulation of the business model for tax specialists.370 this practical grounding of these writers is especially interesting given their philosophical sensitivities and commitments to duties (such as defending the tax system to clients) that may seem more likely to have been deduced by someone unconcerned with financial, competitive, and practical pressures. in this practice-oriented content, it initially may be surprising to discover the 1949 tax committee on the importance of natural law. but when the tax committee issued its report, the importance of natural law was not considered to be an academic issue.371 in the 1930s, the skepticism of the legal realists and positivists had prevailed among legal theorists and lawyers. however, the rise of totalitarianism in the 1930s and 1940s “forced many to think again.”372 the rejection of natural law jurisprudence by german lawyers had been blamed for their legal authorizations of nazi acts.373 the result in america was a retreat from both realism and positivism and a revival of natural law jurisprudence.374 thus, the tax bar likely had the fear of totalitarianism in mind when it produced its report on natural law, emphasizing the necessity of the objective moral grounding of reliable legal analysis. this historical context reveals the practical concerns behind the report, though the report itself had no practical guidance. despite the tax committee’s consensus on natural law, the tax lawyers expressed differences on the relationship between law and morals. both merle h. miller and norris darrell emphasized the objective continuum between the law and morals, and even claimed a very practical connection between the two. both explained the important role of a lawyer’s moral sense in his daily work. mr. miller believed the lawyers and judges shared a moral sense, and he believed that adherence to the moral sense by lawyers and judges would lead them toward the same legal conclusions.375 mr. darrell believed that a sustainable tax plan was one in which legal and moral propriety often shade into one another.376 mr. miller and mr. darrell’s view 369. cahn et al., successful tax lawyer, supra note 26, at 8, 10 (statements by harry j. rudick and robert n. miller). 370. id. 371. mccloy et al., moral issue, supra note 37, at 9–11. 372. richard primus, a brooding omnipresence: totalitarianism in postwar constitutional thought, 106 yale l.j. 423, 427–34 (1996) (discussing how the problem of totalitarianism of nazi germany and the soviet union transformed american legal thought). 373. id. 374. id. 375. see supra text at notes 317–25. 376. bittker, professional responsibility, supra note 23, at 101 (statements by norris darrell). 48 florida tax review [vol. 12:1 was that law and morality are coherent, and that good legal judgment requires good moral judgment. in their view, morality was theoretically objective and practically essential. in contrast, randolph e. paul was convinced that the tax lawyer’s moral sense had no place in legal analysis.377 his concern was that the lawyer’s moral sense might be a risk to the client’s objective. interestingly, mr. paul explicitly pushes the lawyer away from his moral concerns when providing tax advice in the same context as pushing the lawyer away from his policy concerns. given mr. paul’s role as a key tax policy advisor for franklin d. roosevelt,378 it may well be that mr. paul was keenly aware of advantages his clients were provided under the tax code that, on policy grounds, he believed should not be available. his emphasis on tax lawyers being involved in tax legislation, even if it was not in the interests of their clients, may evidence this concern.379 it may well be that mr. paul was focusing on tax benefits to which the client’s entitlement was certain, warning only that the tax lawyer’s personal sense that the law’s policy was ill-founded were irrelevant. in contrast, mr. miller and mr. darrell appear to have been focusing on tax benefits that were uncertain and the importance of an equitable sense when assessing the technicalities of the uncertainties. after all, mr. miller, at least, emphasized that the lawyer and judge share this sense and as it guides judges, so it should guide lawyers. mr. paul never mentions judges considering these issues, which suggests these would not be the types of issues on which the moral sense of judges would be relevant. perhaps mr. paul was merely arguing that when a tax benefit is certain, the lawyer’s moral or political sense against it should not be an impediment to his client claiming it. the tax lawyers writing on these topics were devoted american patriots united by their cold war concerns. merle h. miller focused on the tax system as the “very life blood of the government operating” under the capitalist system.380 mr. miller characterized taxes as the price paid for maintaining the capitalist system. remembering that the highest marginal tax rate at the time mr. miller was writing was 92 percent381 makes evident how high the risk of communism must have been in his estimation. from our perspective today, his argument seems almost paradoxical: the government should take up to 92 percent of taxpayers’ taxable income in order to protect them from the system in which the government has 100 percent “of the 377. paul, tax adviser, supra note 4, at 418–19. 378. see supra note 18. 379. id. 380. miller, morality, supra note 20, at 1082–83. 381. the highest marginal tax rates during this period were: 94% in 1945; 91% in 1946-1951; 92% in 1952-1953; 91% in 1954-1963; 77% in 1964; and 70% in 1965. tax foundation, supra note 7. 2012] legal ethics and federal taxes 49 properties.”382 he argued that not only should americans pay their share of taxes but they should do so knowing that “paying a great deal more would not be an overpayment for the privilege of american citizenship.”383 while he did not urge americans to pay more than their fair share, his sentiment brings to mind the contrasting remark made in an earlier time by judge learned hand that there is not a “patriotic duty to increase one’s taxes.”384 dean griswold argued that with this national security threat, there were no expenditures americans could make that would “benefit us more than that we pay to the government in taxes[.]”385 mortimer caplin, robert n. miller, and norris darrell also explicitly sounded patriotic tones — praising the defense of country and the government agents who worked to defend the government’s revenue386 — and professor hellerstein emphasized the duties a lawyer owes to his government as a citizen.387 this patriotism was no doubt inspired by cold war threats, but it also reflects the broad support for the mass income tax policy.388 even though the highest marginal income tax rates for most of this period were over 90 percent,389 and even though during the early 1950s, more than 200 federal tax officials resigned, were removed, 382. miller, morality, supra note 20, at 1082–83. 383. see miller, taxpayer’s duty, supra note 68, at 9. 384. helvering v. gregory, 69 f.2d 809, 810–11 (2d cir. 1934), aff’d, 293 u.s. 465 (1935). 385. griswold, blessings of taxation, supra note 28, at 1002. in reflecting on the supreme court’s tax jurisprudence during the war against nazi aggression, it is interesting that he concluded the court favored the government in those in some part “because there was a war on.” id. at 1000. 386. see supra text at notes 76–81. 387. cahn et al., ethical problems, supra note 1, at 9 (statements by jerome hellerstein). 388. the broad support was produced by the defeat of the totalitarian regimes in world war ii and the post war surge in prosperity. brownlee, taxation in america, supra note 2, at 119–20. this new system had brought big changes in a small period of time: from 1939 to 1945, the number of individual income tax payers increased more than ten-fold (from 3.9 million to 42.6 million). though the richest 1 percent accounted for 32 percent of the income tax revenue, almost 90 percent of the labor force was now filing income tax returns. id. at 115– 17. in 1940, the income tax accounted for only 16 percent of all taxes collected at all levels of government, but by 1950 it accounted for more than 51 percent. the implementation of the new mass tax regime “succeeded because of the popularity of the war effort.” the two were connected in the public mind in some part due to a walt disney-produced propaganda cartoon starring donald duck and watched by more than 32,000,000 theatre-going americans in 1942. id. 389. see supra note 381. 50 florida tax review [vol. 12:1 and/or were indicted in connection with a string corruption scandals,390 these tax lawyers presented themselves as patriotic and optimistic supporters of their government and its tax system. there was considerable agreement among the writers that tax lawyers were in need of moral improvement,391 as were their clients.392 it seems likely, and was explicitly mentioned by several, that there could be considerable agreement on the resolution of specific moral problems, even though there might be considerable disagreement on the more abstract issue of whether or not tax lawyers had a special “duty to the system.”393 indeed, emphasizing the practical rather than theoretical, several of the writers claimed that moral problems need not even be debated in strictly moral terms, as they were convinced that good morals, good lawyering, and good business coincide.394 the pragmatism of these men led them not only to prefer solving particular problems to arguing theoretically, but also led them to collapse the moral, technical, and business aspects of tax lawyering into what today we might call a “best practices” approach. those writers who argued for a special duty for tax lawyers emphasized the self-assessing nature of the system and the need for strong moral principles among the taxpayers in the context of their duties as citizens in a democracy.395 professor maguire mentioned the “high degree of acquiescence and cooperation” needed from both taxpayer and their experts.396 norris darrell phrased it as the duty “to help make our selfassessing income tax system work,”397 which included, in his mind, making it work without requiring police state methods.398 merle h. miller emphasized that the duty to be honest and comply with the democraticallyimplemented tax system was especially important given the cold war’s demands.399 professor hellerstein argued that a citizen “owes his 390. in the early 1950s, a string of corruption scandals prompted congress to investigate the bir, where it discovered the consequences of political patronage and substantial corruption. more than 200 then-current and former tax officials resigned, were removed, and/or were indicted. in 1952, truman released a plan for reorganized the bir, and the reorganization carried over into the eisenhower administration. thorndike, reforming, supra note 6, at 755–59, 761–64. 391. see supra text at notes 47–56. 392. see supra text at notes 93, 129, 137, 303, 336, 339. 393. see supra part ii.d. 394. see supra text at notes 303, 323. 395. see supra text at notes 90, 117, 124, 125. 396. maguire, conscience and propriety, supra note 24, at 45. 397. darrell, propriety in tax practice, supra note 82, at 2. 398. id. at 23. 399. miller, morality, supra note 20, at 1083. 2012] legal ethics and federal taxes 51 government and his neighbors” his share of taxes, and that this recognition was necessary to avoiding moral chaos in the tax system.400 in addition to the claims about a general special duty, there were claims about specific duties tax lawyers owed. one commonly cited duty was becoming involved in improving the tax law and its administration. norris darrell and randolph e. paul both argued that the tax lawyer should be willing to improve the system, even if it meant taking positions contrary to the positions of his clients.401 mark h. johnson made a related but different point, which was that the tax lawyer ought not to work to advance his client’s positions through the bar associations but engage only in “disinterested public service” there.402 a second commonly cited duty was the duty of tax lawyers to educate their clients in an effort to improve their tax morality. merle h. miller argued that the tax lawyer ought to increase the layman’s respect for the system and always be careful to correct his client’s misconceptions.403 he believed the tax lawyer ought to increase the client’s respect for the system and appreciation of honestly complying.404 professor hellerstein argued the tax lawyers’ duty to improve tax morality extended beyond his clients and to the community at large.405 the duty of a tax lawyer as a tax ethics educator (at least for his clients) had wide support among the writers in the period.406 one wonders what today’s tax lawyers would think of such a duty. perhaps the debate over whether or not tax lawyers had a special duty to the tax system can be understood, in part, as an effort to identify the benefits tax lawyers provided to the tax system. in some part, the different characterizations of the benefits tax lawyers provided seem to reflect whether the writer was focused on the tax lawyer as a litigator or focused on the tax lawyer as an advisor. those who focused on litigation emphasized the benefits lawyers provide through the adversarial system. mark h. johnson attributed the coherence, uniformity, and equitable nature of the tax law to tax lawyers functioning as adversaries with the government on behalf of their clients.407 he thought that a client knowing “his advisor is in his own corner, and is not in the middle of the ring as a referee” increased the client’s support for the tax system and, as a result, reduced the temptation of clients to 400. see supra text at notes 89–95. 401. bittker, professional responsibility, supra note 23, at 102–03 (statements by norris darrell); paul, tax adviser, supra note 4, at 434. 402. johnson, theory, supra note 86, at 36. 403. miller, morality, supra note 20, at 1083. 404. id. 405. cahn et al., successful tax lawyer, supra note 26, at 14. 406. see supra text at notes 121, 137, 148–51. 407. johnson, theory, supra note 86, at 27, 35. 52 florida tax review [vol. 12:1 engage in wholesale tax evasion.408 professor barnes also argued that the tax lawyer, simply by lawyering, makes the tax system more effective.409 those who argued for a special duty on tax lawyers were less focused on lawyers as adversaries and more focused on lawyers as advisors. for example, professor hellerstein focused on advising clients about deductions and preparing transactional documents when arguing for a duty to the system.410 norris darrell argued that the tax lawyer ought to convince the client to behave as he, the lawyer, would when faced with the duty to calculate and report his own tax liabilities.411 he thought it was important for the tax lawyer to be willing to disappoint the client with his advice.412 and merle h. miller thought the tax lawyer contributed “greatly to the well being of the country at large” by killing off bad tax schemes at inception.413 professor maguire, thomas n. tarleau, norris darrell, randolph e. paul, and seymour s. mintz all agreed that tax lawyers engaged in litigation are engaged in an adversarial process not significantly different than others — but that more perplexing ethical issues of tax practice occur outside of the court room.414 one perplexing issue outside the court room was whether or not to disclose “doubtful but arguable points in a tax return.”415 only professor hellerstein argued for disclosing all positions it was reasonably clear the government would oppose, regardless of the strength of the taxpayer’s or government’s position.416 other writers focused on the quality of the government’s anticipated position. norris darrell and randolph e. paul argued that it is difficult to lay down a general rule, but usually debatable issues should be disclosed unless the debate would arise only because the government was unreasonably stubborn on a given issue.417 gerald wallace took this approach a step further, concluding there should be no duty of 408. id. at 31. 409. barnes, voluntary assessment system, supra note 25, at 1035. 410. see cahn et al., ethical problems, supra note 1, at 5, 7 (statements by jerome hellerstein). 411. darrell, propriety in tax practice, supra note 82, at 23. 412. darrell, tax minimization devices, supra note 21, at 988. 413. miller, morality, supra note 20, at 1076. 414. cahn et al., ethical problems, supra note 1, at 10 (statements by thomas tarleau); maguire, conscious and propriety, supra note 24, at 30; darrell, propriety in tax practice, supra note 82, at 22–23; holland et al., panel discussion, supra note 85, at 24 (statements by seymour s. mintz). 415. bittker, professional responsibility, supra note 23, at 92 (statements by norris darrell). 416. see supra text at notes 218–21. 417. bittker, professional responsibility, supra note 23, at 92; supra text at notes 224–27. 2012] legal ethics and federal taxes 53 disclosure so long as one believed the government’s position to be wrong.418 making the duty to disclose turn on anticipating the government’s response and being able to assess the quality of that response before it is made is a more complicated standard than assessing the quality of one’s own position. mark h. johnson and boris bittker each focused on the assessing one’s own position, with mr. johnson claiming no disclosure was needed so long as the position was reasonable, and professor bittker claiming no disclosure was needed so long as it reflects an honest belief about the tax liability.419 in addition to the substantive quality of the position, professor bittker cited concerns about overwhelming the government with disclosures and the difficulty in defining the lines of a general duty of disclosure.420 his concern was that the lofty rhetoric of taxpayers actively cooperating with the government should be checked by the likelihood of unintended consequences. the discussion of the duty of disclosure highlights the complexity of the tax lawyer’s role in a self-assessing system — the need to self-assess the quality of one’s own legal advice, the need to assess the quality of the government’s anticipated legal response, and the administrative needs and limits of the system. notably, no one alleged that an adversarial relationship between the taxpayer and the government meant that the government had no right to demand disclosure or that the taxpayer had the right to engage in the audit lottery. there was wide agreement that there was no special duty on tax lawyers who were litigating. but borris bittker,421 mark j. johnson,422 and professor john potts barnes423 were adamant that there was no special duty on tax lawyers in any situations, and randolph e. paul, though not “adamant” about the lack of such special duty, thought it was rather doubtful.424 none of these lawyers, however, should be understood as arguing for a low ethical standard. indeed, their concern was quite different. they argued that all lawyers are subject to high ethical standards, and to claim that tax lawyers are subject to especially high standards runs the risk of implying other lawyers are subject to lesser standards. their concern was to defend the ethical integrity of the bar as a whole, worrying that characterizing tax lawyers as having special ethical concerns made too much 418. cahn et al., ethical problems, supra note 1, at 31 (statements by gerald wallace). 419. bittker, professional responsibility, supra note 23, at 253–55; johnson, theory, supra note 86, at 32. 420. bittker, professional responsibility, supra note 23, at 253. 421. id. at 267–69. 422. johnson, theory, supra note 86, at 28. 423. barnes, voluntary assessment system, supra note 25, at 1039. 424. paul, tax adviser, supra note 4, at 425. see maguire, conscious and propriety, supra note 24, at 27. 54 florida tax review [vol. 12:1 of a difference between tax lawyers and other members of the bar. from this perspective, the debate over a special duty of tax lawyers reflects an interesting tension between those authors who emphasized the similarities between tax lawyers and other lawyers, and those who emphasized the differences between different types of lawyers. was the tax lawyer a tax professional who happened to be lawyer or a lawyer who happened to have tax expertise? one wonders how much this discussion indirectly reflected concerns over how the tax field ought to be divided between lawyers and accountants. during this period, accountants were being accused of engaging in the unauthorized practice of law for tax-related work,425 lawyers who were also accountants were forbidden from practicing both professions,426 and, as dean griswold put it, “[t]he two great professions of law and accountancy were squared away for a battle royal.”427 perhaps this battle with accountants persuaded those who denied any special duty on tax lawyers to do so as an effort to establish that tax lawyers were not only primarily but essentially and exclusively lawyers, sharing professional commonalities with all the other members of the bar but no other profession. tax lawyering was lawyering, and only tax lawyers were authorized to do it, was perhaps the subsurface theme. interestingly, within only a couple of years, randolph e. paul, one of the most influential tax lawyers during this time, switched his emphasis from the differences between tax lawyers and other lawyers to the similarity between the two. perhaps this shift was influenced in some part by his sensitivity to this inter-professional debate, and his lending his weight to the proposition that tax lawyers were lawyers, not a unique or hybrid “tax professional” with duties and powers still open for description.428 425. see, e.g., agran v. shaprio, 127 cal. app. 2d supp. 807, 273 p.2d 619 (1954). 426. in 1961 the aba standing committee on professional ethics issued ethics opinion 297, which prohibited a lawyer-accountant from practicing both. the following year, opinion 305 took the position that those who are both lawyers and accountants are not entitled to hold themselves out only as accountants but to engage in the practice of law. maintaining the division between lawyers and accountants was foremost in the mind of at least some members of the committee. michael s. ariens, american legal ethics in an age of anxiety, 40 st. mary’s l. rev. 343, 436 (2008) [hereinafter ariens, american legal ethics]. 427. erwin n. griswold, role of lawyer in tax practice, 10 u.s.c. sch. l., major tax planning 1, 1 (1958) (commenting on the consequence of the agran case creating strife between lawyers and accountants). see also erwin n. griswold, lawyers, accountants and taxes, 10 rec. ass’n b. city n.y. 52 (1955) reprinted in 18 tex. b. j. 109 (1955); erwin n. griswold, a further look: lawyers and accountants, 41 a.b.a. j. 1113 (1955). 428. paul, tax adviser, supra note 4, at 425. see maguire, conscious and propriety, supra note 24, at 27. 2012] legal ethics and federal taxes 55 when it came to describing how it is tax lawyers ought to go about being good tax lawyers, perhaps the most interesting emphasis was the deemphasis of technical analysis. randolph e. paul characterized tax law as less formal and technical than other fields of law.429 robert n. miller claimed the tax lawyers have to rely more on practical wisdom than technical analysis,430 and merle miller argued that confidence in a technical approach to taxation was the mark of naïve clients rather than good tax lawyers.431 norris darrell described the acquisition of knowledge of the tax code, regulations, and rulings, as one requiring “an inordinate expenditure of time,” but only the very first step in tax advising.432 this technical knowledge had to be placed in the light of the client’s situation, legal history, congressional purpose, and moral propriety.433 the tax lawyer was called upon for his judgment, which mr. darrell compared with that of a “perfume smeller or wine tester,” and certainly never called upon to cleverly “jig-saw cut” technical arguments.434 merle miller emphasized the importance of being “as zealous in developing a sense of moral fairness as in acquiring a technical working knowledge of the code,” as he believed that a lawyer who failed to accept the relevance of his own moral sensibilities would push his clients into trouble.435 randolph e. paul warned against putting “undue trust in the letter of the law,” remembering the underlying purpose of the law, and relying on professional intuition when giving tax advice.436 in sum, broad judgment was what a tax lawyer needed and not mere technical expertise.437 this judgment is informed not only by knowledge of the law and its purpose, but also, mark h. johnson argued, by the study of literature and history.438 robert n. miller described the necessary type of judgment not as a professional attribute but a personal one — the judgment that led the lawyer into a well-balanced personal life was what he had in mind.439 thus, in these tax lawyers’ minds, good technical analysis was necessary but insufficient for good tax lawyering. good tax lawyers were wise, not merely clever. 429. paul, responsibilities, supra note 57, at 381. 430. id. at 9. 431. miller, morality, supra note 20, at 1075. 432. darrell, tax minimization devices, supra note 21, at 984. 433. id. at 985–89; bittker, professional responsibility, supra note 23, at 101 (statement by norris darrell). 434. darrell, tax minimization devices, supra note 21, at 988. 435. miller, morality, supra note 20, at 1076–77. 436. paul, tax adviser, supra note 4, at 417. 437. see paul, responsibilities, supra note 57, at 378–79, 381, 385; paul, tax adviser, supra note 4, at 416–17. 438. cahn et al., successful tax lawyer, supra note 26, at 4–5 (statements by mark h. johnson). 439. id. at 9 (statements by robert n. miller). 56 florida tax review [vol. 12:1 in the past decade especially, we have become accustomed to detailed practice regulation from the treasury department440 — and detailed comments from tax bar committees.441 it is helpful to remember there was not the same type of guidance, regulation, or committee work during most of the period in which these lawyers were writing.442 indeed, some of the lawyers called for increased efforts of exactly this sort. professor maguire called for “marching orders” from the bar or treasury department for “a number of commonplace situations produced by tax practice,” and his call was echoed by norris darrel and mortimer caplin.443 the tax lawyers writing in 1945-1965 were sketching their personal approaches on ethical issues without having to consider, or having the benefit of considering, much sustained corporate reflection and articulation. it is interesting that they also sketched their ethical approaches without significant reference to either the aba canon of professional ethics or any state bar’s rules; today it would be unthinkable that a lawyer would seriously analyze professional ethics issues without using the ethics rules as rules. perhaps the boldness with which some of these older approaches were expressed is attributable to the then wide-open range of the discussion, unbounded by much formal guidance or regulation, much bar committee work, or much interest in formal ethics rules. their bold and open discussion preceded the evolution of legal ethics into the law of lawyering,444 and it shows. one is left to ponder what the perspective of these earlier tax lawyers with their earlier understanding of professional ethics would have on many of today’s issues. with their philosophical concern for the relationship between law and morals, how would they perceive theorientation of the discourse on the technical regulation of the profession by the treasury 440. see david weisbach and brian gale, the regulation of tax advice and advisors, 130 tax notes 1279 (mar. 14, 2011). 441. see, e.g., aba tax section offers views on proposed circular 230 guidelines, tax notes, dec. 20, 2010, at 1319. 442. there was some committee work in this area. for example, in 1951, the american bar association and the american institute of certified public accountants issued an advisory statement of principles relating to practice in the field of federal income taxation. see lawyers and certified public accountants: a study of interprofessional relationships, 36 tax law. 26, 27 (1982). in 1965 the american bar association issued formal opinion 314 on standards for tax return advice. see aba comm. on prof’l ethics, formal op. 314 (1965) reprinted in 51 a.b.a. j. 671 (1965). 443. see supra notes 53–56, 105; see generally supra part ii.f. 444. for a discussion of the development of legal ethics into the law of lawyering governed by the aba model rules, see, e.g., ariens, american legal ethics, supra note 426, at 444–53. 2012] legal ethics and federal taxes 57 department?445 with their interest in improving both the tax savings and the tax morality of their clients, how would they perceive the attacks and defenses of tax shelter lawyering?446 with their emphasis on providing solid tax advice, what would they make of today’s opinion and disclosure standards?447 if they had witnessed the last half-century’s developments of tax law, tax lawyering and tax law administration, how would their ideas of the duty to the system have developed?448 given their love of country and their experience of the cold war and near-confiscatory tax rates, how would they react to today’s anti-tax rhetoric during the “war on terror” and much, much lower rates? while it is interesting to ponder how the tax lawyers of more than half century ago would consider us today, it is perhaps more interesting to ponder how the tax lawyers of 2065 will. 445. see, e.g., camilla e. watson, legislating morality: the duty to the tax system reconsidered, 51 u. kan. l. rev. 1197, 1197 (2003); david t. moldenhauer, circular 230 opinion standards, legal ethics and first amendment limitations on the regulation of professional speech by lawyers, 29 seattle u. l. rev. 843, 874 (2006). 446. see, e.g., richard lavoie, deputizing the gunslingers: co-opting the tax bar into dissuading corporate tax shelters, 21 va. tax rev. 43, 90 (2001). 447. see, e.g., brett r. wells, voluntary compliance: “this return might be correct but probably isn’t,” 29 va. tax rev. 645 (2010). 448. see, e.g., david j. moraine, loyalty divided: duties to clients and others — the civil liability of tax lawyers made possible by acceptance of a duty to the system, 63 tax law. 169, 172 (2009). legal ethics and federal taxes, 1945-1965: patriotism, duties, and advice ii. legal ethics for tax lawyers: a review of the 1945-1965 literature iii. reflections florida tax review florida tax review volume 14 2013 number 7 275 reforming the charitable contribution substantiation rules by ellen p. aprill* i. introduction ............................................................................. 275 ii. the impact of the charitable contribution substantiation rules .............................................................. 278 iii. the history and substance of the substantiation rules ............................................................................................ 286 iv. judicial gloss ........................................................................... 297 v. what can be done? .................................................................. 307 i. introduction in may 2012, the tax court issued two decisions denying income tax deductions for gifts to charitable organizations because the taxpayers had failed to comply with applicable substantiation rules. in mohamed v. commissioner,1 the taxpayer in 2003 and 2004 donated real property unquestionably worth more than $15 million to his charitable remainder unitrust. the taxpayer himself filled out the form 8283 required for certain noncash contributions without reading the instructions. he did not fill out the form completely and did not attach the required appraisal, although, as the tax court acknowledged, the form 8283 at the time directed that an appraisal be attached only for artwork worth at least $20,000. moreover, the taxpayer, an experienced real property appraiser, prepared the appraisal himself. because of the taxpayer’s position as donor — and also as trustee of the charitable remainder trust and as donee — his appraisal was not an independent appraisal. it did not and could not meet the requirement of a qualified appraisal under regulations section 1.170a-13(c)(5)(iv)(a) and (c).2 * john e. anderson professor of law, loyola law school. 1. 103 t.c. memo (cch) 1814, t.c. memo (ria) ¶ 2012-152. 2. all subsequent statutory references, both in text and in footnotes, are to the internal revenue code of 1986, as amended, unless otherwise specified. 276 florida tax review [vol. 14:7 the tax court rejected the taxpayer’s argument that the deduction be allowed on the basis of substantial compliance with the regulations’ requirements. the court explained that substantial compliance is not possible without a qualified appraisal because such an appraisal is an essential requirement of the statutory scheme. the opinion concluded with this regret: we recognize that this result is harsh — a complete denial of charitable deductions to a couple that did not overvalue and may well have undervalued, their contribution — all reported on forms that even to the court’s eyes seemed likely to mislead someone who didn’t read the instructions. but the problems of misvalued property are so great that congress was quite specific about what the charitably inclined have to do to defend their deduction, and we cannot in a single sympathetic case undermine those rules.3 less than two weeks earlier, in durden v. commissioner,4 the tax court had denied a charitable contribution deduction claimed in 2007 for cash contributions of more than $25,000 given primarily to the taxpayers’ church. the taxpayers had failed to obtain a contemporaneous acknowledgment from the church stating whether any goods or services had been provided in consideration for the contribution, as required by section 170(f)(8)(b) of the internal revenue code and regulations section 1.170a13(f)(2) for any contribution of $250 or more. the taxpayers received such a letter in 2009, but that letter did not meet the “contemporaneous” requirement.5 3. mohamed, 103 t.c. memo (cch) at 1820. 4. 103 t.c. memo (cch) 1762, t.c. memo (ria) ¶ 2012-140. 5. a contemporaneous written acknowledgment is required for any contribution of $250 or more in order for a donor to take the charitable contribution deduction. see i.r.c. § 170(f)(8)(b). it must include the amount of cash and a description (but not value) of any property other than cash contributed, state whether the donee organization provided any goods or services in consideration, in whole or in part, for any property contributed, and also entail a description and good-faith estimate of the value or service provided by the donee organization (other than intangible religious benefits). i.r.c. § 170(f)(8)(b)(i)-(iii). a written acknowledgment is “contemporaneous” if it is obtained by the taxpayer on or before the earlier of: (1) the date the taxpayer files the original return for the taxable year of the contribution, or (2) the due date (including extensions) for filing the original return for the year. i.r.c. § 170(f)(8)(c); reg. § 1.170a-13(f)(3). quite surprisingly, the requirements for a contemporaneous written acknowledgment do not include stating the date of the contribution. the date of contribution, however, is important. an acknowledgment received after january 1 of year 2, but before the filing or due date of the taxpayer’s return for year 1, could relate to a gift in either year 1 or year 2. because of such an ambiguity, the year of contribution of an almost million-dollar gift and the validity of the written acknowledgment were important issues in the recent criminal tax trial of los angeles businessman howard berger. berger was acquitted of the charge related to the charitable contribution along with all other 2013] reforming the charitable contribution substantiation rules 277 the taxpayers argued that they had substantially complied with the statutory requirements. as in mohamed, the tax court in durden rejected the substantial compliance argument. it found that a specific and timely statement regarding provision of goods or services provided, including a specific statement if none were provided, to be essential information required by the statute since such information is necessary to determine the deductible amount of the taxpayers’ contributions. the tax court acknowledged that it had permitted charitable contribution deductions in some situations where taxpayers had demonstrated only substantial compliance with the statutory requirements. it described those cases, unlike this one, as involving “procedural requirements where, despite a lack of strict compliance, the taxpayer substantially complied by fulfilling the essential statutory purpose.”6 these two cases lit a firestorm of outrage in various circles, including the tax-law professor listserv. that a group of academics that tends to be pro-rule and pro-government objected so vociferously to these cases should give one pause about the set of rules these cases apply. (i will return at the end of this paper to the academics’ suggestions for change.) the line that the tax court has drawn between failures that satisfy the judicial doctrine of substantial compliance and those that do not also demands consideration. the question of how to apply the substantiation rules and how to determine the appropriate use of the substantial compliance doctrine becomes particularly compelling for charitable gifts after june 2004, when congress explicitly enacted a “reasonable cause” exception for failures related to the qualified appraiser and qualified appraisal requirements.7 this article critically examines the substantiation regime for charitable contributions. it begins by reviewing two reasons why the income tax charitable contribution substantiation rules merit consideration. first, the charitable contribution deduction is important for both its size and its distribution, and the substantiation rules work to safeguard its integrity. second, in the case of the charitable contribution, unlike many other income tax provisions, the treasury and the internal revenue service cannot look to third parties with self-interested incentives that help ensure compliance. the substantiation rules substitute for third party corroboration. part iii of the charges. see kurt orzeck, santa monica man acquitted of tax fraud, santa monica patch, sept. 20, 2011, http://santamonica.patch.com/articles/santa-monica -man-acquitted-of-tax-fraud. although most organizations probably include the date of contribution currently, i suggest that the regulations applicable to the contemporaneous written acknowledgment be revised to require the acknowledgment to include the date of the contribution. 6. durden, 103 t.c. memo (cch) 1762. see discussion on tax court cases permitting substantial compliance infra part iv. 7. see american jobs creation act of 2004, pub. l. no. 108-357, § 883, 118 stat. 1418, 1631 (codified at i.r.c. § 170(f)(11)(a)(ii)(ii)). 278 florida tax review [vol. 14:7 article sets out, as briefly as possible, the complicated regime regarding the substantiation of charitable contributions, including the legislative history and applicable regulations. part iv examines applicable case law. review of legislation, regulations, and case law suggests strongly that we make an effort to reform the current scheme; in turn, part v presents a number of possible reforms. these suggestions include inflation adjustments, regulatory changes, and making greater use of technology. finding approaches that appropriately balance the need to control overvaluation with the need to encourage legitimate charitable contributions is a difficult but important challenge. ii. the impact of the charitable contribution substantiation rules the charitable contribution substantiation rules matter for two very different reasons: first, the place of the charitable contribution deduction in the federal income tax system makes protection of its integrity important, and second, these rules demonstrate the need for special enforcement mechanisms when the government cannot take advantage of third parties to monitor compliance.8 the total dollar amount of all charitable contribution deductions demonstrates its importance to the federal income tax. it is costly to the federal government. according to the joint committee on taxation (jct), the revenue loss for the charitable contribution deduction in fiscal year 2013 by individuals and corporations will amount to $41.8 billion, and for fiscal years 2013 to 2017 the projected total is $238.8 billion.9 the charitable contribution deduction ranks among the federal government’s top ten tax expenditures.10 8. i thank celia roady for encouraging me to explore these considerations. 9. joint committee on taxation, estimates of federal tax expenditures for fiscal years 2012-2017, jcs-1-13, table 1 (feb. 1, 2013) (listing numbers separately for deductions for charitable contributions to educational institutions, those for health organizations, and those for charitable contributions other than for education and health; totals are author’s calculations). 10. see top ten tax expenditures: jct releases its annual report, the committee for a responsible budget (jan. 12, 2010), http://crfb.org/blogs/topten-tax-expenditures-jct-releases-its-annual-report. tax expenditures are the subject of voluminous scholarship, but for purposes of this paper the definition on the tax expenditure publications page of the joint committee on taxation will suffice: “in general, tax expenditures include any reductions in income tax liabilities that result from special tax provisions or regulations that provide tax benefits to particular taxpayers.” publications on tax expenditures, joint committee on taxation (updated feb. 2013), https://www.jct.gov/publications.html?func=select&id=5. 2013] reforming the charitable contribution substantiation rules 279 a key rationale for the charitable contribution deduction is that it operates as a subsidy to provide an incentive for giving.11 many countries envy the record in the united states for charitable giving, and rightly so. in 2011, the world giving index of the charities aid foundation of great britain ranked the united states first among countries globally.12 the many supporters of the deduction-subsidy point out that socalled treasury or “dollar” efficiency justifies its cost. treasury or dollar efficiency means that the deduction increases giving to charitable organizations by more than the amount lost by the fisc.13 of course, treasury or dollar efficiency requires that amounts taken as charitable contributions accurately state the amounts charities receive. the substantiation rules seek to ensure this match. the charitable contribution deduction is available only to those who itemize deductions and not to those who take the standard deduction. in 2010, for those who itemized, the charitable contribution deduction 11. see c. eugene steuerle & martin a. sullivan, toward more simple and effective giving: reforming the tax rules for charitable contributions and charitable organizations, 12 am. j. tax pol’y 399, 403 (1995) (citing incentives as the primary purpose of the deduction). there are others, however, who believe that the charitable contribution deduction is required to measure income accurately because contributions to others diminish ability to pay. for a classic statement of this point of view, see william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309 (1972). robert j. shiller, professor of economics and finance at yale university, recently stated his position in the new york times: “income that is freely given away should not even be considered as taxable income.” robert j. shiller, economic view: please don’t mess with the charitable deduction, n.y. times, dec. 15, 2012, at bu 7 [hereinafter shiller, please don’t mess with the charitable deduction]. 12. world giving index 2011: a global view of giving trends, charities aid foundation, 11 (dec. 2011), https://www.cafonline.org/pdf/world_giving_ index_2011_191211.pdf. in 2012, the united states fell to fifth. world giving index 2012: a global view of giving trends, charities aid foundation, 13 (dec. 2012), https://www.cafonline.org/pdf/worldgivingindex2012web.pdf. 13. see ellen p. aprill, churches, politics, and the charitable contribution deduction, 42 b.c. l. rev. 843, 856–60 (2001); ilan benshalom, the dual subsidy theory of charitable deductions, 84 ind. l.j. 1047, 1059–61 (2009); lilian v. faulhaber, the hidden limits of the charitable deduction: an introduction to hypersalience, 92 b.u. l. rev. 1307, 1334, 1339 (2012); brian galle, the role of charity in a federal system, 53 wm. & mary l. rev. 777, 821, 831–33 (2012); david e. pozen, remapping the charitable deduction, 39 conn. l. rev. 531–57 (2006). authors galle, benshalom, and pozen discuss additional justifications for the deduction, as has miranda fleischer. see miranda perry fleischer, equality of opportunity and the charitable tax subsidies, 91 b.u. l. rev. 601 (2011); miranda p. fleischer, theorizing the charitable tax subsidies: the role of distributive justice, 87 wash. u. l. rev. 505 (2010). 280 florida tax review [vol. 14:7 represented the third largest itemized deduction.14 however, the worth of the deduction to a taxpayer depends on the taxpayer’s marginal rate. because high-income taxpayers tend to be in higher marginal tax rate brackets, higher income taxpayers generally have a lower tax price of giving than do lower income taxpayers. as a result of this differential, highincome taxpayers may face the largest tax incentives for giving, while lowincome taxpayers may face relatively small tax incentives for giving even if they itemize.15 nevertheless, only 34.4 percent of individual taxpayers itemized deductions in 2010, which was down 1.5 percent from 2009.16 of those who itemized, 82 percent claimed the charitable contribution deduction.17 nonitemizers, however, make substantial charitable contributions even though they do not receive a tax benefit for these gifts. giving usa estimated total charitable contributions by individuals in 2010 to be $211.77 billion.18 for the same year, the irs statistics of income reported total charitable contribution deductions of $170.24 billion.19 based on these numbers, taxpayers who did not itemize donated $41.53 billion to charity, or almost 20 percent of total charitable giving in 2010.20 14. internal revenue service, statistics of income bulletin, 9 (fall 2012), http://www.irs.gov/pup/taxstats/productsandpubs/12fallbul.pdf [hereinafter i.r.s., income bulletin]. 15. joint committee on taxation, present law and background relating to the federal tax treatment of charitable contributions, jcx-55-11, at 35 (oct. 14, 2011). 16. i.r.s., income bulletin, supra note 14, at 8. 17. id. at 9 (percentage calculated by author based on numbers in figure e). 18. giving usa 2011: the annual report on philanthropy for year 2010: executive summary, giving usa foundation at the center on philanthropy at indiana university, 5 (june 2011), http://big.assets.huffingtonpost.com/ givingusa_2011_execsummary_print-1.pdf. 19. i.r.s., income bulletin, supra note 14, at 9. 20. the jct undertook a similar comparison of charitable contributions claimed on tax returns as reported by irs statistics of income data and individual donations as reported by giving usa for 2008 and found that an estimated $56.4 billion in charitable contributions came from non-itemizers. joint committee on taxation, present law and background relating to the federal tax treatment of charitable contributions, jcx-55-11, at 37–39 (oct. 14, 2011). the jct reported a somewhat different number from giving usa for total charitable contributions in 2010, (i.e., $209.64 billion) because it used the giving usa 2009 report instead of the number in the more recent report and therefore estimated that $39.4 billion of charitable contributions made by individuals were not claimed as itemized deductions. joint committee on taxation, present law and background relating to the federal tax treatment of charitable contributions, jcs-4-13, at 45–46 (feb. 11, 2013). this jct report indicated that 2013] reforming the charitable contribution substantiation rules 281 that non-itemizers nonetheless contribute large amounts to charity heightens the importance of the charitable contribution substantiation rules. taxpayers who do not itemize deductions receive fewer tax benefits from the same behavior than those who do.21 if itemizers increase their charitable contribution deductions by overvaluing the amount of the contributions, nonitemizers suffer further in comparison. if such overvaluations were to be seen as pervasive, the disparity between tax benefits enjoyed by itemizers and non-itemizers would grow, and public faith in the tax system as a whole could diminish. as professor john brooks has written about the standard deduction more generally, “if middle-income taxpayers see themselves as being taxed on a different tax base than high-income taxpayers, it could undermine belief in the tax system as fundamentally fair.”22 if the tax base of many high-income taxpayers is reduced — or perceived as being reduced — because of overvaluing charitable contributions, fundamental fairness evaporates. indeed, the legislative history of the deficit reduction act of 1984 (defra), which introduced detailed substantiation rules, spoke specifically of such overvaluation leading to a “disrespect for the tax laws.”23 overvaluation is a particular risk with the charitable contribution deduction. then irs commissioner mark w. everson explained at a senate hearing in 2005, “overvaluations are difficult to identify, substantiate and charitable contributions in 2011 of $217.79 billion was the highest level since 2007, when total contributions amounted to $233.11 billion. id. 21. of course, the standard deduction assumes a certain amount of charitable contributions, and if non-itemizers would benefit more from itemizing than taking the standard deduction, they would switch to itemizing. as john brooks has written, “if the standard deduction is intended to be a proxy for personal deductions like the charitable deduction, then non-itemizers are already getting the benefit of their charitable deductions — and then some. but to many taxpayers, it probably does not feel like they are getting the benefit, and in part they are right, since they do not feel the incentive effects of the tax deduction at the margin.” john r. brooks ii, doing too much: the standard deduction and the conflict between progressivity and simplification, 2 colum. j. tax. l. 203, 228 (2011) [hereinafter brooks, doing too much] (footnotes omitted). for a brief period beginning in 1981, non-itemizers were allowed to take the deduction in whole or in part. see economic recovery act of 1981, pub. l. no. 97-34, 95 stat. 172 (1981). suggestions to again permit the charitable contribution deduction for non-itemizers surface regularly. see, e.g., shiller, please don’t mess with the charitable deduction, supra note 11; congressional budget office, options for changing tax treatment of charitable giving, 15–17 (may 24, 2011), http://cbo.gov/publication/ /42185. 22. brooks, doing too much, supra note 21, at 231. he further observes that “[t]he standard deduction also has the effect of minimizing any well-intentioned incentives written into the code.” id. at 230. 23. joint committee on taxation, general explanation of the revenue provisions of the deficit reduction act of 1984, jcs-41-84, at 504 (dec. 31, 1984). 282 florida tax review [vol. 14:7 litigate. further, donors and recipient charities do not have adverse interests that would help establish a correct valuation.”24 overvaluation of charitable contributions appears annually on the irs list of the dozen top tax scams.25 in other contexts, tax administrators can rely on third parties. as leandra lederman has detailed, the government looks to third parties in order to ensure compliance with tax laws in a variety of situations.26 information reporting and withholding by third parties have proven particularly successful. amounts subject to withholding (e.g., wages and salaries) have a net misreporting percentage of only 1.2 percent. amounts subject to third party information reporting, but not to withholding (e.g., interest and dividend income) have a slightly higher net misreporting percentage of 4.5 percent. amounts subject to partial third-party reporting (e.g., capital gains) have a still higher net misreporting percentage of 8.6 percent. amounts not subject to withholding or other information reporting (e.g., schedule c income or other income) are the least visible, with a much higher net misreporting percentage of 53.9 percent.27 the government can also take advantage of situations “in which third parties, in acting out of their own self-interest will verify the taxpayer’s claim.”28 according to lederman, compliance concerns, particularly concerns about false claims, explain asymmetrical treatment of various tax items.29 for example, section 104 excludes from income amounts recovered for personal injury but does not permit a deduction for unrecovered amounts. if a taxpayer is injured in a car accident, amounts received from the tortfeasor for the injured party’s uninsured medical expenses, pain and suffering, and lost wages are excluded from the taxpayer’s income.30 if, however, the injured 24. exempt organizations: enforcement problems, accomplishments, and future direction: hearing before the s. comm. on fin., 109th cong. 166 (2005) (statement of mark w. everson, commissioner of internal revenue), http://www.finance.senate.gov/imo/media/doc/metest040505.pdf. 25. i.r.s. news release ir-2012-22 (feb. 16, 2012), http://www.irs.gov/ uac/irs-releases-the-dirty-dozen-tax-scams-for-2012. 26. leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stan. l. rev. 695 (2007) [hereinafter lederman, statutory speed bumps]. 27. id. at 698 (quoting charles p. rettig, nonfilers beware: who’s that knocking at your door?, j. tax prac. & proc., oct.–nov. 2006, at 15–16). 28. lederman, statutory speed bumps, supra note 26, at 700. 29. see generally id. 30. see i.r.c. § 104. 2013] reforming the charitable contribution substantiation rules 283 taxpayer is unable to recover these amounts because, for example, the tortfeasor lacks insurance, the taxpayer cannot take a deduction for the costs he or she bears. in the former but not the latter case, a third party has an economic incentive to vet the injured taxpayer’s claim. similarly, employers have an incentive not to underreport employees’ wages because they deduct as a business expense the wages they report as paid to their employees.31 in some cases, tax treatment of one party depends directly on another party’s treatment of a tax item. for example, employers can generally deduct nonqualified deferred compensation payments made to employees only when the amounts are included in income by employees.32 when the third party does not have an arm’s-length relationship with the taxpayer, however, the government cannot rely on the third party to help ensure compliance. lederman offers nonresident aliens, foreign corporations, and, as commissioner everson also noted, tax-exempt entities as examples of tax-indifferent third parties without an offsetting interest that motivates the third party to verify a u.s. taxpayer’s income tax benefits.33 a charity receiving a contribution has neither a tax nor an economic incentive to judge independently the amount reported as a deduction by a donor. concurring with others, the jct has observed that “[u]nlike in an arm’s length negotiation, in a charitable contribution situation, the interests of a donor and a donee organization are not adverse.”34 under current law, the recipient organization has only limited reporting obligations. as part of the contemporaneous written acknowledgment that a donor must obtain to claim a deduction for a charitable contribution of $250 or more, a recipient organization must value any goods or services it provides to the donor.35 the recipient, however, has no obligation to determine or report the amount of a property donation. while the form 8283 that a donor must file with his or her tax return for certain property donations requires the donee’s acknowledgment, it specifies that the acknowledgment “does not indicate agreement with the claimed fair market value.”36 31. see i.r.c. § 62. 32. see §§ 83(h), 404(a)(5), 409a. 33. lederman, statutory speed bumps, supra note 26, at 734. 34. joint committee on taxation, present law and background relating to the federal tax treatment of charitable contributions, jcx 4-13, at 41 (feb. 11, 2013). 35. i.r.c. § 170(f)(8)(b). also, for quid pro quo contributions in excess of $75, the organization must provide the donor with a good-faith estimate of the good or services provided. i.r.c. § 6115(a)(2). 36. however, if the donee disposes of contributed property valued at more than $5,000 within three years of receipt, the donee must file form 8282 and disclose the amount received upon disposition. i.r.c. § 6050l. 284 florida tax review [vol. 14:7 the substantiation rules therefore attempt to make up for the lack of arm’s-length third-party verification.37 for most contributions of property valued at more than $5,000, a qualified appraisal and appraisal summary involving the appraiser, as described in more detail below, is required. thus, an appraiser does report information as a third party. the appraiser, however, does not have any self-interest opposed to the donor. changes made to the charitable contribution substantiation rules by the pension protection act of 2006 look to professional norms by requiring credentials, training, and experience from appraisers, as well as increased penalties on appraisers for gross overvaluation. the substantiation requirements attempt to serve as a surrogate for an adverse third-party self-interest as a means of obtaining more accurate and reliable appraisals.38 nonetheless, a recent report of the treasury inspector general for tax administration (tigta) used statistical samples to project that just in 2010 “more than 273,000 taxpayers claimed approximately $3.8 billion in potentially unsubstantiated noncash contributions,” resulting in “an estimated $1.1 billion reduction in tax.”39 in other contexts, however, we do not require elaborate substantiation to support self-interested reporting. in particular, as noted above, schedule c income has a high rate of misreporting. “according to government reports, most individuals with business income fail to pay all their taxes, although some appear to cheat more than others.”40 underreporting of income from small businesses figures prominently into the tax gap, (i.e., the difference between what taxpayers owe and what they pay). “in the aggregate, small business owners report less than half of their 37. like the charitable contribution deduction, the business deduction for travel meals and entertainment has also proved susceptible to abuse through overvaluation. as a result, since 1962 congress has imposed special substantiation rules for these expenses, although the requirements are not as onerous as those for the charitable contribution deduction. section 274(d) requires a taxpayer to be able to substantiate the amount of the expense, its time and place, a business purpose of the item, and the business relationship of any person entertained. 38. see infra part iii for additional discussion of these rules. these requirements are not as strict, of course, as the requirement of auditor independence, but they attempt to serve much the same function. 39. treasury inspector gen. for tax admin., many taxpayers are still not complying with noncash charitable reporting requirements, ref. no. 2013-40-009, at 6 (dec. 20, 2012), http://www.treasury.gov/tigta/audit reports/2013reports/201340009fr.pdf [hereinafter treasury inspector general, many taxpayers are still not complying]. 40. susan cleary morse, stewart karlinsky & joseph bankman, cash businesses and tax evasion, 20 stan. l. & pol’y rev. 37, 37 (2009) [hereinafter morse, karlinsky, & bankman, cash businesses]. 2013] reforming the charitable contribution substantiation rules 285 income.”41 yet, we do not have a burdensome substantiation regime for small-business deductions comparable to that for charitable contribution deductions. how, then, can the government justify this differential treatment? first, charitable deductions and business deductions play very different roles in our tax system. we tax net, not gross, income allowing deductions for the costs of producing income. “[d]isallowing or limiting the business deductions of the self-employed would be inconsistent with a normative income tax. moreover, allowing anything less than a full deduction for the business expenses of the self-employed could stifle entrepreneurship, and, as a result, probably would not be politically viable.”42 in contrast, “charitable contributions are perhaps the purest example of personal deductions, having almost no business or income-producing purpose.”43 the charitable contribution deduction, in other words, is particularly a creature of legislative grace.44 having fashioned the deduction, congress can condition it, including requiring substantiation, as it sees fit. second, evidence suggests that underreporting of business income, at least for cash businesses, results primarily from the failure to report income, not from overstating deductions. authors of a recent survey found that “interviewees generally considered overstating deductions an inferior strategy relative to misreporting income. ‘never do anything with deductions,’ one business owner told us.”45 41. id. at 38 (citing internal revenue service and u.s. dep’t of the treasury, reducing the federal tax gap: a report on improving voluntary compliance 13-14 (2007)). 42. lederman, statutory speed bumps, supra note 26, at 721–22 (footnotes omitted). 43. brooks, doing too much, supra note 21, at 217. 44. “whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefore can any particular deduction be allowed.” new colonial ice co. v. helvering, 292 u.s. 435, 550 (1934). 45. morse, karlinsky & bankman, cash businesses, supra note 40, at 51; cf. u.s. gov’t accountability office, gao-07-1014, a strategy for reducing the tax gap should include options for addressing sole proprietor noncompliance 10 (2007) (finding 73 percent of sole proprietors made an error on their total expenses line resulting in a $40 billion net overreporting of expenses); office of the taxpayer advocate, 2012 report to congress, http://www.taxpayeradvocate.irs.gov/userfiles/file/full-report/most-litigatedissues.pdf (listing section 162 expenses among the most litigated issues); office of the taxpayer advocate, factors influencing voluntary compliance by small businesses: preliminary survey results, http://www.taxpayeradvocate. irs.gov/userfiles/file/full-report/research-studies-factors-influencing-voluntarycompliance-by-small-businesses-preliminary-survey-results.pdf (associating dis trust of the national government and the irs with low compliance). 286 florida tax review [vol. 14:7 thus, justifications exist for establishing special substantiation requirements for the charitable contribution deduction. these justifications, however, do not prescribe what substantive rules balance the dual needs of encouraging charitable giving and discouraging abuse. over the decades, the substantiation rules have grown more and more intricate, as described below, and the question arises as to whether they continue to achieve their purpose or impose too great a burden compared to their benefit. iii. the history and substance of the substantiation rules currently, an elaborate and complicated set of statutory provisions require substantiation of charitable contributions for such contributions to be eligible for deduction from the income tax. requirements vary with the nature and amount of property donated. the statutory provisions explicitly state that no deduction will be allowed if a taxpayer fails to meet the substantiation and record-keeping requirements.46 (the following describes the applicable rules generally because recounting all the specific rules for various types of property would take more pages than, i believe, readers would have the patience to read). the charitable contribution deduction dates back to the war revenue act of 1917, just four years after the introduction of the federal income tax.47 from the first enactment of the charitable contribution deduction, congress has expressed concern about substantiating the amount claimed as a deduction. the 1917 provision provided a deduction for: contributions or gifts actually made within the year to corporations or associations organized and operated exclusively for religious, charitable, scientific, or educational purposes, or to societies for the prevention of cruelty to children or animals, . . . such contributions or gifts shall be allowable as deductions only if verified under rules and regulations prescribed by the commissioner of internal revenue, with the approval of the secretary of the treasury.48 46. for an overview and summary of those rules, see carla neeley freitag & barbara l. kirschten, charitable contributions: income tax aspects, 521 tax mgmt. (bna) worksheet 1 [hereinafter freitag & kirschten, charitable contributions]. 47. see generally war revenue act of 1917, pub. l. no. 65-50, 40 stat. 300 (1917). 48. id., ch. 63, § 1201(2), 40 stat. at 330 (emphasis added). 2013] reforming the charitable contribution substantiation rules 287 over the past thirty years, congress has repeatedly returned to the charitable contribution substantiation rules and strengthened them each time in an attempt to prevent abuse — particularly overvaluation. the first effort took place in connection with the economic recovery tax act of 1981 (erta).49 this legislation permitted a temporary deduction for charitable contributions by non-itemizers, and the legislative history reflected “the expectation that the regulations would be developed to provide appropriate substantiation requirements.”50 new legislative rules regarding substantiation were introduced in 1984 as part of the defra,51 in 1993 as part of the omnibus budget reconciliation act (obra),52 in 2004 as part of the american jobs creation act (ajca),53 and most recently in 2006 as part of pension protection act (ppa).54 before january 1, 1983, the regulations explained that the income tax return was the source for reporting on charitable contributions.55 contributions of money required reporting of the name of the donee as well as the amount and date of the payment of each contribution. property contributions called for reporting the kind of property contributed, the method used to determine its fair market value at the time of contribution, and, if relevant, application of section 170(e), which reduces the deduction by the amount of gain that would not have been long-term capital gain if the property had been sold at its fair market value, among other information. for claimed deductions above $200, additional information was required in an attachment.56 as the jct has explained, as early as 1981, the treasury and the irs were permitted to use their “authority under the code to prescribe additional regulations, rules, and tax return requirements as needed to assure substantiation and verification of charitable deductions.”57 relying on this 49. economic recovery tax act of 1981, pub. l. no. 97-34, 95 stat. 172 (1981) [hereinafter erta]. 50. notice of proposed rulemaking, substantiation of charitable contributions, 48 fed. reg. 17616 (april 25, 1983). 51. deficit reduction act of 1984, pub. l. no. 98-369, 98 stat. 691 [hereinafter defra]. 52. omnibus budget reconciliation act of 1993, pub. l. no. 103-66, 107 stat. 312 [hereinafter obra]. 53. american jobs creation act of 2004, pub. l. no. 108-357, 118 stat. 1418 [hereinafter ajca]. 54. pension protection act of 2006, pub. l. no. 109-280, 120 stat. 780 [hereinafter ppa]. 55. reg. § 1.170a-13(d). 56. freitag & kirschten, chartitable contributions, supra note 46, at part vi-a. 57. joint committee on taxation, general explanation of the economic recovery tax act of 1981, jcs 71-81, at 50 (dec. 31, 1981). https://a.next.westlaw.com/link/document/fulltext?findtype=l&pubnum=1077005&cite=uuid(iba36a7544a-f64d9a91531-07f0dad172a)&originationcontext=document&transitiontype=documentitem&contextdata=(sc.search) 288 florida tax review [vol. 14:7 legislative history, the irs and treasury promulgated regulations section 1.170a-13, effective for contributions made in taxable years beginning after 1982. these regulations require taxpayers making a charitable contribution of money to keep a cancelled check, a receipt, or other reliable written records showing the name of the donee, the date of the contribution, and the amount of the contribution.58 for donations of property, the donor had to have a receipt with the name of donee, the date and location of the contribution, a reasonably detailed description of the property, including its value, and a reliable written record. for contributions over $500 of property other than money, the regulations required additional records, including the manner of acquisition and, for property held less than six months before contribution, its cost or other basis. shortly after promulgations of these regulations, congress, as part of defra, set forth in an off-code provision expected substantiation requirements and a directive to the treasury to issue regulations under section 170(a)(1), which provided that a charitable deduction is allowed only if the contribution is verified in the manner specified by treasury regulations. section 155(a) of defra provided that, for non-cash donations in excess of $5,000 for most property and $10,000 for nonpublicly traded stock, regulations be promulgated requiring a taxpayer to obtain a qualified appraisal by an appraiser other than the taxpayer or the donee and to attach an appraisal summary to the first return on which the deduction is claimed.59 because these rules represent the first detailed congressional foray into substantiation requirements, i quote section 155 of defra in full: sec. 155. substantiation of charitable contributions; modifications of incorrect valuation penalty. (a) substantiation of contributions of property. — (1) in general. — not later than december 31, 1984, the secretary shall prescribe regulations under section 170(a)(1) of the internal revenue code of 1954, which require any individual, closely held corporation, or personal service corporation claiming a deduction under section 170 of such code for a contribution described in paragraph (2) — (a) to obtain a qualified appraisal for the property contributed, (b) to attach an appraisal summary to the return on which such deduction is first claimed for such contribution, and 58. t.d. 8002, 49 fed. reg. 50663 (dec. 31, 1984). 59. see irs form 8283, http://www.irs.gov/pub/irs-pdf/f8283.pdf, for the current required appraisal summary. 2013] reforming the charitable contribution substantiation rules 289 (c) to include on such return such additional information (including the cost basis and acquisition date of the contributed property) as the secretary may prescribe in such regulations. such regulations shall require the taxpayer to retain any qualified appraisal. (2) contributions to which paragraph (1) applies. — for purposes of paragraph (1), a contribution is described in this paragraph — (a) if such contribution is of property (other than publicly traded securities), and (b) if the claimed value of such property (plus the claimed value of all similar items of property donated to 1 or more donees) exceeds $5,000. in the case of any property which is nonpublicly traded stock, sub-paragraph (b) shall be applied by substituting “$10,000” for “$5,000.” (3) appraisal summary. — for purposes of this subsection, the appraisal summary shall be in such form and include such information as the secretary prescribes by regulations. such summary shall be signed by the qualified appraiser preparing the qualified appraisal and shall contain the tin of such appraiser. such summary shall be acknowledged by the donee of the property appraised in such manner as the secretary prescribes in such regulations. (4) qualified appraisal. — the term “qualified appraisal” means an appraisal prepared by a qualified appraiser which includes — (a) a description of the property appraised, (b) the fair market value of such property on the date of contribution and the specific basis for valuation, (c) a statement that such appraisal was prepared for income tax purposes, (d) the qualifications of the qualified appraiser, (e) the signature and tin of such appraiser, and (f) such additional information as the secretary prescribes in such regulations. 290 florida tax review [vol. 14:7 the jct has explained that while these provisions were prompted in part by marketed tax shelter schemes,60 “congress believed that these substantiation requirements will prove more effective in deterring taxpayers from inflating claimed deductions than relying solely on the uncertainties of the audit process and on penalties imposed on those overvaluations that are detected on audit.”61 the legislative history continues: the congress understands that the treasury department remains concerned whether the substantiation and penalty provisions of the act will prove sufficient to preclude taxpayers from overvaluing charitable donations of property in all circumstances . . . . the congress expects the treasury and internal revenue service to monitor the effectiveness of the new provisions and to notify the taxwriting committees if there are continuing valuation concerns that should be addressed by further legislation . . . . the treasury and internal revenue service are encouraged to utilize fully [their] regulatory authority and compliance tools available under the present law with respect to improper or overvalued claims of charitable deductions . . . .62 the treasury responded with regulations section 1.170a-13(c), incorporating these requirements for contributions made after 1984.63 the 60. as the jct described, in the typical tax shelter, donors would acquire artwork, hold it for the required capital gains period, and donate it at an appreciated fair market value. “the shelter package may include an ‘independent’ appraisal, and the potential donor may be assured that his or her subsequent gift will be accepted by a charitable organization.” joint committee on taxation, general explanation of the revenue provisions of the deficit reduction act of 1984, jcs-41-84, at 503 (dec. 31, 1984) [hereinafter jct, general explanation of defra]. 61. jct, general explanation of defra, supra note 60, at 504. section 155(b)(1) of defra also added section 6050 to the code requiring a donee to report disposition of charitable contribution property within two years of its receipt. further, section 1215(1)-(2) of the ppa changed the period of time to three years. see i.r.s. form 8282, http://www.irs.gov/pub/irs-pdf/f8282.pdf. additionally, section 1215(a)(1) of the ppa added a provision codified at section 170(e)(7), limiting or recovering the donor’s tax benefits for such dispositions of tangible personal property. 62. jct, general explanation of defra, supra note 60, at 504–05. 63. t.d. 8003, 49 fed. reg. 50657 (dec. 31, 1984) (temporary regulations), superseded by t.d. 8199, 1988-1 c.b. 99 (may 5, 1988) (final regulations). a qualified appraisal was not required for publicly traded stock. 2013] reforming the charitable contribution substantiation rules 291 regulations require that an appraisal be made not more than sixty days prior to the date of contribution of the appraised property and that the appraiser’s fee not be based on a percentage of the appraised value of the property. they define a qualified appraiser as one who includes on the appraisal summary — to be made on form 8283 — a declaration that the individual either holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis and that, among other requirements, the appraiser’s qualifications described in the appraisal render the appraiser qualified to make the appraisal and that the appraiser is not a person excluded from being a qualified appraiser, such as the donee or the taxpayer. the regulations provide an opportunity for the donor to submit the appraisal summary within ninety days of a request from the irs if the donor has failed to attach an appraisal summary to the donor’s return as required, as long as the failure to include the summary is a good faith omission.64 (in announcement 90-25,65 the irs directed that for deductions of art totaling $20,000 or more, the qualified appraisal must be attached with the summary appraisal form 8382, as well as an eight-by-ten inch color photograph). not quite a decade later, in 1993 as part of obra, congress enacted section 170(f)(8), effective for contributions made on or after january 1, 1994.66 for contributions of $250 or more, this provision requires a contemporaneous written acknowledgment from the charitable donee rather than relying solely on a canceled check. the written substantiation from the charity to the donor must state whether the donee provided any goods or services in connection with the contribution and must include a good faith estimate of the value of any goods or services provided. the legislative history specifies that if the charity provides no goods or services, the acknowledgment must include a statement to that effect.67 goods or services that “consist solely of intangible religious benefits” that are not “generally sold in a commercial transaction outside the donative context” need to be acknowledged but not valued.68 obra also added requirements for quid pro quo contributions exceeding seventy-five dollars requiring the charity to inform the contributor in writing of a good faith estimate of the value of goods or services furnished in a part-gift, part-sale transaction. 64. see reg. § 1.170a-13(c)(4)(iv)(h). 65. 1990-8 i.r.b. 25. the announcement also observed that a significant percentage of taxpayers fail to attach form 8283 to their tax returns to support noncash charitable contribution deductions and reminded them to do so. id. 66. obra, supra note 52, § 13172(a), 107 stat. at 455. obra also made numerous changes to the penalty and provisions for tax underpayments and valuation overstatements, including those for fraud, all which are applicable to taxpayers who claim excessive charitable contribution deductions. 67. h.r. conf. rep. no. 103-213 at 565 n.30 (1993). 68. see i.r.c. § 170(f)(8)(b)(iii). 292 florida tax review [vol. 14:7 congress appears to have intended the contemporaneous written acknowledgement requirement and the requirement regarding quid pro quo contributions to prevent taxpayers from claiming as charitable contributions amounts that are not in fact contributions, such as school tuition. the jct estimated that these requirements would raise $469 million between 1994 and 1998.69 an acknowledgment is “contemporaneous” if the taxpayer obtains it on or before the sooner of the date on which the taxpayer files a return for the taxable year in which the contribution was made or by the due date, including extensions, for filing the return.70 the legislative history also explains that the substantiation requirement for contributions of $250 or more does “not impose an information reporting requirement upon charities; rather, it places the responsibility upon taxpayers who claim an itemized deduction for a contribution of $250 or more to request (and maintain in their records) substantiation from the charity of their contribution and any goods or service received in exchange.”71 in 1994, the irs and treasury, after providing some transition guidance, issued temporary and proposed regulations implementing these procedures, including special rules for contributions made through payroll deductions.72 after a public hearing, further proposed regulations were issued in august 1995.73 the 1995 proposed regulations, among other things, expand the category of goods or services that could be disregarded, such as certain annual membership payments of seventy-five dollars or less. they also address substantiation of out-of-pocket expenses. the proposed regulations regarding payroll deductions were finalized in october 1995,74 and the rest of the proposed regulations related to the acknowledgment requirement became final in december 1996.75 a little more than a decade after obra 1993, congress returned again to the charitable contribution substantiation rules in the ajca, applicable to contributions made after june 3, 2004.76 congress extended to all c-corporations the requirement of a qualified appraisal for property over $5,000. congress also specified in the code that, for contributions over $500, 69. joint committee on taxation, estimated budget effects of the revenue provisions of h.r. 2264 (the omnibus budget reconciliation act of 1993) as agreed to by the conferees, jcx-11-93 (aug. 4, 1993). 70 i.r.c. § 170(f)(8)(c). 71. senate finance committee report on the revenue provisions of obra 1993, 93 tax notes today 132–38 (june 22, 1993). 72. t.d. 8544, 59 fed. reg. 27458 (may 27, 1994) (temporary regulations); 59 fed. reg. 27515 (may 27, 1994) (proposed regulations). 73. 60 fed. reg. 39896 (aug. 4, 1995). 74. t.d. 8623, 60 fed. reg. 53126 (oct. 12, 1995). 75. t.d. 8690, 61 fed. reg. 65946 (dec. 16, 1996). 76. ajca, supra note 53, § 883, 118 stat. at 1631. 2013] reforming the charitable contribution substantiation rules 293 taxpayers, except certain c-corporations, must include with the return a description of the property “and such other information as the secretary may require.”77 the ajca also provided that if the amount of the contribution of property other than cash, inventory, or publicly traded securities exceeds $5,000, then the donor (whether an individual, partnership, or corporation) must prepare a qualified appraisal and, for contributions above $500,000, attach the qualified appraisal to the donor’s tax return. “congress believed that requiring c-corporations to obtain a qualified appraisal for charitable contributions of certain property in excess of $5,000, and requiring that appraisals be attached to a taxpayer’s return for large gifts, would reduce valuation abuses.”78 the legislation specified that no deduction shall be allowed if the taxpayer failed to meet requirements regarding obtaining a qualified appraisal and attaching information about the property or including information regarding the property unless failure to meet these requirements as applicable “is due to reasonable cause and not to willful neglect.”79 the ajca established special elaborate rules regarding deductions for contributions of used vehicles (i.e., automobiles, boats, and airplanes), effective after december 31, 2004. these rules limit the donor’s deduction in most cases to the gross proceeds received by the donee upon sale of the vehicle, which the donee must report to the donor, and which the donor must reveal on his or her tax return.80 congress did not wait another decade to tighten further the charitable contribution substantiation requirements. just two years later, in the ppa, congress made additional changes, effective after august 17, 2006.81 section 170(f)(17) provides that no deduction is to be allowed for any contribution of a cash, check, or other monetary gift unless the donor maintains as a record of the contribution a bank record or a written communication from the donee showing the name of the donee organization, the date of the contribution, and the amount of the contribution. the jct has explained that this provision “is 77. i.r.c. § 170(f)(11)(b). 78. joint committee on taxation, general explanation of tax legislation enacted in the 108th congress, jcs-5-05, at 462 (may 31, 2005). 79. ajca, supra note 53, § 883(a), 118 stat. at 1631, (codified at i.r.c. § 170(f)(11)(a)(ii)(ii)). the ajca also included exceptions from the new requirements for contributions of more than $5,000 and those of more than $500,000 for readily valued property, including publicly traded securities, as defined in i.r.c. § 6050l. 80. ajca, supra note 53, § 884, 118 stat. at 1632 (codified at i.r.c. § 170(f)(12)). the legislation also included a special provision limiting the tax deduction for gifts of copyrights, patents, and the like (in general) to the amount of income received by the donee. id. § 882(b)(1), 118 stat. at 1630 (codified at i.r.c. § 170(m)). 81. ppa, supra note 54, § 1217, 120 stat. at 1080 (codified at i.r.c. § 170(f)(17)). 294 florida tax review [vol. 14:7 intended to provide greater certainty, both to taxpayers and to the secretary, in determining what may be deducted as a charitable contribution.”82 the ppa provided statutory requirements for “qualified appraisal” and “qualified appraiser.” these provisions specify, for example, that a qualified appraisal must be conducted by a qualified appraiser “in accordance with generally accepted appraisal standards” and that, in general, a qualified appraiser has “earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations prescribed by the secretary” as well as regularly performs appraisals for compensation.83 the ppa also introduced special rules for certain conservation easements on historic property, including submission of photographs, description of development, and a fee of $500 if a taxpayer is claiming a deduction in excess of $10,000.84 the ppa made a number of changes to the penalty regime for valuation misstatements. it added a new penalty provision applicable to appraisers when the claimed value of property based on an appraisal results in a substantial or gross valuation misstatement under section 6662. in such cases, new section 6695a imposes a penalty on any person who prepared the appraisal and who knew, or reasonably should have known, the appraisal would be used in connection with a return or claim for refund.85 the ppa also expanded the scope of valuation misstatements by lowering the threshold for imposing accuracy-related penalties on donors under section 6662.86 before the ppa, a “substantial” valuation misstatement took place if a taxpayer misstated value by 200 percent of the correct valuation, and a “gross” valuation misstatement occurred if the value was misstated by 400 percent. the ppa lowered these triggers to 150 percent and 200 percent, respectively. 82. joint committee on taxation, technical explanation of h.r. 4, the “pension protection act of 2006,” jcx-38-06, at 305–06 (aug. 3, 2006). 83. ppa, supra note 54, § 1213(c), 120 stat. at 1076 (codified at i.r.c. § 170(f)(13)). the special rules for conservation easements on historic property apply to restrictions on exteriors of buildings described in section 170(h)(4)(c)(ii) (buildings in registered historic districts). id. 84. ppa, supra note 54, § 1213(c), 120 stat. at 1076 (codified at i.r.c. § 170(f)(13)). the ppa also added a requirement that for donations to donor advised funds the contemporaneous acknowledgment from the sponsoring organization must state that it has exclusive control over the donated funds. ppa, supra note 54, § 1234(a), 120 stat. at 1100 (codified at i.r.c. § 170(f)(18)(b)). 85. ppa, supra note 54, § 1219, 120 stat. at 1084 (codified at i.r.c. § 6695a(a)(1)). 86. id. the penalties imposed on donors did not change. they remain 20 percent of the underpayment attributable to the underpayment for a substantial valuation misstatement and 40 percent for a gross misstatement. the ppa, however, removed a “reasonable cause” defense in the case of gross valuation misstatements. 2013] reforming the charitable contribution substantiation rules 295 on november 13, 2006, the irs issued notice 2006-96,87 giving transition relief for the qualified appraisal and appraiser rules, applicable to claimed deductions of property for more than $5,000, for returns filed after august 17, 2006 and before the effective date of anticipated regulations. the notice explained, for example, that an appraisal will be treated as having been conducted in accordance with generally accepted appraisal standards “if, for example, the appraisal is consistent with the substance and principles of the uniform standards of professional appraisal practice.”88 to satisfy education and experience requirements in valuing the type of property, the appraiser can make “a declaration in the appraisal, that because of the appraiser’s background, experience, education, and membership in professional associations,” the appraiser is so qualified.89 to satisfy the requirement for appraising real property, an appraiser can be licensed or certified for the type of property being appraised in the state where the property is located.90 for property other than real property, the appraiser can have “successfully completed college or professional-level coursework” relevant to the property being valued and have at least two years of experience, so long as this information is described in the appraisal.91 the notice requested comments. in december 2006, the irs published a notice giving guidance on how taxpayers making charitable contributions by payroll deduction could comply with the reporting requirements of the ppa for contributions of less than $250.92 the notice defined compliance as requiring documents from the employer, as well as the pledge card or other document, showing the name of the donee. in august 2008, the irs and treasury issued proposed regulations to implement the statutory requirements for the substantiation and recordkeeping requirements introduced both by the ajca and the ppa.93 the proposed regulations provide that the required bank record or other written communication for charitable contributions include the name of the donee, the date of the contribution, and the amount of the contribution. the proposed regulations provide, that, to satisfy the reasonable cause exception of section 170(f)(11)(a)(ii)(ii), the donor must submit with the return a detailed explanation of why the failure to comply was due to reasonable 87. 2006-2 c.b. 902. the notice explains that for returns filed on or before august 17, 2006, existing treasury regulations define “qualified appraisal” and “qualified appraiser.” 88. id. 89. id. 90. id. 91. id. 92. notice 2006-110, 2006-2 c.b. 1127. 93. 73 fed. reg. 45908 (aug. 7, 2008). 296 florida tax review [vol. 14:7 cause and not to willful neglect and must have timely obtained a contemporaneous written acknowledgment and a qualified appraisal, if applicable. the proposed regulations warn, “consistent with the congressional purpose for enacting section 170(f)(11) of reducing valuation abuses, the irs and the treasury department anticipate that the ‘reasonable cause’ exception will be strictly construed to apply only when the donor meets the requirements for the exception as specified in the regulations.”94 the qualified appraiser and appraisal requirements in the proposed regulations are similar but not identical to the rules announced in notice 2006-96. for example, the proposed regulations do not include the provision in the notice that, for real estate appraisers, education and experience are sufficient if the appraiser holds a license or certificate to value the type of property in the state where the property is located because the proposed regulations “set forth more specific requirements applicable to all appraisers.”95 (these proposed regulations have yet to be finalized,96 and, thus, further detail regarding them seems unnecessary and overly burdensome to the reader). this legislative and regulatory history carries several implications. on one hand, congress considers substantiation necessary and important. on the other, frequent changes and strengthening of these rules seem to indicate that congress has not been satisfied that substantiation efforts have achieved their purpose. the failure of the irs and treasury to finalize regulations proposed in 2008 suggests that the irs and treasury find keeping up with congressional requirements challenging. at the same time, two circuit courts have recently urged the irs and treasury to promulgate yet further regulations. in kaufman v. commissioner,97 the first circuit court of appeals rejected the irs’s “overly aggressive interpretations of existing regulations” as to the requirements of a qualified appraisal,98 but also observed “one can imagine irs regulations that require appraisers to be functionally independent of donee organizations . . . and require more specific market-sale based 94. id. (emphasis in original) 95. id. 96. finalizing these regulations is an item on the irs and treasury 2012– 2013 priority guidance plan. see dep’t of the treasury, 2012-2013 priority guidance plan (nov. 19, 2012), http://www.irs.gov/pup/pub/irs-utl/20122013_pgp.pdf. 97. 687 f.3d 21 (1st cir. 2012). 98. in 2012, conservation easements received considerable attention. see david van den berg, irs scrutinizing conservation easements, 137 tax notes today 19 (oct. 1, 2012) [hereinafter van den berg, conservation easements]. issues in these cases frequently involve substantiation requirements, as discussed further below. 2013] reforming the charitable contribution substantiation rules 297 information to support any deduction.”99 in scheidelman v. commissioner,100 the court of appeals for the second circuit wrote, “and, of course, the treasury department can use the broad regulatory authority granted to it by the internal revenue code to set stricter requirements for a qualified appraisal.”101 (both of these cases involved conservation easements and will be discussed further below in the section of the paper addressing case law for these types of charitable contributions). all this suggests that the current regime is not working satisfactorily. moreover, judicial invocation of the substantial compliance doctrine in some situations, but not others, further complicates enforcement and raises additional questions about the current scheme. iv. judicial gloss long-standing section 170(a)(1) provides that a charitable contribution “shall be allowable as a deduction only if verified under regulations prescribed by the secretary.” section 170(f)(8), enacted in 1993, states that no deduction shall be allowed for any contribution of $250 or more unless the taxpayer obtains a contemporaneous written acknowledgment. in 2004, congress provided in section 170(f)(11) that no charitable contribution deduction shall be allowed unless the taxpayer meets applicable substantiation requirements, including other requirements the secretary may impose. despite this language, at some times, but not others, courts, in particular the tax court, have permitted substantial compliance, rather than strict compliance, with the substantiation and record-keeping requirements.102 the contours and limits of the substantial compliance doctrine are uncertain, and the application of the doctrine to this area of tax law is further complicated by the 2004 enactment of a reasonable cause exception to certain appraisal requirements. some provisions of the internal revenue code and the treasury regulations explicitly permit substantial compliance.103 none of the statutes or regulations governing substantiation of the charitable contribution 99. kaufman, 687 f.3d at 31. the court continued: “forward looking regulations also serve to give fair warning to taxpayers.” id. at 31–32. 100. 682 f.3d 189 (2nd cir. 2012). 101. id. at 198. 102. the tax court, however, frequently denies a charitable contribution deduction for taxpayers who fail to satisfy the substantiation requirements without any discussion of substantial compliance. see, e.g., linzy v. commissioner, 102 t.c. memo (cch) 482, t.c. memo (ria) ¶ 2011-264; perry v. commissioner, t.c. summ. op. 2011-76; kirman v. commissioner, 101 t.c. memo (cch) 1625, t.c. memo (ria) ¶ 2011-128. 103. see, e.g., i.r.c. § 2642(g)(2) (allocation of gst exemption); reg. § 1.167(a)-11(f)(2) (flush language) (method of making depreciation election). 298 florida tax review [vol. 14:7 deduction provides for “substantial compliance.” judicial invocation of the substantial compliance doctrine, however, is not unusual or unique to the tax law. it has perhaps been most thoroughly examined by professor john langbein of yale law school in connection with the requirements for execution of wills.104 as he has explained, courts have used the substantial compliance doctrine as a “near-miss standard.”105 the tax court cases applying the substantial compliance doctrine to the charitable contribution substantiation requirements rely primarily on bond v. commissioner.106 in bond, in 1986 the taxpayers in 1986 donated two blimps to an organization exempt from tax under section 501(c)(3). their appraiser filled out the relevant sections of the appraisal summary on form 8283, but the appraiser did not prepare or send to the petitioners any other separate written appraisal before the due date for petitioners’ filing of their 1986 return, as required by the applicable regulations. the appraiser supplied his qualifications and details regarding his appraisal methods in a letter shortly after the beginning of the taxpayers’ audit. the government asserted that, by not obtaining and attaching to their income tax return a written appraisal of the blimps, the taxpayers failed to satisfy the requirements for a charitable deduction. the tax court concluded, however, that the reporting requirements of the regulations, “while helpful to respondent in the processing and auditing of returns on which charitable deductions are claimed,” do not “relate to the substance or essence of whether or not a charitable contribution was actually made” and are therefore “directory [advisory] and not mandatory.”107 the tax court 104. see john h. langbein, excusing harmless errors in the execution of wills: a report on australia’s tranquil revolution in probate law, 87 colum. l. rev. 1 (1987) [hereinafter langbein, excusing harmless errors]; john h. langbein, substantial compliance with the wills act, 88 harv. l. rev. 489 (1975). 105. langbein, excusing harmless errors, supra note 104, at 53. a court invoking substantial compliance is to be differentiated from a court of equity ignoring statutory requirements. indeed, when taxpayers who failed to comply strictly or substantially with the charitable contribution deduction appraisal requirements asked the tax court to nonetheless allow the deduction despite their failure because it would be inequitable not to do so, the tax court explained, “we are not a court of equity and do not possess general equitable powers.” ney v. commissioner, t.c. summ. op. 2006-154. the tax court, however, has acknowledged that it applies equitable principles, including that of substantial compliance. see woods v. commissioner, 92 t.c. 776, 784 (1989) (“[w]e have applied the equity-based principles of waiver, duty of consistency, estoppel, substantial compliance, abuse of discretion, laches, and the tax benefit rule.”) (footnotes omitted). see generally leandra lederman, equity and the article i court: is the tax court’s exercise of equitable powers constitutional?, 5 fla. tax rev. 357 (2001). 106. 100 t.c. 32 (1993). 107. id. at 41. 2013] reforming the charitable contribution substantiation rules 299 concluded that the taxpayers had substantially complied with the regulatory requirements: [the] petitioners . . . met all of the elements required to establish the substance or essence of a charitable contribution, but merely failed to obtain and attach to their return a separate written appraisal . . . even though substantially all of the specified information except the qualifications of the appraiser appeared in the form 8283 attached to the return. the denial of a charitable deduction under these circumstances would constitute a sanction which is not warranted or justified.108 that is, the tax court in bond saw as crucial the conducting of the appraisal by a qualified appraiser, not timely reporting regarding the appraisal. in a later case, hewitt v. commissioner,109 the taxpayers did not obtain qualified appraisals before filing their return, and the tax court did not permit the deduction. as hewitt explained, nothing in bond “relieves petitioners of the requirement of obtaining a qualified appraisal.”110 nonetheless, i find the tax court’s conclusion in bond questionable and internally inconsistent. despite the reporting requirements being mandated by congress in defra, the court stated that the reporting requirements are directory and not mandatory; the question the court sets for itself is whether a charitable contribution was made. if such is the case, appraisal information could always be submitted after the due date of the return as long as the appraisal summary of form 8283 is completed and submitted. moreover, the court looked to the form 8283, one of the reporting requirements, and asked whether it gives substantially all the required information, an inquiry inconsistent with the question that it had just announced — whether a charitable contribution has in fact been made. then, to conclude that the information on the form 8283 is adequate, the court not only discounted the importance of disclosing the appraiser’s qualifications, but also wrongly asserted that only the appraiser’s qualifications were lacking. in fact, only in the letter later submitted did the appraiser describe 108. id. at 41–42. 109. 109 t.c. 258 (1997), aff’d without opinion, 166 f.3d 332 (4th cir. 1998). 110. id. at 264. hewitt further noted, bond “held that the appraisal summary itself constituted the required appraisal.” id. at 263. the case explained that the primary purpose of defra section 155 was to “provide a mechanism whereby respondent would obtain sufficient return information in support of the claimed valuation of charitable contributions of property to enable respondent to deal more effectively with the prevalent use of overvaluations.” id. at 265. 300 florida tax review [vol. 14:7 the methods used in the appraisal.111 the tax court in bond ignored completely the ex ante impact of the qualified appraisal requirement, and its reasoning flies in the face of the congressional intent in enacting the defra provisions to no longer rely “solely on the uncertainties of the audit process.”112 indeed, the tax court’s doctrine of substantial compliance has been criticized by the seventh circuit en banc. in prussner v. united states,113 a case involving the qualified use valuation under the estate tax, an opinion by judge posner characterized the tax court’s formulation as both confusing and difficult to apply. he wrote: reading the tax court’s decisions on the subject of substantial compliance is enough to make one’s head swim. tax lawyers can have no confidence concerning the circumstances in which noncompliance with regulations governing the election of favorable tax treatment will or will not work a forfeiture. the result has been a surge of unnecessary litigation well illustrated by the present suit. we think the doctrine should be interpreted narrowly . . . . the common law doctrine of substantial compliance should not be allowed to spread beyond cases in which the taxpayer had a good excuse (though not a legal justification) for failing to comply with either an unimportant requirement or one unclearly or confusingly stated in the regulations or the statute. 114 in bruzewicz v. united states,115 an illinois district court applied this critique explicitly both to bond and the tax court’s approach to substantiation of the charitable contribution deduction.116 111. the opinion states that “[i]n performing the appraisal, . . . [the appraiser] made written computations, schedules, and notes, but was unable to locate them at the time of trial.” bond, 100 t.c. at 33–34. 112. see supra text accompanying note 61. 113. 896 f.2d 218 (7th cir. 1990). 114. id. at 224. 115. 604 f. supp. 2d 1197 (n.d. ill. 2009). 116. see also hendrix v. united states, 106 a.f.t.r. 2d 2010-5373 (s.d. ohio 2010) (denying substantial compliance with qualified appraisal requirements on grounds that the sixth circuit limits the doctrine to statutory provisions that specifically provide for substantial compliance). the court in hendrix also explains that, should the doctrine be considered, “the substantial compliance doctrine is not a substitute for missing entire categories of content; rather, it is at most a means of accepting a nearly complete effort that has simply fallen short in regard to minor procedural errors or relatively unimportant clerical oversights.” id. at 5377. 2013] reforming the charitable contribution substantiation rules 301 in the recent mohamed case, judge holmes asserted that, “[s]ince bond, few taxpayers have succeeded in showing substantial compliance”117 and nicely summarized the tax court cases that declined to apply the substantial compliance doctrine on the grounds that the taxpayer failed to comply with an “essential requirement” of a governing statute. for our purposes, i will rely on and quote his discussion of those cases: • failing to get an appraisal. see todd v. commissioner, 118 t.c. 334, 336, 347, 2002 wl 638550 (2002) hewitt, 109 t.c. at 260, 264; jorgenson v. commissioner, t.c. memo. 2000-38, 2000 tax ct. memo lexis 38, at *25–*26. • failing to fill out section b of form 8283 (the appraisal summary). see hewitt, 109 t.c. at 260, 264; smith v. commissioner, t.c. memo. 2007-368, 2007 tax ct. memo lexis 387, at *51, aff’d, 364 fed. appx. 317 (9th cir. 2009).118 • having someone without expertise in appraisals complete the appraisal, see smith, 2007 tax ct. memo lexis, at *48 (cpa wasn't licensed appraiser); d’arcangelo v. commissioner, t.c. memo. 1994-572, 1994 tax ct. memo lexis 575, at *24 (high-school principal not qualified to appraise art supplies, and was employee of donee and therefore ineligible to be qualified appraiser). • having an appraisal prepared at the wrong time (i.e., either more than 60 days before the gift or after the return was filed), see jorgenson, 2000 tax ct. memo lexis 38, at *13, *25–*26 (appraisal prepared after tax return filed); d’arcangelo v. commissioner, 1994 tax ct. memo lexis 575, at *28–*29 (appraisal at least six years before gift); see also fehrs fin. co. v. commissioner, 487 f.2d 184, 189 (8th cir. 1973) (in 117. mohamed v. commissioner, 103 t.c. memo (cch) 1814, 1819, t.c. memo (ria) ¶ 2012-152, at 1175. 118. it is hard for me to see how the cases finding that this failing violates an essential requirement of the governing statute are consistent with bond. 302 florida tax review [vol. 14:7 case about complete redemption of stock, taxpayers provided statutorily required agreement to irs only after adverse decision by tax court), aff’g 58 t.c. 174, 1972 wl 2426 (1972); friedman v. commissioner, t.c. memo 2010-45, 2010 tax ct. memo lexis 46, at *11 (appraisals performed years after due dates of returns). • including insufficient information or inappropriate information in an appraisal or appraisal summary, see smith, 2007 tax ct. memo lexis 387, at *48 (appraisal of partnership shares “terse” and appraisal actually of assets held by partnership, not the shares themselves).119 judge holmes, however, failed to discuss the cases, besides bond, where the tax court has found substantial compliance. my summary of cases relying on substantial compliance with the charitable contribution substantiation rules, in the format that judge holmes adopted, includes the following: • recordkeeping failures. see van dusen v. commissioner, 136 t.c. 515 (2011) (records acceptable substitute for cancelled checks for out-ofpocket expenses of less than $250); daniel v. commissioner, 74 t.c. memo (cch) 151, t.c. memo (ria) ¶ 1997-328 (1997) (no receipt from donee or written records but good faith attempt to provide information). • failure to meet contemporaneous written acknowledgment requirements. see simmons v. commissioner, 98 t.c. memo (cch) 211, t.c. memo (ria) ¶ 2009-208 (2009) (deeds satisfy 119. id. the tax court, also in an opinion by judge holmes, rejected the taxpayers’ substantial compliance in a post-mohamed case when the taxpayers offered an appraisal of property owned by a corporation instead of their interests in the corporation. see estate of evenchik, 105 t.c. memo (cch) 1231, t.c. memo (ria) ¶ 2013-34. 2013] reforming the charitable contribution substantiation rules 303 contemporaneous acknowledgment requirement; no mention in case of required “no goods or services” statement); mudd v. commissioner, t.c. summ. op. 2004-1, 2004 tax notes today 6–15 (jan. 8, 2004) (charity supplied only letter that listed items claimed to be donated; no discussion in case of required “no goods or services” statement).120 • appraisal premature by several months. see consol. investors grp. v. commissioner, 98 t.c. memo (cch) 601, t.c. memo (ria) ¶ 2009-290 (2009) (appraisal three months premature nonetheless obtained prior to filing tax return). • uncertainty regarding dates in appraisal report. see friedberg v. commissioner, 102 t.c. memo (cch) 356, t.c. memo (ria) ¶ 2011-238 (2011) (ambiguity in report as to date appraised and value on date of contribution of conservation easement but within sixty days of contribution).121 • failure to specify that appraisals were prepared for income tax purposes. see simmons v. commissioner, 98 t.c. memo (cch) 211, t.c. memo (ria) ¶ 2009-208 (2009) (statement that owner was contemplating donation of conservation easements sufficient). both friedberg and simmons involve conservation easements. of late, cases involving substantiation of this type of charitable contribution from the tax court and the article iii courts have been particularly numerous. as a recent article related,122 a large number of conservation 120. these decisions are particularly surprising, given that durden stated that the “no goods or services” statement was necessary for a charitable contribution deduction and cited two earlier cases, both after mudd, but one before simmons. durden v. commissioner, 103 t.c. memo (cch) 1762, 1763, t.c. memo (ria) ¶ 2012-140, at 1096. 121. the tax court nonetheless found the appraisal report not to be qualified on other grounds, as discussed below with other conservation easement cases. 122. see van den berg, conservation easements, supra note 98. 304 florida tax review [vol. 14:7 easement decisions were handed down in 2012, many, of which dealt with substantiation issues.123 in the article, some practitioners allege that the irs has been taking an aggressive litigation position, pushing the boundaries of interpretation, and thwarting congressional intent by using “non-substantive procedural compliance to deny otherwise legitimate deductions.”124 these practitioners call for increased reliance on the substantial compliance doctrine and clarifying regulations. an irs attorney responded that challenges at issue involve noncompliance with the statute, not technical foot faults. several very recent tax court cases reject the substantial compliance doctrine, but nonetheless come to conclusions that seem consistent with it. as in simmons, the tax court in averyt v. commissioner125 accepted the conservation deed as a contemporaneous acknowledgment. the court was satisfied that the deed “recites no consideration received in exchange for it.”126 according to the court, “the conservation deed, taken as a whole, provides that no goods or services were received in exchange for the contribution.”127 the case makes a claim, to me unconvincing, that, while durden held that the statute requires an “affirmative statement” as to whether the donee organization provided any goods or services, “we did not hold, and the statute does not require, that the statement take any particular form or contain any particular wording.”128 averyt ignores the legislative history, quoted in durden: “if the donee organization provided no goods or services to the taxpayer in consideration of the taxpayer’s contribution, the written substantiation is required to include a statement to that effect.”129 rp golf, llc v. commissioner130 and irby v. commissioner131 followed the lead of averyt. rp golf, llc held that a conservation agreement stating that the easement contribution was made “in consideration of the covenants and representations contained herein and for other good and valuable consideration” nonetheless stated that “no goods or services were received in [the] exchange,” when taken as a whole.132 in irby, the tax court found the contemporaneous written acknowledgment requirement satisfied for a bargain sale of a conservation easement by combining statements in the 123. other frequently encountered issues are perpetuity requirements, subordination, and valuation. id. 124. id. 125. 104 t.c. memo (cch) 65, t.c. memo (ria) ¶ 2012-198. 126. id. at 68. 127. id. 128. id. at 69. 129. durden, 103 t.c. memo (cch) at 1763 (quoting h.r. conf. rept. no. 103-213, at 565 n.30 (1993), 1993-3 c.b. 393, 443). 130. 104 t.c. memo (cch) 413, t.c. memo (ria) ¶ 2012-282. 131. 139 t.c. no. 14, tax ct. rep. (cch) 59, 235 (2012). 132. rp golf, llc, 104 t.c. memo (cch) at 416 (emphasis added). 2013] reforming the charitable contribution substantiation rules 305 option agreements for the purchase of conservation easement; forms 8283 attached by taxpayers to income tax returns; the settlement agreements prepared by the title company in the transaction, which listed the amounts paid as part of the bargain sale; and the deeds for the easements, which described the properties and listed the responsibilities and rights of the donors and donees. the tax court explained that it had found “no authority to indicate, that the contemporaneous written acknowledgment may not be made up of a series of documents.”133 that is, in all of these cases, the tax court went beyond simmons and decreed that with silence taxpayers had satisfied strict, not simply substantial, compliance with the requirement of an affirmative statement.134 as forgiving as the tax court has been regarding the contemporaneous acknowledgment in the conservation easement context, it has been unforgiving regarding the need for a qualified appraisal to include a valuation method and specific basis for the determined value. when it comes to these factors, the tax court has recently rejected substantial compliance because it sees them as essential. in friedberg v. commissioner, the court recognized that the method of valuation and specific basis requirements in regulations section 1.170a-13(c)(3)(ii) “relate to the substance or essence of the contribution and the substantial compliance doctrine therefore does not apply.”135 in scheidelman v. commissioner, the tax court decreed, “without any reasoned analysis, . . . [the appraiser’s report] is useless.”136 in rothman v. commissioner, the tax court went further and declared, “the substantial compliance doctrine has continuing but limited application in a post-section 170(f)(11) world.”137 in both scheidelman and rothman, the tax court 133. irby, 139 t.c. no. 14 at 4831. 134. another recent case, cohan v. commissioner, 103 t.c. memo (cch) 1037, t.c. memo (ria) ¶ 2012-8, discussed and rejected the substantial compliance doctrine in connection with a contemporaneous acknowledgment of a $4.5 million dollar gift of real estate interests. there, however, the donee, the nature conservancy, had failed to include consideration that the taxpayers had received and of which the taxpayers were aware. the letter failed to include crucial information, and, given their knowledge, the taxpayers could not reasonably rely on it. thus, there was no substantial compliance. 135. 102 t.c. memo (cch) 356, 366, t.c. memo (ria) ¶ 2011-238, at 1618. the appraiser in that case used property in washington, d.c., and new orleans to determine the after value of property subject to an easement in new york city. 136. 100 t.c. memo (cch) 24, 29, t.c. memo (ria) ¶ 2010-151, at 916 (quoting friedman v. commissioner, 99 t.c. memo (cch) 1175, t.c. memo (ria) ¶ 2010-45) (alteration in original), vacated, f.3d 189 (2d cir. 2012), remanded to 105 t.c. memo (cch) 1117, t.c. memo (ria) ¶ 2013-18. 137. rothman v. commissioner, 103 t.c. memo (cch) 1864, 1868, t.c. memo (ria) ¶ 2012-163, at 1246, vacated and reconsidered at 104 t.c. memo 306 florida tax review [vol. 14:7 rejected, when applying the before-and-after approach to determine an easement, the practice of an appraiser applying a fixed percentage to the “before” value of the property in order to arrive at the “after” value.138 in sum, in these very recent conservation easement cases, the tax court has asked only whether strict compliance has been met. it has found strict compliance regarding contemporaneous acknowledgment satisfied by language in deeds and found it lacking in valuation method and specific basis for valuation. at the same time that the tax court claims to be moving away from substantial to strict compliance, two circuits have embraced the reasoning underlying the doctrine. in kaufman v. shulman,139 after rejecting the tax court’s conclusion that the taxpayer failed to comply with the extinguishment requirement for a conservation easement, the first circuit rebuffed the irs’s alternative claim that the appraisal at issue was not a qualified appraisal because the appraiser lacked “analytical moorings.” the first circuit wrote that “whether the valuation was overstated, grossly or otherwise, is a factual question different from whether the formal procedural requirements were met, either strictly or under the ‘substantial compliance’ doctrine, which may forgive minor discrepancies.”140 that is, the court claimed to shun the question of substantial compliance with the substantiation requirement. yet, the court went on to say that failures with the form 8283, such as not including the date and manner of acquisition of the property or its cost or other basis, were not defects that in any way prejudiced the irs. such is precisely the reasoning the tax court adopted in developing and applying its substantial compliance doctrine. moreover, contrary to the appellate court’s assertion, the date of acquisition (cch) 126, t.c. memo (ria) ¶ 2012-218 (vacated as to valuation method and specific basis in light of scheidelman v. commissioner, 682 f.3d 189 (2d cir. 2012), discussed immediately below, but concluding nonetheless that the appraisal was not qualified because of numerous other failings, such as description of property, disclosure of terms of agreement, and communication of mortgages, among others). the tax court determined in both the first and second rothman opinions that whether the taxpayers could rely on the reasonable cause exception of § 170(f)(11)(a)(ii)(ii) was an issue to be decided after trial. id. 138. the percentage was based on an article by an irs employee entitled façade easement contributions. professor roger colinvaux has explained that the easement in scheidelman was donated at a time when it was common to use a discount rate in accordance with information irs guidance, but that the irs has since revoked that guidance. see van den berg, conservation easements, supra note 98. 139. 687 f.3d 21 (1st cir. 2012). 140. id. at 29 (footnote omitted). 2013] reforming the charitable contribution substantiation rules 307 and the cost or other basis give the irs crucial information as to possible overvaluation.141 in scheidelman v. commissioner,142 the second circuit rejected the tax court’s position regarding valuation method and specific basis for valuation. to the appellate court, the appraiser’s “reasoned analysis” may be “unconvincing,” but “it is incontestably there.”143 in the second circuit’s view, that is all the regulations require. in reaching its conclusion, the court cited hewitt v. commissioner,144 to assert that the appraisal at issue “provides the irs with sufficient information to evaluate the claimed deduction and ‘deal more effectively with the prevalent use of overvaluations.’”145 again, a circuit court relied on the reasoning the tax court has adopted for invoking the substantial compliance doctrine. the second circuit also looked to substantial compliance explicitly in scheidelman. in rejecting the irs argument regarding failures in the form 8283, the court observed that the taxpayer had submitted two forms 8283, which together gave all the required information. the court accepted treating these two forms as one, either on the doctrine of substantial compliance or under the reasonable cause exception of section 170(f)(11)(a)(ii)(ii). equating substantial compliance and reasonable cause seems to me analytically suspect. substantial compliance excuses near misses; reasonable cause can excuse far greater failures. yet, both these approaches demonstrate the importance — and the difficulties — of developing a way to accommodate the seemingly irresistible judicial urge to permit the deduction for valuable contributions to charities that fail to comply strictly with the applicable substantiation rules. v. what can be done? our system risks drowning under the weight of the charitable contribution substantiation requirements. stretching the analogy more than a little, we might say that the rules resemble those developed for the ptolemaic 141. consider, for example, real property bought in january for $1,000,000, which the owner donates three months later (that is, a period less than the holding period for long-term capital gain), claiming a value of $1,500,000. the information regarding the cost and date of acquisition signals overvaluation to the irs. see also i.r.c. § 170(e) (reduction of charitable contribution deduction by the amount that would not have been long-term capital gain had the property been sold at its fair market value at the time of contribution). i thank karin gross for this example. 142. 682 f.3d 189 (2nd cir. 2012), remanded to 105 t.c. memo (cch) 1117, t.c. memo (ria) ¶ 2013-18. upon remand, the tax court found the easement to have no value. 143. id. at 198. 144. 109 t.c. 258 (1997), aff’d per curiam, 166 f.3d 332 (4th cir. 1998). 145. scheidelman, 682 f.3d at 198 (quoting hewitt, 109 t.c. at 265). 308 florida tax review [vol. 14:7 universe, becoming more and more elaborate awaiting the paradigm shift presented by copernicus’s theory, as described by thomas kuhn in his famous book, the structure of scientific revolutions. we currently have pages upon pages of regulations setting forth rules for substantiating charitable contributions, but these regulations have yet to address changes made by either the ajca or the ppa. appellate courts, practitioners, and academics struggling with conservation easements in particular call upon our tax administrators to issue yet further regulations. the current state of affairs regarding substantiation of charitable contribution deductions cries out for reform. how to reform the regime in a way both practical and effective, however, is less clear. below, i sketch out a number of possibilities. on the tax law professors listserve, tax professors offended by mohamed and durden offered several suggestions for reform. one proposed giving the tax court authority to provide equitable relief when there has been a legitimate charitable gift to a legitimate charity. the equitable relief now available to innocent spouses might offer a model in this regard, although experience under the innocent spouse provision suggests that giving the tax court authority to provide equitable relief must be undertaken carefully, with attention to process as well as substance.146 another model for equitable relief would be the harmless error provision in the uniform probate code,147 which, at the urging of professor langbein,148 is intended to replace the substantial compliance doctrine. under the harmless error doctrine (also known as a dispensing power), a court can admit a document to probate even if it fails to follow the required formalities of execution if clear and convincing evidence establishes that the decedent intended the document to be his will. an analogous provision for substantiation could permit a charitable contribution that failed to comply with substantiation requirements nonetheless to be deducted if clear and convincing evidence established that it was a legitimate gift.149 perhaps any equitable forgiveness of substantiation failures could give rise to a partial, rather than a full, deduction in order to maintain an incentive for strict compliance.150 the analogy to the harmless error provision of the uniform probate code, however, is limited at best. the uniform probate code introduced the 146. see bryan t. camp, the unhappy marriage of law and equity in joint return liability, 108 tax notes 1307 (sept. 12, 2005). 147. see unif. probate code § 2-501 (amended 1997). 148. see supra note 104. 149. see victoria a. levin, the substantial compliance in tax law: equity vs. efficiency, 40 ucla l. rev. 1587 (1993). 150. other changes discussed below could also consider allowing only a partial, rather than a full, deduction in the case of substantiation failures. 2013] reforming the charitable contribution substantiation rules 309 harmless error provision so that required formalities of execution — intended to protect the testator151 —do not in fact prevent fulfillment of the testator’s intent. the charitable contribution substantiation rules, in contrast, are designed to protect the federal fisc, not the donor, by ensuring that an objectively appropriate amount, not the donor’s desired value, is deducted as a charitable contribution.152 another professor on the taxprof listserv suggested relief along the lines of section 9100, which permits automatic six and twelve-month extensions of time in which to file for certain elections. such an approach seems to me promising, but it would require that the taxpayer become aware of the need to satisfy the substantiation requirements. thus, continued use of the regulations permitting the taxpayer to supply substantiation information within ninety days of an irs request, as described below, might be preferable.153 going beyond suggestions from the taxprof listserv, i, like others, believe that rethinking conservation easement contributions as a whole would seem a high priority. as the jct has written, “charitable deductions of qualified conservation contributions present particularly serious policy and compliance issues.”154 a number of scholars have offered reform suggestions. daniel halperin has urged that the deduction for such contributions be eliminated and replaced with either a program of direct grants or limited-budget tax credits administered by an expert agency.155 roger colinvaux also has argued for converting the deduction to a credit with different levels of tax benefit depending on satisfaction of various conservation criteria, but also offers as a second-best approach changing the measure of the tax benefit to the fair market value of the underlying fee 151. see ashbel g. gulliver & catherine j. tilson, classification of gratuitous transfers, 51 yale l.j. 1, 2–5, 9–10 (1941). 152. i thank professor susan gary for her articulation of this point at the nyu national center on philanthropy and law october, 2012, conference. 153. this professor also suggested a broad reasonable cause exception. i discuss this approach below, in connection with the current reasonable cause exception. 154. joint committee on taxation, present law and background relating to the federal tax treatment of charitable contributions, jcx-4-13, at 42 (feb. 11, 2013). the report continues, “valuation is especially problematic because the measure of the fair market value of the easement . . . is highly speculative, considering that, in general, there is no market and thus no comparable sales data for such easements.” id. the report also notes that in 2004 the irs issued notice 2004-41, 2004-1 c.b. 31, informing taxpayers that it will examine conservation easement donations closely. id. 155. see, e.g., daniel halperin, incentives for conservation easements: the charitable deduction or a better way, 74 law & contemp. probs. 29 (2011). 310 florida tax review [vol. 14:7 interest.156 recent recommendations made by nancy mclaughlin focus on the “granted in perpetuity” requirement and include additional reporting on form 990 for organizations that modify, release, or extinguish easements, and requiring similar reporting by governmental entities.157 for at least some real estate donations, an advisory council similar to the irs art advisory panel could be helpful.158 the art advisory panel, created in 1968, advises and makes recommendation to the art appraisal services unit of the irs office of appeals. twenty-five renowned art experts, who volunteer their time, evaluate and review appraisals of works of art in closed meetings. all tax returns with an appraisal of a single work of art or cultural property valued at $50,000 or more that has been selected for audit must be referred to the panel. the panel’s recommendations are advisory, but the irs has adopted 93 percent of the panel’s recommendations in full. while the work of the panel goes to valuation issues during audit rather than substantiation of deductions claimed on tax returns, expanding such panels might make it possible to loosen some substantiation rules. expansion of appraisal panels to other types of gifts would, of course, involve costs. under current law, taxpayers who make a charitable contribution of an item of art that has been appraised at $50,000 or more may request a statement of value from the irs for income tax charitable deduction purposes. such a request must include a qualified appraisal, an appraisal summary, and a user fee in the amount of $2,500 (for up to three items of art) and must be filed before filing the first income tax return that reports the charitable contribution.159 the availability of statements of value, with appropriate user fees, could be expanded to other types of property. changes to regulations are also possible. both section 170(f)(8), the provision requiring the contemporaneous written acknowledgment, and section 170(f)(11), the provision setting forth requirements for the qualified appraisal and qualified appraiser, authorize regulations “that may provide that some or all of the requirements [of the respective provisions] do not 156. roger colinvaux, the conservation easement tax expenditure: in search of conservation value, 37 colum. j. envtl. l. 1 (2012). 157. nancy a. mclaughlin, extinguishing and amending tax-deductible conservation easements: protecting the federal investment after carpenter, simmons, and kaufman, 13 fla. tax rev. 217, 295 (2012). 158. this description is based on the annual summary report for fiscal year 2011 of the art advisory panel of the commissioner of the internal revenue, http://www.irs.gov/pub/irs-utl/annrep2011.pdf http://www.irs.gov/pub/irs-utl/annrep 2011.pdf and the irs webpage on art appraisal services, http://www.irs.gov/ individuals/art-appraisal-services. 159. rev. proc. 96-15, 1996-1 c.b. 627; see also irs, art appraisal services, http://www.irs.gov/individuals/art-appraisal-services (last updated jan. 25, 2013). 2013] reforming the charitable contribution substantiation rules 311 apply in appropriate cases.”160 thus, the irs and treasury have the ability to promulgate regulations to give relief from the rigors of the substantiation rules. the irs and treasury, perhaps with congressional urging or direction, could revise the proposed regulations regarding “reasonable cause” for failure to follow the qualified appraisal and qualified appraiser rules. rather than strictly construing the exception, the irs and treasury could provide some safe harbors that address some commonly encountered small problems, such as failure to specify that an appraisal was prepared for income tax purposes. given the regulatory authority to create exceptions, even without legislative action, “reasonable cause” relief could be extended as well to the contemporaneous acknowledgment requirement for taxpayers unable to obtain the required documentation from the charity, despite attempts to do so. (a donee charity, for example, could have dissolved or not respond to a donor’s request for the information.) in adopting a “reasonable cause” provision, the proposed regulations for implementing the ajca and the ppa eliminate the provision of the current regulations that permits a donor who fails to file a form 8283 appraisal summary with the return to do so within ninety days of a request from the irs if the original failure is a good faith omission.161 i would recommend that the ninety-day provision be retained along with an expanded reasonable cause provision. such an approach gives the taxpayer an opportunity to correct an error upon notice, protecting both the taxpayer and the tax administrator, without any need to define or determine reasonable cause. expanding the ninety-day provision to permit receipt of a written acknowledgment of a contribution from the donee charity after a showing that the donee refused to provide the acknowledgment despite requests to do so seems reasonable. unlike obtaining appraisals, obtaining the required acknowledgment rests in the control of the donee, not the donor, and thus allowing a corrective mechanism seems appropriate. since audits occur many years after a donation, the donee organization may no longer exist or may not always have records sufficient to make the required statement that “no good or services were provided,” but, at least in some cases, obtaining the belated acknowledgment should be possible. 160. i.r.c. § 170(f)(8)(e), (11)(h). i thank john easton for his comments at the nyu center for philanthropy and law october, 2012, conference emphasizing the importance of this regulatory authority. i also note that the current regulations do exercise this authority to create exceptions in a number of situations. for example, in valuing goods or services provided, organizations can disregard those with insubstantial value provided to donors or employees of donors as well as certain membership benefits. reg. § 1.170a-13(f)(8), (9). 161. reg. § 1.170a-13(c)(4)(h). 312 florida tax review [vol. 14:7 in contrast, allowing appraisals to be undertaken long after the contribution would not sufficiently protect the government. thus, the proposed regulations on the reasonable cause exception introduced in the ajca require a timely appraisal, and i would not endorse a change to that requirement. at the same time that i support loosening the contemporaneous written acknowledgment requirement in some circumstances, i also recommend revising the regulations to require that the contemporaneous written acknowledgment be a separate document, specifically drafted to satisfy this substantiation requirement. i made this recommendation in light of the recent tax court decisions in averyt,162 rp golf, llc,163 and irby,164 which found various documents and combinations of documents to satisfy the contemporaneous written acknowledgment requirement. the acknowledgment, as noted earlier, should also be required to give the date of the contribution. making increased use of technology, such as matching forms 8282, the form required of a donee that disposes of a charitable gift within three years of receipt, and the form 8283 appraisal summary could also aid enforcement for those charitable contributions disposed of by the donee charity within three years. given section 170(e)(7), added by the ppa, to limit or recapture part of the donor’s deduction for such dispositions of tangible personal property, perhaps the irs is already doing so, although i found nothing in my research identifying such a program. additional monitoring of form 8283 and its absence is needed. as noted earlier, a recent report of tigta found that the irs continues to allow unsupported deductions for noncash contributions. tigta recommended that the irs expand its current processes to identify tax returns that do not have a required form 8283 or qualified appraisal attached to the tax return as well as make some revisions to the form 8283, and the irs agreed with these recommendations.165 162. 104 t.c. memo (cch) 65, t.c. memo (ria) ¶ 2012-198. 163. 104 t.c. memo (cch) 413, t.c. memo (ria) ¶ 2012-282. 164. 139 t.c. no. 14, tax ct. rep. (cch) 59, 235 (2012). 165. the report recommended that the form 8283 and related instructions be revised to: (1) require taxpayers to include the contribution date in addition to the donee acknowledgment of receipt for donations of noncash property of more than $ 5,000; (2) clarify that taxpayers must group similar items and claim the aggregate value of the noncash contributions as deductions regardless of the number of different organizations to which the donations are made; and (3) require taxpayers to include the number of shares donated when reporting contributions of securities. treasury inspector general, many taxpayers are still not complying, supra note 39, at 11–12. tigra also recommended that the irs develop a process to verify the accuracy of noncash contribution amounts captured in irs data systems from individual returns. the irs disagreed with this recommendation. id. at 12–13. 2013] reforming the charitable contribution substantiation rules 313 other technologies also need to be taken into account. charities have begun encouraging donors to text contributions.166 after the devastating january 12, 2010, earthquake in haiti, congress quickly passed special legislation to aid in relief. the legislation included a provision that specifically stated, for “cash contribution[s] made for the relief of victims in areas affected by the earthquake in haiti . . . a telephone bill showing the name of the donee organization, the date of the contribution, and the amount of the contribution shall be treated as meeting the recordkeeping requirements of section 170(f)(17),”167 which otherwise requires that donors of less than $250 maintain a bank record or written communication from the donee. a statute or regulations should expand the phone record rules to all charitable contributions to which section 170(f)(17) applies.168 the irs could also work with charities and phone providers to determine if there is a way for phone records to generate records that satisfy the “no goods or services” statement required of a contemporaneous written acknowledgment for donations of $250 or more.169 i imagine, for example, that there could be special text numbers for donations for which no goods or services are provided, and thus, the contemporaneous written acknowledgment could be provided, with the phone company deemed to be acting as the agent of the charity. 166. see, e.g., lauren mcgann, attention nonprofits: young adults love texting donations, nieman journalism lab (july 7, 2010, 4:30 p.m), http://www.niemanlab.org/2010/07/attention-nonprofits-young-adults-love-textingdonations/; american red cross, text message, http://www.redcriss.org/ support/donating-fundraising/donations/text-messaging. at least one section 501(c)(3) group has formed to provide exempt organizations with the ability to accept donations by text. see mobile giving foundation, http://www. mobilegiving.org/. 167. h.r. 4462, 111th cong. (2010) (enacted). president obama signed the bill on january 22, 2010. see govtrack.us, http://www.govtrack.us/ congress/bills/111/hr4462. as of january 15, 2010, more than $10 million had been raised for haiti through mobile texting, of which more than $8 million went to the red cross. douglas stanglin, mobile texting donations to red cross for haiti now tops $8 million, usa today (jan. 15, 2010, 6:06 p.m.), http://content. usatoday.com/communities/ondeadline/post/2010/01/mobile-texting-donations-tored-cross-for-haiti-now-tops-5-million-/1#.um9nrerx2_8. 168. many websites mistakenly assume that the special haiti rules now apply to all charitable contributions made by phone. see, e.g., joanne fritz, how to make a charitable donation with your mobile phone, about.com: nonprofit charitable orgs, http://nonprofit.about.com/od/fordonors/a/how-to-make-acharitable-donation-with-your-mobile-phone.htm; ben alexander, thoughts on charitable giving, accountingweb (dec. 6, 2012), http://www.accountingweb. com/article/thoughts-charitable-giving/220425. 169. i thank robert j. shiller for this suggestion. 314 florida tax review [vol. 14:7 increased use of technology should also involve tax preparation software. schedule a of form 1040 includes a reminder to see the instructions if the taxpayer has made a contribution of $250 or more and that form 8283 must be attached for contributions other than by cash or check of more than $500. such reminders may or may not be effective. but even if they are, only a small percentage of individual tax returns are now filed manually using the paper forms. according to irs filing season statistics for the week ending june 8, 2012, more than 82 percent of individual income tax returns were e-filed.170 thus, it becomes important to know to what extent tax preparation software encourages compliance with the charitable contribution substantiation rules by reminding taxpayers about the contemporaneous written acknowledgment and qualified appraisal rules. turbotax, for example, generates form 8283, but asks its users only about donations over $500.171 that is, it does not include any reminders regarding the 170. see irs, filing seasons statistics for week ending june 8, 2012, http://www.irs.gov/uac/filing-season-statistics-for-week-ending-june-8,-2012 (last updated aug. 4, 2012). the total number individual income tax returns received as of june 8, 2012, are 137,200,000. total e-filing receipts are 113,074,000, with 71,017,000 of that total filed by tax professionals and 42,056,000 self-prepared. id. i thank larry zelenak for help in locating these numbers. 171. see turbotax deluxe online, https://turbotax.intuit.com/login/ https://turbotax.intuit.com/login/start.jsp?prioritycode=3468337910&productid=16 &abtest=random%3d87670&loginpage=start2https://turbotax.intuit.com/login/start.j sp?prioritycode=3468337910&productid=16&abtest=random%3d87670&loginpag e=start2. there are some issues with generation of form 8283 on turbotax. for the tax year 2011, turbotax support notes that “turbotax does not group similar donated items for which a deduction of more than $5,000 is claimed for section b of form 8283. in this case, separate section bs of form 8283 must be completed for each recipient organization.” calculations not supported by turbotax for tax year 2011, turbotax, http://turbotax.intuit.com/support/iq/fed-form-availability/ calculations-not-supported-by-turbotax-for-tax-year-2011/gen83848.html (last updated jan. 28, 2013). when i entered both cash and property contributions on h&r block at home, another well-known tax software package for people who prepare their own taxes, the program reminded me: remember to attach a contemporaneous written acknowledgment for the declaration of the appraiser as required by section 170(f)(8). this acknowledgment must contain the amount of cash and a description of any property contributed, whether the donee organization provided any goods or services in consideration for any property contributed and, if so, a description and good faith estimate of such good or services. see block at home, http://taxes.hrblock.com/hrblock/interview/loadframe. hrbx?tn=interview&targetata=interview&taxtype=tcd&ht=fh&r. it failed to 2013] reforming the charitable contribution substantiation rules 315 contemporaneous written acknowledgment for donations of $250 or more. accountants whom i polled informally at a recent conference also reported that their tax preparation software will generate the form 8283 but does not include reminders about the contemporaneous written acknowledgment. the treasury and the irs could work with tax preparation software companies to request that the programs include questions about contemporaneous written acknowledgment. legislative changes, of course, are also possible. the $250 threshold for the written acknowledgment and the over $500 and $5,000 thresholds for additional substantiation could be raised from time to time or be automatically adjusted for inflation.172 in theory at least, establishing adverse tax interests between donors and donee charities could also improve compliance. legislation, for example, could subject charities to some kind of tax penalty for failing to provide contemporaneous written acknowledgment. charities could face penalties for gross overvaluations for property contributions that they acknowledge on form 8283. they could be required to report to the donor the value assigned to contributed property on form 990.173 as a practical matter, however, congress would almost surely view the burden to donee organizations of such changes to the law as in excess of possible benefits.174 currently, in egregious situations, a donee organization could find itself subject to penalties under the abusive tax shelter provisions.175 approaches endorsed in connection with basic reform of the charitable contribution deduction more generally would also have an impact on substantiation. for example, some have suggested a floor that would remind me that i needed this acknowledgment for gifts of $250 and above, whether or not an appraisal is required. 172. according to the cpi inflation calculator, $250 in 1994 is equal to $388 in 2012. see cpi inflation calculator, http://146.142.4.24/cgibin/cpicalc.pl?cost1=250&year1=1994&year2=2012. 173. i.r.c. § 170(f)(8)(d) provides that the contemporaneous written acknowledgment would not be required for “a contribution if the donee organization files a return, on such form and in accordance with such regulations as the secretary may prescribe,” giving the information required in the acknowledgment. no regulations permitting this safe harbor have been proposed or promulgated. a statute along the lines of this provision could give the secretary authority to require the value assigned to donated property above some specified amount be included on an organization’s form 990 annual information return. 174. as noted earlier, the form 8283 currently specifies that acknowledgment by the donee does not represent agreement with the claimed fair market value. 175. see i.r.c. § 4965 (excise tax on tax-exempt entities entering into prohibited tax shelters). a prominent exempt organization practitioner has told me that a well-known university has been penalized under this provision. 316 florida tax review [vol. 14:7 permit deductions only for giving each year above a set percentage of agi.176 such a floor would relieve taxpayers of the need to keep records of charitable contributions unless they expected to exceed the floor. in other areas of tax law, justifications for floors have included lessening the burden of recordkeeping for taxpayers. as the jct wrote regarding imposition of the two-percent floor on miscellaneous itemized deductions introduced in the tax reform act of 1986, “this floor will relieve taxpayers of the burden of recordkeeping unless they expect to incur expenditures in excess of the floor. also, the percentage floor will relieve the internal revenue service of the burden of auditing deductions for such expenditures when not significant in aggregate amount.”177 similarly, congress enacted the standard deduction in 1944 in part so that a taxpayer “is not required to itemize and substantiate his non-business deductions.” 178 of course, a floor would not address substantiation concerns for contributions of very valuable real estate, art, or other property that raise particular concern about abuse. small contributions, however, have a large revenue effect in the aggregate. in 2009, for example, the total claimed value of deductions for clothing and household items shown on form 8283 was $11.2 billion, representing 36.2 percent of total claimed value of contributions on form 8283 and 88 percent of the number of donations so 176. see, e.g., roger colinvaux, brian galle & eugene steuerle, urban institute, evaluating the charitable deduction and proposed reforms 13 (2012) [hereinafter colinvaux, galle & steuerle, evaluating the charitable deduction] (“[f]loors . . . tend not to affect incentives at the margin, but instead simply provide less of a subsidy for the first dollars of contribution that more likely would be given anyway.” (footnote omitted)); congressional budget office, options for changing tax treatment of charitable giving 11–12 (2011). 177. joint committee on taxation, 99th cong., general explanation of the tax reform act of 1986 at 78, jcs-10-87 (may 4, 1987). 178. s. rep. no. 78-885 (1994) at 4, reprinted in 1944 c.b. 858, 860. 2013] reforming the charitable contribution substantiation rules 317 reported.179 for 2010 such items represented 58 percent of noncashcharitable contributions.180 more revolutionary departures from current law would also influence substantiation requirements. we could eliminate the charitable contribution deduction for contributions of at least some tangible personal property. as colinvaux, galle, and steuerle point out, in-kind donations account for roughly a quarter of the amount of all gifts. there is good reason, however, to think that deductions for some gifts of tangible personal property are problematic, for example where valuation is difficult or the gift likely would be made anyway (depreciated property in clothes or household goods).181 if such a path were to be pursued, careful thought as to the treatment of artwork would be needed because of concern for museums. perhaps only contributions of depreciable personal property could be limited or prohibited. another revolutionary departure would be to rely on direct grants to charities triggered by private donations, such as the british grants called gift aid. such an approach offers another reform that could ease substantiation concerns as well as, according to one study, make taxpayers more responsive.182 under this program, the charity can claim from the government 20 percent of any donation it receives (20 percent is the basic income tax rate). taxpayers with tax rates over this 20 percent basic income tax rate are allowed to claim a reduction in their taxes for amounts above 20 percent.183 gift aid avoids the issues of property contributions because, with 179. roger colinvaux, charitable contributions of property: a broken system reimagined, 50 harv. j. on legis. ____ (2013) (forthcoming) (relying on pearson liddell & janette wilson, individual noncash contributions, 2009, stat. of income bull., no. 4, (spring 2012 at 62)). in contrast, for 2009, the claimed value of deductions for art, for which the irs has established both the art advisory panel and the statement of value procedure as well as maintaining in-house expertise on art valuation, was only $984 million. id. at 59. tigta has reported that “approximately 21 million and 20 million individual claimed noncash contributions,” for 2011 and 2012, respectively. treasury inspector general, many taxpayers are still not complying, supra note 39, at 1. 180. joint committee on taxation, present law and background relating to the federal tax treatment of charitable contributions, jcx-4-13, at 47 (feb. 11, 2013). 181. colinvaux, galle & steuerle, evaluating the charitable deduction, supra note 176, at 17. 182. id. at 14–15, 21. 183. from my understanding of gift aid, claiming back a higher tax rate seems complicated and likely to involve some of the same recordkeeping issues we 318 florida tax review [vol. 14:7 the exception of donated goods to charity shops, it involves only gifts of money. in connection with efforts to avoid the fiscal cliff, suggestions have been made to cap itemized deductions in total, or charitable contribution deductions in particular.184 any such changes would also have an impact on substantiation rules. if a low cap were placed on total itemized deductions, itemized deductions that are more easily verified, such as state taxes and mortgage interest, could displace claimed charitable contribution deductions, “leaving upper-income taxpayers no incentive to give to charity.”185 without contributions, there is no need for substantiation. given the options listed above, of the more radical changes to the charitable contribution deduction, i am personally enamored of a floor. fundamental changes, with the possible exception of permitting nonitemized deductions, seem unlikely.186 if so, reform of the substantiation rules becomes all the more important to protect the integrity of the charitable contribution deduction. for possible changes to the substantiation rules themselves, i urge expansion of the statement of value program as well as promulgation of regulations that expand the “reasonable cause” exception and regulations that give taxpayers the opportunity to obtain a written acknowledgment within ninety days of an irs request if the donee organization failed to provide the documentation after a donor request. at the same time, i suggest having the government increase use of technology, in particular by working with cell phone providers to develop acceptable contemporaneous written acknowledgments and with providers of tax return software to include reminders about the need for the contemporaneous written acknowledgment in their programs.187 the problems of enforcement and complexity that the charitable contribution deduction substantiation rules produce as well as the burdens they place on donors suggest strongly that we undertake the difficult task of reforming this area. currently face. see hm revenue and customs, giving to charity through gift aid, http://www.hmrc.gov.uk/individuals/giving/gift-aid.htm. 184. see joint committee on taxation, present law and background relating to the federal tax treatment of charitable contributions, jcx-4-13, at 51–52 (feb. 11, 2013). 185. see fred stokeld, dollar cap on charitable deduction would be harsher than percentage limit, charity reps say, 2012 tax notes today 240–8 (dec. 13, 2012). 186. fred stokeld, scholars and charities argue for charitable deduction for non-itemizers, 2013 tax notes today 32–5 (feb. 15, 2013) (summarizing a day-long hearing before the house ways and means committee in which most witnesses argued against fundamental changes limiting the deduction). 187. working with software providers to include reminders might be helpful for other tax compliance issues as well. florida tax review volume 13 2012 number 5 florida tax review article extinguishing and amending tax-deductible conservation easements: protecting the federal investment after carpenter, simmons, and kaufman nancy a. mclaughlin university of florida college of law florida tax review volume 13 2012 number 5 article extinguishing and amending tax-deductible conservation easements: protecting the federal investment after carpenter, simmons, and kaufman nancy a. mclaughlin 217 ii florida tax review volume 13 2012 number 5 the florida tax review is a publication of the graduate tax program of the university of florida college of law. each 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of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 13 2012 number 5 217 extinguishing and amending tax-deductible conservation easements: protecting the federal investment after carpenter, simmons, and kaufman by nancy a. mclaughlin * i. introduction ............................................................................. 218 ii. carpenter on extinguishment ............................................. 223 a. so-remote-as-to-be-negligible argument ....................... 225 b. cy pres argument ............................................................. 229 1. tax-deductible easements as restricted gifts .... 229 2. applicability of cy pres ....................................... 236 (i) availability with regard to restricted gifts ....................................... 237 (ii) cy pres process ...................................... 237 (iii) general charitable intent ....................... 238 (iv) cy pres would not have trumped parties’ express right to extinguish ...... 240 c. conservation easements extinguishable by mutual agreement are not deductible ............................. 242 d. extinguishment regulation: optional provisions or necessary restrictions? ............................. 245 1. necessary restrictions ......................................... 246 (i) history of deduction provision .............. 246 (ii) tax court opinions ................................ 250 a. kaufman v. commissioner ......... 250 b. carpenter v. commissioner ....... 255 c. mitchell v. commissioner .......... 257 (iii) regulations ............................................. 258 (iv) reasons underlying the federal extinguishment requirements ................. 260 * nancy a. mclaughlin (j.d. university of virginia) is the robert w. swenson professor of law at the university of utah s.j. quinney college of law. thanks to roger colinvaux, james a. mclaughlin, jeff pidot, ann taylor schwing, stephen j. small, steve swartz, w. william weeks, and others for their helpful thoughts and comments on earlier drafts or portions of drafts. ©2012 by nancy a. mclaughlin. all rights reserved. 218 florida tax review [vol. 13:5 a. impartial judicial decision maker ......................................... 260 b. high standard ............................ 263 c. holder’s share of proceeds ....... 263 d. holder’s use of proceeds .......... 264 2. need for uniform federal standards .................. 265 (i) consistent protection of federal investment ................................. 265 (ii) efficiency ................................................ 266 (iii) equity ...................................................... 267 (iv) effectiveness ........................................... 268 3. federal and state law interaction ...................... 269 iii. hard cases make bad law—simmons and kaufman ........ 271 a. proceeds regulation ......................................................... 272 b. rights to change or abandon easements ......................... 277 1. noncompliance with regulations ........................ 277 2. tax-exempt rules do not ensure protection in perpetuity ......................................................... 278 3. right to change or abandon may render conservation easement provisions nonbinding........................................................... 283 4. local law does not ensure protection in perpetuity ......................................................... 284 5. accommodating change does not require unlimited rights to change or abandon .......................................................... 285 c. first circuit’s advice ........................................................ 287 iv. charting a course .................................................................. 289 a. irs guidance .................................................................... 290 b. rules for amendments....................................................... 292 c. revisions to the regulations ............................................. 296 d. recommendations of others ............................................. 297 v. conclusion ................................................................................. 298 i. introduction the internal revenue service‘s victory in carpenter v. commissioner represented an important step in the agency‘s ongoing efforts to both address abuses and establish precedent consistent with congressional intent in the conservation easement donation context. 1 while congress has 1. carpenter v. commissioner, 103 t.c.m. (cch) 1001, t.c.m. (ria) ¶ 2012-001 (2012). for reports of abuse, see, e.g., abusive transactions involving charitable contributions of easements, irs, http://www.irs.gov/charities-&-non2012] tax-deductible conservation easements 219 clearly favored providing a charitable income tax deduction under internal revenue code section 170(h) to encourage the donation of conservation easements, congress also has been willing to do so only if the easements are ―granted in perpetuity‖ to government and nonprofit holders ―exclusively for conservation purposes,‖ and the conservation purposes of such easements are ―protected in perpetuity.‖ 2 in carpenter, the tax court addressed a key aspect of the protectedin-perpetuity requirement — the circumstances under which government and nonprofit holders can agree to extinguish tax-deductible conservation easements. this is a critically important issue. federal taxpayers are investing billions of dollars in conservation easements intended to permanently protect unique or otherwise significant land areas or structures. 3 profits/conservation-easements; margaret jackson, easement deals lead to inquiries, den. post, nov. 25, 2007, at a01; jennie lay, conservation easement conundrums, high country news, mar. 31, 2008, http://www.hcn.org/issues/367/ 17604?searchterm=conservation+easement+conun; craig r. mccoy & linda k. harris, saving treasures that benefit few, phila. inquirer, feb. 24, 2002, at a01; lisa provence, scenic treasure: how conservation lines the pockets of the rich, the hook, mar. 3, 2011, at 18; joe stephens & david b. ottaway, developers find payoff in preservation, wash. post, dec. 21, 2003, at a01; joe stephens, for owners of upscale homes, loophole pays; pledging to retain the facade affords a charitable deduction, wash. post, dec. 12, 2004, at a01; joe stephens & david b. ottaway, how a bid to save a species came to grief, wash. post, may 5, 2003, at a01; joe stephens, local laws already bar alterations; intervention by trusts is rare for preservation, wash. post, dec. 12, 2004, at a15; joe stephens & david b. ottaway, nonprofit land bank amasses billions, wash. post, may 4, 2003, at a01; joe stephens & david b. ottaway, nonprofit sells scenic acreage to allies at a loss; buyers gain tax breaks with few curbs on land use, wash. post, may 6, 2003, at a01; joe stephens, tax break turns into big business, wash. post, dec. 13, 2004, at a01. for criticisms of the incentive offered to conservation easement donors under section 170(h) and proposals for reform, see, e.g., jeff pidot, reinventing conservation easements: a critical examination and ideas for reform (lincoln institute of land policy 2005), http://www.lincolninst.edu/ pubs/dl/1051_cons%20easements%20pfr013.pdf; roger colinvaux, the conservation easement tax expenditure: in search of conservation value, 37 colum. j. envtl. l. 1, 9–10 (2012) [hereinafter colinvaux, in search of conservation value]; daniel halperin, incentives for conservation easements: the charitable deduction or a better way, 74 law & contemp. probs. 29 (2011) [hereinafter halperin, incentives for conservation easements]. 2. see i.r.c. §§ 170(h)(1), 170(h)(2)(c), 170(h)(5)(a). see also s. rep. no. 96-1007 (1980), reprinted in 1980 u.s.c.c.a.n. 6736 (legislative history of section 170(h)). 3. see, e.g., colinvaux, in search of conservation value, supra note 1, at 9–10 (estimating a total revenue loss of $3.6 billion from the federal charitable income tax deduction provided to individual conservation easement donors from 2003 through 2008; the figure would be larger if it included corporate donations); s. 220 florida tax review [vol. 13:5 astounding amounts of governmental and judicial resources are also being expended to ensure that the easements are not overvalued, that they satisfy the elaborate conservation purposes and other threshold requirements, and that the donations are properly substantiated. for example, as indicated in appendix a, which lists the cases to date involving challenges to deductions claimed with respect to easement donations, thirty-two such cases (more than half), have been decided since 2005, and the irs has indicated that there are more than 200 additional cases in the litigation pipeline. 4 this enormous upfront investment of foregone revenues and government and judicial resources will be for naught, however, if the purportedly permanent protections prove to be ephemeral because government and nonprofit holders fail to enforce the easements, or agree to improperly release, modify, or extinguish the easements. 5 rep. no. 96-1007, supra note 2, pt. 2, at 9, reprinted in 1980 u.s.c.c.a.n. at 6745 (―provisions allowing deductions for conservation easements should be directed at the preservation of unique or otherwise significant land areas or structures‖); s. rep. no. 96-1007, supra note 2, pt. 2, at 13, reprinted in 1980 u.s.c.c.a.n. at 6748 (―the bill explicitly provides that [the ‗exclusively for conservation purposes‘] requirement is not satisfied unless the conservation purpose is protected in perpetuity‖). 4. see also notice 2004-41, 2004-1 c.b. 31 (warning that the irs intends to disallow improper deductions and impose penalties and excise taxes on taxpayers, promoters, and appraisers involved in abusive transactions); staff of joint comm. on taxation, 109th cong., 1st sess., options to improve tax compliance and reform tax expenditures, 281 (jan. 2005), http://www.jct.gov/ publications.html?func=showdown&id=1524 (detailing problems with the incentive and proposing reforms); 1 staff of s. comm. on fin., 109th cong., 1st sess., rep. of staff investigation of the nature conservancy, (comm. print 2005), http://finance.senate.gov/ (same); instructions for form 8283 (rev. dec. 2006), http://www.irs.gov/pub/irs-pdf/i8283.pdf (requiring a detailed supplemental statement in the case of conservation easement donations); 2011 instructions for schedule d (form 990) http://www.irs.gov/pub/irs-pdf/i990sd.pdf (requiring detailed additional information in the case of organizations holding conservation easements); complaint for permanent injunction and other relief, united states v. mcclain, civ. no. 11-1087 (d.d.c. june 14, 2011) (suit filed by the department of justice (doj) against the trust for architectural easements (tae) alleging abusive and illegal façade easement donation practices); stipulated order of permanent injunction, united states v. mcclain, civ. no. 11-1087 (d.d.c. july 15, 2011) (settlement of doj‘s suit against tae by injunction permanently prohibiting tae from engaging in certain practices); irs conservation easement audit techniques guide, http://www.irs.gov/pub/irs-utl/conservation_easement.pdf (detailed guidance for the examination of charitable contributions of conservation easements). 5. see, e.g., nancy a. mclaughlin, internal revenue code section 170(h): national perpetuity standards for federally subsidized conservation easements, part 2: comparison to state law, 46 real prop. tr. & est. l.j. 1, 28–42 (2011) 2012] tax-deductible conservation easements 221 both congress and the treasury department were aware of this danger, and they built significant safeguards into section 170(h) and the regulations to ensure that the conservation purposes of tax-deductible conservation easements would, in fact, be ―protected in perpetuity.‖ one of those safeguards is regulation section 1.170a-14(g)(6) (the extinguishment and proceeds regulation), which addresses both the circumstances under which a tax-deductible conservation easement can be extinguished and the payment of proceeds to the holder to be used for similar conservation purposes in such event. a related safeguard is regulation section 1.170a14(c)(2) (the restriction on transfer regulation), which mandates that the holder be prohibited from transferring the easement, whether or not for consideration, unless the transfer is either to another qualified holder that agrees to continue to enforce the easement or pursuant to an extinguishment that complies with the extinguishment and proceeds regulation. carpenter provides significant guidance regarding compliance with the extinguishment component of the regulations, as well as the role of state law in ensuring that conservation easements are properly administered and enforced over the long term. the case also, however, has created confusion with respect to the state law cy pres doctrine and has caused some to argue that the process for extinguishment set forth in the regulations should be viewed as optional, and states, localities, and even holders should be free to adopt their own extinguishment procedures in lieu of satisfying federal tax law requirements. this article examines carpenter against the backdrop of the legislative history of section 170(h), state law, and public policy. it clarifies the manner in which the state law cy pres doctrine and its general charitable intent requirement should be analyzed with regard to tax-deductible [hereinafter mclaughlin, national perpetuity standards, part 2] (describing cases in which government and nonprofit holders agreed to improperly amend or terminate perpetual conservation easements); infra notes 242–44 and accompanying text (discussing concerns about conservation easement amendments, including concerns highlighted in the senate finance committee‘s report following its investigation of the nature conservancy); staff of j. comm. taxation, 109th cong., 1st sess., description of revenue provisions contained in the president‘s fiscal year 2006 budget proposal, 239–41 (comm. print 2005), http://www.jct.gov/ publications.html?func=startdown&id=1523 (proposal to impose significant penalties on charities that remove, fail to enforce, or inappropriately modify conservation easements, or transfer easements without ensuring that the conservation purposes will be protected in perpetuity); jim waymer, new conservation rules open door for developers to build on set-aside acreage, florida today (sept. 14, 2012) (―it is land supposedly protected forever from development. but new [local] rules could allow landowners to back out of ‗conservation easements,‘ promises they made not to build on pristine land in exchange for tax breaks or other benefits.‖). 222 florida tax review [vol. 13:5 conservation easements. it offers suggestions as to how best to comply with the extinguishment regulation given the tax court‘s rulings in carpenter and other relevant cases. it discusses the court‘s holding that the taxdeductible conservation easements at issue in carpenter constitute restricted charitable gifts under state law and the importance of this status in ensuring that easements are administered in accordance with their terms and purposes over the long term. it also explains that congress enacted section 170(h) to subsidize the acquisition of perpetual conservation easements, or those that are extinguishable by a court only upon frustration of their purposes, and congress specifically did not defer to states, localities, or easement holders regarding transfer, release, or other extinguishment of tax-deductible easements. also examined are the reasons underlying the restriction on transfer, extinguishment, and proceeds regulations, as well as the policy reasons supporting the application of uniform rules in this context. two recent circuit court decisions, simmons v. commissioner and kaufman v. commissioner, are also discussed. 6 although those decisions do not directly address the extinguishment regulation, this article explains that they undermine the irs‘s efforts to enforce the perpetuity requirements in section 170(h) and the regulations, and open the door to loss of the federal investment in conservation easements and significant abuse. this article concludes that the irs‘s strategy of relying on litigation to establish clear rules consistent with congressional intent in this context appears unlikely to be successful, and another approach is needed. the article recommends that the treasury department and the irs clarify the regulations and issue other forward-looking guidance regarding the manner in which taxpayers must satisfy the critically important protected-inperpetuity requirements if they wish to continue to benefit from generous (generally six-figure) deductions. 7 without clear uniform rules addressing 6. commissioner v. simmons, 646 f.3d 6 (d.c. cir. 2011); kaufman v. commissioner (kaufman iii), 687 f.3d 21 (1st cir. 2012). 7. the following chart indicates the number of donations of conservation easements encumbering land in the year designated and the average amount per donation: number of donations year average amount per donation 2005 2,307 $787,062 2006 3,529 $422,092 2007 2,405 $812,369 2008 3,158 $372,925 2009 2,102 $463,073 see pearson liddell & janette wilson, individual noncash contributions, 2009, stat. of income bull., spring 2012, at 63; pearson liddell & janette wilson, individual noncash contributions, 2008, stat. of income bull., winter 2011, at 77; pearson liddell & janette wilson, individual noncash contributions, 2007, 2012] tax-deductible conservation easements 223 the transfer, amendment, and extinguishment of tax-deductible conservation easements, the purportedly perpetual protections provided by such easements will erode over time, and the enormous public investment in these instruments will be lost. 8 ii. carpenter on extinguishment in carpenter, the irs challenged over $2.7 million of charitable income tax deductions claimed with respect to a number of conservation easements donations. 9 the taxpayers involved had acquired parcels of land located in teller county, colorado, from a limited liability company and shortly thereafter donated conservation easements encumbering the land to a colorado land trust. 10 the conservation easement deeds were virtually identical and contained the following provision addressing extinguishment: extinguishment – if circumstances arise in the future such that render the purpose of this conservation easement impossible to accomplish, this conservation easement can be terminated or extinguished, whether in whole or in part, by judicial proceedings, or by mutual written agreement of both parties, provided no other parties will be impacted and no laws or regulations are violated by such termination. . . . 11 the irs sent a notice of deficiency to each taxpayer disallowing the claimed deductions on the ground that the conservation easement donations failed to comply with the requirements under section 170. 12 each of the taxpayers timely filed a petition with the tax court and their cases were consolidated. 13 the irs filed a motion for partial summary judgment in the tax court arguing that the conservation purposes of the taxpayers‘ conservation easements were not protected in perpetuity as required by section 170(h)(5)(a) because the deeds permit the parties to extinguish the stat. of income bull., spring 2010, at 53; pearson liddell & janette wilson, individual noncash contributions, 2006, stat. of income bull., summer 2009, at 68; janette wilson, individual noncash contributions, 2005, stat. of income bull., spring 2008, at 69. 8. see supra note 5. 9. see carpenter v. commissioner, 103 t.c.m. (cch) 1001, 1002, t.c.m. (ria) ¶ 2012-001 at 2 (2012). 10. id. 11. id. 12. id. 13. id. 224 florida tax review [vol. 13:5 easements by mutual agreement. 14 in particular, the irs argued that the taxpayers failed to satisfy the requirements of regulation section 1.170a14(g)(6)(i) (the extinguishment regulation), which provides: extinguishment – (i) in general. if a subsequent unexpected change in the conditions surrounding the property that is the subject of a donation . . . can make impossible or impractical the continued use of the property for conservation purposes, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding and all of the donee‘s proceeds (determined [as provided in regulation section 1.170a14(g)(6)(ii) (the proceeds regulation) 15 ]) from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution. 16 14. carpenter, 103 t.c.m. (cch) at 1002, t.c.m. (ria) ¶ 2012-001 at 3. 15. the proceeds regulation provides: proceeds – in the case of a donation made after february 13, 1986, for a deduction to be allowed under this section, at the time of the gift the donor must agree that the donation of the perpetual conservation restriction gives rise to a property right, immediately vested in the donee organization, with a fair market value that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift, bears to the value of the property as a whole at that time . . . . [t]hat proportionate value of the donee‘s property rights shall remain constant. accordingly, when a change in conditions give[s] rise to the extinguishment of a perpetual conservation restriction under [the extinguishment regulation] paragraph . . . , the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction, unless state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the prior perpetual conservation restriction. reg. § 1.170a-14(g)(6)(ii). 16. the regulations contain numerous additional requirements intended to ensure that a tax-deductible conservation easement will be enforceable in perpetuity and its conservation purpose protected in perpetuity, including: (i) the ―restriction on transfer‖ requirement, see reg. § 1.170a-14(c)(2); (ii) the ―no inconsistent use‖ requirement, see reg. § 1.170a-14(e)(2); (iii) the ―general enforceable in perpetuity‖ requirement, see reg. § 1.170a-14(g)(1); (iv) the ―mortgage subordination‖ requirement, see reg. § 1.170a-14(g)(2); 2012] tax-deductible conservation easements 225 the taxpayers made two arguments in response: the ―so-remote-asto-be-negligible‖ argument and an argument based on the state law doctrine of cy pres. 17 because the irs moved for partial summary judgment, it bore the burden of proof, and the court was required to infer facts in the manner most favorable to the taxpayers. 18 the taxpayers nonetheless lost on both counts. a. so-remote-as-to-be-negligible argument the taxpayers‘ first argument was based on regulation section 1.170a-14(g)(3) (the so-remote-as-to-be-negligible regulation), which provides: a deduction shall not be disallowed . . . merely because the interest which passes to, or is vested in, the donee organization may be defeated by the performance of some act or the happening of some event, if on the date of the gift it appears that the possibility that such act or event will occur is so remote as to be negligible. the taxpayers claimed that summary judgment was inappropriate because there was a material question of fact as to whether the possibility of extinguishment in accordance with the terms of the easement deeds was so remote as to be negligible. 19 in other words, the taxpayers argued that failure to comply with the extinguishment regulation could be excused if it could be shown that, despite such failure, the possibility of extinguishment was so remote as to be negligible. (iv) the ―mining restrictions‖ requirement, see reg. § 1.170a-14(g)(4); (v) the ―baseline documentation‖ requirement, see reg. § 1.170a14(g)(5)(i); and (v) the ―donee notice,‖ ―donee access,‖ and ―donee enforcement‖ requirements, see reg. § 1.170a-14(g)(5)(ii). for a detailed discussion of these requirements and the legislative history of section 170(h), see nancy a. mclaughlin, internal revenue code section 170(h): national perpetuity standards for federally subsidized conservation easements, part 1: the standards, 45 real prop. tr. & est. l.j. 473 (2010) [hereinafter mclaughlin, national perpetuity standards, part 1]. 17. carpenter, 103 t.c.m. (cch) at 1003, t.c.m. (ria) ¶ 2012-001 at 3– 4. 18. 103 t.c.m. (cch) at 1002, t.c.m. (ria) ¶ 2012-001 at 3. 19. 103 t.c.m. (cch) at 1003, t.c.m. (ria) ¶ 2012-001 at 4. 226 florida tax review [vol. 13:5 the tax court disagreed. citing its previous holding in kaufman v. commissioner (kaufman ii), 20 the court stated that the so-remote-as-to-benegligible standard does not modify the extinguishment regulation. 21 accordingly, the irs is not required to make a showing with respect to the possibility of extinguishment in determining whether an easement complies with the extinguishment regulation. the court explained that the issue was not whether there was a possibility that events could occur that would trigger the easement deeds‘ extinguishment provision, but whether, upon the happening of such events, the ability to extinguish the easements as provided in the deeds — by mutual agreement of the parties — violated the requirements of the extinguishment regulation. 22 thus, although there was a genuine issue of material fact as to whether circumstances could arise that would trigger the easement deeds‘ extinguishment provision, it did not preclude the entry of summary judgment on the issue of whether the donations failed to comply with the extinguishment regulation. as the court explained: ―disputes over material facts that are not outcome determinative do not preclude the entry of summary judgment.‖ 23 in a subsequent case, mitchell v. commissioner, the tax court similarly held that the so-remote-as-to-be-negligible standard could not be applied to excuse the taxpayer‘s failure to comply with the regulations‘ mortgage subordination requirement. 24 the court also took the opportunity to review the decisions that had been rendered thus far on the so-remote-as-to 20. kaufman v. commissioner (kaufman ii), 136 t.c. 294 (2011), vacated and remanded in part on other grounds, kaufman iii, 687 f.3d 21 (1st cir. 2012). 21. carpenter, 103 t.c.m. (cch) at 1002-03, t.c.m. (ria) ¶ 2012-001 at 4–5. 22. id., 103 t.c.m. (cch) at 1003, t.c.m. (ria) ¶ 2012-001 at 4. 23. id., 103 t.c.m. (cch) at 1003-04, t.c.m. (ria) ¶ 2012-001 at 4–5 (citing anderson v. libberty lobby, inc., 477 u.s. 242, 248 (1986)). 24. mitchell v. commissioner, tax ct. rep. (cch) dec. 59, 013, tax ct. rep. (ria) dec. 138.16 (2012). regulation section 1.170a-14(g)(2), the mortgage subordination regulation, provides that ―no deduction will be permitted . . . for an interest in property which is subject to a mortgage unless the mortgagee subordinates its rights in the property to the right of the qualified organization to enforce the conservation purposes of the gift in perpetuity.‖ in mitchell, the conservation easement donor failed to obtain a subordination agreement from the holder of an outstanding mortgage on the subject property until two years following the donation. the donor argued that such failure could be excused because the probability that the donor would have defaulted on the mortgage (and the easement would be eliminated) during the two year period was so remote as to be negligible. the tax court rejected that argument, noting that the requirements of the mortgage subordination regulation are strict requirements that may not be avoided by invoking the so-remote-as-to-be-negligible standard. id., tax ct. rep. (cch) dec. 59, 013, at 4637, tax ct. rep. (ria) dec. 138.16, at 195. 2012] tax-deductible conservation easements 227 be-negligible issue. it explained that the so-remote-as-to-be-negligible standard could not be used to avoid the mortgage subordination requirement of regulation section 1.170a-14(g)(2), 25 the judicial proceeding requirement of regulation section 1.170a-14(g)(6)(i), 26 or the proceeds requirement of regulation section 1.170a-14(g)(6)(ii). 27 the tax court in mitchell also held that the d.c. circuit‘s holding in commissioner v. simmons was distinguishable. 28 in simmons, the irs argued that two façade easements failed the perpetuity requirement in section 170(h) because each easement deed provided that the holder had the right to consent to changes or abandon some or all of its rights under the easement. the d.c. circuit held for the taxpayers, in part because it found that the possibility the donee would abandon its rights under the easements was so remote as to be negligible. 29 in distinguishing simmons, the tax court in mitchell explained that the d.c. circuit applied the so-remote-as-to-benegligible standard ―to defeat a general argument made by the commissioner as to the conservation easement‘s grant in perpetuity;‖ the d.c. circuit did not apply that standard to defeat a specific subparagraph of regulation section 1.170a-14(g). 30 carpenter and mitchell suggest that it is unlikely the so-remote-asto-be-negligible standard can be successfully invoked to avoid any of the specific requirements set forth in section 170(h) and the regulations. that would be both appropriate and sensible. the specific requirements in section 170(h) and the regulations establish bright-line rules that promote efficient and equitable administration of the federal tax incentive program. if individual taxpayers could fail to comply with those requirements and claim that their donations are nonetheless deductible because the possibility of defeat of the gift is so remote as to be negligible, the irs and the courts would be required to engage in an almost endless series of probability assessments with regard to each individual conservation easement donation. by including specific requirements in section 170(h) and the regulations, 25. see id. 26. see id., tax ct. rep. (cch) dec. 59,013, at 4636–37, tax ct. rep. (ria) dec. 138.16 at 194–95 (citing to kaufman ii, 136 t.c. 294; carpenter, 103 t.c.m. (cch) 1001, t.c.m. (ria) ¶ 2012-001). 27. see id. (citing to kaufman ii, 136 t.c. 294; carpenter, 103 t.c.m. (cch) 1001, t.c.m. (ria) ¶ 2012-001). 28. mitchell, tax ct. rep. (cch) dec. 59, 013, at 4637, tax ct. rep. (ria) dec. 138.16 at 195; commissioner v. simmons, 646 f.3d 6 (2011). 29. simmons, 646 f.3d at 11–12. see infra part iii for a critique of simmons. 30. mitchell, tax ct. rep. (cch) dec. 59, 013, at 4637, tax ct. rep. (ria) dec. 138.16 at 195 (emphasis added). 228 florida tax review [vol. 13:5 congress and the treasury department presumably intended to avoid just such inquiries. 31 subsequent to mitchell, however, the first circuit vacated kaufman ii in part in kaufman v. commissioner (kaufman iii) and reintroduced some confusion and uncertainty regarding the so-remote-as-to-be-negligible standard. 32 on the one hand, the first circuit appeared to agree with the tax court that the so-remote-as-to-be-negligible standard cannot be invoked to cure a failure to comply with the extinguishment or proceeds regulations. in kaufman ii, the tax court held that a mortgage subordination agreement obtained in connection with the donation of a façade easement impermissibly qualified the provision included in the easement deed to satisfy the proceeds regulation. 33 in vacating that holding in kaufman iii, the first circuit specifically noted that it was not relying on the so-remote-as-to-be-negligible regulation ―because, as the tax court noted [in kaufman ii], ‗[o]ne does not satisfy the extinguishment provision . . . merely by establishing that the possibility of a change in conditions triggering judicial extinguishment is unexpected.‘‖ 34 on the other hand, in agreeing with the d.c. circuit‘s holding in simmons that a grant to the holder of the right to consent to changes or abandon the easement does not render the easement nondeductible, the first circuit in kaufman iii cited to simmons for the proposition that ―deductions ‗cannot be disallowed based upon the remote possibility [that the donee organizations] will abandon the easements.‘‖ 35 that quoted statement suggests that taxpayers might be able to invoke the so-remote-as-to-benegligible standard to cure failures to comply with the requirements of section 170(h) and the regulations in some circumstances. that suggestion is unfortunate given that the d.c. circuit‘s reasoning underlying the quoted statement was flawed, 36 as well as the earlier noted rationale for not 31. see also id. (―the drafters of [the mortgage subordination requirement] saw taxpayers defaulting on their mortgages as more than a remote possibility. therefore they drafted a specific provision which would absolutely prevent a default from destroying a conservation easement‘s grant into perpetuity.‖). 32. kaufman iii, 687 f.3d 21 (1st cir. 2012). 33. kaufman ii, 136 t.c. at 310–13, vacated and remanded in part, kaufman iii, 687 f.3d 21. the proceeds regulation is reproduced supra note 15. 34. kaufman iii, 687 f.3d at 27. 35. id. at 28. 36. the d.c. circuit inappropriately relied on stotler v. commissioner, 53 t.c.m. (cch) 973, t.c.m. (p-h) ¶ 87, 275 (1987), which interprets the 1979 version of the deduction provision, rather than section 170(h) and the regulations. see simmons v. commissioner, 646 f.3d. 6, 10–11 (d.c. cir. 2011). it was not until 1980 that congress, in response to concerns about abuse, added the protected-inperpetuity requirement to the deduction provision and provided significant guidance regarding the meaning of that new requirement in the legislative history, much of 2012] tax-deductible conservation easements 229 permitting the so-remote-as-to-be-negligible standard to be so invoked. as discussed in part iv, along with addressing other concerns relating to the holdings in simmons and kaufman iii, the treasury department and the irs should revise the regulations or issue other guidance clarifying that the soremote-as-to-be-negligible standard cannot, under any circumstances, be invoked to cure a failure to comply with the specific requirements of section 170(h) and the regulations. b. cy pres argument as an alternative to their so-remote-as-to-be-negligible argument, the taxpayers in carpenter made an argument based on the state law doctrine of cy pres. they argued that (1) the easement donations created charitable trusts or constituted restricted charitable gifts, and (2) the doctrine of cy pres thus applied, and extinguishment of the easements would therefore require a judicial proceeding despite the fact that the deeds expressly grant the parties the right to extinguish by mutual agreement. 37 the tax court addressed these two assertions in turn. 1. tax-deductible easements as restricted gifts because the highest court in colorado had not yet ruled on whether the gift of a perpetual conservation easement to a charitable organization constitutes a charitable trust or a restricted charitable gift, the tax court applied what it found to be colorado law ―after giving proper regard to relevant rulings of other courts of the state.‖ 38 while the court determined that the taxpayers had not created charitable trusts as a result of their gifts of the easements, it held that such gifts did constitute restricted gifts. 39 the which was incorporated into the regulations, which were not issued until 1986. see mclaughlin, national perpetuity standards, part 1, supra note 16, at 475–86 (explaining the history of the deduction provision). accordingly, the d.c. circuit‘s reliance on stotler, which interprets the 1979 version of the deduction provision, as authority for the interpretation of the protected-in-perpetuity requirement, which was not enacted until 1980, and regulation section 1.170a-14(g)(1), which was not issued until 1986, was inappropriate. see mclaughlin, national perpetuity standards, part 2, supra note 5, at 14–15 (discussing this point in more detail). the d.c. circuit also did not recognize that the change and abandonment proviso was an impermissible qualification of the restriction on transfer provision included in the deed to satisfy regulation section 1.170a-14(c)(2). see infra note 193 and surrounding text. 37. carpenter v. commissioner, 103 t.c.m. (cch) 1001, 1004, t.c.m. (ria) ¶ 2012-001 at 5 (2012). 38. id., 103 t.c.m. (cch) at 1004, t.c.m. (ria) ¶ 2012-001 at 5. 39. id., 103 t.c.m. (cch) at 1004-05, t.c.m. (ria) ¶ 2012-001 at 5–6. 230 florida tax review [vol. 13:5 court explained that restricted gifts are ―contributions conditioned on the use of a gift in accordance with the donor‘s precise directions and limitations.‖ 40 the court also noted that at least one commentator has argued that conservation easements eligible for federal charitable contribution income tax deductions are, by definition, charitable gifts made for a specific purpose, i.e., restricted gifts. 41 the tax court explained that the gifts of the conservation easements were restricted gifts because the ―‗deeds restricted greenlands‘ use of the gifts to ‗preserve and protect in perpetuity the conservation values of the property for the benefit of this generation and generations to come.‘‖ 42 in other words, the easements were not donated to greenlands to be used or disposed of as it might see fit in accomplishing its general charitable conservation mission. rather, each easement was donated to greenlands for a specific charitable purpose — the protection of the particular property encumbered by the easement for the conservation purposes set forth in the deed in perpetuity. accordingly, the gifts of the easements constituted restricted gifts, and greenlands is required to administer those gifts ―in accordance with the donor‘s precise directions and limitations. ‖43 40. id., 103 t.c.m. (cch) 1004, t.c.m. (ria) ¶ 2012-001 at 6 (quoting michael m. schmidt & taylor t. pollock, modern tomb raiders: nonprofit organizations’ impermissible use of restricted funds, 31 colo. law. 57, 58 (2002)). 41. id. (citing mclaughlin, national perpetuity standards, part 2, supra note 5, at 23). mclaughlin, national perpetuity standards, part 2, supra note 5 at 23, explains: conservation easements eligible for federal charitable income tax deductions are also, by definition, charitable gifts made for a specific purpose — the protection of the particular property encumbered by the easement for one or more of the conservation purposes enumerated in section 170(h) in perpetuity. under state law, the donee of a charitable gift made for a specific purpose must administer the gift consistent with its stated terms and charitable purpose. for a discussion of the principles applicable to restricted charitable gifts in the conservation easement context, see, e.g., nancy a. mclaughlin, amending perpetual conservation easements: a case study of the myrtle grove controversy, 40 u. rich. l. rev. 1031 (2006); nancy a. mclaughlin & w. william weeks, hicks v. dowd, conservation easements, and the charitable trust doctrine: setting the record straight, 10 wyo. l. rev. 73 (2010) [hereinafter mclaughlin & weeks, setting the record straight]; nancy a. mclaughlin, conservation easements: perpetuity and beyond, 34 ecology l. q. 673 (2007) [hereinafter mclaughlin, conservation easements: perpetuity and beyond]. 42. carpenter, 103 t.c.m. (cch) at 1004, t.c.m. (ria) ¶ 2012-001 at 6. 43. charitable gifts made to government entities and charitable organizations can be either restricted or unrestricted. an unrestricted charitable gift 2012] tax-deductible conservation easements 231 the court‘s holding that the conservation easements did not constitute charitable trusts but did constitute restricted gifts highlights an issue that sometimes creates confusion. in some states, gifts made to charitable corporations for specific purposes are referred to as charitable trusts. 44 in other states, such gifts are referred to as absolute, conditional, or restricted gifts, rather than technical trusts. 45 regardless of the label, however, the recipient corporation must administer the gift in accordance with the terms and purpose specified by the donor. 46 a leading case in this context explains: is a contribution of money or property that the donor makes without attaching any conditions on its use by the recipient entity or organization. an entity or organization in receipt of an unrestricted charitable gift is free to use that gift as it sees fit in accomplishing its general public or charitable mission. the typical unrestricted charitable gift is the fifty dollar check written to a favorite charity at the end of the calendar year or the twenty dollar bill dropped in the church collection plate on sunday, both of which the donor intends will be used by the recipient organization as it sees fit in accomplishing its general charitable mission. unrestricted charitable gifts of land are commonly called ―tradelands,‖ reflecting that the land can be sold and the proceeds used by the charity in accomplishing its general charitable mission. a restricted charitable gift, in contrast, is a contribution of money or property that the donor makes to a government entity or charitable organization to be used for a specific charitable purpose and often according to carefully negotiated terms. see, e.g., john k. eason, the restricted gift life cycle, or what comes around goes around, 76 fordham l. rev. 693, 698, 708–09 (2007) (restricted charitable gifts give rise to trust or trust-like duties, in particular the duty to abide by the terms of the gift). 44. see, e.g., chattowah open land trust v. jones, 636 s.e.2d 523, 525–27 (ga. 2006) (devise of testator‘s residence and surrounding acreage to a land trust for the purpose of maintaining the property in perpetuity exclusively for conservation purposes within the meaning of section 170(h) ―unambiguously created a charitable trust‖ and testator‘s failure to use the term ―trust‖ or ―trustee‖ did not alter the outcome as strict use of those terms is not required to establish a trust). 45. see, e.g., george w. vallery mem. fund. v. saint luke‘s cmty. found., 883 p.2d 24, 28 (colo. app. 1993) (referring to a bequest for a specific charitable purpose as ―an outright but restricted gift rather than a trust,‖ and an ―absolute bequest to a charitable organization‖). 46. see, e.g., lefkowitz v. lebensfeld, 68 app.div.2d 488, 496 (1979) (―these cases reflect the never disturbed equitable doctrine that although gifts to a charitable organization do not create a trust in the technical sense, where a purpose is stated a trust will be implied, and the disposition enforced by the attorney-general, pursuant to his duty to effectuate the donor‘s wishes.‖); st. joseph‘s hosp. v. bennett, 22 n.e.2d 305, 308 (n.y. 1939) (while ―[n]o trust arises . . . in a technical sense‖ a charitable corporation ―may not . . . receive a gift made for one purpose and use it for another . . . .‖). 232 florida tax review [vol. 13:5 ―[e]quity will afford protection to a donor to a charitable corporation in that the [a]ttorney [g]eneral may maintain a suit to compel the property to be held for the charitable purpose for which it was given to the corporation‖ . . . . ―the general rule is that charitable trusts or gifts to charitable corporations for stated purposes are [enforceable] at the instance of the [a]ttorney [g]eneral . . . . it matters not whether the gift is absolute or in trust or whether a technical condition is attached to the gift.‖ ―the theory underlying the power of the [a]ttorney [g]eneral to enforce gifts for a stated purpose is that a donor who attaches conditions to his gift has a right to have his intention enforced.‖ 47 the difference in terminology used to describe gifts made to charitable corporations for specific purposes can be traced to a time in u.s. history when charitable trusts were not valid in some states. 48 during this 47. carl j. herzog found. v. univ. of bridgeport, 699 a.2d 995, 997–98 (conn. 1997) (quoting lefkowitz, 68 app.div.2d at 494–95 (1979) (emphasis added). see also, e.g., scott & ascher on trusts § 37.1.1 (5th ed. 2009) (―many of the principles that apply to charitable trusts also apply to charitable corporations. in both cases, the attorney general can maintain a suit to prevent diversion of the property to purposes other than those for which it was given. likewise, in both cases, cy pres may be available‖). a few of the procedural rules applicable to trusts do not apply in the case of gifts to charitable corporations. see, e.g., evelyn brody, from the dead hand to the living dead: the conundrum of charitable-donor standing, 41 ga. l. rev. 1183, 1209 (2007) (―[a] restricted gift . . . does not impose on the corporate charity the trust law procedural requirements for providing information to beneficiaries (although the charity would have to respond to a request for information from the attorney general) [or] for judicial accounting.‖). 48. see, e.g., james j. fishman, the development of nonprofit corporation law and an agenda for reform, 34 emory l.j. 617, 624–30, 652 (1985) [hereinafter fishman, development] (describing ―the tangled history of the charitable trust in this country‖); j. w. oler, annotation, nature of estate created by, and enforceability of, provision in devise or bequest to charitable, religious, or educational corporation as to particular purpose of the corporation for which it shall be used, 130 a.l.r. 1101 (2012) [hereinafter oler, nature of estate] (―[s]ome jurisdictions early adopted the view that charitable trusts were invalid as lacking beneficiaries definite enough to enforce the trust . . . . [s]uch trusts [also] were not everywhere recognized as being immune from restrictions against perpetuities.‖). for an interesting discussion of the evolution of the laws governing charitable conveyances in the united states, see note, the enforcement of charitable trusts in america: a history of evolving social attitudes, 54 va. l. rev. 436 (1968). 2012] tax-deductible conservation easements 233 period, courts in these states validated gifts made to charitable corporations for specific purposes by resorting to the expediency of characterizing such gifts as absolute or conditional, rather than as technical trusts. 49 such gifts, however, still had to be applied to the particular purpose specified by the donor, the term ―absolute‖ in this context meaning ―not in trust‖ (and therefore not invalid), rather than that the gift was conveyed to the donee to be used in its discretion for any of its general purposes (i.e., absolute did not mean unrestricted). 50 old habits die hard, and courts in some states continue today to characterize gifts made to charitable corporations for specific purposes as absolute or conditional, rather than as trusts, even though charitable trusts are now valid in all fifty states. 51 for convenience and 49. professor fishman explains: to sustain a charitable bequest in the nineteenth century in states such as new york, courts had to find an intent to make an absolute gift to the specific corporation for its proper purposes, rather than an attempt to create a trust for indefinite and uncertain beneficiaries. to avoid a forfeiture of a testator‘s intent, courts engaged in the most tortuous reasoning to find that an absolute gift was intended to the corporation, even when the instrument used such precise terminology as: ―i give, devise and bequeath . . . to . . . in trust. . . .‖ fishman, development, supra note 48, at 629. see also, e.g., oler, nature of estate, supra note 48 (―in minnesota uses and trusts were abolished by statute, except as therein specifically authorized . . . . circumvention of the effect of this statute, in order to validate a testator‘s charitable disposition to a corporation for a corporate purpose, was accomplished . . . by adoption of the convenient view that such a gift was not in trust, but was ‗absolute‘ or on condition.‖). the court in lefkowitz v. lebensfeld, 68 app.div.2d 488, 494–95 (1979), describes the history of the development of the law in this context in new york. 50. see, e.g., st. joseph’s hosp., 22 n.e.2d at 307 (―even when the courts found that a gift to a charitable corporation for a corporate purpose was an ‗absolute‘ gift and not a trust, they also indicated that directions in regard to the manner in which the gift was to be held and used would be enforced‖). 51. marion r. fremont-smith, governing nonprofit organizations: federal and state law regulation 47 (2004). in an attempt to reduce the confusion caused by the different labeling of gifts made to charitable corporations for specific purposes, the american law institute‘s restatement (third) of trusts provides that all such gifts constitute ―charitable trusts,‖ while the institute‘s principles of the law of nonprofit organizations (tentative draft) takes the opposite tack and provides that all such gifts are ―restricted gifts.‖ see restatement (third) of trusts § 28 cmt. a (2003); principles of the law of nonprofit organizations § 400 (tentative draft no. 2, mar. 18, 2009). while such attempts to reduce the confusion are laudable, they presumably would be more effective if the institute took a consistent position. it also seems likely that state courts will continue to use the different terminology based on precedent in any event. 234 florida tax review [vol. 13:5 descriptive purposes, gifts made to charitable corporations for specific purposes are often simply referred to as ―restricted gifts,‖ 52 and they will be referred to as such in the remainder of this article. the status of federally subsidized conservation easements as restricted gifts is key for a number of reasons. first, such status ensures that nonprofit and government holders will be required under state law to administer the easements ―in accordance with the donor‘s precise directions and limitations‖ — that is, in accordance with the specific provisions of the easements, many of which will have been included to comply with federal tax law requirements. 53 if the provisions included in a conservation easement to satisfy federal tax law requirements are not legally binding on the parties to the easement, they would constitute mere window dressing and the conservation purposes of the contributions would not be protected in perpetuity as mandated by congress. 54 second, restricted gift status ensures that the state attorney general will have standing to call holders to account for failing to administer conservation easements consistent with their stated terms and purposes. although the irs has a few arrows in its quiver, such as the power to revoke the tax-exempt status of a nonprofit (but not governmental) holder that confers an impermissible private benefit on a property owner through the modification or termination of a conservation easement, 55 it is not clear that 52. see generally, e.g., principles of the law of nonprofit organizations § 400 (tentative draft no. 2, mar. 18, 2009), discussed supra note 51; michael m. schmidt & taylor t. pollock, modern tomb raiders: nonprofit organizations’ impermissible use of restricted funds, 31 colo. law. 57 (2002). 53. see conservation easement handbook: managing land conservation and historic preservation easement programs 160–61 (janet diehl & thomas s. barrett eds., 1988) [hereinafter diehl, 1988 conservation easement handbook] (providing a checklist of ―provisions relating to irs requirements‖); thomas s. barrett & stefan nagel, model conservation easement and historic preservation easement, 1996: revised easements and commentary from ―the conservation easement handbook‖ 11 (1996) [hereinafter barrett, 1996 conservation easement handbook] (same); elizabeth byers & karin marchetti ponte, the conservation easement handbook 313–14 (2d ed. 2005) [hereinafter byers, 2005 conservation easement handbook] (same). 54. see mclaughlin, national perpetuity standards, part 2, supra note 5, at 20. 55. see, e.g., i.r.s. priv. ltr. rul. 201110020 (march 11, 2011) (revoking an organization‘s tax-exempt status in part because the organization agreed to amend a conservation easement to permit additional development on the subject property and thereby conferred a private benefit on the landowner). but see nancy a. mclaughlin & w. william weeks, in defense of conservation easements: a response to the end of perpetuity, 9 wyo. l. rev. 1, 75–78 (2009) [hereinafter mclaughlin & weeks, in defense of conservation easements] (explaining that 2012] tax-deductible conservation easements 235 the irs has the ability, even if it had the resources and desire, to sue to enjoin improper modifications or terminations or to have such actions declared null and void. that task falls primarily to the state attorney general, who supervises the administration of charitable assets in the state on behalf of donors and the public. 56 accordingly, state attorneys general play a critical role in ensuring that tax-deductible perpetual conservation easements are administered in accordance with their stated terms and purposes over the long term. 57 restricted gift status also means that (1) state courts are likely to interpret tax-deductible conservation easements in favor of accomplishing their charitable conservation purposes, rather than in favor of the free use of land; 58 (2) tax-deductible easements may be excluded from the bankruptcy estates of donee charitable corporations; 59 (3) actions to recover tax denying a holder ―eligible donee‖ or ―tax-exempt‖ status are relatively toothless sanctions when it comes to ensuring that conservation easements are administered in accordance with their terms and purposes over the long term). the tax benefit rule is also of limited usefulness because it would apply only in limited circumstances (i.e., where the transaction financially benefits the original donor). see, e.g., martin j. mcmahon, jr. & lawrence a. zelenak, federal income taxation of individuals 3.07[1] (2nd ed. 2012). 56. see fremont-smith, supra note 51, at 305–07. see also nancy a. mclaughlin & w. william weeks, salzburg v. dowd: another look, 33 wyo. law. 50, 52 (2010) (explaining that the irs is charged with enforcing federal tax laws, while state attorneys general and state courts are charged with ensuring that charitable gifts are administered in accordance with their stated terms and purposes, and it is therefore no surprise that the irs was not involved in any of the cases to date involving the improper modification or termination of conservation easements). 57. see, e.g., mclaughlin, national perpetuity standards, part 2, supra note 5, at 39–42 (discussing salzburg v. dowd, in which the wyoming attorney general filed suit objecting to a wyoming county‘s termination of a tax-deductible easement at the request of new owners of the land); id. at 28–30 (discussing the myrtle grove controversy, in which the maryland attorney general filed suit objecting to a land trust‘s amendment of a tax-deductible conservation easement to allow a seven-lot upscale development on the protected property). 58. see, e.g., jackson v. phillips, 96 mass. 539, 550, 556 (1867) (―[g]ifts to charitable uses are highly favored, and will be most liberally construed in order to accomplish the intent and purpose of the donor. . . . if the words of a charitable bequest are ambiguous or contradictory, they are to be so construed as to support the charity, if possible.‖); board of trs. of univ. of n. c. v. unknown heirs, 319 s.e.2d 239, 242 (n.c. 1984) (―it is a well recognized principle that gifts and trusts for charities are highly favored by the courts. thus, the donor‘s intentions are effectuated by the most liberal rules of construction permitted.‖). 59. see, e.g., evelyn brody, the charity in bankruptcy and ghosts of donors past, present, and future, 29 seton hall legis. j. 471, 472 (2005) (―[t]he courts will try to identify those charitable assets that are restricted in such a manner that they survive the bankruptcy proceeding.‖). 236 florida tax review [vol. 13:5 deductible easements that have been improperly transferred, released, modified, or terminated may not be barred by laches or the statute of limitations; 60 (4) conservation easements should not be extinguished pursuant to the doctrine of merger if the government or nonprofit holder acquires title to the subject land because the required ―unity of ownership‖ generally will not be present; 61 and (5) attempts by state legislatures to alter the terms of existing tax-deductible easements may be found unconstitutional on a number of grounds, including the prohibition on impairment of private contracts. 62 accordingly, restricted charitable gift status provides significant protection of the public interest and investment in tax-deductible conservation easements and is key to the success of the tax-incentive program, which depends on the proper administration and enforcement of the easements over the long term. 2. applicability of cy pres having found that the conservation easement donations in carpenter constituted restricted gifts, the tax court next turned to whether the doctrine of cy pres was applicable to such gifts and, if so, whether it prevented the parties from exercising the right granted to them in the deeds to mutually agree to extinguish the easements. 63 the tax court correctly determined that the doctrine of cy pres was available with regard to the gifts of the easements, but it did not prevent the parties from exercising their right to mutually agree to extinguish the easements. as explained below, however, the court‘s analysis requires some clarification and will hopefully be revised in future decisions. 60. see, e.g., tauber v. virginia, 499 s.e.2d. 839, 845 (va. 1998) (laches may not be pled successfully as a defense in an equitable proceeding to bar the state attorney general from asserting a claim on behalf of the public to insure that charitable assets are distributed in accord with the charitable purposes to which they should have been devoted); trs. of andover theological seminary v. visitors of theological inst. in phillips acad. in andover, 148 n.e. 900, 918 (mass. 1925) (―generally it is true that no length of time of diversion from the plain provisions of a charitable foundation will prevent its restoration to its true purpose.‖). 61. see nancy a. mclaughlin, conservation easements and the doctrine of merger, 74 law & contemp. probs 279 (2011) (explaining that the two estates would be ―in the same person at the same time,‖ but generally would not be held ―in the same right‖). 62. see, e.g., mclaughlin & weeks, in defense of conservation easements, supra note 55, at 88–91 (gathering the relevant authorities). 63. carpenter v. commissioner, 103 t.c.m. (cch) 1001, 1004-05, t.c.m. (ria) ¶ 2012-001 at 6–7 (2012). 2012] tax-deductible conservation easements 237 (i) availability with regard to restricted gifts the tax court first determined that, under colorado law, ―‗even in the absence of a formal trust, the doctrine of cy pres is available when there is an absolute bequest to a charitable organization.‘‖ 64 thus, the doctrine of cy pres was available with respect to the restricted gifts of the conservation easements. this holding is unremarkable and consistent with the laws governing restricted gifts. 65 (ii) cy pres process the tax court next described the doctrine of cy pres: [1] if property is given . . . to be applied to a particular charitable purpose, and it is or becomes impossible or impracticable or illegal to carry out the particular purpose, and [2] . . . the settlor manifested a more general intention to devote the property to charitable purposes, [3] the [gift] will not fail but the court will direct the application of the property to some charitable purpose which falls within the general charitable intention of the settlor. 66 this three-step process is the traditional form of the cy pres doctrine. in the second step, if the court does not find that the donor manifested a general 64. id., 103 t.c.m. (cch) at 1004-05, t.c.m. (ria) ¶ 2012-001 at 6 (quoting george w. vallery mem. fund. v. saint luke‘s cmty. found., 883 p.2d 24, 28 (colo. app. 1993)). see also supra note 50 and accompanying text, (explaining that the term ―absolute‖ in this context means the gift was not technically made ―in trust,‖ but the gift is still restricted and the holder is still legally bound to administer the gift in accordance with its stated terms and purpose). 65. see, e.g., uniform trust code § 413 cmt. (2000) (―the doctrine of cy pres is applied not only to trusts, but also to other types of charitable dispositions, including those to charitable corporations.‖); restatement (second) of trusts § 348 cmt. f (1959) (―the doctrine of cy pres is applicable to gifts to charitable corporations as well as to gifts to individual trustees for charitable purposes.‖); scott & ascher on trusts § 37.1.1 (5th ed. 2008) (―[m]any of the principles that apply to charitable trusts also apply to charitable corporations . . . in both cases, cy pres may be available.‖); bogert & chester, the law of trusts and trustees § 431 (3rd ed. 2008) (―the cy pres power is applied to absolute gifts to charitable corporations or other organizations, as well as to gifts in trust; and it applies in the case of transfers by deed.‖). 66. carpenter, 103 t.c.m. (cch) at 1005 n.6, t.c.m. (ria) ¶ 2012-001 at 7 n.6 (quoting dunbar v board of trs. of clayton college, 461 p.2d 28, 30 (colo. 1969)). 238 florida tax review [vol. 13:5 intention to devote the property that was the subject of the gift to charitable purposes (a ―general charitable intent‖) and, instead, determines that the donor had specific intent to devote the property to only the donor‘s designated charitable purpose and none other, the court may not apply the cy pres doctrine to modify the purpose of the gift. in such a circumstance, the charitable gift would ―fail,‖ and the property that was the subject of the gift would pass back to the donor or the donor‘s residuary beneficiaries or intestate heirs. 67 (iii) general charitable intent the irs argued that the cy pres doctrine was inapplicable to the restricted gifts of the conservation easements because the taxpayers ―did not manifest a more general intention to devote the property to charitable purposes.‖ 68 the tax court agreed, and this is where its analysis went slightly off track. the court was misled as to the property at issue when analyzing the general charitable intent requirement. in holding that cy pres was inapplicable to the gifts of the conservation easements, the court stated: [w]e are called upon to determine whether petitioners manifested a more general intent to devote the property to a general charitable purpose beyond the restrictions placed in the conservation easement deeds. . . . . we do not find that petitioners intended to donate their property to greenlands with a general charitable purpose. the deeds make clear that petitioners wanted to retain all rights over the donated property not specifically granted to greenlands in the conservation easement deeds. should the purpose of the deeds become impossible to fulfill, petitioners 67. see scott & ascher on trusts § 39.5.3 (5th ed. 2009). for a case in which the court found that the donor lacked a general charitable intent and the charitable gift failed and passed to the donor‘s heirs, see evans v. abney, 224 ga. 826 (1968), aff‘d 396 u.s. 435 (1970)), where senator augustus o. bacon‘s trust under his will, which left a city park to be used only by white people, was found illegal and impossible of performance, but the doctrine of cy pres could not be applied because the senator did not have a general charitable intent; he left no doubt as to his wish that park be operated only on a segregated basis. 68. carpenter, 103 t.c.m. (cch) at 1005, t.c.m. (ria) ¶ 2012-001 at 7. the irs need not have argued that cy pres is inapplicable to the restricted gifts of the conservation easements because, as explained below, even if cy pres were determined to be applicable, it would not have prevented the parties from exercising the right granted to them in the deeds to mutually agree to extinguish the easements (i.e., it would not have saved the parties‘ deductions). 2012] tax-deductible conservation easements 239 demonstrated no intention to have the donated property put to some other general charitable use. 69 in its references to the ―property‖ in the foregoing excerpts, the court is referring to the land subject to the conservation easements. however, the property at issue in the cy pres analysis is the property that was the subject of the gift and, in carpenter, the property that was the subject of each gift was a conservation easement, not the underlying land. accordingly, the court should have asked whether the taxpayers manifested a general intent to devote the easements (or the value attributable thereto) to charitable purposes should the purposes of the easements ever become impossible or impracticable to carry out. the answer to that question should have been yes because the easement deeds, consistent with the proceeds requirement of the regulations, contain provisions entitling the holder (greenlands) to a percentage of the proceeds from the sale, exchange, or involuntary conversion of the property following extinguishment of the easement. 70 specifically, in the event the purpose of one of the easements becomes impossible to accomplish, the easement is extinguished, and the newly unencumbered property is sold, greenlands would be entitled to a share of proceeds as compensation for the easement (the property right it holds on behalf of the public) and, as a charity, it would be required to use those proceeds consistent with its 69. 103 t.c.m. (cch) at 1005, t.c.m. (ria) ¶ 2012-001 at 6–7 (emphasis added). 70. see deed of conservation easement between kalyn m. carpenter, grantor, and the greenlands reserve, grantee, dated december 24, 2003 (on file with author) at 7, which provides: 13. extinguishment – . . . the amount of the proceeds to which grantee shall be entitled, after the satisfaction of the prior claims, from any sale, exchange, or involuntary conversion of all or any portion of the property subsequent to such termination or extinguishment, shall be determined, unless otherwise provided by colorado law at the time[,] in accordance with paragraph 14, below. 14. proceeds – this conservation easement constitutes a real property interest immediately vested in grantee, which the parties stipulate to have fair market value determined by multiplying the fair market value of the property unencumbered by the conservation easement (minus any increase in value after the date of this grant attributable to improvements) by the ratio of the value of the conservation easement at the time of this grant to the value of the property, without deduction for the value of the conservation easement, at the time of the grant. all of the conservation easement deeds at issue in carpenter were virtually identical. see carpenter, 103 t.c.m. (cch) at 1002, t.c.m. (ria) ¶ 2012-001 at 2. 240 florida tax review [vol. 13:5 charitable conservation mission. 71 by including provisions in a conservation easement deed tracking the proceeds regulation, 72 an easement donor manifests an intent to devote the easement (the charitable gift), or more accurately, the proceeds attributable to that gift upon extinguishment, to similar charitable purposes, rather than to have the gift ―fail‖ and the proceeds attributable to the gift pass back to the donor or the donor‘s residuary beneficiaries or intestate heirs. 73 accordingly, the taxpayers in carpenter should have been found to have manifested a general charitable intent with respect to their gifts of the easements. as explained in the following section, however, that finding would not have saved their deductions. (iv) cy pres would not have trumped parties’ express right to extinguish even if the court had found that the taxpayers in carpenter manifested a general charitable intent with respect to their gifts of the easements, it would not have meant that the cy pres doctrine operated to mandate a judicial proceeding to extinguish the easements. cy pres would 71. see deed of conservation easement between kalyn m. carpenter, grantor, and the greenlands reserve, grantee, dated december 24, 2003 (on file with author) at 7. 72. the proceeds regulation is reproduced supra note 15. to fully comply with the regulations, the proceeds provisions in the easements at issue in carpenter should have mandated that the grantee use its share of the proceeds following extinguishment ―in a manner consistent with the conservation purposes of the original contribution.‖ see reg. § 1.170a-14(g)(6)(i). 73. see, e.g., kostarides v. central trust co., 122 n.w.2d 729, 733 (1963) (language in a will providing that, in the event the donor‘s original charitable purpose becomes partially or wholly impossible, the trustee shall apply the funds to other similar charitable purposes, ―discloses a very decided general charitable intent. it is difficult to imagine how it might have been expressed more clearly‖). state courts are likely to find that a conservation easement donor had a general charitable intent even if the easement does not contain a proceeds clause. see nancy a. mclaughlin, rethinking the perpetual nature of conservation easements, 29 harv. envtl. l. rev. 421, 479 (2005) (explaining that state courts almost invariably find that a donor had a general charitable intent if the gift fails after it has been in existence for some period of time, some states apply a presumption of general charitable intent, and some states have abolished the requirement altogether); restatement (third) of property: servitudes § 7.11 cmt. b (2000) (―because conservation servitudes are usually intended to be ‗perpetual,‘ finding that the grantor‘s intent was broad enough to encompass a more general conservation or preservation purpose than the particular use specified in the instrument will ordinarily be justified absent a contrary provision in the document creating the servitude‖). 2012] tax-deductible conservation easements 241 still be inapplicable because the deeds expressly dictate what should be done if it becomes impossible to accomplish the donor‘s charitable conservation purpose (i.e., extinguishment of the easement by judicial proceeding or by mutual agreement of the parties and payment of a share of proceeds to greenlands). 74 the cy pres doctrine does not trump the express terms of a restricted charitable gift. rather, it operates as a safety valve, allowing a court to step in and modify the purpose of a restricted gift if, over time, the donor‘s stated purpose becomes impossible or impractical and the gift does not dictate what should be done in such circumstances. if the gift does state what should be done in such circumstances, the terms of the gift control. 75 accordingly, even if the court had found that the taxpayers in carpenter manifested a general charitable intent with respect to their gifts of the easements, the cy pres doctrine would not operate to prevent the parties from exercising their right — expressly granted to them in the deeds — to mutually agree to extinguish the easements. this has important ramifications for tax-deductible conservation easements. in kaufman ii, the tax court noted that the extinguishment regulation ―appears to be a regulatory version of the doctrine of cy pres.‖ 76 by incorporating that regulatory version of the cy pres doctrine into a conservation easement deed, the donor eliminates the need for the court to apply the state law version of the doctrine to extinguish the easement in the event continued use of the property for conservation purposes becomes impossible or impractical. the provisions of the deed expressly dictate what should be done in such circumstances, and those provisions would control. 77 74. see, e.g., kostarides, 122 n.w. 2d at 733 (cy pres did not apply because the provision of the will expressly dictated what should be done with the funds if it became impossible to accomplish the donor‘s charitable purpose in the manner he specified). 75. see id. see also restatement (third) of trusts § 67 (2003) (―unless the terms of the trust provide otherwise [the doctrine of cy pres will apply]‖) (emphasis added); id. § 67 cmt. b (―a trust provision expressing the settlor‘s own choice of an alternative charitable purpose will be carried out, without the need to apply the cy pres doctrine . . . .‖). 76. kaufman ii, 136 t.c. 294, 307 (2011), vacated and remanded in part on other grounds, kaufman iii, 687 f.3d 21 (1st cir. 2012). 77. the state law cy pres doctrine might continue to apply to such a conservation easement in one circumstance — if (i) the stated conservation purpose of the easement is narrow (such as to protect grizzly bear habitat), (ii) continuing to protect the subject property for that narrow purpose becomes impossible or impractical due to changed conditions, but (iii) continuing to protect the property for other conservation purposes, such as open space or for public outdoor recreation, is not impossible or impractical. in such a case, a state court might apply the cy pres 242 florida tax review [vol. 13:5 c. conservation easements extinguishable by mutual agreement are not deductible having found that the cy pres doctrine did not operate to prevent the parties from extinguishing the easements by mutual agreement, the tax court next turned to whether the ability to extinguish a conservation easement by mutual agreement violates the requirements of the extinguishment regulation. the tax court concluded that it does. it held that conservation easements that may be extinguished by mutual agreement of the parties — even if subject to a standard such as ―impossibility‖ — fail as a matter of law to comply with the enforceability in perpetuity requirements under regulation section 1.170a-14(g) and, thus, are not protected in perpetuity as required under section 170(h)(5)(a). 78 although the conservation easements at issue in carpenter expressly provide that they are extinguishable by mutual written agreement of the parties, the tax court‘s analysis is not confined to such circumstances. in an earlier portion of the opinion, the court explained: to determine whether the conservation easement deeds comply with requirements for the conservation easement deduction under federal tax law, we must look to state law to determine the effect of the deeds. state law determines the nature of the property rights, and federal law determines the appropriate tax treatment of those rights. 79 the court then looked to colorado law to determine how conservation easements may be extinguished and noted that, pursuant to the doctrine to modify the conservation purpose of the easement, while leaving the easement otherwise intact. such a modification would be consistent with the extinguishment regulation and, by extension, the terms of a deed incorporating that regulation. the extinguishment regulation does not contemplate that a tax-deductible conservation easement will be extinguished if changed conditions make impossible or impractical the continued use of the property for a narrowly defined conservation purpose. rather, it appears to impose a much higher bar for extinguishment, requiring that changed conditions have made impossible or impractical the continued use of the property for ―conservation purposes‖ generally. see reg. § 1.170a14(g)(6)(i). the extinguishment regulation does not, however, provide a mechanism for the modification of the conservation purpose of a conservation easement while leaving the easement intact. it only addresses extinguishment. accordingly, the state law cy pres doctrine could be applied to modify the purpose of the easement in such a circumstance. 78. carpenter v. commissioner, 103 t.c.m. (cch) 1001, 1005, t.c.m. (ria) ¶ 2012-001, 7–8 (2012). 79. id., 103 t.c.m. (cch) at 1004, t.c.m. (ria) ¶ 2012-001 at 5. 2012] tax-deductible conservation easements 243 colorado easement enabling statute, ―[c]onservation easements in gross may, in whole or in part, be released, terminated, extinguished, or abandoned by merger with the underlying fee interest . . . or in any other manner in which easements may be lawfully terminated, released, extinguished or abandoned.‖ 80 the court acknowledged that ―conservation easements may be extinguished through many means under colorado state law, including by mutual consent of the parties.‖ 81 given that, is there a way in states with enabling statutes similar to colorado‘s to comply with the extinguishment regulation? 82 the answer is yes. if (1) a conservation easement expressly provides that it is extinguishable only in the manner provided in the regulations (in a judicial proceeding, upon a finding that continued use of the property for conservation purposes has become impossible or impractical, and with a payment of at least the required minimum proportionate share of proceeds to the holder to be used ―in a manner consistent with the conservation purposes of the original contribution‖); (2) that provision is not qualified in any manner (e.g., by other provisions in the deed or an outside agreement); (3) the state enabling statute does not preclude enforcement of that provision, 83 80. id. 81. id. 82. see mclaughlin, national perpetuity standards, part 2, supra note 5, apps. a, b, for a survey of over one hundred state enabling statutes. 83. in most cases, the state conservation easement enabling statute should not preclude the enforcement of provisions included in a conservation easement deed to comply with the federal tax law restriction on transfer, extinguishment, division of proceeds, and other requirements. see mclaughlin, national perpetuity standards, part 2, supra note 5, at 22–23. one can, however, imagine a state statute that provides that all conservation easements created under its auspices may be transferred, released, or terminated pursuant to only the process set forth in the statute and regardless of the specific terms included in the deed. if such a statute were enacted in a state (or if an existing state statute were interpreted to operate in that fashion), conservation easements subject to the statute should not be eligible for a deduction because the easements could not satisfy the requirements of section 170(h) and the regulations regardless of their terms. donors wishing to convey easements eligible for federal tax incentives could escape the application of such a statute by conveying nonstatutory appurtenant easements (i.e., along with a conservation easement drafted to comply with federal tax law requirements, the donor would convey to the donee a small ―anchor‖ parcel to which the easement would be appurtenant, thus ensuring the enforceability of the easement under the common law of the state). see nancy a. mclaughlin, condemning conservation easements: protecting the public interest and investment in conservation, 41 u.c. davis l. rev. 1897, 1901–02 (2008) (noting that this technique was used to validate conservation easements before the enactment of state enabling statutes). 244 florida tax review [vol. 13:5 and (4) the easement constitutes a restricted gift under state law, 84 then the easement should comply with the extinguishment requirements of the regulations. in such a case, although the enabling statute provides that a conservation easement may be released or extinguished in the same manner as other easements, including by mutual agreement of the parties, the holder could not simply agree to release or extinguish the easement because it would be legally bound to administer the easement (a restricted gift) ―in accordance with the donor‘s precise directions and limitations‖ (i.e., in accordance with the terms of the deed). 85 although state courts should recognize the restricted gift status of tax-deductible conservation easements, particularly after carpenter, there is a risk that some may not. to ensure that holders will be legally bound to administer such easements in accordance with their stated terms and purposes over the long term, which is essential to the success of the tax incentive program, the treasury department should revise the regulations to mandate that a tax-deductible conservation easement include a statement that the easement was conveyed, in whole or in part as a charitable gift for a specific purpose, the grantor intends to claim federal tax benefits as a result of the gift, and the grantor intends that the grantor and grantee (and their successors and assigns) will be legally bound by the terms of the easement. if this were done, it would minimize the risk that state court judges unfamiliar with the requirements of section 170(h) and the regulations might fail to recognize the status of a tax-deductible conservation easement as a restricted charitable gift and the binding nature of the restriction on transfer, extinguishment, division of proceeds, and other provisions included in the deed to satisfy federal tax law requirements. in the meantime, cautious donors should include a provision in their easement deeds confirming that the gift constitutes a restricted gift under state law. in addition, donors should refuse to accede to the demand of some holders that they include a provision in their conservation easement deeds stating that the conveyance does not 84. the uniform conservation easement act, which contains language similar to that found in the colorado enabling statute regarding modification and termination, explains that the act ―leaves intact the existing case and statute law of adopting states as it relates to the modification and termination of easements and the enforcement of charitable trusts‖ and ―independently of the act, the attorney general could have standing [to enforce a conservation easement] in his capacity as supervisor of charitable trusts.‖ uniform conservation easement act § 3, cmt. (2007). for a discussion of this aspect of the uniform conservation easement act, see mclaughlin & weeks, setting the record straight, supra note 41, at 81–85. 85. if a conservation easement is silent regarding extinguishment, but is extinguishable only in a judicial proceeding and upon a finding of impossibility or impracticality because it is a restricted gift and cy pres applies, the easement should satisfy the extinguishment regulation. 2012] tax-deductible conservation easements 245 constitute a restricted gift (or is an unrestricted gift) because such a provision should render the easement ineligible for federal tax incentives. 86 d. extinguishment regulation: optional provisions or necessary restrictions? as discussed above, the tax court in carpenter ruled that conservation easements extinguishable by mutual agreement of the parties, even if subject to a standard such as impossibility, fail as a matter of law to comply with the extinguishment regulation requirements. in the section of the opinion containing that ruling, judge haines also noted, in part, that ―the extinguishment regulation provides taxpayers with a guide, a safe harbor, by which to create the necessary restrictions to guarantee protection of the conservation purpose in perpetuity.‖ 87 that statement has caused some to argue that the provisions of the extinguishment and proceeds regulations should be considered optional, and states, localities, and even holders should be free to craft their own extinguishment procedures. 88 however, a more narrow interpretation of judge haines‘s statement is called for when it is read in context and in light of (1) the history of the deduction provision; (2) other tax court cases addressing the extinguishment regulation; (3) the regulations as a whole; and (4) the reasons underlying the provisions addressing extinguishment in the regulations. part ii.d.1 below examines judge haines‘s statement in context and in light of the foregoing sources and reasons. it concludes that the provisions of the extinguishment and proceeds regulations should be viewed, not as optional, but as imposing ―the necessary restrictions‖ on extinguishment. it further explains that those regulations should be viewed as providing taxpayers with safe harbor language or a blueprint by which to build a conservation easement that addresses extinguishment in a manner that satisfies section 170(h)‘s protected-in-perpetuity requirement. 86. a few holders have been insisting on this provision in an attempt both to prevent the holder from being legally bound to administer the easement in accordance with its terms and purposes over the long term and to prevent the state attorney general from having standing to call the holder to account for failing to do so. 87. carpenter v. commissioner, 103 t.c.m. (cch) 1001, 1005, t.c.m. (ria) ¶ 2012-001, 7 (2012). 88. see jessica e. jay, when perpetual is not forever: the challenge of changing conditions, amendment and termination of perpetual conservation easements, 36 harv. envtl. l. rev. 1 (2012) [hereinafter jay, perpetual is not forever], critiqued in ann taylor schwing, perpetuity is forever, almost always: why it is wrong to promote amendment and termination of perpetual conservation easements, 37 harv. envtl. l. rev. (2012) (forthcoming 2012) (noting, in part, that jay relies on case law that does not support her thesis). 246 florida tax review [vol. 13:5 there also are a number of compelling policy reasons for imposing uniform restrictions on the extinguishment of tax-deductible conservation easements, and for not deferring to states, localities, or holders regarding this critical issue. those policy reasons are discussed in part ii.d.2 below. part ii.d.3 then briefly explains the interaction of federal and state law in this context. 1. necessary restrictions (i) history of deduction provision the author has previously described in detail the history of the conservation easement deduction provision, congress and the treasury department‘s concerns about abuse, and the consequent elaborate requirements of section 170(h) and the regulations, and there is no need to restate that entire analysis here. 89 accordingly, what follows is a brief discussion of only the most relevant aspects. congress sought, through section 170(h), to subsidize the acquisition of conservation easements that would permanently protect the conservation values of unique or otherwise significant properties. 90 congress also sought to restrict the ability of government and nonprofit holders to sell, trade, release, or otherwise transfer such easements, except for transfers made to other qualified holders that agree to continue to enforce the easements. 91 in addition, although congress recognized that state courts might extinguish tax-deductible conservation easements if continuing to use the properties for conservation purposes should become impossible or impractical due to changed conditions, congress anticipated that such extinguishments would be rare and opted to leave it to the treasury department to craft rules to protect the federal interest and investment in conservation in such an unlikely event. 92 the extinguishment and division of proceeds regulations should thus be viewed as an acknowledgment by the treasury department that changed 89. see generally mclaughlin, national perpetuity standards, part 1, supra note 16; mclaughlin, national perpetuity standards, part 2, supra note 5. 90. see supra note 3 (quoting the legislative history of § 170(h)). see also mclaughlin, national perpetuity standards, part 1, supra note 16, at 476–86. the term ―conservation values‖ used herein encompasses all of the values tax-deductible conservation easements are intended to protect in perpetuity, including habitat, open space, historic, recreational, and educational values. see i.r.c. § 170(h)(4)(a). 91. see s. rep. no. 96-1007, supra note 2, reprinted in 1980 u.s.c.c.a.n. 6736; mclaughlin, national perpetuity standards, part 1, supra note 16, at 480–83, 486. 92. see mclaughlin, national perpetuity standards, part 1, supra note 16, at 484–85. 2012] tax-deductible conservation easements 247 conditions might, in rare circumstances, render the continued use of property for conservation purposes impossible or impractical, and as a direction that the conservation purpose of an easement will nonetheless be treated as protected in perpetuity if, in such circumstances: (1) the restrictions are extinguishable in a judicial proceeding; (2) the holder is entitled to at least a minimum proportionate share of the proceeds from a subsequent sale, exchange, or involuntary conversion of the property; and (3) the holder is required to use such proceeds ―in a manner consistent with the conservation purposes of the original contribution.‖ 93 there is no indication that congress or the treasury department contemplated that it would be permissible for perpetual conservation easements subsidized through section 170(h) to be extinguished in other circumstances, such as when continued protection of the targeted conservation values has not become impossible or impractical, or when a state or local public official or board determines that termination is essential to the orderly development of the area or in the public interest. 94 in fact, if congress or the treasury department had intended for taxdeductible conservation easements to be extinguishable according to varied procedures developed by states and localities, they presumably would have included a provision to that effect in section 170(h) or the regulations. congress specifically deferred, in part, to state and local policies in section 170(h) with regard to satisfaction of the open space conservation purposes test, which refers to the preservation of land ―pursuant to a clearly delineated federal, state, or local governmental conservation policy.‖ 95 the treasury department also specifically deferred to state law in the regulations with regard to the allocation of proceeds following an involuntary conversion. 96 93. reg. § 1.170a-14(g)(6). 94. see mclaughlin, national perpetuity standards, part 2, supra note 5, at apps. a, b (surveying the modification and termination provisions of over one hundred state enabling statutes). 95. see i.r.c. § 170(h)(4)(a)(iii)(ii). congress explained ―this provision is intended to protect the types of property identified by representatives of the general public as worthy of preservation or conservation.‖ s. rep. no. 96-1007, supra note 2, pt. 2, at 11, reprinted in 1980 u.s.c.c.a.n. at 6747. congress did not, however, leave the decision regarding satisfaction of the open space conservation purposes test solely to state or local policy. rather, section 170(h) requires the donor to separately establish that the donation ―will yield a significant public benefit.‖ i.r.c. § 170(h)(4)(a)(iii)(ii). 96. see reg. § 1.170a-14(g)(6)(ii) (mandating that the donee must be entitled to at least a minimum percentage share of proceeds following extinguishment, ―unless state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the prior perpetual conservation restriction‖). as to why the treasury department deferred to state law on this point, see mclaughlin, national perpetuity standards, part 1, supra note 16, at 510 n.145 and accompanying text. 248 florida tax review [vol. 13:5 but there is no mention in section 170(h), the regulations, or the legislative history regarding deference to state and local extinguishment procedures, even though some states had statutory extinguishment procedures in place at the time of the enactment of section 170(h) and the drafting of the regulations. 97 consistent with basic rules of construction, it should be presumed that omission was purposeful, 98 and that the treasury department intended to impose a uniform set of rules that would protect the federal investment in those rare cases where changed conditions frustrate the purpose of a tax-deductible perpetual easement. the foregoing interpretation is also consistent with the explanation of the extinguishment regulation provided by one of the principal drafters of the regulations. in his treatise on section 170(h), which was published soon after the regulations were issued in 1986, stephen j. small posed the question of ―what can be done when natural or economic conditions change and the once-important conservation interests associated with property subject to an easement no longer exist[?]‖ 99 he answers that question in his explanation of the extinguishment regulation as follows: [the extinguishment regulation] represents a recognition by the service that perpetual may not really be perpetual . . . . 97. see, e.g., va. code ann. § 10-153 (1980, 1986) (current version at va. code ann. § 10.1-1-1704 (2012)) (open-space land protected by a conservation easement can be converted or diverted if (i) the public body holding the easement determines it to be ―essential to the orderly development and growth of the urban area‖ and ―in accordance with the official comprehensive plan;‖ and (ii) other real property of at least equal fair market value and of as nearly as feasible equivalent usefulness and location for use as permanent open-space is substituted within a reasonable period not exceeding one year, unless the public body determines that such open-pace land or its equivalent is no longer needed); ca. govt. code § 51093 (west 1974) (the holder of an open space easement can abandon the easement at the request of a landowner if (i) the holder determines that certain conditions have been met, including that no public purpose will be served by keeping the land as open space; (ii) public hearings are held; and (iii) the landowner pays an ―abandonment fee‖ that is deposited in the state‘s general fund); mass. gen. laws ann. ch. 184, § 32 (west 1980, 1986) (conservation restrictions ―may be released, in whole or in part, by the holder for such consideration, if any, as the holder may determine, in the same manner as the holder may dispose of land or other interests in land, but only after a public hearing‖ and approval of a certain public official or officials). 98. see, e.g., keene corp. v. united states, 508 u.s. 200, 208 (1993) (―‗[w]here congress includes particular language in one section of a statute but omits it in another . . . it is generally presumed that congress acts intentionally and purposefully in the disparate inclusion or exclusion.‘‖) (quoting russello v. united states, 464 u.s. 16, 23 (1983) (citation omitted)). 99. stephen j. small, the federal tax law of conservation easements § 14.02, 14–3 (4th ed. 1997). 2012] tax-deductible conservation easements 249 [there may be a] subsequent change or destruction of the conservation interests that were the subject of the donation . . . . [t]his section of the regulations makes it clear to the donee organization that in such a situation the restrictions can be extinguished by judicial proceedings and the property can be sold or exchanged, as long as the subsequent application of proceeds follows the rules of [the proceeds regulation]. to those who suggest this may be a cumbersome way to deal with the problem, i would respond that these restrictions are supposed to be perpetual in the first place, and the decision to terminate them should not be made solely by interested parties. with the decision-making process pushed into a court of law, the legal tension created by such judicial review will generally tend to create a fair result. 100 finally, it is notable that the deduction provision was revised, first in 1977 to eliminate the deduction‘s availability with regard to thirty-year (or longer) term easements and require that all tax-deductible easements be ―granted in perpetuity,‖ and then again in 1980 (when section 170(h) was enacted) to further mandate that the conservation purposes of the easements must be ―protected in perpetuity.‖ 101 in explaining the new protected-inperpetuity requirement, congress stated, inter alia, that it intended ―to limit the deduction only to those cases where the conservation purposes will in practice be carried out;‖ that it contemplated that ―contributions will be made to organizations which have the commitment and the resources to enforce the [easements] and protect the conservation purposes;‖ and that the new protected-in-perpetuity requirement ―also is intended to limit deductible contributions to those transfers which require that the donee (or successor in interest) hold the conservation easement . . . exclusively for conservation purposes (i.e., that [the easement] not be transferable by the donee except to other qualified organizations that also will hold the [easement] exclusively for conservation purposes).‖ 102 it is difficult to review this history and arrive at the conclusion that congress intended to subsidize the acquisition, not of perpetual conservation easements extinguishable by a court only upon frustration of their purposes, but of easements extinguishable pursuant to 100. id. § 16.03, 16–4. 101. see mclaughlin, national perpetuity standards, part 1, supra note 16, at 476–83. 102. s. rep. no. 96-1007, supra note 2, pt. 2, at 14, reprinted in 1980 u.s.c.c.a.n. at 6749. 250 florida tax review [vol. 13:5 widely variable state and local procedures and before their purpose have become frustrated. (ii) tax court opinions a. kaufman v. commissioner the tax court‘s first extended discussion of the protected-inperpetuity requirement of section 170(h)(5)(a), and the extinguishment regulation in particular, appeared in kaufman ii. 103 although the first circuit vacated and remanded kaufman ii in part in kaufman iii, the tax court‘s analysis of the extinguishment regulation in kaufman ii remains important for a number of reasons. to begin with, the first circuit limited its analysis of regulation section 1.170a-14(g)(6) in kaufman iii to the question of whether a lender agreement impermissibly qualified the provision included in a façade easement to satisfy the proceeds regulation; the court did not discuss the extinguishment regulation. 104 second, the tax court‘s analysis of the extinguishment regulation in carpenter is based, in part, on its discussion of that regulation in kaufman ii. accordingly, the analysis and holding in carpenter cannot be fully understood without an understanding of the tax court‘s analysis of the extinguishment regulation in kaufman ii. third, the tax court‘s opinion in kaufman ii provides insight into how the extinguishment regulation should be interpreted to be consistent with congressional intent. 105 in kaufman ii, the tax court explained that section 170(h) is an exception to the general rule that partial interests in property are not deductible and noted the various requirements that must be met to be eligible for the deduction. 106 the court noted, in particular, that regulation section 1.170a–14(g), which consists of (g)(1) through (g)(6), ―elaborates on the enforceability-in-perpetuity requirement.‖ 107 with regard to the extinguishment regulation, the court explained: paragraph (g)(6) is entitled ―extinguishment‖ and recognizes that, after the donee organization‘s receipt of an interest in property, an unexpected change in the conditions surrounding the property can make impossible or impractical 103. kaufman ii, 136 t.c. 294, 307 (2011), vacated and remanded in part on other grounds, kaufman iii, 687 f.3d 21 (1st cir. 2012). 104. kaufman iii, 687 f.3d at 26–28. 105. see infra part iii (critiquing kaufman iii). 106. kaufman ii, 136 t.c. at 313, vacated and remanded in part, kaufman iii, 687 f.3d. 21. 107. id. at 305. 2012] tax-deductible conservation easements 251 the continued use of the property for conservation purposes. subdivision (i) of paragraph (g)(6) provides that those purposes will nonetheless be treated as protected in perpetuity if the restrictions limiting use of the property for conservation purposes ―are extinguished by judicial proceeding and all of the donee‘s proceeds * * * from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution.‖ 108 with regard to the extinguishment and proceeds regulations combined, the tax court explained: the drafters of section 1.170a–14, income tax regs., undoubtedly understood the difficulties (if not impossibility) under state common or statutory law of making a conservation restriction perpetual . . . . they understood that forever is a long time and provided what appears to be a regulatory version of cy pres to deal with unexpected changes that make the continued use of the property for conservation purposes impossible or impractical. 109 the tax court in kaufman ii did not refer to the extinguishment regulation as optional, or but one of many possible ways in which a taxdeductible conservation easement can be extinguished. nor did it indicate that it would be permissible for states, localities, or holders to craft their own extinguishment procedures for tax-deductible easements. rather, the court described the extinguishment regulation in the same manner as its principal drafter, stephen j. small — as a recognition that changed conditions might render the continued use of the subject property for conservation purposes impossible or impractical, and a description of the process by which the easement can be extinguished in such a circumstance. it is not surprising that the treasury department incorporated what ―appears to be a regulatory version of cy pres‖ into the regulations to address extinguishment. 110 congress, the treasury department, and the charitable conservation organizations that testified in support of section 170(h) were aware of the status of tax-deductible conservation easements as charitable gifts and of state law governing the administration and enforcement of such gifts. at the congressional hearings on proposed section 170(h), and in response to the treasury department‘s concern that charitable conservation 108. id. at 306. 109. id. at 306–07. 110. see id. at 307. 252 florida tax review [vol. 13:5 organizations might not properly enforce conservation easements, nineteen land trusts submitted an appendix to their testimony in which they acknowledged the status of tax-deductible conservation easements as ―charitable grants‖ and noted the power and duty of courts of competent jurisdiction and state attorneys general to enforce such grants. 111 the treasury department also may have recognized that the cy pres standard of impossibility or impracticability provides as close to perpetual protection of the purpose of a charitable gift as one can obtain under existing u.s. law. 112 in addition, unlike the real property law doctrine of changed conditions, the doctrine of cy pres ensures that if a conservation easement is extinguished, proceeds attributable to the easement will remain in the charitable sector to be used for similar conservation purposes on behalf of the public. 113 also important in the kaufman ii opinion is footnote seven, to which judge haines specifically referred in carpenter. 114 footnote seven provides: our concern in kaufman v. commissioner, 134 t.c. 182 (2010), was with the allocation of proceeds on a sale, exchange, or involuntary conversion of property following 111. see minor tax bills: hearings before the subcomm. on select revenue measures of the house comm. on ways and means, 96th cong. 238, 242 (1980) (app. to testimony of french and pickering creeks conservation trust, the brandywine conservancy, and other conservation organizations in re h.r. 7318 on june 26, 1980). 112. the american law institute recognized this when it promulgated the restatement (third) of property, which applies a special set of rules based on the doctrine of cy pres to the modification and termination of conservation easements, explaining that, ―[b]ecause of the public interests involved, these servitudes are afforded more stringent protection than privately held conservation servitudes, which are subject to modification and termination under § 7.10 [the property law doctrine of changed conditions].‖ see restatement (third) of prop.: servitudes § 7.11 cmt. a (2000). see also, e.g., bogert & chester the law of trusts and trustees § 439 (3rd ed. 2008) (explaining that in applying cy pres ―the court will not substitute a new scheme merely because it or the trustee believes it would be a better plan than that which the settlor provided‖); mclaughlin & weeks, in defense of conservation easements, supra note 55, at 70–73 (explaining that courts apply the ―impossibility or impracticality‖ standard conservatively in the charitable gift context). 113. cy pres is distinguishable from the real property law doctrine of changed conditions, in part, because of the requirement that the holder of the easement receive compensation upon extinguishment and use such compensation for similar conservation purposes. see, e.g., restatement (third) of property: servitudes, § 7.11 cmt. c (2000) (in other instances where changed conditions lead to the termination of a servitude, such as in residential subdivisions, there is seldom an entitlement to damages). 114. carpenter, t.c.m. (cch) at 1005, t.c.m. (ria) ¶ 2012-1, at 7. 2012] tax-deductible conservation easements 253 judicial extinguishment of a conservation restriction burdening the property. we did not then, nor do we now, rule on whether the language establishing the restriction [i.e., the conservation easement deed] must incorporate provisions requiring judicial extinguishment (and compensation) in all cases in which an unexpected change in surrounding conditions frustrates the conservation purposes of the restriction. such a rule is suggested, however, by the last sentence in [regulation section 1.170a–14(c)(2), the restriction on transfer regulation]. 115 it is not surprising that the tax court was unwilling to rule that a tax-deductible conservation easement deed must incorporate provisions requiring judicial extinguishment and compensation to the holder in the event the purpose of the easement is frustrated due to changed conditions. the question of whether an easement must expressly state that it is extinguishable only as provided in the extinguishment and proceeds regulations was not before the court and, unlike the restriction on transfer regulation, the extinguishment and proceeds regulations do not specifically state that certain language must be included ―in the instrument of conveyance‖ for the easement to be deductible. 116 the court also was aware that a conservation easement that is silent regarding extinguishment may nonetheless be extinguishable only as provided in the regulations (in a judicial proceeding, upon a finding that continued use of the property for conservation purposes has become impossible or impractical, and with a payment of proceeds to the holder to be used for similar conservation purposes) if the doctrine of cy pres applies. 117 115. kaufman ii, 136 t.c. at 307 n.7, vacated and remanded in part, kaufman iii, 687 f.3d. 21. 116. compare, e.g., reg. § 1.170a-14(c)(2) (―a deduction shall be allowed for a contribution under this section only if in the instrument of conveyance the donor prohibits . . .‖) (emphasis added), with reg. § 1.170a-14(g)(6)(ii) (―for a deduction to be allowed under this section, at the time of the gift the donor must agree that . . .‖) (emphasis added). 117. see kaufman ii, 136 t.c. at 304, vacated and remanded in part, kaufman iii, 687 f.3d. 21 (referring to sources discussing the application of cy pres to conservation easements, including the restatement (third) of property: servitudes § 7.11 (2000)). see also, e.g., uniform conservation easement act § 3, cmt. (2007) (―the act leaves intact the existing case and statute law of adopting states as it relates to the modification and termination of easements and the enforcement of charitable trusts. thus . . . the governmental body or charitable organization holding a conservation easement, in its capacity as trustee, may be prohibited from agreeing to terminate the easement (or modify it in contravention of its purpose) without first obtaining court approval in a cy pres proceeding.‖); 254 florida tax review [vol. 13:5 the tax court did note, however, that a rule requiring incorporation of the provisions of the extinguishment and proceeds regulations into an easement deed is suggested by the last sentence of the restriction on transfer regulation. the restriction on transfer regulation provides that a deduction will be allowed for the donation of a conservation easement only if the instrument of conveyance prohibits the donee (and its successors or assigns) from subsequently transferring the easement, whether or not for consideration, unless (1) the transfer is to another ―eligible donee;‖ and (2) the eligible donee agrees that ―the conservation purposes which the contribution was originally intended to advance will continue to be carried out.‖ 118 the regulation also clarifies, however, that this restriction on transfer requirement will still be met if, upon impossibility or impracticality, the easement is extinguishable (and thereby transferable) in accordance with the extinguishment and proceeds provisions of the regulations. 119 the implication, which is supported by the legislative history to section 170(h) and the fact that congress and the treasury department did not defer to the state enabling statutes regarding extinguishment, is that the restriction on transfer requirement will not be met if the easement is extinguishable (and thereby transferable) in some other manner. thus footnote seven neither states nor implies that the provisions of the extinguishment regulation are optional. uniform trust code § 414 cmt. (2000) (―even though not accompanied by the usual trappings of a trust, the creation and transfer of an easement for conservation or preservation will frequently create a charitable trust‖). 118. reg. § 1.170a-14(c)(2). 119. id. the last sentence of the restriction on transfer regulation specifically references the proceeds regulation, which in turn references the extinguishment regulation. to make sense of the cross-references, however, one must refer to proposed regulation section 1.170a-13, published in the federal register on may 23, 1983, because the treasury department apparently failed to update the cross-references in the final regulations. see prop. reg. § 1.170a-13, 48 fed. reg. 22941-48 (may 23, 1983). in addition, the treasury department‘s failure to specifically reference a judicial proceeding in its references to extinguishment and compensation in the restriction on transfer regulation should not be interpreted to have any special import. as explained in food and drug admin. v. brown & williamson tobacco corp., 529 u.s. 120, 133 (2000): it is a ―fundamental canon of statutory construction that the words of a statute must be read in their context and with a view to their place in the overall statutory scheme.‖ a court must therefore interpret the statute ―as a symmetrical and coherent regulatory scheme,‖ and ―fit, if possible, all parts into an harmonious whole.‖ id. (citations omitted) (quoting gustafson v. alloyd co., 513 u.s. 561, 569 (1995); davis v. mich. dep‘t of treasury, 489 u.s. 803, 809 (1989); ftc v. mandel bros., inc., 359 u.s. 385, 389 (1959)). 2012] tax-deductible conservation easements 255 b. carpenter v. commissioner the next tax court case to discuss the extinguishment regulation was carpenter itself. 120 as previously discussed, judge haines held in carpenter that conservation easements that may be extinguished by mutual consent of the parties, even if subject to a standard such as impossibility, fail as a matter of law to comply with the enforceability in perpetuity requirements under regulation section 1.170a-14(g). in discussing this holding, judge haines noted, in part: we have previously discussed the restrictions required by the extinguishment regulation. in [footnote seven of kaufman ii], we declined to rule that a conservation deed must require a judicial proceeding to extinguish an easement for the easement to be perpetual. we once again decline to create an absolute rule. rather, we find that the extinguishment regulation provides taxpayers with a guide, a safe harbor, by which to create the necessary restrictions to guarantee protection of the conservation purpose in perpetuity. 121 it is this paragraph that has caused some to argue that the extinguishment regulation should be viewed as optional, and that states, localities, and even holders should be free to craft their own extinguishment procedures. however, judge haines‘s reference to ―the restrictions required by the extinguishment regulation‖ in the first sentence of the paragraph quoted above suggests that he does not view such restrictions as optional. in addition, in light of the language of footnote seven in kaufman ii to which he specifically refers, judge haines‘s unwillingness to create an ―absolute rule‖ in the second sentence of the passage quoted above should be viewed as an unwillingness to create an absolute rule that one must expressly incorporate certain provisions regarding extinguishment into a conservation easement deed for the easement to be tax-deductible. judge haines may have been unwilling to create such a rule for the same reasons noted above with regard to kaufman ii (the question was not before the court, the extinguishment and proceeds regulations do not specifically state that certain language must be included ―in the instrument of conveyance,‖ and an easement that is silent regarding extinguishment may nonetheless be extinguishable only in the manner set forth in the regulations). 120. carpenter v. commissioner, 103 t.c.m. (cch) 1001, t.c.m. (ria) ¶ 2012-001 (2012). 121. id., 103 t.c.m. (cch) at 1005, t.c.m. (ria) ¶ 2012-001 at 7 (citation omitted). 256 florida tax review [vol. 13:5 judge haines also did not state that the extinguishment regulation is a safe harbor. rather, he stated ―the extinguishment regulation provides taxpayers with a guide, a safe harbor, by which to create the necessary [or absolutely essential] restrictions to guarantee protection of the conservation purpose in perpetuity.‖ 122 he also quoted stephen j. small‘s treatise, in which small explained that the ―restrictions are supposed to be perpetual in the first place, [and] the decision to terminate them should not be [made] solely by interested parties‖ (i.e., by the landowner and the holder, both of which stand to benefit financially from the extinguishment), and ―[w]ith the decision-making process pushed into a court of law, the legal tension created by such judicial review will generally tend to create a fair result.‖ 123 accordingly, when judge haines‘s statement is read in full and in context, it suggests that the ―the necessary [or absolutely essential] restrictions‖ on extinguishment are those set forth in the extinguishment regulation, although there may be more than one way to comply with those restrictions. finally, if carpenter were interpreted to allow tax-deductible conservation easements to be extinguished pursuant to widely variable procedures adopted by states, localities, or individual or coalitions of holders, then to paraphrase the fourth circuit in united states v. blair, the safe harbor would become a ―safe ocean,‖ and the regulatory exception for extinguishment (designed to apply in very limited circumstances) would swamp the statutory rule (that the easements be ―granted in perpetuity‖ and their conservation purposes ―protected in perpetuity‖). 124 accordingly, the better view is that the extinguishment and proceeds regulations set forth ―the necessary restrictions‖ on extinguishment and provide taxpayers with a guide or set of instructions by which to build a conservation easement that addresses extinguishment in a manner that satisfies section 170(h)‘s protected-in-perpetuity requirement. in other words, the extinguishment regulation provides taxpayers with safe harbor language, which, if it is incorporated into a conservation easement deed, not qualified by other provisions or by a separate agreement, and legally binding on the parties under state law, will ensure that the taxpayer satisfies the extinguishment component of the protected-in-perpetuity requirement. in fact, including such language in tax-deductible conservation easements has been a longstanding practice of well-advised donors. 125 122. id. (emphasis added). see the american heritage dictionary 1207 (3rd ed. 1992) (defining ―necessary‖ as ―absolutely essential‖). 123. carpenter, 103 t.c.m. (cch) at 1005, t.c.m. (ria) ¶ 2012-001 at 7. 124. see united states v. blair, 661 f.3d 755, 773 (4th cir. 2011). 125. see diehl, 1988 conservation easement handbook, supra note 53, at 155, 160–61 (providing a checklist of provisions relating to irs requirements and model extinguishment and proceeds provisions for inclusion in conservation easement deeds); barrett, 1996 conservation easement handbook, supra note 2012] tax-deductible conservation easements 257 c. mitchell v. commissioner judge haines‘s opinion in mitchell, 126 which was issued three months after the issuance of the carpenter opinion, also suggests that he does not view the provisions of the extinguishment regulation as optional. although mitchell is primarily focused on the regulation‘s so-remote-as-tobe-negligible standard and mortgage subordination requirement, judge haines makes a number of references to the extinguishment regulation in the opinion. he refers to the various subparagraphs of regulation section 1.170a-14(g), including (g)(6), as ―legally enforceable restrictions‖ that will prevent uses of the retained interest inconsistent with the conservation purposes of the donation as required by regulation section 1.170a14(g)(1). 127 he describes the extinguishment regulation in the same (nonoptional) way it was described in kaufman ii. 128 and he refers to both the judicial proceeding and proceeds requirements of regulation section 1.170a14(g)(6) as ―specific requirements:‖ the drafters of [the mortgage subordination regulation] saw taxpayers defaulting on their mortgages as more than a remote possibility. therefore they drafted a specific provision which would absolutely prevent a default from destroying a conservation easement‘s grant in perpetuity. similarly, the drafters included [the extinguishment and proceeds regulations] to address similar albeit different concerns. we refused to apply the so-remote-as-to-benegligible standard in both carpenter and kaufman ii. both were cases where the taxpayer attempted to use the soremote-as-to-be-negligible standard to avoid a specific requirement of the regulations (i.e., the judicial proceeding requirement of section 1.170a–14(g)(6)(i) . . . and the proceeds requirement of section 1.170a–14(g)(6)(ii) . . .). 129 accordingly, none of the references in mitchell to the extinguishment regulation suggest that judge haines or the tax court view 53, at 11, 17–18 (same); byers, 2005 conservation easement handbook, supra note 53, at 313–14, 375 (same). 126. mitchell v. commissioner, tax ct. rep. (cch) dec. 59,013, tax ct. rep. (ria) dec. 138.16 (2012). 127. id., tax ct. rep. (cch) dec. 59, 013, at 4634–35, tax ct. rep. (ria) dec. 138.16, at 190–91. 128. id., tax ct. rep. (cch) dec. 59,013, at 4634–35, tax ct. rep. (ria) dec. 138.16, at 191. see supra note 108 and accompanying text. 129. id., tax ct. rep. (cch) dec. 59,013, at 4636, tax ct. rep. (ria) dec. 138.16, at 195. 258 florida tax review [vol. 13:5 the provisions of that regulation as optional or but one of many possible ways that tax-deductible perpetual conservation easements may be permissibly extinguished. (iii) regulations the regulations themselves also indicate that the requirements of the extinguishment regulation should not be viewed as optional. the opening paragraph of the regulations explains that a charitable income tax deduction is generally not allowed for the donation of a partial interest in property, 130 but a special exception is made ―for the value of a qualified conservation contribution if the requirements of this section are met.‖ 131 as stephen j. small explained in his treatise on section 170(h), ―[a]s far as congress and treasury are concerned, a taxpayer who donates an easement continues to use and enjoy the property, and the requirements for taking an income tax deduction simply must be tighter to ensure that there is also a significant long-term public benefit associated with the donation.‖ 132 in addition, both the restriction on transfer and proceeds regulations specifically reference the extinguishment regulation and do not suggest that the provisions of that regulation are optional. as explained in the discussion of kaufman ii above, the restriction on transfer regulation provides that the restriction on transfer requirement will not be violated if, upon impossibility or impracticality, the easement is extinguishable (and thereby transferable) in accordance with the provisions of the extinguishment and proceeds regulations. the implication, which is supported by the legislative history of section 170(h) and the fact that congress and the treasury department did not defer to the state enabling statutes regarding extinguishment, is that the restriction on transfer requirement will be violated if the easement is extinguishable (and thereby transferable) in some other manner. the proceeds regulation is also inextricably tied to the extinguishment regulation. although, for ease of reference, this article refers to those two provisions as ―regulations,‖ they are part of a single paragraph in the regulations entitled ―extinguishment‖ — section 1.170a-14(g)(6). the proceeds regulation, which is subparagraph (g)(6)(ii) of that paragraph, provides in part [w]hen a change in conditions give[s] rise to the extinguishment of a perpetual conservation restriction under [sub]paragraph (g)(6)(i) [i.e., the extinguishment 130. charitable gifts of partial interests in property are generally not deductible because of the potential for abuse and lack of assured benefit to the public when a donor retains use and enjoyment rights with respect to donated property. 131. reg. § 1.170a-14(a) (emphasis added). 132. see small, supra note 99, at 2-2 to -3. 2012] tax-deductible conservation easements 259 regulation], the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to [the minimum proportionate share of proceeds specified in the proceeds regulation]. 133 the proceeds regulation is intended to ensure that the federal investment in a conservation easement will be protected in the event continued use of the property for conservation purposes becomes impossible or impractical and the easement is extinguished in a judicial proceeding. if extinguishment occurs through some other means, the proceeds regulation would appear to be inapplicable. it seems unlikely that the treasury department intended to impose strict rules regarding protection of the federal investment if extinguishment occurs as specified in the extinguishment regulation, but leave the door open to potential loss of that investment, as well as to premature extinguishments, by permitting holders to agree to extinguish easements in other circumstances. a taxpayer might argue that an alternative method of extinguishment ―substantially complies‖ with the requirements of the extinguishment regulation, but the taxpayer would face an uphill battle. the tax court is generally willing to apply the doctrine of substantial compliance only to requirements that are ―procedural or directory‖ or ―given with a view to the orderly conduct of business,‖ such as some of the substantiation requirements of regulation section 1.170a-13(c). 134 the tax court does not apply the substantial compliance doctrine to requirements that relate to the ―substance or essence‖ of the legislation. 135 the extinguishment and proceeds regulations should be viewed as relating to the substance or essence of the legislation given that they, along with the other ―enforceable in perpetuity‖ requirements of regulation section 1.170a-14(g), are intended to ensure, not that the donor has properly substantiated his entitlement to the deduction, but that the conservation purpose of the easement will be protected in perpetuity as mandated by section 170(h)(5)(a) (i.e., that a gift of a qualifying conservation contribution has actually been made). 133. reg. § 1.170a-14(g)(6)(ii) (emphasis added) (reproduced supra note 15). 134. see, e.g., bond v. commissioner, 100 t.c. 32, 41 (1993) (quoting taylor v. commissioner, 67 t.c. 1071, 1077-78 (1977)). 135. see, e.g., hewitt v. commissioner, 109 t.c. 258 (1997); crow v. commissioner, 28 empl. benefits cas. 2558, t.c.m. (ria) ¶ 2002-178 (2002); estate of clause v. commissioner, 122 t.c. 115 (2004); estate of tamulis v. commissioner, 92 t.c.m. (cch) 189, t.c.m. (ria) ¶ 2006-183 (2006), aff’d, 509 f.3d 343 (2007); mohamed v. commissioner,103 t.c.m. (cch) 1814, t.c.m. (ria) ¶ 2012-152 (2012). in mohamed, the tax court noted that, ―[s]ince bond, few taxpayers have succeeded in showing substantial compliance.‖ mohamed, 103 t.c.m. (cch) at 1819, t.c.m. (ria) ¶ 2012-152, at 1175. 260 florida tax review [vol. 13:5 (iv) reasons underlying the federal extinguishment requirements additional support for interpreting the provisions of the extinguishment regulation as ―necessary restrictions‖ comes from an understanding of why the regulations were drafted the way they were. 136 the regulations authorize the deductibility of a conservation easement that is extinguishable (1) in a judicial proceeding; (2) upon a finding that continued use of the subject property for conservation purposes has become impossible or impractical due to an unexpected change in conditions; (3) with a payment of at least a minimum percentage share of proceeds to the holder; and (4) provided the holder uses such proceeds ―in a manner consistent with the conservation purposes of the original contribution.‖ 137 the treasury department included each of these four requirements in the regulations for a reason, and examining those reasons underscores the importance of each requirement. a. impartial judicial decision maker the extinguishment regulation contemplates that extinguishment will occur in the context of a judicial proceeding. the requirement of a judicial proceeding, coupled with the high threshold standard of ―impossibility or impracticality,‖ should operate to prevent federally subsidized conservation easements from being extinguished to satisfy shortterm and often shortsighted economic, political, and development interests. state and local government officials, governing bodies, and administrative panels are likely to be subject to economic, political, and development pressures that could cause them to agree to extinguish conservation easements even if the easements continue to protect unique or otherwise significant conservation values. 138 judges, on the other hand, generally sit in 136. see supra note 122 and accompanying text (discussing judge haines‘s statement in carpenter that ―the extinguishment regulation provides taxpayers with a guide, a safe harbor, by which to create the necessary restrictions‖ (emphasis added)). 137. see reg. § 1.170a-14(g)(6). 138. see, e.g., ralph e. heimlich & william d. anderson, 2001 economic research service, u.s.d.a., agricultural economic report no. 803, development at the urban fringe and beyond: impacts on agriculture and rural land, 4–5 (june 2001), http://www.ers.usda.gov/ publications/aer803/aer803.pdf, (discussing the difficulties facing states and localities in developing and implementing appropriate land use plans); sarah schindler, the future of abandoned big box stores: legal solutions to the legacies of poor planning decisions, 83 u. colo. l. rev. 471 (2012). 2012] tax-deductible conservation easements 261 relative remove from self-interested constituents and the immediacy of such pressures, which are likely to be particularly high when it comes to attempts to develop protected lands. 139 in addition, in applying the impossibility or impracticality standard in the charitable gift context, judges are conservative and do not authorize a change in the donor‘s specified charitable purpose simply because they or the donee believe the assets could be put to a better or more efficient use. 140 judges also have hundreds of years of precedent, including many cases involving charitable gifts of real estate to be used for specific purposes, to help inform their decisions in this context. accordingly, judges play an indispensible role as guardians of federally subsidized conservation easements and the conservation values they are intended to preserve in perpetuity for the benefit of the public. moreover, the unwillingness of congress and the treasury department to rely on state and local policies, officials, or agencies to protect the federal investment in conservation easements is evident from the open space conservation purposes test, which refers to the preservation of land ―pursuant to a clearly delineated federal, state, or local governmental conservation policy.‖ 141 congress explained, ―this provision is intended to protect the types of property identified by representatives of the general public as worthy of preservation or conservation.‖ 142 congress did not, however, leave the decision regarding satisfaction of the open space conservation purposes test solely to state or local policy. rather, section 170(h) requires the donor to separately establish that the donation ―will yield a significant public benefit,‖ and congress included factors to be considered 139. see jill r. horwitz & marion fremont-smith, the common law power of the legislature: insurer conversions and charitable funds, 83 the millbank quarterly 225 (2005), http://www.law.umich.edu/centersand programs/lawandeconomics/abstracts/2007/ documents/07-013horwitz.pdf. state judges are not entirely free from the influence of politics given that they are appointed or elected and do not serve for life. there are a number of safeguards, however, that help to ensure that judges maintain independence, including: retention reelections; codes of judicial conduct that emphasize independence, impartiality, and integrity; judicial conduct boards that investigate and prosecute judges who violate a code of judicial conduct; and judges‘ ability to disqualify themselves when they believe their impartiality may be subject to question. 140. see supra note 112. see also, e.g., cohen v. city of lynn, 598 n.e.2d 682 (1992) (a city‘s conveyance to a private developer of land previously deeded to the city to be used ―forever for park purposes‖ was invalidated because continuing to use the land for park purposes had not become impossible or impracticable). 141. i.r.c. § 170(h)(4)(a)(iii)(ii). 142. s. rep. no. 96-1007, supra note 2, pt. ii, at 11 (1980), reprinted in 1980 u.s.c.c.a.n. at 6747. 262 florida tax review [vol. 13:5 in evaluating public benefit in the committee report accompanying the legislation. 143 the regulations further provide that acceptance of a conservation easement by an agency of a state or local government only ―tends to establish the requisite clearly delineated governmental policy, . . . such acceptance, without more, is not sufficient.‖ 144 the treasury department was concerned that, while some states and localities might have a rigorous process for review of conservation easement acquisitions, others may have no process at all, or political or other factors that have very little to do with the conservation purposes of the gift might influence the process. 145 accordingly, the treasury department determined that permitting a conservation easement to qualify under section 170(h) based solely on an acceptance by a state or local government agency would be inappropriate because such acceptance might mean nothing at all. 146 these same concerns obviously apply in the extinguishment context and with even more force given the economic and political pressures that may be brought to bear to extinguish easements. 147 143. i.r.c. § 170(h)(4)(a)(iii)(ii); s. rep. no. 96-1007, supra note 2, pt. ii, at 11–12, reprinted in 1980 u.s.c.c.a.n. at 6746–47. 144. reg. § 1.170a-14(d)(4)(iii)(b). 145. see small, supra note 99, at § 8, 8–5. 146. see id. 147. one might argue that the judicial proceeding requirement should be deemed satisfied if the decision to extinguish a conservation easement is made by a state or local official or board, but is subject to judicial review. that is not what the extinguishment regulation provides, however, and there is no guarantee that such a two-tiered process would be as efficient or effective in protecting the federal investment as the process set forth in the regulation, particularly given that the extinguishment of tax-deductible conservation easements should be a rare occurrence. moreover, significant questions regarding any such appeals process would arise. for example, who would have standing to seek judicial review of the decision by a state or local official or board to extinguish an easement? what period of time would be granted to seek such review? what standard of review would be imposed on the court? if few persons are entitled to bring such an appeal, or the period of time within which to bring the appeal is short, then appeals would be unlikely, even if the decision to terminate the easement is without merit. and if a court could reverse the decision only if there has been an abuse of discretion or clear error of law (or pursuant to some similarly demanding standard), the court would not exercise independent review as the drafters of the regulations contemplated, and reversals would be unlikely. there also would be no assurance of consistent protection of the easements or equitable treatment of donors and subsequent landowners if the various elements of the decision-making and judicial review processes varied from state to state and program to program, as they inevitably would. 2012] tax-deductible conservation easements 263 b. high standard the extinguishment regulation contemplates that tax-deductible conservation easements will be extinguished only if it is established that continued use of the subject property for conservation purposes has become impossible or impractical due to an unexpected change in conditions. as previously noted, this standard provides as close to perpetual protection of the purpose of a charitable gift as one can obtain under existing u.s. law. the standard, properly applied, should protect conservation easements from being extinguished to satisfy short-term state and local political, economic, and development interests. 148 some might be concerned that the high standard for extinguishment will mean that projects of great importance to the public (such as construction of highways or electric transmission towers and lines) could be hindered or precluded by the existence of conservation easements. that concern would be unfounded. when the best place to locate a public works project is on land that is protected because it has unique or otherwise significant conservation values, the government has recourse to its power of eminent domain and can institute condemnation proceedings with respect to both the subject land and the easement. c. holder’s share of proceeds the proceeds regulation provides that, at the time of the donation of a conservation easement, the donor must agree that the donation gives rise to a property right, immediately vested in the donee, with a fair market value that is at least equal to the proportionate value that the easement, at the time of the gift, bears to the value of the property as a whole at that time. 149 that proportionate value, which is generally expressed as a percentage, must remain constant. 150 and when a change in conditions gives rise to the extinguishment of a conservation easement as provided in the extinguishment regulation, the donee, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that minimum (or floor) percentage value. 151 the extinguishment and proceeds regulations were carefully designed to ensure that, if a conservation easement is extinguished upon frustration of its purpose, at least a minimum percentage share of proceeds from the subsequent sale or exchange of the property will be payable to the 148. see supra note 140 and accompanying text. 149. reg. § 1.170a-14(g)(6)(ii). 150. id. 151. id. see supra note 96 (explaining that there is an exception to this rule in the case of conversions). 264 florida tax review [vol. 13:5 holder to be used ―in a manner consistent with the conservation purposes of the original contribution.‖ 152 in other words, the regulations ensure that the federal investment in the easement will not be lost (and will not pass as a windfall to the donor or subsequent owner of the property) and, instead, will remain in the charitable sector to be used for similar conservation purposes. by requiring that the holder receive at least the designated minimum (or floor) percentage of proceeds following extinguishment, the proceeds regulation also protects against valuation abuse. 153 d. holder’s use of proceeds as noted above, following the extinguishment of an easement, the donee must use its share of the proceeds ―in a manner consistent with the conservation purposes of the original contribution.‖ although the irs has not issued guidance regarding the type of uses that would be deemed ―consistent with the conservation purposes of the original contribution,‖ certain uses should clearly be unacceptable, such as, in the case of government holders, the use of such proceeds to build roads or fund other development infrastructure. moreover, allowing the proceeds from the extinguishment of federally-subsidized conservation easements (which could be in the multiple millions of dollars for a single easement) to be added to the general operating funds of either government and nonprofit holders could create significant perverse incentives for such holders to seek extinguishments. accordingly, the ―use of proceeds‖ provision in the extinguishment regulation serves two important purposes. it ensures that the federal funds invested in conservation and historic preservation through section 170(h) will continue to be used for those purposes in the event some easements are extinguished due to impossibility or impracticality. it also ensures that section 170(h), which congress enacted specifically to 152. see reg. § 1.170a-14(g)(6)(i). 153. for example, assume a landowner donates a conservation easement with respect to land valued at $1 million and claims a deduction based on an appraisal indicating that the value of the easement is $900,000 (i.e., the donor claims the easement reduces the value of the land by 90 percent at the time of its donation). assume also that the donor receives a tax benefit from the deduction of $315,000 (the amount of income tax the donor otherwise would have paid at an assumed rate of 35 percent absent the $900,000 deduction). then a number of years later, after the statute of limitations has run on the donor‘s deduction, the easement is extinguished in a judicial proceeding and a court-supervised appraisal finds that the easement is (and likely was at the time of its donation) worth only 10 percent of the value of the land. absent the minimum percentage requirement in the regulations, the holder might receive only 10 percent of the proceeds upon a subsequent sale of the land (or $100,000, assuming no change in the value of the unencumbered land), even though the public invested $315,000 in the easement. 2012] tax-deductible conservation easements 265 encourage and subsidize the permanent ―preservation of unique or otherwise significant land areas or structures,‖ 154 does not become a mechanism by which federal taxpayers indirectly provide millions of dollars of general operating funds to nonprofits and state and local governments. as the foregoing illustrates, each of the four federal extinguishment requirements performs a critical function. accordingly, none should be considered optional. 2. need for uniform federal standards there are also a number of compelling policy reasons for imposing uniform restrictions on the extinguishment of tax-deductible conservation easements and for not deferring to states, localities, or holders regarding this critical issue. (i) consistent protection of federal investment as noted in the introduction, federal taxpayers are investing billions in ostensibly ―perpetual‖ conservation easements through section 170(h). 155 this significant federal investment is protected by: (1) requiring that all taxdeductible easements satisfy the elaborate conservation purposes and other threshold requirements of section 170(h) and the regulations; (2) prohibiting government and nonprofit holders from selling, releasing, or otherwise transferring such easements, whether or not for consideration, except to other eligible donees who agree to continue to enforce the easements; and (3) requiring that all such easements satisfy the ―enforceability in perpetuity‖ and other requirements of the regulations, including the requirements of the extinguishment and proceeds regulations. if tax-deductible easements could be extinguished pursuant to varied procedures set forth in state enabling statutes, there would be little consistency in the protection of the federal investment. at present, over one hundred state statutes authorize the creation or acquisition of conservation easements, and the provisions of those statutes addressing the transfer, release, modification, and termination of easements vary widely from jurisdiction to jurisdiction and program to program. 156 such statutes are also subject to legislative revision or repeal when development pressures increase or state and local priorities change. these points are worth emphasizing. state legislatures enact state statutes, not with the intent to protect the federal 154. see s. rep. no. 96-1007, supra note 2, pt. ii, at 9, reprinted in 1980 u.s.c.c.a.n. at 6745. 155. see colinvaux, in search of conservation value, supra note 1. 156. see mclaughlin, national perpetuity standards, part 2, supra note 5, apps. a, b. 266 florida tax review [vol. 13:5 investment in perpetual conservation easements, but with state and local interests in mind, including state and local economic and development interests. for example, the virginia open space land act authorizes a seven-member politically-appointed board (as well as counties, municipalities, and community development authorities) to extinguish open space easements to make way for ―orderly development and growth‖ regardless of whether such easements continue to protect unique or otherwise significant conservation values. 157 consistent protection across the states of the federal investment in tax-deductible conservation easements and the values they are intended to preserve in perpetuity for the benefit of the public can be assured only if such easements are subject to uniform rules regarding extinguishment. congress presumably recognized this when it declined to defer to the states regarding extinguishment and, instead, authorized deductions only for perpetual easements, or those that are transferable only to other qualified organizations that agree to continue to enforce the easements and terminable only upon frustration of their purposes. (ii) efficiency if the extinguishment regulation were interpreted as setting forth only one of possibly many ways in which tax-deductible conservation easements could be permissibly extinguished, the irs and the courts would be forced to engage in many and repeated assessments of proposed alternative extinguishment procedures. each of the over one hundred state enabling statutes would have to be assessed, and every revision to a statute implicating the transfer, modification, release, abandonment, or extinguishment of easements would necessitate a new assessment. moreover, there is no indication of the standards that should be used by the irs or the courts in assessing the acceptability of alternative extinguishment procedures. neither section 170(h) nor the regulations indicate that alternative procedures are acceptable, much less the standards that should be used to assess such procedures, and the tax court in carpenter rejected the argument that an alternative procedure should be deemed acceptable if it can be shown that the possibility of extinguishment pursuant to such procedure is so remote as to be negligible. permitting alternative and variable methods of extinguishment would also increase the already considerable complexities and uncertainties associated with valuing tax-deductible conservation easements. 158 instead of 157. see id. at 45–48. 158. for a discussion of the complexities and uncertainties associated with valuing tax-deductible conservation easements, see, e.g., joint comm. on taxation, 112th cong., 2d sess., description of revenue provisions 2012] tax-deductible conservation easements 267 assuming that the easements will be extinguished only in the unlikely event of impossibility or impracticality, both donor and irs appraisers would have to assess the probability of extinguishment and its effect on value with regard to each alternative extinguishment procedure, and those probabilities would change over time if state and local officials and boards were to authorize a growing number of extinguishments. (iii) equity equitable considerations provide a third compelling policy reason for interpreting the regulations as imposing uniform restrictions on extinguishment. to be eligible for a federal charitable income tax deduction with regard to the donation of a conservation easement, easement donors must satisfy the elaborate threshold requirements set forth in section 170(h) and the regulations, which apply uniformly to all donations regardless of the location of the subject property or the state statute pursuant to which the easement is created. to ensure equitable treatment of donors and subsequent owners of the burdened properties, the standards for extinguishment of such easements should be similarly uniform. that is, easement donors and subsequent owners in montana and michigan should not be able to more easily obtain extinguishment of the easements burdening their properties than similarly situated property owners in maine or minnesota — i.e., ―protected in perpetuity‖ should not have a different meaning from state to state or program to program. the spectacle of federally subsidized, ostensibly perpetual conservation easements being more easily terminated in some states than in others would call into question the legitimacy of and diminish public support for the federal tax incentive program. while some differences in the application of any set of extinguishment standards are inevitable, such differences and consequent inequities will obviously be minimized if the same standards apply uniformly to all tax-deductible conservation easements. moreover, an extensive body of case law developed over hundreds of years in the charitable gift context underlies the extinguishment regulation‘s ―impossibility or impracticality‖ standard and will serve as a guide to courts when applying that standard to easements. contained in the president‘s fiscal year 2013 budget proposal, at 565–73 (2012), https://www.jct.gov/publications.html?func=startdown&id=4464; halperin, incentives for conservation easements, supra note 1, at 31; nancy a. mclaughlin, increasing the tax incentives for conservation easement donations—a responsible approach, 31 ecology l. q. 1, 68–91 (2004). 268 florida tax review [vol. 13:5 (iv) effectiveness a final reason for imposing uniform restrictions on extinguishment is effectiveness. tax-deductible conservation easements are supposed to permanently protect properties that have been identified as having unique or otherwise significant conservation values, and congress and the treasury department anticipated that extinguishment of such easements upon frustration of their purposes would be the rare exception rather than the rule. accordingly, the regulations set a very high bar for extinguishment — a judicial proceeding and a finding that continued use of the property for conservation purposes has become impossible or impractical due to unexpected changed conditions. alternative procedures for extinguishment adopted by states, localities, or individual or groups of holders are unlikely to be as effective in carrying out congress‘s intent regarding permanence because states, localities, and government and nonprofit holders craft extinguishment standards with their own interests, rather than federal interests, in mind. 159 moreover, given that extinguishment should be the rare exception rather than the rule, there should be no need for alternative extinguishment procedures. particularly when the difficulties associated with assessing the relative effectiveness of different procedures as well as the likelihood of substantial inequities from state to state and program to program are taken into account. accordingly, rather than relaxing the restrictions on extinguishment (an approach virtually guaranteed to increase the donation of marginal easements as well as abuse), greater care should be taken at the time of acquisition to ensure that federally subsidized easements protect properties that have unique or otherwise significant conservation values, and those values are likely to endure over time. 160 the effectiveness of the federal tax incentive can also be viewed from a different perspective — that of encouraging conservation easement donations. the promise made to easement donors that their particular properties will be ―protected in perpetuity,‖ or at least until circumstances change so profoundly that continued use of the property for conservation purposes has become impossible or impractical, appears to be a major factor motivating many conservation easement donations. 161 if that promise could no longer be made, and states, localities, and holders were permitted to 159. see, e.g., supra note 157 and accompanying text. 160. see mclaughlin, conservation easements: perpetuity and beyond, supra note 41, at 706 (explaining that ―the type of long-term protection afforded by perpetual conservation easements is not appropriate in all circumstances‖ and such easements should not be used indiscriminately). 161. see mclaughlin & weeks, in defense of conservation easements, supra note 55, at 15. 2012] tax-deductible conservation easements 269 release, swap, or otherwise extinguish tax-deductible easements subject to standards that accord more weight to the short-term interests of the holder or the public than to the goal of protecting the properties‘ conservation values, the number of easement donations, at least by those primarily motivated by a desire to protect their land, could be expected to decline. in contrast, those motivated primarily by the prospect of receiving tax benefits would likely view the relaxing of restrictions on extinguishment as a possible way to maximize the financial benefits they can obtain from the transaction. 162 rather than interpreting the extinguishment regulation in a manner contrary to the intent of congress and the drafters of the regulations, the proper course for those who wish to obtain a federal subsidy for the donation of conservation easements that may be modified or extinguished through a variety of procedures adopted by states, localities, or holders is to present a proposal for such a subsidy to congress to be discussed and debated in a public process. it may be that the american public does not wish to subsidize the acquisition of conservation easements that are more easily modifiable and extinguishable in montana or michigan than in maine or minnesota. moreover, any such federal subsidy, even if it had public support, should include detailed standards by which to assess the acceptability of the proposed modification and extinguishment procedures, as well as mechanisms to address the added valuation complexities, the dangers of parochialism, and the increased opportunities for abuse. 3. federal and state law interaction states are, of course, free to craft whatever modification and extinguishment procedures they deem appropriate for state-funded conservation easements, and many have done so. 163 government and nonprofit holders are similarly free to raise funds and purchase conservation easements that are modifiable or terminable as they may see fit or upon the satisfaction of conditions of their choice, subject to whatever requirements might be imposed by the applicable state enabling statute and assuming they negotiate with the grantor for this discretion and memorialize such discretion in the easement deed (instead of representing that the easement is 162. for example, if an easement increases in value relative to the value of the property it encumbers over time, and the holder‘s entitlement to proceeds upon extinguishment is limited to the minimum (or floor) percentage value established at the time of the easement‘s donation, the landowner could make a tidy sum through extinguishment. see mclaughlin, national perpetuity standards, part 1, supra note 16, at 510–12. 163. see mclaughlin, national perpetuity standards, part 2, supra note 5, apps. a, b (surveying the state enabling statutes, some of which establish statefunded easement purchase programs). 270 florida tax review [vol. 13:5 perpetual). 164 to the extent landowners and holders wish to benefit from the federal charitable income tax deduction, however, they should be required to satisfy the requirements set forth in section 170(h) and the regulations. this does not mean that federal law preempts state law. rather, it means that, to be eligible for the federal deduction, conservation easement donors must satisfy the requirements in section 170(h) and the regulations as well as any additional requirements that may be imposed on the creation, modification, or extinguishment of conservation easements under the applicable state enabling statute. 165 this is not a new concept. congress is free to condition the receipt of federal tax incentives upon the satisfaction of federal requirements, 166 and it has been standard operating practice for wellrepresented easement donors to draft their easements to satisfy both state and federal requirements. 167 as judge haines explained in carpenter, in determining whether a conservation easement complies with the requirements for the deduction under section 170(h), one looks to state law to determine the nature of the property rights embodied in the easement, but ―[f]‖ederal law determines the appropriate tax treatment of those rights.‖ 168 accordingly, in determining whether a conservation easement complies with the extinguishment and proceeds requirements of regulation section 1.170a-14(g)(6), one would look to the terms of the deed and state law to determine how the easement 164. much of the controversy over the manner in which conservation easements can be permissibly modified or terminated could be avoided if deeds expressly addressed the issue. if this were done, all parties in interest — donors, holders, the irs, state attorneys general, funders, and the taxpaying public — would be on notice of the terms of the transaction. 165. see mclaughlin, national perpetuity standards, part 2, supra note 5, at 20–26 (discussing the interaction of federal and state law in the conservation easement context). 166. see, e.g., estate of gillespie v. commissioner, 75 t.c. 374, 378–79 (1980) (whether a particular transfer qualifies for a federal estate tax charitable deduction is a matter of federal concern, and congress may prescribe requirements for tax-deductible gifts to charity). 167. see supra note 125 and accompanying text. 168. carpenter v. commissioner, 103 t.c.m. (cch) 1001, 1004 t.c.m. (ria) ¶ 2012-001 (2012) at 5. in a more recent case, the tax court explained this concept as follows: ―a common idiom describes property as a ‗bundle of sticks‘ . . . . state law determines only which sticks are in a person‘s bundle. . . . once property rights are determined under state law, as announced by the highest court of the state, the tax consequences are decided under federal law.‖ patel v. commissioner, tax ct. rep. (cch) dec. 59,100, at 4665, tax ct. rep. (ria) dec. 138.23, at 235 (2012) (emphasis added) (citations omitted) (quoting united states v. craft, 535 u.s. 274, 278–79 (2002)). 2012] tax-deductible conservation easements 271 may be extinguished, and then ask whether that easement, so configured, satisfies federal tax law requirements. if the holder can agree to extinguish the easement other than in a court proceeding upon a finding of impossibility or impracticality, or the holder is not entitled to at least its minimum proportionate share of proceeds following extinguishment, or the holder is not required to use those proceeds for similar conservation purposes, the conservation easement should not be tax-deductible. similarly, if the conservation easement deed dutifully incorporates provisions that track the restriction on transfer, extinguishment, and proceeds regulations, but those provisions are qualified in some manner or are not legally binding on the parties, the easement should not be tax-deductible. iii. hard cases make bad law – simmons and kaufman commissioner v. simmons 169 and kaufman v. commissioner (kaufman iii) 170 both involved deductions for façade easement donations that the irs challenged on a variety of grounds. 171 although neither case directly addresses the extinguishment regulation at issue in carpenter, two of the circuit courts‘ holdings in these cases may have an impact on the issue addressed in this article — the circumstances under which government and nonprofit holders can agree to extinguish tax-deductible conservation easements. as discussed below, the circuit court holdings in simmons and kaufman iii evidence a decided impatience with the irs‘s attempts to use litigation to establish clear rules in the conservation easement donation context. unfortunately, that impatience led to holdings that are inconsistent with the statutory mandate that the conservation purpose of an easement be protected in perpetuity and open the door to loss of the federal investment and significant abuse. the holdings are examples of the old adage that ―hard cases make bad law,‖ which ―refers to the danger that a decision operating harshly on the defendant may lead a court to make an unwarranted exception or otherwise alter the law.‖ 172 the holdings are also contrary to the ―familiar rule‖ that ―an income tax deduction is a matter of legislative grace and . . . the burden of clearly showing the right to the claimed deduction is on the taxpayer.‖ 173 169. commissioner v. simmons, 646 f.3d 6 (d.c. cir. 2011). 170. kaufman iii, 687 f.3d 21 (1st cir. 2012). 171. simmons, 646 f.3d 6; kaufman iii, 687 f.3d 21. 172. see bryan a. garner, dictionary of legal usage 403 (3d ed. 2011). 173. see indopco, inc. v. commissioner, 503 u.s. 79, 84 (1992) (―deductions are strictly construed and allowed only ‗as there is a clear provision therefor‘‖). 272 florida tax review [vol. 13:5 on the positive side, the holdings will hopefully spur the irs and the treasury department to focus some of their energy and resources on issuing forward-looking regulations and other guidance regarding how to satisfy the critically important protected-in-perpetuity requirements. recommendations for such revisions and guidance are discussed in part iv, but first, the bad law. a. proceeds regulation in two detailed and carefully considered ―regular‖ opinions, the tax court held that lorna kaufman was not eligible for a deduction under section 170(h) for the donation of a facade easement due to a failure to comply with the proceeds regulation. 174 although the easement contained a clause entitling the holder to the regulations‘ mandated minimum proportionate share of proceeds following extinguishment, the clause was qualified by an outside agreement with the bank that held a mortgage on the subject property at the time of the easement‘s donation. rather than agreeing to subordinate its rights to the rights of the holder ―to enforce the conservation purposes of the gift in perpetuity,‖ as required by regulation section 1.170a-14(g)(2) (the mortgage subordination regulation), the bank retained priority rights to all insurance or condemnation proceeds, including those paid following extinguishment of the easement. the tax court held that this constituted an impermissible qualification of the clause included in the easement to satisfy the proceeds regulation. the first circuit reversed, but its analysis is troubling. it noted that lorna kaufman ―had no power to make the mortgage-holding bank give up its own protection against fire or condemnation.‖ 175 while that certainly is true, it misses the point. the point is not whether kaufman had the power to make the bank give up certain rights, but whether the conservation easement she donated satisfied the requirements of section 170(h) and the regulations and, in particular, the requirements intended to protect the public investment in the easement in the event of its extinguishment. if a lender refuses to subordinate its rights to the rights of the holder ―to enforce the conservation purposes of the gift in perpetuity,‖ which the first circuit acknowledged 174. kaufman v. commissioner (kaufman i), 134 t.c. 182 (2010) and kaufman ii, 136 t.c. 294 (2011), vacated and remanded in part, kaufman iii, 687 f.3d 21 (1st cir. 2012). ―regular‖ tax court opinions are generally issued in cases that the court believes involve sufficiently important legal issues or principles. see http://www.ustaxcourt.gov/taxpayer_info_after.htm#after8. regular opinions can be cited as legal authority and appealed, and the tax court treats them as binding precedent. id. see also peter a. lowy, u.s. federal tax research, 100-2d tax. mgmt. (bna) a-63. for a reproduction of the proceeds regulation, see supra note 15. 175. kaufman iii, 687 f.3d at 26. 2012] tax-deductible conservation easements 273 could be interpreted to include the holder‘s right to post-extinguishment proceeds, 176 the property owner has a number of options. the property owner could consider paying down the mortgage to a point at which the lender would be willing to so subordinate, paying off the mortgage, or refinancing with a different bank willing to so subordinate before making the donation. alternatively, the property owner could not make the donation or make the donation but not claim federal tax benefits. in sum, the fact that a particular bank might refuse to subordinate its rights to the rights of the easement holder to receive its minimum proportionate share of post-extinguishment proceeds is not a justification for relaxing the regulations‘ specific requirements. 177 the first circuit‘s argument regarding superiority of tax liens is similarly unpersuasive. 178 the fact that tax liens may reduce the amount of proceeds available to be allocated between the two parties following extinguishment (the owner of the encumbered property and the holder of the easement) has nothing to do with whether it is appropriate for the property owner‘s lender to be given first priority to whatever proceeds are available. the holder of a conservation easement is the owner of a valuable property 176. see id. at 27 n.5 (noting that the mortgage subordination requirement could be read broadly to require a lender to subordinate its rights to the right of the donee to receive post-extinguishment proceeds, which pursuant to the extinguishment regulation, must be used to advance conservation purposes). see also mclaughlin, national perpetuity standards, part 1, supra note 16, at 492–94 (arguing that this is the correct interpretation of the mortgage subordination requirement on technical grounds and because the value attributable to ―the gift‖ that was made for the benefit public and for which a federal subsidy was provided should remain in the charitable sector and be devoted to similar conservation purposes, as opposed to being paid to the landowner‘s lender). because the irs ―disclaimed‖ this reading of the mortgage subordination requirement, the first circuit did not pursue the issue. kaufman iii, 687 f.3d at 27 n.5. 177. it also is not clear that kaufman‘s bank refused to subordinate its rights to the rights of the easement holder to receive its minimum proportionate share of post-extinguishment proceeds. the bank may have been presented with only the ―limited‖ subordination agreement at issue in the case since that appears to have been the standard form used in the historic preservation context. see infra note 182 and accompanying text. it may be that lenders would be willing to fully subordinate their rights to the holder‘s right to receive a share of post-extinguishment proceeds, if asked, if the debt to equity ratio would remain sufficiently low after the donation of the easement. 178. kaufman iii, 687 f.3d at 26 (―the kaufmans had . . . no power to defeat tax liens that the city might use to reach the . . . insurance proceeds — tax liens being superior to most prior claims‖). 274 florida tax review [vol. 13:5 right on behalf of the public 179 and should be entitled to receive the portion of the postextinguishment proceeds attributable to that property right in preference to the landowner‘s lender, whose security interest should be limited to the proceeds attributable to the property owner‘s property interest (i.e., the encumbered property). it also should not be acceptable to relegate the holder of a conservation easement to obtaining its portion of the available proceeds from the property owner. the regulations appropriately provide that the holder must be entitled to a portion of ―the proceeds‖ following extinguishment, not that the holder should have a potentially expensive-topursue claim against the possibly judgment-proof property owner for its portion. 180 the first circuit‘s holding appears to have been driven more by its irritation with the irs‘s strategy of using litigation to establish clear rules in this context than a desire to ensure that holders of conservation easements receive a share of proceeds following extinguishment to be used to replace lost conservation values on behalf of the public. the first circuit also seems to have been particularly influenced by the arguments made by the national trust for historic preservation (nthp) in its amicus brief filed in support of the taxpayer. 181 the nthp argued that the type of ―limited‖ subordination agreement obtained by kaufman had ―been widely used for decades in thousands of easements without a reported objection by the [irs],‖ and that the tax court‘s rulings in kaufman, if allowed to stand ―could disallow tax deductions for thousands of easement donations across the country.‖ 182 however, the historic preservation organizations should have known that limited subordination agreements might not comply with federal tax law requirements. the commentary to the model conservation easement in the conservation easement handbook published in 1988 explains that a limited subordination agreement is intended to ―neutralize‖ the provision included in a conservation easement deed to satisfy the regulation‘s proceeds requirement, but notes that the assumption that such an agreement satisfies the requirements under section 170(h) and the regulations is ―untested.‖ 183 the 2005 edition of the handbook similarly notes the disagreement within the land trust community over whether such agreements comply with federal 179. see reg. § 1.170a-14(g)(6)(ii) (―for a deduction to be allowed . . . at the time of the gift the donor must agree that the donation of the [easement] gives rise to a property right, immediately vested in the donee organization‖). 180. id. 181. brief for the national trust for historic preservation as amicus curiae supporting petitioners, kaufman iii, 687 f.3d 21 (1st cir. 2012) (no. 15997-09) [hereinafter nthp brief, kaufman iii]. 182. id. at 6–7. 183. see diehl, 1988 conservation easement handbook, supra note 53, at 207. 2012] tax-deductible conservation easements 275 tax law requirements. 184 accordingly, the historic preservation organizations arguably should have worked with a taxpayer to request a private letter ruling or other guidance from the irs before endorsing the use of an untested and potentially noncompliant subordination agreement in thousands of donation transactions. 185 the nthp also asserted that the tax court‘s ruling in kaufman ii, if affirmed, would ―halt the voluntary donation of conservation easements involving mortgaged properties.‖ 186 whether that assertion is accurate with regard to façade easement donations is unclear. 187 that assertion is not accurate with regard to the donation of conservation easements encumbering land. donors to organizations accepting large numbers of such conservation easements have been able to secure ―full‖ subordination agreements from lenders, in which the lenders agree to subordinate their rights to all of the rights of the holder under a conservation easement, including, implicitly, the holder‘s right to receive its minimum percentage share of proceeds following extinguishment. 188 in addition, the land trust alliance is advising donors to 184. see byers, 2005 conservation easement handbook, supra note 53, at 456 (explaining that, although some practitioners think limited subordinations are permissible, ―[o]thers would argue, at least with respect to extinguishment, that the division-of-proceeds requirement is what allows ‗the conservation purpose‘ of the grant to ‗nonetheless be treated as protected in perpetuity‘ in the eyes of the irs, and a lender must therefore subordinate to it as well‖). 185. see supra note 173 and accompanying text (explaining that deductions are a matter of legislative grace and the burden is on the taxpayer to show he has a right to the claimed deduction). although conservation easement donors should be and often are represented by their own legal counsel, as a practical matter many rely in large part on the donee and the donee‘s ―template‖ easement and supporting documents because the donee is a repeat player. 186. nthp brief, kaufman iii, supra note 181, at 23. 187. see supra note 177. 188. for example, the virginia outdoors foundation, which holds most of the easements conveyed in the state of virginia, uses a template conservation easement that provides for the lender‘s subordination of its rights to all the rights of the holder under the easement, including, implicitly, the holder‘s right to proceeds upon extinguishment. see va. outdoors found., easement documents and forms, vof easement template, 18 (may 10, 2011), http://www.virginiaoutdoors foundation.org/vof_land-documents.php; see also opening brief for respondent at 61–62 n.13, kaufman i, 134 t.c. 182, adhered to on denial of reconsideration by, 136 t.c. 294 (no. 15997-09) (explaining that the compact of cape cod conservation trusts uses a subordination agreement template in which the lender ―agrees to subordinate and hold its mortgage subject to the terms and provisions of [the conservation easement] to the same extent as if said mortgage had been recorded subsequent to the recording of [the conservation easement]‖). 276 florida tax review [vol. 13:5 continue to obtain full subordination agreements from lenders, despite the first circuit‘s holding in kaufman iii. 189 although the façade easement donors, the historic preservation organizations, and the irs all bear some blame in this context, the first circuit clearly sympathized with the predicament in which the donors and historic preservation organizations found themselves following the tax court‘s rulings in kaufman ii. the first circuit also objected to the irs‘s ―impromptu reading‖ of the proceeds regulation, 190 which can be viewed as an objection to the irs‘s attempt to enforce its interpretation of the regulation without having provided taxpayers with fair warning regarding that interpretation. an unfortunate result of the first circuit‘s holding on this issue may be a nationwide race to the bottom regarding subordination agreements. lenders that previously were willing to sign full subordination agreements are unlikely to agree to continue to do so if it is not necessary to secure the deduction. this, in turn, will mean that the valuable property interest — the easement — that was conveyed as a charitable gift to the government or nonprofit holder to be held and enforced for the benefit of the public, and in which the public heavily invested, may incongruously serve as security for the donor‘s debt in the event of extinguishment. thus, donors will be poised to obtain a double benefit or windfall from conservation easement donations: (1) a sizable charitable income tax deduction upon the donation plus (2) use of the proceeds attributable to the easement (the charitable gift) upon extinguishment to pay down the donor‘s debt on the subject property instead of being paid to the holder to replace lost conservation values. in fact, the ability to ―neutralize‖ the clause included in a conservation easement deed to satisfy the proceeds requirement in this manner may encourage donors to obtain mortgages on their properties before donating easements, perhaps even through controlled entities where the sole purpose of the mortgage is to neutralize the proceeds clause. if it truly is impossible to obtain full subordination agreements in the façade easement donation context, the proper solution is not the first circuit‘s race to the bottom approach with regard to all easement donations. rather, congress and the treasury department should consider whether continued investment in façade easements on properties subject to mortgages is worth the risk of the loss of that investment in the event of extinguishment. 189. see land trust alliance, irs and tax court overturned again, http://www.landtrustalliance.org/conservation/conservation-defense/conservationdefense-news/irs-and-tax-court-overturned-again (last visited sept. 23, 2012) (―donors still must obtain a lender subordination to the entire conservation easement, including the payment on extinguishment clause, and record it at the same time as the conservation easement despite this new ruling.‖) (emphasis in original). 190. kaufman iii, 687 f.3d 21, 27 (1st cir. 2012). 2012] tax-deductible conservation easements 277 if the answer to that question is yes, appropriate rules should be developed to minimize the risk. for example, the regulations could be revised to permit limited subordination agreements, but only if the debt-to-equity (or loan to value) ratio is sufficiently low at the time of the donation and, thus, the risk that the public would lose its investment in the event of extinguishment is minimal. b. rights to change or abandon easements the first circuit in kaufman iii also agreed with the d.c. circuit‘s holding in simmons that it is permissible for the donor of a tax-deductible perpetual conservation easement to grant the holder the right to consent to changes to or abandon some or all of its rights under the easement. 191 the first circuit adopted the d.c. circuit‘s problematic and contradictory explanations for this holding, namely that (1) ―[a]ny donee might fail to enforce a conservation easement, with or without a clause stating it may consent to a change or abandon its rights,‖ (2) a tax-exempt holder would exercise such rights ―at its peril,‖ but (3) a holder needs such rights ―to accommodate such change as may become necessary to make a building livable or usable for future generations while still ensuring the change is consistent with the conservation purpose of the easement.‖ 192 there are a number of serious problems with this holding and the contradictory explanations. 1. noncompliance with regulations the change and abandonment language at issue in kaufman and simmons impermissibly qualifies the clause included in the deeds to comply with the restriction-on-transfer requirement of regulation section 1.170a14(c)(2): grantee covenants and agrees that it will not transfer, assign or otherwise convey its rights under this conservation easement except to another ―qualified organization‖ described in section 170(h)(3) of the internal revenue code of 1986 and controlling treasury regulations, and grantee further agrees that it will not transfer this easement unless the transferee first agrees to continue to carry out the conservation purposes for which this easement was created, 191. id. at 28. for criticism of the d.c. circuit‘s holding and analysis with respect to this issue in simmons, see mclaughlin, national perpetuity standards, part 2, supra note 5, at 11–19. 192. kaufman iii, 687 f.3d at 28. 278 florida tax review [vol. 13:5 provided, however, that nothing herein contained shall be construed to limit the grantee’s right to give its consent (e.g., to changes in a façade) or to abandon some or all of its rights hereunder. 193 neither circuit court explained how the italicized proviso is consistent with the restriction on transfer, extinguishment, or proceeds regulations, given that a holder could transfer or extinguish an easement by abandoning its rights thereunder, and, pursuant to the proviso, could do so without complying with the restriction on transfer, extinguishment, or proceeds requirements. 194 in addition, even absent the proviso, the clause fails to state that the transferee, at the time of the transfer, must qualify as an ―eligible donee‖ as required by regulation section 1.170a-14(c)(2). 195 moreover, neither court acknowledged that a holder could exercise the right to consent to changes that are not consistent with the purpose of the easement in violation of the requirement that the conservation purpose of the easement be protected in perpetuity. 196 2. tax-exempt rules do not ensure protection in perpetuity the first circuit in kaufman iii stated that the concern posited by the irs — that the proviso gives the holder a blank check to consent to changes or abandon an easement — can be addressed by ―the irs‘s own regulations,‖ which ―require that tax-exempt organizations . . . be operated 193. conservation easement deed of gift between dorothy simmons, grantor, and the l‘enfant trust, grantee 3 (nov. 18, 2003) (on file with author) (emphasis added); conservation easement deed of gift between ms. dorothy simmons, grantor, and the l‘enfant trust, grantee 3 (jan. 26, 2004) (on file with author) (emphasis added). see also preservation restriction agreement between lorna e. kaufman, grantor, and the national architectural trust, inc., grantee 4 (dec. 22, 2003) (on file with author). 194. in assessing the acceptability of the proviso, both circuit courts focused solely on the general requirement in regulation section 1.170a-14(g)(1), and neither mentioned regulation section 1.170a-14(c)(2) (the restriction on transfer regulation) or regulation section 1.170a-14(g)(6)(i) and (ii) (the extinguishment and proceeds regulations). 195. reg. § 1.170a-14(c)(2) (―subsequent transfers must be restricted to organizations qualifying, at the time of the subsequent transfer, as an eligible donee under paragraph (c)(1) of this section‖). an ―eligible donee‖ is ―a qualified organization [that has] a commitment to protect the conservation purposes of the donation, and [has] the resources to enforce the restrictions‖ as specified in regulation section 1.170a-14(c)(1). 196. i.r.c. § 170(h)(5)(a). 2012] tax-deductible conservation easements 279 ‗exclusively‘ for charitable purposes.‖ 197 however, the requirement that a tax-exempt organization operate exclusively for charitable purposes does not ensure that the conservation purposes of tax-deductible conservation easements will be protected in perpetuity as required by section 170(h)(5)(a) and the regulations. first, many state and local government entities accept tax-deductible conservation easement donations and those entities are not subject to the rules governing tax-exempt organizations — a fact the circuit courts did not address. thus, counties, cities, towns, community development authorities, and other state and local government entities granted unlimited rights to consent to changes or abandon tax-deductible conservation easements would be free to exercise those rights without any fear of losing tax-exempt status. in addition, while a nonprofit holder could lose its tax-exempt status for consenting to a change or abandoning a conservation easement and thereby conferring an impermissible private benefit on the property owner, it is not clear that such a holder would risk losing its tax-exempt status for agreeing to change or abandon (i.e., extinguish) an easement, in whole or in part, provided it received adequate compensation and used that compensation consistent with its general charitable mission. the requirement that a taxexempt organization operate exclusively for charitable purposes means the organization must engage primarily in activities that accomplish one or more of the exempt purposes specified in section 501(c)(3) and not confer impermissible benefits on private parties. 198 that requirement is not designed to ensure that the conservation purposes of tax-deductible conservation easements are protected in perpetuity as required by section 170(h)(5)(a). accordingly, pursuant to the proviso at issue in simmons and kaufman, a nonprofit holder might be able to agree to release the restrictions in or abandon a conservation easement, in whole or in part, in exchange for cash to be added to the holder‘s general operating funds without risking loss of tax-exempt status. converting what were supposed to be perpetual conservation easements to cash could obviously prove very lucrative for nonprofits. a nonprofit holder might also be able to agree to abandon (i.e., extinguish) a conservation easement in exchange for a new conservation easement encumbering a different property (i.e., the holder could agree to exercise its right to abandon to effectuate a ―swap‖) without risking loss of 197. kaufman iii, 687 f.3d at 28. 198. see staff of joint comm. on taxation, historical development and present law of the fed. tax exemption for charities and other taxexempt orgs. 49, 52–53 (comm. print 2005), https://www.jct.gov/ publications.html?func=startdown&id=1586. prohibited private benefit and private inurement can occur in many different forms, including receipt of less than fair market value on the sale or exchange of property. see id. at 53. 280 florida tax review [vol. 13:5 tax-exempt status. 199 indeed, in the amicus brief filed in support of the taxpayer in simmons, the nthp and other historic preservation organizations stated that they view the abandonment proviso as granting them the right to freely engage in swaps: affording a conservation easement-holding organization the right to abandon an easement also is sound policy, if the circumstances of the abandonment would result in a significantly greater public benefit. for example, the organization might decide to enter an agreement with a developer that releases a single easement (e.g., on a single, modest building next to a metro stop) in exchange for easements on significant additional properties (e.g., an entire block of nearby buildings). the right to say yes or no in such a circumstance . . . allows a responsible easement-holding organization to fulfill its mission and to ensure that historic preservation can co-exist with changing times. 200 however, congress clearly did not intend, through section 170(h), to subsidize the acquisition of conservation easements that would be fungible or 199. swaps, which involve the removal of property from an easement‘s restrictions in exchange for the encumbrance of some other property, are sometimes referred to as ―trades‖ or ―reconfigurations.‖ 200. brief for the national trust for historic preservation et al. as amici curiae supporting appellee at 16–17, commissioner v. simmons, 646 f.3d 6 (d.c. cir. 2011) (no. 10-1063). this position is directly contrary to the position taken by the land trust alliance in its 2007 report on conservation easement amendments, which instructs: if the conservation easement was the subject of a federal income tax deduction, then internal revenue code section 170(h) and the treasury regulations section 1.170a-14 apply. such an easement must be ―granted in perpetuity‖ and ―the conservation purpose [of the contribution must be] protected in perpetuity.‖ the easement must be transferable only to another government entity or qualified charitable organization that agrees to continue to enforce the easement. the easement can only be extinguished by the holder through a judicial proceeding, upon a finding that continued use of the encumbered land for conservation purposes has become ―impossible or impractical,‖ and with the payment to the holder of a share of proceeds from a subsequent sale or development of the land to be used for similar conservation purposes. land trust alliance, amending conservation easements: evolving practices and legal principles, research report 24 (august 2007), http://learningcenter.lta.org/ attached-files/0/65/6534/amendment_report_final_web.pdf [hereinafter land trust alliance, amending conservation easements]. 2012] tax-deductible conservation easements 281 liquid assets in the hands of their government or nonprofit holders. 201 moreover, congress was acutely aware of the potential for abuse in this context. during the congressional hearings leading up to the enactment of section 170(h), concern was expressed that the laws and restrictions that bind charitable organizations generally are not sufficient to ensure tax-deductible conservation easements will continue to be used for the purposes for which they were donated. 202 in his testimony before congress, the treasury department‘s then deputy assistant secretary for tax policy, daniel halperin, explained: [i]t is not clear to us whether procedures exist to insure that a donated partial interest in property, such as a conservation easement contributed to a private charitable organization, will continue to be used for conservation purposes and for the benefit of the general public. without mechanisms to insure the continued use of the donated interest for such purposes, it is not clear that the public interest is being properly served. 203 accordingly, in enacting section 170(h) in 1980, congress imposed substantial new limitations on the deduction. 204 in particular, congress did not rely on the general requirement that tax-exempt organizations operate exclusively for charitable purposes to ensure the proper administration and enforcement of tax-deductible easements over the long term. instead, congress specifically added the protected-in-perpetuity requirement to section 170(h)(5)(a) and provided significant guidance regarding the meaning of that new requirement in the legislative history, including its expectation that holders would not be free to sell, trade, release, or otherwise transfer tax-deductible perpetual conservation easements, except for transfers made to other qualified holders that agree to continue to enforce the 201. see generally s. rep. no. 96-1007, supra note 2, reprinted in 1980 u.s.c.c.a.n. 6736. see also mclaughlin, national perpetuity standards, part 1, supra note 16, at 476–87 (discussing the history of the deduction provision). 202. see, e.g., miscellaneous tax bills: hearing before the subcomm. on select revenue measures of the house comm. on ways and means, 96th cong. 5–6, 12 (1979) [hereinafter miscellaneous tax bills: hearing] (statement of daniel i. halperin, deputy assistant secretary for tax policy, department of the treasury). 203. id. at 12. 204. see generally, s. rep. no. 96-1007, supra note 2, reprinted in 1980 u.s.c.c.a.n. 6736. see also, mclaughlin, national perpetuity standards, part 1, supra note 16, at 478–80. 282 florida tax review [vol. 13:5 easements. 205 the treasury department then incorporated much of the legislative history into the regulations in the form of the restriction on transfer and other perpetuity-related requirements. 206 moreover, with regard to swaps specifically, this author has previously explained: [t]o be eligible for the federal subsidy under section 170(h), a conservation easement must satisfy one or more of the fairly elaborate conservation purposes tests as well as the myriad other requirements in section 170(h) and the treasury regulations at the time of its donation. if swaps were permissible, the owner of the land and the holder of the easement could, on the day following the donation or any time thereafter, agree to remove ten, fifty, or even one hundred percent of the original land from the protection of the easement in exchange for the protection of some other land, and the new land and the provisions governing its protection would not have to meet the threshold conservation purposes tests or any of the other requirements in section 170(h) and the treasury regulations. permitting swaps would thus render satisfaction of the threshold conservation purposes tests and other requirements in section 170(h) and the treasury regulations a meaningless exercise . . . . 207 permitting holders to agree to swaps would also violate the restriction on transfer, extinguishment, and proceeds regulations, as those regulations prohibit swaps except in carefully prescribed circumstances — i.e., when it can be shown to the satisfaction of a court that continuing to use the originally protected property for conservation purposes has become impossible or impractical, the holder receives something of sufficient value in exchange (worth at least its minimum proportionate share of proceeds), and the protection of the new property is ―consistent with the conservation purposes of the original contribution.‖ 208 in a march 2012 information 205. see s. rep. no. 96-1007, supra note 2, pt. ii, at 13–14, reprinted in 1980 u.s.c.c.a.n. at 6748–49. see also mclaughlin, national perpetuity standards, part 1, supra note 16, at 475–76. 206. see regs. §§ 1.170a-14(b)(2), -14(c), -14(e), -14(g)(1)-(6). see also mclaughlin, national perpetuity standards, part 1, supra note 16, at 487–513 (describing the requirements in the regulations). 207. see mclaughlin, national perpetuity standards, part 1, supra note 16, at 520–23. the goal of a swap is to free property from an easement‘s restrictions so that the property can be put to previously prohibited uses. 208. see regs. §§ 1.170a-14(c)(2), -14(g)(6). 2012] tax-deductible conservation easements 283 letter, the irs confirmed that the contribution of a conservation easement that authorizes swaps other in accordance with the extinguishment and proceeds requirements of regulation section 1.170a-14(g)(6) will not be eligible for a federal charitable income tax deduction under section 170(h). 209 3. rights to change or abandon may render conservation easement provisions nonbinding as explained above, congress did not rely on the general requirement that tax-exempt organizations operate exclusively for charitable purposes to ensure the proper administration and enforcement of taxdeductible easements over the long term. instead, congress added the protected-in-perpetuity requirement to section 170(h)(5)(a) and provided significant guidance regarding the meaning of that new requirement in the legislative history. the treasury department then incorporated much of the legislative history into the regulations, which contain numerous requirements intended to ensure that the conservation purpose of a tax-deductible conservation easement will be protected in perpetuity. in most cases, donors satisfy these perpetuity-related requirements by including specific clauses in the conservation easement deed that track the regulations, such as restriction on transfer, extinguishment, and proceeds clauses. 210 absent qualification, these clauses should be legally binding on both parties to the easement (the owner of the subject property and the holder of the easement) because, as recognized by the tax court in carpenter, a tax-deductible conservation easement should constitute a restricted gift under state law, or a contribution conditioned on the use of the gift in accordance with the donor‘s precise directions and limitations. in addition, the state attorney general should have standing to sue the holder for failing to administer and enforce the easement consistent with its stated terms and purpose. 211 where the holder is granted an unlimited right to consent to changes or abandon an easement as in simmons and kaufman, however, the legally binding nature of the easement terms under state law is called into question. 212 a state court faced with interpreting a conservation easement 209. irs information letter no. 2012-0017 (march 5, 2012), 2012 tnt 66–25, http://www.irs.gov/pub/irs-wd/12-0017.pdf. 210. see supra note 125 and accompanying text. 211. see supra note 47 and accompanying text. 212. the right to consent to changes and abandon the easements granted to the holders in simmons and kaufman is expressly not limited by other provisions in the deeds. the proviso states that ―nothing herein contained shall be construed to limit the grantee’s right to give its consent (e.g., to changes in the façade) or to abandon some or all of its rights hereunder.‖ see supra note 193 and accompanying text (emphasis added). 284 florida tax review [vol. 13:5 that grants the holder such a right may find that the holder can exercise that right in any manner (e.g., to modify, swap, or extinguish the easement in whole or in part), provided only that such action is consistent with the holder‘s general public or charitable mission. 213 accordingly, granting the holder the unlimited right to consent to changes or abandon a conservation easement may render the restriction on transfer, extinguishment, proceeds, and other provisions included in the easement deed to satisfy federal tax law requirements nothing more than window dressing (to be abided by until the statute of limitations has run on the donor‘s deduction and then amended away, renegotiated, or simply ignored as the holder and owner may see fit from time to time). the d.c. circuit and the first circuit did not recognize that, to ensure the conservation purposes of tax-deductible conservation easements are protected in perpetuity as required by section 170(h)(5)(a), the easements must be constructed in such a manner that both the property owner and the government or nonprofit holder will be legally bound by the easement terms. it makes little sense, for example, to mandate that the instrument of conveyance prohibit the holder from transferring the easement except to another eligible donee that agrees to continue to enforce the easement if the holder is free (after the statute of limitations has run on the donor‘s deduction) to amend away, renegotiate, or ignore that provision. 4. local law does not ensure protection in perpetuity the d.c. circuit in simmons also implied that the conservation purposes of the façade easements at issue were protected in perpetuity because ―any change in the façade to which [the holder] might consent would have to comply with all applicable laws and regulations, including the district‘s historic preservation laws.‖ 214 however, although there often is substantial overlap between historic preservation laws and the restrictions in a façade easement, historic preservation laws are subject to change, which is the reason for layering a perpetual conservation easement on the property (i.e., historic preservation laws do not ensure that the conservation purposes will be protected in perpetuity in the manner required by section 170(h) and the 213. any conditions imposed on the modification or extinguishment of conservation easements under state law would presumably have to be satisfied, but many state enabling statues impose no such conditions. see generally, mclaughlin, national perpetuity standards, part 2, supra note 5. in addition, the conditions that are imposed in some states generally are not consistent with federal tax law requirements. see id. 214. commissioner v. simmons, 646 f.3d 6, 11 (d.c. cir. 2011). 2012] tax-deductible conservation easements 285 regulations). 215 moreover, this imperfect backstop is generally not present in the context of conservation easements encumbering land (i.e., conservation easements encumbering land typically do not merely duplicate state or local restrictive zoning or other laws; they impose substantial new restrictions on the development and use of the property). accordingly, government and nonprofit holders granted the unlimited right to consent to changes or abandon conservation easements encumbering land would generally be able to exercise those rights to reduce or eliminate the protection of the land‘s conservation values. whether this makes the rulings on this issue in simmons and kaufman iii inapplicable to conservation easements encumbering land is not clear, as neither of the circuit courts discussed this issue. 5. accommodating change does not require unlimited rights to change or abandon a word is also in order concerning the amici curiae‘s representations regarding the need for flexibility to respond to changing conditions. the amici argued (and the circuit courts assumed) that the consent and abandonment proviso is ―needed to allow a charitable organization that holds a conservation easement to accommodate such change as may become necessary ‗to make a building livable or usable for future generations‘ while still ensuring that change is consistent with the conservation purpose of the easement.‖ 216 but the amici failed to inform the circuit courts that it is fairly standard practice within the land trust community and consistent with the land trust alliance‘s recommended best practices to address the need to be able to respond to changing conditions — and at the same time comply with the protected-in-perpetuity requirement of section 170(h)(5)(a) — by including an appropriately limited ―amendment clause‖ in the easement deed. 217 the typical amendment clause grants the holder the express right to agree to changes or amendments, but only if the amendments are, among 215. whether a façade easement has any value is a separate issue. where the restrictions in a façade easement are substantially identical to those imposed by state or local historic preservation laws, there is little likelihood that such laws will be changed, and the holder has the unlimited right to consent to changes or abandon the restrictions in the easement in any event, one would expect the easement to have little or no value. 216. simmons, 646 f.3d at 10; kaufman iii, 687 f.3d 21, 28 (1st cir. 2012). 217. see, e.g., byers, 2005 conservation easement handbook, supra note 53, at 377 (―amendment provisions are becoming more common to assure and limit the holder‘s power to modify.‖ (emphasis omitted)); land trust alliance, amending conservation easements, supra note 200, at 17 (―easement holders should include an amendment clause to allow amendments consistent with the easement‘s overall purposes, subject to applicable laws.‖). 286 florida tax review [vol. 13:5 other things, consistent with the conservation purpose of the easement. 218 in fact, since its first publication in 1988, the conservation easement handbook has contained model ―restriction on transfer‖ provisions that are not qualified as in simmons and kaufman iii, as well as model ―amendment clauses‖ that specifically limit amendments to those that are consistent with the purpose of the easement. 219 such provisions are all that is needed to ―allow a charitable organization that holds a conservation easement to accommodate such change as may become necessary ‗to make a building livable or usable for future generations‘ while still ensuring the change is consistent with the conservation purpose of the easement.‖ 220 in sum, the holdings in simmons and kaufman iii sanctioning the deductibility of conservation easements that grant the holder the unlimited right to consent to changes or abandon its rights under the easement are contrary to the restriction on transfer, extinguishment, proceeds, and other protected-in-perpetuity requirements in section 170(h) and the regulations. the holdings also create the potential for the improper modification, swapping, and extinguishment of tax-deductible easements and, thus, significant abuse. 221 while both circuit courts contemplated that a holder 218. the typical amendment clause generally provides as follows: amendment. if circumstances arise under which an amendment to or modification of this easement would be appropriate, grantors and grantee are free to jointly amend this easement; provided that no amendment shall be allowed that will affect the qualification of this easement or the status of grantee under any applicable laws, including [state statute] or section 170(h) of the internal revenue code . . . and any amendment shall be consistent with the purpose of this easement, and shall not affect its perpetual duration. any such amendment shall be recorded in the official records of __________ county, [state]. diehl, 1988 conservation easement handbook, supra note 53, at 164 (emphasis added). 219. see id. at 161, 220–21 (providing model restriction on transfer provisions); supra note 218 (reproducing a model amendment provision). 220. simmons, 646 f. 3d at 10. 221. for cases involving holders‘ agreements to improperly modify or extinguish tax-deductible perpetual conservation easements, see mclaughlin, national perpetuity standards, part 2, supra note 5, at pt. iii.b. one such case — the myrtle grove controversy — involved the nthp‘s agreement to amend a taxdeductible conservation easement protecting a 160-acre historic tobacco plantation from subdivision to allow a seven-lot upscale residential subdivision on the property. id. at 28–30. the maryland attorney general filed suit objecting to the amendment on the grounds that the easement was a charitable gift held for the benefit of the public and it could not be amended as proposed without court approval and a finding that continuing to protect the property‘s conservation and historic values had become impossible or impractical (which it had not). the case eventually settled with the easement remaining intact. the myrtle grove easement did not grant the holder the 2012] tax-deductible conservation easements 287 would be able to exercise its unlimited right to consent to changes or abandon an easement only in a manner consistent with the conservation purposes of the easement, 222 neither provided a convincing rationale for that conclusion. an argument might be made that a holder that agrees to amend or abandon a conservation easement in a manner contrary to its stated conservation purposes, or to transfer, swap, or extinguish an easement in a manner contrary to the restriction on transfer, extinguishment, and proceeds regulations, should no longer qualify as an ―eligible donee.‖ 223 an argument might also be made that donations to such a holder should not be deductible because they cannot satisfy the protected-in-perpetuity requirement. such arguments, however, even if successful, would do nothing to ensure the protection of existing conservation easements. moreover, congress never intended for the federal investment in conservation easements and the conservation values they are intended to protect in perpetuity to hang by such a precarious thread. rather, congress intended that tax-deductible easements would specifically prohibit the holder from transferring the easement except to another qualified organization that agrees to continues to enforce the easement, and that the treasury department would craft rules to protect the public investment in the unlikely event that a state court extinguishes an easement due to frustration of its purpose (which the treasury department did). the circuit courts in simmons and kaufman iii ignored this history and their holdings significantly undermine the protection of the federal investment in conservation easements over the long term. accordingly, the holdings sanctioning use of the change and abandonment proviso should be limited to the d.c. and first circuits and façade easement donations and, as noted below, the treasury and the irs should address the problem in those circuits through forward looking regulations or other guidance. c. first circuit’s advice in the latter part of its opinion in kaufman iii, the first circuit addressed the issue of valuation. 224 it chastised the irs for attempting to convert the ―inherently factual issue‖ of valuation into a set of violations of the right to consent to changes or abandon its rights under the easement. see mclaughlin, conservation easements: perpetuity and beyond, supra note 41, at 690–93. for concerns about amendments, see infra part iv.b. 222. both opinions state ―[t]he clauses permitting consent and abandonment . . . have no discrete effect upon the perpetuity of the easements.‖ simmons, 646 f.3d at 10; kaufman iii, 687 f.3d at 28. simmons also states ―the donated easements will prevent in perpetuity any changes to the properties inconsistent with conservation purposes.‖ simmons, 646 f.3d at 11. 223. see reg. § 1.170a-14(c)(1) (defining ―eligible donee‖). 224. kaufman iii, 687 f.3d at 29. 288 florida tax review [vol. 13:5 procedural requirements relating to the appraisal of an easement ―in disregard of the[] language and purpose‖ of those requirements. 225 the first circuit also noted, however, that façade easements that duplicate local law restrictions may be worth little or nothing, 226 that a holder receiving large cash contributions from easement donors has a substantial economic incentive to facilitate donation transactions and ensure high valuations, and that appraisers who receive fees for a succession of appraisals for gifts of easements ―assuredly‖ have an interest in remaining on the list of those recommended by holders to potential easement donors. 227 the first circuit acknowledged the legitimacy of the irs‘s concerns about abuse in the easement donation context 228 as well as the ―difficulty of detecting and investigating suspicious cases one by one.‖ 229 it then suggested a way for the irs to address valuation abuse in lieu of its current tactic of ―overly aggressive . . . interpretations of existing regulations:‖ without stifling congress‘ aim to encourage legitimate easements, one can imagine irs regulations that require appraisers to be functionally independent of donee organizations, curtail dubious deductions in historic districts where local regulations already protect against alterations, and require more specific market-sale based information to support any deduction. forward looking regulations also serve to give fair warning to taxpayers . 230 kaufman iii is not the first case in which a court has expressly invited the treasury department to amend its regulations. 231 although the first circuit offered this advice with regard to the regulations relating to 225. id. 226. id. at 31. see also supra note 215. 227. kaufman iii, 687 f.3d at 32. 228. id. (―we do not question the irs‘s concern, transcending this case, that individuals and organizations have been abusing the conservation statute ‗to improperly shield income or assets from taxation‘‖). 229. id. 230. id. (emphasis added). 231. see, e.g., estate of petter v. commissioner, 653 f.3d 1012, 1023–24 (9th cir. 2011) (―[w]e expressly invite[ ] the treasury department to ‗amend its regulations‘ if troubled by the consequences of our resolution of th[is] case.‖) (quoting mayo found. for med. educ. & research v. united states, 131 s. ct. 704, 713 (2011) (quoting united dominion indus., inc. v. united states, 532 u.s. 822, 838 (2001))); scheidelman v. commissioner, 682 f.3d 189, 198 (2d cir. 2012) (―[o]f course, the treasury department can use the broad regulatory authority granted to it by the internal revenue code to set stricter requirements for a qualified appraisal.‖). 2012] tax-deductible conservation easements 289 valuation, the same advice applies with even greater force to the regulations that implement section 170(h)(5)(a)‘s protected-in-perpetuity requirement. as noted in the introduction, the enormous up-front investment in taxdeductible conservation easements will be for naught if the purportedly perpetual protections prove to be ephemeral because government and nonprofit holders are able to release, sell, swap, or otherwise extinguish the easements in disregard of the restriction on transfer, extinguishment, proceeds, and other perpetuity-related requirements. it is not enough that conservation easement donors accurately value the easements, properly substantiate their donations, and satisfy the conservation purposes tests under section 170(h); they must also comply with the critically important protected-in-perpetuity requirements. iv. charting a course carpenter provides significant guidance regarding the meaning of section 170(h)‘s protected-in-perpetuity requirement and the operation of the extinguishment regulation in particular. it tells us that the so-remote-as-tobe-negligible standard in the regulations cannot be invoked to forgive a failure to comply with the extinguishment regulation. it tells us that conservation easements extinguishable by mutual agreement of the parties, even if subject to a standard such as impossibility, fail as a matter of law to comply with the extinguishment regulation. it tells us that the extinguishment regulation provides taxpayers with a guide by which to incorporate the necessary restrictions on extinguishment into a conservation easement deed. and it indicates that tax-deductible conservation easements, which are by definition charitable gifts made for a specific purpose, should be treated as restricted gifts under state law, or ―contributions conditioned on the use of [the] gift in accordance with the donor‘s precise directions and limitations.‖ 232 the confusion carpenter created with respect to the state law doctrine of cy pres is unfortunate, but could be easily remedied by clarifying the doctrine‘s operation in future tax court decisions or at the state court level. the speculation regarding the manner in which tax-deductible easements may be permissibly extinguished is more troubling, as are the circuit court decisions in simmons and kaufman iii, which undermine the irs‘s ability to enforce compliance with the protected-in-perpetuity requirements and open the door to the loss of the federal investment in conservation easements and significant abuse. some donors and holders will heed carpenter‘s advice regarding the extinguishment regulation‘s serving as a guide by which to create the 232. carpenter v. commissioner, 103 t.c.m. (cch) 1001, at 1004 t.c.m. (ria) ¶ 2012-001, at 6 (2012). 290 florida tax review [vol. 13:5 necessary restrictions and will incorporate (or continue to include) provisions tracking the extinguishment and proceeds regulations in their conservation easement deeds. others, however, will draft easements with an eye toward complying with only state statutory or voluntarily adopted extinguishment procedures, or will grant the holder the right to consent to changes to or abandon its rights under the easement, in each case with the goal of retaining maximum flexibility to modify, transfer, release, swap, or otherwise extinguish the easements. accordingly, consistent with the advice of the first circuit, the irs and the treasury department should issue forward looking regulations and other guidance that will provide taxpayers with fair warning regarding how to satisfy the critically important protected-in-perpetuity requirements. some recommendations regarding the development, content, and form of regulatory revisions and other guidance are set forth below. such revisions and other guidance should be designed to ensure that (1) uniform federal rules govern the transfer, amendment, and extinguishment of taxdeductible conservation easements; (2) there is transparency, in that the easements clearly state the manner in which they can be transferred, amended, and extinguished; (3) the terms of the easements addressing transfer, amendment, and extinguishment are standardized, which will facilitate compliance and review, as well as interpretation and enforcement over the long term; and (4) there is assurance that the terms included in the easements to comply with federal tax law requirements are not qualified by other provisions in the deed or by separate agreement and will be legally binding on both parties to the easement under state law. a. irs guidance the irs has already issued some guidance pertaining to the protected-in-perpetuity requirement. as earlier noted, in an irs information letter dated march 5, 2012, the irs confirmed that the contribution of a conservation easement that authorizes swaps other than in in accordance with the extinguishment and proceeds regulations will not be eligible for a federal charitable income tax deduction under section 170(h). 233 in another irs letter dated september 18, 2012, the irs confirmed that, while state law may provide a means for extinguishing a conservation easement for state law purposes, the requirements of section 170(h) and the extinguishment and proceeds regulations must nevertheless be satisfied for a contribution to be deductible for federal income tax purposes. 234 while these letters are helpful, they are unlikely to stop the gamesmanship in the drafting of conservation easements, and some may continue to argue that the extinguishment and 233. see supra note 209. 234. irs information letter (sept. 18, 2012), uil: 170.14-00. 2012] tax-deductible conservation easements 291 proceeds regulations should be viewed as optional, and states, localities, and even holders should be free to adopt their own extinguishment procedures. accordingly, both to help well-intentioned taxpayers comply with the restriction on transfer, extinguishment, and proceeds regulations and to reduce gamesmanship in the drafting of easements, the irs should issue more formal guidance confirming that the provisions of the restriction on transfer, extinguishment, and proceeds regulations are not optional and, instead, represent ―the necessary restrictions‖ on the transfer and extinguishment of tax-deductible conservation easements. the guidance should also ideally include explicitly approved safe harbor clauses, which, if they are incorporated into a conservation easement deed, not qualified by other terms of the easement or by separate agreement, and legally binding on the parties under state law, will ensure satisfaction of the restriction on transfer, extinguishment, and proceeds requirements. 235 such safe harbor clauses and resulting standardization of key provisions of tax-deductible easements would greatly facilitate not only taxpayer compliance but also irs and court review of easement donation transactions. 236 standardization would also promote consistency in the interpretation and enforcement of taxdeductible easements over the long term by state attorneys general and the courts across the fifty states. 237 the guidance should also explain the irs‘s expectation that the terms of tax-deductible easements will be legally binding on the parties under state law. in the words of carpenter, the contributions should be restricted gifts or ―contributions conditioned on the use of [the] gift[s] in accordance with the donor‘s precise directions and limitations.‖ 238 the guidance should explain that if the terms of a conservation easement are not 235. the irs has issued similar guidance in other contexts. see, e.g., rev. proc. 2007-45, 2007-2 c.b. 89 (inter vivos charitable lead annuity trusts); rev. proc. 2007-46, 2007-2 c.b. 102 (testamentary charitable lead annuity trusts). 236. it would, of course, be impossible to standardize conservation easement instruments completely, as each easement, like the property it protects, will be unique in certain respects. moreover, each state has its own rules governing the formalities associated with real estate conveyances. standardization of the provisions relating to the perpetuity requirements in section 170(h) and the regulations, however, is possible and desirable. 237. see mclaughlin, national perpetuity standards, part 2, supra note 5, at 68–69 (explaining that the terms of tax-deductible conservation easements currently vary widely from holder to holder and even donation to donation, and this variability has led to a difficult interpretive task for the irs and state and federal courts). 238. carpenter, 103 t.c.m. (cch) at 1004 t.c.m. (ria) ¶ 2012-001, at 6. 292 florida tax review [vol. 13:5 binding on the parties under state law, the donation of the easement will not be eligible for a deduction under section 170(h). 239 guidance from the irs regarding the expected status of tax-deductible conservation easements as restricted gifts and the legally binding nature of the terms of such gifts under state law would have the added benefit of greatly assisting state attorneys general and state judges, who (as earlier explained) are on the front lines enforcing such gifts on behalf of the public. 240 such guidance would also put other relevant parties, including state legislatures, on notice of what is required if they want property owners in the state to be able to benefit from federal tax incentives for the donation of conservation easements. that is, the restriction on transfer, extinguishment, division of proceeds, and other terms included in easement instruments to satisfy federal tax law requirements must be complied with in addition to any conditions or limitations that may be imposed on the modification, transfer, release, or other extinguishment of conservation easements under the applicable state law. b. rules for amendments in providing forward looking rules addressing the protected-inperpetuity requirement in section 170(h)(5)(a), the irs and the treasury department will need to address the issue of conservation easement amendments. because tax-deductible conservation easements are intended to endure in perpetuity, or for as long as continuing to protect the property for conservation purposes remains possible or practicable, one can reasonably assume that some of these instruments will need to be amended from time to time to respond to changing conditions. the requirements in section 170(h) that a conservation easement be granted in perpetuity and its conservation purpose be protected in perpetuity would appear to establish the basic parameters for a permissible grant of amendment discretion to the holder and property owner. the conservation purpose of an easement would not be protected in perpetuity if the parties have the discretion to amend the easement in ways that adversely impact or change such purpose. on the other 239. see, e.g., supra note 83 and accompanying text (explaining that a state enabling statute might preclude enforcement of terms included in a conservation easement deed to satisfy federal tax law requirements); see supra note 86 and accompanying text (explaining that some holders insist that donors state in the conservation easement that the conveyance is an unrestricted gift in an attempt to render the provisions of the deed not legally binding on the holder). 240. see, e.g., supra note 57 and accompanying text. not surprisingly, the cases to date involving challenges to improper modifications and terminations of conservation easements have taken place in state courts and have not involved the irs. see mclaughlin, national perpetuity standards, part 2, supra note 5, at pt. iii.b. 2012] tax-deductible conservation easements 293 hand, the conservation purpose of an easement would not be jeopardized if the parties have the discretion to agree to only those amendments that further, or are at least consistent with, such purpose. the limited ―amendment clauses‖ typically included in conservation easement deeds reflect this approach; they authorize the holder and property owner to agree to amendments, but only if the amendments are, among other things, consistent with the purpose of the easement. 241 however, determining when an amendment furthers or is consistent with the conservation purpose of an easement, or adversely impacts or changes that purpose, can be difficult. 242 the potential for private benefit and private inurement and loss of the federal investment is particularly high in the context of amendments. 243 some holders use creative labeling to disguise the true nature of the changes they agree to make with regard to taxdeductible conservation easements. 244 and simmons and kaufman iii 241. see supra note 218 and accompanying text. 242. see, e.g., 1 staff of s. comm. on finance, 109th cong., 1st sess., report of staff investigation of the nature conservancy, exec. summary, at, 9 (comm. print 2005), http://finance.senate.gov/ [hereinafter sfc report] (―modifications to an easement held by a conservation organization may diminish or negate the intended conservation benefits, and violate the present law requirements that a conservation restriction remain in perpetuity.‖); id. pt ii, at 5 (expressing concern about ―trade-off‖ amendments, which both negatively impact and further the conservation purpose of an easement but on balance are arguably either neutral with respect to or enhance such purpose, because of the difficulty associated with weighing increases and decreases in conservation benefits as well as private benefit concerns). see also mclaughlin, national perpetuity standards, part 2, supra note 5, at pt. iii.b. (discussing cases involving holders‘ improper amendment of conservation easements). 243. see, e.g., sfc report, supra note 242, pt. ii, at 5 (―the private benefit prohibition aspect of the [amendment] procedure can be a subjective inquiry, with no bright lines available to make the determination‖). the amendment of a conservation easement may increase the fair market value of the encumbered property and thereby confer an impermissible private benefit on the property owner. for example, some organizations reportedly have been amending older conservation easements to update the language and otherwise ―modernize‖ the easements. in some cases, conservation easements that prohibited all commercial uses (and for which tax benefits were granted based, in part, on that prohibition) have been amended to permit commercial uses that are consistent with the purpose of the easement. in such cases, the amendments may have significantly increased the fair market value of the subject properties and, absent compensation to the holder on behalf of the public, conferred an impermissible private benefit on the property owners. 244. see, e.g., mclaughlin, national perpetuity standards, part 1, supra note 16, at 520–23 (describing bjork, 886 n.e.2d 563, appeal denied, 897 n.e.2d 249, in which a land trust characterized the partial extinguishment of a conservation easement in exchange for the protection of other land — a partial swap — as an ―amendment‖); land trust accreditation commission, accreditation 294 florida tax review [vol. 13:5 mistakenly suggest that holders can be granted unlimited rights to consent to changes, at least in the façade easement context. accordingly, rules must be developed to govern amendments and ensure that the federal interest and investment in tax-deductible conservation easements and the conservation values they are intended to preserve in perpetuity are appropriately protected. just what those rules should be is beyond the scope of this article, but for the same fourfold policy reasons discussed in part ii with regard to extinguishment — consistent protection of the federal investment, efficiency, equity, and effectiveness — the amendment of tax-deductible conservation easements should be subject to overarching uniform federal rules that apply in addition to any conditions or limitations that may be imposed on amendments by the applicable state enabling statute or voluntarily adopted by holders. because the issue of amendments is complex, congress should consider requesting that the treasury department, the irs, or one of the taxwriting committees study the issue with the goal of recommending uniform federal rules. 245 the request could, for example, be made in conjunction with extending the enhanced tax incentives available with regard to conservation easement donations. a good starting point for such a study would be the information the irs has gathered thus far from the annual form 990 filings of nonprofit organizations. since 2006, nonprofit organizations holding conservation easements have been required to report the number of conservation easements they modified, transferred, released, or extinguished, in whole or in part, during the tax year and to explain the changes. 246 other sources of information include the senate finance committee‘s report requirements manual: a land trust‘s guide to understanding key elements of accreditation, 69 (may 2012), http://www.landtrustaccreditation. org/storage/downloads/requirementsmanual.pdf (explaining that some organi zations have been characterizing partial and full swaps, which involve the extinguishment in whole or in part of the original easement, as ―amendments‖). recent revisions to the instructions for schedule d to the form 990 are intended to prevent holders from disguising the true nature of changes made to tax-deductible conservation easements; see i.r.s. 2011 instructions for schedule d (form 990) 2, http://www.irs.gov/pub/irs-pdf/i990sd.pdf (―an easement is . . . released, extinguished, or terminated when all or part of the property subject to the easement is removed from the protection of the easement in exchange for the protection of some other property or cash to be used to protect some other property‖ and ―calling an action a ‗swap‘ or a ‗boundary line adjustment‘ does not mean the action is not also a modification, transfer, or extinguishment‖). 245. among the tax-writing committees, the senate finance committee or joint committee on taxation would appear to be best suited to the task given their previous consideration of section 170(h). see supra notes 4 and 242. 246. see i.r.s. 2011 instructions for schedule d (form 990), supra note 244, at 2. 2012] tax-deductible conservation easements 295 following its investigation of the nature conservancy, which examined amendments the conservancy agreed to as well as the organization‘s amendment policies; 247 the land trust alliance‘s 2007 research report on amendments; 248 and a former administration‘s proposal to impose significant penalties on any charity that removes, fails to enforce, or inappropriately modifies a conservation easement, or transfers such an easement without ensuring that the conservation purposes will be protected in perpetuity. 249 the treasury department or the irs should develop a standardized amendment clause to be included in tax-deductible conservation easement deeds that grants the holder and property owner limited discretion to agree to amendments that are consistent with the purpose of the easement. detailed guidance regarding the type of amendments that fall within and outside of that grant of discretion and the required components of the amendment process (e.g., when an appraisal is necessary to assess private benefit) should be provided. and a system of federal oversight or federal requirements should be developed for more complex amendments (including those that are not consistent with the purpose of an easement), as they are the most vulnerable to abuse. more specific instructions regarding the manner in which modifications, transfers, releases, and extinguishments are reported on schedule d of the form 990 should also be provided to assist those filing and reviewing the forms and to minimize confusion and obfuscation. 250 at present, the manner in which these activities are reported (if at all) on the form 990 varies dramatically from organization to organization. 251 the more transparent the reporting process, the more it will discourage inappropriate amendments and terminations and assist federal and state regulators in detecting and preventing abuses. finally, consideration should be given to requiring state and local government entities accepting tax-deductible conservation easements to similarly report annually on their modification, transfer, release, and extinguishment activities as a condition of retaining ―eligible donee‖ status. many state and local government entities acquire and hold tax-deductible 247. see sfc report, supra note 242. 248. see land trust alliance, amending conservation easements, supra note 200. 249. see staff of joint comm. taxation, 109th cong., 1st sess., description of revenue provisions contained in the president‘s fiscal year 2006 budget proposal, 239–41 (comm. print 2005), https://www.jct.gov/publications.html?func=startdown&id=1523. 250. in addition to appropriately categorizing the changes made, holders should be required, for example, to explain how amendments complied with the federal requirements developed as a result of the suggested study, and how any extinguishment complied with the extinguishment and proceeds regulations. 251. the form 990s are available at http://www.guidestar.org. 296 florida tax review [vol. 13:5 conservation easements, but such entities are not required to file form 990s. requiring reporting from such entities would similarly discourage inappropriate amendments and terminations and assist regulators in detecting and preventing abuses. c. revisions to regulations the treasury should consider revising the regulations to, inter alia, clarify the various protected-in-perpetuity requirements and the manner in which taxpayers must comply with those requirements if they expect to benefit from ―six-figure deductions.‖ 252 for example: 1. the regulations could be revised to provide that a deduction shall be allowed for the donation of a conservation easement only if the instrument of conveyance states that the grantor conveyed the easement in whole or in part as a charitable gift for a specific purpose, the grantor intends to claim federal tax benefits as a result of the gift, and the grantor intends that the grantor and grantee (and their successors and assigns) will be legally bound by the terms of the easement. 2. regulation section 1.170a-14(g)(6) could be revised to provide that a deduction shall be allowed for the donation of a conservation easement only if the instrument of conveyance prohibits the grantee (and its successors and assigns) from extinguishing the easement (whether through sale, release, abandonment, swap, or otherwise) except as expressly provided in that regulation. 253 3. regulation section 1.170a-14(c)(1) could be revised to provide that a qualified organization will not be treated as having ―a commitment to protect the conservation purposes of the donation‖ and, thus, will lose its ―eligible donee‖ status if it agrees to modify, amend, sell, swap, release, extinguish, or otherwise transfer tax-deductible conservation easements in contravention of the restriction on transfer, extinguishment, and proceeds requirements and the rules developed to govern amendments. 4. regulation section 1.170a-14(g)(3) (the so-remote-as-to-benegligible regulation) could be revised to clarify that it cannot be invoked to 252. the first circuit noted in kaufman iii that ―[s]ection 170(h) does not allow taxpayers to obtain six-figure deductions for gifts of lesser or no value.‖ kaufman iii, 687 f.3d 21, 30 (1st cir. 2012). equally true is that section 170(h) should not allow taxpayers to obtain six-figure deductions for gifts of conservation easements where the conservation purposes of the easements are not protected in perpetuity. 253. see also mclaughlin, national perpetuity standards, part 1, supra note 16, at 511–12, suggesting that the proceeds regulation be revised to eliminate perverse incentives to extinguish conservation easements. 2012] tax-deductible conservation easements 297 forgive a failure to comply with the specific requirements in section 170(h) and the regulations. 5. the practicalities of obtaining mortgage subordinations could be studied and, depending on the result of the study, the mortgage subordination regulation could be either clarified or modified to appropriately protect the public investment in the event of extinguishment of an easement encumbering property subject to a mortgage. 254 6. safe harbor clauses, examples, and illustrations could be provided to further clarify and facilitate compliance with the rules. d. recommendations of others another possible response to the current conundrum the irs faces in policing conservation easement donation transactions is to simply repeal section 170(h) and replace it with either a direct spending program or a limited budget tax credit program, in each case administered by an expert federal agency. the goal would be to maximize the public benefit obtained from the federal expenditure on conservation easements while minimizing the potential for abuse. harvard law professor daniel halperin recently proposed these reforms. 255 professor halperin formerly served as the treasury department‘s deputy assistant secretary for tax policy and testified on behalf of that department regarding the deduction for conservation easement donations during the congressional hearings preceding the enactment of section 170(h). 256 professor halperin argues that the deduction under section 170(h) is wasteful, inefficient, and subject to abuse. 257 he cites as primary concerns the potential that easements will not be enforced over the long term, the inadequacy of public benefit, overvaluation, and the lack of budget control. 258 he also notes that abuses are likely given that the donor ―retains the benefit of the land subject to the easement and may use it in [ways] that endanger[] the conservation value[s].‖ 259 while professor halperin provides numerous reasons to consider repeal, and the irs‘s difficulties in policing conservation easement donation 254. see supra pt. iii.a. 255. see daniel halperin, a better way to encourage gifts of conservation easements, 136 tax notes 307 (2012) [hereinafter halperin, a better way]. 256. see, e.g., miscellaneous tax bills: hearing, supra note 202, at 3–4 (statement of hon. daniel i. halperin, deputy assistant secretary for tax policy, department of the treasury). 257. halperin, a better way, supra note 255, at 307. 258. id. at 308–11. 259. id. at 307. 298 florida tax review [vol. 13:5 transactions add further fuel to the fire, 260 there is a long history of support for section 170(h) in congress. perhaps in recognition of this, professor halperin also recommends that certain changes be made if the deduction is continued. relevant to this article and the perpetuity requirements, he explains that ―[a]ccurate valuation of the easement at the time of contribution is insufficient if there is inadequate protection of the perpetual easement because of failure to monitor, ignoring violations, amendment of the easement conditions, or otherwise.‖ 261 accordingly, he recommends that eligible donees of tax-deductible easements be limited to organizations that meet rigorous uniform standards, that an excise tax be imposed on officers and directors for non-enforcement, and that a federal agency other than the irs be involved in enforcement. 262 v. conclusion the enormous up-front investment in tax-deductible conservation easements will be for naught if the purportedly perpetual protections prove to be ephemeral because government and nonprofit holders are able to release, sell, swap, or otherwise extinguish the easements in disregard of the restriction on transfer, extinguishment, proceeds, and other perpetuity-related requirements. it is not enough that conservation easement donors accurately value the easements, properly substantiate their donations, and satisfy the conservation purposes tests under section 170(h); they must also comply with the critically important protected-in-perpetuity requirements. carpenter was an important victory for the irs and, by extension, the public, because it provides some key guidance regarding compliance with the protected-in-perpetuity requirements. however, carpenter has also engendered some confusion and speculation, and the circuit court decisions 260. see appendix a, infra (illustrating that the irs has spent considerable time, money, and staff resources on litigation in this context since 2005, but has lost five of the six cases appealed from the tax court to the circuit courts during this time: glass, whitehouse, simmons, scheidelman, and kaufman iii). 261. halperin, a better way, supra note 255, at 313. 262. id. at 307, 313. professor halperin recommends that ―eligible donees‖ be limited to ―large institutions with a large portfolio of easements and resources and motives to enforce the easement[s].‖ id. at 307. however, status as an eligible donee should not depend on the size of the entity or the number of easements it holds. some large institutions with large easement portfolios may be engaged in abusive transactions or operate in disregard of federal tax law requirements and the laws governing the administration of charitable gifts, while some smaller organizations with modest easement portfolios may operate in compliance with the law and perform extraordinary services to the public in their limited geographic area. thus, more refined measure of assessing ―eligible donee‖ status should be developed. 2012] tax-deductible conservation easements 299 in simmons and kaufman iii have compounded the problem by undermining the irs‘s efforts to enforce the protected-in-perpetuity requirements. clear federal rules regarding the transfer, amendment, and extinguishment of conservation easements that are consistent with congressional intent are needed, whether in the form of revisions to the regulations, formal or informal guidance from the irs, or additions to § 170(h). without such rules, the purportedly perpetual protections provided by tax-deductible easements will erode over time and the enormous public investment in these instruments and the conservation values they are intended to protect for the benefit of future generations will be lost. 300 florida tax review [vol. 13:5 appendix a the table below lists the cases to date involving challenges to charitable deductions claimed with respect to conservation easement donations. the cases are listed in the order in which they were issued. however, the date of the donation (or purported donation) is noted in the right-hand column because the law governing the deductibility of conservation easement donations has changed over time and the date of donation may be an important factor in analyzing the relevance of an older case to a current controversy. 263 in particular, section 170(h) was enacted in 1980 and is effective for transfers made after december 17, 1980. among other things, section 170(h) revised the conservation purposes for which tax-deductible easements may be granted and added the protected-in-perpetuity requirement of section 170(h)(5)(a). 264 regulations interpreting section 170(h) were published jan. 14, 1986, and are effective with respect to contributions made on or after december 18, 1980, with several exceptions. 265 263. for the history of section 170(h), see mclaughlin, national perpetuity standards, part 1, supra note 16, at 476–86. 264. thus, for example, stotler v. commissioner, 53 t.c.m. (cch) 973, t.c.m. (p-h) ¶ 87,275, which involved a conservation easement donation made in 1979, should carry no persuasive weight in interpreting the protected-in-perpetuity requirement of section 170(h)(5)(a) or the regulations interpreting that section as that requirement and those regulations were not in effect at the time of the 1979 donation. the d.c. circuit made this mistake in simmons. see supra note 36. 265. see reg. § 1.170a-14(j). the mortgage subordination, division of proceeds, baseline documentation, and donee notification, access, and enforcement rights requirements apply only to donations made after february 13, 1986. see id. §§ 1.170a-14(g)(2), -14(g)(6)(ii), -14(g)(5)(i), -14(g)(5)(ii). the provision requiring a reduction in amount of the donor‘s deduction for any increase in the value of certain property owned by the donor or a related person as a result of the donation (typically referred to as ―enhancement‖) applies only to donations made after january 14, 1986. see id. § 1.170a-14(h)(3)(i). 2012] tax-deductible conservation easements 301 cases listed in order of date of opinion date of donation 1977 thayer v. commissioner, t.c. memo. 1977-370. 1969 1985 todd v. united states, 617 f. supp. 253 (w. d. pa. 1985). 1979 hilborn v. commissioner, 85 t.c. 677 (1985). 1979 1986 stanley works v. commissioner, 87 t.c. 389 (1986). 1977 akers v. commissioner, 799 f.2d 243 (6th cir. 1986), aff’g, t.c. memo. 1984-490. 1977 symington v. commissioner, 87 t.c. 892 (1986). 1979 1987 stotler v. commissioner, t.c. memo. 1987-275. 1979 1988 fannon v. commissioner, 842 f.2d 1290 (4th cir. 1988) (unpublished), modifying, t.c. memo. 1986-572. 1979 losch v. commissioner, t.c. memo. 1988-230 (1988). 1980 richmond v. united states, 699 f. supp. 578 (e. d. la. 1988). 1980 1989 fannon v. commissioner, t.c. memo. 1989-136. 1978 1990 higgins v. commissioner, t.c. memo. 1990-103. 1981 dorsey v. commissioner, t.c. memo. 1990-242. 1981 griffin v. commissioner, t.c. memo. 1989-130. 1981 1991 schapiro v. commissioner, t.c. memo. 1991-128. 1981 & 1984 1992 clemens v. commissioner, t.c. memo. 1992-436. 1982 dennis v. united states, 70 a.f.t.r.2d 92-5946 (e. d. va. 1992). 1980 1993 mclennan v. united states, 994 f.2d 839 (fed. cir. 1993), aff’g 23 cl. ct. 99 (1991). 1980 mclennan v. united states, 994 f.2d 839 (fed. cir. 1993), aff’g, 24 cl. ct. 102 (1991). 1980 1994 schwab v. commissioner, t.c. memo. 1994-232. 1983 302 florida tax review [vol. 13:5 1995 satullo v. commissioner, t.c. memo. 1993-614, aff’d, 76 a.f.t.r.2d 95-6536 (11th cir. 1995). 1985 1997 great northern nekoosa v. united states, 38 fed. cl. 645 (1997). 1981 johnston v. commissioner, t.c. memo. 1997-475. 1989 browning v. commissioner, 109 t.c. 303. 1990 2000 strasburg v. commissioner, t.c. memo. 2000-94. 1993 & 1994 2006 turner v. commissioner,126 t.c. 299 (2006). 1999 ney v. commissioner, t.c. summ. op. 2006-154 (2006). 2001 glass v. commissioner, 471 f.3d 698 (6th cir. 2006), aff’g, 124 t.c. 258 (2005). 1992 & 1993 goldsby v. commissioner, t.c. memo. 2006-274. 2000 2009 bruzewicz v. united states, 604 f. supp. 2d 1197 (n.d. ill. 2009). 2002 hughes v. commissioner, t.c. memo. 2009-94. 2000 kiva dunes v. commissioner, t.c. memo. 2009-145. 2002 herman v. commissioner, t.c. memo. 2009-205. 2003 2010 lord v. commissioner, t.c. memo. 2010-196. 1999 evans v. commissioner, t.c. memo. 2010-207. 2004 2011 schrimsher v. commissioner, t.c. memo. 2011-71. 2004 boltar v. commissioner, 136 t.c. 326 (2011). 2003 1982 east l.l.c. v. commissioner, t.c. memo. 2011-84. 2004 commissioner v. simmons, 646 f.3d 6 (d.c. cir. 2011), aff’g, t.c. memo. 2009-208. 2003 & 2004 didonato v. commissioner, t.c. memo. 2011-153. 2004 herman v. commissioner, t.c. bench op. (sept. 22, 2011). 2003 friedberg v. commissioner, t.c. memo. 2011-238. 2003 2012 carpenter v. commissioner, t.c. memo. 2012-1. 2003 esgar corp. v. commissioner, t.c. memo. 2012-35. 2004 butler v. commissioner, t.c. memo. 2012-72. 2003 & 2004 mitchell v. commissioner, 138 t.c. no. 16 (2012). 2003 dunlap v. commissioner, t.c. memo. 2012-126. 2003 scheidelman v. commissioner, 682 f.3d 189 (2nd cir. 2012), vacating and remanding, t.c. memo. 2010-151. 2004 2012] tax-deductible conservation easements 303 wall v. commissioner, t.c. memo. 2012-169. 2003 averyt v. commissioner, t.c. memo. 2012-198. 2004 kaufman v. commissioner (kaufman iii), 687 f.3d. 21 (1st cir. 2012), vacating and remanding in part, kaufman ii, 136 t.c. 294 (2011) and kaufman i, 134 t.c. 182 (2010). 2003 rothman v. commissioner, t.c. memo. 2012-218, vacating in part, t.c. memo. 2012-163. 2004 trout ranch l.l.c. v. commissioner, 110 a.f.t.r.2d 2012-5621 (10th cir. aug. 16, 2012) (unpublished), aff’g, t.c. memo. 2010-283. 2003 foster v. commissioner, t.c. summ. op. 2012-90 (sept. 11, 2012). 2003 rp golf, l.l.c. v. commissioner, t.c. memo. 2012-282. 2003 whitehouse hotel ltd. p‘ship v. commissioner, 139 t.c. no. 13 (2012), on remand from, 615 f.3d 321 (5 th cir. 2010), vacating and remanding, 131 t.c. 112 (2008). 1997 irby v. commissioner, 139 t.c. no. 14 (2012). 2003 & 2004 florida tax review florida tax review volume 11 2011 number 9 stateless income by edward d. kleinbard∗ abstract .................................................................................................. 700 i. introduction ....................................................................................... 701 a. stateless income......................................................................... 701 b. an illustrative example: the double irish dutch sandwich .... 706 c. overview and conclusions of article ........................................ 713 ii. the current u.s. tax system is an ersatz territorial regime ...................................................................................................... 715 a. worldwide and territorial tax paradigms .............................. 715 b. the current u.s. tax system..................................................... 717 c. revenue collections under the current system ....................... 722 d. arbitrage and domestic base erosion ...................................... 724 e. the tax distillery ...................................................................... 725 iii. stateless income in operation .................................................. 727 a. the value of stateless income tax planning .......................... 727 b. mechanics of stateless income tax planning ......................... 728 1. business earnings stripping ......................................... 728 2. transfer pricing ............................................................ 733 3. legal system arbitrage ................................................. 737 c. how large is stateless income? .............................................. 737 1. cash tax liabilities ...................................................... 737 2. accounting evidence ..................................................... 744 ∗ professor of law, university of southern california gould school of law. i thank william kessler, yungsheng wang and douglas wicks for their research assistance in the preparation of earlier versions of this article. helpful comments on this article were received from rosanne altshuler, joseph bankman, tim edgar, edward mccaffery, martin j. mcmahon, jr., michael knoll, patrick oglesby and daniel shaviro, as well as participants in presentations at the university of florida levin college of law, the university of southern california gould school of law, stanford law school, and the university of pennsylvania law school. the author is solely responsible for all errors of fact, law or economic theory. 700 florida tax review [vol. 11:9 iv. implications of stateless income ............................................. 750 a. the fruitless search for source ............................................... 750 b. capture of “tax rents” ............................................................. 752 c. domestic base erosion through tax arbitrage ....................... 757 d. competiveness of u.s. firms: statutory and effective tax rates ........................................................................................ 758 e. competitiveness of u.s. firms: lock-out ................................. 762 f. summary of implications ........................................................... 768 v. responding to a world imbued with stateless income ....... 770 abstract this paper and its companion, the lessons of stateless income, together comprehensively analyze the tax consequences and policy implications of the phenomenon of “stateless income.” stateless income comprises income derived for tax purposes by a multinational group from business activities in a country other than the domicile of the group’s ultimate parent company, but which is subject to tax only in a jurisdiction that is not the location of the customers or the factors of production through which the income was derived, and is not the domicile of the group’s parent company. google inc.’s “double irish dutch sandwich” structure is one example of stateless income tax planning in operation. this paper focuses on the consequences to current tax policies of stateless income tax planning. the companion paper extends the analysis along two margins, by considering the implications of stateless income tax planning for the reliability of standard efficiency benchmarks relating to foreign direct investment, and by considering in detail the phenomenon’s implications for the design of future u.s. tax policy in this area, whether couched as the adoption of a territorial tax regime or a genuine worldwide tax consolidation system. this paper first demonstrates that the current u.s. tax rules governing income from foreign direct investments often are misapprehended: in practice the u.s. tax rules do not operate as a “worldwide” system of taxation, but rather as an ersatz variant on territorial systems, with hidden benefits and costs when compared to standard territorial regimes. this claim holds whether one analyzes these rules as a cash tax matter, or through the lens of financial accounting standards. this paper rejects as inconsistent with the data any suggestion that current law disadvantages u.s. multinational firms in respect of the effective foreign tax rates they suffer, when compared with their territorial-based competitors. this paper’s fundamental thesis is that the pervasive presence of stateless income tax planning changes everything. stateless income privileges multinational firms over domestic ones by offering the former the 2001] stateless income 701 prospect of capturing “tax rents” — low-risk inframarginal returns derived by moving income from high-tax foreign countries to low-tax ones. other important implications of stateless income include the dissolution of any coherence to the concept of geographic source, the systematic bias towards offshore rather than domestic investment, the more surprising bias in favor of investment in high-tax foreign countries to provide the raw feedstock for the generation of low-tax foreign income in other countries, the erosion of the u.s. domestic tax base through debt-financed tax arbitrage, many instances of deadweight loss, and — essentially uniquely to the united states — the exacerbation of the lock-out phenomenon, under which the price that u.s. firms pay to enjoy the benefits of dramatically low foreign tax rates is the accumulation of extraordinary amounts of earnings (about $1.4 trillion, by the most recent estimates) and cash outside the united states. stateless income tax planning as applied in practice to current u.s. law’s ersatz territorial tax system means that the lock-out effect now operates in fact as a kind of lock-in effect: firms retain more overseas earnings than they profitably can redeploy, to the great frustration of their shareholders, who would prefer that the cash be distributed to them. this tension between shareholders and management likely lies at the heart of current demands by u.s.-based multinational firms that the united states adopt a territorial tax system. the firms themselves are not greatly disadvantaged by the current u.s. tax system, but shareholders are. the ultimate reward of successful stateless income tax planning from this perspective should be massive stock repurchases, but instead shareholders are tantalized by glimpses of enormous cash hoards just out of their reach. i. introduction a. stateless income like happy families, all multinational business enterprises are alike, in at least one critical respect: they all possess a special tax attribute, which is the ability to generate stateless income. by “stateless income,” i mean income derived by a multinational group from business activities in a country other than the domicile (however defined) of the group’s ultimate parent company, but which is subject to tax only in a jurisdiction that is not the location of the customers or the factors of production through which the income was derived, and is not the domicile of the group’s parent company.11 stateless income thus can be understood as the movement of 1. i first used this term in edward d. kleinbard, throw territorial taxation from the train, 114 tax notes 547, 559 (feb. 5, 2007) [hereinafter kleinbard, territorial taxation]. 702 florida tax review [vol. 11:9 taxable income within a multinational group from high-tax to low-tax source countries without shifting the location of externally-supplied capital or activities involving third parties. stateless persons wander a hostile globe, looking for asylum; by contrast, stateless income takes a bearing for any of a number of zero or low-tax jurisdictions, where it finds a ready welcome. as an example, a u.s. firm that sells software in germany earns stateless income when (through mechanisms described below) the added value from the sales to german consumers is taxed in ireland rather than germany. the same analysis would apply to a german firm whose income from sales to u.s. or french customers comes to rest for tax purposes in luxembourg. the ability to generate stateless income is an attribute generally shared by most multinational enterprises, regardless of their parent companies’ domiciles. it is a quality shared in practice by multinational firms domiciled in the united states (the last redoubt of putative worldwide taxation of income from foreign direct investments) and those domiciled in jurisdictions with “territorial” tax regimes. it is an attribute not available to wholly domestic firms. the phenomenon of stateless income is not the same as the phenomenon of capital mobility. as traditionally understood, capital mobility involves a person’s ability to locate real investments or third-party activity with a view to minimizing the tax burden imposed thereon; it is “the elasticity of supply of a location-denominated factor with respect to its net [after-tax] reward in that location.”2 the phenomenon of stateless income, by contrast, comprises the movement of taxable income within a multinational group without shifting any location-dependent factor supplied by third parties. the straightforward application of optimal tax theory to the phenomenon of actual capital mobility leads, for example, to the policy recommendation that a small open economy should not impose any tax on returns to imported capital; this recommendation reflects a coherent theory in which efficient global markets lead to identical after-tax returns on business income, wherever situated.3 stateless income tax planning, by contrast, is the domicile of a multinational enterprise’s ultimate parent company is referred to in the literature as the “residence” country. a country other than the residence country in which a multinational group derives business or investment income is referred to as the “source” country. 2. joel slemrod, location, (real) location, (tax) location: an essay on mobility’s place in optimal taxation, 63 nat’l tax j. 843, 844 (2010). slemrod points in the direction of stateless income with his concept of “tax mobility;” this article argues that stateless income is an even more pervasive phenomenon than slemrod’s paper might suggest. 3. george r. zodrow, capital mobility and capital tax competition, 63 nat’l tax j. 865, 881 (2010). 2001] stateless income 703 divorced from actual market transactions; it undercuts the functions of markets in setting market–clearing after-tax returns on capital investments, by offering advantageously–situated multinational enterprises the opportunity to earn what this article calls “tax rents.” stateless income is an inevitable by-product of fundamental international income tax norms, like the recognition of the separate tax personas of different juridical persons, even when they are commonly owned, or the general practice of treating interest on indebtedness as deductible to the payor.4 those particular norms enable “earnings stripping” — the extraction of pretax earnings from a source country through taxdeductible payments to offshore affiliates. one example of earnings stripping is capitalizing one group subsidiary located in a low-tax country with equity, and then causing that subsidiary to lend its capital to an affiliate in a high-tax country. the widely-shared tax norms on which stateless income relies also encompass, for example, a multinational enterprise’s relative freedom under consensus “transfer pricing” rules5 to deal with a subsidiary as if it were an independent actor, or to treat the subsidiary’s capital (furnished by the parent) as if that capital were separate from the parent’s assets for purposes of measuring the business risks undertaken by the subsidiary (and therefore the share of group income properly attributable to the subsidiary).6 similarly, 4. see, e.g., richard j. vann, taxing international business income: hardboiled wonderland and the end of the world, 2 world tax j. 291, 322–23 (2010) [hereinafter vann, hard-boiled wonderland] (noting that the principle of “freedom of contract” among affiliated companies in a multinational group is inherently inconsistent with the theory of the firm explanation for the prevalence of multinational enterprises). these norms are summarized through the prism of the organization for economic cooperation and development (“oecd”) model convention in markus leibrecht and thomas rixen, double tax avoidance and tax competition for mobile capital, in international tax coordination: an interdisciplinary perspective on virtues and pitfalls, 61, 63–71 (martin zagler ed., 2010). 5. “transfer pricing” rules refer to the terms under which the affiliated members of a multinational group should be viewed as dealing with each other for purposes of determining the income of each member of the group. 6. the oecd, a supranational organization comprised of 33 member states, including the united states and many other developed economies, publishes extensive guidance on the taxation of multinational businesses representing the consensus views of its members. it has recently published comprehensive guidance on transfer pricing issues in international tax administration. oecd transfer pricing guidelines for multinational enterprises and tax administrations (2010) [hereinafter oecd guidelines]. the oecd guidelines emphatically reject the idea of approaching the taxation of a multinational group of companies by ignoring the separate juridical 704 florida tax review [vol. 11:9 those norms contemplate that a multinational enterprise can situate economic rents attributable to unique business opportunities in low-tax countries, because pure business opportunities generally are not regarded as subjects of transfer pricing analysis in the first instance.7 existence of subsidiaries and apportioning group income to worldwide activities on a “formulary apportionment” basis: [t]he the arm’s length principle follows the approach of treating the members of an mne group as operating as separate entities rather than as inseparable parts of a single unified business. because the separate entity approach treats the members of an mne group as if they were independent entities, attention is focused on the nature of the transactions between those members and on whether the conditions thereof differ from the conditions that would be obtained in comparable uncontrolled transactions. id. at 33. the oecd guidelines continue: oecd member countries reiterate their support for the consensus on the use of the arm’s length principle that has emerged over the years among member and non-member countries and agree that the theoretical alternative to the arm's length principle represented by global formulary apportionment should be rejected. id. at 41. for a comprehensive critique of the arm’s-length principle as applied to intangible assets (the most important class of assets in modern transfer pricing disputes), see yariv brauner, value in the eye of the beholder: the valuation of intangibles for transfer pricing purposes, 28 va. tax rev. 79, 96–104 (2008) [hereinafter brauner, value in the eye of the beholder]. 7. hospital corp. of am. v. commissioner, 81 t.c. 520 (1983). the case involved, inter alia, the application of section 367, which imposes a “toll charge” on the outbound transfer from the united states of certain appreciated property, including intangible assets (for which a special regime exists under section 367(d)). in hospital corp., the u.s. taxpayer presented a newly-formed foreign affiliate with an opportunity to enter into a lucrative contract to manage an overseas medical facility owned by an unaffiliated group. id. at 532. the court in hospital corp. found that section 367 was not implicated by the arrangement, because the “opportunity to contract” did not constitute “property” to which section 367 might apply. id. at 589–90. the court did conclude, however, that seventy-five percent of the net income of the foreign affiliate was attributable to the u.s. taxpayer under the principles of section 482. id. at 301–02. the internal revenue service non-acquiesced as to the decision, but noted that “the tax court’s finding that ‘opportunity to contract’ was not property is not clearly erroneous.” see action on decision 1987-2 c.b. 1, 1, 2 n.22 (oct. 26, 1987). in the same vein, the oecd guidelines appear to take the position that a business opportunity is not a tax-cognizable intangible asset to which transfer pricing rules might apply. oecd guidelines, supra note 6, at 191–93 (defining commercial intangible assets subject to transfer pricing scrutiny as comprising trade and marketing intangibles, neither of which in turn is defined as including the simple right to pursue a lucrative opportunity), 256–67 (“the arm’s length principle does not require compensation for a mere decrease in the expectation of an entity’s future profits. when applying the arm’s length principle to business restructurings, the 2001] stateless income 705 stateless income also flourishes because of nations’ collective failure to agree on other critical international tax norms that would determine the “source” of income — that is, the mechanical rules by which income is attributed to one jurisdiction or another, based on the perceived economic contribution in that jurisdiction to the generation of that income. this failure reflects the fundamental commercial and economic ambiguity surrounding the locus of the value added through the exploitation of intangible assets. the consequences of this failure in turn are exacerbated by aggressive transfer pricing strategies. as the earlier examples of income stripping demonstrate, however, stateless income tax planning encompasses more than the exploitation of the collective failure to develop binding normative source rules for income derived from intangible assets. and as this article demonstrates, whatever first-order coherence in the definition of the source of income might exist in turn is vitiated when stateless income tax planning is layered on top of basic sourcing principles, because that planning can take income originally “booked” in an economically-rational jurisdiction and in a second, separate step move that income to another, lower-taxed jurisdiction. multinational firms thus get at least two bites at the stateless income generation apple. first, they can rely on the norms of freedom of contract within the group, the purportedly arm’s-length nature of arrangements reached by a parent company and its wholly-owned subsidiary (freshly capitalized by the parent), and ambiguities in the international consensus rules surrounding the source of returns to intangible assets to situate in a lowtax jurisdiction returns from factors most plausibly situated in high-tax countries (e.g., sales to local customers).8 second, multinational firms can use “earnings stripping” strategies to move income tentatively situated in a jurisdiction with the most plausible claim to be the source of that income to another (low-tax) jurisdiction, typically through the creation of an item of intragroup deduction/income inclusion (e.g., intercompany interest, rents, or royalties). that second stage earnings stripping strategy need not have any nexus to the generation of the income. because the generation of stateless income relies on norms woven deep into the warp and woof of virtually every tax system, it is not possible to understand the consequences of a country’s system for taxing income from question is whether there is a transfer of something of value (rights or other assets) or a termination or substantial renegotiation of existing arrangements . . . .”), 266–67 (distinguishing the case of an indirect transfer of long-term customer contracts). see also lee a. sheppard, tax officials contemplate bleak future for corporate tax base, 129 tax notes 169, 170 (oct. 11, 2010) [hereinafter sheppard, tax officials] (“significantly, the oecd[] . . . says that a transfer of a business opportunity or profit potential is not a transfer of a cognizable asset requiring compensation.”); vann, hard-boiled wonderland, supra note 4, at 326 (oecd guidelines appear to countenance that risk may be assigned within a group at will). 8. see, e.g., vann, hard-boiled wonderland, supra note 4, at 313–43. 706 florida tax review [vol. 11:9 foreign direct investments without appreciating the first-order importance of stateless income tax planning. when unchecked, stateless income strips source countries (including the united states as the location of subsidiaries of foreign-controlled groups) of the tax revenues attributable to income generated in those jurisdictions. its availability also distorts the investment decisions of multinational firms, and under current u.s. rules distorts a u.s. multinational firm’s decision whether to repatriate that stateless income back to the united states. the phenomenon of stateless income is closely allied with the problem of residence country base erosion, principally through aggressive transfer pricing strategies.9 as used in this article, however, the term is reserved for strategies to reduce high-tax source country income. nonetheless, the policy recommendations made by this article respond to both issues, for two reasons. first, the technologies employed in source and residence country base erosion overlap. second, the article’s ultimate goal of outlining a coherent approach to cross-border taxation in light of the stateless income phenomenon implicates the familiar question of whether that proposed approach distorts investment decisions as between source and residence countries. b. an illustrative example: the double irish dutch sandwich the phenomenon of stateless income risks appearing vague, and its analysis tedious. recent news stories on the internal tax planning of u.s. firms like microsoft, forest laboratories and google, however, have injected needed drama to the narrative, by providing useful insights into how firms generate stateless income in practice.10 this section uses google inc.’s 9. examples of recent papers emphasizing how current arm’s-length transfer pricing rules invite the erosion of residence country tax revenues include yariv brauner, cost sharing and the acrobatics of arm’s length taxation, 38 intertax 554 (2010) [hereinafter brauner, cost sharing], and harry grubert, foreign taxes, domestic income, and the jump in the share of multinational company income abroad: sales aren’t being globalized, only profits (dec. 7, 2009), http://web.gc.cuny.edu/economics/seminarpapers/spring2010/grubert_march16.pdf [hereinafter, grubert, foreign taxes and domestic income]. 10. richard waters, tax drives us tech groups to tap debt, financial times, feb. 6, 2011, p. 15 col. 6 (microsoft); jesse drucker, u.s. companies dodge $60 billion in taxes with global odyssey, bloomberg, may 13, 2010, http://www.bloomberg.com/news/2010-05-13/american-companies-dodge-60-billion -in-taxes-even-tea-party-would-condemn.html (forest laboratories); jesse drucker, google 2.4% rate shows how $60 billion lost to tax loopholes, bloomberg, oct. 21, 2010, http://www.bloomberg.com/news/2010-10-21/google-2-4-rate-shows-how60-billion-u-s-revenue-lost-to-tax-loopholes.html (google). in the same vein, microsoft’s very recent announcement of plans to acquire skype software s.a.r.l. (a 2001] stateless income 707 “double irish dutch sandwich” structure to illustrate how stateless income tax planning relies on deeply embedded global tax norms, and how it operates to disassociate taxable income from any connection with any location in which the value-adding activities that generated that income could plausibly be said to lie.11 the same story (in a number of cases, literally so, because the double irish dutch sandwich is an easily-replicable staple of current stateless income tax planning) could be told of many other u.s. multinational firms.12 in 2003, a few months before its initial public offering, google inc. entered into a cost sharing agreement with a newly-organized wholly-owned irish subsidiary, google ireland holdings (“ireland holdings”), under which ireland holdings acquired the rights to google inc.’s search and advertising technologies and other intangible property for the territory comprising europe, the middle east, and africa (“emea”). google commenced its irish operations in 2003 with five employees.13 ireland holdings made an undisclosed “buy-in” payment for rights to the google technologies as they then existed, and further appears to have agreed pursuant to a “cost sharing agreement” to bear future development costs in proportion to the size that the emea market bore to the worldwide luxembourg-based company) has been explained as a tax-efficient use of the firm’s vast hoard of offshore cash. see zaid jilani, microsoft structured acquisition of skype to avoid u.s. taxes, http://thinkprogress.org/ 2011/05/13/microsoft-skypetax-havens/ [hereinafter jilani, microsoft structured acquisition]. 11. the facts that follow are drawn principally from jesse drucker, google 2.4% rate shows how $60 billion lost to tax loopholes, bloomberg, oct. 21, 2010, http://www.bloomberg.com/news/2010-10-21/google-2-4-rate-shows-how-60billion-u-s-revenue-lost-to-tax-loopholes.html [hereinafter drucker, google 2.4% rate] as supplemented by inferences drawn from joseph b. darby iii and kelsey lemaster, double irish more than doubles the tax saving: hybrid structure reduces irish, us and worldwide taxation, 11 practical u.s./int’l tax strategies 2 (2007) [hereinafter darby & lemaster, double irish]. since google’s tax planning is not transparent to outside observers, it is possible that there are some slight mischaracterizations of details in the text, but these would not change the thrust of the points made therein. 12. as one example roughly contemporaneous with google’s double irish dutch sandwich, see jeffrey l. rubinger & william b. sherman, holding intangibles offshore may produce tangible tax benefits, 106 tax notes 938 (feb, 21, 2005), proposing a complex structure involving norwegian companies to achieve comparable results. 13. angus kelsall, dublin go bragh, google blog (oct. 6, 2004), http://googleblog.blogspot.com/2004/10/dublin-go-bragh.html (“a year ago, dublin became the first location for google’s regional operations outside the u.s. we designed it to serve google customers across multiple time zones and languages spanning europe, the middle east and africa. there were just five of us in 2003. today we’ve built a team of 150. . . .”). 708 florida tax review [vol. 11:9 market for those technologies.14 as a practical matter, that buy-in payment likely reflected in part the then-market capitalization of google (which in turn would have been a good proxy for the value of its intangible assets); that value in turn presumably was much smaller than the value that might have been inferred post-ipo.15 regardless, in 2006 google eventually negotiated an advance pricing agreement with the internal revenue service that accepted the bona fides of the 2003 buy-in payments for the then-existing intangibles; the terms of the advance pricing agreement (like all such agreements) are not public. the google structure immediately after entering into the cost sharing agreement can be represented schematically as follows: 14. for a brief summary of cost sharing agreements, see staff of the joint comm. on tax’n, present law and background related to possible income shifting and transfer pricing (jcx-37-10) 25–29, 111–14 (2010) [hereinafter jct, income shifting and transfer pricing]. veritas software corp. v. commissioner (symantec), 133 t.c. 297 (2009), offers an important window into how cost sharing agreements actually were constructed at times proximate to the formation of ireland holdings. in veritas, the tax court accepted as correct the $118 million dollar cost-sharing “buy-in” payments made by an irish subsidiary of a u.s. parent company beginning in 1999 against a challenge by the internal revenue service that the correct number for the buy-in payment was $1.675 billion. see id. at 315–16. for brief summaries, see, e.g., kerwin chung, cindy hustad, & alan shapiro, tax court rejects irs’s costsharing buy-in analysis, 125 tax notes 1343 (dec. 21, 2009); stephen blough, charles cope, & thomas zollo, veritas vincit, 126 tax notes 839 (feb. 15, 2010). more recently the internal revenue service announced that it would not appeal the veritas decision. cindy hustad and alan shapiro, irs decides not to appeal veritas; action on decision issued, 129 tax notes 1342 (dec. 20, 2010). the relevant treasury regulations covering cost sharing arrangements were revised in 2009; the new regulations arguably give the internal revenue service more scope to insist that buy-in payments like those at issue in veritas must take notice of the value of transferred “platform” intangibles as a long-lived continuing foundation that gives incremental value to subsequent research and development work. 15. there is no publicly-available information on the size or calculation of the buy-in payment or on the operations of ireland holdings before the cost sharing agreement was entered into; the text’s description relies on the author’s general experience and conversations with market professionals, and therefore may not strictly comport with google’s actual case. the author believes, however, that the presentation is a fair summary of practice in this area in general. 2001] stateless income 709 in a sense, the most remarkable aspect of the entire structure is contained in this schematic. it is the ready acceptance by countries of the fantastic notions that (i) a wholly-owned subsidiary has a mind of its own with which to negotiate “arm’s-length” contractual terms with its parent, (ii) capital provided to the subsidiary by the parent somehow becomes the property of an independent actor (the subsidiary) with which it can take business risks that for tax purposes are not simply assimilated into those borne by the parent (as both provider of the capital and ultimate economic owner of the assets acquired therewith), and (iii) a multinational enterprise that exists as a global platform to exploit a core set of intangible assets best is analogized to wholly independent actors taking on limited and straightforward roles in a vertical chain of production or a horizontal array of distribution of a product. the second and third of these notions in particular transcend the question of transfer pricing — in the second case, because of the international tax norm that equity owners are not required to include in income any minimum current return on their investment, and in the third case, because the global assets and synergies that a multinational group exploits are attributes of the group as whole, not any one member. within a few years, the structure had morphed. first, ireland holdings had become a dual resident company: that is, for u.s. tax purposes it remained an irish corporation (because that is its place of incorporation), but for irish tax purposes ireland holdings became a resident of bermuda (because that is where its “mind and management” are centered). second, ireland holdings had put the emea rights to the core technologies to work by licensing them to a subsidiary organized as a dutch company (“google bv”), which in turn had licensed the rights to a lower-tier subsidiary, google ireland limited (“ireland limited”). ireland limited licenses the technologies throughout the 710 florida tax review [vol. 11:9 emea territories, and collects billions of dollars of advertising revenues from the use of those technologies. presumably, each of google bv and ireland limited has “checked the box”16 — that is, has made a special election relevant only for purposes of u.s. tax law not to be characterized as a corporation. because each has a single owner and has elected not to be regarded as a corporation for u.s. tax purposes, each is treated as a disregarded entity — a “tax nothing” — for u.s. purposes, but continues as a juridical person for all non-u.s. tax purposes. here one can see another fantastic element of international tax planning. by virtue of a simple tax return election a company can disappear from view for purposes of u.s. tax law, while remaining relevant for purposes of all other fiscal systems, thereby facilitating a host of tax system arbitrage opportunities. ireland limited today employs about 2,000 employees; it is not clear how many of them are engaged in the sale and marketing of google products in the emea territory, and how many are working as engineers in the development of extensions of those technologies.17 technically, it is possible for a foreign subsidiary to perform its obligations under a cost sharing agreement by hiring affiliates to do the actual work, using capital provided 16. treas. reg. § 301.7701-3(b)(2). that is the structure proposed in darby and lemaster, double irish, supra note 11. like all federal income tax return materials, “check-the-box” filings are not publicly available. 17. in a 2008 video interview, john herlihy, the manager of google ireland, described google’s irish operations as the second largest google office in the world. at the time, google ireland employed 1350 employees, of whom 900 worked in the “online [sales] team,” 250 “on the technology side,” and 200 apparently in corporate support type functions for the emea operations. interview with john herlihy, v.p. online sales, e,ea, google, http://www.youtube.com/watch?v=pyzsllmqz xm&nr=1&feature=fvwp (last visited may 19, 2011). google describes its irish operations this way: what we do in dublin is help millions of google users and customers right across europe, the middle east, and africa (emea) to get the most from our products. google’s dublin office is the emea operations headquarters. that means we support everyone who uses our products: the search engine that we are most known for, plus consumer products like gmail and calendar, advertising products like adwords and adsense, right through to business solutions for major corporations. in dublin we also build on our existing products and create new ones, employing some of the finest engineering talent in the world. many of the dublinbased teams are engaged in supporting other google offices across the emea region, working in areas like finance, payroll, legal, and hr. google dublin, http://www.google.ie/intl/en/jobs/dublin/ (last visited may 20, 2011). http://mail.google.com/mail/help/intl/en-gb/about.html http://www.google.ie/googlecalendar/overview.html https://adwords.google.com/select/login https://www.google.com/adsense/login/en_ie/ 2001] stateless income 711 by the parent to pay those affiliates until it generates its own revenues. again, one sees at work the fantastic idea that a subsidiary has both capital and an appetite for risk that can be separated from those of its parent.18 the structure now can be summarized in this illustration: now the full stateless income generation machine can be seen. income earned from the use of the google intangibles by customers (or, to the extent relevant, affiliates) in high-tax countries streams directly to ireland limited as a component of ireland limited’s advertising fees, without bearing source-country tax, because the fees paid are deductible in the source 18. treasury regulations governing cost sharing agreements were revised in 2008 to adopt the “investor model” of arm’s length pricing. treas. reg. § 1.482-7t (as amended by t.d. 9441, 2009-7 i.r.b. 460). this model emphasizes the idea that an affiliate that contributes only cash to a cost sharing agreement built around existing high-value intangible assets should make buy-in payments that leave the affiliate with only a normal return on its operations. jct, income shifting and transfer pricing, supra note 14, at 25–29, 111–14. but the regulations do not reject the idea of a “cash box” subsidiary participating in a cost sharing agreement in the first instance, and might be expected only to lead to transfers of intangible assets at a somewhat earlier stage of development. moreover, “cash box” subsidiaries can contract with and license intangible assets from their u.s. parent; those transactions are not ignored for u.s. tax purposes. id. at 115–16. 712 florida tax review [vol. 11:9 country.19 while much of ireland limited’s income presumably comes directly from third-party customers in the emea region, the same sort of structure can be used to strip out income from local affiliates that in turn serve local customers and then to move that income to ireland. the net effect in either case is that income from the exploitation of the google intangibles throughout the emea region is taxed only in ireland. ireland imposes a 12.5 percent corporate income tax on irish resident companies; ireland limited therefore is subject to that tax rate on its net income, but ireland limited makes very large deductible royalty payments to google bv for the use of the core google intangibles originally transferred in 2003 (and since extended by investments made under the internal cost sharing agreement). google bv in turn makes royalty payments almost exactly as large to ireland holdings. the latter is a bermuda company from an irish perspective, and bermuda has no corporate income tax. google bv exists because royalties paid directly from an irish company to a bermuda company (that is, from ireland limited to ireland holdings) would be subject to an irish withholding tax.20 that tax does not apply to royalties paid to a company resident in an eu member state, even one that is an affiliate and that apparently serves no purpose but the elimination of irish withholding tax. the netherlands does not impose withholding tax on the outbound royalties paid to ireland holdings, and contents itself with collecting a small tax (essentially a fee for the use of its tax system) on the modest “spread” between the royalties google bv receives and those it pays on to ireland holdings. it is normal in dutch tax practice to negotiate this sort of spread in advance with the dutch tax authorities. meanwhile, from a u.s. tax point of view, neither ireland limited nor google bv exists at all. the united states sees only an irish (not bermuda) company (irish holdings) with a bermuda branch, where most of its net income comes to rest. the end result is a near-zero rate of tax on income derived from customers in europe, the middle east, and africa that is attributable to the high-value intangibles that encompass the bulk of 19. whether the fees are characterized as paid in respect of the provision of advertising services or as licensing fees for the use of the google platform is a technical issue whose resolution is irrelevant to this simple narrative. within the european union in particular member states cannot impose source-country withholding tax on royalties paid to a company resident in another state. moreover, ireland has a good tax treaty network whose treaties often reduce the tax rate on royalties paid between firms in the two treaty countries to zero. 20. darby and lemaster do not discuss the role of the dutch firm, either because the authors viewed it as a proprietary twist on the basic “double irish” idea or because it had not yet come into vogue. darby & lemaster, double irish, supra note 11. the article by drucker does discuss it. drucker, google 2.4% rate, supra note 11. 2001] stateless income 713 google’s economic factors of production, and a very low rate of tax on returns attributable to the services of google’s irish-based sales force. this stateless income generation machine is referred to as a “double irish” structure because of the use of the two irish firms; the “dutch sandwich” sobriquet follows from the insertion of google bv as a sort of tax filler between the two irish firms. importantly, the structure is easily replicable by others (and in fact has been reported to be in widespread use among u.s. technology firms);21 there is nothing in the structure that relies on any unique business model or asset of google’s. from the point of view of sophisticated u.s. multinational firms, this arrangement is simply one tool among many in the stateless income planning toolkit. c. overview and conclusions of article this article accepts as an arbitrary postulate the existence of a corporate income tax that in fact is meant to burden corporate income in some coherent fashion. the article asks the question, how does the pervasive phenomenon of stateless income affect the operation of that tax today? the article’s answer is that the pervasive presence of stateless income tax planning changes everything. as the example of google’s double irish dutch sandwich structure implies, it destroys any possible coherence to the concept of the geographic source of income, on which all territorial tax systems rely. it erodes the tax base of high-tax countries in which multinational firms are domiciled through debt-financed tax arbitrage. it privileges multinational firms over domestic ones by offering the former the prospect of capturing what the article terms “tax rents” — low-risk inframarginal returns derived by moving income from high-tax foreign countries to low-tax ones. and since the costs required to accomplish it create noting of economic value, it leads to deadweight loss. the article presents a comprehensive picture of the role of stateless income in international tax planning, in contrast to existing literature’s tendency to focus on a series of discrete problems. the article demonstrates why the eradication of stateless income in the field is a highly implausible scenario. finally, the article considers the policy implications of stateless income tax planning for the design of tax systems. section ii of this article briefly reviews the current u.s. tax system for taxing the returns to corporate foreign direct investment. beyond a recitation of these rules and principles, section ii argues that the current u.s. tax rules governing income from foreign direct investments often are misapprehended. in practice the u.s. tax rules do not operate, as many presentations suggest, as a “worldwide” system of taxation, but rather as an 21. drucker, google 2.4% rate, supra note 11. 714 florida tax review [vol. 11:9 ersatz variant on territorial systems, with hidden benefits and costs when compared to standard territorial regimes. section iii demonstrates how the current u.s. tax system, which purports to tax the worldwide income of u.s.-resident multinational firms, in fact, affords those firms the opportunity to operate in a quasi-territorial tax environment and to earn stateless income in the same manner that their territorial-based competitors do. section iii continues by reviewing available “cash” tax and financial accounting data to demonstrate that u.s.-based multinational firms today enjoy this favorable attribute. section iv considers the policy implications of stateless income tax planning for current income tax systems. when viewed from the perspective of u.s. tax policy, those implications include the dissolution of any coherence to the concept of geographic source, the systematic bias toward offshore rather than domestic investment, the more surprising bias in favor of investment in high-tax foreign countries to provide the raw feedstock for the generation of low-tax foreign income in other countries, the erosion of the u.s. domestic tax base through debt-financed tax arbitrage, many instances of deadweight loss, and — essentially uniquely to the united states — the exacerbation of the lock-out phenomenon, under which the price that u.s. firms pay to enjoy the benefits of dramatically low foreign tax rates is the accumulation of extraordinary amounts of earnings (roughly $1.4 trillion, by the most recent estimates22) and cash outside the united states. section iv explains how stateless income tax planning enables multinational firms to capture “tax rents.” in brief, if one accepts the premise that after-tax returns on business income converge on a single worldwide level, then pre-tax returns must diverge, with commensurately higher pre-tax returns in high-tax countries.23 stateless income tax planning permits multinational firms to earn high-tax country pre-tax returns and then to migrate those to a low-tax jurisdiction, thereby capturing supranormal returns. one policy implication that section iv rejects as inconsistent with the data is that current law disadvantages u.s. multinational firms in respect of the effective foreign or aggregate tax rates they suffer when compared with their territorial-based competitors. whether those tax burdens are measured by reference to actual cash taxes paid, or to the financial accounting statements that are the lens through which shareholders and other stakeholders view publicly-held firms, many u.s. multinational firms today enjoy global effective tax rates closely comparable to those enjoyed by foreign-based competitors. indeed, the most adroit u.s. firms have been so extraordinarily successful in stateless income tax planning that they have 22. j.p. morgan & co., north american equity research, u.s. equity strategy flash (june 27, 2011). 23. see infra part iv.b. 2001] stateless income 715 become hoist on their own petard. they have removed so much income from their tax bases in both the united states and in high-tax foreign jurisdictions, that they now are running out of remotely feasible ways of reinvesting the huge sums accumulating in their low-tax subsidiaries. stateless income tax planning as applied in practice to current u.s. law’s ersatz territorial tax system means that the lock-out effect now actually operates as a kind of lock-in effect: firms retain more overseas earnings than they profitably can redeploy, to the great frustration of their shareholders, who would prefer that the cash be distributed to them. this tension between shareholders and management likely lies at the heart of current demands by u.s.-based multinational firms that the united states adopt a territorial tax system. the firms themselves are not greatly disadvantaged by the current u.s. tax system, but shareholders are. the ultimate reward of successful stateless income tax planning from this perspective should be massive stock repurchases, but instead shareholders are tantalized by glimpses of enormous cash hoards just out of their reach. a companion paper to this article, the lessons of stateless income, picks up the analysis at this point; its themes are briefly described in section v. the lessons of stateless income considers the consequences of a world imbued with stateless income for the efficiency norms by which international tax proposals are judged, and then analyzes how one might go about developing a new international tax system that would address the idiosyncratic lock-out effect, that would be robust to stateless income tax planning, that would offer u.s. firms a reasonably pro-competitive international business environment, and that would protect u.s. tax revenues. ii. the current u.s. tax system is an ersatz territorial regime a. worldwide and territorial tax paradigms the usual point of departure in debating the design of systems to tax corporate income derived from foreign direct investment is to contrast worldwide and territorial solutions. “foreign direct investment” is itself a term of art, and one not actually used in most tax codes. the u.s. tax term for a foreign subsidiary is a “controlled foreign corporation.”24 tax laws also 24. i.r.c. § 957(a) (definition). technically, a controlled foreign corporation is a foreign corporation in which “united states shareholders” own more than 50 percent of the voting power or value of the stock of that corporation. id. a “united states shareholder” is defined by section 951(b) as a “united states person” (as defined in section 957(c)) that owns 10 percent or more of the voting power of the stock of the controlled foreign corporation (employing the complex indirect and constructive ownership rules of section 958). 716 florida tax review [vol. 11:9 often treat income derived by a foreign company in which a parent holds a significant non-controlling stake (e.g., five or ten percent) as income from foreign direct investment.25 a true worldwide system would consolidate the operations of foreign subsidiaries with those of the parent company for tax purposes, so that (for example) foreign losses could offset domestic income. (as described below, the united states, although often described as a worldwide system, does not allow this.) to avoid double taxation, worldwide systems invariably are paired with the availability of foreign tax credits; these are dollar-for-dollar credits against the tentative income tax owed on worldwide income for the foreign taxes that the group has incurred to earn its foreign income. the standard counterpoint to a worldwide system for taxing income from foreign direct investment is a territorial tax system, which is understood to mean a system under which the country in which the parent company of the group is domiciled (the residence country) forgoes any claim to tax source country earnings — that is, the active foreign business earnings of foreign subsidiaries or branches of the parent company. because source country tax is a final tax, territorial tax systems do not employ a foreign tax credit. every major country other than the united states today relies principally on a territorial system to tax the active business earnings of a multinational enterprise’s foreign subsidiaries. 25. france and the netherlands, for example, offer resident firms a “participation exemption” from corporate tax for foreign shareholdings of at least five percent. code général des impôts (general tax code), art. 145 (fra.); wet op de vennootschapsbelasting 1969 (corporate income tax law of 1969), art. 13 (neth.). and, as noted in the preceding footnote, the u.s. internal revenue code uses a 10 percent threshold to define a “united states shareholder;” that shareholder need not have a controlling interest in a foreign firm. similar definitions of “foreign direct investment” apply in standard presentations of international investment stock and flow data. for example, the u.s. commerce department’s bureau of economic analysis (bea) defines a foreign “affiliate” as a foreign enterprise in which a u.s. firm has at least a 10 percent ownership interest (measured by voting power, which is assumed to equal profits interests). raymond j. mataloni, jr. u.s. bureau econ. analysis, a guide to bea statistics on u.s. multinational companies, 75 survey current bus. 38, 39, 41 n.8 (1995). a foreign affiliate that is more than 50 percent owned by a u.s. entity or entities is referred to as a “majority owned foreign affiliate.” id. at 44. the international monetary fund (imf) also follows a ten percent rule for defining “foreign direct investment.” imf statistics dep’t, coordinated direct investment survey guide, (2010), http://www.imf.org/external/np/sta/cdis/pdf/ 2009/120109.pdf. the united states is in the process of aligning its data collection and presentation with the recommendations of the imf. see kristy l. howell & robert e. yuskavage, modernizing and enhancing bea’s international economic accounts: recent progress and future directions, 90 survey current bus. 6 (2010), http://www.bea.gov/scb/pdf/2010/05%20may/0510_modern.pdf. 2001] stateless income 717 countries that rely on a territorial tax model for foreign direct investment generally do not treat interest and royalty income paid by a foreign subsidiary to its parent company as income qualifying for territorial tax relief.26 the assumption is that these income streams have been deducted from the income of the foreign subsidiary in the source country, and therefore would be taxed nowhere if not taxed in the residence country of the parent of the group. of course, actual practice of course is much more complex than the sketch of these polar models might suggest. for example, many countries that employ territorial systems for taxing income earned from foreign direct investments also rely on worldwide taxation for certain abuse cases, or for income that is thought to be passive investment income or highly mobile. in those cases where the worldwide income backstop is invoked, a foreign tax credit also usually is available. b. the current u.s. tax system. the u.s. tax system is conventionally described as employing a worldwide tax base, with the important exception that the net income, but not the net loss, of a foreign subsidiary is includible in the taxable income of its u.s. parent company only when directly or indirectly made available to the u.s. parent.27 (in a true worldwide system, foreign subsidiary net losses as well as profits would be fully included in the u.s. group’s tax return as that income was earned.) this is a false picture of the u.s. tax system in operation. for the reasons explained below, it is more accurate to say that, in practice, and in the hands of sophisticated multinational firms, the u.s. tax 26. kleinbard, territorial taxation, supra note 1, at 556–57. a welldesigned territorial tax system would fully include royalty and interest income from foreign affiliates without any ability to offset the resulting tax liability with foreign tax credits attributable to other foreign income, thereby preventing the “blending” of high and low tax rates that would reduce the effective tax rate. 27. a standard treatise is joseph isenbergh, international taxation: u.s. taxation of foreign persons and foreign income (4th ed. 2006) [hereinafter isenbergh, international taxation]. other useful (and briefer) summaries include rosanne altshuler, recent developments in the debate on deferral, 87 tax notes 255, (2000); j. clifton fleming jr., robert j. peroni & stephen e. shay, worse than exemption, 59 emory l. j. 79 (2009) [hereinafter fleming, peroni & shay, worse than exemption]; michael j. graetz, taxing international income: inadequate principles, outdated concepts and unsatisfactory policies, 54 tax. l. rev. 261 (2001); grubert & altshuler, corporate taxes in the world economy: reforming the taxation of cross-border income, in fundamental tax reform 319 (john w. diamond & george r. zodrow eds., 2008) [hereinafter grubert & altshuler, corporate taxes in the world economy]. 718 florida tax review [vol. 11:9 system today operates as an ersatz territorial tax regime, with two odd twists.28 first, some extraordinary (that is, significantly larger than normal) repatriations of overseas profits to the u.s. parent are subject to u.s. taxation; as a result, the current system strongly discourages extraordinary repatriations. second, untaxed foreign income paid to the u.s. parent in the form of interest or royalty payments can be sheltered from u.s. tax through the use of unrelated foreign tax credits (which would not be the case in a territorial regime).29 the united states fundamentally deviates from a worldwide tax norm by offering u.s. firms the opportunity for “deferral,” under which the active business earnings of a u.s. company’s foreign subsidiary (but not a foreign branch) are not taxed in the united states until those earnings are in some fashion repatriated to the u.s. parent.30 this “deferral” aspect of u.s. law is technically the base case. observers often misunderstand the economic value to a taxpayer of deferring the inclusion of income that economically has accrued and is available for reinvestment. very generally, the value of deferring income in the domestic context (for example, salary income used to fund a regular individual retirement account) is that no tax is imposed on earnings attributable to the reinvestment of the original deferred amount during the term of the deferral. tax is not forgiven or discounted on the original deferral. instead, it is the tax-exempt compounding of returns on the reinvestment of the original deferred amount that gives rise to a tax benefit. 28. see fleming, peroni & shay, worse than exemption, supra note 27, at 149 (concluding that the current u.s. international tax system can create a system that is as generous or more generous that a well-designed territorial system). see also j. clifton fleming, jr., robert j. peroni & stephen e. shay, some perspectives from the united states on the worldwide taxation vs. territorial taxation debate, 3 j. austl. tax teachers ass’n 35, 44 (2008); j. clifton fleming jr., robert j. peroni & stephen e. shay, deferral: consider ending it, instead of expanding it, 86 tax notes 837 (2000); lawrence lokken, does the u.s. tax system disadvantage u.s. multinationals in the world marketplace?, 4 j. tax’n global transactions 43 (2004) [hereinafter lokken, does the u.s. tax system disadvantage]. 29. grubert & altshuler, corporate taxes in the world economy, supra note 27, at 325, 327. 30. isenbergh, international taxation supra note 27, at 68:1-68:2 (“the separate legal identity of corporations is a central determinant of u.s. taxation. . . . a foreign corporation, even though owned by americans, may operate beyond the immediate reach of the u.s. taxing power. . . . the separate identity of corporations in the u.s. tax system means that a foreign corporation is not formally a u.s. person, . . . and has no immediate u.s. income tax obligation on foreign source income.”). 2001] stateless income 719 deferral puts a taxpayer in the position of earning a tax-exempt rate of return on the after-tax value of the original deferred amount.31 the ability of a u.s. firm to defer u.s. tax on its returns from foreign direct investment operates similarly, except that the tax imposed on unrepatriated earnings is not zero, but whatever is the foreign rate on those reinvested earnings. nonetheless, from a u.s. perspective international deferral, like domestic deferral, operates to exempt entirely from u.s. tax the compounding of returns on low-taxed unrepatriated income until that income is repatriated. in practice, however, international deferral goes further, by coming close to exempting from u.s. tax the original deferred earnings as well, because u.s. tax on foreign earnings can be deferred indefinitely and without regard to natural lifespans. u.s. firms that can afford to defer indefinitely the repatriation of foreign earnings thus can obtain a tax result strikingly similar to a territorial regime.32 the practical consequences of the deferral principle are dramatic. the accumulated earnings of foreign subsidiaries of u.s. resident parent companies totaled roughly $1 trillion in 2008 and today total approximately $1.4 trillion, after net extraordinary dividends in 2005 of about $312 billion in response to the one-year repatriation tax holiday offered by internal revenue code section 965.33 as a result of deferral, the united states retains only a residual claim to tax the active business earnings of foreign subsidiaries when that income in some fashion is made available to the u.s. parent (and then after allowable foreign tax credits are claimed). repatriation of a foreign subsidiary’s active business income, and with it the triggering of residual u.s. tax liability, can 31. staff of the joint comm. on tax’n, present law and analysis relating to tax treatment of partnership carried interests and related issues, part ii (jcx-63-07) 7 (2007). 32. fleming, peroni & shay, worse than exemption, supra note 27, at 149. 33. for the one-year repatriation holiday figure, see melissa redmiles, statistics of income division, irs, the one-time received dividend deduction, 27 soi bull. spring 2008, at 103. for the $1 trillion figure, see economic recovery advisory board, the report on tax reform options 82, www.whitehouse.gov/sites/default/files/microsites/perab_tax_reform_report. pdf [hereinafter perab report] (“u.s. companies reported over $1 trillion of permanently reinvested earnings on 2008 financial statements.”). for the $1.4 trillion figure, see j.p. morgan & co., north american equity research, u.s. equity strategy flash (june 27, 2011). those offshore earnings are generally understood to be in large measure retained abroad solely to avoid the residual u.s. tax on repatriation. see, e.g., id. (“u.s. multinationals have a strong incentive to keep their overseas earnings outside the u.s. as a result of the interplay between the high u.s. statutory corporate tax rate and deferral.”). section iv.b. of this article discusses the meaning of “permanently reinvested” earnings. http://www.whitehouse.gov/sites/default/files/microsites/perab_tax_reform_report 720 florida tax review [vol. 11:9 take the form of an actual cash dividend, or one of various forms of constructive distribution, such as a loan of funds to a u.s. affiliate.34 the united states also taxes on a current basis (for this purpose, through a deemed dividend mechanism) certain categories of passive investment income or highly mobile income earned by foreign subsidiaries of u.s. firms. this disfavored income, which is not eligible for deferral, is termed “subpart f income.”35 the technical operation of subpart f is too complex to be susceptible of summary. over the last several years, however, the scope of the subpart f system has been cut back, so that increasing amounts of u.s. firms’ foreign earnings can qualify as active business income, and therefore are eligible for “deferral.”36 this scaling back of the subpart f system in turn has greatly enhanced the ability of u.s. firms both to operate in a quasi-territorial environment and to generate stateless income.37 a u.s. multinational firm can claim foreign tax credits against its tentative u.s. tax liability for the foreign income taxes incurred in earning foreign income actually included in its u.s. tax return, but the detailed application of those rules is even more cruelly byzantine than are the subpart f rules.38 foreign taxes can be claimed as credits only to the extent of the u.s. tax that would have been imposed on the taxpayer’s foreign income; this can be understood as a ceiling of 35 percent (the u.s. corporate tax rate) multiplied by the firm’s taxable foreign income, with that foreign income being determined under u.s. principles.39 this formula is referred to as the “foreign tax credit limitation.” if a firm has more credits than it can claim in a year, it is said to be in an “excess credit” position; a firm that has foreign source taxable income that is not completely sheltered by foreign tax credits is said to be in an “excess limitation” position. the u.s. foreign tax credit limitation calculation includes important rules that treat u.s. domestic borrowings as supporting a firm’s worldwide 34. i.r.c. § 956 (investment of a controlled foreign corporation’s earnings in united states property). 35. see i.r.c. § 952. 36. see lawrence lokken, whatever happened to subpart f u.s. cfc legislation after the check-the-box regulations, 7 fla. tax rev. 185 (2005) [hereinafter lokken, whatever happened to subpart f]. lokken offers a series of hypothetical examples that demonstrate how the implementation of the check-thebox regulations has caused subpart f to lose its power to prevent u.s.-domiciled multinational enterprises from generating what this article calls stateless income. id. at 202–05. 37. see infra part iii. 38. isenbergh, international taxation, supra note 27, considers the topic in more detail. 39. i.r.c. § 904(a). 2001] stateless income 721 assets in proportion to the relative tax bases (costs) of those assets.40 for this purpose, the relevant asset of a foreign subsidiary is the parent’s investment in the affiliate’s equity (and any debt claims held by the parent), not the gross assets of the subsidiary. interest expense incurred by a u.s. corporation is fully deductible, but to the extent the expense arises from debt that is deemed to support foreign assets, the interest expense is treated as derived from foreign sources. the net effect of the interest allocation rules is to reduce a u.s. firm’s foreign income solely for u.s. tax purposes, while leaving unaffected its actual foreign tax liability. the rules therefore operate to constrain a u.s. firm’s ability to utilize foreign tax credits, because those credits are limited to the tentative u.s. tax on foreign source income (as determined under u.s. tax principles). nonetheless, so long as a u.s. firm does not drive its effective foreign tax rate above the u.s. statutory rate after taking these interest expense allocation rules into account, the rules are not binding. as a result, firms that succeed through stateless income planning in driving down their foreign tax bills have substantial capacities to incur u.s. interest expense without adversely affecting their ability to utilize foreign tax credits.41 the u.s. foreign tax credit, deferral, and subpart f rules interact in complex ways that often are underappreciated by analysts of the current system. critically, a u.s. firm can choose to defer or repatriate income from its foreign subsidiaries on a subsidiary-by-subsidiary basis. the foreign tax credits that flow up to the u.s. parent in turn depend on the foreign tax burdens imposed on the specific subsidiary whose income is repatriated (which income in turn is calculated under u.s. principles). moreover, foreign tax credits are not linked to a specific item of income. thus, “excess” credits from one item of income (that is, foreign tax imposed at a rate greater than the u.s. tax rate on that item of income) can be redeployed to offset tentative u.s. tax on unrelated low-taxed foreign-source income. a u.s. firm’s available foreign tax credits can be applied to reduce its u.s. income tax liability in respect of any foreign-source income of the same general nature — in practice, any income ultimately derived from active business operations. “active” business income in turn includes some income that in ordinary language might be viewed as passive investment returns, such as royalties or interest income derived from foreign 40. i.r.c. § 864(e); treas. reg. §§ 1.861-9, -9t. 41. more technically, by driving down its foreign effective tax rate before considering interest expense, a firm can incur more interest expense in the united states without bumping into the section 904 ceiling on foreign tax credit utilization. the lower effective foreign tax rate (pre-u.s. interest expense) creates more capacity to absorb without adverse consequences the fraction of u.s. interest expense that is allocated against foreign source income. 722 florida tax review [vol. 11:9 subsidiaries, so long as those subsidiaries in turn derive their income from active business operations.42 one important consequence of these design features of the u.s. foreign tax credit rules is that royalty and interest payments received by u.s. affiliates from foreign subsidiaries today are both significant in amount and partially tax-free everywhere in the world, which is not the case in properly constructed territorial tax systems. these items bear little tax when they are received in the united states because they generally are deductible in the source country, and are in turn sheltered from tax in the united states through the blending of high-tax foreign income from other sources to shelter these zero-taxed items. 43 c. revenue collections under the current system as a result of the interactions of the complex rules summarized above, the united states today collects almost trivially small revenues from its current system for taxing the foreign income of u.s. multinational firms. in 2004, for example, the united states collected $18.4 billion in tax from the foreign operations of u.s. multinationals. this amount includes not only taxes on dividends paid by foreign subsidiaries, but also taxes on subpart f income (constructive dividends that are treated as distributed to the u.s. parent by operation of law), as well as interest and royalty income paid from controlled foreign corporations to u.s. affiliates.44 yet in 2004, foreign subsidiaries paid $47 billion in dividends to their u.s. parents, generated $48 billion in subpart f income taxable to u.s. owners, paid another $59 billion in royalties to u.s. affiliates, and paid $12 42. i.r.c. § 904(d). 43. fleming, peroni & shay, worse than exemption, supra note 27; lawrence lokken, territorial taxation: why some u.s. multinationals may be less than enthusiastic about the idea (and some ideas they really dislike), 59 smu l. rev. 751, 759–70 (2006) [hereinafter lokken, territorial taxation]. as lokken notes, a complete catalogue of techniques could fill several volumes. however, he discusses three commonly-used mechanisms in concrete examples. see also kleinbard, territorial taxation, supra note 1, at 556–58. 44. the figure represents the 35 percent u.s. statutory tax rate applied to the aggregate “excess limitation” income reported by those u.s. firms in excess limitation for the year. personal correspondence with dr. harry grubert, senior research economist, u.s. treasury department. (on file with author) grubert & altshuler, corporate taxes in the world economy, supra note 27, at 326–27, identifies several shortcomings with this approach to measuring the effective tax burden on foreign income; since these shortcomings point in opposite directions, and since no better data exist, it is necessary to use this measure. those authors also analyze in detail the components of the u.s. residual tax on foreign income for 2000, when that tax totaled $12.7 billion. 2001] stateless income 723 billion in interest — altogether, some $166 billion in total repatriations out of foreign earnings.45 the $18.4 billion in u.s. tax collections represents a u.s. tax rate of about 11 percent on that repatriated income. by way of contrast, if the united states had employed a territorial tax system, it would have collected a modest amount of tax on the $95 billion of dividend and subpart f income actually or constructively repatriated in 2004.46 it would, however, have collected roughly $25 billion (35 percent of $71 billion) on the royalty and interest income received by u.s. firms from their foreign subsidiaries — some $6.6 billion more than it actually collected under the current “worldwide” system. in that same year, profitable foreign subsidiaries of u.s. firms (that is, those subsidiaries that reported positive income for the year) earned net income of some $433 billion before foreign income taxes (but after interest and royalty payments to affiliates), and $365 billion after payment of foreign taxes and before any repatriations to the united states.47 after taking into account dividends paid to u.s. parent companies and taxable subpart f income ($95 billion), $270 billion (74 percent) of the after-foreign-tax net earnings of profitable foreign subsidiaries was not taxed on a current basis in the united states.48 the $270 billion of net earnings of profitable foreign subsidiaries untaxed by the united states was approximately half as large as the $533 billion in total taxable income (foreign and domestic) reported by all u.s. 45. for the first two figures, see irs, soi tax stats – controlled foreign corporations, http://www.irs.gov/taxstats/bustaxstats/article/0,,id=96282,00.html (may 20, 2011). the data are measured employing u.s. tax principles, rather than u.s. gaap. for the last figure, see infra part iii. tbl. 1. 46. if one imagines that subpart f income would be defined in a territorial tax system comparably to its current definition, then even under such a hypothetical territorial tax regime u.s. tax would be owed on the $48 billion of subpart f income includible in the income of u.s. shareholders, after taking into account foreign tax credits attributable to that income. if one assumes that the $48 billion in subpart f income brought with it foreign tax credits at the global average of 16 percent, then the residual u.s. tax would be in the neighborhood of $11 billion. 47. see supra note 45 (providing irs soi data for controlled foreign corporations for 2004). the data are measured employing u.s. tax principles, rather than u.s. gaap. as indicated in the text, the figures presented here ignore foreign subsidiaries that reported a loss for the year. 48. the data in the text assume that dividends are paid first out of current earnings, so that dividends paid in 2004 can be presented as distributed out of 2004 earnings. the data do not show how much cash was retained by foreign subsidiaries of u.s. firms, in part because controlled foreign corporations can distribute cash out of “previously taxed income” (basically, subsidiary income previously taxed to the u.s. parent under subpart f); such distributions are excludible from the u.s. parent company’s taxable income. i.r.c. § 959(a). in 2004 controlled foreign corporations distributed $43.8 billion of previously taxed income. 724 florida tax review [vol. 11:9 corporations that claimed any foreign tax credits on their 2004 income tax returns (essentially all firms with international operations), on which $119 billion in u.s. tax was paid (after all tax credits, including credits for foreign income taxes paid).49 and $270 billion in after-foreign-tax 2004 foreign subsidiary earnings that went untaxed by the united states on a current basis looms large — about 43 percent — even when compared with the $633 billion of all after-tax corporate income of any type that was subject to u.s. corporate income tax for that year, including the income of entirely domestic firms.50 d. arbitrage and domestic base erosion the current u.s. regime for the taxation of foreign direct investment not only collects trivially small revenues (as suggested above, smaller than those that would be collected under some scenarios if the united states were to switch to a territorial system), but also exposes the u.s. corporate tax on the domestic tax base of u.s. multinationals to systematic erosion through straightforward tax arbitrage strategies.51 current law has the pernicious effect of implicitly encouraging domestic leverage to fund a firm’s domestic cash needs, while leaving lowtaxed foreign earnings abroad. this strategy allows u.s. multinational firms to operate in a quasi-territorial tax environment, by supplying the u.s. parent company with cash to fund its domestic operations from two sources: the low-taxed stream of regular course foreign operations (as described above) and domestic borrowings. the attendant increase in domestic interest expense in turn is allocated in part against foreign operations for purposes of the foreign tax credit limitation rules described earlier. nonetheless, so long as the firm’s foreign earnings are sufficiently low-taxed before taking into account the increase in the firm’s foreign effective tax rate from the application of those expense allocation rules, the limit is simply not binding. as one recent example, at the end of its fiscal quarter ending december 31, 2010, microsoft corporation had $29.5 billion in permanently reinvested earnings, and worldwide held $41 billion in cash and short-term investments. yet in february 2011, microsoft borrowed $2.25 billion in the u.s. capital markets. a recent news report in the financial press has asserted that microsoft issued these debt obligations to fund dividends and stock buybacks while avoiding any repatriation tax, because 80 to 90 percent of its 49. see irs, soi tax stats – corporate foreign tax credit statistics, http://www.irs.gov/taxstats/bustaxstats/article/0,,id=96337,00.html (last visited may 20, 2011). 50. irs, 2004 corporation source book of statistics of income (line 73 minus line 82). 51. see also infra part iv.c. 2001] stateless income 725 cash and short-term investments are held outside the united states.52 moreover, the article suggests that this pattern is becoming more common among u.s. technology companies generally. a u.s. multinational firm’s systematic use of domestic borrowing to replicate the cash flow advantages enjoyed by other firms in territorial regimes (where foreign earnings can costlessly be repatriated) erodes the u.s. corporate tax base, because the firm’s interest expense is deductible in the united states, while the foreign earnings are not included. the combination of “deferral,” as turbocharged by stateless income planning, and incomplete domestic expense allocation rules, which often are not binding, thus lead to classic tax arbitrage, no different in character than if taxpayers could borrow freely to buy tax-exempt municipal bonds. e. the tax distillery a sophisticated u.s. firm manages the residual u.s. tax on repatriated foreign earnings by manipulating the complex interactions between the u.s. deferral and foreign tax credit rules in a manner that can be analogized to a tax distillery. the firm’s tax director functions as the master distiller, confronted by hundreds of casks of foreign income, one cask for each category of income earned by each foreign subsidiary. each cask sits waiting to be tapped by the master distiller as needed, and each dram of foreign income drawn from a cask brings with it a different quantum of foreign tax credits. the master distiller takes instructions from the chief financial officer as to how much cash must be repatriated to the united states each year, and then sets about perfecting a blend of income and credits so that the residual u.s. tax on the resulting liqueur is as small as possible. these blends might, for example, encompass complex “triangular” flows, in which a low-taxed subsidiary’s income is routed through highertaxed subsidiaries to associate the repatriation with greater tax credits.53 and when direct repatriations cannot be sheltered by foreign tax credits, u.s. firms often can simply borrow in the u.s. capital markets, relying in part on the implicit credit of their substantial retained overseas earnings.54 52. jilani, microsoft structured acquisition, supra note 10. 53. rosanne altshuler & harry grubert, repatriation taxes, repatriation strategies and multinational financial policy, 87 j. pub. econ. 73, 75 (2002) (“instead of investing in passive assets or reinvestment, the low-tax affiliate with potentially high taxes on direct repatriations can invest in, or lend to, a related foreign affiliate. this keeps the funds within the worldwide corporation and generates a triangular flow of funds with the mnc. further, as long as the related downstream affiliate is not located in a low-tax country, it can become the vehicle for tax-free repatriation by the low-tax subsidiary.”). 54. id. 726 florida tax review [vol. 11:9 through adroit tax planning the tax director can replenish the casks of high-tax and low-tax foreign income, while keeping untapped income offshore and waiting to be drawn down as needed. the aggregate result, as summarized above, is a very low effective u.s. residual tax rate on regular repatriations. at the same time, the operation of the distillery tends to drive down the effective foreign tax rate associated with unrepatriated foreign earnings, because the purpose of the distillery is to strip out from indefinitely-deferred foreign earnings all the foreign tax credits that are needed to offset current repatriations of zero-taxed or low-taxed foreign income. the typical corporate tax distillery is built to handle a certain maximum annual throughput of foreign income and associated foreign tax credits. if business exigencies were to call for a very large repatriation in one year, the tax director’s intricate distillation apparatus would be overwhelmed and a substantial residual u.s. tax liability incurred. it is for this reason that the right way to see the u.s. rules for taxing income from foreign direct investment as they apply to ordinary course operations is as a de facto territorial tax system with a contingent (and firm-specific) residual tax liability associated with large-scale repatriations. it also follows from the above that it is a mistake to confuse the modest u.s. tax cost to u.s. firms of ordinary course foreign income repatriations with the costs that would be incurred to repatriate the roughly $1.4 trillion of foreign untaxed earnings of u.s. multinationals. because the tax distilleries are not scaled to handle throughput of this magnitude, and because they would quickly run out of high-tax casks of foreign income were they to attempt to accommodate this volume of production, the actual u.s. tax cost of repatriating all of a firm’s stock of low-taxed deferred foreign earnings (made even lower-taxed by virtue of years of stripping out foreign taxes to use against regular repatriation flows) would be expected to be quite high.55 another way of saying this is that the u.s. taxes collected today on regular flows of foreign earnings are an average cost applied to a certain volume of repatriations; that average cost bears little relationship to the marginal cost of bringing back the firm’s much larger stores of very lowtaxed deferred income. this issue becomes critically important in contemplating whether u.s. firms would change their behavior very much if the united states were to move to a territorial tax system; the point made here is that the forgone tax charges that a u.s. firm would then enjoy when compared with current law would be much larger than would be implied by the modest u.s. tax rate imposed on regular course repatriations under the current system. 55. microsoft corp., 2010 annual report, 58 n.13 (noting a $9.2 billion cost to repatriate all of its extant foreign earnings). see infra text accompanying notes 93–95. 2001] stateless income 727 iii. stateless income in operation a. the value of stateless income tax planning part ii of this article has explained how the current u.s. tax system operates in practice as an ersatz sort of territorial tax system, within the bounds of ordinary course repatriation flows. this result in turn comes at an important cost, which is the retention of low-taxed foreign earnings by a firm’s foreign subsidiaries. if a u.s. firm seeks to maximize the aggregate benefits obtainable under present u.s. tax law (as many clearly do, in light of the roughly $1.4 trillion that they collectively hold in indefinitely-deferred low-taxed foreign income), there are important reasons to minimize the firm’s foreign tax liabilities. first, a u.s.-based multinational firm typically needs to “borrow” only a fraction of its total foreign tax liabilities to shelter its regular course repatriations of earnings to the united states. second, that firm obtains no current cash or financial accounting benefit for any remaining taxes associated with its indefinitely-deferred earnings. to the contrary, any foreign taxes paid on its indefinitely-deferred earnings are simply a current cash cost and an increment to its effective tax expense for financial accounting purposes. moreover, as described below, the financial performance of a public firm, including the comparison of its tax expense to that of its global peers, ordinarily is judged through the prism of financial accounting. as a result, foreign taxes paid on indefinitely-deferred earnings are at best a contingent asset, while the cash saved from lowering those taxes is a real asset with an immediate and visible value. third, the firm’s tax distillery needs to leave room in its blend for the bump in foreign effective tax rates triggered by the foreign tax credit interest expense rules described earlier. if the distillery starts with too high a foreign tax concentrate, it will not be able to avoid incurring excess foreign tax credits, which from a chief financial officer’s point of view is the same as losing the tax deductibility of some of the firm’s domestic interest expense. put another way, a firm’s ability to arbitrage the current system (by creating deductible u.s. interest expense that erodes the high-taxed domestic tax base) depends on having access to low-taxed foreign income. as a result, u.s. firms today have every reason to aggressively pursue strategies to reduce their foreign tax burdens on their unrepatriated as well as repatriated earnings. this is the function of stateless income tax planning. 728 florida tax review [vol. 11:9 b. mechanics of stateless income tax planning this subpart briefly describes a few of the most important and straightforward tax planning tools by which u.s. multinational firms can generate stateless income — that is, can cause income generated by economic activity in a high-tax jurisdiction to be taxed only in a low-tax foreign jurisdiction.56 booking such income in a low-tax jurisdiction by itself is not sufficient; the income also must be characterized as income arising from an active business (more technically, as income not described in subpart f). at the outset, it is important to emphasize that stateless income generation is not simply a synonym for aggressive “transfer pricing” of transactions among affiliated companies. that phenomenon is real and greatly exacerbates the problem. but stateless income exists for reasons more fundamental than that, relating at their core to the global tax norm of treating corporate subsidiaries as separate juridical entities whose tax liabilities should be calculated without reference to their ownership. 1. business earnings stripping the most obvious way to generate stateless income is through internal group leverage — causing an affiliate in ireland, for example, to lend to an affiliate in germany. in 1984, the united states pioneered the repeal of source-country (the jurisdiction of the borrower) withholding tax on most cross-border interest flows by repealing the withholding tax on portfolio interest paid to foreign investors.57 since then most other countries have followed suit, as part of the long-term trend to the global integration of financial markets. while it is true that some countries, in particular the united states, do not extend their general exemption from withholding tax to interest paid to offshore affiliates of the borrower,58 most tax treaties (and, in the eu, relevant directives) do so; firms can rely on those treaties to avoid withholding tax notwithstanding domestic law. in most cases, therefore, multinational firms can “strip out” high-tax source country earnings through internal group leverage.59 in practice, this 56. see lokken, territorial taxation, supra note 43, at 759–69 for discussion of some more exotic techniques, which can yield results superior to outright exemptions. 57. i.r.c. §§ 871(h), 881(c). 58. i.r.c. § 871(c)(3)(b), (c). 59. see harry huizinga, luc laeven & gaetan nicodeme, capital structure and international debt shifting, 88 j. fin. econ. 80 (2008); mihir a. desai, c. fritz foley & james r. hines jr., a multinational perspective on capital structure choice and internal capital markets, 59 j. fin. 2451 (2004). the latter 2001] stateless income 729 ability is subject only to two broad constraints. first, the affiliate debt must be respected as such under the laws of the source country. second, some countries, such as germany and australia, have adopted “thin capitalization” rules, which limit a borrower’s ability to deduct interest on debt if the borrower’s capital structure is deemed to be excessively leveraged.60 similarly, in its role as a source country (that is, as a host for the local operations of foreign-based multinationals), the united states limits base erosion through the code’s “interest stripping” provision, which can be understood as a species of thin capitalization.61 the critical difference is that a true thin capitalization rule applies to all interest paid, while the u.s. rule operates only to limit interest paid to affiliates that are not u.s. persons or that otherwise are tax-exempt. the same analysis can be extended to other forms of deductible expenses, but internal group leverage is the starkest example, because it requires no physical infrastructure or staff in the low-tax jurisdiction that “earns” the interest income. the structure’s efficacy relies on several core normative principles of income tax statutes around the world. first, separate juridical entities are respected as separate taxpayers, even when commonly controlled. second, the legal form of a capital investment (as debt or as equity) largely drives the tax analysis of that instrument.62 third, there is a strong international consensus to determine the income tax liabilities of firms through the application of the “arm’s-length principle,” which contemplates that affiliated firms are taxed separately, but their transactions with each paper, for example, concludes in part that “there is strong evidence that affiliates of multinational firms alter the overall level and composition of debt in response to tax incentives.” id. at 2452. moreover, “firms use internal capital markets opportunistically when external finance is costly and when there are tax arbitrage opportunities.” id. at 2484. see also julie h. collins & douglas a. shackelford, global organizations and taxes: an analysis of the dividend, interest, royalty, and management fee payments between u.s. multinationals’ foreign affiliates, 24 j. acct. & econ. 151 (1998) (employing data from 1990 and finding substantial evidence of tax-efficient routing of (nondeductible) dividends and (deductible) royalties and interest among foreign subsidiaries of u.s.-domiciled multinational firms). as the text makes clear, the opportunities to tax-optimize such payments among foreign affiliates of u.s. firms have become more complete in recent years, due to changes in u.s. law and regulations. 60. see tim edgar, jonathan farras & amin mawant, foreign direct investment, thin capitalization, and the interest expense deduction: a policy analysis, 56 can. tax j. 803, 810 (2008); tim edgar, policy forum: interest deductibility restrictions — expecting too much from reop?, 52 can. tax j. 1130 (2004). 61. i.r.c. § 163(j). 62. see edward d. kleinbard, designing an income tax on capital, in taxing capital income (henry j. aaron, leonard e. burman & c. eugene steuerle eds. 2007). 730 florida tax review [vol. 11:9 other are tested to ensure that their terms are consonant with the terms under which unrelated entities would do business.63 the combination of these principles in application allows for economically meaningless internal leverage to accomplish significant source country income tax base erosion. in years prior to 1997, the united states constrained the ability of u.s. multinationals to generate stateless income through internal group leverage or other earnings stripping cash flows, because u.s. law at the time characterized as subpart f income most interest income (or other income items deducted by the payor) earned by a foreign subsidiary domiciled in a low-tax jurisdiction. as a consequence, a u.s. multinational group could strip income from one foreign jurisdiction to another, but by doing so the u.s. parent company would be taxed immediately on the interest income recognized by the low-taxed affiliate. this state of affairs was said to be consistent with a capital export neutrality philosophy, because at the margin a u.s. firm could not costlessly generate low-taxed non-subpart f foreign income when making investments in high-tax foreign jurisdictions.64 as a result, it could be argued that subpart f encouraged u.s. firms to make investment decisions without regard to any special tax planning opportunities that might be available in respect of foreign investments. the business community, however, argued forcefully that the u.s. international tax system, taken as a whole, put u.s. firms at a competitive disadvantage.65 moreover, u.s. business firms were incredulous that the united states would deliberately discourage u.s. firms from reducing their foreign tax liabilities.66 in 1997, the tax tectonic plates shifted, with the introduction of the “check-the-box” treasury regulations.67 whether as a result of a conscious shift to a different guiding principle or as ad-hoc responses to industry pleas for a competitive international tax environment, these regulations 63. see supra note 6 (discussing oecd guidelines.). 64. see office of tax policy, department of the treasury the deferral of income earned through u.s. controlled foreign corporations: a policy study 119 (2000). 65. see, e.g., national foreign trade council, addressing offshore tax avoidance without harming the international competitiveness of u.s. businesses 1 (warning u.s. policymakers to evaluate all international tax reforms in light of competitiveness). 66. the best example of this mutual incomprehension was the promulgation of, and reaction to, notice 98-11, 1998-1 c.b. 433. notice 98-11 provided that regulations would be proposed to prevent taxpayers from utilizing hybrid branch arrangements to reduce foreign tax while avoiding the corresponding creation of subpart f income. the notice achieved instant notoriety, and no such regulations ever were issued. 67. treas. reg. § 301.7701-3. 2001] stateless income 731 substantially vitiated the scope of subpart f as a guardian against stateless income generating techniques. 68 the check-the-box regulations permitted u.s. firms effectively to avoid the strictures of subpart f in many instances by electing, solely for u.s. tax purposes, to treat a foreign corporate subsidiary as a tax-transparent vehicle, rather than a separate taxable entity to which the rules of subpart f might apply. when a check-the-box election is made in respect of a whollyowned subsidiary, the subsidiary is referred to as a “disregarded entity,” because its separate juridical status is ignored for all u.s. tax purposes. instead, the subsidiary is treated as an extension of its sole corporate owner. to take one common fact pattern, imagine that a u.s. multinational enterprise owns an irish first-tier subsidiary, which in turn owns a french second-tier subsidiary. the u.s. parent company “checks the box” in respect of the french subsidiary, which thereupon becomes entirely disregarded for u.s. tax purposes, but not for irish or french tax purposes. now the irish first-tier subsidiary lends money to its french subsidiary. for irish and french tax purposes, the interest expense in france and the interest income in ireland are treated as real, with the result that french business income is now taxed to that extent at irish rates. for u.s. purposes, however, there is only one company — an irish subsidiary with branch operations in france — and transactions between a branch and its home office are generally ignored for u.s. tax purposes. as a result, subpart f income cannot arise. altshuler and grubert have found a pronounced change in the effective foreign tax rates of u.s. multinational firms after 1996, which they plausibly ascribe to the effects of check-the-box tax planning.69 more recently, grubert’s review of nonpublic treasury files shows a decline in those effective foreign tax rates of five percentage points from 1996 to 2004. while some of that decline is attributable to reductions in statutory rates in some countries, a significant fraction represents the migration of stateless 68. see lokken, whatever happened to subpart f, supra note 36, at 209 (“as a result of these devices, subpart f has fallen increasingly short of the goal of curbing tax haven sheltering.”); see also martin j. mcmahon jr., economic substance, purposive activity, and corporate tax shelters, 94 tax notes 1017 (2002). 69. rosanne altshuler & harry grubert, the three parties in the race to the bottom: host governments, home governments and multinational companies, 7 fla. tax rev. 153 (2005) [hereinafter altshuler & grubert, the three parties in the race to the bottom]. altshuler and grubert found that from a period after 1997, when “check-the-box” was implemented, to 2002, intercompany equity income rose from $40.7 billion to $120.8 billion, and that in the same period there was almost 100 percent growth in the equity income of foreign affiliates of u.s. firms in seven major low-tax countries (bermuda, cayman islands, ireland, singapore, the netherlands, luxembourg, and switzerland). id. at 170. 732 florida tax review [vol. 11:9 income to low-tax jurisdictions without subpart f consequences through the use of check-the-box tax planning. stateless income generation through income stripping was further nurtured by congress, which in 2004 enacted section 954(c)(6) of the internal revenue code. this provision largely vitiated any remaining vitality in subpart f’s role as a guardian against stateless income planning, because it turned off the application of subpart f when one controlled foreign corporation pays deductible interest, royalties, or rents to another, so long as the first subsidiary’s payments are derived from active business income. this “pass-through” rule was enacted in temporary form (and as extended in 2010, is scheduled to expire after 2011), which has limited its attractiveness as a planning tool when compared to the check-the-box regulations, but there are important instances in which section 954(c)(6) extends the reach of stateless income tax planning opportunities. section 954(c)(6)’s enactment is too recent for its impact to appear in the data. a third example of a recent administrative or legislative change that has had the effect of facilitating business earnings stripping by u.s. multinational firms is the adoption of revised “dual consolidated loss” regulations in 2007.70 this exotic corner of the tax law aims to limit the ability of u.s. firms to “double dip,” by claiming the same deduction in two different countries, if by doing so the deduction is made available to other companies (whether related or not). for example, imagine that a u.s. firm owns a first-tier subsidiary that is treated as a u.s. corporation under u.s. rules, but a french corporation under french rules, and that the subsidiary in turn is the parent of a french consolidated group. further assume that the subsidiary incurs a loss. the dual consolidated loss regulations would prevent the u.s. group from claiming that loss on the u.s. consolidated tax return and also using the loss to shelter the income of lower-tier french subsidiaries from french income tax. the 2007 revisions to the detailed treasury regulations that articulate these rules provided for the first time clear guidance that interest paid between a check-the-box disregarded entity and its parent could not give rise to a prohibited dual consolidated loss, even though that loss was deducted against the income of two consolidated groups. for example, imagine that in the example above the u.s. parent company borrows funds from third parties and then lends those funds to its french first tier subsidiary, which is now a check-the-box disregarded entity. by virtue of this interest expense, the french subsidiary operates at a loss, which it applies against the income of its lower-tier subsidiaries for french tax purposes. one third-party borrowing has now been deducted inside two consolidated groups. although the statute and prior history of the regulations could have supported the opposite conclusion, the 2007 regulations expressly 70. treas. reg. § 1.1503(d)-1 to -8. 2001] stateless income 733 condoned this form of earnings stripping. again, not enough time has passed for the effect of these new regulations to be visible in the treasury data files. 2. transfer pricing a great many studies have found that taxpayers both within and without the united states have relied on transfer pricing strategies (the prices at which intragroup transactions are effected) to generate stateless income.71 to take one favorite example, grubert and altshuler found that in 2002 foreign manufacturing subsidiaries of u.s. firms operating in ireland (a lowtax country with the powerful additional attraction of being a member of the european union) were almost three times as profitable in proportion to their sales as was the mean of all such foreign manufacturing subsidiaries.72 as i have observed elsewhere, it cannot be simply the luck of the irish that explains the extraordinary profitability of irish members of worldwide groups.73 transfer pricing strategies are particularly effective because of the central role of high-value unique intangible assets as profit drivers for 71. representative works include: jct, income shifting and transfer pricing, supra note 14; brauner, value in the eye of the beholder, supra note 6; kimberly a. clausing, the revenue effects of multinational firm income shifting, 130 tax notes 1580 (march 28, 2011) [hereinafter clausing, revenue effects]; mihir a. desai, new foundations for taxing multinational corporations (nov. 15, 2003) (unpublished manuscript, http://papers.ssrn.com/sol3/papers.cfm?abstract_ id=483802); grubert & altshuler, corporate taxes in the world economy, supra note 27; harry grubert, intangible income, intercompany transactions, income shifting, and the choice of location, 56 nat’l tax j. 221 (2003) [hereinafter grubert, intangible income]; michael p. devereux & christian keuschnigg, the distorting arm’s length principle in international transfer pricing (apr. 20, 2008), (unpublished papers), (http://www.sbs.ox.ac.uk/centres/tax/symposia/documents/ 2008/keuschniggalp.pdf, oxford university centre for business taxation); martin a. sullivan, transfer pricing costs u.s. at least $28 billion, 126 tax notes, 1439 (2010); martin a. sullivan, u.s. multinationals paying less foreign tax, 118 tax notes 1177 (2008); martin a. sullivan, u.s. multinationals shifting profits out of the united states, 118 tax notes 1078 (2008); hearing on transfer pricing issues before the h. comm. on ways and means, 111th cong. (testimony of thomas a. barthold, chief of staff, joint comm. on tax’n), http://jct.gov.publications. html?fanc=startdown&id-3693. 72. grubert & altshuler, corporate taxes in the world economy, supra note 27, at 322–23. the european union’s core member tax rate is now around 30 percent. while the 2002 treasury files indicate that the average statutory tax rate for u.s. manufacturing subsidiaries abroad is about 29 percent, their effective tax rate on net income is only about 16 percent. 73. kleinbard, territorial taxation, supra note 1, at 551–54. http://www/ 734 florida tax review [vol. 11:9 multinational firms.74 indeed, desai and hines lay out a persuasive case that the theory of the multinational firm can in large measure be explained by its role as a platform from which to exploit unique global intangibles.75 almost by definition, it is very difficult to validate the pricing of intragroup licenses or other contracts involving these unique assets. moreover, arm’s-length principles simply do not address the allocation of group income attributable to the synergies that explain the reason for the group’s existence in the first place. transfer pricing strategies are particularly important for u.s. firms that seek to generate stateless income by shifting profits from the united states (as opposed to a high-tax foreign jurisdiction) to a low-tax foreign country. the interest stripping strategy outlined earlier, for example, does not work to strip income of a u.s. firm to a low-tax offshore affiliate, by virtue of a number of subpart f rules designed to protect the u.s. tax base in those circumstances. transfer prices, of course, are subject to scrutiny under the arm’s-length principle, but once a high-value intangible is transferred outside the united states (including through a license that does not fully compensate the u.s. owner), the foreign owner or licensee generally can exploit the intangible without triggering subpart f income. the foreign affiliate that controls the intangible can exploit it through licensing to affiliates in high-tax foreign countries with the business earnings stripping consequences outlined earlier. alternatively, in some cases, such as pharmaceutical manufacturing or retail sales of computer software, the low-tax affiliate can employ the intangible to manufacture a product for resale to affiliates located in other jurisdictions. 74. for recent news stories outlining transfer pricing strategems involving both u.s. tax avoidance and stateless income planning, see drucker, google 2.4% rate, supra note 11; martin a. sullivan, microsoft moving profits, not jobs, out of the u.s., 129 tax notes 271 (2010); jesse drucker, u.s. companies dodge $60 billion in taxes with global odyssey, bloomberg, may 13, 2010, http://www.bloomberg.com/news/2010-05-13/american-companies-dodge-60billion-in-taxes-even-tea-party-would-condemn.html; peter cohn, are multinationals evading taxes?, national journal, sept. 4, 2010 at 13; simon bowers, google’s subsidiaries allow company to avoid £450 m tax on uk advertising, guardian, dec. 20, 2009; terry macalister, google is accused of uk tax avoidance, guardian, apr. 20, 2009; prem sikka, op-ed., shifting profits across borders, guardian, feb. 12, 2009; glenn r. simpson, wearing of the green: irish subsidiary lets microsoft slash taxes in u.s. and europe, wall st. j., nov. 7, 2005, at a1. 75. mihir a. desai & james r. hines jr., evaluating international tax reform, 56 nat’l tax j. 487, at 488–89 (“[m]ultinational firms are thought to engage in foreign direct investment when ownership confers specific advantages relative to arms-length relationships, so activities are most profitably undertaken within the firm.”); vann, hard-boiled wonderland, supra note 4, at 293–99. 2001] stateless income 735 while the data showing the effects of transfer pricing strategies are clear, convincing, and generally accepted, it is helpful to break these strategies into three logically distinct categories. the first is the aggressive use of “cost sharing” arrangements.76 under this strategy, one affiliate (invariably located in a low tax jurisdiction) agrees to shoulder a portion of the development costs of a new intangible asset (which in turn often is an extension of some kind of an existing intangible), and in return receives the exclusive royalty-free use of the resulting asset in the affiliate’s assigned geographic territory. so, for example, an irish subsidiary of a u.s. firm might agree to assume a portion of the cost of testing and bringing to market an existing ethical pharmaceutical compound for a new indication; the portion assumed would be designed to reflect the potential value of a successful product in the eu, as compared to the rest of the world. cost sharing and check-the-box strategies are synergistic, because a foreign subsidiary that acquires region-wide ownership of an intangible through a cost sharing arrangement can in turn license the intangible to other affiliates in the region without triggering subpart f income if those affiliates are disregarded appendages of the intangibles owner for u.s. tax purposes.77 researchers have identified cost sharing as a significant contributor to noneconomic transfer pricing outcomes.78 it will not surprise many readers to learn that low-tax affiliates that enter into cost sharing agreements with their high-tax parent companies rarely are saddled with money-losing projects.79 this factual skewing of outcomes is one important reason for the disparities across affiliate incomes that are observed. just as remarkably, the money risked by the low-tax subsidiary is simply supplied as a capital contribution by the parent.80 the risk sharing on 76. see brauner, cost sharing, supra note 9; jct, income shifting and transfer pricing, supra note 14, at 25-29, 111–14. 77. see grubert, foreign taxes and domestic income, supra note 9; supra note 10, 12. 78. see brauner, cost sharing, supra note 9; jct, income shifting and transfer pricing, supra note 14; clausing, revenue effects, supra note 71, at 705; grubert, intangible income, supra note 71 (finding that income derived from r&d intangibles account for about half the income shifted from high-tax to low-tax countries, and that subsidiaries undertake a large number of transactions, thus increasing the opportunities to shift income); julie roin, can the income tax be saved? the promise and pitfalls of adopting worldwide formulary apportionment, 61, 171–75, 182–85 (2008). 79. the famous counterexample that proves the rule is xerox corporation. john mulligan, how ireland almost ruined the photocopier king, [irish] sunday trib. (apr. 22, 2001), http://www.tribune.ie/article/2001/apr/22/how-ireland-almostruined-the-photocopier-king/. 80. newly-revised cost sharing regulations seek to minimize the advantages of the baldest of such arrangements; whether the new regulations will prove 736 florida tax review [vol. 11:9 which cost sharing rules are predicated thus is no more meaningful than if the parent company were to pay “insurance” premiums to a subsidiary whose only insurance customer was the parent. but in the latter case, courts have long recognized that such “insurance” arrangements do not in fact shift risk from the parent company, and therefore do not accomplish the economic purpose of insurance in the first place; the resulting premiums accordingly are not deductible.81 the second cluster of transfer pricing strategies that firms rely on to generate stateless income is simply aggressive contractual terms.82 in a world where licenses of high-value internally-created intangibles have no observable market value and where the arm’s-length principle itself fails to assign the synergies created by operating as a multinational enterprise, firms can be expected to adopt intragroup contractual terms that favor low-taxed affiliates. the u.s. internal revenue service in particular has recognized and struggled with this problem, both in administrative regulations and through litigation, but every case it brings is a multimillion dollar commitment of time and resources, and success is not assured.83 aggressively low buy-in payments in cost sharing agreements or in contractual license terms can be described as simply a question of getting the transfer price “right,” but the data all point to the fact that the internal revenue service, despite years of effort, has largely lost the battle.84 profits of low-taxed foreign subsidiaries are systematically greater than profits of u.s. or high-taxed foreign siblings, for reasons inexplicable except by reference to widespread transfer pricing gaming. the third logical group of transfer pricing strategies to generate stateless income is the case of a pure business opportunity.85 a multinational efficacious remains to be seen. for a politely skeptical view, see hearing before the h. ways and means comm., 111th cong. (testimony of r. william morgan, managing director, horst frisch incorporated) (2010). [hereinafter morgan testimony] 81. see, e.g., humana, inc. v. commissioner, 881 f.2d 247 (6th cir. 1989). 82. jct, income shifting and transfer pricing, supra note 14, at 77– 83 (delta company example). 83. see veritas software corp. et al. (symantec) v. commissioner, 133 t.c. 297 (2009) (cost sharing arrangement between veritas software and its irish subsidiary in which veritas assigned all its existing intangibles to its subsidiary in return for royalties and a buy-in payment of $118 million between the two was an arm’s-length transaction); morgan testimony, supra note 80. 84. see supra note 75, 76. see also jct, income shifting and transfer pricing, supra note 14; kleinbard, territorial taxation, supra note 1, at 552–55. 85. see hospital corp. of am. v. commissioner, 81 t.c. 520 (1983). absent a finding that the arrangement lacks a business purpose, the current rules only allow for price adjustment of the transaction, and not its complete disregard. see sheppard, tax officials, supra note 7. 2001] stateless income 737 group often is in a position to exploit a special business opportunity in circumstances in which the group is reasonably confident that the project will be very profitable; in such circumstances, it frequently is the case that relevant transfer pricing statutes will not treat the assignment of that opportunity at the very outset of the project to a low-taxed affiliate as an intragroup transfer of any asset to which transfer pricing principles might be applied at all.86 unlike the first two instances of transfer pricing issues, this is a conceptual limitation in the application of transfer pricing principles. 3. legal system arbitrage a third standard tool in stateless income planning is the arbitrage of different legal systems. for example, an instrument might be treated as taxdeductible debt in one jurisdiction, but as equity in the hands of the investor from the perspective of the latter’s jurisdiction. more commonly, the u.s. “check-the-box” regulations described earlier permit firms to present their operations as conducted by one entity for non-u.s. tax purposes, but by another under u.s. tax principles. c. how large is stateless income? there is strong evidence that multinational firms substantially reduce their aggregate worldwide tax burdens through stateless income planning. in light of the obviousness of the assertion to anyone working in the field, this subsection only briefly reviews some of that evidence, looking at both “cash” tax liabilities (that is, the tax liabilities shown as due on the taxpayer’s actual tax returns) and financial accounting data. the conclusion is that the evidence strongly implies that u.s. firms are operating in a tax environment not very different from that of foreign competitors in territorial tax systems. 1. cash tax liabilities the actual tax liabilities of u.s. multinational firms are confidential, because corporate tax returns, like individual ones, are not released to the public.87 fortunately, the internal revenue service statistics of information 86. see supra note 7. when the oecd invited commentary on its newly issued oecd guidelines, many organizations argued that such business opportunities were potentially outside the scope of transfer pricing. see letter from pricewaterhousecoopers to jeffrey owens, director oecd centre for tax policy and administration (sept. 2, 2010), www.oecd.org/dataoecd/52/7/46043673.pdf. 87. u.s. gaap accounting requires companies to set out their cash tax payments in a year, but those payments are an undisclosed amalgam of estimated tax payments for the current year, final payments for the preceding year, payments or 738 florida tax review [vol. 11:9 division publishes tax data on controlled foreign corporations biennially; the presentation includes the aggregate “earnings and profits” of all controlled foreign corporations having positive earnings and profits for the year in question, and the foreign income taxes paid or accrued by these profitable foreign companies in respect of that year. 88 the term “earnings and profits” is a technical tax term of art, and for this purpose can be understood as a measure of income calculated using fundamental tax norms like the realization principle, but with more economic measures of key items (such as depreciation) than would apply for purposes of calculating taxable income for a domestic income tax return. in 2006 (the most recent year for which such data have been released), the internal revenue service statistics of information division’s public data show that controlled foreign corporations with positive earnings in that year had earnings and profits (before taxes) of $587.8 billion. those firms paid or accrued foreign income taxes of $96.6 billion in respect of that year.89 these data therefore suggest that u.s.-controlled foreign corporations actually paid or accrued foreign taxes in respect of their 2006 economic income at an effective rate of 16.4 percent. the same figure for 2004 was comparable, at 15.7 percent. in a very recent study relying on treasury nonpublic data, grubert studied 754 large nonfinancial u.s. multinational corporations and 111 financial ones for which data were available for both 1996 and 2004; this population represented about 80 percent of all the foreign income of u.s.based multinationals in the later year.90 grubert reported that the effective foreign tax rate of the foreign subsidiaries of these firms was 21.3 percent in 1996; that same figure fell to 15.9 percent in 2004.91 (this of course accords with the 2004 and 2006 statistics of information data on the larger universe of all u.s.-controlled foreign corporations summarized in the preceding refunds received as a result of audit settlements, and similar factors. the net amount shown in the financial statement therefore does not correspond to a firm’s income tax liability in respect of that year. 88. for greater detail on the calculation of this information, see lee mahoney & randy miller, controlled foreign corporations, 2004, irs statistics of information bulletin, summer 2008, 49, 58–59. (the biennial article for 2006 has not yet been published, but the data have been posted to the statistics of information’s website.) 89. technically, these taxes include taxes paid to u.s. possessions. id. at 59. 90. harry grubert, foreign taxes, domestic income, and the jump in the share of multinational company income abroad: sales aren’t being globalized, only profits 11 (oxford univ. centre for bus. tax’n, working paper wp09/26), http://www.sbs.ox.ac.uk/centres/tax/papers/pages/paperwp0926.aspx [hereinafter grubert, foreign taxes and domestic income, working paper]. 91. id. at appendix table. 2001] stateless income 739 paragraph.) to put that 15.9 percent effective foreign tax rate in context, the government accountability office calculated that for 2004 the weighted average u.s. domestic effective tax rate for large profitable u.s. corporations was 25.1 percent; the median stood at 31.8 percent.92 as described in the next subsection, financial accounting data suggest that these low tax rates are not shared universally by all u.s. multinationals, but rather are concentrated in some sectors, such as technology and pharmaceutical manufacturing. this in turns suggests that the foreign tax rates enjoyed by controlled foreign corporations in these industries often must be materially lower than the 16 percent average effective tax rate. for example, microsoft corporation’s financial statements in its 2010 annual report indicated that the company has $29.5 billion in “permanently reinvested earnings” outside the united states (that is, after foreign-tax earnings of foreign subsidiaries that microsoft does not currently intend to repatriate to the united states).93 microsoft also noted that the tax cost of repatriating those earnings to the united states would be $9.2 billion.94 these numbers suggest that microsoft’s permanently reinvested foreign earnings enjoyed an effective foreign income tax rate in the neighborhood of 4 percent.95 as another example, largely by virtue of the double irish dutch sandwich structure described above, google inc.’s 2009 financial statements imply that google paid an effective tax rate on its foreign income of roughly 2.4 percent.96 as one final example, the pharmaceutical firm 92. u.s. gov’t accountability office, gao-08-950, u.s. multinational corporations: effective tax rates are correlated with where income is reported 12 (2008). 93. microsoft corporation, 2010 annual report, p. 59 http://www.microsoft.com/investor/reports/ar10/10k_dl_dow.html. the next subsection describes the concept of “permanently reinvested earnings” in more detail. 94. id. some of this $9.2 billion repatriation tax cost might be attributable to foreign withholding taxes, but those taxes in turn ordinarily are fully creditable in the united states; as a result, the division of the repatriation tax cost between foreign withholding tax and u.s. residual income tax does not affect the calculation summarized in the following sentence in the text. 95. 9.2/29.5 = 31 percent, implying that foreign tax credits associated with the repatriation of all permanently reinvested earnings would amount to only about four percentage points. 96. see drucker, google 2.4% rate, supra note 11. the 2.4 percent figure technically relies on financial accounting data, because that is all the public information that is available. the author appears to have calculated the figure as follows. note 14 to google’s 2009 consolidated financial statements attached to its 2009 form 10-k set out the firm’s income from foreign operations and its provisions for foreign income taxes (see google, 2009 annual report, http://investor.google. com/documents/2009_google_annual_report.html). the author apparently took as 740 florida tax review [vol. 11:9 johnson & johnson reported in its public financial statements for 2007 that its operations in ireland and puerto rico alone reduced its financial accounting provision for income taxes from the statutory rate of 35 percent to 26.2 percent.97 that is, income reported for tax purposes in ireland and puerto rico was so large as to reduce the worldwide financial accounting tax provision of johnson & johnson by 8.8 percentage points. readers will appreciate that this reduction in worldwide tax costs (as measured for financial statement purposes) is not proportionate to the relative size of the irish and puerto rican pharmaceutical markets in comparison to those of all the markets in which johnson & johnson operates. these extraordinarily low effective foreign income tax rates theoretically could be explained if most countries had commensurately low statutory corporate income tax rates. but that is a false hypothesis. the unweighted average of the maximum statutory corporate income tax rates of member states of the oecd in 2006 was just about 28 percent (25.6 percent in 2010, excluding in this case the united states).98 and working with firmspecific confidential u.s. treasury data, treasury department economist harry grubert and professor rosanne altshuler calculated that for the year 2002 u.s. multinational firms faced an average foreign statutory tax rate of 29 percent, weighted by the firms’ foreign incomes.99 as another example, koninklijke philips electronics n.v (philips), a major dutch multinational industrial group, reported in its 2007 annual report that the weighted average his numerator the total financial accounting tax provision (current and deferred) for foreign taxes for the three-year period 2007-09, and took as his denominator the firm’s total from foreign operations for the same three-year period. it is possible of course that there can be significant differences between gaap accounting determinations of what constitutes income from foreign operations and the income that a u.s. multinational firm actually treats as income includible on the tax returns of its foreign subsidiaries. 97. johnson & johnson, 2007 annual report, p. 56, http://files.shareholder. com/downloads/jnj/1275963148x0x171267/057640f8-b2c0-4b0f-9f54-7a24a 553c3ce/2007ar.pdf. at year end 2007 johnson & johnson’s permanently reinvested earnings totalled $24.2 billion. 98. oecd, oecd in figures 2009 58 (oecd publishing) (2009), table of 2006 comparative income tax rates (28.1 percent oecd simple average of maximum corporate statutory rates, including subnational taxes on corporate income). 99. see harry grubert & rosanne altshuler, corporate taxes in the world economy: reforming the taxation of cross-border income 322–23 (rutgers univ., dept. of econ. working paper no. 2006-26), ftp://snde.rutgers.edu/rutgers/wp/ 2006-26.pdf (29 percent effective statutory rate for foreign subsidiaries in 2003). see infra, text at notes 127-130 for 2010 figures and discussion. 2001] stateless income 741 statutory tax rate of all the jurisdictions in which it did business was 26.9 percent.100 some of the difference between statutory and effective tax rates can be explained by tax preferences like accelerated depreciation, but it is highly improbable that most can be. to the contrary, the general trend in corporate tax systems for many years has been lower statutory rates combined with broader bases, which operate to reduce the value of tax preferences.101 and the oecd’s annual statistical survey shows that, when comparing 1995 to 2005, corporate tax revenues rose on average across the oecd member states, both as a fraction of country gdp and as a fraction of country tax revenues.102 it is stateless income tax planning that explains the success of u.s. firms in reducing their average effective foreign income tax rate in the 20022006 period to the neighborhood of 16 percent, and particularly adroit firms in reducing it to single digits. there also is strong circumstantial evidence of stateless income tax planning in the extraordinary magnitude of interest and royalty payments made by u.s. firms’ foreign subsidiaries (technically, controlled foreign corporations) to other foreign subsidiaries. table 1 sets out the relevant data for 2004 and 2006 (the most recent year for which data are available), as prepared by the internal revenue service statistics of information division: 100. koninklijke philips electronics n.v., 2007 annual report, note 6 to us gaap financial statements & note 42 to ifrs financial statements, http://xbrl.rienks.biz/company/annualreport/koninklijke_philips_electronics_n.v./2 007. the text returns to philips at [text at note 119], where its financial statements are compared to those of a u.s. competitor, general electric company. 101. johannes becker & clemens fuest, optimal tax policy when firms are internationally mobile, (oxford univ. centre for business tax’n, working paper no. 09/07), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=863484. becker and fuest suggest that the optimal tax strategy to address the increasing mobility of international firms is a tax rate cut coupled with a broadened base. 102. oecd 2008 revenue statistics, tables 12 and 13. http://www.oecdilibrary.org/taxation/revenue-statistics-2008_rev_stats-2008-en-fr. the figures are unweighted averages. in most large economies foreign-owned domestic firms are a minority of the local economy. as result, these rising corporate tax revenues can be explained by increasing profitability of domestically– owned firms, or increasing effective tax rates on them. http://xbrl.rienks.biz/company/annualreport/koninklijke_philips_electronics_n.v./2007 http://xbrl.rienks.biz/company/annualreport/koninklijke_philips_electronics_n.v./2007 742 florida tax review [vol. 11:9 table 1: royalty and interest paid by controlled foreign corporations103 rents, royalties & license fees interest year paid to us related parties paid cfc to cfc paid to us related parties paid cfc to cfc 2004 $59,275,141,484 $13,489,657,755 $12,419,547,764 $42,039,808,030 2006 $66,719,388,821 $12,659,524,687 $25,139,162,746 $67,012,282,063 as can be seen, in 2006 controlled foreign corporations of u.s. parent firms made approximately $80 billion in (presumptively) deductible royalty and interest payments to other controlled foreign corporations. and this sum in turn vastly understates the actual quantity of such payments, because it completely ignores payments by a “disregarded entity” — a subsidiary of a controlled foreign corporation that for u.s. tax purposes is treated as having no separate juridical existence, but which is very much alive and counted as a company for local tax purposes. the google facts described earlier are a real life example of enormous (presumably, multi-billion dollar) royalty streams among foreign affiliates of a u.s. multinational group that work to accomplish stateless income goals but that are invisible for u.s. tax purposes. as another example, if an irish controlled foreign corporation owned 100 percent of a german second-tier subsidiary and “checked the box” with respect to the german entity, for u.s. tax purposes the separate existence of the german company would terminate and the irish corporation in turn would be viewed as directly engaged in business in germany through a branch operation. when the german company paid interest or royalties to its irish parent, those payments generally would be deductible for german tax purposes (the relevant inquiry for stateless income purposes), but would be invisible in the data collected by the internal revenue service and summarized above. the other factor pointing to widespread stateless income tax planning is the often-observed importance of a handful of very low-tax jurisdictions, such as ireland, singapore, switzerland, bermuda, and the cayman islands in explaining the foreign effective corporate income tax rates of u.s. firms.104 this concentration of u.s. multinational firms’ 103. electronic communication from the u.s. internal revenue service, statistics of information division (sept. 27, 2010) (on file with the author). 104. clausing, revenue effects, supra note 71 (showing importance of ireland, luxembourg, bermuda, switzerland and other low-tax countries as the situs of u.s.-domiciled multinational firms’ profits); martin sullivan, extraordinary profitability in low-tax countries, 120 tax notes 724 (august 25, 2008) (“lowtax ireland is particularly prone to high profitability.”); martin sullivan, u.s. 2001] stateless income 743 reported incomes in a handful of relatively small foreign economies whose only common feature is their low tax rates belies the notion that u.s. firms’ low effective foreign tax rates in the 2002-06 period were attributable simply to tax preferences that were generally available in high-tax countries. harry grubert’s most recent paper is not an inquiry into the constituent parts of stateless income as such; instead, it studies the factors that explain the surge in the foreign share of the worldwide income of u.s. multinationals from 1996 (when the foreign share of worldwide income of u.s. firms stood at 37.1 percent) to 2004 (when the foreign share reached 51.1 percent).105 nonetheless, in the course of his analysis, grubert identifies several themes consistent with the pervasive presence of stateless income tax planning in general. for example, grubert attributes about 2 percentage points of the 5.4 percentage point decline in foreign effective tax rates from 1996 to 2004 to the implementation of check-the-box strategies.106 and more generally, he finds evidence that lower tax rates abroad are positively correlated not only with a larger foreign portion of a firm’s worldwide income, but also with higher profit margins on sales abroad, and lower profit margins domestically.107 the fruits of stateless income tax planning are that by mid-2011 foreign subsidiaries of u.s. firms held about $1.4 trillion in retained lowtaxed earnings (net of the $312 billion in special dividends that qualified for the one-year repatriation holiday afforded by section 965 of the internal revenue code).108 to the same effect, grubert, in the recent study summarized earlier, found that, from 1996 to 2004 (i.e., in the period immediately preceding the one-time repatriation tax holiday), the share of multinationals shifting profits out of the united states, tax notes, march 10, 2008; martin sullivan, a challenge to conventional tax wisdom, 44 tax notes int’l 841 (dec. 11, 2006) (30 percent of the pre-tax profits of foreign affiliates of u.s. firms were located in very low-tax countries, a figure greatly disproportionate to employment or physical capital there); altshuler & grubert, the three parties in the race to the bottom, supra note 69, at 170, 182 (finding that from 1997 to 2002 there was almost 100 percent growth in the income of foreign affiliates of u.s. parent companies in seven major low-tax countries (bermuda, cayman islands, ireland, singapore, the netherlands, luxembourg, and switzerland), and that this income represented roughly 40 percent of worldwide income from equity investments). 105. grubert, foreign taxes and domestic income, working paper, supra note 90, at 10, 12. 106. id. 107. id. at 19-20. as a result, “not only do companies shift income from high tax foreign countries to low tax foreign countries but also from the united states abroad.” 108. j.p. morgan & co., north american equity research, u.s. equity strategy flash (june 27, 2011). 744 florida tax review [vol. 11:9 u.s. firms’ worldwide income that was retained by foreign subsidiaries each year climbed from 17.4 percent to 31.4 percent.109 2. financial accounting evidence in a very real sense, current cash tax liabilities are not as important to a firm as are its audited financial accounting statement provisions for taxes, because u.s. generally accepted accounting principles (gaap) are the lens through which investors judge public firms.110 indeed, investors have little choice in the matter. a firm’s u.s. corporate income tax return is confidential, while gaap financial statements of publicly-held firms of course are not. and here again one sees evidence that u.s. multinational firms enjoy very low effective foreign tax rates that can logically be explained only through stateless income tax planning. u.s. gaap accounting for taxes is an odd mixture of different concepts.111 very generally, the idea behind the tax reconciliation table in a firm’s tax footnote to its financial statement is to calculate a hypothetical tax burden equal to the u.s. statutory rate (35 percent) applied to gaap (not tax) measures of the firm’s income. differences between the actual u.s. tax burden and the hypothetical gaap figure must be accounted for, either as temporary differences (e.g., differences in depreciation accounting conventions) or as permanent differences (e.g., irreversible differences between the gaap and tax accounting measures of income, such as taxexempt bond interest income). financial accounting further assumes that temporary timing differences between income as measured for gaap and tax law purposes will reverse at the statutory rate; these temporary differences multiplied by the statutory tax rate give rise to a “deferred tax asset” when gaap timing benefits run ahead of the tax law and a “deferred tax liability” in the converse case. permanent differences, however, are 109. grubert, foreign taxes and domestic income, supra note 9, at 2. 110. john r. graham, michelle hanlon & terry shevlin, real effects of accounting rules: evidence from multinational firms’ investment location and profit repatriation decisions, j. acct. res. (forthcoming 2011) [hereinafter braham, hanlon & shevlin, accounting rules]. this article argues that gaap accounting for taxes in fact dominate cash tax costs. gaap accounting now requires firms to set out their cash tax payments for a year. this category is not the same as the tax liabilities shown as due on the firm’s tax returns for the year, because the financial accounting category is a simple record of cash flows: tax payments in respect of prior years are conflated, for example, with estimated payments in respect of the current year. as previously noted, this article uses the phrase “cash” taxes to mean the tax liabilities shown as due on the taxpayer’s tax returns for the year in question. 111. see id. for a more detailed description of gaap applicable to taxes relating to foreign earnings. 2001] stateless income 745 reflected simply as a reduction in the firm’s tax expense, and therefore its effective tax rate. in particular, u.s. gaap does not require any deferred tax liability to be established for the contingent residual u.s. tax liability that might be incurred on the repatriation of “permanently reinvested” low-tax foreign earnings. a better term for this amount might be “indefinitely reinvested” foreign earnings. so long as a firm can demonstrate that it has no current plan to repatriate foreign income and does not have an identified need to do so, it need not provide for the potential liability for doing so on its gaap financial statements.112 this means that low-taxed “permanently reinvested” earnings bring down a firm’s gaap tax expense. it also means that firms that defer the repatriation of active foreign earnings are not penalized relative to competitors in territorial systems, when viewed through the lens through which investment decisions ordinarily are made. two recent complementary empirical studies confirm the intuitive heuristic that gaap accounting for taxes on foreign earnings dramatically affects the repatriation decision. in one, blouin, krull and robinson, working with confidential bureau of economic analysis data, conclude that “our empirical tests tell a consistent story; [gaap] reporting incentives [for permanently reinvested earnings] deter the repatriation of foreign earnings.”113 in the other, graham, hanlon and shevlin report the results of an extensive survey of firm tax executives; the authors conclude that “the ability to not recognize the u.s. income tax expense on foreign earning in financial statements . . . is an important consideration in real corporate investment decisions regarding location of operations and whether to repatriate foreign earnings to the u.s. or reinvest the foreign earnings overseas.”114 some studies have suggested that the market in fact discounts stock prices for the u.s. residual tax that firms actually disclose in their financial statements as estimates of the cost of repatriating their permanently reinvested earnings.115 even if the market does discount these stocks, recent 112. a more technical description would be that the facts drive a required financial accounting result, but that the company controls the relevant facts, including those relating to its future plans. 113. jennifer l. blouin, linda k. krull & leslie a. robinson, is u.s. multinational intra-firm dividend policy influenced by reporting incentives? 6 (tuck sch. of bus. working paper no. 2009-68), http://ssrn.com/abstract=1468135. the authors also find that public companies are more sensitive to the accounting benefits of permanently reinvested earnings than are private firms, which is consistent with the point made earlier in the text that financial accounting is the lens through which stakeholders view public firms. 114. graham, hanlon & shevlin, accounting rules, supra note 110, at 3. 115. see mark bauman & ken shaw, the usefulness of disclosures of untaxed foreign earnings in firm valuation, 30 j. am. tax. assoc. 53 (2008) 746 florida tax review [vol. 11:9 corporate practice seems to tilt heavily in favor of not quantifying estimated repatriation tax costs. for example, out of the thirty constituent members of the 2010 dow jones industrial average, only three disclosed their 2007 estimated tax costs to repatriate their permanently reinvested earnings.116 in sum, from the perspective of investors, the u.s. global tax regime often operates much like a territorial system. for example, in 2007 (chosen as the last year before the current financial crisis) the effective u.s. gaap tax rate for the global operations of general electric company (ge) and its gaap-consolidated subsidiaries was 15.1 percent.117 (this means, of course, that ge’s effective foreign income tax rate for the year was far lower, as the 15.1 percent figure represents an average of foreign and u.s. income tax rates on their respective proportions of firm income.) the non-inclusion of any gaap liability for u.s. taxes on foreign operations accounted for 15.2 percentage points of the difference between the statutory rate of 35 percent and the reported global tax rate of 15.1 percent.118 by way of rough comparison, philips, which is domiciled in a territorial tax country (the netherlands) and is a competitor of general electric in many markets, prepares its financial statements under both u.s. gaap and international financial reporting standards (ifrs). as previously noted, philips reported for 2007 that the weighted average statutory tax rate of the jurisdictions in which it did business was 26.9 percent; its effective financial accounting tax rate for the year was 13.9 percent applying u.s. gaap, and 11.1 percent under international financial (“this result is due to estimated repatriation tax amounts exhibiting downward bias, and less accuracy for actual repatriation tax effects, relative to firm-disclosed repatriation tax amounts”); julie h. collins, john r.m. hand & douglas a. shackelford, international taxation and multinational activity 143–172 (james r. hines, jr. ed. 2000). bryant-kutcher, eiler, and guenther also found evidence that firms’ stock prices were discounted for disclosed repatriation tax costs, but only if those firms also had accumulated high levels of excess foreign cash, presumably in an effort to avoid repatriation taxes. see lisa bryant-kutcher, lisa eiler & david a. guenther, taxes and financial assets: valuing permanently reinvested foreign earnings, 61 nat’l tax j. 699, 701 (2008). by contrast, at least one study concludes that the market does not discount stock prices for the unreported tax liability from permanently reinvested earnings. dan dhaliwal & linda krull, permanently reinvested earnings and the valuation of foreign subsidiary earnings (2006), http://www.entrepreneur.com/tradejournals/ article/197721239.html (last visited, aug. 18, 2011). also, while the collins, hand, and shackelford model, for example, concludes that stock prices are negatively affected by disclosed but unquantified tax liabilities, it does not estimate with statistical significance the size of this effect. 116. see table 2, infra. 117. ge, 2009 annual report, p. 93, http://www.ge.com/ar2009 (showing 2007 as well as 2009 effective tax rate data). 118. id. http://www.ge.com/ar2009 2001] stateless income 747 reporting standards (ifrs).119 under either accounting standard, the tax cost reported to investors was not dramatically different from that reported by ge.120 the substantial difference under either measure between philips’ global weighted average statutory tax rate (26.9 percent) and its financial accounting provision for income taxes (13.9 or 11.1 percent) also is consistent with the fundamental stateless income story that this article addresses. an examination of the financial accounting results of a larger population of major u.s. firms shows again that many appear to earn significant stateless income, sufficient to drive down their worldwide effective tax rates by a substantial amount. the following table (table 2) shows the fiscal year 2007 financial statement global effective tax rates for firms that in 2010 were constituents of the dow jones industrial average. (2007 was chosen as the last year not affected by the recent global economic crisis.) the list of constituent firms includes some companies whose operations are primarily domestic, and others (the natural resources firms) for which foreign taxes are both extraordinarily high and a substitute for royalties to the sovereigns in which they operate. column 3 lists the contributions of permanently reinvested earnings to that effective tax rate; like the second column, these figures are calculated by each firm and reported in the notes to its financial statements. very generally, column 3 represents each firm’s calculations of the effect of all the factors that are reflected in the effective tax rate associated with its permanently reinvested earnings on the firm’s global reported effective tax rate. those factors include differences in tax rates (which in turn are attributable both to real operations in low-tax jurisdictions and to stateless income tax planning), but also other differences between u.s. gaap accounting and the taxes actually scheduled to be collected on the foreign operations in question (for example, a tax-motivated “foreign tax credit generator” transaction). although the data presented in column 3 technically include factors other than the difference between the u.s. tax rate and the tax rates that a firm actually enjoys on foreign income, it is realistic to assume that the permanent differences summarized in column 3 do in fact primarily relate simply to low foreign tax rates.121 119. philips 2007 annual report, pp. 155, 219, http://xbrl.rienks.biz/ company/annualreport/koninklijke_philips_electronics_n.v./2007. 120. the text, of course, presents one year’s comparison between two companies, not a statistically valid sample, but the point retains some illustrative power of the importance of “permanently reinvested” foreign earnings to the reported tax liabilities of u.s. firms. 121. to test this intuition, i have attempted to isolate in very approximate terms how much of column 3 is attributable to firms enjoying low tax rates on their permanently reinvested income, as opposed to any of the other factors that firms reflect in the data presented in column 3. 748 florida tax review [vol. 11:9 column 4 lists each firm’s accumulated permanently reinvested earnings at the end of 2007. column 5 identifies those firms that provided an estimate of the u.s. residual tax cost of repatriating their permanently reinvested earnings, along with their estimate thereof. to do so, i first estimated the growth in current year permanently reinvested earnings for firms other than financial or natural resources companies listed in table 2. (there are 24 such firms in table 2 for which the available disclosure provided the necessary information.) since actual current year contributions to permanently reinvested earnings are not disclosed, i estimated the number by comparing accumulated permanently reinvested earnings at the end of 2006 and 2007. (this calculation of course is inaccurate to the extent a firm has reclassified permanently reinvested earnings as no longer permanently reinvested, or vice versa.) i assumed that those earnings were taxed at a rate of 16 percent (the average effective foreign tax rate applicable to u.s.-controlled foreign corporations in 2006); that assumption of course likely is wrong when applied to any individual firm, but should be roughly accurate when the results are averaged. i then calculated for each such firm the difference between (i) the u.s. statutory rate of 35 percent and (ii) that 16 percent rate, each applied to the calculated approximation of current year permanently reinvested income, and expressed the result as a contribution in percentage points. the unweighted average for the 24 selected firms of the percentage point effect on their effective tax rates of permanent differences relating to foreign income (i.e., column 3) was 7.8 percent. the unweighted average of the alternative estimate outlined above was 7.5 percent. this suggests that the intuition that the bulk of column 3 relates simply to lower tax rates and not to other more exotic financial accounting issues is reasonably accurate. 2001] stateless income 749 table 2: effective tax rates and permanently reinvested earnings of constituent firms of 2010 dow jones industrial average for fiscal years ending in 2007 (1) (2) (3) (4) (5) company name etr (%) percentage point effect on etr of permanent differences relating to foreign operations122 accumulated pre (in billions of dollars) disclosed cost to repatriate pre (in billions) 3m 32.1 (2.8) $5.7 not provided alcoa 34.6 (3.7) $8.8 not provided american express 27.3 (5.1) $4.9 $1.1 at&t 34.4 (0.0) immaterial immaterial bank of america 28.4 (2.3) $5.8 $0.9 boeing 33.7 not provided not provided not provided caterpillar 30.0 (4.7) $7 not provided chevron 41.9 8.3 $20.6 immaterial cisco 22.5 (12.8) $16.3 not provided coca-cola 24.0 (10.8) $11.9 not provided disney 37.2 (0.5) immaterial immaterial dupont 20.0 (7.5) $9.6 not provided exxon mobil 44.4 10.4 $56 immaterial ge 15.5 (15.7) $62 not provided hewlettpackard 20.8 (13.2) $7.7 not provided home depot 38.1 0.0 $1.2 not provided ibm 28 (6.0) $18.8 not provided intel 23.9 (4.7) $6.3 not provided johnson & johnson 20.4 (18.0) $24.2 not provided jpmorgan chase 32.6 (1.1) $3.6 not provided kraft 30.5 (4.9) $3.9 not provided mcdonald’s 34.6 (7.5) $6.7 not provided 122. as reported by firms in their 2007 financial statements. these figures include not only the tax savings from permanently reinvested earnings, but also any other permanent benefit. in looking at these figures, it is important to remember that if, for example, a u.s. firm earns 50 percent of its pretax income domestically, and records a reduction in its global effective tax rate of 6 percentage points, in reality its foreign effective tax burden would be some 12 percentage points below the u.s. rate. 750 florida tax review [vol. 11:9 merck 2.8 (35.5) $17.2 not provided microsoft 30.0 (5.1) $6.1 $1.8 pfizer 11.0 (21.6) $60 not provided procter & gamble 29.7 (4.3) $17 not provided travelers 26.0 (0.0) $0.4 not provided united technologies 28.8 (5.2) not provided not provided verizon 42.0 5.9 $0.9 not provided wal-mart 33.6 (1.8) $8.7 not provided unweighted average 28.6 (5.9) the variability in effective tax rates is extraordinary, but not surprising to specialists. it is consistent with a story in which firms driven by economic rents derived from high-value intangible assets (the pharmaceutical and technology companies, for example) find it particularly easy to generate stateless income, while consumer firms have somewhat less ability to do so, and natural resources firms face higher tax rates abroad (where the bulk of their resource extraction takes place) than in the united states. iv. implications of stateless income this section considers the immediate implications of a world imbued with stateless income for current tax systems for taxing foreign direct investment. the discussion emphasizes the united states, but attempts also to identify issues that are particularly important for territorial systems. the companion article, the lessons of stateless income, extends this discussion along two margins, by analyzing what the pervasive presence of stateless income means for standard efficiency norms by which international income tax systems are judged, and by reviewing how those systems might be revised to be more robust to the corrosive effects of stateless income. a. the fruitless search for source the global tax norms that define the geographic source of income or expense are largely artificial constructs.123 is interest income earned and 123. see, e.g., wolfgang schön, international tax coordination for a second-best world (part i), 1 world tax j. 67, 68 (2009) (“[t]he whole concept of ‘source’ has become less and less meaningful as a starting point for international tax allocation.”); tim edgar, jonathan farrar & amin mawani, foreign direct investment, thin capitalization, and the interest expense deduction: a policy 2001] stateless income 751 taxed where the lender is located and capital provided, or at the location of the borrower, where the capital is put to use? the accepted norm, and thus the general operating rule, is the former, which is why source countries typically give deductions for interest paid to nonresident affiliates of a local firm. and if a u.s. parent company borrows externally but then contributes those funds to the equity of a subsidiary, should the interest deduction remain with the u.s. parent? if not, how should the interest expense be apportioned among members of the group? by tracing? by a fungibility standard? the artificiality of the global norms that define the source of income is a well-known problem, for which solutions are not obvious.124 but territorial tax solutions require their resolution, because the source rules that are adopted determine the jurisdiction with the right to tax the income in question. source rules thus are central to the entire operation of territorial tax systems. source rules also are important for the current u.s. tax system, analysis, 56 can. tax j. 803, 834–41 (2008); michael j. graetz, a multilateral solution for the income tax treatment of interest expenses, 62 bull. for int’l tax. 486, 489 (2008) [hereinafter graetz, a multilateral solution]; hugh j. ault & david p. bradford, taxing international income: an analysis of the u.s. system and its economic premises, in taxation in the global economy 11 (assaf razin & joel slemrod, eds. 1990). when referring to the “source” of income or expense, the text is describing where that item is includible in income or deducted. if a u.s. firm lends funds to a foreign affiliate, the resulting interest income is taxed in the united states; the fact that for u.s. foreign tax credit purposes that income is described as “foreign source” does not alter where it is taxed, but rather (under the unique conceptual confusions of the current u.s. system) simply makes it more likely that the income will be sheltered from tax anywhere in the world through the use of the cross-crediting techniques described earlier in this article. 124. see, e.g., vann, hard–boiled wonderland, supra note 4, at 291, 305– 43 (2010). graetz, a multilateral solution, supra note 123, eloquently describes the artificiality of source rules applicable to locating the includibility or deductibility of interest, and then recommends in effect a global multilateral treaty to apportion interest expense on pure fungibility of assets principles to all members of an affiliated group of companies, without regard to the identity of the particular affiliate that actually borrowed the funds. another way of looking at this is that graetz proposes the worldwide adoption of a formulary income standard, but applied only to interest expense. such a solution would be very desirable, but if one is going to hypothesize that it is realistic, why not also hypothesize that worldwide agreement can be obtained on formulary apportionment of all components of taxable income? as we have few examples today of functional multilateral income tax treaties outside the special (and limited) case of the european union, it would be desirable to develop more immediate solutions that look to unilateral action. 752 florida tax review [vol. 11:9 although they do not play quite the same central role as they do in territorial regimes, because source rules drive the ability of a u.s. taxpayer to claim foreign tax credits. stateless income tax planning compounds the meaninglessness of income tax source rules. even if a multinational enterprise’s income is sourced in the first instance by every country according to some economically rational set of agreed-upon principles, stateless income tax planning simply extracts the income from the source country (for example, through deductible interest, royalty, or fee payments) and deposits it in a taxfriendlier locale. for example, google’s sales to german advertisers are deducted by those customers on their german income tax returns, while google ireland has no permanent establishment in germany to which that income is attributable. as a result, google’s income derived from providing advertising services in germany effectively is untaxed in germany. that income is sourced in the first instance to ireland, as the domicile of the putative owner of the intangible assets that give rise to the advertising income. but then, in a second step unrelated to the wisdom of the first-level source rule, that income migrates to bermuda, via the double irish dutch sandwich mechanism described earlier. the result is that in a world imbued with stateless income tax planning, there can be no meaning at all to source, because transactions one or more steps removed from a firm’s original value-adding operation serve to redirect that income to friendlier locales. the efforts to date devoted to clarifying source rules largely overlook how these second or third step internal transactions — all perfectly consistent with arm’s-length standards and other bedrock global tax norms — completely erode the value of that work. stateless income planning thus poses dramatic challenges for the design of international tax systems.125 b. capture of “tax rents” global capital markets are liquid and efficient, and many countries have eliminated or greatly scaled back barriers to foreign investment in their local economies. moreover, for most direct and portfolio investment, source 125. michael devereux, taxation of outbound direct investment: economic principles and tax policy considerations, 24 oxford rev. econ. pol’y 698, 713 (2008) (“identifying where profit is generated is a fundamental problem of conventional corporation taxes in an international setting. in some ways it is a problem with which the world has learned to live, even though allocating profit among source countries is in practice a source of great complexity and uncertainty. but this problem is not just one of complexity and uncertainty: it can — and perhaps should — also affect the fundamental design of the tax system.”). 2001] stateless income 753 country net income tax effectively is the final tax on cross-border investment income.126 as a result, one should expect that global after-tax returns on corporate marginal investments will converge, because foreign and local investors will provide capital to those jurisdictions where after-tax marginal returns exceed world norms, and will withdraw capital from those where returns are below normal.127 but corporate income tax rates differ around the world, which means that pre-tax marginal returns necessarily must differ if after-tax returns do not. stateless income tax planning offers multinational firms, but not wholly domestic ones, the opportunity to convert high-tax country pre-tax marginal returns into low-tax country inframarginal returns, by redirecting pre-tax income from the high-tax country to the low-tax one.128 by doing so, 126. this view is consistent with the facts that (i) there does not exist in the world today any significant example of a true “worldwide” foreign direct investment income tax system (in which active business income of a foreign subsidiary is taxed immediately to the parent company), (ii) portfolio investments in corporate firms (whether domestic or cross-border) are not taxed on a pass-through basis (and therefore the income of such firms is taxed only on a source basis), and (iii) direct investments by individuals in domestic firms also generally are not taxed on a passthrough basis. in theory withholding taxes also might be taken into account, but in practice withholding taxes often are eliminated or greatly reduced by treaties or tax planning (e.g., the use of equity derivative contracts), and in any event are source rather than residence country burdens. as such, they simply add to the effective tax rate imposed by the source country. 127. the standard view in economics presentations is that under the conditions suggested by the text, net business income earns the same after-tax (not pre-tax) risk-adjusted returns around the world. see, e.g., george zodrow, capital mobility and capital tax competition, 63 nat’l tax j. 865, 881 (2010); fadi shaheen, international tax neutrality: reconsiderations, 27 va. tax rev. 203, 211, 213–14 (2007). these points are developed at greater length in the companion paper, the lessons of stateless income, at sections iii.a. and c. but see michael knoll, reconsidering international tax neutrality, u. penn. l. school research paper no. 09-16 (may 2009), http://ssrn.com/abstract=1407198 (arguing from counterfactual case of true “worldwide” taxation of net business income). 128. it might be argued that multinational firms are so successful in generating stateless income that their investment behavior changes global asset prices, by bidding up prices for high-tax country assets. if multinational firms were the price setters in corporate investments around the world, and they in turn paid no tax anywhere (or conversely, paid residence-country tax on everything), then one might see convergence in pre-tax rather than after-tax risk-adjusted corporate net incomes (just as should be true for interest income today). this scenario seems implausible, for several reasons. first, all domestic investors and all portfolio investors (whether domestic or cross-border) are postcorporate tax investors. see supra note 126. since much cross-border investment today is portfolio investment, there is no particular reason to assume that direct 754 florida tax review [vol. 11:9 multinational firms can be said to capture “tax rents.” their inframarginal returns stem not from some unique high-value asset, but rather from their unique status as structurally able to move pretax income across national borders. for example, assume that the united states has a corporate tax rate of 35 percent, sylvania’s tax rate on domestic income is 25 percent, and freedonia imposes a 10 percent tax rate on domestic income. moreover, capital is globally mobile, and capital markets are efficient. as a result, after-tax normal returns on capital invested in business firms are the same around the world. assume that this global after-tax rate is 5 percent. what this implies is that pre-tax normal corporate returns will vary from country to country to reflect differences in tax burdens. pre-tax corporate returns in the united states will be 7.7 percent, while in sylvania those returns will be 6.67 percent, and in freedonia 5.56 percent. a u.s. firm, confronted with earning a 5 percent after-tax return on a marginal investment, will opt instead to invest, not in low-tax freedonia, but rather in high-tax sylvania, and then through stateless income tax planning move the sylvanian pre-tax 6.67 percent return to freedonia. after freedonian income taxes on that 6.67 percent marginal return, the u.s. firm will enjoy an after-tax marginal return of 6 percent, rather than the global prevailing 5 percent rate. the incremental 1 percent return that comes without any incremental risk is an example of tax rents. at least as applied to u.s.-domiciled companies, tax rents are easier to harvest from foreign jurisdictions than they are from a multinational firm’s own country of residence.129 u.s. firms thus prefer investments in foreign investment by multinational firms sets asset prices. second, not even this paper and its companion argue that all multinational firms convert 100 percent of cross-border investment income into zero-taxed returns. third, as developed in the lessons of stateless income, the ability to generate stateless income is a form of “status” tax arbitrage, which means that it is an attribute available only to some investors competing for a particular investment. (indeed, as effective tax rate studies show, it is not even a status equally distributed among all multinational firms.) fourth, investment opportunities that yield normal returns often are relatively fungible, or can be replicated through greenfield construction. as in the domestic market for municipal bonds, or tax shelters, it seems implausible to think that market forces by themselves would be sufficient to vitiate the “tax rents” story developed in the text. 129. for example, if a u.s domestic affiliate of a u.s. multinational group pays interest to a foreign affiliate, that income will constitute subpart f income. i.r.c. §§ 954(a)(1), (c)(1)(a). when a foreign affiliate in a high-tax jurisdiction pays interest out of active business earnings to an affiliate in a low-tax jurisdiction, that interest income is not subpart f income, by virtue of section 954(c)(6), which specifically excludes from subpart f income dividends, interest, rents, and royalties received or accrued from a controlled foreign corporation . . . to the extent attributable or properly allocable (determined under rules similar to the rules of 2001] stateless income 755 high-tax countries to investments in the united states because the former are more easily employed in stateless income planning. the income already is foreign source, and straightforward earnings stripping technologies that are unavailable for domestic income can be used to move that income to a lowtax affiliate.130 the net effect is an odd incentive for u.s. firms to invest in high-tax foreign countries, to provide the raw feedstock for the stateless income generation machine to process into low-taxed permanently reinvested earnings. the tax rents that are thereby generated are retained outside the united states, to preserve their value. this last point, when combined with the arbitrage possibilities described in the next subsection, effectively answers the question often posed by the private sector as to why the united states should care if u.s.domiciled multinational firms minimize their foreign income tax liabilities. the simple answer is that the pursuit of tax rents, combined with the erosion of the domestic tax base through leverage, leads to both distorted investment decisions by domestic firms and sharply reduced domestic tax revenue collections. the best counterargument is that capital, like nature, abhors a vacuum, and that foreign investors will replace domestic firms as investors in the u.s. domestic markets.131 but this argument confuses u.s. investment with u.s. taxable income.132 to a foreign-domiciled multinational firm, the subparagraphs (c) and (d) of section 904(d)(3)) to income of the related person which is neither subpart f income nor income treated as effectively connected with the conduct of a trade or business in the united states. i.r.c. § 954(c)(6). the section 954(c)(6) look-through provision is a temporary provision that recently was extended through 2011. 130. for example, interest income paid by a u.s. affiliate to a controlled foreign corporation may be subject to withholding tax in the absence of tax treaty protection (i.r.c. § 881(c)(3)(c)), and in any event gives rise to u.s.-source subpart f income, usually as foreign personal holding company income (i.rc. § 954(a)(1), (c)), or alternatively as an investment in u.s. property under section 956) foreign income taxes in turn are not creditable against u.s. source income. moreover, “check-the-box” tax planning is generally not available to move income from a u.s. parent group to an offshore affiliate. none of these limitations apply when the income originally is earned outside the united states. 131. for a summary of the research underlying this counterargument, see james r. hines, jr., reconsidering the taxation of foreign income, 62 tax l. rev. 269, 280 (2008-2009) [hereinafter hines, reconsidering the taxation of foreign income]. 132. id. at 278 (“to a first approximation there is little effect of additional foreign investment on domestic tax revenue.”) hines offers no evidence in support of this assertion. it may be that he assumes that investment and taxable income generally are closely positively correlated. a principal theme of this article, by contrast, is that stateless income tax planning and analogous strategies employed by 756 florida tax review [vol. 11:9 united states is just another source country, and a particularly high-tax one at that. thus, it may be that foreign multinational firms replace any missing u.s. investment, but the empirical issue goes beyond that question, and must consider as well whether foreign firms are themselves wholly unschooled in u.s.-domiciled multinational groups in respect of the u.s. tax base have substantially disassociated investment from taxable income. in one fairly recent study on earnings stripping the u.s. treasury department concluded that the evidence for the proposition that foreign-controlled domestic firms systematically stripped income out of the united states was ambiguous. u.s. dep’t. treas., report to the congress on earnings stripping, transfer pricing and u.s. income tax treaties, at 3 (nov. 2007). (“as discussed below, it is not possible to quantify with precision the extent of earnings stripping by foreign-controlled domestic corporations generally. however, there is strong evidence of earnings stripping by the subset of foreign-controlled domestic corporations consisting of inverted corporations (i.e., former u.s.-based multinationals that have undergone inversion transactions).”). the treasury department study has been treated skeptically. see, e.g., stephen e. shay, ownership neutrality and practical complications, 62 tax l. rev. 317, 322 (2009). its conclusions also appear to be at least partially inconsistent with those reached in a contemporaneous report by the general accountability office, tax administration: comparison of the reported tax liabilities of foreign and u.s.-controlled corporations 1998-2005 (2008), http://www.gao.gov/new. items/d08957.pdf. (“fcdcs reported lower tax liabilities than usccs by most measures shown in this report.” id. at 3.) the gao report acknowledges, however, that there are several non-tax related factors, such as the average age of foreign and domestic-controlled domestic corporations, that might explain some of the differences in results. the treasury study can be criticized as having taken an excessively narrow view of earnings stripping as comprising only the excessive use of deductible interest. see, e.g., the treasury study at 7 (“earnings stripping usually refers to the payment of excessive deductible interest by a u.s. corporation to a related person when such interest is tax exempt (or partially tax exempt) in the hands of the related person. consequently, the treasury department has [studied] . . . the shifting of income of domestic corporations offshore through related-party debt and associated interest payments.”). this would ignore, for example, the entirely straightforward decision of a foreign acquiror to keep its valuable intangible assets outside the united states and to license them to its new u.s. subsidiary. for a more complete picture of the role of interest expense in the tax liabilities of foreign-controlled domestic companies, see harry grubert, debt and the profitability of foreign-controlled domestic corporations in the united states (u.s. dep’t treas. ota technical working paper no. 1, 2008) (finding no evidence of systematic earnings stripping through interest deductions). one interesting observation made by grubert is that his “control” population comprised u.s. multinational enterprises. id. at 6. to the extent that the control population were themselves enthusiastic users of earnings stripping opportunities, the foreigncontrolled domestic companies studied by grubert could appear normal in their behavior, while in fact engaging heavily in earnings stripping. 2001] stateless income 757 the arts of stateless income planning when it is the united states that is the source country. moreover, the same researchers who argue that foreign investment into the united states serves as a substitute for u.s. investment that has moved offshore also argue for a positive “headquarters” effect, in which investment by a firm generates investment (and income) associated with its headquarters operations in addition to those associated with the incremental investment itself.133 notwithstanding the existence of some statutory protections against earnings stripping,134 and the ambiguous studies of earnings stripping through internal group leverage noted immediately above, there thus are good reasons to believe that the united states is a net revenue loser in respect of cross-border investment flows. its tax system encourages domestic firms to invest disproportionately outside the united states, and (as the next subsection discusses) to finance domestic cash flow needs through u.s. borrowings that erode the u.s. tax base. the u.s. tax base is shifted outside the united states through domestic leverage incurred to support foreign earnings, genuine foreign earnings in turn migrate to low-tax locales, and those low-taxed foreign earnings are allowed to compound u.s.-tax free indefinitely. c. domestic base erosion through tax arbitrage a u.s. firm’s stateless income tax planning yields inframarginal tax rents. these rents come at a contingent cost, however: they can be enjoyed only if the earnings are retained outside the united states. this gives rise to the “lock-out” phenomenon discussed below. at the same time that they capture tax rents through stateless income tax planning, u.s. firms finance much of their funding needs (including dividends and stock repurchases) through domestic u.s. borrowing. the resulting interest deductions erode the u.s. corporate tax base through a classic tax arbitrage operation, in which the returns on offshore investments fall outside the u.s. tax net, while interest expense is deducted on debt that arguably would not be incurred if those returns were repatriated and the income included in the u.s. tax base. as the earlier example of microsoft corporation’s recent debt financing suggests, this arbitrage operation is not a theoretical abstraction. 133. see, e.g., mihir desai, c. fritz foley & james r. hines jr., domestic effects of the foreign activities of u.s. multinationals, 1 am. econ. j. econ. pol’y 181 (2009) (10 percent greater foreign investment is associated with 2.6 percent greater domestic investment). 134. see i.r.c. § 163(j). 758 florida tax review [vol. 11:9 as described earlier, a few special rules exist whose nominal purpose it is to limit this arbitrage — in particular, those that treat a fraction of u.s. interest expense as a reduction in foreign income. by doing so, the limitation works to increase a firm’s effective foreign tax rate on its repatriated income, thereby making it more difficult to claim foreign tax credits. in practice, however, this limitation often does not constrain the full deductibility of u.s. interest expenses. stateless income planning in general makes current law’s limitation less effective, because that planning drives down foreign effective tax rates (thereby increasing a firm’s capacity to absorb the operation of the limitation). in turn, the tax director, in her capacity as master blender of the tax distillery, chooses which casks of foreign income to tap in creating her annual vintage of repatriated income to take this rule into account, and therefore creates a very low-taxed repatriated foreign income blend (including interest and royalty income) that has capacity to absorb the allocation of u.s. expense.135 more fundamentally, there are no practical limits beyond those imposed by the marketplace on the amount of debt a u.s. firm can issue to third-party investors and then claim tax deductions for the resulting interest expense. moreover, there is no rule of current law that directly disallows or defers otherwise-deductible domestic interest expense because it arises on debt that arguably was incurred indirectly to repatriate low-tax foreign permanently reinvested earnings. given that the united states has high statutory corporate tax rates compared to world norms, it would be extraordinary to think that u.s. firms, having successfully captured tax rents through the operation of their stateless income generators, would not complete the tax minimization circle by funding their global cash needs through u.s. domestic borrowings. as an economic matter, the consequence is to turbocharge the benefits of stateless income tax planning by migrating (through domestic interest deductions) what would have been u.s. taxable income to stateless status. d. competiveness of u.s. firms: statutory and effective tax rates the united states today has (or at least will soon have) the highest federal statutory corporate tax rate of any of the world’s largest economies.136 relying in part on this fact, and in part on their assertion that 135. james r. hines, jr., foreign income and domestic deductions, 61 nat’l tax j. 461, 463–64 (2008) (“taxpayers whose foreign income is lightly taxed by foreign governments, and who, therefore, owe residual u.s. tax on that income, receive the benefit of full domestic deductibility of expenses incurred in the united states.”). 136. the government of the previous record holder, japan, had announced plans to reduce its national total (central and sub-central government) corporate tax 2001] stateless income 759 the united states imposes a worldwide tax on the income of u.s. multinational firms, many such enterprises have argued that the current u.s. tax system makes them uncompetitive against foreign multinationals operating with territorial tax regimes.137 the data point in a different direction. as a preliminary matter, the gap between u.s. and world corporate tax rate norms is sometimes overstated. many analysts find it convenient to rely on an annual oecd dataset for this purpose.138 using this source, the simple unweighted average of 2010 corporate tax rates among the 30 oecd countries, excluding the united states, was 25.6 percent. this dataset must be applied with caution in three respects. first, the dataset includes sub-central government taxes on corporate income; this explains why the u.s. rate is described as 39.2 percent. it is appropriate to include sub-central government taxes when comparing the competitive tax environment of u.s. domestic firms to foreign firms, or when measuring the foreign tax burden on inbound investment in a particular country, but it is not appropriate to include u.s. sub-central government taxes when measuring an actual or hypothetical u.s. statutory tax burden on u.s.-domiciled multinational firms contemplating an outbound investment, because as a general matter foreign income is not taxed by the states of the united states.139 the right statutory rate comparison in that case is the total rate to 34.5 percent on april 1, 2011. those plans were temporarily postponed as a result of that country’s devastating earthquake in march 2011. 137. “competitiveness” is not a concept that is well developed in the economic literature. for two recent efforts to situate the term more firmly in economic analysis, see eckhard siggel, international competitiveness and comparative advantage: a survey and a proposal for measurement, 6 j. indus. competition & trade 137 (2006); michael knoll, the corporate income tax and the competitiveness of u.s. industries, 63 tax l. rev. 771 (2009). michael knoll kindly called the former paper to my attention. u.s. multinational firms can fairly be said not to be deeply troubled by any terminological ambiguity. to such a firm, an “anticompetitive” measure is any cost that along any dimension might be greater than the comparable cost faced by a firm not domiciled in the united states. as an anecdotal matter, it has been this author’s experience that within this framework no quantum of pro-competitive factors can ever outweigh the damage imagined to be done by a single anti-competitive one. 138. for 2010 data, see oecd tax database, corporate and capital income taxes, table ii.1, http://www.oecd.org/document/60/0,3746,en_2649_ 34897_1942460_1_1_1_1,00.html#c_corporatecaptial. 139. no state directly taxes foreign income under its general corporate income or franchise tax. three states (idaho, montana and north dakota) require global consolidation and apportionment of income; if firms report consistently higher profits on a separate company basis outside the united states than they do inside, the effect of this rule may be to increase firms’ tax liabilities in those states. 760 florida tax review [vol. 11:9 (central and sub-central) foreign tax rate to the u.s. federal statutory rate (35 percent). second, the simple unweighted average of oecd statutory rates mixes rates imposed by economies of greatly disparate size; in general, however, there is an inverse relationship between the size of an economy and its corporate tax rate. in 2010, for example, the unweighted average of the five largest oecd economies other than the united states was roughly 32 percent, and the unweighted average of the next six economies was 28 percent.140 giving equal weight to the smallest 19 economies (where u.s. firms by definition face smaller markets) misstates the tax burdens fairly attributable to a multinational firm’s global economic opportunities (if undistorted by stateless income planning). finally, the oecd dataset does not include non-oecd countries, in particular, the “brics” — brazil, russia, india and the people’s republic of china. these are very important markets, of course. their 2010 unweighted average corporate tax rate was 28.25 percent.141 more fundamental to the thrust of this article, u.s.-domiciled multinational firms do not in fact bear a 35 percent tax burden in respect of their non-u.s. income. the data summarized in section ii suggest that residual u.s. tax today is a small fraction of total foreign earnings. the data summarized in section iii in turn suggest that many u.s. multinational firms are able to employ stateless income tax planning techniques to drive down their cash foreign tax liabilities and their gaap financial accounting effective foreign tax rates to levels far below the foreign tax statutory average. taken together, these data imply that the current u.s. tax system is not a direct competitive burden on many u.s. firms’ current foreign operations. instead, the data on cash u.s. tax liabilities, the gaap financial accounting record (which in turn is the lens through which financial stakeholders perceive a company) and the experience of seasoned legal finally, three states (california, utah and west virginia) permit worldwide consolidation and apportionment at the taxpayer’s election. 140. author’s calculations from the dataset cited supra note 127. the five largest economies ex-usa comprise: japan, germany, the united kingdom, france and italy. the next six comprise: canada, spain, korea, mexico, australia and the netherlands. see christopher heady, directions in overseas tax policy, in melbourne institute – australia’s future tax and transfer policy conference 8, http://taxreview.treasury.gov.au/content/content.aspx?doc=html/conference_report.h tm. 141. author’s calculation from data in kpmg corporate and indirect tax survey 2010, http://www.kpmg.com/lu/en/issuesandinsights/articlespulications/ pages/kpmg%27scorporateandindirecttaxratesurvey2010.aspx. the author’s calculation employs the standard (nonpreferential regime) maximum corporate income tax rate, which is consistent with the oecd methodology. 2001] stateless income 761 practitioners alike all point to many u.s. firms operating in an environment much closer in practice to territorial systems — indeed, superior to them in respect of intragroup interest, royalties and license fee income.142 in the same vein, grubert’s recent study of several hundred u.s. multinational firms, employing nonpublic treasury data, concludes that from 1996 to 2004 there was no meaningful correlation between lower foreign tax rates and the growth rate of u.s. firms.143 from this he concludes that “the importance of low taxes on foreign income for u.s. ‘competitiveness’ does not, at least on this evidence, have much empirical support.”144 there is evidence, however, particularly in the public financial statements of affected firms, that the benefits of stateless income tax planning are not evenly distributed across u.s. industries. some industries enjoy extraordinarily low effective foreign tax rates, while others reap more modest rewards. those in the latter category (for example, services and retail firms) have reason to believe that the current u.s. tax system for foreign direct investment is an uncompetitive environment for them, if not for other u.s. multinational firms. by contrast, u.s. firms that do enjoy the benefits of stateless income do not suffer significant u.s. residual tax costs in the aggregate on their regular course repatriations of foreign earnings. nor do such residual taxes appear measurably to influence the thinking of investors viewing a u.s. firm through the lens of gaap accounting. in sum, the interactions across the different components of current u.s. corporate tax law as applied to foreign direct investment offer sophisticated multinational taxpayers, particularly (but not exclusively) those in intangibles-driven businesses, the opportunity to earn income from foreign operations that is taxed no more heavily (and in some cases is taxed more lightly) than is the offshore income of territorial-based competitors. that income is just as susceptible of cash tax minimization through stateless income tax planning as is the foreign income of territorial tax competitors, and that income is reported to shareholders and other stakeholders through financial statements that portray a u.s. firm largely as if it operated under a territorial tax regime. some u.s. multinational firms have an easier time than do others of generating large quantities of stateless income by virtue of their age or industry, but the example of general electric company’s effective tax rate serves as an effective reminder that those firms that invest heavily in 142. the author counts himself as a seasoned, if now superannuated, practitioner, having practiced in the field for 30 years before graduating to a more contemplative career. see also j. clifton fleming jr., robert j. peroni & stephen e. shay, worse than exemption. 59 emory l. j. 79 (2009). 143. grubert, foreign taxes and domestic income, supra note 9, at 19. 144. id. 762 florida tax review [vol. 11:9 stateless income tax technicians can achieve extraordinary effective tax rate results, and capture tax rents along the way.145 the components of u.s. law that interact with each other in ways that can be manipulated to produce territorial-type tax liabilities include deferral, the treatment of each foreign subsidiary as a separate cask of income and credits, foreign tax credit blending across intercompany royalties and interest as well as dividends, cost sharing, check-the-box, and section 954(c)(6) “look through” treatment of interaffiliate deductible payments. these interact in turn in ways favorable to sophisticated firms with global international tax norms like the treatment of a subsidiary as an economic actor separate from its parent company, the honoring of intragroup debt finance, and the arm’s-length standard. e. competitiveness of u.s. firms: lock-out over the last several years, economists and tax law specialists have authored dozens of articles addressing how the united states should tax income from foreign direct investments. the volume of literature is inexplicable when viewed against the trivial tax collections currently at issue and u.s. firms’ success in arranging their affairs to operate in a quasiterritorial tax environment. the academic efforts, however, are not necessarily perverse, if measured against the possible welfare costs to the country of roughly $1.4 trillion in offshore permanently reinvested earnings, some significant portion of which is not necessary to support firms’ offshore operations.146 the “lock-out” phenomenon that current law engenders may burden firm managers less than they sometimes maintain, but it and related phenomena can nonetheless have material welfare costs for the united states. the lock-out effect refers to the fact that a firm’s benefits from stateless income planning are contingent upon the firm not repatriating more foreign earnings than its tax distillery can process. because so many u.s. firms have been so successful in developing multibillion dollar pools of lowtaxed foreign permanently reinvested earnings, those firms in turn are compelled as a practical matter to keep a large percentage of their foreign earnings and cash outside the united states solely to avoid this residual tax. for the reasons described in the preceding subsection, the real tax issue for the managers of those u.s. multinational firms that are able to 145. see supra text, at notes 112–13. 146. in this connection, recall that u.s. firms repatriated some $312 billion in extraordinary dividends in response to the one-year repatriation holiday afforded by section 965, at a time when total permanently reinvested earnings were much lower than the current figure. 2001] stateless income 763 engage in widespread stateless income tax planning is not current u.s. taxation of foreign operations, or even current u.s. taxation of ordinary course cash repatriations of low-taxed foreign source income; it is the extraordinary accumulation of profits and cash in foreign subsidiaries, and the inability of most firms’ tax resources to absorb a very large repatriation dividend. this distorts behavior (for example, by encouraging firms to borrow in the united states and to make relatively unproductive investments outside the united states), and leads to deadweight loss. a recent business news story illustrates this point effectively. after suggesting (plausibly, in the experience of this author) that the “lock-out” effect drives u.s. firms to make foreign acquisitions, simply because they need some use for the cash they have accumulated outside the united states, it quotes the chief executive officer of cisco systems to the effect that “cisco has $30 billion of its $38 billion in cash parked abroad because of higher u.s. taxes.”147 another recent article describes how ebay “has 70 percent of its cash outside the us and [as a result] is hunting for acquisitions in europe.”148 in theory, the lock-out phenomenon could exist without stateless income strategies, for example, if every country but the united states had taxed corporate income at rates comparable to those of ireland. in practice, however, the profits recorded for tax purposes in ireland and similar countries are wholly disproportionate to the size of their economies, which suggests that the lock-out phenomenon in practice is closely bound with stateless income tax planning opportunities. one popular formulation of the deadweight loss attributable to the lock-out phenomenon is that the u.s. economy has been deprived of the use of u.s. firms’ permanently reinvested earnings, presumably to the detriment of job creation and other economic activity in the united states. this formulation of the problem is vastly overstated. to the extent that permanently reinvested earnings are held in liquid financial assets, those assets are highly likely to take the form of u.s. dollar denominated debt instruments, such as u.s. bank deposits, u.s. commercial paper, u.s. government securities and other debt instruments of u.s. obligors.149 the reason simply is that in each case the u.s. parent company relies on the u.s. dollar as its functional currency for gaap purposes, and unhedged 147. serena saito, tech companies go shopping abroad, bloomberg businessweek, sept. 2, 2010, http://www.businessweek.com/magazine/content/ 10_37/b4194031986280.htm. 148. richard waters, tax drives us tech groups to tap debt, financial times, february 7, 2011 at 15. 149. the “investment in u.s. property” rules of i.r.c. § 956 are not implicated by the acquisition of debt (or, for that matter, equity) instruments of unrelated u.s. corporations. i.r.c. § 956(c)(2)(f). 764 florida tax review [vol. 11:9 investments in other currencies would expose it to income statement volatility through exchange rate fluctuations. for this reason, it can be expected that a large fraction of u.s. firms’ liquid permanently reinvested earnings already is employed in the u.s. economy. other measures of this deadweight loss have been the subject of spirited debate.150 without restating all of that dialog, one practical mode of inquiry into whether the “lock-out” phenomenon imposes substantial costs on u.s. firms from their own perspective is to ask whether u.s. firms are capital constrained, by virtue of needing to satisfy their funding needs by particularly costly borrowing in the united states, rather than repatriating cash from abroad. there is little statistical or anecdotal evidence to support such a capital constraint story for the major u.s. multinational firms that account for the bulk of u.s. firms’ income from foreign direct investment.151 many large firms with low effective foreign tax rates in fact have very low debt-toassets ratios, or do not need to borrow at all.152 indeed, since contingent residual u.s. taxes on the repatriation of “permanently reinvested” earnings are not recorded as liabilities on u.s. gaap financial statements (and in many cases are not even quantified in the notes thereto), and since those financial statements are prepared on a global consolidated basis (so that the location of cash or liquid investment assets is not specified) one would expect that prospective lenders in the public capital markets might to that extent overvalue the net worth and liquidity of firms with extensive foreign operations, thereby facilitating borrowings in the united states. when such 150. see mihir a. desai & james r. hines, jr., old rules and new realities: corporate tax policy in a global setting, 57 nat’l tax j. 937 (2004) (desai and hines estimate $10 billion in indirect efficiency losses due to retained earnings due to residual tax on dividends.); harry grubert, comment on desai and hines, “old rules and new realities: coporate tax policy in a global setting” 58 nat’l. tax j. 263 (2005) (rejecting desai and hines’ proposition because dividends account for a relatively small amount of revenue); mihir a. desai & james r. hines, jr., reply to grubert, 58 nat’l. tax j. 275 (2005); harry grubert, mnc dividends, tax holidays and the burden of the repatriation tax: recent evidence, (oxford univ. centre for bus. tax’n, working paper no. 09/27), http://www.sbs.ox.ac.uk/ centres/tax/documents/working_papers/wp0927.pdf. 151. cf. lisa bryant-kutcher, lisa eiler & david a. guenther, taxes and financial assets: valuing permanently reinvested foreign earnings, 56 nat’l tax j. 705 n. 16 (2008) (“only seven percent of u.s. firms that accumulate excess cash outside the united states to avoid the u.s. repatriation tax appear to be constrained in their access to capital markets.”) 152. as examples from the dow jones industrial average companies listed earlier, hewlett-packard, travelers and (until recently) microsoft. http://www.sbs.ox.ac.uk/ 2001] stateless income 765 firms do borrow domestically there is scant evidence that they suffer punitively high borrowing costs.153 there is implicit evidence that supports the idea that large u.s. multinational firms with substantial “permanently reinvested” earnings are not capital-constrained in the united states. in 2004, congress enacted a one-year foreign income repatriation holiday. u.s. firms responded by repatriating $312 billion in cash dividends in excess of their normal aggregate dividend repatriation rate (about $50 billion/year).154 (most of these repatriations occurred in 2005, but by virtue of the vagaries of differences in corporate fiscal years some took place in 2004 and 2006.) a subsequent study concluded that this gigantic influx was not correlated with repayments of domestic debt, or with incremental investment in domestic property, plant or equipment (as would be expected if large u.s. multinational firms were capital constrained in the united states), but was strongly positively correlated with stock buy-backs.155 153. for example, as previously described, microsoft corporation reported $29.5 billion in permanently reinvested earnings at june 30, 2010 (the end of its fiscal year). at the end of its fiscal year 2011 second quarter (december 31, 2010), microsoft reported holding $41.2 billion in cash, cash equivalents and short-term investments. (as previously described, gaap financial statements do not describe the location within a multinational group of these items.) in february 2011, microsoft borrowed $2.25 billion in the public capital markets, including $1 billion of 5.30 percent notes due in 30 years and $500 million of 4.00 percent notes due in 10 years. 154. edward d. kleinbard & patrick driessen, a revenue estimate case study: the repatriation holiday revisited, 120 tax notes 1191 (sept. 22, 2008). 155. dhammika dharmapala, c. fritz foley & kristen j. forbes, watch what i do, not what i say: the unintended consequences of the homeland investment act (nber working paper series, working paper no. 15023, 2009), http://www.nber.org/papers/w15023.pdf (“repatriations did not lead to an increase in domestic investment, employment or r.& d., even for the firms that lobbied for the tax holiday stating these intentions,”); floyd norris, tax breaks for profits went awry, n.y. times, june 4, 2009, at b1. (“there is no evidence that companies that took advantage of the tax break — which enabled them to bring home, or repatriate, overseas profits while paying a tax rate far below the normal rate — used the money as congress expected.”); charles i. kingson, the great american jobs act caper, 58 tax l. rev. 327, 388–91 (2005) (unreality of dedicating uses to which repatriated funds could be put in light of fungibility of money). dell, for example, lobbied for the holiday in order to fund a new plant, bringing back $4 billion, and only spend $100 million on the plant, which they admitted they would have built anyway, and then used $2 billion for share buyback. ironically, the 2004 legislation prohibited the use of dividends eligible for the special repatriation holiday to fund stock buy-backs. the paradox is solved once one discovers that the prohibition did not incorporate any fungibility of money concept, so that firms could both accomplish their corporate finance objectives and 766 florida tax review [vol. 11:9 perhaps the most that one can say about the costs to u.s. firms of the lock-out phenomenon is that those firms that have been extraordinarily successful in stateless income tax planning have become hoist on their own petard. they have been so successful in their stateless income tax planning, and have removed so much income from the tax base in both the united states and in high-tax foreign jurisdictions, that they now are running out of remotely feasible ways of reinvesting those huge sums accumulating in their low-tax subsidiaries.156 the cost of deferral therefore probably is rapidly increasing, by virtue of u.s. firms’ outstanding record of generating stateless income in the first place.157 another way of stating this conclusion is that the lock-out effect operates in fact as a kind of lock-in effect: firms retain more earnings (in this case overseas) than they profitably can redeploy, to the great frustration of their shareholders. the result is that shareholders are not able to optimize their portfolios, because the profits earned by successful multinational firms are retained in relatively low-yielding liquid investments or reinvested in suboptimal foreign acquisitions, all by virtue of the confluence of their great success in stateless income tax planning, on the one hand and the lock-out phenomenon, on the other. shareholders would prefer that the cash be distributed to them, but companies cannot afford to comply. this tension between shareholders and management — the lock-out effect as, in fact, a lock-in effect — probably lies at the heart of current demands by multinational firms that the united states adopt a territorial tax system. the firms themselves are not disadvantaged materially by the current u.s. tax system, but shareholders are. the ultimate reward of successful stateless income tax planning from this perspective should be massive stock repurchases, but instead shareholders are tantalized by glimpses of enormous cash hoards just out of their reach. the very recent report of the president’s economic recovery advisory board (perab) is largely consistent with the above analysis. that report began its discussion of the issue by correctly observing that u.s. firms pay little u.s. tax on their foreign operations, but that the “lock-out” problem comply with the law by segregating different pools of cash for different corporate expenditures. 156. c. fritz foley, jay c. hartzell, sheridan titman & garry twite, why do firms hold so much cash? a tax-based explanation, 86 j. of fin. econ. 579 (2007) (u.s. tax rules for foreign direct investment induce u.s. firms to accumulate excessive cash). 157. see supra text at notes 117–22. see also lisa bryant-kutcher, lisa eiler & david a. guenther, taxes and financial assets: valuing permanently reinvested earnings, 56 nat’l tax j. 699, 702–03 (2008) (“since u.s. tax law provides an incentive for foreign subsidiaries to defer repatriation of cash, managers must trade off the negative impact of u.s. repatriation taxes on firm value with the lower benefits that come from reinvesting foreign earnings in financial assets”). 2001] stateless income 767 nonetheless exists.158 it then noted that, “because us mncs have been successful in reinvesting their income abroad and deferring u.s. taxes, this [the u.s. system’s] tax disadvantage may be small. nevertheless, u.s. companies . . . bear costs that arise from tax-induced inefficiencies in their financial structure — costs that their competitors based in territorial countries do not bear.”159 as suggested above, this, in fact, is the nub of the real competitiveness issue to the extent one exists. the objective tangible evidence of inefficient financial structures would come in the form of higher borrowing costs for u.s. multinational firms that are compelled to leave cash abroad and borrow domestically. but if that is the concern, then the behavior of u.s. firms with respect to the 2004 legislation’s one-year dividend repatriation holiday is puzzling. at the same time, the perab report demonstrates the dangers of drawing policy implications from an incomplete meditation on how the u.s. system for taxing foreign direct investment actually operates.160 in particular, the perab report makes three competitiveness arguments that do not follow from its own conclusion quoted above. the perab report first claims that “the combination of lower foreign corporate tax rates and the territorial system of corporate taxation used by other countries reduces the cost of production for foreign firms competing with u.s. companies outside of the u.s. — thus raising the relative cost of u.s. mncs operating in lower-tax foreign jurisdictions.” 161 but that assertion is belied by the absence of any evidence of actual current u.s. tax burdens, or any adverse u.s. gaap financial accounting consequence to relying on deferral. to be sure, u.s. firms maintain disproportionately large tax departments to twist the valves and levers of the tax liqueur blending process, and u.s. firms also find themselves with excess cash outside the united states, and make suboptimal investments to put that cash to use. but those are at best arguments concerning the cost of the lock-out effect, not about day-to-day operational costs in a foreign jurisdiction. second, the perab report argues that “the [u.s.] worldwide/deferral approach to corporate taxation favors foreign firms operating in their own country compared to u.s. firms in that country.”162 if 158. perab report, supra note 33, at 82 (emphasis added). u.s. companies reportedly have over $1 trillion of permanently reinvested earnings. the report also states that many business people would repatriate a significant portion of the income if there were another tax holiday or a reduction in the corporate tax rate. 159. id. at 86. (emphasis added). 160. id. at 82–94. 161. id. at 86. 162. id. 768 florida tax review [vol. 11:9 anything, experience suggests exactly the opposite: in many countries it is easier for a multinational firm from a second country to implement stateless income tax planning with respect to the first than it is for a domestic multinational enterprise to strip income out of its home jurisdiction. third, the perab report argues that “the worldwide/deferral tax approach also puts u.s. mncs at a disadvantage in the acquisition and ownership of businesses in other countries compared to foreign companies that operate under a territorial approach.”163 this is a high-level restatement of the capital ownership neutrality argument. if used as a competitiveness argument, it rests on the fundamental misapprehension that the u.s. tax system actually collects significant revenues from firms’ international business operations or impedes their access to capital. in the absence of actual tax costs or adverse gaap accounting consequences, one is hard pressed to identify any operational disadvantages that flow from the u.s. tax system. and if used to advance a more abstract efficiency argument the argument is undercut by the analysis developed in the companion paper, the lessons of stateless income. f. summary of implications despite their protestations, u.s. multinational firms in fact enjoy substantially all the benefits of their territorial tax competitors, including the opportunity to employ stateless income tax planning to capture large tax rents (or to drive down their effective foreign tax rates into the single digits, which in practice is the same thing by another name) – with one exception. that is the lock-out effect, which leads u.s. firms to hold extraordinary amounts of cash equivalents outside the united states, solely to preserve the efficacy of their stateless income generation machines. the united states’ unique combination of a quasi-territorial tax regime, its enfranchisement of stateless income tax planning through idiosyncratic rules like check-the-box, and the lock-out effect leads to particularly large deadweight losses. the current u.s. tax system causes u.s.-domiciled multinational firms, first, to prefer investments in foreign high-tax countries over investments in the united states (to set the stage for stateless income tax generation); second, to establish low-tax affiliates of sufficient size and activity to serve as receptacles of stateless income; third, to invest time and resources in manning the various dials and gauges of the tax planning mechanisms required to create and defend stateless income 163. id. the perab report uses the example of a foreign company that can pay more than a u.s. company to acquire a firm in a low-tax country because the net-of-tax profits resulting from the acquisition will be higher for the foreign company than for the u.s. bidder. 2001] stateless income 769 generation; and fourth, to retain the resulting earnings and cash in those lowtaxed receptacles, in order to preserve both the cash and the financial accounting gains inhering in the production of stateless income. the results are distortions in original investment decisions, the distribution of earnings, and in reinvestments, as well as wasteful expenditures to maintain the apparatus. u.s. firms prefer investments in foreign high-tax countries to investments in the united states because the former are more easily employed in stateless income planning. the result is the first deadweight loss described above. firms must invest in foreign low-tax locations solely to create vehicles of a heft adequate to convince tax authorities in high-tax jurisdictions to respect the transactions into which the low-tax affiliate enters. this is particularly acute in the case of cost sharing and other intangible transfer pricing strategies, where tax planners place a premium on moving portable research jobs to the low-tax affiliate, to improve the prospects of prevailing in very large transfer pricing disputes. all of this investment is wasteful. firms then must invest significant time and resources in the planning and execution of stateless income strategies. again, all of this is simply deadweight loss. finally, firms can reap the rewards of stateless income strategies for both cash tax and financial accounting purposes only by keeping the resulting profits and cash in their low-tax vehicles. thus, stateless income planning feeds directly into the lock-out phenomenon. the lock-out phenomenon is driven by low effective foreign tax rates and current law’s deferral rules. stateless income tax planning in turn pushes a firm’s effective foreign tax rate downwards still further. the preservation of the benefits of stateless income through the acceptance of lock-out distorts firm behavior in welfare-decreasing ways for the simple reason that u.s. multinational firms must find some non-u.s. use for their permanently reinvested foreign earnings, which can distort their investment decisions. firms also may ignore u.s. investment opportunities that on a pretax basis would be preferred. the lock-out phenomenon has the pernicious effect of implicitly encouraging domestic leverage to fund cash needs, while leaving low-taxed foreign earnings abroad. this strategy allows u.s. multinational firms to compete in a quasi-territorial environment (by preserving the benefits of stateless income tax planning through deferral and financial accounting treatment of such earnings as “permanently reinvested”), but erodes the u.s. corporate tax base, because the interest expense is deductible in the united states, while the foreign earnings are not. the combination of deferral, as turbocharged by stateless income planning, and incomplete domestic expense allocation rules, which often are not binding, thus lead to u.s. tax base 770 florida tax review [vol. 11:9 erosion and the quarantining of much of the firm’s cash outside the united states. and in the case of foreign-based multinationals, stateless income tax planning technologies can be applied to the united states as a source country, thereby reducing u.s. domestic tax revenues directly. in summary, it is difficult to find genuine evidence that the current u.s. system for taxing foreign direct investment has hobbled the “competitiveness” of u.s. firms, as that term is used, for example, by multinational firms and trade associations in lobbying for another repatriation holiday or a territorial tax system without meaningful constraints. it is not difficult, however, to accept as plausible the thesis that stateless income tax planning and allied phenomena have significant longterm welfare implications for the united states. those costs are uniquely compounded by the lock-out effect, which is an unavoidable cost of american stateless income tax planning. v. responding to a world imbued with stateless income if stateless income tax planning were expunged and rational source rules generally adopted (including for the source of expenses incurred to fund worldwide activity), then the design of tax policy for foreign direct investment would become embarrassingly easy. every country would adopt a territorial tax system, and in doing so would satisfy every known articulation of worldwide efficiency norms. the simple reason for this solution is that the world today offers reasonably liquid and open global markets for savings and investment. one therefore might expect that after-tax returns from marginal real investments would be the same around the world; in other words, every business would suffer the same tax burden, when implicit as well as explicit taxes were considered. 164 in such a state, a u.s. firm would face the same tax costs for foreign as well as domestic investment (once implicit taxes were considered), and the norm of capital export neutrality would be satisfied.165 that u.s. firm also would face the same local tax rates as would local competitors (and competitors in third countries that adopted similar comprehensive source rules), thereby satisfying the norm of capital import neutrality. in this state, it would make no sense to add an additional layer of residence-country tax: 164. this is the central theme of the lessons of stateless income. 165. as developed in the lessons of stateless income, the idea is that tax capitalization (the bidding up of prices for assets whose returns are tax-favored) will lead to convergence in after-tax risk-adjusted global returns on net business income. “implicit taxes” are another way of stating the same phenomenon. they simply are the measure of the lower pre-tax return that an investor accepts by virtue of bidding up the price of a tax-favored asset. 2001] stateless income 771 doing so would only drive down after-tax returns on investments for affected cross-border investors to levels below what they could obtain at home. but stateless income fundamentally erodes this expectation. as section iv has discussed, the whole point of stateless income tax planning is that it enables savvy multinational firms to capture “tax rents,” by deflecting high-tax source country pre-tax returns to very low-tax jurisdictions, and by effectively doing the same with residence country pre-tax returns through arbitrage. the end result is that multinational firms can capture a rate of return much higher than world after-tax norms, without incremental risk, as a result of planning opportunities available only to a subset of potential investors. and, as further described above, stateless income planning compounds the meaninglessness of the entire concept of the “source” of income. how should international tax systems respond? one suggested answer has been to minimize the importance of the problem. for example, in james hines’ most recent article recommending that the united states adopt a territorial tax system (and couple that with no expense allocation rules), hines dismisses the traditional efficiency norm of capital export neutrality as an outmoded framework consumed by “the inefficiencies that may arise from too many factories in tax havens.”166 if only that were the issue, hines’ policy prescriptions might survive, even if one quarreled with his underlying reasoning, because one could count on nontax factors to limit investments in bricks and mortar factories across the tax havens of the world. but the issue of course is not that the current u.s. tax system encourages investments in property, plant, and equipment on various islands; it is that the system improperly countenances the relocation of income without real investment from high-tax jurisdictions to those lowtax locales. income wholly disproportionate to investment is the challenge of stateless income. the companion paper to this, the lessons of stateless income, picks up at this point by exploring the implications of stateless income tax planning for standard efficiency norms that are used to evaluate international tax reform proposals. that paper shows that critical assumptions to some of these efficiency norms are irrevocably eroded through the pervasive presence of stateless income. moreover, tax system design is about more than efficiency models, and in this case in particular the standard efficiency models all tend to a certain level of myopia, under which efficiency along one margin is emphasized to the exclusion of all others. 167 this leads to the 166. hines, reconsidering the taxation of foreign income, supra note 131, at 282. 167. harry grubert & rosanne altshuler, corporate taxes in the world economy: reforming the taxation of cross-border income, fundamental tax reform: issues, choices, and implications 319, 331–33 (john w. diamond & george r. zodrow eds., 2008). grubert and altshuler also point out that efficiency 772 florida tax review [vol. 11:9 sterile exercise that i previously have described as “the battle of the neutralities.”168 the lessons of stateless income therefore continues by considering how u.s. international tax policy might be revised as a practical matter, not only to address the lock-out phenomenon (its most obvious deadweight cost today), but also to be robust to the corrosive effects of stateless income tax planning. in each case, the article emphasizes pragmatic solutions for which there are some prospects of both implementation and success. wishful thinking along the lines of “transfer pricing enforcement must be enhanced”169 is eschewed. the lessons of stateless income argues that u.s. policymakers today confront a hobson’s choice between two imperfect and fundamentally opposing policies to address both stateless income tax planning and the deadweight losses associated with the lock-out effect. first, the united states could adopt a territorial tax system that effectively addressed stateless income planning through a radical and comprehensive set of source rules covering both income and expenses. in that case, foreign-source active business income could freely be repatriated without further tax. alternatively, the united states could adopt a worldwide tax consolidation regime; in that case, foreign-source income earned by u.s.-based multinationals also could be freely repatriated to the united states, because it would have already been taxed by the united states. criteria are only part of the process multinational firms face in their foreign investment decisions. they argue, for example, that the capital ownership neutrality principle ignores the critical role of the location of intangible capital, does not address opportunities for income shifting to alter the overall effective tax rates for multinational firms, magnifies opportunities for income-shifting that are unavailable to purely local competitors. id. 168. kleinbard, territorial taxation, supra note 1, at 555. 169. cf. mihir a. desai & james r. hines jr., old rules and new realities: corporate tax policy in a global setting, 57 nat’l tax j. 937, 954 (2004) (acknowledging that territorial tax systems put additional pressure on transfer pricing enforcement, but not proposing any solutions); james r. hines jr., reconsidering the taxation of foreign income, 62 tax l. rev. 269, 296–97 (2008) (“this article follows almost all of the preceding literature in taking enforcement matters to be outside the scope of the present inquiry, in large part because the traditional case for worldwide taxation is not presented in those terms.”). in fact, it would seem incumbent on those proposing a new tax system for the united states that so conspicuously puts additional pressure on a beleaguered tax enforcement mechanism critical to the protection of the u.s. tax base to propose how that enforcement mechanism could be expected to function in the new environment. and as it happens, at least one article has been published that explicitly relies on the problems of transfer pricing mechanisms in formulating a case for worldwide taxation. kleinbard, taxation, supra note 1, at 548. 2001] stateless income 773 for 40 years, public finance economists, legal scholars, and policymakers have debated which solution dominates the other. this article demonstrates that the question cannot be answered in practice without also considering the implications of stateless income for the design of territorial tax systems in particular. conclusions that are logically coherent in a world without stateless income do not follow once the pervasive presence of stateless income tax planning is considered. the lessons of stateless income concludes that the hobson’s choice reduces to one between the highly implausible — a territorial tax system with teeth — and the manifestly imperfect — worldwide tax consolidation. because the former is so unrealistic while the imperfections of the latter can be mitigated through the choice of tax rate (and ultimately by a more sophisticated approach to the taxation of capital income), the project ultimately concludes by recommending a worldwide tax consolidation solution. florida tax stateless income by edward d. kleinbard0f( abstract 700 i. introduction 701 a. stateless income 701 b. an illustrative example: the double irish dutch sandwich 706 c. overview and conclusions of article 713 ii. the current u.s. tax system is an ersatz territorial regime 715 a. worldwide and territorial tax paradigms 715 b. the current u.s. tax system 717 c. revenue collections under the current system 722 d. arbitrage and domestic base erosion 724 e. the tax distillery 725 iii. stateless income in operation 727 a. the value of stateless income tax planning 727 b. mechanics of stateless income tax planning 728 1. business earnings stripping 728 2. transfer pricing 733 3. legal system arbitrage 737 c. how large is stateless income? 737 1. cash tax liabilities 737 2. accounting evidence 744 iv. implications of stateless income 750 a. the fruitless search for source 750 b. capture of “tax rents” 752 c. domestic base erosion through tax arbitrage 757 d. competiveness of u.s. firms: statutory and effective tax rates 758 e. competitiveness of u.s. firms: lock-out 762 f. summary of implications 768 v. responding to a world imbued with stateless income 770 abstract i. introduction ii. the current u.s. tax system is an ersatz territorial regime a. worldwide and territorial tax paradigms b. the current u.s. tax system. c. revenue collections under the current system d. arbitrage and domestic base erosion e. the tax distillery table 1: royalty and interest paid by controlled foreign corporations103f iv. implications of stateless income b. capture of “tax rents” d. competiveness of u.s. firms: statutory and effective tax rates e. competitiveness of u.s. firms: lock-out f. summary of implications v. responding to a world imbued with stateless income for 40 years, public finance economists, legal scholars, and policymakers have debated which solution dominates the other. this article demonstrates that the question cannot be answered in practice without also considering the implications of stateles... florida tax review volume 13 2012 number 6 florida tax review article the principle of territoriality and its implementation in the proposal for a council directive on a common consolidated tax base (ccctb) michael lang university of florida college of law florida tax review volume 13 2012 number 6 article the principle of territoriality and its implementation in the proposal for a council directive on a common consolidated tax base (ccctb) michael lang 305 florida tax review volume 13 2012 number 6 the florida tax review is a publication of the graduate tax program of the university of florida college of law. each volume consists of ten issues published by tax analysts. the subscription rate, payable in advance, is $125.00 per volume in the united states and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that 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assistant professor of law yolanda jameson visiting assistant professor samuel c. ullman adjunct professor of law emeritus culverhouse eminent scholar board of advisors hugh j. ault boston college j. martin burke university of montana charlotte crane northwestern university jasper l. cummings jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina reed shuldiner university of pennsylvania theodore s. sims boston university graduate editors rachel barlow ashley haskins justin hoyle grant marshall isabelle taylor suzie ward gary williams seth williams executive assistant trudi m. reid florida tax review volume 13 2012 number 6 information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: ―articles,‖ ―commentaries,‖ and ―book reviews.‖ the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in either word perfect or microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manuel. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. manuscripts selected for publication as articles generally are expected to be published within three months after acceptance. all tax law and policy positions presented are solely those of the authors. the editors, the university of florida college of law and tax analysts do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 13 2012 number 6 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 13 2012 number 6 305 the principle of territoriality and its implementation in the proposal for a council directive on a common consolidated corporate tax base (ccctb) by michael lang i. the ccctb concept ................................................................ 306 ii. achievement of the territoriality principle ............... 310 a. comprehensive taxation of resident companies ............. 310 b. exemption of foreign permanent establishments, dividends, and capital gains ................. 315 c. taxation of eu permanent establishments and third-country residents ................................................... 322 iii. derogation to the principle of territoriality ............ 326 a. taxation of interest and royalties .................................... 326 b. the switch-over clause ................................................... 326 c. controlled foreign companies (“cfc”s) ....................... 331 iv. transparent entities .............................................................. 337 a. qualification of entities in third countries ..................... 337 b. eu permanent establishments of third-country entities and transparency .............................................................. 339 c. controlled foreign companies and transparency ........... 340 v. double taxation conventions ............................................. 341 a. priority of dtcs with third countries ............................. 341 b. dtcs and foreign controlled companies ....................... 343 c. dtcs and transparency ................................................... 346 vi. conclusion and outlook ....................................................... 346  professor dr. michael lang is head of the institute for austrian and international tax law at vienna university of economics and business administration (―wu‖), director of the ll.m. program in international tax law at wu, and spokesman of the ―doctoral program in international business taxation‖ of the wu. this paper was completed on 28 march 2012 and is based on the author’s lecture on 7 october 2011 at the university of florida. the author would like to thank daniel blum, martina gruber, eline huisman, ina kerschner, and veronika treitl for their support in connection with searching the literature for material, creating the annotations and proofreading and discussing this paper. 306 florida tax review [vol. 13:6 i. the ccctb concept the eu commission put forward its proposal for a directive for a common consolidated corporate tax base (―ccctb‖) with some delay after long preliminary work. 1 that proposal provides for a uniform corporate tax base that may be relied upon in all eu member states. its underlying objective is to reduce the administrative burden for companies. 2 a group that is subject to the ccctb rules will no longer have to determine transfer prices. the concept therefore also assumes a consolidated tax base. the ccctb system is optional and not intended to replace the set of corporate tax rules of the member states. businesses operating in several member states will no longer inevitably encounter different corporate tax systems but will, according to the proposal of the european commission, be able to opt for one uniform tax base throughout the european union. 3 still, the proposal provides only for a harmonization of tax bases, as each member state will be applying its own rates to its share of the taxpayer’s tax base. tax competition will be maintained but will experience a higher degree of regulation and transparency. 4 1. proposal for a council directive on a common consolidated corporate tax base (ccctb), com (2011) 121/4 [hereinafter ccctb proposal]. on the idea and history of ccctb see michel aujean, the ccctb project and the future of european taxation, in common consol. corp. tax base 11 (michael lang, pasquale pistone, joseph schuch & claus startinger eds., 2008). 2. see ccctb proposal, supra note 1, at 4; j.a.r. van eijsden, the onestop-shop approach: a discussion of the administrative and procedural aspects of the ccctb draft directive, in ccctb: selected issues 127, 127 (dennis weber ed., 2012). 3. see ccctb proposal, supra note 1, art. 4, 6; kubik & massoner, der aktuelle stand der common consolidated corporate tax base (ccctb): was bisher geschah und noch geschehen wird, 48 fj 13 (2009); matthias petutschnig, neuer anlauf zur common consolidated corporate tax base, östz 2011, 325, 327; [hereinafter petutsching, neuer anlauf]; elisabeth riener-micheler, gemeinsame konsolidierte körperschaftsteuerbemessungsgrundlage: ein vorschlag der eu, cfoaktuell 2011, 95 (95); guido förster & sebastian krauß, der richtlinienvorschlag der europäischen kommission zur gemeinsamen konsolidierten körperschaftsteuer-bemessungsgrundlage (gkkb) 16 march 2011, istr 2011, 607, 611. for the requirements of forming a group, see claus staringer, requirements for forming a group, in common consolidated corporate tax base, supra note 1, at 115. 4. see ccctb proposal, supra note 1, art. 4. 2012] eu ccctb proposal 307 the ccctb concept is ambitious. accordingly, objections and obstacles existed from the very beginning. the parliaments of some member states have issued comments expressing doubts whether the proposal was compatible with the principle of subsidiarity enshrined in eu law. 5 some critics believe that the objective of consolidation simply goes too far and advocate that the focus should be on a common tax base at least during an initial phase. 6 there were also concerns that companies could either opt for the ccctb or the national tax bases. 7 some member states even generally 5. see ipex, http://www.ipex.eu/ipexl-web/result/simple.do?text=+ ccctb +subsidiarity&start= (for the comments of the parliaments of the nine member states: bulgaria, ireland, malta, the netherlands, poland, romania, slovakia, sweden, united kingdom); see also rita szudoczky, is the ccctb proposal in line with the principle of subsidiarity?: negative opinions submitted by national parliaments in the „yellow card procedure,‟ in ccctb: selected issues 93, 93– 94 (dennis weber ed., 2012); vascega & van thiel, the ccctb proposal: the next step towards a corporate tax harmonization in the european union?, 51 european tax’n 374, 377 (2011) [hereinafter vascega & van thiel, next step]; k. von brocke & g. rottenmoser, harmonisierung direkter steuern? die gkkb im lichte der rechtsetzungskompetenzen der eu, iwb 2011, 620, 623. these concerns were invalidated in the reasons for the proposal, see ccctb proposal, supra note 1, at 9–10, according to which, [t]he proposal is limited to combating tax obstacles caused by the disparities of national systems in computing the tax base between associated enterprises. . . . that the best results in tackling those obstacles would be achieved if a common framework regulated the computation of the corporate tax base and cross-border consolidation. indeed, these matters may only be dealt with by laying down legislation at the level of the union, since they are of primarily a cross-border nature. this proposal is therefore justified by reference to the principle of subsidiarity because individual action by the member states would fail to achieve the intended results. 6. see n. herzig, harmonisierung der steuerlichen gewinnermittlung in der europӓischen union, stuw 2006, 156 (161 et seq.); mayr, ccctb: eine realistische betrachtungsweise, 18 swi 288, 289 (2008) [hereinafter mayr, realistische betrachtungsweise]; r.u. füllbier, überlegungen zum steuerlichen konsolidierungsbegriff und zur systematisierung von gruppenbesteuerungssystemen vor dem hintergrund europäischer entwicklungen, in unternehmenssteuerrecht und internationales steuerrecht — gedächtnisschrift dirk krüger 211, 222 (strunk, wassermeyer & kaminski eds., 2006). 7. see richard d. pomp & andreas gerten, die gemeinsame konsolidierte körperschaftsteuer-bemessungsgrundlage: (r)evolution der konzernbesteuerung? 17 istr 377, 392 (2008). an optional system was also rejected by the german government. see federal government’s answer to an inquiry of mps dr. thomas gambke, britta haßelman, lisa paus, further mps and fraktion bündnis 90/die grünen, gemeinsame konsolidierte körperschaftsteuer-bemessungsgrundlage, 6 308 florida tax review [vol. 13:6 rejected a harmonization of direct taxes signaling that they would never agree with a ccctb directive that was applicable throughout the european union. 8 many experts assume that the ccctb concept could eventually only be a form of ―enhanced cooperation‖ provided by union law in which not all member states are required to participate. 9 meanwhile, the european parliament has dealt with the proposal and has proposed several changes. 10 the danish presidency of the council of the european union has also grasped the opportunity to suggest a ―compromise proposal.‖ 11 the proposed changes deal with details as well as questions of principle. the european parliament, for instance, has expressed its desire to limit the optionality of the system: european companies and european cooperative societies, which are, by definition, transnational, are considered to june 2011. but see jesper barenfeld, a common consolidated corporate tax base in the european union — a beauty or a beast in the quest for tax simplicity, 61 bull. for int’l tax’n 258, 260 (2007). on the pros and cons of optionality, see johanna hey, ccctb — optionality, in common consolidated corporate tax base, supra note 1, at 102–08. 8. these states were the united kingdom, ireland, estonia, the czech republic, slovakia, and critically germany who stated: ―the federal government is critical of the proposal in as far as it concerns consolidation and the relevant administrative part. as a result of the introduction of a ccctb, germany would risk considerable, lasting fiscal deficits.‖ see comments of the federal government of 5 february 2011, n.7. 9. the principle of unanimity was relaxed by the treaty of nice, which provides for the possibility of enhanced cooperation enhanced cooperation agreements where at least eight states may cooperate without the other states being able to oppose. this facilitates the enforceability of coordination measures on a political level. the treaty of lisbon provides that at least nine member states must be involved in cooperation. see consolidated version of the treaty on european union art. 20, mar. 3, 2010, 2010 (c 83) 27; consolidated version of the treaty on the functioning of the european union, art. 326–34, mar. 30, 2010, 2010 o.m. (c 83) 189; m-a. mamut, auf dem weg zur common consolidated corporate tax base (ccctb), 16 swi 425, 429, n.33 (2006); mayr, realistische betrachtungsweise, supra note 6, at 288; luca cerioni, european union — postponement of the commission‟s proposal for a ccctb directive: possible ways forward, 64 bull. for int’l tax’n 98, 101 et seq. (2010); vascega & van thiel, next step, supra note 5, at 380; petutschnig, neuer anlauf, supra note 3, at 333. 10. see generally european parliament legislative resolution of 19 april 2012 on the proposal for a council directive on a common consolidated corporate tax base (ccctb), prov (2012) 0135 [hereinafter european parliament resolution]. 11. presidency note, council of the european union, 4 april 2012, no. 8387/12 [hereinafter presidency note]. 2012] eu ccctb proposal 309 have opted to apply this directive from two years after its date of application. all other companies that qualify under this directive, except for micro, small and medium-sized enterprises, as defined in commission recommendation 2003/361/ec, should also apply this directive not later than five years after its date of application. when evaluating the impact of the ccctb, the commission should examine whether it should also be made mandatory for such micro, small and medium-sized enterprises. 12 the financial and economic crisis has boosted the discussions on tax harmonization. in a joint letter to van rompuy, the president of the european council, merkel and sarkozy pleaded for concluding the negotiations on a common consolidated corporate tax base until the end of 2012. 13 discussions on eu taxes are increasingly intense, and the commission itself has meanwhile come forward with a proposal for a directive on a financial transaction tax, a tax that would at least partly directly flow into the eu budget. 14 against this backdrop, it seems already less drastic to propose simply a harmonization of the national tax bases. in view of the dramatic economic developments in greece and other eu member states, critics could more willingly accept harmonization in the field of economic and fiscal policy. at the same time, the currency union is imperiled now more than ever. due to erosion processes, measures to create common tax bases could also be put off to a time in the distant future. for all these reasons, it is extremely uncertain at this point whether, when, and in which form the forwarded ccctb proposal will become part of union law. the fact that a specific proposal for a directive has been 12. european parliament resolution, supra note 10, at amend. 14 (footnote omitted). the skepticism concerning the optionality of the system becomes clear when one thinks of the tax planning possibilities that would arise due to this optionality. however, companies will be able to avoid the application of the ccctb rules by choosing a legal form that is not covered by the scope of the directive, for instance the establishment as a partnership. the provisions currently in force of the many tax systems allow for changes in the legal form of a company without additional tax burdens. mandatory application of rules carries the inherent risk of motivating taxpayers and their advisers to explicitly plan their structure in order to fall within the set requirements or not. 13. letter from angela merkel, chancellor of germany and nicolas sarkozy, president of france to herman van rompuy, president of the european council (aug. 17, 2011); see also traversa & helleputte, taxation of eu resident companies under the current ccctb framework, in ccctb (lang/schuch/staringer et al. eds., forthcoming 2012). 14. proposal for a council directive on a common system of financial transaction tax and amending directive 2008/7/ec, com (2011) 594. 310 florida tax review [vol. 13:6 available since 2011 has further boosted the discussions. the scientific analysis involves not only mere considerations in respect of the concept of such a common consolidated corporate tax base, but also concrete proposals for the rules as such. it will be up to scholars to review that proposal critically and to point to doubts and weaknesses, if any, to pave the ground for an advancement of the proposal. if the competent eu bodies should decide to make the ccctb concept reality, whatever its form may be, they should be able to rely on those considerations. this paper will focus on some provisions of the proposal that are relevant for companies that are tax residents outside the european union or for commercial activities carried outside the eu, and for eu resident companies that operate in third countries. this paper will primarily discuss the territoriality principle, on which the ccctb concept is based, and its legal technical structure. however, this paper will not discuss other provisions of the proposal, even if those should specifically address thirdcountry scenarios, such as those concerning deductibility of donations, 15 the transfer of assets, 16 or deductibility of interest. 17 ii. achievement of the territoriality principle a. comprehensive taxation of resident companies at least at first sight, the provisions of the ccctb proposal distinguish between worldwide taxation and purely territorial taxation. pursuant to article 6(6) of the proposal of the commission, ―[a] company resident in a member state that opts for the system provided for by this directive shall be subject to corporate tax under that system on all income derived from any source, whether inside or outside its member state of residence.‖ on the other hand, article 6(7) provides that ―[a] company resident in a third country that opts for the system provided for by this directive shall be subject to corporate tax under that system on all income from an activity carried on through a permanent establishment in a member state.‖ the directive shall hence be applicable to companies that are resident both inside and outside the european union. article 2 of the proposal distinguishes between ―companies established under the laws of a member state‖ and ―companies established under the laws of a third country.‖ the first group is subject to a ―list system‖ primarily known from 15. ccctb proposal, supra note 1, art. 12, 16. 16. ccctb proposal, supra note 1, art. 31. 17. ccctb proposal, supra note 1, art. 81. according to the compromise proposal of the danish presidency, this article should be deleted and replaced by an ―interest limitation rule.‖ presidency note, supra note 11, art. 14a. 2012] eu ccctb proposal 311 other directives in the area of taxation. 18 a company established under the laws of a member state is subject to the directive if it takes one of the forms listed in annex i and is subject to one of the corporate taxes listed in annex ii or to a similar tax subsequently introduced. however, annex ii treats the companies rather differently. the list of legal forms is exhaustive for some states. in other cases, there is a general clause, for example, for ―other companies constituted under french law subject to the french corporate tax.‖ 19 while the list of companies, albeit different for each member state, eventually seems to be exhaustive, there is a general clause for corporate taxes which provides that not only the corporate taxes listed in annex ii, but also similar taxes subsequently introduced are eligible. such a comparability test is known from article 2(4) of the organization for economic corporation and development model convention (―oecd-mc‖) 20 or article 3(a)(iii) of the interest and royalties directive. 21 while the provisions of the oecd-mc and those of the interest and royalties directive are largely consistent, the authors of the ccctb proposal have used an entirely different language in article 2(1)(b). this is an unsuitable approach because the objective of those regulations seems to be the same in all these cases. different language will lead to the risk of legal practice inferring a divergent content. in addition, article 2(3) of the proposal provides that the commission may adopt delegated acts ―in order to amend annexes i and ii 18. council directive 2011/96/eu of 30 november 2011 on the common system of taxation applicable in case of parent companies and subsidiaries of different member states, annex i, 2011 o.j. (l 345) 8 [hereinafter parentsubsidiary directive]; council directive 2003/49/ec of 3 june 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different member states, annex, 2003 o.j. (l 157) 49. 19. ccctb proposal, supra note 1, annex i(k). 20. organisation for economic co-operation and development, comm. on fiscal affairs, model tax convention on income and capital, art. 2, ¶ 4 (updated 2010) [hereinafter oecd-mc]. accordingly, the convention shall apply ―also to any identical or substantially similar taxes that are imposed after the date of signature of the convention in addition to, or in place of, the existing taxes.‖ id. 21. council directive 2003/49/ec of 3 june 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different member states, art. 3(a)(iii), 2003 (l 157) 51 (stating ―to one of the following taxes without being exempt, or to a tax which is identical or substantially similar and which is imposed after the date of entry into force of this directive in addition to, or in place of, those existing taxes.‖); see also proposal for a council directive on a common system of taxation applicable to interest and royalty payments made between associated companies of different member states, art. 2(c)(iii), com (2011) 714 final (nov. 11, 2011) [hereinafter interest and royalties directive]. 312 florida tax review [vol. 13:6 to take account of changes to the laws of the member states concerning company forms and corporate taxes.‖ pursuant to article 127(1) of the proposal, the power to adopt delegated acts shall be conferred on the commission for an indeterminate period of time. pursuant to article 128(1), the delegation of powers may be revoked at any time by the council. furthermore, pursuant to article 129(1), the council may object to a delegated act within a period of three months from the date of notification. if, on the expiry of this period, the council has not objected to the delegated act, it shall be published in the official journal of the european union and shall enter into force on the date stated therein pursuant to article 129(2). the delegated act may be published in the official journal of the european union if the council has informed the commission of its intention not to raise objections. accordingly, the list of corporate forms referred to in annex i may be extended by way of comitology. 22 in case of ―a similar tax subsequently introduced,‖ however, the adjustment must be made by the member state itself or, in case of a lack or erroneous transposition by the member state, the common tax base may be applied in direct reliance on the directive. other than the introduction of newly created corporate forms, the introduction of new taxes does not require a comitology procedure to ensure that these are covered by the directive, obviously because annex i contains a general clause anyway for those member states that consider an automatic adjustment appropriate in case of new corporate forms. a similar provision can be found in article 2 of the parent-subsidiary directive and in article 3 of the interest and royalties directive. these directives even provide for a similarly differentiated list system for the corporate forms. that system is not subject to change by way of comitology, while a comparability test is sufficient in case of corporate taxes within the framework of the ccctb. article 2(1) of the ccctb proposal — just like article 2(2) — merely requires that the company ―is subject to‖ one of the corporate taxes, while article 2(1)(c) of the parent-subsidiary directive and article 3(1)(iii) of the interest and royalties directive requires that the company be subject to tax ―without being exempt.‖ this implies that the company may be subject to the ccctb rules even if it is exempt. 23 accordingly, we would have to distinguish between companies exempt from national corporate tax to which the directive may be applied, and those companies that are not subject to national corporate tax in the first place and thus cannot be subject to the scope of application of the directive. there is little point in terms of legal 22. see richard lyal, comitology, in common consolidated corporate tax base, supra note 1 at 49; ccctb working group, ccctb: possible elements of a technical outline, 26 july 2007, ccctb/wp/057/, items 10, 16, 25, 46, 66. 23. see luca cerioni, the commission‟s proposal for a ccctb directive: analysis and comment, 65 bull. for int’l tax’n, 515, 516 (2011) (applying a broad interpretation). 2012] eu ccctb proposal 313 policy to make that distinction, as that approach would make the coincidental national legislative techniques relevant for purposes of eu law. 24 however, these differences in language must not be over emphasized because while the parent-subsidiary directive, on the one hand, and the interest and royalties directive, on the other hand, are different, that fact is not material. while article 2(1)(c) of the parent-subsidiary directive emphasizes that the company must be subject to one of the taxes stated therein ―without the possibility of an option,‖ this reference cannot be found in the interest and royalties directive. still, it would be desirable if the authors of the ccctb proposal followed the wording of provisions of an already existing directive in order to avoid additional problems of interpretation that can arise from these very differences. article 6 of the ccctb proposal substantially distinguishes between companies that are residents for tax purposes in a member state and companies that are not residents for tax purposes in a member state. the first group is entirely subject to the directive. the second group can be subject to the provisions of the directive only in respect of its permanent establishments located in the eu. pursuant to article 6(3) of the proposal, a company that has its registered office, place of incorporation, or place of effective management in a member state shall be considered a resident for tax purposes in that member state. contrary to article 2(a)(ii) of the parentsubsidiary directive and article 3(a)(ii) of the interest and royalties directive, the residence criteria must be autonomously derived from eu law, 25 without any reference to national law. the language of article 6(3) of the ccctb proposal in turn rather reminds us of article 4(1) oecd-mc, although it is not fully identical with it. article 4(1) oecd-mc does not specifically mention the registered office and merely refers to the place of ―management‖ and not to ―effective management.‖ the terms ―effective management,‖ however, can be found in the so-called tie-breaker rule of article 4(3) oecd-mc. rather than being similar to article 4(1) oecdmc, article 6(7) of the ccctb proposal is similar to article 4(1) un-mc and to article 4(1) us-mc, both referring to the ―place of incorporation.‖ again, regrettably enough, the authors of the proposal have not relied upon already existing expressions. this might have shed light on the meaning of those regulations in reliance on already issued opinions. instead, they have followed their own course. article 6(3) of the ccctb proposal lays down an additional criterion to determine a company’s residence, namely whether it ―is not, 24. id. at 517. 25. see council directive 2003/123/ec of 22 december 2003 on the common system of taxation in the case of parent companies and subsidiaries of different member states, art. 2(1)(b), 2003 o.j. (l 7) 41; interest and royalties directive, supra note 21, art. 2(c)(ii). 314 florida tax review [vol. 13:6 under the terms of an agreement concluded by that member state with a third country, regarded as tax resident in that third country.‖ if the tie-breaker rule of a dtc hence makes the third country the country of residence, the company will lose its residence in the european union and will be considered a third-country entity for tax purposes. based on the dtcs that are modeled after the oecd model convention, a company’s residence is determined by the place of ―effective management.‖ there are, however, a number of dtcs that deviate from the wording of the oecd-mc or in case of dual residence, do not grant treaty benefits at all or grant these benefits only after the conduct of mutual agreement procedures. 26 in these cases, a company will lose its eu-residence only if a mutual agreement procedure has been concluded. if a company is not considered resident in any state according to a dtc, it cannot be deemed resident in a third country. this also applies if there is no dtc with a third country or if the dtc is not applicable. if companies that are a resident of two states either are not entitled to treaty benefits or are ―under observation‖ for purposes of application of a dtc, and the competent authorities reserve the right to clarify their entitlement by way of a mutual agreement procedure in a particular case, this disadvantage suddenly becomes a blessing for the purpose of the directive. in terms of legal policy, the diametric difference in evaluation between dtc and the proposal is not comprehensible at first sight. concededly, article 2 of the parent-subsidiary directive and article 3 of the interest and royalties directive are based on a similar concept, 27 although the ccctb proposal has its own terminology. as a result of the two existing directives, the absence of treaty benefits turns into an advantage for purposes of the directive. ultimately, the directive’s scope of application depends on the content of the concluded dtcs and can hence be different in each member state. this can only be due to the fact that, as a result of the company’s residence outside the european union for purposes of the dtc, the company can be taxed in the eu member state only in respect of income from sources in the member state, hence resembling more a nonresident than a resident. for both the existing directives and the ccctb proposal, the question now is whether it is worth accepting that the scope of the directive not only varies from member state to member state, but also, on the other 26. for the first example, see the dtc austria-liechtenstein. for the second example, see dtc bulgaria-latvia, bulgaria-lithuania, estonia-finland, estonia-canada, estonia-latvia, estonia-lithuania, estonia-turkey, estoniabelarus, finland-canada, finland-latvia, finland-lithuania, finland-turkey, finland-belarus, canada-mexico, canada-philippines, canada-thailand, latviacanada, latvia-turkey, latvia-belarus, lithuania-canada, lithuania-turkey, lithuania-belarus, thailand-turkey. 27. see interest and royalties directive, supra note 21, art. 2. 2012] eu ccctb proposal 315 hand, depends on in which third country the company is still resident. should these companies generally be regarded as being resident in the eu, it would be useful to adopt in the directive the wording of the tie-breaker rule laid out in article 4(3) oecd-mc. in that case, however, companies taxable in respect of their world-wide income would sometimes be considered nonresidents also in the european union for purposes of the ccctb rules. pursuant to article (4) of the ccctb proposal, companies resident in several member states would be subject to precisely that rule in order to determine in which member state they are a resident. article 6(6) of the ccctb proposal provides that a company resident in a member state that is covered by this directive ―shall be subject to corporate tax under that system on all income derived from any source, whether inside or outside its member state of residence.‖ similarly, article 6(7) provides in respect of a company resident in a third country that it ―shall be subject to corporate tax under that system on all income from an activity carried on through a permanent establishment in a member state.‖ this language hence implies that the concept of income is very broad, because the focus is on ―all‖ and — at least in article 6(6) — ―from any source, whether inside or outside its member state of residence.‖ article 10 of the ccctb proposal provides that the tax base shall be calculated as revenues minus exempt revenues, deductible expenses, and other deductible items. revenues, in turn, are defined in article 4(8) of the proposal. revenues hence include also ―subsidies and grants, gifts received, compensation and ex-gratia payments.‖ the second sentence of article 4(8) of the proposal specifically notes that revenues shall not include equity raised by the taxpayer or debt repaid to it. income can also be defined on the basis of other provisions: article 9(1) of the proposal provides that in computing the tax base, profits, and losses ―shall be recognized only when realized.‖ the concept of income, hence, is determined also by the realization principle. pure appreciation of assets will therefore not trigger taxable income. exemptions from the realization principle — such as the provisions for controlled foreign companies pursuant to article 82 of the ccctb proposal — are specifically mentioned. further indications are offered by the exemptions. article 11(d) specifically exempts proceeds from a disposal of shares. this implies that capital gains otherwise qualify as income. b. exemption of foreign permanent establishments, dividends, and capital gains the provision of article 11(e) of the ccctb proposal largely recognizes the territoriality principle. it exempts from corporate tax ―income of a permanent establishment in a third country.‖ at the same time, article 11(c) exempts ―received profit distributions,‖ and article 11(d) ―exempts proceeds from a disposal of shares.‖ other than the exemption of permanent 316 florida tax review [vol. 13:6 establishments in third countries, both provisions apply regardless of the residence of the entity that distributes profits or whose shares are disposed. it makes no difference whether an eu-resident company operates in a third country through a permanent establishment or through shares in another company. this provision is characterized by the principle of neutrality as to corporate form. both profits of permanent establishments and the profit distributions of the companies are exempt. in both cases, the capital gains are exempt. the compromise proposal of the danish presidency, however, weakens this concept. received profit distributions shall only be exempt from corporate tax if a minimum holding of 10 percent exists. the same should hold for proceeds from a disposal of shares. further exceptions of the exemption are envisaged for profit distributions from shares held for trading as well as profit distributions received by life insurance undertakings. the limit of 10 percent appears to be derived from the parent-subsidiary directive. the terminology, however, does not match. the minimum holding requirement of 10 percent is especially unsuitable for the ccctb rules because, due to the exemption of permanent establishments in third countries, profits made through minimal holdings in partnerships are not included in the tax base. the requirement of a minimum holding therefore makes little sense. however, in other cases, income from third countries may be subject to tax. for example, if it is not ―income of a permanent establishment‖ or if a taxpayer engages in commercial activities in a third country without establishing a fixed place of business, it will still be taxed on his worldwide income. the principle of attraction does not apply either. consequently, the mere existence of a permanent establishment in another state will not lead to an exemption of all income generated in this state. since the proposal only exempts ―income of a permanent establishment,‖ the income has to be attributable to the permanent establishment. the concept of permanent establishment is defined in detail in article 5 of the proposal. this definition is largely modeled after article 5 of the oecd-mc. the authors of the proposal hence have decided to follow neither the model of article 3(c) of the interest and royalties directive, which merely defines permanent establishments along the lines of article 5(1) of the oecd-mc, 28 nor article 2(b) of the parent-subsidiary directive that combines this brief definition of a permanent establishment with a subject-to-tax-clause. again, the proposal did not fully adopt article 5 of the oecd-mc. consequently, the meaning of the expression that is missing in the oecd model, according to which the permanent establishment of a taxpayer must be ―in a state other than the state in which its central management and control is located,‖ remains unclear. there is no 28. see interest and royalties directive, supra note 21, art. 2(e). 2012] eu ccctb proposal 317 apparent reason for this derogation from article 5 of the oecd-mc. not only does this addition seem superfluous, it also raises doubts as will be shown below. the danish presidency has now proposed to replace the phrase ―in which its central management and control is located‖ with ―in which it is resident for tax purposes.‖ 29 with this amendment, the new version of the definition of a permanent establishment also deviates from the example set in article 5 of the oecd-mc. the question why the drafters of this definition did not completely align to the oecd-model convention cannot be answered. now, difficulties in interpretation may arise. the proposal, as provided by the commission, does not contain any provision that specifically refers to the allocation of profits. since numerous provisions are parallel to those of the oecd-model — such as those regarding permanent establishments — the principles relevant in connection with article 7 of the oecd-mc could apply. 30 however, specifically the issue of allocation of profits to permanent establishments has no definite answer within the oecd. article 7 of the oecd-ma was thoroughly restated by the update 2010. 31 in the context of eu law, however, the question arises whether the allocation of profits to a permanent establishment should not be governed by those principles that are enshrined in the eu arbitration convention. 32 article 4(2) of the eu arbitration convention provides as follows: where an enterprise of a contracting state carries on business in another contracting state through a permanent establishment situated therein, there shall be attributed to that permanent establishment the profits that it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. 29. presidency note, supra note 11, art. 4(7). 30. ccctb working group, an overview of the main issues that emerged at the third meeting of the subgroup on international aspects (sg4), 13 december 2006, ccctb/wp/049/, §§ 13 et seq. 31. see plansky, die gewinnzurechnung zu betriebsstätten im recht der doppelbesteuerungsabkommen 248 et seq. (2010) (regarding the implementation of the aoa in article 7 of the oecd-mc 2010); see also s. bendlinger, paradigmenwechsel bei der auslegung des betriebsstättenbegriffs im dba-recht durch die oecd, 16 swi 358; bendlinger, die betriebsstätte im oecd-musterabkommen 21 swi 61 (2011). 32. convention on the elimination of double taxation in connection with the adjustment of profits of associated enterprises 90/463/eec, 1990 o.j. (l 225) 10. 318 florida tax review [vol. 13:6 this rule is visibly modeled after the former article 7(2) of the oecd-mc, 33 although the latter did not contain the reservation in respect of the special provisions of article 7(3) of the oecd-mc and article 7(3) of the oecd-mc, just like paragraphs (4) and (5) of article 7 oecd-mc are not reflected in the eu arbitration convention. provided that the principles enshrined in the eu arbitration convention adopted in 1990 are considered relevant, it seems reasonable to allocate profits on the basis of the opinions adopted in the oecd-mc and the 1977 oecd commentary. already the bilateral dtcs do not provide any basis for the oecd commentary’s opinion that the current version of the oecd commentary should be relied upon for an interpretation of dtcs concluded even earlier. 34 this position is even less relevant for an interpretation of the eu arbitration convention. this opinion, known as authorized-oecd-approach (aoa), could prevail only if it can be inferred from the principles already enshrined in the 1977 oecd-mc and the commentary. however, the provisions of articles 78 and 79 of the ccctb proposal should be taken into account. although concerning only associated enterprises and, at least at first sight, not the relations between headquarters and permanent establishment, the last subparagraph of article 78(1) provides that a taxpayer ―shall be regarded as an associated enterprise to its permanent establishment in a third country,‖ and similarly a nonresident taxpayer ―shall be regarded as an associated enterprise to its permanent establishment in a member state.‖ this implies that the relations between headquarters and permanent establishments are governed by the provisions on relations between associated companies laid down in article 78, although that is not absolutely certain. article 79 governs ―relations between associated enterprises‖ and hence presupposes at least the existence of two associated companies, while the last subparagraph of article 78(1) regards the taxpayer as an ―associated enterprise to its permanent establishment,‖ and thus does not stipulate that both the taxpayer and its permanent establishment must each be considered as ―associated‖ companies. once these concerns are overridden, the legal consequences laid down in article 78(f) of the proposal are relevant also for the relations between headquarters and permanent establishment. however, article 79 is somewhat — albeit not fully — 33. see oecd-mc, supra note 20, art. 7(2). 34. see michael lang, die bedeutung des musterabkommens und des kommentars des oecd-steuerausschusses für die auslegung von doppelbesteuerungsabkommen, in aktuelle entwicklungen im internationalen steuerrecht (1994); michael lang, keine bedeutung der jüngeren fassung des kommentars des oecd-steuerausschusses für die interpretation älterer doppelbesteuerungsabkommen, iwb 1996, 923 et seq.; michael lang, introduction to the law of double taxation conventions 45 et seq. (2010). 2012] eu ccctb proposal 319 modeled after article 9 of the oecd-mc and article 4(1) of the eu arbitration convention. 35 this could be a reason to grant the permanent establishment greater independence from its headquarters in the context of attributing its profits; this would be possible pursuant to article 4(2) of the eu arbitration agreement. against this backdrop, the provisions of the proposal could also be inspired by the fundamental idea of the authorized oecd approach. if the proposal of the danish presidency would be implemented, these doubts would disappear as article 79, according to the compromise proposal, would receive a second paragraph in which the determination of income attributable to a permanent establishment shall be defined more clearly: income attributable to a permanent establishment is the income the permanent establishment might be expected to earn, in particular in its dealings with other parts of the taxpayer, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the taxpayer through the permanent establishment and through the other parts of the taxpayer. 36 this wording was noticeably, if not completely, taken from the 2010 version of article 7(2) oecd-mc. it therefore carries, also with regard to the contents, the same understanding of a broad independence of the permanent establishment, which is connected to this provision. furthermore, article 11(e) of the ccctb proposal can also lead to an exemption of income from sources within the european union. this exemption applies if a permanent establishment’s income in a third country includes interest or royalties from the european union. if the assets of a usbased permanent establishment of a german company include french bonds and interest, it is attributable to that permanent establishment. french interest is also exempt. revenues that are specifically exempt pursuant to article 11(c) of the ccctb proposal include also ―received profit distributions.‖ the authors apparently want to avoid economic double taxation of profits by exempting the profit distributions as such. obviously, the authors want to leave it at the fact that the lower-level entity is regularly taxable, its tax base being determined according to national law or the ccctb directive. the recipient 35. ccctb working group, related parties in ccctb, 13 december 2006, ccctb/wp/041/, §§ 13 et seq. 36. presidency note, supra note 11, art. 79. 320 florida tax review [vol. 13:6 entity should not be taxable again. this provision does not differentiate by residence of the distributing company and, hence, is applicable to ―received profit distributions‖ from third countries. again, the language the authors of the proposal have selected is not fully consistent with the language of the parent-subsidiary directive. while the parent-subsidiary directive refers to ―distributions of profits,‖ the ccctb proposal refers to ―received profit distributions.‖ one explanation could be that the exemption can thereby be distinguished from the tax liability of certain ―non-distributed income of an entity‖ expressed as an exception in article 82(1) in conjunction with article 83(5). based on the proposal of the danish presidency, however, the reference to ―non-distributed‖ income of an entity would be omitted at least in article 82(1). 37 this is the consequence of the extension of the scope of the cfc rules to permanent establishments in low tax countries. the exemption of ―received profit distributions‖ does not define the legal nature of the participation that establishes the right to receive profit distributions. it is therefore uncertain whether corporate law is relevant here or whether a mere obligation is sufficient, provided a corresponding share is held in equity. similarly, the specific requirements that an entity has to fulfill to qualify as a source of ―distributions of profits‖ are not defined. some indications for a definition of ―distributions of profits‖ could be found in article 82(1)(a) of the proposal. the provisions for ―controlled foreign companies‖ are supposed to subject to direct taxation income received by the foreign entity at the level of the shareholder or persons with a similarly controlling position. these provisions shall apply if the taxpayer, by itself or together with its associated enterprises, holds a direct or indirect participation of more than 50 percent of the voting rights, owns more than 50 percent of the capital, or is entitled to receive more than 50 percent of the profits of that entity. supposedly, taxpayers could also receive distributions of profits if they either have voting rights, hold capital, or are entitled to profits. however, pursuant to article 83(2) of the proposal, the income to be included in the tax base ―shall be calculated in proportion to the entitlement of the taxpayer to share in the profits of the foreign entity,‖ implying that only an entity entitled to the profits can have a ―received profit distribution.‖ 38 37. presidency note, supra note 11, art. 82. 38. the compromise proposal of the danish presidency even extended the requirements set in article 82(1)(a) to cases in which the taxpayer holds because of an agreement with other investors more than 50% of the voting rights, or has because of an agreement the full control over the financial and operating policies of the entity, or has the authority to appoint or dismiss members of the board of directors jointly holding more than 50% of the voting rights in the board of directors, or power to cast more than 50% of the votes in the board of directors. 2012] eu ccctb proposal 321 another approach could be based on the definition of dividends. although the ccctb proposal does not contain such a definition, its article 81(2) specifies interest in conformity with article 11(3) of the oecd-mc, which has also been adopted in the interest and royalties directive. 39 one could infer that the authors of the proposal understood dividends pursuant to article 10(3) of the oecd-mc. 40 again, it is an entirely different question whether ―received profit distributions‖ could be clarified based on that understanding. in connection with revenues, article 4(8) of the proposal refers, among other things, to ―proceeds from disposal of assets and rights, interest, dividends and other profit distributions,‖ suggesting that profit distributions must be understood much broader than dividends. paragraph 11 of the directive’s recitals, on the other hand, assumes that ―[i]ncome consisting in dividends, the proceeds from the disposal of shares held in a company outside the group and the profits of foreign permanent establishments should be exempt.‖ quite obviously, the authors of the proposal had in mind the exemptions of article 11(c), (d), and (e), which include ―received profit distributions,‖ ―proceeds from a disposal of shares,‖ and ―income of a permanent establishment in a third country.‖ this shows that the expressions ―income consisting in dividends‖ and ―received profit distributions‖ were used synonymously in this context. furthermore, article 11(d) of the proposal exempts proceeds from a disposal of shares. that provision does not build on the previously discussed exemption of ―received profit distributions.‖ due to the systematic context, it is presumably a requirement that the entity in which a share is held and that is exempt in respect of ―received profit distributions‖ is the same form of entity. the ccctb rules are broader than the parent-subsidiary directive, which merely necessitates the exemption of profit distributions. this is a consistent systematic approach, since a shareholder frequently faces the presidency note, supra note 11, art. 82(1)(a). 39. michael lang, hybride finanzierungen im internationalen steuerrecht 114 et seq. (1990); clemens nowotny, vwgh zum abkommensrechtlichen begriff der einkünfte aus zinsen isv art 11 abs 3 oecdma, östz 2004, 137; ccctb working group, taxable income, 23 september 2005, ccctb/wp/017, § 15; krister andersson, comments on document ccctb\wp\042 (2006) 1 et seq.; ccctb proposal, supra note 1, art. 11(4); wassermeyer, in doppelbesteuerung — oecd-musterabkommen dba österreich — deutschland, kommentar, art. 11, ¶ 71 (wassermeyer, lang & schuch eds., 2010). 40. based on the proposal of the danish presidency, however, this argument ceases to apply as article 82 should be deleted. the ―interest limitation rule,‖ which is meant to replace article 81, does no longer provide for a definition of interest. 322 florida tax review [vol. 13:6 option of realizing the profits generated by his entity either in the form of profit distributions or in the form of capital gains. for all these cases, article 72 provides that for determining the tax rate applicable to a taxpayer, without prejudice to article 75, revenue that is exempt from taxation pursuant to article 11(c), (d), or (e) may be taken into account. this exemption with progression will be of little relevance whenever the rate of corporate tax is flat. the exemption with progression rules could be significant whenever different tax categories or different rates are applicable to distributed and retained profits. interestingly enough in this context, this provision refers to ―revenue‖ while the proposal uses the terms ―proceeds‖ or ―income‖ elsewhere. this could be significant in respect of a possible negative exemption by progression. the fact that this provision mentions only revenue and hence a positive gross amount, could imply that the ccctb should not allow a negative exemption with progression. based on the assumption that revenue is a gross figure, the expenses attributable to third-country income could not be taken into account. this would hardly make sense in terms of legal policy as this would not lead to an exemption of foreign income in cases of high related expenses. c. taxation of eu permanent establishments and third-country residents companies resident in third countries may also be subject to the ccctb in respect of their eu-based permanent establishments. in determining the tax base, the profits attributable to the permanent establishment will be included. 41 the nonresident then forms a group together with that permanent establishment and the other qualified subsidiaries. pursuant to article 2 of the proposal, the proposed directive shall apply to a company established under the laws of a third country if it has a similar form to one of the forms listed in annex i and if it is subject to one of the corporate taxes listed in annex ii. a similarity test must be carried out in respect of companies established under the laws of a third country. this provision hence differs from that applicable to eu-resident companies, although it does not specify the relevant parameters needed to make a comparison. presumably, this comparison shall not involve the corporate forms accepted in the specific member state, as third-countries should not be qualified differently in each member state. still, the common features of the corporate forms listed in annex i are not evident. this similarity test is even more complicated by the fact that the list of annex i may be supplemented by way of a comitology procedure, with no similarity test being necessary, leaving broader scope for discretion: the commission is supposed ―to take 41. ccctb working group, the territorial scope of the ccctb, 9 march 2006, ccctb/wp/026/, § 30. 2012] eu ccctb proposal 323 account of changes to the laws.‖ this gives the similarity test a dynamic element, and it may be different depending on the status of annex i. interestingly enough, other than for companies established in the eu, no similarity test is necessary in respect of corporate tax; rather the company must be subject to one of the corporate taxes listed in annex ii. this is presumably an editorial error since it is difficult to see why companies that are subject to a similar tax introduced later on in respect of their eu permanent establishments should not automatically be covered by the directive in that case. in view of the non-discrimination of permanent establishments enshrined in existing dtcs with third countries, this discrimination could raise concerns. pursuant to article 3(1) of the proposal, the commission shall annually adopt a list of third-country company forms. this list shall meet the requirements laid down in article 2(2)(a) of the proposal and shall be adopted in accordance with the examination procedure provided therein. in that case, a simplified authorization procedure applies: pursuant to article 5 of regulation number 182/2011, 42 the committee shall deliver its opinion by the majority laid down in article 16(4) and (5) of the treaty on european union and, where applicable, article 238(3) of the tfeu 43 for acts to be adopted on a proposal from the commission. where the committee delivers a positive opinion, the commission shall adopt the draft implementing act. however, the corporate forms are not listed exhaustively. nevertheless, the fact that a company form is not included in the list of thirdcountry company forms referred to in paragraph 1 shall not preclude the application of this directive to that form. this makes sense because the commission cannot always keep track of all changes in legislation worldwide. in this context, however, the question arises whether national legislators must implement that provision in a manner to allow administrative authorities and, eventually, the courts to carry out an examination procedure, or whether the national legislator itself is required to carry out an examination procedure and make continuous adjustments. since national legislators, just like the commission, cannot always keep track of all changes in legislation worldwide, national legislators might content themselves with ordering an examination procedure by way of a general clause, which shall then be handled pursuant to the list prepared by the commission according to article 3(2). the company forms referred to in that list must be regarded as similar in any case, although the fact that a company 42. regulation (eu) no 182/2011 of the european parliament and of the council of 16 february 2011 laying down the rules and general principles concerning mechanisms for control by member states of the commission’s exercise of implementing powers, o.j. l 55/13. 43. consolidated version of the treaty on the functioning of the european union, 2008 o.j. c 115/47 [hereinafter tfeu]. 324 florida tax review [vol. 13:6 form is not included in the list does not preclude the application of this directive to that form. in view of the tax base, article 6(7) of the proposal combines territorial taxation with world-wide taxation of income: a company resident in a third country is subject to tax only on income from an activity carried on through a permanent establishment in a member state. this means that a permanent establishment must exist and that income must be attributable to the permanent establishment. on the other hand, income from that activity is taxable whether the activity concerns only the state of the permanent establishment or another eu member state or even a third country. consequently, if a us-resident company has a permanent establishment in the european union to which interest from the united states is attributable, that permanent establishment is taxable under the ccctb regime. pursuant to article 6(2) of the proposal, a company that is not resident for tax purposes in a member state may opt for the system provided for by this directive under the conditions laid down therein in respect of a permanent establishment maintained by it in a member state. whether a permanent establishment exists again depends on the definition set forth in article 5 of the proposal. as discussed above, this definition is largely modeled after the oecd model convention. as a consequence, the question arises whether the numerous exemptions discussed above are applicable to nonresident companies as well. this would be the case under eu law only if the freedom of establishment applied. besides situations involving european economic area (―eea‖) states, this could only refer to situations within the european union. arguably, the free movement of capital will not necessitate an extension of these exemptions to permanent establishments in relation to other third countries. however, this may be necessary since dtcs with third countries contain provisions that prohibit discrimination of permanent establishments. the wording of the relevant exemptions as such is regularly not confined to resident companies. article 11 of the proposal does not contain such a restriction at all. that provision generally exempts from corporate tax the proceeds mentioned therein without distinguishing as to whether these are earned by an eu resident or non-eu resident. accordingly, the exemptions laid down in article 11(c), (d) and (e) are applicable as well. consequently, if the dividends are attributed to the permanent establishment, profit distributions are also exempt at the level of the permanent establishment. the same applies to proceeds from a disposal of shares that are part of the business assets of that permanent establishment. based on the proposal of the danish presidency, however, one would have to keep the added restrictions in mind, especially the required minimum holding of 10 percent. the exemption of a permanent establishment’s income in a third country could be relevant as well. for example, if a construction company 2012] eu ccctb proposal 325 resident in a third country has a permanent establishment in an eu state and carries out from that state a building site in a third country, that building site qualifies as a permanent establishment pursuant to article 5 of the proposal if it lasts longer than twelve months. if that is the case, the building site profits cannot be taxed at the level of the permanent establishment in the eu member state. 44 although one could argue that it is not a permanent establishment of a taxpayer, which is located in a state other than the state in which the taxpayer’s central management and control is located, we should nevertheless not overemphasize that inadequacy of article 5 of the proposal. otherwise, the results would be different if the state of residence of the company is a third country other than the country in which the building site is carried out. it would be inappropriate to arrive at different results here. the version of the definition of a permanent establishment which was proposed by the danish presidency would lead to similar issues. according to this version, the word order ―in which its central management and control is located‖ shall be replaced by ―in which it is resident for tax purposes.‖ 45 this wording would not include cases in which the state of residence and the pe state are identical. this result is obviously dubious. another question is whether the exemption with progression referred to in article 72 of the ccctb proposal would be applicable in these and other situations. again, that provision certainly does not specifically refer to eu resident taxpayers. hence, there is no obstacle to applying the exemption with progression clause here as well. for systematic reasons, there are frequent calls also in the field of national tax systems for an application of the exemption with progression also in the state of limited tax liability to avoid inappropriate preferred treatment as a result of the exemption method. 46 against this backdrop, nothing speaks against applying article 72 in this situation. 44. on the dtc problems of ―sub permanent establishment,‖ see klaus d. buciek, ―unterbetriebsstätte‖ und außensteuerrecht, in unternehmen, steuern — festschrift flick 647 (klein, stihl, wassermeyer, piltz & schaumburg eds., 1997); gassner & hofbauer, die unterbetriebstätte, in gassner/lang/lechner/schuch/staringer (eds), die beschränkte steuerpflicht im einkommen — und körperschaftsteuerrecht 83, 85 et seq. (wolfgang gassner, michael lang, eduard lechner, josef schuch & claus staringer eds., 2004); lang, die unterbetriebstätte im abkommensrecht, in körperschaftsteuer, internationales steuerrecht, doppelbesteuerung — festschrift wassermeyer 709, 715 et seq. (rudolf gock, dietmar gosch & michael lang eds., 2005). 45. see supra note 29. 46. peter haunold, michael tumpel & christian widhalm, eugh: negativer progressionsvorbehalt bei beschränkter steuerpflicht geboten, 17 swi 486 (2007); e. marschner, die steuerpflicht nach § 1 abs. 4 estg und das gemeinschaftsrecht, 82 swk s-692–94 (2007). http://www.lindeonline.at/xaver/start.xav?sid=wu45wien364ph8ds0heiiv329895693175&startbk=lexikon-st&bk=lexikon-st&start=%2f%2f*%5b%40attr_mid%3d'progressionsvorbehalt'%5d&anchor=el#xavertitleanchore 326 florida tax review [vol. 13:6 iii. derogation to the principle of territoriality a. taxation of interest and royalties the ccctb concept is characterized by the principle of territoriality. initially, the authors of the proposal have assumed a comprehensive concept of income that is not confined to eu sources and have then restricted that taxation of worldwide income through the exemptions discussed above. 47 as a consequence, however, any income subject to that concept is taxable and not exempt. business profits generated outside the european union that are not attributable to a permanent establishment located outside the european union are therefore taxable pursuant to the ccctb rules. the same applies to other non-exempt income — particularly interest and royalties. the authors of the proposal have emphasized the taxable nature of that income by incorporating a credit for foreign taxes in article 76. this provision requires income to be included in the tax base, making it taxable in the european union. b. the switch-over clause under certain circumstances, a switch-over from the exemption method to the credit method is possible with respect to the exemptions referred to in paragraphs (c) and (d) of article 11. this switch-over is possible if the company that made the profit distributions — or the entity whose shares are disposed of — were subject to tax at a rate which was too low in the company’s country of residence. 48 this fact will revive the tax liability, while the exemptions referred to in paragraphs (c) and (d) of article 11, are eliminated with the aim of avoiding double non-taxation, or taxation under the general regime in a country. in contrast to the proposal of the danish presidency, the proposal of the commission envisages to extend this regime also to permanent establishments. the switch-over pursuant to article 73 shall apply if, ―under the general regime in that third country,‖ the entity that made the profit distributions — the entity the shares in which are disposed of or the permanent establishment were subject — in the entity’s country of residence or the country in which the permanent establishment is situated is subject to ―a tax on profits at a statutory corporate tax rate lower than 40% of the average statutory corporate tax rate applicable in member states.‖ the 47. see supra part ii.a. 48. ccctb working group, ccctb: possible elements of a technical outline, § 120, ccctb/wp/057, 26 july 2007. 2012] eu ccctb proposal 327 european parliament, however, prefers to apply the switch-over clause in case profits are taxable at a statutory corporate tax rate lower than 70 percent of the average statutory corporate tax rate applicable in the member states. alternatively, that provision shall apply if the company is subject to ―a special regime in that third country that allows for a substantially lower level of taxation than the general regime.‖ the first provision of article 73(a) of the proposal merely asks if the taxpayer is subject to ―a tax on profits, under the general regime in that third country, at a statutory corporate tax rate lower than 40% of the average statutory corporate tax rate.‖ only the normal tax rate is relevant and not the taxpayer’s specific tax burden. the switch-over occurs in any event if the nominal tax rate is lower than this threshold. the switch-over applies even if the tax burden is high due to broad tax bases with only few exceptions, and even if it is higher than in the controlling shareholder’s member state. here is an example: a company resident in a member state has a permanent establishment in a third country that generates profits of 100,000 determined according to ccctb rules. due to other tax base rules in that state, the permanent establishment’s profit amounts to 500,000 according to the domestic law of the third country. at a nominal tax rate of 8 percent, the corporate tax burden amounts to 40,000. the switch-over clause applies although the actual tax burden in the other state — in relation to the ccctb tax base — is 40 percent. on the other hand, article 73(a) does not apply if the nominal tax rate exceeds the threshold, even if the effective tax burden is low or even zero due to the tax base provisions. in that case, the switch-over could take place only if the requirements of article 73(b) are fulfilled. for purposes of article 73(a) the question arises as to whether there can be several ―general regimes‖ — for example, if different tax rates apply to different types of corporate forms or if different tax rates apply to profit distributions and retained profits. article 73(b) of the ccctb proposal seems to preclude that, as it refers to ―the general regime.‖ in those cases, it can be rather difficult to identify a single ―general regime.‖ the alternative requirement of article 73(b) applies only if the taxpayer is subject to “a special regime in that third country that allows for a substantially lower level of taxation than the general regime.‖ for example, if the corporate tax rate is generally 40 percent in the third country, a company may take advantage of a 20 percent special tax rate because the permanent establishment is located in an area of the third country for which tax subsidies are granted. this ―allows for a substantially lower level of taxation than the general regime.‖ article 73(b) also requires this tax rate to be ―substantially‖ lower than the general regime. there is no identifiable standard to measure substantiality. assume that a tax rate which is 20 percent lower than the general regime qualifies as a substantially lower rate. this example shows that a 20 percent special tax rate may trigger a switch-over, 328 florida tax review [vol. 13:6 while a 15 percent regular tax rate will not regularly do so as long as the average applicable statutory corporate tax rate is lower than 15 percent. aside from paragraph (a), paragraph (b) of article 73 does not refer to the ―statutory corporate tax rate applicable in the member states,‖ but only to the ―level of taxation.‖ paragraph (b) does not appear to refer to the nominal tax rate but simply compares the tax rate under the general regime with that which the special regime ―allows for.‖ consequently, special provisions concerning the tax base should presumably fall under this provision. consider this example: the corporate tax rate is generally 40 percent in the third country. since the company’s permanent establishment is located in an area of the third country for which tax subsidies are granted, the company may recognize special depreciation. its profit therefore is 500,000. profits would have amounted to 1,000,000 without that special depreciation. the tax burden would have amounted to 400,000 at a 40 percent tax rate, but only 200,000 of tax is payable under the special regime. the taxpayer reduced its tax burden to 20 percent in relation to the general regime. the requirements for the application of article 73(b) are fulfilled. 49 some of these examples show that the provision can also apply in cases where there is no need for it in terms of legal policy. particularly, article 73(b) of the proposal leads to unjustified differentiation. if the tax rate under the general regime and the tax rate allowed under a special regime do not amount to 40 percent and 20 percent respectively, but to 11 percent and 9 percent, the latter will presumably not be regarded as substantially lower as required under article 73(b). if the average rate of taxation relevant under article 73(a) is 10 percent, it will not trigger a switch-over even though the tax rate under the special regime is lower. furthermore, a third country that disguises its benefits as general regimes and provides for a nominally higher tax rate can allow the resident companies or permanent establishments to escape the provisions of article 73. these differentiations are undoubtedly dubious. the legal uncertainty that this regime creates is alarming. the applicable average corporate tax rate pursuant to article 73(a) of the proposal is easily determinable and will be notified by the commission in advance. still, the proposal does not clearly define a standard upon which the ―substantiality‖ article 73(b) calls for must be determined. the 40 percent threshold defined by article 73(a) can at best be an indication, but in a 49. according to the german wording of article 73(b), a switch-over would also occur under ―a special regime‖ (―sonderregelung‖), if it were applicable in a member state. while article 73(a) refers to ―in that third country‖ (―betreffenden drittland‖), this requirement is missing in article 73(b) of the german version. the english version, however, also clarifies that article 73(b) is applicable only to a special regime ―in that third country.‖ 2012] eu ccctb proposal 329 different context. if one nevertheless relied upon that threshold, the above examples involving a 20 percent tax rate under a special regime would not be substantially lower and, therefore, would not trigger the applicability of article 73(b) — the 20 percent would merely represent 50 percent of the regular tax rate. the danish presidency has proposed to delete the requirement of ―substantiality‖ in article 73(b). this would resolve several unclarities previously discussed. however, it would be questionable if every special rule that leads to a lower taxation would trigger a switch-over. a slightly lower tax burden, compared to the normal level of taxation, for certain types of income in a high tax country may still be higher than the tax burden in most of the other states. it can be just as difficult in a particular case to identify a ―special regime.‖ which provisions qualify as ―special regimes‖ will probably have to be determined in comparison with the ―general regime.‖ on the other hand, the ccctb regime will have to be the standard. exemptions available in the third country for capital gains, profit distributions, or profits generated by permanent establishments in other third countries will presumably not be special regimes. although article 73 of the proposal is titled ―switch-over clause,‖ the clause as such merely provides for an exception from the exemptions referred to in article 11(c), (d), and, in the version of the commission proposal, (e) and triggers a revival of the tax liability with respect to that income. the clause does not provide for a credit as such. still, article 74 gives that impression: ―where article 73 applies to the income of a permanent establishment in a third country, its revenues, expenses and other deductible items shall be determined according to the rules of the system provided for by this directive.‖ this provision would only make sense if the permanent establishment’s income were to be taken into account for the ccctb tax base for purpose of the credit method and, specifically, the calculation of the maximum credit. however, neither article 73 nor article 74 of the proposal provides for an obligation to credit. this might be the reason why the danish presidency has proposed to completely abolish article 74 of the commission proposal. a credit obligation can, however, be derived from article 76 of the proposal. if income has already been taxed in another member state or in a third country, the foreign tax can be credited under that provision, except with respect to income that is exempt pursuant to paragraphs (c), (d), and (e) of article 11. the text of these provisions does not mention as requirements the terms ―interest‖ and ―royalties‖ that are mentioned in the title. the underlying objective is to credit foreign tax in order to eliminate double taxation in all cases in which it is not eliminated by way of exemption. in the absence of other available provisions, article 76 of the proposal can be relied on as basis for the credit obligation connected with the switch-over. its wording so permits because it refers to ―income which has 330 florida tax review [vol. 13:6 been taxed . . . in a third country‖ and exempts only ―income which is exempt under article 11(c), (d) or (e).‖ the exemption pursuant to article 11(c) and (d) does not apply because it is precluded by article 73. 50 it is questionable whether the scope of application of article 76 is so broad to procure also an indirect credit of corporate tax imposed upon the third-country entity in the cases in which article 73 of the proposal denies an exemption for ―received profit distributions.‖ such an indirect credit is necessary if the switch-over is supposed to eliminate double taxation just like the exemption provided in article 11(c). the parent-subsidiary directive maps out that option as an alternative to an exemption. 51 although express provisions for the calculation of the prior tax burden in the third country do not exist, that is certainly permissible according to the wording of article 76. article 76(5) of the proposal, which was deleted in the compromise proposal of the danish presidency, merely refers to ―deduction for the tax liability in a third country.‖ the provision does not specify whose tax liability in the third country that is. based on that wording, those cases would allow both a direct 50. according to the commission proposal, article 73 also excludes the exemption according to article 11(e). see also matthijs vogel, withholding taxes and relief for double taxation, in ccctb: selected issues 191, 197 n.18 (dennis weber ed., 2012) [i]n my view the proposal clearly provides that if the (income) exemption of art. 11 (c), (d) or (e) is denied pursuant to art. 73, a tax credit is still available according to art. 76. if art. 73 applies, the respective income is not exempt under art. 11 (c), (d) or (e). . . . as a result, the door is open for a tax credit under article 76 as that article states that a tax credit is available for ―income which has been taxed in another member state or in a third country, other than income which is exempt under art. 11 (c), (d) or (e).‖ 51. see generally parent-subsidiary directive, supra note 18. article 4 reads: where a parent company or its permanent establishment, by virtue of the association of the parent company with its subsidiary, receives distributed profits, the member state of the parent company and the member state of its permanent establishment shall, except when the subsidiary is liquidated . . . tax such profits while authorising the parent company and the permanent establishment to deduct from the amount of tax due that fraction of the corporation tax related to those profits and paid by the subsidiary and any lower-tier subsidiary, subject to the condition that at each tier a company and its lower-tier subsidiary fall within the definitions laid down in article 2 and meet the requirements provided for in article 3, up to the limit of the amount of the corresponding tax due. id; see also georg kofler, mutter-tochter-richtlinie, art. 4, ¶ 23 et seq. (2011). 2012] eu ccctb proposal 331 and an indirect credit. it does not expressly regulate the criteria according to which the corporate tax of the distributing company shall be determined. whoever considers it necessary that ―received profit distributions‖ be credited indirectly pursuant to article 76 need not necessarily defend that view also with respect to capital gains, which article 73 precludes from the exemption of article 11(d) and that are again considered taxable because it is even more difficult to attribute the company’s underlying corporate tax to the capital gains. capital gains need not exclusively represent the amount of profits generated but not yet distributed by the company. the appreciation of the share earned by way of capital gains may also be based on assumed future expected yields, reflect general market developments, or be marked by subjective ideas of a buyer and seller. in any event, if profits are distributed to the new shareholder after the sale, the company’s corporate tax would again be credited. this being so, an indirect credit of corporate tax should not be acceptable in the case of sales. however, assuming that the more convincing arguments speak against an indirect credit in the case of a sale, there is indeed doubt as to whether that form of crediting foreign tax is permissible in the case of received profit distributions. the wording of the relevant rules does not seem to provide any indication for a differentiation between the two cases. another argument strengthens these doubts: only article 76 of the proposal can be viewed as a legal basis for an indirect credit because its wording is open. a broad interpretation of article 76 of the proposal risks making its scope of application endless. in that case, one would also have to consider crediting the tax of the paying company in case of interest and royalties. the authors of the proposal cannot have intended that consequence. all this speaks for leaving it at a direct credit based on the current proposal and, in case of taxable profit distributions or proceeds from the sale of shares, to credit only the tax of the third country imposed upon the recipient. the title of article 76, which refers to taxes ―at source,‖ seems to point in the same direction. the lacking option of an indirect credit, however, is not convincing in terms of legal policy. c. controlled foreign companies (“cfc”s) a mere switch-over is not always the only option. in select situations the proposal also considers it acceptable to look through the entity resident outside the european union. article 82 of the proposal contains such a cfc clause. 52 the tax base shall include the non-distributed income of an entity 52. for a discussion on cfc rules in the ccctb system, see georg kofler, cfc rules, in the common consolidated corporate tax base 725, 725–49 (michael lang et al. eds., 2008) [hereinafter kofler, cfc rules]. 332 florida tax review [vol. 13:6 resident in a third country where certain conditions are met. 53 the commission has opted for such a rule, although certainly not all member states have adopted cfc rules in their national tax systems. 54 it has preferably adopted a provision that allows a look-through approach only if certain rather strict conditions are met. in any event, it specifically exempts companies whose principal class of shares is regularly traded on one or more recognized stock exchanges. furthermore, pursuant to article 82(2) of the proposal, companies with residency in an eea state, with which there is an agreement on the exchange of information under international law, are exempt as well. according to the proposal of the danish presidency, the scope of the cfc-rule should be extended in various ways. the exemption for companies, whose principal class of shares is regularly traded on one or more recognized stock exchanges, shall be deleted again. 55 furthermore, companies that are resident in a third country party to the european economic area agreement and with which there is an agreement on the exchange of information comparable to the exchange of information on request provided for in directive 2011/16/eu can, according to this danish proposal, fall within the scope of the cfc-rule. 56 permanent establishments in third countries, which were taken out of the scope for the switch-over clause, fall, according to the proposal of the danish presidency, within the scope of the cfc-rule. the rule is applicable to entities ―resident in a third country.‖ there is no separate definition of what ―resident‖ is supposed to mean. according to their very wording, the provisions of article 6(2) and (3) of the proposal 53. see mario tenore, cfc rule, in ccctb: selected issues 299, 306 (daniel weber ed., 2012) [hereinafter tenore, cfc rule]. 54. jaroslav dado & milan sedmihradsky, national report czech republic, in cfc legislation, tax treaties and ec law 125, 127 (michael lang et al. eds. 2004); eric von frenckell, national report belgium, in cfc legislation, tax treaties and ec law 97, 99 (michael lang et al. eds., 2004); katharina haslinger, national report austria, in cfc legislation, tax treaties and ec law 73, 75 (michael lang et al. eds., 2004); georgios matsos, national report greece, in cfc legislation, tax treaties and ec law 281, 283 (michael lang et al. eds. 2004); lionel noguera & allen steichen, national report luxembourg, in cfc legislation, tax treaties and ec law 409, 411 (michael lang et al. eds., 2004); martine j. peters, national report netherlands, in cfc legislation, tax treaties and ec law 433, 435 (michael lang et al. eds., 2004). for information on bulgaria, ireland, latvia, malta, poland, romania, slovakia, slovenia, and cyprus, see cfc key features comparison, ibfd tax research platform, http://online.ibfd.org/kbase/#topic=kf-compare&format= ghtml&wt.z_nav=search&collection=kf&files=kf_bg,kf_cy,kf_ie,kf_lv,kf_mt,kf_pl ,kf_ro,kf_sk,kf_si. 55. presidency note, supra note 11, art. 82(1)(d). 56. see id. art. 82(2). 2012] eu ccctb proposal 333 are not applicable because they govern only the residency of companies, not that of entities. the fact that article 6(3) and (4) do not only simply refer to companies but state that the criteria laid down in article 6(3) are relevant ―for purposes of paragraphs 1 and 2‖ suggests that an analogous application of these rules is impossible. moreover, an application of article 82 of the proposal requires that the taxpayer ―by itself, or together with its associated enterprises, holds a direct or indirect participation of more than 50% of the voting rights,‖ ―owns more than 50% of the capital,‖ or ―is entitled to receive more than 50% of the profits of that entity.‖ in turn, there must be a participation of more than half of the voting rights, of the capital, or of the profits of the enterprise. at least with respect to voting rights, an indirect participation is sufficient. furthermore, the rule also applies if the taxpayer fulfills this requirement only ―together with its associated enterprises.‖ consequently, however, there can be more than one taxpayer who can hold ―by itself, or together with its associated enterprises, . . . a direct or indirect participation of more than 50% of the voting rights‖ of the foreign entity. this prompts the following question: to which of these enterprises will the cfc rule apply? 57 according to its wording, several enterprises subject to the ccctb regime could have to apply article 83 of the proposal with respect to the same foreign entity. if the proposal of the danish presidency would be adopted, article 82 would also be applicable to taxpayers who hold[] because of an agreement with other investors more than 50% of the voting rights, or [have] because of an agreement the full control over the financial and operating policies of the entity, or [have] the authority to appoint or dismiss members of the board of directors jointly holding more than 50% of the voting rights in the board of directors, or power to cast more than 50% of the votes in the board of directors, 58 then these possibilities seem to multiply. article 83(2) of the proposal clarifies, however, that ―income to be included in the tax base shall be calculated in proportion to the entitlement of the taxpayer to share in the profits of the foreign entity.‖ alongside the switch-over clause in article 73 of the proposal, the cfc rule applies only if under the general regime of the third-country profits are subject to corporate tax at a statutory rate of less than 40 percent of the average statutory rate of corporate tax applicable in the member state or if the entity can rely on a special regime that allows for a substantially lower 57. see tenore, cfc rule, supra note 53, at 311. 58. presidency note, supra note 11, art. 82(1)(a). 334 florida tax review [vol. 13:6 level of taxation than the general regime. accordingly, the look-through approach shall apply only if in the third country there is a low rate of taxation either under the general regime or specifically with respect to the enterprise. consequently, article 82 can also be relevant if the lower rate of corporate taxation is subject to a high rate of effective corporate taxation by virtue of a different tax base in the third country. 59 the danish presidency has questioned the 40 percent limit and proposed deleting the requirement of substantiality, as it had also done in the switch-over clause. 60 the european parliament has decided to include profits into the tax base which, ―under the general regime in the third country, are taxable at a statutory corporate tax rate lower than 70% of the average statutory corporate tax rate applicable in the member states.‖ 61 furthermore, according to the commission proposal, more than 30 percent of the entity’s income must fall under one or several of the categories referred to in paragraph (3). those categories are (1) interest or any other income generated by financial assets (paragraph 3(a)); (2) royalties or any other income generated by intellectual property (paragraph 3(b)); (3) dividends and income from the disposal of shares (paragraph 3(c)); (4) income from movable property (paragraph 3(d)); (5) income from immovable property, unless the member state of the taxpayer would not have been entitled to tax the income under an agreement concluded with a third country (paragraph 3(e)); and (6) income from insurance, banking and other financial activities (paragraph 3(f)). the provision of article 82(1)(c) initially creates the impression that it is irrelevant whether the above income is attributable to only one or to several of those categories. the crucial aspect under article 82(1)(c) is that more than 30 percent of the income accruing to the entity falls ―within one or more of the categories set out in paragraph 3.‖ eventually, however, the introductory sentence of article 82(3) clearly shows that the category is decisive: ―the following categories of income shall be taken into account for the purposes of point (c) of paragraph 1, in so far as more than 50% of the category of the entity’s income comes from transactions with the taxpayer or its associated enterprises.‖ a single form of income or, as referred to in article 82(1)(c), ―category‖ is taken into account for the purpose of computing the 30 percent threshold only if more than 50 percent of the category of the entity’s income comes from transactions with the taxpayer or its associated enterprises. every category of income shall apparently be taken into account separately. here is an example: a company resident in a low-tax country derives 60 percent of its profits from trading goods of any kind with independent 59. ccctb working group, anti-abuse rules, §§ 26 et seq. ccctb/wp/065/, 26 march 2008. 60. see presidency note, supra note 11, art. 82(1)(b). 61. european parliament resolution, supra note 10, amend. 29. 2012] eu ccctb proposal 335 third parties, and 20 percent each from interest and royalties. forty percent of interest and 80 percent of royalties come from transactions with the shareholder. in that case, article 82 is not applicable, since only royalties are harmful income, and these represent only 20 percent of total profits. however, if 60 percent of interest and 60 percent of royalties come from transactions with the shareholder, article 82 will be applicable to the entire profit because interest and royalties are then considered harmful and together represent 40 percent and thus more than 30 percent. it is difficult to see the meaning behind this regime. the proposal of the danish presidency to forgo the requirement that more than 50 percent of the category of the entity’s income comes from transactions with the taxpayer or its associated enterprises, would lead to more appropriate results. similarly, it is not understandable why, according to the commission proposal, income from immovable property (article 82(3)(e)) should exclusively be exempt if the member state of the taxpayer would not have been entitled to tax the income under an agreement concluded with a third country. admittedly, the state of residence can lose the right to tax according to the oecd-mc, yet there are numerous bilateral dtcs that also exempt certain categories of interest in the state of residence. 62 there is no reason why different rules should apply here. the proposal of the danish presidency to abolish this exception is therefore, in this case, equally convincing. the consequences of an application of article 82 are governed in article 83 of the commission proposal, which provides that income to be included in the tax base shall be calculated according to the rules of articles 9 through 15. thus, rather than directly relying upon the tax base of the company in the third country, the tax base is recalculated clearly based on the assumption that companies in third countries are residents in the european union. as a result, dividends or proceeds from a disposal of shares must be exempt pursuant to article 11 of the proposal. the same is true for proceeds from a disposal of shares derived from the third country or another third country. similarly, the income of a permanent establishment in a third country shall not be included in the tax base. article 11 itself does not distinguish whether the income is then taxed in that other third country. however, if the company is actually a resident in the european union, article 73 orders an exception from the exemptions provided in paragraphs (c), (d), and (e) of article 11. according to its spirit, the exception laid down in article 73, thereby triggering a switch-over, should also be applicable in these situations. yet it is not applicable according to its wording because article 83(1) simply refers to articles 9 to 15 of the proposal. that provision differs from the last sentence of article 84(1), which is applicable to transparent entities and provides that ―the income shall be computed under 62. michael lang, überlegungen zur österreichischen dba-politik, 22 swi 108, 111–27 (2012). 336 florida tax review [vol. 13:6 the rules of this directive,‖ and it also differs from article 74, which provides that the ―revenues, expenses and other deductible items‖ of a permanent establishment in a third country “shall be determined according to the rules of the system provided for by this directive.‖ consider this example: a company subject to the ccctb regime holds a 100 percent participation in a company resident in the low-tax country a. that company exclusively derives income from dividends that come from a participation in a low-tax country b. the company resident in b generates its profits from interest earned from loans granted to other group companies and is taxed at a rate of only 5 percent on those profits. provided that article 82 is applicable to the company resident in a, the income shall be calculated pursuant to articles 9 through 15. the dividends from b would have to be exempt, which is why the cfc rule would eventually not apply. however, if article 73 is likewise applied, the dividends must be included in the tax base, and the cfc rule becomes effective. with this in mind, it is a welcoming proposal of the danish presidency to replace the reference to articles 9 through 15 for the wording ―the rules of this directive.‖ this would resolve the discussed questions and would furthermore lead to appropriate and clearly attainable results. the legal consequence of article 83 of the proposal does not consist of a full ―look-through approach.‖ pursuant to the second sentence of article 83, losses of the foreign entity shall not be included in the tax base but shall be carried forward and taken into account when applying article 82 in subsequent years. 63 according to the proposal of the danish presidency, the same should hold for losses of a permanent establishment. article 83 of the proposal prevents economic double taxation if the foreign entity distributes profits in subsequent years or if its shares are disposed of in subsequent years. accordingly, the income previously included in the tax base pursuant to article 82 is deducted again when the entity’s profits are distributed or when its shares are disposed of. article 83(4) and (5) apparently presupposes that the otherwise relevant exemption of article 11(c) and (d) does not apply because the application of article 82 also triggers a switch-over pursuant to article 73. based on the proposal of the danish presidency, this argumentation proves to be problematic. according to the changed wording, article 73 will obtain a counterexception and the deletion of the exemptions provided for in articles 11(c) and (d) shall not be applied for holdings according to article 82(1)(a). the exemptions would thus be applicable again. 63. for a discussion on the treatment of losses in the ccctb system, see moreno gonzález & j. a. sanz díaz-palacios, treatment of losses, in the common consolidated corporate tax base (michael lang et al. eds., 2009). 2012] eu ccctb proposal 337 iv. transparent entities a. qualification of entities in third countries the proposal also contains rules on transparent entities. 64 where an entity is treated as transparent, a taxpayer holding an interest in the entity shall include its share in the income of the entity in the taxpayer’s own tax base. for purposes of this calculation, the income shall be computed under the rules of this directive. transactions between a taxpayer and the entity shall be disregarded in proportion to the taxpayer’s share of the entity. there are no regulations on the criteria to be relied upon for the computation of the taxpayer’s share such as those for controlled foreign companies. pursuant to article 84(1), for entities with residency in a member state, the relevant criterion is their treatment in that member state. if the entity is treated as transparent in the member state of its location, the shareholder’s state of residence must also adopt that qualification. this article does not define any criteria to determine residency. an analogous application of article 6(3) of the proposal is problematic for the reasons discussed above, as these provisions refer only to companies and are specifically relevant only for the purposes of paragraphs (1) and (2). pursuant to article 85 of the proposal, transparency in the case of third-country entities is determined in a diametrically opposed form, based on the ―law of the member state of the taxpayer.‖ ―if at least two group members hold an interest in the same entity located in a third country, the treatment of the latter shall be determined by common agreement among the relevant member states. if there is no agreement, the principal tax authority shall decide.‖ article 85 of the proposal does not provide for independent legal consequences in the case of shares in third-country entities. these can be inferred from article 84 of the proposal. the income of the transparent entity is considered to be a proportion to the shareholder’s tax base. pursuant to article 84(3), the taxpayer shall be entitled to relief from double taxation in accordance with article 76(1), (2), (3), and (5). 65 again, the question arises whether an indirect credit is acceptable as well. if the third-country entity is not treated as transparent there, the tax will be imposed on the account of a taxpayer other than the legal entity that is taxable under the law of the member state. even if an indirect credit is not regarded as acceptable on the basis of article 76, the treatment might be different if the provisions of 64. ccctb working group, personal scope of the ccctb, §§ 17 et seq., ccctb/wp/040/, 26 july 2006. 65. the danish presidency accepted articles 84 and 85 without any amendments and has thus also accepted the reference to article 76(5), even though the presidency itself chose to delete this provision in its compromise proposal. 338 florida tax review [vol. 13:6 article 84(3) could suggest such an understanding. article 84(3) would lose its meaning otherwise, as the general obligation to credit third-country taxes already arises from article 76. in the context of article 84, the reference to article 76 could suggest an indirect credit. if the entity that is treated as transparent has a permanent establishment in the third country that fulfills the requirements laid out in article 5, the entity’s assumed transparency will lead to the permanent establishment being regarded proportionally as that of the taxpayer. consequently, the exemption of article 11(e) of the proposal would apply, and the income must then be disregarded for the purpose of calculating the tax base. if a third-country entity is qualified as non-transparent, received profit distributions are exempt pursuant to article 11(c), and proceeds from a disposal of shares are exempt pursuant to article 11(d). against that backdrop, it makes little difference whether a third-country entity is treated as transparent since the profits generated there from that entity are obviously exempt anyway. this would, however, be different based on the proposal of the danish presidency concerning minor holdings. if the holding is below 10 percent, the exemption of articles 11(c) and (d) will not apply. the profit distributions of a non-transparent company resident in a third country will then be liable to tax. the appropriateness of this result can be questioned. however, if the third-country entity is treated as transparent, it is exempt within the european union if it has a permanent establishment in the third country and if the profits can be attributed to it. in other words, if the third-country entity is a corporation established under the laws of that country, which derives only interest and does not have its own permanent establishment, article 85 of the proposal will tax the interest received by the third-country entity at the level of its shareholders in the european union. if the indirect credit is considered unacceptable, this situation may even give rise to double taxation because the same interest is attributable to the company located in the third country according to the law of that third country and, according to the proposal, to the shareholder in the european union. in a similar case, however, even double non-taxation may occur. if the third-country entity without a permanent establishment is treated as transparent in its state of establishment, interest it receives might not be taxed at all in that state. however, if it is not regarded as transparent pursuant to article 85 of the proposal, income will not be attributed to the eu-resident shareholder for purposes of the directive, and any subsequent transfer of the third-country entity’s profits is then qualified as received profit distribution and is exempt pursuant to article 11(c) of the proposal. a tax liability could at best be inferred from article 73 of the proposal if the profits are not taxed in the third country, for example, because there is no permanent establishment. then again, the application of article 73 is opposed by the 2012] eu ccctb proposal 339 fact that the tax exemption is the result of its transparent treatment rather than the consequence of a low rate of taxation. if that consequence arises from the tax system as a whole, there will be no ―special regime‖ that could also trigger the application of article 73. a ―dividend‖ paid by the third-country entity to the eu shareholder cannot be taxed. in the case of transparent entities, it is more difficult to derive that tax exemption from article 11(c) of the proposal because a lookthrough approach is applied to the ―distributing‖ entity pursuant to article 84 et seq. consequently, the ―distributing‖ entity cannot be identified easily. however, to assume a tax liability would be inconsistent with the purpose of the rule, as it lies in the very nature of transparency to immediately tax the company’s profits without having to wait for their transfer to the shareholder. as a consequence, the lack of taxability of profits transferred to the shareholder can obviously be derived from the system laid out in article 84 et seq. this result would not change if the proposal of the danish presidency would be adopted and the exemptions of articles 11(c) and (d) were made dependent on the existence of a minimum holding of 10 percent. b. eu permanent establishments of third-country entities and transparency in any event, the criteria that may be relied upon pursuant to article 85 of the proposal for third-country entities differ from those that are relevant pursuant to article 2(2) for the companies established according to the law of a third country. pursuant to article 85, the only criterion is the qualification according to the national law of the shareholder’s state of residency in the european union. pursuant to article 2(2), it is decisive whether the company ―has a similar form to one of the forms listed in annex i.‖ in reliance on the opinion discussed above, the different forms must be compared and the major features of all forms listed in annex i must be identified. even if the focus is merely put on a similarity with those forms that are listed in annex i for the relevant state of the permanent establishment, the criteria need not be the same as those that apply according to the national laws of that state for the purpose of classifying foreign companies for purposes of corporate tax. difficult interpretation problems and even distortions may arise from the differences between article 85 and article 2(2) of the proposal. 66 the following is an example: a company resident in eu-member state a holds a 50 percent share in a subsidiary in a third country. the third 66. see matthijs vogel et al., initial comments on common consolidated corporate tax base: proposal for a council directive, in 4 highlights & insights on eur. tax’n 5, 60 (2011) [hereinafter highlights & insights]. 340 florida tax review [vol. 13:6 country entity has a permanent establishment in eu-member state b. the third country regards the company resident in that state as the taxpayer while the national tax law of state a treats the company as transparent. if state b applies the examination procedure required in article 2(2) of the proposal with respect to the permanent establishment located in its territory, the entity of the third country qualifies as a ―company‖ according to the proposal. in this event, the subsidiary’s income shall be included proportionally in the tax base of the company that is a resident in a pursuant to article 85. the same is true for the profits attributable to the third-country entity’s permanent establishment in the european union. after all, the permanent establishment is not an independent enterprise and, therefore, cannot be qualified pursuant to article 84. the permanent establishment’s income cannot be exempt, since article 11(e) applies only to permanent establishments in a third country. the third-country entity itself, however, is regarded as the taxpayer in member state b. pursuant to article 6(2) of the proposal, it may opt for the application of the rules of the directive for its eu permanent establishment. in that case, a group cannot be formed with the company resident in state a, because the share amounts to only and not more than 50 percent. as a consequence, the profits attributable to the permanent establishment located in state b must be recognized both at the level of the company resident in state a and also at the level of the thirdcountry entity itself and are thus taxable in state b where the permanent establishment is located. in this case, the application of the directive leads to double taxation in the european union. the tax imposed in b can at best be credited in state a if the reference in article 84(3) to article 76 of the proposal is interpreted as to also allow an indirect credit. c. controlled foreign companies and transparency another question is the relationship between the rules in article 84(f) on transparent entities and those in article 82 et seq. on controlled foreign companies. this question seems unimportant at least at first sight since both sets of rules pierce the corporate veil in that the profits of the third-country entity are proportionally attributed to the shareholder’s profits. the legal consequences, in turn, seem to be the same. this result is called into question, however, if one considers the profits subsequently transferred to the shareholder. as discussed, such payments are not taxable at the level of the shareholder if the third-country entity is treated as transparent pursuant to article 85. however, distributions are taxable if the cfc rules of article 82 et seq. are applicable. due to the exception laid out in article 73, the exemption of article 11(c) does not apply. article 83(4) indirectly confirms that tax liability, stipulating that the amounts of income previously included in the tax base shall be deducted from the tax base. at least the last mentioned argument remains valid against the backdrop of article 73, which 2012] eu ccctb proposal 341 would in its proposed amendment by the danish presidency, keep the exemption of article 11(c) intact. in case the cfc rules and those rules concerning transparent entities provide for different legal consequences, there is evidence to support the supposition that the cfc rule is not relevant because it can be found in chapter xiv of the proposal that, as evidenced by its title, deals with ―antiabuse rules.‖ if a general rule such as that on transparent entities regulates the attribution of income to the eu shareholder, then there is no need to bring the anti-abuse rules into play. v. double taxation conventions a. priority of dtcs with third countries the relationship between the directive and the double tax conventions (dtcs) is complex. 67 there is a tight network of dtcs between the eu-member states, and between member states and third countries. the provisions of union law take precedence over dtcs in the relations between the member states. although already emanating from primary law, 68 this principle is repeated in article 8 of the ccctb proposal: ―the provisions of this directive shall apply notwithstanding any provision to the contrary in any agreement concluded between member states.‖ still, the dtcs do not entirely lose their meaning in the scope of application of this directive. treaty law takes precedence only if the dtc rules are opposed to a regulation of the directive. within the european union, certainly this is not always the case. for example, article 76 of the proposal regulates the credit of those taxes that were already paid in another member state or even in a third country. accordingly, subject to article 76, withholding taxes imposed on interest, royalties, and any other income taxed at source in a member state or in a third country may be credited in the taxpayer’s state of residence. that credit is not available if a dtc exists between the state of residence and the other member state that prevents the other member state 67. ccctb working group, international aspects in the ccctb, §§ 17 et seq., ccctb/wp/019/, 18 november 2005; analysis and comment, supra note 20, at 518; highlights & insights, supra note 66, at 60. 68. see georg kofler, doppelbesteuerungsabkommen und europäisches gemeinschaftsrecht 265–1196 (2007) [hereinafter doppelbesteuerungsabkommen]; j. schuch & a. stieglitz, dbaund eudiskriminierungsverbote und verfahrensrecht, in die diskriminierungsverbote im recht der doppelbesteuerungsabkommen 407, 417–33 (michael lang et al. eds., 2006); marco laudacher, rechtsfindung nationaler richter im fall der unionsrechtskonformen auslegung und des anwendungsvorrangs, ufsjournal 164 (2012); see also t. schindler, vorrang für menschenrechte oder marktfreiheiten?, 27 rdw 807 (2009). 342 florida tax review [vol. 13:6 from imposing withholding tax. accordingly, the dtc continues to be applicable after all. the ccctb proposal does not contain general rules with respect to third countries. article 351 tfeu stipulates that the rights and obligations from agreements concluded before 1 january 1958 or, for acceding states, before the date of their accession between member states and third countries, shall not be affected by this treaty. to the extent that such agreements are not compatible with the treaty, the member states shall take all appropriate steps to eliminate the incompatibilities. this can even necessitate the termination of the international treaty. 69 based on a contrario reasoning, however, later treaties that are incompatible with union law must even be disregarded, and union law will therefore have precedence in any event. 70 according to the — albeit controversial — opinion of advocate general kokott, 71 an analogous application of article 351(1) tfeu 72 is conceivable “where an international obligation on the part of a member state conflicts with a subsequently agreed measure of secondary law.‖ 73 this can mean that the currently applicable dtcs with third countries are still applicable and will take precedence over the directive until the change or termination of the dtc. however, article 351 tfeu regulates only conflicts between dtcs and the directive. such a conflict does not exist if a dtc allows dividends to 69. doppelbesteuerungsabkommen, supra note 68, at 432–1196. 70. see supra part ii.a. 71. the opinion which rejects an analogous application relies upon the member states’ obligation not to impair the community’s later exercise of competence. see pietro manzini, the priority of pre-existing treaties of ec member states within the framework of international law, 12 ejil. 781, 785–92 (2001). 72. tfeu, supra note 43; see also consolidated version of the treaty establishing the european community, art. 307, 2006 o.j. (c321) e/37 [hereinafter ec treaty]. 73. case c-188/07, commune de mesquer v. total france sa and total int’l ltd., 2008 e.c.r. i-4501 (op. of advocate gen kokott). the analogous application of ec treaty article 307 — which corresponds to article 351 tfeu — to agreements concluded before 1 january 1958, or after the accession of a member state in an area of competence for which the community did not yet have competence on the execution date is predominantly affirmed by legal scholars. see lorenzmeier, verhӓltnis zu früheren vertrӓgen der mitgliedstaaten (nizzafassung), in das recht der europäischen union 40, at egv art. 307 (eberhard grabitz & meinhard hilf eds., 2009); kirsten schmalenbach, verhӓgen zu früeren der mitgliedstaaten, in euv/aeuv — das verfassungsrecht der europäischen union mit europäischer grundrechtecharta 4, aveu art. 351 (ex-art. 307 egv) (christian calliess et al. eds., 2011); von eckhard pache & joachim bielitz, das verhältnis der eg zu den völkerrechtlichen verträgen ihrer mitgliedstaaten, eur 316 (2006). 2012] eu ccctb proposal 343 be credited and if those dividends must be exempt under the directive. an exemption within the european union is not incompatible with the dtc as the latter does not impose a tax liability. in that event, the credit may eventually be meaningless, especially if the maximum amount of credit under the dtc is zero. there is, however, a conflict between a dtc and the directive if a dtc — in derogation to the oecd-mc — stipulates an exemption of interest in the state of residency, while article 6(6) and article 76 of the ccctb proposal subject that interest to tax. in such a case, the dtc exemption has priority within the scope of the application of article 351 tfeu — possibly extended by way of analogy. similarly, if the dtc exempts income from a permanent establishment in the third country, and a permanent establishment for purposes of treaty law has already existed for six months in case of construction projects, a conflict exists that must be resolved in favor of the dtc. the same applies if a dtc between a member state and a third country qualifies a construction project to be a permanent establishment only if it has existed more than eighteen months and a nonresident needs fifteen months for a construction projection in an eu state. according to the directive, the company resident in the third country could already opt for the ccctb system with respect to its permanent establishment, while the dtc prevents that state’s taxation right so that the directive will prevail subject to article 351 tfeu. finally, some articles of the ccctb proposal directly address dtc rules. for example, article 76(5) of the proposal — which should be deleted according to the compromise proposal of the danish presidency — stipulates that the creditable third-country tax may not exceed the final corporate tax liability of a taxpayer ―unless an agreement concluded between the member state of its residence and a third country states otherwise.‖ that provision apparently represents the obligation to refund a withholding tax imposed by a third country similar to what the european court of justice had in mind in the amurta case. 74 such rules must certainly be borne in mind even if they are included in a later dtc. similarly, there is no obligation to amend those dtcs as would otherwise be necessary pursuant to article 351(2) tfeu. b. dtcs and foreign controlled companies against that backdrop, the question now becomes whether dtcs preclude the application of the cfc rules. article 82 of the ccctb proposal addresses bilateral agreements twice. pursuant to article 82(2) of the proposal, paragraph (1) shall not apply where the third country is party to the european economic area and ―there is an agreement on the exchange of 74. case c=379/05, amurta sgps v. inspecteur van de belastingdienst/amsterdame, 2007 e.c.r. i-09569. 344 florida tax review [vol. 13:6 information comparable to the exchange of information on request provided for in directive 2011/16/eu.‖ 75 article 82(3) also lists as one of the categories of potentially harmful income as that income from immovable property ―unless the member state of the taxpayer would not have been entitled to tax the income under an agreement concluded with a third country.‖ still, both regulations — which should be deleted according to the compromise proposal of the danish presidency — do not provide any indication to clarify the relationship between article 82 et seq. and the dtcs generally. dtc rules that — possibly by way of analogy — fall within the ambit of article 351 tfeu can preclude the application of article 82 et seq. only if the provisions of the directive are incompatible with them. the decisive question is whether there is such a conflict. courts that have had to address the relationship between national cfc rules and dtcs have provided completely different answers to this question. here are two different examples: first, the finnish supreme court held the application of the finnish cfc rule compatible with the dtc. 76 the judgment was primarily based on the objective and purpose of the dtc and the oecd commentary. second, the french conseil d’etat adopted an entirely different stance in its judgment on 28 june 2002 that concerned schneider sa. 77 the court held that the 1966 dtc between france and switzerland, modified in 1969 and modeled after article 7(1) oecd-mc, required the exemption of income that may be taxed in switzerland pursuant to article 7(1) of the dtc because the swiss subsidiary had its place of management in switzerland and did not have a permanent establishment in france. the court maintained that the goal of preventing double taxation did not allow any other interpretation of the treaty rules. it is unproductive for a solution to rely on the objective of the dtcs alone. 78 although dtcs are intended to prevent double taxation, they can only do so only within their scope of application. 79 as a result of cfc rules, the two states will attribute the income to different persons, and the dtcs usually will not focus on ensuring protection against such economic double 75. highlights & insights, supra note 66, at 59. 76. re a oyj abp, 20 march 2002, kho 596/2002/26, 4 int’l tax l. rep., 1009 (2002) (belgium-finland tax treaty) [fin.]; see also marjaana helminen, national report finland, in 8 cfc regulations, tax treaties and ec law 191 204–20 (michael lang et al eds., 2004). 77. re societé schneider electric, 28 june 2002, conseil d’etat [supreme administrative court] no. 232276, 4 int’l tax l. rep. 1077 (2002) [fr.]; see also p. douvier & d. bouzoraa, france: court of appeals confirms incompatibility of cfc rules with tax treaties, 41 eur. tax’n 184 (2001). 78. michael lang, die besteuerung von einkünften bei unterschiedlichen personen aus dem blickwinkel des dba-rechts, 10 swi 527, 527–35 (2000). 79. id. at 533–35. 2012] eu ccctb proposal 345 taxation. 80 the model-commentary does not offer a solution either. it is the treaty rule that is decisive, and its content must be interpreted in reliance on the commentary. based on an appropriate view, however, this applies only if the version of the commentary that addresses the issue had already been available when the relevant dtc was concluded. 81 in the case of those dtcs that are modeled after the oecd model, article 7 is one possible distributive rule. pursuant to article 7 oecd-mc, the profits of an enterprise of a contracting state shall be taxable only in that state, unless the enterprise carries on business in the other contracting state through a permanent establishment situated therein, and the profits are attributable to that permanent establishment. the state of residency does not have a right to tax if those profits must be exempt under the method of taxation rules. in the case of such a foreign controlled company, the profits of which are attributable to the eu company, the dtc can achieve that effect only if the attribution of profits, for purposes of treaty law, also leads to its qualification as a permanent establishment of the eu company. it is, however, highly doubtful whether that attribution, decided on national level, could also impact article 7 oecd-mc. 82 article 7 oecd-mc is, however, applicable only if article 10 oecd-mc does not apply, as the latter has priority pursuant to the rules of subsidiarity of treaty law. if the participation in such an entity represents a share in a company, i believe that the requirements for an application of article 10 oecd-mc are fulfilled, as the share is causal for the tax liability pursuant to article 82 et seq. 83 this applies not only to the distribution of profits but also to the profit itself. however, the application of article 10 oecd-mc is occasionally doubtful; for example, because there is no payment. 84 in my opinion, however, the term ―pay‖ must not be construed so restrictively and should cover any event 80. see oecd-mc, supra note 20, art. 23a (commentary); id. art. 23a–b (commentary), ¶ 2. 81. verwaltungsgerichtshof [vwgh] [supreme administrative court] 31 july 1996, docket no. 92/13/0172, 21 may 1997, 96/14/0084; see also michael lang, das oecd-musterabkommen 2001 und darüber hinaus: welche bedeutung haben die nach abschluss eines doppelbesteuerungsabkommens erfolgten änderungen des oecd-kommentars?, 10 istr 538 (2001); avery jones, the effect of changes in the oecd commentaries after a treaty is concluded, 56 bull. int’l fiscal documentation 102 (2002). 82. michael lang, cfc-regelungen und doppelbesteuerungsabkommen, 11, istr 717, 718–23 (2002); michael lang, personengesellschaften im dba-recht, 10 swi 60, 65 (2000). 83. michael lang, cfc regelungen und doppelbesteuerungsabkommen, 11 istr 717, 721 (2002). 84. kofler, cfc rules, supra note 52, at 738–49. 346 florida tax review [vol. 13:6 that triggers a tax liability within the scope of art 10 oecd-mc. 85 whoever considers article 10 oecd-mc applicable will conclude that the eu member state is not prevented from applying article 82(f). c. dtcs and transparency the same considerations could apply with respect to participations in those companies that are qualified as taxpayers in the third country, while being treated as transparent in the eu-member state in which the shareholder is a resident. foreign controlled companies are only one special case of those scenarios. as a result, these cases must be treated equally for purposes of treaty law. the fact that the title of chapter xiv, which concerns foreign controlled companies, is ―anti-abuse rules‖ does not change anything. consequently, there is strong evidence that those profits can be recognized in the member state pursuant to article 84(f), either pursuant to article 10 or 7 of the oecd-mc, if the third-country entity’s permanent establishment is not regarded as the permanent establishment of the shareholder. distributions undoubtedly fall under article 10 oecd-mc. the fact that they are exempt in the member state under article 11(c) 86 of the ccctb proposal should not prevent the third country from applying the dtc and the limitation of withholding tax as provided therein. treaty benefits may be claimed despite the fact that proceeds from shares are exempt. however, the last sentence of article 76(1) of the proposal prevents a credit of the remaining withholding tax that is lawfully imposed. vi. conclusion and outlook the ccctb proposal represents an impressive legal achievement. its authors were able to propose provisions that largely make the principles of the proposal a reality in a convincing manner. still, especially those of the proposal’s rules that are relevant for third-country scenarios give rise to difficult questions of interpretation. given the complexity of the matter, these, or other instances of doubt, would presumably arise even if the authors had chosen another method of regulating it. 85. h.j. aigner, cfc-gesetzgebung und dba-recht, 12 swi 407, 411–14 (2002); see also klaus vogel, klaus vogel on double taxation conventions, art. 10, ¶ 22 (3d ed. 1997); michael lang, cfc regulations & double taxation treaties, bull. int’l fiscal documentation 51, 56–58 (2003). 86. again, attention should be paid to the fact that the danish presidency wishes to make this exemption dependent on a minimum holding of 10 percent. 2012] eu ccctb proposal 347 aside from detailed suggestions, there are several legal improvements that could be made to the proposal. when regulating certain questions, the authors of the oecd-mc and of other directives, such as the parent-subsidiary directive and the interest and royalties directive, encountered similar challenges. having recognized this, the authors of the ccctb proposal have followed those rules in many respects. that makes sense, as it would be a waste of resources to re-invent the wheel, so to speak. incorporating existing provisions by reference rather allows practitioners to rely upon scholarly legal writing and case law issued with respect to existing legislation. the fact that the provisions of the proposal largely, but not entirely, follow those models affects that advantage and gives rise to many interpretational difficulties. the editors of the proposal are called upon to opt for and — if the factual context suggests — to fully build each provision on a certain model. certain provisions of the proposal unnecessarily build on the national laws of the member states; the transparency rules, for example, are determined by the national law of the shareholder’s member state. in some partial areas, this approach thwarts the objective of the directive, which is to create a common tax base, and makes its application more difficult. the directive’s provisions should be autonomous whenever possible without having to refer to the national law. the transparency rules are also an example of what the directive regulates a single question — namely, how to classify foreign entities for the purpose of the directive — in a different manner. many problems of interpretation could be avoided if those questions were resolved according to uniform criteria. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe biometrics: solving the regressivity problem 651 florida tax review volume 7 2006 number 10 biometrics: solving the regressivity of vats and rsts w ith “smart card” technology by richard thompson ainsworth introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 653 summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657 part i: identity cards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 660 a. european application -the smart id card in the eu . . . . . 669 1. the tax impact of digital id’s in europe . . . . . . . . . . 672 2. benchmarking digital tax service in the eu . . . . . . 672 3. american application (rst only) . . . . . . . . . . . . . . . 674 4. the real id act of 2005: an american smart id card . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676 b. the function creep effect (linear and hyper) . . . . . . . . . . . 678 1. prediction -linear function creep in the american rsts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680 2. benchmarking digital tax service in the american rsts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681 part ii: fully digital consumption tax regimes . . . . . . . . . . . 684 a. digitizing the vat in the eu . . . . . . . . . . . . . . . . . . . . . . . . . 684 1. digital notices, digital returns, digital periodic and recapitulative statements . . . . . . . . . . . . . . . . . . . . . 685 2. digital invoices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 686 3. the test case: the digital sales directive – article 26c . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 689 b. digitizing the rst in the u.s. . . . . . . . . . . . . . . . . . . . . . . . . . 691 1. digital intermediaries – certified service providers (csps) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 695 652 florida tax review [vol. 7:10 part iii: certified tax compliance software . . . . . . . . . . . . . . 698 a. the digital context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 698 1. certification of enterprise data . . . . . . . . . . . . . . . . . 699 a. the 90-day certification cycle of sarbanes-oxley and other governance regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 699 b. false certifications under section 302 and 404 are criminalized . . . . . . . . . . . . . . . . . 703 2. tax application – certification of automated consumption tax software solutions . . . . . . . . . . . . . . 704 3. oecd – from ottawato tax software certification . 704 4 ssuta – reality of rst software certification . . . . . 706 part iv: conclusion and proposal surgically targeting consumption tax relief . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 709 a. inverting the argument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 710 1. the fraud problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 710 a. targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 711 b. verification . . . . . . . . . . . . . . . . . . . . . . . . . . 712 2. the surgical capacity problem . . . . . . . . . . . . . . . . . . 713 3. the audit/compliance problem . . . . . . . . . . . . . . . . . . 715 b. the proposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 716 appendix a . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 appendix b . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 734 2006] biometrics: solving the regressivity of vats and rsts 653 1. “the strict definition of biometrics is the science that involves statistical analysis of biological characteristics. a (slightly) more pragmatic definitions is: biometrics n. the application of computational methods to biological features, especially with regard to the study of unique biological characteristics of humans.” richard hopkins, an introduction to biometrics and large scale civilian identification, 13 int’l. rev. l. computers & tech. 337 (1999). 2. see alan a. tait, value added tax: international practice and problems 59 (1988) (arguing that it is a thankless task to try to design a progressive vat and recommending instead that “distributional issues are better served by income taxation and by carefully targeted transfers to the households it is wished to help.”); richard a. & peggy b. musgrave, public finance in theory and practice 443 (1976) (explaining that vat is regressive because “the ratio of consumption to income (the average propensity to consume) falls when moving up the income scale, so does the ratio of tax burden to income.”); robert j. landry iii, the regressivity of individual state taxes from 1980 to 2000: a nationwide comparison, 41 state tax notes 899. (sept. 25, 2006) (insert parenthetical as modified). (indicating that even though california has a regressive retail sales tax [comparing the sales tax burden of a hypothetical poor person as a percent of income with the state tax burden of a hypothetical rich person as a percent of income] it has the second most progressive tax system of any of the states due primarily to the progressive strength of its income tax). new analysis questions the premise of this argument – that the search for progressivity in consumption taxes should be abandoned because the income tax can be relied upon to make the whole tax system progressive. this premise may not hold in a developing contrary context, because the income tax is very weak. thus, making the consumption tax the only real hope for progressivity in those tax systems. see richard m. bird & eric m. zolt, redistribution via taxation: the limited role of the personal income tax in developing countries, 52 ucla l. rev. 1627, 1682 (2005) (arguing that because the personal income tax plays a limited role in wealth distribution in developing countries policymakers, “concerned with distributive issues can and should pay close attention even to apparently minor features of consumption tax design and biometrics: solving the regressivity of vats and rsts w ith “smart card” technology introduction biometric identifiers embedded in national identity cards puts a1 formerly impossible goal of consumption taxation within the grasp of policymakers for the first time. never before has it been possible to design a broad-based, single-rate consumption tax that is truly and independently progressive. 2 654 florida tax review vol. 7:10 implementation, because such details may have more important distributive effects than the income taxes in such countries.”). 3. for example, consider the new zealand and south african vats. both have (1) very broad (but not comprehensive) tax bases, (2) a single-rate, but do not have (3) a mechanism for providing measured (selective) relief to the poor. for an international assessment of the breadth of the tax bases of the new zealand and the republic of south africa vats see alan schenk & oliver oldman, value added tax: a comparative approach in theory and practice 27 (2001) (indicating that the base of the new zealand vat is much broader than the eu vat base, and that new zealand has become the model for other equally broad vats such as the vat in south africa and botswana). in both new zealand and the republic of south africa the vat is imposed at a single rate. new zealand’s rate is 12.5% (goods & services tax act § 8(1) (1985) (n.z.). south africa’s rate is 14%. (acts online, value-added tax act § 7(1) (1991), http://www.acts.co.za/vat/vat_introduction.htm (last visited oct 5, 2006). vat act §7(1) (act no. 89 of 1991) amended up to and including taxation laws second amendment act, 2005 (no. 10 of 2005) (s.a.) at http://www.acts.co.za/vat/index.htm). new zealand expressly resisted making universal base concessions for the purchase of necessities. supplies of basic food products and medical services, for example, are subject to tax. there are only eleven categories of zero-rated supplies, ten of which deal with exports, and one other dealing with the disposal of a “going concern.” (goods & services tax act §§ 11, 11a and 11b) (1985) (n.z.). there are eight categories of exempt supplies, four of which deal with real estate. the others deal with financial intermediation services, penalty or default interest, the supply of fine metals, and supplies made by a non-profit organization. (goods & services tax act § 14) (1985) (n.z.). the republic of south africa could not go as far as new zealand even though policy analysts wanted to follow new zealand. political demands were strong for visible relief through the exemption of basic necessities. thus, south africa adjusts the new zealand model, allowing a a zero-rate for all insurance provided medical and dental supplies, value-added tax act supra § 10(21a), and a zero-rate for the purchase of all basic foodstuffs, value-added tax act supra § 11(1)(j) & schedule 2(b)(1). thus, neither new zealand nor south africa provides measured relief for the poor. new zealand provides no relief. south africa provides universal relief for the purchase of necessities by rich and poor alike. 4. liam ebrill, michael keen, jean-paul bodin & victoria summers, the modern vat 105-12 (2001) (indicating that the standard imf advice is for a vat that has a single rate with a broad base, and that progressivity should be considered an attribute of a fiscal system as a whole and achieved most effectively through direct expenditures); see also sanjeev gupta et al., should equity be a goal of economic p o l i c y , i m f e c o n o m i c i s s u e s n o . 1 6 ( j a n . 2 2 , 1 9 9 9 a t http://www.imf.org/external/pubs/ft/issues/issues16/index.htm (stating that the imf regularly advises that a broad base and a low rate is the controlling policy in all taxes). no consumption tax has ever had all three of the critical attributes of a progressive consumption tax: a broad base, a single-rate, and measured relief for those in greatest need. although economists have urged that a broad base and3 a single-rate be pursued over progressivity, most consumption taxes instead4 2006] biometrics: solving the regressivity of vats and rsts 655 5. jurisdictions attempting to follow this advice study the new zealand experience. the four hallmarks of new zealand’s broad based vat are (1) zero-rating limited to exports and international services, (2) exempt supplies limited to real estate and financial services, (3) inclusion of the government sector in the base, and (4) an attempt to include at least some financial intermediation services in the base. “[c]ountries which have adopted a gst-type regime after studying the new zealand experience include canada, south africa, thailand, fiji, singapore and australia.” alastair mckenzie, gst: a practical guide, 1 cch new zealand (2002). however, economic theory does not translate the same way in all political contexts. for example, both singapore and fiji base their vats on the new zealand model, but the political and economic situations within each of these vats differ significantly. these differences are reflected in the vat statutes. singapore followed the new zealand model much more closely than did fiji. the reason has to do with the level of economic development, the presence of a strong centralized government in singapore, and the polarized, ethnic-based political strife of fiji. singapore consciously designed its consumption tax with the standard imf economic advice in mind. it did not try to achieve progressivity within the tax itself, focusing instead on a broad base with a single rate. the singapore goods and services tax act is primarily based on the u.k. value added tax act of 1983, but at critical points the new zealand goods and services tax act is applied instead of the uk model. the new zealand overlay makes the singapore tax base very broad. zero-rated supplies are limited to exports and international services, and exempt supplies are limited to land and financial transactions. singapore does not follow new zealand with respect to the inclusion of the government sector in the tax base, nor does it extend the vat to any financial intermediation services. savjeev gupta et al., international monetary fund, should equity be a goal of economic policy? (1999), http//www.imf.org/external/pubs/ft/issues/issues16/index.htm (last visited oct. 5, 2006). singapore statutes online, goods & services tax act, cap. 117a, §§ 21, 22, 28 & fourth sched. (1993) http://statutes.agc.gov.sg/ (last visited oct. 5. 2006) (from the main page enter 117a into cap. no. field and select goods and services tax act). singapore’s stated intention to follow new zealand was set out in a white paper issued at the inception of the singapore vat: beyond exempting companies with turnovers below $1m, we do not intend to further exempt specific goods or services. goods and services tax can then be applied across-the-board. this way we avoid the problems faced by other countries . . . . instead of exempting essentials, new zealand took the opposite route. after examining the experiences of countries with complex goods and services tax schemes, new zealand decided to hardly exempt any items from its goods and services tax. instead it offset the goods and services tax’s impact by reducing other taxes and giving direct rebates to citizens through their comprehensive welfare system. seek progressivity at the expense of both base and rate considerations.5 656 florida tax review vol. 7:10 fiji also listened to the economic advice of the imf when it introduced a vat in 1992. once again the new zealand vat was consulted, but when the base was considered fiji political realties resisted the economists. in fiji, zero-rated supplies include the supply of sugar cane, prescription medicines, drugs, and fertilizers for planting sugar cane. in addition, for the 2000 tax year all “essential food items” defined to be “tinned fish, flour and sharps, powdered milk, edible oil, rice and tea” were zerorated. exemptions include “the supply and provision of the right to partake in any gambling” and “the supply of education by an educational institution.” the government sector is not included in the vat, and no effort is made to tax financial intermediation services. value added tax decree 1991 (revised to 30 april 2003) first sched. §§ 5 & 8; second sched. §§ 16, 17 & 22 (fiji). 6. richard bird & piereer-pascal gendron, vat revisited: a new look at the value added tax in deveoping and transitional countries 20 n.37 & 45-46 n.78 (2005) at http://www.fiscalreform.net/research/pdfs/vatr%20final%20report%20181005. pdf (indicating that concern with “distributional issues” lead to “political unrest” in mexico, colombia, the philippines, guatemala – where opposition was characterized by the political slogan “el iva no va” (no to vat) – and canada – where it was responsible for the defeat of the canadian government that proposed it). 7. landry, supra note 2, at 906 “the overall rankings show that most state tax systems are regressive. thirty states’ tax systems are regressive; 21 are progressive . . . . sales and excise taxes generally are regressive among the states and add to the regressive nature of a state tax system.” in fact, landry’s tables indicate that in 2000 the rst was significantly regressive in each state [comparing the sales tax burden of his hypothetical poor person as a percent of income in table 7 with the state tax burden of his hypothetical rich as a percent of income in table 8]. the states with the most regressive rsts are west virginia, mississippi, tennessee, idaho, south carolina, north carolina, new mexico, kansas, utah, and arkansas. louisiana has the least regressive rst. landry indicates that the louisiana rst is 16% more burdensome on the poor than it is on the rich (considering the rst as a percentage of income). west virginia, which has the most regressive rst in the united states, is ten times as regressive as louisiana. west virginia’s rst is 172% more burdensome on the poor than on the rich [arrived at using landry’s figures by dividing the difference between the rst burden on the rich and the poor in each state by the burden on just the rich in each state]). 8. bird & gendron, supra note 6, at 94 (indicating that in both vat and rst “. . . by far the most common exemption for equity reasons is that of food”); john f. due & john l. mikesell, sales taxation: state and local structure and administration 74 and 79 (2d ed. 1994) (noting that the exemption for food is “. . . the most expensive the reason is entirely political. popular acceptance of a consumption tax frequently requires that efforts be made to mitigate the perception of unfairness arising from taxing the poor when they purchase necessities. these mitigation6 efforts almost always fail to transform the tax into a progressive levy. 7 the essential problem (under the current system) is that, when tax relief is granted, it is universal not surgical. thus, for example, under most consumption tax regimes rich and poor alike enjoy an exemption for the purchase of food for home consumption. similar exemptions broadly apply to8 2006] biometrics: solving the regressivity of vats and rsts 657 . . . cost[ing] a state from 20% to 25% of sales and use tax revenue . . . [and] is perhaps the largest mistake the states have made in their sales tax structures, . . . larger volumes of expenditure of persons above the lowest income levels are freed from tax for no justification whatsoever”). see, e.g., value added tax act 1994, sched. 8 group 1 general item 1 (u.k.) (zero-rating “food of a kind used for human consumption”) at http://www.opsi.gov.uk/acts/acts1994/ukpga_19940023_en_1.htm; mass. gen. laws ch. 64h, §6(h) and mass. regs. code tit. 64h.6.5(4), § 830 (exempting food products for human consumption unless they are included in a meal sold by a restaurant). 9. see, e.g., 2 state tax guide (cch) ¶ 900-480 (2005) (indicating that in all states, except illinois, prescription medicines are exempt for sales and use tax); value added tax act 1994, sched., 8 group 12 item 1 and notes 2, 5 (u.k.) (zero-rating the supply of “qualifying goods” dispensed to and individual for his “personal use” where the dispensing is by a registered pharmacist on “prescription”). 10. ebril, supra note 4, at 83-100-12 (listing vat exemptions that have become commonplace around the world, and arguing against the advisability of them). 11. the regressivity of a consumption tax – the concept that the weight of a consumption tax falls less heavily on the wealthy than on the poor or disadvantaged – can be considered from various perspectives. the following examples illustrate these perspectives by considering the two major variables in the argument: (a) the single year verses the lifetime measure of consumption and (b) the ratio of consumption tax paid to total income verses the ratio of consumption tax paid to consumed income. first example – the basic argument. assume a rich man earns 1,000 and a poor man 100 in a jurisdiction where consumption is taxed at 10%. if the rich man consumes half of his income, and saves the other half, his consumption tax is calculated as follows: [1,000 – 500] = 500 x 10% = 50. if the poor man consumes all that he earns, his consumption tax is calculated as follows: 100 x 10% = 10. the effective tax rate based on total income in a single year is 5% for the rich man [50/1,000 = 5%], and 10% for the poor man [10/100 = 10%]. however, based on consumed income the tax is prescription medicines. the near universality of these exemptions classify them9 as true necessities. however, with each universal exemption – tax practice10 compromises tax theory without achieving progressivity. technology offers policymakers a surgical option. three critical technology-intensive developments (“smart” national ids; fully digital consumption tax regimes; certified tax calculation software) make it possible for a new breed of consumption tax to be designed. through technology – relief can be granted to select individuals (the poor or the handicapped, for example), within the context of a broad-based, single-rate consumption tax of either vat or rst design. summary of the argument this paper proceeds in three initial parts, each of which examines one of these tax-technology developments. a concluding section follows in a fourth part that assesses and applies these technological developments and presents a specific proposal for tax reform targeting regressivity in the consumption tax.11 658 florida tax review vol. 7:10 neutral. both rich and poor pay tax on their consumption at a 10% rate. consumption taxes are commonly considered regressive based on single year and total income comparisons. opponents frequently shift the focus from total income to consumed income. second example – the lifetime consumption permutation. if one assumes that all income is eventually consumed (over a lifetime) then it can be argued that the consumption tax is not regressive (when based on a total income). in the above example, assume that over a lifetime both the rich and the poor man will spend all of their income. under this assumption, both rich and poor will be taxed at the same overall 10% rate. this lifetime consumption hypothesis is questionable. wealthy individuals commonly pass on income that is earned and not consumed. sometimes this inherited wealth carries over unconsumed for many generations. third example – the universal exemption permutation. notice that exempting necessities does not necessarily change these results. assume that 20% of the rich man’s consumption (100) and 20% of the poor man’s consumption (20) is spent on exempt necessities. based on a single year and total income analysis, the rich man’s tax burden is 4% [500 – 100 = 400 x 10% = 40; and 40/1,000 = 4%]. the poor man’s tax burden is 8% [100 – 20 = 80 x 10% = 8; and 8/100 = 8%]. thus, the tax remains regressive. this does not always need to be the result. it may be possible (although it is probably difficult to achieve in practice) for a statute to identify exemptions that constitute a very large portion of the poor man’s consumption (80%) but very little of the rich man’s consumption (20%). in this case the rich man’s tax burden would remain at 4%, but the poor man’s burden would fall to 2%. this is the result many jurisdictions are trying to achieve through universal exemptions on necessities. consider the south african exemption for all basic foodstuffs, something that would be expected to be biased toward the poor. however, the exemption for all insurance-provided medical and dental supplies that south africa also allows has the opposite bias (assuming that the poor are less likely than the rich to have medical and dental insurance.) see supra note 3. fourth example – lifetime consumption in conjunction with universal exemptions. if considered over a lifetime (x 50), and under the assumptions specified above, a consumption tax can actually appear to be progressive. using the figures in the first example, the rich man’s aggregate tax burden would be 9% [50,000 – 5,000 = 4,500 x 10% = 450; and 450/50,000 = 9%], and the poor man’s aggregate tax burden would be 8% [5,000 – 1,000 = 4,000 x 10% = 400; and 400/5,000 = 8%]. once again however, this result is based on the unlikely assumption that the unconsumed income of wealthy individuals is fully consumed in their lifetime and not passed on from generation to generation as savings. fifth example – the surgical exemption through technology. what technology offers is the ability to exempt the poor man, but not exempt the rich man on the purchase of necessities. it is possible to surgically reduce the tax burden of the poor through selectively applied exemptions (based on either a single year or lifetime time frame, or on a total income or total consumed income basis) so that the weight of the tax falls more heavily on the rich than the poor. part 1 considers biometric identifiers embedded in national identity “smart cards.” it observes that they are here today. they are currently in use in 2006] biometrics: solving the regressivity of vats and rsts 659 12. richard t. ainsworth, the digital vat: a proposal for the president’s advisory panel on federal tax reform, president’s advisory panel on federal tax reform (apr. 30, 2005) at http://comments.taxreformpanel.gov/ (on file with author) (proposal in response to the second request for comments); richard t. ainsworth, the digital vat (d-vat) 25 va. tax rev. 875 (2006) (presenting a expanded and developed analysis of the prior submission to the panel). asia and parts of the eu with comprehensive eu implementation just over the horizon. similar ids in america will be in place by 2008 under the real id act. this part then argues that these cards are slowly (through the function creep of the technology) transforming tax delivery services in the eu, and will do the same in the u.s. it further argues that excess capacity in these cards can effect a hyper change in the delivery of tax services – it can allow the surgical application of consumption tax exemptions to the needy thereby allowing a broad base and single rate to be applied in all other situations. part 2 considers fully digital consumption tax regimes. it observes that fully digital consumption tax systems are here today in both vat and rst systems. in the eu a limited digital reporting and payment “pilot” is operational under the digital sales directive, while in the u.s. a limited digital reporting, payment, and calculation “pilot” is in full operation under the streamlined sale tax. this part then argues that the time has come for a comprehensive digital consumption tax, similar to the one proposed to the president’s advisory panel on federal tax reform. with a digital consumption tax in place, full12 advantage could be taken of the capacity of the “smart” id to exempt the poor from the tax. (although greatly enhanced by a fully digital consumption tax, the tax delivery benefits of the “smart” id are not dependent on it. in some instances, even under a digital consumption tax, paper processes may be needed in small businesses or remote locations). part 3 considers certified compliance software. it observes that software certification regimes for global vat compliance have been proposed by the oecd, and are operational under the streamlined sales tax in the u.s. this part then argues that certification of tax software is the final piece in solving the consumption tax’s regressivity puzzle. tax calculation software not only (a) answers the global demand for corporate governance reform through certification of software solutions but it (b) is the vehicle through which the “smart” id will effectuate the exemption of the poor. part 4 provides a summary of the previous parts by turning the argument of this paper on its head – it considers the regressivity of the consumption tax from the perspective of the traditional barriers to the establishment of a progressive tax instead of from the perspective of the technology that allows us to resolve it. this summary specifically looks at the barriers of (a) tax fraud, (b) surgical capacity and (c) audit/ compliance. this part then closes with a proposal for tax reform that will eliminate the regressivity of the consumption tax. 660 florida tax review vol. 7:10 13. united states general accounting office, electronic benefits transfer: use of biometrics to deter fraud in the nationwide ebt program, gao/osi-95-20, sept. 1995 at 4 (reporting that from june 1991 through july 1994 the los angeles county department of public services used fingerprinting of welfare recipients to eliminate 3,000 previously-approved entitlement cases, saving over $14 million); john d. woodward, biometric scanning, law and policy: identifying the concerns – drafting the biometric blueprint, 59 u. pitt l. rev. 97, 152 (1997) (indicating that the states of connecticut, illinois, massachusetts, new jersey, new york, pennsylvania and texas are using similar fingerprint imaging to prevent welfare fraud). globally it is the health care sector is a leader in identifying where smart card efficiency gains can be found – increasing quality and decreasing the cost of care. both government and private sector institutions have adopted smart card technology. for example, an eu council regulation made health care available to citizens temporarily present in another member state, and this in turn quickly lead to the adoption of private sector smart cards containing patient medical data, as well as an eu-wide smart card to facilitate the sharing of services among countries. commission regulation 1408/71 of 14 june 1971 on the application of social security schemes to employed persons, to selfemployed persons, and to members of their families moving within the community, a r t i c l e 2 2 ( 1 ) ( a ) , 1 9 7 1 o . j . ( l 1 4 9 ) a t http://www.dwp.gov.uk/advisers/docs/lawvols/bluevol/pdf/a9_2001.pdf). see also attila naszlady & janos naszlady, patient health record on a smart card, 48 int. j. med. informatics 191 (1998) (studying the adoption of smart card technology in hungary for efficient communication of patient histories and the findings of physical examinations); administrative commission on social security for migrant workers decision 189 of 18 june 2003 aimed at introducing a european insurance card to replace the forms necessary for application of council regulation (eec) no 1408/71 and (eec) no 574/72 as regards access to health care during a temporary stay in a member state other than the competent state or the state of residence, o.j. (l 276) 1; administrative commission on social security for migrant workers decision 190 of 18 june 2003 concerning the technical specifications of the european health insurance card, o.j. (l 276) 4. outside of the eu see also alvin t. s. chan, www+ smart card: towards a mobile health care management system 57 int. j. med. informatics 127 (2000) (presenting a study on extending medical smart card technology through world wide web applications as a standard interface tool for accessing medical records contained within smart cards, conducted and implemented in hong kong); benoit a. aubert & genevieve hamel, adoption of smart cards in the medical sector: the canadian experience, 53 soc. sci. & med. 879 (2001) (presenting a canadian study on the adoption of smart card technology in the medical sector that stresses the need for providing both direct benefits to the user and completeness of information for acceptance by the medical professional). part i: identity cards national identity cards with biometric identifiers play a central role in present day public and private sector efficiency and security efforts. as these13 14 2006] biometrics: solving the regressivity of vats and rsts 661 similar efforts in the u.s. were advanced under a reform of the u.s. health care system. although ultimately unsuccessful, the clinton health security act (h.r. 3600/ s.1757, 103d cong., 1st sess. (1993)) made the issuance of a health security “smart” card a key component in the program. the card was intended to identify the holder as a person entitled to health benefits and was designed to permit access to patient medical data through a system of databases, improving the quality of care and minimizing administrative costs. william h. minor, identity cards and databases in health care: the need for federal privacy protections, 28 colum. j.l. & soc. probs. 253, 256 (1995). 14. united states general accounting office, electronic government: aviation security: challenges in using biometric technologies, gao-04-785t, may 19, 2004 at 24 (reporting on progress made in the adaptation of biometric smart card technologies in airport security systems); united states general accounting office, electronic government: progress in promoting adoption of smart card technology, gao-03-144, jan. 2003 at 13-14 (reporting on the progress of 62 u.s. government smart card security and efficiency oriented programs established over the prior two year period); united states general accounting office, technology assessment: using biometrics for border security, gao-03-174, nov. 2002 at 4-5 (providing an assessment of the seven leading biometric technologies including facial recognition, fingerprint recognition, hand geometry, iris recognition, retina recognition, signature recognition, and speaker recognition and determining that the first four not only are suitable for border security, but have successfully been used in border control pilot projects); united states general accounting office, information security challenges in using biometrics, gao-031137t, sept. 9, 2003 at 4-5 (subcommittee testimony of the chief technologist of applied research and methods, keith a. rhodes, assessing the costs and benefits of using biometric identifiers in a national border control security system). 15. biometric identifies were added to eu passports and travel documents. facial image biometrics are required, fingerprint biometrics are optional. council regulation (ec) no 2252/2004, 2004 o.j. (l 385) 1, at art. 1(2). the express reason for the biometric facial image was that, “[t]he facial image is interoperable and can be used in our relations with third countries such as the u.s. however, the fingerprint could be added as an option for member states who wish to do so, if they want to search their national databases, which would be currently the only possibility for identification.” commission proposal for a council regulation on standards for security and biometrics cards become more and more commonplace, it is time for the tax collector to consider whether or not it is willing to use some of the excess functionality of these cards for tax purposes – functionality that would accurately and immediately associate the identified person with a deserved consumption tax exemption – functionality that would then interact with a certified tax calculation system to precisely remove the tax on just the purchases that are exempt consumption for this particular consumer (within any combination of dollar, quantity or frequency of purchase limitations desired). security concerns have understandably received heightened attention in the post september 11th world, and the capabilities of “smart cards” in this context are precipitating a global convergence of identity information. privacy15 662 florida tax review vol. 7:10 in eu citizens’ passports, com(2004)116 final at 7. on june 2, 2006 the commission proposed applying biometric identifiers to eu visas through the common consular instructions (cci). in a press release the commission vice-president franco frattini, commissioner responsible for freedom, security and justice, declared: this proposal will have a knock on effect: it will facilitate the visa issuing procedure, prevent visa shopping, facilitate checks at external borders and strength the fight against fraud and, within the territory of the member states, assist in the identification and return of illegal immigrants and the prevention of threats to the internal security of the member states. . . . common application centers will have the advantage of reinforcing and streamlining local consular cooperation between member states as resources can be pooled and shared, which will be of benefit to both states and visa applicants. one central access point will even ensure that the data protection requirements, to which i attach the greatest importance, are more easily met. press release ip/06/717 (june 2, 2006) at http://ec.europa.eu/idabc/en/document/ 5674/355. 16. there is general consensus that privacy rights are threatened by national identity cards systems, a threat that grows more serious when smart card technologies are involved. some societies have for a long time resolved this issue in favor of identity cards others have not. a growing body of legal scholarship is responding to the new technologies. some focuses on security issues and terrorist threats, others focus on the promise of governmental or commercial efficiencies. inconsistent conclusions have been reached. some find that an individual’s right of privacy weighs more heavily than society’s needs – others reach the opposite result. these differences are more than mere “preferences.” one of the main reasons for inconsistency centers on the definition privacy. james whitman argues that europeans and americans respond to identity cards differently precisely because their understand of privacy is different. according to whitman, a european’s understanding of privacy is a dignity-based concept – privacy is violated when there is an unauthorized portrayal of the self. however, an american’s sense of privacy is more liberty-based – privacy is violated when the state makes an unauthorized intrusion into the sanctity of the home. whitman synthesizes his observations with the following rhetorical questions: “why is it that americans comply with court discovery orders that open essentially all of their documents for inspection, but refuse to carry identity cards? why is it that europeans tolerate state meddling in their choice of baby names?” james q. whitman, the two western cultures of privacy: dignity versus liberty, 113 yale l.j. 1151, 1160, 1204 (2004). when legal scholars consider the privacy problem of embedding national identity cards with smart chips therefore, it is conceptually much easier to identify and protect against an abuse of privacy rights when privacy rights are defined in dignity terms – the european conception – rather than in liberty terms – the american conception. identity cards are acceptable in dignity terms as long as comprehensive concerns are considerable. nevertheless, both advocates and opponents of16 2006] biometrics: solving the regressivity of vats and rsts 663 regulations are in place that will prevent unauthorized disclosures. the classic dignitybased defense of privacy can be found in the eu data protection directive. (directive 95/46/ec of the european parliament and of the council 95/46/ec, on the protection of individuals with regard to the processing of personal data and on the free movement of such data , 1995 o .j . (l 281) 31 at http ://europa.eu.int/eurlex/lex/lexuriserv/lexuriserv.do?uri=celex:31995l0046:en:html) (setting out detailed rules on all aspects of data processing, the confidentiality and security of the processing, the criteria to be met for appropriate data processing systems, the information required to be provided to the data subject, the data subject’s right of access, right to object, and the establishment of authorities to supervise and provide remedies in cases of privacy violations). when whitman considers the roots of the american, liberty-based sense of privacy he focuses on the bill of rights, in particular the fourth amendment’s prohibition of unlawful search and seizure. the classic statement of liberty-based privacy rights is found in boyd v. united states, 116 u.s. 616 (1886) (forbidding the government to seize the documents of a merchant in a customs case where the court issued an aggressive declaration of the “sanctity” of the american home). liberty-based privacy advocates therefore, object to more than the unauthorized disclosure of private information, they object to the state’s mandate that identity data be assembled and made readily available to the state. when legal scholars with a liberty-based sense of privacy consider national identity cards with embedded smart chips the scale weighs heavily against the cards. preventing unauthorized disclosure, no matter how efficient, cannot blunt the impact of the state’s mandate itself, and with the seemingly limitless capacity of smart chips to hold data the privacy defense of a national smart id card becomes difficult. see richard sobel, the demeaning of identity and personhood in national identification systems, 15 harv. j. l. & tech. 319 (2002) (arguing that even before september 11, 2001 the movement in america toward a system of national identification numbers, databanks and identity cards contradicted the “constitutional and philosophical bases of democratic government and undermine[d] the fundamental foundations of political and personal identity . . . by transforming personhood from an intrinsic quality inhering in individuals into a quantity designated by numbers, represented by physical cards, and recorded in computer banks.”). sobel’s argument (based in a liberty-based conception of privacy) cannot be met head-on by advocates of smart identity cards that define privacy in dignity terms. see daniel j. steinbock, national identity cards: fourth and fifth amendment issues, 56 fla. l. rev. 697 (2004) (assuming the existence of identity cards to be inoffensive per se, and then demonstrating that adequate fourth and fifth amendment protection exist to protect individual privacy.) whitman’s privacy dichotomy is both analytically useful and deceptively simple. it is usefulness comes from its ability to ferret out the nuances of the privacy debate. its deception is in its suggestion that the dichotomy he offers is a real culturally specific attribute – so that the national smart id card could be accepted in the eu after comprehensive data protection rules are put in place, while they will never be accepted in the u.s. because the card itself is an offensive state mandate. the social reality of the dichotomy is its deception. it is reasonably clear that most countries have privacy concern with smart national id cards that has both dignity and liberty components. 664 florida tax review vol. 7:10 the u.s. has a strong tradition of seeing privacy in dignity terms. perhaps the most cited of all american law review articles, the warren and brandeis article on the right of privacy makes this argument. warren and brandeis argue that privacy is the “right to be let alone,” and that public disclosure of private facts so affronts human dignity that it should be protected as a matter of constitutional right. samuel d. warren & louis d. brandeis, the right to privacy, 4 harv. l. rev. 193, 195 (1890). for whitman, the warren and brandeis position is an anomaly. it is a “patch” of continental law that like a “. . . patch[es] of snow [that] sometimes survive[s] in a hollow on an early spring day . . . [will soon] melt away.” (whitman supra at 1203). it would be a mistake for national identity card advocates to ignore either the dignity or the liberty conception of privacy. the first can be met by making the cards voluntary, the second by adopting comprehensive data protection rules. 17. gwen wendy kennedy, thumbs up for biometric authentication! 8 comp. l. rev. & tech. j. 379, 379 (2004) (favoring biometric identity cards and indicating that “[t]he only remaining impediment to the large-scale deployment of biometric authentication devices is the perceived threat to privacy.”); lawrence o. gostin et al., privacy and security of personal information in a new health care system, 270 jama 2487, 2487 (1993) (indicating that even though the clinton health security act was defeated, “[t]he collection and transmission of vast amounts of health information in automated form will occur with or without reform of the health care system.”); sobel supra note 16, at 320 (opposing biometric identity cards but indicating that the movement toward a national identity system in the u.s. had begun and seemed unstoppable long before the terrorist attacks of september 11, 2001). 18. stephen moore, a national identification system: testimony before the us house of representatives subcommittee on immigration and claims, judiciary committee, (may 13, 1997) (reporting that over 500 irs agents were uncovered in 1995 using the government’s confidential taxpayer database to check on the financial status of friends, neighbors, or famous people, and that public outrage was considerable, but that less than 10 agents lost their jobs, and within two years later a similar incident occurred, again with hundreds of agents) at http://www.cato.org/testimony/ctsm051397.html; office of technology assessment, congress of the united states, information security and privacy in network environments, 2-3 (1994) (ota-tct606). 19. sobel supra note 16, at 343-49 (recording the most notorious abuses of national identity card systems as: (1) the requirement that american slaves carry “passes” in order to travel away from plantations before the american civil war, (2) the power of the secretary of state to deny passports (a national identity document) to individuals deemed to be communists under the passport act of 1926 before the supreme court found the statute unconstitutional in kent v. dulles, 357 u.s. 116 (1958), (3) the use of identity cards by the nazis to identify jews for extermination during world war ii, (4) the use of “passes” by the south african government to control the movement of black men and women during apartheid, (5) the system of identity cards used in rwanda for distinguishing between hutus and tutus that facilitated the national identity smart cards agree that there is little likelihood that this movement will slow down. the best that can be done is to offer protections17 against mistakes, misuse, and abuse, while we try to extend the social18 19 2006] biometrics: solving the regressivity of vats and rsts 665 genocide, (6) the use of the census bureau by franklin delano roosevelt prior to pearl harbor to collect data on japanese-americans for later isolation in internment camps); see also neda matar, are you ready for a national id card? perhaps we don’t have to choose between fear of terrorism and need for privacy, 17 emory int’l l. rev. 287, 310-13 (2003). 20. gerard noiriel, the french melting pot: immigration, citizenship, and national identity, tr. geoffroy de laforcade (minneapolis, university of minnesota press, 1996) xix, 45-90 (discussing the revolution in identity that occurred during this period and the critical role that identity cards played in making this happen). 21. hong kong special administrative region identity card project, initial privacy impact assessment report at 15 (nov. 2000) [citing from speech by attorney general moving the first reading of the registration of persons bill 1949 and objects and reasons for the bill, hong kong legislative council hansard, 1949, pp. 225-27] at http://www.legco.gov.hk/yr00-01/english/fc/esc/papers/esc27e1.pdf (last visited aug. 2, 2006). 22. legislative council panel on security: policy initiative of the security bureau, lc paper no. cb(2)64/05-06(01) at 6 (indicating that by the end of august 2005 an estimated 2.85 million residents had been issued new smart identity cards) at http://www.legco.gov.hk (last visited aug. 2, 2006). 23. legislative council brief, application for new identity cards (persons born in or before 1942, in 1990 to 1992 or 1997 to 2003) order, sbcr 1/1486/81 (setting out the schedule based on year of birth for mandatory smart card replacement for three additional groups of residents) available at http://www.legco.gov.hk (last visited aug. 2, 2006). benefits of this highly accurate and immediate form of identification. this paper concerns itself with benefits that can be realized in consumption taxes. history of national identity cards and biometric identifiers. national identity cards have been around for a long time, and have served many purposes. identity cards were introduced in france in the 1890’s and were used primarily to regulate immigration, integration and assimilation. the french cards were seen as a means of preserving the “frenchness of france.” 20 hong kong made paper national identity cards mandatory in 1949. the hong kong cards performed social service functions in addition to providing a measure of national security from “foreign” chinese nationals. the hong kong cards were intended to “. . . assist measures that might be found necessary for the maintenance of law and order and for the distribution of food or other commodities as a result of prevailing conditions of political and economic unrest.” hong kong probably holds the record for the longest continual use of21 a mandatory national identity card system (among the democratic governments where they are currently in use). even with its assimilation into the people’s republic of china, hong kong has no intention of discontinuing identity cards. on august 19, 2003 hong kong began a transition to “smart” id cards, a22 process that (as of july 2006) is ongoing.23 666 florida tax review vol. 7:10 24. two original (ancient) chinese documents record the use of fingerprints. the first is by prime minister hsiao he. in the text han disciplines, written approximately in 200 b.c., it was required that legal testimonials must be certified with “hand prints.” the second source is from the qin dynasty (b.c. 248 to b.c. 206). in 1975 archeologists found bamboo slices (essentially ancient books where the writing was engraved on the bamboo) that describe the ancient science and technology of identifying murders and other criminals. in one case a thief is identified through footprints previously taken. (personal communication from professor xiaoqiang yang, sun yat-sen university school of law, guangzhou, china, on file with author, and confirmed by li-huan (joyce) lin, senior tax associate, taxware, l.p.). see also david lyon, identity cards: social sorting by databases, oxford internet institute, in te rne t issue b rief n o. 3 (nov. 2 0 0 4 ) a t ht tp : / /www.inte rne tinstitute.ox.ac.uk/resources/publications/ib3all.pdf (last visited aug. 2, 2006); johan bloommé, evaluation of biometric security systems against artificial fingers (phd dissertation, linkoping university, sweden, 2003) at 10-11 (considering the history of fingerprints in more detail, and indicating their use not only in the chinese qin dynasty, but in babylon, as well as 14th century persia; and also reviewing the work of professor marcello malpighi at the university of bologna in 1686, sir william hershel’s fingerprinting of indian natives in 1856, dr. henry faulds’ method of fingerprint classification devised in the 1870’s, the work of sir francis galton whose book “fingerprints” in 1892 first observed that fingerprints were scientifically unique identifiers, and finally the work of the argentine police officer juan vucetich, who is credited with the modern world’s first criminal fingerprint identification case in 1892) at http://www.ep.liu.se/exjobb/isy/2003/3514/ (last visited aug. 2, 2006). 25. biometrics at the frontiers: assessing the impact on society, technical report for the european parliament committee on citizens’ freedom and rights, justice and home affairs (libe), institute for prospective technological studies (feb. 2005) at 35 (indicating that biometric identifiers are commonly dividend into three broad categories: (1) physiological biometric features – height, weight, body odor, the shape of the hand, the pattern of veins, retina, or iris, the face and patterns on the skin of thumbs or fingers; (2) behavioral biometrics – voice patterns, signature and keystroke sequences and gait (the body movement while walking); (3) dna) at http://cybersecurity.jrc.es/docs/libe%20biometrics%20march%2005/iptsbiometics _fullreport_eur21585en.pdf (last visited aug. 2, 2006). considered by themselves, biometric identifiers have a longer history than identity cards. fingerprints pressed in wax were used as far back as the third century b.c. to authenticate written documents. documents from the qin dynasty in china are the oldest extant evidence of the use of biometrics (fingerprints) as identifiers. fingerprints remain among the most reliable of all24 biometric identifiers, and along with iris, and face recognition are the most25 easily digitized and incorporated into the memory chips on smart cards. contemporary use of smart national identity cards. modern security concerns are digitally merging biometric identification into the traditional id 2006] biometrics: solving the regressivity of vats and rsts 667 26. embedding a biometric (fingerprint) on a microchip in a card is an exceptionally easy task. a detailed and technical explanation of the process in the context of a biometrically secure credit card is provided by jain and pankanti: here’s how it would work. when activating your new card, you would load an image of your fingerprint onto the card. to do this, you would press your finger against a sensor in the card – a silicon chip containing an array of micro-capacitor plates. (in large quantities, these fingerprint-sensing chips cost only about $5 each.) the surface of the skin serves as a second layer of plates for each micro-capacitor, and the air gap acts as the dielectric medium. a small electrical charge is created between the finger surface and the capacitor plates in the chip. the magnitude of the charge depends on the distance between the skin surface and the plates. because the ridges in the fingerprint pattern are closer to the silicon chip than the valleys, ridges and valleys result in different capacitance values across the matrix of plates. the capacitance values of different plates are measured and converted into pixel intensities to form a digital image of the fingerprint. next, a microprocessor in the smart card extracts a few specific details, called minutiae, from the digital image of the fingerprint. minutiae include locations where the ridges end abruptly and locations where two or more ridges merge, or a single ridge branches out into two or more ridges. typically, in a live-scan fingerprint image of good quality, there are 20 to 70 minutiae; the actual number depends on the size of the sensor surface and the placement of the finger on the sensor. the minutiae information is encrypted and stored, along with the cardholder’s identifying information, as a template in the smart card’s flash memory. at the start of a credit card transaction, you would present your smart credit card to a point-of-sale terminal. the terminal would establish secure communications channels between itself and your card via communications chips embedded in the card and with the credit card company’s central database via ethernet. the terminal then would verify that your card has not been reported lost or stolen, by exchanging encrypted information with the card in a predetermined sequence and checking its responses against the credit card database. next, you would touch your credit card’s fingerprint sensor pad. the matcher, a software program running on the card’s microprocessor, would compare the signals from the sensor to the biometric template stored in the card’s memory. the matcher would determine the number of corresponding minutiae and calculate a fingerprint similarity result, known as a matching score. even in ideal situations, not all minutiae from the input and template prints taken from the card – a move from paper to plastic. before hong kong converted to smart26 668 florida tax review vol. 7:10 same finger will match. so the matcher uses what’s called a threshold parameter to decide whether a given pair of feature sets belong to the same finger or not. if there’s a match, the card sends a digital signature and a time stamp to the point-of-sale terminal. the entire matching process could take less than a second, after which the card is accepted or rejected. anil k. jain & sharathchandra pankanti, a touch of money, ieee spectrum on-line (july 2006) at http://www.spectrum.ieee.org/jul06/4123 (last visited aug. 2, 2006). 27. implemented in december 1999, the finnish cards are valid for three years. they are issued to finish citizens and foreigners residing permanently in finland. it is an official travel document in the eu and features a photograph and a microchip. the face of the card shows the id card number, name, sex, personal identity code, date of expiration, nationality (finnish citizens only), issuing authority, photograph of the holder and signature of the holder. the microchip digitally stores all of the data on the face of the card. in addition the microchip holds certificates that will allow the holder to make electronic transactions within administrations of social and health service organizations, perform on-line authentications as well as provide encryption and digital signature. certificates hold the following information: name of the issuer of the certificate, name of the certificate holder, electronic transaction identifier of the certificate holder, validity of the certificate, data on the method for calculating the public key of the certificate holder, country code of the issuer of the certificate, serial number of the certificate data on the calculation method for signing the certificate, data on the certificate policy, data on the storage of the certificate, and other technical data needed for use of the certificate. bills committee of the legislative council: registration of persons (amendment) bill 2001, experience of using smart identity cards in other countries, lc paper no. cb(2)2836/01-02(02) 1 & annex 3-7 at http://www.legco.gov.hk (last visited feb. 23, 2006). 28. as of july 2000, brunei required identity cards for all citizens and permanent residents aged twelve or above, and all temporary residents staying in brunei for longer than three months. the data collected for the brunei card includes the name (including chinese characters, if any) full address of place of residence, race, place and date of birth, physical abnormalities (if any), citizenship, blood type photograph, fingerprint impressions, and other information deemed necessary by the registration officer. although confirmation was not provided by brunei it is assumed that this information is both digitally stored on the embedded chip and available on the face of the card. id. 1 & annex 3-6. 29. as of july 2001, malaysia required identity cards for all malaysian citizens or permanent residents aged twelve or above (approximately 18 million cards). the face of the card includes the card number, name resident address, citizenship, sex, religion (only for those of muslim faith), the old id card number and a serial number. the microchip stores all of the data on the face of the card, and includes a digital photo, identity cards it surveyed similar programs in finland, brunei and27 28 malaysia. smart cards in finland are voluntary, whereas those in brunei and29 2006] biometrics: solving the regressivity of vats and rsts 669 digital fingerprint, driving license information, passport number, and expiration of passport, e-cash information. id. at 1 & annex 3-7. 30. satat dass, yongfang zhu & anil jain, validating a biometric authentication system: sample size requirements, ieee transactions on pattern a n a l y s i s a n d m a c h i n e i n t e l l i g e n c e ( f o r t h c o m i n g 2 0 0 6 ) a t http://biometrics.cse.msu.edu/publications/generalbiometrics/dasszhujain_sample size_pami06.pdf (last visited aug. 2, 2006). 31. theodore h. cohen, cross-border travel in north america: the challenge of u.s. section 110 legislation, canadian american public policy no. 40 (oct. 1999) occasional paper series of the canadian-american center, university of maine at orono (noting that the automated entry-exit system for all u.s. border crossing was mandated in 1996, and that the immigration and naturalization service was to have in place an operational database (without biometric identifiers) by the end of 1998 (illegal immigration reform and immigrant responsibility act of 1996 (iirira), pub. l. no. 104-208, § 110, 110 stat. 558-59 (1996), 8 u.s.c. 1221), but that the deadline for this database assembly was pushed back in october 1998 in response to opposition from u.s. business groups bordering canada when concerns were raised by u.s. automakers at the detroit-windsor crossing where just-in-time production lines crossed the border). because the volume of data, even with smart card technology, exceeded ins capacity congress amended § 110 and limited the entry-exit system to the 50 most highly trafficked land ports by the end of 2004, and all ports of entry by the end of 2005 (immigration and naturalization service data management improvement act of 2000 (dmia), pub. l. 106-215, § 2, 114 stat. 337 (2000), 8 u.s.c. 1365a). the visa tracking system that existed prior to september 11, 2001 was improving, however it primarily covered passengers arriving by airplane and consisted of a paper form stamped at the port of entry, returned to the airline, and then entered manually into the database. this paper-based, manual data entry system was transformed into a highly automated system of machine-readable, tamper-resistant visas and passports with digitized biometric identifiers after september 11, 2001. by october 26, 2004 all u.s. visas were required to incorporate a biometric identifier. facial recognition (digital photo) and fingerprint scanning (electronic fingerprints) were taken of all nonimmigrant visa applicants at u.s. embassies and consulates. upon arrival the biometrics on the visa could then be compared with the biometrics of the person presenting the visa (enhanced border security and visa entry reform act of 2002 (ebsver), pub. l. no. 107-173, §§ 301-03, 116 stat. 552-53 (2004), 8 u.s.c. 1731-32) the database may be made available to other federal, state and local law enforcement officials. (8 u.s.c. 1365a(f)). malaysia are mandatory. biometric identification systems can be effectively certified, and their performance can be independently validated.30 a. european application – the smart id card in the eu accelerated by the u.s. move to incorporate biometric identifiers in u.s. visas and a u.s. mandate that similar technology be used in foreign passports under the visa waiver program, european governments redoubled31 670 florida tax review vol. 7:10 citizens of the twenty-seven countries that participate in the u.s. visa waiver program, many of them european (andorra, australia, austria, belgium, brunei, denmark, finland, france, germany, iceland, ireland, italy, japan, liechtenstein, luxembourg, monaco, the netherlands, new zealand, norway, portugal, san marino, singapore, slovenia, spain, sweden, switzerland, and the united kingdom) are treated differently. because individuals holding passports from these countries are allowed to enter and stay within the u.s. for 90 days without a visa, these countries were required to issue machine-readable, tamper-resistant passports containing biometric data. the deadline for biometric passports was the same as the deadline for the issuance of biometric visas, october 26, 2004. (ebsver §303(b)(1), 116 stat. 553, 8 u.s.c. 1732(b)(1)) with this set of requirements, all persons entering and leaving the u.s. were now subject to the same biometric data requirements. the u.s. is pushing for comprehensive biometric identification at the borders as fast, or faster than technology and inter-governmental relations will allow. for example, the deadline of october 26, 2004 set by ebsver for biometrics identifiers in passports issued by the countries in the visa waiver program was too ambitions, and needed to be extended for one year to october 26, 2005. (pub. l. 108-299, 118 stat. 1100, 8 u.s.c. 1732 (august 9, 2004). but even with this extension two of the twentyseven countries in the visa waiver program (france and italy) failed to meet the deadline, and as a result citizens of these countries will be required to secure a visa to enter the u.s. if they hold non-electronic passports issued prior to october 26, 2005. these passports are required to have digitized biometric identifiers. valid machinereadable passports issued prior to this date are still accepted. (egovernment news, france and italy miss u.s. passport deadline (nov. 1, 2005) at http://europa.eu.int/idabc/en/document/5095/355 (last visited aug. 2, 2006). the only exceptions to the requirement for biometrics in visas or passports to enter the u.s. involve citizens (but not permanent residents) of canada, and citizens of the british overseas territory of bermuda (unless criminally ineligible or have previously violated the terms of their immigration status). citizens and permanent residents of mexico must secure a border crossing card (also known as laser visa), which is a biometric, machine-readable document obtained like a visa at us embassies and consulates. none of these exceptions are universal. exceptions-to-these-exceptions apply in each instance. 32. thessaloniki european council, presidency conclusions at 3 (jun. 19 & 20, 2003) (“. . . [a] coherent approach is needed in the eu on biometric identifiers or biometric data, which would result in harmonized solutions for documents for third country nationals, eu citizens passports and information systems (vis and sis ii). the european council invites the commission to prepare the appropriate proposals, starting with visas, while fully respecting the envisaged timetable for the introduction of the s c h e n g e n i n f o r m a t i o n s y s t e m i i . ” ) a t http://europa.eu.int/constitution/futurum/documents/other/oth200603_en.pdf (last visited aug. 2, 2006). existing efforts toward the development of an integrated system of mutually recognized passports and national identity cards, both with embedded biometric identifiers. the push and pull of security and privacy concerns are more than32 evident in the eu debates. the madrid bombings further underscored the need 2006] biometrics: solving the regressivity of vats and rsts 671 33. see rebekah alys lowri thomas, biometrics, international migration and human rights 4 (global commission on international migration, global migration perspectives, no. 17, jan. 2005). 34. the following sequence of events is instructive. (1) on february 18, 2004 the european commission submitted a draft resolution on standard security features and biometrics in eu citizens’ passports. in this draft the commission proposed that passports and other travel documents should include a storage medium with a digital facial image. although the facial image was mandatory, member states were allowed to add digital fingerprints into the passports by national law. the draft regulation suggests the fingerprints be stored in a national database. (com(2004) 116 final, o.j. (c 98) 39). (2) on october 25-26, 2004 the text of the proposal was changed as a result of input from the justice and home affairs council so that both facial and fingerprint biometrics were incorporated as mandatory features. (com 15139/2004). (3) the european parliament’s non-binding resolution of the commission’s proposal for a council regulation was adopted on december 2, 2004 with 471 votes in favor, 118 votes against and 6 abstentions. however, the parliament rejected both the mandatory inclusion of biometric fingerprints, and the creation of a central database of eu passports and travel documents. (4) on december 13, 2004 the council adopted regulation (ec) no. 2252/2004 which did not take into account the suggestions of the parliament. the regulation came into force on january 18, 2005 and envisages the inclusion of digital facial images within 18 months and digitized fingerprints within 36 months after the adoption of technical specifications and standards. (5) technical specifications and standards were adopted on february 28, 2005. (com(2005) 409 final). 35. idabc [interoperable delivery of european e-government services to public administrations, businesses and citizens] e-government news (oct. 13, 2005) reporting on a study published in card technologies (indicating that of the 13.1 million smart cards 10 million are national service cards for the online authentication of citizens and another 2 million are electronic identity cards that include a digital photo and fingerprint of the holder, and that beginning in january 2006 these e-id cards will replace all paper ids with the expectation that each citizen will have one within five years) at http://europa.eu.int/idabc/en/document/4985/355 (last visited aug. 2, 2006). 36. id, at text & summary table. for immediately accurate national identity cards. at the same time,33 longstanding concerns over the creation of new centralized databases and the digital integration of pre-existing databanks were heightened as the scope of the privacy threat posed by digital id’s was now global in scope, rather than purely local.34 italy currently leads all european governments in the use of smart card technology for identification. over 13.1 million cards have been issued as of october 2005. the rest of europe has issued about 1.8 million smart cards35 with estonia (800,000) and belgium (585,000) falling a distant second and third.36 672 florida tax review vol. 7:10 37. idabc stands for interoperable delivery of european e-government services to public administrations, businesses and citizens. 38. in belgium and estonia smart id cards are mandatory for all citizens. in italy after 2006 traditional paper id’s are no longer issued and have been replaced with smart id’s. 39. european commission, egovernment indicators for benchmarking eeurope (feb. 22, 2001) at http://ec.europa.eu/idabc/servlets/doc?id=18401 (last visited aug. 2, 2006). 1. the tax impact of digital id’s in europe it is not surprising therefore that the recently completed idabc egovernment observatory benchmarking survey placed the tax administrations37 of italy, estonia and belgium at the forefront of technological applications of e-government tax services. each country has a national electronic portal linked to the tax administration through which taxpayers can enter into secure, encrypted, fully transactional tax relationship with the authorities. the digital capacity of each tax administration’s web site facilitates far more than the mere submission of digital returns. these sites allow a full range of declarations, payments, and comprehensive forms downloading capabilities, authentication, full case handling, decision requests, confidential document deliveries and notifications. the critical component facilitating this comprehensive range of digital tax services is the ability of the tax administration to rely (with legal certainty) on government-issued smart id cards to accurately and securely identify taxpayers. 38 it is clear that this comprehensive range of digital taxpayer services, accessed through e-government web portals is the consequence of the receptivity of tax administrations to technology in conjunction with the appearance of the “smart” id. when the comparable web services of the american rsts are examined the range of tax services provided are nowhere near as comprehensive as those in the eu although american tax administrations appear equally receptive to tax technology as their eu counterparts, none of the american web portals can be considered fully transactional, a standard achieved in eighteen of the twenty-five eu member states. the reason is clear. the u.s. lacks a nationally recognized digital id. 2. benchmarking digital tax service in the eu the idabc benchmarking survey has assessed european adoption of smart card technology for national id’s and government e-services each year for the past five years. the european commission announced the creation of idabc on february 22, 2001, and the internal market council agreed upon the benchmarks and measured functionalities of the survey. on march 23-24,39 2006] biometrics: solving the regressivity of vats and rsts 673 40. the four benchmarks are: 1. informational (only): online information about public services is provided. 2. interactional: online information about public services plus downloadable forms. 3. two-way interactional: online information and downloadable forms plus full processing of forms, including authentication functions. 4. fully transactional: online information, downloadable forms, full processing, authentication, plus full case handling, decision, and delivery functions, including payment. 41. idabc e-government observatory, e-government in the member states of the european union, 5th edition (may 2006) at http://europa.eu.int/idabc/egovo (last visited aug. 2, 2006). 42. the five countries are: austria, finland, italy, the netherlands, and sweden. 43. the two countries are: belgium and estonia. 44. the fourteen countries are: cyprus, france, germany, hungary, ireland, latvia, lithuania, malta, poland, portugal, slovakia, slovenia, spain and the united kingdom. 45. the four countries are: czech republic, denmark, greece, and luxembourg. 46. the exceptional countries and their benchmarks in personal and corporate income taxes, vat and customs are listed below (if not specified the benchmark is “4”): czech republic – customs is benchmarked at 3. hungary – personal income tax is benchmarked at “3,” vat and customs benchmarked at “2.” 2001 the stockholm european council endorsed the commission’s benchmarking methodology (a grading scale from 1 to 4 ) and the public40 services measured (20 basic public services – 12 for citizens and 8 for businesses). four of the twenty public services concern tax matters – government/taxpayer relations in personal income tax, corporate income tax, vat and customs administration. the fifth idabc report issued in may 2006 draws three important41 conclusions: (1) eu adoption of smart id card technologies is very fast growing. of the twenty-five eu member states: (a) seven already have national smart card id’s (five are voluntary, two are mandatory ); (b) fourteen have42 43 smart id card programs under development; and (c) only four have no44 announced plans for national smart id cards. (2) all eu countries have web45 portals. most allow direct and secure interaction between citizens and government agencies through these portals either with digital signatures contained in smart id cards or with digital certificates issued by accrediting agencies. (3) tax administrations have aggressively adapted to smart id card technological opportunities. with only seven exceptions, all eu tax46 674 florida tax review vol. 7:10 latvia – personal income tax, corporate income tax, and vat are all benchmarked at “1.” luxembourg – personal income tax and corporate income tax are benchmarked at “2.” poland – personal income tax, corporate income tax, and vat are all benchmarked at “2.” slovakia – vat is benchmarked at “2,” and customs is benchmarked at “1.” slovenia – customs is benchmarked at “2.” 47. the idabc report is nearly 600 pages in length. the critical tax observations made under each of the 25 member states are summarized infra appendix a. 48. this figure is based on a recent count with the best available information, and represents 46 state level jurisdictions (including washington, d.c.), 1,732 counties, 5,571 cities, and 229 districts. at one extreme is texas with 1,370 taxing jurisdictions (124 counties, 1,141 cities, and 104 districts in addition to the state itself), and at the other extreme are states like connecticut, hawaii, and maine where there is only one taxing jurisdiction at the state level. administrations are benchmarked at stage “4” across all taxes – they have fully transactional relationships with taxpayers over the net. each of the seven47 “exceptional” cases are countries that are benchmarked at stage “4” for some, but not all, taxes. 3. american application (rst only) setting out an american matrix for a comparative u.s.-eu assessment of smart card technologies (so that the rst and vat can be compared) is complicated by a number of factors: (a) the jurisdictional level and number of jurisdictions at which the american rst is imposed, (b) the absence of any significant degree of national coordination of the sub-national rsts (other than an occasional and very high-level constitution inquiry), and most significantly (c) the lack of a government-authorized e-infrastructure – a digital national id and government-certified digital signature. thus, at the outset, the american states are necessarily behind the eu in both (1) the adoption of smart id cards and in (2) the correlative depth of their government-taxpayer technology interface. the american retail sales tax is a sub-national (and frequently a substate level) tax. where the eu has twenty-five national vat regimes coordinated by the sixth directive, the u.s. has forty-five relatively independent states (and the district of columbia) where rsts are imposed. but, there are not just forty-six rsts in the u.s. – there are 7,588. the rst48 is found at the state, county, city, and district levels of government. these rsts are constructed on non-harmonized bases, employ non-uniform rates, and are built upon fundamentally conflicted foundations of both destination and origin design. 2006] biometrics: solving the regressivity of vats and rsts 675 49. walter hellerstein, u.s. subnational state sales tax reform: the streamlined sales tax project, 6 (international tax dialogue vat conference, rome, italy (march 14-15, 2005) (indicating that, “[i]n the absence of federal legislation requiring the states to conform to some national norm, the american constitutional structure not only tolerates diversity among the states, it tends to celebrate it. . . . to be sure, there are constitutional constraints on the states’ fiscal powers when they burden the national common market. but these restraints are limited and, in contrast to state corporate and personal income taxes that conform closely to the national model, there is no national consumption tax that serves as a similar model for the states.”) at http://www.itdweb.org/vatconference/pages/home.aspx (last visited aug. 2, 2006). 50. richard t. ainsworth, the one-stop-shop for vat and rst: common approaches to eu-us consumption tax issues, 2005 tax notes int’l 693 (feb. 21, 2005). 51. cohen supra note 31. thus, although there is a structural similarity among the american rsts there is an exceptional degree of diversity in the details. neither federal legislation nor a significant series of constitutional rulings control the contours of these taxes. this is not to say that the rsts lack all harmonization. the49 sheer number of these levies has always made some coordination essential. almost since the beginning, some states have coordinated their local level rsts thorough “one-stop-shops” where many (or all) of the rsts in a single state are managed through a single set of reporting rules, tax base measures, and rate restrictions. these state-coordinated systems are frequently automated for50 reporting and payment purposes. but this assemblage of non-comprehensive one-stop-shops is a far cry from the type of control that arises in the eu vat under the sixth directive where all member states must adhere to a single set of rules, occasionally with clearly defined optional methodologies, and where derogations from standards require commission approval. finally, the u.s. has no national id, and certainly has no government standard for digital identification – it has no e-government infrastructure that will facilitate easy citizens-to-government digital correspondence. thus, the kinds of secure digital correspondence that most citizens in the eu expect to have with their government as a matter of course are simply not the norm in the u.s. the events of september 11, 2001 have changed american perceptions about digital ids. the u.s. is far more concerned today with embedding biometric identifiers in national ids through smart card technologies than ever before. there have been two notable u.s. pushes for these kinds of ids – the first is for secure identity documents at the borders (passports and visa documents of foreigners ) – the second is for domestic ids of americans (the51 real id act of 2005). based on the eu experience, american rst taxpayers should expect to see some changes when the american “smart” ids are in place. the real id 676 florida tax review vol. 7:10 52. sobel, supra note 16, at 323, n. 10, 11, 12 & 13 (identifying these five databases as: (1) the immigration reform and control act of 1986 (“irca”) pub. l. no. 99-603, 100 stat. 3359 (1986); (2) the illegal immigration reform and immigrant responsibility act of 2996 (“iirira”) pub. l. no. 104-208, 110 stat. 3009-546 to 3009-724 (1996); (3) the personal responsibility and work opportunity reconciliation act of 1996 (“welfare reform act”) pub. l. no. 104-193, 110 stat. 2105 (1996); (4) the health insurance portability and accountability act of 1996 (“hipaa”) pub. l. no. 104-191, 110 stat. 1936 (1996) and (5) the federal aviation administration id requirement and computer assisted passenger screening system (“caps”), and indicating that this assembly of databanks can be enhanced with data from the fbi’s national crime information center 2000, the department of transportation, the social security administration and a whole series of educational databanks.). 53. idabc report supra note 47 & infra appendix a, at france. 54. idabc report supra note 47 & infra appendix a, at france. act should significantly change the way americans relate to their taxing authorities – even though improving this relationship was certainly not one of the stated or intended benefits of the real id act. once digital id’s (complete with biometric identifiers and encrypted digital signatures) become commonplace in america, it will only be a matter of time before taxpayers (and tax authorities) demand that a fully digital, fully transactional web portal be opened. 4. the real id act of 2005: an american smart id card long before september 11, 2001 some americans saw the basic components of an american national id system being put in place (informally). five very large databases holding a great deal of information about americans were constructed in the late 1980’s and 1990’s. a national id could be52 established by linking these databases. it would simply require the assignment of a unique digital identifier to every american and then merger of the databases. to make this into a useful tool against terrorist one or more biometric identifiers associated with each person would need to be added. if done covertly such a “constructed” national id would likely produced a public outcry – similar to the outrage seen in france when the magazine le monde exposed a similar french undertaking (march 21, 1979). this event53 remains one of the reasons that smart id cards are encountering more resistance in france than elsewhere in europe. it also accounts for the french insistence that biometric data on smart id cards be stored anonymously and in separate files.54 the american smart id card is not being developed covertly, but it is being constructed indirectly. on may 11, 2005 president bush signed the real 2006] biometrics: solving the regressivity of vats and rsts 677 55. the real id act started out as h.r. 418, which passed the house. it was attached to a military spending bill (h.r. 1268) and was enacted as pub. l. no. 109-13. 56. id. at § 202 (a)(1). 57. id. at § 202 (b). 58 id. at § 202 (c)(2)(b) & (3). 59. id. at § 202 (d)(1). 60. id. at § 202 (d)(12). 61. the nh house and senate passed a resolution, “. . . declare[ing] its opposition to the federal real id act of 2005, public law 109-13, and urges congress to enact its repeal keeping the state out of the real id act.” the reason for the resolution was specifically that “. . . the collection of biometric identifying information, . . . is an intrusion of privacy; . . . [that it] creates a de facto national identification card . . . [and that ] the costs imposed on the states by the real id act . . . may run well into the hundreds of millions of dollars over the next 5 years;” 2006 n.h. s. con. res. 8. 62. both utah s.b. 227 amending the utah code [utah code § 53-3-207 (1)(b)] effective march 8, 2005 and tennessee s.b. 3430 [tenn. code ann. § 55-50-102 (18)] effective may 29, 2004 passed laws to implement the real id act before the real id act of 2005 into law. the act sets minimum document requirements for55 state driver’s licenses, without which “. . . a federal agency may not accept, for any official purpose, a driver’s license or identification card issued by a state to any person. . . . ” the minimum requirements are:56 (1) the person’s full legal name. (2) the person’s date of birth. (3) the person’s gender. (4) the person’s driver’s license or identification card number. (5) a digital photograph of the person. (6) the person’s address of principle residence. (7) the person’s signature. (8) physical security features designed to prevent tampering, counterfeiting, or duplication of the document for fraudulent purposes. (9) a common machine-readable technology, with defined minimum data.57 two parts of this federal legislation make the real id into a de facto national id in the minds of many: (1) the standardized requirements specifying how the states must verify the minimum required data on driver’s licenses and58 the related requirement that the source documents for this verification be retained in digital files, and (2) the requirement that all states link their59 databases. 60 there is opposition to the real id act of 2005. but there are also61 significant levels of support. some states, tennessee and utah for example, complied with the licensing aspect of this legislation well in advance of its effective date (may 11, 2008). however, the more costly aspect, the scanning62 678 florida tax review vol. 7:10 id act was signed into law federally. hat are issuing driving privilege, or certificate cards under the real id act, § (c)(2)(c) for individuals who cannot prove their legal status in the u.s. to obtain liability insurance, although with a “temporary diver’s license.” these documents are valid for one year and are clearly marked an not qualifying as a “real id.” 63. the legislation in tennessee has no provision for retaining a digital record of source documents, and the law in passed in utah only requires that the social security numbers (ssn) or temporary identification number (itin) be retained in digital files. [utah 53-3-205(9)(b)]. 64. real id act supra note 55, at §204(a) & (b). 65. ab 2895. passed aug. 27, 2004. vetoed sept. 22, 2004. re-introduced as s.b. 60, passed sept. 8, 2005, vetoed oct. 10, 2005. re-introduced as s.b. 1160 jan. 10, 2006. s.b. 1160 does not contain a provision that would make the temporary licenses visibly different from regular licenses. 66. biometrics at the frontiers, supra note 25, at 10. 67. john t. cross, comment: age verification in the 21st century: swiping away your privacy, 23 j. marshall j. computer & info. l. 363 (2005) (discussing the common use of driver’s licenses for age verification at bars and convenience stores by swiping the license through a scanning machine that then records name, address, expiration date, and sometimes social security number, electronic fingerprint and the electronic image of the holder, and the lack of state of federal laws protecting the data); rina c.y. chung, hong kong’s “smart” identity card: data privacy issues and implications for a post-september 11th america, 4 asian-pacific l. & pol’y j. 442 (2003) (discussing instances where bar management uses scanned id data to “. . . develop customer lists based on specific characteristic, and target groups of customers of all source documents and the assembly of the digital database, is not being carried out early. states are waiting for federal funding and regulation.63 64 california passed legislation several times that closely (but not exactly)65 conformed to the real id act. the california legislation failed to include a provision on “temporary drivers’ licenses” (those issued to people who failed to meet the data verification requirements – primarily illegal immigrants) that would make these documents visibly different from the standard license. governor schwarzenegger vetoed the earliest version of this legislation on cost considerations (september 22, 2004) and then vetoed the follow-up legislation (october 7, 2005). legislation has been reintroduced. b. the function creep effect (linear and hyper) the hong kong survey observed that function creep was one of most notable characteristics of national identity smart cards. eu documents refer to this characteristic as “the diffusion effect.” function creep occurs when new66 technology (in this instance biometrics in identity cards) becomes so established or accepted in a society that adaptations both unforeseen and unintended by the technology initiators become commonplace. 67 2006] biometrics: solving the regressivity of vats and rsts 679 for a particular event (e.g., an ‘all-male-performer show’ that would appeal to women in the 21-34 age range),” an example which is based on a news report by jennifer lee, welcome to the database lounge, n.y. times, mar. 21, 2002, at g1.) 68. rebekah alys lowri thomas, global migration perspectives: biometrics, international migrants and human rights 11-13 (global commission on international migration, research paper no. 17, jan. 2005) (indicating that function creep’s downside is the privacy concerns raised by increased profiling, skimming of data, private companies improperly obtaining [retaining] data, and the use of comprehensive crossdata-base searching all because biometrics embedded in national identity cards provide the “handle” to do so, resulting in abusive ‘stop and search’ procedures for migrants). see supra note 14. in many respects, this paper is all about function creep – function creep with beneficial tax applications. its major premise is that when a jurisdiction68 with a technology-receptive tax administration adopts a national identity smart cards system, changes will be seen in the basic delivery of tax services – preexisting online information, downloadable forms, processing, and authentication services will be supplemented with fully digital case handling, decisions, and delivery functions. however, there are two distinct kinds of function creep – one is passive and predictable (linear function creep), while the other is active and dynamic (hyper function change). linear function creep is a natural and intuitive extension in digital form of a formerly non-digital process. comparing the tax functionality of the e-government interface in the eu with the similar interface in the states of the u.s. one can predict the direction of change. the u.s. portals are not nearly as robust as those in the eu, and the reason is the absence of a national id with secure digital features in the u.s. thus, a predictable result of the adoption of a national smart id with encrypted digital signature functionality in the u.s. would be advances in tax services through the u.s. eportals along lines of the eu the malaysian identity card provides several good examples of linear function creep. formally called the government multi-purpose card (gmpc) the malaysian card is the product of an open-ended collaboration of five government agencies, the national registration department, the road transportation department, the immigration department, the ministry of health and the royal malaysian police. the malaysian card functions as a passport, a driver’s license, and an access card to government facilities. the open infrastructure of the card allows it to serve in the private sector – and this is the function creep effect – as e-cash and an automated teller machine (atm) access card, as well as a vehicle for the payment of fees for public transport services, and “touch and go” auto toll and parking services. the implementation of public key infrastructure (pki) within the cards in 2003 allows e-commerce transactions and ensures the authenticity and integrity of 680 florida tax review vol. 7:10 69. registration of persons (amendment) bill 2001, experience of using smart identity cards in other countries supra note 27 at 3 & annex 15-16. 70. registration of persons (amendment) bill 2001, experience of using smart identity cards in other countries supra note 27 at annex 15-16. 71. registration of persons (amendment) bill 2001, experience of using smart identity cards in other countries supra note 27 at annex 15-16. 72. joe burns, basic html, in html goodies (defining “hyper” in the context of the h-t-m-l initials that stand for hyper text markup language. “. . . hyper is the opposite of linear. it used to be that computer programs had to move in a linear fashion. this [comes] before this, this [comes] before this, and so on. html does not hold to that pattern and allows the person viewing the world wide web page to go a n y w h e r e , a n y t i m e t h e y w a n t . ” ) a t http://www.htmlgoodies.com/primers/html/article.php/3478141 (last visited aug. 2, 2006). 73. real id act supra note 55, at §202(b)(7). data. the id card legislation in malaysia does not restrict future incorporation69 of additional non-government data on the card. the same is true in finland and70 brunei.71 but more than linear function creep is possible. with active intervention the government can merge the digital id with other marketplace technologies to not only improve the basic delivery of tax services, but to reform the system itself – a wholesale re-composition of the structure of the consumption tax. this intervention can transform the consumption tax into a truly and independently progressive tax. national ids with smart chips will allow the surgical identification of taxpayers-in-need, those who are entitled to tax exempt status when purchasing necessities. this can be done without compromising the broad base of the tax on the same supplies made to members of society. this is a reform that will target the regressvity that is inherent in all contemporary consumption tax regimes (vats as well as rsts). this is more than a linear function creep it is a hyper function change.72 1. prediction – linear function creep in state rst administration. if funding for the construction of the american digital database is made available to the states, and if political opposition remains mild, then it seems reasonable that some time between 2008 and 2010 the u.s. will have a smart national id card. in addition, because the real id act only sets minimum standards for card content, the american card, like most smart id cards globally, will be open for new uses and new data elements. the addition of a legally recognized, state or federally certified digital signature embedded in the card is only the most obvious addition – the real id act only demands that an individual’s physical signature be captured. thus, based on eu and other73 country experiences with open technology smart ids, once the id becomes 2006] biometrics: solving the regressivity of vats and rsts 681 74. the results from applying the four-part idabc benchmarking standard at the u.s. state level are summarized infra appendix b. this summary only applies to the rst. thus, it covers only forty-five states plus the district of columbia. in appendix a the comparable analysis for the eu was much broader. it included all taxes, and was divided into three categories: (1) smart id cards; (2) electronic portal; and (3) tax administration & technology. the same scope and breakdown is not followed in appendix b. the scope is more limited, and the analysis is focused on category three: tax administration & technology. the first category (smart id cards) is applicable in no state, and the second category (electronic portal) has been fully functional in every state for some time. the issue considered was whether a state’s tax web site operates at “stage 1,” “stage 2,” “stage 3,” or “stage 4” with respect to the state-level consumption tax, a tax administration & technology question. the information is a “snapshot” collected on july 18, 2006. changes are occurring so rapidly in this area that this profile will be out-of-date shortly. [note: a new category of “almost stage 3” seemed appropriate, and was used on occasion.]. 75. n.y. dep’t. of tax & finance, release (sept. 23, 2003) at http://www.tax.state.ny.us/press/archive/2003/nelectronicserv.htm (last visited aug. 2, 2006). although the state of new york announced in september 2003 that taxpayers would be allowed to access a new electronic service for sales taxes through the business service center. taxpayers can request a password to view or pay open assessments. after requesting a password on-line, taxpayers can log into the business service center and view their “consolidated statement of tax liabilities” which will display the realtime status of a taxpayer’s open assessments, including any balance due. widely held, is easily and frequently used by a large portion of the population, at low or no cost to government and citizen, then tax delivery services begin to change. to measure the extent of the change that should be expected in the u.s. one simply needs to benchmark the current system and project developments along the eu trajectory. 2. benchmarking digital tax services in the american rsts. applying the benchmarks developed by idabc e-government observatory to the u.s. states, the difference in the level of technical facility is striking. the most extreme case are the two states that still do not allow e-filing of any sales and use tax returns (colorado and michigan). no eu country is at this level. more generally however, the place where divergence is most apparent is the observation that the eu tax administrations were commonly benchmarked at “stage 4,” whereas the u.s. states are all benchmarked at “stage 3” or lower.74 in all cases what is missing from the u.s. systems is the digital handling of the full range of case activities, decision requests, confidential document75 deliveries and notifications, declarations, and authentications that are standard in the eu systems. all of these functions require secure identity verification, something readily found in smart id cards with an embedded, encrypted digital signature. 682 florida tax review vol. 7:10 76. all e-filed returns must be maintained on paper for six years. ariz. rev. stat. § 42-1105(f). 77. paper signature cards must be retained for electronically filed returns. ark. reg. 2000-2(1) (e) & (f) & 5(a). amended returns must be filed on paper with “amended” printed or stamped at the top of the return. (ky. rev. stat. ann. § 45.345. 78. registration requires a form to be downloaded, completed and then mailed to the tax office. the tax office then mails the taxpayer a user id and password providing access to the etsc site. office of tax & rev., notice regarding electronic filing requirements (jan. 15, 2004). similar requirements can be found widely: florida requires completion of the registration/authorization form (form dr-600f) and the electronic filing agreement (form dr-653). 7 9 . m i s s o u r i d e p a r t m e n t o f r e v e n u e w e b s i t e : http://www.dor.mo.gov/tax/business/payonline.htm (last visited aug. 2, 2006) (requiring a duplicate set of paper returns for all returns filed electronically). 80. r.i. div. of taxes, federal/state online filing, at http://www.tax.state.ri.us/elf/on-line.htm (last visited aug. 2, 2006) (indicating that, in order for the rhode island e-filing and e-payment system to work a taxpayer must file both a federal and state return, and that if a taxpayer has already filed a federal return using another electronic filing service, state returns cannot be filed electronically). 81. vt. stat. ann. tit. 32, §§ 9243 (indicating that the commissioner can mandate state e-payment if a taxpayer is making federal e-payments). 82. the washington taxes subject to the eft requirement include all taxes administered by the department of revenue under wash. rev. code § 82.32, with the following exceptions: city and town taxes on financial institutions (wash. rev. code § 82.14a); county tax on telephone access lines (wash. rev. code § 82.14b; cigarette tax (wash. rev. code § 82.24); enhanced food fish tax (wash. rev. code § 82.27); leasehold excise tax (wash. rev. code § 82.29a); and forest tax (wash. rev. code § 82.33). 83. ca. sbe tax info. bull. no. 12-1-05 (dec. 1, 2005) (indicating that e-filing is not allowed in california for taxpayers required to make prepayments or to pay taxes by electronic funds transfer (eft)). 84. 20 ill. comp. stat. ann. 2505/39c-1a; ill. admin. code tit. 86, § 760.100 (indicating that e-filing is voluntary in illinois, and limited to two sales and use tax forms, form st-1 (sales and use tax return) and form st-2 (multiple site attachment for form st-1)). taken as a whole, there is considerable variation in the u.s. systems. some remain reliant on paper processes (arizona, arkansas, connecticut,76 77 78 and missouri ), while others make state e-payments dependent on the79 taxpayer’s federal e-payment commitment (rhode island, and vermont ). in80 81 other states e-filing and e-payment solutions are offered selectively. some discriminate based on tax type (washington ), while others discriminate within82 a tax type based on types of sales and use tax returns (california, illinois,83 84 2006] biometrics: solving the regressivity of vats and rsts 683 85. ky. rev. stat. ann. § 45.345 (indicating that amended returns must be filed on paper with “amended” printed or stamped at the top of the return). 86. thirteenth month returns, those using special rates, and all amended returns. these returns must be filed on paper forms. see “who can use this system” at https://ec3.state.nm.us/crs-net/help/whouse.htm (last visited aug. 2, 2006). 87. utah state tax commission, online sales and use tax filing at http://tax.utah.gov/sales/salestaxonline.html (last visited aug. 2, 2006) (indicating that sales and use tax returns that must be filed on paper include tc-61f, tc-61fv, tc61t, and tc-61w, and that in addition amended returns and late-filed returns remain paper-based even though most but not all sales and use taxpayers are able to make payments on line). 88. although voluntary the illinois system limits e-filing to two sales and use tax forms, form st-1 (sales and use tax return) and form st-2 (multiple site attachment for form st-1) (20 ill. comp. stat. ann. 2505/39c-1a; ill. admin. code tit. 86, § 760.100). voluntary electronic funds transfer are also limited, but not in a harmonious manner. e-payments are voluntary with the following forms: art-1 (payment only); pst-1 (payment only); pst-3, (for accelerated sales tax filers); rr-3 (for accelerated sales and use tax filers). (ill. admin. code tit. 86, § 750.500(e)). 89. 2006 s.d. laws h1048, §1; s.d. codified laws § 10-46e-7; s.d. codified laws § 10-59-39 (recent legislation linking e-payment and e-filing by requiring taxpayers to e-file a return by the 23rd day of the month following each monthly period if they e-pay the tax by the second to the last day of the month following each monthly period). 90. tex. tax code ann. tit. 111, § 626 (providing for mandatory e-filing linked to mandatory e-payment, and therefore the e-filing of a sales and use tax return is required if the tax payments are required under eft). 91. mich. comp. laws §§ 205.56(3); 205.96(3). 92. vt. stat. ann. tit. 32, §§ 9243 (providing the commissioner with the authority to mandate state e-payments if prior payments by the taxpayer were with checks that were uncollectible). 93. idabc report supra note 47 & infra appendix a, at cyprus, czech republic, france, germany, greece, luxembourg, malta, portugal, slovakia, spain, and the united kingdom (indicating that in these countries there is a “stage 4” tax web site kentucky, new mexico, and utah ). some states allow e-filing only when85 86 87 the taxpayer is making e-payments (illinois, south dakota, and texas ),88 89 90 while others do the reverse allowing e-payments, but not the e-filing of the related return (michigan ). still other states view e-payment requirements in91 tax-enforcement rather than purely tax-efficiency terms (vermont ).92 this is not to say that american jurisdictions could not achieve eu levels of performance without national smart id cards. a number of eu member states use agency-specific certifications of digital signatures to achieve “stage 4” benchmarking, but this is normally a temporary accommodation as the country moves toward a national digital id and a single electronic portal facilita ting a ll citizen-to-government and government-to-citizen correspondence. with 7,588 rst jurisdictions however, the u.s. cannot move93 684 florida tax review vol. 7:10 without a national id, thus the certification of the digital signature is by the tax administration). 94. set to expire on june 30, 2006 the digital sales directive was extended to december 31, 2006. council directive 2006/58/ec of 27 june 2006 amending council directive 2002/38/ec as regards the period of application of the value added tax arrangements applicable to radio and television broadcasting services and certain electronically supplied services, 2006 o.j. (l 174) 5. 95. european commission, eeurope – an information society for all, com(2000)0130 final at http://europa.eu.int (last visited aug. 2, 2006) (indicating that the “lisbon strategy” is a shorthand expression for the broad e-commerce policy objectives set out at the lisbon european council of march 24 and 24, 2000). 96. communication from the commission to the council, the european parliament, the economic and social committee and the committee of the regions, eeurope 2005: an information society for all. an action plan to be presented in view ahead with multiple “smart” ids, one for each jurisdiction. what the u.s. needs is a single federal level “smart” id and authenticated digital signature regime. this will allow the u.s. to move strongly to “stage 4” benchmarking. when the real id provides this functionality the linear function creep of this technology – something that has been observed from hong kong to the eu – will have a significant impact on state tax administrations. much more is possible however, if national ids are linked to a fully digital consumption tax operating with certified compliance software. part ii: fully digital consumption tax regimes “smart” national ids are part of a larger technology context that is having a dramatic effect on consumption tax administration. both mandatory and voluntary national identity smart card systems are being developed simultaneously with eu and u.s. experimentation in fully digital vats and rsts (on a voluntary business participation basis). the digital sales directive in the eu provides for a paperless vat reporting and payment environment for non-established businesses selling to final consumers in the eu in similar94 fashion the streamlined sales tax under the certified service provider (csp) model allows businesses to enter a paperless world of rst compliance. it will soon be time for these “pilot” programs to be expanded, and to be linked with the “smart” id. a. digitizing the vat in the eu digitizing the vat in europe is part of a broad effort to bring the efficiencies of an information society to the eu dubbed the “lisbon strategy,”95 this is an effort to make the eu a more competitive, dynamic knowledge-based economy, with improved employment and social cohesion by 2010. a number96 2006] biometrics: solving the regressivity of vats and rsts 685 of the sevilla european council, 21/22 june 2002. com(2002)263 final, at http://ue.eu.int (last visited aug. 2, 2006) (presenting the specific steps expected to be taken to achieve the “lisbon strategy” by 2010). 97. council directive of 20 december 2001 amending directive 77/388/eec with a view to simplifying, modernizing and harmonizing the conditions laid down for invoicing in respect of the value added tax. 2001/115/ec, 2002 o.j. (l 15) 24, at http://europa.eu.int (last visited aug. 2, 2006) [the invoicing directive]. 98. council directive of 7 may 2002 amending and amending temporarily directive 77/388/eec as regards the value added tax arrangements applicable to radio and television broadcasting services and certain electronically supplied services, 2002/38/ec, 2002 o.j. (l 128) 41 at http://europa.eu.int (last visited aug. 2, 2006) [the digital sales directive]. 99. sixth council directive 77/388/eec of may 17 1977, at former art. 22(1)(a), 1977 o.j. (l 145) 1, at http://europa.eu.int (last visited aug. 2, 2006). 100. id. at (new) art. 22, added by the digital sales directive, supra note 98. 101. id. at (new) art. 22(4)(a), as amended by the digital sales directive, supra note 98. 102. id. at (new) art. 22(6)(a), as amended by the digital sales directive, supra note 98. (on periodic statements); article 22(6)(b), as amended by the digital sales directive, supra note 98 (on recapitulative statements). of changes have been made in the sixth directive in line with this movement. council directive 2001/115/ec of december 20, 2001 and council directive97 2002/38/ec of may 7, 2002 were two of the key decisions moving the98 european vat in the digital direction. 1. digital notices, digital returns, digital periodic and recapitulative statements council directive 2002/38/ec of may 7, 2002 made four significant changes to the sixth directive with respect to digitizing the vat. first, the requirement to provide notice that taxable activity has begun, or has terminated, can now be performed in every member state electronically, and99 if a member state wants to it can require all taxpayers to do so. secondly,100 vat returns that formerly were entirely paper, may now be filed in every member state electronically. and as with the notices of activity beginning and ending, a member state has the option to require that all vat returns be filed electronically. similar changes were made in provisions relating to both101 periodic statements, and recapitulative statements. each may be filed electronically, or may be subject to a member state’s requirement that all such statements be electronically filed. 102 there is a common theme in these modifications of the sixth directive. in each instance council directive 2002/38/ec applies a two-part structure, first allowing any taxpayer throughout the eu (at their own election) to file documents electronically instead of on paper, and secondly, permitting member 686 florida tax review vol. 7:10 103. proposal for a council directive amending directive 77/388/eec with a view to simplifying, modernizing and harmonizing the conditions laid down for invoicing in respect to value added tax. (november 17, 2000) com(2000)650 final at 6, at http://europa.eu.int (last visited aug. 2, 2006) (referencing a study carried out for the commission estimated the cost of an electronic invoice at eur 0.28 to 0.47, as against eur 1.13 to 1.65 for a traditional invoice resulting in a savings per invoice could between eur 0.66 to 1.37). 104. sixth directive, supra note 99, at (new) art. 22, as amended by the digital sales directive, supra note 98 (listing seven other critical administrative aspects of the european vat as: (1) registration, (2) identification numbers, (3) keeping accounts, (4) keeping a register, (5) submitting a return, (6) submitting a statement, and (7) submitting a recapitulative statement). 105. alan schenk, aba section of taxation, value added tax – a model statute and commentary, 120 n. 172 (1989) (“the seller’s invoice is a key element in an invoice vat. at levels before the retail sale, the vat listed on the seller’s invoice can be used to cross-match the seller’s output tax liability against the buyer’s input credit on its purchases. . . . experience in europe suggests that civil servants do not have much time to cross-match invoices. see carlson, value added tax: european experiences and lessons for the united states, reprinted in 1980 department of treasury (office of tax analysis) 51. korean and taiwan have relied on an elaborate computer system of cross-matching invoices sent to the government by the seller and the buyer.”). 106. case 123/87, léa jorion, née jeunehomme v. belgian state, 1988 e.c.r. 4517 (ag sir gordon slynn famously characterized the invoice as “the ‘ticket of admission’ to right to deduct.”). 107. sixth directive, supra note 99, at (new) art. 22(3)(c), as amended by article 28h added by the digital sales directive, supra note 98 (“the member state shall determine the criteria for determining whether a document serves as an invoice.”). states to go further, mandating electronic submission of these documents by all taxpayers. 2. digital invoices far more important to digitizing the vat are the efforts made under council directive 2001/115/ec to begin the process of digitizing the invoice.103 the bedrock principles of the european vat are embedded in the invoice.104 almost all critical legal, accounting, reporting, and enforcement issues are tied to information found on the invoice. an invoice performs three basic105 functions: (1) it contains the information needed to determine which vat regime is applicable to a particular transaction, (2) it enables tax authorities to carry out enforcement controls, and (3) it allows the purchaser to prove their right to deduction.106 there is nothing in the original sixth directive that considers electronic invoicing. old article 22(3)(c) is silent. through article 28h council107 directive 2001/115/ec amends article 22(3)(c) to unambiguously authorize the 2006] biometrics: solving the regressivity of vats and rsts 687 108. id. at (new) art. 22(3)(c), as amended by article 28h added by the digital sales directive, supra note 98 (“invoices issued pursuant to point (a) may be sent either on paper or, subject to an acceptance by the customer, by electronic means.”). 109. id. at (new) art. 22(3)(c), as amended by article 28h added by the digital sales directive, supra note 98 (specifically referencing the electronic signatures rules in article 2(2) of directive 1999/93/ec, of 13 december 1999 on a community framework for electronic signatures, 2000 o.j. (l 13)12, at http://europa.eu.int (last visited june 9, 2006)). 110. id. at (new) art. 22(3)(c), as amended by article 28h added by the digital sales directive, supra note 98 (specifically referencing electronic data interchange (edi) as defined in article 2 of commission recommendation 1994/820/ec of 19 october 1994 relating to legal aspects of electronic data interchange 1994 o.j. (l 338) 98, at http://europa.eu.int (last visited june 9, 2006)). 111. id. at art. 22(c)(second paragraph), as amended by the invoicing directive, supra note 97. use of electronic invoices, subject to a customer’s acceptance. the108 amendments of article 28h go to great lengths to establish a new legal framework within which member states must accept electronic invoices. “invoices sent by electronic means shall be accepted by member states provided that the authenticity of the origin and integrity of the contents are guaranteed [either] by means of advanced electronic signature . . . or by109 means of electronic data interchange (edi). . .”110 111 it is clear that conditions are expected to develop, to change over time. the amendments to article 22(3)(c) made by article 28h include a provision that: “the commission will present, at the latest on december 31, 2008, a report, together with a proposal, if appropriate, amending the conditions on electronic invoicing in order to take account of possible future technological developments in this field.” the two-part theme of council directive 2002/38/ec (allowing any taxpayer at their own election to file electronically and then permitting member states to mandate an electronic submission) is not carried over into the invoicing adjustments made by council directive 2001/115/ec. missing is the authority for a member states to mandate electronic invoices. additionally, electronic invoicing is not left entirely to the seller’s discretion. it is the buyer’s acceptance of an electronic form of invoicing that is the critical pre-condition to usage. two additional modifications to article 22 by council directive 2001/115/ec have a direct impact on electronic invoicing. these adjustments pave the way for standardization of the electronic invoicing process – first by allowing for third-party involvement in preparation of invoices (outsourcing the invoice) – secondly by setting out exclusive, uniform legal requirements for valid invoices. 688 florida tax review vol. 7:10 112. id. at art. 22(3)(b), as amended by the invoicing directive, supra note 97 (listing the 12 items that must appear on an invoice, and two more (13 and 14) that may occasionally appear: (1) the date of issuance of the invoice; a sequence number that uniquely identifies the invoice; (2) the vat identification number of the seller; (3) the vat identification number of the buyer (if the customer is required to pay vat on the transaction); (4) full name and address of the buyer; (5) the quantity and nature of the good/ extent and nature of the services supplied; (6) the date on which the supply was completed, or the date on which the payment was made – in so far as that date can be determined and differs from the date of issuance of the invoice, (1) above; (7) the taxable amount; unit price exclusive of tax, discounts, and rebates; (8) the vat rate applied; (9) the vat amount payable; (10) where either an exemption applies, or where the buyer is liable selfassess the vat, reference to the section of the sixth directive or the national law that allows this procedure; (11) special rules for the supply of new means of transportation require particulars under article 28a(2); (12) special rules related to margin schemes require reference to national laws; original article 22(3) required the taxable person to issue his or her own invoice. council directive 2001/115/ec amends article 22(3)(a) in the following manner (additions in italics): (a) every taxable person shall ensure that an invoice is issued, either by himself or by his customer or, in his name and on his behalf, by a third-party, in respect of goods and service which he has supplied or rendered to another taxable person or to a non-taxable legal person. every taxable person shall also ensure that an invoice is issued either by himself or by his customer or, in his name and on his behalf, by a third party, in respect of the supplies of goods, . . . similarly, original article 22(3)(b) referred to a non-exhaustive list of statements that needed to be mentioned on the invoice. the list could be extended by any member state if it wished. amended article 22(3)(b) harmonizes the statements required on an invoice and removes the authority112 2006] biometrics: solving the regressivity of vats and rsts 689 (13) in instances where a tax representative is used, then the vat identification number as well as the name and address of that representative needs to be listed). 113. id. at art. 9(1) (presenting the specific sourcing issue, the fall back sourcing provision, that placed any service not covered in the series of exceptions that make up the rest of article 9 into a residual category that sourced the supply where the supplier was located, thereby placing the supply in the us for digital sales by many us companies into the eu). 114. id. at art. 21 (indicating that a reverse charge is a self-assessment obligation imposed on businesses purchasing taxable supplies). of local administrations to require additional statements. in addition, the third subparagraph of article 22(3)(b) stipulates that: “member states shall not require invoices to be signed.” the explanatory memorandum to the proposal indicated that this provision was needed to remove yet another potential barrier to electronic invoicing. 3. the test case: the digital sales directive – article 26c the lisbon european council focused the commission’s attention on one particularly troublesome aspect of digital commerce, the sale of digital products to non-taxable eu customers by non-eu businesses. the technical issue was sourcing, the place of supply. the sixth directive sourced these supplies outside the eu, making them not subject to vat. consumption (use and enjoyment) however, was clearly occurring within the eu.113 the solution worked out by the commission had technical and practical aspects. on the technical side, as of may 7, 2002 all electronically supplied services from non-eu businesses were listed within the exceptions of article 9(2)(e). a special rule dealing with similar b2c transactions was added in article 9(2)(f). thus, vat now became due on these sales. the place of supply had been moved within the eu. working out the practical side of this solution was more complicated – involving the first application of a completely digital solution to a theoretical vat problem in eu vat law. there are several aspects of the solution. first, b2b transactions (non-eu businesses supplying eu businesses), by far the largest part of e-commerce in monetary terms, were handled rather simply through a reverse charge procedure. the second aspect dealing with b2c114 transactions (non-eu businesses supplying eu final consumers) promised to be a bigger problem. because consumers do not file vat returns (they are not “taxpayers” in vat terms) a reverse charge procedure is not possible. the only solution for b2c sales was to require the non-eu business to collect and remit the tax. under the then current rules, for those businesses willing to comply there were essentially two options. they could either (1) establish themselves 690 florida tax review vol. 7:10 115. id. at art. 9(1) (indicating that in this instance the place of supply for digital services would be the member state where the supplier is established, thereby subjecting the business to direct taxation in that state). 116. id. at arts 9(2)(f) & 21 (indicating that the place of supply of digital services is where the customer resides, and requiring registration and the filing of returns in as many as 25 states). 117. id. at art. 26c(b)(1). 118. id. at art. 26c(b)(2) (“the non-established person shall state to the member state of identification when his activity as a taxable person commences, ceases or changes to the extent that he no longer qualifies for the special scheme. such a statement shall be made electronically.”). 119. id. at art. 26c(b)(9) (“the non-established taxable person shall keep records of the transactions covered by this special scheme in sufficient detail to enable the tax administration of the member state of consumption to determine that the value added tax return referred to in (5) is correct. these records should be made available electronically on request to the member state of identification and the member state of consumption.”). in a member state, or (2) register in each member state where they made115 taxable supplies. neither option was optimal. although under the first option116 all digital sales would be sourced to one eu jurisdiction, the place where the business was established (article 9(1)), establishment itself led to direct tax obligations. the formerly non-eu business would become a real eu business for tax and regulatory purposes. sourcing of sales under this option would be origin-based. the second option also had disadvantages. under this option a business could conceivably be required to register in 25 member states, file 25 sets of vat returns, and do so in as many as 20 different languages. sourcing of sales under this option would be destination-based. article 26c was adopted to provide a third alternative. this was a onestop-shop option. it allowed non-eu established businesses to select a single “member state of identification” where they could register, but not be established, under a simplified arrangement. vat from sales made throughout the eu would be determined on a destination-basis using the rates and rules of the jurisdiction where the customer resided. however the vat collected on these sales would be paid over to the member state of identification on a single electronic return. importantly, article 26c requires all communication between the taxpayer and the member state to be electronic, if the taxpayer elects to file according to this special scheme. registration and all notifications about117 changes in status, statements and recapitulative statements, filing of118 119 2006] biometrics: solving the regressivity of vats and rsts 691 120. id. at art. 26c(b)(5) (“the non-established taxable person shall submit by electronic means to the member state of identification a value added tax return for each calendar quarter . . .”). 121. id. at art. 26c(b)(7) (“the non-established taxable person shall pay the value-added tax when submitting the return. payment shall be made to the bank account denominated in euro, designated by the member state of identification.”). 122. id. at art. 26c(b)(3)(second paragraph) (“the member state of identification shall notify the non-established taxable person by electronic means of the identification number allocated to him.”). 123. proposal for a council directive amending directive 77/388/eec as regards the rules governing the right to value added tax, 1998 o.j. (c 219)16, at http://europa.eu.int (last visited aug 2, 2006) (proposing a similar digital scheme, without provision for a single payment of eu-wide vat obligations, but with a single return and filing obligations has been proposed by the commission under article 22b). 124. european commission, amended proposal for a council directive amending directive 77/388/eec as regards the place of supply of services (submitted by the commission pursuant to article 250(2) of the ec treaty) com(2005)334 final at 13. member states have provided the commission with information showing that on 30 june 2004 there were 617 live registrations for non-established taxable persons availing themselves of the simplified scheme. in the year to 30 june 2004, these non-established persons paid vat totaling 90,315,000 euro. returns, payments of vat amounts due and collected, and even120 121 communications by the member state to the non-established taxpayer, must122 be in electronic form. article 26c therefore presents in microcosm a fully functional digital vat. if elected by the taxpayer, member states are required to accept and engage in this fully digital relationship. it is estimated that123 approximately 617 taxpayers participate in the article 26c digital vat.124 b. digitizing the rst in the u.s. digitizing the american rst is a daunting task. the minimum standard for a digital consumption tax is an e-filed tax return. however, in a significant number of u.s. states with rsts there are limited provisions for e-filing returns, to say nothing of all the other e-functionalities that constitute a fully transactional (“stage 4”) e-tax system under idabc benchmarking – the capacity for a full range of digital declarations, comprehensive forms downloading capabilities, digital authentication, full case handling, decision requests, confidential document deliveries and notifications all through a secure digital medium and uniform web portal. in a 2006 survey the federation of tax administrators examined e-filing options in sales and use taxes in the forty-five 692 florida tax review vol. 7:10 125. federation of tax administrators, state ec snapshots (updated april 18, 2006) at http://taxadmin.org/fta/edi/ecsnaps.html indicates that alabama, arkansas, georgia, kentucky, maryland, michigan, mississippi, nebraska, nevada, new jersey, utah, vermont and west virginia require some or all rst returns to be filed on paper. this determination is not a dire at it may seem. in many of these states many sales and use tax returns can be e-filed, and in most cases there is a commitment by the state to move toward fully digital filing options. 126. the 854 jurisdictions are comprised of 12 states [alaska has no state level rsts but numerous sub-state level rsts], 281 counties, 559 cities and 2 districts. 127. for example, the following eight states have mandatory e-filing and epayment systems in place for “large” consumption tax filers. these filing requirements are frequently reported on the state web pages. in connecticut electronic filing is m a n d a t o r y i f a n n u a l l i a b i l i t i e s e x c e e d $ 1 0 0 , 0 0 0 . (http://www.drs.state.ct.us/electronicservices/fastfiling.htm). in florida all zero returns must be filed electronically as well as the returns for filers who have in excess of $ 3 0 , 0 0 0 i n a n n u a l l i a b i l i t y i n t h e p r i o r y e a r . (http://www.state.fl.us/dor/forms/dr15inst.html). in louisiana businesses with liabilities i n e x c e s s o f $ 2 0 , 0 0 0 m u s t p a y b y e f t . (http://www.rev.state.la.us/sections/eservices/default.asp#efbt). missouri has a mandatory e-filing system for all taxpayers who had in excess of $15,000 in liability in 6 of the previous 12 months, at http://www.dor.mo.gov/tax/business/payonline.htm (last visited aug. 2, 2006). new york has a mandatory e-filing system, called propfile, for t a x p a ye r s w i th l ia b i l i t ie s in e x c e s s o f $ 5 0 0 , 0 0 0 a n n u a l ly a t http://www.tax.state.ny.us/prompt/sales_tax/sttoc00.htm (last visited aug. 2, 2006). oklahoma has a mandatory e-filing program for taxpayers with in excess of $100,000 in liability per month at http://www.oktax.state.ok.us/oktax/quicktax.html (last visited aug. 2, 2006). in texas electronic filing is mandatory for filers with a past year sales tax liability of $100,000 or more. this filing must be through edi if there are more than 30 texas locations at http://www.window.state.tx.us/webfile/index.html (last visited aug. 2, 2006). utah requires taxpayers with liabilities in excess of $96,000 to e-file at http://www.tax.ex.state.ut.us/sales/salestaxonline.html (last visited aug. 2, 2006). 128. xml (extensible markup language): xml is a newer technology and one that shows promise of coming closest to the goal of a universal language for electronic commerce. in xml, a “tag” is attached to each data element within a transaction, giving information concerning both the semantic meaning of the data element itself, but also its structure within the tax-reporting document. because the “tags” are not prestates (plus the district of columbia). the fta identified thirteen states125 (containing 854 discrete rst jurisdictions ) that had significant paper return126 filing requirements. in the majority of states that do have e-filing functionality, the system is voluntary – paper filing remains a common practice. many states have made e-filing mandatory for “large” taxpayers, although the definition of a “large taxpayer” varies from state to state at the present time the three main127 electronic solutions for rst e-filing in the u.s. are: extensible markup language – xml, electronic data interchange – edi, and internet based. 128 129 2006] biometrics: solving the regressivity of vats and rsts 693 determined by any generic xml standard, xml is “extensible”meaning that the user may extend the language through the definition of any document. a tax return document definition may be transmitted along with the data or stored in a database. the databases would be that of the taxpayer and the tax administration. xml capability is built into leading internet browsers. taxpayers with internet access and a browser can ‘interpret’ xml by linking to the database server containing the document definition. an xml transmission can be associated with a “style sheet” indicating how the data is to be displayed and manipulated. thus, xml allows the taxing authority to create an internet filing application, control how the taxpayer interacts with the application through the browser, and specify unambiguously the meaning and structure of the data within the tax return. the state of california currently offers sales and use tax filing over the web using xml. http://www.boe.ca.gov/elecsrv/efiling/srvprovider.htm (last visited aug. 2, 2006). 129. edi (electronic data interchange): edi is a computer application to computer application system. information is transmitted in standardized format. consensus bodies set edi standards. edi is best used in the following situations: large volume transmitters (edi is very receptive to large data volumes); self-programmers; third-party bulk filers; batch applications (where real time responses are not expected); industry segments (where a large edi commitment has been made). prior to the emergence of new electronic technologies to transact business, edi was the best way for a business to reduce its paper processing cost, as well as the costs, errors and time delays associated with data entry. large corporations, their customers and suppliers implemented edi in the mid-1980’s and 1990’s. the use of edi for tax filing was a natural extension. one of the drawbacks to edi is that specialized software is needed to translate normal business records into edi format for transmission. small and mid-sized businesses saw this as a barrier for tax filings. thus, software vendors (california offers taxpayers the ability to file through two companies that are electronic returns operators; see http://www.boe.ca.gov/elecsrv/efiling/srvprovider.htm (last visited aug. 2, 2006); participation is voluntary) and tax administrations (indiana’s e-filing system, called “trust file,” involves a software program that is offered free of charge; see http://www.in.gov/dor/electronicservices/insite/btef.html (last visited aug. 2, 2006); as well as kansas, see http://www.ksrevenue.org/rcuwebfile.htm (last visited aug. 2, 2006) (participation is voluntary) developed applications that made edi a viable option for these businesses. because the edi technology is embedded in the tax filing software, no knowledge of the technical specifications involved in creating an edi-formatted data file are needed. an additional barrier to edi concerns the transmission of the tax data from the taxpayer to the tax authority. edi has traditionally made use of the “value added network” (van) for data transmission. both the tax authority and the taxpayer must 694 florida tax review vol. 7:10 maintain a “mailbox” provided by the van. the taxpayer transmits edi tax filings to the tax authority’s mailbox, and receives acknowledgments in the taxpayer’s mailbox. the van has advantages and disadvantages. the advantage is that the tax authority needs to maintain only one communications interface. it does not have to maintain communications lines to support a large volume of taxpayer calls, nor does it have to support a variety of communications speeds and protocols. the van also enforces the security of the transmissions. however, van costs generally include not only the monthly mailbox fee, but also the costs of the toll calls and a per-character transmission charge. to overcome this some tax administrations pay the toll and transmission charges f o r t a x p a y e r s ( f l o r i d a ’ s e a s y l i n k v a n i s e x p l a i n e d a t http://www.state.fl.us/dor/forms/dr15inst.html (last visited aug. 2, 2006); south c a r o l i n a ’ s e a s y l i n k v a n i s e x p l a i n e d a t http://www.sctax.org/electronic+services/default.htm (last visited aug. 2, 2006). 130. the streamlined sales and use tax agreement, at http://www.streamlinedsalestax.org (last visited aug. 2, 2006). 131. sellers without a physical presence in a state could not be compelled to collect tax on sales destined for that state, according to the u.s. supreme court’s decision in quill corp. v. north dakota, 504 u.s. 298 (1992). the stated goal of the sstp is to simplify and modernize sales and use tax administration in member states with an eye toward getting congress to overturn this decision. 132. these nineteen states are divided into two groups, the full members, and the associate members. a full member state is a state that is in compliance with the streamlined sales and use tax agreement through its laws, rules, regulations, and policies. those states are: indiana, iowa, kansas, kentucky, michigan, minnesota, nebraska, new jersey, north carolina, north dakota, oklahoma, south dakota, and west virginia. an associate member state is either (a) a state that is in compliance with the streamlined sales and use tax agreement except that its laws, rules regulations and policies to bring the state into compliance are not in effect but are scheduled to take effect on or before january 1, 2008, or (b) a state that has achieved substantial compliance with the terms of the streamlined sales and use tax agreement taken as a whole, but not necessarily each provision, and there is an expectation that the state will achieve compliance by january 1, 2008. those states are: arkansas, nevada, ohio, tennessee, utah and wyoming, see http://www.streamlinedsalestax.org (last visited aug. 2, 2006). streamlined sales and use tax agreement (ssuta). although130 nowhere near as advanced as the eu by idabc standards, efforts are underway in the u.s. to strengthen e-government capabilities. in the rst the most notable example is the streamlined sales tax. this effort broadly seeks technological solutions to the problems that beset the rst. the streamlined sales tax project (sstp) was organized in march 2000, largely in response to the states’ perception that they were losing sales tax revenue from increasing online sales. after five years of effort, ssuta came131 into effect on october 1, 2005. it has an initial governing board of nineteen states.132 2006] biometrics: solving the regressivity of vats and rsts 695 133. those states are kentucky, michigan, nebraska, new jersey and west virginia, see http://www.streamlinedsalestax.org (last visited aug. 2, 2006). 1 3 4 . t h o s e s t a t e s a r e a r k a n s a s a n d u t a h , s e e http://www.streamlinedsalestax.org (last visited aug. 2, 2006). 135. streamlined sales and use tax agreement, supra note 130, at § 318(d) (indicating that the intent of the ssuta is to facilitate electronic filing of returns in all jurisdictions under the agreement.) 136. id. at §§ 318(a); 318(b). 137. id. at § 325. 138. id. at §§ 303; 401(a); 401(c); 404. 139. member states must provide an amnesty for uncollected or unpaid sales and use tax (together with penalty or interest) to a seller that registers under the agreement, provided the seller was not registered in that state in the 12-month period preceding the state’s participation in the agreement. sellers must register within 12 months of the state’s participation to benefit, and the amnesty does not apply to matters for which the seller has received notice of the commencement of an audit. 140. streamlined sales and use tax agreement, supra note 130, at § 203 (defining a certified service provider (csp) as “[a]n agent certified under the of the thirteen states that were identified by the fta as having significant paper return obligations for the rst, five of them are among the thirteen founding “full” members of the ssuta. two others are “associate”133 founding members of the ssuta. participation in ssuta by these states is134 significant, because ssuta states have agreed to harmonize their tax bases, standardize their electronic reporting requirements, restrict jurisdictional135 reporting obligations for local rsts to state level filings, and generally streamline the collection of state and local rsts. a standardized system for136 refunds is also established, both for end consumers, and for businesses remitting the tax.137 on october 1, a centralized online registration system, and an138 amnesty for qualifying sellers came into effect. registration constitutes an139 agreement by sellers to collect and remit tax for sales into all full member states. this registry will function like the registration system under the digital sales directive where non-established taxpayers (non-eu businesses) receive a unique identification number that is recognized for vat purposes throughout the eu in a very real sense the ssuta is an agreement between governments and business to technologically simplify and harmonize the rst in exchange for a sincere effort by business to increase voluntary collection. 1. digital intermediaries – certified service providers (csps). the concept of a digital intermediary is the most innovative aspect of the ssuta. there are two aspects to the digital intermediary, both involve certified software programs – the first is the certified service provider (csp)140 696 florida tax review vol. 7:10 agreement to perform all the seller’s sales and use tax functions, other than the seller’s obligation to remit tax on its own purchases.”). 141. id. at § 202 (defining a certified automated system (cas) as a “[s]oftware certified under the agreement to calculate the tax imposed by each jurisdiction on a transaction, determine the amount of the tax to remit to the appropriate state, and maintain a record of the transaction.”). 142. id. at § 207 (defining a certified proprietary system (cps) as the system owned by “[a] seller that has sales in at least five member states, has total annual sales of at least five hundred million dollars, has a proprietary system that calculates the amount of tax due each jurisdiction, and has entered into a performance agreement with the member states that establishes a tax performance standard for the seller.”). 143. in 2001 four states (kansas, michigan, north carolina, and wisconsin) participated in a pilot project to test the csp concept. three firms applied to participate as csp’s, (taxware international, pitney-bowes/vertex, and e-salestax), two were certified as csps, (taxware international, pitney-bowes/vertex). the pilot project was successful in establishing the viability of the csp concept. the streamlined sales tax project web site indicates: “the pilot project established that the use of a third-party provider was viable. systems and procedures were established that resulted in the actual collection and remittance of sales and use tax by a vendor on behalf of a retailer. knowledge and experience was obtained by the participating states and vendors.” see http://www.streamlinedsalestax.org (last visited aug. 2, 2006). 144. streamlined sales and use tax agreement, supra note 130, at §§ 501(a), (b), (c) and (d). – the second is the certified automated system (cas) or certified proprietary141 system (cps). only the csp will be considered here. the csp, cas and cps142 are considered in more detail in part iii. ssuta provides for the certification of third-party service providers (csps), entities that will provide point of sale, automated tax determination143 systems for businesses. csps file returns and make tax payments for taxpayers. because the csps will function in this manner with respect to all144 rst obligations of the taxpayer in each of the streamlined states, the csp is essentially a private sector multi-jurisdictional one-stop-shop. if the ssuta were to be adopted by all the states with rsts, then the csp would handle rst obligations for all 7,588 jurisdictions. the csp would be the equivalent of the “member state of identification” under article 26c of the sixth directive. in both instances the taxpayer enters into a voluntary relationship with a third party who then interface with each of the governments concerned. the three critical differences between the eu and u.s. approaches are: (1) where article 26c uses the treasury of one of the member states as the intermediary, the ssuta uses a private sector third-party provider, (2) where the taxpayer under article 26c remains the party obligated to determine the tax amount due, under the ssuta it is the csp who actually performs the calculations with software certified by the government concerned, and (3) where 2006] biometrics: solving the regressivity of vats and rsts 697 145. uniform sales and use tax administration act [usuta] (as approved on dec. 22, 200, and as amended on jan. 22, 2001) § 9(a) (indicating that, “a seller that contracts with a certified service provider is not liable to the state for sales or use tax due on transactions processed by the certified service provider unless the seller misrepresented the type of items it sells or committed fraud. in the absence of probable cause to believe that the seller has committed fraud or made a material misrepresentation, the seller is not subject to audit on the transactions processed by the certified service provider. a seller is subject to audit for transactions not processed by the certified service provider.”) the usuta is the “enabling” legislation that authorizes a state’s participation in the ssuta. 146. however, depending on the payment arrangements, the taxpayer may (but not necessarily) looses the value of the “float” on monies drawn from the taxpayer’s account to pay the taxes due. the interest earned between the time of this withdrawal and the due date of the payment to the government may be a “cost.” 147. streamlined sales and use tax agreement, supra note 130, at § 328 (indicating that the states have an obligation to provide a taxability matrix of rate and product or service taxability in a downloadable format. csps and sellers are relieved of liability for collecting the wrong amount of tax if they relied on erroneous data provided in the matrix); and § 304 (indicating that the state rate or base changes will only be effective on the first day of a calendar quarter, and are obligated to provide as much advance notice of changes as possible). 148. id. at § 306. 149. com(2005)334 final supra note 124. taxpayers under article 26c remain subject to normal audit in all jurisdictions, under the ssuta the taxpayer will be subject only to limited audit for fraud.145 under both article 26c and the ssuta the use of intermediaries (the government or the private sector) comes at no cost to the taxpayer. however,146 under the ssuta there is a clear expectation of cooperation between the taxation authorities and the csp in terms of providing accurate and timely information about changes in rates or other critical tax determinants. csp’s147 are expressly relieved of liability from having charged and collected an incorrect amount of tax, if the error was due to erroneous data provided by the state.148 thus, while article 26c offers breadth of digital intermediary functionality (all 25 eu countries are covered) for non-established businesses selling to final consumers, the ssuta’s csp offers depth of digital intermediary functionality (full calculation, reporting and payment of obligations) for all of the states joining the sst. as would be expected, efforts are underway in the eu to extend article 26c to b2b transactions, and under149 the ssuta to expand state membership. consumption taxes, both vats and rsts, are on the cusp of a digital revolution. pilot programs in the eu and u.s. have proven that this tax is particularly receptive to digitization. efficiencies of the marketplace, demands of the tax administration as well as the sheer volume of transactions involved in these taxes make the digital solution optimal. although the “smart” id does 698 florida tax review vol. 7:10 150. eric woodman, information generation: berkeley study measures gargantuan information boom, emc2, at http://www.emc.com (last visited aug. 2, 2006) referencing school of information management and systems at the university of california at berkeley, how much information? (2000). not need a fully digital consumption tax regime to deliver a certificate of exemption, a fully digital consumption tax would make the operation of the system seamless. both record-keeping and verification requirements would be far simpler. thus, if the eu and u.s. “pilots” can be deemed a success, it is time to consider expansion of these digital regimes. however, in all of these efforts to digitizing the consumption tax, both in the eu and in the u.s., the sticking point has never really been the ability to digitize, but it has rather been with verification – how do we know that what was digitized was accurate. in this regard, the final piece of the regressivity puzzle in consumption taxes is the certification of the tax calculation software. part iii: certified tax compliance software almost all business information today – including the critical data needed for determining consumption taxes – is digitized. digitizing business data has not been a problem for some time now. the problem has been in the controls – in what has been done with the data. the solution to this problem, one that has been broadly applied from tax administrations to security regulators, has been to certify (pre-audit and confirm) the accuracy of the software and computer systems that control the data. corporate governance reform on a global scale in the wake of enron and other accounting failures have focused attention on the certification of financial data and processes – certifications of profits, losses and more comprehensively of the cash flow itself. in addition, certification is required of the internal controls over the data and systems. in this context therefore, it stands to reason that as traditional paper-based consumption tax regimes are being replaced by fully digital tax systems, that government certification of the accuracy of taxpayer’s automated tax calculation systems are coming to the forefront of tax policy discussions. tax compliance is, after all, simply a subset of the larger field of accurate enterprise-wide financial reporting. a. the digital context in 2000 the university of california at berkeley’s school of information management systems conducted the first study of newly created information, and demonstrated that 93% of the three billion gigabytes of data generated worldwide (using 1999 data) was computer generated. updated in150 2002, a new study reached much the same conclusions, and indicated (using 2006] biometrics: solving the regressivity of vats and rsts 699 151. peter lyman and hal r. varian, executive summary, school of information management and systems at the university of california at berkeley, how much information? (2003) (oct. 27, 2003) at http://www.sims.berkeley.edu (last visited aug. 2, 2006) (“how big is five exabytes? if digitized, the 19 million books and other print collections in the library of congress would contain about ten terabytes of information; five exabytes of information is equivalent in size to the information contained in half a million new libraries the size of the library of congress print collections.”). 152. id. at executive summary. 153. the sarbanes-oxley act of 2002 (p.l. 107-204, 116 stat. 274.101) at § 906. (amending the criminal code and imposing a fine of not more than $1,000,000 and 10 years in prison, or both, for a signing officer who certifies a report “knowing” it to be false. for a “willful” violation the penalties rise to not more than $5,000,000, 20 years in p r i so n , o r b o th . ) t h e fu l l te x t o f th e la w is a t 2001 and 2002 data) that “. . . about 5 exabytes of new information [was]151 created in 2002. ninety-two percent of the new information was stored on magnetic media, mostly hard disks. . . . film represented 7% of the total, paper 0.01%, and optical media 0.002%.” thus, it may be presumed that almost all152 enterprise source data content for operations, accounting, audit, as well as tax filing, financial reporting, regulatory submissions, and almost all other purposes is digitized both in generation and in storage. in other words, there is no paper and ink parentage for most source documents. thus, if the provenance of almost all enterprise data is digital, not physical, it makes sense to determine, collect, report, and enforce transaction tax obligations digitally. in addition, if the trend in transaction taxes is for fully digital vats and rsts, then it only makes sense for tax administrations to move in the direction of certifying the output of the systems that determine and report the taxes that are due. the oecd has proposed a multi-jurisdictional certification for automated vat systems, and the streamlines stales and use tax has begun certifying rst systems in the u.s. the certification of transaction tax compliance systems is especially welcomed by businesses, particularly the large multinationals that are being pressed to certify enterprisewide financial processes by the sarbanes-oxley act of 2002 and related foreign governance rules. 1. certification of enterprise data a. the 90-day certification cycle of sarbanes-oxley and other governance regulations for the largest businesses, the certification of tax data is a subset of a larger movement compelling the business, the c.e.o., and the c.f.o. to certify the accuracy of financial records. the sarbanes-oxley act of 2002153 700 florida tax review vol. 7:10 http://www.law.uc.edu/ccl/soact/soact.pfd (last visited aug. 2, 2006). 154. see wardell, thomas, international accounting standards in the wake of enron: the current state of play under the sarbanes-oxley act of 2002, 28 n.c. j. int’l l. & com. reg. 935 (2003); note, the good the bad and their corporate code of ethics: enron, sarbanes-oxley, and the problems with legislating good behavior, 116 harv. l. rev. 2123 (2003). 155. france responded to enron with the loi de sécurité financière. it was approved 17 july 2003, and published 2 august 2003. the law is published in the o f f i c i a l f r e n c h j o u r n a l , 2 a u g u s t 2 0 0 3 . i n f r e n c h a t http://www.legifrance.gouv.fr/waspad/untextedejorf?numjo=ecox0200186l (last visited aug. 2, 2006). 156. australia began a comprehensive corporate law economic reform program in 1997 (the clerp initiative). the ninth package reforms in this initiative took up the enron issue of auditor independence. corporate disclosure: strengthening the financial reporting framework, is referred to as clerp 9. the reform program was presented to parliament on december 2, 2003. the complete legislations package can be found at http://www.treasury.gov.au/documents/700/pdf/clerp_bill.pdf (last visited aug. 2, 2006). 157. japan’s response had two aspects: (a) it amended the “certified public accountant law” (kouninkaikeishihou 1948-8-1) through “an act to amend part of the certified public accounting law” (kouninkaikeishihou no ichibu wo kaisei suru houritsu 2004-4-1), and (b) it issued cabinet office ordinances (naikakuhurei 2004-41). in the law, promulgated june 6, 2003, a new government oversight and inspection agency, the cpa and auditing oversight board (cpaaob) was established. in article 5 of the related cabinet ordinance, rules on auditor independence were published. these rules are a literal translation of sox. the japanese law and ordinances were effective april 1, 2004. 158. directive 2006/43/ec of the european parliament and of the council of 17 may 2006 on statutory audits of annual accounts and consolidated accounts, amending council directives 78/660/eec and 83/349/eec and repealing council directive 84/253/eec, 2006 o.j. (l157) 87 at http://europa.eu.int/eurlex/lex/johtml.do?uri=oj:l:2006:157:som:en:html (last visited aug. 2, 2006). mandates wide-ranging reforms in the public company financial reporting process. the act attempts to restore confidence in the management of public companies following the post-enron outcry over the accounting problems that shook investor confidence in the us securities market. identifying trusted providers of essential tax services for global businesses is close to the heart of this legislation.154 sarbanes-oxley however, does not stand alone. similar legislation has been enacted in france, australia and japan. additional legislation is155 156 157 planned in each of the 25 countries of the european union following recent modification of the eighth corporate directive. in part, these countries are158 following a us lead, but they are also responding to their own domestic, enronlike financial collapses. australia witnessed the collapse of hih (march, 2006] biometrics: solving the regressivity of vats and rsts 701 159. hih was the largest general insurance company in australia. accounting entries hid claims that exceeded accounting reserves, forcing the company’s liquidation. see hih royal commission (justice neville owen), report of the hih royal commission, 2003 at http://www.hihroyalcom.gov.au/finalreport/ (last visited aug. 2, 2006), and m. de martinis, do directors, regulators, and auditors speak, hear and see no evil? evidence from the enron, hih and one.tel collapses, 15 aust. j. corp. l. 66 (2006). 160. one.tel was one of australia’s largest telecommunications companies. one.tel paid high performance bonuses to the directors as the company was on the verge of collapsing. that internal incentives could have rewarded directors of a failing company outraged australians and accelerated reform efforts there. 161. in ahold earnings were overstated due to improper booking of supplier discounts. 162. in parmalat $3.5 billion in false assets were recorded in caymen island subsidiaries. 163. brian kim, recent development: sarbane-oxley act, 40 harv. j. on legis. 235 (2003). 164. considerable academic debate has focused on the global convergence of corporate governance practices. see lucian a. bebchuck & marc j. rowe, a theory of path dependence in corporate ownership and governance, 52 stan. l. rev. 127 (1999); amir. n. licht, the mother of all path dependencies toward a cross-cultural theory of corporate governance systems, 26 del. j. corp. l. 147 (2001); larry e. ribstein, politics, adaptation and change, 8 aust. j. corp. l. 246 (2001); roberta romano, a cautionary note on drawing lessons from comparative corporate law, 102 yale l. j. 2021 (1993). some have seen this convergence “coinciding with the civil/common law divide,” see paul von nessen, corporate governance in australia: converging with international norms, 15 aust. j. corp. l. 1, 47, n. 73 (2003) citing further to paul g. maloney, the common law and economic growth: hayek might be right, 30 j. leg. stud. 503 (2001). 2001) and one.tel (july, 2001). in france there were serious corporate159 160 governance problems with vivendi (july 2002), in the netherlands there was the near bankruptcy of ahold (february, 2003). in italy parmalat (february,161 2003) faced corporate fraud accusations and near collapse. 162 without question, management practices within the world’s largest corporations are changing. if regulatory authorities achieve a global163 convergence of these standards the contours of this change may be uniform.164 without convergence, certification requirements become more cumbersome and may vary depending on where business is conducted and which financial markets are accessed. however, regardless of the specific rules, the means employed to comply with these certifications is not in doubt. it will be a digital compliance conducted as often as possible through certified systems. the reason for this is (a) the timing of the certifications (every 90 days in some instances) and (b) the severity of the penalties. 702 florida tax review vol. 7:10 165. the concern with cash flow accountability constitutes a change in emphasis for the sec. securities and exchange commission, final rule: certification of disclosure in companies’ quarterly and annual reports, (rin 3235-ai54) at ii(b)(3) indicating: the certification, as adopted, states that the overall financial disclosure fairly presents, in all material respects, the company’s financial condition, results of operations and cash flows. we have added a specific reference to cash flows even though §302 of the act does not include such an explicit reference. we believe that it is consistent with congressional intent to include both income or loss and cash flows within the concept of “fair presentation” of an issuer’s results of operations. the certification statement regarding fair presentation of financial statements and other financial information is not limited to a representation that the financial statements and other financial information have been presented in accordance with “generally accepted accounting principles” and is not otherwise limited by reference to generally accepted accounting principles. we believe that congress intended this statement to provide assurances that the financial information disclosed in a report, viewed in its entirety, meets a standard of overall material accuracy and completeness that is broader than financial reporting requirements under generally accepted accounting principles. in our view, a “fair presentation” of an issuer’s financial condition, results of operations and cash flows encompasses the selection of appropriate accounting policies, proper application of appropriate accounting policies, disclosure of financial information that is informative and reasonably reflects the underlying transactions and events and the inclusion of any additional disclosure necessary to provide investors with a materially accurate and complete picture of an issuer’s financial condition, results of o p e r a t io n s and cash f lo w s . (e m p h a sis a d d e d ) , a t http://www.sec.gov/rules/final/33-8124.htm (last visited aug. 2, 2006). consider just the u.s. legislation. § 302 of sarbanes-oxley required the sec to adopt rules mandating that the principal executive officer(s) and the principal financial officer(s) certify in each quarterly and annual report that there are no untrue statements of material fact or omission, and that the financial statements fairly present the financial condition and operation of the company. in addition, § 404 of sarbanes-oxley requires an annual certification of the “effectiveness of the internal control structure and procedures for financial reporting.” thus, there are quarterly certifications of the results and annual certifications of the system. transaction taxes are a major aspect of this certification, because final sec regulations consider financial control over cash flow to be as important165 2006] biometrics: solving the regressivity of vats and rsts 703 166. u.s. securities and exchange commission, rin 33-8124: “final rule: certification of disclosure in companies’ quarterly and annual reports,” (aug. 29, 2002, effective date) at www.sec.gov/rules/final/33-8124.htm (last visited aug. 2, 2006). 167. sarbanes-oxley act of 2002, supra note 153, at § 906 (indicating that a knowing violation of the certification provisions carries up to a $1,000,000 fine, 10 years imprisonment, or both, and that willful violations carry up to a $5,000,000 fine, 20 years imprisonment, or both). 168. id. at § 304. 169. id. at § 308. 170. id. at § 1105. 171. id. at § 804. 172. id. at § 1106. 173. id. at § 1106. 174. nasdaq, summary of nasdaq corporate governance proposals as of february 26, 2003 (2003) (revising the earlier november 20, 2002 proposals) at 4-5 at http://www.nasdaq.com (last visited aug. 2, 2006); new york stock exchange, corporate governance rule proposals reflecting recommendations from the nyse corporate accountability and listing standards committee (as approved by the nyse board of directors august 1, 2002) at 17-18 at http://www.nyse.com/pdfs/corp (last visited aug. 2, 2006). 175. sarbanes-oxley act of 2002, supra note 153, at § 302 (setting out the requirement that there must be quarterly “discloser controls and procedures” by ceo and cfo’s); u.s. securities and exchange commission, rin 3235-ai54 “certification of disclosure in companies’ quarterly and annual reports” (aug. 28, 2002, release as financial control over profit and/ or loss. transaction taxes – calculated on166 a percentage of gross sales (normally between 10 and 25%) – are almost always material cash-flow figures. b. false certifications under sections 302 and 404 are criminalized167 new penalties have been created; traditional penalties have been expanded. the penalties are directed at both individuals and companies. if financial statements need to be restated due to material non-compliance senior management may have to return bonuses, and profits must be disgorged.168 169 violators can be barred from future public company service. fines are170 increased, sentences increased, and sentencing guidelines have been171 172 tightened. systemic errors that point to the design of internal controls over173 cash flow need to be disclosed and quickly remedied. to fail to do so would risk the delisting of corporation from exchanges.174 the reach of sarbanes-oxley (to say nothing of the related foreign legislation) is global – sections 302 and 404 and related penalty provisions apply not only to domestic companies, but extend to foreign issuers. and to175 704 florida tax review vol. 7:10 date; august 29, 2003, effective date) (expressly extending this rule to foreign issuers and their ceo’s and cfo’s) at www.sec.gov/rules/final/33-8124.htm (last visited aug. 2, 2006). sarbanes-oxley act of 2002, supra note 153, at § 404 (setting out the requirements for “internal controls over financial reporting” by ceo’s and cfo’s); u.s. securities and exchange commission, rin 3235-ai66 “management’s report on internal control over financial reporting and certification of disclosure in exchange act periodic reports” (june 5, 2003, release date; august 14, 2003, effective date) (similarly expressly extending this rule to foreign issuers and their ceo’s and cfo’s) at www.sec.gov/rules/final/33-8238.htm (last visited aug. 2, 2006). 176. securities exchange act of 1934, 15 u.s.c. sections 78 et seq. 177. oecd, electronic commerce: taxation framework conditions 5 (oct. 8, 1998) (setting out the framework principles of a consumption tax as: (a) taxation should be in the place of consumption, (b) digital goods should be taxed as services, (c) imported services and intangible products should be reverse charged, and (e) cooperative systems be put in place to collect taxes. in tax administration the framework established principles (a) to develop electronic signature ids, (b) to reach international agreement on accepting digital signatures, and (c) to develop make matters even more serious, § 3 of sarbanes-oxley makes any violation of the act also a violation of the securities exchange act of 1934, opening the176 door for shareholder suits under § 10b-5. 2. tax application – certification of automated consumption tax software solutions to satisfy vat and rst collection and reporting obligations globally, multinational companies have for a long time turned to software solutions. two parallel efforts are underway to develop comprehensive certification regimes for transaction tax software, one for vats under the direction of the oecd, and another for the rst under the ssuta. the regimes are similar, but reflect the different realities of the multi-national effort in vat certification and the purely domestic, multi-state effort in the u.s. rsts. 3. oecd – from ottawa to tax software certification the availability of software packages that effectively determine the full range of global vat obligations has been a recognized fact of business life for over a decade. these packages automatically identify taxable transactions, make an accurate calculation of tax, and provide for the automated production of returns, or perform electronic filing. tax payments, refunds, and tax audits can all be carried out electronically. these software solutions have been a topic of continued interest in the oecd the 1998 ottawa ministerial conference initiated a public discussion on issues in e-commerce with the taxation framework conditions. the ottawa177 2006] biometrics: solving the regressivity of vats and rsts 705 internationally compatible information requirements for record retention, record format, access to third party database arrangements, and agreed periods for record retention) at http://www.oecd.org (last visited aug. 2, 2006). 178. oecd, report by the consumption tax technical advisory group (tag) (dec. 2000) (considering place of consumption, tax collection options, consumption tax barriers to e-commerce development, and a simplified interim approach) at http://www.oecd.org (last visited aug. 2, 2006); oecd, report by the technology technical advisory group (tag) (dec. 2000) (considering the technological implications of various e-commerce collection models, and making recommendations for further research) at http://www.oecd.org (last visited aug. 2, 2006); oecd, consumption tax aspects of electronic commerce: a report from working party no. 9 on consumption taxes to the committee on fiscal affairs (feb. 2001) (assessing and consolidating the work of the tags completed the previous year) at http://www.oecd.org (last visited aug. 2, 2006); oecd, implementation of the ottawa taxation framework conditions (2003) (assessing progress since ottawa and setting out the research goals in third party providers, certified software, audit interface for remote enforcement in consumption taxes) available at http://www.oecd.org (last visited aug. 2, 2006); directorate for financial, fiscal and enterprise affairs, committee on fiscal affairs, oecd report on automating consumption tax collection mechanisms, (daffe/cfa(2003)43/ann5) (july 1-2, 2003) at http://www.oecd.org (last visited aug. 2, 2006). 179. oecd, consumption tag, supra note 178, at 8 (discussing how “business members feel strongly the simpler the solution, the greater the level of compliance would be and that future requirements should leverage the developments of commercial business models.”) 180. oecd, technology tag, supra note 178, at 14-90 (considering collection models, jurisdiction verification systems, party identification and classification systems, credit card applications, registration systems, the tax at source and transfer model, trusted third party models, hybrid tax and transfer and clearinghouse models, electronic payments, electronic invoicing, electronic remittance and reporting, electronic record integrity systems and electronic database solutions.) conference was followed by a series of reports that broadly examined tax law applications and the administrative impact of digital technology. throughout178 its work the oecd’s primary concern has been with the cross-border aspect of digital commerce. businesses pressed strongly, and the oecd conceded179 early, that globally effective e-solutions to consumption tax problems were already in place, and that these solutions, in aggregate, contained the elements of a fully digital compliance model. participation in global commerce was and180 is synonymous with participation in e-commerce and e-tax compliance. during the opening months of 2005 the oecd issued further reports. this time they focused on the use of certified intermediaries for determining, reporting and remitting cross-border consumption taxes. the oecd expressly anticipates the “emergence of global intermediaries” and is proposing standards 706 florida tax review vol. 7:10 181. oecd, electronic commerce: facilitating collection of consumption taxes on business-to-consumer cross-border e-commerce transactions 9 (feb. 11, 2005) (“a global intermediary may be based in one country and would undertake intermediary activities in as many countries as suppliers are required to collect and remit consumption taxes on behalf of e-commerce suppliers. in cases where satisfactory levels of approval or financial security are evident, countries could be more relaxed …”) at http://www.oecd.org (last visited aug. 2, 2006). 182. oecd, guidance note: guidance for the standard audit file – tax (may, 2005) at http://www.oecd.org (last visited aug. 2, 2006). 183. oecd, guidance note: guidance on tax compliance for business and accounting software (may 2005) at http://www.oecd.org (last visited aug. 2, 2006). 184. oecd facilitating collection, supra note 181, at 10 & 17-21; oecd, automating consumption, supra note 178, at 10-14 at http://www.oecd.org (last visited aug. 2, 2006). 185. oecd, guidance note: accounting software 11 (indicating that, “[t]his guidance is published at a time when corporate governance is under scrutiny as never before, as governments worldwide demonstrate a firm resolve to increase corporate responsibility and accountability through legislations such as the sarbanes-oxley act in the us, and the eu ruling that all listed companies in europe must adopt the international financial reporting standards by 2005 at the latest. this guidance does not deal with corporate governance issues specifically, but its key principles, especially in the establishment of internal controls and access to data entry for compliance and substantive testing of these controls will be a useful tool in enabling businesses to meet the essential requirements of this type of legislation.”) at http://www.oecd.org (last visited aug. 2, 2006). 186. streamlined sales and use tax agreement, supra note 140 at § 203. 187. streamlined sales and use tax agreement, supra note 140 at § 203. for their certification in consumption tax matters. guidance notes are181 available on the proper structure, format, and application of an e-tax audit file,182 as well as on the evaluation of tax accounting software. these oecd183 guidance notes are a first effort to develop a tax-specific international software certification regime. it is clear that the oecd anticipates the development of software certification programs similar to those under the ssuta. some vat system certifications may be single-jurisdiction based, while others may be multi-jurisdictional. the oecd’s work expressly references the software certification aspects of ssuta they also expressly link the vat software-184 standard setting effort to the rules of corporate governance under the sarbanesoxley act, and the international financial reporting standards that became mandatory throughout the eu by the close of 2005.185 4. ssuta – reality of rst software certification the ssuta provides three models for software certification: the certified service provider (csp); the certified automated system (cas); and186 187 2006] biometrics: solving the regressivity of vats and rsts 707 188. streamlined sales and use tax agreement, supra note 142 at § 207. 189. in 2001 four states (kansas, michigan, north carolina, and wisconsin) participated in a pilot project to test the csp concept. three firms applied to participate as csp’s, (taxware international, pitney-bowes/vertex, and e-salestax), two were certified as csps, (taxware international, pitney-bowes/vertex). the pilot project was successful in establishing the viability of the csp concept. the streamlined sales tax project web site indicates: “the pilot project established that the use of a third-party provider was viable. systems and procedures were established that resulted in the actual collection and remittance of sales and use tax by a vendor on behalf of a retailer. knowledge and experience was obtained by the participating states and vendors.” see http://www.streamlinedsalestax.org (last visited aug. 2, 2006). 190. streamlined sales and use tax agreement, supra note 130 at § 501 (c) and (d). 191. uniform sales and use tax administration act, supra note 145 at §§ 9(b) and (c) (for cas and cps respectively). 192. stephen moore, an uneasy marriage: sellers and certified service providers, 21 j. state tax’n 65, 72 (2003). (“the relationship [between sellers and service providers] is inherently adversarial and each party needs to develop audit strategies for protecting itself from the other party in what may prove to be an unhappy marriage for these partners in commerce. . . . can csps audit sellers to determine whether there is probably cause to believe that a seller has committed fraud or made a material misrepresentation?” moore asks what would happen if a seller simply provides faulty information to the csp without, rising to the level of misrepresentation or fraud, but there tax collection was short nevertheless?). 193. american institute of certified public accountants, professional standards, vol. 1 au § 319 the effect of information technology on the auditor’s consideration of internal control in a financial statement audit, as amending sas no. 55 consideration of internal control in a financial statement audit. the certified proprietary system (cps). in 2001 the viability of the csp model188 was successfully tested in a pilot project, and on june 1, 2006 three software189 companies, taxware, l.p., exactor and avalara, became the first three csps. taxware additionally was certified as a cas. the other certifications provided by the ssuta, the certified automated system (cas) and the certified proprietary system (cps), allow for the certification of automated systems that are kept in-house. in these cases190 the relief from liability is dependent on the taxpayer properly using the certified system. questions about liability allocation among all these systems (csp,191 cas and cps) remain, and as with all yet-to-be-fully-implemented programs, are best considered as “works-in-progress” until they become fully operational in the states.192 the ssuta certification process involves measuring software against three third party standards; (1) the aicpa’s sas 94 and (2) the usgao193 708 florida tax review vol. 7:10 194. u.s. government accounting office, accounting and information management division, federal information systems control audit manuel, (fiscam) vol. 1 (gao-aimd12.19.6) at http://www.gao.gov/special.pubs/ai12.19.6.pdf (last visited aug. 2, 2006). 195. international organizations for standardization, iso 17799: information technology, security techniques, code for information security management (iso/iec 17799:2005). 196. streamlined sale tax project, certification standards (rev. 5/17-04) (provides a detailed application of sas 94, fiscam and iso 17799 to the ssuta) at http://www.streamlinedsalestax.org/ (last visited aug. 2, 2006). 197. oecd facilitating collection, supra note 181, at 17-18 (discussing a range of government “approvals” for tax accounting software and indicating that at one extreme is “accreditation” – an approval process functions simply as a mechanism to “formally identify” software that meets certain criteria of acceptability – while at the other extreme is “certification” – an approval process that designates software as “an officially authorized mechanism to perform specified functions” – reaching a conclusion that the ssuta the oecd uses the term “certification” in this same manner even though the oecd discussion is broader than that found in ssuta documents) at http://www.oecd.org (last visited aug. 2, 2006). federal information systems control audit manual. in addition, csp’s and194 cas software developers must comply with (3) iso number 17799 of the195 international organization for standardization. a similar expectation for196 objective standards for certification is discussed in the oecd materials.197 essentially the ssuta certification is conducted in two steps; (1) an extensive security check of the software system, the developer and the service provider, and (2) a comprehensive test of tax calculation and return preparation capabilities is carried out by running hypothetical tax scenarios through the system. it is a relatively easy matter for an automated tax calculation system to match up the skew code of a good or service purchased with a tax rate to determine the tax due. it is not at all a large leap in technology for a tax calculation system to be programmed to recognize that a different rate should be applied where an exemption (or zero-rating) code is received from a “smart” id that is passed during the purchasing process. from a systems perspective the question presented is no different than that presented when the same item is processed through a system, but for multiple taxing jurisdictions. different jurisdictions frequently have different rates and reporting requirements for the same items. this is no different. rather than performing a multi-jurisdictional discrimination for the same product, in this instance the system is asked to discriminate within the same jurisdiction among both products and purchasers based on a certificate embedded in a “smart” id. thus, because highly discriminatory, multi-jurisdictional tax calculation systems are currently being certified today under the ssuta, it is not difficult to imagine that the same type of discrimination function (within a single 2006] biometrics: solving the regressivity of vats and rsts 709 198. see supra note 11 and accompanying text. 199. due & mikesell, supra note 8 at 74 (indicating that the exemption for food products for human consumption reduces the tax base by 20-25%). 200. bird & gendron, supra note 8 at 10, table 2.1 (listing the french vat rates at 19.6%; 5.5% and 2.1%; with regional rates of 0.9%, 2.1%, 8.0% 13.5% and 19.6% in corsica; rates of 1.05%, 1.75%, 2.1% and 8.5% in the french overseas departments with the exception of french guyana). jurisdiction) can similarly be certified as accurate. this functionality only waits for the embedding of certificates of exemption into “smart” ids. the certified automated tax calculation system therefore completes the circle. for the first time, a consumption tax can now be designed that is progressive, and which will utilize exceptionally broad bases without burdening the poor. this new breed of consumption taxes can be simplified through the imposition of a single rate for all consumption. the only exceptions will be for transactions where a digital exemption certificate is passed through a scanner when the purchase of goods or services is consummated. if the tax system itself is set up to accept digital processing of returns, digital invoices, and electronic funds remission as well as the other myriad of compliance requirements, then a robust and certified tax calculation system will assure not only the accuracy of the tax, but the accuracy of all reporting obligations in a real-time, preaudited format. part iv: conclusion and proposal surgically targeting consumption tax relief regressivity is an inherent problem of the consumption tax. in traditional form consumption taxes burden the poor more heavily than the wealthy because the poor consume all of their income whereas the wealthy consume only a portion of it. what the wealthy save is not taxed. 198 although surgical options that would exempt specific individuals-inneed when they purchase identified products have been considered before, the volume of transactions that pass through a broad-based consumption tax simply exceed the capacity of paper-intensive systems to handle them. as a result, when a consumption tax provides relief to those in need, it does so through universal exemptions and/ or multiple rates. even though these relief mechanisms are themselves a problem, there is little aside from tax theory to oppose them. these relief efforts either drastically compromise the base, or199 seriously complicate the taxing mechanism. 200 technology offers an answer. consumption taxes (both vats and rsts) can benefit from three technological advances: (1) widespread adoption of national identity smart cards embedded with biometric identifiers; (2) fully digital consumption tax regimes; and (3) certified consumption tax software solutions. the tax policy opportunity is to harness these developments – to do 710 florida tax review vol. 7:10 201. the range of possible difficulties here should not be minimized. accuracy is at a premium. “false positives” and “false negatives” are possible under both criteria. it is a problem if ineligibles enroll, just as it is a problem if eligible individuals or entities are not able to enroll. secondly, even if an accurate target population is identified the system must accurately verify that only those individuals are actually making the purchases – a second chance for false negatives and positives to impact the system. more than passively observe the linear function creep of this technology into the consumption tax field. the opportunity is to use technology to design the first broad-based, single rate consumption tax that is truly and independently progressive. a. inverting the argument the argument of this paper can be summarized by turning it on its head. if we consider the establishment of a truly progressive consumption tax from the perspective of the barriers that have prevented it, rather than from the perspective of the technology that now enables it, we see three distinct problems. (1) the fraud problem – how to assure that only those entitled to make exempt purchases are allowed to do so. (2) the surgical capacity problem – how to design a system that is capable of sifting through thousands of transactions, selecting only those that qualify for exemption, and then taxing the rest without interrupting the efficient flow of commerce. (3) the audit/ compliance problem – how to effectively audit a system where exempt transactions are not singularly tied to the type of good or service provided by the supplier, but are instead tied to the dual requirements of an entitled individual and a designated supply. 1. the fraud problem. there are two aspects to the fraud problem – targeting and201 verification. the tax system is compromised if unauthorized individuals or entities are able to bypass security, and enroll in the group targeted for exemption. thus, targeting must be accurate. in addition, once the target group is identified fraud prevention requires controls so that only individuals (or 2006] biometrics: solving the regressivity of vats and rsts 711 202. unresolved, the fraud problem alone is sufficient to kill a program of targeted exemptions. for example, after examining the costs of the government’s general subsidy on propane, the dominican republic determined in 2001 that it would replace this subsidy with a program of coupons that would target the poor who used propane for heating an cooking. others would pay market prices for propane. the coupon program was projected to be a less costly and more economically rational way to provide assistance. within two years the program failed. the failure was due in part to the inability of the government to effectively target individuals in need (an effort that needs to begin well in advance of the termination of the subsidy), and in part due to official corruption. government subsidy coupons soon became available on the black market. those with access to coupons effectively split the value of the discount with commercial enterprises. in 2003 the general subsidy was reintroduced, even though it was clear that 70% of all propane consumption was by businesses (transportation, hotels and other private industries) and 30% was consumed by households (the rich, middle class and poor combined). litigation in various fraud enforcement actions is ongoing. personal communication, ramon frias, (former) deputy director of the general directorate on internal taxes (dominican republic) july 5, 2005 (on file with author). 203. ferdinando regalia & marcos robles, social assistance, poverty and equity in the dominican republic 10-13 (inter-american development bank, re2-05007, dec. 2005) (indicating that targeting can work in developing countries, but that design and implementation details have a considerable effect on the final distributional outcome of the effort, and emphasizing the importance of (1) a consolidated national database, (2) proper identification of individuals, (3) updating an re-certification of databases, and (4) database management needs to be flexibly designed). 204. id. at 12 & n. 25 (indicating that targeting social programs to the poor in the dominican republic was difficult because as much as 25% of the population that would qualify as poor lacked personal identification documents, and that in other countries (mexico and nicaragua) this targeting process was greatly facilitated by holograms and pictures on ids issued by the social service agency). entities) within the target group are allowed to benefit from the exemption.202 thus, verification must be accurate. a. targeting targeting is a difficult and time-consuming task. it is not fully susceptible to automation. the most difficult part is making case-by-case entitlement judgments, a function normally performed by social services agencies, not the tax administration. in developing countries this targeting function has proven particularly difficult to carry out for a number of reasons,203 the most significant being that many of those in most need do not carry identity documents. 204 712 florida tax review vol. 7:10 205. see supra note 28 & 29 and accompanying text. 206. see supra notes 43 and accompanying text, 47, & infra appendix a at belgium and estonia. 207. see supra notes 42 and accompanying text, 47 & infra appendix a at austria, finland, italy, the netherlands, and sweden. 208. see supra note 47, infra appendix a at cyprus, france, germany, hungary, ireland, latvia, lithuania, malta, poland, portugal, slovakia, slovenia, spain, and the united kingdom, & note 55 and accompanying text. 209. electronic benefits transfer supra note 13 and accompany text. 210. richard hopkins, supra note 1, at 338-39 (indicating that,“[v]erification by biometrics asks the question ‘am i who i say i am?’ it works by comparing a previously stored piece of biometric data against an actual physical biometric as read by a scanner. typical applications for this technology are for gaining access to buildings or for proving entitlement to welfare payments. . . . identification by biometrics asks the wider question of ‘who am i?” it works by comparing a scanned biometric against a library of stored biometric data. in the idea form of the process each individual in the library is compared and the question ‘am i this person?” is asked. identification is therefore like a very long series of individual verifications. each such verification is known as a ‘match.’”). in this respect, a mandatory national id, like that currently in use in hong kong, brunei, malaysia, belgium and estonia would be helpful. a205 206 voluntary national id, like those now in use in austria, finland, italy, the netherlands, and sweden and soon to be implemented in cyprus, france,207 germany, hungary, ireland, latvia, lithuania, malta, poland, portugal, slovakia, slovenia, spain, the united kingdom, and the united states would208 be nearly as effective. if the “voluntary” nature of these ids is tied to other necessary privileges, like a driver’s license (as under the real id act of 2005) or the receipt of welfare entitlements (as in the los angeles welfare fraud prevention program) then these ids would become de facto mandatory ids. b. verification. once the target population is identified the success of smart id’s with biometric identifiers in preventing fraudulent entitlement claims is very good. this was the case in los angeles where over 3,000 fraudulent welfare cases were identified between 1991 and 1994 through the use of fingerprint biometrics in welfare-ids. saving over $14 million, the los angeles success story quickly lead to similar programs in connecticut, illinois, massachusetts, new jersey, new york, pennsylvania and texas. biometric ids can solve the209 fraud problem once the target group is identified. thus, verification of consumption tax exemptions is easily within the grasp of present technology. it is important to note that the biometric id is being asked to perform a verification function not an identification function. verification is cost210 effective and technologically viable today. identification, although 2006] biometrics: solving the regressivity of vats and rsts 713 211. arun a. ross, karthik nandakumar & anil k. jain, handbook of multibiometrics (2006) (discussing the current state of the science of digital identification systems operating through multibiometric identifiers). 212. richard hopkins, supra note 1, at 338-39, 347,& 362. this study contrasts the feasibility of biometric verification and biometric identification systems for a country with a population of approximately 25 million people. he concludes that a verification system is viable, but an identification system would be difficult to put in place today. essentially, “[b]iometric verification performs the same function as a pin number, password or signature, but involves measurements performed on a physical biometric . . . it is usually deemed to be more secure . . . [and has] a high degree of accuracy. . . . however, in a biometric identity system, just to be completely successful in determining that there are no duplicate identities, the system would effectively have to compare a new enrollee against all the people already enrolled in the database. thus, to enroll a single individual into a population of 1 million people, 1 million individual verifications would effectively need to be performed. imagining a system where 25 million people are enrolled at a steady rate of 5 million people per year over 5 years would require in the fifth year that each one of the 5 million people enrolled would have to be compared to over 20 million people already in the system. during this year over 100 million matches (asking ‘am i this person?’) will need to take place. “if we assume human experts were employed to operate the system and each individual match took 5 seconds for a highly trained person, over 3 million experts working round the clock would be necessary to cope with the workload!” . . . [thus,] [w]hat seemed at first to be a perfectly reasonable request: ‘establish unique identities for 25 million people within 5 years using biometrics’ now seems unreasonable.” under hopkins’ “reasonable assumptions” the underlying requirements of this identification system for 25 million people is in fact a request to implement a system that performs 3.5 million biometric comparisons per second, and at this throughput the system should ensure that for each comparison (a) only 1 in 20 true matches are missed and that (b) only 1 in 1,000 million non-matches are wrongly construed as matches. based on these requirements hopkins believes that it is “. . . unlikely that the us or an eu country will adopt a biometrically enabled identity system in the foreseeable future.” technologically possible usually requires multiple biometric identifiers and extensive data-base matching, is not presently financially manageable.211 212 2. the surgical capacity problem the concept of surgically exempting an identified segment of the population from a consumption tax is not new; having the technical capacity to do so is. in 1972 selma j. mushkin considered a very similar problem; the problem of exempting a target population on a graduated scale (based on family income) from government fees and charges imposed on necessary services. mushkin proposed using a variety of paper ids, credit cards, coupon books, 714 florida tax review vol. 7:10 213. each of these limitation can be encoded on a “smart” chip in an id: frequency of use, a period of time, age, changes in income levels, overall quantitative limits can be set as operative parameters determining whether or not the individual presenting the card will be allowed to purchase exempt from tax. 214. marjorie c. willcox & selma j. mushkin, public pricing and family income: problems of eligibility standards, in public prices for public products, 395, 407-08 (selma j. mushkin, ed., 1972). stamps, tokens or punch cards. limitations based on frequency of use, a period of time, age criteria, as well as adjustments for changes in income levels, probability of unauthorized use, and overall quantitative limits on benefits were accommodated as variables. 213 mushkin presented an “experimental demonstration” in the context of a school lunch program. the critical variable in this program was that bills for lunches would be sent home monthly to parents. this mechanism allowed time for making adjustments in the charges based upon family income levels. some would pay in full, others would pay at a discount, and still others would be fully exempt. she indicated: the experiment might be designed more or less as follows. each child in a school might be issued a numbered plastic card that could be read by a machine. on inserting the card in a computer card reader, the child is admitted to the lunchroom. the machine would scan each number presented to ensure (if repeated use is considered a problem) that the number had not been presented before during that particular meal period. if there are problems regarding card exchanges, or thefts, a random number generator can provide the basis for a quality control check on the match between card user and card ownership. the information is stored to be used to prepare monthly billing to all parents. the bill would be adjusted for the income of the parents on a sliding scale. thus, for example, lunch might be “free” to all children in families with an income equal to less than one and one-half times the current welfare maximum allowance for that size of family . . . . 214 this experiment contains the germ of the surgical exemption principle. its expression is hampered by the technology of the day. even though “. . . the proposed approach depends heavily upon a central computer with inexpensive remote readers,” micro-capacity chips and the flexibility of contemporary software applications are not contemplated. these missing pieces limit the vision of her experiment. 2006] biometrics: solving the regressivity of vats and rsts 715 215. benjamin higgins, self-enforcing incentive tax system for underdeveloped countries, in economic development: principles, problems and policies (1959) 531-532. there is no expectation that a single, secure id with biometric identifiers is possible; no vision that ids will have the capacity to record and immediately display qualifications to entitlement programs. thus, the horizon of the experiment is pulled back – simple credit purchases with time-delayed billings is what this example is all about. secondly, the prospect of an instantaneous exemption for a cash point-of-sale transaction is not imagined. the experiment does not anticipate that software programs will automate both the sales and exemption/ adjustment aspects of the transaction in real time. however, today we have the technical capacity to surgically exempt individuals from state-imposed charges on necessities in real time. it is technically no different for an individual to make a purchase with a credit card than it is for a person to swipe a national id authorizing a consumption tax exemption for designated purchases. thus, today’s technology removes the surgical capacity barrier to the establishment of a truly progressive consumption tax. 3. the audit/ compliance problem although mushkin’s experimental demonstration depends heavily upon a central computer with inexpensive remote readers, she does not speculate on the capacity of the digital economy. it would have been valuable if she had. fully automated transactional compliance, remote digital audits of businesses extending exemptions, is not contemplated. however, fourteen years earlier, in 1959, benjamin higgins, director of the mit center for international studies saw the contours and the tax compliance implications of a fully digital economy. higgins observed that such a system would allow for the dramatic streamlining of tax determination. the context was a tax advisory mission to indonesia. higgins indicates, it became apparent that conceptually simple extensions of existing statistical operations would permit the government to follow the flow of goods through every stage of the economy, providing the base for a completely efficient system of income, sales and excess inventory taxes. . . . with these materials an appropriate system of coding and [ibm computer] cards, it would be technically possible to compute for any period after the starting date, the average stocks, sales, and incomes of every firm.215 716 florida tax review vol. 7:10 216. supra at notes 150, 151, & 152 and accompanying text. 217. supra notes 130 to 148 and accompanying text. 218. supra notes 177 to 185 and accompanying text. 219. richard t. ainsworth, carousel fraud in the eu: a digital vat solution, 42 tax notes int’l. 443 (may 1, 1006). 220. there are exceptions in both vat and rst systems. in both systems final consumers can be legal persons. these entities sometimes qualify for exemption from the consumption tax. see sixth directive supra note 99, at art. 14(1)(g) (importation of goods under diplomatic or consular arrangements, international organizations); mass. gen. laws ch. 64h, § 6(e) (exempting purchases by any corporation, foundation, institution, or other organization if the organization is exempt from federal income tax under irc § 501(c)(3)). in these instances an institutional id with a smart card as the uc berkeley studies have made clear, the digital economy that benjamin higgins foresaw is here today: (a) because 93% data generated worldwide is computer generated – based on three billion gigabytes of global data observed in 1999, and the five exabites of global data observed in 2002, and (b) because 92% the new information generated is stored on magnetic media, mostly hard disks (2002 study). because there is no paper and ink216 parentage for most source documents today, the economy is, for all practical purposes, a digital one. it only makes sense then that today’s audit and compliance functions should be performed digitally. a certified tax determining system is a preaudited, real time compliance system. in the consumption field systems like this are currently in place and operational under the streamlined sales tax.217 proposals to extend certification to vat compliance are under study by the oecd, and have been advanced as a solution to the eu’s carousel fraud218 problem. 219 therefore the final barrier to the establishment of a truly progressive consumption tax, the audit and compliance problem, also falls away with technology, when the software performing the tax determination is certified in advance of its use. b. the proposal this paper proposes a technological re-thinking of consumption taxes (vats and rsts) to resolve the inherent regressivity problem of these taxes. three proven technological developments (1) exemption certificates tied to biometric data and embedded in national identity smart cards, (2) fully digital consumption tax regimes, and (3) certified tax determination software make it possible for the first time to design a broad-based, single rate consumption tax that is truly and independently progressive. the point-of-sale is where most of the activity under this proposal will occur. at the point-of-sale a final consumer (who qualifies to purchase220 2006] biometrics: solving the regressivity of vats and rsts 717 exception certificate will need to be issued. in addition, under both systems there are instances where sales made by certain institutions are exempt from either the vat or rst. in these transactions an id with a smart card exemption certificate will need to be issued. see sixth directive supra note 99, at art. 13a(1) (exempting supplies by the postal service, and hospitals); mass. gen. laws ch. 64h, § 6(cc) (exempting sales by a church or synagogue of meals prepared by its members and served on its premises by its members to members or guests if the proceeds of the sales are to be used for religious or charitable purposes). 221. embedding biometrics in an identity card is neither a complicated or expensive process. 222. the purchase would be zero-rated not exempt. a zero-rated transaction allows the retailer to claim back all input vat paid. when making an exempt sale a retailer cannot claim an input credit and as a result the purchased item is carries with it the cost of the vat paid by the retailer to the wholesaler. 223. the cost for a biometric scanner (fingerprint) is minimal, and like all technology is continually going down. a. k. jain, a. ross & s. prabhakar, an introduction to biometric recognition, 14 ieee transactions on circuits and systems for video technology, special issue on image-and-video-based biometrics 4, 9 (jan. 2004) (indicating that finger print scanners cost about $20 us when ordered in large quantities). in instances where an individual did not have his national id with him, it would be technically possible to extend the right for an exemption through biometrics alone. doing this would require maintaining records of an individual’s exemption qualifications within the retailer’s computer system similar and allowing access to this data through just the application of a biometric identifier at the retailer’s sales terminal. systems like this are regularly applied on college campuses where access is granted to university facilities through biometrics alone. vincent kiernan, show your hand not your id: colleges use biometric scanners to screen for access to dining halls, labs, dorms, gyms, and computer networks 52 chron. high’r ed. a-28 (dec. 2, 2005) (indicating that biometric scanning technology is widely used in higher education, and that it is not only less expensive than standard ids per student, but more accurate). 224. supra note 26 and accompanying text. 225. supra part ii. exempt of the consumption tax) will present a national id smart card to a retailer when making a purchase of otherwise taxable goods or services. biometric identifiers in the card will confirm that the person presenting the221 card is a person who qualifies for an exempt purchase under the rst, or for a zero-rated purchase under the vat. a secure communications channel will222 223 then be established via a communications chip in the card. the smart chip in224 the id, interacting with retailer’s financial system through the digital interface, will identify the goods and services (limited as necessary by quantity or dollar amount) that the final consumer may purchase without paying consumption tax. because the consumption tax system under this proposal is fully digital, and because all tax determinations are made by a certified service225 provider (or a certified automated system purchased by the retailer, or a certified proprietary system developed independently by the retailer) exemptions will be 718 florida tax review vol. 7:10 226. supra part iii. 227. supra note 26 and accompanying text. 228. supra note 146 and accompanying text. 229. it would be expected that a voluntary system would most likely achieve the same end results as a mandatory system over time, particularly as the cost of a biometric reader is approximately $20.00 and if the certified service provider option is offered to retailers at no charge. additionally, retailers making a high number of sales to potentially exempt final consumers would eventually find their customer base eroded as individuals went to a retailer who was equipped to provide the exemption. processed and recorded automatically. as in biometric credit card transactions226 today, this process will take less than a second. 227 the participation of sellers in this system could be either voluntary or mandatory. under a mandatory system all businesses making sales to final consumers, some of whom could qualify for exemption (rst) or zero-rated purchases (vat), would be required to secure biometric readers and have their accounting and their consumption tax determination system set up to recognize certificates embedded in ids. third party providers could offer these services to retailers for a fee, or the government could provide these services at no charge, as under the streamlined sales tax. transactions made outside the228 system as well as all transactions not associated with a qualifying “smart” id would bear the full weight of the consumption tax – at the single standard rate. under a voluntary system two approaches are possible. sellers who do not voluntarily participate could either be denied the right to honor exempt purchases, effectively making all sales from their establishments taxable at the single standard rate, or they could be required to keep auditable paper records of exempt transactions (recording the person who made the purchase, the item purchased, along with the government issued code that associates the person and the exempt purchase). 229 this is an aggressive response to technological change. it suggests that rather than wait for gradual change brought about through the linear function creep of technology, tax policy professionals should be hyper responsive. they should respond in a manner that fundamentally redesigns the system. this is an old suggestion, but its time has come. in 1961, a time probably very near the dawn of the computer age in tax policy discussions, the future nobel economist, william vickrey posed a rhetorical question about the electronic data processing (edp) revolution that was just beginning. he asked: “does edp open up possibilities for reforming the way in which tax liability is defined?” vickrey’s answer was hyper responsive. what is required is a re-thinking of the problems of tax policy in terms of socially desirable goals. once the problem has been defined and alternative choices explored, then the machines 2006] biometrics: solving the regressivity of vats and rsts 719 230. william vickrey, electronic data processing and tax policy, 14 nat’l. tax j. 271 at 271 and 285 (sept. 1961). can be adapted to fit the requirements of the solution. as automation increases, the whole social structure of our environment will be subject to revolutionary change; tax administration must keep abreast of this change.”230 the problem (to re-state vickrey) is how to exempt from the consumption tax (rst or vat) select individuals when they purchase specifically determined goods or services, while at the same time maintaining a single rate broadly based on all other purchases of goods and services in the economy. if this problem is re-thought with modern technology in mind it can be solved. it is a simple matter of embedding exemption certificates inside of “smart” ids equipped with biometric identifiers, and then processing sales transactions through certified tax calculation software operating within the context of a digital vat or rst regime. not only is the technology to do this is available today but all the critical pieces have been part of successful pilot projects. the time has come to design the first truly and independently progressive consumption tax. 720 florida tax review vol. 7:10 appendix a austria. (1) smart id card. a voluntary citizen card (bürgerkarte), first issued in february 2003, contains an embedded electronic signature and digital certificates. smart cards technology enables citizens to securely access electronic public services and complete administrative procedures electronically. austria’ concept of e-id is original. there is not just one type of citizen card, instead any card, which makes it possible to sign electronically in a secure form, and to store personal data is suitable for use as a citizen card. thus, membership cards issued by certain entities (e.g. the austrian computer society, the federal economic chamber, etc.) as well as bankcards can include citizen card functionality. in addition, a “light” citizen card service has been developed that can be used with mobile phones, enabling citizens to digitally sign documents and conduct secure transactions with the government. thus, the citizen card is not dependent on a particular form of technology. citizens select the technology to be used. the government certifies the digital medium – double-encrypted numeric identifiers and sector-specific personal identifies are required. (2) electronic portal. on may 19, 2004 the austrian government launches an official electronic delivery service (zustelldienst). the service allows citizens and officials to send secure e-mails with official acknowledgement of receipt. registered e-mails have legal status. a digital signature is required for use of the system. (3) tax administration & technology. finanzonline enables electronic filing (declaration and notification of assessment) of personal and corporate income tax returns, as well as the filing of vat returns, declarations and notifications. access at https://finanzonline.bmf.gv.at/. the austrian federal ministry for economic affairs and labor (bmwa), as part of its “paperless foreign trade administration” (papierlose aussenhandelsadministration – pawa), offers companies to obtain import licenses and submit customs declarations over the internet. access at https://www.pawa.bmwa.gv.at/. personal and corporate income tax, vat and customs administration are all benchmarked at “stage 4” compliance. id. at 12, 14, 20, 27, 29, 33 & 34. belgium . (1) smart id card.. a mandatory system of e-id’s was initiated in 2000, officially launched in march 2003 (as a pilot), and is expected to be completed by the end of 2009. belgium expects that it will be the first european country to issue e-id’s to the entire population (10 million). belgium was the first country in the world to issue electronic passports complying with the recommendations of the international civil aviation organization (icao). the passports contained a facial image in a microchip. fingerprints will be added after european legislation is passed. (2) electronic portal. on february 18, 200 the belgian government began development of an e-government portal. the federal portal http://www.belgium.be is launched in november 2002. (3) tax administration & technology. tax-on-web enables electronic filing 2006] biometrics: solving the regressivity of vats and rsts 721 (declaration and notification of assessment) of personal income tax returns. accessed at http://www.taxonweb.be/. similar e-filing for the corporate income tax is at http://www.minfin.fgov.be/. intervat enables the submission of digital vat returns. edivat allows submission via edi conventions. an electronic customs declaration system has been in place since 1982, called sadbel (systeme automatisé de dedouanement pour la belgique et le luxembourg). the system allows businesses to submit their declarations by communicating directly with the central computer of the customs and excise administration by modem/telephone line. on january 1, 2006 this system was replaced with a web-based application. use of the web-based system will be mandatory in 2008. accessed at http://fiscus.fgov.be/interfdafr/. the customs and excise administration has developed a web-based application called web-n.c.t.s. for managing transit operations based on the eu’s new computerized transit system (ncts). on march 18, 2005 belgium began implementation of an integrated system to process tax returns and collection for citizens and businesses. the system will centralize taxpayer data into a “simplified fiscal account” to optimize management. the system will cover the entire tax management process – calculation, declaration, registration, collection, early payment, control and claims handling. personal and corporate income tax, vat and customs administration are all benchmarked at “stage 4” compliance. id. at 39, 40, 53, 55, & 60-1. cyprus. (1) smart id cards. cyprus is not as advanced as other member states. cyprus plans on introducing e-id smart cards, but has not done so yet. statutory authority is in place for electronic signatures as of 2004. (2) electronic portal. the government portal, http://www.cyprus..gov.cy, is an institutional web site. a new multi-channel e-government portal is due to be launched. this portal will incorporate transactional capabilities. the gateway will provide security, authentication, encryption, decryption, as well as web-based workflow for interconnection of departmental back-end systems. the portal is expected in 2007. (3) tax administration & technology. in tax areas cyprus is much more advanced. taxisnet permits electronic filing (declaration and notification of assessment) of personal income tax, corporate income tax and vat. accessed at http://taxisnet.mof.gov.cy/. a similar system called theseas allows traders or their authorized agents to submit import declarations for the clearance of goods. accessed at http://www.mof.gov.cy/ce/theseas/. thus, the entire tax system in cyprus is benchmarked at “stage 4.” id. at 69, 73, 74, 78, & 79. czech republic. (1) smart id cards. there is no central e-id card infrastructure in the czech republic, and as of may 2006 there is no plan to adopt one. e-signatures are permitted, and three companies have been certified to issue valid e-signatures for citizens to use in their relations with the government (filing tax returns, submitting court petitions, etc.). in one area – health – there is an effort to replace existing health care cards with smart cards. 722 florida tax review vol. 7:10 (2) electronic portal. the public administration portal, http://portal.gov.cz, was launched in october 2003 and is being implemented gradually in interlinked phases. some limited transactional services are offered. (3) tax administration & technology. in spite of the czech republic’s seeming resistance to technology generally, the situation in tax is different. personal and corporate income tax returns, as well as vat and customs declarations may be filed electronically (declaration and notification of assessment). accessed at http://cds.mfcr.cz/. although the customs administration is benchmarked at “stage 3,” all other aspects of the tax administration is benchmarked at “stage 4.” at stage 3 there is two-way interaction, processing of electronic forms (including e-signature), but not full case handling, decisions and delivery (including payments). id. at 89, 91, 97, 99, & 103. denmark. (1) smart id cards. denmark has launched an ambitious program to issue (at no charge) digital signatures to all 1.3 million citizens. it does not have plans to introduce card-based electronic id’s. the software-based digital signature (oces – public certificate for electronic services) can be used for both public and private sector transactions. denmark does have medical e-id’s. all medical records (as far back as 1977) are available on-line through a secure e-service portal (http://www.sundhed.dk). (2) electronic portal. the national portal http://.danmark.dk simply provides public information and limited services. (3) tax administration & technology. with respect to matters of taxation denmark is highly automated. electronic filing (declaration and notification of assessment) of personal income tax is 100% automated. almost all tax information is collected by the tax authority electronically, placed on a pro-forma electronic return, and sent to the taxpayer for modification and digital signature. accessed at http://www.toldskat.dk/. the same web site provides fully functional declaration and payment capabilities in corporate income tax and vat. this site also provides the “just-in-time” web-based e-customs system. it allows import declarations through the internet or edi (electronic data interchange). the entire tax system in denmark is benchmarked at “stage 4” compliance. id. at 108, 110, 114, 121-22, & 126-27. estonia. (1) smart id cards. in january 2002 estonia introduced a mandatory e-id card for all citizens and permanent foreign nationals over 15 years of age. the card is the primary document for identifying citizens and foreign residents and its functions are to be used in any form of business, government or private communications. the cards have physical (biometric) identification functions as well as secure authentication and legally binding digital signature capability in a microchip that contains personal data, certificates, and a permanent e-mail address (forename.surname@eesti.ee). the cards have been issued to over 50% of the population (777,000 cards) and are expected to exceed 1 million cards by 2007. [in addition to the national e-id card, estonian citizens can access online public services through their internet banking cards [more than 70% of estonian 2006] biometrics: solving the regressivity of vats and rsts 723 residents use internet banking, the highest proportion in europe.] estonia was the first country in the world to allow its citizens to vote (nationwide) over the internet using national e-id cards. finland and estonia signed an agreement in may 2003 to harmonize concepts and practices between the two countries regarding digital signatures. the project promotes the “universal digital signature.” (2) electronic portal. estonia’s e-government portal is http://www.eesti.ee. it was launched in march 2003 and provides a single point of access to government information. through authentication (via the national id) the portal allows citizens to fill in forms and submit electronic forms access personal data, and perform transactions. (3) tax administration & technology. in october 2000 estonia developed the e-taxboard (e-maksuamet, at http://www.emta.ee/). the e-taxboard allows estonian taxpayers to access their tax files, view, collect and submit personal, corporate and vat returns on-line. vat refund applications are also accepted. the estonian tax and customs board developed an e-customs application (e-toll) that enables on-line submission of customs declarations. the entire estonian tax system is benchmarked at “stage 4” compliance. id. at 131-32, 138-40, 143, 145, & 14950. finland. (1) smart id cards. finland is a world leader in the adoption of e-id cards. the finnish card features biometric (facial) id, an e-number that allows identification and digital signatures. the card is an official travel document within the eu. the chip in the finnish card was upgraded in 2003. in 2004 citizens were allowed to volunteer to include health data on the single e-id (a digital health card can be used instead of incorporating all information on one card.) although the card is not mandatory, the number embedded in it is mandatory when conducting government business. uptake of the e-id remains low in finland, and has inspired a series of government-sponsored upgrades, and modifications to improve demand. on november 24, 2004 the population registration center and the telecom operator sonera presented the citizen certificate, a mobile id scheme. this mobile id (m-id) is a governmentguaranteed electronic identity embedded in a sim card that allows mobile phone users to identify themselves. finland (similar to estonia) has an online identification system based on identification codes issued by finnish banks. (2) electronic portal. the citizen’s portal was launched in 2002, http://www.suomi.fi/. it provides a single access point to public information, administrative forms, and services. this new portal, replacing an earlier portal that was initiated in 1997, supports authentication base on both pki and on the bank’s authentication system for certain transactions. there is a central administrative forms service, http://www.lomake.fi, and a dedicated business portal, http://www.yrityssuomi.fi. (3) tax administration & technology. the tax administration is very receptive to technology. personal and corporate income tax as well as vat returns, declarations and payments are fully digital. access at http://www.vero.fl/. the personal income tax return is pre-filled by 724 florida tax review vol. 7:10 the government similar to the system in denmark. fully digital customs declarations can be filed with the national board of customs at http://tulli.fl/. the entire finish tax system is benchmarked at “stage 4” compliance. id. at 154,-55, 157, 162, 167-68, &172-73. france. (1) smart id cards. there are plans in france for e-id cards, but as yet there are no french cards. there is no centralized e-identification infrastructure for e-government in france. this is in part attributable to the public resistance spawned by reaction to a march 21, 1979 newspaper expose in le monde revealing the existence of a project by the ministry of the interior to interconnect electronic files containing personal data by using a unique personal identifier. code named safari (systeme automatisé pour les fichiers administratifs et le repertoire des individus) the revelation resulted in the prime minister prohibiting further development pending the development of rules. the french government has transposed the eu e-signature directive into french law (march 2000) and has an e-signature framework policy (pris, july 2005). the government has launched an e-id project called ines (identité nationale electonique sécuriséé) that was endorsed by the prime minister (april 11, 2005). the future french e-id card will have a microchip containing all identity information about the holder, two biometric identifiers (facial and fingerprint), and an electronic signature. personal information would be stored in a new database, and biometric data stored anonymously in a separate file. the french e-id will be mandatory, and citizens will charged a fee. (2) electronic portal. the public portal http://service-public.fr/ provides a comprehensive single access point to information and services for citizens (since october 2002) and for businesses (since november 2003). however, it does no more than provide information. (3) tax administration & technology. in spite of french resistance to e-id cards, in the tax area technology is welcomed. personal and corporate income tax returns, declarations and payments are fully digitized. accessed at http://www.impots.gouv.fr/. online declaration and payment of vat obligations can be accomplished in full digital format. accessed at http://tva.dgi.minefi.gouv.fr/. a full service e-customs function for declarations and payments is also in place. accessed at http://www.douane.gouv.fr/. thus, the entire french tax system is benchmarked at “stage 4” compliance. id. at 17780, 185, 195, 197, & 201-02. germany. (1) smart id cards. biometric passports were issued by germany, beginning on november 1, 2005. the passports contained an embedded radio frequency identification (rfid) chip storing personal data as well as digital facial image, with a scan of the right and left index fingerprint scheduled added in march 2007. other than this passport application, there is no e-id infrastructure currently in use. however, an e-id project has been launched with pilots carried out in 2002. the german e-id card (digitale personalausweis) will include an electronic signature and biometric identifiers stored on a smart 2006] biometrics: solving the regressivity of vats and rsts 725 card. in march 2005 the german government presented a plan aimed at a common e-card strategy to coordinate the various e-card projects ongoing in germany (e-health card, e-id card and the jobs card). the german e-id card will be introduced in 2007. (2) electronic portal. the german e-government portal http://www.bund.de/ is passive, provides access to the services of the federal administration as well as entry into the state and municipality web sites. there is access to an online forms server. a december 1, 2001 survey identified 375 services that would be moved on line by 2005 (a figure that was surpassed by march 18, 2005). (3) tax administration & technology. the tax-specific functionality on the internet is interactional and transactional, exceeding the internet functionality of government overall. the elster website enables online filing and payment of personal and corporate income tax returns as well as vat declarations, returns, and payments. accessed at http://www.elster.de/. comparable capacity for the submission of customs declarations and payments was launched in october 2002. accessed at http://www.zoll-d.de/. thus, the entire german tax system is benchmarked at “stage 4” compliance. id. at 20607, 214, 221, 223, & 227-28. greece. (1) smart id cards. there is no centralized e-id infrastructure in greece, and there is no plan to adopt one. the government has presented a digital strategy for the period 2006-2013 which would enable a “great leap,” but nothing in the strategy considers e-id’s. government sanctioned digital signatures are part of the strategic plan, and are expected in 2008. (2) electronic portal. the greek approach to e-government has been decidedly less technology intensive that other member states. greece has establish a series of physical location – citizen service centers (800 currently and expected to number over 1,000) that provide a “one-stop-shop” solution through a linked ip network that can be accessed through the centers, or over the internet. the centers are open 8am to 8pm monday through friday, and with limited hours on saturday. internet access is at http://www.kep.gov.gr/. however, the greek approach has strong human service element. (3) tax administration & technology. in the tax area the digital services theme is more in evidence than in the rest of the greek approach to e-government. the personal and corporate income taxes as well as vat (declarations and notices of assessment) and customs clearance are facilitated through the taxisnet service that was instituted in may 2000. payment, return processing, electronic certificates, and downloadable forms are all available. accessed at http://www.taxisnet.gr/. thus, the entire greek tax system is benchmarked at “stage 4” compliance. id. at 232, 234, 236, 242-43, & 247-48. hungary. (1) smart id cards. there is currently no central e-id infrastructure in hungary, although the government does have plans for an e-id card. in october 2002 a pilot project on e-signatures and e-id cards was launched. requirements and specifications for the e-id card (huneid) were published 726 florida tax review vol. 7:10 in 2004. (2) electronic portal. on april 1, 2005 a transactional gateway was established called “client gate” (ügyfélkapu) which allows access to transactional e-government services after a secure authentication registration (however authentications are not currently through a national e-id). (3) tax administration & technology. in the tax area hungary is not keeping pace with e-solutions in other eu member states. in the personal income tax forms can be downloaded and returns filed electronically. for the corporate income tax more functionality is available (conditional on a chip card and reader) provided by the tax office (using pki technology). vat forms can be downloaded from the website, but returns are only accepted by the largest taxpayers. access at http://www.apeh.hu/. in customs there are basic interactive tools available on line, certain forms can be downloaded, and with permission be submitted electronically, accessed at http://www.vam.hu/. only the corporate income tax is benchmarked at “stage 4” compliance. the personal income tax is rated at “stage 3.” both the vat and the customs functions are benchmarked at “stage 2.” id. at 252-54, 257, 263-64, & 268-69. ireland. (1) smart id cards. in june 2004 the irish government established an expert group to introduce a standard framework for public service cards (ppc), making use of the personal public service (pps) number in a manner that could be used for e-id and authentication purposes. the intent is to design a single multi-purpose card. the public service broker (psb) coordinates the irish egovernment initiative. the psb interfaces between the government and public, improving service delivery through conventional (in person and telephone) and self-service (on-line) electronic channels (the “reachservices” portal). the psb currently uses the pps number as a unique identifier, even though it was initially intended for use for tax and social welfare purposes. an integrated smart card electronic ticketing system, as of march 21, 2005, is operational for all public transportation services in the country. (2) electronic portal. r eachservices is ire land ’s e-governm ent por ta l, accessed a t http://www.reach.ie/. it provides a single point of access for informational, interactive and transactional public services. the reachservices portal is the psb interface. the portal includes a single identification and authentication process and a single electronic payment facility. the portal allows registered users to conduct transactions with the government from one central access point at any time. (3) tax administration & technology. full compliance with personal and corporate income taxes as well as vat and customs obligations – returns processing and payments can be achieved on line, accessed at http://www,roe.ie/. the entire irish tax system is benchmarked at “stage 4” compliance. id. at 273-75, 281, 287-88, & 292-93. italy. (1) smart id cards. on march 31, 2005 italian law mandated that all paper id’s be replaced with electronic id’s by the end of 2005. only digital id’s were issued from 2006 forward. the italian e-id card (cie) was launched 2006] biometrics: solving the regressivity of vats and rsts 727 in 2001, and after two experimental phases in 2003 and 2004, distribution to requesting citizens over 15 years old began, with the goal of total replacement by 2011 (40 million cards). the cie has a microchip, optical memory and an icao machine-readable strip. the card contains personal data (fiscal code, blood group, and fingerprint scan). data is stored on the card, not in a central database; it is released only with a pin code. the optical memory does not allow fingerprint reconstruction. before the full implementation of the cie a national services card (cns), smart card had been developed (as a temporary measure) to allow secure identity recognition on line. however the cns did not constitute legal “proof” of identity, and was not a legal travel document like the cie. (2) electronic portal. the italian web portal is at http://www.italia.gov.it/. it is a comprehensive and secure e-government portal for all public services. (3) tax administration & technology. personal and corporate income tax and vat returns, declarations, and payments can be made on-line, accessed at http://fisconline.agenziaentrate.it/. similarly for customs declarations and payment. the customs agency has a fully transactional on-line system, accessed at https://telematico.agenziadogane.it/. the entire italian tax system is benchmarked at “stage 4” compliance. id. at 297-98, 301, 306, 311-12, & 31617. latvia. (1) smart id cards. there is currently no central e-id infrastructure, but there is an e-id card project. the latvian parliament passed a law of personal identification documents on may 23, 2002 requiring either an identity card or passport as an identity document for every citizen over 15 years of age. a regulation issued in 2004 provides for electronic chips in id cards holding basic personal data, as well as a biometric (facial) and electronic signature. this regulation is not fulfilled at the moment because of the absence of a “certification service provider.” on june 15, 2005 the latvian government entered into an agreement with latvia post and lattelekom ltd to fulfill the requirements of the law and regulation. the tax system in latvia is considerably behind other member states. (2) electronic portal. latvia doe not currently have an e-government services portal. a state portal at http://www.lvonline.lv/ had been launched in 2002 to provide a single access point for all government information and services, but had to be stopped because of lack of funding. a new development effort was undertaken in 2005. (3) tax administration & technology. in the tax area the situation is (potentially) much better. an electronic declaration system (http://www2.vid.gov.lv) is available. it is designed to allow full service (return submission, payments, declarations, data checks, and e-mail confirmation) for tax transactions. however, regulations on the storage and circulation of electronic documents are not in place yet, thus all filings, payments and information requests must still be done on paper. customs however has a fully digital functionality, as businesses can use the computerized transit control system to submit customs declarations and payments, accessed at http://www.vid.gov.lv/. as a result of these difficulties, 728 florida tax review vol. 7:10 the latvian tax system is generally benchmarked at “stage 1” compliance. the customs function however, is benchmarked at “stage 4.” id. at 321, 323, 329, 333-34, & 339. lithuania.. (1) smart id cards. there is no central e-id infrastructure in lithuania at the present time. however, a government “concept paper” adopted in december 2002 urges the development of an e-id that will include personal data, social insurance details and medical records. e-signature legislation was enacted on july 11, 2000 setting out requirements for certification and the rights and obligations of service providers. a pilot program was initiated in may 2004. (2) electronic portal. in january 2004 the lithuanian government opened a full service digital service portal for citizens and businesses, available at http://www.govonline.lt. (3) tax administration & technology. in the tax area, a fully transactional system operates in personal and corporate income tax as well as vat. the system accepts all returns, provides notifications of assessment, and new forms, as well as allows monitoring and management of filings, accessed at http://deklaravimas.vmi.lt/. the lithuanian customs administration runs a similar web site that allows fully transactional submission of declarations and payments, accessed at http://www.cust.ly/. the whole lithuanian tax system is benchmarked at “stage 4” compliance. id. at 344-45, 349, 355-56, & 360-61. luxembourg. (1) smart id cards. there is no central e-id system in luxembourg, and there is no government plan to adopt one. in march 2003 the luxtrust economic interest group (a public-private partnership) was formed to manage the development of a public key infrastructure (pki) for e-commerce and e-government. a new e-government master plan presented on june 13, 2005 does not mention e-id’s. electronic payments and digital signatures are authorized in legislation passed on august 14, 2000. (2) electronic portal. there is currently no full e-government services portal in luxembourg. a onestop portal is expected to go live some time in 2006. a business portal, http://www.entreprises.public.lu/, is already in operation. it provides a one-stopshop for information and services. (3) tax administration & technology. in the tax area luxembourg is behind other member states in direct taxes, but a fully transactional systems is in place in vat and customs. web sites allow forms to be downloaded for personal and corporate income taxes, accessed at http://impotsdirects.public.lu/. the vat functionality allows payments and submission of returns, accessed at https://saturn.etat.lu/etva. a fully electronic customs declaration system has been operational for several years called sadbel (systeme automatisé de dedouanement pour la belgique et le luxembourg). thus, the luxembourg tax system has a dual benchmarking. it is considered at “stage 2” compliance for direct taxes, and at “stage 4” for customs and vat. id. at 364, 366, 370-71, & 374-75. 2006] biometrics: solving the regressivity of vats and rsts 729 malta. (1) smart id cards. on march 18, 2004 the maltese government launched its e-identity (a secure network key enabling citizens to conduct interactive and transactional e-services where strong identity security is required). this is not an identity card, and a paper card system remains in place. (2) electronic portal. the government of malta’s portal is an institutional site, accessed at http://www.gov.mt. it provides access to information and has some interactive and transactional services. (3) tax administration & technology. in august 2004 the maltese inland revenue then launched an on-line payment system based on the government’s electronic payment gateway (epg). a digital signature law was passed on january 16, 2001. personal and corporate income taxes are fully digitized for returns and payments, accessed at http://www.ird.gov.mt/. similar functionality is available with the vat accessed at http://www.vat.gov.mt/, and with customs, accessed at http://ces.gov.mt/. the entire maltese tax system is benchmarked at “stage 4” compliance. id. at 379-80, 384, 388-89, & 392-93. the netherlands. (1) smart id cards. the netherlands has an e-id system (digid) in place, and intends to introduce an e-id card (enik) by august 28, 2006. apart from a user name/ password for citizens (basic level), a digid authentication method for businesses is being developed, and an internet banking methodology for digital signatures (medium level) is being incorporated. the e-nik will supplement the biometric passport that was in trials beginning on september 1, 2004. the passport (and the e-nik) include two biometrics (facial and fingerprint). on september 12, 2005 the dutch government announced the creation of an electronic child file for all netherlands children. as of january 1, 2007 each child born in the netherlands will be assigned a unique numeric identifier and an electronic file that will initially contain medical information, domestic relations, and as the child grows the school records and social services and police will be able to add data (as relevant). once operational, all previously issued paper files of dutch children will be digitized. unique and uniform identification numbers for citizens (citizens service number – csn) and for businesses (companies and institutions number – cin) are being introduced as of january 1, 2006. (2) electronic portal. the netherlands portal at http://www.overheid.nl/ provides access to a growing amount of information, as well as a one-stop-shop for a number of interactive and transactional services. (3) tax administration & technology. the netherlands tax system is benchmarked at “stage 2” compliance for vat, because the web site only provides on-line downloadable forms, however in the other tax areas, both personal and corporate income taxes and customs the netherlands is benchmarked at “stage 4” compliance. id. at 397-98, 402, 407-08, & 414-15. poland. (1) smart id cards. there is no central e-id infrastructure in poland. the development of a “multifunctional personal document” (mpd) – an 730 florida tax review vol. 7:10 intelligent, pki-ready smart card that could replace the current plastic id card – is being studied. the e-id would be based on the current identification numbers and reference databases (pesel for individuals and regon for businesses). (2) electronic portal. there is also no central e-government portal in poland. this too, is a key project under development. (3) tax administration & technology. poland is behind many member states in the tax area. for the personal and corporate income tax, as well as the vat it is possible to download forms (only), accessed at http://www.mf.gov.pl/. the ministry of finance announced on april 20, 2005 that e-tax filing services will commence in 2006, with a priority given to the largest taxpayers. full e-filing is not expected for all taxpayers until 2012. for customs purposes the situation is better. customs declarations can be made with single administrative d o c u m e n t s ( s a d ) u s i n g o n l i n e f o r m s , a c c e s s e d a t http://www.mf.gov.pl/sluzba_celna/. the polish tax system is benchmarked generally at “stage 2” compliance (personal and corporate income taxes and vat). it is benchmarked at “stage 4” compliance in customs. id. at 419-20, 420-21, 428-29, & 433-34. portugal. (1) smart id cards. there is currently no central e-id infrastructure in portugal, although in april 2005 the new government announced plans for the creation of a multi-purpose citizen card. the card will combine id, tax, social security, health insurance and electoral information. distribution is expected to start in 2006. (2) electronic portal. the citizen’s portal was launched in march 2004, providing digital access to over 700 services (20% of which are fully transactional). (3) tax administration & technology. in the tax area, personal and corporate income taxes are fully transactional over the internet, as is the vat, accessed at http://www.e-financas.gov.pt/. customs is similarly established as a fully transactional, digital system, accessed at http://www.e-financas.gov.pt/de/jsp-dgaiec/msin.jsp. the portuguese tax system is benchmarked at “stage 4” compliance. id. at 438-39, 441, 444, 450-51 & 45455. slovakia. (1) smart id cards. there is currently no central e-id infrastructure in slovakia, but the government has announced plans to introduce high-tech id’s and passports, likely with multiple biometric identifiers. the e-id cards will incorporate digital signatures. the passports issued as of april 2005 are “biometric-ready,” with facial identifiers incorporated by september 2006 and fingerprint scans by march 2008. (2) electronic portal. the current electronic portal, accessed at http://www.obcan.sk, provides basic information on public services. it allows users to locate government officials who can help resolve a problem. a new central government portal (currently in the design stage) will offer more transactional services. (3) tax administration & technology. in the tax area, a secure national tax portal “e-tax” was made available march 7, 2005. the personal and corporate income tax is fully transactional for holders 2006] biometrics: solving the regressivity of vats and rsts 731 of the government guaranteed electronic signature, accessed at http://www.drsr.sk/. vat transactions can be handled at the same site, but functionality is limited to downloadable forms. the customs administration web site only provides information, accessed at http://www.colnasprava.sk/. thus, the slovakia tax system is benchmarked at “stage 4” for income tax, “stage 2” for vat, and “stage 1” for the customs administration. id. at 459-60, 469-70, & 474-75. slovenia. (1) smart id cards. a public key infrastructure (pki) has been deployed in slovenia, and four certification authorities have been accredited. an e-id card project has been launched, but is not yet operational. (2) electronic portal. in may 2006 a government-wide portal for e-services (esju) was launched, the tax administration had previously (march 1, 2004) established a dedicated tax portal “edavki” (etaxes). the slovenian general certification authority (sigen-ca) began operation on july 9, 2001 and began issuing qualified digital certificates for natural and legal persons. (3) tax administration & technology. in the tax area, personal and corporate income as well as vat taxpayers can participate in a fully transactional digital interface with the government through the internet, accessed at http://edavki.durs.si/. the customs administration however only has forms available for download on the internet, accessed at http://carina.gov.si/. the slovenian tax system is generally benchmarked at “stage 4” (income tax and vat). customs is benchmarked at “stage 2.” id. at 479-81, 490-91, & 494-95. spain. (1) smart id cards. the spanish government officially approved the creation and distribution of new e-id cards containing biometric identifies (after pilot testing) on february 13, 2004. the e-id card was to be implemented in phases with distribution beginning in 2005. however, the pilot project was delayed until 2006, and card distribution is now expected in late 2007. the electronic national identity document (dni) project was initiated in 2001 to facilitate the use of digital signatures and digital identities (assigned by the spanish certification authority (ceres)). the e-id cards will permit digital signatures as well as provide biometric and other basic identification data. (2) electronic portal. launched in september 2001, and revamped in may 2003 the portal, http://www.administracion.es, is a gateway to information and services. as of october 2003 it provides a secure government notification service. as part of “plan conecta” for the development of e-government services (2004-2007) a new portal will be established at http://www.ciudadano.es. interactive and transactional services will be available on this portal. (3) tax administration & technology. in the tax transactional and interactive services are already available in personal and corporate income taxes as well as vat and customs. the regimes are in a fully transactional digital medium, accessed at h t t p s : / / a e a t . e s / . t h e c u s t o m s f u n c t i o n a l i t y i s a t https://aeat.es/aeatse.html?https://aeat.es/aduanet/aduanaie.html. the spanish 732 florida tax review vol. 7:10 tax system is benchmarked at “stage 4” compliance. id. at 499-00, 502, 504, 506, 511-12, & 515-1. sweden. (1) smart id cards. biometric passports and biometric e-id’s (nationellt identitetskort) were issued in sweden on october 1, 2005. the passport has an rfid (radio frequency identification) microchip. the e-id is not mandatory, but functions as a valid travel document within the schengen area. the biometric identifier is a digital facial image. the documents contain a traditional chip that permits secure access to e-government services. swedish citizens can continue to use (for the time being) non-official electronic id cards issued by the swedish post, that are based on standards approved in 1998 by the swedish standards institute to access some government services as well as software based e-id’s (in particular the bankid developed by the largest swedish banks.) (2) electronic portal. launched in october 2004 the new swedish e-government portal http://www.sverige.se is not intended to be a single point of entry to the public sector. instead it is an “intentions-based” orientation point for individuals looking for links to public sector sources of information and services. (3) tax administration & technology. the tax administration sites are more transactional. personal and corporate income tax as well as vat obligations can be satisfied in fully transactional digital mediums, accessed at http://skatteverket.se/. similar full transactional digital access is available tin customs area, accessed at http://www.tullverket.se/. thus the whole swedish tax system is benchmarked at “stage 4” compliance. id. at 520, 526, 531-32, & 536-37. united kingdom . (1) smart id cards. the e-id card is controversial in the uk. initially proposed by the government on november 11, 2003, an e-id card bill [linking the e-id database with the e-passport database] was introduced to parliament in november 2004. the bill passed the house of commons (february 10, 2005), but was not voted on by the house of lords. it was reintroduced on may 25, 2005, passed the house of commons (october 18, 2005), but the house of lords uncoupled the e-id from the e-passport database, thereby making significant portions of the e-id data voluntary. this is unacceptable to the government, and the bill will be reintroduced. the government would prefer e-id cards with a microchip for storing personal data along with biometric identifiers (facial, fingerprint and iris scan) and an electronic signature. distribution has been anticipated by 2008. thus, the current e-id infrastructure in the uk is based on either a digital certificate issued by an accrediting certification authority or through a user id issued by the government gateway along with a password (chosen by the user). the government gateway was launched in february 2001. it is a central registration and authentication engine that enables secure authenticated e-government transactions over the internet. on june 15, 2004 a biometric iris scan border control system was put in place at key airports to efficiently identify regular 2006] biometrics: solving the regressivity of vats and rsts 733 travelers and foreign work permit holders. (2) electronic portal. launched in march 2004 http://www.direct.gov.uk is the uk government’s citizen portal. it is a single point of entry to government services. since april 2004 the site is available via digital tv sets (10 million in the uk). (3) tax administration & t e c h n o l o g y . i n t h e t a x a r e a , p e r s o n a l i n c o m e t a x [http://www.hmrc.gov.uk/individuals/tmaself-assessment.html] and corporate i n c o m e t a x [h t tp : / /w w w .h m rc .g o v .u k /c t s a / in d e x . h t m l ] , v a t [http://customs.hmrc.gov.uk] and customs [http://www.hmrc.gov.uk/online] obligations can be satisfied though a full transactional digital interface with the government over the internet. the u.k. tax system is benchmarked at “stage 4” compliance. id. at 541, 543-44, 554, 561, 563, & 567-68. 734 florida tax review vol. 7:10 appendix b alabama: tax administration & technology. alabama is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.ador.state.al.us. (3) all sales and use tax returns are required to be filed electronically (ala. admin. code r. 810-1-6.12(2)). persons who are unable to utilize the electronic filing system must use the department’s telephone voice response system (ala. admin. code r. 810-16-.12(3)). in certain circumstances, a waiver is available from the commissioner to file in another approved manner. alabama uses an internet based system for filing returns and accepting tax payments. all taxpayers may pay electronically, but those with over $25,000 in liability are required to pay electronically (ala. admin. code r. 810-13-1-.01; ala. admin. code r 810-13-1-.20). (4) all ruling requests must be submitted in writing. no provision is made for electronic filing of these requests (ala. code § 40-2a-5.(e)(1975)). in addition, because there is no provision for digital case handling, decision, and delivery functions, the system is not fully transactional. arizona: tax administration & technology. arizona is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.revenue.state.az.us. (3) taxpayers may voluntarily file returns on line but must firs t regis ter a t http://www.aztaxes.gov and are required to supply the state with a signature card (on paper) (ariz. admin. code § r 15-10-504(a)(2); ariz. admin. code § r 15-10-502). an electronic funds transfer system is in place, requiring registration and use of ach debit (and in certain circumstances allowing ach credit (ariz. admin. code § r 15-10-301-07). electronic return preparers must maintain paper documents (ariz. rev. stat. § 42-1105(f)) that would otherwise be sent to the department of revenue for six years following the later of the return’s due date or filing date. (ariz. admin. code § r 15-10-502(b)). (4) all ruling requests must be submitted in writing. no provision is made for electronic filing of these requests (ariz. rev. stat. § 42-2101). in addition, because there is no provision for digital case handling, decision, and delivery functions, the system is not fully transactional. arkansas. tax administration & technology. arkansas is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.arkansas.gov/dfa/excise_tax_v2/et_su_ forms.html. (3) the commissioner is authorized to allow electronic filing of returns (ark. code ann. § 26-18-301), and has done so. these returns can be filed at https://www.ark.org/dfa/artax/salestax/index.php. there are significant 2006] biometrics: solving the regressivity of vats and rsts 735 signature requirements in arkansas that have paper-based requirements. form ar8453ol needs to be filed with the arkansas department of revenue to support electronic filings. (ark. reg. 2000-2(1) (e) & (f) & 5(a)). an electronic funds transfer system is in place and is required for all taxpayer with liabilities in excess of $20,000 (ark. code ann. § 26-19-104 & 105(a)(1); ark. reg. 2000-5). (4) all ruling requests must be submitted in writing. no provision is made for electronic filing of these requests, and all correspondence outside of the prescribed ruling request format are not binding (ark. reg. § gr-75 & 76) at http://www.arkansas.gov/dfa/rules/et1992_4.pdf. the arkansas system is neither fully transactional, nor is it two-way interactional due to the paperbased signature requirements. california. tax administration & technology. california is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.boe.ca.gov. (3) the california state board of equalization (sbe) launched its free electronic filing or “boe-file” service for california sales and use tax returns of eligible taxpayers in 2005. it can be accessed under “e-file” at www.boe.ca.gov. electronic filing of sales and use tax returns has been available since 2001 through third party service providers that charged fees ranging from $4.95 to $9.95. (cal. rev. & tax code § 6452; news release, no. 63-c, cal. state board of equalization, sept. 20, 2005). an electronic funds transfer system is available, and is mandatory for taxpayers with an estimated tax liability of $10,000 per month (cal. rev. & tax code § 6479.3). there are some unusual aspects to e-filing in california which make it not a “stage 3” jurisdiction: (a) e-filing is limited to taxpayers who file form boe-401-a, with schedule a only; or form boe-401-ez, and who conduct business at a single location, and (b) e-filing is not allowed for taxpayers required to make prepayments or to pay taxes by electronic funds transfer (eft). (ca. sbe tax info. bull. no. 12-1-05 (dec. 1, 2005). (4) a person can request an opinion on the application of sales or use tax. these opinions are not rulings and are not issued or allowed to be requested electronically (cal. rev. & tax code § 6596; cal. code regs. rev. & tax 1705(b)(1)). in addition, because there is no provision for digital case handling, decision, and delivery functions, the system is not fully transactional. colorado. tax administration & technology. colorado is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.revenue.state.co.us/main/home.asp. (3) the executive director is authorized to prescribe (through rules and regulations) voluntary alternative methods for the making, filing, signing, subscribing, verifying, transmitting, receiving, or storing of returns (colo. rev. stat. § 3921-120(1) & (3)). although there are provisions for electronic filing of personal 736 florida tax review vol. 7:10 income tax and fuel tax, the is no authorization for e-filing sales and use taxes (colo. rev. stat. §§ 39-22-604960; 39-27-105). an exception is available for “zero” returns, sales and use tax returns where no tax is due. these returns may be filed electronically at http://www.taxview.state.co.us/zero/. colorado has provisions for electronic payments on the main web site, and has a mandatory eft program for taxpayers owing more than $75,000 that was put in place january 1, 2002 (colo. rev. stat. § 39-26-105(5); colo. code regs. § 39-26105.5; colo. pub. drp-5782). (4) there is currently no private letter ruling process in colorado, although one had bee considered in 1999. technically, the statutes only allows for an administrative hearing before the director to produce a “ruling by the director”. (colo. dep’t. rev. annual liaison meeting with cpa soc., bar assoc. enrolled agents & public accountants (nov. 18, 1999). there is no provision for digital case handling, decision, and delivery functions. thus, the colorado system is neither fully transactional, nor is it two-way interactional. connecticut. tax administration & technology. connecticut is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.ct.gov/drs/site/default.asp. (3) the commissioner is authorized (by providing notice in the return instructions) to allow the filing on any tax return through any technology on an ongoing basis as that technology develops (conn. agencies regs. § 12-690-1; conn. gen. stat. § 12-690). this notice has been provided for the sales and use tax through the department of revenue’s web site. eft is available for persons who file sales or use tax return on a monthly or quarterly basis, and can be required by the commissioner in instances where the prior year’s liability exceeded $10,000 (conn. gen. stat. § 12-686(a)(1)). (4) all ruling requests must be submitted in writing. no provision is made for electronic filing of these requests (conn. gen. stat. § 12-2(a)(2); conn. policy. stat. 2000(7) procedures in handling requests for issuance of rulings). in addition, because there is no provision for digital case handling, decision, and delivery functions, the connecticut system is not fully transactional. district of columbia. tax administration & technology. the district of columbia is “almost a stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions a r e a v a i l a b l e o n t h e w e b a n d c a n b e d o w n l o a d e d a t http://otr.cfo.dc.gov/otr/site/default.asp. (3) any registered taxpayer is allowed to file electronically (d.c. mun. regs. 105.11). this is a requirement for bulk filers, and taxpayers whose liability exceeds $25,000. any tax payment may be made electronically (d.c. code ann. § 47-4402(c); d.c. mun. regs. 105.11). this system is not fully digital as the registration process requires a form to be downloaded at http://www.taxpayerservicecenter.com/getstarted.jsp, and the 2006] biometrics: solving the regressivity of vats and rsts 737 completed form mailed to the address indicated. the tax office will then mail the taxpayer a user id and password providing access to the etsc site. after this process is completed, the site can be used to view the taxpayer’s accounts, file monthly sales and use tax returns, and make monthly payments (office of tax & rev., notice regarding electronic filing requirements (jan. 15, 2004)). (4) all ruling requests must be submitted in writing. no provision is made for electronic filing of these requests on the d.c. web site. in addition, because there is no provision for digital case handling, decision, and delivery functions, the district of columbia system is not fully transactional. florida. tax administration & technology. florida is “almost a stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.myflorida.com/dor/gta.html. (3) any registered taxpayer is allowed to file electronically (fla. stat. ann. §§ 212.11(1)(f)(1) & 202.30; fla. admin. code ann. r. 12-24.003) but those filing a zero return, or a combined return, or who have multiple business locations in the state, or who have a liability exceeding $30,000 are required to file and pay electronically. all taxpayers may pay electronically, but those required to file electronically are also required to pay electronically through eft (fla. stat. ann. §§ 213.755; fla. tax info. pub. no. o1a01-14 (oct. 8, 2001)). this system is not fully digital. to begin filing electronically, taxpayers must complete (signature required) the registration/authorization form (form dr600f) and the electronic filing agreement (form dr-653) and mail them to the department. (4) all ruling requests must be submitted in writing (fla. admin. code ann. r. 12-11.003(1)). no provision is made for electronic filing of these requests on the florida web site. in addition, because there is no provision for digital case handling, decision, and delivery functions, the florida system is not fully transactional. georgia. tax administration & technology. georgia is “almost a stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and c a n b e d o w n l o a d e d a t http://www.etax.dor.ga.gov/salestax/st3forms/st3_indx.shtml. (3) in july 2006, georgia expanded its e-file and e-pay program to include sales and use taxes (ga. important bulletins, may 2006). taxpayers are required to file electronically if they are required to pay sales and use tax by electronic funds transfer (eft). the e-file and e-pay program will also be available if taxpayers want to voluntarily file and pay electronically (ga. comp. r. & regs. r. 560-32-.26(5)). electronic funds transfer must be used when the liability in connection with any return, report, or document exceeds $10,000 (ga. code ann. § 48-2-32; ga. comp. r. & regs. r. 560-3-2-.26). this system is not fully digital. payments are made through ach debit or ach credit after submission 738 florida tax review vol. 7:10 of paper forms (ga. form eft 001; ga. form eft 002) to the tax authority (ga. comp. r. & regs. r. 560-3-2-.26(3)(b) & (c)). (4) all ruling requests must be submitted in writing (ga. comp. r. & regs. r. 560-3-1-.04). no provision is made for electronic filing of these requests on the florida web site. in addition, because there is no provision for digital case handling, decision, and delivery functions, the florida system is not fully transactional. hawaii. tax administration & technology. hawaii is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.ehawaiigov.org/efile. (3) as of 2002 the internet filing program of the hawaii department of taxation was expanded to the general excise (sales) and use tax return and reconciliation. haw. tax news, 6:1 (haw. dept. of taxation, spring 2002). statute authorizes the filing of tax returns and other tax-related documents by electronic, telephonic, or optical means (haw. rev. stat. § 231-8.5). tax payments are accepted through various electronic media (haw. rev. stat. § 231-9.9). the program is mandatory for anyone with an annual tax liability exceeding $100,000. persons not required to pay tax electronically may request permission to do so (haw. admin. code, no 18-231-9.9-03). upon the issuance of regulations, the department of taxation will be able to accept tax payments by credit card or debit card (haw. rev. stat. § 231-9.4). (4) written rulings are issued to taxpayers (haw. rev. stat. § 231-19.5) only on written request (haw. admin. code, no 18-231-19.508). no provision is made for electronic filing of these requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the hawaii system is not fully transactional. idaho. tax administration & technology. idaho is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.tax.idaho.gov/. (3) the state tax commission established rules for the filing of tax returns and other documents via electronic transmission (idaho code § 63-113). the system is voluntary, and available for anyone filing an idaho return (idaho code § 63-115). filing and payment of taxes must be made by electronic funds transfer when the amount due is $100,000 or greater (idaho code § 67-2026). the method of electronic funds transfer must be made through the automated clearing house system (ach) operated by the federal reserve by the ach debit or ach credit method (idaho code § 67-2026). (4) written rulings are issued to taxpayers (idaho code § 675255) only on written request (idaho code § 63-105). no provision is made for electronic filing of these requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the idaho system is not fully transactional. 2006] biometrics: solving the regressivity of vats and rsts 739 illinois. tax administration & technology. illinois is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) even though forms documents and instructions are available on the web and can be downloaded at http://www.revenue.state.il.us/, their electronic use is limited. (3) e-filing is voluntary in illinois, and limited to two sales and use tax forms, form st-1 (sales and use tax return) and form st-2 (multiple site attachment for form st-1). illinois intends to eventually allow more extensive filing of returns and other documents (20 ill. comp. stat. ann. 2505/39c-1a; ill. admin. code tit. 86, § 760.100). participation in the e-filing program results in a requirement that all associated payments must be made through electronic means (ill. admin. code tit. 86, § 760.220). taxpayers with an annual tax liability of $200,000 or more must make all payments by electronic funds transfer. an annual tax liability is the sum of the taxpayer’s liabilities reported on form st-1, sales and use tax return (20 ill. comp. stat. ann. 2505/2505210; 35 ill. comp. stat. ann. 120/3; 35 ill. comp. stat. ann. 115/9; 35 ill. comp. stat. ann. 110/9). not all taxpayers may pay electronically. currently, the department of revenue is accepting voluntary electronic funds transfer payments of the following: art-1, automobile rental occupation and use tax return (payment only); pst-1, prepaid sales tax return (payment only); pst3, prepaid sales tax quarter-monthly payment (for accelerated sales tax filers); rr-3, sales and use tax quarter-monthly payment (for accelerated sales and use tax filers). (ill. admin. code tit. 86, § 750.500(e)). (4) written rulings are issued to taxpayers only on written request (20 ill. comp. stat. ann. 2515/3; 5 ill. comp. stat. ann. 100/5-145; ill. admin. code tit. 86, § 1200). no provision is made for electronic filing of these requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the illinois system is not fully transactional. indiana. tax administration & technology. indiana is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.in.gov/dor/. (3) since 1998 the indiana department of revenue has offered an electronic tax-filing program for retail sales and use taxes. taxpayers are able to send tax returns and payments in a single transaction by using a compatible personal computer with a modem and a computer program named in-s.i.t.e. the computer program and filing service are provided free of charge and are available to single return taxpayers or service providers (ind. tax dispatch, ind. dept of rev., 1:3 (aug., sept., oct. 1998). e-payments are mandatory if estimated monthly sales and use tax liability exceeds $10,000 (ind. code § 6-2.5-6-1(g)). however, if a sales and use tax payment is made by electronic funds transfer, the taxpayer is not required to file a monthly return (ind. code § 6-2.5-6-1(h)). (4) written rulings are issued to taxpayers, but only on written request. even though the commissioner has authority to do so through regulation (ind. code § 6-8.1-6-7), no provision is 740 florida tax review vol. 7:10 made for electronic filing of these requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the indiana system is not fully transactional. iowa. tax administration & technology. iowa is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.state.ia.us/tax/. (3) businesses that are registered to collect iowa sales or use tax must use the e-file & pay system. iowa sales and retailer’s use taxes became available on e-file & pay in july 2005, and consumer’s use tax was added on october 1, 2005. the e file & pay system allows taxpayers to file their return information by telephone or via the internet. paper returns will no longer be available. tax payments are remitted electronically through e file & pay. (iowa tax e-news, iowa dept. of rev., mar. & june 2005). (4) written rulings are issued to taxpayers, but only on written request (iowa admin. code r. 701-7.56(421). no provision is made for electronic filing of these requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the iowa system is not fully transactional. kansas. tax administration & technology. kansas is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms documents and instructions are available on the web and can be downloaded at http://www.ksrevenue.org/. (3) all kansas sales and use tax returns can be filed through this web site. a taxpayer whose total sales tax liability exceeds $100,000 in any calendar year must remit tax payments by electronic funds transfer by the due date (kan. stat. ann. § 75-5151). all remittances required under the retailers’ sales tax act and the compensating (use) tax act, may be made to the department of revenue utilizing either ach (automated clearing house) credit or debit procedures (kan. rev. dep’t. pub. notice no. 04-11 (nov. 2, 2004). (4) any person required to collect sales tax as a retailer may request a letter ruling seeking clarification of a tax issue (kan. stat. ann. § 79-3646; kan. admin. regs. 92-19-59). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the kansas system is not fully transactional. kentucky. tax administration & technology. kentucky is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://revenue.ky.gov/.(3) kentucky has allowance for electronic filing and payment, but the provisions are not comprehensive. taxpayers holding a valid sales and use tax permit may file kentucky sales tax returns electronically, but not use tax returns. payments may also be made using 2006] biometrics: solving the regressivity of vats and rsts 741 e-check or credit card, in addition to debit card, electronic funds transfer (eft), and regular check. once a taxpayer begins filing electronically, paper returns will no longer be sent to the taxpayer. the filing system is not completely digital as amended returns must be filed on paper with “amended” printed or stamped at the top of the return. (ky. rev. stat. ann. § 45.345; ky. sales tax facts, 5:1 (dec. 2003); ky e-tax faq’s, ky. rev. cabinet. (jan. 2004). eft is required when payments exceed $10,000, or when aggregate filings are for 100 or more taxpayers. (ky. rev. stat. ann. § 131.155). (4) kentucky does not have a provision for ruling requests in sales and use tax. no provision is made for electronic ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the kentucky system is not fully transactional. louisiana. tax administration & technology. louisiana is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.rev.state.la.us/. (3) louisiana permits electronic returns and e-payments on voluntary basis and requires e-returns and e-payments for amounts over $10,000 (reduced to $5,000 after 2007) (la. rev. stat. ann. § 47:1519; la. admin. code tit. 61, § 4910). (4) any person required to collect sales tax as a retailer may request a letter ruling seeking clarification of a tax issue (la. admin. code tit. 10, § 101). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the louisiana system is not fully transactional. maine. tax administration & technology. maine is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.maine.gov/revenue/. (3) maine permits electronic returns and e-payments on voluntary basis of all returns through the maine automated tax system (mats) (me. tax alert, bureau of taxation, oct. 1993) and requires e-returns and e-payments for amounts over $400,000 (code me. r. § 102). (4) any person required to collect sales tax as a retailer may request a letter ruling seeking clarification of a tax issue (me. rev. stat. ann. tit. 36, § 112). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the maine system is not fully transactional. maryland. tax administration & technology. maryland is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.comp.state.md.us/. (3) e-filing is generally available in maryland to businesses collecting sales and use taxes. eft is also 742 florida tax review vol. 7:10 voluntary, but required for businesses with a tax liability in excess of $10,000 md. code ann. §13-104(a)(1); md. code ann. §2-105(3)). e-returns and epayments are linked. a person making tax payments using the ach credit, ach debit, direct debit, or wire transfer method cannot file a corresponding (paper) return or report if the payment was for a sales and use tax report (com/rad-098), (md. regs. code § 03.01.02.05(b)(4). (4) the comptroller is authorized to adopt reasonable regulations for the administration of the sales and use taxes (including letter rulings) (md. code ann. §2-103; md. regs. code 03.01.01.03). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the maryland system is not fully transactional. massachusetts tax administration & technology. massachusetts is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.dor.state.ma.us/. (3) the commissioner is authorized to establish procedures providing for the payment, refund, or abatement of taxes, interest, or penalties by the electronic transfer of funds (mass gen. laws ch. 62c, § 78; mass gen. laws ch. 62c, § 5) and has done so. these voluntary options are mandatory if tax liabilities (including income, excise, room occupancy meals and telecommunications) exceed $10,000 in the preceding calendar year. other thresholds apply. once the taxpayer is required to file and pay electronically for one year all subsequent returns must also be filed and payments made electronically (ma. tech. info. rel. nos. 04-30 (oct. 26, 2004); 03-11 (july 1, 2003); 02-22 nov. 25, 2002)). all new businesses that are required to register with the massachusetts department of revenue on or after september 1, 2003, must use electronic means to file certain returns and make tax payments (ma. tech. info. rel. nos. 04-30 (oct. 26, 2004). (4) any person required to collect sales tax as a retailer may request a letter ruling seeking clarification of a tax issue (mass. regs. code tit. 830, § 62c.3.2). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the massachusetts system is not fully transactional. michigan. tax administration & technology. michigan is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.michigan.gov/treasury. (3) there is currently no provision for the michigan sales and use tax return to be filed electronically, although there is authority for electronic funds transmission of taxes due. eft payment obligations vary. for example, a retailer or other business that had a total michigan sales and use tax liability (after certain subtractions) in the previous calendar year of $720,000 or more must remit to the department, by electronic funds transfer (eft) an amount equal to 50% of the tax liability 2006] biometrics: solving the regressivity of vats and rsts 743 (mich. comp. laws §§ 205.56(3); 205.96(3)). (4) any person required to collect the sales tax as a retailer may request a letter ruling seeking clarification of a tax issue (mich. admin. bul. 1989-34). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the michigan system is not fully transactional. minnesota. tax administration & technology. minnesota is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.taxes.state.mn.us/. (3) sales and use tax returns and most other business tax return information must be filed electronically via the internet, computer-to-computer, telephone, and other electronic methods. (minn. sales tax newsletter, minnesota department of revenue (dec. 1999)). payment through eft is voluntary, however, taxpayers with $20,000 or more of sales and use tax liability in the state’s fiscal year ending june 30, 2005, must pay their tax electronically for payments due in calendar year 2006. taxpayers with $10,000 or more of sales and use tax liability in the state’s fiscal year ending june 30, 2006, must pay their tax electronically beginning with payments due in calendar year 2007 (minn. stat. § 289a.20(4)). (4) minnesota has no provision for letter rulings either in paper or electronic form. in addition, because there is no provision for digital case handling, decision, and delivery functions, the minnesota system is not fully transactional. mississippi. tax administration & technology. mississippi is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.mstc.state.ms.us/. (3) the tax commission requires sales and use taxpayers to who have liabilities over $20,000 or more to wire transfer funds through the federal reserve system or another approved electronic payment medium (miss. code ann. §§ 27-3-81 & 27-3-83; miss. rule 4). through rule 4 the commission notifies in writing certain taxpayers and their agents (180 days in advance) that they are required to e-file and e-pay. although the e-file and e-pay option is open to all taxpayers the commission has determined that this approach would provide a gradual shift to full digital filing. (4) any person required to collect sales tax as a retailer may request a letter ruling from the department of revenue requesting clarification of a tax issue (miss. tax comm. admin. practices & procedures pt. 1, §108.03; miss rule 1). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the mississippi system is not fully transactional. 744 florida tax review vol. 7:10 missouri. tax administration & technology. missouri is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.mstc.state.ms.us/. (3) missouri provides a limited means for electronic filing of sales and use tax returns. it also facilitates the payment of sales and use taxes through electronic means. because e-filing is limited to zero-returns (returns with zero gross receipts and zero tax liability) a full paper returns is still required for all taxpayers paying electronically. (mo. form 4789 instructions – sales tax detailed instructions and information book (rev. 11-2005)). in addition, the missouri web site provides that, monthly, quarterly, or annual filers of sales and use tax returns can pay the amount due of a currently filed return by using this payment option. the missouri department of revenue will still require a paper form of the tax return. this payment option is only available to sales and use tax filers with an open account. filers must enter the following information: missouri tax id, file period, and amount due for the currently filed period. this payment does not constitute filing of a sales tax return (voucher form or form 53-1) or a use tax return (form 53u-1). a paper filing of your sales a n d / o r u s e t a x r e t u r n s a r e s t i l l r e q u i r e d . (http://www.dor.mo.gov/tax/business/payonline.htm) (4) any person required to collect sales tax as a retailer may request a letter ruling from the department of revenue requesting clarification of a tax issue (mo. code regs. ann. tit. 12, §1-1.020). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the missouri system is not fully transactional. nebraska. tax administration & technology. nebraska is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.revenue.state.ne.us/. (3) the tax commissioner has authority to accept electronically filed applications, returns, and other documents (neb. rev. stat. § 77-1784(1)), and has the authority to require payment through electronic means (neb. rev. stat. § 77-1784(2)). through its web site, the commissioner has set out the rules for e-filing and epayment of sales and use taxes. all taxpayers may use electronic processing. electronically filed returns are given the same legal status as paper returns (neb. rev. stat. § 77-1784(6)). e-filing and e-payment are mandatory if tax amounts due exceed $20,000 (neb. rev. stat. § 77-1784). (4) nebraska has no provision for taxpayer to request a letter ruling seeking clarification of a sales and use tax issue. no provision is made for electronic filing of such a request. in addition, 2006] biometrics: solving the regressivity of vats and rsts 745 because there is no provision for digital case handling, decision, and delivery functions, the missouri system is not fully transactional. nevada. tax administration & technology. nevada is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.revenue.state.ne.us/. (3) nevada is in the process of adding e-filing capabilities on its web site (july 7-27, 2006), but currently has functionality only for e-payments (nev. uncodified reg., lcb file no. r06205). when completed, all taxpayers will be able to file on-line by affixing the taxpayer’s electronic signature to an e-return. e-payments may be submitted only by ach debit or ach credit. if a return is submitted electronically but payment is mailed, a copy of the printout of the electronic return confirmation page must be submitted with the payment and must be postmarked by the return due date (nev. admin. code § 360.22 (r062-05); nev. admin. code § 360.23 (r062-05). (4) nevada provides that taxpayers seeking advice may request a letter ruling clarifying a sales and use tax issue (nev. rev. stat. ann. §§ 372.725: 374.725). no provision is made for electronic filing of such a request. in addition, because there is no provision for digital case handling, decision, and delivery functions, the nebraska system is not fully transactional. new jersey. tax administration & technology. new jersey is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.state.nj.us/treasury/taxation/. (3) e-filing is voluntary and mandatory. a registered sales and use taxpayer whose gross receipts for a quarter are zero may voluntarily e-file, as well as taxpayers whose gross receipts for a quarter is greater than zero, but in this instance only if the taxpayer is authorized for the electronic funds transfer program. the director must give written approval (a) to the taxpayer with respect to payment by eft and (b) to the method chosen for making its eft payments (n.j. admin. code §18:2-3.10(a)). taxpayers that no longer desire to participate in the voluntary eft program must give the director written notice at least 30 days in advance of the date on which they wish to withdraw from participation in the program (n.j. admin. code §18:2-3.10(a)). e-filing is mandatory when sales and use tax payments must be made by electronic funds transfer. eft is mandatory when the taxpayer has a prior year liability of $10,000 or more. (n.j. stat. ann. § 54:48-4.1) (4) any person required to collect sales tax as a retailer may request a letter ruling from the regulatory services branch of the new jersey division of taxation seeking clarification of a tax issue. no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the new jersey system is not fully transactional. 746 florida tax review vol. 7:10 new mexico. tax administration & technology. new mexico is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.state.nm.us/tax/eser.htm. (3) most businesses subject to the gross receipts tax may use electronic returns and payment options, but not 13th month returns, those using special rates, and all amended returns. these returns must be filed on paper forms. (see, “who can use this system” at https://ec3.state.nm.us/crs-net/help/whouse.htm). (4) any person required to collect sales tax as a retailer may request a letter ruling seeking clarification of a tax issue (n.m. stat. ann. § 9-11-6.2). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the new mexico system is not fully transactional. new york. tax administration & technology. new york is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.tax.state.ny.us/. (3) all businesses may be voluntary participants in sales tax e-file and e-payment options. taxpayers whose annual sales tax liability is more than $500,000.00 are required to participate. the tax is to be remitted either via electronic funds transfer or certified check (n.y. dep’t. of tax and finance., press release (nov. 20, 2001)). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (n.y. comp. codes r. & regs. tit. 20 § 2376.2). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the new york system is not fully transactional. although, through a new electronic service for sales taxes taxpayers can request a password to view or pay open assessments. north carolina. tax administration & technology. north carolina is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.dor.state.nc.us/. (3) all businesses may voluntarily participant in sales tax e-file and e-payment options. (n.c. dep’t. of rev., online filing and payments, sales and use tax (nov. 18, 2002)). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (n.c. gen. stat. § 105-264.43). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the north carolina system is not fully transactional. north dakota. tax administration & technology. north dakota is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is 2006] biometrics: solving the regressivity of vats and rsts 747 provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.nd.gov/tax/. (3) north dakota sales tax returns may be filed on the internet using sales tax webfile. webfile is accessible on the office of the state tax commissioner’s website. sales and use tax permit holders may pay the tax over the internet using a secure webfile system. webfile payments are submitted by check, automated clearinghouse (ach) debit, ach credit (n.d. office of the state tax comm., sales tax newsletter (mar. 2006)). (4) any person required to collect sales tax as a retailer may request an advisory opinion from the research and statistics section seeking clarification of a tax issue (n.d. cent. code §§ 57-39.2-19 & 57-40.2-13). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the north dakota system is not fully transactional. ohio. tax administration & technology. ohio is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://tax.ohio.gov/. (3) ohio provides for both electronic payment and electronic filing of returns. the system is voluntary unless amounts exceed $75,000 (ohio rev. code ann. §§ 5739.02; 5739.122; 5739.12; 5741.12; 5741.121). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (ohio rev. code ann. § 5703.53). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the ohio system is not fully transactional. oklahoma. tax administration & technology. oklahoma is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.oktax.state.ok.us/. (3) the oklahoma quicktax system accepts e-returns from all taxpayers. in its voluntary aspect, taxpayers electing to file and remit under the eft program must follow the same schedules described above for businesses that are required to participate based on tax amounts due (okla. stat. tit. 68 § 1365(c)). the mandatory aspect of the program requires every person owing an average of $2,500 or more per month in total sales or use taxes in the previous fiscal year to remit the tax due and participate in the electronic funds transfer and electronic data interchange program (okla. stat. tit. 68 § 1365(d); okla. admin. code tit. 710, § 65-217(b)). they must remit the tax due and participate in the tax commission’s efunds and e-data exchange program, according to a prescribed schedule. (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (okla. admin. code tit. 710, § 1-3-73). no provision is made for electronic filing of ruling requests. in addition, because 748 florida tax review vol. 7:10 there is no provision for digital case handling, decision, and delivery functions, the oklahoma system is not fully transactional. pennsylvania. tax administration & technology. pennsylvania is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.revenue.state.pa.us/. (3) the pennsylvania department of revenue is authorized to allow the electronic filing of any tax return or document (72 pa. cons. stat. § 10003.8). the department has done so by allowing all taxpayers to file their sales and use tax returns electronically using the pa. tides program. a sales and use tax payment of $20,000 or more must be remitted by electronic funds transfer (eft) (pa. dep’t. of rev. reg. § 5.3). eft payments may be either ach debit or ach credit. (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (72 pa. cons. stat. § 6 & 61 pa. cons. stat. § 3.3). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the pennsylvania system is not fully transactional. rhode island. tax administration & technology. rhode island is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.tax.ri.gov/. (3) the rhode island e-filing system is voluntary (r.i. reg. eft 00-01(ii), but it is also tied to the federal system. in order for the e-filing and e-payment system to work a taxpayer must e-file both a federal and state return. if a taxpayer has already filed a federal return using another electronic filing service, state returns cannot be filed electronically. (r.i. div. of taxes, federal/state online filing, at http://www.tax.state.ri.us/elf/on-line.htm). if any tax liability exceeds $10,000, both the return and payment must be made by electronic means (r.i. gen. laws § 44-1-31; r.i. reg. eft 00-01). taxpayers that are required to pay employment taxes to the irs by electronic funds transfer also are required to file returns electronically with rhode island (r.i. gen. laws § 44-1-31). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (r.i. gen. laws § 42-35-8). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the rhode island system is not fully transactional. south carolina. tax administration & technology. south carolina is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.sctax.org/default.htm. (3) the department of revenue is authorized by the state treasurer to accept electronic returns and 2006] biometrics: solving the regressivity of vats and rsts 749 electronic forms of tax payment (s.c. code ann. § 12-54-75). south carolina has added e-file and e-payment functionality to its web site for all taxpayers (sales edi/eft; esales; business telfile). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (s.c. code ann. §§ 12-4-320 & 1-23-10(4); s.c. rev. proc. #05-2). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the south carolina system is not fully transactional. south dakota. tax administration & technology. south dakota is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.state.sd.us/drr2/revenue.html. (3) south dakota has allowed for e-filing and e-payment of sales and use tax returns since 1999 (s.d. sales tax newsletter, s.d. dep’t. of rev. (june 1999)). recent legislation links e-payment and e-filing by requiring taxpayers to e-file a return by the 23rd day of the month following each monthly period if they e-pay the tax by the second to the last day of the month following each monthly period (2006 s.d. laws h1048, §1; s.d. codified laws § 10-46e-7; s.d. codified laws § 10-59-39). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (s.d. codified laws § 10-59-27; s.d. admin. r. 64:06:01:01:08 10). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the south dakota system is not fully transactional. tennessee. tax administration & technology. tennessee is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.state.tn.us/revenue/. (3) taxpayers whose sales and use tax payments exceed $5,000 must e-file and e-pay (tenn. code ann. § 67-1-703(b)), and must continue to do so until the commissioner of revenue advises the taxpayer to file by another method. taxpayers designated for e-filing are notified by the commissioner of revenue and advised of the requirements that must be met. those who have not been notified by the department of revenue are not required to e-file and e-pay, but may volunteer to do so (tenn. code ann. § 67-1-703(b)). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (tenn. code ann. § 67-1-109). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the tennessee system is not fully transactional. 750 florida tax review vol. 7:10 texas. tax administration & technology. texas is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.window.state.tx.us/m23taxes.html. (3) the comptroller of public accounts is authorized to allow any taxpayer to file sales and use tax returns by means of electronic transmission if (a) the taxpayer enters into a written agreement with the comptroller, and (b) the method of electronic transmission is compatible. certain taxpayers are required to file any returns and reports electronically (texas admin. code ann. tit. 34 § 3.9). the government code requires certain persons to transfer funds to the comptroller by electronic funds transfer (tex. gov’t code ann. tit. § 404, § 95). mandatory e-filing is linked to mandatory e-payment. the e-filing of a sales and use tax return is required of the tax payments are required under eft. (tex. tax code ann. tit. 111, § 626). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (tex. admin. code tit. 34, §1.28). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the texas system is not fully transactional. utah. tax administration & technology. utah is a “stage 2” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://tax.utah.gov/. (3) utah law requires that the tax commission must allow internet-based sales and use tax filings (utah code ann. § 63d-1-105(1)(d)), however this capacity is being phased in. at the present time some, but not all utah sales and use tax returns can be filed on line. returns that must be filed on paper include tc-61f, tc-61fv, tc-61t, and tc-61w. in addition amended returns and late-filed returns remain paper-based. similarly, most but not all sales and use taxpayers are able to make payments on line. (utah state tax commission, online sales and use tax filing at http://tax.utah.gov/sales/salestaxonline.html). sellers whose state and local sales and use tax liability totaled $96,000 or more for the previously calendar year must transmit monthly tax payments by electronic funds transfer (utah code ann. § 59-12-108(2)). sellers who are not required to pay taxes electronically may elect to do so by contacting the commission within 30 days before the beginning of a new fiscal year. such sellers are subject to the same requirements and penalties as mandatory filers (utah admin. code r. § r865-19s-86(e)(2)). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (utah code ann. § 59-1-210; utah tax rule 861-1a-34). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the utah system is not fully transactional. 2006] biometrics: solving the regressivity of vats and rsts 751 vermont. tax administration & technology. vermont is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.state.vt.us/tax/. (3) filing of sales and use tax returns and payment of taxes may be performed electronically on a voluntary basis. the commissioner is authorized to require payments by eft from certain taxpayers (those who pay federal taxes electronically, and those who have previously submitted two or more uncollected checks) (vt. stat. ann. tit. 32, §§ 9243; 9776 & 5842(a)(4)(d)). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (vt. stat. ann. tit. 3, § 808). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the vermont system is not fully transactional. virginia. tax administration & technology. virginia is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.tax.virginia.gov/. (3) sales and use tax returns can be filed electronically, and payments may be made through eft (va. code ann. § 58.1-9(c)). if a taxpayer’s monthly sales and use tax liability exceeds $20,000, the taxpayer may be required to make the payments by electronic funds transfer (eft) (va. code ann. § 58.1-202.1). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (va. code ann. § 58.1-204). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the virginia system is not fully transactional. washington. tax administration & technology. washington is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://dor.wa.gov/. (3) payment may be made to the department of revenue by cash, check, cashier’s check, money order, and in certain cases by electronic funds transfers or other electronic means approved by the department (wash. rev. code § 82.32.080; wash. admin. code §45820-228 (rule 228)). the e-filing program (elf) is not open to all tax types, but includes the consumption tax administered by the department of revenue (wash. rev. code § 82.32.080; wash. admin. code §458-20-22802(4)). for taxpayers participating in the elf program paper returns are not needed, and payments must be electronic (through the ach debit method). taxpayers who have taxes due of $240,000 or more in a calendar year are required to pay by electronic funds transfer (wash. rev. code § 82.32.080; wash. admin. code §458-20-22802). filing of sales and use tax returns and payment of taxes may be performed electronically. (4) any person required to collect sales tax as a 752 florida tax review vol. 7:10 retailer may request an advisory opinion seeking clarification of a tax issue (wash. rev. code § 458-20-100(9)). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the washington system is not fully transactional. west virginia. tax administration & technology. west virginia is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.wvrevenue.gov/. (3) west virginia accepts electronic returns for sales and use tax (wv/cst-200 and wv/cst-220). an electronic signature will be accepted in lieu of an original handwritten signature when filing electronic records (w. va. code st. r. §§ 110-10d-2.6 & 110-10d5). while the department’s eft program is available to all taxpayers, the department may require the use of eft by taxpayers whose aggregate state, county, special district, or stadium sales and use tax liability exceeded $10,000 for the prior calendar year. (w. va. dep’t. rev, sales and use tax report, no. 2-20 (june 2000)). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (w.va. code ann. § 11-10-5r). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the west virginia system is not fully transactional. wisconsin. tax administration & technology. wisconsin is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.dor.state.wi.us/. (3) wisconsin department of revenue has sales and use tax electronic filing and payment options available for all taxpayers (sales telefile, sales internet process, file transmission, and electronic funds transfer) (wis. dep’t, rev., sales and use tax report, no. 106 (mar. 2006); wis. dep’t, rev., tax bull. no. 146 (feb. 2006)). administrative rules require certain sales and use tax returns to file electronically. sales and use tax registrants are given 90 days notice before the due date of the first period where they are required to file electronically. (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (wis. stat. ann. § 73.035). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the wisconsin system is not fully transactional. wyoming. tax administration & technology. wyoming is a “stage 3” benchmarked jurisdiction. (1) comprehensive web-based tax information is provided. (2) forms, documents and instructions are available on the web and can be downloaded at http://www.dor.state.wi.us/. (3) taxpayers may report and 2006] biometrics: solving the regressivity of vats and rsts 753 pay sales and use taxes electronically by using the wyoming internet filing service (wifs). taxpayers must first enter an electronic filing agreement with wifs (wyo. dep’t. rev, taxing issues, 6:3 (oct. 1, 2003). (4) any person required to collect sales tax as a retailer may request an advisory opinion seeking clarification of a tax issue (wyo. stat. ann. § 39-11-102(a)(i)(d). no provision is made for electronic filing of ruling requests. in addition, because there is no provision for digital case handling, decision, and delivery functions, the wyoming system is not fully transactional. page 1 page 2 page 3 page 4 page 5 _toc113893571 _toc113893572 _toc113893677 page 6 page 7 _ref142378905 _ref142378905 page 8 _ref142359994 _ref142359994 page 9 page 10 _ref142359724 _ref142359724 _ref142377850 _ref142377850 page 11 _ref142377729 _ref142377729 page 12 page 13 page 14 _ref142378763 _ref142378763 page 15 page 16 _ref142361597 _ref142361597 page 17 page 18 page 19 page 20 _ref142364995 _ref142364995 page 21 _ref142379931 _ref142379931 page 22 _ref142365164 _ref142365164 _ref142378003 _ref142378003 _ref142378021 _ref142378021 page 23 _ref142363992 _ref142363992 page 24 page 25 page 26 ole_link1 page 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journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 14 2013 number 5 was blackstone's initial public offering too good to be true?: a case study in closing loopholes in the partnership tax allocation rules by emily cauble* abstract typically, publicly traded entities must be treated as corporations for tax purposes. blackstone group lp is publicly traded, yet it is not treated as a corporation for tax purposes. why not? blackstone group lp utilizes complex tax structuring in order to qualify for an exception from the typical corporate tax treatment and, in the process, saves millions of dollars in tax liability annually. members of congress have proposed reforms that would have prevented blackstone group lp from reducing its tax liability in this manner. however, these reforms were not enacted this article takes a different approach. it argues that existing law already provides the irs with the tools needed to challenge the legitimacy of the results claimed by blackstone group lp. in the process, this article highlights an important and unintended loophole in existing partnership tax allocation rules specifically, the failure of the rules to adequately address allocations among related partners. finally, this article proposes that the irs use general tax law standards to close this unintended loophole. *assistant professor, michigan state university college of law (visiting at depaul university college of law). the author would like to thank daniel barnhizer, jennifer bird-pollan, samuel brunson, adam chodorow, heather field, jerold friedland, andrew gold, max helveston, david herzig, michael jacobs, jeffrey kwall, cary martin, martin mcmahon, andrea monroe, daniel morales, susan morse, michael sant'ambrogio, joshua sarnoff, jeffrey shaman, stephen siegel, susannah camic tahk, jeremy telman, deborah tuerkheimer, ben walther, mark weber, the editors of the florida tax review, and participants at the 16th annual critical tax theory conference hosted by the university of california hastings college of law in april 2013 for their valuable comments. this article will be presented at the law and society conference in boston, massachusetts in june 2013. 153 florida tax review 1. introduction ...................................... 155 ii. background: what does the blackstone group structure attempt to accomplish? . . . . . . . . . . . . . .. .. . . 159 a. publicly traded partnership rules ....... ................ 163 b. distribution by a corporation ................... 164 c. tax treatment of a u.s. corporation ........ .......... 164 d. tax treatment of a nonu.s. corporation ..... ...... 165 e. partnership allocations........................ 166 f. summary: how the pieces come together ..... ..... 169 iii. the blackstone group structure takes advantage of an unintended loophole in the partnership tax allocation rules..................................... 169 a. the partnership tax allocations rules...... ........... 174 1. economic effect: the rules ....................... 175 (i) capital account maintenance ...... ...... 176 (ii) liquidating based on capital account balances ............................... 177 2. economic effect: the implicit assumption: unrelated partners ...................... 177 3. substantiality: the rules.................. 178 4. substantiality: the implicit assumption: unrelated partners ...................... 182 b. the blackstone group structure takes advantage of the partnership tax allocation rules' inability to prevent tax-motivated allocations among related partners. ...................... ...... 186 iv. congressional response ................... ........ 188 v. proposal: using existing standards to close the unintended loophole in the partnership tax allocation rules...................................... 190 vi. responding to possible objections .................... 197 a. the irs should not invoke a standard like section 482 in an area covered by specific rules ........... 198 b. challenging the current structure would lead to undesirable consequences ................ ..... 199 c. blackstone group's structuring produces a logical result despite illogical rules .......... ............ 200 d. the damage is contained................. ..... 204 e. blackstone group did not engage in egregious tax abuse ..........................................205 vii. conclusion ............................... ......... 206 154 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? i. introduction from time to time, journalists, lawmakers, and scholars have discussed and criticized the tax treatment of various aspects of the private equity industry. over the past year, publicity regarding bain capital, the private equity firm founded by mitt romney, has dragged the private equity industry back into the public spotlight. particularly in light of the ongoing budgetary crisis, this attention will likely reignite debate over possible reforms to the tax treatment of private equity. the likelihood that actual reform will occur seems slim, given that lawmakers have proposed and failed to enact reform in the past. thus, rather than propose legislative reform, this article advocates a different approach. in particular, this article focuses on one particular transaction in which some private equity firms have engaged initial public offerings and argues that the irs could challenge the tax treatment of these transactions under current law rather than wait for congress to act. this article will discuss one such initial public offering, which was undertaken in 2007 by blackstone, and demonstrate how the irs could challenge blackstone's claimed tax consequences. more significantly, this article will use the blackstone transaction and other initial public offerings to illustrate a broader tax problem and its solution. blackstone (the "blackstone firm"), a private equity firm like bain capital, sponsors various private equity funds, real estate funds, and hedge funds. when the blackstone firm sponsors a fund, outside investors such as pension plans, educational endowments, financial institutions, and wealthy individuals agree to invest money in the fund. the blackstone firm selects projects and securities in which the fund will invest, and, in exchange for its efforts, the blackstone firm receives a management fee plus a percentage of the profits earned by the fund (referred to as "carried interest"). blackstone group lp trades on the new york stock exchange (nyse).' blackstone group lp is an entity that earns a portion of what the blackstone firm receives by way of management fees and carried interest from the various funds that it sponsors. thus, anyone who buys an interest on the nyse in blackstone group lp is entitled to share in what the blackstone firm receives as a fund sponsor. blackstone group lp is publicly traded, yet unlike many publicly traded companies, it manages to avoid being treated as a corporation for tax purposes. consequently, blackstone group lp is not required to pay corporate-level tax on any of its income, avoiding millions of dollars in tax 1. the blackstone group l.p., registration statement (form s-1) (mar. 22, 2007), http://www.sec.gov/archives/edgar/data/1393818/000104746907002068/a21 76832zs-1.htm [hereinafter blackstone s-1]. for further discussion of the tax structuring used by blackstone group lp, see victor fleischer, taxing blackstone, 61 tax l. rev. 89 (2008) [hereinafter fleischer, taxing blackstone]. 155 florida tax review liability annually. 2 complex tax structuring enables blackstone group lp to benefit from this atypical tax treatment. in particular, although entities that are publicly traded typically must be treated as corporations for tax purposes, a publicly traded partnership is eligible for partnership tax treatment in a given year if at least 90 percent of the partnership's gross income consists of certain types of "qualifying income" in that year and all previous years during which the partnership was publicly traded. without complex structuring, blackstone group lp would earn some qualifying income and some non-qualifying income and could very easily fail to meet this 90 percent gross income test.4 to avoid this result, blackstone group lp uses the structure shown in figure 1 below to ensure that it always meets the 90 percent gross income test.5 in this structure, the underlying partnership, an entity treated as a partnership for tax purposes, allocates all qualifying income directly to blackstone group lp and allocates all non-qualifying income to subsidiaries of blackstone group lp that are treated as corporations for tax purposes. allocating qualifying income directly to blackstone group lp ensures that such income retains its qualifying nature, and allocating all non-qualifying income to corporate subsidiaries transforms such income into qualifying income before it reaches blackstone group lp. as a result, blackstone group lp earns 100 percent qualifying income and avoids being treated as a corporation for tax purposes. blackstone group lp is not the only entity that has benefited from this structure. other private equity groups, including fortress, kkr, and carlyle, are publicly traded and use a similar approach. these publicly traded entities avoid enormous amounts of tax liability by using such structuring. for instance, by one estimate, blackstone group lp and its owners save $150 million in taxes annually.6 likewise, kkr and its owners save an 2. see infra note 6 and accompanying text. 3. i.r.c. § 7704(a) (stating general rule that publicly traded entities must be treated as corporations); i.r.c. § 7704(c) (providing exception). 4. see infra note 26 and accompanying text. 5. see infra part ii. 6. fleischer, taxing blackstone, supra note 1, at 96-97. these estimates compare the tax liability resulting from the actual structure to the tax liability that blackstone group and its owners would incur if blackstone group lp earned all income directly. if blackstone group lp's structure were challenged, it is possible that private equity firms engaging in initial public offerings (ipos) would change the terms of the ipos so that the publicly traded entities were entitled to earn only qualifying carried interest income and no management fees. as a result, the treasury might collect little additional tax revenue because the publicly traded entities would still be treated as partnerships for tax purposes. however, private equity firms could not make this adjustment without significantly changing the underlying economic 156 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? estimated $277 million in taxes annually.7 furthermore, this structure has not been used exclusively by private equity groups. a recent article in the wall street journal featured a publicly traded firm that specializes in running cemeteries and benefits from a similar technique. members of congress proposed reforms that would have put an end to the tax advantages claimed by blackstone group lp and similar companies.9 however, these reforms sought to change the publicly traded partnership rules rather than address the root of the problem the manner in which tax items are allocated by the underlying partnership. moreover, the proposed reforms were not enacted. unlike the reforms proposed by congress, this article focuses on the allocations by the underlying partnership. existing tax regulations restrict how a partnership, like the underlying partnership, can allocate income among its partners. lawmakers intended for these regulations to deter excessively tax-motivated allocations, believing that they could achieve the objective of disallowing tax-motivated allocations by requiring partnerships to follow technical, mechanical rules.'o however, although the mechanical rules might have a chance of preventing a partnership from utilizing tax-motivated allocations if its partners are unrelated and, thus, have opposing economic interests, the rules are ill-suited for restricting the allocations of a partnership when its partners are related and their economic interests are aligned." the structure used by blackstone group and numerous other taxpayers takes advantage of this significant unintended loophole in the partnership tax allocation rules. in particular, because the partners in the underlying partnership are related, the underlying partnership is able to allocate income in a tax-motivated manner without running afoul of the literal language of the partnership tax allocation rules. fortunately, existing tax law offers a tool that can be used to close the unintended loophole in the partnership tax allocation rules highlighted by this article. perhaps because it is not unusual for technical tax rules to contain unintended gaps, existing tax law provides general standards that the irs can use to challenge taxpayers who abuse the gaps. this article deal so that investors in the publicly traded entities were no longer entitled to receive a share of management fees. 7. john d. mckinnon, more firms enjoy tax free status, wall st. j., jan. 10, 2012, http://online.wsj.com/article/sb1000142405297020373350457702 6361246836488.html. 8. id. 9. see infra part iv. 10. see infra notes and accompanying text. 11. i use the term "unrelated" to refer to partners with opposing economic interests, and i use "related" to refer to partners with economic interests that are aligned. for further discussion of when partners would be "related," see infra note. 157 florida tax review proposes that the irs use such a standard to protect the tax system from taxpayers, like blackstone group, who exploit the partnership tax rules' unintended failure to police allocations among related partners. in particular, this article proposes that the irs invoke section 482 to challenge the results claimed by blackstone group. section 482 deals broadly with the ubiquitous problems arising from the fact that related parties do not negotiate at armslength and, in turn, might manage their transactions in a way designed purely to minimize aggregate tax liability.12 this article contributes to the existing literature in two significant ways. first, rather than discuss legislative reforms that would alter the results claimed by blackstone group and other taxpayers, this article argues that these transactions are vulnerable to challenge under current law. this conclusion is significant because it suggests that steps could be taken to address the transactions even if congress fails to act. second, this article highlights an important shortcoming of the partnership tax allocation rules that has received little attention by scholars. 3 this article begins to fill this void in the existing literature by discussing the failure of the partnership tax allocation rules to regulate allocations among related partners and suggesting how the irs could use existing tax-law standards to compensate for the current partnership tax rules' shortcomings. the irs could use this proposed solution broadly because it would apply whenever related entities form a partnership and engage in tax-motivated allocations. finally, because recent publicity regarding bain capital, the private equity firm founded by mitt romney, has once again focused public attention on the private equity industry, 4 now is a particularly opportune time to examine tax structuring used by private equity funds. further, this topic is especially timely given the nation's fiscal problems and the search for additional sources of tax revenue.'5 12. for further discussion of section 482, see infra part v. 13. one article does briefly discuss the fact that the partnership tax allocation rules, when literally applied, may permit tax-motivated allocations among related partners. see richard m. leder, tax-driven partnership allocations with economic effect: the overall after-tax present value test for substantiality and other considerations, 54 tax law. 753, 769, 779-80 (2001) [hereinafter leder, tax-driven partnership allocations]. however, leder's article does not demonstrate in detail how the partnership tax allocation rules are implicitly premised on the assumption that partners are unrelated and have opposing economic interests. 14. see, e.g., mark maremont, tax rule opens rich vein for debate: romney's favorable treatment for some bain income draws attention to murky reaches of irs code, wall st. j., jan. 28, 2012, at a6, http://online.waj.com/ article/sb 10001424052970203363504577187100058632034.html. 15. see, e.g., jane sasseen, with tax advantages looking shaky, private equity seeks a new path, n.y. times deal book, jan 21, 2013, http://dealbook. nytimes.com/2013/01/2 1/with-tax-advantages-looking-shaky-private-equity-seeks-a[vol. 14:5158 2013] was blackstone's initial public offering too good to be true? this article proceeds as follows: part ii describes the structure used by blackstone group lp. part iii highlights a dangerous, unintended loophole in the partnership tax allocation rules namely their inability to prevent tax-motivated allocations among related partners. part iv discusses congressional responses to the blackstone group lp structure. part v proposes that the irs should invoke existing tax-law standards to close the loophole in the partnership tax allocation rules, enabling the irs to challenge the tax consequences claimed by blackstone group and other taxpayers. part vi considers and responds to potential objections to the proposal in part v. part vii concludes that none of the objections discussed in part vi justify the irs's inaction, and, as a result, the irs should challenge the results claimed by blackstone group lp. ii. background: what does the blackstone group structure attempt to accomplish? although entities that are publicly traded typically must be treated as corporations for tax purposes, a publicly traded partnership is eligible for partnership tax treatment in a given year if at least 90 percent of the partnership's gross income consists of certain types of "qualifying income" in that year and all previous years during which the partnership was publicly traded.' 6 "qualifying income" includes dividend income, interest income, capital gain income, and other types of investment income.' 7 with regard to the purpose of this 90 percent qualifying income rule, legislative history indicates that congress thought it was inappropriate to impose corporatelevel tax on dividend income, interest income, and other types of investment income because owners of the publicly traded partnership could earn such income directly rather than through a publicly traded intermediary.18 maintaining partnership tax status is advantageous. if an entity is treated as a corporation for tax purposes, generally the entity itself will be subject to tax ("entity-level tax").19 furthermore, owners of the entity may be subject to tax when they sell ownership interests in the entity or receive certain distributions from the entity.20 if an entity is treated as a partnership for tax purposes, the entity will not be subject to tax. instead, any items of new-path/ ("as washington grapples with the country's fiscal woes, the private equity industry is grudgingly facing a new reality: its long-held tax advantages are likely to disappear."). 16. i.r.c. § 7704(a) (providing general rule that publicly traded entities must be treated as corporations); i.r.c. § 7704(c) (providing exception). 17. i.r.c. § 7704(d). 18. see infra note 164. 19. see i.r.c. § 11. 20. see i.r.c. § 301 (addressing distributions from corporations); i.r.c. § 1001 (regarding gain from sale of ownership interests). 159 florida tax review tax income, gain, loss, or deduction recognized by the entity will be passed through to the entity's owners for the owners to take into account directly when computing their own taxable income.2 1 thus, treatment as a corporation generally involves two levels of tax both an entity-level tax and an owner-level tax.22 by contrast, treatment as a partnership involves only one level of tax, the tax imposed at the owner level.23 blackstone group lp earns management fees and carried interest income received by the blackstone firm from the funds that it sponsors. management fees are not qualifying income. carried interest income may be, in part, qualifying income but also, in part, non-qualifying income depending on the types of activities in which the blackstone firm's funds engage, as discussed in more detail below.24 thus, without complex structuring, blackstone group lp would earn some qualifying income (a portion of its carried interest) and some non-qualifying income (management fees and a portion of its carried interest). if, in a given year, less than 90 percent of blackstone group lp's total gross income was qualifying income, blackstone group lp would be treated as a corporation in that year and in all future years.2 5 judging from its actual historical earnings, blackstone group lp likely would fail this 90 percent test but for the tax structuring it uses. for example, according to its most recent annual report, in 2011, blackstone group lp earned $1.8 billion 26in management fees and $1.2 billion in carried interest income. as a result, even assuming all carried interest income was qualifying income, blackstone group lp would have failed the 90 percent gross income test because only 40 percent (or $1.2 billion divided by ($1.2 billion plus $1.8 billion)) of its gross income would have been qualifying income. if blackstone group lp were treated as a corporation, it would be required to pay corporate-level tax on all of its income (qualifying income and non-qualifying income). to avoid this result, blackstone group lp uses the structure shown in figure 1 27below to ensure that it meets the 90 percent gross income test in all years. 21. see i.r.c. § 701. 22. see supra notes 19 and 20 and accompanying text. 23. see supra note 21 and accompanying text. 24. see infra part ii.e. 25. i.r.c. § 7704(c). this is true assuming that blackstone group lp would not be entitled to relief for inadvertent failure to comply with the 90 percent gross income test. see i.r.c. § 7704(e) (describing such relief). 26. the blackstone group l.p., annual report (form 10-k), 77 (feb. 28, 2012), http://www.sec.gov/archives/edgar/data/1393818/000119312512085636/d23 2355dl0k.htm. 27. this is a somewhat simplified version of the actual structure, which can be seen in blackstone s-1, supra note 1, at 11. for a detailed discussion of how this structure is derived from the facts in blackstone's registration statement, see the attached appendix. 160 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? figure 1. blackstone structure simplified allocation of qualifying carried interest payment of management fees 161 allocation of nonqualifying carried interest partnership florida tax review in this structure, the underlying partnership is an entity treated as a partnership for tax purposes. the underlying partnership allocates qualifying carried interest income directly to blackstone group lp.28 because this income is allocated directly to blackstone group lp, it retains its original character, and, thus, all income blackstone group lp receives directly from the underlying partnership is qualifying income.29 the underlying partnership pays management fees and allocates non-qualifying carried interest income to either "u.s. subsidiary" (an entity formed in the united states) or "non-u.s. subsidiary" (an entity formed in canada). 30 both of these entities are treated as corporations for u.s. tax purposes.3' because they are corporations, when these entities distribute cash to blackstone group lp, blackstone group lp recognizes dividend income or capital gain income.3 2 dividend income and capital gain income are types of qualifying income. 33 thus, non-qualifying income allocated or paid to u.s. subsidiary and non-u.s. subsidiary is converted into qualifying income before it reaches blackstone group lp, which is the only reason nonqualifying income is allocated or paid to these entities.34 as a result, blackstone group lp earns 100 percent qualifying income because its income consists of qualifying income received directly from the underlying partnership, dividend income received from u.s. subsidiary or non-u.s. subsidiary, and capital gain income received from u.s. subsidiary or nonu.s. subsidiary.35 consequently, regardless of the mix of carried interest and management fees received in any particular year, blackstone group lp will always qualify for the exception from corporate tax treatment because at least 90 percent of its income (more specifically, 100 percent of its income) will be qualifying income. 36 finally, u.s. subsidiary will pay corporate-level 28. see blackstone s-1, supra note 1, at 202-04. see also infra appendix. 29. "character" of income refers to the type of income. for instance, if the underlying partnership earned dividend income and allocated such income to blackstone group lp, blackstone group lp would recognize dividend income. for further discussion of the underlying partnership's allocations, see infra part ii.e. 30. blackstone s-1, supra note 1, at 202-04. see also appendix. 31. blackstone s-1, supra note 1, at 202-04 ("u.s. subsidiary" in the simplified structure is the counterpart to "blackstone holdings i gp inc." and "blackstone holdings ii gp inc." in the actual structure, and "non-u.s. subsidiary" in the simplified structure is the counterpart to "blackstone holdings v gp lp" in the actual structure.). 32. see i.r.c. § 301. 33. i.r.c. § 7704(d). 34. see id. 35. see supra notes 29, 34 and accompanying text. 36. see blackstone s-1, supra note 1, at 202 ("we intend to manage our affairs so that we will meet the [90 percent gross] income exception in each taxable year. we believe we will be treated as a partnership and not as a corporation for u.s. [vol. 14:5162 2013] was blackstone's initial public offering too good to be true? tax on income it earns, so corporate-level tax is not completely avoided. however, although u.s. subsidiary pays corporate-level tax on the nonqualifying income it earns, no entity in the structure pays corporate-level tax on the qualifying income allocated directly to blackstone group lp, and non-u.s. subsidiary pays no corporate-level tax on the non-qualifying income allocated to it, as discussed in more detail below. 8 by contrast, if blackstone group lp did not employ this structure and were treated as a corporation for tax purposes, it would be subject to corporate-level tax on all income (qualifying income and non-qualifying income). 9 a complete understanding of this structure requires some knowledge of multiple areas of tax law. in turn, this section will discuss each necessary building block and then conclude by illustrating how all of the building blocks come together in the structure used by blackstone group lp. a. publicly traded partnership rules although many business entities can elect to be treated as partnerships or corporations for tax purposes, certain entities must be treated as corporations. 4 0 for example, entities that are publicly traded typically must be treated as corporations for tax purposes. 4 ' an entity that is listed on an established securities exchange, like the new york stock exchange, is publicly traded.42 thus, blackstone group lp is publicly traded and would fall within the general rule mandating corporate tax treatment but for the fact that it is structured to qualify for an exception from this general rule.43 federal income tax purposes. simpson thacher & bartlett llp will provide an opinion to us based on factual statements and representations made by us, including statements and representations as to the manner in which we intend to manage our affairs and the composition of our income, that we will be treated as a partnership and not as an association or publicly traded partnership (within the meaning of section 7704 of the code) subject to tax as a corporation for u.s. federal income tax purposes."). 37. however, the structure may also be designed to reduce the amount of taxable income recognized by u.s. subsidiary. see infra part ii.c. 38. see infra part ii.d. 39. see supra notes 26-27 and accompanying text. 40. regs. §§ 301.7701-3(a) (providing ability to elect tax classification to many entities); 301.7701-2(b)(1), (388) (describing entities that must be treated as corporations). 41. i.r.c. § 7704. 42. see i.r.c. § 7704(b)(1). a partnership will also be publicly traded if interests in the partnership are traded on a "secondary market (or the substantial equivalent thereof)." i.r.c. § 7704(b)(2). 43. see infra part ii.f. (summarizing how the structuring accomplishes this objective). 163 florida tax review regarding the exception (the "90 percent gross income exception"), publicly traded entities nevertheless may be eligible for partnership tax treatment if at least 90 percent of their income consists of certain types of "qualifying income."44 "qualifying income" includes dividend income, interest income, capital gain income, and other types of investment income.45 b. distributions by a corporation when a corporation distributes cash to its shareholders, the shareholders may recognize dividend income or capital gain income.46 in particular, to the extent that the distribution does not exceed the corporation's available earnings and profits, shareholders will recognize dividend income.47 if the distribution does exceed earnings and profits, shareholders could potentially recognize gain from the sale of stock in the corporation, which will be capital gain income in most cases.4 8 thus, the income recognized by blackstone group lp as a result of receiving distributions from u.s. subsidiary and non-u.s. subsidiary will be dividend income or capital gain income.49 c. tax treatment ofa u.s. corporation a u.s. entity treated as a corporation for tax purposes is subject to tax, generally at a rate of 35 percent, on all of its taxable income.50 thus, if blackstone group lp were treated as a corporation, it would owe a 35 percent tax on all of its taxable income. 44. i.r.c. § 7704(c). for more on the purpose for this qualifying income exception, see infra note 164. 45. i.r.c. § 7704(d). 46. this assumes the shareholders are receiving distributions because they are shareholders and not because of some other relationship they have with the corporation, such as an employment relationship. see i.r.c. § 301 (providing that the treatment described applies only to distributions made by a corporation to a shareholder "with respect to its stock"). 47. i.r.c. §§ 301(c)(1), 316. 48. i.r.c. § 301(c)(3)(a). 49. see blackstone s-1, supra note 1, at 202-04. see also infra appendix. the tax treatment of a shareholder of a non-u.s. corporation could differ from what is described in the text if the non-u.s. corporation earned passive income. in this case, special "anti-deferral" rules could apply. however, assuming only active income is allocated to non-u.s. subsidiary, the anti-deferral rules would not apply to the blackstone group lp structure. 50. i.r.c. § 11. 164 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? furthermore, in the structure used by blackstone group lp, u.s. subsidiary is subject to 35 percent tax on all of its taxable income.5 1 its taxable income consists of management fees and allocations of nonqualifying income received from the underlying partnership less allowable expenses. in order to increase the deductible expenses incurred by u.s. subsidiary, blackstone group lp might loan funds to u.s. subsidiary and charge u.s subsidiary interest. 52 as a result, u.s. subsidiary could deduct this interest expense, reducing its taxable income.13 moreover, the interest income received by blackstone group lp from u.s. subsidiary would be qualifying income and, consequently, would not jeopardize its ability to comply with the 90 percent gross income exception.54 d. tax treatment ofa non-u.s. corporation a non-u.s. corporation is subject to u.s. tax only on u.s. source income and income effectively connected with a u.s. trade or business.55 furthermore, a corporation is considered a non-u.s. corporation simply by virtue of the fact that it is formed outside of the united states.5 6 non-u.s. subsidiary, shown in figure 1, was formed in alberta, canada and elected to 51. id.; see also blackstone s-1, supra note 1, at 202-04 ("u.s. subsidiary" in the simplified structure is the counterpart to "blackstone holdings i gp inc." and "blackstone holdings ii gp inc." in the actual structure); infra appendix. 52. from blackstone's documents, it is not entirely clear whether they used debt to reduce u.s. subsidiary's taxes in this manner. however, fortress, a similar company that engaged in a similarly structured initial public offering, did use debt in this manner. see, e.g., susan beck, the transformers, am. law. nov. 1, 2007, at 94 ("the blocker [(the counterpart to u.s. subsidiary in the fortress structure)] would borrow a large amount of money from another fortress subsidiary, according to two people familiar with the deal. the blocker's interest payments on this debt, which are deductible, would wipe out much of its taxable income . . . . it's not clear if blackstone's blocker corporations are heavily debt-laden to wipe out taxable income."); see also, blackstone s-1, supra note 1, at 61 ("the wholly-owned subsidiaries of the blackstone group l.p. will concurrently with the reorganization and may from time to time thereafter enter into intracompany lending arrangements with one another." this statement may or may not refer to using debt to reduce corporate-level tax paid by u.s. subsidiary). 53. see i.r.c. § 163 (providing for an interest deduction). the ability to deduct interest would be subject to certain limitations. for example, if u.s. subsidiary were too thinly capitalized, some of the debt could be recast as equity for tax purposes. likewise, if blackstone group lp charged an interest rate that was higher than a market rate, the debt could be recast as equity for tax purposes. 54. i.r.c. § 7704(d)(1)(a). 55. i.r.c. §§ 881-882. 56. i.r.c. § 7701(a)(4), (5). 165 florida tax review be treated as a corporation for u.s. tax purposes.5 7 thus, non-u.s. subsidiary is a non-u.s. corporation. presumably, the underlying partnership allocates to non-u.s. subsidiary only income that is not u.s. source and is not effectively connected with a u.s. trade or business." as a result, non-u.s. subsidiary has no u.s. tax liability. moreover, although special anti-deferral rules can apply to non-u.s. corporations in some circumstances, as long as non-u.s. subsidiary earns only active income, these rules would not apply to non-u.s. subsidiary. finally, non-u.s. subsidiary likely owes no canadian tax because it is formed as an alberta limited partnership that is likely a flow-through entity for canadian tax purposes,5 9 despite its elective treatment as a corporation for u.s. tax purposes. e. partnership allocations entities treated as partnerships for tax purposes are not subject to tax at an entity level.60 instead, partnerships allocate to their partners all items of tax gain, loss, income, and deduction recognized by the partnership, and each partner takes into account amounts allocated to that partner when determining his, her, or its taxable income.' moreover, the character of income allocated to a partner is the same as the character of the income earned by the partnership.6 2 carried interest is a right to receive profits earned by a partnership and, thus, is an interest in a partnership. consequently, the person or entity that holds the right to carried interest will be allocated a share of income earned by the partnership. moreover, because the character of income allocated to a partner depends on the character of income earned by the 57. blackstone s-1, supra note 1, at 204 ("blackstone holdings v gp l.p. [(the counterpart to non-u.s. subsidiary in the actual structure)] is taxable as a foreign corporation for u.s. federal income tax purposes."). 58. see id. ("blackstone holdings v gp l.p. [(the counterpart to non-u.s. subsidiary in the actual structure)] is expected to be operated so as not to produce [effectively connected income]."). 59. id. at 60 (stating that blackstone holdings v gp l.p. (the counterpart to non-u.s. subsidiary in the actual structure) is an alberta limited partnership); aba section of taxation, choice of entity ownership of real estate including cross border investments 28-29 (2007), http://www.americanbar.org/content/ dam/aba/events/realproperty trust estate/joint fall/2007/choice of entityownersh ip_of real.authcheckdam.pdf (table indicating that limited partnerships receive flowthrough tax treatment in canada). 60. i.r.c. § 701. 61. id. 62. i.r.c. § 702(b). 63. i.r.c. §§ 701-702. [vol. 14:5166 2013] was blackstone's initial public offering too good to be true? partnership, the character of carried interest depends on the type of underlying partnership income allocated to the person or entity that receives carried interest.6 the blackstone firm sponsors funds that engage in a variety of activities and earn a variety of different types of income. in particular, the blackstone firm's funds earn dividend income, capital gain income, and interest income, all of which are types of "qualifying income" for purposes of the 90 percent gross income exception. the blackstone firm's funds also earn break-up fees. when a private equity fund is planning to acquire a business, if the deal is not ultimately consummated, the private equity fund may receive a break-up fee from the current owner of the business. this break-up fee is likely non-qualifying income.66 some funds sponsored by the blackstone firm might earn other types of non-qualifying income. for example, if a blackstone real-estate fund owns and operates a hotel, it would receive non-qualifying income from providing services. some of the non-qualifying income earned by the blackstone firm's funds will be treated as income from operating a u.s. business, and some non-qualifying income will be treated as income from operating a non-u.s. 64. i.r.c. § 702(b). 65. i.r.c. § 7704(d). 66. see, e.g., fleischer, taxing blackstone, supra note 1, at 108 (concluding that it would be difficult to characterize break-up fees as qualifying income). furthermore, in plr 200823012, the irs concluded that a termination fee received by a taxpayer as a result of an abandoned merger agreement was ordinary income rather than capital gain income. the irs based its conclusion on an "origin-of-theclaim" analysis. in particular, because the fee was designed to compensate the taxpayer for profits it would have earned if the merger was consummated and because such profits would have been ordinary income, the termination fee was ordinary income. however, it should be noted that some would characterize break-up fees resulting from a failure to purchase stock as compensating a taxpayer for lost profits on a stock investment. see, e.g., other pass through entities, 735-2d tax mgmt. (bna) vii-c ("the tax issue, therefore, is whether a break-up fee reimburses the fund for lost profits on a stock investment. if so, then the break-up fee is a surrogate for capital gain . . . ."). under this view, at least some break-up fees could be qualifying income. 67. income from providing services is not a type of qualifying income. i.r.c. § 7704(d). if the blackstone firm's funds hold interests in hotels through entities treated as corporations for tax purposes, however, carried interest received with respect to the hotels could be qualifying income (in particular, dividend income and capital gain income received from the corporations). yet, if the blackstone firm's funds hold interests in hotels through corporations, it is possible that the blackstone firm receives carried interest with respect to the hotel through an entity formed between the corporation and the hotel that is treated as a partnership for tax purposes. in that case, the carried interest would be treated as services income and, in turn, non-qualifying income. 167 florida tax review business. for instance, depending on the facts, break-up fees could be treated as non-qualifying income from operating a u.s. business or as nonqualifying income from operating a non-u.s. business.68 likewise, nonqualifying services income from operating a hotel could be treated as income from operating a u.s. business or as income from operating a non-u.s. business depending on where the hotel is located and other facts.6 9 in summary, first, some of the carried interest allocated by the underlying partnership to its partners will be qualifying income. carried interest in this first category includes, for instance, the portion of carried interest that consists of dividend income, interest income, and capital gain income. second, some of the carried interest will be non-qualifying income attributable to a u.s. business. carried interest in this second category includes services income from operating a u.s. hotel or break-up fees from failing to acquire a u.s. business. third, some of the carried interest will be non-qualifying income attributable to a non-u.s. business. carried interest in this third category includes services income from operating a non-u.s. hotel or break-up fees from failing to acquire a non-u.s. business. the underlying partnership allocates qualifying carried interest directly to blackstone group lp.7o because income allocated by a partnership to a partner retains its character in the hands of the partner, blackstone group lp recognizes qualifying income as a result of this allocation.7 ' the underlying partnership allocates carried interest that consists of non-qualifying income that is u.s. business income to u.s. subsidiary.7 2 the underlying partnership also pays management fees to u.s. subsidiary.73 as discussed above, u.s. subsidiary will be subject to entitylevel tax on this income, possibly reduced by interest expense resulting from interest that it may pay to blackstone group lp.74 the underlying partnership allocates carried interest that consists of non-qualifying income that is non-u.s. business income to non-u.s. subsidiary.75 as discussed above, non-u.s. subsidiary will not be subject to entity-level tax on this income.76 68. under an origin-of-the-claim analysis, the break-up fee could be treated as income from operating a u.s. business if the company to be acquired operated a u.s. business. if, instead, the company operated a non-u.s. business, the break-up fee could be treated as income from operating a non-u.s. business. 69. the source of income from providing services generally depends on where the services are performed. see i.r.c. §§ 861(a)(3), 862(a)(3). 70. blackstone s-1, supra note 1, at 202-04. see also infra appendix. 71. i.r.c. § 702(b). 72. blackstone s-1, supra note 1, at 202-04. see also infra appendix. 73. blackstone s-1, supra note 1, at 202-04. see also infra appendix. 74. see supra part ii.c. 75. blackstone s-1, supra note 1, at 202-04. see also infra appendix. 76. see supra part h.d. 168 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? f. summary: how the pieces come together if blackstone group lp directly earned the income to which it is entitled, less than 90 percent of blackstone group lp's income would consist of qualifying income, and, as a consequence, blackstone group lp would be treated as a corporation for tax purposes.77 to avoid this result and, in the process, save substantial tax liability, blackstone group lp uses the structure illustrated above in figure 1. in this structure, the underlying partnership allocates or pays any non-qualifying income to u.s. subsidiary or non-u.s. subsidiary and allocates any qualifying income directly to blackstone group lp. as a result, blackstone group lp earns 100 percent qualifying income (either income allocated directly to it or dividend income, capital gain income, and, possibly, interest income received from u.s. subsidiary and non-u.s. subsidiary). consequently, blackstone group lp qualifies for the 90 percent gross income exception, is treated as a partnership for u.s. tax purposes, and avoids having to pay corporate-level tax on all of its income. corporate-level tax is not entirely avoided, as u.s. subsidiary pays corporate-level tax on some of the income allocated to it. however, qualifying income allocated to blackstone group lp and income allocated to non-u.s. subsidiary escape corporate-level tax. these results hinge on the underlying partnership's tax allocations. hence, part iii will demonstrate that the underlying partnership's tax allocations exploit a loophole in the current partnership tax allocation rules. iii. the blackstone group structure takes advantage of an of an unintended loophole in the partnership tax allocation rules as discussed above, a partnership allocates among its partners tax items that the partnership recognizes.78 partnerships are not free, however, to allocate items among partners in any manner whatsoever. if partnerships were completely unconstrained in their ability to allocate tax items, they could too easily allocate items in a manner that minimized the partners' aggregate tax liability. in order to demonstrate, consider the following example. example 1. assume tom and leslie, two unrelated individuals, form a partnership. each individual contributes $100. the partnership acquires land for $200 at the beginning of year i and sells the land for $300 during year 1. 77. see supra notes 26-27 and accompanying text. 78. see supra part ii.e. 169 florida tax review in year 2, the partnership liquidates, distributing $150 cash to each partner. regarding the tax consequences, in year 1, the partnership recognizes $100 of tax gain. the partnership does not pay entity-level tax on this gain but, rather, allocates it between tom and leslie. assume tom would be subject to a tax rate of 50 percent on gain from the sale of the land, while leslie would be subject to a tax rate of 0 percent on gain from the sale of the land.79 if the partnership were allowed to do so, it would allocate $100 tax gain to leslie (who pays no tax on the gain) and $0 tax gain to tom."o as numerous other commentators have observed, the purpose of the rules governing partnership tax allocations is to prevent excessively tax79. for example, leslie could be subject to 0 percent tax if (1) leslie recognized tax losses from other sources that would offset gain allocated to her from the partnership, and (2) she did not recognize other income from which the losses could be deducted. 80. even if the partnership were allowed to do this, tom would not escape tax indefinitely because in year 2, at the time of the liquidation, tom would recognize $50 of tax gain and leslie would recognize $50 of tax loss. tom recognizes $50 of tax gain because tom's basis in his partnership interest just prior to liquidation will be $100. his basis equals the $100 cash he contributed plus $0 tax gain allocated to him. see i.r.c. § 705(a). because this basis is $50 lower than the amount of cash he receives on liquidation, he recognizes $50 of tax gain. see i.r.c. § 731(a)(1). leslie recognizes $50 tax loss on liquidation. leslie's basis in her partnership interest just prior to liquidation is $200, which equals the $100 cash she contributed plus the $100 tax gain allocated to her by the partnership. see i.r.c. § 705(a). because the amount of cash she receives on liquidation (i.e., $150) is $50 lower than her basis in the partnership, leslie recognizes $50 tax loss on liquidation. see i.r.c. § 73 1(a)(2). however, although tom eventually recognizes $50 tax gain, tom nevertheless can benefit from the allocations for two reasons. first, tom is able to defer tax liability until the year in which the partnership liquidates. second, it is possible that the character of gain recognized by tom on liquidation is different than gain from the sale of the land, and it is taxed more favorably than gain from the sale of the land so that tom may pay a rate of tax on the gain in year 2 that is less than 50 percent. see i.r.c. § 731(a) (flush language) (providing that gain recognized by tom as a result of the partnership distributing cash to him will be treated as gain from the sale of his interest in the partnership); i.r.c. § 741 (providing that gain from the sale of a partnership interest is treated as capital gain subject to the exceptions set forth in section 751 which would not apply to a partnership that holds no assets other than cash). [vol. 14:5170 2013] was blackstone's initial public offering too good to be true? motivated allocations.81 moreover, the rules strive to accomplish this goal by requiring a link between tax allocations and the partners' economic benefits and burdens. to demonstrate, consider the following example. example 2. assume the same facts as example 1. given the restrictions on how partnerships can allocate tax items, the partnership could only allocate $50 more tax gain from the sale of the land to leslie than tom if leslie and tom agreed that leslie would receive $50 more cash than tom. thus, the partnership could allocate all $100 tax gain from the land 81. see, e.g., 1 arthur b. willis & philip f. postlewaite, partnership taxation i 10.01[3][b] (7th ed. 2011) [hereinafter willis & postlewaite, partnership taxation] (discussing how the purpose of the restrictions on partnership tax allocations is to prevent using partnership tax allocations for tax avoidance purposes); david hasen, partnership special allocations revisited, 13 fla. tax rev. 349, 350 (2012) ("congress seems to have had in mind that income assignments among partners should be permissible as long as they are not, or are not unduly, tax-motivated."); andrea monroe, too big to fail: the problem of partnership allocations, 30 va. tax rev. 465, 487 (2012) [hereinafter monroe, too big to fail] ("[t]he substantiality requirement . . . became the treasury's chief tool for distinguishing legitimate from abusive allocations."). this is not to say that the treasury regulations contain a requirement that allocations have a business purpose. rather, the point is simply that the technical rules in the treasury regulations exist for a reason, and that reason is to sort between allocations that are excessively taxmotivated and allocations that have at least some non-tax effect. 82. see, e.g., 1 william s. mckee, william f. nelson & robert l. whitmire, federal taxation of partnerships and partners 10.02[1] (3d ed. 2004) [hereinafter mckee, nelson & whitmore, partnerships and partners] ("the complexity and detail of these regulations should not obscure the overriding principle of economic substance upon which they are based. if a partner will benefit economically from an item of partnership income or gain, that item must be allocated to him so that he bears the correlative tax burden. conversely, if a partner will suffer the economic burden of an item of partnership loss or deduction, he must be allocated the associated tax benefit. in other words, tax must follow economics."); willis & postlewaite, partnership taxation, supra note 81, 10.01[2] ("[ujnder the statutory scheme, the items of partnership tax income and loss must be allocated to the partners who realize the economic benefits or bear the economic burdens associated with those items."); monroe, too big to fail, supra note 81, at 487 (stating that the partnership tax allocation rules require that "if a partner receives an allocation for tax purposes, then she must also bear the economic benefit or burden corresponding to such allocated item"); gregg d. polsky, deterring taxdriven partnership allocations, 64 tax law. 97, 97 (2010) [hereinafter polsky, deterring] (describing the purpose of one part of the allocation rules as "requiring that allocations be consistent with the economic deal"). 171 florida tax review to leslie if the partnership distributed $200 cash to leslie and $100 cash to tom on liquidation.8 3 tying tax allocations more closely to economic gains and losses discourages tax-motivated allocation schemes. in example 1, when there were no restrictions on how a partnership could allocate tax items, the partnership could allocate less tax gain to tom (resulting in tax savings) without distributing less cash to tom. stated differently, assume that, for business reasons, the partners have agreed to share all cash equally. in such a case and absent restrictions on partnership tax allocations, the partners would agree to the allocations in example 1 purely for tax reasons because they could save taxes without disturbing their intended business deal. by contrast, example 2 reflects the current restrictions on tax allocations.84 assume that, for business reasons, the partners have agreed that the partnership will distribute all cash equally between tom and leslie. in order to distribute cash in this manner, the partnership must also allocate tax gain from the land equally (or $50 to each partner). if, instead, the partnership allocated all tax gain to leslie, tom would save $25 in taxes ($50 times 50 percent tax rate), but tom would also forgo $50 of cash on liquidation. assuming tom and leslie are unrelated and, thus, have opposing economic interests, tom would not agree to an arrangement in which he loses $50 of cash merely to save $25 of tax liability because this arrangement makes him $25 less wealthy after tax.85 thus, if tom and leslie have opposing economic interests and do agree to allocate $50 more tax gain to leslie and distribute $50 more cash to leslie, one can infer that they did not agree to this arrangement merely to save tom $25 in taxes. therefore, one would assume that the partners had a non-tax business reason for agreeing to the arrangement.86 perhaps, for example, leslie was responsible for selecting 83. see regs. § 1.704-1(b)(2)(ii)(d). if the partnership distributes all $200 cash to leslie on liquidation, neither leslie nor tom will recognize tax gain or loss on liquidation. just prior to liquidation, tom's basis in his interest in the partnership would be $100 (the $100 cash he contributed plus the $0 tax gain allocated to him by the partnership). see i.r.c. § 705(a). as a result, tom recognizes no tax gain or loss when he receives $100 cash from the partnership on liquidation. see i.r.c. § 73 1(a). just prior to liquidation, leslie's basis in her interest in the partnership would be $200 (the $100 cash she contributed plus the $100 tax gain allocated to her by the partnership). see i.r.c. § 705(a). as a result, leslie recognizes no tax gain or loss when she receives $200 cash from the partnership on liquidation. see i.r.c. § 731(a). 84. see regs. § 1.704-1(b)(2)(ii)(d). 85. this is true unless the year of the partnership's liquidation is sufficiently far in the future that saving $25 of tax liability today is worth more than losing $50 of cash on liquidation. 86. see supra note 81. 172 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? the land that the partnership purchased, and, as a result, the partners agreed that she would benefit from any economic gain realized upon the sale of the land and bear any economic loss realized upon the sale of the land. thus, tom willingly parts with $50 cash from the sale of the land in order to abide by the partners' business arrangement and not for the sole purpose of saving taxes. the foregoing analysis hinges completely on the fact that tom and leslie are unrelated and, thus, have opposing economic interests. if, instead, tom and leslie were closely related so that they were indifferent regarding the manner in which they shared in economic gain and loss, then the current restrictions on tax allocations would do nothing to prevent tom and leslie from designing tax allocations with the sole objective of saving tax. in example 2, for instance, tom might gladly agree to an arrangement in which he parts with $50 of cash merely to save $25 of tax if the cash he relinquishes winds up in the hands of a close relative, leslie. thus, when the partners are related, the allocation rules do nothing to prevent entirely taxmotivated allocations. in order to more fully demonstrate how the allocation rules depend, implicitly, upon the assumption that partners are unrelated, part iii.a will describe the mechanics of the partnership tax allocation rules in more detail. the essential points of the analysis are as follows: first, lawmakers intended for the partnership tax allocation rules to deter overly tax-motivated 87. special rules are provided for allocations among individuals in certain cases. see, e.g., i.r.c. § 704(e). the special rules can apply if one partner (the "donor") provides a gift of a partnership interest to another partner (the "donee"), directly or indirectly, such as by giving the donee property that the donee, subsequently, contributes to the partnership. in addition, the special rules apply if one family member sells a partnership interest to another family member. when the special rules apply, the irs can reallocate income among the affected partners if the allocations in the partnership agreement do not adequately compensate these partners for the services and capital they contribute. for further discussion, see mckee, nelson & whitmire, partnerships and partners, supra note 82, 14.05. the special rules, however, do not require reallocation of income among family members who were not parties to a gift or sale of a partnership interest. id. t 14.059[c][2]. for more information on allocations among family members in situations not covered by section 704(e), see id. ("[i]t is unclear whether the commissioner can reallocate partnership income among related persons who are admittedly partners . . . but who are not subject to § 704(e)(2). prior to the enactment of § 704(e), the service argued on a number of occasions that partnership income could be so reallocated. the courts generally were reluctant to remake the partners' contract except in situations of clear abuse. in general, it seems that family partners who are not subject to § 704(e)(2) should have the same freedom to allocate partnership income among themselves as unrelated partners. on the other hand, because of the lack of adversity that may exist among family partners, allocations that are palpably unreasonable may be subject to attack."). 173 florida tax review allocations;88 second, although the allocation rules might achieve this objective when partners are unrelated, because of how the rules are designed they do nothing to discourage related partners from engaging in entirely taxmotivated allocations; and, third, from these first two observations, one can infer that the partnership tax allocation rules are, implicitly, premised on the assumption that partners are unrelated. as a result, blackstone group lp and other partnerships formed by related partners can utilize entirely taxmotivated allocations and technically comply with the letter, but not the spirit, of the existing regulations. they do so by exploiting an unintended loophole in the partnership tax allocation rules specifically, the rules' failure to police allocations among related partners. a. the partnership tax allocation rules the treasury regulations provide that allocations in a partnership agreement will be respected (i.e., they will not be successfully challenged by the irs) if the allocations are consistent with "the partners' interests in the partnership" or the allocations have "substantial economic effect."89 the following discussion focuses on the substantial economic effect test.90 for partnership agreement allocations to be respected under the substantial economic effect test, the allocations must overcome two hurdles. 91 "first, the allocation[s] must have economic effect." 92 "second, the 88. see supra note 81 and accompanying text. 89. see regs. § 1.704-1(b)(1)(i). an allocation will also be respected if the allocation is deemed to be in accordance with the partners' interests in the partnership. id. this rule only applies to certain types of allocations not relevant to the analysis of the blackstone group structure. 90. an understanding of the partners' interests in the partnership ("pip") is not essential for purposes of understanding the blackstone group lp structure. pip is a vague concept that is intended to measure the manner in which the partners have agreed to share the economic benefit or burden to which a given tax allocation corresponds. regs. § 1.704-1(b)(3)(i). to determine the partners' interests in the partnership, one must examine all the facts and circumstances that relate to the economic arrangement of the partners, including the partners' relative contributions to the partnership, the interests of the partners in economic profits and losses, the interests of the partners in cash flow and other non-liquidating distributions, and the rights of the partners to distributions of capital upon liquidation. regs. § 1.7041(b)(3)(i)-(ii). once a partner's economic share is determined, tax items must be allocated in a way that is consistent with that economic share to be respected under the pip test. regs. § 1.704-1(b)(1)(i). for further discussion of pip, see bradley t. borden, the allure and illusion ofpartners'interests in a partnership, 79 u. cin. l. rev. 1077 (2011). 91. regs. § 1.704-1 (b)(2)(i) ("the determination of whether an allocation of income, gain, loss, or deduction (or item thereof) to a partner has substantial economic effect involves a two-part analysis . . . ."). [vol. 14:5174 2013] was blackstone's initial public offering too good to be true? economic effect of the allocation[s] must be substantial." 93 this second hurdle is often called the "substantiality" requirement.94 1. economic effect: the rules partnership agreement allocations most commonly aim to overcome the "economic effect" hurdle by complying with the "alternate test for economic effect."9 in order to comply with this test, (1) a partnership must maintain a capital account for each partner in a manner specified in the treasury regulations; 96 (2) the partnership must liquidate based on positive capital account balances;97 and (3) the partnership must take steps to ensure that no partner's capital account balance becomes or remains impermissibly negative. as it is only necessary to understand the first and second 92. id. 93. id. 94. see regs. § 1.704-l(b)(2)(iii). 95. there are two other ways that an allocation can have economic effect: (1) if the allocation complies with the "basic test" for economic effect; or (2) if the allocation has "economic effect equivalence." see regs. § 1.704-l(b)(2)(ii)(b) (describing the basic test for economic effect); regs. § 1.704-1(b)(2)(ii)(i) (describing economic effect equivalence). because these possibilities are not relevant to the blackstone group structure, they are not discussed in this article. 96. regs. §§ 1.704-1(b)(2)(ii)(d)(1) (providing that to comply with the alternate test for economic effect, the allocations must comply with regulations section 1.704-l(b)(2)(ii)(b)(1)); 1.704-1(b)(2)(ii)(b)(1) (providing that the partnership agreement must maintain a capital account for each partner in accordance with the rules in regulations section 1.704-1 (b)(2)(iv)). 97. regs. §§ 1.704-1(b)(2)(ii)(d)(1) (providing that, to comply with the alternate test for economic effect, the allocations must comply with regulations section 1.704-1(b)(2)(ii)(b)(2)); 1.704-1(b)(2)(ii)(b)(2) (providing that the partnership must make liquidating distributions in accordance with the positive capital account balances of the partners). 98. regs. § 1.704-l(b)(2)(ii)(d)(3). regarding this third requirement, a partner has a deficit restoration obligation (a "dro") to the extent that the partner would have to contribute cash to the partnership on liquidation if that partner's capital account balance were negative. the third requirement consists of taking steps to ensure that no partner's capital account will become (or remain) negative in excess of that partner's dro. in particular, under the third requirement, (1) the partnership must not allocate items to a partner that will cause the partner to have a negative capital account balance (after factoring in certain expected distributions to the partner and other expected future events) that exceeds that partner's dro (if any), and (2) the partnership agreement must contain a qualified income offset (which provides that, if a partner's capital account balance does become negative in excess of that partner's dro, the partnership will allocate income to the partner to i175 florida tax review requirements in order to understand blackstone group's structure, only these requirements will be discussed below.99 (i) capital account maintenance to comply with the capital account maintenance prong of the alternate test for economic effect, a partnership must maintain a capital account for each partner according to specific rules.' 00 in particular, each partner's capital account, at any point in time, must equal: (1) all cash contributed to the partnership by that partner, 01 plus (2) the fair market value of all assets (net of liabilities) contributed to the partnership by that partner,10 2 plus (3) all items of tax gain or income allocated to that partner by the partnership,10 3 minus (4) all cash distributed to that partner by the partnership, 104 minus (5) the fair market value of all assets (net of liabilities) distributed to that partner by the partnership, 05 minus (6) all items of tax loss or deduction allocated to that partner by the partnership.106 thus, in example 2 above, the partnership would maintain a capital account for tom and leslie. each partner's capital account would initially equal $100 because each partner initially contributed $100 cash to the partnership. when the partnership allocated $100 tax gain to leslie and no tax gain to tom, leslie's capital account becomes $200, and tom's capital account remains $100. eliminate the excess negative balance as quickly as possible). regs. § 1.7041(b)(2)(ii)(d). 99. for discussion of the third requirement, see supra note 98. 100. see supra note 96. 101. regs. § 1.704-l(b)(2)(iv)(b)(1). 102. regs. § 1.704-l(b)(2)(iv)(b)(2). 103. regs. § 1.704-l(b)(2)(iv)(b)(3). technically, the regulations refer to adjusting capital accounts by "income or gain" which means book income or book gain (rather than tax income or tax gain). see regs. § 1.704-l(b)(2)(iv)(d)(3). however, as long as the partnership recognizes the same amount of tax gain as book gain with respect to a transaction, one can think of this adjustment as referring to tax gain or income because tax gain or income will be allocated in the same manner as book gain or income when these items are equal. id. 104. regs. § 1.704-1(b)(2)(iv)(b)(4). 105. regs. § 1.704-1(b)(2)(iv)(b)(5). 106. regs. §§ 1.704-1(b)(2)(iv)(b)(6)-(7). technically, the regulations refer to adjusting capital accounts by "loss and deduction" which means book loss or book deduction (rather than tax loss or tax deduction). see regs. § 1.7041 (b)(2)(iv)(d)(3). however, as long as the partnership recognizes the same amount of tax loss as book loss with respect to a transaction, one can think of this adjustment as referring to tax loss or deduction because tax loss or deduction will be allocated in the same manner as book loss or deduction when these items are equal. id. 176 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? (ii) liquidating based on capital account balances in order to comply with the liquidation requirement, the partnership, upon liquidation, must distribute cash to the partners proportionately based on the positive balances in their capital accounts.o thus, in example 2 above, when the partnership distributes $300 cash to the partners in liquidation, it must distribute $200 to leslie (who has a $200 capital account balance) and $100 to tom. consequently, because leslie was allocated the entire $100 tax gain from sale of the land, leslie also benefits from the entire $100 economic gain from sale of the land, as she receives $100 more cash than what she contributed. assume, instead, the partnership intended to distribute the cash equally to the partners ($150 to each partner) on liquidation. in that case, in order for the tax allocations to have economic effect and be respected, the partnership would have to allocate the tax gain from sale of the land equally among the partners ($50 to each partner). as a result of this allocation, each partner's capital account just prior to liquidation would be $150 ($100 cash contributed plus $50 tax gain allocation), and, if the partnership distributes $150 cash to each partner, the partnership will comply with the requirement of liquidating based on capital account balances. what the partnership cannot do is allocate all tax gain ($100) to leslie (bringing capital account balances to $200 for leslie and $100 for tom) but distribute the $300 cash equally among the partners ($150 to each partner). more generally, the requirements of the alternate test for economic effect help to ensure that net tax items allocated to a partner over the life of the partnership will correspond to the net economic gain or loss realized by that partner over the life of the partnership.108 if a partnership allocates more tax gain to a partner, his or her capital account increases, meaning that partner will receive more cash on liquidation of the partnership if not before. if a partnership allocates more tax loss to a partner, his or her capital account decreases, meaning that partner will receive less cash on liquidation of the partnership. 2. economic effect: the implicit assumption: unrelated partners ensuring that tax allocations correspond to economic gains and losses might deter tax-motivated allocations among unrelated partners but does nothing to prevent related partners from allocating items in a manner 107. see supra note 97. 108. see supra note 82. 177 florida tax review designed solely to reduce tax liability.109 to demonstrate, consider again the facts of example 2. if the partnership complies with the economic effect requirement, the partnership can allocate $50 less tax gain to tom (saving him $25 in taxes) only if the partners agree that tom will receive $50 less cash. losing $50 cash will deter tom from agreeing to the allocations for the sole purpose of saving $25 in taxes if the $50 cash lost by tom benefits an unrelated partner. if, however, the partner who receives $50 cash is closely related to tom, he may readily agree to the allocations for the exclusive purpose of reducing his tax liability. 3. substantiality: the rules in order for allocations to be respected under the substantial economic effect test, the allocations must have economic effect (which will be true if the allocations meet the alternate test for economic effect described above), and the allocations must comply with the substantiality requirement. this substantiality requirement exists because the alternate test for economic effect alone does not prevent many potential tax-motivated allocation schemes, even in partnerships with unrelated partners."10 in order to demonstrate, consider the following example. example 3. two individuals, ron and anne, form a partnership to provide legal services. ron is a u.k. citizen and not a resident of the united states. anne is a u.s. citizen. ron and anne each contribute $1,000 cash to the partnership. the partnership provides some legal services in the united kingdom out of its u.k. office and some legal services in the united states out of its u.s. office. thus, in any given year, the partnership will recognize some income from providing legal services in the united states and some income from providing legal services in the united kingdom. anne is subject to 35 percent u.s. tax on income 109. even among unrelated partners, some entirely tax-motivated allocations will slip through the cracks. see infra note 110 and accompanying text. therefore, this article does not claim that the substantial economic effect rules function flawlessly when partners are unrelated. rather, this article argues that the substantial economic effect rules have no chance of restricting, in any meaningful way, allocations among related partners whose economic interests are aligned. 110. not all tax-motivated allocation schemes are prevented by the substantiality requirement even when partners are unrelated. for further discussion, see mark p. gergen, reforming subchapter k: special allocations, 46 tax l. rev. 1 (1990) [hereinafter gergen, reforming subchapter k]; calvin h. johnson, partnership allocations from nickel-on-the-dollar substance, 134 tax notes 873 (feb. 13, 2012); leder, tax-driven partnership allocations, supra note 13. 178 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? from legal services, regardless of where the services are performed. ron is subject to 35 percent u.s. tax on income from providing legal services in the united states but no u.s. tax on income from providing legal services in the united kingdom. the partnership agreement provides that a capital account will be maintained for each partner in accordance with the rules described above and liquidating distributions will be made based on capital account balances. the partnership agreement further provides that the partnership will allocate to each partner 50 percent of total income recognized by the partnership, but the income allocated to ron will consist entirely of income from the united kingdom to the extent possible. thus, in year 1, for example, if the partnership recognizes $300 of income from the united kingdom and $700 of income from the united states, the partnership would allocate to ron $300 of u.k. income and $200 of u.s. income, and the partnership would allocate to anne $500 of u.s. income."' the allocations in example 3 have economic effect because the partnership maintains capital accounts and provides for liquidation based on capital account balances.1 12 however, the allocations are, nonetheless, entirely tax-motivated. the allocations ensure that, regardless of the types of income earned by the partnership, each of ron and anne will receive 50 percent of the cash distributed on liquidation. each partner contributed $1,000, so the partners' initial capital account balances are equal ($1,000 each). further, each partner is always allocated 50 percent of the total income recognized by the partnership, so the partners' capital account balances will remain equal (in example 3, above, for instance, each partner's capital account increases by $500 to become $1,500). thus, when the partnership liquidates based on capital account balances, the partnership will distribute cash equally between anne and ron. consequently, anne and ron receive the same amount of cash as they would have received if the partnership had allocated each item of income equally between the partners. in example 3, above, for instance, if the partnership allocated u.s. income equally ($350 to each) and u.k. income equally ($150 to each), each partner's capital account would still 111. see regs. § 1.704-1(b)(5) ex. (10)(ii) (providing a similar example). 112. this analysis assumes that the partnership also takes steps to ensure that no partner's capital account balance becomes or remains impermissibly negative. see regs. § 1.704-1(b)(5) ex. (10)(ii) (reaching the conclusion that allocations have economic effect in the context of a similar example); see also supra note 98. i179 florida tax review increase by $500 so that capital accounts would remain equal and cash would be distributed equally on liquidation. however, the allocations contained in the agreement save ron taxes compared to what would have resulted from allocating each item of income equally. in particular, if ron were allocated 50 percent of each type of income, ron would be subject to $122.50 u.s. tax liability (35 percent times $350 u.s. income). by contrast, under the agreement, ron is allocated only $200 of u.s. income, and therefore, ron is subject to only $70 of u.s. tax liability (35 percent times $200). anne's tax liability is the same under the agreement as it would be if anne were allocated 50 percent of each type of income. anne is subject to a 35 percent u.s. tax rate on u.s. income and u.k. income, so anne incurs u.s. tax liability of $175 (35 percent times $500) when she is allocated $500 of total income, regardless of how much of the income is u.s. source and how much is u.k. source.1 13 in summary, the allocations in the agreement described in example 3 allow ron to save $52.50 of tax liability without affecting anne's tax liability or the amount of cash received by either partner. thus, the allocations are entirely tax-motivated because the allocations have no effect other than to reduce ron's tax liability. the second prong of substantial economic effect (the substantiality requirement) is intended to disallow tax-motivated allocation schemes like the one described in example 3 and other schemes that economic effect, alone, would not prevent.1 14 in order to comply with substantiality, allocations in a partnership agreement must overcome a number of obstacles, the most stringent of which is contained in regulations section 1.7041 (b)(2)(iii)(a) which provides: 113. this analysis ignores the effect of the allocations, if any, on anne's ability to use foreign tax credits. 114. terence floyd cuff, proposed regulations try unsuccessfully to fix a broken set of substantiality rules, 104 j. tax'n 280, 282 (2006) ("the aftertax filter of 'substantiality' in the regulations represents an effort to objectify what is an inherently subjective inquiry whether the transaction is motivated by business profit as opposed to tax profit."); gergen, reforming subchapter k, supra note 110, at 15 (an allocation that violates substantiality is "likely to be tax driven since the partner who benefits from the allocation will seek it for tax reasons and the other partner will be (at worst) indifferent to it"); monroe, too big to fail, supra note 81, at 487; polsky, deterring, supra note 82, at 99 ("if a partnership expects to receive different types of income or gain, or different types of deduction or loss, the partnership could consistent with the economic effect prong still allocate the items in a tax-advantaged way while not changing the real, overall economic deal ... . the second prong of the substantial economic effect test (substantiality) is intended to inhibit this type of tax planning."). 180 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? [t]he economic effect of an allocation . .. is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation . . . were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation ... were not contained in the partnership agreement.115 in short, an allocation lacks substantiality if it may make one partner better off (after tax) and is not likely to make any partner substantially worse off (after tax) compared to what would occur if the allocation were not in the partnership agreement.' 16 applying this test to example 3 reveals that the allocations lack substantiality. in order to apply the test, we compare what each partner is likely to receive, after tax, as a result of the allocations to what each partner would have received if the partnership allocated each type of income to each partner pro rata based on the capital each partner contributed (or 50 percent to each partner)."' at the time the partners agree to allocate items as 115. there are other hurdles that an allocation must overcome in order for the allocation to pass substantiality. for example, the allocation cannot be a "shifting allocation" and the allocation cannot be a "transitory allocation." see regs. §§ 1.704-1(b)(2)(iii)(b), (c). consideration of these tests, however, is not necessary for purposes of understanding the analysis described in this article. 116. regarding what occurs if the allocation were not in the partnership agreement, the treasury regulations instruct us to determine what would occur if everything were allocated based on pip. regs. § 1.704-1(b)(2)(iii)(a). pip is a facts and circumstances test, as described above. see supra note 90. furthermore, for purposes of determining pip that is used as a baseline for testing allocations for substantiality, we must ignore the potentially suspect allocation that is being evaluated. regs. § 1.704-1(b)(2)(iii)(a) ("references in this paragraph (b)(2)(iii) to a comparison to consequences arising if an allocation . . . were not contained in the partnership agreement mean that the allocation . .. is determined in accordance with the partners' interests in the partnership . . . disregarding the allocation . . . being tested under this paragraph (b)(2)(iii).") (emphasis added). 117. as described above, to determine the partners' interests in the partnership that is used as a baseline for purposes of testing whether or not allocations have substantiality, one must examine all the facts and circumstances that relate to the economic arrangement of the partners, including the following: the partners' relative contributions to the partnership, the interests of the partners in economic profits and losses, the interests of the partners in cash flow and other nonliquidating distributions, and the rights of the partners to distributions of capital upon liquidation, (but one must ignore the allocation being tested). see supra notes 90, 181 florida tax review described in example 3, ron's after-tax consequences may be enhanced compared to what would occur if he were allocated 50 percent of u.s. income and 50 percent of u.k. income. in particular, his pre-tax consequences (in other words, the amount of cash he receives) will remain unchanged, but he will save taxes as long as the partnership recognizes at least some u.k. income and at least some u.s. income (because rather than being allocated 50 percent of the u.s. income, he will be allocated less u.s. income and more u.k. income). thus, ron may be better off after tax (and is, indeed, better off after tax if the partnership, in fact, recognizes the amount and types of income shown in example 3). moreover, at the time the partners agree to allocate items as described in example 3 there is a strong likelihood (in fact, it is certain) that anne's after-tax consequences will not be substantially diminished (indeed, they will not be diminished at all) compared to what would occur if anne were allocated 50 percent of u.s. income and 50 percent of u.k. income. regardless of whether anne is allocated 50 percent of each type of income or 50 percent of total income (with a mix that might involve more than 50 percent of u.s. income), anne experiences the same after-tax consequences because she receives the same amount of cash pre-tax (50 percent of all cash distributed by the partnership) and incurs the same amount of tax liability (35 percent times 50 percent of all income recognized by the partnership). thus, the allocations in example 3 lack substantiality and can be successfully challenged by the irs. the allocations in example 3 are suspect because anne has no reason not to go along with allocations that save ron taxes as long as the allocations do not make anne worse off. thus, the allocations in example 3 can be wholly tax-motivated. they allow one partner to save tax liability without interfering with the partners' business deal or the tax liability incurred by another partner. 4. substantiality: the implicit assumption: unrelated partners like the economic effect test, the substantiality test implicitly relies on the assumption that partners in a partnership are unrelated and, thus, have opposing economic interests. the fact that the test depends on this assumption can be further demonstrated by the following examples. example 4a. assume the same facts as example 3 except that the partnership agreement provides that anne will be allocated 90 percent of the u.s. income and 10 percent of 116. after ignoring allocations of u.s. income and u.k. income (the allocations being tested) the only fact that remains is that the partners made equal contributions to the partnership. thus, it is likely that each partner's interest in the partnership is 50 percent for purposes of testing the substantiality of the allocations. 182 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? the u.k. income, and ron will be allocated 10 percent of the u.s. income and 90 percent of the u.k. income. at the time the partners agree to these allocations, they do not know how much income the partnership will earn. as it turns out, the partnership earns $1,000 of income from the united kingdom and $100 of income from the united states."' ron and anne are unrelated. the allocations described in example 4a pass the substantiality test and should be respected. looking at the actual results realized by the partnership in example 4a, the allocations enhance ron's after-tax consequences compared to what would occur if each type of income were allocated equally to each partner, but the allocations diminish anne's aftertax consequences compared to what would occur if each type of income were allocated equally to each partner." 9 the table below compares the after-tax consequences of each partner under the agreement to the consequences that would follow if each type of income were allocated equally to each partner. as shown in this table, the allocations in the partnership agreement increase ron's after-tax profit ($906.50 compared to $532.50) but lessen anne's after-tax profit ($123.50 compared to $357.50). 118. see regs. § 1.704-1(b)(5), ex. (10)(i) (providing a similar example). 119. the substantiality test requires examining what was likely to occur at the time the partners agreed to the allocation in question. see regs. § 1.7041(b)(2)(iii)(a) ("[t]he economic effect of an allocation ... is not substantial if, at the time the allocation becomes part of the partnership agreement [the allocation may make one partner better off (after tax) and is not likely to make any partner substantially worse off (after tax) compared to what would occur if the allocation were not in the partnership agreement].") (emphasis added). however, although the test requires examining what was likely to occur as of the time the partners agreed to the allocations, the actual results realized by the partnership provide important evidence of what was likely to occur as of the time the partners agreed to the allocations. indeed, in the context of some of the substantiality tests (particularly, the shifting allocation test and the transitory allocation tests), the actual results realized by the partnership establish a rebuttable presumption regarding what was likely to occur as of the time the partners agreed to an allocation. see regs. §§ 1.7041 (b)(2)(iii)(b)(2) (providing the rebuttable presumption in the context of the shifting allocation test); 1.704-1(b)(2)(iii)(c)(2) (providing the rebuttable presumption in the context of the transitory allocation test); see also supra note 115 (mentioning the shifting allocation and transitory allocation tests). 183 florida tax review table 1 results of partnership results if u.s. and u.k. agreement income were allocated equally anne ron anne ron pre-tax $190 $910 $550 $550 proitl20 u.s. tax $190 total $10 u.s. $550 total $50 u.s. liability income income x income x income x35%= 35% = 35% = x35%= $66.50 $3.50 $192.50 $17.50 after$190 $66.50 $910-$3.50 $550$550tax -$123.50 = $906.50 $192.50 $17.50 profit = $357.50 = $532.50 because the allocations in the partnership agreement decrease anne's after-tax profit, the allocations will pass the substantiality test. moreover, the underlying rationale behind this result is that unrelated partners with opposing economic interests will not agree, for purely tax reasons, to allocate items in a way that could worsen the after-tax economic position of at least one partner. in other words, because the allocations make anne worse off after tax, it is no longer suspected that the allocations are solely tax-motivated. in example 3, the allocations appear to be solely taxmotivated because the only possible effect of the allocations is to reduce ron's tax liability. by contrast, in example 4a, in addition to lowering ron's tax liability, the allocations have the effect of reducing the amount of cash received by anne. assuming the partners have opposing economic interests, anne would be unwilling to risk forgoing cash merely to lower ron's tax liability. thus, if the partners do agree to the allocations in example 4a, one can infer that the partners had non-tax business reasons for doing so.121 perhaps, for example, ron is responsible for managing the 120. this amount is determined by the increase to each partner's capital account. if the partnership agreement allocates to anne $90 of u.s. income and $100 of u.k. income, her capital account will increase by $190 so she will receive $190 more cash. if the partnership agreement allocated to ron $10 of u.s. income and $900 of u.k. income, his capital account will increase by $910 so he will receive $910 more cash. if the partnership instead allocated each type of income equally to each partner, the partnership would allocate $500 of u.k. income and $50 of u.s. income (or $550 total income) to each partner, and each partner's capital account would increase by $550. 121. see supra note 81. 184 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? partnership's u.k. office, and anne is responsible for managing the partnership's u.s. office. in order to encourage each partner to manage his or her office well, the partners could agree that ron will benefit disproportionately from profits generated by the u.k. office, and anne will benefit disproportionately from profits generated by the u.s. office. thus, in example 4a, when the u.s. office is less profitable than the u.k. office, anne agrees to receive less than half of the partnership's profits in order to abide by the partners' business deal and not to save ron taxes. now consider a slightly different example. example 4b. assume the same facts as example 4a except that anne and ron are close relatives. because all other facts are the same as example 4a, table 1 above again illustrates the after-tax profit realized by each partner under the agreement compared to what would have occurred if the partnership allocated each type of income equally to each partner. still, the allocations make anne worse off after tax. however, now that anne and ron are close relatives, this result provides no assurance that the allocations are not purely tax-motivated. if ron and anne are closely related, as far as each individual is concerned, a dollar distributed by the partnership to ron may be the same as a dollar distributed by the partnership to anne. in that case, the partners could freely agree to the allocations in example 4b solely to reduce their tax liability. if the partners are indifferent regarding how they share after-tax profit, they will look only to total after-tax profit in deciding how the partnership allocates items among the partners. in example 4b, the allocations result in a total after-tax profit of $1,030 (anne's $123.50 plus ron's $906.50), which is $140 higher than the $890 after-tax profit (anne's $357.50 plus ron's $532.50) that would have resulted if the partnership allocated each type of income equally to each partner. the $140 difference results solely from saving taxes paid by the partners (saving $126 in taxes for anne and $14 in taxes for ron). as long as the partners do not care how they share after-tax profit, they would agree to the allocations in example 4b for the sole purpose of saving $140 in taxes, and the substantiality test would not prevent this type of tax-motivated allocation scheme. 122 in other words, the substantiality test implicitly depends on the assumption that partners are unrelated and, thus, have opposing economic 122. even under these facts, it is possible that anne and ron may have agreed to the allocations for business reasons and not just tax reasons. however, the fact that the allocations pass the substantiality test provides no assurance that they agreed to the allocations for non-tax reasons. 185 florida tax review interests. if this assumption does not hold true, substantiality does not adequately police tax-motivated allocations. b. the blackstone group structure takes advantage of the partnership tax allocation rules' inability to prevent tax-motivated allocations among related partners as shown in figure 1 above, three partners (in particular, blackstone group lp, u.s. subsidiary, and non-u.s. subsidiary) receive allocations from the underlying partnership. specifically, the underlying partnership allocates qualified carried interest to blackstone group lp, non-qualified u.s. carried interest to u.s. subsidiary, and non-qualified non-u.s. carried interest to non-u.s. subsidiary. in order for these allocations to have economic effect, the underlying partnership can simply maintain a capital account for each of the partners and liquidate based on capital account balances. 12 3 it is likely the underlying partnership does both of these things, so the allocations will have economic effect. regarding substantiality, assume for purposes of illustration, that each partner contributed an equal amount of capital to the underlying partnership.124 as a result, the allocations would pass muster under the substantiality test as long as at the time the partners agreed to the allocations it was likely that the after-tax consequences of at least one partner would, in present value terms, be substantially diminished compared to what would happen if that partner were allocated one-third of each type of income.125 assuming that the partners agreed to the allocations at a time when the partners did not know what type and amount of income the underlying partnership would earn in each year, this requirement is likely met.126 123. this analysis assumes that the underlying partnership also takes steps to ensure that no partner's capital account balance becomes or remains impermissibly negative. see supra note 98. 124. as discussed below, even if this assumption is incorrect, the overall conclusion of the analysis above still holds true. see infra note 128 and accompanying text. 125. see supra notes 115-117 and accompanying text. 126. see also regs. § 1.704-1(b)(5), ex. (10)(i) (providing an example in which a partnership agrees to allocate disproportionate amounts of non-u.s. income to a non-u.s. partner at a time when the partners could not predict with reasonable certainty the amount and type of income the partnership would earn and concluding that the allocations have substantial economic effect). if, instead, the partners knew the type and amount of income that the underlying partnership would earn, then it is likely the partners contributed capital in a given ratio intended to guarantee that at least one partner would be worse off, after tax, as a result of the underlying partnership's allocations. the partners would have done this to ensure that the 186 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? for instance, at the time the partners agreed to the allocations, it could have been likely that the underlying partnership would earn $1.2 billion of total carried interest (consisting of $600 million of qualified carried interest, $300 million of non-qualified u.s. carried interest, and $300 million of non-qualified non-u.s. carried interest). under these facts, the allocations in the agreement make u.s. subsidiary worse off after tax compared to what would happen if u.s. subsidiary were allocated one-third of all carried interest. in particular, as a result of the allocations in the agreement, u.s. subsidiary earns $195 million in after-tax profit ($300 million of nonqualified u.s. carried interest minus 35 percent tax rate times $300 million). if u.s. subsidiary were allocated one-third of all carried interest, u.s. subsidiary would earn $260 million in after-tax profit ($400 million carried interest minus 35 percent tax rate times $400 million). thus, the allocations comply with the literal language of the substantiality test.12 7 the assumption that each partner contributed an equal amount of capital to the underlying partnership was used merely for illustrative purposes, and it could be that the partners did not contribute equal amounts to the underlying partnership. however, the overall conclusion of the analysis above still holds true. specifically, if the allocations by the underlying partnership pass the substantiality test, they do so only because at least one of the partners in the underlying partnership receives less after taxes than what it would receive if all items of income were allocated among all three partners pro rata based on their capital contributions.128 the underlying partnership's allocations comply with the literal language of the substantial economic effect rules because, under these rules, the fact that the allocations worsen u.s. subsidiary's (or another partner's) after-tax position removes the allocations from suspicion. the rationale for this result is that no partner would agree to allocations that make him, her, or allocations complied with the technical requirements of the substantial economic effect test. 127. this is true assuming that related entities should be treated as separate partners when applying the substantiality tests, a matter that is not entirely free from doubt because the irs has suggested otherwise. see leder, tax-driven partnership allocations, supra note 13, at 779 (mentioning a field service advisory in which the irs suggested that related parties could be treated as one partner when applying the substantiality tests). for the advisory, see field serv. advisory (sept. 10, 1993), 1993 wl 1469410, stating: "given the present facts, it is important to examine the economic relationship of the partners of the partnership. while the substantiality regulations do not specifically address the issue of related partners, section 1.704l(b)(2)(iii)(a) does require the service to consider each partner's tax attributes." 128. if the allocations do not result in at least one partner in the underlying partnership receiving less, after tax, than what it would receive if all items of income were allocated pro rata among the partners, then the irs could easily challenge the underlying partnership's allocations for lacking substantial economic effect. 187 florida tax review it worse off after-tax absent a compelling non-tax business reason for doing so.1 29 however, although this rationale may apply to a partnership in which the partners have opposing economic interests (such as the partnership described above in example 4a), this rationale simply does not apply when the economic interests of the partners are aligned (such as in the blackstone group lp structure or in example 4b). in the blackstone group lp structure, u.s. subsidiary and non-u.s. subsidiary (two of the partners in the underlying partnership) are wholly-owned by blackstone group lp (the third partner in the underlying partnership). thus, the economic interests of the three partners in the underlying partnership are completely aligned, and all three partners in the underlying partnership are indifferent regarding how after-tax profits are shared among them. consequently, the fact that the allocations by the underlying partnership make u.s. subsidiary (or any other partner in the underlying partnership) worse off after tax provides no assurance that the allocations are not tax-motivated. indeed, as described in part ii above, the allocations are entirely motivated by the goal of saving corporate-level tax that would be imposed on all of blackstone group lp's income if it were treated as a corporation for tax purposes. iv. congressional response following the announcement of the initial public offering of blackstone group lp, senators max baucus and charles grassley proposed legislation that would have made blackstone group lp's structure ineffective. 30 in particular, under this legislation, the exception from corporate tax treatment for publicly traded partnerships that earn predominately passive income would not apply to blackstone group lp and similar entities because the exception effectively would not apply to any partnership that earned carried interest income, management fees, or similar income, directly or indirectly. 13 ' the legislation would not have immediately applied to blackstone group as it contained a grandfathering provision.132 specifically, the new legislation would not have applied for five years to any partnership that, as of june 14, 2007, was already publicly traded or had 129. see supra part iii.a. 130. s. 1624, 1 10th cong. (2007). for further discussion of the legislation, see fleischer, taxing blackstone, supra note 1, at 104-20. 131. s. 1624, 110th cong. (2007). for further discussion of the legislation, see fleischer, taxing blackstone, supra note 1, at 104-20. 132. s. 1624, 110th cong. (2007). for further discussion of the legislation, see fleischer, taxing blackstone, supra note 1, at 104-20. 188 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? already filed a registration statement with the sec in contemplation of an initial public offering.'3 3 in addition to the proposal described above, proposals less squarely directed at the blackstone group structure would, if enacted, make the structure less effective. for example, in 2009, congressman levin introduced legislation that, among other things, would have treated all carried interest income as non-qualifying income for purposes of the publicly traded partnership rules.'34 the blackstone group structure is potent largely because qualified carried interest income allocated directly to blackstone group lp is not subject to corporate-level tax. if all carried interest income were non-qualifying income, the underlying partnership would not earn any qualifying income that it could allocate directly to blackstone group lp. as a consequence, either blackstone group lp would have to abandon its current structure and resign itself to being treated as a corporation for tax purposes or the underlying partnership would have to modify its allocations so that almost all of its income was allocated to either u.s. subsidiary or non-u.s. subsidiary.135 the income allocated to u.s. subsidiary would be subject to corporate-level tax.136 none of the proposed reforms described above address the unintended loophole in the partnership tax allocation rules specifically, the rules' inability to police adequately allocations among related partners. moreover, none of the proposed reforms have been enacted. however, recent publicity regarding bain capital has once again focused public attention on the private equity industry.'3 7 thus, it is possible that lawmakers will revisit these reforms or that the irs will consider other ways of challenging the results claimed by blackstone group lp. this article proposes a way for the irs to do precisely that. 133. s. 1624, 110th cong. (2007). for further discussion of the legislation, see fleischer, taxing blackstone, supra note 1, at 104-20. 134. h.r. 1935, 111th cong. (2009). there are many other ways in which existing law could be changed to alter the results claimed by blackstone group lp. rather than focus on potential legislative or regulatory changes, however, this article considers a way in which the results claimed by blackstone group could be challenged under current law. 135. the text refers to "almost all" income rather than "all" income because blackstone group lp could earn up to 10 percent non-qualifying income and still comply with the 90 percent gross income exception. 136. this structure still has some benefits because of the potential use of interest expense to reduce u.s. subsidiary's tax liability and because non-u.s. subsidiary is not subject to tax. see supra parts ii.c and ii.d; see, also, fleischer, taxing blackstone, supra note 1, at 105. 137. see supra notes 14-15 and accompanying text. 189 florida tax review v. proposal: using existing standards to close the unintended loophole in the partnership tax allocation rules even under current law, the irs could challenge the results claimed by blackstone group lp. thus, rather than wait and hope for congress to reconsider reforms that were not enacted in the past, the irs could take action now. in particular, the irs could rely on existing standards to close the unintended loophole in the partnership tax allocation rules that blackstone group lp's structure exploits. as discussed above in part iii, the technical partnership tax allocation rules are incapable of restricting allocations among related partners, resulting in this often-abused loophole.138 to address this shortcoming of the partnership tax allocation rules, the irs could invoke existing standards. doing so would not be unprecedented because it is not unusual for tax rules to have gaps or for the irs and courts to rely on standards to fill gaps. as others have observed, lawmakers design rules, in tax law and elsewhere, to accommodate the most typical fact patterns.139 furthermore, as others have argued, tax rules based on the most typical fact patterns leave gaps that taxpayers can exploit by adjusting their transactions to take the rules into account.140 luckily, a 138. one might argue that blackstone group lp's structure actually exploits the shortcomings of a standard rather than a rule. blackstone group lp's structure takes advantage of failings of the substantiality test, and the substantiality test has some standard-like qualities given that, in some respects, it is a vague test. vague aspects of the substantiality test include the fact that it is not entirely clear when one should conclude that a partner's after-tax consequences "may" be enhanced by allocations or when one should conclude that there is a "strong likelihood" that no partner will be worse off after tax. for purposes of the analysis above, it is not crucial to classify substantiality as a rule or a standard. either way, the substantiality test is implicitly based on the assumption that partners are unrelated and, therefore, is ill-equipped to address allocations among related partners. 139. see, e.g., martin j. mcmahon jr., beyond a gaar: retrofitting the code to rein in 21st century tax shelters, 98 tax notes 1721, 1722 (march 17, 2003) [hereinafter mcmahon, beyond a gaar]; david a. weisbach, formalism in the tax law, 66 u. chi. l. rev. 860, 867-69 (1999) [hereinafter weisbach, formalism]. for a related point, see louis kaplow, rules versus standards: an economic analysis, 42 duke l.j. 557, 577 (1992), suggesting that lawmakers should design rules to cover frequently occurring fact patterns by stating: "[t]he greater the frequency with which a legal command will apply, the more desirable rules tend to be relative to standards." 140. see, e.g., noil b. cunningham & james r. repetti, textualism and tax shelters, 24 va. tax rev. 1, 33 (2004) [hereinafter cunningham & repetti, textualism]; daniel i. halperin, halperin expresses support for partnership anti190 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? solution to this pervasive problem exists. in particular, standards can fill gaps left by tax rules that envision only the typical case.14 1 moreover, because standards fill the gap left by rules designed for the typical case, courts and the irs should readily apply standards to atypical cases (or cases that the rules did not contemplate).14 2 abuse reg., public comment on regulations, 94 tnt 152-36 (aug. 4, 1994) ("[m]ore specific rules will invite taxpayers and advisors to devise approaches that will dodge the specific inhibitions."); calvin h. johnson, h.r. _ , the anti-skunk works corporate tax shelter act of 1999, 84 tax notes 443, 445 (july 19, 1999) [hereinafter johnson, the anti-skunk works] ("loopholes can be created in any human tax system unless the system is defended and repaired. shelters take razorthin fissures of no material concern and turn them into gaping holes in the tax base."); kyle d. logue, tax law uncertainty and the role of tax insurance, 25 va. tax rev. 339, 366 (2005) ("[wlhatever tax rules are adopted, no matter how specific or detailed or comprehensive they are, sophisticated taxpayers with fancy tax lawyers and accountants will always find opportunities for aggressive or abusive tax avoidance. put differently, it simply is not possible to write tax laws that are devoid of all unintended loopholes."); mcmahon, beyond a gaar, supra note 139, at 1722; andrea monroe, what's in a name: can the partnership anti-abuse rule really stop partnership tax abuse?, 60 case w. res. l. rev. 401, 409 (2010) [hereinafter monroe, what's in a name]; daniel n. shaviro & david a. weisbach, the fifth circuit gets it wrong in compaq v. commissioner, 94 tax notes 511, 512-13 (jan. 28, 2002) [hereinafter shaviro & weisbach, the fifth circuit]; weisbach, formalism, supra note 139, at 869 ("uncommon transactions that are taxed inappropriately become common as taxpayers discover how to take advantage of them."). 141. see, e.g., cunningham & repetti, textualism, supra note 140, at 6; johnson, the anti-skunk works, supra note 140, at 445 ("the court-made equitable doctrines such as substance over form, sham transaction, and step transaction give the law a vigor that helps the law defend against aggressive misinterpretations of the statute to avoid tax."); monroe, what's in a name, supra note 140, at 413; shaviro & weisbach, the fifth circuit, supra note 140, at 513; weisbach, formalism, supra note 139, at 876 ("[i]n crafting a tax law that includes an anti-abuse rule, drafters need not be terribly concerned with rare transactions that might be mistaxed because attempts to take advantage of them will be covered by the anti-abuse rule."). 142. see, e.g., deborah a. geier, interpreting tax legislation: the role of purpose, 2 fla. tax rev. 492, 493 (1995); alan gunn, the use and misuse of anti-abuse rules: lessons from the partnership antiabuse regulations, 54 smu l. rev. 159, 164 (2001); weisbach, formalism, supra note 139, at 880 ("the statute's purpose is relevant because it allows us to identify which transactions the drafters contemplated in designing the simple rules and which they did not; that is, which transactions were sufficiently common to be considered when the law was promulgated."). along similar lines, others have observed that legislative intent or purpose is relevant for purposes of determining whether a transaction is a tax shelter, is abusive, or otherwise is subject to challenge. see, e.g., joseph bankman, the economic substance doctrine, 74 s. cal. l. rev. 5, 13-15 (2000); joseph 191 florida tax review applying these general ideas to the partnership tax allocation rules leads to the conclusion that the irs and the courts should rely on standards when partners are related because the existing rules, implicitly, assume that partners are unrelated and have opposing economic interests.143 in the case of blackstone group lp, and other partnerships formed by related partners, the irs could rely on a number of standards to challenge the claimed results. 144 bankman, the new market in corporate tax shelters, 83 tax notes 1775, 1787 (june 21, 1999); joshua d. blank, what's wrong with shaming corporate tax abuse, 62 tax l. rev. 539, 539 (2009); sarah b. lawksy, probably? understanding tax law's uncertainty, 157 u. pa. l. rev. 1017, 1032 (2009); leandra lederman, w(h)ither economic substance?, 95 iowa l. rev. 389, 396-97 (2010) [hereinafter lederman, w(h)ither]; michael l. schler, ten more truths about tax shelters: the problem, possible solutions, and a reply to professor weisbach, 55 tax l. rev. 325, 331 (2002) [hereinafter schler, ten more truths]. it should be noted that this view of how to interpret standards has not always convinced courts. see, e.g., marvin a. chirelstein & lawrence a. zelenak, tax shelters and the search for a silver bullet, 105 colum l. rev. 1939, 1940 (2005) ("recent litigation between taxpayers and the government has had mixed results, with taxpayers winning in more than a few instances by persuading the courts that 'rules are rules' and that congress alone, and not the courts, must patch the leaky tire if congress thinks a patch is needed."); david a. weisbach, the failure of disclosure as an approach to shelters, 54 smu l. rev. 73, 77 (2001). 143. for purposes of analyzing the blackstone group structure, it is not necessary to decide precisely when partners should be considered "related" because, under any plausible definition, the partners of blackstone group are "related." this is true because two of blackstone group's three partners are wholly-owned by the third partner. this article does not address when allocations among less closely related entities should be challenged nor does this article address when allocations among family members should be challenged. in the case of family members, the irs might argue that, in some situations, family members could be treated as one partner when applying the substantiality tests. see supra note 127. furthermore, in some cases allocations among family members could be subject to section 704(e). see supra note 87. 144. for instance, the irs might argue that related partners should be treated as one partner when applying the substantial economic effect test. see supra note 127. the irs could also invoke the partnership anti-abuse rule contained in regulations section 1.701-2. for further discussion of the partnership anti-abuse rule, see monroe, what's in a name, supra note 140. the partnership anti-abuse rule provides: [i]f a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of [the partnership tax rules], the commissioner can recast the transaction for federal tax purposes, as appropriate to achieve tax results that are consistent with the intent of [the partnership tax rules] .... 192 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? this article will focus on section 482 particularly because it represents the irs's most promising grounds for challenging the legitimacy of the underlying partnership's allocations.145 regarding section 482, the partnership tax allocation rules are, by no means, the only tax rules that work most effectively when parties have opposing economic interests. tax rules, generally, function best in a setting involving unrelated parties with opposing economic interests dealing at arm's length. for example, when a person or entity sells property to another person or entity, the tax gain or tax loss recognized by the seller generally depends on the amount received from the buyer. 146 thus, if a seller disposes of property for a lower price, the seller will recognize less tax gain (or more tax loss) than the amount the seller would recognize if he or she sold the property for a higher price. this tax treatment relies on the assumption that the buyer and seller have opposing economic interests so that the price paid reflects economic reality. assume, instead, the facts of the following example. example 5. a u.s. corporation (uscorp) owns 100 percent of the stock of a non-u.s. corporation (nonus). uscorp sells property to nonus for a price determined by the parties. in example 5, the price established by the parties will not necessarily reflect economic reality. rather, the parties might use a price lower than the market price if doing so minimizes the parties' aggregate tax liability. section 482 deals broadly with the ubiquitous problems arising from the fact that related parties do not negotiate at arm's length, and, thus, might manage their transactions in a way designed purely to minimize aggregate tax liability. specifically, section 482 provides: in any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the united states, and whether or not affiliated) regs. § 1.701-2(b). the regulations contain a list of factors that may indicate, but do not necessarily establish, that a partnership was used for a prohibited purpose. id. these factors include, among others, whether substantially all of the partners are related to one another. in the blackstone group lp structure, all of the partners are related given that two of the partners (u.s. subsidiary and non-u.s. subsidiary) are wholly-owned subsidiaries of the third partner (blackstone group lp). 145. for further discussion of how the irs might invoke section 482 to challenge allocations that have substantial economic effect but that involve related partners, see leder, tax-driven partnership allocations, supra note 13, at 769, 77980. 146. i.r.c. § 1001. 193 florida tax review owned or controlled directly or indirectly by the same interests, the secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. in example 5 above, the irs could use section 482 to challenge the results claimed by the parties if the price used is inconsistent with an arm'slength price. 14 7 in the context of partnership tax allocations, the treasury regulations specifically provide that the irs may use section 482 to challenge partnership tax allocations when partners are related. 148 in particular, regulations section 1.704-1(b)(1)(iii) states: "[a]n allocation that is respected under [the substantial economic effect rules] nevertheless may be reallocated under other provisions, such as section 482 . . . ." this language is supplemented by the following example: example 28. (i) b, a domestic corporation, and c, a controlled foreign corporation, form bc, a partnership organized under the laws of country x. b and c each contribute 50 percent of the capital of bc. b and c are wholly-owned subsidiaries of a, a domestic corporation .... the bc partnership agreement provides that, for the first fifteen years, bc's gross income will be allocated 10 percent to b and 90 percent to c, and bc's deductions and losses will be allocated 90 percent to b and 10 percent to c. the 147. regs. § 1.482-1(b)(1) ("[t]he standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer."). 148. for further discussion, see leder, tax-driven partnership allocations, supra note 13, at 785-87. see also mckee, nelson & whitmire, partnerships and partners, supra note 82, 3.04[4] ("while there is limited case law dealing with the application of § 482 to partnerships, the courts have not been reluctant to apply it to situations where partners are related or are under common control .... the scope of § 482 is broad enough to encompass . . . partnerships between corporations and their controlling shareholders, . . . assuming the controlling shareholders are viewed as 'organizations, trades, or businesses' for purposes of § 482 . . . ."); id. 10.03[3] ("[aln allocation provision, which is in substance a contract among the partners as to how they will share the partnership's income and loss, can distort the income of the partners vis-a-vis each other. accordingly, § 482 should apply to permit the service to correct such distortions where certain partners are under common control."). 194 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? partnership agreement also provides that, after the initial fifteen year period, bc's gross income will be allocated 90 percent to b and 10 percent to c, and bc's deductions and losses will be allocated 10 percent to b and 90 percent to c. (ii) apart from the application of [the substantial economic effect rules], the commissioner may reallocate or otherwise not respect the allocations under other sections . . . . for example, bc's allocations of gross income, deductions, and losses may be evaluated and reallocated (or not respected), as appropriate, if it is determined that the allocations result in the evasion of tax or do not clearly reflect income under section 482.149 example 28 is similar to the blackstone group lp structure. in example 28, a partnership has two partners (b and c), both of which are corporations and both of which are wholly-owned by a third corporation (a). the partnership allocates items between b and c in a way that minimizes the partners' aggregate tax liability. given that b and c are "organizations, trades or businesses" and are "owned or controlled, directly or indirectly, by the same interests," example 28 concludes that the irs could challenge the allocations under section 482, even if the allocations comply with the substantial economic effect rules. in addition, the irs has successfully invoked section 482 to challenge partnership tax allocations in the past. in rodebaugh v. commissioner,' 50 the taxpayers (husband and wife) each owned stock in several corporations. the corporations, in turn, were partners in a partnership, and the partnership allocated tax items among the partners in a way that was designed to minimize the partners' aggregate tax liability. the irs invoked section 482 to challenge the manner in which the partnership allocated income among the corporations, and the court held in favor of the irs.15 1 furthermore, although rodebaugh was decided before the adoption of the current partnership tax allocation rules, since the adoption of the current rules, the irs has continued to assert that section 482 can apply in the partnership tax allocation context. 152 149. regs. § 1.704-l(b)(5), ex. 28. 150. 33 t.c.m. (cch) 169, t.c.m. (ria) t 1974-36 (1974). 15 1. id. 152. see, e.g., field serv. advisory (sept. 10, 1993), available at 1993 wl 1469410 ("it is the service's position that section 1.704-l(b)(1)(iii) of the regulations permits the use of section 482 to reallocate a partner's distributive share of any partnership item despite the validity of the allocation under section 704(b), provided that the requirements of section 482 are met."); field serv. advisory (may 195 florida tax review if section 482 applies to example 28 and the facts in rodebaugh, it also could apply to the blackstone group lp structure. in the blackstone group lp structure, the underlying partnership allocates income among three partners blackstone group lp, u.s. subsidiary, and non-u.s. subsidiary all of which are "organizations, trades, or business"' and all of which are "owned and controlled, directly or indirectly, by the same interests."1 54 thus, even though the allocations by the underlying partnership may literally comply with the substantial economic effect rules,155 the irs could challenge those allocations under section 482. in particular, the irs might reallocate additional amounts of non-qualifying carried interest income directly to blackstone group lp. furthermore, the irs might challenge the payment of management fees to u.s. subsidiary under section 482 and conclude that blackstone group lp should be treated as if it received some portion of the management fees directly. management fee income and other non-qualifying income reallocated to blackstone group lp under section 482 should be treated as non-qualifying income. when applying section 482 in other contexts, if the irs determines that a party should have earned more income of a given character, the additional income the party must report is deemed to have that character.'56 for instance, if a 14, 1993), available at 1993 wl 1469438 (making a similar statement); field serv. advisory (jan. 1, 1993), available at 1993 wl 1469419 (making a similar statement). the irs has also stated: "we note, however, that the scope of section 1.704-1(b)(1)(iii) vis-a-vis section 482 has not been clearly delineated . . . ." field serv. advisory (sept. 10, 1993), available at 1993 wl 1469410. 153. an "organization" includes "a sole proprietorship, a partnership, a trust, an estate, an association, or a corporation." regs. § 1.482-1(i)(1). thus, this term is broad enough to include all three partners. 154. the regulations under section 482 provide that the irs may reallocate items among "controlled taxpayers." see regs. § 1.482-1(a)(2). the regulations define "controlled taxpayer" to include "any one of two or more taxpayers [which can include any person, organization, trade or business, whether or not subject to tax] owned or controlled directly or indirectly by the same interests." regs. §§ 1.482-1(i)(3), (5). this part of the definition includes u.s. subsidiary and non-u.s. subsidiary as both are wholly-owned by blackstone group lp. the regulations further state that "controlled taxpayer" also includes "the taxpayer that owns or controls the other taxpayers." regs. § 1.482-1(i)(5). thus, blackstone group lp is also a "controlled taxpayer," and the irs can reallocate income among blackstone group lp, u.s. subsidiary, and non-u.s. subsidiary under section 482. 155. see supra part iii.b. 156. see, e.g., krueger co. v. commissioner, 79 t.c. 65 (1982); proctor and gamble co. v. commissioner, 95 t.c. 323 (1990) (irs argued that when a corporation should have additional royalty income under section 482, the additional income should be treated as royalty income for purposes of the subpart f rules; although the court held in favor of the taxpayer, it did so on other grounds and concluded section 482 should not require the taxpayer to report additional income at 196 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? party is required to report additional interest income, the party is treated as earning additional interest income. 57 as a result, if the irs invokes section 482 to re-allocate additional management fee income and other nonqualifying income directly to blackstone group lp, blackstone group lp would be treated as earning non-qualifying income. thus, depending on the amount of income re-allocated to it, blackstone group lp could fail to meet the requirements of the 90 percent gross income exception so that it would be treated as a corporation for tax purposes. vi. responding to possible objections despite the availability of means to challenge the results claimed by blackstone group lp, one might argue that the irs should refrain from initiating a challenge for several reasons (each of which is described and evaluated below).' as discussed in the following, none of the potential objections justify inaction by the irs. all); regs. § 1.482-l(g)(2)(ii) (stating that applying section 482 could cause a corporation to earn additional subpart f income); rev. rul. 78-133, 1978-1 c.b. 171 (concluding that a corporation that failed to charge interest on loans made to related corporations should have additional income under section 482 and the additional income should be interest income for purposes of applying the personal holding company tax provisions). 157. see, e.g., krueger co., 79 t.c. 65; rev. rul. 78-133, 1978-1 c.b. 171. 158. one might also argue that the blackstone group structure is no different than the blocker corporation structure used by many tax-exempt entities when investing in real estate funds, hedge funds, and private equity funds. for further discussion of this structure, see emily cauble, harvard, hedge funds and tax havens: reforming the tax treatment of investment income earned by taxexempt entities, 29 va. tax rev. 695 (2010). this structure has been sanctioned by the irs in private letter rulings. see priv. ltr. rul. 2002-51-016 (dec. 30, 2002); priv. ltr. rul. 2002-51-018 (dec. 20, 2002). the blackstone group structure, however, is different than the blocker corporation structure used in the private letter rulings. in the private letter rulings, a charitable remainder trust indirectly owned an interest in a blocker corporation that, in turn, owned an interest in a partnership ("lower-tier partnership"). all income that the charitable remainder trust received from lower-tier partnership was funneled through the blocker corporation. the lower-tier partnership did not allocate or pay some income to the blocker corporation while allocating or paying other income to the charitable remainder trust directly. by contrast, the underlying partnership in the blackstone group structure allocates and pays only some income to u.s. subsidiary and non-u.s. subsidiary. as a result, the irs could challenge the blackstone group structure by challenging the underlying payments and allocations. thus, the irs would not need to change its position regarding blocker corporations, generally, in order to challenge the blackstone group structure. 197 florida tax review a. the irs should not invoke a standard like section 482 in an area covered by specific rules some might argue that section 482 is vague and should be supplanted with the more detailed substantial economic effect rules.'59 if the detailed rules do not work properly when partners are related, the treasury should revise the rules. although revising the rules may be advisable, this vagueness argument is unpersuasive. the substantial economic effect rules are premised on the assumption that partners in a partnership are unrelated and, thus, have opposing economic interests.160 the blackstone group lp structure, in which the partners are related, was designed to take advantage of rules that did not contemplate the structure used by blackstone group. 6 1 standards, rather than rules, should apply to a structure that takes advantage of rules that did not contemplate it, and a standard necessarily will be vague in order to be sufficiently flexible to fill in gaps left by rules.16 2 moreover, in this instance, the specific rules explicitly state that they do not supplant section 482, the more general standard. 163 given that this warning is contained within the specific rules, taxpayers cannot persuasively argue that they relied on the specific rules' certainty to provide a safe harbor from the vague standard of section 482. 159. see, e.g., leder, tax-driven partnership allocations, supra note 13, at 787 ("the purpose of regulation section 1.704-1(b) was to provide a significant degree of certainty to taxpayers who diligently follow the detailed requirements for substantial economic effect. the use of section 482 to override it should be sharply limited to cases in which related taxpayers are not dealing at arm's length."). 160. see supra parts iii.a.2, iii.a.4. 161. see supra part iii.b. 162. for example, even while making the argument that the specific substantial economic effect rules should generally supplant section 482 and other general standards, richard leder acknowledges that section 482 might apply when partners in a partnership are related. see leder, tax-driven partnership allocations, supra note 13, at 787 ("the use of section 482 to override [the substantial economic effect test] should be sharply limited to cases in which related taxpayers are not dealing at arm's length.") (emphasis added). for a similar argument, see monroe, what's in a name, supra note 140, at 454 ("although a comprehensive analysis of uncertainty's role in partnership taxation is well beyond this article's scope . ... [tihe introduction of greater uncertainty into subchapter k might have a positive effect on partnership taxation . . . . subchapter k overflows with complex and technical statutory provisions . .. . although intended, at least in part, to increase certainty of partnership taxation .... [yet, technical rules] ... create new fault lines ripe for exploitation by taxpayers at extraordinary public cost."). 163. see supra note 148 and accompanying text. 198 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? b. challenging the current structure would lead to undesirable consequences challenging blackstone group lp's structure could lead to undesirable consequences in two ways.' first, current investors in blackstone group lp purchased their interests based on the assumption that blackstone group lp would be treated as a partnership for tax purposes.16 5 if it were treated as a corporation instead, those investors would lose wealth as a result of a decline in the value of the interests that they hold. second, blackstone group lp provides an avenue for ordinary individuals to hold economic interests in private equity funds, real estate funds, and hedge funds, despite the fact that ordinary individuals cannot typically invest in these vehicles directly given the large minimum investment required to purchase an interest in such funds.166 challenging blackstone group lp's 164. blackstone group might also argue that the structure achieves results that are consistent with the purpose of providing a special rule for publicly traded partnerships that earn predominately qualifying income. however, such an argument is unpersuasive. regarding the purpose for the special qualifying income rule, legislative history indicates that congress thought it was inappropriate to impose corporate-level tax on dividend income, interest income, and other types of investment income because owners of the publicly traded partnership could earn such income directly, rather than through a publicly traded intermediary. see, e.g., fleischer, taxing blackstone, supra note 1, at 109-10. in blackstone group, the qualifying income is a portion of carried interest that the blackstone firm receives from the funds that it manages. thus, as professor fleischer argues, because investors in blackstone group could not directly acquire a right to receive carried interest from a blackstone fund, the rationale for the qualifying income exception does not apply to the qualifying income earned by blackstone group. id. 165. investors may not have been entirely justified in making this assumption given that blackstone's s-1 warns of the risk that blackstone group lp could be treated as a corporation for tax purposes. see blackstone s-1, supra note 1, at 52 (stating in the risk factors section: "the value of your investment in us depends largely on our being treated as a partnership for u.s. federal income tax purposes, which requires that 90% or more of our gross income for every taxable year consist of qualifying income . . . . we may not meet these requirements or current law may change so as to cause, in either event, us to be treated as a corporation for u.s. federal income tax purposes or otherwise subject to u.s. federal income tax."). 166. see, also, fleischer, taxing blackstone, supra note 1, at 118-19 ("the blackstone deal actually provides more meaningful egalitarian access to the capital markets by allowing public investors to participate, albeit indirectly, in alternative asset classes without forcing a financial intermediary to pay an entity-level tax."). furthermore, one could argue that congress's failure to enact reform that would have altered the results claimed by blackstone group suggests that the irs should not challenge those results. 199 florida tax review claimed tax consequences could prevent other fund sponsors from engaging in public offerings in the future, thereby limiting the opportunities for ordinary individuals to acquire indirect economic interests in such funds. furthermore, challenging blackstone group lp's tax consequences could cause it to be treated as a corporation for tax purposes so that ordinary individuals could invest in funds only if they did so through an entity subject to corporate-level tax.167 these concerns may have merit. 16 8 however, if it is desirable to allow ordinary individuals to invest in blackstone group lp and benefit from the tax treatment claimed by blackstone group lp, then congress should reform the publicly traded partnership rules so that the results claimed by blackstone group are actually consistent with law. for example, congress could provide that every publicly traded partnership must pay entity-level tax on all of its non-qualifying income (less allowable deductions), but no publicly traded partnership pays entity-level tax on its qualifying income. taking the approach of acquiescing to taxpayers' manipulation of the partnership tax allocation rules is an undesirable alternative to reforming the publicly traded partnership rules if lawmakers want to sanction the results claimed by blackstone group.170 c. blackstone group's structuring produces a logical result despite illogical rules the 90 percent gross income exception results in what is called a "cliff effect," meaning that small non-tax changes can produce drastic tax changes. in order to demonstrate, assume the following facts: example 6. a publicly traded partnership has earned $899 of qualifying income and $100 of non-qualifying income in a given year. the partnership will earn one more dollar of income before the year closes. if the additional dollar is non-qualifying income, the partnership will not meet the requirements of the 90 percent gross income exception because less than 90 percent of its income will be qualifying income. as a result, assuming the partnership has no 167. id. 168. if these concerns do have merit, they would also represent reasons to avoid congressional reforms that would tax blackstone group lp as a corporation. even if legislative reform contained a delayed effective date, it would still affect current investors, although to a somewhat lesser extent. see, e.g., michael j. graetz, legal transitions: the case of retroactivity in income tax revisions, 126 u. pa. l. rev. 47, 49, 57-58 (1977); louis kaplow, an economic analysis of legal transitions, 99 harv. l. rev. 509, 518 (1986). 169. for further discussion, see infra part vi.c. 170. see infra note 175 and accompanying text. 200 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? available deductions, the partnership will be subject to corporatelevel tax of 35 percent times $1,000 or $350. if, instead, the additional dollar was qualifying income, then 90 percent of the partnership's gross income would be qualifying income, and the partnership would be subject to $0 of entity-level tax. thus, $350 of potential tax liability depends on how merely one dollar of income is earned. cliff effects are generally criticized.'71 as demonstrated by example 6, two partnerships could be identical in all respects but for how one dollar of income is earned. if that one dollar is qualifying income, the partnership owes no tax liability, and if that one dollar is non-qualifying income, the partnership owes significant tax liability. such a result is arbitrary and, therefore, potentially unfair.1 7 2 171. for criticism of cliff effects in tax generally, see lily l. batchelder, what should society expect from heirs? the case for a comprehensive inheritance tax, 63 tax l. rev. 1, 91 n.303 (2009); karen c. burke & grayson m.p. mccouch, death without taxes?, 20 va. tax rev. 499, 531 (2001); glenn e. coven, taxing corporate acquisitions: a proposal for mandatory uniform rules, 44 tax l. rev. 145, 174-75 (1989); deborah l. paul, the taxation ofdistressed debt investments: taking stock, tax law. 37, 40 (2010); david a. stein, ubit issues in investment partnerships: what tax-exempt organizations (and their taxable partners) should know, in 11 the partnership tax practice series: planning for domestic and foreign partnerships, llcs, joint ventures & strategic alliances 2012 198-1, 198-15 (louis s. freeman ed., 2012); clinton g. wallace, the case for tradable tax credits, 8 n.y.u. j.l. & bus. 227, 234 (2011); lawrence zelenak, doing something about marriage penalties: a guide for the perplexed, 54 tax l. rev. 1, 59 (2000); lawrence zelenak, taxing gains at death, 46 vand. l. rev. 361, 416-17 (1993). 172. rules that create cliff effects might also be criticized for distorting taxpayers' decisions. in example 6, for instance, the partnership has a very strong tax motivation to earn one dollar of qualifying income rather than one dollar of nonqualifying income. this strong tax incentive could encourage the taxpayer to earn one dollar of qualifying income even when there are good non-tax reasons to engage, instead, in the activity that would generate non-qualifying income. although rules that produce cliff effects can distort taxpayers' decisions, it is not clear that gradual rules would distort decisions to a lesser extent overall. under a gradual rule that provides that all non-qualifying (and no qualifying income) is subject to entity-level tax, the decisions of a partnership under the facts of example 6 will be less subject to distortion than such decisions would be under current law. under current law, the taxpayer incurs $350 tax by earning one dollar of non-qualifying income so tax consequences almost certainly will dissuade the taxpayer from engaging in the activity that generates that income. by contrast, under a gradual rule, the taxpayer would only incur an additional thirty-five cents of tax and thus might still undertake the activity despite the tax consequences. however, compared to current law, a gradual rule could cause even greater distortions in the decisions of partnerships that 201 florida tax review a rule that causes a "cliff effect" can be contrasted with a rule under which tax results change gradually in response to incremental non-tax changes. for instance, instead of the current publicly traded partnership rules (under which a publicly traded partnership bears no entity-level tax if at least 90 percent of its gross income is qualifying income but bears entity-level tax on all of its income if only 89.99 percent of its income is qualifying income), tax law could provide that every publicly traded partnership pays entity-level tax on all of its non-qualifying income (less allowable deductions), but no publicly traded partnership pays entity-level tax on its qualifying income. thus, in example 6, if the additional one dollar earned by the partnership is non-qualifying income, assuming no available deductions, the partnership's tax liability is $101 times 35 percent (or $35.35). if the additional one dollar earned by the partnership is qualifying income, the partnership's tax liability is $100 times 35 percent or ($35). consequently, the only additional tax burden borne by the partnership as a result of earning an additional one dollar of non-qualifying income is 35 cents (35 percent times the additional dollar). by contrast, under current law, the additional dollar results in an increase in tax liability from $0 to $350. the blackstone group lp structure manufactures results that mimic the results of the gradual rule described above. in particular, under the blackstone group lp structure, non-qualifying income is subject to corporate-level tax (or at least most of it is), 73 but qualifying income is not subject to corporate-level tax. the same result follows from the gradual rule described above. thus, blackstone group lp effectively planned around a rule that causes an undesirable "cliff effect." for this reason, the results claimed by blackstone group may be more sensible and less arbitrary than the results that follow from the laws that currently exist.174 earn well over 90 percent qualifying income, for example. under current law, such partnerships can earn one dollar of non-qualifying income or one dollar of qualifying income without incurring any entity-level tax. thus, tax consequences will not distort the decision between the two types of income. under a gradual rule, such partnerships could earn one dollar of qualifying income without incurring any entitylevel tax but would incur thirty-five cents of entity-level tax as a result of earning one dollar non-qualifying income. thus, as compared to current law, a gradual rule could cause greater distortions in the decisions made by partnerships with well over (or well under) 90 percent qualifying income. for a similar discussion, see weisbach, formalism, supra note 139, at 873-74. 173. it is not all subject to corporate-level tax because of the potential use of interest expense to reduce u.s. subsidiary's tax liability and because non-u.s. subsidiary is not subject to tax. see supra parts ii.c., ii.d. 174. along similar lines, professor fleischer suggested that blackstone group might argue that its structure leads to more sensible results than what the law provides because the structure brings its tax treatment closer to pass-through tax treatment enjoyed by similar entities. see fleischer, taxing blackstone, supra note 1, [vol. 14:5202 2013] was blackstone's initial public offering too good to be true? the problem with this rationale for the irs's inaction is that, although it might justify changing the publicly traded partnership rules so that they include a gradual rule like the one described above, it does not justify allowing blackstone group to remedy the problem by using a structure that takes advantage of unintended consequences of the partnership tax allocation rules. allowing blackstone group to work around the current partnership tax allocation rules erodes the integrity of the tax system and contributes to the perception that sophisticated taxpayers are not subject to the same tax rules that apply to the rest of us. 175 moreover, it may embolden at 111 ("blackstone's strongest argument is to push for a principled distinction between firms that are subject to the corporate tax and firms that are not . . . . many active oil and gas, timber, and other energy companies can operate as ptps under the passive income exception, and some do. similarly, many real estate firms operate without paying a corporate level tax, either through the ptp rules (which allow certain rental activities to qualify as passive income) or the reit rules. congress created a special rule for reits . .. which allows them to 'cleanse' small amounts of 'bad' income through a taxable reit subsidiary, much like the blocker entity in the [blackstone group] structure. insurance companies, cooperatives, and other industry groups have their own methods of managing corporate tax liability. why not blackstone?"). 175. for a similar argument in the context of blackstone, see fleischer, taxing blackstone, supra note 1, at 114, stating: "the more powerful 'rule of law' argument relates to the gamesmanship of the deal. rather than lobby for a legislative change, blackstone thumbed its nose at congress, cleverly structuring its way around the corporate tax. it relied on self-help . ... while certainly not a crime, there is something to be said for responding swiftly to new structures that erode the corporate tax base. the bill, in other words, has some independent merit as a matter of protecting the integrity of the tax system, however theoretically flawed that system may be." for a similar argument regarding tax planning generally, see david a. weisbach, ten truths about tax shelters, 55 tax l. rev. 215, 225 (2002) [hereinafter weisbach, ten truths], stating: the most difficult case is where there is an obvious wart on the tax system and tax lawyers help clients plan around the problem. for example, a given transaction might be grossly overtaxed relative to others, creating economic distortions. for various reasons, including the difficulty of drafting the law precisely, planning may reduce the tax to the appropriate amount more cheaply than actually amending the law. but this is a dangerous path because it depends on judgments about the merits of the underlying law. it is generally not a defense to a violation of the law that the law is stupid (try this next time you get pulled over for speeding). it is, therefore, not clear that we should think that planning around warts in the law is socially valuable. 203 florida tax review taxpayers to take advantage of the partnership tax allocation rules in other situations involving related partners with consequences that could be even more objectionable than the results of the blackstone group structure. d. the damage is contained one might argue that challenging blackstone group is unnecessary because the universe of publicly traded entities that can effectively engage in the type of structuring used by blackstone group is limited for two reasons. first, the structure reduces blackstone group lp's tax liability primarily by allowing qualifying income to escape corporate-level tax.'16 thus, a business that earns insignificant amounts of qualifying income cannot save substantial tax liability by using the structure. for example, a business that earns income primarily from operating an active business in the united states could not make effective use of the structure used by blackstone group lp. second, if a business is already organized under state law as an incorporated entity, the business would automatically be treated as a corporation for tax purposes regardless of the type of income that it earns.177 such a business would have to undertake a restructuring to use the blackstone group structure, and the restructuring itself could trigger adverse tax consequences. 78 although not all businesses can effectively utilize the blackstone group structure, many other businesses could potentially use the structure, particularly new businesses that are not dissuaded by the costs of restructuring. 179 as a result, challenging the structure could still raise 176. the structure also reduces tax imposed on non-qualifying income because of the potential use of interest expense to reduce u.s. subsidiary's tax liability and because non-u.s. subsidiary is not subject to tax. see supra parts ii.c., ii.d. 177. regs. § 301.7701-2(b)(1). 178. for example, the shareholders of the corporation could contribute corporate stock to a partnership, and the corporation could, in turn, distribute some of its assets (assets that produce qualifying income) to the partnership. if the fair market value of these assets exceeded the corporation's tax basis in the assets, the corporation would recognize tax gain as a result of the distribution. i.r.c. § 311 (b)(1). 179. see fleischer, taxing blackstone, supra note 1, at 115 ("it's unclear whether the blackstone structure . . . might create a domino effect beyond investment fund managers. blackstone's business closely resembles the merchant banking and, to some extent, the investment banking activities of goldman sachs, morgan stanley, merrill lynch, and other wall street firms. if congress fails to act, it puts these banks at a competitive disadvantage, which may encourage them to spin-off their merchant banking and other asset management activities into separate entities."). 204 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? significant tax revenue from businesses that do or could use the structure.180 furthermore, challenging this transaction could prevent other taxpayers from establishing partnerships in order to take advantage of the partnership tax allocation rules' failure to adequately constrain allocations among related partners. thus, because the damage is not as contained as it may first appear to be, the irs should take action, particularly at a time when the u.s. treasury desperately needs increased tax revenue. e. blackstone group did not engage in egregious tax abuse one might argue that the structure used by blackstone group lp was not overly abusive. in particular, the underlying transaction (i.e., the initial public offering) was a legitimate business transaction, and blackstone group simply structured the transaction in a manner designed to achieve very favorable tax consequences. although it is true that many transactions involve more egregious tax abuse than the blackstone group lp structure, that fact and the fact that the underlying business transaction is legitimate should not immunize the structure from challenge.' 8' in tax law, entire doctrines are built around the idea that there are limits on the ways in which taxpayers can arrange legitimate business transactions.' 8 2 under these doctrines, if a taxpayer 180. this assumes that the increased tax revenue collected from blackstone group and other, existing publicly traded partnerships would not be offset by decreased tax revenue resulting from the fact that challenging the structure could discourage other, similar entities from engaging in initial public offerings. this assumption is not necessarily unfounded. see, e.g., fleischer, taxing blackstone, supra note 1, at 113 ("[i]t is difficult to predict the behavior of other private equity firms considering going public. kkr and others have proceeded with plans to go public following the introduction of the blackstone bill; it seems likely that, as with investment banks, private investment fund managers will seek the permanent capital and liquidity that public equity provides. on the other hand, it is certain that the blackstone bill will increase the cost of doing so and affect the decision at the margin."). 181. see, e.g., lederman, w(h)ither, supra note 142, at 402 ("[t]he fact that a strategy is integrated into the taxpayer's business, rather than existing alongside it, should not affect the determination of whether that strategy is abusive. if the activity is abusive, it is socially wasteful regardless of how connected it is to the taxpayer's business."); schler, ten more truths, supra note 142, at 337-39 (suggesting that "real business transactions done in a funny way" should be impermissible when they reach results unintended by congress); shaviro & weisbach, the fifth circuit, supra note 140, at 513 ("[w]e should always keep in mind that even the most mundane tax planning is not the same as, say, curing sick people, inventing a new product, or even driving a bus."). 182. for example, the step transaction doctrine limits how taxpayers can arrange legitimate business transactions. discussion of this doctrine is beyond the 205 florida tax review arranges the transaction in a way not contemplated by existing tax rules, the transaction is subject to challenge. moreover, there are good reasons for placing limits on structuring legitimate business transactions because, without such limits, taxpayers can take advantage of the unintended tax consequences of existing tax rules. vii. conclusion blackstone group lp uses a structure that inappropriately exploits a loophole in the current partnership tax allocation rules. the irs could and should challenge blackstone group's results under available standards that are designed to close loopholes in tax rules. some of the arguments against the irs taking action may, at first glance, appear legitimate. however, a closer examination reveals that although some of these arguments might justify legislative reform to the publicly traded partnership rules, they do not excuse a failure to challenge tax structures that flout current law. this is particularly true because blackstone group's structure represents merely one example of the manner in which related partners can exploit a loophole in the partnership tax allocation rules. therefore, challenging blackstone group's structure will deter other taxpayers from manipulating the existing rules at a large cost to the public. scope of this article. for more information on this topic, see boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts t 4.3.5 (2012) and jeffrey c. glickman & clark r. calhoun, the "states" of the federal common law tax doctrines, 61 tax law. 1181, 1187 (2008), quoting smith v. commissioner and stating: "the step transaction doctrine generally applies in cases where a taxpayer seeks to get from point a to point d and does so stopping in between at points b and c. the whole purpose of the unnecessary stops is to achieve tax consequences differing from those which a direct path from a to d would have produced. in such a situation, courts are not bound by the twisted path taken by the taxpayer, and the intervening stops may be disregarded or rearranged." 206 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? 207 appendix i. actual blackstone structure as shown in the blackstone s-1,1 83 the actual structure used is reflected in figure 2 below. 183. blackstone s-1, supra note 1, at 11. i igu~ t 2 blackst inc sti u iute from s~ i a' at. <9w ~n 5 >4 'k kk< ~ .~ 'v 4 -~ n~'-~ n 7 n -k-i v ! 5t 2013] was blackstone's initial public offering too good to be true? ii. simplifying adjustments in figure 2, the entities labeled entities f, g, h, i, and j, indirectly receive management fees and carried interest from funds sponsored by the blackstone firm. 18 4 entities f, g, h, i, and j are treated as partnerships for tax purposes. because partnerships are pass-through entities for tax purposes, from a tax perspective, the results of the structure would be the same if entities a, b, c, d, and e directly owned assets and directly received income that entities a, b, c, d, and e own or receive, indirectly, through entities f, g, h, i, and j, respectively. moreover, according to the s-1, the structure is designed so that income received by entities c and d will be qualifying income."' thus, all non-qualifying carried interest and management fees (which are non-qualifying) must be allocated or paid indirectly to entities a, b, or e. finally, according to the s-1, entity e is not expected to earn any income that is effectively connected with a u.s. trade or business. 8 6 in turn, only non-qualifying carried interest income that is not effectively connected with a u.s. trade or business is allocated indirectly to entity e. figure 3 below shows the structure in figure 2 simplified to take into account the discussion in this part ii. 184 the blackstone s-1 refers to these entities, collectively, as "blackstone holdings" and states that subsidiaries of blackstone holdings will be entitled to management fees and carried interest. see blackstone s-1, supra note 1, at 10. 185. id. at 203. 186. id. at 204 ("blackstone holdings v gp l.p. is expected to be operated so as not to produce [effectively connected income]."). 209 i i '1? li i igut c ~ blackslone st ~tatux ft urn s 1 iuth simplili tug ~djuduie un f2 >1 7 4 . . ...... * qualitin ii i; __ i n. 0 2013] was blackstone's initial public offering too good to be true? 211 iii. further simplifying adjustments as shown in figure 3 above, blackstone group lp holds interests in five subsidiaries (labeled entity a, entity b, entity c, entity d, and entity e above). entities a and b are u.s. entities treated as corporations for tax purposes. from a tax perspective, the results of the structure would be the same if entities a and b were combined into one corporation. thus, the structure discussed in this article, and shown above in figure 1, combines entities a and b into one entity ("u.s. subsidiary"). entity e is a non-u.s. entity treated as a corporation for tax purposes. in the structure discussed in this article, and shown in figure 1, entity e is labeled "non-u.s. subsidiary." entities c and d are treated as partnerships for tax purposes. because partnerships are pass-through entities for tax purposes, from a tax perspective, the results of the structure would be the same if blackstone group lp directly owned and received what it owns and receives indirectly through entities c and d. figure 4 below shows the structure in figure 3 simplified to take into account the discussion in this part iii. 1 i f gunre 4i. b ackstone structure f rm s w ~ith f urthe simifyu\;ig adjustmnents t management fee & non quaifing ( t i lv i & lit b carne intre tht1 s o effctied cnted w i i l-.2013] was blackstone's initial public offering too good to be true? iv. how income reaches the various entities according to the blackstone s-1, prior to the initial public offering, various entities ("contributed businesses") were entitled to receive management fees and carried interest from blackstone funds.187 in particular, with respect to each fund, an investment advisor was entitled to receive management fees, and a managing member was entitled to carried interest. following the restructuring undertaken prior to the initial public offering, the contributed businesses have been owned by subsidiaries of u.s. subsidiary, blackstone group lp, and non-u.s. subsidiary. furthermore, because the subsidiaries that own the contributed businesses are pass-through entities for tax purposes, from a tax perspective, the results of the structure would be the same as if blackstone group lp, u.s. subsidiary, and non-u.s. subsidiary owned the contributed businesses directly. given the information provided in the blackstone s-1 and discussed in this appendix, there are three ways that blackstone group lp and its subsidiaries might earn income from the contributed businesses so as to ensure that blackstone group lp qualifies for the 90 percent gross income exception. the three possible structures are discussed below. a. possibility one the first possible structure is shown in figure 5 below. as figure 5 shows, each fund ("underlying fund") sponsored by the blackstone firm pays management fees to an investment advisor that is owned by u.s. subsidiary. each underlying fund also allocates carried interest to a managing member. the managing member, in turn, allocates some carried interest (in particular, carried interest that is qualifying income) directly to blackstone group lp, allocates some carried interest (in particular, nonqualifying carried interest that is u.s. source income or is effectively connected with a u.s. trade or business) to u.s. subsidiary, and allocates some carried interest (in particular, non-qualifying carried interest that is not u.s. source income and is not effectively connected with a u.s. trade or business) to non-u.s. subsidiary. this structure is similar to figure 1 because the underlying fund pays management fees, indirectly, to u.s. subsidiary, and the underlying fund, indirectly, allocates some carried interest to each of blackstone group lp, u.s. subsidiary, and non-u.s. subsidiary. if blackstone group lp uses this structure, the irs could invoke section 482 to challenge the income 187. id. at 57. 188. blackstone s-1, supra note 1, at 57. 189. id. 213 214 florida tax review [vol. 14:5 allocations by the managing member of each underlying fund and the payment of management fees entirely to the investment advisor. i~~~ ~~ i i 1 i/ t i a/ctino no/ uliyn no/us care/itrs n 1191 ii i i i it> quliyin w i n n lv '( aiivl ii rv a n n p 17 'i n iiii u florida tax review b. possibility two the second possible structure is shown in figure 6 below. as figure 6 shows, in the second possible structure, like in the first possible structure, each underlying fund pays management fees to an investment advisor that is owned by u.s. subsidiary. however, unlike the first possible structure, in the second possible structure, the managing member of each underlying fund (which receives allocations of all carried interest from that fund) is owned entirely by only one of u.s. subsidiary, non-u.s. subsidiary, or blackstone group lp. in order to implement this structure, with respect to each underlying fund, blackstone would have to predict whether the underlying fund would generate carried interest that is predominately qualifying income, predominately u.s. non-qualifying income, or predominately non-u.s. non-qualifying income. blackstone's predictions would determine whether the managing member of the underlying fund would be owned by u.s. subsidiary (if carried interest were expected to be predominately u.s. non-qualifying income), non-u.s. subsidiary (if carried interest were expected to be predominately non-u.s. non-qualifying income), or blackstone group lp (if carried interest were expected to be predominately qualifying income). if blackstone group lp uses the structure shown in figure 6, the discussion in this article of challenges to partnership tax allocations would be irrelevant because no partnership specially allocates different types of carried interest to different partners. however, the irs could, nevertheless, invoke section 482 to challenge the payment of management fees entirely to the investment advisor. moreover, the structure shown in figure 6 is the least likely of the three possible structures discussed in this part iv of the appendix because it relies on the blackstone firm's ability to accurately forecast the types of income that will be earned by a given underlying fund. more significantly, this structure would inappropriately constrain the blackstone firm's ability to select investments on behalf of a given underlying fund. for example, assume the blackstone firm predicted that an underlying fund would generate predominately qualifying income so that blackstone group lp directly owned the fund's managing member. once this decision was made, the blackstone firm's obligation to the investors in the underlying fund to select investments that generate favorable after-tax returns could be at odds with its obligation to seek to ensure that the blackstone group lp qualified for the 90 percent gross income exception. this is true because the investors in the underlying fund do not own an interest in blackstone group lp. rather, they invest either directly in the underlying fund or they invest through other entities that invest in the underlying fund. as a result, the after-tax return realized by these investors does not depend on whether or not blackstone group lp qualifies for the 90 percent gross income exception. thus, a conflict could arise if the 216 [vol. 14:5 2013] was blackstone's initial public offering too good to be true? 217 blackstone firm identified a beneficial investment that would generate nonqualifying income. acquiring this investment could be beneficial for investors in the underlying fund but detrimental for investors in blackstone group lp. i/f figur e 6. posvsibihty two vns . -ali a i i ii / 2013] was blackstone's initial public offering too good to be true? c possibility three the third possible structure is shown in figure 7 below. as figure 7 shows, in the third possible structure, like in the first two possible structures, each underlying fund pays management fees to an investment advisor that is owned by u.s. subsidiary. unlike in the previous structures, in the third structure, each underlying fund would form a number of subsidiaries treated as partnerships for tax purposes. when each underlying fund acquired an asset that was expected to generate non-qualifying, u.s. income, the underlying fund would hold that asset through a subsidiary ("sub 1" in figure 7) that would allocate carried interest to managing member 1, which would be owned by u.s. subsidiary. when each underlying fund acquired an asset that was expected to generate qualifying income, the underlying fund would hold that asset through a subsidiary ("sub 2" in figure 7) that would allocate carried interest to managing member 2, which would be owned by blackstone group lp. finally, when each underlying fund acquired an asset that was expected to generate non-qualifying, non-u.s. income, the underlying fund would hold that asset through a subsidiary ("sub 3" in figure 7) that would allocate carried interest to managing member 3, which would be owned by non-us subsidiary. if blackstone group lp indeed uses the structure shown in figure 7, the irs likely could challenge the structure and re-characterize it as the structure shown in figure 8. figure 8 shows the results of the irs challenging figure 7 and claiming that sub 1, sub 2, sub 3, and each underlying fund should be treated as one partnership for tax purposes. the irs could base this challenge on the fact that all entities have the same owners and the fact that the economic arrangements of the entities are interdependent.' 90 regarding the second fact, investors in each underlying fund will insist that the carried interest received from sub 1 may not solely depend on how the assets of sub 1 have performed but must instead depend on the performance of all assets held directly or indirectly by the underlying fund. finally, once the third possibility is re-characterized as shown in figure 8, it is similar to the structure shown in figure i because each underlying fund pays management fees indirectly to u.s. subsidiary, and each underlying fund indirectly allocates some carried interest to each of blackstone group lp, u.s. subsidiary, and non-u.s. subsidiary. therefore, if blackstone group lp uses this structure, the irs could challenge the 190. see, e.g., gregory may, wrongs and remedies: the u.s. tax treatment of multinational partnerships of individuals, 104 tax notes 1509, 1522-24 (june 21, 2004) (describing how the irs could collapse parallel partnerships into a single partnership particularly if the partnerships "set distributions by reference to their combined profits"). 219 220 florida tax review [vol. 14:5 income allocations by each underlying fund under section 482, and the irs could invoke section 482 to challenge the payment of management fees entirely to the investment advisor. figure 7 . poss bi ity three~a pamn of. k manement glctino carrnci intres ii a ocaio of iarie ntrs i ua f in nn qua carr d ineres fe m un li ng i fund volume 14 florida tax review article watching the watchers: preventing i.r.s. abuse of the tax system samuel d. brunson f university of eflorida levin college of law 1818ants 2013 number 6 tcharity really does begin at home: florida tax review volume 12 2012 number 9 629 the monetization of business tax credits by thomas w. giegerich * abstract this article examines the history of the development of federal incentive tax credits, from the enactment of the investment credit in 1962 to the cash grant in lieu of credits regime introduced as part of the american recovery and reinvestment act of 2009, and methods for “monetizing” tax credits developed in the context of state tax credits as well as federal tax credits (and associated taxation issues). the principal thesis of the article is that (1) the current array of federal business tax credits addressed in the article are in the nature of subsidies rather than structural components of the computation of a “correct” tax; and (2) therefore constraining the monetization of these tax credits through the imposition of normative-based substantive requirements is inappropriate. as the article states in conclusion, if the judgment is that tax expenditures of this kind play a useful role (i.e., they should not simply be repealed), then the articulation of the underlying goals and intended beneficiaries of current tax-based subsidies should be sharpened and our existing “delivery mechanisms” closely examined and possibly overhauled. i. introduction ............................................................................. 631 ii. history and overview of federal business tax credits and officially sanctioned monetization structures ..................................................... 640 a. the early years ....................................................................... 640 1. the investment credit ..................................................... 640 2. historic rehabilitation tax credit .................................. 644 3. energy tax credit ........................................................... 645 4. alcohol fuels credit ....................................................... 647 5. nonconventional source fuels credit ............................ 648 * partner, mcdermott, will & emery. the author gratefully acknowledges the substantial assistance provided by his associate, amy e. drake, in the preparation of this paper. this article was originally presented as a paper at the tax club on december 21, 2011 at a meeting held in the new york city chapter of the harvard club. 630 florida tax review [vol.12:9 b. the tax benefit transfer rules ............................................... 650 1. enhanced incentives for capital investment ................... 650 2. the safe harbor leasing rules ...................................... 651 3. revision and repeal of the safe harbor leasing rules .. 658 4. the friendship dairies case ........................................... 659 c. the tax reform act of 1986: neutrality and targeted tax credits ..................................................................................... 660 d. the low-income housing tax credit and express carve-out from a pre-tax profit requirement ......................................... 664 1. in general ....................................................................... 664 2. no requirement of pre-tax profit .................................. 666 3. the lihtc program as credit monetization technique ........................................................................ 669 4. section 1602 grant program .......................................... 672 e. the new markets tax credit ................................................... 673 f. legislative developments with respect to energy credits since 1986 ............................................................................... 678 1. extension of the energy credit ....................................... 678 2. the production tax credit .............................................. 679 a. in general ............................................................... 679 b. role as subsidy ....................................................... 680 c. rev. proc. 2007-65 .................................................. 681 d. optional election for energy credit ....................... 683 3. 2005 enhancements to the energy credit ....................... 684 4. response to the economic downturn: the arra grant program ................................................................ 684 iii. federal tax credit monetization structures in practice.................................................................................. 689 a. renewable energy projects ..................................................... 689 1. in general ....................................................................... 689 2. illustration of partnership flip structure ....................... 689 3. lease structure ................................................................ 690 4. reliance on targeted return ........................................... 691 b. other tax credit transactions in practice ............................. 691 c. the sacks case ........................................................................ 691 d. the historic boardwalk case ................................................. 695 iv. enactment of section 7701(o)............................................... 703 a. basic summary of the provision .............................................. 703 b. relevant legislative history.................................................... 706 c. irs field directive on the codified economic substance doctrine ................................................................................... 709 v. the case for a new federal tax benefit transfer regime ...................................................................... 710 2012] monetization of business tax credits 631 vi. overview of select state business tax credits and officially sanctioned monetization structures ................................................................................. 717 a. refundable state tax credits .................................................. 717 b. transferable state tax credits ................................................ 718 c. flexible partnership allocation schemes................................ 719 d. traditional partnership allocation schemes .......................... 721 e. hybrid schemes ....................................................................... 721 vii. federal tax treatment of state tax credit grants, transfers and allocations .................................. 722 a. survey of the guidance ............................................................ 722 b. the tempel case ..................................................................... 730 c. the virginia historic tax credit case ................................... 733 d. proposal for a unifying rule ................................................... 740 viii. conclusion ................................................................................. 742 i. introduction within the last year or so, two cases have been handed down addressing partnership allocations of tax credits. in virginia historic tax credit fund 2001 v. commissioner, 1 the question was whether a purported allocation of virginia historic rehabilitation tax credits under the terms of the governing operating agreement should be respected as such or instead should be recast as a sale of the state tax credits by the partnership 2 to the state tax credit “investors.” many states allow for outright transfers of state tax credits (with associated, if somewhat muddled, federal tax consequences), but virginia is not among them, and the question before the court was whether the substance of the transaction entered into by the virginia state tax credit investors, the partnership and the project developer was — under the section 707 3 disguised sale rules or otherwise — a sale of tax credits, notwithstanding the facial impossibility of such a sale in light of the fact that the state tax credits at issue were by the terms of the enabling legislation “nontransferable.” 1. 639 f.3d 129 (4th cir. 2011), rev’g 98 t.c.m. (cch) 630 (2009). 2. references to “partnership” and “partner” include state law partnerships and limited liability companies classified as partnerships for u.s. federal tax purposes, and their members. 3. unless otherwise indicated, section references are to the internal revenue code of 1986, as amended, or the internal revenue code of 1954, as amended, as the context makes clear, or the treasury regulations promulgated thereunder. 632 florida tax review [vol.12:9 in historic boardwalk hall, llc v. commissioner, 4 the question was whether a purported allocation of federal historic rehabilitation tax credits under the terms of the operating agreement among the parties should be respected or set aside effectively as an impermissible attempt to “sell” tax credits (the federal historic rehabilitation tax credit not being transferable within the intendment of its enabling legislation). according to the government, the overall transaction amounted to a scheme to transfer tax credits (for a price) to a party whose participation in the project lacked the characteristics of an equity investment necessary for it to lay claim to the tax credits. in virginia historic tax credit, under the applicable virginia legislation the credits in question could not be sold, but could be allocated among the partners of a partnership in whatever manner the partners agreed. when the internal revenue service (“irs”) first adopted the position in chief counsel advice 5 that the allocation scheme adopted by the parties in that case was tantamount to, and should be treated as, a sale of the tax credits for federal tax purposes (arguing that the state tax credit investors were not partners in the partnership and, in any event, the purported allocation of state tax credits was a disguised sale under section 707), the state of virginia weighed in to re-confirm that for virginia tax purposes the allocation of credits among the parties would be respected. 6 federal tax law does not permit federal tax credits to be allocated among partners in whatever manner they agree. in fact, it seems readily apparent that an attempt to allocate federal tax credits in the manner used by the parties in virginia historic tax credit to allocate the virginia tax credit would be impermissible under section 704 and would not be given effect. 4. 136 t.c. 1 (2011). 5. i.r.s. chief couns. adv. 2007-04-028 (jan. 26, 2007); i.r.s. chief couns. adv. 2007-04-030 (jan. 26, 2007). 6. va dep’t of taxation, rulings of the tax commissioner, no. 0782 (may 25, 2007) [i]t appears that the historic rehabilitation credits would be granted under virginia law to a partnership validly created under virginia law. the statute, va. code ann. § 58.1-339.2, refers to various determinations by virginia agencies and values assessed by local tax authorities. it expressly requires that credits granted to a partnership be passed through to the partners. there is nothing in virginia law that ties any amount or determination related to the credit to the federal tax treatment of a related item. therefore, the irs action based upon a deemed purchase of state tax credits, which by its terms is limited to the calculation of federal income tax, does not require the virginia agencies administering the credit to similarly ignore actions otherwise valid under virginia law and revoke the credit because of the deemed purchase. 2012] monetization of business tax credits 633 under section 704, a partner’s distributive share of income, gain, loss, deduction, or credit is generally determined by the partnership agreement. 7 if, however, a particular allocation to a partner in the partnership agreement does not have “substantial economic effect,” 8 the allocation of partnership items to a partner is re-determined based on the “partner’s interest in the partnership,” 9 so that the allocation corresponds with the manner in which the partners have agreed to share the economic benefit or burden corresponding to the income, gain, loss, deduction, or credit that is allocated. 10 the allocation of credits cannot have substantial economic effect 11 and therefore must be allocated based on the partners’ interests in the partnership. in the case of the investment tax credit, allocation of the credit based on allocations of cost or qualified investment in accordance with regulations section 1.46-3(f) (generally, in accordance with the ratio in which the partners divide general profits) satisfies this requirement. in the case of other tax credits, if a partnership expenditure (whether or not deductible) that gives rise to a tax credit in a partnership taxable year also gives rise to valid allocations of partnership loss or deduction (or other downward capital account adjustments) for the year, then the partners’ interests in the partnership with respect to the credit (or the cost giving rise to it) are in the same proportion as the partners’ respective distributive shares of the loss or deduction (and adjustments). 12 regulations section 1.7041(b)(4)(ii) further provides that identical principles apply in determining the partners’ interests in the partnership regarding tax credits, such as the credit under section 45 (the production tax credit), that arise from receipts of the partnership (whether or not taxable). returning to virginia historic tax credit, parties putatively making substantial equity contributions to a partnership and yet receiving only a one percent interest in partnership profits and losses in the aggregate were allocated all of the state tax credits — an allocation scheme that clearly would be impermissible if tested under standards such as those described above (i.e., federal tax credits could not be allocated that way). further, these parties (1) were due to have their contributions refunded if the tax credits 7. i.r.c. § 704(a). 8. that is, the allocation is not “consistent with the underlying economic arrangement of the partners.” see reg. § 1.704-1(b)(2)(ii)(a). 9. reg. § 1.704-1(b)(1)(i). 10. reg. § 1.704-1(b)(3)(i). 11. see reg. § 1.704-1(b)(4)(ii) (“[a]llocations of tax credits . . . are not reflected by adjustments to the partners’ capital accounts (except to the extent that adjustments to the adjusted tax basis of partnership section 38 property in respect of tax credits . . . give rise to capital account adjustments under paragraph (b)(2)(iv)(l) of this section). thus, such allocations cannot have economic effect under paragraph (b)(2)(ii)(b)(1) of this section.”). 12. see regs. §§ 1.704-1(b)(4)(ii), 1.46-3(f). 634 florida tax review [vol.12:9 were not received or were revoked; and (2) agreed to a buy-out of their partnership interests following receipt of the credits for less than a penny on the dollar. 13 interestingly, the tax court sided with the taxpayer in virginia historic tax credit and found that the arrangement did not constitute a sale of the state tax credits. although the tax court acknowledged that “investors received assurance that their contributions would be refunded” if the tax credits were not received or were revoked, the court concluded this was offset by the risk the investors took “that the resources would [not] remain available in the source partnership” to back up that assurance. 14 further, the quid pro quo nature of the exchange — suggesting as it did the possible invocation of a section 707 disguised sale argument — was downplayed on the basis of a finding that the transactions were “not simultaneous” and the investors were “subject to the entrepreneurial risks of the partnership’s operations.” 15 although, in the main, the decision of the tax court honed to technical considerations such as these, policy considerations played a role in the court’s reasoning as well, the court noting at one juncture: “[i]t is a policy of the federal government to give maximum encouragement to organizations and individuals undertaking preservation by private means and to assist states in expanding and accelerating their historic preservation programs and activities.” 16 the fourth circuit, on the other hand, was neither swayed by considerations of policy nor sympathetic to the taxpayer’s technical arguments, finding that: [t]he only risk here was that faced by any advance purchaser who pays for an item with a promise of later delivery [rather than] . . . the risk of the entrepreneur who puts money into a venture with the hope that it might grow in amount but with the knowledge that it may well shrink. 17 13. the investors all were bought out for a small percentage of their original contribution amounts within months of their initial investments after receiving the tax credits (receiving collectively approximately $7,000 in respect of approximately $7,000,000 contributed by them to the capital of the partnership). see infra note 393 and accompanying text. 14. 98 t.c.m. (cch) 630, 640 (2009), rev’d, 639 f.3d 129 (4th cir. 2011). 15. id. at 641. 16. id. at 632 (referencing the national historic preservation act of 1966, 16 u.s.c. § 470-1 (2006)). 17. virginia historic tax credit fund 2001 v. commissioner, 639 f.3d 129, 145–46, rev’g 98 t.c.m. (cch) 630 (2009). 2012] monetization of business tax credits 635 the broader backdrop against which the virginia historic tax credit case was decided includes the highly variable state tax systems for addressing tax credits, with some states having instituted refundable tax credits 18 and others transferable tax credits 19 and still others non-transferable tax credits, 20 in some cases with lenient rules for partnerships as to the allocation of the credits 21 and in other cases requiring allocation in 18. examples include michigan’s brownfield redevelopment credit, mich. comp. laws § 208.1437 (2010) (repealed effective on contingency by 2011 mich. pub. acts 39) (refundable provision, mich. comp. laws § 208.1437(18) (2010)); arizona’s renewable energy operations credit, ariz. rev. stat. ann. § 43-1164.01(2011) (west) (refundable provision, ariz. rev. stat. ann. § 431164.01.f (2011) (west)); and new mexico’s renewable energy production tax credit, n.m. stat. ann. § 7-2a-19 (west 2011) (refundable provision, n.m. stat. ann. § 7-2a-19(k) (west 2011). 19. examples include iowa’s wind energy production tax credit, iowa code ann. § 476b (2011) (west) (provision allowing transfers at iowa code § 476b.7 (west 2011)); oklahoma’s credit for electricity produced from zeroemission facilities, okla. stat. tit. 68, § 2357.32a (2011) (provision allowing transfers at okla. stat. tit. 68, § 2357.32a(f) (2011)); connecticut’s urban and industrial site reinvestment credit, conn. gen. stat. ann. § 32-9t (west 2011) (provision allowing transfers at conn. gen. stat. ann. § 32-9t(n) (west 2011)). 20. examples include mississippi’s equity investment (new markets) tax credit, miss. code ann. § 57-105-1 (west 2011) (provision prohibiting transfer at miss. code ann. § 57-105-1(2) (2011)); ohio’s historic building rehabilitation credit, ohio rev. code ann. § 149.311 (west 2011) (provision prohibiting transfer at ohio admin. code 122:19-1-06(d) (west 2011); however, the credit is refundable). 21. a case in point, of course, is virginia’s historic rehabilitation tax credit, va. code ann. § 58.1-339.2 (west 2011) (“credits granted to a partnership or electing small business corporation (s corporation) shall be allocated among all partners or shareholders, respectively, either in proportion to their ownership interest in such entity or as the partners or shareholders mutually agree as provided in an executed document. . . .”). other examples include illinois’ new markets tax credit, 20 ill. comp. stat. ann. 663/15 (west 2011) (“no tax credit claimed under this act shall be refundable or saleable on the open market. tax credits earned by a partnership, limited liability company, s corporation, or other “pass-through” entity may be allocated to the partners, members, or shareholders of that entity for their direct use in accordance with the provisions of any agreement among the partners, members, or shareholders. any amount of tax credit that the taxpayer, or partner, member, or shareholder thereof, is prohibited from claiming in a taxable year may be carried forward to any of the taxpayer’s 5 subsequent taxable years.”); and new mexico’s renewable energy production tax credit, n.m. stat. ann. § 7-2a-19(h) (west 2011) (“a taxpayer may be allocated all or a portion of the right to claim a renewable energy production tax credit without regard to proportional ownership interest if: (1) the taxpayer owns an interest in a business entity that is taxed for federal income tax purposes as a partnership; (2) the business entity [would otherwise qualify for the credit]; [and] (3) the taxpayer and all other taxpayers 636 florida tax review [vol.12:9 proportion to the parties’ ownership interests in the partnership or in accordance with similarly restrictive requirements. 22 in historic boardwalk — involving the federal historic rehabilitation tax credit — the parties purported to live within the strictures of section 704(b), and in fact the irs never challenged the validity of the allocation of the tax credit as such (all items of income, gain, loss, deduction and credit were allocated 99.9 percent to pitney bowes and 0.1 percent to the new jersey state exhibition authority (“njsea”)). 23 rather, the irs argued in the alternative that (1) the partnership was a sham; (2) the taxpayer (pitney bowes) was not a partner in the partnership; (3) the partnership never took ownership of the property that underwent rehabilitation; and (4) the claimed tax benefit should be denied pursuant to the partnership anti-abuse rules set forth in section 1.701-2. in support of its arguments, the irs pointed to competing call and put options held by njsea and pitney bowes, respectively, that it argued were structured to lock in pitney bowes’ return without regard to the success of the venture; the protection of pitney bowes’ preferred return via a guaranteed investment contract and bargained-for tax benefits via a tax benefits guaranty agreement; the fact that njsea alone was responsible for operating deficits and that the partnership’s debt all was nonrecourse to pitney bowes; the absence of a pre-tax profit motive on the part of pitney bowes, according to the irs’s characterization of the facts and law; and, in the irs’s view, the absence of participation by pitney bowes in upside potential and downside risk and the retention by njsea of the benefits and burdens of ownership following the purported transfer of ownership of the property from njsea to the partnership, among other things. here too the tax court rejected the government’s arguments and held for the taxpayer. in doing so, again the tax court seemed attracted by policy considerations: allocated a right to claim the renewable energy production tax credit pursuant to this subsection own collectively at least a five percent interest in a qualified energy generator . . . .”). 22. see, e.g., arizona’s credit for solar energy devices, ariz. rev. stat. ann. § 43-1164(f) (2011) (west) (“co-owners of a business, including corporate partners in a partnership, may each claim only the pro rata share of the credit allowed under this section based on the ownership interest or financial investment in the system.”); montana’s credit for preservation of historic buildings, mont. code ann. § 15-31-151(3) (2011) (“if the credit under this section is claimed by a small business corporation . . . or a partnership, the credit must be attributed to shareholders or partners, using the same proportion used to report the corporation's or partnership's income or loss for montana income tax purposes.”). 23. historic boardwalk hall, llc v. commissioner, 136 t.c. 10 (2012). in addition, pitney bowes was entitled to a preferred return payable out of available cash flow equal to 3 percent of its investment per annum. id. 2012] monetization of business tax credits 637 respondent’s contention that pitney bowes was unnecessary to the transaction because njsea was going to rehabilitate the east hall without a corporate investor overlooks the impact that pitney bowes had on the rehabilitation: no matter njsea’s intentions at the time it decided to rehabilitate the east hall, pitney bowes’ investment provided njsea with more money than it otherwise would have had; as a result, the rehabilitation ultimately cost the state of new jersey less. . . . the legislative history of section 47 indicates that one of its purposes is to encourage taxpayers to participate in what would otherwise be an unprofitable activity. congress enacted the rehabilitation tax credit in order to spur private investment in unprofitable historic rehabilitations. as respondent notes, the east hall has operated at a deficit. without the rehabilitation tax credit, pitney bowes would not have invested in its rehabilitation, because it could not otherwise earn a sufficient net economic benefit on its investment. the purpose of the credit is directed at just this problem: because the east hall operates at a deficit, its operations alone would not provide an adequate economic benefit that would attract a private investor. further, if not for the rehabilitation tax credit, njsea would not have had access to the nearly $14 million paid to it as a development fee for its efforts in rehabilitating the east hall. 24 this case currently is on appeal to the third circuit. 25 the broader backdrop against which to consider the significance of historic boardwalk includes the many transactions that have been consummated that can be said to have some of the same structural elements as historic boardwalk and the enactment of section 7701(o), codifying the economic substance doctrine. section 7701(o), in brief, requires that for the intended tax consequences of a transaction for which the economic substance doctrine is “relevant” to be respected, the transaction must have a meaningful economic effect and substantial purpose apart from federal income tax 24. id. at 15–17. it would appear that absent the investment by pitney bowes final project costs simply would have been $14 million lower. 25. notice of appeal, historic boardwalk hall, llc v. commissioner, no. 11-1832 (3d cir. apr. 14, 2011). the government filed its opening brief on october 27, 2011. the petitioner filed its brief on december, 15, 2011. 638 florida tax review [vol.12:9 effects for the tax consequences to be respected. 26 on this latter score, although the tax years before the court in historic boardwalk predate the enactment of section 7701(o), tax advisors practicing in the area have taken some comfort from the tax court’s opinion in historic boardwalk and its support for taking the tax credits into account — given the congressional mandate — as part of the taxpayer’s economic return in evaluating the substance of the transaction. 27 the argument on legislative policy grounds is that incentive tax credits should be taken into account in testing for pre-tax profit because congress enacted the credits to incentivize investment in projects it understood otherwise would be uneconomic, and to do differently would defeat legislative intent. the current cash grant program instituted in 2009 by the american recovery and reinvestment act (“arra”) 28 that provides grants in lieu of the federal production tax credit and energy credit undergirds this reasoning by laying bare the essential nature as subsidies of the credits for which cash grants are an alternative. however, even if one accepts the thrust of the argument, as discussed below, the issues in historic boardwalk extend well beyond this. historic boardwalk shows the machinations that parties will go through to extract a federal tax credit and related tax benefits — while concurrently limiting exposure to the underlying project to the greatest extent possible — and leads to a question: what if federal business tax credits (the investment credit, 29 including the energy credit 30 and historic rehabilitation 26. health care and education reconciliation act of 2010, pub. l. no. 111-152, § 1409(a), 124 stat. 1029, 1067–68 [hereinafter hcera 2010] (adding i.r.c. § 7701(o)). section 7701(o)(2) provides that potential for a profit only factors into meeting these requirements if the present value of the “reasonably expected pretax profit” is substantial when compared against the present value of expected net tax benefits. 27. see michael bauer & kevin juran, the economic substance of tax credits, 131 tax notes 499, 503 (may 2011) (concluding “the tax court’s opinion appears to provide additional support for respecting some transactions that have the effect of transferring tax credits between parties as compensation for investing, at least when the transaction appears to be congressionally sanctioned.”). the authors also offer a cautionary query as to “what, if anything, should be made of the fact that the tax court had the opportunity to hold that the economic substance doctrine was irrelevant to the instant case and opted not to?” id. 28. american recovery and reinvestment act of 2009, pub. l. no. 111-5, §§ 1602–03, 123 stat. 115, 362–66 [hereinafter arra 2009]. 29. the investment credit as originally enacted under section 46 is currently only available in the case of: (1) the rehabilitation credit (section 47); (2) the energy credit (section 48); (3) the qualifying advanced coal project credit (section 48a); (4) the qualifying gasification project credit (section 48b); (5) the qualifying advanced energy project credit (section 48c); and (6) the qualifying therapeutic discovery project credit (section 48d). 2012] monetization of business tax credits 639 credit, 31 production tax credit, 32 low-income housing tax credit, 33 and new markets tax credit 34 ) were made transferable (or, alternatively, refundable) as many state tax credits are? what are the factors that would need to be taken into account? what precedents exist? what lessons can we learn from the cash grant program? returning to the already malleable world of state tax credits, virginia historic tax credit highlights the uncertain federal tax effects of varying ways to deal with state tax credits. another case that will be considered below, tempel v. commissioner, 35 considers the question of the character of the gain realized upon a sale of a state tax credit for federal tax purposes and reaches a conclusion at odds with earlier irs pronouncements on the subject. it seems curious that the federal tax treatment of state tax credits — and, in turn, effectively, the value of state tax credits — should vary based on whether the state tax credit is transferable or non-transferable or is transferred to another party, or simply used by the original recipient of 30. as noted in the preceding footnote, the energy tax credit is a component of the investment credit. section 48 generally provides a credit equal to a percentage of the basis of each “energy property” placed in service during a taxable year. currently, the applicable percentage is 30 percent for solar property, fuel cell property, and small wind property and 10 percent for all other energy property, including geothermal and microturbine sources. prior to 2005, the applicable percentage for all energy property (at that time, only solar property and geothermal property were eligible) was 10 percent. 31. section 47 provides a 10 percent credit for the rehabilitation of buildings placed in service before 1936 and a 20 percent credit for the rehabilitation of certified historic structures. like the energy tax credit, the historic rehabilitation tax credit is a component of the investment credit. see supra note 29. 32. section 45 provides a tax credit based on the kilowatt hours of electricity produced by the taxpayer from certain “qualified energy resources.” the credit amount is adjusted for inflation. i.r.c. § 45(b)(2). currently, the credit is 2.2 cents per kilowatt hour on the sale of electricity produced from the qualified energy resources of wind, closed-loop biomass, geothermal energy, and solar energy and 1.1 cent per kilowatt hour on the sale of electricity produced in open-loop biomass facilities, small irrigation power facilities, landfill gas facilities, trash combustion facilities, qualified hydropower facilities, eand marine and hydrokinetic energy facilities. see notice 2011-40, 2011-1 c.b. 806. in general, the credit is only available with respect to electricity produced during the period of ten years starting on the date the qualified facility was originally placed in service. 33. section 42 provides ten yearly credit installments that have a present value equal to 70 percent of the cost of new low-income housing units and 30 percent of cost of used or federally subsidized units. 34. section 45d provides a credit equal to 5 percent of a “qualified equity investment” for the first 3 years and 6 percent for the next 4 years. 35. 136 t.c. 341 (2011). 640 florida tax review [vol.12:9 the credit to reduce its own taxes, and should be as generally uncertain as it is. what would a unifying set of rules look like? this article will explore these topics in depth. ii. history and overview of federal business tax credits and officiallysanctioned monetization structures a. the early years 1. the investment credit in 1962, congress enacted the investment credit — the first federal tax credit aimed at encouraging capital investment. 36 a taxpayer generally was permitted to reduce its federal income tax by 7 percent of the amount it invested in qualifying property (generally new capital equipment with tax lives greater than three years) placed in service during the year. 37 under the original statute, a taxpayer claiming the credit was required to reduce its tax basis in the property in respect of which the credit was being claimed by the full amount of the credit. 38 if the taxpayer disposed of the property before the end of its useful life, the taxpayer was required to recapture a portion of the credit. 39 the rationale for the tax credit was explained by president kennedy, in an economic report submitted to congress along with his budget proposals, as follows: the tax credit increases the profitability of productive investment by reducing the net cost of acquiring new 36. revenue act of 1962, pub. l. no. 87-834, § 2, 76 stat. 960, 962–73. the other component of the stimulus plan was the treasury department’s reduction in the useful lives of capital assets for depreciation purposes. s. rep. no. 87-1881, at 12 (1962), reprinted in 1962 u.s.c.c.a.n. 3304, 3314 (“[f]aster depreciation . . . [shares with tax credits the characteristic] of giving the investor in equipment a monetary reward beyond what he would receive on the basis of realistic accounting.”). 37. the portion of the investment taken into account was one-third in the case of property with a useful life of four to five years, two-thirds in the case of property with a useful life of six to eight years, and 100 percent for property with longer lives. i.r.c. § 46(c)(2) (1962). the rate was increased from 7 percent to 10 percent in 1975. tax reduction act of 1975, pub. l. no. 94-12, § 301(a), 89 stat. 26, 36 [hereinafter tra 1975]. 38. i.r.c. § 48(g) (1962). 39. i.r.c. § 47 (1962). the recapture regime was established in order “to guard against a quick turnover of assets by those seeking multiple credit.” s. rep. no. 87-1881, at 18 (1962), reprinted in 1962 u.s.c.c.a.n. 3304, 3320; h.r. rep. no. 87-1447, at 13 (1962). 2012] monetization of business tax credits 641 equipment. it will stimulate investment in capacity expansion and modernization, contribute to growth of our productivity and output, and increase the competitiveness of american exports in world markets. 40 the legislative history accompanying the enactment explains that the provision requiring a reduction in the basis of the property in respect of which the credit is claimed (by the amount of the credit) was included because “there is no reason to allow the taxpayer depreciation with respect to the portion of the investment in effect paid for by the government.” 41 a mere two years later, in 1964, the requirement was removed 42 on the ground that it “severely restricted the incentive effect of the investment credit.” 43 two years subsequent to that, in 1966, the investment credit was suspended — from october 1966 to march 1967. 44 the investment credit was repealed from april 1969 to august 1971, 45 reinstated, increased in 1975 to 10 percent, 46 significantly expanded in 1981 (see discussion in part i.b.1. below) and repealed with finality as part of the tax reform act of 1986 (subject to grandfather provisions). vestiges remain in the form of various credits hung under the rubric of “investment credit” pursuant to section 46, such as the historic rehabilitation credit under section 47 and the energy credit under section 48. 47 the history of enactment, suspension, repeal, and reintroduction of the investment credit in the early years indicates a legislative attempt to manage the pace of economic growth through the giving or withholding of 40. president john f. kennedy, economic report of the president (jan. 1962). 41. s. rep. no. 87-1881, at 19 (1962). 42. revenue act of 1964, pub. l. no. 88-272, § 203, 78 stat. 19, 33–35. 43. s. rep. no. 88-830, at 40 (1964). according to the senate report accompanying public law 88-272, the basis reduction provision [i]n effect . . . converted the 7-percent credit into a 3½-percent credit for corporations, plus a 7-percent initial depreciation allowance. this result occurs because the decrease in basis of the asset which may be written off means that the equivalent of approximately one-half of the investment credit is recouped over the life of the asset in substantially the same manner as an initial depreciation allowance. this effect substantially reduces the incentive effect of the credit, since it means that approximately half of the benefits must be restored over the useful life of the asset. in effect, this transforms one-half of the credit into an interest-free loan. id. 44. act of nov. 8, 1966, pub. l. no. 89-800, 80 stat. 1508. 45. tax reform act of 1969, pub. l. no. 91-172, 83 stat. 487. 46. tra of 1975, supra note 37, § 301(a), 89 stat. at 36. 47. see infra note 125–29, 187–91 and accompanying text. 642 florida tax review [vol.12:9 tax incentives — to accelerate or slow, as opposed to cause, in absolute terms, economic investment. reportedly, the suspension of the credit in october 1966 was in direct response to an overheated economy and a boom in new investments. announced to last through december 1967, the suspension was meant to restrain the pace of investment outlays. however, when the economy began to sag early in 1967 the suspension of the investment credit was lifted after only five months in march 1967. economists since have noted that the lag between enactment (or suspension) of such stimulus to investment activity and actual marketplace response as measured by investment outlays is such that legislative actions like the one in 1966 are destined to miss the mark. 48 the investment credit was neither transferable nor refundable, thereby generally restricting its value to taxpayers with current tax liabilities. 49 however an element of the investment credit, dating back to first enactment, is the ability of a lessor to “cede” its investment credit to “the party actually generating the demand for the investment” — the lessee. 50 the provision was explained in the senate report as follows: if the lessor makes this election, then the lessee is treated for purposes of this provision as if he had acquired the property himself, that is, generally he will be treated as if he had acquired the property for the lessor’s cost or other basis for the property. however, if the lessor constructed the property (or a corporation controlled by or which controlled the lessor did so) the lessee is treated as having acquired the property for its fair market value. the useful life of the property in the hands of the lessee in such cases is to be its useful life in the hands of the lessor for purposes of computing the size of the credit available. this is true whether or not the lease itself is for a shorter period of time. of course, in such cases if the lessee does not renew the lease and hold the property for the estimated useful life of 48. see john lintner, do we know enough to adopt a variable investment tax credit?, in federal reserve bank of boston conference series 11, credit allocation techniques and monetary policy 113, (1973). 49. the senate report notes that “[t]he tax credit, under the bill, as amended by your committee (sec. 46(a)(2)) may not exceed the tax liability, or if the tax liability is in excess of $25,000, may not exceed $25,000 plus 25 percent of the tax liability over this amount. this . . . is designed to prevent [the credit] from relieving the taxpayer from any substantial contribution.” s. rep. no. 87-1881, at 17 (1962) (emphasis added). the inclusion of credit carry backs and carry forwards was seen as ameliorative. see h.r. rep. no. 87-1447, at 10 (1962). 50. s. rep. no. 87-1881, at 19 (1962). 2012] monetization of business tax credits 643 the property in the hands of the lessor, then a downward adjustment will be made in his investment credit. where the lessee is allowed the investment credit there is no adjustment of the lessor’s basis for depreciation . . . but a reduction of the lessee’s deduction for rent is provided. 51 under the current formulation, a lessor may elect to treat the lessee of property eligible for the historic rehabilitation credit under section 47 or the energy credit under section 48 (both discussed below) as having purchased the property for its fair market value, 52 thus allowing the lessor to shift the credit to the lessee. 53 generally, only corporate lessors may elect to cede the credit. 54 the lessor is not required to reduce its basis in the property; rather, the lessee must ratably include 50 percent of the amount of the credit (or the entire amount of the credit in the case of the rehabilitation tax credit) in its gross income over the shortest recovery period applicable to the property. 55 51. id. at 19–20. 52. in the case of a short-term lease (i.e., where the lease is for a period of less than 80 percent of the property’s useful life if such useful life is over 14 years, and the lease is a not a “net lease” where the lessor is guaranteed a specified return), the lessee is treated as having acquired a portion of the property for an amount equal to a fraction, the numerator of which is the term of the lease and the denominator of which is the class life of the property, multiplied by the fair market value of the property. reg. § 1.48-4(c)(3)(i). likewise the lessor is treated as having retained a qualified investment in the property. reg. § 1.48-4(c)(3)(ii). 53. i.r.c. § 48(d) (repealed in 1990). current section 50(d)(5) provides that “rules similar to the rules of . . . [pre-1990] section 48(d)” shall apply for credits listed in current section 46. therefore, these rules also apply to the qualifying advanced coal project credit under section 48a, the qualifying gasification project credit under section 48b, the qualifying advanced energy project credit under section 48c, and the qualifying therapeutic discovery project credit under section 48d. 54. i.r.c. § 46(e)(3) (repealed in 1990) (as made currently applicable by i.r.c. § 50(d)(1)). exceptions, however, are provided if: (1) the lessor manufactured or produced the property itself; or (2) if the term of the lease is less than 50 percent of the useful life of the property and if, during the first twelve months after the property is transferred to the lessee, the lessor’s deductions under section 162 (exclusive of rents and reimbursed amounts with respect to such property) exceed 15 percent of the rental income. 55. i.r.c. § 48(d)(5) (repealed in 1990) (as made currently applicable by i.r.c. § 50(d)(5)). the lessee’s rent deduction is no longer reduced by the amount of the credit. 644 florida tax review [vol.12:9 2. historic rehabilitation tax credit the first expansion of federal incentive credits came in 1978. the revenue act of 1978 added section 48(g) (since renumbered section 47), 56 providing an investment tax credit equal to 10 percent of qualified expenditures for rehabilitating properties 20 years or older. 57 the credit was increased in 1981 to 15 percent for 30-year buildings, 20 percent for 40-year buildings, and 25 percent for certified historic structures. 58 section 47 currently provides a 10 percent credit for qualified rehabilitated buildings placed in service before 1936 and a 20 percent credit for the rehabilitation of certified historic structures. the taxpayer must reduce its basis in the property by the full amount of the credit 59 and is required to recapture a percentage of the credit if it disposes of the property with five years of the date the property is placed in service. 60 in enacting the rehabilitation tax credit, congress explained as follows: buildings and their structural components have not been eligible for the investment tax credit since it was enacted in 1962. at that time, the congress was primarily concerned about the substantially greater average age of machinery and equipment in domestic manufacturing facilities than in the facilities of major foreign producers of the same products. presently, there is a similar concern about the declining usefulness of existing, older buildings throughout the country, primarily in central cities and older neighborhoods of all communities. the pattern of change, in part, reflects basic demographic and economic trends. the 56. section 48(g) was re-designated section 47 by section 11813 of the revenue reconciliation act of 1990. revenue reconciliation act of 1990, pub. l. no. 101-508, § 11813, 104 stat. 1388–400, 1388–556 (1990) [hereinafter rra 1990]. 57. revenue act of 1978, pub. l. no. 95-600, § 315(b), 92 stat. 2763, 2828–29. 58. economic recovery tax act of 1981, pub. l. no. 97-34, §212, 95 stat. 172, 235–40 [hereinafter erta 1981]. in 1986, the credit was reduced to 10 percent for buildings placed in service before 1936 and 20 percent for certified historic structures. tax reform act of 1986, pub. l. no. 99-514, § 251, 100 stat. 2085 2183–89 (1986) [hereinafter tra 1986]. 59. i.r.c. § 50(c)(1). 60. i.r.c. § 50(a). the taxpayer must recapture 100 percent of the credit if the property is disposed of in the first year. the amount of recapture is reduced by 20 percent in each subsequent year, and there is no recapture after five years. id. 2012] monetization of business tax credits 645 pattern also is a response to changing architectural and engineering designs of buildings and the internal placement and flow of activities in manufacturing and commercial enterprise. the committee believes that it is appropriate now to extend the initial policy objective of the investment credit to enable business to rehabilitate and modernize existing structures. this change in the investment credit should promote greater stability in the economic vitality of areas that have been developing into decaying areas. 61 3. energy tax credit the energy tax act of 1978 added a 10 percent energy tax credit available to business taxpayers for investment in certain forms of energy property, including solar and wind energy property, but also including property such as shale oil equipment. 62 it was available in combination with the regular investment credit. qualifying energy property was to be subject to quality and performance standards to be issued by the irs after consultation with the department of energy. in enacting the energy tax credit, congress explained as follows: in reviewing the use of energy by the various sectors of the economy, the committee was informed that in 1975, industry used 20.5 quadrillion btu’s, or 36 percent of the total 56.5 quadrillion btu’s consumed for all purposes. the committee noted that industry has relied increasingly on oil and natural gas in the past two decades, rather than on coal, and that conservative use of all energy sources has been a rare practice. in view of the vulnerability of the economy to possible disruptions in the supply of natural gas and oil, and 61. h.r. rep. no. 95-1445, at 86 (1978) (emphasis added). 62. energy tax act of 1978, pub. l. no. 95-618, § 301, 92 stat. 3174, 3194–3201. see staff of joint comm. on taxation, 112th cong., present law and analysis of energy-related tax expenditures and description of the revenue provisions contained in h.r. 1380, the new alternative transportation to give americans solutions act of 2011, at 29 (comm. print 2011), [hereinafter jct, energy-related tax expenditures], http://www.jct.gov/publications/.html?func=startdown&id=4360 (“as the rationale for many of the tax incentives for renewable energy and conservation is to reduce the use of fossil fuels, many have questioned the rationale for tax subsidies for fossil fuel production. the principal argument in favor of the tax incentives for fossil fuel production is that a healthy domestic fossil fuels production base serves national security goals, by reducing our dependence on foreign sources of oil.”)’ 646 florida tax review [vol.12:9 in view of potential savings of oil and gas through more prudent use, the committee believes it is essential to encourage industry to conserve oil and natural gas and to convert, when economically and technically feasible, to sources of energy other than oil and natural gas. accordingly, the committee has provided for a limited period of time, a series of tax credits which are designed to encourage conservation and conversion and the development of advanced energy technology. consistent with these objectives, the committee bill denies the regular investment tax credit and accelerated depreciation methods for the purchase of new oil or natural gas fueled boilers and combustors . . . . the committee believes that in providing a positive incentive for conversion and conservation in the form of additional tax credits, and a disincentive in the form of the denial of certain current tax advantages, industry will be motivated to make significant efforts to conserve its use of scarce oil and natural gas as well as convert to other forms of fuel. 63 interestingly, the energy credit as originally enacted was refundable in the case of wind and solar projects. 64 the refundable element was accomplished by treating the credit as if it were allowed by then section 39 (since redesignated section 34), 65 rather than by section 38. 66 in addition, stacking rules were structured to allow a refund of excess credits when applying the nonrefundable investment credit (i.e. the regular investment credit and the energy credit for energy property other than solar or wind energy) and the (refundable) energy credit in tandem. the rationale for making the credit refundable was to “allow all businesses, irrespective of their income tax liability, to receive the full incentive effect.” 67 63. h.r. rep. no. 95-496, pt. 3, at 117 (1977). 64. see i.r.c. § 46(a)(10)(c) (1978). in instances where nonrefundable, the energy credit was available to be applied against 100 percent of tax liability. contrast the limitation on use of the investment credit as originally enacted. see supra note 49 and accompanying text. 65. at the time of the energy tax act of 1978, the provisions currently located in section 34 were located in section 39. section 39 was re-designated as section 34 by section 471(c) of the deficit reduction act of 1984, pub. l. no. 98369, § 471(c), 98 stat. 494, 826, 198-d [hereinafter dra 1984]. 66. to the extent a credit allowed under section 34 exceeds the taxpayer’s income tax liability, section 6401 treats such excess as an overpayment. 67. s. rep. no. 95-529, at 71 (1977), reprinted in, 1978 u.s.c.c.a.n. 7942, 8003 (“the committee believes that the urgency of the energy problem 2012] monetization of business tax credits 647 the crude oil windfall profits tax act of 1980, without explanation, simultaneously repealed the refundable element of the energy credit and increased the energy credit for solar, wind, and geothermal properties to 15 percent. 68 4. alcohol fuels credit the crude oil windfall profits tax act of 1980 also added section 44e, the alcohol fuels credit, 69 which provided a 40-cent-per-gallon credit for the production of alcohol and alcohol blended fuels (in the case of blended fuels, the credit would only apply to the alcohol portion of the fuel). 70 simultaneously, section 86 (since renumbered section 87) 71 was enacted, which required the taxpayer to include in gross income an amount equal to the amount of the alcohol fuels credit allowed. 72 the energy tax act of 1978 had provided an exemption from the 4-cent-per-gallon federal excise tax on motor fuel for motor fuel that was comprised of at least 10 percent alcohol. concerned that this exemption provided no incentive to producers to produce fuel with greater than 10 percent alcohol (or, indeed, with any alcohol if less than 10 percent alcohol), congress adopted the alcohol fuels credit described above and required its inclusion in requires a power measure designed specifically to reduce the consumption of oil and natural gas by industrial, utility, and institutional users.”). 68. crude oil windfall profit tax act of 1980, pub. l. no. 96-223, § 221, 94 stat. 229, 260–61 (1980) [hereinafter cowpta 1980]. see infra notes 188–227 and accompanying text (discussing the current iteration of energy credits). 69. section 44e was re-designated section 40 by section 471(c)(1) of the deficit reduction act of 1984. dra 1984, supra note 65, § 471(c)(1), 98 stat. at 826. 70. cowpta 1980, supra note 68, § 232(b)(1), 94 stat. at 273. 71. section 86 was re-designated as section 87 by section 121(a) of the social security amendments of 1983. social security amendments of 1983, pub. l. no. 98-21, § 121(a), 97 stat. 65, 80. 72. cowpta 1980, supra note 68, § 232(c), 94 stat. at 276–77. the question presents itself as to the implication to state taxes of such federal credit regimes. for example, as noted, section 87 requires that a taxpayer claiming the federal cellulosic biofuels credit take the credit into income. if “state follows federal,” could a taxpayer be faced with paying additional state taxes due to an income inclusion triggered by a credit against federal taxes producing no state tax benefit and not reflecting an “accretion to wealth” for state tax purposes? anecdotal evidence suggests that a number of states are advancing such a position (rendered all the more dubious when one considers the derivation of the income inclusion requirement). see infra note 73 and accompany text. 648 florida tax review [vol.12:9 in income to coordinate the credit with the excise tax exemption. 73 currently, the alcohol fuels credit is the sum of the alcohol mixture credit, the alcohol credit, the small ethanol producer credit, and the cellulosic biofuel producer credit. 74 the alcohol fuels credit (other than the cellulosic biofuel producer credit) expired on december 31, 2011. 75 the cellulosic biofuel producer credit will expire after december 31, 2012. 76 5. nonconventional source fuels credit finally, the nonconventional source fuels credit (originally located at section 44d, then section 29, and now section 45k) was established under the crude oil windfall profit tax act of 1980 77 and provided a production tax credit for the production of fuels derived from nonconventional sources equal to $3 multiplied by barrel-of-oil equivalent of qualified fuels sold by the taxpayer. in enacting the nonconventional source fuels credit, congress explained as follows: the committee believes that a tax credit for the production of energy from alternative sources will encourage 73. see staff of joint comm. on taxation, 97th cong., general explanation of the crude oil windfall profit tax act of 1980, at 92 & n.3 (comm. print 1981): the reason for this income inclusion is that the benefit is intended to be generally the same as the benefit of a 4-cent-pergallon excise tax exemption for a gallon of gasohol which is comprised of 10 percent alcohol and 90 percent otherwise taxable motor fuels. . . . because the excise tax is a deductible expense for the person on whom it is imposed (the producer in the case of gasoline or the retailer in the case of diesel fuel or special motor fuels), it is necessary to have an amount equivalent to the income tax credit (or refund) includible in income to produce the same net tax effect. thus, for a taxpayer in the 40 percent marginal tax bracket, a 40 cent excise tax exemption is worth 24 cents after income tax since the loss of the deduction will increase income tax liability by 16 cents. similarly a 40 cent income tax credit plus the inclusion in income of 40 cents will result in a benefit of 24 cents after income tax. 74. i.r.c. § 40(a). 75. i.r.c. § 40(e)(1). 76. see i.r.c. § 40(b)(6)(h), (e)(1). 77. cowpta 1980, supra note 68, § 231, 94 stat. at 268–72. 2012] monetization of business tax credits 649 the development of these resources by decreasing the cost of their production relative to the price of imported oil. these alternative energy sources typically involve new technologies, and some subsidy is needed to encourage these industries to develop to the stage where they can be competitive with conventional fuels. the information gained from the initial efforts at producing these energy sources will be of benefit to the entire economy. thus, the production credit in the committee substitute is designed to apply only for a limited period of time, after which the committee expects that no special incentive will be needed. 78 this credit was allowed to expire at different times for different fuels and was fully phased out in 2010. 79 a section 29 credit monetization structure that was in vogue for a time relied on a retained production payment technique: the property owner “s” would sell the property producing the qualified fuel to the purchaser “p” for (i) cash; (ii) a retained production payment equal to not more than 95 percent of the estimated present value of the production from the entire property; (iii) a contingent interest in any reserves that may exist after the production of all the currently estimated reserves; (iv) a percentage of the value of the section 29 credits generated from the property; and (v) an option to reacquire the property at a date certain for its then fair market value. in addition, s entered into a management contract with p to manage the property for a fee. this transaction effectively transferred the credits from s to p because (i) p was treated as holding the full economic interest in the property and owning the qualified fuel at the time of production and sale; and (ii) s’s retained production payment was not treated as an economic interest but as a purchase money mortgage under section 636. 80 78. s. rep. no. 96-394, at 87 (1979). 79. see i.r.c. §§ 45k(e) (credit generally applies only to fuel produced from a well or in a facility placed in service after december 31, 1979 and before january 1, 1993, and which is sold before january 1, 2003); § 45k(f) (extension for biomass and liquid, gaseous, or solid fuels produced from coal: production facility must be placed in service before july 1, 1998 and fuel must be sold before january 1, 2008); § 45k(g) (extension for coke and coke gas: facility must be placed in service before january 1, 1993 or after june 30, 1998 and before january 1, 2010; and fuel must be sold during four year period beginning on the later of january 1, 2006, or the date the facility is placed in service). 80. see, e.g., i.r.s. priv. ltr. rul. 2001-03-009 (jan. 22, 2001); i.r.s. priv. ltr. rul. 2001-02-010 (jan. 16, 2001), i.r.s. priv. ltr. rul. 2000-50-004 (dec. 18, 2000). 650 florida tax review [vol.12:9 b. the tax benefit transfer rules 1. enhanced incentives for capital investment the economic recovery tax act of 1981 81 (erta) ushered in significant reductions in the federal income tax payable by capital-intensive businesses via the enactment of the accelerated cost recovery system (acrs), significantly shortening the recovery periods for capital investments, and the enhancement of the investment credit. 82 by comparison to the asset depreciation range (adr) system that preceded it, under which an asset’s cost basis (less salvage value) was recovered over its estimated useful life, the new acrs allowed for depreciation of the cost of many types of assets (without reduction for salvage value) over as little as five, or, in certain cases, even three years 83 using statutory percentages based on the 150 percent declining balance method (markedly faster than economic depreciation of the asset). furthermore, a full 10 percent investment credit was allowed for eligible property in the 5-year and 10-year recovery classes and 15-year public utility property class. 84 finally, under erta it continued to be the case that the basis of the property was not required to be reduced by the amount of the investment credit. 85 the combined effect of these changes in certain cases was to eliminate tax, or even establish a negative tax rate, on income from qualifying capital equipment. 86 the allowance of an interest 81. erta 1981, supra note 58, 95 stat. at 172. 82. see h.r. conf. rep. no. 97-215, at 289–90 (1981), reprinted in 1981 u.s.c.c.a.n. 285, 377–78 (over $140 billion in tax savings predicted for the period through 1986 on the basis of these provisions). 83. the cost of eligible property was recovered over a three-year, five-year, ten-year or fifteen-year recovery period, depending on the recovery class of the property as classified with reference to the adr system of prior law. 84. erta 1981, supra note 58, § 211(a), 95 stat. at 227. for property with a useful life of 3 years, however, the credit was limited to 60 percent. the amount of income tax liability that could be reduced by investment credits in any year was limited to $25,000 plus 85 percent of the tax liability in excess of $25,000. unused credits could be carried back three and forward fifteen years. 85. the requirement that basis be reduced by the amount of the investment tax credit was repealed in 1964. see supra note 42 and accompanying text. the basis reduction requirement was not reinstated until 1982. see tax equity and fiscal responsibility act of 1982, pub. l. no. 97-248, § 205(a)(1), 96 stat. 324, 427–28 [hereinafter tefra 1982]. 86. this is a function of comparing the present value of taxes to be incurred in respect of the income to be generated by the asset over its economic useful life to the present value of the tax benefit to be generated by acrs deductions and the investment credit. a provision permitting 100 percent expensing of the cost of a capital asset has a similar effect. see alvin c. warren, jr. & alan j. auerbach, transferability of tax incentives and the fiction of safe harbor leasing, 95 harv. 2012] monetization of business tax credits 651 expense deduction in connection with the financing of such equipment only increases the likelihood of a negative tax rate on such income. 87 2. the safe harbor leasing rules erta also included in newly enacted section 168(f)(8) a “safe harbor leasing” regime, apparently in part in response to the perception that the enhanced incentives for capital investment enacted as part of erta otherwise would not be exploited to fullest advantage, as many taxpayers could lack a sufficient base fully to take, current advantage of them. 88 under the safe harbor leasing rules, an owner of “new section 38 property” qualifying for accelerated cost recovery deductions and investment credit (other than a qualified rehabilitated building), via an election, could transfer “federal tax ownership” of the property to a second party under the auspices of a sale-leaseback or other form of putative lease without giving up substantive ownership of the property. thus, the purchaser of federal tax ownership of the property would be entitled to the associated tax benefits of ownership even though it were to possess none of the benefits or burdens of ownership and without doubt would flunk the modern “economic substance” standard of section 7701(o). the “federal tax owner” could then cede the investment credit to the “lessee,” if the parties so agreed, under the mechanism discussed above. assuming that under “true lease” principles the “lessee” is the substantive owner of the property, the substantive owner in such a case accomplishes a sale of the acrs deductions while retaining the investment credit. otherwise (i.e., absent the election to cede the credit) the transaction effects a sale of both the acrs deductions and the investment credit to a purchaser lacking the traditional hallmarks of an owner of the property. 89 the senate committee report explained the rationale for enacting the safe harbor leasing rules as follows: l. rev. 1752, 1754–56 (1982) [hereinafter warren & auerbach, fiction of safe harbor leasing]. see also h.r. rep. no. 99-426, at 145 (1985) (under law prior to 1986 act changes “a corporation in the top tax bracket can now write off about 110 percent of the cost of a new car in just three years, even though the car . . . will on average remain in operation for an additional seven or eight years”). 87. warren and auerbach, fiction of safe harbor leasing, supra note 86, at 1757 & n.22. in theory, just as interest expense on a borrowing to acquire an asset that generates a tax-exempt return is disallowed under section 265, so too should interest expense on a borrowing to acquire a “deductible” asset. 88. i.r.c. § 168(f)(8). an argument reportedly strongly advanced at the time by lobbyists for the transportation, steel, and paper-making industries. see richard s. koffey, safe harbor leasing, 34 u.s.c. ann. inst. on fed. tax’n, 2-1, 2-20 & n. 47 (1982) [hereinafter koffey, safe harbor leasing]. 89. see infra note 96 (illustrating the mechanical operation of the rules). 652 florida tax review [vol.12:9 the committee recognizes that some businesses may not be able to use completely the increased cost recovery allowances and the increased investment credits available for recovery property under acrs. acrs will provide the greatest benefit to the economy if acrs deductions and investment tax credits are more easily distributed throughout the corporate sector. under present law, three-party financing leases (“leverage” leases) are now widely used to transfer tax benefits to users of property who do not have sufficient tax liability to absorb those benefits. the committee has decided to facilitate the transfer of acrs benefits through these types of transactions. under current administrative practice, however, lease characterization is subject to specific irs guidelines. moreover, court decisions have not prescribed clear guidelines as to the appropriate tax characterizations of financing leases. since the committee has decided that lease characterization should be more available, the committee bill establishes an exception to current judicial and administrative guidelines dealing with leasing transactions. . . . the committee bill creates a safe harbor that guarantees that a transaction will be characterized as a lease for the purposes of allowing investment credits and capital cost recovery allowances to the nominal lessor. lessors will be able to receive cost recovery allowances and investment tax credits with respect to qualified leased property, while it is expected that lessees will receive a very significant portion of the benefits of these tax advantages through reduced rental charges for the property (in the case of finance leases) or cash payments and/or reduced rental charges in the case of sale-leaseback transactions. 90 thus, the tax characterization of the transaction as a lease was a matter of stipulation by agreement. such factors as pre-tax profit, location of title to the property, and the benefits and burdens of ownership of the property (as between lessor and lessee) were not taken into account. under the terms of the lease, the lessee could have a bargain purchase option to acquire the property. the property could be of a kind such that its value and use is specific to the lessee (so-called “limited use property”); moreover, a party could act as lessor solely for a percentage of the property (and be permitted a parallel percentage of the tax benefits). 90. s. rep. no. 97-144, at 61–62 (1981) (emphasis added). 2012] monetization of business tax credits 653 there were certain vestiges of the irs “true lease” guidelines referred to in the committee report above that remained in place but for the purpose of preventing parties from “gaming the system” rather than out of some notion that any remnant of economic substance should be retained as a predicate for tax ownership. 91 these vestiges included a minimum “at risk” investment by the nominal lessor of 10 percent of its adjusted basis in the property (one author speculates this was included to give the lessor an incentive to ensure transactions met the requirements of the rules, thereby taking on some of the irs’s audit burden and safeguarding against fraud and abuse) 92 and a maximum lease term generally equal to 90 percent of the asset’s useful life (to put an end point on the income deferral opportunity embedded in the lease structure). 93 the safe harbor leasing provisions also required a minimum lease term equal to the recovery period for the asset (to 91. rev. proc. 75-21, 1975-1 c.b. 715, modified by rev. proc. 76-30, 19762 c.b. 647, rev. proc. 79-48, 1979-2 c.b. 529, and rev. proc. 81-71, 1981-2 c.b. 731, modified and superseded by rev. proc. 2001-28, 2001-1 c.b. 1156. revenue procedure 75-21 provided that the irs will consider the lessor in a leverage lease transaction to be the owner of property if: (1) the lessor maintains a minimum unconditional “at-risk” investment of 20 percent throughout the entire lease term, including extensions; (2) the lessee does not have a contractual right to purchase the property from the lessor at a price less than its fair market value or have a contractual right to cause any other party to purchase the property; (3) the lessee does not furnish any part of the cost of the property or any improvements or additions to the property, except for severable additions or improvements that are owned by the lessee and are “readily removable without causing material damage to the property;” (4) the lessee does not lend to the lessor any of the funds necessary to acquire the property or guarantee any indebtedness created in connection with the acquisition of the property by the lessor; and (5) the lessor represents and demonstrates that it expects to receive a profit from the transaction apart from tax benefits. revenue procedure 75-21 has been modified and superseded by revenue procedure 2001-28, which is generally the same as revenue procedure 75-21, but (1) allows the lessee to furnish amounts to pay for certain severable and nonseverable improvements; (2) clarifies that the “uneven rent test” of regulations section 1.467-3(c)(4) will not affect the ability of a taxpayer to obtain an advance ruling under revenue procedure 2001-28; and (3) clarifies that the service will not issue advance rulings with respect to the lease of “limited use property,” i.e., property for which at the end of the lease term there will probably be no potential lessees or buyers. see also rev. proc. 75-28, 1975-1 c.b. 752, modified and superseded by rev. proc. 2001-29, 2001-1 c.b. 1160 (setting forth information and representations required to be furnished by taxpayers in requests for advance rulings on leveraged lease transactions within the meaning of revenue procedure 75-21); proc. 2007-65, 2007-45 c.b. 967 (providing a safe harbor for wind farm partnerships between project developers and investors if certain conditions are met). see infra part ii.f.2.c. (discussing revenue procedure 2007-65). 92. see koffey, safe harbor leasing, supra note 88, at 2–14. 93. id. 654 florida tax review [vol.12:9 preclude a “lessee” from securing rent deductions at a faster pace than cost recovery deductions under section 168 that otherwise would be available to it if it retained “federal tax ownership”) and included rules regulating the maturity of the debt, the setting of the interest rate, and the timing of rent and interest. in light of the fact that under the safe-harbor leasing rules, the “tax owner” did not need any real connection to the asset generating the tax benefits (it simply claimed the tax benefit), the safe harbor leasing rules were set up to visit the consequences of a recapture event on the lessee-user rather than the nominal tax owner. 94 if the lessee-user acquired the property and subsequently disposed of it, it was subject to the recapture rules of sections 47 and 1245 “as if the lessee had been considered the owner of the property for the entire term of the lease.” 95 as can be seen, the effect of section 168(f)(8) was to render both the investment credit and the cost recovery deductions available in respect of purchases of new equipment transferable, but only separately transferable via the ceding mechanism. the construct was not such as to allow sales of tax credits in the manner that some of the state tax systems of today do (the topic taken up in part vi below). to the contrary, in a “wash lease” structure (which was the paradigmatic form of safe harbor lease) the nominal lessor was charged with an accrual of rent offset by matching amounts of principal and interest deemed owing under a purchase money loan from the lessee, and the lessee was permitted a rental deduction. 96 even though the lease 94. the regulations promulgated under section 168(f)(8) ensured that one of the parties to a safe harbor lease had a connection to the asset, whereas on the face of the statute arguably the transaction could be entirely notional (neither party having any connection to the asset being “leased”). regulations section 5c.168(f)(8)-1(d) provided as follows: notwithstanding any other section, if neither the lessor nor the lessee would be the owner of the property without regard to section 168(f)(8), or, if any party with an economic interest in the property (other than the lessor or lessee or any subsequent transferee of their interests) claims acrs deductions or any investment tax credit with respect to the leased property, an election under section 168(f)(8) with respect to such property shall be void as of the date of the execution of the lease agreement. 95. staff of joint comm. on taxation, 97th cong. comm. print general explanation of the economic recovery act of 1981, at 107 (1981), http://www.jct.gov/publications.html?func=startdown&id=2397. any credit or depreciation recapture by the lessor will not be again recaptured by the lessee. id. 96. to illustrate: corporation a purchases “5-year recovery property” eligible for the investment credit for $100,000. corporation a has significant net operating loss carryovers and therefore decides to sell the acrs deductions and investment credit to corporation b. to accomplish this, corporation a, in form, sells the property to corporation b for $20,000 in cash plus an $80,000 amortizing 2012] monetization of business tax credits 655 effectively was a fiction, the required tax reporting flowed from the tenets of a true lease. 97 in their article on the safe harbor leasing regime, warren and auerbach comment: “[t]he itc and acrs deductions can be seen either as structural components of the income tax that reduce the effective tax rate or as government subsidies that are located in the internal revenue code merely as a matter of convenience.” 98 of course, if viewed in the former light, as incident to the computation of the “normal tax” of the taxpayer, these tax benefits should be no more transferable than the deduction for any other expense incurred in the conduct of a taxpayer’s business. 99 when expenses outstrip current income, the carryover provisions of the code ensure that, over time, taxes are normalized as an asset produces revenue. by contrast, if the acrs/itc benefits are viewed instead as a subsidy, transferability of the benefits can be justified as a mechanism for delivering the subsidy. 100 a transfer of tax benefits via the safe harbor leasing rules purchase money nonrecourse note (“note”) payable over ten years, calling for level payments. corporation b leases the property back to corporation a pursuant to a 10year lease, calling for rent payments precisely matching the payments due under the note. the documentation for the transaction includes an explicit set-off provision, exonerating the parties from any obligation to make any actual payments of rent or principal and interest, respectively. finally, under the terms of the lease, corporation a has the right to “repurchase” the property at the end of the lease for $10. if the parties make a joint election under section 168(f)(8), in exchange for its up-front payment of $20,000, corporation b will be entitled to claim $100,000 in acrs deductions over five years (no basis reduction for the investment credit was required at the time) and a $10,000 investment credit with respect to the property. corporation b also will end up with $80,000 in net income (rental income less interest expense will equate to the principal amount of the note). over the term of the lease, corporation a will end up with $80,000 in net deductions (gross rent expense less interest income under the note should equal the principal amount of the note). in the foregoing example, the putative lessee has defrayed the cost of acquisition of the property by $20,000, the amount of the putative lessor’s up-front payment. in this way, the lessor can be seen as a vehicle of the u.s. treasury department. in light of the $20,000 “government” subsidy, which reduced the lessee’s net investment from $100,000 to $80,000, the lessee will be entitled to only $80,000 in deductions. having “fronted” the $20,000 to the lessee, the lessor is “reimbursed” by the treasury via the net transferred tax benefits. 97. see infra note 105 and accompanying text. 98. see warren & auerbach, fiction of safe harbor leasing, supra note 86, at 1756. 99. see koffey, safe harbor leasing, supra note 88, at 2–4. 100. as warren and auerbach remark: [i]f the purpose of acrs and the itc is to reduce capital income taxation, loss companies should not be included among the beneficiaries of these provisions, because such companies are 656 florida tax review [vol.12:9 operated to de-link the tax benefits from the asset upon which predicated and deliver a cash benefit to the transferor divorced from any future production of income by the asset — the hallmark of a subsidy. 101 interestingly, in the period leading up to enactment of erta, prior to turning to the safe harbor leasing solution, congress gave some consideration to making the investment credit refundable 102 in order that start-up companies and loss companies not otherwise in a position to take advantage of the credit on a current basis would be on par with profitable companies able to make full use of the credit. 103 the portion of the credit in excess of the company’s current tax liability would trigger a right on the part of the company to a cash payment (subsidy) from the government. as discussed above, refundability already had been experimented with in the context of the energy credit in 1978 and was newly repealed at this juncture. the idea of making the credit refundable reportedly was set aside due to concerns as to the potential for fraud and abuse and, perhaps more pointedly, the possible requirement for an appropriation and involvement of the appropriations committee in the tax legislative function. 104 in addition, it already effectively exempt. if, however, acrs and the itc are considered subsidies rather than a means of reducing capital income taxation, the principle of competitive neutrality supports extending these subsidies to loss companies. . . . warren & auerbach, fiction of safe harbor leasing, supra note 86, at 1760–61 (footnote omitted). the transfer mechanism, of course, is a way of extending the subsidy to loss companies. 101. so viewed, acrs and the itc “constitute an expenditure program by which the government intends to reduce the price of recovery property in order to encourage its purchase, capital formation, and the economic benefits that are thought to ensue.” id. at 1758. 102. see koffey, supra note 88, at 2–3 (recounting that senator danforth, a member of the senate finance committee, endorsed this idea). 103. see supra note 100 and accompanying text (alluding to the concept of “competitive neutrality”). 104. see 127 cong. rec. 30,916–17 (1981) (statement of senator russell b. long) [hereinafter statement of senator long]: mr. president, this senator has always felt that it would have made even better sense to say with the investment tax credit that it was refundable. . . . some years ago senator kennedy joined me in offering just such a bill. i see my friend from new jersey (mr. bradley) finds some appeal in that approach. i say you would not have to have a leasing arrangement. . . . that would be the logical way or the most logical way to do it. but if you seek to do it that way, you run into a problem. the 2012] monetization of business tax credits 657 was perceived that a refundable credit would not have allowed for sufficient flexibility as to the party to be allocated acrs deductions with respect to qualified property (whereas the safe harbor leasing rules effected a transfer of the right to these deductions via election). 105 the concern about fraud and abuse is often cited by those opposed to liberal use of refundable credits as a mechanism for implementing social goals. 106 the fact that refundability was perceived as encroaching on the province of the appropriations committee, whereas transferability was not, perhaps underscores a failure of the system. 107 appropriations committee feels that we might use a refundable tax credit, even though it might be a good device in certain situations it might tend to be used in lieu of an appropriation to do something. and so our friends on the appropriations committee tend to resist very bitterly, in a determined fashion, to use of a refundable tax credit to achieve such a purpose. . . . now, if we are not going to use that, then there are ways the taxwriting committee can achieve the same purpose in ways that fall entirely within the jurisdiction of the taxwriting committee; hence, the leasing rule. . . . senator long credits the safe harbor leasing idea, not to the senate finance committee or the house ways & means committee, but to a suggestion made by the treasury department and, in particular, to an article appearing in the wall street journal written by john e. chapoton of the treasury. 105. see koffey, safe harbor leasing, supra note 88, at 2–3. cf. staff of joint comm. on taxation, 97th cong., safe harbor leasing provisions under accelerated cost recovery system 2 (comm. print 1981), http://www.jct.gov/publications.html?func=showdown&id=2366: during consideration of the tax bill, three options were considered: (1) a refundable investment tax credit, (2) a pure sale of tax benefits, and (3) a safe harbor guarantee of lease treatment. the first two options were not adopted primarily because of administrative difficulties in determining whether the property has been disposed of by the user in a transaction requiring recapture of investment credit or depreciation. instead, the leasing rules were chosen as a means of introducing a form of transferability of tax benefits that differs from pure transferability in that the lessor must pick up an income stream from the transaction in the form of rent payments. 106. this objection to the use of a refundable credit was raised in the context of the discussion leading to the enactment of the safe-harbor leasing rules. see koffey, safe harbor leasing, supra note 88, at 2–3. see also lily l. batchfelder, fred t. goldberg, jr. & peter r. orzag, efficiency and the incentives: the case for refundable tax credits, 59 stan. l. rev. 23, 65–66 (2006). 107. the current director of the congressional budget office, douglas w. elmendorf, has taken the position that certain tax expenditures are “more similar to 658 florida tax review [vol.12:9 3. revision and repeal of the safe harbor leasing rules the safe-harbor leasing rules were short-lived. within six months of enactment, there were calls for either repeal of the provision or sweeping changes to it. as reported in the february 19, 1982, edition of the new york times, “senator dole, chairman of the senate finance committee, today in effect halted one of the most disputed aspects of last year’s sweeping tax cut: the sale of unused business tax credits. . . .” 108 nonprofit governmental agencies, such as new york’s metropolitan transit authority, were benefiting from it, as were “profitable companies, such as occidental petroleum corporation and the ltv corporation.” 109 senator dole commented that “[h]owever desirable many tax theorists find the current safe harbor leasing rules in the abstract, they are indefensible in a year in which the federal deficit will reach nearly $100 billion,” and he vowed “to see that this hemorrhage to the treasury is halted today.” 110 the immediate upshot was the replacement of the safe harbor leasing rules with the “finance leasing rules” enacted as part of the tax equity and fiscal responsibility act of 1982. 111 under these new rules, the fact that the lessee had an option to purchase the property from the lessor at a fixed price of 10 percent or more of its original cost or that the property is “limited use property” was not to be taken into account in determining if the lease is a true lease. 112 the rules were generally to be effective for agreements entered into beginning in 1984, subject to certain specified restrictions. 113 however, entitlement programs than to discretionary spending because they are not subject to annual appropriations and any person or entity that meets the requirements can receive the benefits.” douglas w. elmendorf, cong. budget office, confronting the nations fiscal policy challenges 45 (2011), http://www.cbo.gov/ftpdocs/124xx/doc12413/09-13-fiscalpolicychallenges.pdf. one commentator has suggested that this statement is a “gross generalization” as many tax expenditures, commonly referred to as “extenders,” including the new markets tax credit, are subject to annual renewal, much like annual appropriations . . . [and] many tax expenditures cannot be claimed by any person or entity that simply meets the requirements; the lihtc, tax-exempt bond financing and nmtc are such examples. michael j. novogradac, super committee takes center stage, novogradac j. of tax credits, oct. 2011, at 3, http://www.novoco.com/journal/2011/10/novogradac _jtc_2011-10_ww_pg4.pdf. 108. jonathan fuerbringer, business tax cut affecting leasing appears near end, n.y. times, feb. 20, 1982, at 11. 109. id. 110. id. 111. tefra 1982, supra note 85, § 209, 96 stat. at 442–47. 112. id. at § 209(a). 113. id. at § 209(d). 2012] monetization of business tax credits 659 the tax reform act of 1984 postponed the effective date so as to generally apply to agreements entered into after december 31, 1987. 114 the tax reform act of 1986, in turn, repealed the finance leasing rules altogether, effective for agreements entered into after december 31, 1986. 115 4. the friendship dairies case the repeal of the safe harbor leasing rules, of course, marked a return to the status quo ante under which the eligibility of a lessor to claim accelerated depreciation deductions and the investment credit was dependent on the lease qualifying as a “true lease” under administrative guidance and judicial decisions. friendship dairies, inc. v. commissioner 116 serves as an appropriate counterbalance to the foregoing discussion of the safe harbor leasing rules. the tax year involved was 1980, thus pre-dating the liberalizations under erta. the taxpayer was the lessor under a sale-leaseback of computer equipment that had “no possibility of economic profit without taking the investment tax credit into account.” 117 the taxpayer conceded it would not have entered into the transaction but for the promised investment credit, and the court found that the tax objective was the only real purpose of the transaction. the interesting facet of the case is the court’s consideration of whether, as the taxpayer urged, the investment credit could be considered in evaluating the profit potential of the transaction. it did so with reference to congressional intent. based on its examination of the legislative history of the revenue act of 1962, the court concluded that “[t]he credit was not intended to serve as a substitute for economic profit”: 118 the house report states that the credit “will stimulate additional investments since it increases the expected profit” from the use of depreciable assets. h. rept. no. 1447, supra, 1962-3 c.b. at 412. the senate report states that the credit “will stimulate investments, first by reducing the net cost of acquiring depreciable assets, which in turn increases the rate of return after taxes arising from their acquisition.” s. rept. no. 1881, supra, 1962-3 c.b. at 717. at no point do the committee reports indicate that the credit was intended to transform unprofitable transactions into profitable ones. 119 114. dra 1984, supra note 65, § 12, 98 stat. at 503–05. 115. dra 1986, supra note 58, § 201(a), 100 stat. at 2121–37 116. 90 t.c. 1054 (1988). 117. id. at 1061. 118. id. at 1065. 119. id. at 1065–66 (emphasis in last sentence added). 660 florida tax review [vol.12:9 the court therefore concluded that the investment credit cannot be considered in analyzing a lease transaction for economic substance. simply put, o.p.m. was selling, and petitioner was buying an investment tax credit . . . . it would be a distortion of congressional intent to conclude that it was intended that petitioner be induced to engage in a paper transaction that did not in any way affect the demand for computer equipment. 120 accordingly, the taxpayer’s deductions for depreciation and its claimed investment tax credit were disallowed. the conclusion of the court in friendship dairies is consistent with the view of the investment credit and accelerated depreciation deductions as “structural components” of the code incident to the computation of the normal tax of the taxpayer and, as such, not appropriately “transferable.” for these tax benefits to be incident to the computation of the taxes of a lessor, the lessor should have sufficient indicia of ownership of the underlying assets to warrant it. c. the tax reform act of 1986: neutrality and targeted tax credits the tax reform act of 1986 (“1986 act”) famously broadened the tax base and reduced tax rates — an idea actively under consideration today and in accord with the thinking reflected in the simpson-bowles report. 121 in 1986, the top corporate tax rate was reduced from 46 percent to 34 percent and the top individual tax rate was reduced from 50 percent to 28 percent. “loopholes” were closed through the enactment of such provisions as the passive activity loss rules. among the goals of base broadening was to take the internal revenue code out of the business of picking “winners” and “losers” in business by eliminating tax incentives that favored certain types of businesses over others and in doing so allowing for a dramatic cut in tax rates while achieving revenue neutrality. this, in part, was achieved by repealing the investment credit: 120. id. at 1067 (emphasis added). 121. nat’l comm’n on fiscal responsibility and reform, the moment of truth 15 (2010) [hereinafter nat’l comm’n, moment of truth], http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/them omentoftruth12_1_2010.pdf (plan is designed to “[s]harply reduce rates, broaden the base, simplify the tax code, and reduce the deficit by reducing the many ‘tax expenditures’ — another name for spending through the tax code.”). 2012] monetization of business tax credits 661 under present law, the tax benefits arising from the combination of the investment tax credit and accelerated depreciation are more generous for some equipment than if the full cost of the investment were deducted immediately — a result more generous than exempting all earnings on the investment from taxation. at the same time, assets not qualifying for the investment credit and accelerated depreciation bear much higher effective tax rates. the output attainable from our capital resources is reduced because too much investment occurs in tax-favored sectors and too little investment occurs in sectors that are more productive, but which are tax-disadvantaged. the nation’s output can be increased simply by a reallocation of investment, without requiring additional saving. the committee believes the surest way of encouraging the efficient allocation of all resources and the greatest possible economic growth is by reducing statutory tax rates. a large reduction in the top corporate tax rate can be achieved by repealing the investment tax credit without reducing the corporate tax revenues collected. one distorting tax provision is replaced by lower tax rates which provide benefits to all investment. a neutral tax system allows the economy to most quickly adapt to changing economic needs. 122 at the same time sustaining and improving global competitiveness was an articulated concern. thus, the modified accelerated cost recovery system established by the 1986 act in certain instances enhanced the already generous cost recovery system under acrs, changing the rate of acceleration under the cost recovery schedules for property in the 5-year and 10-year classes from the 150-percent declining balance to the 200-percent 122. s. rep. no. 99-313, at 96 (1986). the “blue book” put it this way: congress desired to make the tax treatment of diverse economic activities more even. neutral taxation promotes the efficient allocation of investment and yields productivity gains without requiring additional saving. the act repeals the investment tax credit, which discriminated against long-lived investment and was used as a tax shelter device. the incentive for investment provided by the credit instead will be provided by lower tax rates and accelerated depreciation. staff of joint comm. on taxation, 100th cong., general explanation of tax reform act of 1986, at 10 (comm. print 1987), http://www.jct.gov/jcs-1087.pdf. 662 florida tax review [vol.12:9 declining balance method, and adding a 7-year recovery class. 123 the senate finance committee report offers this explanation: the committee believes some further acceleration in the rate of recovery of depreciation deductions should be provided to compensate partly for the repeal of the investment tax credit. the committee is cognizant that other nations heavily subsidize business investments through tax and other policies, and the committee does not believe such policies can be completely ignored. therefore, it was the committee’s judgment that to maintain the international competitiveness of u.s. business changes were necessary to the accelerated cost recovery system which, in certain cases, provided greater incentives than those existing under present law. . . . together with the large tax rate reductions, investment incentives will remain high and the nation’s savings can be utilized more efficiently. 124 in addition, the energy credit and the historic rehabilitation credit (as discussed above, both introduced in 1978) were extended (in both cases, subject to various adjustments) despite the repeal of the regular investment credit. 125 the senate report accompanying the 1986 act explains the extension of the energy credit as follows: 123. a 20-year class of personal property also was established. 124. s. rep. no. 99-313, at 96 (1986). 125. the energy credit for solar energy property was set to 15 percent in 1986, 12 percent in 1987, and 10 percent in 1988, and was to terminate thereafter. the geothermal tax credit was extended at 15 percent in 1986 and 10 percent in 1987 and 1988 and set to terminate thereafter. the tax credit for biomass energy property was set at 15 percent in 1986 and 10 percent in 1987 and set to terminate thereafter. the credit for ocean thermal property was set at 15 percent through 1988 and was to terminate thereafter. wind energy tax credits were allowed to expire at the end of 1985. see h.r. rep. no. 99-426, at 218–22 (1986); s. rep. no. 99-313, at 274–77 (1986); h.r. conf. rep. no. 99-841, vol. 2, at 128–29 (1986). the house bill extended the energy tax credits for solar and geothermal property. the committee stated that these alternative energy sources had “demonstrated responsiveness to the credit and warrant[ed] additional limited support.” h.r. rep. no. 99-426, at 220 (1986). the house eliminated the energy credits for wind, ocean thermal, and biomass property, explaining that these sources have not demonstrated that the stimulation to demand from a tax credit is necessary. the absence of favorable technological developments in other renewable energy areas or the inability to find ways to reduce potentially high capital or operating costs have convinced the committee that the energy tax credits for most of the 2012] monetization of business tax credits 663 the committee believes that it is desirable to retain energy tax credits for renewable energy sources in order to maintain an after-tax price differential between renewable and fossil fuel sources. the recent steep decline in petroleum prices has eliminated the incentive to purchase or produce renewable fuel sources and the required equipment. without the additional stimulus from the tax credit to purchase or produce renewable fuels, the experience gained in the production and use of such fuels and the technological competence developed in their production during the past decade will dissipate, and will not be available to call on if a fossil fuel shortage recurs. 126 further, the senate report describes the rationale for extension of the rehabilitation credit: the committee has concluded that the incentives granted to rehabilitations in 1981 remain justified. the committee believes that such incentives are needed because the social and aesthetic values of rehabilitating and preserving older structures are not necessarily taken into account in investors’ profit projections. additionally, a tax incentive is needed because market forces might otherwise channel investments away from such projects because of the extra costs of undertaking rehabilitations of older or historic buildings. 127 in the case of the historic rehabilitation credit, it can be argued, the mission had changed since its first enactment in 1978. as noted in the discussion above, the rehabilitation credit originally represented an extension of the “initial policy objective of the investment credit.” 128 it also had much broader sweep — available in the case of buildings twenty years or older. in 1981, the credit had been refined and re-focused on older buildings and certified historic structures. the 1986 act, in turn, reduced the credit for other renewable energy property are premature and have failed to stimulate a meaningful level of demand. id. in contrast, the senate amendments extended the credits for wind, ocean thermal, and biomass energy property. see s. rep. no. 99-313, at 275–77 (1986). the conference report followed the senate amendments in the case of biomass and ocean thermal property and followed the house bill in the case of wind property. h.r. conf. rep. no. 99-841, vol. 2, at 128–29. 126. s. rep. no. 99-313, at 275–76 (1986) (emphasis added). 127. s. rep. no. 99-313, at 753 (1986) (emphasis added). 128. see supra note 61 and accompanying text. 664 florida tax review [vol.12:9 rehabilitation of historic structures from 25 percent (applicable previously to historic structures) to 20 percent and otherwise restricted applicability of the credit solely to buildings placed in service before 1936, for which a 10 percent rehabilitation credit was fixed (previously fixed at 15 percent for 30year old buildings and 20 percent for 40-year old buildings). thus, the regular investment credit was viewed as a “structural” component of the code that violated the principle of neutrality and was in need of replacement. a combination of further acceleration of depreciation deductions and the dramatic reduction in tax rates effected by the 1986 act was viewed as a superior incentive to investment lacking the prior bias in favor of short-lived assets. in contrast, congress concurrently extended tax credits subsidizing programs advancing specific social and public policy goals and enacted the low-income housing credit (“lihtc”). 129 d. the low-income housing tax credit and express carve-out from a pre-tax profit requirement 1. in general the low-income housing tax credit (“lihtc”) was enacted as part of the 1986 act. generally, under section 42 the lihtc is claimed over a period of 10 years in installments that have a present value equal to 70 percent of the “qualified basis” of new “qualified low-income buildings” and 30 percent of the “qualified basis” of used or federally subsidized buildings. 130 no reduction in the tax basis in the property is required to account for the provision of the tax credit, and depreciation deductions are allowed with respect to the property in accordance with the modified accelerated cost recovery system (“macrs”) introduced by the tax reform act of 1986. 131 129. tra 1986, supra note 58, § 252(a), 100 stat. at 2189–205. 130. the lihtc was made available for buildings placed in service after december 31, 1986. i.r.c. § 42(e). for buildings placed in service in 1987, the credit allowed for each year was set at 9 percent of the “qualified basis” (for new qualified low-income buildings) and 4 percent of the “qualified basis” (for used or federally subsidized buildings). the housing and economic recovery act of 2008 added a temporary minimum credit rate for non-federally subsidized new buildings: for buildings that are placed in service after july 30, 2008, and before december 31, 2013, the lihc percentage cannot be below 9 percent of the “qualified basis,” even if the present value calculation described in the text would yield a lower yearly percentage. housing and economic recovery act of 2008, pub. l. no. 110-289, § 3002(a), 122 stat. 2654, 2879 [hereinafter hera 2008]. 131. a “qualified low-income building” is any building which is part of a qualified low-income housing project at all times during the 15–year compliance period. i.r.c. § 42(c)(2). the qualified basis is an amount equal to the “applicable 2012] monetization of business tax credits 665 in broad outline, the lihtc rules function today as they did when first enacted. under the lihtc program, the irs allocates credits to staterun housing agencies that, in turn, award the credits to housing projects proposed by developers meeting the federal criteria for low-income housing and any additional strictures established by the applicable state. the developer acquires equity financing for the project from investors in return for tax benefits (centered on the lihtc), which generally constitute the sole component of the investors’ return. 132 thus the recipients of the lihtcs are neither the providers, nor the consumers and beneficiaries of the projects being subsidized, and typically — and permissibly so, for the reasons discussed below — have no real interest in the projects beyond the tax benefits. 133 the 1986 act included a number of provisions such as the passive activity loss rules making real estate investment less attractive, and in part the lihtc can be seen as an antidote to encourage continued investment in real estate focused on the low-income community. 134 however, the new lihtc regime was far more sweeping than this, both as to its design and fraction” of the “eligible basis” of a qualified low-income building. i.r.c. § 42(c)(1)(a). for new property, the “eligible basis” generally is its adjusted basis as of the close of the first taxable year of the credit period, without regard to sections 1016(a)(2) and (3) (i.e., no downward adjustment for depreciation taken). see i.r.c. § 42(d)(1), (d)(4)(d). the “applicable fraction” is the lesser of the “unit fraction” or the “floor space fraction.” i.r.c. § 42(c)(1)(b). the “unit fraction” is a fraction (i) the numerator of which is the number of low-income units in the building; and (ii) the denominator of which is the number of residential rental units in such building. i.r.c. § 42(c)(1)(c). the “floor space fraction” is a fraction (i) the numerator of which is the total floor space of the low-income units in such building; and (ii) the denominator of which is the total floor space of the residential rental units in such building. i.r.c. § 42(c)(1)(d). a unit in a building qualifies as a “low-income unit” if it is rent-restricted and the individuals occupying such unit meet a income limitation. i.r.c. § 42(i)(3). the lihtc rules described herein are substantially similar to the rules as enacted in 1986. under macrs, the taxpayer may depreciate residential real property using the straight-line method over 27.5 years, using the mid-month convention. see i.r.c. § 168(b)(3)(b), (c), (d)(2). 132. see mihir desai, dhammika dharmapala & monica singhal, investable tax credits: the case of the low income housing tax credit 3 (harvard kennedy school faculty research working paper series, working paper no. rwp08-035, 2008) [the “desai study,” hereinafter desai et al., investable tax credit]. 133. in fact, the desai study found that “the real estate sector accounts for a negligible share of credits claimed.” id. at 29. the authors note that “this suggests that the separation of the provision of the service from the tax beneficiary allowed by investable tax credits has been important.” id. 134. id. at 3. 666 florida tax review [vol.12:9 intent. the senate report states that the low-income housing credit was meant to rectify the perceived defects in the existing tax preferences for lowincome housing (e.g., tax-exempt bond financing and accelerated cost recovery deductions). 135 in particular, the prior incentives “operate[d] in an uncoordinated manner, result[ed] in subsidies unrelated to the number of low-income individuals served, and fail[ed] to guarantee that affordable housing [would] be provided to the most needy low-income individuals.” 136 they were not effective in limiting incentives to “those persons truly in need of low-income housing,” did not limit the rent that could be charged to lowincome individuals, and did not link the degree of subsidy to the number of units servicing low-income persons. 137 the low-income housing credit was designed to address these defects by requiring that residential rental projects could only qualify for the low-income housing credit if, for a period of 15 years, a minimum of 20 percent of the housing units in the project were occupied by individuals with income of 50 percent or less of area median income, and the rent charged to tenants living in units for which the credit was allowable did not exceed a specified amount. as stated in the senate report: “in return for providing housing at reduced rents, owners of rental housing receive a tax credit designed to compensate them for the rent reduction.” 138 property eligible for the lihtc is subject to an at-risk limitation. the credit is nonrefundable and subject to the generally applicable cap on income tax liability that can be reduced by a general business credit (subject to carryover rules). 139 a provision of the passive activity loss rules treats the credit (but not losses) as arising from rental real estate activities in which the taxpayer actively participates. 140 finally, as already noted, the basis of property for depreciation purposes is not reduced by the amount of lowincome credits claimed. 2. no requirement of pre-tax profit alone among federal tax credits, the lihtc has been granted an express reprieve from the requirement of a pre-tax profit. in a 1988 private letter ruling, 141 the irs determined that the section 183 not-for-profit 135. s. rep. no. 99-313, at 758 (1986). 136. id. 137. id. 138. id. 139. see i.r.c. § 42. 140. i.r.c. § 469(i)(6)(b)(1). 141. i.r.s. priv. ltr. rul. 89-11-025 (dec. 16, 1988). 2012] monetization of business tax credits 667 rules 142 did not apply to disallow credits and deductions to a limited partnership, “fund m,” which was the sole limited partner in a partnership formed to acquire, build, and operate low-income housing projects. under the facts of the ruling, the proposed limited partners of fund m were to be subchapter c corporations not subject to the passive activity loss rules of section 469. fund m’s capital contribution to each project partnership, to be paid over the first seven years of the applicable project, was to provide roughly one-third of the total requirements of each project, including the funding of an operating reserve required to secure financing to which all excess cash flow from operations was to be added; at the end of the first fifteen years the reserve was to be used to reduce the amount of outstanding debt. due to the rent and occupancy restrictions imposed by section 42, the project partnerships were not anticipated to make any cash distributions from operations to fund m during this first fifteen-year period, which was the anticipated duration of all of the project partnerships. moreover, it was anticipated that the projects would fail to provide value appreciation such as to constitute a meaningful return on investment. 143 however, giving effect to section 42, the project partnership invested in by fund m would enable it to earn returns competitive with returns generally realized by limited partner investors on their equity capital. a ruling was requested on behalf of fund m, two additional related funds, and the general and limited partners of the funds that “the ‘not-forprofit’ rules under section 183 of the code would not limit credits and deductions otherwise available to the funds and the partners arising from the acquisition, construction, rehabilitation, and operation of low-income housing through the project partnerships.” the irs so ruled. as a prefatory matter, the irs noted that although section 183(a) refers to activities of individuals and s corporations, according to revenue ruling 77-320 144 it also applies to limit deductions at the partnership level and requires that partners’ distributive shares reflect the adjustment in allowable deductions. the private letter ruling then recounts the basic requirements for a project to qualify for the lihtc, and particularly the limitations on rent charged to low-income individuals and the requirement that at least 20 percent of units in a given development for which the credit is being claimed be occupied by low-income individuals — the implication, of course, being that such restrictions presumably could prevent a low-income 142. section 183(a) provides, in general, that if an individual or an scorporation engages in a not-for-profit activity, no deduction attributable to such activity shall be allowed. 143. if a project was sold for a price equal to taxes due on sale plus debt, fund m effectively would receive no return of cash. 144. 1977-2 c.b. 78. 668 florida tax review [vol.12:9 housing project from making a pre-tax profit. however, the ruling provides no more explicit rationale for its holding. 145 regulations section 1.42-4(a), promulgated in 1992, codifies this holding of the 1988 ruling. thus, regulations section 1.42-4(a) provides: “[s]ection 183 does not apply to disallow losses, deductions, or credits attributable to the ownership and operation of a building for which the section 42 low-income housing credit is allowable.” the preamble to the treasury decision promulgating regulations, section 1.42-4 states as follows: although no explicit reference is contained in section 42 or its legislative history regarding its interaction with section 183, the legislative history of the low-income housing credit indicates that congress contemplated that tax benefits such as the credit and depreciation would be available to taxpayers investing in low-income housing, even though such an investment would not otherwise provide a potential for economic return. therefore, to reflect the congressional intent in enacting section 42, the regulatory authority under section 42(n) is being exercised to provide that section 183 will not be used to limit or disallow the credit. 146 thus, the generally applicable requirement of a potential for a pretax profit as a predicate for entitlement to the tax benefits flowing from a capital investment is “turned off.” the investor “fronts” a rent subsidy on behalf of the federal government (curtailing or eliminating any pre-tax profit) 145. in fact, somewhat oddly, the private letter ruling makes no mention of revenue ruling 79-300, 1979-2 c.b. 112, involving a predecessor to the lihtc program, section 236 of the national housing act. revenue ruling 79-300 concludes that the construction and operation of an apartment project for low and moderate income housing under that legislation is not an activity to which section 183 applies: the . . . legislative history indicates that in limiting rental charges, congress assumed deductions of tax losses would be allowed to encourage investment in projects providing decent housing for low or moderate income families under the act. consequently, application of section 183 of the code to the present case would frustrate congressional intent in enacting the housing legislation. therefore, section 183 will not be applied to disallow losses incurred in activities to provide low and moderate income housing under section 236 of the national housing act. id. 146. t.d. 8420, 1992-2 c.b. 13. 2012] monetization of business tax credits 669 and is “reimbursed” by the treasury via the lihtc and associated tax benefits. still, the investor (typically, a partnership) otherwise must be the “owner” of the project under substantive federal income tax principles. thus, regulations section 1.42-4(b) provides as follows: [l]osses, deductions, or credits attributable to the ownership and operation of a qualified low-income building with respect to which the low-income housing credit under section 42 is allowable may be limited or disallowed under other provisions of the code or principles of tax law. see, e.g., sections 38(c), 163(d), 465, 469; knetsch v. united states, 364 u.s. 361 (1960), 1961-1 c.b. 34 (“sham” or “economic substance” analysis); and frank lyon co. v. commissioner, 435 u.s. 561 (1978), 1978-1 c.b. 46 (“ownership” analysis). 147 accordingly, section 42 is not a repeat of the safe harbor leasing rules under which the “federal tax owner” of a project is determined by election. to the contrary, section 42 is constructed to provide a tax credit to owners of residential rental property that have agreed to reduced rents in return for the credit. the credit is conditioned on compliance with program requirements, with the penalty for noncompliance being recapture of prior credits. generally, any change in ownership by a taxpayer of a building subject to the compliance period is also a recapture event. a new owner of the building during its 15-year compliance period is eligible to continue to receive the credit as if the new owner were the original owner. 148 3. the lihtc program as credit monetization technique as previously discussed, leasing is a technique for monetizing tax benefits. 149 safe-harbor leasing freed leasing from the strictures of the irs 147. reg. § 1.42-4(b) (citations in original). 148. see i.r.c. § 42(j). the accelerated portion of credits claimed in previous years will be recaptured upon a transfer. i.r.c. § 42(j)(3). an exception is provided if it is reasonably expected the building will continue to be operated as a qualified low-income building for the remainder of the compliance period. i.r.c. § 42(j)(6). 149. in his statement in defense of the proposed adoption of the safe-harbor leasing rules, senator long offered this explanation: leasing started when we passed the investment tax credit in 1962 under president kennedy. this was such a strong tax advantage that companies could hardly afford not to take advantage of it. those who were not paying enough taxes to take advantage of the 670 florida tax review [vol.12:9 “true lease” guidelines for a short-time and in so doing created a purely form-driven — and therefore arguably more efficient — tax benefit transfer mechanism. the stated goal was to better facilitate the transfer of tax benefits from parties with a tax base to those lacking a sufficient tax base (start-up companies and loss corporations). as already noted, the safe harbor leasing rules therefore are best viewed simply as a mechanism for delivering a subsidy. however, from any distance, this was a rather opaque point, and moreover, the apparent beneficiaries of the provision that emerged, as a matter of public perception, were “indefensible.” the lihtc program, by contrast, has had a clear public policy goal and is unmistakably a federal subsidy administered through the code. the intended beneficiaries of the program are clear and clearly defensible. the credit itself singly is the mechanism for delivering the subsidy, and lihtc transactions, simply put, are tax credit monetization transactions. as one paper analyzing the lihtc program puts it, “the government allocates tax credits to developers of low-income housing who then sell the credits, often via intermediaries, to investors in exchange for equity financing.” 150 the authors — who refer to low-income housing tax credits as “investable credits” 151 — further note as follows: unbundling the tax benefits is required to ensure a level playing field among different providers of the desired service. the absence of investability would shift production away from potentially efficient nonprofit developers and forprofit developers with little or no tax liability. in short, the investable nature of the credits undoes the bias toward providers with taxable income. 152 otherwise, nonprofit developers, for example, either would require a direct subsidy in order to participate on an equal footing with for-profit developers, or a refundable as opposed to non-refundable tax credit. tax credit found it advantageous to arrange for someone else to buy the equipment and lease it to them so that they could have the advantage of the investment tax credit. statement of senator long, supra note 104, at 30,915. 150. desai, et al., investable tax credits, supra note 132, at 1. 151. this apparently is to connote that an investor may invest for the credit and secure its desired return without regard to the economic performance of the underlying assets. a “non-investable tax credit” would be a credit that is “valuable only to for-profit producers with sufficient tax liability.” id. at 15. in the context of low-income housing, such a credit “would be exposed to the specific tax positions of the provider of low-income housing alone.” id. at 15–16. 152. id. at 2. 2012] monetization of business tax credits 671 advantages of an investable tax credit over a direct government subsidy that are noted include the institutional capacities of tax administrators, an established mechanism for enforcing program requirements, 153 and a lessened risk of “regulatory capture” by special interest groups: tax expenditures are decided by the house ways and means and senate finance committees as opposed to industry-focused committees and agencies arguably more easily swayed to support subsidies that are “inefficiently large.” 154 further, the “investable nature” of the credit neutralizes the “production bias” otherwise inherent in a tax-based subsidy. 155 as the authors note: comparable devices to achieve this neutrality — either refundable tax credits or an untrammeled leasing market — have proven politically unpopular and operationally complicated. as such, investable tax credits provide the same virtues as these devices but in a more politically tenable manner. investable tax credits may also improve ex post compliance by providing a punishment mechanism for projects that fail to comply and by encouraging delegated monitoring by investors. extending investable tax credits to other domains promises to provide these benefits in other settings characterized by these concerns. 156 on the other hand, the lihtc program is not necessarily a particularly efficient method for delivering the intended subsidy. insofar as investors factor a “risk premium” into the “price” paid for credits to account for the risk that a project falls into noncompliance, with attendant risk of forfeiture of credits, a lower subsidy is delivered by the program. 157 a period 153. this includes the ability to enforce program requirements after completion of the project based on the structure of the credit and the credit recapture rules. neither a direct subsidy nor a refundable credit would accomplish this goal as effectively while at the same time providing the developer front-end financing. the investors in the project in effect become “delegated monitors.” see id. at 18. 154. desai et al., investable tax credits, supra note 132, at 10. a further advantage relates to the requirement under the community reinvestment act (“cra”) that banks provide credit in their local communities. one metric on which banks are judged is investments in low-income communities. investments eligible for the lihtc can double-count towards cra requirements, thus “open[ing] up the possibility that entities may be willing to bid the price of tax credits above their actuarially fair value as they can jointly realize tax advantages and fulfill cra obligations.” id. at 17. 155. id. at 31. 156. id. 157. id. at 25. 672 florida tax review [vol.12:9 of reduced demand due to a general downturn in the economy (i.e., fewer investors with the requisite tax base) similarly will negatively impact prices. finally, syndication and other transaction costs historically have diverted a substantial portion (up to roughly 30 percent) of the funds invested in lowincome housing projects away from the projects themselves. 158 4. section 1602 grant program section 1602 of arra established, for 2009 only, a grant program under which states could elect to receive cash grants from the federal government in lieu of an allocation of lihtcs. 159 under the section 1602 grant program, a grant was made from the federal government to designated state housing credit agencies. the state agencies then made cash subawards to projects qualifying for the credit under section 42. the states were responsible for developing procedures for making the subawards and for assuring compliance with the section 42 rules. the taxpayer’s basis in a qualified low-income building was not reduced by the amount of any grant subaward. 160 moreover, “[b]ased on the legislative history of the act,” subawards made pursuant to section 1602 were excluded from the gross income of recipients and were exempt from taxation. 161 arra also established tax credit assistance program (“tcap”) grants administered by state agencies under which grants were available 158. according to the desai study, “syndication costs may consume 1027% of equity invested in low-income housing credit projects” (citing a 1997 gao study). desai et al., investable tax credits, supra note 132, at 26. a second study cited by desai study (cummings and dipasquale (1997)) found that “the average ratio of net equity to gross equity . . . is 0.71.” id. 159. arra 2009, supra note 28, § 1602, 123 stat. at 362–64. in addition, section 3022 of the housing and economic recovery act of 2008 provided that the low-income housing tax credit and rehabilitation credit could offset alternative minimum tax liability. hera 2008, supra note 130, § 3022, 122 stat. at 2893–94. fannie mae, one of the largest consumers of low-income housing credits, had previously announced that it might be subject to the alternative minimum tax, which may have depressed the demand for lihtcs and contributed to the overall decline in credit prices in 2007 and 2008. desai, et al., investable tax credits, supra note 132, at 30. fannie mae had invested $620.5 million in tax credits in the first six months of 2007, but only $10 million in the first six months of 2008. donna kimura, syndicators foresee muted second half, apartment fin. today (october 2008), http://www.housingfinance.com/aft/articles/2008/oct/1008-capital-tax-credit.htm. 160. see i.r.c. § 42(i)(9)(b) (added by arra 2009, supra note 28, § 1401, 123 stat. at 352). 161. notice 2010-18, 2010-14 i.r.b. 525. 2012] monetization of business tax credits 673 until september 2011. 162 in contrast to the section 1602 grants, the tcap grants were includible in gross income. 163 e. the new markets tax credit like the lihtc, the new markets tax credit (“nmtc”), enacted pursuant to the community renewal tax relief act of 2000 and codified as section 45d, 164 ostensibly is geared to benefit the low-income community. its purpose is to secure “qualified equity investments” for “target populations” within the “low-income community” via the provision of a tax credit. 165 the provision is structured to provide a tax credit in an amount equal to 39 percent of a taxpayer’s equity investment over a seven-year period in return for investment in low-income communities. 166 the amount of available nmtcs is a function of the authority granted to the treasury department. the initial grant of authority for investments during the 2001 to 2007 period was $15 billion ($5.85 billion in credits). since then, the treasury has reserved additional grants of authority of $5 billion of investment for each of 2008 and 2009 and $3.5 billion of investment for each of 2010 and 2011. pursuant to a delegation of authority, the tax credits are distributed by the community development fund initiative (“cdfi”) to qualified investor groups in rounds. under section 45d, an investor must make a “qualified equity investment” (“qei”) 167 in cash into a “qualified community development 162. arra 2009, supra note 28, tit. xii, 123 stat. at 203–26. 163. see, e.g., i.r.s. chief couns. adv. 2011-06-008 (feb. 11, 2011). 164. see community renewal tax relief act of 2000, pub. l. no. 106554, § 121, 114 stat. 2763a-587, 2763a-605 to 2763a-610 (incorporating by reference h.r. 5662, 106th cong. (2000)). 165. see i.r.c. § 45d(b), (e). 166. the credit is five percent in each of the first three years and six percent for the remaining credit allowance dates. i.r.c. § 45d(a)(2). 167. for an investment to constitute a qei, substantially all of the cash must be used by the cde to make “qualified low-income community investments.” i.r.c. § 45d(b)(1)(b). the term “equity investment” encompasses any stock other than non-qualified preferred stock (as defined in section 351(g)) and any capital interest in a partnership. i.r.c. § 45d(b)(6). a “qualified low-income community investment” is (a) any capital or equity investment in, or loan to, any qualified active low-income business, (b) the purchase from another qualified community development entity of any loan made by such entity which itself is a qualified low-income community investment, (c) [the provision of] financial counseling and other services specified in regulations prescribed by the secretary to businesses located in, and residents of, low-income communities, 674 florida tax review [vol.12:9 entity” (“cde”) 168 — typically taking the form of a partnership interest. the cde, in turn, must invest the qei in a low-income community project either directly or through approved entities. a cde may make an investment in, or make a loan to, a business engaged in the rental to others of real property located in a low-income community so long as the property is not residential rental property, and there must be substantial improvements located on the property. 169 the cde allocates the credits to the investors. the basis in the property is reduced by the amount of the credit, 170 and the credit is subject to recapture if a “recapture event” with respect to an equity investment in a cde occurs during the seven-year credit period (the entity ceases to be a cde, the proceeds of investment are not used as required, or the investment is redeemed by the entity). 171 the full amount of previously claimed credits is recaptured and a non-deductible interest charge is imposed on the amount of the recaptured credits. 172 at the time of its enactment, the nmtc “received little fan-fare or public attention beyond those already in the know.” 173 h.r. 5662 was introduced, voted on, and passed all on the same day (december 14, 2000) and signed into law a week later on december 21, 2000, “tucked away into obscurity within the massive appropriations act.” 174 the legislative history and (d) any equity investment in, or loan to, any qualified community development entity. i.r.c. § 45d(d)(1). 168. for an entity to qualify as a cde it must be a domestic corporation (including a non-profit corporation) or partnership (1) whose primary mission is serving, or providing capital, for low-income communities or persons; (2) that provides low-income resident representation on its governing body; and (3) that is formally certified by the director of the cdfi as a cde. i.r.c. § 45d(c)(1). 169. reg. § 1.45d-1(d)(5)(ii). however, the business cannot consist primarily of the development or holding of intangibles for sale or license, nor can it consist of the operation of any golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, or other gambling facility. reg. § 1.45d1(d)(5)(iii). finally, the business’s principal activity cannot be farming. reg. § 1.45d-1(d)(5)(iii). 170. i.r.c. § 45d(h). 171. i.r.c. § 45d(g). 172. i.r.c. § 45d(g)(2). 173. roger m. groves, the de-gentrification of new markets tax credits, 8 fla. tax rev. 213, 217 n.15 (2007) [hereinafter groves, new markets tax credits]. 174. id. the appropriations act was title i of the consolidated appropriations act of 2001. pub. l. no. 106-554, tit. i, 114 stat. 2763, 2763a-3 to 2763a-12 (2000). 2012] monetization of business tax credits 675 offers little in the way of explanation of the reasoning behind the new regime beyond the purposes stated in the legislative language itself. 175 one commentator has observed that the features of the nmtc legislation evidence that “congress intended each party to the transaction as purposely designed as a mere conduit to the delivery of equity capital to existing low-income community residents, not new entrants without the economic need.” 176 however, in practice, the nmtc rules apparently have allowed, and effectively encouraged, investment in low-income communities that is not always in practice for the benefit of the residents of these communities. thus, projects receiving approximately $2 billion in tax credit subsidies have included a performing arts center for opera, symphony, and ballet, a 617-room convention center and hotel, museums, upscale commercial office space, and tourist centers. 177 developments since do not seem to have materially altered the functioning of the credit. 178 175. in the february 1999 “green book” outlining the president’s revenue proposals for the following fiscal year, the treasury had described a proposal for a “new markets tax credit.” dep’t of the treasury, general explanations of the administration’s revenue proposals 33–36 (1999), http://www. treasury.gov/resource-center/tax-policy/documents/general-explanations-fy2000.pdf. the green book noted that under current law, “there are limited tax incentives for investing and making loans to businesses in low-income communities” and that “[b]usinesses in our nation’s inner cities and isolated rural communities often lack access to equity capital to grow and succeed.” id. at 33. therefore, “[t]o help attract new capital to these businesses,” it proposed “a new tax credit for equity investments in these businesses.” id. 176. groves, new markets tax credits, supra note 173, at 221. 177. id. at 225–26 (the author includes a complete table of projects he refers to as “problematic purposed projects”). by the same token, the nmtc program also has brought support to community healthcare facilities, child care centers, senior centers and affordable housing for local residents. id. at 234. 178. section 221 of the american jobs creation act of 2004, expanded the definition of “low-income community.” american jobs creation act of 2004, pub. l. no. 108-357, § 221, 118 stat. 1418, 1431 [hereinafter ajca 2004). the ajca 2004 added section 45d(e)(2), directing the treasury to prescribe regulations under which certain “targeted populations” were to be considered “low-income communities.” id. at § 221(a). in 2006, the irs issued a (now obsolete) notice offering guidance on section 45d(e)(2) until final regulations are adopted. see notice 2006-60, 2006-2 c.b. 82. proposed regulations adopting the notice 2006-60 rules without significant changes were promulgated in 2008 and have since been finalized. see reg. § 1.45d-1 (as amended by t.d. 9560, 2012-4 c.b. 299); prop. regs. § 1.45d-1, 73 fed. reg. 54,990 (2008). the ajca 2004 also added new section 45d(e)(4), treating population census tracts with a population of less than 2,000 as “low-income communities” if the tract is within an empowerment zone under section 1391, and is contiguous to one or more other low-income communities. ajca 2004, supra § 221(b), 118 stat. 676 florida tax review [vol.12:9 in a march 2011 report, the government accountability office (“gao”) suggested converting the nmtc into a grant program in order to “increase program efficiency and reduce the overall cost of the program.” 179 it reasoned as follows: [r]eplacing the tax credit with a grant likely would increase the equity that could be placed in low-income businesses and make the federal subsidy more cost-effective. when cde sells credits to investors to raise additional funds, the price investors pay for the credits reflects market conditions and the investors’ attitudes toward risk. according to cde representatives gao interviewed in 2009, when the demand for nmtcs was highest, before the housing market collapse and 2008 credit crisis, the tax credits sold for $0.75 to $0.80 per dollar. therefore, the federal subsidy intended to assist low-income businesses was reduced by 20 percent to 25 percent before any funds were made available to cde. representatives from cde [whom] gao interviewed also noted that with low demand for the tax credits, as was the case when gao conducted its work during 2009, the credits generally sold for about $0.65 to $0.70 and have sold for as at 1431. finally, the ajca 2004 added section 45d(e)(5), modifying the income requirement for census tracts within high migration rural counties. id. at § 223(c). in 2006, section 102 of the tax relief and health care act, added new section 45d(i)(6), directing the treasury to adopt regulations to “ensure that nonmetropolitan counties receive a proportional allocation of qualified equity investments.” tax relief and health care act of 2006, pub. l. no. 109-432 § 102, 120 stat. 2922, 2934. the treasury also issued proposed regulations in 2008 providing that there will be no recapture of the new markets tax credit upon a section 708(b)(1)(b) termination of a partnership cde and clarified when a cash distribution by a partnership cde to its partners would be treated as a redemption triggering a recapture event. prop. reg. § 1.45d-1, 73 fed. reg. 46,572 (2008). most recently, in 2011, the treasury issued proposed regulations that would expand the allowable options for the reinvestment of cde proceeds. prop. reg. § 1.45d-1, 76 fed. reg. 32,882 (2011). the proposed changes are described by the opportunity finance network (a network of community development financial institutions in philadelphia) as “very limited and unlikely to have a significant impact.” liz white, tax credits: comments offer insights on issues, problems with irs changes to new markets tax credit, 187 daily tax rep. bna g-5 (2011). see also liz white, tax credits: time limit, risk prevent non-real estate investments in new markets credit program, 190 daily tax rep. bna g-1 (2011). 179. u.s. gov’t accountability office, gao-11-318sp, opportunities to reduce potential duplication in government programs, save tax dollars, and enhance revenue 276 (2011) [hereinafter gao [hereinafter gao nmtc report http://www.gao.gov/assets/320/315920.pdf. 2012] monetization of business tax credits 677 little as $0.50 or less. after accounting for cde and other third-party fees, such as asset management and legal fees, about 50 percent to 65 percent of the federal subsidy generally reaches low-income businesses. in a grant program, these up-front reductions in the federal subsidy could be largely avoided. if the grant program is well designed and at least as effective as the credit in attracting private investment, it could save a significant portion of the estimated $3.8 billion five-year revenue cost of the current program. 180 the gao report has garnered some disagreement, with one commentator arguing that in analyzing a “a theoretically-equivalent cash grant program to the nmtc program,” the nmtc is up to 15 percent more efficient. 181 interestingly, in january 21, 2010, comments to a draft of the gao nmtc report, the treasury department took umbrage at the gao’s recommendation that the nmtc program be replaced with a program of grants to cdes. 182 first, it observes, the nmtc is “likely more cost-effective than a grant, since investors in nmtcs are required to pay taxes on the value of their nmtc investments” whereas many of the cdes to which grants would be made are non-profits. 183 second, it argues that “[s]witching from a tax credit to grant [would] require significant programmatic changes on the part of the treasury department,” noting, among other things, that “compliance elements normally undertaken by the irs as part of tax audits would be shifted to the cdfi fund.” 184 third, the treasury submission 180. id. at 276–77 (emphasis added). 181. michael j. novogradac, tax credits are more efficient than cash grants, novogradac j. of tax credits, nov. 2011, at 1, http://www.novoco. com/journal/2011/11/novogrodac_jtc_2011-11-ww-pg4.pdf. 182. letter from the dep’t of the treasury cmty. dev. fin. inst. fund to michael brostak, dir. for tax issues, u.s. gov’t accountability office (jan. 21, 2010), in gov’t accountability office, gao-10-334, new markets tax credit 55-58 (2010) [hereinafter dep’t of the treasury letter]. 183. id. at 56. 184. id. the treasury department comments state as follows: in fact, such a change would alter all aspects of program implementation, including the following: (i) irs regulations would have to be amended and new cdfi fund regulations governing the administration of grants would need to be drafted; (ii) the cdfi fund’s application materials and selection processes would have to be altered to provide for a more substantive review of the awardee’s financial capacity to administer the grant; (iii) the cdfi fund would have to create a disbursement tracking system to award and monitor the funds, in a manner that satisfies federal grant-making requirements; [and] (iv) award agreements would 678 florida tax review [vol.12:9 argues, conversion to a grant program would eliminate the “extra layer of investor due diligence” embedded in a tax credit program and “could lead to higher incidences of non-compliance.” 185 finally, the treasury observes that a low-income business receiving a direct grant (in lieu of a tax credit to the tax equity investor) may be unable to attract the same amount of debt capital to its project, and on the same terms and conditions, particularly since the debt investor and equity investor in many nmtc deals are often the same person. 186 f. legislative developments with respect to energy credits since 1986 1. extension of the energy credit the omnibus budget reconciliation act of 1990 eliminated expired and obsolete investment tax credit provisions and enacted new sections 46 through 50. 187 the new “investment credit” was the sum of the new section 48(a) energy credit, section 48(b) reforestation credit, 188 and new section 47 rehabilitation credit. the new energy credit, as re-codified in section 48(a), was a 10 percent credit, and was only available for solar and geothermal property. as originally enacted in 1990, the energy credit was set to expire on december 31, 1991. 189 it was later extended to june 30, 1992, 190 and made permanent in 1992 pursuant to the energy policy act of 1992. 191 the committee report stated that it believed that it is important to provide tax-based support for the development of alternative energy sources. moreover, the committee believes that making the credits for investment in solar and geothermal property permanent will provide potential investors in long-term projects an additional degree have to be modified and all awardees would have to agree to the terms and conditions governing uses of federal grant dollars, which entails a host of new burdens for awardees. id. 185. id. 186. dep’t of treasury letter, supra note 182, at 56–57. 187. rra 1990, supra note 56, tit. xi, 104 stat. at 1388–400. 188. the reforestation credit was repealed in 2004 by section 322(d)(2) of the american jobs creation act of 2004; ajca 2004, supra note 178, § 322(d)(2), 118 stat. at 1475. 189. i.r.c. § 48(a)(2)(b). 190. tax extension act of 1991, pub. l. no. 102-227, § 106, 105 stat. 1686, 1687. 191. energy policy act of 1992, pub. l. no. 102-486, § 1916, 106 stat. 2776, 3024 [hereinafter epa 1992]. 2012] monetization of business tax credits 679 of certainty as to the availability of the credits that may have been lacking in the past. 192 2. the production tax credit a. in general the energy policy act of 1992 also added section 45, 193 which provides a per-kilowatt hour credit (a “production tax credit”) on the sale of electricity produced from qualified renewable energy resources during the ten year period following the date when the facility producing the energy is first placed in service. 194 the amount of the credit is not includible in the taxpayer’s gross income. 195 at the time of passage, the house report stated that “[t]he credit is intended to enhance the development of technology to utilize the specified renewable energy sources and to promote competition between renewable energy sources and conventional energy sources.” 196 under section 45(b), the credit is phased out as the market price of electricity exceeds certain threshold levels and is subject to reduction if the project was financed with government grants, tax-exempt bonds, other federal tax credits, or government-subsidized financing programs. 192. h.r. rep. no. 102-474, pt. 6, at 47 (1992). 193. epa 1992, supra note 191, § 1914(a), 106 stat. at 3020–23. as originally enacted, this legislation provided a 1.5 cent credit for each kilowatt hour of energy produced from wind and closed-loop biomass. currently it provides a 2.2 cent per kilowatt hour credit on the sale of electricity produced from wind, closedloop biomass, geothermal energy and a solar energy, and 1.1 cent per kilowatt hour on the sale of electricity produced in open-loop biomass facilities, small irrigation power facilities, landfill gas facilities, trash combustion facilities, qualified hydropower facilities, and marine and hydrokinetic energy facilities. i.r.c. § 45(b)(2), (b)(4). according to a joint committee study, as of the time of its writing “[i]n practice, investors have only found it profitable to invest in wind facilities [as among the eligible types of facilities].” staff of joint comm. on taxation, 109th cong., present law and background relating to tax credits for electricity production from renewable sources 14 (comm. print 2005) [hereinafter jtc, tax credits for electricity production], http://www.jct.gov/publications.html?func=showdown&id=1579. 194. under section 45(b)(4), a five-year credit period applies in the case of electricity produced and sold from certain facilities. 195. while this seems to be well accepted, the basis for this conclusion is elusive. cf. jct, tax credits for electricity production, supra note 193, at 8 n.5 (“under general income tax principles, such a subsidy [i.e., the production tax credit] paid to the taxpayer would be includable in taxable income as part of revenue.”). 196. h.r. rep. no. 102-474, pt. 6, at 42 (1992). 680 florida tax review [vol.12:9 b. role as subsidy unlike the lihtc and nmtc, which are meant to deploy taxpayerinvestors effectively to deliver a subsidy to a separate intended beneficiary presumptively unable to use the tax credit (low-income persons), the production tax credit has as its primary target for a subsidy the producer of electricity. for a taxpayer with a positive tax liability, the electricity production credit is equivalent to a subsidy that pays the taxpayer for each kilowatt-hour of electricity produced in addition to the price at which the producer sells the electricity. that is, a tax credit that reduced a taxpayer’s tax liability and therefore increases the taxpayer’s bottom line produces a benefit to the taxpayer similar to a direct subsidy that is paid to the taxpayer to improve the taxpayer’s top line. . . . an alternative way to assess the value of the credit to the taxpayer should be to think of the credit as part of the taxpayer’s stream of receipts across the life of the taxpayer’s investment in the renewable energy project. in this view, the value of the credit to the taxpayer is equal to the value of the payment the taxpayer would have to receive annually per kilowatt-hour of electricity produced over the life of the project to produce a revenue stream that is equal in present value to the revenue produced by the credit over the life of the project (recognizing that generally the credit only produces revenue for the first ten years of the project and nothing thereafter). 197 still another passage is worthy of quoting: the electricity production tax credit is economically equivalent to an open-ended subsidy, available to any taxpayer with no requirement to make an application to a government agency for the subsidy. if a taxpayer believes that the sum of electricity prices plus the credit creates a profitable rate of return, the taxpayer will invest in a qualifying facility. in theory, investors should invest in qualifying facilities up to the point where the return from 197. jct, tax credits for electricity production, supra note 193, at 8–9. 2012] monetization of business tax credits 681 additional investment in qualifying facilities is no greater than the return on alternative investments. 198 thus, the credit under section 45(a)(2)(b) generally is a function of the quantity of electricity produced at a “facility owned by the taxpayer” in turn “sold by the taxpayer.” 199 the joint committee report from which the passage above is excerpted goes on to note the inherent inefficiencies in the tax credit mechanism, since some projects, based on the effect of geographical location on costs, energy resources (such as wind), and similar considerations, “would be profitable investments in the absence of any subsidy.” 200 c. revenue procedure 2007-65 recognizing that project developers often lack the tax base to avail themselves of tax incentives such as the production tax credit, in revenue procedure 2007-65, 201 the irs established a safe harbor for “wind farm” partnerships between project developers and participating investors. if a transaction conforms with the requirements of the safe harbor, the irs will respect the allocation of the section 45 production tax credits under section 198. id. at 16–17 (internal footnote omitted). 199. i.r.c. § 45(a)(2)(b), (d). in the case of biomass facilities, to the contrary, if the owner of the facility is not the producer of electricity the credit goes to the “lessee or operator” of the facility. see i.r.c. § 45(d)(2)(c), (d)(3)(c). under section 45(e)(3), if a facility has multiple owners the credit is to be allocated in accordance with their relative interests in gross sales from the facility. 200. jct, tax credits for electricity production, surpa note 193, at 17. see also h.r. rep. no. 102-474, pt. 6, at 42 (1992): the committee believes that the development and utilization of certain renewable energy sources should be encouraged through the tax laws. a production-type credit is believed to target exactly the activity that the committee seeks to subsidize (the production of electricity using specified renewable energy sources). the credit is intended to enhance the development of technology to utilize the specified renewable energy sources and to promote competition between renewable energy sources and conventional energy sources. the committee believes that if the national average price of electricity is sufficiently high, the need for a tax subsidy is reduced. accordingly, the tax credit will be phased out in the event that the price of electricity generated from these sources is sufficiently high. 201. 2007-2 c.b. 967. 682 florida tax review [vol.12:9 704(b). 202 the term “investors” is defined as “partners in the project company whose investment return is reasonably anticipated to be derived from both § 45 credits and participation in operating cash flow.” 203 revenue procedure 2007-65 is not intended to provide substantive rules and its provisions are not to be used as audit guidelines. rather, it is intended to provide guidance to taxpayers establishing or participating in wind energy partnerships in lieu of the issuance of private letter rulings. among its requirements are these: (i) the developer must have a minimum one percent interest in each material partnership item at all times; (ii) the investor must have a minimum interest in partnership income and gain at all times equal to at least five percent of the investor’s largest percentage interest in partnership income and gain; (iii) the investor must make a minimum unconditional investment in the partnership equal to at least 20 percent of the sum of the fixed capital contributions; and (iv) at least 75 percent of the sum of the fixed capital contributions plus reasonably anticipated contingent capital contributions to be contributed by an investor with respect to an interest in the partnership must be fixed and determinable. 204 purchase and sale rights are subject to specific constraints: (1) neither the developer nor the investor (or any related party) may have a contractual right to purchase the wind farm, any property included in the wind farm, or an interest in the partnership unless the purchase price is either a price that is not less than the fair market value of the property determined at the time of exercise or, if the purchase price is determined prior to exercise, a price that the parties reasonably believe, based on all facts and circumstances at the time the price is determined, will not be less than the fair market value of the property at the time the right may be exercised. further, the developer may not have a contractual right to purchase the property earlier than five years after the qualified facility is first placed in service; 202. but see reg. § 1.704-1(b)(1)(iii) (“[a]n allocation of loss or deduction to a partner that is respected under section 704(b) and this paragraph may not be deductible by such partner if the partner lacks the requisite motive for economic gain (see, e.g., goldstein v. commissioner, 364 f.2d 734 (2d cir. 1966. . . .”). 203. rev. proc 2007-65, 2007-2 c.b. 967 (emphasis added). 204. cf. i.r.s. priv. ltr. rul. 2008-05-007 (feb. 1, 2008); i.r.s. priv. ltr. rul. 2007-26-007 (june 29, 2007); i.r.s. priv. ltr. rul. 2007-14-013 (apr. 6, 2007); i.r.s. priv. ltr. rul. 2006-17-010 (apr. 28, 2006); i.r.s. priv. ltr. rul. 2006-17-009 (apr. 28, 2006); i.r.s. priv. ltr. rul. 2005-27-006 (july 8, 2005); i.r.s. priv. ltr. rul. 2004-07-001 (feb. 13, 2004); i.r.s. priv. ltr. rul. 2004-39-026 (sept. 24, 2004); i.r.s. priv. ltr. rul. 2003-07-076 (feb. 14, 2003); i.r.s. priv. ltr. rul. 200309-024 (feb. 28, 2003). these rulings allow up to 50 percent of the consideration paid by the tax equity investor in a section 29 or 45k transaction to be in the form of contingent payments. 2012] monetization of business tax credits 683 (2) the partnership cannot have a contractual right to cause any party to purchase the wind farm or any property included in the wind farm, excluding electricity; and (3) the investor may not have a contractual right to cause any party to purchase its partnership interest in the partnership. among other requirements, no person may guarantee or otherwise insure the investor the right to any allocation of the production tax credit; the partnership must bear the risk that the available wind resource is not as great as anticipated or projected; 205 and the production tax credit must be allocated in accordance with regulations section 1.704-1(b)(4)(ii). needless to say, the point behind these requirements is to ensure that the parties claiming the production tax credit are the parties having the predominant substantive investment and benefits and burdens of ownership of the project whose development the tax credit was meant to foster. to place a down payment on the ultimate thesis of this article, one could observe that the role of the tax equity financiers presumably would cost the developer less dearly if these requirements of substance were waived and the tax equity investors were permitted to simply front the federal subsidy for a fee. d. optional election for energy credit as part of the arra, discussed in more detail below, congress added section 48(a)(5), which allows taxpayers owning “qualified property” placed in service after 2008 and before 2014 (before 2013 in the case of wind facilities) to irrevocably elect the 30 percent energy credit (see discussion below) in lieu of the production tax credit. 206 “qualified property” is defined as tangible property that is used as an integral part of a section 45 qualified investment credit facility (not including a building or its structural components) for which depreciation (or amortization in lieu of depreciation) is allowed. 207 the effect of this election is to cause such property to be treated as “energy property” for purposes of section 48, even if it otherwise would not qualify as such. as the joint committee on taxation explained, “[t]he congress believes that current economic circumstances are constraining investments in facilities that ordinarily would utilize the 205. a guarantee regarding wind resource availability may be provided by a third party not related to the developer or other parties associated with the transaction if the project company or an investor directly pays the cost of a premium for such guarantee. 206. arra 2009, supra note 28, § 1603, 123 stat. at 364–66; i.r.c. § 48(c)(5). 207. i.r.c. § 48(a)(5)(d). 684 florida tax review [vol.12:9 production tax credit, and wishes to give maximum flexibility to taxpayers to choose the tax incentive that will deliver the greatest benefit to them.” 208 3. 2005 enhancements to the energy credit in 2005, the amount of the energy credit was increased from 10 percent to 30 percent for solar energy property without apparent fanfare or explanation. 209 in 2008, small wind energy property was also made eligible for the 30 percent credit. 210 4. response to the economic downturn: the arra grant program 211 the economic downturn that became pronounced following the lehman brothers bankruptcy filing threw many companies that historically were participants in tax credit transactions (including the major banks and (surviving) investment banks) into loss positions, with the consequence that tax credit transactions lost their attraction. continued stimulus of targeted areas of investment such as renewable energy no longer could be delivered via tax credit subsidies. thus, in february 2009, president obama signed arra into law. 212 section 1603(a) of arra reads as follows: upon application, the secretary of the treasury shall, subject to the requirements of this section, provide a 208. staff of joint comm. on taxation, 111th cong., general explanation of tax legislation enacted in the 111th congress 105 (comm. print 2011) [hereinafter “jct, general explanation”]. 209. energy policy act of 2005, pub. l. no. 109-58, § 1337, 119 stat. 594, 1038. in addition, fuel cell property and qualified microturbine property were made eligible for the energy credit. 210. emergency economic stabilization act of 2008, pub. l. no. 110-343, § 104, 122 stat. 3765, 3770–71. 211. while the focus of this article is credits and grants, of course, there have been significant liberalizations of the depreciation regime as well in the wake of the economic crisis — e.g., 50 percent bonus depreciation for property placed in service after december 31, 2007 and before january 1, 2013 and 100 percent bonus depreciation for property placed in service between september 8, 2010 and december 31, 2011. see i.r.c. § 168(k)(1), (5). 212. see aara 2009, supra note 28, 123 stat. at 115; the recovery act, recovery.gov, http://www.recovery.gov/about/pages/the_act.aspx (lasted visited mar. 23, 2012). the 2010 tax relief, unemployment insurance reauthorization, and job creation act, extended the grant program under section 1603(a) of arra until the end of 2011. tax relief, unemployment insurance reauthorization, and job creation act of 2010, pub. l. no. 111-312, § 707(a)(1), 124 stat. 3296, 3312 [hereinafter tra 2010). 2012] monetization of business tax credits 685 grant to each person who places in service specified energy property to reimburse such person for a portion of the expense of such property as provided in subsection (b). 213 under the grant program, qualified applicants receive a cash grant in an amount equal to 30 percent of renewable project costs in lieu of the energy tax credit and the production tax credit. eligible projects include solar power projects, municipal waste projects, combined heat and power projects, wind power projects, hydropower projects, system property power projects, biomass power projects, marine and hydrokinetic power projects, geothermal power projects, fuel cell power projects, gas landfill power projects, and microturbine power projects. recipients of the grant are not required to include the grants in income, but are required to reduce their tax basis in the predicate projects by an amount equal to 50 percent of the grant. this, of course, reduces future depreciation deductions and has the effect of increasing income over the recovery period for the project. of course, fundamentally, the requirement of only a 50 percent reduction in basis delivers a further subsidy (albeit a tax based subsidy). highlights of the grant program (as modified by the tax relief act of 2010) are as follows: 214 (1) grants are only available for property placed in service during 2009, 2010 or 2011 or for property placed in service after 2011 if construction began on the property in 2009, 2010 or 2011. (2) grant applications for all property are due by october 1, 2012. (3) ownership requirements: (a) projects cannot be owned by government entities or tax-exempt organizations or foreign persons or entities. 213. arra 2009, supra note 28, § 1603(a), 123 stat. at 364. 214. general guidance regarding the grant program is available on the treasury department’s webpage. recovery act, u.s. dep’t of the treasury, http://www.treasury.gov/initiatives/recovery/pages/1603.aspx (last updated jan. 18, 2011) (including program guidance). see u.s. treasury dep’t of the fiscal assistant sec’y, payments for specified energy property in lieu of tax credits under the american recovery and reinvestment act of 2009, at 2 (rev. 2011) [hereinafter treasury dep’t, program guidance], http://www. treasury.gov/initiatives/recovery/documents/b%20guidance%203-29-11%20revised %20(2)%20clean.pdf, for the most recent version of the program guidance for the section 1603 grant. 686 florida tax review [vol.12:9 (b) projects also cannot be owned by any partnership or other pass-through which has disqualified partners (e.g., tax-exempt owners). (c) disqualified persons, however, can own interests in projects if they do so through taxable subchapter c corporations. (4) additional rules and tests apply in determining whether construction has begun for grant purposes. (5) the grant is subject to recapture under “rules similar to the rules of section 50.” it is clear that, in enacting the grant program, congress intended to hone to the principles in place governing the production tax credit and energy credit. the conference report states that “[t]he grant may be paid to whichever party would have been entitled to a credit under section 48 or section 45, as the case may be.” 215 elsewhere the conference report states “[i]t is intended that the grant provision mimic the operation of the credit under section 48. for example, the amount of the grant is not includable in gross income.” 216 nonetheless, while as an example only a “taxpayer” can claim a credit under section 45 and the production tax credit, in turn, is computed based on the amount of electricity sold by “the taxpayer,” at least one commentator has suggested it is less than clear whether an applicant for a cash grant under arra section 1603 necessarily has to be “the taxpayer.” 217 in fact the commentator makes a suggestion, which is somewhat intriguing in relation to the thesis of this article, that a person placing property in service and holding legal title to the property arguably may be eligible for a section 1603 grant even where “a second person has a bundle of economic rights and obligations with respect to the property that cause that second person to be treated as the owner of the property for federal income tax purposes.” 218 in any event, as discussed in part iii below, as a practical matter, it does not seem industry participants and their advisors are taking such a 215. h.r. rep. no. 111-16, at 621 (2009); see jct, general explanation, supra note 208, at 110. 216. jct, general explanation, supra note 208, at 110. 217. neil d. kimmelfield, grants in lieu of tax credits under the recovery act — a square peg in a round hole, 112 j. of tax’n 21, 28 (2010) [hereinafter kimmelfield, grants in lieu of tax credits]. 218. id. the author asks whether “if treasury chooses to issue a grant to an applicant with respect to an eligible property without first asking whether a person other than the applicant has the benefits and burdens of ownership of the property, is it appropriate for a court to pursue that inquiry if treasury later seeks return of the grant proceeds?” id. 2012] monetization of business tax credits 687 formalistic view in connection with grant applications. without more, then, the recipient of the grant generally would be the party that will be claiming macrs deductions with respect to the qualifying property. exceptions to this would include the lease context where the lessor cedes the grant to the lessee. (section iii of the program guidance provides that an applicant eligible for the grant “must be the owner or lessee of the property and must have originally placed the property in service.” 219 ) also, in the partnership context, there likely will be a fair amount of flexibility as to how the grant is distributed among the partners. 220 it also should be possible, using the partnership form, for a developer to construct qualified property, place it in service, and thereafter locate investors to purchase interests in the partnership. the partnership, as original user of the project, should be able to apply for the grant. it has been suggested it may even be reasonable to request a grant using basis as adjusted under section 743(b) if a section 754 election is in place. 221 the application process is very involved and requires extensive documentation as to the eligibility of the project, placement in service of the project and documentation of the cost of the property 222 — sufficiently so that many developers (quite apart from considerations of tax base) cannot “go it alone” without the involvement of “tax equity investors” because they need the investors’ funds to support the development and construction of the project pending receipt of the grant. rather, the developer leverages the eventual grant money to gain required funding earlier in the process. for their part, the investors sometimes look to the grant for a substantial part of their return. however, the allocation of the grant between the developer and 219. treasury dep’t, program guidance, supra note 215. section iv.g of the program guidance requires that “[t]he original use of the property must begin with the applicant.” id. 220. kimmelfield, grants in lieu of tax credits, supra note 217, at 42 (“a grant received by a partnership increases the capital of the partnership, and a special allocation of the grant can have an economic effect on the partners by affecting their right to current or future distributions. accordingly, it should be permissible for a partnership to specially allocate among its partners the 50% portion of a grant that is reflected in a permanent increase in the basis of the partnership's property, and the partners should be entitled to take that allocation into account in adjusting the bases of their partnership interests under section 705(a)(1)(b)”). 221. id. at 34. 222. for a project with a cost basis in excess of $500,000, the applicant must provide the certification of an independent accounting firm as to the accuracy of all claimed costs. requests for grants under $1 million require the accountant to make judgments as to the eligibility of the subject property. see kimmelfield, grants in lieu of tax credits, supra note 217, at 36–37, for a complete discussion of the intricacies of the attestation requirement. 688 florida tax review [vol.12:9 the investors is a matter of negotiation and the structuring of the overall economics of the project, and can vary widely from one project to the next. anecdotal evidence suggests that the grant process has departed from its tax “roots” somewhat substantially and generally in ways favorable to the applicants. examples include leases of facilities by grant recipients to municipalities (in the tax credit context, this would be disqualifying) and failure to apply the section 50 recapture rules as they would apply in the credit context. the rules governing projects covered by the grant program effectively are being made “on the fly,” in discussions with representatives of the treasury department, via e-mail correspondence and by word-ofmouth. at the conclusion of this process, upon receipt of a complete and final grant application, the treasury department may (1) notify the applicant that the application is approved (in which case payment of the grant is due within five days of the notice); 223 (2) require additional information (in which case the applicant has 21 days to respond); or (3) reject the application and provide the applicant its reasons. 224 if the treasury department rejects an application, the determination is final and “no administrative appeal is available.” 225 sole recourse would appear to be a lawsuit. if the treasury department makes a section 1603 payment and subsequently determines the payment was in error, unless the recipient of the grant returns the funds voluntarily, similarly the treasury department’s sole recourse would appear to be a lawsuit. obviously, this is a far cry from the procedural implications of a subsidy delivered via tax credit, complete with self-reporting, audit, administrative appeal, and established forums for judicial review. 226 223. section 5 of the terms and conditions segment of the program guidance requires grant recipients to make annual reports to treasury regarding the performance of the property for five years after it is placed in service. section 6 requires a certification that no recapture event (e.g., the property is disposed of or ceases to be specified energy property) has occurred. treasury dep’t, program guidance, supra note 214. 224. see id. at 4. 225. kimmelfield, grants in lieu of tax credits, supra note 217, at 35. 226. see id. at 34–35 (providing a more extensive discussion of these points). in a recent generic legal advice memorandum, am 2011-004, dated september 27, 2011, the office of chief counsel (passthroughs and special industries) addresses the income tax consequences of an overpayment of section 1603 grants (includable in income) and repayments of overpayments (deductible). while this implies that the treasury is intending to audit awards of grants (and, in fact, the author understands a number of audits are underway), the procedures for this are unclear. see also supra note 153 and accompanying text (structure of lihtc facilitates enforcement of program requirements). 2012] monetization of business tax credits 689 loss of the section 1603 grant mechanism in 2012 (absent extension) will leave taxpayers with the production tax credit and energy tax credit regimes discussed above (subject to scheduled expirations). iii. federal tax credit monetization structures in practice a. renewable energy projects 1. in general typically, project developers are not in a position to make use of tax benefits such as depreciation deductions and tax credits to any significant degree. therefore, of necessity, developers routinely partner with “tax equity investors” through various mechanisms. two structures are commonly used to finance renewable energy projects by allocating tax benefits to tax equity investors in exchange for their investments. these structures are the partnership flip structure and the lease structure, both discussed further below. a safe harbor for the partnership flip structure that actually borrows heavily from a combination of the irs’s “true lease” guidance and rulings practice under section 29 227 was established in the context of wind energy projects in revenue procedure 2007-65, discussed above. in practice, taxpayers routinely rely on the revenue procedure outside the context of wind projects as well. these same structures are being deployed in the cash grant context both as a vehicle to bridge finance the grant and to make appropriate use of depreciation deductions via the involvement of the tax equity investor. 2. illustration of partnership flip structure a typical renewable energy partnership structure based on rev. proc. 2007-65 can be illustrated as follows. e, a tax equity investor, contributes $100 in cash to partnership in exchange for a 99 percent interest in all items of income, gain, loss, deduction (including macrs depreciation), and credits/grants. s, a strategic partner, contributes $90 in assets to partnership in exchange for a one percent interest in all partnership items of income, gain, loss, deduction (including macrs depreciation), and credits/grants. partnership will obtain a credit/grant of 30 percent of the project costs. it may also be eligible for state incentives. in the grant scenario, there is considerable flexibility as to the 227. see supra note 204 and accompanying text. 690 florida tax review [vol.12:9 allocation of the grant among the partners. 228 this will similarly be true as to any state cash incentives. under the terms of the agreement, 99 percent of the credit/grant is allocated to e; once e achieves a specified internal rate of return taking into account the credit/grant and other tax-related benefits to e from participation in the project, the interest of e in the partnership “flips” such that e thereafter has a 5 percent interest, and s has a 95 percent interest in all partnership items of income, gain, loss, deduction (including macrs depreciation), and credits (including credit/grant). the end result is that e realizes the lion’s share of its return as an equity investor over the first five years (the recapture period) on the strength of the credit/grant. thereafter e maintains a 5 percent interest in the project. 3. lease structure the parties can employ either a sale-leaseback structure or a “straight” lease transaction whereunder in either case the tax equity investor acquires the project and leases it to the developer under a lease satisfying the conditions for a true lease and claims all tax credits and depreciation deductions associated with the project. alternatively, the tax equity investor can cede the credit/grant to the lessee (retaining the macrs deductions). under yet another structure, the developer can play the role of lessor under the lease and cede the credit/grant to the tax equity investor, as lessee. in this case, the tax equity takes up the entrepreneurial roles of operator/lessee, albeit it may contract for operations and maintenance and similar services with the developer/lessor. the lease monetization structure can be illustrated as follows. tax equity contributes $100 to tax equity llc. tax equity llc purchases the energy project from project llc for $100. strategic investor contributes $80 to project llc in exchange for 100 percent of the interests in project llc. tax equity llc leases the energy project to project llc for an up-front prepaid lease payment of $80 funded by strategic investor’s contribution or periodic lease payments equal to $80 on a present value basis. the parties agree that under applicable law tax equity llc is the tax owner of the energy project entitled to the macrs depreciation deductions related to the energy project. the $30 energy credit or grant and any state cash incentives may be claimed by tax equity llc or project llc, as the parties agree. the foregoing is subject to the proviso that the lease qualifies as a “true” lease for federal tax purposes. 228. see supra note 220 and accompanying text. by contrast, as noted above, allocation of the energy credit must be in accordance with the requirements of section 704(b). see supra notes 8–12, and accompanying text. 2012] monetization of business tax credits 691 4. reliance on targeted return a pre-tax internal rate of return (“irr”) to the tax-equity investor in the range of two to three percent commonly has been deemed sufficient to establish the validity of such transactions for federal tax purposes, counting tax credits and grants allocable to the investor as cash for this purpose. practices in light of the enactment of section 7701(o) (see part iv below) are still developing. 229 b. other tax credit transactions in practice as in the case of renewable energy transactions, nmtc transactions reportedly are structured to provide investors with a targeted irr earned over the section 45d seven-year credit period through a combination of the credits and (generally) a cash-on-cash return. anecdotal evidence suggests that historic rehabilitation tax credit transactions generally call for an annual cash distribution (3-percent cash-on-cash apparently is common) and include a schedule showing an anticipated return of investment over the life of the project. in lihtc deals, indications are that the developer/general partner generally retains 80 to 90 percent of the cash flow. a detailed explanation of the techniques for structuring these transactions — from the use of leverage 230 to lease pass-through structures — is beyond the scope of this article. among the issues tax planners often need to address are debt-equity and related issues presented by the use of guarantees and other risk mitigation devices. c. the sacks case sacks v. commissioner 231 is notable for its determination that a transaction projected to lose money on a pre-tax basis and lacking a pre-tax profit motive, and dependent on tax credits for its profitability, is not necessarily on that account a sham requiring a disallowance of the tax benefits claimed by the taxpayer. in sacks, the taxpayer was among an investor group that purchased solar water heating equipment for leaseback to the seller, bfs solar incorporated (“bfs”). bfs’s business plan was to lease the units to homeowners. rent payable to the taxpayer under the head lease consisted of 229. see infra notes 280–81 and accompanying text. see also n.y. state bar ass’n tax section report on codification of the economic substance doctrine, 24 n.61 (2011) [hereinafter nysba report], http://www.nysba.org/ content/contentfolders20/taxlawsection/taxreports/1228-ltr.pdf. 230. see, e.g., rev. rul. 2003-20, 2003-1 c.b. 465 (use of leverage in nmtc transactions). 231. 69 f.3d 982 (9th cir. 1995), rev’g 64 t.c.m. (cch) 1003 (1992). 692 florida tax review [vol.12:9 a base rent for a fixed term of 53 months plus a percentage of the homeowners’ lease payments to have the units on their roofs (50 percent of the portion of sublease rents in excess of bfs’s base rent payable to the taxpayer). the taxpayer made a 50 percent down payment for the equipment in cash and executed an interest-bearing negotiable recourse note in favor of bfs for the balance of the purchase price. 232 all of the units in question were installed in homes and leased to homeowners. the taxpayer claimed depreciation deductions, the regular investment credit and the energy credit for the units for the 1983, 1984 and 1985 tax years. it was questionable whether the investment would produce a profit without taking into account these tax benefits. the irs disallowed the tax benefits on the basis that the taxpayer’s investment was a sham transaction, and the tax court sustained that determination, finding that the taxpayer had purchased a “package of tax benefits.” 233 the ninth circuit reversed. the ninth circuit’s holding in sacks is sometimes cited for the notion that “subsidy-like” targeted tax credits should be treated like cash and included as part of the taxpayer’s pre-tax profit. however, what the court actually articulated as the basis for its holding is something different: “where a transaction has economic substance, it does not become a sham merely because it is likely to be unprofitable on a pre-tax basis.” 234 among the factors the court cites for concluding the transaction had “genuine economic effects” and was not a sham were (1) the taxpayer’s recourse obligation to pay the promissory note, (2) the fact that the taxpayer paid fair market value for the units, (3) the fact that the business of installation of solar water heaters was genuine and (4) the fact that the business consequences of a rise or fall in energy prices and solar energy devices were genuinely shifted to the taxpayer. 235 the court noted that “the tax benefits would have existed for someone, either bfs solar or mr. sacks, so the transaction shifted them but did not create them from thin air.” 236 the court placed heavy reliance on the recourse nature of the taxpayer’s obligations, holding the tax court’s finding that the taxpayer “was not at risk” to be clearly erroneous. 237 at another juncture, the court 232. the taxpayer also granted bfs a security interest in the equipment and assigned bfs the rents payable under the head lease (i.e., the rent payable by bfs) to secure payment of the notes. 233. sacks v. commissioner, 64 t.c.m. (cch) 1003, 1022 (1992). 234. sacks, 69 f.3d at 991 (emphasis added). the court described economic substance and business purpose as “simply more precise factors to consider” in determining whether a transaction has non-tax economic effects, noting it had “repeatedly and carefully noted that this formulation cannot be used as a ‘rigid two-step analysis.’” id. at 988. 235. id. 236. id. 237. id. at 989. 2012] monetization of business tax credits 693 notes that the taxpayer “participates more fully in the attributes of ownership than the taxpayer in frank lyon”: 238 mr. sacks, unlike mr. lyon’s company, owns the potential for upside gain on the water heaters. in frank lyon, the bank had the contractual right to buy out the investor for what the investor had in the deal plus a 6% return on the down payment. 435 u.s. at 567, 98 s. ct. at 1294. if the value of the building went up, the bank could exercise its option and reap all of that gain. in contrast, mr. sacks owns the solar water heaters, whether they turn out to be duds or bonanzas. if energy prices rise faster than the price of solar water heaters fall, mr. sacks stands to make more money. after 53 months, when the units are still well within amcor’s warranty period and their useful life by any measure, mr. sacks owns them free and clear and can negotiate whatever deal the market will bear. if energy prices were to fall substantially, mr. sacks would be stuck with writing checks to cover his notes, and doing something with all the economically useless hardware. 239 the ninth circuit expressed skepticism as to a number of the tax court's factual findings, including its determination that a pre-tax profit was unlikely and subsidiary findings of fact as to useful life, salvage value, future energy costs and related matters. however, the court concluded it need not reach a conclusion regarding whether these findings of fact were clearly erroneous, as “[i]n this particular sale-leaseback transaction . . . even if these findings of fact were correct, we would still reject the sham determination.” 240 the court continued: mr. sacks’ investment did not become a sham just because its profitability was based on after-tax instead of pre-tax projections. it is undisputed that he stood to make money on an after-tax basis. “the fact that favorable tax consequences were taken into account . . . is no reason for disallowing those consequences.” frank lyon, 435 u.s. at 580. where a transaction has economic substance, it does not become a sham merely because it is likely to be unprofitable on a pretax basis. if in a sale-leaseback, the purchaser retains 238. id. sacks, 69 f.3d at 991 (referring to frank lyon co. v. united states, 435 u.s. 561 (1978)). 239. id. 240. id. 694 florida tax review [vol.12:9 significant risks and benefits of ownership and is “the one whose capital was committed” based on cash or negotiable full recourse promissory notes, then the possible imprudence of his investment does not disqualify him from taking the depreciation deductions and tax credits. id. at 572, 581, 1298, 98 s. ct. at 1302. this is true even though the investor paid more “because [the investor] anticipated the benefit of the depreciation deductions.” id. at 5801, 98 s. ct. at 1302. 241 finally, as to the absence of pre-tax profitability the court observed: if the government treats tax-advantaged transactions as shams unless they make economic sense on a pre-tax basis, then it takes away with the executive hand what it gives with the legislative. a tax advantage such as congress awarded for alternative energy investments is intended to induce investments which otherwise would not have been made. congress sought, in the 1977 energy package, of which the solar tax credits were a part, to increase the use of solar energy in u.s. homes and businesses. h.r. rep. no. 95-543, 95th cong. 1st sess., 1978 u.s.c.c.a.n. 7673, 7678 (stating that among the goals of the national energy act is that there be solar energy in more than 2-1/2 million homes by 1985). if the commissioner were permitted to deny tax benefits when the investments would not have been made but for the tax advantages, then only those investments would be made which would have been made without the congressional decision to favor them. the tax credits were intended to generate investments in alternative energy technologies that would not otherwise be made because of their low profitability. see h.r. rep. no. 496 at 8304. yet the commissioner in this case at bar proposes to use the reason congress created the tax benefits as a ground for denying them. that violates the principle that statutes ought to be construed in light of their purpose. cabell v. markham, 148 f.2d 737 (2d cir. 1945) (l. hand, j.). 242 thus, tax credits were not in the eyes of the court a substitute for a pre-tax profit. to the contrary, a transaction otherwise having economic 241. id. 242. id. at 992. 2012] monetization of business tax credits 695 substance does not become a sham because it is predicated on an after-tax profit, at least where the tax benefits in question are perceived by congress as necessary to entice taxpayers to make the investment in question for the very reason of its lack of profitability or low profitability. d. the historic boardwalk case in historic boardwalk hall, llc v. commissioner, 243 the tax court extends and, in extending, arguably alters the principle established in sacks, by taking tax credits into account to establish economic substance. in historic boardwalk, as touched on briefly in the introductory section of the paper, a tax equity investor (pitney bowes) and a state instrumentality (new jersey sports and exposition authority or “njsea”) formed historic boardwalk hall, llc (“hbhall”) to own a convention center qualifying as a certified historic structure and eligible for 20 percent rehabilitation tax credits. in return for a cash contribution of approximately $18.2 million (to be made in stages), pitney bowes was to receive 99.9 percent of all partnership items, a 3-percent preferred return on its investment, and a guarantee of the tax benefits, including depreciation deductions and historic rehabilitation tax credits. njsea would receive 0.1 percent of all partnership items. njsea had an option to repurchase pitney bowes’ interests at any time upon giving notice that it intended to sell, dispose of, or refinance the convention center, among other things. upon exercise, njsea would have to pay pitney bowes the present value of its remaining projected tax benefits and cash flow. njsea also had a call option over pitney bowes’ interests exercisable for 12 months beginning 60 months after the convention center was placed in service. pitney bowes had a put option with respect to its interest exercisable if njsea did not exercise the call option. 244 the put option could be exercised during a 12 month period beginning 84 months after the convention center was placed in service. both the put and call options were exercisable at a price equal to the greater of: (1) 99.9 percent of the fair market value of 100 percent of the membership interests in hbhall, or (2) any accrued and unpaid preferred return payable to pitney bowes. njsea was required to purchase a guaranteed investment contract (“gic”) to backstop its payment obligations in the event it were to reacquire pitney 243. 136 t.c. 1 (2011). 244. pitney bowes also had an additional put option on its interest in the partnership exercisable only until january 15, 2001 at a put price equal to (1) capital contributions plus 15 percent interest, plus (2) fees and expenses, plus (3) $100,000, except that the $100,000 amount was only payable if rehabilitation tax credits for 2000 were less than $650,000 or phase 3 of the rehabilitation was not in service as of december 31, 2000. 696 florida tax review [vol.12:9 bowes’ interest in hbhall. 245 njsea also placed money in escrow to secure its payment obligations under the put and call options. (at the time of the trial, none of these options had been exercised.) in addition, pitney bowes and hbhall executed a “tax benefits guaranty agreement” by which the projected tax benefits allocable to pitney bowes were guaranteed. njsea was to fund any payments made under the guaranty. 246 additional details regarding the transaction are captured in the following schematic: atlantic county improvement authority new jersey sports and exposition authority (“njsea”) spectator management group historic boardwalk hall llc (“hbhall”) pb historic renovations, llc atlantic city convention center authority historic boardwalk hall management agreement long-term lease of “east hall” for $1 pitney bowes 99.9% d operating agreement 0.01% capital contribution of $18.2m and $1.2m “investor loan” c $57.2 construction loan commitment b developer’s fee of $14m; njsea guaranteed completion of the project and was liable for all cost overruns. if hb hall paid any overruns, developer’s fee reduced pro tanto. ____________________________ a equated to all amounts expended to date by njsea. interest rate set at 6.09% per annum. fixed annual amounts were payable by hbhall to the extent it had sufficient cash flow to make the payments. b interest rate set at 0.1% per annum. c interest rate started at 7.1% per annum and increased to 8.22% in 2009 d interest in profits, losses, credits and distributions 87-year sublease of east hall for $53.6m “acquisition note” a the irs argued that the partners lacked any business motivation other than transferring tax credits from njsea to pitney bowes, that the rehabilitation credits must be ignored in evaluating the economic substance of the transaction, and that, accordingly, hbhall was a sham. in part, the 245. funds contributed by pitney bowes were used to pay down a portion of njsea’s acquisition loan to hbhall; njsea used the funds so received to purchase the gic. 246. historic boardwalk, 136 t.c. at 15. 2012] monetization of business tax credits 697 government rested its argument on the existence of counterbalancing economic compulsions embedded in the put and call options it argued were structured to assure that, whether the venture was profitable or unprofitable, pitney bowes’ interest would be retired after the expiration of the credit recapture period. the irs further contended that the parties knew that hbhall would not earn a profit, that the 3-percent return in any event was sub-optimal, and that the investment (apart from tax benefits) produced a negative cash flow for pitney bowes on a present value basis. the irs also cited the various contractual provisions — the tax benefits guaranty agreement, the operating deficit guaranty, the completion guaranty — and the fact that all the partnership debt was nonrecourse to pitney bowes to show that “the parties’ economic positions were all fixed and unaffected by the return from historic boardwalk hall in any circumstance.” 247 the taxpayer argued that (1) as a matter of congressional intent, the economic substance doctrine is inapplicable (because the historic rehabilitation tax credit is in the nature of a subsidy to encourage investment in unprofitable projects); (2) alternatively, the tax credits can be taken into account in determining whether the transaction has economic substance and provided the taxpayer a net economic benefit; (3) the taxpayer had a “chance of earning a profit” even without taking the credit into account; and (4) in any event, the 3-percent preferred return gives the transaction economic significance. the tax court held that hbhall was not a sham and did not lack economic substance, finding that the 3-percent preferred return and the expected tax benefits should be viewed together, and viewed as a whole, the transactions had economic substance. 248 further, the court noted, “pitney bowes, njsea, and historic boardwalk hall had a legitimate business purpose — to allow pitney bowes to invest in the east hall’s rehabilitation.” 249 the court took express note that “[m]ost of pitney bowes’ capital contributions were used to pay a development fee to njsea” 250 but cast this in a favorable light, “pitney bowes’ investment provided njsea with more money than it otherwise would have had.” 251 as if meeting an unspoken objection to this line of reasoning, the court noted “[r]espondent does not allege that a circular flow of funds resulted in pitney bowes receiving its 3-percent preferred return on its capital contributions.” 252 247. id. at 21. 248. the court did not take up the argument that the economic substance doctrine is inapplicable. 249. historic boardwalk, 136 t.c. at 24. 250. id. 251. id. 252. id. the court does not seem to consider the fact that part of the contribution effectively was used to purchase the gic. 698 florida tax review [vol.12:9 the court offered additional factors in support of its holding: pitney bowes “faced the risk that the rehabilitation would not be completed,” and faced potential liability for environmental hazards if the insurance coverage was inadequate and njsea was financially unable to cover its indemnification of pitney bowes for such risk. 253 as to the implications of “side agreements and guaranties,” the court stated “they were necessary to attract an equity investor,” 254 and rather than showing a lack of economic substance “show that the east hall and historic boardwalk hall did in fact affect the parties’ economic positions — the agreements were meant to prevent the transaction from having a larger impact than the parties had bargained for.” 255 the court stated (without citation to the legislative history) that the legislative purpose of section 47 is “to encourage taxpayers to participate in what would otherwise be an unprofitable activity,” noted that the east hall had operated at a deficit, observed that “[t]he purpose of the credit is directed at just this problem,” and concluded that without the credit no private investor would have invested and njsea “would not have had access to the nearly $14 million paid to it as a development fee . . . .” 256 with reference to its prior decision in friendship dairies, the court noted it had “disregarded a sale-leaseback transaction which had no chance of profitability” and determined “[t]his case is distinguishable on its facts.” 257 in conclusion, on this prong of the government’s attack, the court concluded as follows: the rehabilitation of the east hall was a success. historic boardwalk hall has been operating and continues to operate day to day, with the east hall being used as a convention facility. in conclusion, historic boardwalk hall had objective economic substance. 258 the court’s discussion of the sacks case was at the start of the opinion, and the foregoing essentially was the court’s exegesis of its extension of the reasoning of the ninth circuit in that case. in response to the irs’s argument that the “development fee” was a disguised purchase price for the tax credits, 259 the court noted that a 253. id. at 25. pitney bowes invested through a special purpose entity. in addition, it was a named insured on the insurance policy. 254. historic boardwalk, 136 t.c. at 25. compare this to the requirements of rev. proc 2007-65. see supra note 204–05 and accompanying text. 255. historic boardwalk, 136 t.c. at 26. 256. id. 257. id. at 27. for friendship daires, see supra text at notes 116–120. 258. id. 259. the government, in its brief, made much of the fact that the confidential offering memorandum issued by njsea repeatedly characterized the 2012] monetization of business tax credits 699 development fee is a qualified rehabilitation expense under section 1.4812(c)(2), and further that “[r]espondent does not argue that any portion of the rehabilitation credits claimed is inappropriate or attempt to disallow any of historic boardwalk hall’s claimed credits on the ground that the development fee was not a qualified expense.” 260 having so disposed of the sham argument, the court rejected the government’s next argument that pitney bowes was not a partner in the hbhall partnership finding it “clear” in combination with its holding that hbhall had economic substance that pitney bowes was a partner in the partnership. as to the irs’s argument that pitney bowes’ interest was more akin to debt than equity, the court noted that even were it to “ignore the tax credits,” pitney bowes’ interest is not more like debt than equity “because pitney bowes is not guaranteed to receive a 3-percent return every year.” 261 in fact, without reference to the gic, the court stated that “pitney bowes might not receive its preferred return until njsea purchased [its] membership interest, if at all.” 262 the irs’s third argument was that hbhall never acquired tax ownership of the east hall in light of all of the burdens of operation and rehabilitation retained by njsea (including the risk it was not guaranteed to receive payments on its acquisition loan each year) and njsea’s call option. the court recognized factors pointing in both directions, but concluded that njsea transferred the benefits and burdens of ownership of the east hall to hbhall. on the question of njsea’s purchase option, the court noted with reference to the tax credit recapture rules that “the statute demonstrates an anticipation of repurchase and creates a disincentive. congress established a means to police early dispositions and created a deterrent to a premature buyout. for these reasons, njsea’s purchase option was not contrary to the purpose of the rehabilitation tax credit.” 263 finally, the court rejected the irs’s arguments under the regulations section 1.701-2 anti-abuse rules. 264 it did so largely in reliance on example 6 transaction as a “sale” of the tax credits. see opening brief for respondent at 85, historic boardwalk hall, llc v. commissioner, 136 t.c. 1 (2011) (no. 11273-07). 260. historic boardwalk, 136 t.c. at 25. the irs, of course, had disallowed the claimed tax credits in their entirety on the basis that the transaction constituted an impermissible attempt to purchase the tax credits. 261. id. at 30. 262. id. of course, if true, this cuts both ways. 263. id. at 33. interestingly, the original rationale for a recapture rule was to prevent taxpayers from “churning” — selling after the credit is generated and using the proceeds to make an additional investment qualifying for a tax credit. the focus was not on “repurchases” by other parties to the transaction. see supra note 39 and accompanying text. 264. historic boardwalk, 136 t.c. at 34–37. regulations section 1.701-2(b) gives the commissioner the authority to recast transactions for federal income tax 700 florida tax review [vol.12:9 of regulations section 1.701-2(d), dealing with an allocation of low-income housing tax credits (rejecting the irs’s attempt to distinguish the example either factually or based on the fact that section 42 does not require a pre-tax profit motive) and congressional intent: purposes if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal income tax liability in a manner that is inconsistent with subchapter k. regulations section 1.701-2(a) provides that the following requirements are implicit in the intent of subchapter k (paraphrasing): (1) the partnership must be bona fide and each partnership transaction or series of related transactions must be entered into for a substantial business purpose; (2) the form of each partnership transaction must be respected under substance over form principles; and (3) the tax consequences under subchapter k to each partner of partnership operations and of transactions between the partner and the partnership must accurately reflect the partners’ economic agreement and clearly reflect the partner’s income. regulations section 1.701-2(a)(3) notes certain provisions of subchapter k adopted for reasons of administrative convenience or to promote certain policy objectives (“special provisions”) the application of which may produce results inconsistent with the clear reflection of income requirement, and provides that if a transaction satisfies requirements (1) and (2), the clear reflection of income requirement will be treated as satisfied to the extent that the application of such a special provision to the transaction and the ultimate tax results, taking into account all the relevant facts and circumstances, are clearly contemplated by the special provision (citing, among others, example 6 of regulations section 1.701-2(d) (as an illustration of the application of the “value equals basis rule” of regulations section 1.704-1(b)(2)(iii)(c)). the regulations provision states that the determination of whether a transaction involving a partnership ought to be recast is made with consideration given to the statutory provision giving rise to the tax benefits and all pertinent facts and circumstances. regulations section 1.701-2(c) provides a nonexclusive list of factors to be considered, including whether: (1) the present value of the partners’ aggregate federal tax liability is substantially less than had the partners owned the partnership’s assets and conducted the partnership’s activities directly; (2) one or more partners who are necessary to achieve the claimed tax results either have a nominal interest in the partnership, are substantially protected from any risk of loss from the partnership’s activities, or have little or no participation in the profits from the partnership’s activities other than a preferred return that is in the nature of a payment for the use of capital; (3) partnership items are allocated in compliance with the literal language of regulations sections 1.704-1 and 1.704-2, but with results that are inconsistent with the purpose of section 704(b) and those regulations; or (4) the benefits and burdens of ownership of property nominally contributed to the partnership are in substantial part retained (directly or indirectly) by the contributing partner (or a related party). 2012] monetization of business tax credits 701 although pitney bowes’ aggregate tax liability was reduced as a result of this transaction, congress intended to use the rehabilitation tax credit to draw private investments into public rehabilitation. further the regulations clearly contemplate a situation in which a partnership is used to transfer valuable tax attributes from an entity that cannot use them . . . to individuals who can. 265 265. historic boardwalk, 136 t.c. at 37. regulations section 1.701-2(d), example 6, describes a and b, high-bracket taxpayers, and x, a corporation with net operating loss carryforwards, who form a general partnership to own and operate a building that qualifies for the lihtc. the project is financed with both cash contributions from the partners and nonrecourse indebtedness. the partnership agreement specially allocates income and deductions, including depreciation deductions attributable to the building, to a and b equally in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the building. the lihtc credits are allocated to a and b in accordance with the allocation of depreciation deductions. the nonrecourse indebtedness is validly allocated to the partners under the rules of section 1.752-3, thereby increasing the basis of the partners’ respective partnership interests. the basis increase created by the nonrecourse indebtedness enables a and b to deduct their distributive share of losses from the partnership against their nonpartnership income and to apply the credits against their tax liability: at a time when the depreciation deductions attributable to the building are not treated as nonrecourse deductions under section 1.704-2(c) (because there is no net increase in partnership minimum gain during the year), the special allocation of depreciation deductions to a and b has substantial economic effect because of the value-equals-basis safe harbor contained in section 1.704-1(b)(2)(iii)(c) and the fact that a and b would bear the economic burden of any decline in the value of the building (to the extent of the partnership’s investment in the building), notwithstanding that a and b believe it is unlikely that the building will decline in value (and, accordingly, they anticipate significant timing benefits through the special allocation). moreover, in later years, when the depreciation deductions attributable to the building are treated as nonrecourse deductions under section 1.704-2(c), the special allocation of depreciation deductions to a and b is considered to be consistent with the partners’ interests in the partnership under section 1.704-2(e). reg. § 1.701-2(d) ex. 6(ii). the example further states that “subchapter k is intended to permit taxpayers to conduct joint business activity through a flexible economic arrangement without incurring an entity-level tax . . . . thus, even though the partners’ aggregate federal tax liability may be substantially less than had the partners owned the partnership’s assets directly (due to x's inability to use its allocable share of the 702 florida tax review [vol.12:9 the court did not reach (and the irs did not brief) what a technical analysis under subchapter k could reveal based on its findings — i.e., assuming that the partnership is not a sham, pitney bowes is a bona fide partner, hbhall is the tax owner of east hall and the anti-abuse rules do not apply. based on the parties’ briefs, it would appear that pitney bowes had no deficit restoration obligation. while pitney bowes nominally held 99.9 percent of the equity on account of its $18.2 million capital contribution (implying an equity contribution by njsea of approximately $19,000), njsea, a 0.1 percent partner, had loaned hbhall approximately $100 million. was this debt or equity? the tax advisers to pitney bowes were concerned about this, as noted in the irs’s opening brief, 266 yet the irs did not in fact brief the issue. if debt, was it recourse or nonrecourse? was it “partner nonrecourse debt”? if so, would depreciation deductions essentially all nonetheless be allocable to pitney bowes? (presumably not and in any event section 704(d) would limit pitney bowes’s deductions.) what was the section 704(b) analysis that justified allocating 99.9 percent of the tax credits to pitney bowes? does it matter (if factually correct) that the project was more or less assured of losing money and there was no realistically foreseeable net cash flow? what impact should the use of contributed capital to buy a gic have on the analysis? njsea’s purported call option? pitney bowes’ put option? the tax benefit guaranty? should part of the funds supplied by pitney bowes have been allocated to the cost of the gic (i.e., as acquired on pitney bowes’s behalf)? to payment for the tax benefit guaranty? if so, how much? was some or all of the development fee a guaranty fee? if not, why did njsea agree to the guarantees? if so, then at a minimum was some portion of the developer’s fee ineligible for the rehabilitation tax credit? how does one account for the completion and operating deficit guarantees? so, there is a whole host of unexamined or underexamined issues. however, we can observe that an historic rehabilitation project was completed and the section 47 credit operated to defray the costs. the question to be considered by the third circuit on appeal ultimately is whether the tax court was right to conclude on the facts before it that the parties’ transaction, to borrow from gregory v. helvering, accomplished “the thing which the statute intended.” 267 while sacks articulates the principle that a transaction otherwise having economic substance does not become a sham because it is predicated on an after-tax profit, at least where the tax benefits effectively function as a partnership's losses and credits) . . . the transaction is not inconsistent with the intent of subchapter k.” id. at (iii). 266. opening brief for respondent at 31, historic boardwalk hall, llc v. commissioner, 136 t.c. 1 (2011) (no. 11273-07). 267. gregory v. helvering, 293 u.s. 465, 469 (1935). 2012] monetization of business tax credits 703 targeted, congressionally mandated subsidy, the question is whether a corollary rule can also be articulated: viz., a transaction otherwise lacking economic substance is not imbued with economic substance because it generates a profit after accounting for associated tax benefits, even where the tax benefits effectively function as a targeted, congressionally mandated, subsidy. such a transaction would seem to be the kind of “paper transaction” eschewed by the court in friendship dairies. 268 however, the credit at issue in that case was the regular investment credit, and the court specifically concluded that “at no point do the committee reports indicate that the credit was intended to transform unprofitable transactions into profitable ones.” 269 in historic boardwalk, the credit at issue, in contrast, was one that the tax court expressly determined was enacted to encourage participation in otherwise unprofitable activities. against that backdrop, the tax court found the requisite economic substance existed, viewing non-tax economics and the tax credits together and taking into account the risks and realities of the investment as it found them to be (and notwithstanding the significant extent to which pitney bowes was insulated from the risk of loss). whether the corollary rule above is a fair extrapolation from existing case law is unclear. what is clear is that, under the case law, the absence of a pre-tax profit and profit objective in tax credit subsidy cases is not dispositive of the outcome. iv. enactment of section 7701(o) a lot of these [tax credit] deals are not economically feasible without the tax benefits, so maybe they should not be respected, but the policy is to promote investment. we’re hoping for legislative history and economic substance guidance. 270 a. basic summary of the provision section 1409 of the health care and education reconciliation act of 2010 (the “2010 act”) 271 added new section 7701(o) to the code, effective with respect to transactions entered into on or after march 31, 2010. section 7701(o)(1) (entitled “clarification of economic substance doctrine”) 268. see supra notes 116–20 and accompanying text. 269. friendship dairies, inc. v. commissioner, 90 t.c. 1054, 1065-66 (1988). 270. statement of christopher kelley, special counsel, internal revenue service office of assoc. chief counsel (passthroughs and special indus.), in lee a. sheppard, news analysis: partnership administrative update, 127 tax notes 962, 963 (may 31, 2010). 271. hcera 2010, supra note 26, § 1409, 124 stat. at 1067–70. 704 florida tax review [vol.12:9 provides that, in the case of any transaction “to which the economic substance doctrine is relevant,” the transaction shall be treated as having economic substance only if (i) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position; and (ii) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction. section 7701(o)(5)(a) provides that the term “economic substance doctrine” means “the common law doctrine under which tax benefits under subtitle a with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.” section 7701(o)(5)(c) states that the determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if section 7701(o) had never been enacted. section 7701(o)(2)(a) provides that a transaction’s potential for profit shall be taking into account in determining whether the transaction satisfies the requirements of section 7701(o)(1) only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits. 272 for transactions entered into on or after march 31, 2010, to which the economic substance doctrine is relevant, section 7701(o)(1) mandates the use of a conjunctive two-prong test to determine whether a transaction shall be treated as having economic substance. the first prong, found in section 7701(o)(1)(a), requires that the transaction change in a meaningful way 272. the 2010 act also added section 6662(b)(6), which provides that the accuracy-related penalty imposed under section 6662(a) applies to any underpayment attributable to any disallowance of a claimed tax benefit because of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet any similar rule of law (collectively a section 6662(b)(6) transaction). id. at § 1409(b)(2). in addition, the 2010 act added section 6662(i), which increases the accuracy-related penalty from 20 percent to 40 percent for any portion of an underpayment attributable to one or more section 6662(b)(6) transactions with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return or in a statement attached to the return. furthermore, new section 6662(i)(3) provides that certain amended returns or any supplement to a return shall not be taken into consideration for purposes of section 6662(i). id. at § 1409(b)(2). finally, the 2010 act amended section 6664(c) so that the reasonable cause exception for underpayments found in section 6664(c)(1) shall not apply to any portion of any underpayment attributable to a section 6662(b)(6) transaction; similarly amended section 6664(d) so that the reasonable cause exception found in section 6664(d)(1) shall not apply to any reportable transaction understatement (within the meaning of section 6662a(b)) attributable to a section 6662(b)(6) transaction; and amended section 6676 so that any excessive amount (within the meaning of section 6676(b)) attributable to any section 6662(b)(6) transaction shall not be treated as having a reasonable basis. id. at § 1409(c), (d). 2012] monetization of business tax credits 705 (apart from federal income tax effects) the taxpayer’s economic position. the second prong, found in section 7701(o)(1)(b), requires that the taxpayer have a substantial purpose (apart from federal income tax effects) for entering into the transaction. in notice 2010-62, 273 providing interim guidance regarding the codification of the economic substance doctrine, the irs states that it will continue to rely on relevant case law under the common-law economic substance doctrine in applying the two-prong conjunctive test in section 7701(o)(1): accordingly, in determining whether a transaction sufficiently affects the taxpayer’s economic position to satisfy the requirements of section 7701(o)(1)(a), the irs will apply cases under the common-law economic substance doctrine (as identified in section 7701(o)(5)(a)) pertaining to whether the tax benefits of a transaction are not allowable because the transaction does not satisfy the economic substance prong of the economic substance doctrine. similarly, in determining whether a transaction has a sufficient nontax purpose to satisfy the requirements of section 7701(o)(1)(b), the irs will apply cases under the common-law economic substance doctrine pertaining to whether the tax benefits of a transaction are not allowable because the transaction lacks a business purpose. 274 as to the determination of whether a transaction falls within the operation of section 7701(o) (i.e., is a transaction to which the economic substance doctrine is “relevant”), the notice provides that the irs will continue to analyze when the economic substance doctrine will apply in the same fashion as it did prior to the enactment of section 7701(o). if authorities, prior to the enactment of section 7701(o), provided that the economic substance doctrine was not relevant to whether certain tax benefits are allowable, the irs will continue to take the position that the economic substance doctrine is not relevant to whether those tax benefits are allowable. 275 the notice states that “[t]he treasury department and the irs do not intend to issue general administrative guidance regarding the types of transactions 273. notice 2010-62, 2010-40 i.r.b. 411. 274. id. 275. id. 706 florida tax review [vol.12:9 to which the economic substance doctrine either applies or does not apply.” 276 b. relevant legislative history there is no official legislative history accompanying the enactment of section 7701(o). the principal document practitioners are consulting for assistance in understanding the provision, therefore, is the joint committee explanation of the provision. 277 the jct technical explanation acknowledges the existence of overlapping common-law doctrines that courts can apply to deny the tax benefits of a tax-motivated transaction notwithstanding that the transaction may conform to the literal technical requirements of a tax provision — among them, the “economic substance” doctrine, but also “closely related doctrines” such as the “sham transaction doctrine,” “business purpose doctrine,” and “substance over form doctrine.” the jct technical explanation notes the conflicting views expressed in judicial decisions as to the role of business purpose in the economic substance evaluation and variations in the formulation of what constitutes a sufficient non-tax economic benefit to justify claimed tax benefits. section 7701(o), it explains, “provides a uniform definition of economic substance, but does not alter the flexibility of the courts in other respects.” 278 276. id. 277. staff of joint comm. on taxation, 111th cong., technical explanation of the revenue provisions of the “reconciliation act of 2010,” as amended, in combination with the “patient protection and affordable care act,” 142 (comm. print 2010) [hereinafter “jct, technical explanation”]. arguably, the house budget committee’s report, h.r. rep. no. 111-443 (2010), constitutes official legislative history. however, this is questionable as it is based on an explanation of the codification proposal prepared by the house ways & means committee, and is dated october 14, 2009, for h.r. 3200, 109th cong. (2005), a bill containing differences from the final legislation. see nysba report, supra note 229, at 13 n.33, for a more comprehensive discussion. as also discussed in the nysba report, while reports prepared by the joint committee staff do not rise to the level of legislative history, given the timing of the release of the jct technical explanation (four days before either house of congress voted on the final legislation) and the absence of any other congressional guidance on the law, as enacted, the jct technical explanation should carry greater weight in this case than in the case of jct reports generally. id. 278. jct, technical explanation, supra note 277, at 152. in a similar vein, elsewhere the jct technical explanation states that “[t]he provision is not intended to alter or supplant any other rule of law, including any common-law doctrine or provision of the code or regulations or other guidance thereunder; and it is intended the provision be construed as being additive to any such other rule of law.” id. at 155. 2012] monetization of business tax credits 707 on the threshold question of whether the economic substance doctrine is “relevant” to a transaction, the jct technical explanation states that “[t]he determination . . . is made in the same manner as if [section 7701(o)] had never been enacted. thus, the provision does not change present law standards in determining when to utilize an economic substance analysis.” 279 pinned to this statement is footnote 344 — a footnote that has garnered a fair amount of attention for its relevance to tax credit transactions: if the realization of the tax benefits of a transaction is consistent with the congressional purpose or plan that the tax benefits were designed by congress to effectuate, it is not intended that such tax benefits be disallowed. see, e.g., treas. reg. sec 1.269-2, stating that characteristic of circumstances in which an amount otherwise constituting a deduction, credit, or other allowance is not available are those in which the effect of the deduction, credit, or other allowance would be to distort the liability of the particular taxpayer when the essential nature of the transaction or situation is examined in the light of the basic purpose or plan which the deduction, credit or other allowance was designed by the congress to effectuate. thus, for example, it is not intended that a tax credit (e.g., section 42 (low-income housing credit), section 45 (production tax credit), section 45d (new markets tax credit), section 47 (rehabilitation credit), section 48 (energy credit), etc.) be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage. 280 the meaning of footnote 344, of course, is less than clear. after all, in both sacks and historic boardwalk, when presented with transactions involving tax credits of the type enumerated, the courts utilized an economic substance analysis, albeit a different version of the economic substance analysis than that required by the new “uniform” definition. yet, the implication of footnote 344 would seem to be that the economic substance doctrine is not relevant in such cases. rather the test is whether the transaction triggering the tax credit is one in which “in form and substance” the taxpayer made “the type of investment” or undertook “the type of activity” that the credit was intended to “encourage.” 279. id. 280. id. 708 florida tax review [vol.12:9 is this to say that tax credit transactions fall under “closely related” doctrines such as “sham transaction” and “substance over form?” clearly, the requirement that tax credit transactions conform “in form and substance” to the relevant legislative mandate confirms that the taxpayer claiming the credit must meet a substantive test — perhaps just not the test laid out in section 7701(o)(1). 281 literally speaking, section 7701(o), where applicable, does not impose a pre-tax profit/profit motive test. rather, it requires that the transaction “changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position” 282 and that the taxpayer has a substantial non-tax purpose for entering into the transaction. the taxpayer in sacks ostensibly could meet this test. however, if pre-tax profit potential is offered as the predicate for satisfying the economic substance test, the heightened standards of section 7701(o)(2) (present value of reasonably expected pre-tax profit substantial in relation to present value of expected net tax benefits) must be satisfied. as commentators have noted, it is not clear that many tax credit transactions would satisfy this test, and certainly not if the conclusion is that tax credits cannot be treated as “cash” for purposes of the pre-tax profit test. 283 if a tax credit transaction does not pass muster on 281. see nysba report, supra note 229, at 25 (recommending that for non-abusive leasing and tax equity transactions nonetheless not clearly intended by congress, irs and treasury issue specific guidance “such as an update to the leasing, wind energy and similar guidelines or other means, that would instruct taxpayers as to the proper method for conducting those transactions such that they were sufficiently economic to be viewed as ‘appropriate’ and not in violation of section 7701(o).”). see also id. at 76–77 (proposing safe harbors “for when transactions of this nature are deemed to satisfy section 7701(o) by specifying minimum amounts of genuine ‘at risk’ investment and profit without regard to tax benefits (e.g., a minimum, pre-tax irr)).” 282. jct, technical explanation, supra note 277, at 155. 283. see supra part iii. a. 4., iii. b. see also hershel wein, tax credit investments and the ossification of the economic substance doctrine 24 (oct. 24, 2011) [hereinafter wein, tax credit investments] (unpublished article) (on file with the (other) tax club) (“as the new provision states that only pre-tax amounts are to be utilized in determining the existence of pre-tax profit in a transaction, a strong argument can be made that the credits as cash approach no longer has any legal basis and the court in historic boardwalk hall would have been hard pressed to adopt its analysis if section 7701(o) has been applicable”). cf. toby cozart, does section 7701(o)’s pre-tax profit test permit tax equity financings? part one: present valuation, 52 tax mgm’t memorandum 267, 270 (2011) (referring to “advice frequently rendered by responsible tax advisers, under prior law, with respect to tax-incentivebased financings” that require transactions to show “a 2-3% pre-tax irr, taking income tax credits (or treasury cash grants) into account as the equivalent of cash” and noting that “[s]ome law firms representing tax equity investors have reportedly adopted this advice for purposes of opining on these 2012] monetization of business tax credits 709 that basis, then does it simply fail? footnote 344 suggests further inquiry — or perhaps a different inquiry — is needed, but it would seem the transaction may yet fail if, for example, the investors are too insulated from the risks and realities of the venture (i.e., such that allowance of the tax benefits would be perceived as resulting in a distortion of tax liabilities). while the requirement of a meaningful equity stake at the risk of the venture is nothing new, the question is how this fits in an age of 30 percent tax credits and grants. the jct technical explanation sheds no additional light. as regards leasing transactions in general, it states that “like all other types of transactions, [they] will continue to be analyzed in light of all the facts and circumstances.” 284 c. irs field directive on the codified economic substance doctrine on september 14, 2010, the irs large business and international division (“lb&i”) issued a procedural directive to the field requiring approval at the level of director of field operations (“dfo”) of any proposal to impose the new strict liability penalty under section 7701(o) pursuant to section 6662(b)(6). 285 on july 15, 2011, lb&i issued a further directive (the “directive”) providing guidance on when it is appropriate to seek dfo approval to raise the economic substance doctrine on audit. 286 it also sets forth a series of inquiries the examiner must develop and analyze in order to seek approval for ultimate application of the doctrine in the examination. the first step of a four-step process the examiner is to undergo is an evaluation of whether the circumstances in the case are such that application of the economic substance doctrine likely is not appropriate. the transactions subsequent to § 7701(o)’s effectiveness, when they otherwise conclude that the transaction is not abusive.”). cozart further notes that, even taking tax credits (and grants) into account as the equivalent of cash, use of the “net present value approach” recommended by the new york state bar association tax section executive committee for determining pre-tax profit that relies on the taxpayer’s cost of funds as the discount rate “could invalidate a great many tax equity financings in the marketplace if the esd were deemed relevant.” id. at 274. “more fundamentally,” he states, “[it] would generally deprive developers and sponsors of the relevant property, who wish to retain a subordinate economic interest in it, of an economic justification for entering into the transaction.” id. 284. jct technical explanation, supra note 277, at 153. 285. heather c. maloy, comm’r, irs large and mid-size bus. div., directive for industry directors, lmsb-20-0910-024 (sept. 14, 2010). see supra note 272 and accompanying text. 286. heather c. maloy, comm.’r, irs. large bus. & int’l div., lb&i directive for industry directors, lb&i-4-0711-015 (july 5, 2011) [hereinafter the maloy, lb&i directive]. 710 florida tax review [vol.12:9 directive notes that among such cases is a “transaction that generates targeted tax incentives [and] is, in form and substance, consistent with congressional intent in providing the incentives.” 287 on the other hand, application of the doctrine may be appropriate where a transaction is “highly structured” or a taxpayer’s “potential for gain or loss is artificially limited.” 288 if the examiner concludes that application of the doctrine may be appropriate under circumstances where the transaction involves tax credits “that are designed by congress to encourage certain transactions that would not be undertaken but for the credits” then the examiner is required to obtain specific approval of his or her manager in consultation with local counsel before proceeding with application of the doctrine. 289 further, in all cases, an examiner is not to apply the economic substance doctrine if “another judicial doctrine (e.g., substance over form or step transaction) more appropriately address[es] the noncompliance that is being examined.” 290 this likewise is the case if recharacterizing the transaction (e.g., recharacterizing debt as equity) is a more appropriate line of attack. finally, the directive provides as follows. [u]ntil further guidance is issued, the penalties provided in sections 6662(b)(6) and (i) and 6676 are limited to the application of the economic substance doctrine and may not be imposed due to the application of any other ‘similar rule of law’ or judicial doctrine (e.g., step transaction doctrine, substance over form or sham transaction).” 291 v. the case for a new federal tax benefit transfer regime the enactment of section 7701(o) has both highlighted and heightened the uncertainties as to the tax treatment of transactions involving targeted tax incentives. at the same time, in recognition of this, corollary to the enactment of section 7701(o) has been the pronouncement in the jct technical explanation that “[i]f the realization of the tax benefits of a 287. id. others include transactions that have a significant risk of loss. 288. id. 289. id. 290. id. 291. maloy, lb&i directive, supra note 286. see wein, tax credit investments, supra note 283, at 29–30 (considering the elasticity of the “sham transaction doctrine” in the case law). cf. reg. 1.42-4(b); supra notes 141–48 and accompanying text (despite non-applicability of a pre-tax profit requirement in the context of lihtc, a lihtc nonetheless may be disallowed on other grounds, including “sham or economic substance analysis”). 2012] monetization of business tax credits 711 transaction is consistent with the congressional purpose or plan that the tax benefits were designed by congress to effectuate, it is not intended that such tax benefits be disallowed.” 292 we have the further statement in the jct technical explanation that “it is not intended that a tax credit . . . be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was designed to encourage.” 293 this is mirrored by the directive, which notes that among the transactions to which application of the economic substance doctrine likely is inappropriate is a “transaction that generates targeted tax incentives [that is], in form and substance, consistent with congressional intent in providing the incentives.” 294 since the determination of whether the economic substance doctrine is “relevant” is meant to be made as though section 7701(o) never was enacted, such statements imply a conclusion that under the case law the economic substance doctrine has not been deemed relevant to tax credit transactions. as discussed above, that really is not a supportable stance. be that as it may, a fairly specific test has now been enunciated. thus, if a taxpayer makes an investment or engages in a transaction meant to generate targeted tax incentives and it is determined that the transaction in fact, in form and substance, conforms with congressional intent in providing the incentive (the “congressional intent test”), presumably that is the end of the inquiry. some commentators lament that this is an ambiguous test, and that is a fair comment, but a test nonetheless it is. presumably, under this test, if a transaction conforms with congressional intent in form but not in substance, the transaction fails and the hoped-for tax benefit will be disallowed. the directive could be read as implying, to the contrary, that in such a case one instead then proceeds to an analysis under section 7701(o). however, that may be a false inference. as noted above, the directive states that an examiner is not to apply the economic substance doctrine if another judicial doctrine, such as substance over form, “more appropriately addresses the noncompliance that is being examined.” 295 the central challenge for tax credit transactions under the congressional intent test is to determine what constitutes a transaction in form and substance that is the “type of investment” or “type of activity” that the credit was designed to encourage. in the lihtc context, we know the transaction need not generate a pre-tax profit. it seems reasonable to extrapolate that this is true as to the full array of tax credits available today. after all, the initial judgment on this question currently reflected in 292. jct technical explanation, supra note 277, at 152 n.344. 293. id. 294. maloy, lb&i directive, supra note 286. 295. id. 712 florida tax review [vol.12:9 regulations section 1.42-4 was reflected in a revenue ruling, 296 and courts can entertain the same points of policy and legislative intent as can the treasury in the context of a revenue ruling as evidenced by the ninth circuit’s decision in sacks. 297 does the transaction generating the tax credit in question not only “need not generate” but in fact “need not to generate” a pre-tax profit? there seemingly is some logic to support that notion, since the operative intent is to benefit and thereby incentivize transactions and investments that would be unprofitable but for the tax incentives. however, that implies a level of transaction-specific factual scrutiny that is both administratively impractical and decidedly outside the contemplation of the legislators. to the contrary, as explained in a recent joint committee print, 298 tax credits and other subsidies apply to “infra-marginal activity” — activity that would have occurred without the provision of the incentive. the result is that “for such activity the government incurs an expense in subsidizing it in order to induce others at the margin to engage in the tax-favored activity.” 299 this marks an “inherent inefficiency” in the tax credit mechanism since some projects “would be profitable investments in the absence of any subsidy.” 300 the more pertinent threshold questions would appear to be (1) whether the tax credit in question is, indeed, in the nature of a subsidy and (2) if so, who the intended beneficiaries are. in the simple case there are no difficulties discerning this. for example, a taxpayer engages directly in activities eligible for the production credit, taking all risks inherent in the targeted business and entitled to all rewards. this is a clear case of a “transaction pursuant to which, in form and substance,” the taxpayer engaged in a “type of activity that the credit was intended to encourage.” if, however, the producer lacks a sufficient tax base to use the production tax credit and associated depreciation deductions, some form of tax credit monetization structure will need to be deployed to deliver the benefit of the subsidy to the producer. as discussed above, the typical vehicles for this are lease structures and partnership “flip” transactions. the “true lease” guidelines set forth in rev. proc. 2001-28 and the rev. proc. 2007-65 safe harbor for partnership flip structures involving wind projects provide benchmarks (albeit pre-section 7701(o) benchmarks) for evaluating whether an investor is participating and invested sufficiently in a project to be justified in claiming a tax credit and other tax benefits associated with investment in a project. however, insofar as tax credit transactions are structured to insulate the 296. see supra note 145 and accompanying text. 297. see supra note 231 and accompanying text. 298. see jct, energy-related tax expenditures, supra note 62, at 24. 299. id. 300. see jct, tax credits for electricity production, supra note 193, at 17. 2012] monetization of business tax credits 713 investor from economic risk and depend on a combination of tax credits and cash flow to demonstrate “pre-tax profit,” satisfaction of the congressional intent test is by no means assured. 301 in the lihtc context, as discussed in part ii.d.2. above, the irs and the treasury department concluded that “congress contemplated that tax benefits such as the credit and depreciation would be available to taxpayers investing in low-income housing, even though such an investment would not otherwise provide a potential for economic return.” at the same time, section 1.42-4(b) preserves the idea that “losses, deductions, or credits attributable to the ownership and operation of a qualified low-income building . . . may be limited or disallowed under other provisions of the code or principles of tax law,” including “sham” or “economic substance” analysis and “ownership analysis.” 302 the quid pro quo for committing to an investment generating below-market rents and a pre-tax loss is the lihtc and associated benefits but the taxpayer claiming lihtcs has to have sufficient hallmarks of ownership to sustain its position. the transaction cannot be a sham. if another person has a superior claim to ownership of the project (for example, such person holds a dollar purchase option), it will not suffice to lay claim to the lihtcs that the “investor” holds legal title to the property. it would seem conformity in “form and substance” with congressional intent means at least passing muster under the type of sham/economic substance/ownership analysis that is referenced by regulations section 1.42-4(b). however, historically, outside the lihtc context, it appears that most advisers have concluded that an investor’s tax position is better secured if it in fact can show a pre-tax profit in connection with the investment. thus, whereas the developer, lacking a tax base, would like to retain all of the cash flow from the project and allocate the investors solely tax benefits for their return, this will meet with the objection that the investors must show a pre-tax profit. the tax credits may even be counted as cash in calculating “pre-tax” profit, but without some allocation of cash flow as well, the investors may be unable to demonstrate a pre-tax profit. 303 one commentator has observed that “[t]he adoption of [such] a credits as cash approach . . . puts a brake on the use of structures which are 301. see kevin juran & michael bauer, tax-based leasing, tax credits and economic substance, 76 daily tax rep. (bna) j-4 (2010) (“when does the absence of both a true economic profit and a meaningful equity stake at risk mean that in form and substance the transaction is not one which the credit was intended to encourage?”). 302. reg. § 1.42-4(b) (citing frank lyon co. v. united states, 435 u.s. 561 (1978)). 303. see generally supra note 281–82 and accompanying text. see also wein, tax credit investments, supra note 283, at 18 (“under the credits as cash approach . . . some of the pre-tax cash flow will have to be allocated to the investor to satisfy the esd.”). 714 florida tax review [vol.12:9 essentially pure sales of tax benefits to investors, at least in those instances when the credits alone are insufficient to generate a ‘profit.’” 304 however, this leads, more or less directly, to the question of what would be so bad about that. in fact, the notion that the tax law requires that the investor extract more in the way of non-tax economic benefits from the sponsor/developer that is the “natural” beneficiary of the subsidy in order for the subsidy to operate appears to be a perversion of applicable non-tax policy goals. the goal of the system should be the efficient delivery of the government subsidy to the intended beneficiary. uncertainty as to the ability of investors to successfully claim the targeted tax incentives, attendant complexities in the structuring of transactions’ and high transaction costs run counter to this goal. if, in order to claim the targeted tax benefits, the investor must demonstrate a meaningful equity stake in the venture subject to the risks of the venture, it will require a higher return commensurate with the risks it has assumed, which return will reduce the subsidy delivered via its investment. indeed, a requirement, on whatever predicate, that the investor show an expectation of profit from cash flow and residual value over and above the economic return provided by the tax benefits or grant erodes the subsidy effect. the foregoing observations notwithstanding, consistent with generally accepted tax policy principles, under the current state of the law a substance test applies. this appears to be a function of a normative view of the tax benefits in question — i.e., seeing the tax credits and accelerated depreciation deductions as structural components of the income tax incident to the computation of the “normal tax” of the taxpayer. the early history of the investment credit (discussed in part ii.a. above) comports with this understanding and provided ballast for the tax court’s holding in friendship dairies that a transaction tantamount to a sale of the investment credit “would be a distortion of congressional intent” 305 that must not stand. it can be argued that the historic rehabilitation tax credit, as originally enacted, similarly was designed as a structural component of the income tax, rather than a subsidy. it marked an extension of the “initial policy objective of the investment credit” 306 to apply to longer-lived structures (properties a mere twenty years old or older) as well as equipment. like the investment credit, the focus of the historic rehabilitation tax credit was on broad policy goals such as modernization and stimulation of 304. see id. at 18. elsewhere, this same author observes that “[a] requirement that the tax capital investor earn a ‘significant’ pre-tax return (as compared to the tax benefits) would result in the end user of the property making excessive payments to lease the property, and generating more after-tax profit than the tax capital investor market would otherwise require.” id. at 28. 305. friendship dairies, inc. v. commissioner, 90 t.c. 1054, 1067 (1988). 306. h.r. rep no. 95-1445, at 86 (1978). 2012] monetization of business tax credits 715 investment within a broad class of property generally. 307 in 1981, the historic rehabilitation tax credit was re-focused on older buildings and certified historic structures and further restricted (but preserved) under the 1986 act. in preserving the credit in 1986, the senate report explained that a “tax incentive is needed” because “the social and aesthetic values of rehabilitating and preserving older structures are not necessarily taken into account in investors’ profit projections.” 308 this is “economist-speak” for a subsidy (values such as those referenced are “positive externalities” that justify a subsidy). 309 the energy credit, as first enacted, included both a carrot (credit for alternative energy investments) and a stick (denial of credit and accelerated depreciation for new fossil fuel boilers and combustors). as previously noted, the credit for investment in wind and solar projects originally was refundable, clearly signaling that the credit was intended from the outset as a targeted subsidy in those cases. finally, as discussed above, while the 1986 act had as its primary goal greater neutrality in the tax system, it also turned to the use of tax credits qua subsidies to achieve targeted objectives – in extending the historic rehabilitation and energy tax credits, but most particularly with enactment of the lihtc. 310 thus, the case can be made that a normative view of these tax credits is misplaced. indeed, with the enactment in 1981 of the safe harbor leasing rules, for a short time the case was successfully made that even the basic investment credit and accelerated depreciation deductions should be viewed as subsidies and therefore “non-structural.” 311 this, in part, was a function of the sheer magnitude of the tax benefits, establishing as they did a negative effective tax rate on income from qualifying equipment. congress thus concluded the tax benefits should be transferable and that “unfettered” leasing rules would serve as the delivery mechanism both to effect transfers 307. see supra notes 56–61 and accompanying text. 308. see s. rep. no. 99-313, at 753 (1986). 309. see jct, energy-related tax expenditures, supra note 62, at 21– 22. 310. the lihtc is perhaps the clearest case of a quid pro quo: the investor “fronts” a subsidy (by accepting below market rents) and is reimbursed via the lihtc and accelerated depreciation deductions. 311. analytically, only the accelerated portion of depreciation deductions should have been viewed as in the nature of a subsidy and therefore transferable. that is, the user should be allowed depreciation deductions matching economic depreciation of the assets; the “buyer” should be allowed to claim the accelerated deductions “and recapture them as the asset depreciates economically and a deduction is allowed to the user.” koffey, safe harbor leasing, supra note 88, at 2– 5. 716 florida tax review [vol.12:9 of the benefits and to secure a substantial portion of the subsidy for the transferor (lessee/user). in the current timeframe, significant tax incentives have been enacted to encourage investment in renewable energy projects in particular. the energy credit demonstrably functioned as a subsidy even before the enactment as part of arra of the cash grant program. as noted above, a grant-in-lieu-of program also was adopted for a time for lihtc projects and the gao has recommended converting the nmtc into a grant program. all of this points to the conclusion that the modern array of business tax credits discussed in this article — the historic rehabilitation tax credit, production tax credit, energy credit, lihtc, and nmtc — are not best seen as structural components of the income tax, but rather as “government subsidies that are located in the internal revenue code merely as a matter of convenience.” 312 so understood, the focus should be on determining the most efficient means of delivering these subsidies to the intended beneficiaries. in certain cases, the intended beneficiary may have a sufficient tax base to claim the tax incentives itself on a current basis but in many, and perhaps most, cases this will not be so and some mechanism for monetizing the tax incentives will be needed. this article posits that a new “tax benefit transfer” regime would serve this objective far better than a continued muddle over what satisfies the congressional intent test. the latter is likely to include a requirement that the investor earn some demonstrable pre-tax profit or have a meaningful at risk equity stake or both. if, however, the investor is meant to function as the delivery mechanism by which the true intended beneficiary of the program receives a subsidy (for which the investor is compensated via the tax benefits), these requirements would appear to be impediments: the investor will charge a premium for taking risks (these can be mitigated by “side agreements and guarantees” but these in turn may imperil the tax analysis); the complications added to the transaction will increase transaction costs (which invariably come “off the top”); and the requirement of a pre-tax profit for the investor of necessity comes at the expense of other participants in the project. the question of how best to design such a new tax benefit transfer regime, of course, is a complicated one. further, it presumes that a continuation of the subsidies in question is desirable. obviously, if congress were to adopt a proposal such as that made in the simpson-bowles report — viz., to eliminate nearly all tax expenditures — that would render this discussion moot. 313 of course, a decision to convert the current tax credits to direct subsidies similarly would eliminate consideration of re-designing tax credit subsidies. 312. see supra note 98 and accompanying text. 313. see nat’l comm’n, moment of truth, supra note 121. 2012] monetization of business tax credits 717 in part vi, below this article briefly explains the experiences of some of the states in regard to monetization of tax credits. part vii examines the associated federal income tax implications. finally, part viii offers some concluding thoughts that hopefully pull together all of the threads of discussion in this article. vi. overview of select state business tax credits and officially sanctioned monetization structures as noted in the introduction, there is a significant degree of variability in the handling of tax credits by the states. some states have initiated refundable tax credits and others transferable tax credits and still others non-transferable tax credits, sometimes with lenient partnership allocation rules that facilitate “transfers” and sometimes not. 314 a. refundable state tax credits in 2000, maryland enacted the “clean energy production tax credit,” 315 offering a state income tax credit of 0.85 cents per kwh for electricity generated from qualified renewable sources. in early 2010, the maryland energy administration issued a report recommending that the production tax credit be made either refundable or transferable, “to enable those with insufficient or no tax liability to utilize the incentive.” 316 it noted that “[t]o date, the tax credit program has been underutilized; approximately $5.1 million of the authorized $25 million in tax credits have been allocated.” 317 the report drew on the experiences of other states that had enacted comparable programs. for example, iowa’s transferable production tax credit programs had resulted in “iowa’s total installed wind capacity of 3,053 mw (as of june 2009) rank[ing] second among all states.” 318 oklahoma’s freely-transferable “zero-emissions facilities production tax credit” had caused “growth in renewable energy generation in oklahoma [to be] fifth fastest among all states.” 319 in june 2010, the maryland state legislature passed legislation allowing corporations and individuals to claim 314. see supra notes 18–22 and accompanying text. 315. md. code ann., tax-gen. § 10-720 (2000). 316. md. energy admin., maryland energy outlook 70 (2010), http://www.energy.state.md.us/documents/meofinalreportjan2010.pdf. 317. id. at 73. 318. id. at 71. 319. id. at 72. 718 florida tax review [vol.12:9 a refund in the amount of any excess credit. 320 in doing so, it joined a number of other states that have adopted refundable tax credits. 321 b. transferable state tax credits in june 2005, iowa enacted production tax credits for producers of wind energy (“section 476b credit”) 322 and other producers of renewable energy (“section 476c credit”). 323 the owner of an eligible facility is allowed a credit for each kilowatt hour of energy produced (1.5¢/kwh for the section 476c credit; 1.0¢/kwh for the section 476b credit) during the 10 year period beginning on the date the facility was placed in service. in 2008, the section 476b credit was changed from being transferable only one time to being freely transferable. 324 the section 476c credit may also be transferred, but only one time. 325 any consideration received by the transferor of the tax credit certificates will not be included in the transferor’s gross income. likewise, any consideration paid for the tax credit certificate will not be deducted from the transferee’s income. the iowa department of revenue will issue a replacement tax credit certificate to the transferee. 326 the statutes direct the iowa department of revenue to “develop a system for the registration of the wind energy production tax credit certificates issued or transferred under this chapter and a system that permits verification that any tax credit claimed on a tax return is valid and that transfers of the tax credit certificates are made in accordance with the requirements of this chapter.” 327 320. md. code ann., tax-gen. § 10-720(d), amended by maryland clean energy incentive act of 2010, 2010 h.b. 464, effective july 1, 2010. 321. see supra note 18 and accompanying text. 322. iowa code ann. § 476b (west 2011). 323. iowa code ann. § 476c (west 2011). 324. iowa code ann. § 476b.7, amended by 2008 s.b. 2405, effective jan. 1, 2008. 325. iowa code ann. § 476c.6 (west 2011) (for these purposes, “a decision between a producer and purchaser of renewable energy regarding who claims the tax credit issued pursuant to this chapter shall not be considered a transfer . . . .”). 326. see, e.g., iowa code ann. § 476b.7 (west 2011) (“within thirty days of transfer, the transferee must submit the transferred tax credit certificate to the department . . . . within thirty days of receiving the transferred tax credit certificate and the transferee's statement, the department shall issue one or more replacement tax credit certificates to the transferee . . . . a tax credit shall not be claimed by a transferee under this chapter until a replacement tax credit certificate identifying the transferee as the proper holder has been issued. a replacement tax credit certificate may reflect a different type of tax than the type of tax noted on the original tax credit certificate.”). 327. iowa code ann. § 476b. 9 (west 2011). 2012] monetization of business tax credits 719 in late 2009, iowa governor chet culver designated a sevenmember “tax credit review panel” to review iowa’s existing tax credit programs. 328 among the panel’s findings were that “[t]ransferability allows entities that are the direct beneficiaries of the tax credit program with low or zero tax liability to still benefit from a tax credit, and it also allows those entities to immediately receive cash from an award, not waiting until they file their tax return.” 329 however, it also found as follows: transferability of tax credits complicates the projection of revenues and the tracking of credits, creates uncertainty about when credits will be claimed because the purchasing entity may utilize a different fiscal year than the entity awarded the credit, and siphons resources from awarded entities through brokerage fees. in essence, the individual or entity that benefits from the tax credit is not the entity that is the objective of the tax credit program or is undertaking the original intent of the public policy for the tax credit program. once tax credits are transferred, it creates limited recourse for the state to recover funds claimed in instances where the business awarded the original credit does not fulfill the contracted obligations or if the credit was awarded in error. additionally, transferability has also resulted in abuses in some tax credit programs. 330 the report ended by recommending the elimination of the transferability provisions for both the section 476b and section 476c credits. 331 these recommendations seem not to have been adopted by the legislature. other examples of transferable state tax credits are noted in part i. 332 c. flexible partnership allocation schemes new mexico’s renewable energy production tax credit offers a tax credit of $0.01/kwh for companies that generate electricity from wind and biomass and a $0.027/kwh credit for companies that generate electricity 328. letter from richard oshlo, interim dir., iowa dep’t of mgmt., to chester j. culver, iowa governor (jan. 8, 2010), http://www.desmoinesregister.com. 329. state of iowa tax credit review panel, state of iowa tax credit review report 4 (2010), http://www.com.state.ia.us/tax_credit_review/ files/taxcreditstudyreviewreportfinal_reportfinal1_8_2010.pdf. 330. id. 331. id. at 10. 332. see supra note 19. 720 florida tax review [vol.12:9 from solar energy. 333 to qualify for the credit, the taxpayer must either hold title to a “qualified energy generator” 334 or lease from a county or municipality, under authority of an industrial revenue bond, the property on which the generator operates. a taxpayer may be allocated all or a portion of the right to claim the credit without regard to its proportional ownership interest, so long as (1) the taxpayer owns an interest in a business entity that is taxed for federal income tax purposes as a partnership, (2) the partnership (or a lower-tier partnership) would qualify for credit; and (3) the taxpayer and all other taxpayers allocated a right to claim the credit collectively own at least a 5 percent interest in the qualified energy generator. 335 the partnership must provide notice of the allocation to the new mexico energy, minerals, and natural resources department (“emnrd”) and the emnrd must approve the allocation in writing. 336 the taxpayer must request a certification of eligibility for the credit from the emnrd. to claim the credit, the taxpayer must attach to their income tax return (1) the certificate of eligibility; (2) the allocation notice approved by the emnrd; (3) documentation of the amount of electricity produced by the renewable energy facility for the tax year; and (4) renewable energy production tax credit claim form rpd-41227. another case in point is virginia’s state historic rehabilitation tax credit, 337 which provides that credits granted to a partnership may be allocated among all partners, either in proportion to their ownership interest in the partnership, or as the partners mutually agree. 338 the virginia department of historic resources must certify the amount of rehabilitation expenses eligible for the credit, and the certification letter will make reference to the partnership agreement or other partnership document that allocates the credits to the partners. 339 the faqs for the rehabilitation credit 333. n.m. stat. ann. § 7-2a-19 (west 2011). the credits are available for 10 years. the credit amount for solar varies in each of the ten years from $.015/kwh to $.04/kwh, but comes out to an average of $.027/kwh over a ten-year period. 334. a “qualified energy generator” means “a facility with at least one megawatt generating capacity located in new mexico that produces electricity using a qualified energy resource and that sells that electricity to an unrelated person.” n.m. stat. ann. § 7-2a-19(f)(2) (west 2011). 335. n.m. stat. ann. § 7-2a-19(h) (west 2011). 336. n.m. stat. ann. § 7-2a-19 (h) (west 2011). see also new mexico taxation and revenue dep’t, claiming tax credits for crs taxes and business-related income 10 (rev. 2010), http://www.tax.newmexico.gov/ sitecollectiondocuments/publications/fyi-publications/fyi-106_claiming%20 tax%20credits%20for%20crs%20taxes%20and%20business%20r elated%20income%20-%20june%202009.pdf. 337. va. code ann. § 58.1-339.2 (west 2011). 338. va. code ann. § 58.1-339.2.a (west 2011). 339. 17 va. admin. code § 10-30-140(b) (2006). 2012] monetization of business tax credits 721 state that while the tax credits may not “technically” be sold, they “may be syndicated through the use of limited partnerships” which is a “common tool for bringing investors into a rehabilitation project.” 340 d. traditional partnership allocation schemes new mexico’s qualified business facility rehabilitation credit may be claimed by individual partners in a partnership, but only in an amount equal to the partner’s pro rata share of the credit. 341 an individual claiming the credit derived from a partnership must provide a schedule listing the names, addresses and social security numbers or federal employer identification numbers of all partners in the partnership, the pro rata share of the credit of each partner, and the federal employer identification number and new mexico combined reporting system identification number, if any, of the partnership. 342 e. hybrid schemes arizona’s solar and wind energy tax credit, 343 established in 2006, 344 provides a personal and corporate tax credit equal to 10 percent of the installed cost of a “solar energy device.” 345 the tax credit is nonrefundable 346 and may be carried forward for up to five years. 347 where the credit is claimed by partners in a partnership, each partner may only claim a pro rata share of the credit “based on the ownership interest or financial 340. va. dep’t of historic res., rehabilitation tax credits: frequently asked questions, virginia.gov, http://www.dhr.virginia.gov/tax_credits/tax_credit _faq.htm (last visited dec. 8, 2011). 341. n.m. stat. ann. § 7-2-18.4(e) (west 2011) (“a taxpayer who otherwise qualifies and claims a credit on a restoration, rehabilitation or renovation project on a building owned by a partnership or other business association of which the taxpayer is a member may claim a credit only in proportion to his interest in the partnership or association.”). 342. n.m. code r. § 3.3.13.11(i)(2) (lexisnexis 2011). 343. ariz. rev. stat. ann. § 43-1085 (west 2011); ariz. rev. stat. ann. § 43-1164 (west 2011); ariz. rev. stat. ann. § 41-1510.01 (west 2011). 344. h.r. 2429, 47th leg., 2nd sess. (ariz. 2006). 345. the program guidelines for the solar energy tax credit program state that “wind generator systems” are also included in the definition of solar energy devices. ariz. commerce auth., commercial/industrial solar energy tax credit program: program guidelines 2 (2011), http:/www.azcommerce.com/ assets/pdfs/incentives/commercial-industry-solar-program/solar-guidelines.pdf. 346. id. at 3. 347. ariz. rev. stat. ann. § 43-1085(e) (west 2011); ariz. rev. stat. ann. § 43-1164(e) (west 2011). 722 florida tax review [vol.12:9 investment in the system.” 348 in 2007, however, the credit was revised retroactively to allow taxpayers who qualify for the credit to transfer the credit to third-party organizations “that financed, installed, or manufactured” the solar energy devices. 349 the party that installs the solar energy device must apply to the arizona commerce authority for a credit certificate in order to claim the credit. upon completion of the project, it is required to submit a completion report, stating the name, address, and telephone number of the third-party financier if it is electing to pass through the credit to a third party. the arizona commerce authority will only certify requests to pass on the entire credit allocation for a specific solar energy device, and will not approve requests to pass on only a portion of a credit. in contrast, arizona’s renewable energy industry credit, which provides a 10 percent credit to a taxpayer who either locates or expands a renewable energy manufacturing facility or renewable energy business headquarters in arizona, and is subject to the same partnership allocation rules as the solar and wind energy tax credit, is not specifically transferable to a third-party, but instead is refundable. 350 vii. federal tax treatment of state tax credit grants, transfers and allocations a chronological survey (not intended to be exhaustive) of the hodgepodge of rulings (revenue rulings, private letter rulings (“plrs”) and chief counsel advice (“cca”)), cases, and other guidance addressing the federal tax treatment of state tax credit grants, transfers’ and allocations is set forth below. they are interesting, not only for their specific holdings, but also on occasion for their description of a state’s tax credit regimes. a. survey of the guidance revenue ruling 79-315 351 — treatment of recipient. holding 3 of revenue ruling 79-315 provides that if all or a portion of a state tax rebate (the ruling addresses a program of tax rebates enacted by the iowa legislature) is credited against tax due for a taxable year, the amount credited is treated as a reduction of the outstanding liability and is neither includible in income nor allowable as a section 164 deduction. 348. ariz. rev. stat. ann. § 43-1085(f) (2011) (west); ariz. rev. stat. ann. § 43-1164(f) (west 2011). 349. h.r. 2491, 48th leg., 1st sess., § 2 (ariz. 2007). 350. ariz. rev. stat. ann. § 43-1085.01 (west 2011); ariz. rev. stat. ann. § 43-1164.01 (west 2011); ariz. rev. stat. ann. § 41-1511 (west 2011). 351. rev. rul. 79-315 1979-2 c.b. 27. 2012] monetization of business tax credits 723 plr 8742010 352 — treatment of purchaser. pursuant to an applicable state law program, t purchased tax credits (allowable over a five year period) from y by paying y an amount equal to the present value of the tax credits. under the facts presented in the ruling, t’s participation in the program was required by state law in the conduct of t’s business. the ruling concludes that t should be permitted a deduction under section 162 for amounts paid to y to acquire y’s state tax credits in the years and in the proportions the credits to which the amounts paid relate are applied as an offset to state taxes. to the extent the credits are applied as an offset to state taxes in future years, t should recognize such tax-offsets as a reduction in the deduction for state excise taxes in the years the credits are applied as an offset to state taxes. snyder v. commissioner 353 — treatment of recipient. the state of ohio provided a reduction in taxes (formulated as a percent of wagers) for holders of horse-racing permits who made certified capital improvements to their facilities. the tax reduction was structured to apply for six years or until equaling 70 percent of the cost of the improvements. the tax court had held that certification of improvements satisfied the all events test such that the taxpayer should have included the amount of the tax reduction in income in full in the year of certification of the capital costs. however, before the case reached the sixth circuit, the irs acknowledged that its prior position regarding the tax reductions was erroneous, and agreed with the taxpayer that the proper treatment of the tax reduction was simply “to reduce the deductions available to [the partnership] for its pari-mutuel tax obligations, which reduced deductions accrue as those become due.” 354 the sixth circuit agreed with this analysis. the court noted that this case “does not involve any right on the part of [the taxpayer] to receive an amount of money from the state of ohio; it simply involves a right to start paying the state less in taxes than would have to be paid in the absence of the right.” 355 the court held there was no “income” from the state of ohio for the partnership to accrue. 356 cca 200126005 357 — treatment of purchaser. cca 200126005 addresses the tax treatment of a purchaser of colorado state tax credits granted for donations of conservation easements. the cca concludes that the purchaser’s application of the purchased credit in satisfaction of its tax liability is “analogous to a taxpayer being permitted to pay its state tax liability by transferring property to the state” and such payment is deductible 352. i.r.s. priv. ltr. rul. 87-42-010 (july 10, 1987). 353. no. 89-1276, 1990 wl 6953 (6th cir. feb. 1, 1990). 354. id. at *4. 355. id. 356. id. 357. i.r.s. chief couns. adv. 2001-26-005 (june 29, 2001). 724 florida tax review [vol.12:9 under section 164. the credit was refundable in certain circumstances (but only in the hands of the original recipient) and transferable. a companion cca addressing promised guidance for the original recipient of the colorado conservation easement credit concludes the issues are best addressed in published guidance and declines to express a view. 358 the cca does, however, outline a number of issues peculiar to the interplay of the credit with the grant of the easement and the charitable contribution deduction. cca 200211042 359 — treatment of recipient/seller. the credit in question in cca 200211042 was a missouri income tax credit based on environmental remediation expenditures. it could be claimed for the year in which the costs were incurred or over twenty years. if the expenditures were made by an s corporation or partnership, the missouri law specified the credit was to be claimed by the members of the entity based on proportional share ownership. the credit also was transferable; in the case of a transfer the state would reissue the credit in the name of the transferee. the ruling recites that brokers facilitated sales of the credits at between eighty and ninety cents on the dollar. the cca addresses two questions: the federal tax consequences of receipt of the state tax credit and the federal tax treatment of a sale of the tax credit. it concludes that receipt of the credit is not includible in income; if the recipient uses the credit to reduce its state taxes this simply reduces the recipient’s federal tax deduction for state taxes pro tanto: generally, a state tax credit, to the extent that it can only be applied against the recipient’s current or future state tax liability, is treated for federal income tax purposes as a reduction or potential reduction in the taxpayer’s state tax liability. the amount of the credit is not included in the taxpayer’s federal gross income, or otherwise treated as a payment from the state, and is not deductible as a payment of state tax under § 162 or § 164. cf. rev. rul. 79-315, 1979-2 c.b. 27, holding (3) (iowa income tax rebate). similarly, an accrual-basis taxpayer is not required to take the value of such future tax credits into income; the credits will simply reduce the taxpayer’s otherwise-deductible tax liabilities as, and if, they accrue. see snyder v. united states, 894 f.2d 1337 (6th cir. 1990). 360 358. i.r.s. chief couns. adv. 2002-38-041 (sept. 20, 2002). 359. i.r.s. chief couns. adv. 2002-11-042 (mar. 15, 2002). 360. the ruling explains that refundable credits similarly do not generate income except to the extent of the actual refund. the portion of the credit that 2012] monetization of business tax credits 725 the ruling notes that transferability is a hallmark of “property” and that this feature of the credit suggests the issuance of the credit should be includible in income. however, the ruling concludes that the right of transferability, without more, should not require that outcome: “the remediation tax credit retains its character as a reduction or potential reduction in state tax liability, unless and until it is actually sold to a third party.” 361 having so concluded as to the tax consequences of receipt of the tax credit, the ruling notes the recipient thus has no tax cost basis in the credit and therefore upon a sale of the credit will be required to include the gross proceeds of sale in income. the ruling further determines that the income should be reported as ordinary income. after first acknowledging that under section 1221 the term “capital assets” includes “all classes of property not specifically excluded by section 1221,” 362 and further that none of the listed exceptions in section 1221 appears to apply to the state tax credit, the ruling states that nonetheless the tax credit is not a capital asset: [d]espite § 1221’s apparent broad definition of capital asset, the supreme court has stated “it is evident that not everything which can be called property in the ordinary sense and which is outside the statutory exclusions qualifies as a capital asset”; rather, “the term ‘capital asset’ is to be construed narrowly in accordance with the purpose of congress to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year.” commissioner v. gillette motor transport, inc., 364 u.s. 130. 134 (1960) . . . . accordingly, the court has held that certain interests that are concededly “property” in the ordinary sense are not capital assets. id.; hort v. commissioner, 313 u.s. 28 (1941) (unexpired lease); commissioner v. p.g. lake, inc., 356 u.s. 260 (1958) (oil payment rights). * * * * a taxpayer who sells a remediation tax credit has parted with all rights in the credit. however, as discussed above in connection with its original issuance, the credit, even though it is transferable, primarily represents the right to a reduction operates to zero out the state tax is not includible in income, but rather simply reduces the allocable federal tax deduction for state taxes. 361. i.r.s. chief couns adv. 2002-11-042 (mar. 15, 2002). 362. id. 726 florida tax review [vol.12:9 or potential reduction in the holder’s tax liability. it is not incident to, and does not create an estate in, property that is itself a capital asset. while it does not represent compensation for specific services, it was issued as an incentive for the recipient to engage in remediation activities. moreover, in that sense it has already been “earned”. . . . although the credit is not a right to a stream of ordinary income, it is a right to reductions in tax payments normally deductible from ordinary income. as a transferable asset, the credit has a certain market value that may fluctuate over time; however, as a credit against a state tax liability, it does not appreciate or depreciate and can be used at any time for its stated amount by any holder with a tax liability. finally, the original issuance of the credit was not treated for federal tax purposes as a transfer of property includable in the recipient’s income; the recipient has no “tax cost” or other basis in the credit, no investment, and no risk of loss. balancing these factors, we conclude that the remediation tax credit is not property for purposes of § 1221. 363 cca 200445046 364 — treatment of purchaser. cca 200445046 addresses whether the purchasers of massachusetts historic rehabilitation tax credits and low-income housing tax credits have made a “payment” for purposes of section 164(a) when they file their state tax returns and use the purchased credits to reduce their state tax liability. the cca concludes in the affirmative, but clarifies that the payment made by the purchaser to the transferor of the credit is not a payment of tax or a payment in lieu of a tax for purposes of section 164. rather, having purchased the credit for value, the credit is “property” in the purchaser’s hands; therefore, the use of the credit by the purchaser to reduce its state taxes is akin to the transfer of property to the state in satisfaction of the transferee’s liability — a payment of tax for purposes of section 164. the cca involved two massachusetts tax credits — an historic rehabilitation tax credit and lihtc. a massachusetts taxpayer eligible for the applicable credit is entitled to transfer it (on prior notice to the massachusetts department of revenue) pursuant to a transfer contract with 363. id. 364. i.r.s. chief couns. adv. 2004-45-046 (nov. 5, 2004). see also i.r.s. priv. ltr. rul. 2003-48-002 (nov. 28, 2003). 2012] monetization of business tax credits 727 the transferee “without the requirement of transferring any ownership interest in the project or any interest in the entity which owns the project.” 365 cca 200704028 366 — treatment of recipient/seller and purchaser of nominally nontransferable credits. cca 200704028 is the pre-cursor to the virginia historic tax credit litigation. the facts of the case, of course, are more elaborately set forth in the tax court and fourth circuit decisions. simplifying somewhat, the cca describes individual investors investing cash in a partnership and receiving, in the aggregate, a 1 percent partnership interest and an allocation of 100 percent of certain state rehabilitation tax credits. the investors were described as “taxpayers who were interested in reducing their state taxes, but for reasons such as being subject to the alternative minimum tax (amt), were indifferent to the state taxes deduction under § 164 for federal tax purposes.” 367 the investors granted options to the partnership to repurchase their interests for fair value for a period of one year. however, most of the investors sold their interests after only a matter of months to one of the key promoters for a small fraction of their investments. consequently, the investors claimed large capital losses on their federal income tax returns. the investors were told that they would not receive any material economic interest in the partnership, and the marketing materials stated that the investors’ returns would be dependent entirely upon the allocation of the state tax credits and the tax loss on the sale. the cca concludes that the investors are not partners in a partnership for federal income tax purposes and accordingly the transaction should be “recast under the principles of the substance-over-form doctrine” as “direct sales and purchases of the credits.” 368 the partnership generating the credits thus must report gains from the sale of the credits allocable to the 365. i.r.s. chief couns. adv. 2004-45-046 (nov. 5, 2004) (quoting from 830 mass. code regs. 63.38r.1(7)(a) (lexisnexis 2011), governing transfers of the massachusetts historic rehabilitation tax credit.) the wording of 760 mass. code regs. 54.07(1) (lexisnexis 2011), governing transfer of the lihtc is nearly identical. the former permits transfers by “any taxpayer allowed to take the historic rehabilitation credit . . . to any individual or entity.” the latter permits transfers by “any taxpayer with an ownership interest in a qualified massachusetts project with respect to which there has been allocated massachusetts low-income housing tax credit and any taxpayer to whom the right to claim massachusetts low-income housing tax credit has been allotted or transferred . . . to any other massachusetts taxpayer eligible to claim a federal low-income housing tax credit with respect to the original or a different qualified massachusetts project.” the historic rehabilitation tax credit may be transferred in whole or in part, whereas in the case of the lihtc the transferor is required to transfer the entire credit attributable to periods after the transfer date. 366. i.r.s. chief couns. adv. 2007-04-028 (jan. 26, 2007). see also i.r.s. chief couns. adv. 2007-04-030 (jan. 26, 2007). 367. i.r.s. chief couns. adv. 2007-04-028 (jan. 26, 2007). 368. id. 728 florida tax review [vol.12:9 developers, promoters, and other partners in the partnership. when the investors use the credits to reduce their state tax liability they will engage both in a taxable disposition of the credits under section 1001 and a payment of state taxes deductible under section 164. the losses claimed by them on the sales of putative partnership interests will be disallowed. the cca further concludes the transaction should be “recharacterized as a disguised sale of property under § 707(a)(2)(b)” and “recast under the partnership anti-abuse rule”: 369 the use of the partnership form enabled the promoters of the transactions to effect the sale of large numbers of credits at a profit of $f per dollar of credit without incurring gain at any level. moreover, by design the investors claimed large amounts of capital losses from the sale of their purported “partnership interests” in [partnership] to the promoters at a price a fraction (e) of their bases. these manufactured deductions effectively substituted for state tax payments the investors could not otherwise benefit from, typically because such payments would not have been deductible for amt purposes. additionally, [partnership] failed to make § 754 elections and, therefore, had inflated inside bases. this use of the partnership form is inconsistent with the intent of the subchapter k, which is to permit taxpayers to conduct joint business activity through a flexible economic arrangement without incurring an entity-level tax. 370 the irs office of chief counsel concurrently released am 2007002, addressed to the deputy division counsel for the small business/selfemployed division, responding to a request for advice on “a partnership structure . . . that is being used to market transferable and nontransferable state income tax credits . . . to generate federal income tax losses.” 371 the facts and legal analysis largely track the cca, with the exception of the omission of a discussion of section 707. 2008 coordinated issue paper 372 — treatment of recipient. in 2008, the irs national office issued a position paper relating to state and local 369. the cca also concludes that whether an investor in a partnership is a partner constitutes a “partnership item” under the tefra partnership procedures. 370. i.r.s. chief couns. adv. 2007-04-028 (jan. 26, 2007). 371. i.r.s. adv. mem. 2007-002 (jan. 26, 2007). 372. i.r.s., coordinated issue paper all industries-state and local location tax incentives, lmsb-04-0408-023 (may 23, 1008). see also, i.r.s., coordinated issue paper all industries-exclusion of income: noncorporate entities and contributions to capital, lmsb04-1008-051 (nov. 18, 2008). in this coordinated issue paper, the irs states that “neither section 118 nor any common 2012] monetization of business tax credits 729 location tax incentives (rate reductions, abatements, property tax reductions, and other incentives, as well as tax credits) in reaction to the practice of certain corporate taxpayers of treating the incentive as income excludable under section 118 (albeit triggering a basis reduction under section 362(c)) while claiming a federal tax deduction for the full, unabated tax applicable in the absence of the incentive. the position paper concludes that (1) a state or local location or similar tax incentive is not income under section 61; (2) even if it is, it would generally not be excludible from income as a non-shareholder contribution to capital under section 118(a); and (3) a location tax incentive is not deductible as tax paid or accrued in the taxable year under section 164 (to the contrary, the tax incentive simply reduces the taxpayer’s state and local tax obligations). the position paper relies on revenue ruling 79-315 and snyder, both discussed above, among other authorities. the position paper expressly does not address “the correct federal tax treatment of state or local refundable credits, transferable credits (including nominally nontransferable credits that are treated for federal tax purposes as transferable, under the virginia historic tax credit cca discussed above) or tax benefits provided in return for specific consideration, such as services, property or the use of property.” 373 lafa 20085201f 374 — treatment of recipient. a 2008 memorandum issued by associate area counsel in detroit addresses michigan economic growth authority (“mega”) credits. eligibility for the credits was tied to the creation of “qualified new jobs.” the credits were non-transferable but were refundable. the memorandum concludes that “refundability, by itself, does not cause the entire credit to be treated as a payment from the state.” 375 rather the credit is includable in gross income to the extent it exceeds the taxpayer’s tax liability and is made available to the taxpayer as a cash payment, and otherwise is a reduction in the amount of state tax expense (and in the amount allowable as a deduction under section 164). the memorandum further concludes that credit refunds includible in income do not qualify as a non-shareholder contribution to capital under section 118, among other reasons because the intent of the state in granting the credit is to subsidize operating expenses, not capital formation. cca 201147024 376 — treatment of recipient/seller and purchaser. cca 201147024 addresses questions arising with respect to the receipt and law contribution to capital doctrine permits the exclusion from gross income of amounts paid to non-corporate entities by a non-owner.” 373. i.r.s., coordinated issue paper all industries-state and local location tax incentives, lm5b-04-0408-023, (may 23, 2008). 374. i.r.s., legal adv. issued by field attorneys, 2008-52-01f (nov. 26, 2008). 375. id. 376. i.r.s. chief couns. adv. 2011-47-024 (nov. 25, 2011). 730 florida tax review [vol.12:9 transfer of various non-refundable, transferable massachusetts tax credits, including (among others) the massachusetts historic rehabilitation tax credit and lihtc. 377 consistent with earlier rulings, including cca 200211042, it concludes that the taxpayer receiving the tax credit should not be viewed as having received property in a realization event resulting in a section 61 income inclusion, notwithstanding a right to transfer the credit. further, it concludes that a transfer of the credit to another taxpayer for return consideration is a sale, that the original recipient of the credit has no tax cost basis in the credit and that therefore the gross proceeds of the sale are includible in income as gain on the sale. the cca departs from prior guidance such as cca 200211042, in light of the decision in tempel (discussed below), and concludes that a taxpayer qualifying for one of the nonrefundable tax credits addressed in the cca generally would realize capital gain on the sale of the credit. 378 finally, the cca concludes vis-à-vis the purchaser of the tax credit that, for federal tax purposes, the use of the tax credit to satisfy the purchaser’s state tax liability is a transfer of property to the state in satisfaction of the liability, not a reduction in the liability. as a result, in the year or years the purchaser applies the tax credit to satisfy its state tax liability, the purchaser will realize gain or loss under section 1001 equal to the difference between the basis of the tax credit and the amount of liability satisfied by the application of the tax credit. 379 in addition, the purchaser will be treated as having made a payment of state tax for purposes of section 164(a). b. the tempel case tempel v. commissioner 380 addresses the federal income tax consequences of sales of colorado conservation easement income tax credits. 381 the taxpayers (husband and wife) had donated a qualified conservation easement to charity and received the credits as a result of their donation. they sold some of the credits and retained the balance, allocating 377. cf. i.r.s. chief couns. adv. 2004-45-046 (addressing the federal income tax treatment of the purchase of such credits). see also supra notes 364–65 and accompanying text. 378. the cca states that: “[w]e do not agree with the reasoning in tempel that the multi-factor analysis in cases like foy and gladden applies only when there are contract rights at issue. . . . however, we accept the conclusion of the tax court in tempel and mcneil, which the court could have reached under the established multi-factor test, that a nonrefundable state tax credit that does not fall within the statutory exclusions in § 1221(a) is a capital asset for purposes of § 1221.” 379. see also i.r.s. priv. ltr. rul. 2009-51-024 (dec. 18, 2009). 380. 136 t.c. 341 (2011). 381. see supra notes 357–58 and accompanying text. 2012] monetization of business tax credits 731 the professional expenses they incurred in connection with donation of the property, pro rata, as “basis” in the credits. the donation to charity and sale of credits both occurred in december 2004. the taxpayers originally reported their gains as short-term capital gains. on audit, the irs disallowed the basis claim and characterized the gains as ordinary rather than capital. on crossmotions for summary judgment before the court, the taxpayers claimed that their gains should have been reported as long-term capital gains. the tax credits in question were refundable under certain circumstances not factually present in the case. the credits also were transferable; transferees were permitted to use the credits only to offset their tax liability and were ineligible for a refund in all cases. the parties stipulated that the conservation easement contribution was neither a sale or exchange of the easement nor a quid pro quo transaction. the court agreed with the taxpayers that the tax credits at issue were capital assets and agreed with the irs that the taxpayers had neither basis, nor a long-term holding period in the tax credits. on the central issue of the character of the gain, the court addressed much of the same authorities addressed in cca 200211042 discussed above and, specifically, articulated the proposition that the term “capital asset” is “not without limits beyond those imposed by statute” (i.e., the eight categories of property specifically excluded from the definition of “capital assets” set forth in section 1221). 382 however, after a brief review of the case law, the court concluded that “the substitute for ordinary income doctrine is the only recognized judicial limit to the broad terms of section 1221.” 383 the court, in turn, concluded that the colorado tax credits do not come within the substitute for ordinary income doctrine on the grounds that: (1) a government-granted tax credit is not a contract right; (2) the tax credits are not a substitute for a tax refund that would have been ordinary income because the facts do not establish a refund would have been forthcoming; (3) a reduction in state tax liability (the default outcome in the absence of a sale of the credits) is not an accession to wealth; and (4) the taxpayer “never possessed a right to income” on account of the credits and “did not sell a right either to earned income or to earn income.” 384 the court’s decision is compatible with the irs’s position discussed above that “the right of transferability, without more” is insufficient to require the receipt of a tax credit to be included in income. 385 however, this 382. tempel, 136 t.c. at 346. 383. id. 384. id. at 348–52. 385. see, e.g., i.r.s. chief couns. adv. 2002-11-042 (“[t]he remediation tax credit retains its character as a reduction or potential reduction in state tax liability, unless and until it is actually sold to a third party.”) see also supra notes 359–63 and accompanying text. 732 florida tax review [vol.12:9 position really is discernible only from guidance from the office of chief counsel to the field, whereas the tax court cites browning v. commissioner 386 and revenue ruling 79-315 as the authority for its decision. revenue ruling 79-315, as briefly summarized above, addresses the issuance of a nontransferable tax rebate (in the form of a tax credit or, in the absence of a tax liability, cash refund); to the extent credited against tax due it is treated simply as a reduction in the liability and is neither includible in income nor allowable as a section 164 deduction. the browning case involved a bargain sale of property to a charity and held that the tax benefits generated by the transaction are not includible in the taxpayer’s amount realized for purposes of computing the charitable contribution deduction. 387 neither authority is on point. if, to the contrary, an income inclusion is deemed triggered by issuance of a transferable tax credit to a taxpayer, the taxpayer would have a tax cost basis in the credit, so that a subsequent sale of the credit at a discount from face either produces no gain or loss (if the credit was valued based upon its realizable value on sale) or results in a loss (if the credit was included in income at its face value) presumably to be characterized as ordinary, and a net ordinary income inclusion in the amount of the cash received on sale. the taxpayer that instead simply uses the tax credit would be entitled to an offsetting section 164 deduction in light of the income inclusion (at face) and thus no net deduction, and increased ordinary income for federal income tax purposes in the amount of the state tax credit (same arithmetic result as exclusion of the credit from income and denial of a section 164 deduction). such an approach in tempel would have produced a more sensible outcome. 388 deployment of the underlying principle also might have implications in cases like virginia historic tax credit as will be discussed in part vii.d. 386. 109 t.c. 303, 324–25 (1997). 387. the government argued that “the value of tax deferral received from the installment sale of the easement to the county, the tax-free nature of the interest on the county’s debt, and the value of the charitable contribution deduction all must be subtracted from the fair market value of the easement in determining the amount of any gift to the county.” id. at 324. 388. accord robert feldgarden, letter to the editor, tempel: allowing capital gain on unappreciated property, 131 tax notes 329 (apr. 18, 2011) (suggesting the taxpayer in tempel should have been required to include the fair market value of the state tax credits in gross income (based on the sales price of the credits sold of approximately 85 cents on the dollar) upon issuance). see also infra note 415 and accompanying text. 2012] monetization of business tax credits 733 c. the virginia historic tax credit case in virginia historic tax credit, 389 the court of appeals for the fourth circuit ruled that a partnership’s purported allocations of virginia state historic rehabilitation tax credits to certain of its partners for the 2001 and 2002 tax years amounted to “sales” of the tax credits for federal tax purposes, pursuant to section 707. it did so “[a]ssuming, without deciding, that a ‘bona fide’ partnership existed.” 390 the tax court had determined, to the contrary, that the state tax credit investors (the “investors”) were in fact partners in a bona fide partnership for federal tax purposes and that the transactions between these investors and the partnership were not disguised sales under section 707; rather the tax court held that “the substance of the transactions matched their form.” 391 under the virginia legislation, any person rehabilitating a historic property that obtained state approval and certification of the project by the virginia department of historic resources was entitled to receive tax credits for up to 25 percent of eligible renovation costs. 392 the tax credits generally were not transferable but the virginia legislation authorized a partnership in receipt of the state tax credits to divide them among the partners “as the partners . . . mutually agree.” 393 an exception to the rule against transfer of the credits was made in 1999 to allow for a one-time transfer (by sale or otherwise) of credits for projects that had received certification prior to the finalization of the rules, to protect projects that had been structured on the assumption the credits would be transferable. the structure involved in virginia historic tax credit was as follows: 389. virginia historic tax credit fund 2001 v. commissioner, 639 f.3d 129 (4th cir. 2011), rev’g 98 t.c.m. (cch) 630 (2009). 390. 639 f.3d at 137. 391. virginia historic tax credit fund 2001 v. commissioner, 98 t.c.m. (cch) 630, 635 (2009). 392. va. code ann. § 58.1-339.2 (west 2011). 393. va. code ann. § 58.1-339.2(a) (west 2011). 734 florida tax review [vol.12:9 virginia historic tax credit fund 2001, llc (“2001 llc”) virginia historic tax credit fund 2001 scp, lp (“scp lp”) virginia historic tax credit fund 2001 scp, llc (“scp llc”) virginia historic tax credit fund 2001, l.p. (“2001 lp”) 99% 99% 97% 1% 1% one percent interests in each of scp lp, scp llc and 2001 lp (the “funds”) were reserved for investors. 2001 llc scp lp scp llc 2001 lp 99% 99% 97% 1% 1% 8 investors $$ for 1% 93 investors $$ for 1% 181 investors $$ for 1% operating partnerships c. $6m allocation of state tax credits c. $3.2 m state tax credits via “one time sale” permission total tax credits acquired: $9.2m total price “paid”: $5.13m (c. 55¢ to the dollar) amounts received from investors: $6.99m developers 2012] monetization of business tax credits 735 each investor was promised a specific amount of the credits and a limited partnership interest in exchange for a capital contribution. each investor “paid” between 74¢ and 80¢ for each dollar of tax credit and was allowed a refund (net of expenses) of its investment if the credits could not be obtained. the total amount raised from investors in this way was approximately $6.99 million. as a practical matter, the investors in each of the three funds depicted above received in return (apart from the tax credits) an aggregate one percent interest in the respective funds and were advised they would “receive no material amounts of partnership income or loss.” 394 each investor granted its fund an option permitting the general partner to purchase the investor’s interest for fair market value during 2002. in april 2002, the funds distributed schedules k-1 to the investors designating to each investor his promised amount of the tax credits. in may 2002, the promoter-partners of the funds bought out all the investors, paying them each .001 times their contribution for a total buyout cost of approximately $7,000. the buy-out had two notable apparent effects: (1) ostensibly for 2002 it triggered a tax loss of approximately $7 million for the investors upon sale of their interests in the funds (notwithstanding their enjoyment of $9.2 million in state tax credits against an investment of $7 million); and (2) it generated a “windfall” for the continuing partners — we will return to the question of taxability — of approximately $1.53 million ($6.99 million received from the investors less the $5.15 million paid to developers or contributed to operating partnerships less syndication costs and other expenses of $330,986). for tax purposes, the funds reported the money paid to the operating partnerships and others in exchange for tax credits under the grandfather provision for sales of credits as deductible expenses (query on what theory), while reporting the $6.99 million received from the investors as non-taxable capital contributions, so that the funds’ tax returns showed a loss of $3.28 million in total for 2001 and 2002. moreover, the funds did not have section 754 elections in place, so (under then applicable law) there was no step down in the inside basis of partnership property associated with the acquisition by the promoter-partners of the investors’ interests at negligible values. the irs took the position that the investors were not actual partners and that the putative capital contributions therefore were proceeds of sales of state tax credits to the investors. in the alternative, the irs argued that the 394. virginia historic tax credit, 639 f.3d at 134. 736 florida tax review [vol.12:9 transaction between the investors and the funds were “disguised sales” under section 707. either argument would suffice for the irs to prevail. 395 the tax court held for the taxpayers. it did so on the following grounds: (1) the intent to form a partnership as tested under objective factors; 396 (2) the existence of a valid business purpose to achieve state tax savings (the parties apparently having stipulated that “any federal tax consequences were incidental”); 397 and (3) conformity between the form and substance of the transaction. the virginia program’s base-broadening allocation provision encourages capital contributions to cover the credit gap between cost and available financing. this allocation provision allows state investors to contribute capital to historic rehabilitation projects without interfering with the allocation of federal tax credits. . . . [t]his form was compelled by realities of public policy programs, generally, and the virginia program, specifically. respondent ignores these realities and argues that the amounts of the contributions, the timing of the transactions, and the investors’ lack of risk suggest that the transactions were in substance sales. respondent argues that the entire amount of an investor’s contribution went to the purchase of his or her allocated state tax credits. we find instead that the contributions were pooled to facilitate investment in the developer partnerships, to purchase additional credits under the one-time transfer provision to meet the needs of the partnerships, to cover the expenses of the partnerships, to insure against the risks of the partnerships, and to provide capital for successor entities in which many of the investors participated year after year and for other rehabilitation projects. these pooled capital contributions were critical to the success of both the virginia historic funds and the developer partnerships. 398 the court noted that “[t]he parties have stipulated that the investors remained in the partnerships until after the partnerships had fulfilled their 395. note that the government did not argue a third possible avenue of attack — namely, that there was a taxable capital shift occasioned by the investors $7 million investment in return for an aggregate one percent interest. 396. virginia historic tax credit, 98 t.c.m. (cch) at 639 (relying on such authorities as commissioner v. culbertson, 337 u.s. 733 (1949) and luna v. commissioner, 42 t.c. 1067 (1964)). 397. id. 398. id. at 639–40. 2012] monetization of business tax credits 737 purpose.” 399 it noted the investors bore certain risks, including noncompletion of the projects 400 and a potential lack of resources to honor their rights to refunds if the anticipated credits are not obtained, 401 and further noted that the investors shared their risks, pro rata to their interests, across the projects generating the credits. finally, the court rejected the irs’s disguised sale argument noting that “the substance of these transactions reflect valid contributions and allocations rather than sales.” 402 section 707(a)(2)(b) allows the irs to treat a transaction that occurs between a partner and his partnership as though it occurred “between the partnership and one who is not a partner” if the partner transfers money to the partnership in exchange for “a related direct or indirect transfer of money or other property by the partnership to such partner,” such that the transaction is “properly characterized as a sale or exchange.” transactions are “presumed sales” when they occur within two years of one another, yet the tax court found that the transactions in question were not disguised sales because the transactions were “not simultaneous” 403 and the investors faced “entrepreneurial risks” in the partnership. [t]here is no disguised sale when the transactions are not simultaneous and the subsequent transfer is subject to the entrepreneurial risks of the partnership’s operations. . . . the investors were promised certain amounts of credits in the subscription agreements, but there was no guarantee that the partnerships would pool sufficient credits. this risk, as well as the other risks addressed in our discussion of business purpose, represent the risks of the enterprise. accordingly, we conclude that the transactions are not disguised sales. we further hold that the partnerships did not have $7 million 399. id. at 640. 400. according to the fourth circuit decision discussed below, the respective partnership agreements provided that the funds would only invest in completed projects “thereby eliminating a significant area of risk.” virginia historic tax credit fund 2001 v. commissioner, 639 f.3d 129, 134 (4th cir. 2011), rev’g 98 t.c.m. (cch) 630 (2009). 401. the fourth circuit further notes that the right to a refund was supported by guarantees in certain cases. id. at 145. 402. virginia historic tax credit, 98 t.c.m. (cch) at 641. 403. the fourth circuit opinion notes that the subscription agreements executed by the state tax credit investors stated that the amount each paid was “in exchange for the allocation of a corresponding number of tax credits ‘simultaneously with investor’s admission.’” virginia historic tax credit, 639 f.3d at 135 (emphasis in original). 738 florida tax review [vol.12:9 in unreported income from these transactions in either of the years at issue. 404 the government appealed the tax court’s decision to the fourth circuit reiterating the arguments it had presented at the trial level. the fourth circuit reversed the tax court, finding that the transactions at issue were “sales” under section 707. as already noted, it assumed, without deciding, that a bona fide partnership existed. the court first conducted a thorough review of the disguised sale rules, including the detailed factors for determining the presence of a sale or exchange set forth in regulations sections 1.707-3 and 1.707-6. citing otey v. commissioner, 405 the court noted that section 707 “prevents use of the partnership provisions to render nontaxable what would in substance have been a taxable exchange if it had not been ‘run through’ the partnership.” 406 it noted that under regulations section 1.707-6 the determination of whether a transfer by a partnership of property to a partner and one or more transfers of money or other consideration by that partner to the partnership are to be treated as a sale of the property to the partners is to be tested with reference to the rules of regulations section 1.707-3, including the presumption that all transfers “made within two years” of each other are sales unless the facts and circumstances “clearly establish” otherwise. 407 it then took up the argument advanced by the funds that section 707 could not apply because the transactions did not involve an exchange of money for “property” — i.e., because the state tax credits are not property. as discussed above, it is well-established that transferable credits can be brought and sold as items of property with the attendant consequences. however, the virginia historic state tax credits were non-transferable and non-heritable under applicable state law and this formed the basis for the taxpayer’s argument. the court examined whether the rights associated with the virginia tax credits embodied essential property rights, such as the right to use and exclude others from use, whether the rights were “valuable” and whether they are transferable (noted as a relevant but “not essential” factor), and concluded the transfer of tax credits at issue was a transfer of “property.” it dismissed the virginia law prohibition on transfer as a “nominal prohibition” only: as the facts here illustrate, it is a relatively simple matter in virginia to effectuate a third-party transfer by forming a 404. virginia historic tax credit, 98 t.c.m. (cch) at 641. 405. 70 t.c. 312, 317 (1978). 406. virginia historic tax credit, 639 f.3d at 138. 407. id. at 139. 2012] monetization of business tax credits 739 partnership with an interested buyer who is then “allocated” the credits in exchange for a contribution to the partnership. to hold that these tax credits, which the funds undeniably gave to investors in exchange for money, are not property simply because they could not be directly bought and sold would elevate form over substance in precisely the manner we are advised to guard against. 408 the court next turned to the question of whether these transfers should be properly recharacterized as “sales” under section 707 and the factors enumerated in regulations section 1.707-3. in determining that they should be, the court took a number of factors into account — from the essential certainty as to timing and amount of the credits to be received, to the legally enforceable rights of the investors created under the agreements, to the right to refunds, to the size of the investments in relation to the investors’ “general and continuing interest[s] in partnership profits,” 409 to the transitory nature of the investors’ status as partners. as to the tax court’s reliance on “entrepreneurial risk” as a basis for setting aside the irs’s disguised sale argument, the fourth circuit offered that “upon closer examination” the risks are “speculative and circumscribed.” 410 to the contrary, the court concluded, the “investors were promised what was, in essence, a fixed rate of return on investment rather than any share in partnership profits tied to their partnership interests.” 411 in a final footnote, the court acknowledged the transactions were undertaken “with the partial goal of aiding virginia’s historic rehabilitation efforts” and takes the occasion to observe that the virginia program “is not under attack here.” 412 to the contrary, “[t]he funds remain free to continue their partnership arrangement with investors under virginia law, and investors remain free to utilize the historic rehabilitation tax credits they receive through this arrangement in their state tax filings.” 413 as can be seen from the survey of authorities above, transferable state tax credits effectively are deemed to “become property upon transfer” (albeit — with the exception of the virginia historic tax credit cca itself — none of the authorities examined above took up the question in the context of section 707). therefore, if as the fourth circuit found the 408. id. at 141–42. 409. id. at 144. 410. id. at 145. 411. virginia historic tax credit, 639 f.3d at 145. 412. id. at 146 n.20. 413. id. 740 florida tax review [vol.12:9 allocation scheme in virginia historic tax credit was tantamount to a sale of the credits, the “property” characterization fits rather easily. 414 note the implications to the purchasers of the credits of the court’s decision (albeit the direct holding of the case addresses the tax treatment of the “sellers” of the credits): presumably, consistent with the guidance reviewed above, the investors had a $7 million tax cost basis in the credits, were entitled to a $9.2 million deduction for state taxes deemed paid with the credits (subject to the alternative minimum tax rules), and recognized $2.2 million of gain from use of the credits to satisfy the tax. in contrast, if the transaction had been respected, the investors would have had $9.2 million of additional ordinary income for federal tax purposes (because the deduction for state taxes would have been reduced by that amount) and a $7 million capital loss on disposition of their interests. the decision is likely to help bring parity to the federal tax treatment of various state tax incentive schemes. d. proposal for a unifying rule virginia historic tax credit reflects a determination sub silentio that the receipt of (effectively) transferable state tax credits is not a realization event — this notwithstanding the fourth circuit’s holding that the state tax credits constitute “property” for purposes of section 707. this is consistent with the authorities reviewed above, including tempel. if, to the contrary, receipt of transferable state tax credits were a realization event, then 99 percent of the income arising from the funds’ newly issued credits would have been allocable to the continuing partners of the funds, as would have any gain or loss on the subsequent sale of the credits. pro rata use of the credits (i.e., if used rather than sold) would have resulted in offsetting section 164 deductions. as to the credits that were purchased by the funds, under the authorities discussed above use of the purchased credits to satisfy state 414. assume partners in a partnership contribute funds for development of a project and incident to the development of the project tax credits are allocable pro rata among the partners based on their relative capital accounts. in such a case, while the credits may have been part of a collective quid pro quo between the partners and the partnership, no one would argue a “sale” or other taxable event had occurred because there was no quid pro quo between partners or between certain partners and the partnership (and hence between partners). that is, enjoyment of the tax credits in such case would be proportionate to each partners’ investment. it is the existence of the prohibited quid pro quo (allocating tax credits as the partners mutually agree and adjusting other economics to accommodate for it in a manner such that the partners allocated the credits have no other meaningful interest in the partnership) that belies the argument that the credits were non-transferable. thus, as the fourth circuit effectively held, the argument that the credits cannot be “property” because they are non-transferable is both circular and begs the question. 2012] monetization of business tax credits 741 tax obligations would trigger gain realization under section 1001 insofar as the credits were purchased at a discount from face. the holding of the fourth circuit, of course, is that the purchased credits in that case effectively were resold to the investors, triggering gain on that account to the funds. the investors, therefore, were to be the ones to recognize gain on use of the credits at a discount. in the discussion of tempel above, this article posits that a more sensible approach to resolving the taxation of the receipt and subsequent sale of tax credits in that case would have been, in fact, to treat the original receipt of the tax credit as a taxable event. if the recipient uses the credit the face amount of the credit would be required to be included in income subject to an offsetting section 164 deduction. if (as in tempel) the recipient sells the credit — the question of valuation thereby resolved — the tax credit would be included in income at fair value and the recipient would realize no gain or loss on the sale (if instead the recipient had included the tax credit in income at face value, it would realize a loss (presumably an ordinary loss) on sale). one could further refine this alternative theorization of the tax consequences of receipt and use or sale of state tax credits by requiring inclusion in income of the face amount of the state tax credits only if and at such time as the credits are used (also triggering an offsetting section 164 deduction) and inclusion in income at fair value if and at such time as sold. 415 further, the rule could be limited to those instances involving transferable state tax credits — both those that are transferable pursuant to the express provisions of the enabling legislation and those that are nominally nontransferable (such as the virginia historic tax credits), but effectively transferable via a “flexible” allocation scheme or otherwise. it is submitted that such an approach would result in there being a set of uniform and internally consistent answers as to the federal tax treatment of state tax credit grants, transfers and allocations. cca 200211042, discussed above, addressed the question of whether receipt of a transferable state tax credit should be includable in income. while acknowledging that transferability is a hallmark of “property,” it nonetheless concludes that the right of transferability, without more, should not require that outcome. to the contrary, the state tax credit “retains its character as a reduction or potential reduction in state tax liability” — effectively, the absence of a tax as opposed to an accretion to wealth — “unless and until it is actually sold to a third 415. accord robert feldgarden, the federal tax treatment of state tax credits, 127 tax notes 560, 563 (may 3, 2010), (citing warren jones co. v. commissioner, 524 f.2d 788 (9th cir. 1975), rev’g 60 t.c. 663 (1973)). feldgarden notes that transferability “provides some basis for treating . . . earning of the credit as a taxable event. . . . when the credit is claimed or sold . . . the [recipient] should be required to include its value in gross income for that year unless it is a corporation and the requirements of section 118 are satisfied . . . .” 742 florida tax review [vol.12:9 party.” 416 it is submitted that unless it offends bedrock principles as to the definition of “income,” the alternative conclusion (receipt of transferable state tax credits is an income event) leads to clearer and more consistent outcomes. viii. conclusion there has been a convergence of events affecting tax-based subsidies. the simpson bowles report recommends their elimination. while efforts are afoot among some to persuade congress to extend the cash grant program in effect for certain renewable energy projects through the end of 2011, as of the writing of this article this quintessential program for the monetization of tax credits is due to expire — more a victim of its “success” than failure. 417 certain tax credits are up for extension or will be soon. 418 section 7701(o) has introduced an extra measure of uncertainty as regards acceptable structures for tax credit transactions. the government’s appeal of the tax court’s decision in historic boardwalk to the third circuit is being closely watched; industry observers have expressed concern that an adverse decision could seriously undermine the market for tax credit transactions. 419 416. i.r.s. chief couns. adv. 2002-11-042 (mar. 15, 2002). 417. see shamik trivedi, future uncertain for energy tax incentive extension, 2011 tnt 236–3 (dec. 8, 2011) (quoting a commentator for the proposition that programs like the section 1603 program may be “victim[s] of their own success” which given their cost may not be extended). the article notes that as of november 11, 2011, $9.78 billion in section 1603 grants had been made to 4,254 recipients. see also eric lipton & clifford kraus, a gold rush of subsidies in clean energy search, n.y. times, nov. 9, 2011 (noting that when the obama administration and congress expanded the clean energy incentives in 2009 “a goldrush mentality took over” as “[f]rom 2007 to 2010, federal subsidies [for renewable energy projects] jumped to $14.7 billion from $5.1 billion.”). 418. see liz white, lawmakers question keeping, expanding temporary tax credits for renewable energy, 241 daily tax rep. (bna) g-3 (2011) (with numerous energy tax credit provisions expiring at the end of the year, and another five expiring at the end of 2012, including the wind industry’s 2.2-cent-per-kilowatthour production tax credit, members of a senate panel “expressed concerns . . . over keeping renewable energy industries on government subsidies for extended periods of time through tax credits rather than allowing the marketplace to run its course”). 419. see john leith-tetrault, history and the hill: the irs’ appeal of boardwalk hall v. commissioner raises concerns in the htc industry, novogradac j. of tax credits, dec. 2011, at 4 (noting potential “far-reaching impact” and high stakes “not just for the federal htc, but all similar credit transactions including the low-income housing tax credit, new markets tax credit and renewable energy tax credits.”). the author comments: [u]nlike the facts in virginia tax credit fund . . . boardwalk involves a conservatively structured operating partnership. . . . 2012] monetization of business tax credits 743 the government’s victory in the fourth circuit in the case of virginia historic tax credit has heightened concern as to the taxpayer’s chances in the historic boardwalk appeal. in its brief filed with the third circuit on october 27, 2011, as to be expected, the government exploits its victory in the fourth circuit. the common element in the two cases as framed by the government is that the taxpayer’s position fails on “substance-over-form” grounds. in both cases, the government argues the transaction in question was tantamount to a sale of the tax credits, leading to an invalidation of the allocation of the tax credits in the historic boardwalk case (involving, as it does, an allocation of federal credits) and sale treatment for the allocation of the tax credits in the virginia historic tax credit case (involving an allocation of state tax credits). interestingly, in its attempt to assuage concerns as to the reach of section 7701(o) in the context of tax-credit transactions, the jct technical explanation and the irs directive have articulated the congressional intent test, which requires that a tax credit transaction measure up to congressional intent “in form and substance.” a possible implication of a government victory before the third circuit in historic boardwalk is that for deals to pass muster they must have more substance than was demonstrated in that case — the tax credit investor must demonstrate greater benefits and burdens of ownership. without doubt, the principle that the tax benefits of ownership of an asset are to be afforded the substantive owner (subject to the ability to cede the investment credit to a lessee) is well-established as a matter of tax policy. however, part v makes the case that the ultimate policy goals of the current array of federal tax credits discussed in this article would be better served by adoption of a tax benefit transfer regime such as the short-lived safe-harbor leasing rules enacted under erta. upon the expiration of the cash grant program and a return to the status quo ante for renewable energy projects, given current economic conditions, the tax base problem that led to the enactment of the grant program in the first place is likely to persist. constraining the monetization of tax credits through the continued imposition of substantive requirements — and, after the third circuit renders judgment in historic boardwalk potentially “enhanced” substantive requirements — will only hinder the the pending appeals court decision may well answer the question that the irs continues to pose in a number of circumstances: whether traditional historic tax credit (htc) structures that rely on managing member guaranties, fixed priority returns and standard put and call exit strategies to attract limited partner capital can meet the requirements for characterization as a federal tax partnership. id. 744 florida tax review [vol.12:9 delivery of tax-based subsidies to their intended beneficiaries. 420 if, to the contrary, the goal is “investable credits” (a phrase coined for lihtcs), 421 that is where the focus should be placed. as was true in 1981, adoption of a tax benefit transfer regime, of course, would require legislative action. the survey of initiatives undertaken by some of the states is a potential source of instruction in connection with the design of a federal system of “investable” credits. part vii examined the emerging federal tax treatment of the issuance, transfer and allocation of state tax credits and suggests that in both tempel and virginia historic tax credit the courts missed the opportunity to characterize the issuance of transferable state tax credits as an income inclusion event for federal income tax purposes. part vii. d. offers a “unifying rule” that proceeds from that idea. the underlying thought might even warrant consideration in the design of a federal tax benefit transfer regime. a system of refundable credits has some of the elements of a cash grant program. like the cash grant approach, it addresses the core issue of absence of a tax base head-on. it presumably would require a congressional appropriation. it likely would fit within existing enforcement mechanisms more easily than the section 1603 cash grants. in theory, it would eliminate the need for other forms of tax credit monetization. however, in practice, the use of refundable credits may not attract the wider base of financial support for certain projects that an “investable” credit would. 422 a study by desai, dharmapala, and singhal found that the lihtc was successful in attracting largely non-real estate investors to invest in lowincome housing projects. 423 this correlates to the fact that lihtc investors are investing for the credit; fundamentally, these investors are not making an economic bet on real estate. the tax benefits of the investment are “unbundled” which, in turn, “undoes the bias toward providers with taxable income” otherwise inherent in tax-based subsidies. 424 the desai, dharmapala, and singhal study notes “comparable devices” to neutralize this bias: refundable credits and “an untrammeled leasing market” (presumably a reference to the safe-harbor leasing rules). 425 as noted in the preceding discussion, the adoption of the safe-harbor leasing rules under erta was preceded by a period of analysis and evaluation of a number of alternative options, including not only a 420. one can question the need for and basic value of these subsidies, but that is a subject for a different article. 421. see supra note 151 and accompanying text. 422. see, e.g., supra note 150–58 and accompanying text. 423. desia et al., investable tax credits, supra note 132. 424. see supra note 152 and accompanying text. 425. see supra note 156 and accompanying text. 2012] monetization of business tax credits 745 refundable investment tax credit but also a “pure sale of the benefits.” 426 the choice of a “safe harbor guarantee of lease treatment” seemed to reflect both a concern, on the one hand, to come up with a regime that addressed the acrs benefit as well as the investment tax credit and a desire, on the other hand, to require the (nominal) lessor to “pick up an income stream from the transaction in the form of rent payments.” 427 the resulting construct was not uncomplicated. there are numerous examples of transferable state tax credits, involving varying types and degrees of protection against the risk of “fraud and abuse.” among other things, a well-designed system presumably would seek to ensure that as between the transferor and transferee (or as among the partners and the partnership, in the case of a “flexible” allocation scheme) one can discover the requisite “bundle of sticks” of ownership. that is, a third party should not have a superior claim to substantive ownership. 428 which among these various options or others warrants consideration, if any, depends on one’s frame of reference. if the judgment is that all tax expenditures should go, the question is moot. however, if the judgment is that some tax expenditures should stay, given the budgetary crisis facing the united states, as a starting point the articulation of the underlying goals and intended beneficiaries of current tax-based subsidies should be sharpened and our existing “delivery mechanisms” closely examined and possibly overhauled. 426. see supra note 105 and accompanying text. 427. see supra note 105 and accompanying text. on the question of macrs depreciation deductions for subsidized projects, it seems that a program of transferable tax credits, without more, would not do anything to “relocate” the deductions. depreciation deductions, of course, have a “structural” aspect insofar as allowable depreciation deductions match economic depreciation. accelerated depreciation deductions, on the other hand, include a “subsidy” component. in theory, a “purchaser” could be allowed to claim accelerated deductions provided the purchaser recaptures them as the owner of the asset claims depreciation over the economic useful life of the asset. however, there does not appear to be any precedent for such an approach; moreover, this might be viewed as taking the subsidy argument too far. 428. see supra note 94 and accompanying text. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe tcharity really does begin at home: florida tax review volume 11 2011 number 2 75 the corporate income tax: a persistent policy challenge by jane g. gravelle i. introduction ...................................................................................... 76 ii. in the beginning ................................................................................ 77 iii. the growth of the income tax .................................................... 79 a. tax rates rise ........................................................................... 79 b. interaction between corporate and the individual tax ............ 80 c. publicity of tax returns ............................................................ 81 iv. issues and research in the early years .................................... 82 v. the 1950s to the 1980s: the era of investment subsidies and economic modeling of the corporate tax ...................... 83 a. modeling the corporate tax and integration proposals .......... 83 b. integration proposals ................................................................ 84 c. savings and risk ........................................................................ 84 d. investment subsidies .................................................................. 85 e. the corporate world after 1986 .............................................. 86 vi. international tax issues: the spoiler? .................................... 87 a. history of foreign tax provisions ............................................ 87 b. revenue and compliance .......................................................... 89 c. reconsideration of who bears the burden ............................... 89 d. economic efficiency issues and constraints on integration ..... 90 vii. policy options.................................................................................. 91 76 florida tax review [vol.11:2 the corporate income tax: a persistent policy challenge by jane g. gravelle* i. introduction a newspaper article published in late october 2010 describes a scheme referred to as the “double irish” with a “dutch sandwich” that used a variety of rules to reduce taxes on the income of the search company google to 2.4 percent.1 the method involved transferring the intangible asset developed by google in the united states to an irish holding company, with another, active, irish subsidiary of that firm selling advertisements in europe. the sales subsidiary paid royalties, eliminating its own irish tax. the royalties were diverted through a subsidiary in the netherlands to avoid the 20 percent irish withholding tax on royalties. the netherlands subsidiary then made payments to the irish holding company whose tax residence was in bermuda, with no tax. as a result, the income avoided both the 35 percent u.s. corporate tax and the 12.5 percent irish corporate tax. although not a company that is a household name, forest laboratories, a drug company, used a similar scheme but, in its case, exported pills made in ireland back to the united states.2 both articles described how many companies are using, or considering, such a plan. these examples illustrate problems with enforcing the intent of the corporate tax with respect to multinational firms. at the same time, arguments are made both by multinationals, and some researchers, that the tax rate in the u.s. is too high and should be lowered to make u.s. firms competitive and that, in any case, the tax falls on labor and not capital. in some ways, the discussion of corporate tax issues has appeared to be * senior specialist in economic policy, congressional research service, library of congress, washington, dc. b.a., m.a., university of georgia; ph.d., george washington university. this article was presented as the inaugural ellen bellet gelberg tax policy lecture at the university of florida levin college of law on november 12, 2010. the views in this study do not reflect the views of the congressional research service. 1. jesse drucker, google 2.4 percent rate shows how $60 billion lost to tax loopholes, bloomberg, oct. 21, 2010, http://www.bloomberg.com/news/201010-21/google-2-4-rate-shows-how-60-billion-u-s-revenue-lost-to-tax-loopholes.html. 2. jesse drucker, u.s. companies dodge $60 billion in taxes in global odyssey, bloomberg, may 13, 2010, http://www.bloomberg.com/news/2010-0513/american-companies-dodge-60-billion-in-taxes-even-tea-party-wouldcondemn.html. 2011] the corporate income tax 77 transformed into a discussion of international corporate tax issues, as if only that issue matters. the corporate income tax and issues associated with it have evolved from earlier years, when the economy was essentially a closed economy, assets and goods tended to be tangible, and the corporate tax was esteemed as a reliable and easily collectible source of revenue, whatever its other faults. is the international evasion/avoidance rate a major or minor issue? how much have the issues that surrounded the corporate income tax evolved over time? are the debates and research that have filled our law and economics journals still relevant, or are they obsolete? should our domestic corporate tax rate be held hostage to the tax rates of other countries? this study traces the evolution of the tax and its features alongside the evolution of ideas and research to the important issues surrounding the corporate tax in the past and whether they inform the present. as the past is examined, certain ideas that tend to be quickly rejected, at least by policy makers, such as making corporate returns public, were not only accepted in the early years, but an important justification for the tax. some issues, such as revenue, always remain, while others, such as who bears the burden of the tax, moved from uncertain, to settled, to uncertain again. some, such as the benefit principle of corporate taxation, have become obsolete. and yet other issues, such as the use of the corporate tax as a shelter from high income tax rates, seem to be ignored in the current debate over the corporate tax rate. ii. in the beginning the corporate tax, enacted in 1909, predated the sixteenth amendment and the individual income tax, enacted in 1913.3 it was enacted by a republican congress and president as an excise tax (hoping to protect it from the supreme court decision outlawing the 1894 income tax).4 the proximate cause of the tax was to avoid a potential confrontation between congress and the courts arising from a push for a general income tax whose constitutionality was in question – a push that was made in the senate by a combination of democrats and liberal republicans who sought to deflect high tariffs as well. thus, ironically, the original corporate tax was supported by conservative republicans and opposed by democrats and liberal republicans who supported a more general income tax.5 in addition to 3. see corporate tax act of 1909, pub. l. no. 61-4, ch. 6, § 38, 36 stat. 11, 112 (1909) (imposition of corporate tax); u.s. const. amend. xvi. (ratified feb. 3, 1913); revenue act of 1913, pub. l. no. 63-16, ch. 16, 38 stat. 114 (1913) (imposition of income tax). 4. pollock v. farmers’ loan and trust co., 157 u.s. 429 (1895). 5. an account of the 1909 congressional deliberations that led to the corporation income tax is presented in considerable detail in sidney ratner, taxation 78 florida tax review [vol.11:2 proposing a corporate tax to head off the general income tax and the potential pitfalls of another consideration by the supreme court, president taft and the conservative republicans proposed a constitutional amendment to allow an income tax.6 despite the rather confusing state of affairs surrounding the first corporation income tax, the backdrop for this extraordinary chain of events was the growing popular support for the income tax and its ability to impose taxes on the wealthy, to reduce the concentration of power, and to provide for a flexible revenue source.7 president taft also argued that the tax would provide government and the public knowledge of gains and profits of corporations and prevent the abuse of power. the original measure was drafted to achieve several expectations of the president: additional revenue of $50 million per year, government information about and supervision of corporations, and discouraging excessive borrowing. in the latter case, however, despite concerns that deducted interest would encourage the substitution of bonds for stock, the decision was made to allow the deduction of interest on bonds.8 returns were to be public. nevertheless, even in this early debate, senator borah, one of the republican insurgents who supported an income tax, raised the issue of whether the tax might be shifted to those who already bore the burden of government (that is, consumers who paid the tariffs).9 the house, under pressure from the president, agreed to the corporate tax in conference, but with the rate reduced from two percent to one percent. the proposed corporate tax was criticized by business interests as discouraging initiative, killing the profit motive, hampering recovery from the 1907 panic, and sanctioning government prying into business. after enactment it was challenged in court by numerous corporations. the rationale of the supreme court in finding the tax constitutional was that it was an excise tax on the privilege of doing business in the corporate capacity.10 and democracy in america, 265-297 (octagon books 1980) (1942) and in roy g. blakely & gladys c. blakey, the federal income tax, 22-59 (longmans, green and co. 1940). this debate is also discussed more briefly in john f. witte, the politics and development of the federal income tax, 74-75 (univ. of wis. press 1967), and in w. elliot brownlee, federal taxation in america, 49-53 (cambridge univ. press 2004) (1996). 6. see stanley d. solvick, william howard taft and the payne-aldrich tariff, 50 miss. valley hist. rev. 424, 435 (1963). 7. ratner, supra note 5; brownlee, supra note 5. 8. blakey, supra note 5, at 43, 46. 9. ratner, supra note 5, at 288. 10. id. at 295. 2011] the corporate income tax 79 thus, out of the hurried original adoption of the corporate income tax, some issues have remained a part of the policy debate to this day: the distributional effects and incidence of the tax, its usefulness as a revenue raiser, discouragement of corporate activity, and distorting debt-equity choices. the objective of corporate control and public information about corporations has faded, however, and tax returns are not public. similarly, the benefit principle argued during the debate and considered by the courts as a justification is generally not accepted by economists as a rationale for the tax.11 iii. the growth of the income tax a. tax rates rise by 1913, with the republican party split, the democrats were in power and a general income tax was enacted with bipartisan support,12 an income tax which the corporate tax became a part of. rates were low for both taxes and the tax was clearly aimed at the rich, although motivated also by revenue needs.13 tax rates were increased in 1916,14 and according to brownlee, the basic principle underlying the individual income tax was ability to pay, while the benefit principle supported the corporation tax.15 the debate over the corporate tax has been described as “whether the modern corporation was the central engine of productivity, which tax policy should reinforce, or whether it was an economic predator, which tax policy could and should tame.” 16 one could argue that, in some ways, that tension exists today. another history, however, claims that the rise in the corporate tax was due to the pressing needs for war revenue and the deficit.17 in any case, during world war i an excess profits tax was introduced and accounted for two-thirds of federal revenue.18 after world war i, when the excess profits tax accounted for the bulk of revenues, republicans returned to power and enacted the mellon tax 11. joseph a. pechman, federal tax policy, 135-36 (the brookings institution 1966). 12. see revenue act of 1913, supra note 3. 13. brownlee, supra note 5, at 55. 14. revenue act of 1916, pub. l. no. 64-271, ch. 463, 39 stat. 756 (1916). 15. brownlee, supra note 5, at 64. 16. brownlee, supra note 5, at 61. 17. witte, supra note 5, at 81-82. 18. brownlee, supra note 5, at 64-65. 80 florida tax review [vol.11:2 cuts.19 the arguments for cutting taxes on corporations and high income individuals would seem familiar to someone observing the corporate tax debate today: tax reductions were necessary to stimulate economic expansion and restore prosperity, and high taxes caused damaging behavioral responses — reduction in entrepreneurial effort, passing the tax on to customers, and avoiding taxes by moving investments into tax favored avenues.20 nevertheless, while the excess profits tax was eliminated, normal corporate taxes were retained. unlike the individual income tax, where rates rose and fell during the two wars, the basic corporate top rates of around thirteen percent were retained after world war i, rose again in world war ii to around forty percent, and were retained afterward, eventually rising to around fifty percent in early 1951, and remaining in that general neighborhood until 1986.21 (the world war ii excess profits tax was eliminated, however.) b. interaction between corporate and individual tax another issue addressed early on was the interaction between individual and corporate taxes. the individual income tax was initially imposed as a normal tax which was relatively low (one percent) and a surtax.22 from the beginning of the income tax until 1936, dividends were excluded from the tax base for purposes of the normal tax.23 thus, there was early recognition of the double tax imposed under the corporate and individual income taxes. at the same time, there was also concern about the use of corporations to shelter income of wealthy individuals from the higher individual surtaxes. from 1921 to 1936, a series of penalties on surpluses and improper accumulations were imposed.24 since undistributed earnings were not taxed until realized as capital gains (and then often at preferred rates) and dividend payments were discretionary, individuals who were subject to surtax rates that ranged as high as sixty-three percent during the period, as compared to corporate rates of around thirteen percent, could 19. see revenue act of 1921, pub. l. no. 67-98, ch. 136, 42 stat. 227 (1921); revenue act of 1924, pub. l. no. 68-174, ch. 233, 43 stat. 253 (1924), revenue act of 1926, pub. l. no. 69-19, ch. 27, 44 stat. 9 (1926). 20. witte, supra note 5, at 74. 21. for a history of income tax rates, see pechman, supra note 11, at 31323. 22. see supra note 3. 23. for a history of the tax treatment of dividends, see jane g. gravelle, the taxation of dividend income: an overview and economic analysis of the issues, congressional research service, april 1, 2008, rl31597. 24. ratner, supra note 5, at 418, 466, 470. 2011] the corporate income tax 81 avoid tax through this mechanism. how effective these penalties were is not known, but in 1936, president roosevelt proposed to substitute a tax on undistributed earnings, with repeal of the penalty taxes and full inclusion of dividends in the individual income tax base. one of its purposes was to prevent leakage in the tax system. the final legislation retained the corporate tax but added a tax that was graduated according to undistributed profits.25 the penalty tax was reduced for firms subject to this tax. further increases in penalties on personal holding companies were adopted in 1937.26 with fierce business opposition to the undistributed profits tax and a recession in 1937, legislation was adopted to eliminate the undistributed profits tax, against roosevelt’s opposition.27 c. publicity of tax returns a second issue in this early period was the publicity of tax returns.28 as noted above, one of president taft’s objectives for the corporate tax in 1909 was to use the information gathered to aid in regulation and transparency. corporate tax returns were initially public under the 1909 law, but that law was amended in 1910 to allow public inspection only at the direction of the president.29 treasury regulations permitted stockholders to inspect returns, and, in the case of corporations with publicly traded stock, access was available to all. in the 1913 law, information on individual returns was not revealed, although information on corporate returns was made available. in 1924, however, all tax returns were made public. after newspapers published lists of taxpayers and ran articles on local citizens, the disclosure of both was eliminated in 1926. today tax returns are not public, and other relationships between taxpayers and the internal revenue service are not known (although proposals for making corporate returns public were made in 2003 in the wake of the enron collapse).30 for example, in the google case none of the details of the advance pricing agreement that permitted google to transfer its intangible asset to ireland are public. 25. id. at 472-73. 26. id. at 477. 27. id. at 474. 28. see david lenter, joel slemrod & douglas shackelford, “public disclosure of corporate tax return information: accounting, economics and legal perspectives,” national tax journal, vol. 61, dec. 2003, pp. 803-830 for a history of the disclosure of tax return information. 29. blakey & blakey, supra note 5, at 98. 30. lenter, slemrod & shackelford, supra note 28. 82 florida tax review [vol.11:2 iv. issues and research in the early years some of the early arguments for the corporate tax have largely been abandoned, such as the claim that a tax is justified because of benefits received from the state (limited liability) or to reduce concentrations of power.31 the most prominent issues surrounding these early years of the corporate income tax were the effects on the high income and possible disincentives, and, of course, the ability to raise revenue, issues that remain today. arguments that the corporate tax would soak the rich or devastate incentives were not based so much on evidence as on speculation. the infant economics research of the day did not have much to say about this issue.32 economists discussed the possibility that the tax would be shifted to consumers (echoing issues raised by senator borah in 1909) or possibly back to wages. most economists believed that shifting could not occur in the short run, with profit maximizing firms, since setting a different price when the firm could not alter capital would not lead to maximum pre-tax profit, and therefore not to maximum after-tax profit. with increasing reliance of economic research on more sophisticated statistical methods, in the 1950s a number of studies examining profit data were used to estimate whether the tax was shifted, culminating in the research by krzyzaniak and musgrave in 1963, which indicated that the tax was shifted in the short run.33 if the tax falls on consumers in the short run or the long run, it is not a progressive tax that falls on higher incomes but a largely proportional tax falling on the same groups as the tariffs the tax initially replaced. these short run results tended to be viewed suspiciously by some economists, as they did not accord with theory.34 in 1962, about the same time that krzyzaniak and musgrave published their study, a seminal paper appeared by arnold harberger that was to shape the analysis of the corporate tax until the present.35 ultimately, the profession abandoned the attempt to estimate the incidence of the tax with direct statistical methods and instead turned to general equilibrium 31. pechman, supra note 11. 32. for a review of this research, see jane g. gravelle, corporate income tax: incidence, economic effects and structural issues, in john g. head & richard krever, tax reform in the 21st century, 359-61 (kluwer law international bv 2009). 33. marian krzyzaniak & richard a. musgrave, the shifting of the corporation income tax: an empirical study of its short-run effect upon the rate of return (johns hopkins press 1963). 34. gravelle, supra note 32, at 360-61. 35. arnold harberger, the incidence of the corporate tax, 70 j. polit. econ. 215, 215-40 (1962). 2011] the corporate income tax 83 models of the corporate tax which embedded economic relationships such as the substitutability of labor for capital in production and the substitutability across goods by the consumer. harberger’s analysis indicated that the corporate tax was spread, but spread to other forms of capital, with its incidence the same as a general tax on capital. in this view, the tax remained a progressive one. v. the 1950s to the 1980s: the era of investment subsidies and economic modeling of the corporate tax a. modeling the corporate tax and integration proposals the harberger model revolutionized thought about the corporate tax. in this model, initially a simple two-sector model that could be solved on paper, corporations raised prices to their consumers as capital left the corporate sector, but prices in the noncorporate sector fell. assuming consumers did not vary systematically across the goods they purchased, there was no effect on tax burden through this mechanism. as capital migrated to the noncorporate sector, its greater abundance reduced its rate of return, while as capital left the corporate sector the return rose but not enough to fully offset the tax. for reasonable assumptions about the ability of firms to substitute capital and labor and consumers to substitute products, wages were left unchanged and the entire burden was borne by capital. the model, however, also highlighted efficiency issues, and created a method of estimating the magnitude of the distortions in production (too much capital in the noncorporate sector and too little in the corporate sector) and consumption (too much noncorporate output). subsequent models explored many variations. in general, they found the incidence results to persist despite many modifications.36 many of these modeling exercises stressed the distortions arising from the corporate tax, not only in the allocation of capital between the corporate and noncorporate sectors, but also in debt-equity ratios, dividend payout ratios, and lock-in effects from taxes on capital gains.37 36. for a review of closed economy models and incidence, see jennifer c. gravelle, cong. budget office, corporate tax incidence: review of general equilibrium estimates and analysis 35-41 (2010), available at http://www.cbo.gov/ftpdocs/115xx/doc11519/05-2010-working_papercorp_tax_incidence-review_of_gen_eq_estimates.pdf. 37. see jane g. gravelle, economic effects of taxing capital income 7590 (1991) for a review. 84 florida tax review [vol.11:2 b. integration proposals economists increasingly began to discuss ways of integrating the corporate and individual income tax. one integration method, already considered in 1936, was to tax undistributed earnings at the corporate level and dividends at the individual level.38 ideally, to eliminate the differences between corporate and noncorporate investment, corporations should be treated as partnerships, with each stockholder taxed directly on his or her share. but it has become clear that with modern corporations and millions of shares constantly changing hands, this purist approach will not work. the undistributed profits tax approach was now referred to as a dividend deduction. if the corporate rate and the top individual rate were close together, taxes could be eliminated at the individual level, but that was not the case during this era. other alternatives were to provide a dividend credit for firm taxes paid on dividends. in general, the best approach depended on other elements of the tax structure, and, as will be seen subsequently, on the importance of the open economy.39 c. savings and risk increasingly complex models also considered the effects of capital income taxes on savings (although this effect was not unique to the corporate tax). most direct evidence on savings rates found little evidence of a relationship between tax rates and savings rates.40 dynamic models that either treated the economy as one infinitely-lived person, or that included cohorts of individuals with finite life spans, found mixed results for savings effects depending on the model and whether the capital income tax was replaced with a wage tax or a consumption tax.41 many economists came to have reservations about these models that depicted super-rational, perfectlyinformed individuals making savings decisions. finally, economists had long recognized that capital income taxes offset some of their burden with the reduced variance of return: when income falls, the government shares in the reduction, just as it shares in the rise. with perfect offset of losses, indeed, one could argue that there is no burden of the tax.42 38. see supra notes 24-26 and accompanying text. 39. gravelle, supra note 37, at 90-93 (reviewing alternative approaches). 40. id. 41. gravelle, supra note 32, at 374-375 for a review. 42. see, e.g., evsey v. domar & richard a. musgrave, proportional income taxation and risk-taking, 58 q. j. econ. 388 (1944); roger gordon, taxation of corporate capital income: tax revenues vs. tax distortions, 100 q. j. econ. 1 (1985). 2011] the corporate income tax 85 d. investment subsidies while economic analysis was making strides in modeling the incidence of the corporate tax, and to some extent other behavioral effects, events were occurring within the corporate tax that created new challenges: the growth of investment subsidies. a variety of preferences had occurred in the corporate tax beginning in the early years; indeed, depreciable lives had been largely left to the taxpayer’s discretion (although the straight-line method was required).43 not surprisingly, this freedom to set deductions led to revenue shortfalls, and in 1934 the internal revenue service began to prescribe useful lives.44 if the lives and methods were correct, income would be taxed at higher than the statutory rate with inflation because depreciation deductions were not stated in current dollars. with the statutory rate at fifty-two percent in 1954, the effective rate on new investment at the firm level was estimated at sixty-three percent.45 (this measure of effective tax rate examines a prospective investment and estimates the pre-tax return given a required after-tax, with the effective tax rate the difference in returns as a share of the pre-tax return). in 1954, adoption of accelerated methods appeared to bring depreciation in line with statutory rates at prevailing inflation rates, with an effective tax rate of fifty percent.46 but in 1962, the adoption of an investment tax credit and shorter depreciable lives led to an estimated fortytwo percent rate.47 the statutory rate was cut to forty-eight percent by the 1964 legislation.48 the investment credit was on-again, off-again during the 1960s and inflation increased substantially in the late sixties causing effective tax burdens to rise which largely offset new shorter lives introduced in 1971.49 dramatically shorter lives in 1981, however, pushed effective rates towards thirty-five percent, as compared to a statutory tax rate of fortysix percent.50 43. gravelle, supra note 37, at 263-67 (providing a history of depreciation policy and the investment credit). 44. revenue act of 1934, pub. l. no. 73-216, 48 stat. 680 (1934). 45. see jane g. gravelle, the corporate tax: where has it been and where is it going?, 57 nat’l tax j. 903, 905 (2004). 46. revenue act of 1954, pub. l. no. 83-591, § 167, 68a stat. 5 (1954); gravelle, supra note 45, at 905. 47. revenue act of 1962, pub. l. no. 87-834, § 38, 76 stat. 1009 (1962); rev. proc. 62-21, 1962-2 c.b. 418; gravelle, supra note 45, at 905. 48. revenue act of 1964, pub. l. no. 88-272, 78 stat. 19 (1964). 49. revenue act of 1971, pub. l. no. 92-178, § 109, 85 stat. 508 (1971). 50. economic recovery tax act of 1981, pub. l. no. 97-34, 95 stat. 172 (1981); gravelle, supra note 45, at 905. 86 florida tax review [vol.11:2 this era of fluctuating tax rates and varying investment subsidies ended in the mid 1980s when inflation began to subside and stabilize, and the tax reform act of 1986 broadened the base and lowered the rate.51 the statutory corporate rate was lowered to thirty-four percent, the investment credit was repealed, and depreciation more in line in present value with economic depreciation was enacted. the tax rate in 1987 was estimated to be about the same as the statutory rate, although that rate has since declined a few percentage points because of the further decline in inflation (partially offsetting an increased depreciable life for nonresidential buildings and a one percentage point increase in the corporate rate).52 economists experienced some lags in coming to terms with how to analyze these subsidies, as well as the effects of inflation, on overall investment and on investment in assets of different durabilities. the first modern theory examining investments in depreciable assets was not published until 1963, and taxes were not immediately incorporated into the analysis.53 through some auspicious developments in theory and in evidence on economic depreciation rates, along with devising a simple method of communicating with policy makers (effective tax rates), economists could show how investment subsidies produced distortions across assets of durability and could, indeed, lead to negative tax rates, as was the case in 1981.54 while this analysis may not have been responsible for the eliminating of subsidies in 1986, it provided analytic support for these revisions. e. the corporate tax world after 1986 in a closed economy world, the corporate tax was beginning to look quite sensible. rates were actually slightly above the top individual rate (although that did not last past 1993) and, for that reason, it was possible to consider some different integration methods, such as eliminating taxes at the individual level on dividends. in the late 1980s, the treasury department engaged in an extensive study of corporate integration and exclusion of dividends at the individual level was considered a possible option.55 the treasury studied a comprehensive business income tax (cbit) that taxed 51. tax reform act of 1986, pub. l. no. 99-514, 100 stat. 2085 (1986). 52. gravelle, supra note 45, at 905. 53. dale jorgenson, capital theory and investment behavior, 53 am. econ. rev. 247 (1963); gravelle, supra note 32, at 372-374 (discussing the forces that came together, both theoretical and empirical, that allowed economists to access investment subsidies). 54. gravelle, supra note 45, at 905. 55. u.s. dept. of treasury, report on integration of the individual and corporate tax systems, washington, d.c., u.s. government printing office, 1992. 2011] the corporate income tax 87 earnings from debt and equity only at the firm level. a reduction in the tax rate on dividends was enacted in 2003, although it was a temporary part of the bush tax cuts.56 other developments in the tax system, such as the large fraction of corporate stock now held in tax-exempt retirement plans, made reducing individual level taxation less expensive. inflation rates were lower which, along with lower firm level rates, reduced the debt equity distortion. depreciation methods appeared to treat different assets in a relatively neutral fashion. vi. international tax issues: the spoiler? even as the corporate tax was being reformed, events were leading to new wrinkles in corporate tax policy making: the increasingly open economy, the growing importance of intangible assets, and more sophisticated methods of avoiding the corporate tax through international profit shifting. a. history of foreign tax provisions through most of the development of the corporate income tax, not a great deal of attention had been paid to international issues. legal principles meant that income of foreign subsidiaries was not subject to u.s. tax until it was repatriated (paid to the parent as a dividend). for income that was taxed, the first corporate tax allowed a deduction for foreign taxes paid, which was converted into a credit in 1918.57 in 1921, foreign tax credits were limited to the aggregate u.s. tax due on foreign source income (the “overall limit”). at that time, the two basic features of u.s. tax with respect to foreign source income were the same as those today: taxes on foreign source income could be deferred indefinitely and taxes paid to foreign countries in excess of the u.s. tax could be used to offset u.s. tax on income from low tax countries (cross crediting). in addition to cross-crediting by country, differential foreign tax rates that vary by type of income could be cross credited. during various periods in history, beginning in 1932, an alternative per-country limit which applied on a country-by-country basis was allowed or required, although regulations that sourced income to holding companies rather than the sources of their income allowed firms to achieve overall 56. jobs and growth tax relief reconciliation act of 2003, pub. l. no. 108-27, 117 stat. 752 (2003). 57. the history of international tax provisions is discussed in detail, through 1989, in william p. mcclure & herman b. bouma, the taxation of foreign income from 1909 to 1989: how a tilted playing field developed, 43 tax notes 1379, 1381 (1989). 88 florida tax review [vol.11:2 limits on their own. the per-country limit was eliminated in 1976.58 however, income has been separated at various times into different foreign tax credit baskets by type of income which prevent cross-crediting. in the 1986 tax reform act, the initial treasury and administration proposals were to reinstate the per-country limit, but the bill ultimately expanded the number of foreign tax credit baskets from two to several.59 in 2004, numerous baskets were returned to two baskets, passive and active.60 in 1961, the kennedy administration proposed to tax foreign source income currently (except for non-tax-haven income in less developed countries).61 while this provision was not adopted, certain passive income that was easily shifted was currently taxed (referred to as subpart f income). in the early 1970s, the burke-hartke proposals to eliminate deferral and end the foreign tax credit received attention, but had no success. in 1978, president carter again proposed ending deferral.62 despite these attentions to international tax issues, most principal decisions about the corporate tax were made without much consideration for these concerns. the tax reform act of 1986 was no exception: the rate of the tax was chosen to be revenue neutral and close to the top marginal individual tax rate. nevertheless, the tax rate reduction in the u.s., along with rate reductions that also occurred in the u.k. and ireland, led to a trend in falling rates around the world.63 in 1982, statutory tax rates, including sub-national taxes, were fifty percent or higher in the g-7 and australia, except for italy (thirty-nine percent) and canada (forty-four percent), with indications of significant variations in the effective tax rates on investment in equipment and buildings.64 by 2005, they ranged from thirty percent to 58. tax reform act of 1976, pub. l. no. 94-455, 90 stat. 1720 (1976). 59. tax reform act of 1986, pub. l. no. 99-514, § 904, 100 stat. 2085 (1986). 60. american jobs creation act of 2004, pub. l. no. 108-357, 118 stat. 1418 (2004). 61. message from the president of the united states relative to our federal income tax system, apr. 20, 1961, reprinted as m. r. doc. no. 87-140, at 6-7 (1961). 62. president jimmy carter, tax reduction and reform message to the congress (jan. 20, 1978), available at http://www.presidency.ucsb.edu/ws/index. php?pid=31055. 63. see cong. budget office, corporate income tax rates: international comparisons (2005), available at http://www.cbo.gov/ftpdocs/69xx/doc6902/11-28corporatetax.pdf. 64. jane g. gravelle, economic effects of investment subsidies, in tax reform in open economies: international and country perspectives 38, 39, (iris claus, et al. eds., 2010). 2011] the corporate income tax 89 forty percent.65 one could argue that the u.s. started the “race to the bottom.” the open economy with international investment, as well as trade, changes the nature of some of the traditional issues and policy proposals. b. revenue and compliance first, with respect to revenue and compliance, collecting the corporate tax is more difficult. the tax gap for corporations was estimated in 2001 at about $32 billion, or about fifteen percent of revenues at that time,66 but some authors estimate another $30 billion of revenue was lost in international profit shifting.67 estimates vary substantially, and the cost may have increased with the increasing importance of intangible assets that are difficult to value, as well as new techniques made possible by “check-thebox” rules. (these rules allow a firm to elect to recognize or disregard a subsidiary). c. reconsideration of who bears the burden the open economy also led to a reconsideration of who bears the burden. in the 1980s, economists began to make the point that in a small open economy with rates of return and worldwide prices of a single good fixed, labor bears 100% of the burden of a capital income tax.68 this effect occurs through the migration of capital to other countries in the face of the tax, with a smaller capital stock lowering the wage rate. however, the share falling on labor falls as the size of the economy grows, and also if perfect mobility of capital and perfect substitutability of products does not exist. a review of open economy models of increased sophistication showed five important drivers of incidence: country size, capital intensity of the taxed and traded sector, factor substitution in production, capital mobility, and product substitution.69 based on empirical estimates, one review of these models and evidence suggested about sixty percent of the tax 65. id. at 39. 66. james bickley, cong. research serv., r40219, tax gap, tax enforcement, and tax compliance proposals in the 111th congress (2010). 67. for a review of estimates of the revenue cost of international profit shifting, see jane g. gravelle, tax havens: international tax avoidance and evasion, 62 nat’l tax j. 736 (2009). 68. see, e.g., laurence kotlikoff & laurence h. summers, tax incidence in handbook of public economics (alan j. auerbach & martin s. feldstein, eds., vol. 2 1987). 69. gravelle, supra note 30. 90 florida tax review [vol.11:2 fell on capital and forty percent on labor.70 the author also pointed out two issues that pushed the incidence further towards falling on capital. first, if debt is taken into account, and is more mobile, higher tax rates could have the opposite effect by increasing capital inflows and benefitting labor, since debt is subsidized at the firm level.71 (two factors cause debt to be subsidized, rather than taxed at a zero rate: the ability to deduct the inflation portion of the interest rate and the tax subsidies allowed through accelerated depreciation and other provisions that reduce the effective tax rate on the flow of income below the statutory rate). secondly, if all countries estimate incidence as if their tax were the only tax, the overall burden of worldwide taxes would be incorrect, as, worldwide, the tax falls on capital.72 this point is particularly important if countries tend to raise or lower their taxes in response to others. if only the differential from the average tax rate worldwide tax rate is allocated in part to labor, over ninety percent of the burden falls on capital.73 a series of empirical studies, reminiscent of the 1950s, also tried to estimate corporate tax incidence directly through statistical methods, and tended to show a link between the corporate tax and wages (largely using cross country studies) but the results of these studies have been subject to criticism, showing the positive relationships to depend heavily on specification.74 despite open economy challenges, it still appears that the corporate tax is a progressive tax that largely falls on capital income. d. economic efficiency issues and constraints on integration the open economy issue led to consideration of a new distortion, allocation of capital worldwide. for outbound capital, although multinationals claimed neutrality and fairness require treatment of foreign subsidiaries to be the same as their local competitors (which implied that foreign source income not be taxed), economic theory indicated world wide efficiency required equal treatment of foreign and domestic investment (requiring current taxation and foreign tax credits). policies that maximized national welfare required current taxation of foreign source income and a deduction for foreign taxes.75 70. id. at 25. 71. id. at 28. 72. id. at 30. 73. id. at 31-33. 74. jane g. gravelle & thomas l. hungerford, corporate tax reform: should we really believe the research?, 121 tax notes 419 (2008). 75. these issues are discussed in jane g. gravelle, international corporate income tax reform: issues and proposals, 9 fla. tax rev. 471 (2009). 2011] the corporate income tax 91 multinational firms also argued u.s. taxes should be cut to make the united states a more competitive location. according to economic theory, however, for inbound treatment, worldwide efficiency was in turn driven by tax rates in the u.s. versus tax rates faced by various countries’ firms in other places. optimal taxation from the u.s. standpoint depended on the mobility of capital and on the foreign parent’s tax rate.76 open economy considerations with respect to inbound treatment also complicate corporate tax integration. in an open economy, it is better to impose corporate source taxes at the individual level, where taxes apply on a residence/ownership basis, than at the firm level, which can affect allocation of capital. the exemption of a large amount of income from tax at the individual level through tax exempt retirement funds now becomes a liability in integrating the tax without losing too much revenue. also, reducing the subsidy for debt finance, either directly through limiting interest deductions or indirectly through lower tax rates, becomes less attractive if debt is more highly mobile than equity. vii. policy options the most important corporate policy issue is the proposal to cut the corporate tax, with or without base broadening, in order to be “competitive” with other countries. a recent article, for example, proposes to cut the tax rate to twenty-five percent77 and the tax reform proposal advanced by senators wyden and gregg cut the corporate rate to twenty-four percent.78 despite proposals to expand the corporate tax base, such expansion is difficult, for a variety of economic and political reasons.79 in addition, although these reforms would reduce the revenue cost, they would offset the reduction in the effective tax rate. thus, it is likely that a revenue loss, perhaps a significant one (in the neighborhood of $100 billion per year) would arise.80 76. id. 77. see kevin hassett, end, don’t extend, bush tax cuts for a fresh start, bloomberg, nov. 7, 2010, http://www.bloomberg.com/news/2010-11-08/end-don-textend-bush-tax-cuts-to-start-new-commentary-by-kevin-hassett.html. 78. s. 3018, 111th cong. § 201 (2010). this bill also ended deferral and instituted a per-country foreign tax credit limit. 79. see jane g. gravelle, practical tax reform for a more efficient income tax, 30 va. tax rev. 389 (2010). some of the most significant revenue raisers are unlikely to be revised, among them lengthening the depreciable lives for equipment. 80. for example, for 2013, when the economy has recovered, corporate revenues are projected at $350 billion, and a rate reduction to twenty-five percent would reduce the yield by $100 billion. see congressional budget office, the budget and economic outlook: fiscal years 2010 to 2020 (2010), at 79, http://www.cbo.gov/ftpdocs/108xx/doc10871/01-26-outlook.pdf. 92 florida tax review [vol.11:2 the argument for lowering the corporate rate to attract capital relates largely to increasing inbound investment, since, as discussed below, there are a variety of tools that could be used to reduce outbound investment by corporations. however, inbound equity appears to be less than ten percent of the total potential corporate tax base, and when capital outside the corporate sector and debt are taken into account, about four percent of the total u.s. capital stock.81 to lower the u.s. corporate rate for the objective of attracting more inbound capital, given important needs for revenue, concerns about distribution, and the creation of tax shelters for the wealthy, seems to be the tail wagging the dog. nor is a lower rate likely to increase u.s. welfare, as the additional tax revenue on new inbound investment would be offset by lost tax revenue from the lower tax rate on earnings on existing imported capital income.82 in addition, lowering the rate could accomplish little if it reduces the import of more mobile debt-financed capital. perhaps more importantly, if history is a guide, it is likely that other countries would further lower their tax rates, offsetting the effects of lowering the u.s. rates. while reducing the u.s. tax rate might stem the flow of outbound investment, an alternative is to increase u.s. taxation of foreign source income (or provide some revenue neutral combination of increasing taxation of foreign source income with some small reduction in the rate). some options, such as combining an end to deferral with a percountry foreign tax, probably could raise a significant amount of revenue, perhaps as much as $60 billion.83 president obama’s fiscal year 2011 budget proposes three 81. for data on corporate profits including those associated with inbound and outbound capital (repatriated) see bureau of economic analysis, national income and product accounts data, table 6.16d, corporate profits by industry (2011), http://www.bea.gov/national/nipaweb/tableview.asp?selectedtable=239& viewseries=no&java=no&request3place=n&3place=n&fromview=yes&freq =year&firstyear=2004&lastyear=2009&3place=n&update=update&javabox=n o. for data on unrepatriated profits, see bureau of economic analysis, international economic accounts (2011), http://www.bea.gov/international/index.htm. estimates assume the corporate capital stock is half of the total capital stock and that debt shares are one third, as reported in gravelle, supra note 32, at 293. 82. the optimal tax rate is 1/(1+e) where e is the elasticity of inbound capital. see gravelle, supra note 48, at 476. 83. tax expenditures estimates project a revenue gain from ending deferral without changes in the foreign tax credit at $13 billion for fiscal year 2013. see joint committee on taxation, estimates of federal tax expenditures for fiscal years 2009-2013 (2010), at 29, http://www.jct.gov/publications.html?func= startdown&id=3642. limiting the foreign tax credit should increase that amount significantly as well as raise revenue from repatriating income. the joint committee on taxation has estimated a revenue gain of $66 billion in fiscal year 2013 for the combination of a percountry foreign tax credit limit and ending deferral (estimate provided by senator ron wyden). 2011] the corporate income tax 93 significant revisions: disallowing a current deduction for parent company interest for the share equal to the share of profits not repatriated, restricting the share of foreign tax credits available to the share of income repatriated, and taxing the excess return to intangible transfers to a foreign subsidiary as subpart f income.84 these provisions would raise about $10 billion in the short run and $7 billion in the long run. the principal reservations about increased taxation of foreign source income, such as eliminating deferral and restricting credits, tend to be twofold. companies might invert (move their headquarters abroad) and investors could avoid the increased taxation of foreign source income by investing in foreign corporations. inversion could be limited by restrictions similar to those enacted in 2004 (treating these firms as u.s. firms for a long period of time),85 or other stricter provisions (treating firms permanently as u.s. firms, imposing an exit tax, or basing headquarters on a facts and circumstances determination). changes in individual portfolio investment cannot be used to target particular subsidiaries of multinational firms, but rather reflect the tax burden of the entire firm. some small shifts in investment may occur as rates of return change due to any tax revision, but do not seem a specific barrier to international tax revisions. stricter treatment of foreign source income would also reduce the ability to shift profits. google’s method of tax avoidance would not operate without deferral. 84. see u.s. department of treasury, general explanation of the administration’s fiscal year 2011 revenue proposals (2010), http://www. bsmlegal.com/pdfs/008greenbook2011.pdf. one of the proposals, disallowing splitting of foreign tax credits from income, has already been enacted. 26 u.s.c. § 909 (2010). 85. american job creation act of 2004, pub. l. no. 108-357, 118 stat. 1418 (2004). the corporate income tax: a persistent policy challenge ii. in the beginning 77 iii. the growth of the income tax 79 iv. issues and research in the early years 82 v. the 1950s to the 1980s: the era of investment subsidies and economic modeling of the corporate tax 83 vi. international tax issues: the spoiler? 87 vii. policy options 91 the corporate income tax: a persistent policy challenge i. introduction ii. in the beginning iii. the growth of the income tax iv. issues and research in the early years v. the 1950s to the 1980s: the era of investment subsidies and economic modeling of the corporate tax b. integration proposals c. savings and risk d. investment subsidies e. the corporate tax world after 1986 vi. international tax issues: the spoiler? a. history of foreign tax provisions b. revenue and compliance c. reconsideration of who bears the burden d. economic efficiency issues and constraints on integration vii. policy options florida tax review florida tax review volume 15 2014 number 2 89 equity in the distribution of tax preferences for pensions: capping the amount allowable in tax-preferenced retirement plans by norman p. stein * john a. turner ** i. introduction ............................................................................... 89 ii. the problem ................................................................................. 92 iii. the proposal: required distributions from accounts in excess of a ceiling amount .............................. 97 iv. issues and criticism concerning the proposal ............... 97 a. penalty against skillful investing ........................................... 98 b. fluctuations in asset value ..................................................... 98 c. disincentive for plan sponsorship .......................................... 99 d. a tax on ordinary rates of return for certain individuals................................................................................ 99 e. problem can be addressed by more vigorous enforcement actions .............................................................. 100 f. proposal would have modest revenue impact .................... 100 g. the proposal and defined benefit plans ............................... 101 v. alternative approaches ....................................................... 102 vi. a note about roth iras ........................................................ 104 vii. conclusion ................................................................................. 104 viii. postscript .................................................................................. 105 i. introduction tax-preferenced retirement plans are designed to be vehicles for saving for retirement, not massive tax shelters for wealthy individuals. because tax preferences for retirement savings cause a loss in federal tax * professor of law, earle mack school of law at drexel university. ** director, pension policy center, washington, d.c; ph.d. economics, university of chicago. the authors are grateful to daniel halperin, regina jefferson, dana muir, karen ferguson, ron gebhardtsbauer, david mccarthy, calvin johnson, martin mcmahon, and anna rappaport for comments on earlier drafts and for discussion of the issues raised in this paper. 90 florida tax review [vol. 15:2 revenue, and are one of the largest sources of tax expenditures, 1 it has long been a principle in pension policy and tax law in the united states and in other countries to limit the amount of retirement tax preferences an individual can receive. specifically, u.s. tax law sets limits on the maximum benefit provided by a tax-preferenced defined benefit plan and the maximum contribution to either a tax-preferenced defined contribution plan or individual retirement account (“ira”). 2 it was never the intent of congress, the tax policy, or pension policy communities that tax-preferenced plans should provide a tax preference for wealthy individuals to accumulate massive savings in retirement plans. indeed, the conventional understanding of providing tax subsidies for the affluent to save for retirement is not to incentivize them to save, since the affluent will save adequately without such incentives, but to induce them to establish plans to capture tax benefits for themselves and then require them to include rank-and-file employees in the plans thus established. 3 the purpose of the section 415 limits is to control the tax subsidies for the wealthy so that the tax incentives for them to establish plans do not impose excessive revenue loss to the government treasury. 4 1. staff of joint comm. on taxation, 112th cong., estimates of federal tax expenditures for fiscal years 2011-2015 (jcs-1-12), (2012), https://www.jct.gov/publications.html?func=startdown&id=4386. 2. the code has included express limitations on the amounts that can be contributed to defined contribution plans and the benefits that can be provided under defined benefit plans since i.r.c. § 415 was enacted as part of erisa in 1974. see, e.g., john a. turner, pensions, tax treatment, in the encyclopedia of taxation and tax policy 295 (joseph j. cordes et al., 2d ed. 2005), http://www.tax policycenter.org/uploadedpdf/1000541.pdf; norman p. stein, simplification and i.r.c. § 415, 2 fla. tax rev. 69 (1994) [hereinafter, stein, simplification and irc § 415). we note that the limits on individual retirement accounts (except for certain employer-sponsored plans that uses individual retirement accounts as the recipient of employer contributions, see i.r.c. §§ 408(k) (simplified employee pension) & 415(k)) are lower than those that apply to qualified retirement plans. cf. i.r.c. § 415(c) ($51,000 in annual additions to defined contribution plans, plus $5,500 “catch-up” contribution for employees who are at least age 50) and i.r.c. § 219(b)(5) ($5,500 for contributions to individual retirement accounts plus $1,000 “catch-up” contribution for individuals who are at least age 50). but individuals may roll over certain distributions from a qualified plan to an individual retirement account so individual retirement accounts can include accumulations in a defined contribution plan or a lump sum commutation of a benefit in a defined benefit plan. i.r.c. § 402(c). 3. see, e.g., alicia munnell, the economics of private pensions 51 (1982); daniel i. halperin, tax policy and retirement income: a rational model for the 21st century, in search for a national retirement income policy (1987). 2014] equity in the distribution of tax preferences for pensions 91 despite the limits, some wealthy individuals have been able to use tax-preferred retirement to accumulate extraordinary fortunes. recent press reports focused on former governor and presidential candidate mitt romney’s individual retirement account have drawn new attention to this problem. 5 this paper addresses foreclosing the use of iras to accumulate extraordinary fortunes by suggesting approaches to improving the equity of the distribution of tax preferences for pensions that would limit the size of tax-preferenced retirement savings accumulations. it would make individual retirement accounts and employer-sponsored tax-preferenced retirement accounts conform to the generally-held understanding of their purpose, which is to be a tax-preferenced source of reasonable levels of retirement income rather than a tax shelter for extraordinary wealth accumulation. although we suggest several approaches, our preferred approach is to set a cap on the maximum amount an individual could hold in tax-preferenced defined contribution plans and iras. 6 individuals would be required to take distributions when their account exceeds the cap. we suggest that such a cap 4. senator russell long described the purpose of § 415 as follows: [section 415] makes the tax laws regarding pension plans fairer by limiting the amount of the contributions or benefits that can be provided to any individual under such a plan. the fact that present law does not provide such specific limitations has made it possible for extremely large contributions and benefits to be made under qualified plans for some highly paid individuals. while there is, of course, no objection to large retirement benefits in themselves, it is not appropriate to finance extremely large benefits in part at public expense through the use of special tax treatment. 120 cong. rec. s.29946 (aug. 22, 1974) (statement of sen. russell long). 5. see, e.g., mark maremont, bain gave staff way to swell iras by investing in deals, wall st. j., mar. 29, 2012, http://online.esj.com/article. sb1000142052970204062704577223682180407266.html; michael kranish & beth healy, romney built a golden ira while he was at bain, boston globe, aug. 11, 2012, http://articles.boston.com/2012-08-11/politics/33138965_1_bain-partners-irassimplified-employee-pension-plan; tom hamburger, mitt romney exited bain capital with rare tax benefits in retirement, wash. post, sept. 2, 2012, http://www.washingtonpost.com/politics/mitt-romney-exited-bain-capital-with-raretax-benefits-in-retirement/2012/09/02/1bddc8de-ec85-11e1-a80b-9f898562d010_ story.html; michael j. graetz, mitt romney’s financial mysteries, new york times, july 30, 2012, http://www.nytimes.com/2012/07/31/opinion/the-mysteriesof-mitt-romneys-financial-records.html?_r=0. 6. this would include amounts in so-called “roll-over” iras, i.e., iras set up to receive single-sum distributions from qualified retirement plans. 92 florida tax review [vol. 15:2 be set at $5 million, indexed for inflation. the choice of that limit is not, as we explain, arbitrary, but the exact dollar amount of the limit is not, in any event, crucial to the proposal. we also suggest alternative proposals, including limiting (with certain exceptions) investments in tax-preferred retirement accounts to publicly-traded investment products. this paper includes three sections: first, a discussion of the problem (including how retirement accumulations can grow to the extraordinary levels attained by mr. romney); second, a description of our preferred proposal and a discussion of issues related to that proposal; and third, a discussion of some variations and alternatives to the proposal. ii. the problem the primary limits on contributions to and benefits from taxpreferenced (tax qualified) retirement plans (sponsored by employers) are set out in section 415 of the code. the plan contributions are adjusted to keep pace with the cost of living. in 2013, due to the cost of living adjustment, the limit on an annual benefit received from a defined benefit plan increased from $200,000 to $205,000. 7 for defined contribution plans, the limit on total annual contributions, including both employer and employee contributions, increased from $50,000 to $51,000. 8 in addition, persons 50 and older may contribute an additional $5,500 annually. 9 a person whose income is below a certain level, or who does not participate in an employer sponsored qualified retirement plan, can also make deductible contributions to an individual retirement account. here, the annual contribution limit is $5,500 annually, increased to $6,500 for persons at least 50 years of age. 10 except for roth retirement accounts, individuals must commence something approaching ratable distributions of their retirement savings once they attain age 70 1/2. 11 the time period for the distribution is the life or life expectancy of the individual and a designated beneficiary. 7. i.r.c. § 415(b); irs announces pension plan limitations for 2013, ir 2012-77 oct. 18, 2012, http://www.irs.gov/uac/irs-announces-pension-planlimitations-for-2013 [hereinafter irs 2013 pension plan limitations]. 8. i.r.c. § 415(c); irs 2013 pension plan limitations, supra note 7. 9. i.r.c. § 414(v); irs 2013 pension plan limitations, supra note 7. 10. i.r.c. § 219(b)(5). 11. i.r.c. § 401(a)(9) (the actual rule does not require an initial minimum distribution until april 15 of the year following the year the employee attains age 70.5). the rules, which are exceedingly complex, are designed to prevent individuals from using tax-preferenced retirement accounts as means of building tax-preferenced estates rather than providing a source of retirement income. see diane bennett et. al., taxation of distributions from qualified plans (2d ed. 1988). roth 2014] equity in the distribution of tax preferences for pensions 93 in 2010, the median value of assets of families with retirement savings held in retirement savings accounts was $44,000. in the age group where the family head was 55 to 64, the median value of assets in retirement accounts was $100,000. 12 the median balance for the bottom half of income earners is $0. 13 by comparison, some wealthy individuals have accumulated tens of millions of dollars in their iras and qualified plans. for example, former presidential candidate mitt romney has been reported to have $87 million or more in his ira. 14 romney’s taxadvantaged retirement plan accumulation is thus roughly 870 times larger than that of a typical american household in his age group that has any tax-preferenced pension savings. the tax benefit an individual receives from tax-preferenced retirement savings depends largely on how much investment income the account generates. thus, persons with huge amounts in ira accounts gain tax benefits disproportionately to mean or median account balances because of the large amount of investment income in their accounts. the tax deferral on amounts contributed to a tax-preferenced pension fund are roughly equivalent to receiving a zero rate of taxation on investment income from after-tax contributions during the period that funds are retained in the plan. 15 vehicles—which are 401(k) and ira accounts in which a participant chooses to have otherwise pre-tax contributions made post-tax in exchange for tax exemption for distributions—are exempted from most of the minimum distribution rules. i.r.c. § 408a(c)(5). minimum distribution rules, however, do apply to the successors in interest on the death of the account holder. i.r.c. § 408a(c)(5). 12. arthur kennickel et. al., changes in u.s. family finances from 2007 to 2010: evidence from the survey of consumer finances, 98 federal reserve bulletin 2, (2012), http://www.federalreserve.gov/pubs/bulletin/2012/pdf/scf12. pdf. 13. see memo from dr. teresa ghilarducci, irene and bernard schwartz, chair of economic policy and analysis, new school for social research (on file with authors). 14. some estimates put the value of mr. romney’s ira at higher amounts, with the blog tpm indicating that the ira holds upwards of $100 million. see brian beutler, tpm, august 3, 2012, http://tpmdc.talkingpointsmemo.com/2012/09/demlawmakers-make-example-of-romney-enormous-ira.php. this may, however, be based on articles such as the following: see william d. cohan, the secret behind romney’s magical ira, bloomberg, july 15, 2012, http://bloom.bg/m13pn1; see also tom hamburger, mitt romney exited bain capital with rare tax benefits in retirement, wash. post, sept. 2, 2012 (stating that an estimated value of mr. romney’s individual retirement account is $87 million), http://www.washington post.com/politics/mitt-romney-exited-bain-capital-with-rare-tax-benefits-in-retirement/ 2012/09/02/1bddc8de-ec85-11e1-a80b-9f898562d010_story.html. 15. see, e.g., daniel i. halperin, interest in disguise: taxing the “time value of money,” 95 yale l.j. 506 (1986); peter brady, the tax benefits and 94 florida tax review [vol. 15:2 if mr. romney were to follow the rule of thumb of withdrawing 4 percent of his account balance every year after he retires, that would provide a tax-preferenced annual benefit of approximately $3.5 million, which exceeds the median lifetime earnings of the average american worker. 16 as noted, section 415 of the code was adopted to limit taxpreferenced retirement savings to an amount that will provide a reasonable but not excessive retirement income (and presumably to prevent extreme disparities in the amount of tax-preferenced retirement savings). 17 yet the existence of mr. romney’s ira indicates that at least some wealthy individuals are able to accumulate vast wealth in their tax-preferred retirement plans. 18 the accumulation of vast wealth in iras is not permitted revenue costs of tax deferral, investment company institute (2012), http://www.ici.org/pdf/ppr_12_tax_benefits.pdf. 16. the 4 percent rule is a rule of thumb designed to ensure that individuals will have a small risk of running out of money in old age. the rule, which was popularized and named by bill bengen, a financial planner, was based on monte carlo simulations showing that a 65-year old could withdraw annually 4 percent of an investment portfolio (half equity, half fixed income), annually increase the withdrawal amount by the rate of inflation, and have a 93 percent chance of dying before exhausting his resources. see shefali anand, testing the 4%-per-year retirement rule, wall st. j., march 5, 2012, http://online.wsj.com/article/ sb10001424052970203960804577241143142670660.html?mod=wsj_personalfin ance_investing. note that in many scenarios, this investment strategy will leave a legacy for heirs, something that is not the case in a defined benefit plan if the benefit is taken in its ordinary annuity form. we also modeled a withdrawal rate of 4 percent annually, without inflation adjustment, for a $5,000,000 portfolio invested exclusively in safe fixed income securities paying a 2 percent interest rate. in such a case, the investor could make $200,000 withdrawals for 35 years before fully drawing down his assets. we also employed various on-line annuity calculators that indicated $5,000,000 would purchase an annual annuity somewhat in excess of $300,000. see, e.g., https://www.tsp.gov/planningtools/annuities/annuitycalc_results.shtml; http://www. immediateannuities.com/ information/rates.html?rates=32312dbbe21b97e766f2d2f8af3f48ed. 17. see supra, notes 2 and 3. 18. one influential actuary with whom we spoke, a retired director of research for a major national consulting firm, estimated that there might only be approximately 100 people with iras as large as mr. romney’s (interview on file with authors). we also contacted jack vanderhei, the director of research at the employee benefits institute (“ebi”), who indicated that there is no such data now, but that ebi is currently in the process of creating a data set that can provide at least some relevant data (interview on file with authors). the actuary we spoke with also observed that there are no special reporting requirements for super-sized iras. in contrast, there is some relevant data for qualified defined contribution plans, 2014] equity in the distribution of tax preferences for pensions 95 in the united kingdom. in the united kingdom, the lifetime allowance sets the maximum pension benefits a person can receive over their lifetime from pensions that receive preferential tax treatment. that limit for 2012 is £1.5 million, or approximately $2.4 million in lifetime benefits. 19 that limit is the combined limit for all pensions, both defined benefit and defined contribution, that the individual owns. 20 ireland also has such a limit, currently set at 2.3 million euros. 21 and for a brief period of time, the united states imposed an excise tax on annual distributions above a certain level. 22 we turn now to the question of how, despite the limits in section 415, mr. romney’s ira was able to grow so large. romney’s firm, bain capital, sponsored a type of employer-plan known as a sep ira. such plans permit a firm to make contributions to individual retirement plans established by the firm’s employees up to the section 415 limits, which was $30,000 for all or most of the years mr. romney was employed at bain. 23 the total contributions made to his ira was probably at least $450,000, but certainly although the reporting for such plans does not include breakdowns of individual accounts. 19. amounts above the limit are subject to a special tax that is 25 percent of annual distributions above the lifetime limit, with a 55 percent tax on lump distributions in excess of the cap (annual distributions are subject to income tax as well). bbc pension scheme, new benefits handbook 19-20 (jan. 2013), http://downloads.bbc.co.uk/mypension/en/new_benefits_handbook_january_2013.pd f. http://www.bbc.co.uk/mypension/sites/newbenefits/pages/what-is-the-maximumpension-i-can-earn.shtml. see also i.r.c. § 4980a. 20. id. 21. see generally, ireland: pension development network, http://www. pensiondevelopment.org/122/ireland.htm (last visited november 9, 2013). the figure had been set at 5.4 million euros but was reduced in 2010. 22. see i.r.c. § 4980a, which imposed a 15 percent tax on annual aggregate benefits distributions in excess of $150,000 from all qualified plans and iras. section 4980a also imposed a parallel tax on qualified plan and ira accumulations on death. see generally, bruce wolk, the new excise and estate taxes on excess retirement plan distributions and accumulations, 39 fla. l. rev. 987 (1987); daniel i. halperin & marla schnall, regulating tax-qualified pension plans in a hybrid world, 58 n.y.u. ann. inst. fed. tax’n, at 5–37 (2000) [hereinafter, halperin & scnhall, tax-qualified pension plans]; see stein, simplification and i.r.c. § 415, supra note 2. congress repealed § 4980a effective for distributions after 1996. see pub. l. 105-34, title x, sec. 1073(a), 111 stat. 948 (1997). 23. pension soft corporation, rounded/unrounded 415(c) limits through 2014, http://www.pensionsoft.com/references_limits_unrounded_415 c.html (last visited november 9, 2013). it is not clear when mr. romney left bain, but the limit was $35,000 in 2001 and $40,000 in 2002. http://www.bbc.co.uk/mypension/sites/newbenefits/pages/what-is-the-maximum-pension-i-can-earn.shtml http://www.bbc.co.uk/mypension/sites/newbenefits/pages/what-is-the-maximum-pension-i-can-earn.shtml 96 florida tax review [vol. 15:2 less than $1 million, depending on when he left bain capital and thus stopped contributing. 24 there are two possible explanations for how approximately half a million dollars to one million dollars could result in an $87 million dollar accumulation; the explanations are not mutually exclusive and both may have played a role. the first possible explanation is that the ira investments provided an extraordinary rate of return on investment (by our calculations it would be in the range of at least 20 percent to almost 30 percent annually over the last 28 years depending on how much mr. romney contributed to the plan). the second possible explanation is that the investments, which apparently were not publically traded, were purchased by the ira for less than their actual value (which would of course be a violation of the limits in current law). 25 it should also be said that some have speculated that the investments were “carried interest” amounts in certain limited partnerships that would have been taxable to the ira as unrelated business income had the ira held the investment interests directly, but that this tax was avoided through the use of offshore “blocker” entities. 26 24. we have not been able to establish the dates he started or stopped contributing from the public information available to us. 25. there has been press speculation about whether the ira’s investments were undervalued. william d. cohan, the secret behind romney’s magical ira, bloomberg, july 15, 2012, http://bloom.bg/m13pn1. 26. section 513 of the code imposes a 35 percent tax on most active business income earned by a tax-exempt entity, a tax that is expressly applicable to individual retirement accounts. i.r.c. § 408(e)(1). this would include partnership income allocated to a tax-exempt entity. some have speculated that romney may have avoided the tax on unrelated income through the use of blocker corporations, which are entities in tax-haven nations through which the business income is funneled. see mark marmont, romney’s unorthodox ira, wall st. j., jan 19, 2012, http://online.wsj.com/article/sb10001424052970204468004577168973507 188592.html (quoting michael knolls, who notes that blocker corporations are often used to avoid the tax on unrelated business income). the blocker corporation then pays dividends to the ira; the dividends are not subject to the tax on unrelated business income. although a blocker corporation would have spared romney’s ira the unrelated business tax, it would have only provided a significant tax benefit only to the extent that the blocker corporation was itself exempt from united states taxation on the income allocable to the blocker corporation and was also subject to a low offshore tax rate, issues beyond the scope of the paper. but see willard b. taylor, “blockers,” “stoppers,” and the entity classification rules, 64 tax law. 1 (2011). 2014] equity in the distribution of tax preferences for pensions 97 iii. the proposal: required distributions from accounts in excess of a ceiling amount this paper proposes setting a cap on the amount an individual can hold in tax-preferenced defined contribution plans and iras. we suggest a cap of $5 million, indexed for inflation, although another figure could be substituted. we arrived at the $5 million amount based on the amount of retirement income an account would provide. using the rule of thumb that an individual can withdraw 4 percent of assets in retirement without overly risking running out of money during retirement, that maximum amount would permit an annual retirement benefit of $200,000, far above that received by most americans but allowing the system to also provide taxpreferenced benefits for upper income americans. 27 this is the same maximum benefit that can currently be paid from a defined benefit plan under the section 415 limitation applicable to such plans. this proposal provides a simple, bright line solution to the problem of excessive amounts in iras and other defined contribution pensions for some americans. the proposal retains the intent of the pension system to provide tax-preferenced benefits that are sufficient for the retirement needs of most americans, while limiting the maximum tax preference available and thus the maximum tax expenditure per person participating in the pension system. the proposal would improve the equity in the distribution of tax preferences across income classes and would prevent the use of taxpreferenced pensions as massive tax shelters by wealthy individuals. by international standards, the limit set in this proposal is generous. the limit proposed here of $5 million is more than twice the limit in the united kingdom. a proposal for such a limit in canada would set the limit at $2 million. 28 iv. issues and criticisms concerning the proposal below we respond to several issues raised by the proposal, including what we anticipate would be arguments against the proposal. 27. see supra note 13. 28. james pierlot & siddiqi faisal, why we need a lifetime retirement saving limit, benefits canada, (nov. 10, 2011), http://www.benefitscanada.com/ pensions/governance-law/why-canada%e2%80%99s-aging-workforce-needs-a-life time-retirement-saving-limit-22662. 98 florida tax review [vol. 15:2 a. penalty against skillful investing a possible criticism of the proposal is that it would penalize people who are extraordinarily skillful or lucky in their investments and have achieved larger amounts in their iras. the response to that criticism is the fundamental point of this paper, which is that it is the intent of congress to limit the maximum tax preference an individual can receive from a retirement plan, not to award skillful or lucky investment performance. a further response to that criticism is that the ceiling in this proposal has been set at a fairly generous level. the proposed ceiling, which is for individuals, is almost 100 times the median account balance for households in 2010. 29 moreover, the suggestion that the proposal is a penalty is itself misguided; rather, it is just a withdrawal of the benefits of tax deferral. a skillful or lucky investor will still be better off than an unlucky or unskilled investor. they will just lose the ability to leverage their good results with tax benefits aimed to help people have adequate income security in retirement. b. fluctuations in asset value people might exceed the maximum in some years but fall below it in subsequent years due to fluctuations in the value of assets. the effect of fluctuations in assets could be mitigated by basing the test for exceeding the limit on a multi-year average (for example, three years) of the end-of-year value in the account. people exceeding the limit using that test would be required to withdraw the excess and pay appropriate taxes on the amount. people exceeding the limit in any year would not be permitted to contribute to the account the following year, but would not be required to make withdrawals from the account unless the specified multi-year average exceeded the limit. alternatively, the rule might require withdrawal only after accounts exceed the limit for a defined period, perhaps three years, or the rule might require withdrawals ratably over a defined period of time. the tax for early withdrawals under any such alternative could possibly be waived, but that issue is not explored here. 30 29. u.s. census bureau, income, poverty, and health insurance coverage in the united states: 2011, at 7 (2012), http://www.census.gov/prod/ 2012pubs/p60-243.pdf. 30. section 72(t) imposes a 10 percent excise tax on most plan distributions made prior to the year in which the account’s owner attains age 59½. 2014] equity in the distribution of tax preferences for pensions 99 c. disincentive for plan sponsorship firms might decide not to contribute to plans if their owners are at the cap, resulting in rank-and-file employees losing the opportunity to save for retirement. this may be true in some situations, but the problem—if it is a problem—would be limited to a small number of firms. d. a tax on ordinary rates of return for certain individuals people who receive the maximum section 415 contributions for each year during their working career might exceed the cap even if their rate of return is not extraordinary by historical standards. 31 over a 35-year contribution history, for example, a rate of return of approximately 5.4 percent would produce retirement savings in excess of the suggested $5 million cap in a world with no inflation. this compares to a negative real rate of return on average for pension funds in the united states between december 2001 and december 2010. 32 jack bogle, founder of the mutual fund company vanguard, estimates a decade later that the nominal rate of return on stocks will be between 7 and 7.5 percent over the next decade, and that a balanced portfolio of 60 percent stocks and 40 percent bonds will yield about 6 percent nominal, 33 suggesting that a real rate of return of 5.4 percent would be high. 34 31. this suggests that the section 415(c) limit on annual additions to defined contribution plans may be excessive for individuals who make contributions at or near the maximum throughout their career. professor dan halperin and marla schnall have suggested that it might be reasonable to lower the section 415(c) limits on annual additions and permit catch-up contributions for older workers, but only if their account balances at an older age are inadequate to supply adequate retirement income. see halperin & schnall, supra note 22. it might also be possible to expressly coordinate the limits with age, with the limits increasing as the participant ages. in such case, the limit for any particular age would be set as the present value of the age 65 limit. this approach, however, would be more complex than the current system, and might have its own equitable oddities, especially during periods when the discount rate for calculating present value was subject to large annual fluctuations. 32. oecd pensions outlook 2012, pensions outlook 2012 media brief (2012), http://www.oecd.org/finance/private-pensions/50560110.pdf. 33. see carla fried, that retirement calculator may be lying to you, bloomberg, oct. 03, 2011, http://www.bloomberg.com/news/2011-10-03/thatretirement-calculator-may-be-lying-to-you.html. 34. we also note that most people in individual account retirement plans invest through mutual funds, whose actual return is net of fees. 100 florida tax review [vol. 15:2 e. problem can be addressed by more vigorous enforcement actions some of the individuals who have accumulated great wealth in their iras (or employer-sponsored retirement plans) have been able to do so through the purchase of non-publicly traded securities from their employers or others that may have been undervalued, and then had large gains after being purchased for the ira. 35 some may argue, then, that rather than setting a cap on allowable account values, the issue of undervalued non-publicly traded securities should be addressed through more vigorous enforcement actions by the irs. while the irs should certainly police relevant valuation issues, our “cap” proposal addresses the broader issue of excessive taxsheltered accumulations regardless of the cause. moreover, more strenuous irs action relating to valuation of assets purchased by retirement plans or iras would probably not completely solve even the problem of overvaluation. for one thing, the issue of the valuation of non-publicly traded securities is complex, with the possibility of disagreements as to proper valuations. to have an effective enforcement program, the irs would probably need to expand reporting requirements for iras and section 401(k) plans so that non-publicly traded investments are disclosed when they are purchased from a party with a meaningful relation or affiliation with the taxpayer; expanded reporting requirements would impose new compliance burdens on taxpayers; and irs enforcement activities and taxpayer responses to such activities might have significant costs. in contrast, the proposal advanced here is simple and clear cut and would be relatively easy to enforce. since it is plausible for a person to exceed the cap by contributing the maximum amount every year, though few people do that, focusing on valuation alone will not address our main concern, which is excessive tax benefits. f. proposal would have modest revenue impact the proposal would presumably affect relatively few individuals and bring in relatively little in increased tax revenue to the federal and state governments. that point may be correct, but the primary motivation for the proposal is not only to increase aggregate tax revenue, which it would do to at least some extent, but to improve the equity of the distribution of tax preferences. the proposal would address the perception that some wealthy 35. see tom hamburger, mitt romney exited bain capital with rare tax benefits in retirement, wash. post, sept. 2, 2012, http://www.washingtonpost.com/ politics/mitt-romney-exited-bain-capital-with-rare-tax-benefits-in-retirmeent/2012/0 9/02/1bddc8de-ec85-11e1-a80b-9f898562d010_story.html. 2014] equity in the distribution of tax preferences for pensions 101 individuals are taxed on much more favorable terms than typical americans, and it will produce some, revenue and perhaps meaningful, amount of revenue. 36 g. the proposal and defined benefit plans section 415 provides separate limits for defined benefit plans and defined contribution plans. an employer may thus sponsor both types of plans, and individual employees may receive both a defined benefit (currently up to $200,000 per year, commencing at age 62), and a defined contribution accumulation based on annual contributions (currently set at $50,000, with an additional $5,500 contribution for individuals who are 50 or older). the proposal we have outlined would not apply to defined benefit plans, which raises several issues. the first issue is that the maximum defined benefit has a value of approximately $5 million dollars, which means that an individual who maximizes his participation in both types of plans could accumulate approximately $10 million in tax-advantage assets. one response to this would be to subject accumulations of both types of plans to separate caps but also to an overall combined cap, which might be set, for example, at $7.5 million. 37 this would not, however, solve the discrimination problem, for the person with both a defined benefit and a defined contribution plan would still be able to accumulate more than a person who had only a defined contribution plan. but this is precisely the consequence of the current structure of section 415, which permits a person who participates in both a defined contribution and a defined benefit plan to accumulate more assets than a person could accumulate using only one plan type. and one can argue that the resulting discrimination is good to the extent it provides an incentive for a firm to offer employees both types of plans, defined contribution and defined benefit. the proposal could also be modified to having a single cap but it would include adding the value of benefits accrued in a defined benefit plan 36. as noted, we do not have data showing how many large aggregate retirement account balances exist. see supra note 18. we suspect, however, that there are not many, so it seems probable that the proposal will produce some but not substantial revenues. 37. in lieu of setting a separate cap for defined benefit plans, the section 415(c) limit could apply to the benefit to be paid by the defined benefit plan rather than subject the present value of a defined benefit to a dollar cap. but under section 415 today, the subsection (b) limits applies separately to the defined benefit plan of each employer that an individual works for, so some individuals might have more than one maximum defined benefit. 102 florida tax review [vol. 15:2 to the accumulations in defined contribution plans and iras, which is the approach used in the united kingdom. the code includes assumptions for converting a benefit into a lump sum, so such a conversion would not be a source of major technical difficulty. 38 if the proposal is not modified to apply to defined benefit plans, one can object to it on the grounds that it will discourage participants from taking benefits from defined benefit plans as a lump sum (rather than an annuity) and rolling the lump sum into an individual retirement account (which would be subject to the cap). one can respond by noting that providing incentives for people to keep benefits in the annuity form ordinarily paid by defined benefit plans rather than taking a lump sum benefit is a positive rather than negative feature of the proposal. but the proposal could be modified to exempt rollover iras where the rollover came from a defined benefit plan. v. alternative approaches there are other possible approaches to limiting the growth of accumulations. one such approach, which we do not advocate because of its complexity, would be a tax on retirement plan accumulations above an aggregate cap. if the cap were set at $5 million, any accumulation above that level would be subject to a tax, either the individual’s marginal tax rate or a special excise tax. this approach, however, would necessitate a complex statutory scheme because (i) individuals would then need to be credited with basis in their account to reflect amounts on which tax was already paid; (ii) rules would have to be devised to determine how basis should be recovered on plan distributions; (iii) rules would have to be devised to determine how basis should be allocated between roth and non-roth accounts; (iv) rules would have to be developed to treat losses that occur after the account has paid tax because it exceeded the cap; and (v) rules might have to be developed to integrate an individual’s overall tax situation and the tax on the plan. in contrast, the proposal that we advocate is relatively straightforward and easy to implement. in a 2000 paper, professors daniel halperin and marla schnall presented an interesting and elegant variation on an in-plan tax that would avoid basis complications. 39 their paper suggested defining maximum accumulation levels for individual account owners at different ages and “taxing the investment income of the trust derived from the excess assets and 38. one concern might be volatility of the discount rate, although this concern could be addressed by some sort of smoothing of the discount rate over a period of time. 39. see halperin & schnall, tax-qualified pension plans, supra note 22. 2014] equity in the distribution of tax preferences for pensions 103 then fully taxing the distribution.” assuming uniform tax rates, this approach ultimately treats the excess investment income identically to the way it would have been treated if it were earned outside of a plan. but the authors acknowledged the difficulties of identifying excess assets at ages prior to normal retirement age. as an alternative that avoids this difficulty, they proposed taxing investment return above a defined rate of return, with the defined rate set at the return necessary to reach a targeted benefit amount (perhaps equal to the section 415 limit for defined benefit plans) at retirement age. but here they acknowledged that adjustments would have to be made for accounts where maximum contributions had not been made and thus concludes that such a tax would “be difficult to implement.” 40 it would also be possible to take an approach that focused on permissible investments for owner-directed plan accounts. in particular, owners of self-directed accounts could be limited to publicly traded investments, 41 with the exception that participants could invest in the nonpublicly traded stock of their employer, subject to the statutory limits relating on diversification. 42 this would not, of course, limit a person’s ability to 40. see id. 41. there may be issues in placing clear definitional limits on the meeting of publicly-traded investments, but these issues seem to us of a type with which legislators and regulators often grapple, even if imperfectly. there may also be issues of the impact on certain investment markets if individual account plans are barred from holding certain types of investments, particularly if any such restrictions required plans to divest certain current holdings. as to the former issue, presumably people who have access to such investments within a plan will also have access to such investments outside the plan, so the effect on markets might not be all that pronounced. moreover, this proposal would not apply to plans with pooled accounts, although even here there may be questions as to what is meant by a pooled account in the case of, for example, an individual retirement account or a section 401(k) plan that covers only one or a small number of individuals. again, though, these seem to be issues that could be dealt with by regulations, again, even if imperfectly. 42. an additional exception might be created for non-publicly traded investment opportunities that are available to all participants in a plan without regard to minimum investment requirements. one exception to such an exception, however, is that some such investments may carry too much risk for some participants and thus might result in people ill-equipped to manage the risks making such investments. this may in itself be a reason not to create such an exception. moreover, if the purpose of a rule limiting individually-directed accounts to publicly traded investments is to limit the ability of wealthy tax-motivated investors to use the tax-deferral of qualified plans to provide tax deferral for investments not generally available to most investors, then it might be advisable to limit such an exception to plans that cover a large number of rank-and-file participants. and such an exception would not prevent the creation of midas-touch iras; it would just 104 florida tax review [vol. 15:2 invest in privately-offered investments, such as the investments mr. romney’s ira purchased from bain, but would require that they be made outside the plan where there would not be valuation problems and where the income they produce would be subject to annual taxation. it would also prevent the use of privately-held blocker corporation to avoid the tax on unrelated business income. (of course, the wealthy could still invest in offshore corporations, but would not be able to employ the taxexempt status of an ira or qualified plan to shelter unrelated business income from tax.) more generally, the approach might also improve the overall equity of retirement plans at the margins, since affluent individuals would not have special opportunities to leverage the tax benefits of taxpreferred retirement accounts through investment opportunities only available, or at least only readily available, to the wealthy. vi. a note about roth iras the proposals in this paper do not distinguish between assets in a traditional retirement account and assets in a roth ira or roth 401(k). clearly, $5 million in assets in a roth ira are worth more to the individual than $5 million in assets in an ira because no future taxes are due on assets in the roth ira. this proposal does not address that issue, but we note that the proposal is consistent with other aspects of the current treatment of roth and regular retirement vehicles where the limits on allowable contributions are the same. 43 vii. conclusion this paper proposes setting a cap on the amount an individual can hold in tax-preferenced defined contribution plans and iras of $5 million, indexed for inflation. this simple proposal would improve the equity of the distribution of tax preferences in the pension system. the discussion has not fully detailed how the proposal might be implemented, but has instead require that few rank-and-file employees also be able to participate in special investment opportunities. rules designed to deal with these concerns might be difficult for regulators to create and enforce. thus, these concerns seem to auger against such an exception if a prohibition against non-publicly traded assets were implemented. 43. we do not, however, mean to suggest that we endorse the treatment of roth vehicles. see daniel halperin, i want a roth ira for xmas,” 81 tax notes 1567 (1998); daniel halperin, fun and games with the roth ira, 112 tax notes 167 (2006). 2014] equity in the distribution of tax preferences for pensions 105 focused on the concept and the broad outlines of the proposal. the proposal is in keeping with the intent of congress and the tax and pension policy communities to limit the maximum tax preference an individual can receive on a pension plan. it is similar in concept to a limitation in pension law in the united kingdom. the proposal would be relatively easy to enforce. the proposal would result in an increase in taxes paid by some wealthy people, without an increase in marginal tax rates. the paper also briefly discusses some alternative approaches that merit consideration. each of the proposals would increase tax equity and would address the perception that wealthy individuals in the united states enjoy special tax preferences that are not open to most americans. it would also raise some additional tax revenues in a time of budgetary stress. viii. postscript the president’s 2014 budget proposal includes a proposed cap on future contributions to defined contribution plans and accruals to defined benefit plans. 44 the president’s proposal, which bears some but in many ways superficial similarity to the proposal we make in our paper, would prohibit future contributions and benefit accruals for an individual for whom the present value of the aggregate of all tax-benefited retirement plans exceeds the present value of the section 415(b) limits, using as a discount rate the interest rates prescribed in section 417(e). this postscript describes the president’s proposal and compares it to the proposal in this paper. the description of the president’s by the department of treasury makes clear that the cap would apply to every taxpayer regardless of age, with each employer and former employer with a defined benefit plan being required to report the present value of the accruals to the taxpayer, and each ira custodian, employer and former employer being required to report the account accumulation, on an annual basis. using the current section 417(e) discount rate—about 4 percent—the department of treasury notes that the maximum value of all tax-benefited retirement savings for a 65-year old would be approximately $3.4 million dollars. a report prepared by the employee benefits research institute calculates that the maximum present value for a 25-year old would be $800,000, but that an increase in the 44. department of the treasury, general explanations of the administration’s fiscal year 2014 revenue proposals, 165 (april 2013), http://www.treasury.gov/resource-center/tax-policy/documents/general-explanation s-fy2014.pdf. 106 florida tax review [vol. 15:2 discount rate to 8 percent would reduce the maximum present value to $132,000. 45 the department of treasury estimates that this proposal would raise $9 billion in a ten-year budget window. the president’s proposal differs in several fundamental ways from the proposal in this paper, although both proposals are intended to reduce the tax expenditure for qualified plans by pruning back the benefits for affluent taxpayers and thus to recalibrate the distribution of the qualified plan tax expenditure among different income groups. the key differences between the proposals are the following: (1) the proposal made in this paper is an attempt to scale back the amount that can be held in tax-preferred individual accounts in qualified plans and individual retirement accounts. the president’s proposal, in contrast, would place limits on the aggregate value of individual accounts and accruals in defined benefit plans and would limit that total value to the present value of the separate limit on defined benefit plans. this would reverse a 1996 congressional judgment that taxpayers should be able to participate fully in both types of plans and would be a far more dramatic reduction of the total limit than the proposal made in this paper. (2) the proposal in this paper would require that a taxpayer take distributions when her aggregate individual accounts exceed the limit, while the president’s proposal would only prohibit future contributions. thus, the president’s proposal would not reduce large account balances in place at the time the proposal were adopted and would continue to permit future large account balances to grow through returns on investment. we note that because the proposal in this paper would affect large account balances in existence at the time of passage, it would probably raise larger amounts of revenue in early years than the president’s proposal, but because it would affect fewer taxpayers and generally provides a higher maximum limit, would probably raise less revenue in the long run than the president’s proposal. 45. see jack vanderhei, the impact of a retirement savings account cap, ebri issue brief no. 389, 5 (aug. 2013), http://www.ebri.org/pdf/briefspdf/ebri _ib_08-13.no389.retsvgscap.pdf. 2014] equity in the distribution of tax preferences for pensions 107 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe tcharity really does begin at home: florida tax review volume 10 2010 number 6 411 economic substance doctrine: how codification changes decided cases by bret wells i. overview of codified economic substance doctrine ..................................................................................... 416 a. substantive rules contained in new section 7701(o) ...... 419 b. new penalty regime under section 6662(b)(6) and section 6664(c)(2) ...................................................... 427 ii. review of decided cases illuminates where section 7701(o) changes judicial holdings ..................... 428 a. woods investment co. v. commissioner ........................... 428 b. textron, inc. v. united states ............................................ 431 c. cottage savings association v. commissioner ................. 435 d. guardian industries corp. v. united states ...................... 438 e. the limited, inc. v. commissioner ................................... 441 f. shell petroleum v. united states ....................................... 446 g. son-of-mirror and the general utilities repeal ............... 449 iii. conclusion ................................................................................. 452 appendix ....................................................................................... 454 412 florida tax review [vol. 10:6 economic substance doctrine: how codification changes decided cases by bret wells* health care reform mesmerized the nation last spring and created strong rhetoric on all sides. in climatic fashion, on march 25, 2010, congress passed h.r. 4872, the health care and education reconciliation act of 2010 (the reconciliation act). this legislation modified legislation that was signed into law several days earlier in h.r. 3590, the patient protection and affordable care act (p.l. 111-148). president obama stated that the passage of these bills represents a major accomplishment for his administration.1 although this legislation will be remembered in the popular press for starting a new chapter in the country’s health care system, the passage of the reconciliation act also starts an important new chapter in the nation’s tax jurisprudence. in this regard, section 1409 of the reconciliation act adds a new section 7701(o) to the internal revenue code.2 this provision seeks to codify and clarify the judicially-created economic substance doctrine. from its inception, the economic substance doctrine has been used to prevent taxpayers from subverting the purpose of the tax code by engaging in transactions that are fictitious or lack economic reality simply to reap a tax benefit. in this respect, the economic substance doctrine is similar to other common law canons of construction that are employed in circumstances where the literal terms of a statute can undermine the ultimate purpose of the statute.3 congress had debated for years whether to codify the judicially * visiting professor of law, university of houston law center. the author wishes to thank calvin h. johnson and ira shepard for their comments and suggestions on earlier drafts of this manuscript. the views expressed in this paper are solely the views of the author. 1. white house press release, remarks by the president on health insurance reform in portland, maine (apr. 1, 2010), http://www.whitehouse.gov/the-press-office/remarks-president-health-insurancereform-portland-maine. 2. the text of § 7701(a) is in appendix i. 3. staff of joint comm. on taxation, 111th cong., description of revenue provisions contained in the president’s fiscal 2010 budget proposal part two: business tax provisions, at 34 (2009); staff of joint comm. on taxation, 111th cong., technical explanation of the revenue provisions of the reconciliation act of 2010, as amended, in combination with the patient protection and affordable care act, at 142 (2010) [hereinafter joint comm. technical explanation]. 2010] economic substance doctrine 413 created economic substance and business purpose doctrines, and now that debate is over.4 to understand how we got here, it is necessary to consider common mistakes that the tax system must protect against.5 at its core, the u.s. tax system attempts to treat a transaction consistently between parties and consistently over the entire life of a transaction. however, because of the complexity of the u.s. tax system and because business arrangements are often comprised of multiple steps from a tax perspective, the literal application of the u.s. tax laws to complex business transactions can create fundamental “transactional inconsistencies.” such inconsistencies represent a mistake from a tax policy perspective, but tax mistakes happen.6 a mistake can be further categorized as either a whipsaw mistake, a double dip mistake, or a loss or a tax credit generator mistake. a whipsaw mistake arises whenever a taxpayer can change her position “mid-stream” and can benefit from that “bait and switch.”7 a whipsaw mistake can also exist when different parties to the same transaction can take different positions.8 in either situation, a whipsaw mistake creates a transactional inconsistency that causes the tax system to have a net revenue loss because of an inconsistency. another common mistake is a double dip mistake. a double dip mistake 4. see, e.g., abusive tax shelter shutdown act of 1999, h.r. 2255, 106th cong. (1999); dep’t of treasury, the problem of corporate tax shelters: discussed, analysis, and legislative proposals (1999). for an early work that appears to have been the genesis for the codification effort, see calvin h. johnson, the anti-skunk works corporate tax shelter of 1999, 84 tax notes 443 (1999). 5. many earlier versions of the codification of economic substance doctrine, some of which were adopted by the house, also provided special rules for applying what was essentially a per se lack of economic substance in transactions with tax indifferent parties that involved financing and artificial income and basis shifting. see, e.g., h.r. 2345, 110th cong., 1st sess. (2007); h.r. 2, 108th cong., 1st sess. (2003). these rules did not make it into the enacted version. 6. it is appropriate to refer to transactional inconsistencies as a mistake because congress has articulated a desire that the tax laws should accurately account for the income of the taxpayer. see irc § 446(b) (providing that if the taxpayer’s method of accounting “does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the secretary, does clearly reflect income”). when a transactional inconsistency causes a taxpayer’s income to not be clearly and accurately reflected on a tax return, the purposes of § 446(b) have been frustrated. 7. see, e.g., f. david lake, jr., the whipsaw problem in federal tax controversies, 34 n.y.u. ann. inst. on fed. tax’n 867 (1976); kenneth l. harris, should there be a “form consistency” requirement? danielson revisited, 78 taxes 88 (mar. 2000). 8. see, e.g., special committee on whipsaw, section of taxation, american bar association, final report, 30 tax law. 127 (1976); harvey s. gilbert & steve mather, whipsaw revisited, 43 tax law. 343 (1990). 414 florida tax review [vol. 10:6 occurs when multiple deductions are created for the same economic loss in multiple jurisdictions.9 because of the complexity of u.s. tax laws, crossborder transactions can often lead to inconsistent tax treatment between the u.s. tax system and another country’s tax system such that a double dip benefit may arise. a third common mistake, a loss or tax credit generator mistake, is a transaction entered into primarily to permit a u.s. taxpayer to take the position that it has the right to claim a deduction, loss, or credit for tax purposes when the loss, deduction, or credit has not been incurred economically so that the tax benefit can be used to offset (i.e., “shelter”) other taxable income or gain.10 given the creativity and sophistication of the tax bar, taxpayers can affirmatively find ways to put themselves into a mistake situation if the tax laws were literally applied. playing in such mistakes is much like “playing in the rain.” we generally know when we are playing in the rain. in the end, mistakes should and generally do get corrected, and so a tax planning strategy that captures value from a tax mistake is not a “built-to-last” strategy: the rain will stop and the sun will come out again. the drama is not in terms of whether the rain will stop; the drama is in determining which branch of government will fix the mistake and whether a taxpayer can benefit from the mistake while it is raining or whether a court will thunder its disapproval. judge posner, speaking for the seventh circuit in yosha v. commissioner, made this same point in the following statement: well, what is wrong with all this? . . . there is no rule against taking advantage of opportunities created by congress or the treasury department for beating taxes . . . . many transactions are largely or even entirely motivated by the desire to obtain a tax advantage. but there is a doctrine that a transaction utterly devoid of economic substance will not be allowed to confer such an advantage . . . . if mrs. gregory had won, either congress would have had to amend the statute (which it did anyway, however) or there would have been a flurry of sterile reorganizations — reorganizations not only motivated solely by a desire to 9. see, e.g., t.d. 9315, 2007-1 c.b. 891 (noting that a “double dip” that congress sought to prevent occurs when a dual resident corporation uses a single economic loss once to offset income that was subject to u.s. tax, but not foreign tax, and then uses the same economic loss a second time to offset income subject to foreign tax, but not u.s. tax); t.d. 8999, 2002-2 c.b. 78 (limiting the ability of a domestic reverse hybrid entity from utilizing u.s. tax treaty relief because of a concern that the use of income tax treaties to manipulate the inconsistencies between u.s. and foreign tax laws created a double dip benefit). 10. see, e.g., david hariton, how to define “corporate tax shelter,” 84 tax notes 883 (1999). 2010] economic substance doctrine 415 avoid taxes but having no consequences other than to avoid taxes.11 the question of who should win in the context of a mistake raises competing notions of fairness and competing notions of equity. rewarding taxpayers for their mistakes motivates tax practitioners to find more and more mistakes to the benefit of the sophisticated taxpayer.12 such a system creates cynicism about the fairness of the nation’s tax laws because it allows some taxpayers who plan for mistakes to receive a preference over similarly situated taxpayers who do not plan for mistakes.13 however, a counter-equity argument can be made that taxpayers should be able to rely on the plain meaning of the tax laws. tax laws are, by their very nature, enforced exactions.14 there is something unfair about collecting an enforced exaction when the tax laws do not specifically authorize the exaction. due to these competing notions of fairness, any tax mistake will create an inequity to someone, and so the question is who will suffer that inequity? it is in this context that new section 7701(o) has now entered the discussion and has sought to clarify and in many cases re-draw the line for where the taxpayer can benefit from a mistake and where the taxpayer cannot.15 11. yosha v. commissioner, 861 f.2d 494, 497-98 (7th cir. 1988). 12. see, e.g., calvin h. johnson & lawrence zelenek, codification of general disallowance of artificial losses, 122 tax notes 1389 (2009). 13. see dep’t of treasury, supra note 4, at 3 (stating that corporate tax shelters breed disrespect for the tax system—both by the people who participate in the tax shelter market and by others who perceive unfairness. a view that welladvised corporations can and do avoid their legal tax liabilities by engaging in these tax-engineered transactions may cause a “race to the bottom.” if unabated, this could have long-term consequences to our voluntary tax system far more important than the short-term revenue loss we are experiencing). 14. see commissioner v. newman, 159 f.2d 848, 850-51 (2d cir. 1947) (“over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. everybody does so, rich or poor and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. to demand more in the name of morals is mere cant.”). 15. some have argued that a positive rule of law should be adopted where the taxpayer is not allowed to benefit from a mistake regardless of the business purpose of the transaction. see, e.g., marvin chirelstein & lawrence zelenak, essay: tax shelters and the search for a silver bullet, 105 colum. l. rev. 1939 (2005). 416 florida tax review [vol. 10:6 i. overview of codified economic substance doctrine the modern articulation of the judicially-created economic substance doctrine traces its roots back to frank lyon co. v. united states where the court upheld the taxpayer’s treatment of an early version of a sale-in / leaseout transaction, stating as follows: [w]here, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by taxavoidance features that have meaningless labels attached, the government should honor the allocation of rights and duties effectuated by the parties.16 from this statement in frank lyons, the courts in subsequent cases developed several different formulations of the economic substance doctrine. under one formulation, the so-called “conjunctive test,” the courts would apply the economic substance doctrine only when a transaction had both (1) economic substance and (2) a non-tax business purpose.17 under a second formulation of the economic substance doctrine, the so-called “disjunctive test,” the courts would apply the economic substance doctrine only when a transaction did not have either (1) economic substance or (2) a non-tax business purpose.18 yet a third formulation of the economic substance doctrine appeared in acm partnership v. commissioner, where the court concluded that “these distinct aspects of the economic sham inquiry do not constitute discrete prongs of a ‘rigid two-step analysis,’ but rather represent related factors both of which inform the analysis of whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes.”19 thus, as a result of these various opinions, the legislative history indicates that congress was concerned that these divergent articulations created confusion over the manner in which the economic substance doctrine should be applied.20 notwithstanding this congressional 16. frank lyon co. v. united states, 435 u.s. 561, 583-84 (1978). 17. see, e.g., klamath strategic inv. fund v. united states, 568 f.3d 537 (5th cir. 2009); pasternak v. commissioner, 990 f.2d 893, 898 (6th cir. 1993); james v. commissioner, 899 f.2d 905 (10th cir. 1990); new phoenix sunrise corp. v. commissioner, 132 t.c 161 (2009); coltec indus., inc. v. united states, 454 f.3d 1340 (fed. cir. 2006). 18. see ies indus. v. united states, 253 f.3d 350, 358 (8th cir. 2001); rice’s toyota world, inc. v. commissioner, 752 f.2d 89 (4th cir. 1985). 19. acm p’ship v. commissioner, 157 f.3d 231, 247 (3d. cir. 1998). 20. staff of joint comm. on taxation, 111th cong., description of revenue provisions contained in the president’s fiscal 2010 budget proposal part two: 2010] economic substance doctrine 417 concern, it is unclear whether these divergent formulations of the economic substance doctrine resulted in any actual conflict in the decided cases.21 the courts had also differed with respect to the nature of the non-tax economic benefit a taxpayer was required to establish in order to withstand an economic substance challenge. some courts required merely that a potential economic profit exist in order for a transaction to withstand challenge under the economic substance doctrine.22 other courts applied the economic substance doctrine to disallow tax benefits unless the economic profit potential were more than insignificant in comparison to the tax benefits of the transaction.23 yet other courts asked whether a stated business benefit—for example, cost reduction, as opposed to profit-seeking—of a particular transaction was actually obtained through the transaction in question.24 finally, some courts have considered, but ultimately rejected, bootstrap arguments that a tax benefit can create a valid business purpose when the tax benefits increase the company’s stock price.25 with this backdrop in mind, congress decided to codify the economic substance doctrine in order to achieve a number of objectives. first, congress was concerned that divergent articulations of the economic substance doctrine had led to an uneven application of this doctrine.26 business tax provisions, at 36-37 (2009); joint comm. technical explanation, supra note 3, at 143-44. 21. see, e.g., rose v. commissioner, 868 f.2d 851, 853 (6th cir. 1989) (“this court will not inquire into whether a transaction’s primary objective was for the production of income or to make a profit, until it determines that the transaction is bona fide and not a sham.”); kirchman v. commissioner, 862 f.2d 1486, 1492 (11th cir. 1989) (“once a court determines a transaction is a sham, no further inquiry into intent is necessary.”); pasternak, 990 f.2d 893, 898 (6th cir. 1993) (“if the transaction lacks economic substance, then the deduction must be disallowed without regard to the niceties of the taxpayer’s intent.”); cherin v. commissioner, 89 t.c. 986, 993 (1987) (noting that even if a taxpayer has a profit objective, the investment is not recognized for tax purposes if the transaction lacks economic substance). thus, considerable support exists for the proposition that a taxpayer’s subjective intent will not resurrect a deduction that has no economic substance behind it. 22. see, e.g., knetsch v. united states, 364 u.s. 361 (1960); goldstein v. commissioner, 364 f.2d 734 (2d cir. 1966). 23. see, e.g., sheldon v. commissioner, 94 t.c. 738 (1990). 24. see coltec indus., inc. v. united states, 454 f.3d 1340 (fed. cir. 2006). 25. see am. elec. power, inc. v. united states, 136 f. supp. 2d 762, 79192 (s.d. ohio 2001), aff’d, 326 f.3d.737 (6th cir. 2003); wells fargo & co. v. united states, 91 fed. cl. 35, 84 (2010). 26. staff of joint comm. on taxation, 111th cong, description of revenue provisions contained in the president’s fiscal 2010 budget proposal part two: business tax provisions, at 36 (2009); joint comm. technical explanation, supra note 3, at 143. 418 florida tax review [vol. 10:6 secondly, the decision to codify the economic substance doctrine also was motivated by a congressional concern27 over the decision of the court of federal claims in coltec industries, inc. v. united states.28 in the coltec case, the court of federal claims outright questioned the legitimacy of the economic substance doctrine, stating that “the use of the ‘economic substance’ doctrine to trump ‘mere compliance with the code’ would violate the separation of powers.”29 however, in that case the trial court found that the particular transaction at issue did not lack economic substance, and thus the trial court did not actually rule on the doctrine’s validity.30 nevertheless, on appeal, the court of appeals for the federal circuit vacated the court of federal claims decision and explicitly endorsed the validity of the economic substance doctrine by holding that the transaction in coltec lacked economic substance and failed for that reason.31 finally, given the budget estimates associated with the codification of the economic substance doctrine, it can be inferred that congress believed that the codification of the economic substance doctrine would further enhance the successful application of this doctrine and would curtail aggressive tax planning.32 now that congress has finally codified the economic substance doctrine, it is an appropriate time to consider how we think tax jurisprudence will be impacted as a result of section 7701(o)’s addition to the internal revenue code. the remainder of part i provides an overview of new section 7701(o) and the new penalties that have been enacted to enforce compliance with this new provision. part ii of this article then analyzes how several important historical court decisions may have been altered if new section 7701(o) had applied at the time those earlier court decisions were decided. 27. staff of joint comm. on taxation, 111th cong., description of revenue provisions contained in the president’s fiscal 2010 budget proposal part two: business tax provisions, at 37 (2009); joint comm. technical explanation, supra note 3, at 144. 28. coltec indus., inc. v. united states, 62 fed. cl. 716 (2004), vacated and remanded, 454 f.3d 1340 (fed. cir. 2006), cert. denied, 549 u.s. 1206 (2007). 29. id. at 756. 30. id. at 754-56. 31. coltec indus., inc. v. united states, 454 f.3d 1340, 1360 (fed. cir. 2006). 32. see staff of joint comm. on taxation, estimated revenue effects of the amendment in the nature of a substitute to h.r. 4872, “the reconciliation act of 2010,” in combination with the revenue effects of h.r. 3590, the “patient protection and affordable care act (‘ppaca’),” (estimating $4.5 billion of additional tax revenue through 2019 as a result of § 7701(o)). 2010] economic substance doctrine 419 a. substantive rules contained in new section 7701(o) new section 7701(o)(1) sets forth the following requirement for applying the statutory economic substance doctrine to a particular transaction: section 7701(o) clarification of economic substance doctrine— (1) application of doctrine—in the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if— (a) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (b) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.33 the codification of the economic substance doctrine in new section 7701(o)(1) clarifies and standardizes the application of the economic substance doctrine, but importantly it does not establish explicit rules for determining when the doctrine should be applied. thus, an important initial question is when will the economic substance doctrine be relevant within the meaning of section 7701(o)(1)? new section 7701(o)(5)(c) states that “[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if [new section7701(o)] had never been enacted.” according to the legislative history, “the provision [section 7701(o)(5)(c)] does not change present law standards in determining when to utilize an economic substance analysis.”34 furthermore, the legislative history goes on to state that “the fact that a transaction meets the requirements for specific treatment under any provision of the code is not determinative of whether a transaction or series of transactions of which it is a part has economic substance.”35 finally, the legislative history indicates that the economic substance doctrine is relevant unless the tax benefits are consistent with all applicable provisions of the code and the purpose of such provisions.”36 thus, the court will need to engage in a facts and circumstances inquiry as to whether a particular result is “consistent 33. see irc § 7701(o)(1) (emphasis added). 34. see joint comm. technical explanation, supra note 3, at 152. 35. id. at 153. 36. id. at 152. 420 florida tax review [vol. 10:6 with” the purpose of the tax laws.37 it is unclear whether the court will decide this issue as part of a de novo review or whether the court will give some level of deference to the government’s assertion that the economic substance doctrine is “relevant.”38 however, the legislative history did indicate that “[t]he provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice, are respected merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.”39 the list of transactions intended to be immunized from the application of section 7701 includes: (1) the choice between capitalizing a business enterprise with debt or equity; (2) u.s. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter c; and (4) the choice to utilize a related-party entity in a transaction, provided that the arm’s length standard of section 482 and other applicable concepts are satisfied.40 given that the legislative history sets forth a limited “angel list” of approved transactions and states that this list is non-exhaustive, one would expect that the tax community will request the treasury department to utilize its rulemaking authority to further expand the list of safe transactions that need not have a non-tax motivation. leasing transactions were not placed on an “angel list” and thus will continue to be scrutinized based on all of the facts and circumstances. when the economic substance doctrine does apply, new section 7701(o) standardizes the methodology for its application. in this regard, new section 7701(o)(1) adopts a conjunctive analysis under which a transaction has economic substance only if (a) the transaction changes the taxpayer’s economic position in a meaningful way apart from federal income tax effects 37. id. at 153. 38. compare conn. gen. life ins. co. v. commissioner, 177 f.3d 136, 143-46 (3d cir. 1999) (giving some deference to the irs’s interpretation of a regulation offered for the first time during that particular controversy), with csi hydrostatic testers v. commissioner, 103 t.c. 398, 408-09 (1994), aff’d, 62 f.3d 136 (5th cir. 1995) (granting some deference to an irs litigating position only when that position was based on a published irs position or was a longstanding administrative position). 39. see joint comm. technical explanation, supra note 3, at 152. 40. id. at 152-53. 2010] economic substance doctrine 421 and (b) the taxpayer has a substantial business purpose, apart from federal income tax effects, for entering into the transaction. in earlier versions of this legislation, section 7701(o)(1)(b) had added the following additional statement: “[a]nd the transaction is a reasonable means of accomplishing such purpose.”41 it is not clear what difference in application was intended by the deletion of this qualifier language in the final statutory language. the conjunctive test set forth in section 7701(o)(1)(a) and (b) resolves the split between the circuits (and between the tax court and certain circuits)42 by rejecting the view of those courts that held the economic substance doctrine was satisfied if there were either (1) a change in the taxpayer’s economic position or (2) a non-tax business purpose.43 furthermore, new section 7701(o)(5)(d) allows the economic substance doctrine to be applied to a single transaction or to a series of transactions. in this respect, new section 7701(o)(5)(d) and its associated legislative history is likely to have a significant impact on how a transaction will be framed under the economic substance doctrine. to better understand this assertion, it is appropriate to review the standards for applying business purpose and economic substance under judicial case law that predates section 7701(o)’s enactment. in the landmark case of gregory v. helvering, judge learned hand set forth the following boundaries for the business purpose doctrine: we agree with the board and the taxpayer that a transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one choose, to evade, taxation. any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the treasury; there is not even a patriotic duty to increase one’s taxes.44 commentators have forcefully argued that this statement in gregory and similar statements in other cases grant the taxpayer the right to structure an overall transaction in the most tax advantageous manner as long as the 41. see, e.g., h.r. 2345, 110th cong., 1st sess. (2007); h.r. 2, 108th cong., 1st sess. (2003). 42. see joint comm. technical explanation, supra note 3, at 154. 43. for cases that had articulated the “disjunctive test,” see generally ies indus., inc. v. united states, 253 f.3d 350, 353 (8th cir. 2001); rice’s toyota world v. commissioner, 752 f.2d 89 (4th cir. 1985). 44. gregory v. helvering, 69 f.2d 810 (2d cir. 1934), aff’d, 293 u.s. 465 (1935). 422 florida tax review [vol. 10:6 overall transaction has economic substance and business purpose.45 in contrast, the federal circuit in coltec stated that the taxpayer in that case failed to meet the requirements of the economic substance doctrine by focusing on the tax motivations for one particular step in an overall transaction that failed to possess economic substance and business purpose: [t]he transaction to be analyzed is the one that gave rise to the alleged tax benefit. for example, in basic inc., where the taxpayer underwent an inter-company transfer of stock to allow the parent to sell the stock to a third-party with little taxable gain, our predecessor court looked for the economic substance of the inter-company transfer of stock—not of the ultimate sale of stock to the third-party. the court explained that if the business purpose of the ultimate sale could be used to justify the unnecessary inter-company transfer, then “all manner of intermediate transfers could lay claim to ‘business purpose’ simply by showing some factual connection, no matter how remote, to an otherwise legitimate transaction existing at the end of the line.”46 in reaching its opinion, the federal circuit cited the gregory decision extensively and then cited two other circuit courts for the 45. see david hariton, the frame game: how defining the “transaction” decides the case, 63 tax law. 1 (2009); david hariton, when and how should the economic substance doctrine be applied?, 60 tax l. rev. 29, 43-44 (2006) [hereinafter hariton, economic substance] “[s]ubsequent courts adopted and applied the reasoning of gregory v. helvering to disallow tax benefits arising from a transaction that lacked business purpose and economic substance considered as a whole. and i believe that courts should continue to apply the ‘economic substance doctrine’ in this manner today rather than broaden it further, lest its coherence be undermined.”); david hariton, sorting out the tangle of economic substance, 52 tax law. 235 (1999). 46. coltec indus. v. united states, 454 f.3d 1340, 1356 (fed. cir. 2006) (citations omitted); see also black & decker corp. v. united states, 436 f.3d 431, 442 (4th cir. 2006) (“[e]ssential question posed in taxpayer’s motion is whether the irs adduced sufficient facts to go to trial on its argument that taxpayer lacked ‘any reasonable expectation of a profit’ from the transaction that generated the claimed $560 million capital loss reported on the 1998 return. we conclude that the irs offered ample evidence to permit a reasonable trier of fact to find in the irs’s favor.”); nicole rose corp. v. commissioner, 320 f.3d 282, 284 (2d cir. 2002) (“the relevant inquiry is whether the transaction that generated the claimed deductions . . . had economic substance.”); acm p’ship v. commissioner, 157 f.3d 231, 260 & n.57 (3d cir. 1998) (stating that the tax court properly excluded profits from certain aspects of related transactions in order to determine profit potential for the transaction tested for economic substance). 2010] economic substance doctrine 423 proposition that a transaction should be disaggregated to analyze the component part that created the tax mistake. with this backdrop in mind, it appears that section 7701(o)(5)(d) seeks to make clear that the government has the ability to disaggregate transactions and to test each transactional step individually. the legislative history goes further in this regard by stating that this provision “does not alter the court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the doctrine,” thus by implication suggesting that a court should exercise this authority.47 furthermore, the legislative history favorably cites the coltec case and then states that a court has the ability “to bifurcate a transaction in which independent activities with non-tax objectives are combined with an unrelated item having only taxavoidance objectives in order to disallow those tax-motivated benefits.”48 this ability to disaggregate, isolate, or bifurcate a tax-motivated aspect of a larger transaction resolves the conflict that had developed among the courts as to whether the economic substance doctrine is applied on an overall basis or whether this doctrine applies to each separate step individually.49 new section 7701(o) does not explicitly require a taxpayer to have a pre-tax profit in order for a transaction to have a substantial business 47. see joint comm. technical report, supra note 3, at 153. for cases that favorably allowed a bifurcation approach, see generally acm p’ship, 157 f.3d at 256 n. 48; james v. commissioner, 899 f.2d 905, 910 (10th cir. 1990) (“the only transactions at issue in this case are the purported sales by the communications group to the joint ventures. these sales cannot be legitimized merely because they were on the periphery of some legitimate transactions.”); karr v. commissioner, 924 f.2d 1018, 1023 (11th cir. 1991) (“the activities of the other entities involved in exploiting the koppelman process, however, cannot necessarily be attributed to poga [the taxpayer].”); long term capital holdings v. united states 330 f. supp. 2d 122 (d. conn. 2004); aff’d, 150 f. app’x 40 (2nd cir. 2005). 48. see joint comm. technical explanation, supra note 3, at 153. 49. compare coltec, 454 f.3d at 1358 (“the first asserted business purpose focuses on the wrong transaction—the creation of garrison as a separate subsidiary to manage asbestos liabilities . . . [w]e must focus on the transaction that gave the taxpayer a high basis in the stock and thus gave rise to the alleged benefit upon sale.”) with shell petroleum, inc. v. united states, 102 a.f.t.r. 2d 5085, 5111 (s.d. tex. july 3, 2008) (“[t]he court has found no 5th circuit cases, and the parties have cited none, similarly dissecting or, ‘slicing and dicing’ as it was referred to in oral arguments, an integrated transaction solely because the government aggressively chooses to challenge only an isolated component of the overall transaction. indeed, commentators have criticized coltec’s disregard of the larger context in which the intended § 351 exchange occurred.”); see also hariton, economic substance, supra note 45, at 40–44 (2007) (stating that coltec’s narrow framing of the operative transaction represents a “fundamental misunderstanding” of the supreme court’s seminal decision in gregory v. helvering, 293 u.s. 465 (1935), which instead supports the notion that transactions must be viewed as a whole). 424 florida tax review [vol. 10:6 purpose.50 however, if the taxpayer’s substantial business purpose does rely on an argument that a transaction has a profit motivation, then new subsections 7701(o)(2) through (4) set forth the following criteria for analyzing whether this profit potential is substantial enough to satisfy economic substance concerns: (2) special rule where taxpayer relies on profit potential— (a) in general—the potential for profit of a transaction shall be taken into account in determining whether the requirements of subparagraphs (a) and (b) of paragraph (1) are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. (b) treatment of fees and foreign taxes— fees and other transaction expenses shall be taken into account as expenses in determining pre-tax profit under subparagraph (a). the secretary shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases. (3) state and local tax benefits—for purposes of paragraph (1), any state or local income tax effect which is related to a federal income tax effect shall be treated in the same manner as a federal income tax effect. (4) financial accounting benefits—for purposes of paragraph (1)(b), achieving a financial accounting benefit shall not be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of federal income tax.51 as set forth above (emphasis added), in calculating the expected profit potential, new section 7701(o)(2)(b) requires that transaction costs be taken into account. what is more, in a departure from prior law,52 new 50. see joint staff comm. technical explanation, supra note 3, at 154-55. 51. irc §§ 7701(o)(2)-(4), (emphasis added). 52. see compaq computer corp. v. commissioner, 277 f.3d 778, 784 (5th cir. 2001) (holding that “the tax court erred as a matter of law by disregarding the gross amount of the royal dutch dividend”), rev’g 113 t.c. 214 (1999) (treating foreign taxes as an expense for purposes of computing compaq’s profit on the adr transaction); notice 2004-19, 2004-1 c.b. 606, withdrew notice 98-5, 1998-1 c.b. 2010] economic substance doctrine 425 section 7701(o)(2)(b) also requires the treasury department to issue regulations to treat foreign taxes as expenses for purposes of calculating the reasonably expected pre-tax profit potential of a transaction. in addition, new section 7701(o)(3) provides that the state or local income tax effect of a transaction that is related to a federal income tax effect is treated in the same manner as a federal income tax effect.53 thus, state tax savings that piggyback on federal income tax savings cannot provide either a profit potential or a business purpose. similarly, new section 7701(o)(4) provides that a financial accounting benefit cannot satisfy the business purpose requirement if the financial accounting benefit originates in a reduction of federal income tax.54 finally, once the reasonably expected pre-tax profit potential is determined, new section 7701(o)(2)(a) requires the taxpayer to then apply present value concepts before determining whether the reasonably expected profit is substantial. the requirement to utilize net present value concepts directly overturns the holding of consolidated edison co. of new york v. united states.55 in the consolidated edison case, the court rejected the use of any net present value analysis in determining the application of the judicially developed economic substance doctrine.56 thus, taken in their totality, these statutorily prescribed adjustments represent a significant alteration in how the reasonably expected pre-tax profit potential will be calculated when compared with the diversity of methods that is contained in existing case law. it is also important to note that section 7701(o)(2) does not provide an explicit return threshold, and in this respect the enacted version differs from earlier proposals that would have only required the reasonably expected pre-tax profit from the transaction to exceed a risk-free rate of return.57 instead of providing for a safe-harbor profit threshold, new section 7701(o)(2)(a) requires that the expected pre-tax profit potential must be substantial in comparison to the expected tax benefits. thus, section 7701(o) does not simply allow a transaction to withstand attack even though it has business purpose or some positive profit level. instead, the economic consequences must be substantial in comparison to the tax benefits being created. this standard requires a weighing of the relative benefits of a transaction, and as such this comparative approach causes the court to make 334 (stating that foreign taxes should be treated as an expense for purposes of determining economic profit). 53. see joint comm. technical explanation, supra note 3, at 154. 54. id. 55. consol. edison co. of n.y. v. united states, 90 fed. cl. 228 (2009). 56. id. at 328-29. 57. see, e.g., h.r. 2345, 110th cong, 1st sess. (2007); h.r. 2, 108th cong., 1st sess. (2003); see also joseph bankman, articles and essays: the economic substance doctrine, 74 s. cal. l. rev. 5, 23-26 (2000) (discussing various alternative approaches that could have been adopted). 426 florida tax review [vol. 10:6 an analysis of the relative tax versus non-tax motivations. this comparative analysis appears to increase the required showing on the part of the taxpayer of the level of non-tax benefits beyond what has generally been required under existing case law.58 although it is clear that new section 7701(o) requires taxpayers to demonstrate a substantial economic consequence for a transaction, the standard set forth in section 7701(o) does leave several unresolved questions. in this regard, would the net present value of the reasonably expected potential profit be “substantial” if it were at least equal to 33% of the net present value of the expected tax benefits? what would be the result if the reasonably expected net present value of the potential pre-tax profit were less than 33% of the expected tax benefits but more than 20% of the net present value of the expected tax benefits? would an economic consequence of this amount be “substantial” within the meaning of new section 7701(o)(2)? suppose a transaction showed minimal non-tax profitability but did create several subjective economic consequences to the taxpayer. would the nontax economic consequences in this situation be “substantial”? these questions are left unresolved, but the burden is clearly on the taxpayer to demonstrate the substantial nature of the non-tax benefits for engaging in a tax preference transaction. as two concluding points, it is important to note that new section 7701(o)(5)(b) specifically provides that the statutory modifications and clarifications apply to an individual only with respect to “transactions entered into in connection with a trade or business or an activity engaged in for the production of income.” finally, the legislative history also states that the codification of the economic substance doctrine supplements existing judicial doctrines but does not alter or supplant any other judicial interpretive doctrines such as the business purpose, substance over form, and step 58. see tifd iii-e, inc. v. united states, 342 f. supp. 2d 94, 111 (d. conn. 2004) (stating that “[i]n evaluating the economic substance of a transaction, courts are cautioned to give more weight to objective facts than self-serving testimony,” and holding for the government, but the analysis involved a transaction that possessed extremely minor economic consequences), rev’d and remanded, 459 f.3d 220 (2nd cir. 2006); dep’t of treasury, supra note 4, at 97 (stating that the administration’s proposal for codifying the economic substance doctrine “does not look to motive or business purpose, as these concepts are viewed as subjective and potentially subject to taxpayer manipulation.”); bankman, supra note 56, at 27-28 (“[a] primary criticism of the business purpose test is that it leads to the creation of false or misleading documents that evidence nontax motives.”); hariton, economic substance, supra note 45, at 53-54; yoram keinan, the many faces of the economic substance’s two-prong test: time for reconciliation? 1 n.y.u. j.l. & bus. 371, 400 (2005) (discussing the overly subjective nature of business purpose and the resulting uncertainty and uncertain for tax shelter analysis). 2010] economic substance doctrine 427 transaction doctrines.59 thus, one would expect that the step transaction doctrine’s various “formulations,”60 including the end result test,61 remain as an independent inquiry for the courts. furthermore, the expressed endorsement of these judicial doctrines in the legislative history to section 7701(o) is likely to further embolden the courts to further develop these judicial doctrines given that the courts now have expressed congressional endorsement of these judicial doctrines. b. new penalty regime under section 6662(b)(6) and section 6664(c)(2) new section 6662(b)(6), in conjunction with new section 6664(c)(2), imposes a strict liability 20 percent penalty for an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance. the penalty is increased to 40 percent if the taxpayer did not adequately disclose the relevant facts on the original return or an amended return filed before the taxpayer was contacted for audit.62 one would expect that the enhanced penalty provided in section 6662(i) for undisclosed positions will be the subject of significant future discussion among tax professionals and taxpayers because there is an inherent tension between the need to “disclose just enough” about a transaction in order to meet the requirements of section 6662(i) while at the same time taxpayers will be motivated to “not disclose too much.” as this gets sorted out in practice, one would expect that the courts will look to the underlying policy behind section 6662(i) and will accept a taxpayer’s disclosure as being sufficient only when the disclosure in fact reasonably provides sufficient information to the irs to identify the specific aspects of the transaction that give rise to section 7701(o) concerns. because a “reasonable cause” exception to section 6664(c) is unavailable, outside (or in-house) analysis and opinions of counsel or other tax advisors will not insulate a taxpayer from the penalty if a transaction is found to lack economic substance. likewise, new section 6664(d)(2) precludes a reasonable cause defense to imposition of the section 6662a reportable transaction understatement penalty for a transaction that lacks 59. joint comm. technical explanation, supra note 3, at 155. 60. see penrod v. commissioner, 88 t.c. 1415, 1433 (1987). 61. the most expansive formulation of the step transaction doctrine has been called the “end result test.” under the end result test, steps will be collapsed if they are “component parts of an overall plan.” see crenshaw v. united states, 450 f.2d 472, 475 (5th cir. 1971), (citations omitted); see also security indus. ins. co. v. united states, 702 f.2d 1234 (5th cir. 1983); king enters. v. united states, 418 f.2d 511 (ct. cl. 1969). for a further discussion of the end result test, see stephen s. bowen, the end result test, 72 taxes 722, 722–24 (dec. 1994) (“[t]he end result test is very much the order of the day.”). 62. see irc § 6664(i). 428 florida tax review [vol. 10:6 economic substance. what is more, section 6662a(e)(2) has been amended to provide that the section 6662a penalty imposed with respect to a reportable transaction understatement does not apply to a transaction that lacks economic substance if a 40 percent penalty is imposed under section 6662(i). a similar no-fault penalty regime applies to excessive erroneous refund claims that are denied on the ground that the transaction on which the refund claim was based was a transaction that lacked economic substance.63 however, under the “every dark cloud has a silver lining” maxim, the section 6662(b)(6) and section 6664(c)(2) penalty regime does not apply to any portion of an underpayment on which the section 6663 fraud penalty is imposed. ii. review of decided cases illuminates where section 7701(o) changes judicial holdings the cases that are set forth in the following sections present careful tax planning strategies that created a mistake and allowed the taxpayer to benefit from this mistake. for the most part, these transactions have not been considered as tax shelter cases. other cases could have been chosen, but these were chosen because they raise fundamental interpretive questions with respect to new section 7701(o)’s application to complex business transactions. by analyzing the application of new section 7701(o) in light of the facts set forth in these historic cases, part ii draws some important conclusions about how tax planning and tax jurisprudence outside of the tax shelter context is likely to be impacted as a result of section 7701(o)’s addition to the u.s. tax laws. a. woods investment co. v. commissioner64 the decision in woods investment co. is thoughtprovoking because it helps to frame the issue of whether new section 7701(o) changes the landscape for the government to argue against the application of its own regulations. 1. the historical basis for the opinion in woods investment co., the taxpayer’s consolidated group computed consolidated net income with reference to accelerated depreciation claimed by its operating subsidiary. however, for purposes of making investment basis adjustments in the stock of the operating subsidiary under former regulations section 1.1502-32(a), the parent reduced its basis in the 63. see § 6676(c). 64. woods inv. co. v. commissioner, 85 t.c. 274 (1985). 2010] economic substance doctrine 429 subsidiary stock using straight-line depreciation. the taxpayer relied on treasury regulations that existed at the time that required taxpayers to make investment basis adjustments using straight-line depreciation. the parent company sold its investment in its subsidiary and reported a gain of $1,472,378. if the taxpayer had used a consistent method of depreciation for purposes of computing its consolidated taxable income and for purposes of making its investment basis adjustments, its gain on the disposal of the subsidiary would have been $12,252,266. the irs issued a deficiency notice stating that the parent should have reduced its subsidiary stock basis for the excess amount of accelerated over straight-line depreciation in order to avoid a “double deduction.”65 thus, there was a mistake, and this mistake represented a mistake based on a transactional inconsistency in that the taxpayer was stating that its depreciation was one amount for one part of its tax return and then was claiming that its depreciation was a lower amount for a different part of the same tax return. but, in the taxpayer’s defense, this inconsistent assertion was literally required as a technical matter under the consolidated return regulations that existed at the time. the court in woods investment co. refused to fix the whipsaw mistake that was created by the consolidated return regulations. in fact, the court said that the mistake was one of the commissioner’s own doing and if he wanted to have a different result then the government should change its own regulations. the following statement was particularly poignant: in 1982, although respondent changed his position to the one he advances herein, he failed to amend his regulations to reflect his new position. based upon the foregoing, we conclude that petitioner reached the result mandated by respondent’s consolidated return regulations and section 312(k) in computing its basis in the subsidiaries’ stock. we believe that judicial interference sought by respondent is not warranted to alter this result. this court will apply these regulations and the statute as written. if we were to make a judicial exception with respect to the adjustment for depreciation, we would be opening our doors for respondent every time he was dissatisfied with a certain earnings and profits adjustment. if respondent believes that his regulations and section 312(k) together cause petitioner to receive a “double deduction,” then respondent should use his broad power to amend his regulations. see henry c. beck builders, inc. v. commissioner, 41 t.c. 616, 628 (1964). since respondent 65. see id. at 279. 430 florida tax review [vol. 10:6 has not taken steps to amend his regulations, we believe his apparent reluctance to use his broad power in this area does not justify judicial interference in what is essentially a legislative and administrative matter.66 thus, woods investment co. presented the court with a mistake in how the law was being applied, and the court stated that this mistake needed to be fixed by another branch of government. the service announced that it would not appeal the decision in woods investment co.67 congress eventually fixed the mistake highlighted by woods investment co. for dispositions occurring after december 15, 1987, by adding section 1503(e) to the code. 2. how new section 7701(o) would change things in a world where new section 7701(o) now applies, the opinion in woods investment co. would need to be substantially rewritten. the court would not be able to simply dismiss the government’s statements that a double deduction created under the consolidated return regulations should be fixed by the administrative branch. the irs made a showing in woods investment co. that the result achieved under the consolidated return regulations by the taxpayer in that case was unintended, and the government also demonstrated that several interpretive administration rulings had been issued that confirmed the government’s assertion. thus, it would appear that sufficient grounds would exist for the court to find that the mistake created by the consolidated return regulations in woods investment co. represents a situation in which the economic substance doctrine is “relevant.”68 thus, it would appear that new section 7701(o) opens the door for the commissioner to argue against the plain meaning of its own regulations when those regulations lead to an unintended result. assuming, as is likely to be the case, that the government would be able to convince the tax court that the economic substance doctrine is “relevant” to the consolidated return mistake because a double deduction is not consistent with the purpose of the tax laws, the burden would be on the taxpayer to demonstrate that the transaction that had given rise to this tax mistake changed the taxpayer’s position in a meaningful way and had a substantial non-tax purpose.69 if the taxpayer could meet its burden of proof with respect to the requirements contained in section 7701(o)(1)(a) and (b), 66. id. at 281-82 (emphasis added). 67. announcement 86-32, 1986-12 i.r.b. 26, 1986 i.r.b. lexis 264 (mar. 24, 1986) . 68. § 7701(o)(1). 69. irc §§ 7701(o)(1)(a), (b). 2010] economic substance doctrine 431 then it could capture an unintended benefit from this mistake. although not free from doubt, it would appear that the taxpayer would likely be able to meet its burden of proof in the fact pattern presented in woods investment co. because (1) the taxpayer’s effort to sell a real operating subsidiary changed the taxpayer’s economic position in a meaningful way, and (2) the taxpayer should be able to demonstrate that the disposal of a real operating subsidiary has a substantial business purpose apart from the tax benefits of such a sale. so, as to the disposal transaction, this transaction would likely satisfy the economic substance doctrine. likewise, as to the transactions that gave rise to the right to claim accelerated depreciation deductions at the operating subsidiary level, the taxpayer would likely satisfy economic substance concerns if it could show that the assets subject to accelerated depreciation were used in a meaningful way in the business of its subsidiary and if it could show that those assets were acquired for a substantial business reason apart from their tax depreciation. thus, new section 7701(o) opens the door for the irs to argue against the plain meaning of its own regulations in cases such as woods investment co. but the actual holding in that particular case probably would not change because the transactions used to create the mistake had substantial economic consequences to the taxpayer. however, having said this, it is important to note that the court would be required to go through a fact finding exercise before reaching this conclusion and that a failure by the taxpayer to meet its factual burden of proof under section 7701(o)(1) with respect to the acquisition of depreciable assets and the disposal of its subsidiary would be fatal. thus, this analysis indicates that new section 7701(o) appears to eliminate the taxpayer’s ability to assert arguments of government estoppel or detrimental reliance when the regulations that are being relied upon create a tax mistake to which section 7701(o) is relevant. if subsequent judicial cases concur in this assessment, then section 7701(o) will have an important impact on the course of future tax jurisprudence. b. textron, inc. v. united states70 the facts in the textron case are fascinating because they present the issue of how the government will be able to bifurcate a transaction to isolate one narrow aspect of an overall transaction for purposes of applying the economic substance doctrine. 1. the historical basis for the opinion textron took tax deductions in the amount of $1,259,714.67 for worthless securities and $4,670,520.02 for bad debts for the taxable year 70. textron, inc. v. united states, 561 f.2d 1023 (1st cir. 1977). 432 florida tax review [vol. 10:6 ended january 2, 1960 with respect to its wholly owned subsidiary, hawaiian textron, inc. (“hawaiian”). in april, 1960, textron acquired the assets of the bell defense group from bell aircraft corporation using hawaiian as the receptacle. textron transferred approximately $16,500,000 to hawaiian to purchase bell’s assets, and hawaiian’s name was changed to bell aerospace corporation (“bell”). bell, in contrast with hawaiian, made money. hawaiian’s operating loss carryover of $6,745,025.35 was fully utilized by bell (pursuant to section 172 of the internal revenue code). the net result was that bell, a subsidiary of textron, offset its profits by using a loss carryover that its predecessor, hawaiian, had accumulated, and textron claimed an additional tax deduction for its investment in hawaiian. thus, for one economic loss, textron claimed a double deduction. this represents a loss-generator mistake or perhaps a whipsaw mistake. the deductions for the worthless stock and bad debts of hawaiian under section 165 and section 166 were disallowed on audit and refund litigation ensued. the district court of rhode island ruled in favor of the taxpayer,71 and the case was subsequently appealed to the first circuit. the first circuit recognized that a mistake had been made, but the court believed that the mistake should be corrected by congress, not the courts, and so the court explicitly refused to apply judicial equity considerations in its decision.72 judge coffin, writing for the majority of the first circuit, reasoned as follows: admittedly, textron has turned its hawaiian sow’s ear into a silk purse—and filled it at treasury expense. but this is a matter that should be cured by statute or regulation, not by a far reaching retroactive court decision. the dissent, agreeing that the service’s approach must fail, introduces a theory that the service has advanced diffidently at best. the dissent would brand as a “double deduction” textron’s worthless stock and debt claim and bell aerospace’s carry-over loss deductions. we have grave doubts about the dissent’s casual eliding of the distinction between parent and subsidiary. they are separate taxpayers. in the absence of a consolidated return, cf. ilfeld co. v. hernandez, 292 u.s. 62 (1934), treating the two corporations as one may not be justified. but cf. marwais steel co. v. commissioner, 354 f.2d 997 (ninth cir. 1965). it is no answer to invoke the maxim that substance must prevail over form. textron’s subsidiary was never a sham 71. textron, inc. v. united states, 418 f. supp. 39 (d.r.i. 1976), aff’d, 561 f.2d 1023 (1st cir. 1977). 72. textron, 561 f.2d at 1026-27. 2010] economic substance doctrine 433 corporation lacking any substantial business purpose. in the first place, we are not inclined to adopt a policy of ignoring the distinction between parent and subsidiary in all tax cases. in the second place, corporate taxation is an area of careful planning, planning that will be seriously disrupted if courts simply ignore separate entities whenever it seems “fairer” to do so. we decline to inject so massive and unsettling a dose of “equity” into the tax laws without a clear invitation from the service and a careful exploration of the issue by both sides.73 in contrast to the majority opinion, judge bownes stated in dissent that the court should apply substance over form principles and not allow a parent-subsidiary arrangement to create a double deduction. in fact, the dissenting opinion written by judge bownes is remarkably consistent with the economic substance doctrine as codified by section 7701(o). in any event, as a matter of tax history, neither the tax court nor the first circuit fixed the textron mistake.74 in the end, congress eventually fixed this mistake statutorily by adding current section 382(g)(4)(d) to the code. under section 382(g)(4)(d), a worthless stock deduction claimed by a more than 50% shareholder creates an ownership change for the subsidiary. given that a subsidiary in the textron fact pattern would be considered worthless at the time of this fictional ownership change, the section 382 limitation would be zero. thus, in the words of the court, the taxpayer in textron was able to turn a mistake (a “sow’s ear,” in the court’s own words) into a “silk purse” and “filled it at treasury expense.”75 2. how new section 7701(o) would change things new section 7701(o) arguably would have changed the holding in textron if it had existed at the time that the textron case was decided. in this regard, the court would be required to employ equitable doctrines to determine whether the taxpayer’s “careful planning”76 in the textron transaction would withstand attack under the economic substance doctrine. the irs made a showing in textron that the result achieved by the taxpayer in that case was unintended because the taxpayer received the economic benefit of a double deduction. but, under new section 7701(o), a 73. id. (footnotes omitted). 74. for a thoughtful review of the judicial options to handle the textron mistake, see william natbony, twice burned or twice blessed—double deductions in the affiliated corporation context, 6 j. corp. tax’n 3 (1979). 75. textron, 561 f.2d at 1026. 76. id. 434 florida tax review [vol. 10:6 court can longer simply “decline to inject so massive and unsettling dose of ‘equity’ into the tax laws”77 because that is exactly what new section 7701(o) explicitly requires a court to do. furthermore, if the textron case were analyzed in the context of new section 7701(o), it seems fairly clear that there are ample grounds to find that the double deduction mistake in textron is not consistent with the underlying purpose of the tax laws. if the court made this finding as part of a de novo review of the court record or if the court gave some deference to the government’s assertion about the underlying purpose of the tax laws, then in either case the result would be that the economic substance doctrine would likely be considered relevant to the tax planning transaction implemented in the textron case. once the economic substance doctrine were found to be relevant to the textron mistake, the burden would be on the taxpayer to demonstrate that the transaction, or series of transactions, changed the taxpayer’s position in a meaningful way and had a substantial non-tax purpose.78 if the taxpayer could meet its burden of proof with respect to these requirements that are contained in sections 7701(o)(1)(a) and (b), then it could still benefit from this mistake even though a double deduction was created. certainly, the acquisition of an aerospace business represented a meaningful change in the economic position of textron’s investments, and the acquisition of this profitable business clearly had a substantial non-tax business purpose. however, the irs would likely argue that the acquisition of a new business is not the key aspect of the transaction that needs to be tested. instead, the irs would focus its concern on the question of whether the use of hawaiian was an extraneous and unnecessary part of the transaction that does not satisfy economic substance doctrine concerns. in this regard, new section 7701(o)(5)(d) allows the economic substance doctrine to be applied to a single transaction or to a series of transactions. the staff of the joint committee report indicates that the provision gives a court the ability “to bifurcate a transaction in which independent activities with non-tax objectives are combined with an unrelated item having only tax-avoidance objectives in order to disallow those tax-motivated benefits.”79 based upon new section 7701(o)(5)(d) and the legislative history of this provision, the irs would seek to bifurcate the use of hawaiian from the rest of the series of transactions and then argue that the use of hawaiian had no economic substance except for tax avoidance purposes. in this analysis, the irs could show that the taxpayer’s claim of a worthless stock deduction with respect to the hawaiian stock indicates that the taxpayer admits that hawaiian had no continued business significance or business purpose. the irs would therefore claim that the taxpayer’s own representation about the 77. id. 78. irc §§ 7701(o)(1)(a), (b). 79. see joint comm. technical explanation, supra note 3, at 153. 2010] economic substance doctrine 435 total lack of a business prospect or any future business use for the hawaiian subsidiary shows that its use in the acquisition of a new business was solely tax motivated. by this line of argument, the irs would then argue that the use of hawaiian in any transaction after it became worthless would have been solely motivated by tax reasons. by disaggregating the transaction into this separate step inquiry and then bifurcating the use of hawaiian away from the overall transaction, the irs would have strong arguments to disallow the use of any of hawaiian’s net operating loss carryforwards. thus, the bifurcation authority set forth in section 7701(o)(5)(d) along with the legislative history to this provision now calls into question the ability of a taxpayer to bootstrap a tax motivated step into an overall transaction that has economic consequences unless the tax motivated step has a “substantial” economic consequence when judged on a stand-alone basis. in textron, the taxpayer inserted an unnecessary tax motivated step (the use of hawaiian) that created a tax mistake when it was included in a larger transaction that had overall economic consequences that were substantial. under new section 7701(o)(5)(d), it would appear that the government would be able to isolate the use of hawaiian to contest its addition to the overall transaction. this ability to narrowly target its attack on one aspect of an overall transaction promises to have a significant impact on the course of future litigation with respect to the application of the economic substance doctrine. c. cottage savings association v. commissioner80 new section 7701(o) only applies the economic substance doctrine when that doctrine is “relevant” under existing law. the cottage savings fact pattern is interesting because it raises the issue of the scope of what is a “relevant transaction” to which the economic substance doctrine may apply. 1. the historical basis for the opinion in cottage savings, the taxpayer exchanged mortgage pool interests that it owned for other mortgage pool interests. the practice of generating losses by means of “reciprocal sales” resulted from a change in accounting requirements promulgated in 1980 by the federal home loan bank board (fhlbb) as “memorandum r-49.” by observing r-49’s criteria, savings associations attempted to generate income tax refunds by entering into “reciprocal sales” transactions that produced deductible losses but could avoid booking a loss for financial statement purposes on its mortgage pools. based on “reciprocal sales” transactions with four other ohio savings institutions, cottage savings claimed losses on its 1980 corporate income tax 80. cottage savings ass’n v. commissioner, 499 u.s. 554 (1991). 436 florida tax review [vol. 10:6 return from sales of mortgage loans at less than book value. the resulting income tax refunds claimed for 1980 and carry-back years exceeded $677,000. the tax court found that the mortgage pool swaps had no independent business purpose and were solely motivated by a desire to claim tax benefits, but ruled in favor of the taxpayer and allowed a valid tax deduction.81 the sixth circuit reversed, holding that the taxpayer had not experienced a deductible loss under section 165.82 the supreme court reversed the sixth circuit decision and held that the taxpayer’s loss was in fact deductible.83 2. how new section 7701(o) would change things the facts in cottage savings are interesting because these facts raise the issue of when the economic substance doctrine is relevant to a transaction. given the findings of the tax court that the transaction had no business purpose and did not change the taxpayer’s economic position in any meaningful way, it is clear that the taxpayer would not be able to meet its burden of proof under section 7701(o)(1), so if the economic substance doctrine were relevant then the taxpayer would lose in this fact pattern. however, strong arguments can be made that the economic substance doctrine is not relevant to this transaction. the taxpayer in cottage savings was not claiming a double deduction, nor was it utilizing a lossgenerating mistake. in point of fact, the taxpayer had already suffered an economic loss that had not been recognized for financial or tax reporting purposes. the fact that the taxpayer used a tax planning technique in order to recognize a loss that already represented an economic loss is not a transactional inconsistency.84 furthermore, taxpayers that originate mortgage loans can now elect to mark-to-market their financial positions for tax purposes,85 and so a taxpayer like the one in cottage savings now can realize its losses even without the need to create an actual sale or exchange 81. cottage savings ass’n v. commissioner, 90 t.c. 372 (1988), rev’d, 890 f.2d 848 (6th cir. 1989), aff’d in part, rev’d in part and remanded, 499 u.s. 554 (1991). 82. cottage savings ass’n v. commissioner, 890 f.2d 848 (6th cir. 1989), aff’s in part, rev’d in part and remanded, 499 u.s. 554 (1991). 83. cottage savings, 499 u.s. 544. 84. see doyle v. commissioner, 286 f.2d 654, 659-60 (7th cir. 1961) (“the cases cited by the commissioner in which loss deductions were disallowed because of lack of economic substance have this consistent element: taxpayers, by manipulation or chicanery, were attempting to create a loss deduction. however, here taxpayer has suffered a capital loss because of the depreciation in value of her stocks at the time of sale. the only question is whether taxpayer realized her loss at the proper time.” (emphasis added)). 85. irc § 475(b)(2). 2010] economic substance doctrine 437 transaction under current law if it made a section 475(b) election.86 thus, given this situation, this transaction is not the type of tax planning strategy for which the economic substance doctrine should be relevant because the tax result creates a tax benefit that is not premised on a transactional inconsistency and has not created a fundamental tax mistake.87 86. many banks are dealers for purposes of § 475 because they regularly originate and sell loans. see rev. rul. 97-39, holding 2, 1997-2 c.b. 62. by enacting § 475, congress effectively gave taxpayers an election for loans that are made to customer that are not intended to be resold, and so under current law a taxpayer like cottage savings can choose whether they want to have mark-to-market treatment since avoidance of mark-to-market treatment requires an affirmative identification under § 475(b)(2). see reg. § 1.475(c)-1(c)(1)(i) (“a taxpayer that regularly purchases securities from customers in the ordinary course of a trade or business (including regularly making loans to customers in the ordinary course of a trade or business of making loans) but engages in no more than negligible sales of the securities so acquired is not a dealer in securities within the meaning of § 475(c)(1) unless the taxpayer elects to be so treated or, for purposes of § 471, the taxpayer accounts for any security (as defined in § 475(c)(2)) as inventory.”); reg. § 1.475(c)-1(c)(1)(ii) (a taxpayer . . . elects to be treated as a dealer in securities by filing a federal income tax return reflecting the application of § 475(a) in computing its taxable income.); chief couns. adv. 200731029 (aug. 3, 2007) (discussing substantive requirement to make election to avoid mark-to-market treatment and discussing that loan participations are securities within the meaning of § 475). see also tech. adv. mem. 200120001 (may 5, 2001) (“consequently, taxpayer would not be a dealer in securities subject to § 475 unless taxpayer waived the exemption afforded by § 1.475(c)-1(c) by filing a federal tax return reflecting the application of § 475 and meeting any other requirements imposed by rev. proc. 97-43.”); rev. rul. 97-39, holdings 8, 17, 1997-2 c.b. 62, 64, 65 (identification must be made within 30 days of loan origination for loans that are not intended to be sold to make a valid election out of mark-to-market treatment); field serv. adv. 199909005 (nov. 20, 1998) (deals with taxpayer that waives exemptions from § 475). the determination of whether a taxpayer is a dealer in securities is done on an entity-byentity basis, so a controlled group can have some of their subsidiaries subject to § 475(a)’s mark-to-market treatment while another subsidiary is not subject to markto-market treatment. see fsa 200047012 (nov. 27, 2000). once a taxpayer identifies an asset as “held for investment” and chooses to not apply the mark-tomarket principles of § 475(a), the irs may not allow them to change that designation absent a strong showing of a factual change in purpose. see chief couns. adv. 200817035 (apr. 25, 2008). 87. but see cottage savings, 890 f.2d 848. 438 florida tax review [vol. 10:6 d. guardian industries corp. v. united states88 the facts in guardian industries are interesting because it uses a common tax planning technique to create a foreign tax credit mistake that created significant benefits for the taxpayer. 1. the historical basis for the opinion in guardian industries, the taxpayer owned its luxembourg operations through guardian industries europe, s.a.r.l. (“gie”). gie, in turn, held controlling interests in several other luxembourg companies that engaged in actual manufacturing operations in luxembourg. the luxembourg tax authorities taxed the income from guardian’s affiliates in luxembourg on a “fiscal unity” basis. under the luxembourg laws, the ultimate parent company, namely gie, was the company that was responsible for paying taxes for the fiscal unity group. for u.s. tax purposes, gie was classified as a “disregarded entity” of the u.s. company that owned gie.89 however, all of the luxembourg operating companies were treated as separate controlled foreign corporations for u.s. tax purposes. the taxpayer claimed that all of the luxembourg taxes represented direct taxes paid by the u.s. parent of gie since gie was a “disregarded entity” and since gie was the technical “taxpayer”90 of the luxembourg taxes. however, none of the luxembourg income was taxable in the u.s. since that income was earned by controlled foreign corporations and was not otherwise subject to immediate taxation under the u.s. subpart f tax rules. the above tax planning technique allowed the taxpayer to “split” the foreign tax credits away from the foreign income to which those foreign taxes related. due to this “splitter” technique, the u.s. foreign tax credits were claimed and used on the u.s. tax return of guardian industries while the associated luxembourg-sourced income was not currently subject to u.s. taxation. the court of federal claims and the federal circuit ruled in favor of the taxpayer. first, the court stated that there was no indication that regulations section 1.901-2(f)(1) contemplated any inquiry into which party earned the income under foreign law and found that gie was the technical taxpayer under luxembourg law. the court recognized that the government believed that the purpose of the foreign tax credit would be frustrated by allowing guardian to claim a credit for taxes paid on income earned by foreign subsidiaries when the income of those subsidiaries has never been taxed in the united states. however, the court refused to fix this mistake, stating that the treasury department has the ability to draft a regulation that 88. guardian indus. corp. v. united states, 477 f.3d 1368 (fed. cir. 2007). 89. see reg. § 301.7701-3(b). 90. see reg. § 1.901-2(f)(1). 2010] economic substance doctrine 439 would not allow foreign taxes to be split from the associated foreign income, and it has not done so. thus, the court applied a literal reading of the regulations and found that gie was the party liable for the tax under luxembourg law within the meaning of regulations section 1.901-2(f)(1) and that the government should fix its regulations if it wanted a different result. the treasury department has responded in an ad hoc manner to foreign tax credit generator transactions. originally, the treasury department articulated that abusive foreign tax credit transactions would be addressed by the economic substance doctrine, with any foreign taxes being treated as an expense for purposes of determining whether a substantial pretax profit potential existed for the tax strategy.91 however, after losing the compaq case,92 the government repealed notice 98-5 in a subsequent notice.93 congress responded by enacting new section 901(k), which in turn requires the taxpayer to have a minimum holding period in the foreign stock in order to claim u.s. foreign tax credits for dividend withholding taxes.94 the treasury department then embarked on several regulatory and administrative actions to deal with foreign tax credit generator transactions. to begin with, on october 19, 2006, the treasury department amended the regulations under section 704 to require foreign tax credits to be allocated among the partners in accordance with their “interests in the partnership.”95 thus, partners no longer can agree to make special allocations of a partnership’s foreign tax credits that “split” the taxes away from the associated foreign income to which they relate.96 on july 16, 2008, the treasury department issued temporary and proposed regulations that provide that a foreign tax payment is not a compulsory tax payment and thus is not a creditable tax under section 901 if the foreign tax payment were attributable to a structured passive investment arrangement.97 for this purpose, temporary regulations section 1.901-2t(e)(5)(iv)(b) defines a structured passive investment arrangement as an arrangement that satisfies six mechanical tests. several commentators argued that the mechanical “six factor test” set forth in these regulations represent a static rule that is not capable of 91. notice 98-5, 1998-1 c.b. 334-36. 92. compaq computer corp. v. commissioner, 277 f.3d 778 (5th cir. 2001) (holding that the tax court erred as a matter of law by disregarding the gross amount of the royal dutch dividend), rev’g 113 t.c. 214 (1999) (treating foreign taxes as an expense for purposes of computing compaq’s profit on the adr transaction). 93. see notice 2004-19, 2004-1 c.b. 606. 94. see irc § 901(k). 95. t.d. 9292, 2006-2 c.b. 914-915. 96. see reg. § 1.704-1(b)(4)(viii). 97. temp. reg. § 1.901-2t(e)(5(iv)(a). 440 florida tax review [vol. 10:6 meeting evolving business conditions, and as a result the government would have been better served to have adopted a principle-based approach similar to the one that it originally had announced in notice 98-5.98 in the preamble to its temporary regulations, the government explicitly rejected a principlebased rule similar to the one that had been articulated in notice 98-5 because the irs and treasury department were concerned that such a rule would create uncertainty for both taxpayers and the irs.99 yet, less than two years later, congress enacted new section 7701(o) which sets forth the same principle-based approach that the government criticized as creating “too much uncertainty” in the preamble to t.d. 9416.100 the irs also has issued an audit directive that designates foreign tax credit generator transactions as a “tier i issue,” and as such all large case examination teams must issue prewritten information disclosure requests to inquire about foreign tax credit generator transactions and any audit investigation of these issues must be coordinated with a designated national technical advisor.101 finally, congress has now addressed this issue by enacting new section 909(a), which provides that the foreign tax associated with a foreign tax credit splitting event is not to be taken into account by the taxpayer until the taxable year in which the related income is taken into account by the taxpayer.102 2. how new section 7701(o) would change things the facts in guardian industries are interesting because it presents a situation in which a taxpayer created a foreign corporation that was treated as a disregarded entity in order to create a transactional inconsistency.103 the 98. kevin dolan, foreign tax credit generator regs: the purple people eater returns, 2007 tnt 118-33, (june 19, 2007); bret wells, comment letter on proposed treas. reg. 1.901-2(e)(5), 2007 tnt 160-10 (aug. 6, 2007). 99. t.d. 9416, 2008-2 c.b. 1142, 1147. 100. id. 101. internal revenue service, lmsb tier i issue foreign tax credit generator directive, (feb. 19, 2009), http://www.irs.gov/businesses/article/o,,id =204526,oo.html. 102. see irc § 909(a), as added by section 211 of the education jobs and medicaid assistance act, pub. l. no. 111-126, 124 stat. 2389, 6-8 (2010); staff of joint comm. on taxation, 111th cong., technical explanation of the revenue provisions of the senate amendment to the house amendment to the senate amendment to h.r. 1586, scheduled for consideration by the house of representatives on august 10, 2010, 2-7 (2010). 103. an entity that is treated as an entity for tax purposes in a foreign jurisdiction but is disregarded as a separate taxpayer for u.s. tax purposes is referred to in the tax literature as a “hybrid entity.” the use of hybrid entities provides opportunities to create differences in how foreign jurisdictions and the u.s. tax laws will treat transactions that are conducted by the hybrid entity. see irc § 894(c). 2010] economic substance doctrine 441 transactional inconsistency was that the taxpayer could treat the u.s. owner of gie as the taxpayer for purposes of claiming u.s. tax credits but did not treat the u.s. owner as the taxpayer that earned the associated foreign income. it is unclear what business purposes gie may have served under luxembourg law, but it is doubtful that the business need for that particular entity would be substantial in comparison with the tax benefits that were being created. thus, as a preliminary matter, this situation would present a situation to which section 7701(o)(1) would appear to be directly applicable. however, the legislative history indicates that a u.s. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment represents a transaction that is intended to be immunized from the application of the economic substance doctrine.104 thus, the use of a hybrid entity in guardian industries would appear to be a tax motivated decision that the legislative history indicates is not a “relevant transaction” that is subject to challenge under section 7701(o)(1). furthermore, the legislative history also makes clear that the choice of capitalizing a business enterprise with debt or with equity is another tax motivated transaction that is not a “relevant transaction” within the meaning of section 7701(o)(1).105 thus, double dip mistakes premised on the use of hybrid entities or hybrid instruments appear to be outside the scope of inquiry under section 7701(o). because the double dip mistake created in guardian industries is premised on the use of a hybrid entity, the legislative history to new section 7701(o) insulates this transaction from challenge by reason of new section 7701(o). nevertheless, the commissioner of the internal revenue service has recently stated that the current administration remains concerned about double dip structures.106 if that is so, then the government will need to address those concerns through additional regulations since the legislative history to new section 7701(o) condones the use of hybrid entities and hybrid instruments as “basic business transactions that under longstanding judicial and administrative practice are respected.”107 thus, new section 7701(o) may address double dip transactions like those presented in the compaq case, but it is unlikely to address double dip planning benefits generated through the use of hybrid entities (as in guardian industries) or hybrid instruments. e. the limited, inc. v. commissioner108 the facts in the limited provide an interesting case to consider the potential impact of new section 7701(o) on tax planning strategies that 104. see joint comm. technical explanation, supra note 3, at 152–53. 105. id. at 152. 106. news release ir-2008-137 (dec. 8, 2008). 107. see joint comm. technical explanation, supra note 3, at 152-153. 108. the limited, inc. v. commissioner, 286 f.3d 324 (6th cir. 2002). 442 florida tax review [vol. 10:6 attempt to repatriate untaxed foreign earnings in a manner that circumvents section 956. 1. the historical basis for the opinion the taxpayer in the limited sold its merchandise in its own retail stores and by catalog. the taxpayer accepted payment for its merchandise by either cash, check, or credit card. with respect to credit card transactions, the taxpayer accepted its own private-label credit card and also accepted credit cards issued by a third-party bank or other financial institution. on march 15, 1989, the taxpayer formed a wholly-owned subsidiary, world financial network national bank (“wfnnb”), and organized this subsidiary under the national bank act.109 on may 1, 1989, the comptroller of the currency issued a charter certificate to wfnnb authorizing it to commence the business of banking as a national banking association. the business of wfnnb was to provide private-label credit cards to the taxpayer’s retail customers. the taxpayer also conducted extensive operations outside the united states through various controlled foreign corporations. one such controlled foreign corporation was mast industries (far east) ltd. (“mfe”). mfe was a contract manufacturer for the taxpayer. mfe declared no significant dividends from the early 1980s through 1993, resulting in untaxed accumulated earnings and profits in excess of $330 million at the end of 1993. on january 12, 1993, the directors of mfe resolved to organize and capitalize mfe n.v. to engage in group financing activities and to provide a means of investing and reinvesting liquid assets and funds. mfe n.v. had no employees. on january 28, 1993, mfe transferred $175 million to mfe n.v. as a capital contribution. on this same date, mfe n.v. purchased eight certificates of deposit from wfnnb for $174.9 million. on january 28, 1993, wfnnb transferred the $174.9 million to another u.s. affiliate in order to reduce its intercompany line of credit that had been extended to it by that other u.s. affiliate. the tax court held that mfe n.v.’s investment in cds issued by wfnnb represented an investment in u.s. property that was taxable under section 956. in this regard, the tax court noted that section 956 was enacted to tax as dividends the repatriated earnings of controlled foreign corporations.110 an exception to section 956 was made for deposits with persons carrying on the banking business. however, given the limited purpose of wfnnb (to issue credit cards to customers) and given that the 109. see 12 u.s.c. § 24 (1994). 110. the limited, inc. v. commissioner, 113 t.c. 169, 183-85 (1999), rev’d, 286 f.3d 324 (6th cir. 2002). 2010] economic substance doctrine 443 purchase of the cds by mfe n.v. made the untaxed earnings of mfe available for use by its only u.s. shareholder, the tax court found that the repatriation that occurred in this particular case was the type of repatriation transaction that section 956 intended to subject to immediate taxation.111 in so holding, the tax court believed that mfe n.v.’s investments in cds were not the type of “deposits with persons carrying on the banking business” that congress intended to carve-out from the scope of section 956 when it crafted an exception in section 956(b)(2)(a) for certain banking deposits.112 the sixth circuit reversed the decision of the tax court, and in its opinion the sixth circuit criticized the tax court for not resolving the case through an ordinary and natural reading of section 956(c)(2)(a) but instead “raced to the legislative history of [section] 956.”113 the sixth circuit argued that congress could have easily written the banking exception in section 956(b)(2)(a) to have read in a different or more narrow manner if it had so desired, but it did not do so. the sixth circuit then stated that regardless of the reasons that may or may not have been motivating congress when it crafted the banking exception set forth in section 956(b)(2)(a), the plain language of the banking exception contained in section 956(b)(2)(a) provides for no related-party prohibition, and thus there is no need to examine the legislative history to decide whether one should exist. 2. how new section 7701(o) would change things the decision in the limited presents an interesting case where the taxpayer complied with every stated requirement in the statutory provisions, but arguably new section 7701(o) would not allow the taxpayer to prevail. as the tax court stated, section 956 was enacted to subject undistributed foreign earnings of a controlled foreign corporation to immediate taxation when those earnings have been repatriated. the statutory language uses a broad definition of an investment in “united states property,” and the exceptions to that definition were ones that fundamentally were intended to represent transactions that were not repatriation transactions. making a deposit with a bank was not viewed as a repatriation transaction, but there is no indication that congress intended this exception to section 956 to swallow up the general rule that a repatriation of foreign earnings in the form of a loan to the u.s. affiliate is subject to taxation under section 956. certainly, if the taxpayer made an investment in a bank account and that investment collateralized a loan to a u.s. affiliate, then that would represent an 111. id. at 189-91. 112. id. at 190–91. 113. the limited, inc. v. commissioner, 286 f.3d 324, 335 (6th cir. 2002). 444 florida tax review [vol. 10:6 investment in u.s. property.114 the taxpayer in the limited created an internal bank that had a significant business purpose. but, this one transaction (the issuance of cds to wfnnb) created a significant tax benefit that far exceeded the non-tax benefits for having issued those particular cds. thus, the tax court’s decision would likely now have been upheld, not reversed, if section 7701(o) had existed at the time this case was decided. the sixth circuit refused to look at the underlying purpose of section 956, but now section 7701(o)(1) requires that this be done. the facts in the limited case support the argument that the taxpayer’s planning strategy had a legitimate business purpose, but at the same time this tax planning strategy created a significant tax benefit in that it allowed a substantial repatriation of foreign earnings that circumvented the application of section 956. in this fact pattern, it would appear that the tax benefits far exceeded the non-tax benefits of issuing a cd in an intercompany transaction with a related party. as a result, the government would appear to have the better argument for applying section 7701(o) because the non-tax motives do not appear to be substantial enough in relation to the expected tax benefits as prescribed by section 7701(o)(2)(a). thus, this analysis indicates that new section 7701(o) will serve to significantly reduce the taxpayer’s ability to rely on the plain meaning of a statutory provision when the plain meaning of that statutory provision creates a tax mistake to which section 7701(o) is relevant. if subsequent judicial cases concur in this assessment, then section 7701(o) should decrease the number of cases in which the courts will pass the buck back to congress to legislatively correct tax mistakes like the one in the limited. although the government may have a good opportunity to address repatriation strategies that circumvent section 956 in ways that resemble the fact pattern set forth in the limited, the government is likely to not be able to use section 7701(o) against repatriation strategies that utilize the reorganization provisions. for example, in one common transaction called a “killer b” reorganization, a subsidiary would acquire parent stock from the parent directly or on the open market. the acquisition of the parent stock was funded in part by the issuance of debt by the acquiring subsidiary. the acquiring subsidiary would then use the parent stock to acquire a target corporation in a transaction intended to qualify as a reorganization under section 368(a)(1)(b) or as a triangular reorganization under section 368(a)(1)(c).115 after the acquisition, funds from the target subsidiary would then be used to repay the acquisition debt in a manner that would not create dividend income to the parent company or implicate section 956. thus, the 114. see irc § 7701(l), (permitting re-characterization of “multiple-party financing transactions”). 115. see notice 2006-85, 2006-2 c.b. 677; notice 2007-48, 2007-1 c.b. 1428. 2010] economic substance doctrine 445 effect of the overall transaction was to allow cash from foreign subsidiaries to be repatriated to the u.s. parent company without a tax cost on the repatriation. another foreign repatriation technique that has been popularized in recent years is known as the “all-cash d reorganization.” in this transaction, one corporation transfers substantially all of its properties to a controlled foreign corporation in exchange for cash. the transferor corporation then immediately liquidates. the transaction is intended to qualify as a reorganization under section 368(a)(1)(d) and the cash distributed in the liquidation of the transferor corporation is treated as boot in the reorganization.116 however, pursuant to section 356(a)(2), the boot is taxable as a dividend only to the extent of the gain in the stock.117 the killer b reorganization and the all-cash d reorganization represent repatriation strategies that circumvent the application of section 956. however, the legislative history to section 7701(o) lists reorganization transactions as transactions that under “longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.”118 thus, assuming that adequate business purpose exists for the reorganization under existing case law, these transactions would not be assailable by reason of section 7701(o) even if the tax benefits from these reorganizations far exceeded in value the non-tax benefits. in response to these repatriation techniques that were designed to circumvent the application of section 956, the government has responded on several fronts. in this regard, in order to address the killer b reorganization, the treasury department has issued temporary regulations to treat as a distribution under section 301 the amount of money plus the fair market value of other property that the subsidiary used to acquire the parent stock in the killer b transaction.119 further, these temporary regulations provide that to the extent the subsidiary buys the parent stock from a person other than the parent, then the transaction is recast to be treated as if the subsidiary made a distribution of cash to the parent company, and the parent company stock is then deemed to have been contributed to the subsidiary from the parent company.120 in response to the all-cash d reorganization, the treasury department has issued proposed regulations that would subject the full amount of the boot to taxation under its authority under section 367(b).121 at the same time, the administration has also proposed to amend section 116. reg. § 1.368-2(l); rev. rul. 2004-83, 2004-2 c.b. 157; rev. rul. 70240, 1970-1 c.b. 81. 117. notice 2008-10, 2008-1 c.b. 277. 118. see joint comm. technical explanation, supra note 3, at 153. 119. temp. reg. § 1.367(b)-14t(b)(1). 120. temp. reg. § 1.367(b)-14t(b)(3). 121. notice of proposed rulemaking, 2008-2 c.b. 867; prop. reg. § 1.367(a)-3(d)(2)(vi)(b). 446 florida tax review [vol. 10:6 356(a)(2) so that the boot in a reorganization is not limited to the amount of the gain.122 f. shell petroleum v. united states123 the facts of shell petroleum present an interesting case in which the taxpayer created a potential double deduction through a business restructuring. internal restructurings are common and tax planners will often attempt to capture tax savings as part of a restructuring transaction. the irs announced that it would challenge124 and in fact has successfully challenged internal restructurings and related party transactions that captured tax benefits similar to those obtained in shell petroleum, but in these other cases the courts found that the business purpose and non-tax economic consequences were insignificant.125 in shell petroleum, the court accepted that the taxpayer had a legitimate business purpose for its restructuring transaction, and so the facts provide an interesting situation to consider the contours of internal tax planning now that new section 7701(o) is in place. 1. the historical basis for the opinion in shell petroleum,126 the taxpayer transferred non-producing oil and gas properties that had depreciated in value, along with some incomeproducing properties, to a special purpose subsidiary in exchange for common stock and preferred stock in the new subsidiary. the preferred stock had a high “carryover” basis but a low fair market value. the transferor corporation then sold the preferred stock to investors in order to raise capital and recognized approximately $354 million of loss on this sale. the income 122. u.s. treasury dep’t, general explanation of the administration’s fiscal year 2011 revenue proposals 38 (feb. 1, 2009), available at http://www.treas.gov/offices/tax-policy/library/greenbk10.pdf. 123. shell petroleum, inc. v. united states, 2008-02 u.s.t.c. ¶ 50,422 (s.d. tex 2008). 124. see, e.g., notice 2002-21, 2002-1 c.b. 730 (inflated basis); notice 2001-17, 2001-1 c.b. 730 (contingent liability); notice 2000-44, 2000-2 c.b. 255 (son of boss); notice 99-59, 1999-2 c.b. 761 (boss); notice 2001-45, 2001-2 c.b. 129 (basis shifts). 125. see, e.g., coltec indus., inc. v. united states, 454 f.3d 1340 (fed. cir. 2007); long term capital holdings v. united states, 330 f. supp. 2d 122 (d. conn. 2004) (contribution of built-in loss stock to partnership lacked economic substance), aff’d, 150 f. app’x 40 (2d cir 2005); jade trading, llc v. united states, 80 fed. cl. 11 (2007), rev’d in part, 598 f.3d 1372 (fed. cir. 2010) (reversing and remanding on a separate issue, but affirming the court of federal claims decision that the transaction lacked economic substance). 126. shell petroleum, 2008-02 u.s.t.c. ¶ 50,422. https://checkpoint.riag.com/getdoc?docid=t0rulng70:15859.1&pinpnt= 2010] economic substance doctrine 447 producing properties produced sufficient cash flow to fund the dividends on the preferred stock. because the underlying subsidiary took property with a built-in loss, it was left for another day to determine whether the subsidiary would be entitled to recognize ordinary losses if and when it sold the built-in loss properties in the future.127 thus, this transaction created a duplication of losses—one for shell by selling the preferred stock in the new subsidiary and another loss for the new subsidiary if and when it disposed of the built-in loss properties.128 the taxpayer was able to demonstrate that the incorporation of the subsidiary along with the issuance of preferred stock was done in order to generate additional capital for the corporation and also in order to provide better focus over the non-producing assets. the taxpayer also stated that the tax department did not explain the tax benefits of the transaction to the corporate officers responsible for making the decision to engage in this transaction so that the taxpayer could clearly demonstrate that the transaction was motivated by non-tax business considerations. the district court held in favor of the taxpayer, reasoning that the record demonstrated sufficient nontax business purposes because the internal restructuring allowed the corporation to provide better fit-and-focus to distressed properties and also provided a means to raise capital. thus, the court found that the taxpayer in shell petroleum accomplished legitimate, non-tax objectives in a manner that maximized the attendant tax benefits under then-existing law. shell could have employed different means to achieve its objectives, but the means it took were ones that accomplished legitimate business purposes and also captured significant tax benefits. congress responded to correct this mistake by enacting section 362(e)(2) as part of the american jobs creation act of 2004. pursuant to section 362(e)(2), the transferee’s aggregate adjusted basis of the property transferred in a section 351 transfer shall not exceed the aggregate fair market value of such property immediately after the transfer. the aggregate reduction in basis shall be allocated among the properties transferred in proportion to the relative built-in loss that the properties exhibit. moreover, if the transferor and transferee both elect, the transferor’s basis in the stock received in exchange for property can be reduced to its fair market value in lieu of reducing the basis in the property transferred. thus, section 362(e)(2) is directly aimed at the sort of double dipping that shell was able to 127. the properties were § 1231 properties, the loss on which could be ordinary. 128. for a further discussion of this loss duplication, see robert willens, shell oil’s double-dipping strategy pays off, 120 tax notes 687 (aug. 18, 2008). 448 florida tax review [vol. 10:6 accomplish and thus represents a legislative solution to the mistake that shell was able to benefit from.129 2. how new section 7701(o) would change things the decision in shell petroleum is interesting because it presents a carefully planned transaction that had a legitimate business purpose but at the same time captured enormous tax savings. under new section 7701(o), a court presented with these same facts would be required to compare the relative value of the potential non-tax benefits to the potential tax benefits from the transaction. from a comparison standpoint, the legitimate business objectives, although significant enough to justify the transaction from a business perspective, nevertheless appear to pale in comparison to the more than $100 million of immediate tax savings created by the internal restructuring. thus, the government could well argue on the factual record presented in shell petroleum that the legitimate business objectives that were accomplished in shell petroleum are not substantial enough when viewed in relation to the net present value of the transaction’s expected tax benefits (i.e., $350 million of losses of which $320 million were usable immediately). so, how large must the non-tax benefits be in a transaction to be “substantial in relation to the . . . tax benefits”130 of the transaction? this line of inquiry represents uncharted territory and holds open the possibility that a taxpayer could have a meaningful business purpose for an internal restructuring that is not “substantial enough” when viewed in relation to the expected tax benefits that were created in the transaction. after positing this fact pattern, professor bankman commented on this aspect of an earlier version of section 7701(o)(2) as follows: one suspects that any intelligent application of the economic substance test requires some consideration of the relationship between tax benefits and nontax benefits. but basing a test primarily on the relationship between the benefits raises problems of its own. suppose, for example, that a transaction offers a healthy pretax rate of return but even greater tax benefits. ought the transaction to be at risk under the economic substance test? the better view is that a 129. section 362(e)(2) does not apply if a transferor corporation and the transferee corporation file a consolidated return, reg. § 1.1502-80(h) (as amended in 2008), but reg. § 1.1502-36 (2008) operates to prevent double deductions in consolidated return situations. 130. see irc § 7701(o)(2)(a) (emphasis added). 2010] economic substance doctrine 449 transaction that produces a substantial pretax return is immune from challenge on economic substance grounds.131 however, the final language that was adopted in section 7701(o)(2) did not address the problems highlighted by professor bankman almost a decade earlier. thus, it can be expected that the government will interpret section 7701(o)(2)(a) as requiring a straight comparison of the taxpayer’s expected tax benefits to the non-tax benefits of a transaction. under this comparative methodology, the taxpayer in shell petroleum would appear to have generated tax benefits that far exceed the non-tax benefits of the restructuring transaction that occurred in that case. this conclusion would be made even stronger if the irs could isolate on the economic benefits of transferring the non-producing properties to a new subsidiary. the district court in shell petroleum refused to “slice and dice” the transaction narrowly as had the court in coltec, but under section 7701(o)(5)(d) it would appear that such bifurcation now should be done. as a result, the combination of the bifurcation rule of section 7701(o)(5)(d) along with the comparative benefit analysis contained in section 7701(o)(2) work to place a significantly higher burden on the taxpayer to substantiate the non-tax economic consequences for its internal restructuring transaction. this comparative benefit approach creates a sliding scale and as such represents a slippery slope for future litigants. the need to demonstrate an increasingly higher level of economic substance when the associated tax benefits are high represents a marked departure from prior law. one can anticipate that this aspect of new section 7701(o) will be the subject of considerable future debate among commentators and the subject of future litigation. g. son-of-mirror and the general utilities repeal the son-of-mirror transaction is interesting because it raises the question of whether new section 7701(o) would be relevant to arguably the highest profile tax mistake in a generation. 1. the historical basis for the opinion shortly after the 1986 act, techniques were developed to circumvent the repeal of the general utilities doctrine.132 one such technique, the sonof-mirror transaction, involved a situation in which an acquiring company would acquire the stock of a target company at fair market value. after the 131. bankman, supra note 57, at 26. 132. for the general utilities doctrine, see boris i. bittker & james s. eustice, federal income taxation of corporations and shareholders, ¶ 8.20 (7th ed. 2002). 450 florida tax review [vol. 10:6 acquisition, the acquiring company would cause the target company to distribute its wanted assets to the acquirer, thus generating gain within the acquirer’s consolidated group and thereby increasing the acquirer’s basis in the stock of the target by the amount of that gain. the acquirer then could sell the target’s stock at a time when only unwanted assets were held by the target company. as a result, an artificial loss was created that approximated the amount of the previously recognized gain that occurred upon the distribution of the wanted assets out of the target subsidiary. this technique, if successful, permitted portions of a target company to be disposed of without the payment of tax on the target’s built-in gain, thus using the consolidated return regulations to thwart general utilities repeal.133 the service immediately responded to the son-of-mirror technique by issuing notice 87-14.134 in notice 87-14, the service announced that it would deny the intended tax benefits of a son-of-mirror type transaction by regulations to be issued in the future that would have retroactive effect. what transpired thereafter involved the treasury department issuing multiple revisions to the consolidated return loss disallowance rules, and in the process having one version of the regulations held to be invalid.135 the 133. for a further analysis of the son-of-mirror technique and other techniques that were in vogue at the time, see eric m. zolt, the general utilities doctrine: examining the scope of the repeal, 65 taxes 819 (1987). 134. 1987-1 c.b. 445. 135. on sept. 19, 1991, the irs and treasury department published reg. § 1.1502-20 (the loss disallowance rule). see t.d. 8364, 1991-2 c.b. 43. on july 6, 2001, in rite aid corp. v. united states, 255 f.3d 1357 (fed. cir. 2001), the court of appeals for the federal circuit held that the duplicated loss provisions of the loss disallowance rules were an invalid exercise of regulatory authority. because only the loss duplication factor of reg. § 1.1502-20 was at issue in rite aid, the irs believes that the finding of invalidity applied only to that factor and not to the factors dealing with the son-of-mirror problem. see notice 2002-11, 2002-1 c.b. 526 (“it is the service’s position that the rite aid opinion implicates only the loss duplication aspect of the loss disallowance regulation. . . .”). in response to the rite aid decision, the irs and treasury department promulgated two regulations to replace the loss disallowance rules. the first, temp. reg. § 1.337(d)-2t (temporary general utilities regulation), was published on mar. 12, 2002, to address the circumvention of general utilities repeal. see t.d. 8984, 2002-1 c.b. 668. the second, temp. reg. §1.1502-35t, was published on mar. 14, 2003, to address the inappropriate duplication of loss. see t.d. 9048, 2003-1 c.b. 645. t.d. 9048 also included certain related provisions promulgated under temp. reg. §1.1502-21t and temp. reg. § 1.1502-32t. on mar. 3, 2005, the temporary regulation was adopted without substantive change as final reg. § 1.337(d)-2. see t.d. 9187, 2005-1 c.b. 778. on sept. 17, 2008, the irs and treasury department issued final unified rules for loss on subsidiary stock through reg. § 1.1502-36. see t.d. 9424, 2008-2 c.b. 1012. for a discussion of the final unified loss disallowance regulations that now represents the end of this sordid tale, see david friedel, final loss disallowance rules: a new 2010] economic substance doctrine 451 current response to the efforts to circumvent the general utilities repeal, including the son-of-mirror technique, is contained in treasury regulations section 1.1502-36. 2. how new section 7701(o) would change things ironically, although the son-of-mirror technique and similar techniques created major mistakes that potentially thwarted congress’ desire to repeal the general utilities doctrine, it would appear that new section 7701(o) would have no impact on these transactions. the decision to dispose of a business segment or unwanted assets has a significant economic consequence to the selling entity. thus, the act of disposing of a subsidiary would appear to have a substantial economic purpose apart from tax benefits. furthermore, the desire to distribute wanted assets out of a subsidiary before selling the subsidiary would also appear to have a substantial purpose because these assets arguably need to be segregated away from the unwanted assets in order for the unwanted assets to be sold. the irs might argue that a choice to sell the stock of a subsidiary instead of selling the underlying assets represents a tax motivated decision, but it seems undebatable that the ability to chose either to sell assets or to sell the stock of a subsidiary represents the type of business transaction that, under longstanding judicial and administrative practice, is respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.136 thus, although the son-of-mirror technique represented a serious threat to the repeal of the general utilities doctrine, it appears that new section 7701(o) would not have been able to attack this technique. thus, the solution to the tax mistake that was brought to light by this technique requires a legislative or regulatory response, and again the regulatory response to fix that mistake has spanned almost twenty years. thus, the key take-away from this particular transaction is that tax benefits derived that are directly linked with acquiring or disposing of businesses are unlikely to implicate new section 7701(o) unless some extraneous step is added to the transaction that creates a tax benefit that substantially exceeds the non-tax benefits arising from adding this taxfavored step to the overall transaction. in the fact pattern set forth in the sonof-mirror transaction, this does not appear to have been the case. world order, 35 j. corp. tax’n 33 (2008) (“to call these final rules complicated would be a great understatement.”). 136. see joint comm. technical explanation, supra note 3, at 152–53. 452 florida tax review [vol. 10:6 iii. conclusion the codification of the economic substance doctrine begins an important new chapter for tax jurisprudence. the analysis in this article leads to the conclusion that section 7701(o) does not stop taxpayers from reaping the benefit of all tax mistakes. thus, in the future, as has been the case in the past, there will still be instances in which a taxpayer will be able to “play in the rain” without a court thundering its disapproval. this will be the case when a tax mistake is premised on transactions that have significant non-tax benefits that can satisfy the standards of new section 7701(o)(1) or where a tax mistake relies on transactions that are considered “accepted business transactions,” such as reorganizations or the use of hybrid entities and hybrid securities. thus, sophisticated taxpayers still have important tools at their disposal to create opportunities to benefit from a tax mistake. however, that is not to say that section 7701(o) does not represent an important change in the landscape. although section 7701(o) certainly does not protect the fisc against all tax mistakes, it does significantly alter the landscape with respect to the taxpayer’s ability to benefit from many of the types of mistakes that were available in the past. new section 7701(o) provides the government with more latitude to argue against the plain meaning of its own regulations and the plain meaning of statutory provisions when the plain meaning of the statute or regulation, whichever the case may be, creates an unintended consequence. the courts will need to address what level of deference to give to the government when it asserts that its own regulations or the plain meaning of a statute creates an inappropriate result, but it now appears that a court cannot summarily refuse to act when the government’s own regulation or a statutory provision leads to a mistake, as has often been the case in the past. furthermore, section 7701(o) clarifies that the government has authority to require each step in an overall transaction to independently possess substantial economic consequences. consequently, section 7701(o)(5)(a) appears to give the government much greater leeway to bifurcate and disaggregate an overall transaction than under prior law. a key question, however, will be when the economic substance doctrine is relevant to a particular transaction. in cottage savings, a transaction that had no non-tax economic consequences created a substantial tax benefit to the taxpayer, but this tax benefit was not inconsistent with the policies of current law. although section 7701(o) applies generally to all transactions that are “relevant” transactions, many of the double dip mistakes and the foreign tax credit generator mistakes are likely to be largely unaffected by section 7701(o), since the legislative history makes it clear that hybrid entities and hybrid instruments (the sources of much of the tax arbitrage opportunities) are accepted techniques under current law. however, repatriation tax planning that avoids the contours of section 956 or the contours of the 2010] economic substance doctrine 453 subpart f tax regime may well be subject to much more scrutiny as a result of section 7701(o)’s addition to the code, particularly when those repatriation strategies do not rely on a reorganization or the step that creates the tax mistake is not based on a hybrid entity or hybrid security. internal restructuring projects that create significant tax savings, such as the one in shell petroleum, are likely to have more difficulty in the future because the taxpayer will need to show that the non-tax economic benefits from these internal restructurings are substantial when viewed in relation to the tax benefits derived from the internal restructuring exercise. this comparative benefit analysis is likely to create a difficult factual proof problem for the taxpayer. thus, although new section 7701(o) does not fix all mistakes, new section 7701(o) taken as a whole enhances the government’s arguments with respect to the application of the economic substance doctrine. as a result, it is likely that taxpayers will find that a court is going to be more likely to thunder its disapproval when there is a rainstorm of mistakes. thus, playing in the rain may not be as profitable for taxpayers as it has been in the past, and so new section 7701(o) may serve to further dampen aggressive tax planning. if that is the legacy of new section 7701(o), then the enactment of this new regime will indeed represent an important new chapter in the nation’s tax jurisprudence. 454 florida tax review [vol. 10:6 appendix i: h.r. 4872: health care and education reconciliation act of 2010. sec. 1409. codification of economic substance doctrine and penalties. (a) in general—section 7701 of the internal revenue code of 1986 is amended by redesignating subsection (o) as subsection (p) and by inserting after subsection (n) the following new subsection: “(o) clarification of economic substance doctrine— “(1) application of doctrine—in the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if— “(a) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and “(b) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction. “(2) special rule where taxpayer relies on profit potential— “(a) in general—the potential for profit of a transaction shall be taken into account in determining whether the requirements of subparagraphs (a) and (b) of paragraph (1) are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. “(b) treatment of fees and foreign taxes—fees and other transaction expenses shall be taken into account as expenses in determining pre-tax profit under subparagraph (a). the secretary shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases. “(3) state and local tax benefits—for purposes of paragraph (1), any state or local income tax effect which is related to a federal income tax effect shall be treated in the same manner as a federal income tax effect. “(4) financial accounting benefits—for purposes of paragraph (1)(b), achieving a financial accounting benefit shall not be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of federal income tax. “(5) definitions and special rules—for purposes of this subsection— https://checkpoint.riag.com/getdoc?docid=t0tcode:37790.1&pinpnt= 2010] economic substance doctrine 455 “(a) economic substance doctrine— the term “economic substance doctrine” means the common law doctrine under which tax benefits under subtitle a with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. “(b) exception for personal transactions of individuals—in the case of an individual, paragraph (1) shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income. “(c) determination of application of doctrine not affected—the determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted. “(d) transaction—the term “transaction” includes a series of transactions.” (b) penalty for underpayments attributable to transactions lacking economic substance— (1) in general—subsection (b) of section 6662 is amended by inserting after paragraph (5) the following new paragraph: “(6) any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.” (2) increased penalty for nondisclosed transactions—section 6662 is amended by adding at the end the following new subsection: “(i) increase in penalty in case of nondisclosed noneconomic substance transactions— “(1) in general—in the case of any portion of an underpayment which is attributable to one or more nondisclosed noneconomic substance transactions, subsection (a) shall be applied with respect to such portion by substituting “40%” for “20%.” “(2) nondisclosed noneconomic substance transactions—for purposes of this subsection, the term “nondisclosed noneconomic substance transaction” means any portion of a transaction described in subsection (b)(6) with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return. “(3) special rule for amended returns—in no event shall any amendment or supplement to a return of tax be taken into account for purposes of this subsection if the amendment or supplement is filed after the earlier of the date the taxpayer is first contacted by the secretary regarding the examination of the return or such other date as is specified by the secretary.” 456 florida tax review [vol. 10:6 (3) conforming amendment—subparagraph (b) of section 6662a(e)(2) is amended— (a) by striking “section 6662(h)” and inserting “subsections (h) or (i) of section 6662;” and (b) by striking “gross valuation misstatement penalty” in the heading and inserting “certain increased underpayment penalties.” (c) reasonable cause exception not applicable to noneconomic substance transactions— (1) reasonable cause exception for underpayments—subsection (c) of section 6664 is amended— (a) by redesignating paragraphs (2) and (3) as paragraphs (3) and (4), respectively; (b) by striking “paragraph (2)” in paragraph (4)(a), as so redesignated, and inserting “paragraph (3);” and (c) by inserting after paragraph (1) the following new paragraph: “(2) exception—paragraph (1) shall not apply to any portion of an underpayment which is attributable to one or more transactions described in section 6662(b)(6).” (2) reasonable cause exception for reportable transaction understatements—subsection (d) of section 6664 is amended— (a) by redesignating paragraphs (2) and (3) as paragraphs (3) and (4), respectively; (b) by striking “paragraph (2)(c)” in paragraph (4), as so redesignated, and inserting “paragraph (3)(c);” and (c) by inserting after paragraph (1) the following new paragraph: “(2) exception—paragraph (1) shall not apply to any portion of a reportable transaction understatement which is attributable to one or more transactions described in section 6662(b)(6).” (d) application of penalty for erroneous claim for refund or credit to noneconomic substance transactions—section 6676 is amended by redesignating subsection (c) as subsection (d) and inserting after subsection (b) the following new subsection: “(c) noneconomic substance transactions treated as lacking reasonable basis—for purposes of this section, any excessive amount which is attributable to any transaction described in section 6662(b)(6) shall not be treated as having a reasonable basis.” (e) effective date— (1) in general—except as otherwise provided in this subsection, the amendments made by this section shall apply to transactions entered into after the date of the enactment of this act. 2010] economic substance doctrine 457 (2) underpayments—the amendments made by subsections (b) and (c)(1) shall apply to underpayments attributable to transactions entered into after the date of the enactment of this act. (3) understatements—the amendments made by subsection (c)(2) shall apply to understatements attributable to transactions entered into after the date of the enactment of this act. (4) refunds and credits—the amendment made by subsection (d) shall apply to refunds and credits attributable to transactions entered into after the date of the enactment of this act. tcharity really does begin at home: * professor of law, university of houston law center. ** clarence j. teselle professor of law, university of florida fredric g. levin college of law. 433 recent developments in federal income taxation: the year 2006 ira b. shepard* martin j. mcmahon, jr.** i. accounting ............................................................................... 435 a. accounting methods ........................................................ 435 b. inventories ....................................................................... 438 c. installment method .......................................................... 438 d. year of receipt or deduction .......................................... 438 ii. business income and deductions ......................................... 438 a. income ............................................................................. 438 b. deductible expenses versus capitalization ..................... 440 c. reasonable compensation .............................................. 443 d. miscellaneous deductions ............................................... 443 e. depreciation & amortization .......................................... 448 f. credits ............................................................................. 448 g. natural resources deductions & credits ....................... 448 h. loss transactions, bad debts and nols ........................ 453 i. at-risk and passive activity losses ................................ 453 iii. investment gain ...................................................................... 453 a. capital gain and loss .................................................... 453 b. interest ............................................................................ 456 c. section 1031 .................................................................... 456 d. section 1033 .................................................................... 457 iv. compensation issues .............................................................. 457 a. fringe benefits ................................................................ 457 b. qualified deferred compensation plans ........................ 459 c. nonqualified deferred compensation, section 83, and stock options ........................................................... 465 d. individual retirement accounts ...................................... 467 v. personal income and deductions ....................................... 469 a. rates ................................................................................ 469 b. miscellaneous income ..................................................... 469 c. profit-seeking individual deductions ............................. 472 d. hobby losses and § 280a home office and vacation homes ............................................................................. 473 434 florida tax review vol.8:si e. deductions and credits for personal expenses .............. 472 f. education ........................................................................ 475 vi. corporations ........................................................................... 475 a. entity and formation ...................................................... 475 b. distributions and redemptions ....................................... 476 c. liquidations .................................................................... 477 d. s corporations ................................................................ 477 e. reorganizations .............................................................. 478 f. corporate divisions ........................................................ 479 g. miscellaneous .................................................................. 479 vii. partnerships ............................................................................ 481 a. formation of taxable years ............................................ 481 b. allocations of distributive share, partnership debt, and outside basis ............................................................ 481 c. distributions and transactions between the partnership and partners ................................................ 481 d. sales of partnership interests, liquidations, and mergers .................................................................... 481 e. inside basis adjustments ................................................. 481 f. partnership audit rules .................................................. 482 g. miscellaneous .................................................................. 482 viii. tax shelters ............................................................................ 482 a. tax shelter cases ............................................................ 482 b. identified “tax avoidance transactions” ......................... 493 c. disclosure and settlement ............................................... 495 d. tax shelter penalties, etc. ............................................... 502 e. tax shelters miscellaneous ............................................. 504 ix. exempt organizations and charitable giving ............... 505 a. exempt organizations ..................................................... 505 b. charitable giving ........................................................... 507 x. tax procedure ......................................................................... 510 a. interest, penalties and prosecutions ............................... 510 b. discovery: summonses and foia ................................... 512 c. litigation costs ............................................................... 514 d. statutory notice ............................................................... 514 e. statute of limitations ...................................................... 515 f. liens and collections ...................................................... 515 g. innocent spouse .............................................................. 520 h. miscellaneous .................................................................. 523 xi. withholding and excise taxes ............................................ 532 a. employment taxes .......................................................... 532 b. excise taxes .................................................................... 532 xii. tax legislation ....................................................................... 534 a. enacted ........................................................................... 534 b. pending ........................................................................... 544 2007] recent developments in federal income taxation 435 recent developments in federal income taxation: the year 2006 by ira b. shepard martin j. mcmahon, jr. this recent developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the most recent twelve months — and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide marty the opportunity to mock our elected representatives. the outline focuses primarily on topics of broad general interest (to the two of us, at least) – income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. any mistakes in this outline are marty’s responsibility; any political bias or offensive language is ira’s. i. accounting a. accounting methods 1. tax court rules that trader in securities failed to make timely mark-to-market election. lehrer v. commissioner, t.c. memo. 2005-167 (7/11/05). the taxpayers (in an amended petition to the tax court) sought to make an election under § 475(f) to treat stock trading losses as ordinary losses instead of capital losses, which would have substantially reduced the irs’s assessments for the three years involved. the 436 florida tax review [vol. 8:si irs argued that even if mr. lehrer was a “trader in securities” during the years in issue, he failed to make an effective mark-to-market election under § 475(f) pursuant to rev. proc. 99-17, 1999-1 c.b. 503, and moved for summary judgment. the lehrers conceded that they did not make a mark-tomarket election on their tax returns but argued that an effective mark-tomarket election was made on their first amendment to petition the tax court. further, the lehrers argued that rev. proc. 99-17 lacks “precedential value as it simply announces the service’s position.” • the tax court further stated: a taxpayer engaged in a trade or business as a trader in securities is eligible to elect to recognize gain or loss on any security held in connection with his trade or business at the close of the taxable year as if the security were sold for its fair market value at year end. sec. 475(f)(1)(a)(i); see chen v. commissioner, t.c. memo. 2004-132. in general, any gains or losses resulting from the mark-to-market election shall be treated as ordinary income or loss. sec. 475(d)(3)(a), (f)(1)(d). if a taxpayer is in the business as a trader in securities and made a mark-to-market election with respect to sales of securities held in connection with his business, his net loss from that business would be an ordinary loss, deductible in full under section 165; if the mark-to-market election is not made, the net loss would be a capital loss deductible only to the extent of any capital gains plus $3,000. see secs. 165(a), (c), (f), 1211(b)(1); chen v. commissioner, supra. in chen, we held that the taxpayer was not a ‘trader in securities’ for the relevant year for purposes of section 475(f) and, therefore, did not address the taxpayer’s argument regarding whether he should be permitted to make an untimely, retroactive mark-to-market election because section 475(f) was not available to him. as a result, we are presented with a novel issue: whether an allegation contained in an amendment to petition qualifies as an effective mark-to-market election. the statute and regulations do not provide procedures that specify the time and manner to make a mark-to-market election. *** the legislative history states that ‘the election will be made in the time and manner prescribed by the secretary of the treasury and will be effective for the taxable year for which it is made and all subsequent taxable years, unless revoked with the consent of the secretary.’ see h. conf. rept. 105148, at 446 (1997), 1997-4 c.b. (vol. 1) 323, 768. thus, the secretary has authority to prescribe the time and manner of the election.” 2007] recent developments in federal income taxation 437 a. but another taxpayer who failed to make a timely mark-to-market election under § 475 is granted relief by the tax court. vines v. commissioner, 126 t.c. 279 (5/11/06). taxpayer was a birmingham, alabama plaintiffs’ lawyer who settled a class action lawsuit during 1999 and received compensation of about $17 million in each of the years 1999 and 2000. in 2000, he decided to leave the practice of law and begin a business of trading securities; between january 28 and april 14, 2000 [the day his trading account was liquidated for failure to cover a margin call after technology stocks declined], he had net trading losses of more than $25 million. he did not make a § 475(f) election with his application for automatic extension of his 1999 income tax return, which was filed timely on april 17, 2000, because neither he nor his cpa was aware of the applicability of that provision. in june 2000, he became aware of a possibility of deducting his trading losses as ordinary losses, and promptly sought § 9100 relief from the april 17th due date that was prescribed in rev. proc. 99-17, 1999-1 c.b. 503, for the filing of form 3115 to adopt the mark-to-market method for his securities trading business. judge wells granted relief under reg. § 301.9100-3(c) because the taxpayer made no securities trades between april 14 and july 21, the date on which he filed his § 475(f) election, and therefore the taxpayer gained no advantage or benefit of hindsight from the delay. (1) attorney’s fees, however, were denied. vines v. commissioner, t.c. memo. 2006-258 (11/30/06). the court held that the government’s position was substantially justified because the issue was one of first impression and “[b]ased on the lack of guidance available at the time, [the court could not] say that it should have been ‘obvious’ to respondent from the onset of the litigation that respondent's position was in error.” 2. accountant’s persistent omission of a step in the computation of the lifo value of inventories required a change of accounting method to correct. huffman v. commissioner, 126 t.c. 322 (5/16/06). a correction to the inventory method employed by s corporations that owned automobile dealerships constituted an accounting method change that requires a § 481 adjustment, and was not simply the correction of a mistake in arithmetic. judge halpern held this to be an accounting method change because the accountant reached an erroneous result over a 10to 20year period by omitting a computational step required by reg. § 1.472-8, related to the link-chain, dollar-value method of pricing lifo inventories, which caused understatements and overstatements in the lifo value of inventories but did not result in the permanent omission of gross income. 438 florida tax review [vol. 8:si • the correction of an erroneous formula – one that omitted a step for calculating inventories under the linkchain, dollar value method of valuing inventory over a 10 to 20 year period – resulted in a timing error, not a mere computational error. generally, corrections to the taxpayer’s inventory accounting method constitute a change of accounting method. furthermore, correction of a systematic erroneous method of calculating inventories on a recurring basis without a change in the overall inventory method, constitutes a change of accounting method rather than the correction of a computational error. b. inventories there were no significant developments regarding this topic during 2006. c. installment method there were no significant developments regarding this topic during 2006. d. year of receipt or deduction 1. anticipated warranty expenses are not deductible in the year taxpayer sold warranted motor vehicles. chrysler corp. v. commissioner, 436 f.3d 644 (6th cir. 2/8/06), aff’g t.c. memo. 2000-283 (8/31/00). the court held that the taxpayer was not permitted to deduct anticipated warranty expenses in the year it sold warranted motor vehicles to its dealers, because the warranty claims had not yet been made. the court followed united states v. general dynamics corp., 481 u.s. 239 (1987), and distinguished united states v. hughes properties, inc., 476 u.s. 593 (1986), when it followed the tax court in holding that the last event in the fixing of petitioner’s liability occurred no sooner than when a warranty claim was filed with petitioner by one of its dealers or by one of the retail customers. ii. business income and deductions a. income 1. supplier’s advances are immediately includible in income. karns prime & fancy food, ltd. v. commissioner, t.c. memo. 2005-233 (10/5/05). a $1.5 million advance received by the taxpayerretailer from a supplier that was evidenced by a promissory note with the proper indicia of debt nevertheless was not a true debt, because the parties 2007] recent developments in federal income taxation 439 concurrently entered into a supply agreement pursuant to which the debt would be forgiven if the taxpayer purchased the quantity of product required under the supply agreement over its term; in substance, there was no unconditional obligation to repay the advance because the amounts under the note were due only if the supply agreement was materially breached by taxpayer. a. the ninth circuit disagrees. westpac pacific food v. commissioner, 451 f.3d 970 (9th cir. 6/21/06), rev’g t.c. memo. 2001-175 (7/16/01). “cash advance trade discounts” received by a retailer from a manufacturer in exchange for volume purchase commitments, subject to pro rata repayment if the volume commitments were not met, were not includable in gross income when received because these amounts were adjustments to the cost of goods sold and the cash advances were includible in income by virtue of taxpayer’s inventory accounting system. 2. taxpayer has cod income when liabilities are discharged by a guarantor’s payment to the creditor after waiving any right to reimbursement from the taxpayer. miller v. commissioner, t.c. memo. 2006-125 (6/15/06). taxpayer-debtor realized cod income upon guarantor’s payment of debt to the creditor because guarantor had waived any right to reimbursement rights in advance. judge gale further held that liabilities the cancellation of which give rise to cod income are counted in full as liabilities even though, because taxpayer was insolvent and the loan was guaranteed by a solvent third party, there was virtually no likelihood that taxpayer-debtor would be called upon to pay them. the primary obligor on a recourse obligation is “at-risk” notwithstanding a guarantor’s waiver of right to reimbursement because the creditor had the right to enforce the loan against taxpayer, and taxpayer had no rights to reimbursement from any other person. the fact that taxpayer was insolvent when the loan fell due and the creditor sought repayment directly from the guarantor was not relevant. 3. no current taxation of settlement funds beneficially owned by a governmental entity. tipra § 201(a) added code §§ 468b(g)(2) and (3), which provide that certain settlement funds established before 2011 pursuant to consent decrees in order to resolve claims under the comprehensive environmental response, compensation, and liability act of 1980 (cercla) are treated as beneficially owned by a state or federal governmental entity, and are thus exempt from tax under § 468b(g)(1). a. these provisions were made permanent by the tax relief and health care act of 2006 § 409. 440 florida tax review [vol. 8:si b. deductible expenses versus capitalization 1. irs identifies issues to be addressed in forthcoming proposed regulations on tangible property costs. notice 2004-6, 2004-1 c.b 308 (12/23/03). these issues include [using the numbering from the notice]: (1) what general principles of capitalization should be applied? (2) what is the appropriate “unit of property”?; (3) what is the starting point for determining whether property value is increased or useful life is prolonged?; (11) should the regulations provide “repair allowance” type rules?; (12) should the regulations provide a de minimis rule?; (13) when should the “plan of rehabilitation” doctrine be applied?; (15) are there circumstances where tax treatment should follow financial or regulatory accounting treatment? a. at long last, the long-promised tangible property proposed regulations are out. reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 71 f.r. 48590 (8/21/06). the proposed regulations include a repair allowance system that would permit expenditures on each class of property up to a specified percentage of cost to be deducted as repairs, with any excess required to be capitalized; the percentage is to be determined based on the principle that a taxpayer will spend 50 percent of cost on repairs over the macrs recovery period. there are other rules, such as a twelve-month rule, unit-of-property rules for four categories of property [regulated industry property, buildings and structural components, other personal property, and other real property], but there is no de minimis rule – however, the absence of a de minimis rule does not change the current practice of permitting agreements between taxpayers and irs examining agents not to select assets with minimal cost for review. amounts paid that materially increase the value of a unit of property must be capitalized, as must be amounts paid that substantially prolong economic useful life. • these proposed regulations would expressly provide that “[a] taxpayer must capitalize amounts paid to acquire or produce real or personal property having a useful life substantially beyond the taxable year, including land and land improvements, buildings, machinery and equipment, and furniture and fixtures . . . having a useful life substantially beyond the taxable year [, and also] amounts paid to acquire real or personal property for resale and to produce real or personal property for sale.” transaction costs to acquire property also are expressly required to be capitalized. the proposed regulations also expressly require capitalization of any amount paid “for permanent improvements or betterments made to increase the value of any property.” the proposed regulations provide detailed rules for determining the proper “unit of property” with respect to which the 2007] recent developments in federal income taxation 441 capitalization requirement will be applied. the unit of property concept is employed to distinguish deductible repairs to a component of a unit from capitalized replacement costs of a unit of property that contributes to the functionality of another larger unit of property. for example, a truck, aircraft, or boat engine might or might not be a separate unit of property from the remainder of the truck, aircraft, or boat. • the test under these proposed regulations for distinguishing capital expenditures from repairs is whether the expenditure improves the property. an expenditure improves a unit of property if the expenditure either (1) materially enhances the value of the property as compared with the status of the property prior to the condition necessitating the expenditure, or (2) restores the property. the “materially enhances the value” test will apply in both cases of normal wear and tear as well as cases when the expenditure arises from a sudden, unexpected, or unusual external circumstance. under the proposed regulations, when the event necessitating the expenditure is normal wear and tear, the condition of the property immediately prior to the event necessitating the expenditure is the condition of the property after the last time the taxpayer corrected the effects of normal wear and tear or, if the taxpayer has not previously corrected the effects of normal wear and tear, the condition of the property when it was first placed in service by the taxpayer. this comparison rule for wear and tear applies even if the taxpayer engages in regular, cyclical maintenance of the property to correct the effects of normal wear and tear. • the “materially enhances value” test does not require an actual determination of an increase in the fair market value of the property. the irs rejected an actual valuation test in favor of conventions. an expenditure materially increases the value of property only if it: (1) ameliorates a condition or defect that either existed prior to the taxpayer's acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of the acquisition or production, (2) is for work performed prior to the date the property actually is placed in service by the taxpayer, (3) adapts the unit of property to a new or different use (including a permanent structural alteration to the unit of property), (4) results in a betterment (including a material increase in quality or strength) or a material addition (including an enlargement, expansion, or extension) to the unit of property; or (5) results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, or quality of output of the unit of property. • the proposed regulations also provide that a federal, state, or local regulatory requirement that a taxpayer perform certain repairs or maintenance is not relevant in determining whether 442 florida tax review [vol. 8:si the amount paid improves the property. furthermore, the proposed regulations provide that repairs that do not directly contribute to an improvement are not required to be capitalized under § 263(a) merely because they are made at the same time as an improvement. this rule rejects the judicial “plan of rehabilitation doctrine” under which otherwise deductible repairs incurred as part of a general plan of rehabilitation must be capitalized. nevertheless, expenditures that otherwise would have been deductible as repairs but which contribute to a specific improvement that must be capitalized likewise must be capitalized. • the repair allowance rules in these proposed regulations are similar to those in the class life asset depreciation rules (cladr), which were in effect from the late 1960s to 1980 (when they were superseded by acrs). under the new comprehensive elective repair allowance rule, if the taxpayer elects to use the repair allowance method, it must be used consistently for all property and for all future years until the election is revoked, which requires the irs’s consent. under the proposed regulations, all amounts paid for materials and labor during the taxable year to repair, maintain, or improve repair allowance property are deductible under § 162 to the extent they do not exceed the “repair allowance amount.” the “repair allowance amount” is determined separately for each macrs property class, and for any particular class is determined by multiplying the repair allowance percentage in effect for that class by the average unadjusted basis of repair allowance property in that class. for buildings that are repair allowance property, the repair allowance method is applied separately to each building. • amounts paid to repair, maintain, or improve the repair allowance property in any particular macrs class (or with respect to a particular building) that exceed the repair allowance amount must be capitalized. taxpayers may choose between two methods for depreciating the capitalized amount. one method is to treat the capitalized amount as a separate single asset and to depreciate the asset in accordance with the appropriate macrs class. the other method is to allocate the capitalized amount for a particular macrs class among all repair allowance properties in the particular macrs class in proportion to the unadjusted basis of each item of property in that macrs class as of the beginning of the taxable year. for purposes of subsequent depreciation, regardless of which method is elected, the capitalized amount is treated as a § 168(i)(6) improvement and is treated as placed in service by the taxpayer on the last day of the first half of the taxable year in which the amount is paid, before application of the convention under § 168(d). for example, the capitalized amount for a calendar year taxpayer would be treated as placed in service on june 30 of the taxable year. although the single asset method entails less complexity, that method does not allow a taxpayer to take the capitalized amount into account in computing gain or loss 2007] recent developments in federal income taxation 443 recognized on the disposition of any particular item of repair allowance property. 2. anschultz co. v. commissioner, t.c. memo. 200640 (3/13/06), reconsideration denied, t.c. memo. 2006-124 (6/14/06). the taxpayer properly made a first-level allocation under reg. §§ 1.263a1(e)(3)(i) and 1.451-3(d)(6)(i) of indirect costs between (1) property produced under long-term contract [which was not subject to § 263a], and (2) property produced and held by the taxpayer for its own use [which was subject to § 263a]. judge haines held that the “reasonableness” standard of reg. § 1.263a-1(f)(4) does not apply to interpret “reasonable allocation” in reg. § 1.451-3(d)(6)(i) when only § 460 is at issue. 3. big loser in 1996 olympics: corporate president paid $5 million to indemnify his corporation, lost his job, and got no deduction either. tigrett v. united states, 96 a.f.t.r.2d 2005-5649 (w.d. tenn. 8/3/05), as amended, 96 a.f.t.r.2d 2005-6341 (9/2/05). the $5 million paid to a corporation by its president/minority shareholder in satisfaction of his contractual obligation to indemnify the corporation against losses from a specific venture [the house of blues venue in centennial park in atlanta during the 1996 olympics] that he advocated the corporation to undertake constituted a capital contribution – not a business expense – because taxpayer had no possibility of personal business profit from the specific venture by the corporation. a. tigrett affirmed, 99 a.f.t.r.2d 2007-501 (6th cir. 1/12/07). taxpayer failed to prove that the contribution to capital was an ordinary business expense or a business loss. c. reasonable compensation there were no significant developments regarding this topic during 2006. d. miscellaneous deductions 1. the irs never seems able to catch up with movements in the price of gasoline, and more tinkering is in store for 2005. rev. proc. 2004-64, 2004-49 i.r.b. 898 (11/17/04), superseding rev. proc. 2003-76, 2003-43 i.r.b. 924. the optional standard mileage rate for business use of automobiles will increase on 1/1/05 from 37.5 cents per mile to 40.5 cents per mile; the mileage rate for medical and moving will increase 444 florida tax review [vol. 8:si from 14 cents per mile to 15 cents per mile; and the mileage rate for giving services to a charitable organization will remain at 14 cents per mile. a. the irs noticed that fuel prices went up recently, so a 9/1/05 increase in mileage rates was announced. announcement 2005-71, 2005-2 c.b. 714 (9/12/05). on 9/1/05, the optional standard mileage rate for business use of automobiles will increase to 48.5 cents per mile, and the standard mileage rate for medical and moving expenses will increase to 22 cents per mile. the rate for charitable miles remains at the statutory [§ 170(i)] 14 cents per mile. b. splitting the difference between the first eight months of 2005 and the last four for 2006. rev. proc. 2005-78, 2005-2 c.b. 1177 (12/2/05). mileage rates effective on or after 1/1/06 are as follows: business, 44.5 cents per mile; medical and moving, 18 cents per mile; general charitable contribution deduction, 14 cents per mile (statutory); hurricane katrina charitable contribution deduction, 32 cents per mile (with a hurricane katrina charitable use of automobile reimbursement rate permitted without income effect of up to 44.5 cents per mile). c. the irs knows that gas prices are scheduled to increase after the 2006 elections, just as they knew back in december 2005 that they were scheduled to decrease before the 2006 elections. rev. proc. 2006-49, 2006-47 i.r.b. 936 (11/1/06). for 2007, it is 48.5 cents per business mile and 20 cents per medical and moving mile. the statutory rate for charitable mileage under § 170(i) remains at 14 cents per mile. 2. section 201 of the jobs act of 2004 amends § 179 to extend the $100,000 amount for expensing [and the $400,000 phase-out threshold] for small businesses through years beginning before 2008. a. increased § 179 amount extended through 2009. tipra § 101 amends § 179 to extend the increased amount for expensing through years beginning before 2010. 3. this deduction should prove so effective that it will be extended to all business income. section 102 of the jobs act of 2004 adds new § 199 to provide a nine percent deduction for u.s. manufacturing income, i.e., “income attributable to domestic production activities.” for corporations, the deduction allowed by § 199 is a percentage of the lesser of “qualified production activities income” or taxable income. for individual taxpayers engaged in manufacturing, the taxable income 2007] recent developments in federal income taxation 445 limitation is replaced by a limitation based on adjusted gross income. the deduction will be phased in over six years, beginning with 2005. the percentage begins at three percent for 2005 and rises to nine percent after 2009, but in no event can the deduction exceed 50 percent of the w-2 wages paid by the taxpayer during the year for which the deduction is sought. §§ 199(a) and (b). thus, the deduction is unavailable to a sole proprietor or partnership with no employees. although the deduction is available to individuals, corporations, and pass through entities, only items attributable to the conduct of a trade or business can be taken into account. § 199(d)(5). • qualified production activities income is defined as the excess of “domestic production gross receipts” over the sum of (1) the cost of goods sold allocable to domestic production gross receipts, (2) other deductions, expenses, or losses directly allocable to domestic production gross receipts, and (3) a ratable portion of other deductions, expenses, and losses not directly allocable to domestic production gross receipts or to any other class of income. § 199(c)(1). domestic production gross receipts are gross receipts derived from (1) the lease, rental, license, or sale, exchange, or other disposition of (a) “qualifying production property,” defined as tangible personal property, computer software, and sound recordings, produced (in whole or in significant part) by the taxpayer in the united states, (b) a “qualified film” produced by the taxpayer, or (c) electricity, natural gas, or potable water produced by the taxpayer in the united states; (2) construction performed within the united states, or (3) architectural or engineering services performed in the united states for united states construction projects. section 199(c)(4)(b) excludes from the definition of domestic production gross receipts any receipts from (1) the sale of food and beverages prepared by the taxpayer at a retail establishment, or (2) the transmission or distribution (as contrasted with the production) of electricity, natural gas, or potable water. a. if the statute appears to have a short shelf-life, the guidance under it should be even more ephemeral. notice 2005-14, 2005-1 c.b. 498 (1/19/05). this notice provides lengthy guidance on the new manufacturing deduction. pending promulgation of what surely will be voluminous regulations governing the allocation of deductions, expenses, and losses for the purpose of calculating qualified production activities income, notice 2005-14 provides interim guidance. b. proposed regulations. reg-105847-05, income attributable to domestic production activities: deduction, 70 f.r. 67220 (11/4/05). the irs published voluminous [224 pages] proposed regulations [§§ 1.199-1 through -8] relating to the deduction for u.s. manufacturing income under § 199. the “shrinking back” concept of taking 446 florida tax review [vol. 8:si the deduction for only the value of the beans in a cup of brewed coffee, or for the value of the u.s.-manufactured shoelaces on a pair of foreignmanufactured sneakers is being much discussed. c. finally, final regulations! final § 199 regulations are out and are 247 pages long in the internal revenue bulletin, but that is only 137 pages in lexis and 55 pages in the federal register. t.d. 9263, income attributable to domestic production activities, 71 f.r. 31268, 2006-25 i.r.b. 1063 (6/1/06). you have to be addlepated if you expect a summary. d. “w-2 wages” include only those allocable to domestic production activities. tipra § 514 amends § 199(b) to provide that “w-2 wages” includes only wages properly allocable to domestic production gross receipts. e. rev. proc. 2006-22, 2006-23 i.r.b. 1033 (5/24/06). this revenue procedure provides guidance for calculating w-2 wages that reflects the additional limitations imposed by tipra. three methods are provided for the calculation, the unmodified box method, the modified box 1 method, and the tracking wages method. f. t.d. 9293, tipra amendments to section 199, 71 f.r. 61662 (10/19/06). the irs has promulgated temporary regulations regarding the proper allocation of w-2 wages to domestic production gross receipts. proposed regulations, reg-127819-06, are based on the text of the temporary regulations. 4. tool allowance is not paid under an accountable plan. namyst v. commissioner, t.c. memo. 2004-263 (11/17/04). reg. § 1.62-2(f) conditions application of the netting rule [permitting an abovethe-line deduction of employee business expenses pursuant to an accountable plan] on the employee being required to return excess advances to the employer. the taxpayer, instead, was required to include expense reimbursements in gross income because although he was required to [and did meticulously] account to the employer for his expenses, he was not obligated to return any excess advances to the employer. a. affirmed. namyst v. commissioner, 435 f.3d 910, 2006-1 u.s.t.c. ¶50,163 (8th cir. 1/27/06). these payments did not meet the standards set forth in reg. § 1.62-2 for payments to qualify as being part of an “accountable plan” because the payments were not differentiated between reimbursements of expenses and for payments with 2007] recent developments in federal income taxation 447 respect to tools. the court affirmed the tax court’s refusal to treat substantiated payments as made under a qualified accountable plan while treating unsubstantiated payments as payments under a nonaccountable plan because the plan as a whole must meet the requirements of an accountable plan for such treatment. 5. irs rules on accountable plans. rev. rul. 200656, 2006-46 i.r.b. 874 (11/13/06). if employers pay expense allowances in excess of the amount that may deemed substantiated without requiring actual substantiation of all the expenses or repayment of the excess amount and the expense allowance arrangement has no mechanism or process to determine when an allowance exceeds the amount that may be deemed substantiated, then the failure of the arrangement to treat the excess allowances as wages for employment tax purposes causes all payment made under the arrangement to be treated as made under a nonaccountable plan. this rule is not effective for taxable periods ending on or before 12/31/06 in the absence of intentional noncompliance. • the facts of this ruling involve reimbursement of long-haul truck drivers for meal and incidental expenses on a “cents-per-mile driven” basis that regularly exceeds $52 per day – the amount determined by § 4.04 of rev. proc. 2005-67, 2005-2 c.b. 729. 6. this truck driver case applies the reimbursement doctrine twice. transport labor contract/leasing, inc. v. commissioner, 461 f.3d 1030 (8th cir. 8/23/06). taxpayer provided professional employer organization (“peo”) services to smalland medium-sized trucking companies by hiring truck drivers as its employees and then leasing them back to its trucking company clients. the issue was whether it or the trucking company had to take the § 274(n) haircut when the drivers were paid a fixed per diem, with the per diem being treated as an expense reimbursement. the tax court held that the peo was the common law employer, and stopped there. the eighth circuit (judge loken) reversed as a matter of law on the ground that the § 274(e)(3)(b) exception applied because the taxpayer itself incurred the per diem expenses “under a reimbursement or other expense allowance arrangement” with the trucking companies for which it accounted to them. 7. “sleep or rest” does not require a hotel room. bissonnette v. commissioner, 127 t.c. 124 (10/23/06). the tax court (judge haines) allowed a deduction for meal expenses incurred by a ferryboat captain during sixto seven-hour layovers in harbor during singleday, 15to 17-hour sea voyages because the taxpayer’s very demanding job required sleep or rest during the layovers and the length of the layovers 448 florida tax review [vol. 8:si increased his expenses because he had to buy meals. however, meal expenses incurred during one-hour layovers (and occasional longer layovers) during which the taxpayer did not rest were not deductible. 8. the tax relief and health care act of 2006 § 108 extends the § 62(a)(3) above-the-line $250 deduction for k-12 teacher classroom expenses to 2006 and 2007. 9. the tax relief and health care act of 2006 § 109 extends the expensing of brownfields remediation costs to 2006 and 2007. it also provides that sites contaminated by petroleum products will be eligible for the deduction. e. depreciation & amortization 1. tipra § 207 adds new § 167(g)(8) to provide for the election of 5-year amortization of costs of musical compositions and copyrights placed in service during years beginning after 2005 but before 2011. a taxpayer not making the election may use any cost recovery method otherwise permitted, including the income forecast method. 2. the tax relief and health care act of 2006 § 113 extends the § 168(e)(3)(e) 15-year depreciation periods for leasehold improvements and for restaurant improvements to 2006 and 2007. f. credits 1. the tax relief and health care act of 2006 § 104 extends the research credit through 2007 and creates an additional alternative simplified credit for 2007. a. more time to make research credit elections for 2006 years. the tax relief and health care act of 2006 § 123 extends the time for making research credit elections for taxable years ending after 2005 to the later of 4/15/07 or such time as specified by the treasury. a similar rule shall apply to other elections under expired provisions. g. natural resources deductions & credits 1. first: energy efficient commercial buildings; “greening-up” an existing building. section 179d, added to the code by 2007] recent developments in federal income taxation 449 the energy tax incentives act of 2005, provides a deduction for the cost of “energy efficient commercial building property” placed in service during 2006 or 2007. qualified property must be installed in a building within the united states as part of (1) the interior lighting systems, (2) the heating, cooling, ventilation, and hot water systems, or (3) the building envelope, and must be certified as being installed pursuant to a plan designed to reduce the building’s total annual energy and power costs by at least 50 percent in comparison to a hypothetical reference building. the deduction may not exceed $1.80 per square foot of the property. the statute directs the treasury department, in consultation with the department of energy, to promulgate regulations setting forth methods of calculating and verifying energy and power costs. in the case of an expenditure made by a public entity (such as a public school), the statute directs the treasury department to promulgate regulations allocating the deduction to the designer of the property in lieu of the owner. • if a building does not satisfy the overall 50 percent reduction standard, a partial deduction (limited to $0.60 per square foot) is allowed for system-specific energy efficient property, if a specific system (i.e., (1) interior lighting, (2) heating, cooling, ventilation and hot water, or (3) building envelope) satisfies system-specific targets to be established by regulation (with the statute providing an interim target, in the case of lighting system retrofits). a. the tax relief and health care act of 2006 § 204 extends the § 179d deduction for energy efficient commercial buildings to 2008. 2. second: new energy efficient home credit. section 45l, added to the code by the energy tax incentives act of 2005, provides a credit, in the amount of either $2,000 or $1,000, to an eligible contractor (including the producer of a manufactured home) who constructs and sells an energy efficient home to a person who will use the home as a residence. to qualify for the $2,000 credit, the home must be certified (in accordance with guidance to be prescribed by the treasury department) as having a level of annual heating and cooling energy consumption at least 50 percent below the level of a comparable hypothetical reference dwelling unit, with at least one-fifth of the energy savings attributable to the building envelope. the $1,000 credit, which applies only to manufactured homes, requires at least a 30 percent reduction in energy consumption, of which at least one-third must be attributable to the building envelope. manufactured homes are also eligible for the $2,000 credit, if they satisfy the usual requirements for that credit. the credit is available only with respect to 450 florida tax review [vol. 8:si homes the construction of which is substantially completed after 2005, and which are purchased during 2006 or 2007. the credit is part of the general business credit. • the credit is effective for homes substantially completed after 8/08/05 and sold after 12/31/05 but before 1/01/08). a. procedures for getting the home certified. notice 2006-27, 2006-11 i.r.b. 626 (2/22/06), updated by announcement 2006-88, 2006-46 i.r.b. 910 (10/30/06). the irs has published procedures that an eligible contractor may follow to certify that a dwelling unit, other than a manufactured home, is an energy efficient home that satisfies the requirements of § 45l(c)(1). certification must be performed by resnet or an equivalent energy rating network. resnet’s website is located at http://www.natresnet.org. b. notice 2006-28, 2006-11 i.r.b. 628. this notice contains procedures that an eligible contractor may follow to certify that a dwelling unit that is manufactured home satisfies the requirements of §§ 45l(c)(2) and (3). c. the tax relief and health care act of 2006 § 205 extends the code § 45l credit for new energy efficient homes to 2008. 3. third: alternative motor vehicle credit. section 30b, added to the code by the energy tax incentives act of 2005, provides a credit for certain “alternative motor vehicles.” the credit is available in the year a qualifying vehicle is placed in service–for either business or personal use–by the taxpayer. the credit is generally allowed to the owner of the vehicle, including the lessor of a vehicle subject to a lease. if a vehicle is sold to a tax-exempt user, the person who sold the vehicle to the user may claim the credit, but only if the seller clearly discloses the amount of the credit to the user. § 30b(h)(6). a taxpayer claiming the credit must reduce his basis in the vehicle by the amount of the credit. • a new qualified hybrid motor vehicle is a vehicle, the original use of which commences with the taxpayer that uses both an internal combustion engine and a rechargeable battery system, that meets specified emission standards, and that meets specified minimum standards for maximum available power. for cars and light trucks, the credit amount is the sum of the fuel economy component and the conservation component, determined under the same rules applicable to leanburn vehicles. for other vehicles, the credit is a percentage of the excess of the 2007] recent developments in federal income taxation 451 manufacturer’s suggested retail price (msrp) for the vehicle over the msrp of a comparable non-hybrid vehicle–20 percent if the vehicle achieves at least a 20 percent increase in city fuel economy relative to a comparable non-hybrid vehicle, 30 percent for an increase of at least 40 percent, and 40 percent for an increase of at least 50 percent. section 30b(d) is effective for property placed in service after 12/31/05 and generally before 1/01/10. hybrid vehicles are the only green vehicles currently being mass produced.1 the new hybrid motor vehicle credit applies, in differing amounts, to passenger automobiles and light trucks, and other hybrid motor vehicles. a. irs releases notice 2006-9 providing guidance on the qualified hybrid tax credit. notice 2006-9, 2006-6 i.r.b. 413 (1/13/06). this notice sets forth interim guidance, pending the issuance of regulations, relating to the new advanced lean-burn technology motor vehicle credit under § 30b(a)(2) and (c) of the internal revenue code and the new qualified hybrid motor vehicle credit under § 30b(a)(3) and (d). b. ir-2006-56 (4/7/06). the irs acknowledges the certification by ford of certain models of the ford escape and mercury mariner hybrids for credit amounts between $1,950 and $2,600. c. ir-2006-57 (4/7/06). the irs acknowledges the certification by toyota of certain models of the toyota prius, the toyota highlander, and the lexus rx400h for credit amounts between $2,200 and $3,150. d. let no good deed go unpunished. ir2006-112 (7/13/06). employer incentives in the form of cash rebates to employees who purchase environmentally friendly hybrid vehicles are to be included in the employees’ income as compensation. 4. fourth: nonbusiness energy property credit. certification is obtained by the manufacturer. section 25c, added to the code by the energy tax incentives act of 2005, provides a nonrefundable credit for certain expenditures to improve the energy efficiency of a taxpayer’s principal residence. in the case of “qualified energy efficiency improvements” (qeeis), the credit equals 10 percent of the cost of the improvements. a qeei is any energy-efficient building component (i.e., insulation, exterior windows and doors, and certain coated metal roofs) satisfying criteria established by the 2000 international energy conservation code, if the original use of the component commences with the taxpayer and the component is expected to remain in use for at least five years. the other 1. but see manufacturers’ web sites for other available colors. 452 florida tax review [vol. 8:si category of credit-eligible costs is “residential energy property expenditures” (repes). repes are expenditures for the following types of property, if they are installed in the taxpayer’s principal residence and satisfy energy efficiency standards to be promulgated by the secretary of the treasury pursuant to detailed statutory instructions: (1) main air circulating fans, (2) natural gas, propane or oil furnace or hot water boilers, and (3) “energyefficient building properties” (electric heat pump water heaters, electric heat pumps, geothermal heat pumps, central air conditioners, and water heaters using natural gas, propane, or oil). for repes the credit amount is established by schedule: the first $50 of the cost of a main air circulating fan, the first $150 of the cost of a natural gas, propane, or oil furnace or hot water boiler, and the first $300 of the cost of any item of energy-efficient building property. there is a lifetime limit of $500 on the aggregate credits a taxpayer may claim under § 25c, of which no more than $200 may be based on expenditures for windows. the credit is available only for property placed in service in 2006 or 2007. a. certification to be obtained from manufacturer. notice 2006-26, 2006-11 i.r.b. 622 (2/22/06). pending the issuance of regulations, this notice provides procedures that manufacturers may follow to certify property as either an “eligible building envelope component” or “qualified energy property.” it also provides guidance regarding the conditions under which taxpayers seeking to claim the § 25c credit may rely on a manufacturer’s certification (or, in the case of certain windows, an “energy star” label). 5. fifth: credit for residential energy efficient property, e.g., solar panels. section 25d, added to the code by the energy tax incentives act of 2005, provides a nonrefundable credit for certain expenditures on residential energy-efficient property. qualifying property is of three types: photovoltaic property (which uses solar energy to generate electricity), solar water heating property, and fuel cell property (which converts a fuel into electricity using electrochemical means). the property must be installed in a dwelling unit located in the united states and used by the taxpayer as a residence (principal residence, in the case of fuel cell property). expenditures allocable to a swimming pool or hot tub are not eligible for the credit. the credit equals 30 percent of qualifying expenditures, subject to annual ceilings (on the credit amounts, not on credit-eligible expenditures) of $2,000 for photovoltaic property, $2,000 for solar water heating property, and $500 per half kilowatt of capacity of fuel cell property. the credit is available only for property placed in service in 2006 or 2007. 2007] recent developments in federal income taxation 453 a. the tax relief and health care act of 2006 § 206 extends the code § 25d credit for residential energy efficient property to 2008. 6. interim guidance under the cs, etc. credit. notice 2006-88, 2006-42 i.r.b. 686 (9/26/06). this notice provides interim guidance on the tax credit under § 45(c)(1)(c) for electricity produced from open-loop biomass. 7. the tax relief and health care act of 2006 § 118 extends the code § 613a(c)(6)(h) temporary suspension of the 100 percent of taxable income limit on percentage depletion for oil and natural gas produced from marginal properties to taxable years beginning in 2006 and 2007. h. loss transactions, bad debts and nols 1. jefferson smurfit corp. v. united states, 439 f.3d 448 (8th cir. 3/6/06), rehearing denied, 2006 u.s. app. lexis 13606 (6/1/06). judge murphy held that a tentative nol carryback allowed under § 6411 is subject to adjustment after the subsequent audit of the year in which the nol arose – even if the tax court has issued a final order determining the taxpayer’s liability for the carryback year. i. at-risk and passive activity losses there were no significant developments regarding this topic during 2006. iii. investment gain a. capital gain and loss 1. the third circuit devised a new test for determining whether the sale of a right to an income stream produced capital gain or ordinary income. lattera v. commissioner, 437 f.3d 399 (3d cir. 2/14/06), cert. denied, 127 s. ct. 1328 (2/20/07). the taxpayer sold all of his rights to all of the remaining payments under a winning lottery ticket. the court rejected the “substitute for ordinary income” analysis as overly-broad, and instead devised a test related to the “family resemblance” of a particular transaction to traditional capital assets analysis. the family 454 florida tax review [vol. 8:si resemblance test was based on the (1) “type of ‘carve out’” – horizontal versus vertical – and the (2) “character of asset” involved. the court reasoned that “[b]ecause a vertical carve-out could signal either capital-gains or ordinary-income treatment, ... when we see a vertical carve-out, we proceed to the second factor – character of the asset – to determine whether the sale proceeds should be taxed as ordinary income or capital gain.” • under the character of the asset analysis, assets that constitute a right to earn income from the property accrued in the future merit capital-gains treatment, while assets that constitute a right to receive income accrued in the past merit ordinary-income treatment. applying this analytical model the court concluded, “because a right to lottery payments is a right to earned income (i.e., the payments will keep arriving due simply to ownership of the asset), the lump-sum payment received by the latteras should receive ordinary-income treatment.” note that under this test, the taxpayer in mcallister v. commissioner, 157 f.2d 235 (2d cir. 1946), would continue to be entitled to capital gains treatment on the sale of a life estate, because the income therefrom would not yet have accrued at the time of the sale. • other courts of appeals that have addressed the issue likewise have held that the proceeds from the sale of lottery winnings are ordinary income, not capital gains, although the reasoning of the different courts varies. a. lottery winners’ sale of rights to lottery installments results in ordinary income under the substitute-forordinary-income doctrine. watkins v. commissioner, 447 f.3d 1269 (10th cir. 5/10/06). the court followed earlier lottery assignment cases in so holding, including united states v. maginnis, 356 f.3d 1179 (9th cir. 2004), and davis v. commissioner, 119 t.c. 1 (2002). particularly, the court followed the reasoning in commissioner v. p.g. lake inc., 356 u.s. 260 (1958), which held that the “substance of what was assigned was the right to receive future income” and the “substance of what was received was the present value of income which the recipient would otherwise obtain in the future” and “consideration was [not] paid for an increase in the value of the income-producing property.” • the court held that the proceeds were ordinary income under the “substitute-for-ordinary-income doctrine,” while “refus[ing] to enter the fray” regarding whether the analysis under maginnis or that under lattera should be applied, and while declining to “formulate any specific test regarding the doctrine’s application.” b. wolman v. commissioner, 180 fed. appx. 830 (10th cir. 5/19/06), followed watkins. 2007] recent developments in federal income taxation 455 2. capital gain treatment for sales of self-created musical works. tipra § 204 adds new § 1221(b)(3) to permit taxpayers to elect to treat the sale or exchange of self-created musical compositions or copyrights in musical works sold or exchanged after 12/31/06 and before 1/1/11 as the sale or exchange of a capital asset. this capital asset treatment is to be inapplicable for § 170(e) purposes, so the amount of the charitable deduction of such assets continues to be reduced by the amount of appreciation inherent in such assets. section 1221(b)(3), added to the code in 2006, permits a taxpayer to elect to treat a self-created musical work as a capital asset, if the taxpayer sells or exchanges the work before 2011. the 2006 legislation, however, also amended § 170(e)(1)(a) to provide that new §1221(b)(3) is not taken into account in determining the amount of any charitable deduction for the donation of a self-created musical work. a. made permanent by the tax relief and health care act of 2006 § 412. 3. reg-109367-06, section 1221(a)(4) capital asset exclusion for accounts and notes receivable, 71 f.r. 44600 (8/7/06). proposed regulations to clarify when accounts or notes receivable are acquired in payment for inventory or services rendered within the meaning of § 1221(a)(4), which has the effect of permitting loss on the sale or exchange of such accounts or notes receivable to be ordinary. these regulations would exclude situations where the accounts or notes receivable are acquired for consideration other than § 1221(a)(1) property or services. 4. merlo v. commissioner, 126 t.c. 205 (4/25/06). the tax court (judge haines) held that limitations on capital losses under §§ 1211 and 1212 apply for purposes of calculating alternative minimum taxable income. thus, capital losses realized in 2001 upon worthlessness of stock acquired pursuant to the exercise of incentive stock options did not create an amt nol that could be carried back to reduce amti in 2000 [the year of exercise]. 5. proposed regulations will treat taxpayers who exchange property for an annuity as if they had sold the property. reg141901-05, exchanges of property for an annuity, 71 f.r. 61441 (10/18/06). the treasury has published proposed regulations that would provide a single set of rules for the taxation of an exchange of property for an annuity contract. essentially, the proposed rules will treat the transaction as if the property was sold for cash equal to the value of the annuity contract [as determined under § 7520] and the proceeds were used to buy an annuity 456 florida tax review [vol. 8:si contract; however, taxpayers may continue to structure transactions as § 453(b) installment sales. these proposed regulations do not change existing reg. § 1.1011-2 for charitable gift annuities, but will change prior law on exchanges of appreciated property for private annuities to the extent it permitted open transaction treatment or ratable recognition as the annuities were paid. the effective date is 10/18/06, with a delayed effective date of 4/18/07 for non-abusive transactions. • these proposed regulations would bring the current treatment of exchanges of appreciated property for private annuities into line with the tax treatment of exchanges for commercial annuities. before these regulations are applicable, the law generally postponed tax on the exchange based on the assumption that the value of a private annuity contract could not be determined for federal income tax purposes. b. interest 1. interest-free loans to continuing care facilities may be without limit through 2010. tipra § 209 adds new § 7872(h), which removes the $100,000 dollar cap for excepting interest-free loans to continuing care facilities from the imputed interest rules for years through 2010. it also reduces the minimum age of qualifying lenders from 65 to 62. a. made permanent by the tax relief and health care act of 2006 § 425. c. section 1031 1. while all exchanges of real property interests are not, ipso facto, like-kind exchanges under § 1031, this taxpayer’s exchange was. peabody natural resource co. v. commissioner, 126 t.c. 261 (5/8/06). the tax court (judge gerber) held that receipt of coal mining property and appurtenant coal supply contracts with electric utility companies in exchange for gold mining property without supply contracts was a § 1031 exchange without boot. the coal supply contracts were not separate intangible property. the tax court articulated the standard to be applied in deciding whether real property interests are considered to be likekind as follows. to decide whether an exchange is like kind within the meaning of section 1031(a), we must compare the exchanged properties to ascertain whether the nature and character of the transferred rights in and to the respective properties are substantially alike.... in making this comparison, consideration is to be given to the respective 2007] recent developments in federal income taxation 457 interests in the physical properties, the nature of the title conveyed, the rights of the parties, the duration of the interests, and any other factor bearing on the nature or character of the properties as distinguished from their grade or quality. • for example, under this standard, rights appurtenant to land, such as leases and mineral supply contracts, are part of the bundle of rights incident to ownership of the land that are not separate property interests but merely constitute a distinction in the grade or quality of the old and new mining properties. d. section 1033 there were no significant developments regarding this topic during 2006. iv. compensation issues a. fringe benefits 1. guidance on health savings accounts. notice 2004-2, 2004-1 c.b. 269 (12/23/03). the irs has issued guidance in q&a form on health savings accounts under new § 223 (added by § 1201 of the medicare prescription drug improvement, and modernization act of 2003). this guidance provides basic information about hsas. this new provision offers health spending accounts without the “use it or lose it” requirement of health fsas. a. reg-138647-04, employer comparable contributions to health savings accounts under section 4980g, 70 f.r. 50233 (8/26/05). the treasury proposed regulations that would provide guidance on employer comparable contribution to hsas under § 4980g, which provides an excise tax on the failure of an employer to make “comparable contributions” to the hsas of all comparable participating employees [employees in the same category of “self-only” or “family”] when it makes a contribution to any employee’s hsa. b. final regulations in q&a form. t.d. 9277, employer comparable contributions to health savings accounts under section 4980g, 71 fr 43056 (7/28/06). the final regulations provide guidance on how to interpret the comparable contribution rules that 458 florida tax review [vol. 8:si employers must follow if they contribute funds to an employee’s health savings account. c. the tax relief and health care act of 2006, § 302, adds new code § 106(e) to permit one-time transfers to health savings accounts from health flexible spending arrangements and health reimbursement arrangements. d. the tax relief and health care act of 2006, § 303, amends code § 223(b)(2) to repeal the annual deductible limitation on hsa contributions and allow contributions of $2,700 ($5,454 family) even if the deductible is less that those amounts. e. the tax relief and health care act of 2006, § 302, adds new code § 4980g(d) to provide for an exception to the current requirement that employer contributions to hsas be “comparable” for all employees by allowing employers to provide additional contributions to lower-paid workers. f. the tax relief and health care act of 2006, § 307, adds new code § 408(d)(9) to permit one-time distributions from iras to fund hsas. this would allow those who cannot afford to fully fund an hsa with direct contributions to move ira money to a more taxadvantaged position. 2. the irs rules that if a self-funded health reimbursement plan provides medical expense reimbursements for nondependents after the death of the employee and the last of his dependents, it will “mess up” the entire plan for all employees by making such reimbursements includible in income of any employee who receives reimbursements under the plan. rev. rul. 2006-36, 2006-36 i.r.b. 353 (8/14/06). medical expense reimbursements made to employees for payments of the medical expenses of a beneficiary other than the employee’s spouse or dependents are not excludable from gross income under § 105(b). additionally, none of the payments from the reimbursement plan during the plan year to any person, including amounts paid to reimburse the medical expenses of an employee or the employee’s spouse or dependents, is excludable from gross income. • this ruling is effective for health reimbursement plans after 2008, except that it is immediately effective for health reimbursement plans that added such a provision after 8/14/06. • to what extent will this ruling mess up plans that provide for payments for non-dependent domestic partners? the 2007] recent developments in federal income taxation 459 irs has previously ruled that insured plans that offer domestic partner coverage will not be completely “tainted,” but that the cost of such insurance will be includible in the employee’s income. b. qualified deferred compensation plans 1. “mr. gotbucks, meet senator roth.” reg152354-04, designated roth contributions to cash or deferred arrangements under section 401(k), 70 f.r. 10062 (3/2/05). the treasury has proposed regulations relating to an election under § 402a that will be available beginning in 2006 for employees to designate contributions to a 401(k) plan made under a qualified cash-or-deferred arrangement as roth contributions. these contributions will be currently includible in gross income but qualified distributions will be excludable from gross income. a. final regulations on roth contributions under qualified cash or deferred arrangements under § 401(k). t.d. 9237, designated roth contributions to cash or deferred arrangements under section 401(k), 71 f.r. 6 (1/3/06). these final regulations, §§ 1.401(k)-1(f) and 1.401(k)-2(b), require a pre-tax alternative elective contribution to the roth account. they also require an irrevocable designation to be made by the employee at the time of the cash or deferred election, and require that roth contributions be maintained by the plan in a separate designated roth account for the employee. matching contributions will not be permitted to be allocated to a designated roth account. the regulations are effective for taxable years beginning after 12/31/05. • the final regulations retain the requirement that a designated roth contribution must satisfy the requirements applicable to any other elective contributions made under a qualified cash or deferred arrangement. thus, designated roth contributions are subject to the nonforfeitability and distribution restrictions applicable to elective contributions and are taken into account under the actual deferral percentage test (adp test) of § 401(k)(3) in the same manner as pre-tax elective contributions. similarly, designated roth contributions may be treated as catch-up contributions and serve as the basis for a participant loan. 2. mrd requirements apply to designated roth accounts in qualified plans, but not to amounts rolled over to roth iras. reg-146459-05, designated roth accounts under section 402a, 71 f.r. 4320 (1/26/06). these proposed regulations provide comprehensive guidance on the taxation of distributions from designated roth accounts. there is no inclusion in income if the distribution is a qualified distribution, which is a distribution that is made after a 5-taxable-year period of 460 florida tax review [vol. 8:si participation and that is either made after the employee attains 59-1/2 years of age, or is made after the employee’s death, or is attributable to the employee’s being disabled. the 5-taxable-year period, during which a distribution is not a qualified distribution, begins on the first day of the employee’s taxable year for which the employee first had designated roth contributions made to the plan and ends when 5 consecutive taxable years have been completed. however, if a direct rollover is made from a designated roth account under another plan, the 5-taxable-year period for the recipient plan begins on the first day of the employee’s taxable year for which the employee first had designated roth contributions made to the other plan, if earlier. 3. how to implement what god hath roth. notice 2006-44, 2006-20 i.r.b. 889 (4/24/06). this notice contains a sample amendment to enable plan sponsors to provide for designated roth contributions in their 401(k) plans. 4. t.d. 9256, revised regulations concerning disclosure of relative values of optional forms of benefit, 71 f.r. 1479802 (3/24/06). final regulations under § 417(a)(3) address the content requirements applicable to explanations of qualified joint and survivor annuities and qualified preretirement survivor annuities payable under retirement plans. these regulations provide that the explanation must disclose the relative value of any optional forms of benefit compared to the value of the qjsa if the actuarial present value of that optional form of benefit is less than that of the qjsa. effective for explanations provided for annuity starting dates beginning on or after 2/1/06. 5. plan participants can now get some help on investing their 401(k) accounts. pension protection act, § 601, amends erisa § 408 and code § 4975 to permit employers and plan trustees to provide investment advice through an “eligible investment advice arrangement” to participants and beneficiaries of defined contribution plans who direct the investment of their accounts, by creating another exclusion from prohibited transaction treatment. these provisions are effective for advice provided after 12/31/06. 6. congress – in reaction to enron – requires that 401(k) participants get what peter lynch calls “di-worse-ification” rights with respect to employer securities. pension protection act § 901 adds new code § 401(a)(35) to provide diversification rights with respect to publicly traded employer securities held by a defined contribution plan. this subsection is effective with respect to plan years beginning after 12/31/06. 2007] recent developments in federal income taxation 461 a. notice 2006-107, 2006-51 i.r.b. 1114 (11/30/06). this notice provides transitional guidance regarding § 401(a)(35), together with a model notice to plan participants concerning employer securities. 7. cash balance plan proposed regulations provide a green light for adoptions of cash balance plans favoring younger employees, including permission to require quasi-geriatrics to spin their [retirement accrual] wheels during “wear-away” periods. reg-20950086 and reg-164464-02, reductions of accruals and allocations because of the attainment of any age; application of nondiscrimination cross-testing rules to cash balance plans, 67 f.r. 76123 (12/11/02). these proposed regulations provide guidance on age discrimination requirements under §§ 411(b)(1)(h) and 411(b)(2), including the allocation of these requirements to cash balance pension plans. • a cash balance plan is a defined benefit plan under which an employee has a hypothetical individual account that provides a benefit upon retirement based upon pay credits and interest credits – a concept that closely resembles a defined contribution plan. section 411(b)(1)(h) provides that a defined benefit plan fails to comply with the age discrimination rules of § 411(b) if benefit accrual is ceased or reduced on the attainment of any age, and § 411(b)(2) provides that a defined contribution plan similarly fails to comply unless the rate at which amounts are allocated to an employee’s account is not similarly ceased or reduced because of age. • a cash balance qualifies, inter alia, only if “the participant accrues the right to future interest credits (without regard to future service) at a reasonable rate of interest that does not decrease because of the attainment of any age.” • the rules for conversion of traditional defined benefit plans to cash balance plans require that either (1) the converted plan defines the benefit as the sum of the benefits under the traditional defined benefit plan and the cash balance account, or (2) the converted plan must establish each participant’s opening account balance as an amount not less than the actuarial present value of the participant’s prior accrued benefit. the second alternative would permit a “wear-away” period during which the participant will not accrue net benefits for some period after the conversion. 462 florida tax review [vol. 8:si a. treasury and irs withdraw the proposed cash-balance plan nondiscrimination regulations. announcement 2003-22, 2003-17 i.r.b. 846 (4/7/03). the proposed nondiscrimination regulations under § 401(a)(4) that would have required a modified form of cross-testing, which were proposed at the same time as the proposed cash balance regulations, are withdrawn because (as proposed) they would make it difficult “for plan sponsors converting long-standing traditional pension plans to cash balance plans to provide different types of transitional relief to plan participants.” the announcement states that the withdrawn proposed regulations will be re-proposed. b. section 205 of the consolidated appropriations act, 2004, pub. l. 108-199 (enacted 1/23/04), provided that none of the funds made available in the appropriations act could be used to issue any rule or regulation that implemented the proposed agediscrimination regulations or any regulations reaching similar results. c. proposed cash balance plan regulations are completely withdrawn. announcement 2004-57; 2004-2 c.b. 15 (6/15/04). the december 2002 proposed regulations were withdrawn in order to give congress the opportunity to consider the administration’s legislative proposal and to address cash balance plan issues through legislation. d. district court finds that ibm cash balance plan violates erisa – but case is reversed after congress passes the pension protection act of 2006. cooper v. ibm personal pension plan, 274 f. supp. 2d 1010 (s.d. ill. 7/31/03). the court held that the plan violated erisa §§ 204(b)(1)(g) [reduction of accrued benefit solely on increases in age or service] and 204(b)(1)(h) [rate of benefit accrual decreases once a certain age is attained]. e. seventh circuit reverses ibm case, but only after congress acts to legalize cash balance plans. cooper v. ibm personal pension plan, 457 f.3d 636 (7th cir. 8/7/06), rehearing denied, 2006 u.s. app. lexis 23227 (7th cir. 9/1/06), rev’g 274 f. supp. 2d 1010 (s.d. ill. 7/31/03). the seventh circuit (judge easterbrook) analyzes the situation by comparing erisa § 204(b)(1)(h) [the anti-age discrimination provision applicable to defined benefit plans] with erisa § 204(b)(2)(a) [the anti-age discrimination provision applicable to defined contribution plans]. judge easterbrook makes the point that “benefit accrual” in § 204(b)(1)(h) does not have the same meaning as “accrued benefit,” which 2007] recent developments in federal income taxation 463 is defined in erisa § 3(23)(a) as an amount “expressed in the form of an annual benefit commencing at normal retirement age.” • judge easterbrook ascribes to the district court its conclusion that cash balance plans discriminate on account of age based on an example comparing the benefit received by a 30-year-old who leaves ibm at age 50 with the benefit received by a 45-year-old who retires at age 65, and states that the district court based its conclusion of discrimination on the fact that the difference in accrued benefit at age 65 – attributable to 15 additional years of compound interest – is not counterbalanced by the fact that older workers generally draw higher salaries. he rejects this interpretation of the statute that “treats the time value of money as age discrimination.” • judge easterbrook reinforces this conclusion by noting it is identical to the view of the treasury department expressed in the december 2002 proposed regulations which concluded that the proper question to ask is, “if this employee were younger, would the hypothetical balance have grown more this year?” f. the world is now safe for cash balance plans. pension protection act § 701 amends erisa §§ 203, 204 and 205, code §§ 411 and 417, and adea § 4(i)(2) to provide that cash balance plans do not per se violate the prohibition on age discrimination. g. or is it? in re citigroup pension plan erisa legislation, 470 f. supp. 2d 323 (s.d. n.y. 12/12/06). the court (judge scheindlin) disagreed with the seventh circuit’s cooper decision and found that cash balance plans violate the prohibition on age discrimination. h. notice 2007-6, 2007-3 i.r.b. 272 (1/16/07). the irs is beginning to process determination letter and examination cases in which an application for a determination letter or a plan under examination involves an amendment to change a traditional defined benefit plan into a cash balance plan. this notice also provides transitional guidance on the requirements of code §§ 411(a)(13) and 411(b)(5), which were added by § 701(b) of the pension protection act. 8. the increased funding limits provided in the 2001 act are made permanent. pension protection act § 811 repeals the sunset provision of egtrra as applied to the provisions relating to pensions and iras. 9. pension protection act § 812 makes the code § 25b saver’s credit permanent. 464 florida tax review [vol. 8:si 10. beginning in 2008, 401(k) plans may contain an automatic contribution feature. pension protection act § 902 adds new code § 401(k)(13) to permit qualified automatic enrollment in 401(k) plans, under which an employee is enrolled to make elective contributions unless he or she affirmatively elects otherwise. this provision is effective for plan years beginning after 12/31/07. 11. nonspouse plan beneficiaries can receive the same treatment as nonspouse ira beneficiaries. pension protection act § 829 adds new code § 402(c)(11) to permit nonspouse beneficiaries to roll their benefits over to an “inherited ira,” which will be subject to the distribution rules applicable to beneficiaries, i.e., distributions over the life of the beneficiary under code § 401(a)(9). 12. enron survivors get some “catchup” to go with their tea and sympathy. pension protection act § 831 amends code § 219 to permit certain 401(k) plan bankruptcy survivors to make additional deductible “catchup” contributions to an ira during the years 2007 to 2009, if transactions related to the bankruptcy led to an indictment or a conviction. 13. anti-cutback rules were not violated by plan amendments in accordance with statutory change [from pbgc rate to treasury rate] in the applicable interest rate for the present value calculation of pension plan lump-sum payments to retirees. stepnowski v. commissioner, 124 t.c. 198 (4/26/05). in this declaratory judgment case, judge cohen held that an amendment made by petitioner’s employer, hercules incorporated, to its pension plan’s lump-sum option did not violate the anti-cutback rule of § 411(d)(6). the amendment was made in 2001 during the gust amendment period and permitted the plan sponsor to use the higher 30-year treasury bond discount rate permitted under § 417(e)(3)(a) in computing the lump sum, as opposed to the lower pbgc rate that was required by that code provision prior to its amendment by the uruguay round agreements act of 1994, pub. l. 103-465. a. affirmed, 456 f.3d 320 (3d cir. 7/27/06). the hercules plan was amended before the expiration of the deadline, as extended by the commissioner, for making such amendments. 14. t.d. 9280, section 411(d)(6) protected benefits, 71 f.r. 45379 (8/9/06). these final regulations provide guidance in the interaction between the § 411(d)(6) anti-cutback rules and the § 411(a) nonforfeitability requirements. under these regulations, plan amendments that change the plan’s vesting computation period do not violate § 411(d)(6) 2007] recent developments in federal income taxation 465 – even though amendments affecting vesting, accrued benefits, or protected benefits do violate that provision. c. nonqualified deferred compensation, section 83, and stock options 1. section 409a adds a new layer of rules for nonqualified deferred compensation. section 885 of the jobs act of 2004 adds new § 409a, which modifies the taxation of nonqualified deferred compensation plans for amounts deferred after 2004. section 409a has changed the tax law governing nonqualified deferred compensation by making it more difficult to successfully avoid current inclusion in gross income of unfunded deferred compensation. nevertheless, § 409a has not completely supplanted prior law. the fundamental principles of prior law continue in force but have been modified in certain respects. a. section 409a guidance provides transition rules and excludes stock appreciation rights from the purview of that section. notice 2005-1, 2005-1 c.b. 274 (12/20/04), modified by notice 2006-100, 2006-51 i.r.b. 1109 (12/18/06). these notices provide guidance in q&a form with respect to the application of § 409a. b. proposed regulations incorporate much of the guidance in notice 2005-1. reg-158080-04, application of section 409a to nonqualified deferred compensation plans, 70 f.r. 57930 (10/4/05). these proposed regulations incorporate much of the guidance provided in notice 2005-1, as well as “substantial additional guidance.” they identify the plans and arrangements covered by § 409a and describe the requirements for deferral elections and the permissible timing for deferred compensation payments. they also extend the deadline for “documentary compliance” to 12/31/06, but 1/1/05 remains as the effective date for statutory compliance (although there are transition rules applicable for 2005). c. irs allows almost two years to bring offshore rabbi trust assets home. notice 2006-33, 2006-15 i.r.b. 754 (3/21/06). this notice provides transition relief with respect to the application of § 409a(b) to provide that nonqualified plan assets remaining in offshore trusts on 3/21/06 will not trigger income inclusion if the plan conforms with the requirements of § 409a(b) by 12/31/07. 466 florida tax review [vol. 8:si d. transition relief extended for nqdc under § 409a. notice 2006-79, 2006-43 i.r.b. 763 (10/5/06). although the irs expects that the proposed regulations will become final by the end of 2006, the proposed effective date of 1/1/07 for the final § 409a regulations is extended to 1/1/08. additional transition relief is provided through 12/31/07. e. interim guidance on withholding and reporting requirements for 2005 and 2006. notice 2006-100, 2006-51 i.r.b. 1109 (11/30/06). interim guidance to employers and payers on their wage withholding requirements for calendar years 2005 and 2006 with respect to compensation and amounts includible in gross income under § 409a, as well as guidance to service providers on their income tax reporting and payment requirements for amounts includible in gross income under § 409a for those years. 2. underfunded plan restricts nqdc for certain top employees. pension protection act § 116 adds new code § 409a(b)(3) to provide that any assets set aside in a nonqualified deferred compensation arrangement for top employees [those covered by code § 162(m)(3) or subject to § 16(a) of the securities exchange act of 1934] will be currently taxable to them if the transfer is made during any period that the employer’s defined benefit pension plan is in a so-called “at-risk status.” 3. stock options are not exercised when the service recipient provides nonrecourse financing because such exercise is merely the continuation of the option, but they are exercised when a third-party lender provides financing on a nonrecourse basis. palahnuk v. united states, 70 fed. cl. 87 (2/28/06), aff’d 475 f.3d 1380 (fed. cir. 2/12/07). the purchase of employer’s stock pursuant to a nonstatutory stock option using funds obtained through borrowing on a margin account with a third party lender, with the loan secured by the purchased stock, constituted a completed transfer for purposes of § 83; the arrangement was not in substance a continuing option under reg. §§ 1.83-3(a)(2) and 1.83-1(a)(7), ex. (2), because the benefits of ownership and risk of decline in value had been transferred to taxpayer. a. facq v. commissioner, t.c. memo. 2006111 (5/23/06). this case reaches the same result under virtually identical facts. b. ninth circuit tells taxpayer, “that’s tough.” united states v. tuff, 469 f.3d 1249 (9th cir. 12/4/06), aff’g 359 f. supp. 2d 1129 (w.d. wash. 2/4/05). in this case compensatory stock was 2007] recent developments in federal income taxation 467 transferred and vested for purposes of § 83 when the option was exercised with funds provided as margin debt by a third party brokerage firm. these stock purchases do not qualify for the reg. § 1.83-3(a)(2) exception for treating a stock option exercised with a nonrecourse note as in substance the grant of an option. 4. rev. proc. 2006-31, 2006-27 i.r.b. 32 (6/13/06). this revenue procedure provides the procedures to request consent to the revocation of a § 83(b) election. reg. § 1.83-2(f) permits a § 83(b) election to be revoked only with the consent of the commissioner. consent will be granted only where the election was made under a mistake of fact as to the underlying transaction. valuation mistakes, a decline in the property’s value, and failure to satisfy conditions for the property vesting are not considered mistakes of fact. the failure of a service provider to understand the substantial risk of forfeiture associated with the transferred property or to understand the tax consequences of making a § 83(b) election is not a mistake of fact. 5. remember when “inappropriate dating” was just a reference to wayne hays and elizabeth ray, gary hart and donna rice, bill clinton and monica lewinsky, gary condit and chandra levy, or barney frank and steve gobie? backdated stock options give rise to tax problems, but “innocent employees” may have their § 409a taxes paid by their employer. announcement 2007-18, 20079 i.r.b. 625 (2/8/07). this announcement institutes a compliance resolution program that permits employers to pay the additional § 409a taxes due to the exercise in 2006 of discounted stock options and stock appreciation rights for employees who are not corporate insiders. this is because the backdated stock options and stock appreciation rights were “in the money” when issued, and are, therefore, not excluded from § 409a by the regulations thereunder. of course, these employer payments will be additional wages in the year in which they are made. • this program offers only administrative convenience, and does not result in any benefit to the taxpayers involved. d. individual retirement accounts 1. mr. gotbucks will be able to convert his traditional ira to a roth after 2009. tipra § 512 amends § 408a(c) to remove the $100,000 modified adjusted gross income limitation for the conversion of a traditional ira to a roth ira, effective for taxable years 468 florida tax review [vol. 8:si beginning after 2009. for conversions made in 2010, at the election of the taxpayer, the amount required to be included in gross income will not be taxed in 2010 but will be taxed ratably in 2011 and 2012. 2. the hero act adds new code § 219(f)(7) to allow members of the armed forces serving in a combat zone to make contributions to their individual retirement plans even if the compensation on which such contribution is based is excluded from gross income. the provision is retroactive to 2004. 3. middle-aged geriatrics can make direct contributions from their iras to charities, and thus avoid deduction reductions under § 68. pension protection act, § 1201, adds new code § 408(d)(8) to permit tax-free distributions up to $100,000 directly to charities that are publicly supported under § 509(a)(1) and (2) [but not § 509(a)(3)] from iras owned by individuals over 70½ years of age. this provision has the effect of negating the erosion of charitable contribution deductions under § 68; these direct contributions will also be counted toward the minimum distribution requirements. this provision will be effective only for 2006 and 2007. a. announcement 2006-93, 2006-48 i.r.b. 1017 (11/7/06). this announcement provides procedures that § 501(c)(3) tax-exempt organizations may use to request a change in their public charity classification in light of the pension protection act. these procedures would permit middle-aged geriatrics to use new code § 408(d)(8) to permit tax-free distributions up to $100,000 directly to charities that are publicly supported under § 509(a)(1) and (2) [but not § 509(a)(3)] from iras owned by individuals over 70½ years of age. 4. gee v. commissioner, 127 t.c. 1 (7/24/06). an early distribution from the ira into which taxpayer’s deceased spouse’s ira was rolled over was a premature distribution subject to the 10% penalty tax under § 72(t) because the amount received from the deceased spouse’s ira lost its character as a distribution made to a beneficiary upon a decedent's death when it was transferred to taxpayer’s separately owned ira, and thus was not exempt from the 10% penalty tax under § 72(t)(2)(a)(ii). 2007] recent developments in federal income taxation 469 v. personal income and deductions a. rates 1. tipra § 101 extends through 12/31/10 the 15 percent rates for capital gains and dividends which had been scheduled to expire in 2008. 2. tipra § 301 amends § 55(d)(1) to extend the increased amt exemption amount for individuals for the 2006 year. a. tipra § 302 amends § 26(a)(2) to extend the use of certain nonrefundable personal credits through the 2006 year. 3. tipra § 510 amends § 1(g)(2)(a) to increase the age below which the kiddie tax is applicable from 14 to 18, effective for years beginning after 2005. b. miscellaneous income 1. who threw the overalls in mrs. murphy’s chowder? compensation for a personal injury that relates to something that could have been enjoyed tax-free is not income under the sixteenth amendment. murphy v. irs, 460 f.3d 79 (d.c. cir. 8/22/06), vacated, 99 a.f.t.r.2d 2007-396 (12/22/06). taxpayer received environmental whistleblower damages of $70,000 from the new york national air guard in 2000. the damages were awarded “for mental pain and anguish” and “for injury to professional reputation.” the court (judge ginsburg) held that § 104(a)(2), as amended in 1996 to exclude non-physical personal injuries from the exemption, was unconstitutional because “compensation for a nonphysical personal injury is not income under the sixteenth amendment if, as here, it is unrelated to lost wages or earnings.” judge ginsburg’s rationale was based upon the consideration that the award of compensatory damages was a substitute for a “normally untaxed” personal quality, good or asset, citing o’gilvie v. united states, 519 u.s. 79 (1996) (punitive damages were taxable pre-1996 act because they were not a substitute for a normally untaxed benefit), and raytheon prod. corp. v. commissioner, 144 f.2d 110 (1st cir. 1944) (“in lieu of what were the damages awarded?”). judge ginsburg looked to the commonly understood meaning of the term “incomes” at the time of the adoption of the sixteenth amendment, and found that the term did not include damages for nonphysical personal injuries that were unrelated to lost wages or earning capacity. 470 florida tax review [vol. 8:si • the issue is whether there was a pre§ 104(a)(2) common law exclusion that survived the codification in 1918 and the amendments in 1996. • the court rejected taxpayer’s argument that her award was for “bruxism” which she argued was a physical injury or physical sickness. • the court further dismissed the irs as a defendant, holding that only the co-defendant united states was a proper defendant. • the government moved for rehearing en banc. in response, the panel vacated its opinion. • this decision temporarily threw the treatment of compensatory damages for nonphysical personal injuries into a state of chaos when the court held the 1996 amendment to § 104(a)(2) requiring damages received for nonphysical personal injuries includable in gross income to be unconstitutional. the court found that “the damages were awarded to make murphy emotionally and reputationally ‘whole’ and not to compensate her for lost wages or taxable earnings of any kind. the emotional well-being and good reputation she enjoyed before they were diminished by her former employer were not taxable as income.” from this starting point, the court reasoned that because the damages were received in “‘in lieu of” something ‘normally untaxed’ ... her compensation is not income under the sixteenth amendment; it is neither a ‘gain’ nor an ‘accession[ ] to wealth.’” the court found further support for its holding by looking to what it determined to have been “the commonly understood meaning of the term [income] which must have been in the minds of the people when they adopted the sixteenth amendment.” the court concluded that “the framers of the sixteenth amendment would not have understood compensation for a personal injury — including a nonphysical injury — to be income.” this conclusion was based largely on two 1918 rulings, one by the attorney general [31 op. att’y gen. 304 (1918)] and one by the treasury department [t.d. 2747, 20 treas. dec. int. rev. 457 (1918)], both of which predated the enactment of the statutory predecessor of § 104(a)(2), which concluded that payments received as compensation for personal injuries (without specifying the nature of the injury) were “‘capital’ as distinguished from income’” (in the attorney general’s opinion) and “doubtful whether ... required to be included in gross income” (in the treasury department ruling). the court considered its conclusion to be bolstered by a 1922 ruling of the bureau of internal revenue [sol. op. 132, i-1 cb 92 (alienation of affection; defamation of personal character)] that damages received for a nonphysical tort were income, noting that the ruling “regarded such compensation not merely as excludable under the irc, but more fundamentally as not being income at all.” 2007] recent developments in federal income taxation 471 • the court’s reasoning in the opinion is tenuous, at best, and it is unlikely that other circuits or the tax court will follow this opinion. there are two salient weaknesses, among others, in the court’s reasoning. first, it is very difficult to see any connection between the 1918 administrative pronouncements and the intent of those who adopted the sixteenth amendment five years earlier. second, the court ignores that in 1921, after the enactment of the statutory predecessor of § 104(a)(2), but before the 1922 ruling cited by the court, the bureau of internal revenue changed its position and ruled that damages for nonphysical personal injuries were includable in gross income because they are not specifically excluded by the statute [sol. mem. 957, 1 cb 65 (libel); sol. mem. 1384, 2 cb 71 (alienation of affection)]. in 1922 the bureau reversed its position solely because of the holding in eisner v. macomber, 252 u.s. 434 (1920), which at that time was read to limit the constitutional meaning of “income” to “gain derived form capital, from labor, or from both combined.” this narrow crabbed view of the constitutional meaning of income has long since been discredited by subsequent supreme court cases, allowing virtually all accessions to financial wealth from any source, and in any form, to be includable in gross income under the statute. after eisner v. macomber was shorn of its vitality, the irs again took the position that in many cases damages for nonphysical personal injuries were includable in gross income, but prior to 1996 the courts generally held such damages were excluded under the statutory provisions of § 104(a)(2) and its predecessors, not because the damages were not “income” within the meaning of the sixteenth amendment. • in other words, the reasoning of the court of appeals for the district of columbia in murphy was grounded in the supreme court’s view of the constitutional meaning of “income” under the sixteenth amendment in 1920. congress, on the other hand, enacted the 1996 statutory amendments taxing all damages for nonphysical personal injury in light of subsequent supreme court’s jurisprudence regarding the constitutional meaning of “income” under the sixteenth amendment that effectively relegated the narrow eisner v. macomber view to the dustbin of constitutional law history. depending on the court’s opinion following rehearing, the flawed reasoning of the original decision in murphy similarly should be relegated to the dustbin of judicial history. 2. california registered domestic partners may not use poe v. seaborn to split income between themselves because that case applies only to a property status arrangement that is “an incident of matrimony.” ilm 200608038, 2006 tnt 39-13 (2/24/06). a registered domestic partner under the california domestic partner rights and responsibilities act of 2003 is required to include in gross income all of his 472 florida tax review [vol. 8:si earned income, and not one-half of the combined income earned by both registered domestic partners. the legal memorandum relies on commissioner v. harmon, 323 u.s. 44, 48 (1944), which in holding poe v. seaborn inapplicable to arrangements under an oklahoma statute allowing married couples to elect community property status, stated, “the important fact is that the community system of oklahoma is not a system, dictated by state policy, as an incident of matrimony.” 3. congress serves up some alka-seltzer to those caught by the amt in the dot com bubble. the tax relief and health care act of 2006 § 402 added new code § 53(c) to make the amt credits for prior years’ amt liability into a refundable credit [as opposed to a credit limited to the difference between the regular tax liability and the tentative amt liability for the year]. taxpayers who have unused amt credits – including those arising from incentive stock option grants – will be allowed to claim a refundable credit in the amount of the greater of (1) 20 percent of his long-term unused amt credits, or (2) the lesser of (a) $5,000 or (b) the amount of the taxpayer’s long-term unused minimum credit for the year. this latter is the portion attributable to tax years before the third tax year immediately preceding the tax year in question. the relief phases out for higher income taxpayers in the same manner as the phase-out of personal exemptions when agi exceeds $150,000. these provisions are effective only for years 2007-2012. c. profit-seeking individual deductions 1. you can rely on eeny, on meeny and on miny – but you cannot rely on moe. a tax lawyer may not rely on his accountants to avoid penalties. kovacevich v. commissioner, 177 fed. appx. 561 (9th cir. 4/12/06). the amount paid by an attorney to settle a lawsuit brought against him by a former client was an unreimbursed employee business expense because the attorney was a statutory employee of his wholly owned legal professional corporation through which he practiced. therefore, the amount paid was deductible only as a miscellaneous itemized deduction, subject to the various applicable limitations. • a § 6662 penalty was imposed despite taxpayer’s claim that he relied on his outside accountants, moe & associates, because he had a “reputation as a competent tax attorney” with “self-avowed expertise in the field of tax law.” 2007] recent developments in federal income taxation 473 d. hobby losses and § 280a home office and vacation homes there were no significant developments regarding this topic during 2006. e. deductions and credits for personal expenses 1. when will trust investment advisory fees get up off the § 67 floor? rudkin testamentary trust v. commissioner, 124 t.c. 304 (6/27/05) (reviewed, 18-0), aff’d, 467 f.3d 149 (2d cir. 10/18/06) (2-0). the tax court (judge wherry) held that amounts paid for investment management advice by trusts set up by a family involved in the founding of the pepperidge farm food products company (which was sold to campbell soup company in the 1960s) are not subject to the § 67(e) exception to the § 67(a) floor of 2 percent of agi (which limits the deductibility of employee business expenses and miscellaneous itemized deductions to amounts exceeding that floor). in reaching this result, the court determined that these expenses did not qualify for the exception in § 67(e)(1) under which costs paid or incurred in connection with the administration of a trust that wouldn’t have been incurred if the property weren’t held in the trust are allowed as deductions in arriving at adjusted gross income. the tax court explained that the statutory text of § 67(e)(1) creates an exception allowing for deduction of trust expenditures without regard to the 2% floor where two requirements are satisfied: 1) the costs are paid or incurred in connection with administration of the trust; and 2) the costs would not have been incurred if the property were not held in trust. • in 1992, the tax court held that a trust’s investment advice costs were subject to the 2% floor. (o’neill trust v. commissioner, 98 t.c. 227 (1992)). however, the sixth circuit reversed the tax court in o’neill trust and held that investment counseling fees paid by the trust to aid the trustees in discharging their fiduciary duty to the trust beneficiaries were not subject to the 2% floor under the § 67(e)(1) exception. (994 f.2d 302 (6th cir. 1993)). subsequently, the sixth circuit approach was rejected by the irs (nonacq, 1994-2 c.b. 1); the federal circuit (mellon bank, n.a. v. united states, 265 f.3d 1275 (fed. cir. 2001)); and the fourth circuit (scott v. united states, 328 f.3d 132 (4th cir. 2003)). in reaching their decisions, the federal and fourth circuits emphasized the importance of not interpreting the statute so as to render superfluous any portion of it. they said that if courts were to hold that a trust’s investment-advice fees were fully deductible, the second requirement of § 67(e)(1) would have been rendered meaningless. 474 florida tax review [vol. 8:si • the sixth circuit’s rationale was stated as follows: the tax court reasoned that “individual investors routinely incur costs for investment advice as an integral part of their investment activities.” nevertheless, they are not required to consult advisors and suffer no penalties or potential liability if they act negligently for themselves. therefore, fiduciaries uniquely occupy a position of trust for others and have an obligation to the beneficiaries to exercise proper skill and care with the assets of the trust. (994 f.2d at 304) a. the second circuit affirms and gives a third interpretation of “an unambiguous statute.” 467 f.3d 149 (2d cir. 10/18/06) (2-0). judge sotomayer held that § 67(e) was unambiguous and permitted a full deduction only for those types of trust expenses that an individual could not possibly incur. 2. notice 2006-86, 2006-41 i.r.b. 680 (9/20/06). this notice provides interim guidance to clarify the rule under § 152(c)(4) [as amended by the working families tax relief act of 2004] for determining which taxpayer may claim a qualifying child when two or more taxpayers claim the same child. the tie-breaking rule is to apply to the following provisions as a group: (1) head of household filing status, (2) the § 21 child and dependent care credit, (3) the § 24 child tax credit, (4) the § 32 earned income credit, (5) the § 129 exclusion for dependent care assistance, and (6) the § 151 dependency deduction. 3. the tax relief and health care act of 2006, § 101, extends the above-the-line deduction for higher education expenses under code § 222 to 2006 and 2007. 4. the tax relief and health care act of 2006, § 102, extends the code § 164(b)(5) election to deduct state and local general sales taxes [instead of state income taxes] to 2006 and 2007. 5. the tax relief and health care act of 2006, § 302, adds new code § 106(e) to permit one-time transfers to health savings accounts from health flexible spending arrangements and health reimbursement arrangements. 6. the tax relief and health care act of 2006, § 302, adds new code § 4980g(9)(d) to provide for an exception to the current requirement that employer contributions to hsas be “comparable” 2007] recent developments in federal income taxation 475 for all employees by allowing employers to provide additional contributions to lower-paid workers. 7. the tax relief and health care act of 2006, § 303, amends code § 223(b)(2) to repeal the annual deductible limitation on hsa contributions and to allow contributions of $2,700 ($5,454 family) even if the deductible is less than those amounts. 8. the tax relief and health care act of 2006 § 307 adds new code § 408(d)(9) to permit a once-in-a-lifetime, tax-free transfer from an ira to fund the taxpayer’s hsa deductible contribution amount. this would allow those who cannot afford to fully fund an hsa with direct contributions to move ira money to a more tax-advantaged position. 9. the tax relief and health care act of 2006, § 419, adds new code § 163(h)(3)(e) to establish a new itemized deduction for the cost of mortgage insurance on a qualified personal residence. the deduction is phased-out ratably by 10% for each $1,000 by which the taxpayer’s agi exceeds $100,000. thus, the deduction is unavailable for a taxpayer with an agi in excess of $110,000. the provision is effective for amounts paid or accrued (and applicable to the period) after 12/31/06 and before 1/1/08 for mortgage contracts issued after 12/31/06. f. education 1. section 529 plan treatment made permanent. the pension protection act, § 1304, provides that the changes contained in the 2001 act [egtrra] with respect to code § 529 qualified tuition programs will be permanent, i.e., will not sunset in 2011. these include the provision that makes qualified withdrawals from qualified tuition accounts exempt from income tax, and the provisions that permit rollovers from one beneficiary to another [including first cousins]. vi. corporations a. entity and formation 1. debt vs. equity discussed at length. indmar products co. v. commissioner, 444 f.3d 771 (6th cir. 4/14/06) (2-1), rev’g t.c. memo. 2005-32 (2/23/05). in a case disallowing interest deductions for 476 florida tax review [vol. 8:si the years 1998-2000, judge mckeague held that advances made beginning in the 1970s to a company by its shareholders more closely resembled debt than equity because of the fixed 10 percent interest rate and regular monthly interest payments, as well as the execution of demand promissory notes beginning in 1993. the opinion contains a lengthy discussion of the debt vs. equity issue. • in his concurring opinion judge rogers, in drawing the distinction between issues of fact and issues of law, stated: for instance, assume an ordinance taxes the keeping of pet dogs. jo is assessed a tax for keeping fido, and jo appeals. the question “is fido a dog?” may be factual or it may be legal. if jo claims only that fido is a really a cat, then the issue is factual. no one argues that the legal definition of dog includes cats; the only dispute is regarding the actual nature of fido. on the other hand, if both parties agree that fido is a prairie dog, the question “is fido a dog?” is a purely legal one. there is no dispute about the nature of fido; the only dispute involves what the legal meaning of “dog” is. of course if the city says fido is a schnauzer while jo says that fido is actually a prairie dog, the question “is fido a dog” is mixed if both legal and factual aspects of the seemingly single question are in dispute. • judge moore dissented on the ground that the tax court’s findings were not clearly erroneous. b. distributions and redemptions 1. basis can live long after the stock is “redeemed.” who’d a thunk it? reg-150313-01, redemptions taxable as dividends, 67 f.r. 64331 (10/18/02). the irs has proposed replacing the “proper adjustment” to the basis of remaining stock rule of reg. § 1.302-2(c), which takes into account the unused basis of redeemed stock when the redemption is treated as a § 301 distribution. prop. reg. § 1.302-5 would provide that the redeemed shareholder [who is taxed under § 301] would retain the basis of the redeemed stock as a basis item separate from any remaining shares, whether or not the shareholder continues to actually own the stock of the redeeming corporation, and take it into account as a loss deduction at some future date. the loss subsequently can be claimed under either the “final inclusion date” rule or the “accelerated loss inclusion date” rule. the “final inclusion date” rule allows the loss deduction on the date on which the redeemed shareholder would have qualified under § 302(b)(1), (2) or (3) if the facts on that date had been the facts immediately after the redemption, or 2007] recent developments in federal income taxation 477 alternatively, when an individual shareholder dies or a corporate shareholder is liquidated in a transaction to which § 331 applies. the “accelerated loss inclusion date” rule allows the redeemed shareholder to claim a loss attributable to the unutilized basis when the shareholder subsequently recognizes a gain on stock of the redeeming corporation, but the loss may be claimed only to the extent of the gain recognized. because the loss attributable to the basis of the redeemed stock is treated as recognized on the redemption date, the attributes (e.g., character and source) of the loss are fixed on the redemption date, even if such loss is not taken into account until after the redemption date. these rules apply to § 304(a)(1) transactions taxed under § 301 by treating the unutilized basis in the redeemed corporation stock as basis in the stock of the acquiring corporation. special rules apply to partnerships, in consolidated returns [prop. reg. § 1.150219(b)(5)], and to foreign corporations. these rules do not apply to redemptions of § 306 stock, but they do generally apply even in the case of a corporation wholly owned by a single shareholder, whether a corporation or an individual. • these regulations are a reaction, in part, to basis shifting transactions, such as that described in notice 2001-45, 2001-2 c.b. 129 [the so-called bank of america transaction]. • it has been noted that if nuclear disaster ever overcomes the earth, only the cockroach and basis would survive. a. they ran the proposed regulations up the flagpole, but nobody saluted. back to the drawing board “for further study.” announcement 2006-30, 2006-19 i.r.b. 879 (5/8/06). the irs announced the withdrawal on 4/19/06 of the 2002 proposed regulations on the treatment of the basis of stock redeemed or treated as redeemed in distributions governed by § 301. c. liquidations there were no significant developments regarding this topic during 2006. d. s corporations 1. pension protection act, § 1203, amends code § 1367(a)(2) to provide that on the charitable contribution of appreciated property by an s corporation, the reduction in shareholder basis in the s 478 florida tax review [vol. 8:si corporation stock is limited to the shareholder’s pro rata share of the basis of the contributed property. 2. garwood irrigation co. v. commissioner, 126 t.c. 223 (5/1/06). an s corporation that is due a refund in excess of $10,000 with respect to a § 1374 built-in gains tax is entitled to interest at two percentage points above the federal short-term rate. interest is not limited to the lower corporate rate of one-half percent above the afr because § 6621 applies only to c corporations, not to s corporations. however, because taxpayer was a corporation, the noncorporate rate of three percent above the afr did not apply – even though taxpayer was an s corporation. 3. t.d. 9302, prohibited allocations of securities in an s corporation, 71 f.r. 76134 (12/20/06). these final regulations provide guidance concerning requirements under § 409(p) for esops holding stock of s corporations. they provide that if there is a prohibited allocation during a nonallocation year, the esop fails to satisfy the § 4975(e)(7) requirement and is no longer an esop; as a result of this, the plan also would fail to satisfy the § 401(a) qualification rules and the s corporation would face a § 4979a excise tax. e. reorganizations 1. t.d. 9242, statutory mergers and consolidations, 71 f.r. 4259 (1/26/06). these final regulations adopt proposed regulations (reg-117969-00) issued in 2005 based upon temporary regulations (t.d. 9038) issued in 2003. the final regulations replace the requirement in reg. § 1.368-2(b)(1) that a merger or consolidation under § 368(a)(1)(a) be effected under the laws of a state, etc. with more general language that qualifies transactions “effected pursuant to the statute or statutes necessary to effect the merger or consolidation.” mergers involving disregarded entities qualify if all the assets and liabilities of the target are transferred to the acquirer and the target ceases to exist. 2. all cash (d) reorgs are now in the regs. t.d. 9303, 71 f.r. 75879 (12/19/2006). temp. reg. § 1.368-2t provides that the distribution requirement under §§ 368(a)(1)(d) and 354(b)(1)(b) is deemed to have been satisfied despite the fact that no stock and/or securities are actually issued in a transaction otherwise described in section 368(a)(1)(d) if the same person or persons own, directly or indirectly, own all of the stock of the transferor and transferee corporations in identical proportions. to a limited extent, the attribution rules in § 318 are invoked to determine whether the same person or persons own, directly or indirectly, own all of the stock of the transferor and transferee. an individual and all members of 2007] recent developments in federal income taxation 479 his family that have a relationship described in § 318(a)(1) are treated as one individual; and stock owned by a corporation is attributed proportionally to the corporation’s shareholder without regard to the 50 percent limitation in § 318(a)(2)(c). • ownership in absolutely identical proportions is not required. a de minimis variation in shareholder identity or proportionality of ownership in the transferor and transferee corporations is disregarded. the regulations give as an example of a de minimis variation a situation in which a, b, and c each own, respectively, 34%, 33%, and 33% of the transferor’s stock and a, b, c, and d each own, respectively, 33%, 33%, 33% and 1% of the transferee’s stock. stock described in § 1504(a)(4) — nonvoting limited preferred stock (that is not convertible) — is disregarded for purposes of determining whether the same person or persons own all of the stock of the transferor and transferee corporations in identical proportions. • when a transaction qualifies as a § 368(a)(1)(d) reorganization under the regulations, a nominal share of stock of the transferee corporation will be deemed to have been issued in addition to the actual consideration. that nominal share of stock is deemed to have been distributed by the transferor corporation to its shareholders and, in appropriate circumstances, further transferred to the extent necessary to reflect the actual ownership of the transferor and transferee corporations. f. corporate divisions 1. tipra § 202 amended code § 355(b) to simplify the active trade or business test by looking at all corporations in the distributing corporation’s and the distributed subsidiary’s affiliated groups to determine if the active trade or business test is satisfied. a. the tax relief and health care act of 2006, § 410, made the tipra modification to § 355(b) permanent. g. miscellaneous corporate issues 1. sale of shares by a taxpayer to his brother in a closely held corporation claiming a net operating loss deduction resulted in a § 382 change of control that triggered the limitation on nol carryovers. garber industries holding co. inc. v. commissioner, 124 t.c. 1 (1/25/05). the tax court (judge halpern) held that the family aggregation rule of § 382(1)(3)(a)(i) applies solely from the perspective of individuals who are shareholders (as determined under the attribution rules of § 382(1)(3)(a)) of the loss corporation. thus, the sale of stock from one sibling to another that resulted in a more than 50 percent increase in stock 480 florida tax review [vol. 8:si ownership by the purchasing sibling triggered the application of § 382. the fact that each sibling and either of their parents would be viewed as a single shareholder did not result in the siblings being treated as a single shareholder where neither of their parents was a shareholder. the court recognized the possibility that the rule it announced might result in arbitrary distinctions between cases in which a parent of the siblings also was a shareholder and cases in which the parent was not a shareholder, but concluded that the announced rule was the one most compatible with the statutory language and legislative history. • one of the garber brothers (charles) had his interest in the corporation decreased from 68 percent to 19 percent and the other brother (kenneth) had his interest increased from 26 percent to 65 percent in a 1986 “d” reorganization. in 1988, kenneth sold all of his remaining shares to charles, with the result that charles’s interest in the corporation increased from 19 percent to 84 percent. the parents of charles and kenneth were both deceased, and, when living, never had any ownership interest in the corporation. • the court refused to follow taxpayers’ argument that siblings are treated as one individual under the nol aggregation rule, which provides that an individual and all members of his family described in § 318(a)(1), i.e., spouses, children, grandchildren, and parents, are treated as one individual. • judge halpern also refused to follow the commissioner’s argument that the family aggregation rule does not apply because none of the parents and grandparents of the garber brothers were alive at the beginning of the 3-year testing period immediately preceding the 1998 transaction. instead, he concluded that a third interpretation was correct, i.e., that the family aggregation rule of § 382(1)(3)(a)(i) applies from the perspective of individuals who are shareholders of the loss corporation (as determined under the attribution rules of § 382(1)(3)(a)), and that the brothers were unrelated under this perspective. judge halpern held that the family aggregation rule of § 382(1)(3)(a)(i) applies solely from the perspective of individuals who are shareholders (as determined under the attribution rules of § 382(1)(3)(a)) of the loss corporation. thus, the sale of stock from one sibling to another that resulted in a more than 50 percent increase in stock ownership by the purchasing sibling triggered the application of § 382. the fact that each sibling and either of their parents would be viewed as a single shareholder did not result in the siblings be treated as a single shareholder where neither of their parents was a shareholder. the court recognized the possibility that the rule it announced might result in arbitrary distinctions between cases in which a parent of the siblings also was a shareholder and cases in which the parent was not a shareholder, but concluded that the 2007] recent developments in federal income taxation 481 announced rule was the one most compatible with the statutory language and legislative history. a. affirmed by the fifth circuit. 435 f.3d 555 (5th cir. 1/9/06). the court of appeals held, that the tax court properly interpreted § 382 as applied to a sale of stock between two shareholder brothers when no parent or grandparent was a shareholder of the loss corporation because § 382 incorporates the limited family description from § 318, which limits the relatives of a shareholder to spouse, parents, children, and grandchildren. vii. partnerships a. formation and taxable years there were no significant developments regarding this topic during 2006. b. allocations of distributive share, partnership debt, and outside basis there were no significant developments regarding this topic during 2006. c. distributions and transactions between the partnership and partners 1. notice 2006-14, 2006-8 i.r.b. 498 (2/2/06). the irs has requested comments on how to simplify the current regulations under § 751(b) (applicable to partnership distributions treated as sales or exchanges) on how to determine a partner’s share of “hot assets” and how to treat disproportionate distributions. d. sales of partnership interests, liquidations and mergers there were no significant developments regarding this topic during 2006. e. inside basis adjustments there were no significant developments regarding this topic during 2006. 482 florida tax review [vol. 8:si f. partnership audit rules there were no significant developments regarding this topic during 2006. g. miscellaneous there were no significant developments regarding this topic during 2006. viii. tax shelters a. tax shelter cases 1. significant taxpayer victory when its summary judgment motion was granted; the contingent liability transaction was upheld despite its being a listed transaction under notice 2001-17. black & decker corp. v. united states, 340 f. supp. 2d 621 (d. md. 10/20/04, revised, 10/22/04). judge quarles held that the transaction could not be disregarded as a sham because it had economic implications for the parties to the transaction as well as to the beneficiaries of taxpayer’s health plans. • under the fourth circuit test in rice’s toyota world v. commissioner, 752 f.2d 89 (1985), “[t]o treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists.” taxpayer conceded for purposes of its motion “that tax avoidance was its sole motivation.” the court held that “[a] corporation and its transactions are objectively reasonable, despite any tax-avoidance motive, so long as the corporation engages in bona fide economically-based business transactions.” • note how judge quarles shifted the second prong of the test from “reasonable possibility of profit” to “bona fide business transaction.” • the transaction was a listed tax shelter under notice 2001-17, 2001-1 c.b. 730. • in 1998, black & decker sold three of its businesses and realized significant capital gains. that same year, black & decker created black & decker healthcare management inc. (bdhmi), to which it transferred approximately $561 million dollars, with bdhmi assuming $560 million dollars in contingent employee healthcare claims against black & decker. black & decker then sold the bdhmi stock to a third-party for $1 million dollars, and claimed a $560 million loss on the 2007] recent developments in federal income taxation 483 grounds that its basis in the bdhmi stock was $561 million dollars. the court concluded that §§ 357(c)(3) and 358(d)(2) applied and that black & decker’s basis in the bdhmi stock properly was not reduced by the amount of the contingent employee healthcare claims. it rejected the irs contention that the claims had to be deductible by the transferee (bdhmi), and, based upon the legislative history of § 357(c)(3), concluded that there was no reduction in basis because the contingent claims were liabilities that would have been deductible by the transferor shareholder had it paid the claims. a. government’s summary judgment motion had been denied earlier on a pro-taxpayer rationale. black & decker corp. v. united states, 2004-2 u.s.t.c. ¶ 50,359, 94 a.f.t.r.2d 2004-5690 (d. md. 8/3/04). the facts as stated in the opinion were as follows. in 1998, b & d sold three of its businesses. as a result of these sales, b & d generated significant capital gains. id. that same year, b & d created black & decker healthcare management inc. (“bdhmi”). b & d transferred approximately $561 million dollars to bdhmi along with $560 million dollars in contingent employee healthcare claims in exchange for newly issued stock in bdhmi. b & d sold its stock in bdhmi to an independent third-party for $1 million dollars. because b & d believed that its basis in the bdhmi stock was $561 million dollars, the value of the property it had transferred to bdhmi, b & d claimed approximately $560 million dollars in capital loss on the sale, which it reported on its 1998 federal tax return. b & d applied a portion of the capital loss to offset its capital gains from selling the three businesses, and carried back and carried forward the remaining capital loss to offset gains in prior and future tax years. (citations omitted) • the court went on to analyze and conclude that §§ 357(c)(3) and 358(d) applied so the basis of the subsidiary’s stock is not reduced by the amount of the contingent employee healthcare claims. it rejected the irs’s contention that the claims had to be deductible by the transferee [the subsidiary], and held that (based upon the 1978 legislative history to § 357(c)(3)) the only requirement is that the claims must be deductible by taxpayer [the transferor corporation]. • section 358(h), added in 2000 and amended in 2002, would preclude this result for assumptions of liability after its 10/18/99 effective date. if the basis of stock received in a § 351 transaction otherwise would exceed its fair market value, § 358(h) requires that the basis of the stock be reduced (but not below the fair market value) by the amount 484 florida tax review [vol. 8:si (determined as of the date of the exchange) of any § 357(c)(3) liability that was assumed by the corporation. for this purpose, “liability” is broadly defined to include “any fixed or contingent obligation to make payment, without regard to whether the obligation is otherwise taken into account for purposes of [the income tax].” b. black & decker in the fourth circuit: the holding that basis was not reduced by contingent deductible liabilities was affirmed, but the holding that the transaction did not lack economic substance was reversed and the case was remanded for trial. black & decker corp. v. united states, 436 f.3d 431 (4th cir. 2/2/06), aff’g denial of government’s motion for summary judgment at 2004-2 u.s.t.c. ¶ 50,359, 94 a.f.t.r.2d 2004-5690 (d. md. 8/3/04), rev’g grant of taxpayer’s motion for summary judgment at 340 f. supp. 2d 621 (d. md. 10/22/04), and remanding for trial. judge michael’s opinion held that the government motion for summary judgment was properly denied because the statute in effect at the time of the transaction permitted taxpayer to do what it did, rejecting the government’s arguments that legislative history and public policy required reversal. he stated that “we are not convinced that the language of § 357(c)(3) is so unclear as to permit us to rely on this policy argument and adopt the irs’s reading.” he concluded that the contingent liability taxpayer transferred “falls within the § 357(c)(3) exception for ‘liability the payment of which . . . would give rise to a deduction.’” • however, judge michael held that the government was entitled to a trial on the issue of whether the transaction was a sham, stating that the transaction should be scrutinized for its real economic effects, including whether there are reasonable expected profits from the transaction. he refused to follow united parcel serv. of am., inc. v. commissioner, 254 f.3d 1014, 1019 (11th cir. 2001). 2. a second taxpayer victory in a listed contingent liability transaction is reversed on appeal. coltec industries, inc. v. united states, 62 fed. cl. 716 (fed. cl. 10/29/04), vacated and remanded, 454 f.3d 1340 (fed. cir. 7/12/06). taxpayer transferred its asbestos liabilities to an asbestos case management entity [“garrison”], which was an existing shell subsidiary that had no assets, together with a related party note for $375 million and some other miscellaneous assets. it sold about 6.67 percent of the garrison stock to two banks for a total of $500,000 and reported a multimillion dollar loss that saved it over $82 million in taxes. a. court of federal claims opinion: judge susan g. braden found that this transaction satisfied all the requirements of 2007] recent developments in federal income taxation 485 existing law. judge braden rejected the concept of a court applying the economic substance doctrine to tax cases on the ground that taxpayers “must be able to rely on clear and understandable rules established by congress to ascertain their federal tax obligations.” after discussing the complexity of the economic substance doctrine, she concluded “that where a taxpayer has satisfied all statutory requirements established by congress, as coltec did in this case, the use of the ‘economic substance’ doctrine to trump ‘mere compliance with the code’ would violate the separation of powers.” • as illustrated by rev. rul. 95-74, 1995-2 c.b. 36, § 357(c)(3) applies not only to cash method accounts payable, but also to liabilities of accrual method transferors that have not yet been allowed as a deduction under the economic performance rules of § 461(h) or because the liability is too contingent. as a result, § 358(d)(2) applies and the transferor shareholder’s basis in the stock received in the exchange is not reduced by the liability. aggressive tax planners took advantage of this pattern of the interaction of the various statutory provisions to create artificial double deductions. here, in a transaction subject to § 351 one corporation, garlock, contributed to another corporation, garrison, cash, a $375 million promissory note to garlock from a related corporation, and certain other property. in connection with the transfer, garrison assumed $371.2 million of garlock’s contingent liabilities for asbestos product liability damage claims (neither of the events necessary to establish the fact of the liability had occurred, i.e., the filing of a lawsuit asserting a claim and an adjudication of liability). shortly thereafter, garlock sold a significant number of the shares of garrison and claimed approximately $370 million of losses, having determined the basis of the garrison stock with reference to an exchanged basis under § 358 that was not reduced to reflect the assumption of the contingent asbestos liabilities. since the liabilities were contingent and the liabilities would have been deductible by the transferor upon payment, the court held that the liabilities were within those described in §§ 357(c)(3)(a) and 358(d)(2), and thus neither § 357(c)(1), requiring the recognition of gain to the extent that the amount of liabilities exceed the basis of the contributed assets, nor § 358(d)(1), requiring the reduction of the transferred basis assigned to the stock, applied. therefore, garlock’s basis in garrison properly was the exchanged based of the transferred property, unreduced by the amount of liabilities assumed by garrison, and the loss was allowed. b. federal circuit opinion: taxpayer is hung out to dry by the federal circuit on the economic substance issue. the court (judge dyk) first found that the loss was allowable under the literal terms of the statute as it existed at the time of the transaction because (1) the liabilities fell within § 357(c)(3), (2) § 357(b)(1) was not relevant, and (3) § 358(d)(2) excluded the liabilities from “money received,” so that 486 florida tax review [vol. 8:si the basis of the company’s stock was increased by the note and was not reduced by the assumed contingent asbestos liabilities. however, judge dyk further found that the transaction that gave rise to the alleged tax benefit, which he narrowed down to say that the transfer of the $375 million note to garrison in exchange for the assumption of the contingent asbestos liabilities, had no meaningful economic purpose except the tax benefits to coltec and, therefore, “must be ignored for tax purposes.” • in finding lack of economic substance, judge dyk adopted an objective view of the transaction, in which he found that the transfer of the asbestos liabilities to a subsidiary would not affect coltec’s obligation to pay them and had no effect on third-party asbestos claimants. he also held that the fourth circuit’s disjunctive test for application of the economic substance doctrine, that it must both have the subjective motivation of tax avoidance and lack the objective motivation of business purpose [i.e., a reasonable possibility of pre-tax profit], was inapplicable and that the law of the federal circuit was changed to require that taxpayer meet both prongs to pass the economic substance test. two of the cases upon which judge dyk relied were frank lyon co. v. united states, 435 u.s. 561 (1978), and ups v. commissioner, 254 f.3d 1014 (11th cir. 2001). 3. the second circuit reverses a taxpayer victory in a self-liquidating partnership note transaction, in which the lion’s share of taxable income was allocated to tax-indifferent parties, on the ground that the tax-indifferent dutch banks were not really equity partners. tifd iii-e, inc. v. united states, 342 f. supp. 2d 94 (d. conn. 11/1/04), rev’d, 459 f.3d 220 (2d cir. 8/3/06), taxpayer petition for rehearing, 2006 tnt 188-17 (9/18/06) (“castle harbour”). a. district court opinion: the court found that the creation of castle harbour, a nevada llc, by general electric capital corp. subsidiaries was not designed solely to avoid taxes, but to spread the risk of their investment in fully-depreciated commercial airplanes used in their leasing operations. gecc subsidiaries put the following assets into castle harbor: $530 million worth of fully-depreciated aircraft subject to a $258 million non-recourse debt, $22 million of rents receivable, $296 million of cash, and all the stock of another gecc subsidiary that had a value of $0. two tax-indifferent dutch banks invested $117.5 million in castle harbour. under the llc agreement, the tax-indifferent partner was allocated 98 percent of the book income and 98 percent of the tax income. • the book income was net of depreciation and the tax income did not take depreciation into account [because the airplanes were fully depreciated]. depreciation deductions for 2007] recent developments in federal income taxation 487 book purposes were on the order of 60 percent of the rental income for any given year. • scheduled distributions in excess of book income would have resulted in the liquidation of the investment of the dutch banks in eight years, with the dutch banks receiving a return of approximately nine percent, with some “economically substantial” upside and some downside risk. castle harbour was terminated after five years because of a threatened change in u.s. tax law, but during that period about $310 million of income was shifted to the dutch banks for a tax saving to the gecc subsidiaries of about $62 million. • query whether § 704(b) was properly applied to this transaction? • this appears to be a lease-stripping transaction in which the income from the lease was assigned to foreign entities while the benefits of ownership were left with a domestic entity. • the court (judge underhill) held that satisfaction of the mechanical rules of the regulations under § 704(b) transcended both an intent to avoid tax and the avoidance of significant tax through agreed upon partnership allocations. in this partnership, 2 percent of both book and taxable income was allocated to gecc, a united states partner, and 98 percent of both book and taxable income was allocated to partners who were dutch banks. the dutch banks were foreign partners who were not liable for united states taxes and thus were indifferent to the u.s. tax consequences of their participation in the partnership. because the partnership had very large book depreciation deductions and no tax depreciation, most of the partnership’s taxable operating income, which was substantially in excess of book taxable income, was allocated to the tax-indifferent foreign partners, even though a large portion of the cash receipts reflected in that income was devoted to repaying the principal of loans secured by property that gecc had contributed to the partnership. the overall partnership transaction saved gecc approximately $62 million in income taxes, and the court found that “it appears likely that one of gecc’s principal motivations in entering into this transaction – though certainly not its only motivation – was to avoid that substantial tax burden.” the court understood the effects of the allocations and concluded that “by allocating 98% of the income from fully tax-depreciated aircraft to the dutch banks, gecc avoided an enormous tax burden, while shifting very little book income. put another way, by allocating income less depreciation to tax-neutral parties, gecc was able to “re-depreciate” the assets for tax purposes. the tax-neutrals absorbed the tax consequences of all the income allocated to them, but actually received only the income in excess of book depreciation.” nevertheless, the court upheld the allocations. “the tax benefits of the *** transaction were the result of the allocation of large 488 florida tax review [vol. 8:si amounts of book income to a tax-neutral entity, offset by a large depreciation expense, with a corresponding allocation of a large amount of taxable income, but no corresponding allocation of depreciation deductions. this resulted in an enormous tax savings, but the simple allocation of a large percentage of income violates no rule. the government does not – and cannot – dispute that partners may allocate their partnership’s income as they choose. neither does the government dispute that the taxable income allocated to the dutch banks could not be offset by the allocation of non-existent depreciation deductions to the banks. and *** the bare allocation of a large interest in income does not violate the overall tax effect rule.” • judge underhill concluded: the government is understandably concerned that the castle harbour transaction deprived the public fisc of some $62 million in tax revenue. moreover, it appears likely that one of gecc’s principal motivations in entering into this transaction though certainly not its only motivation was to avoid that substantial tax burden. nevertheless, the castle harbour transaction was an economically real transaction, undertaken, at least in part, for a non-tax business purpose; the transaction resulted in the creation of a true partnership with all participants holding valid partnership interests; and the income was allocated among the partners in accordance with the internal revenue code and treasury regulations. in short, the transaction, though it sheltered a great deal of income from taxes, was legally permissible. under such circumstances, the i.r.s. should address its concerns to those who write the tax laws. b. second circuit opinion: the second circuit, in an opinion by judge leval, held that the dutch banks were not partners because their risks and rewards were closer to those of creditors than partners. he used the facts-and-circumstances test of commissioner v. culbertson, 337 u.s. 733 (1949), to determine whether the banks’ interest was more in the nature of debt or equity, and found that their interest was overwhelmingly in the nature of a secured lender’s interest, “which would neither be harmed by poor performance of the partnership nor significantly enhanced by extraordinary profits.” • in acm partnership v. commissioner, t.c. memo. 1997-115, aff’d, 157 f.3d 231 (3d cir. 1998), cert. denied, 526 u.s. 1017 (1999). [colgate], judge laro wrote a 100+ page analysis to find that there was no economic substance to the arrangement. the next contingent payment installment sale case in the tax court was asa investerings partnership v. commissioner, 118 t.c. 423 (2002), aff’d, 201 f.3d 505 (d.c. cir. 2000), cert. denied, 531 u.s. 871 (2000) [allied signal], 2007] recent developments in federal income taxation 489 in which judge foley wrote a much shorter opinion finding that the dutch bank was not a partner; the d.c. circuit affirmed on judge foley’s holding that the dutch bank was not a partner. the irs began to pick up this lack-ofpartnership argument and began to use it on examinations. later, the tax court (judge nims) used the economic substance argument in saba partnership v. commissioner, t.c. memo. 1999-359, vacated, 273 f.3d 1135 (d.c. cir. 2001), on remand, t.c. memo. 2003-31 [brunswick], which the dc circuit remanded based on asa investerings to give taxpayer the opportunity to argue that there was a valid partnership [which it could not do, as judge nims found on remand]. even later, the d.c. circuit reversed the district court in boca investerings partnership v. united states, 314 f.3d 625 (d.c. cir. 2003), rev’g 167 f. supp. 2d 298 (d.d.c. 2001), cert denied, 540 u.s. 826 (2003) [wyeth, or american home products] case based upon this lack-ofpartnership argument – even though cravath planned boca carefully so that if the dutch bank was knocked out, there would still be a partnership – based upon its asa investerings and saba findings on appeal that there was no partnership. now we have judge leval of the second circuit adopting the lack-of-partnership argument that judge foley used because he preferred to rest his decision on this ground as opposed to making a finding of lack of economic substance. 4. a district court finds for the taxpayer in a coli case in an incredible opinion. dow chemical co. v. united states, 250 f. supp. 2d 748 (e.d. mich. 3/31/03). in a carefully-detailed opinion judge lawson found that dow did correctly almost everything that camelot and aep did incorrectly. the interest rate on policy loans was not unreasonably high, and a positive pre-tax cash flow was expected. the court found that there was a business purpose for the coli arrangements, i.e., to provide retiree benefits. the premiums for the first three years were payable with policy loans and the premiums for years four through seven were payable 90% with partial [cash] withdrawals (from policies whose cash value had been previously borrowed) and 10% with cash from the taxpayer. judge lawson found that the partial withdrawals were “shams in fact” because there was no cash value left in the policies to borrow, but that the § 264(c)(1) test was met because of the payments of 10% of the premiums by taxpayer with its own cash in years four through seven. the court found that the § 264(c)(1) safe harbor did not require level premiums over the first seven years and that the “premium” for each of years four to seven was the 10% paid in cash. judge lawson found that reg. § 1.264-4(c)(1)(ii) (which required level premiums) was invalid, and he rejected the holding in both in re cm holdings, 301 f.3d 96 (3d cir. 2002), and american electric power, inc. v. united states, 136 f. supp. 2d 762 (s.d. ohio 2001), that the fourout-of-seven test required level premiums. 490 florida tax review [vol. 8:si • in finding that taxpayer expected a positive pre-tax cash flow, judge lawson refused to admit into evidence a statement in taxpayer’s protest that could have led to a contrary conclusion on the ground that rule 408 of the federal rules of evidence provides that statements made during settlement negotiations are inadmissible at trial. a. there’s no harm in asking? not from asking judge lawson! dow chemical co. v. united states, 278 f. supp. 2d 844 (e.d. mich. 8/12/03). the government’s motion to amend the court’s judgment was granted in part and denied in part, but left intact the same judgment and basic result. ironically, since the motion opened up all findings of fact, judge lawson reversed his earlier finding that the partial withdrawals in years four through seven were “shams in fact,” thus making moot the government’s argument relating to the logical consequences of this earlier finding, i.e., that taxpayer did not meet the four-of-seven test because it did not pay the entire premium in each of years four through seven from its own funds. b. dow is reversed by the sixth circuit. dow chemical co. v. united states, 435 f.3d 594 (6th cir. 1/23/06) (2-1), cert. denied, 127 s. ct. 1251 (2/10/07). the sixth circuit reversed and held that the dow coli plans were “economic shams” because there was little likelihood that dow would make substantial cash infusions in the future, so the pre-tax cash flows would at all times be negative, following knetsch v. united states, 364 u.s. 361 (1960). this holding eliminates the court’s need to decide the proper discount rate, as well as issue of the exclusion of dow’s tax protest letters under rule 408 of the federal rules of evidence [inadmissibility of statements made during settlement negotiations]. the court further held that there would be little or no inside build-up and that dow’s possible mortality gains were limited under the plans. • judge ryan dissented on the ground that the majority opinion improperly read knetsch to hold as “a general principle of law that future profits are not even relevant to the economic substance inquiry when the taxpayer’s projected future investment in a particular plan is greater than its past investment in the plan, regardless whether the projected future investment is feasible and there is evidence that it is likely to occur;” instead, judge ryan states that knetsch indicated only that the court made a credibility assessment and determined that mr. knetsch did not intend to make the $4 million future investment necessary to pay off the loan. judge ryan would also have found that the dow plans transferred mortality risk to the insurers so mortality gains were possible. 2007] recent developments in federal income taxation 491 5. tax avoidance scheme works in the court of federal claims. principal life insurance company v. united states, 70 fed. cl. 144 (3/17/06). the court (judge allegra) upheld a transaction structured to eliminate the § 453a interest charge on the deferred tax liability for the gain to be recognized on about $478 million of installment notes held by each of taxpayer and prudential life insurance company. these installment notes (arising from a sale of commercial mortgages to one another) were in turn sold to wholly-owned consolidated subsidiaries in order to trigger gain recognition under § 453b(a)(1) and eliminate the interest charge while the triggered gain was deferred under [pre-1991] reg. § 1.1502-13. judge allegra held that the sale of the notes to the consolidated subsidiary was bona fide, and was not a capital contribution under § 351 because “while [the subsidiary] might be viewed as thinly capitalized, there is no indication that it was inadequately capitalized,” following frank lyon co. v. united states, 435 u.s. 561 (1978). the one non-tax purpose found by the court for using taxpayer’s subsidiary to hold the prudential installment notes was as a so-called “bankruptcy-remote entity” often used in securitized lending to lessen the likelihood that a bankruptcy court will order a substantive consolidation of an insolvent parent with a solvent subsidiary. 6. district court upholds blips tax shelter on taxpayer’s partial summary judgment motion. klamath strategic investment fund, llc v. united states, 440 f. supp. 2d 608 (e.d. tex. 7/20/06). the court (judge ward) held that the premium portion of the loans received from the bank in connection with the funding of the instruments contributed to the partnership was a contingent obligation, and not a fixed and determined liability for purposes of § 752. the transaction was entered into prior to the release of notice 2000-44, 2000-2 c.b. 255, which related to son-of-boss transactions. judge ward held that a regulation to the contrary, t.d. 9062, was not effective retroactively, and was therefore invalid as applied to these transactions. judge ward held that there was clear authority existing at the time of the transaction that the premium portion of the loan did not reduce taxpayer’s basis in the partnership. a. fighting duplication and acceleration of losses through partnerships before june 24, 2003. t.d. 9062, assumption of partner liabilities, 68 f.r. 37414 (6/24/03). temp. reg. § 1.752-6t provides rules, similar to the rules applicable to corporations in § 358(h), to prevent the duplication and acceleration of loss through the assumption by a partnership of a liability of a partner in a nonrecognition transaction. under the temporary regulations, if a partnership assumes a liability, as defined in § 358(h)(3), of a partner (other than a liability to which § 752(a) and (b) 492 florida tax review [vol. 8:si apply) in a § 721 transaction, after application of §§ 752(a) and (b), the partner’s basis in the partnership is reduced (but not below the adjusted value of such interest) by the amount of the liability. for this purpose, the term “liability” includes any fixed or contingent obligation to make payment, without regard to whether the obligation is otherwise taken into account for federal tax purposes. reduction of a partner’s basis generally is not required if: (1) the trade or business with which the liability is associated is transferred to the partnership, or (2) substantially all of the assets with which the liability is associated are contributed to the partnership. however, the exception for contributions of substantially all of the assets does not apply to a transaction described in notice 2000-44, 2000-2 c.b. 255 (or a substantially similar transaction). • the temporary regulations purport to be effective for transactions occurring after 10/18/99 and before 6/24/03. b. klamath on the merits: it does not work because it lacks economic substance, but no penalties. the authorities discussed in the holland & hart and olson lemons opinions provide “substantial authority.” klamath strategic investment fund, llc v. united states, 99 a.f.t.r.2d 2007-850, 2007-1 u.s.t.c. ¶ 50,223 (e.d. tex. 1/31/07). the transactions lacked economic substance because the loans would not be used to provide leverage for foreign currency transactions, but no penalties were applicable because taxpayers passed on a 1999 investment and they thought they were investing in foreign currencies and the tax opinions they received that relied on relevant authorities set forth in the court’s earlier opinion provided “substantial authority” for the taxpayers’ treatment of their basis in their partnerships. 7. transcapital leasing associates 1990-ii, l.p. v. united states, 97 a.f.t.r.2d 2006-1916 (w.d. tex. 3/31/06). in a complex mainframe computer leasing transaction, the taxpayer essentially received over $11,000,000 in tax deductions, without any corresponding income or economic loss, in consideration of a $559,947 fee; the 20:1 tax write-off was “an artificial creation of a tax avoidance structure that bifurcated ‘phantom’ income from ‘phantom’ loss.” the court applied a sham transaction analysis to find that the taxpayer “had no legitimate business purpose other than tax avoidance for entering into the [leasing transaction] and there was no reasonable expectation of profit. ... the ... transaction [was] solely shaped by tax avoidance objectives and completely lacking in profit potential.” 8. this decision might have a “colming” effect on the irs. colm producer, inc. v. united states, 460 f. supp. 2d 713 (n.d. tex. 10/16/06). the court (judge godbey) upheld the disallowance of a loss 2007] recent developments in federal income taxation 493 of about $102.7 million on the sale of a limited partnership interest in december 1999. the partnership interest was funded by the ettman family trust with $2 million plus the contribution of the $102.5 million proceeds of the short sale of $100 million (face value) of u.s. treasury notes subject to the obligation to replace the borrowed t-notes. the partnership interest was then sold to an unrelated third party for $1.8 million. held, the obligation to replace the borrowed t-notes [on the closing of the short sale] should have been treated as a liability under § 752. judge godbey held that – although contingent liabilities were not included as liabilities under § 752 – the obligation to close the short sale was a “liability” based upon his reading of the black’s law dictionary definition [“the quality or state of being legally obligated or accountable” or “a financial or pecuniary obligation”]; he reinforced his conclusion by citing rev. rul. 95-26, 1995-1 c.b. 131, and salina partnership lp v. commissioner, t.c. memo. 2000-352. 9. hi-lili, hi-lili, lilo! district court grants summary judgment to the government in a lilo transaction. bb&t corp. v. united states, 2007-1 u.s.t.c. ¶50,130, 99 a.f.t.r.2d 2007-376 (m.d. n.c. 1/4/07). taxpayer, a financial services corporation, leased equipment from a wood pulp manufacturer [a head lease] and re-leased it back to the wood pulp manufacturer in a “lease-in-lease-out” (lilo) transaction and claimed substantial rent and other deductions. the court held that the form of the transaction should not be respected for tax purposes because taxpayer did not acquire a current leasehold interest in the equipment and incurred no risk of loss. the reciprocal offsetting obligations were disregarded because, in substance, the taxpayer acquired only a future interest in the right to use and possess the equipment – and acquired that interest only if the owner-sublessee did not exercise its option to buy-out taxpayer’s interest in the head lease. the transaction did not substantially affect the wood pulp manufacturer’s rights to use and possess the property. b. identified “tax avoidance transactions.” 1. transactions involving significant book-tax differences are removed from the list of reportable transactions because they are covered by schedule m-3. notice 2006-6, 2006-5 i.r.b. 385 (1/6/06). transactions involving significant book-tax differences are removed from the list of reportable transactions. 2. accrual over the term of the notional principal contract of the noncontingent component of the nonperiodic payment to be received at the end of the term is required. rev. rul. 2002-30, 2002-1 c.b. 971 (5/6/02). when a notional principal contract provides for payment 494 florida tax review [vol. 8:si comprised of noncontingent and contingent components, the appropriate method for the inclusion into income or deduction of the noncontingent component of the nonperiodic payment is over the term of the npc. interest must also be accounted for in a manner consistent with reg. §§ 1.446-3(f)(2) (ii) or (iii), and 1.446-3(g)(4). • taxpayer agrees to make quarterly payments to counterparty based on the three-month libor multiplied by a notional principal amount of $100,000,000. in return, at the end of 18 months, the counterparty will pay taxpayer 6 percent per year multiplied by a notional principal amount of $92,000,000 [or, $8,280,000], and, in addition, the counterparty will either pay taxpayer $8 million times the percentage increase in the stock index, or taxpayer will pay the counterparty $8 million times the percentage decrease in the stock index. the ruling holds that, to offset the taxpayer’s deductible quarterly payments, the taxpayer must ratably accrue over the 18-month term the $8,280,000 that taxpayer will receive from the counterparty at the end of the term. a. an arrangement similar to that of rev. rul. 2002-30 is identified as a listed tax shelter. notice 2002-35, 2002-1 c.b. 992 (5/6/02). the transaction in this notice involves the use of a notional principal contract (npc) to claim current deductions for periodic payments made by a taxpayer, while disregarding the accrual of a right to receive offsetting payments in the future. under the npc, taxpayer is required to make periodic payments to a counterparty at regular intervals of one year or less based on a fixed or floating rate index. in return, the counterparty is required to make a single payment at the end of the term of the npc that consists of a noncontingent component and a contingent component. the noncontingent component, which is relatively large in comparison the contingent component, may be based upon a fixed or floating interest rate; the contingent component may reflect changes in the value of a stock index or currency. • this transaction may be entered into without any initial cash investment by the taxpayer. the counterparty may lend the money to the taxpayer, who pays it back in installments as purportedly deductible payments. the taxpayer may engage in other transactions, such as interest rate collars, for purposes of limiting risk with respect to the npc transaction. • taxpayer seeks to deduct the ratable daily portion of each periodic payment to which that portion relates, but taxpayer does not accrue income with respect to the nonperiodic payment until the year the payment is received. 2007] recent developments in federal income taxation 495 • the proper treatment of the payments is that the nonperiodic payment to be received by the taxpayer at the end of the term of the npc must be accrued ratably over the term of the npc, as set forth in rev. rul. 2002-30, 2002-1 c.b. 971. • transactions that are the same as, or substantially similar to, the transaction described are identified as “listed transactions” for purposes of temp. reg. §§ 1.6011-4t(b)(2) and 301.60112t(b)(2). b. certain notional principal contracts are no longer listed transactions. notice 2006-16, 2006-9 i.r.b. 538 (2/13/06), clarifying and modifying notice 2002-35, 2002-1 c.b. 992. c. disclosure and settlement 1. the big four settle with the irs on tax shelters. deloitte settled with the irs and agreed to a penalty to be determined after the irs settled with the other three. a. the pwc deal. ir-2002-82 (6/27/02). the irs announced in a news release that it cut a deal with pricewaterhousecoopers (pwc) “to resolve issues relating to tax shelter registration and list maintenance under the internal revenue code.” the irs news release, which is similar to one issued last august regarding merrill lynch, says that without admitting or denying liability, pwc has agreed to make a ‘substantial payment’ to the irs to resolve issues in connection with advice rendered to clients dating back to 1995. under the agreement, pwc will provide to the irs certain client information in response to summonses. it will also work with the irs to develop processes to ensure ongoing compliance with the shelter registration and investor list maintenance requirements, according to the release. b. the ey deal. ir-2003-84 (7/2/03). the irs announced in a news release that it has settled ernst & young’s potential liability under the tax shelter registration and list maintenance penalty provisions for a nondeductible payment of $15 million. see 2003 tnt 1281. c. the kpmg deal: the price of settling goes up dramatically. ir-2005-83 (8/29/05). the irs and the justice department announced in a news release that kpmg llp has admitted to criminal wrongdoing and agreed to pay $456 million in fines, restitution and penalties as part of an agreement to defer prosecution of the firm. nineteen 496 florida tax review [vol. 8:si individuals, chiefly former kpmg partners including the former deputy chairman of the firm [jeffrey stein], as well as a new york lawyer [r.j. ruble] were indicted in the southern district of new york in relation to the “multi-billion dollar criminal tax fraud conspiracy”; several of those indicted were partners in kpmg’s washington national tax group. d. judge kaplan refuses to find prosecutorial misconduct in the deferred prosecution agreement. united states v. stein, 428 f. supp. 2d 138 (s.d.n.y. 4/4/06), as corrected 4/5/06. judge kaplan denied a motion to dismiss based upon alleged prosecutorial misconduct by reason of the alleged manipulation of kpmg in the deferred prosecution agreement. this dpa required the firm “upon pain of corporate death, [to] espouse a government-approved version of [the] facts.” judge kaplan based his decision on the ethical provision applicable to all attorneys that prohibits them from coercing witnesses to give false testimony. he further held that nothing in the dpa pressures individual kpmg employees to testify in any particular way, but that the dpa merely requires the firm to disavow any assertion by an affiliated individual that is inconsistent with the dpa’s statement of facts. e. in its post-enron war against white collar crime, the justice department’s notion that what is fair against organized crime is also fair against white collar crime receives a [temporary?] setback. judge kaplan finds prosecutorial misconduct in the use of the thompson memorandum to prevent kpmg from continuing its customary practice of paying attorney’s fees for individuals caught up in controversy by reason of their affiliation with the firm. united states v. stein, 435 f. supp. 2d 330 (s.d.n.y. 6/26/06), as amended, 7/14/06. the court held that the justice department’s thompson memorandum policy [continued from the holder memorandum] of basing a determination of whether a firm is “cooperating” with the government on its refusal (unless compelled by law) to advance legal fees for affiliated individuals unless they in turn fully cooperated with the government, as it was applied by the prosecutors in this case, was an unconstitutional interference with defendants’ ability to use resources that – absent the government’s misconduct – would be otherwise available to them for payment of attorneys’ fees. the resources in question were funds that would have customarily been received by these defendants from kpmg to pay their attorneys. • judge kaplan subsequently refused to eliminate from his opinion a statement that prosecutors in the case were “economical with the truth.” he also refused to eliminate from his opinion the names of the prosecutors involved. 2006 tnt 130-10. 2007] recent developments in federal income taxation 497 • judge kaplan’s decision has been appealed to the second circuit, which has stayed its implementation pending the appeal. • the thompson memorandum was replaced on 12/11/06 by the mcnulty memorandum which requires threats to prosecute entities “unless” they do something [e.g., waive attorney client privilege] or “if” they do something [e.g., advance legal fees] to emanate from a higher level of the justice department. f. judge kaplan indefinitely postpones the federal criminal trial against 16 former kpmg employees, an outside investment adviser and a lawyer. united states v. stein, 461 f. supp. 2d 201 (s.d.n.y. 11/13/06). judge kaplan cited fears that defendants may be unable to pay their lawyers in postponing the trial, which was scheduled to begin in january 2007. the issues are now in the second circuit. see lynnley browning’s article in the new york times business section (11/15/06). (1) on 12/20/06, judge kaplan stated that jury selection for the trial would begin on 9/17/07. 2006 tnt 246-2. 2. is this really the last chance global settlement initiative? announcement 2005-80, 2005-2 c.b. 967 (11/14/05). the irs announced settlement initiative for 21 transactions, not all of them listed as “abusive tax shelters,” together with the accuracy-related penalty that will be imposed [varying from 5% and 20%] unless the transaction was disclosed under announcement 2002-2, 2002-1 c.b. 304, or the taxpayer relied upon a more-likely-than-not opinion from a non-disqualified tax advisor that considered all the relevant facts and did not assume any unreasonable facts. the terms of the settlement require that improperly-claimed tax benefits be disallowed, but transaction costs will generally be allowed as an ordinary loss. promoters and related persons are not normally eligible for the settlement initiative, and persons engaged in a transaction that had been designated for litigation, persons in litigation, persons against whom the fraud penalty was imposed or considered and persons under criminal investigation are ineligible for the settlement initiative. taxpayers must notify the irs of their intent to participate by 1/23/06 by making an election on form 13750 (“election to participate in announcement 2005-80 settlement initiative”), and sending it, together with all required attachments, to the service. 498 florida tax review [vol. 8:si a. frequently asked questions (“faqs”) on the announcement 2005-80 settlement initiative (rev. 12/12/05), 2005 tnt 239-8 and the irs web site. son of boss transactions are ineligible for the settlement initiative. b. strong encouragement for taxpayers to use the announcement 2005-80 global settlement initiative. section 303 of the go zone act of 2005 amends § 903 of the jobs act of 2004 to provide that the code § 6404(g) post-18-month interest suspension will not apply at all to reportable and listed transactions that are still open on 12/14/05 unless the taxpayer is participating in a settlement initiative described in announcement 2005-80 or the irs has determined that the taxpayer “has acted reasonably and in good faith.” section 903 of the jobs act of 2004 provided that the interest suspension for reportable and listed transactions would not apply after 10/3/04. 3. proposed circular 230 changes that do not relate to tax shelters are nevertheless controversial, what with new restrictions on the use of contingent fees, monetary penalties for practitioners and their firms, and public hearings before aljs. reg-122380-02, regulations governing practice before the internal revenue service, 71 f.r. 6421 (2/3/06). proposed regulations have been issued after considering comments received in response to questions posed in an advance notice of proposed rulemaking (anprm) at 67 f.r. 77724 (12/19/02), as well as amendments made to 31 u.s.c. § 330 by the american jobs creation act of 2004. changes include: (1) changing references to the office of the director of practice to the office of professional responsibility; (2) adding to the definition of “practice before the [irs]” in § 10.2(d) “rendering written advice with respect to any entity, transaction plan or arrangement, or other plan or arrangement having a potential for tax avoidance or evasion”; (3) revoking the authorization of an unenrolled return preparer to represent a taxpayer during an examination of a return that he or she prepared; (4) eliminating the ability of a practitioner to charge a contingent fee for services rendered in connection with the preparation or filing of an amended tax return or claim for refund or credit, although contingent fees are permissible for services rendered in connection with the irs’s examination of, or challenge to, an amended return or claim for refund or credit filed prior to the taxpayer receiving notice of the examination of, or challenge to the original tax return, § 10.27; (5) adding to the standards applicable with respect to tax return positions in § 10.34, the requirement that a practitioner may not advise a client to submit “a document, affidavit or other paper … to the [irs]” if (a) its purpose is to delay or impede the administration of the federal tax laws, (b) it is frivolous or groundless, or (c) it contains or omits 2007] recent developments in federal income taxation 499 information in a manner that demonstrates an intentional disregard of a rule or regulation; (6) adding to the sanctions in § 10.50 the authority to impose a monetary penalty on the practitioner who engages in conduct subject to sanction, as well as the authority to impose a monetary penalty on the “employer, firm or entity” of a practitioner acting on its behalf provided that the employer, firm or entity knew or reasonably should have known of such conduct; and (7) modifying the definition of disreputable conduct in § 10.51 to include willful failure to sign a tax return the practitioner prepared or unauthorized disclosure of returns or return information. • the most controversial proposed change is a provision in § 10.72(d) that all hearings, reports, evidence and decisions in a disciplinary proceeding be available for public inspection, with protection of the identities of any third party taxpayers contained in returns and return information for use in the hearing. 4. warm-up the photocopier for those tax accrual workpapers. announcement 2002-63, 2002-2 c.b. 72 (7/8/02). in auditing returns filed after 7/1/02 that claim any tax benefits from a “listed transaction,” see notice 2001-51, 2001-2 c.b. 190, superseded by notice 2003-76, 2003-2 c.b. 1181, superseded by notice 2004-67, 2004-2 c.b. 600, the irs may request tax accrual workpapers. listed transactions will be determined “at the time of the request.” neither the attorney client privilege nor the § 7525 tax practitioner privilege protects the confidentiality of the workpapers. a. specific procedures regarding requests for tax accrual workpapers. chief counsel notice cc-2003-012 (4/9/03). this notice provides procedures to be used regarding requests for tax accrual and other financial audit workpapers. b. the definition of “tax accrual workpapers” is clarified. chief counsel notice cc-2004-010 (1/22/04), supplementing cc-2003-012. the general definition is as follows: tax accrual workpapers are those audit workpapers, whether prepared by the taxpayer or by an independent accountant, relating to the tax reserve for current, deferred and potential or contingent tax liabilities, however classified or reported on audited financial statements, and to footnotes disclosing those tax liabilities on audit financial statements. they reflect an estimate of a company’s tax liabilities and may also be referred to as the tax pool analysis, tax liability 500 florida tax review [vol. 8:si contingency analysis, tax cushion analysis, or tax contingency reserve analysis. • documents created prior to or outside of the consideration of whether reserves should be created are not within the definition of tax accrual workpapers nor are workpapers reconciling book and tax income, but they both “likely fall within the scope of the general idrs issued at the beginning of an examination and should be produced … even though no request for the tax accrual workpapers has been made.” c. the government seeks summons enforcement for textron’s tax accrual workpapers. united states v. textron, inc., 2006 tnt 84-19 (d. r.i. 4/28/06). in its supporting brief, 2006 tnt 84-4, the government argued that all tax accrual workpapers should be disclosed because textron engaged in several listed transactions, specifically, six separate sale-in, lease-out (“silo”) transactions in 2001, which were designated as listed transactions in notice 2005-13, 2005-1 c.b. 630. • united states v. arthur young & co., 465 u.s. 805 (1984), which held that tax accrual workpapers to be available to the government because they were relevant to a legitimate irs inquiry, is strongly supportive of the government’s position. taxpayer may rely upon the work product doctrine for protection because the tax accrual workpapers clearly are not covered by the attorney-client privilege. 5. the work product doctrine works in the sixth circuit. united states v. roxworthy, 457 f.3d 590 (6th cir. 8/10/06). in response to an irs informal document request, yum! brands, inc. claimed that seven documents were protected by the work product doctrine. it turned over five of the documents under a limitation of waiver agreement but refused to turn over the remaining two documents, which were memoranda both dated 3/29/00, prepared by kpmg that analyzed the tax consequences of stock transfers made in connection with the creation of a captive insurance company, which involved a loss of $112 million for tax purposes, but not book purposes. on summons enforcement [against yum’s vice president, tax] the magistrate and district court ordered the documents produced, but the sixth circuit (judge cole) held that the two memoranda were protected work product because they included they were prepared in anticipation of litigation and included “possible arguments that the irs could mount against yum’s chosen tax treatment of the transactions and possible counter-arguments.” 2007] recent developments in federal income taxation 501 • the court stated: [i]n united states v. adlman, 68 f.3d 1495, 1496 (2d cir. 1995) (adlman i), an accounting firm prepared documents evaluating the tax consequences and likely irs challenges to a company’s proposed reorganization in which the company would claim a capital loss of $290 million. the second circuit held that the district court erred in concluding that the prospect of litigation was too remote for work-product privilege to apply, observing that “[i]n many instances, the expected litigation is quite concrete, notwithstanding that the events giving rise to it have not yet occurred.” id. at 1501. the court remanded the matter for the district court to apply the proper standard. • the standard test to be used to establish whether documents were prepared “in anticipation of litigation” is the question of whether the “documents can be said to have been created because of the prospect of litigation” (the “because of” test) – as opposed to whether they would have been prepared in substantially the same form in the absence of prospective litigation. in applying the test, the court is to ask “(1) whether a document was created because of a party’s subjective anticipation of litigation, as contrasted with an ordinary business purpose, and (2) whether that subjective anticipation of litigation was objectively reasonable.” • the court noted that the reason for the requesting party to seek such documents is usually to see the “[tax professionals’] assessment of the [transaction’s] legal vulnerabilities, in order to make sure it does not miss anything in crafting its legal case,” which it noted was precisely the type of discovery protected by the work product doctrine. • the court rejected the irs argument that the memoranda were not prepared in anticipation of litigation, but “were more likely prepared to assist yum in the preparation of its taxes and the avoidance of understatement penalties if the irs disagreed with yum’s tax treatment . . . .” • the court finally held that the fact that the memoranda bore an attorney-client privilege designation, not a workproduct designation, should not alone settle the inquiry as to whether they were prepared in anticipation of litigation. 6. new disclosure and list maintenance regulations. t.d. 9295, ajca modifications to the section 6011, 6111, and 6112 regulations, 71 f.r. 64458 (11/2/06). these final and temporary regulations 502 florida tax review [vol. 8:si are part of a package of four regulations and proposed regulations that modify the rules for disclosing reportable transactions and list maintenance requirements following the enactment of the jobs act of 2004. a. reg-103038-05, ajca modifications to the section 6011 regulations, 71 f.r. 64488 (11/2/06). these proposed regulations modify the rules on the disclosure of reportable transactions. they also eliminate the special rule for lease transactions, making those transactions subject to the same disclosure rules as other transactions. b. reg-103039-05, ajca modifications to the section 6111 regulations, 71 f.r. 64496 (11/2/06). these proposed regulations provide rules for the disclosure of reportable transactions under § 6111 by material advisors. c. reg-103043-05, ajca modifications to the section 6112 regulations, 71 f.r. 64501 (11/2/06). these proposed regulations would provide rules for material advisors who must prepare and maintain investor lists under § 6112. the list must identify each person who was advised with respect to any reportable transaction. the proposed regulations would also require the material adviser to include the names of other material advisers to the transaction and any designation agreement to which the material adviser is a party. they also clarify that the list must include an itemized statement of information, a detailed description of the transaction, and copies of documents related to the transaction. d. tax shelter penalties, etc. 1. united states v. gleason, 94 a.f.t.r.2d 2004-6344 (m.d. tenn. 8/25/04), aff’d, 432 f.3d 678 (6th cir. 12/29/05). tax shelter promoter was permanently enjoined under § 7408 from selling the so-called “tax toolbox” which would permit the deduction of personal expenses by falsely characterizing them as business expenses. a. anderson v. irs, 442 f. supp. 2d 365 (e.d. tex. 5/18/06). penalties under § 6700 were imposed on a customerpromoter, who sold 81 “tax toolbox” tax reduction schemes. 2. mortensen v. commissioner, 440 f.3d 375 (6th cir. 2/28/06). the court (judge martin) affirmed the imposition of the § 6662(a) negligence penalty imposed for the 1991 year on an investor in “the 1,000 lb. tax shelter,” which was one of the hoyt cattle-breeding partnerships. the court found that taxpayer, who was college educated with a degree in engineering, could not reasonably rely on his father’s telling him that he [the 2007] recent developments in federal income taxation 503 father] showed the information about the investment to [an unnamed] tax attorney and that the “attorney looked over it and he said there was nothing illegal.” the court further held he could not rely on information provided by hoyt and hoyt’s “enrolled agent” status because hoyt had a conflict of interest, and he could not rely on a co-worker’s trip to the hoyt ranch where he saw cows and an operating business. • taxpayer did not show “reasonable cause” under § 6664(c)(1) with respect to penalties on disallowed cattle tax shelter deductions resulting from the “hoyt 1000 lb. tax shelter” where (1) taxpayer claimed reliance on the advice of tax shelter promoter, who happened to be an enrolled agent, (2) taxpayer never sought any advice from a disinterested tax professional with whom he dealt directly regarding the partnership investment generally or correctness of the his schedule k-1 from the partnership, despite continuing large losses resulting from a small investment and receipt of continuous warnings from the irs that the deductions were improper, and (3) taxpayer claimed reliance on the tax court’s opinion in bales v. commissioner, t.c. memo. 1989-568, which upheld deductions claimed by other taxpayers in different years in a different cattle tax shelter partnership organized by the same promoter. • the court further held that mortensen’s reliance on bales v. commissioner, t. c. memo. 1989-568, was unwarranted because it involved “different investors, different partnerships, different taxable years, and different issues,” although the court held that while “we believe it to be a closer case on this issue, we cannot conclude that the tax court clearly erred.” • the court stated, “the issue is not whether a taxpayer is wholly successful in determining the tax legitimacy of a desired investment, but whether he is negligent for not reasonably investigating in the first place,” and “a reasonable taxpayer after bales would still have sought independent counsel.” a. van scoten v. commissioner, 439 f.3d 1243 (10th cir. 3/9/06). the tenth circuit made a substantially similar analysis on substantially similar facts denying the § 6664(c)(1) “reasonable cause” exception to accuracy related penalties for another investor in the “hoyt 1000 lb. tax shelter.” 3. tax-exempt organizations will be subject to tax shelter penalties. tipra § 516(a) adds new § 4965 to impose an excise tax on tax-exempt entities entering into prohibited tax shelter transactions. the tax will be 35 percent of the greater of (a) the entity’s net income or (b) 75 504 florida tax review [vol. 8:si percent of the proceeds received by the entity that are attributable to the transaction. a. tipra § 516(b) also amends § 6033(a) to provide disclosure requirements and amends § 6652(c) to provide penalties for nondisclosure. b. tipra § 516(b) also adds new code § 6011(g), which requires a taxable party to a prohibited tax shelter transaction to provide a disclosure statement to any tax-exempt entity which is also a party to the transaction, indicating that the transaction is a prohibited tax shelter transaction. a failure to make a disclosure required under § 6011(g) is subject to penalty under § 6707a, the penalty amounts being equal to those imposed for other violations of § 6011 that are penalized by § 6707a. e. tax shelters miscellaneous 1. “too good to be true?” notice 2006-31, 2006-15 i.r.b. 751 (3/16/06). this notice reminds taxpayers not to engage in abusive tax-avoidance schemes that purportedly allow them to reduce or eliminate taxes based on “false or frivolous arguments.” the notice states that “[i]f an idea to save on taxes seems too good to be true, it probably is.” a. the rulings concurrently released and published are: rev. rul. 2006-17, 2006-15 i.r.b. 748 (3/16/06) (inserting the phrase “nunc pro tunc” on a return or other document has no legal effect); rev. rul. 2006-18, 2006-15 i.r.b. 743 (3/16/06) (submitting zeroincome returns through a misinterpretation of § 3401(c) to the effect that “wages” are paid only to federal employees and persons living in washington, dc is a frivolous position); rev. rul. 2006-19, 2006-15 i.r.b. 749 (3/16/06) (attributing income to a purported trust and claiming expense deductions for “fiduciary fees” in the amount of that income is a frivolous position); rev. rul. 2006-20, 2006-15 i.r.b. 746 (3/16/06) (claims that american indians are exempt from taxes under a general “native american treaty” have no merit); and rev. rul. 2006-21, 2006-15 i.r.b. 745 (3/16/06) (claiming there is no requirement to file an income tax return because the instructions do not display a current control number assigned by omb under the paperwork reduction act of 1980, pub. l. no. 96-511 [codified at 44 u.s.c. § 3501] is a frivolous position). • while the above rulings involve tax protester-type schemes, the phrase “too good to be true” is not the be-all and end-all of tax planning. see, n. jerold cohen, “too good to be true and too 2007] recent developments in federal income taxation 505 bad to be true,” 109 tax notes 1437 (dec. 12, 2005), described as follows: “in this report, the author questions whether it is fair to impose penalties on taxpayers on the grounds that their tax results were ‘too good to be true’ when the literal language of our code often produces results that many would think were either too good or too bad to be true.” ix. exempt organizations and charitable giving a. exempt organizations 1. irs rules that seller-funded down-payment assistance programs do not qualify for exemption because the donors benefit from the transactions. rev. rul 2006-27, 2006-21 i.r.b. 915 (5/4/06). this ruling examines three scenarios, the first and third [which conduct broad-based fundraising programs] qualify for exemption, but the second [which relies on a payment from the home seller] does not. 2. according to the fifth circuit, it was the irs that should have stayed home when it tried to show there was value in a group of home healthcare agencies that lost money on every transaction but might have made a profit on the volume. caracci v. commissioner, 456 f.3d 444 (5th cir. 7/11/06) (per curiam), rev’g 118 t.c. 379 (2002). the fifth circuit reversed the tax court and held that § 4958 excise taxes on excess benefits [intermediate sanctions] of more than $250 million [??!!] were improperly proposed against the sta-home agencies, a group of familyowned and operated home health care agencies, on their conversion from tax-exempt corporations to nonexempt corporations. the decision was based on the significant errors in the analysis of the government’s valuation expert, who provided the only support for the imposition of excise taxes. the fifth circuit concluded that, based on the record, the taxpayers did not receive any “net excess benefit” as a matter of law. • the court faulted the government for issuing deficiency notices based on a brief intermediate internal analysis because the taxpayers refused to consent to an extension of the statute of limitations. 3. pension protection act § 1212 amends code §§ 4941-4945 to double the excise taxes on self-dealing and excess benefit transactions. 4. irs announces its credit counseling compliance project for tax-exempt credit counseling organizations. chief counsel 506 florida tax review [vol. 8:si advice memorandum, cca 200620001 (5/9/06). this memorandum contains two examples of credit counseling organizations: (1) abc, which uses an educational methodology, and qualifies for exempt status under § 501(c)(3), and (2) def, which primarily promotes debt management plans without considering whether it is appropriate in light of each client’s individual circumstances, and does not qualify for exempt status. • the irs also provided a core analysis tool to help determine whether the credit counseling organization qualifies for exemption. 2006 tnt 94-12 (5/15/06). a. ir-2006-80 (5/15/06). the irs released a report on tax-exempt credit counseling agencies. the executive summary may be found at 2006 tnt 94-10. b. the irs receives an assist from congress in weeding out the “bad” credit counseling organizations. pension protection act, § 1220, adds new code § 501(q) to provide more definite rules governing tax-exempt credit counseling organizations, including, e.g., a limitation on the portion of the exempt organization’s income that may be derived from debt management plan services. 5. all tax-exempt organizations will be required to file annual electronic notices. pension protection act, § 1223, adds new code § 6033(i) to require electronic filing of an annual informational notice by all exempt organizations not currently required to file [specifically, organizations with gross receipts under $25,000 and churches] on pain of losing tax-exempt status. this provision is effective for years beginning in 2007. 6. pension protection act § 1225 amends code § 6014 to require public disclosure of unrelated business income tax returns of § 501(c)(3) organizations. this provision is effective for returns filed after date of enactment. 7. pension protection act §§ 1231-1235 provide for new rules and greater accountability for donor advised funds and sponsoring organizations [e.g., community foundations], which are defined in these provisions. they also provide new requirements for supporting organizations, which are excluded from private foundation status under code § 509(a)(3); private foundation grants to type iii supporting organizations that are not functionally integrated supporting organizations are not “qualifying distributions” and may give rise to excise taxes. 2007] recent developments in federal income taxation 507 a. announcement 2006-93, 2006-48 i.r.b. 1017 (11/7/06). this announcement provides procedures that § 501(c)(3) tax-exempt supporting organizations described in § 509(a)(3) may use to request a change in their public charity classification in light of the effect of the pension protection act. these changes would permit middle-aged geriatrics to use new code § 408(d)(8) to make tax-free distributions from their iras [owned by individuals over 70½ years of age] up to $100,000 directly to charities that are publicly supported under § 509(a)(1) and (2) [but not § 509(a)(3)]. b. notice 2006-109, 2006-51 i.r.b. (12/4/06). interim guidance regarding the application of requirements in the pension protection act with regard to the criteria for private foundations considering distributions to supporting organizations that can be used to determine whether the supporting organization is a type i, type ii, or functionally-integrated type iii supporting organization. the notice also provides for relief for payments that were made pursuant to an agreement that was binding on the organization on the 8/17/06 date of enactment – even though the amended statute became effective for transactions occurring after 7/25/06. 8. the tax relief and health care act of 2006 § 424 amends code § 664(c) to replace the rule that removes the tax exemption of a charitable remainder trust for any year in which the trust has any unrelated business taxable income. instead, there will be a 100-percent excise tax on the ubti of a charitable remainder trust. b. charitable giving 1. sklar v. commissioner, 125 t.c. 281 (12/21/05), as amended, 2/7/06. taxpayers have repeatedly unsuccessfully sought to claim charitable contribution deductions for payments with respect to which they have received a quid pro quo is tuition payments to religious schools that provide both secular and religious education. even if tuition can be mathematically prorated between the portion attributable to the secular education and the portion attributable to religious education, or the taxpayer can demonstrate that the tuition exceeds the value of the secular education, the deduction has been disallowed because taxpayers were unable to demonstrate any charitable intent in paying the tuition. the special exception for religious benefits does not apply to payments to religious schools. 2. no full fair market value deduction for contributed self-created musical compositions and copyrights. tipra 508 florida tax review [vol. 8:si § 204 amends § 170(e)(1)(a) to provide that capital asset treatment, i.e., full fair market value deduction, is to be inapplicable to contributed self-created musical compositions and copyrights. the amount of the charitable deduction for the contribution of such assets is still to be reduced by the amount of appreciation inherent in non-ltcg assets, and, therefore, contributions of such assets will give rise to a deduction equal only to basis. 3. not asking is not the same as asking, getting and giving up by contribution – because he could not have gotten what he said he could have gotten. turner v. commissioner, 126 t.c. 299 (5/16/06). a real estate developer, who purchased property that could be subdivided into 30 residential lots under current zoning, could not get a contribution deduction for a § 170(h)(1) qualified conservation easement by forgoing an application for denser zoning usage under which he claimed to be entitled to develop up to 62 residences on smaller lots. one-half of the parcel was wetlands that could not have been developed, and only 30 houses could have built on the parcel in any event. therefore, the conveyance did not “preserve” any open space that otherwise could have been developed. the 20-percent accuracy-related penalty was also upheld. 4. glass v. commissioner, 124 t.c. 258 (5/25/05). the tax court held that the contribution of a perpetual conservation easement that restricted development of certain portions of the taxpayers’ lakefront residential lot, but which did not otherwise affect the taxpayers’ use or enjoyment of the property, was a qualified conservation contribution under § 170(h) because it protected a relatively natural habitat of specifically identified wildlife, including bald eagles, and plants. a. glass affirmed. glass v. commissioner, 471 f.3d 698 (6th cir. 12/21/06). the sixth circuit held that the easements prohibited any activity or use of the encumbered property that would undermine their stated conservation purpose, and the reserved rights were carefully limited so as to ensure that the identified plant and wildlife habitats on the encumbered property continued to be protected. 5. the pension protection act makes the following changes to rules governing charitable contributions: a. pension protection act § 1213 amends code § 170(h)(4) to provide that a donated façade easement must include an enforceable restriction which preserves the entire exterior of the building, 2007] recent developments in federal income taxation 509 and prohibits any change inconsistent with the historical character of the exterior. b. bwana can deduct only the cost of taxidermy when he donates his big game trophies to a museum. pension protection act § 1214 adds new code § 170(f)(15) to provide a limitation on deductibility of trophy mounts to the lesser of the fair market value of the trophy or the cost of taxidermy, effective for contributions after 7/26/06. c. pension protection act § 1215 adds new code § 170(e)(7) to provide for recapture of the deduction in excess of the basis of exempt use tangible personal property if the property is disposed of within three years of the date of the donation. a civil penalty of $10,000 is provided under § 6720b for fraudulent identification of exempt use property. d. president clinton could no longer deduct the underwear he contributes to charity, but monica might still deduct her blue dress with white polka dots. pension protection act § 1216 adds new code § 170(f)(16) to deny deductions for clothing and household items unless such clothing or household item is in “good used condition or better.” treasury may issue regulations denying a deduction for a contribution of clothing or household items of minimal monetary value. there is an exception for a contribution of a single item of clothing or a household item for which a deduction of more than $500 is claimed if the taxpayer attaches to his tax return a qualified appraisal with respect to the property. e. those $20 bills placed in the collection plate each week will no longer be deductible without a receipt. pension protection act § 1217 adds new code § 170(f)(17) to deny deductions for monetary gifts unless the donor has a bank record or a receipt showing the name of the donee organization, the date of the contribution and the amount of the contribution. this provision is effective in 2007. (1) notice 2006-110, 2006-51 i.r.b. 1127 (12/2/06). a contribution made by payroll deduction can be substantiated by (1) a pay stub, form w-2, or other document furnished by the employer that sets forth the amount withheld during a taxable year by the employer for the purpose of payment to a donee organization, together with (2) a pledge card or other document prepared by or at the direction of the donee organization that shows the name of the donee organization. f. fractional interests in tangible personal property must carry with them substantial use by the donee in its exempt function. pension protection act § 1218 adds new code § 170(o) 510 florida tax review [vol. 8:si to provide for recapture of any deduction (plus interest) allowed with respect to any fractional interest in tangible personal property unless the donor conveys all of the remaining interest in the property to the charity within the earlier of ten years or the donor’s death. additionally, recapture will take place unless within that period the donee has had substantial physical possession of the property and used the property in a use related to a purpose or function constituting the basis for the organization’s exemption. g. pension protection act § 1219 adds new code §§ 170(f)(11)(e) and 6695a and amends code §§ 6662, 6664 and 6696 to provide more oversight of appraisers, as well as impose stricter penalties on both appraisers and taxpayers. (1) notice 2006-96, 2006-46 i.r.b. 902 (10/19/06). this notice provides transitional guidance relating to the new definitions of “qualified appraisal” and “qualified appraiser” in §§ 170(f)(11)(e) and 6695a regarding substantial or gross valuation misstatements, as added by § 1219 of the pension protection act of 2006. x. tax procedure a. interest, penalties and prosecutions 1. but will he be a “survivor” in the u.s. court for the district of rhode island? a justice department news release, dated 9/8/05, announced that richard hatch was indicted on charges of tax evasion for failing to report about $1,037,000 dollars of income from the television reality series and about $391,000 of income from other sources. www.usdoj.gov/opa/pr/2005/september/05_tax_463.htm. he was convicted on 1/25/06, 2006 tnt 17-6. 2. when is disclosure adequate? there are different rules for disclosure of a tax shelter, of transactions that lack reasonable basis and supporting records, and for preparer penalty purposes. rev. proc. 2005-75, 2005-2 c.b. 1137 (12/12/05). this revenue procedure updates guidance on whether disclosure of a position taken on a tax return is adequate for purposes of the § 6662(d) accuracy-related penalty and the § 6694(a) preparer penalty. • there is a new paragraph in § 4.01(5) cautioning that the entry of an amount on a line will not provide adequate disclosure if it is attributable to a tax shelter or “if it does not have a 2007] recent developments in federal income taxation 511 reasonable basis and supporting records,” as well a limitation on its effectiveness for preparer penalty purposes. • there is also a requirement in § 4.02(1)(d) that the contemporaneous written acknowledgment required under § 170(f)(12) for charitable contributions of motor vehicles be attached to the return. 3. united states v. hempfling, 2006-1 u.s.t.c. ¶50,205, 96 a.f.t.r.2d 2005-6578 (e.d. cal. 9/23/05). in a suit seeking an injunction under §§ 6700 and 7408 against a promoter of scheme: (1) purporting to demonstrate that there is no law requiring individuals to file federal income tax returns or pay income taxes, and (2) insulating purchasers who stopped filing tax returns from any charge of willful failure to file a tax return the court denied the promoter’s motion to dismiss, holding that the first amendment does not protect such “false or fraudulent commercial speech.” a. united states v. hempfling, 431 f. supp. 2d 1069 (e.d. calif. 2/22/06). the court again refused to dismiss on defendant’s contention that he had new evidence that the sixteenth amendment was never properly ratified. the court further held that the issuance of an injunction against the promotion of abusive tax shelters does not violate the noerr-pennington doctrine (see eastern r. conf. v. noerr motors, 365 u.s. 127 (1961); mine workers v. pennington, 381 u.s. 657 (1965)), which protects the right to petition the government for redress of grievances. 4. t.d. 9309, qualified amended returns, 72 f.r. 903 (1/9/07) treas. reg. § 1.6664-2(c) provides that the amount reported on a “qualified amended return” will be treated as an amount shown as tax on the taxpayer’s return for purposes of determining whether there is an underpayment of tax subject to an accuracy-related penalty. generally speaking a return is not a qualified amended return if it is filed (1) after the irs has served a john doe summons on a third party with respect to the taxpayer’s tax liability, (2) for a taxpayer who has claimed tax benefits from undisclosed listed transactions, after the irs requests information related to the transaction that is required to be included on a list under § 6112 from any person who made a tax statement to or for the benefit of the taxpayer, or any person who gave material aid, assistance, or advice to the taxpayer, or (3) after the date on which published guidance is issued announcing a settlement initiative for a listed transaction in which penalties, in whole or in part, are compromised or waived. 512 florida tax review [vol. 8:si 5. united states v. petrino, 2006 tnt 87-7 (e.d. n.y. 5/2/06). robert fink won a jury acquittal for paul d. petrino, an accountant charged with tax evasion for filing returns based on the argument that wages and salaries are not subject to federal income tax. fink said, “the jury was convinced that the government did not negate [petrino’s] good faith.” 6. mcgowan v. commissioner, 187 fed. appx. 915 (11th cir. 6/28/06). taxpayer’s conviction under § 7206(1) of willfully making and subscribing false individual income tax returns and under § 7206(2) of willfully aiding and assisting in the preparation of false corporate income tax returns for the his s corporation did not collaterally estop him from arguing successfully to a jury that his individual returns were not fraudulent because intent to evade taxes is not an element of crimes under § 7206. 7. government lawyers should “work with vigor” because the seventh circuit does a time-and-motion study of the doj tax division. szopa v. united states, 460 f.3d 884 (7th cir. 8/21/06). judge easterbrook held that the doj tax division is setting the presumptive sanction for a frivolous appeal in this tax protest case too high because it should not take 53 attorney hours plus 8 hours of paralegal time to prepare a 15-page brief in response to taxpayer’s brief of 9 double-spaced typed pages based entirely on the argument that “non-corporate citizens of the united states need not pay ‘income taxes.’” the court did note that the tax division is free to request more when “the case is especially complex or the tax protester’s argument especially long and opaque.” 8. the tax relief and health care act of 2006 § 407 modifies the code § 6702 penalty for frivolous tax submissions by increasing the amount of the penalty from $500 to $5,000 and by applying it to all taxpayers and to all types of federal taxes. the submissions to which the provision applies are requests for a collection due process hearing, installment agreements, offers-in-compromise, and taxpayer assistance orders. the provision permits the irs to disregard such requests, and to impose a penalty of up to $5,000 for such requests, unless the taxpayer withdraws the request after being given an opportunity to do so. b. discovery: summonses and foia 1. honi soit qui mal y pense. united states v. bdo seidman, llp, 2005-1 u.s.t.c. ¶ 50,264, 95 a.f.t.r.2d 2005-1725 (n.d. ill. 3/30/05). the district court ruled that only one of 267 documents withheld from irs scrutiny by the intervenors were unprotected by privilege or work product, or both. [the unprotected document was an e-mail sent by 2007] recent developments in federal income taxation 513 a bdo employee.] in ruling that the crime-fraud exception did not apply, judge holderman found that neither the existence of cookie-cutter tax opinions nor the irs listing of substantially similar transactions as abusive tax shelters by the irs was determinative because “the tax code and underlying regulations is [sic] full of complexities and uncertainties.” he further stated that “just because one of bdo’s consulting agreements has been found to have [been] fraudulent does not mean that all consulting agreements entered into by bdo were fraudulent.” • judge holderman found the test for the § 7525(b) tax shelter exception to be the same as for the crime-fraud exception. • footnote 2 of the opinion sets forth the categories of information contained in the privilege log. inasmuch as the adequacy of another privilege log in this litigation was questioned, the categories in this privilege log might be a useful guide. a. the attorney-client privilege does not attach to communications relating to planning to commit tax fraud. subsequently, at 2005-2 u.s.t.c. ¶ 50,447, 95 a.f.t.r.2d 2005-2835 (n.d. ill. 5/17/05). judge holderman found that there was a prima facie case for the remaining document examined in camera not being privileged, by reason of the crime-fraud exception, and the intervenors failed to present sufficient explanation to rebut that presumption. the document involved an investment in distressed debt with the sole motive of obtaining a loss for tax purposes. • the government had argued that “document a-40 is not part of legitimate year-end tax planning, but instead is part of the overall abusive sham tax shelter transaction perpetrated by bdo and invested in by intervenor cullio and others.” • judge holderman refused to quash the summons seeking production of document a-40, which he held related to an “abusive sham tax shelter investment,” because the irs made a prima facie case that the crime-fraud exception to the attorney-client privilege applied and taxpayer failed to provide a satisfactory explanation of why the document should not be disclosed under the crime-fraud exception; there were eight indicators of potential fraud: (1) the marketing of pre-packaged transactions by bdo; (2) the communication by the taxpayer to bdo with the purpose of engaging in a pre-arranged transaction developed by bdo or a third party with the sole purpose of reducing taxable income; (3) bdo and/or the taxpayer attempting to conceal the true nature of the transaction; (4) actual or constructive knowledge by bdo that the taxpayers lacked a legitimate business purpose for entering into the transaction; (5) vaguely worded consulting agreements; (6) failure by bdo to provide services under the 514 florida tax review [vol. 8:si consulting agreement despite receipt of payment; (7) mention of a particular tax shelter that had been identified by the irs as a “listed transaction”: and (8) use of boiler-plate documents). • both of judge holderman’s decisions are on appeal to the seventh circuit. 2. the powell requirement that the summonsed documents provide information not already in the irs’s possession is being more rigorously enforced. united states v. monumental life ins. co., 440 f3d 729 (6th cir. 3/3/06), rev’g 345 f. supp. 2d 712 (w.d. ky. 10/8/04). the sixth circuit reversed the district court and denied enforcement of an irs summons because the irs already had in its possession many of the documents containing the information sought in the summonsed documents – even though it obtained the information after the summons was issued. the burden is on the government rather than on the taxpayer to demonstrate that the government's interests outweigh the taxpayer’s hardship, and the government was offered the opportunity to craft a more narrowly-tailored summons. c. litigation costs 1. urban v. united states, 2006-1 u.s.t.c. ¶50,211, 97 a.f.t.r.2d 2006-751 (n.d. ill. 1/24/06). attorney’s fees were awarded in a § 6672 case where (1) the government’s “physical evidence was totally insufficient to prove its case,” and (2) the government based its case on testimony of witnesses that was “inherently incredible ... biased, selfserving, perhaps acquired in a deal with the irs and ... impeached at trial.” 2. the circuits are split on whether attorney’s fees may be awarded to a pro se taxpayer, but the second circuit has not yet spoken. a bankruptcy court in new york answers “yes.” in re hudson, 97 a.f.t.r.2d 2006-2693 (bankr. n.d. n.y. 5/16/06). a pro se taxpayer who prevails against government’s position that was not substantially justified can recover an amount equal to reasonable attorney’s fees. d. statutory notice 1. in cases where the irs has determined that the taxpayer realized unreported income, the commissioner must provide a minimal evidentiary foundation for the deficiency determination before the presumption of correctness attaches to it. mcmanus v. commissioner, t.c. memo. 2006-057 (3/27/06). without a minimal evidentiary foundation for the deficiency determination, judge haines held that the burden of going 2007] recent developments in federal income taxation 515 forward with the evidence shifts from the taxpayer to the commissioner – wholly apart from § 7491 – on the ground that the notice of deficiency is arbitrary. e. statute of limitations 1. benson v. commissioner, t.c. memo. 2006-55 (3/27/06). items on the tax returns of brother-sister corporations reflecting payments between them, which on the facts were found to be constructive dividends to their common shareholder, did not constitute adequate disclosure with respect to the shareholder’s return to prevent the § 6501(3)(1)(a) six-year statute from being applicable. 2. the informal claim doctrine may not apply in a suit for refund. computervision corp. v. united states, 445 f.3d 1355 (fed. cir. 4/20/06). an amendment of a refund claim filed after the statute of limitations had run and which claimed a different amount under a different theory was not germane to the original refund claim and thus did not relate back. a. or, it may apply. parker hannifin corp. v. united states, 71 fed. cl. 231 (fed. cl. 5/23/06). an amendment of a refund claim after the statute of limitations had run on an original timely-filed refund claim seeking approximately $89,000 of allegedly overpaid interest on a deficiency, to increase the claim to approximately $9.1 million, was germane to the original refund claim because it was based on the same theory, and thus related back. f. liens and collections 1. greene-thapedi v. commissioner, 126 t.c. 1 (1/12/06). the tax court is divested of jurisdiction where the irs applies an overpayment from another year to satisfy a deficiency after issuing a determination in a cdp hearing, even though taxpayer is contesting existence of the liability on the asserted grounds that she had not received a deficiency notice. because there was no action subject to review, taxpayer had “no independent basis to challenge” the underlying tax liability in the tax court, because it could not exercise jurisdiction over a refund claim. 2. tax court makes it easier to find abuse of discretion in collection due process hearings, but the courts of appeals won’t play along. robinette v. commissioner, 123 t.c. 85 (7/20/04) (reviewed, 14-3), rev’d, 439 f.3d 455 (8th cir. 3/8/06). in 1995, the taxpayer had entered into an offer in compromise (based on doubt as to collectibility) 516 florida tax review [vol. 8:si relating to years prior to 1992, which required that he file timely returns for 1995 through 1999. the returns for 1995 through 1997 were timely filed, but the 1998 return was never received. the taxpayer and his accountant claimed that on the day the 1998 return was due, his accountant prepared it, the taxpayer signed it, and the accountant mailed it using a private postage meter [uh-oh]. the irs declared the compromise in default. after a due process hearing in which the taxpayer claimed good faith compliance and offered alternative proof of mailing, including a copy of the 1998 return, the appeals officer issued a notice of determination to proceed with collection, because the appeals officer would accept only a certified or registered mail receipt as proof of mailing. even though the tax court’s review of collection due process hearings is for abuse of discretion, in a reviewed opinion by judge vasquez (in which 5 judges joined), the tax court held that it may consider evidence presented at trial that was not in the administrative record (but may not consider new issues). the court held that the administrative procedures act review provisions do not apply to § 6330(d) proceedings, and admitted the taxpayer’s testimony that he signed and delivered returns to his accountant for mailing, the accountant’s testimony regarding the procedures used to mail the return, and other evidence not in the administrative record indicating that the return was mailed. although the testimony was admitted, it did not prove timely mailing because the accountant used a private meter and the return was not received until several years later when the copy was delivered to appeals. nevertheless, the court held that the taxpayer did not materially breach the offer in compromise and that the appeals officer abused his discretion in declaring the compromise in default. there were an indescribable number of overlapping concurrences by an additional nine judges, in some of which the five “majority” judges joined, and one of which concurring opinions was supported by more judges than supported the “majority” opinion; there were three dissents. a. chief counsel’s response. chief counsel notice cc-2004-031 (9/1/04). deborah butler provides guidance to chief counsel attorneys as to how to handle collection due process cases in light of the tax court’s decision in robinette. the recommended course of action when such evidence is presented to the court is to ask for a remand of the case to appeals for a supplemental determination. b. murphy v. commissioner, 125 t.c. 301 (12/29/05), aff’d, 469 f.3d 27 (1st cir. 11/20/06). the tax court (judge halpern) declined to overrule robinette, but excluded as irrelevant the taxpayer’s proffered testimony as to the nature of his illness which allegedly precluded him from making a larger offer in compromise because taxpayer 2007] recent developments in federal income taxation 517 had “more than an adequate opportunity to provide [the appeals officer] with all of the evidence” and declined to do so. the court went on to state: “an appeals officer does not abuse her discretion when she fails to take into account information that she requested and that was not provided in a reasonable time.” c. robinette reversed because the case should have been reviewed based upon the evidence presented to the appeals officer. robinette v. commissioner, 439 f.3d 455 (8th cir. 3/8/06). inasmuch as the tax court reviews the decision of an appeals officer under an “abuse of discretion” standard of review, the record on review under both the administrative procedure act and general principles of administrative law is “ordinarily limited to consideration of the decision of the agency … and of the evidence on which it was based.” • judge colloton did not think that because the tax court traditionally conducts de novo proceedings in deficiency cases, congress meant it to conduct such proceedings in collection due process cases. d. murphy affirmed; eighth circuit decision in robinette followed. 469 f.3d 27 (1st cir. 11/20/06). the first circuit affirmed the tax court’s decision in murphy, but on different grounds. the court of appeals held that the administrative record rule applies to a taxpayer’s cdp hearing appeal to the tax court, citing the eighth circuit’s decision in robinette. judicial review normally should be confined to the information that was before the irs when making the challenged rulings. 3. manko v. commissioner, 126 t.c. 195 (4/20/06). on the taxpayer’s challenge to enforcement of a levy, judge kroupa held that where a taxpayer has executed a closing agreement on form 906, which only finally determines one or more separate items affecting the taxpayer's liability, the irs must nevertheless issue a statutory notice of deficiency before proceeding to collect any deficiency. 4. zapara v. commissioner, 126 t.c. 215 (4/25/06). where the irs failed to comply with taxpayer’s request to sell seized stock within 60 days, the tax court (judge thornton) granted equitable relief by granting taxpayer a credit for the value of the seized stock as of the date by which it should have been sold under the statute; because the irs’s failure to adhere to follow the statutory mandate in § 6335(f) frustrated taxpayer’s ability to use the stock to satisfy tax liabilities and increased taxpayer’s risk with respect to the stock therefore, the irs must assume the risk of loss with respect to the stock. 518 florida tax review [vol. 8:si 5. cox. v. commissioner, 126 t.c. 237 (5/3/06). an appeals officer is not disqualified from conducting a collection due process hearing for a later year by virtue of conduct of a prior collection due process hearing for the same taxpayer with respect to an earlier year, which is not “prior involvement” within the meaning of § 6330(b)(3), where the record does not otherwise call into question his impartiality. 6. gorospe v. commissioner, 451 f.3d 966 (9th cir. 5/3/06), cert. denied, 127 s. ct. 987 (1/8/07). the ninth circuit affirmed the tax court’s determination that it did not have jurisdiction over an appeal from collection due process proceedings with respect to trust fund recovery penalties under § 6630(d)(1)(b), because the tax court did not have jurisdiction over the underlying liability. [section 6330(d) has been amended to provide the tax court with exclusive jurisdiction over review of all cdp determinations issued on or after 10/17/06.] 7. partial payment to be required on the submission of an offer-in-compromise. tipra § 509 adds new § 7122(c) to require partial payments of 20 percent of lump-sum offers-in-compromise [oddly defined to include all offers featuring five or fewer installments], or the first installment of periodic payment offers-in-compromise, with the submission of such offers. offers submitted without the required payments (unless a waiver is provided for under regulations to be issued) are to be returned to the taxpayer as unprocessable. • tipra also added code § 7122(f), which provides that an offer-in-compromise is deemed to have been accepted by the irs if the irs has not rejected it within two years of the date on which it was submitted. a. notice 2006-68, 2006-31 i.r.b. 105 (7/11/06). this notice contains interim guidance pending promulgation of final regulations. payments accompanying lump sum offers will be treated as a payment of tax, and not as a refundable deposit. if the taxpayer submits a periodic payment offer, it must be accompanied by the first installment, and subsequent installments must be timely paid during the period of evaluation of the offer-in-compromise by the irs, and will be similarly treated as payments of tax. any applicable user fee must be paid along with the partial payment, but the user fee will serve to reduce the taxpayer’s tax liability dollar-for-dollar. voluntary payments in excess of the required payments will be treated as refundable deposits if they are not designated as tax payments by the taxpayer. the payment requirement can be waived with 2007] recent developments in federal income taxation 519 respect to an offer submitted by a low-income taxpayer or with respect to an offer submitted based solely on the basis of doubt as to liability. 8. bell v. commissioner, 126 t.c. 356 (5/22/06). the tax court (judge foley) held that taxpayer was properly barred from challenging the underlying liability in a § 6220 due process hearing because he had the opportunity to appeal to the tax court from a determination letter issued after a previous § 6330 due process hearing and failed to do so. 9. barnes v. commissioner, t.c. memo. 2006-150 (7/24/06). the tax court (judge laro) held that the irs properly rejected taxpayers’ offer in compromise based on promotion of effective tax administration because the taxpayers failed to identify compelling considerations of public policy or equity. a compromise based on promotion of effective tax administration is further not warranted because taxpayer’s liability arose from a tax shelter scheme in which they were allegedly defrauded by the promoter, because “[a] compromise on that basis would place the government in the unenviable role of an insurer against poor business decisions by taxpayers.” the irs properly rejected the offer in compromise based on the alternative ground of doubt as to collectibility because the taxpayers offered less than they were able to pay and the irs’s rejection of the offer was “a reasonable application of the guidelines, which we decline to second guess,” and was not abusive or unfair. judge laro noted that under reg. § 301.7122-1(c)(3), “economic hardship” exists where a taxpayer is “unable to pay his or her reasonable basic living expenses,” and the taxpayers must articulate with specificity the purported economic hardship they will suffer if they are not allowed to compromise their liability. • judge laro refused to consider additional evidence offered by taxpayers that was not offered during the administrative proceeding, stating, “as we read petitioners’ memorandum in the light of the record as a whole, petitioners wanted to include the external evidence in the record of this case to prove that [the appeals officer] abused her discretion by not considering facts and documents that they had consciously decided not to give to her.” 10. cristopher cross, inc. v. united states, 461 f.3d 610 (5th cir. 8/21/06). an appeals officer did not abuse her discretion in returning an offer in compromise as “nonprocessable” based upon the internal revenue manual. taxpayer had offered $85,000 on a deferred payment schedule to settle an assessed liability for employment taxes of $134,078 for four quarters. the offer was rejected because (1) the taxpayer had not timely made federal tax deposits of estimated tax, and (2) it had 520 florida tax review [vol. 8:si more than sufficient equity in accounts receivable and moveable assets to pay the tax in full. 11. pension protection act § 855 amends code § 6330(d) to provide that all appeals of collection due process determinations are to be made to the tax court. the provision is effective for determinations made more than 60 days after the august 17, 2006 date of enactment. a. cc-2007-001 (10/13/06). 2006 tnt 201-7. the irs has provided guidance regarding the amendment to § 6330(d) providing the tax court with exclusive jurisdiction over review of all cdp determinations issued on or after 10/17/06. 12. t.d. 9290, miscellaneous changes to collection due process procedures relating to notice and opportunity for hearing upon filing of notice of federal tax lien, 71 f.r. 60835 (10/17/06). these final regulations amend the regulations relating to a taxpayer's right to a hearing under § 6320 after the filing of a notice of federal tax lien (nftl). they make certain clarifying changes in the way collection due process hearings are held and specify the period during which a taxpayer may request an equivalent hearing. the final regulations affect taxpayers against whose property or rights to property the internal revenue service (irs) files a nftl. these regulations are effective 11/16/06. a. t.d. 9291, miscellaneous changes to collection due process procedures relating to notice and opportunity for hearing prior to levy, 71 f.r. 60827 (10/17/06). these final regulations amend the regulations relating to a taxpayer's right to a hearing before or, in limited cases, after levy under § 6330. they make certain clarifying changes in the way cdp hearings are held and specify the period during which a taxpayer may request an equivalent hearing. the final regulations affect taxpayers against whose property or rights to property the internal revenue service (irs) intends to levy. these regulations are applicable to requests for cdp hearings after 11/16/06. g. innocent spouse 1. no “plain language” limitation of the tax court’s jurisdiction in this case. ewing v. commissioner, 118 t.c. 494 (5/31/02). the taxpayer and her husband filed a joint return but did not pay all of the tax shown on the return. subsequently, before the irs asserted any deficiency, the taxpayer requested equitable relief from joint and several 2007] recent developments in federal income taxation 521 liability under § 6015(f). the irs denied relief and mailed a notice of determination that was not mailed to the taxpayer’s last known address, but was actually received by the 88th day after it was mailed. the taxpayer’s petition for review was postmarked 92 days after the mailing of the notice, and was received and filed seven days later. the commissioner moved to dismiss on the ground that the petition was not timely filed. the tax court sua sponte raised the issue of whether it had jurisdiction under § 6015(e) to review the irs’s denial of § 6015(f) relief where no deficiency had been asserted. [section 6015(e), granting the tax court jurisdiction to review denials of § 6015 relief, as amended by the consolidated appropriations act of 2001, begins, “in the case of an individual against whom a deficiency has been asserted and who elects to have subsection (b) or (c) apply...”] in a reviewed opinion by judge ruwe, the majority (9-4) held that the tax court has jurisdiction to review a denial of § 6015(f) relief in a stand alone petition where the taxpayer is seeking relief from liability of tax shown on the return, without a deficiency having been asserted. the court further held that the petition was timely because it was filed more than 6 months after the date she submitted her request for relief [see § 6015(e)(1)(a)], the irs failed to mail the notice of determination to taxpayer’s last known address, and the misaddressed notice prejudiced the taxpayer’s ability to file her petition within 90 days after the mailing of the notice. the court concluded that: [t]he language “against whom a deficiency has been asserted” was inserted into section 6015(e) to *** to prevent taxpayers from submitting premature requests to the commissioner for relief from potential deficiencies before the commissioner had asserted that additional taxes were owed. *** congress was concerned with the proper timing of a request for relief for underreported tax and intended that taxpayers not be allowed to submit a request to the commissioner regarding underreported tax until after the issue was raised by the irs. there is nothing in the legislative history indicating that the amendment of section 6015(e) ***, was intended to eliminate our jurisdiction regarding claims for equitable relief under section 6015(f) over which we previously had jurisdiction. the stated purpose for inserting the language “against whom a deficiency has been asserted” into section 6015(e) was to clarify the proper time for a taxpayer to submit a request to the commissioner for relief under section 6015 regarding underreported taxes. we conclude that the amendment of section 6015(e) does not preclude our jurisdiction to review the denial of equitable relief under 522 florida tax review [vol. 8:si section 6015(f) where a deficiency has not been asserted. in the instant case, petitioner filed a claim for relief from joint and several liability for an amount of tax correctly shown on the return but not paid with the return. because respondent has not challenged the tax reported on the return, no deficiency has been asserted. in this situation, petitioner may be entitled to relief under section 6015(f) because subsection (f) applies where “it is inequitable to hold the individual liable for any unpaid tax or any deficiency.” [citations omitted]. • judge laro’s dissent argued that the tax court lacked jurisdiction to review the denial of § 6015 relief in the absence of a deficiency, because he considered § 6015(e)(1) to be a “clear statutory mandate from congress” limiting the tax court’s jurisdiction to review denials of § 6015 relief to deficiency cases. a. ewing v. commissioner, 122 t.c. 32 (1/28/04). in a reviewed opinion by judge colvin, the tax court held that even though the standard for reviewing the commissioner’s failure to grant equitable relief under § 6015(f) is abuse of discretion, the tax court’s review is not necessarily limited to the facts that were in the administrative record. judges halpern, holmes, chiechi, and foley dissented. b. reversed, vacated and dismissed because the tax court did not have jurisdiction over taxpayer’s petition in which she claimed innocent spouse relief. commissioner v. ewing, 439 f.3d 1009 (9th cir. 2/28/06). judge tashima held that the tax court did not have jurisdiction to review wife’s petition for equitable relief under § 6015(f) because there was no deficiency asserted against her and she did not elect relief under § 6015(b) or (c), as is required by § 6015(e) in order for the tax court to have jurisdiction over an innocent spouse claim. the phrase in § 6015(e) “against whom a deficiency has been asserted” was added in 2001. 2. ordlock v. commissioner, 126 t.c. 47 (1/19/06) (reviewed, 10-8). taxpayer is not entitled to a refund of amounts from community property used to pay her husband’s tax liabilities understatements because under california state law community property is subject to an obligation of one spouse. 3. imagine the other stories he was ready to believe. motsko v. commissioner, t.c. memo. 2006-17 (2/2/06). the tax court 2007] recent developments in federal income taxation 523 (judge holmes) held that a taxpayer who signed a joint return prepared by his subsequently-imprisoned wife more than a year late, at a time when he knew that prior returns were under audit, had a “duty of inquiry” because a reasonable person in his position would have gotten suspicious that [his wife] was no longer behaving as expected.” inasmuch as the taxpayer made no inquiry, he did not qualify for the safe harbor in rev. proc. 2000-15, 2001-1 c.b. 448, § 4.02, and equitable relief was denied based on a balancing of the eight factors listed in the revenue procedure. incidentally, taxpayer did not own the business he thought he owned; it was owned by a partnership between his wife and her brother. 4. campbell v. commissioner, t.c. memo. 2006-24 (2/15/06). a wife who was financially unsophisticated had no knowledge of, and no duty to inquire as to, husband’s sham losses purportedly incurred in commodities trading account – even though the trades were through an account in her name – because she was only a nominee, the sophisticated transactions “looked legitimate on paper,” and “a reasonable person with [the wife’s] educational background, devoid of any specific knowledge in options trading, could not be expected to discover that the trades were fictitious.” 5. rev. rul. 2006-16, 2006-14 i.r.b. 694 (4/30/06). a taxpayer is not precluded from seeking innocent spouse relief under § 6015 by virtue of a prior bankruptcy case filed by the taxpayer and the taxpayer’s spouse in which the irs filed a proof of claim, if the bankruptcy court did not make an actual determination of the liability. on the other hand, if the requesting spouse had been the debtor in the bankruptcy case and had meaningfully participated in the dischargeability proceeding, and the bankruptcy court had determined the tax liability on the merits, that determination generally would have precluded the requesting spouse from subsequently receiving § 6015 relief. h. miscellaneous 1. there is a form 1099 for tax exempt interest in your future. tipra § 502 amends code § 6049(b)(2) to eliminate the exception for tax-exempt interest from reporting requirements. thus payors of tax-exempt interest will be required to report such interest on form 1099. this provision is applicable to interest paid after 12/31/05. a. notice 2006-93, 2006-44 i.r.b. 798 (10/4/06). provides transitional relief for payors of tax-exempt interest during 2006 and the first quarter of 2007. 524 florida tax review [vol. 8:si 2. tax court may apply the doctrine of equitable recoupment. pension protection act § 858 amends code § 6214(b) to authorize the tax court to apply the doctrine of equitable recoupment. 3. duty of consistency prevents tax gamesmanship. janis v. commissioner, 461 f.3d 1080 (9th cir. 8/21/06). taxpayer, as coexecutor of his father’s estate, agreed with the irs on a discounted value [for blockage] of an extensive art collection held by his father [in a sole proprietorship, the sidney janis art gallery] included in the estate on the premise that flooding the market with the art works would depress the value of the art works. later, in valuing the art gallery’s inventory, taxpayer used the full undiscounted value of more than $36 million instead of the estate tax value of $14.5 million for purposes of calculating the gallery’s income. judge mckeown held that the duty of consistency should be applied in order to prevent inequitable shifting of positions by the taxpayer. • the doctrine requires that there be (1) a representation by the taxpayer [here, as beneficiary and co-executor of his father’s estate], (2) reliance by the commissioner, and (3) a change in position by the taxpayer after the statute of limitations has run. the court noted that “[s]uch tax gamesmanship is exactly what the duty of consistency is designed to prevent.” 4. houston sb/se taxpayers may be guinea pigs for fast-track settlements. announcement 2006-61, 2006-36 i.r.b. 390 (8/22/06), corrected by announcement 2006-97, 2006-50 i.r.b. 1108 (12/11/06). the irs has extended the lmsb fast-track settlement program to sb/se. the program will be available for a two-year test period, and for the first six months will be available only for taxpayers in chicago, houston, and st. paul. rev. proc. 2003-40, 2003-1 c.b. 1044, implemented the program. the program is effective beginning 9/5/06. 5. tax court grants taxpayer’s motion for leave to file a motion to vacate an order dismissing his case for lack of jurisdiction, and holds that the motion should be deemed filed on the date it was mailed, rather than on the date it was received. stewart v. commissioner, 127 t.c. 109 (10/3/06) (reviewed, 18-0). the tax court (judge ruwe) determined that the timely-mailing/timely-filing provisions of § 7502 would apply to a motion for leave to file a motion to vacate an order of dismissal for lack of jurisdiction, so the tax court’s earlier decision would not become final after the 90-day period for appeal had elapsed under § 7481(a). the tax court will no longer follow its decision in manchester group v. commissioner, t.c. memo. 1994-604, rev’d, 113 f.3d 1087 (9th cir. 1997). 2007] recent developments in federal income taxation 525 6. i’m from the irs and i’m here to help you comply with fin 48. the irs announced on 10/17/06 an lmsb initiative to help taxpayers resolve on an expedited basis their issues with financial accounting standards board interpretation no. 48 (fin 48), “accounting for uncertainty in income taxes – an interpretation of fasb statement no. 109.” 2006 tnt 201-17. requests for fin 48 resolution must be submitted at least 45 days before the end of taxpayer’s fiscal year; the expedited procedure is not recommended for fiscal years ending after 3/31/07. 7. t.d. 9300, guidance necessary to facilitate business electronic filing, 71 f.r. 71040 (12/8/06). the treasury has promulgated final regulations on eliminating regulatory impediments to businesses filing electronic returns. 8. individuals who follow lauren bacall’s instructions will be entitled to between 15 and 30 percent of the collected proceeds resulting from their information. the tax relief and health care act of 2006 § 406 amends code § 7623 to reform the reward program for individuals who provide information regarding violations involving an individual whose gross income exceeds $200,000 for the relevant year if the tax, penalties, interest and additional amounts in dispute exceed $2 million. generally, the provision establishes a reward floor of 15% and a cap of 30% of the collected proceeds (including penalties, interest, additions to tax and additional amounts) if the irs moves forward with an administrative or judicial action based on information brought to the irs's attention by an individual. under certain specified circumstances, the provision permits awards of lesser amounts. the provision allows an abovethe-line deduction for attorneys’ fees and costs paid by, or on behalf of, the individual in connection with any award for providing information regarding violations of the tax laws. 9. burton kanter in trouble again. investment research associates, ltd. v. commissioner, t.c. memo. 1999-407 (12/15/99). in a 600-page opinion burton kanter was held liable for the §6653 fraud penalty by reason of his being “the architect who planned and executed the elaborate scheme with respect to the kickback income payments . . . . in our view, what we have here, purely and simply, is a concerted effort by an experienced tax lawyer [kanter] and two corporate executives [claude ballard and robert lisle] to defeat and evade the payments of taxes and to cover up their illegal acts so that the corporations [employing the two corporate executives] and the federal government would be unable to discover them.” 526 florida tax review [vol. 8:si a. so far, he is unable to wriggle out, the way he did 25 years ago when he was acquitted by a jury.2 the taxpayers subsequently moved to have access to the special trial judge’s “reports, draft opinions, or similar documents” prepared under tax court rule 183(b). they based their motion on conversations with two unnamed3 tax court judges that the original draft opinion from the special trial judge was changed by judge dawson before he adopted it. they were turned down because the tax court held that the documents were related to its internal deliberative processes. see, tax court order denying motion, 2001 tnt 2331 (4/26/00) and (on reconsideration) 2001 tnt 23-30 (8/30/00). taxpayers sought mandamus from the fifth, seventh and eleventh circuits, but were unsuccessful. b. and the tax court’s procedures are vindicated and taxpayer ballard loses on appeal on the fraud issue in the eleventh circuit. ballard v. commissioner, 321 f.3d 1037 (11th cir. 2/13/03), aff’g t.c. memo. 1999-407. the eleventh circuit affirmed the tax court decision and rejected the taxpayers’ argument that changes allegedly made by the tax court special trial judge were improper. judge fay stated: even assuming dick’s [taxpayers’ lawyer’s] affidavit to be true and affording petitioners-appellants all reasonable inferences, the process utilized in this case does not give rise to due process concern. while the procedures used in the tax court may be unique to that court, there is nothing unusual about judges conferring with one another about cases assigned to them. these conferences are an essential part of the judicial process when, by statute, more than one judge is charged with the responsibility of deciding the case. and, as a result of such conferences, judges sometimes change their original position or thoughts. whether special trial judge couvillion prepared drafts of his report or subsequently changed his opinion entirely is without import insofar as our analysis of the alleged due process violation pertaining to the application of [tax court] rule 183 is concerned. despite the invitation, this court will simply not interfere with another court’s deliberative process. 2. his partner (and son-in-law) was convicted and imprisoned. see united states v. baskes, 649 f.2d 471 (7th cir. 1980), cert. denied, 450 u.s. 1000 (1981). 3. kanter’s attorney revealed the names of the two judges when asked at oral argument to the seventh circuit as tax court judge julian jacobs and chief special trial judge peter j. panuthos. see the text at footnote 1 of judge cudahy’s dissent in the seventh circuit kanter estate opinion, below. 2007] recent developments in federal income taxation 527 the record reveals, and we accept as true, that the underlying report adopted by the tax court is special trial judge couvillion’s. petitioners-appellants have not demonstrated that the order of august 30, 2000 is inaccurate or suspect in any manner. therefore, we conclude that the application of rule 183 in this case did not violate petitioners-appellants’ due process rights. accordingly, we deny the request for relief and save for another day the more troubling question of what would have occurred had special trial judge couvillion not indicated that the report adopted by the tax court accurately reflected his findings and opinion. c. and the tax court’s procedures are vindicated and taxpayer kanter’s estate4 loses on appeal on the fraud issue in the eleventh circuit estate of kanter v. commissioner, 337 f.3d 833 (7th cir. 7/24/03) (per curiam) (2-1), aff’g in part and rev’g in part t.c. memo. 1999-407. the court found that the nondisclosure of the special trial judge’s original report was proper, following the eleventh circuit’s ballard opinion. it affirmed the tax court’s findings on the issues of deficiencies, fraud and penalties, but reversed on the issue of the deductibility of kanter’s expenses for his involvement in the aborted sale of a purported john trumball painting of george washington because “kanter has shown a distinct proclivity to seek income and profit through activities similar to the failed sale of the painting.” d. and the tax court’s procedures are vindicated but taxpayer lisle’s estate wins on appeal on the fraud issue in the fifth circuit. estate of lisle v. commissioner, 341 f.3d 364, 2003 u.s.t.c. ¶ 50,606, 92 a.f.t.r.2d 2003-5566 (5th cir. 7/30/03), aff’g in part and rev’g in part t.c. memo. 1999-407. the fifth circuit (judge higginbotham) followed the eleventh and seventh circuits on the nondisclosure of the special trial judge’s original report by the tax court. the court affirmed the findings of deficiencies, except for the deficiency in a closed year because the government’s proof of lisle’s fraud did not rise to the level of “clear and convincing evidence.” e. justice ginsburg to tax court judges: “you article i judges don’t understand your own rules, so let me tell you what you meant when you adopted them in 1983.” ballard v. commissioner, 544 u.s. 40 (3/7/05) (7-2), reversing and remanding 337 f.3d 833 (7th cir. 7/24/03) and 321 f.3d 1037 (11th cir. 2/13/03). justice ginsburg held that the tax court may not exclude from the record on appeal 4. burton kanter died on october 31, 2001. 528 florida tax review [vol. 8:si nor conceal from the taxpayers the original draft reports of special trial judges under tax court rule 183(b). justice ginsburg so held because no statute authorizes the concealment and the rule’s “current text” does not warrant it. her reading of tax court rule 183 is that it does not authorize the tax court to treat the special trial judge’s rule 183(b) report as a draft subject to collaborative revision. she held that it is particularly important that the process be transparent in fraud cases such as this one. • chief justice rehnquist’s dissenting opinion, joined in by justice thomas, states that the “tax court’s compliance with its own rules is a matter on which we should defer to the interpretation of that court.” he concludes that “seminole rock deference” [bowles v. seminole rock & sand co., 325 u.s. 410 (1945)] should extend to an article i court’s interpretation of its own rules as well as to an executive agency’s interpretation of its rules. he further notes that the issue of compliance with rule 183 was not presented to the supreme court, and that under supreme court rule 14.1(a) the “court does not consider claims that are not included within a petitioner’s questions presented.” he notes, “only by failing to abide by our own rules can the court hold that the tax court failed to follow its rules.” f. the eleventh circuit orders that the special trial judge’s report be added to the record. ballard v. commissioner, 2005-1 u.s.t.c. ¶50,393 (11th cir. 5/17/05). the report was 300 pages. g. tax court proposes new rule on special trial judges’ reports. on july 7, 2005, tax court chief judge joel gerber announced that the court proposes to amend its rules to provide (in proposed rule 183) substantially the same procedure it had before the 1983 change, which would allow parties to review and file objections to a special trial judge’s recommended findings of fact and conclusions of law before the case is reassigned to a presidentially appointed judge for decision. h. tax court releases judges’ statements. in an order dated 7/19/05, chief judge gerber of the tax court released statements from chief judge cohen, judge dawson and special trial judge couvillion outlining the procedures followed in the submission, review and adoption of the memorandum opinion in investment research associates, ltd. the statements were that the proposed report submitted by the special trial judge was deemed unsatisfactory by judge dawson and then-chief judge cohen in that the facts found did not support the proposed opinion. after the chief judge’s request that judge jacobs take charge of the matter was declined because kanter’s lawyer was a close friend, judge couvillion 2007] recent developments in federal income taxation 529 withdrew the proposed report the day before a scheduled meeting with judge dawson and chief judge cohen. following the withdrawal, judge dawson and special trial judge couvillion collaborated on the report. i. more fallout from the ballard decision. the tax court identified and located 117 initial opinions submitted by special trial judges under tax court rule 183(b). 2005 tnt 175-2 (9/8/05). four of the opinions were changed (other than that in ballard), with the changes resulting in taxpayer-favorable holdings in three of the four. there is a dispute as to what happened in johnson v. commissioner, t.c. memo. 1992-369, with taxpayer’s attorney recalling that special trial judge goldberg congratulated him at the tax court’s november 1992 on his win in the case, and seemed surprised when taxpayer’s attorney responded that he had lost the case; special trial judge goldberg disputes that the conversation took place. j. tax court press release, 9/21/05. the tax court announced that it has adopted amendments to tax court rules 182 and 183, relating to special trial judges’ reports in cases other than small tax cases. the special trial judge’s recommended findings of fact and conclusions of law are to be served on the parties, who may file written objections and responses. after the case is assigned to a regular judge, any changes made shall be reflected in the record and “[d]ue regard shall be given to the circumstance that the special trial judge had the opportunity to evaluate the credibility of witnesses, and the finding of fact recommended by the special trial judge shall be presumed to be correct.” k. chief counsel notice cc-2005-017 (9/27/05). this notice describes procedures for handling motions filed by previous tax court petitioners “who now seek to vacate decisions based on ballard-type claims in which they argue that the special trial judge’s draft opinion was changed before the tax court issued it as a reported opinion.” l. the eleventh circuit remands the case to the tax court – after reinstating the special trial judge’s report. ballard v. commissioner, 429 f.3d 1026 (11th cir. 11/2/05) (per curiam). the case was remanded to the tax court with the following instructions: (1) the “collaborative report and opinion” is ordered stricken; (2) the original report of the special trial judge is ordered reinstated; (3) the tax court chief judge is instructed to assign this case to a previouslyuninvolved regular tax court judge; and (4) the tax court shall proceed to review this matter in accordance with the supreme court’s dictates and with its newly-revised rules 182 and 183, giving “due regard” to the credibility 530 florida tax review [vol. 8:si determinations of the special trial judge and presuming correct fact findings of the trial judge. specifically, the eleventh circuit ordered that former chief judge cohen, judge dawson and judge couvillion are not to be involved in the new review. m. estate of lisle v. commissioner, 431 f.3d 439 (5th cir. 11/22/05) (per curiam). remands the case to the tax court with orders to: (1) strike the “collaborative report” that formed the basis of the tax court’s ultimate decision; (2) reinstate judge couvillion’s original report; (3) refer this case to a regular tax court judge who had no involvement in the preparation of the aforementioned “collaborative report” and who shall give “due regard” to the credibility determinations of judge couvillion, presuming that his fact findings are correct unless manifestly unreasonable [in dealing with the remaining issues of tax deficiency]; and (4) adhere strictly hereafter to the amended tax court rule in finalizing tax court opinions. n. estate of kanter v. commissioner, t.c. memo. 2006-46 (3/16/06). the tax court (judge haynes) denied the estate’s motion to abate the tax assessments entered after its initial decision [when it failed to post a bond under § 7485 to stay the assessment or collection of the tax liabilities in dispute during the pendency of the appeals] because under § 7486 in order for collection to be abated the appellate court must “disallow in whole or in part” the deficiency determined by the tax court, and no appeals court in this case made any finding regarding the correct amount of the estate’s deficiencies. judge haynes followed estate of smith v. commissioner, 115 t.c. 342 (2000). judge haynes granted the commissioner’s motion to stay proceedings and maintain the status quo in order to preserve his position in relation to other creditors. the estate had made an offer-in-compromise to the appeals office based on doubt as to liability and collectibility, which was denied. o. on remand, in a 458-page opinion judge haynes of the tax court pours out kanter and ballard. estate of kanter v. commissioner, t.c. memo. 2007-21 (2/1/07). the tax court (judge haynes) found that certain of the special trial judge’s findings of fact were “manifestly unreasonable” because they were “internally inconsistent or so implausible that a reasonable fact finder would not believe [the recommended finding]” or they were “directly contradicted by documentary or objective evidence.” judge haynes therefore found that the kanter-related entities were shams, that “kanter, ballard, and lisle participated in a complex, well-disguised scheme to share kickback payments earned jointly 2007] recent developments in federal income taxation 531 by kanter, ballard, and lisle,” and that they earned income during the years at issue which they failed to report. • judge haynes found that – based upon factors such as (1) failure to report substantial amounts of income, (2) concealment of the true nature of the income and the identity of the earners of the income, (3) use of sham, conduit, and nominee entities, (4) reporting kanter’s and ballard’s income on iras [and another entity’s] tax returns, (5) commingling of kanter’s and ballard’s income with funds belonging to others, (6) phony loans, (7) false and misleading documents, and (8) failure to cooperate during the examination process by engaging in a “strategy of obfuscation and delay” – the commissioner demonstrated by “clear and convincing evidence” that kanter and ballard filed false and fraudulent tax returns for each of the years at issue. • judge haynes held that the tax court is “obliged to review the recommended findings of fact and credibility determinations set forth in the stj report under a ‘manifestly unreasonable’ standard of review, and ... may reject such findings of fact and credibility determinations only if, after reviewing the record in its entirety, [it] conclude[s] that the recommended finding of fact or testimony (1) is internally inconsistent or so implausible that a reasonable fact finder would not believe it, or (2) is not credible because it is directly contradicted by documentary or objective evidence.” furthermore, judge haynes held that a special trial judge’s credibility determinations may be rejected under the “manifestly unreasonable” standard of review without rehearing the disputed testimony. • judge haynes further found that the appropriate standard for determining whether the assignment of income doctrine should be applied had been appropriately articulated in united states v. newell, 239 f.3d 917, 919-920 (7th cir. 2001), as follows: to shift the tax liability, the assignor [taxpayer] must relinquish his control over the activity that generates the income; the income must be the fruit of the contract or the property itself, and not of his ongoing income-producing activity. ... this means, in the case of a contract, that in order to shift the tax liability to the assignee the assignor either must assign the duty to perform along with the right to be paid or must have completed performance before he assigned the contract; otherwise it is he, not the contract, or the assignee, that is producing the contractual income — it is his income, and he is just shifting it to someone else in order to avoid paying income tax on it. 532 florida tax review [vol. 8:si xi. withholding and excise taxes a. employment taxes 1. tipra § 511 adds new § 3402(t) to provide for a withholding tax of 3-percent on payments made to persons providing property or services to governmental entities. b. excise taxes 1. telephone excise tax inapplicable to charges that do not vary by distance, says the eleventh circuit in its latest pronouncement on the “plain meaning” of the tax statutes. american bankers insurance group v. united states, 408 f.3d 1328 (11th cir. 5/10/05). the long distance services provided by at&t to taxpayer were not within the “toll telephone service” to which § 4252(b)(1) applies because the rates do not vary by “distance and elapsed transmission time” and the unambiguous statute uses these terms conjunctively; the “plain meaning” of the statute requires both the time and the distance to vary. even though there are separate charges for calls depending upon where they fall within one of three toll bands used (intrastate, interstate and international), the rates do not vary by distance per se because calls between places closer to one another often cost more than calls between places further apart. the eleventh circuit reversed the district court’s grant of summary judgment for the government. a. this one is the most fun to read because of the interplay between majority and dissenting opinions as to the meaning of “and.” officemax inc. v. united states, 428 f.3d 583 (6th cir. 11/2/05) (2-1), motion for rehearing en banc denied, 2006 u.s. app. lexis 8294 (6th cir. 3/30/06). federal excise tax on long-distance calls does not apply unless the charges vary based upon both time and distance. the majority opinion held that “and” means “and” but the dissent argued that “and” could also mean “or.” when this three percent tax on toll telephone calls was enacted in 1965, there was only one long-distance telephone provider and its charges were based upon both the distance and time of the call [or on a flat rate for unlimited calling on a wats line, to which the tax also applied]. the majority held that a literal reading of the statute was required because a tax should only apply to that which its language taxes. the dissent would “not encourage lawyers to play word games at the expense of the public fisc.” b. the irs takes a hard line. notice 200579, 2005-2 c.b. 952 (11/14/05). the irs will continue to litigate this issue 2007] recent developments in federal income taxation 533 and will continue to assess and collect the § 4251 tax on long distance communications services. c. amtrak’s long-distance telephone service is not subject to the excise tax on toll telephone services because the payment was based solely on time. national railroad passenger corp. (amtrak) v. united states, 431 f.3d 374 (d.c. cir. 12/9/05). the court affirmed the district court and concluded that the statute was unambiguous, and the “and” in § 4252 was to be read conjunctively. d. the second circuit agrees that the telephone excise tax does not apply. fortis inc. v. united states, 447 f.3d 190 (2d cir. 4/27/06) (per curiam). e. so does the third circuit in a lengthy analysis of the meaning of the word “and” and a shorter analysis of the meaning of the word “distance.” reese brothers, inc. v. united states, 447 f.3d 229 (3d cir. 5/9/06). f. “enough, already!” the irs cries, “uncle.” notice 2006-50, 2006-25 i.r.b. 1141 (5/25/06), revoking notice 2005-79, 2005-2 c.b. 952 (11/14/05). the irs announced that it will stop assessing the § 4251 telephone excise tax on long distance services, and that it will provide for refunds of taxes paid on services billed after 2/28/03 and before 8/1/06. these refunds are to be requested on 2006 federal income tax returns, the right to which will be preserved by the irs scheduling overassessments under § 6407. individuals are eligible to receive a safe harbor amount, which has not yet been determined. interest received on the refunds will have to be reported as 2007 income. g. irs announces safe harbor amounts for telephone tax refunds for individuals. on 8/31/06, the irs announced the safe harbor refund amounts of telephone tax available to individual taxpayers [without records or other proof of actual amounts paid] are $30 for individual filers, with a $10 increase for each additional exemption claimed on the 2006 return, up to a maximum of $60. 2006 tnt 170-2. h. the irs announces safe harbor amounts for telephone tax refunds for businesses. on 9/16/06, the irs announced the safe harbor refund amounts of telephone tax available to business taxpayers [without records or other proof of actual amounts paid]. the refund is to be computed on new form 8913 based upon the taxpayer’s april and september 2006 telephone bills, by making calculations based upon the 534 florida tax review [vol. 8:si difference between the telephone tax charged on these two bills. 2006 tnt 222-11. i. ir-2007-16 (1/25/07). the irs said that early findings show some individual taxpayers have requested apparently improperly large amounts for the special telephone tax refund, such as requesting a refund on the entire amount of their phone bills, or making requests for thousands of dollars indicating they had phone bills in excess of $100,000 – an amount exceeding their income. the irs also noted that some tax preparers are helping their clients file apparently improper requests. xii. tax legislation a. enacted 1. the tax increase prevention and reconciliation act of 2005 (sic) (“tipra”), pub. l. 109-222, was signed by president bush on 5/17/06. 2. heroes earned retirement opportunities act (“hero act”), pub. l. 109-227, 120 stat. 385, was signed by president bush on 5/29/06. 3. the pension protection act of 2006 (“pension protection act”), pub. l. 109-280 was signed by president bush on 8/17/06. 4. a state may not tax nonresident partners on retirement income that is sourced in that state. pub. l. 109-264, which amends 4 u.s.c. § 114(b)(1) to limit state taxation of nonresidents on retirement income paid to partners on account of their in-state services performed during the years the retirement income was accrued, was enacted on 8/3/06. the provision was enacted in response to new york’s attempt to tax retirement income of partners based on the position that 4 u.s.c. § 114 applied to the retirement income of nonresident employees, and not partners. b. pending 1. pub. l. 109-432, the tax relief and health care act of 2006 was signed by president bush on 12/20/06. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review florida tax review volume 13 2012 number 8 397 designing a u.s. exemption system for foreign income when the treasury is empty* by j. clifton fleming, jr.** robert j. peroni*** stephen e. shay**** i. introduction ............................................................................. 398 ii. the double taxation conundrum ....................................... 401 iii. the international law solution........................................ 402 iv. flirting with a flawed territoriality ........................... 403 v. going territorial in the midst of a current and long-run fiscal crisis ........................................................... 406 a. dimensions of the crisis ................................................... 406 b. forfeiting the residual tax .............................................. 408 c. gaining revenue by switching to a zero rate ................. 410 * copyright © by j. clifton fleming, jr., robert j. peroni, and stephen e. shay. all rights reserved. for helpful comments on earlier drafts of this article, we thank participants at a taxation law panel of the law & society association annual meeting in chicago on may 29, 2010, participants at a brigham young university law school workshop on june 3, 2010, participants at the tulane university law school tax roundtable in march 2011, participants at the seventh annual international tax symposium at the levin college of law on october 7, 2011, and participants at the conference on company law and tax law in the post-gfc era, sponsored by monash university, in prato, italy, on september 24-25, 2012. ** ernest l. wilkinson chair and professor of law, j. reuben clark law school, brigham young university; adjunct research fellow, department of business law and taxation, monash university. *** fondren foundation centennial chair for faculty excellence and professor of law, the university of texas school of law; adjunct research fellow, department of business law and taxation, monash university. professor peroni thanks former dean lawrence sager, former interim dean stefanie lindquist, and dean ward farnsworth for their generous research support and melissa bernstein, his former university of texas law library liaison, for her research assistance. professor peroni dedicates this article to his loving parents, betty peroni and the late emil peroni, for their tremendous support and inspiration over the years. **** professor of practice, harvard law school. professor shay thanks the harvard law school and the harvard fund for tax policy research for summer research assistance. 398 florida tax review [vol. 13:8 d. goodbye to the revenue gain ........................................... 411 e. principles for preserving the revenue gain ..................... 412 vi. a principled dividend exemption system ......................... 413 a. dividends out of what? .................................................... 413 1. active income that does not bear a meaningful foreign tax ...................................... 413 2. passive income .................................................... 426 b. who qualifies? ................................................................. 428 1. corporate shareholders ...................................... 428 2. individual shareholders ....................................... 430 c. should royalty, interest, and services payments from foreign corporations qualify for exemption? ........ 431 1. royalties............................................................... 431 2. other untaxed foreign income ........................... 435 3. export sales ......................................................... 435 4. indifference to foreign taxes .............................. 439 d. gain (or loss) from the sale of stock of a cfc ............... 439 vii. branch exemption ................................................................... 441 viii. certain structural issues .................................................... 445 a. export sales redux ........................................................... 446 b. misallocated expenses ...................................................... 448 c. foreign losses .................................................................. 452 ix. competitiveness vs. revenue ................................................ 456 x. conclusion ................................................................................. 458 i. introduction the u.s. government faces a well-documented long-term revenue shortage that is unlikely to be cured by government expenditure reductions. thus, it is curious that there is currently considerable pressure for the united states to adopt some type of territorial or exemption system1 under which 1. under an exemption system, a residence country will confer a tax exemption on most foreign-source business income earned by its residents. exemption systems are also frequently referred to as territorial systems because a country employing such a regime will tax only income earned within its own territory, even if the income earner is its resident. this article follows the prevailing rhetorical practice by using “exemption system,” “territorial system,” and “territoriality” as interchangeable terms, notwithstanding the technical differences in how territorial and exemption systems are implemented in practice by various countries. as noted by some commentators, a true territorial system exempts all foreign-source income from taxation by the residence country, whereas an exemption system exempts only some types of foreign-source income (usually active foreign business income) from taxation by the residence country. see lawrence lokken & yoshimi kitamura, credit v. exemption: a comparative study of double 2012] exemption when the treasury is empty 399 most foreign-source active business income earned by u.s. resident corporations would become substantially free of u.s. income tax. although we are not fans of territoriality, we recognize that a significant reform of the u.s. international tax system is necessary. in other articles, we have expressed our clear preference for strengthening the u.s. worldwide taxation system2 by repealing the deferral privilege and instituting a per-country foreign tax credit limitation.3 however, if such a reform is not tax relief in the united states and japan, 30 nw. j. int’l l. & bus. 621, 622 (2010) [hereinafter lokken & kitamura, credit v. exemption] (pointing to singapore as an example of a country with a true territorial system). regarding current support for adoption by the united states of a territorial or exemption system, see president’s council on jobs and competitiveness, road map to renewal 47–48 (2011) [hereinafter jobs council, road map] (stating that “[m]any members” of president obama’s business advisory council “believe the united states should move to a territorial system”); the nat’l comm’n on fiscal responsibility and reform: the moment of truth 33 (2010) [hereinafter deficit comm’n, moment of truth] (advocating adoption of an exemption system). 2. under a pure worldwide system, a residence country taxes its residents on the sum of their domestic-source and foreign-source income but allows a credit for foreign taxes paid by residents on foreign-source income. because such a system taxes worldwide income, a pure worldwide regime is sometimes referred to as a “full inclusion system.” as discussed later in this article in relation to the united states, we recognize, as others have, that no country employs a pure worldwide system just as no country employs a pure exemption system. 3. see generally j. clifton fleming, jr., robert j. peroni & stephen e. shay, an alternative view of deferral: considering a proposal to curtail, not expand, deferral, 20 tax notes int’l 547 (jan. 31, 2000); j. clifton fleming, jr., robert j. peroni & stephen e. shay, fairness in international taxation: the ability-to-pay case for taxing worldwide income, 5 fla. tax rev. 299 (2001) [hereinafter fleming, peroni & shay, fairness in international taxation]; robert j. peroni, back to the future: a path to progressive reform of the u.s. international income tax rules, 51 u. miami l. rev. 975, 986–94 (1997) [hereinafter peroni, back to the future]; robert j. peroni, j. clifton fleming, jr. & stephen e. shay, getting serious about curtailing deferral of u.s. tax on foreign source income, 52 smu l. rev. 455 (1999) [hereinafter peroni, fleming & shay, getting serious]. for a legislative proposal along these lines, see bipartisan tax fairness and simplification act of 2011, s. 727, 112th cong., 1st. sess. (2011) (requiring current taxation of the income of controlled foreign corporations). for other commentaries supporting international tax reform in the form of a full inclusion system, see reuven s. avi-yonah, the logic of subpart f: a comparative perspective, 79 tax notes 1775 (june 29, 1998); jane g. gravelle, does the concept of competitiveness have meaning in formulating corporate tax policy?, 65 tax l. rev. 323 (2012); robert a. green, the future of source-based taxation of the income of multinational enterprises, 79 cornell l. rev. 18 (1993); jeffrey m. kadet, u.s. international tax reform: what form should it 400 florida tax review [vol. 13:8 politically feasible, we believe that a properly designed exemption or territorial system could be an improvement over the current u.s. international tax regime, which is badly flawed for multiple reasons.4 in any event, there is a significant likelihood that congress will sooner or later be considering legislation to create a u.s territorial or exemption system. accordingly, it is important for academics and policymakers to thoughtfully discuss the structure of such a system.5 we hope that this article will contribute to that conversation. our fundamental point is that because of the u.s. fiscal situation, it is particularly important that a u.s. territorial system not forgo more revenue than is necessary to achieve the system’s appropriate ends. part ii illustrates why nations of the world take ameliorative action to mitigate double income taxation that could chill international trade and leave us with a poorer planet. part iii explains the customary international law solution to the double taxation conundrum. part iv describes the current u.s. flirtation with territoriality. part v briefly outlines the long-run u.s. fiscal challenge and argues that any u.s. territorial system should be structured to limit aggravation of the fiscal problem. part vi describes the dividend exemption element of a properly structured territorial system, and take?, 65 tax notes int’l 363 (jan. 30, 2012); edward d. kleinbard, the lessons of stateless income, 65 tax l. rev. 99, 101, 152-66 (2011) [hereinafter kleinbard, lessons]; edward d. kleinbard, throw territorial taxation from the train, 114 tax notes 547 (feb. 5, 2007); see also kimberly a. clausing, a challenging time for international tax policy, 136 tax notes 281 (july 16, 2012) [hereinafter clausing, challenging time] (arguing that an unlimited u.s. territorial system “would increase employment in low-tax countries by about 800,000 jobs” and that in the present weak u.s. economy “those new, low-tax-country jobs could displace jobs at home”). for the view that the united states should pursue incremental international tax reform, rather than enact either a full inclusion system or an exemption system for foreign-source income, see david l. cameron & philip f. postlewaite, incremental international tax reform: a review of selected proposals, 30 nw. j. int’l l. & bus. 565 (2010); robert h. dilworth, president’s economic recovery advisory board: suggested considerations in fundamental reform of the united states tax treatment of income from cross border trade and investment, 30 nw. j. int’l l. & bus. 551 (2010); robert h. dilworth, tax reform: international tax issues and some proposals, 35 int’l tax j. 5 (sept. 2009). 4. see generally j. clifton fleming, jr., robert j. peroni & stephen e. shay, worse than exemption, 59 emory l.j. 79 (2009) [hereinafter fleming, peroni & shay, worse than exemption]. 5. house ways and means committee chairman david camp has published a draft proposal to shift the united states to an exemption system. see ways and means discussion draft and its technical explanation, http://waysandmeans.house.gov/taxreform/. senator michael enzi has introduced a similar, if less ambitious, proposal. see united states job creation and international tax reform act of 2012, s. 2091, 112th cong. 2d sess. (2012). 2012] exemption when the treasury is empty 401 part vii outlines the branch exemption component of such a system. part viii deals with certain structural issues. part ix discusses “competitiveness” concerns and the relevance of tax expenditure analysis. in part x, we summarize our conclusions. ii. the double taxation conundrum every country has a normative claim, based on the ability-to-pay principle, to tax its residents on their foreign-source income,6 and the exercise of this normative claim is indisputably permitted by customary international law.7 in addition, every country has a normative claim, based on a benefits-received rationale,8 to tax income earned by foreigners within its borders, and the exercise of this normative claim is also indisputably permitted by customary international law.9 thus, the foreign-source income of a resident of a particular country (the “residence country”) is potentially subject to taxation by both the residence country and the foreign country (the “source country”) where the income was earned.10 more than insubstantial 6. see ilan benshalom, the new poor at our gates: global justice implications for international trade and tax law, 85 n.y.u. l. rev. 1, 75 (2010); fleming, peroni & shay, fairness in international taxation, supra note 3; roy rohatgi, basic international taxation 12 (2002) [hereinafter rohatgi, basic international taxation]. for a discussion of the connection of source-based taxation and residence-based taxation to the international law concept of sovereignty, see diane m. ring, what’s at stake in the sovereignty debate?: international tax and the nation-state, 49 va. j. int’l l. 155 (2008). 7. see restatement (third) of the foreign relations law of the united states § 412(1)(a) (1987); reuven s. avi-yonah, international tax as international law: an analysis of the international tax regime 22–27 (2007) [hereinafter avi-yonah, international tax as international law]; michael s. kirsch, the role of physical presence in the taxation of cross-border personal services, 51 b.c. l. rev. 993, 999 (2010) [hereinafter kirsch, physical presence]; see also kim brooks, global distributive justice: the potential for a feminist analysis of international tax revenue allocation, 21 can. j. women & l. 267, 280 (2009) [hereinafter brooks, global distributive justice]. 8. see kirsch, physical presence, supra note 7, at 1040; stephen e. shay, j. clifton fleming, jr. & robert j. peroni, the david r. tillinghast lecture: “what’s source got to do with it?” — source rules and international taxation, 56 tax l. rev. 81, 88–106 (2002) [hereinafter shay, fleming & peroni, source rules]; rohatgi, basic international taxation, supra note 6, at 12. 9. see restatement (third) of the foreign relations law of the united states §§ 411–12; avi-yonah, international tax as international law, supra note 7, at 27; brooks, global distributive justice, supra note 7, at 280; kirsch, physical presence, supra note 7, at 999. 10. see charles h. gustafson, robert j. peroni & richard crawford pugh, taxation of international transactions: materials, text 402 florida tax review [vol. 13:8 double taxation will discourage growth of international business that advances the welfare of both the residence country and the source country. for example, assume that domco is incorporated under the laws of patria, a country that taxes the foreign-source income of its residents (including corporations formed under patria law) at a 35 percent rate. further assume that domco contemplates opening a branch business in neighborland where the before-tax rate of return would be higher than in patria. neighborland taxes business profits at 20 percent. if both countries exercise their normatively justified taxing jurisdictions to the fullest extent, each dollar of profit earned by domco’s neighborland branch will bear a total income tax burden of 55 percent while the local neighborland competitors will pay only a 20 percent tax on their profits. moreover, additional profits produced by expanding patria operations will bear a tax of only 35 percent. unless relief action is taken by patria or neighborland, or by both countries acting jointly, the double taxation faced by domco’s proposed neighborland branch will discourage the branch’s establishment, even though its establishment would be economically desirable because domco can earn a higher before-tax rate of return in neighborland than at home in patria.11 iii. the international law solution customary international law gives the residence country (patria in the preceding example) the responsibility for mitigating international double taxation.12 the principal means for doing so are the worldwide taxation (with credit) method and the exemption system. under the first of these approaches, the residence country taxes its residents on their worldwide and problems 22, 39, 304–06 (4th ed. 2011) [hereinafter gustafson, peroni & pugh, taxation of international transactions]. 11. for example, if domco can earn before-tax returns of 8 percent by expanding its patria business and of 10 percent by opening a new business in neighborland, the 35 percent patria tax will result in an after-tax return in patria of 5.2 percent, while the 55 percent combined patria and neighborland taxes will produce an after-tax return in neighborland of only 4.5 percent. in this situation, domco will prefer investing in an expansion of its patria business instead of in a new neighborland business even though the latter is the economically superior alternative on a before-tax basis. 12. see restatement (third) of the foreign relations law of the united states § 413 cmt. a; brooks, global distributive justice, supra note 7, at 281; kirsch, physical presence, supra note 7, at 1001; lokken & kitamura, credit vs. exemption, supra note 1, at 621; see also yariv brauner, an international tax regime in crystallization, 56 tax l. rev. 259, 265–66, 284–85 (2003) [hereinafter brauner, crystallization]. 2012] exemption when the treasury is empty 403 incomes while granting a credit for foreign income taxes.13 this approach permits the residence country to collect a so-called residual tax in cases where the residence country tax on a resident’s foreign-source income exceeds the credit for foreign tax on that income.14 thus, in the preceding hypothetical, if patria employed worldwide taxation with a foreign tax credit, it would collect a 15 percent residual tax15 on income produced by domco’s neighborland branch. under the exemption system, residence countries exempt foreignsource active business income from their income tax regimes.16 stated differently, a residence country that takes the exemption approach forgoes collection of any residual tax on the foreign-source active business income of its residents and effectively imposes a zero tax rate on that income.17 iv. flirting with a flawed territoriality since 1918, the united states has employed worldwide taxation with a foreign tax credit. recently, however, there has been considerable pressure from some members of the u.s. multinational corporate community, 13. see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 307. 14. id. at 304–05, 307. 15. thirty-five percent minus twenty percent equals fifteen percent. this is based on the simplifying assumption that the neighborland income would be domco’s only foreign-source income. if domco earned high-taxed income in other countries and if patria had a loose foreign tax credit limitation such as that currently employed by the united states, then foreign tax imposed by the other countries in excess of the 35 percent patria rate might reduce or eliminate the 15 percent residual tax. see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 407–10, 422. 16. id. at 21–23, 305–06; brauner, crystallization, supra note 12, at 284– 85. the residence country’s allowance of a deduction for source-country tax is a third approach to solving the international double taxation problem, but it is only partially effective and rarely used. see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 23, 304; cf. kimberly clausing & daniel shaviro, a burden-neutral shift from foreign tax creditability to deductibility?, 64 tax l. rev. 431, 431-33 (2011) [hereinafter clausing & shaviro, creditability to deductibility] (arguing for superiority from national welfare perspective of deducting rather than crediting foreign taxes). 17. see staff of joint comm. on tax’n, jcx-22-06, the impact of international tax reform: background and selected issues relating to u.s. international tax rules and the competitiveness of u.s. businesses 2 (2006) [hereinafter staff of joint comm., impact of international tax reform]; joann m. weiner, formulary apportionment: the way to tax profits in the eu, 47 tax notes int’l 322, 325 (july 23, 2007). 404 florida tax review [vol. 13:8 academia, and the examples of other countries18 for the united states to transform its taxation of foreign-source active business income from the historic approach to a territorial or exemption approach.19 in prior work, we have pointed out that the present u.s. regime for taxing foreign-source income is unacceptable and requires major reform because it allows a zero tax rate to be achieved on certain foreign-source income that is not subject to double taxation, and, in some cases, it even allows a negative rate of tax to be achieved on foreign-source income.20 we have argued, however, that fairness and efficiency considerations make 18. many of the major trading partners of the united states, including most recently japan and the united kingdom, have adopted exemption or territorial systems. see generally robin d. beran, david hartnett, anneli collins & jonathan stuart-smith, session 2: lessons in reform — discussion of recent tax reform in other countries, 88 taxes 37 (june 2010); jim carr, jason hoerner & adrian martinez, new foreign dividend systems in japan and the u.k.: tax considerations for distributions from u.s. subsidiaries, 38 bna tax mgmt. int’l j. 319 (2009). a number of the cited reasons these countries adopted territorial systems are inapposite to circumstances in the united states and reflect materially different circumstances. for example, the membership of the united kingdom in the european union and the relative size and role of the london stock exchange in the united kingdom affected the united kingdom’s tax policy decisions in ways that are not relevant in the united states. whether the tax policies of other countries should be used as models for the united states is a recurring question that deserves a broader and more substantial analysis. see stephen e. shay, keynote address, 88 taxes 49, 49-51 (june 2010). 19. see, e.g., business roundtable & business council, policy burdens inhibiting economic growth (june 21, 2010) [hereinafter business roundtable, policy burdens], http://businessroundtable.org/uploads/hearingsletters/downloads/20100621_letter_to_omb_director_orszag_from_brt_and_bc _with_attachments.pdf; mihir a. desai & james r. hines, jr., old rules and new realities: corporate tax policy in a global setting, 57 nat’l tax j. 937 (2004); j.d. foster & curtis s. dubay, obama international tax plan would weaken global competitiveness, the heritage found. (apr. 5, 2009), http://www.heritage.org/research/reports/2009/05/obama-international-tax-planwould-weaken-global-competitiveness. the u.s. multinational corporate business community’s historical indifference to territoriality has been due to the fact that the present, highly flawed, u.s. worldwide regime allows u.s. multinational corporations to exceed the limits of a principled exemption system. see generally fleming, peroni & shay, worse than exemption, supra note 4; national foreign trade council, inc., the nftc’s report on territorial taxation, 27 tax notes int’l 687 (aug. 5, 2002) [hereinafter national foreign trade council, inc., nftc report]. 20. see generally fleming, peroni & shay, worse than exemption, supra note 4. 2012] exemption when the treasury is empty 405 territoriality the wrong solution for the united states.21 instead, the defects in the present u.s. regime should be corrected so that it achieves the efficiency and fairness objectives of a principled worldwide system.22 nevertheless, the u.s. multinational business community shows signs of abandoning its traditional lack of enthusiasm for territoriality and of moving towards supporting a u.s. exemption system (although the enthusiasm for territoriality definitely varies from industry to industry and from company to company within an industry).23 broad multinational business support surely increases the political pressure to adopt territoriality. the beneficiaries of zero or negative tax rates do not, however, meekly surrender them. thus, if the u.s. congress undertakes to craft a territorial or exemption system for foreign-source active business income, the international business community will undoubtedly lobby for a flawed system that preserves aspects of the present regime which are more generous to taxpayers than a properly designed territorial system would be.24 in our view, the united states should never adopt a taxation scheme with features that amount to unprincipled transfers of largesse. adherence to 21. see j. clifton fleming, jr., & robert j. peroni, exploring the contours of a proposed u.s. exemption (territorial) tax system, 109 tax notes 1557 (dec. 19, 2005) [hereinafter fleming & peroni, exploring the contours]; fleming, peroni & shay, fairness in international taxation, supra note 3; peroni, fleming & shay, getting serious, supra note 3; j. clifton fleming, jr., robert j. peroni & stephen e. shay, perspectives on the worldwide v. territorial taxation debate, 125 tax notes 1079 (dec. 7, 2009) [hereinafter fleming, peroni & shay, worldwide v. territorial]; j. clifton fleming, jr., robert j. peroni & stephen e. shay, some perspectives from the united states on the worldwide taxation v. territorial taxation debate, 3 j. australasian tax teachers ass’n 35 (2008) [hereinafter fleming, peroni & shay, perspectives from the united states]; see also samuel c. thompson, jr., obama’s international tax proposal is too timid, 123 tax notes 738 (may 11, 2009) [hereinafter thompson, obama’s international tax proposal]. 22. see generally fleming, peroni & shay, worse than exemption, supra note 4. 23. see, e.g., business leaders in support of a territorial tax system, h. comm. on ways & means, waysandmeans.house.gov/uploadedfiles/ intl_quotes.pdf; pamela f. olson, peter merrill, michael mundaca, michael reilly & jaime spellings, session 6. staking new ground: exploring a potential territorial system of taxation, 90 taxes 55, 65-66 (june 2012) [hereinafter olson, merrill, mundaca, reilly & spellings, new ground]; randall jackson, international proposals a threat to competitiveness, panelists say, 126 tax notes 1045 (mar. 1, 2010); business roundtable, policy burdens, supra note 19, at 17. 24. see, e.g., john m. samuels, american tax isolationism, 123 tax notes 1593 (june 29, 2009) [hereinafter samuels, american tax isolationism] (vice president and senior tax counsel of general electric company arguing that domestic expenses allocable to deferred foreign income should be currently deductible against u.s.-source income even though this magnifies the distortive benefit of deferral). 406 florida tax review [vol. 13:8 this standard is particularly important in the context of the current u.s. revenue situation, which we shall briefly describe in the next section. v. going territorial in the midst of a current and long-run fiscal crisis a. dimensions of the crisis the u.s. government is experiencing a well-recognized fiscal crisis. this crisis results from a projected deficit spending path that will cause the aggregate federal debt to increase as a percentage of gross domestic product (gdp) and, potentially, to eventually exceed annual gdp. since a great deal has already been written about the trajectory of the u.s. federal budget and indebtedness,25 we limit ourselves to two data points in support of our contention that although the united states should never adopt a territorial system with wasteful features, unwarranted revenue loss is particularly objectionable in the context of the current u.s. fiscal predicament. with respect to this predicament, the non-partisan congressional budget office (cbo) has recently concluded that if congress’s taxing and spending behavior continues to follow historical patterns and policies of the past decade, the resulting budget deficits will cause publicly held federal debt to be more than 90 percent of gdp in 2022 and almost 200 percent of gdp by 2037,26 a debt level that the cbo characterizes as “unsustainable.”27 25. see, e.g., cong. budget office, the 2012 long-term budget outlook (june 2012) [hereinafter cbo 2012 budget outlook]; deficit commission, moment of truth, supra note 1, at 10–11; alan j. auerbach & william g. gale, déjà vu all over again:on the dismal prospects for the federal budget, 63 nat’l tax j. 543 (2010) [hereinafter auerbach & gale, déjà vu]; alan j. auerbach & william g. gale, the federal budget outlook: no news is bad news, 136 tax notes 1597 (sept. 24, 2012); edward d. kleinbard, the role of tax reform in deficit reduction, 133 tax notes 1105 (nov. 28, 2011) [hereinafter kleinbard, deficit reduction]; stephen e. shay, daunting fiscal and political challenges for u.s. international tax reform, bull. for int’l tax’n, apr.–may 2012, at 229; george k. yin, bush income tax cuts should not be extended, 123 tax notes 117 (apr. 6, 2009) [hereinafter yin, bush tax cuts]. for a leading commentator who takes a different view on the issue of whether the united states is in a current fiscal crisis and argues that the current anti-deficit discourse is simplistic and misguided, see neil h. buchanan, good deficits: protecting the public interest from deficit hysteria, 31 va. tax. rev. 75 (2011) [hereinafter buchanan, good deficits]. 26. see cbo 2012 budget outlook, supra note 25, at 11, 19. the assumption that future taxing and spending policies will mimic historical patterns seems reasonable. see alan j. auerbach & william g. gale, tempting fate: the federal budget outlook, 132 tax notes 375, 376 (july 25, 2011) [hereinafter gale & auerbach, tempting fate] (“a more plausible way to project future outcomes 2012] exemption when the treasury is empty 407 these projected debt levels are truly extraordinary. u.s. federal indebtedness has exceeded 70 percent of gdp during only one other period, the 1943-1951 era when the united states was carrying the debt load incurred to finance world war ii.28 thus, the debt levels anticipated by the cbo are unprecedented for a time in which the united states is not engaged in total war. in addition to taking the united states into largely uncharted territory, government debt at these levels of gdp exposes the united states to serious risks. for example, high levels of federal debt increase the likelihood of a u.s. fiscal crisis in which investors are not willing to buy u.s. government debt unless it carries a substantially increased interest rate.29 this added expense would limit government spending for social welfare and defense and would cause the value of existing u.s. debt to fall, resulting in large losses to pension funds, mutual funds, and other financial institutions.30 extraordinary debt levels would reduce the government’s ability to respond to recessions and international crises through temporary deficit spending.31 most importantly, high levels of government debt and high interest rates would crowd out private borrowing, slow private investment, and depress u.s. economic growth. the u.s. fiscal challenge is not a new phenomenon, but it has particular urgency at the present time. as two prominent public finance economists have recently explained: the unsustainability of federal fiscal policy has been discussed since at the least the 1980s. but the problem has increased in importance and urgency in recent years for several reasons. first, the medium-term projections have deteriorated significantly. second, the factors driving the long-term projections — the retirement of the baby boomers, the aging of the population, and the resulting pressure on may be to assume that future congresses will act more or less like previous congresses.”). currently effective u.s. law provides for automatic tax increases and spending cuts in 2013 that would have a significant restraining effect on the growth of federal debt. however, the cbo anticipates that these increases and cuts would cause a recession and believes that “[f]uture fiscal policy is likely to differ from that embodied in current law.” cong. budget office, an update to the budget and economic outlook: fiscal years 2012 to 2022, 32, 35 (aug. 2012). this supports the view that the automatic spending cuts and tax increases embedded in current law are unlikely to become effective. 27. cbo 2012 budget outlook, supra note 25, at 5. 28. see id. at 19. 29. see id. at 43–44. 30. see id. at 44. 31. see id. at 43. 408 florida tax review [vol. 13:8 medicare and to some extent social security — were several decades away in the 1980s but are now imminent. third, there are increasing questions about the rest of the world’s appetite for u.s. debt, since the united states has changed from a net creditor country in 1980 to a vast net debtor. fourth, many countries and many u.s. states are also facing daunting fiscal prospects.32 of course, it is arithmetically possible for the united states to reduce its projected deficits and debt amount by leaving tax levels as they are while making major reductions in spending. there is nothing in recent history, however, to suggest that it is politically feasible for congress to solve the u.s. deficit problem solely by spending cuts.33 b. forfeiting the residual tax if u.s. deficits are to be trimmed to a sustainable level, increased tax revenues are a critical component of a politically plausible solution.34 the u.s. corporate sector historically accounts for approximately 10 percent of federal revenues. any congressional actions that would reduce corporate tax revenues should surely be viewed with deep skepticism and concern.35 moreover, it will be very difficult, politically, to raise taxes on individual taxpayers while allowing u.s. multinational corporations to escape u.s. tax on their foreign-source business income. against the preceding fiscal background, a proposal to replace the u.s. worldwide international income tax system with an exemption or territorial system would seem to be an illogical response to a need for revenue. to see why, return to the patria example in part ii where patria 32. auerbach & gale, tempting fate, supra note 26, at 375. but see buchanan, good deficits, supra note 25. 33. see rosanne altshuler, katherine lim & roberton williams, desperately seeking revenue, 63 nat’l tax j. 331, 332 (2010); martin a. sullivan, taxes must rise, 127 tax notes 369, 370–71 (apr. 26, 2010); yin, bush tax cuts, supra note 25, at 118–19; see also auerbach & gale, déjà vu, supra note 25, at 554 (“[i]t is simply implausible that cutting health care spending growth alone can solve the long-term fiscal imbalance.”); kleinbard, deficit reduction, supra note 25, at 1110 (“cbo projections demonstrate that the continuation of current revenue and entitlements policies would mean that the federal government would run a deficit in the coming decade even if it were to spend zero on all non-defense discretionary spending programs.”). 34. see supra note 33. 35. see clausing, challenging time, supra note 3, at 283 (“[g]iven today’s budget climate, avoiding further erosion of the corporate tax base should be a priority.”). see generally yin, bush tax cuts, supra note 25. 2012] exemption when the treasury is empty 409 taxes its residents’ foreign-source income at a 35 percent rate, and neighborland taxes business profits at 20 percent. under a worldwide system, patria would allow residents who earn neighborland income a credit for the neighborland tax but would, nevertheless, collect a 15 percent residual tax on that income (35 percent 20 percent = 15 percent). if, however, patria employs an exemption or territorial system, it would waive the 15 percent residual tax and collect no revenue with respect to income earned in neighborland by patria residents. in the u.s. context, this loss of the residual tax has a significant impact on the federal deficit. although the united states does not currently operate an explicit exemption system, its worldwide system is encumbered with a deferral privilege36 and other features, which in practice substantially achieve an exemption result.37 the staff of the joint committee on taxation has calculated that the u.s. revenue loss from this exemption-like deferral privilege was $21.5 billion for fiscal year 2011 and will total $97.7 billion for the fiscal years 2011-2015 period.38 in the face of the daunting deficit 36. in other words, the u.s. tax on foreign-source active business income earned through foreign corporations is deferred until the income is repatriated to the united states through dividends or realized through stock sales. 37. see fleming, peroni & shay, worse than exemption, supra note 4. assuming the same pre-tax rates of return in the united states and abroad and unchanging tax rates, the benefit of postponing repatriation is not from avoiding the tax on repatriation but from reinvesting the deferred earnings at a higher after-tax return (than if repatriated) so they grow faster (before the u.s. tax is imposed). the benefit of deferring the repatriation tax under these assumptions (separate from foreign tax credit and other issues discussed in worse than exemption) can exceed in present value terms the u.s. tax on repatriation. an exemption system achieves this same benefit, when repatriation is deferred, plus exemption from u.s. tax on repatriation. we thank professor alvin warren for this observation. in practice, companies have utilized strategies that effectively allow deferred earnings to be used in the united states without reporting an income inclusion under section 956. see memorandum from sen. carl levin, subcommittee chairman, and sen. tom coburn, ranking member, to members of the permanent subcommittee on investigations of offshore profit shifting and the u.s. tax code, 25-27 (sept. 20, 2012), http://www.hsgac.senate.gov/download/?id=7b9717af-592f-48be-815bfd8d38a71663 (describing hewlett-packard short-term loan program intended to circumvent current inclusion); see also paul w. oosterhuis & daniel m. mccall, what’s in order for assets crossing the border?, 88 taxes 41, 44–48 (mar. 2010) (describing patterns of transactions avoiding repatriation tax and irs responses). 38. staff of joint comm. on tax’n, 112th cong., 2d sess., estimates of federal tax expenditures for fiscal years 2011-2015, 32 (comm. print 2012) [hereinafter staff of joint comm., estimates]. estimates of tax expenditures are not equivalent to revenue estimates since the former do not take into account behavioral responses of taxpayers; however, tax expenditure estimates provide an indication of the magnitude of the amounts involved. see id. at 25; staff http://www.hsgac.senate.gov/download/?id=7b9717af-592f-48be-815b-fd8d38a71663 http://www.hsgac.senate.gov/download/?id=7b9717af-592f-48be-815b-fd8d38a71663 410 florida tax review [vol. 13:8 problems described above, why would the united states replace its worldwide system with an exemption system that may produce an even greater revenue loss? one response is that a switch from the present, highly flawed u.s. worldwide system to a principled exemption or territorial system could actually result in a deficit-reducing revenue gain. we explain how in the next section. c. gaining revenue by switching to a zero rate in its present form, the u.s. worldwide system, degraded by selfinflicted legislative and regulatory wounds, allows u.s. multinational corporations to exploit tax deferral, defective cost allocation rules, loose transfer pricing rules, cross-crediting, and deduction of overall foreign losses, thereby achieving more favorable u.s. tax results than would be available under a properly designed exemption system.39 thus, the u.s. treasury would likely gain revenue by switching to a principled exemption system.40 indeed, in 2005, the staff of the joint committee on taxation of joint comm. on tax’n, jcx-46-11, summary of economic models and estimating practices of the staff of the joint committee on taxation 3 (2011). 39. see fleming, peroni & shay, worse than exemption, supra note 4. the active finance and active insurance exceptions of section 954(h) and (i), the lookthrough exception of section 954(c)(6), the regulatory adoption of check-the-box entity classification rules in 1996, the reduction in scope for foreign base company services income in notice 2007-13, 2007-1 c.b. 410, and the contract manufacturing regulations adopted in 2008 are examples of legislative, regulatory, and administrative developments limiting the scope of the anti-deferral rules of current law. 40. see cong. budget office, reducing the deficit: spending and revenue options 187 (mar. 2011) (calculating a $76.2 billion revenue gain for the 2012-2021 period from adoption of a well-designed territorial system); u.s. dep’t of the treas., approaches to improve the competitiveness of the u.s. business tax system for the 21st century 58 (2007) [hereinafter u.s. treas. dep’t, approaches], http://www.treasury.gov/resource-center/tax-policy/ documents/approaches-to-improve-business-tax-competitiveness-12-20-2007.pdf (supporting the proposition that replacing the current system with an exemption system would increase revenue by approximately $40 billion over 10 years); rosanne altshuler & harry grubert, where will they go if we go territorial? dividend exemption and the location decisions of u.s. multinational corporations, 54 nat’l tax j. 787, 798 (2001) (“[f]or the typical investment in a low-tax country abroad, dividend exemption with expense allocations is likely to increase effective tax rates relative to the current system.”); harry grubert, enacting dividend exemption and tax revenue, 54 nat’l tax j. 811, 816 (2001) [hereinafter grubert, enacting dividend exemption] (calculating static revenue gain of $9.7 billion in 1996 if the united states had used a principled exemption system in that year); 2012] exemption when the treasury is empty 411 estimated that replacing the highly defective u.s. worldwide system with a proposed exemption system that was principled and theoretically correct would produce a $54.8 billion revenue gain over the fiscal years 2005-2014 period.41 by contrast, an unprincipled exemption system would lose substantial revenue.42 in the context of the u.s. financial needs described above, the prospect of a revenue gain from switching to an exemption or territorial system is undeniably attractive.43 d. goodbye to the revenue gain but there will be no significant revenue gain from replacing the current u.s. worldwide system with an exemption or territorial regime unless the latter is correctly structured. an exemption system that perpetuates existing defects would not help the united states climb out of its fiscal hole, and the adoption of a defective system would represent the loss of an opportunity for the united states to make progress towards a sustainable fiscal path. thus, congress should resist revenue-losing departures from a principled exemption system, except to the extent that a departure can pass a edward d. kleinbard, stateless income, 11 fla. tax rev. 699, 722–23 (2011) [hereinafter kleinbard, stateless income] (calculating that if the united states had employed a well-designed territorial system, it would have collected approximately $6.6 billion more revenue in 2004 than it actually collected under the defective u.s. worldwide system). 41. for explanation of the joint committee staff’s exemption proposal, see staff of joint comm. on tax’n, jcs-02-05, options to improve tax compliance and reform tax expenditures 189–96 (2005) [hereinafter staff of joint comm., options]. for the revenue estimate, see id. at 427. 42. see the president’s econ. recovery advisory bd., the report on tax reform options 90 (aug. 2010) (“according to rough estimates from the treasury, a simplified territorial system without full expense allocation rules would lose approximately $130 billion over the 10-year budget window.”). 43. as explained in prior work, we believe that an even better way to increase revenues is to enact legislative reforms that would cure the flaws in the current u.s. worldwide system. see fleming & peroni, exploring the contours, supra note 21; fleming, peroni & shay, fairness in international taxation, supra note 3; peroni, fleming, & shay, getting serious, supra note 3; fleming, peroni & shay, perspectives from the united states, supra note 21; fleming, peroni & shay, worldwide vs. territorial, supra note 21; fleming, peroni & shay, worse than exemption, supra note 4; see also samuel c. thompson, jr., assessing the following systems for taxing foreign-source active business income: deferral, exemption, and imputation, 53 how. l.j. 337 (2010); thompson, obama’s international tax proposal, supra note 21. if it is not politically possible to address the flaws of the current system, however, then under the heroic assumption that it were possible to replace the present defective system with a well-designed exemption regime, we would favor it over current law. 412 florida tax review [vol. 13:8 cost/benefit test.44 given the present fiscal circumstances, the cost/benefit test should be rigorously applied. e. principles for preserving the revenue gain in contemplating the content of a properly designed exemption or territorial system, it is critical to keep in mind that so far as economics and customary international law are concerned, an exemption system’s purpose is to avoid a double tax barrier to international business by eliminating residence-country tax on the foreign-source income of residents, thus leaving the source-country tax as the single applicable levy. neither economics nor international law nor equitable principles require the residence country to go further.45 consequently, when a resident’s foreign-source income does not bear a significant foreign tax, the economic and international law rationales for exempting that income from residence-country tax vanish, and the income in question is fairly includible in the residence country’s tax base pursuant to the ability-to-pay principle that validates the residence country’s right to tax the foreign-source income of its residents.46 stated differently, a principled exemption system will not grant a zero residence-country tax rate to foreign-source income that has escaped a more-than-de minimis sourcecountry tax. in addition, a principled territorial system will never create a negative domestic tax rate. to do so would go beyond providing double taxation relief and would amount to an affirmative subsidy for foreign-source income that can be justified only if the subsidy can pass a rigorously applied cost/benefit test.47 we now turn to the matter of applying these broad principles to the designing of an exemption or territorial system that would replace the existing u.s. worldwide system in the midst of a national fiscal crisis. 44. see j. clifton fleming, jr. & robert j. peroni, reinvigorating tax expenditure analysis and its international dimension, 27 va. tax rev. 437, 525– 28 (2008) [hereinafter fleming & peroni, reinvigorating]. 45. see supra notes 6–17 and accompanying text. 46. see fleming, peroni & shay, fairness in international taxation, supra note 3. 47. see fleming & peroni, reinvigorating, supra note 44; see also lokken & kitamura, credit v. exemption, supra note 1, at 630 (“the purpose of the foreign tax credit is to alleviate double taxation, and this goal is fully achieved by reducing u.s. tax on doubly taxed income to zero . . . . u.s. tax . . . should not be less than zero.”). 2012] exemption when the treasury is empty 413 vi. a principled dividend exemption system the central feature of a territorial system is an exemption from residence country tax for dividends paid by foreign corporations out of the “right kinds of profits” to the “right kind of shareholder.”48 we address the question of the “right kinds of profits” in part vi.a and the issue of the “right kind of shareholder” in part vi.b. part vi.c is a discussion of whether a territorial system’s dividend exemption should be expanded to include certain types of non-dividend income. in part vii, we will discuss application of the exemption approach to foreign income earned directly through an unincorporated foreign branch. a. dividends out of what? 1. active income that does not bear a meaningful foreign tax a. the need for a subject-to-tax requirement assume that usco is a u.s. domestic corporation that pays u.s. income tax at a 35 percent rate. usco owns 100 percent of the single class of stock of fs, a corporation formed under the laws of lowtaxia, a tax haven with no corporate profits tax and no withholding tax on dividends. in year 1, fs earns a $1 million active business profit, all of which is paid as a dividend to usco at year end. because this dividend is paid out of untaxed foreign profits and is free of foreign withholding tax, the united states can tax it in full without causing a double tax result. moreover, failing to tax the dividend means surrendering up to 35 percentage points of u.s. residual tax. thus, as explained in part v.c, the united states would be remiss if it did not impose its corporate tax on usco’s receipt of the dividend. does the answer change if the $1 million profit bears a 1 percent lowtaxia corporate profits tax? assuming that the united states allows an indirect foreign tax credit under section 902 for the lowtaxia levy,49 no 48. as stated by the staff of the joint committee on taxation: “in theory, exemption could be allowed as income is earned, whether directly or through foreign companies. by contrast, territorial systems of the major u.s. trading partners generally provide exemptions for dividends received by resident companies from foreign companies.” staff of joint comm. on tax’n, jcx-33-11, background and selected issues related to the u.s. international tax system and systems that exempt foreign business income 8 (2011) [hereinafter staff of joint comm., background and issues]. 49. a plausible argument can be made that if foreign-source income is excluded from the benefit of a u.s. exemption system because it bears a rate of foreign tax that is too low to present a meaningful double tax issue, then a u.s. 414 florida tax review [vol. 13:8 double tax issue will arise if the united states applies a residual tax on the $1 million dividend paid by fs to usco, and failure to impose u.s. tax would amount to walking away from as much as 34 percentage points of u.s. residual tax revenue even though doing so is not required by international law. the preceding analysis leads to the suggestion that a principled exemption system should include a subject-to-tax requirement. that is, the exemption regime should not apply to dividends unless a meaningful foreign tax has been paid in respect of the earnings distributed,50 or the dividend deduction for that foreign tax is adequate — there is no need for the complexity of a direct and indirect foreign tax credit. the international practice, however, is to allow direct and indirect credits for foreign tax imposed on non-exempt income. see staff of joint comm., background and issues, supra note 48, at 8. we have adopted that approach in subsequent portions of this article, and there seems to be no reason to carve out special treatment for one particular class of non-exempt income (i.e., foreign-source income that does not bear a meaningful foreign tax). indeed, the carve-out would seem to increase complexity with little offsetting benefit. 50. as noted by two commentators: “a dividends exemption is intended to be part of a system for alleviating double taxation, not a means of allowing companies to avoid domestic taxation on repatriations of income that has not been subject to substantial taxation anywhere in the world.” lokken & kitamura, credit v. exemption, supra note 1, at 646; see also staff of joint comm., background and issues, supra note 48, at 8; staff of joint comm. on tax’n, jcx-55-08, economic efficiency and structural analyses of alternative u.s. tax policies for foreign direct investment 38 (2008) [hereinafter staff of joint comm., analyses of alternative policies]; u.s. dep’t of the treas., international tax reform: an interim report 42–43 (1993) [hereinafter u.s. treas. dep’t, interim rep.]; hugh j. ault & brian j. arnold, comparative income taxation: a structural analysis 467 (3d ed. 2010) [hereinafter ault & arnold, comparative taxation]; michael j. graetz, the david tillinghast lecture, taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 54 tax l. rev. 261, 330–31 (2001) [hereinafter graetz, inadequate principles]; michael j. graetz & paul w. oosterhuis, structuring an exemption system for foreign income of u.s. corporations, 54 nat’l tax j. 771, 783 (2001) [hereinafter graetz & oosterhuis, structuring an exemption system]. existing regulations under the foreign tax credit limitation provide rules for assigning foreign tax to income under u.s. tax principles. see reg. § 1.904-6. a report by an american bar association section of taxation task force gave the following example of the problematic results that could arise if there were no requirement that the foreign income be subject to a meaningful foreign tax: [a] local [u.s.] manufacturer that has only one line of products and only sells products to u.s. customers [] could benefit from manufacturing the product in ireland (whether through a cfc or an irish branch), selling the product back to the united states, paying the irish corporate tax on the manufacturing earnings at a 2012] exemption when the treasury is empty 415 payor is a resident in a country with which the united states has a bilateral tax treaty that reciprocally waives the subject-to-tax requirement.51 but what if lowtaxia applied a 35 percent tax to the fs profits from which the $1 million dividend was paid to usco. although the u.s. indirect foreign tax credit would alleviate double taxation, there would be no u.s. residual tax revenue to protect because the credit would fully offset the preforeign tax credit u.s. levy.52 this clear difference from the 1 percent foreign tax scenario, where up to 34 percentage points of u.s. residual tax were at stake,53 means that there would be no compelling reason to treat the dividend as non-exempt.54 clearly, somewhere between a 35 percent lowtaxia rate and a 1 percent lowtaxia rate, there is a foreign tax rate benchmark below which the u.s. residual tax is too large to abandon and above which the residual tax is too small to justify the complexity of moving otherwise exempt foreign income into a credit regime. finding the tipping point at which a subject-totax rule should switch on and off is a challenge. b. the benchmark there are multiple candidates, directly or by analogy, for the appropriate benchmark. for example, section 954(b)(4) provides that a foreign-source income item that would otherwise be subject to current u.s. taxation as foreign base company income or insurance income is excused from current u.s. taxation if the item “was subject to an effective rate of 12.5% tax rate and repatriating any unused cash to the u.s. parent as exempt earnings. aba tax’n sec. task force, report of the task force on international tax reform, 59 tax law. 649, 723 (2006) [hereinafter aba tax’n sec., task force rep.]; see also fleming & peroni, exploring the contours, supra note 21, at 1566; george k. yin, reforming the taxation of foreign direct investment by u.s. taxpayers, 118 tax notes 173, 180 (jan. 7, 2008) (would require exempt income to be subject to tax somewhere). 51. see staff of joint comm., background and issues, supra note 48, at 8; ault & arnold, comparative taxation, supra note 50, at 467. 52. thirty-five percent u.s. tentative tax minus an indirect credit for the 35 percent lowtaxia tax equals zero u.s. residual tax. 53. in the 1 percent scenario, the u.s. indirect credit for the 1 percent foreign tax leaves up to a 34 percent u.s. residual tax (assuming no cross-crediting). 54. this suggests that in determining whether a foreign tax is so small that it does not count as meaningful, the most important factor is the spread between the u.s. tax rate and the foreign tax rate because that spread determines the u.s. residual tax that will be lost if the u.s. exemption system is allowed to apply. avoiding double taxation is not the salient issue because income that is ineligible for exemption would qualify for the foreign tax credit regime. 416 florida tax review [vol. 13:8 income tax imposed by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11.”55 under current law, this means a foreign effective rate greater than 31.5 percent.56 this suggests that dividends should be excluded from a u.s. exemption system unless they are paid out of foreign-source income that has borne a foreign effective tax rate that is greater than 90 percent of the top u.s. corporate rate. alternatively, the american law institute (ali) has suggested that if foreign-source income bears foreign effective tax at a rate that is less than 50 percent or perhaps 66 2/3 percent “of the u.s. rate paid by the taxpayer,” it could appropriately be placed in a “low-tax” basket to limit cross-crediting under the u.s foreign tax credit system.57 this suggests using a benchmark of 66 2/3 percent or 50 percent of the u.s. effective tax rate on the income to identify foreign income that would qualify as the source of exempt dividends. under current law, this would translate into an effective foreign tax rate condition for exemption of 23 percent or 17.5 percent if the effective u.s. rate equaled the top corporate rate of 35 percent. two u.s. scholarly commentators suggested in 2001 that if there is to be a benchmark foreign rate for purposes of identifying foreign-source income that can appropriately support exempt dividends, the benchmark should be set at an effective foreign tax rate greater than 75 percent of the u.s. effective tax rate58 (resulting in a minimum foreign tax rate of 26 1/4 percent under current law if the effective u.s. tax rate equaled the maximum u.s. corporate rate of 35 percent) and, more recently, another commentator has suggested an effective foreign corporate tax rate of at least 20 percent.59 finally, in october 2011, the u.s. house of representatives committee on ways and means released a discussion draft of a u.s. international tax reform proposal. this proposal includes an exemption or territorial system with an alternative anti-base erosion provision that incorporates a subject-to-tax requirement. specifically, this provision would disqualify foreign income as the source of exempt dividends unless either the 55. i.r.c. § 954(b)(4). 56. thirty-five percent times ninety percent equals thirty-one point five percent. 57. see american law institute, federal income tax project: international aspects of united states income taxation 328–29 (1987) [hereinafter ali, international proposals]. however, the ali recommended against a low-tax basket primarily because of the practical problems of calculating the effective foreign tax rate. see id. at 329–32. for our discussion of this matter, see infra notes 62–70 and accompanying text. 58. see graetz & oosterhuis, structuring an exemption system, supra note 50, at 783. 59. see robert c. pozen, a two-pronged approach to reforming international corporate taxes in the u.s., 63 tax notes int’l 951, 952 (sept. 26, 2011). 2012] exemption when the treasury is empty 417 effective foreign tax rate on the income was greater than 10 percent or the business activity that produced the foreign income was confined to the dividend payor’s country of incorporation.60 all of the preceding proposals for identifying the point at which a foreign tax rate is sufficiently consequential seem to be based on rough estimates or hunches, although we note that because the irish corporate tax rate is 12.5 percent, the 10 percent prong of the ways and means proposal may be intended to avoid any impact on many u.s.-owned irish cfcs that sell their irish-manufactured products in the united states and other countries besides ireland.61 however, as we have discussed above, the 60. see h. comm. on ways & means, technical explanation of the ways and means discussion draft provisions to establish a participation exemption system for the taxation of foreign income, 33–34 (2011) [hereinafter ways & means technical explanation], http://waysandmeans. house.gov/uploadedfiles/final_te_--_ways_and_means_participation_exemption_ discussion_draft.pdf. the technical explanation of the discussion draft says, “at least 10 percent.” however, the draft legislative language sets the requirement “in excess of 10 percent.” h. comm. on ways & means, discussion draft § 331b (2011) [hereinafter ways & means discussion draft], http://waysandmeans.house. gov/uploadedfiles/discussion_draft.pdf; see also philip d. morrison, chairman camp’s territorial proposal and the potential expansion of subpart f, 41 tax mgmt. int’l j. 90, 90 (2012) (the low-taxed income disqualification would require “all income of a cfc to be currently taxed in the united states if the income is derived outside the cfc’s country of incorporation and it is subject to a foreign effective tax rate of 10% or less.”); david g. noren, the ways and means committee international tax reform discussion draft: key design issues, 41 tax mgmt. int’l j. 167, 173 (2012) (“[u]nless a cfc is essentially selling into its own home-country market, an effective rate of 10% or less will lead to the treatment of the cfc’s income as subpart f income . . . .”). senator mike enzi has introduced a bill proposing dividend exemption that would disqualify income from exemption if the effective foreign tax rate was less than 50 percent of the highest u.s. corporate tax rate (17.5 percent under current law, i.e., 50 percent of 35 percent = 17.5 percent). see s. 2091, 112th cong., 2d sess. (2012). 61. in fact, multinational corporations are able to and do achieve effective tax rates in ireland and other countries well below 12.5 percent or even 10 percent. see jesse drucker, google 2.4% rate shows how $60 billion lost to tax loopholes, bloomberg, oct. 21, 2010, http://www.bloomberg.com/news/2010-1021/google-2-4-rate-shows-how-60-billion-u-s-revenue-lost-to-tax-loopholes.html.21. for example, microsoft was reported to pay tax for its 2011 fiscal year at an effective tax rate for financial statement purposes of approximately 4 percent on an aggregate of $15 billion of earnings before tax in puerto rico, ireland, and singapore. see testimony of stephen e. shay before the u.s. senate permanent subcommittee on investigations of the committee on homeland security and government affairs hearing on offshore profit shifting and the u.s. tax code (sept. 20, 2012), http://www.hsgac.senate.gov.subcommittees/investigations/ hearings/offshore-profit-shifting-and-the-us-tax-code. 418 florida tax review [vol. 13:8 objective in choosing the appropriate foreign effective tax rate is to identify the point below which the u.s. residual tax is too significant to surrender by conferring an exemption. resolving that conundrum is beyond the scope of this article because it requires a calculation and consideration of revenue gains and losses from other features of a u.s. exemption system as well as a consideration of the u.s. government’s overall revenue needs. thus, the issue of the appropriate benchmark involves data and modeling that is beyond the scope of this article. clearly, however, in the context of current u.s. revenue needs, any u.s. territorial system that is ultimately adopted should avoid conferring exemption on dividends paid out of foreign income that has not borne a material foreign income tax. such income does not present a meaningful double taxation case but instead creates the prospect of a u.s. residual tax that is too large to give away. there is, nevertheless, strong opposition to this conclusion. the following statement accurately captures the opposition argument: in particular, a system based on a minimum effective rate of tax in a foreign jurisdiction would be fundamentally flawed. effective tax rates vary substantially from year to year based largely on differing rules in different countries affecting the timing of income and expenses. accelerated depreciation and the deduction of various liability reserves are but two examples of how foreign effective tax rates can be substantially lower in some years and substantially higher in other years than comparable u.s. rates on income as measured for u.s. tax purposes. a minimum effective tax rate requirement set at higher than a de minimis level would inevitably result in situations where income from the same country, including countries with relatively high statutory rates, would be exempt in some years but taxable in others. the uncertainty and complexity of such a rule for both taxpayers and tax administrators make it clearly anti-competitive.62 in fact, however, the u.s. international tax regime has found a way to respond to these objections in an analogous situation. section 954(b)(4) provides that for purposes of computing the subpart f income of a controlled foreign corporation (cfc): [f]oreign base company income and insurance income shall not include any item of income received by a 62. see national foreign trade council, inc., nftc report, supra note 19, at 702; see also ali, international proposals, supra note 57, at 329–32. 2012] exemption when the treasury is empty 419 controlled foreign corporation if the taxpayer establishes to the satisfaction of the secretary that such income was subject to an effective rate of income tax imposed by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11.63 this provision requires essentially the same computation that would be necessary if a subject-to-tax requirement were included in a u.s. territorial or exemption system. while the section 954(b)(4) computation is not simple, and there is uncertainty in marginal cases, regulations have made it workable,64 and the same approach could be taken with respect to the subject-to-tax requirement of a u.s. exemption system. c. the cliff effect structuring a subject-to-tax requirement in terms of a minimum foreign effective rate does, however, create a cliff effect that raises two theoretical possibilities. first, low-tax foreign countries might respond by raising their tax rates to a point just above the u.s. minimum rate threshold so that u.s. corporate taxpayers earning income in those countries would be beneficiaries of a u.s. tax exemption rather than a credit for foreign tax payments.65 the u.s. treasury would be a loser in this scenario. second, u.s. corporations might forgo opportunities to increase their pre-tax profits through strategies that would drop their effective tax rate in a particular country from above the u.s. minimum rate threshold to a point below it.66 world welfare would decrease in this scenario. the phenomenon of international tax competition67 will surely act as a restraint on the first of these scenarios, and both scenarios could be mitigated by attaching a phasein to the u.s. minimum rate threshold. for example, the united states might give a one-third exemption to income subject to at least a 10 percent foreign effective tax rate, a two-thirds exemption where the foreign effective tax rate 63. i.r.c. § 954(b)(4). 64. see 3 joseph isenbergh, international taxation: u.s. taxation of foreign persons and foreign income ¶ 74.39.3 (4th ed. 2006) [hereinafter isenbergh, international taxation]. the current section 954(b)(4) regulations do not include foreign dividend withholding taxes in the effective tax rate computation. this omission would have to be corrected. 65. see olson, merrill, mundaca, reilly & spellings, new ground, supra note 23, at 63. 66. see id. 67. see generally reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573 (2000); diane ring, democracy, sovereignty and tax competition: the role of tax sovereignty in shaping tax cooperation, 9 fla. tax rev. 555 (2009). 420 florida tax review [vol. 13:8 is at least 15 percent, and a complete exemption at the 20 percent or above level.68 this approach would require low-tax countries to make larger, and less likely, tax rate increases that would have to affect investors from all countries (not just the united states) in order to secure a full u.s. exemption with respect to income earned within their borders. it would also mean that foreign tax minimization would be less likely to result in loss of the entire u.s. exemption. d. the listed country approach alternatively, congress could give the treasury the authority to designate a list of countries whose tax systems are sufficiently robust so that, on average, they will impose a substantial source tax on u.s. multinational corporations even if they fail to do so in some cases. income sourced in those countries would automatically have subject-to-tax status. income derived from unlisted countries would fail the subject-to-tax requirement and be disqualified as a source for exempt dividends.69 while this alternative would not have the taxpayer-specific precision of the section 954(b)(4) approach, it would avoid creating a cliff effect, and it would increase certainty and reduce compliance costs. if the creation of the list was insulated from political pressure so that low-tax countries that allow themselves to be used as tax havens, such as switzerland, ireland, luxembourg, singapore, and hong kong (to name a few), were excluded from the approved list, the list approach could serve as an acceptable compromise in light of the fact that 68. for example, the effective rate test in option a of chairman camp’s discussion draft is phased in. see ways & means discussion draft, supra note 60, § 331a (adding new i.r.c. § 954(f)(2)). under current u.s. tax law, if a foreign country applies a higher than normal tax rate to income earned within its borders by u.s. residents in order to take full advantage of the u.s. foreign tax credit, the foreign tax credit is available only for the normal portion of the foreign tax. the excess is a non-creditable “soak-up” tax. see reg. § 1.901-2(c). presumably a similar rule would apply for purposes of determining whether a foreign tax is sufficient to satisfy the subject-to-tax requirement. 69. see generally h. david rosenbloom, from the bottom up: taxing the income of foreign controlled corporations, 26 brook. j. int’l l. 1525 (2001) [hereinafter rosenbloom, from the bottom up] (making such a proposal); staff of joint comm., impact of international tax reform, supra note 17, at 8–9; u.s. treas. dep’t, interim rep., supra, note 50, at 42–43; graetz & oosterhuis, structuring an exemption system, supra note 50, at 783. australia and spain apply versions of this approach. see staff of joint comm., background and issues, supra note 48, at 16, 35. the presence of a treaty alone is not sufficient to assure that income will be subject to more than a de minimis amount of tax. see, e.g., tom bergin, special report amazon’s billion-dollar tax shield, reuters, dec. 6, 2012, http://uk.reuters.com/article/2012/12/06/uk-tax-amazon-idukbre8b50at2012120 6 (describing use of luxembourg companies to avoid tax). 2012] exemption when the treasury is empty 421 the united states faces a severe revenue constraint and, therefore, should avoid waiving residual tax on income of u.s. residents that is not significantly taxed anywhere else in the world. in this context, the relative weights given to precision and to revenue generation should be shifted somewhat towards the latter in the policy-making process. e. locational distortion finally, it seems clear that in comparison with a u.s. worldwide system that has been reformed to cure its considerable defects,70 a u.s. exemption system would erode the beleaguered u.s. tax base by encouraging u.s. resident corporations to locate new or expanded business activity in low-tax foreign countries instead of in the united states.71 this phenomenon would be considerably magnified if the u.s. exemption system were to permit the foreign location to be one where no meaningful local tax has to be paid as a cost of carrying on business there.72 this is not a good policy outcome, and it is particularly objectionable in the present u.s. revenue context. f. implicit taxes return now to the earlier example of usco, a u.s. resident corporation paying u.s. income tax at a 35 percent rate, and its wholly owned, active business subsidiary, fs, which is incorporated in lowtaxia, a country without a corporate profits tax or a dividend withholding tax.73 assume that the united states and lowtaxia are the world’s only countries, that u.s. corporations like usco can earn a 10 percent pre-tax return on investments in u.s. business activities, and that the united states provides a tax exemption for all dividends from foreign subsidiaries regardless of whether the subsidiaries have paid any foreign tax. the theory of tax capitalization suggests that because the after-tax return to u.s. corporations on their u.s. investments is 6.5 percent,74 u.s. corporations will be willing to pay a purchase price for tax-free investments in lowtaxia businesses that 70. see jobs council, road map, supra note 1, at 47–48; daniel e. kwak, america’s refusal to ‘race to the bottom’: worldwide vs. territorial taxation, 65 tax notes int’l 387, 393–94 (jan. 30, 2012). see generally fleming, peroni & shay, worse than exemption, supra note 4; peroni, fleming & shay, getting serious, supra note 3. 71. see generally fleming, peroni & shay, worldwide vs. territorial, supra note 21. 72. see aba tax’n sec., task force rep., supra note 50, at 730; staff of joint comm., impact of international tax reform, supra note 17, at 5. 73. see supra notes 49–51 and accompanying text. 74. 10 percent – (10 percent × 35 percent) = 6.5 percent. 422 florida tax review [vol. 13:8 will result in a 6.5 percent rate of return.75 u.s. corporations that do so are said to bear a 35 percent implicit tax76 because their 6.5 percent rate of return in lowtaxia is 35 percent less than the 10 percent pre-tax rate of return available in the united states.77 these u.s. corporations are then regarded as bearing the same rate of tax, 35 percent, on their lowtaxia investments as on their u.s. investments.78 does this suggest that the dividends fs pays to usco should be regarded as having come from income that bore a 35 percent foreign tax, a level of taxation that is surely sufficient to satisfy the demands of any subject-to-tax requirement? stated more broadly, if the explicit source tax on foreign income and the implicit tax on that income sum up to a meaningful levy, does the implicit tax concept obviate the need for including a subject-to-tax requirement in a u.s. exemption system? with respect to this inquiry, professor kleinbard has pointed out, “implicit taxes are not collected by a government, but instead are reflected in an investor’s yield.”79 in addition, professor weisbach has observed that “[i]mplicit taxes are misnamed. implicit taxes are not taxes in the sense of the confiscation of resources by the government. they are simply asset price adjustments in response to a tax benefit or detriment.”80 it may be that the term “implicit tax” has rhetorical utility in some settings. in the context of the usco hypothetical, however, professors kleinbard and weisbach remind us that although usco suffered an implicit tax, it did not actually pay any tax to lowtaxia. instead, usco paid a price for a lowtaxia investment that was higher than otherwise because of applicable u.s. and lowtaxia tax exemptions. consequently, usco experienced a lower pre-tax rate of return than if it had made a taxable investment in the united states. but earning less is not the same as paying a meaningful tax to both a residence country and a source country on the same income, thereby triggering the residence country’s international law obligation to provide double taxation relief. 75. see kleinbard, lessons, supra note 3, at 118. 76. for general explanations of the implicit tax concept, see myron s. scholes, mark a. wolfson, merle erickson, edward l. maydew & terry shevlin, taxes and business strategy: a planning approach 121–22, 125– 27 (3d ed. 2005); harry watson, implicit taxes, in the encyclopedia of taxation and tax policy 185 (joseph j. cordes, robert d. ebel & jane g. gravelle eds., 2d ed. 2005). 77. 6.5 percent = 10 percent – (10 percent × 35 percent). 78. see joel slemrod & jon bakija, taxing ourselves 78 (4th ed. 2008). professor kelinbard has recently provided a thorough analysis of why this full 35 percent implicit tax would be unlikely to occur in the real world. see kleinbard, lessons, supra note 3, at 118–29. 79. kleinbard, lessons, supra note 3, at 118. 80. david a. weisbach, implications of implicit taxes, 52 smu l. rev. 373, 374 (1999). 2012] exemption when the treasury is empty 423 in the context of designing a u.s. exemption system,81 this means that we must recognize that the purpose of such a system is to mitigate international double taxation levied by governments.82 the purpose is not to rescue u.s. corporations from low pre-tax rates of return resulting from having paid a price to a private party that was increased by the market to reflect tax exemptions. thus, usco’s implicit tax does not create a case for double taxation relief, and a u.s. exemption regime should not apply to dividends paid by fs out of lowtaxia income. a territoriality proponent might, however, argue that the preceding analysis is bogged down in legal formalisms and that the real purpose of a territorial or exemption system is to apply the economic theory of capital import neutrality (cin).83 that theory asserts that worldwide economic efficiency will be maximized if countries refrain from taxing the foreignsource incomes of their residents so that only source-country tax applies, even if the source-country tax is zero.84 therefore, so the argument goes, a territorial or exemption system is the optimum regime because sourcecountry taxation is the only form of taxation allowed under such a system.85 we agree that territorial or exemption systems are often associated with cin,86 and under an extreme version of cin, dividends received by usco from fs should be exempt from u.s. tax even if the fs profits that supported the dividends bore zero foreign tax.87 however, no major commercial nation employs an exemption system that adopts the extreme version of cin.88 they all recognize that exemption systems must strike a balance between double taxation relief and protection of residence country 81. see id. at 377 (“[w]e care about implicit taxes, but it is difficult to make general statements about which way they cut. . . . [o]ne must think about them in a given context, but each case will be different.”). 82. see ault & arnold, comparative taxation, supra note 50, at 446– 47; lokken & kitamura, credit vs. exemption, supra note 1, at 646. 83. for an explanation of cin, see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 21. 84. see staff of joint comm., impact of international tax reform, supra note 17, at 2, 5, 57–59; u.s. treas. dep’t, interim rep., supra note 50, at 41–42. 85. see staff of joint comm., impact of international tax reform, supra note 17, at 5. 86. see staff of joint comm., options, supra note 41, at 186; see also staff of joint comm., impact of international tax reform, supra note 17, at 5, 59; u.s. treas. dep’t, interim rep., supra note 50, at 41–42. 87. see staff of joint comm., background and issues, supra note 48, at 8; staff of joint comm., impact of international tax reform, supra note 17, at 2; u.s. treas. dep’t, interim rep., supra note 50, at 41–42. 88. see staff of joint comm., background and issues, supra note 48, at 8. 424 florida tax review [vol. 13:8 tax bases from excessive erosion.89 for example, they generally exclude from exemption passive income generated by cross-border investments, and several of them have subject-to-tax requirements.90 thus, the better view is that an exemption or territorial system is a method for mitigating double taxation levied by governments. from that standpoint, it is critical that although investments in low-tax countries like lowtaxia suffer pre-tax rate of return reductions that are often called implicit taxes, there is no double taxation because the implicit tax represents forgone income rather than a duplicative payment to a government. therefore, the implicit taxes that result from low explicit foreign taxes should be irrelevant with respect to the double taxation conundrum. their existence does not make out a case for rejecting a subject-to-tax requirement in an exemption system. at this point, many pro-exemption advocates would argue that the preceding analysis is irrelevant because the purpose of exemption systems is to make u.s. multinational corporations more competitive in low-tax foreign markets and that an exemption system that does nothing more than alleviate international double taxation is deficient per se.91 this is actually a demand for a competition subsidy delivered through the tax system, and we will discuss this aspect of territoriality in part ix. g. applying the subject-to-tax rule to a dividend exemption system in theory, a subject-to-tax requirement could be applied by requiring each foreign subsidiary of a u.s. corporation to create an accounting pool of income that was disqualified from exemption by the subject-to-tax requirement and a separate accounting pool for income that was not disqualified. dividends paid by the foreign subsidiary to a u.s. parent could then be treated as drawn proportionately from each pool or as coming initially from only one of the pools and then from the other when the first was exhausted.92 dividends would be taxable to the extent they were allocable to the disqualified income pool under the applicable ordering rule. this approach to the subject-to-tax requirement would, however, confer a problematic deferral benefit on the disqualified low-tax income, and 89. see staff of joint comm., background and issues, supra note 48, at 2, 4–5, 8–10; u.s. treas. dep’t, interim rep., supra note 50, at 41–42; ault & arnold, comparative taxation, supra note 50, at 447, 474–75. 90. see staff of joint comm., background and issues, supra note 48, at 8–10; staff of joint comm., impact of international tax reform, supra note 17, at 2, 4; ault & arnold, comparative taxation, supra note 50, at 476– 85. 91. see supra note 23. 92. cf. i.r.c. § 959(c). 2012] exemption when the treasury is empty 425 it would be unusual. countries that disqualify certain types of income from serving as the source of exempt dividends usually do so indirectly and in a way that avoids deferral. they typically allow a full exemption for the dividend (or a fraction thereof that reflects an adjustment for expenses allocable to foreign income),93 but at the same time they maintain cfc regimes94 that, speaking in simplified terms, require the disqualified portion of the foreign subsidiary’s income to be currently included in the income of the domestic parent. in this way, disqualified income is indirectly barred from both exemption treatment and deferral.95 consistent with this pattern, countries that impose subject-to-tax requirements generally do so by treating low-taxed foreign income as disqualified income that is subject to current inclusion under the cfc regime.96 this is the approach taken in the october 2011 ways and means discussion draft, which would generally retain subpart f and treat certain low-taxed foreign income as subpart f income.97 it has the advantage of utilizing a familiar regime that has been in place since 1962, although it is out of date and badly in need of reform. consequently, the approach of implementing a subject-to-tax requirement by treating low-taxed foreign income as subpart f income strikes us as satisfactory. assuming that subpart f is retained, with some modification, and that some income is subject to current taxation, foreign tax credits should be available under section 960 with respect to taxable subpart f income. h. tiered structures recall the example of usco, a u.s. resident corporation paying u.s. tax at a 35 percent rate, and its wholly owned, active business subsidiary, fs, which is incorporated in lowtaxia, a country without a corporate profits tax 93. see infra notes 178–79 and accompanying text. 94. the u.s. cfc regime, familiarly known as subpart f, is contained in i.r.c. §§ 951–965 and is the subject of a vast body of literature. for a detailed survey of the subpart f provisions, see 1 joel d. kuntz & robert j. peroni, u.s. international taxation ch. b3 (1992) [hereinafter kuntz & peroni, u.s. international taxation]. 95. see staff of joint comm., background and issues, supra note 48, at 3–4, 8–10; ault & arnold, comparative taxation, supra note 50, at 476–77; kleinbard, lessons, supra note 3, at 144–45. 96. see staff of joint comm., background and issues, supra note 48, at 8–10. 97. see ways & means technical explanation, supra note 60, at 33– 34. strangely, the ways and means discussion draft allows an additional tax to be imposed upon distribution of previously taxed subpart f income by exempting only 95 percent of the previously taxed amount. we believe that this is not the appropriate approach to this issue. see infra notes 99, 107, and accompanying text. 426 florida tax review [vol. 13:8 or a dividend withholding tax. we have argued that dividends from fs to usco should not qualify for a u.s. exemption because they are not paid out of income that has incurred a meaningful foreign tax. conversely, the fs dividends should be exempt if the fs business income incurred a meaningful foreign tax. should that conclusion be any different if the lowtaxia active business is conducted by fs’s wholly owned lowtaxia subsidiary, fs2, and fs’s income consists of dividends from fs2? clearly not. a u.s. exemption system should effectively look through the dividends received by usco from fs to their ultimate source and should allow an exemption to the extent that a meaningful foreign tax was borne as the income travelled through one or more corporate layers to usco.98 a practical way to achieve this end is to treat any low-taxed income of fs2 as subpart f income, apply the hopscotch rules in sections 951(a)(1) and 958(a)(2), and exempt the dividend distributions of fs2’s previously taxed earnings.99 2. passive income the preceding sections have dealt with structuring a u.s. tax exemption for dividends paid out of the foreign active business income of a foreign subsidiary. we have argued that the exemption should not be available unless the active business income has borne a meaningful foreign tax. perhaps surprisingly, however, it seems that passive income should never be exempt even if it has been subject to a substantial foreign tax. the common explanation for this apparent incongruity is that the capital that produces passive income is so highly mobile and so independent of particular markets and national economies that it can be shifted to low-tax jurisdictions much more easily than the capital that yields active business income.100 accordingly, if exempt dividends could be paid out of a foreign subsidiary’s passive income, there would be a massive migration of passive income-producing capital to low-tax jurisdictions that would dwarf the similar taxpayer behavior regarding the transfer of active business capital to low-tax jurisdictions like ireland.101 thus, so the argument goes, it is all a 98. see staff of joint comm., options, supra note 41, at 190. 99. see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 530–31. this mechanism would address the issue identified earlier in this article. see supra note 97. 100. see, e.g., staff of joint comm., impact of international tax reform, supra note 17, at 4–5; u.s. treas. dep’t, interim rep., supra note 50, at 41–42; ault & arnold, comparative taxation, supra note 50, at 475; graetz & oosterhuis, structuring an exemption system, supra note 50, at 774–75; michael s. knoll, the corporate income tax and the competitiveness of u.s. industries, 63 tax l. rev. 771, 783 n.49 (2010). 101. see supra note 100. 2012] exemption when the treasury is empty 427 matter of degree, and the source of exempt dividends must be limited to active business income. regardless of whether one is impressed by the dubious logical force of this argument, the major commercial nations that employ territorial systems are overwhelmingly united in excluding passive income as a source of exempt dividends.102 thus, as two of us said in an earlier article, “[b]ecause the principal argument in favor of a u.s. exemption regime [in comparison to a worldwide taxation system] is to make u.s. multinationals more competitive with exemption country multinationals in the markets of low-tax foreign countries, there is no need for the united states to outdo the competition by exceeding the generosity of other exemption countries.”103 if a u.s. exemption system provided a tax exemption for foreign-source passive income, it would be giving away revenue that no other significant exemption system country has chosen to surrender, which would be particularly objectionable in the context of the current u.s. fiscal situation. passive income should not qualify as a source for exempt dividends and should continue to be treated as currently taxable subpart f income. the preceding analysis means that a u.s. exemption system must make a distinction between active and passive income and provide rules for currently taxing the latter. both the 2005 joint committee staff exemption proposal and the 2011 ways and means discussion draft exemption proposal use the subpart f income definition and the subpart f regime for these purposes.104 that is a convenient solution because it relies on a welldeveloped body of law (albeit one that needs substantial revision).105 102. see staff of joint comm., background and issues, supra note 48, at 8; staff of joint comm., impact of international tax reform, supra note 17, at 4; staff of joint comm., options, supra note 41, at 187; ault & arnold, comparative taxation, supra note 50, at 475; see also terrence r. chorvat, ending the taxation of foreign business income, 42 ariz. l. rev. 835, 856 (2000) [hereinafter chorvat, ending foreign business tax] (recommending that passive income not be treated as exempt income in an exemption system). 103. fleming & peroni, exploring the contours, supra note 21, at 1563 (footnote omitted). 104. with respect to the joint committee staff proposal, see staff of joint comm., options, supra note 41, at 191. with respect to the ways and means discussion draft, see ways & means technical explanation, supra note 60, at 18. 105. we leave for another day an analysis of whether the section 954(h) exclusion of active banking and financing income from subpart f income is appropriate and whether there are practical ways to make subpart f more effective. see, e.g., aba tax’n sec., task force rep., supra note 50, at 777–812. we also defer a discussion of our preference for replacing subpart f with a pass-through regime, a topic on which we have extensively written. see peroni, fleming & shay, getting serious, supra note 3, at 507–19. 428 florida tax review [vol. 13:8 granted, the subpart f income definition reaches certain sales and services income that is not truly passive. this sales and services income does, however, have the same potential to be shifted to low-tax jurisdictions as income that is literally passive,106 and so it is appropriate to treat it as if it were passive. assuming that subpart f is retained, foreign tax credits with respect to taxable subpart f income would be available under section 960 and previously taxed earnings should be exempt when distributed.107 b. who qualifies? 1. corporate shareholders with respect to corporate shareholders owning stock in a foreign corporation, two principal issues arise under a properly designed exemption system. first, what is the requisite amount of stock that a domestic corporation must own in the foreign corporation for dividends paid to it to qualify for exemption? second, will the exemption system apply to dividends paid to a domestic corporation owning the requisite percentage of stock in a foreign corporation that is not a cfc. with respect to the first issue, most exemption systems limit the applicability of the dividend exemption to domestic corporations owning at least 10 percent of the foreign corporation’s stock. domestic corporations having a less than 10 percent interest generally do not qualify for exemption.108 in our view, a u.s. exemption system should adopt this approach. for this purpose, stock ownership should probably include not only actual ownership but also indirect and constructive ownership, as is true under the subpart f regime of current law. the logic for this 10 percent threshold approach is simplicity and administrability. in order to be able to report income under the exemption system, a shareholder needs to be able to obtain information about the foreign corporation’s income and expenses.109 corporate shareholders with a less than 10 percent interest are less likely to be in a position to obtain that information. moreover, the 10 percent 106. see graetz & oosterhuis, structuring an exemption system, supra note 50, at 775; see also staff of joint comm., options, supra note 41, at 189–91 (effectively treating “highly mobile income” as passive income). 107. see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 498. 108. see, e.g., staff of joint comm., options, supra note 41, at 190; president’s advisory panel on federal tax reform, simple, fair & progrowth: proposal to fix america’s tax system 134 (2005) [hereinafter president’s tax reform advisory panel]. 109. see, e.g., peroni, fleming & shay, getting serious, supra note 3, at 511. 2012] exemption when the treasury is empty 429 threshold is a common dividing line in the international tax rules for separating corporate stock interests that are viewed as direct investments (which qualify for tax benefits such as the indirect credit in section 902) versus those that are viewed as portfolio investments (the income with respect to which is passive investment income).110 with respect to the second issue, three possible approaches could be taken. one approach would be to limit the exemption system to foreign corporations that are cfcs. this would considerably narrow the possible scope of the exemption system and require retention of all of the current international tax rules relating to so-called noncontrolled 10/50 foreign corporations. if the deferral principle were retained with respect to such corporations, as would likely be the case, this approach would also create planning opportunities to avoid the exemption system rules with respect to foreign corporations owning large amounts of income not eligible for the exemption regime. a second approach would be to apply the exemption system to a domestic corporation’s 10 percent or greater stock interest in a noncontrolled foreign corporation only if the domestic corporation so elects. the major argument in favor of this approach is that it allows a u.s. shareholder to avoid application of the exemption system in situations where it is unable to obtain the necessary information concerning the nature of the income earned by the foreign corporation in order the apply the rules of the exemption system. however, taxpayer elections are a one-way ratchet — they only work to the detriment of the fisc and create tax-planning opportunities for well-advised taxpayers. moreover, this approach would also require retention of all of the current international tax rules relating to noncontrolled 10/50 foreign corporations. one way to reduce the scope of the election is to limit it to 10 percent or more u.s. shareholders in non-publicly traded foreign corporations that are not cfcs. the third approach would be to apply the exemption system to any domestic corporate stock interest in a foreign corporation that equals or exceeds the 10 percent threshold, regardless of whether the foreign corporation involved is a cfc, on a non-elective basis. on balance, we think that this is the best approach because there seems to be little logic to limiting the exemption system only to foreign corporations meeting the definition of a cfc, and mandating application of the exemption system will permit simplification of the current international tax rules relating to noncontrolled 10/50 foreign corporations and reduce tax-planning opportunities that undermine the u.s. tax base. 110. see, e.g., gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 494–95. 430 florida tax review [vol. 13:8 2. individual shareholders the major focus of proponents of territorial taxation is on domestic corporate investment in foreign corporations; little attention has been paid to how foreign-source income earned by individuals should be treated under such a system.111 however, the question arises as to whether a properly designed territorial system should apply to individuals, either with respect to the dividends they receive from a foreign corporation or with respect to foreign income that they earn directly as individual business proprietors or investors. with respect to dividends, we would not apply the same rules to 10 percent or more individual shareholders of foreign corporations as those that apply to domestic corporate shareholders meeting the 10 percent ownership threshold. under the u.s. corporate system of classical corporate taxation, earnings are taxed once at the corporate level and after-tax earnings are taxed again at the level of the shareholder. there is no risk of double corporatelevel taxation where a foreign corporation is owned directly by a non-c corporation shareholder. moreover, the u.s. classical corporate tax system assumes that dividends between members of a corporate group should be taxfree or bear very little tax.112 this assumption, however, does not apply to dividends received by individual shareholders. in addition, if a u.s. exemption system provided a tax exemption for dividends received by non-c corporation shareholders, it would be giving away revenue that no other significant exemption system country has chosen to surrender, and in a situation where any international double taxation arising from a foreign withholding tax on the dividend income is ameliorated by a direct foreign tax credit under section 901. thus, we would continue to apply current law to non-c corporation shareholders. one related matter bears mention here. if an individual taxpayer earns foreign-source business income directly, rather than through a foreign corporation, one could argue that logic and horizontal equity considerations support applying the territorial system to such income earned by an individual, but only with respect to the types of income that would qualify for exemption if earned by a foreign corporation or by a branch of a foreign corporation. however, the comparison is not apt as the individual is not subject to a separate additional level of taxation of this income and the individual is protected against double taxation on foreign business income by the availability of a foreign tax credit. moreover, no other significant exemption country has chosen to take this approach, thereby surrendering the 111. see graetz & oosterhuis, structuring an exemption system, supra note 50, at 780. 112. see, e.g., i.r.c. §§ 243, 1501. 2012] exemption when the treasury is empty 431 residual tax on such income.113 thus, we do not favor extension of the exemption system to foreign business income earned directly by individuals. c. should royalty, interest, and services payments from foreign corporations qualify for exemption? 1. royalties foreign-source royalties received by u.s. residents typically bear no foreign income tax because the foreign payors are allowed to deduct the royalty payments when computing foreign taxable income and the payments are frequently exempted from foreign withholding tax by an applicable income tax treaty. thus, there is usually no international double taxation with respect to the foreign-source royalty receipts of u.s. taxpayers and, therefore, no reason to provide double taxation relief. surprisingly, however, the u.s. international income tax regime effectively ignores this point with regard to foreign-source royalties paid by a cfc to its u.s. parent corporation. this is the case because look-through rules in section 904(d)(3) of current law provide that lowor zero-taxed foreign-source royalties received by a u.s. parent corporation from a subsidiary that is a cfc go into the general category foreign tax credit limitation basket. that basket also includes both high-foreign-taxed dividends paid to the u.s. parent corporation by other cfcs and any directly-earned active foreign business income of the parent that bears a high foreign tax.114 foreign taxes on this 113. some countries provide an exemption for foreign-source personal service income earned by resident individuals. see ault & arnold, comparative taxation, supra note 50, at 468–69. the u.s. version of this exemption is found in section 911. the present discussion deals only with the question of whether the exemption system should be extended to foreign business activities of u.s. resident individuals when the activities do not consist primarily of the individuals’ performance of personal services. we postpone to a subsequent article a discussion of whether section 911 should be repealed or modified. for policy discussions regarding the section 911 exclusion, see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 454–57; kuntz & peroni, u.s. international taxation, supra note 94, at ¶ b1.04[1]; charles i. kingson, a somewhat different view, 34 tax law. 737 (1981); john d. maiers, the foreign earned income exclusion: reinventing the wheel, 34 tax law. 691 (1981); renée judith sobel, united states taxation of its citizens abroad: incentive or equity, 38 vand. l. rev. 101 (1985). 114. see, e.g., lawrence lokken, territorial taxation: why some u.s. multinationals may be less than enthusiastic about the idea (and some ideas they really dislike), 59 smu l. rev. 751, 764–67 (2006) [hereinafter lokken, territorial taxation]. 432 florida tax review [vol. 13:8 income that exceed the u.s. tax thereon are then offset against the u.s. tax on the foreign-source royalties — a process known as “cross-crediting.” this can substantially diminish the u.s. tax on the royalties or reduce it to zero even though the royalties do not suffer any significant double taxation.115 the following example illustrates this dynamic. example 1 usco, a u.s. multinational corporation with a 35 percent u.s. marginal effective income tax rate, owns all the stock of subco, a cfc operating in the foreign country of lowtaxia. lowtaxia has an income tax treaty with the united states that exempts royalties paid to a u.s. resident from lowtaxia income tax unless the royalties are attributable to a permanent establishment maintained by the u.s. resident in lowtaxia. usco licenses a lowtaxia patent to subco for use in its lowtaxia manufacturing business. for the current year, subco pays usco royalties of $100,000 under its license for the lowtaxia patent, which is treated as foreign-source income under section 862(a)(4). lowtaxia allows subco to deduct these royalties in computing its taxable income. usco is exempt from lowtaxia withholding tax on the royalties by reason of the income tax treaty with the united states. under the look-through rules in section 904(d)(3), usco’s royalty income falls within the general category income limitation basket, which also contains other foreign income of usco bearing taxes that exceed the u.s. tax thereon by $35,000. usco is allowed to cross credit these excess foreign taxes against the $35,000 of u.s. tax on the zero-foreign-taxed lowtaxia royalty income, thus eliminating the entire u.s. tax on that income. this means that the $100,000 of royalty income is completely taxexempt, having borne no tax in either the united states or lowtaxia. 115. see staff of joint comm., analyses of alternative policies, supra note 50, at 8 (“according to one study, almost two-thirds of royalties were sheltered by excess foreign tax credits in 2000.”); staff of joint comm., options, supra note 41, at 188; harry grubert & john mutti, taxing international business income: dividend exemption versus the current system 35 (2001) [hereinafter grubert & mutti, taxing international business income] (“in 1994, this flow of excess credit royalties reduced the u.s. tax liabilities of u.s. parents by $2.7 billion, of which $2.0 billion was in manufacturing.”); graetz & oosterhuis, structuring an exemption system, supra note 50, at 774; grubert, enacting dividend exemption, supra note 40, at 812. 2012] exemption when the treasury is empty 433 to repeat a now familiar theme, the international law obligation of the united states to mitigate international double taxation of foreign-source income does not extend to foreign-source income that is largely or entirely free of foreign tax and, therefore, largely or entirely free of double taxation. moreover, there is no equitable imperative that requires a zero u.s. tax rate for such income. thus, the u.s. practice, illustrated in example 1, of effectively imposing a zero tax rate on foreign-source royalty income goes beyond the international law and equitable obligations of the united states. nevertheless, the euphoria of a zero tax rate is hard to give up and it is highly likely that u.s. multinational corporations will press to have their foreignsource royalty receipts included within the income items that are exempted from u.s. income tax by a u.s. exemption system.116 this pressure should be resisted with respect to foreign-source royalties that do not bear a meaningful foreign tax117 because conferring an exemption on such royalties would exceed the double tax relief purpose of a territorial system118 and would, therefore, amount to a tax expenditure subsidy for developing and exploiting foreign intellectual property.119 this point will be elaborated on in part ix. in addition, foreign-source royalties that are not significantly taxed in a foreign jurisdiction can be taxed by the united states without having to face the problem of the cliff effect described in part vi.a.1.c. it might be argued that if a u.s. territorial system does not exempt foreign-source royalties, u.s. parent corporations will move their research and development activities to cfcs resident in low-tax countries; the u.s. parent corporations will have those subsidiaries develop all of the new 116. see group comments on jct report on compliance, tax expenditure reform, 2005 tax notes today 49-36 (mar. 15, 2005) [hereinafter group comments] (business group objects to exemption system that would tax foreignsource royalties); see also u.s. treas. dep’t, approaches, supra note 40, at 59–63 (report by bush administration treasury department giving support to an exemption system that would not tax foreign-source royalties). 117. but see chorvat, ending foreign business tax, supra note 102, at 856 (arguing that the foreign-source royalties paid to a u.s. corporation by a cfc affiliate corporation should not be subject to u.s. tax). 118. see staff of joint comm., options, supra note 41, at 191; president’s tax reform advisory panel, supra note 108, at 134; see also staff of joint comm., options, supra note 41, at 189, 195; grubert & mutti, taxing international business income, supra note 115, at 36; graetz & oosterhuis, structuring an exemption system, supra note 50, at 774 n.4, 776 (concluding that an exemption system should not apply to foreign-source royalties received by a u.s. corporate parent payee that are deductible by the foreign corporate payor and not subject to substantial foreign withholding taxes); grubert, enacting dividend exemption, supra note 40, at 813, 815–16. 119. we do not discuss in this article proposals for lower rates of tax for foreign royalty income. these tax expenditures should be assessed like any other — under a rigorous cost/benefit analysis. 434 florida tax review [vol. 13:8 technology for the u.s. parents’ corporate groups and earn the royalty income that results from licensing the new technology; and the subsidiaries will then pay the royalties to the u.s. parents in the form of exempt dividends.120 from this standpoint, the united states will have driven u.s. research and development work to foreign locations without having gained tax revenue. however, if section 954(c)(2)(a) and (c)(3)(a)(ii) is repealed with respect to royalties that do not bear a meaningful foreign tax, so that such royalties are included in subpart f income even when derived in the active conduct of a business or from a related corporation, the royalties in this hypothetical situation would be currently taxable as explained in part vi.a.1.g. if this approach is taken, denying exemption treatment to foreignsource royalties received by a u.s. parent corporation from a controlled foreign subsidiary should create little incentive to move technology development operations to low-tax foreign countries. the suggestion has been made that if foreign-source royalties are not treated as exempt by a u.s. territorial system, foreign subsidiaries will pay inflated exempt dividends and artificially low taxable royalties to their u.s. parent corporations.121 this strategy will undoubtedly be attempted and the problematic tool of transfer pricing enforcement appears to be the only answer. nevertheless, this less than ideal answer seems better than giving an unprincipled exemption to all foreign-source royalty income received from foreign subsidiaries, particularly in light of the revenue needs of the united states. finally, a u.s. exemption system should prevent, through foreign tax credit limit basketing or a per-country limitation, the cross-crediting of high foreign taxes against the u.s. tax on foreign-source royalty income. otherwise, the revenue from denying exemption treatment to royalties will be compromised. 120. see staff of joint comm., background and issues, supra note 48, at 11; peter merrill, oren penn, hans-martin eckstein, david grosman & martijn van kessel, restructuring foreign-source-income taxation: u.s. territorial tax proposals and the international experience, 111 tax notes 799, 811 (may 15, 2006); david g. noren, designing a territorial tax system for the united states, 40 tax mgm’t int’l j. 643, 648 (2011). 121. see staff of joint comm., background and issues, supra note 48, at 11; aba tax’n sec., task force rep., supra note 50, at 723. 2012] exemption when the treasury is empty 435 2. other untaxed foreign income the current u.s. international income tax system treats certain income items as having a foreign source even though they are typically subject to little or no foreign tax.122 examples include certain transportation income attributable to transportation that begins or ends in the united states, certain income derived from a space or ocean activity, international communications income, and shipping income, which the current statute and regulations treat (in whole or in part) as foreign-source income.123 another example would be a u.s. person’s income from services that are performed outside the united states124 but which are not attributable to an office or other fixed base in any foreign country and, thus, unlikely to be taxed by any foreign country.125 such income is often effectively exempt from u.s. income tax under the current u.s. international tax system because of the cross-crediting opportunities provided by the current u.s. tax law.126 as explained in connection with the preceding discussion of royalties, this zero tax treatment exceeds the international law and equity-based obligations of the united states; accordingly, the case for including such income within the reach of the exemption system is exceedingly weak. nevertheless, the beneficiaries can be expected to insist that these income items be included in the income that is exempted from u.s. taxation by a u.s. territorial system. 3. export sales inventory sales income is sourced to the place of sale under sections 861(a)(6), 862(a)(6), and 865(b), and under the regulations127 and case 122. see fleming, peroni & shay, worse than exemption, supra note 4, at 145; graetz & oosterhuis, structuring an exemption system, supra note 50, at 776. 123. see, e.g., i.r.c. § 863(c), (d), (e); reg. §§ 1.863-4, -8, -9. 124. such personal service income would be treated as foreign-source income under the place-of-performance rule in sections 861(a)(3) and 862(a)(3) of current law. 125. see supra note 122. 126. see fleming, peroni & shay, worse than exemption, supra note 4, at 145; shay, fleming & peroni, source rules, supra note 8, at 152–53. 127. see reg. § 1.861-7(c). the regulations, however, have long had a taxavoidance exception to the title passage rule, which provides that the place where the substance of the sale occurred, instead of the place where title passed, will be treated as the place of sale if the “sales transaction is arranged in a particular manner for the primary purpose of tax avoidance.” id. this tax-avoidance exception has had little practical effect in preventing manipulation of the inventory source rules because the government has been generally unsuccessful when litigating its application. see 3 boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts 73–42 to 73–43 (rev. 3d ed. 2005) [hereinafter bittker & lokken, 436 florida tax review [vol. 13:8 law,128 the place of sale of inventory is defined as the location where the seller’s rights, title, and interest in the inventory pass to the buyer.129 if the u.s. seller is also the inventory’s manufacturer, the “export sales source rule” arbitrarily treats the resulting income as 50 percent production income and 50 percent sales proceeds,130 with the production component sourced to the location of the production assets131 and the sales portion generally sourced to the location of the sale as identified by the title passage test.132 thus, the 50 percent notional sales income component usually will be characterized as foreign-source if title to the inventory passes to the purchaser outside the united states.133 stated differently, the export sales source rule of current law does not attempt to actually relate the source of export sales income to the economic activity that generated the income.134 instead, this rule arbitrarily allows no less than 50 percent of the u.s. manufacturer’s income from an export sale to be treated as having a foreign source even when the income bears no material foreign tax and even if most of the taxpayer’s economic activity giving rise to the income (i.e., producing and arranging for sale of the goods) takes place within the united states.135 taxation of income, estates, and gifts]; gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 100; 1 philip f. postlewaite & samuel a. donaldson, international taxation: corporate and individual 46 (4th ed. 2003). consequently, the title passage test is the governing rule for determining the place of sale for inventory property, with few exceptions. see, e.g., i.r.c. § 865(e)(2). 128. see, e.g., liggett group, inc. v. commissioner, 58 t.c. memo (cch) 1167 (1990); a.p. green exp. co. v. united states, 284 f.2d 383 (ct. cl. 1960). 129. this rule is often referred to as the “title passage test.” 130. see i.r.c. §§ 863(b), 865(b); reg. § 1.863-3(a), (b). 131. see reg. § 1.863-3(c)(1). 132. see i.r.c. §§ 861(a)(6), 862(a)(6), 863(b), 865(b); reg. §§ 1.8633(c)(2), 1.861-7(c). 133. see reg. § 1.863-3(b)(1). under a second alternative, a taxpayer may elect to determine the amount of production income by using the so-called “independent factory or production price” if the taxpayer can establish that such an independent factory or production price exists. see reg. § 1.863-3(b)(2). under a third, rarely used alternative, a taxpayer may allocate the income from export sales between the production and sales function based on the taxpayer’s books of account, but only if the taxpayer has received the irs district director’s advance permission and if certain other requirements in the regulations are met. see reg. § 1.863-3(b)(3). 134. see u.s. dep’t of the treas., the deferral of income earned through u.s. controlled foreign corporations 22 (2000); u.s. treas. dep’t, interim rep., supra note 50, at 31, 32 (concluding that the export sales source rule of current law “can reach results that depart significantly from the ‘economic nexus’ principle”); 1 isenbergh, international taxation, supra note 64, at ¶ 19:29. 135. 2 u.s. dep’t of the treas., tax reform for fairness, simplicity, and economic growth 365–67 (1984) [hereinafter u.s. treas. dep’t, tax 2012] exemption when the treasury is empty 437 consequently, a u.s. taxpayer/manufacturer can treat 50 percent of its income from the export sale of inventory manufactured entirely within the united states as foreign-source income even if the u.s. manufacturer makes the sale entirely from a u.s. office and even though no foreign country is likely to impose any tax on the sales income because the u.s. exporter does not maintain a foreign sales office.136 in fact, a u.s. manufacturer’s income from export sales of inventory usually bears little or no foreign income tax,137 unless the u.s. manufacturer/exporter has a sales office or other fixed place of business or sales employees in the foreign country of sale.138 this means that if a u.s. inventory manufacturer sells to a foreign customer and passes title to the goods abroad, the result is zero-foreign-taxed income, half of which is characterized as foreign-source sales income for u.s. foreign tax credit purposes.139 as noted above, this result often occurs even though most, if not all, of the income producing activity occurred in the united states. the zero-foreign-taxed income result explained in the preceding paragraph is important because of cross-crediting. to be specific, a u.s. manufacturer/exporter that has incurred foreign income tax in excess of the reform]; u.s. dep’t of the treas., the president’s tax proposals to the congress for fairness, growth, and simplicity 399 (1985) [hereinafter u.s. treas. dep’t, president’s 1985 tax proposals]. 136. see reg. § 1.863-3(b)(1); u.s. treas. dep’t, interim rep., supra note 50 at 32; ali, international proposals, supra note 57, at 32; lokken, territorial taxation, supra note 114, at 768–69. 137. most foreign countries would not tax income from the sale of inventory property merely because title to the inventory property sold passes within the country. u.s. treas. dep’t, president’s 1985 tax proposals, supra note 135, at 399; u.s. treas. dep’t, interim rep., supra note 50, at 32; ali, international proposals, supra note 57, at 354. thus, under current law, the title passage test for determining the source of the sales portion of the income from the export sale effectively facilitates a u.s. taxpayer artificially creating zero-taxed foreign-source sales income to expand the taxpayer’s foreign tax credit limitation and increase the opportunities for cross-crediting. see u.s. treas. dep’t, tax reform, supra note 135, at 365; u.s. treas. dep’t, president’s 1985 tax proposals, supra note 135, at 350–51, 399–400; ali, international proposals, supra note 57, at 354. this enhances the opportunities for a taxpayer to achieve tax results that are more harmful to the u.s. fisc than those that would obtain under a properly designed exemption system. cf. fleming, peroni & shay, worse than exemption, supra note 4, at 139; shay; fleming & peroni, source rules, supra note 8, at 153. 138. see, e.g., u.s. dep’t of the treas., report to the congress on the sales source rules 1 (1993); see also, e.g., u.s. treas. dep’t, tax reform, supra note 135, at 365–67; u.s. treas. dep’t, president’s 1985 tax proposals, supra note 135, at 399. 139. see, e.g., donald j. rousslang, the sales source rules for u.s. exports: how much do they cost?, 62 tax notes 1047 (feb. 21, 1994). 438 florida tax review [vol. 13:8 u.s. tax on other active foreign business income, such as income from services performed abroad, can use the excess credits to absorb the u.s. tax otherwise payable on the low-foreign-taxed export sales income that was artificially characterized as foreign-source by the export sales source rule.140 the result under the present u.s. regime is a zero u.s. tax on foreign-source export sales income that bears little or no foreign tax.141 under a properly designed exemption system, a u.s. manufacturer’s income from low or zero foreign taxed export sales would not qualify for exemption because it would not suffer any meaningful double taxation.142 thus, such income would be subject to the full u.s. income tax. nevertheless, the beneficiaries of the current export sales source rule can be expected to press for its inclusion in a u.s. exemption system because benefits once enjoyed are hard to surrender. this pressure should be resisted.143 conferring a zero tax rate on export sales income that bears little or no foreign tax would both lack any equitable basis and exceed the double tax relief purpose of an exemption system, and, therefore, would amount to a tax expenditure subsidy for manufacturer/exporters that would be unlikely to satisfy an appropriately rigorous cost/benefit analysis. this point will be discussed further in part viii.a. 140. see u.s. treas. dep’t, interim rep., supra note 50, at 32; fleming, peroni & shay, worse than exemption, supra note 4, at 139–40; peroni, back to the future, supra note 3, at 1007; see also u.s. dep’t of the treas., background paper, treasury conference on business taxation and global competitiveness 48 (2007). the joint committee staff’s estimate of the cost of the export sales source rule for 2011–2015 is $31 billion. see staff of joint comm., estimates, supra note 38, at 32. 141. see, e.g., aba tax’n sec., task force rep., supra note 50, at 703–05; fleming, peroni & shay, worse than exemption, supra note 4, at 139; charles i. kingson, the foreign tax credit and its critics, 9 am. j. tax pol’y 1, 20–22 (1991); robert j. peroni, j. clifton fleming, jr. & stephen e. shay, reform and simplification of the u.s. foreign tax credit rules, 101 tax notes 103, 118 (oct. 6, 2003). 142. see graetz & oosterhuis, structuring an exemption system, supra note 50, at 776 (concluding that “income from export sales not attributable to an active foreign business” should not qualify for exemption under a properly designed exemption system); see also grubert & mutti, taxing international business income, supra note 115, at 10; grubert, enacting dividend exemption, supra note 40, at 814. 143. it is noteworthy that senator enzi’s bill, s. 2091, would treat export sales income as u.s.-source income for purposes of the foreign tax credit limitation. see s. 2091, § 213, 112th cong., 2d sess. § 213 (feb. 9, 2012). 2012] exemption when the treasury is empty 439 4. indifference to foreign taxes opponents of the positions taken in this article will likely argue that if a u.s. exemption system is made inapplicable to foreign-source income that does not bear a meaningful foreign tax, u.s. multinationals will lack any motivation to reduce their foreign taxes below the “meaningful” threshold because doing so would create residual u.s. tax liability.144 however, the most egregious failures to reduce foreign taxes could be limited by incorporating the “compulsory payment” requirements of the regulations for creditability of foreign taxes.145 in addition, taxpayers will wish to minimize a foreign tax below the meaningfulness threshold if there are doubts about the creditability of the tax for u.s. tax purposes. taxpayers will also wish to minimize foreign taxes for time value of money reasons if there is a timing gap between the time the foreign tax is paid and the time it is accruable for u.s. foreign tax credit purposes. finally, in many cases, there will be no minimization opportunities with respect to a foreign tax and, with tax havens, there will be little or no foreign tax to minimize. it would not be appropriate to let the income in those cases escape a u.s. residual tax because of a concern that u.s. residents will not minimize foreign taxes in other cases. d. gain (or loss) from the sale of the stock of a cfc another issue that arises regarding the proper scope of a territorial system concerns the proper treatment of gain or loss from the sale of the stock of a cfc under such a system. taxation of 100 percent of the stock sale gains would conflict with the basic premise of a territorial system; accordingly, exemption to some extent is appropriate. there are several possible approaches to this issue, all of which have some problems. one approach to the treatment of gains from the sale of stock of a cfc would be to exempt gain only to the extent of the stock’s allocable share of exempt but undistributed earnings of the cfc.146 we support this approach because it allows exemption only to the extent of the stock gain 144. see, e.g., clausing & shaviro, creditability to deductibility, supra note 16, (criticizing the availability of a u.s. foreign tax credit for making u.s. residents indifferent to the amount of creditable foreign tax they incur so long as the foreign tax liability does not exceed the u.s. federal income tax liability); daniel shaviro, the case against foreign tax credits, 3 j. legal analysis 65 (2011) (same). 145. see reg. § 1.901-2(e)(5). 146. see staff of joint comm., options, supra note 41, at 191; see also staff of joint comm. on tax’n, jcx-42-11, present law and issues in u.s. taxation of cross-border income 91 (2011) [hereinafter staff of joint comm., taxation of cross-border income]; graetz & oosterhuis, structuring an exemption system, supra note 50, at 776. 440 florida tax review [vol. 13:8 that is attributable to earnings that actually have been meaningfully taxed at the corporate level. stock gain in excess of that amount is not usually taxed by the source country and therefore should be taxed by the residence country and not exempted. this approach is consistent with our thesis throughout this article of understanding exemption as a means to avoid double corporate taxation but not to exempt from taxation income that is not taxed by another country. this approach also has some intuitive appeal because it is relatively simple to administer.147 a second possible approach would be to exempt all gain from the sale of cfc stock (or the percentage of gain that corresponds to the percentage of dividends that are exempt, as explained in part viii.b) on the theory that the gain is attributable to the present value of the expected future income from appreciated corporate assets that will give rise to income qualifying for exemption under the territorial system.148 this is a taxpayerfavorable approach and is the simplest method for dealing with this issue. however, it would be overly inclusive to the extent that the cfc’s assets are the kind of assets that produce non-exempt income, and it would distort corporate behavior by encouraging foreign corporations to retain, rather than distribute, their earnings that do not qualify for exemption. thus, it would create an end-run around the rules limiting the types of corporate income that qualify for exemption under a properly designed territorial system. accordingly, we view this approach as the least acceptable of the three possibilities discussed here. a third possible approach would be to require the selling u.s. shareholder to look through the stock of the cfc to the underlying assets of the corporation. under this approach, the selling u.s. shareholder would have to allocate the gain from the sale of the cfc stock between the unrealized appreciation attributable to corporate assets that produce income qualifying for exemption and those corporate assets that produce income not qualifying for exemption.149 only the portion of the stock sale gain attributable to appreciation in the assets producing exempt income would itself be exempt from tax. this approach is more precise and theoretically correct than exempting all stock sale gain. it is also the most complex 147. however, this approach has been criticized by some commentators as conceptually flawed because it does not properly take into account the gain attributable to the present value of the expected future income from appreciated corporate assets giving rise to income qualifying for exemption under the territorial system. see staff of joint comm., taxation of cross-border income, supra note 146, at 91. 148. see id. 149. see staff of joint comm., taxation of cross-border income, supra note 146, at 91; graetz & oosterhuis, structuring an exemption system, supra note 50, at 776. 2012] exemption when the treasury is empty 441 approach and would involve difficult allocation and valuation issues (always a source of practical problems in the tax system). with respect to losses, there are the same three possible alternative approaches, each with its advantages and disadvantages. however, if any loss deduction is going to be allowed under either the first or third approach above, thought must be given to the possibility of tax-motivated lossgenerating transactions by taxpayers and what that means regarding the need for anti-abuse rules relating to losses. those anti-abuse rules, of course, would create additional complexity and might undermine the administrability of an exemption system. this has led some proponents of territorial taxation to propose complete disallowance of any deduction for losses from the sale of cfc stock, regardless of whether all or some portion of gain from the sale of cfc stock is subject to taxation.150 this asymmetrical treatment of losses from the sale of cfc stock has the virtue of protecting revenue as well as simplicity and administrative convenience, but lacks a consistent conceptual foundation. on balance, we favor symmetrical treatment of gains and losses from the sale of cfc stock, which means that we probably would disallow cfc stock sale losses only to the extent that they arise from an activity giving rise to exempt foreign-source income. vii. branch exemption in part vi, we described the structure and limits of a principled dividend exemption system in the context of usco, a u.s. domestic corporation that owns all the stock of fs, a corporation formed under the laws of lowtaxia and carrying on an active business there. we concluded that under a u.s. territorial or exemption system, dividends distributed by fs to usco should be exempt from u.s. income tax but only to the extent that they are paid out of active foreign-source income that has borne a meaningful foreign tax. should similar conclusions apply if fs is usco’s unincorporated branch in lowtaxia? the case for a positive answer seems compelling. if foreign active income merits a u.s. exemption when it is realized by a u.s. corporation indirectly in the form of dividends from a foreign subsidiary, then there is strong intuitive appeal for treating the same income as exempt 150. see staff of joint comm., options, supra note 41, at 191; see also staff of joint comm., taxation of cross-border income, supra note 146, at 92. several countries with territorial systems use this complete loss disallowance approach, including germany and the netherlands. see staff of joint comm., background and issues, supra note 48, at 26, 33. 442 florida tax review [vol. 13:8 when it is earned directly through the u.s. corporation’s foreign branch operations.151 however, foreign-source branch losses should not be deductible against a u.s. corporation’s u.s.-source income.152 we will develop that point fully in part viii.c., so at this point we will simply say that there should be no deduction of foreign branch losses against u.s. income because allowance of the deduction would confer an unwarranted and distortive subsidy on the foreign operations. in addition, for reasons given in part vi, the u.s. exemption system should not apply to passive branch income or to branch income that has not borne a meaningful foreign tax. thus, while foreign branch operations should be included in a u.s. exemption system, they should be included in a way that quarantines and disallows the deduction of foreign branch losses as well as excludes from exemption treatment both foreign branch income that does not bear a meaningful foreign tax and foreign passive branch income. the question is how to accomplish these ends. none of the answers are simple. one approach is to structure the u.s. exemption system so that it treats a branch as if it were a wholly owned foreign subsidiary to which subpart f applies. this is the path recommended in the 2011 ways and means discussion draft,153 the bush tax reform advisory panel report,154 and in the 2005 joint committee staff proposal.155 taking this path would automatically block branch losses from being deducted against u.s.-source income156 and it would also prevent the u.s. exemption from applying to passive foreign income and low-taxed foreign income, assuming that subpart f income is defined to include the latter. the controlled subsidiary approach would make explicit the transfer pricing issues that exist between parent corporations and “real” subsidiaries but which create substantial practical difficulties in practice in dealings with a branch. treating the branch as a controlled foreign corporation brings the outbound asset transfer rules of section 367 into play and in practice may make it easier to apply section 482 to assure that the united states receives its fair share of income. particularly with respect to use of an intangible in 151. see jane g. gravelle, cong. research serv. r42624, moving to a territorial income tax: options and challenges 35 (2012) [hereinafter gravelle, options and challenges]; graetz & oosterhuis, structuring an exemption system, supra note 50, at 774. 152. see ault & arnold, comparative taxation, supra note 50, at 473. 153. see ways & means technical explanation, supra note 60, at 22. 154. see president’s tax reform advisory panel, supra note 108, at 106. 155. see staff of joint comm., options, supra note 41, at 191. 156. this assumes that section 904(f)(5), which allows overall foreign losses to be deducted against u.s. source income, is repealed. 2012] exemption when the treasury is empty 443 the sale of property, separating the branch essentially transforms what would be a sale by the branch with an embedded intangible into a sale with a royalty back to the home office. cash transfers from the branch to corporate headquarters will have to be characterized as exempt distributions, taxable rents, royalties, or service fees.157 the effort to conform transfer pricing with a branch to that with a subsidiary is consistent with the oecd’s effort to achieve that result.158 what if usco forms a wholly owned u.s. subsidiary, ds, and then forms a partnership to operate the lowtaxia branch with usco having a 99 percent interest in the partnership and ds holding the other 1 percent?159 should a taxpayer be allowed to use this self-help to achieve pass-through treatment instead of foreign subsidiary treatment? the u.s. exemption system could be structured to deny its benefit to the u.s. partners’ share of foreign passive income and low-taxed foreign income and to prohibit overall foreign losses from being deducted against the u.s. partners’ domestic income.160 in addition, the existence of a partnership would require the identification of rents, royalties, or service fees, achieving part of the objective of the deemed cfc rule. moreover, in an exemption system, it will be necessary to apply section 367-type principles (including the section 367(d) rules for intangibles) with respect to transfers to a domestic or foreign partnership that has a foreign trade or business. if these protections are present, a taxpayer should be permitted to use “self-help” to cause a branch to be held by a partnership.161 the second approach to proper treatment of a foreign branch is to characterize it as a disregarded entity,162 but deny the u.s. exemption to the branch’s foreign-source passive and low-taxed income, and prohibit deduction of the branch’s overall foreign losses against usco’s u.s.-source 157. see gravelle, options and challenges, supra note 151, at 35–36. the bush tax reform advisory panel report noted that under its exemption proposal, royalty income would have to be imputed to foreign branches. president’s tax reform advisory panel, supra note 108, at 240. 158. see oecd, model tax convention on income and capital, art. 7, § 2 (2010). 159. see, e.g., gravelle, options and challenges, supra note 151, at 35. 160. the ways and means discussion draft delegates these issues to treasury to solve in regulations, ways & means technical explanation, supra note 60, at 22, but it seems to us that many of these questions need to be resolved by congress in the statute itself. 161. this approach possibly could be extended to a foreign legal entity that is treated as a disregarded entity under the u.s. check-the-box entity classification regulations, provided that the disregarded entity is treated in the same way described in the text above for a partnership. 162. see reg. § 301.7701-2(a). 444 florida tax review [vol. 13:8 income.163 this approach, however, would require that costs be allocated between usco’s headquarters and the branch, and that the branch’s share of the costs then be allocated between income qualifying for exemption and disqualified income. similar allocations have to be made under current u.s. law for foreign tax credit purposes.164 more importantly, there would usually be a treaty between the u.s. and the country where the branch was located and the branch would usually be a permanent establishment for treaty purposes.165 consequently, allocations between headquarters and the branch would typically be governed by established principles of treaty law.166 thus, the disregarded entity approach to structuring an exemption system may not be worse for taxpayers than current law regarding cost allocations but it certainly will not be simple. indeed, the disregarded entity approach would be better for taxpayers if they are allowed to make sales through the branch using a home office intangible without charging a royalty to the home office. embedding the intangible return in the cost of the product opens the door to avoiding u.s. tax on the return to the intangible held in the united states and is one reason we prefer the deemed cfc approach or the use of a regarded partnership. regardless of whether usco’s lowtaxia branch is regarded as a wholly owned foreign subsidiary or as a disregarded entity, the united states would have to decide whether its exemption system would treat asset transfers by usco to the branch as taxable events or as nonrecognition transfers. the current scope of taxable transfers should be expanded to take account of the fact that in an exemption system there is no second bite at the tax apple as there is in the deferral system of current law.167 these are complex technical issues that are beyond the scope of this article and that warrant substantial focus. 163. in general, this is the approach taken by the australian exemption regime. see ault & arnold, comparative taxation, supra note 50, at 468–69, 474; see also staff of joint comm., background and issues, supra note 48, at 16. 164. see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 691–93. 165. see u.s. model income tax convention of november 15, 2006, art. 5, § 2 [hereinafter u.s. model treaty]. 166. see u.s. model treaty, supra note 165, at art. 7; u.s. model technical explanation accompanying the united states model income tax convention of november 15, 2006, at 22–25 (2006). 167. there is a divergence of views regarding this issue. see, e.g., ault & arnold, comparative taxation, supra note 50, at 488–91; rosenbloom, from the bottom up, supra note 69, at 1552–53. addressing the outbound transfer issues goes hand-in-hand with developing revised transfer pricing rules adequate to handle the increased pressures that would result from shifting to an exemption system. 2012] exemption when the treasury is empty 445 in short, the case for including qualified foreign branch income in a u.s. exemption system seems compelling. the problems are solvable and the complexities are probably no worse than those that currently exist under the u.s. worldwide system with a limited foreign tax credit. but handling branches within an exemption system is clearly not easy, so one can understand japan’s decision to exclude foreign branches from its recently adopted exemption system.168 however, if that approach were taken by the united states, it would leave u.s. multinational corporations free to elect, to the detriment of the fisc, between (1) a controlled subsidiary that can pay exempt dividends, but not exempt royalties, interest, and services fees, and (2) a branch whose transfers to corporate headquarters are generally not subject to u.s. tax regardless of how they are characterized, but that lacks the separate legal personality required to participate in transfer pricing tax-minimization strategies. this would have the undesirable and economically inefficient effect of making tax planning, rather than business considerations and economics, the fundamental driver of the choice between a foreign controlled subsidiary and a foreign branch.169 on balance, it clearly seems better to include branches in a u.s. exemption system. viii. certain structural issues for international law purposes, the role of an exemption system is to prevent international double taxation of foreign-source income by reducing the residence country tax on that income to zero. nothing in this rationale suggests that the residence country should dip below zero by conferring a negative rate of tax and no normative principle supports negative taxation.170 stated differently, a principled exemption system stops at zero. 168. see generally lokken & kitamura, credit v. exemption, supra note 1, at 629. 169. see also staff of joint comm., background and issues, supra note 48, at 10. 170. a negative rate of tax arises when an inappropriate tax saving effectively causes the tax rate on a particular income item to fall below zero. for example, assume that individual a borrows $100 at 10 percent per annum interest to purchase a $100 tax-exempt municipal bond that pays 10 percent per annum interest. from a before-tax standpoint, this makes no sense because the 10 percent interest charge on the loan offsets the 10 percent interest received on the bond so that the bond investment produces an economic return of $0 even though the bond interest is tax exempt. if, however, a also earns salary income taxable at a marginal rate of 35 percent and the tax system allows her to deduct the loan interest expense against her salary, the deduction will save $3.50 in tax. since the loan was incurred to acquire the bond, not to earn salary, deduction of the loan interest expense against salary income is inappropriate. the interest expense should be deducted against the bond 446 florida tax review [vol. 13:8 the present u.s. international income tax regime goes beyond this zero limit by effectively conferring a negative u.s. tax rate in certain situations. below, we explain how those scenarios arise under current u.s. law and why congress should resist beneficiary pressure to make them part of a u.s. exemption system. a. export sales redux part vi.b.3 has explained how the export sales source rule causes the present u.s. international tax system to confer a zero tax on income that bears little or no foreign tax. that, however, is not the end of the rule’s mischief. the rule can also create a negative tax on export sales income within the present u.s. regime. example 2 illustrates this point. example 2 assume that usco, a u.s. multinational corporation, has a marginal effective u.s. income tax rate of 35 percent and a marginal effective tax rate of 45 percent on its active foreign business income earned in hightaxia, a foreign country. during the current year, usco has total worldwide pre-tax income of $1,000,000, $500,000 of which is u.s.-source income from transactions occurring entirely within the united states. usco earns $300,000 of pre-tax foreign-source business income in hightaxia and pays $135,000 of foreign income tax to that country. usco also produces inventory in the united states and sells the inventory to independent foreign distributors in otherland. title to the inventory passes from usco to the foreign distributors at the time that the distributors receive the inventory in otherland. usco has $200,000 of pre-tax income from these inventory sales during the current year. interest where it will produce no tax saving because the bond interest is tax exempt. for this reason, the inappropriate $3.50 tax saving produced by incorrectly deducting the loan expense from a’s salary income is commonly referred to as a $3.50 negative tax on the bond interest that increases the return on the bond from $0 to $3.50 per annum. (an alternative explanation is that the deduction reduces the aftertax cost of the $10 interest expense to $6.50 so that the $10 interest receipt produces $3.50 of net income.) because the $3.50 return is entirely a product of manipulating the tax system and does not involve any real economic gain, congress concluded that the result in the foregoing example was unacceptable and blocked it by enacting the disallowance provisions of section 265. this provision prevents interest on a loan incurred to finance a tax-exempt bond investment from being deducted against taxable income. 2012] exemption when the treasury is empty 447 none of that income is taxed by otherland because usco has no office or fixed place of business there. under the current u.s. export sales source rule, usco may treat onehalf (i.e., $100,000) of this inventory sales income as foreign-source income even though it is not subject to tax in any foreign country and, in terms of economic connection, should be characterized as entirely u.s.-source income. thus, usco has total pre-tax foreign-source income of $400,000, consisting of $300,000 earned in hightaxia and $100,000 artificially created by the export sales source rule with respect to transactions with otherland distributors. under current u.s. law, this latter $100,000 of foreignsource income falls within the general category income limitation basket, where the high foreign taxes on usco’s active foreign business income in hightaxia can be cross credited against the zero-foreign-taxed $100,000 of export sales income. usco’s foreign tax credit limitation for the general category income limitation basket is $140,000 (i.e., $400,000/$1,000,000 × $350,000 = $140,000), so all $135,000 of the foreign taxes paid by usco can be credited in the current year. in effect, usco’s total “real” foreignsource income for the current year of $300,000 (excluding the $100,000 of export sales income that is improperly treated as foreign-source income under current law) effectively bears a negative u.s. tax. this is because the u.s. credit for the $135,000 of tax paid to hightaxia eliminates the entire $105,000 of u.s. tax on the $300,000 of properly characterized foreign-source income ($300,000 × .35 = $105,000) and also reduces the 35 percent u.s. tax on the $100,000 of artificially characterized foreign-source income from $35,000 to $5,000. thus, $30,000 of u.s. tax is saved with respect to $100,000 of income that is, in substance, u.s.-source income that should not produce a foreign tax credit. this inappropriate saving amounts to a 10 percent negative tax on the $300,000 of “real” foreignsource income (i.e., $30,000 / $300,000 = .10). this negative tax result exceeds the double tax relief purpose of an exemption system. nevertheless, it seems likely that the benefit of a negative tax will be even harder to surrender than the benefit of a zero tax. consequently, taxpayers presently enjoying the effects of the export sales source rule in the u.s. system can be expected to press for inclusion of the rule, and its negative tax consequence, in a u.s. exemption system. as explained earlier, however, nothing in international law requires an 448 florida tax review [vol. 13:8 exemption system to go below zero and no equitable norm requires a subzero result. thus, a negative tax rate in a u.s. exemption system would be a tax expenditure that should be subjected to rigorous cost/benefit analysis. b. misallocated expenses a general principle of the u.s. income tax is that expenses allocable to exempt income should not be allowed as income tax deductions171 unless congress deliberately chooses to increase the exempt activity’s tax advantage by reducing the effective u.s. tax rate below zero.172 nevertheless, the current u.s. international income tax system allows certain deductions that effectively create a negative u.s. tax even though there is no evidence that congress intended to confer such a benefit. example 3 illustrates this phenomenon. example 3 usco, a u.s. multinational corporation is taxed on its u.s.-source income at 35 percent. usco owns all the stock of subco, a lowtaxia corporation actively engaged in manufacturing operations. lowtaxia is a tax haven that has no income tax and no withholding tax on dividends. under current u.s. income tax law, u.s. tax on subco’s lowtaxia income is deferred until that income is distributed to usco as dividends.173 usco incurs $100,000 of expense at its u.s. headquarters solely for its own benefit to monitor subco’s management and operations. because the united states defers the u.s. tax on subco’s income until subco pays dividends to usco, usco should be required to defer a u.s. deduction for the $100,000 expense until subco pays the related income to usco. nevertheless, under current law, usco is allowed to deduct the $100,000 expense at the time it is incurred.174 failure to defer the deduction means that during the period that subco holds the related income offshore, usco effectively enjoys an interest-free loan from the u.s. government equal to the $35,000 u.s. tax saving 171. see, e.g., i.r.c. § 265. 172. see supra note 170. 173. see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 24–26, 485–86. the exceptions to this rule do not apply to manufacturing income. 174. see generally reg. § 1.861-8(g) ex. 18; priv. ltr. rul. 88-06-002 (sept. 24, 1987); priv. ltr. rul. 79-28-006 (mar. 29, 1979). 2012] exemption when the treasury is empty 449 produced by immediate deduction of the $100,000 expense.175 the value of this $35,000 interest-free loan is effectively a negative u.s. tax on the subco income. this negative tax is a subsidy that distorts taxpayer choice between domestic and foreign investment because the subsidy is available only with respect to foreign investments. the benefit to usco would be even more dramatic if the united states were operating an exemption system. in that case, the subco income would never be taxed by the united states and usco would enjoy a $35,000 benefit forever; not just the benefit of a $35,000 interest-free loan during the period that u.s. tax on subco’s income is deferred. in other words, an exemption system allowing usco to deduct $100,000 of administrative expense against its u.s.-source income, even though the expense is economically allocable to subco’s exempt income, would produce a permanent, but inappropriate, $35,000 net tax saving to usco that would effectively be a negative u.s. tax on the subco income. for reasons previously given, neither the double tax relief rationale of an exemption system nor equitable considerations require that an exemption system provide the negative tax benefit that results from allowing a deduction against taxable income for a parent corporation’s headquarters expenses that are related to exempt foreign income earned by a foreign subsidiary. nevertheless, taxpayers that enjoy approximately that benefit under the present u.s. system, as illustrated in example 3, will surely push for a u.s. exemption system that allows such expenses to be deducted against taxable u.s. income. in doing so, they will likely point out that several major commercial nations allow their resident corporations to deduct costs that support the earning of exempt or deferred foreign-source income if the costs are incurred within the residence country.176 therefore, u.s. 175. when dividends are ultimately paid to usco, the $100,000 expense deduction will not be allowed against those dividends because it was already claimed in an earlier year. thus, usco will have $100,000 more income at the time of the dividend distribution than if the expense deduction had been delayed. this will give the u.s. treasury $35,000 more tax on the dividends than otherwise and will amount to a “recapture” of usco’s earlier $35,000 tax saving, but the treasury will not collect any interest on the $35,000 because this tax was not due until usco received the extra $100,000 of dividends. consequently, the $35,000 tax saving in the earlier year that is recovered without interest in the later year is equivalent to a $35,000 interest-free loan from the treasury to usco. 176. see james r. hines, jr., foreign income and domestic deductions, 61 nat’l tax j. 461, 463 (2008); samuels, american tax isolationism, supra note 24, at 1594–95; t. timothy tuerff, manal corwin, paul oosterhuis, john m. samuels & david walker, keynote panel session 1: tax reform—in search of a 21st century u.s. tax system, 88 taxes 19, 22 (june 2010); group comments, supra note 116; 450 florida tax review [vol. 13:8 taxpayers will argue that u.s. resident corporations should not be barred from deducting such costs against their u.s.-source income because to do so would make them less competitive in foreign markets.177 this is, of course, nothing more than a reiteration of the competitiveness argument that fails for the reasons discussed below in part ix. a closely related argument is that if the costs incurred in the united states are allocated to exempt foreign-source income and made deductible only against that income, it is highly likely that the relevant foreign countries will reject the u.s. position and will not allow the allocated expenses to be deducted for purposes of computing source-country tax on the foreign-source income. if so, there will be no current deduction in either the united states or the foreign country for the affected costs in spite of the fact that the costs have actually been incurred.178 in other words, u.s. opponents of cost allocation implicitly insist that tax competition will not force foreign countries to respect the u.s. allocation and that the inability of u.s. multinationals to deduct the allocated costs in the respective foreign countries will render these multinationals less competitive in foreign markets.179 we are not convinced that all source countries are so resistant to tax competition, but even if they are, this line of argument is nothing more than a tailored version of the competitiveness rationale that is examined in part ix and found wanting. finally, even if u.s. multinational corporations are made less competitive by a u.s. exemption system that bars deducting costs against taxable u.s.-source income when the costs are economically connected to exempt foreign-source income, example 3 indicates that allowing a u.s. see also staff of joint comm., background and issues, supra note 48, at 9 (“most jurisdictions with territorial systems permit deductions for resident companies’ expenses for generating exempt foreign income.”). 177. see u.s. treas. dep’t, approaches, supra note 40, at 61–62; michael j. mcintyre, a program for international tax reform, 122 tax notes 1021 (feb. 23, 2009); samuels, american tax isolationism, supra note 24, at 1594– 95; see also advisory panel on canada’s system of international taxation, final report: enhancing canada’s international tax advantage 53 (2008) http://www.apcsit-gcrcfi.ca/07/cp-dc/pdf/finalreport_ eng.dpf (making the competitiveness argument to justify allowing deductions against canadian domestic income for interest expenses that support foreign investment). but see martin a. sullivan, the effects of interest allocation rules in a territorial system, 136 tax notes 1098, 1102 (sept. 3, 2012) (arguing that allocating interest expense to exempt foreign-source income does not harm the international competitiveness of u.s. multinational corporations). 178. see graetz & oosterhuis, structuring an exemption system, supra note 50, at 782; martin a. sullivan, obama chooses a clumsy way to limit deferral, 123 tax notes 1163, 1164–65 (june 8, 2009). 179. see sources cited supra note 177. 2012] exemption when the treasury is empty 451 deduction for such costs is a tax expenditure subsidy that must undergo a rigorous cost/benefit analysis to see if it can compete with other important uses for u.s. federal revenue. this is particularly so in light of the current u.s. fiscal situation. one last issue merits discussion here. a number of countries employing exemption systems reduce the percentage of income qualifying for exemption by some stated percentage (e.g., 5 percent) as an alternative to disallowing a domestic corporation’s expenses relating to earning exempt dividend income from its foreign corporate holdings.180 thus, under those systems, no expense allocation or apportionment rules apply to disallow any portion of a domestic corporation’s expenses that may be properly allocable to the tax-exempt dividend income. this approach reduces complexity by eliminating the time-consuming and costly disputes that arise under the deduction allocation and apportionment rules. however, by using an arbitrary percentage in place of a fact-based allocation and apportionment deduction disallowance approach, this approach will result in the overtaxation of some dividend income paid by foreign corporations (to the extent that the domestic corporation’s expenses that would properly be allocable to the exempt dividend income and disallowed, expressed as a percentage of the dividend income paid by the foreign corporation, are less than the arbitrary percentage used in place of expense disallowance rules) and the undertaxation of other such dividend income (to the extent that the domestic corporation’s expenses that would properly be allocable to the exempt dividend income and disallowed, expressed as a percentage of the dividend income paid by the foreign corporation, are greater than the arbitrary percentage used in place of expense disallowance rules). for this reason, we believe that a properly designed exemption system should not use this approach; instead it should use properly constructed expense allocation and apportionment rules.181 alternatively, if this percentage haircut approach 180. this rule is sometimes referred to as an expense “haircut.” countries using some variation of this approach include france, germany, japan, and switzerland. see staff of joint comm., background and issues, supra note 48, at 23, 25, 28, 40. 181. the exemption proposals of both the bush tax reform commission and the staff of the joint committee on taxation would retain the allocation and apportionment rules to determine which deductions are properly allocable to exempt dividend income and, thus, are nondeductible. see president’s tax reform advisory panel, supra note 108, at 134; staff of joint comm., options, supra note 41, at 190; see also staff of joint comm., taxation of cross-border income, supra note 146, at 83–84. commentators graetz and oosterhuis also favored retaining allocation and apportionment rules for deductions in their exemption system proposal, although they argued that “stewardship expenses” should be narrowly defined in such a system because any such expenses allocable to exempt income would not be deductible in any jurisdiction — an inappropriate 452 florida tax review [vol. 13:8 is to be adopted in place of allocation and apportionment of deduction rules, we believe that it makes sense for the percentage haircut to vary by industry group so that industry groups with higher expenses allocable to tax-exempt foreign income on average would have a higher percentage haircut, and those with lower expenses allocable to such income on average would have a smaller percentage haircut. these percentages could be developed by treasury and irs studies as has been done to determine the class lives of assets for depreciation purposes. c. foreign losses since 1913, u.s. federal income tax law has provided that u.s. residents are generally taxable on both their u.s.-source and foreign-source income at the time it is earned. as mentioned earlier, a major exception to this general rule is the so-called “deferral principle” or “deferral privilege” under which u.s. residents are allowed to conduct profitable overseas business activities through a cfc without paying u.s. tax on the resulting income until the foreign corporation makes dividend distributions or the u.s. residents sell the cfc’s stock at a price that reflects its accumulated earnings. in the interim, payment of u.s. income tax on the foreign corporation’s earnings is deferred without incurring an interest charge.182 thus, because there is no interest charge, the effect of this deferral privilege is to shrink the u.s. tax on the foreign-source income. this shrinkage increases with the passage of time and causes the tax’s present value to approach zero if the period between the earning of the income and the dividend distribution (the deferral period) is sufficiently long.183 consequently, the effective u.s. tax rate on foreign-source income earned by a foreign corporation that pays a low foreign tax is less — often dramatically less — than the effective u.s. tax rate on income from u.s. operations, and this tax preference is a distortive incentive for u.s. residents to locate their business operations in low-tax foreign countries. because income from foreign operations is lightly taxed as a result of the deferral privilege, losses from foreign operations ought not to be deductible against more heavily taxed u.s.-source income. to allow the deduction would boost the deferral result, in their opinion, for expenses incurred to earn business income. see graetz & oosterhuis, structuring an exemption system, supra note 50, at 781–82. we take a different view. see supra text accompanying notes 178–80. 182. see gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 24–26, 485–86. the exceptions to this rule are readily avoidable. see, e.g., peroni, fleming & shay, getting serious, supra note 3, at 459–64. this discussion and example 4 assume that the necessary avoidance criteria are satisfied. 183. see fleming, peroni & shay, worse than exemption, supra note 4, at 96–104. 2012] exemption when the treasury is empty 453 privilege’s bias towards establishing business and investment activities in low-tax foreign countries. this point is illustrated by the following example: example 4 assume that usco, a u.s. multinational corporation that pays u.s. federal income tax at a marginal effective tax rate of 35 percent, is deciding between building a factory in the united states or in lowtaxia, a tax haven that has no business profits tax, no withholding tax, and no branch profits tax. also, assume that the effective rate of u.s. federal income tax on the profits of a lowtaxia factory operated through subco, usco’s lowtaxia cfc, will be only 5 percent because subco will not pay dividends for many years, and, under current federal income tax law, there will be no u.s. tax on subco’s profits until dividend payments are made or usco sells subco stock. (the lowtaxia tax rate will, of course, be zero.) clearly, the u.s. system biases usco in favor of locating the new facility in lowtaxia. now assume that usco expects the new factory to produce losses during a multi-year start-up period regardless of where it is located. if usco builds the factory in lowtaxia, operates the factory as an unincorporated branch during the start-up period, and is allowed to deduct the initial losses against u.s.-source income, thirty-five cents of u.s. tax saving on u.s.-source income will result from each dollar of branch loss even though the lowtaxia branch generates no u.s.-source income. this outcome is effectively a negative u.s. tax on the lowtaxia branch during the start-up years that will magnify the incentive for usco to locate the new factory in lowtaxia initially as a branch operation184 that will later be transferred to subco to gain the benefit of deferral when the factory becomes profitable. congress responded to this problem by providing that a taxpayer can deduct foreign-source branch losses against u.s.-source income only to the extent that the losses exceed the taxpayer’s positive foreign-source income, if any, from other operations.185 if, however, a taxpayer has an overall foreign 184. see generally staff of joint comm., analysis of alternative policies, supra note 50, at 60. 185. see i.r.c. § 904(f)(5); gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 679–80. 454 florida tax review [vol. 13:8 source loss, the overall loss is deductible against u.s.-source income, thus producing the incentive enhancement illustrated in example 4.186 this is highly significant. under the u.s. income tax regime, deductible losses of a foreign branch are immediately taken into account on the owner’s u.s. income tax return whereas profits earned by a cfc are generally not subject to u.s. tax until paid out as dividends or until a stock sale occurs. thus, overall foreign-source branch losses are quite likely to occur because the preceding factors will cause u.s. taxpayers to (1) bunch loss activities in foreign branches, so the losses will be immediately available to the u.s. owner and (2) move the activities to cfcs when they become profitable in order to defer u.s. tax on the foreign-source income. the u.s. tax system weakly addresses this strategy with the socalled “branch loss recapture rules,” which require that a foreign branch’s prior losses must be added to the u.s. owner’s income when the branch’s assets are transferred to a cfc.187 however, because the resulting tax increase occurs in a year subsequent to the years when tax savings were realized from the branch loss deductions, the time value of money concept188 establishes that the strategy of operating through a foreign branch during the start-up loss period and then switching to a cfc operation when profits begin to flow remains an attractive move and an additional incentive to locate business operations in low-tax foreign countries. the relationship of the preceding discussion to a possible u.s. exemption system lies in the fact that as a general rule, only domestic business losses are deductible under an exemption system. this is because the tax base is limited to net domestic business income and foreign losses are 186. see bittker & lokken, taxation of income, estates, and gifts, supra note 127, at 71–27 to 71–29. granted, the overall foreign-source loss is “recaptured” by recharacterizing an appropriate amount of foreign-source income as u.s.-source income in later years for foreign tax credit limitation purposes, see i.r.c. § 904(f)(1), but because of the time value of money, this recharacterization does not eliminate the advantage of deducting an overall foreign loss against u.s.source income. 187. see i.r.c. § 367(a)(3)(c); reg. § 1.367(a)-6t; bittker & lokken, taxation of income, estates, and gifts, supra note 127, at 71–27 to 71–29; gustafson, peroni & pugh, taxation of international transactions, supra note 10, at 855–59; isenbergh, international taxation, supra note 64, at ¶ 92.10; kuntz & peroni, u.s. international taxation, supra note 94, at ¶ b2.04[4][g][ix]; see also fleming, peroni & shay, worse than exemption, supra note 4, at 148. 188. see generally joseph m. dodge, j. clifton fleming, jr. & robert j. peroni, federal income tax: doctrine, structure, and policy 145–47 (4th ed. 2012). 2012] exemption when the treasury is empty 455 irrelevant in calculating that amount.189 allowing a deduction for foreign losses against domestic income would magnify the exemption system’s distortive effect on the decision whether to locate business operations in the taxpayer’s residence country or in a low-tax foreign country. this point is illustrated by the following example: example 5 forco is a corporation resident in foreignlandia, an exemption system country that uses the foreignlandia dollar as its currency. forco is debating whether to build a new manufacturing facility in foreignlandia or in lowtaxia, which has no business profits tax, no withholding tax, and no branch profits tax. foreignlandia imposes a tax on domestic corporate profits at an effective rate of 30 percent. when forco considers the positive prospects of its new facility — i.e., potential profits — it will conclude that foreignlandia’s exemption system encourages location of the facility in lowtaxia to shelter those profits from the 30 percent foreignlandia tax. when forco then considers the risks — loss years in the start-up phase — forco will recognize that if foreignlandia allows lowtaxia losses to be deducted from forco’s foreignlandia income, each dollar of lowtaxia loss will save thirty cents of tax on foreignlandia domestic income even though the foreignlandia income is not generated by the lowtaxia operation. thus, these tax savings would amount to a negative foreignlandia tax on the lowtaxia operation during loss years and will enhance the exemption system’s bias in favor of forco building the new facility in lowtaxia. consequently, exemption systems typically prohibit the deduction of foreign losses. but to repeat a familiar point, it is painful for the beneficiaries of negative taxes to let them go. thus, if the united states adopts an exemption system, the beneficiaries of the negative taxes produced by the current u.s. federal income tax treatment of overall foreign losses illustrated in example 4 can be expected to argue that the united states should depart from the international consensus and allow losses from exempt foreign activities to be deducted against u.s.-source income. this argument should be rejected because it has no basis in international law and, for the reasons 189. see ault & arnold, comparative taxation, supra note 50, at 476–77. 456 florida tax review [vol. 13:8 given above, would magnify the distortive effects of a u.s. exemption system. ix. competitiveness vs. revenue in earlier parts of this article we have explained that a properly designed u.s. exemption system will fully satisfy the international law obligation of the united states to relieve double taxation and that if an exemption system goes beyond double taxation relief, it is, to that extent, a subsidy regime that effectively spends u.s. revenue for a limited set of beneficiaries at a time when there is not nearly enough money in the treasury to fund pressing public needs. however, many of the proponents for replacing the current u.s. international income tax regime with a territorial system have not been significantly concerned with the nature and extent of the u.s. international law obligation to ameliorate double taxation. instead, the advocacy in favor of territoriality has centered on securing a competitiveness subsidy190 through the tax system for the foreign activities of u.s. multinational corporations.191 in an earlier work, we argued that this competiveness plea has numerous flaws.192 first, it misdefines competitiveness as improvement in the after-tax profitability of already successful u.s. multinational corporations instead of more broadly as improvement in the living standard of americans.193 and even if competitiveness was defined in terms of the 190. see, e.g., staff of joint comm., impact of international tax reform, supra note 17, at 5; r. glenn hubbard, tax policy and international competitiveness, 82 taxes 213 (mar. 2004); olson, merrill, mundaca, reilly & spellings, new ground, supra note 23, at 60, 64–66; phillip r. west, across the great divide: a centrist tax reform proposal, 130 tax notes 1025, 1040 (feb. 28, 2011). for a commentator who supports adoption of an exemption system on the grounds that it would increase worldwide economic efficiency, rather than competitiveness grounds, see chorvat, ending foreign business tax, supra note 102. 191. for an explanation of the subsidy effect of an exemption system, see fleming, peroni & shay, worldwide v. territorial, supra note 21, at 1091. as professor kleinbard has observed, the competitiveness argument in favor of territoriality “is indistinguishable from a call for export subsidies, on the grounds that other countries offer export subsidies.” kleinbard, lessons, supra note 3, at 129. 192. see fleming, peroni & shay, worldwide v. territorial, supra note 21, at 1085–86. 193. the world economic forum defines competitiveness as “the set of institutions, policies, and factors that determine the level of productivity of a country.” world economic forum, the global competitiveness report: 2012-2013, at 4 (klaus schwab ed., 2012), http://reports.weforum.org/globalcompetitiveness-report-2012-2013/. the world economic forum’s report focuses on various factors in defining competitiveness, including institutions, infrastructure, 2012] exemption when the treasury is empty 457 financial interests of u.s. multinational corporations, the need for that kind of competitiveness subsidy has never been convincingly established. isolated anecdotes of u.s. corporations responding predictably to tax-reduction opportunities have been brought forward194 but there has never been a systematic demonstration that a comprehensive subsidy, such as a broadly applicable territorial regime, is required to make the general population of u.s. multinational corporations competitive in foreign markets. indeed, a recent study by a leading public finance economist has concluded that “[t]he importance of low tax burdens on foreign income for u.s. worldwide ‘competitiveness’ does not seem to have much empirical support.”195 the same study finds an absence of strong empirical support for the contention that low u.s. tax burdens on the foreign income of u.s. multinational corporations increases u.s. domestic investment.196 more generally, the competitiveness argument conflicts with orthodox economic theory as explained by another prominent public finance economist: [t]he argument that because most other countries do not tax their foreign subsidiaries, the united states also should not do so in order to allow its firms to compete abroad does not stand up to economic analysis. a country does not compete in the manner that a firm does, because its resources (labor and savings provided by its citizens) do not disappear if another firm undercuts prices; they are simply used in a different way. that is, a country does not compete with the rest of the world, it trades with them, both its products and its capital. it can generally be shown that the united states would still be better off, or at least no worse macroeconomic environment, health and primary education, higher education and training, goods and labor markets efficiency, innovation, and market size. using this approach to measuring competitiveness, the united states was ranked first overall in the world economic forum’s global competitiveness report in 2007-2008 and 2008-2009, second overall in 2009-2010, fourth overall in 2010-2011, fifth overall in 2011-2012, and seventh overall in 2012-2013. id. at 359 (for u.s. rankings after the 2010-2011 report); world economic forum, the global competitiveness report: 2009-2010, at 320 (klaus schwab ed., 2009) (for u.s. rankings prior to the 2010-2011 report); see also staff of joint comm., taxation of cross-border income, supra note 146, at 88. 194. see, e.g., bret wells, what corporate inversions teach about international tax reform, 127 tax notes 1345 (june 21, 2010). 195. harry grubert, foreign taxes and the growing share of u.s. multinational company income abroad: profits, not sales, are being globalized, 65 nat’l tax j. 247, 268 (2012) [hereinafter grubert, foreign taxes]. 196. id. at 257. 458 florida tax review [vol. 13:8 off, if it taxes foreign and domestic investments by its firms at the same rate, even if other countries do not.197 finally, even if there was a convincing demonstration that u.s. multinational corporations needed a publicly funded subsidy, this need should be required to undergo a cost/benefit analysis in which it competes against other salutary uses for the currently inadequate u.s. revenue stream. this has never happened. x. conclusion the thrust of this article has been to argue that if the united states decides to replace its current crippled international income tax regime with an exemption or territorial system, then the policy discussion needs to be fundamentally reframed. to be specific, in preceding portions of this article we have pointed out that the united states is in a serious revenue bind and that replacing the badly flawed u.s. international income tax system with an exemption or territorial system would likely gain much-needed revenue for the treasury if the replacement system were properly structured. we have also identified the following design characteristics that the replacement system must have in order to fulfill its revenue potential: 1. a robust subject-to-tax requirement and continued current taxation of passive and mobile income under an updated subpart f regime; 2. disqualification from exemption for royalties, interest, services payments, and other foreign-source items that do not bear a significant foreign tax; 3. elimination of the current tax exemption for 50 percent of the income from u.s. export sales; 4. allocation of domestic expenses to foreignsource exempt income in a more realistic way than an inadequate 5 percent “haircut;” and 5. a prohibition against deducting foreign losses from u.s.-source income. as we have explained in earlier parts of this article, a territorial system that lacks these features would exceed the international law obligation of the united states to alleviate international double taxation suffered by u.s. residents, and to that extent the united states would simply 197. gravelle, options and challenges, supra note 151, at 17; see also eric toder, international competitiveness: who competes against whom and for what?, 65 tax l. rev. 505, 507–08, 532–34 (2012). 2012] exemption when the treasury is empty 459 be engaging in the transfer of scarce revenue to the u.s. multinational community. the response of territoriality advocates is that providing relief from double taxation is only an incidental consideration with respect to adoption of a u.s. exemption system, that the primary purpose of such a system is to deliver a competitive assistance subsidy to u.s. multinationals, and that design features that would raise revenue are ipso facto objectionable because they would curtail the competitiveness subsidy effect of a u.s. exemption system.198 this response is supplemented by the argument that even if an exemption system lacking these five critical design features would exceed the requirements of international law, represent bad tax policy, and lose badly needed revenue, the united states must, nevertheless, take that path because other commercially important countries have done so. thus, the united states must mimic those countries and engage in a race to the bottom so that its multinationals can compete on a level playing field.199 this narrower use of the competitiveness argument has the same flaws as its application to the more general question of whether a territorial system should be adopted as a replacement for the current u.s. international taxation regime. but even if one were to credit the competitiveness argument in this more limited context, it must be recognized that the game has changed. the united states is in a revenue crisis, and a correctly designed territorial system would have the twin virtues of helping to ease that crisis while ensuring that the united states satisfies its international law obligation. by contrast, a u.s. territorial system that lacks the five critical design features described in this article would amount to a tax expenditure that diverts scarce revenue to the benefit of a narrow subset of u.s. taxpayers.200 198. see, e.g., barbara angus, tom neubig, eric solomon & mark weinberger, the u.s. international tax system at a crossroads, 127 tax notes 45, 59 (apr. 5, 2010) (generally objecting to a subject-to-tax requirement); olson, merrill, mundaca, reilly & spellings, new ground, supra note 23, at 65 (same and also generally objecting to a territorial regime that raises revenue); see also martin a. sullivan, let’s promote the competitiveness of all american businesses, 133 tax notes 1175, 1179 (dec. 5, 2011) [hereinafter sullivan, promote competitiveness of all] (“u.s. multinationals are not interested in territorial systems . . . [that effect] an overall tax increase. nor do u.s. multinationals want a territorial system that is revenue neutral relative to current law. they want a territorial system that reduces their taxes.”). 199. but see gravelle, options and challenges, supra note 151, at 17 (“[m]oving to a territorial system because other countries have generally done so does not mean such a system is desirable either for them or for the united states.”). 200. this point is roughly illustrated by the fact that approximately 2,040,000 c corporation returns were filed for 2004. see staff of joint comm. on tax’n, jcx-66-12, selected issues relating to choice of business entity 5 (2012). however, about 80 percent of the foreign income earned that year by u.s. multinational corporations was earned by fewer than 900 corporations. grubert, 460 florida tax review [vol. 13:8 in the best of times, that kind of tax expenditure should be required to undergo a rigorous cost/benefit analysis and be ranked against other meritorious revenue uses. in the currently difficult times from a u.s. revenue standpoint, those requirements merit extra attention. foreign taxes, supra note 195, at 251; see also sullivan, promote competitiveness of all, supra note 198, at 1175, 1178–79 (noting that tax system features that promote the competitiveness of u.s. multinationals harm u.s. businesses that focus on the domestic market and/or on exporting from the united states). tcharity really does begin at home: florida tax review volume 12 2012 number 8 629 an empirical study of innocent spouse relief: do courts implement congress’s legislative intent? by stephanie hunter mcmahon∗ abstract under existing law spouses are jointly and severally liable for taxes assessed with respect to their joint income tax returns. as a result, the irs may pursue either spouse for any taxes owed on those returns. because congress was concerned that the irs was seeking taxes from the “wrong” spouse under the joint and several liability regime, it expanded relief for “innocent” spouses in 1998. many critics of this relief complain that, as it is applied, the statute offers too little relief to spouses, generally wives, who sign returns while being deceived or compelled by their mates. however, there has been no empirical study of whether the current relief is, in fact, what congress intended. this article fills the void by first evaluating the provision’s legislative history to determine what relief congress intended to provide when it acted in 1998. the article then examines the 444 cases appealing for relief under this provision in order to evaluate whether judges are deciding cases invoking the provision consistent with that congressional objective. this article’s empirical study of the success and failure of the innocent spouse provision from congress’s perspective concludes that the courts are generally applying innocent spouse relief as congress intended. i. introduction ............................................................................. 630 ii. the law in development ....................................................... 635 a. background ............................................................................ 636 b. congressional action ............................................................. 639 iii. the law in play ....................................................................... 645 ∗ associate professor, university of cincinnati college of law. the author would like to acknowledge the comments on previous drafts of this article from the 2011 law and society conference, the 2011 critical tax conference, the 2011 junior tax conference, and the university of cincinnati faculty workshop, in particular chris bryant, paul caron, kristin kalsem, francine lippman, susie morse, and michael solimine, as well as comments from dorothy brown, margaret drew, and carl smith and for the financial support of the harold c. schott foundation. 630 florid tax review [vol.12:8 a. mechanics of the study ............................................................ 647 1. choice of courts ........................................................ 648 2. breakdown of provisions ............................................ 654 3. summary .................................................................... 660 b. characteristics of requesting spouse .................................... 661 1. sex ............................................................................. 661 2. marital status ............................................................ 663 3. other characteristics ................................................ 665 4. summary .................................................................... 668 c. nature of the tax burden ....................................................... 669 1. unfair burden ............................................................ 669 a. source of liability ........................................ 669 b. knowledge of liability ................................. 673 c. benefit from liability .................................... 679 2. crushing burden ....................................................... 685 a. economic hardship ...................................... 685 b. not borne by others ..................................... 689 3. summary .................................................................... 692 d. characteristics of non-requesting spouse ............................ 693 1. abusive ...................................................................... 693 2. legally obligated under state law ........................... 698 3. intervening ................................................................. 702 4. summary .................................................................... 704 iv. conclusion ................................................................................ 705 part i. introduction when kathleen sullivan married joseph alioto in 1978, she probably thought her future was secure.1 she was the well-educated daughter of the owner of the new england patriots and he was a prominent antitrust attorney who had spent eight years as mayor of san francisco.2 the couple “enjoyed a loving, supportive, and harmonious marital relationship, and mayor alioto believed it was his absolute duty to care and provide for his family.”3 however, after joseph’s death in 1998 that duty was shown to have gone unmet. although when they married kathleen knew that joseph was fighting the internal revenue service (irs), little did kathleen know when they filed their joint tax returns each year that joseph was not paying their federal 1. alioto v. commissioner, 96 t.c.m. (cch) 63, 64, t.c.m. (ria) ¶ 2008185 at 986. 2. id., 96 t.c.m. (cch) n.3, 65 n.7, t.c.m. (ria) ¶ 2008-185 at 985–87. 3. id., 96 t.c.m. (cch) 63, 64, t.c.m. (ria) ¶ 2008-185 at 986. 2012] empirical study of innocent spouse relief 631 taxes.4 only when handling joseph’s estate did kathleen learn of their total tax liability.5 by that time, she had been a homemaker to the wealthy attorney and politician for twenty years. for the next decade kathleen fought this tax liability that, by the time of her final resolution, totaled $1,985,511.6 the irs argued that kathleen was liable for this tax because she had signed the couple’s joint returns. the internal revenue code provides that every time a married couple signs a joint return, each spouse becomes jointly and severally liable for paying tax on the income that is reported, or failed to be reported, on that return.7 this means that if a couple chooses to file jointly, the irs can collect from either spouse the taxes due. spouses remain jointly and severally liable even after they divorce or one spouse dies. congress has created several exceptions to this joint and several liability, and it was an exception in section 6015 of the code that ultimately provided kathleen relief.8 as discussed in part ii of this article, congress intended this relief for wives who were unfairly left oppressive tax burdens by their divorced or deceased husbands. primary responsibility for granting or denying this “innocent spouse” relief was given to the irs, but the judiciary was given oversight over administrative denials.9 kathleen twice appealed to courts before she finally won.10 4. id. at the time of their marriage joseph was fighting the irs over charitable deductions. alioto v. commissioner, 40 t.c.m. (cch) 1147, t.c.m. (ph) ¶ 80,360. the couple also had “protracted negotiations” regarding their 1978 return. alioto v. commissioner, 67 t.c.m. (cch) 2133, t.c.m. (ria) ¶ 1994-051 at 94–235. the irs satisfied the couple’s 1993 and 1994 liabilities from joseph’s estate. kathleen had previously been granted innocent spouse relief for 1989, 1990, and 1991 pursuant to a stipulated decision in docket no. 3013-95. alioto, 96 t.c.m. (cch) 63, 66, t.c.m. (ria) ¶ 2008-185 at 990. 5. in dec. 1996, the government seized over $2 million in community property to satisfy prior tax obligations but kathleen still thought the family’s net worth was over $16 million. alioto, 96 t.c.m. (cch) 63, 65, t.c.m. (ria) ¶ 208185 at 987. 6. id., 96 t.c.m. (cch) 63, 64, t.c.m. (ria) ¶ 2008-185 at 986. 7. i.r.c. § 6013(d)(3). 8. i.r.c. § 6015; alioto, 96 t.c.m. (cch) 63, 71, t.c.m. (ria) ¶ 2008185 at 997. 9. i.r.c. § 6015(e). the irs created factors to consider when applying the provision, and courts often incorporate these factors in their opinions. rev. proc. 2003-61, 2003-2 c.b. at 296, superseding rev. proc. 2000-15, 2000-1 c.b. 447. the irs has recently updated the factors it will consider when applying section 6015(f). notice 2012-8, 2012-4 i.r.b. 309. this change does not affect the findings of the study, although the revised factors should cause the irs not to contest relief under fact patterns in which they would have contested relief under revenue procedure 2003-61.carl smith argues that courts should not rely on the treasury department’s factors. carlton m. smith, innocent spouse: let’s bury that “inequitable” revenue procedure, 131 tax notes 1165 (2011) [hereinafter smith, “inequitable” revenue 632 florid tax review [vol.12:8 that kathleen was widowed and left with a staggering tax bill that her husband’s estate could not satisfy worked in favor of her claim for relief. moreover, the court concluded, “during the years in issue mrs. alioto reasonably believed that mayor alioto was a man of wealth, a man who was on top of everything, and a man in control.”11 because she reasonably expected joseph to pay the taxes, the court placed all of the blame for the unpaid tax on her husband. congress last liberalized the innocent spouse rules granting kathleen relief in 1998.12 that year, 95 percent of married couples filed jointly, approximately 49 million couples of whom 1.25 million were assessed additional taxes.13 for some of those 1.25 million couples, the system is thought to have failed because the liability for taxes owed was imposed on the “wrong” spouse.14 this can happen for many reasons: the “right” spouse is hard to locate, no longer has money to pay the tax, or has funds that are harder to collect. in 1998, the senate’s sponsor of section 6015 estimated that 50,000 women were held jointly and severally liable for their husbands, and the governor’s accounting office estimated that 35,000 spouses were held liable who had separated or divorced from the person with whom they had filed.15 it was to help these spouses that congress first enacted, and then liberalized, innocent spouse relief.16 since 1998, section 6015 contains three means to relief: a limited equitable relief for those meeting statutory requirements; an allocation of liability for divorced, widowed, or separated spouses; and a general equitable relief to be granted by the secretary of the treasury. a review of cases invoking this innocent spouse relief provision contributes to existing scholarship in two significant ways. first, it provides an empirical study of one of the ten issues most litigated by the irs. this is valuable not only because of the issue itself but, more generally, empirical procedure]. the issue should not be whether the courts use the factors but how they do so. to the extent courts give substance to the factors, they develop the law for the irs to apply. 10. alioto, 96 t.c.m. (cch) 63, 64, t.c.m. (ria) ¶ 2008-185 at 986. 11. id., 96 t.cm. (cch) 63, 70, t.c.m. (ria) ¶ 2008-185 at 995. 12. internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, § 3201(a), 112 stat. 685, 734-40 (1998). 13. treasury department, report to the congress on joint liability and innocent spouse issues (1998), 9 [hereinafter report on joint liability]. 14. id. at 21. 15. 144 cong. rec. 4474 (1998); u.s. general accounting office, gao/t-ggd-98-72, alternatives for improving innocent spouse relief [hereinafter gao, alternatives]. 16. see supra part ii. 2012] empirical study of innocent spouse relief 633 research in taxation remains an under-developed area, despite an increased focus on this type of research in recent years.17 unlike prior empirical research focused on statutory interpretation, judicial motivations, or taxpayer responses, this study furthers the scholarly agenda by examining whether, and to what extent, courts implement congressional intent as described in a statutory provision’s legislative history.18 this new focus offers a unique ability to examine the operations of, and the interaction between, the branches of the federal government. for this purpose, part ii draws congressional intent from the congressional record and committee reports. although there are risks with assuming these sources contain congress’s intent with respect to the innocent spouse provision, the consistency of views expressed therein suggests that there was a dominant vision of what this provision was 17. national taxpayer advocate, 2010 annual report to congress 414 (2011) [hereinafter nta, 2010 annual report]. see also michael j. bommarito ii et al., an empirical survey of the populations of u.s. tax court written decisions, 30 va. tax rev. 523 (2011) [hereinafter bommarito, empirical survey]; assaf likhovski, the duke and the lady: helvering v. gregory and the history of tax avoidance adjudication, 25 cardozo l. rev. 953, 971–72 (2004); daniel m. schneider, empirical research on judicial reasoning: statutory interpretation in federal tax cases, 31 n.m. l. rev. 325, 325 (2001); leandra lederman, which cases go to trial?: an empirical study of predictors of failure to settle, 49 case w. l. rev. 315 (1999); michael a. livingston, reinventing tax scholarship: lawyers, economists, and the role of the legal academy, 83 cornell l. rev. 365, 368 (1998); nancy staudt, empirical taxation, 13 wash. u. j.l. & pol’y 1, 2 n.8, lists all empirical tax articles from 1993 to 2002. 18. for normative support of the use of legislative intent, see thomas w. merrill, the common law powers of federal courts, 52 u. chi. l. rev. 1, 32–33 (1985); martin redish & theodore chung, democratic theory and the legislative process: mourning the death of originalism in statutory interpretation, 68 tul. l. rev. 803 (1994); daniel rodriguez & barry weingast, the positive political theory of legislative history: new perspectives on the 1964 civil rights act and its interpretation, 151 u. pa. l. rev. 1417 (2003). for a discussion of judges’ decisionmaking in tax cases, see bommarito, supra note 17; nancy staudt et al., judging statutes: interpretive regimes, 38 loy. l.a. l. rev. 1909, 1911 (2004); schneider, supra note 17; lederman, supra note 17; john coverdale, text as limit: a plea for a decent respect for the tax code, 71 tul. l. rev. 1501 (1997); michael a. livingston, practical reason, “purposivism” and the interpretation of tax statutes, 51 tax l. rev. 677 (1996); deborah geier, interpreting tax legislation, 2 fla. tax rev. 492 (1995) [hereinafter geier, interpreting]; michael a. livingston, congress, the courts, and the code: legislative history and the interpretation of tax statutes, 69 tex. l. rev. 819 (1991); lawrence zelenack, thinking about nonliteral interpretations of the internal revenue code, 64 n.c. l. rev. 623 (1986). 634 florid tax review [vol.12:8 intended to accomplish.19 the article then analyzes whether courts effectively use that intent to apply the facts and circumstances tests laid out in the statute. second, this article contributes specifically to the current public policy debate on innocent spouse relief, most of the debate being critical of joint and several liability.20 one critic concludes that joint and several liability is “generally inequitable on its face” and others contend that innocent spouse relief is a “failure” or has become a “guessing game,” and in the midst of this debate the treasury department liberalized its interpretation of one of the three section 6015 tests in january 2012.21 while some of what 19. see lawrence solan, private language, public laws, 93 geo. l.j. 427 (2007); daniel rodriguez & barry weingast, the paradox of expansionary statutory interpretation, 101 nw. u. l. rev. 1207 (2007); william buzbee, the one-congress fiction in statutory interpretation, 149 u. pa. l. rev. 171 (2000); kenneth shepsle, congress is a “they,” not an it, 12 int’l rev. l. & econ. 239 (1992). for a discussion of congressional intent in the tax area, see steven dean & lawrence solan, tax shelters and the code, 26 va. tax rev. 879, 903 (2007); deborah grier, interpreting, supra note 18, at 503–04; michael livingston, congress, courts and the code, 69 tex. l. rev. 819 (1991). 20. for articles in law reviews since the 1998 change see j. abraham gutting, note, the “price” is right: an overview of innocent spouse relief and the critical need for a uniform approach to interpreting knowledge requirement of internal revenue code § 6015, 2 charleston l. rev. 751 (2008); m. megan kerns, note, duress: a perplexing barrier to relief from joint and several liability, 58 hastings l. j. 1123 (2007) [hereinafter kerns, duress]; richard beck, failure of innocent spouse reform, 51 n.y.l. sch. l. rev. 928, 932 (2006) [hereinafter beck, failure]; adrianne hodgkins, comment, getting a second chance: the need for tax court jurisdiction over irs denials of relief under section 66, 65 la. l. rev. 1167 (2005); lily kahng, innocent spouses: a critique of the new tax laws governing joint and several tax liability, 49 vill. l. rev. 261 (2004); svetlana g. attestatova, note, the bonds of joint tax liability should not be stronger than marriage: congressional intent behind § 6015(c) separation of liability relief, 78 wash. l. rev. 831 (2003) [hereinafter attestatova, bonds of joint tax liability]; kari smoker, comment, irs restructuring and reform act of 1998: expanded relief for innocent spouses—at what cost? a feminist perspective, 60 ohio st. l. j. 2045 (1999); amy c. christian, joint and several liability and the joint return, 66 u. cin. l. rev. 535, 535 (1998) [hereinafter christian, joint and several liability]. in addition, one practitioner recently completed a how-to book for seeking innocent spouse relief. robert b. nadler, a practitioner’s guide to innocent spouse relief: proven strategies for winning section 6015 tax cases (2011) [hereinafter nadler, innocent spouse relief]. 21. christian, joint and several liability, supra note 20, at 536; beck, failure, supra note 20, at 931; steve johnson, should congress reform the 1998 reform act: the 1998 act and the resources link between tax compliance and tax simplification, 51 kan. l. rev. 1013, 1058 (2003). 2012] empirical study of innocent spouse relief 635 is written reviews a subset of the cases analyzed below, none makes a systematic evaluation of them. consequently, the authors’ normative assessments often assume an empirical result. part iii of this article provides empirical data for those engaged in this debate and an examination of whether courts are implementing the law as congress intended. a content analysis of the 444 cases on innocent spouse relief decided between july 22, 1998, the effective date of the latest round of legislative change, and april 15, 2011, requires an examination of these cases’ murky facts and circumstances. this analysis finds that, although there remains uncertainty as to how a particular case will be decided ex ante, courts are doing a relatively good job implementing congress’s intent. however, courts have not developed consistent interpretations of the factors the treasury department uses to define that intent. part iv concludes with reasons for these results; it does not make a normative evaluation of whether this relief is sufficient or whether courts should implement a statute in accordance with its legislative history. the normative evaluation will come in the second part of a two-part project. this first part examines whether the cases handed down since 1998 show that the regime is accomplishing its legislative purpose, and the second part will assess whether we should be satisfied with that result or whether we should prefer one of the proffered alternatives. thus, this article is an objective analysis of the law as it operates and judges the success and failure of the innocent spouse law from congress’s perspective. part ii. the law in development the internal revenue code requires anyone liable for federal income tax to file a federal tax return.22 married couples are allowed to calculate their liability by filing jointly.23 if couples choose to file jointly, both spouses are required to sign the joint return; however, failure to sign the joint return is not an absolute bar to its validity.24 spouses’ intent is the dispositive factor.25 couples may choose to file jointly for many reasons. joint filing generally offers favorable tax brackets (compared to filing as married filing separately), the ability to claim certain tax credits, administrative convenience, and other real or perceived advantages. 22. i.r.c. § 6011(a). 23. i.r.c. § 6013(a). if spouses do not file jointly, they are required to file as married persons filing separately. i.r.c. § 1(d). 24. reg. § 1.6013-1(a)(2). 25. see malkin v. united states, 3 f.supp. 2d 493 (d.n.j. 1998); crew v. commissioner, 44 t.c. memo. 1145 (1982); estate of campbell v. commissioner, 56 t.c. 1 (1971). 636 florid tax review [vol.12:8 a separate question from how married couples file their returns is how does the irs collect the liability due? each spouse is currently jointly and severally liable for the joint return.26 from the collection perspective, once a joint return is filed, the resulting taxes are not “his” or “her” taxes but “their” taxes, even if only one spouse earns the income reported on the return and even if only one spouse participates in the return’s preparation. a. background the treasury department has consistently supported joint and several liability, but only congressional action made this result certain. the treasury department explained its original imposition of joint and several liability in 1923 on the grounds that “a single joint return is one return of a taxable unit and not two returns of two units on one sheet of paper.”27 however, in the 1935 case of cole v. commissioner,28 the ninth circuit refused to accept the executive branch’s conclusion, arguing that the joint return did not cause spouses to lose their individual identities for tax purposes.29 the language of cole left open the possibility that congress could impose joint and several liability, and congress did so in 1938.30 the house concluded, “it is necessary, for administrative reasons, that any doubt as to the existence of such liability should be set at rest, if the privilege of filing such joint returns is continued.”31 after having watched years of litigation, congress gave the executive branch a reprieve from future litigation on the subject.32 in the first five decades of the income tax, the only means for overcoming joint and several liability was for a spouse to prove that he or she signed the return under duress.33 this defense is still available but 26. i.r.c. § 6013(d)(3); reg. § 1.6013-4(b). 27. t.d. 1882, 15 treas. dec. int. rev. 203 (1913). 28. cole v. commissioner, 81 f.2d 485 (9th cir. 1935). 29. id. 30. revenue act of 1938, pub. l. no. 75-554, § 51(b), 52 stat. 447, 476 (1938); h.r. rep. no. 75-1860, at 29–30, 48 (1938); h.r. conf. rep. no. 75-2330 (1938). 31. h.r. rep. no. 75-1860, at 30. 32. thereafter the court treated the joint return as creating a single unit liable for the collective taxes. taft v. helvering, 311 u.s. 195, 198 (1940); helvering v. janney, 311 u.s. 189, 192 (1940). 33. reg. § 1.6013-4(d). “duress” in section 6015(c)(3)(c) is interpreted as abuse and not legal duress, although that is not how senator bob graham, author of the provision, used the phrase in the congressional record. reg. §1.6015-3(c)(2)(v); 144 cong. rec. s4473 (1998). with a finding of duress, there is no joint return on which to impose joint and several liability. see gormeley v. commissioner, 98 2012] empirical study of innocent spouse relief 637 remains hard to prove because it is a subjective analysis.34 in addition, courts have held that the victim spouse must prove not just abuse but that the joint tax return was signed under duress.35 although duress does not have to be as extreme as receiving a threat of death immediately prior to signing a return, there must be a constraint of will so strong that it makes a person reasonably unable to resist a demand to sign. in the early 1970s, congress decided that the duress defense was insufficient after several cases were decided in which wives were held liable for taxes on funds their husbands had embezzled. these wives were almost always divorced. of the ten cases handed down between 1965 and 1971 in which the husband was an embezzler, seven of the couples were divorced and one wife was widowed.36 although these cases did not win significant attention in the popular press, their judges repeatedly called for congressional reform.37 in fact, the tax court once lamented, “although we have much sympathy for petitioner’s unhappy situation and are appalled at the harshness of this result in the instant case, the inflexible statute leaves no room for t.c.m. (cch) 420, 421, t.c.m. (ria) ¶ 2009-252 at 1859. raymond v. commissioner, 119 t.c. 191, 197 (2002). for those successfully claiming duress, spouses are treated as married filing separately, possibly losing credits and becoming subject to higher tax brackets, whereas those claiming innocent spouse relief may be relieved of all liability. m. meghan kerns, duress, supra note 20, at 1144. 34. see in re hickley, 256 b.r. 814, 825 (2000); malkin v. united states, 3 f.supp. 2d 493, 499 (d.n.j. 1998). 35. hickley, 256 b.r. at 828; wiksell v. commissioner, 67 t.c.m. (cch) 2360, 2368–69, t.c.m. (ria) ¶ 1994-099 at 94–486 – 87; see also stanley v. commissioner, 45 t.c. 555, 562 (1966) (“proof that a starving man was ordered at gunpoint to eat a piece of bread would not, standing alone, be satisfactory proof that it had been eaten involuntarily.”). 36. wissing v. commissioner, 54 t.c. 1428, 1428 (1970); abrams v. commissioner, 53 t.c. 230, 231 (1969); huelsman v. commissioner, 416 f.2d 477, 478 (6th cir. 1969); sharwell v. commissioner 419 f.2d 1057, 1058 (6th cir. 1969); scudder v. commissioner, 48 t.c. 36, 38 (1967); davenport v. commissioner, 48 t.c. 921, 922 (1967); wenker v. commissioner, 25 t.c.m. (cch) 1237, 1237, t.c.m. (p-h) ¶ 66,240 at 1387; hackney v. commissioner 24 t.c.m. (cch) 655, 655–56, t.c.m. (p-h) ¶ 65,127 at 717–18. of the six cases where the couple remained married, in four the wife was the embezzler. hauser v. commissioner, 29 t.c.m. (cch) 909, 909, t.c.m. (p-h) ¶ 70,207 at 997; peters v. commissioner, 51 t.c. 226, 228 (1968); pridgen v. commissioner, 26 t.c.m. (cch) 131, 131, t.c.m. (p-h) ¶ 67,023 at 143; horn v. commissioner, 387 f.2d 621, 622 (5th cir. 1967); kenny v. commissioner, 25 t.c.m. (cch) 913, 913, t.c.m. (p-h) ¶ 66,174 at 1026; bonner v. commissioner, 25 t.c.m. (cch) 517, 517, t.c.m. (p-h) ¶ 66,096 at 580. 37. for the one article in the new york times, see elizabeth fowler, new tax rules aid innocent spouse in case of fraud on a joint return, n.y. times, jul. 29, 1971. 638 florid tax review [vol.12:8 amelioration. it would seem that only remedial legislation can soften the impact of the rule of strict individual liability.”38 when couples remained married, the tax court was less sympathetic.39 not all courts felt impotent to provide at least certain wives relief. the sixth circuit complained, “we are not convinced . . . that the statute is so inflexible that an innocent wife who has been victimized by a dishonest husband must be subjected to an additional appallingly harsh penalty by the united states government.”40 shortly before congress acted, the sixth circuit began crafting a balancing test to be used when determining whether a wife could be granted relief.41 as these cases progressed through the courts, congress completed a year of major revisions to the tax code triggered by revelations that 154 wealthy taxpayers had not paid any income tax, and congressional attention continued to focus on improving tax administration.42 joint and several liability was one part of that administration. after a round of hearings, congress claimed that the rule of joint and several liability resulted in a “grave injustice” in the administration of the income tax.43 in 1971, congress legislated relief, which the treasury department did not oppose, and thereby averted the need for the sixth circuit’s exercise of judicial power.44 this congressional relief was intended as a hardship relief provision for those taxpayers in serious financial difficulty and was never intended to apply to all joint filers.45 the 1971 provision, enacted as section 6013(e) of 38. scudder, 48 t.c. at 41. 39. “accordingly, even though mary may not have known of or benefited from the embezzlement activity (a fact which we tend to doubt), we must nevertheless reject the petitioners’ contention that mary is not liable for the deficiencies asserted by the respondent.” hauser, 29 t,c.m. (cch) 909, 914, t.c.m. (p-h) ¶ 70,207 at 1002. 40. huelsman, 416 f.2d at 480–81. 41. sharwell, 419 f.2d at 1061. 42. comm. ways and means and comm. on fin., 91st cong., 1st sess. tax reform studies and proposals u.s. treasury department, pt. 1, 89–94 (comm. print 1969). 43. s. rep. no. 91-1537, at 2 (1970); h. rep. no. 91-1734, at 2 (1970). 44. act of jan. 12, 1971, pub. l. no. 91-679, § 1, 84 stat. 2063, 2063 (1971); s. rep. no. 91-1537 (1970). congress had previously enacted at least one private tax bill helping individual couples. see richard beck, the innocent spouse problem, 43 vand. l. rev. 317, 349–50 (1990) [hereinafter beck, innocent spouse problem]. 45. see s. rep. no. 91-1537 at 3; h.r. rep. no. 91-1734 at 3; staff of the joint committee on taxation, present law and background relating to tax treatment of “innocent spouses” (jcx-6-98) (1998) [hereinafter joint 2012] empirical study of innocent spouse relief 639 the code, only offered relief in cases involving income omitted from the return where the spouse seeking relief could prove that he or she met certain strict requirements.46 although section 6013(e) was somewhat liberalized in 1984, innocent spouse relief continued to operate as a hardship provision.47 the requesting spouse had to prove that the joint return contained a “substantial understatement” of tax attributable to “grossly erroneous” items of the other spouse; in signing the return, the spouse seeking relief did not know, and had no reason to know, of the understatement; and, under the circumstances, it would be inequitable to hold the spouse seeking relief liable for the understatement. the substantial omission requirement meant that for most taxpayers the omission had to exceed 25 percent of the gross income shown on the return.48 that the requesting spouse did not know or have reason to know was “rooted in the common law of restitution” as a means of ensuring the requesting spouse was “wholly innocent.”49 and a floor amount of tax liability at $500 prevented small claims from gaining relief.50 b. congressional action concerned about the equity of joint and several liability for joint return filers, in 1995, the american bar association (aba) resolved that it be repealed.51 congress responded to the aba by directing the general accountability office (gao) and the treasury department to study section 6013(e) and to evaluate the aba’s proposal.52 the inquiry was no longer committee on taxation, present law and background]; gao, alternatives, supra note 15, at 7. 46. i.r.c. § 6013(e)(3) (repealed). 47. deficit reduction act of 1984, pub. l. no. 98-369, § 424, 98 stat. 494, 801. for a description of the 1984 changes, see lisa edison-smith, “if you love me, you’ll sign my tax returns” spousal joint and several liability for federal income taxes and the “innocent spouse” exception, 18 hamline l. rev. 102 (1994). 48. i.r.c. § 6013(e)(4)(a) (repealed). 49. report on joint liability, supra note 13, at 16; s. rep. no. 91-1537, at 6089. 50. i.r.c. § 6013(e)(3) (repealed). 51. aba, proceedings of the 1995 midyear meeting of the house of the delegates, 120 no. 1 ann. rep. a.b.a. 5–6 (1995); section resolutions, 13 a.b.a. sec. tax’n newsl. 13 (1994). see also domestic relations comm., am. bar assoc. section on tax’n, comments on liability of divorced spouses for tax deficiencies on previously filed joint returns, 50 tax law. 395 (1997). on the other hand, the american institute of certified public accountants proposed a uniform 10% threshold of gross income for all requests. aicpa proposes legislative changes on tax treatment of marriage and divorce, 67 tax notes 87 (1995). 52. taxpayer bill of rights ii, pub. l. no. 104-168, §401, 110 stat. 1452, 1459 (1996). 640 florid tax review [vol.12:8 whether innocent spouse relief worked as hardship relief but whether it provided “meaningful relief in all cases where such relief is appropriate.”53 these departments both concluded that, although existing relief was not perfect, it was best not to limit a spouse’s liability to his or her “share” of the couple’s taxes.54 with this information, the house subcommittee on oversight held a day of hearings on innocent spouse relief.55 these hearings were part of broader hearings focused on a complete restructuring of the irs with the aim of curbing perceived overzealousness in revenue collection. the republican congress sought to require the irs to give renewed attention to taxpayers as “customers,” which meant expanding many programs, late in the process extended to include greater innocent spouse relief.56 by the time the final bill was before congress, it was thought to give “david the taxpayer an arsenal of powerful slingshots to use against goliath the irs.”57 the four witnesses on innocent spouse relief at the senate finance committee hearings were divorced women.58 these women told stories certain to elicit sympathy for the wives and anger at the tax system: tales of ex-husbands who not only stuck their ex-wives with extraordinary tax burdens but also shirked their responsibility for child support and of an irs that told one wife that there was no reason to go after her former husband for 53. h.r. rep. no. 104-506, sec. 401 (emphasis added). 54. u.s. gov’t accounting office, gao/ggd-97-34, information on the joint and several liability standard (1997). although its recommendations were limited, the gao noted that the irs did not receive many requests and “denied most of them.” id. at 4. the treasury department worried that proposals for proportionate liability “would impose increased burdens on taxpayers and the irs yet would still require some kind of equitable relief provisions in certain egregious situations.” report on joint liability, supra note 13, at 2. the treasury department made no estimation of the cost of repeal although it noted such problems as a lack of computing capacity and the need to hire seasonal workers. id. at 3, 27– 29. 55. treasury department report on innocent spouse relief: hearing before the subcomm. on oversight of the h. comm. on ways and means, 105th cong. 1 (1998) [hereinafter oversight subcommittee]. 56. h. r. conf. rep. no. 105-599, at 252–55 (1998). see also 144 cong. rec. s1780 (1998); 143 cong. rec. h10027, h10032 (1997). 57. 144 cong. rec. h5353 (1998) (statement of representative william archer). 58. senate committee on finance, unofficial transcript of finance hearing on innocent spouse tax rules, 78 tax notes 1009 (1998) [hereinafter finance committee]. there remains a sense that congress acted because divorced or separated women were frequently targeted for former husbands’ taxes. michael schlesinger, obtaining innocent spouse relief in the face of the service’s propensity to litigate, 109 j. tax’n 102, 105 (2008). 2012] empirical study of innocent spouse relief 641 taxes owed because it could collect from her.59 for those proposing changes to innocent spouse relief, the concern was that taxpayers who should be receiving relief were unsuccessful in obtaining relief under section 6013(e). senator bob graham complained that section 6013(e) was “theoretical” relief because it was “virtually impossible for the standards of that innocent spouse provision to be met.”60 senator william roth declared that “the agency is all too often electing to go after those who would be considered innocent spouses because they are easier to locate, as well as less inclined and able to fight.”61 thus, in their effort to reform the irs, some within congress saw revision of innocent spouse relief as an opportunity to limit the irs’s ability to collect taxes from some wives.62 “nine out of 10 innocent spouses are women. maybe that is because they are more likely to pay up when confronted by the irs. maybe it is because women sometimes have fewer resources to defend themselves. in either case, singling out women for abusive collection is just plain wrong.”63 in response to the “horror stories” the senate had heard, one senator focused his comments only on divorced or separated wives.64 others expanded their consideration to the widowed or to wives whose husbands had embezzled from them.65 the one reference to husbands as victims in the congressional record was meant to surprise the listeners that this could be a problem for husbands as well.66 for those advocating for a new innocent spouse provision, there was a recognition that liberalized relief would be “fairly expensive . . . in terms of the potential for lost revenue.”67 nevertheless, there was no discussion on 59. finance committee, supra note 58. 60. 144 cong. rec. s4473-74 (1998) (statement of senator bob graham). 61. finance committee, supra note 58. see also 144 cong. rec. s4028, s4033 (1998). 62. all but one mention of innocent spouse relief in the congressional record referred to wives, most often divorced wives. see also 144 cong. rec. s7647 (1998); 144 cong. rec. s1072-73 (1998); 144 cong. rec. s1071 (1998); 144 cong. rec. s4493 (1998); 144 cong. rec. s4027 (1998); 144 cong. rec. s4475 (1998); 144 cong. rec. h5354. 63. 144 cong. rec. s725 (1998) (statement of senator jon kyl). 64. 144 cong. rec. s7653 (1998) (statement of senator jack murkowski). see also 144 cong. rec. s7642 (1998). 65. 144 cong. rec. s7628 (1998) (statement of senator judd gregg); s7634 (statement of senator harry reid). 66. but see 144 cong. rec. s4504 (1998) (statement of senator olympia snowe). 67. 144 cong. rec. s4474 (1998) (statement of senator bob graham). despite the sense of congress, there is a general sense in discussions of innocent spouse relief that “the consequences to the fisc are not cause for alarm. . . .” jonathan 642 florid tax review [vol.12:8 the floor of the actual cost of this relief. there was also no discussion of cases that might appear less sympathetic on their face — congress kept referring to wives who were deceived before being left crushing tax burdens, often while caring for the couples’ children.68 in the rush to expand taxpayer protections from the irs, congress swept through this change to tax practice without fully vetting the cost or the reach of the new provision. that does not mean that proponents were unaware of, or unconcerned about, potential abuse of innocent spouse relief. there were concerns, and rightly so, that some taxpayers may try to abuse the innocent spouse rules by knowingly signing false returns, or transferring assets for the purpose of avoiding the payment of tax, and then claim to be innocent. obviously, no one would want to open the door to that type of fraud.69 for all of the cases where there might be abuse of this new provision, proponents of liberalization were quick to claim that “relief will not be available in cases of fraud, or if the irs proves the taxpayer claiming innocent spouse relief had actual knowledge of an item giving rise to the tax liability.”70 on the heels of this debate and as part of its comprehensive reform of the irs, congress repealed section 6013(e) and enacted new section 6015, but the result was not what either house had initially proposed.71 the house of representatives would have removed the hardship nature of the earlier relief but not otherwise changed the law.72 the senate, on the other hand, would have allowed all spouses (married and divorced) to apportion liability between them.73 with a relatively free rein because the administration was t. trexler, contesting innocent spouse relief: the intervention pardox, 126 tax notes 499, 499 (2010) [hereinafter trexler, contesting]. 68. see supra notes 59–67. 69. 144 cong. rec. s4474 (1998) (statement of senator alphonse d’amato). 70. 144 cong. rec. s7623 (1998) (statement of senator william roth). 71. internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, 112 stat. 685, 734 (1998). 72. h. r. rep. no. 105-364, at 19–20 (1997); joint committee on taxation, present law and background, supra note 45. 73. s. rep. no. 105-174, at 56–57 (1998). it was important to one of the senate bill’s authors that the bill “would not change the tax tables to eliminate the reduced taxes that many times accompany joint filing;” couples were to enjoy the best of marriage bonuses (for those entitled to them) and separate liability. 144 cong. rec. s1073 (1998) (statement of senator bob graham). the senate’s liberalization, assuming no interaction with any other proposal, was estimated to cost 2012] empirical study of innocent spouse relief 643 cowed, the last thing the conference committee considered was innocent spouse relief and, with the house and senate versions before it, the committee reached a compromise providing three distinct means of relief.74 in the conference committee’s first new provision, as the house had proposed, the 1971 innocent spouse relief was liberalized into current section 6015(b). pursuant to section 6015(b), a requesting spouse only has to demonstrate that a tax liability is owed because of an understatement attributable to the other spouse’s erroneous item; that the requesting spouse did not know, or have reason to know, of the existence of that erroneous item; and that, taking into account all the facts and circumstances, it would be inequitable to hold the requesting spouse liable for the taxes due.75 the conference committee also incorporated from the senate’s version of the bill section 6015(c), which apportioned liability for divorced or legally separated spouses or those spouses who have lived apart for the prior twelve months.76 pursuant to section 6015(c), a requesting spouse’s liability can be limited to his or her share of the couple’s liability. unlike with section 6015(b), inequity is not a factor under section 6015(c). instead, section 6015(c) eliminates the presumption of unity for spouses who no longer function as a marital unit.77 the presumption is in favor of this allocation unless the irs can prove that the requesting spouse had actual knowledge of the tax liability.78 in addition to these two forms of broadened but still limited relief, the conference committee added a third form of equitable relief to be granted at the irs’s discretion.79 section 6015(f) grants the irs tremendous $5.157 billion between 1997 and 2007. joint committee on taxation, comparison of the estimated budget effects of h.r. 2676 (jcx-44-98) (1998). 74. unofficial transcript of tax analysts program on irs restructuring and reform act, 2008 tnt 146-50; h. conf. rep. no. 105-599, at 251–55. 75. i.r.c. § 6015(b). a spouse can get proportional relief under section 6015(b) if he or she can demonstrate lack of knowledge of the extent of the understatement. i.r.c. § 6015(b)(2). 76. i.r.c. § 6015(c). a widow is treated as though no longer married. h.r. conf. rep. no. 105-599, at 252 n16. 77. bryan camp, the unhappy marriage of law and equity in joint return liability, 108 tax notes 1307, 1314 (2005). 78. i.r.c. § 6015(c)(3)(c). congress had asked the gao and treasury department for an evaluation of binding the irs to negotiated settlements between divorcing and separating spouses; congress was not willing to go so far in the final legislation. h. r. rep. no. 104-506, at 7–8 (1996); sec. 401; oversight subcommittee, supra note 55. 79. h. r. conf. rep. no. 105-599 at 254. 644 florid tax review [vol.12:8 latitude in providing relief if the prior two provisions are inapplicable.80 this provision allows that “the secretary may relieve such individual of such liability” if, “taking into account all the facts and circumstances, it is inequitable to hold the individual liable.”81 section 6015(f) is also the only means to relief for spouses where there is the underpayment of tax on a correct return, as opposed to an understatement of tax on the return.82 this final tripartite relief provision was cobbled together, crafted during a period of tremendous legislative change affecting the business operations of the irs, and the statutory language lays out no singular vision of when and why particular spouses should be granted relief. there was, however, nothing in the final reports to indicate that there had been a change from the earlier statements made in congress. even with the very different approaches proposed by each house, the provision’s goal was to grant relief from liability to divorced or separated wives who were left crushing tax burdens by their nefarious husbands. the 1998 act required the treasury department to quickly draft rules implementing the new provision, as the law was effective upon enactment.83 these rules and regulations then guided the irs in its determination of whether relief should be granted to particular claims. the treasury regulation interpreting the equitable prongs of section 6015(b) and (f) are currently based on factors provided in revenue procedure 2003-61, although the irs has recently proposed changes to the revenue procedure for section 6015(f), but under both provisions the irs considers whether the requesting spouse received a significant benefit, directly or indirectly, beyond normal support from the unpaid taxes; was abused; or will suffer economic hardship if relief is not granted.84 in this 80. i.r.c. § 6015(f). in 2006, the tax court was given jurisdiction to review stand-alone equitable relief determinations. tax relief and health care act of 2006, pub. l. no. 109-432, div. c, §408, 120 stat. 2922, 3061 (2006). 81. i.r.c. § 6015(f). 82. the conference committee would not extend section 6015(c) to reported but unpaid tax but, instead, left that for equitable relief. h. conf. rep. no. 105-599 at 254–55 (1998). the irs treats elections under section 6015(b) and (c) as an application under section 6015(f); however, an application of section 6015(f) relief does not automatically trigger an application of section 6015(b) and (c). reg. §1.6015-1(a)(2). 83. u.s. gov’t accounting office, gao-01-589t, information on selected irs tax enforcement and collection efforts 17 (2001) [hereinafter gao, information]. 84. rev. proc. 2003-61, 2003-2 c.b. 296, superseding rev. proc. 2000-15, 2000-1 c.b. 447; notice 2012-8, supra note 9. the treasury department’s guidelines for section 6015(f) are more extensive than for section 6015(b) and include certain threshold conditions plus additional levels of factors before the commissioner will grant a request for equitable relief. id., at 298. 2012] empirical study of innocent spouse relief 645 weighing of factors as directed by revenue procedure 2003-61, no single factor is determinative, and the irs must weigh all of the factors together.85 nevertheless, under this rule while reason to know of the tax deficiency “will not be weighed more heavily than other factors,” actual knowledge of it is “a strong factor weighing against relief.86 some courts use these factors as a mathematical equation, adding up those factors that weigh for and those against relief to determine whether relief should be granted.87 throughout this attempt by the treasury department to clarify the statute is an attempt to create rules applying section 6015 to spouses for whom congress intended relief. the next part will assess to what extent courts feel the treasury department’s rules accomplish that objective.88 in addition, the next part will evaluate to what extent courts apply congressional intent — the desire to provide relief to divorced, deserted, or widowed wives unfairly left with an overwhelming tax liability created by their former husbands. part iii. the law in play as the irs adapted to its new focus on customer service — in the middle of an economic downturn — the irs received 1,200 applications for innocent spouse relief per week in mid–2000.89 more than 46,000 taxpayers had already made 79,000 applications for relief.90 as the irs dealt with this onslaught of relief requests, it worked to give substance and meaning to the new provision. from its legislative history, section 6015 was created with the intention of providing relief to “innocent spouses”; however, determining who was “innocent” proved costly to administer.91 the cincinnati service 85. id., at 298. 86. id. although the revenue procedure authorizes consideration of other factors, little evidence of weighing additional factors is apparent from the cases. pursuant to notice 2012-8, actual knowledge will no longer be weighed more heavily than other factors. notice 2012-8, § 4.03(2)(c)(i), supra note 9. 87. see, e.g., greer v. commissioner, 97 t.c.m. (cch) 1075, 1079, t.c.m. (ria) ¶ 2009-020 at 112–13. motsko v. commissioner, 91 t.c.m. 711, 714-15, t.c.m. (ria ¶ 2006-017 at 104. pursuant to notice 2012-8, no one factor or majority of factors necessarily controls the determination for equitable relief. notice 2012-8, § 4.03(2), supra note 9. 88. more recent developments in the treasury department’s interpretation of this provision are discussed infra. 89. steve johnson, the 1998 act and the resources link between tax compliance and tax simplification, 51 u. kan. l. rev. 1013, 1044 (2003) [hereinafter johnson, the 1998 act]. 90. id. 91. joint committee on taxation, estimated budget effects of titles i-viii of the conference agreement relating to h.r. 2676, 79 tax notes 1741 (1998). 646 florid tax review [vol.12:8 center integrated case processing system (icp) began operations as the nation’s primary reviewer of relief requests in january 2001.92 of the 48,461 claims for relief sought in 2005, 42.5 percent were denied without reaching the merits and an additional 29.0 percent were disallowed in full.93 reviewing these denials, the national taxpayer advocate found that 29 percent of the irs’s rejections were because the liability had already been paid and another 6 percent were rejected because the requesting spouse confused innocent spouse relief and injured spouse relief.94 in 26 percent of cases, a joint return had not been filed or a joint return had been filed but the couple was not married or did not sign the return, and in 19 percent, no return had been filed.95 many of these errors were the result of taxpayers filing for incorrect years and they likely refiled for the correct years.96 the treasury inspector general of tax administration found that the irs properly resolved 94 percent of the cases it reviewed in 2004.97 if icp denies relief, requesting spouses may appeal to the appeals office.98 in fiscal year 2010, appeals heard 5,341 section 6015 claims (less 92. gao, information, supra note 83, at 18. 93. national taxpayer advocate, 2005 annual report, at 329 (2006) [hereinafter nta, 2005 annual report]. this is down from the 48.7% defective on their face in 1999-2001. u.s. gov’t accounting office, gao-02558, irs innocent spouse program performance improved; balanced performance measures needed 34 (2002) [hereinafter gao, innocent spouse program]. 94. nta, 2005 annual report, supra note 93, at 331. taxes already paid was up from 19.4% in 1999-2001 but confusion with injured spouse relief was down from 6.6%. gao, irs’s innocent spouse program performance improved, supra note 93, at 34. 95. nta, 2005 annual report, supra note 93, at 331. that the couple did not file a joint return or filed it incorrectly was down from 30.6% in 1999-2001. gao, innocent spouse program, supra note 93, at 34. 96. not noting the incorrect filings double-counts these taxpayer errors as valid claims. if the problem is an incorrect year, the irs sends the requesting spouse a letter indicating the years that have joint liabilities and inviting appropriate applications for relief. nta, 2005 annual report, supra note 93, at 332 n.32. 97. tigta, the innocent spouse review function, may 2005, ref. 200540-075, at 5–6. treas. inspector gen. for tax admin., ref. no. 2005-40-075, the innocent spouse centralized review function ensured accurate relief determinations, but improvements could increase customer service 5–6 (2005) [hereinafter tigta, accurate relief determinations]. 98. in 2005, each case took on average 192 days to process, 807 days if the application went to appeals. nta, 2005 annual report, supra note 93, at 423. while centralized processing is more efficient, there is concern that its efficiencies cause some cases to be denied the relief congress intended. scott schumacher, innocent spouse, administrative process: time for reforms, 130 tax notes 113 (2011) [hereinafter schumacher, administrative process]. 2012] empirical study of innocent spouse relief 647 than 4 percent of all appeals) and 4,610 were closed that year.99 in the appeals process, additional relief was granted in 35 percent of the claims in 2005.100 in a survey conducted by the aba section of taxation, 73.1 percent of those surveyed believed that the appeals office is “generally fair” and, for those handling innocent spouse cases in the two years before the survey, only 17 percent thought the appeals office did not exercise independence from the auditors initially denying relief.101 while one commenter found that the appeals office “rubberstamp[s] whatever the service has done,” 62.7 percent were satisfied with the way the appeals office handled their innocent spouse cases.102 while 71.5 percent of claims were denied relief, only 2.7 percent of those not deemed ineligible on their face were litigated in the tax court.103 nevertheless, there are complaints that too many cases are not resolved by the administrative process and find their way into the judicial system.104 although that is a normative assessment not being evaluated in this article, innocent spouse relief was listed as one of the top ten litigated issues in the taxpayer advocate’s 2010 annual report and for every year since 2001 except for 2003.105 any requesting spouse may seek relief from the tax court as long as a petition is filed no later than ninety days after the irs mails its final determination notice to the requesting spouse or if the irs fails to issue a ruling within six months.106 this article examines the 444 litigated cases involving claims for innocent spouse relief that have been decided since the 1998 legislative enactment. it evaluates the standards courts apply against the legislative history. in addition, the article explores which particular factors are most likely to weigh for or against relief. a. mechanics of the study this sample includes all recorded federal tax decisions in the lexis database handed down between july 22, 1998, and april 15, 2011, that include the words “innocent spouse,” “tax,” and “6015.” each case was coded for a variety of information and compiled into a spreadsheet, including 99. irs data book 2010, table 21. 100. nta, 2005 annual report, supra note 93, at 330. 101. aba, section of taxation, survey report on independence of irs appeals, august 11, 2007, 1–2. 102. id. at 12. 103. nta, 2005 annual report, supra note 93, at 329–330 n.23. 104. schumacher, administrative process, supra note 98. schumacher also complains that denials are often made without explanation. id. 105. nta, 2010 annual report, supra note 17, at 414. 106. i.r.c. § 6015(e)(1). 648 florid tax review [vol.12:8 information about the parties (education, employment history, role in family finances, etc.), the liability (source, amount, etc.), and the parties’ relation to the liability (knowledge of, benefit from, etc.).107 when cases were appealed, information from earlier or later appeals were used to supplement the spreadsheet. in this content analysis, it is not the goal to rank the importance of variables but to look for patterns within the cases that might otherwise be missed while retaining the language and tone of these varied cases.108 this article is concerned with the results of these opinions and not how judges reached their conclusions or what interpretive technique they adopted. the author acknowledges that there is a limit to the information that can be gleaned from this methodology. first, not all cases that were filed resulted in written opinions. some were settled and others resulted in unwritten bench opinions.109 therefore, the opinions used in this sample are not all cases filed or decided in the courts. second, judicial opinions are available only for those claims for which the taxpayer had the resources and inclination to pursue relief in court. thus, there is a selection bias in the cases. the litigated cases should be among those claims with the less favorable factors for relief as those with more favorable factors would presumably have been granted relief during administrative review.110 despite these limitations, this analysis should provide valuable information regarding the implementation of innocent spouse relief. moreover, this review furthers analysis of the extent to which courts defer to executive agencies and the extent to which they implement congressional intent. 1. choice of courts the courts included in this sample are all of the federal courts that review federal tax cases. federal tax cases are held for trial before the tax court, district courts, and the court of federal claims.111 decisions of the 107. in the charts below, unless a particular case is referenced, case names are not provided to control for footnote length. this information, as well as the spreadsheet, is available from the author. 108. as a result, this article does not purport to provide predictive indicators of how a particular case might be resolved. moreover, the small sample size for many of the issues considered prevent arguing their statistical significance. for a discussion of content analysis, see mark hall & ronald wright, systematic content analysis of judicial opinions, 96 cal. l. rev. 63 (2008). although a regression analysis might find additional hidden patterns or associations between factors, because of the sample size and the desire to retain the stories of the requesting spouses themselves, that work is left for a future project. 109. bommarito, empirical survey, supra note 17, at 530. 110. ideally, this assumption will be tested by a later study at icp. 111. see 28 u.s.c. § 1345(a)(1); 26 u.s.c. § 7422; flora v. u.s., 357 u.s. 63 (1958). 2012] empirical study of innocent spouse relief 649 tax court and district courts are appealed to the appropriate circuit court of appeals; decisions of the court of federal claims are appealed to the federal circuit.112 no innocent spouse case has yet been decided by the supreme court. because courts often considered different factors and issues when a case was on appeal, the 9.5 percent of cases heard on appeal are counted separately from the underlying trial opinion. the final tally of innocent spouse cases was 444.113 the tax court issues three different types of decisions: regular, memorandum, and summary. in addition to regular opinions, the tax court’s memorandum decisions are not officially published and present nothing more than factual issues.114 summary opinions are issued when the amount in dispute is $50,000 or less and the taxpayer elects to have the case conducted under a “small tax case” proceeding using simplified rules of evidence, practice, and procedure and waives the right to appeal.115 all tax court opinions are included in this sample because they disclose how facts and reasoning interact in the decision-making process. the tax court is the only court in which a taxpayer does not have to first pay the liability and then sue for a refund, and about 90 percent of all tax cases are heard in the tax court.116 before 1998, 90 percent of innocent spouse cases were initially heard in the tax court; since 1998, 91.8 percent (or slightly more than for all tax cases) have been initiated there.117 112. i.r.c. § 7482; 28 u.s.c. §§ 1294, 1295. 113. there are 492 cases as a result of the search; forty-eight cases are not relevant to this study. bankruptcy and state court decisions are excluded from the sample. 114. james maule, instant replay, weak teams, and disputed calls, 66 tenn. l. rev. 351, 368 (1999) [hereinafter maule, instant replay]. 115. i.r.c. § 7463. 116. irs data book 2010, table 27. there are three jurisdictional bases upon which the tax court may review a claim for innocent spouse relief. first, section 6015(e) provides that a spouse who has requested relief can petition the irs’s denial of relief or petition the irs’s failure to make a timely determination. such cases are referred to as “stand alone” cases in that they are independent of any deficiency proceeding. stand-alone basis was extended to section 6015(f) in 2006. see supra note 81. second, the tax court may exercise jurisdiction when a claim is raised as an affirmative defense in a petition for redetermination of a deficiency filed pursuant to section 6213(a). butler v. commissioner, 114 t.c. 276, 287–88 (2000). finally, the tax court may exercise jurisdiction when the issue is properly raised in a collection proceeding under sections 6320 and 6330. i.r.c. § 6330(c)(2)(a)(i). 117. stephen a. zorn, innocent spouses, reasonable women and divorce: the gap between and the internal revenue code, 3 mich. j. gender & l. 421, 424–5 (1996) [hereinafter zorn, innocent spouses]. 650 florid tax review [vol.12:8 choice of courts tax court court of claims district court circuit court number of cases 369 2 31 42 percentage of cases 83.1% 0.5% 7.0% 9.5% number of wins118 136 1 9 8 winning percentage 36.9% 50.0% 29.0% 19.0% not only are most cases initiated in the tax court, but 88.3 percent of the total taxpayer wins were in the tax court and taxpayers’ tax court winning percentage, if you discount the two cases heard in the court of claims, is the highest. this is despite the fact that taxpayers do not have to prepay their liabilities in the tax court and so weaker cases would presumably be brought there because of the lower cost. based on the 2010 data for the ten most litigated issues, taxpayers’ overall success rate of 20.6 percent was significantly lower than the 34.7 percent rate in this sample for innocent spouse relief.119 unlike those studies finding the tax court biased in favor of the government, the tax court is not dismissive of innocent spouse claims.120 in fact, in united states v. boscaljon,121 the court ordered that an innocent spouse claim be raised for a 74-year-old wife even though she had not requested such relief.122 however, throwing oneself, or one’s client, on the mercy of the tax court does not often work. in gormeley v. 118. counted as wins for the requesting spouse and not for an intervenor. 119. nta, 2010 annual report, supra note 17, at 417. because of the irs’s recent change in position on the statute of limitations for section 6015(f), six cases will result in taxpayer victories. notice 2011-70, 2011-32 i.r.b. 135. these cases are not counted as winning cases in this sample because the change was beyond the period of review. 120. for the debate regarding the tax court’s bias, see maule, instant replay, supra note 114; deborah a. geier, the tax court, article iii, and the proposal advanced by the federal courts study committee: a study in applied constitutional theory, 76 cornell l. rev. 985, 998–1000 (1991). one study concludes that tax court trial judges, but not appellate judges, do exhibit a bias. b. anthony billings et al. are u.s. tax court decisions subject to the bias of the judge? 55 tax notes 1259, 1266 (1992) [hereinafter billings, decisions]. 121. 105 a.f.t.r. 2d 1501 (2010). 122. id. it is unlikely ms. boscaljon was granted relief because her house was ultimately foreclosed upon. see 2010 u.s. dist. lexis 46354. 2012] empirical study of innocent spouse relief 651 commissioner,123 the court quoted the requesting spouse’s counsel as stating, “so, what i’m trying to ask the court here to do is try to help my client out here by finding a way to rule because this is an equitable thing that congress really wanted to help taxpayers get some ruling from the court under 6015(e).”124 the court would not overlook that the client had not filed a petition within the 90-day window and, therefore, the court did not have jurisdiction to evaluate the merits of the case.125 the tax court, where the majority of innocent spouse cases are heard, is composed of nineteen judges (sixteen judges are currently sitting) who have each been appointed by the president and confirmed by the senate for fifteen-year terms. unless the tax court sits en banc, decisions by individual judges who hear cases are reviewed by the chief judge and, possibly, the full tax court.126 in addition to regular judges, special trial judges may be appointed by the chief judge from time to time. the following chart only includes judges who have ruled on at least five innocent spouse cases. 123. 98 t.c.m. (cch) 420, t.c.m. (ria) ¶ 2009-252. 124. id., 98 t.c.m. (cch) 420, 421, t.c.m. (ria) ¶ 2009-252 at 1859. 125. id., 98 t.c.m. (cch) 420, 421–22, t.c.m. (ria) ¶ 2009-252 at 1860. see also carlton smith, how can one argue ‘it’s not my joint return’ in tax court?, 124 tax notes 1266 (2009). the case was appealed to the third circuit but, before appeal, the irs abated assessment because of an improperly filed notice of determination. email with carl smith, cardozo tax clinic, june 5, 2011. 126. billings, decisions, supra note 120, at 1266. 652 florid tax review [vol.12:8 tax court judges hearing innocent spouse cases chiechi cohen colvin dawson foley gerber goeke appointing president bush reagan reagan kennedy clinton reagan w. bush sex female female male male male male male no. of cases 14 23 10 9 9 10 19 taxpayer won 2 4 6 6 3 3 10 winning percentage 14.3% 17.4% 60.0% 66.7% 33.3% 30.0% 52.6% haines halpern holmes jacobs kroupa laro marvel appointing president w. bush bush w. bush reagan w. bush bush clinton sex male male male male female male female no. of cases 14 6 12 5 8 8 15 taxpayer won 7 3 5 3 2 1 7 winning percentage 50.0% 50.0% 41.7% 60.0% 25.0% 12.5% 46.7% nims ruwe swift thornton vasquez wells wherry appointing president carter reagan reagan clinton clinton reagan w. bush sex male male male male male male male no. of cases 7 16 9 10 20 10 10 taxpayer won 2 9 5 2 6 0 1 winning percentage 28.6% 56.3% 55.6% 20.0% 30.0% 0.0% 10.0% armen carluzzo couvillion dean goldberg panuthos appointing president special trial judge special trial judge special trial judge special trial judge special trial judge special trial judge sex male male male male male male no. of cases 12 11 17 23 17 16 taxpayer won 6 4 5 8 6 6 winning percentage 50.0% 36.4% 29.4% 34.8% 35.3% 37.5% 2012] empirical study of innocent spouse relief 653 from this sample of cases, there is a wide range of success rates before these judges, ranging from 0 percent to 66.7 percent. the political party of the appointing president does not appear to influence the likelihood of a judge’s decisions. the number of female judges is small but it too does not appear to be an indicator, although female judges appointed by republican presidents have a lower-than-average taxpayer success rate of 17.8 percent. although taxpayers are more likely to win before special trial judges, at a 37.5 percent rate, the number is not significantly higher than the winning percentage before regular judges, 35.7 percent. of course, to the extent past decisions are an indicator of future holdings, there are some judges that a taxpayer would rather come before than others. there was a dissent in only eleven cases heard by the full court, or 2.5 percent, despite the lack of agreement as to the meaning of various equitable factors discussed below. all but two of these cases involved primarily procedural issues, namely the scope of judicial review of irs determinations and whether the regulatorily-imposed two-year limit for appeals under section 6015(f) was permissible. the latter issue has received much attention.127 although the statutory language of section 6015(b) and (c) expressly imposes a two-year window for taxpayers to apply for relief, until july 2011 the treasury department imposed the same limit for claims for relief under section 6015(f).128 the validity of this regulatory limit was repeatedly contested in the courts. in lantz v. commissioner,129 a divided tax court held the regulation was invalid, a holding that was followed in manella v. commissioner,130 but their decisions were overturned by the 127. nta, 2010 annual report, supra note 17; bryan t. camp, interpreting statutory silence, 128 tax notes 501 (2010); patrick j. smith, gaps in the seventh circuit’s reasoning in lantz, 128 tax notes 1375 (2010); robert b. nadler, equitable relief: time to level the playing field, 133 tax notes 899, 902– 03 (2006); william brown, recent cases expand potential for obtaining innocent spouse relief, 83 practical tax strategies 86, 90 (2009). 128. notice 2011-70, supra note 119; reg. § 1.6015-5(b)(1); t.d. 9003, 2002-32 i.r.b. 294. this was despite a letter from commissioner shulman to jim mcdermott, u.s. house of representatives (apr. 20, 2011), 2011 tnt 86–34. moreover, the treasury department’s chief counsel instructed the irs attorneys not to seek summary judgment for violating the two-year limit but to continue to argue that relief is unavailable. office of chief counsel, c.c.n. cc-2009-012, designation for litigation: validity of two-year deadline for section 6015(f) claims under treas. reg. § 1.6015-5(b)(1) (2009); office of chief counsel, c.c.n. 2010-11, validity of the two-year deadline for section 6015(f) claims under treas. reg. § 1.6015-5(b)(1) and the seventh circuit reversal of lantz (2010). 129. 132 t.c. 131 (2009), rev’d., 607 f.3d. 479 (7th cir. 2010). 130. 132 t.c. 196 (2009), rev’d., 631 f.3d 115 (3d cir. 2011). 654 florid tax review [vol.12:8 seventh and third circuits.131 before the irs removed this limitation, the same issue was pending in four other circuits.132 not all judges agree as to how various factors for relief should be interpreted, despite most cases not having dissents.133 nevertheless, because this study tests whether courts implement congressional intent, these judicial decisions are measured against the legislative history. each decision is taken at face value because the concern is the results of cases rather than the motivations of judges.134 in judging the results, the facts and reasoning given in opinions are assumed to be accurate, understanding that they may not be. 2. breakdown of provisions although congressional intent can be identified in committee reports and the congressional record, it is not an operational blueprint. as a result, the irs and courts disagree as to its application to particular facts. overruling the irs, courts granted taxpayers relief, at least in part, in 34.7 percent of the litigated cases. of the 154 cases in which the taxpayer prevailed, the government did not oppose relief in thirty-six;135 the taxpayer won only in part in twenty-six; and in forty-nine the taxpayer won procedural claims (such as in opposition for summary judgment or for remand). in ninety-one cases, which are 20.5 percent of the total number of section 6015 cases, the requesting spouse won complete relief.136 131. jones v. commissioner, 642 f.3d 459 (4th cir. 2011), also found the regulation valid. camp, supra note 127, argues that the different purposes of (b), (c), and (f) relief justify tax court’s decision in lantz. smith, gaps in the seventh circuit reasoning in lantz, supra note 127, questions the rationale of the seventh circuit. 132. see nta, 2010 annual report, supra note 17, at 502. 133. see, e.g., supra part iii.c.1.c. and iii.c.2.a. 134. this approach is similar to bradley w. joondeph, exploring the “myth of parity” in state taxation: state court decisions interpreting public law, wash. u. j.l. & pol’y, 205 (2003). for a discussion of how to judge judicial motivation, see tonja jacobi and matthew sag, taking the measure of ideology: empirically measuring supreme court cases, 98 geo. l.j. 1, 8 (2009); carolyn shapiro, coding complexity, bringing law to the empirical analysis of the supreme court, 60 hastings l.j. 477 (2009); lee epstein et al., ideological drift among supreme court justices: who, when and how important, 101 nw. u.l. rev. 1483 (2007); daniel scheider, empirical research on judicial reasoning: statutory interpretation in federal tax cases, 31 n.m. l. rev. 325 (2001). 135. litigation continues because the non-requesting spouse as intervenor opposes relief for the requesting spouse. see supra part iii.d.3. 136. the categories of winning cases do not equal the total wins because some cases fit in multiple categories. for example, those in which judges did not oppose relief may also count as complete relief. 2012] empirical study of innocent spouse relief 655 the means to obtaining relief are through one of three avenues provided in section 6015. each avenue applies to different, and limited, circumstances. which of the three provisions offers the best chance of success depends in large part on the facts of the case. as described in the prior part, sections 6015(b) and (c) offer more automated processes because the statutory and regulatory factors to be considered are significantly fewer than imposed on the broad equitable relief of section 6015(f). this was intentional. the conference report for the 1998 act noted that relief under section 6015(f) was to be an equitable last resort.137 under section 6015(b), the burden of proof is on the requesting spouse; the taxpayer must prove his or her claim by the preponderance of the evidence.138 two key characteristics of section 6015(b) cases are that these cases involve only the understatement of taxes owed on a joint return and they require a balancing of factors under its equitable prong. in the eleven successful cases decided on the merits solely under section 6015(b), the court found in each that the requesting spouse had no knowledge of the deficiency. in eight of the nine in which the court mentioned substantial benefit, the court found there was none; and in the four cases in which the court mentioned economic hardship, the court found that it would result for the requesting spouse. it is difficult to decipher other common characteristics of successful claims. five cases involved couples that were still married, three of which involved investments in a tax shelter. some requesting spouses were stay-at-home mothers, one was a paralegal, one was a police officer. like section 6015(b), section 6015(c) involves only the understatement of taxes owed on a joint return; however, there is no balancing of equitable factors. the least subjective means of relief, spouses who request relief under section 6015(c) must be divorced, separated, or widowed, but of the twenty-nine successful cases decided on the merits solely under section 6015(c), two cases involved married couples where the husband was in jail, seemingly in defiance of the regulations that do not treat a temporary absence as a separation.139 with a presumption for the taxpayer, one might expect to see fewer than thirty cases brought by requesting spouses under section 6015(c) alone. looking at these thirty cases plus the twenty additional cases appealed on multiple grounds that were decided based in part on section 6015(c), requesting spouses won on the merits in thirty-four, plus an additional four on procedural issues. although the standard for the taxpayer is that he or she must prove the claim by a preponderance of the evidence, the burden of proving the requesting spouse had actual knowledge of the understatement, and thereby not qualified for 137. h.r. conf. rep. no. 105-599, at 254 (1998). 138. nadler, innocent spouse relief, supra note 20, at 83. 139. reg. § 1.6015-3(b)(3)(i). 656 florid tax review [vol.12:8 relief, is on the irs.140 all but three of the successful cases on the merits under section 6015(c) turned on lack of actual knowledge of the deficiency by the requesting spouse.141 sections 6015(b) and (c) provide relief only for the understatement of tax liability; the tax returns themselves must be incorrect. section 6015(f) is broader and can provide relief for both the understatement and underpayment of tax. in cases seeking section 6015(f) relief alone, 78.3 percent arose at least in part from the underpayment of tax on correctly filed returns. the burden under section 6015(f) is on the taxpayer to prove the equity of relief.142 however, courts have ruled that the commissioner’s determination to deny relief under section 6015(f) is subject to de novo review and that the administrative record may be supplemented at trial.143 not all tax court judges agree with this approach and neither does the irs, which contends that the requesting spouse must show that the commissioner’s denial of relief was an abuse of discretion.144 as with section 6015(b), section 6015(f) requires a balancing of equitable factors. of the fifty-five cases granting relief on the merits solely under section 6015(f), in sixteen the court found that the requesting spouse had actual knowledge of the deficiency and, in six, that the requesting spouse had reason to know of it. there was significant division in the cases on whether the requesting spouse would suffer an economic hardship if made liable for the tax. in only four did the court find that the requesting spouse had substantially benefited from the deficiency. finally, as with section 6015(b), there were no common characteristics of the requesting spouse. 140. nadler, innocent spouse relief, supra note 20, at 83-84. under section 6015(c), the burden of proving the appropriate allocation of tax items is on the requesting spouse. i.r.c. § 6015(c)(2). in three of the cases granting section 6015(c) relief, issues of allocation were raised. in two of those cases, the court chastised the irs for not attempting an allocation. foy v. commissioner 89 t.c.m. (cch) 1299, 1304–05, t.c.m. (ria) ¶ 2005-116 at 923. bulger v. commissioner, 89 t.c.m. (cch) 1457, 1462–63, t.c.m. (ria) ¶ 2005-147 at 1140–41. in the final case, the government worked through the allocation provisions when each spouse sought relief, but the court granted only partial relief to the husband. charlton v. commissioner, 114 t.c. 333 (2000). 141. nevertheless, in seven cases the courts noted that the requesting spouse either had constructive knowledge or reason to know of the liability. 142. nadler, innocent spouse relief, supra note 20, at 83–84. 143. commissioner v. neal, 557 f.3d 1262, 1264 (11th cir. 2010); ewing v. commissioner, 122 t.c. 32, 38–39 (2004); porter v. commissioner, 132 t.c. 203, 210 (2009), aff’g 130 t.c. 115 (2008). 144. cc-2009-021, 2009 tnt 125–5; cc notice (35)000-338 (2000). see also patrick j. smith, standards for tax court review in equitable innocent spouse cases, 2012 tnt 42-6. toni robinson & mary ferrari, protecting the innocent, 2000 tnt 181–100. 2012] empirical study of innocent spouse relief 657 before beginning a more detailed analysis of when relief is granted, it is important to note that not all of the litigated cases are meritorious. because taxpayers have a right to appeal a denial of relief by the irs, some claims that are invalid on their face have made their way onto the judicial docket. for example, a threshold question for spouses to win relief from joint and several liability is that spouses must sign or intend to sign joint returns. although the absence of a joint return is a common reason the irs initially declines relief, eight cases were decided based on a lack of a joint return and, in each, the court held there was no jurisdiction for granting section 6015 relief. in one, the ninth circuit upheld the tax court’s denial of jurisdiction for spouses who face joint liability under community property laws but do not file joint returns.145 in a ninth case, one spouse claimed (but failed to win) innocent spouse relief because the other spouse would not agree to file jointly and, as a result, the requesting spouse suffered a larger tax bill.146 whether a joint return exists is but one question that causes cases to be decided on procedural grounds rather than on the merits. cases decided on procedural grounds § 6015(b) § 6015(c) § 6015(f) combination other brought under 2 10 47 69 30 won under 0 2 18 23 7 of the sample, 158, or 35.4 percent, were resolved based solely on procedural issues, and taxpayers won 31.6 percent of the cases decided on procedural grounds.147 in 50.6 percent of these procedural cases, issues of untimeliness, res judicata, and lack of jurisdiction were the basis of the court’s decision. that so many cases were decided on procedural issues is not necessarily a sign of wasteful litigation. many of these cases resolved 145. in christensen v. commissioner, 523 f.3d 957, 962 (9th cir. 2008), aff’g 90 t.c.m. (cch) 642, t.c.m. (ria) ¶ 2005-299, a husband was jointly liable under community property laws despite filing separately. there is no right to appeal to the tax court under section 66 which provides limited community property relief. 146. rogers v. commissioner, t.c. summ. op. 2010-13. 147. in some cases, claims for some years were resolved on procedural and other years on the merits. the taxpayer advocate found that 31% of the cases decided in fiscal year 2010 involved procedural issues, with 55% decided in favor of the government, 36% in favor of the taxpayer, and one split decision; 72% involved an examination of the merits, and, of those, 62% were in favor of the irs, 27% in favor of the taxpayer, and 12% in split decision. nta, 2010 annual report, supra note 17, at 500. 658 florid tax review [vol.12:8 important questions: for example, they have questioned whether a particular regulatory provision is valid and whether a right to intervene extends to heirs. these developments occur in the courts because of the limited guidance provided by the statute as well as taxpayers’ relatively easy access to the courts. in the discussion below, procedural cases are included in the sample unless otherwise stated. the reason for this inclusion is because, although an exact percentage is unknown, most section 6015 claims are settled.148 procedural decisions that extend the period for negotiations between requesting spouses and the irs can operate to the advantage of either party. however, one gao report found that settlements generally operate to the advantage of requesting spouses.149 therefore, it is important to include in consideration those decisions that prolong or shorten the process. nonetheless, more cases, 64.3 percent, were decided on the merits than on procedural grounds, a large number under each subsection. cases decided on the merits § 6015(b) § 6015(c) § 6015(f) combination of (b), (c), &/or (f) other brought under 14 20 110 139 4 won on any grounds 4 16 40 44 1 winning percentage 28.6% 80.0% 36.4% 31.7% 25.0% percentage of total wins 3.8% 15.2% 38.1% 41.9% 1.0% § 6015(b) § 6015(c) § 6015(f) combination of (b), (c), &/or (f) other won based on section 11 29 54 6 5 percentage of total wins 10.5% 27.6% 51.4% 5.7% 4.8% taxpayers used section 6015(f) to seek relief much of the time, relying on the provision, at least in part, in 83.6 percent of their appeals decided on the merits. taxpayers also tended to appeal under multiple provisions, claiming under multiple provisions 48.4 percent of the time. of 139 cases brought under a combination of subsections, 108 were either a general section 6015 appeal or an appeal under all three subsections. 148. gao, innocent spouse program, supra note 93, at 30. 149. of the cases settled between 1996 and 2001, 55% resulted in the taxpayer being absolved of liability, 33% in a reduction of liability, and 12% the liability remained the same. id. 2012] empirical study of innocent spouse relief 659 judges, on the other hand, tended to provide relief under one subsection and, like taxpayers, judges relied heavily on section 6015(f). despite some expectation that courts would grant “relatively few” section 6015(f) cases when requesting spouses had been denied relief on other grounds, over 50 percent of the time that relief was granted, it was granted under section 6015(f), which by definition, means the requesting spouse did not qualify under section 6015(b) or (c).150 courts also used section 6015(c) to grant relief when a taxpayer sought relief under a combination of subsections.151 these results are not static over time. taxpayers’ reliance on section 6015(f) in cases decided on the merits has increased.152 taxpayers’ reliance over time the data shows an upward trend in appeals under section 6015(f) after a dip in 2006, but a decline in the combination of appeals after a peak in 2004. a question that cannot be answered from this data is why taxpayers would not always appeal using at least some combination of section 6015(f). 150. section 6015(f) was relied on alone 55 times and used in conjunction with another subsection 4 more times. johnson, the 1998 act, supra note 89, at 1059. see also smith, “inequitable” revenue procedure, supra note 9. id. 151. section 6015(c) relief could be complete if the court allocated all liability to the other spouse. see reg. § 1.6015-3(d)(4). 152. the chart does not include cases decided in 2011 because the dataset includes a shortened period. 0 5 10 15 20 25 30 §6015(b) §6015(c) §6015(f) 660 florid tax review [vol.12:8 there are two things to note with respect to taxpayers’ reliance on the three subsections. first, there was a backlog of cases begun before 1998, but this should not greatly affect the conclusions below regarding the implementation of congressional intent because the same analysis should have been applied to these holdover cases. it does mean, however, that there might have been an artificially large number of cases in the early years as taxpayers waited for the more lenient provision before pressing their cases in court. second, the decrease in the number of section 6015(f) cases in 2006 was likely the result of ewing v. commissioner,153 which held the thenexisting version of section 6015(e) did not grant the tax court jurisdiction to decide subsection (f) claims in stand-alone appeals.154 congress extended this jurisdiction in december 2006.155 it is harder to draw conclusions based on successful cases because there are few wins in any given year. nevertheless, some trends can be seen. courts’ reliance over time much as with taxpayers, judges’ reliance on section 6015(f) has increased over time, although judges were more willing to rely on section 6015(c) than were taxpayers. the number of cases in which judges relied on a combination of subsections has remained small. 3. summary as with most cases involving federal taxation, the vast majority of innocent spouse cases are litigated in the tax court. although some judges appear to be more likely to grant relief than others, no pattern is discernible regarding which types of judges are more likely to rule in favor of relief. 153. 439 f.3d 1009 (9th cir. 2006), rev’g 122 t.c. 32 (2004). 154. id. at 1015. 155. see supra note 79. 0 2 4 6 8 10 12 §6015(b ) §6015(c ) §6015(f) 2012] empirical study of innocent spouse relief 661 from the data, courts appear most willing to grant relief under section 6015(c) and, thereby, to apportion liability between spouses. however, courts are not unwilling to use section 6015(f) and to go to the merits of these cases in deciding whether relief is warranted. the factors gathered from the cases will be discussed more fully below. this data allows us to evaluate the extent to which courts implement the legislature’s intent. as seen already, the broadening of the relief under section 6015(f) was intended by congress; the expectation was that the equitable provision would give taxpayers a final means of relief and taxpayers and judges are willing to use it as such. below, the article examines whether or not divorced, separated, or widowed wives who were unfairly left crushing tax burdens by their nefarious husbands — women in the factual situation with which congress was concerned — are more or less likely to be granted relief. b. characteristics of requesting spouse when congress debated expanding innocent spouse relief in 1998, its focus was on aiding divorced, separated, or widowed wives.156 the question addressed in this section is to what extent do those granted relief fit this characterization. 1. sex relief from joint and several liability is often perceived, both in congress and by academics, as relief for women.157 before the 1998 change in law, 90 percent of petitioners for innocent spouse relief were women.158 at that time, men won ten of the forty-two cases (or 23.8 percent) that they brought at the trial level and women won ninety-two of 393 cases (or 23.4 percent) that they brought.159 although their trial level winning percentages were similar, men never won on appeal and women won sixteen times (but had two opinions in their favor overturned).160 in the period since 1998, women have continued to bring most cases for innocent spouse relief. the following chart includes all cases decided on whatever grounds, grouped based on whose behalf relief was claimed. for 156. see supra notes 59–67; finance committee, supra note 58; oversight subcommittee, supra note 55; 144 cong. rec. s7647 (july 8, 1997). 157. see supra notes 59–67. 158. zorn, innocent spouses, supra note 117, at 424. 159. id. at 425 n.10. 160. id. at 425 n.10. 662 florid tax review [vol.12:8 example, if a husband claimed relief as beneficiary of his wife’s estate, it was coded as a wife’s suit.161 gendered relief brought trial case won trial case wife husband both162 wife husband 338 59 4 128 16 brought appeal won appeal 37 5 0 8 0 from the evidence, congress was right to identify innocent spouse relief as a women’s issue. wives sought relief in 85.4 percent of total cases, 85.3 percent of the trial cases and 88.1 percent of appeals. not only do women bring more cases, courts appear to be more sympathetic to wives than to husbands. wives won 21.6 percent of their appeals and 37.4 percent of their trials and husbands won 0.0 percent of their appeals and 25.4 percent of their trial cases. as a result of the dominance wives have in bringing suit, wives won 89.5 percent of total taxpayer victories. although women are more likely to litigate a claim for innocent spouse relief, both spouses can apply for relief and, if they each win, allocate liability between them.163 because much relief is granted in earlier administrative phases, it is hard to determine from the available data when both spouses sought relief, although both spouses definitely sought relief in four. if only one spouse is granted innocent spouse relief, the other remains liable for the entire debt. in response to this continuing liability, some nonrequesting spouses have protested in court. courts, however, have been unsympathetic to non-requesting spouses who sought to reduce their liability as a result of the other spouse being granted relief. 161. a non-requesting spouse might contest liability of the estate of a requesting spouse if the statute of limitations has run against the non-requesting spouse. see jonson v. commissioner, 353 1181, 1182–83 (10th cir. 2003). united states v. boscaljon, 105 a.f.t.r. 2d 1501 (2010) was excluded because the government instigated the request. 162. this column reflects cases when each spouse independently sought relief. 163. joint committee on taxation, overview of present law relating to the innocent spouse, offers-in-compromise, installment agreement, and taxpayer advocate provisions of the internal revenue code, 3 (jcx-22-01) (2001). 2012] empirical study of innocent spouse relief 663 2. marital status as much as congress identified innocent spouse relief as a women’s issue, congress also identified it with divorced or separated women.164 the requesting spouse’s marital status at the time the couple filed the return and at the time appeal was made to the courts can often be determined. for purposes of the following chart, the couple was coded as separated, divorced, or widowed if a couple was separated, divorced, or widowed for at least one year for which a claim of relief was made. if the court noted that a spouse was in the process of separating or divorcing, the couple was coded as separated or divorced. these two choices highlight the number of requesting spouses who were not in traditional relationships at the time of filing the return or are more consistent with congressional sympathies at the time of trial. marital status of those seeking relief at time of filing at time of trial wife requesting husband requesting wife requesting husband requesting married 312 44 99 8 separated (legally or physically) 31 14 12 5 divorced 11 3 210 45 widowed 6 2 44 5 other/never legally married 20 4 13 4 excluding those spouses for whom marital status is unknown or who were never married, most couples were married (86.6 percent) when they filed but divorced (59.6 percent) when they took their case to trial.165 nevertheless, forty-eight spouses (13.3 percent) filed the joint return when widowed, separated, or divorced from the non-requesting spouse. also a significant number, 107, or 25.0 percent, sought relief from joint and several liability while still married to the non-requesting spouse. many of these couples, 25.2 percent, faced liabilities as a result of an investment in a tax shelter and 29.9 percent faced liabilities as a result of unpaid taxes. in 86.7 percent of the litigated cases in which couples remained married and knowledge of the unpaid tax or the unreported item was raised, the requesting spouse was deemed to have some amount of knowledge, with 164. see supra text at notes 55–65. 165. the national taxpayer advocate reported that of those seeking relief in 2001, 34% were single filers and 51% filed as “head of household.” nta, 2005 annual report, supra note 93, at 328. thus, 85% were unmarried. 664 florid tax review [vol.12:8 40 percent having actual knowledge of the tax deficiency. these spouses are not consistent with the stereotype portrayed by congress when it enacted expanded relief in 1998. examining the marital status of those winning relief, winning at either the trial court or on appeal is coded a victory. if a spouse won on a procedural matter or if a spouse won only in part, the claim was also coded as victorious. marital status of winning taxpayers at time of filing at time of trial wife requesting husband requesting wife requesting husband requesting married 116 11 17 1 separated (legally or physically) 11 5 6 1 divorced 3 0 92 14 widowed 1 0 19 0 other/never legally married 6 2 4 1 as congress focused heavily on divorced, separated, and widowed spouses in 1998, so too the courts are more sympathetic to those spouses at trial. excluding those for whom marital status was not one of the traditional categories, 132 of 150, or 88.0 percent, of successful spouses were separated, divorced, or widowed at trial. only 14.2 percent of those who remained married were successful at trial. at the same time, it is best to have been married when filing the return; 81.9 percent of those who were successful were married at the time of the filing. some of these opinions reflect a traditional view of marriage. in korchak v. commissioner,166 the court questioned: should she be punished for being a loving, trusting wife, a homemaker and mother…? had she asked any questions about madison recycling, her husband and the accountant would have reassured her. . . . it would be egregious to take away her retirement at an age when she earned that right. the innocent spouse relief was designed for these circumstances.167 166. 92 t.c.m. (cch) 199, t.c.m. (ria) ¶ 2006-185. 167. id., 92 t.c.m. (cch) 199, 209, t.c.m. (ria) ¶ 2006-185 at 1272. 2012] empirical study of innocent spouse relief 665 but meeting the traditional congressional archetype is not always enough to win relief. in torres v. commissioner,168 an immigrant woman was held responsible for her former husband’s debts despite the irs conceding that she had no knowledge of the understatement of liability.169 although the court considered the case to be close, that she significantly benefited from the understatement and would not suffer an economic hardship from paying the tax “constrain us to conclude that it would not be inequitable to hold petitioner liable.”170 based on a balancing of equitable factors, the court held this wife liable.171 few husbands claiming relief lived in non-traditional arrangements. nevertheless, husbands seeking relief who relied on their wives to handle family finances won relief 38.5 percent of the time, which is more often than husbands normally won. on the other hand, in maluda v. commissioner,172 an estranged wife took the money the husband claimed was designated to pay the tax attributable to her husband’s income.173 the court did not grant him relief.174 in stewart v. commissioner,175 that the husband knew his wife was employed was sufficient to overcome his claim that his wife handled all of the family’s finances. 3. other characteristics many members of congress depicted innocent spouses as “women, most of them working moms struggling to make ends meet.”176 a review of common characteristics of requesting spouses should shed light on whether the courts shared an image of those worthy of relief. from the facts of the cases, there is nothing distinctive about wives or husbands who seek relief. for example, in twenty-six cases, requesting wives were teachers or former teachers, in nineteen they were nurses or former nurses, in one she was a 168. t.c. summ. op. 2009-170. 169. id. 170. id. 171. id. 172. 98 t.c.m. (cch) 545, t.c.m. (ria) ¶ 2009-281. 173. id. 174. 98 t.c.m. (cch) 545, 546, t.c.m. (ria) ¶ 2009-281 at 2040. the husband stipulated to unfavorable facts. while the court wanted to grant relief, it felt constrained not to. id. 175. see t.c. summ. op. 2010-31. 176. 144 cong. rec. s4493 (1998) (statement of senator spencer abraham). see also cong. rec. h10003 (1997) (statement of representative jerry weller), s1072 (statement of senator al d’amato), s4473 (statement of senator bob graham), h5356 (statement of representative johnson); finance committee, supra note 58 (statement of chairman johnson). 666 florid tax review [vol.12:8 producer at abc and another two had phds, and in five they had attended law school. in two cases the requesting husband was guilty of a crime related to the tax filing; in eight the husband was trained as a lawyer or had (or was obtaining) his mba; and in four the wife had embezzled the unreported income. thus, there were many different types of people who requested innocent spouse relief. the following chart provides information regarding the education level of the requesting spouse. education level requesting relief winning relief husband wife total husband wife total less than high school 2 9 11 1 7 8 (72.7%) high school / ged 4 39 43 0 19 19 (44.2%) some college or less than 4 year degree 4 28 32 3 13 16 (50.0%) college degree 12 69 81 3 23 26 (32.1%) postgraduate 8 15 23 1 5 6 (26.1%) spouses did better than average when the court mentioned the requesting spouse’s education level. compared to the total average winning percentage of 34.7 percent, these spouses won 39.5 percent of their claims. the amount of education and the perception of education also matter, with those having lesser education generally doing better. in three of the four cases in which the court found the requesting spouse was well or highly educated, judges denied relief. for the three claims with graduate degrees in business, one won in small part. of the eight claims for relief made by lawyers, all lost. because congress depicted innocent spouses as those who were struggling with the tax burden (sometimes as housewives and sometimes as single working mothers), the following chart examines their employment, both at the filing and at the trial.177 177. compare finance committee, supra note 58, at [8] and [176]. 2012] empirical study of innocent spouse relief 667 employment requesting relief winning relief husband wife total husband wife total non-requesting spouse primary earner at filing 2 72 74 0 36 36 non-requesting spouse not primary earner at filing 38 169 207 11 58 69 not employed at trial 2 47 49 1 25 26 employed at trial 33 148 181 9 48 57 from a small sample, when husbands requested relief and their wives were the couples’ primary earners, husbands never won relief. more surprisingly, if husbands requested relief when their wives were not the primary earners, husbands won 28.9 percent of the time. on the other hand, when wives requested relief and their husbands were primary earners, wives won relief 50.0 percent of the time; and if the non-requesting husband was not the primary earner, the wife won 34.3 percent of the time. judges also granted relief to 53.1 percent of those requesting spouses noted not to be employed at the time of the trial and only to 31.5 percent of those who were then employed. finally, congress concluded, “perhaps most egregious of all . . . [collection] efforts are often undertaken without regard to the impact that they will have on the welfare of the innocent children involved. . . .”178 care for dependent children requesting relief winning relief husband wife total husband wife total caring for children 10 73 83 2 35 37 almost 45 percent of requesting spouses who were noted as caring for dependent children were granted relief. although not mentioned by congress, one characteristic that might be important for winning relief in the courts is whether the requesting spouse is represented by counsel at trial.179 178. id. at [22]. 179. for fiscal year 2010, thirty-six section 6015 cases were appealed to the courts, of which 56% of the requesting parties were pro se. this was the lowest 668 florid tax review [vol.12:8 representation requesting relief winning relief husband wife total husband wife total represented 22 182 204 4 68 72 pro se 45 198 243 13 69 82 wives (47.9 percent) are more likely than husbands (32.8 percent) to be represented when appealing the denial of innocent spouse relief. however, representation does not appear to be a critical matter for determining whether a spouse wins. in total, 35.3 percent of represented spouses won; 33.7 percent won when they were pro se. on the other hand, wives won 37.4 percent of the time when they were represented and 34.8 percent when they were pro se; husbands won 18.2 percent when they were represented but 28.9 percent when they were pro se. included in those who were pro se are eleven cases in which either the requesting spouse or the non-requesting spouse, if the couple remained married, was an attorney. in those eleven cases (of which six wives were the requesting spouse), the requesting spouse lost each time. 4. summary from the available evidence, courts appear to share congress’s expectations that wives will request innocent spouse relief and that certain types of wives are more likely to be the intended beneficiaries of relief. for example, having a marital status both when filing the return and litigating in court that conforms to stereotypes can be helpful in winning relief. the existence of traditional marital relationships does not always work for or against requesting wives, although husbands who take untraditional roles find it hard to win relief. although other characteristics of requesting spouses vary greatly, those spouses most likely to win are those that conform to congressional archetypes, such as those who are unemployed or care for dependent children. those without a high school education are more likely than their percentage among the ten most litigated issues. nta, 2010 annual report, supra note 17, at 416. of the twenty cases in which the taxpayer was pro se, the taxpayer prevailed in whole or in part six times, or 30%. id. at 417. when the taxpayer was represented, in sixteen cases, the taxpayer prevailed eight times, or 50%, the most successful among the top ten issues. id. leandra lederman and warren b. hrung, do attorneys do their clients justice? an empirical study of lawyers’ effects on tax court litigation outcomes, 41 wake forest l. rev. 1235, 1282 (2006), conclude that represented clients do better in tax court litigation. 2012] empirical study of innocent spouse relief 669 more educated counterparts to win relief. the need for representation is less clear, although it is more helpful for wives than husbands. c. nature of the tax burden in its 1998 debates, congress concentrated on spouses burdened by an “unfair obligation” who “have become financially wiped out when they find themselves liable for taxes, interest, and penalties because of actions by their spouse of which they were unaware.”180 this section explores to what extent do those granted relief fit this characterization. 1. unfair burden a. source of liability as congress considered the circumstances surrounding the generation of tax liabilities, so too might those circumstances influence whether a court perceives a burden as unfair. for example, courts might be less sympathetic if the deficiency arose from an investment in a tax shelter or if large, or small, amounts of revenue are at stake. on the other hand, that the requesting spouse’s subsequent refunds are used to pay an old debt might be more sympathetic than if the spouse is litigating other tax issues and innocent spouse relief is only one of many taxpayer defenses. the section 6015 cases reflect many sources of liability. in cases with multiple issues, each issue was counted separately. source of liability unpaid tax unreported income disallowed tax shelter disallowed deductions other not provided number of cases 180 110 50 45 41 40 percentage of cases 38.6% 23.6% 10.7% 9.7% 8.8% 8.6% number won 65 36 14 22 12 14 winning percentage 37.8% 32.7% 28.0% 48.9% 29.3% 35.0% most cases seeking innocent spouse relief involved properly reported but unpaid tax. with respect to these appeals, courts granted relief more often than the average success rate for innocent spouse cases of 34.4 percent. tax returns that understated couples’ income are both appealed less frequently than unpaid tax cases and have a lower winning percentage, despite the fact 180. 144 cong. rec. s1072 (statement of senator d’amato); s4511 (1998) (statement of senator dodd). 670 florid tax review [vol.12:8 that underreporting of taxes constitutes a much larger proportion of the gross tax gap than the underpayment of taxes.181 there were significantly fewer cases involving disallowed deductions, but their winning percentage was much higher. of the twenty-four cases when courts noted the culpability of requesting spouses beyond that of mere knowledge of the tax deficiency, requesting spouses lost all of their claims. on the other hand, in the ten opinions noting that the requesting spouse was not culpable in the tax evasion, the requesting spouse won 60 percent of the time. for investments in tax shelters specifically, spouses who had invested in tax shelters appealed an irs denial of relief fifty times. requesting spouses involved with the invalidation of tax shelters were granted relief 28.0 percent of the time. one law firm, merriam, pierson, and gellner, litigated sixteen cases that arose from tax shelters, each involving buyers of interests in fraudulent partnerships, and won one case in which the irs conceded it did not prove the requesting spouse had actual knowledge of the investment and three cases for litigation costs because the irs did not initially grant relief. in general, a significant source of tax avoidance is self-employment income. self-employed taxpayers have relatively low overall compliance rates, at 43 percent, compared to those who earn wages, where taxpayers pay approximately 98 percent of their taxes.182 because of these lower compliance rates, self-employed spouses might unfairly leave their mates with unpaid tax bills. in 103 cases, or 23.2 percent of all section 6015 cases, the non-requesting spouse was self-employed and courts granted relief in 50.5 percent. on the other hand, in twenty-seven cases, 6.1 percent, the requesting spouse was self-employed and, in that context, won relief in only 22.2 percent. thus, self-employment by non-requesting spouses appears to increase the chance of relief being granted while the self-employment of requesting spouses decrease it. who prepares the couple’s tax return may also play a role in how a court will perceive the source of liability. for the following chart, twentyseven returns were counted as both spouse-prepared and professional / software prepared if one spouse was stated to work closely with the return preparer or to use the software. 181. underreporting of the individual income tax constitutes $235 billion and the underpayment of all taxes is $46 billion. irs news release, irs estimates $450 billion gross tax gap for 2006, table 1, 2012 tnt 5-51. 182. irs news release, irs updates tax gap estimates, ir 2006-28 (feb. 14, 2006) (accompanying charts). nina olson, olson testifies on fairness in irs enforcement, 2007 tnt 44–28. 2012] empirical study of innocent spouse relief 671 return preparer wife prepares & seeks relief wife prepares/ husband seeks relief husband prepares & seeks relief husband prepares/ wife seeks relief professional preparer /software shelter promoter number of cases 17 8 13 42 135 17 percentage of cases 3.8% 1.8% 2.9% 9.5% 30.4% 3.8% number won 6 6 3 22 50 5 winning percentage 35.3% 75.0% 23.1% 52.4% 37.0% 29.4% in 239, or 53.8 percent, of section 6015 cases, the court did not indicate who prepared the return. however, in thirty cases that do make this observation, the spouse seeking relief also prepared the return. in these cases, the requesting spouse’s success rate was 30 percent, but women did significantly better than men. on the other hand, a wife requesting relief when her husband prepared the return won 52.4 percent of the time, but a husband requesting relief when his wife prepared the return won 75 percent of the time. spouses’ success rate when a shelter promoter prepared the return is less than spouses’ success rate in cases involving tax shelter investments generally. as shown below, who handled family finances was used as an indicator of knowledge of the source of the liability in 34.7 percent of cases. family finances wife controls finances & seeks relief wife controls finances / husband seeks relief husband controls finances & seeks relief husband controls finances / wife seeks relief separate finances both controlled number of cases 39 13 2 73 12 15 percentage of cases 25.3% 8.4% 1.3% 47.4% 7.8% 9.7% number won 10 5 0 43 11 2 winning percentage 25.6% 38.5% 0% 58.9% 91.7% 13.3% judges noted most frequently when the husband controlled the finances and the wife sought relief, and they granted relief in these cases 58.9 percent of 672 florid tax review [vol.12:8 the time.183 similarly, when wives controlled the finances and husbands sought relief, courts granted relief more than the average success rate.184 courts are most likely to grant relief when judges note that couples keep their finances separate. if both spouses participate in family finances (or husbands handle the finances and then seek relief), relief is much harder to obtain. similarly, although the subset is small, working in the same business with the non-requesting spouse affects the courts’ decisions, unless the requesting spouse is clearly a dependent worker. for example, in sykes v. commissioner,185 the wife kept the records for her husband’s law practice and was held liable for taxes on income the business generated. on the other hand, in harper v. commissioner,186 the wife sometimes drove patients at a substance abuse treatment facility operated by her husband but otherwise had no knowledge of the business’s finances, and she was held not responsible for knowing of the operation’s income. finally, what caused the requesting spouse to initiate the request might impact judges’ perception of the tax burden. in 17.1 percent of section 6015 cases, the court noted that the government had used the requesting spouse’s refund, garnished wages or accounts, or imposed a levy on property in order to satisfy the liability. in 7.6 percent of those cases, the court granted relief. in 12.8 percent of all section 6015 cases, the court noted that the government had issued a notice of determination or intent to collect and, in 33.3 percent of these cases, the court granted relief. finally, in 4.1 percent of cases the court noted that the requesting spouse was litigating other tax issues and, in 44.4 percent, the court granted relief. this result could lead one to conclude that judges do not weigh this factor significantly when considering relief for requesting spouses. 183. for example, in doyle v. commissioner, 94 fed. appx. 949 (3d cir. 2004), despite having only a high school education, the wife was held to know about a horse breeding tax shelter because of her role writing family checks and handling household expenses. “nancy certainly should have been alerted to the prospect that ‘something is rotten in the state of denmark’ when she signed a tax return that deducted almost 70% of the couple’s gross income–something that on its face reduced the family’s apparent income to a level totally at odds with the couple’s lifestyle.” id. at 952. 184. when a husband relied on his wife to handle the family’s finances, as his mother had done when he was a child, the court held he still had a duty to inquire. molsbee v. commissioner, 98 t.c.m. (cch) 331, 332, t.c.m. (ria) ¶ 2009-231 at 1732. 185. 98 t.c.m. (cch) 105, 151, 156, t.c.m. (ria) ¶ 2009-197 at 1473– 74, 1480. 186. t.c. summ. op. 2010-153. 2012] empirical study of innocent spouse relief 673 b. knowledge of liability committee reports, and many statements made on the congressional floor, stressed that an innocent spouse has no knowledge of his or her spouse’s actions.187 in two of the methods for obtaining relief under § 6015, congress included the requesting spouse’s knowledge of the tax deficiency as a factor in determining whether the spouse was unfairly saddled with a tax burden.188 congress did not include knowledge of liability in the more openended equitable relief of section 6015(f); but, under the treasury department’s rules interpreting section 6015(f), knowledge is included as an equitable factor.189 for cases decided on the merits (so that knowledge would be a consideration), the requesting spouse’s knowledge was raised in 269 cases, or 93.7 percent. moreover, in six cases decided on procedural grounds, for which knowledge is not a deciding factor, the court noted that the requesting spouse had knowledge or reason to know and, sided with the government in all but one. therefore, it is unsurprising that when a wife conceded knowledge but argued it was “legally irrelevant” the court disagreed.190 whether imposed by congress or the treasury department, what the knowledge standard is depends on the type of relief the requesting spouse is claiming. for purposes of section 6015(b) and (f), whether the requesting spouse knew, or had reason to know, of the understatement (or underpayment for section 6015(f)) is determined by whether the irs can prove the spouse actually knew of the deficiency or whether a reasonable person in similar circumstances would have known.191 the irs may deny relief if the taxpayer had reason to know of the cause of the deficiency, although it is only one factor to be weighed pursuant to the equity prong. until the irs’s recent proposed changes, however, actual knowledge, was “a 187. see h. rep. no. 105-174; h. rep. 105-599; 144 cong. rec. s4492 (statement of barbara boxer), s4500 (statement of dianne feinstein), s1072 and h7623 (statement of william roth), and s7653 (statement of carol moseley-braun). 188. i.r.c. § 6015(b)(1)(c); i.r.c. § 6015(c)(3)(c). knowledge is tested at the time the original return was filed to encourage married couples to file amended returns. see billings v. commissioner, 94 t.c.m. (cch) 183, 186–87, t.c.m. (ria) ¶ 2007-234 at 1426 (2007). 189. rev. proc. 2003-61, 2003-2 c.b. 296, 298; notice 2012-8, § 4.03(2)(c), supra note 9. 190. mellen v. commissioner, 84 t.c.m. (cch) 530, 538, t.c.m. (ria) ¶ 2002-280 at 1703 (2002). 191. reg. § 1.6015-2(c). before 1998, the courts gave the explanation that spouses had “reason to know” for denying relief approximately 55% of the time. zorn, innocent spouses, supra note 117, at 425. 674 florid tax review [vol.12:8 strong factor weighing against equitable relief” in cases where taxes are understated on the return.192 how to judge what one should reasonably know depends both on the cause of the tax liability and how the judge applies the test. for cases of underpayment of taxes on correctly filed returns, the irs questions whether the requesting spouse had reason to know the non-requesting spouse would not pay the tax.193 similarly, the irs considers whether the requesting spouse did not know or have reason to know of the item giving rise to the deficiency when taxes are understated.194 courts’ applications of these tests are not so clear, particularly when evaluating understatements. for example, for income understated on the return, the question can be whether the requesting spouse knew of the underlying transaction producing the income or should have known (or questioned) about additional income based on family expenses.195 for overstated deductions, that requesting spouses must know of the underlying transaction can be applied as whether a reasonable person looking at the return would question whether the deduction was odd and so trigger an obligation to inquire or as whether the requesting spouse had actual knowledge of the transaction that produced the overstated deduction.196 unlike section 6015(b) and (f), in section 6015(c), which provides for apportioned relief, congress placed the burden on the irs to prove that the requesting spouse had actual knowledge of the understatement to the satisfaction of the courts.197 actual knowledge is meant to be a higher standard than the reason to know test provided in section 6015(b) and (f); however, scholars complain that it has been interpreted by the courts to require only knowledge of the underlying transaction and that this 192. rev. proc. 2003-61, 2003-2 c.b. 296, 298; notice 2012-8, § 4.03(2)(c)(i), supra note 9. 193. id. 194. id. the regulations adopt a facts and circumstances test. reg. § 1.6015-2(c), 3(c)(2)(b)(1). 195. compare mitchell v. commissioner, 292 f.3d 800, 803-04 (d.c. cir. 2002) with ohrman v. commissioner, 86 t.c.m. (cch) 499, 503, t.c.m. (ria) ¶ 2003-301 at 1666 (2003), aff’d, ohrman v. commissioner, 157 fed. appx. 997 (9th cir. 2005). 196. compare hopkins v. commissioner, 121 t.c. 73, 80 (2003) with phemister v. commissioner, 98 t.c.m. (cch) 163, 171, t.c.m. (ria) ¶ 2009-201 at 1503 (2009). in price v. commissioner, referenced in forty-seven cases in this sample, the ninth circuit reasoned that since erroneous deductions are necessarily reported on a tax return, any spouse who signs the joint return is put on notice that an income-producing transaction occurred. 887 f.2d 959, 965 (9th cir. 1989). 197. i.r.c. § 6015(c)(3)(c). this has been interpreted to mean actual knowledge of the factual circumstances which gave rise to the erroneous deductions. see king v. commissioner, 116 t.c. 198, 204 (2001); reg. § 1.6015-3(c)(2)(b)(2). 2012] empirical study of innocent spouse relief 675 “weaken[s] the intended remedial effect.”198 the treasury department states that if the requesting spouse made a “deliberate effort” to avoid learning about the taxes owed or jointly owned the property, the irs can conclude the spouse had actual knowledge.199 the following chart examines the types of knowledge that courts have found in cases decided on the merits.200 as discussed above, although cases were often brought under a combination of subsections, courts tended to grant relief under only one subsection. findings of knowledge § 6015(b) § 6015(c) § 6015(f) § 6015(b), (c), and/or (f) brought wins brought wins brought wins brought wins court finds actual knowledge 6 3 4 31 13 68 1 court finds constructive knowledge or reason to know 2 2 4 41 6 33 3 spouse or irs concedes knowledge 1 0 5 1 2 court finds no knowledge 4 11 11 15 26 30 24 5 unknown; not discussed 1 4 3 4 3 5 when taxpayers won under section 6015(b), the court always found that the requesting spouse did not know or have reason to know of the deficiency. this was not the case for wins under section 6015(f) or section 6015(c), the latter being unexpected because one of section 6015(c)’s requirements is that the requesting spouse must not have actual knowledge of the deficiency. for 56.6 percent of requesting spouses who won under section 6015(f), the court found no knowledge, but in 37.7 percent of the cases won under section 6015(f), the requesting spouse either had actual knowledge or reason to know of the deficiency. the results are similar under section 6015(c). for 57.7 percent of requesting spouses who won under section 6015(c), the court found no knowledge of the deficiency. however, 198. i.r.c. § 6015(c)(3)(c); beck, failure, supra note 20, at 948. see also attestatova, bonds of joint tax liability, supra note 20, at 863–64, senators bob graham, al d’amato, dianne feinstein, and tim johnson introduced an amendment to make the actual knowledge test apply at the time the individual signed the return. 144 cong. rec. s4544 (1998) (proposed amendments to h.r. 2676). 199. reg. § 1.6015-3(c)(iv). requesting spouses can overcome actual knowledge if they were victims of domestic violence and did not challenge the filing for fear of retaliation. reg. § 1.6015-3(c)(v). 200. cases for litigation costs or on other grounds are omitted from the chart. 676 florid tax review [vol.12:8 in 15.4 percent of the cases in which a spouse won under section 6015(c), the court found actual knowledge; and in 11.5 percent, the court did not discuss knowledge despite it being a requirement for deciding relief on the merits. courts found constructive knowledge when a requesting spouse did not review the completed return or signed a blank return. requesting spouses were expected to know what they signed unless they were prevented from reviewing the return. in twenty-six of the cases decided on the merits, judges found that there was constructive knowledge.201 in addition, in jones v. commissioner,202 the court found that if a requesting spouse was on notice that the other spouse had unreported income but did not know the exact amount of income, the requesting spouse must fulfill a duty of inquiry or risk being charged with constructive knowledge of the understatement. nevertheless, the requesting spouse in jones was granted relief under section 6015(f) after balancing all of the factors weighing for equitable relief. in several cases, spouses were required to exercise greater diligence than simply requesting information. in cheshire v. commissioner203 and wiksell v. commissioner,204 wives noticed either an ineligible deduction or unreported income on the return and asked about the tax consequences of the mistakes. for that reason, they were held to have actual knowledge of the deficiency and, ultimately, denied relief. much as ignorance of what is on the return provides little relief, ignorance of the law is unlikely to win relief if it means relieving one spouse completely, despite the aba’s 1995 proposal that would have allowed ignorance of the law as a defense.205 in the seven cases in which a spouse claimed reliance on bad advice, either from a return preparer or tax software, the resulting ignorance of the law was no excuse for lack of knowledge. in one case, a wife who prepared the couple’s tax return failed to win relief because she had incorrectly relied on an accountant’s opinion that certain of her former husband’s disability income was excluded from tax.206 in another case, the wife signed relying relied on her divorce attorney’s incorrect 201. but see sunleaf v. commissioner, 97 t.c.m. (cch) 1283, 1286, t.c.m. (ria) ¶ 2009-052 at 413-14 (2009) (wife who relied on her husband to file the returns and, therefore, did not review them, was granted relief). 202. 99 t.c.m. (cch) 1457, 1460, t.c.m. (ria) ¶ 2010-112 at 667 (2010). see also kruse v. commissioner, 100 t.c.m. (cch) 524, 525, t.c.m. (ria) ¶ 2010-270 at 1636 (2010); pierce v. commissioner, t.c. summ. op. 2003126. 203. 282 f.3d 326, 300 (5th cir. 2002). 204. wiksell v. commissioner, 67 t.c.m. (cch) 2360, 2367, t.c.m. (ria) ¶ 94,099 at 94–485 (1994), rev’d, wiksell v. commissioner, 90 f.3d 1459 (9th cir. 1996). 205. aba, proceedings of the 1995 midyear meeting, supra note 51, at 5– 6. 206. jaske v. commissioner, t.c. summ. op. 2010-85. 2012] empirical study of innocent spouse relief 677 explanation of the creation of loss “credits.”207 in both cases, reliance was to their detriment. judges also hold that lack of knowledge of joint and several liability is no excuse but with greater reservation. in kelly v. commissioner,208 a wife claimed that she believed she had to file jointly because she was married. “on the basis of the level of petitioner’s education, the amount of her control over the filing of the tax returns, and her extensive communication with the tax preparer, the court finds this argument unpersuasive. even if petitioner did not have a comprehensive understanding of tax laws, she had reason to know of her joint and several liability for the taxes shown on the joint returns.”209 in washington v. commissioner,210 a wife “was under the impression that she was required to file a joint return because she was married at the time” (although she had previously filed as married filing separately).211 after balancing equitable factors, the court granted relief but not on the basis of ignorance of the law. judges are more sensitive to claims of ignorance of the law when relief is being granted under section 6015(c). in mora v. commissioner,212 both spouses relied on a tax shelter promoter but the liability was allocated to the husband. similarly, in king v. commissioner,213 the husband, a used car salesman, also owned a cattle ranch. the wife kept the records for the venture and prepared the couple’s tax returns. the tax court sustained the wife’s separation of liability under section 6015(c) because the tax treatment of the venture depended upon the husband’s subjective intent to make a profit. although the wife knew of the business, the irs was required to prove that the wife knew that the ranch operated as a hobby and not for profit. the treasury department supports a stronger position against ignorance of the law defenses for fear that it would necessarily lead to further expansion of this defense: “there is no apparent reason why the tax liability of both spouses should not be excused if they both did not understand the tax consequences of their transaction.”214 in other words, both spouses may be equally ignorant so that it might inequitable to excuse one but not both from the liability. in this sample, no court has responded to this concern. 207. estate of gurr, t.c. summ. op. 2002-7. 208. 100 t.c.m. (cch) 507, 512, t.c.m. (ria) ¶ 2010-267 at 1615 (2010). 209. id. 210. 120 t.c. 137, 202 (2003). 211. id. 212. 117 t.c. 279, 281 (2001). 213. 116 t.c. 198, 205-06 (2001). 214. report on joint liability, supra note 13, at 51. see also t.d. 9003, supra note 128, at 29. 678 florid tax review [vol.12:8 ignorance of the law is, therefore, sometimes an excuse. ignorance of the facts underlying the return tends to be more leniently considered, although this standard is not applied consistently. for example, in braden v. commissioner,215 the court held that a husband had no knowledge of the deficiency despite knowing his former wife had received a distribution from her father’s estate. “although ms. braden certainly was in a position to know that the distributions came from her father’s ira’s, the record does not contain any evidence that she or anyone else told petitioner that the distributions consisted of ira withdrawals and interest income or gave him any reason to conclude the distributions were taxable.”216 on the other hand, in charlton v. commissioner,217 a husband was not allowed to rely upon summaries of schedule c expenditures provided by his wife when he prepared the couple’s returns. the question runs through these cases of what a spouse, particularly a wife, can be expected to know about family finances. however, the more a requesting spouse is told about family finances, the more likely the spouse is to be held knowledgeable of tax deficiencies.218 it is hard to win relief if a spouse discusses finances with the requesting spouse even if the requesting spouse ultimately defers.219 it is also hard to win relief if the judge finds that the spouse should have known more about the family’s finances. in alt v. commissioner,220 a doctor funneled his earnings through dozens of corporations to reduce the couple’s tax liability. the court was unpersuaded by the argument that the doctor’s wife, a college-educated, 74-year-old woman “was reared in a culture that demanded women refrain from questioning [the] breadwinner regarding fiscal matters.”221 of course, not all couples in traditional relationships that limit access to information fare so 215. 81 t.c.m. (cch) 1380, 1383, t.c.m. (ria) ¶ 2001-069 at 527 (2001). 216. id. 217. 114 t.c. 333, 336 (2000). see also capehart v. commissioner, 204 fed. appx. 618, 620 (9th cir. 2006), aff’g, capehart v. commissioner, t.c.m. (ria) ¶ 2004-268 (2004); grossman v. commissioner, 182 f.3d 275, 231 (4th cir. 1999). 218. compare sowards v. commissioner, 85 t.c.m. (cch) 1517, 1529, t.c.m. (ria) ¶ 2003-180 at 970–71 (2003), with pierce v. commissioner, 85 t.c.m. (cch) 1553, 1560, t.c.m. (ria) ¶ 2003-188 at 1007–08 (2003). 219. see golden v. commissioner, 548 f.3d 487 (6th cir. 2008). 220. 101 fed. appx. 34, 42 (6th cir. 2004), cert denied, 543 u.s. 1000 (2004). in one pre-1998 case, judge mary ann cohen refused to allow a wife to seek innocent spouse relief after her husband pursued a different tax case covering the same tax year. the court found she “implicitly authorized” her husband to pursue the case and assumed that “it would be taken care of” by her husband. levin v. commissioner, 71 t.c.m. (cch) 2938, 2942, t.c.m. (ria) ¶ 96,211 at 96–1558 (1996). 221. alt, 101 fed. appx. at 42. 2012] empirical study of innocent spouse relief 679 badly. in thirty-two cases in which there was a traditional relationship, defined as the requesting spouse not working outside the home (unless working for the non-requesting spouse) and not handling family finances, the requesting spouse won 68.8 percent of the time. from this review, the application of the knowledge or reason to know standard does have a significant amount of inconsistency. reliance on judges to determine the credibility of witnesses is a necessary part of evaluating this factor. witness credibility was specifically raised in 110 cases, or 24.8 percent. credibility number of cases husband wins wife wins both credible 4 0 3 neither credible 7 0 1 husband credible 13 5 4 husband not credible 5 0 1 wife credible 54 0 37 wife not credible 26 0 4 irs credible 1 0 0 to the extent that one thinks the judicial system is good at evaluating witnesses, this is less a concern than for those who are more skeptical of judicial wisdom. one thing is clear, the knowledge factor is not a rote checkthe-box formulation. c. benefit from liability richard beck argues that the treasury department did not support the repeal of joint and several liability because “it saw hobgoblins of abuse waiting to pounce, in the form of fraudulent schemes where one spouse would transfer all the couple’s assets to the other to put them beyond the i.r.s.’s reach.”222 congress shared this fear. when congress expanded innocent spouse relief, it was concerned that taxpayers would transfer assets to avoid paying taxes and that some requesting spouses would unfairly receive tax relief.223 only those who were unfairly left with a tax bill should be relieved of liability.224 222. beck, failure, supra note 20, at 948 n.87. 223. see finance committee, supra note 58, at 183 (statement of sen. john chafee); 144 cong. rec. 7623 (1998) (statement of sen. william roth); h.r. rep. no. 105-599, at 253–54 (1998); h.r. rep. no. 105-364, pt. 1, at 152–53 (1997). 224. see notes 58–68. 680 florid tax review [vol.12:8 according to the treasury department, if a requesting spouse received a significant benefit from the underpayment of taxes, requiring the requesting spouse to pay the tax is not inequitable.225 however, a significant benefit is only one factor to be considered under the equitable prong of sections 6015(b) and (f) as a means of measuring whether the requesting spouse would unfairly benefit from liability relief. there is no reference to significant benefit in section 6015(c), which does not have an equity component, although an allocation is prohibited if spouses transferred property to avoid tax.226 one critic claims that the “law-abiding spouse often receives no financial benefit from the other spouse’s underpayment,”227 but the courts do not share this view. whether a spouse significantly benefits from a tax deficiency has been held the most important factor of equity.228 in 169 of the cases decided on the merits, the issue of significant benefit was raised. significant benefit court finds significant benefit court finds no benefit irs concedes no benefit court finds factor neutral number of cases 76 68 20 5 taxpayer wins 35 7 13 0 when the court found that the requesting spouse enjoyed no significant benefit from the tax deficiency, the requesting spouse won relief in 51.5 percent of cases; when the irs conceded there was no benefit, the requesting spouse won 65.0 percent of the time. on the other hand, when the court found the requesting spouse did benefit, relief was granted in 9.2 percent of cases. the issue of significant benefit was raised more often under section 6015(f) than under section 6015(b) because there are more section 6015(f) cases, but there was no meaningful difference in how the factor was used if the case was won under section 6015(b) or (f). this factor was raised in only two cases decided on section 6015(c) alone, despite section 6015(c) not requiring an equitable analysis. regulations define whether a requesting spouse significantly benefited from a tax deficiency as whether the spouse received a benefit 225. reg. § 1.6015-2(d); rev. proc. 2003-61, 2003-2 c.b. 296, 299. 226. i.r.c. § 6015(c)(4). 227. christian, joint and several liability, supra note 20, at 570–71. 228. cheshire v. commissioner, 282 f.3d 326, 338 (5th cir. 2002). 2012] empirical study of innocent spouse relief 681 beyond normal support.229 however, the regulations fail to define normal support. evidence of a benefit may, but does not have to, consist of transfers of property between spouses made at any time.230 the example provided in the regulations is of a spouse receiving life insurance proceeds beyond normal support and the insurance premiums are traceable to items omitted from gross income.231 in the two cases involving life insurance, one found there was a significant benefit and the other did not. in bozick v. commissioner,232 the court held that a requesting spouse received insurance proceeds, not because of the tax avoidance, but “because her husband paid for the life insurance policy throughout his lifetime. . . .”233 on the other hand, in george v. commissioner,234 the court held that if a husband had paid his taxes, there would have been less in the ira or insurance for the wife to receive on his death. struggling to apply this factor, judges have not agreed on what it means to create a significant benefit.235 improving cash flows, even if the money was reinvested in the tax shelter generating the cash flows, is sometimes a significant benefit to both spouses.236 similarly, paying a child’s college tuition may be a significant benefit to both spouses.237 thus, as with the knowledge standard, there is uncertainty in the application of this factor. 229. reg. § 1.6015-2(d). 230. id. 231. id. 232. 99 t.c.m. (cch) 1242, 1244, t.c.m. (ria) ¶ 2010-61 at 355 (2010). 233. id. 234. t.c.m. (ria) ¶ 2004-261 at 1581 (2004). 235. the government expects that the test for determining whether there is an economic benefit to be harder to apply in states where couples live under a community property regime; however, this arose in only one case and, in it, the court held that the wife was unlikely to receive any benefit from community funds. irs releases publication on innocent spouse relief, 2008 tnt 71-63 (april 8, 2008); haltom v. commissioner, t.c.m. (ria) ¶ 2005-209 at 1597 (2005). 236. compare capehart v. commissioner, t.c.m. (ria) ¶ 2004-268 at 1642 (2004), aff’d, capehart v. commissioner, 204 fed. appx. 618 (9th cir. 2006), juell v. commissioner, 94 t.c.m. (cch) 143, 148, t.c.m. (ria) ¶ 2007-219 at 1372–73 (2007), and abelein v. commissioner, t.c.m. (ria) ¶ 2004-274 at 1718 (2004). see also casula v. commissioner, t.c. summ. op. 2008-49; wizen v. commissioner, t.c. summ. op. 2007-99. 237. in the one case where the requesting spouse was being sent to college during the years of tax deficiency, this expenditure was held not to be a significant benefit. griffin v. commissioner, t.c. summ. op. 2005-41. 682 florid tax review [vol.12:8 ambiguity also exists in the weight to be given to this factor and who bears the burden of proof. in schultz v. commissioner,238 the court held that when the irs did not prove that the requesting spouse significantly benefited from the tax deficiency, whether the requesting spouse received a significant benefit was a neutral factor that weighed in favor of relief. thus, the burden of proof was on the irs. on the other hand, in smolen v. commissioner,239 the court concluded that there was no evidence that the taxpayer did not receive a significant benefit and, therefore, the factor weighed against relief. in smolen, the taxpayer bore the burden of proof. both cases were brought under section 6015(f). perception of the couple’s lifestyle might influence a judge’s willingness to find a significant benefit. when a couple enjoys a lavish lifestyle, it is harder for the requesting spouse to claim there was no such benefit. in twenty-two of the cases in which a significant benefit was found, the court portrayed the couple as well off, and in only one of those cases was the requesting spouse granted relief. the court frequently questions whether there was an extravagant lifestyle and, if not, finds there was no significant benefit regardless of the amount of taxes avoided.240 whether a judge will find that a couple lived lavishly is often evaluated in comparison to prior years. in butler v. commissioner,241 the court held that “although the record demonstrates that petitioner enjoyed a high standard of living during 1992 and maintained accounts at various upscale department stores where she made significant purchases, there is no evidence in the record indicating whether such expenditures were out of the ordinary when compared to petitioners’ spending habits in prior years.”242 on the other hand, unusually lavish expenditures and trips abroad are evidence of receipt of a significant benefit.243 if the requesting spouse receives assets in order to preserve them from creditors, this is often sufficient evidence that the requesting spouse would not be unfairly burdened by the tax liability. for example, in ohrman 238. 100 t.c.m. (cch) 353, 355, t.c.m. (ria) ¶ 2010-233 at 1387 (2010). 239. t.c. summ. op. 2010-106. 240. see, e.g., sjodin v. commissioner, t.c.m. (ria) ¶ 2004-205 at 1248– 49 (2004), vacated and remanded, sjodin v. commissioner, 2006-1 u.s. tax cas. (cch) ¶ 50,357, 97 a.f.t.r.2d (ria) 2006-2622 (8th cir. 2006) 241. 114 t.c. 276, 285 (2000), abrogated, porter v. commissioner, 132 t.c. 203 (2009). see also stolkin v. commissioner, 96 t.c.m. (cch) 143, 143 t.c.m. (ria) ¶ 2008-211 at 1099–1100 (2008) 242. id. 243. see, e.g., alt, 101 fed. appx. at 43; doyle v. commissioner, 94 fed. appx. 949, 953 (3d cir. 2004). 2012] empirical study of innocent spouse relief 683 v. commissioner,244 a couple was legally separated but remained living together. the husband had transferred more than $782,000 in property to his wife one week after the irs sent the couple a letter stating their tax deficiency. under the separation agreement, the husband retained only his personal belongings. the court concluded: [p]etitioner’s use of state family law as a vehicle to lend legitimacy to mr. ohrman’s transfer of assets and income to her is the type of abuse that congress expressly intended to stop by adding paragraph (4) to section 6015(c). while the state of oregon’s equitable distribution rules provided the mechanism for the transfer of mr. ohrman’s assets and income to petitioner, they do not negate the principal purpose for which the transfer occurred, the avoidance of tax.245 on this basis, the court denied the wife innocent spouse relief so that the innocent spouse rules would not protect family property. when the requesting spouse was not the transferee, not all transfers failed to protect assets from the irs. in wiener v. commissioner,246 two or three months after the irs assessed the joint tax liability, the husband transferred the family home to a trust established by his father. the court held: although we understand respondent’s concern about the timing of the transfer, we reject respondent’s implied argument that the transfer was a transfer between spouses as part of a fraudulent scheme by such spouses within the meaning of rev. proc. 2000-15, sec. 4.01(5). the transfer was not between petitioner and mr. wiener; it was between petitioner and the charles wiener trust.247 the wife was therefore granted innocent spouse relief, even though she and her husband continued to reside in the home. on the other hand, in andrews 244. 86 t.c.m. (cch) at 504, t.c.m. (ria) at 1666 (2003). see also doyle v. commissioner, 85 t.c.m. (cch) 1108, 1111–12, t.c.m. (ria) ¶ 2003-96 at 468–69 (2003), aff’d, doyle v. commissioner, 94 fed. appx. 949 (3d cir. 2004); pierce, 85 t.c.m. (cch) at 1561, t.c.m. (ria) at 1009. but see united states v. evans, 513 f. supp. 2d 825 (w.d. tex. 2007), corrected on reconsideration, united states v. evans, 100 a.f.t.r.2d 2007-6811 (w.d. tex. 2007). 245. ohrman, 86 t.c.m. (cch) at 505, t.c.m. (ria) at 1668. 246. 96 t.c.m. (cch) 227, 234, t.c.m. (ria) ¶ 2008-230 at 1230 (2008). 247. id. 684 florid tax review [vol.12:8 v. united states,248 a woman transferred substantially all of her assets to her son when she realized there was tax liability due and her suit to quiet title to her home failed. considering the requesting spouse’s unclean hands, the court noted in that wiener the non-requesting spouse transferred the property; in andrews, the requesting spouse was the transferor. when determining whether a requesting spouse enjoyed a significant benefit from the tax deficiency, courts often ignore the fungibility of money. instead, courts are likely to find a significant benefit if the government can trace money owed the government to specific expenditures. in argyle v. commissioner,249 the irs traced the nonpayment of tax to the purchase of a new car, and the court agreed that this was a significant benefit. receiving money on divorce if traceable to the deficiency, even if the marriage was abusive, has been held to be a sufficiently significant benefit.250 on the other hand, in jones v. u.s.,251 the court held that although there remained some assets that were acquired during the marriage, none were traceable to the understated income and, therefore, the wife did not significantly benefit. in addition, courts rarely look at what would have happened if the taxes had been paid. in billing v. commissioner,252 in which a husband sought relief, the court held that it was not a significant benefit to the husband that the couple was able to continue their free-spending lifestyle and afford to purchase a larger house because the wife had spent most of the embezzled money on herself. the court did not consider whether the couple could have afforded the lifestyle or the larger house if the wife had been required to fund her own spending from non-embezzled funds. applying a mathematical analysis to determine whether the requesting spouse significantly benefited is also unsatisfying as neither congress nor the treasury department has provided a numerical amount that constitutes a significant benefit. nevertheless, in haltom v. commissioner,253 the court applied such an approach. it concluded that of the $275,000 that the husband, as the non-requesting spouse, contributed to family finances from 1990 to 1992, $230,000 benefited the requesting spouse — only $25,000 more than the income they reported. because this was less than 15 percent of the couple’s adjusted gross income, the requesting spouse was held not to 248. 69 f. supp. 2d 972, 974 (n.d. ohio 1999), aff’d, andrews v. taylor, 225 f.3d 658 (6th cir. 2000). 249. t.c. summ. op. 2010-129. 250. estate of gurr, t.c. summ. op. 2002-7. 251. 322 f. supp. 2d 1024 (d.n.d. 2004). 252. 94 t.c.m. (cch) 183, 187, t.c.m. (ria) ¶ 2007-234 at 1427 (2007). see also beatty v. commissioner, 93 t.c.m. (cch) 1422, 1427, t.c.m. (ria) ¶ 2007-167 at 1123 (2007). but see george v. commissioner, supra note 234. 253. t.c.m. (ria) ¶ 2005-209 at 1597. 2012] empirical study of innocent spouse relief 685 have significantly benefited and, therefore, the burden was unfairly imposed on her. 2. crushing burden a. economic hardship in 1998, members of congress referred to the “financial and emotional distress” imposed on innocent spouses by unrelieved tax burdens.254 although congress had been concerned about innocent spouses’ economic hardship, after the enactment of section 6015 the irs was deluged with many claims for relief by divorced or separated spouses before the irs had noticed anything wrong with the couples’ returns.255 in 2000, congress responded by enacting a prohibition on filing claims for relief until a deficiency was asserted.256 therefore, a requesting spouse must now be assessed, and therefore suffer a tax deficiency, before he or she can seek relief under section 6015(c). this is consistent with the original congressional desire that the tax burden to be relieved should impose true hardship on the requesting spouse. in its interpretation of the statute, the irs incorporated this congressional objective as one equitable factor for purposes of sections 6015(b) and (f).257 for this purpose, the irs defines economic hardship as the inability to pay reasonable basic living expenses.258 determining whether a requesting spouse will suffer economic hardship requires a facts and circumstances test that looks at each requesting spouse’s unique circumstances.259 these circumstances include the requesting spouse’s age; employment status and ability to earn; number of dependents; the amount reasonably necessary for food, clothing, and housing; the cost of living for 254. 144 cong. rec. s1073 (1998) (statement of sen. bob graham). see also notes 58–68. 255. robert steinberg, three at bats against joint and several tax liability: (1) innocent spouse (2) the election to limit liability and (3) equitable relief: the treasury and courts begin to interpret irc 6015 after enactment of the irs restructuring and reform act of 1998, 17 j. am. acad. matrim. law. 403, 407 (2001) [hereinafter steinberg, three at bats]; ryan donmoyor, aba tax section meeting: divorce lawyers, tax lawyers split on election of proportionate liability, 98 tnt 149-2 (august 4, 1998) [hereinafter donmoyor, divorce lawyers]. 256. consolidated appropriations act 2001, pub. l. no. 106-554, appx. g, § 313, 114 stat. 2763, 2763a640-43 (2000). for debates regarding the value of the protective elections see donmoyer, divorce lawyers, supra note 255; steinberg, three at bats, supra note 255, at 407. 257. rev. proc. 2003-61, 2003-2 c.b. 296, 298 258. this definition is made by reference to reg. § 301.6343-1(b)(4). 259. reg. § 301.6343-1(b)(4). 686 florid tax review [vol.12:8 the geographic area; and any extraordinary circumstances. therefore, when one critic of the current innocent spouse relief stated that failing to find economic hardship is “in essence determining that she would have no trouble paying the tax,” that is not the measure of economic hardship.260 the issue of economic hardship was raised in 187 of the section 6015 cases, but of the seventy-two cases granting relief at least in part on equitable grounds, 22.2 percent, the court did not mention economic hardship.261 however, as shown in the following chart, when judges found economic hardship, it was a strong factor in favor of relief. economic hardship found not find irs conceded requesting spouse conceded not enough evidence neutral or no conclusion number of cases 40 42 5 9 85 6 percentage of cases 21.4% 22.5% 2.7% 4.8% 45.5% 3.2% number of win 37 7 3 2 11 2 winning percentage 92.5% 16.7% 60.0% 22.2% 12.9% 33.3% in order for a requesting spouse to establish that imposition of liability would create an economic hardship, evidence of the requesting spouse’s financial situation must be presented. in 44.9 percent of the cases raising the issue of economic hardship, the court noted that the requesting spouse did not offer sufficient evidence to support a claim of hardship. it was insufficient when one requesting spouse argued, “it is simply baffling that respondent cannot determine for itself that petitioner would suffer economic hardship if relief from joint and several liability is not granted when it was garnishing $557.45 from her paychecks leaving her a paltry $356.55 for two (2) weeks take home pay.”262 similarly, hardship was not established when a wife claimed that if all of her assets were liquidated and paid towards the assessment, the couple would still owe more than $1 million in taxes or when another wife argued that the economic hardship factor was “discriminatory and unconstitutional.”263 260. schumacher, administrative process, supra note 98; commissioner v. neal, 557 f.3d 1262, 1278 (2009); alt, 101 fed. appx. at 44. 261. although more cases defined economic hardship under section 6015(f) than under section 6015(b), there was no meaningful difference in the interpretation of the factor if the case was won under one or the other. 262. ware v. commissioner, 93 t.c.m. (cch) 1196, 1198, t.c.m. (ria) ¶ 2007-112 at 789 (2007). 263. chou v. commissioner, 93 t.c.m. (cch) 1152, 1158, t.c.m. (ria) ¶ 2007-102 at 732 (2007); demirjian v. commissioner, 87 t.c.m. (cch) 841, 844, 2012] empirical study of innocent spouse relief 687 there is, however, no more definitive rule defining economic hardship than that provided by the regulations. the national taxpayer advocate reported that 65 percent of those requesting relief make less than $30,000 per year.264 that information is unconfirmed by the opinions. however, some amount of annual earnings might make it impossible to be too heavily burdened. in feldman v. commissioner,265 the court found that an attorney earning $130,000 per year was “totally dissimilar from other requesting spouses, who were living at or near poverty level at the time of their request.”266 in schepers v. commissioner,267 the requesting spouse complained that he would be required to work until he was seventy-five to pay off the liability. the court dismissed this concern, finding that collection would likely be confined to the ten-year collection period and the requesting spouse would therefore not suffer unduly. the relative inconsistency of the application of the treasury department’s standard is illustrated by a comparison of rice v. commissioner268 and stephenson v. commissioner.269 in rice, the court argued that the wife appeared “to have the ability to work more than 20 hours a week and to earn more income,” and she was not granted relief.270 on the other hand, in stephenson, the wife was held to face economic hardship although she had quit three jobs. although one can imagine how these cases could be reconciled, the court did not undertake that informative step that would aid the irs in future applications of the factor. to measure whether an unmitigated tax burden would be crushing to the requesting spouse (or cause economic hardship), courts generally require specific information regarding the requesting spouse’s expenses and income, although these amounts do not always have to be substantiated.271 t.c.m. (ria) ¶ 2004-22 at 113 (2004). but see korchack v. commissioner, 92 t.c.m. (cch) 199, 217, t.c.m. (ria) ¶ 2006-185 at 1283 (2006). 264. nta, 2005 annual report, supra note 93, at 328. 265. 86 t.c.m. (cch) 50, 52, t.c.m. (ria) ¶ 2003-201 at 1092 (2003). 266. id. 267. 99 t.c.m. (cch) 1343, 1344, t.c.m. (ria) ¶ 2010-80 at 500 (2010). 268. t.c. summ. op. 2008-69. 269. 101 t.c.m. (cch) 1048, 1050, t.c.m. (ria) ¶ 2011-16 at 70 (2011). 270. t.c. summ. op. 2008-69. 271. see, e.g., drayer v. commissioner, 100 t.c.m. (cch) 465, 467–68, t.c.m. (ria) ¶ 2010-257 at 1550 (2010); kosola v. commissioner. 99 t.c.m. (cch) 1141, 1145, t.c.m. (ria) ¶ 2010-34 at 211 (2010). although the 1984 version of relief included a new spouse’s income when determining whether a requesting spouse would suffer economic hardship, the provision was omitted in 1998. i.r.c. § 6013(e)(4)(d) (repealed in 1998). in farmer v. commissioner, the court held that even though a wife had remarried, there was economic hardship because the wife could not support herself out of her own assets. 93 t.c.m. (cch) 1052, 1054, t.c.m. (ria) ¶ 2007-74 at 581 (2007). similarly, the court would not 688 florid tax review [vol.12:8 nevertheless, sufficient proof often requires significant disclosure of personal information. when a requesting wife refused to answer questions about her residence or other assets, it was deemed impossible for her to suffer an economic hardship.272 on the other hand, in one case where abuse was alleged, the court held that when a wife said she did not have the requisite information regarding economic hardship because she did not want to ask her husband, the irs had an obligation to probe further.273 despite the facts and circumstances nature of economic hardship, some generalizations can be drawn from the cases regarding what is required to meet this factor for relief. first, the test is personal to the requesting spouse and cannot be claimed by a requesting spouse’s estate.274 on the other hand, the liability need not create economic hardship, a requesting spouse may win relief if the spouse would be in hardship regardless of the liability; however, simply living in a precarious financial situation is insufficient.275 similarly, a contingent future hardship, even if caused by loss of a job at the irs, is insufficient to establish an economic hardship as is a difficulty in liquidating one’s assets.276 in motsko v. commissioner,277 even though a requesting husband could not use his assets because they were tied up in divorce proceedings, “that does not render them valueless” and they were used to negate economic hardship.278 declaration of bankruptcy is one possible indicator of economic hardship. allow the irs to presume that a requesting spouse’s children would continue paying her expenses. ferrarese v. commissioner, 84 t.c.m. (cch) 400, 402, t.c.m. (ria) ¶ 2002-249 at 1542–43 (2002). 272. d’aunay v. commissioner, 87 t.c.m. (cch) 1134, 1136-37, t.c.m. (ria) ¶ 2004-79 at 495–96 (2004). 273. nihiser v. commissioner, 95 t.c.m. (cch) 1531, 1532, t.c.m. (ria) ¶ 2008-135 at 744 (2008). 274. see jonson v. commissioner, 118 t.c. 106 (2002), abrogated, porter v. commissioner, 132 t.c. 203 (2009). 275. beatty, 93 t.c. memo. (cch) at 1426, t.c. memo. (ria) at 1121; gilliam v. commissioner, t.c. summ. op. 2004-37. 276. smith v. commissioner, 98 t.c.m. (cch) 349, 352, t.c.m. (ria) ¶ 2009-237 at 1761 (2009); kalinowski v. commissioner, 81 t.c.m. (cch) 1081, 1086, t.c.m. (ria) ¶ 2001-21 at 173 (2001). 277. 91 t.c.m. (cch) 711, 714, t.c.m. (ria) ¶ 2006-17 at 103 (2006). 278. id. 2012] empirical study of innocent spouse relief 689 bankruptcy filing husband claimed relief husband won relief winning percentage wife claimed relief wife won relief winning percentage husband filed 6 1 16.7% 19 9 47.4% wife filed 2 0 0.0% 11 7 63.6% couple filed 3 1 33.3% 30 13 43.3% each filed 0 0 0.0% 2 0 0.0% in 42.5 percent of cases, one of the spouses or former spouses had declared bankruptcy, but there was no consistent finding of economic hardship (or significant benefit) in cases mentioning bankruptcy. however, there does appear to be a gender component as wives who claimed relief, whether they or their husbands filed for bankruptcy, did significantly better than when husbands claimed relief and there was a bankruptcy filing. prior grants of section 6015 relief should help alleviate economic hardship. in forty-three section 6015 cases, the requesting spouse had previously been granted some amount of section 6015 relief. nevertheless, in 37.2 percent, thus slightly more than the average success rate of innocent spouse cases, the requesting spouse won further relief. thus, some judges use consideration of economic hardship when determining the equity of granting relief, but when they do so they are defining their own individual sense of when a tax burden will be crushing. for some judges, that there were other avenues for relief for the requesting spouse was sufficient to deny a finding of economic hardship, regardless of whether a requesting spouse wanted to pursue those options. for example, in rogers v. commissioner,279 a husband did not receive relief in the tax court, which noted that he was also seeking relief in the family court. in martinez v. commissioner,280 the court noted the wife’s situation was “highly sympathetic and credible”; however, “if petitioner is truly suffering from economic hardship, or is unable to pay the debt, then she may want to approach the irs with a request for relief under a different principle, such as an offer-in-compromise or other collection alternative. . . .”281 b. not borne by others in 1998, representative nancy johnson, chairwoman of the house ways and means oversight subcommittee, said before the hearings, “where 279. t.c. summ. op. 2010-13. see also schwind v. commissioner, t.c. summ. op. 2008-119; thompson v. commissioner, t.c. summ. op. 2008-39. 280. t.c. summ. op. 2008-165. 281. id. 690 florid tax review [vol.12:8 one spouse has fulfilled their full obligation as a wage-earning, tax-paying american, they can be assured they can get complete relief, and we, the rest of the public, will struggle with their non-performing spouse.”282 thus, at least some in congress were willing to relieve the requesting spouse of a tax burden with the understanding that the revenue might never be collected. the treasury department resisted johnson’s approach because it would put the federal government in a less favorable position than other creditors who retained joint and several liability.283 it remains to be examined whether judges, recognizing the economic burden potentially placed on requesting spouses, are influenced by the amount of government revenue that might be lost. the treasury inspector general for tax administration found that for fiscal year 2004, 6,555 requesting spouses were granted relief in the amount of $117.6 million and 10,439 were denied relief of $260.8 million.284 these numbers cannot be confirmed from the sample because not all section 6015 cases report the amount of taxes that may be relieved. of the 444 cases, it is possible to discern the amount of the tax obligation involved in 352 cases, or 79.1 percent, but it is not always clear if these sums include interest, penalties, or prior payments. amount of liability < $10,000 $10,000 $50,000 $50,001 $100,000 $100,001 $1 million >$1 million number of cases 113 102 34 74 29 number won 40 38 9 26 4 winning percentage 35.4% 37.3% 26.5% 35.1% 13.8% of the opinions that include reference to how much tax revenue is involved, 32.1 percent of the cases involved amounts less than $10,000 and 61.1 percent involved less than $50,000. only 8.2 percent of these opinions involved claims with tax bills of over $1 million, and only 13.8 percent of requesting spouses were able to win these high-value cases. of all of the cases referencing this factor that were won by the requesting spouse, 74.4 percent involved less than $100,000 in taxes. that a large percentage of cases involve relatively smaller sums is surprising because the irs’s methods for prioritizing collection focus on the aggregate amount of taxes owed, so that smaller revenue amounts get less 282. oversight subcommittee, supra note 55, at 32. 283. id. 284. tigta, accurate relief determinations, supra note 97, at 7-8. 2012] empirical study of innocent spouse relief 691 attention until interest and penalties accrue.285 smaller amounts should therefore be a smaller percentage of deficiencies asserted. nonetheless, innocent spouse relief may be one of the ways these lower-income taxpayers have to contest collection. in cummings v. commissioner,286 a divorced woman working two jobs was granted relief from a $506 liability that originated in her husband’s self-employment. she was granted relief based on her economic hardship and the fact that she did not receive a significant benefit from the nonpayment. however, smaller revenue amounts are no guarantee of relief. in freulich v. commissioner,287 a widow had income from gambling that generated $606 in taxes. the tax court would not grant her relief because the gambling was her income. in yet another case, that $2,300 of taxes owed seemed small in comparison to the requesting wife’s annual income of $46,000 was enough for the court to discount economic hardship.288 as with small revenue claims, it is hard to define what will win a large revenue case. in chou v. commissioner,289 the couple was fighting the assessment of tax because, if placed in the earlier year as the irs claimed, the couple would owe almost $2 million more in alternative minimum tax because of the exercise of stock options that quickly declined in value. the couple lost. unlike in chou, in barranco v. commissioner290 and pierce v. commissioner,291 the couples enjoyed extravagant lifestyles and blatantly abused the tax system. in those cases the couples also lost. for the three cases with more than $1 million of tax liability owed which were won on the merits, all involved requesting wives, none of the wives were found to have knowledge of the deficiency, two arose from investments in tax shelters, two wives had phds and one had a masters degree, and in two cases the husband handled the family’s finances but in the other the wife handled them. except for very large revenue cases, the amount of the liability does not appear to affect the outcome of the case. similarly, whether the nonrequesting spouse would be able or unable to pay the taxes owed was raised in only ninety-seven section 6015 opinions.292 therefore, in 78.2 percent of all section 6015 cases, no mention was made of the ability to recover from 285. olson testifies on fairness in irs enforcement, 2007 tnt 44-28 (mar. 5, 2007). 286. t.c. summ. op. 2007-77. 287. t.c. summ. op. 2007-124. 288. meadows v. commissioner, t.c. summ. op. 2007-42. 289. 93 t.c.m. (cch) 1152, 1156 t.c.m. (ria) ¶ 2007-102 at 730 (2007). 290. 85 t.c.m. (cch) 778, 785, t.c.m. (ria) ¶ 2003-18 at 70–71 (2003). 291. 85 t.c.m. (cch) 1553, 1560, t.c.m. (ria) ¶ 2003-188 at 1008 (2003). 292. in 57% of the cases in which reference was made to the other spouse, the non-requesting spouse was deceased. 692 florid tax review [vol.12:8 the non-requesting spouse. of those ninety-seven cases, only seven stated or implied that the non-requesting spouse could pay the tax. in 43.3 percent of the cases in which the court mentioned that the non-requesting spouse was in no financial position to pay the taxes owed, the requesting spouse nevertheless won relief, above the average success rate. therefore, judges do not seem particularly concerned about the government losing revenue. in some cases, requesting spouses have been relieved of liability not only for taxes attributable to the non-requesting spouse but also for liability on their own earnings or for refunds they have received.293 for example, in gilbert v. commissioner,294 a husband was granted section 6015(f) relief from a tax liability attributable to his own earnings because his wife handled the family’s financial affairs and the court found that he had no reason to know that she would not pay the taxes owed. in yakubik v. commissioner,295 a husband was granted relief when he did not know of his wife’s embezzled funds. the underreporting of income allowed the couple to claim the earned income tax credit, and relief meant that he was not required to pay back the refund they had received. the amount of refund was larger in campbell v. commissioner,296 in which a wife was relieved of liability after her husband settled a $2.8 million liability for $100,000. the couple had received a $314,000 refund that did not have to be repaid. 3. summary although congress was concerned about the irs unfairly imposing a crushing tax burden on innocent spouses, courts are concerned with only certain features of that burden. judges are not particularly concerned about the circumstances surrounding the application for innocent spouse relief. neither what motivated the requesting spouse, the tax issues involved, or (at least for all but the largest tax obligations) the amount of revenue at stake appear to significantly affect how judges rule. there might be some indicators favoring relief, such as the existence of disallowed deductions or unpaid taxes both having a slightly higher than average success rate, and judges are possibly suspicious when a requesting spouse is self-employed, but these factors are not dominant. judges care more strongly about the amount of knowledge the requesting spouse possessed of the deficiency and whether the requesting spouse benefited from it. however, both knowledge of the liability and 293. but see freulich, t.c. summ. op. 2007-124. 294. t.c. summ. op. 2007-16. 295. t.c. summ. op. 2008-74. 296. 91 t.c.m. (cch) 735, 737, t.c.m. (ria) ¶ 2006-24 at 138 (2006). the house was also in the requesting spouse’s name and the husband’s situation had since improved. 2012] empirical study of innocent spouse relief 693 whether a requesting spouse benefited are vaguely defined. despite the regulations, courts have yet to establish a generally applicable rule to define these factors. what seems extravagant or crushing to one judge might not to another. thus, judges impose their own interpretation of congressional intent without producing judicial guidelines for what that intent means in practice. d. characteristics of non-requesting spouse congress’s 1998 debates regarding innocent spouse relief depicted the “other” spouse as saddling the innocent spouse with unfair and crushing tax burdens.297 this section evaluates whether the non-requesting spouses of those granted relief by the courts should be characterized as such based on the available evidence. 1. abusive as described in the prior part, consequences differ significantly if a court finds a requesting spouse signed a return under abuse as opposed to duress.298 if a spouse signs a return under duress, there is no joint return.299 originally, if a spouse signed as a result of abuse not amounting to duress there was no relief. despite current attention directed to the problem of domestic violence, little attention was given to it in 1998, but for an amendment late in the legislative process that recognized the problem.300 the irs subsequently issued guidance providing that if a requesting spouse 297. see notes 58–68. there is nothing to prevent both spouses from seeking innocent spouse relief and allocating liability between them. this was not mentioned in congressional debates. 298. this section does not make any statement about what should constitute abuse or which spouses were actually abused. the former is beyond the scope of this article and the latter determination is too fact specific to be made from the evidence available in the opinions. for more on domestic violence, see deborah m. weissman, the personal is political — and economic: rethinking domestic violence, 2007 byu l. rev. 387 (2007); michelle madden dempsey, what counts as domestic violence: a conceptual analysis, 12 wm. & mary j. women & l. 301 (2006); mary ann dutton & lisa goodman, coercion in intimate partner violence: toward a new conceptualization, 52 sex roles 743 (2005); emily j. sack, battered women and the state: the struggle for the future of domestic violence policy, 2004 wis. l. rev. 1658 (2004). 299. rev. proc. 2003-61, 2003-2 c.b. 296, 297. 300. 144 cong. rec. s4468, s4500 (1998) (statements of various senators); kerns, duress, supra note 20; gary m. fleischman & jeffrey j. bryant, a critique of the innocent spouse equitable relief provisions, 90 tnt 1716 (mar. 19, 2001); sheryl stratton & emily field, innocent spouse issues plague practitioners, irs, and courts, 2000 tax notes 115-4 (june 14, 2000). 694 florid tax review [vol.12:8 can prove to have been abused, the spouse has a stronger case for equitable relief under section 6015(b) and (f) and can overcome actual knowledge of the deficiency under section 6015(c). nevertheless, for the equitable test as applied in these cases abuse was only one factor among many, and it is not intended be given more weight than other factors.301 neither the statute nor the regulations define abuse. some critics claim that because there is no clear standard defining abuse, it is too hard for requesting spouses to prove. while the recent notice defines abuse broadly, prior to its publication national taxpayer advocate nina olson denounced the irs in 2011 for denying an abused woman relief.302 in her opinion, irs employees who handle these cases demonstrate an unconscionable lack of knowledge about domestic violence.303 the case at issue was stephenson v. commissioner,304 in which the irs granted an ex-wife relief for one year but not for another, focusing on her lack of economic hardship, her receipt of a significant benefit from the unpaid tax, and her knowledge of the deficiency. the court overturned the irs and extended relief for both years. the court opined that “the verbal abuse turned into physical abuse, and mr. stephenson began throwing items at petitioner when he became angry . . . . if petitioner asked what she was signing, mr. stephenson made threats of violence or told her she was not intelligent enough to understand. . . .”305 in the court’s and the taxpayer advocate’s opinion, the abuse was sufficient to outweigh the other factors and establish equitable relief. the following charts document the number of cases referencing abuse and the number of cases over time. the latter chart looks only at whether the judge found or dismissed the claim of abuse. 301. rev. proc. 2003-61, 2003-2 c.b. 296, 298. arguing that denying relief “effectively reject[s] our allegations of abuse” implicitly suggests that abuse be made a trumping factor, which is not what congress intended. schumacher, administrative process, supra note 98. the lack of abuse is not meant to weigh against relief, although the irs has argued unsuccessfully that lack of abuse should weigh against a requesting spouse. see washington v. commissioner, 120 t.c. 137 (2003). abuse and financial control by the nonrequesting spouse has been given greater weight for finding relief for pusposes of section 6015(f). notice 2012-8, § 4.03(2)(c)(ii), (iv), supra note 9. 302. fred stokeld, taxpayer advocate blasts irs’s handling of innocent spouse case, 2011 tax notes 16-9 (jan. 25, 2011); notice 2012-8, § 4.03(2)(c)(iv), supra note 9. 303. id. 304. 101 t.c.m. (cch) 1048, 1049 t.c.m. (ria) ¶ 2011-16 at 69 (2011). 305. id. 2012] empirical study of innocent spouse relief 695 claims of abuse requesting spouse claims abuse judge notes no abuse total abuse claims judge dismisses abuse claims judge upholds abuse claims number of cases 93 56 34 22 taxpayer wins 25 21 5 16 findings of abuse over time from the data, judges are cognizant of abuse claims. in 149 cases, courts mentioned abuse and in 62.4 percent of those courts mentioned abuse only to state that it was not alleged in the case. it is also not true that “[t]here are few, if any, decided cases in which abuse was present and the court denied innocent spouse relief.”306 in twelve cases there was at least a mention of abuse but it was unclear from the opinion whether the court concluded that there was abuse for purposes of its section 6015 analysis. in 60.7 percent of the cases in which abuse was alleged, the judge found that there was no abuse, but in 14.7 percent of those cases the requesting spouse was, nonetheless, granted relief. in 27.3 percent of the cases in which the judge found that there was abuse, the judge did not grant relief. one reason judges give for being hesitant to find abuse, particularly mental or emotional abuse, is that a claim of abuse can itself be abused. “we are aware of the danger that requesting spouses, in trying to escape financial liability, may easily exaggerate the level of nonphysical abuse. innocent 306. nadler, innocent spouse relief, supra note 20, at 40. 0 2 4 6 8 10 12 14 16 18 judge notes no abuse total claims of abuse 696 florid tax review [vol.12:8 spouse cases often spring from the dissolution of troubled marriages, and there is an obvious incentive to vilify the nonrequesting spouse.”307 in all the cases where abuse was alleged, all but two involved divorced, separated, or widowed spouses. it is difficult to decipher from the cases what claim or level of abuse is sufficient to outweigh other considerations weighing against relief. details of abuse are necessary and police involvement preferable, although rarely do the opinions note a significant amount of detail regarding the abuse. in knorr v. commissioner,308 the court did not find abuse when the requesting spouse provided only generalized claims of abuse. in collier v. commissioner309 the court noted the need for specific details with independent corroboration. on the other hand, in fox v. commissioner,310 the court weighed abuse as a positive factor for relief where a police report corroborated the requesting spouse’s claim of assault. despite courts’ hesitancy to find abuse, in nihiser v. commissioner,311 the tax court ruled that abuse is not limited to physical abuse and may include verbal and mental abuse. what qualifies as verbal or mental abuse is unclear, although a threat of a voodoo hex will not meet this criteria.312 similarly, financial irresponsibility, alleged brainwashing, or destroying someone’s credit alone does not amount to abuse.313 in twentyfive cases, requesting spouses claimed to have been the subject of mental or emotional abuse but not physical abuse; the requesting spouse won 32 percent of these cases. however, in only four of them did the court find that there was abuse. there appears to be a gendered component to judges finding abuse, although the sample is small. once a judge finds abuse, husbands fare better than wives. 307. nihiser, 95 t.c.m. (cch) at 1536, t.c.m. (ria) at 750. 308. t.c.m. (ria) ¶ 2004-212 at 1324 (2004). 309. 83 t.c.m. (cch) 1799, 1809, t.c.m. (ria) ¶ 2002-144 at 908 (2002). 310. 91 t.c.m. (cch) 731, 734, t.c.m. (ria) ¶ 2006-22 at 132 (2006). 311. 95 t.c.m. (cch) 1531, 1536, t.c.m. (ria) ¶ 2008-135 at 751 (2008). 312. gilmer v. commissioner, t.c. summ. op. 2007-132. 313. pugsley v. commissioner, 100 t.c.m. (cch) 454, 458, t.c.m. (ria) ¶ 2010-255 at 1535 (2010); stolkin, 96 t.c.m. (cch) at 145, t.c.m. (ria) at 110203; pierce, t.c. summ. op. 2003-126; barnes v. commissioner, t.c.m. (ria) ¶ 2004-266 at 1624 (2004). 2012] empirical study of innocent spouse relief 697 gender of abuse claimants claimed abuse judge found abuse percentage of claims spouse won case winning percentage wife 51 21 41.2% 15 72.4% husband 5 1 20.0% 1 100.0% for example, in schultz v. commissioner314 and gilmer v. commissioner,315 husbands claimed to have been abused. in the former, despite a finding of abuse, the husband was denied relief because the income was attributable to him and “he does not claim that he would have challenged the treatment of any items on the returns.”316 in the latter, the judge did not find abuse a factor favoring relief because the requesting spouse did not corroborate his claim. not highlighted in the above chart, both spouses claimed abuse in five cases and, in these cases, judges concluded there was no abuse or, if there was abuse, it did not impact their decision. in some cases, judges needed to be convinced that the requesting spouse signed the return only because of the abuse. in wiksell v. commissioner,317 the tax court agreed that the husband had dragged the wife out of bed and threw her against the wall, that he had held her hair and slammed her head against the wall in front of her children, and that he had consistently intimidated her and the children and belittled and tormented them. nevertheless, the ninth circuit affirmed, repeating the tax court’s earlier findings denying relief: “we are simply not convinced that carpender would not have signed the two returns only because of demands by david. . . . [specifically, she] failed to establish a nexus between spousal abuse generally and duress in specific instances, the specific instances in this case being carpender’s signing of these two tax returns.”318 reliance on an expert alone might be insufficient for this objective, although practitioners expect that it would facilitate relief.319 in wiksell, as in only one other abuse case, 314. 100 t.c.m. (cch) 353, 354, t.c.m. (ria) ¶ 2010-233 at 1385 (2010). 315. t.c. summ. op. 2007-132. 316. the husband was granted relief for the portion of the income attributable to his wife. 100 t.c.m. (cch) at 354, t.c.m. (ria) at 1386. 317. wiksell, 67 t.c.m. (cch) at 2367, t.c.m. (ria) at 94–485. 318. wiksell v. commissioner, 215 f.3d 1335, *3 (9th cir. 2000), aff’g, wiksell v. commissioner, 77 t.c.m. (cch) 1336, t.c.m. (ria) ¶ 99,032 (1999). 319. michael schlesinger, obtaining innocent spouse relief in the face of the service’s propensity to litigate, 109 j. tax’n 102, 107 (2008). 698 florid tax review [vol.12:8 the court made mention of the requesting spouse’s expert testimony.320 in these cases the court was not persuaded because the content of the expert’s testimony was found insufficient to prove abuse. procedurally, abuse in cases when there is a claim for innocent spouse relief raises other concerns that are beyond the scope of this article, but which are likely to decrease the number of appeals to the courts. congress requires that the irs contact the non-requesting spouse when it receives an application for innocent spouse relief.321 no exceptions are granted, even for victims of domestic violence.322 during its internal review, the irs does not disclose personal information that does not relate to the determination of relief. however, if the requesting spouse appeals to the courts, personal information, such as an address, might be disclosed unless a protective order has been issued.323 this issue was not raised in any of the cases in this sample.324 2. legally obligated under state law in 1998, much of the discussion in congress focused on divorced spouses and extending relief to these individuals.325 courts had disallowed taxpayer arguments that for a divorce court to require a spouse to sign a joint return amounted to duress.326 the executive branch similarly did not share 320. 67 t.c.m. (cch) at 2367-68, t.c.m. (ria) at 94–486; collier v. commissioner, 83 t.c.m. (cch) 1799, 1809, t.c.m. (ria) ¶ 2002-144 at 908 (2002). 321. i.r.c. § 6015(h)(2); reg. § 1.6015-6. 322. the irs suggests that a spouse who fears abuse write “potential domestic abuse case” at the top of form 8857. see steinberg, three at bats, supra note 255, at 412. 323. r. prac. & p. u.s. tax ct. 325; office of chief counsel, c.c.n. cc-2005-011, frequently asked questions regarding litigation of section 6015 cases in tax court 3-4 (2005). the tax court is required to disclose information and provide an opportunity for intervention. i.r.c. § 6015(e)(4). 324. cases might not have arisen on this issue because of the chilling effect on abused spouses of potential disclosure to abusers. 325. all references in the senate finance committee hearing were to couples whose marriages had come to an end. finance committee, supra note 58, at 148. in the house’s hearings, representative johnson urged the irs follow divorce decrees and was “extremely disappointed” that the irs was not more receptive to the proposal. oversight subcommittee, supra note 55, at 20. 326. steve r. johnson, the duress or deception defense to joint and several liability, 6 j. tax prac. & proc. 15 (2004); price v. commissioner, 86 t.c.m. (cch) 203, 204, t.c.m. (ria) ¶ 2003-226 at 1276 (2003); berger v. commissioner, 71 t.c.m. (cch) 2160, 2172, t.c.m. (ria) ¶ 96,076 at 96–628 (1996). 2012] empirical study of innocent spouse relief 699 congress’s concern,327 although the irs later made marital status a factor for determining whether a requesting spouse should be entitled to equitable relief.328 when asked to consider following divorce decrees’ allocations of liability, the treasury department worried that the irs is not a party to divorce proceedings and that there is nothing in a divorce proceeding to protect the government’s interests.329 to allow divorce or separation agreements to allocate liability for federal tax purposes in a way inapplicable to other creditors would allow state law to trump federal revenue collection.330 some couples proved eager to do so.331 thus, there was tension between congress and the executive as to the weight to be given to private agreements. under pre-1998 law, the tax court repeatedly ruled that tax allocation agreements between spouses and former spouses were not binding on the federal courts, but federal courts no longer apply this rule consistently.332 for example, one court dismissed the significance of the couple’s divorce decree, proclaiming in a case otherwise requiring a balancing of factors, “we need not discuss petitioner’s claim regarding the judgment for dissolution of marriage because such a claim is a state matter.”333 on the other hand, finding the apportionment of liability weighed heavily in favor of relief under section 6015, another court ruled, “the most important factor in this case is intervenor’s legal obligation under the north carolina court’s order to either directly pay the 1998 federal tax liability or indemnify petitioner for his payment thereof.”334 although 255 of the couples in which a spouse requested relief, or 59.6 percent, were divorced or divorcing by the time of the trial, only 243 327. see report on joint liability, supra note 13, at 43. 328. rev. proc. 2003-61, 2003-2 c.b. 296, 298. 329. see report on joint liability, supra note 13, at 43. because the rights of other creditors remain, following state divorce decrees shifts collections from the federal government to other creditors and often does little to help the requesting spouse. id. at 41–44. 330. oversight subcommittee, supra note 55, at 20 (statements of donald lubick and linda willis); report on joint liability, supra note 13, at 28–9. 331. see, e.g., acoba v. commissioner, t.c. summ. op. 2010-64. 332. pesch v. commissionerr, 78 t.c. 100, 129 (1982); bruner v. commissioner, 39 t.c. 534, 537 (1962); neeman v. commissioner, 13 t.c. 397, 399 (1949), aff’d per curiam 200 f.2d 560 (2d cir. 1952); casey v. commissioner, 12 t.c. 224, 227 (1949); ballenger v. commissioner, 14 t.c.m. (cch) 651, 651, t.c.m. (p-h) ¶ 55,171 at 55–544 (1955); willis, supra note 55, at 2. 333. glenn v. commissioner, t.c. summ. op. 2005-127. 334. gay v. commissioner, t.c. summ. op. 2003-36. see also bruen v. commissioner, 98 t.c.m. (cch) 400, 404–05, t.c.m. (ria) ¶ 2009-249 at 1834– 36 (2009); withers v. commissioner, t.c. summ. op. 2010-73. 700 florid tax review [vol.12:8 had completed their divorce. of those, only 103 opinions mentioned an allocation between spouses of the tax liability. divorce and separation decrees number of cases taxpayer won winning percentage husband made liable 34 17 50.0% wife made liable 3 1 33.3% some division of liability 23 10 43.5% jointly liable 9 3 33.3% opinion mentions no or ambiguous provision 30 7 23.3% no mention in opinion 140 64 45.7% other 4 2 50.0% fifty-eight of the opinions stated that the couples’ divorce decrees allocated at least a portion of the tax liabilities to a non-requesting spouse. in twentysix of those, or 44.8 percent, the court granted relief consistent with the divorce decree, but none relied solely upon the divorce decree for its determination. one reason for reticence to rely on divorce decrees is that courts share the irs’s concern that couples will use separation and divorce agreements to take advantage of the tax system.335 in one case a court worried, “in an effort to avoid paying tax liabilities, married taxpayers . . . could structure future payments so that ownership is attributable to the spouse requesting relief under section 6015, while continuing a jointly financed lifestyle.”336 in response to this fear, divorce and separation agreements are given no evidentiary value if the requesting spouse had reason to know the non-requesting spouse would not fulfill the legal obligation.337 in seven of the cases under review, liability was allocated under a divorce decree but the court found that the other spouse was aware at the time of the agreement that the obligation would not be paid. the requesting spouse won none of these cases. in thirteen of the cases both spouses agreed to share liability or the requesting spouse agreed to be solely liable. nonetheless, in 23.1 percent of those cases, the court granted innocent spouse relief to the liable spouse. for 335. rev. proc. 2003-61, 2003-2 c.b. 296, 297; oversight committee, supra note 55, at 11; report on joint liability, supra note 13, at 43. 336. ordlock v. commissioner, 126 t.c. 47, 58 (2006). 337. rev. proc. 2003-61, 2003-2 c.b. 296, 298. 2012] empirical study of innocent spouse relief 701 example, in maier v. commissioner,338 the irs allowed relief despite a divorce agreement providing that the spouses would be jointly liable; the husband intervened but the court had no jurisdiction to hear his claim. in instances where courts granted relief despite agreements to the contrary, the requesting spouse won a better deal than intended by congress. although some critics of innocent spouse relief worry that allowing divorced couples this second bite at the allocation apple might be turning the tax court into a new divorce court, few cases turned on this issue. moreover, few cases invoked a family courts’ requirement that spouses sign a return. in the only case in which the issue came up squarely, bruen v. commissioner,339 the divorce court had ordered amended returns be filed jointly with each equally responsible. on the returns, the wife wrote “under protest pursuant to amended judgement [sic] following divorce nisi” above her signature but, according to the court, this was to protest being forced to pay any of the tax liability, not to void the joint return. filing jointly decreased the couple’s liability by $7,882. even when cases are not contingent on what the family court requires, courts handling tax matters become embroiled in family affairs. one court complained, “this case arises from a troubled five-year marriage that produced two children, constant bickering, and numerous mutual accusations of wrongdoing. . . . in this case where neither of the main parties is credible, we piece together the fragments of truth as best we can to decide whether she is entitled to relief under section 6015.”340 even if the court decides to grant innocent spouse relief, a requesting spouse can still be held jointly liable in divorce court if settlements have not yet been finalized.341 in addition to divorce and separation decrees, courts must also examine other state-imposed obligations and means of relief. community property offers the opportunity for relief or additional liability. the statute provides that section 6015 is to be applied without regard to community 338. 360 f.3d 361, 363–64 (2d cir. 2004), aff’g, maier v. commissioner, 119 t.c. 267 (2002). 339. 98 t.c.m. (cch) 400, 402, t.c.m. (ria) ¶ 2009-249 at 1831 (2009). weight v. commissioner, 86 t.c.m. (cch) 98, 99, t.c.m. (ria) ¶ 2003-214 at 1147 (2003), involved a divorce decree-mandated joint return and one issue was whether the return was timely, but the case was decided on other grounds. in james v. commissioner, t.c. summ. op. 2004-176, the family court required the couple file separate returns. 340. stergios v. commissioner, 97 t.c.m. (cch) 1057, 1057, t.c.m. (ria) ¶ 2009-15 at 81 (2009). 341. see melvyn b. frumkes, equitable distribution of tax liabilities, 20 j. am. acad. matrim. law. 179 (2006). see also williams v. commissioner, t.c. summ. op. 2009-19, in which the court reserved power pending the outcome of the innocent spouse case. 702 florid tax review [vol.12:8 property law.342 that provides only limited protection as, depending on the state, separate debts can be satisfied from community property. one community property advocate urged that spouses not have separate taxes come out of community property.343 the treasury department refused to follow the suggestion,344 and courts have agreed. although 157 cases arose in community property states, only ten hinged on community property laws, and in all but one the law was interpreted for the benefit of the government. for example, in united states v. stolle,345 the district court held that under california community property laws, “community property tax is available to satisfy a debt from either spouse, even if the other spouse is not responsible for the debt.”346 other state law property rules, such as transferee liability, also apply.347 however, courts have largely dismissed these obligations to the advantage of requesting spouses, so that they provide little revenue for the government.348 in this sample, only two cases involved transferee liability, and both were resolved to the advantage of the requesting spouse. in jones v. united states,349 a couple had claimed substantial losses as a result of investments in tax shelters that were subsequently disallowed. the district court ruled that the statute of limitations for transferee liability, one year beyond that of the taxpayer, had lapsed. in united states v. evans,350 transfers by an executrix of her late husband’s property to her children were set aside as fraudulent conveyances; however, her fiduciary liability was barred by res judicata as a result of an earlier ruling insulating the executrix herself. 3. intervening without debate, in 1998 non-requesting spouses were granted the right to participate in the administrative process and to intervene before the tax court in innocent spouse cases, although some academics have since 342. i.r.c. § 6015(a). 343. t.d. 9003, supra note 128. 344. id. rev. rul. 2004-74, 2004-2 c.b. 84, 85–86 sets out a five-step process for determining how much of an overpayment the irs may apply against one spouse’s separate tax liability. 345. 2000 us dist. lexis 5454 at *18 (c.d. cal. march 15, 2000). 346. id. 347. reg. § 1.6015-1(j)(1). 348. christian, joint and several liability, supra note 20, at 592–77; beck, innocent spouse problem, supra note 44, at 402–08. 349. 322 f. supp. 2d at 1026; i.r.c. § 6901(c)(1). 350. 513 f. supp. 2d at 834. 2012] empirical study of innocent spouse relief 703 questioned the wisdom of allowing husbands to intervene.351 more husbands than wives intervene, as shown in the following chart. in the chart, a win by the government against the requesting spouse was counted as a win for the intervening spouse unless the intervening spouse intervened on behalf of the requesting spouse.352 intervenors total cases intervened when government conceded intervened on behalf of requesting spouse interven or won husband as intervenor 61353 20 4 25 wife as intervenor 21 2 0 13 in eighty-two of the 444 section 6015 cases, or 18.5 percent, the nonrequesting spouse intervened; 43.6 percent of the time an intervenor opposed relief, the intervenor won.354 husbands won 41.0 percent of the time they intervened while wives won 61.9 percent, in part because husbands were much more likely (90.9 percent) to intervene when the government conceded relief to the other spouse. four husbands (in five cases) intervened on behalf of a former spouse. excluding cases where the government conceded relief or intervention was on behalf of the requesting spouse, husbands won as intervenors 56.8 percent of the cases. the number of cases with intervenors is limited because section 6015 does not grant the tax court jurisdiction over non-requesting spouses’ petitions to review grants of relief by the irs unless they are appealed by the requesting spouse to the courts. thus, in all cases where the intervenor sought an appeal, the court denied jurisdiction. however, the irs cannot 351. i.r.c. § 6015(h)(2), (e)(4); beck, failure, supra note 20, at 950. for a discussion of the rights of intervening (and participating) spouses see rule 325, supra note 295. see also rev. proc. 2003-19, 2003-1 c.b. 371. 352. in only three cases did the intervening spouse win without a government victory, and in each of those cases the spouse won the right to intervene. 353. there are three cases for which is it is impossible to confirm if the intervenor intervened on behalf of or against the requesting spouse; however, in one the spouses remained married. 354. these results differ from those found by trexler, contesting, supra note 67, who only looks at cases decided on the merits. see text supra page 20. 704 florid tax review [vol.12:8 settle a case once a requesting spouse files a petition in the tax court unless the non-requesting spouse agrees.355 the justification given by the courts for denying jurisdiction (in addition to the lack of statutory authority) is that spouses who file joint returns are jointly and severally liable for the entire liability.356 therefore, intervenors suffer no actual harm when the other spouse is granted relief. for example, in maier v. commissioner,357 when a new york divorce decree stipulated that both spouses remain liable for all taxes due but the irs granted the wife relief, the court held, “to the extent that petitioner believes that he has suffered an injustice due to a flaw in the controlling statutory provisions, his recourse may be to seek a legislative remedy.”358 in twenty-two of the cases involving intervenors, or 26.8 percent, the irs had already conceded relief to the requesting spouse by the time of the trial but the intervenor nonetheless appealed. the intervenor lost every time. after villela-willcox v. commissioner,359 it is questionable whether an intervenor can prevail once the government concedes relief, despite the court’s assurance that “[u]nder appropriate circumstances, we would not be reluctant to deny section 6015(c) relief to a requesting spouse if evidence offered by an intervenor, rather than the commissioner, demonstrated that such relief was unavailable because of the requesting spouse’s ‘actual knowledge’ of ‘the item giving rise to the deficiency.’”360 however, in villela-willcox, the court found the intervenor to be the more credible witness and the “intervenor’s evidence shows petitioner’s connection and involvement with intervenor’s participation” in the tax shelter at issue. nevertheless, the court concluded that although “intervenor’s evidence is persuasive, . . . it is not so compelling to require that the settlement between respondent and petitioner be disregarded.”361 4. summary courts generally place less emphasis on the characterization of nonrequesting spouses than did congress, but the weight given to these factors 355. corson v. commissioner, 114 t.c. 354, 364–65 (2000). for fiscal year 2010, the non-requesting spouse intervened in ten cases, or 28% of the time. nta, 2010 annual report, supra note 17, at 500. 356. see holloway v. commissioner, 322 fed. appx. 421 (6th cir. 2008), cert. denied, 129 s. ct. 1535 (2009); baranowicz v. commissioner, 432 f.3d 972 (9th cir. 2005). 357. 119 t.c. 267, 276, aff’d, maier, 360 f.3d 361 (2d cir. 2004). 358. id. 359. t.c. summ. op. 2009-75. 360. id. 361. id. 2012] empirical study of innocent spouse relief 705 might be increasing. for example, courts are increasingly sensitive to the issue of abuse in claims for innocent spouse relief, although that sensitivity does not mean that courts often find abuse to be a mitigating factor sufficient to outweigh other factors weighing against relief. similarly, courts often decide cases in a manner consistent with divorce decrees that allocate liability between former spouses but without overtly relying on those allocations. on the other hand, courts are not opposed to intervening spouses, the nefarious husband, unless the irs concedes relief to the requesting spouse. therefore, in courts’ evaluation of these factors, consistent with the current treasury department guidance, most appear unwilling to give perceived negative features of non-requesting spouses greater weight than other factors that weigh for or against relief. part iv. conclusion after a decade of fighting, kathleen alioto won relief from almost $2 million in taxes. a year earlier, however, another former politician’s wife was not victorious.362 susan wilson and her husband, former arkansas state senator nick wilson, were ordered to return a refund they had received. the refund stemmed from $373,089 of illegal kickbacks nick received when defrauding the federal and state governments and which the couple had reported on their joint tax returns. once caught, and as part of his sentencing, nick was required to make restitution. after doing so, the wilsons claimed a $128,676 refund based on the income they had earlier reported. the government sent the couple a refund check and then demanded its return. susan sought to keep the refund, claiming she was an innocent spouse. the court did not think the innocent spouse provisions applied in susan’s case; the provision could not be stretched that far. “that susan wilson was not aware of the criminal activity is not relevant.”363 although the court felt little need to discuss the issue in detail, susan was still married, had benefited from the refund, and, while her husband might be nefarious, there was nothing to indicate that he had acted nefariously towards her. therefore, susan did not fit within the congressional model of an innocent spouse, and she had to repay the refund. when congress enacted section 6015 in 1998, the primary concern was providing relief to those it deemed “innocent” and, although congress did not define the term with precision, there was a focus on divorced and separated wives whose husbands had created crushing tax burdens and then unfairly left their wives to pay the bill. it was important to congress that the 362. united states v. wilson, no. 4:06cv001628, 2007 u.s. dist. lexis 86900 (e.d. ark. nov. 26, 2007); david firestone, arkansas lawmakers indicted in vast corruption case, n.y. times, april 28, 1999 at a18. 363. wilson, 2007 u.s. dist. lexis 86900 at *10. 706 florid tax review [vol.12:8 tax deficiency resulted from an error created by the non-requesting spouse and that the requesting spouse not have caused the liability.364 congress did not want innocent spouse relief to become a means by which couples could avoid their “just” taxes.365 the court did not feel susan fit this mold. the treasury department, when interpreting the statute, expanded on this congressional intent, creating a checklist for relief that is often referenced in judicial decisions. that checklist has recently been revised. however, a review of the cases demonstrates that courts apply their own interpretation of congressional intent, only loosely confined by the terms provided by the executive agency. this result occurs despite the fact that the tax court, in particular, is being deluged with innocent spouse cases and the court’s individualized evaluation requires fact specific examinations that it might otherwise delegate to the irs. thus, in their evaluations of individual claims, courts are using the treasury department’s factors to their own ends as they seek to provide relief to divorced or separated wives who were unfairly left oppressive tax burdens by their guilty husbands. therefore, the gender of the requesting spouse is somewhat important — marital status is more so. that the tax burden be a crushing one is important in the eyes of the courts, but the standard is fuzzily defined. it has been hard for the courts to define clear limits to economic hardship that can be applied with consistency in the innocent spouse context. the same can be said of whether the tax burden is being unfairly imposed on the requesting spouse, but it is important to the courts whether the requesting spouse had knowledge of the tax deficiency. the nature of the non-requesting spouse is less important. whether the requesting spouse is abused appears to matter to many judges, but the sample is small. divorce or separation decrees assigning liability can also operate as secondary evidence but will rarely decide a case. although these guidelines can be gleaned from the cases, in their opinions judges are neither crafting precise definitions of many of these terms nor defining the relative importance of each. clearer guidance needs to be established by congress, and definitions by the treasury department, to provide more accurate predictive power for individual cases. despite these difficulties, this article can respond to the fear that the complexities of section 6015 has meant that the innocent spouse regime “degenerate[d] into a global subjective test of whether the spouse seeking relief can move the judge to sympathy.”366 for those claims that are twice denied by the irs but progress to the courts, the taxpayers who are most likely to win are those for whom congress intended to provide relief, while spouses like susan wilson are often, but not always, denied. 364. see notes 58–68. 365. id. 366. beck, failure, supra note 20, at 942. 2012] empirical study of innocent spouse relief 707 the problem remains that litigating relief can be complicated and costly for both taxpayers and the government. as with all equity claims, the factors considered by the courts may be inconsistently applied. as a result, some within congress are unsatisfied with current relief, or at least the complaints innocent spouse relief receives, and propose further liberalizing section 6015.367 whether the irs’s recently liberalized factors for section 6015(f) relief are a response to this new desire or are consistent with congress’s 1998 intent for that section is left for a later day. unless clarity of purpose and in operation is provided for in any new legislation, however, a further liberalized law is likely to face the same criticism as the law of the past, regardless of courts’ ability to implement congress’s desires. 367. laura saunders, a new push to protect spouses, wall st. j., may 28, 2011, at b9. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe 186 florida tax review volume 7 2005 number whatever happened to subpart f? u.s. cfc legislation after the check-the-box regulations by lawrence lokken i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 ii. development of cfc legislation . . . . . . . . . . . . . . . . . . . . . . . 189 iii. subpart f after check-the-box regulations . . . . . . . . . . . 195 a. check-the-box regulations . . . . . . . . . . . . . . . . . . . . . . . . . . 195 b. check-the-box schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198 c. is there a problem? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 d. solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 1. examples 1 and 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 2. example 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206 3. other check-the-box schemes . . . . . . . . . . . . . . . . . 208 iv. conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210 2005] whatever happened to subpart f? 187 * lawrence lokken is hugh culverhouse eminent scholar and professor of law at the university of florida college of law. the author thanks philip r. west of steptoe & johnson, washington, dc, who commented on an earlier version of this paper at the international tax symposium and provided much helpful advice. for mr. west’s analysis of the issues discussed in this article, see philip r. west, re-thinking checkthe-box: subpart f, 83 taxes 29 (march 2005). the author also thanks dr. jan sedemund, rechtsanwalt, of kpmg deutsche treuhand-gesellschaft ag, köln, germany, for help on issues of german law. 1. the provisions are subpart f of part iii of subchapter n of chapter 1 of subtitle a of the internal revenue code. 2. irc § 951(b). see irc § 7701(a)(30) (“united states person” includes u.s. citizens and residents, domestic corporations and partnerships, and certain estates and trusts). 3. irc § 957(a), discussed in 3 boris i. bittker & lawrence lokken, federal taxation of income, estates & trusts ¶ 69.2 (warren, gorham & lamont rev. 3d ed. 2005) [hereinafter bittker & lokken]. see irc § 7701(a)(5) (corporation is foreign if it is organized under laws of a jurisdiction other than the united states, a u.s. state, or the district of columbia). 4. irc §§ 61(a)(7); 301(c)(1). 5. irc § 61(a). domestic corporations are, however, allowed credit for income taxes paid to foreign countries. irc § 901, discussed bittker & lokken, supra note 3, ¶ 72.1. whatever happened to subpart f? u.s. cfc legislation after the check-the-box regulations by lawrence lokken* i. introduction the u.s. congress, in 1962, enacted provisions commonly known as subpart f, under which u.s. shareholders of controlled foreign corporations1 (cfcs) are taxed on their ratable shares of some corporate income, whether or not distributed. a u.s. shareholder is a u.s. person who owns at least 10% of a foreign corporation’s voting stock, directly, indirectly, or constructively. a2 foreign corporation is a cfc if more than 50% of its stock, by vote or value, is so owned by u.s. shareholders.3 apart from subpart f, the united states taxes shareholders on corporate income only as it is distributed to them as dividends. because domestic4 corporations are taxed on their worldwide incomes, the lack of a shareholder-5 level tax on undistributed corporate income does not insulate this income from 188 florida tax [vol7:3 6. irc §§ 881, 882. see bittker & lokken, supra note 3, ¶ 67.1.1. 7. rosanne altshuler & harry grubert, the three parties in the race to the bottom: host governments, home governments and multinational companies, 7 fla. tax rev. 152 (2005). 8. id. at 171. 9. for arguments for broadening subpart f, see j. clifton fleming, jr., robert j. peroni & stephen e. shay, fairness in international taxation: the ability-to-pay case for taxing worldwide income, 5 fla. tax rev. 299 (2001); j. clifton fleming, jr., robert j. peroni & stephen e. shay, deferral: consider ending it instead of expanding it, 86 tax notes 837 (feb. 7, 2000); robert j. peroni, j. clifton fleming, jr. & stephen e. shay, getting serious about curtailing deferral of u.s. tax on foreign source income, 52 smu l. rev. 455 (1999). for arguments for narrowing subpart f, see national foreign trade council, foreign income project, international tax policy for the 21st century (2001). u.s. taxation. however, a foreign corporation is subject to u.s. tax on only income effectively connected with the conduct of a trade or business in the united states and certain income from u.s. sources, even if its shareholders are u.s. persons. thus, apart from subpart f, the united states imposes no tax on6 foreign income of u.s.-owned foreign corporations until it is distributed to the shareholders or the shareholders sell their shares. subpart f limits, but does not eliminate, this deferral opportunity. as described more fully in part ii of this article, a principal reason for the enactment of subpart f was to curb u.s. companies’ ability to shelter income from taxation in tax haven countries. however, evidence collected by altshuler and grubert indicates that subpart f has not, in recent years, been effective in preventing u.s. multinational enterprises from using corporations organized in countries commonly considered to be tax havens as vehicles for sheltering large amounts of income from significant taxation by any country. in particular, they7 conclude that the united states’ adoption of the so-called check the box regulations in 1996 has allowed u.s. multinational enterprises to significantly reduce the effective rates of taxation of their non-u.s. incomes. they estimate that “in 2002 u.s. companies paid $7 billion less in host country taxes compared to 1997 by using intercompany payments deductible in the paying country but exempt from tax in the recipient.” as shown in part iii, the check-8 the-box regulations facilitate structures accomplishing such no-tax results. the purpose of this article is to explore means by which the originallyintended function of subpart f could be reclaimed from the inroads allowed by the check-the-box regulations. the article is not intended to contribute to the growing literature on whether u.s. tax policy should be to broaden or narrow the scope of subpart f. the treasury, in adopting the check-the-box9 2005] whatever happened to subpart f? 189 10. see ps-43-95, 1996-1 cb 865 (referring, in proposing check-the-box regulations, to “the increased flexibility under local law” in shaping attributes of business organizations and resulting artificiality of historical distinctions between corporations and other forms of business organization), discussed in bittker & lokken, supra note 3, ¶ 85.4. 11. message from the president of the united states relative to our federal tax system (apr. 20, 1961), reprinted in h.r. doc. no. 87-140 at 8-9 (1961). 12. id. at 9. countries not among the developed nations of the world are now usually called “developing countries,” implying, optimistically and surely contrary to fact, that all of them are progressing toward development. president kennedy used the term “underdeveloped countries,” implying a desire that they be more developed. subpart f used more neutral terminology, “less developed countries.” irc § 955 (before amendment in 1976). regulations, did not intend to alter the policies reflected in subpart f. my10 purpose in this article is only to determine whether the balance between deferral and current taxation, unintentionally upset by the regulations, may feasibly be restored. ii. development of cfc legislation soon after taking office, president kennedy submitted a message to congress advocating a general elimination of the deferral privilege with respect to income originating in developed countries and income of tax haven entities. to the extent that these tax havens and other tax deferral privileges result in u.s. firms investing or locating abroad largely for tax reasons, the efficient allocation of international resources is upset, . . . and profits are retained and reinvested abroad which would otherwise be invested in the united states. certainly since the post-war reconstruction of europe and japan has been completed, there are no longer foreign policy reasons for providing tax incentives for foreign investment in the economically advanced countries.11 although generally not requiring immediate taxation of undistributed earnings of cfcs from developing countries, the president’s recommendations would have eliminated “the tax haven device anywhere in the world, even in the underdeveloped countries, through the elimination of tax deferral privileges for those forms of activities, such as trading, licensing, insurance, and others, that typically seek out tax haven methods of operation.” if these changes reduced12 “the rate of expansion of some american business operations,” the president concluded, the “reduction would be consistent with the efficient distribution of 190 florida tax [vol7:3 13. message from the president of the united states relative to our federal tax system (apr. 20, 1961), reprinted in h.r. doc. no. 87-140 at 9 (1961). 14. staff of house comm. on ways & means, 1 legislative history of h.r. 10650, 87th cong., the revenue act of 1962 at 126 (comm. print 1967) (statement of hon. douglas dillon, secretary of treasury, before the committee on ways and means of the house of representatives, on the president’s message on taxation, may 3, 1961). 15. id. at 70. capital resources in the world . . . and fairness to competing firms located in our own country.”13 in a statement to the house ways and means committee, treasury secretary douglas dillon stressed one of the two principal themes of the president’s message: the policy that later became known as capital export neutrality. “to avoid the artificial encouragement to investment in other advanced countries as compared with investment in the united states, we propose that american corporations be fully taxed each year on their current share in the undistributed profits realized by subsidiary corporations organized in economically advanced countries.” secretary dillon contrasted this policy14 with the policy that later became known as capital import neutrality: either we tax the foreign income of u.s. companies at u.s. rates and credit income taxes paid abroad, thereby eliminating the tax factor in the u.s. investor’s choice between domestic and foreign investment: or we permit foreign income to be taxed at the rates applicable abroad, thereby removing the impact, if any, which the tax rate differences may have on the competitive position of the american investor abroad. both types of neutrality cannot be achieved at once. i believe that reasons of tax equity as well as reasons of economic policy clearly dictate that in the case of investment in other industrialized countries we should give priority to tax neutrality in the choice between investment here and investment abroad.15 congress, being unpersuaded by the case for an undiluted policy of capital export neutrality, generally rejected the administration’s call to end deferral of undistributed cfc profits earned in economically advanced countries. in shaping the legislation that became subpart f, however, it accepted the recommendation to eliminate deferral of tax haven earnings. the senate finance committee, commenting on the 1962 bill by which subpart f was enacted, noted that the house bill . . . did not eliminate tax deferral generally, but instead was concerned primarily with what had been referred to as “tax haven” devices. to accomplish this result the house bill in general sought to end tax deferral for income derived by 2005] whatever happened to subpart f? 191 16. s. rep. no. 1881, 87th cong., 2d sess., reprinted at 1962-3 cb 703, 78485. senator eugene j. mccarthy objected: [t]he controlled foreign corporations provision erects a barrier to the achievement of vital national objectives, namely the expansion of trade and an improvement in our balance-of-payments position. we cannot promote either of these related objectives through a restrictive policy which, in the hope of correcting tax abuses, slashes with a broad sword at america’s overseas subsidiaries. . . . there are controlled corporations which have been established in foreign countries primarily, if not solely, for purposes of tax avoidance here in the united states. it is also true that some of these subsidiaries probably serve no real purpose as far as the interests of the united states are concerned. we should not throw the baby out with the bath water but should reconsider the means by which we undertake to correct abuses. . . . . . . . [subpart f’s] approach to overseas income is far too complex in its administration, far too selective in its application, and far too uncertain in its effects. id. at 1057. senators carlson, bennett, butler, curtis, and morton found subpart f “truly amazing” and predicted that “normal trade relations will be seriously disturbed.” id. at 1059. on the other hand, senators douglas and gore argued for legislation at least as broad as the president had recommended: the best and indeed the only sure way to achieve substantial equity, guard against the untoward weakening of american industry and assist in the solution of the balance-of-payments problem through taxation is to tax american taxpayers annually on income and profits earned anywhere in the world. . . . this entire section [of the bill containing subpart f], embodying as it does the tax haven approach, ought to be deleted and have substituted therefor the complete removal of the deferral privilege. id. at 1126-27. u.s. controlled foreign corporations from insurance abroad of u.s. risks; for certain foreign investment income of these corporations; for their income from foreign sales subsidiaries which are separately incorporated from their manufacturing operations; and . . . earnings . . . indirectly brought back to the united states without full payment of u.s. tax.16 in these broad outlines, the house bill was accepted by the senate and enacted into law. twenty-four years later, the staff of the joint committee on taxation summarized the policies underlying subpart f as follows: 192 florida tax [vol7:3 17. staff of joint comm. on tax’n, 99th cong., 2d sess., general explanation of the tax reform act of 1986 at 964-65 (comm. print 1987). 18. td 8767, 1998-1 cb 875. i do not, in this paper, undertake a comprehensive analysis of the relative merits of capital export neutrality and capital import neutrality, but i cannot resist a brief comment on the treasury’s reference to “the it has long been the policy of the united states to impose current tax when a significant purpose of earning income through a foreign corporation is the avoidance of tax. such a policy serves to limit the role that tax considerations play in the structuring of u.s. persons’ operations and investments. because movable income earned through a foreign corporation could often be earned through a domestic corporation instead, congress believed that a major motivation of u.s. persons in earning such income through foreign corporate vehicles often was the tax benefit expected to be gained thereby. congress believed that it was generally appropriate to impose current u.s. tax on such income earned through a controlled foreign corporation, since there is likely to be limited economic reason for the u.s. person’s use of a foreign corporation. congress believed that by eliminating the u.s. tax benefits of such transactions, u.s. and foreign investment choices would be placed on a more even footing, thus encouraging more efficient (rather than more tax-favored) uses of capital.17 the treasury stated more recently: subpart f was enacted by congress to limit the deferral of u.s. taxation of certain income earned outside the united states by foreign corporations controlled by u.s. persons. limited deferral was retained after the enactment of subpart f to protect the competitiveness of controlled foreign corporations (cfcs) doing business overseas. . . . this limited deferral furthers the objective of allowing a cfc engaged in an active business, and located in a foreign country for appropriate economic reasons, to compete in a similar tax environment with non-u.s. owned corporations located in the same country. . . . u.s. international tax policy seeks to balance the objective of neutrality of taxation between domestic and foreign business enterprises (seeking neither to encourage nor to discourage one over the other), while keeping u.s. business competitive. subpart f strongly reflects and enforces that balance . . . .18 2005] whatever happened to subpart f? 193 objective of allowing a cfc engaged in an active business, and located in a foreign country for appropriate economic reasons, to compete in a similar tax environment with non-u.s. owned corporations located in the same country.” the idea that u.s. taxation of the income of cfcs somehow affects the competitive position of u.s. companies in foreign countries is a common theme of tax lobbyists for these companies. it is usually presented as being so obvious as not to require explanation. see, e.g., national foreign trade council, foreign income project, international tax policy for the 21st century 12–14 (2001). the idea is, however, based on assumptions that are far from obvious. assume x corp., a delaware corporation, has a subsidiary in country f, fc, which produces and sell goods in country f. a u.s. tax on fc’s undistributed profits, imposed on x corp., would affect x’s competitive position in country f only if it were to be reflected in lower wages paid or higher prices charged by fc because, in country f, x and fc only compete in the markets for labor and goods. on the other hand, if the tax only impacts corporate profits, it only affects x’s ability to compete in the markets for capital, and if x and fc obtain their equity capital in the united states, the tax has no effect on the competitive position of x or fc in country f. classical economists believed that taxes on corporate profits are borne by shareholders alone, but modern economists have entertained the possibility of these taxes being borne, to some extent, by labor and consumers as well. neither theory or empirical analysis has, however, yielded a definitive answer to the question. 19. irc § 953, discussed in bittker & lokken, supra note 3, ¶ 69.3. 20. irc § 954(c), discussed in bittker & lokken, supra note 3, ¶ 69.4. 21. irc § 954(d), discussed in bittker & lokken, supra note 3, ¶ 69.5. a common theme in all of these explanations is that the intended target of subpart f is not low foreign tax rates. if a cfc is actively engaged in business in a low-tax country, income of this business is not usually subpart f income. the intended target is instead income that has been channeled into a low-tax environment that has no substantial economic connection with the income. two categories of cfc earnings are taxed directly to u.s. shareholders: subpart f income and earnings invested in u.s. property. subpart f income is principally a collection of types of income that congress found susceptible to tax haven manipulation, including the following: 1. income from insuring risks outside the cfc’s country of incorporation.19 2. passive income, which the statute refers to as foreign personal holding company (fphc) income, including dividends, interest, royalties, rents, net gains on sales and exchanges of property productive of passive income, net gains from commodities transactions, net foreign currency gains, and income from notional principal contracts.20 3. income from sales of goods purchased from or sold to or on behalf of related persons if the goods are neither produced nor sold for use in the country in which the cfc is organized.21 194 florida tax [vol7:3 22. irc § 954(e), (before repeal in 2004 by pub. l. no. 108-357, § 415, 118 stat. 1418), discussed in bittker & lokken, supra note 3, ¶ 69.6. 23. irc § 954(f), discussed in bittker & lokken, supra note 3, ¶ 69.7. 24. irc § 954(g), discussed in bittker & lokken, supra note 3, ¶ 69.8. 25. irc § 952(a), discussed in bittker & lokken, supra note 3, ¶ 69.10. 26. irc §§ 952(a), 952(c), discussed in bittker & lokken, supra note 3, ¶ 69.10. 27. irc §§ 951(a)(1)(b), 956, discussed in bittker & lokken, supra note 3, ¶ 69.11. 28. irc § 1248, discussed in bittker & lokken, supra note 3, ¶ 69.14. 29. for a survey of cfc legislation as of 2001 and 1997, see int’l fiscal ass’n, limits on the use of low-tax regimes by multinational business: current measures and emerging trends, cahiers de droit fiscal int’l, vol. lxxxvib (2001); sandler, tax treaties and controlled foreign company legislation: pushing the boundaries (kluwer 2d ed. 1998). 30. in its 1998 report on harmful tax competition, the oecd suggested that countries might consider adopting cfc legislation as a means of defending their systems of residence taxation against erosion by tax haven schemes. organisation for economic cooperation and development, harmful tax competition: an emerging global issue (oecd 1998). several countries have since adopted cfc legislation, at least partially in response to the oecd report. 4. income from services performed for or on behalf of a related person outside of the country under the laws of which the cfc is organized.22 5. income from shipping operations in foreign commerce.23 6. income from processing, transporting, or distributing oil or gas.24 also, income of any character may be subpart f income if the cfc engages in certain activities proscribed by congress, such as paying illegal bribes or kickbacks, participating in an international boycott, or doing business in a country on bad terms with the united states. subpart f income is the sum of25 all of the foregoing or, if less, the cfc’s earnings and profits for the year.26 cfc earnings other than subpart f income are taxed directly to u.s. shareholders if they are invested in “united states property,” such as shares or debt instruments issued by a u.s. affiliate of the cfc or real property located in the united states. moreover, if a cfc accumulates earnings that are not27 taxed to u.s. shareholders as subpart f income or as earnings invested in u.s. property, a u.s. shareholder’s gain on selling stock of the cfc is treated as a dividend to the extent of the earnings attributable to the stock sold.28 the united states was the first country to enact cfc legislation, but about 25 other countries have since adopted such legislation. the basic29 compromise made by the u.s. congress in 1962 – to curb tax haven abuses without eliminating deferral of all cfc income – has guided the development of most cfc legislation in other countries. in pursuing this goal, however,30 2005] whatever happened to subpart f? 195 31. for the portfolio exemption, see §§ 871(h), 881(c), discussed in bittker & lokken, supra note 3, ¶ 67.2.2. many countries have used approaches in their cfc legislation quite different from that of the u.s. subpart f. the first countries to follow the u.s. lead on such legislation were canada and germany, in 1972. the canadian and german legislation generally follows the approach of the u.s. legislation. in each case, the legislation identifies particular kinds of income as tax haven income and taxes resident shareholders on only these types of cfc income. this approach might be called a tainted income approach. beginning with japan in 1978 and the united kingdom in 1984, most countries adopting cfc legislation have used what might be called a tainted entity approach, under which the legislation and related administrative actions identify corporations to be considered tax haven companies and tax resident shareholders on all income of these corporations, regardless of its source or nature. the tainted income and tainted entity approaches both have strengths and weaknesses. proponents of a tainted income approach may point to the fact that the income tax laws of virtually every country have tax haven features. for example, the u.s. rule exempting portfolio interest income of foreign investors from u.s. withholding tax makes the united states attractive as a tax haven for some foreign investors in debt securities (e.g., u.s. treasury obligations). an31 approach based on a sorting of countries between tax haven countries and other countries may therefore miss tax haven schemes utilizing entities resident in countries not generally considered to be tax havens. on the other hand, a tainted income approach is vulnerable to tax planners’ creativity in crafting schemes that effectively shelter income in tax haven countries without the income falling within any of the categories of tainted income. legislation based on a tainted entity approach may avoid this trap by taxing resident shareholders on all income shifted to an entity resident in a tax haven country, regardless of its character. iii. subpart f after check-the-box regulations a. check-the-box regulations u.s. income tax law generally recognizes only two types of business entities: corporations, which are taxable entities and the income of which is potentially subject to tax a second time when distributed to shareholders, and partnerships, which are fiscally transparent in the sense that they are not taxed but their income is attributed to their members as recognized for federal tax purposes. this duality applies to foreign as well as domestic entities. a 196 florida tax [vol7:3 32. irc § 7701(a)(3). 33. morrissey v. cir, 296 us 344 (1935). 34. see bittker & lokken, supra note 3, ¶ 85.3.2. 35. reg. § 301.7701-2(a)(3) (before amendment in 1996). 36. see, e.g., keatinge, ribstein, hamill, gravelle & connaughton, the limited liability company: a study of the emerging entity, 47 bus. lawyer 375 (1992) business entity organized under the laws of or resident in a foreign country is thus, for u.s. income tax purposes, either a corporation or a partnership. outside of the arena of taxation, the world is considerably more complex, as the internal revenue code recognizes in defining “corporation” to include, “associations” and “joint stock companies,” in addition to entities generally known as corporations. the supreme court decided in 1935 that the32 term “associations,” which the code does not define, should be interpreted to encompass any organization that resembled a corporation, as commonly understood, more than it resembled any other form of organization recognized by the tax law. the treasury embraced this decision by regulations that33 identified four corporate characteristics considered most useful in distinguishing corporations from partnerships: continuity of life, centralized management, limited liability, and free transferability of interests. under the34 regulations existing immediately before the treasury adopted the check-the-box regulations, a business entity exhibiting three or four of these characteristics was a corporation, while an entity not having more than two of the characteristics was a partnership.35 the corporate resemblance test was always difficult to apply, but this difficulty took on the character of futility with the emergence of the limited liability company (llc). unknown in the united states 30 years ago but now recognized by all 50 of the states, the llc is a very flexible form of business organization. all members of an llc enjoy immunity from personal liability36 for debts of the entity, but under the laws of most states, other corporate characteristics exist or do not exist at the members’ convenience. an llc may, but need not be, centrally managed, its life may be fixed by the members’ agreement, and each member’s ability to transfer his or her interest in the entity may also be determined by agreement. the members’ choices on these matters, while potentially important, likely do not usually go to the essence of the entity’s nature. llc laws thus provide the corporate characteristic probably most highly prized – limited liability for all members, while allowing the members to couch their operating agreement in terms suiting their tax convenience without significantly affecting their business relationship. 2005] whatever happened to subpart f? 197 37. see ps-43-95, 1996-1 cb 865. 38. td 8697, 61 fed. reg. 66,584 (dec. 18, 1996), reprinted in 1997-1 cb 215. 39. reg. § 301.7701-2(b)(1), (8). 40. reg. § 301.7701-3(a). 41. see, e.g., http://en.wikipedia.org/wiki/gmbh, last visited 17 november 2005. 42. see gmbh gesetz. 43. körperschaftsteuergesetz § 1(1). the treasury saw the check-the-box regulations as doing little more than giving legal sanction to the practical reality of electivity. under the37 regulations, which were adopted in 1996 and became effective as of the beginning of 1997, an entity organized under the corporation laws of a u.s.38 state, or under the laws of a foreign country analogous to state corporation laws, is a corporation for u.s. tax purposes. any business entity not39 encompassed by this per se rule may elect to be either a corporation or fiscally transparent. a fiscally transparent entity is a partnership if it has two or more40 owners. if it has only one owner, it is disregarded as an entity separate from its owner, and the owner is deemed to own all of the entity’s assets and to be the obigor of all of its liabilities. although the emergence of the llc was the precipitating fact, the regulations allow any entity other than a per se corporation to elect its status. an ordinary partnership may, for example, elect to be a corporation for u.s. tax purposes. apart from the regulations’ implications for international income, the treasury’s judgment about the effects of the regulations was probably correct. taxpayers and the irs experienced considerable difficulty in applying the corporate resemblance test, and given that the test usually allowed well-advised taxpayers to structure their unincorporated business entities to be either corporations or partnerships, as they chose, the resources spent on applying the test were largely wasted. by substituting an election for that test, the treasury simplified this aspect of the tax law without sacrificing any substantial governmental interest being served by the resemblance test. however, the check-the-box regulations revolutionized the u.s. international tax practice. the laws of many other countries allow entities similar to the llc, but they often classify these entities as corporations for tax purposes. for example, the gesellschaft mit beschränkter haftung (gmbh) is one of the principal forms of business organization in germany. the owners41 of a gmbh enjoy immunity from liability for debts of the entity, but a gmbh is not centrally managed, and whether it has the other corporate characteristics cited in the corporate resemblance regulations depends on the owners’ operating agreement. a gmbh is, however, considered a corporation for42 purposes of german taxation.43 198 florida tax [vol7:3 44. rev. rul. 93-4, 1993-1 cb 225, declared obsolete by rev. rul. 98-37, 1998-2 cb 133. 45. the regulations’ facilitation of hybrids did not come as a surprise to the treasury. in its first official indication that it was considering a wholly elective system, the treasury said: an elective approach could expand the potential that exists under the current classification regulations for hybrid structures. the service and treasury are considering whether it is appropriate to address inconsistent classification in any rules to be proposed and also are considering how the tax benefits or detriments that may result from inconsistent classification can be addressed through the tax treaty process. . . . . . . . because any change in the existing classification regulations is intended generally to simplify the rules without resulting in a substantial change in the classification of unincorporated organizations, the service and treasury must consider whether an elective approach should be modified with respect to foreign organizations. notice 95-14, 1995-1 c.b. 297, 298. 46. the term “reverse hybrid entity” appears in a few regulations. see, e.g., reg. § 1.894-1(d)(2). a gmbh that is a partnership or disregarded entity for u.s. tax purposes, but a corporation for german tax purposes, is an example of a hybrid entity. although it was possible for a gmbh to be a hybrid entity under the corporate resemblance regulations, the check-the-box regulations make hybrid44 status as easy as filling out a one-page form. the regulations allow the same45 ease of achieving hybrid status for entities organized in other countries that have entities analogous to the u.s. llc and treat them as corporations for local tax purposes. the regulations make it equally easy to create a so-called reverse hybrid entity – an entity that is fiscally transparent under the laws of a relevant foreign country but is classified as a corporation for u.s. tax purposes. for46 example, if a u.s. multinational enterprise causes two of its corporate members to organize a partnership to make an investment or carry on an activity in a foreign country, that country likely treats the partnership as fiscally transparent. if the partnership elects to be an association taxable as a corporation for u.s. tax purposes, it is a reverse hybrid entity. b. check-the-box schemes taxpayers have learned to use hybrid entities to defeat the application of subpart f. three examples are given below. 2005] whatever happened to subpart f? 199 47. in a variation on example 1, ipco is wholly owned by lco, another subsidiary of delco, that is organized under the laws of country l (the country in which opco is incorporated and operates) and is classified as a corporation for u.s. tax purposes. because ipco is also a disregarded entity in this variation, its technology is considered owned by lco, the license to opco is deemed made by lco, and the royalties are treated as though paid by opco to lco. lco is a cfc, and its royalty income is within the general definition of fphc income under § 954(c)(1)(a). however, the royalties are excepted by § 954(c)(3)(a) because they are received from a related corporation for the use of property within the country (country l) under the laws of which the cfc is organized. example 1. delco, a delaware corporation, produces and sells widgets in the united states and elsewhere using valuable technology that it has developed. foreign rights to this technology are owned by an entity organized under the laws of country h, which has no income tax and in which no significant operations of the delco group are located. the country h entity (ipco) is owned by a corporation (opco) that is organized under the laws of country l and is wholly owned by delco. opco licenses the technology from ipco, uses it in producing and selling widgets, and pays royalties for this use to ipco equal to 5% of opco’s revenues from these sales. the corporate income tax rate in country l is 35%, but the royalty that opco pays to ipco is deductible in determining opco’s country l taxable income. country l imposes a withholding tax of 10% on ipco’s royalty income. because ipco is subject to no tax in its home country, the net effect of the royalty payments is to reduce income tax on an amount equal to the royalties from 35% (the additional country l tax opco would pay if it had no deduction for royalty expense) to 10% (the country l withholding tax on the royalties). ipco elects to be a disregarded entity for u.s. tax purposes, and opco is therefore deemed to own the assets and owe the liabilities of ipco. since an entity cannot license property to itself or collect royalties from itself, the license agreement between ipco and opco is disregarded for u.s. tax purposes. as viewed for u.s. tax purposes, income of the opco/ipco entity derives solely from producing and selling goods. none of it is subpart f income.47 example 2. this example is the same as example 1, except that the parent-subsidiary relationship between ipco and opco is reversed. delco is sole owner of ipco, which is a corporation for tax purposes in all relevant countries, and ipco is sole owner opco, which licenses technology owned by ipco, uses it in producing and selling widgets, and pays royalties for this use to ipco equal to 5% of its revenues from these sales. opco elects to be a disregarded entity, and ipco is therefore considered, for u.s. tax purposes, to own the assets and be the obligor of the liabilities of opco. since ipco is deemed to be both the owner and the user of the technology, the licence agreement and the royalties paid under it are disregarded for u.s. tax purposes. 200 florida tax [vol7:3 48. if country g has an income tax treaty with the united states that forbids source-based withholding taxes on interest, as many u.s. treaties do, there may be no withholding tax on the interest. however, if the treaty follows the u.s. model income tax convention of september 20, 1996, treaty benefits are denied by article 4(1)(d), which states that income “derived through an entity that is fiscally transparent under the laws of either contracting state” is considered income of “a resident of a state [only] to the extent that the item is treated for purposes of the taxation law of such contracting state as the income, profit or gain of a resident.” since the income of prs is, for u.s. tax purposes, considered income of only prs, an entity that the united states does not treat as a u.s. resident, neither prs nor its owners qualify for treaty benefits with respect to the interest income. 49. if, for example, florco and ds have equal interests in prs, each of them is a u.s. shareholder under § 951(b), and prs is wholly owned by u.s. shareholders. 50. irc § 954(c)(1)(a). 51. irc § 954(c)(3)(a)(i). 52. irc § 954(d)(3) (person is related to cfc if it and cfc are controlled by same person or persons; control is ownership of more than 50% of the interests, directly, indirectly, or constructively). as in example 1, the license arrangement reduces the worldwide tax burden on income represented by the royalties from 35% to 10%, but because the checkthe-box election causes the royalties to disappear for u.s. tax purposes, no cfc has subpart f income. example 3. florco, a florida corporation, produces and sells gidgets in the united states and elsewhere. its operations in foreign country g are conducted by a wholly owned subsidiary, gco, which is organized under the laws of and managed within country g. florco and one of its domestic subsidiaries (ds) are the partners of a partnership (prs) organized under the laws of country g. prs lends $1,000 to gco at 10% interest. country g taxes gco on its income at 35%, but it allows gco a deduction for its annual interest payment to prs of $100. prs is a pass-through entity for country g purposes. its partners, not being resident in country g, are subject to country g tax only on income from sources in country g; because the interest payment to prs is from country g sources, country g imposes a 10% withholding tax on it.48 for u.s. tax purposes, prs elects to be classified as a corporation. prs is a cfc. its income, interest, would normally be foreign personal holding49 company (fphc) income and hence subpart f income. however, interest50 received by a cfc from a related person is not fphc income if the related person is a corporation organized under the laws of the same country as the cfc and uses a substantial part of its assets in a trade or business located in that country. prs is a related person with respect to gco, gco and prs are51 52 organized under the laws of the same foreign country (country g), and gco interest income is therefore not fphc income, and none of the income of gco or prs is subpart f income. 2005] whatever happened to subpart f? 201 53. see, e.g., notice 98-11, 1998-1 cb 433. 54. see, e.g., cooper, melcher & stretch, suddenly saving foreign taxes is abusive? an untenable proposal, 79 tax notes 885 (may 18, 1998); gannon, calianese, layden, moreland & seo, subpart f, hybrid entities, and other little things, 79 tax notes 473 (apr. 27, 1998), reprinted in 16 tax notes int’l 1467 (may 4, 1998); leblang, deferred gratification: a more rational approach for taxing u.s. multinationals, 27 tax mgmt. int’l j. 539 (1998); new york state bar ass’n tax section, notice 98-11: tax treatment of hybrid entities, 79 tax notes 877 (may 18, 1998), reprinted in 16 tax notes int’l 1669 (may 25, 1998); tax executives institute, hybrid arrangements notice “poor tax policy,” 16 tax notes int’l 1003 (mar. 30, 1998). see also avi-yonah, u.s. notice 98-11 and the logic of subpart f: a comparative perspective, 16 tax notes int’l 1797 (jun. 8, 1998); tillinghast, an oldtimer’s comment on notice 98-11, 78 tax notes 1739 (mar. 30, 1998); yoder, subpart f in turmoil: low-taxed active income under siege, 77 taxes 142 (mar. 1999). 55. the device illustrated by example 1 would likely not work if country l had cfc legislation, and the device illustrated by example 3 might be frustrated by a rule that an entity is taxable by country g as a corporation, even though it would normally be fiscally transparent, if more than one half of the interests in the entity are owned by c. is there a problem? the irs has identified situations such as those in the examples as circumventions of subpart f. in these cases, u.s. companies structure53 transactions and investments to divert income of types normally caught by subpart f (royalties and interest) into tax haven entities. in examples 1 and 2, the recipient entity is organized in a country easily identified as a tax haven. in example 3, the recipient is organized in a country that is not generally a tax haven, but it functions as a haven entity because of the conflicting treatments of the entity under the tax laws of country g and the united states. although each of the examples exhibits tax haven sheltering of the kind intended to be attacked by subpart f, a strategic check-the-box election prevents any of the enterprise’s income from being subpart f income. some commentators have argued that the results in the examples are not inconsistent with the aims of subpart f. the essential compromise54 reflected in subpart f is an objective to curb tax haven sheltering without denying tax deferral to income from active business operations in low-tax countries. in the examples, delco and florco carry on active businesses in foreign countries, and the devices that they employ to minimize foreign taxes may be seen as devices to lower the effective rate of tax on income from these businesses. although the countries in which the businesses are carried on have nominal income tax rates of 35%, they allow the effective rate to be reduced through the devices employed by delco and florco. because these countries55 202 florida tax [vol7:3 persons resident for tax purposes in a country or countries that treat the entity as a corporation for tax purposes. 56. irc § 954(c)(3)(a)(ii). 57. according to the treasury, the results in example 1 are “contrary to the policies and rules of subpart f” because “one of the purposes of subpart f is to prevent cfcs from converting active income that is not easily moveable and is earned in a jurisdiction in which a business is located for non-tax reasons, into passive, easily moveable income that is shifted to a lower tax jurisdiction primarily for tax avoidance.” td 8767, 1998-1 cb 875. 58. irc § 954(c)(3)(a)(i). tolerate the reductions in their taxes resulting from these devices, they are somewhat lower-tax jurisdictions than appears from their nominal rates. the argument does not, in my opinion, succeed in squaring the results in the examples with the purposes of subpart f. in example 1, if ipco, the entity receiving the royalties, elected to be a corporation for u.s. tax purposes, rather than a disregarded entity, it would be a cfc, and its income would be subpart f income, even though the economic consequences of the transactions would be the same as in the original example. similarly, in example 2, if opco, the payor of the royalties, elected to be a corporation for u.s. tax purposes, the royalties it pays to ipco would be subpart f income of ipco. royalties from a related corporation are excluded from fphc income, and hence subpart f income, only if they are paid for the use of property within the country in which the cfc is organized. this same-country exclusion does not56 apply in example 1 or example 2, even if ipco and opco are corporations for u.s. tax purposes, because the licensee, opco, does not use the technology in the country in which ipco is organized. the same-country exclusion evidently derives from congress’ conclusion that if a cfc receives royalties based on uses of intellectual property in the country in which it is organized, the choice of the cfc’s place of organization and the choice of the cfc as the vehicle for holding the intellectual property are likely based on economic factors, not tax minimization goals, and taxation of the royalties is determined by the tax policies of the country that is the situs of the economic activity from which the income derives (use of the intellectual property). the existence of this narrowly framed exclusion is evidence that congress did not intend that royalties (or other passive income) received from a related person that is actively engaged in business should generally fall outside the subpart f regime.57 the device in example 3 utilizes a statutory same-country exclusion: the exclusion of interest that a cfc receives from a related corporation that is incorporated in the same country as the cfc and uses a substantial part of its assets in a trade or business located in that country. however, the results the58 device achieves surely fall outside the intended scope of the exclusion. the assumption evidently underlying the exclusion is that if a cfc receiving 2005] whatever happened to subpart f? 203 59. according to the treasury, subpart f is intended “to prevent cfcs (including those engaged in active businesses) from structuring transactions designed to manipulate the inconsistencies between foreign tax systems to inappropriately generate lowor non-taxed income on which united states tax might be permanently deferred.” notice 98-11, 1998-1 cb 433, i. interest and the related payor of the interest are both resident in the country in which the payor is actively carrying on business, that country’s system of residence-based taxation will apply to all income of both entities; if the level of taxation is low, the case is simply one of doing business in a low-tax country, a situation subpart f is not intended to cover. in example 3, however, the recipient of the interest, prs, is not taxed as a resident of the country in which it is organized because, under the laws of that country, it is fiscally transparent. prs is not taxed as a resident of the united states either because, for u.s. tax purposes, it is a foreign corporation. thus, although prs is owned by u.s. persons, is organized in country g, and its income is from sources in country g, its income is not taxed on a residence basis by either country. the policy of the same-country exclusions might be seen as one of waiving u.s. residence-based taxation under subpart f of income that is likely subject to residence-based taxation in the country in which the income derives, directly or indirectly, from active business operations. avoiding residencebased taxation in all countries is not consistent with policies underlying any aspect of subpart f.59 d. solutions the examples illustrate devices exploiting differences between u.s. rules for classifying entities for tax purposes and equivalent rules of foreign countries. in example 1, ipco is considered a corporation under the tax laws of country l, the residence country of opco, the user of ipco’s intellectual property and the payor of the royalties received by ipco, but is a disregarded entity for u.s. tax laws, while, in example 2, opco is a corporation under country l law but is a disregarded entity for u.s. tax purposes. in example 3, prs is a corporation for u.s. tax purposes and a partnership under the tax laws of country g. as noted earlier, the check-the-box regulations facilitate such inconsistencies. 1. examples 1 and 2. soon after adopting the regulations, the treasury began reacting to devices exploiting them. it has proposed, but not yet adopted, regulations 204 florida tax [vol7:3 60. prop. reg. § 1.954-9. the regulations were initially promulgated in 1998 as temporary regulations, then withdrawn under political pressure, and finally reissued in 1999 as proposed regulations, with the promise that they generally would not become effective until five years after they were adopted as final regulations. for this history and more on the details of the proposed regulations, which are greatly simplified here, see bittker & lokken, supra note 3, ¶ 69.13.1. 61. prop. reg. § 1.954-9(a). targeting transactions of the kind illustrated by examples 1 and 2. in order for60 the proposed regulations to apply, a cfc must own a disregarded entity that is treated as a corporation under the laws of a relevant foreign country, the cfc must make a payment to or receive a payment from the entity, and this payment must be disregarded for u.s. tax purposes and treated, under the tax laws of a relevant foreign country, as a payment between separate entities. if the61 payment has the effect of reducing foreign taxes and would be fphc income, were it not disregarded for u.s. tax purposes, nonsubpart f income of the cfc equal to the payment is recharacterized as subpart f income. the proposed regulations would apply in example 1 because (1) opco, a cfc, owns a disregarded entity (ipco), (2) ipco is classified as a corporation under the laws of a relevant foreign country (country l, where opco is organized and does business), (3) opco makes payments to ipco (the royalties), (4) these payments have the effect of reducing foreign taxes (without the deduction for the payments, opco would pay country l tax at 35% on the amount of the payments; with the payments, this amount is only subject to a country l withholding tax of 10%), and (5) the payments would be fphc income if ipco were a corporation for u.s. tax purposes. under the proposed regulations, income of opco on sales of goods equal to the royalties would be recharacterized as fphc income. the proposed regulations would also apply in example 2 because (1) ipco, a cfc, owns a disregarded entity (opco), (2) opco is taxed as a corporation under the laws of a relevant foreign country (country l, where it is organized and does business), (3) opco makes payments to ipco (the royalties), (4) the deduction allowed to opco for these payments under country l law have the effect of reducing foreign taxes, and (5) the payments would be fphc income if opco were a corporation for u.s. tax purposes. under the proposed regulations, income on opco’s sales of goods equal to the royalties would be considered fphc income. it is not clear that if the treasury adopted the proposed regulations as final regulations, the courts would upheld them as a valid construction of the statutes. under the proposed regulations, items that are not otherwise within any category of subpart f income would be recharacterized as fphc income. nothing in the statutes explicitly authorizes this recharacterization. the code 2005] whatever happened to subpart f? 205 62. irc § 954(c)(1). 63. for an argument that the regulations are not valid, see gregg polsky, can treasury overrule the supreme court? 84 b.u. l. rev. 185 (2004). but see littriello v. us, 2005-1 ustc (cch) ¶ 50,385 (wd ky. 2005) (finding regulations valid). defines fphc income dividends, interest, royalties, and several other specifically-described items of gross income. it does not authorize the62 treasury to classify other types of income as fphc if necessary to avoid circumvention of the congressional purposes of subpart f. the problem is one of entity classification and might better be attacked on the basis of entity classification. in examples 1 and 2, the royalties disappear for u.s. tax purposes because the payor (opco) and the payee (ipco) are deemed to be the same person. the proposed regulations derive from a belief that the separate existence of these entities cannot be ignored for purposes of subpart f because doing so obscures the fact that fphc income does, in substance, exist. rather than denying disregarded entity status, however, they would taint particular income as a substitute for the income that would be fphc if payor and payee were considered separate entities. the statutory basis for this approach seems weak. the treasury’s power to promulgate regulations on entity classification should provided adequate authority to correct the problem. moreover, the problem is exacerbated, if not created, by the check-the-box regulations, and if the check-the-box regulations are valid, the authority under which they were63 issued should allow the treasury, by further regulations, to require corporate status for an entity normally within the elective regime of the regulations. the treasury might therefore consider reformulating the proposed regulations as amendments to the check-the-box regulations, providing that when the conditions for the application of the proposed regulations are satisfied, the entities making and receiving the relevant payment, which is called a “hybrid branch payment,” must both be treated as a corporation for all u.s. tax purposes, regardless of any election made by or for the entity. in examples 1 and 2, this approach would treat ipco and opco as corporations for all u.s. tax purposes, ipco would be a cfc, and its royalty income would be fphc income. it may be objected that this approach would go beyond the proposed regulations, affecting income other than hybrid branch payments. however, this consequence does not seem inappropriate since the problem arises from the classification of the payor or payee of a hybrid branch payments. to prevent small hybrid branch payments from determining the status of an entity for which fiscal transparency is overall unobjectionable, the treasury could carve out an exception to the suggested rule, allowing fiscal transparency for an entity 206 florida tax [vol7:3 64. compare irc § 954(b)(3)(a). 65. irc § 954(c)(3)(a). making or receiving hybrid branch payments if these payments are less than the lesser of 5% of the entity’s gross income or $1 million.64 2. example 3. neither the treasury nor the irs has formally responded to devices structured along the lines of example 3, perhaps because they became aware of these transactions after they had formulated their response to transactions of the kind illustrated by examples 1 and 2 and endured the ensuing political storm. the solution to the example 3 problem may be simpler than that to the issue posed by examples 1 and 2. by statute or regulations, congress or the treasury might provide that for purposes of the statutory same-country exclusions, the term “a corporation created or organized under the laws of the65 same foreign country” only includes an entity that is a corporation for purposes of the tax laws of both the united states and that “same foreign country.” this rule would deny the same-country exclusion in example 3, where prs, an entity treated as a partnership for foreign tax purposes but as a corporation for u.s. tax purposes, receives interest income from a related corporation organized under the laws of the same foreign country. without the benefit of the exclusion, the interest would be fphc income and therefore potentially subpart f income. regulations adopting this solution might be attacked on the ground that the definitions prescribed by section 7701(a), including the definition of “corporation” under which the check-the-box rules were adopted, apply wherever the defined terms are “used in this title” (title 26 of the united states code, the internal revenue code), except “where . . . otherwise distinctly expressed or manifestly incompatible with the intent thereof . . . ” nothing in the statutory same-country rules “distinctly express[es]” an intention that the section 7701(a) definition of “corporation” should not apply. arguably, applying the same-country rules with the section 7701(a) definition, which makes no reference to an entity’s status under foreign tax law, is not “manifestly incompatible” with the rules’ intent. if so, a special definition of “corporation” for purposes of those rules contradicts section 7701(a). although congress did not spell out its reasons for including the samecountry rules in subpart f, the policy most readily inferred from the rules supports a regulation adopting the suggested rule. congress probably assumed that if a corporation is organized in a country in which it carries on a trade or business or in which it uses intellectual property and pays dividends, interest, 2005] whatever happened to subpart f? 207 66. chevron usa, inc. v. natural resources defense council, inc., 467 us 837, 844 (1984). 67. bankers life & cas. co. v. u.s., 142 f3d 973, 983 (7th cir. 1998). 68. id. at 983. rents, or royalties to a related cfc organized under the laws of the same country, the recipient will likely be subject to the same regime of residence taxation with respect to the payment as is the payor with respect to its business income. if the country taxes both the payor and payee on a residence basis with respect to the item, a low effective rate of tax on the item can be explained as a result of doing business in a low-tax country, not as an exploitation of a tax haven device. however, this assumption holds true only if the “same country” taxes the recipient cfc as a corporation. the assumption is contrary to fact if the recipient is a partnership under the tax laws of that country and its partners are not residents of the country and are therefore not subject to residence taxation in the country. in that case, treating the cfc as a “corporation” for purposes of the same-country exclusions is “incompatible with the intent” of the exclusions. whether the section 7701(a) definition of “corporation” is, in this context, “manifestly incompatible” with the intent of the exclusions is perhaps a matter of judgment. the courts, however, traditionally defer to the treasury’s judgment on issues addressed by regulations on which competent analysts may reasonably disagree. the supreme court has held that “a court may not substitute its own construction of statutory provision for a reasonable interpretation made by the administrator of an agency.” one court has said:66 “if we conclude the statute is either ambiguous or silent on the issue, we . . . examine the reasonableness of the regulation. if the regulation is a reasonable reading of the statute, we give deference to the agency’s interpretation.”67 however, a court should enter into this inquiry only if “the plain meaning of the text . . . supports . . . the regulation” and should find a regulation invalid if the plain meaning of the text “opposes” the interpretation prescribed by the regulation. arguably, the supreme court might say that68 because the text of the statutory same-country exclusions provides no indication of the underlying policy, the plain meaning of the statutes requires that the exclusions be applied with the section 7701(a) definition of “corporation.” against this argument, it might be noted that the words in section 7701(a), “manifestly incompatible with the intent,” indicates that congress wanted purpose to play a larger role than would be the case under a “plain meaning” inquiry. if the treasury considers the risk of the suggested regulation being held contrary to the plain meaning of the statutory text to be unacceptably high, it should ask congress for legislation adopting the rule. 208 florida tax [vol7:3 69. reg. § 1.901-2(f)(1). 70. see mary c. bennett, whose tax is it anyway? foreign tax credits in a check-the-box world, 83 taxes 35 (mar. 2005). 71. indirect ownership should be determined by treating interests owned by foreign entities as owned ratably by their owners. see irc § 958(a)(2). 3. other check-the-box schemes the solutions suggested above leave one significant question unanswered: even if they succeed in bringing income of the types illustrated by the examples back within the ambit of subpart f, will they be equally successful in frustrating other check-the-box schemes for defeating subpart f, including schemes not yet conceived? the question is not easily answered. moreover, check-the-box schemes also plague other areas of international tax policy. assume two u.s. members of a u.s.-based multinational enterprise organize a partnership under the laws of foreign country z, where the partnership actively carries on business and which imposes tax on the resulting income at 35%. if the partnership is fiscally transparent under the laws of country z but elects to be a corporation for u.s. tax purposes, the u.s. tax results are as follows: under the so-called technical taxpayer rule, the u.s. partners are entitled to credit for the country z tax on the partnership’s income if they are the persons “on whom [country z] law imposes legal liability for such tax.” however, since the partnership is a corporation69 for u.s. tax purposes and its income is not subpart f income, the income is subject to u.s. tax only as it is distributed to the partners. as a result, the country z taxes are immediately creditable, even if u.s. taxation of the income burdened by these taxes is indefinitely deferred, a result contrary to the policy70 of the foreign tax credit to alleviate double taxation. to respond more comprehensively to check-the-box schemes, the treasury might consider two amendments to the check-the-box regulations, one to curb uses of hybrids and the other to address reverse hybrids: hybrid rule: an entity is mandatorily classified as an association, taxable as a corporation, for all u.s. tax purposes unless (1) u.s. persons do not own more than 10% of the interests in the entity, directly or indirectly, or (2) the entity is fiscally71 transparent under the laws of the country in which it is organized, each country in which it carries on business, and 2005] whatever happened to subpart f? 209 72. a de minimis exception to the latter portion of the test could be included, under which payments deductible under the laws of countries treating the entity as not fiscally transparent would disregarded if, in the aggregate, they do not exceed the lesser of 5% of the entity’s gross income or $1 million. see irc § 954(b)(3)(a). each country that allows a deduction for any payment to the entity.72 the reasons for the exceptions to the rule are as follows: if u.s. persons do not own more than 10% of the interests in an entity, directly or indirectly, the united states’ tax interest in the entity is probably not sufficient to force corporate classification. if the entity is fiscally transparent under the laws of all relevant foreign countries, it is not a hybrid entity. under this rule, ipco would be a corporation for u.s. tax purposes in example 1 and opco would be a corporation in example 2, regardless of any election made under the check-the-box regulations, because (1) the entity is indirectly owned by a u.s. person (delco) and (2) it is not fiscally transparent under the laws of country l, which is the source of the royalties and allows deductions for them. this rule would also frustrate some devices for separating creditable taxes from the income on which the taxes are imposed. assume usco, a delaware corporation, manufactures and sells fidgets in foreign country z. manufacturing operations are organized as one country z company, sales operations as another such company, and a third country z company, which is directly owned by usco, is sole owner of the manufacturing and sales companies. the three country z entities are taxable as corporations under country z law, but are not per se corporations under the check-the-box regulations. the entities elect to file on a consolidated basis under country z’s fiscal unity regime, which makes the group parent liable for the entire tax on the group’s income. under the present regulations, usco may elect to treat the country z holding company as a disregarded entity for u.s. tax purposes, while treating the manufacturing and sales companies as corporations for these purposes. as a result, usco may claim credit for all country z taxes on the income of the country z group, but the income of the manufacturing and sales companies is taxable to usco only as the companies distribute the income to the holding company. under the proposed rule, the holding company would be a corporation for u.s. tax purposes because it is owned by a u.s. person (usco) and it is not fiscally transparent under the laws of the country in which it is organized. 210 florida tax [vol7:3 73. see irc § 951(b) (u.s. shareholder is u.s. person owning at least 10% of foreign corporation’s voting stock, directly, indirectly, or constructively). 74. a de minimis exception to the latter portion of the test could be included, under which payments deductible under the laws of countries treating the entity as not fiscally transparent would disregarded if, in the aggregate, they do not exceed the lesser of 5% of the entity’s gross income or $1 million. see irc § 954(b)(3)(a). 75. supra text accompanying note 48. reverse hybrid rule: an entity is fiscally transparent for all u.s. tax purposes with respect to each u.s. person who would be a u.s. shareholder,73 were the entity a corporation for u.s. tax purposes, if it is fiscally transparent under the laws of the country in which it is organized, a country in which it carries on business, or a country that allows a deduction for a payment to the entity.74 under this rule, prs, the reverse hybrid entity in example 3, would be a75 partnership for u.s. tax purposes, as it is under the tax laws of country g, because (1) both of its partners (florco and its domestic subsidiary) would be u.s. shareholders if prs were a corporation for u.s. tax purposes and (2) prs is fiscally transparent under the laws of country g, where it is organized and which allows deductions for payments to prs (its interest income). this rule would also frustrate some devices for separating creditable taxes from income on which the taxes are imposed. for example, if two u.s. members of a u.s.-based multinational enterprise organize a partnership under the laws of foreign country z, where the partnership actively carries on business and which imposes tax on the resulting income at 35%, the rule would preclude the partnership from being classified as a corporation for u.s. tax purposes if it is fiscally transparent under the laws of country z. if the entity is treated as a partnership for u.s. tax purposes, u.s. partners would be allowed credit for taxes on the partnership’s income, but the united states would also tax them on this income. iv. conclusions the treasury’s adoption of the check-the-box proved to be a very troubling development for international tax policy. this paper explores how the regulations facilitated devices that divert income into the shelter of tax havens while steering clear of subpart f. as a result of these devices, subpart f has fallen increasingly short of the goal of curbing tax haven sheltering. the paper suggests that with relatively small changes in the regulations and the subpart f statutes, congress and the treasury could go far toward restoring subpart f 2005] whatever happened to subpart f? 211 to its intended scope. congress and the treasury should take these steps promptly. page 1 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 page 16 page 17 page 18 page 19 page 20 page 21 page 22 page 23 page 24 page 25 page 26 florida tax review volume 10 2010 number 2 a proposal for an elective tax benefits transfer system by professor ronald w. blasi i the proposal ...................................... 269 ii. organization of paper ....................... ....... 272 m. impact of tax benefits ............................. 273 a. current system distorts a firm's tax liability and cash flow ................................. 274 b. current system distorts reported earnings ... ...... 276 c. current system impedes effectiveness of tax incentive legislation ........................... ...... 278 d. current system distorts competitive status of lessors ....280 e. current system distorts decision making of lessees....... 280 f. examples...................................282 example 1. current system with full crd utilization by lessor ........................................ 282 example 2. current system: unused crd...... ..... 284 example 3. proposed system: shifted benefit from crd ................................. 284 example 4. proposed system: shared benefit from crd ................................. 285 iv. proposal supported by microeconomic theory ............ 286 a. "utility" maximized/inefficiency minimized by proposed system................... ................. 286 b. supply and demand analysis predicts effectiveness of proposal .................................. 288 c. charting supply and demand of leased property ........... 289 1. demand chart......................... 289 2. supply chart .................... ..... 290 3. equilibrium ................. ......... 291 4. supply equilibrium shift-deadweight loss created.............................. 291 5. supply and demand equilibrium shiftdeadweight loss eliminated......... ....... 293 267 florida tax review v. proposal supported by current statutory law ........... 293 a. tax benefit transfers ................... ...... 293 1. tax credit transfers ............... .............. 294 2. tax basis transfers-to other taxpayers ........... 296 3. tax basis transfer-to other property owned by taxpayer.............................298 b. tax avoidance intent.........................................................299 1. current statutory provisions employing tax avoidance .................... ....... 299 2. statutory constraints on tax avoidance..............301 vi. proposal supported by current judicial doctrines .... 303 a. judicial constraints on tax avoidance.............................303 b. is there a business purpose for the transaction?..........305 c does taxpayer have tax avoidance intent? .................... 306 d. does structure of transaction reflect its purpose? ......... 307 vii. taxation of transferred tax benefits .............. 308 viii. conclusion ....................................... 310 268 [vol. 10:2 a proposal for an elective tax benefits transfer system abstract this article proposes an elective tax benefit transfer system to be available to lessors of property who use that property in their trade or business. it describes why the current linkage of tax benefits to property ownership is economically inefficient, causing it to have several significant disadvantages to the parties and to the economy, as a whole. the article discusses how the current system reduces a firm's cash flow and reported earnings, diminishes the intended effect of tax incentive legislation, distorts competition and decision making, and inhibits investment in efficient business assets. it is submitted that the proposed system corrects all of the shortcomings, while not violating any tenet of taxation and being consistent with congressional attempts to limit tax avoidance. i. the proposal federal income tax law has evolved to a point where it is time to abandon the linkage between property ownership and entitlement to cost recovery deductions and property related credits for leases of new equipment and software.' this paper proposes that lessors be granted an election to transfer to lessees cost recovery deductions (hereinafter, "crd") 2 and tax credits associated with property that is leased under an arrangement that * professor blasi is the mark and evelyn trammell professor of tax law at georgia state university college of law. he was the former chair of the aba tax section's committee on banking and savings institutions. he expresses his gratitude for the extraordinarily helpful research assistance provided by ms. laura reinhold, a third-year law student, and mr. michael tillman-davis, the reference and faculty services librarian, at georgia state university college of law. he also thanks professor mary radford and mr. willard timm, his colleagues at the college of law, mr. stanley hackett of troutman and sanders, and mr. rob holzman, managing director, crestview capital advisors, for their very helpful comments on various drafts of this article. 1. investment during 2008 in equipment and software exceeded $1.1 trillion. bureau of economics analysis, national income and products accounts, fixed asset accounts, available at http://www.bea.gov/national/fa2004/e&s.pdf. see also, equipment leasing & finance foundation, u.s. equipment finance market study, 2007-2008. 2. the term "cost recovery deductions" or "crd" will be used in this paper to describe both depreciation and amortizations deductions. it is common for depreciation to describe cost allocation of tangible property and for amortization to describe that allocation for intangible property. investing in new equipment or other business property may also generate tax credits that reduce tax liability on a dollarfor-dollar basis. discussed at section v of this paper are two property related credits: the low-income housing credit and the new market's tax credit. irc §§ 42 and 45d. 2010] 269 florida tax review qualifies, for federal income tax purposes, as a true lease, i.e. a lease in which the lessor is treated as the true owner of the property. this proposal is timely because of the proliferation of property related tax incentives. congress has been producing an expanding inventory of accelerated cost recovery provisions and property related credits in an effort to achieve a variety of non revenue raising policy objectives. unless tax benefits are able to be transferred, the intended impact of tax incentive legislation, including economic stimulus legislation, will likely not be achieved, and the nation's economy will not expand as expected. the proliferation of tax benefits also has exacerbated distortions in the relative competitiveness of lessors as well as in the decision making of lessees. finally, both cash flow and reported earnings of the parties is negatively affected by current law constraints on tax benefit transferability. as the discussion of microeconomic principles set forth below will demonstrate, permitting tax benefits to be sold will increase their efficiency. for example, a lessor of equipment may elect to sell some or all of the equipment's crd to the lessee. the taxpayer may prefer to convert these tax benefits into cash because it may not be in a position to realize part or all of the tax savings that the deductions could generate. the tax benefits, themselves, may not be worth to the property owner what they may be worth to the transferee. if the lessor were permitted to liquidate the tax benefits, the lessor would be able to reduce rent, yet derive the same after-tax return from its investment. the government should be indifferent as to which party to the transaction utilizes the tax benefit so long as they are used for the intended purpose. nearly 30 years ago, in the economic recovery tax act of 1981 ("erta"), congress enacted, then almost immediately repealed, legislation referred to as "sale harbor leasing.'a it was radical tax legislation that was 3. a true lease for tax purposes is defined in rev. proc. 2001-28, 2001-1 c.b. 1156. the factors set forth in the guidelines include representations relating to: the minimum unconditional at risk investment of the lessor, renewal or extension options, purchase or sale rights, the lessee's investment in the property. these guidelines superseded earlier guidelines. rev. proc. 75-21, 1975-1 c.b. 715; rev. rul. 55-540, 1955-2 c.b. 39. for a comprehensive and critical analysis of the linkage between property ownership and taxation, in general, see, noel b. cunningham and deborah h. schenk, taxation without realization: a "revolutionary" approach to ownership, 47 tax l. rev. 725 (1991-1992). 4. pub. l. no. 97-34, 95 stat. 172 (1981). this provision was intended to increase the likelihood that the cash flow benefit would be realized from the erta's liberalized cost recovery and investment credit provisions. in the tax equity and fiscal responsibility act of 1982, pub. l. no. 97-248, 96 stat. 324, congress repealed the safe-harbor leasing rules. 270 [vol. 10:2 a proposal for an elective tax benefits transfer system significantly different from this proposal.' although it also permitted tax benefits to be transferred, they were transferrable to the lessor, not to the actual user of the property, as this called for in this proposal. by virtue of a fictitious sale/leaseback transaction, the nominal lessor became the deemed owner of the property to whom tax benefits were thereby transferred. fundamental tenets of taxation were violated in the process, as was noted in the conference committee report that accompanied the legislation: "the new provision is a significant change overriding several fundamental principles of tax law. traditionally, the substance of a transaction rather than its form controls the tax consequences of a transaction. in addition, a transaction generally will not be given effect for tax purposes unless it serves some business purpose aside from reducing taxes. because the leasing provision was intended to be only a transferability provision, many of the transactions that will be characterized as a lease under the safe harbor will have no business purpose (other than to transfer tax benefits). when the substance of the transaction is examined, the transaction may not bear any resemblance to a lease."' this proposal does not contravene any anti-tax avoidance statutory provision or judicial doctrines. to respect current law limits on trafficking in tax benefits, the proposed system restricts tax benefit transfers to the lessee. the proposal is limited to tax benefit transfers by the true owner of property (the lessor) to the party possessing the right to use the property (the lessee). it is consistent with the business purpose doctrine by permitting tax benefit transfers only as an adjunct to a bona fide lease of property and not when tax avoidance is the primary intent behind the transaction. the proposal also calls for adherence to the substance over form doctrine. no fiction is created to establish the owner's entitlement to the tax benefits. the lessor from 5. states have not shied away from similarly radical tax legislation. for e.g., see the georgia entertainment industry investment act of 2008, o.c.g.a § 48-740.26 (2009), which permits production companies to sell tax credits earned for film, video, or digital production in the state. 6. for a critical discussion of the fictional leasing transactions constructed by the safe-harbor leasing legislation see, alvin c. warren, jr. and alan j. auerbach, transferability of tax incentives and the fiction of safe harbor leasing, 95 harv. l. rev. 1752 (1982). 7. general explanation of the economic recovery tax act of 1981, jcs 71-81, title ii business incentive provisions, no. 7, sec. 0 (1981) (joint comm. on taxation). 8. tomasulo, "net operating losses and credit carryovers: the search for corporate identity," 20 tax notes 835, sep. 12, 1983. 2712010] florida tax review whom the tax benefits will be transferred will be the actual owner of the property, and the lessee or purchaser, the actual user.9 h. organization of paper this paper has five sections. it begins by establishing that improving the economic efficiency of property related tax benefits is needed and justified for several reasons: (a) consistent with the income tax being imposed on income net of reasonable business expenses, cost recovery deductions represent a business expense that should be fully deductable from gross income, (b) the reported earnings of firms should properly reflect tax expense, (c) tax deductions and credits that are designed to incentivize behavior are more likely to achieve their economic or social objectives if they are allowed to be transferred, (d) the current system distorts the competitive status of lessors, and (e) the current system distorts decision making of lessees. in the second section, there is a discussion, with illustrations, of how laws of microeconomics support the proposal. it is demonstrated that the volume of property transfers eligible for tax depreciation or credit and the demand therefore can be predicted to increase if the parties to these transactions are free to allocate tax benefits between themselves. the effect of government tax policy on property transfers will be illustrated, and it will be show that full utilization of intended tax benefits will avoid the inefficiency caused by underutilized tax benefits. the third section of the paper will establish that the proposal is supported by current internal revenue code provisions.10 it will be explained that even though tax avoidance may be a significant factor considered by the parties before entering into a transaction underlying the proposed tax benefit shift, there is no proscription in current law that would prevent tax benefit transfers intended as an adjunct of a bona fide business transaction. provisions will be identified that currently allow tax benefits to be transferred among taxpayers, even taxpayers that are not owners of the property giving rise to the tax benefit and even when a tax avoidance intent influences the transaction. in the fourth section of the paper, the judicial constraints on tax avoidance will be discussed. judicial doctrines dealing with business purpose 9. one of the reasons for the repeal of the erta safe-harbor leasing rules was concern that its revenue cost was large. general explanation of the revenue provisions of the tax equity and fiscal responsibility act of 1982, h.r. 4961, 97th cong, pub. l. no 97-248, p. 53. this proposal is considerably more modest in terms of its potential revenue impact. 10. all references to the "internal revenue code," "code," "section," or "irc" are to the internal revenue code of 1986, as amended. 272 [vol. 10:2 a proposal for an elective tax benefits transfer system and substance over form will be analyzed and applied to the proposal. it will be established that the proposal is consistent with these rules the final section of the paper contains a recommendation for how the transfer of tax benefits should be taxed. the intended tax-free transfer of tax benefits will be shown to be consistent with the current treatment of realized of tax benefits, and it can be reconciled with tax benefits transferred as an adjunct of tax-free property exchanges under current law. iii. the impact of tax benefits on lessors and lessees the constitution authorizes a tax to be imposed "...on incomes, from whatever source derived... ."1 congress first exercised the "full measure of its taxing power [footnotes omitted]"' 2 in the revenue act of 1913, a statute designed merely to raise revenue to supplement federal excise taxes, tariffs, and custom duties, the primary sources of federal government revenue at the time.'3 as the income tax assumed the dominant revenue raising role, its ability to serve as a tool of social and economic policy was recognized. with increasing frequency, federal income tax provisions have been designed to encourage investment in targeted property and activities, promote savings, redistribute wealth, stimulate the economy, while, of course, raising most of the federal government's revenue. the ancillary objectives are accomplished largely through the use of tax incentives designed to allow taxpayers to avoid the income tax's revenue raising objective. tax benefits take a variety of forms. they are offered as provisions that defer or exclude income, accelerate or enlarge deductions, or permit credits against tax liability. for many commercial enterprises, one of the most significant incentives that congress provides is the allowance for accelerated crd. however, unless crd are permitted to be transferred, accelerated cost recovery may fail as an incentive that influences investment behavior and the policy objective of accelerating these deductions may not be achieved. the benefits flowing from tax incentives that are utilized are numerous. as will be discussed below, in the short-term a firm's cash flow and reported earnings will increase. several long-term and indirect benefits also result. for example, the acquisition of new equipment made feasible by 11. u.s. const. amend. xvi. 12. comm'r. v. glenshaw glass co., 348 u.s. 426, 429 (1955), rehearing denied, 349 u.s. 925 (1955). 13. the revenue act of 1913, pub. l. no. 16, 38 stat. 114, ch. 16, contained the statutory imposition of the income tax at § ii(a)(1) where it provided, in part, "[t]hat there shall be levied ... upon the entire net income arising or accruing from all sources ... a tax of i per centum per annum upon such income..." 2010] 273 florida tax review the tax benefits also result. new equipment likely will operate more efficiently than the equipment it replaces, thereby further increasing reported earnings and cash flow. the firm's domestic and international competitiveness may be enhanced, especially if the depreciable property is a material factor in the firm's income generation. on a larger scale, the collective cost savings realized by improved profitability will enhance the size and strength of the nation's economy. a. current system distorts lessors' tax liability and cash flow for tax liability and cash flow to be properly calculated, all allowable tax benefits should be taken into account. this fundamental principal of tax law was recognized in the first income tax statute, which permitted businesses to deduct most costs associated with earning the income that comprised taxable income, the income tax base.14 principal among these deductions was the property related deduction for cost recovery. unless tax liability takes into account allowed deductions and credits, the firm's tax liability is overstated and its cash flow is understated. the revenue act of 1913 provided "[t]hat is computing net income for the purpose of the normal tax there shall be allowed as deductions: ... sixth, a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business, ..."1s crd continues to be the most significant property related deduction. currently, it is allowed under section 167, a section that contains language nearly identical to the 1913, provision. the section provides in pertinent part that "[t]here shall be allowed as a depreciation deduction a reasonable allowance for the ,016exhaustion, wear and tear ... of property used in the trade or business ... . the allowance for depreciation has long been justified as a reasonable business expense on the theory that the amount of the annual deduction represents that portion of the property's initial value that is estimated to be consumed during the accounting period in generating income of that period. in 1927, justice brandeis wrote in u.s. v. ludey: "the depreciation charge permitted as a deduction from the gross income in determining the taxable income of a business for any year represents the reduction, during the year, of the capital assets through wear and tear of the plant used. the amount of the allowance for depreciation is the sum which should be set aside for the taxable year, in order 14. irc § 63. 15. the revenue act of 1913, § ii g(b), 38 stat. 172234(a)(7). the excise tax act of 1909, § 38(2d), 36 stat. 112, 113, permitted a similar deduction. 16. irc §§ 167 and 168. [vol. 10:2274 a proposal for an elective tax benefits transfer system that, at the end of the useful life of the plant in the business, the aggregate of the sums set aside will (with the salvage value) suffice to provide an amount equal to the original cost. the theory underlying this allowance for depreciation is that by using up the plant a grandual [sic] sale is made of it. the depreciation charged is the measure of the cost of the part which has been sold. when the plant is disposed of after years of use, the thing then sold is not the whole thing ,,l7originally acquired. conversely, a distortion of tax liability occurs when a firm is unable to benefit from allowable deductions. the cost of the item to which the deduction relates becomes significantly greater whenever it does not yield a tax savings. by permitting crd to be transferred for consideration, a firm is able to reduce asset cost, albeit indirectly, by the amount of the cash consideration received for the tax benefit, as the incentivized depreciation rules intend. ability to use tax benefits depends upon there being tax liability, before taking into account any tax benefits. a firm without adequate federal tax liability will be unresponsive to tax incentive legislation.' 8 insufficient tax liability may be attributable to several factors, including market conditions peculiar to the taxpayer or general economic conditions. moreover, it may occur during either strong or weak economic times. for instance, if the taxpayer were a tax sensitive business, in a strong business environment taxable income may be eliminated by tax deductions. equipment leasing firms are especially vulnerable to deficiencies in taxable income. by the nature of their business they generate significant crd from the property they purchase to lease. if the lessor is unable to deduct crd, the cost of the property is not partially offset by tax savings, causing a rational equipment lessor to refrain from entering into new leases, unless rent can be increased. it the taxpayer were in this position, to benefit from the deductions 17. u.s. v. ludey, 274 u.s. 295, 300-301 (1927). 18. deductions in excess of current taxable income will result in a "net operating loss," which is usually allowed to be carried over to subsequent periods. irc §§ 172, 465, 469 are examples of sections that permit a deferral of deductions that cannot be currently used by the taxpayer. an excess of credits over tax liability before credits will result in a credit carryover. the deferral of the deduction's benefit will reduce its present value. for example, the present value of a tax savings of $350 that is deferred for three years, assuming a discount rate of 4.5% compounded annually, would be $294, a 16% reduction in cost savings. a firm that is a member of a consolidated group is permitted to offset its tax losses against the taxable income of other members of the consolidated group. treas. reg. §§ 1.1502-2 and 21. 2010] 275 florida tax review and credits, the tax benefits would have to be transferred for valuable consideration. the proposal addresses the deficiency in current law by providing for the tax-free receipt of compensation for transferred tax benefits.19 the compensation received should equal the value of the benefits transferred, an amount equal to the benefit if it were retained and fully utilized by the transferor. realized tax benefits have a positive effect on cash flow, not only in the year of deduction, but over time. funds not used to pay tax are available to generate additional cash flow. this cycle generation of cash flow, reinvestment of cash flow, generation of cash flow continues, in theory, indefinitely. for example, if $100 of tax is saved each year for 5 years and if the after-tax rate of 4% is earned on the cash not used to pay tax, the compounded amount of additional cash at the end of the fifth year from the $100 annual tax savings would be approximately $563.00.20 as the additional $63 of cash flow is generated over the 5 year period, it is reinvested and it generates even more additional cash flow. this cash flow benefit is not achieved if the deductions do not result in a tax savings. b. current system distorts lessors' reported earnings for financial reporting purposes, leasing transactions could be placed into one of two categories: capital leases or operating leases.2 ' in the former the incidents of ownership are transferred to the lessee. in tax parlance, this is sometimes referred to as a "conditional sales contract." an operating lease is one in which the lessor retains ownership of the leased property.22 generally accepted accounting principles ("gaap"), pursuant to which firms determine their net income for financial reporting purposes, similarly require earnings to be charged for depreciation expense in order to be property reflected. however, reported earnings can be distorted by current 19. the tax treatment of the payment and receipt of compensation for tax benefits is discussed in § vii of this paper. 20. the compounded amount of an annuity of $100 at a 4% discount rate is the sum of the value at the end of each of the 5 periods multiplied by the tax savings. thus, s = $100 (1 + .04)5. 21. statement of financial accounting standards 13 prescribes the factors that are to be used to classify a lease as a capital lease or an operating lease for financial reporting purposes. 22. for a discussion of the implications of off-balance sheet lease financing arrangements, see report prepared by the office of the chief accountant, office of economic analysis, division of corporate finance, u.s. securities and exchange commission, report and recommendations pursuant to § 401(c) of the sarbanesoxley act of 2002 on arrangements with off-balance sheet implications, special purpose entities, and transparency of filings by issuers, beginning at p. 60. 276 [vol. 10:2 a proposal for an elective tax benefits transfer system tax law whenever a firm is unable to utilize all tax benefits. the proposal eliminates potential distortion whenever potentially unused tax benefits are transferred to a party who uses them in exchange for valuable consideration. financial literature describes crd as "the process of allocating the cost of assets such as plant and equipment to the period in which the company receives the benefits from these assets." 23 a firm's earnings for financial reporting purposes and for income tax purposes are both negatively affected when tax benefits do not reduce tax liability; however, the effect of tax benefits on reported earnings is quite different from the effect on tax liability. reported earnings are reduced by tax expense, just are they are by other business expenses; however, the reduction is less (a favorable result) if the tax benefit actually reduces the firm's federal income tax liability. this positive effect on reported earnings is equal to the firm's marginal tax rate multiplied by the deduction or by the face amount of a tax credit. for example, a firm in the 35% marginal income tax bracket will have a net reduction in reported earnings of only 65% of the cost of depreciable property if the deduction reduces federal income tax liability. in the parlance of tax planners, the deduction is "tax effected" for financial reporting purposes when it is deductible for federal income tax purposes. if, or to the extent that, the tax deduction does not result in an actual reduction in federal income tax liability, the deduction may not be tax effected. this will create a distortion in reported earnings because a portion or all of the cost of the business asset will not reduce gaap tax expense. financial accounting standards statement no. 109 provides that if there is only a 50% or less likelihood that the item will be taken into account in the future, the item is not permitted to be tax effected for reported earnings purposes. 24 gaap does not require conformity between the method used to depreciate property for tax purposes and the method used for financial reporting purposes. in fact, it is customary to employ a straight line method for financial accounting, even though accelerated depreciation is customarily used for tax purpose. this creates what is referred to as a timing difference; that is, a difference between when tax expense is charged to financial accounting income and when it is paid to the u.s. treasury. any excess of the financial accounting provision for income taxes over the amount reported on the firm's tax return creates a deferred tax asset.2 5 timing differences of this nature do not distort reported earnings. 23. diamond, stire and stire. financial accounting reporting and analysis 481 (south-western college publishing, 2000). 24. accounting for income taxes. statement of fin. accounting standards no. 109, §§ 17e, 97 (fin. accounting standards bd. 1992). 25. whenever an item of income or expense is taken into account in different years in determining net income for financial reporting purposes or taxable 2010] 277 florida tax review the amount of compensation received for the tax benefits should be includible in book income as other receipts from property sales, but on a taxfree basis. by treating the amount received for tax benefits this way, the firm is placed in the same after-tax position it would be in if it realized the tax benefits directly.26 c. current system impedes effectiveness of tax incentive legislation congress enacts special crd rules to incentivize investment in a wide variety of business assets. illustrations of some of these rules include irc section 167(f) for computer software, irc section 168(1) for biomass ethanol plant property, irc section 168(e)(4) for railroad grading or tunnel bore, etc... . these provisions accelerate cost recovery by both shortening the assets depreciable life and accelerating the rate at which business assets' cost is recoverable.27 tax incentives consciously elevate macroeconomic and social objectives above the tax accounting matching concept and the tax law's revenue raising objective. legislation that accelerates crd assumes that the investment behavior of a firm's manager can be significantly influenced by the allure of reduced current tax liability.29 this was the rational for 1954 internal revenue code's significant liberalization of depreciation rules that allowed for the 200% declining balance method and shortened recovery periods.30 income for income tax purposes the book expense for income taxes will not equal the amount of tax reported on the tax return. financial accounting standards statement no. 109 prescribes rules for determining deferred income taxes and intraperiod tax allocation. 26. the tax treatment of the payment and receipt of compensation for tax benefits is discussed in § vii of this paper. 27. it also is recognized that many types of equipment contribute more to a firms earnings in the early years than in later years of the equipment's life. 28. a fundamental concept of tax law that appears to be violated by accelerated depreciation is the longstanding principle that income must be "clearly reflected;" that is, the expense for the period are matched with the income from the period. irc § 446. 29. a critical analysis of accelerated depreciation is found in yoram margalioth, not a panacea for economic growth: the case of accelerated depreciation, 26 va. tax rev. 493 (2006-2007). 30. the amended legislation barred the irs from challenging a taxpayer's depreciation if the useful life that the irs determined to be accurate differed from the taxpayer's useful life of the property by 10% or less. the statutory amendments prompted the irs to alter its pronouncement containing the period over which cost is recovered. prior to 1962, depreciation lives were set forth in bulletin f. in that year, rev. proc. 62-21, 1962-2 c.b. 418 was promulgated. it set forth useful lives for four broad groups and 56 classes of assets within those groups. [vol. 10:2278 a proposal for an elective tax benefits transfer system the senate finance committee justified those depreciation liberalization rules saying: "more liberal depreciation allowances are anticipated to have far-reaching economic effects. the incentives resulting from the changes are well timed to help maintain the present high level of investment in plant and equipment. the acceleration in the speed of the tax-free recovery of costs is of critical importance in the decision of management to incur risk. the faster tax write-off would increase available working capital and materially aid growing businesses in the financing of their expansion. for all segments of the american economy, liberalized depreciation policies should assist modernization and expansion of industrial capacity, with resulting economic growth, increased production, and a higher standard of living."3 years later, in response to the weakness in the economy in 1981, erta was enacted. the preamble to the act stated that it is designed "to encourage economic growth through ... acceleration of capital cost recovery of investment in plant, equipment, and real property ... one of the centerpieces of the erta was the section 168 accelerated cost recovery system. the acrs system replaced the prior depreciation rules with an administratively simpler and accelerated system. in connection with the most recent recession, congress again turned to cost recovery rules to stimulate a flagging economy. among the provisions contained in the american recovery and reinvestment act of 2009 (hereinafter, "the 2009 act") was one that liberalized the "bonus depreciation" rules that allow for immediate expensing of the cost of many business assets. as will be demonstrate below, there is a paradox caused by this linkage when the tax law is used to stimulate the economy: in weak economic times when incentives are most needed the incentive provided in tax benefits tends to have less of an impact, or none at all, than they do during periods when the economy is strong. by linking tax incentives to property ownership, the size and vitality of the economy as a whole is artificially retarded. fewer transactions will take place because tax benefits may not be able to reduce cost. the "economic growth, increased production, and ...higher standard of living" expected to occur from crd are unlikely to be realized unless stimulus legislation operates in a tax law environment in 31. s. rep. no. 83-1622, p. 26 (1954). 32. preamble to the economic recovery tax act of 1981, pub. l. no. 9734, h.r. rep. no. 4242 (1981). 2010] 279 florida tax review which transferability of crd is permitted." inefficient use of tax deduction and credit legislation also created and exaggerated disparities between businesses. those firms that are able to use the incentive are placed at a competitive advantage over those firms unable to realize the tax benefits. d. current system distorts lessors' competitive status competitive neutrality is a fundamental economic principal. it calls for all parties who operate in a market to be treated in a similar fashion. tax policy and other governmental imposed restrictions should not distort the market equilibrium.3 4 under the current tax system, lessors operating in the same market can easily be in financially dissimilar positions, merely because of tax rules. one lessor may be able to utilize all tax benefits, while another lessor may not. for example, a lessor that is a member of a consolidated group of corporations which contains a corporation that generates significant taxable income is able to derive the full benefit from tax deductions and credits because the consolidate return rules permit the losses of one corporation to be offset against the income of another corporation. a leasing company without the ability to offset its tax losses against the income of another corporation would have a higher cost of operation.3 s thus, those lessors who are able to benefit fully from tax incentives are in a financial position to charge lower rent than lessor's whose property cost is not reduced by tax benefits. if tax benefits are permitted to be decoupled from the lessor's property and allowed to be transferred to the lessee, the relative competitive status of lessors will become more neutral. those lessors who are able to benefit from the tax deductions and credits associated with the property they lease will no longer be at an advantage over the lessors unable to absorb those tax benefits. e. current system distorts lessee decision making the current system significantly distorts the lessee's decision making because the desire for tax benefits competes with concerns associated with obsolescence. many lessees are inclined to lease instead of purchase property because of they believe that the property is likely to become obsolete; however, if the property is leased, the taxpayer forgoes the 33. h.r. no. 83-1337 (ii), p. 4048 (1954). 34. william d. eggers, competitive neutrality: ensuring a level playing field in managed competitions. reason public policy institute, how-to guide no. 18, p. 6, mar. 1998. 35. for this reason the current tax rule may also hampers entry of new leasing firms into the leasing market. 280 [vol. 10:2 a proposal for an elective tax benefits transfer system tax benefits associated with the property. tax neutrality advocates that business decisions should not be affected by tax rules. instead, tax law should neither encourage nor discourage taxpayers from entering into certain transactions. 37 although competitive factors may result in a portion of the value of the tax benefits restricted to a lessor being reflected in reduced rent, restrictions on tax benefit transfers and the absence of perfect competition make distortions likely to occur. obsolescence can take many forms. economic obsolescence occurs when replacement of equipment offers lower ownership costs. as an example, an air conditioning unit becomes economically obsolete when it is less expensive to replace the unit with a more energy-efficient one than it would be to continue using the existing unit. when innovation makes an existing product inferior to a new generation of products, the existing product becomes technologically obsolete. for example, a new operating system might offer additional functionality, making the old operating system technologically obsolete but still useful. functional obsolescence occurs when a product can no longer be used. this type of obsolescence generally occurs when a standard changes. for example, printers with parallel ports are no longer useful when current computers only possess usb ports. in some industries, obsolescence is frequently planned by manufacturers. this planned obsolescence is "the production of goods with uneconomically short useful life so that customers will have to make repeat purchases."39 for example, automobile manufacturers regularly modify to their models so as to schedule obsolescence. if tax benefits were available regardless of whether the property were purchased or leased, as proposed, the lessee's decision will not be distorted by tax considerations. 36. by leasing property, lessees also avoid incurring indebtedness to purchase the leased property. 37. the concept of neutrality in taxation is derived from adam smith's canons of taxation. see adam smith, an inquiry into the nature and causes of the wealth of nations, book v, ch. 2, part ii, v.2.25-28 (methuen & co 1904) (1776). "accelerated depreciation is almost certain to give some assets lower effective tax rates than others and so violate the tax neutrality standard." james mackie, capital cost recovery in the encyclopedia of taxation and tax policy (joseph j. cordes, robert d. ebel, and jane g. gravelle, eds., urban institute press 2d ed.) (2005). additionally, under irc § 167, only certain types of property may be depreciated, further frustrating the tax neutrality maxim 38. attempts to make existing property compatible are usually possible, but create additional costs to the owner. in such situations, economic obsolescence and functional obsolescence frequently overlap. 39. jeremy bulow, an economic theory of planned obsolescence, 101 q.j. econ., no. 4, p.729 (1986). 2010] 281 florida tax review f. examples the following four examples illustrate the effect on a hypothetical leasing transaction of a lessor's inadequate taxable income and how the proposal addresses that deficiency.40 the leasing transactions comply with the definition of true leases for tax purposes and operating leases for financial reporting purposes.4 ' in the first and second examples, the effect under current law of crd on the computation of a lessor's taxable income and the tax treatment of rental payments to both lessor and lessee is shown. in the first example, it is assumed that the lessor is able to utilize all crd, but in the second example some of the crd is not utilized. the third and fourth examples illustrate the proposed system. first, a shift of all crd to the lessee is illustrated and then a partial shift. these examples demonstrate that the proposed system fosters transactions that otherwise would not be entered into because of the current tax system's linkage of crd's with property ownership. example 1: current system with full crd utilization by lessor under the current system, when a property owner utilizes all crd, the tax savings is equal to the taxpayer's basis in property multiplied by the maximum marginal tax rate to which the taxpayer is subject.42 in general, tax basis is equal to the properties cost, and for most corporate taxpayers the maximum marginal tax rate is 35%.43 40. the benefit from tax deductions must consider the present value of the tax savings taking into account any future period in which the benefit is realized. for a discussion of the value of more or less rapid depreciation allowances see, douglas a. kahn, accelerated depreciation tax expenditure or proper allowance for measuring net income?, 78 mich. l. rev. 1 (1979); walter blum, accelerated depreciation: a proper allowance for measuring net income?!!, 78 mich. l. rev. 1172 (1980); douglas a. kahn, accelerated depreciation revisited a reply to professor blum, 78 mich. l. rev. 1185 (1980). 41. rev. proc. 2001-28, 2001-1 c.b. 1156. these guidelines superseded earlier guidelines. rev. proc. 75-21, 1975-1 c.b. 715; rev. rul. 55-540, 1955-2 c.b. 39. 42. tax basis of business property is eligible for depreciation. irc § 167(c); treas. reg. § 1.167(g)-1. the basis of property that may be depreciated is usually its cost. irc § 1012. provisions of limited application prescribe tax basis to be other than an cost, e.g., § 358 (substituted, irc § 7701(a)(42)), irc § 362 (transferred basis, irc § 7701(a)(43)) and irc § 1014 (fair market value). 43. irc § 11 sets forth the various tax brackets for corporate taxpayers, with the 35% bracket being reached when taxable income exceeds $10,000,000. 282 [vol. 10:2 a proposal for an elective tax benefits transfer system in this example and in the ones that follow, is it assumed that the lessor and lessee are both in the 35% federal income tax bracket and that the lessor purchases property costing $1000 that it intends to lease. if the lessor uses all crd associated with the property ($1000), the net cost of the property to the lessor, excluding any residual value, is $650 because the crd reduces tax liability by $350 ($650 = $1000 (.35 x $1000)). it is also assumed that at the end of the lease term, the lessor sells the leased property for $100.00, its residual value. because the lessor has a zero tax basis in the property at that time, the proceeds would yield after-tax income of $65.00. the cost reduction can be passed on to the lessee through reduced rental payments, shared by the parties, or retained in full by the lessor, all depending upon competitive and other market factors. regardless of which party benefits from the crd, the leasing transaction would be made more feasible. the full $350 government cost subsidy would be taken into account. assume further that the lessor requires a minimum after-tax return on its investment ("roi") of 13%, and the lessee can afford to pay no more than $715.00 in rent (after tax deduction for rent paid) over the term of the lease. the lessee is prepared to pay more than the properties net cost ($650.00) if it were to purchase the property outright because of concerns with obsolescence and the lessor's the inability to obtain suitable financing. under these parameters, the parties would both find a lease that calls for $1100.00 in pre-tax rental payments to be acceptable, as set forth below:" income to lessor cost to lessee 1100.00 +-rent <1100.00> 350.00 4tax savings on crd -065.00 +residual (after-tax) -0<385.00> +tax <liab.> savings on rent 385.00 <1000.00> +<cost of property> -0130.00 net benefit <cost>to parties <715.00> the lessor's after-tax roi (13%) is calculated as equal to the lessor's after-tax income ($130) divided by the lessor cost of the property ($1000)). the rental income ($1100), the tax savings from the crd ($350), and the income from the sale of the property after the expiration of the lease (aftertax) are cash inflows to the lessor. they are partially offset by the tax liability that the lessor is required to pay on the rental income ($385.00 = .35 x $1100.00 and the cost of the property ($1000).45 the lessee's rental cost 44. all positive numbers are cash inflows and all negative numbers are cash outflows. 45. rental income is includible in a taxable income. irc §§ 61 and 63. 2010] 283 florida tax review net of taxes, $715.00, is equal to the gross rent ($1100.00) less the tax savings from deducting rental expense ($385.00 = .35 x 1100.00)." example 2: current system: unused crd if the lessor were unable to deduct crd, the lessor's cost of the leased equipment increases. for the lessor to realize the same after-tax roi, the rent payable by the lessee would have to increase to cover this additional cost. if the lessee is unwilling to pay increased rent to compensate the lessor for the lost tax benefit, the transaction will not be entered into. assuming that the lessor is able to utilize only $900 of the $1000 cost recovery deduction, the cost of the property to the lessor, before residual, increases to $685. the lessor's roi drops to 9.5%, as follows: rental income $1100.00 tax savings from crd of $900 315.00 residual (after-tax) 65.00 tax liability on rent <385.00> cost of property <1000.00> net benefit to lessor $ 95.00 given the lessor's requirement that the lease generate an after-tax roi of at least 13%, the lessor's inability to realize a tax benefit from the crd and the lessee's refusal to increase the rent would cause the lessor not to enter into the lease. example 3: proposed system: shifted benefit from crd if the proposed system were adopted, and if the parties agree that the lessee will provide appropriate compensation to the lessor for the transferred crd, the parties would be in the identical position they were in when the lessor was able to fully use crd's. assume that the lessee compensates the lessor for the $350 tax benefit with a nontaxable cash payment of $350, an amount equivalent to the tax benefit.47 under this scenario, the lessor and the lessee are satisfied entering into the lease. 46. rent expense is deductible as an ordinary and necessary expense incurred in carrying on a trade or business under irc § 162. 47. any amount of compensation paid for the crd that is greater or less than $350 results in a net benefit to the lessor or a net cost to the lessee. section vii of this paper discusses the taxation of the payment and the receipt of the consideration for transferred cost recovery deductions. 284 [vol. 10:2 a proposal for an elective tax benefits transfer system full shift of crd to lessee (lessor unable to use $1000 crd) income to lessor 1100.00 -0350.00 65.00 <385.00> <1000.00> 130.00 +rent tax savings from crd +-cash for tax savings residual (after-tax) +tax <liab.> savings on rent -+ <cost of property> net benefit <cost> to parties cost to lessee <1100.00> 350.00 <350.00> -0<385.00> -0<715.00> example 4: proposed system: shared benefit from crd in this example, as in example 3, it is assumed that the lessor is unable to use $100 of the crd. however, the lease would be entered into if the lessor were permitted to transfer to the lessee the $100 of unused crd. for the lessor to realize the same after-tax roi an additional non-taxable cash payment of $35, equal to the tax benefit on the $100 of tax benefit that otherwise would be unused, would have to be made by the lessee. the cash flows associated with this transaction appear in the following chart: partial shift of crd to lessee (lessor unable to use $100) income to lessor 1100.00 315.00 35.00 65.00 <385.00> <1000.00> $ 130.00 -rent +-tax savings from crd-+ +-cash for tax savings residual (after-tax) 4tax <liab.>tax savings on rent -+ <cost of property> 4 net <cost> benefit to parties -cost to lessee <1100.00> 35.00 <35.00 -0385.00 -0<$715.00> the reported earnings and cash flow of the lessor (and, presumably, the lessee) would be favorably affected in examples 1, 3, and 4 because the benefit of all deductions is realized. as demonstrated in examples 3 and 4, under the proposed system, it is irrelevant which party to the transaction realizes the tax benefit. 2010] 285 florida tax review iv. proposal supported by microeconomic theory laws of economics, in particular, microeconomics, prove the efficiency of the proposed system by predicting increases in the supply of, and demand for, leasing transactions.4 8 microeconomics also aids in understanding the impact of government tax policy the market for leased properties.49 an important concept in microeconomics is "elasticity." it describes the effect on supply and demand caused by price changes. because tax policy affects price, taxes being a component of the cost of an item, government tax policy indirectly has a significant influence on the supply and demand of an item. examples will show the impact on supply and demand under the current law and under the proposal. supply and demand curves, essential tools of microeconomic analysis, visually depict the effect of tax policy on supply and demand. as discussed below, they reveal that (a) unused tax benefits associated with property will have a depressive effect on leasing transactions, (b) if market forces are permitted to influence which party to a leasing transaction utilizes the tax benefits associated with the property, the value of tax benefits will more likely equal their objectively calculated maximum possible value,o (c) because the proposed system reduces the likelihood that tax benefits will be sub-optimized, it should increase the supply and the demand of property eligible for lease with the attendant positive effects on the parties and the economy as a whole. a. "utility" maximized/inefficiency minimized by proposed system a principal goal of market-based economic systems is to allocate resources in a way that satisfies "people's needs and desires" in as efficient a manner as possible.5 the efficiency of the economy is optimized when as 48. microeconomics is a branch of economics that deals with the decision making tendencies of individuals, firms, and some local governments. 49. economics, fifteenth edition, p. 55 (paul a. samelson and william d. nordhaus, eds., mcgraw-hill, inc., 1995). classical economic theory looked to market forces alone for resource allocation. adam smith's belief in the dominance of self-interest is evident from his statement that "[i]t is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest." adam smith, an inquiry into the nature and causes of the wealth of nations, book i, ch. 2, part 1.2.2 (methuen & co 1904) (1776). thus, classical economic theory looked to market forces alone for resource allocation. 50. for deductions this is the highest marginal tax rate multiplied by the amount of the deduction and for credits it is the face amount of the credit. 51. economics, fifteenth edition, pp. 12, 73 (paul a. samuelson and william d. nordhaus, eds., mcgraw-hill, inc., 1995). 286 [vol. 10:2 a proposal for an elective tax benefits transfer system many efficient trades as possible are made.5 2 when this is done, the "utility," or satisfaction that market participants derive from their limited resources, is maximized. the efficient use of limited resources, such as tax benefits, is essential for an economy to operate at the optimum level. inefficiencies typically increase costs and decrease transactions.5 the well established economic principle of utility maximization finds it origins in the writings of jeremy bentham, an eighteenth century philosopher, who defined utility as "that property in any object, whereby it tends to produce benefit ... or to prevent the happening of mischief, pain ... to the party whose interest is considered ... . bentham wrote "[o]f an action that is conformable to the principle of utility one may always say either that it is one that ought to be done or at least that it is not one that ought not to be done."55 thus, a system that eliminates inefficiencies and maximizes the utility of the parties to a transaction "ought to be done." under the current system, if a lessor fully utilizes its tax benefits, the rent charged for the item (its price) could be less than if the lessor's cost of the item were not reduced by tax benefits. if, and to the extent that, the lessor were unable to optimize tax benefits, rent would have to be increased for the lessor to cover its increased cost. as rent increases, the demand for the item can be predicted to decrease. of course, if a different lessor, such as a member of a profitable consolidated group, were able to fully utilize tax benefits, then the transaction would be entered into, but the tax law would have distorted the competitive status of the lessors. 52. jonathan gruber, public finance and public policy, second edition, p. 4 (worth publishers, 2007). 53. ideally, policy makers should attempt to keep the economic pie as large as possible, while securing funds to promote their social welfare objective. some degree of trade-off between the size of the economic pie and the government's ability to provide for the welfare of society is preferred. ideally, policy makers should attempt to keep the economic pie as large as possible, while securing funds to promote their social welfare objective. these are not necessarily inconsistent goals. having a smaller economic pie may not be all bad. funds acquired by taxing a transaction can be used to promote what the political leaders believe be the social welfare of the society. jonathan gruber, public finance and public policy, second edition, p. 50 (worth publishers, 2007). 54. john stewart mill significantly expanded bentham's philosophy. while mill embraced the philosophical underpinning of the economic objective of bentham's utility theory, he argued that happiness or satisfaction varies among people and an economic system should seek to raise the quality of satisfaction as determined by a more sophisticated (educated) group. 55. jeremy bentham, an introduction to the principles of morals and legislation, p. 2 (hafner publishing co., 1948). 2010] 287 florida tax review b. supply and demand analysis predicts effectiveness of proposal the following graphs reveal the effect of crd on the supply and demand of leased property. they will show that the current system causes a decrease in the demand for leased property when crd are underutilized. regardless of whether the lessee is willing to pay higher rent or the lessor absorbs the increased cost, increased cost reduces the combined "utility" to the parties of the transaction. conversely, if tax law is amended to permit the lessor to transfer unused deductions to the lessee, both parties are benefited and utility enhanced. the slope of supply and demand curves reveals the elasticity of supply and demand; that is, the extent to which changes in price affect the quantity of the property supplied and demanded. both rent charged for property and the price of an associated tax benefit are subject to elasticity theory. the price paid for tax benefits is elastic when the value of tax benefits to the property owner is less than to the potential transferee." this occurs, for instance, whenever the nature of the property owner's business causes it to have less of a need for tax benefits. the price paid for tax benefits is likely to be less elastic during times of general economic weakness, when both a lessor and a lessee are likely to place a lower value on deductions or credits. the application of microeconomics laws establish that utility associated with tax benefits varies inversely with price that a transferee is willing to pay for them. the willingness of a property owner to sell tax benefits generally moves directly in proportion to their value. the demand for tax benefits reveals the degree of utility they yield to a prospective transferee. if utility declines but price is unchanged, the demand for the tax benefit also declines. the normal relationships between price and the value 56. the extent to which price is elastic is determined by dividing the percentage change in quantity demanded by the percentage change in price. the elasticity of demand may vary depending on several factors including (a) whether the item is a "necessity," (b) whether there are substitutes for the item, and (c) whether the timing of the acquisition of the item is flexible. 57. one significant variable that could change the impact of a tax on the consumer and producer is whether the consumer has options to purchase substitute goods or services and other transactions that could provide the consumer and producer with a similar level of satisfaction. conversely, if the transaction is merely optional or if there are substitute transactions, then demand for the financial transactions is elastic. a consequence of this elasticity would be for the drop in the quantity demanded for the financial transactions at given prices to adversely affect the profits derived by the financial institution from this type of transaction. the financial institution will have to discontinue production of financial transactions to avoid a financial loss. 288 [vol.10:2 a proposal for an elective tax benefits transfer system to the property owner of the deductions are what cause the classic demand curve to slope downward and the supply curve to slope upward. c. charting supply and demand of leased property the application of these economic principles to a hypothetical leasing transaction is depicted on the following demand and supply charts. in the first two charts, hypothetical levels of demand and supply are graphed. in the third chart, the number of leases entered into is predicted, assuming that the lessor currently utilizes all tax benefits. what happens when tax benefits are not fully utilized is depicted in the fourth chart. the fifth chart shows the positive effect on the number of transactions when the proposed system replaces current law. 1. demand chart this chart shows the quantity of leases entered into at rents ranging from 1.0 to 3.0. the quantity of leases demanded appears on the horizontal 18axis and the rent appears on the vertical axis. demand for leased equipment 3.5 3.0 2.5 2.0 rent 1.5 1.0 0.5 0.0 1 2 3 4 5 quantity of leases predictably, as rent decreases from 3.0 to 1.0, the quantity of leases that are likely to be demanded increases from 1 to 5. the downward sloping 58. for illustrative purposes, the slope of this demand curve is linear. normally, the slope will change in a nonlinear way causing the line to be curved. moreover, it is not necessarily the case that the curved line will be a "smooth" curve. variables can often change in a nonlinear and erratic fashion. 2010] 289 florida tax review relationship between quantity demanded and rent charged depicts the economic "law of downward-sloping demand." economic theory attributes the slope of a demand curve to the "substitution effect" and the "income effect." because of the substitution effect, a lessee would be inclined, as rent increases to substitute other property for the more expensive leased property. a party may be more inclined to lease less productive property or property with a higher likelihood of early obsolescence. the income effect shows that a lessee's limited financial resources constrain the lessee's demand. although this chart reveals the number of leases that the lessee is willing to enter into, it does not predict the number of leases that would be entered into. only after considering the lessor's willingness to lease the property can that be predicted. 2. supply chart the next chart shows the hypothetical quantity of leases for that same property that the lessor is willing to enter into at those same rents, assuming that the lessor is able to utilize all tax benefits associated with the leased property. supply of leased equipment 3.5. 3.0 2.5 rent 2.0 1.5 1.0 m 0.5 0.0 1 2 3 4 5 quantity of leases the upward slope of the supply curve reveals that as rent increases (the vertical axis) from 1.0 to 3.0 the lessor is willing to enter into an increasingly larger number, 1 to 5 units, of leases (the horizontal axis). there are several explanations for the increase in rent as the number of leases willing to be entered into also increases. economic theory propounds a law of diminishing returns, which provides that a higher percentage of cost will 290 [vol.10:2 a proposal for an elective tax benefits transfer system be incurred to enter into each additional lease. the higher cost could be associated with the limited supply of property available to the lessor or the diminishing capacity to utilize tax benefits. in this chart, however, all tax benefits are used. 3. equilibrium in the next chart, the previously constructed demand and supply curves are overlaid to determine the point at which the demand and supply are in equilibrium. supply and demand in equilibrium 3.5 3.0 2.5 2.0rent 1.5 1.0 0.5 0.0 1 2 3 4 5 quantity of leases at rent of 2.0, where the supply and the demand curves intersect, the market for the leased property is in equilibrium. the quantity of leases to the left of equilibrium, 3.0, are likely to be entered into because, until 2.0 of rent is reached, the rent expense paid by the lessee and realized by the lessor are acceptable to both parties. in other words, the quantity of leases demanded and supplied are equal. beyond this point (to the right of equilibrium), the rent sought by the lessor is incompatible with the rent that the lessee is willing to pay for the additional leases. 4. supply equilibrium shift-deadweight loss created the next graph reveals what occurs when the lessor is unable to fully utilize crd. the increase in the purchase price of the leased property resulting from the lessor's inability to reduce cost by tax savings creates a "deadweight loss that causes the acceptable rents to increase, or to shift upward on the chart. 2010] 291 florida tax review equilibrium shift 3.5. 3.02.5rent 1.5 1.00.5 0.0 1 2 3 4 5 quantity of leases a "deadweight loss" is the amount of lost satisfaction experienced by purchasers and suppliers when the cost of supply increases. in a situation involving a lessor and lessee it quantifies the reduced number of leasing transactions entered into because of the inefficiency caused by unutilized tax benefits.5 9 the deadweight loss is greater if demand is elastic; that is, it increases at a greater rate as the tax cost increases. increased costs that cause slight changes to equilibrium will have little or no effect on the amount of deadweight loss. because the lessor's cost of the leased property increases, the rent charged would have to increase for the lessor to realize its acceptable roi. when this occurs, the quantity of leases that are entered into, assuming demand remains static, declines by 10% (.5 fewer leases). only if the lessor were able to increase rent to compensate for the increased cost from unutilized tax benefits, will the quantity of leases remain the same.60 in either case, in this situation, either the lessor or the lessee would be worse off. 59. john maynard keynes explains this with a story in which a failing business repeatedly raises prices in order to become profitable, all the while the higher prices have the effect of increasing the business's losses. in theory, if prices were lowered, sales may increase along with overall profits. thus, it is often said that the economic effect of a tax increase may be a decrease tax revenues or the economic effect of a decrease in taxation may be an increase in tax revenue. john maynard keynes, the collected writings of john maynard keynes (macmillan, cambridge university press, 1972). 60. the extent to which transactions will decrease is, in part, a function of the "elasticities." for example, an inelastic demand will result no decrease in transactions. 292 [vol. 10:2 a proposal for an elective tax benefits transfer system 5. supply and demand equilibrium shft---deadweight loss eliminated the next chart demonstrates that if the proposed system were adopted and the tax benefits were sold to the lessor, the increased cost, expressed as additional rent, would be acceptable to the lessee because it would be offset by an equal amount of tax savings. the deadweight loss is eliminated. the equilibrium point would then shift back to the right because the slope of the demand curve would also shift to the right. proposed system 3.5 3.0 2.5 rent 1.51.0 0.5 0.0 1 2 3 4 5 quantity of leases assuming that the full value of the tax benefits are exchanged for a comparable amount of rent, the quantity of leases entered into would be 3.0, the same as under the third chart when the lessor was able to deduct all crd.61 v. proposal supported by current statutory law a. tax benefit transfers the conference committee report accompanying erta indicated that safe-harbor leasing tax benefit transfers violated the anti-avoidance, 61. these examples do not take into account the income tax that is paid on the rental income or the deductions that are allowed on the rental expense because the tax is paid on the income or reduced by the expense regardless of whether tax benefits are utilized. 2010] 293 florida tax review business purpose, and sham transaction tenets of taxation.62 although current law would have to be amended to allow the proposed sale of tax benefits, the following discussion explains why the proposal does not violate any of these (or other) tax tenets. in fact, the proposal is consistent with modem day tax provisions that permit, or in some cases require, the mobility of tax benefits and that encourage transactions by harnessing tax avoidance intent. the discussion begins with a review of statutory law relating to tax incentive provisions that provide for the purchase of tax credits and the transfer of tax basis. next, statutory provisions aimed at preventing tax benefit transfers when tax avoidance is evident will be examined. these discussions will be followed by a brief analysis of judicial tax doctrines relating to tax avoidance, business purpose, and substance over form. 1. tax credit transfers current law permits a tax-free acquisition of tax credits for cash or other property by a taxpayer who does not hold legal title to the property generating the credit and who may have no involvement with the activity in which the credit generating property is employed. the new markets tax credit and the low-income housing credit are two of several examples of incentive provisions that permit tax benefit transfers despite the obvious presence of a tax avoidance intent. the new markets tax credit ("nmtc") is designed "to encourage investors to make investments in low-income communities that traditionally lack access to capital." the nmtc rules allow any "taxpayer who holds a qualified equity investment" in a "qualified community development entity" to take a tax credit, spread over six years, equal to approximately 39% of the taxpayer's investment.s congress designed the nmtc to provide an inducement that a development entity may employ to raise capital for the development of low-income community projects. through the end of 2008, a total of $19.5 billion of nmtc have been awarded to 364 applicants. 6 62. see discussion of erta at § i, hereof. 63. other tax incentives are also available when taxpayers make loans to, or equity investments in, small businesses owned by socially or economically disadvantaged persons certain and licensed by the small business administration. 64. irc § 45d. the community renewal tax relief act of 2000, pub. l. no. 106-554, § 121(a), 114 stat. 2763 (2000). gao report, "new markets tax credit," apr. 2009, gao-09-536. 65. irc § 45d. 66. community development financial institutions fund, new markets tax credit program, available at www.cdfifund.gov/whatwe-do/programs-id.asp? programld-5, last revised aug. 17, 2009. 294 [vol. 10:2 a proposal for an elective tax benefits transfer system the low-income housing credit ("lihc") has a similar purpose. it is designed to be an "efficient mechanism for encouraging the production of low-income rental housing."67 the report of the senate finance committee that accompanied the legislation, describe the intended efficiency and incentive aspects of the legislation: "the committee is concerned that the existing tax preferences for low-income rental housing have not been effective in providing affordable housing for low-income individuals. the committee believes a more efficient mechanism for encouraging the production of low-income rental housing can be designed than the variety of subsidies existing under present law."68 the lihc may be claimed with respect to newly constructed or substantially rehabilitated qualified low-income housing. the credit is available to any taxpayer having a beneficial interest in a special purpose trust, which is the customary vehicle for holding title to the property. the credit is equal to the "applicable percentage" of the "qualified basis of each qualified low-income building." in general, the applicable percentage for any month is the percentage which will yield over a 10-year period amounts of credit which will have a present value equal up to 70% of the qualified basis of the low-income building. the credit may be transferred by acquiring the underlying property. a taxpayer who purchases a building is entitled to the credit to which the prior owner of property was entitled. the intention of taxpayers who invest in the properties qualifying for either the nmtc or the lihc is to reduce their tax liability. the credit acquisitions, however, are accompanied by bona fide investments that achieve a congressional objective. nonetheless, the investor has a relationship to the credit generating property not unlike the relationship that a passive investor has in property held by a publicly traded corporation. the taxpayer to whom the credit is transferred does not hold title to the property that generates the credit nor does the taxpayer have to be involved in the activity in which the property was employed. both of these provisions, and the several others that are similar in their scope, do not restrict sale of credits to a counterparty in a transaction involving the lease of property. thus, in this respect, they are considerably more liberal than the proposed system. what they do have in common with the proposed system is the ability of the 67 irc § 42. pub. l. no. 99-514, h.r. rep. no. 3838, 99th cong. § x (1986). the credit was significantly expanded by the community renewal act of 2000, pub. l. no. 106-554, 114 stat. 2763 (2000). 68. h.r. rep. no. 99-3838, p. 758 (1986). 69. irc § 42(d)(7). 2010] 295 florida tax review property owner to sell valuable tax benefits as an adjunct to a transaction that has a significant non tax purpose. 2. tax basis transfers-to other taxpayers there are several current tax law provisions that permit tax basis to be transferred in exchange transactions between unrelated taxpayers, even when the relationship between the transferor and the owner of the property after the basis transfer is quite remote. a tax basis shift often yields tax deductions to the transferee with respect to the underlying property because tax deductions typically inhere in tax basis. consequently, the ability to shift basis under current law is usually the equivalent of shifting tax benefits.70 so long as the transferred basis occurs in conjunction with one of the several nonrecognition provisions in the code, a transfer of tax benefits inherent in the basis of the transferred property will be respected.71 unrecognized gain or loss typically is preserved in the transferred basis in nonrecognition transactions. the following discussions of sections 351 and 1041 illustrate the opportunity to transfer tax benefits inherent in tax basis. both sections allow for tax nonrecognition because of strong policy reasons. in the case of section 351, the purpose of the nonrecognition rule is to facilitate the formation of capital in those situations where only the form of ownership has changed,72 and in section 1041 congress eliminated the conflicting treatment of property transfers between spouses occasioned by different state laws. strong policy objectives behind incentive legislation are adequate to justify the transferred basis rule of the proposed system. section 351 prescribes a nonrecognition rule for transfers of property in exchange for stock in a corporation controlled by the transferor or group of transferors immediately after the transfer. with its companion transfer basis rule contained in section 362, it has the effect of permitting tax benefits to be transferred from the transferee to a corporation and then shared by the corporation's shareholders. a simple illustration reveals how significant tax benefits can be shifted to the corporation and then, albeit indirectly, to the other corporate shareholders. assume that there are two transferors, transferor a and transferor b. transferor a transfers to newly formed corporation c property 70. another tax benefit associated with tax basis is the reduction that it has on the amount of realized gain. 71. irc § 7701(a)(45). a nonrecognition transaction is an exception to the general tax rule that requires the recognition of gain or loss whenever property is disposed of. irc § 1001(c). 72. treas. reg. § 1.1002-1(c); portland oil co. v. comm'r, 109 f.2d 479, 488 (1st cir. 1940). 296 [vol.10:2 a proposal for an elective tax benefits transfer system with a tax basis of 40 and a fair market value of 100, and transferor b transfers to corporation c property with a tax basis of 160 and a fair market value of 100. thus, there is 60 built-in gain in a's property and 60 of builtin loss in b's property. section 351 in conjunction with section 362 will cause the tax burden associated with half of transferor a's built-in gain to be indirectly shifted to transferor b in exchange for one-half of the stock of the corporation and one-half of the tax benefit associated with transferor b's built-in loss is shifted to transferor a for the other one-half of stock.73 sharing the characteristics of tax basis is a permissible transfer of tax benefits.74 the notion that nonrecognition is appropriate because a mere change in the form of ownership has occurred fails to account for the possible remoteness of the ownership interest after the transfer. it is irrelevant under the rules of sections 351 and 362 what the percentage of ownership that the transferor has in the transferee corporation after the transaction, what the relationship that the transferors has with the other shareholders, and what the transferors involvement is with the transferred property after the transaction. more significantly, it appears that there is no restriction on transferor a agreeing before the transfers that transferor b will receive more than half of the stock of the corporation in consideration of the tax benefit he is transferring. any additional consideration received for tax benefits will not be treated as taxable boot. transferring tax deductions themselves is permitted in section 351 transactions by virtue of section 357. it permits deductions with respect to a liability of a transferor to be transferred to a corporation in exchange for stock.7 5 to the extent that the payment of the liability generates a corporate tax deduction or an addition to the corporation's tax basis, the tax savings flowing therefrom will inure to the benefit of all shareholders.7 6 to illustrate, assume that transferor d transferred $30,000 of liabilities for unpaid utilities, salaries, and other operating expenses to corporation d in a transaction that qualified under section 351. assume also that there were two other transferors. one-third of transferor d's deductions would inure to the benefit of each of the other shareholders. thus, with respect to both tax basis and tax deductions current law permits an indirect shift of tax 73. this assumes that transferor b and the corporation have made the basis election provided for in irc § 362(e)(2)(c). for there to be a valid nonrecognition transaction under irc § 351 there must be a valid business purpose for the transaction. the business purpose doctrine is discussed below. 74. even before a disposition of property, the transferee corporation will realize the effect of any built-in gain or loss through greater or lesser crd. 75. these deductions may be shifted to the corporation in an irc § 351 transaction under the provisions of irc § 357(a) and (c)(3) but only when the transferor transfers other property to the corporation. 76. rev. rul. 95-74, 1995-2 c.b. 36; hempt bros., inc., v. u.s., 490 f.2d 1172 (3rd cir. 1974). 2010] 297 florida tax review benefits. the applicable section 351 and 357 nonrecognition rules and basis or deduction transfer provisions are mandatory, not elective. tax law provisions also prescribe a mandatory nonrecognition rule with accompanying tax basis shift in certain property transfers (not necessarily exchange transactions) between individual taxpayers. for example, section 1041, which mandates nonrecognition of gain or loss on transfers of property between spouses or former spouses incident to a divorce, requires the transferor's tax basis to be shifted to the transferee.7 8 it is irrelevant whether the property may have been transferred for no consideration, for its market value, or for any another amount.7 9 3. tax basis transfers-to other property owned by taxpayer current law also prescribes rules for tax benefit transfers between or among properties owned by a single taxpayer in a way that may accelerate the tax benefits to the property owner. a few of the numerous nonrecognition transactions in which basis is shifted from one property owned by a taxpayer to other (usually acquired) property, include transfers to controlled corporations,80 transfers to a partnership," receipt of stock or stock rights, 82 like-kind exchanges, including exchanges of insurance contracts, and involuntary conversions.84 to illustrate, tax benefits can be accelerated by virtue of the likekind exchange rules of section 1031. assume that transferor a exchanges vacant farm land with a basis of $60 and a fair market value of $100 for rental property owned by transferor b. tax rules permit the taxpayer to avoid recognizing the $40 of gain on this transaction, but require the taxpayer to ascribe the $60 farm land basis to the rental real property, the 77. that the drafters recognized the shifting nature of irc § 351 rules can be discerned from the very different approach taken in the rules applicable to transfers of property to partnerships. irc § 704(c) expressly prohibits the shifting of a transferor partner's tax benefits (and burdens) to the other partners. instead, any benefits associated with tax basis and deductions are traced back to the particular transferor and are not shared by the other partners. 78. irc § 1041(b)(2). 79. a similar rule is contained in irc § 1015(a) for gifts, generally. pursuant to this rule, a tax basis rule applicable when gifts are made requires the donor's tax basis to be shifted to the donee. an exception is provided when the fair market value of the property at the time of the gift exceeds the donor's tax basis and the property is sold by the donee at a loss. 80. irc § 351 and § 358. 81. irc § 721 and § 722. 82. irc § 307. 83. irc § 1031(d) and § 1035. 84. irc § 1033(b). 298 [ vol. 10: 2 a proposal for an elective tax benefits transfer system "exchanged basis property." after the exchange, transferor a is permitted to take crd equal to the portion of the $60 basis that is properly allocable to the building and other like-kind depreciable property acquired in the exchange. before the transaction no crd were allowed because the entire basis was attached to land, which is a nondepreciable asset. b. tax avoidance intent under current statutory law, a taxpayer's intention to avoid tax, the principal or sole purpose for the proposed sale of tax benefits, will not prevent the proposed tax benefit transfers. as discussed below, statutory law expressly incentivizes taxpayers with tax avoidance. however, statutory provisions also exist that deny tax benefit transfers when (a) tax avoidance intent is not associated with a code provision designed to further some congressional social or economic objective or (b) when the transaction containing tax avoidance intent is entered into without an overriding business purpose. 1. current statutory provisions employing tax avoidance commenting on the allure of tax avoidance, the renowned british economist john maynard keynes is said to have quipped: "[t]he avoidance of taxes is the only intellectual pursuit that carries any reward."8 6 realizing, as this quote reveals, the antipathy that taxpayers have toward tax liability, he advocated in favor of tax incentives and other types of governmental intervention in the economy when stimulus was needed. the code is replete with sections that contain implicit congressional legitimization of tax avoidance intent. the discussion above of the nmtc and lihc and the economic stimulus provisions are illustrations of congressional intervention in the economy with legislation that harnesses tax avoidance tendencies. more targeted concerns associated with energy independence prompted the enactment of tax incentive provisions contained in the emergency economic stabilization act of 2008. according to the law's preamble, it purpose was "...to amend the internal revenue code of 1986 to provide incentives for energy production and conservation ... 85. irc § 7701(a)(44). 86. the forbes book of business quotations 820 (ted goodman ed., black dog & leventhal publishers) (1997). 87. pub. l. no. 110-343, 122 stat. 3765 (2008). see also, the preamble to the american recovery and reinvestment act of 2009 that describes the purpose of the legislation as: "making supplemental appropriations for job preservation and creation, infrastructure investment, energy efficiency and science, assistance to the unemployed, and state and local fiscal stabilization, for the fiscal year ending sep. 2010] 299 florida tax review the incentives enacted include accelerated crd and tax credits for various energy related investments. for example, the 2008 act cut in half the cost recovery period for any qualified smart electric meter and any qualified smart electric grid system,88 and qualified all cellulosic biofuels for an immediate cost recovery deduction equal to 50% of the cost of the biofuel facilities.89 the 2008 act also enhanced the provisions of the existing energy credit by allowing the credit to be taken for investments in an expanded category of property. it increased the credit limit for fuel cell property, removed prohibition on public utility property qualifying for the credit, allowed the credit for alternative minimum tax purposes, etc... .90 the credit for electricity produced from renewal resources,9' the qualifying advanced coal project credit,9 2 and the qualifying gasification project credit, 93 the biodiesel fuels and alternative fuel credit 94 were also expanded. numerous other targeted provisions that depend on taxpayers' tax avoidance tendencies have been enacted over the years to advance more targeted government objectives. they provide additional evidence of congresses approval of tax avoidance intentions. for example, special accelerated cost recovery rules have been enacted to encourage investment in pollution control facilities," research and experimentation expenditures, 96 reforestation expenditures, soil and water conservation expenditures, etc... . these special rules are more favorable than, and, thus, provide an added incentive to, the accelerated cost recovery rules applicable to other business property. all of these provisions evidence congressional approval of tax avoidance as an incentive to address a social or economic policy concern. the transfer of tax benefits is the tool used to achieve the objective. so long as the underlying transaction required by the tax avoidance legislation is engaged in, the tax benefit transfer is acceptable. 30, 2009, and for other purposes." pub. l. no. 111-5, 123 stat. 115, h.r. rep. no. 5 (2009). 88. irc § 168(e)(3)(d). 89. irc § 168(l)(1)(b). 90. irc § 48. 91. irc § 45. 92. irc § 48a. 93. irc § 48b. 94. irc § 40a. 95. irc § 169. 96. irc § 174. 97. irc § 194. 98. irc § 175. 300 [vol. 10:2 a proposal for an elective tax benefits transfer system 2. statutory constraints on tax avoidance unless appropriate limitations accompany the proposal, tax abuse is likely to result. as one court observed, "[a] tax system of rather high rates gives a multitude of clever individuals in the private sector powerful incentives to game the system."" current law prescribes limits on tax benefit transfers in transactions where tax avoidance intent is evident. although the proposed system, as discussed below, does not violate any of these limits, it should constrain its tax avoidance orientation with reasonable limitations on transferring tax benefits, and these constraints should be consistent with current statutory tax avoidance limitations. following is a discussion of salient provisions of current statutory law that deny tax benefit transfers if tax avoidance is the intent of the transaction. there is no absolute or overarching proscription against tax avoidance contained in the code. instead, congress has designed targeted sections that deny or limit tax benefits if tax avoidance is found to exist. for example, section 532 imposes an accumulated earning tax on corporations "formed or availed of for the purpose of avoiding the income tax with respect to its shareholders ... ,"'0o and section 7872 treats as a below-market loan to which interest is imputed any such loan "the principal purpose of the interest arrangement of which is the avoidance of any federal tax."o0 with some of these provisions, tax avoidance must rise to the level of being the "principal purpose" for entering into the transaction, but with other provisions a lower threshold is sufficient to deny expected tax benefits. the tax anti-avoidance section with the broadest scope, the one that applies to the widest variety of property transfers, and the one that probably has the richest judicial history is section 269. it employs the "principal purpose" standard.10 2 the section 269 "principal purpose" threshold, and not a lower threshold for denial of tax benefits, should be employed in the proposed system because tax avoidance is intended under the proposed system to incentivize the parties to engage in a purchase or leasing 99. asa investerings p'ship v. comm'r, 201 f.3d 505 (d.c. cir. 2000). earlier, mr. justice cardozo in burnet v. wells, 289 u.s. 670, 676 (1933) referred to the proclivity to craft tax avoidance schemes as stemming from taxpayers' "fertility of invention." 100. irc § 532(a). the evidence that established the purpose to avoid income tax is prescribed in irc § 533. 101. irc § 7872(c)(1)(d). in addition to these sections regulations deny tax benefit transfers. for e.g., treas. reg. § 1.1502-15, -21, and -22, regarded as quasistatutory provisions because of the specific grant of rule making authority in the area of consolidated returns prescribed in irc § 1502, deny net operating loss carryovers. 102. irc § 269 limits the transfer of tax benefits when control of a corporation takes place or when property is acquired in a transferred basis transaction. 2010] 301 florida tax review transaction. thus, it is expected be one of the purposes for entering into the transaction, but as a mere adjunct to a bona fide commercial transaction. section 269 is helpful in other ways when designing anti-abuse elements of the proposed system. the section's legislative history and the regulations promulgated under the section contain useful guidance on the meaning of the term "tax avoidance," a term not defined in the code, and when tax avoidance becomes the "principal purpose" of an acquisition. a thorough discussion of section 269 is beyond the scope of this paper, but some of the highlights of its legislative history are instructive to understand the limits on its scope imposed by the "principal purpose" standard. section 269 disallows "the benefit of a deduction, credit, or other allowance" in acquisitions of a controlling interest in a corporation or property of a corporation where basis is shifted, if the "principal purpose for which such acquisition was made is evasion or avoidance of federal income tax ... . a 1943 house ways and means committee report accompanying the enactment of the predecessor to section 269 states that the section was "designed to put an end promptly to any market for, or dealings in, interests in corporations or property which have as their objective the reduction through artifice of the income or excess profits tax liability."'0according to the related senate report, the section becomes operative whenever "the evasion or avoidance purpose outranks, or exceeds in importance, any other one purpose." 05 current treasury regulations under section 269 state that evidence of the proscribed purpose exists whenever "the transaction was not undertaken for reasons germane to the conduct of the business of the taxpayer, by the unreal nature of the transaction such as its sham character, or by the unreal or unreasonable relation which the deduction, credit, or other allowance bears to the transaction."10 6 103. irc § 269. 104. h. r. rep. no. 78-871, § 49 (1943). the predecessor to irc § 269 as § 29 of the internal revenue code of 1939, added to the law by the revenue act of 1943, 58 stat. 47 (1943). the scope of § 129 was narrowed in the senate so that the final version of the section required more than a mere "interest" in "property." for a discussion of the events that led up to the enactment of this provision, see, harry j. rudick, acquisitions to avoid income or excess profits tax: section 129 of the internal revenue code, 58 harv. l. rev. 196 (1944). 105. s. rep. no. 78-627, § 59 (1943), as reprinted in 1944 c.b. 973, 1017. in the earlier house version of the section, tax avoidance needed to be only one of the principal purposes of the acquisition. 106. treas. reg. § 1.269-2(b). the regulations say that the phrase is not limited to cases involving criminal or civil penalties for fraud. treas. reg. § 1.269-1. "evasion or avoidance" is broad enough to encompass most acquisitions of a deduction or other tax benefit which lowers overall tax liability or which exempts an otherwise taxable entity from taxation. although the regulations indicate that the absence of business purpose may be sufficient to trigger the irc § 269 disallowance 302 [vol. 10:2 a proposal for an elective tax benefits transfer system determining whether a "principal purpose" is present requires application of a subjective test that examines all surrounding facts and circumstances to determine the taxpayer's state of mind. 07 that subjective determination is aided by examining the objectively observable purpose for the transaction. as the fifth circuit stated, "[t]heoretically the question of purpose is purely subjective; pragmatically, however, the trier of fact can only determine purpose from objective facts."' 08 vi. proposal supported by current judicial doctrines a. judicial constraints on tax avoidance in the absence of an express statutory constraint on tax avoidance, there are well established judicial limitations on tax benefit transfers that encompass transactions, generally. they are vastly more expansive than the statutory rules; however, the judicial rules suffer from being less precise, and because the opinions in which they are contained are subject to the vagaries of the facts before the court, they appear to lack uniformity in their scope, applicability, and predictability. nonetheless, as broad as the judicial limitations are, they are not so broad as to prevent tax benefits transfers under the proposed system. rule, the 5th circuit held otherwise when saying: "section 269 is directed to the principal purpose for the acquisition of control of a corporation, not the absence of a business purpose in acquiring a corporation's assets." canaveral int'l corp. v. comm'r, 61 t.c. 520 (1974). the three-part test set forth in the regulations is also used in judicial scrutiny of transactions not covered by irc § 269. see § vi.a of this paper where this is discussed. 107. initially, the irs was not especially successful in irc § 269 cases because courts tended to find that most corporate acquisitions and property transfers at issue served a valid business purpose. see berland's, inc. v. comm'r, 16 t.c. 182 (1951) (acq.); alcorn wholesale co. v. comm'r, 16 t.c. 75 (1951) (acq.); wage, inc. v. comm'r, 19 t.c. 249 (1952) (acq. and nonacq.); commodores point terminal corp. v. comm'r, 11 t.c. 411 (1948) (acq.). beginning in 1957, however, courts adopted a narrower view of business purpose. thus, the 4th circuit in coastal oil was particularly skeptical of the taxpayer's choice of vehicle for acquiring a particular loss corporation. coastal oil storage co. v. cir, 242 f.2d 396 (4th cir. 1957) the tax court, in canaveral int'l corp denied tax benefits under section 269 because, while there was a valid business purpose for acquiring stock of a corporation with a high basis and low value, there was no business purpose for the particular method of acquisition. canaveral int'l corp. v. comm'r, 61 t.c. 520 (1974) (acq.) in all, while the courts have not compelled taxpayers to select the least favorable tax structure, they do require that the taxpayer demonstrate a substantial business reason for selecting the particular acquisition method. 108. bobsee corporation v. u.s., 411 f.2d 231, 238 (5th cir. 1969). 2010] 303 florida tax review although courts articulate similar tests for determining whether tax avoidance prevents anticipated tax benefits from being realized, they do not employ consistent language when describing key components of the tests. the terms, "intent" and "purpose," are frequently used in different ways, and the term "motive" is sometimes substituted for "intent" and occasionally for the term "purpose."'0 in this paper, the taxpayer's "motive" will be used to describe what caused the taxpayer to enter into the transaction, e.g., was the reason for entering into the transaction to reduce taxes, to increase profits, etc... . motive, as thus defined, is seldom in issue in tax avoidance cases."o the taxpayer's "intent" for entering into a transaction will be a term used to describe the taxpayer's subjective expectation for what the transaction will yield, e.g., did the taxpayer have as its objective for entering into the transaction to generate tax deductions, to increase cash flow, etc... . this is usually a controlling factor. the "purpose" for entering into the transaction is what the taxpayer objectively sought to obtain from the transaction, e.g., a reduction in tax liability, an increase in pretax profits, etc... .11 in addition to possessing the requisite intent and purpose, courts examine a transaction to determine whether the form of the transaction accurately reflects its substance. despite the semantic confusion, the following three tests emerge from an analysis of the judicial analysis tests. in most instances, courts apply the tests conjunctively: 109. the 3rd circuit in acm p'ship v. comm'r, 157 f.3d 231 (3rd cir. 1998), stated that for a transaction to be respected for tax purposes it must have "objective economic substance" and it must have "subjective business motivation." the court of appeals for the eleventh circuit stated that "naturally, the evaluation of the level of profit motive possessed by a taxpayer in entering into a transaction involves an inquiry into the subjective motive or intent of the taxpayer. kirchman v. comm'r, 862 f.2d 1486, 1491 (11th cir. 1989). 110. apart from considering a taxpayer's intent and purpose for entering into the transaction, courts also will examine whether the structure of the transaction accurately reflects its purpose or whether its structure is intended to conceal a tax avoidance intent. this issue will be discussed below under the heading "sham transactions." s11l. an illustration of judicial misuse of terminology that results in confusing the underlying principles is contained in rice's toyota world, inc., v. comm'r, 752 f.2d 89, 92 (4th cir. 1985) where in affirming the tax court the it was stated: "the business purpose inquiry simply concerns the motives of the taxpayer in entering the transaction. the record in this case contains ample evidence to support the tax court's finding that rice's sole motivation for purchasing and leasing back the computer under the financial arrangement used was to achieve the large tax deductions that the transaction provided in the early years of the lease." 304 [vol. 10:2 a proposal for an elective tax benefits transfer system * is there a business purpose for the transaction? * if there is no business purpose, does the taxpayer have tax avoidance intent? * does the structure of the transaction reflect its purpose? determining whether the taxpayer intended to engage in tax avoidance is a subjective inquiry. the perceived purpose of the transaction, whether it is to reduce tax liability, to maximize income, etc..., is determined from examining objective factors. form and substance inquiries will turn on the "economic realities" of the transaction. it is beyond the scope of this paper to provide a comprehensive discussion of these three tests, but an overview of them and the relationship to the proposed system is set forth below.112 b. is there a business purpose for the transaction? the requirement that a transaction have a business purpose was designed to ensure that tax benefits cannot be realized from a transaction if it is engaged in merely for the purpose of tax reduction.113 as with the taxavoidance intent requirement, the business purpose requirement has never been adopted into statutory law as a condition to transfer of tax benefits in general.114 a business purpose exists if the taxpayer has a profit motive for entering into a transaction, and reduction of taxes is not a business purpose."' 5 in gregory v. helvering, the case most often credited with establishing the business purpose requirement, the putative corporate reorganization was struck down because it was found to have no purpose other than to reduce taxes. the supreme court noted that a transaction "... having no business or corporate purpose ... " but designed solely to effectuate 112. for a discussion of the business purpose doctrine, see, generally boris i. bittker and james s. eustice, federal income taxation of corporations and shareholders (warren, gorham & lamont, 7th ed.) 1 12.61[1]. see also, acquisitions made to avoid taxes: section 269, 34 va. l. rev. 539 and wetzler, "notes of the economic substance and business purpose doctrines" tax notes, jul. 2, 2001 (92 tax notes 127). 113. acm partnership v. comm'r, 157 f.3d 231 (3rd cir. 1998). 114. it is contained in irc § 357(b), where it is a test to determine whether tax avoidance was the purpose of certain transfers of liabilities to a corporation. see also, treas. reg. §§ 1.368-1(c) and 1.355-2(b); rev. proc. 96-30, 1996-19 i.r.b. 8 (appendix a). 115. rice's toyota world, inc. v. comm'r, 81 t.c. 184 (1983). 3052010] florida tax review the taxpayer's tax avoidance intention to reduce taxes would not be respected for tax purposes. 116 c does taxpayer have tax avoidance intent? the taxpayer's intent for entering into the transaction is significant only if there is no business purpose for the transaction. if the taxpayer has a tax avoidance intent and if the transaction lacks any economic or commercial purpose, it will not be respected for federal income tax purposes."' conversely, if there is a business purpose, tax avoidance intent will not prevent realization of the tax benefits. one of the threshold issues decided in gregory was whether a transaction that appeared to comply with all statutory requirements for a taxfree reorganization would, nonetheless, fail to do so if the taxpayer's intent for entering into the transaction were to avoid taxes. writing for the second circuit, judge l. hand stated uncategorically that "... a transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one chooses, to evade, taxation."' 18 the supreme court affirmed both the decision and its reasoning saying: "[t]he legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted."" 9 when faced with the same issue, numerous other courts have adopted the gregory holding. for example, the seventh circuit in 1997 stated: "[a] tax-avoidance motive is not inherently fatal to a transaction. a taxpayer has a legal right to conduct his business so as to decrease (or 116. gregory v. helvering, 69 f.2d 809 (2nd cir. 1934), affd, 293 u.s. 465 (1935); casebeer v. comm'r, 909 f.2d 1360, 1363 (9th cir. 1990) stated: "... the purpose of a transaction should be the guide." casebeer v. comm'r, 909 f.2d 1360, 1363 (9th cir. 1990) defined a sham transaction as a transaction that "has no business purpose or economic effect other than the creation of tax deductions." lerman v. comm'r, 939 f.2d 53 (3rd cir. 1991). even if a transaction has a business purpose, the part of the transaction to which it relates may be separated from another part that has no business purpose if it appears that the taxpayer attempted to cloth the segment of the transacting lacking a nontax business purpose with the mantle of respectability. 117. frank lyon v. united states, 435 u.s. 561, 583-84 (1978); knetsch v. united states, 364 u.s. 361, 365-66 (1960). to the contrary, "where a transaction objectively affects the taxpayer's net economic position, legal relations, or non-tax business interests, it will not be disregarded merely because it was motivated by tax considerations." holladay v. comm'r, 649 f.2d 1176, 1179 (5th cir. 1981); acm p'ship, 157 f.3d at 248 n.31. 118. gregory, 69 f.2d at 811. i19 gregory, 293 u.s. at 469. 306 [vol.10:2 a proposal for an elective tax benefits transfer system altogether avoid) the amount of what otherwise would be his taxes." 20 the fifth circuit stated: "... it is also well established that where a transaction objectively affects the taxpayer's net economic position, legal relations, or non-tax business interests, it will not be disregarded merely because it was motivated by tax considerations."' 2 1 the tax court echoed these sentiments saying that: "[t]axpayers generally are free to structure their business transactions as they see fit, even if motivated by tax avoidance, provided a nontax or business purpose also is present."' 22 d. does structure of transaction reflect its purpose? the structure of the transaction must accurately reveal a business purpose. merely structuring a transaction in such a way as to convey the misleading impression that the transaction has a business purpose, of course, will fail to satisfy the business purpose requirement. when courts have determined that a transaction's profit or business form is a mask to its tax avoidance purpose, the substance of the transaction will be elevated over its form, and the attempted obfuscation will fail. thus, a leasing transaction in which possession is retained by the lessor will be ineffective under this doctrine in qualifying for the proposed system's tax benefit transfer provisions. the substance over form doctrine can be traced to a principle expressed by justice holmes in corliss v. bowers, where he wrote that "... taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed-the actual benefit for which the tax is paid." 23 more recently, in frank lyon co. v. u.s., the court considered whether the form of a sale/leaseback transaction should be given effect for tax purposes. it expanded upon its earlier statement and elevated it to the status of a "doctrine" saying: "[i]n applying this doctrine of substance over form, the court has looked to the objective economic realities of a transaction rather than to the particular form the parties employed." 24 this doctrine is now regularly applied by lower courts to invalidate a variety of tax avoidance schemes that are found to actually lack business purpose. thus, in del commercial properties, inc. v. commissioner, the district of columbia circuit stated that although taxpayers "are entitled to structure their transactions in such a way as to minimize tax," there must be a 120. n. indiana pub. serv. co. v. comm'r, 115 f.3d 506, 511 (7th cir. 1997). 121. acmpartnership, 157 f.3d at 248. 122. sanderson v. comm'r, 50 t.c.m. (cch) 1033 (1985); gregory, 293 u.s. at 469; rice's toyota world, inc., 81 t.c. at 195-96. 123. corliss v. bowers, 281 u.s. 376 (1930). 124. frank lyon, 435 u.s. at 573. 2010] 307 florida tax review purpose for the "business activity ... other than tax avoidance" and that purpose cannot be a "facade."l2 5 in acm partnership v. commissioner the third circuit similarly concluded that: "we must 'look beyond the form of [the] transaction' to determine whether it has the 'economic substance that [its] form represents." [citations omitted.]1 2 6 the tax court in falsetti v. commissioner defined "sham in substance" as the "expedient of drawing up papers to characterize transactions contrary to objective economic realities and which have no economic significance beyond expected tax benefits." 2 7 vii. taxation of transferred tax benefits assuming that the proposed system is adopted, three fundamental principles of tax law must be reconciled: 1) converting a deduction or a credit into a tax savings does not give rise to any income to the taxpayer. 2) a sale or exchange of property requires gain or loss to be determined, and, unless an exception applies, any realized gain or loss thus determined is then recognized,12 8 and 3) when property is purchased, the purchaser's tax basis is the taxpayer's cost of the property.129 125. del commercial properties, inc. v. comm'r, 251 f.3d 210 (d.c. cir. 2001); asa investerings p'ship v. comm'r, 201 f.3d 505 (d.c. cir. 2000). see also n. indiana pub. serv. co., 115 f.3d at 512 (stating that the irs cannot "disregard economic transactions ... which result in actual, non-tax-related changes in economic position"). in gregory, the transaction was in full compliance with the letter of the statute but it violated its spirit. this is not different from setting up a transaction so that its facts would appear one way but its substance was otherwise. in both of these transactions, the form is not reflecting its substance. in the reorganization area, the form may comply with the form required by the statute, but the substance may be otherwise, as in gregory. 126. acm partnership v. comm'r, 157 f.3d 231 (3rd cir. 1998). the supreme court has refused to permit the transfer of formal legal title to shift the incidence of taxation attributable to ownership of property where the transferor continues to retain significant control over the property transferred." comm'r v. sunnen, 333 u.s. 591 (1948); helvering v. clifford, 309 u.s. 331 (1940). comm'r v. tower, 327 u.s. 280, 291 (1946); helvering v. lazarus, 308 u.s. 252, 255 (1939). see also comm'r v. p.g. lake, inc., 356 u.s. 260, 266-67 (1958); comm'r v. court holding co., 324 u.s. 331, 334 (1945). comm'r v. duberstein, 363 u.s. 278, 286 (1960). 127. falsetti v. comm'r, 85 t.c. 332, 347 (1985). 128. irc § 1001(c). 129. irc § 1012(a). 308 [vol. 10:2 a proposal for an elective tax benefits transfer system tax benefits are property rights. inherent in business property is the right granted by congress to the owner to reduce tax liability by claiming various deductions and credits associated with the property. 30 if those rights are transferrable, they become property themselves because property has been defined as encompassing anything that may be transferred.' 3' the supreme court has said that "[t]he only relevant definitions of 'property' to be found in the principal standard dictionaries [footnote omitted] are ... that 'property' is the physical thing which is a subject of ownership, or that it is the aggregate of the owner's rights to control and dispose of that thing." 3 2 thus, assuming that amendments are made to the code appropriate to allow the sale of tax benefits, the right of a property owner to claim crd or tax credits would be treated as property disposed of in a transaction in which gain or loss would have to be determined and the acquiring taxpayer would have to determine its basis in the acquired property. 33 if these rules are applied, income or deduction may be created at the time the tax benefit is sold and the transferee would take a basis that will be equal to only 35% of the transferor's basis. current law provisions that allow tax deductions and credits to be transferred treat the transfer of tax benefits as tax-free events. for example, the sale of the "qualified equity investment" that transfers a nmtc results in no gain or loss with respect to the credit to the transferor. moreover, provisions that allow for "nonrecognition" of gain or loss never impose taxable boot status on any consideration attributable to the value of transferred tax benefits, such as built-in losses and crd. in a section 351 transaction the transferor of property who receives stock neither realizes nor recognized any gain with respect to the value of stock attributable to the basis of the transferred property. consistent with the current treatment of tax benefits, the proposed system's objective of merely shifting a tax benefit, not creating any income or deduction or altering the amount of tax basis in the process, would be achieved by expressly treating the transfer as a nonrecognition exception to the general recognition rule of section 1001.134 the lessor would neither realize nor recognize any gain or loss on the sale of benefits. after the sale, it would have no basis in the leased property that it continues to own. if the 130. this "right" is said to have been granted as "a matter of legislative grace ... ." deputy v. du pont, 308 u.s. 488, 493 (1940). 131. in hempt bros., inc. v. u.s., 354 f.supp. 1172, 1175 (m.d.pa.1973), affd, 490 f.2d 1172 (3rd cir. 1974), cert. denied, 419 u.s. 826 (1974). 132. crane v. comm'r, 331 u.s. 1, 6 (1947). 133. black's law dictionary defines "property" as, among other things, "the right to possess, use, and enjoy a determinate thing (either a tract of land or a chattel); the right of ownership ... ." 134. irc § 7701(a)(45). 2010] 309 florida tax review lessor eventually sells the property after the term of the lease expires for its residual value, it will determine its gain on the transaction by comparing its amount realized with a zero tax basis. granting the transaction nonrecognition treatment would yield the intended consequences for the purchaser. instead of taking a cost basis in the tax benefit, normal nonrecognition rules call for a transferred tax basis. because both the entitlement to, and the amount of, property related tax credits are determined with reference to tax basis, a transferred basis rule that places the transferee in the shoes of the transferor will facilitate tax credit transfers, as well. viii. conclusion a tax-benefit allocation system with appropriate anti-abuse safeguards will contribute toward a more efficient utilization of tax incentives. such a system is to the advantage of both taxpayers and the government. tax liability, cash flow, and reported earnings will be more accurately reflected, competition and decision making will not be distorted, and taxable transactions intended by the government to be encouraged by stimulus legislation will occur with greater frequency. the proposed system furthers these objectives while operating within the confines of well established anti-avoidance statutory and judicial rules. 310 [vol. 10:2 florida tax review florida tax review volume 13 2013 number 9 461 everything you always wanted to know about farid but were afraid to ask* by linda galler** i. introduction .................................................................................... 462 ii. the facts according to the courts ......................................... 464 iii. the true story ................................................................................ 466 a. before they met: doris ................................................................. 466 b. before they met: s.s. ................................................................... 467 c. the first divorce ........................................................................... 468 d. the second marriage and doris’s acquisition of shares .............. 469 iv. why were the facts not the facts? ........................................ 473 a. why the government might have agreed to the stipulated facts 475 b. why doris might have agreed to the stipulated facts ................. 478 v. doris’s basis under the real facts .......................................... 479 a. the transfer of shares was a gift before the marriage ................ 479 b. gifts to mistresses are excluded from income............................... 482 vi. lessons learned ............................................................................. 485 a. tax considerations ........................................................................ 485 b. litigation considerations .............................................................. 487 c. ethical considerations ................................................................... 489 * younger readers might be interested to know that everything you always wanted to know about sex but were afraid to ask was a 1972 woody allen film that took its title from a book of the same name by david reuben, m.d. unlike the film, the book was not comedic. indeed, dr. reuben was not happy about the movie and told the l.a. herald-examiner, “i didn’t enjoy the movie because it impressed me as a sexual tragedy. every episode in the picture was a chronicle of sexual failure, which was the converse of everything in the book.” jeff stafford, everything you always wanted to know about sex . . . but were afraid to ask, turner classic movies, http://www.tcm.com/thismonth/article/?cid=12726&rss=mrqe (last visited july 25, 2012). this article suggests that the farid story is more like allen’s movie than reuben’s book. ** professor of law, maurice a. deane school of law at hofstra university. the author wishes to thank lisa spar of the hofstra law library for assistance in locating sources. special thanks to melissa gobin, hofstra law school class of 2011, for her invaluable research assistance. 462 florida tax review [vol. 13:9 vii. conclusion ..................................................................................... 491 epilogue: what happened to doris and s.s.? ................................ 492 a. the remainder of the marriage ..................................................... 492 b. doris .............................................................................................. 498 c. s.s. .................................................................................................. 500 i. introduction students engaged in the study of federal income taxation routinely examine the case of farid-es-sultaneh v. commissioner,1 in which the court of appeals for the second circuit addressed a wife’s tax basis in stock she received under the terms of an antenuptial agreement. while the case invariably engenders a lively and engaging class discussion, the black letter law ultimately is straightforward: her basis equaled the fair market value of the shares on the date they were received because they were acquired for consideration (that being the release of marital rights in her future husband’s property). the government had argued that her basis was the same as her husband’s (a carryover basis) because she received the stock as a gift. perhaps students’ enthusiasm for the case results from a sense that they simply do not know the full story. after all, why would an engaged woman accept stock worth $787,5002 in exchange for the possibility of receiving over $33 million upon her husband’s death — particularly when her fiancé was twenty-five years her senior with a life expectancy of only sixteen and one-half years?3 the recital of facts in the court’s opinion4 reflects that the marriage was brief and, one might suspect, tumultuous. students are also confused by the case name: how did an american citizen end up as farid-es-sultaneh? alas, neither the trial court nor the court of appeals betrayed even the slightest interest in the taxpayer’s motives or the details underlying what surely must have been a titillating tale. 1. 160 f.2d 812 (2d cir. 1947) (farid ii), rev’d, 6 t.c. 652 (1946) (farid i). 2. this figure was computed by multiplying the number of shares received (2,500) by the fair market value per share on april, 24, 1924 (as stated in the court of appeals opinion). farid ii, 160 f.2d at 813; see also stipulation of facts ¶ 11, farid i, 6 t.c. 652 (no. 2968). for the significance of this particular date, see infra text accompanying notes 17–19. 3. see infra text accompanying notes 23–27. 4. the facts stated in the tax court’s opinion are brief. see farid i, 6 t.c. at 652. the facts recited by the appellate court, however, present a fuller account. see farid ii, 160 f.2d at 813–14. 2013] about farid 463 this article reflects the results of a research expedition into the journalistic past and offers the real account.5 as one might suspect, the story would merit front-page coverage in celebrity gossip magazines if it occurred in modern times, involving as it did fame, wealth, serial separation and reconciliation, and sundry allegations of gold digging and infidelity. surprisingly, the real story is not reflected in the facts set forth in either the trial or appellate court decision. indeed, had the real facts been placed in issue, the case might well have been decided for the government. this discrepancy raises thought-provoking and important questions about the role of fact development in litigation and fact finding in the judicial process. this article explores the impact, both in this case and generally, of litigating on the basis of “facts” that are not true, the strategic decisions that lawyers make in developing facts, and the ethical considerations implicated in framing a story. this article begins by describing the facts as they were found and relied upon by the courts in farid. it then recounts another version — the true story — and considers whether the real facts might have occasioned a different result, concluding that the correct facts would have produced a win for the government and a carryover basis. indeed, farid is a model case for the notion that everything in law revolves around facts.6 how a story is told or how a fact finder understands a series of facts guides the court’s ruling as much as a judge’s understanding of applicable law.7 this article speculates on the motives of counsel in the case for both sides in stipulating to facts that were untrue and concludes that some strategic advantage probably induced them to agree to the facts as we have come to know them over the years. finally, this article ruminates on lessons taught by farid in the context of substantive tax law, litigation strategy generally, and ethical considerations. an epilogue provides curious readers with the rest of the farid story; while irrelevant to the legal issue in the farid litigation, the tale of farid’s life is both fascinating and extraordinary. 5. the story presented here is as real or true as the press reports of the day. the facts related herein, other than those explicitly referred to as derived from judicial opinions, are based exclusively on contemporaneous newspaper articles. 6. stefan h. krieger & richard k. neumann, jr., essential lawyering skills 11 (4th ed. 2011) (“the analysis of facts permeates this [important] book because the analysis of facts permeates the practice of law.”). 7. id. at 188; see generally id. at 131–40, 177–80. 464 florida tax review [vol. 13:9 ii. the facts according to the courts because the case was fully stipulated, the pertinent facts were never in dispute.8 the lower court (united states tax court), therefore, was not called upon to find facts based on evidence presented but merely adopted verbatim the stipulations crafted and agreed upon by lawyers for the government and for the taxpayer. whereas the tax court’s recital of the facts was brief, the court of appeals’ extended account is fully consistent with the stipulation of facts submitted to the tax court.9 the taxpayer, doris farid-es-sultaneh (“doris”),10 was an american citizen who sold shares of common stock in s.s. kresge company in 1938 for $230,802.36.11 doris had acquired the shares from her ex-husband, s.s. kresge (“s.s.”).12 in december 1923, when s.s. was married to another woman and doris was unmarried, he delivered 700 shares to her; these shares had a fair market value of $290 per share.13 the shares were to be held by doris “‘for her benefit and protection in the event that the said kresge should die prior to the contemplated marriage between the petitioner [doris] and said kresge.’”14 s.s. divorced his first wife on january 9, 1924 and, on or about january 23, 1924, he delivered another 1,800 shares to 8. farid ii, 160 f.2d 812, 813 (2d cir. 1947); see also farid i, 6 t.c. 652 (1946). most tax court cases are tried on stipulated facts; live testimony is rare. jane c. bergner, mertens law of federal income taxation § 50.90 (2012). current tax court rule 91 sets out a mandatory pretrial stipulation procedure covering, inter alia, factual matters that are not in dispute. tax ct. r. 91(a). a stipulation is treated as a conclusive admission of a party but only for purposes of the pending litigation. tax ct. r. 91(e); borchers v. commissioner, 95 t.c. 82, 90 (1990), aff’d, 943 f.2d 22 (8th cir. 1991) (stipulated facts are treated in the same manner as facts found by the court on the basis of evidence presented at trial). why the parties in farid i might have acquiesced in the particular facts in the case is considered later in this article. see infra part iii. 9. see stipulation of facts, supra note 2. 10. the taxpayer was known as “doris” through most of her life. see infra note 31 and accompanying text. 11. to get a sense of size of the transaction, the amount realized on the sale in 1938, $230,802, is equivalent to $3,756,310.73 in 2012 u.s. dollars. cpi inflation calculator, u.s. board of labor and statistics, http://data.bls.gov/cgibin/cpicalc.pl (last visited jul. 25, 2012). 12. mr. kresge was known as “s.s.” s.s. kresge dead; merchant was 99, n.y. times, oct. 19, 1966, at 1. 13. farid ii, 160 f.2d at 813; see also farid i, 6 t.c. at 652. the stipulation of facts states that the value of this stock was $280 per share. stipulation of facts, supra note 2, ¶ 2. 14. farid ii, 160 f.2d at 813 (quoting from the stipulation of facts ¶ 2, farid-es-sultaneh v. commissioner, 6 t.c. 652 (1946) (no. 2968)). 2013] about farid 465 doris, these to be held for the same purpose as the first 700 shares.15 no value was stated for the 1,800 shares.16 on april 24, 1924, doris and s.s. executed an antenuptial agreement in which: she acknowledged the receipt of the shares “as a gift by the said sebastian s. kresge, pursuant to this indenture, and, as an ante-nuptial settlement, and in consideration of said gift and said ante-nuptial settlement, in consideration of the promise of said sebastian s. kresge to marry her, and in further consideration of the consummation of said promised marriage” she released all dower and other marital rights, including the right to her support to which she otherwise would have been entitled as a matter of law when she became his wife.17 the couple married “immediately after the ante-nuptial agreement was executed.”18 the value of the stock on april 24, 1924 was $315 per share and rose to $330 per share on may 6, 1924, when the shares were transferred to doris on the corporation’s books.19 doris and s.s. divorced on may 18, 1928. doris claimed no alimony, and none was awarded to her.20 because of a series of stock dividends over the years, doris’s adjusted basis per share in 1938 (the year at issue) was $10.66⅔ per share computed on the basis of the fair market value 15. id.; see also farid i, 6 t.c. at 652. 16. the stipulation of facts states that the value of this stock was $290 per share. stipulation of facts, supra note 2, ¶ 2. 17. farid ii, 160 f.2d at 813. the language within the quotation marks is from the antenuptial agreement. see stipulation of facts, supra note 2, at exhibit 1a. the stipulation of facts states that the 2,500 shares referred to in the agreement were the same shares previously received by doris in december 1923 and january 1924. id. ¶ 3. the alternative version of facts reflects that doris believed she was going to receive 2,500 additional shares under the agreement. see infra notes 52–62 and accompanying text. 18. farid ii, 160 f.2d at 813; see also farid i, 6 t.c. at 652. 19. farid ii, 160 f.2d at 813. 20. id. 466 florida tax review [vol. 13:9 per share at “the time” of her acquisition,21 and $0.159091 computed as a carryover of s.s.’s adjusted basis.22 the court of appeals’ recital of facts concluded by noting the couple’s ages and life expectancies as of the date of their marriage23 and the value of s.s.’s wealth. doris was thirty-two years old with a life expectancy of thirty-three and three-fourths years (i.e., sixty-five and three-fourths years).24 s.s. was fifty-seven years old with a life expectancy of sixteen and one-half years (i.e., seventy-three and one-half years).25 he was then worth approximately $375,000,00026 and owned real estate worth approximately $100,000,000.27 iii. the true story before recounting the alternative version of doris’s story, a brief synopsis of her life and of s.s.’s life, prior to their marriage, is provided here. a. before they met: doris the future mrs. kresge began life as mabel doris mercer.28 she was born in 1889 to captain george a. mercer, reported variously as a pittsburgh police captain, a superintendent of buildings in allegheny, pennsylvania,29 and as a partner of andrew carnegie.30 by the time ms. mercer applied for a license to marry s.s., she had dropped “mabel” from use.31 21. id. according to the stipulation of facts, the value per share on april 24, 1924 was $14 per share, but doris used $10.66⅔ per share as her adjusted basis. stipulation of facts, supra note 2, ¶¶ 11–12. the discrepancy is not explained. 22. farid ii, 160 f.2d at 813. it is unclear what date the court referred to as “the time” of doris’s acquisition since she received the shares in two blocks, on two dates, and the corporation recorded her ownership on a third date. 23. see stipulation of facts, supra note 2, ¶ 15 (reflecting life expectancies on april 24, 1924, the date of the marriage). 24. farid ii, 160 f.2d at 814. 25. id. at 813. 26. $375,000,000 in 1924 is worth $5,032,412,281 in 2012. cpi inflation calculator, supra note 11. 27. farid ii, 160 f.2d at 813. $100,000,000 in 1924 is worth $1,343,197,661 in 2012. cpi inflation calculator, supra note 11. 28. p.l. harden wedded to mabel mercer, n.y. times, apr. 18, 1911, at 3. 29. id. 30. from the magazine, time, may 5, 1924. 31. see s.s. kresge obtains license here to wed, n.y. times, apr. 24, 1924, at 9 (license issued to s.s. kresge and doris mercer). 2013] about farid 467 at the age of 17, doris became engaged to carl borntraeger, a ward of industrialist henry c. frick.32 neither captain mercer nor mr. frick was pleased with the relationship. there reportedly was a scene, and as a result, doris ran away to new york city to pursue a life on the stage. she landed a minor role on broadway in a musical comedy, earl and the girl. displeased, captain mercer tricked his daughter into taking a trip home to pennsylvania. once over the state line, captain mercer confined his daughter against her will in the episcopalian country home in germantown.33 within a month, doris and carl implemented an escape plan worthy of a b movie, involving a seemingly secure second floor window, a linen sheet, a mad slide, and a fall to the ground. the couple returned to new york city but never married.34 in 1911, doris married percival l. harden, publisher of the club fellow, a weekly gossip newspaper — also known to some as a “reputation monger”35 and as a “tattle magazine”36 — published in new york and chicago. it was mr. harden’s second marriage, his first having ended in divorce. however, his second marriage soon met the same fate as the first and ended in 1918.37 after harden’s death in 1930, doris is reported to have said: “my first husband was a delightful, worldly man. he was charming not only to me but unfortunately to every other woman he met. naturally, that was unsettling.”38 b. before they met: s.s. sebastian kresge is best remembered as the founder of s.s. kresge company (the “company”). at the time of his death in 1966,39 the company 32. interestingly, doris and frick are buried in the same cemetery — homewood cemetery in pittsburgh, pennsylvania. other notable “inhabitants” include ketchup magnate h.j. heinz ii, former u.s. senator h.j. heinz iii, and baseball hall of famer pie traynor. homewood cemetery, find a grave, http://www.findagrave.com/php/famous.php?page=cem&fscemeteryid=45139 (last visited aug. 7, 2012); homewood cemetery, janie & tim (aug. 14, 2011), http://janieandtim.com/?p=627 (photographs of notable graves). 33. s.s. kresge wed again, n.y. times, apr. 25, 1924, at 20. 34. p.l. harden wedded to mabel mercer, supra note 28, at 3. 35. national affairs: jardines, time, aug. 23, 1926, at 11. 36. the press: so many of them, time, apr. 21, 1930, at 28. 37. third wife sues harden, n.y. times, dec. 23, 1926, at 10. 38. the press: end of a gossipist, time, apr. 28, 1930, at 29. mr. harden took his own life in a new york hotel room. harden, publisher, ends life by shot, n.y. times, apr. 18, 1930, at 24. 39. despite a life expectancy, in 1947, of sixteen and one-half years when he was fifty-seven years old, s.s. lived to be 99. farid ii, 160 f.2d 812, 813 (2d cir. 468 florida tax review [vol. 13:9 owned 930 stores throughout the united states, canada, and puerto rico — 670 kresge variety (“5-and-10-cent”) stores, 150 kmart department stores, and 110 jupiter discount stores.40 s.s. is also remembered as a generous philanthropist, primarily through the kresge foundation, which he established in 1924 — coincidentally the same year in which he divorced his first wife and married doris — through an initial contribution of $1.3 million and which made grants of $70 million during his lifetime.41 s.s. was born in 1867 on a farm in bald mountain, pennsylvania. as a young man he worked as a traveling salesman. one customer who particularly impressed s.s. was frank woolworth, who had founded a 5-and10-cent store chain several years earlier. resolving to enter that same business, s.s. went into partnership with john g. mccrory, becoming a halfowner of a 5-and-10-cent store in memphis and another in detroit. the partners eventually split, with each partner taking full ownership of one store. s.s. became sole owner of the detroit emporium and soon began opening kresge stores throughout the midwest.42 the company went public in 1912. s.s served as president from 1907 to 1925 and as chairman of the board from 1913 until shortly before his death. in 1925, when s.s. left the presidency, the company operated 307 stores. that same year, s.s. purchased a large interest in stern brothers, a new york department store, and smaller interests in the fair, a chicago department store that eventually became part of montgomery ward & co., and kresge newark, inc., a newark department store that later became chase newark store. s.s. also was president for many years of the kresge realty company.43 s.s. resided in detroit from 1899 until he moved to new york city in 1924.44 c. the first divorce although s.s.’s courtship of doris began while kresge was married to another woman, the ground for divorce alleged by the first mrs. kresge 1947). he died in 1966, outliving doris by more than three years. see infra notes 258–60 and accompanying text. 40. s.s. kresge dead; merchant was 99, supra note 12, at 1. annual sales exceeded $851 million in 1965, when the company employed 42,000 people. id. at 38. 41. s.s. kresge dead; merchant was 99, supra note 12, at 38. 42. id. mr. mccrory’s collection of stores grew as well. in 1987, mccrory stores bought all of the kresge stores that were still operating. isadore barmash, a kresge-mccrory reunion, n.y. times, apr. 4, 1987, at 33. for a history of the mccrory businesses, see isadore barmash, for the good of the company: work and interplay in a major american corporation (1976). 43. barmash, a kresge-mccrory reunion, supra note 42, at 33. 44. id. 2013] about farid 469 was cruelty, not adultery.45 her divorce pleadings never mentioned another woman but instead described her husband as “frequently sullen and morose,”46 with a “moody disposition and temperament,”47 refusing to speak to her or their children for days at a time. he was a “nagger” and a “scolder,” she alleged, who refused to accept responsibility for his children.48 the couple had five children, two of whom were minors at the time of the divorce. their oldest son, stanley, was already working with his father at the time.49 the divorce settlement reportedly was $10,000,000.50 d. the second marriage and doris’s acquisition of shares s.s. and doris married in new york on april 24, 1924.51 a year later, the couple was in court. doris sued s.s. seeking 17,500 shares of company stock, which she asserted he had promised her before their marriage as a settlement in lieu of her dower rights.52 news reports at the time valued her claim at $7,000,000.53 the complaint alleged that the couple had reached an oral agreement, that s.s. was supposed to have had a written agreement drawn up to reflect the terms of that agreement, but that the document ultimately drafted and signed reflected only 2,500 shares.54 (this document is the same agreement referred to in the later tax case). doris further alleged that her husband had caused her to sign the antenuptial agreement “by persuasion, artifice, and fraud.”55 in this regard, it may be noted that both farid opinions indicated that the agreement was signed 45. s.s. kresge obtains license here to wed, supra note 31, at 9. 46. id.; see also wife of kresge gets divorce on cruelty charge, chi. trib., jan. 12, 1924, at 2. 47. kresge trial delayed, n.y. times, aug. 19, 1923, at 6. 48. id. 49. see stanley s. kresge, the s.s. kresge story, 24–25 (1979) (stanley worked at a detroit kresge store during school vacations, became a manager-trainee in 1923, and then managed several 5-and-10-cent stores before joining the company’s headquarters staff in 1930). stanley became chairman of the board when his father stepped down many years later but retired a year later. sebastian s. kresge, 98, quits as head of chain he founded, n.y. times, jun. 22, 1966, at 63; stanley sebastian kresge, 85, retailer and philanthropist, n.y. times, jul. 3, 1985, at d19. 50. wife sues kresge for $7,000,000 stock, n.y. times, june 23, 1925, at 1. mrs. kresge was given sole possession of “the palatial kresge residence” in detroit. wife of kresge gets divorce on cruelty charge, supra note 46, at 2. 51. s.s. kresge wed again, supra note 33, at 20. 52. wife sues kresge for $7,000,000 stock, supra note 50, at 1. 53. id.; mrs. kresge reduces claim to $1,000,000, n.y. times, july 14, 1925, at 21. 54. wife sues kresge for $7,000,000 stock, supra note 50, at 1. 55. id. 470 florida tax review [vol. 13:9 immediately before the wedding ceremony.56 one can speculate on the pressure the bride might have been under at that time. the complaint also alleged that mr. kresge had failed to deliver even the 2,500 shares referred to in the agreement.57 doris’s lawyer told reporters that s.s. had promised to transfer the shares by may 1, 1925 and, having failed to make any such transfers, had shortly thereafter moved out of the couple’s home. he intimated that a separate matrimonial action would be brought.58 for reasons now unknown, doris hired a new lawyer, who amended the original complaint to demand only the transfer of the 2,500 shares mentioned in the antenuptial agreement.59 doris’s attorney claimed that the 2,500 shares, together with a stock dividend of 1,250, were worth $2,000,000.60 the reason for the reduced demand is unclear. one might speculate, however, that the new attorney understood the statute of frauds, under which certain contracts, including contracts in consideration of marriage, are unenforceable unless in writing.61 in his opening statement at trial, doris’s lawyer told the following story. the couple met in january 1921, and “a friendship between them had developed in march.”62 doris was then studying music, and mr. kresge asked her how much her studies would cost to complete. she replied “$10,000,” whereupon s.s. opened a brokerage account for her and deposited sufficient securities to provide doris with that amount. when s.s. closed the account in 1923, it had provided doris with $145,000 in income. s.s. had promised to replace the account with 2,500 shares of company stock but instead offered doris 2,000 shares in kresge department store. doris declined the offer in favor of shares in the publicly-traded company. s.s. immediately transferred 700 company shares to her and promised to transfer 1,800 more at a later date, explaining that he was a married father of five children and did not want to be associated with such a large gift to woman who was not his wife. s.s. admonished doris not to have the shares transferred to her on the books of the company because he wished the gift to be kept secret. once s.s.’s divorce was finalized, he urged a quick marriage so that the couple would be husband and wife before news of their liaison 56. farid ii, 160 f.2d 812, 813 (2d cir. 1947); farid i, 6 t.c. 652 (1946). 57. wife sues kresge for $7,000,000 stock, supra note 50, at 1. 58. id. 59. mrs. kresge reduces claim to $1,000,000, supra note 53, at 21. 60. justice paves way for kresge reunion, n.y. times, mar. 9, 1926, at 1. 61. see, e.g., hunt v. hunt, 64 n.e. 159 (n.y. 1902); see also restatement (second) of contracts § 124 (1981). 62. justice paves way for kresge reunion, supra note 60, at 5. unless otherwise indicated, the descriptions of counsels’ opening statements and quotes therefrom are set forth in this article. 2013] about farid 471 reached the press. s.s. then asked for an antenuptial agreement that provided doris with 2,500 shares in addition to the 2,500 that she already owned. s.s.’s account, as related in his attorney’s opening statement, differed from doris’s attorney’s in several material respects. most importantly, defense counsel claimed there was only one block of 2,500 shares, the shares that were referred to in the antenuptial agreement.63 while asserting that these shares were not “a gift to cover up [s.s.’s] friendship for [doris] before their marriage,”64 s.s.’s lawyer did acknowledge that s.s. had transferred the 2,500 shares to doris prior to their wedding.65 the latter assertion is consistent with the stipulation of facts in farid, which, while referring to a single block of 2,500 shares, indicated that s.s. had delivered all of those shares to doris prior to execution of the antenuptial agreement and the marriage.66 according to this lawyer’s statement, doris was to receive $10,000 a year from s.s. for purposes of her music study. a brokerage account was set up to provide her with that amount without “leav[ing] behind a trail of his conduct.”67 s.s.’s lawyer claimed that doris had received $205,000 from the brokerage account before it was closed.68 as to the couple’s relationship, s.s.’s attorney conceded that his client “was attentive to miss mercer in a central park west apartment” for which he paid all of the expenses.69 “their friendship was most agreeable. she was nice to him, and there was no question but that he was infatuated with her.”70 upon their engagement, which occurred after s.s.’s first wife asked for a divorce but before that divorce became final, s.s. and doris discussed an antenuptial agreement. counsel claimed that the possibility of putting 5,000 shares of company stock in trust for doris was discussed but that the parties ultimately agreed on an outright transfer of 2,500 shares.71 counsel asserted that doris “developed a strong affection for money” and that when s.s. realized that “she was more fond of his stock and money than of himself,” he moved out of their apartment.72 at that time, he had already transferred 700 shares to her. doris apologized, s.s. moved back in and, “to 63. id. 64. id. 65. kresges settle; reunion expected, n.y. times, mar. 20, 1926, at 3; see also mrs. kresge put on 3 year trial as dutiful wife, chi. trib., mar. 21, 1926, at 17. 66. stipulation of facts, supra note 2, ¶¶ 2–4. 67. justice paves way for kresge reunion, supra note 60, at 5. 68. id. 69. id. 70. id. 71. id. 72. justice paves way for kresge reunion, supra note 60, at 5. 472 florida tax review [vol. 13:9 show his good intentions,” s.s. transferred 1,800 more shares to doris.73 only then did the divorce from his first wife and the subsequent marriage to doris take place. doris’s suit was settled after opening statements and before any testimony was given.74 the couple did not announce the terms of their settlement. press accounts were inconsistent,75 but at least one report indicated that doris received cash but no additional shares.76 thus, the question of whether s.s. had promised doris one or two blocks of 2,500 shares was never publicly resolved. while doris’s version of the facts differed in significant respects from s.s.’s version, it is notable for purposes of this article that doris’s version also varied from the stipulation of facts to which she subsequently agreed in the tax court. in litigation with s.s., doris claimed there were two blocks of 2,500 shares — the 2,500 shares she received prior to the marriage, which were hers irrespective of the antenuptial agreement, and the 2,500 additional shares she was entitled to under that agreement in exchange for releasing her marital property rights. in tax court, however, doris agreed to stipulations that referred only to a single block of 2,500 shares.77 moreover, the stipulations explicitly stated that the 2,500 shares doris received prior to the marriage were the same 2,500 shares referred to in the antenuptial agreement.78 notably, the shares themselves were delivered to doris, in street name, prior to the wedding. hence, there are two possible versions of the facts: (1) the 2,500 shares that doris received prior to her marriage were not the subject of the 73. id. 74. the matter was settled after the presiding judge urged the couple to seek counsel from the minister of the church they attended. kresges settle; reunion expected, supra note 65, at 3. 75. see, e.g., reconciliation of kresges ends legal dispute, chi. trib., mar. 20, 1926, at 3 (more than $1,000,000, of which $100,000 was in cash); mrs. kresge put on 3 year trial as dutiful wife, supra note 65, at 17 (financial settlement contingent upon doris being a “dutiful wife” for three years; paid out incrementally); s.s. kresge reveals settlement terms, n.y. times, mar. 22, 1926, at 21 (statement of s.s. released by doris’s lawyer denying that settlement imposed any conditions on doris). in pleadings filed in a divorce action several years later, s.s. stated that he had given doris $100,000 to settle the suit. mrs. kresge fights husband’s suit, n.y. times, apr. 18, 1928, at 27. 76. reconciliation of kresges ends legal dispute, supra note 75, at 3. 77. stipulation of facts, supra note 2, ¶¶ 2–4. 78. id. ¶ 3 (“the twenty-five hundred (2,500) shares of stock referred to in said agreement is the twenty-five hundred (2,500) shares referred to in paragraph 2 hereof.”). paragraph three goes on to state that doris had not reported, for federal income tax purposes, the receipt of the 2,500 shares in 1923 (the first 800) or in 1924 (the remaining 1,700). id. 2013] about farid 473 antenuptial agreement, which contemplated an additional 2,500 shares; or (2) there was only one block of 2,500 shares, and the antenuptial agreement referred to shares that doris already owned at the time the agreement was executed.79 before considering the significance of the disparate accounts, one might reasonably ask why doris, indeed why both parties to the tax dispute, agreed to seek a judicial determination based on facts that varied materially from doris’s prior version of the story. iv. why were the facts not the facts? farid was decided on stipulated facts. in its present version, tax court rule 91 requires parties to stipulate facts “to the fullest extent to which complete or qualified agreement can or fairly should be reached.”80 in 1945, 79. the language of the antenuptial agreement itself is susceptible of either interpretation. in stating the reasons for the contact, the agreement speaks in the future tense, stating that s.s. “desires to make provision for the immediate benefit and protection of [doris].” the operative clauses are worded in the present tense, stating that s.s. “hereby gives, assigns, transfers, and sets over unto the said doris mercer, absolutely two thousand five hundred (2,500) shares” and that doris “hereby acknowledges receipt from the said sebastian s. kresge of two thousand five hundred (2,500) shares.” stipulation of facts, supra note 2, at exhibit 1-a. 80. tax ct. r. 91(a)(1). “included in matters required to be stipulated are all facts, all documents and papers or contents or aspects thereof, and all evidence which fairly should not be in dispute.” tax ct. r. 91(a)(1). the tax court has characterized the pretrial stipulation process as “the bedrock of tax court practice.” branerton corp. v. commissioner, 61 t.c. 691, 692 (1974). according to the definitive history of the tax court, the stipulation requirement is: largely responsible for the court’s ability to keep current with the thousands of cases docketed each year. by eliminating the necessity of proof at trial with respect to uncontroverted issues of fact, pretrial stipulations result in savings of time and expense for both the courts and the parties. moreover, the necessity of complying with the stipulation procedures forces opposing counsel to consult and to develop the facts of their case in advance of trial. as a result, issues are perceived and litigating risks are evaluated at an early stage of the proceedings. many observers believe that the high rate of pretrial settlements that obtains in the tax court is largely due to this fact of its practice. harold dubroff, the united states tax court: an historical analysis 277 (1979)(citations omitted). former chief judge tannenwald listed the advantages of the stipulation process as follows: first, and perhaps foremost, the stipulation process will force counsel to face the realities of the issues involved and, as a consequence, will often encourage partial, if not complete, settlement. second, careful attention to the preparation of a 474 florida tax review [vol. 13:9 when the stipulation of facts in farid was filed, stipulations were common in the tax court, but the practice was not yet mandatory.81 a stipulation generally is treated as a conclusive admission by the parties to the stipulation but is binding only in the pending case and not for any other purpose, nor can it be used against any of the parties in any other case or proceeding.82 there being no contested issues of fact, doris and the government jointly moved for a decision without trial.83 the stipulations, and the court’s findings of fact which incorporated them, did not reflect doris’s earlier version of the circumstances under which doris received company shares from s.s., raising the question of why the parties’ lawyers might have agreed to the stipulations. one possibility is that counsel for one or both, most likely the government, did not know the true facts.84 doris had received the shares more than twenty years prior to commencement of the tax court proceeding and had been divorced from s.s. for seventeen years. another possibility is that taxpayer’s counsel wished to save his client from embarrassment. it is also possible that one or stipulation of facts will enable the parties to state undisputed subsidiary facts with a degree of precision that in many cases will not be reflected in the oral testimony of witnesses with its inherent uncertainties. third, the more complete the stipulation of facts, the less time will be required for the trial itself and the more meaningful the trial will be. to the extent that written material is stipulated, needless expenditure of time in marking exhibits and offering them into evidence is avoided. . . . finally, it is important to note that gaps in the stipulation can cause an issue to be decided against the party having the burden of proof. theodore tannenwald, jr., tax court trials: an updated view from the bench, 47 tax law. 587, 591 (1994). for an interesting discussion of practical considerations in the stipulation process, see robert r. veach, stipulating facts in tax court, 34 taxes 669 (1956). 81. see dubroff, an historical analysis, supra note 80, at 277–83. 82. tax ct. r. 91(e). 83. see tax ct. r. 122(a). 84. interestingly, the internal revenue manual of today admonishes government attorneys to stipulate only to facts they know to be true. i.r.m. 35.4.7.1; see also i.r.m. 35.4.7.3 (“the initial draft [by the government attorney] should be based upon the known facts and documents contained in the administrative file, admissions contained in the pleadings, answers to informal or formal discovery, requests for admissions, and other facts or documents secured during trial preparation.”). had the government attorneys in farid i been governed by today’s manual, they might not have been able to agree to stipulate as they did in the case. the antenuptial agreement does not refer to shares having been received by doris prior to the marriage. moreover, the facts alleged in doris’s petition are consistent with her position in the prior litigation with s.s. amended petition ¶ 5(d), farid i, 6 t.c. 652 (1946) (no. 2968). 2013] about farid 475 both parties assumed a strategic advantage from the facts as stipulated. it is impossible to know.85 a. why the government might have agreed to the stipulated facts perhaps the government was willing to accept the stipulation because it believed in the strength of judicial precedent, which it regarded as endorsing its position.86 in retrospect, this was a poor decision, but, at the time, the government’s confidence was probably justified. indeed, the government won in the tax court; the portion of the tax court’s opinion discussing the law and its application of the facts at bar took up only one sentence. the court merely cited two supreme court decisions that it 85. the applicable rules of lawyers’ ethics at the time were the aba canons of professional ethics. canons of prof’l ethics (1908). (the canons were adopted by the new york state bar association in 1909. robert t. begg, revoking the lawyers’ license to discriminate in new york: the demise of a traditional professional prerogative, 7 geo. j. legal ethics 275, 283 n.36 (1993) (citing 32 report of n.y. state bar ass’n 167 (1909)). unlike present day rules, the canons were brief (forty numbered paragraphs) and general in nature. canon 22 (“candor and fairness”) stated in part: “it is unprofessional and dishonorable to deal other than candidly with the facts in taking the statements of witnesses, in drawing affidavits and other documents, and in the presentation of causes.” canons of prof’l ethics canon 22. in contrast, today’s rule, aba model rule of professional conduct 3.3, is quite specific, stating in part: a lawyer shall not knowingly: (1) make a false statement of fact or law to a tribunal or fail to correct a false statement of material fact or law previously made to the tribunal by the lawyer; . . . or (3) offer evidence that the lawyer knows to be false. if a lawyer, the lawyer’s client, or a witness called by the lawyer, has offered material evidence and the lawyer comes to know of its falsity, the lawyer shall take reasonable remedial measures, including, if necessary, disclosure to the tribunal. model rules of prof’l conduct r. 3.3 (2012). new york adopted its version of the model rules in 2009, http://www.nysba.org/content/navigationmenu/for attorneys/professionalstandardsforattorneys/professional_standardsforattorneys/ professional_standar.htm. thus, if the stipulation had been submitted under the current rules, one could reasonably infer that counsel was not aware that the stipulation was at odds with doris’s prior version of the facts. one cannot reach the same conclusion under the canons. of course, it is possible, in either case, that doris’s prior version was false (i.e., that there was only one block of 2,500 shares) and that the stipulation is accurate. 86. today’s internal revenue manual prohibits irs attorneys from agreeing to stipulations of facts not known to be true, even if they believe that particular facts are irrelevant. i.r.m. 35.4.7.4. facts that are known to be true may be stipulated to at the request of taxpayer’s counsel, however, even if irs attorneys believe that the particular facts are irrelevant. id. 476 florida tax review [vol. 13:9 regarded as directly on point: the determination of the commissioner is approved upon the authority of wemyss v. commissioner, 234 u.s. 303, and merrill v. fahs, 324 u.s. 308.87 wemyss and merrill both were decided less than eleven months before the government filed its brief in farid and a mere thirteen months (to the day) before the tax court rendered its decision.88 wemyss involved a transfer of stock by mr. wemyss to his fiancée, mrs. more, a widow, prior to their marriage. the transfer was prompted by mrs. more’s concern that her interests in two trusts created by her deceased husband would cease upon her remarriage. the shares transferred to her by mr. wemyss would compensate for her loss of income under the trusts. the couple married within a month after the shares were transferred. rejecting the taxpayer’s arguments that mrs. more had given consideration in the form of the marriage and that the transfer compensated her for income she would have lost under the trusts, the supreme court held that the entire value of the shares was a gift subject to federal gift tax.89 the court found that consideration in the common law sense is irrelevant under the gift tax statute, which provided that “[w]here property is transferred for less than an adequate and full consideration in money or money’s worth, then the amount by which the value of the property exceeded the value of the consideration shall, for the purpose of the tax imposed by this title, be deemed a gift.”90 thus, consideration not reducible to a money value, such as love and affection, a promise of marriage, etc., is disregarded for gift tax purposes.91 the court also reasoned that consideration must benefit the transferor (donor) in order to afford relief from the gift tax (i.e., the consideration must be received by the donor, not merely given or given up by the donee).92 merrill, a companion case to wemyss, concerned an antenuptial agreement between a man of substantial means and his fiancée, miss desmare, whose assets were “negligible.”93 pursuant to the agreement, mr. merrill agreed, within ninety days after the marriage to establish an irrevocable trust for his new wife and to provide in his will for two additional trusts for the benefit of his wife and their surviving children. in return, miss desmare released all rights she might acquire as wife or widow in her 87. farid i, 6 t.c. 652, 653 (1946).). the tax court’s opinion was only four paragraphs long. 88. see infra notes 96–97 and accompanying text. 89. commissioner v. wemyss, 324 u.s. 303 (1945). 90. id. at 306–07 (quoting revenue act of 1932, § 503, 47 stat. 169, 247 (1932) (current version at i.r.c. § 2512(b))). 91. id. at 305. 92. id. at 307–08. 93. merrill v. fahs, 324 u.s. 308, 309 (1945). 2013] about farid 477 husband’s property except the right to maintenance and support. the parties married, and the terms of the agreement were carried out. as in wemyss, the court in merrill focused on the question of whether there had been “adequate and full consideration in money or money’s worth.”94 reviewing the legislative history of the phrase in the context of the estate tax, the court concluded that “adequate and full consideration” excludes relinquishment of dower and marital rights for both estate and gift tax purposes.95 wemyss and merrill were decided on march 5, 1945. the government filed its trial brief in farid on february 26, 1946,96 and the tax court issued its decision on april 5, 1946.97 although the tax court briefs are no longer available, a transcript of oral arguments before the tax court reflects that the government’s argument was straightforward: the supreme court’s reasoning in wemyss and merrill should apply to the facts in farid.98 with the exception of one paragraph, the government’s argument in its brief on appeal to the second circuit was the same: . . . that the present case is governed and the issue herein is resolved by the rules laid down by the supreme court in commissioner v. wemyss, 324 u.s. 303, and merrill v. fahs, 324 u.s. 308, upon the authority of which the tax court sustained the commissioner’s determination herein.99 thus, it is likely that the government was willing to accept the taxpayer’s version of the facts — reflecting a quid pro quo exchange of dower and marital rights for company shares because it believed that those facts would support a holding in its favor under the reasoning of wemyss and merrill. it must have been a great surprise to the government that the court of appeals did not regard the income tax as subject to the same standards,100 94. id. at 311–13. 95. id. at 312–13. 96. docket entries, farid i, 6 t.c. 652 (no. 2968). 97. id. 98. transcript of testimony, appendix to brief for petitioner-appellant at 29, farid ii, 160 f.2d 812 (2d. cir. 1947) (no. 154-20400).the government’s brief to the second circuit reflects an expanded argument; it is unclear whether the embellishments were argued to the tax court or not. 99. brief for the respondent at 11, farid ii, 160 f.2d 812 (no. 154-20400); see also id. at 21–22. 100. “in our opinion the income tax provisions are not to be construed as though they were in pari materia with either the estate tax law or the gift tax statutes.” farid ii, 160 f.2d at 814. 478 florida tax review [vol. 13:9 given the supreme court’s emphatic conclusion that the estate tax and gift tax rules are in pari materia and must be construed together.101 a single paragraph in the government’s second circuit brief hints at what might have been a winning argument: that the transfers of shares by s.s. to doris were gifts without consideration because they occurred before the marriage, at a point when doris had no interest in her future husband’s property or estate that she could give up in exchange. however, the government did not pursue this argument. b. why doris might have agreed to the stipulated facts doris’s counsel might have stipulated to a different version of the facts than doris had earlier propounded because he was unfamiliar with doris’s earlier account of the story. the attorney who wrote the tax court brief and who made oral arguments entered his appearance in the litigation more than twenty years after doris signed the antenuptial agreement and almost eighteen years after she was divorced from s.s.102 (the stipulation of facts was filed five months after this attorney’s entry of appearance).103 before the internet age, indeed before the microfilm age, perhaps old stories became lore,104 then myth, and maybe then were forgotten. maybe doris chose not to share the full story with her lawyers, merely sharing with him her copy of the antenuptial agreement and noting that she had received only (one block of) 2,500 shares from s.s. prior to their marriage. perhaps doris’s lawyer stipulated to the facts because they reflected doris’s best chance of winning in the tax court. if she had both acknowledged receiving the 2,500 shares prior to her marriage and alleged that they belonged to her without conditions as of the date of transfer, as she had in her prior litigation with s.s., the tax court might have reasonably concluded that those shares were a gift, without consideration, on the date of transfer, dictating a carryover basis. this point is analyzed in part v.a. of this article. 101. “the guiding light is what was said in estate of sanford v. commissioner, 308 u.s. 39, 44, 60 s.ct. 51, 56, 84 l.ed. 20: ‘the gift tax was supplementary to the estate tax. the two are in pari materia and must be construed together.’” merrill, 324 u.s. at 311–13. 102. docket entries, supra note 96, at 3 (entry of appearance of august merill, sept. 10, 1945). mr. merill replaced another attorney, james maxwell fassett, whom doris had originally retained. id. at 1–2. 103. docket entries, supra note 96, at 3 (stipulation of facts filed dec. 10, 1945). 104. one might speculate that doris was not interested in reliving the past. indeed, as part iii of this article and the epilogue demonstrate, she lived a colorful and somewhat embarrassing life. 2013] about farid 479 v. doris’s basis under the real facts if doris’s earlier version of the facts had been presented to the tax court, her acquisition of shares would have been characterized as a gift, and she would have taken a carryover basis in the shares as a result. a. the transfer of shares was a gift before the marriage when doris sued s.s. seeking additional shares, counsel for both parties agreed that s.s. had transferred 2,500 shares to doris prior to their marriage, at a time when s.s. was married to another woman.105 s.s. first transferred 700 shares and later transferred an additional 1,800.106 the stipulation of facts in farid is consistent on this point, declaring that s.s. transferred 700 shares to doris in december 1923 and the remaining 1,800 on or about january 23, 1924.107 the stipulation expressly states that all 2,500 shares were to be held by doris “for her benefit and protection in the event that said kresge should die prior to the contemplated marriage.”108 when doris received the 2,500 shares in two installments, she became the owner of those shares as a matter of law.109 under common law principles, ownership of property is transferred when there is a gift — “a voluntary, immediate transfer of property without consideration from one person (the donor) to another person (the donee).”110 once an inter vivos gift has been made, it is irrevocable.111 all three requirements for a valid inter 105. justice paves way for kresge reunion, supra note 60, at 5. 106. id. 107. stipulation of facts, supra note 2, ¶ 2. 108. id. 109. the shares were held in street name. see infra text accompanying notes 119–124. in the absence of information on how the account was titled, this article assumes that doris was the sole beneficial owner. this assumption is consistent with both the second circuit opinion and the stipulation of facts, which state that the shares were delivered to doris. (they do not, for example, reflect or imply the creation of a joint account with right of survivorship or an account in s.s.’s name payable to doris upon his death. see restatement (second) of property: donative transfers § 32.4 cmts. d & e, reporter’s notes 3 & 4 (1992)). in the litigation between doris and s.s., s.s.’s attorney asserted in his opening statement that the parties had discussed placing the shares in trust, “but this [idea] was abandoned.” justice paves way for kresge reunion, supra note 60, at 5. 110. john g. sprankling, understanding property law § 5.02 (2d ed. 2007). 111. id. 480 florida tax review [vol. 13:9 vivos gift — intent, delivery, and acceptance112 — were present at the instant the shares were transferred to doris.113 1. intent both versions of the facts support a conclusion that s.s. intended to make an immediate gift when he transferred the shares. there is no evidence to the contrary; there is no reason to suspect, for example, that s.s. intended the gift to take effect only when he and doris became husband and wife. indeed, the stipulation of facts directly contradicts such a notion in stating that doris would have kept the shares had s.s. died prior to the wedding.114 likewise, there was no mention in either litigation of conditions on the gift, such as an obligation to return the shares if the couple did not marry.115 nonetheless, without any factual basis, doris’s brief in the second circuit asserted that possession of the shares had been turned over to her conditionally prior to execution of the antenuptial agreement.116 2. delivery the second circuit opinion in farid explicitly states that s.s. delivered the shares to doris. 112. id. § 5.03[a]. 113. cf. estate of copley v. commissioner, 15 t.c. 17 (1950), aff’d, 194 f.2d 364 (7th cir. 1952). in copley, a couple entered into an antenuptial agreement and married in 1931, prior to enactment of the federal gift statute. the husband agreed to transfer $1,000,000 to his wife immediately after their marriage but made the actual transfers in 1936 and 1944. the court held that for gift tax purposes, the gifts occurred when the agreement became binding in 1931. one commentator has indicated that the principle applied in copley does not apply to transfers that are made prior to the marriage. leon gabinet, tax aspects of marital dissolution § 14.4 (2d ed. 2011). the analysis in this article is consistent with gabinet’s position; an antenuptial agreement is irrelevant with respect to a gift that was completed prior to the marriage. 114. stipulation of facts, supra note 2, ¶ 2. 115. conditional gift issues often arise in the context of engagement rings, where courts are called upon to decide whether a ring must be returned when an engagement is broken. the legal issue is whether the ring was given subject to an implied condition subsequent (i.e., the marriage). see restatement (third) of property: wills & other donative transfers § 6.2 cmt. m (2003); sprankling, understanding property law, supra note 110, § 5.03[b]. as stated above, the stipulation of facts in farid i reflects that there were no conditions on the transfer of shares. (doris received an engagement ring from s.s. reportedly valued at $16,000. justice paves way for kresge reunion, supra note 60, at 5). 116. brief for appellant at 14, farid ii, 160 f.2d 812 (2d. cir. 1947) (no. 154-20400). 2013] about farid 481 in december 1923 when the petitioner, then unmarried, and s. s. kresge, then married, were contemplating their future marriage, he delivered to her 700 shares of the common stock of the s. s. kresge company which then had a fair market value of $290 per share. the shares were all in street form and were to be held by the petitioner “for her benefit and protection in the event that the said kresge should die prior to the contemplated marriage between the petitioner and said kresge.” the latter was divorced from his wife on january 9, 1924, and on or about january 23, 1924 he delivered to the petitioner 1800 additional common shares of s. s. kresge company which were also in street form and were to be held by the petitioner for the same purposes as were the first 700 shares he had delivered to her.117 this wording is consistent with the stipulation of facts.118 the shares were held in “street name,” a practice under which shares are recorded in corporate records as owned by a brokerage firm on behalf of an unnamed customer.119 under this common arrangement, the brokerage, not the beneficial owner, is the holder of record.120 the individual investor retains all rights of ownership (e.g., how the stock is voted and whether to sell).121 thus, the fact that s.s. transferred doris’s stock to an account in street name before the marriage and had the corporation register the stock in her name after the marriage122 has no bearing on the date of delivery or transfer so long as the brokerage account was hers.123 the opinion and 117. farid ii, 160 f.2d at 813 (emphasis added). the opinion goes on to state that doris signed the antenuptial agreement at a time when she “still retained the possession of the stock so delivered to her.” id. 118. farid ii, 160 f.2d at 813. press coverage of doris’s attorney’s opening statement when she sued s.s. reflects the same language. justice paves way for kresge reunion, supra note 60, at 5. 119. see louis loss, joel seligman & troy paredes, fundamentals of securities regulation 799 (6th ed. 2011). 120. robert w. hamilton, money management for lawyers and clients § 14.6 (1999). a beneficial owner who is not a record owner is not recognized by the corporation as a shareholder for dividend, voting or other purposes. the beneficial owner has legally enforceable rights, however, to compel the record owner to vote the shares as she demands and to turn over any dividends received. id. 121. alan r. palmiter, corporations § 19.2 (5th ed. 2006). 122. stipulation of facts, supra note 2, ¶ 4 (s.s. caused the shares to be transferred to doris on the company’s books on or about may 6, 1924). 123. see morrison v. commissioner, 53 t.c. memo (cch) 251, t.c. memo (p-h) ¶ 87,112 (1987) (for purposes of the charitable contribution deduction, 482 florida tax review [vol. 13:9 stipulation of facts support a conclusion that it was. indeed, doris’s attorney in the prior litigation asserted that s.s. had insisted on the delay in recording the premarital transfer on the corporate books because “as a man with a wife and five children, he wanted it kept secret.”124 3. acceptance there is nothing to indicate that doris did not accept the shares. therefore, it is reasonable to conclude that she did.125 in turn, if the preceding analysis is correct, the gift was complete well before doris signed the antenuptial agreement, and she owned those shares at the time she signed the agreement.126 the shares, then, could not have constituted legal consideration for her agreement to cede her marital and property rights because she did not actually receive anything in return for giving up those rights; the shares were already hers. the gift was received prior to the marriage without condition and, therefore, doris should have taken a carryover basis.127 b. gifts to mistresses are excluded from income doris’s lawyers could have argued that she was entitled to a cost (market value) basis in the shares because they were received in exchange a gift of stock held in street name is complete on the date on which the brokerage transfers shares to the donee’s account). 124. justice paves way for kresge reunion, supra note 60, at 5. 125. see restatement (third) of property: wills & other donative transfers § 6.1 cmt. i (2003) (acceptance by donee is presumed, subject to donee’s right to refuse or disclaim). 126. this approach is consistent with the tax court’s analysis of similar facts in marshman v. commissioner, 31 t.c. 269 (1958), rev’d on other grounds, commissioner v. marshman, 279 f.2d 27 (6th cir. 1960). in marshman, the taxpayer had divorced in 1934. in 1937, her ex-husband asked her to remarry him, and, as a condition to remarriage, the taxpayer asked him to provide “some financial security.” marshman, 279 f.2d at 28. her ex-husband then transferred shares of publicly traded stock to the taxpayer, and the next day, the couple remarried. however, the second marriage met the same fate as the first. the taxpayer then sold some of her shares after the divorce, raising the question of her basis in the stock for purposes of calculating the gain realized on the sale. the tax court determined that the shares had been acquired by gift prior to the marriage, resulting in a carryover basis. 127. the facts alleged in doris’s tax court petition implied that she would argue that the shares were bargained for consideration in exchange for her interest in the brokerage account that s.s. had previously established for her. amended petition, supra note 84, ¶ 5(d). this argument, however, was not pursued. 2013] about farid 483 for services.128 such an argument, of course, could have been embarrassing to doris.129 in the absence of authority,130 however, doris’s attorney might well have prevailed had he urged this line of reasoning. subsequent jurisprudence, nonetheless, has not been sympathetic to this argument. although there were no cases on point at the time farid was litigated, courts that have considered the issue since then have invariably held that transfers of cash or property from married men to their mistresses are excludable gifts where there is no evidence that the recipient is or has been engaged in the business of prostitution. basic principles for determining whether a transfer or payment is a gift are set forth in commissioner v. duberstein.131 although the duberstein articulation is considered the governing rule or standard,132 the supreme court explicitly declined to “promulgate a new ‘test’ in this area to serve as a standard to be applied by the lower courts and by the tax court in dealing with the numerous cases that arise.”133 the court preferred instead that fact finders apply their own “experience[s] with the mainsprings of human conduct to the totality of the facts of each case.”134 nonetheless, students of the tax law invariably define a gift by reference to duberstein, as a transfer 128. property that is received as compensation for services takes a basis equal to its fair market value because that is the amount includable in the taxpayer’s income for the year of receipt. boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts ¶ 41.2.5 (2d/3d ed. 1998). if a taxpayer had received compensation in cash in an amount equal to the fair market value of the property actually received, and had used that cash to purchase property at a fair market value price, the cost basis in that property would be its fair market value. a different basis cannot be justified merely because the property is acquired directly. id. 129. doris did not report the receipt of shares in income when she received them. this fact, however, is equally damning under her argument in farid i, which the court of appeals subsequently adopted. in any event, the statute of limitations had run. see i.r.c. § 6501. 130. the first case to address the tax consequences of payments to a mistress who was not a prostitute was decided in 1966, twenty years after the tax court issued its decision in farid i and nineteen years after the second circuit rendered its decision. starks v. commissioner, 25 t.c. memo (cch) 676, t.c. memo (p-h) ¶ 66,134 (1966) (payments were gifts). 131. 363 u.s. 278 (1960). 132. see, e.g., united states v. mckee, 506 f.3d 225, 247 (3d cir. 2007); lane v. united states, 286 f.3d 723, 728-29 (4th cir. 2002); peracchi v. commissioner, 143 f.3d 487, 496 (9th cir. 1998); goodwin v. united states, 67 f.3d 149, 151–52 (8th cir. 1995) (“applying duberstein’s objective, no-talisman approach to evaluating transferor intent”); united states v. harris, 942 f.2d 1125, 128–29, 1131 (7th cir 1991). 133. duberstein, 363 u.s. at 284–85. 134. id. at 289. 484 florida tax review [vol. 13:9 motivated by “‘a detached and disinterested generosity.’”135 the “most critical consideration”136 is the transferor’s intention; “‘[w]hat controls is the intention with which payment, however voluntary, has been made.’”137 thus, a transfer that is made “‘out of affection, respect, admiration, charity, or like impulses’”138 is a gift, while a transfer that proceeds “from ‘the constraining force of any moral or legal duty,’139 or from ‘the incentive of anticipated benefit’ of an economic nature,’”140 or is made “‘in return for services rendered,’”141 is not. applying this test to determine whether doris’s receipt of the shares, at a time when she was s.s.’s paramour, was an excludable gift or taxable income would necessitate determining whether s.s. was motivated by altruism or by an expectation of reciprocity.142 parsing a man’s emotions is not easy and so, not surprisingly, courts have had difficulty characterizing transfers of money to mistresses in the context of long-term relationships. as one judge stated, “the motivations of the parties in such cases will always be mixed. the relationship would not be long term were it not for some respect or affection. yet, it may be equally clear that the relationship would not continue were it not for financial support or payments.”143 deciding whether a transfer is purely out of affection or, alternatively, is motivated by hopes of continuing in an adulterous relationship, presents a thorny challenge of divining complex motivations. 144 in a series of cases (the “mistress cases”), the tax court has been called upon to decide whether funds paid or property transferred by men to women in the context of nonmarital relationships were excludable gifts or 135. id. at 285. (quoting commisioner v. lobue, 351 u.s. 243, 246 (1956)). 136. id. 137. id. (quoting bogardus v. commissioner, 302 u.s. 34, 45 (1937) (brandeis, j., dissenting)). 138. duberstein, 363 u.s. at 285 (quoting robertson v. united states, 343 u.s. 711, 715 (1952)). 139. id. 140. id. (quoting bogardus, 302 u.s. at 41). 141. id. (quoting robertson, 343 u.s. at 714). 142. see united states v. harris, 942 f.2d 1125 (7th cir. 1991) (reversing criminal convictions of two women who received money from a wealthy widower because the government failed to present sufficient evidence of his intent regarding the money he gave them). 143. id. at 1132. 144. invariably, “efforts to determine a single dominant intent underlying long-term, informal relationships contain problems of information, valuation, and consistency that expose courts’ inability to grapple with the intimate details of relationships undefined by law.” debra lefler, “keeping books on romance:” the gift exclusion in nonmarital relationships, 105 nw. u. l. rev. 1739, 1742 (2011). 2013] about farid 485 includable in the recipient’s gross income.145 in each opinion, the court examined the facts presented in light of duberstein in an effort to discern the swain’s intent. although each decision was based on its own particular facts, as envisioned in duberstein, the breakdown appears to be that men who made “gifts” to women in the business (or even previously in the business) of selling companionship were held not to have intended gifts146 while men who made gifts to women who were not in business were held to have made nontaxable gifts.147 thus, because there is no evidence that doris ever placed her sexual services on the market, it is likely that the shares given by s.s. to doris prior to their marriage would have been treated as excludable gifts, conferring upon doris a carryover basis. vi. lessons learned a. tax considerations the black letter law emerging from farid may be unassailable — where property is acquired in exchange for other property, the basis in the newly acquired property is its fair market value on the date received. indeed, this is the holding in the seminal case of philadelphia park amusement co. 145. toms v. commissioner, 63 t.c. memo (cch) 2234, t.c. memo (ria) ¶ 1992–125 (1992); austin v. commissioner, 49 t.c. memo (cch) 520, t.c. memo (p-h) ¶ 85,022 (1985); reis v. commissioner, 33 t.c. memo (cch) 1333, t.c. memo (p-h) ¶ 74,287 (1974); libby v. commissioner, 28 t.c. memo (cch) 915, t.c. memo (p-h) ¶ 69,184 (1969); starks v. commissioner, 25 t.c. memo (cch) 676, t.c. memo (p-h) ¶ 66,134 (1966); brizendine v. commissioner, 16 t.c. memo (cch) 149, t.c. memo (p-h) ¶ 57,032 (1957); blevins v. commissioner, 14 t.c. memo (cch) 840, t.c. memo (p-h) ¶ 55,211 (1955). see lefler, supra note 144, at 1741 (discussing the “mistress cases”). 146. toms, 63 t.c. memo (cch) 2234, t.c. memo (ria) ¶ 1992-125; brizendine, 16 t.c. memo (cch) 149, t.c. memo (p-h) ¶ 57,032; blevins, 14 t.c. memo (cch) 840, t.c. memo (p-h) ¶ 55,211; see also lefler, supra note 144 at 1754–57 (courts have “used prostitution as a proxy for intent”). 147. austin, 49 t.c. memo (cch) 520, t.c. memo (p-h) ¶ 85,022; reis, 33 t.c. memo (cch) 1333, t.c. memo (p-h) ¶ 74,287; libby, 28 t.c. memo (cch) 915, t.c. memo (p-h) ¶ 69,184; starks, 25 t.c. memo (cch) 676, t.c. memo (p-h) ¶ 66,134. similarly, the tax court has held that payments or gifts between unmarried cohabitating couples are gifts. estate of cavett v. commissioner, 79 t.c. memo (cch) 1662, t.c. memo (ria) 2000-091 (2000); pascarelli v. commissioner, 55 t.c. 1082 (1971), aff’d, 485 f.2d 681 (3d cir. 1973). “if these cases make a rule of law, it is that a person is entitled to treat cash and property received from a lover as gifts, as long as the relationship consists of something more than specific payments for specific sessions of sex.” united states v. harris, 942 f.2d 1125, 1133–34 (7th cir. 1991). 486 florida tax review [vol. 13:9 v. united states.148 the difference between the courts’ analyses in the two cases, however, is that the decision in philadelphia park is premised on the property exchange having been taxable. the basis in the newly acquired property must be its fair market value in order to ensure that recognized gain is not recognized again or that recognized loss is not taken into account twice.149 the second circuit opinion in farid, however, nowhere recognizes the relationship between taxability on the initial exchange and basis in the acquired property. thus, doris achieved the best of all proverbial worlds — no taxable gain on the exchange in which she acquired the shares, and a basis step–up.150 surprisingly, there appear to be no cases in which the government has argued that a person in doris’s position realizes gain on the release of marital rights in exchange for property, prior to marriage. the issue has come up, however, in the analogous context of marital breakups, where a divorcing spouse cedes her marital rights in a bargained for exchange for property. in the divorce context, the irs’s administrative position for many years was that (1) there was no gain or loss to a spouse who released marital rights in exchange for property and (2) her basis nonetheless was the fair market value of the property on the date of it was received.151 one would 148. 126 f. supp. 184 (ct. cl. 1954). 149. id. at 188–89 (“to maintain harmony with the fundamental purpose of these sections, it is necessary to consider the fair market value of the property received as the cost basis to the taxpayer. the failure to do so would result in allowing the taxpayer a stepped-up basis, without paying a tax therefor, if the fair market value of the property received is less than the fair market value of the property given, and the taxpayer would be subjected to a double tax if the fair market value of the property received is more than the fair market value of the property given. by holding that the fair market value of the property received in a taxable exchange is the cost basis, the above discrepancy is avoided and the basis of the property received will equal the adjusted basis of the property given plus any gain recognized, or that should have been recognized, or minus any loss recognized, or that should have been recognized.”) 150. following the logic in united states v. davis, 370 u.s. 65 (1962), s.s. should have been taxed on the transfer of shares to doris. boris i. bittker, martin j. mcmahon, jr. & lawrence a. zelenak, federal income taxation of individuals ¶ 30.04[4] (3d ed. 2002); david westfall et al., estate planning law and taxation ¶ 11.07[1] (2003). since 1984, prudent planning would be to transfer shares after the couple is married in order to take advantage of i.r.c. § 1041. 151. rev. rul. 67-221, 1967-2 c.b. 63; davis, 370 u.s. at 73 n.7 (“under the present administrative practice, the release of marital rights in exchange for property or other consideration is not considered a taxable event as to the wife.”). revenue ruling 67-221, which essentially confirms the statement in davis, does not indicate whether there is no gain or loss realized, or recognized. 2013] about farid 487 hope that the irs would have taken the same position with respect to premarital transfers but there is no authority.152 since 1984, attorneys advising clients in doris’s position can rely on section 1041, which provides that gain or loss is not recognized on property transfers between spouses and that property received from a spouse is treated as a gift, even if there is consideration, with the result that the transferee takes a carryover basis.153 although a fair market value basis usually is preferable to a carryover, the certainty of clear statutory authority is comforting nonetheless. because section 1041 applies only to transfers between spouses, however, modern antenuptial agreements typically delay property transfers until after a couple is married.154 b. litigation considerations outside the context of section 1041 and without the certainty of precedential principles, doris achieved a stunning result only because her attorneys framed her story as an exchange of valuable property rights for shares. had the tale been cast instead as perhaps it should have been, with doris receiving gifts of shares from a paramour at a time he was legally estopped from marrying her on account of a prior matrimonial entanglement, both courts likely would have regarded the transfer of shares as a gift notwithstanding the couple’s subsequent marriage. doris’s counsel’s strategy was a long shot, in light of wemyss155 and merill,156 but brilliant in the end. students of farid will never know, however, whether counsel’s actions were intentional or inadvertent. the importance of the stipulation of facts in farid cannot be overstated, certainly from a procedural standpoint (as the tax court did not participate in the fact “finding” process) but, perhaps more importantly, from the perspective of influencing the outcome of the case. doris could have been portrayed in a less sympathetic manner, as an aspiring actress who seduced an older, married gentleman of prominence, and who was able to induce her lover to transfer substantial sums of money and stock to her. such a depiction would have been entirely consistent with the actual facts as they were reported in the newspapers of the day, and would probably have resulted in a less favorable judicial outcome. the stipulation of facts, however, downplays the tawdriness of the couple’s relationship while, at the same time, emphasizes the magnitude of the inheritance rights doris 152. accord bittker, mcmahon & zelenak, supra note 150 at ¶ 5.02[6]. 153. i.r.c. § 1041(a), (b). 154. bittker, mcmahon & zelenak, supra note 150 at ¶ 5.02[6]. 155. commissioner v. wemyss, 324 u.s. 303 (1945). 156. merrill v. fahs, 324 u.s. 308 (1945). 488 florida tax review [vol. 13:9 relinquished in exchange for a mere 2500 shares. portrayed in this light, the story portends a sympathetic ending. trial lawyers know the importance of facts in winning a case. to succeed with a jury, a trial lawyer must weave a story from the evidence in a manner that evokes empathy for her client’s position.157 similarly, the way that facts are presented in an appellate brief’s statement of facts can persuade indirectly, through an organization that emphasizes favorable facts and through choices of wording that affect the reader without stating anything that opposing counsel could reasonably claim is inaccurate.158 whether the facts as stipulated in farid resulted from a strategic decision by doris’s lawyer, or not, they portrayed doris in the most favorable light possible given that (1) she agreed in writing to relinquish her marital property rights in exchange for 2500 shares and (2) she received 2500 shares. viewed in this light, farid provides a perfect example for the legal storytelling movement, which emphasizes the use of story and narrative techniques in law practice and teaching.159 legal storytelling scholarship teaches that “[t]he heart of persuasive legal advocacy is the facts of the client’s story.”160 as described by one commentator: the basic concept of storytelling in legal writing is to turn the client/plaintiff/defendant into the main character of a story with a compelling plotline . . . . the fundamental principle espoused by most of these [legal storytelling] scholars is that there is a power in stories that lawyers should harness in their advocacy. those promoting storytelling in the law contend that well-constructed stories have as much power to persuade as well-developed and well-reasoned legal arguments that rely on logic and precedent.161 while it is impossible to know how the appellate judges who decided for the taxpayer in farid regarded doris, it is likely that their opinion of her was 157. kenneth d. chestek, the plot thickens: the appellate brief as story, 14 legal writing 127, 131 (2008). 158. richard k. neumann, jr., legal reasoning and legal writing § 29.1 (6th ed. 2009). 159. jeanne m. kaiser, when the truth and the story collide: what legal writers can learn from the experience of non-fiction writers about the limits of legal storytelling, 16 legal writing 163, 163–64 (2010). 160. kathryn stanchi, persuasion: an annotated bibliography, 6 j. ass’n legal writing dirs. 75, 77 (2009); cf. robert h. jackson, advocacy before the supreme court: suggestions for effective case presentations, 37 a.b.a. j. 801, 803 (1951) (“it may sound paradoxical, but most contentions of law are won or lost on the facts.”). 161. kaiser, supra note 159 at 165–66. 2013] about farid 489 more favorable than it would have been had they been presented with the real facts. at best, the stipulation of facts might have aroused their sympathy and, at worst, it might have left them agnostic; nothing in the opinion implies a negative impression. c. ethical considerations the importance of facts and how they are presented in litigation might tempt attorneys to ignore facts that are unhelpful or to shade the truth in making their clients’ cases. the aba model rule of professional conduct 3.3 addresses such enticements by mandating candor in all aspects of judicial proceedings.162 the model rules, of course, were adopted many years after farid was litigated, but modern lawyers engaged in the process of stipulating facts must be mindful of them. model rule 3.3 provides in relevant part: (a) a lawyer shall not knowingly: (1) make a false statement of fact or law to a tribunal or fail to correct a false statement of material fact or law previously made to the tribunal by the lawyer; . . . or (3) offer evidence that the lawyer knows to be false. if a lawyer, the lawyer’s client, or a witness called by the lawyer, has offered material evidence and the lawyer comes to know of its falsity, the lawyer shall take reasonable remedial measures, including, if necessary, disclosure to the tribunal. . . . . (c) the duties stated in paragraph[] (a) . . . continue to the conclusion of the proceeding.163 this rule applies only to conduct in proceedings before a “tribunal,” defined to include, inter alia, “a court,”164 and envisioning, generally, a “body act[ing] in an adjudicative capacity when a neutral official, after the presentation of evidence or legal argument by a party or parties, will render a binding legal judgment directly affecting a party’s interests in a particular 162. model rules of prof’l conduct r. 3.3 (2012). see also model rules of prof’l conduct r. 4.1 (2012). aba model rule 4.1 prohibits untruthfulness to others, generally. the major differences between model rule 3.3 and model rule 4.1 are that model rule 3.3 (1) applies to all statements regardless of materiality and (2) can require a lawyer to disclose information otherwise protected by model rule 1.6 (confidentiality of information). 163. model rules of prof’l conduct r. 3.3. 164. model rules of prof’l conduct r. 1(m). 490 florida tax review [vol. 13:9 matter.”165 certainly the tax court is a tribunal for purposes of this rule.166 the internal revenue service, however, is not.167 thus, while other principles of ethics require honesty in dealings with the irs,168 model rule 3.3 does not. the distinction is meaningless in the context of tax court litigation, however, because a stipulation of facts agreed to by taxpayer’s counsel and the irs will be submitted to the court, thereby implicating model rule 3.3.169 the proscriptions against making false statements and offering false evidence apply only to statements and evidence that a lawyer knows are false. therefore, if a lawyer reasonably believes that a client’s story is truthful, she does not violate model rule 3.3 in recounting that story to the court.170 (this, of course, raises questions regarding a lawyer’s duty to inquire and, perhaps, conscious ignorance.171) it follows that model rule 3.3 precludes counsel from agreeing to stipulate to facts, which they know are untrue. in hindsight, it is obvious that doris’s counsel gained a great advantage from the manner in which the stipulation of facts was drafted, 165. id. 166. indeed, practitioners appearing before the tax court are required to comply with the aba model rules. tax ct. r. 201(a) (2010). 167. aba comm. on ethics & prof’l responsibility, formal op. 314 (1965). the opinion reasons as follows: [the irs] has no machinery or procedure for adversary proceedings before impartial judges or arbiters, involving the weighing of conflicting testimony of witnesses examined and cross-examined by opposing counsel and the consideration of arguments of counsel for both sides of a dispute. while its procedures provide for ‘fresh looks’ through departmental reviews and informal and formal conferences procedures, few will contend that the service provides any truly dispassionate and unbiased consideration to the taxpayer. although willing to listen to taxpayers and their representatives and obviously intending to be fair, the service is not designed and does not purport to be unprejudiced and unbiased in the judicial sense. 168. e.g., model rules of prof’l conduct r. 4.1. 169. cf. model rules of prof’l conduct r. 3.3 cmt. 1 (rule applies when the lawyer is representing a client in an ancillary proceeding conducted pursuant to the tribunal’s adjudicative authority, for example a deposition). 170. cf. model rules of prof’l conduct r. 3.3 cmt. 3 (“an advocate is responsible for pleadings and other documents prepared for litigation, but is usually not required to have personal knowledge of matters asserted therein, for litigation documents ordinarily present assertions by the client, or by someone on the client’s behalf, and not assertions by the lawyer.”). 171. see restatement (third) of the law governing lawyers § 120 cmt. c (2000). 2013] about farid 491 both because the story it told did not reflect the true facts in material respects and because it painted a picture of doris that was most sympathetic. this article has suggested that doris’s counsel might have been unaware of the factual discrepancies but also proposed that he might have agreed to the stipulation purely for strategic reasons. counsel for the government might have agreed to the stipulations for the same reasons. indeed, the very nature of the tax court’s stipulation procedure, mandatory as it is and without scrupulous involvement or oversight by the court, invites strategic but dishonest participation. it is clear, however, that even if both sides are happy with the wording in any or all respects, counsel violate their duty of candor under model rule 3.3 by submitting a stipulation of facts, which they know is false. thus, strategic stipulations must be avoided. perhaps this is why the internal revenue manual prohibits irs attorneys from agreeing to stipulations of fact that are not known to be true, even if they believe that the particular facts are irrelevant.172 vii. conclusion at the outset, the purpose of the research project culminating in this article was merely to uncover the secrets of princess doris farid-essultaneh. in the process, however, it became apparent that something was amiss. the story of doris’s courtship and marriage, in particular how she came to acquire shares that she later sold, was inaccurately reflected in the evidence on which her tax case was litigated and decided and, therefore, also in the appellate court opinion that has been parsed and memorized by generations of tax students. whether the differences between the story told here and that recounted in the stipulation of facts in the case were intentionally devised, or not, probably will never be known. these differences significantly affected the outcome of the case, and raise thoughtprovoking and important questions about the role of fact development and fact finding in the judicial process. lawyers and students alike should be schooled in the role and art of storytelling, but also cautioned against lying in the process. doris’s tale provides a rich illustration of the power of a story well told.173 had the courts known the facts as they really happened, a victory for the government would have been the likely result. 172. i.r.m. 35.4.7.4. 173. “the mastery of effective story telling is not what you say but how you say it. how you tell a story effects [sic] how the universe preserves it.” kerry parker films, http://kerryparkerfilms.com/ (last visited oct. 21, 2012). 492 florida tax review [vol. 13:9 epilogue: what happened to doris and s.s.? for those of us who have studied farid, the desire to know what happened to doris, and perhaps to s.s., is palpable.174 here follows a brief chronicle of the remaining years of the couple’s brief marriage and their divorce, and selected stories from their fascinating lives. a. the remainder of the marriage despite reports that the couple had reconciled after settling doris’s suit seeking an additional 2,500 shares, the marriage remained tumultuous. less than three months after the legal proceedings had ended, doris sailed to europe alone.175 six weeks later, with doris abroad, s.s. sued for divorce, claiming that the couple had separated and never reconciled.176 doris returned from europe, vowing to fight s.s.’s “unwarranted action.”177 s.s. initiated the divorce action in detroit.178 the likely explanation for his decision to file in michigan rather than in new york, where the couple lived and had married, is that grounds for divorce in michigan were broader than in new york, which permitted divorce solely on the ground of adultery.179 the suit charged doris with abandonment.180 it is also possible that s.s. believed that a court in detroit would be more sympathetic to him than a court in new york. the company was headquartered in detroit and 174. e.g., reuven s. avi-yonah, tax stories and tax histories: is there a role for history in shaping tax law?, 101 mich. l. rev. 2227, 2230 (2003) (asserting that “the story of walter [sic] kresge’s prenuptial agreement with farides-sultaneh would make for more interesting reading than the humdrum divorce in [united states v.] davis, [370 u.s. 65 (1962)],” which was discussed in a book reviewed in the cited article; davis is discussed supra at notes 150–151 and accompanying text). betraying a lack of information on “the real story,” prof. aviyonah describes doris as persian belly dancer. id. at 2230 n. 22. doris, of course, was born and raised in pittsburgh. see supra notes 29–32 and accompanying text. 175. kresge’s wife sails; divorce talk denied, n.y. times, june 1, 1926, at 17. 176. kresge asks divorce from second wife, chi. trib., july 16, 1926, at 1. 177. mrs. kresge returns to fight divorce suit, n.y. times, aug. 21, 1926, at 5 (quoting doris). 178. id. 179. j. herbie difonzo & ruth c. stern, addicted to fault: why divorce reform has lagged in new york, 27 pace l. rev. 559, 559 (2007). new york became the last state to adopt no fault divorce in 2010. n.y. dom. rel. law § 170(7) (mckinney 2010); timothy tippins, new york matrimonial law and practice § 14:1.10 (2011). 180. can’t halt kresge suit, n.y. times, oct. 12, 1926, at 46. 2013] about farid 493 s.s. presumably had professional and personal relationships there. new york, on the other hand, was home only to his extramarital dalliances. rather than responding in detroit, doris persuaded a new york court to enjoin s.s. from prosecuting the michigan action because he was a resident of new york. in the new york court’s view, the court in detroit lacked jurisdiction over the matter.181 the judge presiding in michigan, however, did not consider himself bound by the new york injunction and permitted the action to continue, but noted that s.s. himself was subject to the injunction and, therefore, could be held in contempt by the new york court should he proceed.182 s.s. withdrew his action and doris withdrew hers.183 six months later, in may 1927, s.s. tried again. this time, he specifically claimed to have established residence in michigan.184 doris did not respond initially,185 choosing instead to commence divorce proceedings in new york.186 although doris did not seek alimony, she asked the court to compel s.s. to pay her attorneys’ fees, arguing that her assets and income should not be impaired by the proceeding, in light of s.s.’s philandering.187 evidence was introduced concerning a “raid,” in april 1927, of a manhattan apartment maintained by s.s. under the name mr. jones.188 doris had retained the services of a detective agency,189 which had followed s.s. and a 181. kresge enjoined in divorce action, n.y. times, oct. 10, 1926, at 18. 182. can’t halt kresge suit, supra note 180, at 46. 183. kresge drops divorce, n.y. times, nov. 5, 1926, at 3; kresges drop legal battles; no explanation, chi. trib., nov. 5, 1926, at 14. the attorney who represented doris in defending against the michigan divorce, as well as in the earlier litigation over the entitlement to shares, ultimately sued her to collect his fees. asks $51,000 as fee from mrs. kresge, n.y. times, sept. 15, 1927, at 33. 184. kresge sues wife again for divorce, n.y. times, may 8, 1927, at 27. 185. kresge’s wife fails to reply to divorce suit, chi. trib., aug. 7, 1927, at 20. 186. mrs. kresge asks divorce, n.y. times, oct. 25, 1927, at 27. 187. wife’s attorney charges kresge is philanderer, chi. trib., dec. 17, 1927, at 3. 188. asserts s.s. kresge was caught in a raid, n.y. times, dec. 17, 1927, at 10. 189. doris apparently neglected to pay her private detective’s bill. valerian o’farrell, head of the detective agency, travelled to france, where doris sought refuge after the divorce, to collect the $32,066 balance due on his $46,016 fee; he was unsuccessful. kresge’s ex-wife sued by detective, n.y. times, jan. 25, 1929, at 3; ex-mrs. kresge divorce snooper asks $32,000 fee, chi. trib., mar. 23, 1929, at 4. he then filed suit against doris in new york. kresge’s ex-wife sued by detective, supra, at 3. 494 florida tax review [vol. 13:9 young woman, gladys ardelle fish, to the apartment,190 where ms. fish was found under the bed,191 “scantily clad.”192 s.s.’s attorney argued that “he couldn’t see how the state of dress or undress of a co-respondent in a divorce action can influence the granting of counsel fees.”193 a housekeeper testified that ms. fish “was a frequent visitor, came at all hours and had her own key . . . . the housekeeper said she must have remained all night occasionally because she saw the young woman there in the morning. she said that a much younger woman than miss fish was also a visitor.”194 the divorce complaint alleged misconduct with various women, including a sixteen-yearold girl.195 the court declined to order s.s. to pay doris’s counsel fees.196 s.s. did not contest the divorce or personally appear in court.197 nonetheless, a jury trial lasting one hour was held. after fifteen minutes of 190. wife’s attorney charges kresge is philanderer, supra note 187, at 3. ms. fish was reported to be twenty-five years of age. (s.s. was sixty-one.) mrs. kresge is denied counsel fees in divorce, chi. trib., dec. 23, 1927, at 13. 191. wife’s attorney charges kresge is philanderer, supra note 187, at 3. the detectives also testified that liquor was found in the apartment, “only a few feet from where the woman’s legs were sticking out from under the bed.” swear kresge had liquor in his love nest, chi. trib., dec. 18, 1927, at 1. s.s. was known as a supporter and benefactor of the anti-saloon league, an organization that advocated prohibition. id. after the trial, leaders of the anti-saloon league debated whether to return a $500,000 gift it had received from s.s. but decided to keep it. will keep kresge’s gift, n.y. times, feb. 8, 1928, at 12; refuse kresge’s $500,000 gift, appeal to drys, chi. trib., feb. 8, 1928, at 16; bishop declares s.s. kresge gift “pure business,” chi. trib., feb. 9, 1928, at 3. rev. james thomas, an episcopal minister, defended the decision on religious grounds: “in this case i should say, the thought to be applied is, that the lord gave it, though the devil brought it, so the league should keep it.” kresge’s gifts, time, feb. 20, 1928, at 37. 192. swear kresge had liquor in his love nest, supra note 191, at 1. 193. wife’s attorney charges kresge is philanderer, supra note 187, at 3. 194. asserts s.s. kresge was caught in a raid, supra note 188, at 10. the housekeeper also testified that she had seen ms. fish in bed one sunday morning, with s.s. being present in the room. ms. fish was introduced as s.s.’s secretary. kresge held guilty by divorce jury, n.y. times, feb. 7, 1928, at 23. 195. wife’s attorney charges kresge is philanderer, supra note 187, at 3; kresge held guilty by divorce jury, supra note 194, at 23; bishop declares s.s. kresge gift “pure business,” supra note 191, at 3 (seventeen-year-old girl). ms. fish’s parents asserted that their daughter and s.s. were “mere friends,” having met at church in new york. their pastor described her as “one of the finest girls and best workers in the church — a sweet, innocent girl.” n.y. times, dec. 18, 1927, at 30. the chicago daily tribune described ms. fish as “the merchant millionaire’s light o’ love.” mrs. kresge is denied counsel fees in divorce, chi. trib., dec. 23, 1927, at 13. 196. mrs. kresge is denied counsel fees in divorce, supra note 195, at 13. 197. jury trial granted to mrs. kresge, n.y. times, jan. 10, 1928, at 55; kresge held guilty by divorce jury, supra note 194, at 23. 2013] about farid 495 deliberation, the jury returned a verdict of misconduct (with ms. fish)198 and the court signed an interlocutory divorce decree, effective in 90 days.199 no alimony was sought because there was an antenuptial agreement, and none was granted.200 doris issued the following statement: the limitless power of money buys the means to influence public opinion. therefore, it is best to bear injustice in silence until one can present truth proved by hard facts. two people could separate with dignity and not desire to harm each other, so i was content to keep my status and to lead a quiet life without interfering with my husband’s affairs or asking any favors whatsoever. my present action was forced upon me in selfdefense. for two years i have been persecuted and tortured by two unprincipled litigations brought in the state of michigan by my husband in his endeavor to gain his freedom by most unscrupulous means. in order to protect my good name i had to spend all my income fighting these groundless litigations, but although i won in both instances it was certain that this persecution would continue, consuming my means and breaking my health. the only salvation for me was to obtain my freedom by proving the faithlessness and hypocrisy of mr. kresge. this was a painful ordeal, but truth was on my side and that is why i won. i can no longer now be prey to double-dealing and treachery. i always had a firm belief in the justice and protection of a higher power. in my case these have prevailed.201 198. kresge held guilty by divorce jury, supra note 194, at 23. the chicago tribune reported that the jury “convicted kresge of seven charges of infidelity.” refuse kresge’s $500,000 gift, appeal to drys, chi. trib., feb. 8, 1928, at 16; see also interlocutory decree is asked by mrs. kresge, chi. trib., feb. 16, 1928, at 4 (“guilty of infidelity on seven separate occasions”). 199. divorce granted mrs. kresge on infidelity plea, chi. trib., feb. 19, 1928, at 7. 200. kresge held guilty by divorce jury, supra note 194, at 23. later press reports referred to a divorce settlement of $10,000,000, s.s. kresge marries for the third time, n.y. times, nov. 28, 1928, at 16; $2,000,000, $100,000 jewel loss on plane; princess victim, chi. trib., mar. 29, 1943, at 15; and $3,000,000, princess charges $99,500 swindle, n.y times, may 1, 1947, at 26. 201. kresge held guilty by divorce jury, supra note 194, at 23. 496 florida tax review [vol. 13:9 even though doris got a divorce order in new york, the michigan divorce action filed by s.s. continued. doris moved to examine her husband before the michigan trial about her allegations that his legal residence was in new york.202 the judge “refused to order the testimony taken, on the ground that the decree in the new york divorce case” made the michigan action unnecessary.203 nonetheless, the papers filed by the parties in connection with doris’s motion, which included s.s.’s initial pleadings, became available to curious reporters, who reported on the tawdry allegations.204 s.s. alleged acts of cruelty, primarily that doris had attempted to extort $10,000,000 from him in exchange for bearing his child.205 if he refused, s.s. claimed, doris had threatened “one of the biggest scandals you ever heard of.”206 doris reportedly responded to s.s.’s refusal to accept her offer by having “an operation” at a cost of $1,000.207 a statement later released by s.s. clarified that doris was pregnant when she made the demand and that she terminated the pregnancy when s.s. refused to pay the demanded sum.208 “this was against my wishes,” he said, “as it was my desire that there should be children born as a result of the marriage.”209 the complaint also alleged that doris had an “intimate and close relationship” with two men, both referred to as “mr. w.,”210 whom s.s. and several friends found inside doris’s locked new york apartment.211 doris denied all of the allegations in a statement that she distributed to reporters.212 first, doris “emphatically” denied that s.s. had accused her of infidelity; his charges, she said, were limited to “conduct unbecoming a wife, whatever he meant by that.”213 as to her supposed demand for $10,000,000 to bear his child, doris stated, “mr. kresge never wanted any more children, as he already has five by his former wife, and the disgrace he 202. mrs. kresge fights husband’s suit, n.y. times, apr. 18, 1928, at 27. 203. id. 204. id. 205. id.; wife wanted $10,000,000 to bear him child, says kresge, chi. trib., apr. 18, 1928, at 3. 206. wife wanted $10,000,000 to bear him child, says kresge, supra note 205, at 3; mrs. kresge fights husband’s suit, supra note 202, at 27. 207. wife wanted $10,000,000 to bear him child, supra note 205, at 3. 208. glad to be rid of wife, kresge says, chi. trib., may 22, 1928, at 1. 209. wife wanted $10,000,000 to bear him child, says kresge, supra note 205, at 3. 210. id.; mrs. kresge fights husband’s suit, supra note 202, at 27. 211. wife wanted $10,000,000 to bear him child, supra note 205, at 3. 212. wife of kresge denies she was untrue to him, chi. trib., apr. 19, 1928, at 10; mrs. kresge denies husband’s charges, n.y. times, apr. 19, 1928, at 27. 213. wife of kresge denies she was untrue to him, supra note 212, at 10; mrs. kresge denies husband’s charges, supra note 212, at 27. 2013] about farid 497 has covered himself with proves that he shows no love, consideration or regard for them.”214 regarding the allegations concerning the other gentlemen, she explained that they were father and son. the older “mr. w.” was a mutual friend of the couple’s, who had endeavored to effect a reconciliation between them.215 at the time the older mr. w. was discovered in doris’s apartment, he was there upon s.s.’s request that he speak to doris alone to try to convince her to change her mind about the divorce.216 the friends referred to in s.s.’s pleadings were actually private detectives hired by s.s. to follow doris and mr. w.217 doris claimed one of them had provided her with a sworn statement that mr. w. was seated in a single chair, smoking, when they entered the apartment.218 the statement went on to say that “[t]here was no sign of anything irregular in the behavior, dress or condition of either ‘mr. w.’ or mrs. kresge” and that “[w]e found nothing wrong there.”219 according to doris, the younger mr. w. had merely escorted doris home from time to time after visits with the older mr. w. and his wife and children at their residence.220 on may 18, 1928, the statutory period for the new york court’s interlocutory decree expired without objection, and the kresges’ divorce became final.221 s.s. withdrew the michigan action.222 he issued a statement declaring that he was “glad to be rid of” doris and denied all of the charges she had made during the divorce proceedings concerning other women.223 doris sailed to europe on may 30.224 214. wife of kresge denies she was untrue to him, supra note 212, at 10; mrs. kresge denies husband’s charges, supra note 212, at 27. 215. wife of kresge denies she was untrue to him, supra note 212, at 10; mrs. kresge denies husband’s charges, supra note 212, at 27. 216. wife of kresge denies she was untrue to him, supra note 212, at 10; mrs. kresge denies husband’s charges, supra note 212, at 27. 217. wife of kresge denies she was untrue to him, supra note 212, at 10; mrs. kresge denies husband’s charges, supra note 212, at 27. 218. wife of kresge denies she was untrue to him, supra note 212, at 10; mrs. kresge denies husband’s charges, supra note 212, at 27. 219. wife of kresge denies she was untrue to him, supra note 212, at 10; mrs. kresge denies husband’s charges, supra note 212, at 27. 220. wife of kresge denies she was untrue to him, supra note 212, at 10; mrs. kresge denies husband’s charges, supra note 212, at 27. 221. kresge divorce now final, n.y. times, may 19, 1928, at 30. 222. kresge hails divorce, n.y. times, may 22, 1928, at 7. 223. glad to be rid of wife, kresge says, supra note 208, at 3. 224. thaw sails for a rest, n.y. times, may 31, 1928, at 19. among the passengers travelling on the same voyage was harry k. thaw. id. years earlier, thaw had murdered architect stanford white in madison square garden. see douglas o. linder, harry thaw trials (stanford white murder), famous trials (2009), http://law2.umkc.edu/faculty/projects/ftrials/thaw/thawaccount.html (last visited oct. 21, 2012). the story of that jealous rivalry is the basis of the novel, 498 florida tax review [vol. 13:9 b. doris 1. doris becomes a princess in 1933, doris married a persian prince whom she had met in paris.225 press reports refer to the groom as farid khan sadri226 and as prince farid of sadri-azam.227 his cousin was the deposed former shah of persia (now iran).228 during his cousin’s reign, the prince held the title “farid-essultaneh.”229 the couple divorced in 1936.230 by paid advertisement following the divorce, the prince asserted that doris had no legal right to use his name.231 nevertheless, doris referred to herself as princess doris farides-sultaneh for the rest of her life232 (which explains the title of her tax case). 2. doris loses her wealth doris’s fortunes turned. in 1947, needing money to pay taxes on her new jersey estate,233 doris consigned the 28-karat engagement ring that she ragtime, by e. l. doctorow. thomas l. chadbourne, an attorney who founded the law firm now known as chadbourne & parke, was a fellow passenger, as well. thaw sails for a rest, supra, at 19. see generally thomas l. chadbourne, the autobiography of thomas l. chadbourne (charles c. goetsch & margaret l shivers, eds. 1985). 225. report mrs. kresge wed, n.y. times, feb. 4, 1933, at 10. time magazine described the prince as the “onetime chamberlain to persia’s late ahmed shah kadjar,” milestones, time, feb. 13, 1933. ahmed shah kadjar was the shah of persia from 1909 until 1925. michael p. zirinsky, imperial power and dictatorship: britain and the rise of reza shah, 1921-1926, 24 int’l j. middle e. studies 639 (1992). ahmed was the last shah of the qajar dynasty; he was exiled to europe in 1923 and deposed in 1925. mansoureh ettehadieh, qajar, ahmad, shah of iran, encyclopedia of the modern middle east (2004). 226. report mrs. kresge wed, supra note 225, at 10. 227. divorce parts prince and ex-mrs. kresge, n.y. times, july 1, 1936, at 8. 228. the princess, the glen alpin conservancy, http://glenalpin.org/ the-princess-period.html (last visited oct. 21, 2012). 229. divorce parts prince and ex-mrs. kresge, supra note 227 at 8. 230. id.; milestones, supra note 225. 231. divorce parts prince and ex-mrs. kresge, supra note 227 at 8; prince to write book on his divorce from mrs. s.s. kresge, chi. trib., july 1, 1936, at 3. 232. see, e.g., the princess, supra note 228 (“the telephone company listed her as the princess, so that was how everyone in harding knew her); princess farides-sultaneh, 74, ex-wife of s.s. kresge, dead, n.y. times, aug. 13, 1963, at 31. 233. doris purchased the sixteen-room, 18-acre morristown estate in 1940. the princess, supra note 228; princess to auction $75,000 furnishings, n.y. times, sept. 8, 1949, at 36. known as glen alpin, the estate was sold at a sheriff’s sale in 2013] about farid 499 received from s.s. to a fifth avenue (new york city) jeweler.234 constantino vincent riccardi, who turned out to be a convicted stock swindler (among other things),235 convinced doris that he could get a higher price for the ring. he also persuaded her to add six other jewelry pieces and proposed marriage, inducing her to ship furnishings from her new jersey home to his home in arizona.236 six truckloads of furniture, rugs, paintings, and other household goods travelled westward before doris realized that she had been taken. doris reported the thefts, which included $99,500 worth of jewels, to law enforcement.237 riccardi was convicted and sentenced to ten years in prison.238 in 1949, doris announced an auction of the furniture and furnishings of her estate.239 doris hoped for proceeds of $75,000, but the auction brought in only $39,000.240 the house and grounds were also put up for sale.241 3. her death doris died of leukemia on august 13, 1963. she was seventy-four years old and had no known survivors.242 1954 and is now owned by a charitable organization dedicated to its preservation. the princess, supra note 228. 234. princess charges $99,500 swindle, supra note 200, at 26. according to the new york times, doris first met mr. riccardi when he visited her estate as a prospective buyer in 1945. id. this was the same year in which the tax court rendered its decision in farid, raising the possibility that doris’s finances were not what they were during her marriage to s.s. 235. riccardi had been arrested at least ten times prior to meeting doris. id.; new york locates ‘master swindler,’ n.y. times, may 29, 1948, at 28 (“arrested a dozen times”). he had been convicted of a stock swindle in new york in 1937 and had served three years in state prison before winning a retrial, which prosecutors never initiated. he was enjoined from dealing in securities in new york. he had been disbarred in california for embezzlement. princess charges $99,500 swindle, supra note 200, at 26. 236. princess charges $99,500 swindle, supra note 200, at 26. 237. id. 238. riccardi gets 10 years, n.y. times, june 22, 1948, at 6. 239. princess to auction $75,000 furnishings, supra note 233, at 36. 240. princess’ auction brings in $39,000, n.y. times, sept. 14, 1949, at 33. 241. id. doris’s obituary in the new york times stated that she had been sued in 1959 for $13,000 in bad debts and had paid with receipts from sales of art and furniture. princess farid-es-sultaneh, supra note 232 at 31. 242. princess farid-es-sultaneh, supra note 232, at 31. 500 florida tax review [vol. 13:9 c. s.s. 1. s.s. marries again only months after divorcing doris, s.s. married again. on october 28, 1928, mrs. clara k. swaine, a divorcee, became the third mrs. kresge in a private ceremony.243 clara’s age was given as thirty-four; s.s. was fiftyone at the time.244 the wedding took place at the home of clara’s mother in kunkletown, pennsylvania, twenty-five miles from s.s.’s childhood home.245 clara, however, had spent most of her life, and resided at the time, in new york city.246 like doris, clara “was musically inclined.”247 “friends of the couple were not surprised at their marriage because they have been seen together a great deal during the past year.”248 shortly after the wedding, the methodist episcopal conference disciplined the pastor who performed the wedding ceremony.249 the church, it seems, permitted marriage following divorce only if the ground was unfaithfulness,250 which was not the case in either of s.s.’s divorces. the minister was excused by the conference after apologizing for having failed to investigate the circumstances of s.s.’s divorces.251 s.s. led a quieter life with clara than he had with doris. they resided in mountainhome, pennsylvania, near s.s.’s childhood home, and later wintered in miami.252 although s.s. remained active in the affairs of the company and in other businesses, he rarely was in the public limelight.253 2. s.s. focuses on his work s.s. stepped down as company president in 1925,254 during his marriage to doris, but continued to serve as chairman until he was ninety 243. s.s. kresge marries for the third time, supra note 200, at 16. 244. id. 245. id. 246. id. 247. id. 248. s.s. kresge marries for the third time, supra note 200, at 16. 249. rebuked in kresge case, n.y times, mar. 14, 1929, at 18; pastor regrets helping kresge wed; absolved, chi. trib., mar. 14, 1929, at 3. 250. pastor regrets helping kresge, supra note 249, at 3; will inquire on kresge, n.y. times, nov. 29, 1928, at 30. 251. id.; rebuked in kresge case, supra at 249, at 18. 252. s.s. kresge dead; merchant was 99, supra note 12, at 38. 253. id. 254. during the 1920’s, s.s. purchased an interest in stern brothers, a new york department store, and the fair, a store in chicago. he later sold both. id. 2013] about farid 501 eight. he also continued, until that time, to serve as trustee of the kresge foundation, a philanthropic foundation he established in 1924 (coincidentally, perhaps, the same year in which he divorced his first wife and married doris) and to which he donated over $65 million.255 at the time s.s. stepped down from both positions, in june of 1966, he was the oldest chairman and the one with the longest tenure (fifty-three years) of any new york stock exchange listed company. during his stewardship, the company launched kmart discount stores. it operated 136 kmarts at the time s.s. resigned, as well as 673 kresge 5-and-10-cent stores and 110 jupiter stores. in 1965, the company’s annual sales exceeded $851 million and its employment force exceeded 42,000 people. the kresge foundation gave over $70 million in grants during the same years.256 3. his death s.s. was hospitalized in july 1966, shortly after stepping down from his positions with the company and the foundation. he died three months later at the age of ninety-nine. his third wife, clara, was at his bedside. in addition to his wife, s.s. was survived by his five children from his first marriage.257 in an ironic twist, s.s. outlived both doris and his life expectancy, as quantified by the second circuit in farid. to show that the marital property rights exchanged by doris had substantial value, the opinion noted s.s.’s net worth and the value of his real estate holdings at the time of the marriage, and to demonstrate the likelihood that doris would predecease s.s., entitling her to a share of that wealth if not for her exchange of marital property rights for shares in the company, the court specifically noted that doris was thirtytwo years old when she married s.s., with a life expectancy of thirty-three and three-fourths years (i.e., sixty-five and three-fourths)258 and s.s. was fifty-seven years old at the time, with a life expectancy of sixteen and onehalf (i.e., seventy-three and one-half).259 in fact, doris died at the age of seventy-five, predeceasing s.s. 4. the kresge legacy 255. s.s. kresge dead; merchant was 99, supra note 12, at 38. 256. id. 257. id. 258. farid ii, 160 f.2d 812, 814 (2nd cir. 1947). 259. id. at 813. 502 florida tax review [vol. 13:9 over the strenuous objections of s.s.’s son, stanley, the company changed its name to kmart corporation in 1977.260 in 1987, kmart corporation sold its remaining kresge and jupiter stores in the united states to mccrory stores, which discontinued the brand.261 (ironically, john mccrory had been s.s.’s partner when he opened his first stores).262 kmart corporation filed for chapter 11 bankruptcy on january 22, 2002,263 emerging on may 6, 2003 as kmart holding corporation.264 in 2005, kmart holding purchased sears, roebuck and company and changed its name to sears holdings corporation.265 as a result, s.s.’s surname no longer is reflected in either the corporate or store names. the kresge name continues to flourish in the philanthropic world. s.s. funded the kresge foundation with an initial contribution, in 1924, of $1.6 million and added an additional $60.5 during his lifetime.266 today, the foundation holds assets of $3.1 billion and makes gifts far exceeding $100 million annually in each of seven areas: arts and culture, community development, detroit, education, environment, health, and human services.267 five of s.s.’s descendants serve or have served on the foundation’s board of trustees, carrying on s.s. kresge’s mandate to “promote human progress.”268 260. stanley sebastian kresge, 85, retailer and philanthropist, supra note 49, at d19. 261. company briefs, n.y. times, jun. 2, 1987, at 22; barmash, a kresgemccrory reunion, supra note 42, at 33. 262. see supra note 42 and accompanying text. 263. danny hakim & leslie kaufman, kmart files bankruptcy, largest ever for a retailer, n.y. times, jan. 23, 2002, at c1. 264. constance l. hays, a new start, a new name. but have things really changed as kmart comes out of bankruptcy?, n.y. times, may 7, 2003, at c9. 265. kmart completes acquisition of sears, n.y. times, mar. 25, 2005, at c3. 266. about us, the kresge foundation, http://www.kresge.org/about-us (last visited oct. 21, 2012). 267. id.; see also melia tourangeau, kresge foundation, learning to give, http://www.learningtogive.org/papers/paper209.html (last visited oct. 21, 2012) (“the kresge foundation has made incredible contributions to the fields of medical research, higher education, health and human services, and the arts by providing bricks and mortar support for non-profit organizations in need of new facilities and equipment. if one were to go to virtually any large university, arts organization, hospital or research institute around the country, chances are the kresge name would be somewhere.”). 268. about us, supra note 266. 2013] about farid 503 i. introduction ii. the facts according to the courts iii. the true story a. before they met: doris b. before they met: s.s. c. the first divorce d. the second marriage and doris’s acquisition of shares iv. why were the facts not the facts? a. why the government might have agreed to the stipulated facts b. why doris might have agreed to the stipulated facts v. doris’s basis under the real facts a. the transfer of shares was a gift before the marriage 1. intent 2. delivery 3. acceptance b. gifts to mistresses are excluded from income vi. lessons learned a. tax considerations b. litigation considerations c. ethical considerations vii. conclusion epilogue: what happened to doris and s.s.? a. the remainder of the marriage b. doris c. s.s. florida tax review florida tax review volume 11 2011 number 8 643 the global shadow bank — systemic risk and tax policy objectives: the uncertain case of foreign hedge fund lending to u.s. borrowers and transacting in u.s. debt securities by julie a.d. manasfi* i. introduction .................................................................................... 644 ii. the tax laws in this area lag behind financial innovation—a look at the taxation of foreign hedge fund lending to u.s. borrowers and transacting in u.s. debt securities ................................................................................ 648 a. hedge funds generally ................................................................ 648 b. introduction to hedge fund structures ........................................ 649 c. foreign hedge fund lending to u.s. borrowers and transacting in u.s. debt securities .................................................................. 651 d. u.s. taxation of foreign lending to u.s. borrowers and transacting in u.s. debt securities ............................................. 654 e. some examples of how the current law is ill-equipped to deal with these shadow banking transactions ................................... 661 iii. we should consider whether the current uncertainty increases systemic risk ............................................................... 663 * assistant professor whittier law school, 2010–present; visiting assistant professor in taxation, loyola law school, los angeles 2008–2010; associate, sidley austin llp, 2004–2008; associate, white & case llp, 2004; ll.m. in taxation, new york university school of law, 2004; j.d., new york university school of law, 2003; b.a., university of california los angeles, 2000. i would like to thank the following people for their helpful contributions and comments: theodore seto, katherine pratt, jennifer kowal, ellen april, joseph sliskovish, the whittier law school faculty, the loyola law school tax policy colloquium class fall 2008, michael guttentag, eric zolt, kirk stark, martin j. mcmahon, and the participants of the southern california junior faculty conference of 2009. 644 florida tax review [vol. 11:8 iv. the current uncertainty frustrates the very international tax policy objectives that this regime was enacted to promote ............................................................. 671 a. the tax policy behind the exemption for a foreign person’s capital gains on sale that are not connected with a u.s. trade or business ......................................................................... 672 b. the tax policy behind the enactment of the exemption for “portfolio interest” received by foreign persons that is not connected with a u.s. trade or business .................................... 672 c. the tax policy behind the enactment of the safe harbor for trading in securities for one’s own account .............................. 674 d. the current uncertainty is economically inefficient, adds to the deadweight loss of taxation, and frustrates the tax policy objectives the regime was enacted to implement ....................... 675 v. conclusions, suggestions, and moving forward ................ 677 i. introduction the structure of the global financial system has drastically changed in the last few decades with the rise of what has been called a shadow banking system.1 the term “shadow banking system” refers to the fact that financial institutions outside the traditional banking system have acted as 1. see paul krugman, the return of depression economics and the crisis of 2008 163 (2009) (“[t]he shadow banking system expanded to rival or even surpass conventional banking in importance.”); hedge funds, systemic risk, and the financial crisis of 2007–2008: hearing before the h. oversight comm. on hedge funds, 111th cong. (2008) (statement of andrew lo), http://ssrn.com/ abstract=1301217 (“in particular, many financial institutions now provide some of the same services that banks have traditionally provided, but are outside of the banking system.”); bill gross, beware our shadow banking system, cnn.com (2007), http://money.cnn.com/2007/11/27/news/newsmakers/gross_banking.fortune/ (“my pimco colleague paul mcculley has labeled it the ‘shadow banking system’ because it has lain hidden for years.”); see robin blackburn, subprime crisis, new left review, mar.–apr. 2008, at 50, 68–69 (“this ‘hidden’ system had expanded rapidly in the 1990s and 2000s as a consequence of deregulation, which allowed many financial institutions to take on banking functions and loosened the rules that govern borrowing and lending.”); gillian tett & paul davies, out of the shadows: how banking’s secret system broke down, financial times, dec. 2007, at 17 (“yet while investors are scrutinizing some of the industry’s best-known names, a spectre will be silently haunting events: the state of the little-known, so-called ‘shadow’ banking system. a plethora of opaque institutions and vehicles have sprung up in american and european markets this decade, and they have come to play an important role in providing credit across the financial system.”). 2011] the global shadow bank 645 intermediaries between investors and borrowers and have increasingly undertaken roles traditionally played by banks, including lending capital to u.s. businesses.2 these intermediaries have included investment banks, hedge funds, and others that have expanded liquidity in many global financial markets, arguably increasing market efficiency.3 with the recent financial crisis in the u.s. starting in 2007, much attention has been drawn to the issue of whether and to what extent financial regulation should keep pace with financial innovation and the shadow banking system.4 however, the internal revenue code’s failure to adequately keep pace with financial innovation is often ignored. one example of how the tax laws lag behind financial innovation can be found in the taxation of foreign persons lending to u.s. borrowers or transacting in u.s. debt securities. most of the u.s. federal income tax law governing this area was written before complex shadow banking transactions and sophisticated debt products were even contemplated.5 this leaves a great 2. hedge funds, systemic risk, and the financial crisis of 2007–2008: hearing before the h. oversight comm. on hedge funds, 111th cong. 4 (2008) (statement of andrew lo), http://ssrn.com/abstract=1301217. in the lending context, this role may consist of being an intermediary between investors and borrowers (i.e., funneling funds from the investor to the borrower). the non-bank institution will thereby profit from fees and/or the difference in interest rates that it pays the investors and what it receives from the borrowers. this role may also consist of purchasing debt securities on the secondary market. for further discussion specific to hedge funds see infra part ii. these non-bank institutions may include hedge funds, investment banks, structured investment vehicles, and other non-bank entities. 3. id. (description of the financial intermediaries); see roger ferguson & david laster, fin. stability rev., apr. 2007, at 45, 47–48 (hedge funds have contributed to market efficiency and financial stability by expanding liquidity and thereby lowering the cost of capital). 4. james bullard, christopher j. neely & david c. wheelock, systemic risk and the financial crisis: a primer, 91 fed. res. bank of st. louis rev. 403 (2009); benjamin s. bernanke, chairman, u.s. federal reserve, speech at the federal reserve bank of chicago’s annual conference on bank structure and competition: risk management in financial institutions (may 15, 2008); benjamin s. bernanke, chairman, u.s. federal reserve, speech at the federal deposit insurance corporation’s forum on mortgage lending for low and moderate income households: financial regulation and financial stability (july 8, 2008); benjamin s. bernanke, chairman, u.s. federal reserve, speech at the federal reserve bank of kansas city’s annual economic symposium: reducing systemic risk (aug. 22, 2008); cong. oversight panel, 111th cong., special report on regulatory reform (2009); garry j. schinasi, r. sean craig, burkhard drees & charles kramer, modern banking and otc derivatives markets: the transformation of global finance and its implications for systemic risk, 203 int’l monetary fund occasional paper 1 (2001). 5. e.g., the revenue act of 1936 created an early version of the business versus passive distinction that will be discussed infra part iv and established that http://ssrn.com/abstract=1301217 646 florida tax review [vol. 11:8 deal of uncertainty about how the tax laws should be interpreted and applied. particularly problematic is that the taxation outcome depends on a mushy standard of whether a foreign person is engaged in a u.s. trade or business of lending. in order to analyze these uncertainties and their potential effects in more detail, i will concentrate on financial innovation in the hedge fund industry, focusing on transactions in which foreign hedge funds lend money into the u.s., either directly to u.s. borrowers or by purchasing debt securities. policymakers must choose where the boundaries of what rises to the level of a u.s. trade or business should be drawn, or re-drawn, given the growth of complex debt transactions. any particular line drawn will be controversial. in fact, inefficiencies can arise when economically similar transactions are taxed differently.6 the taxpayer whose transactions fall on the business side of the line will argue that the distinctions are arbitrary and their transactions are economically similar to those transactions that just barely fall on the passive investment side of the line. there will undoubtedly be room for disagreement about any line drawn because there are important and competing tax policy considerations that straddle any line. the goals of this article are not to propose where these lines should be drawn. the goals of this article are much more fundamental. first, part ii will identify how certain tax laws lag behind shadow bank transactions that are becoming more and more commonplace. i will explore typical foreign hedge fund lending transactions and demonstrate how the current law provides inadequate guidance as to how these transactions will be taxed. part iii will discuss why it may be absolutely vital to fix this problem — suggesting that we should consider the possibility that this kind of uncertainty in the taxation of certain shadow bank transactions may increase systemic risk, making the u.s. financial system more fragile. whether hedge funds are systemically important because of their interconnectedness to the financial system and credit channels is currently foreign persons and corporations selling their passive investment would not be taxed on the resulting capital gains. revenue act of 1936, ch. 690, §§ 211, 231, 49 stat. 1648 (codified as amended in scattered sections of 26 u.s.c.). an early version of the safe harbor for trading in stock or securities for one’s own account (which will also be discussed) was enacted in the 1936 act and this safe harbor was revised in the 1966 foreign investors tax act. foreign investors tax act of 1966, pub. l. no. 89-809, 80 stat. 1541 (codified as amended in scattered sections of 26 u.s.c.). 6. david a. weisbach, an efficiency analysis of line drawing in the tax law, 29 j. legal stud. 71, 74 (2000) (discussing the “line-drawing problem” in the context of the realization requirement, debt/equity distinction, and independent contractor/employee distinction). 2011] the global shadow bank 647 being discussed at the highest levels of our government.7 i posit that we should at the very least also consider whether tax uncertainty in the transactions that create the interconnectedness and credit channels increases systemic risk. part iv will look at the tax policy reasons for the current law’s enactment and will posit that the existing uncertainty frustrates these very tax policy goals. finally, part v will contend that no matter what rules or standards policymakers adopt to fix the problem in this area, the rules or standards should get to the substance of the transactions and not merely the form. in order to adopt a substantive approach, the irs needs more information about foreign funds and their transactions. we should at least consider the use of two disclosure regimes currently being fashioned that will potentially already be applied to certain foreign persons for other purposes — (1) the fatca provisions8 of the hiring incentives to restore employment act of 2010 (the “hire act”)9 to capture u.s. persons attempting to evade u.s. tax via foreign vehicles, and (2) the disclosure and reporting provisions applied to certain nonbank financial institutions and investment advisors under the dodd–frank wall street reform and consumer protection act (hereinafter the “dodd–frank act”) in the regulatory arena.10 in fact, these new tools, if applied in this area, may be instrumental not only to the implementation of rules or standards in this area but also to the issue of what the rules or standards should be, based on what has the potential to be effectively implemented. 7. under the dodd–frank act, infra note 10, the financial stability oversight council has been delegated the task of designating nonbank financial institutions that are systemically important. 8. fatca refers to the foreign account tax compliance act of 2009, h.r. 3933, 111th cong. (1st sess. 2009), which was never enacted. the provisions discussed in this article were introduced in fatca but enacted as part of the hiring incentives to restore employment (hire) act of 2010, infra note 9. 9. pub. l. no. 111-147, 124 stat. 71 (2010). 10. pub. l. no. 111-203, 124 stat. 1376 (2010). this was signed into law by president obama on july 21, 2010. the dodd–frank act was passed in response to the financial crisis of 2007–2010 and generally, among other things, reforms the existing regulatory structure for financial institutions, increasing the oversight of certain nonbank financial institutions regarded as a systemically important. 648 florida tax review [vol. 11:8 ii. the tax laws in this area lag behind financial innovation — a look at the taxation of foreign hedge fund lending to u.s. borrowers and transacting in u.s. debt securities a. hedge funds generally “hedge funds” are private pools of capital that typically restrict their investors to high net worth individuals and institutions in order to escape the types of disclosure and regulations requirements that currently apply to banks and mutual funds.11 this means that hedge funds have flexibility in the investment strategies and financial instruments that they employ. this also means they can be highly leveraged. the term “hedge” initially came from funds’ tendencies to hedge or, reduce market risk on an investment, i.e., holding offsetting positions so that if the market rose the funds profited from the increase in the long position over the decrease in the short position, and if the market fell the funds profited from the increase in the short position over the decrease in the long position. today’s hedge funds investment strategies vary widely. hedge fund managers often receive a management fee of 2 percent of the net asset value of the fund and 20 percent of returns in excess of some benchmark.12 this may create an incentive for hedge fund managers to take on risk and leverage in order to maximize returns.13 11. in general hedge funds are currently largely unregulated. although investing money through a hedge fund is considered investing in a security under the securities act of 1933, registration is not required if no public offering is made and only accredited investors are permitted to invest. regulation d of the securities act of 1933 governs what constitutes an accredited investor for that purpose. in addition a hedge fund is an investment company under the investment company act of 1940 but is not required to register as such if an exemption applies. many hedge funds attempt to meet the exemptions provided in either section 3(c)(1) or 3(c)(7) of the investment company act of 1940. section 3(c)(1) exempts any issuer of securities whose outstanding securities are not beneficially owned by more than 100 persons and is not making and does not presently propose to make a public offering of its securities. section 3(c)(7) of the investment company act of 1940 exempts issuers where each investor is a qualified purchaser and no public offering is made or contemplated. a qualified purchaser for this purpose is generally intended to be a sophisticated investor as determined by the amount of money such purchaser has in investments in general. see john kambhu, til schuermann & kevin j. stiroh, hedge funds, financial intermediation, and systemic risk, 291 fed. res. bank of new york staff rep. 1 (2007); see generally, alan l. kennard, the hedge fund versus the mutual fund, 57 tax law. 133 (2004). in addition, hedge fund investment advisors generally do not register as such under the investment advisors act of 1940 because they have 15 or fewer clients (or funds). 12. victor fleischer, two and twenty: taxing partnership profits in private equity funds, 83 n.y.u. l. rev. 1, 3 (2008). 13. see kambhu, schuermann & stiroh, hedge funds, supra note 11, at 3. http://papers.ssrn.com/sol3/cf_dev/absbyauth.cfm?per_id=327126 http://papers.ssrn.com/sol3/cf_dev/absbyauth.cfm?per_id=327126 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=892440 2011] the global shadow bank 649 b. introduction to hedge fund structures funds that solicit capital from foreign investors are increasingly using a “master-feeder” structure.14 a “master–feeder” structure, although providing many tax and non-tax benefits, tends to amplify the uncertainties in the taxation of foreign funds lending to u.s. borrowers and transacting in u.s. debt securities. in a typical “master–feeder” structure, a u.s. limited partnership (see #1 in figure 1 below, primarily an investment vehicle for u.s. taxable investors) and a foreign corporation (see #2 in figure 1 below, primarily an investment vehicle for u.s. tax-exempt and non-u.s. investors) invest in parallel in another entity, the “master fund,” which is a pass-through entity for u.s. tax purposes (see #3 in figure 1 below). the u.s. limited partnership and the foreign corporation are known as the feeder funds. figure 1: master-feeder structure #3 foreign master fund ‘#2 foreign corporation ( feeder fund) investments limited partnerinvestment advisor (gp) potential performance allocation (20%) potential management fee (2%) non-u.s. investors u.s. investors investment advisor potential management fee 2% limited partner #1 u.s. lp (feeder fund) u.s. tax exempt investors 14. alternatives to the master-feeder structure when a fund is soliciting capital from foreign investors include a parallel structure in which a foreign corporation for u.s. tax purposes invests in tandem with a domestic fund (although not through a master fund). in another variation, the foreign corporation could invest in a flow–through entity for u.s. federal income tax purposes with the investment advisor as the general partner of the flow-through entity such that the investment advisor could receive a profit allocation instead of a performance fee. the difference between this alternative and a “master–feeder” structure is that a domestic fund does not also invest in that lower tier flow-through entity. 650 florida tax review [vol. 11:8 because the master fund is taxed as a partnership for u.s. tax purposes, the investment advisor can be the general partner of the master fund. therefore the investment advisor can receive a special profit allocation as a partner in lieu of all or a portion of a performance fee. a performance fee is generally characterized as ordinary income, which is taxed at a higher rate than a special profit allocation, all or part of which will be treated as capital gain, depending on the mix of income earned by the master fund’s underlying investments.15 a special profit allocation, however, does not provide the same fee deferral options for federal income tax purposes.16 the use of master-feeder structures is increasing because of the potential for the investment advisor to convert all or a portion of the performance fee into an incentive allocation and for other non-tax reasons. these non-tax reasons include (1) achieving a critical mass of assets in the master fund,17 (2) reducing equalizing trades between foreign and domestic funds investing in parallel,18 (3) improving operating efficiencies 15. see i.r.c. § 61(a) (“except as otherwise provided [in subtitle a of the i.r.c.], gross income means all income from whatever source derived.”); i.r.c. § 702(b) (providing the character of any items of income in a partner’s distributive share of certain items shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership). see also fleischer, two and twenty, supra note 12, at 1 (“by taking a portion of their pay in the form of partnership profits, fund managers defer income derived from their labor efforts and convert it from ordinary income into long-term capital gain.”). 16. see generally, i.r.c. § 409a (allowing for fee deferral under certain circumstances). 17. consolidating assets among the foreign and domestic funds into the master fund will give the master fund a larger asset base which, among other benefits, can be more attractive to lenders and investors. a single pool of assets may also make it easier for a fund to meet “qualified institutional buyer” or other similar asset-based qualifying status definitions allowing access to less regulations investments (such as the rule 144a market — the private resales of securities to institutions) while the feeder funds may not qualify on their own. 18. in addition, trading is done at the master fund level, resulting in one portfolio. therefore, the need to split tickets or engage in equalizing trades between funds of like strategy is avoided. this simplifies the day-to-day operations of the investment manager. 2011] the global shadow bank 651 for the investment advisors,19 (4) providing the flexibility to customize the feeder funds,20 and (5) providing a uniform performance record.21 with the rise of the “master-feeder” structure, the u.s. federal income tax uncertainties as to whether or not the foreign master fund, and thereby the foreign feeder fund, is considered engaged in u.s. business for u.s. federal tax purposes are even more pronounced. since the master fund also has a domestic feeder fund and thereby u.s. investors, the investment advisor may be tempted to have the master fund invest in the u.s. to a point which would cause the master fund to be engaged in a u.s. business.22 the increased use of the master-fund structure actually heightens the potential for these issues since there is one master fund investing for both u.s. and foreign persons.23 if the master-fund were considered to be engaged in a u.s. business, the foreign feeder corporation would also be considered to be engaged in a u.s. business.24 the consequences of being considered to be engaged in a u.s. business for this purpose will be discussed below. c. foreign hedge fund lending to u.s. borrowers and transacting in u.s. debt securities lending directly to borrowers is called loan origination. loan origination by foreign funds to u.s. borrowers is uncommon because these 19. the total number of funds investing is consolidated since a foreign feeder fund and a domestic feeder fund invest in a master fund and the master fund procures the investments. this creates operating efficiencies for the investment advisor, such as simplifying and facilitating monitoring, risk management and the other investments strategy analyses performed by the investment advisor. it also avoids the need to enter into more than one set of documents with counterparties. 20. there is flexibility in customizing the feeder funds to the needs of specific groups of investors (e.g., feeder funds may have different term arrangements, fee structures, or they may accept subscriptions in different currencies). 21. funds with the same strategies will have a uniform performance record in the master fund. 22. in fact, many of the u.s. investors may even prefer the characterization of the master fund as engaging in a financing business because then section 162 (which applies to trading but not investing) could apply instead of section 212 (whereby the general itemized deduction limits apply) to deduct relevant expenses. 23. many foreign hedge fund offering memoranda state that the fund or the investment advisor believes that the fund should not be considered to be in a u.s. trade or business of lending but that it cannot give complete assurance of that conclusion. in addition, many investment advisors leave themselves the room to attempt to structure around these issues by forming a u.s. corporation or a limited liability company to hold the offending investment or to invest through affiliated or non affiliated companies formed in the caymans or elsewhere. 24. i.r.c. § 875. 652 florida tax review [vol. 11:8 funds typically do not want to be considered to be engaged in a u.s. lending business for u.s. federal income tax purposes. therefore, many foreign funds purchase debt securities, either from the secondary debt market (exchanges or on the over-the-counter market) or on the primary market (where debt securities are first sold to the public). a primary market debt securities purchase is often accomplished via a large loan “syndication.” in addition, debt securities may be packaged together. in a typical syndication, a group of lenders will fund a very large loan. there will be a lead lender in the position of an administrative agent that typically negotiates the loan as an agent for the others in the syndicate. there are usually two tranches of money: (1) one tranche immediately put up by the syndicate members, and (2) another tranche that is “warehoused” by the lead lender, meaning the lead lender advances the funds and then finds investors later to take the credit risk and/or buy it. the lead lender may earn its primary return in the form of fees for arranging the loan and negotiating the terms. one form of such a loan syndication is shown in figure 2 below.25 figure 2: loan syndicates us borrowers loan syndicate foreign hedge funds syndicate loan $ lead lender $ borrower’s note lead lenderpurchase price $ participation or assignment of debt securities non-syndicate members, such as foreign hedge funds, acquire portions of the loan, in many cases within 24 or 48 hours of the original funding. these hedge funds even may have committed to purchasing the interest prior to the original funding (a “forward commitment”). this forward 25. see generally, victoria ivashina & david scharfstein, loan syndication and credit cycles, 100 amer. econ. rev. 57 (2010) (for a general description of loan syndication). 2011] the global shadow bank 653 commitment may or may not contain a material adverse change (mac) clause allowing the hedge fund to back out if there is a major change in the borrower’s financial status. foreign hedge funds typically do not provide the money directly to the borrower, but this becomes complicated when the loan itself is a revolving line of credit. in addition, the hedge fund may or may not have been involved with the lead lender’s negotiation with the borrower. in many cases the fund will not negotiate terms with the borrower directly, but will keep tabs on those negotiations through the lead lender or syndicate member and indicate to the lead lender or syndicate member terms it will or will not be willing to accept. this may influence or perhaps even dictate the deal terms with the borrower. the foreign hedge fund may purchase from the syndicate a “participation” with the lead bank or syndicate member, whereby the lead bank or syndicate member remains involved and passes on interest and other payments from the borrower to the participant. the foreign hedge fund may also acquire a portion of the loan through an assignment, whereby the fund actually steps into the shoes of the lead bank or the syndicate member with respect to the loan documents for that portion of the loan.26 a hedge fund may also enter into a derivative contract with a syndicate member. to complicate matters, foreign hedge funds may use related u.s. hedge funds, or hedge funds controlled by the same investment advisor, to get closer to the loan origination. a related u.s. hedge fund may acquire a larger portion of the loan than it actually plans to hold as a syndicate member or from a syndicate member, intending to “warehouse” the excess amount for future resale to a foreign affiliate. in fact, because of the fast moving nature of these investments and commitments some investment advisors initially commit to purchase these debt securities through a u.s. hedge fund or entity that never intends to hold the investment very long, and they then later decide how to allocate the investment amongst their various managed or affiliated foreign funds. in an attempt to circumvent the argument that such a u.s. hedge fund is merely an agent for the foreign funds and to put some distance between the original loan origination and the foreign funds, some u.s. funds “season” the debt securities. this means that the u.s. fund does not sell interest to its foreign affiliates until after it has held the loan for a fixed period of time, often 3 months or so. however, the offering memoranda of many of these parallel funds disclose that many of these affiliated funds intend to invest in “lockstep.” this means the u.s. fund and affiliated foreign hedge fund intend to make the same or similar investments (perhaps in different proportions). in addition, sometimes these affiliated hedge funds 26. although outside the scope of this article, the “participation” versus “assignment” distinction can produce very different results with respect to u.s. and other countries withholding taxes on foreign persons. 654 florida tax review [vol. 11:8 perform equalizing trades of other securities during the seasoning period. a hedge fund may or may not price such a seasoned sale based on the market conditions at the time of the sale (as opposed to the time of the origination or the time when u.s. affiliate purchased the debt security). in addition, some foreign funds have the right to reject an assignment from a u.s. affiliate and some occasionally do. some affiliated funds are completely under the control of a common investment advisor, while others intentionally vest the rejection right in someone not under the control of the investment advisor. another complicating factor is that hedge funds often invest in many different positions in the same borrower. some invest in pipes (private investment in public equity) in the form of short-term loans paid in stock, notes convertible into stock, and non-convertible notes or warrants for stock. the idea is that the debt component will protect the downside while the equity component gives the fund the upside. certain foreign hedge funds specialize in the debt securities of companies in financial trouble. these debt securities tend to be significantly discounted to reflect the default risk. this type of debt is thought of as “loaning to own,” or seeking to acquire an equity interest in a business by first acquiring the outstanding debt securities. d. u.s. taxation of foreign lending to u.s. borrowers and transacting in u.s. debt securities the united states taxes foreign lending to u.s. borrowers and transacting in u.s. debt securities in a manner that, at first blush, may seem very generous.27 a foreign person’s interest income and profit on the sale of u.s. debt instruments are generally exempt from u.s. federal income tax if the income is not effectively connected to a trade or business in the united states.28 the key to unlocking this “generosity” is for the income to be characterized as passive investment income instead of income connected with a u.s. business.29 if nonresident aliens or foreign corporations 27. see lee a. sheppard, news analysis — neither a dealer nor a lender be, part 2: hedge fund lending, 108 tax notes 729 (2005). 28. this assumes that with respect to the interest, the portfolio interest exemption applies. see i.r.c. § 881(c)(1). note however the portfolio interest exception does not apply to a “bank.” i.r.c. § 881(c)(3)(a). a hedge fund should not be considered a “bank” for this purpose since it is not regulated as a bank under i.r.c. § 58. priv. ltr. rul. 98-22-007 (feb. 10, 1998). with respect to capital gains see infra note 30. 29. the u.s. generally taxes nonresident aliens and foreign corporations on two types of income: (1) income that is effectively connected with the conduct of a trade or business in the u.s. (“eci”) and (2) fixed, determinable, annual or periodical income from u.s. sources that is not eci (“fdap”). i.r.c. §§ 871(b) and 882(a). capital gains are not fdap so if capital gains are not eci they are not taxed. 2011] the global shadow bank 655 (hereinafter “foreign persons”) have income that is connected with a u.s. business, that income will be taxed at the regular graduated tax rates applicable to u.s. persons and corporations.30 a foreign person engaged in a u.s. business will also generally have to file a u.s. tax return.31 certain lending activities will certainly rise to the level of a lending or financing business in the united states, such as a frequent loan origination to u.s. borrowers. other lending activities seem to clearly constitute passive investing, such as the long-term holding of debt securities purchased on the secondary market. however, there is a broad range of activities in between these two extremes, and precedent in the middle is quite uncertain. the stakes are high for the proper characterization of what constitutes a u.s. trade or business, because if the foreign person is not engaged in a u.s. business, interest income and capital gains on the sale of a u.s. debt instrument are generally exempted from u.s. federal income tax.32 the code and treasury regulations do not provide a thorough definition of what constitutes being engaged in a u.s. business for this purpose.33 however, there is a safe harbor for foreign persons trading (and not dealing) in stock and securities, including debt securities, for their own account.34 situations that do not fall squarely within the limited statutory interest is fdap but may be exempt from u.s. federal income tax if it qualifies as “portfolio interest” or if there is a reduction or elimination of the tax under a double taxation treaty. 30. id. such business income may also be subject to a “branch profits tax” at a rate of 30 percent. i.r.c. § 884. 31. see i.r.c. § 6012. 32. see supra note 30. 33. see i.r.c. § 864(b) (the definition of “trade or business in the united states” includes the performance of personal services within the u.s.). 34. i.r.c. § 864(b)(2)(a)(i), (ii). note that prop. reg. § 1.864(b)-1 provides that the term “engaged in a trade or business in the united states” (“etb”) does not include effecting transactions in derivatives (including certain hedging transactions) and does not apply, however, to any foreign person who is a dealer in stocks, securities, commodities, or derivatives. “trading” is defined in treasury regulations as “effecting of transactions” in stocks or securities which includes “buying, selling . . ., or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, on margin or otherwise, . . . and any other activity closely related thereto (such as obtaining credit for the purpose of effectuating such buying, selling, or trading).” reg. § 1.864-2(c)(1), (2)(i). the securities trading safe harbor does not apply to dealers. treasury regulations define a “dealer” for this purpose as “a merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom.” i.r.c. § 864(b)(2)(a)(ii); reg. § 1.864-2(c)(2)(iii). this is distinguished from buying, selling, or holding stocks or securities for investment or speculation. in making this determination, all of the foreign persons’ stock and securities transactions will be 656 florida tax review [vol. 11:8 definition of a u.s. business or within a safe harbor are left to the principles in the applicable code and treasury regulation sections and varied case law.35 a treasury regulation lists factors for determining whether or not a foreign person’s income is effectively connected with a banking, finance, or similar u.s. business.36 the treasury regulation factors include: [r]eceiving deposits of funds from the public, [m]aking personal, mortgage, industrial, or other loans to the public, [p]urchasing, selling, discounting, or negotiating for the public on a regular basis, notes, drafts, checks, bills of exchange, acceptances, or other evidences of indebtedness, [i]ssuing letters of credit to the public and negotiating drafts drawn thereunder, [p]roviding trust services for the public, or [f]inancing foreign exchange transactions for the public.37 by its terms this regulation assumes that the foreign person is engaged in a u.s. business and applies whether or not income is connected to that u.s. business.38 the tax court has said that these factors also provide a “useful framework” for determining whether a foreign person or corporation is engaged in a u.s. business.39 only a few cases provide any guidance on what constitutes an active lending business for this purpose. in 1953 the tax court looked at the issue in pasquel v. commissioner, 40 but pasquel provides limited guidance since the foreign person made only one loan. also, based on general case law, if the activities are “considerable, continuous, and regular” a u.s. trade or business will exist.41 for there to be a u.s. business, the foreign person’s taken into account, even those that occur outside of the u.s. being characterized as a “dealer” for this purpose means that the securities trading safe harbor will not apply and the foreign person is may be considered engaged in a u.s. business under common law principles unless another safe harbor applies. reg. § 1.864-2(c)(2)(iv). 35. see rev. rul. 88-3, 1988-1 c.b. 268 (must apply applicable treasury regulations to the “facts and circumstances”). 36. reg. § 1.864-5(b)(2)(i). 37. id. 38. id. this makes sense since this regulation was promulgated under the authority of code section 864(c) which addresses eci not etb. 39. inverworld, inc. v. commissionner, 71 t.c.m. (cch) 3231 (1996). 40. 12 t.c.m. (cch) 1431 (1953); 41. see pinchot v. commissioner, 113 f.2d 718, 719 (2d cir. 1940) (a nonresident alien was engaged in a u.s. trade or business because real estate management required “regular and continuous” activity including purchasing materials and making contracts); de amodio v. commissioner, 34 t.c. 894, 906 (1960), aff’d, 299 f.2d 623 (3d cir. 1962) (the negotiation of leases, collection of 2011] the global shadow bank 657 activities generally must go beyond simple passive investment or ownership of property.42 in addition, the activities must relate to earning profit, although no profit need be generated.43 nevertheless, simply receiving profits is not enough to find that a foreign person is engaged in a u.s. business.44 isolated activity, without “sustained activity,” also generally is not enough to find a trade or business.45 similarly, clerical and ministerial activity is generally not enough to find a trade or business.46 the tax court has held that the words “trade or business” for this purpose should be “interpreted consistently with the general body of law on this subject.”47 this suggests that other contexts in the code in which the rent, and payment of taxes and insurance amounted to a u.s. trade or business); spermacet whaling & shipping co. v. commissioner, 30 t.c. 618, 634 (1958), aff’d, 281 f.2d 646 (6th cir. 1960). 42. see continental trading, inc. v. commissioner, 265 f.2d 40, 43 (9th cir. 1959), cert. denied, 361 u.s. 827 (1959); see also gen. couns. mem. 18,835, 1937-2 c.b. 141 (mere management of investments was insufficient to constitute carrying on a trade or business); neill v. commissioner, 46 b.t.a. 197 (1942) (mere ownership of property in the form of a single building did not constitute the carrying on of a business); higgins v. commissioner, 312 u.s. 475, 478 (1941) (no amount of activity can convert investment into a trade or business). 43. see, e.g., investors’ mortg. sec. co. v. commissioner, 4 t.c.m. (cch) 45, 47 (1945); pinchot v. commissioner, 113 f.2d 718, 719 (2d cir. 1940); lewenhaupt v. commissioner, 20 t.c. 151, 162 (1953), aff’d, 221 f.2d 227 (9th cir. 1955); gen. couns. mem. 18,835, 1937-2 c.b. 141, 143 (the taxpayer (through his agent) executed leases, rented property, collected rents, kept books of account, supervised repairs, paid taxes and mortgage interest, insured property, and purchased and sold property and this was “beyond the scope of mere ownership of real property, or the receipt of income from real property”). 44. see snell v. commissioner, 97 f.2d 891, 892 (5th cir. 1938). 45. linen thread co. v. commissioner, 14 t.c. 725 (1950) (two isolated sales in the u.s. did not constitute a trade or business in the u.s.); cf. johansson v. united states, 336 f.2d 809 (5th cir. 1964) (a nonresident alien prize fighter in one world championship fight in the united sates was held to be a u.s. trade or business). 46. scottish am. inv. co. v. commissioner, 12 t.c. 45, 59 (1949) (activities of u.s. office of foreign trusts did not constitute a trade or business and the u.s. office was merely a helpful adjunct to the foreign trusts); spermacet whaling & shipping co., 30 t.c. at 634, (receiving monthly statements and correspondence and making certain payments were “ministerial and clerical in nature” and involved little exercise of the discretion or business judgment “necessary to the production of the income in question”); linen thread co., 14 t.c. 736 (delivery of goods, handling of paperwork and collection of payment by the u.s. office was not enough to constitute a u.s. trade or business where the profit generating activity occurred abroad). 47. dekrause v. commissioner, 33 t.c.m. (cch) 1362, 1364 (1974); whipple v. commissioner, 373 u.s. 193, 201 (1963); see also folker v. johnson, 658 florida tax review [vol. 11:8 business concept is used may be helpful. analogous authorities suggest that the number and amount of loans is important in the determination of whether or not a lending trade or business exists.48 these authorities seem to indicate that foreign persons may be able to make a limited number of loans and not be considered to be in an active lending business in the united states.49 analogous authorities have also looked at the time and effort devoted to lending activities,50 the maintenance of an office for the lending activity,51 promoting oneself as a lender,52 maintenance of books and records for lending activities,53 and the presence of employees or other dependent agents.54 in the context of writing off business debt, there is some authority for the proposition that a loan made to acquire, protect, or enhance an investment where the dominant motive is to earn a return from the 230 f.2d 906 (2nd cir. 1956). with respect to other areas of the code, the irs has recognized that rules in the etb context may “differ in some respects from those used in determining whether a taxpayer is engaged in a trade or business under other sections of the code.” rev. rul. 88-3, 1988-1 c.b. 268. 48. see serot v. commissioner, 68 t.c.m. (cch) 1015, 1022–23 (1994); mccrackin v. commissioner, 48 t.c.m. (cch) 248, 251 (1984) (taxpayer was engaged in lending trade or business, where taxpayer made sixty-six loans to twelve unrelated borrowers over fifteen years); jessup v. commissioner, 36 t.c.m. (cch) 1145, 1150 (1977) (trade or business of lending existed where taxpayer engaged in thirty-one loan, endorsement, or guarantee transactions with seventeen unrelated persons over ten years); cushman v. united states, 148 f.supp. 880 (d.c. ariz. 1956); minkoff v. commissioner, 15 t.c.m. (cch) 1404 (1956). 49. for example, in imel v. commissioner, 61 t.c. 318, (1973), the tax court held that eight or nine loans made over the course of four years was not a trade or business for purposes of allowing a deduction for business bad debts. the irs also issued a private letter ruling holding that a partnership that represented that it would not originate on average more than five new mortgages a year over any five year period was deemed to not be engaged in a trade or business for purposes of treating the partnership as a corporation. priv. ltr. rul. 97-01-006 (jan. 3, 1997). it should be noted that that private letter rulings are taxpayer specific rulings furnished by the irs in response to requests made by taxpayers and cannot be used as precedent. in addition this particular ruling was interpreting the legislative history specific to section 7704(d) (treating certain publicly traded partnerships as corporations). see also stuart leblang & rebecca rosenbert, toward an active finance standard for inbound lenders, 31 tax mgm’t int’l j. 131, 141 (2002). 50. united states v. henderson, 375 f.2d 36, 41 (5th cir. 1967); ruppel v. commissioner, 53 t.c.m. (cch) 829, 832, 834 (1987); jessup, 36 t.c.m. (cch) at 1150. 51. henderson, 375 f.2d at 41; cushman, 148 f. supp. 880). 52. henderson, 375 f.2d at 41. 53. id., see also ruppel, 53 t.c.m. at 832; serot, 68 t.c.m. (cch) at 1022–23 (1994); carraway v. commissioner, 67 t.c.m. (cch) 3139 (1994). 54. cushman, 148 f. supp. at 880. 2011] the global shadow bank 659 investment cannot lead to a “business” debt because the loan is related to the investing activities rather than to a lending business.55 in the context of business deductions, the supreme court in higgins v. commissioner56 rejected the proposition that management of one’s own securities could constitute a business given “sufficient extent, continuity, variety and regularity” finding that “no amount of personal investment management would turn those activities into a business.” although higgins dealt with business deductions, courts have consistently held that the higgins reasoning applied in this context.57 rulings in this area have been unhelpful.58 further, the irs will not “ordinarily” issue rulings or determination letters regarding whether a taxpayer is engaged in a trade or business within the united states and whether income is effectively connected with the conduct of a trade or business within the united states.59 agency issues further complicate this area. activities of agents can be imputed to foreign persons. the precedent in this regard is somewhat mixed with the irs and courts taking aggressive positions on imputation at times and at other times being reluctant to impute actions of an agent to a 55. see whipple, 373 u.s. at 197, 202 (1963); german v. commissioner, 7 t.c.m. (cch) 1738 (1999) (petitioner was not entitled to a bad debt deduction because the petitioner was not engaged in the trade or business of lending money). 56. 312 u.s. at 218 (no amount of activity can convert investment into a trade or business). 57. dekrause, 33 t.c.m. (cch) at 1364, 74-1290; liang v. commissioner, 23 t.c. 1040 (1955); cont. trading, inc. v. commissioner, 265 f.2d 40, 43 (9th cir. 1959), cert. denied, 361 (1959). 58. in rev. rul. 73-227, 1973-1 c.b. 338, the irs determined that u.s. source interest income of a foreign subsidiary of a u.s. parent was effectively connected with a u.s. trade or business. rev. rul. 73-227 provided minimal analysis on the etb issue and was subsequently revoked by rev. rul. 88-3, 1988-1 c.b. 268. the later ruling stated that the conclusion in ruling 73-227 “may be unsound” because it simply concluded without discussion that the foreign person is etb. the later ruling provides that this determination should be made applying the rules to the facts. id. 59. rev. proc. 2008-7, 2008-1 c.b. 229, 230 (listed as “areas in which ruling or determination letters will not ordinarily be issued: whether a taxpayer is engaged in a trade or business within the u.s., and whether income is effectively connected with the conduct of a trade or business within the u.s.; whether an instrument is a security as defined in [reg.] § 1.864-2(c)(2); whether a taxpayer effects transactions in the u.s. in stocks or securities under [reg.] § 1.864-2(c)(2); whether an instrument or item is a commodity as defined in [reg.] § 1.864-2(d)(3); and for purposes of [reg.] § 1.864-2(d)(1) and (2), whether a commodity is of a kind customarily dealt in on an organized commodity exchange, and whether a transaction is of a kind customarily consummated at such place.”). http://web2.westlaw.com/find/default.wl?vc=0&ordoc=0303774087&rp=%2ffind%2fdefault.wl&db=780&serialnum=1959202531&findtype=y&ap=&fn=_top&rs=wlw9.01&ifm=notset&mt=tax&vr=2.0&sv=split http://riacheckpoint.com/getdoc?docid=t0rulings:50240.1&pinpnt= 660 florida tax review [vol. 11:8 foreign person.60 courts have generally taken an expansive view on imputation when the relationship between the agent and the foreign person is “regular” or “continuous” rather than “casual” or “isolated.”61 one commentator summed up the mixed character of the precedent in this area by stating that “questions of imputation can be answered only with the help of considerable intuition.”62 in a general legal advice memorandum, which is non-binding authority, the irs concluded that if a u.s. agent performed lending activities on behalf of a foreign corporation pursuant to a service contract — such as locating borrowers, performing credit analysis, and negotiating borrowing terms, the foreign corporation had a u.s. lending business even if the agent lacked authority to conclude contracts on behalf of the foreign corporation.63 in practice, these determinations are made by the investors themselves, practitioners, the irs, and courts.64 many different practitioner and industry-developed standards interpreting uncertainties have arisen.65 lawyers, accountants, and other service providers advise of particular applications of uncertainties in order to reach a “should” or “will” opinion. 60. see tech. adv. mem. 80-29-005 (mar. 27, 1980) (the irs imputed the actions of an operator of oil property to the foreign owner of the properties on the basis of the foreign person’s ownership of assets); see also, rev. rul. 55-617 1955-2 c.b. 774 (holding that sales of an independent commission agent were imputable); see also, de amodio v. commissioner, 34 t.c. 894, 906 (1960), aff’d, 299 f.2d 623 (3d cir. 1962) (the purchase and management of real estate by “independent” real estate agents cause the foreign taxpayer to be etb); cf. tech. adv. mem. 81-47-001 (jan. 3, 1970) (no u.s. trade or business found because independent agent used); cf. amalgamated dental co. v. commissioner, 6 t.c. 1009 (1946) (actions of a u.s. supplier not imputed to a foreign corporation because of an independent agency relationship). 61. see de amodio, 34 t.c. at 906 (the purchase and management of real estate by “independent” real estate agents cause the foreign taxpayer to be etb); handfield v. commissioner, 23 t.c. 633 (1955) (sales by a u.s. distributor were attributable to a foreign person). 62. see joseph isenbergh, international taxation – u.s. taxation of foreign persons and foreign income 21:15 (1997). 63. chief couns. mem. preno-119800-09 (sept. 22, 2009); i.r.c. § 6110(k)(3). the memorandum notes that the u.s. corporation’s activities relating to loan origination were conducted on a considerable, continuous, and regular basis from its u.s. office. 64. david r. sicular & emma q. sobol, selected current effectively connected income issues for investment funds, 56 tax law. 719 (2003) (“practitioner-developed rules”); see also, joel kuntz & robert peroni, u.s. international taxation 1.04 (“all cases not governed by section 864(b) are left to the courts and the service.”). 65. see sicular & sobol, effectively connected income, supra note 64, at 722. http://web2.westlaw.com/find/default.wl?vc=0&ordoc=0303774087&rp=%2ffind%2fdefault.wl&db=350&serialnum=1962113891&findtype=y&ap=&fn=_top&rs=wlw9.01&ifm=notset&mt=tax&vr=2.0&sv=split http://web2.westlaw.com/find/default.wl?vc=0&ordoc=0303774087&rp=%2ffind%2fdefault.wl&db=350&serialnum=1962113891&findtype=y&ap=&fn=_top&rs=wlw9.01&ifm=notset&mt=tax&vr=2.0&sv=split 2011] the global shadow bank 661 without further legislative guidance, these constantly shifting, non-uniform standards often quickly become industry benchmarks for transaction after transaction.66 e. some examples of how the current law is ill-equipped to deal with these shadow banking transactions many investment advisors argue that most of the debt-related transactions described above fall within the securities trading safe harbor, or that the foreign hedge fund is not engaged in an active financing business. imbedded in these positions are the following contentions: (1) the relevant activities constitute trading and not dealing in debt securities, so the securities trading safe harbor applies; (2) the relevant activities do not rise to the level of an active financing business in that either (a) there is no loan origination so these activities are not thrown out of the securities trading safe harbor; or (b) in the alternative, limited loan origination does not rise to the level of an active financing business; and (3) even if certain hedge funds are engaged in an active financing business, income from other securities trading activities are not connected to such financing business (in other words, securities trading can be segregated and still fall under the securities trading safe harbor even if a foreign hedge fund is otherwise engaged in an active financing business).67 below, i will explore below some of the uncertainty that relates to these positions. with respect to the securities safe harbor, the distinction between trading and dealing is unclear. trading is defined in the regulations merely as “effecting of transactions in stocks or securities,” which includes “buying, selling . . ., or trading in stocks, securities,” . . . and any other activity closely related thereto (such as obtaining credit for the purpose of effectuating such buying, selling, or trading).”68 a “dealer” is defined in the regulations for this purpose as “a merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom.”69 this is distinguished from buying, selling, or holding stocks or securities for investment or speculation.70 distinguishing 66. see supra note 59. 67. note that there substantial issues concerning whether activities related to restructuring distressed debt amount to loan origination which are outside the scope of this article. 68. reg. 1.864-2(c)(1), (2)(i). 69. i.r.c. § 864(b)(2)(a)(ii); treas. reg. § 1.864-2(c)(2)(iii). 70. in making this determination, all of the foreign persons’ stock and securities transactions will be taken into account, even those that occur outside of the u.s. being characterized as a “dealer” for this purpose means that the securities trading safe harbor will not apply and the foreign person may be considered engaged 662 florida tax review [vol. 11:8 between trading and dealing to determine whether or not the safe harbor applies has been as elusive as the trade or business concept itself. what rises to the level of “loan origination” is also unclear in this context. although the foreign funds may not be lending directly to u.s. borrowers in form, in substance the foreign funds may be driving the loan terms with forward commitments and pre-closing understandings with the syndicate members. there is no clear authority for distinguishing between an alleged “old and cold” debt security bought on the secondary market and what constitutes loan origination in this context. does a forward commitment to purchase a portion of the loan before the original loan transaction closes put a foreign fund in an origination position? does a mac clause, a provision giving the foreign fund an out if there is a material adverse change, make us feel more comfortable about the position that a forward commitment does not translate into an origination position? how long must the foreign hedge fund wait after the original loan closing to purchase debt securities on the secondary market without risk of being accused of loan origination? many funds wait only 24 or 48 hours. is this enough? what if there are equalizing trades between a u.s. affiliate who purchased the debt securities at closing and a foreign fund for any value shifts during that time? sometimes a u.s. affiliate does not sell debt securities to its foreign affiliate until after the u.s. affiliate has held the loan for a fixed period of time, often 3 months or so. this strategy is often called “seasoning” the debt securities. what if the affiliated funds invest in “lockstep” with the foreign funds and provide equalizing trades during the seasoning period? agency issues further complicate matters. perhaps the lead lender or syndicate member is an agent for the foreign fund. often the foreign hedge fund is on the syndicate member’s speed dial for transaction after transaction. in addition, to what extent can the foreign fund or its investment advisor formally or informally participate in the original loan negotiations? is it a problem if the foreign fund provides loan document comments to the borrower (or to the syndicate member)? finally, if there is loan origination or deemed loan origination, how much loan origination is required before the foreign fund will be considered engaged in a u.s. trade or business is unclear in this context.71 in a u.s. business under common law principles unless another safe harbor applies. reg. § 1.864-2(c)(2)(iv). 71. pasquel v. commissionner, 12 t.c.m. (cch) 1431 (1953); see also pinchot v. commissioner, 113 f.2d 718, 719 (2d cir.1940) (a nonresident alien was engaged in a u.s. trade or business because real estate management required “regular and continuous” activity including purchasing materials and making contracts); de amodio v. commissioner, 34 t.c. 894, 906 (1960), aff’d, 299 f.2d 623 (3d cir. 1962) (the negotiation of leases, collection of rent, and payment of taxes http://web2.westlaw.com/find/default.wl?vc=0&ordoc=0303774087&rp=%2ffind%2fdefault.wl&db=350&serialnum=1962113891&findtype=y&ap=&fn=_top&rs=wlw9.01&ifm=notset&mt=tax&vr=2.0&sv=split http://web2.westlaw.com/find/default.wl?vc=0&ordoc=0303774087&rp=%2ffind%2fdefault.wl&db=350&serialnum=1962113891&findtype=y&ap=&fn=_top&rs=wlw9.01&ifm=notset&mt=tax&vr=2.0&sv=split 2011] the global shadow bank 663 whether or not the securities trading safe harbor can apply to segregate securities trading from an active financing business is unclear in this context. at least one commentator, lee sheppard, contends that the safe harbor itself assumes that trading is the taxpayer’s only contact with the united states. sheppard argues that once the taxpayer is in some other business in the united states (i.e. lending), then the securities trading income would be effectively connected with that other business.72 in other words, only securities trading standing alone is eligible for the securities trading safe harbor. but even sheppard calls for guidance on this point.73 other commentators contend segregation is possible.74 iii. we should consider whether the current uncertainty increases systemic risk what is “systemic risk?” it is difficult to concisely define. “but i know it when i see it”— justice potter stewart, concurring opinion in jacobellis v. ohio, 378 u.s. 184, 197 (1964) (regarding possible obscenity in the the lovers.) there is no widely accepted uniform definition of systemic risk.75 one way to define systemic risk is that it is the risk of collapse of an entire and insurance amounted to a u.s. trade or business); spermacet whaling & shipping co. v. commissioner, 30 t.c. 618, 634 (1958), aff’d, 281 f.2d 646 (6th cir. 1960); cont. trading, inc. v. commissioner, 265 f.2d 40, 43 (9th cir. 1959), cert. denied, 361 u.s. 827 (1959); gen. couns. mem. 18,835, 1937-2 c.b. 141 (mere management of investments was insufficient to constitute carrying on a trade or business); neill v. commissioner, 46 b.t.a. 197 (1942) (mere ownership of property in the form of a single building did not constitute the carrying on of a business); higgins v. commissioner, 312 u.s. 475, 478 (1941) (no amount of activity can convert investment into a trade or business). 72. lee a. sheppard, news analysis — neither a dealer nor a lender be, part 2: hedge fund lending, 108 tax notes 729 (2005). 73. id. 74. leblang & rosenberg, toward an active finance standard, supra note 49. 75. see steven l. schwarcz and imen anabtawi, regulating systemic risk, 85 notre dame l. rev. (forthcoming 2011) (recognizing that the “term ‘systemic risk’ has been used in various ways, sometimes inconsistently.”); see also steven l. shwarcz, systemic risk, 97 geo. l.j. 193, 196–97, 247–48 (2008). alan greenspan stated that the “very definition [of systemic risk] is still somewhat unsettled.” george g. kaufman, bank failures, systemic risk, and bank regulation, 16 cato j. 17, 21 n.5 (1996) (quoting alan greenspan, remarks at a conference on risk measurement and systemic risk, board of governors of the federal reserve system (nov. 16, 1995)). http://web2.westlaw.com/find/default.wl?vc=0&ordoc=0303774087&rp=%2ffind%2fdefault.wl&db=780&serialnum=1959202531&findtype=y&ap=&fn=_top&rs=wlw9.01&ifm=notset&mt=tax&vr=2.0&sv=split 664 florida tax review [vol. 11:8 financial system or market “serious enough to quite probably have significant adverse effects on the real economy.”76 the “real economy” simply refers to the goods, services, and resources aspects of the economy, as opposed to financial markets.77 essentially systemic risk involves a potential cascading failure in a system or market due to interlinkages and interdependencies.78 this chain reaction is often likened to the quintessential example of a banking panic.79 banking panics historically have occurred when customers withdrew their deposits from a bank in fear that the bank would become insolvent, causing a chain reaction of runs on other banks.80 the chain reaction may have occurred because other banks were owed money by the troubled bank or simply because general populous fear spread.81 it is thought that much of the great depression’s economic damage was caused by bank runs.82 while regulators have typically looked at banks as sources of systemic risk, because of the shadow bank system, we must look at the linkages or connectedness of the entire financial system, 76. the 2001 g10 report on consolidation in the financial sector suggested a working definition: “systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainly about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy.” the g10 report on consolidation in the financial sector, http://www. oecd.org/document/60/0,3343,end_2649_34593_1895868_1_1_1_1,00.html. george kaufman, & kenneth scott, what is systemic risk, and do bank regulators retard or contribute to it? 7 indep. rev. 371 (2003) (“systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts.”). 77. financial times lexicon, http://lexicon.ft.com/term?term=realeconomy (last visited sept. 9, 2011). 78. see schwarcz, systemic risk, supra note 75; see also, monetary policy and systemic risk regulation: hearing before the subcomm. on domestic monetary policy and technology of the h. committee on financial services, 111th cong. (2009) (testimony of john taylor) (“by definition a systemic risk in the financial sector is a risk that impacts the entire financial system and real economy, through cascading, contagion, and chain-reaction effects.”). 79. see generally george g. kaufman, banking and currency crisis and systemic risk: lessons from recent events, econ. perspectives, federal reserve bank of chicago, issue q iii at 9–28 (2000). 80. rajkamal iyer & manju puri, understanding bank runs: the importance of depositor-bank relationships and networks (nber working paper no. 14280, 2008, http://www.nber.org/papers/w14280; gary gorton, banking panics and business cycles¸ oxford econ. papers 40, 751–781 (1988). 81. gorton, banking panics, supra note 80, at 760. 82. benjamin bernanke, nonmonetary effects of the financial crisis in the propagation of the great depression, 3 am. econ. rev. 73, 257–76 (1983). http://www.oecd.org/document/60/0,3343,end_2649_34593_1895868_1_1_1_1,00.html 2011] the global shadow bank 665 including non-bank financial institutions, not only those of the traditional banking system. some scholars contend that the recent economic crisis of 2007-2010 was a run by investors on the shadow banking system.83 folks in the hedge fund industry have long argued against hedge funds’ systemic importance on the grounds that their transactions are only a small piece of the overall market.84 however, systemic risk does not only stem from being “too big to fail” in terms of market share.85 the dodd– frank act recently created the financial stability oversight council (the “fsoc”), in part to identify, monitor, and respond to risks to the financial stability of the united states.86 the fsoc is to designate certain nonbank financial companies to be supervised by the federal reserve’s board of governors, considering among other things “the extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies,”87 “the important of the company as a source of credit . . . and as a source of liquidity for the united states financial system,”88 and the “interconnectedness of the company.”89 clearly congress felt that there were 83. gary gorton, questions and answers about the financial crisis prepared for the u.s. financial crisis inquiry commission (2010), wall st. j. online, http://online.wsj.com/public/resources/documents/crisisqa0210.pdf. 84. gregory brown, jeremiah green & john hand, are hedge funds systemically important? (2010), http://papers.ssrn.com/sol3/papers.cfm?abstract_id =1689079 (“the claims against hedge funds have been disputed by portfolio managers and industry representatives on the grounds that their market transactions were relatively small compared to total trading activity.”); laurence fletcher, no hedge fund now poses systemic risk: ltcm partner, thompson rueters (june 1, 2009), http://www.reuters.com/article/2009/06/01/us-globeop-ltcm-idustre5505 4020090601 (quoting hans hufschmid, chief executive at a fund servicing firm and former long term capital management partner “i find it hard to believe — i don’t think a hedge fund today is big enough to pose a systemic risk.”). 85. e.g., anne rivière, the future of hedge fund regulation: a comparative approach: united states, united kingdom, france, italy, and germany 35, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1663553 (citing rama cont, amal moussa & andrea minca, too interconnected to fail: contagion and systemic risk in financial networks, working paper, columbia center or fin. engineering (2009) (“indeed, the failure of ltcm, a hedge fund worth $4 billion posed a systemic risk because of its exposure to banks, while the failure of amaranth, which was worth more than the double ($9.5 billion) had no systemic impact.”)). 86. dodd–frank wall street reform and consumer protection act, pub. l. no. 111-203, 124 stat. 1376, § 111 (establishment of the fsoc), §§ 112(a)(1)(a), (c) and (a)(2)(c) (2010). 87. id. at § 113(a)(2)(c). 88. id. at § 113(a)(2)(d). 89. id. at § 113(a)(2)(g). 666 florida tax review [vol. 11:8 factors in determining systemic risk that need to be looked at in addition to the size and scale of the activities of the company.90 in a recent g-20 commissioned study, the international monetary fund also determined that institutions that were interconnected, could impair financial markets regardless of their size.91 professor hal scott stated in his testimony before the u.s. senate committee on banking, housing and urban affairs about proposed rules that would prohibit certain holdings and proprietary trading by bank or bank owners, that “the absolute size of an institution is not the predicate for systemic risk; it is rather the size of its debt, its derivatives positions, and the scope and complexity of many other financial relationships running between the firm, other institutions, and the wider financial system.”92 a draft report by the fsoc that has not yet been publicly released as this article is being written allegedly states that hedge funds and private equity firms could pose a systemic risk to the financial system.93 since the collapse of long term capital management’s (ltcm) master fund in 1998, scholars have also alleged that hedge funds may have a role in systemic risk.94 ltcm was a hedge fund that financially failed following the russian 90. this is evidenced by the multi-faceted approach to defining “nonbank financial companies” that will be supervised and regulated by the federal reserve board of governors. see id. 91. staff of the international monetary fund and the bank for international settlements, and the secretariat of the financial stability board, systemically important institutions, markets and instruments (2009), http://www.imf.org/ external/np/g20/pdf/100109.pdf. 92. implications of the “volcker rules” for financial stability, hearings before the banking, housing, and urban affairs united states senate, 111th cong. 51 (2010) (prepared written statement of prof. hal scott). professor hal scott was testifying about the implications of the volcker rules for financial stability (volcker rules) and proposed size limitations on banks. the proposed volcker rules provide that “no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.” press release, white house, president obama calls for new restrictions on size and scope of financial institutions to rein in excesses and protect taxpayers (jan. 21, 2010). 93. rebecca christie & ian katz, hedge fund may pose systemic risk in crisis, u.s. report says, bloomberg (2011), http://www.bloomberg.com/news/ 2011-02-17/hedge-funds-may-pose-systemic-risk-in-crisis-u-s-report-says.html. this is pivotal finding because, as discussed, the fsoc has been designated the task of defining nonbank financial institutions that will be subject to supervision and oversight by the federal reserve board of governors. 94. see nicholas chan, mila getmansky, shane m. haas & andrew lo, systemic risk and hedge funds, in risks of financial institutions 235 (mark carey & rene stulz, ed., 2007). 2011] the global shadow bank 667 financial crisis in 1998.95 the major creditors participated in a $3.625 billion bailout that was organized by the federal reserve bank of new york to prevent a larger market disruption.96 federal reserve bank of new york president mcdonough, in his 1998 congressional testimony after the ltcm collapse, stated: [t]there was a likelihood that a number of credit and interest rate markets would experience extreme price moves and possibly cease to function for a period of one or more days and maybe longer . . . most importantly, this would have led to further increases in the cost of capital to american businesses.97 in fact, a study by the bank of france estimated that “17 banks would have collectively lost 3 to 5 billion dollars if ltcm hadn’t been bailed out.”98 if systemic risk is the collapse of an entire financial system that has effects on the real economy,99 what are some of the potential linkages between hedge funds and the real economy? one link is credit channels, or banks’ direct exposure to hedge funds.100 bank lending affects the real 95. roger lowenstein, genius failed: the rise and fall of longterm capital management 144–46 (2000). contra paul krugman, rashomon in connecticut: what really happened to long-term capital management?, slate (1998), http://www.slate.com/id/1908 (discussing ltcm’s failure to take into account the risk of temporary market-pricing irrationality). 96. frank partnoy, infectious greed: how deceit and risk corrupted the financial markets 261 (2003). 97. hedge fund operations: hearing before the h. comm. on banking and fin. servs., 105th cong. 18–19 (1998) (statement of william j. mcdonough). 98. rivière, hedge fund regulation, supra note 85, at 35 (citing tomas garbaravicius & frank dierick, hedge funds and their implications for financial stability, european central bank occasional paper no. 34 (2005), http://www.ecb.int/pub/pdf/scpops/ebocp34.pdf). 99. see supra note 77. 100. kambhu, schuermann & stiroh, hedge funds, supra note 11, at 7–8; rivière, hedge fund regulation, supra note 86, at 35–36; robert e. rubin, arthur levitt, alan greenspan & brooksley born (the president’s working group on financial markets), hedge funds, leverage, and the lessons of long-term capital management (1999), http://www.treasury.gov/resource-center/fin-mkts/documents/ hedgfund.pdf; g. a. walker, global capital flows: the recent report from the financial stability forum, l. bus. rev. am., winter/spring 2001, at 165; financial stability forum, update of the fsf report on highly leveraged institutions (2007), http://www.financialstabilityboard.org/publications/r_0705.pdf; chan, et al., systemic risk and hedge funds, supra note 94; benjamin s. bernanke, chairman, u.s. fed. res., remarks at the federal reserve bank of atlanta’s 2006 financial 668 florida tax review [vol. 11:8 economy,101 and hedge funds have a symbiotic relationship with banks.102 for example, banks may be exposed to hedge funds by selling various financial products to hedge funds.103 banks also may sell various prime brokerage services to hedge funds.104 as result there may be ramifications of hedge funds’ failures on interconnected banks with respect to credit channels.105 the idea is that if a hedge fund fails, a bank with significant exposure to that hedge fund may not be willing or able to extend credit to borrowers that otherwise would be qualified for such credit.106 further, markets conference (may 16, 2006), http://www.federalreserve.gov/ boarddocs/speeches/2006/200605162/default.htm; callum mccarthy, speech at suerf (dec. 7, 2006), http://www.fsa.gov.uk/page/library/communication/ speeches/2006/1207cm.shtml; phillipp hildebrand, hedge funds and prime broker dealers: steps toward a ‘best practice proposal,’ fin. stability rev., apr. 2007, at 68. 101. adam ashcraft, are banks really special? new evidence from the fdic induced failure of healthy banks, 95 am. econ. rev. at 1712, 1728 (2005) (“this paper has developed evidence that healthy-bank failures have significant and apparently permanent effects on real economic activity. while there are important caveats to keep in mind concerning the interpretation of pro forma failed bank balance sheets, much of this effect can be explained by a severe contraction of bank lending.”); see also kambhu, schuermann & stiroh, hedge funds, supra note 11, at 10 (citing ashcraft, id.) 102. chan et al., systemic risk and hedge funds, supra note 94, at 309. 103. traditional banks could, for example, sell loan portfolios as bonds to securitization vehicles (securitizations, conduits, structured investment vehicles (sivs), limited purpose finance corporations (lpfcs), collateralized loan obligations (clos), collateralized bond obligations (cbos), collateralized debt obligations (cdos), and specialist credit managers) that are in turn financed by investors (including hedge funds). gorton, questions and answers, supra note 83 at 9. 104. id. prime brokerage is a term used for a bundled package of services offered which may include lending securities, hedge fund start up services, clearance and custody of assets, portfolio reporting, branding and marketing, compliance, risk management and financing through margin loans and repurchase agreements. see kambhu, schuermann, & stiroh, hedge funds, supra note 11, at 4. 105. chan et al., systemic risk and hedge funds, supra note 94, at 309; rivière, hedge fund regulation, supra note 85 at 35–36; kambhu, schuermann & stiroh, supra note 11, at 11–12. 106. kambhu, schuermann & stiroh, hedge funds, supra note 11, at 11–12 (discussing that collateralizing these exposures may not be enough to mitigate against this risk because collateral values may fall. however, recognizing that banks’ current exposures are heavily collateralized and each bank has some interest in mitigating these risks). cf. rivière, hedge fund regulation, supra note 85, at 36 (stating the failure of amaranth didn’t have a “destabilizing effect because counterparties to these funds held sufficient collateral.”). 2011] the global shadow bank 669 affected banks could fail themselves or reduce liquidity they provide to other funds and banks, further disrupting financial markets and credit channels.107 in addition to banks’ direct exposure to hedge funds, scholars are also considering whether hedge fund difficulties could disrupt broader financial activity, affecting the capital markets and credit channels.108 some scholars suggest that hedge funds’ management incentive structure may lead managers to be risk-preferring and to provide inflated valuations which lead to distorted risk calculations by counterparties.109 the fact that many hedge funds are highly leveraged is also a concern.110 if these highly leveraged funds fail, they may be forced to sell positions at fire-sale prices, causing losses to counterparties.111 in addition, these losses could lead to additional defaults, and market participants who were not counterparties might be affected through price adjustments and increased market uncertainty if the failed fund held a large enough position in a particular market.112 the lack of transparency and complexity of certain financial instruments could make understanding who actually bears what risk more difficult, impeding a workout.113 finally, it is also currently being debated whether hedge funds may amplify the effects of a crisis in the ways that they respond to a crisis, 107. kambhu, schuermann & stiroh, hedge funds, supra note 11, at 13 (citing hyun song shin, risk and liquidity in a system context (bis working paper no. 212, 2006). 108. kambhu, schuermann & stiroh, hedge funds, supra note 11, at 13. 109. rivière, hedge fund regulation, supra note 85, at 37 (“the first one that needs to be mentioned is this inherent the conflict of interests that is posed by valuation. there is indeed a natural incentive to provide inaccurate, inflated valuation of the portfolio because the compensation of hedge fund managers is directly calculated based on this value. this can lead to distorted assessments by counterparties and clients and generate risk.”). 110. rubin et al., leverage, supra note 100, at 23 (“leverage allows an investor to take on higher risks, including those risks that are shed by others. thus, the leveraged exposure of investors with higher risk appetites can be a vehicle that allows a larger number of risk-averse investors to reduce their risks. while the leverage that supports the reallocation of risk provides benefits, it can be fragile. in a volatile market, high levels of leverage increase the likelihood that a leveraged entity will fail, in part because the size of potential losses can seriously deplete and even wipe out the entity’s net worth.”); chan et al., systemic rise and hedge funds, supra note 94 at 331 (“the use of leverage by hedge funds, however, raises the specter of financial market contagion and leaves open the question of whether markets are more robust than in the past or whether increased hedge fund participation has elevated the potential for financial market calamity.”). 111. benjamin s. bernanke, chairman, u.s. fed. res., remarks at the federal reserve bank of atlanta’s 2006 financial markets conference (may 16, 2006), http://www.federalreserve.gov/boarddocs/speeches/2006/200605162/default.htm. 112. id. 113. kambhu, schuermann & stiroh, hedge funds, supra note 11, at 3. 670 florida tax review [vol. 11:8 i.e., short selling transactions,114 and in the way their investors redeem their interests in the funds only after a lock-up period, potentially en masse.115 it is by no means settled that hedge funds create or increase systemic risk, since such a determination would require data that has not been compiled about foreign hedge funds, namely revealing counter party credit exposures, the net leverage of hedge funds, and the interconnectedness to banks. nevertheless, the potential for hedge funds to have a systemic impact is there. and if this is so, we should also be considering whether uncertainty in the federal income tax consequences of hedge fund lending transactions makes these funds more susceptible to failure or whether the uncertainty of the taxation of certain transactions could impede credit markets. the crux of the problem is that the irs might decide to enforce the mushy or non-existent u.s. trade or business precedent with respect to shadow bank transactions in a way that causes funds to recognize unexpected income for federal income tax purposes. we should then consider whether the potential imposition of tax at the highest tax rate, 35 percent, at any unexpected point, could increase the potential systemic risk with respect to funds failing or certain lending transactions being chilled, impeding credit markets. these offshore hedge funds gamble that the rules will be interpreted and applied in the way that their legal advisors think they will be. if they lose that gamble and are too interconnected to fail, will we all lose? this is something that we must consider. in fact, in late 2009 the office of chief counsel of the irs issued a memo to the director of field operations for financial services and stated: “we understand that foreign corporations and non-resident aliens may have used other strategies to originate loans in the u.s. giving rise to effectively connected income. we encourage you to develop these cases. . . .”116 114. brown, green & hand, systemically important?, supra note 84, at 19 (“[o]ur findings suggest that the real risk posed by hedge funds more likely concerns their ability to increase the severity or duration of a crisis, as opposed to initiating it.”); issing comm. of the group of twenty finance ministers and central bank governors, new financial order recommendation 5 (2009) (the issing committee in charge of preparing the london g20 meeting noted that “hedge funds played a role in crisis transmission, due to their strong reliance on bank financing and maturity mismatch. in the crisis, these characteristics contributed to pro-cyclical behaviors, in particular to deleveraging and asset sales, which had a negative impact on market liquidity.”). cf. high-level group on financial supervision, de laroisière report 24 (2009), http://ec.europa.eu/internal_market/finances/docs/ de_larosiere_report_en.pdf (the report concludes financial stability was not affected by the hedge fund industry). 115. rivière, hedge fund regulation, supra note 85, at 37. 116. chief couns. mem. preno-119800-09 (sept. 22, 2009). 2011] the global shadow bank 671 iv. the current uncertainty frustrates the very international tax policy objectives that this regime was enacted to promote if a u.s. person buys a debt instrument originally issued by a u.s. borrower, the u.s. person will generally have to pay federal income tax on the interest received on that debt instrument and on any gain realized upon sale.117 if a foreign person buys that same debt instrument, assuming certain conditions are met, the foreign person may not have to pay federal income tax on the interest received or on the gain realized upon sale.118 why does the u.s. tax a foreign person’s interest income and gain from the sale of a passive investment in the united states less than it taxes the same investment made by a u.s. person? this part will explore the tax policy reasons behind three seemingly generous provisions in the context of lending in the u. s.: (1) the exemption for a foreign person’s capital gains on sales that are not connected with a u.s. trade or business;119 (2) the exemption for “portfolio interest” received by foreign persons that are not connected with a u.s. trade or business; and (3) the safe harbor which allows foreign persons trading in debt securities for their own account to be eligible for items (1) and (2) above by treating the trading as a passive investment instead of an active u.s. business. the current uncertainty in whether a foreign person is engaged in a u.s. trade or business frustrates these very tax policy objectives. a. the tax policy behind the exemption for a foreign person’s capital gains on sale that are not connected with a u.s. trade or business the 1936 act established that foreign persons selling their passive investments would not be taxed on the resulting capital gains.120 the 117. i.r.c. §§ 61(a)(3) and (4), 1001. 118. this assumes that the interest income and profit on sale are not effectively connected with a u.s. trade or business. it also assumes that the portfolio interest exemption applies. i.r.c. §§ 871(h) & 881(c). see roger royse, rra ‘93 limits application of portfolio interest exemption, 79 j. tax’n 360 (1993); see also, alan i. appel, withholding net will now catch more debt arrangements, 4 j. int’l tax’n 464 (1993). 119. since u.s. source ordinary income is automatically treated as effectively connected to a u.s. trade or business, if there is one, pursuant to i.r.c. § 864(c)(3), i will focus on capital gains from sale in this article. 120. the revenue act of 1936, supra note 5, at §§ 211, 231 (creating an early version of the business versus passive distinction). foreign persons not engaged in a u.s. trade or business that did not have an office or place of business in the u.s. were subject to a gross-basis withholding tax at a flat rate on certain passive income (not including capital gains from sales). however, foreign persons that were 672 florida tax review [vol. 11:8 reasoning behind this exemption was two-fold. first, congress determined that these capital gains were administratively difficult to collect.121 second, it was thought that the exemption would result in additional revenue from taxes on u.s. brokers’ income.122 in other words, congress wanted to decrease collection difficulties and increase revenue by encouraging foreign persons to make these passive investments in the u.s., and the line that was drawn was that if these investments rose to the level of a u.s. trade or business, then the foreign person would be taxed like a u.s. person. b. the tax policy behind the enactment of the exemption for “portfolio interest” received by foreign persons that is not connected with a u.s. trade or business generally a foreign person receiving “portfolio interest”123 is not taxed on that interest if it is not effectively connected with a u.s. trade or business and certain other conditions are met.124 congress enacted the portfolio interest exemption in 1984.125 its main rationale was to allow u.s. persons access to financing abroad at a lower cost.126 it was thought that if engaged in a u.s. business or had an office or place of business in the u.s. were subject to a net-basis income tax at rates that applied to u.s. persons on all of their u.s. source income. immediately prior to the 1936 act, foreign persons were generally subject to an annual tax on their net income received from all u.s. sources and a gross-basis withholding tax on certain u.s. source passive income with the possibility of deductions and credits if an income tax return was filed. see revenue act of 1916, ch. 463, §§ 1, 10, 39 stat. 756, 765; see also, revenue act of 1918, ch. 18, §§ 217, 221(a), 221(d), 237, 40 stat. 1057, 1069–73, 1080. see also, sicular & sobol, effectively connected income, supra note 64, at 722. 121. h.r. rep. no. 74-2475, at 9, 21 (1936). 122. id. 123. portfolio interest for this purpose includes most interest received from unrelated borrowers by taxpayers other than banks. the exemption does not apply to foreign banks (except for u.s. government debt), to foreign corporations that are 10 percent shareholders of the u.s. debtor, or to interest received by certain foreign corporations from a related person. i.r.c. § 881(c). in addition to the exemption on certain portfolio interest, interest on bank deposits are also exempted from the withholding tax under the code and many tax treaties exempt treaty country residents from u.s. tax on interest income not attributable to u.s. permanent establishments. i.r.c. §§ 871(i)(2)(a), 871(i)(3), and 881(d). 124. id. 125. deficit restoration act of 1984, pub. l. no. 98-369, § 127, 98 stat. 494 (1984). 126. staff of the joint comm. on tax’n, 98th cong., general explanation of the revenue provisions of the deficit reduction act of 1984, 391–94 (comm. print 1984). 2011] the global shadow bank 673 the exemption were not enacted u.s. borrowers would be at a competitive disadvantage against borrowers from other countries.127 congress was concerned with the eurobond market in particular.128 the eurobond market is a network of underwriters and financial institutions that market bonds issued by private parties and other borrowers. a u.s. borrower’s borrowing cost is typically higher to the extent that foreign lenders require that payments be grossed up for the lender’s u.s. withholding tax.129 before the portfolio interest exemption, u.s. borrowers often borrowed in the eurobond market through finance subsidiaries organized in the netherlands antilles to avoid u.s. withholding taxes on interest payments.130 the netherlands antilles imposed no taxes on interest paid by the subsidiary to the foreign lender, and this interest was assumed to be exempt from u.s. withholding tax as foreign source income. interest paid by the u.s. borrower to the netherlands antilles subsidiary was exempt from u.s. tax under an income tax treaty.131 these structures increased borrowing transaction costs to u.s. borrowers and probably provided incomplete access to the eurobond market for u.s. borrowers because of the structural planning and because the irs challenged some of these structures.132 in addition, the legislative history provides that the portfolio interest exemption was enacted to achieve an overall gain to the economy by expanded investment, improved u.s. balance of payments, and resulting expansion in earnings and employment because of stimulation to investment banks, brokerage firms, and commercial banks.133 in addition, congress thought the revenue lost would be minimal because the tax rate on interest payments made by u.s. borrowers to foreign lenders was often reduced by treaty and there would potentially be increased foreign investment and thereby increased revenue from the additional economic activity.134 there was a fear that if the exemption were not enacted, some foreign persons would not invest in debt securities in the u.s.135 finally, the costs of collecting taxes attributable to interest paid to foreign persons was thought to be high.136 127. id. 128. id. 129. id. 130. id. 131. id. 132. id. 133. id. 134. id. 135. id. 136. id. 674 florida tax review [vol. 11:8 c. the tax policy behind the enactment of the safe harbor for trading in securities for one’s own account as discussed above, there is a safe harbor for foreign persons trading and not dealing in stock and securities (including debt securities) for their own account.137 if this safe harbor for trading in securities for one’s own account is met, certain trading in stock and securities will not be considered a u.s. trade or business for this purpose.138 the legislative history is sparse on the reasons for enacting an early version of the safe harbor (providing that this provision was added to “clarify” what it meant to be “engaged in trade or business in the u.s.”).139 the early version of the safe harbor enacted in 1936 raised many questions. it seemed clear that owning stocks, securities, or commodities for investment was covered by the 1936 safe harbor and did not constitute a u.s. business.140 it also seemed clear that “dealing” in stocks, securities, or commodities was not covered by the 1936 safe harbor.141 however, the 1936 safe harbor resulted in considerable litigation over hazy distinctions between these two boundaries.142 in 1966, the foreign investors tax act revised the safe harbor enacted in the 1936 act. in discussing the reasons for the provision, the house report identifies that there was some confusion as to the application of the safe harbor under the 1936 act and further states that “the confusion . . . may have acted to deter some foreign investment in the united states.”143 further in 1963, president kennedy appointed a task force on “promoting 137. see supra note 34. 138. there is another safe harbor for trading in stocks or securities through an independent agent but not through an office of fixed place of business in the u.s., hereinafter referred to as the independent agent safe harbor. most foreign hedge funds would not be able to argue that they are trading through an independent agent since their investment advisors in the u.s. routinely take a twenty percent profit interest in the fund as a general partner. since most foreign hedge funds argue that much of what they do with regard to debt transactions falls under the securities trading safe harbor, i will not focus on the independent agent safe harbor. i.r.c. § 864(b)(2)(c). 139. s. rep. no. 74-2156, at 21–22 (1936); see also, sicular & sobol, effectively connected income, supra note 65, at 726. 140. higgins v. commissioner, 312 u.s. 475, 478 (1941) (passive investment activity, including making deposits and keeping records, in relation to securities investments cannot convert investment into a trade or business). 141. see james sitrick, u.s. taxation of stock and securities trading income of foreign investors, 30 j. tax’n 98, 98–99 (1969); joseph isenbergh, the “trade or business” of foreign taxpayers in the united states, 61 taxes 972, 980 (1983). 142. see also sicular & sobol, effectively connected income, supra note 64, at 726–27. 143. id. 2011] the global shadow bank 675 increased foreign investments in u.s. corporate securities and increased foreign financing for u.s. corporations operating abroad.”144 the task force concluded that “the most immediate and productive ways to increase the flow of foreign capital” to the united states would be to adjust the laws concerning the taxation of foreign persons.145 in describing the purpose and background of the bill, the legislative history cites both the task force report and the treasury department’s subsequent proposed tax legislation designed to increase foreign investment in the united states.146 the legislation was proposed as part of president kennedy’s “program to improve the u.s. balance of payments.”147 the bill’s stated primary object was the “equitable tax treatment by the united states of nonresident aliens and foreign corporations” while recognizing that the initial bill proposed by the treasury department was designed primarily to stimulate investments by foreigners in the u.s.148 d. the current uncertainty is economically inefficient, adds to the deadweight loss of taxation, and frustrates the tax policy objectives the regime was enacted to implement some level of certainty is desirable for taxpayers to be able to structure their affairs. i do not weigh in on whether a rule (e.g., louis kaplow’s example of a rule: “driving in excess of 55 mph” is prohibited) or a standard (e.g., louis kaplow’s example of a standard: “driving at an excessive speed” is prohibited) would be more beneficial in this area. what i do contend is that whether policymakers choose a rule or a standard, such rules or standards should be written with today’s complex shadow banking transactions in mind. in other words, uncertainty should not stem from the fact that the laws are too old to keep up with society’s financial innovation. since most of the relevant law was written before these complex shadow banking and debt transactions were contemplated, practitioner-developed rules have arisen in response to the uncertainty in the area.149 these rules are constantly shifting because each practitioner has different standards to get to the “should” or “will” opinion that their client seeks, and each client is 144. see h.r. rep, no. 89-1450, at 26; s. rep. no. 89-1707, at 9–10. 145. task force on promoting increased foreign investment in united states corporate securities and increased foreign financing for united states corporations operating abroad, report of the president 21 (1964) (commonly known as the “fowler task force report”). 146. see h.r. rep, no. 89-1450, at 26. 147. id. 148. id. 149. see louis kaplow, rules versus standards: an economic analysis, 42 duke l. j. 557 (1992). 676 florida tax review [vol. 11:8 willing to accept varying levels of risk on where the lines are drawn.150 some foreign hedge funds live with this uncertainty, spending tremendous amounts of time and money to poll various practitioners and those in the industry for a consensus of how far they can go before crossing the line. others restrict their own activities, potentially affecting the extent to which foreign capital is invested in the united states. these constantly changing, non-uniform, standards are economically inefficient. in other words, hedge funds that would have more actual marginal benefit than marginal cost may not be purchasing debt securities because they are risk averse to the tax uncertainty while hedge funds that have more actual marginal cost than marginal benefit may still be buying the debt securities because of a willingness to take risks with respect to the tax uncertainty. this occurs because their marginal cost in terms of u.s. federal income taxes payable is somewhat of a gamble in terms of how much activity will constitute a u.s. lending business and thereby lead to a hefty tax bill. society loses with respect to this market inefficiency tweaking the supply and demand of these debt products. there is deadweight loss in this context, or a loss to society due to the reduction in the sales of the debt securities because of the tax uncertainty that is not captured by government revenue. there is also the risk that those hedge funds that are risk–taking with respect to the tax uncertainty will subsequently find an unexpected tax liability, which leads us to again ask the questions about systemic risk if these risk takers are interconnected enough. in addition, society loses with respect to the time and money hedge funds spend in procuring practitioner driven standards. those resources could be used in a more economically productive way. the policy rationale for the three rules described above can be summed up by stating that they were enacted because collection of the corresponding taxes was difficult and to encourage foreign financial investment in the united states.151 uncertainty in these tax laws may frustrate the objective of encouraging foreign financial investment in the u.s. the legislative history of the securities trading safe harbor specifically discusses that the confusion in the application of the early version of the safe harbor “may have acted to deter some foreign investment in the united states.”152 the confusion of the current rules may be doing the same thing here at a time in which the u.s. desperately needs more liquidity. clearly a foreign person considering whether or not to invest in the united states must calculate the extent to which an investment would 150. see sicular & sobol, effectively connected income, supra note 64, at 778. 151. see supra parts iv(a)–(c). 152. see supra note 144. 2011] the global shadow bank 677 generate u.s. tax liability. if the foreign person is subject to substantial income tax in its home country, this inquiry may not be so important since its home country may allow the investor a tax credit for u.s. taxes paid. however, many potential foreign investors are subject to minimal tax in their home country on income from u.s. investments, which makes the determination of u.s. tax liability key in deciding where to invest funds. v. conclusions, suggestions, and moving forward the issue of where to draw the u.s. trade or business line is and always has been a difficult one because of competing tax policy considerations.153 proponents for a u.s. trade or business rule or standard that is more generous to foreign persons may argue, among other things that: • the united states should attract foreign investment to keep the united states productive and help with the unemployment rate. • revenue loss would be small because tax rates are already reduced by treaty, and an increase in foreign investment will increase economic activity and thereby overall u.s. tax revenue. • there are considerable costs to collection from foreign funds, and a strict standard would lead foreign funds not investing in debt securities in the u.s. • u.s. borrowers would be at a competitive disadvantage against borrowers from other countries. proponents for a u.s. trade or business rule or standard less generous to foreign persons may argue, among other things that: • u.s. investors are subject to higher u.s. taxes on the same passive investments. • u.s. bargaining power in taxation treaties would be diminished if we were generous with all countries. • the united states could become a tax haven. • foreign investment will not necessarily increase if there is a race between countries to the most generous or if foreign persons are merely paying the foregone u.s. tax to their home countries. 153. see generally david a. weisbach, line drawing, doctrine, and efficiency in the tax law, 84 cornell l. rev. 1627, 1649–51 (1999). 678 florida tax review [vol. 11:8 in addition, there may be special considerations that policymakers want to consider given the current need for liquidity in the u.s. following the recent financial crisis.154 irrespective of which direction policymakers choose on the substantive question of what rises to the level of a u.s. trade or business, or if that should even be the relevant inquiry, i posit that given the complex form of shadow bank transactions between foreign persons and their u.s. affiliates/lead lenders, whatever standards or rules are adopted should get to the substance and not merely the form of the transactions. in other words, if the relevant inquiry is to what extent a foreign person originated loans, the inquiry should not be centered on how close foreign persons get to loan origination in form but how close a foreign person gets to loan origination in substance — perhaps focusing on who actually bears the risk of making these loans at origination. for example, the following deal terms could be relevant in such an inquiry: whether there was a forward commitment allowing the foreign fund to get out if the borrower collapsed financially; the extent to which the foreign person drives the original loans through negotiations with the borrower or with the lead lender; the extent of oversight by the foreign fund over the syndicate negotiating with the borrower; whether there seems to be an established “seasoning” period; and who bears the risk of market fluctuations during that period. (to determine who bears market risk, we could consider whether during that seasoning period there are any equalizing trades between u.s. funds and foreign funds, and at the end of the seasoning period is the purchase price based on the fmv at the time of the original loan or at the end of the seasoning period. i acknowledge that any approach that gets to the substance of these deals would be difficult to implement and enforce with the current lack of transparency regarding these transactions and foreign funds. that is precisely why i suggest that before we decide where the u.s. trade or business line should be or even what the relevant inquiry should be, we need to look at what information the irs has access to about these foreign funds and their transactions and to perhaps additional or new information gathering tools needed to appropriately tax these shadow bank transactions. currently, foreign hedge funds that receive interest from u.s. borrowers on debt securities merely provide u.s. persons with a form certifying their foreign status and claiming the portfolio interest exemption described above.155 foreign persons who do not have income that is effectively connected with a 154. e.g., john g. gaine, irs tax correspondence apr. 9, 2008, managed funds group suggests ways to alleviate liquidity crises in u.s. capital markets, 34 ins. tax rev. 1181 (june 1, 2008). 155. i.r.s. form w-8ben (2006). 2011] the global shadow bank 679 u.s. trade or business do not generally have to file a u.s. tax return.156 clearly, without more information from the foreign funds, investment advisors, and counterparties to the transactions, any approach that gets to the substance of these deals would be impossible. given recent legislative developments both in taxation and in the regulation of nonbank financial institutions, there are a few new options to consider with respect to giving the irs the tools it needs to implement any kind of substantive approach in this area. first, perhaps we should look to the fatca provisions of the hire act as an example of a mechanism for information gathering from foreign funds.157 starting on january 1, 2013, a “foreign financial institution” must enter into an agreement with the u.s. department of treasury or it will be subject to a 30 percent withholding tax that will be imposed on payments to it of, among other things, u.s. source interest and the proceeds from the sale of property that produces u.s. source interest or dividends.158 the objective behind this is to track down u.s. persons who are attempting to evade u.s. taxes by using offshore accounts and vehicles.159 most foreign hedge funds and foreign blocker corporations would have to disclose certain information about any u.s. beneficial owners or face a withholding tax on certain u.s. source income.160 156. upon receipt of interest payments from u.s. borrowers they would merely need to submit form w-8ben essentially stating they are a foreign person. id. 157. see supra note 9. 158. i.r.c. § 1472. this is not an additional tax, however, if a foreign financial institution fails to provide the agreement with the u.s. treasury and gets withheld against, such institution would not be entitled to a refund of this amount even if the income qualified for a an exemption from general withholding (i.e., the portfolio interest exception). 159. see supra note 9. 160. i.r.c. § 1472(d) broadly defines a “foreign financial institution” to include any foreign entity that (i) accepts deposits in the ordinary course of a banking or similar business, (ii) holds financial assets for the account of others as a substantial portion of its business, or (iii) is engaged (or holds itself out as being engaged) primarily in the business of investing, reinvesting or trading in financial assets (including securities, partnership interests, commodities, or any interest in such securities, partnership interests or commodities). notice 2010-60 provides guidance on this statutory definition and indicates that a “business” for fatca purposes is much broader than generally for federal income tax purposes. therefore, in addition to foreign investment and commercial banks and foreign insurance companies, most foreign hedge funds, foreign “blocker corporations,” foreign collateral debt obligation issuers, foreign private equity funds, and other foreign securitization vehicles that are mere “investors” in securities or commodities are likely to be treated as engaged in a business for purposes of fatca and may be treated as “foreign financial institutions” that must enter into an agreement with the 680 florida tax review [vol. 11:8 historically, it has been difficult to collect taxes from foreign persons.161 the mechanism that the fatca provisions use is withholding — i.e., u.s. borrowers that pay interest to a foreign fund would have to retain 30 percent of that interest and pay it over to the irs if the foreign fund failed to comply with the fatca provisions. the u.s. withholding agent has a strong incentive to comply with its fatca withholding obligation because if it wrongfully fails to withhold, it is liable for this amount.162 furthermore, a foreign fund could face this 30 percent withholding tax even if the portfolio interest exemption or another exemption applied to the income in question. in other words, foreign funds that continue to invest in the u.s. will likely have to jump through this hoop for their transactions to be profitable enough to enter into. we should consider whether it makes sense to also, potentially in these very same agreements with the u.s. treasury, obtain information that could help implement and enforce substantive rules or standards in the taxation of the foreign funds themselves and not just in an attempt to corral the u.s. investors in these funds. the second avenue to consider is that investment advisors and foreign funds may already be facing additional disclosures in another arena as well — regulation reporting and disclosures under the dodd–frank act. the private fund investment advisors registration portion of the act163 requires investment advisors to maintain and be subject to securities and exchange commission inspection of the following records for each private fund it advises: assets under management; use of leverage; counterparty credit risk exposure; trading and investment positions; valuation policies and practices; types of assets held; and any other information deemed necessary by the sec, in consultation with the financial stability oversight council.164 while these disclosures may not reach all of the foreign persons that the irs would need to examine to implement substantive rules or standards in this are because of the definition of “private fund” and a limited exemption for “foreign private advisers,” it is worth considering whether there is now, and whether by design there should be, any overlap in the usage of these reports and disclosures. the dodd–frank act requires that the sec and fsoc u.s. treasury department or be subject to the withholding provisions. any foreign financial institution that is more than 50 percent owned by a foreign financial institution or is greater than 50 percent commonly owned with the financial institution is considered part of the same “expanded affiliate group” as the foreign financial institution and is subject to the same reporting and withholding requirements. thus, if a foreign financial institution enters into an agreement with the u.s. treasury department, all other foreign financial institutions that are also members of the expanded affiliate group are required to comply with the agreement. 161. see supra parts iv(a)–(c). 162. i.r.c. § 1474. 163. pub. l. no. 111-203, § 401 et seq., 124 stat. 1376 (2010). 164. id., at § 404(b)(3). 2011] the global shadow bank 681 maintain confidentiality of any private fund information they collect; however, such information may be disclosed to “any government agency or self-regulatory organization requesting the information for purposes within the scope of its jurisdiction.”165 if we, as a nation, are potentially requiring investment advisors (and, for that matter, systemically significant nonbank financial institutions) to report and disclose information about foreign funds, it is worth considering whether these disclosures could help fix other harmful ambiguities in dealing with global shadow bank transactions, such as how these transactions by foreign funds should be taxed in the u.s., and, if the tax uncertainty in this area potentially increases systemic risk, a proposition that in section iii, i contend should be considered, perhaps using dodd–frank related disclosures to help fix this area of the tax law actually does go hand in hand with the dodd–frank act’s stated purpose “[t]o promote the financial stability of the united states by improving accountability and transparency in the financial system.”166 much of the rulemaking and implementation of the ideas in the dodd–frank act are still being fashioned by regulators (the sec, fsoc, the commodity futures trading commission, and the board of governors of the federal reserve system) as this is being written. i do not weigh in, at least in this article, on the very important issues of the extent and degree of financial regulation. i merely suggest that we should consider whether systemic risk to the u.s. financial system can be increased via tax uncertainty within the interconnected web of global shadow bank transactions and thereby whether the disclosure and reporting regimes currently being fashioned to “promote financial stability” could or should be utilized to help fix this area of the tax law. there are competing policy considerations with either of these avenues that clearly need more study. with respect to both using the fatca provisions and the dodd–frank act disclosure and reporting regime, we must consider whether requiring information for this purpose could chill investment and liquidity creation in the u.s. nevertheless it seems that our policymakers are surging ahead in requiring disclosures from foreign financial institutions for the purposes of financial stability generally and tracking down u.s. evaders of u.s. tax. with respect to the dodd–frank act disclosure and reporting, another consideration is whether using information disclosed for taxation purposes would hamper the candidness of information disclosed for systemic risk purposes. these issues clearly need more study and consideration. foreign funds would prefer to stay off of regulators’ and the irs’s radar entirely. obviously after the hire and dodd–frank acts this is not likely. we are entering a new era of regulation and disclosure. it’s time to 165. id., at § 404(c). 166. id., at preamble. 682 florida tax review [vol. 11:8 face the global shadow banking system, both with respect to how we want to regulate it and with respect to how we want to tax it. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe tcharity really does begin at home: florida tax review volume 10 2010 number 5 375 the myth of realization: mark-to-market taxation of publicly-traded securities by david elkins* i. introduction ............................................................................. 376 ii. realization ................................................................................ 378 a. liquidity ............................................................................ 379 b. validation .......................................................................... 381 c. the realization principle ................................................. 381 d. publicly-traded securities ................................................ 383 iii. practical advantages of accrual taxation ................. .384 a. economic effects of deferring tax until realization....... 384 b. tax planning under a realization regime ....................... 388 c. deduction losses .............................................................. 396 iv. counterarguments ................................................................. 400 a. possibility of future depreciation .................................... 400 b. psychology and public opinion ........................................ 401 c. taxing stock market gain differently than gain from other assets ............................................................ 401 d. the possibility of combining realization with an interest charge for deferral ............................................. 405 v. conclusion ................................................................................. 406 * senior lecturer and distinguished teaching fellow, netanya college school of law, israel; visiting professor of law, smu dedman school of law; ll.b. hebrew university of jerusalem 1982, ll.m. bar-ilan university 1992, ph.d. bar-ilan university 1999. i would like to thank christopher hanna for his helpful comments. 376 florida tax review [vol. 10:5 i. introduction in the greco-roman world, touching right hands as a greeting demonstrated that one was weaponless and contributed to a more convivial atmosphere.1 in medieval europe, warriors grasped the right hand of their adversaries during a truce as a precaution against treachery. similarly, when greeting a friend, a knight would extend an ungloved right hand as a token of confidence in the peaceful intentions of his comrade.2 a handshake is still the traditional form of greeting. it continues to denote friendship, or at the least a lack of hostile intent, even though the circumstances in which it arose may no longer be relevant. like the handshake, legal rules and concepts ofttimes survive the situations that fostered their adoption. originally developed as means to contend with certain conditions, they can acquire a life of their own and be applied, out of habit or inertia, even where there is no justification for their existence. however, unlike the innocuous handshake, blindly applying rules and concepts in situations other than those with which they were developed to contend can be counterproductive. in the field of income tax, one of those rules and concepts is the doctrine of realization. although a serious deviation from the pure concept of income, it was adopted nonetheless as a means of contending with practical difficulties inherent in taxing appreciation of assets held by the taxpayer. however, the doctrine of realization continues to be applied even in situations in which there is no practical impediment to imposing tax on appreciation as it accrues. for example, gain from appreciation of publiclytraded securities could easily be taxed as those securities appreciate in value. however, so strong a grip does the doctrine of realization have on the minds of both policymakers and the public that the tax system tenaciously applies the realization doctrine to gain from publicly-held securities.3 the thesis of 1. it has been noted that the right-hand touch was promoted by none other than julius caesar. being left-handed, caesar could thus obtain an advantage by concealing a weapon in his dominant hand. melissa roth, the left stuff: how the left-handed have survived and thrived in a right-handed world 28 (2005). 2. leopold wagner, manners, customs, and observances: their origin and significance 102 (1995). in the orient, the traditional greeting is a bow, not the shaking of hands. it is interesting to speculate that perhaps, where unarmed martial arts were commonly practiced, extending one’s right hand was not considered a friendly gesture. instead, one bowed from a safe distance. 3. as noted by francis bacon: “people usually think according to their inclinations, speak according to their learning and ingrained opinions, but generally act according to custom.” quoted in jean-françois quéguiner, the principle of distinction: beyond an obligation of customary international humanitarian law, in 2010] the myth of realization: mark-to-market taxation 377 this essay is that, for purposes of income tax, publicly-traded securities should be marked to market, with gain or loss recognized as it accrues and not deferred until realization.4 this thesis is based on a theoretical analysis of the realization doctrine and on the practical advantages of taxing gain from publicly-traded securities as they accrue. part ii will examine the realization doctrine from a theoretical perspective as a deviation from the accepted definition of income. its adoption is required when it is impractical to tax gain as it accrues.5 however, when circumstances allow the application of fundamental principles there is no justification to defer accounting for the gain just because the taxpayer has chosen to continue holding the asset. part iii will explore the practical advantages of imposing tax on gain from publicly-traded securities on an accrual basis. part iii.a. discusses the economic effects of the alternate tax regimes. it will explain how deferring tax until realization can cause economic resources to be diverted from their most efficient uses and can contribute to the volatility of the stock market. on the other hand, mark-to-market taxation interferes to a lesser extent with the free flow of economic resources and may actually constitute a factor in the legitimate use of military force: the just war tradition and the customary law of armed conflict 161, 161 (howard m. hensel ed., 2008). 4. for previous discussions of similar themes, see john p. bransfield, proposal to change the federal income taxation of marketable securities, 2 hous. bus. & tax l.j. 328 (2002); samuel d. brunson, taxing investors on a mark-tomarket basis, 43 loy. l.a. l. rev. 507 (2010); eric d. chason, naked and covered in monte carlo: a reappraisal of option taxation, 27 va. tax rev. 135 (2007); daniel halperin, saving the income tax: an agenda for research, 77 tax notes 967 (1997), reprinted in 24 ohio n.u. l. rev. 493 (1998); timothy hurley, “robbing” the rich to give to the poor: abolishing realization and adopting markto-market taxation, 25 t.m. cooley l. rev. 529 (2008); mark l. louie, note, realizing appreciation without sale: accrual taxation of capital gains on marketable securities, 34 stan. l. rev. 857 (1982); deborah l. paul, another uneasy compromise: the treatment of hedging in a realization income tax, 3 fla. tax rev. 1 (1996); clarissa potter, mark-to-market taxation as the way to save the income tax—a former administrator’s view, 33 val. u. l. rev. 879 (1999); david j. shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. 1111 (1986); david slawson, taxing as ordinary income the appreciation of publicly held stock, 76 yale l.j. 623 (1967); david a. weisbach, a partial mark-to-market system, 53 tax l. rev. 95 (1999). 5. it should be emphasized that the essay will proceed from the assumption that gain from publicly-traded securities will continue to be taxed under an income tax. when the tax base is consumption, realization loses its significance. william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1131 (1974) (“the problems of defining realization and prescribing nonrecognition would obviously disappear under either a true accretion-type or a pure consumption-type tax.”); louie, supra note 4, at 861 n.18. 378 florida tax review [vol. 10:5 mitigating stock market volatility. part iii.b. considers tax planning strategies that attempt to exploit the realization doctrine in order to avoid or minimize tax liability. part iii.c. discusses the deduction of losses. it will show that the serious restrictions imposed on the deduction of capital losses, limitations that contract the ideal of a tax imposed on accession to wealth and are the source of both inequity and economic inefficiency, are a direct consequence of the realization doctrine and are unnecessary under an accrual tax regime. thus, mark-to-market taxation would allow unrestricted deduction (or a freely usable credit in lieu) of capital losses from the holding of publicly-traded securities. part iv will contend with arguments in favor of retaining the realization rule for publicly-traded securities. part iv.a. considers the claim that unrealized gain should not be taxed because of the possibility that the value of the security will decrease in the future, erasing some or all of the already-reported gain. part iv.b. will discuss the effect of prevailing public opinion that “paper gain” is not an appropriate subject for taxation. part iv.c. will examine the argument that taxing publicly-traded securities on an accrual basis while other gain is taxed only at realization would create a disequilibrium in the tax structure and that the negative consequences of such a disequilibrium would overwhelm the positive consequences of mark-tomarket taxation. part iv.d. will consider the argument that it is possible to achieve results similar to those obtainable through mark-to-market taxation without abandoning the realization doctrine. part v will summarize the findings. ii. realization in accordance with the theoretical definition as formulated by robert haig and henry simons, “income” is the sum of (a) the value of the taxpayer’s consumption during the period of assessment and (b) the change—whether positive or negative—in the net value of her assets.6 change in net value of assets includes change due to appreciation of those assets. nevertheless, although the owner of property experiences an accession to wealth—and thus “income” in the haig-simons sense of the term—at the time that property appreciates in value, gain is not ordinarily 6. robert murray haig, the concept of income—economic and legal aspects, in the federal income tax 1, 7 (robert murray haig ed., 1921); henry calvert simons, personal income taxation: the definition of income as a problem of fiscal policy 50 (1938). there are those who claim that the originator of the concept was the german economist georg von schanz in an article published toward the end of the nineteenth century, georg von schanz, einkummenbergriff und die eindommensteugesetz, 13 finnanz-archiv 1 (1896), and that the definition should be referred to as the schanz-haig-simons definition. see, e.g., stanley s. surrey & paul r. mcdaniel, tax expenditures 4 (1985). 2010] the myth of realization: mark-to-market taxation 379 taxed until the property is sold or exchanged. the classic reason for deferring taxation on unrealized appreciation is that an attempt to tax unrealized gain would encounter the twin problems of liquidity and evaluation. a. liquidity problems of liquidity arise when accession to wealth is not accompanied by a receipt of liquid assets. in such a situation, the taxpayer, despite being economically better off, may not have access to cash with which to pay the tax. it might seem that liquidity problems should not present an impediment to imposition of tax. facing a tax bill resulting from the appreciation of property, a taxpayer who does not have cash available can sell the appreciated property.7 furthermore, such a forced sale would actually conform to the principles of horizontal equity. the situation of one who does not have the cash to pay tax on appreciation of property and who is forced to sell to pay the tax is similar to the situation of one whose pre-tax income is enough to purchase that same property, but whose post-tax income is insufficient. in both cases, the tax is what prevents the taxpayers from having the property. there is no substantive difference between a tax that prevents the purchase of property and a tax that requires its sale. taxing only realized gain means, in effect, that those holding on to appreciated property can finance their investment using pretax dollars, while new purchasers must finance their investment using post-tax dollars.8 7. another way to raise the funds necessary to pay the tax without selling the property is to borrow the necessary funds. as collateral, the taxpayer could pledge the appreciated property: as long as the tax rate is less than 100%, the property will be necessarily worth more than the tax liability. nevertheless, this solution is problematic. property that is not easily marketed is not easily borrowed against. an obvious example is human capital. a less extreme case is pension rights. when the property is speculative, leveraging the investment increases the level of risk of holding the asset. andrews, supra note 5, at 1143. the taxpayer may not be willing to incur the additional risk. furthermore, taxpayers may be reluctant to invest in speculative assets if they know that the tax system might force them to increase the level of risk in the future. in effect, the choice is between imposing the burden of financing the tax on the unrealized appreciation on the taxpayer or on the government. zelinsky argued that imposing the burden on the government is preferable as its borrowing costs are presumably lower. edward a. zelinsky, for realization: income taxation, sectoral accretionism, and the virtue of attainable virtues, 19 cardozo l. rev. 861, 889–91 (1997). 8. refraining from taxing unrealized gain violates not only horizontal equity but also vertical equity as capital gain is heavily concentrated among the wealthier segments of the population. see, e.g., slawson, supra note 4, at 629–31. for example, in 2007, the top 1% of the population owned 42.7% of the financial wealth in the united states, while the bottom 80% owned a total of 7%. g. william 380 florida tax review [vol. 10:5 nonetheless, liquidity is routinely touted as an obstacle to the taxation of unrealized gain. the possible reasons are as follows: 1. sentimental attachment the holder of an asset may develop a sentimental attachment to that asset, so that for the person concerned the asset has added value beyond the objective economic value. obvious examples include a home, a wedding ring, and a family heirloom. a person may develop a sentimental attachment not only to “personal” assets, but also to “commercial” assets such a business that the taxpayer has built up over a period of years. one who is forced to sell such property in order to pay tax on its appreciation is not in the same position as one who is unable to purchase the property, as the forced sale could involve significant psychological costs.9 2. marketability not all assets are marketable. examples include goodwill, pension rights, and human capital. imposing tax on the appreciation of these assets domhoff, wealth, income, and power (2005), http://sociology.ucsc.edu/whorules america/power/wealth.html. 9. the notion that forcing a sale is more traumatic that preventing a purchase is particularly significant in the public discourse regarding property taxes. whether or not it has any basis in economic theory, the idea that people should not be forced to sell property in order to pay their property tax is widespread. as noted by radin: “the successful argument in recent tax limitation initiatives has been the appeal to save longtime homeowners from losing their homes because of property tax increases.” margaret jane radin, reinterpreting property 228 (1993). see also nordlinger v. hahn, 505 u.s. 1 (1992), upholding the constitutionality of california’s proposition 13, which bases property tax assessment on the value of property at the time of purchase and, as a consequence, during periods of rising property values places a much greater tax burden on more recent purchasers: a new owner has full information about the scope of future tax liability before acquiring the property, and if he thinks the future tax burden is too demanding, he can decide not to complete the purchase at all. by contrast, the existing owner, already saddled with his purchase, does not have the option of deciding not to buy his home if taxes become prohibitively high. to meet his tax obligations, he might be forced to sell his home or to divert his income away from the purchase of food, clothing, and other necessities. in short, the state may decide that it is worse to have owned and lost, than never to have owned at all. id. at 13 (emphasis added). 2010] the myth of realization: mark-to-market taxation 381 could force a taxpayer into bankruptcy even though she is solvent in the sense that the value of her assets is greater than the amount of her liabilities. 3. transaction costs other assets, although marketable in principle, cannot be sold without incurring significant transaction costs. for example, consider the land upon which a business is located. abandoning the realization principle would require the owner each year to pay the government its share of any appreciation in the value of the land. if the necessary funds were not available, the owner might be forced to sell the land and move the business elsewhere, along with all that such a move would entail—locating substitute property, perhaps assembling a new workforce, building up new clientele, and so forth. economic resources would be wasted, to the detriment of both the taxpayer individually and the economy as a whole. it should be added that the imposition of tax on unrealized appreciation might dissuade taxpayers from investing in assets which cannot easily be converted into cash. the fear itself could prevent economic resources from being directed to their most efficient uses. b. valuation unrealized gain cannot be taxed without periodic valuation of assets.10 such a tax regime would require taxpayers, their advisors, the government, and the courts to devote considerable resources to property valuation, and even then there is no guarantee that the evaluation arrived at would equal the actual economic value of the asset. it is highly doubtful whether the advantages of accrual taxation are worth the cost.11 furthermore, for certain assets—such as goodwill or human capital (i.e. capitalized future earning power)—any attempt to quantify their value is an exercise in futility. c. the realization principle due to the problems of liquidity and valuation, the taxation of gain is typically deferred until the asset is sold. at that point, it is no longer necessary to estimate the value of the asset. in addition, as the taxpayer 10. see, e.g., louie, supra note 4, at 865. 11. as examples of taxes requiring asset valuation, zelinsky mentions the estate tax and property taxes. he claims that the degree of accuracy of the valuations obtained in the implementation of those taxes is highly questionable. zelinsky, supra note 7, at 881–82 and sources cited therein. 382 florida tax review [vol. 10:5 typically receives cash in exchange for the asset, requiring the payment of tax at that point will not impose an undue hardship.12 thus, the convention of deferring tax until realization results from administrative convenience and the willingness to consider the possible hardship of imposing tax on unrealized appreciation. nevertheless, the principle of realization has permeated the public consciousness and has acquired an undeserved independent status as a fundamental principle of taxation. the idea that unrealized appreciation does not represent true economic gain and that it should not be subject to taxation is widespread.13 it is arguable that the very term “realization,” describing the sale of the asset, bears part of the responsibility for exaggerating the significance of the principle. although merely semantic, the connotation is that the unrealized gain is unreal. this conception could lead to the conclusion that refraining from taxing unrealized gain is not simply a concession to practical considerations, but is rather necessitated by the platonic nature of income. such is not the case. deferral until realization is warranted to the extent, and only to the extent, dictated by considerations of cost and benefit. when the price of deferral exceeds the benefits thereof, its adoption is no longer justified. in other words, we need to choose the most convenient time—from the perspective of the administration and from the perspective of the taxpayer—to impose the tax.14 whether we call that moment “realization” or whether we say that we should occasionally deviate from the concept of realization—the difference between the two is semantic—choosing the appropriate time to calculate the gain and to impose tax thereupon requires 12. realization has been described as the achilles’ heel of the income tax. william d. andrews, the achilles’ heel of the comprehensive income tax, in new directions in federal tax policy for the 1980s 278 (charls e. walker & mark a. bloomfield eds., 1983). 13. in one of its first decisions concerning the 16th amendment, which authorized congress to impose tax on “incomes, from whatever source derived,” the supreme court held that “income” means realized income. the realization principle thus acquired constitutional status. eisner v. macomber, 252 u.s. 189, 212–14 (1920). today it is widely accepted that realization is not a constitutional requirement, but rather a rule of administrative convenience and that congress is authorized to tax unrealized gain if it chooses to do so. see, e.g., helvering v. horst, 311 u.s. 112, 116 (1940) (“[t]he rule [is] founded on administrative convenience . . . .”); andrews, supra note 5, at 1129 n.27; shakow, supra note 4, at 1112–13. for a discussion of the effect of public perception on the possibility of imposing mark-tomarket taxation in practice, see part iv.b. 14. adam smith, an inquiry into the nature and causes of the wealth of nations 778 [1776] (edwin canaan, ed., 1937) (“every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it.”). 2010] the myth of realization: mark-to-market taxation 383 balancing the advantages and disadvantages inherent in each of the various options. d. publicly-traded securities the rationale of the realization principle is inapplicable to publiclytraded securities. the market value of each security is determined on a constant basis as willing sellers and willing buyers meet on the floor of the exchange. no external valuation is necessary. the fact that an investor or analyst may judge the “true value” of a security to be different than the value at which it is traded is irrelevant: the definition of market value is the price at which a marginal willing seller will sell to a marginal willing buyer.15 with regard to liquidity, the forced sale of an appreciated asset to pay tax on the unrealized appreciation is, as noted above, not always a reasonable option due to sentimental attachment, the difficulty of liquidating the asset, and the transaction costs involved. as a rule, these considerations are irrelevant when the asset considered is a publicly-traded security. the sentimental attachment of an investor to the publicly-traded securities in her portfolio—if such an attachment is even possible—does not reach a level that warrants consideration by the tax system. the attachment between an investor and the securities she holds is entirely unlike the attachment between an individual and, for example, her home or business. ordinarily, liquidation of publicly-traded securities requires no more than a phone call or a click on a computer screen. the costs involved are typically minimal. clearly, the commission one normally pays for selling shares is in an entirely different league than the cost of moving a business to a new location due to the forced sale of the land on which it is located. furthermore, the high degree of liquidity of publicly-traded securities means that the taxpayer can easily repurchase the securities at any time. the sale of publicly-traded securities does not involve the same degree of finality as does the sale of other assets. a taxpayer who sells a security due to a temporary cash-flow problem knows that she can repurchase the security when the cash-flow problem is resolved. repurchasing land or shares in a privately-held corporation is an entirely different matter. 15. moreover, [a] shareholder could not justly complain if in his opinion the market was too low a measure of the value of his shares for tax purposes, because the tax difference would be in his favor. he could not justly complain that it was too high either, because . . . he could sell the shares and, with no tax penalty for liquidating his investment, make an extra profit on the market’s apparent miscalculation. slawson, supra note 4, at 645. 384 florida tax review [vol. 10:5 perhaps even more significant is the divisibility of publicly-traded securities. in most cases, an investor facing a tax liability resulting from the appreciation of securities in her portfolio can sell that portion of her portfolio that represents the government’s share of the appreciation and retain the remainder. this high degree of divisibility is not typical of most assets. thus, the concept of realization is inapplicable to publicly-traded securities; gain from the appreciation of publicly-traded securities should be taxed on an accrual basis rather than only at realization. calculation of the accrued gain, even without an actual sale, generally requires no more than a grade-school exercise in arithmetic. requiring the investor to pay tax annually on the accrued gain imposes no insurmountable hardship. in the worst case scenario, she can sell some of her securities to satisfy the demands of the tax collector. iii. practical advantages of accrual taxation the conclusion that publicly-traded securities should be taxed on an accrual basis is at this stage no more than provisional. we still need to consider the practical effects of the realization requirement when applied to the securities market and compare them with the expected effects of rescinding the requirement of realization. should it appear that taxing gain only when realized is more efficient economically or simpler administratively, the advantages of realization would need to be weighed against the violation of both horizontal and vertical equity inherent in the realization doctrine. to avoid any unnecessary build-up of suspense, i will note already at this juncture that the conclusions will be the opposite. in most cases the realization requirement complicates the tax system, leads to greater inequity than has already been noted, contributes to economic inefficiency, and can undermine public faith in the tax system. a. economic effects of deferring tax until realization 1. lock-in effect deferring tax on unrealized gain creates an incentive to retain appreciated property. a taxpayer holding such property might, therefore, continue to do so even though she would prefer—in the absence of tax considerations—to sell. in other words, the advantage of continued deferral might outweigh the advantage of moving into a different investment. this phenomenon—known as “the lock-in effect”—impairs the flow of economic resources to their most productive uses, creating economic inefficiency and reducing societal welfare. for example, assume that a taxpayer is holding on to a security whose value has risen since it was purchased. due to the accrued gain, 2010] the myth of realization: mark-to-market taxation 385 selling the security will impose an immediate tax burden, while refraining from selling will allow continued deferral of the tax. if the taxpayer is considering selling the security and purchasing another security in its place, she will need to consider not only her expectations regarding the return that each security will deliver in the future, but also the tax cost involved in moving from one security to the other. she may determine that the alternative investment will provide a greater return than her current investment but that the tax cost of adjusting her portfolio will outweigh the advantages.16 the substitution effect prevents resources from being directed to their most efficient uses and, by doing so, negatively impacts total societal 16. specifically, the lock-in effect will be felt whenever ra ap / [ap – t(ap – ac)] > rb > ra, where rx = the expected return of security x (e.g., when security x is expected to increase by 10%, then rx will equal 0.1) a = the currently held security b = the alternative security xp = the present market value of security x xc = the taxpayers basis in security x t = the relevant tax rate. for example, assume that the taxpayer purchased a security for $100, its present market value is $300, the relevant tax rate is 15%, and the taxpayer expects the security to rise in value by a further 50%. she is considering selling the security in order to invest the proceeds in a different security. the question is, what must the anticipated future appreciation of the alternative security be in order to justify the switch? disregarding tax considerations, she would sell the current security and invest in the alternative security whenever the expected appreciation of the alternative security over the period of time during which the current security is expected to increase by 50% is greater than 50%. in other words, she will make the switch whenever rb > ra. however, if she were to sell the current security she would be liable for tax in the amount of ($300-$100) x 15% = $30, and will be left with only $270 to reinvest. in order to persuade her to move to the alternative investment, the alternative investment must promise a return of 56% over the same time period. when the expected appreciation of the alternative investment is greater than the expected appreciation of the currently held investment, but the additional return is insufficient to counteract the disadvantage inherent in the fact that the taxpayer’s investment in the alternative investment is limited to the after-tax proceeds of the sale of the currently held asset, whereas by continuing to hold the current asset she can, in effect, invest the entire value of the asset, tax considerations will dissuade the taxpayer from altering her investment and the substitution effect of the tax will be felt. in our example, where the expected return from the alternative investment is greater than 50% but less than 60%, the substitution effect will cause the taxpayer not to make the change in her investment portfolio. 386 florida tax review [vol. 10:5 welfare. this is particularly true with regard to the capital markets. for example, a corporation trying to raise funds on the market must offer a return at least equal to the prevailing return for securities of comparable risk. a corporation offering a lower return will not be able to convince investors to purchase the securities it is offering. thus, in theory, only those corporations that can put investors’ funds to use in the most efficient manner will be able to sell their securities. however, due to the lock-in effect, a corporation attempting to sell securities may have to convince investors not only that the expected return is not less than that of comparable alternative investments, but that the expected return is sufficiently greater so as to compensate for waiving the advantages of continued deferral of the unrealized gain inherent in currently held assets.17 the lock-in effect is not an inevitable consequence of taxing income, in general, or of taxing capital gains, in particular. it results not from imposing tax on gain, but from deferring the tax until the gain is realized and thereby creating an incentive to continue holding the asset. tax imposed on an accrual basis would not create such incentives. the tax would be imposed whether the asset were sold or held. as the decision to sell would not affect the timing of the tax, the tax would not influence the decision.18 2. the effect of the proposed tax on the volatility of the market nonrecognition of unrealized gains and losses can accentuate market instability and intensify volatility. due to both economic and psychological factors, capital markets routinely undergo periods of rising and falling share prices. where gains and losses are only taken into account for tax purposes when securities are sold, the tax may tend to exaggerate the market’s natural volatility. during a rising market, many securities will contain unrealized gain. selling the investment will expose the investor to tax on the appreciated value. continuing to hold the investment allows the investor to continue deferring the gain. investors may, therefore, prefer holding on to their 17. in the example in footnote 16, in order to convince the investor to sell currently held securities expected to generate a return of 50%, the issuing corporation will need to offer a return, at no greater risk, of no less than 60%. 18. slawson, supra note 4, at 644. the realization principle can also influence the type of investment that the investor will prefer. an investment offering long term appreciation may be preferable to an investment producing currently taxed income. however, it should be noted that economists are unable to quantify the effect of taxes on investors’ decisions. james w. wetzler, comments, how taxes affect economic behavior 277 (henry j. aaron & jerry a. pechman eds., 1981). for a discussion of the possible effects of accrual taxation on the ability of corporations to raise funds on the market, see louie, supra note 4, at 867–70. 2010] the myth of realization: mark-to-market taxation 387 investments where, in the absence of tax considerations, they might have preferred selling. the tax considerations will not, of course, prevent all investors from selling; many will choose to realize their gain despite the tax cost involved. nonetheless, if some continue to hold on to shares that, absent tax considerations, they would have preferred to sell, then the number of shares offered for sale will be less than it otherwise would have been. if the demand for shares is unaffected then, in accordance with the most fundamental law of economics, the price at which the marginal seller and the marginal buyer meet will be higher than it would otherwise have been. thus, taxing appreciation only upon realization may contribute to the creation and intensity of a market bubble. the realization principle may also intensify bear markets. first, as the market will begin its decent from a higher point, due to the effect of the tax in the prior bull phase, the difference between the value of shares at the peak and at the subsequent bottom will likely be greater. second, during a bear market, shares will often contain unrealized losses, which are not recognized for tax purposes. in a mirror image of the bull market, investors may sell stock in order to recognize those losses. the additional selling may mean that the price at which shares are traded will be lower than it would have been absent the tax considerations.19 the phenomenon of exacerbating market volatility is a consequence of recognizing gain or loss only when securities are sold. were gains and losses recognized on an accrual basis, whether or not the assets were sold, the investor would not obtain any tax advantage or suffer any tax disadvantage from continuing to hold the security: past appreciation or depreciation would be recognized even were the security not sold. with regard to the future, the only relevant question the investor would need to ask 19. it is reasonable to assume that the effect of selling in order to realize capital losses will not be felt to the same extent as will refraining from selling in order not to realize capital gain. where the taxpayer expects in the future to earn capital gain, against which the capital loss can be deducted, there may be little or no advantage to realizing the gain now as opposed to later on, nearer in time to the realization of the gain. however, if the taxpayer has already realized gain—perhaps during the bull market that preceded the fall—and if the loss can be deducted against that gain, realization of losses may be advantageous. corporations may carry net capital losses back up to three years. irc § 1212(a)(1)(a). individuals are not allowed to carry capital losses back to previous tax years. irc § 1212(b)(1). therefore, where the taxpayer is an individual, deducting capital losses against prior gain is limited to gains realized in the same tax year. furthermore, we should not ignore psychological factors, even if they have no basis in cold economic analysis. a taxpayer considering selling a security at a loss may be comforted by the fact that, by doing so, she has at least realized a loss that may be beneficial in the future. were capital losses deductible from ordinary income, there would be a much great incentive to realize losses. see infra part iii.c. 388 florida tax review [vol. 10:5 would be whether the anticipated rewards from continuing to hold the security are worth the risks inherent in so doing. this is a purely economic consideration, which is supposed to guide investors in an efficient market. moreover, imposing tax on stock market gain on an accrual basis may act to mitigate to a certain extent the market’s natural volatility and contribute to market stability.20 during a bull market, investors will be liable for tax on their gains, whether or not they sell. some will need or prefer to liquidate shares in order to pay the tax. the shares offered for sale will serve to supply some of the heightened demand for shares typical of an overheated bull market. during a bear market, shares will typically contain unrealized losses. as will be demonstrated, a tax regime that recognizes gains and losses on an accrual basis can allow losses to be deducted, subject to certain caveats, from ordinary income. deducting stock market losses from ordinary income—business income, wages, and so forth—will reduce the investor’s tax bill and increase the amount of cash the investor holds. if some of the funds which would otherwise have been paid in taxes are invested in the capital markets, the additional demand should help moderate the decline. taxing gain from publicly-traded securities on a mark-to-market basis may contain an invisible-hand, countercyclical force to market volatility.21 b. tax planning under a realization regime a tax regime that conditions the recognition of gain or loss on the sale or exchange of the security that has either increased or decreased in value opens the door to a wide variety of tax planning techniques.22 the 20. in general, one of the advantages of an income tax is the fact that it is anticyclical. during periods of economic expansion incomes rise: income tax absorbs some of the additional cash in the hands of the public and contributes to easing the inflationary pressure. during times of economic contraction or recession, tax receipts decrease, putting more money in the hands of the public and increasing the demand for goods and services. see, e.g., graham c. hockley, monetary policy and public finance 267 (1970); richard a. musgrave & peggy b. musgrave, public finance in theory and practice 617–18 (1980). cf. james l. pierce & jared j. enzler, the implications for economic stability of indexing the individual income tax, in inflation and the income tax 173 (henry j. aaron ed., 1976). on the other hand, a tax on stock market gain imposed only at realization is cyclical. as demonstrated in the text, it exacerbates market volatility instead of mitigating it. 21. for an argument that overly volatile markets cause economic resources to be used inefficiently, see james r. rapetti, the use of tax law to stabilize the stock market: the efficacy of holding period requirements, 8 va. tax rev. 591, 613, 619–620 (1989). 22. see, e.g., george m. constantinides, optimal stock trading with personal taxes: implications for prices and the abnormal january returns, 13 j. 2010] the myth of realization: mark-to-market taxation 389 common denominator of these strategies is an attempt to accelerate recognition in the case of losses and to defer recognition in the case of gains. their goal is to allow taxpayers to accrue wealth while deferring, perhaps indefinitely, the payment of tax on such accession to wealth. behind each of these tax-planning techniques is an intentionally created disparity between economic gain and taxable income. economically, the investor experiences an accession to wealth when the value of her securities rises. non recognition of the gains for tax purposes is what causes the disparity. a taxpayer who can create a situation in which her wealth is held in the form of unrealized gain can accrue wealth without having to pay tax on the gain. a tax regime that refrains from taxing unrealized gain cannot afford to ignore the tax planning possibilities that exploit the realization doctrine. to counter these strategies, congress must develop statutory responses. as we will see, the effectiveness of such statutory responses is doubtful. 1. straddles and constructive sales modern sophisticated financial instruments allow investors to exploit the underlying weaknesses of the realization doctrine and to avoid paying tax on economic gain. one such technique for manipulating the realization rules is by means of a strategy known to market players as a “straddle.” in a straddle, the investor establishes two opposite financial positions so that one cancels out the other. for example, the investor can purchase a stock and simultaneously sell the same stock short. alternatively, the investor can purchase a stock and simultaneously sell a “synthetic stock” (by purchasing a put option and writing a call option with identical expiration dates and strike prices),23 or purchase a synthetic stock and simultaneously sell the stock fin. econ. 65 (1984); david m. schizer, sticks and snakes: derivatives and curtailing aggressive tax planning, 73 s. cal. l. rev. 1339 (2000). 23. for example, assume that the investor is holding a share whose market value is $100. the investor can purchase a put option on the share, where the strike price is $120. the price of the put option is, say, $30. simultaneously, the investor can write a call option, with the same expiry date and the same strike price. assume that in exchange for writing the option the investor received $12. the investor is now indifferent to the future price fluctuations of the share because, come what may, she will end up with $120. if on the expiration date of the option the price of the share is more than $120, the investor’s obligation under the call option that she wrote will deprive her of any gain above $120. on the other, if the price of the share on the expiration date of the options is below $120, the investor’s put option will make up the difference. in effect, the package held by the investor—the share plus the put option offset by the obligation under the call option—is more similar to a bond than it is to a share: the price of the package is $118 ($100 for the share plus $30 for the put option minus the $12 received for writing the call option), with a guaranteed 390 florida tax review [vol. 10:5 short. in each of these instances, the two positions are offsetting: what the investor earns on one she will lose on the other.24 the straddle opens a wide field for tax planning opportunities. presumably, at the end of the year, one leg of the straddle will represent a gain while the other will represent a loss. from an economic perspective the investor’s financial position has not changed—assuming we disregard the commissions involved in establishing and maintaining the straddle—as the gain and loss will cancel each other out. however, the investor will be able to realize the loss in one tax year—and use that loss to offset previously realized gain—while deferring realization of the winning leg of the straddle to the following year. engaging in similar transactions year in and year out will allow the investor to continue deferring the tax on her gain indefinitely.25 analytically, the investor—by engaging in the described strategy— transfers into one of the legs of the straddle all of her previously realized gain and transforms it into unrealized gain. by repeating this procedure, gain accruing year after year can be funneled into the unrealized winning leg of a straddle. a second technique employing sophisticated financial instruments to achieve desirable tax results is the constructive sale. an investor who sells an appreciated security—or, more generally, who closes a profitable position— will be liable for tax on the gain. of course, the investor can defer tax on the gain by deferring the sale, but that option may not be viable when the investor no longer wishes to continue being exposed to the risks inherent in maintaining the position. in other words, our investor wants to realize the gain without paying the tax. the suggested planning technique in cases like this is to continue holding the security—thus deferring tax on the gain—while simultaneously acquiring an offsetting position—e.g., selling the share short or selling a synthetic contract – in order to cease exposure to the risks of holding the share. from the investor’s perspective, the position is now closed: any gain or loss will be offset by an equal loss or gain in the opposite position. in this payout of $120 at the expiration date. for a comprehensive analysis of taxing packages of financial instruments that are fundamentally different from their components, see david a. weisbach, tax responses to financial contract innovation, 50 tax l. rev. 491 (1995). 24. louie, supra note 4, at 859–60. 25. not in all cases will it be possible to create and realize a loss through means of the described straddle. if the price of the share at the close of the year is similar to its price on the day the straddle was established, it will not be possible to realize a loss by closing one of the legs of the straddle. nonetheless, if the investor establishes a number of straddles in which the underlying asset is a highly volatile financial instrument, it may be presumed that with regard to at least some of them the investor will be able to realize a loss at the end of the year. 2010] the myth of realization: mark-to-market taxation 391 way, the investor, for the price of the commissions involved, can defer the payment of tax on her gain for practically as long as she wishes. there are three primary methods by which congress, the courts, and the irs can confront the aforementioned planning strategies. the first is for congress to enact, for each planning strategy, a specific legislative provision denying the sought-for tax advantages. existing tax legislation contains a number of such provisions. section 1092 of the internal revenue code provides that losses with respect to a position can be taken into account only to the extent that such losses exceed the gains from offsetting positions. the purpose of this provision is to prevent taxpayers from recognizing gain by selling the losing leg of a straddle while refraining from realizing the gain by retaining the winning leg of the straddle. section 1259 provides that in a constructive sale of an appreciated financial position the taxpayer must recognize gain as if such position had been sold. the second method by which to confront these planning strategies is to rely on general anti-abuse principles such as the economic substance doctrine, the sham transaction doctrine, and the step transaction doctrine.26 the major problem with these solutions is applying them in practice. for example, the term “offsetting positions” is defined in irc section 1092 as follows: a taxpayer holds offsetting positions with respect to personal property if there is a substantial diminution of the taxpayer’s risk of loss from holding any position with respect to personal property by reason of his holding 1 or more other positions with respect to personal property (whether or not of the same kind).27 however, it will not always be clear whether the taxpayer’s investment portfolio contains offsetting positions, particularly as the taxpayer’s entire portfolio may have to be analyzed to determine the risks to 26. the literature involving these doctrines is too vast to be extensively analyzed here. see, e.g., knetch v. u. s., 364 u.s. 361 (1960); gregory v. helvering, 293 u.s. 465 (1935); rice’s toyota world, inc. v. commissioner, 752 f.2d 89 (4th cir. 1985). the common law economic substance doctrine has recently been clarified in irc § 7701(o): a transaction will not be considered to have economic substance unless, apart from the effects of federal income tax, the taxpayer has a substantial purpose for entering into it and it meaningfully changes the taxpayer’s economic position. for the purpose of making such determinations, potential for profit is taken into account only if the present value of the pretax profit is substantial in relation to the present value of the net tax benefits. 27. irc § 1092(c)(2)(a). irc § 1092(c)(3)(a) contains a list of presumably offsetting positions, with irc § 1092(c)(3)(b) clarifying that the presumption in subparagraph (a) is rebuttable. 392 florida tax review [vol. 10:5 which she is actually exposed. the financial instruments available today are many, diverse, and sophisticated, and the affect of each on the overall level of risk inherent in the portfolio may not be obvious. furthermore, as investment portfolios are not static, the extent to which the risk inherent in any position is offset by another position may change by the minute. the same doubts can arise with regard to the question of whether a given change in the taxpayer’s portfolio constitutes a constructive sale of any of the positions therein.28 furthermore, the very act of defining terms such as “constructive sale” invites attempts to frustrate the provision by achieving economic realization that does not meet the requirements for a constructive sale as statutorily defined.29 with regard to the general anti-abuse principles, the problems surrounding their application in practice are legendary. a coherent theory as to when courts will ignore a transaction as a sham and when they will recognize it for tax purposes has not yet been articulated, and it is difficult to predict in advance when a court will ignore any particular transaction as a sham.30 28. see david p. hariton, the tax treatment of hedged positions in stock: what hath technical analysis wrought?, 50 tax la. rev. 803, 805-09 (1995). 29. see, e.g., david a. weisbach, line drawing, doctrine, and efficiency in the tax law, 84 cornell l. rev. 1627, 1636 (1999). from an economic perspective, short-against-the-box transactions look too much like sales for them to be not treated as realization events. because they eliminate the risk of gain and loss, congress changed the law to treat them as sales. it is not clear, however, if this change is appropriate. the new law only moves the line between holding and selling incrementally. the underlying problem, that similar transactions are treated differently, is still there—there is just a new line. the new line is substantially more complex than prior law, and taxpayers can probably avoid unfavorable tax treatment just as easily. it is doubtful that the legislation moves us any closer to a clear definition of the realization requirement. id. (citations omitted). for an unsuccessful (pending appeal) attempt to avoid the § 1259 definition, see anschutz co. v. commissioner, 135 t.c. no. 5 (2010); see david cay johnston, anschutz will cost taxpayers more than the billionaire, 128 tax notes 557 (aug. 2, 2010); david cay johnston, anschutz and a 21st-century tax system, 127 tax notes 699 (may 10, 2010). 30. see, e.g., christopher h. hanna, from gregory to enron: the too perfect theory and tax law, 24 va. tax rev. 737 (2005); martin j. mcmahon, jr., random thoughts on applying judicial doctrines to interpret the internal revenue code, 54 smu l. rev. 195, 195 (2001) (“‘substance controls over form, except, of course, in those cases in which form controls.’ this [is the] immutable law of federal taxation ….”). 2010] the myth of realization: mark-to-market taxation 393 the problems with statutory provisions relying on terms as imprecise as “offsetting positions” or relying on vague common law principles are greatly exacerbated by the practice of self assessment. the irs’s auditing capacity is limited. the government relies, therefore, on the forthrightness of the taxpaying public, on selective audits, and on the threat of criminal and civil penalties imposed on taxpayers discovered to have filed fraudulent returns. it follows that the more vague and imprecise the rules by which tax liability is determined, the more likely there will be a discrepancy between the tax liability according to the taxpayer-prepared return and the tax liability as it would have been ascertained by the irs after a thorough audit. when rules are open to interpretation, taxpayers will naturally tend to interpret them so as to reduce their tax liability. when the rules of the game include such terms as “substantial diminution of the taxpayer’s risk of loss,”31 it is difficult, except in the more obvious cases, to prosecute taxpayers for fraud even though the irs or a court might disagree with their self-assessment. admittedly, statutory provisions cannot describe in precise terms the tax consequences of every possible situation that can occur. in many cases relying on vague and imprecise terms or doctrines is unavoidable. nonetheless, such terms and principles should constitute the last line of defense. relying on them as the primary means by which to combat capital market tax-planning strategies is likely to prove ineffective. the third, and most effective, method of confronting these strategies is to abandon the realization doctrine and tax gains on publicly-traded securities as they accrue. this solution is the simplest, both conceptually and practically.32 most importantly, it focuses on the underlying problem instead of the symptoms. it is the realization doctrine which, when applied to the capital markets, invites the taxpaying public to manipulate the artificial distinction between realized gain and unrealized gain. do away with the doctrine and the problem solves itself.33 31. irc § 1092(c)(2)(a). 32. this is not to say that the goal of simplifying the tax system will necessarily overcome all other considerations. nevertheless, when the complexity arises due to a doctrine that, in the circumstances considered, is unnecessary, the goal of simplification is another reason to jettison the doctrine. for a comprehensive discussion of the place of simplification among the various factors that a legislator needs to consider when designing the tax structure, see edward j. mccaffery, the holy grail of tax simplification, 1990 wis. l. rev. 1267 (1990); daniel q. posin, a case study in income tax complexity: the type a reorganization, 47 ohio st. l.j. 627, 628–629 (1986) (“[v]irtually nothing can be done about the complexity of the federal income tax system.”). 33. weisbach, supra note 4, at 122 (“much of the complexity of current law stems from the realization requirement. pure mark-to-market taxation potentially offers dramatic simplification because all of the realization rules could be repealed.”); see also andrews, supra note 5, at 1131. 394 florida tax review [vol. 10:5 in certain limited situations congress has adopted this approach. section 475 of the internal revenue code describes circumstances in which dealers in securities report gains and losses on a mark-to-market basis. section 1256 requires regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer security futures contracts to be marked to market.34 however, congress has thus far refrained from adopting a general principle that gains from appreciation (and losses from depreciation) of publicly traded securities be recognized for tax purposes as they accrue. 2. wash sales when the value of a security declines, the investor experiences an economic loss that is not recognized for tax purposes prior to sale. selling the security will allow recognition of the loss. however, the investor may believe that the decline is temporary and that, given time, the security will recover. investors in situations such as these often find themselves facing a dilemma: recognizing the loss for tax purposes apparently requires waiving the opportunity of recouping the loss should the value of the investment rise. in order to benefit both from an immediate recognition of the loss for tax purposes and from the potential rise in value of the security, the investor may consider selling the security and immediately repurchasing it: the sale realizes the loss, while the repurchase allows the investor to benefit from the expected recovery.35 congress countered this potential action by prescribing that a loss on the sale of a security will not be recognized if during the 61 day period commencing 30 days before the sale and ending 30 days after the sale the investor purchased the same or fundamentally the same security.36 34. section 1601 of the recently passed dodd–frank wall street reform and consumer protection act limits the scope of irc § 1256 by providing that interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, credit default swaps, and similar agreements are not to be treated as § 1256 contracts. furthermore, securities futures contracts or options on such contracts are no longer treated as § 1256 contracts unless such contract is a dealer securities futures contract. dodd– frank wall street reform and consumer protection act, pub. l. no. 111–203, 124 stat. 1376 (2010). 35. wash sales and straddles may be combined effectively and efficiently: the investor purchases two offsetting positions and waits for one to rise and the other to fall. the losing position is then closed and a similar position immediately opened. the financial risk is minimal, but for tax purposes the loss is realized while the corresponding gain is deferred. see, e.g., louie, supra note 4, at 859. 36. irc § 1091(a). the section does not attempt to differentiate between the investor whose sale and repurchase are tax-motivated and the innocent investor 2010] the myth of realization: mark-to-market taxation 395 why did congress object to wash sales? the question may be clarified by comparing the wash sale to the two strategies discussed above: straddles and constructive sales. in each of these planning techniques, the realization doctrine is manipulated in order to create tax losses unaccompanied by any real economic loss or to realize gain economically without paying tax on that gain. in other words, straddles and constructive sales are exploited with the intention of bringing about disparities between actual accession to wealth, on the one hand, and taxable income, on the other. the motivation to counter these strategies is clear. ostensibly, wash sales are different. when the value of the security declined, the investor suffered an actual economic loss. the sale and repurchase are not an attempt to manipulate the realization doctrine by creating a non-existent loss; rather, the purpose of the wash sale is to create a situation in which taxable income reflects true economic gain and, thus, to overcomes a distortion caused by the realization doctrine. note that were stock market gains taxed on an accrual basis—as this essay argues they should be—the tax system would recognize the loss even without the wash sale. what is wrong with the taxpayer engaging in a little self help to achieve the same result? the answer would appear to be that the realization doctrine, an artificial creature of the tax system, inherently creates a disparity between taxable income and economic gain. this disparity operates sometimes to the advantage of the taxpayer (with regard to gains) and sometimes to the advantage of the government (with regard to losses). were taxpayers to act without regard to the tax consequences of their actions, the cost would presumably be divided arbitrarily between the government and the taxpayers. reality is quite different. the public is well aware of the tax consequences of its behavior and acts accordingly. a taxpayer may defer the sale of an appreciated asset in order to defer paying tax on the appreciation. similarly, a taxpayer who has realized a gain may look for an asset whose value has depreciated in order to sell it and deduct the now-realized loss from the gain. this type of gamesmanship is probably unavoidable and is a necessary and predicable cost of adopting the principle of realization. the line separating acceptable from unacceptable rule manipulation in the context of the realization doctrine is not a matter of substance but rather a matter of degree. when deferring the payment of tax on asset appreciation requires the taxpayer to continue risking the capital invested in that asset, or, alternatively, when the taxpayer needs to sell an asset in order to recognize the loss from its decline in value, there exists a mechanism guaranteeing at least the semblance of symmetry between the non recognition of unrealized gains and the non recognition of unrealized losses. however, if taxpayers are able to recognize losses without forfeiting their acting in response to market developments. in general, the ensnarement of innocent taxpayers is one of the unfortunate side effects of anti-abuse legislation. 396 florida tax review [vol. 10:5 economic interest in the asset concerned, the ostensible symmetry between gains and losses no longer exists. accrual taxation is immune to these dilemmas. selling and repurchasing are not necessary in order to cause the loss to be recognized for tax purposes, as the tax law would recognize the loss even without the wash sale. nonetheless, symmetry between gains and losses would be retained as unrealized gains would also be recognized. in either case, recognition would be unaffected by the act of sale. it should also be noted that the practical difficulties inherent in applying the provisions denying recognition of wash sales are no less that those we encountered earlier with regard to straddles and constructive sales. the question of when the new position is substantially identical to the closed position is not always easy to answer. for example, it is well known that it is possible to construct a portfolio, containing relatively few stocks, that more or less tracks a market index. would the sale of a set of securities with a high degree of coordination with a particular index and the simultaneous purchase of another set of securities, with no security in common but with a similarly high degree of coordination with the same index, be considered a wash sale? can the irs effectively monitor these types of transactions, examining daily the degree of coordination of the taxpayer’s portfolio, or subsets of it, with the various indexes in order to determine whether the changes leave the taxpayer in the same or a similar position with regard to her exposure to the market? it is highly doubtful that such a level of scrutiny is possible. c. deducting losses one of the more complex aspects of taxing gains, in general, and taxing gain from the stock market, in particular, is the treatment of losses. as will be seen, the source of both the technical and the substantive difficulties encountered result from the realization principle. considerations of horizontal equity and economic efficiency require free deductibility of losses. nonetheless, with regard to capital losses, the code severely restricts their deductibility and prescribes, in general, that capital losses can only be deducted to the extent of capital gains.37 the primary reason for restricting the deductibility of capital losses is the ability of taxpayers to realize, and thus recognize, capital losses, while retaining those assets containing unrealized capital gain (“selective realization” or “cherry picking”). were capital losses freely deductible, taxpayers would be able to realize their losses, deduct them against ordinary income, and reduce or even eliminate their taxable income, even though the value of other assets had appreciated. 37.. irc § 1211. where capital losses exceed capital gains, individuals are allowed to deduct $3000 of the excess against ordinary income. irc § 1211(b). 2010] the myth of realization: mark-to-market taxation 397 cherry picking is obviously only possible within a tax regime that defers recognition of gains and losses until they are realized. abandon the realization doctrine and the problem disappears. gains and losses would be recognized in the year they accrue, so that selling or retaining the asset would not affect the taxpayer’s liability. ordinary taxable income plus capital gains minus capital losses would equal economic accession to wealth. for example, assume that at the beginning of the year, a taxpayer purchased capital asset a for $100 and capital asset b for $150 and did not sell them before the end of the year; that at the end of the year, asset a was worth $30 and asset b was worth $190; and that during the year the taxpayer earned wages of $300. the taxpayer’s accession to wealth during the year would be $300 + ($30 – $100) + ($190 – $150) = $270. under a tax regime that recognizes gains and losses as they accrue, taxable income would also be $270. this would not be the result under a regime that recognizes gains and losses only as they are realized. as the assets were not sold, the gain and the loss would not be recognized and taxable income would be $300. selling asset a for $30 would not change the situation. because capital losses are only deductible to the extent of capital gains, the $70 loss would not be deductible and taxable income would still be $300.38 selling both assets before the end of the year would also not change the situation. the gain from asset b is $40 and so only $40 of the capital loss would be deductible, and taxable income would remain $300 (ordinary income of $300 + capital gain of $40 – deductible capital loss of $40).39 the fear of selective realization prevents the tax system from appropriately measuring accession to wealth. another problem with allowing free deductibility of capital losses concerns the preferential rate of tax imposed on long term capital gains in the hands of individual taxpayers.40 allowing taxpayers to deduct capital losses from ordinary income would mean that the government is, in effect, a 15% partner with regard to gains, but a 35% partner with regard to losses. nonetheless, the fact that the government’s share in losses is less than its share in gains is not necessarily an undesirable result. the critical factor in determining whether this result is indeed undesirable is the policy behind granting preferential rates to capital gains in the first place. as a thorough examination of the capital gains preference is beyond the scope of the present essay, a few examples will suffice to demonstrate the relationship between the reason for the preference, on the one hand, and 38. i am assuming that the amount of loss that is allowed to be deducted against ordinary income is relatively insignificant. see supra note 35. 39. should the taxpayer sell asset b while retaining asset a, taxable income would be $340. 40. the issue of the differential tax rate is irrelevant for corporations, for whom the tax rate imposed on capital gain is the same as that imposed on ordinary income. 398 florida tax review [vol. 10:5 the treatment of capital losses, on the other. one common justification for the capital gains preference is the effect of inflation on the measurement of gain. gain is defined as the difference between the amount realized and the adjusted basis. however, as the adjusted basis is stated in nominal dollars instead of in real dollars, the gain as computed by the provisions of the code will, during periods of inflation, overstate real gain. the preferential rate for long term capital gain is said to compensate for the overstatement of gain. whatever the merits of the argument, if inflation is the underlying reason for the capital gains preference, consistency would require not only that the government participate in capital losses to a greater extent than it participates in capital gains, but that it participate in capital losses even to a greater extent that its share of ordinary income. during periods of inflation, while nominal gain overstates real gain, nominal losses understate real losses. assume that a taxpayer purchases an asset for $100 and sells it several years later for $150. cumulative inflation over that time period was 30%. nominal gain, as computed by the provisions of the code is $50. real gain, however, is only $20. were nominal gain taxed at full rates (35%), the tax would be $17.50 ($50 x 35%), or 85% ($17.50/$20) of the real gain. by taxing long term capital gain at the reduced rate of 15%, the tax is only $7.50 ($50 x 15%), or 37.5% ($7.50/$20) of real gain. now assume that instead of selling the asset for $150, the taxpayer sells it for $60. the nominal loss, as computed by the code, is only $40 ($100 $60); the real loss is $70 ($130 $60). were the taxpayer to deduct the nominal loss from income subject to tax at the rate of 15%, the tax savings would be $6 ($40 x 15%), or 8.6% ($6/$70) of the real loss. in other words, while the government participates in 37.5% of the real gain, it participates in only 8.6% of the real loss. even if the loss were deductible against income subject to the full rate of tax (35%), the tax savings of $14 ($40 x 35%) would be only 20% ($14/$70) of the real loss. again the government participates to a much greater extent in gains (37.5%) than in losses (20%). another justification for the preferential rate imposed on capital gain is the problem of international tax competition (the infamous “race to the bottom”). if this is the reason for the preference, then seemingly the extent to which the government should participate in losses would also be a product of that same competition. if the government can get away with limiting the deduction of losses, then it can, in some small measure, make up some of the cost of the capital gains preference. on the other hand, were other countries to offer preferential rates on capital gains coupled with unrestricted deduction of losses—a situation that, to the best of the author’s knowledge, does not exist today—then the united states might be forced to follow suit. in other words, the fact that gains are taxed at a preferential rate does not necessarily imply that allowing full deduction of capital losses is 2010] the myth of realization: mark-to-market taxation 399 inappropriate.41 however, even if as a matter of policy it is determined that the tax benefit from losses should not exceed the rate of tax that would have been imposed in the case of a gain, there are techniques that would allow capital losses in excess of capital gains to be taken into consideration for tax purposes, without forcing the government to participate in losses to a greater extent than it participates in gains. for example, where capital losses exceed capital gains, the taxpayer, instead of deducting the loss, could be granted a credit equal to the excess times the capital gains tax rate. assume that a taxpayer has a capital loss of $100 and ordinary income of $300 and that capital gains are taxed at 15% while ordinary income is taxed at 35% (for the sake of convenience, we will ignore the progressive rate structure). the law as it stands today would not allow the deduction of the capital loss, so the taxpayer would pay tax of $105 ($300 x 35%). this is inappropriate as accession to wealth was only $200, and yet the taxpayer is taxed as if accession to wealth had been $300. allowing a deduction might also be considered inappropriate. true, accession to wealth is $200 and the taxpayer would pay tax of $70 ($200 x 35%); nevertheless, the government is in effect covering 35% of the loss, while it would only have participated in 15% of the gain. the proposed solution is for the taxpayer to receive a credit for the loss in the amount of $15 ($100 x 15%). the total tax liability would be ($300 x 35%) – ($100 x 15%) = $90. the loss would thus result in an immediate tax benefit, while not requiring the government to participate in the loss to a greater extent than it would have participated in a gain. an equivalent technique would be to allow the loss to be deducted but first to multiply it by the ratio of the capital gains rate to the taxpayer’s marginal tax rate. in the example, the taxpayer would be entitled to a deduction of $100 x 15%/35% = $43. taxable income would be $257 ($300 – $43), and the tax would be $90 ($257 x 35%). abolishing the realization requirement for publicly-traded securities would eliminate the problem of cherry picking. once that problem is resolved, the question of how to account for capital losses given the capital gains preference (assuming that for reasons of policy the government does not want to participate in losses beyond the extent of its participation in gains) becomes a relatively simple technical issue. 41. the preferential rate can also be justified as compensation for the restriction on deduction of capital losses. because of the problem of cherry picking, congress may have had no choice but to restrict the deduction of capital losses. this restriction upsets the balance between gains and losses—while gains are always taxed, losses are not always deductible. the low rate of tax on capital gains may be compensation for the imbalance. of course, this reason for the capital gains preference would be irrelevant in the absence of the realization rule. 400 florida tax review [vol. 10:5 iv. counterarguments this part will examine arguments supporting retention of the realization principle with regard to capital gains from publicly-traded securities: the fear of future reduction in value, public opinion and the psychological element, the problem of creating a mixed system in which some assets are taxed currently and others are taxed only on realization, the possibility of retaining the realization doctrine while charging interest for the deferral, and the the low degree of liquidity of certain securities that may prevent the imposition of mark-to-market taxation. a. possibility of future depreciation one argument against imposing tax on “paper gains” is based on the possibility that the value of the asset may decline in the future. in other words, while an asset’s appreciation does constitute accession to wealth, that accession to wealth could dissipate. it is therefore appropriate to wait until the asset is sold before imposing tax in order to ascertain that the accession to wealth is not merely temporary. true, the fear of depreciation in value exists as long as the taxpayer holds onto the asset. it is also true that the future depreciation could completely or partially obliterate the gain. however, the fear of future loss is not normally sufficient to prevent taxation of current gain. every taxpayer who reports a positive income in one year may experience a loss in subsequent years. a business owner cannot defer tax on income by arguing that next year might produce a loss. an investor who sold stock a at a gain and reinvested the funds in stock b cannot normally defer paying tax on the gain because of the fear that asset b will decline in value. their situations are not dissimilar from that of an investor who refrains from selling appreciated securities. in each of these cases the taxpayer experienced an accession to wealth. in each of them there is a fear that the taxpayer’s wealth may decrease in the future. the mere fear of future loss is not enough to defer recognition of gain. what will happen, though, if after the taxpayer reports the gain and pays the appropriate tax, the value of the security declines, eliminating some or all of the gain? would this situation not constitute a hardship for the taxpayer? the answer is that the hardship would be no greater than that in any other case in which the taxpayer experiences a profit in one year and a loss in another. allowing the taxpayer a deduction (or a credit)42 for the loss is supposed to remedy the situation. where for whatever reason it does not, the solution is to be found in the rules governing the deduction of losses. in any case there is no economic or administrative reason to relate differently to 42. see supra part iii.c. 2010] the myth of realization: mark-to-market taxation 401 taxpayers whose gains and subsequent losses resulted from holding onto the same security. b. psychology and public opinion as has been seen, there is no economic basis for distinguishing between “paper profits” and realized profits, at least as far as highly liquid assets are concerned.43 nevertheless, this distinction is deeply embedded in the public consciousness. many believe that while asset appreciation presents the taxpayer with the opportunity to profit by selling the asset, until the sale, appreciation is no more than potential gain, and that it is inappropriate to impose tax on mere potential gain. this broadly-held opinion might be the reason that congress has thus far refrained from imposing an across-the-board mark-to-market tax regime on stock market gain.44 taxes in a democracy require the consent of the governed. where “paper gain” is not considered by the public to be an appropriate subject for taxation, a politician who proposed elimination of the realization rule risks alienating her constituents. even proposals to narrow the scope of the doctrine in order to prevent abuse have sparked heated resistance.45 the problem is real. the utility of proposed tax provisions, equitable and efficient as they may be, is limited in practice if public resistance prevents their enactment. the only solution is education. one aspect of the proposal that is likely to appeal to public sentiment is the free deductibility of (or a credit for) capital losses.46 this possibility may help convince the public that the fairest and most efficient way to tax stock market gains is by abandoning the realization principle. c. taxing stock market gain differently than gain from other assets the tax regime applicable to specific types of income cannot be viewed in isolation from the generally prevailing tax structure. tax provisions that would be advisable were they imposed universally are not necessarily appropriate when applicable only in certain cases.47 43. even zelinsky agrees with this argument: “of course, these taxpayers flunk econ. 101 for believing these things.” zelinsky, supra note 7, at 894. 44. see david m. schizer, realization as subsidy, 73 n.y.u. l. rev. 1549, 1606–09 (1998). 45. see, e.g., id. at 1606–07. 46. see supra part iii.c. 47. see richard g. lipsey & kelvin j. lancaster, the general theory of the second best, 24 rev. of econ. stud. 11, 12 (1956). 402 florida tax review [vol. 10:5 it is possible that, if adopted as a general rule, the imposition of tax on asset appreciation as it occurs would be better than deferring tax until realization. nonetheless, practical considerations—particularly evaluation and liquidity—prevent the adoption of a strictly accrual-based tax system and, in most cases, dictate retention of the realization model. in this instance, the tax system deviates from the ideal. this deviation cannot be ignored when considering the proper tax treatment of gains, when circumstances allow for the imposition of accrual-based taxation. in other words, from the fact that a universally applied accrual-based tax would be preferable to a realization-based tax, one cannot necessarily infer that, in an environment of realization-based tax, imposition of accrual-based tax on gain from a specific type of asset is advisable. the fact that different types of gain would be subject to different tax regimes might create distortions the cost of which would be greater that the benefit achievable from the (narrow) imposition of accrual-based tax.48 the major disadvantage inherent in a system with differential tax regimes is the likelihood that economic resources will be diverted from their most efficient uses. when different investments incur different tax liabilities, the tax consequences could constitute an important factor in choosing investments. when the investment decision is different than it would have been were the tax consequences not factored into the decision, the result, in most cases, is economic inefficiency. specifically, imposing a mark-tomarket tax regime on the stock market while the tax on appreciation of other assets is deferred until realization could damper the demand for publicly-held stock, prevent corporations from raising capital, and distort investment decisions. the losses to society from mark-to-market taxation might overwhelm any gain therefrom.49 nonetheless, it does not appear that the fear of creating disequilibrium in the market by imposing different tax regimes on publiclytraded securities as opposed to non publicly-traded assets is a major impediment to the introduction of mark-to-market taxation. differential tax regimes create economic inefficiencies due to the substitution effect: when a taxpayer faces a choice among several options, she might choose option a because of the attractive tax regime despite the fact that she would have chosen option b in the absence of tax considerations. accordingly, the lesser the substitution effect, the greater the economic efficiency of the tax.50 the substitution effect is a function of the elasticity of the tax base. the more easily the taxpayer can switch from one mode of behavior to 48. see weisbach, supra note 4, at 97. 49. see zelinsky, supra note 7, at 918–47. 50. see jay hausman, in labor supply, how taxes affect economic behavior 27, 27-28 (henry j. aaron & joseph a. pechman eds., brookings institution 1981). 2010] the myth of realization: mark-to-market taxation 403 another, the more significant the tax factor becomes. conversely, the less elastic the tax base, the weaker the substitution effect.51 income tax is not imposed in a uniform manner. income earned through a corporation is taxed differently than income earned directly by an individual; capital gains are taxed differently than ordinary income; passive income is often taxed differently than wages or self-employed income. various and sundry considerations—some justified and some not—have led congress to adopt a tax system composed of different, and competing, tax regimes. just as one who proposes imposing mark-to-market taxation on publicly traded securities cannot ignore the fact that gain from other assets is taxed only upon realization, one who proposes imposing tax on the gain from publicly-traded securities only upon realization cannot ignore the fact that, in any case, the tax structure contains many and varied tax regimes. thus, the question is not whether to institute a tax structure with differential tax regimes. these regimes exist. the real question is where to draw the line between one tax regime and another. because any line, wherever drawn, will encourage taxpayers to change their behavior in order to benefit from the more advantageous tax regime, considerations of efficiency would dictate drawing the line so as to minimize the substitution effect. the economic effect of imposing different tax regimes on publiclytraded securities, on the one hand, and other assets, on the other, depends therefore on the degree of substitutability between the two. for a large number of investors, the advantages of investing in the stock market greatly outweigh any disadvantages of mark-to-market taxation. these advantages include liquidity, the ability to invest relatively small amounts, regulatory oversight, analyst coverage, and more. the absence of these conditions in privately held corporations means that, for a large segment of the population, investing in non publicly-traded shares is not a viable option.52 moreover, while it is true that gain from the appreciation of non publicly-traded shares is deferred until sale, the tax on dividends and interest—including appreciation due to original issue discount—from publicly-traded securities is not so deferred. therefore, harmonizing the tax regime imposed on gain from appreciation of publicly-held stock with that imposed on gain from shares in privately-held corporations, requires the creation of a disequilibrium among the various types of income derived from 51. see david elkins, horizontal equity as a principle of tax theory, 24 yale l. & pol’y rev. 43, 49–50 (2006); weisbach, supra note 29, at 1656. 52. imposing a special tax regime on publicly-traded stock may influence the decision to offer shares to the public in the first place. louie, supra note 4, at 870–71. nonetheless, if we have to establish a border for the accrual tax regime, the line dividing publicly-traded from non publicly-traded stock is not a bad place to do so, given the significant differences between the two. 404 florida tax review [vol. 10:5 the stock market itself. for example, at present the income from investing in companies that distribute a large portion of their earning as dividends is taxed, to a great extent, on an accrual basis, while the gain from investing in companies that tend to reinvest their earnings is taxed only upon realization.53 as noted, the tax system as a whole is composed of a number of different tax regimes. from an efficiency perspective, the best place to delineate the line between them is the point at which substitution is the least likely. in any case, in the absence of strong empirical data demonstrating that the substitution effect is more significant with regard to the choice between investing in publicly-traded stock, on the one hand, and investing in non publicly-traded stock, on the other, than it is with regard to the choice between investing in publicly-traded non-dividend-producing stock, on the one hand, and investing in publicly-traded bonds or publicly-traded dividend-distributing stocks, on the other, the fear of a substitution effect is not a reason to reject mark-to-market taxation on the stock market gains. furthermore, the argument that imposing mark-to-market taxation will deter investment in publicly-traded stock rests on the assumption that taxpayers prefer deferring taxation on gain until those gains are realized. this assumption is not necessarily correct. true, the next best thing to avoiding a tax is deferring it, but mark-to-market taxation allows free deductibility of (or a credit for) losses, a concession that a realization-based system cannot afford.54 in summation, one who objects to mark-to-market taxation because of the fact that non publicly-traded investments will continue to be taxed only upon realization must bear a triple burden of proof. first, it must be shown that the elasticity of the choice between publicly-traded securities and non publicly-traded assets (such as land or stock in privately-held corporations) is greater that the elasticity of the choice between publiclytraded growth stock, on the one hand, and bonds, cds, or publicly-traded income stock, on the other. secondly, it must be shown that, from the taxpayer’s perspective, the tax advantages of deferral outweigh the advantages of free deductibility (or a credit in lieu) of capital loss. thirdly, it must be shown that the economic distortion due to the different tax rules is more significant that the advantages inherent in mark-to-market taxation. opponents of mark-to-market taxation have not yet offered such a proof. 53. the text is referring only to the shareholder-level tax and not the corporate-level tax. 54. see supra part iii.c. 2010] the myth of realization: mark-to-market taxation 405 d. the possibility of combining realization with an interest charge for deferral it may be argued that the advantages of mark-to-market taxation can be achieved without abandoning the realization rule. the idea is that computation of gain and payment of tax would be deferred until realization, but that the taxpayer would be charged interest for the deferral. the interest would reflect the advantage of deferral and would thus mimic mark-tomarket taxation; however, by retaining the principle that income gain is not taxed prior to realization, it would be a less radical departure from traditional income tax doctrine.55 proponents of the interest charge view it as a possible solution to the classic problem of nonrecognition of unrealized gain. in other words, what the commentators have in mind is a typical situation in which valuation and liquidity prevent the imposition of tax on gain prior to realization. the interest charge is intended to mitigate the violation of principles of equity and efficiency inherent in the realization doctrine. a comprehensive analysis of the interest proposal is beyond the scope of the present essay. furthermore, it is unnecessary to consider whether it would be appropriate to adopt a special tax regime for publiclytraded securities were the taxation of gains from the sale of property based on deferral, until realization combines with an interest charge. this essay considers only the alternative regimes for taxing gain from publicly-traded securities, with the general regime of taxing gains at realization taken as a given. under these circumstances, it is difficult to justify deferring the tax until realization and then charging interest for the deferral. the realization doctrine was designed to contend with the twin problems of valuation and liquidity, which prevent taxing appreciation as it occurs. the interest charge was designed to contend with the problems created by the realization doctrine. when considering how to tax those assets for which problems of valuation and liquidity do not exist, it seems hardly logical to adopt a regime of deferring tax until realization coupled with an interest charge. moreover, the two regimes—mark-to-market, on the one hand, and deferral coupled with an interest charge, on the other—will not necessarily arrive at the same result. computing the amount of interest that the taxpayer 55. see irc § 1297 (passive foreign investment companies). see also, mary louise fellows, a comprehensive attack on tax deferral, 88 mich. l. rev. 722 (1990) (discussing the operation of a time-adjusted-realization-event tax); stephen b. land, defeating deferral: a proposal for retrospective taxation, 52 tax l. rev. 45, 73–80 (1996); deborah h. schenk, an efficiency approach to reforming a realization based tax, 57 tax l. rev. 503, 537–41 (2004); weisbach, supra note 4, at 100–02 406 florida tax review [vol. 10:5 should be charged depends upon data—such as the rate of appreciation of the asset during the holding period and the appropriate rate of interest—that are not always simple to determine. various systems have been proposed to supply the figures necessary for computation,56 but the very existence of these competing systems is enough to give one pause. in attempting to mimic the tax burden of a true accrual system, such systems would base computations on estimations that are often arbitrary. when these estimates are inaccurate the results will be distorted. it is hard to justify such a substitute when it is easier to impose tax on the actual gain accrued each year. mark-to-market taxation is not affected by these inexactitudes. each year the taxpayer pays tax on the actual gain accrued during the year. as tax is paid concurrent with the gain, it is unnecessary to determine the interest rate. furthermore, the taxpayer has the option each year of selling securities to pay the tax attributable to that year, an option unavailable when tax is deferred until realization. there the taxpayer is, in effect, forced to borrow funds from the government if she wishes to continue holding onto the security.57 v. conclusion the realization convention was designed to deal with those situations in which it is difficult, in practice, to impose tax on asset appreciation prior to sale. deferring the payment of tax until realization creates economic inefficiency and, more importantly, violates fundamental principles of horizontal and vertical equity. however, in most cases, there is little choice but to surrender to the dictates of reality and wait for sale before the government can claim its share of the gain. valuation and liquidity do not pose serious impediments to taxing appreciation of publicly-traded securities. on the contrary, clinging to the realization principle is what causes problems: disruption of the smooth operation of the market, manipulation of sophisticated financial instruments, and strict limitations on the deduction of capital losses. mark-to-market taxation, on the other hand, is both equitable and efficient: investors would pay tax on their gain as it accrues, and their choice of whether to sell or to hold would not be affected by tax considerations. mark-to-market taxation also allows unrestricted deduction (or a credit in lieu) of capital losses, a provision that would contribute not only to the 56. see supra note 55. 57. see schenk, supra note 55, at 540 (“[s]uppose the tax rate is 40% and t purchased property for $1, which he held for 20 years and then sold for $1,000. t would owe $400 in taxes plus $743 in interest at 10%, or $1,143, more than the sales price.”). 2010] the myth of realization: mark-to-market taxation 407 equity and efficiency of the tax structure but also—and no less importantly— to the public perception of its fairness. countering these advantages is the conception that mere “paper gain” is not a proper subject for taxation. however, this conception, deeply rooted in the public consciousness as it may be, is unwarranted. only the fact that it is so deeply rooted gives it any standing whatsoever. by explaining to the public that taxing gains as they accrue will allow losses also to be recognized as they accrue and, furthermore, will provide investors with an immediate tax benefit even in the absence of capital gains, it may be possible to obtain public support for mark-to-market taxation. 408 florida tax review [vol. 10:5 florida tax review volume 13 2012 number 3 florida tax review article horizontal equity revisited james repetti diane ring university of florida college of law florida tax review volume 13 2012 number 3 article horizontal equity revisited james repetti diane ring 135 florida tax review volume 13 2012 number3 the florida tax review is a publication of the graduate tax program of the university of florida college of law. each volume consists of ten issues published by tax analysts. the subscription rate, payable in advance, is $125.00 per volume in the united states and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, 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number 3 134 the proper tax base structural fairness from an international and comparative perspective essays in honour of paul mcdaniel edited by yariv brauner & martin j. mcmahon jr. virtually all objections to taxation schemes spring from perceptions of unfairness. is tax fairness possible? the question is certainly worth investigating in depth, and that is the purpose of this book. today, as governments are busily making new tax rules in the wake of staggering budget deficits, is perhaps an appropriate time to pay heed to fairness so it can be incorporated as far as possible into tax reform. with twelve contributions from some of the world‘s most respected international tax experts – including the late paul mcdaniel, in whose honor these essays were assembled – this invaluable book focuses on tax expenditure analysis, the quest for a just income tax, and division and/or harmonization of the income tax base among jurisdictions. among the areas of taxation ripe for reform from a fairness point of view the authors single out the following: • tax expenditure budget construction; • tax expenditure reporting; • modern welfare economics as a driver of tax reform; • grantor trust rules; • the notion of ―horizontal equity‖; • the international tax norm of ―income source‖; • transfer pricing; and • jurisdictional application of vat. specific ongoing reforms in the united states, australia, and other countries – as well a detailed analysis of the eu‘s proposed common consolidated corporate tax base (ccctb) – are also examined for fairness. march 2012, 280 pp., hardbound isbn: 9789041132864 price: eur 130.00 / usd 176.00 / gbp 104.00 series on international taxation 39 © 2012 kluwer law international how to order: online: www.kluwerlaw.com or contact our sales departments at: for europe and rest of the world: sales@kluwerlaw.com for usa and latin america: aspen-sales@wolterskluwer.com for canadian customers: cservice@cch.ca for asia and australia: support@cch.com.my www.kluwerlaw.com florida tax review volume 13 2012 number 3 135 horizontal equity revisited by james repetti and diane ring* i. introduction ............................................................................. 135 ii. why he and ve lack normative content ........................... 139 iii. efforts to sustain a design role for he ......................... 142 iv. efforts to find other roles for he ................................. 145 a. he as a process requirement ........................................... 145 b. he as even-handed enforcement ..................................... 151 v. conclusion ................................................................................. 154 i. introduction no tax policy analysis stands complete without examination of equity implications. but despite its role as a traditional pillar of tax policy analysis, equity itself remains a controversial concept. 1 what is meant by the term equity? how should it be measured? is there more than one type of equity? what is the relationship of different types of equity to each other? for decades, scholars and policy makers have explored the possibility that equity is best understood as two distinct concepts — vertical equity and horizontal equity — both of which must be evaluated. 2 horizontal equity *diane ring is a professor of law at boston college law school. james repetti is the william j. kenealy, s.j. professor of law at boston college law school. this article was originally published as chapter 6 in the proper tax base: structural fairness from an international and comparative perspective—essays in honor of paul mcdaniel (yariv brauner & martin j. mcmahon, jr. eds., kluwer law international, 2012), and is reprinted with permission. 1. paul r. mcdaniel & james r. repetti, horizontal equity and vertical equity: the musgrave/kaplow exchange, 1 fla. tax rev. 607 (1993) [hereinafter mcdaniel & repetti, horizontal equity]. 2. richard a. musgrave, the theory of public finance 160 (1959) [hereinafter musgrave, public finance]; louis kaplow, horizontal equity: measures in search of a principle, 42 nat‘l tax j. 139 (1989) [hereinafter kaplow, 136 florida tax review [vol. 13:3 (he) is defined to mean that equals should be treated alike. 3 vertical equity (ve) is defined to mean that an appropriate distinction should be made in the treatment of people who are not alike. 4 although disagreement exists, he in our tax system has generally been thought to require that individuals with the same income should pay the same tax. ve has generally been thought to require a progressive rate structure that imposes progressively higher rates on individuals with higher incomes. despite frequent reliance on both he and ve in tax policy analysis over the years, scholars have engaged in an active and vibrant debate about whether he has any significance independent of ve in designing a tax system. this dispute has been best captured by the debate between two economists, richard musgrave and louis kaplow. kaplow argued in 1989 that he is not a useful tool for tax policy because it has no normative content and no significance distinct from ve. 5 kaplow further asserted that the use of he in tax policy analysis is harmful because ―it will lead policymakers astray when they are encouraged to sacrifice other values in the pursuit of he.‖ 6 thirty years earlier, in 1959, musgrave (musgrave i) had also concluded that he lacked normative content. he stated: the requirements of horizontal and vertical equity are but different sides of the same coin. if there is no specified reason for discriminating among unequals, how can there be a reason for avoiding discrimination among equals? without a scheme of vertical equity, the requirement of horizontal equity at best becomes a safeguard against capricious discrimination — a safeguard which might be he i]; louis kaplow, a note on horizontal equity, 1 fla. tax rev. (1992) [hereinafter kaplow, he ii]; richard a. musgrave, horizontal equity, once more, 43 nat‘l tax j. 113 (1990) [hereinafter musgrave, he]; richard a. musgrave, horizontal equity: a further note, 1 fla. tax rev. 354 (1993). 3. kaplow, he i, supra note 2, at 140–41; musgrave, public finance, supra note 2, at 113. 4. kaplow, he i, supra note 2, at 140–41; musgrave, public finance, supra note 2, at 113. 5. kaplow, he i, supra note 2. 6. id. at 140. see also, e.g., david elkins, horizontal equity as a principle of tax theory, 24 yale l. & pol‘y. rev. 43, 44–62 (2006) (arguing that it is possible to design a tax system that is both economically efficient and distributive but that ―blatantly violates‖ he). for example, this might occur because some variations of he require that the order in which taxpayers are ranked by income be preserved in a tax reform. as discussed, in notes 47–80, the forms of he that require pre-tax ordinal rankings to be preserved are really applying ve, not he. thus, the tension created by such regimes is in fact a tension between efficiency and the distributive justice goals specified by the particular tax system. 2012] horizontal equity revisited 137 provided equally well by a requirement that taxes be distributed at random. 7 indeed, musgrave‘s analysis went a step further. he argued, in musgrave i, that both he and ve were inadequate for formulating tax policy because both depended on a determination of some measure for distinguishing equals and unequals. 8 he reasoned, ―an objective index of equality or inequality is needed to translate either principle into a specific tax system.‖ 9 in other words, the notion that equals should be treated equally requires specification of the criteria used to determine who is equal and who is unequal, and that specification will in turn require appeal to some form of distributive justice. however, in response to kaplow‘s 1989 assertion, musgrave reassessed his own views and decided that he had been wrong (musgrave ii). after surveying various forms of distributive justice, he concluded that he has a normative basis that is firmer than ve, stating: [t]he requirement of he remains essentially unchanged under the various formulations of distributive justice, ranging from lockean entitlement over utilitarianism and fairness solutions. that of ve, on the contrary, undergoes drastic change under the various approaches. while he is met by the various ve outcomes, this does not mean that he is derived from ve. if anything, it suggests that he is a stronger primary rule. 10 in their 1993 article, paul mcdaniel and james repetti (m-r) reviewed this pivotal debate regarding the meaning of ve and he, and ultimately agreed with musgrave i and with kaplow that both he and ve lack independent significance and should be best understood as a single concept. 11 but he has not died. in the intervening years he has survived as a frequently articulated independent policy ground in the assessment of tax policy. why? was earlier analysis faulty, or is something else at work in the tax literature? almost two decades later, this paper reexamines the appropriate role of he in tax policy and the debate that has occurred subsequent to the 1993 m-r paper. in this paper, we agree with musgrave i‘s original assessment and later determinations by kaplow and m-r. he does not serve a useful role in formulating tax policy. he and ve are merely both sides of the same coin, because starting an analysis by asking what the 7. musgrave, public finance, supra note 2, at 160. 8. id. at 161. 9. id. 10. musgrave, he, supra note 2, at 116–17. 11. see mcdaniel & repetti, horizontal equity, supra note 1. 138 florida tax review [vol. 13:3 appropriate criteria are to determine which persons are not alike yields the same result as starting the analysis by asking what criteria should be used to determine whether persons are alike. in addition, we agree with musgrave i and m-r that ve also is not useful without appeal to a theory of distributive justice. but there are important reasons why debate about the role of he has persisted. although he is not a useful substantive tool for tax policy design, it may serve a useful role in: (1) establishing the process to be followed to design tax policy; and (2) assessing the administration of the resulting rules. the first two of these reasons mirrors the insight of musgrave ii. as urged above, equality (the core vision of he) is not independently important in formulating tax policy because taxation is an algorithm that will always tax equally those defined as equals. 12 equality does, however, define the process for designing a tax system by requiring that the government justify its selection of criteria to measure who is equal (and not equal). 13 he lingers in the tax debate because, by starting with the notion that all should be treated equally, he requires a government to articulate a justification for any tax policy that imposes ―different‖ taxation. he tells us that government should communicate the rationale for different treatment; however, it does not tell us what the treatment should be. moving to the level of administration of the tax system, some tax scholars have relied on he to serve as a benchmark for assessing whether governmental administration of the tax law is fair. as musgrave i observed (somewhat negatively), ―[i]n the absence of vertical equity norms, the case for horizontal equity is reduced to providing protection against malicious discrimination, an objective which might be met more simply by a tax lottery.‖ 14 as considered more extensively below, 15 he could be viewed as a safeguard against arbitrary enforcement of tax laws and, therefore, stays at the forefront of tax consciousness because arbitrary enforcement would be particularly pernicious in a system that does not usually make public 12. this result is not avoided by employing a different definition for he that looks to see whether ―similar‖ taxpayers (rather than the ―same‖ taxpayers) are taxed in a ―similar‖ way (rather than the ―same‖ way). whatever criteria are used to identify taxpayers who are ―similar‖ will result in such taxpayers being taxed in a ―similar‖ way. 13. kenneth w. simons, the logic of egalitarian norms, 80 b.u. l. rev. 693, 714 and 748–50 (1990) (arguing that a right to equality requires a decisionmaker to provide a ―rational explanation of a difference in treatment‖) [hereinafter simons, egalitarian norms]. 14. richard a. musgrave, et, ot and sbt, 6 j. pub. econ. 4 (1976).15. see infra test accompanying notes 56–62. 15. see infra test accompanying notes 56–62. 2012] horizontal equity revisited 139 disclosures regarding each taxpayer‘s liability for taxes. 16 he does not define the form of enforcement, but does require the government to justify why enforcement is not uniform. part ii of this article describes why he and ve lack normative content. part iii considers and rejects arguments that have been offered after the m-r article to defend the role of he. part iv suggests that while he is not helpful in designing a tax system because it provides no guidance about what the system should look like, support for he has persisted because of a shared belief that government should communicate the rationale for treating people differently. he tells us that government should communicate the rationale for different treatment, but it does not tell us what that different treatment should be. part iv further suggests that support for the role of he may also be rooted in the notion that government should be even-handed in its enforcement of tax laws. part iv observes, however, that he is not helpful in insuring even-handed enforcement. in a world of finite resources, not every taxpayer can be audited. in deciding who should be audited, it is necessary to refer to something beyond he. part v concludes this article. ii. why he and ve lack normative content in their review of the musgrave-kaplow debate, m-r agreed with musgrave i that ve, the notion that an appropriate difference should be made among taxpayers who are different, lacks normative content because a theory of distributive justice is required to determine the ―appropriate‖ difference that should be made. 17 for example, ve, by itself, does not lead to the conclusion that we need a progressive income tax. it is necessary to refer to an underlying theory of justice and to make some key economic assumptions in order to conclude that a progressive rate structure is desirable. 18 we might, for example, justify the imposition of progressive tax rates on income based on a theory of justice that believes equal tax burdens should be imposed on all taxpayers and on a key assumption about the rate at which the utility of income decreases as income increases. 19 if the utility of income decreases at an accelerating rate as income increases, a progressive rate structure is required to impose equal burdens on taxpayers. 20 it is the reference to some 16. most tax returns are not publicly disclosed. public charities, however, are required to publicly disclose their federal tax returns. i.r.c. § 6104(d). 17. mcdaniel & repetti, horizontal equity, supra note 1. 18. id. at 610. 19. id. 20. technically, the rate will be ―progressive, proportional, or regressive, depending on whether the elasticity of the marginal income utility with respect to income is [, respectively,] greater than, equal to, or less than [one].‖ richard a. musgrave & peggy b. musgrave, public finance in, theory and practice 200 (1973) [hereinafter musgrave & musgrave, public finance]. 140 florida tax review [vol. 13:3 outside normative theory and economic assumptions, rather than reference to ve alone, that designs the tax system. m-r also concluded, as had kaplow and musgrave i, that he lacks independent significance for two reasons. 21 first, a theory of distributive justice that treats different taxpayers differently will always require that equals be treated equally. for example, a system that seeks to impose equal burdens on taxpayers will require that identical burdens be imposed on taxpayers with what has been determined to be equal income. similarly, a system that imposes tax burdens based on the taxpayers‘ abilities to pay will impose the same burden on taxpayers that have the same ability to pay (i.e. that have the same income). he adds nothing to the design of the system and indeed may distract from the proper consideration of the more fundamental issues of distributive justice that underlie the treatment of taxpayers. 22 this is particularly true in a tax system, where liability is calculated by mechanically applying an algorithm to the selected tax base. the focus should be on the selection of the tax base. second, and more broadly, the notion that equals should be treated equally requires specification of the criteria used to determine who is equal. once the criteria for determining equality are selected, it follows that those with the same criteria should be treated the same. 23 but selection of the 21. mcdaniel & repetti, horizontal equity, supra note 1, at 612–13. 22. id. at 620–21. see thomas d. griffith, should “tax norms” be abandoned? rethinking tax policy analysis and the taxation of personal injury recoveries, 1993 wis. l. rev. 1115, 1156–57 (1993); anthony c. infanti, tax equity, 55 buff. l. rev. 1191, 1196 (2008) (criticizing ve and he as being concerned only with economic differences of taxpayers and consequently foreclosing ―consideration of non-economic forms of difference (e.g., of race, ethnicity, gender, sexual orientation, or physical ability) when determining the appropriate allocation of societal burdens, even though these other forms of difference have served, and continue to serve, as the basis for invidious discrimination that already imposes heavy burdens on its victims.‖); leo p. martinez, the trouble with taxes: fairness, tax policy, and the constitution, 31 hastings const. l.q. 413, 422–24 (2004) (observing that application of ve and he require appeal to underlying notions of fairness); see also elkins, supra note 6, at 86–87 (concluding that several possible justifications for horizontal equity can all be proved unsuccessful; and suggesting that ―justification of horizontal equity depends upon the moral entitlement of each individual to his free-market holdings.‖). elkins‘ conclusions about the relationship between he and the taxpayer‘s claim to keep the post-market/pre-tax holdings itself demonstrates that even this use of he is predicated on a normative and distributive conclusion derived outside of he. 23. in the related area of constitutional law, peter westen has argued that equality is a tautology because once the criteria for determining whether persons are the same have been established, it follows that they will be treated similarly. peter westen, the empty idea of equality, 95 harv. l. rev. 537, 547–48 (1982). as in the tax area, this view has stirred significant debate. see, e.g., steven j. burton, 2012] horizontal equity revisited 141 criteria to measure equality requires that we once again refer to distributive justice. for example, should equality be based upon equal incomes or equal amounts of consumption? those concerned about persons with few resources may be troubled by the distributive effect of a consumption tax and, therefore, may favor an income tax. regardless of whether one believes that the criteria must reflect the overall vision of distributive justice in society 24 or alternatively can be more tightly linked to the tax system, 25 selection of the criteria to measure equality will always lead back to distributive justice with the result that he will always be subsumed within ve. m-r concluded, as had musgrave i, that the use of ve and he in designing a tax system is a poor proxy for the actual theory of distributive justice that underpins the design of the tax system and that questions about tax design should be directed to the specific theory of distributive justice. subsequently, liam murphy and thomas nagel took the analysis a step further. they argued that forms of distributive justice frequently applied by tax theorists to design tax systems — determining the tax based on ―benefit‖ received by taxpayers or requiring ―equal sacrifices‖ by taxpayers — were also useless in designing a tax system that seeks to achieve justice. 26 they argued that identifying a just tax requires looking outside the tax system and focusing on the ―broader principles of justice in government.‖ 27 they reason that the starting point of a tax, such as each taxpayer‘s income, is itself the product of government policies. evaluating an income tax based solely on the amount of taxes assessed ignores an important factor — the fairness of the pre-tax incomes earned by the taxpayers. murphy and nagel view the tax system as an instrument that helps achieve governmental objectives for justice. they assess the current state of tax policy analysis as inadequate, stating: comment on “empty ideas:” logical positivist analyses of equality and rules, 91 yale l.j. 1136 (1982); erwin chemerinsky, in defense of equality: a reply to professor westen, 81 mich. l. rev. 575 (1983); kent greenawalt, how empty is the idea of equality?, 83 colum. l. rev. 1167 (1983); kenneth l. karst, why equality matters, 17 ga. l. rev. 245 (1983). 24. see, e.g., liam murphy & thomas nagel, the myth of ownership: taxes and justice 15, 25, 30 (2002) (asserting the unbreakable link between tax fairness and overall justice) [hereinafter murphy & nagel, the myth of ownership]. 25. see, e.g., kevin a. kordana & david h. tabachnick, book review: tax and the philosopher’s stone, 89 va. l. rev. 647, 653–54 (2003) (challenging murphy and nagel‘s rejection of tax system derived ―fairness‖). see infra text accompanying notes 33–35. 26. murphy & nagel, the myth of ownership, supra note 24, at 16–19, 24–30. 27. id. at 30. 142 florida tax review [vol. 13:3 [the] entire [current] approach is flawed in its foundations. if the distribution produced by the market is not presumptively just, then the correct criteria of distributive justice will make no reference whatever to that distribution, even as a baseline. distributive justice is not a matter of applying some equitable-seeming function to a morally arbitrary initial distribution of welfare. despite what many people implicitly assume, the justice of a tax scheme cannot simply be evaluated by checking that average tax rates increase fast enough with income . . . . [o]nce we reject the assumption that the distribution of welfare produced by the market is just, we can no longer offer principles of tax fairness apart from broader principles of justice in government. 28 again, even if one is not fully persuaded by their arguments that traditional tax theories, such as the benefits principle or the equal sacrifice principle, offer nothing to tax policy, their overarching point that tax system design fundamentally turns on decisions about distributive justice and moral principles accurately underscores the hollowness of both ve and he. iii. efforts to sustain a design role for he this part reviews arguments offered by scholars post m-r to revive and support he‘s place in shaping substantive tax policy. in 2003, kevin a. 28. id. for an earlier argument that tax analysis needs to take into account the conditions that gave rise to the distribution of the tax base, see patricia apps, a theory of inequality and taxation 4 (1981) (―[t]ax theory remains firmly grounded upon an innate or inherited endowments theory of inequality. the aim of the analysis here is to examine tax incidence and tax distortions taking account of the way in which institutional inequality is initiated and perpetuated.‖) (footnote omitted). many others also have noted that economic wellbeing is the result of many factors, including the individual‘s initial starting point, the efforts of others, and merit. see, e.g., michael j. graetz, to praise the estate tax, not to bury it, 93 yale l.j. 259, 275–79 (1983) (questioning ―those who simply assume that the market distributes rewards to people who deserve them and denies rewards to people who do not‖); sagit leviner, from deontology to practical application: the vision of a good society and the tax system, 26 va. tax rev. 405, 415–18 (2006) (―[d]ifficulty with the view of the market as neutral or providing just rewards is that, in the real world, people do not enter the market with equal resources including identical or otherwise equivalent talents, skills, or backgrounds.‖); amartya sen, the moral standing of the market, in ethics and economics 1, 1–19 (ellen frankel paul et al. eds., 1995). 2012] horizontal equity revisited 143 kordana and david h. tabachnick suggested such a role for he, but did not elaborate. they stated: while it is true that there can be no blanket rule requiring horizontal equity, it does not follow that issues of uniformity do not count at all. from what we have argued above with respect to the benefit principle and the equal sacrifice principle, it should be clear that issues of uniformity can be relevant, if subordinate, to distributive aims. 29 it is not clear to us exactly what role kordana and tabachnick (k-t) contemplate for he because their discussion of the benefit principle and equal sacrifice principle did not discuss he. indeed, we believe that there is little they could have said. the benefit principle ―requires that taxpayers contribute, via taxation, in proportion to the benefit they derive from government.‖ 30 the equal sacrifice theory states ―that taxation should reduce each taxpayer‘s welfare by an equal amount.‖ 31 since k-t do not focus on he, they did not consider the arguments of musgrave i and kaplow that he would contribute nothing to the design of a tax system. 32 to apply the benefit or equal sacrifice doctrine, it is first necessary to determine how benefits and sacrifice should be measured. for example, should the determination of the amounts of benefits received and the sacrifices made in paying taxes be based on an assumption that the utility of money declines as income increases? 33 to decide this issue reference must be made to theories of welfare economics and theories of declining marginal utility. once those decisions are made, it follows that those obtaining the same utility from benefits received or losing the same utility from taxes paid should be treated the same. in their discussion of the benefit and the equal sacrifice principles, k-t examine murphy and nagel‘s argument that such theories have no role in achieving justice because justice needs to be measured by directly 29. kordana & tabachnick, supra note 25, at 663. 30. id. at 653 (quoting murphy & nagel, the myth of ownership, supra note 24, at 16). 31. id. at 661. 32. he collapses into ve because it is necessary to determine how benefits and sacrifice should be measured in circumstances where persons will have received different amounts of benefits and income. see, e.g., richard a. musgrave & peggy b. musgrave, public finance in theory and practice 239–42 (3d ed. 1980); james r. repetti, democracy and opportunity: a new paradigm in tax equity, 61 vand. l. rev. 1129, 1137–41 (2008) [hereinafter repetti, democracy]. 33. see, e.g., musgrave & musgrave, public finance, supra note 20, at 239–42; repetti, democracy, supra note 31, at 1137–41. 144 florida tax review [vol. 13:3 examining the theory of justice that is guiding all governmental functions (i.e. taxing and spending) k-t state: for murphy and nagel, the benefit principle is subject to the charge of ―myopia‖ — it ignores government spending, that is, the provision of public goods and redistribution, and gives guidance only about how to raise tax revenue. their basic idea, we think, is that if one is committed to a theory of distributive justice, the achievement of the aims of that theory may be hampered by any attempt to comply with the benefit principle. if the overarching conception of distributive justice takes fairness into account but allows for justifiable inequalities, criticisms of resulting inequalities on the basis of fairness are ill-motivated (because the inequalities are justified by the overarching conception of distributive justice). the conception of distributive justice determines fairness in taxation; therefore, a tax policy that at first glance appears inequitable might, all things considered, be justified. for example, a tax structure that is consistent with rawls‘s difference principle may allow for what would appear (under, for example, the benefit principle) to be inequities in tax policy. however, these inequities are, all things considered, justified if the inequities are necessary to maximize the position of the least well-off. thus, the question of justice in taxation is not separable from the question of overall distributive justice. to the extent the benefit principle treats these two questions as separable and addresses only the issue of justice in taxation, it is, for murphy and nagel, objectionable. 34 k-t respond to murphy and nagel in part by positing situations in which the government‘s ―overall distributive justice‖ may leave unanswered specific issues pertaining to the design of the tax system. for those specific design issues, traditional notions of tax equity can be the tie-breaker. they state: if two or more economic schemes equally maximize the demands of the conception of distributive justice, and if one scheme contains a tax system that satisfies the benefit principle while the other(s) do not, one who held the benefit 34. kordana & tabachnick, supra note 25, at 653–54. 2012] horizontal equity revisited 145 principle could invoke it to adjudicate between schemes. doing so is not inconsistent with the maximizing conception of distributive justice. 35 we agree with this insight, but we do not see how it makes the case for an independent role for he in the design of the tax system. satisfaction of the benefit principle (that the tax burden correspond to the level of benefits received) will automatically require that those with equal benefits be treated the same, assuming that this does not conflict with the governmental scheme of ―overall distributive justice.‖ perhaps k-t envision a similar but independent tie-breaker role for he, where such equivalences occur. 36 however, this possible construction of k-t‘s defense of he ultimately would not stand: (1) the tie-breaker reasoning they explicitly used in defense of the benefit principle was in their own terms a ―rarely‖ applicable role; 37 and (2) unlike the benefit principle which provides some of its own content, he, even in this limited setting, still has no independent principles to draw upon in breaking the tie (any principles it would recite would have already formed the basis of ve determinations of taxation). thus, while k-t make the case for application of traditional theories of tax justice, such as the benefit theory, to the design of a tax system, their discussion of the benefit and equal sacrifice theories does not support a role for he. in a subsequent portion of their article that discusses determination of the tax base, k-t do foreshadow an argument that has been employed by others (and examined below) to argue for the independence of he on political process grounds. they assert that ―uniform treatment is preferable . . . out of deference to a democratically made decision, or as a matter of equality or autonomy.‖ 38 the next part examines how others have further articulated what could be termed a ―process‖ role for he. iv. efforts to find other roles for he a. he as a process requirement despite the comprehensive and persuasive arguments that he collapses into ve (and that ve requires the independent selection of norms and criteria grounded in distributive justice), assertions have persisted in the tax literature that he should play an important role in the design of a tax system. as jeffrey kahn has observed, ―[m]any persons do give weight to horizontal equity, and even those who do not frown on unequal treatment of 35. id. at 654–55. 36. id. 37. id. at 655. 38. id. at 667–68. 146 florida tax review [vol. 13:3 the same item.‖ 39 in an effort to discern and specify the undeniable appeal of he, scholars have carved out a role, but one that is not on par with ve and does not make claims on substantive tax policy design. brian galle, in a 2008 paper, defends he as independent of ve, primarily by constructing a role for he that we contend is best understood as one grounded in the context of political process and political theory, and not as an independent policy role. 40 the core of his argument is that he can be understood as standing for the position that the pre-tax allocation of income (specifically the pre-tax ordinal ranking of taxpayers with similar amounts of income) 41 should receive deference from tax writing legislators because that allocation was generated under existing rules (tax and non-tax) approved by an earlier congress: i want to defend here the notion that our accumulations of cash or contentedness, as they stand prior to being subjected to tax, should have some weight. i begin with the idea that pretax distributions may be non-random, and, indeed, may be the deliberately chosen result of a perfectly just system of laws other than the tax laws. to disturb that distribution might then be an injustice, or, at a minimum, could imply that the moral judgment of the taxlaw drafters is superior to the judgment of those who put in place the rest of society. he, therefore, could represent the extent to which the tax system defers to explicit or implicit moral judgments made elsewhere in society or in government. put another way, suppose that we sit as lawmakers on a legislative committee with the authority to draft tax statutes, and we hold sufficient sway over our colleagues to obtain passage of whatever we enact. let us posit that earlier this year, our colleagues enacted a farm subsidy bill whose distributive consequences we find appalling. would it be legitimate or proper for us to enact a 100 percent tax on 39. jeffrey h. kahn, the mirage of equivalence and the ethereal principles of parallelism and horizontal equity, 57 hastings l.j. 645, 652 (2006). 40. brian galle, tax fairness, 65 wash. & lee l. rev. 1323 (2008) [hereinafter galle, fairness]. 41. id. at 1359–61. the notion that he requires the pretax ranking of taxpayers to be preserved is based on the idea that taxpayers who have ―equal shares in the pre-tax distribution‖ should have ―equal shares in the post-tax distribution.‖ elkins, supra note 6, at 73. if the relative rankings of taxpayers changes after tax, that change may indicate that equal taxpayers are not being treated equally because they now have different shares. as discussed infra, text at notes 47–50, the use of such rankings to measure he is very controversial. 2012] horizontal equity revisited 147 receipt of that subsidy? it is arguable, i claim, that the answer is no. if that intuition is correct, then it follows that there are constraints on tax legislation that do not arise purely out of distributive justice norms, but that instead depend on political theories, such as an obligation, again, to defer to the reasonable judgments of others. (citations omitted). 42 galle‘s argument here is specifically about tax reform — not the first tax law written at the start of society, government and the economy, but the tax reform contemplated in the midst of an ongoing legal, economic and tax system. he makes this distinction to move beyond murphy and nagel‘s claim that government and market cannot exist without taxation, and all must be contemplated as a totality. 43 but why grant deference to a prior congress? to support this position, galle envisions the tax writing function as a tripartite role — in which one of the roles lends itself to deference to prior congressional determinations: why would we want, or be obliged, to grant such deference? i suggest here two possible lines of thought. both lines depend on one prior assumption. i assume that the tax code comprises not one, but in fact three distinct governmental systems or modes: raising revenue, redistributing wealth, and enacting other policy goals. each of these modes might have its own set of rules or norms. my claims about he for the most part are limited to tax‘s revenue function, although the absence of he can signal to us that we need to justify our tax decision by resorting to one of the other two modes. turning, then, to the two possibilities, i argue that he can be justified both by the unique purpose of the revenue function as well as on welfare grounds. in order for revenue-raising to serve its basic function, and to command widespread popular acceptance, it must be open to any reasonable view of good government. it follows, albeit along a twisty path, that the principles underlying the revenue function should give significant weight to preexisting distributions of societal goods (footnote omitted). 44 42. galle, fairness, supra note 40, at 1327. 43. id. at 1335. 44. id. at 1327–28. 148 florida tax review [vol. 13:3 essentially, galle‘s core claim (elaborated in more detail) is that the revenue function of tax legislation drafting does not by its own terms incorporate any normative component, and when exercising that function legislators should give deference to the prior, democratically determined choices that resulted in the current pre-tax distribution of resources: in particular, i argue here that, because the sole purpose of revenue is to make possible a flourishing deliberative democracy, and because it is possible that allowing the revenue system [i.e. the revenue function of new tax legislation] to make its own policy judgments would interfere with deliberations elsewhere, the revenue process should simply accept as a given, any reasonably policy choice. 45 thus, in considering tax reform, legislators should not disturb the pre-tax ordinal ranking of taxpayers based on ―income.‖ 46 galle recognizes one of the likely challenges to this articulation of an independent he: that tax legislation is not exclusively a revenue function but includes redistribution and other policy goals on a regular basis and therefore this intertwined role provides no support for deference. in anticipation of this argument, galle offers a separate justification for he grounded in considerations of legislative efficiency: for those who find this form of deontological reasoning unpersuasive, i also roughly model the circumstances in which we can expect respect for he to increase overall societal welfare. taking as given the justice of existing arrangements can reduce the costs of deliberating about alternative rules, as well as the transaction costs and transition costs that attend the political process. at times, though, these gains may be swamped by the inefficiency of separating redistributive ―corrections‖ from the revenue process itself. 47 we think that these are valuable insights, raising interesting and important questions about political process, particularly the iterative dimension of legislative drafting, but they do not defend he as an independent concept of ―fairness.‖ we reach this conclusion for several 45. id. at 1346. 46. id. at 1359–61 (noting that the pre-tax position of taxpayers reflects the ―preferred ranking of individuals‖ by society reflected in prior legislation). 47. galle, fairness, supra note 40, at 1327. 2012] horizontal equity revisited 149 reasons. first, galle‘s core claim of he — that we should preserve the rank order of taxpayers — really constitutes a claim about ve. in their 1993 article, m-r reviewed kaplow‘s critique of economists who argued that he was violated (and thus had an independent function) when a tax law change altered the pre-tax rankings of taxpayers. kaplow makes a key observation: the process of ranking and protecting ranking actually constitutes assessments of and determinations about those who are not equal — which is the domain of ve. 48 further, kaplow notes in his discussion of the economists on ranking (and galle essentially agrees) — if he only requires preservation of ranking, it would do very little. why? consider an abbreviated version of kaplow‘s hypotheticals. 49 in world #1, a has 100 and b has 95 of income before tax. he is violated if, after tax, a has 94 and b has 95. however, in world #2, a has 100 and b has 95 before tax, but after tax a has 147 and b has 51. in this case, he is not violated although the disparity between the taxpayer‘s income has increased significantly. thus, consistent with kaplow i and m-r, we would conclude that a meaningful application of he here is essentially ve, and in any event is literally only about those who are exactly equal under the existing concept of ve. second, the initial concept of the pre-tax ranking of taxpayers (which galle argues he guides us to protect) implies that we know what to count — what goods, services, and benefits are relevant for determining the ranking. but to have a ranking, we must already have in place a concept of ve to define what should be counted (i.e. to define the tax base). this observation alone is not inconsistent with galle‘s argument, but explicitly acknowledging this point helps clarify precisely what galle is claiming. in urging that tax reform be particularly attentive to existing rankings he envisions that in this moment before tax reform there are in place both rules implementing a concept of ve (which defines the tax base and tax burden) and some non-tax legislation that together result in a ―pre-tax reform‖ ordering of taxpayers. it is really the net result (i.e. ordering of taxpayers by income) of the existing tax and non-tax legislation combined that galle urges be protected, given his attention is on tax reform. 50 thus, galle‘s he is an assertion that congress should not change its ve over time, at least not to the extent it could alter taxpayer ranking. 48. kaplow, he i, supra note 2, at 141. 49. kaplow, he ii, supra note 2, at 194–95. 50. use of the phrase ―pre-tax‖ here can be a bit confusing. it is possible that the world as it looks before tax reform produces the following result: under the combination non tax law and existing tax law taken together, certain taxpayers receive $x, and others receive $x +1. we understand galle to say that a problem then arises if and when congress later seeks to implement new tax legislation that would change the net effect of what congress had intended, to date, to be the ultimate rank order of taxpayers. see generally, galle, fairness, supra note 40, at 1346. 150 florida tax review [vol. 13:3 why not change ve? the answer to this leads to our third concern with this articulation of an independent he. the he argument relies on isolating and examining only the revenue raising function of congress (because the he question is directed exclusively at the tax burden assigned to a particular tax payer — and not the totality of that taxpayers experience with the government). however, in reality there are no such constraints on congress — it is free to act in any and all capacities simultaneously — and it does so. legislation regularly reflects a mixture of revenue, redistribution and non-tax policy goals. given this observation, an argument for he grounded in only the revenue function provides no discernible guidance. moreover, it begs the reverse question, ―is it undesirable for congress to undo existing tax policy (rooted in its redistributed and other policy goals) through reforms outside the tax law?‖ ultimately, the decisions of a later congress on tax reform may be best understood as part of both the messy dynamics of the political process and the smoothing process of the republican form of government in which power shifts are meant to occur gradually through the different and overlapping electoral schedules of the president, senate, and house of representatives. finally, galle‘s grounding of he in an efficiency analysis — suggesting costs savings can be generated by assuming the fairness of existing distributions and not engaging in additional tax reform — joins an active dialogue regarding legislative process and efficiency. but as with other efforts described earlier to secure a distinct place for he, we do not consider this an example of he used to prescribe a self-contained notion of fairness for taxpayers. rather, it is use of he terminology in a different conversation about efficiency-based assessments of the legislative process. by introducing the concept of efficiency as a method to evaluate that process, galle is appealing to a different form of distributive justice in order to add content to he. while we disagree with galle‘s defense of he, we think that he has insightfully pointed future debate about he in the correct direction — one that connects the persistence of he to the underlying theme of equality among citizens and the expectation that the government only make changes based on careful consideration and articulated reasoning. he refuses to perish because it represents a presumption for equal treatment under the laws of an egalitarian society. in a related area, a debate about whether equality is an empty concept in the context of the constitution has occurred. 51 surprising agreement exists between those who view equality as an empty concept and those who do not that the government should be required to act for appropriate reasons. that is, even those who argue that equality is an 51. see, e.g., westen, supra note 23 at 547–48; see also, e.g., burton, supra note 23; chemerinsky, supra note 23; greenawalt, supra note 23; karst, supra note 23. 2012] horizontal equity revisited 151 empty concept agree that persons should be protected from government acting for the wrong reason. 52 for example, christopher peters has argued that the case of yick wo v. hopkins, 53 in which the plaintiff was denied a laundry license because of his race, should not be viewed as requiring equality of treatment, but rather requiring that the government correctly apply a substantive rule that privileges should not be granted or denied based on race or ethnicity. peters asserts that equality is empty because it requires one to look to an underlying substantive rule, but once the substantive rule is identified (race is irrelevant) the government must correctly apply such rule. similarly, kenneth simons, an advocate for equality having independent significance, argues that equality requires that the government explain why it is treating people differently. 54 he states that a ―demand for reasons for inequality is one important type of equality right. . . .‖ 55 thus, there is surprising unanimity for a justificatory role for equality in a different area of law. perhaps, the lingering (languishing) loyalty to he in the tax literature reflects this role. he remains in our collective tax consciousness because in a democratic society we expect an explanation for why people are being treated differently. he tells us that government should communicate the rationale for different treatment; it does not tell us what that different treatment should be. b. he as even-handed enforcement up to this point the strongest articulation of an independent role for he is a secondary one: ensuring that the government demonstrates it has carefully considered tax laws that produce different taxation (i.e. different tax bills), given the broad-based commitment to equal treatment in the legal system. thus, he here is not doing the work comparable to ve, which serves (albeit indirectly) as the vehicle for framing our views on the appropriate burden borne by each taxpayer. rather, he should be seen as addressing another part of the regime — not the design of the system, but the process of design. a careful review of the proponents of he, however, reveals that many supporters of he draw upon a role for he in the administration of the tax law. joseph dodge has argued that he serves as a check on the application of utilitarian welfare to individuals. he states: 52. see, e.g., christopher j. peters, equality revisited, 110 harv. l. rev. 1210, 1219–20 (1997). 53. yick wo v. hopkins, 118 u.s. 356 (1886). 54. simons, egalitarian norms, supra note 13, at 714, 748. 55. id. at 748. 152 florida tax review [vol. 13:3 horizontal equity derives from the command that likes should be treated alike, which is a maxim of civil justice whose origins predate, and are independent from, welfare economics. . . . of course, the horizontal equity norm in taxation is incomplete, because it leaves unspecified the index of comparison (for example, ability to pay, standard of living, income and so on). . . . theories of redistribution can be contractarian, utilitarian, or religionbased, but conventional welfare economics is utilitarian, since it inquires into the net social gains and losses from a given policy. it is characteristic (and perhaps a weakness) of utilitarian thinking that the welfare of the individual is readily subordinated to collective welfare. the ethical command that likes should be treated alike is similar to concepts of ―rights‖ in imposing limits on the utilitarian approach. 56 we interpret dodge‘s argument to mean that the right to equal treatment is not a principle of design but instead a principle of conduct that controls all governmental interaction with citizens. indeed, in a subsequent article, dodge describes he and ve as ―formal norms‖ that ―equally-situated persons should be treated equally‖ and ―unequally-situated persons should be taxed differently to an appropriate degree.‖ 57 he uses the term ―formal norm‖ in the rawlsian sense of meaning the process by which laws are administered. 58 he goes on to observe that ―substantive norms‖ then provide a standard to measure equality: the role of ―substantive‖ tax fairness norms is to provide an index or standard of relevant equality and inequality. the 56. joseph m. dodge, a combined market-to-market and pass-through corporate-shareholder intergration proposal, 50 tax l. rev. 265, 276 n.42 (1995). 57. joseph m. dodge, theories of tax justice: ruminations on the benefit, partnership, and ability-to-pay principles, 58 tax l. rev. 399, 401 (2005) [hereinafter dodge, theories of tax justice]. 58. id. at 453 (―this idea of fairness — which otherwise can be referred to as ‗formal justice‘ and (in its tax version) as horizontal equity — has considerable value in itself.‖). at the end of this sentence professor dodge cites to rawls. id. at 453 n.222 (citing john rawls, a theory of justice 58–60 (1971)). in the pages referenced by dodge, rawls states, ―if we think of justice as always expressing a kind of equality, then formal justice requires that in their administration laws and institutions should apply equally (that is, in the same way) to those belonging to the classes defined by them. . . . formal justice is adherence to principle, or as some have said, obedience to system.‖ john rawls, a theory of justice 58 (1971). 2012] horizontal equity revisited 153 most commonly cited substantive tax fairness norms include: (1) the equal-sacrifice norm, (2) the benefits-received-fromgovernment norm, (3) the ―well-being‖ (or ―standard-ofliving‖) norm, and (4) the ability-to-pay norm. 59 the notion that he militates against the arbitrary enforcement of tax law has also been championed by john a. miller. he has observed: the conclusions offered by mcdaniel and repetti are sound in a narrow pedantic sense. my concern is that their analysis fails to allow for the more primitive and malevolent possibilities of human existence. they assume a societal rationality and rule mindedness that assures equality even without relying on the principle of equality. belief in the importance of the principle of equality, on the other hand, assumes that humanity possesses a limitless propensity for persecution and arbitrariness. it is in the context of an irrational and discriminatory world that equality‘s meaning and utility stand out. 60 the role for he proposed by miller is similar to that proposed by dodge and musgrave. he views he as a check on arbitrary or even pernicious application of tax laws to taxpayers. we believe that the common thread running through all of these articulations of an administrative role for he could be stated perhaps more bluntly and with particular force in the case of the income tax system. he plays a distinct, separate and effectively operational role. as a general concept, which could be applicable to government rules and actions beyond the tax arena, he holds that although the concept of ve can comprehensively account for equity concerns 61 in the design of our substantive tax law, something more is needed to address the operational concern that the law (crafted under a vision of ve) need be implemented by government actors in a manner consistent with the terms of the tax law. essentially, he steps in at this secondary stage to serve as an explicit warning that the law should be applied uniformly. perhaps this could be taken as an implicit expectation of any just and democratic government. but isolating this concern — particularly on behalf of individual members of society in their dealings with the arguably significant power of the state — 59. dodge, theory of tax justice, supra note 57, at 401. 60. john a. miller, equal taxation: a commentary, 29 hofstra l. rev. 529, 536 (2000). 61. of course, as articulated above, ve lacks internal normative content and must draw upon some theory of distributive justice and morality. 154 florida tax review [vol. 13:3 can serve as a constant reminder to state actors that good laws are insufficient. society demands good enforcement as well. this secondary, administration-oriented role of he may be singularly important in tax law. although one could imagine a tax system with entirely transparent filings, audits and tax payments, that is not the u.s. system, nor is it common in other comparable tax systems. as a result, there is little opportunity to verify whether the tax law is being applied in a sufficiently consistent manner. litigated cases can provide a limited window on tax enforcement, but they represent a small fraction of the many interactions between the government and taxpayers. moreover, the primary facts available to the outsider are those the judge has chosen to include in the opinion. thus, while case law can assist in understanding positions asserted by the government against taxpayers‘ interests (hence the litigation), it does little to quell the concern that the government may not be applying the law uniformly. the constant reminder regarding uniformity, framed in the compelling language of he, implicitly elevates the standard for administration to the same level as the standard for substantive law design (ve). the prominence of he promotes society‘s goals of norm building in the administrative state and constraining government actors with power and limited public scrutiny. the difficulty with this analysis is that he is not helpful in insuring even-handed enforcement. in a world of finite resources, not every taxpayer can be audited. 62 in deciding who should be audited, it is necessary to refer to something beyond he. for example, such choices may seek to maximize utility — target the taxpayers from whom we can expect to obtain the greatest additional tax revenue (such as those engaged in cash businesses), or they may seek to reinforce progressivity — target high-income taxpayers to insure that they are bearing a progressively greater burden. he does not guide us in selecting among these objectives. it is necessary to once again appeal to some other source to decide how to best accomplish enforcement. v. conclusion in the years since musgrave‘s, kaplow‘s and m-r‘s work evaluating the intellectual landscape on he, the question has continued to generate controversy and debate. perhaps one way to encapsulate the question after all this time is to ask — if we started with he as our motivating concept in setting tax policy and burdens where would we be? if he says treat equals the same, what does our tax system look like? the answer is — we don‘t know because the term has no independent meaning for fairness and 62. the irs examined 1.11 percent of returns filed by individuals in 2010. irs, internal revenue data book 2011, tbl. 9b (march 2012), http://www.irs.gov/pub/irs-soi/11databk.pdf. 2012] horizontal equity revisited 155 equality. we must turn to some theory of distributive justice to determine equality and to determine an appropriate tax burden. at this point he collapses into one concept, which is generally referred to as ve. the crucial point is not that this single concept is ve, but that ve and he are together a single concept which lacks normative content and is itself only a proxy for theories of distributive justice and morality. it is a detour in history that led us to frame the issues of equality and fairness in the tax system in the language of ve and he — a path which has both masked the emptiness of the concepts and overemphasized the possibility of two, distinct fairness inquires. we have been side-tracked from our larger task of tackling our disagreements over the underlying questions of distributive justice and morality, but perhaps can return now with renewed vigor to these intractable questions. for those who remain committed to a gut sense that he means something, we would say, ―yes, but a different something.‖ while he is not helpful in designing a tax system because it provides no guidance about what the system should look like, support for he has persisted because of a shared belief that government should communicate the rationale for treating people differently. the difficulty is that while he may tell us that government should communicate the rationale for different treatment, it does not tell us what that different treatment should be. support for the role of he may also be rooted in the notion that government should be even-handed in its enforcement of tax laws. he is not helpful, however, in insuring evenhanded enforcement since, in a world of finite resources, not every taxpayer can be audited. in deciding who should be audited, it is necessary to refer to something beyond he. but perhaps the close link of tax policy to the process of tax policy creation and the administrative practice explains the unstated but visceral commitment to he that has continued to spark debate over the past 20 years. we do not imagine the debate is over, but we look forward to a deepening inquiry into the driving questions of distributive justice and morality as pillars of our tax policy. tcharity really does begin at home: florida tax review volume 12 2012 number 2 57 tax neutrality and tax amenities by david hasen* abstract efforts to identify and implement an appropriate tax neutrality benchmark have been persistent themes in scholarly and policy debates on international taxation for fifty years. this paper questions whether the concept of tax neutrality has been adequately specified for analyzing the efficiency properties of international tax systems. as distinct from the closed-economy setting, in the open-economy setting, neither tax revenues received nor the burdens that tax revenues pay for may be taken as fixed. because tax revenues finance infrastructure and other productivity-enhancing goods — so-called “tax amenities” — and because capital burdens infrastructure, the reallocation of tax revenues among jurisdictions and the movement of assets and productive capacities across borders cause the amount of tax revenue collected in each jurisdiction to diverge from the revenue target. a consequence is that what are viewed as tax incentive effects, or distortions, improve productivity in some cases. neutrality as a value, however, rests on the idea that tax incentive effects reduce efficiency by causing resources to be allocated away from some optimum non-taxaffected baseline; this idea is what justifies referring to tax-influenced allocations as distortions. an implication is that the baseline is not well specified in the open-economy setting. this article suggests that, in light of these considerations and of the difficulty in implementing a theoretically satisfactory specification of neutrality, an analysis focusing on the allocative, distributive, and competitive properties of international tax rules would be more helpful than * associate professor of law, santa clara university. i thank reuven aviyonah, jim hines, mitchell kane, ed kleinbard, susie morse, fadi shaheen, joel slemrod, bill sundstrom, participants at various colloquia, and the editors of the florida tax review. santa clara university law school provided research support for this article. i remain solely responsible for any errors. 58 florida tax review [vol. 12:2 one focused on their neutrality properties. a simple model relating tax revenue and population to productivity is offered. 2012] tax neutrality and tax amenities 59 i. introduction ....................................................................................... 59 ii. the problem of international double taxation .................... 61 a. the basic problem ............................................................................ 62 1. first variation: worldwide taxation with an unlimited ftc ... 63 2. second variation: territorial taxation ...................................... 66 b. neutrality tradeoffs .......................................................................... 67 1. homogeneous systems ................................................................ 67 2. mixed and limited systems ........................................................ 71 3. conclusion on tradeoffs ............................................................. 74 iii. neutrality generally .................................................................... 76 a. tax neutrality generally .................................................................. 77 b. adapting neutrality to the international setting .............................. 80 1. first possible approach: from non-tax to single-tax world .. 82 2. second possible approach: from single rate to divergent rates .............................................................................. 83 3. third possible approach: from closed to open economies ..... 85 (i) non-preservation of savings neutrality ............................... 87 (ii) non-preservation of production neutrality ........................ 90 (iii) comparison with ownership and competitive neutralities ................................................................................ 91 c. neutrality reformulated ................................................................... 92 1. inadequacies of the lump-sum ideal ......................................... 92 2. neutrality modeling consequences ............................................ 94 iv. neutrality as a combination of rates and amenities ........... 96 a. estimating the value of tax amenities ............................................. 96 1. model .......................................................................................... 98 2. observations ............................................................................. 102 b. productivity consequences of capital flows under the model ..... 103 1. territorial systems ................................................................... 104 2. worldwide systems ................................................................... 106 c. conclusion on neutrality and amenities ........................................ 107 v. allocative, distributional, and competitive effects ......... 110 a. after-tax returns ............................................................................ 111 b. comparisons of systemic effects .................................................... 114 1. territorial systems ................................................................... 114 2. worldwide systems ................................................................... 117 3. mixed systems ........................................................................... 119 vi. conclusion ........................................................................................ 121 appendix ................................................................................................... 123 2012] tax neutrality and tax amenities 59 i. introduction few policy goals loom larger in the economic analysis of international taxation than the promotion of tax neutrality, or the idea that tax considerations should not drive the economic decisions of private actors engaged, or potentially engaged, in cross-border activity.1 talk of neutrality animates official policy discourse,2 while scholarly literature on the subject has become something of a cottage industry.3 many papers are devoted to promoting a particular conception of neutrality over one or more rival conceptions;4 others develop or test various empirical claims about neutrality.5 it is safe to say that the disagreements are substantive and the debates robust.6 operating as part of the background consensus to these debates is the assumption that the idea of tax neutrality has been adequately specified to provide a framework for analysis. this paper questions that assumption. the public finance model in which the concept of tax neutrality originally was developed applies to the closed-economy setting and assumes that taxes represent a pure cost. in that setting, it is possible to formulate the concept of a non-tax-affected world with sufficient rigor (not to say accuracy) to specify a baseline of apparently non-tax-distorted economic activity. the baseline, in turn, serves as the yardstick by which one can measure the distorting effects of taxes. as explained below, a centerpiece of the framework is the assumption that one may take levels of tax-financed infrastructure and other 1 . michael s. knoll, reconsidering international tax neutrality, 64 tax l. rev. 99, 100 (2011) [hereinafter knoll, int’l. tax neutrality]. 2. see, eg., hearing on the impact of international tax reform on u.s. competitiveness: hearing before the subcomm. on select revenue measures of the comm. of ways and means, 109th cong. 5 (2006) (statement of r. glenn hubbard, dean and russell l. carson professor of finance and economics, columbia business school, new york, new york). 3. see daniel shaviro, the david r. tillinghast lecture the rising taxelectivity of u.s. corporate residence, 64 tax l. rev. 377, 385 (2011) [hereinafter shaviro, tax-electivity] (noting that the neutrality issue “has been the dominant question explored and debated in [international tax policy] literature for more than fifty years”). a westlaw search returned 212 results for articles in law journals having the terms “international” and “tax neutrality” in the same sentence. a jstor search of the same terms in economics journals returned 100 results. 4. see, e.g., mihir a. desai & james r. hines jr., old rules and new realities: corporate tax policy in a global setting, 57 nat’l tax j. 937 (2004) [hereinafter desai & hines, old rules]. 5. id. at 946–50 (citing studies). 6. see, e.g., knoll, int’l tax neutrality, supra note 1. 60 florida tax review [vol. 12:2 tax-financed goods that contribute to productivity — “tax amenities,” as i refer to them — as exogenously given.7 the model for the closed-economy setting is ill-suited to a regime of open economies. in such a regime, the problem of non-neutrality arises because any system of rules for taxing cross-border arrangements induces flows of capital, labor, or both across national boundaries and affects patterns of ownership as well.8 it is well understood that these reactions affect the productivity, both of the assets that are somehow shifted in response to the rules and of all factors of production to the extent the relative supplies of and demands for them are shifted through the first effect. but these responses have a third consequence as well: they alter the supply of and demand for tax revenue in every jurisdiction that is a part of the regime. because of the relationship over the long term between tax revenues and the supply of tax amenities, tax incentives circle back to alter the rates of return that function as baselines to start with, thereby upending their status as baselines. expressed in the terms of the standard model, it no longer becomes reasonable either to suppose that funding for tax amenities is exogenously fixed or, as a consequence, to indulge the fiction that taxes represent a pure cost. several conclusions follow. first, it is not clear that the concepts of tax neutrality and tax distortion as they have been formulated are particularly meaningful in the international setting. if no neutral baseline has been articulated, it would seem difficult to justify normative claims about the value of minimizing actual departures, that is, “distortions,” from whatever is taken as the baseline. second, any effort to model the neutrality properties of tax rules for capital flows or ownership patterns must account for the relationship between the provision of tax-financed amenities and the productive capacity of factors of production. (similar problems would apply to the analysis of tax-induced individual migration, but, following most of the literature,9 i assume that individual migration is much less sensitive to tax rules, and i therefore disregard it.) it is not sufficient to account merely for the effects of tax rules on the supply of and demand for either capital or its owners in any given jurisdiction, taking pre-tax rates of return as given. 7. see julie roin, competition and evasion: another perspective on international tax competition, 89 geo. l.j. 543 (2001) [hereinafter roin, competition], for an explanation of the standard model. 8. see knoll, int’l tax neutrality, supra note 1, for a statement of the basic neutrality problem. 9. see, e.g., michael s. kirsch, taxing citizens in a global economy, 82 n.y.u. l. rev. 443, 493 (2007) (noting that few americans change residence in response to tax rates). to the extent labor location is sensitive to taxes, the effects analyzed in this paper would be compounded. see ruth mason, tax expenditures and global labor mobility, 84 n.y.u. l. rev. 1540 (2009), for an extension of neutrality analysis to labor as a tax-sensitive factor of production. 2012] tax neutralities and tax amenities 61 third, to the extent the benefit-purchasing character of taxes plays a role in productivity, worries about tax distortions likely are overstated because higher tax burdens will be correlated with (to be sure, not on a one-to-one basis) higher pre-tax returns. and finally, it seems that a more useful mode of analysis either would begin with a concept of neutrality adequate to the task or, if no such concept is in the offing, would downplay considerations of neutrality in favor of a focus on other significant properties of tax regimes, informed by an idea of how tax revenues affect productivity. these points are developed as follows. part ii briefly reviews the traditional framing of the problem of tax distortions in cross-border investment; readers familiar with the literature on international tax neutrality can skip this discussion. part iii describes the standard model of tax neutrality as developed in the closed-economy setting and argues that its extension to the open-economy setting is problematic because of the effects on productivity of shifting allocations of resources and tax revenues that arise as tax revenues and economic activity move across borders. subpart c of part iii goes on to describe what a theoretically accurate account of neutrality would look like but suggests that a workable model would be difficult to apply. part iv offers, instead, a simple model of the relationship between taxation and productivity that attempts to capture the basic intuitions supporting the criticism of the standard model. part v examines the likely productivity consequences of various tax regimes in light of the model developed in part iv. ii. the problem of international double taxation tax non-neutrality in the international setting arises from the fact that at least two jurisdictions plausibly lay claim to tax income earned from cross-border arrangements: the jurisdiction of the place of investment (the “source” or “host”) and the jurisdiction where its owner resides (the “residence” or “home”). by contrast, in the domestic setting there is generally only one plausible candidate to assess tax, as source and residence (host and home) are identical. recognizing the magnitude of the bias toward domestic investment that would result if both home and host jurisdictions exercised their full prerogatives to tax, states have regularly sought to alleviate the high tax burden that otherwise would fall on cross-border income.10 the general solution has been for residence states to cede all or a portion of their taxing power, whether by treaty, unilateral action, or a combination of the two, so that the total rate faced by a taxpayer in the cross-border setting 10. reuven s. avi-yonah, the structure of international taxation: a proposal for simplification, 74 tex. l. rev. 1301, 1305–07 (1996). 62 florida tax review [vol. 12:2 approximates the rate of one of the two states involved.11 where the effort is successful, exactly one tax (or an amount of tax exactly equal to the tax imposed by one of the states on its residents’ domestic income) applies to all income, whether earned domestically or abroad. thus, so-called “double taxation” is eliminated. the widely-recognized difficulty with these solutions is that they only partially address the problem of non-neutrality, which persists because: (a) the location of capital, the quantity in which capital is supplied, and, in more recent treatments, the identity of capital owners, all are somewhat elastic to taxes; (b) different jurisdictions impose different rates of tax; and (c) different jurisdictions adopt different methods of double-tax relief.12 in particular, because capital or its owner may seek the lowest possible tax, locational or ownership decisions continue to be driven by tax considerations, even though one or the other of the decisions may be taxneutral. the question then becomes which type of neutrality is least distorting over all.13 a. the basic problem to illustrate these points, consider the following three-stage analysis as applied to a simple system consisting of two states, state a and state b, in which a resident of state a has $100 to invest. assume in the first stage that no taxes apply. if the state a resident has an investment opportunity that is expected to yield 9 percent if made in state a, but 10 percent if made in state b, the economically efficient decision is for the resident to make the investment in state b. because no taxes apply, the state a resident realizes $10 of income after one year, and total wealth has concomitantly increased by $10. (in a dynamic model, investors from both states would continue to favor investment in state b until the return there converged with the return in state a, but for present purposes it is sufficient to use a static model.14) now, in the second stage, assume the same situation except that state a adopts a 35 percent rate of tax for all of the income of its residents as well as for income produced domestically by non-residents, and state b 11. see generally adam h. rosenzweig, why are there tax havens?, 52 wm. & mary l. rev. 923 (2010) [hereinafter rosenzweig, tax havens]. 12. michael j. graetz, the david r. tillinghast lecture taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 54 tax l. rev. 261, 272 n.36 (2001) [hereinafter graetz, taxing int’l income]. 13. see desai & hines, old rules, supra note 4, at 955–57, for an example of this type of analysis. 14. see, e.g., fadi shaheen, international tax neutrality: reconsiderations, 27 va. tax rev. 203, 215–17 (2007) [hereinafter shaheen, reconsiderations]. 2012] tax neutralities and tax amenities 63 adopts a 25 percent rate on an analogous basis. in the absence of any relief for double taxation, a resident of either state will face a tax rate at the level imposed solely based on its residence for purely domestic investments, but a rate equal to the sum of the two states’ rates, or 60 percent, for cross-border investments. (it is possible that a state would treat foreign taxes paid as a deductible business expense, but deductibility would merely alleviate the disparity between domestic and cross-border investment, not eliminate it. for the sake of simplicity, i omit discussion of the deduction model here.) accordingly, even though the pre-tax yield and therefore total wealth is greater if the state a resident makes the investment in state b, the state a resident will make the investment domestically because the after-tax yield in state a is greater: 5.85 percent versus 4 percent.15 without relief from double taxation, after one year, $9 of total wealth will be produced instead of $10, meaning that $1 of “deadweight loss” arises in the system. again, although it can be expected that after-tax rates of return will equalize over time as capital investment responds to tax rates, the resulting allocations of capital and labor will be inefficient, or “distorted,” when compared with the allocations that would result in the absence of taxes, taking as a given in the latter case that tax revenues would be provided for in some fashion.16 as described above, the general solution to this problem is either to eliminate one level of tax or to eliminate an amount of tax equal to that imposed by one of the states. thus, consider in a third stage two common alternative methods for achieving a single rate of tax: providing residents a credit against their domestic tax liability for foreign income taxes paid (a “foreign tax credit,” or “ftc”), and exempting residents’ foreign-source income, loss, and expense from domestic tax entirely. as the following discussion makes clear, under either method, the problem of non-neutrality is alleviated but not eliminated. more generally, under any solution to the problem of double taxation where tax rates differ across jurisdictions, nonneutrality arises across some margin of possible taxpayer behavior.17 1. first variation: worldwide taxation with an unlimited ftc to see how tax distortions persist, assume in the first variation that both states tax the income earned in the state but that residence states provide an unlimited ftc to their residents for foreign income taxes paid. this model is generally referred to as residency-based worldwide taxation.18 under the residency-based model, foreign taxes paid by the state’s residents 15. after-tax yields were computed as follows: 5.85 percent is 9 percent reduced by 35 percent, and 4 percent is 10 percent reduced by 60 percent. 16. see, e.g., knoll, int’l tax neutrality, supra note 1, at 104. 17. graetz, taxing int’l income, supra note 12, at 272 n.36. 18. knoll, int’l tax neutrality, supra note 1, at 101. 64 florida tax review [vol. 12:2 reduce domestic tax liability on a dollar-for-dollar basis. further, since, in this case, the credit is “unlimited,” the resident’s tax rate is fixed regardless of the rate in the source state, because the resident state will reimburse its resident any excess of foreign taxes paid over domestic taxes due. such an excess arises when the average tax rate in the source jurisdiction exceeds the average rate in the residence jurisdiction. in this setting, the problem of double taxation is eliminated in the sense that each individual pays the same domestic rate of tax regardless of where the investment is made. moreover, taking as fixed both the quantity of capital available to invest and the identities of the owners of capital, tax neutrality is preserved because the ftc regime eliminates the only remaining tax-based incentive, which is to adjust the location of the investment in response to taxes. (the incentive to change owner location persists, but, as explained below, it does not appear that any efficiency losses flow from changes in owners’ locations.) that is, the resident of state a will face a 35 percent rate of tax whether the investment is made in state a or in state b: if in state a, state b has no basis to tax and the rate is 35 percent; if in state b, the state a resident pays a 25 percent tax to state b and receives a credit in the same amount to be applied against state a’s 35 percent tax, leaving a 10 percent tax to be collected by state a, for a total tax of 35 percent. analogous treatment will apply to an investor situated in state b, who will face a 25 percent rate no matter where the investment is made. (if it is made in state a, the state b investor pays $3.50 in tax but gets $1.00 from state b.) an unlimited foreign tax credit system thus results in neutrality over the location of capital investment. under these assumptions, $10 of wealth is created after one year, just as in the non-tax world, but $3.50 in net tax revenue is collected if the investor resides in state a ($2.50 to state a and $1.00 to state b), and $2.50 if in state b ($3.50 to state a and -$1.00 to state b). this type of neutrality is referred to as capital export neutrality (“cen”) because it removes tax considerations from the decision whether to export capital or invest it at home.19 cen is also sometimes referred to as production neutrality to reflect the idea that the allocation of investment capital is based on pre-tax returns worldwide, meaning that the worldwide distribution and resulting productivity of capital are unaffected by taxes.20 universal residence-based taxation also preserves so-called capital ownership neutrality (“con”), a benchmark recently introduced into the legal literature by mihir desai and james hines.21 a tax system preserves 19. james r. hines jr., reconsidering the taxation of foreign income, 62 tax l. rev. 269, 272 (2009) [hereinafter hines, reconsidering]. 20. id. 21. desai & hines, old rules, supra note 4. they also have introduced the cognate benchmark of national ownership neutrality to reflect national rather than worldwide welfare maximization where ownership is elastic to taxes. id. at 956. the 2012] tax neutralities and tax amenities 65 con when it does not affect patterns of ownership. the importance of con becomes apparent if one considers the fact that ownership patterns, like investment patterns and savings decisions, though perhaps to an even greater degree, are elastic to taxes. in any developed market, firms can buy or dispose of business assets with relative ease, and the transaction and personal costs of doing so are likely to be lower than those of either capital or individual locational shifts. indeed, desai and hines argue that for modern economies, ownership considerations dominate locational decisions because so much of international trade consists of the exploitation of different capabilities sourced in different jurisdictions; it does not primarily involve movements of capital.22 on this view, the typical form of cross-border investment is not the transfer of physical capital or the movement of its owners, but the shift in ownership of stationary capital from one country’s nationals to another’s. concomitantly, when ownership moves out of the jurisdiction, it is more commonly replaced by an offsetting ownership shift elsewhere in the system than by a net movement of capital. new owners step in to fill the void created when property changes hands. in short, crossborder transactions are mostly about aligning competencies to manage fixedbase capital, not about moving capital into or out of productive jurisdictions.23 thus, in the simplest case, suppose that the locations of all capital and all taxpayers are fixed but that taxpayers can acquire capital at home or abroad. in a first-best world without taxes, some optimal pattern of ownership of the fixed supply of worldwide capital will emerge, reflecting on one hand synergies of combined ownership of different productive activities, the advantages of vertical over horizontal integration, and other factors weighing in favor of combination, and on the other hand the advantages of specialized ownership of specialized industries, the limitations of hierarchical organizations to manage large or heterogeneous sets of assets and business opportunities, competitive price pressures, and other factors weighing in favor of dispersed ownership.24 if the introduction of taxes affects the tax burden on prospective owners differently, then tax considerations are apt to alter this optimal pre-tax pattern of ownership, resulting in efficiency losses. because, under a worldwide system, all taxpayers face the same relative cost to any investment, tax-motivated ownership shifts will not arise.25 discussion here is confined to the examination of worldwide welfare-maximizing benchmarks. 22. id. at 956. 23. id. (“[m]ost fdi [(foreign direct investment)] represents transfers of control and ownership, and need not involve transfers of net savings.”). 24. see hines, reconsidering, supra note 19, at 275–77. 25. id. at 276–77. 66 florida tax review [vol. 12:2 2. second variation: territorial taxation although an unlimited residence-based ftc system eliminates capital location incentives, it does not preserve neutrality along a number of other margins, including uniformity in savings versus consumption decisions, uniformity in ownership considerations (in the case of a world of mixed systems for tax relief), and uniformity in investor location; it also does not preserve “competitive neutrality,” which functions less as a genuine neutrality benchmark than, arguably, as a plea for equal treatment. when sensitivity to taxes along these margins is large, distortions may result from pursuing cen that are no less harmful than distortions in patterns of home and host-country investment that worldwide taxation is designed to eliminate. the other major method of double-tax relief, foreign income exemption, or so-called territorial taxation, addresses these problems.26 under a pure form of territorial taxation, states exempt residents’ foreignsource income, loss, and expense from the tax base entirely.27 in this setting, double taxation is eliminated because the only tax investors face on crossborder investment is foreign-source tax. returning to the example above, the resident of state a will face a 25 percent rate of tax if the investment is made in state b, with state a ceding its right to tax entirely, and a 35 percent rate if it is made at home. analogously, a resident of state b will face the same rates on investment in state a and state b that the state a resident faces. a world of territorial systems has the following distinctive properties. first, the after-tax rather than the pre-tax rate is the same everywhere, as investment flows out of low-return jurisdictions and into high-return ones until the worldwide rate equalizes.28 although capital is not optimally allocated (since its allocation is affected by tax considerations), there is a tradeoff in that the decision about whether to save or consume, which is based on after-tax rather than pre-tax rates of return, is no longer affected differentially by taxes. this state of affairs is referred to as “savings 26. most of the oecd member countries tax active foreign business earnings on a basis closer to territoriality than to residence-based taxation. robert carroll, the importance of tax deferral and a lower corporate tax rate, special report no. 174, (tax found., wash. d.c.), feb. 2010, at 5, http://www.taxfoundation.org/files/sr174.pdf. 27. in practice, most territorial systems adopt some worldwide features (and vice-versa) to prevent tax avoidance. edward d. kleinbard, the lessons of stateless income, tax l. rev. (2011) [hereinafter kleinbard, lessons]. as an example, the opportunity to shift profits earned in high-tax jurisdictions to low-tax jurisdictions has caused some territorial jurisdictions, such as japan, to impose floors on the rate applied to certain foreign-source income. 28. knoll, int’l tax neutrality, supra note 1, at 108–09. 2012] tax neutralities and tax amenities 67 neutrality”29 and, by some scholars, as “capital import neutrality” (“cin”).30 second, universal territoriality preserves what is sometimes termed competitive neutrality, or the idea that all investors face the same tax burden on investment in a given source, regardless of their residence. perhaps unfortunately, competitive neutrality also often goes by the name cin.31 although, as explained below, competitive neutrality sounds more in considerations of equality than welfare, it has been particularly influential as a driver of international tax policy in a number of countries, including the u.s.32 third, universal territorial taxation, like universal worldwide taxation, preserves con, as the after-tax return to the owner of a fixed-base investment is the same regardless of who owns it. b. neutrality tradeoffs the framework of international taxation and relief of double taxation described above has set the parameters for scholarly debate on international tax neutrality. this subpart provides an overview of the tradeoffs that the various neutrality benchmarks present and canvasses some of the recent literature on international tax neutrality. 1. homogeneous systems the efficiency question in evaluating any proposed tax system is which of the available arrangements minimizes total deadweight loss for the relevant population.33 here, the relevant population is assumed to be countries worldwide, though in some analyses it is the individual country.34 most scholars have agreed that in the comparison of worlds consisting solely of pure versions of either territorial or worldwide systems, the latter is 29. id. 30. id. 31. peggy b. richman, taxation of foreign investment income: an economic analysis 8 (1963) [hereinafter richman, foreign investment]; knoll, int’l tax neutrality, supra note 1, at 110–11. knoll notes that lawyers have tended to interpret cin as a competitiveness benchmark (explained in the text below), while economists have interpreted it as a savings benchmark, and that the two groups have not always recognized they are talking about different benchmarks in using the term “cin.” 32. edward d. kleinbard, stateless income, 11 fla. tax rev. 699, 730 (2011) [hereinafter kleinbard, stateless income]. 33. daniel shaviro, why worldwide welfare as a normative standard in u.s. tax policy?, 60 tax l. rev. 155, 155–57 (2007) [hereinafter shaviro, worldwide welfare]. 34. see id. at 157. 68 florida tax review [vol. 12:2 superior in promoting worldwide welfare.35 another way of stating the point is that it is believed that promoting production neutrality — again, in the context of the comparison of pure systems — and accepting the associated savings, competitive and investor location distortions produces less deadweight loss than the converse. within the parameters of the standard analysis, this conclusion appears to be well founded. first, consider tax-induced locational shifts. under the stylized assumptions here, the failure to preserve locational neutrality of capital owners under worldwide systems would not seem to merit concern, since the location of the owner ought to have little impact on worldwide productivity. thus, suppose that the quantity of investment capital and the identity of its owners are fixed, so that the sole tax-based incentive that arises under a pure worldwide system is for an owner in a high-tax jurisdiction to move to a low-tax jurisdiction, leaving capital where it is. the owner then would enjoy the low-tax jurisdiction’s crediting of foreign tax paid in excess of source tax due when it makes economic sense to locate the investment in the higher-tax jurisdiction. as a result, total worldwide output would continue to be maximized despite the tax-induced decision to change the residence of the owner. under these circumstances, it is unclear what inefficiency arises. rather, the effects, if any, will be distributive and on administrative costs, as tax revenues will be eroded in low-tax source jurisdictions while administrative costs will be shifted to them. these considerations become somewhat less decisive if one relaxes the unrealistic assumption that the quantity of capital available for investment is fixed. treating this margin as somewhat tax-elastic, the fact that worldwide systems preserve production neutrality must be weighed against the fact that they do not preserve savings neutrality.36 if one assumes there is a single, optimal worldwide rate of return to savings that is approximated by the weighted after-tax return across all jurisdictions, then worldwide taxation introduces distortions in the decision to save or invest. investors located in high-tax jurisdictions will save too much, while those in low-tax jurisdictions will save too little. one may conclude that this situation is non-optimal because worldwide welfare theoretically could be increased if some of the return to savings earned in the low-tax jurisdiction were reallocated to the high-tax jurisdiction.37 a territorial system avoids this distortion because the after-tax return to all investments worldwide will converge into a single worldwide rate, for, if there were differences in the 35. hines, reconsidering, supra note 19, at 274. 36. rosanne altshuler, recent developments in the debate on deferral, 87 tax notes 255, 257 (apr. 10, 2000) [hereinafter altshuler, recent developments]; thomas horst, a note on the optimal taxation of international investment income, 94 q. j. econ. 793, 793 (1980) [hereinafter horst, optimal taxation]. 37. altshuler, recent developments, supra note 36, at 257. 2012] tax neutralities and tax amenities 69 after-tax rate of return in two jurisdictions, capital would flow to the one providing the higher rate (even though the allocation would not be desirable in terms of production efficiency) until the rates were equalized.38 although territorial systems preserve savings neutrality, the proposition that savings neutrality is a proper subject of efficiency analysis when the focus is on worldwide welfare is debatable.39 differing incentives to save or consume across jurisdictions would appear to be more a reflection of differing policy choices about the optimal mix of private and public returns to savings than to be an inefficiency traceable to tax-motivated incentives for cross-border investment.40 further, it is not clear that savings decisions are as responsive as capital location decisions to taxes;41 higher taxes may induce both income and substitution effects among savers, meaning that some taxpayers may save more (on a pre-tax basis) in the presence of the tax than in its absence in order to ensure they have adequate savings in light of a greater tax burden.42 nevertheless, the view that the inefficiency resulting from non-uniformity in returns to savers has equal status with production inefficiency has had a significant influence in the literature,43 and a number of scholars have framed the question of optimal tax design in terms of the relative efficiency losses arising from pursuing either efficiency benchmark — production versus savings.44 finally, consider competitive neutrality, or the idea that some form of neutrality exists when investors meet on an equal tax footing in a given 38. id. 39. hines, reconsidering, supra note 19, at 274. 40. see id. (“as a practical matter, since many national policies influence the return to savers, cin is often dismissed as a policy objective . . . .”). 41. see does atlas shrug? the economic consequences of taxing the rich (joel b. slemrod ed., 2000) (presenting research on the sensitivity of savings decisions to tax rates). 42. for an explanation of income effects, see harvey s. rosen & ted gayer, public finance 19 (9th ed. 2010) [hereinafter rosen & gayer, public finance]. 43. e.g., altshuler, recent developments, supra note 36, at 256 (“the standard result [in the analysis of the efficiency properties of residenceand sourcebased taxation] is that a pure residence system ensures efficiency in investment location decisions whereas a pure source system preserves efficiency in savings decisions.”). 44. see, e.g., altshuler, recent developments, supra note 36, at 258. see generally knoll, int’l tax neutrality, supra note 1, at 100–01; horst, optimal taxation, supra note 36. it also has been observed that the availability of deferral in worldwide systems such as the united states’, coupled with the formality of corporate residence for u.s. tax purposes, makes it easier for taxpayers to shift the location of capital owners to lower-tax jurisdictions, thereby moving toward savings neutrality. altshuler, recent developments, supra note 36, at 257. 70 florida tax review [vol. 12:2 jurisdiction.45 returning again to the discussion example, if states a and b each tax on a territorial basis, then investors from either jurisdiction face the same rate on income from the source that investors located in the source face on their source-based investments, regardless of the rates that states a and b impose on domestic income. this arrangement is competitively “neutral” in the sense that home-country rules do not disadvantage home residents in their competition with other taxpayers for investment in the host. however, as contrasted with cen and, at least arguably, with savings neutrality, the pursuit of cin as competitive neutrality does not promote worldwide welfare; indeed, it does not appear directly to promote the welfare of any constituency other than home-country multinational residents in high-tax jurisdictions, for the benefits to them are offset by detriments to those against whom they compete for investment; this group includes home-country investors that lack access to foreign markets. (and maintaining even this benchmark assumes that other jurisdictions do not retaliate against the residence jurisdiction’s decision to pursue competitive neutrality).46 consequently, competitive neutrality has been characterized as cheerleading for the home team47 rather than a genuine neutrality benchmark, though it might more aptly be characterized as trickle-down neutrality for homecountry residents who, in theory, could benefit from home-country multinationals’ prosperity.48 perhaps the best one can say about competitive neutrality is that it sounds in some theory of investor equality.49 as discussed above, the final neutrality benchmark, con, does not come into play in the comparison of pure homogeneous systems. both the universal adoption of pure worldwide tax systems and the universal adoption of pure territorial systems preserve con.50 45. richman, foreign investment, supra note 31, at 8. 46. see, e.g., kimberly a. clausing, the role of u.s. tax policy in offshoring, in brookings trade forum 2005: offshoring white-collar work 457, 473 (2006). (“thus, capital import neutrality [in the competitiveness sense] generally puts the international competitiveness of a country’s multinational firms ahead of considerations regarding optimal investment location or government revenue. for example, capital may be allocated inefficiently toward low-tax locations because after-tax rates of return in such locations are higher.”) 47. shaviro, worldwide welfare, supra note 33, at 155–56. 48. kleinbard, lessons, supra note 27. 49. shaheen, reconsiderations supra note 14, at 210. 50. mihir a. desai & james r. hines jr., evaluating international tax reform, 51 nat’l tax j. 487, 495 (2003). [hereinafter desai & hines, evaluating int’l tax reform]. 2012] tax neutralities and tax amenities 71 2. mixed and limited systems under standard neutrality models, the case for universal adoption of worldwide systems becomes less decisive once the idealized assumptions of the preceding section are relaxed. in the actual world, no residence-based system provides an unlimited ftc, heterogeneity of methods of double-tax relief obtains, and some amount of deferral of foreign-source income is available even under worldwide systems. each of these real-world features introduces tax distortions for states seeking to promote cen. first, consider the case of the limitation on ftcs. as a practical matter, a country that provides an unlimited ftc would suffer dramatic erosion of its tax base, as net capital importing countries could raise taxes arbitrarily high with no adverse effect on levels of inbound investment from countries using the ftc regime. consequently, no country has permitted ftcs in excess of the taxpayer’s erstwhile domestic tax liability.51 the limitation means that residents of ftc jurisdictions with lower rates face higher taxes on investments in high-tax jurisdictions than on investments at home or in other jurisdictions having rates not in excess of the home rate. residents of high-tax ftc jurisdictions, however, face the same rate on investments wherever located. in addition, residents of high-tax ftc jurisdictions have an incentive to locate both themselves and capital in lowtax jurisdictions, since then, but only then, can they secure the lower tax rate they would otherwise obtain just by relocating themselves and leaving capital where it was in a system of unlimited ftcs. the net effect of both phenomena is to create a worldwide bias towards investment in lower-taxed jurisdictions, which effectively moves the world in the direction of territorial taxation.52 depending on the magnitude of the effects, a formal switch to territoriality could actually be welfare enhancing, since it eliminates taxinduced shifts of ownership that arise under an incomplete implementation of worldwide taxation while preserving savings neutrality and, more importantly, ownership neutrality. heterogeneity of tax systems has a similar effect. in a multi-state world in which one or more jurisdictions adopt territorial taxation, residents of countries employing a residence-based ftc system are at a tax disadvantage when compared with residents in territorial jurisdictions with respect to investment opportunities in low-tax jurisdictions. to illustrate, consider a world composed of states x, y, and z. x and y each impose tax at a flat 35 percent rate on domestic-source income, but whereas x adopts worldwide taxation with an ftc for its residents and nationals, y adopts a 51. see, e.g., i.r.c. § 904(a). 52. hines, reconsidering, supra note 19, at 273; peggy b. musgrave, capital import neutrality, in encyclopedia of taxation and tax policy 50, 50 (joseph j. cordes et al. eds., 2d ed. 2005). 72 florida tax review [vol. 12:2 territorial system under which neither foreign-source income nor foreignsource expense is accounted for. z is a net capital importing country that has adopted a flat 10 percent rate on z-sourced income.53 (z’s method of taxing non-z-sourced income is immaterial for the example.) when compared to y residents, x residents face a tax disadvantage with respect to the z-sourced investment because x residents cannot respond to the tax advantage of the zsourced investment, while y residents can. the difficulty that this type of situation creates forms the basis for regular pleas from u.s. industry for the u.s. to move to a territorial system, as most industrialized nations have done.54 equally importantly, the tax-insensitivity to ownership considerations that arises in a world of residence-based systems disappears in a world of mixed systems.55 in the mixed setting, the incentives that residents of worldwide tax jurisdictions face differ from the incentives that residents of territorial jurisdictions face, as illustrated in the example in the preceding paragraph. in particular, residents of high-tax residence-based jurisdictions will be at a disadvantage compared to residents of high-tax territorial jurisdictions when it comes to investment opportunities in low-tax jurisdictions because they lack the incentive that residents of territorial jurisdictions have to invest in the low-tax jurisdiction. if the contention is true that most cross-border transactions involve shifting ownership of fixedbase capital, the tax disadvantage to a country employing a high-tax worldwide system becomes very large, while the tax loss of shifting to a territorial system becomes very small.56 finally, consider the problem of deferral, as exemplified by the u.s. case. formally, the u.s. pursues cen through worldwide taxation of its citizens and residents together with the provision of a limited ftc.57 consistent with the standard assumptions discussed in section 1, the costs to u.s. individuals of escaping u.s. tax on income they directly own are relatively high, because doing so generally requires the individual to leave the u.s., something most residents are reluctant to do. consequently, it would appear that the u.s.’s promotion of cen increases worldwide welfare more than would its promotion of either version of cin. the difficulty with 53. see kleinbard, lessons, supra note 27, for a discussion of this problem. 54. id. kleinbard describes these pleas as demands that the u.s. move to “cartoon territoriality.” 55. hines, reconsidering, supra note 19, at 276. 56. desai and hines derive $50 billion (in 2004) as a rough estimate of the dollar value of the annual efficiency losses to u.s. multinationals from the u.s. system of quasi-worldwide taxation (i.e., worldwide taxation with significant deferral opportunities). desai & hines, old rules, supra note 4, at 955. 57. see reg. § 1.1-1(b) (u.s. citizens and residents are subject to tax on their worldwide income.); i.r.c. § 901 (foreign tax credit). 2012] tax neutralities and tax amenities 73 this analysis is that under u.s. law, the cost of shifting the identity of the immediate owner of capital to a non-u.s. person is quite low because corporate residency for u.s tax purposes is almost entirely a formal matter. it depends upon the place of incorporation, not the location of significant managerial, production, or other operations, or on ultimate beneficial ownership of corporate capital.58 when coupled with the fact that most active business income of foreign corporations that are owned by u.s. persons is not taxed until it is repatriated,59 the result is a tax system that approaches territoriality because of deferral and the ability of taxpayers to time inclusions with offsetting losses.60 as a consequence, the neutrality question in the u.s. setting has to some extent devolved into a question of determining the appropriate limits on deferral.61 if the ultimate u.s. owners of non-u.s.-source income can defer inclusion for u.s. tax purposes for long enough, the fact that the income ultimately is subject to tax at u.s. rates will not deter taxpayers from shifting formal ownership together with actual capital from domestic to foreign entities. this shifting is completely at odds with cen because the incentive arises to move capital to the low-tax jurisdiction based on the after-tax, not pre-tax, rate of return there. in effect, deferral pushes the system closer to territoriality.62 however, it comes with the further disadvantage that an efficiency loss arises from the tax cost on repatriation of foreign profits under the u.s. system that would be absent under territoriality. because the u.s. continues to tax foreign-source income when it is repatriated, the large incentive to earn income offshore is coupled with a large disincentive to bring it into the u.s.63 this disincentive has 58. i.r.c. § 7701(a)(4). 59. the u.s. system requires immediate inclusion by certain u.s. persons of corporate profits earned through certain controlled foreign corporations and passive foreign investment companies. see i.r.c. §§ 951–65 cfcs, 1291 (pfics). neither of these regimes, however, currently taxes most earnings of actively conducted foreign businesses. 60. see kleinbard, stateless income, supra note 32, at 718–19, for a comprehensive analysis of the problem. 61. see, e.g., altshuler, recent developments, supra note 36, at 255. if, for example, the discount rate is 5 percent, then a ten-year deferral of tax reduces the effective rate by approximately 39 percent; a twenty-year deferral reduces it by 62 percent. 62. e.g., id. at 257; shaviro, worldwide welfare, supra note 33, at 160. 63. it is probably more accurate to say that the disincentive is to bring the cash back efficiently rather to bring it back at all. for example, a u.s. multinational can obtain the economic benefit onshore of earnings held offshore through borrowing secured by the offshore earnings or through other similar mechanisms. the effect of such arrangements is to overcome the gross inefficiency of keeping earnings offshore solely for tax reasons, but it comes at the price of establishing and 74 florida tax review [vol. 12:2 regularly given rise to demands from u.s. multinationals, occasionally successful,64 for both short-run relief in the form of tax holidays and the transition to a full-blown territorial system.65 3. conclusion on tradeoffs against the backdrop of the considerations outlined above, a lively debate in the u.s. context has emerged on the relative merits of worldwide and territorial taxation, principally on the question of whether the u.s. should move to shore up its worldwide system or instead move to more fullblown territoriality.66 those taking the latter position have argued that substantial deadweight loss arises when the residence or owner of capital changes in response to taxes, as it must when the system is heterogeneous or the ftc is limited.67 that is, they have argued that there is no reason to bear the efficiency losses associated with tax-induced changes in ownership and savings non-neutrality, or (taking a national welfare perspective) the losses from competition with investors located in territorial jurisdictions, when the benefits from doing so — limited neutrality with respect to the location of capital, or cen — have been lost anyway. on top of these losses are losses resulting from the incentive to keep offshore earnings offshore unless and until they can be repatriated on a tax-favored basis.68 a territorial system would remove this incentive (as would a purer worldwide one). others have argued that territorial taxation is not inferior to residence-based taxation even maintaining the relevant tax-avoidance strategy. i thank ed kleinbard for identifying this point. 64. see, e.g., american jobs creation act of 2004, pub. l. no. 108-357, § 422, 118 stat. 1418 (2004) (enacting i.r.c. § 965, which provided for a temporary reduction in rate, to 5.25 percent, on certain foreign income repatriated to the united states). 65. see kleinbard, lessons, supra note 27. kleinbard notes that most of these pleas are for systems that he terms “cartoon territoriality” — that is, systems so generous as to effectively permit full tax exemption for u.s. multinationals. id. 66. see, e.g., robert c. pozen, a two-pronged approach to reforming international corporate taxes in the u.s., 63 tax notes int’l 951 (sept. 26, 2011). 67. a prominent example is the proposal that former president george w. bush’s tax reform panel made to move to an exemption system. president’s advisory panel on federal tax reform, simple, fair, and pro-growth: proposals to fix america’s tax system 103-07 (2005). for a critique of the panel’s proposal, see j. clifton fleming jr. & robert j. peroni, exploring the contours of a proposed u.s. exemption (territorial) tax system, 109 tax notes 1557 (dec. 19, 2005) [hereinafter fleming & peroni, exploring]. 68. see desai & hines, old rules, supra note 4, at 938, and kleinbard, lessons, supra note 27 for (quite different) discussions of this problem. 2012] tax neutralities and tax amenities 75 on first-best grounds and that it is much preferable given the much wider use of territorial systems today.69 for example, from the perspective of con, the adoption of territoriality would be superior to remaining with a residencebased system in light of the wide use of territoriality by other countries and the contention that most of the efficiency losses associated with taxing crossborder transactions arise from ownership rather than capital-location or savings distortions.70 on the other side, a number of commentators have argued that the solution to the problem of corporate residence-shifting is to tighten the rules on deferral, thereby moving closer to a true worldwide system, and not to abandon the ideal of cen.71 in response to the desai and hines argument that the dominant margin of tax-induced behavior is ownership, some have argued that ownership is, at best, one of a number of relevant margins of response to tax rules and that no evidence has yet been offered to show that tax-induced ownership effects swamp capital-location effects.72 against the view that worldwide taxation is inadvisable on competitive grounds when most jurisdictions pursue territorial taxation, it has been noted that even territorial jurisdictions tend to adopt worldwide tax features for foreignsource income that is subject to exceptionally low rates, that most industrialized countries tend to have rates roughly comparable to each other (so that tax considerations may be minimized as long as it is not possible to exploit tax havens), and that if the u.s. moved closer to true worldwide taxation, other countries might follow suit.73 which of these positions is correct depends in some measure on who is right about the economic facts — where the margins are more elastic and what efficiency costs result as taxpayers respond to tax incentives along one or another of them. but the assumption that there are answers to these questions depends on the more basic premise that neutrality is a wellformulated concept, for if it is not, then it is not clear what it means to say that one set of tax rules is more distorting than another and, consequently, is associated with greater efficiency losses. the next part makes the case that neutrality has not been well-defined in the international tax literature; the parts following offer an alternative way to consider the relationship between tax rules and productivity and an argument for applying different policy criteria in evaluating international tax rules. 69. e.g., shaheen, reconsiderations, supra note 14, at 205–06. 70. hines, reconsidering, supra note 19, at 282. 71. see, e.g., fleming & peroni, exploring, supra note 67, at 1577. 72. e.g., mitchell a. kane, commentary, considering “reconsidering the taxation of foreign income,” 62 tax l. rev. 299 (2009) [hereinafter kane, considering “reconsidering”]. 73. kleinbard, lessons, supra note 27. 76 florida tax review [vol. 12:2 iii. neutrality generally the discussion in part ii was designed to explicate the problem that double taxation of cross-border income poses for efficiency analysis and to give a flavor for the debates surrounding the relative merits of various methods of double-tax relief. in what follows, i offer a criticism of the supposition that the relevant baselines for the evaluation of tax distortions are well specified under standard approaches. as contrasted with narrower inquiries into whether one or another local legal change is likely to increase or reduce efficiency system-wide, the global question of which international tax regime is closest to an ideal of neutrality has not been well-formulated in the neutrality literature. in the case of local changes, one can make a meaningful evaluation of the effects of a new rule in light of reasonably fixed background conditions; in the case of global changes, current approaches fail to specify an ideal against which the actual world is to be measured because the ideal turns out to be affected by the world for which it is supposed to operate as an ideal. this feedback effect materializes because any system for taxing cross-border arrangements causes economic actors to make decisions that affect not only the amount of tax paid, but which jurisdiction receives it; correlatively, the tax system will cause actors to make decisions that affect the burden in every jurisdiction on tax-financed goods because capital (and perhaps labor), like tax revenues, flows across borders, and because, even when it does not, trade-induced adjustments in productivity will have comparable effects. when economic decisions cause tax revenue streams or capital assets to be redirected from one jurisdiction to another, or affect the local productivity of capital (as under the con analysis), they affect the absolute productivity of the factors of production in all jurisdictions because of the relationship between tax revenues and tax amenities: tax revenues finance productivity-enhancing tax amenities. as productivity rates diverge from prior levels, the rate of return that was supposed to remain uniform across jurisdictions under the relevant benchmark (e.g., pre-tax for production neutrality, after-tax for savings neutrality) diverges as well, meaning that the benchmark is not maintained. one can frame the point as follows. there are not two but at least three moving parts to the analysis of the effects on rates of return of any regime for taxing cross-border income: (1) the flow of capital (and possibly labor or investors) and adjustments to productivity in response to taxes, (2) the adjustments in both net importing and net exporting countries to the relative prices of factors of production that result from these flows, and (3) the effects of (1) and (2) on both tax revenues and the burdens that tax revenues pay for in every affected jurisdiction. analysis of the first two items 2012] tax neutralities and tax amenities 77 is part of the standard fare of neutrality analysis,74 but the third, which generally has been overlooked, is also important to a comprehensive analysis of a tax system’s neutrality properties. because levels of funding for tax amenities affect the absolute rate of return to factors of production in each jurisdiction, tax-induced adjustments to tax revenues or to burdens that tax revenues pay for, no less than changes in the relative supply of and demand for factors of production, will affect the productivity of those factors, and indeed in ways that diverge between the affected jurisdictions. this part illustrates the problem by examining the development of the neutrality model in the domestic setting and the difficulties that arise when the model is appropriated for use in the international setting. subpart a explicates the concept of tax neutrality in general terms. subpart b examines the question of how to articulate the problem of non-neutrality in the international setting, concluding that the most cogent statement of the problem is one that analyzes the effects of moving from a system of closed economies to one of open economies. because this statement also subverts the idea of the single-tax-affected baseline that underwrites the analysis of tax distortions, it turns out that the concept of neutrality in the international setting is not well-formulated under standard approaches. a. tax neutrality generally under the standard public finance model, a tax is optimally efficient when it does not change relative prices.75 a tax that has this property is said to be neutral. correlatively, if taxes do change relative prices, then prices are said to be “distorted” and, when the change alters the decisions of economic actors, the decisions are said to be distorted as well.76 such tax-affected decisions are characterized as distortions because they produce less total social wealth than would result in their absence. this conclusion follows if one accepts the assumptions commonly applied to describe the behavior of rational actors in free markets — namely, that they have ordered preferences, 74. see, e.g., desai & hines, old rules, supra note 4; hines, reconsidering, supra note 19; knoll int’l tax neutrality, supra note 1; shaheen, reconsiderations, supra note 14. 75. see, e.g., rosen & gayer, public finance, supra note 42, at 19. taxinduced changes in relative prices are to be distinguished from tax-induced changes in absolute prices, which also may cause taxpayers to alter the composition of goods and services they consume or the labor they supply. id. to the extent a tax-induced price change is absolute, the alteration in behavior is said to result from so-called income effects, or the fact that the taxpayer is poorer in absolute terms by reason of paying the tax and, consequently, has a lower budget line. id. income effects are not inefficient, though they may be problematic for other reasons, for example, that they reduce the wealth of the wrong person. 76. id. at 329. 78 florida tax review [vol. 12:2 that they are free to deploy their resources to satisfy those preferences, and that there are no externalities.77 in this setting, total social wealth is maximized.78 consequently, when decisions are affected by tax-induced changes to relative prices, the resulting arrangements do not maximize total social wealth because individuals have substituted less-efficient outcomes for more-efficient ones as a means to maximize their after-tax welfare. the reduction in total social wealth that arises through these substitution effects is referred to as the deadweight loss, or excess burden, of taxes.79 the following simple example illustrates these ideas. suppose that a taxpayer faces two investment opportunities, one of which, opportunity a, has an expected value of $x and the other of which, opportunity b, has an expected value of $.9x, in both cases on a pre-tax basis. in the absence of tax considerations, and disregarding the possibility that risk preferences might affect the investment decision, the taxpayer would choose opportunity a. if, however, opportunity a is sufficiently less favorably taxed than opportunity b, the taxpayer will choose opportunity b, other things equal. in such a case, the decision is distorted by taxes as compared to a baseline of the efficiencymaximizing non-tax world. in the example, $0.9x rather than $x of total social wealth is created, simply because the ultimate value to the taxpayer is greater if the non-wealth-maximizing choice is made. the “non-tax” world is a standard heuristic employed to get at the idea that taxes create these sorts of inefficiencies.80 however, the non-tax world cannot function as a true baseline for the simple reason that taxes are necessary to fund infrastructure and other goods that make possible a system of competitive markets in which rational actors satisfy their ordered preferences. in other words, the non-tax world would seem to require taxes in order to function as the baseline against which to measure the effect of taxes. this difficulty, however, can be functionally circumvented if one bears in mind that the problem is not, strictly speaking, the existence of taxes but the fact that most real-world taxes create substitution effects because tax liability is determined, in part, by economic decisions. stated otherwise, realworld taxes alter the relative prices of goods. for example, even a broadbased income tax creates an incentive to work less if leisure goes untaxed because the tax alters the relative prices of work and leisure. consequently, we can expect leisure to be over-supplied and labor to be under-supplied 77. see generally paul a. samuelson & william d. nordhaus, economics 84–106 (19th ed. 2010). 78. this is simply a statement of the first fundamental theorem of welfare economics, which itself can be considered a formal version of adam smith’s theory of the invisible hand. see allan m. feldman, welfare economics, in 4 the new palgrave dictionary of economics 889 (john eatwell et al. eds., 1987). 79. rosen & gayer, public finance, supra note 42, at 329–36. 80. see id. at 330. 2012] tax neutralities and tax amenities 79 even under a broad-based low-rate income tax system, when compared to a system in which tax revenue is raised in some way that does not affect the decision about how much labor to supply. the question, then, is whether it is possible for tax revenue in fact to be supplied in a way that does not affect behavior. in general, a tax imposed without regard to what the taxpayer does — generally referred to as a lumpsum tax — is thought to have this property. a head tax is the simplest example of such a tax. although a head tax may affect taxpayer behavior simply because taxpayers have fewer resources, and may be objectionable on distributive or other grounds, the absolute reduction in wealth it effects does not lead to inefficient substitutions, but only to less consumption (or more production) as a way to compensate for the reduced wealth. relative prices remain unaffected and, as a result, resources continue to be allocated optimally.81 distributive concerns can, theoretically, be addressed either through government redistribution or by tailoring the lump-sum tax liability to whatever non-behavior-affected metric is deemed appropriate.82 if one begins with the idea of a lump-sum-tax-financed world as the baseline, it becomes possible to sketch a model of tax neutrality in the closed-economy setting. a revenue target is exogenously set based upon some procedure by which relevant preferences are aggregated and sorted. this exercise is part of the larger procedure for identifying and implementing what is commonly termed the “social welfare function,”83 or the societal determination about how to weigh individual utilities and other tradeoffs among conflicting values. for example, in a democratic polity, voters might express their preferences about levels of tax-financed amenities through a referendum in which the majority prevails, or the choice might be mediated through the election of representatives empowered to make decisions about such matters.84 the level having been set, a base and rate schedule are then adopted. the latter decisions would, it is hoped, be based on efficiency considerations and take into account as well the various additional costs of administering the tax system. although the base is unlikely to include, much 81. id. at 332. 82. thus, the standard assumption in the public finance literature is that the optimal theoretical tax would be a lump-sum tax assessed on the basis of wage rate or ability (not actual wages). an ability base would seem to combine the tax neutrality properties sought from an efficiency perspective with the desired utilitymaximizing distributive properties, assuming the declining marginal utility of ability. see id. at 333. a large literature addresses the philosophical cogency of this view. see linda sugin, a philosophical objection to the optimal tax model, 64 tax l. rev. 229 (2011) (reviewing the literature). 83. see, e.g., rosen & gayer, public finance, supra note 42, at 44. 84. see sarah b. lawsky, on the edge: declining marginal utility and tax policy, 95 minn. l. rev. 904, 913–14 (2011), for a discussion of social welfare functions. 80 florida tax review [vol. 12:2 less to consist solely of, lump-sum taxes, it is at least possible to have in view the economy that would result if the desired levels of tax-financed amenities were funded with lump-sum taxes.85 that economy represents the “non-tax world,” or more accurately, the non-tax-affected world, and deviations from that world that result from tax-induced substitution effects represent tax distortions. the world has its own distributive and productive properties, including a pre-tax rate of return. it is important to be clear about the conceptual price that employment of the idea of the non-tax-affected world exacts on the theory of tax distortions. initially, the observation that the existence of a rate of return requires tax-financed amenities vitiated the notion of a non-tax-world that would operate as a baseline to measure tax distortions. the motivating idea of that model, however, is not that there are no taxes, but that taxes do not affect decision making by causing taxpayers to substitute more favorablytaxed goods or services for those less favorably taxed. it was then recognized that if taxes were conceptualized as imposed on a lump-sum basis, the link would be severed between the funding of goods paid for with tax revenues and the avoidance behavior of the individuals that pay for them. the resulting model purports to solve the problem of establishing the conditions under which a non-tax-distorted rate of return is possible even though taxes must somehow be collected, but the model is not complete.86 since different quantities of tax-financed goods supplied correspond to different quantities of tax-financed amenities and, in consequence, different private-sector rates of return,87 one cannot establish the rate of return in the non-tax-affected world without a specification of the revenue target. the target itself, however, cannot be derived from the conditions imposed by the model but, rather, must be taken as an exogenously given amount based on a normative judgment — for instance, by ascertaining and applying the operative social welfare function. the pre-tax rate of return, in other words, does not exist as a purely factual datum.. b. adapting neutrality to the international setting the question on the table is whether the closed-economy model can be adapted to the international setting without loss of normative or analytic 85. see roin, competition, supra note 7, at 552 (noting the usefulness of the lump-sum ideal as a baseline against which to measure the distortions of actual taxes in a single jurisdiction). 86. see part iii.c. for a criticism of the view of taxes according to which lump-sum taxation provides a non-tax distorted baseline. 87. see, e.g., lawrence j. lau et al., efficiency in the optimum supply of public goods, 46 econometrica 269, 269 (1978) (noting the “dependence of private consumption, and hence of tax revenue, on the supply of public goods. . . .”). 2012] tax neutralities and tax amenities 81 power. in the international setting, the analog of the non-tax-affected world is the non-double-tax-affected world.88 that is, one level of real, non-lumpsum tax, together with its distortions, is taken as given, and the question is how that level will be maintained with minimal additional distortions in light of the rights of both home and host countries to tax cross-border transactions.89 the trouble is that, as will be developed below, no matter the starting point, tax-motivated behavior that results from the chosen neutrality regime fails to preserve the relevant rate of non-tax-affected return (pre-tax or aftertax) over all affected jurisdictions. as capital flows respond to the tax incentives created under the rules for cross-border transactions, both tax revenues and the burdens that tax revenues pay for are reallocated between home and host jurisdictions. over the long term, the correspondence in each jurisdiction between levels of tax-financed amenities and the burdens on resources and infrastructure that the amenities pay for diverges as well, causing real rates of return to move, often in opposite directions, in home and host jurisdictions. any benchmark defined with reference to the preservation of a rate of return therefore is not met and neutrality is not preserved. this result implies that under standard approaches, the non-double-tax-affected world cannot be specified for any system of independent jurisdictions in which tax rules create incentives that cause tax revenues or the burdens they pay for to be redirected from one jurisdiction to another. the following discussion develops these ideas by examining three possible non-double-tax-affected starting points and evolutions to the realworld case: a tax-free world to which taxes are added on; a world of open economies, each of which initially has the same tax rate and in which rates are then made to differ across jurisdictions; and a world of single-taxed, closed economies that become open economies. it will be seen that only the last of the starting points actually states the problem in a coherent way. but that way of formulating the problem demonstrates both that “neutrality” is 88. technically, it would be more accurate to refer to the analog of the nontax-affected world as the “single-tax-affected world,” since double non-taxation creates problems analogous to those of double taxation. as it is commonly framed, however, the problem is one of double taxation arising from the joint rights of source and residence to tax; double non-taxation generally arises because of tax base inconsistencies or strategic efforts to avoid tax, both topics that fall outside the scope of the present discussion. 89. thus, tax treaties typically describe the elimination of double taxation as the central objective of the treaty. see, e.g., united nations model double taxation convention between developed and developing countries, introduction, ¶ a.2, http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf (“broadly, the general objectives of bilateral tax conventions may today be seen to include the full protection of taxpayers against double taxation (whether direct or indirect) . . . .”). http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf http://unpan1.un.org/intradoc/groups/public/documents/un/unpan002084.pdf 82 florida tax review [vol. 12:2 violated as soon as cross-border trade is introduced, and that over the long term the resulting tax-motivated decisions are as likely to improve overall productivity as to harm it. 1. first possible approach: from non-tax to single-tax world the first approach posits as a baseline a tax-free world and an associated tax-free rate of return to capital.90 in this setting, the question becomes what happens to rates of return and capital allocations when different jurisdictions impose different rates of tax and adopt different methods of double-tax relief. for the reasons stated above, it is difficult to motivate this approach. because taxes are necessary to finance various goods needed for wellfunctioning markets to exist, a genuinely tax-free world would be one that lacked the features of a market economy; it would be one of rudimentary trade. as the preceding subpart explained, this problem arises in the closedeconomy setting as well, but it can be addressed by substituting the concept of the non-tax-affected world for the tax-free world. the non-tax-affected world is operationalized (ideally) through lump-sum taxation. however, the concept of the non-tax-affected world requires an exogenously specified decision about the amount of tax revenue to be raised, since this target, together with other factors, determines the “pre-tax” rate of return. without such a specification, the non-tax-affected world is indeterminate because different levels of exogenously given funding (via lump-sum taxation) result in different rates of private-sector return in the non-tax-affected world. consider, for example, the absolute productivity differences of capital (human and physical) in algeria and canada, two countries of roughly equal population but dramatically different levels of development and histories of taxation. taking gdp per capita as a proxy for capital productivity, capital in canada is approximately 550 percent more productive than in algeria.91 undoubtedly many factors contribute to this difference, but among them are the relative differences in transportation infrastructure, educational opportunities, a well-functioning and reliable administrative state, and other features of industrialization that are paid for over a considerable period with taxes and that contribute to the capacity of private parties to develop and diversify human capital and native resources. not surprisingly, the percentage of gdp that historically has gone to taxes in canada is about four 90. see, e.g., shaheen, reconsiderations, supra note 14, at 214–15. 91. canada’s gdp per capita in 2010 was $39,057, and algeria’s was $6,950, in each case based on purchasing-power-parity dollars. figures are imf estimates. http://tinyurl.com/6e6acpx. http://tinyurl.com/6e6acpx http://tinyurl.com/6e6acpx http://tinyurl.com/6e6acpx http://tinyurl.com/6e6acpx http://tinyurl.com/6e6acpx http://tinyurl.com/6e6acpx http://tinyurl.com/6e6acpx http://tinyurl.com/6e6acpx http://tinyurl.com/6e6acpx 2012] tax neutralities and tax amenities 83 times greater than the percentage in algeria: approximately 32.2 percent as compared to approximately 8 percent.92 2. second possible approach: from single rate to divergent rates a second approach would begin with a world in which all states imposed the same level of tax and adopted some form of double-tax relief, and then examine the efficiency consequences under alternative methods of double-tax relief, if tax rates are subsequently made to diverge. since in the initial state all jurisdictions impose tax at the same rate, it would appear that under any method or methods of double-tax relief, the initial state of the world would be non-double-tax-distorted. thus, the results under worldwide taxation with an unlimited ftc would be the same as under pure territorial taxation. each taxpayer would face one rate of tax that is the same across jurisdictions, paid in every case to the source. the single rate also would apply in a world of mixed jurisdictions, in which some states adopted territorial taxation and the others worldwide taxation with an ftc. again, each taxpayer would face a single rate of tax paid exclusively to the source. however counterfactual as a practical matter, this world at least would provide a theoretical articulation of the standard against which to measure tax distortions: a single-tax-affected world in which all individuals face the same rate of tax regardless of location of individual or capital and regardless of ownership. the system of double-tax relief under varying tax rates that created the least distortion from the baseline of the system under identical tax rates then would be the most efficient. this method of conceptualizing the non-tax-distorted world is somewhat better than the first, but fundamentally it does not address the problem of dealing with tax non-neutrality. it requires the same decision on initial tax rates that individual states operating as closed economies face in setting a revenue target. since heterogeneity on this decision is what characterizes the essential nature of the problem — as well as the actual world — it is not possible to pick a fixed rate that represents a non-distorted baseline without making a normative decision about appropriate levels of tax-financed amenities. therefore, even though it is possible to model the actual world as a set of variations from any particular arbitrarily chosen baseline, one would not be entitled to conclude that the efficiency costs associated with the variations represented distortions. one might counter that, at least within a plausible range, all states would choose to impose taxes at a rate that approximately maximizes the return to privately-held capital. on this view, heterogeneity outside of the range would not be the product of divergent national tastes on levels of tax 92. 2011 index of economic freedom, heritage foundation, http://www.heritage.org/index/explore?view=by-variables (last visited oct. 9, 2011). http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables http://www.heritage.org/index/explore?view=by-variables 84 florida tax review [vol. 12:2 financed amenities; rather it would result from technical or other constraints, such as cognitive bias, on the capacities of different jurisdictions to impose taxes at ideal rates. one then could identify a rate within the range as a neutral target (assuming it could be identified), acknowledging that the target rate functions as a proxy for the range itself. as an initial matter, the notion that wide variations in tax burdens are due to technical or other factors appears to be inconsistent with reality, as widely varying tax burdens measured as a percentage of gdp obtain among countries not apparently under external or technical constraints to tax. as examples, the u.s. combined burden is approximately 26.9 percent, while larger western european countries tend to impose levels nearer to 40 percent, and scandinavian countries hover in the midto high40 percent range.93 further, the assumption that states would, if they could, seek to maximize the returns to privately-held capital within a range faces the technical difficulty that the optimal ratio of public to private investment for such a purpose is likely to depend on a variety of country-specific factors. therefore, it cannot be specified as a uniform world rate. as examples, in order to optimize the exploitation of local resources, different countries may face different requirements for defense spending per capita; for state-funded roads, waterways, and other infrastructure; and for educational outlays. therefore, uniformity in initial starting point will have to be absent unless one assumes that the initial rate is set to meet a worldwide optimal revenue target and that extra collections in some jurisdictions are transferred to other jurisdictions in order to ensure that adequate tax amenities are financed everywhere. neither of these solutions solves the problem of identifying a nondouble-tax-affected world. if initial uniformity is lacking because differing distributions of resources require differing revenue targets (per capita) to fund the same pre-tax rate of return, then the non-double-tax-affected world will have to have different after-tax returns in different jurisdictions in order to preserve the single pre-tax rate of return worldwide. but investors seek to maximize after-tax, not pre-tax, returns, assuming they have the capacity to adjust their investments in response to tax variation. (if they lack the capacity, then the problem of tax non-neutrality does not arise anyway.) consequently, they will arrange their affairs to maximize their after-tax revenue, replicating the problem that the solution is designed to address. if, instead, a single rate with transfer payments is assumed, then a well-formulated model of the non-double-tax-affected world results (if one is willing to accept the imprecision arising from the fact that states may have different tastes for tax-financed amenities within a range). however, this 93. figures are from oecd tax database and are for 2008. oecd tax database, oecd table a, http://www.oecd.org/document/60/0,3746,en_2649_ 34533_1942460_1_1_1_1,00.html. http://www.oecd.org/document/60/0,3746,en_2649_34533_1942460_1_1_1_1,00.html http://www.oecd.org/document/60/0,3746,en_2649_34533_1942460_1_1_1_1,00.html 2012] tax neutralities and tax amenities 85 approach assumes away the problem, since it is the existence of distinct, autonomous jurisdictions that gives rise to the actual problem that analyses of neutrality are designed to address. that is, the problem is how to move towards tax neutrality in a system of sovereign nations that, if they cooperate at all, tend to do so through quite limited means, such as bilateral treaties that are not enforceable through any supra-national authority. the assumption of tax transfer payments coordinated worldwide in effect reformulates the problem as one for a single, closed economy. finally, even if one assumes both that states generally agree that optimal tax rates are those that maximize the return to privately-held capital and that a single rate for all countries could reasonably approximate that optimal rate, it turns out that what is meant by tax neutrality cannot be specified without also articulating an optimal rate. from this perspective, distortions would not be measured by the extent to which patterns of investment in the actual world differ from those that would obtain if some version of territoriality or worldwide taxation were implemented, without absolute adjustments in rates. rather, distortions would have to include a measure of the departure of tax revenue in any particular jurisdiction from what would be necessary to maximize the return to privately-held capital there. as an example, if it turned out that the optimal rate was uniform but, say, 45 percent, then even if every jurisdiction imposed tax at the same rate, there would be tax distortions unless that rate happened to be 45 percent. such an approach is inconsistent with the idea that the non-double-taxaffected world is the world of existing pre-tax returns, coupled with a single level of tax. 3. third possible approach: from closed to open economies a third approach would begin from the well-defined case of a set of closed economies in each of which income taxes are levied at a rate based upon a prior decision about desired levels of tax-financed amenities. within the framework of the problem as traditionally posed — how to preserve the neutrality associated with a single level of tax in the cross-border setting — this approach is superior to the prior two because the starting point is welldefined and apparently tax-neutral; it is in fact the same starting point that is used for the analysis of closed economies. in addition, it enjoys a greater consonance with historical practice, as domestic economies historically have dwarfed international economies in size.94 94. according to the director general of the world trade organization, between 1950 and 2010, world trade grew from approximately 5.5 percent to approximately 29 percent of world gdp. pascal lamy, facts and fictions in international trade economics, speech at conference on trade and inclusive organization (apr. 12, 2010), http://unstats.un.org/unsd/trade/s_geneva2011/ 86 florida tax review [vol. 12:2 in this setting, the question becomes whether and how one can preserve the initial neutrality when borders are opened. it will be seen that what is called neutrality — namely, the removal of tax effects across some specified margin — is compromised once cross-border trade is introduced, unless elasticity along the margin of behavior is not associated with redirection from one jurisdiction to another of either tax revenues or burdens that are paid for with them. in particular, as capital moves or levels of economic activity adjust with the opening of borders, two developments occur: tax revenues in each affected jurisdiction diverge from the target that was set initially (and that was associated with a prior decision about desired productivity levels), and the burden on infrastructure shifts as economic activity increases or declines in the jurisdiction. if either of these changes (that is, burdens or tax collections) while the other does not move in concert, pre-tax rates of return will shift because of the non-correspondence between tax revenues and the requisite supply of tax amenities. if both change (as typically will be the case in a world in which taxes are not of the lump-sum variety) the net effect is uncertain. in most cases, however, because both the resulting effect of changes in tax revenue on capital productivity and the shift in burdens on tax-financed amenities can be large, the divergence from the closed-economy baseline that results has a significant impact on both pre and post-tax rates of return and consequently on the level of taxes necessary to maintain the previously set baseline. the feedback effect of tax-induced capital flows on tax revenues and, ultimately, on the productivity of factors of production makes it impossible to articulate a neutrality standard compatible with cross-border trade among distinct, sovereign tax jurisdictions, as long as one models taxes as pure costs that purchase literally nothing. these ideas can be made clearer with the aid of a discussion example. thus, consider a system of two states, a and b, in which the economies initially are closed. pursuant to their own internal political processes, each state selects a level of tax amenities and a tax base and rate designed to supply those amenities in a reasonably efficient manner. state a taxes at a high average rate, devotes much of its tax revenue to building institutions and infrastructure and, in consequence, has a high level of productivity, expressed as gdp per capita. state b taxes at a low rate and has a correspondingly lower level of productivity. the question is what happens when borders are opened and capital flows from one jurisdiction to the other. refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20econ omics%20(wto%20-%20apr%202010).pdf. http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf 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http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/iads/facts%20and%20fictions%20in%20international%20trade%20economics%20(wto%20-%20apr%202010).pdf 2012] tax neutralities and tax amenities 87 (i) non-preservation of savings neutrality suppose that a and b adopt systems of territorial taxation on the basis that they wish to promote savings neutrality. savings neutrality, it will be recalled, holds when all investors face the same after-tax return to savings. when that criterion is met, it is not possible for total global welfare to be improved by reallocating some savings from investors in low-tax jurisdictions to investors in high-tax jurisdictions (or vice-versa).95 worldwide allocations of goods to savings and consumption are asserted to be pareto-optimal.96 by the terms of the standard analysis,97 universal territorial systems satisfy savings neutrality because they cause capital to flow from high-tax to low-tax jurisdictions until the after-tax return to savings everywhere is the same. in the stylized world under consideration here, when borders are opened, capital is expected to flow from a to b as investors reap the benefits of lower taxes there, which make the after-tax rate of return higher. as capital flows out of a and into b, its relative supply in the former drops and in the latter rises, causing, respectively, an increase and a decline in after-tax rates of return to capital in the two jurisdictions relative to the rates in effect immediately prior to the opening of borders. the flow continues until aftertax rates equalize, at which point equilibrium is reached and the economic return on the decision to save or invest is the same in a and b. savings neutrality, under this view, is preserved. the standard analysis disregards the fact that if capital begins to flow from a to b, then, under territorial taxation, a’s tax revenues will drop, and, over time, the level of tax-financed amenities in a will drop as well. the drop in amenities will lower the pre-tax and after-tax rates of return to investment in a apart from any effect caused by changes in the relative supplies of factors of production there. that is, the drop in amenities will lower the value of a-sited assets in real terms. (note that if a raises its rates to compensate for the reduction in tax revenue, the incentive to move capital out of a to b becomes greater, undermining the effectiveness of the revenueraising measure.) b’s tax revenues will rise with parallel but opposite effects. in this setting, it is not clear what significance there is to the resulting neutrality in savings decisions. the asserted efficiency property of savings neutrality is that it prevents taxes from differentially influencing investors’ decisions to allocate more or less than they would to savings in the absence of taxes,98 or, more accurately, in the absence of lump-sum taxes. the result qualifies as efficient on the standard assumption that non-tax 95. altshuler, recent developments, supra note 36, at 257. 96. id. 97. see, e.g., shaheen, reconsiderations, supra note 14, at 211. 98. altshuler, recent developments, supra note 36, at 257. 88 florida tax review [vol. 12:2 affected decisions maximize productivity, because they are based on real market prices, not tax-affected prices.99 implicit in this formulation is that all tax effects on market prices represent distortions, or, put otherwise, that taxes purchase nothing. the conclusion does not hold, however, if real, (pre-tax) market prices depend on inputs that are supplied with taxes. stated in the converse, if tax amenities contribute to productivity, then real market prices are not given by pre-tax prices, but by those prices plus some portion of assessed taxes, which means that the payment of taxes contributes to the value, not just the price, of the good purchased. in the closed economy setting, this truth was implicitly acknowledged in the recognition that taxes were necessary, but it was disregarded on the basis that tax revenues were supplied through lump-sum taxation. with lump-sum taxation, neither the real tax price of goods (the cost of providing tax amenities) nor the real tax benefit to goods (the value received for that tax price in the form of enhanced productivity) is impounded into prices; taxes are determined and assessed separately from the economic activity that gives rise to the need for tax revenues. where both the supply of tax revenue and the demand for tax benefits may be taken as fixed, as they are in the closed economy setting, this separation poses little difficulty, at least from the perspective of articulating a model that reaches a stable equilibrium.100 in the real-world, open economy setting where goods and taxes flow across borders, things are different. neither the supply of tax payments nor the demand for tax benefits can be taken as fixed. the supply of tax payments is not fixed because taxes are not assessed on a lump-sum basis. the demand for tax benefits is not fixed because the flow of capital across borders and fluctuations in productivity resulting from ownership shifts alter the burden on infrastructure in each jurisdiction and thereby alter the productivity of factors of production there as well. each of these effects poses problems for efficiency analysis, because they cause actual revenue received to diverge from the revenue target required to maintain a given rate of (pre-tax) return. indeed, the fact that the demand for tax benefits adjusts in response to economic activity means that distortions would arise as borders were opened even in a world in which all taxes were of the lump-sum variety. returning to the discussion example, once it is acknowledged that taxes purchase part of the return to savings — that is, that taxes are not merely a cost added on to the price of savings — it is not possible to maintain that the identity of after-tax returns to savings is efficient if tax revenues or the burdens on infrastructure have been redirected from one 99. see supra part iii.a. 100. it does, however, introduce a distortion by failing to incorporate into the cost of goods their tax prices, which results in over-production. see supra part iii.c. 2012] tax neutralities and tax amenities 89 jurisdiction to another along the way. the efficiency produced by ensuring that investment decisions do not differ on substitution grounds from what they would be in pre-tax terms holds only when it is possible to assume that tax benefits will be separately supplied at the level necessary to support the pre-tax rate of return. it is that assumption that makes what are called nontax-affected decisions efficient, because it is that assumption that authorizes backing out the tax cost of goods and the tax benefit purchased for them from their market prices (i.e., representing ideal taxes as lump-sum taxes). the redirection of tax revenues and burdens on infrastructure from one jurisdiction to another in the open economy setting violates the assumption. in order to assess the efficiency properties in that setting, one can no longer assume (if one ever could) that the non-tax-affected world provides a benchmark of efficiency because, as demonstrated above, its efficiency properties depend upon a fixed demand for tax benefits. it is the assumption of a fixed demand for tax benefits, itself following from the assumption that taxes are a pure cost, that ensures the pareto-optimality of non-tax-affected decision making. that same assumption is both necessary to justify backing out tax costs and factually inaccurate, as reflected in the statement of the problem itself: different revenue targets produce different levels of taxfinanced amenities. thus, consider what happens over time as capital flows and tax revenues adjust in the example. the real return to savings will be enhanced in b, the low-tax jurisdiction, as increased tax revenues improve the privatesector pre-tax rate of return there, causing increased investment. this development produces the seemingly odd result that tax-induced behavior causes an increase in productivity, not a reduction. the result is odd if one assumes that taxes are a pure cost, but perfectly sensible if one assumes that taxes buy something, even if only part of what they buy is something acquired in the good produced. capital that remains in a becomes less productive, which means the same physical quantity of capital drops in value compared to the value it had in the pre-trade (not pre-tax) world. the resident of a nominally gets the same return on a-sited investment as the resident of b does on b-sited investment, but the resident of a has less to invest in real terms. the opposite effect in b, however, should be larger if b started with a lower level of tax amenities and lower productivity.101 on balance, it is not clear whether savings decisions in the resulting post-trade world are superior to the decisions that would be made if savings neutrality did not hold. to see this, assume the same facts, except that a and b satisfy all revenue requirements via lump-sum taxation. when borders are opened, capital will flow from b to a because of the superior return there. if that were the sole effect, optimum savings decisions would result when rates equalized. but the inflow of capital to a will impose an additional burden on 101. see infra part iv. 90 florida tax review [vol. 12:2 a’s infrastructure, causing the revenue target to fall short of what is needed to maintain its higher productivity. the opposite effect will occur in b. if revenue targets are not adjusted, then in real terms asset prices in a will drop and in b will increase. after-tax rates of return, however, will be identical in both jurisdictions. if some tax revenue were allocated from b to a (or if some capital were reallocated from a back to b), greater overall productivity would result, meaning that the world of lump-sum taxes is not paretooptimal. this implies that the non-tax-affected world is inferior to the taxaffected world. such an allocation in fact is what occurs under territorial taxation. when capital moves from a to b in the original example, tax revenue is redirected from a to b. productivity in b is increased, resulting in a taxaffected world that is superior to the non-tax-affected world given that b began with fewer tax amenities than a. (ii) non-preservation of production neutrality similar conceptual difficulties arise if a and b instead pursue cen, or identity of pre-tax returns, through a system of residence-based taxation with a ftc. in this case, as capital flows from a to b, a initially will retain some revenue on its residents’ b-sited investments, and there may be only slight adjustments to the levels of tax-financed amenities in a in consequence; indeed, the adjustments could go either way depending on the relative reductions in a’s tax revenue and the demand for it to pay for tax amenities in a at the rate that was chosen before borders were opened. however, the indifference of a’s investors to tax rates in b (at least up to a’s rate) gives b an incentive to raise rates and improve its tax amenities, thereby increasing the pre-tax rate of return in b and, as a result, attracting more capital to b. the increase in b’s productivity will then reduce the residual tax revenue available in a to finance tax amenities there — especially since more capital also will be attracted to b as a result of its improved productivity. again, the result is reduced productivity in a. and, just as in the territorial case, despite the fact that the relevant benchmark is satisfied (here, cen, or identity on pre-tax rates of return), it is clear that tax rules have caused locational adjustments that affect pre-tax rates of return in absolute terms, which were supposed to be preserved under cen. therefore, it again is not clear what the normative significance is of satisfying the benchmark. nor, conversely, is it clear why the fact that the tax law has induced locational adjustments means that the resulting state of affairs is distorted: the pre-tax rate of return in a and b, which was supposed to function as a baseline to measure tax distortions, has itself been shifted in both jurisdictions, while the effect of tax-induced capital flows has been to increase productivity overall. one again is left with the odd result that taxinduced flows of capital — that is, “distortions” — have resulted in greater 2012] tax neutralities and tax amenities 91 rather than less productivity. indeed, tax-induced flows even have resulted in greater rather than less efficiency over all, when the latter is understood to include the realization of latent productive power available to capital and labor. (iii) comparison with ownership and competitive neutralities capital ownership neutrality offers a useful contrast to savings neutrality and production neutrality on the question of the effects of taxation on productivity. the case for pursuing con over other benchmarks rests in large part on the contention that tax-induced ownership effects dominate capital location and savings-spending decision effects.102 to the extent the facts support this contention, the feedback effects just discussed are muted, because tax rules generally do not redirect tax revenues into or out of jurisdictions if capital doesn’t move. there may, however, be adjustments on the demand side for tax amenities even if the location of factors of production is fixed, meaning that some feedback effect may occur. thus, consider again the example of states a and b as borders open, but assume that the only tax-sensitive margin is ownership. in the first scenario, both a and b adopt territorial systems. one would expect ownership shifts to occur as borders are opened, and, if one supposes that better tax amenities reliably produce greater competencies, it seems that in an initial stage there will be a net shift of ownership of b-sited assets to a residents. because gains from non-tax-affected trade can be expected to increase output over all, one would expect tax revenue increases in b as bsited assets become more profitable. however, as long as there is not a net reduction in productivity of assets remaining in a (by whoever held), tax revenue should not decline in a either. whether a-sited assets remain as productive as before depends on what happens when a residents acquire more-profitable assets in b. the con story plausibly holds that when resident investors acquire foreign-sited assets, new owners enter to fill the void created by the investor’s decision to sell property at home in order to finance the foreign acquisition.103 it does not follow that the new investors of the residence-sited assets will be as effective as the old owners, but a guess based purely on intuition is that the long-run tax revenue differences would not be large. if, however, intuition fails and there is a material net reduction, then tax revenue would decline, much as in the case where it is assumed that capital is mobile and ownership is fixed. 102. desai & hines, evaluating int’l tax reform, supra note 50, at 499. 103. hines, reconsidering, supra note 19, at 277–78. 92 florida tax review [vol. 12:2 if a and b each adopt a worldwide ftc system, it would appear that the effect would be more muted still, because residual residence-based tax remains when ownership shifts from low-tax to high-tax residents. these considerations suggest that it is an empirical question whether tax revenue streams or burdens on tax-financed infrastructure will be dramatically affected by tax rules. as indicated above, there is wide disagreement on the question of which margins of investor behavior, if any, dominate in response to tax rules.104 finally, a word on competitive neutrality. as discussed in part ii, treating “competitive neutrality” as a genuine neutrality benchmark seems mistaken because there are no efficiency losses, other than those associated with savings non-neutrality, that result from failure to ensure that home and host residents face identical tax burdens on host-sited investment. not surprisingly, there are no implications for competitive neutrality from the fact that capital will move in response to lower rates (assuming capital location is responsive to tax considerations). competitive neutrality says nothing explicitly or implicitly about relative productivity in home and host. c. neutrality reformulated 1. inadequacies of the lump-sum ideal the preceding considerations highlight the infirmities of neutrality analysis when it proceeds on the basis that taxes represent a pure cost unrelated to the provision of contingently demanded benefits. yet even the statement of the problem of tax neutrality for the closed economy setting, in which the decision on a revenue target is treated as exogenously given, represents an acknowledgment that some, perhaps most, taxes fund benefits that may or may not be provided and that are in some measure associated with identifiable, optional benefits. put simply: most taxes pay for goods that are necessary only if a given level of productivity is desired. if that were not the case, there would be little reason for different levels of tax to be associated with different productivity levels. to the extent taxes fund such optional benefits, the lump-sum ideal is incorrect. recall that the ideal supposes at stage one that tax revenues are financed from without, so that the individuals who benefit from tax revenues bear no cost whatever in supplying them. a level of economic activity then arises that is pareto-optimal under these conditions. by definition, that level is the one such that the cost of engaging in any more activity just equals the 104. see, e.g., kane, considering “reconsidering,” supra note 72, at 310; stephen e. shay, commentary, ownership neutrality and practical complications, 62 tax l. rev. 317, 319–24 (2009). 2012] tax neutralities and tax amenities 93 benefit of doing so.105 in other words, economic activity is supplied until the cost of doing so just equals the benefit. after that point, the costs of any additional economic activity exceed the benefits — for example, in forgone leisure — and thus additional economic activity does not occur. this result follows simply from the rational, utility-maximizing behavior of economic actors. stage two of the basic model then supposes that taxes are imposed on the same economic actors on a lump-sum basis in order to meet the associated revenue target. the result is asserted to be maximally efficient. in other words, the introduction of lump-sum taxes paid by those who enjoy their benefits is assumed not to affect the pareto optimality of the result at stage one, when tax revenues were supplied from without. now, in order for stage two to be pareto-optimal given that stage one is, there must be no incremental costs that individuals bear in supplying tax revenues used to finance the last increment of economic activity. if that were not the case, then it would be possible to improve things by avoiding the cost and not supplying the associated activity, as it is known that the benefit from the activity is just equal to the cost that was incurred before there was any cost to supplying tax revenue. but it is clear that there are incremental costs to supplying tax revenues, inasmuch as taxes cause wealth reductions to those who pay them. this implies that economic activity is inefficiently oversupplied in the standard model. one can restate the point as follows: the pareto optimality of stage two follows only if the cost in taxes of the last bit of activity undertaken when tax revenues were free is zero. but that would be the case only if it were not possible to associate activities with identifiable, tax-financed burdens. clearly, however, almost any activity creates burdens that are paid for with taxes. one can’t get the pin from manchester to london without a road, but if one doesn’t need to get the pin from manchester to london, one may not need the road, or at least not one that good. for that reason, some portion of the burden can be forgone simply by forgoing the activity.106 since the last amount of many activities had economic value only on the assumption that there was no tax cost to them, it follows that things would be improved by not engaging in those last amounts once a tax cost is added in, rather than assessing that portion of the (lump-sum) tax and then engaging in the economic activity. the argument does not imply that taxes function precisely like payments for identifiable benefits. it implies only that, for the overwhelming 105. karl e. case, economics and tax policy 117–118 (oelgeschlager, gunn, & hain, publishers, inc.) (1986). [hereinafter case, economics]. 106. see roin, competition, supra note 7, at 555–62, for an extended discussion of the relevance of benefits that taxes purchase to an analysis of the problem of tax competition. 94 florida tax review [vol. 12:2 share of economic activity, there is some identifiable burden imposed that is paid for with taxes. the lump-sum model denies this, supposing instead that taxes pay for an entirely different kind of good from that supplied through private markets. it supposes, that is, that every benefit paid for with taxes exceeds the tax cost. whereas markets are the setting in which costs are impounded into identifiable goods for which purchasers are fully charged, taxes are the setting in which costs are necessary but do not supply anything identifiable at all. the truth is that most taxes finance activities that fall somewhere in between. 2. neutrality modeling consequences the core of the neutrality concept is the idea that costs are perfectly internalized to those who impose them and associated benefits are correlatively enjoyed.107 indeed, the efficiency properties even of private markets rest on the assumption that they effectively impound costs to private actors.108 thus, the main implication of the considerations here for the analysis of tax neutrality in the cross-border setting is that an adequate conception of neutrality would need to reflect the extent to which various activities result in costs or benefits that are not otherwise internalized to the actor. what i have been referring to as the standard model of efficiency in taxation purports to satisfy that assumption by treating taxes as funding activities the benefits of which are so diffuse and yet so necessary that every dollar of tax revenue up to the last dollar collected finances a benefit greater than its cost.109 therefore, the entire revenue target is taken to represent a cost that is somehow necessary for both any and every benefit that derives from economic activity. for the reasons explored in section 1 of this subpart, that assumption is inaccurate. indeed, as stated at the outset, if the assumption were true it would not be possible to make sense of the fact that different levels of taxation are associated with different levels of economic activity – that is, with the basic framing of the problem of international tax neutrality (or, indeed, of neutrality generally). by the same token, as an ideal, the benefit model of taxation is at least as inaccurate as the standard model. taxes pay for benefits that are enjoyed much more diffusely than are most benefits purchased in private markets. the fact that one needs a good road only if one needs to get the pin from manchester to london does not imply that only the producer of the pin (or, ultimately, its beneficial purchaser) benefits from the road. again, most 107. see case, economics, supra note 105, at 121. 108. id. 109. again, it should be borne in mind that the tax revenues of relevance here are what i have termed “amenity taxes,” not taxes, for example, to fund redistribution or pure consumption goods. 2012] tax neutralities and tax amenities 95 benefits that are purchased with taxes have this character. if that were not the case, benefits supplied with taxes instead could be supplied through private markets. so a model of neutrality that accurately accounted for the burdens that economic activity creates can no more be assimilated to a market model than to the standard model; rather, it would need to identify that portion of burdens that any particular activity creates that are imposed diffusely and then accurately assign the cost of the activity to each individual beneficiary of it. in other words, it would require assigning to individual economic activities the otherwise-externalized costs that they create so that the tax could be assessed to the actor. as a practical matter, there is no way to do this. consider that if the improvements to the manchester-london road are enjoyed more widely than by the pin producer (as they assuredly are), then to preserve neutrality, it is not just the pin producer who needs to be made responsible for the better road; it is a larger, more diffuse group, and one would need some way to identify that group’s members and “how much” each member benefited in order to assign tax liabilities accurately. a vast literature on the pricing of such public goods, originating with the work of erik lindahl,110 has grown up over the last century in an effort to answer these questions. its main conclusion is that the problem is largely intractable as a practical matter, even if it is possible in some cases to articulate theoretically how such goods should be priced.111 the main theoretical problem is that, to the extent a benefit is non-rival and non-excludible, no one has an incentive to disclose his true valuation of the good; rather each has an incentive to give an artificially low signal for the price of the good, because, if the good is supplied, each will be able to enjoy it without having to pay for it.112 added to this core difficulty are the problems of identifying who benefits, which activities burden, and by how much. in light of these difficulties, one could abandon the aspiration to evaluate the productivity consequences of international tax systems on the basis that it is simply not possible to identify a neutral baseline against which to measure distortions that adversely affect productivity. an alternative, which i pursue in the next two parts, is to take an aggregative approach that assumes that tax revenues are associated with economic productivity at a macro-level that can be modeled in a relatively simple manner. the object is 110. see barbara h. fried, the puzzling case for proportionate taxation, 2 chap l. rev. 157, 168–72 (1999) [hereinafter fried, proportionate taxation] (discussing the literature on pricing of public goods initiated by lindahl). 111. paul a. samuelson, the pure theory of public expenditure, 36 rev. of econ. & stat. 387, 388-89 (1954) [hereinafter samuelson, pure theory]. see also, fried, proportionate taxation, supra note 110, at 165–72 (discussing the literature). 112. samuelson, pure theory, supra note 111, at 388–89. 96 florida tax review [vol. 12:2 to get a rough idea of the extent to which expenditures on tax-financed types of benefits contribute to productivity. part iv develops a model that offers some useful hypotheses about the likely productivity properties of international tax systems. implications of the hypotheses are explored in part v. iv. neutrality as a combination of rates and amenities this part and the next attempt to quantify the conceptual points developed in parts iii.b and iii.c. the extent of the effect of tax rules on productivity depends on the nature of the relationship between tax revenues and tax amenities. in this part, i begin with a simple model that offers rough measures of that relationship and of the magnitude of the effect on tax revenues from tax-induced capital flows. i then explore the consequences for productivity under the model when capital enters or leaves the jurisdiction in response to taxes. the object here is not to predict what is likely to happen to actual flows under possible real-world conditions (a topic addressed in part v), but rather to explore the efficiency and productivity of properties of tax systems, assuming that certain flows of tax revenues and of productive activities occur and that these flows are affected by whatever set of tax rules is in place. a. estimating the value of tax amenities technically the question of interest is what quantity of those taxfinanced governmental goods and services that contribute to productivity needed to support a given level of productivity. i have been referring to these goods as “tax amenities.” redistributive taxation and taxation for the provision of what might be called pure consumption benefits, such as public parks for enjoyment, are not relevant to this question. the precise relationship between tax amenities and productivity undoubtedly is quite complex and varies depending on such factors as the size of the jurisdiction, its available resources, social and political views about various matters, and other variables. rather than seek to tease out the relationships between these factors and productivity, i proceed with a more tractable, if less precise, model that seeks to specify the general nature of the relationship between taxation and productivity. it is helpful to begin with the observation that most tax amenities exhibit characteristics somewhere between those of “pure private goods” and “pure public goods.” a pure private good is one whose unit price can be determined under a standard model of supply and demand; it exhibits no externalities and its producer bears all associated costs and enjoys all 2012] tax neutralities and tax amenities 97 associated benefits of producing it.113 pure private goods also exhibit the characteristics of “excludability” and “rivalry,” meaning, respectively, that the good’s availability can be limited to those who pay for it and that one person’s consumption of the supply of the good reduces its availability for consumption by another. a pure public good, by contrast, would be entirely non-rival and non-excludable.114 national defense is close to a pure public good because militias provide a benefit to all residents without regard to the amounts of tax they pay that support national defense and, within limits, without regard to population size. clean air is a similar example. for these goods, it is impossible to exclude those who do not pay for them from enjoying them, and the enjoyment of them by anyone (whether paying or not) does not reduce the quantity available for others to enjoy. in practice, most tax-financed goods exhibit some aspects of nonrivalry and non-excludability, but they are not “pure.”115 (the converse holds to some extent as well: many market-supplied goods have publicgoods features, in that they provide benefits to persons who do not pay for them.)116 locally provided amenities such as street cleaning or schools exhibit less of these characteristics, since ordinary market forces, such as the cost of housing, may determine who gets to enjoy the benefits. a public school may be open only to community residents (excludability), and there are limits to the number of attendees (rivalry). it is well understood that public goods cannot be priced under the standard model applicable to private goods because of endemic market failure, which takes the form of positive externalities.117 in particular, nonexcludability creates a free-rider problem in that the goods are enjoyed by non-purchasers, and non-rivalry means that pricing presents a collective action problem.118 as a consequence, the use of market mechanisms to supply public goods will result in a systematic undersupply unless there is someone who so values the good that it is worthwhile for that person to provide it even if no compensation from other beneficiaries is forthcoming. a large literature explores the problem of funding public goods in a manner that addresses these difficulties.119 113. id. 114. id. 115. id. 116. as one example among many, local real property enhancements may improve property values in the surrounding area. 117. samuelson, pure theory, supra note 111, at 388–89. 118. id. 119. john hudson & philip jones, “public goods”: an exercise in calibration, 124 pub. choice 267 (2005). 98 florida tax review [vol. 12:2 although the pricing of public goods is relevant to the problem of their supply, here the concern is not so much with setting prices but with determining the value they add to factors of production via tax amenities. what, in general, does it cost to supply a given level of productivity, and how is that cost related to the quantity of capital in the jurisdiction, assuming that all tax amenities are financed with tax revenues? if tax amenities were pure private goods, the feedback problem of tax-induced capital flows on tax revenues and, consequently, on tax amenities would disappear. in that case, each unit of capital would be ticketed with just the taxes that it requires in order to be as productive as it is for a given rate of tax, and not more. net capital exports would reduce total taxes collected and, concomitantly, total tax amenities supplied by exactly the amount no longer needed in the jurisdiction to maintain the same level of capital productivity, while net capital imports would increase tax amenities analogously. but tax amenities, even though narrowly construed to include solely those tax-purchased goods that contribute to the productivity of capital, are not pure private goods, and the cost of providing them cannot be assumed to be linearly impounded into taxes assessed on capital. many tax amenities, such as national defense or the broadcast spectrum, have costs that are not systematically related to the quantity of capital in the jurisdiction. other tax amenities, such as a court system, public safety, and transportation infrastructure, have costs that are partly related and partly unrelated to the quantity of capital present in the jurisdiction. more generally, it seems reasonable to suppose that for a given level of capital productivity, tax amenities will be supplied partly from public goods financed with fixed costs and partly from public goods the cost of which varies in some way with the amount of capital in the jurisdiction. 1. model equation (1) attempts to capture these intuitions in a simple, stylized model that relates gdp per capita, a proxy for capital productivity, to the product of the logarithms of total taxes collected per capita and country population, backing out, however, taxes paid for pension contributions. the underlying intuitions are as follows: i. over the range of reasonable possible tax burdens, taxes are positively correlated with capital productivity because taxes pay for infrastructure; 2012] tax neutralities and tax amenities 99 ii. by backing out the largest single item (retirement) that is largely unrelated to productivity, a reasonable approximation of taxes used to fund productive activity is employed;120 iii. especially in the case of public goods, there are returns to scale for larger countries so that, all else equal, the same quantity of tax revenue per capita will fund more tax amenities in a country with a larger population than in a country with a smaller one; and iv. the use of logarithm functions is appropriate because both the marginal benefit from greater tax burdens and the marginal benefit from greater population exhibit the property common to many economic inputs of being constantly declining, so that the next dollar of tax revenue or the next person does not contribute as much as the previous one to the improvement of gdp per capita. thus: gdpi = logn(ti + c1)*logn(pi + c2), (1) where gdpi is gross domestic product per capita as a share of a reference gdp per capita, ti is tax revenue per capita as a share of reference tax revenue per capita, and pi is population as a share of reference population, in each case in country i. the c-terms are constants. reference rates are used to avoid the problem of expressing relative productivity levels and tax burdens in dollars or other units. because the model attempts to derive the consequences of international tax rules on productivity as economies move from relatively closed to more open status, an older data set is a better candidate than a newer one for an approximation of the relationship between tax revenue and population on one hand and productivity on the other for a closed economy. the earliest year for which data are readily available is 1980. at that time, the value of world trade as a percentage of world gdp was 42.1 percent. (by 2007 this value had risen to 62.1 percent.121) expressing total taxes in country i as a fraction of u.s. total taxes in 1980 (in each case, less pension contributions) and population in country i as a fraction of u.s. population in 120. additional outlays that could have been backed out include unemployment insurance, public consumption goods, such as parks, and transfer payments from high-income to low-income persons. the first and third of these items plausibly contribute materially to productivity, while the second is generally inconsequential in amount. see, e.g., office of mgmt. & budget, exec., office of the president, budget of the united states government, fiscal year 2010 (proposing $12 billion, or approximately 0.8 percent of the federal budget, for the department of the interior). 121. international monetary fund, globalization: a brief overview, http://www.imf.org/external/np/exr/ib/2008/053008.htm. 100 florida tax review [vol. 12:2 1980, a regression for then-member oecd countries against the exponent of gdp per capita (expressed as a fraction of u.s. gdp per capita) was run for 1980.122 the parameters derived for the regression are: c1 = 1.3228, and c2 = 2.4750. the two independent variables appear to account for approximately 79 percent of the variation in gdp/capita, although tax revenue per capita alone accounts for nearly 65 percent of total variation.123 substituting these values into equation (1) yields: gdp/capi = logn(ti + 1.2899)*logn(pi + 2.9285), (1’) where gdp/cap is expressed in terms of the fraction of u.s. gdp per capita, ti is expressed as the fraction of total u.s. tax revenue, and pi is expressed as a fraction of u.s. population, all in 1980. total tax revenue includes both income and other taxes and includes sub-national tax revenue. table 1 lists predicted productivity levels under equation (1’) associated with different levels of tax revenue for selected populations and tax revenue values. 122. the data set consisted of all oecd member countries in 1980 except iceland, luxembourg, and sweden. iceland and luxembourg were excluded because they were judged too small in population to be representative, while switzerland was excluded because it was judged to be a tax haven and, therefore, unlikely to exhibit the properties of a relatively closed economy funding its infrastructure primarily with taxes from domestic productive activity. additional attributes of the data set and results for statistical significance are provided in the appendix. 123. r2 for equation (1’) is 0.7979. see appendix. 2012] tax neutralities and tax amenities 101 table 1: productivity at selected tax revenues and populations a. population equal to u.s. population (1980) tax revenue per capita as percent u.s. tax revenue per capita predicted gdp per capita as percent u.s. gdp per capita 200 162.91 180 154.33 160 145.16 140 135.36 120 124.79 100 113.34 80 100.84 60 87.08 40 71.77 20 54.54 b. population equal to one-half u.s. population (1980) tax revenue per capita as percent u.s. tax revenue per capita predicted gdp per capita as percent u.s. gdp per capita 1. 200 139.19 2. 180 131.86 3. 160 124.04 4. 140 115.65 5. 120 106.62 6. 100 96.83 7. 80 86.15 8. 60 74.40 9. 40 61.32 10. 20 46.60 102 florida tax review [vol. 12:2 c. population equal to one-twentieth u.s. population (1980) tax revenue per capita as percent u.s. tax revenue per capita predicted gdp per capita as percent u.s. gdp per capita 1. 200 121.25 2. 180 114.87 3. 160 108.05 4. 140 100.75 5. 120 92.88 6. 100 84.36 7. 80 75.05 8. 60 64.81 9. 40 53.42 10. 20 40.60 2. observations with coefficient of determination (r2) of 0.798, the model may be taken as identifying a meaningful correlation between productivity on one hand and tax amenities and population on the other. as with any model, the establishment of a correlation does not establish causation: the model does prove that higher tax rates or larger populations cause greater productivity. nonetheless, in considering possible alternative explanations for the correlation, it would appear that causation more likely runs in this direction than either in the opposite direction or from some third thing to both productivity increases on one hand and higher tax rates and larger populations on the other. begin with the alternative thesis that high productivity causes higher tax rates. the story could be based on the idea that highly productive countries have a greater taste for tax-financed goods than do less-productive countries. that account may partly explain a portion of higher tax rates in some countries — scandinavia may be a good example — but it largely disregards the fact that most economic activity plainly requires goods that are paid for with taxes.124 moreover, the idea that populations in wealthier countries generally clamor for higher taxes to fund various programs seems counter-intuitive. as for the idea that it is some third thing that causes both productivity and higher taxes, one can only say that it is always possible that an as-yet unidentified factor explains a correlation; however, no such third thing readily comes to mind. rather the fact that so many tax expenditures 124. see, e.g., david hasen, liberalism and ability taxation, 85 tex. l. rev. 1057, 1109 n.203 (2007) (citing literature). 2012] tax neutralities and tax amenities 103 are devoted to goods that enhance productivity suggests the causation runs mostly from tax rates to productivity. similarly, it would seem that in the end higher populations are more responsible for higher productivity than the other way around. while greater productivity may result in higher populations, it seems likely that the resulting higher population in turn increases productivity. smaller countries have fewer opportunities than larger ones to exploit comparative advantage, and the greater opportunities that larger populations have to diversify factors of production would suggest that larger countries are more productive than smaller ones. the limits of the model also should be noted. the model does not purport to explain the relationship between rates or population and productivity at values far outside of observed ranges. average effective tax rates near or in excess of 100 percent obviously would not be associated with higher levels of productivity than are much lower rates, but the model as formulated does not expressly take this limitation into account, as no country imposes an average effective tax rate nearly that high. no claim of explanatory power for rates much outside the range of observed rates (on either side) is made. the model also does not tease out the effects of different kinds of taxes on productivity or, more importantly, the effects of progressivity (or lack of it) on productivity. for example, there likely are different productivity properties from the imposition of taxes primarily on income, on income and consumption, and primarily on consumption. similarly, there likely are different effects depending upon whether those with greater incomes (or who consumer more) are taxed more heavily. and, relatedly, productivity may be related to income or wealth distribution more generally. the model addresses none of these factors. within these limitations, and in light of possible explanations for the observed correlations, it would appear that over the range of reasonable average effective rates, higher taxes do tend to cause higher productivity. in other words, equation (1’) may be interpreted to say that within the range of reasonable average effective tax rates, over time a higher rate is likely to result in productivity gains roughly consonant with the pattern of predictions in table i. b. productivity consequences of capital flows under the model whether and how capital will flow as the world moves from a system of closed economies to one of open economies are topics developed in part v, but here it is worth considering in a general way the revenue and productivity effects that the model predicts assuming that significant amounts of capital do flow into or out of a representative jurisdiction. again, the object in this subpart is simply to get an idea of the relationship between capital flows and productivity consequences, not to offer claims about the 104 florida tax review [vol. 12:2 particular flows that are likely to result from the feedback effects from either altered supplies of tax revenues or altered demands for them. in order to simplify the analysis, the following assumes that all countries derive one-half of their tax revenues from a flat-rate income tax, with the balance derived from taxes and fees not dependent upon the presence of capital in the jurisdiction. it also assumes that one-half of world income is derived from labor and one-half from capital. this assumption is one possible approximation of the generally accepted view that labor accounts for between 40 and 60 percent of gdp, and capital the balance.125 thus, under these assumptions, one-quarter of world tax revenue derives from income taxes laid on capital. 1. territorial systems in a system of universal territoriality, the flow of capital out of a jurisdiction is associated in the short term with the elimination of all income tax revenues generated by the capital from the residence jurisdiction and the generation of new tax revenue in the source jurisdiction (at the source rate). it also is associated with the elimination of tax revenue from labor supplied in conjunction with the operation of that capital in the residence to the extent the labor is not reabsorbed into the residence economy; additional tax revenue resulting from the inflow of capital in the source arises on an analogous basis.126 based upon the assumptions described above, and in light of the associated revenue losses and gains resulting from capital movements, the exodus of one percent of capital from a jurisdiction leads to a minimum 0.25 percent reduction in total tax revenues there. thus, the transfer of 20 percent of the capital from the residence to a source jurisdiction is associated with at least a 5 percent reduction in residence tax revenues. consider a country having a population one-twentieth of the u.s. 1980 population whose initial tax revenues per capita are 1.6 times that of the u.s. in 1980. this would be approximately the situation of a small western european country such as belgium. assume that, after borders are opened, over time the country experiences a 25 percent net capital outflow and an associated 8 percent reduction in tax revenues, factoring in lost productivity from the sub-optimal reallocation of labor to other activities in the residence. although residents would continue to own income generated by off-shore capital, the residence would experience a reduction in 125. malte lübke, labour shares, international labour organisation, technical brief no. 1 (2007), http://www.ilo.org/integration/resources/briefs/ wcms_086237/lang--en/index.htm. 126. david f. heathfield & sören wibe, an introduction to cost and production functions 1–27 (1987). 2012] tax neutralities and tax amenities 105 productivity of approximately 4.5 percent due solely to reductions in tax revenues, from 108 percent of u.s. productivity to about 103.5 percent.127 this drop may not appear to be large, but even an economy 5 percent of the size of the u.s. economy would have approximately $729 billion in annual gdp,128 meaning that a 4 percent reduction in productivity is associated with approximately $29 billion in lost productivity, or more than $1,800 per person per year. perhaps more importantly, a further effect of a reduction in incountry capital productivity is to make foreign investment still more attractive to home-country residents, leading to a cycle of capital exodus that continues for as long as the reduction in productivity associated with lower tax revenues exceeds the increase in capital productivity associated with greater scarcity of capital in the jurisdiction.129 and if the residence responds to falling productivity by reducing tax rates, the problem is likely to get worse unless the drop in rates encourages capital inflows. (whether it does depends upon the tradeoff to foreign investors between lower productivity in the residence and lower taxes there. this subject is addressed in part v.) unless and until the drop in rates encourages net capital inflows, residence productivity will decline further still. when equilibrium is reached, incountry gdp will have declined substantially below the optimum level that existed before borders were opened. whether the drop represents a worldwide productivity loss depends, however, on the capital productivity increase, if any, associated with the movement of capital into source jurisdictions and the associated infrastructure improvements resulting from additional tax revenues there. of importance for the neutrality question is 127. an 8 percent reduction in tax revenue per capita from 1.6 times the u.s. level is 1.472 times the u.s. level. under equation (1’), the resulting productivity is given by: logn(1.472 + 1.2899)*logn(0.05 + 2.71828) = 1.034, or 103.4 percent of u.s. productivity, a drop of approximately four-and-one-half percent from the level for tax revenue per capita equal to 1.6 times that of the u.s. see table 1.c., line 3. 128. for 2010, the oecd estimated u.s. gdp as $14.58 trillion. oecd, gross domestic products in u.s. dollars, http://www.oecd-ilibrary.org/economics/ gross-domestic-product-in-us-dollars_2074384x-table3. according to equation (1’), a country one-twentieth the size of the u.s. with a per capita tax burden equal to 1.6 times that of the u.s. would have gdp per capita of 99 percent of that of the u.s., resulting in an economy approximately 5 percent of the size of the u.s. economy. 129. to be clear, the upward pressure on the price of capital remaining in the jurisdiction resulting from tax-induced outflows is a consistent theme of neutrality analysis. see, e.g., knoll, int’l tax neutrality, supra note 1, at 101–04; shaheen, reconsiderations, supra note 14, at 215–19. the claim here is that the focus equally needs to be on the downward pressure on the price of capital remaining in the jurisdiction (relative to the price of capital in other jurisdictions) that results from the reduced productivity of capital as tax amenities go unsupplied. http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 http://www.oecd-ilibrary.org/economics/gross-domestic-product-in-us-dollars_2074384x-table3 106 florida tax review [vol. 12:2 that, however that analysis plays out, one cannot read off from the fact that capital flows into or out of the jurisdiction that neutrality either has been “maintained” or has not according to the savings neutrality benchmark. in the case of a net capital importer, the situation is roughly reversed. a net 25 percent increase in capital inflow will be associated with a 25 percent increase in tax revenues and rising productivity. of course, this result presupposes that tax rates remain generally constant. as discussed in part v, below, this expectation is not reasonable in a world of territorial states divided into net capital exporting countries and net capital importing countries. 2. worldwide systems in worldwide systems, the productivity consequences of a net inflow of capital, without more, do not differ from those in territorial systems, while the consequences of a net outflow of capital may or may not differ markedly from those in territorial systems. as in a territorial system, the source collects its full rate on imported capital, and the associated benefits to tax amenities all arise there. the productivity consequences in the residence are more ambiguous. if capital moves to a higher-taxed jurisdiction, the result is the same as in a territorial system, assuming the ftc is limited: the residence experiences a net reduction in tax revenues equal to all tax on the departed capital, giving rise to the same reduction in productivity that arises under a territorial system. (if the ftc is unlimited, there is an additional reduction in residence tax revenue equal to the difference between the tax on income at the source rate and the tax on income at the residence rate, resulting in even greater degradation of residence productivity. however, as noted earlier, no system provides or is likely to provide an unlimited ftc.130) if the source jurisdiction taxes at a lower rate than the residence jurisdiction, the residence retains residual tax revenue equal to the difference between the residence country and source country rates applied to net sourcebased investment income. the productivity consequences of the retention are unclear. the model of productivity developed in this part is based on the theory that over the range of reasonably possible tax rates, tax revenues significantly drive the rate of return to privately-held capital. the model further supposes that, for a variety of reasons, the increase or reduction in taxes on capital will be related to the logarithm of the pre-tax rate of return. in other words, if, as capital leaves the jurisdiction, all of the associated tax revenues leave the jurisdiction, the resultant reduction in tax revenues has a downward effect on productivity that exceeds the upward effect from having to supply fewer tax amenities by reason of the reduced quantity of capital 130. see supra part ii.b. 2012] tax neutralities and tax amenities 107 present there. by the same token, however, the departure of capital from a jurisdiction does imply that the burden on infrastructure, and consequently the cost of tax amenities, drops to some extent. therefore, in a worldwide system where capital leaves a high-tax residence for a low-tax source, the effect on residence productivity from reduced tax revenues depends on whether the residual tax revenue in the residence covers the cost of maintaining the reduced need for tax amenities there. this is an empirical question that is a function of a number of variables, including the initial quantity of tax revenue per capita in the residence (a higher amount associated with less reduction in productivity as capital leaves), the difference between the source and resident rates (a greater difference associated with less reduction in productivity as capital leaves) and the size of the residence (a larger population associated with less reduction in productivity as capital leaves). as a general matter, however, one may say that to the extent tax revenue remains in the residence as capital departs for the source, the downward effect on residence productivity is muted, while it may even be the case that there is net increase in productivity. c. conclusion on neutrality and amenities the discussion in this part has developed the thesis, backed by evidence, that the presence in a jurisdiction of what i have termed “tax amenities” — infrastructure and other public or quasi-public goods that are paid for with tax revenues — plays a significant role in the productivity of capital there. the ramifications of the thesis, if true, are reasonably farreaching. part iii developed the argument that any system for taxing crossborder transactions creates incentives that alter the absolute productivity of capital in any jurisdiction, assuming that capital moves or its ownership is adjusted, or that tax revenues are reallocated, in response to tax rules. (similar consequences follow if labor moves or is reallocated, a question not treated here.) changes in absolute productivity in the jurisdiction, no less than tax-induced movements of assets or capabilities or changes to the relative supplies of labor and capital, have an effect on the “pre-tax rate of return” and indicate that productivity enhancements may result from what would count as tax distortions under the standard view of the effects of taxation on productivity. this part suggests that predictions under the amenity approach about whether capital will flow and the productivity consequences of capital flows as borders become more open differ markedly from predictions under the standard models. under those models, productivity is not made to depend on tax revenues, and tax rules accordingly are expected to have effects on productivity largely because of tax-induced changes in allocations of resources to the wrong person or place and resulting misallocations of the 108 florida tax review [vol. 12:2 relative supplies of and demands for factors of production in affected jurisdictions. thus, if, when borders are lifted, the world consists of a system of territorial regimes, under the standard model capital can be expected to flow to the lowest-tax jurisdictions until after-tax rates of return there reach aftertax rates in the next-lowest-taxed jurisdictions, then to those latter jurisdictions, finally reaching a single worldwide after-tax rate with some significant amount of distortion in capital location once all tax benefits have been capitalized.131 this pattern follows if one assumes that taxes generally represent a cost laid on top of other costs to investment, with the difference that, unlike other costs, tax costs purchase nothing that need not be purchased. similarly, if ownership is the dominant margin along which behavior is elastic to taxes and a mixed system of worldwide and territorial regimes is in effect as borders become open, one can expect the identity of owners of capital to shift in similar ways until a single after-tax rate of return is reached with an associated (inefficient) pattern of ownership.132 by contrast, under the approach developed here, it is unclear whether under a territorial regime capital will flow into low-tax jurisdictions or ownership will shift from high-tax to low-tax investors: on one hand, for the resident of a high-tax jurisdiction, the tax burden of investment is lower in a low-tax jurisdiction; but, on the other hand, the absolute rate of return to capital in the low-tax jurisdiction is likely to be lower than it is in a high-tax jurisdiction. whether it makes sense to move capital or change ownership to enjoy those lower tax rates depends on the tradeoff between them and the lower productivity associated with them, since the issue is which combination of low rates and high amenities produces the highest after-tax rate of return. this is an empirical question the answer to which depends on actual productivity levels and tax rates in both jurisdictions. it is perhaps worth noting that the low levels of capital inflow into low-tax jurisdictions suggested by a focus on tax amenities is consistent with observation.133 the theory that generates them also helps to explain the socalled “lucas paradox,” which states that despite the fact that (standard) theory predicts net capital flows to low-cost jurisdictions, observed flows tend to run in the opposite direction — to high-cost jurisdictions.134 it would 131. see, e.g., rosenzweig, tax havens, supra note 11, at 945–47, for a standard statement of the thesis. 132. see, e.g., hines, reconsidering, supra note 19, at 276, for a description of how ownership changes result from tax rules. 133. laura alfaro et al., why doesn’t capital flow from rich to poor countries? an empirical investigation, 90 rev. econ. & stat. 347 (2008). [hereinafter alfaro, capital flow] 134. robert lucas, papers and proceedings of the hundred and second annual meeting of the american economic association, why doesn’t capital flow 2012] tax neutralities and tax amenities 109 appear that the puzzle can be partly explained, or at least better understood, once the role that taxes play in establishing productivity is taken into account. in particular, a jurisdiction’s after-tax return to higher taxes will often, perhaps typically, exceed the after-tax return to lower taxes. for example, under the model set out in part iv, a country one-twentieth the size of the u.s. in population having an initial tax amenity rate equal to 80 percent of the u.s. tax amenity rate in 1980 would have an amenity tax rate of 20.62 percent135 and a model-predicted gdp per capita of 75.05 percent of 1980 u.s. gdp per capita.136 if the tax rate were cut in half, modelpredicted gdp per capita as a fraction of u.s. gdp per capita drops to 53.42 percent. thus, while an investment earning $100 at the higher productivity rate would yield in $79.38 after-tax, the same investment at the lower productivity rate would yield approximately five-sevenths the return on a pre-tax basis, or $71.18. the after-tax return would be $63.28. a rational investor would therefore favor investment in the high-tax jurisdiction.137 from rich to poor countries?, 80 am. econ. rev. 92 (1990). the lucas paradox is more of a puzzle than it is a paradox. lucas attempted to explain the fact that capital flowed into the u.s. much more readily than into india in 1988, despite the fact that theory predicted the marginal productivity of capital in india would be fifty-eight times higher than in the u.s. id. lucas offered two possible explanations: differences in “fundamentals,” or country-specific factors affecting productivity, and market failure. alfaro et al. examine a larger data set for the period 1971-2000 and conclude that fundamentals are the key determinant. in particular, they state: “low institutional quality is the leading explanation for the lucas paradox.” alfaro, capital flow, supra note 133, at 347. the explanation offered in this article is consistent with alfaro inasmuch as many fundamentals, including those affecting institutional quality, tend to be financed with tax amenities. 135. in 1980, the u.s. tax rate (national and sub-national) as a percentage of gdp per capita was 26.40 percent, of which 78.1 percent, or 20.62 percent of gdp, was devoted to spending on tax amenities, defined as all tax outlays other than to fund pensions (social security). data on total taxes as a percentage of gdp and on pension taxes as a percent of gdp, in each case for a range of years, is available from the oecd http://stats.oecd.org/index.aspx?datasetcode=rev. 136. see table 1.c., line 7. 137. other tax explanations for the lucas paradox have been offered. for example, kleinbard notes that the capacity of multinational firms to deflect income economically earned in high-tax jurisdictions to low-tax jurisdictions for tax purposes removes the added cost of investing in high-tax jurisdictions while enabling the investor to reap the greater productivity benefits there. kleinbard, stateless income, supra note 32, at 770–71. kleinbard’s explanation is entirely consistent with the theory of tax amenities offered here, since it presupposes that the absolute pre-tax return to investment in high-tax jurisdictions is superior to that in low-tax ones. http://stats.oecd.org/index.aspx?datasetcode=rev 110 florida tax review [vol. 12:2 finally, there are dramatic welfare consequences to tax-induced capital flows that have gone largely unnoticed in the literature. the link between tax revenues and productivity means that the flow of capital in response to taxes has a multiplier effect on increases in productivity in the source and, at least in the case of territorial systems, on reductions in productivity in the residence, disregarding the very real problem of tax competition (addressed in part v). for the source enjoying net capital inflows, if statutory rates of tax remain constant (which they rarely do in a territorial world) the news generally would be good regardless whether the system is territorial or worldwide, as the source gets all the additional tax revenue associated with the net inflow of capital. the additional tax revenue improves the rate of return in the source, thereby making it more attractive for additional investment. this virtuous circle continues until the improvement in the rate of return is balanced by a reduction resulting from the increased relative supply of capital in the source as a factor of production. by contrast, for a residence country experiencing net capital outflow, the news is likely to be bad — especially in a territorial system. in a territorial system, as capital leaves the residence, productivity declines because of the decline in tax revenues. the decline in productivity makes the residence still less attractive to capital, meaning that still more capital can be expected to depart. the downward spiral continues until the increased scarcity of capital relative to other factors of production in the residence counterbalances any additional reduction in the rate of return to capital resulting from reductions in tax revenues. the point at which equilibrium is reached, however, is likely to be one at which productivity is markedly lower than it would have been if tax revenues were kept at a level sufficient to maintain capital productivity in the residence. whether there is an overall reduction in productivity — that is, a worldwide reduction — depends upon the consequences in the source. it seems safe to say, however, that residence reductions in productivity are less likely in a system of worldwide taxation, as high-tax resident jurisdictions retain some tax revenue after the departure of capital to lower-tax jurisdictions. where the revenue retained is sufficient to maintain productivity levels (as it may be given the reduced burden to finance tax amenities resulting from the net departure of capital), no downward spiral occurs. v. allocative, distributional, and competitive effects part iii laid out the case against the traditional understanding of international tax neutrality, arguing that the effects of capital flows on pretax rates of return render the idea that there exists a worldwide baseline against which one can measure return problematic. part iv developed a model for thinking about cross-border taxation that takes account of the 2012] tax neutralities and tax amenities 111 relationship between tax revenues and the pre-tax rate of return — the effect of so-called tax amenities on productivity. part iv also detailed some of the productivity consequences of capital flows for home and host jurisdictions, assuming that capital moves in response to taxes. this part briefly examines the circumstances under which such capital flows are likely to occur in light of the model and compares predictions of the model with observation. it also surveys the likely allocative, distributional and competitive properties of international tax systems under the model. if the case for pursuing some global form of neutrality fails, these effects loom larger in any effort to develop policy prescriptions for principles of international taxation. a. after-tax returns a range of average effective tax rates and levels of development obtains in the actual world,138 but in broad brush the world consists mostly of a set of industrialized, developed countries and a set of relatively nonindustrialized, undeveloped countries.139 here i consider the situations of a developed and an undeveloped country under alternative international tax regimes as the world moves from closed to open economies, taking into account that under any system, investors generally seek not to minimize their effective tax rates, but to maximize their after-tax returns. in general, the after-tax rate of return is given by: qi = (1 – ti)*ri, (2) where qi is after-tax rate of return, ti is tax rate, and ri is pre-tax rate of return (in each case expressed as decimals), all in country i. in making investment decisions, investors seek a combination of tax rate and rate of return that provides the maximum value for q. many factors are responsible for ri, but for present purposes i bracket all those except taxes and population, which part iv suggests are highly correlated with productivity. using equation (1’), it is possible to derive an expression for ri in terms of ti and population for a world in which all taxes 138. see heritage foundation, 2011 index of world economic freedom, http://www.heritage.org/index/download for a list of all countries and tax rates. it is possible to compute tax revenue per capita using the heritage foundation data. 139. according to the world bank, in 2010, of the 215 countries for which data are available, more than one-half have gross national income (gni) per capita of less than one-half the worldwide average of $9,097. the populations of these countries account for substantially more than one-half of world population. see world bank, gross national income per capita 2010, atlas method and ppp, http://siteresources.worldbank.org/datastatistics/resources/gnipc.pdf. 112 florida tax review [vol. 12:2 are income taxes levied at a flat rate. recall that equation (1’) relates pre-tax rate of return (expressed as the ratio of gdp per capita to that of the u.s. in 1980) to amenity tax rate and country population (also as fractions of the respective u.s. values for 1980) as follows: gdpi = logn(ti + 1.2899)*logn(pi + 2.9285). (1’) taking population as fixed for any particular country i, the second logarithm term becomes a constant and for that country (1’) simplifies to: gdpi = ai*logn(ti + 1.2899), (1’’) where ai is the constant derived by applying the logarithm function to the argument of the second logarithm term in equation (1’), taking as pi the ratio of country i population to u.s. population in 1980. if gdp per capita is taken as a proxy for pre-tax rate of return, then one can rewrite ri as the product of gdpi and some constant, k. however, it is not necessary to derive k if one expresses the after-tax rate of return not directly as a rate but as the ratio of the country i gdp per capita to the same reference gdp per capita that was used in equation (1) (that is, u.s. gdp per capita in 1980), multiplied by one minus the tax rate in country i. (under this procedure, the k term drops out.) therefore, let qi be the ratio of qi to qus-80, u.s. gdp per capita in 1980. then: qi = (1 – ti)*ri, (2’) where ri is simply country i productivity measured against 1980 u.s. productivity, or the expression given on the right side of equation (1’). for a fixed population in country i, that expression is given by equation (1’’), so that: ri = ai*logn(ti + 1.2899). (1’’’) finally, since ti is just the ratio of ti to the reference tax rate, u.s. amenity taxes in 1980 (expressed as the ratio of all u.s. tax revenue to u.s. gdp for the year), or 0.206, equation (1’’’) can be rewritten as: ri = ai*logn((ti/0.206) + 1.2899), (1’’’’) and equation (2’) becomes: qi = (1 – ti)*ai*logn((ti/0.206) + 1.2899). (2’’) equation (2’’) relates the after-tax return in country i to its average amenity tax rate and population, the latter of which it treats as fixed for any given country. for any population size, after-tax return reaches a maximum 2012] tax neutralities and tax amenities 113 at a value for ti of approximately 0.34, or 34 percent,140 though what this maximum value is depends slightly upon population.141 table 2 provides values at selected tax rates for a country having one-quarter the population of the united states in 1980. for such a country, a is 1.156, and at t = .34, qi has a value of 0.633. in other words, the after-tax maximum rate of return in country i, assuming it is one-fourth the size of the u.s. in 1980 population, is approximately 82.3 percent of the pre-tax rate of return in the u.s. in 1980, which translates into approximately 103.7 percent of the after-tax rate of return in the u.s. in 1980.142 table 2 shows that the “sweet spot” for maximum after-tax returns runs from average effective tax rates of about 30 percent to about 40 percent, a range covering average tax rates (expressed as the ratio of total tax revenues to gdp) in developed countries, not developing countries.143 equation (2’’) suggests, contrary to the usual assumptions about the effects of tax rates on investment, that as trade restrictions are lifted, capital is more likely to flow into high-tax jurisdictions than into low-tax ones. the evidence is consistent with this hypothesis.144 the vast majority of international trade takes place among developed countries.145 alfaro et al., summarizing data from the imf and other sources, report that for a sample consisting of 23 developed and 75 undeveloped countries over the period 1971 to 2000, capital inflows per capita to developed countries exceeded those to undeveloped countries by a factor of approximately 5.146 140 the derivative of equation (2’’) with respect to ti is: dqi/dti = (1 ti)*(ai*4.854/(4.854*ti + 1.2899)) – ai*logn(4.854*ti + 1.2899), which reaches a value of zero when ti is approximately 0.340. the second-order derivative is negative at this value of ti, indicating the value is a local maximum in equation (2’’). 141. note that equation (1’) is much less sensitive to variations in population size than tax rate. 142. fraction of u.s. after-tax return in 1980 is given by the ratio to the pre-tax return, divided by one minus the 1980 u.s. amenity tax rate (expressed as a fraction), or 0.206. see supra note 135. 143. in 2008, the unweighted average effective tax rate for all oecd countries was 34.8 percent. oecd tax database, http://www.oecd.org/document/60/0,3746,en_2649_34533_1942460_1_1_1_1,00.ht ml#a_revenuestatistics (table a). by contrast, the unweighted average effective tax rate for all non-oecd countries in 2011 was 19.0 percent. the heritage foundation, 2011 index of economic freedom, http://www.heritage.org/index/explore.aspx?view=by-variables (macro-economic data, all countries). 144. alfaro et al., capital flow, supra note 133, at 352. 145. id. 146. id. 114 florida tax review [vol. 12:2 table 2: selected predicted after-tax rates of return for a country having 25 percent of u.s. population (1980) tax rate (fraction) after-tax return as fraction of 1980 u.s. pre-tax return after-tax return as fraction of 1980 u.s. after-tax return 0.1 0.597364416 75.23481315 0.2 0.754596793 95.03737951 0.3 0.817721901 102.9876450 0.4 0.813837148 102.4983814 0.5 0.759112991 95.60617013 0.6 0.664065935 83.63550823 0.7 0.535971298 67.50268242 0.8 0.380102232 47.87181768 0.9 0.200422488 25.24212698 the bias in favor of capital movements among developed countries does not imply, of course, that there will be no capital flows from developed to undeveloped countries; it implies only that those flows will be dwarfed by flows among developed countries, as indeed they are. in general, the quantity of capital inflows into developing countries appears to have grown steadily over the last fifty years.147 in alfaro’s sample, from 1970 to 1974, net inflows per capita to developing countries were less than $1,000 per year; in the five-year period from 1990 to 1994, they had risen to approximately $2,500 per year; and by 1995 they had more than doubled again, to more than $5,000 per year.148 flows per capita into developed countries in alfaro’s sample grew more quickly still, moving from approximately $1,000 per year in 1975-79 to more than $25,000 per year from 1995 to 2000.149 b. comparisons of systemic effects 1. territorial systems even in a territorial system, investors will not automatically invest in low-tax jurisdictions once borders are lifted, for the reason just discussed that low taxes are highly correlated with lower productivity and lower after-tax returns, and investors seek the highest after-tax return, not the lowest tax rate.150 the relationship between tax rate and population on one hand and 147. id. 148. alfaro, capital flow, supra note 133, at 352. 149. id. 150. see supra part iv. 2012] tax neutralities and tax amenities 115 productivity rate on the other illuminates the choices that countries face as borders become more open. in a world of territorial tax systems, the opening of borders would not be expected to result in massive net capital flows either into or out of developed countries, as most trading will occur with similarly situated partners and the tax advantages of low-tax jurisdictions would seem to be dominated by productive weakness there. rather, the uneven distribution of resources, capabilities and factors of production worldwide (commonly referred to as “comparative advantage”151) means that supranormal returns become available in all countries as borders are opened or, stated otherwise, that new opportunities for gains from trade are as likely to appear in one country as in another on a per capita basis.152 the opportunities that emerge in developed countries, however, are more likely to be attractive than those emerging in developing countries (because of the higher productivity baseline). for a developed country, then, the optimal tax policy would be simply to ensure that neither double taxation nor opportunities for substantial tax avoidance materialize for investors. in the case of trade between developed countries, a territorial system ought not produce tax consequences much different from a worldwide system, as investments should, on balance, be as likely to flow in as out, and, since rates across developed jurisdictions are likely to be similar, forgone tax revenue (on outbound investment) should approximately equal new tax revenue on inbound investment.153 for a developing country, the situation is dramatically different. developing countries will have trouble attracting capital, since productivity rates tend to be much lower. lower productivity rates lead foreign investors to discount investment opportunities offering supra-marginal returns (they discount them, that is, relative to the value that host-country investors place on those opportunities as compared with other opportunities in the host). in a system of worldwide territorial taxation, developing countries theoretically have two ways to deal with the resulting disincentive to inbound investment. 151. paul a. samuelson, where ricardo and mill rebut and confirm articles of mainstream economists supporting globalization, 18 j. econ. persp. 135 (2004). 152. see, e.g., id. for an analysis of comparative advantage in the international setting. samuelson notes that the comparative advantage story may be too rosy in some settings, but he does not question the basic theory. see also desai & hines, evaluating int’l tax reform, supra note 50, at 489. 153. see, e.g., kleinbard, lessons, supra note 27, (noting that taxes should have a minimal impact on choices between domestic and cross-border investment where rates are comparable and opportunities for earnings stripping and other tax avoidance strategies are unavailable); shaviro, tax-electivity, supra note 3, at 391– 92 (noting that reciprocal territorial and reciprocal worldwide taxation involving two countries “comes out exactly the same in the aggregate if the income amounts and applicable tax rates are identical.”). 116 florida tax review [vol. 12:2 they can increase taxes in order to develop infrastructure and improve the pre-tax rate of return, or they can cut taxes to reduce the after-tax cost of investment more directly. table 2 demonstrates why, if no other considerations were in play, the former method ought to be vastly preferable. over the range of average tax rates running from 10 to 30 percent, a one percent increase in average tax rates (measured as a fraction of gdp) is associated with approximately a 0.75 percent increase, on average, in aftertax return. the difficulty with raising rates to improve infrastructure, of course, is that other considerations are in play. higher rates do not directly translate to higher productivity but promote it when governments make effective use of tax revenues to build infrastructure — a time-consuming process.154 where net capital exporters adopt territorial systems, developing countries do not have the luxury of attracting capital by improving infrastructure with the aid of higher rates, because the prospect of improved investment returns materializing far in the future will not generally be attractive to investors whose time horizons typically are much shorter. by contrast, lower tax rates offer investors the opportunity for an immediately improved rate of return. the result is a prisoner’s dilemma among underdeveloped countries: the option of competing on tax rates means that developing countries cannot compete on tax amenities, because investors will move their capital to obtain the more favorable after-tax return that is immediately available. from the perspective of an individual developing country that seeks to attract foreign capital, tax competition becomes the only rational strategy, but it leaves developing countries as a group worse off than if all could cooperate to increase rates.155 instead of improved infrastructure leading to greater capital investment (and still more improved infrastructure as taxes per capita rise), the result is stagnating levels of development in countries that lacked adequate infrastructure in the first place, as under-financed tax amenities continue to go under-financed — another widely observed phenomenon.156 the overall picture that emerges is not pretty. on one hand, developed countries as a group can expect to experience enhanced growth compared with the closed-economy world they leave behind as borders 154. see alfaro, capital flow, supra note 133, at 353–54, for a statement of the point as it relates to institutional quality (noting that the explanatory variables of institutional quality “are slowly changing over time.”). 155. the stanford encyclopedia of philosophy has an extended discussion of the prisoner’s dilemma. steven kuhn, prisoner’s dilemma, the stanford encyclopedia of philosophy, http://plato.stanford.edu/entries/prisoner-dilemma. 156. see, e.g., eugene b. gallagher, sociological studies of third world health and health care: introduction, 30 j. health & soc. behav. 345, 345 (1989) (“[the ‘third world’] is a world characterized economic underdevelopment.”). 2012] tax neutralities and tax amenities 117 become more open and group members reap gains from trade. on the other hand, developing countries that participate in the sweepstakes to attract foreign capital are likely to be mostly unsuccessful and to remain relatively infrastructure-poor to the extent they rely on international trade to fund growth. and, because seeking foreign capital means keeping tax rates low or lowering them compared with the rates they adopted in the system of closed economies, they do in fact increase reliance on foreign investment to fund growth. the result is that these countries all become less able to fund infrastructure from native economic activity and, consequently, more dependent on the vagaries of worldwide patterns of investment and trade to fund tax amenities. in some cases — the most likely candidates would seem to be developing countries that begin with relatively high tax revenues and gdps per capita and then seek to attract additional capital by lowering rates — tax competition will prove ruinous and economic collapse will follow. again, these predictions are largely borne out by the facts. as contrasted with growth in oecd countries, growth in developing countries tends to be sporadic, volatile, and marked by periods of contraction.157 over the long run, it is only about half as large as growth in developed countries.158 the lesson for developing economies in a world of tax competition would seem to be that it is better to stay out of the tax-driven competition to attract capital entirely and rely instead on domestic production and, perhaps, other sources of capital (such as foreign aid) to develop infrastructure. 2. worldwide systems a universal worldwide system with a limited foreign tax credit differs from a territorial system most significantly in that tax rate competition over capital is largely eliminated. as economies become open, investors continue to have the choice to invest in low-tax or high-tax jurisdictions, but investors in capital exporting nations, who typically face high domestic rates, will derive no tax advantage from investment in low-tax jurisdictions because of the residual home-country tax liability on low-taxed foreign earnings. this point is well understood;159 it is simply a feature of worldwide systems. what has not been as widely appreciated is the generally salutary relationship between the absence of tax competition and developing country productivity. developing countries compete for capital by offering the best 157. lant pritchett, understanding patterns of economic growth: searching for hills among plateaus, mountains, and plains, 14 the world bank econ. rev. 221, 222 (2000). 158. id. at 225. 159. see, e.g., kleinbard, stateless income, supra note 32. 118 florida tax review [vol. 12:2 after-tax return to foreign investors. in a territorial world, they theoretically can compete by improving the pre-tax rate of return or by lowering the actual tax rate. for the reasons explored in the last section, the former is superior over the long run, but as a practical matter only the latter is available, leading to a cycle of under-taxation and chronic underdevelopment. by contrast, in a worldwide system, residual taxation by the home country makes direct competition on rates impossible. consequently, if states compete for foreign capital, they can be expected to do so by competing to provide better tax amenities, that is, by raising rates and improving infrastructure. the residual character of an ftc system makes competition to provide tax amenities particularly attractive to developing countries, because it empowers home-country investors to finance the host-country fisc at the expense of the home fisc, rather than of the home-country investors themselves. that is, because home-country investors are reimbursed by the home-country government via the ftc, foreign taxes paid by home residents constitute a wealth transfer from home country to host country where the party in control of the amount of the transfer does not bear its cost. consequently, host countries have access to a source of funding that is to some extent free. in practice, both nondiscrimination rules160 and limits on residence jurisdictions’ ftc largess161 prevent source rates on foreign investors from going too high, but these limits merely blunt the effect; they do not eliminate it, especially since host jurisdictions can return some of the benefits of high rates on their own residents in the form of tax benefits or even direct transfer payments. from a worldwide welfare perspective, it is hard to see how this incentive structure does not improve things, despite the apparent departure from “neutrality” — namely, tax-induced changes on the pre-tax rate of return in each jurisdiction. on one hand, as investment moves among jurisdictions having comparable tax rates, tax revenues should generally rise uniformly because of rising productivity or the reciprocal exploitation of comparative advantage. and, on the other, as investment moves from developed to developing countries, the siphoning of tax revenues to developing countries improves rates of productivity there and may or may not damage productivity in the home jurisdiction. (recall that the effect on 160. see, e.g., treaty establishing a constitution for europe, oct. 29, 2004, art. i-4, 2004 o.j. (c 310)(establishing the “four freedoms,” which, together, have been applied by the european court of justice to prevent member states of the eu from engaging in income tax discrimination). see michael j. graetz & alvin c. warren, jr., income tax discrimination and the political and economic integration of europe, 115 yale l.j. 1186, 1194 (2006). in addition, treaty nondiscrimination provisions routinely require equal treatment of similarly situated citizens and foreign nationals. see, e.g., u.s. model income tax convention of nov. 15, 2006, art. 24(1). 161. see, e.g., i.r.c. § 904. 2012] tax neutralities and tax amenities 119 home country productivity is ambiguous when both capital and some of the associated tax revenue leave the jurisdiction, since some of the tax amenities that the departing revenue finances were needed only to pay for amenities for the capital that has now left.) indeed, even if developing countries respond to the opening of borders by raising their rates to the levels in developed countries, so that all tax revenue associated with exported capital goes to the developing country, worldwide productivity should increase, since the benefit from a marginal dollar of tax revenue in a low-tax jurisdiction will exceed the detriment from the loss of that dollar of tax revenue in the hightax jurisdiction.162 3. mixed systems the world, in fact, is populated mostly by jurisdictions that employ some version of territoriality and a handful of jurisdictions that employ some variant of worldwide taxation — the u.s. being the most prominent example of the latter.163 a world of mixed regimes can change the calculation for any individual jurisdiction about which system it should adopt. for example, as discussed earlier, under standard neutrality models, a proponent of con should be indifferent between a world of worldwide taxation and one of territorial taxation, because the relative prices of all investments will be the same for all residents in every jurisdiction in either world.164 however, the competitive or neutrality properties of pursuing a worldwide regime will not necessarily be preserved if other countries are territorial, or vice-versa.165 also as previously discussed,166 under the standard mode of neutrality analysis, residents of high-tax worldwide jurisdictions are at both an ownership neutrality and a competitive disadvantage when compared with residents of territorial jurisdictions. further, if the most important comparative advantage stemming from international trade derives from the opportunity to allocate ownership to non-residents, the efficiency losses from tax-induced ownership changes (or non-changes) for residents of high-tax 162. this result follows from the logarithmic property of equation (1). 163. see kleinbard, lessons, supra note 27, (noting that territorial systems are overwhelmingly used to tax foreign direct investment). in light of opportunities for deferral and the use of disregarded entities, the u.s. system is more accurately characterized as worldwide lite or even quasi-territorial than as a true worldwide system. kleinbard, stateless income, supra note 32, at 714–15 (describing the u.s. system as an ersatz territorial system). 164. hines, reconsidering, supra note 19, at 276–77. 165. id. at 277. 166. see supra part ii.b.3. 120 florida tax review [vol. 12:2 worldwide jurisdictions are likely to be quite high given the ease with which ownership can be transferred from one person to another.167 most of these worries would appear to be overstated if the theory offered here is accurate. the worry on competitive neutrality is that residents of high-tax worldwide systems will be unable to compete with investors in territorial jurisdictions for favorable investment opportunities in low-tax jurisdictions.168 tax competition among low-tax jurisdictions to attract foreign capital then will exacerbate the problem. the story rests on the view, implicitly ratified under the traditional mode of neutrality analysis, that advantageous investment opportunities in low-tax jurisdictions are likely to be prevalent as borders open because of the reduced tax burden there. under the tax amenity theory, it would seem that low-tax jurisdictions are unlikely to offer many favorable investment opportunities for the same reason — the reduced tax burden.169 and, as reported earlier in this part, the evidence seems to support the theory. capital moving across borders overwhelmingly flows into high-tax jurisdictions, not low-tax ones, even though most jurisdictions employ territorial systems of one sort or another. the story is similar even if the dominant margin along which investors respond to cross-border tax incentives is ownership identity. nothing about the con story suggests that if ownership identity in fact is more tax-elastic and of greater import than the capital location or savings margins, favorable investment opportunities are more likely to arise in lowtax jurisdictions. productivity still seems to require substantial infrastructure, a point that desai and hines themselves suggest: [m]odern scholars view [foreign direct investment, or fdi] as arising from differential capabilities, and consequently differential productivity, among firms, and the extension of intangible assets across borders. this intuition squares well with empirical fdi patterns, which include the fact that most of the world’s fdi represents investment from one high-income country into another, and the fact that a very high fraction of such investment takes the form of acquiring existing businesses.170 desai and hines frame their observation in terms of the movement of investment among high-income rather than high-tax jurisdictions, but the correlation between incomes and taxation is, as noted previously, itself quite 167. desai & hines, evaluating int’l tax reform, supra note 50, at 491–92 (noting the sensitivity of ownership to tax consideratons). 168. kleinbard, lessons, supra note 27. 169. id. at 72. 170. desai & hines, old rules, supra note 4, at 956. 2012] tax neutralities and tax amenities 121 high. apart from tax havens, there are not many high-income jurisdictions that do not have high taxes.171 vi. conclusion taking their cue from the theory of neutrality as developed in the domestic setting, the traditional modes of analyzing international tax neutrality downplay or disregard the link between tax revenues and productivity. such a procedure has a surface plausibility in the domestic setting, where the connection between tax revenues and the provision of identifiable benefits can be disregarded by assuming that a revenue target implicitly associated with some level of productivity is exogenously set. part iii.c. discussed why the approach is theoretically unsatisfactory, but the objections raised there do not make the effort to model neutrality for closed economies in lump-sum terms an entirely unhelpful exercise. the procedure is not available even as a theoretical ideal in the international setting, where tax rules inevitably affect both the magnitude of tax revenues and the identities of their recipients. in the international setting, the only way to make sense of the pre-tax rate of return is to suppose that states begin from a world of closed economies and then move to more open ones. but tax and non-tax investment incentives that arise as that movement takes place redirect tax revenues and alter the burdens on infrastructure, each of which phenomena is alone sufficient to cause the revenue raised to diverge from the exogenously set target and thereby to affect the quantity of tax amenities needed to maintain productivity at the originally chosen rate. over time, as tax amenities exceed or fall short of the requisite amount, the rate of return that was supposed to be taken as the baseline against which to measure the distorting effects of tax rules is adjusted. as a result, what appeared to be a baseline turns out to be no baseline at all. in a final twist, the alterations themselves may well be productivityand even efficiencyenhancing, even though they are “tax-motivated.” where, for example, tax rules encourage low-productivity, low-tax source jurisdictions to compete on the supply of tax amenities (rather than on tax rate), the net effect over time would seem to be (at worst) a slight lowering of productivity in high-tax residence jurisdictions and a much larger increase in the productivity of the sources. on a worldwide basis, that would count as tax-motivated capital shifts leading to arrangements that are welfare-enhancing, not welfarereducing. one inference that may be drawn from these observations is that a more fruitful lens than neutrality through which to view the effects of international tax rules is the competitive, allocative, and distributional properties of various possible tax regimes. from a global welfare 171. see supra part iv. 122 florida tax review [vol. 12:2 perspective, the object of designing a tax regime is not to maximize neutrality but to promote overall welfare, which may require promoting tax “distortions” that improve total productivity. a second inference is that sensitivity to the relationship between tax revenue and productivity suggests that the consequences of adopting various possible methods of double tax relief are likely to be quite different from those assumed under the traditional view. in particular, worldwide regimes are more likely than territorial regimes to promote welfare-enhancing improvements to infrastructure in low-tax jurisdictions. by contrast, territorial taxation tends to promote harmful tax competition among developing countries while yielding little competitive or savings benefit to high-tax jurisdictions. 2012] tax neutralities and tax amenities 123 appendix data for the regression in equation (1): y = ln(p1+x1)*ln(p2 + x2), where: p1: country population in 1980 as fraction of u.s. 1980 population. p2: country tax revenue in 1980 as percentage u.s. tax revenue 1980, backing out all social security contributions. x1, x2: parameters derived by the regression. y: predicted gdp per capita as a fraction of u.s. gdp per capita, 1980. country* p1 p2 y yc y-yc seest yclo ychi australia 0.0643 0.9621 0.8350 0.8899 -0.0549 0.0363 0.8145 0.9654 austria 0.0332 1.1771 0.9191 0.9805 -0.0614 0.0430 0.8911 1.0699 belgium 0.0433 1.1685 0.8925 0.9797 -0.0872 0.0425 0.8914 1.0681 canada 0.1082 0.9807 0.9591 0.9109 0.0482 0.0361 0.8359 0.9859 denmark 0.0225 1.7977 1.2836 1.2200 0.0636 0.0618 1.0915 1.3486 finland 0.0210 0.8249 0.8514 0.8101 0.0413 0.0336 0.7402 0.8800 france 0.2425 0.8207 0.9032 0.8620 0.0412 0.0318 0.7960 0.9281 germany 0.2713 1.0417 0.9105 0.9847 -0.0742 0.0351 0.9116 1.0577 greece 0.0416 0.0444 0.5374 0.3139 0.2235 0.0540 0.2016 0.4263 ireland 0.0150 0.4406 0.6190 0.5920 0.0270 0.0324 0.5247 0.6594 italy 0.2484 0.2869 0.7960 0.5264 0.2696 0.0421 0.4388 0.6139 japan 0.5141 0.5188 0.7947 0.7326 0.0621 0.0365 0.6568 0.8084 korea 0.1678 0.0888 0.1685 0.3629 -0.1944 0.0535 0.2518 0.4741 mexico 0.3008 0.1332 0.2382 0.4136 -0.1754 0.0531 0.3033 0.5240 netherlands 0.0622 1.3235 0.9602 1.0524 -0.0922 0.0467 0.9553 1.1496 new zealand 0.0140 0.7253 0.6463 0.7562 -0.1099 0.0319 0.6899 0.8225 norway 0.0180 1.6240 1.4941 1.1557 0.3384 0.0569 1.0373 1.2741 portugal 0.0430 0.0560 0.3748 0.3235 0.0513 0.0531 0.2131 0.4339 spain 0.1650 0.1302 0.5679 0.3961 0.1718 0.0502 0.2916 0.5005 sweden 0.0366 1.6330 0.9717 1.1658 -0.1941 0.0567 1.0480 1.2836 turkey 0.1983 0.0564 0.1021 0.3390 -0.2369 0.0568 0.2208 0.4571 united kingdom 0.2478 0.8674 0.8299 0.8886 -0.0587 0.0323 0.8214 0.9558 united states 1.0000 0.7810 1.0000 0.9961 0.0039 0.0345 0.9243 1.0678 tax neutrality and tax amenities david hasen0f abstract appendix 123 b. neutrality tradeoffs (i) non-preservation of savings neutrality (ii) non-preservation of production neutrality (iii) comparison with ownership and competitive neutralities a. estimating the value of tax amenities table 1: productivity at selected tax revenues and populations a. after-tax returns b. comparisons of systemic effects appendix * associate professor of law at the sandra day o’connor college of law at arizona state university. i would like to thank rabbi zvi holland, the phoenix community kollel and saul abrams for their patience and perseverance in the face of countless questions regarding halacha and tithing. i would also like to thank saul levmore, ellen aprill, marjorie kornhauser, henry ordower, samuel levine, michael livingston, victor fleischer, yariv brauner, robert clinton, janette silverman, the members of the arizona state university legal theory colloquium, and the participants at the junior tax scholar’s conference at the university of colorado, boulder, for their comments on earlier drafts. finally, i would like to thank my wife, rebel rice, for her patience, support and editorial assistance. 153 florida tax review volume 8 2007 number 1 maaser kesafim and the development of tax law by adam s. chodorow* i. introduction. ............................................................................ 155 ii. jewish legal authority and agricultural tithing. ..... 157 a. jewish legal authority. .................................................... 158 b. agricultural tithing. ........................................................ 160 iii. maaser kesafim origins, status and scope...................... 161 iv. defining income........................................................................ 168 a. gross income. .................................................................. 169 1. gifts and inheritances. ........................................ 169 2. the return of lost property. ............................... 177 3. inflation. .............................................................. 178 b. deductions. ...................................................................... 181 1. allowable deductions. ........................................ 181 2. business meals. ................................................... 183 3. civil taxes........................................................... 186 c. netting and accounting periods. ..................................... 190 v. analysis. ..................................................................................... 195 a. the effect of enforcement and compliance concerns on the development of tax law....................... 195 b. the effect of the legal system on the development of tax law........................................................................ 202 c. the effect of cultural values on the development of tax law........................................................................ 205 vi. conclusion. ............................................................................... 207 154 florida tax review [vol. 8:1 1. gen. 28:22. all bible quotations are from the stone edition of the tanach, published by the mesorah heritage foundation, as part of the art scroll series, c. 1996 mesorah publications, ltd. 2. the simpsons: viva ned flanders, the simpsons, (fox television broadcast jan. 6, 1999). maaser kesafim and the development of tax law “and whatever you will give me, i shall repeatedly tithe to you.” jacob on the temple mount1 “and once again tithing is 10% off the top. that’s gross income, not net. please people, don’t force us to audit. . .” reverend lovejoy, the simpsons2 2007] maaser kesafim and the development of tax law 155 3. this phrase translates as “a tenth of money.” maaser means one-tenth and is often used alone to refer to the amount segregated as a tithe. kesafim means silver or money. throughout this article i have used the hebrew terms for most concepts, as opposed to english translations. while this may be somewhat confusing at first, anyone interested in pursuing further study of jewish tithing must be able to recognize and identify these terms. 4. literally, “tithe” means one-tenth or 10%, but it is not uncommon to see the term used to refer generically to religious giving, even where the amount given is greater or less than 10%. 5. most christian denominations have adopted the practice of tithing in one form or another. in the interests of space, i focus here only on jewish tithing, leaving for another day the exploration of other of other versions of this practice. 6. gen. 28:22 (“and whatever you will give me, i shall repeatedly tithe to you.”). 7. gen. 14:20 (“and he gave him a tenth of everything”). the casual mention of abraham’s gift, without further explanation, suggests that the practice pre-dated abraham. this tradition appears to have its roots in the temple-states of mesopotamia and syria-palestine in the second millennium b.c.e. for a review of literature regarding the precursors to and possible source of the jewish tithing traditions, see jeffery stackert, rewriting the torah: literary revision in deuteronomy and the holiness legislation. forschungen zum alten testament. tübingen: mohr siebeck, 2007 at 231 et seq. and n. 397. 8. see, e.g., deut. 14:22. 9. just what constitutes a “tax” is a matter of some debate. from an economic perspective, any cost imposed by the government could be considered a tax, including traditional taxes, fees, and even regulation. the legal definition of a tax is more limited, but somewhat flexible. while tithing may not qualify as a tax under some definitions, it operates as a tax for purposes that are relevant here. for a discussion of how one defines a tax, see victor thuronyi, comparative tax law (the hague 2003) at pp. 4559. i. introduction maaser kesafim refers to the practice, observed in many orthodox3 jewish communities, of separating out a tithe from one’s income each year to4 be distributed to the poor. the practice can be traced back to jacob, and5 6 arguably to abraham himself. unlike agricultural tithing, which involves only7 produce grown in israel, maaser kesafim encompasses all income, regardless8 of its source. thus, it functions to a large degree an income tax, or more precisely as god’s income tax.9 conceiving of tithing as a form of income tax raises a number of interesting questions, the most salient of which is how income should be defined. for instance, as reflected in reverend lovejoy’s statement in the epigraph above, one must decide whether to allow deductions for federal, state, and local taxes. other questions include whether to include gifts in income, whether to tax nominal, as opposed to real, gains, and whether deductions should be allowed for expenses such as business meals. while these particular 156 florida tax review [vol. 8:1 10. this is the second article in a three part series that explores issues in taxation through the lens of jewish tithing traditions. in the first article, agricultural tithing and (flat) tax complexity, 68 pitt. l. rev. (forthcoming 2007), i considered questions of tax complexity, using agricultural tithing as a vehicle to examine claims that either a flat-rate income tax or an income-based consumption tax would be less complex than our current income tax. the third article, biblical tax systems and the case for progressive taxation, 23 j. of law and religion (forthcoming 2007), i consider questions of progressivity and the extent to which claims that judeo-christian values require progressive taxation can be squared with contrary examples of taxation described in the bible and talmud. 11. many of the source materials used herein are collected in two books designed to guide those who wish to separate tithes from their income. those books are maaser kesafim, on giving a tenth to charity, (4th ed. 1999), (feldheim publishers, jerusalem/new york) edited by cyril domb and referred to hereafter as “mk,” and the laws of tzedakah and maaser, a comprehensive guide, artscroll halachah series, (mesorah publications, ltd. 2001) written by rabbi shimon taub and referred to hereafter as “the laws of tzedakah.” unfortunately for the casual reader, both of these books assume the reader has a level of knowledge regarding jewish law not often found outside the jewish community (and sometimes not even within it). questions are interesting in their own right (and who wouldn’t be interested in what medieval rabbis thought about the deductibility of business meals?), when taken together they amount to a religious tax jurisprudence that is as comprehensive and sophisticated as the law we have created for federal income tax purposes. the income definition rules for the federal income tax and maaser kesafim were developed under significantly different circumstances. the federal income tax rules were developed over the past 100 years as part of our modern legal and political process and may be changed at any time by legislative fiat. their prime goal is to raise revenues to fund government activities, while at the same time promoting a number of unrelated social policy objectives. in contrast, religious authorities developed the tithing rules over thousands of years as part of an interpretive process designed to help people fulfill their religious obligations, which were immutably set down in the torah and the talmud. despite these differences, the analysis of, and answers to, the questions raised above (and many others) are surprisingly similar, reflecting certain universal elements and issues inherent in any income tax system. at the same time, important differences exist, yielding important insights into how the culture and context underlying a given tax system affect its development. in this article, i describe the origins and scope of maaser kesafim and examine a number of income definition rules the religious authorities have developed over the past two thousand years. by comparing those rules to the10 analogous federal income tax rules, i demonstrate how the development of tax law is affected by (1) concerns regarding administration, enforcement, and taxpayer compliance, (2) the structure of the legal system, and (3) the values underlying a tax system. in addition, i hope to make this material known to,11 2007] maaser kesafim and the development of tax law 157 mk contains the only published english translation of some of the sources quoted in this article. where i have relied on such translations, i use the notation “mk” and where difficult to find and untranslated sources are discussed in the laws of tzedakah and maaser, i have used the notation “tz.” 12. american scholars have long compared jewish and american law. some focus on the substantive law, while others have explored the similarities and differences between the structure of the two legal systems and theories of jurisprudence that motivate them. a search for the term “jewish law” in westlaw’s law review database yields over 1,600 hits. for a summary of jewish law references in american legal scholarship up to 1993, see suzanne last stone, in pursuit of the counter-text: the turn to the jewish legal model in contemporary american legal theory, 106 harv. l. rev. 813, 814-21 (1993). 13. this finding is consistent with my conclusion in agricultural tithing and (flat) tax complexity, in which i demonstrated that the agricultural tithing rules were quite complex, despite having a limited income definition, no deductions, and a flat rate. see supra note 10. as maaser kesafim is more analogous to a modern tax system, it provides even more compelling evidence that tax complexity cannot be eliminated simply by flattening the rate structure. and accessible by, american tax scholars, thus contributing to the scholarship comparing jewish and u.s. law.12 the insights gleaned from this study have significant implications as we struggle towards tax reform. first, to the extent that the same pressures that now impinge on our tax system come to bear on any replacement system we devise, we can expect to see the tax laws bend to accommodate such pressures, causing any replacement tax ultimately to take on many of the characteristics of our current income tax. second, maaser kesafim operates as a flat-rate income tax. this study makes clear that adopting a flat-rate tax will not necessarily eliminate tax complexity.13 this article is organized as follows. part ii briefly provides background information regarding the origins and structure of jewish law and the basic rules of agricultural tithing, to which the rabbis often turned in their efforts to develop the rules of maaser kesafim. part iii describes maaser kesafim’s origins, status and scope. part iv compares selected income definition rules developed for maaser kesafim with their federal income tax counterparts. part v analyzes the ways in which culture and context affect income definition. part vi concludes. ii. jewish legal authority and agricultural tithing the rabbis who developed the laws of maaser kesafim did so within the structure and according to the rules of the jewish legal system. they sought to ground their decisions in the torah, the talmud or other ancient authorities to the extent possible, and they often turned to the example of agricultural tithing for guidance. thus, in studying the laws of maaser kesafim, it is helpful to know something regarding both the provenance and structure of the jewish legal 158 florida tax review [vol. 8:1 14. more formally, halacha refers to judaism’s normative rules and encompasses both those that govern interpersonal relationships and those that govern the relationship between mankind and god. see, elon, menachem, i jewish law: history, sources, principles 93-104 (hereafter “jewish law”) (the jewish publication society philadelphia jerusalem 1994). 15. see chodorow, agricultural tithing and (flat) tax complexity, supra note 10. 16. this information is presented largely without footnotes. for those interested in a more detailed explanation of both jewish law and agricultural tithing, see chodorow,agricultural tithing and (flat) tax complexity, supra note 10. see also elon, supra note 14 (describing the provenance and structure of jewish law); an introduction to the history and sources of jewish law (n.s. hecht, b.s. jackson, s.m. passamanek, d. piatelli, a.m rabello eds) clarendon press 1996. 17. for a description of the academic scholarship regarding the bible, see richard friedman, who wrote the bible? (1987). 18. two versions of the gemara exist, one compiled in jerusalem and the other in babylon. tradition, commonly referred to as halacha, and the laws of agricultural tithing.14 i have previously set forth a detailed account of both and will not repeat that15 material here. nonetheless, for those unfamiliar with jewish law or the basic rules of agricultural tithing, i present here a brief summary of the most relevant information.16 significant differences of opinion exist both within judaism and academia regarding the provenance and significance of the earliest written texts and the extent to which the practices described in the torah were actually observed. i present here the literal version, as those who developed the laws of maaser kesafim subscribed to that view.17 a. jewish legal authority according to tradition, moses wrote the first five books of the bible, commonly referred to as the torah. these books contain the laws god gave to moses on mt. sinai and during the sojourn in the desert. as god’s law, it sits atop the legal hierarchy. the mishnah and gemara, collectively referred to as the talmud, were created in the third and seventh centuries of the common era, respectively.18 they contain details of how the laws set forth in the torah were to operate. the rules recorded in the talmud can be broken down into three categories. some were revealed to moses on mt. sinai. however, unlike the rules moses set down in the torah, these rules were passed down as part of an oral tradition until committed to writing in these works. others are rabbinic interpretation of god’s laws. finally, some are rabbinic law, i.e., rules the rabbis developed to “build a fence around the torah” and thereby prevent people from inadvertently violating god’s law. it is often difficult to distinguish which rules are god’s and 2007] maaser kesafim and the development of tax law 159 19. an aramaic phrase meaning “from the torah.” 20. an aramaic phrase meaning “from or of the scholars.” which derive from the rabbis, but the talmud is generally afforded equal weight to the torah. some of the most distinguished rabbis created commentaries on the torah and talmud, which have become an integral part of the legal tradition. for instance, the commentaries of rashi (1040-1105) and the tosofists, rashi’s literal and intellectual descendants, are routinely printed alongside the text of the talmud. such commentaries are often viewed as authoritative regarding the proper interpretation of the underlying texts. in addition, several rabbis have attempted to codify the law. the most important of these efforts for our purposes are the mishneh torah by rabbi moshe ben maimon (1135-1204), (maimonides or rambam), the arbah turim, by rabbenu yaakov ben asher (1269-1340) (the tur), and the shulchan aruch by rabbi yosef karo (1488-1575). as with the torah and talmud, numerous rabbis have written commentaries on these codes, many of which have become authoritative in their own right. examples of such commentaries include the mapa by rabbi moshe be yisrael isserles (c. 1525 – 1572) (rema), and the aruch hashulcan by rabbi yechiel michal epstein (1835-1905), both commentaries on the shulchan aruch. finally, a number of respected rabbis have published their legal opinions either from specific cases they adjudicated or in response to questions posed to them on various aspects of the law. these opinions are known as she’elot u’teshuvot, shu’t, or responsa literature. many of the laws of maaser kesafim were developed in this literature, as people sought the advice of rabbis in their struggle to understand their obligations in an increasingly sophisticated economy. as a result of this structure, religious obligations in judaism can have three sources: the torah (de-oraita), the rabbis (de-rabbanan), and custom19 20 (minhag). the source of the obligation matters because it dictates the extent to which it must be observed. obligations based on the torah and on the oral law later recorded in the talmud have the force of law and must be strictly observed. rabbinic obligations carry similar weight, but the rules are construed somewhat more leniently, as they reflect human, as opposed to divine, law. obligations based on custom carry the least weight and allow for the greatest variation. given the divine source of the law and the dispersion of the jewish people into discrete communities, the jewish legal system differs significantly from that found in the u.s. first, legislative authority is strictly limited, as humans are not permitted to change god’s law. instead, the law must develop as part of an interpretive process, where each new rule must be derived from the torah or talmud, or some other respected authority. second, because the jewish community has been fragmented since biblical times, no judicial or 160 florida tax review [vol. 8:1 21. the obligation to tithe appears at many other points in the bible. see, e.g., leviticus 27:30 (“any tithe of the land, of the seed of the land, of the fruit of the tree, belongs to hashem; it is holy to hashem.”); num. 18:21-24 (“to the sons of levi, behold! i have given every tithe in israel as a heritage in exchange for the esrvice that they perform, the service of the tent of meeting....”); malachi 3:10 (“bring all the tithes into the storage house….”); proverbs 3:9 (“honor hashem with your wealth, and with the first of all your produce.…”). hashem literally means “the name” and is used as a euphemism for god. for a review of the academic literature regarding the origins of this practice, see stackert, supra note 7. 22. deut. 14:29; lev. 27:30. the levites were the descendants of levi (the son of jacob and leah) and served as god’s special servants. num. 3:5 et seq. they were excluded from the division of land that occurred before the jewish people entered israel and instead were given cities in which to live. num. 35:1-8. as a result, the levites depended on the tithe for their sustenance. this tithe was not due to any specific levite, and the donors’ ability to decide who received it created a market place, where those who wished to receive the tithe had to consider how their behavior or rulings would affect potential donors. 23. deut. 12:17-18, 14:23. those who lived far from the temple in jerusalem were authorized to redeem the tithe and save the proceeds until they could travel to jerusalem, purchase food, and consume it there. deut. 14:24-26. political institutions exist capable of resolving differences of opinion as to what the law requires or how it should be interpreted. thus, the legal opinions expressed in the commentaries and codifications are only as persuasive as the reasoning they contain, and the law has developed almost as a conversation across the centuries, with most issues incapable of a final, binding resolution. as discussed below, these two features have a clear impact on how the tithing laws developed. b. agricultural tithing the obligation to tithe agricultural produce applies only to produce grown in israel. it derives primarily from deuteronomy 14:22, which states “you shall tithe the entire crop of your planting, the produce of the field, year by year.” in fact, deuteronomy identifies two tithes. the first is called maaser21 rishon and was to be given to a levite. the second was to be consumed at a22 place of god’s choosing b which was later revealed to be the temple in jerusalem b or given to the poor, depending on the year to which the tithe belonged. the jewish calendar is based on a seven-year cycle. in years one, two, four, and five, the farmer was to take this second tithe (called maaser sheni) to jerusalem and eat it before the temple. in years three and six, the23 farmer was to give this second tithe (now called maaser ani) to the poor. in year seven, known as the sabbatical year, the land was to lie fallow, obviating the need for tithes. the mishnah, the tosefta (a supplement to the mishnah) and the gemara set forth the specific income definition rules regarding which crops 2007] maaser kesafim and the development of tax law 161 24. lev. 19:9; 23:22. 25. the permitted use of maaser is beyond the scope of this article. however, it should be noted that there is significant discussion in the halacha regarding the proper use of such funds. for instance, there is some debate as to whether one can use maaser to satisfy other obligations the torah imposes. for a discussion of the uses to which maaser may be put, see tz at 39-67. to the extent that it is indeed distributed to the poor, rabbi karo identifies eight levels of doing charity. the first is helping someone so that he will no longer need charity. the second level is where neither the donor nor donee know the other’s identity. the third level is where the donor knows the identity of the donee, but the donee is ignorant of his benefactor. the fourth level is where the donee knows the identity of his benefactor, but the donor is ignorant of the person he helps. the fifth level is where one gives to the poor before being asked. the sixth level is where one gives the appropriate amount after being asked. the seventh level is where one gives less than appropriate after being asked, but does so in a pleasant and cheerful manner. the final level is where one gives ungraciously. karo, shulchan aruch, yoreh de’ah 249, mk at 85-121. the poor are defined as those who do not have sufficient liquid assets to live for an entire year. this definition derives from the agricultural tithing rules which set forth who was allowed to collect the produce left in the field during harvest and to receive maaser ani, the agricultural tithe given to the poor in years three and six of the seven year cycle. see mishnah, pe’ah 8 and 9. rabbi yizchak of vienna (1190-1260) and rabbenu efraim (d. 1175) asserted that this same level defined poor for purposes of maaser kesafim. see tur, arbah turim, yoreh de’ah 253; karo, shulchan aruch, yoreh de’ah 253:2. others contended that the level at which one should be defined as poor, and therefore eligible to receive charity, should be updated to reflect the absence were subject to tithes, when the tithe had to be removed, and the year to which the tithes belonged. while most of the specific rules have little relevance to the questions raised in the context of maaser kesafim, religious authorities routinely turned to agricultural tithing for guidance on the larger, structural questions, such as whether to permit deductions (agricultural tithing permitted none) and what accounting period to adopt. in addition to the tithe, the torah sets forth a number of other obligations associated with agriculture. for example, the pe’ah obligation required farmers to leave the corners of their fields unharvested so that the poor could partake of the harvest. amounts left in the fields in satisfaction of this24 obligation (and the other obligations as well) were excluded when determining the amount to tithe. thus, while technically not part of the tithing laws, these obligations reduced the amounts subject to the tithe and therefore form part of the income definition. as described below, religious authorities cited to the exclusion of pe’ah from the income base as they struggled to develop the laws of maaser kesafim. iii. maaser kesafim origins, status and scope as noted in the introduction, maaser kesafim refers to the practice of separating out a tithe from all income and distributing it to the poor. neither25 162 florida tax review [vol. 8:1 of aid measures available to those who lived in agrarian societies. thus, they articulated a standard that focused on whether a person had sufficient assets to produce sufficient income to live on for a year. see rabbi yitzchak of korbil (d. 1280) as described in the tur, arbah turim, yoreh de’ah 253. see also karo, shulchan aruch, yoreh de’ah 253:2. 26. gen. 14:20 (“and he gave him a tenth of everything”). 27. rashi concluded that abraham gave his tithe to malkizedek, the king of salem and god’s high priest, and that the gift was made because malkizedek was a cohen. rashi 14:20 loc. cit, mk at 18. rabbi eliezer, who was involved with the creation of the mishnah, agreed that abraham was the first to tithe but insisted that he gave the tithe to shem, noah’s son, instead of malkizedek. (“r. yehoshua ben korchah says “abraham was the first in the world to tithe. he took all the maaser of sedom and amorah and all the maaser of lot his nephew and gave them to shem the son of noah, as it is written ‘and he gave him a tenth of all.’” pirkei d’rabbi eliezer, ch. 27, mk at 18. 28. gen. 28:22. the bible does not actually describe jacob tithing, but one presumes that he kept his promise. 29. see, e.g., baalai tosafoth on the torah, mk at 19 (concluding that the obligation to tithe from money is derived from jacob’s vow). 30. a midrash employs an interpretive technique where every word in a passage is given meaning. the torah nor the talmud contains an explicit command that one separate out this tithe. thus, the origin, status and scope of the obligation, all of which affect the development of the law, are open to debate. this part explores that debate. discussion of the specific income definition rules is reserved for part iv, below. many early sources assert that the obligation to tithe derives from the torah, based on the fact that the patriarchs abraham and jacob are reported to have tithed. the evidence regarding abraham is somewhat sketchy. in genesis, after a battle, abraham is said to have given one-tenth of his possessions.26 other than the mention of the amount of the gift and the identity of the donor, the bible gives no other details. nonetheless, several respected rabbis have determined that this was the first tithe. the evidence that jacob tithed is27 clearer. after seeing the vision of a ladder stretching to heaven and learning that god would protect jacob and his offspring and give them the land of israel, jacob vowed: “and whatever you will give me, i shall repeatedly tithe to you.” the bible does not describe jacob tithing, but presumably he kept his28 promise. assuming both patriarchs tithed, the difficulty with these passages as the source of the tithing obligation is that it is not clear how their behavior imposes an obligation on their descendants to do so. nonetheless, some rabbis read these passages to do just that.29 others sources assert that the obligation to tithe from all income, regardless of source, is torah-based because it is implicit in the torah obligation to tithe all agricultural produce. for instance, the sifre (a midrash30 from the time of the mishnah) cites the superfluous use of the word “all” in 2007] maaser kesafim and the development of tax law 163 31. see the sifre, as quoted by tosafoth, b. talmud taanith 9a, mk at 20. the portion tosafoth quotes does not exist in the extant copies of the sifre. 32. this material does not appear in the extant version of the midrash devarim rabbah. rather, it appears in passages quoted by both rabbi yeshayahu horowitz and yitzachak abuhav. see shenei luchot hab’rith, deut. 28:3; menoras hamaor, deut 28:3. see also midrash tanchuma, deut 28:3. 33. rema, shulchan aruch, yorah de’ah 274:4, mk at 135. see also sefer chassidim § 144 (an early medieval text dating from around 1200 c.e., construing malachi 3:10 to require that tithes be separated from all income, and not just agricultural income). 34. mordechai, bava kama 192, mk at 24 (“in [the jerusalem talmud at pe’ah 1:1] the law of tithing of money is derived from ‘give honor to the eternal from your possessions.’”). 35.see, e.g., rabbi yaakov ben zvi emden (1697-1776), sheilat yavetz, vol 1, r3, and r. yeshayahu horowitz (the shelah) (1560-1630), amsterdam shelah, p. 242, both of whom argue that the passage in malachi only refers to agricultural tithing. deuteronomy 14:22 as evidence that the obligation described therein encompasses both agricultural and non-agricultural income. in contrast, the31 midrash devarim rabbah (from around 900 c.e.) uses notions of horizontal equity to argue that all who receive income are blessed and therefore the obligation to tithe applies to all, and not just to the farmers. these efforts to32 derive the obligation to tithe on all income from the requirement that one tithe agricultural produce seem tenuous. other sources find the obligation to tithe on all income to be based on bible passages such as malachi 3:10 (“bring all the tithes into the storehouse”) and proverbs 3:9 (“honor hashem with your wealth, and with the first of all your produce”). for instance, rema argued that the torah obligation for agricultural tithing was not effective at the time malichai was written and concluded that the passage refers to maaser kesafim . in contrast, rabbi33 mordechai ben hillel (d. 1298) interpreted the jerusalem talmud to indicate that the obligation to tithe money is based on proverbs 3:9. others dispute34 these conclusions and insist that these passages refer only to agricultural tithing. regardless of who is correct, malachi and proverbs are not part of the35 torah and therefore they cannot create a torah obligation. the predominant view is that maaser kesafim is not a torah obligation. rather, most rabbis believe that it evolved from, and is inextricably interwoven 164 florida tax review [vol. 8:1 36. a mitzvah (pl. mitzvoth) is literally a commandment of god. thus, a mitzvah is a religious obligation, and the phrase “to do a mitzvah” means to fulfill one of god’s commandments. insofar as doing charity is a mitzvah,the phrase is colloquially used to mean doing something nice for someone. 37. tzedakah is often translated as charity, but its root (tzedek) means justice. thus, the obligation to do charity is intertwined with the obligation to do social justice. see samuel j. levine, looking beyond the mercy/justice dichotomy: reflections on the complementary: roles of mercy and justice in jewish law and tradition, 45 journal of catholic legal studies 455, n. 81 (2006). 38. birkei yoseph, shulchan aruch, yoreh de’ah 249, mk at 28. see also rabbi yaakov halevi molin (1355-1422) (maharil), responsum no. 54, mk at 28 (“. . . maaser kesafim, which is rabbinic,. . .”); epstein, aruch hashulchan, yoreh de’ah 249:2, mk at 28 (“in truth, these allocations of one-fifth and one-tenth are not torah obligations, but hte rabbis associated them with [jacob’s vow to tithe in gen 28:22]”); rabbi yoel sirkes (1561-1640), bach, tur, yoreh de’ah 331, mk at 29 (“but the tithe which a person separates from his monetary profits, is not in this category (i.e., that of agricultural tithes) . . . for there is no obligation either torah or rabbinic.”). 39. deut.5:32-33. just what the phrase “walk in the ways of the lord” means is somewhat unclear. the talmud explains that this means “just as he is merciful, we should be merciful, just as he visits the sick, buries the dead, etc.” b. talmud shabbos 133b; see also rambam, mishneh torah, hamada, de’oth 1:6. thus, the rabbis have generally construed it to mean that one should do good deeds. 40. deut.15:8. with, the mitzvoth of tzedakah (charity or righteousness) and gemiluth36 37 chasadim (doing good deeds). thus, while it is linked to torah obligations, most rabbis understand that maaser kesafim is rabbinic or customary in nature. for instance, rabbi chaim yoseph david azuli (1724-1806) (birkei yoseph) stated:“it seems definite that maaser kesafim is not in the category of the mitzvah of maaser ani (the agricultural tithe given to the poor), but the obligation of giving to charity, the rabbis said should be a tenth of one’s possessions; it is a rabbinic observance coming under the law of tzedakah.” what follows is a description of the underlying obligations of38 tzedakah and gemiluth chasadim and an explanation of how the practice of maaser kesafim developed out of them. the obligation of tzedakah is generally traced to deuteronomy 15:7-11, where moses instructs that one must open one’s hand to the poor. the obligation of gemiluth chasadim is also found in deuteronomy and can most literally be described as an obligation to walk in the ways of the lord. it is39 possible to satisfy both obligations by doing good deeds. however, as often as not they are satisfied by giving money or property to those in need. this raises the question of just how much money one must give to satisfy these obligations, a question on which the torah is silent. the general rule for tzedakah is that, if a poor person appears before you and needs charity, you should meet his needs. if the person has fallen on40 hard times (as opposed to being perennially poor), you must try to restore that 2007] maaser kesafim and the development of tax law 165 41. rambam, mishneh torah, zaraim, matanos anayim 7:5. 42. id. (stating that one should give according to his resources if the needs of the poor outstrip one’s ability to give). 43. see, e.g. rambam, mishneh torah, zaraim, matanos anayim 7:5; midrash devarim rabbah, quoted by shenei luchot hab’rith, deut. 28:3; menoras hamaor, deut. 28:3, mk at 22-23. 44. j. talmud, pe’ah 1:1; karo, shulchan aruch, yoreh de’ah 249:1; radbaz loc. cit. (commenting on rambam, mishneh torah, zaraim, matanos anayim 7:5). 45. epstein, aruch hashulchan, yoreh de’ah 251, mk at 38. 46. karo, shulchan aruch, yoreh de’ah 249:2. person to the status to which he was accustomed. this means that, if the person was rich and had servants, you should provide that person with servants.41 depending on one’s resources, this obligation could either be impossible to meet or it could lead to the person giving charity needing charity himself. either way, a requirement that forced someone to beggar himself by doing charity would defeat the very purpose underlying the obligation. to avoid this problem, the religious authorities determined that the obligation should vary according to a person’s means to ensure that the obligation did not cause undue hardship. the use of a means-based test to42 determine the amount of charity and good deeds one is obligated to do raises two questions. the first is what to use as the measure of a person’s means. the second is how to determine the amount of charity one should give as a function of the chosen base. at first blush, wealth seems like the better measure of one’s ability to do charity; a wealthy person with no income is likely better able to give to others without suffering hardship than someone with no assets and a modest income. indeed, many of the sources state that one should give of his “possessions,” suggesting that wealth, and not income, is the proper base for determining one’s obligations. 43 however, in a discussion of gemiluth chasadim, the talmud notes that if one were to give away 20% of his possessions each year, he would soon be destitute and need charity himself, thus defeating the purpose underlying the obligation. accordingly, in light of the iterative nature of the obligation, the talmud concludes that income is the better measure for determining one’s obligation to do good deeds. this reasoning applies equally to the tzedakah44 obligation, and it is generally understood that income is the base for determining one’s charitable obligations. the next question was how much one should give to satisfy the obligations. the authorities describe both lower and upper limits. with regard to tzedakah, the rabbis noted that the obligation was relieved only for those who were completely destitute. otherwise, the obligation would apply only to the rich. for the near destitute, the minimum obligation was one-third of a shekel45 each year. under normal circumstances, one could satisfy the obligation by46 giving away 10% of one’s income, although the rabbis regarded 20% as the 166 florida tax review [vol. 8:1 47. id. at 249:1. 48. some debate exists whether the rabbis imposed the 20% upper limit or whether this limit was part of the revelation to moses on mt. sinai. see, e.g., j. talmud, pe’ah 1:1; b. talmud, taanith 20(b); rabbi eliyahu (the vilna gaon), commentary on pe’ah 1:1, mk at 25; rabbi yitzchak ben moshe of vienna (1180-1250), or zarua: laws of charity: § 13, mk at 23; rema, shulchan aruch, yoreh de’ah 249; epstein, aruch hashulcan, yoreh de’ah 249:3-4. 49. see, e.g., rabbi avraham danzig (1748-1820) chomas adam, laws of tzedakah § 144, mk at 34 (“a very wealthy man may distribute more than one-fifth of his possessions.”); rabbi m. sternbuch, moadim uzuanim, mk at 35 (“it seems obvious that the allocations of one-tenth and one-fifth in regard to charity apply only to one who has inadequate resources.”). see also rabbi s. z. auerbach, mk at 36, hebrew appendix at 19. rabbi feinstein concluded that the amount should be limited to 20% unless there is a question of saving a life. igroth moshe, vol 2, yoreh de’ah 143, mk at 36. 50. j. talmud, pe’ah 1:1. 51. for instance, the baalie tosafoth commentary on the torah (dating to thirteenth century c.e) quotes earlier authority stating that “jacob ordained that tithes should be given from money.” gen. 28:22. see also epstein, aruch hashulchan, yoreh de’ah 249:2, mk at 28 (“in truth these allocations of one-fifth and one-tenth are not torah obligations, but the rabbis associated them with the verse ‘and whatever you give me, i shall repeatedly tithe to you.’”). 52. the word “repeatedly” in this verse is the english translation of an infinitive absolute in which the verb is repeated. english translators take the repetition to imply emphasis – it is often translated as “surely” – but numerous rabbis believe that it reflects a promise to separate out two tithes. the notion of a double tithe raises the question as to whether one should separate out 20% of the original amount, or give 10% of the original amount, and then 10% of what remains. the talmud explains that 20% of the original amount is the appropriate figure. see, e.g., b. talmud, kethuboth 50a; j. talmud, pe’ah 1:1. this differs from the practice in agricultural tithing, where the second tithe is made net of terumah and the first tithe. 53. epstein, aruch hashulchan, yoreh de’ah. 249:2. ideal. several rabbis stated that one should not give more than 20%, but47 48 others concluded that the very wealthy could give more. the discussions of49 gemiluth chasadim yielded similar results. while no set amount is described if the obligation is to be fulfilled by doing good deeds, the jerusalem talmud establishes a precise allocation of 20% of one’s income if the obligation is to be fulfilled by giving money. 50 these amounts derive from a number of sources, revealing the close link between the obligation of tzedakah and the practice of maaser kesafim. gor instance, many rabbis associated the 10% figure with jacob’s vow to tithe.51 others viewed this vow as requiring 20%. others derived the 20% figure by52 reference to the amounts separated for agriculutral tithing purposes.53 regardless of the source, the result is a form of voluntary progressivity. however, unlike most progressive systems, the higher rates apply to all income, not just to marginal income above some threshold. 2007] maaser kesafim and the development of tax law 167 54. the preëmptive separation of maaser raised another issue, namely whether one still had an obligation to do charity for one who appeared before him if he already had separated out and distributed maaser. rambam indicated that the mitzvah of tzedakah existed independent of the limitations on maaser, and one was still obliged. rambam, mishneh torah, matanos anayim 7:5. at the very least, he concluded, one should do something for such a person. 55. see e.g., b. talmud, bava basra 8a; rambam, zaraim, matanos anayim 8:4-12. 56. deut. 6:16 (“you shall not test hashem , your god. . .”). job is, perhaps, the most famous example of this notion. despite behaving well, god treated him rather harshly, thus demonstrating the principle that one could not make a claim against god. the practice of maaser kesafim developed to help ensure that people fulfilled these obligations. rather than wait to see whether a poor person presented himself, people began to separate maaser from their income ex ante and then distribute the money to the poor. this practice serves several54 important functions. first, it makes the doing of charity more systematic and less dependent on chance encounters with those in need. second, it helps people determine the exact scope of their obligation. finally, it ensures that people do not spend all their income, thus rendering them incapable of fulfilling the obligation. while the use of income as the base for determining one’s tzedakah obligation suggests the need for an income definition, the ex ante nature of maaser kesafim requires one. with tzedakah, the need for an income definition arises only where the needs of the poor outstrip the resources of the person doing charity. with maaser kesafim , people must know what their income is, regardless of the needs of the poor, to be able to separate out the appropriate amount. over the past two thousand years, the rabbis have developed a sophisticated income definition, setting forth detailed rules that closely parallel those found in the internal revenue code, regulations, administrative announcements and case law. however, before moving on to explore those rules, two additional points regarding the maaser obligation bear mentioning. first, the practice of maaser kesafim lacks any kind of audit function to ensure compliance. while it is true that the obligation to do charity was at one time enforced by charity collectors who went door to door collecting money, even then each person55 determined his own income and therefore the amount to give. moreover, those who tithed often distributed the funds to a variety of recipients. as a result, no one was in a position to know whether another had properly determined his income or separated out a sufficient amount to meet his obligations. second, the obligation to tithe is undertaken by those who believe it to be a sacred obligation, suggesting a strong compliance norm even absent an audit function. indeed, tithing occupies a special place in judaism. normally, it is not permitted to do a mitzvah and then expect to be rewarded. malachi56 3:10 contains the one exception: “bring all the tithes into the storehouse, and 168 florida tax review [vol. 8:1 57. b. talmud, taanith 9a, (construing the words aser t’aser in deut. 14:22 to mean tithe so that you will become rich). see also rabbenu yonah gerondi (11901263), sefer hayirah, mk at 24 (“even though the creator forbade us to test him in all other matters he allowed us (to test him) in regard to maaser.”); rabbi yitzchak ben moshe of vienna (1180-1250), or zarua: laws of charity, § 13, mk at 23 (“we learn that it is a mitzvah for a person to tithe his money, and as he increases his tithes, so his wealth will increase.”). 58. stanley surrey, complexity and the internal revenue code: the problem of management of tax detail, law & contemp. probs. 675-677 (1969). 59. this is quite different from agricultural tithing, where the general structure is the same, but the specific questions differ significantly. for instance, the determination of whether something is included in income for agricultural tithing purposes depends on whether it is edible, a question not normally asked in the federal income tax context. see chodorow, agricultural tithing and (flat) tax complexity, supra note 10 for a discussion of the specific income definition rules developed for agricultural tithing. let it be sustenance in my temple, test me, if you will, with this, says hashem, master of legions [see] if i do not open up for you the windows of the heavens and pour upon you blessing without end.” this notion that one will be rewarded for tithing is reiterated in the talmud, midrashim, and commentaries thereon. thus, special incentives exist to encourage fulfilling57 this mitzvah. iv. defining income as stanley surrey noted, any income tax system must struggle with the basic questions of income measurement, including (1) what should be included in gross income, (2) what, if any, deductions should be allowed against gross income, and (3) what accounting periods and timing rules to adopt. tithing58 systems are no exception. maaser kesafim imposes a tax on all income, and therefore the specific issues raised are virtually identical to those found in the federal income tax. thus, it is not surprising that the income definition rules59 of maaser kesafim closely mirror those found in the federal income tax. the strong similarities between these two systems make the differences stand out and provide a window into how culture and context affect the development of the law. indeed, it is possible to observe three key effects. the first is the way that compliance and enforcement concerns shape the tax law. the second is the way in which the legal system itself affects the development of the law. the third is how underlying cultural values and the purposes of the tax affect its development. in this part, i compare and contrast several income definition rules, using the three categories identified above to organize the discussion. as most readers are likely more familiar with the federal tax rules than their tithing counterparts, i generally begin with a discussion of the tax rule. i present the analysis in part v. 2007] maaser kesafim and the development of tax law 169 60. see, e.g., gen. 28:22 (“and whatever you will give me, i shall repeatedly tithe to you.”); tosafoth, taanith 9a (quoting a passage from the sifre on deuteronomy (not extant elsewhere) that concluded that the word “entire” (kol) in deut. 14:22 reflected an obligation to tithe from all sources of income, “including loan interest, trading and all other profits,” and not solely from agriculture); midrash devarim rabbah (a 10th century c.e. commentary on deuteronomy) (relying on deut. 28:3 to conclude that tithes should not be paid solely from agricultural profits, but also from profits earned in a city). shenei luchot hab’rith, deut. 28:3; menoras hamaor, deut. 28:3; rabbenu yonah gerondi (1190-1263), sefer hayirah (meaning book of awe), mk at 24 (“from any source of income, whether from teaching, or writing, or labor, or findings, or gifts, or any other source, whether silver or gold, from all a tithe should be separated.”). 61. 348 u.s. 426 (1955). for a discussion of the historical evolution of the income definition for federal income tax purposes, see marjorie kornhauser, the constitutional meaning of income and the income taxation of gifts, 25 conn. l. rev. 1 (1992). 62. this exclusion first appeared in the tariff act of 1913, p.l. no. 16, § 2, 28 stat 114, 167. the house version of the bill did not exclude inter vivos gifts from income. h.r. 3321, 63rd cong., 1st sess. (1913), reprinted in 93 a guide and a. gross income the obligation of maaser kesafim applies to all income, from whatever source derived. thus, the general rule of income inclusion corresponds with60 the scope of the 16th amendment and the “accession to wealth” income definition the supreme court articulated in comm’r v. glenshaw glass. it is61 also consistent with the haig-simons definition of income, in that the source of income is irrelevant. despite this broad definition, questions arise under both systems regarding the meaning of income and the propriety of including specific receipts in income. this section explores three questions with which both systems have struggled and reached different conclusions. they include: (1) whether gifts and inheritances should be included in income; (2) whether returned property should be included in income; and (3) how one should treat nominal, as opposed to economic, gains. 1. gifts and inheritances the question of whether to include gifts and inheritances in income raises two issues. the first is theoretical: should these transfers be considered income under some ideal definition of the term? the second is policy-related: assuming, arguendo, that they should be considered income, should they should they nonetheless be excluded from income? what follows is a discussion of how tax academics, federal tax authorities and the rabbis have approached these issues and the rules they have crafted. from its inception, the internal revenue code has contained a blanket exclusion for all gifts and inheritances. it now contains a blanket exception to62 170 florida tax review [vol. 8:1 analytical index to the internal revenue acts of the united states, 1909-1950 (bernard d. reams ed., 1979), 192. the senate version did include this exclusion, and the senate’s version was adopted in conference. the current version of this exclusion can be found in irc § 102. 63. irc § 102(c). in addition to this blanket exception, the courts have determined that, under certain circumstances, transfers that technically qualify as gifts or inheritances may not be excluded from income. see,e.g., wolder v. comm’r, 493 f.2d 608 (2nd cir. 1974) (determining that an inheritance that functioned as a payment for services could not be excluded from income). 64. for a detailed description of the legislative history and possible justifications for excluding gift from income, see marjorie kornhauser, the constitutional meaning of income and the income taxation of gifts, 25 conn. l. rev. 1 (1992). 65. 252 u.s. 189, 207 (1920). the court defined income as a gain derived from capital or labor or a combination of the two. 66. comm’r v. glenshaw glass, 348 u.s. 426 (1955). 67. william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309, 348-349 (1972). 68. douglas a. kahn & jeffery h. kahn, “gifts gafts and gefts” – the income tax definition and treatment of private and charitable “gifts” and a principled policy the exclusion for gifts from employers to employees. the exact reason63 congress initially decided to exclude them from income is not known.64 howver, under the supreme court’s current income definition, congress could include gifts and inheritances in income if it so chose. thus, the decision to retain the exclusion likely reflects a policy choice, as opposed to a belief that gifts and inheritances do not qualify as income. significant debate exists within academia regarding the proper treatment of gifts and inheritances in an income tax. some early definitions of income excluded such tranfers because they defined income narrowly to include only receipts that were earned from labor, capital, or both. the surpreme court endorsed this view in eisner v. macomber, though not in the context of gifts65 and inheritances. the supreme court has since rejected this narrow view, adopting instead an“accession to wealth” definition of income. the macomber66 definition of income has lost favor with most academics as well. nonetheless, the debate rages on. current theories as to why gifts and inheritances do not qualify as income often focus on whether gift giving can properly be considered “consumption,” one of the component elements that constitute income under the haig-simons definition of income. for instance, william andrews argued that consumption should be viewed on a household basis and that gift giving within the family does not count as consumption. in contrast, douglas and jeffery67 kahn argue that consumption requires the preclusive use of a good and that transferring property from one person to another does not therefore count as consumption. under this type of analysis, the giving of a gift should lead to68 2007] maaser kesafim and the development of tax law 171 justification for the exclusion of gifts from income, 78 notre dame l. rev. 441, 461 (2003). 69. see, e.g., william d. andrews, supra note 67. 70. alvin warren, would a consumption tax be fairer than an income tax?, 89 yale. l. j. 1081, 1088 (1980). 71. indeed, some have argued that congress should repeal the blanket exception for gifts. see, e.g., joseph dodge, beyond estate and gift tax reform: including gifts and bequests in income, 91 harv. l. rev. 1177 (1978); kornhauser, supra note 64. a deduction for the gift-giver and inclusion of the gift by the recipient. however, this could lead to income shifting, and many view the denial of a deduction and exclusion by the recipient as a second best solution that has the same functional result.69 alvin warren took a different approach, arguing that income for tax purposes should equate to society’s annual social product. under this theory, gifts and inheritances should be excluded from income because they do not add to societal wealth. as with the arguments above, the exclusion of gifts could70 be effected either by giving a deduction to the donor and taxing the donee, or by excluding the gift from the donee’s income. other scholars reject these arguments, insisting that gifts and inheritences do properly qualify as consumption, and rejecting the claim that the tax base should equal societal income. such scholars reject the notion that71 consumption requires the preclusive use of a resource. instead, they tend to approach the question of what constitutes consumption from a welfarist or endowment perspective, where the possession of funds reflects the resources at a person’s disposal and the gratuitous transfer is no different from any other type of disposition. as noted above, the current supreme court definition of income permits the taxation of gifts and inheritance. of course, congress could disagree with the supreme court and decide to exclude such tranfers from income on a theoretical basis. however, little evidence exists suggesting that congress has been particularly moved by the academic debate on this issue, and it seems likely that congress understands that it can as tax such transfers both a legal and theoretical matter. thus, the decision to exclude these transfers most reflects a policy decision. unfortunately, it is impossible to know precisely which policy or policies congress intends to promote by excluding gifts and inheritances from income. the most likely candidates include taxpayer liquidity problems, the difficulty of distinguishing gifts from support obligations (which presumably would not be taxable), the difficulty of valuing gifts absent a market transaction, and the desire to promote gift giving. whatever the policy, the blanket exclusion 172 florida tax review [vol. 8:1 72. deborah schenk made a similar point with regard to the realization requirement, showing that it was overbroad to the extent it was designed to address concerns regarding taxpayer liquidity, valuation difficulties, etc. deborah h. schenk, a positive account of the realization rule, 57 tax l. rev. 355 (2004). similarly, the blanket exclusion of gifts cannot be justified on similar grounds because numerous gifts are liquid or readily valued. 73. as described above, another way to solve this perceived problem is to allow the donor a deduction against income and include gifts in the donee’s income. allowing such a deduction is arguably the correct result under the haig-simons definition of income, because the giving of a gift may not count as consumption. however, this solution could lead to income shifting if the donee is in a lower tax bracket than the donor. thus, the denial of a deduction for gifts, combined with the exclusion of gifts from income, can be viewed as a second-best solution to the potential double taxation of gifts. see, e.g., andrews, surpa note 67. is likely overbroad. for instance, if the concern is liquidity or valuation72 difficulties, there is no reason to exclude cash gifts. if the concern is difficulties distinguishing gifts from support obligations, one could exclude all gifts up to a certain amount given to minor children, while taxing the rest. the blanket exception to the exclusion – for gifts from employers to employees – is also overbroad in that it likely includes legitimate gifts in income. nonetheless, the bright-line nature of the rules make them fairly simple to understand and relatively easy to administer. in stark contrast to the bright-line federal income tax rule, the tithing rules are partially intent-based and narrowly tailored to exclude non-cash gifts and inheritances from income only where demonstrated liquidity concerns exist. like their federal tax counterparts, the rabbis who developed the income definition for maaser kesafim considered theoretical and policy questions. however, the rabbis ignored the question of what constitutes consumption and instead focused on receipts. as a result, they have uniformly concluded that gifts and inheritances should be considered income. their analysis of the issues under this standard is strikingly similar to our own. for instance, one of the justifications offered for excluding gifts from gross income under the federal income tax is that including gifts would lead to double taxation of the gift. thus, if a works, is paid with a $100 bill, and then gives that $100 bill to b, both a and b will pay tax on the same $100 bill if gifts are included in income. some see a rule excluding gifts from income as necessary to prevent this purportedly unjust result. in response to this claim,73 victor thuronyi raised the following argument: if individuals should be treated separately, the fact that the donor paid tax should be irrelevant to the treatment of the donee. . . . moreover, it is not accurate to say that the gift is taxed twice. what is taxed is, first, the amount earned by the donor, and, second, the amount transferred to the donee. the 2007] maaser kesafim and the development of tax law 173 74. victor thuronyi, the concept of income, 46 tax l. rev. 45, 74 (1990). as discussed more fully in the text above, several scholars disagree with this reasoning, claiming that the giving of a gift cannot properly be considered consumption and that it therefore cannot be considered income. the point here is not to show that thuronyi is correct but rather that the analysis employed in the federal income tax and tithing literature is often the same. 75. karo, shulchan aruch, yoreh de’ah 331:16. 76. shelah, laws of charity and maaser, mk at 42 (“it seems to me that a person is obliged to give maaser from an inheritance which he has inherited from his father. even if his father was careful to separate maaser during his lifetime, this does not exempt the son from separating from what the almighty has granted him. one cannot argue that the son takes the place of the father since the son represents a different ownership.”). see also epstein, aruch hashulchan, yoreh de’ah 249:6. 77. this conception of the obligation is in marked contrast to that in agricultural tithing, where the obligation follows the property. this difference between the nature of the obligation for agricultural tithing and maaser kesafim reflects the underlying sources of the obligations and the functions they serve. god has a special claim on the produce grown in israel, and food is tevel (prohibited) until god’s portion has been separated out. once that has occurred, the food may be eaten, and a second owner of the produce has no obligation to remove additional amounts. however, where gift is taxed only once, to the donee. thus, a gift is no more subject to double taxation than is a payment for personal services, which is also “taxed twice” – once when earned by the payor and again when received by the payee.74 four hundred years earlier, rabbi karo (1488-1575) made this same point, only in the context of dowries and maaser kesafim: i have seen some who say that maaser need only be separated from the dowry which the bride gives the bridegroom, but not from the dowry which the bridegroom’s father gives him. the reason put forward is that his father has already separated maaser from this money. i was amazed at this suggestion. what is the basis for it? is there any obligation on the money (to be tithed) that one can say that it has been freed? the obligation is on the person who is required to give from what the almighty has granted him, and it is of no relevance that his father or father-in-law has already given (maaser). it is certainly an erroneous view.75 rabbi yeshayahu horowitz (1560-1630) made the same point regarding inheritances.76 these passages reflect a common understanding that the tax or tithe is not attached to money or property, but rather is a personal obligation associated with the receipt of money or property. in the case of judaism, the obligation77 174 florida tax review [vol. 8:1 the first owner failed to remove the tithes, the obligation falls to the second owner. in contrast, for purposes of tzedakah, it is not relevant that someone else previously owned the property or used part of it to aid others. the obligation to aid others is individual. see chodorow, tithing taxes and complexity, supra note 10. 78. double taxation is an issue in the federal income tax. for instance, the basis rules are designed to ensure that taxpayers not pay tax twice on the capital invested in property. however, such rules are not designed to excuse the property itself from taxation once a tax has been paid on it. 79. see, e.g., responsa yad halevi, vol. 2, 44; yosef ometz, ch. tzedakah and maaser, p. 306; derech emunah 7:67, tz at 133. 80. yosef ometz, ch. tzedakah and maaser, mk at 52. is expressed as a mitzvah, which by its very nature applies to people, not objects. in the case of the federal income tax, the obligation (contained in § 1 of the internal revenue code) nominally applies to the income itself, suggesting a different rule. however, as thuronyi explained, the same property can be income to more than one person and therefore taxing the property twice does not necessarily raise a double-tax problem.78 despite the rabbinic consensus that gifts and inheritance should be considered income from a theoretical perspectice, numerous rabbis have articulated exceptions that allow people to exclude such transfers from income, and therefore from the obligation to tithe. as described below, these exceptions derive from concerns regarding liquidity and generally apply where the obligation to tithe would impose a hardship on the recipient. cash gifts must be included in income for maaser purposes. while some rabbis would exclude all non-cash gifts from income, most include non-cash gifts but allow exceptions79 where liquidity is a real issue. as seen below, these liquidity exceptions are as narrow as possible. much of the discussion focuses on gifts and inheritances of land and whether they may be excluded from income for maaser purposes. land is usually quite valuable, and gifts of land are more likely to raises significant liquidity concerns than other types of gifts. in an agrarian society, land is the chief source of wealth and a rule requiring one to give away land is more likely to cause hardship than similar rules applied to other types of property. the discussions of how to treat land reveal an ever increasing sophistication as the rabbis attempt to limit the exception to those instances where liquidity is truly an issue. for instance, rabbi yoseph ben pinchas hahn (1560-1637) wrote: i have seen here a widespread custom that maaser is not taken from land which is acquired as a dowry or an inheritance. it seems certain to me that there is no obligation to give maaser according to their (capital) value but to give maaser from their “produce,” that is, from the rent of the property.80 2007] maaser kesafim and the development of tax law 175 81. this rule mirrors that found in irc § 102(b), which specifies that the income from gifts excluded from income is not also excluded. in addition to addressing liquidity concerns, it also prevents evasion and erosion of the tax base. if the income from gifts were exempt, people could make reciprocal gifts of income producing property and thereby remove their income from the tax base. 82. responsa shaarei simcha, mk at 53. the term poskim literally means deciders and is generally used to refer to preëminent halachic scholars. rabbi hahn does not mention liquidity as the justification for this exclusion, but it seems certain that the exclusion is designed to address that concern. income from a gift of land does not raise the same liquidity problems that the gift of land itself would raise, and therefore he limits the exclusion only to the land itself. despite this limitation, the rule is still overbroad in that it creates a81 blanket exception for all land, even when the recipient has sufficient liquid assets to tithe. rabbi simchah bamberger (1899-1958) also determined that land could be excluded from income. however, unlike rabbi hahn, he limited the exception to situations where the recipient did not have sufficient other liquid assets: . . . it seems to me that if a man has acquired a field as an inheritance or a gift and he has not enough free money to give one tenth of the value of the field to the poor, there is no valid reason which would compel him to sell one-tenth part of the field to give (the proceeds) to the poor; neither have we heard of an instance of this kind in which he is obligated to give onetenth of the field itself to the poor. therefore i take the view that the heir is not obliged to give maaser on the landed property inherited from his father, even though i have not found this explicitly in the poskim.82 in reaching this conclusion, rabbi bamberger attempted to draw a distinction between the practice of maaser, which involves the ex ante separation of money for tzedakah purposes, and tzedakah itself. he conceded that both rambam and the shulchan aruch included land in possessions when determining how much to give to fulfill the mitzvah of tzedakah, but he argued that the maaser obligation applied only to cash and should therefore exclude non-cash gifts, such as land. nonetheless, he concluded that, if a person received a non-cash gift and could tithe without hardship, he should do so. rabbi shlomo zalman auerbach (1900-1995) refined the rule even further. he agreed that only those who truly had liquidity problems could avoid separating maaser on gifts and inheritances of land, but he added an important limitation to the exclusion, namely that where no maaser is separated at the time of receipt, it should be separated when the land is sold or otherwise converted to cash. thus, the lack of liquidity does not permanently excuse someone from 176 florida tax review [vol. 8:1 83. see mk at 53, hebrew appendix at 20. 84. for instance, if a person were forced to sell property to tithe, the impact might depend on the property to be sold. one forced to sell property used in a trade or business would likely suffer a much greater hardship than someone being asked to sell a bond that he had saved for a rainy day. similarly, one’s obligations could have a huge effect on the impact of the tithe. a person with a large family and therefore heavy financial obligations would feel the impact of the obligation to tithe more heavily than a person with a small family and more discretionary income. 85. the federal income tax system has one analogous practice that demonstrates the difficulty of making hardship evaluations. for purposes of determining whether to accept an offer in compromise from a taxpayer who has failed to pay his full tax debt, the irs has promulgated a series of schedules listing allowable expenses, which include both the type of expense and the maximum amount allowed. these schedules are determined on a regional basis to account for differences in the cost of living. the service determines a taxpayer’s income and subtracts allowable expenses to arrive at a figure it claims the taxpayer has available to pay his tax debt. it bases the decision on whether to accept a compromise on this assessment. this process is difficult to administer and leads to significant conflict between taxpayers and the irs, as the average costs the irs allows are often significantly less than the taxpayer’s actual expenses, leading the irs and the taxpayer to reach opposite conclusions regarding the hardship involved in paying past debts. see irc § 7122(d)(2) and associated schedules and regulations. 86. tzedakah u’mishpat, ch. 5, note 27, tz at 133. tithing, it merely defers the time of tithing until the property is converted to cash. in essence, he articulated a realization requirement for gifts or83 inheritances of land. neither rabbi bamberger nor auerbach attempted to define when a person has sufficient liquidity concerns to allow them to exclude land from the maaser obligation. rather, they appear to have left this decision to the individual. such determinations depend on a host of issues, including a person’s liquid assets, illiquid holdings and financial obligations. as a result, if two84 people receive equivalent gifts and have the same level of liquid assets, one may be required to tithe on the value of the gift, i.e., include it in income, while the other may exclude it. given the fact specific nature of the inquiry, it would be difficult to design a simple, uniform rule for making liquidity determinations.85 to complicate matters, several rabbis have noted that the question of whether someone has liquidity concerns may well depend on his intent. they argue that a gift recipient cannot claim to have liquidity problems associated with the receipt of a non-cash gift if he was intending to purchase the gift for himself. in such cases, the person retains the money he would have spent on the gift and therefore cannot be said to have a liquidity problem with respect to the gift. as a result, he must separate out maaser on receipt of the gift.86 for instance, assume a person was going to buy a car for $15,000. instead, he received the car as a gift. as a result, he is able to keep the $15,000 he was intending to spend. he can hardly claim that he would have to sell the 2007] maaser kesafim and the development of tax law 177 87. rabbi auerbach has extended this reasoning to fringe benefits, which are non-monetary compensation. although such benefits are not liquid, one must include them in income unless one can demonstrate that one would not otherwise have purchased the benefit. kol hatorah journal vol. 39, p. 92, no. 5. of course, insofar as benefits are negotiated, unlike gifts, it would be hard to demonstrate that one would not have purchased such benefits. 88. tzedakah u’mishpat, supra note 86. 89. those who assert that one must separate maaser based on the value of the gift received must address another interesting question, insofar as the value of a given gift in the marketplace may not equate to the value the recipient places on the gift. for federal income tax purposes, when property is subject to tax, one must use the “fair market value,” i.e., the value hypothetical unrelated parties would assign to the property in an arm’s length negotiation. see, e.g., regs. 20.2031-6(a). subjective value is simply ignored as impossible to gauge accurately. several rabbis suggest the same rule for tithing purposes. see, e.g., rabbenu jonah gerondi, book of awe; mateh moshe vol. 2., ch. 8. in contrast, rabbi aaron kotler asserts that one should separate out maaser based on one’s subjective value for the object received. thus, if the recipient of a $25,000 car intended to purchase a $15,000 car, and would only have paid $20,000 for the car he actually received, he should separate out $2,000 for maaser purposes. taub, laws of tzedakah at supra note 11 at 134, note 20. car or suffer some other hardship to satisfy the maaser obligation. he has $15,000 in the bank that he would not otherwise have had. in contrast, if he received as a gift something that he was not intending to purchase for himself, he cannot be said to have increased his cash position by that amount, and the liquidity justification may hold, depending on the factors identified above.87 to complicate matters even more, this rule raises the interesting question of what to do if a person receives a gift of greater value than what he intended to spend on himself. to continue with the car example, assume that someone intended to purchase a car for $15,000 but instead received a car worth $25,000 as a gift. on the one hand, he is $25,000 better off than he was before the gift, and should separate out $2,500. on the other hand, from a liquidity perspective, he has only saved $15,000, i.e., the money he would have spent on the car, and should only have to separate out $1,500 for maaser. the rabbis who have considered this question have come down on both sides, with some focusing on the money saved, and others looking at the value received.88 89 2. the return of lost property the treatment of returned property presents another example of how the tax and tithing laws diverge. here, the recipient’s innermost hopes play the primary role in determining the outcome for tithing purposes. under the federal income tax, taxpayers are generally not required to include in income the value of returned property. an exception to this rule arises where one has deducted the loss and later events, i.e., the return of the property, are inconsistent with such a deduction. in such circumstances, 178 florida tax review [vol. 8:1 90. this translates as the book of good deeds and dates to around 1200 c.e. 91. sefer chassidim, § 144, mk at 51. 92. see economic growth and tax relief reconciliation act of 2001, p.l. 107-16, § 803, 115 stat. 149; holocaust restitution tax fairness act of 2002, p.l. 107358, § 2, 116 stat. 3015. states that have excluded such payments from income include arizona, california, and new york, to name but a few. see arizona title 43: taxation of income § 43-1030; california revenue and taxation code § 17155; new york consolidated statutes, tax law § 13. 93. rabbi waldenberg is one of the preëminent living halachic scholars. 94. shut tzitz eliezer, vol. 6 #27, mk at 51. 95. an example may help illustrate the issue. suppose a purchased a car for $10,000 in year 1 and sold the car for $15,000 in year 3. he has a nominal gain of $5,000. however, because of inflation, some portion of the price increase for the car is attributed to inflation, and not to an increase in the real value of the car, as measured recovered property must be included in income under the tax benefit doctrine. the question of inclusion is objectively answered, removing the decision from the taxpayer’s discretion and making it easy to administer. in contrast, for tithing purposes, the sefer chassidim provides that the recovery of lost90 property will be treated as as income subject to tithing only if the recipient has given up all hope of receovery.91 to frame this issue in the context of the accession to wealth standard, the question is what baseline to use for measuring an increase in wealth. under both rules, the default baseline is the period before the property was lost. under the federal rules, the baseline resets to the period after the loss only if one has taken a deduction for the loss, an objectively verifiable fact. in contrast, under the tithing rule, the baseline for measuring an accession to wealth changes whenever a person gives up hope of recovery. it is tempting to think that this rule is of little consequence, insofar as the return of lost property is a rare event. however, these rules are critically important in the context of holocaust reparations, which are paid to numerous people and are often substantial. to the extent such reparations represent the return of, or compensation for, property seized during world war ii, the question arises as to whether such amounts are exempt from the obligation to pay tax and tithe. the federal government and numerous states have enacted special bills clarifying that such recoveries will not be subject to tax. in92 contrast, relying on the sefer chassidim, rabbi eliezer yehudah waldenberg93 concluded that reparations are subject to the obligation to tithe unless the recipient definitely believes that he never gave up hope of recovering the property those reparations represent. thus, the jewish rule is stricter, but94 impossible to enforce. 3. inflation both federal and religous authorities have struggled with the issue of whether to tax nominal or real (i.e., economic) gains. economists and tax95 2007] maaser kesafim and the development of tax law 179 against other good and services. if the total inflation over the three years were above 50%, he would actually have lost money on the car from an economic perspective. if one were to tax nominal gains, the person would pay tax, even though he lost money in real terms. 96. see, e.g., 1 treasury dep’t, tax reform for fairness, simplicity, and economic growth 97 (1984); david h. safavian, indexing tax attributes for inflation: dispelling the myths and advocating change, 1995 det. c. l. rev. 109 (1995); daniel halperin, saving the income tax: an agenda for research, 24 ohio n.u.l. rev. 493 (1998); yoram margalioth, the case for tax indexation of debt, 15 am. j. of tax pol’y 205 (1998). 97. joseph isenbergh, the end of income taxation, 45 tax l. rev. 283, 320321 (1990). 98. noel cunningham and deborah schenk, the case for a capital gains preference, 48 tax l. rev. 319, 337-340 (1993); the end of income taxation, supra note 98, (expressing uncertainty as to whether the benefits of deferral associated with the realization requirement offset the detriments of taxing nominal gain caused by inflation); edward j. mccaffery, the capital gains debate, take two: on indexing and fairness, 44 tax notes 605, 605 06 (july 31, 1989) (arguing that indexing for inflation must be considered in the context of the decision not to tax accrued gains). 99. this is not to say that the internal revenue code ignores inflation entirely. several allowances are indexed for inflation, including the personal exemption and the standard deduction, irc §§ 51(d)(4) and 63(c)(4), as are the tax tables, irc § 1(f) and (i), and various floors and ceilings used for phase outs. see, e.g., irc §§ 221(f) and 68(b)(2). 100. 77 t.c. 1361 (1981). scholars generally acknowledge that an ideal income definition would take inflation into account. nonetheless, congress, with the courts’ approval, has consistently imposed tax on nominal gain. in contrast, rabbi moshe feinstein concluded that one could tithe based on real gain. thus, the federal income tax rule deviates from the ideal or economic notion of income in this respect, while the tithing rule does not. scholars have suggested a variety of means to take inflation into account. some have suggested indexing basis to account for inflation. others96 argue that the best way to account for inflation is to apply a preferential tax rate to gains from property. while this approach is crude in comparison to97 indexing, it is seen as less complicated. critics of these proposals argue that taking inflation into account when determining gain is not appropriate because the tax benefits of deferral associated with the realization requirement (another deviation from the ideal) significantly outweigh the detriment caused by taxing nominal gains. whatever the reason, the federal income tax has eschewed any98 attempt to index basis for inflation, taxes capital gains at a preferential rate, and imposes taxes on nominal, as opposed to real, gains. 99 several taxpayers have challenged this rule, arguing that the notion of income set forth in the constitution refers only to real gain and that congress does not have the power to tax nominal gain. in hellerman v. comm’r, the100 180 florida tax review [vol. 8:1 101. id. at 1364. 102. the court stated: “[the] meaning of income is . . . to be gathered from the implicit assumptions of its use in common speech.” thus the meaning of income is not to be construed as an economist might, but as a layperson might. . . . petitioners’ nominal gain may or may not equal their real gain in an economic sense. nonetheless, neither the constitution nor tax laws “embody perfect economic theory.” id. at 1366 (quoting united states v. oregon-washington r. & nav. co., 215 f 211, 212 (1918)). for a more recent affirmation of this notion, this time in the context of annuity payments, see nordvedt v. comm’r, 116 t.c. 165, 169 (2001). 103. igroth moshe,vol. 5, yoreh de’ah § 2, no. 114, mk at 48. 104. interestingly, rabbi feinstein came to the opposite conclusion regarding the use of nominal dollars as a measuring stick for purposes of determining whether the repayment of a loan involved interest. jewish law bars jews from charging interest to other jews. lev. 25:36-37; deut. 23:20-21; b. talmud, bava metzia 60b. however, to the extent that interest is designed to and does account for the devaluation of money over time, it arguably represents an effort to return to the borrower the same value that tax court held that congress has the power to establish the dollar as a “unit of legal value” for purposes of determining taxable income. thus, even though101 dollars do not have a constant intrinsic value, they do have a constant legal value.102 the issue of inflation does not arise in the sacred texts or in the ancient or medieval rabbinic literature. however, during the 1970s, a time of high inflation both in the u.s. and in israel, the question was quite relevant, and rabbi moshe feinstein concluded that one was permitted to index for inflation when determining income for tithing purposes: . . . for maaser kesafim we are concerned with actual profit. . .. paper money which decreases and increases in value at different times cannot be taken as a fixed standard. therefore, since it is known to all that the paper currency has depreciated, the nominal profit of £1,000 in england or $1,000 in the usa obtained from the sale of a house purchased ten years previously is not to be treated as a real profit (for maaser kesafim). if the house was purchased for 1,000 and sold for 2,000, one must assess how much the 1,000 used in the purchase would be worth today in relation to the 2,000 obtained in the sale.103 rabbi feinstein then identified a cost of living index to be used to adjust the original purchase price, cautioning that only vital commodities should be included in the index so as to avoid items whose prices fluctuated for a variety of reasons not associated with inflation.104 2007] maaser kesafim and the development of tax law 181 was lent and not a charge for the use of the money. nonetheless, based on talmudic discussions of interest, rabbi feinstein determined that one should use nominal dollars to determine whether interest was being paid. accordingly, a lender can only request the borrower to repay the exact amount of the loan, and no more, even where he can show that the dollars paid back were worth less than the dollars lent out. igroth moshe,vol. 5, yoreh de’ah § 2, no. 114, mk at 48. the jewish laws regarding what constitutes interest are quite complex and beyond the scope of this article. 105. see, e.g., rabbi bachrach (“but in regard to business deals which involve expenses, we can say that it is clear that the expenses are to be reckoned as part of the keren [capital]. the profit in excess of the expenses is to be regarded as the ‘new produce’ from which maaser should be separated.”) responsa havoth ya’ir, mk at 56. 106. examples of personal deductions include the deductions for home mortgage interest, see irc § 163(h)(3), environmental causes, see irc § 179a, and personal savings. see irc § 219. in some cases, congress has used tax credits in place of deductions. see e.g., irc § 25a (allowing hope and lifetime learning credits). these personal deductions override the general rule in irc § 262 that personal expenses are not deductible and are generally referred to as “tax expenditures.” b. deductions the second step in determining either taxable or tithable income is to decide whether any deductions against such income should be allowed and, if so, which ones. congress has always permitted deductions for federal income tax purposes. deductions are also allowed for purposes of maaser kesafim,105 though their scope and nature is quite limited when compared to those found in the internal revenue code. given the large number of deduction issues that arise in both contexts, it would be impractical to address them all. instead, i will focus first on the question of whether business and personal deductions should be allowed. i will then turn to the questions of how to treat business meals and civil taxes, two items that have attracted much interest from scholars and legislators. 1. allowable deductions the internal revenue code has always permitted deductions against income. these deductions can be broken down roughly into two categories. the first category includes deductions necessary to measure income, such as the deduction for business expenses under section 162. the second category includes “personal deductions,” i.e., deductions designed to promote social policies external to the measurement and collection of income. 106 despite the distinctions between these two categories of deductions, the lines often blur. several income measurement deductions reflect objectives extraneous to income measurement. for instance, while the accelerated depreciation rules are ostensibly designed to match the costs of assets with the income they generate, leading to a more accurate measurement of income, they 182 florida tax review [vol. 8:1 107. see, e.g., irc §§ 1400l (new york liberty zone) and 1400n (gulf opportunity zone). 108. see, e.g., andrews, supra note 67; mark g. kelman, personal deductions revisited: why they fit poorly in an “ideal” income tax and why they fit worse in a far from ideal world, 31 stan. l. rev. 831 (1979); stanley a. koppelman, personal deductions under an ideal income tax, 43 tax l. rev. 679 (1988); jeffery h. kahn, personal deductions – a tax “ideal” or just another “deal”?, 2002 l. rev. mich. st. u. det. c. l. 1 (2002) (arguing that many personal deductions are consistent with an ideal income tax because they effect progressivity). 109. as rabbi oppenheim observed, business expenses were often significant and if people were obligated to “tithe the difference between the cost [of a good obtained in trade] and selling price without deduction of expenses they would not earn anything.” responsa havoth ya’ir, mk at 59. were also designed to encourage investment and spur economic development.107 moreover, while some of the personal deductions clearly have nothing to do with income measurement, significant scholarship exists debating the question of whether some of these deductions are in fact consistent with ideal notions of income and therefore necessary for income measurement. the net result is that108 the deductions found in the internal revenue code are wide-ranging and often stray far beyond what would be necessary to provide an accurate measure of a person’s income. in contrast, the only deductions allowed for tithing purposes are those that relate to income measurement. moreover, those deductions focus solely on income measurement and do not aim to promote social policy objectives external to those implicit in the practice itself. thus, as with the income inclusion rules described above, the deduction rules found in tithing more closely track what one would expect in an ideal income tax than those found in the federal income tax. the propriety of allowing business deductions for purposes of determining one’s income subject to tithe seems fairly self evident. however,109 unlike congress, which was free to create deductions by simple fiat, the rabbis had to demonstrate that such rules derived from, or at the very least were consistent with, the sacred texts. the torah and talmud are silent on the question of deductions for maaser kesafim. however, in the analogous practice of agricultural tithing, the most obvious source of authority, no deductions whatsoever are allowed. it was therefore necessary to distinguish maaser kesafim from that tithe to justify the allowance of deductions in one, but not the other. rabbi oppenheim (1664-1736) distinguished the two practices by contrasting the miraculous nature of agricultural income with the more pedestrian provenance of commercial income: but we must conclude that there is no comparison between maaser kesafim for business deals and agricultural maaser for 2007] maaser kesafim and the development of tax law 183 110. id. 111. see, e.g., irc § 162; responsa havoth ya’ir, mk at 59. 112. irc § 262; epstein, aruch hashulchan, yoreh de’ah 249:6, mk at 66. some rabbis have contended that one may deduct living expenses before determining the amount of maaser, but they are in a distinct minority. see, e.g., rabbi matisyahu trevis, quoted in shvirei knesses hagedolah, yoreh de’ah 249 and responsum avkas rochel #3, mk at 66. produce of the earth. in the latter case we have a special biblical decree since the whole matter of growth of agricultural produce is a miracle of nature. . . . however, business dealing is a practice among people of the world with no reference to anything miraculous; at the beginning of creation the almighty divided the beneficial resources which are needed by mankind among various countries, and therefore they need one another and supply one another. this is the source of all business dealings, and the world follows its normal routine requiring large capital outlay to provide a small profit, the opposite of the blessing of the lord in regard to agricultural produce.110 although addressed to business expenses, this passage also reveals why maaser kesafim lacks personal deductions. rabbi oppenheim was able to distinguish agricultural profits from business profits, thus removing business expenses from the ban on deductions. his analysis does not support the allowance of any non-business deductions, such as those that can be found throughout the internal revenue code. interestingly, none of the personal deductions debated in the tax scholarship as possibly permissible under an ideal notion of income are allowed for purposes of maaser kesafim. this fact may lend support to those who insist that such deductions are not appropriate for pure income measurement, or it may simply reflect the fact that many tax scholars approach income questions using the haig-simons formulation of income, with its focus on consumption, while the rabbis employ a more traditional receipts approach. 2. business meals business expenses are deductible under both the federal income tax and tithing rules, while personal expenses are not. one of the perennial111 112 problems both of these systems face is that certain expenses have a dual character, and it may be difficult to determine how best to treat them. numerous expenditures fall into the gray zone between business and personal expenses, but the most difficult is probably the business meal. on the one hand, meals consumed in the pursuit of business are truly a cost of business. on the other hand, people must eat. allowing a deduction for business meals may be tantamount to allowing a deduction for a personal living expense. as a result, 184 florida tax review [vol. 8:1 113. td 3101, 3 cb 191 (1920). 114. revenue act of 1921, ch. 136, § 214(a)(1), 42 stat. 227, 239. generally speaking, a taxpayer must be away from home overnight to be considered “away from home” under irc §162(a)(2). united states v. correll , 389 u.s. 299 (1967). 115. pub. l. no. 87-834, §4(b), 76 stat. 960, 976-77. this legislation also imposed a substantiation requirement upon taxpayers that precluded deductions for meals absent evidence of their cost. see irc § 274(d). some taxpayers had claimed deductions based on estimates of their business meal costs. see cohan v. comm’r, 39 f.2d 540 (2nd cir. 1930). congress was concerned that these estimates might have a persistent error in favor of the taxpayer, causing these deductions to be larger than warranted. 116. this is somewhat of an overstatement insofar as the normal extra costs of a meal on the road were deductible. only the “lavish or extravagant” costs were disallowed. 117. irc § 274(n), as enacted in the tax reform act of 1986, p.l. 99-514. 118. the joint committee on taxation’s explanation of the 1986 act stated: the congress believed that prior law, by not focusing sufficiently on the personal-consumption element of deductible meal and entertainment expenses, unfairly permitted taxpayers who could arrange business settings for personal consumption to receive, in effect, a federal tax subsidy for such consumption that was not available to other taxpayers. the taxpayers who benefit from deductibility tend to have relatively high incomes, and in some cases those developing the tax and tithing laws have struggled with how best to treat these meals. originally, the internal revenue code permitted deductions for business meals only to the extent that they exceeded the price “ordinarily required for such purposes at home.” thus, only the extra cost incurred113 because of the business activity was deductible, with the rest considered a nondeductible personal expense. this rule was difficult to administer, as it was not easy to determine how much the taxpayer would normally have spent on a meal at home. indeed, depending on the tastes and habits of each taxpayer, the amounts could vary widely between individuals. in 1921, congress amended the general deduction provisions to allow taxpayers to deduct the entire cost of the meal, so long as they were consumed while in the pursuit of business “away from home.” not surprisingly, some114 taxpayers abused this rule and chose to eat their meals away from home at fancy restaurants. accordingly, in 1962, congress again amended the rules to preclude deductions for any “lavish or extravagant” costs. thus, the rule became115 almost the mirror image of the original, where the ordinary costs of a meal were not deductible, but extra costs were. 116 in 1986, congress tried another approach, arbitrarily reducing the amount allowable as a deduction to 80% of the non-lavish cost. the117 disallowance of the 20% effectively allocated that portion of the expense to the personal side of the ledger. in 1993, in an effort to reduce the budget deficit,118 2007] maaser kesafim and the development of tax law 185 the consumption may bear only a loose relationship to business necessity. . . . staff of the joint committee on taxation, 99th cong., 1st sess., general explanation of the tax reform act of 1986 (p.l. 99-514), released may 4, part 3. this reduction rule reflects the fact that all meals and entertainment inherently involve an element of personal living expenses, but it still allows an 80% deduction where such expenses also have an identifiable business relationship. 119. irc § 274(n); h.r. rep. no. 111, 103d cong., 1st sess. 645 (1993). 120. rabbi laniado wrote: “nevertheless, i am doubtful regarding the expenses of food and drink which a man consumes on a business journey until he returns home, whether they may be deducted; for whether at home or on a journey he must eat and drink. from the writings of [rabbi oppenheim], who uses the analogy of a partner, it would seem to be deductible, for in a partnership such expenses are deducted from the joint fund; however, i am still in doubt, and it seems that he should deduct precisely according to the blessing of his own household (i.e., the additional cost above the normal expenditure which he would incur at home.)” beth dino shel schlomo, yoreh de’ah no. 1, mk at 61. 121. see mk at 61. 122. responsa havoth ya’ir, mk at 61. as a result, he also concluded that deductions should be allowed for clothing and for losses and theft, so long as no negligence was involved.. as described below in pat iv.c, several rabbis relied on partnership law when contemplating the appropriate accounting periods and whether to allow the netting losses against gains. congress further reduced the amount allowable as a deduction to 50% of otherwise allowable costs. the current law thus creates an arbitrary, bright-119 line rule that represents a compromise between the business and personal nature of the expenditure. it also reflects a need for greater revenues that has little to do with the proper allocation of the costs between personal and business expenses. many of the positions described above, and a few others, can be found in the halachic treatment of business meals. for instance, rabbi shlomo laniado (d. 1793) concluded that expenses for meals would have been incurred regardless of any business venture and were really personal expenses that could not be considered when determining income subject to tithe. only those costs in excess of what one would normally have incurred for oneself are deductible. rabbi auerbach concurs in this position.120 121 in contrast, rabbi rabbi oppenheim (1664-1736) relied on an analogy with partnership law to conclude that business meals should be deductible. he posited that god is like a partner and that one should consider whether the expense would be chargeable to an earthly partner in determining whether it was deductible for purposes of maaser. yechiel michael epstein (1835-1905)122 186 florida tax review [vol. 8:1 123. “all expenses incurred in the transaction including traveling expenses and food and drink are all considered as business expenses and can be deducted . . .” epstein, aruch hashulcan, yoreh de’ah 249:6, mk at 61. 124. see part iv.b, supra. 125. responsa shvut yaakov no. 50, mk at 63. 126. such a rule presents a similar issue to that presented by the rules regarding the inclusion of lost property. it depends on the self-reported intent of the person tithing. given the different compliance norms and enforcement needs, such a rule would not likely be found in the federal tax system. 127. bet lechem yehuda, yoreh de’ah 249:1, mk at 63. 128. see. e.g., reverend lovejoy, the simpsons, supra note 2 (“and once again tithing is 10% off the top. that’s gross income, not net. please people, don’t force us to audit. . .”). concurred, concluding that all traveling expenses, including meals, should properly be considered business expenses.123 rabbi yaakov reicher (1670-1733) provides the most interesting rule. relying on rabbi oppenheim’s distinction between the miraculous nature of agricultural income and the pedstrian provenance of normal business income,124 rabbi reicher concluded that deductions should be allowed for business meals if a person went on a trip intending to transact business, but not if he traveled simply open to the possibility that business could be conducted. he reasoned125 that spontaneous business was akin to the miraculous growth of produce. as deductions were not allowed in agricultural tithing as a consequence of the miraculous provenance of agricultural income, deductions for business meals should not be allowed where business “miraculously” occurred. in contrast,126 intended business was caused by human endeavor. he thus permitted deductions in such cases. rabbi zvi ben azriel of alik (c. 1720) rejected this view, arguing that, even where business was intended, the risks of failure were significant. he beleived that the distinction between intended and spontaneous business could not be maintained and concluded that the general rule allowing business expense deductions should govern both cases. thus, he held that the entire cost of a business meal should be deductible, regardless of intent.127 although the tithing rules and tax rules are quite similar (other than rabbi reicher’s intent-based rule and the current, arbitrary tax rule), one important difference bears mentioning. the tax laws described above followed each other seriatim. in contrast, the tithing rules co-exist. thus, those seeking to tithe must determine for themselves, with the aid of their rabbi, which rule to follow. 3. civil taxes one of the persistent questions in tithing is whether one may deduct civil taxes from one’s income when figuring out the amount on which to tithe.128 2007] maaser kesafim and the development of tax law 187 129. under this theory, taxpayers with similar means should be subjected to the same level of tax. those who pay more in state taxes have lower after-tax incomes and therefore should not be subject to the same level of tax. allowing a deduction for state taxes addresses this concern. see william vickrey, agenda for progressive taxation 18-24 (1947). 130. under this theory, the federal government subsidizes state and local spending by allowing a deduction for state and local taxes. some have argued that this subsidy is warranted because states do not take into account the benefits they create but cannot capture when setting tax rates. allowing a subsidy encourages them to collect and spend more than they otherwise would. see, e.g., brookes d. billman, jr. & noël b. cunningham, nonbusiness state and local taxes: the case for deductibility, 28 tax notes 1107 (1985). others have argued that the subsidy encourages progressivity at the wrong level of government and that it should be revised. see, e.g., kirk stark, fiscal federalism and tax progressivity: should the federal income tax encourage state and local redistribution?, 51 ucla l. rev. 1389 (2004). 131. for a review of the literature on the justifications for and challenges to the deduction for state taxes, see brian galle, a republic of the mind: cognitive biases, fiscal federalism, and section 164 of the tax code, 82 indiana law review 711 (2007). 132. for a discussion of the efforts to eliminate the deduction for state taxes during the run-up to the 1986 tax act, see jeffery h. birnbaum and alan s. murray, showdown at gucci gulch: lawmakers, lobbyists and the unlikely triumph of tax reform (1987). 133. irc § 164. state taxes are not deductible under the alternative minimum tax. irc § 56(b)(1)(a)(ii). 134.staff of joint comm. on tax’n. 99th cong., 2d sess., general explanation of the tax reform act of 1986 at 47 (comm. print 1987). (“to the extent that sales taxes are costs of purchasing coumer products or other items representing voluntary this same question – whether to allow a deduction for state taxes – arises in the context of federal income taxation. both congress and the jewish authorities allow such deductions, though the reasons given differ significantly. what follows is a discussion of the respective positions, including the debate over whether to differentiate between income and sales taxes. several justifications have been offered for allowing people to deduct their state and local taxes from their income for federal tax purposes, including horizontal equity and fiscal federalism. nonetheless, significant debate129 130 exists about whether to retain the deduction. from time to time, reformers131 have suggested eliminating the deduction, but so far they have failed to garner sufficient political support to do so. 132 taxpayers currently may deduct most state and local taxes against their income. state income and property taxes have always been deductible, while133 the deductibility of state sales taxes has come and gone. in 1986, congress rescinded the deduction for state sales taxes, asserting that a sales tax should logically be considered as part of an object’s purchase price, and therefore personal conusmption to the extent that the object was purchased for personal use. in 2005, congress restored the deduction for state sales taxes, reflecting134 188 florida tax review [vol. 8:1 purchases, allowing the deduction was unfair because it favored taxpayers with particular consumption patterns and was inconsistent with the general rule that costs of personal consumption by individuals are nondeductible.”) 135. see general explanation of tax legislation enacted in the 108th congress (2005) enacted on may 2005 part seventeen: american jobs creation act of 2004 (public law 108-357) 2005 bluebooks pt. 17 (“the congress recognized that not all states rely on income taxes as a primary source of revenue, and that allowing a deduction for state and local income taxes, but not sales taxes, created inequities across states and may also have created biases in the types of taxes that states and localities chose to impose. the congress believed that the provision of an itemized deduction for state and local general sales taxes in lieu of the deduction for state and local income taxes would provide more equitable federal tax treatment across states, and would cause the federal tax laws to have a more neutral effect on the types of taxes that state and local governments utilize.”). 136. taz, yoreh de’ah 249:1. 137. consider a person who earns $10. such a person would be required to separate out $1 for maaser. now consider the same person who earns $10 and owes $1 in civil tax. absent a deduction for the civil tax, he would separate out $1 in maaser and then another $1 to pay the tax, leaving the government with $1, god with $1 and himself with $8. with a deduction for civil taxes, he would deduct the $1 tax and then separate out the maaser from the remaining $9. in that case, the government would still receive its $1, god would get only $0.90, and the person would retain $8.10. from an economic perspective, one could argue that the person had effectively used $0.10 that would otherwise have been god’s to pay his taxes, retaining the difference for himself. 138. rishon lezion, yoreh de’ah 249:6, mk at 80. a desire to treat all state taxes similarly and not penalize those states (and their residents) that did not have an income tax.135 the general consensus among the rabbis who have considered the question of civil taxes is that one should be allowed to deduct income taxes. significant debate exists about the propriety of allowing a deduction for sales taxes. this debate turns primarily on the individual’s right to and control over the amounts paid. i consider first the early authorities and then turn to the modern debate. the debate began with rabbi david ben shmuel (the taz) (1586-1667), who stated that maaser could not be used to pay civil taxes. a logical136 extension of the taz’s admonition might be that no deduction should be allowed for civil taxes. if one deducts civil taxes in determining income for maaser purposes, the amount of maaser separated is less than it otherwise would be, and from an economic perspective one could argue that maaser had been used to pay such taxes. 137 nonetheless, rabbi chaim ibn atar (1696-1743) concluded that a deduction for civil taxes should be allowed, drawing an analogy between such taxes and pe’ah, the practice of leaving the corners of the field unharvested so that the poor may partake. just as produce left in the fields was not included138 in a farmer’s income for agricultural tithing purposes because the farmer never 2007] maaser kesafim and the development of tax law 189 139. birkei yoseph, yoreh de’ah 249:2. this argument is somewhat surprising because it strictly construes the pe’ah obligation. as reflected above in note 30, the rabbi azuli believed that maaser kesafim was rabbinic in origin, thus affording some latitude in the development of its rules. his refusal to draw an analogy between pe’ah and taxes reflects a stricter view of the what the torah allows than one might expect. 140. igroth moshe, vol. 2, yoreh de’ah § 1, no. 143. 141 b. talmud, gittin 44a; b. talmud, chulin 131a. 142 c.f. maharil, responsum no. 54, mk at 27 (“for this reason maaser kesafim, which is rabbinic, has a particular leniency.”). exercised control over it, he reasoned, so should amounts paid for civil taxes be excluded from one’s income for maaser purposes. while the treatment of pe’ah is handled as an exclusion from income, the way to effect this exclusion for civil taxes is to allow a deduction against income for such taxes. rabbi chaim yosef david azuli (1724-1806) (the birkei yosef), a student of rabbi atar, disagreed, arguing that pe’ah is a special torah obligation in the nature of a gift to the poor, and that one cannot draw an analogy between the practice of pe’ah and the payment of taxes. thus, he concluded that no deduction for civil taxes should be allowed. 139 little else was written on this question until the mid-20th century, when the debate picked up again. rabbi feinstein construed the passage from rabbi atar as applying to income taxes but not to taxes that are transaction based, such as sales taxes. he reasoned that the income tax was like pe’ah, in that the140 person who earned the income never truly controlled the money owed as income tax. the person who earns $10 and owes $1 to the government as income tax really controlled $9 and should tithe on that amount. the same argument cannot be made when this person then takes his $9 and buys something for $2, paying an additional $1 as sales tax. even though the sales tax is not optional, such a person still had earned $9 and had it at his disposal at one time. rabbi feinstein cited talmud passages that indicated that maaser is owed on amounts the king seizes in satisfaction of a debt to support the distinction between income and sales taxes. he reasoned that the taking of the141 property described in the talmud was analogous to the payment of a sales tax. once a person had control over income, he owes a tithe on such income, even though the government later takes the money from him as part of a transaction separate from the act of earning it. in contrast, rabbi yitzchak yaakov weiss (d. 1989) took a more lenient view and construed rabbi atar’s reasoning to apply equally to all taxes. rabbi weiss argued that maaser kesafim was customary in origin, allowing significant leniency in the creation of the rules. he further argued that, for purposes of142 determining income only, one should treat the payment of taxes similarly to the use of funds for tzedakah. after all, taxes generally fund the public good and bear some similarity to tzedakah. thus, if someone earned $100 and then gave away $3 to a charity, he would determine the amount to separate for maaser by first subtracting the $3. similarly, he should be allowed to deduct any taxes 190 florida tax review [vol. 8:1 143. see mk at 80, hebrew appendix. 144. id. 145. in addition, one must develop rules to determine in which period items of income or deductions fall. examples of such rules include those of cash method and accrual accounting, which specify when taxpayers must report income and may claim deductions. an examination of these rules is beyond the scope of this paper. 146. in eisner v. macomber, the supreme court contrasted capital, which it described as “a reservoir supplied from springs” to income, which it described as “as the outlet stream, to be measured by its flow during a period of time.” 252 u.s. 189, 206 (1920). 147. income tax act of oct. 3, 1913, pub. no. 63-16, s 2d, 38 stat. 166 (1913). see irc § 441 and regulations thereunder for a description of the current rules regarding the taxable year. generally it is the taxpayer’s annual accounting period, if paid. however, rabbi weiss suggested that those who can afford not to deduct sales taxes should refrain from so doing.143 rabbi auerbach took a third approach. he agreed with rabbi feinstein that income taxes should be deductible, but not sales taxes. however, consistent with the legislative history of the tax reform act of 1986, he based his argument on the notion that a sales tax was nothing more than part of the purchase price of a given good or service. as such, it could not be deducted. rabbi auerbach also took a broader view of the justification for the deduction. he contended that the reason income taxes could be deducted was that they were mandatory. thus, the focus on taxation was too narrow. he argued that any forced taking, including deposits, mandatory loans to the state of israel or forced insurance, should be deductible for purposes of determining maaser. consistent with the tax benefit rule, he further believed that if the money were later recovered, then it should be included in income for tithing purposes.144 c. netting and accounting periods having determined what must be included in income and what expenditures can generally be deducted, the final step in ascertaining taxable or tithable income is to determine whether specific items of income and expeneses may be netted against one another and to set accounting periods. federal145 income taxation generally permits taxpayers to net all income and expenses incurred during a one-year period. within bounds, it allows taxpayers to offset income and losses from different accounting periods. in contrast, several rabbis argue for transactional accounting, where each transaction is considered separately from all others, thus preculding netting altogether. others argue for tax accounting periods, ranging from three months to one year. in all cases, netting between periods is strictly prohibited. what follows is a discussion of how the different rules developed. the concept of income necessarily incorporates a time element. from146 the beginning, the federal income tax has used an annual accounting period, called the “taxable year.” initally, congress permitted taxpayers to net all147 2007] maaser kesafim and the development of tax law 191 such period is a calendar or fiscal year. irc § 441(b). in some cases, the code allows for a 53-week year, irc § 441(f), or for tax periods shorter than one year. irc § 443(a). 148. revenue act of 1924, § 208(c), 43 stat. 253, 262 (1924). 149. see irc §§ 1211 and 1212. for a history of this limiation, see 3b mertens, the laws of federal income taxation, §§ 22.02-22.03 (1996 rev.). 150. see irc §§ 465 and 469. 151. this could arise either because a taxpayer had income in one year and incurred expenses in another or as a result of progressive tax rates, where the bunching of income could lead taxpayers to incur higher tax burdens than others whose income was earned at a constant rate over time. 152. 282 u.s. 359, 51 s.ct. 150 (1931). 153. this argument is analogous to those raised regarding the taxation of nominal, as opposed to real, gain. 154. id. at 362-3. income and deductions that fell within a tax year. however, to combat potential abuses, over time, congress has imposed a number of limitations on this ability. for instance, in 1924, congress limited the ability to deduct capital losses, a148 restriction that continues to this day, though in altered form. in the 1980s, in149 response to aggressive tax shelter activity, congress imposed restrictions on the ability to deduct losses associated with borrowed funds and from passive investments. nonetheless, the general rule remains that taxpayers are allowed150 to net all income and expenditures incurred within a given taxyear, even if they are earned or incurred in different businesses. originally, each tax year was independent, and income or losses from one year could not be used to offset income or losses from any other year. this independence created the possibility that (1) taxpayers could owe taxes, even when they ultimately lost money, and (2) two taxpayers who made the same amount of profit when measured over the long run, might end up owing different amounts of tax, depending on when they earned their income and incurred their expenses. to remedy this inequity, the trend in federal taxation151 has been to increase the period over which income is measured by reducing the independence of the individual tax years and allowing netting across years. one of the potential distortions of income inherent in an annual accounting regime were showcased in burnet v. sanford & brooks co. the152 taxpayer in that case incurred expenses in one tax year, and received payment in another. although the taxpayer lost money on the project, it was barred by operation of the accounting rules from using the expenses to offset its income. thus, it was required to pay tax, even thought it ultimately lost money. the taxpayer challenged the constitutionality of annual accounting because it lead to a tax where no profit was earned. the taxpayer argued that income should153 be measured on a transactional basis. the supreme court rejected this154 argument and affirmed the annual accounting system as the only practical way 192 florida tax review [vol. 8:1 155. id. at 365. interestingly, at the time sanford & brooks co. was decided, regulations permitted taxpayers to account for their profits and losses on a transactional basis, so long as they kept their books based on such a method. the taxpayer in that case had not done so, and therefore could not avail himself of those regulations. see, e.g., art. 36 of reg. 45, apr. 19, 1919. for a discussion of such regulations, see myron c. grauer, debunking the myth of the historic supremacy of annual accounting for income taxes: a coalescence of non-literal interpretation with original intent analysis, 67 wash. u. l. q. 165, 187 (1989) (discussing the history of the tax accounting rules). 156. see, e.g., hillsboro nat’l bank v. comm’r, 460 u.s. 370, 388-89 (1983) (affirming the general principle of annual accounting, while permitting the tax benefit rule to ameliorate some inequities caused by such a system). 157. see irc § 172. generally, losses may be carried back two or three years (though under some circumstances up to 10 years), thus potentially allowing the taxpayer to restate previously declared income, and carried forward from five to twenty years, depending on the situation. 158. under this rule, where a taxpayer received a tax benefit in a prior year and later events are inconsistent with the receipt of that benefit, the taxpayer must recapture the prior benefit in the year the inconsistent event occurs. see, e.g., hillsboro nat’l bank v. comm’r and united states v. bliss dairy, 460 u.s. 370 (1983). for a discussion of how this rule came into being and has evolved over time, see myron c. grauer, the supreme court’s approach to annual accounting and transactional accounting for income taxes: a common law malfunction in a statutory system?, 21 ga. l. rev. 329, note 12 (1986); patricia white, an essay on the conceptual foundations of the tax benefit rule, 82 mich. l. rev. 483 (1983). 159. see, e.g., arrowsmith v. comm’r, 344 u.s. 6 (1952). for a discussion of arrowsmith and its implications for annual accounting, see deborah h. schenk, arrowsmith and its progeny: tax characterization by reference to past events, 33 rutgers l. rev. 317 (1980-81); joel rabinovitz, effect of prior year’s transactions on federal income tax consequences of current receipts or payments, 28 tax. l. rev. 85 (1972-73). see also, irc § 1212, which permits a taxpayer to carry back and/or forward capital losses that are suspended by operation of irc § 1211. “to produce a regular flow of income [to the government] and apply methods of accounting, assessment, and collection capable of practical operation.”155 although annual accounting has been affirmed numerous times since sanford & brooks co., the courts and congress have created a number of156 exceptions and modifications to the tax law to allow for netting across years. for instance, businesses are now allowed to carry back and forward net operating losses suffered in a given year, so that such losses can be applied to offset income from other years. within limits, this rule prevents the situation157 in sanford & brooks co. from reoccurring and makes it more likely that taxpayers who earn the same income over a period of years will pay the same amount of tax. other examples of rules that modify the strict annual accounting rules include the tax benefit rule, initially created by the courts and then partially codified in § 111, and the rule that events from prior tax years can158 affect the characterization of events that occur in a later tax year.159 2007] maaser kesafim and the development of tax law 193 160. see generally boris i. bittker and lawrence lokken, federal taxation of income, estates and gifts (rev. 3d. ed.) vol. 4a, ¶ 111.3.10 for a description of these provisions. this idea continues to receive significant attention from scholars. see generally, e.g., lily l. batchelder, taxing the poor: income averaging reconsidered, 40 harv. j. on legis. 395 (2003); neil h. buchanan, the case against income averaging, 25 va. tax rev. 1151 (2006). 161. the loss netting rules described above accomplished the same thing to a limited extent. however, they only came into play when a taxpayer suffered losses. 162. noda b’yehuda 2, no. 198, mk at 49. rabbi landau also relied on the example in the jerusalem talmud, pe’ah 1:1 about a person who tithed one fifth of his possessions each year to conclude that tithing should be determined on an annual basis. see also, rabbi zvi ben asriel of alik (c. 1720). beth lechem yehudah,yoreh de’ah 249, mk at 78. 163. see mk at 79, hebrew appendix at 20. from 1964 to 1986, congress sought to ameliorate the problems associated with progressive tax rates by allowing taxpayers to average their income under certain circumstances. these provisions allowed taxpayers to160 avoid the worst effects of steep marginal rates and helped ensure that those who earned the same amounts over the same period paid the same amount in taxes, regardless of when during the period the income was earned. these161 provisions were repealed as part of the tax reform act of 1986, which significantly reduced the top marginal rates. the rabbis who developed the accounting rules for tithing seem completely unconcerned with horizontal equity and the possibility that different people might end up tithing different amounts based solely on the timing of their income and expenses. instead, they are largely driven by the desire to ensure that people not use losses they have incurred to offset amounts owed to god on account of prior profits. this concern affects the decision regarding the use of an accounting period, the length of the accounting period, and the ability to net income and losses across accounting periods. the torah clearly indicates that the proper accounting period for agricultural tithing is one year; it is silent regarding the proper accounting period for maaser kesafim. thus, the rabbis were left to interpret the primary legal sources and argue by analogy to develop the timing rules. many rabbis looked to the agricultural tithing rules to determine the appropriate accounting period for maaser kesafim. for instance, rabbi yechezkel landau (1714-1793) relied on the clear reference to annual accounting to argue in favor of a one-year accounting period for maaser kesafim, where all losses and gains during the year may be netted. rabbi auerbach concurred.162 163 in contrast, rabbi yaakov reicher (c. 1670-1733) relied on the same passage to conclude that transactional accounting is required for maaser kesafim. despite the clear reference to annual periods, he determined that each year was analogous to a separate transaction. as it was improper to use crops from one year to satisfy the tithe of another year, just so, he determined that it 194 florida tax review [vol. 8:1 164. shvut yaakov no. 84, mk at 77-8. others who support transactional accounting for maaser kesafim include rabbi shlomo laniado (d. 1793) (who reached the same conclusion by distinguishing the talmudic partnership laws), beth dino shel shlomo, yoreh de’ah no. 1, mk at 78-9, and rabbi seligman baer bamberger (18071878). see yad halevi, yoreh de’ah no. 131, mk at 79. 165. see, also ahavath chesed, ch. 18, mk at 50 (in which rabbi yisrael meir hacohen (1838-1933) argues that six months is desirable, but one year acceptable). 166. see, e.g., rabbi shlomo laniado (d. 1793), beth dino shel shlomo, yoreh de’ah no. 1, mk at 78-9. 167. once maaser has been separated, it is dedicated to god and cannot be used for other purposes. see beth lechem yehudi, yoreh de’ah no. 249, mk at 78. 168. see part iv.b.3, supra. was inappropriate to offset gains and losses from different transactions. under164 this approach, the “accounting period” is the duration of a given transaction, where only income and expenses from that transaction may be netted together. other rabbis looked to the partnership accounting rules to develop the rules for maaser kesafim. for instance rabbi ya’ir chaim bachrach (16831701) noted that, in partnership law, losses and gains from different deals could be netted so long as they were part of one contract between the partners, such that the different deals were “mutually liable.” thus, where transactions were interconnected, he would allow netting for maaser purposes. however, as the time between the transactions grew, the case for netting seemed weaker and weaker. thus, he recommended establishing an accounting day every three to six months for purposes of determining the amount of maaser owed. others165 rejected the analogy to talmudic partnership rules and instead argued that transactional accounting was required.166 still others have articulated the view that the accounting period for tithing should follow the accounting method the person has adopted for his business, a rule similar to the early tax regulations. thus, as rabbi katz (16161678) explained, if a person has accounted for a loss on his books, then he may not later use the loss to offset a gain. however, if he has not made an account, but rather determines the total income and expenses for the year together at the same time, then he may offset losses against gains as part of that accounting. rabbi zvi ben azriel of alik (c. 1720) concurred but noted that, if maaser has in fact been separated from an earlier gain, it cannot be used to offset a loss, regardless of how the books are kept.167 in many regards, the rabinnic analysis of accounting periods is similar to the concern the taz raised above in connection with the deductibility of civil taxes. if one is allowed to net losses against gains for purposes of determining168 one’s income, the amounts available for maaser are reduced. this is economically equivalent to using maaser money for inappropriate purposes, in this case the covering of business losses. accordingly, most rabbis concurred that netting should be strictly limited to prevent this outcome and pushed for short accounting periods or even transactional accounting. 2007] maaser kesafim and the development of tax law 195 169. for ease of reference, i refer here only to gifts, even though the same rules apply to inheritances.. v. analysis as should now be evident, those who created the laws of maaser kesafim struggled with the same basic issues as those who crafted the federal tax laws. the rules the rabbis developed are often similar to our tax laws, though significant differences exist. these differences stem from a number of causes, including (1) the concerns, or lack thereof, regarding compliance and enforcement, (2) the different sources of legal authority and the structure of the legal systems itself, and (3) the values underlying and motivating the different systems. in this part, i explore the ways in which these factors affect the development of tax law. a. the effect of compliance and enforcement concerns on the development of tax law one of the key differences between the federal tax system and maaser kesafim is the need for enforcement. compliance with the tithing laws is left to the individual, who generally views it as a sacred obligation. god acts as the arbiter over whether the individual properly fulfilled his obligation. accordingly, the practice lacks any human audit function or enforcement mechanisms. the lack of enforcement concerns allowed the rabbis to develop rules that accurately reflect theoretical notions of income, but which would be largely unworkable if they had to be administered. in contrast, the government must enforce the tax laws against a population that largely resents the obligation and constantly seeks ways to avoid it. thus, the tax laws must take into account compliance norms, the resources available to administer the laws, and the government’s ability to evaluate and adjudicate taxpayer claims in a fair and consistent manner. these concerns cause the federal tax laws to deviate significantly from ideal notions of income, as authorities adopt broad, brightline and objective rules that are capable of enforcement. in this section, i explore the impact compliance and enforcement concerns have on the development of the law by comparing the tithng and tax rules for gifts, returned property and meals, all of which were described in169 greater detail above in part iv. the different gift exclusion rules found in tithing and the federal income tax clearly bear the stamp of enforcement concerns, or the lack thereof. i begin with the tithing rules. although the rabbis recognized that gifts normally should be included in income, they crafted limited exceptions for gift recipients who would suffer undue hardship if they had to tithe on the receipt of a noncash gift. thus, the rule deviates from the ideal, but only as much as is necessary to account for liquidity concerns. each individual decides for himself 196 florida tax review [vol. 8:1 170. see part iv.a.1, supra, for a more complete description of these rules. 171. see supra note 85. 172. it also avoids the game playing that might arise were the rule more narrowly crafted. for instance, if cash gifts were included in income, while non-cash gifts were excluded, people might purchase property, give the property, and have the recipient sell it to recover the cash. given the government’s revenue requirements and need to protect the tax base, rules targeted to specific policy concerns would likely require anti-abuse rules, which could significantly complicate the tax code and impose significant compliance costs. whether the exclusion applies to his situation, a determination that may depend on his unstated intent (or lack thereof) to purchase the gift for himself and possibly his subjective valuation of the gift.170 simply recounting the steps that would be necessary to resolve a dispute reveals how unworkable these rules would be in a system where the rabbis, or some other authority, sought to enforce the obligation to tithe. at the outset, one would have to determine whether the gift recipient intended to purchase the gift for himself. if the answer were yes, he could not claim that tithing on the receipt causes liquidity problems and would have to include the value of the gift in income. each individual whose decision to exclude a gift from income was challenged would claim that he did not intend to buy the gift for himself, and the government would be hard pressed to prove otherwise. the same problem would arise if the person conceded that he was going to buy the gift, but claimed that he would have spent far less than the value of what he received and therefore should tithe on the lower value. assuming the government conceded that the recipient did not intend to buy himself the gift in question, it would nonetheless still be necessary to make an individualized determination as to whether tithing on the gift would cause hardship. this would require a detailed inquiry into the recipient’s income and financial obligations. litigating this question would require significant resources, similar in many regards to the inquiry now undertaken in the context of the irs’s offer-in-compromise program, where it considers whether taxpayers have sufficient assets to pay their past-due tax liabilities. thus, it171 would be necessary to determine which financial obligations are allowable in determining hardship, the amount allowable for each type of allowed obligation, etc. unlike the irs, the religious authorities lack the manpower and resources to conduct such inquiries. in contrast, the internal revenue code contains a blanket exclusion of all gifts. while this rule deviates significantly from the definition of income the supreme court has embraced, it obviates the need for the types of inquiries described above. thus, it is easy to administer. to be sure, the exclusion of172 all gifts requires one to distinguish between gifts and other types of transfers, a task that admittedly raises administrative difficulties and must be done on a case-by-case basis. however, even here, the task is easier than what would be required to enforce the tithing rule. 2007] maaser kesafim and the development of tax law 197 173. comm’r v. duberstein, 363 u.s. 278, 285-86 (1960). 174. this is not to say that the internal revenue code is devoid of difficult to administer rules. a number of tax outcomes depend on a taxpayer’s intent, such as with gifts, reasonable compensation, and whether property is held for appreciation or for sale to customers. however, the courts and congress have attempted to develop objective criteria, presumptions and bright-line rules to help guide such inquiries. see, e.g., suburban realty co. v. u.s., 615 f.2d 171, 177-79 (5th cir. 1980) (establishing factors to be used to determine whether property is held for investment); exacto spring corp. v. comm’r, 196 f.3d 833, 838-39 (7th cir. 1999) (establishing an objective test to determine whether compensation is reasonable); irc § 1237 (capital gain treatment for certain real estate sales); irc § 183(d) (creating a presumption regarding profit seeking motives in the hobby-loss context). see also edward yorio, federal income tax rulemaking: an economic approach, 51 fordham l. rev. 1, 48-49 (1982) (advocating replacing rules based on taxpayer intent with more efficient economic tests). 175. see part iv.a.2, supra. the characterization of a transfer as a gift turns on the donor’s intent.173 however, unlike the question of whether someone intended to buy himself a gift, determining whether something is a gift may be done in a somewhat objective manner. for instance, it is possible to observe whether the donor received anything back in return for the purported gift. this ability to rely on objective evidence means that the court’s determination of a donor’s intent is far more likely to be accurate than the assessment of a gift recipient’s intent. in the one area where it may be most difficult to determine intent and where controversies are most likely to arise, i.e., gifts from employers to employees, congress created a bright-line exception to the exclusion, including all such gifts in income. while this rule is overbroad – it undoubtedly leads to taxation where true gifts are intended – it simplifies matters by avoiding the need for difficult inquiries. 174 the lost property rules provide another example of how enforcement concerns affect the development of the law. the question of whether to175 include returned property in income for tithing purposes depends entirely on whether the person receiving the property ever gave up hope of recovering it. while it might, under some circumstances, be possible to asses whether someone intended to buy himself a gift, there is simply no way to determine someone’s innermost hopes regarding property that might have been lost fifty years earlier. nonetheless, the rule is designed to ensure that only “new” receipts are subject to tax. such a rule would be unthinkable in the context of the federal income tax, as taxpayers would have every incentive to claim that they had not given up hope of recovery, and the government would be unable to gainsay such a claim. in light of these concerns, it is not surprising that the federal income tax rule is objective and therefore capable of administration. it requires taxpayers to include returned property in income only if they previously received a tax benefit associated with the loss of the property. in the case of holocaust 198 florida tax review [vol. 8:1 176. see note 92, supra. 177. see part iv.b.2, supra. reparations, for which it seems extermely unlikely that a federal tax loss deduction was taken, federal tax law simply excludes all recoveries, a rule far176 more lenient and easier to enforce than the intent-based rule described above. finally, the different business meal rules found in tithing and federal income tax reflect the effects of enforcement concerns on the development of the law. the federal tax rules reflect a progression from the theoretically177 correct, but difficult to administer, law to an arbitrary, bright-line rule allowing a deduction of only 50% of business meal costs. not only was the original rule difficult for the taxpayer, as he had to determine what portion of his expense he would have incurred absent the business need, but it was impossible to police should a dispute arise, as the government would have had a very difficult time demonstrating what the taxpayer would have incurred absent the business need. the current rule eliminates these problems while recognizing that some portion of the expense is personal and therefore should not be deducted. in contrast, the rabbis who considered the rules for tithing purposes did not need to consider enforcement. as a result, they were free to adopt difficult to administer rules. while some rabbis argued that either none or all of the expenses should be deductible, many argued for a more nuanced position. for instance, rabbi auerbach in the late twentieth century endorsed the excess cost rule, which federal tax authorities abandoned in 1921 as too difficult to enforce. rabbi reicher endorsed an even more difficult rule, one based on whether the person incurring the expense intended to conduct business. he reasoned that profits earned from unintended business were miraculous, and therefore analogous to agricultural tithing. just as agricultural tithing allows no deductions owing to the miraculous nature of the income, just so maaser kesafim should provide no deductions for unintended income. given the difficulties of determining intent, such a rule would be unworkable if the obligation were enforced. to characterize the judaic tithing system as one in which enforcement is of no concern overstates the situation. a more accurate statement might be that, in this religious system, the authority to enforce the law belongs to god. god has both the right and ability to enforce compliance and to mete out punishment for failure to comply. his resources are limitless, rendering irrelevant concerns regarding the cost and energy necessary for case-by-case analysis. his omniscience makes concerns about unverifiable intent irrelevant. thus, the difference between the two systems is not that one is enforced, while the other is not. rather it comes down to the resources and efficacy of the enforcer. the reliance on broad, bright-line rules in the federal tax system reflects the limited capacity of humans to fund enforcement efforts and doubt as to whether such efforts will yield accurate determinations. 2007] maaser kesafim and the development of tax law 199 178. compania gen. de tabacos de filipinas v. collector of internal revenue, 275 u.s. 87, 100 (1927) (holmes, j., dissenting). 179. helvering v. gregory, 69 f.2d 809, 810 (2nd cir. 1934) (citations omitted), aff’d, 293 u.s. 465 (1935) (“[a] transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one choose, to evade, taxation. any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the treasury; there is not even a patriotic duty to increase one’s taxes.”). 180. see, shailagh murray, for a senate foe of pork barrel spending, two bridges too far, washington post, oct. 21, 2005, p. a08. the need for, and limitations of, human enforcement of the federal tax laws suggest a more fundamental reason for the differences between u.s. tax and jewish tithing laws: the different compliance norms observed by members of the two communities (e.g., taxpayers and tithers). given the religious nature of the tithing obligation and the special status it holds (one who tithes is promised earthly riches), one would expect willing and honest compliance with the rules. in contrast, as evidenced by the large tax gap, i.e., the difference between what is owed in taxes each year and what is actually paid, the tax laws do not inspire similar devotion. thus, to a large degree, the concessions made for enforcement purposes reflect the underlying sense that taxpayers cannot be trusted to report and pay the proper amounts. if taxpayers could be trusted to report their income accurately, the difficulties of enforcement would diminish in importance, and the rules might well change in response. the compliance norm in this country reflects a strong impulse to avoid paying taxes whenever possible. thus, while justice holmes famously stated that he did not mind paying his taxes because they are the price we pay for civilization, a more accurate reflection of the sentiments of most american178 taxpayers is judge learned hand’s statement that one does not have a patriotic duty to pay more in taxes than is absolutely necessary. unfortunately, as seen179 in the continuing difficulties witht abusive tax shelters, this aversion often manifests itself as improper evasion. there are certainly many reasons for weak compliance norms and tax avoidance in the u.s., but one factor contributing to a lack of compliance is that the government decides how taxes will be spent. given the variety of government expenditures, which include defense spending, spending on social programs, and earmarks for “bridges to nowhere,” it is likely that a person180 will disagree with the use to which at least some portion of the money is put, decreasing the incentive to comply or even providing a moral justification for tax avoidance or evasion. when combined with the knowledge that audits are rare and that the government’s success in such audits is limited, significant incentives for cheating, or, at least, taking aggressive positions, is quite strong. under these circumstances, rules that give a taxpayer significant discretion to decide whether he has income or which are based on intent are likely to lead to an understatement of income. even if taxpayers do not 200 florida tax review [vol. 8:1 181. taxpayers voluntarily report their income to the government, and they do get to decide for themselves in some cases whether they are entitled to deductions. for example, taxpayers determine in the first instance whether stock is worthless or whether debts are unrecoverable. see irc §§ 165(g) and 166. nonetheless, such decisions are reviewable and judgments can be made based on evidence other than the taxpayer’s intent or subjective belief. thus, while some discretion exists, it is nothing like the jewish tithing rules described in the text above. 182. see supra note 57. 183. see gordon b. dahl and michael r. ransom, does where you stand depend on where you sit? tithing donations and self-serving beliefs, 89 the am. econ. rev. 703 (sept. 1999). 184. id. at 704-05. 185. see id. at 704. 186. id. at 706. intentionally cheat, they will likely decide in their own favor in close cases. thus, the federal income tax rules generally contain few provisions that give such discretion to the taxpayer and which are difficult to enforce.181 in contrast, the obligation to tithe represents a commandment from god and is a part of the religious morality of jews and christians. as noted above in part iii, tithing is the one area where one is allowed to test god. the more one tithes, the richer one may expect to become. thus, there is a special incentive182 to fulfill this obligation. in addition, many of the factors that may lead to a poor compliance norm in the u.s. are absent for tithing. for instance, though jewish law establishes the general uses of the tithes, those who tithe have a great deal of discretion about where and how to distribute their money, eliminating the sense that the money is being misspent. this is not to say that in close cases self-interest will not sometimes sway a tithe-payer, but one who voluntarily undertakes the obligation to tithe because he believes that god commands and encourages it is not likely to cheat when it comes to determining his income. while this observation make intuitive sense, two recent studies provide empirical support. the first study, by gordon dahl and michael ransom, surveyed 1,200 members of the church of latter day saints to test how financial self-interest affected how those who tithed defined income. like183 judaism, the church of latter day saints includes a tithing obligation. members are required to attest to their bishop each year that they have tithed. unlike184 judaism, the church of latter day saints intentionally declines to define income, leaving it up to the individual to fashion his or her own definition.185 dahl and ransom set out to test whether people would make decisions consistent with their financial self-interest. they created a number of hypothetical choices and asked participants to indicate whether they would include the hypothetical items in income for tithing purposes. based on the186 responses, they concluded that the church members’ choices did not correspond 2007] maaser kesafim and the development of tax law 201 187. interestingly, the income definition that emerges from the survey corresponds closely to what we see in the federal income tax and maaser kesafim. it is not clear whether this reflects knowledge of the income tax rules or reflects a more intuitive sense of what counts as income, and when exceptions from the general rules make sense. 188. mcgee, robert w. and gordon cohn m. (2007) jewish perspectives on the ethics of tax evasion, academy of accounting and financial studies journal, forthcoming. 189. id. the study revealed that, even though students generally favored compliance, even when the taxes were used for unjust purposes, the strength with which they favored compliance was far less than under other circumstances. id. at 26-36. this finding supports the notion that those who tithe will have a stronger compliance norm than those who pay taxes because of the ability to control what the money is spent on. 190. gordon cohn, the jewish view on paying taxes, journal of accounting, ethics & public policy 1(2) 109-120 (1998); meir tamari, ethical issues in tax evasion: a jewish perspective, journal of accounting, ethics & public policy, 1(2) 121-132 (1998). 191. this is not to say that every religious jew gladly gives away up to 20% of his income annually and that there is no avoidance behavior. the responsa literature deals with many questions aimed at determining precisely what the obligation entails, and it can be assumed that many of these questions stem from a desire to do what is required and no more. however, once the rules are known, the likelihood of outright cheating is less than what one would expect in civil taxation. to their financial self-interest. while this study focuses on mormons, nothing187 about it suggests that this finding would be specific to mormons. a second study, this time of jewish attitudes towards tax evasion, strongly supports the conclusion that the compliance norm among religious jews is quite strong. robert mcgee and gordon cohn conducted a survey of orthodox jewish students at a branch of tuoro college in new york. they188 found that, these students were strongly opposed to tax evasion, even where the taxes were used for unjust purposes. this empirical finding is consistent with189 the opinions of two seminal articles describing jewish ethics of tax evasion from a theoretical perspective. while compliance with the obligation to pay state190 taxes is different from compliance with the tithing obligation, it is hard to imagine that the compliance norm would differ significantly.191 the net effect of these differences in compliance norms on the development of the law is that the laws of tithing more closely mirror ideal or theortical constructs of income than the federal tax counterparts. jewish authorities can entrust to those who tithe signfiicant discretion to determine what constitutes income or whether they are entitled to a deduction. thus, the extensive use of intent-based rules. in contrast, federal tax authorities routinely act to remove discretion and craft rules that are easy to administer, causing the federal tax definition of income to deviate signfiicantly from ideal notions of income. 202 florida tax review [vol. 8:1 192. for instance, in comparing the relative complexity of u.s. and european tax law, thuronyi has noted that the relative lack of party discipline in the u.s. and the power afforded to individual legislators, either by virtue of committee participation or through the loose legislative process, may well account for the relative complexity of u.s. law. thuronyi, supra note 9 at 20. shaviro reaches a similar conclusion in his effort to assess whether a consumption tax capable of passage in the current political climate will be as simple as consumption tax proponents suggest. his pessimistic conclusion is that sufficient political pressures exist such that any consumption tax that results from the legislative process will deviate significantly from an ideal consumption tax and that such deviations will be the source of significant complexity. daniel shaviro, simplifying assumptions: how might the politics of consumption tax reform affect (impair) the end product? (april 2006). (nyu, law and econ. research paper no. 0617, 2006), at ssrn: http://ssrn.com/abstract=896160. 193. for instance, congress has expressly prohibited a deduction for the first phone line into a house, even if it is used for business purposes. irc § 262(b). 194. deut. 4:2. b. the effect of the legal system on the development of tax law several scholars have noted that the structure and characteristics of a legal system, as well as the politics attendant to it, can have a significant impact on the formation of the law. such effects can readily be seen in the tithing and192 tax rules compared above. at the same time, despite significant differences in structure and underlying legal authorities, because the policies underlying the rules are often similar, the legal analysis is often similar, and significant convergence of the laws is possible. this part begins by outlining the major differences between the two legal systems and then explores how those differences have affected the development of the law. the u.s. and jewish legal systems differ in two major ways. first, the u.s. system gives congress legislative power to change the law at will. thus, congress is able to eliminate ambiguities in the law, amend the law to respond to changing circumstances and new developments and address even the smallest details. in contrast, jewish law is based on god’s revelation on mt. sinai, and193 that law may not be changed in any regard. indeed, it is forbidden to add to or subtract from god’s law. instead, the rabbis must develop the law as part of194 an interpretive process, where each rule is seen to derive from the torah or talmud. second, and equally important, the u.s. court system is organized in a hierarchical manner, while the jewish legal system lacks a formal structure that encompasses all decision makers. as a result, in the u.s., a mechanism exists for resolving disputes and creating uniformity in the law, even absent legislation. in contrast, no mechanism within judaism exists that permits one rabbi to bind others or compel adoption of, or compliance with, a given legal interpretation. thus, rabbinic opinions are only as compelling as the reasoning they contain, and disputes among rabbis regarding what the law requires or allows can never be ultimately resolved. 2007] maaser kesafim and the development of tax law 203 195. irc § 7872. 196. examples of social policy/special interest provisions include those supporting home ownership and education, as well as provisions specifically aimed at the oil and gas industries. see, e.g., irc §§ 121, 25a, and § 611 et seq. 197. where the torah or talmud speaks directly to a question, the rabbis do not have such leeway. for instance, the talmud clearly prohibits using inflation adjusted amounts to determine whether interest is being paid. b. talmud, bava metzia, ch 5. thus, while rabbi feinstein was able to incorporate inflation into the laws of tithing, he was unable to do so with regard to the interest rules. a key consequence of these differences is that the federal definition of income deviates signficantly from ideal notions of income, while the jewish definition tracks the ideal far more closely. the leglislative power gives congress the ability to amend the law to incorporate new economic insights and address new situations, thereby causing the income definition to better approximate ideal notions of income. for instance, in 1984 congress amended the tax law to include imputed interest payments in income for below-market loans, once the economic realities of such loans were fully understood.195 however, more often than not, congress uses this power to cause the law to stray from economic theory and ideal notions of income. as described above in part v.a, some of these deviations reflect concessions to administration and enforcement concerns, such as the decision to tax nominal gains, exclude allgifts from income or create a bright-line, partial deduction for business meals. others reflect political pressures brought to bear on congress to promote social policies external to tax and to benefit special interests. 196 in contrast, the interpretive process and lack of hierarchy in jewish law limit the ability of the rabbis to change the law or add provisions unrelated to pure income measurement. as seen in rabbi feinstein’s decision to allow tithes to be paid on real, as opposed to nominal, gains, the rabbis have some ability197 to incorporate economic insights. however, because they seek to ground each decision in the torah and talmud, they must fit the insight within an preexisting rule. one consequence of this limitation is that the laws of tithing are devoid of arbitrary and bright-line compromises, such as the 50% meal deduction found in the internal revenue code. similarl, when the rabbis felt compelled to create exceptions to the general rules – as in the case of illiquid gifts and inheritances – they could not simply create a new rule. rather, they grounded their exceptions in principles inherent in the practice and limited the exceptions so as to deviate as little as possible from the theoretically correct rule. the legal structure also explains the absence of social policy and special interest provisions in the tithing rules. simply put, it is hard to derive a deduction for alternative fuel cars from the torah and talmud. and, even if some rabbi felt inclined to find such a deduction in the ancient texts, the lack of hierarchy would make it difficult for him to introduce such a change. only those decisions well grounded in the torah, talmud or other respected authorities are 204 florida tax review [vol. 8:1 198. where one finds authorities on point, this leeway is somewhat curtailed. however, even then, room for innovation exists. for instance, as described in part iv.a.1, when rabbi bamberger sought to exclude gifts of land from the maaser obligation, he was faced with authority that clearly included land when determining one’s charitable obligation. he was able to distinguish this authority to achieve his desired result by differentiating between the tzedakah obligation and the maaser obligation. 199. see part iv.b.3, supra. likely to garner support from other rabbis. thus, the power to innovate is quite circumscribed. this is not to suggest that the rabbis were completely powerless to affect the law. indeed, one of the surprising results of this study is how flexible jewish law is and able to adapt to modern developments. the power of the rabbis to affect the law derives from two sources. ironically, the first is the interpretive process, which was seen to limit the rabbis’ power above. the second is the status of the practice as rabbinic or customary. the interpretive process permits significant leeway for creative jurists. where the underlying authorities are silent on a given issue, as is often the case with the issues raised in maaser kesafim, resort must be made to analogies. the more attenuated the analogy, the more leeway exists for creative argument. in such cases, it becomes clear that principles are often more important than the actual authorities on which the rabbis rely. to the extent these principles are198 the same as those that underlie the federal tax system, one would expect and does find that the legal analysis converges, despite differences in the underlying authorities. this effect can clearly be seen in the debates over civil taxes and accounting periods. the rabbis derived the rules regarding the deductibility of civil taxes from analogies to pe’ah, the practice of leaving the corners of the fields unharvested so that the poor may eat, and to talmudic passages not ostensibly related to taxation. the rabbis disagreed regarding whether the199 analogy to pe’ah was warranted and, if so, whether it could properly be extended to cover both income and sales taxes. underlying the citations to the bible and talmud are various principles, such as taxpayer control and autonomy, that guide the analysis. these are the same principles that arise in the federal tax discussion over whether to allow a deduction for state income taxes. given the special nature of pe’ah, and the differences between income and sales taxes, the process of deriving the rules by analogy provided the rabbis with significant opportunities to craft the law. to the extent that the rabbis looked to the same principles underlying the federal tax law, they arrived at similar conclusions. the debate over the proper accounting rules reveals the same creativity and opportunity to shape the law. absent a direct statement regarding the proper accounting period, rabbis sought out analogous situations to determine the appropriate rule. some relied on analogies to agricultural tithing, while others 2007] maaser kesafim and the development of tax law 205 200. see, e.g., maharil, responsum no. 54, mk at 27 (“for this reason maaser kesafim, which is rabbinic, has a particular leniency.”). relied on analogies to partnership law. even where the rabbis relied on the same passages, they often reached opposite conclusions, revealing the latitude possible in the absence of legislative authority. further, the lack of legal hierarchy made it impossible to resolve the differences of opinion. nonetheless, the modern, mainstream view appears to be the one-year accounting period adopted for federal tax purposes. in the case of maaser kesafim, the ability of the rabbis to innovate is enhanced by the perceived source of the obligation. numerous rabbis have pointed out that the obligation is not a torah obligation, meaning that it need not be strictly enforced. in his discussion of how to treat civil taxes, rabbi200 weiss expressly noted that the customary origins of maaser allowed him to craft a reasonable rule and permit deductions that might not otherwise be allowed. although not acknowledged, the rabbis who exclude non-cash gift from income are essentially enforcing the rule of income inclusion more leniently than they might a torah obligation that required the inclusion of gifts. c. the effect of cultural values on the development of tax law the comparison of tithing and tax rules also reveals how a society’s values can play a significant role in the development of the law. the federal tax rules are motivated to a large degree by concerns over horizontal equity, the idea that similarly situated people ought to be treated the same. such concerns play virtually no role in the development of the tithing law. instead, the rabbis are concerned that each individual fulfill his obligation to god, regardless of how others might be treated. the effect these different values have on the development of the law can best be seen by comparing the discussions concerning the accounting period rules and the propriety of deducting state sales taxes. as described above in part iv.c, the use of accounting periods may lead to inequitable results. in particular, two people who earn the exact same total amount may end up with vastly different tax burdens depending on when they earn their income and incur their expenses. problems may be exacerbated if the tax system uses progressive rates, as income bunched in one year may be taxed at a higher rate than the same income spread out over many years. this result violates the principle of horizontal equity. to remedy this concern, the trend in both the legislature and courts has been to break down the separation between tax years and allow netting from one year to the next. thus, the current rules reflect a desire to ensure that those who earn the same amount over time pay the same amount of tax. some scholars have proposed going even further to address concerns regarding horizontal equity. for instance, william vickrey proposed that 206 florida tax review [vol. 8:1 201. william vickrey, averaging of income for income tax purposes, 47 j. pol. econ., 379-97 (1939). 202. from 1964 to 1986, the internal revenue code contained limited income averaging provisions. see generally boris i. bittker and lawrence lokken, federal taxation of income, estates and gifts (rev. 3d. ed.) vol. 4a, ¶ 111.3.10, (for a description of these provisions). 203. see generally, e.g., lily l. batchelder, taxing the poor: income averaging reconsidered, 40 harv. j. on legis. 395 (2003); neil h. buchanan, the case against income averaging, 25 va. tax rev. 1151 (2006). 204. see part iv.b.3, supra. income should be averaged over a taxpayer’s lifetime and taxes adjusted accordingly. under this proposal, there would still be an annual tax year, but201 the years would lose their independent quality. in essence, taxpayers would carry over their income and taxes paid from year to year, adding the current year’s income to all previous income and dividing by the number of years of income, to determine taxable average income. under this proposal, two202 people with the same lifetime income would pay the same in taxes, regardless of when they actually earned their income, thus ensuring that the requirements of horizontal equity, when measured over a person’s lifetime, was satisfied. this idea continues to receive significant attention from scholars.203 in contrast, jewish religious authorities focus on preventing people from netting losses against gains in a way that would lead to the improper use of maaser. such money should go to the poor. it cannot be used to offset one’s business losses. netting reduces the amount available to the poor, and therefore is tantamount to using maaser for improper purposes. several rabbis have suggested shortening the accounting period from one year to six or even three months to avoid netting across long periods of time. other rabbis have rejected the notion of an accounting period altogether, favoring transactional accounting instead. under such a system, people must separate maaser after each transaction and may not use a subsequent loss to reduce the prior amount of gain. the result of these rules is that two people earning the exact same amount of money over some period will likely separate out different amounts of maaser. unlike the congress, the courts, and tax scholars, the rabbis are simply not concerned with this result. consequently, the halacha is devoid of discussions about income averaging and proposals to expand accounting periods beyond one year. the discussions of whether to allow a deduction for sales taxes similarly reflects the different values at play in the two systems. the federal tax204 provisions that previously allowed a deduction for state income taxes, but not for state sales taxes, were seen as creating an unwarranted preference for income taxes and as unfair to those states and their residents that did not have such taxes. thus, congress decided to allow a deduction for state sales taxes to achieve horizontal equity by treating all state taxes the same. thus, the decision 2007] maaser kesafim and the development of tax law 207 was motivated by federalism and a desire to treat people similarly, regardless of whehter their state used an income or sales tax to raise revenues. in contrast, the halachic discussion of whether to allow a deduction for state sales taxes focuses solely on perceived differences between the income and sales taxes and the control a person has over the money he earns. state income taxes are deductible because they were owed as the income was earned. thus, the person paying such taxes never really had control over the money paid to the state. in contrast, sales tax is owed only if a person decides to spend his money on something covered by the tax. until such time, the money is under the control of the person who earns it. questions of horizontal equity or federalism simply do not arise, leading to a general rule that precludes deductions for sales taxes. vi. conclusion maaser kesafim functions as an income tax, similar in many regards to our own. despite the different circumstances under which the tithing and tax rules were developed, the specific income definition rules and the logic underlying them are strikingly similar. nonetheless, significant differences exist. the study of maaser kesafim thus provides a wonderful opportunity to explore the ways in which the culture and context of a tax system affects its development. in particular, comparing the income definitions developed for both systems reveals the ways in which compliance and enforcement concerns, the legal system itself, and cultural values shape the tax law. the need for enforcement and congress’s legislative powers cause the federal income tax to deviate significantly from ideal notions of income. in some cases, these deviations serve to simplify the tax laws, while in others, they serve to create additional complexity. in contrast, the lack of enforcement concerns, coupled with a lack of legislative authority, causes the tithing laws to hew far more closely to ideal conceptions of income, as the rabbis did not feel empowered to create arbitrary, but enforceable, rules or to graft extraneous provisions into the tithing laws. nonetheless, the rabbis demonstrated considerable ability to shape the law, as they worked to derive the tithing rules from the ancient, and often silent, sources. these observations are important as we consider serious tax reform, especially if our goal is to reduce tax complexity. it is likely that the same need for enforcement, legal structure, and cultural values that currently bear on our income tax will come to bear on any new tax system we devise. thus, we can expect that enforcement concerns will cause the tax base definition to deviate from the ideal to create an administrable tax; congress will likely graft provisions to promote social policy onto the tax system, thus complicating the code and people’s ability to comply; special interest legislation will likely arise, further complicating the laws; and society’s underlying values, such as 208 florida tax review [vol. 8:1 205. see, e.g., blum & kalven, the uneasy case for progressive taxation, u. chi. l. rev. (1952). professors blum and kalven assert that progressivity “produces a tax law of almost impenetrable complexity. it invites a distorting attention to the tax aspects of any economic transaction. it affords an excessive stimulus to tax avoidance with perhaps incalculable consequences for taxpayer morale and the general respect for the law.” id. at 434-35. see also charles galvin & boris bittker, the income tax: how progressive should i be? 16 (1969) (“[f]or the principle of progressivity we pay a high price in the extraordinary complexity of our present system.”). 206. see, e.g., office of the sec’y, dep’t of the treadury, tax reform for fairness, simplicity, and economic growth: the treasury department report to the president at 180-81 (1984) (describing the capital gains preference as a “source of substantial complexity”); daniel l. simmons, the tax reform act of 1986: an overview, 1987 byu l. rev. 151, 179 (“not only did [the capital gains] preference provide a major advantage to a form of realized gain, it was perhaps the greatest single contributor to complexity in the internal revenue code. elimination of the capital gains preference may be one of the most significant features of the 1986 act.”). 207. see supra note 10. 208. the agricultural tithe applied only to produce, required in-kind payment, and raised a host of measurement issues not seen in modern income tax systems. horizontal equity, will likely affect the development of the law. thus, despite the promise any tax reform might offer, over time there is a strong likelihood that any new tax system may end up looking quite similar to the current system. more to the point, the comparison of maaser kesafim and the federal income tax refutes claims that flat rate taxation necessarily avoids much of the complexity that plagues our current income tax. critics of progressivity have argued that graduated tax rates should be eliminated because they are a major source of tax complexity. critics of the capital gains tax preference have made205 similar claims. in agricultural tithing and (flat) tax complexity, i used206 207 agricultural tithing, which employs a flat 10% rate, to demonstrate that tax systems lacking such features could also be quite complex. however, because agricultural tithing differs in so many regards from our own income tax, it208 might be tempting to dismiss the comparison as inapposite. the study of maaser kesafim provides another opportunity to explore the complexity of single-rate tax systems, this time with a tax system that closely mirrors our own. as demonstrated above, even absent the difficulties associated with progressive rates or preferential treatment of capital gains, income definition issues generate significant complexity. thus, as we consider tax reform, we should be wary of assertions that removing progressivity from the current tax code or eliminating the capital gains tax preference will necessarily produce a simple tax system. while such changes would likely reduce some of the complexity in the current rules, a study of the rules of maaser kesafim suggests that significant complexity is simply unavoidable. maaser kesafim and the development of tax law microsoft word 1st 5 pages.doc florida tax review volume 10 2010 special issue 79 recent developments in federal income taxation: the year 2009 by martin j. mcmahon, jr.* ira b. shepard** daniel l. simmons*** i. accounting ............................................................................ 84 a. accounting methods ........................................................... 84 b. inventories ........................................................................... 85 c. installment method ............................................................. 85 d. year of inclusion or deduction ........................................... 85 ii. business income and deductions ..................................... 88 a. income ................................................................................. 88 b. deductible expenses versus capitalization ......................... 91 c. reasonable compensation .................................................. 97 d. miscellaneous deductions ................................................. 101 e. depreciation & amortization ............................................ 105 f. credits ............................................................................... 107 g. natural resources deductions & credits .......................... 115 h. loss transactions, bad debts, and nols ......................... 116 i. at-risk and passive activity losses................................. 122 iii. investment gain and income ........................................... 125 a. gains and losses ............................................................... 125 b. interest, dividends, and other current income ................. 131 c. profit-seeking individual deductions ............................... 134 d. section 121 ........................................................................ 135 e. section 1031 ...................................................................... 135 f. section 1033 ...................................................................... 137 g. section 1035 ...................................................................... 137 h. miscellaneous .................................................................... 137 iv. compensation issues .......................................................... 138 a. fringe benefits .................................................................. 138 * stephen c. o’connell professor of law, university of florida, fredric g. levin college of law. ** professor of law, university of houston law center. *** professor of law, university of california at davis, school of law. 2010] recent developments in federal income taxation 80 b. qualified deferred compensation plans ........................... 138 c. nonqualified deferred compensation, section 83, and stock options ............................................................. 139 d. individual retirement accounts ........................................ 139 v. personal income and deductions .................................. 140 a. rates .................................................................................. 140 b. miscellaneous income ....................................................... 140 c. hobby losses and § 280a home office and vacation homes ................................................................ 143 d. deductions and credits for personal expenses ................. 144 e. divorce tax issues ............................................................ 150 f. education ........................................................................... 151 g. alternative minimum tax ................................................. 151 vi. corporations ...................................................................... 152 a. entity and formation ......................................................... 152 b. distributions and redemptions ......................................... 152 c. liquidations ....................................................................... 157 d. s corporations ................................................................... 158 e. mergers, acquisitions and reorganizations ...................... 160 f. corporate divisions........................................................... 163 g. affiliated corporations and consolidated returns ........... 163 h. miscellaneous corporate issues ........................................ 166 vii.partnerships ....................................................................... 168 a. formation and taxable years ........................................... 168 b. allocations of distributive share, partnership debt, and outside basis .............................................................. 168 c. distributions and transactions between the partnership and partners .................................................... 172 d. sales of partnership interests, liquidations and mergers ............................................................................. 173 e. inside basis adjustments .................................................. 174 f. partnership audit rules .................................................... 174 g. miscellaneous .................................................................... 185 viii.tax shelters ..................................................................... 185 a. tax shelter cases .............................................................. 185 b. identified “tax avoidance transactions.” ............................ 204 c. disclosure and settlement ................................................. 204 d. tax shelter penalties, etc. ................................................. 204 ix. exempt organizations and chartitable giving ...... 209 a. exempt organizations ....................................................... 209 b. charitable giving .............................................................. 209 x. tax procedure .................................................................... 211 a. interest, penalties and prosecutions .................................. 211 b. discovery: summonses and foia .................................... 221 81 florida tax review [vol. 10:si c. litigation costs ................................................................. 228 d. statutory notice of deficiency .......................................... 229 e. statute of limitations ........................................................ 229 f. liens and collections ........................................................ 236 g. innocent spouse ................................................................ 240 h. miscellaneous .................................................................... 245 xi. withholding and excise taxes ...................................... 254 a. employment taxes ............................................................ 254 b. self-employment taxes ..................................................... 259 c. excise taxes ...................................................................... 260 xii.tax legislation ................................................................. 262 a. enacted .............................................................................. 262 2010] recent developments in federal income taxation 82 recent developments in federal income taxation: the year 2009 by martin j. mcmahon, jr. ira b. shepard daniel l. simmons this recent developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the most recent twelve months — and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted – unless one of us decides to go nuts and spend several pages writing it up. this is the reason that the outline is getting to be as long as it is. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide dan and marty the opportunity to mock our elected representatives; again, sometimes at least one of us goes nuts and writes up the most trivial of legislative changes. the outline focuses primarily on topics of broad general interest (to the three of us, at least) – income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. any and all of the many mistakes in this outline are marty’s responsibility; any political bias or offensive language is ira’s; and any useful information is dan’s. 83 one of us has recently bec indifferent to any of his ot vir and another of us has bee acknowledge that he’s old responsibility. lazar “la florida tax review [vol. 10:si come a grandfather, and he has become totally ther responsibilities, rginia june oakes mcmahon en a grandfather for over 18 months but still won’t d enough to have a grandchild or accept any other alo” james joseph simmons saadia 2010] recent developments in federal income taxation 84 i. accounting a. accounting methods 1. new and improved automatic consent procedures for changes of accounting methods. rev. proc. 2008-52, 2008-2 c.b. 587 (8/18/08). this revenue procedure provides automatic consent procedures for a wide variety of accounting method changes. rev. proc. 2002-9, 2002-1 c.b. 327, as previously modified and clarified, is clarified, modified, amplified, and superseded. (a) automatic consent updated. rev. proc. 2009-39, 2009-38 i.r.b. 371 (8/27/09). the irs has updated the procedures for obtaining automatic consent and advance consent to change accounting methods. a taxpayer who complies with applicable provisions of this revenue procedure has the irs’s consent to change an accounting method. the extensive list of changes is in the appendix. rev. proc. 97-27, 1997-1 c.b. 680, is modified and clarified, and rev. proc. 2008-52, 2008-2 cb 587 is amplified, clarified, and modified. • normally, when automatic consent is sought from the irs, there is no acknowledgment of the request. 2. is the public company accounting oversight board in the intensive care unit? free enterprise fund v. pcaob, 537 f.3d 667 (d.c. cir. 8/22/08) (2-1), cert. granted, 129 s. ct. 2378 (5/18/09). judge rogers held that the article ii appointments clause was not violated by having members of the pcaob appointed by the sec commissioners, nor was the separation of powers doctrine violated by the for-cause limitation on removal of pcaob members. • judge kavanaugh dissented strongly, stating: the two constitutional flaws in the pcaob statute are not matters of mere etiquette or protocol. by restricting the president’s authority over the board, the act renders this executive branch agency unaccountable and divorced from presidential control to a degree not previously countenanced in our constitutional structure. this was not inadvertent; members of congress designed the pcaob to have “massive power, unchecked power.” 148 cong. rec. at s6334 (statement of sen. gramm). our constitutional structure is premised, however, on the notion that such unaccountable power is inconsistent with individual liberty. “the purpose of the separation and equilibration of powers in general, and of the unitary executive in particular, was 85 florida tax review [vol. 10:si not merely to assure effective government but to preserve individual freedom.” morrison, 487 u.s. at 727 (scalia, j., dissenting); see also clinton v. city of new york, 524 u.s. 417, 450 (1998) (kennedy, j., concurring) (“liberty is always at stake when one or more of the branches seek to transgress the separation of powers.”). the framers of our constitution took great care to ensure that power in our system was separated into three branches, not concentrated in the legislative branch; that there were checks and balances among the three branches; and that one individual would be ultimately responsible and accountable for the exercise of executive power. the pcaob contravenes those bedrock constitutional principles, as well as long-standing supreme court precedents, and it is therefore unconstitutional. b. inventories there were no significant developments regarding this topic during 2009. c. installment method there were no significant developments regarding this topic during 2009. d. year of inclusion or deduction 1. god didn’t answer this trinity’s prayers. trinity industries, inc. v. commissioner, 132 t.c. no. 2 (1/28/09). the taxpayer, which was on the accrual method, built barges for customers, and part of the payment of the purchase price was contractually deferred until 18 months after delivery of each barge. the customers later claimed there were defects in other barges purchased previously and asserted common law rights to offset their claimed damages against the deferred payments. the taxpayer included only the payments actually received and excluded the uncollected deferred payments. the tax court (judge thornton) held that the full contract price was includable in the year the barges were delivered, and the amount could not be reduced by the amount withheld by the purchasers under their asserted right to offset claimed damages. the court reasoned that the offset claims affected only the timing of the taxpayer’s receipt of the sales proceeds, not its right to receive the proceeds. the taxpayer subsequently received the withheld amounts when, pursuant to a settlement agreement, they were applied in compromise of the purchasers’ claims for 2010] recent developments in federal income taxation 86 damages. furthermore, § 461(f) did not apply to allow the taxpayer to deduct the withheld amounts in the year of the sale because the withheld amounts were not “transferred” by the taxpayer, as required by § 461(f), and even if they were constructively “transferred” as asserted by the taxpayer – an argument that the court did not accept – the transfer did not occur in the year the barges were delivered, but in a later year. 2. thirty-five percent is not substantial here, even though it might be elsewhere in the code. nelson v. commissioner, 130 t.c. 70 (2/28/08). section 451(d) permits a cash method farmer who normally reports income from the sale of his crops in the year following crop production to elect to defer treating as income crop insurance proceeds received in a year until the following year. the taxpayers, who routinely reported only 65 percent of income realized from the sale of crops in the year of sale and 35 percent the following year (which the irs stipulated was an acceptable accounting method), were not permitted to defer reporting 100 percent the proceeds of crop insurance until the following year. the court (judge swift) applied rev. rul. 74-145, 1974-1 c.b. 113, which allowed deferred recognition of crop insurance proceeds under § 451(d) to a farmer who, under his normal method of accounting for crop income, deferred to the following year not all but more than 50 percent of his crop income, a percentage which the ruling referred to as a “substantial portion” of the farmer’s annual crop income, and concluded that because the taxpayers did not normally defer a substantial portion of their crop income — 35 percent not being “substantial” for this purpose — § 451(d) was inapplicable. (a) affirmed, 568 f.3d 662 (8th cir. 6/10/09). the court of appeals also followed rev. rul. 74-145, stating as follows: “the legislative history, however, indicates congress intended § 451(d) to ameliorate the effects of forcing farmers to report two years of income in a single tax year. because of congress’ clearly expressed intent, the irs’s revenue ruling reasonably concludes only farmers who customarily defer all or a substantial portion of their crop income to the tax year following production were intended to benefit from a § 451(d) deferment of insurance proceeds.” the court also rejected the taxpayers’ alternative argument that they satisfied the substantial portion test because they deferred more than fifty percent of aggregate annual crop income. reg. § 1.451-6(a)(2) requires a farmer who receives crop insurance proceeds from two or more damaged crops, and elects to defer insurance proceeds under § 451(d), to defer all insurance proceeds attributable to crops constituting a single trade or business. on the basis of this provision, the taxpayers claimed that the substantial portion test applies to the entire farming operation, not to a single crop. the court held that reg. § 1.451-6(a)(2) did not apply because it only applies “[i]n the case of a taxpayer who receives insurance proceeds as a 87 florida tax review [vol. 10:si result of the destruction of, or damage to, two or more specific crops ...” and the insurance proceeds in the instant case related only to one crop. 3. is whether a purported sale is bona fide really a fact question for the jury rather than a question of law? “yes,” says the fourth circuit. volvo cars of north america, llc v. united states, 571 f.3d 373 (4th cir. 7/9/09). volvo sold excess parts inventory to a purchaser who would store the parts for up to 15 years in its own warehouses. under the original 1981 contract, volvo not only retained the right to repurchase the inventory at 90% of standard cost, but in addition, the purchaser was required to notify volvo prior to any planned disposition of volvo parts inventory to third parties, giving volvo an opportunity to repurchase that inventory before was sold it to others. either party had the right to cancel the arrangement unilaterally upon 60 days written notice. an amended 1983 agreement eliminated the right to prior notice before the inventory was sold to a third party. the irs challenged volvo’s loss deductions on the parts sales, asserting that the sales were not bona fide. volvo conceded that under the test of paccar, inc. v. commissioner, 85 t.c. 754 (1985), aff’d, 849 f.2d 393 (9th cir. 1988), the sales pursuant to the first contract [1981 and 1982 sales] were not bona fide, but argued that all of the sales in 1983 and thereafter were governed by the 1983 contract and that they were bona fide sales. in the refund suit, the district court instructed the jury on the four relevant factors set forth by the tax court in paccar, and submitted two questions to the jury: (1) whether there was a bona fide sale of inventory physically transferred before execution of the 1983 contract; and (2) whether there was a bona fide sale of inventory physically transferred after execution of the 1983 contract. the jury returned a verdict in volvo’s favor. however, the district court entered a judgment notwithstanding the verdict in favor of the government with respect to transfers of inventory made prior to execution of the amended contract, concluding as a matter of law that the amended contract did not address inventory previously transferred to the warehouser. on appeal, the fourth circuit (judge niemeyer) vacated the district court’s judgment notwithstanding the verdict. he found that the jury had been properly instructed regarding the relevant law and could have reasonably concluded that the 1983 contract replaced the 1980 contract and covered not only inventory to be transferred after execution of the 1983 contract but also inventory that had been transferred under the 1980 contract and was still in the purchaser’s warehouses or had been purchased by third parties. • the four relevant factors set forth by the tax court in paccar are : (1) who determined what items were taken into inventory; (2) who determined when to scrap existing inventory; (3) who determined when to sell inventory; and (4) who decided whether to alter inventory. 2010] recent developments in federal income taxation 88 4. the taxpayer won the substantive issue, but footfaulted on seeking a change in method of accounting, so most of the deficiency is upheld. but in future years, it’s “ooh la la” for the taxpayer! capital one financial corp. v. commissioner; 133 t.c. no. 8 (9/21/09). this case involved two issues and over $280 million — $175 million for one year alone — (apart from penalties). the first issue was the time that third-party credit card issuers are required to recognize credit card income known as interchange. interchange is the difference between the amount charged on a credit card and the lesser amount remitted to the merchant by the issuing bank. interchange resembles interest in that it is expressed as a percentage of the amount lent, usually with an additional nominal fee, although it is not time-sensitive and does not vary as interest rates fluctuate. the government argued that interchange income was credit card fee income that was recognized under the all events test at the time the interchange accrued — when the cardholder’s credit card purchase was settled through either the visa or mastercard system — while the taxpayer argued that the interchange income was original issue discount (oid) that was properly recognized under § 1272(a)(6)(c)(iii), which was added to the code in 1997, over the anticipated life of the pool of credit card loans to which the interchange related. the tax court (judge haines) agreed with the taxpayer and held that the interchange income was oid. interchange is not a fee for any service other than the lending of money. however, because the taxpayer failed to follow proper procedures to change its accounting methods, the oid method was not available for credit card receivables creating or increasing oid in 1998 or 1999. with certain modifications, the method used by the taxpayer to compute the oid income (using a model developed by kpmg) was reasonable. • a second issue was whether the taxpayer could currently deduct the estimated cost of future redemptions of “miles” it issued to cardholders that could be redeemed for airline tickets, the cost of which would be paid by the taxpayer. the court held that under § 461(h) and reg. § 1.461-4, those expenses could not be deducted currently, but instead were deductible only to the extent that the amounts were fixed and known under the all events test and for which economic performance had occurred. ii. business income and deductions a. income 1. this looks pretty good, but at first a few serious questions were lurking. the 2009 arra, § 1231(a), added code § 108(i), which defers and then ratably includes income arising from business indebtedness discharged by the reacquisition of a debt instrument. this new provision allows a taxpayer to irrevocably elect to include cancellation of 89 florida tax review [vol. 10:si debt income realized in 2009 and 2010 ratably over five tax years, rather than in the year the discharge occurs, if the debt was issued in connection with the conduct of a trade or business or by a corporation. for partnerships and s corporations, the election is made by the partnership or corporation, not by the individual partners or shareholders. i.r.c. § 108(i)(5)(b)(iii). under the § 108(i) election, income from a debt cancellation in 2009 is recognized beginning in the fifth taxable year following the debt cancellation: the income is recognized ratably in each of 2014 through 2018. income from a debt cancellation in 2010 is recognized beginning in the fourth taxable year following the debt cancellation: the income is recognized ratably in each of 2014 through 2018. if a taxpayer elects to defer debt cancellation income under § 108(i), the § 108(a) exclusions for bankruptcy, insolvency, qualified farm indebtedness, and qualified real property business indebtedness do not apply to the year of the election or any subsequent year. i.r.c. § 108(i)(5)(c). thus, the election cannot be used to move the year of inclusion to a year in which it is expected that one of the exceptions will apply. once the election is made, inclusion is inevitable; the statute requires acceleration of inclusion to the taxpayer’s final return in the event of the intervening death of an individual or liquidation or termination of the business of an entity. i.r.c. § 108(i)(5)(d). the acceleration rule also applies in the event of the sale or exchange or redemption of an interest in a partnership or s corporation by a partner or shareholder. • although the statute speaks in terms of cancellation of debt income arising from “reacquisition” of a “debt instrument,” the statutory definitions of “reacquisition” and “an applicable debt instrument,” respectively, are broad enough that the provision applies to most situations in which the debt is cancelled. section 108(i)(3)(b) broadly defines “debt instrument” to include a bond, debenture, note, certificate, or any other instrument or contractual arrangement constituting indebtedness within the meaning of §1275(a). section 108(i)(4)(b) defines “acquisition” to include: (1) an acquisition of the debt instrument for cash; (2) the exchange of the debt instrument for another debt instrument, including an exchange resulting from a modification of the debt instrument (which includes a reduction of the principal amount of the debt); (3) the exchange of the debt instrument for corporate stock or a partnership interest; (4) the contribution of the debt instrument to capital; and (5) the complete forgiveness of the indebtedness by the holder of the debt instrument. • however, the statutory definition of “acquisition” appears to omit the cancellation of a debt in connection with a property transfer, for example, a deed in lieu of foreclosure, although the legislative history contains some indication that this type of debt cancellation is included. • query when and to what extent real estate ownership qualifies as a trade or business. 2010] recent developments in federal income taxation 90 (a) many of the questions are answered. rev. proc. 2009-37, 2009-36 i.r.b. 309 (8/17/09). this revenue procedure provides the exclusive procedure for taxpayers to make § 108(i) elections. debt cancellation in connection with a property transfer is included in § 108(i). section 4.04(3) permits partial elections, with the partnership permitted to determine “in any manner” the portion of the cod income that is the “deferred amount” and the portion of the cod income that is the “included amount” with respect to each partner. section 4.11 permits protective elections where the taxpayer concludes that a particular transaction does not generate cod income but fears that the irs may determine otherwise. a partner’s deferred § 752(b) amount, arising from a decrease in his share of partnership liabilities, will be treated as a current distribution of money in the year that the cod income is included. taxpayers are allowed an automatic one-year extension from the due date to make the election, and taxpayers who made elections before the issuance of the revenue procedure will be given until november 16, 2009 to modify (but not revoke) their existing elections. corporate taxpayers making a § 108(i) election are required to increase earnings and profits for the year of the election. 2. this arbitration award is income rather than a return of capital. who does he think he is, richard hatch? bachmann v. commissioner, t.c. memo. 2009-51 (3/11/09). the taxpayer received an arbitration award of $1,369,729 against his employer, salomon smith barney, inc., based on the taxpayer’s claim that smith barney had failed to compensate him for the use of the taxpayer’s idea to create trust preferred stock. the trust preferred stock arrangement involved the issuance by a group of banks of debt to a trust which in turn issued preferred securities to investors for cash. the court (judge morrison) rejected the taxpayer’s claim that the arbitration award was a return of capital. the court indicated that the taxpayer failed to prove that he had any basis in the idea. in addition, the court opined that the payment from smith barney for the taxpayer’s business idea was nothing more than a payment for services. the court further rejected the taxpayer’s reasonable cause and good faith arguments to impose substantial understatement penalties under § 6662. 3. another claim of a “contribution to capital” exclusion goes down the drain. at&t, inc. v. united states, 103 a.f.t.r.2d 2009-2072 (w.d. tex. 5/4/09). magistrate judge nowak recommended summary judgment treating payments from the federal government for universal telephone access as includible in income and not as contributions to capital under § 118. the decision follows united states v. coastal utilities, inc., 514 f.3d 1184 (11th cir. 2008). 91 florida tax review [vol. 10:si (a) the recommendation was accepted by the district court. at&t, inc. v. united states, 104 a.f.t.r.2d 2009-6036 (w.d. tex. 7/16/09). 4. tax-free dollars to fight gypsy moths and southern pine beetles. rev. rul. 2009-23, 2009-32 i.r.b. 177 (7/27/09). the forest health protection program administered by the us forest service will be treated for purposes of § 126 is substantially similar, within the meaning of § 126(a)(9), to the type of programs described in § 126(a)(1) through (8). cost sharing payments received by nonindustrial private forest landowners to establish an acceptable integrated pest management strategy that will prevent, retard, control, or suppress gypsy moth infestations, southern pine beetle infestations, spruce budworm infestations, or other major insect infestations are eligible for exclusion from gross income to the extent permitted by § 126. the extent of the exclusion is determined under § 126(b) and reg. § 16a.126-1. b. deductible expenses versus capitalization 1. who says § 1060 prevents allocating basis in excess of fair market to tangible assets? not judge kroupa of the tax court. west covina motors, inc. v. commissioner, t.c. memo. 2009291(12/16/09). the taxpayer purchased the assets of another corporation and paid various legal and other transactional fees in connection with the acquisition. most, but not all, of the fees were related to a seller-financing arrangement for the purchased assets. the parties stipulated that the taxpayer paid $6,050,601 for specific assets, including (1) $250,001 for fixed assets, (2) $3.5 million for goodwill, and (3) $2,300,600 for the inventory of used vehicles, parts, and miscellaneous items, as well as acquiring $6,258,074 worth of new and demonstrator vehicle inventory that was subject to a $6,421,047 floor plan line of credit. those legal and transactional fees that were attributable to inventory financing and physical inventory were allocated to the inventory to be taken into account in determining cost of goods sold. the irs argued that because the acquisition was an “applicable asset acquisition” to which § 1060 applied, the remaining legal fees, which were not specifically related to any particular asset, were required to be allocated to goodwill and going concern value under § 1060 because the fairmarket-value limitations of § 1060 precluded an allocation to any other assets. in a stunning decision, judge kroupa rejected the irs’s position and held that even though the acquisition was an “applicable asset acquisition” as defined in § 1060, where the parties, i.e., the taxpayer and the irs, have stipulated “the cost of each asset ... section 1060 does not apply.” accordingly, she agreed with the taxpayer that the legal fees should be allocated proportionately among all of the acquired assets to increase their 2010] recent developments in federal income taxation 92 bases – 2.03% to fixed assets, 18.69% to used vehicles and parts inventory, 50.84% to new and demonstrator vehicles, and 28.44% to goodwill. • former temp. reg. § 1.1060-1t(e), which was the controlling regulation for the year for the transaction, specifically stated: “allocation not to exceed fair market value. the amount of consideration allocated to an asset (other than class iv assets) [defined therein as ‘intangible assets in the nature of goodwill and going concern value’] shall not exceed the fair market value of that asset on the purchase date.” although judge kroupa’s opinion cited that provision, she somewhat mysteriously stated that “[the commissioner] cites no authority requiring legal fees to be allocated under the fair-market-value limitations of section 1060 where the parties have stipulated the cost of each asset, and we find none.” we, on the other hand, believe that former temp. reg. § 1.1060-1t(e) does precisely what judge kroupa believed that no authority required. former temp. reg. § 1.1060-1t(e) was mirrored in former temp. reg. § 1.338(b)-2t(c)(1), and that provision continues to apply in current reg. § 1.338-6(c)(1). in addition, current reg. § 1.338-6(a)(2)(ii) specifically provides that “[t]ransaction costs are not taken into account in allocating adsp or agub to assets in the deemed sale (except indirectly through their effect on the total adsp or agub to be allocated).” even more to the point, current reg. § 1.1060-1(c)(3) now clearly specifically precludes the result in west covina motors from occurring: the seller and purchaser each adjusts the amount allocated to an individual asset to take into account the specific identifiable costs incurred in transferring that asset in connection with the applicable asset acquisition (e.g., real estate transfer costs or security interest perfection costs). costs so allocated increase, or decrease, as appropriate, the total consideration that is allocated under the residual method. no adjustment is made to the amount allocated to an individual asset for general costs associated with the applicable asset acquisition as a whole or with groups of assets included therein (e.g., non-specific appraisal fees or accounting fees). these latter amounts are taken into account only indirectly through their effect on the total consideration to be allocated. • although current reg. § 1.10601(c)(3) post-dates the transaction in west covina motors, and thus was not technically controlling, it is merely a more specific statement of the rule in current reg. § 1.338-6(a)(2)(ii), which in turn merely clarifies current reg. § 1.338-6(c)(1), which is identical to former temp. reg. § 1.338(b)-2t(c)(1), which mirrored former temp. reg. § 1.1060-1t(e), which should have been controlling in west covina. 93 florida tax review [vol. 10:si • the bottom line: don’t take the holding in this case too seriously. its reasoning is suspect. 2. those fancy pyrex® and oneida® branded kitchen products are made by robinson knife manufacturing, which is required to capitalize license fees. robinson knife manufacturing company, inc. v. commissioner, t.c. memo. 2009-9 (1/14/09). the taxpayer designs and produces kitchen tools for sale to large retail chains. to enhance its marketing, the taxpayer paid license fees to corning for use of the pyrex trademark and oneida for use of the oneida trademark on kitchen tools designed and produced by the taxpayer. the taxpayer’s production of kitchen tools bearing the licensed trademarks was subject to review and quality control by corning or oneida. the irs asserted that the taxpayer’s licensing fees were subject to capitalization into inventory under § 263a under reg. § 1.263a-1(e)(3)(ii)(u), which expressly includes licensing and franchise fees as indirect costs that must be allocated to produced property. agreeing with the irs, the court (judge marvel) rejected the taxpayer’s argument that the licensing fees, incurred to enhance the marketability of its produced products, were deductible as marketing, selling, or advertising costs excluded from the capitalization requirements by reg. § 1.263a1(e)(3)(iii)(a). the court noted that the design approval and quality control elements of the licensing agreements benefited the taxpayer in the development and production of kitchen tools marketed with the licensed trademarks. the court rejected the taxpayer’s argument that rev. rul. 20004, 2000-1 c.b. 331, which allowed a current deduction for costs incurred in obtaining iso 9000 certification as an assurance of quality processes in providing goods and services, was applicable to the quality control element of the license agreements. the court noted that although the trademarks permitted the taxpayer to produce kitchen tools that were more marketable than the taxpayer’s other products, the royalties directly benefited and/or were incurred by reason of the taxpayer’s production activities. the court also upheld the irs’s application of the simplified production method of reg. § 1.263a-2(b) to allocate the license fees between cost of goods sold and ending inventory as consistent with the taxpayer’s use of the simplified production method for allocating other indirect costs. 3. the increased cost of double-wides is affirmed. load, inc. v. commissioner, 559 f.3d 909 (9th cir. 3/4/09), aff’g t.c. memo. 2007-51 (3/6/07). the taxpayer sells manufactured homes purchased from the manufacturer by placing models for sale and demonstration on leased lots, where they are sold by independent salespersons. the court adopted the tax court holding and opinion that costs attributable to placement of model manufactured homes on leased retail sales lots were includible in inventory under § 263a. the costs were not on-site storage 2010] recent developments in federal income taxation 94 costs under reg. § 1.263a-1(e)(3)(iii)(i) because transfers to independent resellers prevented the taxpayer from being considered as selling exclusively to retail customers. 4. the irs discovers internet retail sales. notice 2009-25, 2009-15 i.r.b. 758 (4/13/09). under reg. § 1.263a-3(c)(5) storage costs attributable to off-site storage of inventory must be capitalized, but storage costs attributable to the operation of an on-site storage facility are currently deductible. an on-site storage facility is defined as a facility that is physically attached to a retail sales facility, which is a facility where the taxpayer sells merchandise exclusively to retail customers in on-site sales. a facility that functions both as storage for an on-site retail facility and as storage for off-site sales is classified as a dual function storage facility with respect to which costs must be allocated between storage for the on-site retail sales and off-site sales, generally on the basis of gross sales. the irs has recognized that the nature of retail sales has changed in that retailers may both sell merchandise on-site to walk-in customers and make sales over the internet or by facsimile orders from the same facility. the current regulations create problems by requiring these retailers to treat storage facilities attached to a retail sales facility as a dual function storage facility. the notice solicits comments about changed retail business practices resulting from technological advances and existing trends that affect the application of the existing regulations along with information about contemporary business models. the notice also solicits comments regarding changes in the regulations to reflect current business practices. comments were requested before 7/13/09. 5. merger termination fee to defend business from hostile takeover is deductible and not a capital expense. santa fe pacific gold co. v. commissioner, 132 t.c. no. 12 (4/27/09). as part of a strategy to thwart a hostile takeover attempt by newmont usa ltd., a larger mining company, santa fe entered into a merger agreement with the homestake mining company. the homestake merger agreement contained a termination clause, which required santa fe to pay homestake $65 million in the event the merger was terminated by either party. following announcement of the homestake merger agreement, several lawsuits were filed alleging that the santa fe board breached its fiduciary duties to shareholders for failing to negotiate further with newmont and that the homestake merger agreement was entered into to protect the interests of santa fe’s board and management. after negotiations and increased offers from both newmont and homestake, the santa fe board accepted newmont’s stock-for-stock merger offer and paid the termination fee to homestake. santa fe deducted the termination fee. the irs asserted that the fee was a capital expenditure incurred to provide a long term benefit to santa 95 florida tax review [vol. 10:si fe. the tax court (judge goeke) concluded that the termination fee was deductible under § 162 and alternatively that the fee was incurred by santa fe to abandon the merger transaction with homestake and was therefore deductible as an abandonment loss under § 165. the court rejected the irs argument that the fee was incurred as part of an integrated transaction in which the termination fee was paid to extricate santa fe from one contract in order to enter into a more favorable contract and thus was not attributable to an abandoned transaction. • under reg. § 1.263(a)-5(c)(8), which was promulgated after the events in question and thus was not controlling in this particular case, the amount in question would have to be capitalized as a termination payment or as an amount paid to facilitate a second transaction that was mutually exclusive with the first. 6. intelligently pursuing wealth is not a trade or business. woody v. commissioner, t.c. memo. 2009-93 (4/30/09). throughout 2004 the taxpayer investigated and took steps to establish a real estate business, including taking a course on real estate investing from the wealth intelligence academy. the taxpayer purchased an unoccupied rental property on 12/30/04, which was not rented until after 2004. the court (judge gustafson) suggested that the taxpayer was not engaged in a trade or business in 2004 before the rental property was actually held out for rent in a subsequent year. in any event, the court held that all of the expenses incurred before the taxpayer acquired property on 12/30/04, were start-up expenses subject to § 195. in addition, the court held that the taxpayer’s education expense was incurred to prepare for a new trade or business and therefore not deductible under § 162. 7. leasehold improvements treated as a substitute for rent are currently deductible; the transaction did not lack economic substance even though the lessor was a tax indifferent party. remember, § 109 has a parenthetical. hopkins partners v. commissioner, t.c. memo. 2009-107 (5/19/09). hopkins partners operated the sheraton cleveland airport hotel under a lease agreement with the city of cleveland. the agreement provided that the hotel and related parking facilitates were the property of the city. the partnership negotiated a modification to the lease agreement under which the cost of improvements to the hotel and parking facilities by the partnership above a specified level would result in reductions in the amount of rental payments otherwise due under the lease. improvements in any particular year that exceeded the rent otherwise due under the lease were capitalized and depreciated, and were carried forward to be credited against rent in future years. in a year in which previous years’ improvements were credited against rent, hopkins partners deducted the value of the credited improvements, but also treated them as being sold for 2010] recent developments in federal income taxation 96 the credited amount and reported gain to the extent the credited amount exceeded the adjusted basis of the improvements. the court (judge wells) noted that, under reg. § 1.162-11(b), the cost of improvements by a lessee to leased property generally are recoverable through depreciation deductions. the court found an exception, however, in reg. § 1.61-8(c), which requires a lessor to recognize as rental income the cost of improvements placed on real property as a substitute for rent. the court indicated that because the regulation is “clear” that improvements in lieu of rent are treated as “rent” to the lessor, the cost of improvements in lieu of rent are currently deductible by the lessee under § 162(a)(3). the court held that whether improvements are in lieu of rent depended upon the intent of the parties. the court found that the language of the lease agreement treating the cost of improvements as a rent credit, and the testimony of the parties established an intent to treat the cost of improvements as rent. the fact that the lessor was a tax indifferent party did not change the result. the court rejected the irs’s argument that the cost of improvements treated as rent must be limited in duration. the court also held that the immediate transfer of improvements to the city in exchange for rent were not illusory transactions, notwithstanding the fact that the partnership retained control over the improvements. the court also rejected the irs’s contentions that the rent credit agreement lacked economic substance, that the deduction for the improvements failed to clearly reflect income under § 446, and that the deduction was an accounting method change under § 446(e) that required adjustments under § 481. • the potential problems relating to such arrangements include level rent payments under § 467 and the economic performance rules under § 461(h). however, in hopkins partners itself, the terms of the particular arrangement appear to have been carefully and properly structured to avoid running afoul of either § 467 or § 461(h). 8. in the scrum of foreign corporate takeovers, these management costs must be capitalized. canterbury holdings, llc v. commissioner, t.c. memo. 2009-175 (7/27/09). taxpayers were partners in an llc, which in turn formed a new zealand corporation called canterbury holdings to acquire new zealand publicly held shares of lwr industries. ltd. lwr was a 104-year-old garment manufacturing company that owned canterbury brand rugby shirts. canterbury holdings entered into a management agreement with the 2/3 owner of lwr, from which it had an option to purchase lwr stock, to manage lwr during the takeover. at a point, the u.s. llc (in which the taxpayers were members) made direct payments to the former lwr stock holder which it claimed as deductible management expenses. the court (judge holmes) rejected the taxpayer’s assertion that the expenses were incurred to protect the llc’s reputation and credit in its trade or business of acquiring, managing and turning around distressed companies. instead, the court held that the expenditure was 97 florida tax review [vol. 10:si incurred to protect the llc’s investment in its new zealand subsidiary and was thus a capital expense. the court noted that the only purpose of the llc was the single acquisition of lwr and the only purpose of the expenditure was to protect the value of its investment in lwr stock. the court also rejected the taxpayers’ argument that the payments to its new zealand holding company were payments of the management fee through its agent. the court refused to allow the llc to ignore its own organizational choices. the court also disallowed deductions for claimed interest expenses paid by the llc on obligations of the new zealand holding company. however, the court refused to impose accuracy related penalties, finding that the taxpayers reasonably relied on the advice of experienced cpas in claiming the deductions. c. reasonable compensation 1. a provision in arra specifically permitted the aig bonus payments. arra § 7001 (in title vii – limits on executive compensation) amends § 111 of eesa of 2008. eesa of 2008 § 111(b)(3)(d)(iii) specifically exempts from the prohibition “any bonus payment required to be paid pursuant to a written employment contract executed on or before february 11, 2009.” senator dodd (d-ct) – after weaseling around for a while – admitted that he added this exemption to the statute at the request of the treasury department. (a) in 2009, the ides of march fell during an orwellian “hate week” against aig, culminating a house-passed 90 percent tax rate on aig bonus recipients. h.r. 1586, “to impose an additional tax on bonuses received from certain tarp recipients,” was introduced on 3/18/09 by house ways & means committee chair charles rangel (d-ny) and passed by the house on the following day by a vote of 328 to 93. no legislative action has yet occurred in the senate; this can only be attributed to a temporary reprieve from the mid-march madness. 2. tax court distinguishes exacto spring in case appealable to seventh circuit. menard, inc. v. commissioner, t.c. memo. 2004-207 (9/16/04), reconsideration denied, t.c. memo. 2005-3 (1/6/05). in this decision, appealable to the seventh circuit and presumably governed by the “hypothetical independent investor” test of exacto spring corp. v. commissioner, 196 f.3d 833 (1999), the tax court (judge marvel) nevertheless applied the traditional factor of compensation for ceos of comparable publicly-traded corporations to disallow deduction of $13 million of the $20 million of compensation (which included 5 percent of pretax profits) paid to the john r. menard, the ceo and owner of 89 percent of taxpayer’s stock rather than applying solely the hypothetical independent 2010] recent developments in federal income taxation 98 investor test. the court focused on language in treas. reg. § 1.162-7(b)(3), which was not discussed in exacto spring, and which provides as follows: in any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. it is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. (a) on reconsideration, judge marvel made clear that two prongs are required, i.e., (1) that the amounts paid be intended as compensation and (2) that they be reasonable in amount. t.c. memo. 2005-3 (1/6/05). in denying taxpayer’s motion for reconsideration, judge marvel reiterated – as an alternative ground for her decision – that the taxpayer did not intend that its payment be for services in light of (1) it never having paid dividends, (2) the ceo’s contractual obligation to repay any portion of the compensation found to be excessive, and (3) the failure of the board of directors to make any effort to evaluate whether the compensation was excessive. (b) judge posner is bullish on menard, inc., bearish on the tax court. no compensation is unreasonable for judge posner as long as shareholders are happy – even if it’s all in the family. by the way, was it only by chance that judge posner was on the panel for this case? menard, inc. v. commissioner, 560 f.3d 620 (7th cir. 3/10/09). in an opinion by judge posner, the seventh circuit reversed the tax court’s decision, t.c. memo. 2004-207 (9/16/04), reconsideration denied, t.c. memo. 2005-3 (1/6/05), and held that all of the compensation paid to menard was reasonable. in 1998, the tax year at issue, the taxpayer was the third-largest home improvement retailer in the united states, following home depot and lowes. the founder and ceo of the taxpayer, john menard, held all of the company’s voting shares and 56 percent of the nonvoting shares. the remaining shares were held by family members. menard was paid a base compensation of $157,000, a profit share participation of $3 million, plus a bonus equivalent to five percent of the taxpayer’s before tax net income that amounted to over $17 million. the compensation plan had been adopted by the company in 1973. in 1998 the taxpayer earned a return to shareholders of 18.8 percent. judge posner’s opinion reflects displeasure that the tax court (judge marvel) applied its traditional multi-factor test rather than the seventh circuit’s “hypothetical independent investor” test of exacto spring corp. v. commissioner, 196 f.3d 833 (1999). in exacto spring, the seventh circuit created a presumption that “when ... the investors in his company are obtaining a far higher return than they had any reason to expect, [the owner/employee’s] 99 florida tax review [vol. 10:si salary is presumptively reasonable.” the court added that the presumption could be rebutted by evidence that the company’s success was attributable to extraneous factors or that the company intended to pay a dividend rather than salary. judge posner’s opinion found fault with the tax court’s reasoning in numerous respects. ● first, he found that although a comparison of the compensation of the shareholder/employee in question with the compensation of executives of other companies is “helpful only the comparison takes into account the details of the compensation package of each of the compared executives, and not just the bottom-line salary.” he concluded that the tax court failed to conduct such an analysis and because “the tax court acknowledged that the presumption of reasonableness had been established but thought it rebutted by evidence that corporations in the same business as menards paid their ceos substantially less than menards paid its ceo.” he faulted the tax court for its “failure to consider the severance packages, retirement plans, or perks of the ceos with whom it compared menard (although it did take account of their stock options), even though such extras can make an enormous difference to an executive’s compensation.” thus, the fact that the ceo of home depot was paid a mere $2.8 million, and the ceo of lowes was paid $6.1 million (both of which were larger companies), did not suggest that the more than $20 million compensation paid to menard was unreasonable. menard’s compensation was subject to different risk, and the tax court did not consider the severance packages, retirement packages available to the ceo’s of home depot and lowes, although the tax court did consider stock options. according to the court, the ceo of home depot hired two years after the tax year in issue, was paid $124 million in salary, exclusive of stock options, for the six years he held the post and received a severance payment of $210 million (including stock options) when he was fired in 2007.1 ● second, and pointedly relevant to exacto spring corp. as law of the circuit, judge posner emphasized that there was “no suggestion that any of the shareholders were disappointed that the company obtained a rate of return of ‘only’ 18.8 percent.”2 furthermore, the company’s success was not due to windfall factors. “the tax court did 1. to at least one of us, judge posner appears not to be bothered by the fact that he was taking into consideration facts that not only were not in the record, but which did not occur not only after the year in question, but after the trial. one can only surmise that judge posner’s “fact findings” were based on reading newspapers or surfing the internet. 2. two of us note that judge posner glossed over the fact that john menard, held all of the company’s voting shares and 56 percent of the nonvoting shares, with all of the remaining shares being held by family members. 2010] recent developments in federal income taxation 100 not consider the possibility, which the evidence supports, that menard really does do it all himself.” ● third, judge posner criticized the tax court’s conclusion that menard’s compensation, in addition to being excessive, was intended as a dividend, based on (1) his agreement to reimburse the corporation if the deduction for the bonus were disallowed by the irs, and (2) a bonus of 5 percent of corporate earnings year in and year out “looked” more like a dividend than like salary. judge posner concluded that (1) it was prudent, even though not in menard’s personal financial interest, for the corporation to require him to reimburse it if the irs successfully disallowed the deduction, and (2) “5 percent of net corporate income [does not] look at all like a dividend.” the court also noted that it was prudent for the taxpayer to require as part of the bonus plan that menard return the bonus if the taxpayer’s compensation deduction were challenged by the irs. ● fourth, judge posner addressed the tax court’s concern that the board of directors that approved the 5 percent bonus was controlled by menard. judge posner reasoned that since it could not be otherwise, because menard was the only shareholder who is entitled to vote for members of the board of directors, the “logic of the tax court’s position is that a one-man corporation cannot pay its ceo (if he is that one man) any salary!” he went on sarcastically to state that: the tax court’s opinion strangely remarks that because mr. menard owns the company he has all the incentive he needs to work hard, without the spur of a salary. in other words, reasonable compensation for mr. menard might be zero. how generous of the tax court nevertheless to allow menard to deduct $7.1 million from its 1998 income for salary for menard!3 ● fifth, judge posner criticized what he considered to be the tax court’s main focus on whether menard’s compensation exceeded that of comparable ceos, i.e., whether it was objectively excessive, and thus functionally, even though not intentionally a dividend rather than a bonus, instead of focusing on whether the corporation was acting in good faith in paying $17.5 million as a bonus rather than as a dividend. 3. some, but not necessarily all, of us marvel at judge posner’s restrained judicial temperament. 101 florida tax review [vol. 10:si for compensation purposes, the shareholder-employee should be treated like all other employees. if an incentive bonus would be appropriate for a nonshareholder-employee, there is no reason why a shareholder-employee should not be allowed to participate in the same manner. in essence, the shareholder-employee is treated as two distinct individuals for tax purposes: an independent investor and an employee.” owensby & kritikos, inc. v. commissioner, 819 f.2d 1315, 1328 (5th cir. 1987) ... . • additionally, the fact that the next highest paid employee of the taxpayer received a salary of $468,000 was rejected as a factor because the “tax court did not consider the possibility, which the evidence supports, that menard really does do it all himself.” the fact that the taxpayer paid no dividends was not influential because many corporations choose to retain earnings rather than distribute dividends. the court stated that a bonus based on five percent of profits doesn’t look like a dividend, which is normally calculated as an amount per share rather than a percentage of earnings. • it shouldn’t take a court to make decisions on whether compensation is reasonable. they should be left up to pay czar kenneth feinberg. d. miscellaneous deductions 1. the irs responds to high gasoline prices. announcement 2008-63, 2008-28 i.r.b. 114 (6/23/08), modifying rev. proc. 2007-70, 2007-2 c.b. 1162. the irs announced that the business mileage rate for the second half of 2008 will be 58.5 cents per mile – an increase of 8 cents per mile – and that the medical/moving rate will also increase by 8 cents per mile to 27 cents per mile. the statutory rate for charitable mileage under § 170(i) remains at 14 cents per mile. (a) but gas prices abruptly declined in fall 2008. rev. proc. 2008-72, 2008-50 i.r.b. 1286 (11/24/08). the business mileage rate for 2009 will be 55 cents per mile – a decrease of 3.5 cents per mile – and that the medical/moving rate will decrease by three cents to 24 cents per mile. the statutory rate for charitable mileage under § 170(i) remains at 14 cents per mile. (b) mileage rates for 2010. rev. proc. 200954, 2009-51 i.r.b. 930 (12/03/09). mileage rates for business travel after january 1, 2010 drop to 50 cents per mile, remain at 14 cents for charitable use, and drop to 16.5 cents for medical or moving use. 2010] recent developments in federal income taxation 102 2. have you documented that your own cell phone is used for business rather than personal purposes? tash v. commissioner, t.c. memo. 2008-120 (4/29/08). among the many deductions claimed by a lawyer that judge haines disallowed was the deduction claimed for his cellular telephone, because “[t]he record did not indicate whether petitioner used his cellular telephone for business and/or personal calls.” inasmuch as cell phones are listed property, reg. § 1.2745(c) and (f) require substantiation for the deduction. (a) how do you steer the car? it might or might not be ok to drive while talking on your cell phone, but it is imperative to take notes in your log book while chatting on the phone. alami v. commissioner, t.c. memo. 2009-42 (2/23/09). judge vasquez denied the taxpayer’s claimed business deductions for cellular telephone service because the taxpayer failed to establish the amount of time he used his cell phone for business and personal purposes. a cellular phone is “listed property” that is subject to the strict substantiation requirements of § 274(d) pursuant to § 280f(d)(4)(a)(v), and a taxpayer must establish the amount of business use and the amount of total use for the property to substantiate the amount of expenses for listed property. an alternative ground for denying the deduction was that the taxpayer’s employer did not require that he have a cell phone. • query whether there are employer reporting obligations with respect to cell phones furnished to employees who fail to keep records? (b) but, simplified methods for reporting cell phone use are under consideration. notice 2009-46, 2009-23 i.r.b. 1068 (6/8/09). irs is considering methods to simplify treatment of employerprovided cell phones, including: (1) a “minimal personal use method” (if the employee accounts to the employer that he has a personal cell phone for use during business hours); and (2) a safe harbor method under which an employer would treat 75 percent of each employee’s use of the cell phone as business usage. • in a letter to representative skelton, info 2009-0141 (7/8/09), the irs advised that it would be seeking clarifying legislation from congress. 2009 tnt 216-62. (c) and the prez says to congress “delist” cell phones. president obama’s fiscal year 2011 budget calls for congress to amend § 280f to remove cellular telephones form the category of listed property, thereby “effectively removing the requirement of strict substantiation and the limitation on depreciation deductions.” department of the treasury, general explanations of the administrations fiscal year 2011 103 florida tax review [vol. 10:si revenue proposals 26 (february 2010). the substantiation requirements are “burdensome for employers;” it is difficult to document the cost of cell phone calls, and “the cost of accounting for personal use often exceeds the amount of any resulting income.” the proposal specifically contemplates that “a cell phone (or other similar telecommunications equipment) provided primarily for business purposes would be excluded from gross income.” 3. throw another log on the fire! loss of contemporaneous § 274(d) mileage log in a fire doesn’t cause loss of mileage deductions too. freeman v. commissioner, t.c. memo. 2009-213 (9/16/09). judge gustafson allowed the taxpayer a deduction, at mileage rates, for business use of his automobile on the basis of the taxpayer’s credible testimony regarding the route he drove in connection with his auto parts delivery business. the taxpayer had maintained and at one time possessed adequate documentation, in the form of a daily log, to comply with § 274(d), but his failure to produce that daily log was the result of an accidental fire that destroyed his house and the logbook. reg. § 1.2745t(c)(5) allows a taxpayer to “substantiate a deduction by reasonable reconstruction of his expenditures or use” when records are lost through circumstances beyond the taxpayer’s control, including a fire. 4. change of bankruptcy from chapter 11 to chapter 7 is not a realization event. ferguson v. commissioner, 568 f.3d 498 (5th cir. 5/12/09). the court rejected the taxpayer’s argument that involuntary conversion of the taxpayer’s chapter 11 bankruptcy to chapter 7 constituted abandonment in that year of farm property within the bankruptcy estate. the taxpayer did not realize loss from abandonment of bankruptcy estate property until the following year when the property was sold at a foreclosure sale. 5. these pay-phone tax shelters work about as well as pay phones do. doherty v. commissioner, t.c. memo. 2009-99 (5/14/09). the tax court (judge marvel) denied claimed deductions for depreciation, legal fees, and other expenses related to the taxpayer’s investment in pay phones and atms through a program run by alpha telcom, inc. the court found that other than bare legal title the taxpayer did not possess any of the incidents of ownership regarding pay phones and atms. (a) ditto. snyder v. commissioner, t.c. memo. 2009-97 (5/14/09). same date, same judge, same issue, same result. 6. frozen on the ship, and frozen out of half of his meal deductions. kurtz v. commissioner, 575 f.3d 1275 (11th cir. 2010] recent developments in federal income taxation 104 7/23/09), aff’g t.c. memo. 2008-111 (4/22/08). section 274(n)(2)(e) exempts from the 50 percent limitation on deductions for meal expenses any expenses for food or beverages “required by any federal law to be provided to crew members of a commercial vessel.” the eleventh circuit affirmed tax court judge cohen’s holding that § 274(n)(2)(e) did not apply to meal expenses incurred by the taxpayer as an independent contractor on the crew of a commercial fishing boat in the bering sea, because federal law does not require commercial fishing boats to provide meals to crew members. accordingly, only 50 percent of the taxpayer’s shipboard meal expenses were deductible. 7. revised per diem rates for lodging, meal, and incidental expenses. rev. proc. 2009-47, 2009-42 i.r.b 524 (9/30/09). the irs has provided updated rules for employer provided per diem allowances that do not require substantiation, and which may be used by self-employed persons and employees who are not reimbursed for travel expenses. per diem rates for travel within the u.s. are the rates for government travel set forth in 41 c.f.r. ch. 301, appx. a. travelers may use the rates in effect for the first nine months of 2009 for all travel within 2009, or may use the updated rates for travel between october 1 and december 31, 2009. rates for travel outside the continental united states (including alaska and hawaii) are published by the secretary of defense and the secretary of state and are updated monthly. the rates are available at www.gsa.gov. a traveler may use per diem allowances for meals and incidental expenses along with actual lodging expenses. the revenue procedure also provides fixed high-low per diem rates of $258 for a high cost locality, with a list provided, and $163 for travel to any other locality. 8. holding herself out as a contract attorney did not establish a trade or business. forrest v. commissioner, t.c. memo. 2009228 (10/5/09). before 1988 the taxpayer worked as a contract attorney performing work for other attorneys. she then went to work for the california department of corporations, but was terminated from that position in 2000. she worked as a contract attorney in 2000, but not in 2001 and 2002. in 2003 the taxpayer attempted again to work as a contract attorney, incurring expenses, before she was reinstated with the department of corporations in 2003. the court (judge vasquez) held that the taxpayer’s activities were not sufficiently regular or continuous to qualify as a trade or business. the court also concluded that, even if the taxpayer’s prior activities were sufficient to qualify as a trade or business, there was insufficient continuity into her activities in 2003 to constitute a continuation of her previous trade or business. the court also noted that the taxpayer’s attendance at a four day aba meeting and attempts to solicit contract work were not regular and continuous business activates, that she did not negotiate 105 florida tax review [vol. 10:si or perform contract attorney services during the year, and that her efforts were terminated when she resumed employment with the department of corporations. 9. the irs rescues oid interest deductions for borrowers that recognize cod income under the cottage savings regs as a result of loan modifications that don’t reduce principal. notice 2010-11, 2010-4 i.r.b. 326 (12/24/09). pursuant to § 163(e)(5)(f)(iii), the irs has extended through 12/31/10 the suspension of the application of § 163(e)(5), which partially disallows interest deductions with respect to certain applicable high yield discount obligations (ahydos), for “qualified obligations.” an obligation is a “qualified obligation” only if: (1) the ahydo is issued after december 31, 2009, and on or before december 31, 2010, in exchange (including an exchange resulting from a modification of the debt instrument) for an obligation that is not an ahydo; (2) the issuer (or obligor) of the ahydo is the same as the issuer (or obligor) of the obligation exchanged for the ahydo; (3) the ahydo does not pay interest that would be treated as contingent interest for purposes of § 871(h)(4) (without regard to § 871(h)(4)(d)); (4) the ahydo is not issued to a related person (within the meaning of § 108(e)(4)); (5) the issue price of the ahydo is determined under §§ 1273(b)(1), 1273(b)(2), 1273(b)(3), or 1274(b)(3), whichever is applicable, and the regulations thereunder; and (6) the ahydo would not otherwise be an ahydo if its issue price were increased by the amount of any discharge of indebtedness income realized by the issuer (or obligor) upon the exchange. e. depreciation & amortization 1. the economic stimulus act of 2008, p.l. 110185, reinstated the first year 50 percent depreciation allowance of § 168(k) for property placed in service in 2008. (a) the irs says that the old regulations still apply. i.r. 2008-58 (4/11/08). the irs has indicated that reg. § 1.168(k)-1, promulgated under the earlier provision, will apply to bonus depreciation claimed for 2008. the irs promises new guidance regarding additional issues raised under the current provision and covering increased first year deductions under § 179. (b) stimulating deductions. rev. proc. 200854, 2008-38 i.r.b. 722 (8/29/08). this revenue procedure provides guidance regarding amendments in the economic stimulus act of 2008 to § 168(k) allowing a 50 percent additional first year depreciation for certain new property acquired and placed in service during 2008 and to § 179 increasing 2010] recent developments in federal income taxation 106 the dollar limitations for expensing depreciable property for taxable years beginning in 2008. specifically, the revenue procedure clarifies: (1) how the stimulus § 179 deduction interacts with the increased § 179 amounts provided under § 1400n(e) for certain § 179 go zone property; (2) how the stimulus additional first year depreciation deduction interacts with the go zone additional first year depreciation deduction for go zone property; (3) how the stimulus § 179 deduction interacts with the increased § 179 amounts applicable to the kansas disaster area; and (4) how the stimulus additional first year depreciation deduction interacts with the 50 percent additional first year depreciation deduction applicable to the kansas disaster area. • the irs and the treasury department also intend to amend reg. § 1.179-5(c) to permit taxpayers to make a § 179 election without irs consent on an amended return for taxable years beginning after 2007. (c) and 50 percent bonus depreciation continues. the 2009 arra, § 1201, extended the code § 168(k) 50 percent additional first year depreciation allowance to qualified property placed in service before 1/1/10. (aircraft and “long-production-period property” qualify if placed in service before 1/1/11.) (d) and more guidance for extension property. rev. proc. 2009-33, 2009-29 i.r.b. 150 (7/1/09). the revenue procedure provides guidance regarding the election out of additional depreciation, which increases general business credits, for 2009 extension property. the additional first year depreciation is available for 2009 property if the taxpayer had previously elected out for property placed in service in previous years. 2. now that’s a whole lotta expens’n goin’ on! for taxable years beginning in 2008 and 2009, the 2009 arra, § 1202, increases the i.r.c. § 179 maximum deductible amount to $250,000 and provides a phase-out threshold of $800,000. the maximum amount allowed to be deducted under § 179 is increased by another $35,000 for (a) qualified enterprise zone property, i.r.c. § 1397(a)(1), and (b) qualified renewal community property acquired and placed in service after 2001 and before 2010. i.r.c. § 1400j. in addition, for both qualified enterprise zone property and qualified renewal community property, only fifty percent of the cost of property in excess of the threshold for the phase-out is taken into account. i.r.c. § 1397(a)(2). code § 179(e) increases the maximum amount allowed to be deducted under § 179 by $100,000, and increases the phase-out 107 florida tax review [vol. 10:si threshold by $600,000, for qualified disaster assistance property placed in service after 2007 (with respect to disasters declared after that date) and before 2010. the increased expensing and ceiling limits under the 2009 arra also affect the special expensing rules for enterprise zone property, renewal property, and for qualified disaster assistance property. thus, the maximum § 179 deduction for qualified enterprise zone and renewal property is $285,000 for 2008 and 2009 ($250,000 + $35,000). for qualified disaster assistance property in 2008 and 2009 the maximum deduction is $350,000 ($250,000 +$100,000), and the phase-out threshold is $1,400,000 ($800,000 + $600,000). 3. “luxury” car depreciation. rev. proc. 2009-24, 2009-17 i.r.b. 885 (4/9/09). for automobiles placed in service in 2009 that do not qualify as § 168(k) property, the limits on depreciation deductions are $2,960 for the placed in service year, $4,800 for the second tax year, $2,850 for the third tax year, and $1,775 for each succeeding year; for automobiles that qualify as § 168(k) property, the limits are $10,960 for the first year, $4,800 for the second year, $2,850 for the third year, and $1,775 for each succeeding year. for light trucks or vans that are not § 168(k) property, the limits are $3,060 for the first year, $4,900 for the second year, $2,950 for the third year, and $1,775 for each succeeding year; for light trucks or vans that qualify as § 168(k) property, the limits are $11,060 for the first year, $4,900 for the second year, $2,950 for the third year, and $1,775 for each succeeding year. 4. converting corn to ethanol is waste reduction and resource recovery, not a chemical process. notice 2009-64, 2009-36 i.r.b. 307 (8/24/09). the notice contains a proposed revenue ruling to classify tangible assets used to convert corn into fuel grade ethanol as belonging to asset class 49.5 of rev. proc. 87-56, 1987-2 c.b. 674, ten year property with a seven year macrs recovery period. the irs concludes that such assets are not properly assigned to asset class 28, manufacture of chemicals and allied products, which has a 9.5 year class life and five year macrs recovery period. f. credits 1. corporate taxpayers need spreadsheet net present value analysis to figure out this election. the housing assistance tax act of 2008, § 3081, provides for an increase in available § 38 credits for increased research activity in lieu of the § 168(k) 50 percent first year allowance for property placed in service in 2008. for property placed in service after 3/1/08, a corporation may elect to forego the additional deduction under § 168(k) and increase the research credit or minimum tax 2010] recent developments in federal income taxation 108 credit limitation of §§ 38(c) and 53(c) (amt credits are limited to the excess of regular tax over tentative tax) by 20 percent of the bonus depreciation amount. the increase in credits may provide refundable credits against regular tax liability. for eligible property the bonus depreciation amount is the amount of increased depreciation deductions available under § 168(k). the bonus depreciation amount is limited to the lesser of $30 million or six percent of the sum of research credit carryforwards from years beginning after 1/1/06 and minimum tax credits attributable to adjusted minimum tax for years after 1/1/06. depreciation for eligible property for both regular tax and amt purposes is computed under the straight line method. this provision is included in a section of the act entitled “revenue provisions.” • this amendment allows corporate (but not individual) taxpayers to elect to accelerate the amt credit and the research credit in lieu of claiming bonus depreciation. (a) jesus chrysler? and the pork takes a drive in a new car – powered by corn. the housing assistance tax act of 2008, § 3081, also provides that “an applicable partnership” may elect to be treated as making a deemed tax payment in the amount of the least of (1) the bonus depreciation that would be allowed if an election were in effect for the partnership, (2) the amount of the partnership’s research credit for the year, or (3) $30 million (reduced by any deemed payment for a prior taxable year). an applicable partnership is “a domestic partnership that was formed on august 3, 2007, and will produce in excess of 675,000 automobiles during the period beginning on january 1, 2008, and ending on june 30, 2008.” there must be a lot of qualified partnerships out there.☺ (b) and it’s all explained by the irs. rev. proc. 2008-65, 2008-2 c.b. 1082 (10/10/08). section 168(k)(4) allows an election to treat the 50 percent bonus depreciation amount (over regular depreciation) as an increase in the limitation of § 38(c) on the general business credit or as an increase in the § 53(c) limitation on the amount of credit against regular tax liability for lower tentative minimum tax (refundable). the increases are allowed to corporations and the chrysler llc (not identified by name in the revenue procedure). the election is available for qualified property placed in service between 3/31/08 and 1/1/10. the revenue procedure defines eligible property under the various provisions of the housing and economic recovery act of 2008, provides rules for making the election, determining the bonus depreciation amounts, and allocating the bonus depreciation amount between the limitations of §§ 38(c) and 53(c). (c) the irs supplements the explanation. rev. proc. 2009-16, 2009-6 i.r.b. 449 (1/23/09). the revenue procedure 109 florida tax review [vol. 10:si contains rules for electing under § 168(k)(4) to claim an increase in the business tax credit limitation and the amt credit limitation in lieu of claiming 50 percent first year depreciation allowances under § 168(k), and provides rules for allocating the increases among members of a controlled group and to corporate partners of a partnership allowed to make the election (chrysler). the revenue procedure clarifies that an s corporation may make the election, but points out that any business or amt credit limitation increases that result are applied at the corporate level, and not at the shareholder level. this means that the credit limitation increase will only affect credits allowed against tax due on recognized built-in gains under § 1374. (d) one more year! arra § 2001 amended code § 168(k)(4) to extend this election for one year to property placed in service in 2009. 2. a credit for vinny gambini hiring disconnected “yutes.” the 2009 arra, § 1221, added two new categories of eligible employees for 2009 and 2010 under the existing code § 51 work opportunity tax credit: unemployed veterans and “disconnected youths.” to qualify as an unemployed veteran, the employee (1) must have been discharged from active duty in the military (after serving at least 180 days or being discharged for a service-connected disability) during the five-year period ending on the hiring date, and (2) must have received unemployment compensation for at least four weeks during the one-year period ending on the hiring date. a disconnected youth is an individual certified by the designated local agency who is (1) at least age 16 but not yet age 25 on the hiring date, (2) not regularly attending any secondary, technical, or postsecondary school during the six-month period preceding the hiring date, (3) not regularly employed during the six-month period preceding the hiring date, and (4) not readily employable by reason of lacking a sufficient number of skills. (a) disconnected yutes defined. notice 200928, 2009-24 i.r.b. 1082 (5/28/2009). 2009 arra amended § 51 to add two new targeted groups for purposes of the § 51 work opportunity credit: unemployed veterans and disconnected youths who begin work for an employer during 2009 or 2010. this provides guidance on the definition of “disconnected youth.” it also provides transition relief for employers who hire unemployed veterans or disconnected youths after 12/31/08, and before 7/17/09. 3. will this myriad of new credits lead to an electric outlet on every parking meter, even outside of the arctic portions of the 2010] recent developments in federal income taxation 110 u.s.? section 30d, added to the code by the energy improvement and extension act of 2008, was amended by § 1141(a) of the 2009 arra, to provide a plug-in electric drive motor vehicle credit. the statute defines a credit-eligible “new qualified plug-in electric drive motor vehicle” as a motor vehicle, the original use of which is by the taxpayer, that (1) draws propulsion using a traction battery with a capacity of at least 4 kilowatt hours, (2) recharges its battery with an external source of energy, (3) meets certain environmental standards, (4) is acquired by the taxpayer for use or lease (rather than for resale), and (5) is made by a manufacturer. the amount of the credit is $2,500 for each qualifying vehicle placed in service by a taxpayer during a taxable year, with an increase of $417 in the credit amount for each kilowatt hour of traction battery capacity in excess of 4 kilowatt hours. however, for vehicles acquired before january 1, 2010, the total amount of the credit for any one vehicle cannot exceed $7,500 if the vehicle weighs 10,000 pounds or less, cannot exceed $10,000 if the vehicle weighs more than 10,000 pounds but not more than 14,000 pounds, cannot exceed $12,500 if the vehicle weighs more than 14,000 pounds but not more than 26,000 pounds, and cannot exceed $15,000 if the vehicle weighs more than 26,000 pounds. for vehicles acquired after december 31, 2009, only vehicles with a gross vehicle rating of less than 14,000 pounds qualify, and the credit cannot exceed $7,500. once the total number of qualified plug-in electric drive vehicles sold for use in the united states after december 31, 2009, reaches 200,000, the credit will be phased out, with the phase-out period beginning in the second calendar quarter following the calendar quarter in which the 200,000th sale occurs. during the first two calendar quarters of the phase-out period, the credit is 50 percent of the otherwise allowable amount; in the third and fourth calendar quarters, the credit is 25 percent of the otherwise allowable amount; and no credit is allowable after the end of the fourth calendar quarter. • a taxpayer electing to claim the credit must reduce its basis in the vehicle by the amount of the credit. (section 30d(f)(6) permits the taxpayer to elect not to claim the credit.) any deduction or credit otherwise allowable with respect to the purchase of the vehicle must be reduced by the amount of the credit claimed. the statute directs the treasury to promulgate regulations providing for the recapture of the credit with respect to any vehicle which ceases to be credit-eligible property (including the case of a lease period shorter than a vehicle’s economic life). in the case of a qualifying vehicle used in the taxpayer’s trade or business, the credit is part of the general business credit. in the case of qualifying personal use vehicle, the credit is treated as a personal credit, and is allowed against both the regular income tax and the amt. the credit applies to taxable years beginning after 12/31/08, but will not be available for vehicles purchased after 12/31/14. • if the vehicle is placed in service by a tax-exempt entity, the person selling the vehicle to the tax-exempt entity may 111 florida tax review [vol. 10:si claim the credit, but only if the seller discloses to the entity the amount of the credit. § 30d(f)(3). (a) and just to make things simpler, a second, alternative credit for plug-in electric vehicles. the 2009 arra, § 1142(a), significantly revised the § 30 renewable electricity production credit, which now applies only to “plug-in” vehicles. the revisions apply to vehicles acquired after 2/17/09. revised § 30 allows an elective credit equal to 10 percent of the cost of any qualified plug-in electric vehicle placed in service in a trade or business or for personal use up to a maximum pervehicle credit of $2,500. the statute defines a credit-eligible “qualified plugin electric drive motor vehicle” as a motor vehicle, the original use of which is by the taxpayer, that (1) is propelled to a significant extent by an electric motor that draws power from a battery with a capacity of at least 4 kilowatt hours (2.5 kilowatt hours in the case of a 2or 3wheeled vehicle), (2) recharges its battery with an external source of energy, (3) has a gross vehicle rating of less than 14,000 pounds, (4) is acquired by the taxpayer for use or lease (rather than for resale), (5) is made by a manufacturer, and (6) and is either (i) a “low speed vehicle within the meaning of section 571.3 of title 49, code of federal regulations” as in effect on 2/17/09 or (ii) is a 2or 3-wheel vehicle. a taxpayer electing to claim the credit must reduce its basis in the vehicle by the amount of the credit. (section 30(e)(6) permits the taxpayer to elect not to claim the credit.) any deduction or credit otherwise allowable with respect to the purchase of the vehicle must be reduced by the amount of the credit claimed. the statute directs the treasury to promulgate regulations providing for the recapture of the credit with respect to any vehicle which ceases to be credit-eligible property. in the case of a qualifying vehicle used in the taxpayer’s trade or business, the credit is part of the general business credit. in the case of qualifying personal use vehicle, the credit is treated as a personal credit, and is allowed against both the regular income tax and the amt. the credit will not be available for vehicles purchased after 12/31/11. furthermore, for any vehicle acquired after 2/17/09 and before 1/1/10, the § 30 credit is not available if a credit is allowed under § 30d. (b) credit for figuring out how to plug in an old car. the 2009 arra, § 1143(b), amended § 30b to extend the alternative motor vehicle credit to a “plug-in conversion.” the plug-in conversion credit is an amount equal to 10 percent of the first $40,000 of cost to convert a vehicle to “qualified plug-in electric drive vehicle,” as defined in § 30d. the plug-in conversion credit is allowed in addition to any other credits allowed with respect to the vehicle. the credit applies only to conversions placed in service after 2/17/09 and before 1/1/12. in addition, 2010] recent developments in federal income taxation 112 new § 30b(g)(2) permits the § 30b alternative motor vehicle credit to be claimed against the alternative minimum tax for years after 2008. 4. and some tax credit help for homebuilders. section 45l, which previously had been scheduled to expire at the end of 2008, provides a credit, in the amount of either $2,000 or $1,000, to an eligible contractor (including the producer of a manufactured home) who constructs and sells an energy efficient home to a person who will use the home as a residence. the 2009 arra extended the life of the § 45l credit through 2009. 5. pick, choose, and apply a combination of proposed and final regulations. fedex corp. v. united states, 103 a.f.t.r.2d 2009-2722 (w.d. tenn. 6/9/09). federal express claimed $11.6 million of § 41 research credits for years 1997-2007 for a business software development project initiated in 1996 and abandoned as not technologically feasible in 2001. the discovery test of § 41(d)(1)(b) requires that to be eligible for the credit qualified research must be undertaken for the purpose of discovering information which is technological in nature, is useful in the development of a new or improved business component, and the activities must be experimental in nature. reg. § 1.41-4(a)(3) of regulations finalized in 2001, but applicable to expenditures for internal use software incurred after 1985, defined the discovery test as requiring that “research be undertaken to ‘obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering.’” under § 41(d)(4)(e), internal use software is qualified for the research credit only to the extent provided in regulations. reg. § 1.414(c)(6)(vi) provided that internal use software is qualified for the research credit if the software is innovative, development requires significant economic risk, and the software is not commercially available. regulations proposed in 2001 and finalized in 2003, applicable to taxable years ending after 12/26/01, revised the discovery test to apply to research that, “is intended to eliminate certain uncertainty concerning the development or improvement of a business component.” the preamble to the 2001 proposed regulations stated that the irs generally will not challenge return positions consistent with the proposed regulations. (66 f.r. 66362.) the 2003 finalized regulations did not adopt the internal use software test, marking that section of the regulations as reserved. in ann. 2004-9, 2004-6 i.r.b. 441, the service indicated that taxpayers could continue to rely on the internal use software test of the 2001 regulations, but if they did so, they were also subject to the discovery test of those provisions. granting summary judgment, the court (judge mays) accepted federal express’s assertion that it could rely on the broadened discovery test of the 2003 regulations and the internal use software test of the 2001 regulations. the court rejected the irs 113 florida tax review [vol. 10:si argument that the taxpayer cannot “cut and paste” portions of the 2001 and 2003 regulations to produce a favorable result. the court concluded that deference to administrative regulations under chevron u.s.a. inc., v. natural res. def. council, 467 u.s. 837 (1984), requires that taxpayers be permitted to rely on promulgated regulations. the treasury statements in the preamble to the 2003 regulations that indicate that those provisions better reflect legislative history, precludes the irs from forcing the taxpayer to apply the earlier and modified provision. the irs announcement as an interpretation of regulations did not merit chevron deference over the promulgated regulations. the taxpayer was allowed to rely on the internal use software provisions of the 2001 regulations as those provisions were the only regulatory provisions in existence with respect to the taxpayer’s expenditures. 6. with “a little song, a little dance,” the fifth circuit holds that the cohan rule permits courts to estimate qualified research expenditures. united states v. mcferrin, 570 f.3d 672 (5th cir. 6/9/09). through a clerical error, the irs granted the taxpayer’s claim for a refund that was based on § 41 research credits previously unclaimed on taxpayer’s return, but claimed on an amended return prepared by alliantgroup. in the irs suit to recover the refund the burden of proof fell on the irs. reversing the district court, the fifth circuit held that under the rule of cohan v. commissioner, 39 f.2d 540 (2d cir. 1930), if the taxpayer can demonstrate that his activities were qualified research, then the trial court can estimate the expenses associated with those activities. in addition, the court held that the district court erred in not reviewing the claimed research activities under the 2003 final regulations defining “discovery.” the taxpayer’s claim for refund was based on language of regulations proposed in 2001, the preamble to which indicated that taxpayers could rely on the test of the proposed regulations. the case was remanded to the district court for reconsideration under the 2003 regulations. • as noted below, former irs commissioner mark everson has joined alliantgroup as vice chair. 7. can the incomprehensively complicated be “simplified?” reg-130200-08, election of reduced research credit under section 208c(c)(3), 74 f.r. 34523 (7/16/09). these proposed regulations would “simplify” how taxpayers make the election to claim the “reduced research credit” under § 280c(c)(3). 8. there is no research credit for foreign research, but foreign gross receipts do count in calculating the amount of the allowable credit. deere & company v. commissioner, 133 t.c. no. 11 (10/22/09). as in effect for the year at issue, § 41(c)(4) provided that the 2010] recent developments in federal income taxation 114 § 41(a) increasing research credit was equal to the sum of 2.65 percent of so much as of the qualifying research expenses for the taxable year as exceeded one percent of the average annual gross receipts of the taxpayer for the 4 taxable years preceding the credit year, 3.2 percent of the amount of qualifying research expenditures that exceed 1.5 percent of the average gross receipts, and 3.75 percent of the qualifying research expenditures that exceed 2 percent of the average gross receipts for the four year period. the tax court (judge chiechi) rejected the taxpayer’s assertion that average gross receipts under this provision is calculated by excluding the annual gross receipts from foreign branches. the court concluded that nothing in the structure of § 41 nor the legislative history indicates that congress did not intend to include foreign gross receipts in the § 41(c)(4) calculation. the court indicated that if congress had intended to exclude foreign gross receipts, it would have so mandated. the court also concluded that including the foreign gross receipts is not inconsistent with the focus of the research credit on increases in domestic research activities. 9. property sold to customers is “supplies!” huh? tg missouri corporation v. commissioner, 133 t.c. no. 13 (11/12/09). the § 41 research credit includes in qualified research expenses the cost of “supplies used in the course of qualified research.” under § 41(b)(2)(c) supplies include tangible personal property, but do not include property subject to the allowance for depreciation. the taxpayer manufactures automobile parts for customers. in the course of designing and producing new parts the taxpayer designs and engineers production molds that it purchases from a third-party tool maker. once the production molds are ready for the production of parts for the customer the taxpayer sells the molds to the customer. however, the taxpayer retains possession of the molds as it produces parts for the customer. the irs asserted that the molds are property of a character subject to the allowance for depreciation regardless of whether the molds are depreciable property in the taxpayer’s hands. the tax court (judge marvel) accepted the taxpayer’s interpretation of § 41(b)(2)(c) that the exclusion from supplies applies to property that is subject to the allowance for depreciation in the hands of the taxpayer. the court examined language in § 174(c) to conclude that for both purposes the exclusion applicable to depreciable property is applicable to property that is accounted for by the taxpayer as depreciable property. by virtue of its sale of the molds to customers, taxpayer did not retain an economic interest in the molds entitling it to claim depreciation deductions, notwithstanding the taxpayer’s continued possession of the molds. the court also looked to §§ 1239 and 453 to conclude that references in the code to depreciable property are not limited to the extrinsic nature of the property alone, but depend upon the property being depreciable in the hands of the holder. 115 florida tax review [vol. 10:si g. natural resources deductions & credits 1. and they call the wind maria. the 2009 arra, § 1302(a), added to the 30 percent energy credit (investment credit) under code § 46, wind facilities eligible for the § 45 renewable electricity production credit placed in service in 2009 through 2012, and any other facility eligible for the § 45 renewable electricity production credit placed in service in 2009 through 2013 (except small irrigation power facilities, refined coal production facilities, and indian coal production facilities). if the § 48(a) energy credit is claimed for any such facility, the § 45 renewable electricity production credit cannot be claimed. the act also added to the § 46 credit the § 48c qualifying advanced energy credit. • the one of us who’s from texas thinks that wind power is capable of completely replacing oil as an energy source if only the wind industry would deploy its back-up gerbils on calm days. 2. another green energy credit. the 2009 arra, § 1302(b), added the § 48c “qualifying advanced energy project” credit as part of the § 46 investment credit. the credit amount is 30 percent of the investment, measured by basis, in eligible property placed in service in a qualified advanced energy manufacturing project after 2/17/09. a qualified advanced energy manufacturing project is defined as a project that re-equips, expands, or establishes a manufacturing facility for the production of (1) property designed to be used to produce energy from the sun, wind, or geothermal deposits or other renewable resources, (2) fuel cells, microturbines, or an energy storage system for use with electric or hybridelectric motor vehicles, electric grids to support the transmission of intermittent sources of renewable energy, including storage of that energy, (3) property designed to manufacture equipment for use for carbon capture or sequestration, (4) property designed to refine or blend renewable fuels to produce energy conservation technologies (including energy-conserving lighting technologies and smart grid technologies), (5) new § 30d qualified plug-in electric drive motor vehicles, (6) § 30(d) qualified plug-in electric vehicles or components that are designed specifically for use with these vehicles, including electric motors, generators, and power control units, or (7) other advanced energy property designed to reduce green house gas emissions. only (1) depreciable tangible personal property, and (2) “other tangible property (not including a building or its structural components)” — presumably meaning fixtures — used in a qualified advanced energy manufacturing project qualify for the credit. property used in the refining or blending of any transportation fuel, other than renewable fuels, does not qualify. although the accompanying committee report states that the basis of qualified property must be reduced by the amount of credit, the statute does not so provide; presumably a technical correction will be necessary to 2010] recent developments in federal income taxation 116 implement any requirement of a basis reduction. if a credit is allowed under § 48c, no credit is allowed for the expenditure under §§ 48, 48a, or 48b. section 48c(b)(3) limits the credit to qualified advanced energy manufacturing projects certified as eligible by the treasury department, after consultation with the secretary of energy. the maximum amount of credits that may be certified is $2.3 billion. the statute sets time frames for applying for certification and certain procedures and criteria that the treasury department should apply in determining whether any particular project should be certified. the treasury department is required to review projects for which credits have been allocated, and may reallocate credits under certain circumstances. h. loss transactions, bad debts, and nols 1. duh! stock that is still trading is not worthless yet. rendall v. commissioner, 535 f.3d 1221 (10th cir. 8/5/08), aff’g t.c. memo. 2006-174. the taxpayer lent $2 million to a publicly traded company that he had founded. the loan was secured by stock of the company held as security by the lender, merrill lynch. the loan proceeds were used to partially fund construction of a plant in canada to extract crude oil from oil shale. in 1997 the corporation declared bankruptcy in canada and the united states. merrill lynch sold a portion of the taxpayer’s pledged stock to satisfy the debt. the company arranged to sell most of its assets, but retained rights to certain of its patented technologies. at the close of the 1997 tax year the company stock was traded over-the-counter for $3 per share. at that time the corporation still owned numerous technologies, patents, office space, a research facility, and land and continued to employ a team of engineers. the court of appeals affirmed the tax court holding denying a deduction in 1997 for worthless debt. the court agreed with the tax court’s conclusion that at the end of 1997 the taxpayer had not met the standard for treating the debt as worthless, which it described as “fixed by identifiable events that form the basis of reasonable grounds for abandoning any hope of recovery.” • “‘where a debtor company continues to operate as a going concern the courts have often concluded that its debts are not worthless for tax purposes despite the fact that it is technically insolvent.’” (quoting roth steel tube co. v. commissioner, 620 f.2d 1176, 1182 (6th cir. 1980)). • the court also rejected the taxpayer’s claim that it realized no gain on the disposition of its pledged stock. the taxpayer argued that merrill lynch sold the stock without permission and that any income should be taxed to merrill lynch which obtained the stock by theft. the court also upheld the tax court’s allocation of basis to the sold shares on a fifo basis. 117 florida tax review [vol. 10:si (a) but optimism doesn’t always pay when selecting the year to claim a worthless stock loss. bilthouse v. united states, 553 f.3d 513 (7th cir. 1/15/09), aff’g 100 a.f.t.r.2d 2007-6191 (n.d. ill. 9/28/07). the taxpayers were passive investors (they did not materially participate) in an s corporation that had passed-through losses that were suspended. the taxpayers asserted that cancellation of indebtedness income realized by the insolvent s corporation in 1997 increased the taxpayers’ stock basis and that the stock became worthless in 1997, thereby allowing the taxpayers to treat the worthlessness as a disposition, permitting deduction of the passive activity losses. the taxpayers filed a refund claim based on the theory that the stock became worthless in 1997, and that the worthlessness was a complete taxable disposition under § 469(g) that allowed the losses to be claimed. the court of appeals affirmed the district court’s denial of the refund claim on the ground that the stock had become worthless in 1995, not 1997, as claimed by the taxpayer, and that 1995 thus was the year of the disposition. as of 1995, the stock of the corporation had no liquidating value. although it was pursuing a lawsuit from which the shareholders claimed that the corporation expected a large financial recovery that would have allowed it to stay in business, the record did not demonstrate that the lawsuit represented a reasonable possibility that the corporation would remain in business after 1995, because there was no evidence proving any basis for why anyone thought the lawsuit would be successful. the suit was settled in 1997 with no damages being awarded to the corporation. the court stated “a taxpayer relying on the potential value of a company to put off the year of worthlessness must provide objective evidence of this value; merely asserting his self-serving hopes will not do.” 2. carry me back to those long ago days of yore, when there were profits to be offset by today’s nol. the 2009 arra, § 1211(b), amended code § 172 to permit an “eligible small business” to elect to extend the carryback period for a net operating loss arising in 2008 to any number of years greater than two or fewer than six – i.e., the elected carryback period may be five, four, or three years. (absent an election the normal two year carryback rule still applies.) an “eligible small business” is defined in § 172(b)(1)(h)(iv) (through cross references to § 172(b)(1)(f)) as a corporation, partnership, or sole proprietorship with average annual gross receipts of $15 million or less. an election under § 172(b)(1)(h) must be made by the due date (including extensions) for filing the taxpayer’s return for the year the net operating loss arose (i.e., 2008). if the taxpayer is on a fiscal year, the election can be made with respect to either the taxable ending in 2008 or the taxable year beginning in 2008, but not with respect to both taxable years. § 172(b)(1)(h)(ii),(iii). the election is irrevocable. 2010] recent developments in federal income taxation 118 (a) and here’s instructions on how to get back to those days of yore. rev. proc. 2009-19, 2009-14 irb 747 (3/16/09). this revenue procedure provides guidance under § 1211 of 2009 arra, which amended § 172(b)(1)(h) to allow a taxpayer that is an eligible small business to elect a 3-, 4-, or 5-year nol carryback for a taxable year ending after 2007. (b) rev. proc. 2009-19 was modified and superseded by rev. proc. 2009-26. rev. proc. 2009-26, 2009-19 i.r.b. 935 (4/25/09). this revenue procedure was issued because many eligible small businesses inadvertently failed to make valid elections that complied with rev. proc. 2009-19. (c) now the carryback is available to larger businesses as well. section 13 of the worker, homeownership, and business assistance act of 2009 (whaba) amends § 172 to permit larger businesses to make the 2009 arra 2008 and 2009 nol carryback election of up to five years. the election applies with respect to nols incurred in either 2008 or 2009, but not both years. in addition, 2008 or 2009 nols can be used to offset only fifty percent of the taxable income earned in the fifth prior taxable year. this 50 percent limit does not apply to carrybacks of 2008 losses by “eligible small businesses.” in addition, an “eligible small business” may take advantage of the extended carryback rules with respect to both 2008 and 2009 losses, rather than the losses of only one of those years. generally, the extended nol carry back election is not available for tarp recipients or corporations that, at any time during 2008 or 2009 were a member of an affiliated group including a tarp recipient. • this provision also increases the use of nols to offset a corporation’s alternative minimum taxable income by the nols the taxpayer elects to carry back up to five taxable years and removes the 90 percent amt limit. (d) more instructions. rev. proc. 2009-52, 2009-49 i.r.b. 744 (11/20/09). this revenue ruling provides guidance regarding procedures for making the election and its effect. the revenue procedure explains which business can elect the net operating loss carry back periods provided by whaba. 3. “take your submarine sandwich shop and shove it” earns a loss deduction for the franchise fee. alami v. commissioner, t.c. memo. 2009-42 (2/23/09). judge vasquez held that the taxpayer had established abandonment of quiznos restaurant franchise (basis $25,000), and an associated corporate charter (basis $750). the taxpayer continually expressed intent to abandon the franchise by repeatedly expressing to 119 florida tax review [vol. 10:si quiznos representatives his desire to have the franchise fee refunded because he no longer sought to open a quiznos restaurant, he did not contribute the additional money needed to open a quiznos restaurant or select a location within the 1-year limit in the initial franchise agreement, and he filed a complaint with the state attorney general when quiznos failed to respond to repeated requests for a refund. there was no evidence that the taxpayer took any steps to use the corporation for purposes other than running a quiznos franchise; rather, at trial the taxpayer was not even aware whether the corporation remained in existence. 4. the irs comes to rescue the loss deductions of bernie madoff’s ponzi scheme victims. rev. rul. 2009-9, 2009-14 i.r.b. 735 (3/17/09). this revenue ruling, issued in response to the bernie madoff ponzi scheme scandal, comprehensively addresses the tax treatment of losses to investors from criminally fraudulent ponzi investment schemes. as for the proper treatment, the irs ruled as follows: (1) a loss from a ponzi scheme is a loss from a criminal fraud or embezzlement in a transaction entered in profit that is a theft loss, not a capital loss, under § 165; (2) the loss is deductible under § 165(c)(2), not § 165(c)(3). (rev. rul. 71-381 is obsoleted to the extent that it holds that a theft loss incurred in a transaction entered into for profit is deductible under § 165(c)(3) rather than § 165(c)(2).); (3) the loss is an itemized deduction, but is not subject to the limitation on personal losses in § 165(h), or the limitations on itemized deductions in §§ 67 and 68; (4) the theft loss is deductible in the year it is discovered, to the extent that the loss is not covered by a claim for reimbursement, with respect to which there is a reasonable prospect of recovery; (5) the amount of a theft loss is the amount invested in the arrangement, less amounts withdrawn, if any, reduced by reimbursements or recoveries, and reduced by claims as to which there is a reasonable prospect of recovery. where an amount is reported to the investor as income prior to discovery of the arrangement and the investor includes that amount in gross income and reinvests this amount in the arrangement, the amount of the theft loss is increased by the purportedly reinvested amount; and (6) a theft loss in a transaction entered into for profit may create or increase a net operating loss under § 172 that can be carried back up to 3 years and forward up to 20 years; the three-year carryback for a theft loss is permitted under § 172(b)(1)(f). the investor can also qualify as an eligible small business under § 172(b)(1)(f)(iii) and § 172(b)(1)(h)(iv), and if the investor qualifies, under § 172(b)(1)(h)(iv), the investor may elect either a 3-, 4-, or 5-year net operating loss carryback for an applicable 2008 net operating loss. 2010] recent developments in federal income taxation 120 • the ruling also holds that certain relief provisions do not apply: (1) a theft loss in a transaction entered into for profit does not qualify for § 1341 treatment; and (2) a theft loss in a transaction entered into for profit does not qualify for the application of the mitigation rules in §§ 1311-1314 to adjust tax liability in years that are otherwise barred by the period of limitations on filing a refund claim. (a) and a safe-harbor to ease the burden of calculating potential recoveries that affect the amount and proper year for the deduction. rev. proc. 2009-20, 2009-14 i.r.b. 749 (3/17/09). this revenue procedure provides an optional safe harbor under which qualified investors (as defined in the revenue procedure) may treat a ponzi scheme loss as a theft loss deduction. its purpose is to alleviate the problems that arise because highly factual determinations regarding ponzi schemes that are required by rev. rul. 2009-9, which describes the proper treatment regarding claiming ponzi scheme theft losses. the revenue procedure requires many qualifying conditions, and it does not include a person that invested solely in a fund or other entity that invested in the specified fraudulent arrangement (although it can apply to the fund or entity itself). among the qualifying conditions are that the lead figure (1) must have been either (a) charged by indictment or information with a crime that would have been theft if convicted, or (b) subject to a state or criminal complaint alleging such a crime, and (2) either (a) the complaint alleged an admission by the lead figure, or the execution of an affidavit by that person admitting the crime; or (b) a receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen. if the myriad of qualifying conditions is satisfied, the safe harbor deduction amount is computed under the following formula: (1) multiply the amount of the “qualified investment” by — (a) 95 percent, for a qualified investor that does not pursue any potential third-party recovery; or (b) 75 percent, for a qualified investor that is pursuing or intends to pursue any potential thirdparty recovery; (2) subtract from this product the sum of any actual recovery and any potential insurance and/or securities investor protection recovery. • generally speaking, the amount of the “qualified investment” equals the sum of (1) the amount invested (money and the basis of property) in the arrangement, and (2) amounts previously included in gross income by investor that were purportedly reinvested, minus any amounts withdrawn. the safe harbor “discovery year’ for claiming the 121 florida tax review [vol. 10:si deduction is the investor’s taxable year in which the indictment, information, or complaint is filed. • the amount of the deduction so determined is not further reduced by potential direct recovery or potential thirdparty recovery. however, the investor may have income or an additional deduction in a subsequent year depending on the actual amount of the loss that is eventually recovered. special procedures must be followed in completing the investor’s tax return to flag that the investor is claiming a safe-harbor theft loss under the revenue procedure. the taxpayer must sign and attach to the return a statement agreeing: (1) not to deduct in the discovery year an amount in excess of the deduction permitted under the revenue procedure; (2) not to file returns or amended returns to exclude or recharacterize income reported with respect to the investment arrangement in taxable years preceding the discovery year; (3) not to apply § 1341 with respect to the theft loss deduction allowed by the revenue procedure; and (4) not to apply the doctrine of equitable recoupment or the mitigation provisions in §§ 1311-1314 with respect to income from the investment arrangement that was reported in taxable years that are otherwise barred by the period of limitations. • a taxpayer that does not elect to use the safe harbor provided by the revenue procedure is subject to all of the generally applicable provisions governing the deductibility of losses under § 165, including proof that a theft occurred, proof of the year of discovery, and proof that there is no reasonable prospect of recovery. a taxpayer that does not apply the safe harbor and files or amends income tax returns for years prior to the discovery year to exclude amounts reported as income from the investment arrangement must establish that those amounts were actually or constructively received (or accrued by a taxpayer using an accrual method of accounting). (b) but life is tough outside the safe-harbor rule. vincentini v. commissioner, t.c. memo. 2009-255 (11/9/09). judge marvel held that the taxpayer could not deduct any portion of a $511,500 theft loss incurred in fraudulent investment scheme because he failed to prove that he had no reasonable prospect of recovery. the taxpayer offered no evidence regarding (1) whether he had received or would receive any restitution, (2) the status of any restitution payments, (3) the availability of funds from the substantial forfeitures ordered by the state court, (4) whether the perpetrators were judgment proof or had insufficient assets to satisfy the restitution orders, (5) that the forfeitures did not occur as ordered, or (6) that it was otherwise improbable that he would receive restitution pursuant to the restitution orders. 5. why not just give all losses a ten year carryback? in re harvard industries, inc. 568 f.3d 444 (3d cir. 6/17/09). section 172(b)(1)(c) provides for a ten year carryback of specified liability losses, 2010] recent developments in federal income taxation 122 which are defined in § 172(f) as product liability losses that arise out of physical or emotional injury or loss of use of property on account of a defect in products produced by the taxpayer, and liability that arose out of state or federal law, or out of any tort committed by the taxpayer. in a bankruptcy proceeding the taxpayer claimed federal tax refunds based on carrybacks of specified liability losses. the taxpayer produced defective lock nuts for use in aircraft engines. no one was actually injured as a result of the defects, but the taxpayer suffered losses in actions by distributors who could not sell the defective lock nuts. the court concluded that “loss of property” could refer to the loss of the defective product itself so that losses attributable to settlements with distributors who could not sell the defective product qualified under the definition of specified liability losses. the court also held that losses incurred in making payments to its pension plan as required by the pbgc were losses incurred under federal law because of the minimum funding requirements of erisa. finally, the court affirmed lower court rulings that retrospective workers compensation insurance premiums, including the portion of the premiums representing the insurance company’s administrative costs, represented specified liability losses as they arose under state workers compensation laws. i. at-risk and passive activity losses 1. you don’t need a real estate broker’s license from the state to be a real estate broker for purposes of § 469. agarwal v. commissioner, t.c. summ. op. 2009-29 (3/2/09). the taxpayer, who worked full-time as a licensed real estate agent, but was not a licensed real estate broker, deducted losses from a real estate rental activity in which she materially participated against her compensation income. under § 469(c)(7), if more than one-half of the personal services performed by the taxpayer during the year are performed in one or more real property trades or businesses in which the taxpayer materially participates and the taxpayer performs more than 750 hours of services in such activities, then any real property rental activity in which the taxpayer materially participates is not treated as a per se passive activity, and losses are fully deductible against the taxpayer’s income from all sources. section 469(c)(7)(c) defines a real property trade or business as any real property development, redevelopment, construction, acquisition, conversion, rental, management, leasing, or brokerage business. special trial judge dean held that for purposes of § 469(c)(7), the “business” of a real estate broker includes, but is not limited to: (1) selling, exchanging, purchasing, renting, or leasing real property; (2) offering to do those activities; (3) negotiating the terms of a real estate contract; (4) listing of real property for sale, lease, or exchange; or (5) procuring prospective sellers, purchasers, lessors, or lessees. under this standard, a licensed real estate agent qualifies as a real estate broker for 123 florida tax review [vol. 10:si purposes of § 469(c)(7), even if the agent is not a licensed real estate broker under state law. 2. rock, hammer, warehouse – these activities are not an economic unit. senra v. commissioner, t.c. memo. 2009-79 (4/15/09). the taxpayer owned a warehouse through a disregarded llc, which leased the warehouse to a c corporation, 86.75 percent of which was owned by the taxpayer and which employed the taxpayer. the taxpayer deducted losses from the rental activity against his salary from the c corporation, claiming that the warehouse leasing and employment by the c corporation was a single activity under reg. § 1.469-4. the tax court (judge chabot) held that the warehouse activity could not be grouped with the c corporation activity. reg. § 1.469-4(d)(5)(ii) permits an activity that a taxpayer conducts through a c corporation to be grouped with another activity only for the purposes of determining whether the taxpayer materially or significantly participates in the other activity. otherwise, an activity conducted through a c corporation may not be grouped with another activity. thus, the warehouse activity losses could not be deducted against the salary from the c corporation. the court also noted that although the taxpayers may have undertaken their activities with a different structure that would have permitted use of the losses, they are bound by the form of the business they adopted. 3. limited liability partnership and limited liability company membership interests are not presumptively limited partnership interests under the passive activity loss rules. garnett v. commissioner, 132 t.c. no. 19 (6/30/09). the taxpayers held a number of direct and indirect interests in limited liability partnerships and llcs that were engaged in agribusiness. section 469(h)(2) provides that a limited partnership interest will not be treated as an interest with respect to which a taxpayer is a material participant, except as provided in regulations. temp. reg. § 1.469-5t(e) provides that a limited partner materially participates in a partnership activity only if (1) the taxpayer devotes more than 500 hours to the activity in the year, (2) the taxpayer materially participated in the activity for five of the preceding ten taxable years, or (6) the activity is a personal service activity in which the taxpayer materially participated for any three preceding years. temp. reg. § 1.469-5t(e)(3) defines a limited partnership interest as an interest designated as a limited partner interest in a partnership agreement or an interest for which the partner has limited liability. temp. reg. § 1.469-5t(e)(3)(ii) has an exception from the material participation rule for an interest of a limited partner who also holds a general partner interest. the court (judge thornton) concluded that in the case of an interest in a limited liability partnership or a limited liability company, both of which the court describes as different from a limited partnership, the interests are 2010] recent developments in federal income taxation 124 not to be treated as limited partnership interests under § 469(h)(2). holders of such interests are not barred by state law from materially participating in the affairs of the entity and thus hold their interests as general partners within the meaning of the temporary regulations. thus, whether or not the taxpayer is a material participant requires a full factual inquiry and an llc member can satisfy the material participation requirement under any of the seven in temp. reg. § 1.469-5t(a). (a) the court of federal claims agrees. thompson v. united states, 87 fed. cl. 728 (7/20/09). the court (judge block) granted summary judgment treating the taxpayer member/manager of an llc as a material participant. the taxpayer’s degree of participation was stipulated and the only question was whether § 469(h)(2) precluded treating the taxpayer as a material participant in a texas llc. the court noted that § 469(h)(2) treats limited partners differently because of an assumption that limited partners do not materially participate in their limited partnerships. in an llc, on the other hand, all members have limited liability but members may participate in management. the court noted that temp. reg. § 1.4695t(e)(3) treats a partnership interest as a limited partner interest if the holder has limited liability “under the law of the state in which the partnership is organized.” the court held that the quoted language applies only to an entity that is a partnership under state law, which does not include an llc that is a different state law entity that is treated as a partnership for tax purposes. the taxpayer was both a member and manager of the llc. unlike a limited partner, a member manager does not lose limited liability by participation in the management of the llc. the court also recognized that shareholders of an s corporation have limited liability as shareholders, but participate in management, and are not subject to being automatically treated as passive participants. the taxpayer, therefore, was “able to demonstrate his material participation in the activity by using all seven of the temp. reg. § 1.4695t(a) tests.” (b) ditto. hegarty v. commissioner, t.c. summ. op. 2009-153 (10/6/09), is to the same effect. 4. deciding on whether to uphold the commissioner’s rejection of this horse lover’s losses is like pulling teeth. cunningham v. commissioner, t.c. memo. 2009-194 (8/31/09). the taxpayer, a new york dentist, claimed losses from five partnership horse activities in california on returns prepared by a tax return preparer. the court (judge cohen) found that the taxpayer had no knowledge of whether or not the horse activities occurred as represented in the partnership returns. he relied on representations by the return preparer in deducting the partnership losses against their other income. the taxpayer’s suggestion that the court 125 florida tax review [vol. 10:si google the return preparer to ascertain that the taxpayer was mislead by a charlatan and that paying the tax would result in financial hardship did not impress judge cohen, and the deficiency was upheld. the court also rejected the taxpayer’s argument that he had reasonable cause for failing to file a timely return and imposed penalties under § 6651(a)(1). iii. investment gain and income a. gains and losses 1. stimulating stock investments in small business corporations. the 2009 arra, § 1241(a), amended code § 1202 to provide special rules for qualified small business stock acquired in 2009 and 2010, regardless of when the stock is sold. for such stock, seventy-five percent of the gain (rather than fifty percent) is excluded under § 1202(a), and the special rules of § 1202(a)(2) for stock in a qualified empowerment zone business do not apply. 2. gain is recognized on an exchange even if the taxpayer didn’t yet have what she got and she might not have gotten to keep it. united states v. culp, 99 a.f.t.r.2d 2007-618, 2007-1 u.s.t.c. ¶50,399 (m.d. tenn. 12/29/06). the government was granted summary judgment in an erroneous refund suit. the taxpayer exchanged her partnership interest in ernst & young for stock of a corporation acquiring e&y’s consulting business, in a transaction that was not a statutory nonrecognition event; however, the stock was held in escrow to enforce a forfeiture provision if the seller-taxpayer failed to perform certain services as an employee of the acquiring corporation. the court held that the open transaction doctrine was not applicable. if a taxpayer exchanges one property for a different property, the gain realized on the exchange must be recognized in the year the exchange occurs, even though the property received in the exchange is forfeitable if contractual provisions or representations in the contract for exchange are not subsequently satisfied and even though the property received in the exchange is held in escrow to assure enforcement of the forfeitability provisions. (a) the seventh circuit affirmed taxable exchange treatment for an e&y consulting partner in a capgemini exchange. united states v. fletcher, 562 f.3d 839 (7th cir. 4/10/09), aff’g 101 a.f.t.r.2d 2008-588, 2008-1 u.s.t.c. ¶50,149 (n.d. ohio 1/15/08). in this 2000 exchange of taxpayer’s partnership interest in e&y for restricted stock of capgemini, the seventh circuit (judge easterbrook) affirmed the summary judgment award to the government in this erroneous refund suit, 2010] recent developments in federal income taxation 126 and in the process “fletcherized”4 the e&y consulting partner involved because she took inconsistent positions. the taxpayer initially took the position that all of the capgemini shares received vested in the year 2000 (the year of the exchange), but after the stock declined in value took the position that she received income in 2000 only to the extent of cash she received in that year and the remainder of her income was recognized in 2003 (when the stock was worth less than one-fifth of its 2000 value). • judge easterbrook did not appreciate the argument that she signed the “consulting partner transaction agreement” (which provided for taxable gain in 2000) only because she was afraid she would be fired if she did not do so. both the district court and the seventh circuit held that under either commissioner v. danielson, 378 f.2d 771 (3d cir. 1967), or the alternative “strong proof” test, taxpayer was bound by the agreement she signed. the court stated that: fletcher argues that she didn’t “really” agree to the structure that ernst & young and cap gemini (and most of her partners) wanted in 2000. if she had voted no and refused to sign, she maintains, she would have been excluded from the economic benefits and might have been fired. if this is so, then she had a difficult choice to make; it does not relieve her of the choice’s consequences. hard choices may be gut-wrenching, but they are choices nonetheless. even naive people baffled by the fine print in contracts are held to their terms; a sophisticated business consultant who agrees to a multi-million-dollar transaction is not entitled to demand the deal’s benefits while avoiding its detriments. the argument that fletcher can avoid the terms as a matter of contract law is frivolous. all that matters now are the tax consequences of the contracts she signed. • judge easterbrook concluded: the more likely it is that the conditions will be satisfied, and all restrictions lifted, the more sensible it is to treat all of the stock as constructively received when deposited in the account. to see this, suppose that the parties had wanted to defer the recognition of income and had put $ 2.5 million in each partner’s account, with the condition that the whole amount would be forfeited if the temperature in barrow, alaska, exceeded 80° f on january 1, 2005. would the remote possibility of an arctic heat wave enable the partners to defer paying taxes? surely not. see cemco 4. horace fletcher (1849–1919), a health food faddist, argued that food should be chewed thirty-two times before being swallowed. “nature will castigate those who don’t masticate.” 127 florida tax review [vol. 10:si investors, llc v. united states, 515 f.3d 749 (7th cir. 2008). if, on the other hand, the parties agreed that the expartners would receive $ 2.5 million only if the temperature in barrow on january 1, 2005, exceeded 80° f, then none of the partners would constructively receive income in 2000; everything would depend on events in 2005. the sort of contingencies that could lead to forfeitures were within the ex-partners’ control. that implies taxability in 2000, for control is a form of constructive possession. and the agreement to discount the stock by only 5% tells us that the parties deemed forfeitures unlikely. fletcher’s acknowledgment that the risk of forfeiture was small shows that the conditions of constructive receipt in 2000 have been satisfied. thus although we agree with fletcher that the expartners are entitled to contest the tax treatment called for by the 2000 contracts, we hold that the shares are taxable in 2000 at their value on the date of deposit to the accounts at merrill lynch. income was constructively received in that year not because the contract said that everyone would report it so to the irs, but because the parties were right to think that this transaction’s actual provisions made the income attributable to 2000. that the price of capgemini stock dropped in 2001 and later does not entitle the parties to defer the recognition of income. fletcher must repay the refund (and amend her returns for later years to reflect receipt of the income in 2000). 3. the irs gives insureds a partial pass on the “substitute for ordinary income” limitation on capital gains treatment when they sell their life insurance policies. rev. rul. 2009-13, 2009-21 i.r.b. 1029 (5/1/09). this revenue ruling addresses the amount and character of income recognized with respect to the disposition by the insured of a life insurance policy in three different factual situations. first, upon the surrender by the owner of a life insurance contract to the issuer for its cash surrender value, the amount of income recognized is the amount received minus the investment in contract, and the income is ordinary income. second, if a life insurance contract is sold to unrelated person who would not suffer loss if beneficiary died, the amount of income realized is the amount received on sale minus the adjusted basis in contract. the adjusted basis is the total premiums adjusted to properly reflect “cost of insurance,” which is excluded from the contract’s basis in determining the gain realized on the sale. the portion of the gain reflecting inside build-up immediately prior to the sale is 2010] recent developments in federal income taxation 128 ordinary income, but any excess amount is capital gain, which is long term if the contract has been held for more than one year. third, if a term-life contract with no cash surrender value is sold to an unrelated person who would not suffer a loss if beneficiary died, the amount of income recognized is the excess of the amount realized over the adjusted basis of contract; because the cost of insurance each month is presumed to equal to monthly premium paid, there is no inside build-up under contract, and thus the entire amount recognized is long-term capital gain. (a) let the life insurance gambling tax shelter wave begin. the irs gives a third-party purchaser of life insurance who buys the insured’s contract a full pass on the “substitute for ordinary income” limitation on capital gains treatment when he sells the life insurance policy instead of waiting for ordinary gain on the payout. rev. rul. 2009-14, 2009-21 i.r.b. 1031 (5/1/09). this revenue ruling deals with the treatment in three different situations of a cash method taxpayer who purchases a life insurance contract from the insured. in all three situations, the contract was a level premium fifteen-year term life insurance contract without cash surrender value. the purchaser had no insurable interest or relationship to the insured. at the time of purchase, the remaining term of the contract was 7 years, 6 months, and 15 days. the monthly premium for the contract was $500, due and payable on the first day of each month. the purchaser named itself beneficiary under the contract immediately after acquiring the contract. • in the first situation, the purchaser paid the insured $20,000 for the contract, paid premiums totaling $9,000 to keep the contract in force, and received $100,000 under the life insurance contract upon the insured’s death. the ruling concludes that although the life insurance contract was not property described in § 1221(a)(1)-(8), and thus was a capital asset in the purchaser’s hands, “neither the surrender of a life insurance or annuity contract nor the receipt of a death benefit from the issuer under the terms of the contract produces a capital gain.” accordingly, the $71,000 income recognized by the purchaser upon the receipt of the death benefit was ordinary income. • in the second situation, prior to the insured’s death the purchaser sold the life insurance contract to another person for $30,000, after paying the insured $20,000 for the contract and premiums totaling $9,000. the ruling held that the $9,000 of premiums paid by the purchaser to keep the contract in force were capital expenditures, which were added to the original $20,000 basis in the contract. the purchaser recognized a $1,000 gain, which was a capital gain because the life insurance contract was not property described in § 1221(a)(1)-(8), and thus was a capital asset. • the third situation was the same as the first situation, except the purchaser was a foreign corporation that was not 129 florida tax review [vol. 10:si engaged in any u.s. trade or business. the purchaser again recognized $71,000 of income upon the receipt of death benefits. this income is “fixed or determinable annual or periodical” income subject to u.s. under § 881(a)(1), see reg. § 1.1441-2(b); rev. rul. 64-51, 1964-1 c.b. 322; rev. rul. 2004-75, 2004-2 c.b. 109. (b) gross income without cash upon surrender of life insurance policy with outstanding policy loans. barr v. commissioner, t.c. memo. 2009-250 (11/3/09). when an insurance company withholds from the cash surrender value of a life insurance policy upon its surrender amounts necessary to repay policy loans, the withheld amount is constructively realized by the owner of the policy and is included in the amount taxable under § 72(e). 4. small-time, one-time real estate developer gets capital gain treatment. rice v. commissioner, t.c. memo. 2009-142 (6/16/09). the taxpayers purchased a 14.4 acre parcel of land on which to build their “dream home.” they originally planned to keep the entire property and build a single home for them and their children. when mrs. rice became concerned about being too “isolated,” they subdivided a portion of the property and sold eight lots (only six suitable for construction) to six different buyers, over nine years, reserving one lot for their daughter and keeping the remaining land for their residence, on which they built a home with 8,000 square feet of interior space and 4,000 square feet of garages and porches. they had never before (or subsequently) engaged in real estate development and sales activities, and both had full-time jobs. judge kroupa held that the taxpayers realized capital gains, not ordinary income on the sales of the three lots sold during the year at issue. the total number of lots sold in all years was small, and the substantiality and frequency of sales is among the most important factors in determining whether sales were to customers in the ordinary course of business. the lots were sold primarily to friends, friends of friends, and relatives. other than posting a sign outside the subdivision, petitioners did not advertise or promote the sale of lots. their efforts were “more characteristic of those of investors than of dealers.” finally, although the taxpayers made significant improvements to develop and sell the lots, many of those improvements would have been necessary merely to build their own residence. 5. pizza is the eighth deadly sin, and the ninth is stealing the sausage process, even if the damages are taxable. freda v. commissioner, t.c. memo. 2009-191 (8/25/09). the taxpayer supplied pizza hut with pre-cooked sausage prepared with the taxpayer’s patented process. the taxpayer also entered into license and royalty agreements to provide its trade secrets to other pizza hut suppliers. after discovering that 2010] recent developments in federal income taxation 130 pizza hut disclosed the process to an unlicensed supplier who also sold precooked sausage to pizza hut, the taxpayer recovered damages from pizza hut for misappropriation of trade secrets. the court (judge chiechi) held that the damages were received as compensation for lost profits, and thus were taxable as ordinary income. the court rejected the taxpayer’s argument that the damages were for injury to or destruction of the trade secret, a capital asset. 6. new rules for determining basis in securities. the emergency economic stabilization act of 2008 [division b], act § 403, amends § 1012 to create new rules for determining the basis of securities acquired after 12/31/10. the fifo or other conventions for determining the basis of securities when sold must be applied on an account-by-account basis. thus, with respect to a taxpayer who holds the same stock in more than one account, determining the basis of sold securities from any account will be determined solely with regard to the basis of securities in that account. in addition, § 1012(d) provides for averaging the basis of stock acquired in a dividend reinvestment plan. stock in a dividend reinvestment plan is treated as held in a separate account for purposes of determining basis. (a) no more fooling the irs about basis. the emergency economic stabilization act of 2008 [division b], § 403, adding § 6045(g), requires brokers to report the customer’s basis in a “covered security” and whether gain or loss is long-term or short-term, in addition to the existing requirement that the broker report gross sales proceeds. in general, the customer’s basis is to be reported on a first-in firstout method, unless an average basis method is permissible. covered securities include securities acquired through an account with the broker or transferred to the broker from another account on or after an applicable date. january 1, 2011, is the applicable date for stocks. january 1, 2012, is the applicable date for stocks under the average basis method. january 1, 2013, or such later date as is specified by the irs, is the applicable date for any other security. under § 6045a, a taxpayer transferring securities to a broker will be required to report information required by regulations necessary to permit the broker to meet its reporting requirements. section 6045b requires the issuer of any security to report information describing any organizational action that affects the basis of the security. (b) and the irs begins to gear up. reg101896-09, basis reporting by securities brokers and basis determination for stock, 74 f.r. 67010 (12/17/09). these proposed regulations relate to reporting sales of securities by brokers (prop. reg. § 1.6045-1) and determining the basis of securities (prop. reg. § 1.1012-1). the proposed 131 florida tax review [vol. 10:si regulations reflect changes in the law made by the energy improvement and extension act of 2008 that require brokers when reporting the sale of securities to the irs to include the customer’s adjusted basis in the sold securities and to classify any gain or loss as long-term or short-term. the proposed regulations under § 1012 alter how taxpayers compute basis when averaging the basis of shares acquired at different prices, and expand the ability of taxpayers to compute basis by averaging with respect to ric shares and shares specifically held in a dividend reinvestment plan. brokers must furnish information statements to customers by february 15th. the proposed regulations provide for the implementation of new reporting requirements imposed upon persons that transfer custody of stock and upon issuers of stock regarding organizational actions that affect the basis of the issued stock. it also contains proposed regulations reflecting changes in the law that alter how brokers report short sales of securities. b. interest, dividends, and other current income 1. billions and billions of new private activity taxfree bonds. code § 1400u-2, added by § 1401(a) of the 2009 arra, creates a new category of tax-exempt private activity bonds, which are termed “recovery zone facility bonds.” generally speaking recovery zone facility bonds are subject to the rules that apply to qualified private activity bonds, except that they are not subject to the aggregate annual state private activity bond volume limits in § 146 and the § 147(d) restrictions on acquisition of existing property does not apply. under § 1400u-1, $15 billion in recovery zone facility bonds can be issued during 2009 and 2010. each state will receive a share of the national allocation based on that state’s job losses in 2008 as a percentage of national job losses in 2008, although each state will receive a minimum allocation of each of these bonds that is not less than 0.9 percent of the total bonds to be issued. these allocations will be, in turn, sub-allocated to local municipalities in proportion to job losses within the state. municipalities receiving an allocation of these bonds can use the proceeds of the bonds to invest in infrastructure, job training, education, and economic development in areas within the boundaries of the state, city or county. to be designated as an economic recovery zone an area must have significant poverty, unemployment, general distress, or home foreclosures, or be an area for which a designation as an empowerment zone or renewal community is in effect. to qualify as a recovery zone facility bond, 95 percent or more of the net proceeds of the bond issue must be used for “recovery zone property” and the issue must be designated by the issuer as a recovery zone facility bond. “recovery zone property” is any depreciable property to which § 168 applies (or would apply but for § 179): (1) that was purchased by the taxpayer after the designation of the recovery zone took effect; (2) the original use of which in the recovery zone commences with the 2010] recent developments in federal income taxation 132 taxpayer; and (3) substantially all of the use of which is used in the active conduct of a qualified business by the taxpayer in the recovery zone. a “qualified business” is any trade or business except residential rental property or the operation of a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or liquor store. apparently, bars and nightclubs qualify. (a) tribal development bonds. code § 7871, added by § 1402(a) of the 2009 arra, allows indian tribal governments to issue “tribal economic development bonds,” the interest on which is tax exempt under code § 103. tribal economic development bonds issued by an indian tribal government are treated as if such bonds were issued by a state, except that § 146 (relating to state volume limitations) does not apply. a tribal economic development bond is any bond issued by an indian tribal government (1) the interest on which would be tax-exempt if issued by a state or local government, and (2) that is designated by the indian tribal government as a tribal economic development bond. the aggregate face amount of bonds that may be designated by any indian tribal government cannot exceed the amount of national tribal economic development bond limitation allocated to such government. there is a national ceiling of $2 billion, which will be allocated by the treasury department, in consultation with the department of the interior. tribal economic development bonds cannot be used to finance any portion of a casino or any facility located outside of the indian reservation. 2. build america bonds. code § 54aa, added by § 1531 of the 2009 arra, provides a credit for holders of “build america” bonds on any interest payment date. the amount of the credit is 35 percent of the interest payable, and the credit can be claimed against the alternative minimum tax; unused credits can be carried over. a build america bond is any state or local obligation (other than a private activity bond), the interest received on which would otherwise be tax-exempt under § 103, which is issued before 2011 and which the issuer elects to be treated as a build america bond. interest on build america bonds must be included in gross income, and the amount of the credit must be included as well. §§ 54aa(f)(2), 54a(f). the issuer of a “qualified build america bond” can elect to claim a refundable credit equal to 35 percent of the interest payable in lieu of the holder being entitled to the credit. to be a qualified build america bond, one hundred percent of the available project proceeds, less a reasonably required reserve (as defined in § 150(a)(3)), must be used for capital expenditures. for build america bonds that are “designated recovery zone economic development bonds,” the credit rate for the issuer is 45 percent. i.r.c. §§ 1400u-2(a)(1); 6431(g). new § 1400u-2 creates tax credit 133 florida tax review [vol. 10:si bonds for investments in economic recovery zones. new § 1400u-1 authorizes $10 billion in recovery zone economic development bonds that can be issued during 2009 and 2010. to be designated as an economic recovery zone the area must have significant poverty, unemployment, general distress, or home foreclosures, or be any area for which a designation as an empowerment zone or renewal community is in effect. each state will receive a share of the national allocation based on that state’s job losses in 2008 as a percentage of national job losses in 2008, although each state will receive a minimum allocation of each of these bonds that is not less than 0.9 percent of the total bonds to be issued. these allocations will be, in turn, suballocated to local municipalities in proportion to job losses within the state. municipalities that receive an allocation of these bonds can use the proceeds of the bonds to invest in infrastructure, job training, education, and economic development in areas within the boundaries of the state, city or county (as the case may be) that have significant poverty, unemployment or home foreclosures. 3. credits for lenders who buy bonds to build schools. code § 54f, added by § 1521(a) of the 2009 arra, creates another new category of new category of tax-credit bonds for purposes of the § 54a credit: qualified school construction bonds. a taxpayer holding a qualified school construction bond on a credit allowance date is entitled to a tax credit at a rate (determined by the treasury department) that is the percentage rate that would permit issuance of such bonds without either discount or interest cost to the issuer. the amount of the tax credit is determined by multiplying the bond’s credit rate by the face amount of the bond. the credit accrues quarterly, is includible in gross income as if it were an interest payment on the bond, and can be claimed against regular income tax liability and alternative minimum tax liability. unused credits may be carried forward to succeeding taxable years. credits may be separated from the ownership of the underlying bond in a manner similar to the manner in which interest coupons can be stripped from interest-bearing bonds. to qualify, a school construction bond must meet three requirements: (1) 100 percent of the available project proceeds of the bond issue is used for the construction, rehabilitation, or repair of a public school facility or for the acquisition of land on which such a bond-financed facility is to be constructed; (2) the bond must be issued by a state or local government within which such school is located; and (3) the issuer must designate such bond as a qualified school construction bond. the maturity of qualified school construction bonds is the term that the treasury department determines will result in the present value of the obligation to repay the principal on such bonds being equal to 50 percent of the face amount of such bonds, using as a discount rate the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified school 2010] recent developments in federal income taxation 134 construction bonds are issued. there is a national limitation on qualified school construction bonds of $11 billion for each of 2009 and 2010. the statute provides elaborate rules for allocating the allowable dollar volume of bonds among the states, the district of columbia, united states possessions, indian tribal government schools, and large local educational agencies. qualified school construction bonds generally are subject to the arbitrage limitations of § 148, with a number of modifications. however, available project proceeds invested during the three-year spending period are not subject to the arbitrage restrictions (i.e., yield restriction and rebate requirements). in addition, amounts invested in a reserve fund are not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on such fund is not greater than the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified school construction bonds are issued. c. profit-seeking individual deductions 1. judge posner says that the distinction between a temporary and indefinite work location is untenable: “work can be, and usually is, both temporary and indefinite.” but the taxpayer gets bumped anyway. wilbert v. commissioner, 553 f.3d 544 (7th cir. 1/21/09), aff’g t.c. memo. 2007-152 (6/14/07). the taxpayer was a mechanic for northwest airlines, who was laid off at his work location in minneapolis. he exercised seniority rights to bump a mechanic in chicago, but he worked there for only a few days before being bumped by a more senior mechanic. subsequently, he bumped a mechanic in anchorage, and worked there for three weeks before being himself bumped. he then bumped a mechanic at laguardia airport, but worked there for only a week before he was bumped again. three weeks later the airline hired him back, outside the bumping system, to fill an interim position (maximum nine months) in anchorage. he occupied that position for several months before being laid off again. he never had a realistic prospect of returning to work for northwest in minneapolis. he kept his home in minneapolis, where his wife continued to live. because he was working too far from home to be able to live there, he incurred living expenses of almost $20,000 that he would not have incurred had he remained in minneapolis. the tax court denied the deduction, reasoning that because of the indefinite nature of the employment at the alternative locations, the taxpayer was not temporarily away from home. although the court of appeals affirmed, the appellate court’s reasoning (judge posner) differed from that of the tax court. according to judge posner, “[t]he problem with the tax court’s distinction is that work can be, 135 florida tax review [vol. 10:si and usually is, both temporary and indefinite ... .” rather, judge posner looked to the principles of commissioner v. flowers, 326 u.s. 465 (1946), and hantzis v. commissioner, 638 f.2d 248 (1st cir. 1981), that deny the deduction for travel expenses unless the taxpayer has a business rather than a personal reason to be living in two places if he decides not to move. he compared wilbert’s situation to the common case of the construction worker who works at different sites throughout the country, never certain how long each stint will last and reluctant therefore to relocate his home, who is nevertheless denied a deduction. see yeats v. commissioner, 873 f.2d 1159 (8th cir. 1989). (a) ditto, sorta. alami v. commissioner, t.c. memo. 2009-42 (2/23/09). this case presented substantially the same factual situation as wilbert, and the tax court reached the same conclusion on the same grounds as it did in wilbert. • apparently the tax court is no more impressed by judge posner’s reasoning than he is impressed by the tax court’s reasoning. 2. dang that amt. gralia v. commissioner, t.c. memo. 2009-219 (9/21/09). the taxpayer diverted funds from an s corporation in which another shareholder held a minority interest, and by which both shareholders were employed. when the minority shareholder sued him, the taxpayer settled the suit by paying substantial damages. judge halpern held that the damage payments, as well as the taxpayer’s attorney’s fees to defend the suit, were deductible only as either § 212 expenses or employee business expenses under § 162, and thus were miscellaneous itemized deductions. because the taxpayer was in the amt, no tax savings resulted from the deductions. d. section 121 there were no significant developments regarding this topic during 2009. e. section 1031 1. don quixote [a/k/a david aughtry] tilted at the windmill and deflected only the penalty, not the deficiency. ocmulgee fields, inc. v. commissioner, 132 t.c. no. 6 (3/31/09). this opinion by judge halpern applied § 1031(f) to deny tax-free like-kind exchange treatment in the following situation: (1) the taxpayer transferred appreciated real property (wesleyan station) to a qualified intermediary; (2) an unrelated third party purchased the wesleyan station property from the qualified 2010] recent developments in federal income taxation 136 intermediary for cash; (3) a partnership related to the taxpayer sold like-kind property (barnes & noble corner) to the qualified intermediary for cash; and (4) the qualified intermediary transferred the like-kind barnes & noble corner property to the taxpayer. but for the application of § 1031(f)(4), the exchange with the qualified intermediary would have qualified for § 1031 nonrecognition. the taxpayer, who wanted the replacement property to be in the same general geographic area, i.e., middle georgia, as the surrendered property, argued that the reason for the acquisition of replacement property from a related person was that it was unable to locate a suitable replacement property within the time limits imposed on deferred like-kind exchanges by § 1031(a)(3) and reg. § 1.1031(k)-1(b). (we note, however, that a careful reading of the facts reveals that the taxpayer entered into the agreement to acquire the replacement property only five days after the relinquished property was sold and actually closed the purchase before the 45-day identification period had even lapsed.) as argued by the commissioner, judge halpern held that § 1031(f)(4) required recognition because the taxpayer had “structured” the transaction “to avoid the purposes” of the rule of § 1031(f) denying non recognition for an exchange to a related person if the transferee sells the property within two years. based on the legislative history, he concluded that the “basis shifting” that resulted from the transaction “suppl[ied] the principal purpose of tax avoidance.” the basis shift effected an approximately $1.8 million reduction in taxable gain, because if the related party had acquired wesleyan station from the taxpayer in a like-kind exchange for barnes & noble corner, the related party’s substituted basis in wesleyan station, which in the taxpayer’s hands was only around $716,164, would have been $2,554,901 (equal to the related person’s basis in barnes & noble corner). in addition, if § 1031 applied, the gain on the sale of wesleyan station would have been taxed at only 15 percent, the applicable rate for capital gains taxed to the partners of the related partnership, instead of the 34 percent rate that would have applied had the taxpayer sold the property. judge halpern further found the case to be substantially similar to teruya bros., ltd. v. commissioner, 124 t.c. 45 (2005), in which the taxpayer transferred properties to a qualified intermediary, who sold them to unrelated third parties and used the proceeds to purchase like-kind replacement property from a related party. in teruya bros., judge thornton held that the transactions were economically equivalent to direct exchanges between the taxpayer and related party, followed by the related party’s sale of the properties to unrelated third parties, and that they were structured to avoid the purposes of § 1031(f). the taxpayer argued that unlike the taxpayer in teruya bros., it did not have a prearranged plan to use property from a related person to complete a likekind exchange, but judge halpern found that the presence of the prearranged plan in teruya bros. was not a critical element of the holding in that case. nevertheless, the taxpayer avoided the § 6662 negligence penalty because 137 florida tax review [vol. 10:si (1) the return reporting the transaction as a § 1031 like-kind exchange was prepared by an accountant with extensive experience in representing real estate developers, (2) the accountant was aware of all relevant facts, and (3) when the taxpayer filed its return, the tax court had not yet decided teruya bros., and while rev. rul. 2002-83, 2002-2 c.b. 927 (presaging the result in teruya bros.) had been issued, judge halpern did “not think that the ruling left the result free from doubt.” (a) “[i]t appears that these transactions took their peculiar structure for no purpose except to avoid § 1031(f).” teruya bros., ltd. v. commissioner, 580 f.3d 1038 (9th cir. 9/8/09), aff’g 124 t.c. 45 (2005). the taxpayer transferred properties to a qualified intermediary, who sold them to unrelated third parties and used the proceeds to purchase like-kind replacement property from a related party. in the tax court, judge thornton held that the transactions were economically equivalent to direct exchanges between the taxpayer and related party, followed by the related party’s sale of the properties to unrelated third parties, and that they were structured to avoid the purposes of § 1031(f). he further held that taxpayer failed to prove that avoidance was not one of the principal purposes of the transactions under the § 1031(f)(4) exception. the taxpayer argued that even though more gain was recognized by the related party on some of the properties, the only tax consequences of the gain recognition were reduction of the related party’s net operating loss – as opposed to current taxation for taxpayer. the ninth circuit affirmed the tax court’s decision, stating, “it appears that these transactions took their peculiar structure for no purpose except to avoid § 1031(f);” “teruya could have achieved the same property dispositions through far simpler means.” f. section 1033 there were no significant developments regarding this topic during 2009. g. section 1035 there were no significant developments regarding this topic during 2009. h. miscellaneous there were no significant developments regarding this topic during 2009. 2010] recent developments in federal income taxation 138 iv. compensation issues a. fringe benefits 1. economists say that everything happens on the fringes. using fringe benefits to stimulate public transportation. the 2009 arra, § 1151(a), amended code § 132(f) to provide that the $175 ceiling (as adjusted for inflation) on tax-free parking benefits also applies to transit passes and qualified commuter highway vehicle use for months beginning after february 2009 and before 1/1/11. the 2009 amount for the $175 ceiling on tax free parking benefits, as adjusted for inflation, is $230 per month. 2. involuntarily terminated employees will receive assistance with their cobra premiums for a while. the 2009 arra § 3001 (in title iii – premium assistance for cobra benefits) provides premium assistance for cobra benefits to the extent of 65 percent of the otherwise applicable cobra premium. eligibility for this benefit is more restrictive than eligibility for cobra, with elimination of the premium subsidy for high-income individuals as well as for those eligible for another form of medical coverage, e.g., retiree medical. the dol has provided a model notice to individuals pursuant to arra § 3001. • the premium subsidy is only provided with respect to involuntary terminations that occur on or after 9/1/08 and before 1/1/10. (a) and for a while longer. h.r. 3326, § 1010, extends the cobra subsidy period from nine months to 15 months and extends the subsidy to terminations occurring in the first two months of 2010. notification requirements are provided for individuals who may have previously lost assistance but became eligible for the extended subsidy period. b. qualified deferred compensation plans 1. section 72(t) has no catchall hardship exception. dollander v. commissioner, t.c. memo. 2009-187 (8/19/09). there is no general exception to the § 72(t) penalty tax for premature withdrawals from a qualified retirement plan based on the need to withdraw funds due to general “financial hardship.” 139 florida tax review [vol. 10:si c. nonqualified deferred compensation, section 83, and stock options 1. my employer cheated on me (and a lot of others) but it’s still income. gourley v. united states, 104 a.f.t.r.2d 2009-6119 (fed. cl. 8/26/09). the taxpayer, a worldcom employee, exercised nonqualified stock options for 90,300 shares of worldcom stock valued at $42,125 per share on january 28, 2000. the value of the stock was reflected in a w-2 issued to the taxpayer by worldcom. the taxpayer disposed of the stock during 2000 and 2001. on june 25, 2002, worldcom announced a major restatement of its financials admitting that because of fraudulent accounting practices it incurred undisclosed losses from 2000 to 2001. the taxpayer thus claimed in a refund action that the stock he received in january 2000 was worth only $12.52 per share and that the w-2 issued by worldcom was grossly inflated. the court rejected the refund action pointing out that the known fair market value of the worldcom stock on the date of the taxpayer’s exercise formed the basis of the taxpayer’s gross income. the court pointed out that the market price based on imperfect information is nonetheless the prevailing market price. d. individual retirement accounts 1. us weary 70½+ geriatrics do not have to take rmds for the 2009 year. wrera, § 201, amends code § 401(a)(9) to suspend required minimum distributions (“rmds”) from 401(k) plans, iras and similar retirement accounts for 2009. rmds for the year 2008 were not affected, including rmds for 2008 that are permitted to be made in 2009 by reason of an individual’s required beginning date being 4/1/09. 2. a distribution not itself subject to the § 72(t) penalty tax does not trigger a modification of an existing series of substantially equal periodic payments. benz v. commissioner, 132 t.c. no. 15 (5/11/09). section 72(t)(2)(a)(iv) provides an exception from the 10 percent penalty tax on premature ira distributions for distributions that are part of a series of substantially equal periodic payments made for the life of the owner of an ira (or the joint lives of the owner and a designated beneficiary). however, if the series of substantially equal periodic payments is modified within 5 years of the date of the first distribution (other than by reason of death or disability), or before the employee has attained age 59-1/2, the 10 percent penalty tax is imposed retroactively on prior distributions made before the taxpayer attains age 59-1/2, plus interest. within five years of making an election to receive distributions from her ira in a series of substantially equal periodic payments before attaining age 59-1/2, the taxpayer withdrew additional amounts to pay qualified higher education 2010] recent developments in federal income taxation 140 expenses as defined in § 72(t)(7) relating to her son’s college expenses. the tax court (judge goeke) held that a distribution that satisfies the statutory exception to the penalty tax on premature withdrawals under § 72(t)(2)(e) for payment of higher education expenses is not a modification of a series of substantially equal periodic payments. such a withdrawal does not trigger the § 72(t) penalty tax where the taxpayer receives the distribution within 5 years after the taxpayer begins receiving distributions under a series of substantially equal periodic payments. v. personal income and deductions a. rates there were no significant developments regarding this topic during 2009, but there might be in 2010. b. miscellaneous income 1. helping the unemployed. the 2009 arra, 1107(a), amended code § 85 to provide an exclusion for up to $2,400 of unemployment compensation received by an individual in 2009. 2. judge gale rescues a taxpayer who was trying to rely on the wrong exclusionary rule. watts v. commissioner, t.c. memo. 2009-103 (5/18/09). the taxpayer was injured in an automobile accident with an uninsured motorist, but her insurance company denied coverage under one of the two policies issued to the taxpayer and her husband, relying on antistacking provisions in the contracts. eventually, as a result of the settlement of a class action suit against her automobile insurance company, she received a damage award. both the taxpayer and the irs argued the case on the basis of the applicability of § 104(a)(2). judge gale held that because the damage award was not received with respect to “tort or type rights,” it was not excludable under § 104(a)(2). however, notwithstanding the taxpayer’s apparent failure to raise the argument, the damages were excludable under § 104(a)(3) as an amount received through accident or health insurance for personal injuries or sickness. to be eligible to receive damages the taxpayer was required to have been (1) insured under multiple insurance policies purchased from the same company with uninsured motorist coverage, (2) injured through the fault of an uninsured motorist, and (3) denied payment under one of the policies while receiving payment under another. these prerequisites establish that the taxpayer received the settlement payment “through” accident insurance, or under such a policy, for purposes of § 104(a)(3). judge gale rejected the irs’s argument that because the class action lawsuit involved numerous claims beyond those premised on personal 141 florida tax review [vol. 10:si injury (e.g., breach of contract, breach of covenant of good faith and fair dealing, fraud, etc.) and sought compensatory damages, treble damages, punitive damages, and interest, and because the settlement agreement did not expressly allocate any portion of the payment to personal injury and the taxpayer executed a general release of all claims, the taxpayer did not receive the payment “for” personal injury. the determining factor in his decision was that the taxpayer’s eligibility to receive a portion of the settlement fund depended upon her showing that she had not been fully compensated for her injuries. • note that under prop. reg. § 1.1041(c), infra, item 5, published after this decision, the damages received in a suit like this one might be excludable under § 104(a)(2). 3. even if the cop’s cpa might have acted stupidly, the cop wasn’t penalized for an erroneous exclusion of a damage award. longoria v commissioner, t.c. memo. 2009-162 (7/2/09). judge gustafson held that no portion of a $156,667 settlement award in an employment discrimination suit by a puerto rican new jersey state trooper was excludable under § 104(a)(2), even though the taxpayer suffered physical injuries as a result of acts of discrimination, because the complaint in the discrimination suit did not allege that he had suffered any physical injuries as a result of discrimination during his employment. no penalties were assessed, however, because the taxpayer reasonably relied on the erroneous advice of a cpa in excluding the award from gross income. 4. tax free mortgage principal paydowns. rev. rul. 2009-19, 2009-28 i.r.b. 111 (6/23/09). the federal government’s homeowner affordability and stability plan helps homeowners who have defaulted, or are at risk of default, on their mortgages by providing certain incentive payments to lenders/investors on the behalf of homeowner’s that make timely payments on modified loans that reduce the principal balance on the homeowner’s mortgage loan. this revenue ruling holds that the payments are excludable from the homeowner’s income under the general welfare exclusion. 5. treasury proposes to reverse a principle established in a supreme court decision that the government won. reg127270-06, damages received on account of personal physical injuries or physical sickness, 74 f.r. 47152 (9/15/09). the treasury has published proposed regulations (prop. reg. § 1.104-1(c)) under § 104(a)(2) to reflect amendments to § 104 enacted since the current regulations were promulgated and certain judicial decisions. the proposed regulations provide that the § 104(a)(2) exclusion applies to personal physical injuries or physical sickness. emotional distress is not considered a physical injury or physical 2010] recent developments in federal income taxation 142 sickness. however, the proposed regulations provide that damages for emotional distress attributable to a physical injury or physical sickness are excludable under § 104(a)(2). under the proposed regulations, the term damages means an amount received (other than workers’ compensation) through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution. notably, the proposed regulations eliminate the requirement in the current regulations that to be excludable under § 104(a)(2) the damages must be “based upon tort or tort type rights.” thus, damages for physical injuries may qualify for exclusion under § 104(a)(2) even though the injury giving rise to the damages is not defined as a tort under state or common law. the reason for the change was the treasury department’s concern that the supreme court’s interpretation of the tort type rights test in united states v. burke, 504 u.s. 229 (1992), limiting the § 104(a)(2) exclusion to damages for personal injuries for which the full range of tort-type remedies is available, could preclude an exclusion under § 104(a)(2) for redress of physical personal injuries under a “no-fault” statute that does not provide traditional tort-type remedies. • taxpayers may apply the proposed regulations to amounts paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after september 13, 1995 and received after august 20, 1996. 6. some bad tax news for over-burdened consumer credit card debtors who beat the bank. they don’t beat the irs! forgiven accrued but unpaid interest on a consumer loan is cod income. payne v. commissioner, t.c. memo. 2008-66 (3/18/08). judge haynes held that the compromise of credit card debt, including interest, incurred for personal living expenses resulted in recognition of cod income for a cash method taxpayer. the § 108(e)(5) exception for cancellation of purchase money debt did not apply because the only relationship between the debtor and creditor was the debtor-creditor relationship and there was no property sale and purchase between the creditor and debtor that gave rise to the debt. (a) the result must have been so obvious that the tax court was affirmed per curiam. payne v. commissioner, 104 a.f.t.r.2d 2009-7783 (8th cir. 12/22/09). 7. the out of pocket cost of compromising consumer debt does not reduce the amount of cod income. melvin v. commissioner, t.c. memo. 2009-199 (9/8/09). the taxpayers owed chase manhattan bank $13,084 on a consumer credit card, and chase agreed to accept $4,579 to settle the debt. the taxpayers paid a third party (arbitronix) 25 percent of the $8,505 savings, or $2,126 to negotiate the compromise. the 143 florida tax review [vol. 10:si tax court (judge halpern) held that the taxpayers recognized cod income in the full amount of the cancelled debt. the “[taxpayers] received goods and services (and cash advances) on credit; when chase relieved them of their corresponding obligation to pay, petitioners without question received an ‘accession to income.’” the court rejected the taxpayer’s argument that under § 61(a)(12) itself only the net benefit of the debt cancellation was includable in gross income — that is they should have been allowed to offset their “phantom income” with the “loss” they suffered when they paid the fee. judge halpern held that § 61(a)(12) “manifestly does not provide for any kind of deduction.” the taxpayers did not argue for a deduction under § 162 because they acknowledged that the amount was not paid with respect to a business, and they did not argue for a § 212 deduction because they were in the amt. • one of our colleagues who specializes in consumer law commented, “what a rip-off. if the people had called chase themselves they probably could have gotten an even better deal than the third party did, and saved 25 percent.” 8. the irs was not entitled to rely on a naked form 1099-c to show cancellation of indebtedness income occurred in a particular year. linkugel v. commissioner, t.c. summ. op. 2009-180 (12/1/09). the taxpayer’s house was foreclosed upon in 2000, and the mortgagee secured a deficiency judgment in the amount of $35,247, which it made no effort to collect. citigroup acquired the mortgagee in late 2000 and also engaged in no efforts to collect upon the judgment. in 2007, a citigroup subsidiary issued a form 1099-c in the deficiency amount for the 2006 taxable year. the taxpayer failed to include the cancellation of indebtedness income on his 2006 return, and irs determined a deficiency. the taxpayer asserted that the coi income occurred in an earlier year. special trial judge armen held that taxpayer was entitled to a shift in the burden of proof under § 6201(d), which required the irs to present other evidence to support the incidence of the cancellation of debt income in 2006. the irs failed to meet its burden of production. • the court relied on portillo v. commissioner, 932 f.2d 1128 (5th cir. 1991), which was codified as § 6201(d) in the 1996 second taxpayer bill of rights. c. hobby losses and § 280a home office and vacation homes 1. mucking stalls for 60 horses helps avoid the hobby loss limitations. helmick v. commissioner, t.c. memo. 2009-220 (9/22/09). the taxpayers conducted a horse breeding activity involving 4060 horses on property on which they lived. they incurred substantial losses 2010] recent developments in federal income taxation 144 for eleven consecutive years and never made a profit. their other income was a modest salary. judge gustafson allowed the claimed losses, and stated: although their intention to make the activity eventually profitable was objectively unreasonable, it was their genuine subjective intention. by the time of the years in issue, the helmicks had invested so much time and effort in this failing activity that they could see no way out except to somehow make the thing work. no other possible purpose explains their willingness to persist in an activity that had become so frustrating and unpleasant. d. deductions and credits for personal expenses 1. helping entry-level homebuyers invest in the bear housing market. code § 36, added by the housing assistance tax act of 2008, provides a refundable credit for a “first-time homebuyer” who purchases a principal residence on or after 4/9/08, and before 1/1/09. the amount of the credit is the lesser of 10 percent of the purchase price or $7,500 ($3,750 in the case of a married individual filing a separate return). if two or more unmarried persons purchase a principal residence together, the total amount of the credit will be allocated among them as prescribed by the irs. the credit is phased out over the modified adjusted income range of $75,000 to $95,000 ($150,000 to $170,000 in the case of a joint return). a person qualifies as a “first-time homebuyer” if neither the person nor the person’s spouse (if any) owned a principal residence at any time during the three-year period ending on the date of purchase of the credit-generating residence. the credit is not available if the taxpayer purchased the property from a related person or acquired it by gift, or if the taxpayer’s basis in the property is determined under § 1014. (persons are related for this purpose if they are related for purposes of § 267 or § 707, except that the family of an individual under § 267(c)(4) is limited for this purpose to his spouse, ancestors, and lineal descendants.) the credit is also not available: (1) if a credit under § 1400c (relating to first-time homebuyers in the district of columbia) has ever been allowable to the taxpayer; (2) if the taxpayer’s financing is from tax-exempt mortgage revenue bonds; (3) if the taxpayer is a nonresident alien; or (4) if the taxpayer disposes of the residence or ceases to use it as his principal residence before the close of the taxable year. • the amount of the credit is recaptured ratably over the 15-year period beginning with the second taxable year following the taxable year in which the credit-generating purchase was made. for example, if a taxpayer properly claimed a credit of $7,500 for a purchase in 2008, the recapture amount would be $500 in 2010, with another $500 recapture amount in each of the next 14 years. thus, the credit actually 145 florida tax review [vol. 10:si functions as an interest-free loan from the government to the taxpayer. if, prior to the end of the 15-year recapture period, a taxpayer disposes of the creditgenerating residence or ceases to use it as his principal residence, the recapture of any previously unrecaptured credit is accelerated. in the case of a sale of the principal residence to an unrelated person, the recapture amount is limited to the amount of gain (if any) on the sale. there is no recapture (either regular or accelerated) after the death of a taxpayer, and there is no accelerated recapture following an involuntary conversion of a residence if the taxpayer acquires a new principal residence within the next two years. if a credit-generating residence is transferred between spouses or incident to a divorce, in a transaction subject to § 1041, any remaining recapture obligation is imposed solely on the transferee. • although the credit is ordinarily allowed with respect to the year in which the credit-generating purchase occurred, a taxpayer purchasing a home in 2009 (before july 1) may elect to treat the purchase as having been made in 2008, for the purpose of claiming the credit on his 2008 tax return. if the election is made, the first year of the recapture period will be 2010, rather than 2011. (a) the homebuyer credit started out as an interest-free loan, but now it’s outright free money from the federal government. section 1006 of the 2009 arra amended code § 36(h) to extend the life of the first-time homebuyer credit through november 30, 2009, and to increase the amount of the credit to $8,000 for 2009. it also amended § 36(f) to eliminate the recapture of the credit for a home purchased in 2009, unless the home is sold or ceases to be the taxpayer’s principal residence within 36 months of the date of purchase. (b) extended and modified in the worker, homeownership, and business act of 2009. section 11 of the whaba of 2009 amends code § 36 to extend the credit for homes purchased through 5/1/10 (7/1/10, if subject to a binding contract on 5/1/10). extension and modification of first-time homebuyer credit (§ 36) • an individual (and, if married, the individual’s spouse) who has maintained the same principal residence for any five-consecutive year period during the eight-year period ending on the date of the purchase of a subsequent principal residence is treated as a first-time homebuyer. the maximum allowable credit for such taxpayers is $6,500. this provision applies to residences purchased after 11/30/09. • there are, of course, income limitations for the credit, with phaseouts between $225,000 and $245,000 of agi, as well as a purchase price limit of $800,000. 2010] recent developments in federal income taxation 146 (c) we guess doma doesn’t apply to domiciles. notice 2009-12, 2009-6 i.r.b. 446 (1/15/09). this notice explains how to allocate the § 36 first-time homebuyer credit between unmarried copurchasers of a principal residence. any reasonable method is allowed when two unmarried individuals purchase a first home as tenants in common. under some circumstances a full $7,500 credit can be obtained even where one buyer would not qualify for any amount of credit under the phaseout rules, if both contribute to purchase and both are first-time buyers. 2. a little help for the auto industry, but it’s probably not enough. section 1008(b) of the 2009 arra added code § 164(b)(6) to allow taxpayers who do not elect to deduct state and local general sales taxes under § 164(b)(5) to deduct state and local sales and excise taxes paid on the purchase of new cars, light trucks, motorcycles, and recreational vehicles in 2009. the deduction is available only with respect to the first $49,500 of the purchase price, is phased out for taxpayers with adjusted gross incomes (with certain modifications) in excess of $125,000 ($250,000 in the case of a joint return), and is fully phased out when adjusted gross income (as modified) exceeds $135,000 ($270,000 in the case of a joint return). the deduction is allowed as a deduction in computing adjusted gross income and thus is allowable whether or not the taxpayer itemizes deductions. 3. pennies from heaven: the “making work pay” credit. code § 36a, added by § 1001(a) of the 2009 arra, provides individuals a refundable tax credit for 2009, and only for 2009, equal to 6.2% of earned income. the maximum credit is $400 for a single individual and $800 for married taxpayers filing a joint return. the credit amount is reduced (but not below zero) by two percent of taxpayer’s adjusted gross income (with certain limited modifications relating to foreign income) in excess of $75,000 for single taxpayers, or in excess of $150,000 for married couples filing jointly. a taxpayer who is claimed as a dependent by another taxpayer is ineligible for the credit. the credit can be claimed through a reduction in income tax withholding or by claiming the credit on a tax return. (a) all social security recipients are entitled to this payment, i.e., there is no income ceiling on it! section 2201 of the 2009 arra (in the title called assistance for unemployed workers and struggling families) provides for a one-time $250 payment to adults who were entitled to receive social security, etc. payments in any of the months of november 2008, december 2008, or january 2009. this payment will reduce the “making work pay” credit. 147 florida tax review [vol. 10:si 4. “go forth and propagate.” more kids, more eitc. section 1001(a) of the 2009 arra added code § 32(b)(3) to increase the eitc credit rate for taxpayers with three or more children to 45 percent of earned income up to $12,570 for taxable years 2009 and 2010. the act also amended code § 32(b)(2)(b) for 2009 and 2010 to increase the phase-out threshold for joint returns to $5,000 more than the phase-out threshold for single returns (subject to an inflation adjustment in 2010). (a) viva viagra! more stimulating of propagation. section 1004 of the 2009 arra amended code § 24(d) to allow the child tax credit to be refundable to the extent of 15 percent of the taxpayer’s earned income in excess $3,000 for 2009 and 2010. 5. qeeis to your house are the key to a credit. section 25c, added to the code by the energy tax incentives act of 2005 and amended significantly by § 1121 of the 2009 arra, provides a nonrefundable credit for certain expenditures to improve the energy efficiency of a taxpayer’s principal residence. as amended, the credit is available for property placed in service in 2006, 2007, or 2009 (but not for property placed in service in 2008). in the case of “qualified energy efficiency improvements” (qeeis), the credit equals 30 percent of the cost of the improvements (10 percent for years before 2009). a qeei is any energy efficient building component (i.e., insulation, exterior windows and doors, certain coated metal roofs, and asphalt roofs with cooling granules) satisfying criteria established by the 2000 international energy conservation code, if the original use of the component commences with the taxpayer and the component is expected to remain in use for at least five years. the other category of credit-eligible costs is “residential energy property expenditures” (repes). repes are expenditures for the following types of property, if they are installed in the taxpayer’s principal residence and satisfy energy efficiency standards to be promulgated by the treasury department pursuant to detailed statutory instructions: (1) main air circulating fans; (2) natural gas, propane or oil furnace or hot water boilers; and (3) “energy efficient building properties” (electric heat pump water heaters; electric heat pumps; geothermal heat pumps; certain air conditioners; water heaters using natural gas, propane, or oil; and stoves burning biomass fuel). (the §25c credit is not available for geothermal heat pumps placed in service in 2009. instead, a credit is available under §25d.) for repes the credit amount is established by schedule: the first $50 of the cost of a main air circulating fan, the first $150 of the cost of a natural gas, propane, or oil furnace or hot water boiler, and the first $300 of the cost of any item of energy-efficient building property. for years prior to 2008, there was a lifetime limit of $500 on the aggregate credits a taxpayer could claim under § 25c, of which no more than $200 could be based on expenditures for windows. section 1121(a) of the 2010] recent developments in federal income taxation 148 2009 arra amended § 25c(b) to eliminate the lifetime limit and replace it with an aggregate limit of $1,500 for 2009 and 2010. 6. enlisting the tax code to help stop funding both sides in the war on terror: credit for generating power at home. code § 25d, added by the energy tax incentives act of 2005, and modified by the tax relief and health care act of 2006 and by the energy improvement and extension act of 2008, provides a nonrefundable credit for certain expenditures on residential energy-efficient property. qualifying property is of five types: (1) solar electric property (which uses solar energy to generate electricity); (2) solar water heating property; (3) fuel cell property (which converts a fuel into electricity using electrochemical means); (4) small wind energy property (which uses a wind turbine to generate electricity for a residence); and (5) geothermal heat pump property (which uses the ground or ground water to heat or cool a residence). the property must be installed in a dwelling unit located in the united states and used by the taxpayer as a residence (principal residence, in the case of fuel cell property). expenditures allocable to a swimming pool or hot tub are not eligible for the credit. the credit equals 30 percent of qualifying expenditures. for years prior to 2009, the credit was subject to annual ceilings (on the credit amount, not on crediteligible expenditures) of $2,000 for solar electric property, $2,000 for solar water heating property, $500 per half kilowatt of capacity of fuel cell property, $500 per half kilowatt capacity (but not more than $4,000 in total) of small wind energy property, and $2,000 for geothermal heat pump property. (a) as amended by § 1122(a)(1) of the 2009 arra, § 25d(b) provides that, for taxable years beginning after 12/31/08, there are no ceilings except the $500 ceiling on fuel cell property. the credit may be claimed against the amt as well as the regular income tax, and unused credit amounts may be carried forward. the credit is available only for property placed in service before 2017. 7. this cca on deductible home mortgage interest will break a lot of hearts in california – almost as many as the voters broke in november 2008. cca 200911007 (11/24/08; released 3/13/09). this cca addressed the amount of interest that was deductible as “qualified residence interest” under § 163(h)(3)(a) when a residence encumbered by a purchase money mortgage of more than $1 million is co-owned by two unmarried taxpayers both of whom are obligated on the mortgage and for both of whom the residence is the principal residence. the cca holds that the $1 million ceiling on “acquisition indebtedness,” as defined in § 163(h)(3)(b), applies on a residence-by-residence basis as well as on a taxpayer-by-taxpayer basis. its reasoning is as follows. 149 florida tax review [vol. 10:si under § 163(h)(3)(b)(i), acquisition indebtedness is defined, in relevant part, as indebtedness incurred in acquiring a qualified residence of the taxpayer – not as indebtedness incurred in acquiring taxpayer’s portion of a qualified residence. the entire amount of indebtedness incurred in acquiring the qualified residence constitutes “acquisition indebtedness” under § 163(h)(3)(a)(i). in this case, the amount of indebtedness incurred in acquiring [the residence] exceeds $1,000,000. however, under § 163(h)(3)(b)(ii), the amount treated as acquisition indebtedness for purposes of the qualified residence interest deduction is limited to $1,000,000 of total, “aggregate” acquisition indebtedness. this is evident from the parenthetical in § 163(h)(3)(b)(ii). • the cca addressed only the tax consequences of one of the co-owners — the one who originally had owned the property in fee simple and was solely obligated on the mortgage and who subsequently conveyed an undivided ownership interest to a second person who also became obligated on the mortgage. the cca concluded that the interest deductible by the taxpayer in question was to be determined by multiplying the amount of interest the taxpayer paid by a fraction: $1,000,000 divided by the amount of mortgage. thus, for example, if the amount of the mortgage were $1,500,000 and the taxpayer paid $75,000 of interest, the amount of the taxpayer’s interest deduction would be $50,000, i.e., $75,000 x ($1,000,000 ÷ $1,500,000). • some practitioners and tax professors had asserted prior to the issuance of this cca that they assumed that unmarried co-owners could each deduct mortgage interest on $1 million of acquisition indebtedness, thus permitting deduction of interest on a $2 million mortgage on a home they owned in common. at least two of us believe that the reasoning and conclusion of the cca limiting to $1 million the amount of “acquisition indebtedness” that can be taken into account collectively by all of the owners of the residence likely is correct; the third of us lives in california (but probably agrees anyway). a careful reading of the statutory language indicates that because § 163(h)(3)(b)(ii) omits any reference to a “taxpayer,” it limits to $1 million the aggregate amount of “acquisition indebtedness” that maybe taken into account in determining the amount of “qualified residence interest” with respect to all of the taxpayers that might reside in that residential unit. if it does not do so, and each taxpayer who resides in the residence who is an owner and is obligated on the “acquisition indebtedness” mortgage should be entitled to deduct interest paid on up to $1 million of acquisition indebtedness, then on a joint return each of the husband and wife, who are separate and distinct taxpayers (see, e.g. frahm v. commissioner, t.c. memo. 2007-351), would be entitled to deduct interest on up to $1 million of “acquisition indebtedness.” but the statute clearly does not contemplate that result, as evidenced by the 2010] recent developments in federal income taxation 150 limitation on the deduction to the interest on $500,000 of acquisition indebtedness by married taxpayers who file separately. the parenthetical indicates, even though it does not expressly state, that a husband and wife who each own a one-half interest in the residence and are jointly and severally liable on the mortgage can deduct interest on up to only $1 million of acquisition indebtedness. an interpretation of the statute that applies the $1 million ceiling on “acquisition indebtedness,” as defined in § 163(h)(3)(b), on both a residence-by-residence basis, and on a taxpayer-by-taxpayer basis avoids this “marriage penalty” that would otherwise arise. 8. the irs recedes from tax court victories on the scope of “home equity indebtedness.” ilm 200940030 (8/7/09). home mortgage indebtedness in excess of $1,000,000 may qualify as home equity indebtedness under § 163(h)(3)(c). the position taken in the memo is inconsistent with pau v. commissioner, t.c. memo. 1997-43, and catalano v. commissioner, t.c. memo. 2000-82, but is consistent with the instructions in irs pub. 936, home mortgage interest deduction. • shouldn’t this position be stated in a published revenue ruling since tax court decisions are the law and instructions in irs publications are not the law? 9. taxpayer whose blood contained 0.09 percent alcohol was not drunk enough to be grossly negligent. at least he drove more than 400 yards before crashing. rohrs v. commissioner, t.c. summ. op. 2009-190 (12/10/09). the tax court (judge gerber) held that a taxpayer who totaled his 2½-month-old $40,000 pickup truck was entitled to a $33,629 casualty loss deduction because driving with a blood alcohol content of 0.09 percent is not “willful negligence” for purposes of reg. § 1.165-7(a)(3). the court held that taxpayer took care to secure transportation to and from a party he attended, and believed he was not impaired when he drove to his parents’ house and failed to successfully negotiate a turn resulting in his truck sliding off an embankment and rolling over. the court saw no reason to rely on public policy to deny the loss deduction, and the court held that taxpayer was not liable for the § 6662(a) accuracy-related penalty. e. divorce tax issues there were no significant developments regarding this topic during 2009. 151 florida tax review [vol. 10:si f. education 1. stimulating increases in college tuition. section 1004(a) of the 2009 arra added code § 25a(i) to increase the hope scholarship credit for 2009 and 2010 to the sum of (1) 100 percent of the first $2,000 of tuition, fees and course materials, and (2) 25 percent of the next $2,000, paid during the taxable year. the maximum credit is $2,500. the temporarily increased credit has been named the “american opportunity tax credit.” in addition to increasing the amount of the credit, the 2009 arra extends the availability of the credit to the first four years of postsecondary education (in lieu of the prior two-year rule), and adds “course materials” to the expenses eligible for the credit (previously only tuition and fees had been eligible). thus, for 2009 and 2010, the credit can be claimed with respect to a student with respect to whom the credit already had been claimed for two years. the revised credit can be claimed against the alternative minimum tax. forty percent of the allowable credit is refundable, unless the taxpayer is a child subject to the § 1(g) “kiddie tax.” the american opportunity tax credit is phased out for taxpayers with adjusted gross income in excess of $80,000 ($160,000 for married couples filing jointly) under the same formula as the hope scholarship credit. 2. a little stimulus for apple, hp, dell, microsoft, etc. section 1005(a) of the 2009 arra amended code § 529(e)(3)(a) to include as qualified expenses, amounts paid or incurred in 2009 or 2010 for computer technology or equipment (including internet access and related services) used by the beneficiary during the time the beneficiary is enrolled at an eligible institution. expenses for computer software designed for sports, games, or hobbies do not qualify “unless the software is predominantly educational in nature” – whatever that might mean. g. alternative minimum tax 1. whittling away yet more at the original purpose of the amt: why not just rename it the “special tax on blue state taxpayers with kids?” code § 57(a)(5)(vi), added by § 1503(a) of the 2009 arra, provides that interest on private activity bonds issued in 2009 and 2010 will not be treated as a tax preference item for amt purposes; if the bond is issued in one of those years the interest will be tax-exempt for purposes of the amt (as well as for regular tax purposes) even though the interest is received after 2010. 2010] recent developments in federal income taxation 152 vi. corporations a. entity and formation 1. to check the box, 75 days is extended to 3 years and 75 days. rev. proc. 2009-41, 2009-39 i.r.b. 439 (9/3/09). reg. § 301.7701-3(c)(1) provides that an election by an unincorporated entity to be taxed as an association is effective on a date specified in the election on form 8832, or on the date the form is filed if no date is specified. the effective date cannot be more than 75 days before or twelve months after the date on which the form 8832 is filed. under reg. § 301.7701-3(d)(1), an election affecting a foreign entity is relevant when its classification affects the tax liability of any person for federal tax or information purposes. the revenue procedure extends the provisions for relief provided in rev. proc. 2002-59, 2002-2 c.b. 615, to include both an election with respect to newly electing entities and a change in an existing election. this revenue procedure provides for an application to an irs service center for relief from failure to timely file the form 8832 for up to three years and 75 days after the effective date of the election. relief is available if the entity can establish reasonable cause for its failure to timely file its form 8832, the application includes a completed form 8832, and all tax returns affected by the election have been filed consistently with the elected status. the revenue procedure also provides that relief may be sought by an entity not eligible for relief under the terms of the revenue procedure by filing a request for a letter ruling that includes a statement that all required tax and information returns have been timely filed as if the entity classification election had been in effect on the effective date requested. b. distributions and redemptions 1. section 162(k)’s bite is as loud as its bark. ralston purina co. v. commissioner, 131 t.c. 29 (9/10/08). ralston purina claimed a deduction under § 404(k) for payments made to its esop in redemption of ralston purina preferred stock owned by the esop to fund distributions to employees terminating participation in the esop. the commissioner argued the redemption payments were not deductible under either § 404(k)(1) or (5), or alternatively that the deduction was barred by §162(k). the tax court, in a unanimous reviewed opinion by judge nims, held that because ralston purina’s payments were “in connection with the redemption of its own stock,” § 162(k) applied to disallow the deduction. the tax court refused to follow the contrary opinion on almost identical facts in boise cascade corp. v. united states, 329 f.3d 751 (9th cir. 2003). in boise cascade the ninth circuit interpreted the phrase “in connection with” to include only expenses that have their origin in a stock redemption transaction, excluding expenses 153 florida tax review [vol. 10:si that have their origin in a “separate, although related, transaction.” the tax court previously had rejected the ninth circuit’s narrow interpretation of the phrase “in connection with” in fort howard corp. v. commissioner, 103 t.c. 345 (1994), and did so again in ralston purina. the court rejected ralston purina’s argument that because the payments were an applicable dividend under § 404(k), the transaction was excepted from the application of § 162(k) under § 162(k)(2)(a)(ii). the tax court reasoned that the entire transaction potentially deductible as an applicable dividend under § 404(k) — payment from the corporation to the esop and the distribution to the esop participants — must also pass muster under § 162(k), and that the ‘otherwise allowable’ deduction was disallowed because the payment was ‘in connection with’ a repurchase of stock. (a) and the third circuit agrees with the tax court, not with the ninth circuit. conopco, inc. v. united states, 572 f.3d 162 (3d cir. 7/13/09), aff’g 100 a.f.t.r.2d 2007-5296 (d. n.j. 7/18/07). the court held that assuming that conopco’s payments were applicable dividends under § 404(k)(1) — an issue that it did not reach — “where a corporation makes payment to an esop trust in redemption of its stock, the otherwise allowable § 404(k)(1) deduction for an applicable dividend inevitably involves an ‘amount paid or incurred by a corporation in connection with the reacquisition of its stock’ and is therefore barred by § 162(k)(1).” (b) the dog food corporation precedent wasn’t the people’s food corporation’s best friend. general mills v. united states, 554 f.3d 727 (8th cir. 1/26/09). general mills claimed a deduction under § 404(k) for payments made to its esop in redemption of general mills stock owned by the esop to fund distributions to employees terminating participation in the esop. in a very brief opinion, the court (judge benton) held that §162(k) barred the deduction for the “applicable dividend” otherwise allowable under § 404(k). the court followed the tax court’s decision in ralston purina co. v. commissioner, 131 t.c. 29 (9/10/08), and refused to follow the contrary opinion in boise cascade corp. v. united states, 329 f.3d 751 (9th cir. 2003), because it disagreed with the reasoning of boise cascade. 2. every share of stock is a separate item of property and the results of (almost) every subchapter c transaction should be determined with respect to the consideration received in regard to each share. reg-143686-07, the allocation of consideration and allocation and recovery of basis in transactions involving corporate stock or securities, 74 f.r. 3509 (1/21/09). the treasury and irs have published proposed regulations under §§ 301, 302, 304, 351, 354, 356, 358, 2010] recent developments in federal income taxation 154 368, 861, 1001, and 1016 regarding the recovery of stock basis in (1) § 301 distributions and transactions that are treated as § 301 distributions, and (2) sale and exchange transactions to which § 302(a) applies (including certain aspects of reorganization exchanges). the proposed regulations also provide the method for determining gain realized under § 356 and make a number of clarifying, but nonsubstantive, modifications to the rules for determining stock basis under § 358 resulting from a reorganization. the core principal underlying the rules is that each share of stock is a separate unit of property that can be sold or exchanged and the results of a transaction should be determined with respect to the consideration received in regard to each share. • section 301 distributions — a § 301 distribution is received on a pro rata, share-by-share basis with respect to the class of stock upon which the distribution is made. prop. reg. § 1.301-2. a distribution that is not a dividend under §§ 301(c)(1) and 316 can result in gain with respect to some shares of a class while other shares have unrecovered basis. (this is consistent with the holding in johnson v. united states, 435 f.2d 1257 (4th cir. 1971).) • dividend equivalent redemptions — the same basis recovery rules that apply to §301 distributions apply to redemptions that do not qualify under § 302(a) and (b) (“dividend-equivalent redemptions”) and § 304 transactions that are taxed under § 301. prop. reg. §§ 1.302-5(a), 1.304-2. a dividend equivalent redemption results in a pro rata, share-by-share distribution to all shares of the redeemed class held by the redeemed shareholder immediately before the redemption. the term “redeemed class” means all of the shares of that class held by the redeemed shareholder. only the basis of shares of the redeemed class may be reduced before gain is realized. dividend equivalent redemptions can produce gain with respect to some shares while other shares have unrecovered basis. • basis adjustments in dividend equivalent redemptions if less than all of the shares of a single class held by the taxpayer are redeemed — if less than all of the shares of a class of stock held by the taxpayer are redeemed, the redeemed shareholder is treated as exchanging in a tax-free reorganization all of the shares in the class owned before the redemption for the number of shares held after the redemption transaction. prop. reg. § 1.302-5(2). reg. § 1.358-2 applies to preserve the basis of the shares in the shareholder’s remaining shares. thus, a dividend equivalent redemption is generally treated in the same manner, and its results are the same as, a § 301 distribution in which no shares were cancelled. • example — a owns all 100 shares of the common stock (the only class) of x corporation. at different times, a acquired 50 shares for $100 (block 1) and 50 shares for $200 (block 2). the corporation, which has no earnings and profits, redeems all of a’s block 2 155 florida tax review [vol. 10:si shares for $300. under §§ 302(d) and 301, the redemption proceeds are treated as a recovery of basis. the distribution of property is applied on a pro rata, share-by-share basis with respect to each of the shares in the redeemed class owned by a before the redemption. thus, a recognizes a $50 capital gain on block 1 ($150-100) under § 301(c)(3) and has $50 of basis remaining in block 2 ($150-200). to reflect the actual number of shares held by a after the redemption, a’s shares in the redeemed class, including the shares actually surrendered, will be treated as exchanged in a recapitalization under section 368(a)(1)(e). a’s basis in the 50 recapitalized shares is determined under reg. §1.358-2. thus, a has 25 shares with a zero basis (attributable to block 1) and 25 shares with a basis of $50 (attributable to block 2). • basis recovery in dividend equivalent redemptions in which the taxpayer surrenders all of its shares in a single class — if all of the shares of a single class held by a shareholder are redeemed in a dividend equivalent redemption, under prop. reg. § 1.302-5(a)(3), the unrecovered basis is treated as a deferred loss that can be used by the shareholder when (1) the conditions of §§ 302(b)(1), (2), or (3) are satisfied, or (2) when all the shares of the issuing corporation (or its successor) become worthless under § 165(g). the current rules in reg. § 1.302-2(c) that permit unrecovered basis in the redeemed shares to shift to other shares would be revoked. • dividend equivalent reorganization exchanges — if boot is received in a reorganization that qualifies under § 368, the proposed regulations provide that the overall reorganization exchange is taken into account in determining whether a particular exchange in which boot is received is dividend equivalent. for example, if a shareholder exchanges one class of stock for stock and boot and exchanges another class of stock solely for boot, the effect of the overall exchange is considered in determining whether each particular exchange is dividend equivalent. if the boot received in the exchange is a dividend equivalent, an exchange of a class of stock solely for boot is an exchange to which § 302(d), and thus § 301, rather than § 356(a)(2), applies. however, the boot is treated as received pro rata, on a share-by-share basis, with respect to each share in the class. if both stock and boot are received with respect to a surrendered class (or classes) of stock and the boot is dividend equivalent, all of the consideration received in the exchange is treated as received pro rata (by value) with respect to all surrendered shares in the class. prop. reg. §§ 1.354-1(d); 1.356-1(b). however, economically reasonable designations between classes of stock or securities (as opposed to within a class) generally will be recognized. • redemptions given sale or exchange treatment by § 302 — the proposed regulations do not change the rule that in a § 302(a) redemption, a shareholder who owns shares of stock with different bases can decide whether to surrender high basis shares, low basis shares or any combination thereof, as permitted by reg. §1.1012-1(c). the acquiring 2010] recent developments in federal income taxation 156 corporation takes a cost basis in the stock of the issuing corporation that it acquires under § 1012. if § 304 applies and the sale of issuer stock is treated as a sale or exchange, rather than as a § 301 distribution, the basis and the holding period of the common stock of the acquiring corporation that is treated as redeemed will be the same as the basis and holding period of the stock of the issuing corporation actually surrendered. • reorganization exchanges resulting in sale or exchange treatment — if boot received in a reorganization is not a dividend equivalent, § 302(a) applies to the extent shares are exchanged solely for boot. a shareholder can elect to surrender high basis shares, low basis shares or any combination thereof in a non-dividend equivalent redemption, a shareholder engaging in a reorganization exchange in which the boot is not dividend equivalent can designate the shares with respect to which the boot was received and the amount of boot received with respect to each share, provided that the terms of the exchange are economically reasonable. prop. reg. § 1.3541(d)(1). if solely boot is received with respect to a share, the shareholder will recognize gain or loss with respect to that share pursuant to § 302(a), and § 356(a)(1) will not apply. nor will § 356(c) deny the loss. prop. reg. § 1.3541(d)(2). • section 351 exchanges — prop. reg. § 1.351-2(b) would provide that the amount of gain recognized under § 351(b) as a result of the receipt of boot, is determined by allocating the fair market value of each category of consideration received by a transferor among the transferred properties in proportion to each property’s relative fair market value. this is the approach of rev. rul. 68-55, 1968-1 c.b. 140. prop. reg. § 1.3582(g) provides as a general rule that in a § 351 exchange, the aggregate basis of the property transferred (as adjusted for gain and boot) is allocated among all of the shares of stock received in proportion to the fair market values of each share of stock. however, under prop. reg. § 1.358-2(g), if a shareholder transfers stock and other property, the separate bases will be preserved in the § 358 basis of the stock received in the exchange, provided that no liabilities are assumed in the exchange. 3. does this case mean an “accidental” benefit conferred on a corporate shareholder is not a constructive dividend? cox enterprises, inc. v. commissioner, t.c. memo. 2009-134 (6/9/09). a member of cox enterprises’ affiliated group transferred the assets of a television station to a partnership in exchange for a majority interest in the partnership. two family partnerships, the partners of which were family members of three trusts that together held a 98 percent majority interest in cox enterprises contributed cash to the partnership and received minority interests. the irs asserted that under § 311(b), the cox enterprises group recognized income on the constructive transfer to the trusts of a portion of the partnership interest it received in exchange for the assets, because the 157 florida tax review [vol. 10:si partnership interest received by the cox enterprises group member that transferred the assets was worth $60.5 million less than the value of the transferred assets. the commissioner’s theory was that the cox enterprises group had constructively distributed a dividend of an economic portion of its partnership interest to the shareholder trusts by transferring to family partnerships “for the benefit of” the shareholder trusts. on the taxpayer’s motion for summary judgment, for purposes of the motion, the $60.5 million disparity was between the value of the assets and the value of the partnership interest it received in return was admitted. judge halpern found that the undisputed facts established that cox enterprises’ primary purpose was not to provide an economic benefit to the family partnerships and, derivatively, to the shareholder trusts. in summarizing the applicable case law, he quoted gilbert v. commissioner, 74 t.c. 60, 64 (1980): “‘[t]ransfers between related corporations can result in constructive dividends to their common shareholder if they were made primarily for his benefit and if he received a direct or tangible benefit.’ if the benefit to the shareholder is ‘indirect or derivative in nature, there is no constructive dividend.’” applying this legal standard to his factual conclusion, there was not a constructive dividend to the shareholder trusts, even though an economic benefit was conferred on the beneficiaries of the shareholder trusts. judge halpern found the transfer of the television station to the partnership had a business purpose and that because a gratuitous transfer of assets would have violated the board of directors’ fiduciary duty, a purpose to make a gratuitous transfer could not be assumed to exist merely due to the value disparity. accordingly, no gain was recognized under § 311(b). judge halpern rejected the commissioner’s argument that to find a constructive dividend “it is only necessary to establish that appreciated assets left the corporate solution … , for the benefit of its shareholder trusts, to establish that there has been a distribution with respect to [the] shareholder trusts’ stock to which section 311 applies.” 4. reducing e&p for nondeductible expenses. rev. rul. 2009-25, 2009-38 i.r.b. 365 (9/4/09). interest paid by a corporation on a loan to purchase a life insurance policy on an individual for which a deduction has been disallowed under § 264(a)(4) reduces earnings and profits for the taxable year in which the interest would have been allowable as a deduction but for its disallowance under § 264(a)(4). it does not further reduce earnings and profits when the death benefit is received under the life insurance contract. c. liquidations there were no significant developments regarding this topic during 2009. 2010] recent developments in federal income taxation 158 d. s corporations 1. disregarded qsub is still a bank subject to reduced interest deductions for interest incurred to carry tax-exempt obligations. vainisi v. commissioner, 132 t.c. no. 1 (1/15/09). sections 291(a)(3), (e)(1)(b), and 265(b)(3) disallow interest deductions of a financial institution incurred to carry tax-exempt obligations, but allow an 80 percent deduction for interest on tax-exempts acquired after 12/31/82, and before 8/7/86, and for certain qualified tax exempt obligations as defined in § 265(b)(3)(b). section 1361 allows certain financial institutions to elect to be treated as an s corporation, and further allows an s corporation to treat a financial institution as a qualified s corporation subsidiary (qsub). under § 1361(b)(3)(a), a qsub is not treated as a separate corporation except as provided in regulations. reg. § 1.1361-4(a)(3) provides that in the case of a bank that is an s corporation or a qsub of an s corporation, any special rules applicable to banks will apply to an s corporation or a qsub that is bank. the court (judge foley) held that under these provisions the limitations of § 291(a)(3) are applicable to interest deductions claimed by a parent s corporation for interest expense generated by the s corporation’s qsub bank. the court also held that reg. § 1.1361-4(a)(3) is consistent with the enactment of § 1361(b)(3)(a) and its legislative history. 2. suspending the built-in gains tax to goose the economy by encouraging disinvestment in business assets. section 1251(a) of the 2009 arra amended code § 1374 to exempt an s corporation from the built-in gains tax for taxable years beginning in 2009 and 2010 if the seventh taxable year in the recognition period preceded the 2009 and 2010 tax years. this rule applies separately for property acquired from c corporations in carryover basis transactions. 3. another failed attempt to end run the § 1366(d) basis limitation on passed-though losses. kerzner v. commissioner, t.c. memo. 2009-76 (4/6/09). the taxpayers, who were equal partners in a partnership and equal shareholders of an s corporation, attempted to avoid the § 1366(d) limitation on passed-through losses from an s corporation by borrowing money from the partnership and re-lending the loan proceeds to the s corporation, which in turn paid equivalent amounts of rent back to the partnership. the tax court (judge nims) disallowed the pass-through losses, holding that the taxpayers did not acquire any basis in indebtedness from the s corporation from the transactions because they involved a circular flow of funds and there was no real expectation that they would ever repay the borrowed funds. thus the taxpayers had not incurred any economic outlay. 159 florida tax review [vol. 10:si 4. check and elect! a formerly unincorporated entity can move directly to s corporation status. rev. rul. 2009-15, 200921 i.r.b. 1035 (5/8/09). when an unincorporated entity taxed as a partnership becomes a corporation for federal tax purposes, the corporation is eligible to elect to be taxed as an s corporation effective for its first taxable year as a corporation. additionally, the corporation will not be deemed to have an intervening short taxable year in which it was a c corporation. these results occur whether: (1) the entity is an unincorporated entity classified as a partnership that both (a) elects under reg. § 301.7701-3(c)(1)(i) to be treated as a corporation, and (b) elects under § 1362(a) to be taxed as an s corporation, with both elections effective on the same date; or (2) the entity is an unincorporated entity classified as a partnership that both (a) converts into a corporation under a state law formless conversion statute, and (b) elects under § 1362(a) to be taxed as an s corporation, with both elections effective on the same date. 5. roth ira is not an eligible s corporation shareholder. taproot administrative services, inc. v. commissioner, 133 t.c. no. 9 (9/29/09) (reviewed, 12-4). the taxpayer corporation’s sole shareholder was a custodial roth ira account. eligible s corporation shareholders as defined in § 1361 include individuals, estates, certain specifically designated trusts and certain exempt organizations. with an effective date after the year involved in this case, § 1361(c)(2)(a)(iv) was enacted to allow a bank whose stock is held by an ira or roth ira to elect s corporation status. reg. § 1.1361-1(e)(1) provides that a person for whom s corporation stock is held by a nominee, guardian, custodian or agent is deemed to be the s corporation shareholder. however, in rev. rul. 92-73, 1992-2 c.b. 224, the irs ruled that a trust that qualifies as an ira is not a permitted s corporation shareholder. declaring the issue as one of first impression, and indicating that under skidmore deference to revenue rulings depends upon their persuasiveness, the tax court (judge wherry) agreed with the irs’s rationale in the ruling that iras are not eligible s corporation shareholders because the beneficiary of the ira is not taxed currently on the trust’s share of corporate income unlike the beneficiary of a custodial account or the grantor of a grantor trust who is subject to tax on the passthrough corporate income. (the income of the corporation owned by a roth ira would never be subject to tax.) • judge holmes dissented in a beautifully-reasoned opinion which made the point that an ira account is owned by a custodian for the benefit of an individual, who is to be treated as the shareholder, and any unwarranted tax benefits would not accrue because the income of the ira would be taxed under § 511 as ubit. his opinion concluded: 2010] recent developments in federal income taxation 160 this case is a reminder that tax law does not cascade into the real world through a single channel. it meanders instead through a vast delta, and any general principles tugged along by its current are just as likely to sink in the braided and rebraided rivulets of specific code provisions and the murk of regulations as they are to survive and be useful in deciding real cases. taproot thinks it found a course through the confluence of the subchapter s and ira rules that it could successfully navigate. its route would be new, but the stakes are not that great, and the sky will remain standing if we had just read and applied the regulation as it is. 6. revenge for gitlitz? t.d. 9469, section 108 reduction of tax attributes for s corporations, 74 f.r. 56109 (10/30/09). the treasury department has promulgated final regulations proposed in reg-102822-08, section 108 reduction of tax attributes for s corporations, 73 f.r. 45656 (8/5/08). section 108(d)(7)(a) provides that if an s corporation excludes cod income under § 108(a), the excluded amount reduces the s corporation’s tax attributes under § 108(b)(2); section 108(b)(4)(a) provides that the reduction occurs after the s corporation’s items of income, loss, deduction and credit for the taxable year of the discharge pass through to its shareholders. pursuant to § 108(d)(7)(b), reg. § 1.108-7(d) treats any § 1366(d)(3) shareholder carryover losses from prior years and any passed through losses from the current year in excess of the shareholders’ bases as a “deemed nol” of the s corporation that would be reduced under § 108(b). where an s corporation has more than one shareholder during the taxable year of the discharge, a shareholder’s disallowed losses or deductions equal a pro rata share of the total losses and deductions allocated to the shareholder under § 1366(a) during the corporation’s taxable year (including losses and deductions disallowed under § 1366(d)(1) for prior years that are treated as current year losses and deductions with respect to the shareholder under § 1366(d)(2)). the regulations provide that the deemed nol allocated to a shareholder consists of a proportionate amount of each item of the shareholder’s loss or deduction that was disallowed under § 1366(d)(1) in the year of the debt cancellation. the regulations were effective on 10/30/09. e. mergers, acquisitions and reorganizations 1. as the old saying goes, “there’s no tax free basis step-up without a funeral.” this “midco” tax shelter was rejected by the court. enbridge energy co., inc. v. united states, 553 f. supp. 2d 716 (s.d. tex. 3/31/08). in a transaction substantially similar to the transaction described in notice 2001-16, 2001-1 c.b. 730, the taxpayer (midcoast) 161 florida tax review [vol. 10:si acquired the assets of a selling corporation (bishop) through an intermediary (k-pipe). midcoast desired to acquire the bishop assets with a cost basis, but bishop’s shareholder (langley) was unwilling to engage in an asset sale, insisting on a stock sale and purchase. midcoast’s tax advisor, pwc, arranged for the formation of an intermediary, k-pipe merger, and the financing necessary for k-pipe merger to purchase the bishop stock, with the loan to k-pipe merger being secured by midcoast assets. after a downstream merger of k-pipe merger into bishop, bishop, which changed its name to k-pipe group, sold the bishop assets to midcoast. (k-pipe purportedly offset the gain with built-in loss on assets contributed to it by its shareholder in a pre-§ 362(e) year.) thereafter, k-pipe engaged in no business activity and was merely a shell. on cross motions for summary judgment, the district court (judge harmon) upheld the irs’s treatment of the transaction from midcoast’s perspective as a stock sale followed by a § 332 liquidation, which resulted in denying the step-up in basis on which midcoast’s claimed depreciation deductions were based. after disregarding k-pipe because it had no substance other than as a vehicle to allow midcoast to claim a cost basis in the bishop assets in a stock sale transaction without a § 338 election, the court addressed what was the real substance of the transaction: a sale of stock or a sale of assets. because langley would not agree to a direct sale of bishop’s assets, “the only way in which midcoast could have obtained the bishop assets was to purchase the bishop stock and liquidate.” assessment of the § 6662(d) substantial understatement penalty was upheld, and because the transaction was a “tax shelter,” neither the substantial authority nor adequate disclosure exceptions applied. alternatively, there was not substantial authority because the weight of authority in supreme court and fifth circuit cases was held to have required disregarding k-pipe. (a) affirmed! substance over form is alive and well in the fifth circuit. enbridge energy co., inc. v. united states, 104 a.f.t.r.2d 2009-7289 (5th cir. 11/10/09). in a nonprecedential per curiam opinion, the fifth circuit applied the substance over form doctrine in affirming the district court’s decision upholding the irs’s treatment of a “midco” transaction arranged by the buyer as a stock purchase followed by a § 332 liquidation, which resulted in denying the step-up in basis on which the taxpayer’s claimed depreciation deductions were based. imposition of a 20 percent § 6662 penalty also was affirmed. 2. all cash (d) reorgs are now in the final regulations. t.d. 9475, corporate reorganizations; distributions under sections 368(a)(1)(d) and 354(b)(1)(b), 74 f.r. 67053 (12/18/09). in 2006, the treasury department promulgated temp. reg. § 1.368-2t, providing that the distribution requirement under §§ 368(a)(1)(d) and 354(b)(1)(b) is 2010] recent developments in federal income taxation 162 deemed to have been satisfied despite the fact that no stock and/or securities are actually issued in a transaction otherwise described in § 368(a)(1)(d) if the same person or persons, directly or indirectly, own all of the stock of the transferor and transferee corporations in identical proportions. t.d. 9303, 71 f.r. 75879 (12/19/06). to a limited extent, the attribution rules in § 318 are invoked to determine whether the same person or persons own, directly or indirectly, all of the stock of the transferor and transferee. an individual and all members of his family that have a relationship described in § 318(a)(1) are treated as one individual; and stock owned by a corporation is attributed proportionally to the corporation’s shareholder without regard to the 50 percent limitation in § 318(a)(2)(c). ownership in absolutely identical proportions is not required. a de minimis variation in shareholder identity or proportionality of ownership in the transferor and transferee corporations is disregarded. the regulations give as an example of a de minimis variation a situation in which a, b, and c each own, respectively, 34%, 33%, and 33% of the transferor’s stock and a, b, c, and d each own, respectively, 33%, 33%, 33% and 1% of the transferee’s stock. stock described in § 1504(a)(4) – nonvoting limited preferred stock that is not convertible – is disregarded for purposes of determining whether the same person or persons own all of the stock of the transferor and transferee corporations in identical proportions. when a transaction qualifies as a § 368(a)(1)(d) reorganization under the regulations, a nominal share of stock of the transferee corporation will be deemed to have been issued in addition to the actual consideration. that nominal share of stock is deemed to have been distributed by the transferor corporation to its shareholders and, in appropriate circumstances, further transferred to the extent necessary to reflect the actual ownership of the transferor and transferee corporations. identical proposed regulations were simultaneously published. the proposed regulations have been finalized, with certain modifications, as reg. § 1.368-1(e). first, if no consideration is received, or the value of the consideration received in the transaction is less than the fair market value of the transferor corporation’s assets, the transferee corporation is treated as issuing stock with a value equal to the excess of the fair market value of the transferor corporation’s assets over the value of the consideration actually received in the transaction. if the value of the consideration received in the transaction is equal to the fair market value of the transferor corporation’s assets, the transferee corporation will be deemed to issue a nominal share of stock to the transferor corporation in addition to the actual consideration exchanged for the transferor corporation’s assets. in addition, reg. § 1.358-2(a)(2)(iii) has been amended to provide that in a reorganization in which the property received consists solely of non-qualifying property equal to the value of the assets transferred, as well as a nominal share described in the regulations, the shareholder or security holder may designate the share of stock of the transferee to which the basis, if any, of the stock or securities surrendered will attach. 163 florida tax review [vol. 10:si • if an all-cash transaction subject to these regulations occurs between members of a consolidated group, the selling member (s) is treated as receiving the nominal share and additional stock of the buying member (b) under § 1.1502-13(f)(3), which it distributes to its shareholder member (m) in liquidation. immediately after the sale, the b stock (with the exception of the nominal share which is still held by m) received by m is treated as redeemed in a distribution to which § 301 applies. m’s basis in the b stock is reduced under reg. § 1.1502-32(b)(3)(v), and under reg. § 1.302-2(c), any remaining basis attaches to the nominal share. f. corporate divisions there were no significant developments regarding this topic during 2009. g. affiliated corporations and consolidated returns 1. are “new and more precise mechanics” synonymous with “ever-more complicated”? reg-107592-00, consolidated returns; intercompany obligations, 72 f.r. 55139 (9/28/07). the irs has proposed amendments to reg. § 1.1502-13(g) with respect to the treatment of obligations between members of a consolidated group. reg. 1.1502-13(g) applies to three types of transactions: (1) transactions in which an obligation between a group member and a nonmember becomes an intercompany obligation – for example, the purchase by a consolidated group member of another member’s debt from a nonmember creditor or the acquisition by a consolidated group member of stock of a nonmember creditor or debtor (inbound transactions); (2) transactions in which an intercompany obligation ceases to be an intercompany obligation – for example, the sale by a creditor member of another member’s debt to a nonmember or the deconsolidation of either the debtor or creditor member (outbound transactions); and (3) transactions in which an intercompany obligation is assigned or extinguished within the consolidated group (intragroup transactions). the proposed regulations “adopt new and more precise mechanics” for the application of the deemed satisfaction-reissuance model to intragroup and outbound transactions. the following sequence of events to occur immediately before, and independently of, the actual transaction: (1) the debtor is deemed to satisfy the obligation for a cash amount equal to the obligation’s fair market value; and (2) the debtor is deemed to immediately reissue the obligation to the original creditor for that same cash amount. the parties are then treated as engaging in the actual transaction but with the new obligation. with respect to inbound transactions, the irs and the treasury department have concluded that the 2010] recent developments in federal income taxation 164 mechanics of the deemed satisfaction-reissuance model and its application produce appropriate results and, therefore, no change has been proposed. (a) finalized with various clarifications! t.d. 9442, consolidated returns; intercompany obligations, 72 f.r. 55139 (1/5/09). the proposed regulations have been finalized without any significant change in the basic framework of the rules. some of the antiabuse rules have been modified. the final regulations also clarify that the routine modification exception applies to a deemed exchange of intercompany debt for intercompany debt that occurs under reg. § 1.1001-3 as a result of an assumption transaction. the final regulations also clarify that an exception for certain § 351 nonrecognition exchanges is available for transactions in which a debtor’s obligation is assumed. an exception also applies to exchanges to which both §§ 332 and 337(a) apply in which no amount is recognized by either the creditor or debtor member. 2. modernizing the “controlled group” definition regulations. t.d. 9451, guidance necessary to facilitate business election filing; finalization of controlled group qualification rules, 74 f.r. 25147 (5/27/09). this treasury decision has finalized prop. reg. § 1.1563-1, reg161919-05, 71 f.r. 76955 (12/22/06), with no substantive changes. temp. reg. § 1.1563-1t has been removed. amendments to § 1563(a) in 2004 expanded the definition of a brother-sister controlled group to a group of corporations if five or fewer persons who are individuals, estates, or trusts own stock more than 50 percent of the total combined voting power of all classes of stock entitled to vote or more than 50 percent of the total value of shares of all classes of stock of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation. prior to the 2004 amendments, the definition also required the same five or fewer taxpayers to own at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock of each corporation (the 80 percent requirement). the revised regulation reflects the elimination of the 80 percent requirement from the § 1563(a)(2) definition of a brother-sister controlled group. the regulations also clarify an s corporation is treated as a component member of a controlled group only to the extent that a particular tax, and thus a particular tax benefit item subject to § 1561(a), applies. in addition, as amended, the regulations refer generically to the tax benefit items listed in § 1561(a) rather than refer specifically to those items by listing and describing each one. each component member of a controlled group must annually file a form (form 1120, schedule o) with its tax return indicating whether or not an apportionment plan is in effect, and any change is made to the group’s apportionment of its § 1561(a) tax benefit items from the 165 florida tax review [vol. 10:si previous year. the new regulations also provide ministerial changes to facilitate e-filing. 3. a controlled corporation is not a controlled corporation, except when it is controlled. reg-135005-07, clarification of controlled group qualification rules, 74 f.r. 49829 (9/28/09). section 1563(a) defines groups of controlled corporations based on ownership of voting control and value of stock in parent-subsidiary and brother-sister controlled groups (or a combination). section 1563(b) excludes certain controlled corporations from being treated as component members, including, among others, a corporation that was a member of the group for less than half of the days of a testing period, foreign corporations that do not have effectively connected income. section 1561(a) limits the component members of a controlled group to one application of certain benefits and limitations, such as one bite at the taxable income brackets of § 11. in addition, some provisions, such as § 41 which provides a credit for increased research expenditures, treat the members of a controlled group as a single corporation. controlled group for these purposes is defined by reference to § 1563(a). prop. reg. § 1.1563-1(a)(ii) would provide that in determining whether two or more corporations are members of a controlled group under § 1563(a), an excluded member under § 1563(b)(2), while not a component member of a controlled group under § 1563(b)(1), nevertheless is a member of a controlled group under § 1563(a). this proposed regulation is intended to clarify that for purposes of code provisions other than § 1561(a) that reference the definition of a controlled group under § 1563(a) for purposes of limiting tax benefits, all corporations meeting the ownership requirements are taken into account. the irs indicates its belief that the provision is supported by clear statutory language. • the preamble to the proposed regulation states that some taxpayers have taken the position that the limitation of § 41 and similar provisions is applicable only to component members of a controlled group. 4. more controlled group guidance. t.d. 9476, apportionment of tax items among the members of a controlled group of corporations, 74 f.r. 68530 (12/28/09). reg. §§ 1.1561-1 through 1.1561-3 provide rules regarding the apportionment of tax benefit items among corporations that are (1) members of a consolidated group filing a lifenonlife income tax return (life insurance company included with a non-life insurance company) or (2) component members of a controlled group of corporations. 5. more help from the irs for consolidated groups: are they “too big to fail?” t.d. 9458, modification to consolidated return 2010] recent developments in federal income taxation 166 regulation permitting an election to treat a liquidation of a target, followed by a recontribution to a new target, as a cross-chain reorganization, 74 f.r. 45757 (9/4/09). temp reg. § 1.150213t(f)(5)(ii)(b) modifies the election under which a consolidated group can avoid immediately taking into account an intercompany item after the liquidation of member corporation that previously had been sold within the group. under the regulations, if § 332 otherwise would apply to a target’s liquidation into its parent and the parent transfers substantially all of targets assets to a new member, and if a direct transfer of substantially all of the target’s assets to the new member corporation would qualify as a § 368(a) reorganization, i.e., a cross-chain type (d) reorganization, then the liquidation and transfer of substantially all of the assets be disregarded and instead, the transaction will be treated as if target transferred substantially all of its assets to the new corporation exchange for the new corporation’s stock and the assumption of t’s liabilities in a § 368(a)(1)(d) reorganization. the result is that target’s deferred items are not triggered. the temporary regulations generally apply to transactions that occur on or after 10/25/07. the text of the temporary regulations also is text of the proposed regulations. reg-139068-08, 74 f.r. 45789 (9/4/09). h. miscellaneous corporate issues 1. who needs congress to legislate billions of tax benefits via loss carryovers from failing banks that have undergone ownership changes? notice 2008-83, 2008-42 i.r.b. 905 (10/1/08). taxpayers which have acquired failing banks will not be limited by § 382(h) in their deductions for losses on loans or bad debts. under this notice, these losses “shall not be treated as a built-in loss or a deduction that is attributable to periods before the [ownership] change date.” this notice applies whether the acquirer is a private investor (including another bank) or is the treasury. (a) congress tells treasury and the irs, “you can’t do that, but we can grandfather what you did. so there, take this.” section 1261 of 2009 arra, an uncodified provision, generally voided notice 2008-83 for ownership changes occurring after 1/16/09. however, notice 2008-83 will be applied to (1) any ownership change occurring on or before 1/16/09, and (2) any ownership change that occurs after 1/16/09, if the change (a) is pursuant to a written binding contract entered in to on or before 1/16/09, or (b) was described on or before that date in a public announcement or in a filing with the sec required by reason of the ownership change. 2. again, who needs congress to permit continued use of loss carryovers of corporations whose toxic paper is acquired by 167 florida tax review [vol. 10:si treasury? notice 2008-100, 2008-44 i.r.b. 1081 (10/15/08). this notice provides guidance on the application of § 382 to loss corporations whose financial instruments are acquired by treasury as part of the capital purchase program pursuant to eesa. under this program, treasury will acquire preferred stock and warrants from qualifying financial institutions. this notice specifies that treasury will not be treated as a 5 percent shareholder for this purpose. (a) notice 2009-14, 2009-7 i.r.b. 516 (1/30/09). this notice amplifies and supersedes notice 2008-100, 2008-44 i.r.b. 1081, regarding the (non)application of § 382 to corporations the stock or options of which are acquired by the treasury department under the troubled asset relief program. this guidance is optional for taxpayer use, and is focused on treatment of debt, preferred stock, common stock, warrants, and redemption of stock held by the treasury department. any capital contributions made by the treasury pursuant to tarp programs will not be considered to have been made as part of a plan the principal purpose of which was to avoid or increase any § 382 limitation. (b) section 1262 of the 2009 arra added new code § 382(n), which provides that the § 382 limitations on nols do not apply to certain ownership changes under a restructuring plan which (1) is required under a loan agreement or a commitment for a line of credit entered into with the treasury department under the emergency economic stabilization act of 2008, and (2) is intended to result in a rationalization of the costs, capitalization, and capacity with regard to the manufacturing workforce of, and suppliers to, the taxpayer and its subsidiaries. this waiver of § 382 does not apply, however, to an ownership change if, immediately after the ownership change, any person (other than a veba under § 501(c)(9)) owns either fifty percent or more of the total combined voting power or value of the stock of the old loss corporation. related persons (as defined in §§ 267(b) or 707(b)) and persons who are members of a group acting in concert (§ 382(n)(3)(b)) are treated as a single person. the waiver of § 382 does not apply to a subsequent ownership change, unless that ownership change also is described in the preceding sentence. section 382(n) is effective for ownership changes occurring after 2/17/09. (c) notice 2009-38, 2009-18 i.r.b. 901 (4/14/09). this notice amplifies and supersedes notice 2009-14 to provide guidance to corporate issuers with respect to treasury’s acquisition of instruments pursuant to the following eesa programs: (1) the capital purchase program for publicly-traded issuers (public cpp); (2) the capital purchase program for private issuers (private cpp); (3) the capital purchase program for s corporations (s corp cpp); (4) the targeted investment 2010] recent developments in federal income taxation 168 program (tarp tip); (5) the asset guarantee program; (6) the systemically significant failing institutions program; (7) the automotive industry financing program; and (8) the capital assistance program for publiclytraded issuers (tarp cap). 3. help! stop me before i give away any more money without congressional action. notice 2008-101, 2008-44 i.r.b. 1082 (10/15/08). this notice specifies that tarp funds received by banks for “troubled assets” will not be treated as “the provision of federal financial assistance” within the meaning of § 597. that code section requires that “federal financial assistance shall be properly taken into account by the institution from which the assets were acquired.” vii. partnerships a. formation and taxable years there were no significant developments regarding this topic during 2009. b. allocations of distributive share, partnership debt, and outside basis 1. rip van winkle awakened. after 23 years treasury has proposed regulations under § 706(d). reg-144689-04, determination of distributive share when a partner’s interest changes, 74 f.r. 17119 (4/14/09). section 706(d)(1), originally enacted in 1976 and amended in 1984, provides that in any taxable year in which there is a change in a partner’s interest, each partner’s distributive share of partnership items must be determined under a method prescribed by regulations to take into account the partners’ varying interests during the year. pre-1976 regulations, reg. § 1.706-(1)(c)(2), mandated the use of the interim closing of the books method, unless the partnership elected a proration method. the proposed regulations would adopt these rules under the current statutory provision, with significant modifications. the proposed regulations continue to mandate the interim closing of the books method, whenever a partner’s interest is changed, including a partner’s retirement or sale of the partner’s entire interest in the partnership, unless the partnership by agreement among the partners elects to use the proration method. prop. reg. § 1.706-4(a)(1). for purposes of determining allocations to partners whose interests vary during the taxable year, the proposed regulations would require the partnership to allocate partnership items under its method of accounting for the full taxable year to segments of the taxable year representing discrete periods during which partners’ interests vary. prop. reg. § 1.706-4(a)(2). 169 florida tax review [vol. 10:si segments rule.—under the interim closing of the books method, prop. reg. § 1.704-4(c)(2) would allow the partnership to allocate items to a segment of the taxable year ending either on the calendar day a partner’s interest changes, or to adopt a semi-monthly convention under which a change in a partner’s interest during the first fifteen days of a month would require the partnership to close its books as of the last day of the preceding month, and a change in a partner’s interest after the fifteenth day of the month would require the partnership to close its books on the fifteenth day of the month of the change. prop. reg. § 1.706-4(e). under the proration method, the partnership’s items for the entire year would be prorated over the full taxable year and allocated among the partners based on their respective percentage interests during each segment of the taxable year. prop. reg. § 1. 706-4(d)(1). a segment would end on the calendar day on which a partner’s interest changes. prop. reg. § 1.706-4(d)(2) &(e)(1). prohibition on prorating “extraordinary items.—prop. reg. § 1.7064(d)(3) contains special rules under the proration method that would prevent a prorated allocation of “extraordinary” items, which is a problem under the current regulations for a partner who disposes of the partner’s entire interest by liquidation or sale. the proposed regulations would require an allocation of extraordinary items that, in general, arise on a disposition of partnership property to the partners in proportion to their interests at the beginning of the calendar day on which the extraordinary item is taken into account. extraordinary items include, among others, gain or loss on the disposition or abandonment of capital assets, trade or business property, property excluded from capital gains treatment under § 1221(a)(1), (3), (4), or (5) if substantially all of the assets in a particular category are disposed of in one transaction, discharge of indebtedness, and items from the settlement of tort or third-party liability. other stuff.— although the proposed regulations would apply to a change in a partner’s interest attributable to a disposition of a partners entire interest or a partial interest, the proposed regulations would not apply to changes in allocations of partnership items among contemporaneous partners that satisfy the allocation rules of § 704(b), provided that a reallocation is not attributable to a capital contribution to the partnership or a distribution of money or property that is a return of capital. the proposed regulations would also provide safe harbors for changes in the interests of partners in a service partnership under a reasonable method that complies with § 704(b) for taking into account varying interests during the year, and for publically traded units of a publically traded partnership that uses a semi-monthly convention. effective date.—the proposed regulations would be applicable to partnership taxable years beginning after the date of publication of final regulations, but not before taxable years beginning after 12/30/09. 2010] recent developments in federal income taxation 170 2. if you lose it once, you can’t claim it again. leblanc v. united states, 104 a.f.t.r.2d 2009-7611 (fed. cl. 12/4/09). the taxpayers invested as limited partners in an agriculture limited partnership that produced farming expense deductions in its first year of operation. in a tefra audit proceeding, the partnership agreed to the disallowance of a portion of the deductions from transactions lacking economic substance. in a separate tax court proceeding, while the partnership proceeding was still pending, the taxpayers agreed to a settlement disallowing the same deductions on the partners’ return. several years later the taxpayers claimed a loss deduction from abandonment of the partnership interest in a refund suit. the taxpayers claimed that as a result of the settlements with the irs they retained a substantial basis in their partnership interest which resulted in a loss on abandonment of the partnership interest. first, the court rejected the irs assertion that it lacked subject matter jurisdiction because disallowance of the partners’ losses was determined in the partnership proceeding. the court concluded that allowance of an abandonment loss deduction is an affected item subject to determination in a partner’s refund action. the court stated that the partnership prong, allowance of an item, must be determined in the partnership proceeding; then the second prong, the impact of the affected item on the partners’ individual tax liabilities, may be determined in a subsequent partner level proceeding. the court thus held that the sham transaction nature of the investment was determined in the partnership level proceeding, and that determination was not affected by the taxpayers’ partner level settlement agreement, but that the court had jurisdiction to determine the partners’ remaining bases for purposes of claiming their § 165 abandonment losses. the taxpayers asserted that their bases were reduced to zero, and no lower, by losses in the first year of the investment, but that additions to basis in subsequent years, not offset by the first year reductions to basis below zero, created a positive basis in the year of abandonment. the court held that calculation of basis under § 705 is cumulative and reflects a partner’s entire period of ownership. thus income and loss in the current year and prior years is summed in making the calculation. the statutory direction that basis cannot fall below zero does not mean that the history of profits and losses over the history of the partnership is permanently set to zero. further, the basis at the end of one year set at zero does not preclude a calculation of basis at any other time that includes all preceding distributed income and losses. the court also pointed out that the taxpayers’ claim would allow them to recover as abandonment losses the loss deductions previously disallowed in the partnership proceeding. 3. state rehabilitation tax credits for sale, or not. virginia historic tax credit fund 2001 lp v. commissioner, t.c. memo. 2009-295 (12/21/09). the virginia historic rehabilitation credit program contains an allocation provision that allows a developer partnership to 171 florida tax review [vol. 10:si allocate state rehabilitation tax credits to partners in proportion to their ownership interests in the partnership or as the partners mutually agree. the taxpayer partnership was a state tax credit partner in partnerships developing historic rehabilitation projects in virginia. the taxpayer limited partnership, as a state tax credit partner, held a small percentage ownership interest in virginia rehabilitation projects but was allocated most of the rehabilitation tax credits that the developer partnership could otherwise not use. the taxpayer partnership also purchased state tax credits under a one-time transfer provision. the taxpayer in turn received capital contributions from 282 investor limited partners (either directly or through a lower-tier llc or lp). the pooled capital was invested in various developer rehabilitation partnerships. the virginia state rehabilitation credits were allocated to the investor partners. in general each investor was allocated $1 of state tax credit for each $0.74 invested. the investors were “bought out after the partnerships accomplished their purpose.” • the court (judge kroupa) rejected the irs’s alternative assertions that the partnership derived income from the sale of state tax credits to the investors who were not partners, or if the investors were to be recognized as partners in the tax credit partnerships, the transactions constituted disguised sales of the state tax credits under § 707(a)(2)(b). the court was impressed by several elements of the transactions in determining that the investors created a community of interest in profits and losses by joining together for a business purpose: the parties agreed to form a partnership, they acted as partners, the parties pooled resources in that the investors’ contributed capital and the general partners contributed capital and services, and that the partners had a business purpose in terms of deriving a net economic benefit from state income tax savings (which was not a federal tax savings). the court further held that the substance of the transactions was the formation of a partnership rather than the sale and purchase of the state tax credits in part because the transaction was compelled by the form of investment specified by the virginia program that encouraged the use of partnerships as a vehicle for attracting capital into historic rehabilitation. rather than treating the investors as purchasers of state tax credits, the court concluded that the investors’ funds were pooled to facilitate investments in developer partnerships and that the investors remained as participants in the partnerships until the developer partnerships completed rehabilitation projects. • the court also found that the investors bore a risk that the developer partnerships would fail to generate rehabilitation credits. the court rejected the irs’s § 707(a)(2)(b) argument for similar reasons. the court concluded that the substance of the transactions reflects valid contributions and allocations rather than sales based upon the court’s findings that the investors made capital contributions in furtherance of the partnership’s purpose to invest in developer partnerships engaged in historic rehabilitation and to receive state tax credits, the partnerships were able to 2010] recent developments in federal income taxation 172 participate because of the investors’ pooled capital, the state tax credits were allocated to the investors consistent with the allocation provisions of the virginia program, and that the investors were subject to the entrepreneurial risks of the partnerships operations. see reg. § 1.707-3(b)(1). finally, the court held that since the partnership did not have unreported income from the sale of state tax credits, the three year statute of limitation barred assessment and was not subject to extension to six years under § 6229(c)(2) because of an omission of 25 percent of gross income. • one of the taxpayer’s lawyers is a former student of professor mcmahon in the university of florida college of law graduate tax program. [paid advertisement.] c. distributions and transactions between the partnership and partners 1. careful capital accounts and tax accounts are necessary to avoid recognition of gain. robertson v. commissioner, t.c. memo. 2009-91 (4/29/09). the taxpayers (husband and wife) were 51 and 49 percent partners in an automobile engine repair and restoration business operated as an llc. the llc incurred debt to finance land and building acquisitions and operating expenses. the partnership returns were prepared late by a tax return preparer who was under investigation by the irs. the returns were filed late. the preparer died after the returns were filed and the preparer’s landlord disposed of the preparer’s records, including the records of the taxpayers’ llc. with respect to a sale of the partnership assets, followed by distributions of money, the irs asserted deficiencies claiming that the taxpayers had no basis in their partnership interests to offset distributions in one year, and that proceeds on the sale of partnership assets in a second year resulted in capital gain. the court (judge goeke) determined that the taxpayers failed to establish their partnership basis with adequate records, although the court indicated that the taxpayers’ testimony was honest. • the court also held that reliance on the return preparer for timely filings did not relieve the taxpayers of their obligations to timely file returns and imposed late filing penalties under § 6651(a)(1). however, the court found that the taxpayers reasonably relied on the preparer to accurately report their income and rejected proposed negligence penalties under § 6662. 2. layers within the partnership mixing bowl need comment. notice 2009-70, 2009-34 i.r.b. 255 (8/12/09). sections 704(c)(1)(b) and 737 require recognition of built-in pre-contribution gain with respect to property contributed to a partnership on a distribution of 173 florida tax review [vol. 10:si contributed property to a non-contributing partner, or other property to the contributing partner, within seven years of the contribution. regulations proposed in 2007 (prop. regs. §§ 1.704-4(c)(4) and 1.737-2(b), reg143397-06, partner’s distributive share, 72 f.r. 46932 (8/22/07)), provided that in an assets-over partnership merger, the seven-year clock begins anew with respect to built-in gain or loss with respect to property transferred from a merged partnership to the continuing partnership (the surviving partnership whose members own 50% or more of the partnership interests), but the clock dates back to the date of initial contribution with respect to pre-merger gains and losses, creating layers of old and new built-in gains and losses. the proposed regulations adopted the position of notice 2005-15, 2005-1 c.b. 527, which was withdrawn after complaints that the notice was inconsistent with existing regulations. commentators raised numerous questions regarding application of the proposed regulations and the examples, including problems with respect to application of the proposed regulations to tiered partnerships. the irs has again asked for comments on the proposed regulations, addressing, among other things, whether additional events allowing revaluation of partnership property should be included in reg. § 1.704-1(b)(2)(iv)(f), how to provide for partnership allocation of depreciation and other items among different layers, and how to deal with specified issues in tiered partnerships. comments were requested by 2/22/10. 3. forfeitable for decades and thus not guaranteed payments as annually accrued, but 100 percent a guaranteed payment when received. wallis v. commissioner, t.c. memo. 2009-243 (10/27/09). the taxpayer (a tax lawyer) retired as a equity partner in holland & knight, and among other amounts received $240,000 in twelve $20,000 payments over four taxable years. the $240,000 represented accumulated amounts that had been awarded to him as an equity partner over many years, but which were neither currently distributable as awarded nor recorded in the partner’s capital account; rather, the amounts, which were determined annually without regard to partnership income, were payable over a period of time after the partner reached age 68, but were forfeitable if the partner left the firm before that date. the tax court (judge cohen) held that the payments were a guaranteed payment under § 707(c) and § 736(a), taxable as ordinary income, and were not received as distributions under § 731. d. sales of partnership interests, liquidations and mergers 1. too many factors — proposed regulations on disguised sale of a partnership interest are withdrawn. ann. 2009-4, 2009-8 i.r.b. 597 (2/23/09). the irs has withdrawn prop. reg. § 1.707-7 (2004), reg-149519-03, section 707 regarding disguised sales, generally, 69 f.r. 68838 (11/26/04). section 707(a)(2)(b) provides that that a 2010] recent developments in federal income taxation 174 contribution by a partner in connection with a related distribution will under regulations be treated as a disguised sale. regulations proposed in 2004 would have expanded that concept to provide that a transfer of money or property, including an assumption of liabilities, to a partnership by a “purchasing partner” in connection with a related distribution to a “selling partner” would be treated as a purchase and sale of a partnership interest rather than a contribution and distribution. the latter transaction results in lesser or no recognition by the selling partner. the proposed regulation would have applied a multiple factor test to identify a disguised sale of a partnership interest. the tax court in colonnade condominium, inc. v. commissioner, 91 t.c. 793 (1988), adopted a more elegant approach based on an examination of whether there is an adjustment in partnership capital accounts reflecting a contribution and distribution, or whether there is simply a shift in the ownership of unchanged partnership capital. the announcement indicates only that the treasury department and the irs have considered written comments regarding the proposed regulation and will continue to study the matter and may issue guidance in the future. in the meantime, determinations whether a contribution and related distribution constitute a sale of a partnership interest will be based on case law and the legislative history to § 707(a)(2)(b). e. inside basis adjustments 1. intervenor is not allowed to demand that an fpaa be remanded to the irs for an explanation of its views. austin investment fund llc v. united states, 103 a.f.t.r.2d 2009-607 (fed. cl. 1/6/09). in a refund action filed by an llc through its tax matters partner, llc members sought to intervene with a motion to remand the case back to the irs for an explanation of the irs position to support the adjustments made in the fpaa. the court denied the motion pointing out that in cases seeking readjustment of partnership items in an fpaa the court makes a de novo determination of all partnership items. rewriting the fpaa to include a statement of reasons would be unnecessary. in addition, the court indicated that the intervenors cited no authority for their claim that the fpaa was required to be re-written to comply with the administrative procedures act. f. partnership audit rules 1. treasury regulations defining defenses to penalties that may be raised in partnership proceeding are valid. new millennium trading, l.l.c. v. commissioner, 131 t.c. no. 18 (12/22/08). in a tefra partnership proceeding, the determination of all partnership items is binding on the partners and may not be re-determined in another proceeding. section 6221 provides for determination of penalties at the 175 florida tax review [vol. 10:si partnership level and the court may consider reasonable cause defenses of the partnership. section 6230(c)(1)(c) provides that a partner may contest the imposition of penalties in a claim for refund, which includes under § 6230(c)(4) the assertion of partner-level defenses to the penalties. temp. reg. §§ 301.6221-1t(c) and (d) provides that partner level defenses to penalties imposed at the partner level, including the reasonable cause exception of § 6664(c), can only be determined through separate refund actions. on summary judgment, the tax court (judge goeke) rejected an individual partner’s argument that the temporary regulations cannot be applied to deprive the tax court of jurisdiction to consider the partner’s reasonable cause defense to penalties, and upheld the validity of the regulations. the court observed that nothing in §§ 6221 or 6226(f) grants jurisdiction to consider partner-level defenses and that the partner’s remedy under § 6230(c)(4) is to assert partner-level defenses in a refund claim. the court also opined that the regulations do not misinterpret the requirement of § 6664(c)(1) that no penalty may be imposed under §§ 6662 or 6663 if it was shown that there was reasonable cause. the court reached this conclusion by applying the deference rule of chevron u.s.a. inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), and noting that the court of appeals to which the case is appealable, the d.c. circuit, has indicated that treasury regulations are to be given chevron deference. (a) different judge, same result. tigers eye trading, llc v. commissioner, t.c. memo. 2009-121 (5/27/09). in another son-of-boss tax shelter proceeding, the court (judge beghe) treated accuracy-related penalty defenses as affected items determinable only in an individual partnership proceeding and upheld the validity of temp. reg. §§ 301.6221-1t(c) and (d). the court also rejected the irs motions in limine to declare the shelter opinion of curtis, mallet-prevost, colt & mosle llp to be an opinion by a shelter promoter on which the partner could not rely for penalty protection holding that the issue was to be determined in the partnership proceeding. in addition, the court granted the irs motion to reject the expert report of stuart smith on the grounds that the report consisted of legal discussion and argument. • in a lengthy afterword, judge beghe questioned the wisdom of dividing partner and partnership items into separate proceedings in these tax shelter cases and observes that the division creates complex logistical problems at great cost to judicial economy and attorney resources. judge beghe also notes that the irs and treasury have proposed regulations that would allow the irs to convert partnership items to nonpartnership items and allow a single proceeding – but only for listed transactions. 2010] recent developments in federal income taxation 176 2. william strunk jr. & e.b. white, the elements of style, helps identify the statute of limitations as a partnership item. keener v. united states, 551 f.3d 1358 (fed. cir. 1/8/09). the taxpayers invested in tax shelters promoted by amcor in the mid-1980s. in a partnership audit procedure, following issuance of an fpaa, the partnership entered into a settlement agreement with the irs that allowed a percentage of ordinary deductions, but provided that the irs could assert additional tax liability against individual partners plus interest. subsequently the irs assessed additional tax plus penalties against the taxpayers, which they paid in full. in their refund claim the taxpayers asserted that the statute of limitations had expired on the irs’ assessment of tax. the federal circuit (judge prost) affirmed the holding of the court of federal claims that it lacked jurisdiction to determine the refund claims because application of the statute of limitations is a partnership item as defined in § 6231(a) subject to determination in the tefra proceeding. section 6231(a) defines a partnership item as “any item required to be taken into account for the partnership’s taxable year under any provision of subtitle a.” the taxpayer argued that the statute of limitations, provided for under subtitle f, is not a partnership item under this definition. referring to the elements of style, the court concluded that the restrictive phrase “subtitle a” modifies the words that immediately precede it, “taxable year,” and not the words “partnership item.” in citing strunk & white, the court followed prati v. united states, 81 fed. cl. 422 (2008). the court added that reg. § 301.6631(a)(3)-1(b), which includes as a partnership item any determination of the amount, timing, and characterization of items, is a reasonable interpretation of the statutory ambiguity that is entitled to deference under chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984). the court also rejected the taxpayer’s claim for refund of additional interest penalties imposed on tax motivated transactions, holding that a determination that characterizes a partnership transaction as a sham is a partnership item. 3. reverse tefra: partnership items from listed transactions are to be treated as nonpartnership items. reg-138326-07, tax avoidance transactions, 74 f.r. 7205 (2/13/09). the tefra audit rules originally were enacted to allow the irs to address issues in the large tax shelter partnerships of the 1970s with a single partnership level proceeding rather than multiple proceedings involving the same issue against numerous partners. many of the recent abusive tax shelter transactions are structured to provide tax benefits to a single individual through a labyrinth of partnerships and trusts. proposed regulations §§ 301.6231(c)-3 and 301.6231-9 would permit the irs to notify a taxpayer that a partnership item attributable to a listed transaction from an identified partnership will be treated as a nonpartnership item, and thus not subject to the tefra partnership audit rules. the proposed regulations would only apply to 177 florida tax review [vol. 10:si transactions that are identified as a listed transaction under reg. § 1.60114(b)(2) prior to the date the irs notifies the taxpayer that the taxpayer’s partnership items related to the listed transaction will be treated as a nonpartnership item. the irs would determine whether an item would be treated as a nonpartnership item on a partnership-by-partnership and partnerby-partner basis. the determination may include an item that passes through more than one partnership. in the case of an indirect partner who holds an interest in a listed transaction through a lower-tier partnership, the notification may identify only the lower-tier partnership. the determination would not apply to items from partnerships not attributable to a listed transaction, which will remain partnership items. items attributable to listed transactions would remain partnership items unless the irs notifies the taxpayer that the item will be treated as a nonpartnership item. notification will apply to all partnership items from identified partnerships for all taxable years that ended before the date of the notice and all items attributable to that partnership that are related to a listed transaction. when finalized, the proposed regulations would apply to any taxable period ending on or after 2/13/09, the date of publication of the proposed regulations. 4. more woes for investors in hoyt partnerships. river city ranches v. commissioner, 103 a.f.t.r.2d 2009-1088 (9th cir. 2/26/09), aff’g t.c. memo. 2007-171 (7/2/07). the ninth circuit affirmed the tax court’s holding that that the six year statute of limitations under § 6229(c)(1) was applicable because the partnership return (prepared by hoyt) contained a false or fraudulent item, and that the sheep breeding partnerships at issue were sham partnerships lacking economic substance, which justified increased interest penalties under § 6621(c). the tax court had also held that an asserted conflict of interest between the tax matters partner and the other partners did not invalidate waiver of the statute of limitations by the tax matters partner. 5. thou shalt not allow a jury trial to challenge an fpaa assessment. rcl properties, inc. v. united states, 103 a.f.t.r.2d 2009-1784 (d. colo. 4/14/09). the partnership’s tax matters partner deposited an assessed deficiency as required by § 6226(e) and filed a civil action for recovery of the tax. the taxpayer filed a motion requesting a jury trial. the court (judge babcock) noted that under 28 u.s.c. § 2402, civil actions against the united states must be tried without a jury. an exception in 28 u.s.c. § 1346(a)(1) allows jury trials in cases for the recovery of any “internal revenue tax.” however, § 6226(e)(3) provides that a deposit for jurisdictional purposes is not treated as the payment of tax. jurisdiction in § 6226 action is provided under 28 u.s.c. § 1346(e), and is thus not within the exception allowing jury trials of 28 u.s.c. § 1346(a)(1). 2010] recent developments in federal income taxation 178 6. release from debt to restore negative capital account is a partnership item. bassing v. united states, 563 f.3d 1280 (fed. cir. 4/16/09). affirming the court of federal claims, the court (judge bryson) held that the release of one partner’s obligation to restore a capital account deficit is a partnership item. the taxpayer was one of two general partners and also held limited partner interests in a real estate development partnership. the partnership agreement required the taxpayer to restore his capital account deficit. the partnership entered into agreements with its principal creditor to settle outstanding liabilities and liquidate. at the same time the partnership entered into an agreement with the taxpayer, who was insolvent, to discharge the taxpayer’s deficit restoration obligation. the taxpayer reported the discharge as short-term capital gain on a deemed sale of his partnership interest. subsequently the taxpayer filed an amended return treating the forgiveness of his deficit restoration obligation as cancellation of indebtedness income that was excluded under § 108(a)(1)(b) because of his insolvency. the court held that the taxpayer’s refund action filed in the court of federal claims was barred by § 7422(h), which prohibits refund actions attributable to partnership items as defined in § 6231(a)(3). the court reasoned that a capital account deficit is determined under the partnership capital account maintenance rules, based on partnership accounting rules. see reg. § 301.6231(a)(3)-1(b). the release of a debt to restore a negative capital account is also a partnership item because the enforceability of the item is also determined under the partnership capital account maintenance rules so that release of the debt would be treated as cancellation of debt for the partnership. reg. § 301.6231(a)(3)-1(a). the court rejected the taxpayer’s argument that the tax treatment of the discharge of the deficit restoration obligation was an individual, non-partner issue that has no impact on the partnership or other partners. the purpose of the tefra audit rules is served by consistent treatment of capital account deficits for both co-general partners. 7. partner’s outside basis in a tax-shelter partnership is a partner item. napoliello v. commissioner, t.c. memo. 2009-104 (5/18/09). the taxpayer invested in a son-of-boss transaction involving digital foreign currency items. the irs issued an fpaa to the taxpayer as a notice partner. in the uncontested partnership proceeding it was determined that the partnership was a sham that lacked economic substance, that transactions entered into by the partnership should be treated as transacted directly by the partners, and that purported losses claimed on disposition of distributed property with an enhanced basis should be disallowed. the irs assessed a deficiency against the taxpayer based on the partnership items. the tax court previously had held in petaluma fx partners, llc v. commissioner, 131 t.c. 84 (2008), that the determination of whether a partnership was a sham that will be disregarded for federal tax 179 florida tax review [vol. 10:si purposes is a partnership item. in the instant case, the court (judge kroupa) agreed with the irs that the partner’s basis in distributed securities from the sham partnership is an item subject to determination in the partnership proceeding, and not subject to re-determination in the partner-level deficiency proceeding. because the amount of any loss with respect to the partner’s disposition of securities distributed from the partnership required a factual determination at the partner level, the court held that it had jurisdiction in the partner deficiency proceeding to proceed under normal deficiency procedures. the court thus proceeded to determine that the taxpayer claimed loss on the sale of the distributed securities was disallowed, that the taxpayer’s basis in the securities was their direct cost rather than an exchange basis from the partnership interest, and that the taxpayer was not allowed to deduct transaction costs attributable to the investment. the tax court also held that the fpaa gave the taxpayer fair notice of the irs claims. (a) part of the tax court’s holding in petaluma fx partners retains its vitality, but not the part the tax court relied upon in napoliello. petaluma fx partners, llc v. commissioner, 105 a.f.t.r.2d 2010-333 (d.c. cir. 1/12/10). the tax court in this son-ofboss tax shelter case determined that it had jurisdiction in a tefra partnership proceeding to determine that the partnership lacked economic substance and was a sham. since the partnership was disregarded, the tax court concluded that it had jurisdiction to determine that the partners’ outside basis in the partnership was zero. the tax court reasoned that a partner could not have a basis in a partnership interest that did not exist. 131 t.c. 84 (2008). the court of appeals agreed that the tax court had jurisdiction in the partnership proceeding to determine that the partnership was a sham. temp. reg. § 301.6223-1t(a) expressly provides that, “[a]ny final partnership administrative adjustment or judicial determination ... may include a determination that the entity is not a partnership for such taxable year.” the court of appeals held that the regulation was explicitly authorized by § 6233. a partnership item is defined in § 6231(a)(3) as an item required to be taken into account in determining the partnership’s income under subtitle a of the code that is identified in regulations as an item more appropriately taken into account at the partnership level. the court indicated that, “logically, it makes perfect sense to determine whether a partnership is a sham at the partnership level. a partnership cannot be a sham with respect to one partner, but valid with respect to another.” however, the court of appeals concluded that the partners’ bases were affected items, not partnership items, and that the tax court did not have jurisdiction to determine the partners’ bases in the partnership proceeding. the court rejected the irs argument that the tax court had jurisdiction in the partnership proceeding to determine the partners’ outside basis as an affected 2010] recent developments in federal income taxation 180 item whose elements are mainly determined from partnership items. the court held that resolution of the affected item requires a separate determination at the partner level even though the affected item could easily be determined in the partnership proceeding. finally, the court of appeals held that accuracy related penalties under § 6662(a) could not be determined without a determination of the partners’ outside basis in a partner level proceeding and vacated and remanded the tax court’s determination of penalty issues. 8. tax matters partner need not have anything personally at stake. gateway hotel partners, llc v. commissioner, t.c. memo. 2009-128 (6/4/09). over the irs objection, the taxpayer partnership was permitted to substitute as a tax matters partner a new partner who was not a partner during the years subject to tefra partnership audit. the court (judge goeke) concluded that the fact that the tax matters partner’s tax liability will not be affected by the proceeding does not disqualify the substitution. the court observed that, “[t]he tax matters partner’s importance derives from his role as a fiduciary serving on behalf of the other partners, and ‘his personal interest, if any, is beside the point.’” (quoting from computer programs lambda, ltd. v. commissioner, 89 t.c. 198, 205 (1987).) 9. a notice of deficiency relating to partner-level loss limitation rules need not wait for a fpaa. meruelo v. commissioner, 132 t.c. no. 18 (6/9/09). judge vasquez held that the application to a partner of the loss limitation rules of §§ 704(d) and 465 are affected items that require a partner-level determination. a notice of deficiency to a partner based on the application of the loss limitation rules of §§ 704(d) and 465 was not issued prematurely and was valid, even though irs had neither issued a notice of final partnership administrative adjustment for the partnership nor accepted the partnership’s return as filed for the year. the tax court had jurisdiction over the petition. (a) but a notice of deficiency is not proper while the partnership case is still pending. bausch & lomb inc. v. commissioner, t.c. memo. 2009-112 (5/21/09). the court (judge kroupa) granted a motion by the irs to dismiss a deficiency notice for lack of jurisdiction. the irs issued a deficiency notice to the parent of an affiliated group disallowing losses claimed from a limited partnership investment and imposing accuracy related penalties. the deficiencies arose from partnership items and affected items reflected in a fpaa in a partnership level proceeding that was not yet concluded. the court rejected the taxpayer’s argument that its basis in the partnership must be determined in the year of a contribution of a note to the partnership, which is not the year at issue in the 181 florida tax review [vol. 10:si fpaa, and therefore the basis is not a partnership item or affected item in the year subject to the partnership proceeding. the court concluded that the partner’s basis in contributed property is a partnership item subject to determination in the partnership proceeding. 10. the assessment of a deficiency doesn’t have to be on the computer tape if it’s manually processed. williams v. commissioner, t.c. memo. 2009-158 (6/30/09). the statute of limitations under § 6229(a) for assessment of a deficiency attributable to a partnership item or an affected item is three years after the later of the date on which a partnership return is filed, the last day for filing the partnership return. if an fpaa is mailed to the tax matters partner the limitations period is suspended for the time in which a court action may be brought, or if a court action is brought, until the court action becomes final plus one year thereafter. the taxpayer asserted that assessment statute expiration dates (ased) had expired and that the computerized account transcripts did not indicate the assessment until after the ased. the court (judge cohen) concluded that testimony from irs personnel was credible to establish that the assessments were issued manually and that the computer coding lagged the actual issue of the assessment. in addition, since the assessment was dated by august 15, within the aesd, the fact that the notice of assessment was only postmarked on august 21 (after the aesd) did not invalidate the assessment. 11. reasonable cause defense to the gross valuation misstatement penalty is not a partnership item, and by the way, son-ofboss transactions lack economic substance as a matter of law. clearmeadow investments, llc v. united states, 87 fed. cl. 509 (6/17/09). granting summary judgment to the government, the court held that the reasonable cause defense of § 6664(c)(1) to § 6662 accuracy related and substantial misstatement penalties is a partner level defense not subject to the federal claims court’s jurisdiction in a tefra partnership proceeding. the court rejected the taxpayers’ argument that its jurisdiction to consider partnership level penalties under § 6662 empowers the court to address reasonable cause defenses asserted by a partner. notwithstanding contrary language in klamath strategic investment fund ex rel. st. croix ventures v. united states, 103 a.f.t.r. 2d 2009-2220 (5th cir. 5/19/09), the court pointed out that reg. § 301.6221-1(d) and temp. reg. § 301.6221-1t(c)-(d) specifically describe the reasonable cause defense as a partner level defense that may not be asserted in a partnership proceeding. the court also rejected the taxpayer’s argument that although reg. § 1.752-6 applied retroactively to reduce basis by the amount of contingent liability in the son-of-boss transaction, the entity used by the taxpayers was not a partnership but a “multi-member disregarded entity.” (the taxpayers were fortunate that the 2010] recent developments in federal income taxation 182 court did not impose a frivolous argument penalty on this.) the court imposed a 40 percent § 6662 penalty. • the taxpayers – whether providently or not – conceded both the retroactivity of reg. § 1.752-6 and the lack of economic substance in their transaction. 12. partnership audit rules extend the statute of limitations. curr-spec partners l.p. v. commissioner, 2009-2 u.s.t.c. ¶50,578, 104 a.f.t.r.2d 2009-5249 (5th cir. 8/11/09). section 6501(a) provides a three-year statute of limitations for assessing tax deficiencies. section 6229(a) provides that the period for assessing a deficiency attributable to a partnership item does not expire until three years after the later of the date a partnership return or the due date for the partnership return. the irs issued an fpaa disallowing claimed partnership losses four years after the partnership return was filed, and assessed deficiencies against the partners for years into which the losses were carried forward. the assessment to individual losses disallowing the loss carryforwards were within the threeyear statute of limitations applicable to the partners’ returns. the fifth circuit affirmed the tax court holding that § 6229(a) does not establish an independent three-year statute of limitations with respect to partnership items, but merely extends the limitations period of § 6501(a). thus, assessment of a deficiency against partner’s whose individual return remains open is not barred by any limitation period in § 6229(a). (a) the tax court agrees. lvi investors, llc v. commissioner, t.c. memo 2009-254 (11/9/2009). the court (judge nims) followed its holding in curr-spec partners as affirmed by the fifth circuit. section 6501(a) provides a three year assessment period after an individual’s return is filed. section 6229(a) provides that the period for assessing any tax attributable to a partnership item or an affected item expires three years after the latter of the due date of the partnership return or the date the partnership return was filed.. the court held that § 6229 does not override § 6501 and instead sets a minimum limitations period that may extend the § 6501(a) period. 13. basis in a closed year is a partnership item that may be redetermined in an fpaa for an open year. wilmington partners l.p. v. commissioner, t.c. memo. 2009-193 (8/26/09). the irs issued an fpaa for the partnership’s 1993 year that was closed without adjustment. in an fpaa issued for 1999, the irs determined that the partnership’s basis in a reset note contributed in 1993 was zero. the court (judge kroupa) held that nothing in tefra prevents the court from considering events in a closed year to determine the proper adjustments for a docketed year. the court also held that the basis of the contributed note was a partnership item in the 183 florida tax review [vol. 10:si closed year of contribution, and remained a partnership item in each subsequent year. the court rejected the taxpayer’s argument that the fact that § 6228(a)(5) expressly empowers the court to look back at non-docketed items as an offset to an administrative adjustment requested by a tax matters partner under § 6227, does not bar the court from looking at the facts of a non-docketed year in another matter. 14. filing a refund claim before paying the $150 million, rather than paying first, filing second, left the taxpayer out the $150 million on procedural grounds. ackerman v. commissioner, 104 a.f.t.r.2d 2009-5830 (d. d.c. 8/18/09). following a tefra partnership proceeding, the irs notified the taxpayers of the resulting adjustments to their tax liability — over $150 million. within the required sixty days of receiving the notices, the taxpayers filed administrative refund requests to which the irs never responded. subsequently they filed the refund suit. however, the taxpayers did not pay the deficiency until after the administrative refund request was filed. the government argued that § 6230(c) requires that the taxes be paid in full before the administrative refund request is filed, while the taxpayers argued that under § 6230(c) — unlike under § 7422, which governs refund claims generally — it is not necessary to pay the taxes in full before the administrative refund request is filed, but merely before the suit is filed. the court held that, as argued by the government, for the court to have jurisdiction, the taxes must be paid in full before the administrative refund request is filed. the court found the long line of cases imposing the “pay first” rule under § 7422 to be controlling. the court further held that even though accuracy related penalties resulting from the partnership adjustments were partner-level items, § 6230(c) — and not § 6511— nevertheless controlled the period for filing a refund claim. thus, the taxpayer’s refund claim was untimely because it was not filed within 60 days. the suit was dismissed. 15. be careful what you stipulate to. lkf x investments, llc v. commissioner, t.c. memo. 2009-192 (8/25/09). the irs issued a notice of final administrative adjustment (fpaa) to the taxpayer partnership asserting that a llc taxed as a partnership that was used to invest in market-linked deposit transactions (another form of abusive shelter using contingent offsetting payments to generate losses) should be disregarded for tax purposes and that the investors had zero basis in their partnership interest. in the partnership proceeding the parties contested the tax court’s jurisdiction to consider disregard of the partnership and the partners’ bases as partnership items and stipulated that if the court determined that it had jurisdiction the parties would not contest the determinations made in the fpaa other than whether the valuation misstatement penalty imposed under § 6662 applies to any underpayment 2010] recent developments in federal income taxation 184 resulting from the adjustments in the fpaa. the court (judge marvel) granted summary judgment to the irs holding that a determination whether a partnership is a sham, lacks economic substance, or otherwise should be disregarded is a partnership item, following its prior decision in petaluma fx partners, llc v. commissioner, 131 t.c. 84 (2008). the court also held that when a partnership is disregarded for federal income tax purposes, the court has jurisdiction in the tefra proceeding to determine that the partners have zero outside basis. the court added that when the taxpayer stipulates that it would not contest an issue other than on jurisdictional grounds, the court will treat the issue as conceded. finally, the court also held that where the partnership is disregarded and the partners’ outside basis is zero the court had jurisdiction to determine as partnership items the applicability of accuracy related and valuation misstatement penalties under § 6662. the court rejected that taxpayer’s assertion that the valuation misstatement penalty in inapplicable because it was attributable to disregard of the partnership rather than an erroneous valuation. 16. in a son-of-boss litigation the tax court has jurisdiction to determine partner level deficiencies related to affected items. hiding the loss through additional pass-throughs justifies taxpayer-level determinations. desmet v. commissioner, 581 f.3d 297 (6th cir. 9/17/09). the taxpayers formed a partnership in a son-of-boss transaction, then transferred their partnership interests to an s corporation. in the tefra partnership proceeding, which became final, the irs determined that the partnership’s basis in distributed property was zero. rather than directly assessing tax against the taxpayers as computational adjustments resulting from the fpaa under § 6230(a)(1), the irs sent notices of deficiency related to affected items that require partner level determinations under § 6230(a)(2). the taxpayers asserted that the irs was required to assess the tax directly because no additional partner level determinations were necessary and that the statute of limitations had run on the assessment of individual deficiencies. affirming the tax court, the sixth circuit concluded that the partnership proceeding determined only that the partnership was required to reduce its basis on account of its contingent obligation to close the short sale leg of the son-of-boss transaction. the partnership proceeding did not address the taxpayers’ claimed losses through their s corporation. the s corporation’s loss was not addressed in the fpaa. the s corporation’s loss arose from the sale of distributed stock, which could not be determined from the fpaa. thus, the court held that the irs was empowered to bring individual level proceedings to resolve issues regarding the losses passed-through from the s corporation. the court also rejected the taxpayers’ assertion that the procedure allows duplicative proceedings contrary to the purpose of the tefra partnership provisions. 185 florida tax review [vol. 10:si 17. go figure the deposit and come back. russian recovery fund ltd. v. united states, 105 a.f.t.r.2d 2010-310 (fed. cl. 12/14/09). section 6226(a) requires that in order to petition for a readjustment of a partnership item in the court of federal claims, the petitioning partner must provide a deposit of the amount by which the tax liability of the petitioning partner would be increased if the treatment of partnership items on the partner’s return were consistent with the fpaa. reg. § 301.6226(e)-1(a)(1) requires that if the petitioning partners is itself a partnership, the deposit must include the potential liability of each indirect partner. in an arrangement with losses flowing to partners through multiple partnerships, the court holds that the deposit must be calculated by any downstream partner to include losses flowing through the chain of partnerships, and not just losses passing through a single filing partnership. the filing partner’s $50,000 actual deposit was increased to a required deposit of $8 million under this interpretation. rather than dismiss the case, however, the court allowed the taxpayer to show that she made a good faith effort to calculate the required deposit. g. miscellaneous 1. just because the k-1 says you’re the partner doesn’t necessary mean you’re really the partner. windheim v. commissioner, t.c. memo. 2009-136 (6/10/09). a canadian resident who received legal title to a partnership interest from his father (now deceased) was held not to be the beneficial owner of the partnership interest for federal tax purposes. the taxpayer was involved in disputes with his mother and sister over control of family assets. the partnership issued k-1s in the taxpayer’s name in care of his mother. a canadian trial court had held that disbursements by toronto dominion bank of partnership distributions to the taxpayer’s mother were negligent, but that decision was reversed by a higher court holding that the bank was not liable to the taxpayer. a new york court had awarded the taxpayer’s mother a constructive trust over the partnership proceeds. the tax court (judge goeke) held that the taxpayer had no economic benefit from the partnership interest and was thus not a partner subject to tax on partnership income. viii. tax shelters a. tax shelter cases and rulings — the saga starts a long, long time ago, but new mysteries continue to unravel. 1. notice 2000-44. baby boss is a fraud too! notice 2000-44, 2000-2 cb. 255 (8/13/00). “artificial” capital losses generated by baby boss transactions will not be allowed. (note that notice 99-59, 19992010] recent developments in federal income taxation 186 2 c.b. 761, advised taxpayers that losses from “boss” product transactions are not properly deductible.) • scheme #1: the taxpayer purports to borrow at a premium interest rate. for example, a lender gives the taxpayer $3,000 and the parties treat the stated principal amount of the loan as only $2,000, with the remaining $1,000 that must be repaid representing interest. the taxpayer contributes the loan proceeds into a partnership, which assumes the liability, and uses the proceeds to purchase an investment asset worth $3,000. the taxpayer/partner takes the position under §§ 705(a)(2), 722, and 752(b) that his basis in his partnership interest is $1,000 (the $3,000 cash contribution minus the $2,000 assumed liability), even though the value of the partnership interest is zero. the taxpayer then sells the partnership interest for a nominal amount, claiming a $1,000 capital loss. (everyone apparently ignores the $1,000 discrepancy between the cash proceeds of the loan and the $2,000 “principal amount,” which has to produce income to someone sometime.) this short sale variant is also the so-called blips strategy. • scheme #2: the taxpayer simultaneously purchases a call option and writes an offsetting call option, both of which are then contributed to a partnership. the taxpayer takes the position that the basis of the partnership interest equals the basis of the purchased call option, unreduced by the liability associated with the written call option, i.e., that the partnership did not assume a liability when it took responsibility for the written call option. the taxpayer then uses this artificially high basis to claim a capital loss on the sale of his partnership interest. (compare rev. rul. 95-26, 1995-1 c.b. 131, holding that a partnership’s short sale of securities creates a liability.) this offsetting option variant is also the so-called cobra strategy. • notice 2000-44 disallows the losses (under §§165(a) and (c)) produced by both of these baby boss transactions as artificial, citing, in the case of individuals, fox v. commissioner, 82 t.c. 1001 (1984), holding that §165(c)(2) requires a primary profit motive for a loss from a particular transaction is to be deductible. the notice also cites reg. §1.702-2 (the partnership anti-abuse rules). the irs also announced that it was reexamining the partnership basis rules. • compound indicia of criminal tax fraud? the government believes that the baby boss transactions were not being individually reported on schedule d, but instead have been buried in grantor trusts. for example, an individual taxpayer with an unrealized capital gain contributes both the appreciated assets and the baby boss partnership interest into a grantor trust, which sells both, and the individual reports only the net gain or loss from the grantor trust’s transactions on his return, rather than breaking out gains and losses separately, as is required (by reg. §1.671-2). treasury department officials suggest that criminal penalties might apply to this kind of reporting, which willfully conceals the facts. 187 florida tax review [vol. 10:si • changes coming to tax shelter disclosure rules. the recently proposed corporate tax shelter disclosure rules will be changed by dropping of the requirement that a shelter be marketed to a corporation to trigger the requirement that a promoter maintain a customer list. under the amended regulations, a customer list would have to be maintained for a shelter that is exclusively peddled to individuals, provided threshold amounts of fees and tax savings are met. 2. temp. reg. § 1.752-6t. fighting duplication and acceleration of losses through partnerships before june 24, 2003. t.d. 9062, assumption of partner liabilities, 68 f.r. 37414 (6/24/03). temp. reg. § 1.752-6t provides rules, similar to the rules applicable to corporations in § 358(h), to prevent the duplication and acceleration of loss through the assumption by a partnership of a liability of a partner in a nonrecognition transaction. under the temporary regulations, if a partnership assumes a liability, as defined in § 358(h)(3), of a partner (other than a liability to which § 752(a) and (b) apply) in a § 721 transaction, after application of §§ 752(a) and (b), the partner’s basis in the partnership is reduced (but not below the adjusted value of such interest) by the amount of the liability. for this purpose, the term “liability” includes any fixed or contingent obligation to make payment, without regard to whether the obligation is otherwise taken into account for federal tax purposes. reduction of a partner’s basis generally is not required if: (1) the trade or business with which the liability is associated is transferred to the partnership; or (2) substantially all of the assets with which the liability is associated are contributed to the partnership. however, the exception for contributions of substantially all of the assets does not apply to a transaction described in notice 2000-44, 2000-2 c.b. 255 (or a substantially similar transaction). • the temporary regulations purport to be effective for transactions occurring after 10/18/99 and before 6/24/03. the cases which held them to be retroactively effective include: cemco investors, llc v. united states, 99 a.f.t.r.2d 2007-1882 (n.d. ill. 2007), aff’d, 515 f.3d 749 (7th cir. 2008); and maguire partners – master investments, llc v. united states, 103 a.f.t.r.2d 2009-763, 2009-1 u.s.t.c. ¶50,215 (c.d. calif. 2/4/09). the cases which held them not to be retroactively effective include: klamath strategic investment fund, llc v. united states, 440 f. supp. 2d 608 (e.d. tex. 2006), aff’d in part, vacated in part, and remanded, 568 f.3d 537 (5th cir. 5/21/09); sala v. united states, 552 f. supp. 2d 1167 (d. colo. 2008); stobie creek investments, llc v. united states, 82 fed. cl. 636 (fed. cl. 2008); and murfam farms llc v. united states, 88 fed. cl. 516 (fed. cl. 7/30/09). 2010] recent developments in federal income taxation 188 3. klamath. district court upholds blips tax shelter on taxpayer’s partial summary judgment motion. klamath strategic investment fund, llc v. united states, 440 f. supp. 2d 608 (e.d. tex. 7/20/06). the court (judge ward) held that the premium portion of the loans received from the bank in connection with the funding of the instruments contributed to a partnership was a contingent obligation, and not a fixed and determined liability for purposes of § 752. the transaction was entered into prior to the release of notice 2000-44, 2000-2 c.b. 255, which related to son-of-boss transactions. judge ward held that a regulation to the contrary, reg. § 1.752-6 (see t.d. 9062), was not effective retroactively, and was therefore invalid as applied to these transactions. judge ward held that there was clear authority existing at the time of the transaction that the premium portion of the loan did not reduce taxpayer’s basis in the partnership. (a) klamath on the merits: it does not work because it lacks economic substance, but no penalties. the authorities discussed in the holland & hart and olson lemons opinions provide “substantial authority.” klamath strategic investment fund, llc v. united states, 472 f. supp. 2d 885 (e.d. tex. 1/31/07). the transactions lacked economic substance because the loans would not be used to provide leverage for foreign currency transactions, but no penalties were applicable because taxpayers passed on a 1999 investment and they thought they were investing in foreign currencies and the tax opinions they received that relied on relevant authorities set forth in the court’s earlier opinion provided “substantial authority” for the taxpayers’ treatment of their basis in their partnerships. (b) on government motions, judge ward refuses to vacate partial summary judgment decision on the retroactivity of the regulations under § 752, and he permits the deduction of operational expenses, despite his earlier finding that the transactions lacked economic substance, because the taxpayers had profit motives. klamath strategic investment fund, llc v. united states, 99 a.f.t.r.2d 2007-2001 (e.d. tex. 4/3/07). first, judge ward held that even though the loans lacked economic substance, they still existed, and thus the partial summary judgment on the non-retroactivity of the regulations under § 752 was not premised on invalid factual assumptions. second, he held that the existence of profit motive for deduction of operational expenses was based on the purposes of nix and patterson – and not on the motives of presidio, the managing partner of the partnership. (c) affirmed in part, vacated in part, and remanded, 568 f.3d 537 (5th cir. 5/21/09). in ruling unfavorably on the 189 florida tax review [vol. 10:si taxpayers’ cross-appeal of the holding that the transaction lacked economic substance, the fifth circuit (judge garza) followed the majority rule, which “is that a lack of economic substance is sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax avoidance.” he stated, “[t]hus, if a transaction lacks economic substance compelled by business or regulatory realities, the transaction must be disregarded even if the taxpayers profess a genuine business purpose without tax-avoidance motivations.” • in ruling unfavorably on the government’s appeal of the non-imposition of penalties, judge garza stated: the district court found that patterson and nix sought legal advice from qualified accountants and tax attorneys concerning the legal implications of their investments and the resulting tax deductions. they hired attorneys to write a detailed tax opinion, providing the attorneys with access to all relevant transactional documents. this tax opinion concluded that the tax treatment at issue complied with reasonable interpretations of the tax laws. at trial, the partnerships’ tax expert [stuart smith] concluded that the opinion complied with standards established by treasury circular 230, which addresses conduct of practitioners who provide tax opinions. overall, the district court found that the partnerships proved by a preponderance of the evidence that they relied in good faith on the advice of qualified accountants and tax lawyers. 4. maguire partners. maguire partners – master investments, llc v. united states, 103 a.f.t.r.2d 2009-763 (c.d. calif. 2/4/09). two individuals, through various entities, in late 2001 entered into call options spreads, i.e., they sold short call options to aig via an arthur andersen tax strategy and purchased offsetting long call options and promissory notes from the same company; the options were european options, with an asian-style feature, in that they were to be exercised on a particular date based upon the average value of a reit basket over a 90-day period. the partnerships received the long options and notes and assumed the short options. in finding for the government, the court (judge walter) held that the evidence demonstrated that the transactions did not have economic substance because the individuals received no economic benefit, other than an increase in basis, from the transactions. the court also held that the evidence demonstrated that the individuals were motivated by the increased basis and not by any purported hedging benefit. the court held that, under both the step transaction doctrine and the substance-over-form doctrine, the individuals’ actual cost basis was the original amount of their investment – not the increased basis reported by the partnerships, because they had no 2010] recent developments in federal income taxation 190 downside exposure, and only an extremely remote possibility of receiving a return. judge thomas further held that the obligation created by the short option is a liability for purposes of § 752, or alternatively, it had to be taken into account under reg. § 1.752-6 which applies retroactively. he further found that the individuals had been placed on notice by notice 2000-44, issued in august 2000. • the court also held that the partnerships made a gross valuation misstatement under § 6662, citing in support the fact that one of the individual’s partnerships reported an increase in its capital account equal to 67 times the actual economic outlay that the individual paid for the transaction. (a) the court amended its earlier opinion to hold that the partnerships were not liable for the gross valuation misstatement penalties, but were liable for negligence penalties instead. maguire partners – master investments, llc v. united states, 104 a.f.t.r.2d 2009-7839 (c.d. calif. 12/11/09). the court focused its discussion of penalties on the “negligence or disregard of rules or regulations” under 6662(a) and (b)(1) and did not mention the valuation misstatement issue. 5. samueli. a twenty first securities tax shelter bites the dust. samueli v. commissioner, 132 t.c. no. 4 (3/16/09). the taxpayer entered into a tax shelter transaction planned by twenty first securities (of compaq fame), a simplified (☺) explanation of which is as follows. in october, 2001, the taxpayer purchased fixed-income securities (freddie mac principal strips) from a broker on a margin loan (the broker was entitled to hold the securities as collateral for the margin loan) and then “lent” the securities to the broker. the standard form agreement allowed the taxpayer to terminate the transaction and receive identical securities from the broker by giving notices on any business day, but an addendum overrode that provision and provided that the “loan” of the securities would terminate on january 15, 2003, or at the taxpayer’s election on july 1 or december 2, 2002. the taxpayer purchased the securities for $1.64 billion, but immediately “lent” the securities to the broker and received cash “collateral” of $1.64 billion, which he used to repay the margin loan. the loan contracts provided that the taxpayer was entitled to receive all interest, dividends, and other distributions attributable to the securities, but that the taxpayer was obligated to pay the broker a variable rate fee for use of the $1.64 billion cash collateral. in december, 2002, the taxpayer paid the broker $7.8 million of “interest” on the $1.64 billion cash collateral, which was relent to the taxpayer (secured by the securities, which had increased in value). the transaction terminated on january 15, 2003 and the broker was obligated to pay the taxpayer $1.69 billion to purchase the securities in lieu of 191 florida tax review [vol. 10:si transferring them to the taxpayer. the taxpayer was simultaneously obligated to pay the broker $1.68 billion, which reflected repayment of the $1.64 billion cash collateral, plus accrued but unpaid variable rate fees, but the amounts were offset and the broker paid the taxpayer $13.6 million. the taxpayer reported a $50 million long term capital gain and deducted $33 million of interest (cash collateral fees). judge kroupa held that the purported loan transaction did not satisfy the requirements of § 1058. to qualify as a loan of securities under § 1058, the loan agreement must (1) provide for the return to the lender of identical securities; (2) require payments to the lender equal to all interest, dividends, and other distributions on the securities during the period of the loan, and (3) not reduce the risk of loss or opportunity for gain of the transferor of the securities in the securities transferred. if any of these conditions is not satisfied, the purported loan will be treated as a realization event. because the taxpayer could demand return of the securities only on three specified dates, and not at any time during the term of the loan, he could not sell the securities to realize a gain at any and all times that the possibility for a profitable sale arose. thus, the taxpayer’s opportunity for gain with respect to the transferred securities transferred was reduced. judge kroupa rejected the taxpayer’s argument that because the taxpayer had not surrendered all opportunity to realize a gain with respect to the securities that the third condition prerequisite to qualifying for loan treatment under § 1058 had been satisfied. the statutory test for disqualification does not require complete elimination of the benefits of ownership, but merely a reduction. as a result, the “loan” of the securities in 2001 was treated as a sale on which no gain was realized (because the basis and amount realized were identical), and the “repayment” of the securities to the taxpayer in 2003 was treated as a repurchase followed by a resale to the broker on which a $13.5 million short term capital gain was realized. furthermore, the taxpayer was not entitled to deduct the cash collateral fees paid as interest in connection with the purported securities lending arrangement because no debt existed. the cash transferred in 2001 represented the proceeds of the first sale and not collateral for a securities loan. thus, no “cash collateral” was outstanding during the relevant years on which the claimed collateral fees could accrue. (a) if at first you don’t succeed, try again on procedural grounds; however, an amended return is not an administrative adjustment request. samueli v. commissioner, 132 t.c. no. 16 (5/18/09). the taxpayers were ten percent partners in a tax shelter partnership. partnership level deductions claimed by the taxpayers were disallowed in samueli v. commissioner, 132 t.c. no. 4 (3/16/09), a partnership level determination. the taxpayers asserted that deficiencies assessed against them were not partnership items because of amended returns filed by the taxpayers for the year at issue. section 6227 allows a partner to 2010] recent developments in federal income taxation 192 file an administrative adjustment request (aar) on behalf of the partner, which allows a separate determination of an item as a non-partner item. the court (judge kroupa) held that the taxpayer’s amended return was not an administrative adjustment request. the request must follow the form required in reg. § 301.6627(d)-1, which requires that a taxpayer file a partner aar on a form prescribed – form 8082, notice of inconsistent treatment or administrative adjustment request (aar) – and in accordance with the form’s instructions, which require the taxpayer to explain in detail on the form the reasons for the aar reported on the form. the taxpayer is required to file the original form with the taxpayer’s amended income tax return and a copy of the form with the service center where the partnership files its tax return. the court rejected the taxpayer’s argument that because the amended return contained all of the information required on form 8082 for an aar, it constituted an aar. the taxpayer’s claim was dismissed for lack of jurisdiction. 6. new phoenix. not so heavenly bliss. a son-ofboss transaction by any other name still stinks. new phoenix sunrise corporation v. commissioner, 132 t.c. no. 9 (4/9/09). in this paul daugerdas, jenkens & gilchrist structured deal named bliss (basis leveraged investment swap spread), new phoenix sunrise corporation (phoenix) purchased two pairs of digital option contracts in a transaction designed to eliminate $10 million of capital gain realized on an asset sale by a corporate subsidiary included on the taxpayer’s consolidated return. the long portion of the options was purchased from deutsche bank ag for an initial payment of $10.631 million plus two additional payments of $63 million each. the short option was sold to deutsche bank for an initial payment of $10.369 million and two additional payments of $63.066 million. only the $138,750 difference between the purchase and sales prices changed hands. the digital options called for offsetting payments based on the usd/jpl price with a variance in the options of only 0.00002 (2 pips). phoenix contributed the purchased and sold options to a general partnership for a 99% interest. the 1% partner was a dominant shareholder in phoenix. phoenix claimed a basis in its partnership interest in the amount of the cost of the purchased long option. phoenix also claimed that its liability on the short position of the sold option was a contingent liability that did not reduce its basis in the partnership. thereafter, the partnership acquired shares of cisco stock for $149,958. after the options expired, the partnership distributed the cisco stock to phoenix. phoenix claimed a § 732 basis in the cisco stock equal to its partnership interest basis and a $10 million loss on its subsequent sale of the cisco stock. in an exceedingly well-written opinion, the court (judge goeke), rejected the claimed loss on several grounds: 193 florida tax review [vol. 10:si • the taxpayer did not suffer a real economic loss. “the loss claimed as a result of the stepped-up basis in the cisco stock was purely fictional.” • the bliss transaction had no realistic possibility of earning a profit. deutche bank’s control as the calculation agent for the option contracts empowered it to assure that the market rate chosen for the closing of the options would never trigger the so-called “sweet spot” under which the investor would earn substantial profits. • the transaction lacked economic substance. the court stated: absent the benefit of the claimed tax loss, there was nothing but a cash flow that was negative for all relevant periods— the “hallmark of an economic sham” as the court of appeals for the sixth circuit has held. dow chem. co. v. united states, 435 f.3d at 602 (quoting am. elec. power co. v. united states, 326 f.3d 737, 742 (6th cir. 2003). such a deal lacks economic substance. id. because we find that the transaction at issue lacked economic substance, we do not consider mr. wray’s and capital’s profit motive in entering into the transaction. id. at 605 ... . pursuant to the aforementioned cases, the bliss transaction must be ignored for federal income tax purposes. accordingly, the overstated loss claimed as a result of the sale of the cisco stock is disregarded, as is the flowthrough loss from olentangy partners. • the court disallowed a $500,000 deduction for fees paid to jenkens & gilchrist for the tax opinion and structuring the transaction. the fees were not incurred in the production of any income against which a deduction is allowable. • the court also sustained a 40 percent gross valuation penalty under § 6662(e) and (h), holding that the undervaluation penalty is applicable to overstated basis. the court also indicated that the § 6662(d) substantial understatement of tax and the § 6662(c) negligence penalties were applicable. the court rejected the taxpayer’s argument that it reasonably relied on the jenkens & gilchrist tax shelter opinion. because the penalties are not additive, only the gross valuation penalty was imposed. 7. murfam farms. retroactive application of the partnership contingent liability regulation rejected again. murfam farms l.l.c. v. united states, 88 fed. cl. 516 (fed. cl. 7/30/09). the court (judge damich) granted the taxpayers’ motion for partial summary judgment in a cobra tax shelter case (cobra is a son-of-boss digital options shelter under another name) declaring that temp. reg. § 1.752-6t may not be 2010] recent developments in federal income taxation 194 applied retroactively. the court held that retroactive application of the temporary regulation was barred by the prohibition of § 7805(b)(1) on retroactive application of regulations because it was not issued pursuant to a congressional grant of authority. the court further opined that the retroactive application of the regulation was not authorized by § 309(c) of the 2000 act because the abuse it sought to prevent was not the same type of abuse that § 358(h) was designed to prevent, i.e., it “was not to combat the inflation of basis – artificial or otherwise – rather, to preclude the acceleration and/or duplication of losses.” 8. castle harbour. the second circuit reverses a taxpayer victory in a self-liquidating partnership note transaction, in which the lion’s share of income was allocated to a tax-indifferent party, on the ground that the tax-indifferent dutch banks were not really equity partners. tifd iii-e, inc. v. united states, 342 f. supp. 2d 94 (d. conn. 11/1/04), rev’d, 459 f.3d 220 (2d cir. 8/3/06), on remand, 104 a.f.t.r.2d 2009-6746 (d. conn. 10/7/09), as amended, 2009 u.s. dist. lexis 98884 (d. conn. 10/23/09) (“castle harbour”). (a) castle harbour i: district court holds for the taxpayer. the court found that the creation of castle harbour, a nevada llc, by general electric capital corp. subsidiaries was not designed solely to avoid taxes, but to spread the risk of their investment in fully-depreciated commercial airplanes used in their leasing operations. gecc subsidiaries put the following assets into castle harbour: $530 million worth of fullydepreciated aircraft, subject to a $258 million non-recourse debt; $22 million of rents receivable; $296 million of cash; and all the stock of another gecc subsidiary that had a value of $0. two tax-indifferent dutch banks invested $117.5 million in castle harbour. under the llc agreement, the taxindifferent partner was allocated 98 percent of the book income and 98 percent of the tax income. • the book income was net of depreciation and the tax income did not take depreciation into account (because the airplanes were fully depreciated for tax purposes). depreciation deductions for book purposes were on the order of 60 percent of the rental income for any given year. • scheduled distributions in excess of book income would have resulted in the liquidation of the investment of the dutch banks in eight years, with the dutch banks receiving a return of approximately nine percent, with some “economically substantial” upside and some downside risk. castle harbour was terminated after five years because of a threatened change in u.s. tax law, but during that period about $310 million of income was shifted to the dutch banks for a tax saving to the gecc subsidiaries of about $62 million. 195 florida tax review [vol. 10:si • the court (judge underhill) held that satisfaction of the mechanical rules of the regulations under § 704(b) transcended both an intent to avoid tax and the avoidance of significant tax through agreed upon partnership allocations. in this partnership, 2 percent of both operating and taxable income was allocated to gecc, a united states partner, and 98 percent of both book and taxable income was allocated to partners who were dutch banks. the dutch banks were foreign partners who were not liable for united states taxes and thus were indifferent to the u.s. tax consequences of their participation in the partnership. because the partnership had very large book depreciation deductions and no tax depreciation, most of the partnership’s taxable operating income, which was substantially in excess of book taxable income, was allocated to the tax-indifferent foreign partners, even though a large portion of the cash receipts reflected in that income was devoted to repaying the principal of loans secured by property that gecc had contributed to the partnership. the overall partnership transaction saved gecc approximately $62 million in income taxes, and the court found that “it appears likely that one of gecc’s principal motivations in entering into this transaction – though certainly not its only motivation – was to avoid that substantial tax burden.” the court understood the effects of the allocations and concluded that “by allocating 98% of the income from fully tax-depreciated aircraft to the dutch banks,” gecc avoided an enormous tax burden, while shifting very little book income. put another way, by allocating income less depreciation to tax-neutral parties, gecc was able to “re-depreciate” the assets for tax purposes. the tax-neutrals absorbed the tax consequences of all the income allocated to them, but actually received only the income in excess of book depreciation.” nevertheless, the court upheld the allocations. “the tax benefits of the … transaction were the result of the allocation of large amounts of book income to a tax-neutral entity, offset by a large depreciation expense, with a corresponding allocation of a large amount of taxable income, but no corresponding allocation of depreciation deductions. this resulted in an enormous tax savings, but the simple allocation of a large percentage of income violates no rule. the government does not – and cannot – dispute that partners may allocate their partnership’s income as they choose. neither does the government dispute that the taxable income allocated to the dutch banks could not be offset by the allocation of non-existent depreciation deductions to the banks. and … the bare allocation of a large interest in income does not violate the overall tax effect rule.” • judge underhill concluded: the government is understandably concerned that the castle harbour transaction deprived the public fisc of some $ 62 million in tax revenue. moreover, it appears likely that one of gecc’s principal motivations in entering into this transaction though certainly not its only motivation was 2010] recent developments in federal income taxation 196 to avoid that substantial tax burden. nevertheless, the castle harbour transaction was an economically real transaction, undertaken, at least in part, for a non-tax business purpose; the transaction resulted in the creation of a true partnership with all participants holding valid partnership interests; and the income was allocated among the partners in accordance with the internal revenue code and treasury regulations. in short, the transaction, though it sheltered a great deal of income from taxes, was legally permissible. under such circumstances, the i.r.s. should address its concerns to those who write the tax laws. • query whether § 704(b) was properly applied to this transaction? • this appears to be a lease-stripping transaction in which the income from the lease was assigned to foreign entities while the benefits of ownership were left with a domestic entity. (b) castle harbour ii: second circuit reverses. 459 f.3d 220 (2d cir. 8/3/06). the second circuit, in an opinion by judge leval, held that the dutch banks were not partners because their risks and rewards were closer to those of creditors than partners. he used the facts-and-circumstances test of commissioner v. culbertson, 337 u.s. 733 (1949), to determine whether the banks’ interest was more in the nature of debt or equity, and found that their interest was overwhelmingly in the nature of a secured lender’s interest, “which would neither be harmed by poor performance of the partnership nor significantly enhanced by extraordinary profits.” • in acm (colgate), judge laro wrote a 100+ page analysis to find that there was no economic substance to the arrangement. the next contingent payment installment sale case in the tax court was asa investerings (allied signal), in which judge foley wrote a much shorter opinion finding that the dutch bank was not a partner; the d.c. circuit affirmed on judge foley’s holding that the dutch bank was not a partner. the irs began to pick up this lack-of-partnership argument and began to use it on examinations. later, the tax court (judge nims) used the economic substance argument in saba (brunswick), which the dc circuit remanded based on asa investerings to give taxpayer the opportunity to argue that there was a valid partnership, which it could not do, as judge nims found on remand. even later, the d.c. circuit reversed the district court’s boca (wyeth, or american home products) case based upon this lack-of-partnership argument – even though cravath planned boca carefully so that if the dutch bank was knocked out, there would still be a partnership – based upon its asa 197 florida tax review [vol. 10:si investerings and saba findings on appeal that there was no partnership. now the second circuit has adopted the lack-of-partnership argument. (c) castle harbour iii: on remand in castle harbour, the district court found a valid partnership to have existed under § 704(e) because the heading does not alter the clear language of a statute. a valid family partnership is found in the absence of a family. additionally, in his contingent penalty findings, judge underhill stated that his 2004 taxpayer-favorable decision ipso facto means that the taxpayer’s reporting position was based upon substantial authority. 104 a.f.t.r.2d 2009-6746 (d. conn. 10/7/09), as amended, 2009 u.s. dist. lexis 98884 (d. conn. 10/23/09). in a carefully-written5 opinion, judge underhill held that, while the second circuit opinion decided that the partnership did not meet the culbertson totality-of-the-circumstances test (“whether ... the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise”), it did not address the § 704(e)(1) issue. he held that the dutch banks satisfied the requirements of that paragraph, which reads: (e) family partnerships. (1) recognition of interest created by purchase or gift. – a person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person. • in so holding, he relied upon wellsettled law that the title of a statute cannot limit the plain meaning of the text, and that the title is of use only when it sheds light on some ambiguous word or phrase. see also, i.r.c. § 7806(b). • some of the authors observe that it is worth noting that although evans v. commissioner, 447 f.2d 547 (7th cir. 1971), aff’g 54 t.c. 40 (1970), which judge underhill relied upon extensively to reach his conclusion, held that the application of § 704(e)(1) was not limited to the context of family partnerships, evans involved the question who, between two different persons—the original partner or an assignee of the original partner’s economic interest—was the partner who should be taxed on a distributive share of the partnership’s income. although in the family context § 704(e) frequently has been applied to determine whether a partnership exists in the first place, judge underhill’s decision in castle harbour iii is the very 5. one of us thinks the opinion is “carefully-written.” dan and marty, the only two of us who teach and regularly write about partnership taxation, do not so think. ira, who has never taught a course in partnership taxation, appreciates the innovative logic underlying the opinion. 2010] recent developments in federal income taxation 198 first case ever to discover that § 704(e)(1) applies to determine whether an arrangement between two (or more) otherwise unrelated business entities or unrelated individuals constituted a partnership. • it has sometimes been adduced that the fact that a court of applicable jurisdiction subsequently upholds the tax treatment of a transaction should be a strong argument for the proposition that such tax treatment was based upon substantial authority. with respect to the applicability of penalties should he be reversed on appeal, judge underhill stated: to a large extent, my holding in castle harbour i in favor of the taxpayer demonstrates the substantial authority for the partnership’s tax treatment of the dutch banks, as does my discussion above of the dutch banks’ interest in castle harbour under section 704(e)(1). in addition, the government’s arguments against the substantial authority defense are unavailing. (emphasis supplied) • judge underhill also sought to place the application of the penalty provisions in a temporal context when he stated: the government argues that culbertson and second circuit cases like slifka and dyer that interpreted culbertson cannot provide substantial authority for the partnership’s tax position because the second circuit held in castle harbour ii that the dutch banks were not partners under culbertson. the government, however, has not pointed to any second circuit case or other authority, prior to 1997 and 1998 when the castle harbour partners took the tax positions at issue, where the parties’ good faith intention or valid business purpose in forming a partnership was not sufficient to support a conclusion of partnership status for tax purposes. • in the context of the previous two bullet points, it is worth noting that judge underhill’s observations in the immediately preceding bullet point appears to be consistent with reg. § 1.66624(d)(3)(iv)(c), which provides that whether a position was supported by substantial authority must be determined with reference to authorities in existence at the time. but, judge underhill’s observations in the second preceding bullet point appear to be inconsistent with both reg. § 1.66624(d)(3)(iii), and observations in the immediately preceding bullet. however, we are not all in agreement with what judge underhill intended the observations in the second preceding bullet point to mean. • stay tuned for further proceedings on appeal to the second circuit, where the same panel that heard castle harbour ii will hear castle harbour iv. 199 florida tax review [vol. 10:si 9. consolidated edison. taxpayer victory in the court of federal claims in a lease-in, lease-out (lilo) transaction with a dutch utility. on appeal, the taxpayer is likely to hit a dutch wall, i.e., a [timothy] dyk. consolidated edison co. of new york v. united states, 90 fed. cl. 228 (10/21/09). the court of federal claims (judge horn), in a long and careful opinion held that, under the particular facts of this case, the lilo transaction taxpayer entered into with a dutch utility had economic substance, i.e., that no decision as to whether particular options would be exercised was “pre-ordained” and that taxpayer “bore the burdens and benefits of ownership.” in finding that taxpayer had shown that the transaction was a true lease and should be respected, she distinguished factually other lilo cases decided for the government, such as bb & t corporation v. united states, 523 f.3d 461 (4th cir. 2008), and awg leasing trust v. united states, 592 f. supp. 2d 953 (n.d. ohio 2008). • a large portion of the opinion consists of judge horn’s analysis of the expert evidence, with pointed criticism of one expert who “failed to conduct in-depth studies of the … [t]ransaction and gave almost automatic and generalized conclusions on the flaws of lilo and silo transactions for tax purposes.” • alleged “spoliation of evidence” in 2000 by reason of a switch in e-mail systems without preserving all of the thenexisting e-mails, and the desire to protect 1997 memoranda as work product, come into conflict with bad result for the credibility of an in-house lawyer. (“he was considered by the court an unreliable witness, perhaps willing to write or say whatever he thought would assist his then current assignment.”) the court found that litigation was not reasonably anticipated until 2002 at the earliest because negotiations in connection with the irs audit were ongoing until at least that year. the 1997 memoranda were ordered disclosed. 10. another son-of-boss-type shelter bites the dust in the tax court and not even the thighmaster can trim the tax bill. palm canyon x investments, llc, et al. v. commissioner, t.c. memo 2009-288 (12/15/09). in a lengthy opinion the court (judge marvel) held that a son-ofboss investment in offsetting digital option contracts was to be disregarded under the economic substance doctrine. taxpayers alan and suzanne hamel ran a retail business that included the extremely successful “thighmaster,” which featured suzanne hamel, a/k/a the actress suzanne somers, in its advertising. they incorporated alan hamel investments (ahi), which in turn was the sole member of palm canyon, an llc. palm canyon entered into a long digital option contact for a premium of $5 million an offsetting short option for which the counterparty paid a premium of $4.945 million, resulting in a net premium outlay of $55,000. an investment company formed by one of the promoters acquired a membership interest in the llc, thereby allowing the llc to be treated as a partnership. ahi claimed a basis 2010] recent developments in federal income taxation 200 in the llc in the amount of the premium paid for the long position without reduction for the contingent liability represented by the short position assumed by the partnership. on the subsequent liquidation of the partnership, ahi claimed a high basis in a canadian dollars position that was sold for a loss. the contracts were entered into through john ivsan, a tax attorney with cantley & sedacca, llp, who directed them to the dallas branch of deutsche bank to implement the strategy, which created a $5 million ordinary loss. the court avoided the technical issues, and assumed that the transaction satisfied the literal language of § 752 and that under helmer v. commissioner, t.c. memo 1975-160, ahi’s partnership basis was not reduced by the contingent short option liability. the court also avoided the issue of retroactive application of temp. reg. § 1.752-6, which would have required ahi to reduce its basis by the llc’s potential payment on the short option. nonetheless, the court concluded that the transaction failed to satisfy the subjective prong of the economic substance test because the hamels entered into the transaction for the sole purpose of avoiding federal income tax, and failed the objective prong because the taxpayers’ failed to demonstrate that the transactions had any reasonable prospect of earning a profit. the court noted that because of the marketing agent’s ability to determine the spot market exchange rate on the option date, the marketing agent could assure that the option contracts would not hit the “sweet spot” that would make the transaction profitable. the court imposed accuracy related penalties concluding that the transaction qualified as a tax shelter and that the hamels could not reasonably rely on the tax opinion of pryor, cashman, sherman & flynn, llp, which was part of the promoter team and therefore had a conflict of interest in issuing the opinion. 11. government misconduct amounting to fraud does not require a showing of prejudice to justify relief. tax shelter investors entitled to the same deal received by the taxpayers who cooperated with the government. dixon v. commissioner, 316 f.3d 1041 (9th cir. 1/17/03), remanding t.c. memo. 2000-116 and t.c. memo. 1999101. the ninth circuit reversed the tax court finding that misconduct by irs attorneys during the trial of test cases (secretly allowing the deduction of attorney’s fees in exchange for taxpayer cooperation) constituted harmless error. the tax shelter was one designed and administered by honolulu businessman henry kersting, in which participants purchased stock with loans from entities financed by two layers of promissory notes, resulting in their being able to claim interest deductions on their individual returns. judge hawkins held that the taxpayers demonstrated fraud and that a demonstration of prejudice was unnecessary. the tax court was directed to enter judgment in favor of taxpayers on terms equivalent to the secret settlement agreements entered into with the test case taxpayers who cooperated with the government. 201 florida tax review [vol. 10:si (a) chief counsel notice cc-2003-008 (2/3/03). this notice reminds chief counsel attorneys of their obligation to adhere to the highest ethical standards in all aspects of their responsibilities, including representation of the commissioner before the tax court. aba model rules 3.3 (candor to tribunals), 3.4 (fairness to opposing party and counsel), 4.1 (truthfulness in statements to third persons), and 8.4 (misconduct) were discussed in the notice. (b) on remand to the tax court, it really hits the fan for the commissioner – and deservedly so. the misconduct of the government lawyers involved and the commissioner’s failure to fully disclose the misconduct to all taxpayers who had been bound by the outcome of the kersting project test cases infested the stipulated decisions in all of the hundreds of cases settled in accordance with the outcome of the test cases. hartman v. commissioner, t.c. memo. 2008-124 (5/1/08). in a 137-page opinion, the tax court (judge beghe) held that all of the hundreds of kersting tax shelter cases in which stipulated decisions had been entered and which had became final many years ago had to be reopened and the taxpayers’ accounts had to be adjusted administratively in accordance with the settlements received by the taxpayers in the test cases. (c) the tax court awards attorney’s fees to porter & hedges under § 6673, the tests for which are different from those for attorney’s fees under § 7430. dixon v. commissioner, 132 t.c. no. 5 (3/23/09). in awarding fees of $1.1 million to porter & hedges for the services and expenses of its lawyers, henry binder and john irvine, who represented the taxpayers during the remand proceedings following the 2003 ninth circuit decision without charge other than the costs, expenses, and fees that the court might require the irs to pay pursuant to § 6673(a)(2), the tax court (judge beghe) in a masterful opinion held that – unlike § 7430 fees which are limited to reimbursement of the fees paid by taxpayers plus fees which the taxpayers have incurred, i.e., for which they were personally liable – under § 6673 a party who has “multiplied the proceedings ... unreasonably and vexatiously” has injured not only the opposing party but also the court and counsel and is liable for fees without such limitation “other than the requirement that the fees to be paid have been ‘reasonably incurred’ because of such conduct.” judge beghe found applicable to the § 6673 sanctioning statute the broader definition of “incurred” in black’s law dictionary, which means “liabilities cast upon one by act or operation of law, as distinguished from contract.” he concluded that interest on the fee amount was applicable because “in augmenting the award of fees and expenses with interest equivalents, we do no more than mimic decastro’s fee arrangement with the thompsons.” 2010] recent developments in federal income taxation 202 • henry binder died of cancer on december 15, 2006. one of the authors recalls that henry binder was consumed by this case, even during the worst moments of his final illness. 12. transactions underlying a tax shelter are just done for grins in the real world; you can take that to the bank, man! hoosier homer judge grants injunctive relief to tax-indifferent party to a tax shelter contract without requiring the plaintiff to disgorge the $20 million it pocketed for entering into the tax shelter in the first place. hoosier energy rural electric cooperative, inc. v. john hancock life insurance co., 588 f. supp. 2d 919 (s.d. ind. 11/25/08). hoosier energy rural electric cooperative (“hoosier energy”) was the tax indifferent party in a sale-in/lease-out transaction of one of its generating plants for which it received $20 million for its participation. professor joseph bankman of stanford law school furnished an expert opinion in affidavit form that this type of sale-in/lease-out transaction was an abusive tax shelter, leading the court to find that the “deal was an attempt to create an appearance of a sale but without any real economic substance.” pursuant to the documentation of the arrangement, hoosier energy was required to maintain specified adequate security for its obligation to make future lease payments, i.e., provide a credit default swap from a party with at least an aa rating – failing which, it was required to make the agreed-upon termination payment of $120 million to a third-party which was obligated to pay the amount to john hancock life insurance co. (“john hancock”). hoosier energy maintained this security in the form of a guarantee from aig and it did timely make each of its lease payments. upon the falling of aig’s credit rating below the contractually-required standard, hoosier energy sought unsuccessfully to secure an equivalent guarantee. on hoosier energy’s request, chief judge hamilton granted an injunction against enforcement of hoosier energy’s obligation to make the $120 million termination payment to the third party on the ground that the arrangement was entered into solely for tax benefits and was somehow unenforceable against hoover. • chief judge hamilton did state that hoosier energy might at some time in the future be required to give back the $20 million, but that there was no hurry about that. • professor bankman’s affidavit stated that the transaction was similar to that in awg leasing trust v. united states, 592 f. supp. 2d 953 (n.d. ohio 5/28/08). (a) in a later proceeding, judge hamilton pretends to require hoosier energy to give john hancock adequate security to cover the possibility that his 11/25/08 injunction was incorrectly issued. hoosier energy rural electric cooperative, inc. v. john hancock life insurance co., 2008 wl 5216027 (s.d. ind. 12/11/08). judge 203 florida tax review [vol. 10:si hamilton, in addition to a $2 million cash bond, required hoosier energy “to post its own [i.e., meaningless] undertaking to pay john hancock up to an additional $130 million in damages it might suffer from an improper injunction.” (b) affirmed on “temporary commercial impracticability” grounds, but not because the transaction was an abusive tax shelter. 582 f.3d 721 (7th cir. 9/17/09). judge easterbrook held that john hancock’s taxes are a matter for it to resolve with the irs, and that “does not affect hoosier energy’s contractual duties.” he further stated that “temporary commercial impracticability” becomes a pumpkin at year end. on remand, the district court increased the bond substantially. 2009 u.s. dist. lexis 93186 (s.d. ind. 10/5/09). 13. the supreme court enhances the sanctity of arbitration agreements. arthur andersen llp v. carlisle, 129 s. ct. 1896 (5/4/09), rev’g carlisle v. curtis, mallet-prevost, colt & mosle, llp, 521 f.3d 597 (6th cir. 4/9/08). the respondents in this case invested in a son-ofboss type transaction called a “leveraged option strategy.” the investors entered into an investment-management agreement with bricolage capital, llc, which contained a mandatory arbitration provision. only bricolage capital was a signatory to the agreement with the arbitration provision. the investors filed an action for fraud and malpractice against arthur andersen and curtis, mallet-prevost, colt & mosle, llp (who provided the tax opinion). the parties moved for a stay of the district court action under the provisions of the arbitration agreement. the federal arbitration act, 9 u.s.c. § 3, provides for a stay of any action in federal court that is “referable to arbitration under an agreement in writing.” 9 u.s.c. § 16(a)(1)(a) allows an immediate appeal from an order denying a stay. the district court denied the stay. on appeal, the sixth circuit held that it had no jurisdiction to hear the appeal. the supreme court (justice scalia) reversed and remanded the case for further proceedings. • the court concluded that the court of appeals conflated questions of the applicability of 9 u.s.c. §§ 3 and 16(a) with the substantive merits of the question whether non-signatories to a written arbitration agreement possessed contract rights to arbitration under the agreement. “the jurisdictional statute here unambiguously makes the underlying merits irrelevant, for even utter frivolousness of the underlying request requires for a § 3 stay cannot turn a denial into something other than ‘an order ... refusing a stay of any action under section 3.’” • the court further concluded that, in order not to award the “petitioners a remarkably hollow victory,” state law is applicable to determine whether non-signatories to the arbitration agreement 2010] recent developments in federal income taxation 204 may enforce the agreement and thereby obtain a stay of proceedings pursuant to the written arbitration agreement. • the dissenting justices (justice souter joined by chief justice roberts and justice stevens) argued that 9 u.s.c. § 3 offers a stay only to signatories of an arbitration agreement because “it would therefore seem strange to assume that congress meant to grant the right to appeal a § 3 stay denial to anyone as peripheral to the core agreement as a nonsignatory ... .” • this opinion highlights the likelihood that the resolution of questions regarding professional responsibility in tort law of law firms, accounting firms and the banks involved in the promotion of the recent crop of abusive tax shelters will be shielded from public disclosure by confidential arbitration proceedings and only known to the parties involved. b. identified “tax avoidance transactions.” 1. a safe cove (not big enough to be a harbor) for some taxpayers in the tax shelter war. notice 2008-111, 2008-51 i.r.b. 1299 (12/1/08). this notice clarified notice 2001-16, 2001-1 c.b. 730, and superseded notice 2008-20, 2008-6 i.r.b. 406, regarding intermediary transaction tax shelters. a transaction is treated as an intermediary transaction with respect to a particular person only if that person engages in the transaction pursuant to a plan, the transaction contains the four objective components indicative of an intermediary transaction, and no safe harbor exception applies to that person. c. disclosure and settlement there were no significant developments regarding this topic during 2009. d. tax shelter penalties, etc. 1. the e&y deal. ir-2003-84, 2003 tnt 128-1 (7/2/03). the irs announced that it settled ernst & young’s potential liability under the tax shelter registration and list maintenance penalty provisions for a nondeductible payment of $15 million. (a) these “value ideas” did produce extraordinary results for e&y tax partners, but not the results they expected. united states v. coplan, 2007 tnt 105-1. two current and two former partners of ernst & young, robert coplan, martin nissenbaum, richard shapiro, and brian vaughn – all members of its viper (value ideas produce extraordinary results) group – were indicted on 5/30/07 in the 205 florida tax review [vol. 10:si southern district of new york for crimes relating to tax shelters promoted by e&y. the shelters included cds (“contingent deferred swap”); cobra (“currency options bring reward alternatives”); cds add-on; and pico (“personal investment corporation”). (b) more defendants. 2008 tnt 35-23 (2/21/08). the indictment was expanded to add david l. smith, private capital management, and charles bolton to the list of alleged coconspirators. smith is alleged to have introduced the cds strategy to e&y and is further alleged to have licensed the cds transactions to bolton and a group of bolton companies who implemented the transactions. (c) the four indicted members of e&y’s viper group were convicted by a jury following a ten-week trial in the southern district of new york on 5/7/09. the convictions were for conspiracy relating to four tax shelters, tax evasion relating to clients who used a tax shelter transaction known as “cds add-on,” obstructing the irs, and making false statements to the irs. department of justice press release (5/7/09). 2009 tnt 88-122. they were sentenced to prison terms, but released on bail pending appeal. • the doj release further noted that bolton pleaded guilty on 1/22/09 and smith has not been apprehended. it further noted that peter cinquegrani, a former arnold & porter partner who provided opinion letters on e&y tax shelters pleaded guilty to conspiracy to commit tax fraud on 9/11/08, and bell six, a former e&y employee who later went to work for entities that implemented shelters for e&y pleaded guilty to conspiracy to commit tax fraud on 6/14/07. 2. jerry cohen outsmarts the government and mitigates taxpayer penalties. alpha i lp v. united states, 84 fed. cl. 622 (11/25/08), motion for reconsideration denied, 86 fed. cl. 126 (3/16/09). the irs issued fpaas that adjusted the partners’ capital gains and losses based on five theories: (1) § 752; (2) reg. § 1.752-6 (the “retroactive regulation”); (3) the transaction or entities were a sham or lacked economic substance; (4) reg. § 1.701-2 (the partnership anti-abuse regulation); and (5) “none of the transactions of the partnership increases the amount considered at-risk for an activity under § 465(b)(1).” the partners “conceded the adjustments on the ground that none of the transactions of the partnerships increased the amount considered at-risk for any activity under § 465(b)(1) and that the at-risk rules would disallow losses and require the partnerships and their partners to recognize gain on the transactions as set forth in the fpaas.” in addition, the irs asserted that the § 6662 substantial valuation misstatement penalty should apply, but the taxpayers did not concede that issue. rather, the taxpayers argued that valuation misstatement penalties 2010] recent developments in federal income taxation 206 were inapplicable as a matter of law because “any underpayment of tax was not ‘attributable to’ a valuation misstatement, but instead would be attributable to plaintiffs’ concession that [the irs’s] adjustments were correct under [§ 465(b)(1)].” the court (judge hewitt) agreed with the taxpayers and held that where adjustments are made on grounds unrelated to valuation, valuation penalties do not apply. the court also rejected the irs’s argument the court lacked jurisdiction to accept the taxpayer’s concession because “there are not any partnership level determinations to be made with respect to § 465.” the court found that the “concession obviate[d] the need to conduct a trial on valuation issues and therefore achieve[d] the very efficiencies and economies that the elimination of penalties sought to encourage. ... to go behind the concession and attempt to assign to it a specific ground would be to engage in an activity that the elimination of penalties is intended to prevent.” the court also refused to accept the government’s argument that it should consider on the merits the government’s alternative grounds for the adjustments that were based on valuation, i.e., basis, misstatements, solely for the purposes of determining the applicability of penalties. the court agreed with the taxpayers’ argument “that forcing a ‘trial on alternative grounds for adjustments plaintiffs have already conceded violates the purpose and policy behind the valuation misstatement penalties and is simply a waste of the court’s and the parties’ resources.’” (a) taxpayers are not precluded from asserting defenses, but they are bound by their stipulations. alpha i lp v. united states, 89 fed. cl. 347 (fed. cl. 8/26/09). taxpayers are limited to asserting defenses based on the ground under which they made their concessions to avoid valuation penalties. a trial on penalties will not encompass valuation misstatement penalties because the court has already held that valuation misstatement penalties are inapplicable. plaintiffs are not judicially estopped from asserting defenses based on § 465. 3. another irs weapon in the tax shelter war. reg160872-04, section 6707 and the failure to furnish information regarding reportable transactions, 73 f.r. 78254 (12/22/08). prop. reg. § 301.6707-1 would reflect the amendments to § 6707 in the american jobs creation act of 2004. a § 6707 penalty may be assessed against each material advisor required to file a return under § 6111 who fails to file a timely return as required under reg. § 301.6111-3(e) or files a return with false or incomplete information. if more than one material advisor is responsible for filing a return under § 6111 with respect to the same reportable transaction, a separate penalty under § 6707 may be assessed against each material advisor who fails to timely file a return or files a return with false or incomplete information. incomplete information means a form 8918, “material advisor 207 florida tax review [vol. 10:si disclosure statement” (or successor form), filed with the irs that does not provide the information required under reg. § 301.6111-3(d). failure to timely file or the submission of false or incomplete information is intentional if (1) the material advisor knew of the obligation to file a return, and knowingly did not timely file a return, or (2) filed a return knowing that it was false or incomplete. the proposed regulations provide factors that the irs should take into account during the determination whether to rescind all or a portion of a § 6707 penalty. the list of factors generally follows rev. proc. 2007-21, 2007-1 c.b. 613. the regulations will apply to returns the due date of which is after the final regulations are published in the federal register. 4. the tax court does have jurisdiction to determine whether partnership transactions were tax-motivated for penalty purposes. keller v. commissioner, 568 f.3d 710 (9th cir. 6/3/09), rev’g t.c. memo 2006-166. the case concerned the outstanding tax liabilities of 16 partners who invested in cattle partnerships that were sold to investors as “the 1,000 lb tax shelter.” these partnerships were part of a large series of cattleand sheep-breeding partnerships organized, promoted and operated by walter j. hoyt iii from the 1970s through the 1990s, and which have been the subject of extensive litigation over the years. the irs had offered a variety of settlement offers to the partners in the partnerships at issue. when the irs sent notices of intent to levy, the partners requested collection due process hearings and submitted offers in compromise to settle their outstanding tax liabilities. the irs rejected the partners’ offers in compromise and, in collection due process hearings, imposed interest under former § 6621(c) (which imposed a higher interest rate for substantial underpayments that resulted from tax-motivated transactions). in the ensuing litigation, the tax court held that the irs did not abuse its discretion in rejecting the offers in compromise. the court also held that it did not itself have jurisdiction to determine whether the partnerships’ transactions were tax-motivated for purposes of former § 6621(c). • the tax court (judge goeke) based its jurisdiction decision on the fact that the question of whether the transactions were tax-motivated is a partnership item that must be determined in partnership-level proceedings. here, the individual partners were the parties to the various cases being litigated, not the partnerships, so the court held that in these proceedings it did not have jurisdiction to decide the partnership-level issue. the effect of this decision was to leave the service’s imposition of higher interest rates under former § 6621(c) in place. • the ninth circuit (judge rymer) agreed with the tax court that the determination of whether transactions are tax-motivated is a partnership item to be determined at partnership-level proceedings. this rule was formulated by the ninth circuit in river city 2010] recent developments in federal income taxation 208 ranches #1 ltd., 401 f.3d 1136 (9th cir. 2005). however, the partnership proceedings in this case were completed and judgment became final before the river city ranches decision announced this rule. • the tax court has jurisdiction in a collection due process proceeding to decide issues relating to liability that the taxpayer has not had an opportunity to contest (§ 6330(c)(2)(b)). therefore, according to the ninth circuit, in a collection due process proceeding of a partner in a partnership, the tax court has jurisdiction to review the record of a partnership-level proceeding to make a determination about a partnership level issue affecting the partner’s liability that the partner did not have an opportunity to contest. in this case, the ninth circuit believed that the record from the partnership proceedings was sufficient to allow the tax court to determine whether the partnership transactions were tax-motivated. the ninth circuit then performed the review of the partnership proceedings itself and determined that the partnership transactions were tax-motivated. 5. say it ain’t so, bdo. the u.s. attorney for the southern district of new york announced on 6/3/09 that charles w. bee, jr., a former vice-chairman and board member at bdo seidman, pleaded guilty to a three-count felony information charging him with conspiracy to defraud the united states in connection with tax shelter transactions involving clients of his firm and of the law firm jenkens & gilchrist (j&g); tax evasion in connection with a multimillion-dollar tax shelter that bee helped sell to a client of his firm; and to giving material false deposition testimony regarding his firm’s tax shelter practice. 6. “everyone’s doing it” is not a legal principle. 3k investment partners v. commissioner, 133 t.c. no. 6 (9/3/09). in a partnership proceeding to determine whether the partnership reasonably relied on tax opinions in a son-of-boss tax shelter investment in order to avoid § 6662 accuracy related penalties, the partnership sought discovery of all of the son-of-boss tax shelter opinions and a list of firms providing opinions in order to bolster its argument that reliance on opinions of jenkens & gilchrist was reasonable. in denying the discovery motion, the court (judge thornton) observed that, “petitioner’s argument appears to be a variant of the refrain, familiar to parents of teenagers, that ‘everyone’s doing it.’ for the same reason that this does not constitute reasonable cause for teenagers, it would not constitute reasonable cause for petitioner.” the court held that the partnership must establish reasonableness based on the facts of its own case. the court also rejected the partnership’s argument that the undisclosed opinions, which the court described as involving only a small subset of tax advisors, disclosed a general consensus of tax advisors supported good faith reliance. the court also ruled that the undisclosed tax 209 florida tax review [vol. 10:si opinions in the possession of the irs represented confidential taxpayer information protected from disclosure under § 6103(a). 7. the seventh circuit jumps ship on penalties as partnership items. it affirmed a district court holding that no accuracyrelated penalties applied in a son-of-boss case because taxpayers were entitled to rely on tax opinions. american boat company, llc v. united states, 583 f.3d 471 (7th cir. 10/1/09). david jump transferred mississippi river towboats to american boat l.l.c. after an accident in which barges broke loose from a tow boat and nearly caused a disaster by floating into a casino moored in st. louis. in a series of son-of-boss transactions, american boat used treasury note short sales to increase the basis of its tow boats and claim higher depreciation deductions. in a district court proceeding brought by the partnership the trial court held that the son-ofboss transactions were shams, but upheld the partnership’s assertion of a reasonable cause defense under § 6664(c) to accuracy related penalties as a partnership item. the government appealed the penalty issue. • the court stated that the vast majority of courts have held that a partnership may assert a reasonable cause defense as a partnership item on its own behalf based on the conduct of its managing or general partner. the court also noted that a partner may not raise the partner’s own reasonable cause defense in a partnership proceeding, but rejected the irs argument that a reasonable cause defense is limited. the court concluded that a partnership may raise a reasonable cause defense on facts and circumstances common to all partners and which relies on neither an individual partner’s tax return nor his unique conduct. the court further concluded that, while it was a close case, the appellate court was not able to conclude that the district court committed clear error in finding that american boat, through david jump, reasonably relied on the tax opinion of erwin mayer and jenkens & gilchrist in reporting the son-of-boss transaction. ix. exempt organizations and charitable giving a. exempt organizations there were no significant developments regarding this topic during 2009. b. charitable giving 1. one of timothy mcveigh’s lawyers loses again, but the consequences are not as severe this time. jones v. commissioner, 129 t.c. 146 (11/1/07). leslie steven jones, one of timothy mcveigh’s lawyers in the criminal proceeding stemming from the oklahoma city 2010] recent developments in federal income taxation 210 federal building bombing, donated to the university of texas copies of documents received by him from the government in the course of his representation of timothy mcveigh and claimed a charitable contribution deduction for the appraised value. judge cohen upheld the irs’s disallowance of any deduction on the ground that under the relevant state law (oklahoma), the materials were not attorney work product and not being attorney work product, the client, not the lawyer, was the owner of the materials in the case file. because the taxpayer “was not the legal owner of the materials, he was not legally capable of divesting himself of the burdens and benefits of ownership or effecting a valid gift of the materials.” alternatively, even if the material in the file was attorney work product, it constituted “letters, memoranda, and similar property” prepared by the taxpayer’s personal efforts, which by virtue of § 1221(a)(3)(a) was an ordinary income asset, and thus under § 170(e)(1)(a) the deduction was limited to basis, which was zero. (a) affirmed, but on subtly different reasoning. jones v. commissioner, 560 f.3d 1196 (10th cir. 3/27/09). the tenth circuit affirmed the tax court’s decision on the ground that the discovery material was not a capital asset, but did not address whether the taxpayer owned the discovery material under oklahoma law. however, the rationale of the court of appeals for determining that the discovery material was not a capital asset differed from that of the tax court. the tax court held that the discovery material constituted “letters, memoranda, or similar property created by the taxpayer’s own efforts” excluded from the definition of capital asset pursuant under § 1221(a)(3)(a). according to the court of appeals, however, the record clearly demonstrated that the discovery material for which jones claimed a charitable contribution deduction was not created by his own personal efforts, and thus § 1221(a)(3)(a) did not apply to it. rather, the court of appeals held that the discovery material, which was first compiled by the government to assist in its investigation and copies of which were made, organized, and categorized by the government and delivered to the taxpayer for the benefit of jones and his client, was not a capital asset because it constituted letters, memoranda, or similar property “prepared or produced” for the taxpayer within the meaning of § 1221(a)(3)(b). “[t]he discovery material was provided to taxpayer only because of his position as lead counsel for mcveigh, and it was the type of material typically produced for defense counsel in the course of a criminal trial.” 2. tax benefits flow from promising not to build an office building between the first green and second tee. golf course perpetual easements gave rise to charitable contribution deductions. kiva dunes conservation, llc v. commissioner, t.c. memo. 2009-145 211 florida tax review [vol. 10:si (6/22/09). the tax court (judge wells) held that the owner of a golf course was entitled to a charitable contribution deduction for its grant to the north american land trust of a perpetual conservation easement covering a golf course that it owned. he further rejected the asserted § 6662 accuracy-related penalty because the adjustment he made to value was “approximately 10 percent.” 3. the easement has to have some real effect to give rise to a charitable contribution deduction. herman v. commissioner, t.c. memo. 2009-205 (9/14/09). judge gustafson held that a contribution to a charitable organization of an easement burdening developable air rights over a certified historic structure owned by another person did not qualify for a charitable contribution deduction under § 170(h). the easement did not preclude the taxpayer, the structure’s owner, or any subsequent purchaser of the property from altering or demolishing the structure. thus, the conservation easement did not preserve an “historically important land area” or a “certified historic structure” within the meaning of § 170(h)(4)(a)(iv). 4. a possibly faulty conservation easement deduction saved by local preservation laws. simmons v. commissioner, t.c. memo. 2009-208 (9/15/09). judge wherry held that facade conservation easements validly supported a charitable contribution deduction, even though they allowed easement holder to consent to changes to the properties, because any rehabilitative work or new construction on the facades was required to comply with the requirements of all applicable federal, state, and local government laws and regulations. reg. § 1.170a-14(d)(5) allows a donation to satisfy the conservation purposes test even if future development is allowed, as long as that future development is subject to local, state, and federal laws and regulations. that the properties were already subject to local preservation laws did not prevent any charitable contribution deductions, because even though the easements were duplicative in some respects, the easements subjected taxpayer to a higher level of enforcement than that provided by local law. x. tax procedure a. interest, penalties and prosecutions 1. increased penalty for failure to file on time. for returns required to be filed after december 31, 2008, the heroes earnings assistance and relief tax act of 2008 increases the minimum penalty failure to file a return on time to the lesser of $135 or 100 percent of the tax required to be shown on the return. 2010] recent developments in federal income taxation 212 (a) watch out for this one when not filing partnership tax returns for years beginning in 2008! the revenue offset to a tax reduction. p.l. 110-141, “an act to exclude from gross income payments from the hokie spirit memorial fund to the victims of the tragic event at virginia polytechnic institute & state university” was signed by president bush on 12/17/08. section 2 of that act is an off-code provision that adds $1 to the § 6698(b)(1) “failure to file a partnership return” penalty. the $1 addition does not apply to s corporation returns. the $1 increase only applies to a taxable year beginning in 2008. (b) increased penalties for failing to timely file partnership and s corporation returns. section 16 of the worker, homeownership, and business act of 2009 (whaba) amends §§ 6698 and 6699 to increase the penalty for failing to file a partnership or s corporation tax return from $89 to $195. 2. no free trade agreement for ssns. t.d. 9437, amendments to the section 7216 regulations – disclosure or use of information by preparers of returns, 73 f.r. 76216 (12/16/08). this treasury decision amends reg. § 301.7216-3(b)(4) to permit disclosure by a tax return preparer of a taxpayer’s ssn to another tax return preparer located outside the united states only with the taxpayer’s consent. the amended regulation applies to disclosures of tax return information occurring on or after 1/1/09. (a) but there is some freedom for preparers to use taxpayer return information to increase their own profitability. t.d. 9478, amendments to the section 7216 regulations – disclosure or use of information by preparers of returns, 75 f.r. 48 (12/29/09). temp. reg. § 301.7216-2t(n) allows return preparers to compile, maintain, and use a list containing solely the names, addresses, e-mail addresses, phone numbers, taxpayer entity classification, and income tax return form numbers of taxpayers whose tax returns the tax return preparer has prepared, if the list is used only to contact the taxpayers on the list either (1) to provide tax, general business, or economic information for educational purposes, or (2) for soliciting additional tax return preparation services. temp. reg. § 301.7216-2t(p) allows return preparers to disclose return information without penalty for the purpose of a quality or peer review, but only to the extent necessary to accomplish the review. the information also may be used to perform a conflict of interest check. identical proposed regulations were published simultaneously. reg-131028-09, amendments to the section 7216 regulations – disclosure or use of information by preparers of returns, 75 f.r. 94 (12/29/09). 213 florida tax review [vol. 10:si (1) rev. rul. 2010-5, 2010-4 i.r.b. 312 (12/30/09). this revenue ruling provides further guidance and allows disclosure of return information to a return preparer’s malpractice insurance carrier to the extent necessary to obtain insurance or to defend against claims; to defend claims, the tax return itself may be disclosed and it may be disclosed to attorneys engaged to defend against the claim. (2) rev. rul. 2010-4, 2010-4 i.r.b. 309 (12/30/09). this revenue ruling provides further guidance and details circumstances that justify use of lists to contact clients and allowing disclosure of information to a third-party provider who prepares the mailings. 3. it is not criminal tax fraud if you intended to cheat but after the fact discover a rationale that might disprove the existence of any deficiency. justice souter emphasizes that transactions should be treated in accordance with their substance, regardless of the intent of their participants. boulware v. united states, 552 u.s. 421 (3/3/08) (9-0). michael boulware was convicted on nine counts of tax evasion and filing a false income tax return, stemming from his diversion of funds from hawaiian isles enterprises (hie), a closely held corporation of which he was the president, founder, and controlling (though not sole) shareholder. the supreme court emphasized the necessity of a tax deficiency as an essential element of tax evasion under § 7201 in reversing the taxpayer’s conviction. boulware involved a shareholder of a closely held corporation who failed to report millions of dollars from the corporation. “[h]e siphoned off this money primarily by writing checks to employees and friends and having them return the cash to him, by diverting payments by hie customers, by submitting fraudulent invoices to hie, and by laundering hie money through companies in the kingdom of tonga and hong kong.” the funds were used to support his “lavish lifestyle,” and were treated as distributions of property to him from the corporation. boulware sought to introduce evidence that hie had no earnings and profits in the relevant taxable years, and because the amount diverted did not exceed his basis for his stock, there was no dividend under §§ 301(c)(1) and 316, and the entire amount was a return-of-capital treatment under § 301(b)(2). boulware’s argument was that because the return of capital was nontaxable, the government could not establish the tax deficiency required as an element of criminal tax fraud. the trial court refused to admit the proffered evidence, and the ninth circuit affirmed, reasoning that the return of capital theory could be advanced only if at the time the occurred the corporation intended it to be a return of capital, following its prior decision in united states v. miller, 545 f.2d 1204 (9th cir. 1976). the supreme court (justice souter) vacated the conviction. the court concluded: 2010] recent developments in federal income taxation 214 there is no criminal tax evasion without a tax deficiency, ... and there is no deficiency owing to a distribution (received with respect to a corporation’s stock) if a corporation has no earnings and profits and the value distributed does not exceed the taxpayer-shareholder’s basis for his stock. • with respect to the intent question the court reasoned as follows: miller’s view that a criminal defendant may not treat a distribution as a return of capital without evidence of a corresponding contemporaneous intent sits uncomfortably not only with the tax law’s economic realism, but with the particular wording of §§ 301 and 316(a), as well. as those sections are written, the tax consequences of a “distribution by a corporation with respect to its stock” depend, not on anyone’s purpose to return capital or to get it back, but on facts wholly independent of intent: whether the corporation had earnings and profits, and the amount of the taxpayer’s basis for his stock. • the court stated the test to be “that economic substance remains the right touchstone for characterizing funds received when a shareholder diverts them before they can be recorded on the corporation’s books,” and that they “may be seen as dividends or capital distributions for purposes of §§ 301 and 316(a).” he analyzed the treatment of distributions received with respect to a corporation’s stock under § 301(a) and concluded that an exception for criminal cases was improper, and concluded: the implausibility of a statutory reading that either creates a tax limbo or forces resort to an atextual stopgap is all the clearer from the ninth circuit’s discussion in this case of its own understanding of the consequences of miller’s rule: the court openly acknowledged that “imposing an intent requirement creates a disconnect between civil and criminal liability,” 470 f.3d at 934. in construing distribution rules that draw no distinction in terms of criminal or civil consequences, the disparity of treatment assumed by the court of appeals counts heavily against its contemporaneous intent construction (quite apart from the circuit’s understanding that its interpretation entails criminal liability for evasion without any showing of a tax deficiency). • the court declined to address the government’s alternative argument that diversion was an unlawful act akin to embezzlement, rather than a distribution with respect to the corporation’s stock, which would result in §§ 301 and 316 being irrelevant and give rise to 215 florida tax review [vol. 10:si deficiency for failure to report the proceeds of a theft, because that question had not been considered by the court of appeals. (a) boulware on remand. it was a pyrrhic victory before the supreme court. he’s still going to get room and board from the federal government for a few years. the ninth circuit still refuses to permit the use of the “return of capital” theory. united states v. boulware, 558 f.3d 971 (9th cir. 3/9/09). in ruling to affirm boulware’s conviction, the court (judge thomas) held that the proffer of expert testimony to establish the theory that corporate distributions were legally non-taxable because the corporation had no earnings and profits was properly rejected because the expert testimony constituted a legal opinion and it was within the discretion of the trial judge to exclude it. judge thomas went on to hold that in order to be non-taxable the distribution had to be made with respect to the corporation’s stock and there was no affirmative evidence “that any nexus existed between the distribution and boulware’s stock ownership.” “[a]t the very least a taxpayer must tender some evidence of nexus between the corporate distribution and stock ownership, or show that there were no other alternate explanations, in order to proceed with a return of capital theory at trial.” boulware did neither, and thus the district court did not err in declining to allow him to present his theory to the jury. • he further held there was no evidence that boulware’s stock basis equaled or exceeded the $10 million of corporate distributions to boulware. (b) and on the merits in the tax case, boulware’s corporations lose deductions. hie holdings, inc. v. commissioner, t.c. memo. 2009-130 (6/8/09). based on a voluminous trial record, the tax court (judge laro) denied losses and deductions to corporations controlled by boulware and owned in part by his former secretary/mistress in trust for one of their children. the court denied net operating losses arising from nol carryovers, disallowed claimed bad debt deductions, denied deductions for claimed professional fees (related to boulware’s criminal defense and civil proceedings by the former mistress), and upheld constructive dividend treatment for distributions to boulware because professional fees were paid by his constructive withdrawals from the corporations. the court found that the professional fees treated as constructive dividends did not exceed the e&p available for the year. 4. apparently it’s ok to lie on irrelevant attachments to an amended return. united states v. adams, 314 fed. appx. 633 (5th cir. 2/17/09). the taxpayer was convicted under § 7206(1) on two counts of filing a false return. one count was based on the theory that in signing a form 1040x amended return, by virtue of the jurat, the taxpayer 2010] recent developments in federal income taxation 216 falsely swore to truth of an attached copy of his original schedule c, which contained income omissions. (the government did not seek an indictment for making false statements on the original form 1040, because the applicable statute of limitations had run.) the court of appeals reversed the conviction on this count. the jurat on the form 1040x states that the taxpayer has “examined this amended return, including accompanying schedules and statements, and to the best of my knowledge and belief, this amended return is true, correct, and complete.” by specifying that the signer’s examination extends to the amended return and all attachments while limiting the signer’s assurance of truth, correctness, and completeness to just the amended return, the jurat’s language makes a clear distinction between that which the taxpayer examined and that which he swore was true. in the case of an original return, this distinction is insignificant because accompanying schedules and statements are generally considered integral parts of the return to which the jurat applies. in this case, however, the court concluded that the original schedule c, which constituted an integral part of his 1999 form 1040, was not an integral part of the form 1040x. the purpose of the amended return was to report additional gross income from the sale of the business, not the operation of the business, and the form 1040x instructs taxpayers to “[a]ttach only the supporting forms and schedules for the items changed.” 5. it’s no defense to a criminal failure to pay charge that you squandered the money and couldn’t have paid it if you wanted to. united states v. easterday, 539 f.3d 1176 (9th cir. 8/22/08). the defendant was convicted under § 7202 for willful failure to pay over withheld employee payroll and income taxes. he had requested “an ‘ability to pay instruction’ in order to contend to the jury that his failure to pay over the taxes he owed was not ‘willful,’ because he had spent the money on other business expenses and therefore could not pay it to the government when it was due,” but the district court refused to give the instruction. the ninth circuit affirmed, overruling its prior decision to the contrary in united states v. poll, 521 f.2d 329 (9th cir. 1975), on the ground that the subsequent supreme court decision in united states v. pomponio, 429 u.s. 10 (1976), by implication repudiated any requirement of proving ability to pay as an element of the crime of willful failure to pay. possession of sufficient funds to pay the tax is not an element of the crime of under § 7202 (or § 7203). a conviction will be sustained without any showing of the taxpayer’s ability to pay and a taxpayer is not entitled to a jury instruction that to support a conviction the government must prove that the taxpayer could have paid the tax. (a) petition for rehearing en banc denied. united states v. easterday, 564 f.3d 1004 (9th cir. 4/27/09). in denying the 217 florida tax review [vol. 10:si taxpayer’s petition for a rehearing en banc (2-1), judge schroeder amended the original opinion, but reached the same conclusion. in the amended option, the court rejected the taxpayer’s argument that as long as united states v. poll, 521 f.2d 329 (9th cir. 1975), a panel opinion, had not been overruled by an en banc panel of the court, a panel of the ninth circuit was bound to follow poll as law of the circuit. the dissent by judge smith would have upheld the taxpayer’s argument that one panel of the ninth circuit cannot overrule a decision of an earlier panel, even though judge smith agreed that poll was wrongly decided. 6. he was convicted of criminal tax fraud, but in the civil case, the irs couldn’t prove that any of the over $200,000 deficiency was due to fraud, so judge holmes “estimates” $500 of the deficiency due to fraud in order to avoid inconsistency. barrow v. commissioner, t.c. memo. 2008-264 (11/25/08). because the irs issued the deficiency notice more than three years after the return filing date, the deficiency notice was timely only if the understatement of tax was fraudulent. the taxpayer had been convicted of criminal tax fraud with respect to taxable years 1985, 1987, and 1988. in the criminal trial, the government’s primary theory was that barrow had cheated on his taxes by not reporting on his individual returns fees that two health care organizations paid to him as the chairman of the board and a trustee. in the civil action, however, the government’s theory was that barrow’s unreported income was income diverted from the incorporated accounting firm that he headed (because the government also was seeking a deficiency against the accounting firm). the government argued that barrow was collaterally estopped from arguing that the understatement was not fraudulent. the tax court (judge holmes) upheld that the taxpayer’s argument that because the government’s theory with respect to the unreported fees was different in the civil action from in the criminal action, the issues in that regard were not identical — a requirement for collateral estoppel to apply — with respect to the two actions, but that barrow nevertheless was collaterally estopped from arguing that the understatement was not fraudulent because they were “relatively minor items of unreported income or incorrect expenses whose consequences for barrow’s tax liability are unaffected by the switch in government theories between the cases.” because in the criminal trial, the government established willful tax evasion beyond a reasonable doubt, but the jury was not required to return a verdict detailing which items of income had not reported or which claimed expenses had not been paid, collateral estoppel applied with respect to the entire claimed deficiency. however, on the merits, judge holmes found that even though in the criminal case the government proved beyond a reasonable doubt that some part of barrow’s underpayments for 1987 and 1988 were due to fraud, in the civil case the commissioner failed to prove that any particular underpayments were 2010] recent developments in federal income taxation 218 actually due to fraud. recognizing that “it would be inconsistent to hold no part of the underpayment due to fraud,” judge holmes “estimate[d] that $500 in 1987 and 1988 was due to fraud for purposes of applying the fraud penalty.” but because no part of any underpayments for 1984 or 1986 (the accounting firm’s 1988 and 1989 deficiencies) was due to fraud, the commissioner’s determination for those years was not sustained. 7. hip, hip, hypocrisy! treasury press release on the swearing-in of a new secretary of the treasury, http://www.ustreas.gov/news/index1.html (1/26/09). this appointment requires irs employees to feel ashamed – but undeterred – when they propose penalties or criminal prosecutions with respect to an amount of tax owed that does not exceed $48,268. see, also, http://www.ustreas.gov/press/releases/tg01.htm. (a) h.r. 735, the rangel rule bill of 2009, was introduced on 1/28/09 by representative john carter (r-tx). it would permit taxpayers to immunize themselves from penalties and interest when they file a return to pay back taxes. 8. small businesses that underpay estimated taxes are the backbone of the american economy. section 1212 of the 2009 arra amended § 6654(d) to reduce the 100 percent of the prior year’s taxes safe-harbor to 90 percent of the prior year’s taxes for an individual whose adjusted gross income for the prior year was less than $500,000, if more than 50 percent of the gross income on the prior year’s tax return was from a small business (generally defined as a business with fewer than 500 employees). 9. irs gets addicted to announcing amnesty for offshore tax cheats. irs news release ir-2003-05, 2003 tnt 10-11 (1/14/03). an offshore voluntary compliance initiative provided that “eligible taxpayers,” who used offshore payment cards or other offshore financial arrangements to hide their income, may avoid civil fraud and information return penalties (but not failure to pay tax or accuracy-related penalties) if they come forward and pay up by 4/15/03 and provide full details on those who promoted or solicited the offshore scheme. promoters and solicitors are not eligible. the information release contains the following example: for example, a taxpayer who understated his income to avoid $100,000 in taxes in 1999 would wind up paying $149,319 to the government. this includes the tax liability plus $29,319 in interest and an additional accuracy-related penalty of $20,000. 219 florida tax review [vol. 10:si (a) rev. proc. 2003-11, 2003-1 c.b. 311 (1/14/03). this revenue procedure contained detailed procedures for the offshore voluntary compliance initiative, including as an exhibit the “specific matters closing agreement” to be executed by the taxpayer. (b) liechtenstein! ir-2008-26 (2/26/08). the irs announced that it was initiating enforcement action involving more than 100 u.s. taxpayers in connection with accounts in liechtenstein. according to a story in the 2/19/08 wall street journal, (a) heinrich kieber, a former employee of liechtenstein’s largest bank, lgt group, has offered confidential client data to tax authorities on several continents over the past 18 months, and (b) the german government paid roughly €4.2 million ($6.4 million) to an unnamed individual for the same type of information. (c) ubs settles with the justice department for $780 million. on 2/18/09, the swiss bank ubs agreed to pay $780 million under a deferred prosecution agreement over the bank’s offshore services to u.s. taxpayers. it also agreed to hand over the names and account information of some of these taxpayers; however, there were indications that only 250 client names out of 19,000 account holders were being disclosed. 2009 tnt 31-1. (d) the 2009 version is much less of an amnesty than the 2003 version. on 3/26/09, the irs announced several programs relating to penalties on voluntarily disclosed offshore accounts. they have a 3/23/09 effective date, and are good for six months. several internal memoranda explain how the irs intends to process voluntary disclosure claims made regarding offshore accounts. 2009 tnt 57-2. (1) these memoranda include one on examinations of offshore transactions, 2009 tnt 57-32; one on the routing of voluntary disclosure cases, 2009 tnt 57-33; and one authorizing a new penalty structure for voluntary disclosures, 2009 tnt 57-34. (2) ir-2009-84 (9/21/09). the filing deadline for the voluntary disclosure was extended to 10/15/09, and the irs announced there would be no further extensions. (e) the instructions for the new fbar are fubar. ir-2009-58 and announcement 2009-51, 2009-25 i.r.b. 1105 (6/5/09). the irs announced that for the reports of foreign bank and financial accounts (fbars) due on 6/30/09, filers of form td f 90-22.1 2010] recent developments in federal income taxation 220 (rev. 10-2008) need not comply with the new instruction relating to the definition of a united states person, i.e.: united states person. the term “united states person” means a citizen or resident of the united states, or a person in and doing business in the united states. see 31 c.f.r. 103.11(z) for a complete definition of ‘person.’ the united states includes the states, territories and possessions of the united states. see the definition of united states at 31 c.f.r. 103.11(nn) for a complete definition of united states. a foreign subsidiary of a united states person is not required to file this report, although its united states parent corporation may be required to do so. a branch of a foreign entity that is doing business in the united states is required to file this report even if not separately incorporated under u.s. law. • instead, for this year, taxpayers and others can rely on the definition of a united states person included in the instruction to the prior form (7-2000): united states person. the term “united states person” means: (1) a citizen or resident of the united states; (2) a domestic partnership; (3) a domestic corporation; or (4) a domestic estate or trust. (3) notice 2009-62, 2009-35 i.r.b. 260 (8/7/09). by this notice, the irs extended the filing deadline until 6/30/10 to report foreign financial accounts on form td f 90-22.1 for persons with signature authority over (but no financial interest in) a foreign financial account and persons with signature authority over, or financial interests in, a foreign commingled fund. 10. sentence was unreasonably lenient, said third circuit. united states v. tomko, 498 f.3d 157 (3d cir. 8/20/07). a sentence of one year of home confinement in “the very mansion built through the tax evasion scheme at issue,” a $250,000 fine, three years probation, and 250 hours of community service for evading taxes of $228,557, was vacated as unreasonably lenient. the case was remanded for resentencing. (a) however, the court en banc affirmed the district court’s sentence. united states v. tomko, 562 f.3d 558 (3d cir. 4/17/09) (8-5). the majority opinion (judge smith) held that the district court’s variation from the 18 u.s.c. § 3553(a) u.s. sentencing guidelines’ recommendations, which included between twelve and eighteen months’ imprisonment, after consideration of all relevant factors was entitled to “due 221 florida tax review [vol. 10:si deference” despite the fact that some judges in the majority would have imposed prison time on a plumbing contractor who directed numerous subcontractors who were building his multimillion dollar home to falsify information on billing invoices so the invoices would show work done at one of his corporation’s many job sites instead of at his home, resulting in a tax deficiency of $228,557. defendant’s work for habitat for humanity’s pittsburgh affiliate and his willingness to work for its new orleans affiliate post-katrina – despite its beginning after his indictment – appears to have influenced the district court’s downward departure. • judge fisher’s dissent focused on the greater apparent pervasiveness of defendant’s scheme, including his repeated statements that his vacation home in maryland was “a gift from uncle sam,” and found that the district court “exceeded the lower outer limit of the range of appropriate choices it had the discretion to make, and in doing so abused that discretion” because virtually all other “typical tax evader[s]” possessed the same type of mitigating factors relied upon by the district court. 11. tax court jurisdiction to review an otherwise unreviewable assessable penalty can’t piggyback on a related deficiency proceeding. smith v. commissioner, 133 t.c. no. 18 (12/21/09). section 6707a, added to the code by the american jobs creation act of 2004, imposes a penalty for a taxpayer’s failure to include with his return required information with respect to a reportable transaction. the irs assessed a § 6707a penalty against the taxpayer and issued a deficiency notice to his wholly owned corporation with respect to the transaction to which the § 6707a penalty applied. the taxpayer filed a timely petition with the tax court, but judge kroupa held that a penalty imposed under § 6707a is not reviewable by the tax court, even in a deficiency proceeding. although the irs issued a deficiency notice, the notice did not determine the § 6707a penalty. the § 6707a penalty was properly independently assessed without the irs issuing a deficiency notice, and the penalty was thus not within the tax court’s deficiency jurisdiction. the taxpayer’s only redress is though a refund proceeding. 12. there’s no prepayment judicial review for the failure to pay penalty. burke v. commissioner, t.c. memo. 2009-282 (12/8/09). the § 6651(a)(3) addition to tax for failure to pay is not subject to deficiency procedures, but may be collected administratively if it not paid upon notice and demand. b. discovery: summonses and foia 1. district court finds tax accrual workpapers protected by the “work product privilege” and denies the irs petition 2010] recent developments in federal income taxation 222 for summons enforcement. united states v. textron inc., 507 f. supp. 2d 138 (d. r.i. 8/28/07). textron engaged in six silo transactions in 2001 before silos became listed transactions in 2005. under irs procedures, engaging in more than one listed transaction means that the irs will request the entire tax accrual workpapers file. textron produced all requested documents with respect to the silo transactions but refused to turn over its entire workpaper file. judge torres held that the tax accrual workpapers were prepared “because of” anticipated litigation with the irs. he refused to follow contrary authority from the fifth circuit in united states v. el paso company, 682 f.2d 530 (1982), which used the more stringent primary purpose test for determining whether documents were prepared “in anticipation of litigation.” he also held that work product protection was not lost when the tax accrual workpapers were provided to ernst & young for its audit of the company because the aicpa code § 301 on confidential client information made it very unlikely that the accounting firm would provide them to the irs. (a) this split decision has been taken to the banc. united states v. textron inc., 507 f. supp. 2d 138 (d. r.i. 8/28/07), affirmed in part, vacated in part and remanded, 553 f.3d 87 (1st cir. 1/21/09) (2-1), taxpayer’s petition for rehearing denied, (3/24/09), government’s petition for en banc rehearing granted, (3/25/09). the majority opinion (judge torruella) affirmed the holding that textron’s tax accrual workpapers were protected by the work product doctrine on the ground that the first circuit law is that “dual purpose” documents created because of the prospect of litigation are protected even though they were also prepared for a business purpose, i.e., e&y’s audit of textron. it distinguished united states v. el paso company, 682 f.2d 530 (5th cir. 1982), as being part of an existing split between the circuits in the definition of “the anticipation of litigation.” • the majority remanded the case for the district court to consider the questions of whether textron waived workproduct protection by showing its tax accrual workpapers to e&y and whether e&y’s workpapers were within the “control” of textron. • judge boudin dissented on the ground that the proper test should be whether the tax accrual workpapers were prepared “in the ordinary course of business” or were otherwise independently required, and their preparation would not be chilled by lack of protection because they are required by “the financial statement obligations and accounting rules.” he based his opinion on the need for such documents “[i]n the wake of enron and other corporate scandals ... .” he later stated, and, while it may seem one-sided to give the government textron’s blue print to weaknesses in textron’s tax returns, the return is massive — constituting more than 4000 pages; 223 florida tax review [vol. 10:si the government has an important interest in collecting taxes that are owed; and its inquiries into work papers were focused on a specific type of transaction that had been shown to be open to abuse. so context should be kept in mind before shedding too many tears for textron. • the government’s petition for rehearing en banc was granted. (b) reversed by a divided first circuit in an en banc rehearing. the first follows the fifth to el paso. united states v. textron inc., 577 f.3d 21 (1st cir. 8/13/09) (3-2). the majority (judge boudin) held that the work product privilege protects only work done for litigation purposes (the “prepared for” test or the “primary purpose” test), and abandoned the prior first circuit “because of” test, encompassing work done in preparing financial statements that also is prepared in contemplation of litigation. the majority followed united states v. el paso co., 682 f.2d 530 (5th cir. 1982), • judge boudin concluded: textron apparently thinks it is “unfair” for the government to have access to its spreadsheets, but tax collection is not a game. underpaying taxes threatens the essential public interest in revenue collection. if a blueprint to textron’s possible improper deductions can be found in textron’s files, it is properly available to the government unless privileged. virtually all discovery against a party aims at securing information that may assist an opponent in uncovering the truth. unprivileged irs information is equally subject to discovery. the practical problems confronting the irs in discovering under-reporting of corporate taxes, which is likely endemic, are serious. textron’s return is massive — constituting more than 4,000 pages — and the irs requested the work papers only after finding a specific type of transaction that had been shown to be abused by taxpayers. it is because the collection of revenues is essential to government that administrative discovery, along with many other comparatively unusual tools, are furnished to the irs. as bentham explained, all privileges limit access to the truth in aid of other objectives, 8 wigmore, evidence § 2291 (mcnaughton rev. 1961), but virtually all privileges are restricted — either (as here) by definition or (in many cases) through explicit exceptions — by countervailing limitations. the fifth amendment privilege against self2010] recent developments in federal income taxation 224 incrimination is qualified, among other doctrines, by the required records exception, and the attorney client privilege, along with other limitations, by the crime-fraud exception. to sum up, the work product privilege is aimed at protecting work done for litigation, not in preparing financial statements. textron’s work papers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected; and irs access serves the legitimate, and important, function of detecting and disallowing abusive tax shelters. (footnote and internal citations omitted) 2. the work product privilege claim didn’t work, but the § 7525 privilege claim did. valero energy corp. v. united states, 100 a.f.t.r.2d 2007-6473 (n.d. ill. 8/23/07). valero sought to quash summonses issued by the irs to valero’s tax advisor, arthur andersen, relating to certain branch transactions, foreign currency transactions, dual consolidated losses, overall foreign losses, and hedge positions in connection with fluctuation risks. the court (judge kennelly) rejected valero’s claim that the documents were protected by the work product doctrine. he found that the documents were “best categorized as having been prepared during the ordinary course of business, with the possibility of future litigation being secondary at most.” he concluded that “valero confuse[d] the possibility of litigation with the requirement that to be protected, a document must have been prepared because of anticipated litigation. the fact that valero hired arthur andersen with an eye toward the complex nature of the transaction, and the possibility that the irs might investigate, does not support a contention that arthur andersen prepared its materials because valero or andersen anticipated actual litigation.” (under seventh circuit precedent, the work product doctrine applies only when “the document can fairly be said to have been prepared or obtained because of the prospect of litigation.” logan v. commercial union ins. co., 96 f.3d 971, 976–77 (7th cir. 1996) (emphasis in original).) however, the documents were protected under the § 7525 tax practitioner’s privilege as ‘confidential tax advice.’ even though it had the effect of avoiding federal income taxes, the tax shelter exception in § 7525(b) did not apply for two reasons. first, “the transactions in question did not involve the promotion of tax shelters;” nothing in the record indicated that arthur andersen had anything to do with “promotion” of participation in a tax shelter. second, the tax shelter exception only applies to a transaction in which tax avoidance is a “significant purpose,” and not where tax avoidance is merely “one of the purposes” of the transaction. nothing in the record indicated the purpose of the transactions. (under seventh circuit precedent, united states v. bdo seidman, llp, 492 f.3d 225 florida tax review [vol. 10:si 806 (7th cir. 2007), “the burden rests on the opponent of the privilege to prove preliminary facts that would support a finding that the claimed privilege falls within an exception.”) (a) oops, no, the § 7525 privilege did not apply, because the transactions involved promotion of tax shelters. valero energy corp. v. united states, 102 a.f.t.r.2d 2008-5916 (n.d. ill. 8/1/08), on reconsideration, 102 a.f.t.r.2d 2008-5929 (n.d. ill. 8/26/08). on the government’s motion for entry of a further order of an irs summons issued to valero’s tax advisors, arthur andersen, llp, and after an in camera inspection of the requested documents, judge kennelly held that the government “met its burden of showing a foundation in fact that the transactions involved a tax shelter” so the lion’s share of the documents were not privileged. the court refused to construe the word “promotion” in § 7252(b) narrowly, and held that “promotion” includes participation in the organization or sale of a tax shelter. (b) affirmed. “nothing ... limits tax shelters to cookie-cutter products peddled by shady practitioners or distinguishes tax shelters from individualized tax advice.” valero energy corp. v. united states, 102 a.f.t.r.2d 2008-5916 (n.d. ill. 8/1/08), on reconsideration, 102 a.f.t.r.2d 2008-5929 (n.d. ill. 8/26/08), aff’d, 569 f.3d 626 (7th cir. 6/17/09). the seventh circuit, in an opinion by judge evans, affirmed the district court’s order enforcing the summons, noting that “our review of the district court’s ruling is deferential, and we will reverse only if it is clearly erroneous. findings regarding privilege are factintensive, case-specific questions that fall within the district court’s expertise, and, under these circumstances, ‘a light appellate touch is best.’” first, the court of appeals described many of the documents as “the type of information generally gathered to facilitate the filing of a tax return,” which is “accounting advice ... not covered by the privilege, ... whether or not the information made it on the tax returns.” other documents dealt with “inventory methods, compensation packages, or general structure, and analyzed how they affect tax computations.” the court concluded that the documents were discoverable, even though they “‘contain[ed] some legal analysis,’ because it comes part and parcel with accounting advice, and is therefore also open to the government.” finally, the court held that “[n]othing in [the § 6662(d)(2)(c)(ii) definition of a ‘tax shelter’] limits tax shelters to cookie-cutter products peddled by shady practitioners or distinguishes tax shelters from individualized tax advice. instead, the language is broad and encompasses any plan or arrangement whose significant purpose is to avoid or evade federal taxes.” 2010] recent developments in federal income taxation 226 3. law firm was not entitled to materials under foia because they might help its clients to circumvent the law. mayer brown llp v. internal revenue service, 562 f.3d 1190 (d.c. cir. 4/17/09). the d.c. circuit (judge brown) upheld the denial of mayer brown’s foia request for various information relating to the irs’s lilo settlement practices. foia exemption 7(e), 5 u.s.c. § 552(b)(7)(e), shields information if “disclosure could reasonably be expected to risk circumvention of the law,” and revelation of the irs’s settlement practices would risk circumvention of the law, including the internal revenue code. [e]nforcement of the tax laws, a largely self-policed obligation, depends heavily on the personal probity of taxpayers and the deterrent effect of severe and certain sanctions. and, as a slew of high profile cases have recently demonstrated, compliance will often be delayed until enforcement (or unfavorable exposure) is imminent. ... [c]ompanies using lilo schemes would love to have information about the irs’s objectives of settlement, assessment of litigation hazards, and acceptable ranges for settlement. why? because this information would inform their cost-benefit analysis about the advantages of evading the law. constructing a phony tax shelter may only be worthwhile if the irs’s acceptable settlement range is below 80% of the tax liability. once armed with (hypothetical) information that the irs’s acceptable settlements are between 60% and 75%, a questionable tax scheme becomes viable. even a failure may be a win. and, once also armed with information about which cases the irs does not like to litigate, the illegal tax shelter can be designed to minimize the chances of litigation or the likelihood of sanctions. 4. the irs has the burden of showing that the exception to the fatp privilege for corporate tax shelter promotion communications applies. countryside limited partnership v. commissioner, 132 t.c. no. 17 (6/8/09). when the irs moved to compel production of certain meeting notes prepared by one of the taxpayer’s accountant-advisors, the taxpayer claimed that the documents were protected from disclosure by the attorney client privilege and the § 7525 federally authorized tax practitioner (fatp) privilege. the meeting notes “constitute[d] a cumulative chronicle of communications, in part confidential, from clients, including countryside limited partnership ... , to their attorneys for legal advice or to timothy egan ... , whom [the court] found to be an fatp, for tax advice, or from those individuals back to their clients.” the tax court (judge halpern) held that the taxpayer has the 227 florida tax review [vol. 10:si burden of proving the preliminary facts necessary to establish the § 7525 privilege. the commissioner can negate the privilege claim by proving that the requested documents are written communications in connection with the promotion of corporate tax shelters and that the exception in § 7525(b) thus applies. on the facts, judge halpern found that because the meeting notes in question were not themselves communicated to anyone but were merely written summaries of oral communications, they were not a written communication that could satisfy that element of the § 7525(b) exception. the documents in question also were not within the § 7525(b) exception because the commissioner failed to show that the accountant had “promoted” a corporate tax shelter. section 7525 does not define “promotion,” but the legislative history quoted in the opinion provides, “[t]he conferees do not understand the promotion of tax shelters to be part of the routine relationship between a tax practitioner and a client. accordingly, the conferees do not anticipate that the tax shelter limitation will adversely affect such routine relationships.” h. conf. rept. 105-599, at 269 (1998), 1998-3 c.b. 747, 1023. judge halpern found eagan’s relationship to the taxpayer to be a “routine” relationship that did not involve promotion of a tax shelter. mr. egan has had a long, close relationship with the winn organization, preparing returns, assisting with tax planning when asked, answering questions when asked, and responding to notices and inquiries from federal and state tax officials. his advice with respect to the partnership redemptions and associated transactions under review in these cases was furnished (as was similar advice with respect to similar transactions) as part of a long-standing, ongoing, and, hence, routine relationship with the winn organization. mr. egan provided tax advice to the winn organization when requested to do so, and his advice here followed the same regular course of procedure as did his other tax advice, including tax advice related to partnership redemptions. his employer, pwc, had no stake in the outcome of the transactions under review in this case other than in the continued retention of the winn organization as a client. it did not receive a fixed fee or a fee based on a percentage of some claimed tax saving. it was paid by the hour pursuant to a rate schedule for mr. egan’s time in rendering his advice, just as it was for the other services outside of return preparation that he rendered to the winn organization. 5. a stern warning against unwarranted blanket claims of privilege. eulich v. united states, 104 a.f.t.r.2d 2009-6337 (n.d. tex. 9/4/09). in connection with an audit, the irs summonsed certain 2010] recent developments in federal income taxation 228 documents relating to a bahamian trust, and the taxpayer asserted attorney client privilege and work product doctrine protection for ‘voluminous documents” that were submitted for in camera review. the court (judge lindsay) determined that hundreds — we lost count at over 400 — of documents were privileged in whole or in part, and that hundreds — we again lost count at over 400 — of documents were not privileged in whole or in part. the judge lindsay concluded as follows: this review has placed an undue, and in many instances unjustified, burden on the court and its staff. it has stretched scarce judicial resources in a way never contemplated by the court. in many instances, the court does not believe that the claim of privilege was met seq.ade in good faith. petitioner is put on notice that the court will not tolerate such blanket claims of privilege and will impose sanctions as appropriate if such conduct recurs. (emphasis in original.) c. litigation costs 1. a contingent attorney’s fee has been incurred even if it’s not owed. morrison v. commissioner, 565 f.3d 658 (9th cir. 5/13/09). the ninth circuit reversed a tax court decision, t.c. memo 2006103, which held that a taxpayer had not “incurred” attorney’s fees reimbursable under § 7430 when the fees were advanced by a corporation owned by the taxpayer under an agreement providing that the taxpayer would reimburse the corporation if he was able to recover them under § 7430. it should be self evident that when a third person, e.g., a corporation of which the taxpayer is a shareholder, who has no direct interest in the litigation pays attorney’s fees on behalf of a taxpayer, the taxpayer has “incurred” the fees as long as the taxpayer has an absolute obligation to repay the third person, regardless of whether he successfully moves for an attorney’s fees award under § 7430. going a step further, the ninth circuit held that when such a third person pays attorney’s fees on behalf of a taxpayer, the taxpayer has “incurred” the fees if he has only a contingent obligation to pay the fees in the event that he is able to recover them under § 7430. because the nature of the agreement between the taxpayer and the corporation that advanced the attorney’s fees was unclear from the record, the ninth circuit remanded the case to the tax court to apply the definition it adopted of “incurred,” after determining the precise nature of the fee agreement, if any, between the taxpayer and the corporation. 2. clarifying guidance on collecting attorney’s fees from the irs. reg-111833-99, regulations under i.r.c. section 7430 relating to awards of administrative costs and attorneys fees, 74 f.r. 61589 (11/25/09). the treasury department has published proposed 229 florida tax review [vol. 10:si regulations relating to awards of administrative costs and attorneys fees under § 7430 to conform to the amendments made in the taxpayer relief act of 1997 and the irs restructuring and reform act of 1998. among the changes reflected in the proposed regulations are the following. (1) a taxpayer has ninety days after the date the irs mails to the taxpayer a final decision determining tax, interest or penalty, to file an application with the irs to recover administrative costs. (2) a taxpayer has ninety days after the date the irs mails to the taxpayer, by certified or registered mail, a final adverse decision regarding an award of administrative costs, to file a petition with the tax court. (3) individuals filing joint returns should be treated as separate taxpayers for purposes of determining net worth. (4) trusts are subject to the net worth requirements. (5) clarifying changes address the calculation of net worth. (6) several amendments to § 7430 in the irs restructuring and reform act of 1998 are reflected in the proposed regulations: (a) the hourly rate limitation is increased to $125; (b) difficulty of the issues presented and local availability of tax experts may be considered to increase an attorney’s hourly rate; (c) a court should consider whether the irs has lost cases with substantially similar issues in other circuit courts of appeal in deciding whether the irs’s position was substantially justified; (d) if an individual who is authorized to practice before the tax court or the irs is representing the taxpayer on a pro bono basis, the taxpayer may petition for an award of reasonable attorneys fees in excess of the amounts that the taxpayer paid or incurred, as long as the fee award is ultimately paid to the individual or the individual’s employer; (e) the period for recovery of reasonable administrative costs is extended to include costs incurred after the date on which the first letter of proposed deficiency (“30-day letter”) is mailed to the taxpayer, but the taxpayer may be eligible to recover reasonable administrative costs from the date of the 30day letter only if at least one issue (other than recovery of administrative costs) remains in dispute as of the date that the irs takes a position in the administrative proceeding. d. statutory notice of deficiency there were no significant developments regarding this topic during 2009. e. statute of limitations 1. the taxpayer might have been confused by inconsistent letters from the irs, but that’s no excuse. leonard v. united states, 85 fed. cl. 435 (1/30/09). a letter sent to the taxpayer on feb. 29, stating that a formal disallowance of a refund claim that will start the statute of limitations on filing a refund suit would be issued in the following week, 2010] recent developments in federal income taxation 230 did not toll the period of limitations that had been commenced by a letter sent on feb. 6, stating that the refund claim had been disallowed and that a suit for refund could be commenced within two years of the date of the feb. 6 letter. 2. the tax return really does have to rat you out to avoid the six year statute of limitations if the understatement exceeds 20 percent. benson v. commissioner, 560 f.3d 1133 (9th cir. 3/31/09), aff’g t.c. memo. 2006-55 (3/27/06). items on the tax returns of brother-sister corporations reflecting payments between them, which on the facts were found to be constructive dividends to their common shareholder, did not constitute adequate disclosure with respect to the shareholder’s return to prevent the § 6501(e)(1)(a) six-year statute from being applicable. 3. the courts hold that overstating basis is not the same as understating gross income, but the treasury department ultimately plays its trump card by promulgating regulations. section 6501(e)(1) extends the normal three-year period of limitations to six years if the taxpayer omits from gross income an amount in excess of 25 percent of the gross income stated in the return. section 6229(c)(2) provides a similar extension of the statute of limitations under § 6229(a) for assessments arising out of tefra partnership proceedings. a critical question is whether the six year statute of limitations applies if the taxpayer overstates basis and as a consequence understates gross income. (a) the tax court says overstating basis is not the same as understating gross income. bakersfield energy partners, lp v. commissioner, 128 t.c. 207 (6/14/07), overstated basis resulted in an understatement of § 1231 gain. looking to supreme court precedent under the statutory predecessor of § 6501(e) in the 1939 code (colony, inc. v. commissioner, 357 u.s. 28 (1958)), from which the six-year statute of limitations in § 6229(c)(2) is derived and to which it is analogous, the tax court concluded that this understated gain was not an omission of “gross income” that would invoke the six year statute of limitations under § 6229(c)(2) applicable to partnership audits. (b) the ninth circuit likes the way the tax court thinks: bakersfield energy partners is affirmed. bakersfield energy partners, lp v. commissioner, 568 f.3d 767 (9th cir. 6/17/09). the ninth circuit affirmed the tax court on the ground that the language at issue in the instant case was the same as the statutory language interpreted in colony. the court noted, however, that “the irs’s interpretation of §6501(e)(1)(a) is reasonable.” 231 florida tax review [vol. 10:si (c) and a judge of the court of federal claims agrees. grapevine imports, ltd v. united states, 77 fed. cl. 505 (7/17/07). in a tefra partnership tax shelter case, the court of federal claims (judge allegra) held that the § 6501(e) 6-year statute of limitations does not apply to basis overstatements, citing colony, inc. v. commissioner, 357 u.s. 28 (1958). section 6501(e), rather than § 6229(c)(2) as in bakersfield energy partners, lp, applied because in earlier proceedings in the instant case (71 fed. cl. 324 (2006)), the court had held that § 6229 did not create an independent statute of limitations, but instead only provides a minimum period for assessment for partnership items that could extend the § 6501 statute of limitations, and because the fpaa was sent within this sixyear statute of limitations under § 6229(d) the statute of limitations with respect to the partners was suspended. (d) but a district court in florida disagrees. brandon ridge partners v. united states, 100 a.f.t.r.2d 2007-5347 (m.d. fla. 7/30/07). the court refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) 6-year statute of limitations does apply to basis overstatements. the court reasoned that as a result of subsequent amendments to the relevant code sections, the application of colony, inc. v. commissioner, 357 u.s. 28 (1958) is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or services. (“in the case of a trade or business, the term “gross income” means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.”) the court reasoned that to conclude otherwise would render § 6501(e)(1)(a)(i) superfluous. because the transaction at issue was the partnership’s sale of stock, which was not a business sale of goods or services, the gross receipts test did not apply. on the facts, the partners and partnership returns (and statements attached thereto), taken together “failed to adequately apprise the irs of the true amount of gain on the sale of the ... stock.” thus, the partnership did not show that the extended limitations period was inapplicable. (e) and a different judge of the court of federal claims agrees with the district court in florida and disagrees with the prior court of federal claims opinion by the judge in grapevine imports. salman ranch ltd. v. united states, 79 fed. cl. 189 (11/09/07). the court (judge miller) refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) 6-year statute of .imitations does apply to basis overstatements. judge miller reasoned that an understatement of “gain” is an omission of gross income, and that omission can result from a basis overstatement as well as from an understatement of 2010] recent developments in federal income taxation 232 the amount realized. like the brandon ridge partners court, judge miller concluded that the application of colony, inc. v. commissioner, 357 u.s. 28 (1958), is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or services. (“in the case of a trade or business, the term ‘gross income’ means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.”) because the transaction at issue was the partnership’s sale of a ranch, which was not a business sale of goods or services, the gross receipts test did not apply. on the facts, the partners’ and partnership returns failed to adequately apprise the irs of the amount of gain in a variant of the son-ofboss tax shelter. accordingly, the partnership did not show that the extended limitations period was inapplicable. the amended order certified and interlocutory appeal and stayed the case pending further court order, because of the split of opinion between salman ranch, on the one hand, and bakersfield energy partners and brandon ridge partners, on the other hand. (f) and the pro-government opinion by judge miller is slapped down by the federal circuit. salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09). following colony, inc. v. commissioner, 357 u.s. 28 (1958), the federal circuit (judge schall, 2-1) held that “omits from gross income an amount properly includable therein” in § 6501(e)(1)(a) does not include an overstatement of basis. accordingly, the six-year statute of limitations on assessment did not apply — the normal three-year period of limitations applied. judge newman dissented. (g) but a second district court sees it the government’s way. home concrete & supply llc v. united states, 599 f. supp. 2d 678 (e.d. n.c. 10/21/08). the court held that §6501(e) extends the statute of limitations for deficiencies attributable to basis overstatements that result in omitted gross income exceeding 25 percent of the gross income reported on the return. the court refused to follow the tax court’s decisions in bakersfield energy partners and grapevine imports, because it concluded that those cases were erroneously decided. (h) a hiccup from judge goeke in the tax court: overstated basis in an abusive tax shelter is a substantial omission from gross income that extends the statute of limitations. highwood partners v. commissioner, 133 t.c. no. 1 (8/13/09). the taxpayers invested through partnerships in foreign currency digital options contracts designed to increase partnership basis and generate losses marketed by jenkens & gilchrist (son-of-boss and miscellaneous other names). after expiration of the three-year statute of limitations, the irs issued an fpaa to the partnership based on the six-year statute of §6501(e)(1) applicable if 233 florida tax review [vol. 10:si there was a greater than 25 percent omission of gross income on each partner’s or the partnership’s return. the court (judge goeke) held that the digital options contracts produced § 988 exchange gain on foreign currency transactions, which, under the regulations, are required to be separately stated. the long and short positions of the options contracts were treated as separate transactions. thus, failure to report the gain on the short position, not offset by losses on the accompanying stock sale, represented an omission of gross income. the court also rejected the taxpayer’s argument that because the irs asserted that the options transactions should be disregarded in full, there can be no omission of gross income from the disregarded short position. finally, the court refused to apply the adequate disclosure safe harbor of § 6501(e)(1)(a)(ii) because the taxpayer’s netting of the gain and loss from the long and short positions was intended to mislead and hide the existence of the gain and did not apprise the irs of the existence of the gain. (i) but judge haines follows the tax court orthodoxy. beard v. commissioner, t.c. memo. 2009-184 (8/11/09). in a basis offset deal involving contributions of long and short positions in treasury notes contributed to s corporations, the court (judge haines) granted summary judgment to the taxpayer holding that the basis overstatement attributable to the short sale was not an a substantial omission of gross income. because the transaction involved treasury notes, there were no § 988 issues involved. this holding is consistent with bakersfield energy partners v. commissioner, 568 f.3d 767 (9th cir. 6/17/09), and salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09). (j) and the irs loses again in the tax court. intermountain insurance service of vail v. commissioner, t.c. memo. 2009-195 (9/1/09). the court (judge wherry), again following bakersfield energy partners lp v. commissioner, 128 t.c. 207 (2007), granted summary judgment to the taxpayer holding that a basis overstatement is not a substantial omission from gross income that triggers the six year extended statute of limitations under § 6229. (k) finally, the irs gets the upper hand with temporary regulations. t.d. 9466, definition of omission from gross income, 74 f.r. 49321 (9/24/09). temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)-1t both provide that for purposes of determining whether there is a substantial omission of gross income, gross income as it relates to a trade or business includes the total amount received from the sale of goods or services, without reduction for the cost of goods sold, gross income otherwise has the same meaning as under § 61(a). the regulations add that, “in the case of amounts received or accrued that relate to the disposition of property, and except as provided in paragraph (a)(1)(ii) of this section, gross 2010] recent developments in federal income taxation 234 income means the excess of the amount realized from the disposition of the property over the unrecovered cost or other basis of the property. consequently, except as provided in paragraph (a)(1)(ii) of this section, an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of section 6229(c)(2).” (l) but the irs still suffers from a hangover in cases on which the extended statute had run before the effective date of the regulations. utam, ltd. v. commissioner, t.c. memo. 2009-253 (11/9/09). judge kroupa followed bakersfield energy partners to hold that the statute of limitations is not extended to six years pursuant to § 6229(c)(2) or § 6501(e)(1)(a) as a result of a basis overstatement that causes gross income to be understated by more than 25 percent. • although the date of the decision was after the effective date of temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)1t, the result was dictated by prior law effective when the fpaa was issued in 1999. 4. proposed regulations provide an instruction manual on how to start running the otherwise endless statute of limitations on previously unreported listed transactions. notice of proposed rulemaking, period of limitations on assessment for listed transactions not disclosed under section 6011, reg-160871-04, 74 f.r. 55127 (10/7/09). the treasury has published proposed regulations § 301.6501(c)-1(g) under § 6501(c)(10), which extends the statute of limitations when a taxpayer fails to disclose a listed transaction; the statute of limitations does not expire until one year after the earlier of (1) the date on which the taxpayer furnishes the required information, or (2) the date a material advisor (as defined in § 6111) satisfies the list maintenance requirements of § 6112 with respect to a request by the irs. the proposed regulations specify the methods for subsequent disclosure of listed transaction that was not properly disclosed under § 6011. the extended statute of limitations applies only to the tax relating to the listed transaction, but the proposed regulations provide that tax with respect to the listed transaction includes, but is not limited to, adjustments made to the tax consequences claimed on the return plus interest, additions to tax, additional amounts, and penalties that are related to the listed transaction or adjustments made to the tax consequences, as well as any item to the extent the item is affected by the listed transaction even if it is unrelated to the listed transaction. 5. a listed transaction is a listed transaction, is a listed transaction, period. a partner’s statute of limitations can be 235 florida tax review [vol. 10:si determined in a tefra partnership level proceeding. blak investments v. commissioner, 133 t.c. no. 19 (12/23/09) (reviewed, 12-3). the taxpayers engaged in a son-of-boss type transaction in december 2001 and january 2002 that first became a reportable transaction on 2/28/03, when reg. § 1.6011-4 was promulgated. as of that date, they had already filed their 2001 return, but they had not yet filed their 2002 return. reg. § 1.60114(e)(2) required them to attach a statement to their 2002 return disclosing the listed transaction, but when they filed their 2002 return on october 15, 2003, they failed to include the required statement. the irs issued an fpaa on october 13, 2006, challenging the transactions as shams. section 6501(c)(10) was added by the american jobs creation act of 2004 applicable to tax years “with respect to which the period for assessing a deficiency did not expire before” 10/22/04, and the statute of limitations with respect to the taxpayers’ transactions was open on that date. section 6707a, including the definition of listed transactions in § 6707a(c), imposes penalties on failure to provide required information on reportable transactions on returns due after 10/22/04. temp. reg. § 1.6011-4t (and prop. reg. § 1.6011-4), requiring disclosure of defined listed transactions were first published in 2000. in a reviewed opinion by judge haines, the majority first held that although the tax court’s jurisdiction in a partnership proceeding generally is limited to determining “partnership items,” an exception extends jurisdiction over whether the period of limitations has expired as to individual partners presents, because the expiration of the period of limitations can depend on facts that are peculiar to the individual partners, citing rhone-poulenc surfactants & specialties, l.p. v. commissioner, 114 t.c. 533 (2000), appeal dismissed and remanded, 249 f.3d 175 (3d cir. 2001), and curr-spec partners, lp v. commissioner, t.c. memo. 2007-289, affd, 579 f.3d 391(5th cir. 2009). the majority rejected the taxpayers’ argument that there are two types of listed transactions, those entered into before, and those entered into after, 10/22/04, and that extension of the period for assessment under § 6501(c)(10) only applied to transactions for which a return was due after that date. the court concluded that the extension of the statute of limitations under § 6501(c)(10) is effective for tax years for which the period of limitations had not expired on 10/22/04, and that the enactment of the penalty provisions in § 6707a has no bearing on the application of § 6501(c)(10). “[i]t is of no consequence that the transaction in question became a reportable transaction after the transaction had already occurred. the legislative history expressly contemplated such a result.” the court also held that temp. reg. § 1.6011-4t was valid and required disclosure of the taxpayers’ transactions on their 2001 and 2002 returns. the court rejected the taxpayers’ arguments that the temporary regulation violated executive order 12866, which requires office of management and budget review of proposed significant regulatory actions, or that the temporary regulation violated the notice and comment requirements of the administrative 2010] recent developments in federal income taxation 236 procedure act. thus, the statute of limitations remained open on the taxpayers’ transactions under § 6501(c)(10) until one year after the required disclosure was provided. • judge halpern (joined by judges foley and holmes) dissented on the grounds that the tax court does not have the authority in a partnership-level proceeding to decide whether the statute of limitations bars the assessment of a resulting computational adjustment. the dissenters assert that the application of the statute of limitations to the subsequent assessment against the partners is neither a partnership item nor an affirmative defense to the fpaa. f. liens and collections 1. even though she tells us she’s a blues fan, judge marvel says the queen of the blues has a legal obligation to honestly report and pay her income tax liability each year. is this what killed her? taylor v. commissioner, t.c. memo. 2009-27 (2/5/09). the taxpayer, the late koko taylor – the “queen of the blues,” failed to pay estimated taxes or remit full payment with her tax returns for several years. the irs rejected her subsequent offer in compromise, which she grounded on “economic hardship,” because it found no hardship or reasonable cause for failure to pay, and following a collection due process hearing issued a determination that a levy should proceed. the queen of the blues appealed to the tax court, but judge marvel upheld the irs’s determination. both petitioner and respondent repeatedly commented on petitioner’s stature as a beloved and wellknown professional singer as support for their respective positions in these consolidated cases. we disagree with both parties insofar as they contend that a taxpayer’s celebrity status is somehow relevant to what this court must do in deciding whether the commissioner’s collection action may proceed. every taxpayer, no matter how famous or notorious, has a legal obligation to honestly report and pay his or her income tax liability each year and is entitled to fair enforcement of federal tax laws. a taxpayer like petitioner whose business income is generated by performances must carefully comply with estimated tax requirements. the record establishes that petitioner had outstanding tax liabilities for 1998, 2000, and 2001 because she did not make required estimated tax payments when due and that respondent did not abuse his discretion in determining that the filing of an nftl was appropriate and that respondent may proceed to collect petitioner’s outstanding tax liabilities 237 florida tax review [vol. 10:si by levy. respondent gave petitioner ample opportunity to rectify her failure to pay estimated tax when due and considered petitioner’s collection alternatives in accordance with applicable administrative and legal requirements. 2. plaintiff asks the court of federal claims to order the government to return to him an erroneous refund that it recovered through an administrative levy, even though he never filed an administrative refund claim, and amazingly at first the court is willing to listen to the argument. pennoni v. united states, 79 fed. cl. 552 (12/4/07). after the taxpayer failed to file a federal income tax return for tax year 1998, the irs sent him a proposed individual income tax assessment, claiming that he owed $17,764. although the irs eventually agreed that the taxpayer was owed a refund in the amount of $2,801, it sent him a refund check in the amount of $80,166. the irs recognized its mistake after the taxpayer cashed the check, and it sent the taxpayer a notice of balance due and ultimately placed a levy on his bank account and garnished his wages. the taxpayer sued the government, seeking an order requiring it to repay amounts it took from his bank account and wages, plus costs, and the government filed a motion to dismiss the action, claiming that the court lacked jurisdiction because the taxpayer did not file an administrative claim for a refund before he filed suit. the court found that the taxpayer did not have to file an administrative claim before he filed suit because he was not seeking a tax refund. instead, he was suing the government for illegal exaction, and the suit was timely under the six-year statute of limitations pertaining to lawsuits filed under the tucker act, so the government’s motion to dismiss was denied. (a) on second thought, the irs might not have to follow administrative procedures to “reassess” liability for an erroneous refund, but the taxpayer has to follow administrative procedures before filing suit to recover money to which he was never entitled. pennoni v. united states, 86 fed. cl. 351 (2/26/09). the court of federal claims (judge firestone) applied the principles of united states v. clintwood elkhorn mining, 553 u.s. 1 (2008), which held that the requirements of § 7422 are to be strictly construed, to hold that § 7422(a) requires that administrative remedies be pursued before a taxpayer files suit seeking recovery of amounts that the irs has collected by administrative levy, without following deficiency or assessment procedures, to recoup an erroneous refund. the court concluded that “even if the plaintiff is correct in its characterization that the irs improperly used its levy powers to collect a non-tax debt created by the erroneous refund, rather than to collect an unpaid tax liability, this case nonetheless clearly falls within the ‘any sum’ language of section 7422(a). by its terms, section 7422(a) extends beyond suits for 2010] recent developments in federal income taxation 238 ‘the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected,’ to suits for the recovery of ‘any sum alleged to have been excessive or in any manner wrongfully collected.’” • the taxpayer is a tax lawyer who did not dispute that he received and negotiated the check, and that it was an erroneous refund! (b) ditto! strategic housing finance corporation of travis county v. united states, 86 fed. cl. 518 (2/27/09). judge scott interpreted the requirements of § 7422(a) in the same manner as judge firestone did in pennoni and denied a nonprofit housing finance corporation/tax-exempt bond issuer’s refund claim, for which there had no administrative claim filed, seeking to recover an irs-accelerated arbitrage rebate overpayment made under protest. the plaintiff characterized the suit as one for an “illegal exaction” or “illegal taking.” 3. a victory for the taxpayer on cdp procedures turns pyrrhic when the tax court reaches the merits. mason v. commissioner, 132 t.c. no. 14 (5/6/09). the taxpayer sought review of a cdp hearing with respect to § 6672 penalties assessed against her as a responsible person for failure to collect and pay over withholding taxes of a corporation. she had not been permitted to contest liability at the cdp hearing, even though prior to the cdp hearing the taxpayer had not received a notice of the irs’s intent to assess § 6672 penalties. the tax court (judge gerber) held that because the taxpayer had not received a notice of intent to assess a trust fund recovery penalty, she had not had an opportunity to dispute that tax liability under § 6330(c)(2)(b). because the taxpayer did not have an opportunity to dispute the underlying tax liability at any time during the administrative proceedings and had raised the issue at the cdp hearing, the tax court reviewed the liability de novo. however, a notice of intent to assess § 6672 penalties is valid for purposes of assessing the penalties, even though the taxpayer has not received the notice. thus, the penalties were validly assessed. on the facts, the taxpayer was a “responsible person” who willfully failed to pay over withholding taxes and was liable for the trust fund penalties. the irs’s determination to uphold the lien filing was not an abuse of discretion. 4. even the certainly dead face the certainty of taxation. estate of brandon v. commissioner, 133 t.c. no. 4 (8/27/09). judge foley held that a tax lien that is filed after the taxpayer’s death with respect to taxes assessed prior to the taxpayer’s death is valid, even though at the time the lien was filed ownership of the property had passed to the taxpayer’s estate. under § 6321 a tax lien arises when the assessment is made and under § 6322 continues to be enforceable until it is satisfied or it 239 florida tax review [vol. 10:si becomes unenforceable by a lapse of time, and the irs complied with the lien notice and filing requirements. 5. taxpayer’s poverty trumps a proposed levy. vinatieri v. commissioner, 133 t.c. no. 16 (12/21/09). the taxpayer submitted a settlement offer for delinquent taxes, but the irs determined to levy on the taxpayer’s wages and car. even though the irs concluded that the levy would create an economic hardship, the settlement officer determined collection alternatives to the levy, including an installment agreement, an offer-in-compromise, and reporting the account as currently not collectible, were not available because the taxpayer had not filed returns for several years. in a review of a § 6330 cdp hearing, judge dawson held that it was unreasonable and an abuse of discretion for the irs to proceed to levy on the taxpayer’s wages and car, because a levy would have left the taxpayer impoverished. section 6343(a)(1) requires that the irs must release a levy upon all, or part of, a taxpayer’s property if it determines that the levy creates an economic hardship due to the taxpayer’s financial condition. reg. § 301.6343-1(b)(4) provides that a levy creates an economic hardship due to the financial condition of an individual taxpayer and must be released “if satisfaction of the levy in whole or in part will cause an individual taxpayer to be unable to pay his or her reasonable basic living expenses.” because the taxpayer had demonstrated that a levy would render her unable to pay her reasonable basic living expenses, the irs was barred from levying. judge dawson rejected the irs’s argument that because the taxpayer was not in compliance with the filing requirements for all required tax returns, its determination to levy was not unreasonable. • the requirement that taxpayer be currently in compliance with his or her obligations to the irs under its “currently not collectible” (“cnc”) program does not apply to relief under § 6343. 6. “i would gladly pay you tuesday for a hamburger today.” t.d. 9473, agreements for payment of tax liabilities in installments, 74 f.r. 61525 (11/25/09). the treasury department has promulgated final reg. § 301.6159-1, dealing with rules governing the acceptance and rejection by the irs of proposed installment agreements, the terms of installment agreements, modification or termination by the irs, and appeal procedures when the irs rejects or terminates an installment agreement. among the provisions is a requirement that the irs review partial payment installment agreements every two years to determine whether the financial condition of the taxpayer changed enough to warrant an increase in the payments. the irs may terminate an installment agreement if the taxpayer provides materially inaccurate or incomplete information in connection with a requested financial update. the irs will generally notify 2010] recent developments in federal income taxation 240 the taxpayer in writing at least 30 days prior to terminating an installment agreement and describe the reason for the termination, after which the taxpayer may provide information showing that the irs’s reason is incorrect. appeals procedures are provided. the irs cannot levy during the time an installment agreement is pending, unless an installment agreement request was made solely to delay collection. the statute of limitations on collection under § 6502 of the code is suspended for the period that a proposed installment agreement is pending, plus 30 days following a rejection, and during any appeal. 7. nuanced differences in the statutory subsections result in different periods for suspending the statute of limitations on collections. severo v. commissioner, 586 f.3d 1213 (9th cir. 11/20/09), aff’g 129 t.c. 160 (11/15/07). section 6503(h) suspends the running of the period of limitations on collection from the date of the taxpayer’s bankruptcy petition was filed to the date six months after the bankruptcy court issues a discharge order. the more limited suspension of the period of limitations in § 6503(b), which applies to judicial proceedings generally when the taxpayer’s assets are under control of a court, does not apply in bankruptcy situations. 8. ever-expanding tax court jurisdiction over cdp appeals. michael v. commissioner, 133 t.c. no. 10 (10/8/09). judge goeke held that a settlement of the government’s counterclaim in a prior refund suit for § 6694 penalties does not preclude tax court jurisdiction to review a § 6330 cdp determination with respect to collection of the settlement amount. the district court’s dismissal of the refund action with prejudice on the basis of the settlement agreement does not render the administrative statutory collection remedies unavailable. nor does the district court’s retention of jurisdiction for a 60-day enforcement period preclude the irs from pursuing statutory collection remedies, such as a levy. thus, the tax court had jurisdiction to review the irs’s determination to sustain the levy and to determine whether respondent may collect the unpaid penalties by levy. g. innocent spouse 1. the tax court sticks to its position that it has broad discretion in reviewing denial of innocent spouse relief. porter v. commissioner, 130 t.c. 115 (5/15/08) (reviewed, 2 judges dissenting). judge haines held that the tax court continues to follow its holding in ewing v. commissioner, 122 t.c. 32 (2004), vacated on unrelated jurisdictional grounds, 439 f.3d 1009 (9th cir. 2006), that (1) its determination whether the irs abused its discretion in denying innocent 241 florida tax review [vol. 10:si spouse relief under § 6015(f) is made in a trial de novo, and (2) it may consider evidence introduced at trial which was not included in the administrative record. he rejected the irs’s argument that pursuant to the eighth circuit’s decision in robinette v. commissioner, 439 f.3d 455 (8th cir. 2006), rev’g 123 t.c. 85 (2004), the tax court’s review is limited to the administrative record. judge haines distinguished robinette as involving review of a § 6330 cdp determination: “whereas section 6015 provides that we ‘determine’ whether the taxpayer is entitled to relief, section 6330(d) provides for judicial review of the commissioner’s determination by allowing the taxpayer to ‘appeal such determination to the tax court’ and vesting the tax court with ‘jurisdiction with respect to such matter.’ as discussed above, the use of the word ‘determine’ suggests that we conduct a trial de novo.” (a) and the tax court applies a de novo standard of review — the irs gets cut no slack. porter v. commissioner, 132 t.c. no. 11 (4/23/09). this opinion dealt with issues not addressed in porter v. commissioner, 130 t.c. 115 (2008), which held that in determining whether the irs abused its discretion in denying innocent spouse relief under § 6015(f) the tax court conducts a trial de novo, and may consider evidence introduced at trial which was not included in the administrative record. in this reviewed opinion by judge haines, in which eight other judges joined, supported by a concurring opinion of two other judges, the tax court held that it applies de novo standard of review as well as de novo scope of review. jonson v. commissioner, 118 t.c. 106 (2002), aff’d, 353 f3d 1181 (10th cir. 2003), and butler v. commissioner, 114 t.c. 276 (2000), which applied an abuse of discretion standard of review are no longer controlling. applying this standard of review, equitable relief was granted on the facts. six judges dissented from the opinion with respect to the standard of review and two judges who concurred with respect to the standard of review dissented on the merits. (b) and the eleventh circuit agrees with the tax court that it’s more powerful than the irs’s administrative record. commissioner v. neal, 557 f.3d 1262 (11th cir. 2/10/09) (2-1). in an opinion by judge wilson, the eleventh circuit held that the tax court properly considered facts that were not in the administrative record in determining in a trial de novo that the irs abused its discretion in denying innocent spouse relief under § 6015(f). he concluded that commissioner had not shown that the tax court’s reasoning to that effect in ewing v. commissioner, 122 t.c. 32 (2004), vacated on other grounds, 439 f.3d 1009 (9th cir. 2006), and porter v. commissioner, 130 t.c. 115 (2008) was in error, and he rejected the commissioner’s argument that the administrative procedure act required that the tax court’s review be limited to the 2010] recent developments in federal income taxation 242 administrative record. section 6015(e), providing for tax court jurisdiction to review the irs’s denial of innocent spouse relief in a stand-alone petition cannot be read in isolation from the remainder of rules governing tax court review of deficiency “determinations,” which differ from “appeals” from the irs’s decision. [section] 6015 is “part and parcel” of the statutory framework for tax court review of irs deficiency determinations. ... it is from this framework that the “[tax court’s] de novo review procedures emanate.” ... accordingly, when congress chose to use the same statutory language in § 6015 as it used in establishing the longstanding trial de novo procedure for deficiency actions, “it did so in full awareness of [the tax court’s] long history of de novo review,” ... and did not intend to impose a different procedure. thus, per § 559, “the apa does not disturb or supersede [the tax] court’s longstanding de novo judicial review procedures for cases involving spousal relief under section 6015.” ... • the court noted that the legislative history of the apa confirms it does not supersede the tax court’s adjudication procedures, quoting the relevant language from the house report. • finally, the decision regarding the scope of review was not a pyrrhic victory; the taxpayer won on the merits. • judge tjoflat [dis?]respectfully dissents. judge tjoflat wrote a lengthy dissent concluding that the administrative procedure act did apply to limit the tax court’s review to the administrative record. he caustically concluded as follows: today, the court has given the tax court the authority to second-guess the commissioner at its whim, superimposed upon the farce that the commissioner’s determination is given discretionary weight. under such a scheme, why should the commissioner conduct his hearings in a careful and diligent manner? why bother when the commissioner knows that his review of the facts and law will be ignored? for that matter, why should taxpayers be required to fund and use the irs appeals process since any conclusions made by those federal officials will dissipate in the tax court like whispers in the wind? i have found no satisfactory answers to these questions. therefore, i respectfully dissent from the court’s judgment. 2. taxpayer is screwed out of substantive rights by congress’s failure to adequately deal with procedural issues. pollock v. 243 florida tax review [vol. 10:si commissioner, 132 t.c. no. 3 (2/12/09). the taxpayer sought § 6015(f) nondeficiency stand-alone innocent spouse relief. in april 2007, the irs denied the relief before § 6015(e) was amended to confer jurisdiction on the tax court to review denial of such relief. the taxpayer did not seek judicial review of the irs determination. subsequently, congress amended § 6015 to confer jurisdiction on the tax court to hear § 6015(f) nondeficiency standalone cases, effective for tax liabilities “arising or remaining unpaid on or after [december 20, 2006].” when the irs sought to collect the taxes in a lien-enforcement action, the district court invoked the doctrine of equitable tolling to give the taxpayer 30 days to file a petition with the tax court to review the denial of innocent spouse relief. the taxpayer filed her petition within the time limit set by the district court’s order. the tax court (judge holmes), although showing sympathy for the taxpayer’s plight, granted the commissioner’s motion to dismiss for lack of jurisdiction because the taxpayer filed her petition more than 90 days after the irs had mailed the notice of determination to her. the § 6015(e)(1)(a) 90-day limit for filing a tax court petition for review of the irs’s denial of innocent spouse relief is jurisdictional and therefore does not allow for equitable tolling. thus, even though the taxes remained unpaid on december 20, 2006, the tax court lacked jurisdiction because the petition for review had not been timely filed. the timely filing requirement applied even though on the last day for filing a petition, the tax court lacked jurisdiction to review the denial of innocent spouse relief. 3. that regulation ain’t got no equity and it ain’t got no empathy, so it’s invalid. the tax court majority responds to “the sound of [congressional] silence.” lantz v. commissioner, 132 t.c. no. 8 (4/7/09) (reviewed, 12-4). the taxpayer sought equitable relief from joint income tax liability under § 6015(f), but the irs denied relief on the ground that she had not requested relief within two years from the irs’s first collection action, as required by reg. § 1.6015-5(b)(1). consequently, the irs did not reach the substantive issues of the claim. in a reviewed opinion by judge goeke, joined by eleven judges, with four dissents, the tax court held reg. § 1.6015-5(b)(1) to be invalid as applied to § 6015(f) relief. (following the golsen rule, the tax court applied chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), because the seventh circuit held in bankers life & cas. co. v. united states, 142 f.3d 973, 979 (7th cir. 1998), that regulations issued under general or specific authority of the irs to promulgate necessary rules are entitled to chevron deference; reg. § 1.6015-5 was issued under both a general grant of authority under § 7805 and a specific grant of authority in § 6015(h).) the court focused on the explicit inclusion of a two-year deadline in both § 6015(b) and § 6015(c), in contrast to the absence of any deadline in § 6015(f), to find that the 2010] recent developments in federal income taxation 244 regulation was not a reasonable interpretation of the statute under the chevron standard. “‘it is generally presumed that congress acts intentionally and purposely’ when it ‘includes particular language in one section of a statute but omits it in another.’” ... we find that by explicitly creating a 2-year limitation in subsections (b) and (c) but not subsection (f), congress has “spoken” by its audible silence. because the regulation imposes a limitation that congress explicitly incorporated into subsections (b) and (c) but omitted from subsection (f), it fails the first prong of chevron. ... had congress intended a 2-year period of limitations for equitable relief, then of course it could have easily included in subsection (f) what it included in subsections (b) and (c). however, congress imposed no deadline, yet the secretary prescribed a period of limitations identical to the limitations congress imposed under section 6015(b) and (c). • as a result, the irs abused its discretion in failing to consider all facts and circumstances in the taxpayer’s case. further proceedings are required to fully determine the taxpayer’s liability. (a) you don’t have to actually know the irs denied § 6015(b) relief for the statute of limitations on seeking review to have expired, but you can always turn to § 6015(f), which for now appears to have an open-ended period for review. mannella v. commissioner, 132 t.c. no. 10 (4/13/09). the irs sent the taxpayer a notice of intent to levy and notice of the right to a § 6330 cdp hearing on 6/4/04. on 11/1/06, more than two years later, the taxpayer requested § 6015 relief from joint and several liability, which the irs denied on the grounds that the request was untimely. the taxpayer claimed that she did not receive her notice of intent to levy because her former husband received the notices, signed the certified mail receipts, and failed to deliver of inform her of the notices. judge haines held that actual receipt of the notice of intent to levy or of the notice of the right to request relief from joint and several liability is not required for the 2-year period in which to request relief under §§ 6015(b) and (c) to begin. the taxpayer’s request for relief under §§ 6015(b) and (c) was not timely. however, the taxpayer’s claim for relief under § 6015(f), was timely because lantz v. commissioner, 132 t.c. no. 8 (4/7/09), held that reg. § 1.6015-5(b)(1), requiring a request for relief within two years from the irs’s first collection action, is invalid as applied to § 6015(f) relief. 245 florida tax review [vol. 10:si 4. see no evil, hear no evil, but speak evil of exspouse – a perfect formula for § 6015 relief. phemister v. commissioner, t.c. memo. 2009-201 (9/2/09). the taxpayer was entitled to relief from liability on a tax deficiency attributable to her ex-husband’s medical practice under § 6015(b) where she had no meaningful involvement with the business and the adjustments resulted from his failure to substantiate claimed expenses. although his business income supported the taxpayer, it was more than sufficient to have provided support without regard to the disallowed expenses. thus, the disallowed expenses did not result in any meaningful financial benefit to the taxpayer. the taxpayer also was entitled to § 6015(f) equitable relief. she was divorced from her ex-husband, she had no meaningful involvement with the business, his adjustments resulted from his failure to substantiate claimed expenses; she did not know who kept her husband’s books and records, and there was no evidence she reviewed any of his claimed deductions. h. miscellaneous 1. a criminal sentence for obstructing and impeding the administration of federal tax laws was vacated because a cpa’s two “very good” defense counsel failed to retain an expert witness in tax law to determine the proper amount of tax loss. baxter v. united states, 634 f. supp. 2d 897 (n.d. ill. 6/25/09). after plea negotiations, a cpa pleaded guilty to one count of violating § 7212(a) (obstructing and impeding the administration of federal tax laws) and in the plea agreement stated that “the offense involved a tax loss of more than $550,000 [i.e., $576,000]” but the government asserted that she was accountable for a tax loss of $5.1 million for sentencing purposes. the court rejected the $5.1 million amount after a 2005 hearing, but did not understand that the $576,000 amount was included in the rejected $5.1 million tax loss. in this 28 u.s.c. § 2255 proceeding to “vacate, set aside or correct sentence,” judge holderman held that the defendant’s two [“very good”] criminal defense lawyers provided constitutionally ineffective counsel “because they had failed to retain a tax expert to ascertain the correct amount of tax loss attributable to baxter’s criminal conduct and had failed to evaluate the correct tax ramifications of baxter’s criminal conduct for sentencing purposes.” 2. claims for a method for hedging risk in commodities trading are held not to concern patent-eligible subject matter. this leads to the possible conclusion that tax strategies are not patentable. however, the federal circuit did not overrule the state street case and the supreme court has granted certiorari in this case. in re bilski, 545 f.3d 943 (fed. cir. 10/30/08) (9-3), cert. granted sub nom. 2010] recent developments in federal income taxation 246 bilski v. doll, 129 s. ct. 2735 (6/1/09). the federal circuit (judge michel) affirmed a decision of the board of patent appeals and interferences that claims for a method for managing (hedging) the risks in commodities trading did not constitute a patent-eligible subject matter. the meaning of a patentable “process” under 35 u.s.c. § 101 [“whoever invents or discovers any new and useful process, machine [etc.] ... may obtain a patent therefore ... .] includes only the transformation of a physical object or substance, or an electronic signal representative of a physical object or substance.” 3. politics as usual; but different politics now. a union suit no longer means underwear but whether it suits a union (such as the nteu). ir-2009-19 (3/5/09). after conducting an extensive review of the private debt collection program, including the cost effectiveness of the effort, the irs will not renew its contracts with two private debt collection agencies. the irs determined that the work is best done by irs employees who have more flexibility handling cases, which is particularly important with many taxpayers currently facing economic hardship. 4. the government gets a chance to establish a greater deficiency when the civil suit follows the criminal prosecution. mchan v. commissioner, 558 f.3d 326 (4th cir. 2/27/09). the irs is not barred by collateral estoppel from asserting a deficiency in a civil proceeding that is based on the determination of a greater understatement of income than was determined to have been the amount of unreported income in a prior criminal proceeding against the taxpayer. collateral estoppel does not apply “where the party against whom the doctrine is invoked had a heavier burden of persuasion on that issue in the first action than he does in the second.” 5. the taxpayer has no legal remedy to restrain backup withholding. zigmont v. commissioner, t.c. memo. 2009-48 (3/5/09). special trial judge armend held that the tax court lacks jurisdiction to enjoin the irs (under § 6213(a)) from collecting amounts through § 3406 backup withholding. backup withholding is not a deficiency. nor is it a proposed lien or levy subject to cdp procedures that the tax court has jurisdiction to review under § 6330(e)(1). 6. is there two-stop shopping to find out if the redetermined deficiency was discharged in a prior bankruptcy? ferguson v. commissioner, 568 f.3d 498 (5th cir. 5/12/09), aff’g t.c. memo. 2006-32 (2006). if subsequent to the taxpayer’s discharge in bankruptcy the irs issues a deficiency notice for a year prior to the discharge and the taxpayer properly invokes the tax court’s jurisdiction for a redetermination of the deficiency, the tax court lacks jurisdiction to determine whether the taxpayer’s liability was discharged in bankruptcy. 247 florida tax review [vol. 10:si 7. when they called, should he have said, “i gave at the office?” commissioner of internal revenue mark everson announced his resignation to become head of the american red cross. 2007 tnt 76-1 (4/19/07). in his message to irs employees, he said, “together, we have rebalanced the organization, bringing to life the equation: service + enforcement = compliance.” (a) now, we can all look forward to seeing the irs getting stiffed. brown’s successor as acting commissioner will be deputy commissioner for operations support linda stiff, who will assume the position of deputy commissioner for services and enforcement and, on brown’s departure, acting commissioner. 2007 tnt 146-2 (7/30/07). (b) apparently someone at the red cross under mark everson was also getting stiffed. it appears that everson was really “giving at the office.” mark everson resigned his red cross presidency on november 27, 2007 because the red cross board learned that he “engaged in a personal relationship with a subordinate employee.” all in all, it is a sad commentary on the irs that everson could not find anyone there with whom to have a “personal relationship.” (c) is this a come-down? mark everson has joined alliantgroup as vice chair. 2009 tnt 148-3 (8/5/09). “i couldn’t be more pleased that mark everson has decided to join us,” said alliantgroup ceo dhaval jadav. “his service with the irs and with the omb gives him unmatched insight into building positive bridges between taxpayers, cpa firms, and the irs.” 8. two bites at the apple for the irs, because the apples are different varieties. frank sawyer trust of may 1992 v. commissioner, 133 t.c. no. 3 (8/24/09). the trust was the shareholder of four corporations that sold all of their assets for cash, resulting in large capital gains. following the asset sales, the trust sold all of the stock of the corporations to a midco – actually named midco – which purportedly sheltered the corporations’ capital gains with losses from newly contributed high basis, low value assets, following which the assets of the corporations were stripped. initially, the irs asserted a deficiency against the trust on the theory that the corporations had been constructively liquidated while still owned by the trust and the trust had received the cash balances held by the corporations. a docketed tax court case on this issue was settled with the irs conceding that there was no deficiency. subsequently, all four corporations entered into closing agreements with the irs under which substantial taxes were due with respect to the asset sales. at that time, 2010] recent developments in federal income taxation 248 however, all four of the corporations were insolvent. the irs asserted transferee liability against the trust, and the trust raised the defenses of res judicata and collateral estoppel. judge goeke held that neither res judicata nor collateral estoppel applied. the cause of action in the deficiency cases was different than the cause of action in the transferee liability case. the deficiency case dealt with the trust’s fiduciary income tax liability on the sale of the stock in the corporations. that determination would not have required the trust to pay the unpaid tax liabilities of the corporations. the trust’s liability as transferee differs from the trust’s income tax liability. collateral estoppel did not apply because no facts were determined in the earlier proceeding that concluded with the irs’s concession. because the question whether there were liquidating distributions to the trust was not litigated and was not essential to the decisions in the deficiency actions, collateral estoppel did not bar the irs from asserting in the transferee action that there were liquidating distributions from the corporations to the trust. 9. the taxpayer won the complex legal issue, inadvertently conceded the critical factual issue, and thus lost the case. ron lykins, inc. v. commissioner, 133 t.c. no. 5 (9/2/09). a deficiency asserted against the taxpayer corporation for 1999 and 2000 was resolved in a tax court case, ron lykins, inc. v. commissioner, t.c. memo. 2006-35. the taxpayer incurred an nol in 2001, and the taxpayer requested and received a tentative refund attributable to carrying back the nol to 1999 and 2000 before the irs issued the deficiency notice. the deficiency notice did not refer to the nol carrybacks from 2001 or take into account the refunds in its computation of tax liability. subsequently, the irs disallowed the tentative nol carrybacks and taxpayer raised the issue of the nol carrybacks, but the tax court held that there was no deficiency without regard to the nol carrybacks, neither party having put on evidence as to the nol carrybacks. after initially allowing the tentative refund attributable to the nol carrybacks, the irs disallowed them and summarily assessed the amounts of the tentative refunds pursuant to § 6213(b)(3). the irs gave notice of intent to levy and the taxpayer requested a cdp hearing. following the cdp hearing the irs issued a notice of determination to proceed with collection, and the taxpayer appealed. the taxpayer did not attempt to prove the merits of the 2001 nol in either the cdp hearing or the tax court, but argued that under res judicata, the 2006 decision in the original deficiency case barred the irs from asserting that it owed more taxes for 1999 and 2000. the tax court (judge gustafson) first found that collateral estoppel did not bar the taxpayer from raising the 2001 nol carryback, because the merits of the 2001 nol were not “actually litigated” in the prior deficiency case. more importantly, he held that even assuming that either party could have litigated the nol in the prior deficiency case, res judicata did not bar either the taxpayer or the irs from raising or disputing the 2001 nol 249 florida tax review [vol. 10:si carryback and its effect upon the 1999 and 2000 tax liabilities. the reason res judicata did not bar relitigation of the impact of the nol carryback was that § 6511(d)(2)(b) explicitly permits the taxpayer to pay the summary assessments and pursue an overpayment remedy for nol carrybacks without the bar of res judicata. on the other side of the coin, although § 6212(c)(1) generally bars the irs from issuing a second notice of deficiency after a taxpayer has filed a tax court petition, § 6213(b)(1) and (3) expressly allow the irs to determine an additional deficiency that results from a tentative carryback refund even if the irs has previously issued a deficiency notice of for the carryback year and the taxpayer has filed a tax court petition. the court emphasized that it was not holding simply that § 6212(c)(1) by itself trumps res judicata, and that the irs avoids res judicata whenever it is permitted by § 6212(c)(1) to determine an additional deficiency, but that §§ 6411, 6212(c)(1), and 6213(b)(3) create a unique procedure for tentative carryback refunds, because recapture of a tentatively allowed refund is not ordinarily the subject of a taxpayer’s petition in a deficiency case. however, in the end the court held for the irs, concluding that because the taxpayer failed to carry the burden of proving its loss in 2001 and establishing the validity of the carrybacks to 1999 and 2000, having conceded the issue by not raising it the cdp hearing, the proposed levy to collect the summary assessment would be upheld. 10. electronic filing to be required beginning in 2011. section 17 of whaba mandates that the irs require electronic filing by “specified tax return preparers” for all tax returns filed after 12/31/10. specified tax return preparers are “all return preparers except those who neither prepare nor reasonably expect to prepare ten or more individual income tax returns [including returns for estates and trusts] in a calendar year.” 11. burton kanter got in trouble again, and this time it followed him to the grave. investment research associates, ltd. v. commissioner, t.c. memo. 1999-407 (12/15/99). in a 600-page opinion, burton kanter was held liable for the § 6653 fraud penalty by reason of his being “the architect who planned and executed the elaborate scheme with respect to … kickback income payments ... .” • at first, he was unable to wriggle out, the way he did 25 years ago when he was acquitted by a jury. (his partner was convicted and imprisoned. see united states v. baskes, 649 f.2d 471 (7th cir. 1980), cert. denied, 450 u.s. 1000 (1981).) the taxpayers subsequently moved to have access to the special trial judge’s “reports, draft opinions, or similar documents” prepared under tax court rule 183(b). they based their motion on conversations with two unnamed tax court judges that the original draft opinion from the special trial judge was changed by judge 2010] recent developments in federal income taxation 250 dawson before he adopted it. (kanter’s attorney later revealed the names of the two judges, when asked at oral argument to the seventh circuit, as tax court judge julian jacobs and chief special trial judge peter j. panuthos. see the text at footnote 1 of judge cudahy’s dissent in the seventh circuit kanter estate opinion, below.) they were turned down because the tax court held that the documents related to its internal deliberative processes. see, tax court order denying motion, 2001 tnt 23-31 (4/26/00) and (on reconsideration) 2001 tnt 23-30 (8/30/00). (a) and the tax court’s procedures are vindicated and taxpayer ballard loses on appeal on the fraud issue in the eleventh circuit. ballard v. commissioner, 321 f.3d 1037 (11th cir. 2/13/03), aff’g t.c. memo. 1999-407. the eleventh circuit affirmed the tax court decision and rejected the taxpayers’ argument that changes allegedly made to the original draft opinion from the special trial judge by judge dawson before he adopted it were improper. judge fay stated: even assuming dick’s [taxpayers’ lawyer’s] affidavit to be true and affording petitioners-appellants all reasonable inferences, the process utilized in this case does not give rise to due process concern. while the procedures used in the tax court may be unique to that court, there is nothing unusual about judges conferring with one another about cases assigned to them. these conferences are an essential part of the judicial process when, by statute, more than one judge is charged with the responsibility of deciding the case. and, as a result of such conferences, judges sometimes change their original position or thoughts. whether special trial judge couvillion prepared drafts of his report or subsequently changed his opinion entirely is without import insofar as our analysis of the alleged due process violation pertaining to the application of [tax court] rule 183 is concerned. despite the invitation, this court will simply not interfere with another court’s deliberative process. the record reveals, and we accept as true, that the underlying report adopted by the tax court is special trial judge couvillion’s. petitioners-appellants have not demonstrated that the order of august 30, 2000 is inaccurate or suspect in any manner. therefore, we conclude that the application of rule 183 in this case did not violate petitioners-appellants’ due process rights. accordingly, we deny the request for relief and save for another day the more troubling question of what would have occurred had special trial judge couvillion not indicated that the report adopted 251 florida tax review [vol. 10:si by the tax court accurately reflected his findings and opinion. (b) and the tax court’s procedures are vindicated and taxpayer kanter’s estate loses on appeal on the fraud issue in the seventh circuit. estate of kanter v. commissioner, 337 f.3d 833 (7th cir. 7/24/03) (per curiam) (2-1), aff’g in part and rev’g in part t.c. memo. 1999-407. the court found that the nondisclosure of the special trial judge’s original report was proper, following the eleventh circuit’s ballard opinion. it affirmed the findings on deficiencies, fraud and penalties, but reversed on the issue of the deductibility of kanter’s expenses for his involvement in the aborted sale of a purported john trumball painting of george washington because “kanter has shown a distinct proclivity to seek income and profit through activities similar to the failed sale of the painting.” • burton kanter died on october 31, 2001. (c) and the tax court’s procedures are vindicated but taxpayer lisle’s estate wins on appeal on the fraud issue in the fifth circuit. estate of lisle v. commissioner, 341 f.3d 364 (5th cir. 7/30/03), aff’g in part and rev’g in part t.c. memo. 1999-407. the fifth circuit (judge higginbotham) followed the eleventh and seventh circuit decisions upholding the nondisclosure of the special trial judge’s original report by the tax court. (d) justice ginsburg to tax court judges: “you article i judges don’t understand your own rules, so let me tell you what you meant when you adopted them in 1983.” ballard v. commissioner, 544 u.s. 40 (3/7/05) (7-2), reversing and remanding 337 f.3d 833 (7th cir. 7/24/03) and 321 f.3d 1037 (11th cir. 2/13/03). justice ginsburg held that the tax court may neither exclude from the record on appeal nor conceal from the taxpayers the original draft reports of special trial judges under tax court rule 183(b) or under any statutory authority. • chief justice rehnquist’s dissenting opinion, joined by justice thomas, states that the “tax court’s compliance with its own rules is a matter on which we should defer to the interpretation of that court.” (e) the eleventh circuit orders that the special trial judge’s report be added to the record. ballard v. commissioner, 2005-1 u.s.t.c. ¶ 50,393 (11th cir. 5/17/05). (f) tax court changes its rules. (9/20/05). the tax court adopted amendments to tax court rules 182 and 183, 2010] recent developments in federal income taxation 252 relating to special trial judges’ reports in cases other than small tax cases. the special trial judge’s recommended findings of fact and conclusions of law are to be served on the parties, who may file written objections and responses. after the case is assigned to a regular judge, any changes made shall be reflected in the record and “[d]ue regard shall be given to the circumstance that the special trial judge had the opportunity to evaluate the credibility of witnesses, and the finding of fact recommended by the special trial judge shall be presumed to be correct.” (g) the eleventh circuit remands the case to the tax court – after reinstating the special trial judge’s report. ballard v. commissioner, 429 f.3d 1026 (11th cir. 11/2/05) (per curiam). the case was remanded to the tax court with the following instructions: (1) the “collaborative report and opinion” is ordered stricken; (2) the original report of the special trial judge is ordered reinstated; (3) the tax court chief judge is instructed to assign this case to a previously-uninvolved regular tax court judge; and (4) the tax court shall proceed to review this matter in accordance with the supreme court’s dictates and with its newly-revised rules 182 and 183, giving “due regard” to the credibility determinations of the special trial judge and presuming correct fact findings of the trial judge. (h) and the fifth circuit remands it too. estate of lisle v. commissioner, 431 f.3d 439 (5th cir. 11/22/05) (per curiam). the case was remanded to the tax court with orders to: (1) strike the “collaborative report” that formed the basis of the tax court’s ultimate decision; (2) reinstate judge couvillion’s original report; (3) refer the case to a regular tax court judge who had no involvement in the preparation of the “collaborative report,” who in dealing with the remaining issues of tax deficiency must give “due regard” to the credibility determinations of judge couvillion, presuming that his fact findings are correct unless manifestly unreasonable; and (4) adhere strictly hereafter to the amended tax court rule in finalizing tax court opinions. (i) on remand, in a 458-page opinion judge haines of the tax court pours out kanter and ballard. estate of kanter v. commissioner, t.c. memo. 2007-21 (2/1/07). the tax court (judge haines) found that certain of the special trial judge’s findings of fact were “manifestly unreasonable” because they were “internally inconsistent or so implausible that a reasonable fact finder would not believe [the recommended finding]” or they were “directly contradicted by documentary or objective evidence.” judge haines therefore found that the kanter-related entities were shams, that “kanter, ballard, and lisle participated in a complex, well-disguised scheme to share kickback payments earned jointly 253 florida tax review [vol. 10:si by kanter, ballard, and lisle,” and that they earned income during the years at issue which they failed to report. • judge haines found that – based upon factors such as (1) failure to report substantial amounts of income, (2) concealment of the true nature of the income and the identity of the earners of the income, (3) use of sham, conduit, and nominee entities, (4) reporting kanter’s and ballard’s income on iras (and another entity’s) tax returns, (5) commingling of kanter’s and ballard’s income with funds belonging to others, (6) phony loans, (7) false and misleading documents, and (8) failure to cooperate during the examination process by engaging in a “strategy of obfuscation and delay” – the commissioner demonstrated by “clear and convincing evidence” that kanter and ballard filed false and fraudulent tax returns for each of the years at issue. • judge haines held that the tax court is “obliged to review the recommended findings of fact and credibility determinations set forth in the stj report under a ‘manifestly unreasonable’ standard of review, and ... may reject such findings of fact and credibility determinations only if, after reviewing the record in its entirety, [it] conclude[s] that the recommended finding of fact or testimony (1) is internally inconsistent or so implausible that a reasonable fact finder would not believe it, or (2) is not credible because it is directly contradicted by documentary or objective evidence.” furthermore, judge haines held that a special trial judge’s credibility determinations may be rejected under the “manifestly unreasonable” standard of review without rehearing the disputed testimony. • judge haines further found that the appropriate standard for determining whether the assignment of income doctrine should be applied had been appropriately articulated in united states v. newell, 239 f.3d 917, 919-920, as follows: to shift the tax liability, the assignor [taxpayer] must relinquish his control over the activity that generates the income; the income must be the fruit of the contract or the property itself, and not of his ongoing income-producing activity. ... this means, in the case of a contract, that in order to shift the tax liability to the assignee the assignor either must assign the duty to perform along with the right to be paid or must have completed performance before he assigned the contract; otherwise it is he, not the contract, or the assignee, that is producing the contractual income – it is his income, and he is just shifting it to someone else in order to avoid paying income tax on it. (j) and the beat goes on, with a judicial recognition that structural complexity is the norm for “a knowledgeable 2010] recent developments in federal income taxation 254 tax attorney.” ballard v. commissioner, 522 f.3d 1229 (11th cir. 4/7/08). the eleventh circuit (judge fay) reversed, vacated and remanded t.c. memo. 2007-21 (2/1/07) (haines, j.), with instructions to “enter an order approving and adopting judge couvillion’s original report as the opinion of the tax court.” the reason assigned was that judge haines “did not presume judge couvillion’s findings to be correct or give judge couvillion’s credibility determinations their due deference,” concluding that it is no surprise that a knowledgeable tax attorney would use numerous legal entities to accomplish different objectives. this does not make them illegitimate. unfortunately such “maneuvering” is apparently encouraged by our present tax laws and code. (k) “one for all and all for one.” estate of lisle v. commissioner, 541 f.3d 595 (5th cir. 8/25/08) is to the same effect as ballard. (l) a former member of the university of chicago law school faculty, members of which took a pro-kanter stand during the entire litigation because the school was getting big bucks from kanter and/or his estate, decided the last appeal in this matter in favor of burton kanter’s estate. result: the late burton kanter = 1; the irs = zero; the tax court = minus 1. did we mention that the former faculty member was married to a current member of the faculty? kanter v. commissioner, 590 f.3d 410 (7th cir. 12/1/09). the seventh circuit reversed, vacated and remanded t.c. memo. 2007-21 (2/1/07), with instructions to “enter an order approving and adopting the stj’s report as the decision of the tax court.” judge wood found that the stj’s findings were not “clearly erroneous” but “freely acknowledge[d] that a rational person could just as easily have come to the opposite conclusion on this record.” • on his federal income tax returns for the years 1979 through 1989, burton kanter reported that he had no income tax liability. that return position has been vindicated. so it goes. xi. withholding and excise taxes a. employment taxes 1. wisdom from the mount. medical residents may be students for fica taxes. united states v. mount sinai medical center of florida, inc., 486 f.3d 1248 (11th cir. 5/18/07). section 3121(b)(10) provides that employment taxes are not payable with respect to services performed in the employ of a college or university by a student who is enrolled and regularly attending classes. the government argued that 255 florida tax review [vol. 10:si legislative history with respect to the repeal of an exemption for medical interns in 1965 (former § 3121(b)(13)) established as a matter of law that medical residents are subject to employment taxes. the eleventh circuit concluded that § 3121(b)(10) is unambiguous in its application to students and that the statute requires a factual determination whether the hospital is a “school, college, or university” and whether the residents are “students.” (a) this is no april fool. the minnesota district court also finds that medical residents at the university of minnesota are students. regents of the university of minnesota v. united states, 101 a.f.t.r.2d 2008-1532 (d. minn. 4/1/08). the university’s summary judgment motion was granted by the district court, which held that medical residents at the university of minnesota are not subject to employment taxes under the student exclusion of § 3121(b)(10). the court reiterated its conclusion that the full-time employee exception in reg. § 31.3121(b)(10)-2(d), as amended in 2004, is invalid. (b) the district court finds that the mount sinai medical center is a school and the residents are students. united states v. mount sinai medical center of florida, inc., 102 a.f.t.r.2d 20085373 (s.d. fla. 7/28/08). after the decision in minnesota v. apfel, 151 f.3d 742 (8th cir. 1998), mount sinai medical center obtained refunds for fica taxes paid in 1996-1997. the united states filed suit against the medical center for erroneous refunds. following the eleventh circuit’s direction to make a factual determination whether the program qualifies for the § 3101(b)(10) exception, the district court found that the medical center’s residency programs were operated as a “school, college, or university,” that residents were present for training in patient care, which was an intrinsic and mandatory component of the training, and that the residents were “students” who were regularly enrolled and attending classes. the court also found that the students’ performance of patient care services was incident to their course of study. (c) south dakota medical residents are also students. center for family medicine v. united states, 102 a.f.t.r.2d 2008-5623 (d. s. dak. 8/6/08). following minnesota v. apfel, 151 f.3d 742 (8th cir. 1998), the south dakota district court held that medical residents in the center for family medicine (cfm) and university of south dakota school of medicine residency program (usdsmrp) were eligible for the student exception to the definition of employment under § 3101(b)(10). the court rejected the government’s assertion that cfm was not a school, college or university because cfm was affiliated with a non-profit hospital. the court found that cfm’s work includes teaching its medical residents the skills required to practice in their chosen profession. the court also 2010] recent developments in federal income taxation 256 concluded that the students were “enrolled” in the institution and that their attendance at noon conferences and medical rounds established that the students regularly attended classes. tossing a small bone to the government, the court held that chief residents in the programs, who are essentially coordinators for the residency programs, were not students. (d) residents in chicago are also students. university of chicago hospitals v. united states, 545 f.3d 564 (7th cir. 9/23/08). the court affirmed the district court’s denial of the government’s motion for summary judgment based on the government argument that medical residents are per se ineligible for the student exemption from employment taxes under § 3121(b)(10). the court indicates that a case-bycase analysis is required to determine whether medical residents qualify for the statutory exemption. (e) and ditto for medical residents in detroit. united states v. detroit medical center, 557 f.3d 412 (6th cir. 2/26/09). reversing the district court’s summary judgment, the sixth circuit joins the lineup holding that medical residents at the seven detroit area hospitals operated by the detroit medical center in a joint program with wayne state university, which provides graduate medical education, may be students entitled to exemption from employment taxes under § 3121(b)(10). the court remanded the case for further development of the record regarding the nature of the residents’ relationship to the hospitals and the education program. the court indicated that further development of the record would not preclude deciding the matter on summary judgment. the sixth circuit also affirmed summary judgment that the stipends paid to medical residents were not scholarships or fellowships excludible from income under § 117. the court found both that the stipends were received in exchange for services and that the medical residents were not candidates for a degree as required for exclusion under the terms of § 117. (f) and ditto again for sloan-kettering. united states v. memorial sloan-kettering cancer center, 563 f.3d 19 (2d cir. 3/25/09). following similar decisions in the sixth, seventh, eighth, and eleventh circuits, the second circuit court of appeal reversed summary judgment for the united states holding that the district courts for the northern and southern districts of new york erred in holding as a matter of law that medical residents at the albany medical center and the hospitals of the memorial sloan-kettering cancer center were not eligible for exclusion from employment taxes under § 3121(b)(10). the cases were remanded to the trial courts for factual determinations whether the residents were students and whether the hospitals were schools. 257 florida tax review [vol. 10:si (g) but the tide turns for the mayo clinic. mayo foundation for medical education and research v. united states, 568 f.3d 675 (8th cir. 6/12/09). for purposes of the student exclusion from fica taxes under § 3121(b)(10), reg. § 31.3121(b)(10)-2(c) and (d), limit the definition of a school, college, or university to entities whose “primary function is the presentation of formal instruction.” reg. § 31.3121(b)(10)2(d) provides that to qualify as a “student” rather than be classified as an employee, any services rendered must be “incident to and for the purpose of pursuing a course of study” at the institution for which the student provides the services. furthermore, under the regulation, a person whose work schedule is 40 hours or more per week is a full-time employee rather than a student. the district court, in granting refunds of employment taxes, declared the regulation invalid. applying the deference standard of chevron u.s.a. inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), the eighth circuit reversed and remanded the case for entry of judgment for the united states. the court concluded that application of the exemption only to students pursuing a course of study who are not full time employees is a reasonable interpretation of the statute. the court declined to consider whether the portion of the regulation limiting the definition of a school or college is valid because the medical residents were not students under the regulation in any event. 2. ten ways to be a contractor – estate rebuffed in its attempt to collect damages and indemnification on its claim that decedent was an employee of multiple employers rather than an independent contractor. estate of suskovich v. anthem health plans of virginia, inc. 553 f.3d 559 (7th cir. 1/22/09). the decedent worked as a computer programmer for wellpoint, a health insurance company and trasys, an information technology company. the decedent’s estate claimed damages from the companies for failure to treat the decedent as an employee and provide certain employee benefits, and claimed indemnification for employment taxes paid directly by the decedent. the court upheld the district court’s finding that the decedent was an independent contractor based on the district court’s application of the ten factor test for employment status of the restatement (second) of agency. the court concluded, “[i]n fact, overwhelming evidence suggests that he considered himself an independent contractor, filed his tax returns as an independent contractor, and was compensated like an independent contractor. accordingly, the district court properly awarded summary judgment to wellpoint and trasys on this issue.” 3. the tax court follows the sixth and second circuits to hold that pre-2009 employment tax liability of a disregarded llc must be paid by the sole-member. medical practice solutions, llc 2010] recent developments in federal income taxation 258 v. commissioner, 132 t.c. no. 7 (3/31/09). following the decisions in littriello v. united states, 484 f.3d 372 (6th cir. 2007), and mcnamee v. dept. of the treasury, 488 f.3d 100 (2d cir. 2007), both of which upheld the validity of the “check-the-box” regulations in the same context, applying chevron u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), the tax court (judge cohen), held that the check-the-box regulations treating a single member entity that does not elect to be treated as a corporation as a disregarded entity, reg. § 301.7701-3(b), are valid and as a result the sole member of a disregarded limited liability company is responsible for the llc’s unpaid employment taxes. after 1/1/09, under reg. § 301.7701-2(c)(2)(iv), a disregarded entity is treated as a corporation for purposes of employment tax reporting and liability. the court rejected the taxpayer’s argument that the amendment to the regulations, which reverses the prior rule, demonstrates that the prior regulation imposing employment tax liability on the sole-member of the disregarded entity was unreasonable. the court stated that, “in light of the emergence of limited liability companies and their hybrid nature, and the continuing silence of the code on the proper tax treatment of such companies in the decade since the present regulations became effective, we cannot conclude that the above treasury regulations, providing a flexible response to a novel business form, are arbitrary, capricious, or unreasonable.” 4. wage tax relief for reservists. rev. rul. 2009-11, 2009-18 i.r.b. 896 (4/16/09). under § 3401(h), added by the heroes earnings assistance and relief tax act of 2008, differential wages paid to an employee on active duty in the military are treated as wages for purposes of income tax withholding. this revenue ruling explains that these are supplemental wages that are to be added to the employee’s regular wages for the period for purposes of calculating wage withholding. however, differential wages paid to a person providing service to the military for an extended period of time are not wages subject to fica and futa tax. see rev. rul. 69-136, 169-1 c.b. 252. 5. this isn’t a valid “cash method” of accounting. hi-q personnel, inc. v. commissioner, 132 t.c. no. 13 (5/4/09). the taxpayer corporation provided temporary workers for clients for fees related to the work performed. the taxpayer offered the workers a choice between being paid in cash or by check. the taxpayer reported workers paid by check as employees and paid applicable employment taxes. the taxpayer failed to pay employment taxes for workers paid in cash. the taxpayer’s president, luan nguyen, pleaded guilty to federal criminal charges for failing to pay employment taxes on $14,845,019 of wages paid to temporary workers. the court (judge halpern) agreed with the irs that because of its president’s plea agreement in the criminal matter, the taxpayer could not contest its liability 259 florida tax review [vol. 10:si for employment taxes or fraud penalties under the doctrine of issue preclusion or collateral estoppel. the court concluded that the plea agreement was a judgment on the merits with respect to identical issues, and that the corporation’s president and sole shareholder was in privity with it with respect to the obligation to pay employment taxes. the court also concluded mr. nguyen’s guilty plea imputed his fraudulent intent to the corporation for purposes of fraud penalties. 6. both back pay and front pay are subject to withholding. josifovich v. secure computing corp., 104 a.f.t.r. 2d 20095807 (d. n.j. 7/31/09). josifovich entered into a settlement agreement with her former employer for unpaid commission income, violations of the new jersey conscientious employee protection act and the new jersey law against discrimination. the settlement included back pay for prior work and front pay for compensation she would have received after the settlement date. the parties could not agree on whether the payments were subject to wage withholding and sought to resolve the issue in the district court. the court recognized that payments for back wages were subject to wage withholding. the court also concluded that the front pay was based on contract and quasi-contract claims under the new jersey statutes for wages that are thus subject to withholding. the court, which is in the third circuit, did not cite the eighth circuit opinion in newhouse v. mccormick & co., 157 f.3d 582 (8th cir. 1998), which held that front pay is not subject to wage withholding or fica. the court also rejected ms. josifovich’s claim that the damage award in the settlement should be grossed up to account for the withholding taxes. 7. fica in paradise. zhang v. united states, 89 fed. cl. 263 (9/22/09). nonresident aliens, chinese nationals who were temporary contract workers in the commonwealth of the northern mariana islands, were subject to fica taxes. the commonwealth is statutorily connected to guam, which is a u.s. territory, through a covenant that causes the commonwealth to be considered within the u.s. for fica purposes. the court noted that the covenant mandates that, except for fica tax proceeds, income and other tax revenues shall be remitted to the treasury of the commonwealth instead of the u.s. treasury. b. self-employment taxes there were no significant developments regarding this topic during 2009. 2010] recent developments in federal income taxation 260 c. excise taxes 1. refund claims for telephone excise taxes are subject to the three-year statute of limitations of § 6511(a). radioshack corp. v. united states, 566 f.3d 1358 (fed. cir. 5/26/09). radioshack filed a refund action for erroneously collected telephone excise taxes in 1996. the irs stopped collecting the tax in may 2006 and announced in notice 200650, 2006-1 c.b. 1141, that it would accept claims for refund of taxes billed between february 28, 2003, and august 1, 2006, pursuant to claims for refund filed in accord with the notice. the court of appeals affirmed the holding of the federal claims court that the refund action is subject to the three-year statute of limitations of § 6511(a) and the court lacked jurisdiction to consider the refund claims. claims for taxes paid in 2002 are still pending. 2. northstar trekking llc v. united states, 637 f. supp. 2d 676 (d. ak. 5/4/09). the alaska district court (judge sedwick) held that a helicopter glacier tour company that operated alaska glacier tours mostly for tour ship customers did not operate on a regular line and was thus exempt from the air transportation excise tax. 3. telephone excise tax trouble for the government ahead. cohen v. united states, 578 f.3d 1 (d.c. cir. 8/7/09) (2-1). in this telephone excise case, judge janice rogers brown’s majority opinion held that the telephone excise tax challenge litigation violated neither (1) the antiinjunction act, 26 u.s.c. § 7421(a), which provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed,” nor (2) the declaratory judgment act, 28 u.s.c. § 2201(a), which allows for declaratory relief but specifically excludes federal taxes from its reach, because (1) the standalone administrative procedure act, 5 u.s.c. § 702, claim in the instant case is “the anomalous case where the wrongful assessment is not disputed and the litigants do not seek a refund,” and (2) the declaratory judgment act is coextensive with the anti-injunction act (citing circuit precedent). judge brown began her opinion: comic-strip writer bob thaves [creator of frank and ernest (1972)] famously quipped, “a fool and his money are soon parted. it takes creative tax laws for the rest.” in this case it took the internal revenue service’s (“irs” or “the service”) aggressive interpretation of the tax code to part millions of americans with billions of dollars in excise tax collections. even this remarkable feat did not end the irs’s creativity. when it finally conceded defeat on the legal front, the irs got really inventive and developed a 261 florida tax review [vol. 10:si refund scheme under which almost half the funds remained unclaimed. now the irs seeks to avoid judicial review by insisting the notice [notice 2006-50] it issued, acknowledging its error and announcing the refund process, is not a binding rule but only a general policy statement. • judge brown stated that the irs position was “just mean,” and that it “places taxpayers in a virtual house of mirrors.” she continued, “despite the obvious infirmities of [the irs position], the irs still has the chutzpah to chide taxpayers for failing to intuit that neither the agency’s express instructions nor the warning on its forms should be taken seriously.” • judge brown concluded, however, that “[a]ppellant neiland cohen filed his refund claim prematurely and, [we] thus, affirm the district court’s dismissal of his refund claim.” the case was remanded to the district court for its consideration of the merits. • judge kavanaugh dissented, stating that the appellant could simply have followed the procedures of notice 200650. (a) “enough, already!” the irs cries, “uncle.” notice 2006-50, 2006-1 c.b. 1141 (5/26/06), revoking notice 2005-79, 2005-2 c.b. 952. the irs announced that it will stop assessing the § 4251 telephone excise tax on long distance services, and that it will provide for refunds of taxes paid on services billed after 2/28/03 and before 8/1/06. these refunds are to be requested on 2006 federal income tax returns, the right to which will be preserved by the irs scheduling overassessments under § 6407. individuals are eligible to receive a safe harbor amount, which has not yet been determined. interest received on the refunds will have to be reported as 2007 income. 4. the telephone excise tax may involve only oneway communication. irs v. worldcom, inc., 104 a.f.t.r.2d 2009-5881 (s.d. n.y. 8/7/09). worldcom purchased central office based remote access (cobra) services from local exchange carriers in order to receive information across analog dial-up connections and route the communication to its computer servers. reversing the bankruptcy court’s allowance of a refund of the telecommunications excise tax and remanding for further findings, the district court overruled the bankruptcy court’s interpretation of § 4252(a) as requiring capacity for two-way communication in order to impose the telecommunications excise tax. section 4252(a) defines telephone service as “access to a local telephone system, and the privilege of telephonic quality communication with substantially all persons having telephone or radio telephone stations ... .” distinguishing § 4252(b)(2), the court held that 2010] recent developments in federal income taxation 262 the phrase “communication with” does not require communication to and from telephone stations. thus, the essential in-bound nature of communication into the cobra system may fall within the definition of § 4252(a). xii. tax legislation a. enacted 1. arra! or, shall we call it arrgh? the american recovery & reinvestment act of 2009 (“2009 arra”), p.l. 1115, was signed by president obama on 2/17/09. title i of division b of 2009 arra is called the american recovery and reinvestment tax act of 2009; title ii of division b is called assistance for unemployed workers and struggling families. 2. h.r. 3548, the worker, homeownership, and business act of 2009, p.l. 111-92 (“whaba”), was signed by president obama on 11/6/09. 3. h.r. 3326, the 2010 defense appropriations act, p.l. 111-118, which contains the cobra subsidy extension at § 1010, was signed by president obama on 12/19/09. florida tax review volume 12 2012 number 7 a new paradigm for irs guidance: ensuring input and enhancing participation by leslie book i. introduction .............................................. 518 h. irs: more than revenue collection ...................... 531 m. organization of apa concepts and irs rulemaking .......... 535 a. agency rulemaking ................................. 537 b. notice and comment rulemaking versus informal rulemaking in administrative law generally ...... ..... 541 1. legislative rules and apa notice and comment requirements ................................ 542 2. non-legislative rules: interpretive rules and procedural rules..................................... 544 c. irs rulemaking and guidance: the tax-exceptionalism approach? ....................................... 547 d. the impact of tax exceptionalism on public participation .... 551 iv. critique of the foundational apa distinction between "legislative" and "interpretive" regulations applied to the irs ......................................................... 552 v. good guidance requires a better balance between efficiency and participation irrespective of apa classification.......................................555 a. moving beyond current apa classification ....... ....... 555 * professor of law and director, gaduate tax program, villanova university school of law. i am especially grateful for the dedicated research assistance of kristen allen, j.d. candidate, 2012, villanova university school of law. i received helpful comments on an early draft of this article at the 2011 critical tax conference at the university of santa clara school of law, as well as helpful comments regarding the taxpayer advocate service at a presentation on the role of taxpayer ombuds' offices at the albany law school in october of 2010. 1 am also appreciative of the comments and suggestions of bryan camp, keith fogg, dick harvey, nina olson, eric san juan and carlton smith. special thanks to bernard audet for reviewing and providing extensive comments on a later draft. i am grateful to villanova university school of law for its financial support of my research. i dedicate the article to valinda garcia latoff, equal part inspiration and distraction. 517 518 florida tax review [vol. 12:7 b. applying the insight ofprofessors mantel and johnson to the irs.. .................................... 559 c. how the taxpayer advocate service and clinics can help ensure that lower income taxpayers' interests are served in the rulemaking process .............. ..... 566 1. tas..................... .............. 570 a. enhancing the role of the taxpayer advocate ................. 573 b. subregulatory input from tas.......................576 2. clinics ........................... ...... 577 vi. conclusion ............................................. 583 i. introduction cathy is a financially unsophisticated homemaker whose husband engaged in medicare fraud in 1999, for which he was imprisoned the following year.1 cathy had no involvement in the family's financial dealings, legal or otherwise, and was completely unaware of her husband's fraud. as a result of the medicare fraud, the couple owed an additional $900,000 in income taxes for the 1999 taxable year, which the irs attempted to collect from cathy and her husband in 2003.2 in the collections packet issued to cathy, the irs informed her of the availability of "innocent spouse" relief, whereby a spouse may be relieved from joint and several liability when the spouse meets certain requirements.3 cathy, however, declined to elect 1. these introductory facts are based on the events of lantz v. commissioner, 607 f.3d 479, 480-81 (7th cir. 2010). 2. income earned from illegal activities is taxable to the same extent as legally derived income. see, e.g., james v. united states, 366 u.s. 213, 219-20 (1961) (finding income earned from embezzlement activities to be taxable). when two spouses file a joint federal income tax return, the spouses are jointly and severally liable for the amount of the tax, interest, and penalties due in exchange for the privilege of generally favorable rates. see i.r.c. § 6013(d)(3). 3. see i.r.c. § 6015(b) (outlining the elements of an innocent spouse claim). section 6015(b) and (c) provides opportunities for individuals to avoid joint and several liability if detailed requirements are satisfied. section 6015(f) provides an opportunity for relief to individuals who fail to satisfy either the (b) or (c) requirements if "[u]nder procedures prescribed by the secretary, if (1) taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax" or additional liability. while there had been some form of relief from joint and several liability since 1971, in 1998, congress made substantial changes to the so-called innocent spouse regime, including the adoption of equitable relief under section 6015(f). see bryan t. camp, the unhappy marriage oflaw and paradigm for irs guidance innocent spouse relief because her incarcerated husband assured her that he would handle the matter. cathy's husband died without having completed the necessary paperwork, and in 2006 the irs resumed collection activities against cathy. cathy then claimed innocent spouse protection, but a treasury regulation imposed a two-year deadline on such claims, and the irs denied her relief.4 generally, the administrative procedure act (apa) requires that treasury regulations such as the two-year rule be promulgated pursuant to an elaborate notice-and-comment regime, designed to involve the public in the issuance of agency rules binding on the public, thus preserving an element of democracy and accountability for rules that are otherwise issued by unelected treasury officials.sthe case of cathy, and of many contemporaneous cases, specifically dealt with the irs's adoption of the two-year restriction on filing (two-year rule) for equitable innocent spouse relief where the applicable internal revenue code subsection, 6015(f), otherwise did not provide a deadline. the irs's rule, originally announced in the context of a notice,' adopted shortly thereafter in a revenue procedure,8 and eventually promulgated in proposed and final regulations, 0 generated equity in joint return liability, 108 tax notes 1307 (sept. 12, 2005) (reviewing the history and purpose of joint and several liability for married couples). 4. see lantz, 607 f.3d at 481 (discussing the effect of regulation on the taxpayer's claim). 5. see 5 u.s.c. § 553(b), (c) (discussing the requirements for issuance of notice and acceptance of public comments in administrative rulemaking); kristin e. hickman, a problem of remedy: responding to treasury's (lack of) compliance with administrative procedure act rulemaking requirements, 76 geo. wash. l. rev. 1153, 1160 (2008) [hereinafter hickman, a problem of remedy] (noting that agency rules carry the binding force of law and discussing the procedure and policy behind their implementation). 6. reg. § 1.6015-5(b)(1) [hereinafter two-year rule] (imposing a two-year time limit on section 6015(f) relief from joint and several liability). after the imposition of the new limitation, courts struggled to apply the restriction, resulting in the tax court invaliding the rule and several circuit courts of appeal reversing. see hall v. commissioner, 135 t.c. 374, 374 (2010) (holding the time period invalid); mannella v. commissioner, 132 t.c. 196, 196 (2009) (holding the time period invalid), rev'd, 631 f.3d 115, 116 (3d cir. 2011) (holding the time period valid); lantz v. commissioner, 132 t.c. 131, 131 (2009) (holding the time period invalid), rev 'd, 607 f.3d 479, 487 (7th cir. 2010) (holding the time period valid); coulter v. commissioner, t.c. docket no. 1003-09, appeal docketed no. 10-680 (2d cir.). 7. see notice 98-61, 1998-2 c.b. 758. 8. see rev. proc. 2000-15, 2000-1 c.b. 447, superseded by rev. proc. 2003-61, 2003-2 c.b. 296. 9. see relief from joint and several liability, 66 fed. reg. 3888 (proposed jan. 17, 2001) (to be codified at 26 c.f.r. pt. 1). 10. see t.d. 9003, 2002-2 c.b. 294. 2012] 519 florida tax review no formal public comment and no discernible attention outside of the irs in other words, the public did not meaningfully participate at all in its formulation or issuance." considering cathy's case and others like it, this lack of public participation should not surprise anyone. after all, code section 6015, the innocent spouse statute, by its terms was designed to protect spouses who were not involved in the family's financial affairs such spouses would presumably have no awareness of treasury rulemaking activities or incentive to participate in them.12 in cathy's case and many others, the incentive to participate arose only after the deadline to claim innocent spouse relief had passed. while interested parties and taxpayers failed to submit comments on the two-year rule before its adoption, significant controversy erupted after the fact. the tax court concluded that the regulation adopting the two-year rule was invalid,13 two circuit courts of appeal held to the contrary, 14 and commentators criticized the legal analysis of the various opinions." because the two-year rule in practice often prevented abused ex-spouses from having the irs or courts consider their case on the merits, the regulation led to a firestorm of controversy when the public finally became involved.16 11. in announcing the proposed rule (as well as other rules relating to requests for relief) in regulatory form, the treasury took the view that the regulations were exempt from the administrative procedure act and not subject to the noticeand-comment regime that accompanies the issuance of agency legislative rules. see id. in the preamble that accompanied the final regulations, irs noted that it had requested comments from the public in its subregulatory guidance and offered the public the opportunity to comment again with its promulgation of proposed regulations. id. 12. see i.r.c. § 6015(b)(1)(c) ("the other individual filing the joint return establishes that in signing the return he or she did not know, and had no reason to know, that there was such understatement") (emphasis added). 13. lantz v. commissioner, 132 t.c. 131, 131 (2009) (holding the time period invalid) rev'd, 607 f.3d 479 (7th cir. 2010). 14. lantz v. commissioner, 607 f.3d 479, 487 (7th cir. 2010) (holding the time period valid); mannella v. commissioner, 631 f.3d 115, 116 (3d cir. 2011) (holding the time period valid). 15. see, e.g., scott a. schumacher, innocent spouse, administrative process: time for reform, 130 tax notes 113 (jan. 3, 2011) [hereinafter schumacher, time for reform]; patrick j. smith, gaps in the seventh circuit's reasoning in lantz, 128 tax notes 1375 (sept. 27, 2010). 16. some have suggested that the statute and legislative history suggest a legislative decision to not include a two-year rule, though the circuit courts that have concluded differently suggest that the legal issue is at a minimum far from straightforward. cf nat'l taxpayer advoc., 2010 ann. rep. to congress vol.2, 3-4 (2010) [hereinafter nta 2010 ann. rep.] (asserting that after listening to testimony from innocent spouses describing cases where relief would be denied, congress did not include a time restriction in section 6015(f)). 520 [vol. 12:7 paradigm for irs guidance in contrast, the case of the regulations governing the reporting of uncertain tax positions ("utp" regulations), promulgated at roughly the same time as the two-year rule, presents an example of the triumph of the public participation ideal in administrative rulemaking." at a 2010 american bar association tax section meeting in toronto, irs commissioner douglas shulman announced the release of the long awaited schedule utp.18 the irs previously released a draft schedule utp and solicited feedback and comments.19 the final version of the schedule, incorporating the many comments received, underwent liberalizing changes and now requires certain corporations to disclose uncertain tax positions to the irs on their corporate tax returns. 20 the proposal, radical in that it triggered an affirmative tax disclosure tethered to a corporation's reserve for financial accounting purposes, generated a significant amount of concern and public comment in the corporate tax community. 2 1 as soon as the 17. see generally reg. § 1.6012-2(a)(4) (requiring attachment of schedule utp to corporate returns to disclose uncertain tax positions). 18. shulman announces release of final utp reporting schedule and instructions and guidance, 2010 tnt 186-30 (sept. 27, 2010) (tax analysts). for tax years starting in 2010, schedule utp, or uncertain tax position statement, requires certain corporate taxpayers to report uncertain tax positions on their tax returns. 19. see announcement 2010-9, 2010-7 i.r.b. 408; announcement 201017, 2010-13 i.r.b. 515; announcement 2010-30, 2010-19 .r.b. 668; announcement 2010-75, 2010-41 i.r.b. 428. the notice of proposed rulemaking was published later that year. see requirement of a statement disclosing uncertain tax positions, 75 fed. reg. 54,802 (proposed sept. 9, 2010) (to be codified at 26 c.f.r. pt. 1). the irs considered and responded to comments in each solicitation, incorporating an explanation and summary of comments in its final rule. see t.d. 9510, 2011-6 i.r.b. 453 (announcing the final rule). 20. see t.d. 9510, 2011-6 i.r.b. 453 (announcing the final rule). 21. prior to schedule utp, corporations had incentives not to make the irs aware of positions that, at the time, the irs may have challenged by an audit if they were detected. because schedule utp requires all uncertain positions to be stated, significant controversy surrounded its adoption. see, e.g., j. richard harvey, jr., schedule utp: an insider's summary of the background, key concepts, and major issues, 9 depaul bus. & com. l.j. 349 (2011). the irs has taken the position that it has authority to require the completion and filing of the form under a general grant of legislative authority pursuant to sections 7805(a), 6111, and 6112 of the internal revenue code of 1986, as amended. commentators have speculated that the irs's use of regulations, and in particular its claim that it has authority to promulgate under a specific grant pursuant to sections 6111 or 6112 is related to its desire to ensure that its requirement is given greater deference by courts. see jonathan prokup & dustin covello, the schedule utp regulation: is the irs gearing up for battle?, tax blawg (oct. 2, 2011), http://taxblawg.net/2010/09/13/the-schedule-utpregulation-is-the-irs-gearing-up-for-battle/. for a discussion of the degree of deference courts give to regulations and the difference that the tax bar has 2012] 521 florida tax review commissioner's speech revealed the form's final details, and in a manner that reminded me of the equivalent of network reporters parked outside the courtroom awaiting the results of a celebrity trial, high-priced tax lawyers took out their blackberries, droids, and iphones to text and e-mail the details of the revised plan back to their home offices. in the period leading to that event, taxpayers, advisors, and the tax bar as a whole publicly contributed their views in both formal and informal ways to the irs's new program.22 the public engaged in an elaborate give-and-take with the irs and discussed irs positions with highand mid-level irs employees at bar conferences, in the tax press, and in the hallways of the irs itself. although some were disappointed and others pleased with the ultimate guidance issued by the irs,23 the finalized plan to require disclosure of corporations' uncertain tax positions was nonetheless part of a process reflective of public participation, open deliberation, and forthright agency explanation.2 4 traditionally assigned to regulations promulgated under a general grant of authority under section 7805(a) as contrasted with regulations specifically authorized by a particular section within the tax code, see leandra lederman, the fight over "fighting regs" and judicial deference in tax litigation (unpublished manuscript) at http://works.bepress.com/leandra lederman/1/ [hereinafter lederman, the fight over "fighting regs "]; michael asimow, public participation in the adoption of temporary tax regulations, 44 tax law. 343 (1991) [hereinafter asimow, public participation]. 22. for examples of comments submitted to the irs, see jeremiah coder, commenters ask irs to abandon utp reporting proposal, change schedule, 2010 tnt 106-1 (june 3, 2010) (tax analysts); george m. gerachis & christine l. vaughn, attorneys suggest changes to utp reporting proposal, 2010 tnt 111-26 (june 1, 2010) (tax analysts); ernst & young llp, ernst & young voices concerns with utp reporting proposal, 2010 tnt 111-30 (june 1, 2010) (tax analysts); 23. see, e.g., announcement 2010-9, 2010-7 i.r.b. 408 (explaining that the schedule will increase irs efficiency); adam m. braun, note, open reserveations?: united states v. textron inc. and its application to international tax accounting, 86 notre dame l. rev. 823 (2011) (explaining possible global competitive issues stemming from discoverability of utp); bruce d. pingree et al., discovery and privilege issues arising for tax and benefits attorneys, 831 practing l. inst. & admin. prac. series litig 591, 659 (2010) (detailing concern that utp disclosure may be considered a waiver of attorney/client and work product privileges). a few commentators have supported the utp proposal. see, e.g., j. richard harvey jr., schedule utp: views of a former tax adviser and administrator, 128 tax notes 1259 (sept. 20, 2010) (asserting that schedule utp is both necessary and reasonable); kip dellinger, the sky is falling! comments on the utp proposals, 127 tax notes 1495 (june 28, 2010) (contending that criticisms of the irs utp proposals are exaggerated). 24. the tax community noted the give-and-take in the process leading to the adoption of the utp requirements. see irs releases final schedule utp, [vol. 12:7522 paradigm for irs guidance in both announcing the utp regime and initially setting the standards and requirements for equitable relief through the two-year rule, the irs and the treasury sought comments but did not explicitly use the noticeand-comment procedure generally applicable to federal agencies adopting rules with legal effect. 25 as i discuss below, even for regulatory guidance, the irs and the treasury, while generally seeking public input, often take the position that many of their regulations are exempt from the apa notice-andcomment regime. 26 in addition, much of what the irs issues in the form of guidance is subregulatory a variety of notices, announcements, rulings, forms, and questions and answers, often referred to in administrative law as informal guidance published in bulletins or on the irs website. 27 for that guidance, there are no absolute external requirements to facilitate participation or public involvement, though at times, as with the two-year incorporates changes, journal of acct., sept. 24, 2010, http://www.journalofaccountancy.com/web/20i03378.htm. 25. it is true, however, that in both instances, eventually the irs sought comments and published proposed regulations in the federal register. 26. see kristin e. hickman, coloring outside the lines: examining treasury's (lack of) compliance with administrative procedure act rulemaking requirements, 82 notre dame l. rev. 1727, 1729 (2007) [hereinafter hickman, coloring outside the lines] (describing the treasury department's assertion of apa exemption). "treasury acknowledges that apa section 553 governs its various regulatory efforts. treasury also contends, however, that most treasury regulations are interpretative in character and thus exempt from the public notice and comment requirements by the apa's own terms." id 27. the internal revenue code delegates authority for promulgating regulations to the secretary of the treasury. i.r.c. § 7805(a). the treasury formally issues regulations interpreting the internal revenue code, and the office of tax policy within the treasury is significantly involved in reviewing and drafting treasury regulations. see treasury directive 18-02, authority to approve internal revenue regulations (sept. 4, 1986). as a practical matter, the office of chief counsel with the irs often initially drafts most treasury regulations. guidance with respect to tax law other than regulations also generally implicates the involvement of both the treasury and the irs, with drafting done by the irs and treasury approval needed before issuance. see treasury order 111-01, issues of tax policy (mar. 16, 1981) (giving the assistant secretary exclusive authorization to make final determinations of treasury department positions with respect to tax policy). accordingly, for the purposes of this article, i refer to the irs and the treasury interchangeably. guidance from the irs takes many forms, including some that carry questionable weight. see donald l. korb, the four rs revisited: regulations, rulings, reliance, and retroactivity in the 21st century: a view from within, 46 duq. l. rev. 323 (2008); [hereinafter korb, the four r's revisited] jeremiah coder, news analysis: how do faq fit into the guidance puzzle?, 131 tax notes 7 (apr. 4, 2011) (describing frequently asked questions (faqs) as informal irs guidance that helps clarify difficult issues and provide instructions in the absence of formal guidance). 2012] 523 florida tax review rule and schedule utp, the irs often seeks input on the rule that is the subject of informal guidance. 28 as the utp regulations have demonstrated, where affected taxpayers, the tax bar, and commentators have sufficient resources and incentive to participate, the irs may refine its position over time by seeking formal apa-compliant public comment or by utilizing other informal 29avenues of public participation. 9 through intensive participation, taxpayers and their advisors working with schedule utp in years to come will likely accept the process as largely legitimate, or at least responsive to public input. in contrast, when irs rules relate to disadvantaged or lower-income taxpayers without the resources of the corporate community, no similar structure exists to encourage meaningful formal or informal participation in rulemaking.30 unlike the nation's largest corporate taxpayers, abused, 28. see u.s.c. § 553(b)(a) (exempting "interpretative rules" and "general statements of policy" from the notice and comment requirements unless otherwise required by statute); cf kristin e. hickman, irb guidance: the no man's land of tax code interpretation, 2009 mich. st. l. rev. (2009) 239, [hereinafter hickman, irb guidance] (asserting that contrary to the irs's position, a large amount of irs guidance does not fall under the interpretative rule exemption). for further discussion of the irs apa exemption, see infra notes 116-40 and accompanying text. the irs's position that its regulatory guidance is exempt from the apa's notice-and-comment regime is controversial, and courts will possibly take the cue of important scholarship suggesting that this view is improper (and at a minimum outside the administrative law norm pushing back at tax exceptionalism). see hickman, coloring outside the lines, supra note 26, at 1807-08. 29. for further discussion of the irs's utp policy, see ilya a. lupin, uncertain tax positions and the new tax policy of disclosure through the schedule utp, 30 va. tax rev. 663 (2011) (examining the consequences and concerns surrounding schedule utp). corporate taxpayers were concerned that the new schedule would increase "compliance costs, unfairly shift [] the balance of power, [] increase possibility of audits ... and undermine [] the protections allowed by attorney-client privilege." id at 664-65. the irs, on the other hand, believed the new schedule would increase transparency, improve compliance, and help identify areas of tax avoidance and evasion. id. at 664. 30. for further scholarship on equitable relief under § 6015(f), see carlton m. smith, innocent spouse: let's bury that "inequitable" revenue procedure, 131 tax notes 1165 (june 13, 2011); schumacher, time for reform, supra note 15; joseph r. goeke, tax court stands by its holding in lantz that equitable innocent spouse relief reg is invalid, 2010 tnt 184-11 (sept. 22, 2010) (tax analysts). when the irs chooses to issue guidance outside the apa's notice-and-comment regime, it also raises questions as to the appropriate deference that courts should give to the irs approach. this article does not consider that question, a question that scholars and practitioners have extensively discussed. see hickman, irb guidance, supra note 28, at 256-57 (detailing irs's use of interpretative guidance and differing standards of deference); kristin e. hickman, the need for mead: rejecting tax exceptionalism in judicial deference, 90 minn. l. rev. 1537, 1546-72 524 [vol. 12:7 paradigm for irs guidance financially dependent spouses, for example, are not monitoring the irs's cumulative bulletin, draft forms, or web page, or sending proxies to bar conferences. moreover, little in the way of institutional leverage operates to ensure that the irs considers these views, even when the irs asks for input on issues that have great effect on lower-income or disadvantaged taxpayers. rulemaking that fails to benefit from the collective wisdom of those whom the agency is regulating can have significant adverse effects.' those decisions may adversely impact individuals resulting in deprivations of property that might not otherwise occur if the irs had the benefit of greater public input, heighten anxiety regarding unpaid liabilities or claimed credits and refunds in dispute, and even perpetuate the very poverty that the provision in question was meant to ameliorate.3 2 the effect is particularized to the individual that is subject to the rules, but also has systemic effects regarding the overall integrity of the tax system and the public's perception of the tax system and government overall.33 for regulated individuals, rules [hereinafter hickman, the need for mead] (examining tax understandings of legislative and interpretive rules); stanley s. surrey, the scope and effect of treasury regulations under the income, estate, and gift taxes, 88 u. pa. l. rev. 556, 557-58 (1940) (identifying tax regulations in general as interpretative and nonbinding on the taxpayer). but see jasper l. cummings, jr., treasury violates the apa?, 117 tax notes 263 (oct. 15, 2007) (disagreeing with hickman's logic). 31. this article is not a detailed cataloguing of rules that the irs has adopted that implicate lower income or disadvantaged taxpayers. of particular concern are rules that relate to taxpayers who owe a liability but are unable to pay due to financial circumstances. while the irs has broad powers to collect taxes on agreed upon liabilities, the irs evaluates ability to pay in light of a taxpayer's reasonable collection potential. reasonable collection potential involves a consideration of equity in nonexempt assets and a monetized present value of the excess of the taxpayer's income over necessary expenses, as set forth in the internal revenue manual and published on the irs web page. see irm 5.8.4.3.1, (june 1, 2010) http://www.irs.gov/irm/part5/irm 05-008-004.html#d0e86. many substantive determinations that the irs makes in the collection process derive from the concept of reasonable collection potential, such as offers in compromise and installment agreements, and irs determinations to not take enforced collection action against delinquent taxpayers. see keith fogg, buying your clunker back from the irs (working paper on file with author) (discussing the irs's adoption of certain aspects of collection standards as outside any mechanism for public input and devoid of meaningful explanation as to why or how the irs decided on certain rules pertaining to administrative collection determinations). 32. nta 2010 ann. rep. supra note 16, at 3 (explaining that the two-year limitation to section 6015(f) forecloses a class of equitable relief the statute was designed to reach). 33. a rich literature exists on the role that procedural justice plays in the people's acceptance of governmental action. e.g., e. allan lind & tom r. tyler, 2012] 525 florida tax review not particularly well-suited to the circumstances of the very people that the irs is regulating can often lead to unfair results, as in cathy's case. for the aggregate regulated population, rules that fail to take into account interests of classes of taxpayers undermine the very social contract that ties individuals to accepting government conduct.34 provisions regulating low-income or disadvantaged taxpayers, such as the earned income tax credit (eitc), are as important, or even more important, to the lives of those regulated parties as the utp provisions are to the nation's corporate taxpayers. these provisions can make the difference between poverty and the ability to pay rent and meet levels of basic sustenance for the disadvantaged taxpayer. as many taxpayers do not have the skills or means to challenge irs actions once rules are set in place, the irs must take care to adopt the right rules at the outset, rather than hope to refine them through public participation over time. unlike well-heeled taxpayers and their advisors who have ready access to the irs in both formal and informal ways, few structural mechanisms exist to ensure that the irs benefits from the public input of taxpayers or experts who can contribute to the irs's understanding of the issues that relate to less-connected taxpayers. 7 it is for those issues and those taxpayers 38 that this paper proposes a modest, but i believe important, new paradigm. the social psychology of procedural justice, (melvin j. lerner ed., 1988); lawrence b. solum, procedural justice, 78 s. cal. l. rev. 181 (2004). 34. see solum, procedural justice, supra note 33, at 183 (indicating that meaningful participation is a prerequisite for legitimate authority). 35. i.r.c. § 32. the earned income tax credit provides taxpayers who have earned income of less than a certain threshold amount, depending on the number of qualifying children, with a refundable credit which reduces their tax liability and may result in substantial refunds in excess of their tax liability. in 2011, the maximum eitc for a taxpayer with three or more qualifying children is $5,751. 36. for a more detailed analysis of eitc importance, see steve holt, the brookings institution, the earned income tax credit at age 30: what we know, (2006) [hereinafter holt, the eitc at age 30] (surveying recent studies addressing the eitc and concluding that, although important work remains to improve its effectiveness, the eitc remains a significant tool for addressing poverty and incentivizing labor). but see anne l. alstott, why the eitc doesn't make work pay, 73 law & contemp. probs. 285 (2010) [hereinafter alstott, eitc doesn't make work pay] (criticizing those who assert the eitc has been effective in reducing poverty, given inadequate measures of poverty and the eitc's limited effect in light of workers who are subject to involuntary work disruption and thus devoid of earned income and potentially unable to claim the eitc). 37. to be sure, professional organizations such as the american bar association section of taxation (aba tax section) and the american institute of certified public accountants do provide meaningful input on issues beyond those associated with business taxpayers or wealthier individual taxpayers. the aba tax section has provided meaningful financial and logistical support for tax clinics, and [vol. 12:7526 paradigm for irs guidance this article argues that the existing regime for formal and informal public participation in administrative rulemaking has failed low-income and disadvantaged taxpayers, and that greater public participation in the irs's rulemaking process with respect to issues relating to low-income or disadvantaged taxpayers will improve the quality of administrative rules that regulate such taxpayers.39 when irs rulemaking activities touch on large or wealthy taxpayers with the time, resources, and incentive to care, the activities typically generate intense public and interest group attention because huge amounts of money are involved; whether or not the irs engages in formal notice-and-comment rulemaking or pursues more informal avenues is largely irrelevant in these cases because well-resourced taxpayers will find a way to make their voices heard.40 while the degree of public attorneys wishing to work on issues pertaining to lower-income taxpayers, through a standing committee and financial support for attorneys working at clinics. see keith fogg, history of tax clinics (working paper on file with author) (discussing the role of the aba tax section and how it promoted clinics at an early stage and has nurtured their development). the proposals i address relating to tax clinics in part iv of this article will facilitate additional involvement in organizations such as the aba tax section by allowing clinicians, who are often forced to prioritize time and resources, to meet funding concerns, a common issue facing legal service providers generally. see marian wang, budget compromise slashes funds for organizations that help poor deal with predatory lending, domestic violence, foreclosures, propublica (may 16, 2011), http://www.altemet.org/story/150959/budget compromise_slashes funds for organizations that help_poor deal with_predatory _lending,_domesticviolenceforeclossures/ (discussing how legal service providers are often unable to satisfy demand due to resource shortfalls). 38. i do not mean to suggest that only low-income taxpayers face barriers to meaningful participation with irs rulemaking. the paradigm i suggest may have applicability to other, less mainstream taxpayers, such as charitable organizations or non-u.s. based entities. .39. at the highest levels of the obama administration, there is an emphasis on enticing greater participation in agency rulemaking. see benjamin wallacewells, cass sunstein wants to nudge us, n.y. times, may 13, 2010, http:www.nytimes.com/2010/05/16/magazine/i 6sunstein-t.html?pagewanted=all [hereinafter wallace-wells, sunstein, cass sunstein] (examining sunstein's agency directive to improve public participation in the rulemaking process). "'hardly anyone would isolate section 553 of the administrative procedure act' the law that governs the public notice-and-comment period for most federal rules 'as the greatest invention of modern government, . .. [blut i see it as having potential."' id. 40. see, for example, the process surrounding the irs's review of its decision to improve oversight of unlicensed tax return preparers generated intense public and interest group involvement, in part due to the large commercial interests associated with the return-preparer industry, a multi-billiondollar industry. see return preparer review pub. 4832 (rev. 12-2009). the irs began a comprehensive review of its strategy regarding return preparers resulting in identification, education, and competency requirements, stemming in part from criticism of high error rates on 2012] 527 florida tax review participation and agency ex ante consideration of an issue should of course vary depending upon a number of factors (such as impact on the agency and the taxpayers), 41 the limited incentive and lack of resources that lowerincome and disadvantaged taxpayers42 have in ex ante participation warrants a special degree of agency attention to issues that will affect those communities that goes beyond the currently available avenues of public participation in tax rulemaking. further, ex post challenges to tax regulations in court are unlikely to offer an effective remedy for low-income disadvantaged taxpayers due to the expense of litigation and the inherent procedural impediments to suits challenging revenue collection rules.43 commercially-prepared returns and lack of irs oversight of return preparers. see u.s. gov't accountability office, gao-08-38, tax administration: 2007 filing season continues trend of improvement, but opportunities to reduce costs and increase tax compliance should be evaluated 18 (2007) (noting that the irs has not collected information on preparers); treasury inspector gen. for tax admin., 2008-30-147, while documentation was not available to fully assess the return preparer program, identification and processing of preparer penalties can be improved (2008), http://www.treasury.gov/tigta/auditreports/2008reports/200830147 oa_ highlights.pdf (asserting that the irs has failed to investigate suspected preparer penalties in accordance with irs guidelines). announced initially in testimony before the house ways & means oversight subcommittee, irs commissioner doug shulman began the first review through fact-finding and input from interested parties, which included "open meetings" with preparers, consumer advocates, and other interested parties. return preparer review pub. 4832 at 42. the national taxpayer advocate was an early and forceful champion of additional oversight, especially in light of the impact that commercial preparers have had on the lowincome-taxpayer community. see nat'l taxpayer advoc.: fy 2002 ann. rep. to congress 216-30 (2002); nat'l taxpayer advoc: 2003 ann. rep. to congress, at 270-301 (2003); nat'l taxpayer advoc.: 2004 ann. rep. to congress 67-88 (2004). 41. for a more detailed discussion of those factors, see infra note 179 and accompanying text. 42. for purposes of this article i do not adopt a strict definition of lowerincome or disadvantaged taxpayer. see generally i.r.c. § 7526 (defining lowincome by reference to 250% of federal poverty guidelines). there is significant controversy regarding appropriate measuring of poverty in the united states. see alstott, eitc doesn't make work pay, supra note 36, at 292 (criticizing the current u.s. official poverty methodology as an inadequate measure). as professor alstott and others have noted, it is based on an approach from the 1960s that reflected americans as spending approximately one-third of their income on food, with the poverty standard then calculated based upon food costs times three. while these figures are updated annually for inflation, they do not reflect the overall rise in american standard of living and fail to reflect current needs of families. id. 43. for a thorough discussion of the difficulties and disincentives to challenge treasury regulations in court, see hickman, aproblem of remedy, supra [vol. 12:7528 paradigm for irs guidance the article builds on scholars who have considered the role that proxies can play to help address pluralistic imbalances and considers the possible role that two key institutional actors, the taxpayer advocate service (tas) and low income taxpayer clinics (litcs), can play in the irs's rulemaking function. in particular, i call for greater formal and informal mechanisms to ensure that the tas and tax clinics contribute both formally and informally to the irs's rulemaking process. i propose that tas have a more robust role in the formation of guidance through a statutorily-created counsel that would have broad authority to participate in the development and promulgation of irs guidance and specific authority and to submit comments within the notice-and-comment procedure. that role would be backstopped by enhanced tas reporting obligations to congress, which would include informing congress of tas's role in specific projects and explaining the outcome of the progress on particular provisions. in addition, i call for a legislative change to the statutory provision authorizing federally funded litcs. specifically, the statute should define a qualifying clinic activity to include the submission of comments to the irs relating to issues that are germane to the representation of the clinic's clients who have controversies with the irs. not only will a legislative change show congressional recognition of the role of clinics in the rulemaking process, it will further the likelihood that a clinic's submission of comments will contribute to federal funding, especially given the reality that legal service organizations generally and clinic directors and employees have limited resources. importantly, clinic directors may currently view activities such as commenting on rules as potentially harming their chances of funding given that the time needed to comment carries opportunity costs and may currently be viewed as interfering with the clinic's core representational or educational mission. this article highlights how, in light of the increasing role that the irs plays in the lives of individuals with fewer resources, the irs will increasingly have to go beyond the mechanism of formal apa notice and comment, a mechanism that the irs has not consistently used, and one which the irs has claimed does not apply as a legal matter to much of its note 5, at 1154-57 (discussing the general lack of knowledge among practitioners of administrative law principles and unique administrative burdens placed on litigants seeking judicial review in refund or deficiency suits). for example, the antiinjunction act forbids any suit seeking an injunction to restrain the assessment or collection of taxes in effect, it forces litigants to seek redress through refund or deficiency suits. see i.r.c. § 7421(a). similarly, the declaratory judgment act prohibits courts from providing declaratory relief for issues "with respect to federal taxes." 28 u.s.c. § 2201(a). but see cohen v. united states, 650 f.3d 717, 736 (d.c. cir. 2011) (allowing a taxpayer's challenge to the irs's specialized telephone excise tax refund procedure on grounds that the suit did not challenge tax, assessment of tax, or collection of tax). 2012] 529 florida tax review rulemaking functions at any rate. part ii of this article briefly introduces the context in which the irs conducts its rulemaking activities. part iii discusses the apa notice-and-comment regime generally, and more specifically focuses on the treasury and the irs's rulemaking practices. while other scholars have taken direct aim at the shaky legal pedigree of the irs's "taxexceptional" approach to the notice-and-comment regime,44 commentators generally have overlooked the problems associated with lower-income taxpayers' lack of voice in the rulemaking process. to remedy that shortfall, in part iv of this article, i call for changes in agency conduct to encourage public participation in formulating rules. finally, in part v, i build upon a model proposed by administrative law scholars who have suggested legislative reform to the apa and in agency practice to place greater responsibility on administrative agencies to gather input from regulated parties.45 i argue that the irs, when confronted with the need to formulate rules that are likely to impact the lives of disadvantaged or low-income taxpayers, should, to the extent feasible, affirmatively seek out the input of taxpayers, consumer groups, and other experts that would allow the irs to harness the collective wisdom of its increasingly diverse constituency. i suggest broader agency initiatives in seeking views of those regulated, including the use of social networks, and outreach to nontraditional groups affected by irs actions. in addition, i argue for a greater willingness of the irs to put its rules through traditional apa notice-and-comment rulemaking. when its guidance relates to disadvantaged or lower-income taxpayers, however, barriers exist that limit or prevent meaningful involvement, making traditional notice-and-comment rulemaking insufficient. i therefore argue that the irs should foster a collaborative 44. to be sure, long-standing and persuasive arguments exist to treat administrative law differently as it applies to the treasury and the irs, given the overwhelming importance of revenue collection to the overall functioning of an effective government. see, e.g., paul l. caron, tax myopia, or mamas don't let your babies grow up to be tax lawyers, 13 va. tax rev. 517, 53 1-33 (1994) [hereinafter caron, tax myopia] (discussing reasons for differential treatment of tax law as compared to administrative law generally); hickman, the need for mead, supra note 30, at 1541 (discussing arguments in favor of tax exceptionalism). considering the increasing attention given to administrative law concepts in the tax realm, however, the burden is likely to fall on proponents of the exceptionalist argument to demonstrate that the treasury and the irs should remain excepted from general administrative concepts. 45. see stephen m. johnson, good guidance, good griefi, 72 mo. l. rev. 695 (2007) [hereinafter johnson, good guidance] (proposing an amendment to the apa in order to incentivize greater public participation in agency rulemaking). [vol. 12:7530 paradigm for irs guidance relationship between itself and those whom it regulates,46 especially those who may be at the margins of society. h. irs: more than revenue collection this article proceeds with an awareness that the irs is an agency that is central to the federal government. revenue collection is the principal goal of the irs, and policies that impede or dilute the ability to perform that function carry grave risks to society as a whole.4 7 the irs mission statement does not specifically consider the irs's role as a provider of benefits. 48 in addition to bringing in $2.3 trillion in revenues, 49 the irs faces many challenges and delivers a wide range of benefits that have little to do with its core function of collecting taxes.o under increasing pressure to deliver a 46. the collaborative approach in rulemaking may also encourage greater cooperation and compliance generally. scholars have increasingly considered that governments and agencies in particular can promote compliance through a more robust engagement with regulates, rather than relying solely on command and control and sanction-based policies. see valerie braithwaite, responsive regulation and taxation: introduction, 29 law & pol'y 3, 4 (2007) (responsive regulation sets forth a regulatory pyramid with a "series of options that a tax authority might use to win compliance, sequenced from the least intrusive at the bottom to the most intrusive at the top."); ian ayers & john braithwaite, responsive regulation: transcending the deregulation debate (1992) (defining responsive regulation as an idea that regulators must respond to the conduct they seek to regulate); leslie book, refund anticipation loans and the tax gap, 20 stan. l. & pol'y rev, 85, 111 (2009) (considering responsive regulation with respect to its potential benefits for irs tax compliance). 47. see michael lewis, beware of greeks bearing bonds, vanity fair, oct. 1. 2010, http://www.vanityfair.com/business/features/2010/10/greeks-bearingbonds-201010 (discussing the greek financial crisis and the role of taxes, tax compliance norms, and the civic crisis). the lack of a tax compliance norm in greece is a major factor in the fiscal and social crisis. one greek tax collector interviewed by lewis stated "'it's become a cultural trait,' . . . '[t]he greek people never learned to pay their taxes. and they never did because no one is punished. no one has ever been punished. it's a cavalier offense like a gentleman not opening a door for a lady."' id. lewis further explained that not only would enforcing tax compliance be arbitrary due to the overwhelming number of people who don't file, but the average tax case takes about fifteen years to resolve in greek courts. id. 48. the irs's mission is to"[p]rovide america's taxpayers top quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all." see irm 1.2.10.1.1 (dec. 18, 1993), http://www.irs.gov/irm/partl /irm 01-002-01 0.html. 49. revenue collected during the 2010 fiscal year. irs data book, 2010 1 (2010). 50. for an outstanding overview of the challenges facing tax administration, see former irs commissioner lawrence b. gibbs, 2008 erwin l. griswold lecture 5312012] florida tax review myriad of social benefits, 1 respond to late-changing legislation, 52 and shrink the tax gap, the irs like other federal agencies suffers from many of the same tensions endemic in administrative law generally balancing efficiency on one hand with participation, transparency and accountability on the other.54 despite these and other pressures on the irs, congress has increasingly called on the agency to have key roles in non-revenue raising functions associated with home ownership, health care, education, work incentives, and reducing poverty.55 in addition, congress has instituted more before the american college of tax counsel: constancy and change in our federal tax system, 61 tax law. 673 (2008) (predicting the challenges to include operating a technologically outdated filing system, increasing non-compliance, obtaining sufficient appropriations to cover operating costs, and potential conflicts between the irs's need for tax information and taxpayers' rights, among others). 51. the explosion of the use of refundable credits is generating greater academic and policy attention. see nta 2010 ann. rep. vol. 2, supra note 16, at 103 (identifying legal complexity as "a most serious problem of tax administration, particularly with respect to social benefits delivered through the tax law"). "social benefit programs in particular and tax complexity in general arise in large part from tax expenditures, or government spending structured through the revenue system." id. at 104. see also lily batchelder & eric toder, government spending undercover: spending programs administered by the irs, center for american progress 2 (2010), http://www.urban.org/uploadpdf/1001365 undercoverspending.pdf [hereinafter batchelder & toder, government spending undercover] (attributing the relative lack of attention to these programs to their absence from the annual appropriation process and their surface similarity to tax cuts in that they are often accomplished through rebates that reduce tax liabilities); lily l. batchelder, fred t. goldberg, jr. & peter r. orszag, efficiency and tax incentives: the case for refundable tax credits, 59 stan. l. rev. 23 (2006) (arguing from an efficiency perspective that the use of refundable credits is often preferable to other forms of tax expenditures). 52. the estate tax expired in 2009 and was reinstated late in 2010, allowing estates, including those of several billionaires, to go untaxed. see paul sullivan, estate tax will return next year, but few will pay it, n y. times, dec. 17, 2010, http://www.nytimes.com/2010/12/18/your-money/taxes/ i 8wealth.html. the reinstatement put pressure on the irs and executors to implement late-developing statutory changes. 53. see hearing on "bridging the tax gap" before the comm. on finance us. s., 108th cong. (2004) (statement of nicholas p. codic, commissioner for patents). 54. see kristin e. hickman, the promise and the reality of u.s. tax administration, 8-9 minnesota legal studies research paper no. 10-60, 2010, http://ssm.com/abstract-1657060. 55. in light of the charging irs responsibility, the nta proposes the irs mission statement to reflect the irs's role as both revenue collector and social [vol. 12:7532 paradigm for irs guidance formalized procedural protections relating to taxpayers who unquestionably owe a fixed liability to the irs but who are either unable or unwilling to pay those liabilities. those procedural protections, as a general rule, require the irs to consider the individual circumstances of each taxpayer and create and apply rules and standards to allow certain individuals to enjoy relief from the irs's unique powers as a creditor. 7 increasing the responsibilities of the irs relative to non-revenue raising functions, such as administering the earned income tax credit and determining whether individual circumstances warrant relief from liability or alternatives to enforced collection, at a minimum complicates the irs's job. some say it dilutes the irs's mission and jeopardizes the health of the revenue collection system overall.s given the benefit provider. see nat'l taxpayer advoc., 2010 ann. rep. to congress vol. 1, 21 [hereinafter nta 2010 ann. rep. vol. 1]. 56. under the restructuring and reform act of 1998, congress made significant changes to collection methods for those unable to pay their tax liability. see s. rep. no. 105-174, at 67-94 (1998) (establishing new formal procedures for ensuring taxpayer due process in irs collection actions, including the ability to raise collection alternatives posting of bond, substitution of other assets, installment agreements, or offers in compromise); 144 cong. rec. s7717-04, s7719 (prohibiting the irs from rejecting a taxpayer's offer in compromise based upon doubt as to taxpayer liability). 57. irs procedural protections create a tension between discretion and efficiency. one example is the irs automated lien filing practice, which is based on a threshold amount of unpaid liability, rather than on a case-by-case basis. although this may be efficient, critics have asserted that the corresponding financial harm created by the process is significantly more harmful to taxpayers, and, in many instances, results in the irs being unable to collect at all. see michael beller, taxpayer advocate report highlights needfor lien reform, 2011 tnt 126-5 (june 30, 2011) (tax analysts). professor keith fogg argues that the greater push for efficiency and cost-cutting in the filing of low dollar liens has removed avenues for low-income taxpayers' unique circumstances to be heard and has led to the irs wasting resources in filing liens that are unlikely to yield sufficient funds to recoup the costs of the lien filing, much less recover the amount of tax owed. t. keith fogg, systemic problems with low-dollar lien filing, 133 tax notes 88 (oct. 2, 2011). professor fogg proposes that the irs should base its lien filing regime on factors such as real estate equity and taxpayer cooperation, rather than automatic minimum thresholds in amount of tax owed, in order to reduce the administrative burden on the irs and increase the amount of delinquent taxes collected. id. 58. see nta 2010 ann. rep. vol. 1, supra note 56, at 15 (calling for a broadening of the irs's mission to include its roles as both revenue collection agent and benefit administrator). but see jeremiah coder, news analysis: the new irs: expanding the mission?, 128 tax notes 575, (aug. 9, 2010) (quoting former commissioner mortimer caplin's comment that expanding the mission statement of the irs beyond its tax collecting role "goes overboard"). caplin contends that olsen's call for a -new mission statement, although reflective of the irs's current 2012] 533 florida tax review monumental tasks the irs has before it, there should be little surprise that the agency itself, as with many other agencies, often emphasizes efficiency at the expense of participation and genuine accountability in the way it conducts its core rulemaking and adjudicatory functions. 9 while there has been significant academic interest with respect to the effect of the irs's efforts at increasing tax efficiency when it makes individual determinations60 and the lack of compliance with the apa's notice-and-comment regime,6 there has been little attention given to the impact of agency procedure on lower-income individuals. 62 this article is an invitation for policy makers and scholars to consider the importance of participatory values and democratic responsiveness in the context of irs role, pushes the irs in unrelated directions. id. he states, "i'm a critic of new chores continuously imposed on the irs to police social and economic policies." id. 59. see leslie book, the collection due process rights: a misstep or a step in the right direction?, 41 hous. l. rev. 1145, 1158 (2004) [hereinafter book, the collection due process] (describing the tension between irs efficiency and collection due process rules). congress and the courts too have emphasized at various times expediency as a rationale for providing extraordinary powers to the irs. see, e.g., bull v. united states, 295 u.s. 247, 259 (1935) (stressing the importance of prompt and certain tax collection); bob jones univ. v. simon, 416 u.s. 725, 736-37 (1974) (identifying protection of the government's ability to collect taxes in a quick and unimpeded manner as an objective of the anti-injunction act). that emphasis on efficiency, flexibility, and agency discretion is largely attributable to a traditional legislative judicial reluctance to interpose procedural impediments on ensuring the free flow of revenues in the government coffers. see nina e. olson, 2010 erwin n. griswold lecture before the american college of tax counsel: taking the bull by its horns: some thoughts on constitutional due process in tax collection, 63 tax law. 227 (2010). 60. see bryan t. camp, theory and practice in tax administration, 29 va. tax rev. 227, 275 (2009) [hereinafter camp, theory and practice] (describing the tas as providing a 'mechanism to pull taxpayers out of the automatic processing regime" used to increase efficiency and centralize return processing); see also shuyi oei, getting more by asking less: the role of stakeholder dynamics in reforming tax law's offer-in-compromise procedure, 160 u. penn. l. rev. (forthcoming 2012). 61. see hickman, coloring outside the lines, supra note 26, at 1732-40. 62. in addition, there has been some scrutiny around whether the irs is the best agency to administer the provision. see batchelder & toder, government spending undercover, supra note 51 (calling for systematic review of irs spending programs); david a. weisbach & jacob nussim, the integration of tax and spending programs, 113 yale l.j. 955, 1001-02, 1023 (2004) (describing the benefits and the drawback of irs administration of the eitc program as opposed to a more specialized agency). weisbach and nussim conclude that integration of the eitc within the tax system makes more sense than the integration of the food stamp program (fsp) into the tax system due to the degree of responsiveness needed to implement the fsp. id at 1024. [vol. 12:7534 paradigm for irs guidance rulemaking. those themes are often considered when scholars examine the legitimacy and efficacy of agencies other than the irs.63 those scholars have noted that the process by which agencies make rules in and of itself, as with the legislative process, can shortchange parties without resources or voice to participate. when agencies have responsibility for provisions that touch those who are poor and marginalized, merely opening up the guidance process, a significant step in and of itself, is likely to be insufficient to generate input and help maintain agency legitimacy in a democratic government.6 before turning to the challenges agencies face when promulgating rules that relate to low-income individuals, the following section examines agency rulemaking in general and irs rulemaking within that broad context. m. organization of apa concepts and irs rulemaking administrative agencies perform two basic functions: adjudication and rulemaking. 65 the apa66 does not clearly distinguish rulemaking and adjudication, though it does define the agency functions in terms of rules and orders, and those two categories are intended to have "distinct procedural consequences." a "rule," under the apa definition, is an "agency statement 63. see nina a. mendelson, rulemaking, democracy, and torrents of email, 79 geo. wash l. rev. 1343, 1343 (2011) [hereinafter mendelson, rulemaking] (explaining how public proposal and public comments incorporated into the rulemaking process increase legitimacy of agency decisions). 64. see id at 1346 (discussing large amounts of comments received through the e-rulemaking process and asserting that agencies too often discount those from lay people); arthur earl bonfield, representation for the poor in federal rulemaking, 67 mich. l. rev. 511, 511-12 (1968-1969) [hereinafter bonfield, representation for the poor] (explaining that economically underprivileged persons who are effected by federal rulemaking often lack the means to assert their interest regardless of opportunity to do so). 65. alan b. morrison, administrative agencies are just like legislatures and courts except when they're not, 59 admin. l. rev. 79, 83-84 (2007) (describing the development of agency functions). 66. administrative procedure act, 60 stat. 237 (1946) (codified as amended in scattered sections of 5 u.s.c.). 67. gordon g. young, judicial review of informal agency action on the fiftieth anniversary of the apa: the alleged demise and actual status of overton park's requirement of judicial review "on the record," 10 admin. l.j. am. u. 179, 184 (1996) ("the apa's differentiation between adjudicative and legislative [rulemaking] action has proved intelligible only by means of reading common sense and constitutional tradition into the statute."). in essence, the rulemaking role that administrative agencies play is similar to that played by legislative bodies: they promulgate rules, procedures, and standards applicable to both themselves and to 2012] 535 florida tax review of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy or describing the organization, procedure, or practice requirements of an agency."6 an "order," for the purposes of the apa, is defined as "the whole or a part of a final disposition, whether affirmative, negative, injunctive, or declaratory in form, of an agency in a matter other than rulemaking but including licensing."69 under this definition, adjudication refers to an action that results in a final determination of a matter related to a specific person, while rulemaking is a process for "formulating, amending, or repealing a rule," resembling more of a statute in that it applies to a category of regulatees generally.70 the focus on procedure leading to the formation of rules necessarily takes us to a review of general administrative law principles as applied to agency rulemaking. in addition to being descriptive, this section has a normative approach. given the importance of money and power, many scholars considering the relationship between regulated parties and government agencies have noted the potential problems when regulated parties are excluded from or have little opportunity to participate in the formation of rules that are meant to protect or benefit those parties.7 1 rules that are designed to encourage participation in the modem administrative state do not work as well or evenly when the agency is responsible for parties that have few resources, or when bigger, more powerful entities crowd the process and capture agency rulemaking in a variety of ways. in offering a general description and normative approach critical of existing participatory measures in the apa, this section is a prelude to prescriptive measures that can help address the problems it identifies. a. agency rulemaking . recently, courts and academics in particular have focused on the relationship of the irs's rulemaking powers to the apa. while administrative tax law issues largely escaped scrutiny for much of the first five decades following the apa's enactment, scholars and judges alike are now calling for the tax bar's increased awareness of administrative law those they regulate. see charles h. koch, jr., judicial review of administrative discretion, 54 geo. wash. l. rev. 469, 483-87 (2000). 68. 5 u.s.c. § 551(4). 69. 5 u.s.c. § 551(6). 70. michael i. saltzman & leslie book, irs prac. & proc. t 3.02[1] (2010). 71. see bonfield, representation for the poor, supra note 64, at 511 (describing that lower income individuals are inadequately represented in the rulemaking process compared to their middle class and wealthy counterparts). 536 [vol. 12:7 paradigm for irs guidance principles. the apa is a foundational statute and the result of legislative and scholarly debates about the increasingly important role of agencies in the post-new deal world, where power flowed to washington and unelected bureaucrats were increasingly responsible for the welfare of the citizens through administering legislation that touched all aspects of americans' lives . administrative law scholars have long considered how the american administrative state is legitimate in our overall democratic system of government.74 not mentioned in the constitution, agencies today make crucial policy choices and wrestle with crucial policy questions at which statutes either merely hint or delegate completely to agency action. one leading scholar, professor nina mendelson, identifies agency legitimacy as a function of accountability and democratic responsiveness.7 accountability relates to the degree and extent that the agency is obligated to disclose and justify its actions, as well as the opportunity for judicial review of agency actions to ensure that the agency does not act in an arbitrary way.n democratic responsiveness relates to the extent that the agency action "reflects and expresses the popular will."78 in the absence of sufficient 72. see amy s. elliott, chenery principle could help resolve circuit split in review of tax regs, mayo case, 2010 tnt, 216-11 (nov. 9, 2010) (tax analysts) (citing tax court judge mark v. holmes's call for application of the chenery principle to determine the validity of agency action). see also michael asimow, nonlegislative rulemaking and regulatory reform, 1985 duke l.j. 381 (1985) [hereinafter asimow, nonlegislative rulemaking] (exemplifying early criticism of irs rulemaking as contrary to the apa and lacking public input). 73. see george b. shepherd, fierce compromise: the administrative procedure act emerges from new deal politics, 90 nw. u. l. rev. 1557 (1996) (describing debates surrounding the enactment of the apa). the apa was the embodiment of a constraint on the liberal new deal agencies and represented a compromise between individual rights and agency flexibility. id at 1558. "the apa expressed the nation's decision to permit extensive government, but to avoid dictatorship and central planning." id at 1559. 74. see mendelson, rulemaking, supra note 63, at 1344 (describing actions, such as public participation, which legitimate agency rulemaking). 75. id. at 1347 (describing the broadening of agency power from "expertise" to now more judgment-based decisions). 76. id at 1350 (stating that a government action may be seen as democratically responsive to the extent it expresses the popular will). 77. id. at 1348-49 (discussing ways in which agencies can be held accountable for their decisions). mendelson also points that, although agency heads are not elected by the people, the public can still hold agencies accountable by ensuring that those elected officials who are charged with overseeing agency actions do so in a manner that adequately controls them. id at 1349. 78. id. at 1350 (describing when a government action may be democratically responsive). 2012] 537 florida tax review statutory guidance, agency action can be seen as responsively democratic to the extent that it has sufficient presidential or congressional oversight. given institutional limitations associated with either form of oversight, 79 agencies' actions rest more securely in a democracy when they take into account the interests of individuals, or facilitate reasoned and informed debate and discussion, as part of the agency process whereby the agency formulates rules or promulgates guidance.so questions about the legitimacy of irs actions in the democratic state have not traditionally been the subject of scholars considering the place that the irs has within the broader administrative law landscape. this may reflect a longstanding awareness that even in a society as distrustful of taxes as our own after all, our country is founded on a bedrock of concerns 81about state taxing powers the tax collector needs broad powers to assess and collect taxes to ensure that the state coffers are full. all three branches of 79. mendelson, rulemaking, supra note 63, at 1352-55 (describing presidential and congressional short comings). due to the presidential electoral process's focus on swing states, it may be difficult for the president to parallel policy choices to the national preferences, and presidential influence over agency action may not be consistent. id. at 1353-54. congress, on the other hand, may have more effective means at controlling agencies through the power of the purse, but it is still subject to local interests and may in turn have a limited sense of the popular concern. id. at 1354-55. 80. civic republicanism is a theory that "simultaneously seeks to foster individual freedom from government-imposed values and freedom collectively to define the value of the relevant political community." see mark seidenfeld, a civic republican justification for the bureaucratic state, 105 harv. l. rev. 1511, 1528 (1992) [hereinafter seidenfeld, republican justification]. accordingly, government is only legitimate if it acts to further the common good, a concept defined as what is best for the community as determined by the community. id. therefore, when an agency engages in notice and comment rulemaking, as well as providing reasoning for its decisions, it legitimizes agency action. see mendelson, rulemaking, supra note 63, at 1350 citing richard stewart, the reformation of american administrative law, 88 harv. l. rev. 1669, 1683 (1975) [hereinafter stewart, reformation]. pluralist theories of democracy, on the other hand, assert that a government decision is legitimate to the extent that it "hears from and considers even reconciles a wide variety of interests." id. at 1350. therefore, if relevant interests are represented in agency decisions, such as through public opportunity to comment, it is operating in an effectively pluralist manner. pluralistic theories consider public interest "as an aggregation of preferences of stakeholder groups," whereas civic republicans define public interest as a "result of a democratic dialogue in which citizens fully disclose their interests and are open to hearing others' reasons. . . ." id. at 1350-51. 81. see marjorie kornhauser, legitimacy and the right of revolution: the role of tax protests and anti-tax rhetoric in america, 50 buff. l. rev. 819, 824 (2002) (recognizing that anti-tax sentiments are intrinsic in american patriotism since the country's inception). 538 [vol. 12:7 paradigm for irs guidance the federal government have evinced a wariness of imposing constraints on the tax collector 8 2 and have afforded extraordinary discretion to the irs to allow it to bring in needed revenues. in more recent times, academics have lamented at how the irs, and to some extent, the tax bar, tend to view the irs as exceptional, entitled to greater powers and deference than other executive branch agencies. scholars83 and courts84 are poking holes at the need for continued slavish devotion to tax exceptionalism. while american society and jurisprudence have broadly trended toward a greater expectation of procedural regularity in all agency rulemaking activities,85 i believe the current encroachment on tax exceptionalism specifically stems from the changing role of the internal revenue code itself. the modem tax code is implicated in an alphabet soup 82. see cheatham v. united states, 92 u.s. 85, 88-89 (1875) (asserting "all governments, in all times, have found it necessary to adopt stringent measures for the collection of taxes, and to be rigid in the enforcement of them"); book, the collection due process, supra note 59, at 1148 (explaining that prior to cdp provisions, the irs had broad powers to collect taxes without judicial review which many observed as powerful and dangerous). 83. see caron, tax myopia, supra note 44, at 554 (stating that tax law operates largely outside of the insight learned in other administrative law areas); bryan t. camp, tax administration as inquisitorial process and the partial paradigm shift in the irs restructuring and reform act of 1998, 56 fla. l. rev. 1, 3 (2004) [hereinafter camp, inquisitorial] (recognizing that the tax code has generally not adopted ideas from other areas of law such as civil procedure); leandra. lederman, "civil"izing tax procedure: applying general federal learning to statutory notices of deficiency, 30 u.c. davis l. rev. 183, 183 (1996) (asserting that tax law tends to operate separate from other areas of law, depriving it from "cross-fertilization"); danshera cords, how much process is due? i.r.c. sections 6320 and 6330 collection due process hearings, 29 vt. l. rev. 51 (2004) (describing the limitations rra 1998 (specifically cdp provisions) placed on the historically broad powers given to the irs). see hickman, coloring outside the lines, supra note 26, at 1732-40 (2007) (describing treasury's departure from apa rulemaking requirements, resulting in lack of notice and comment opportunity). 84. see mayo found. for med. educ. & research v. united states, 131 s. ct. 704 (2011) (refuting tax exceptionalism with regards to interpretive deference). "mayo has not advanced any justification for applying a less deferential standard of review to treasury department regulations than we apply to the rules of any other agency. in the absence of such justification, we are not inclined to carve out an approach to administrative review good for tax law only. to the contrary, we have expressly recognized the importance of maintaining a uniform approach to judicial review of administrative action.... the principles underlying our decision in chevron apply with full force in the tax context." id at 713 (internal cites omitted). see also cohen v. united states, 650 f.3d 717 (d.c. cir. 2011). 85. lawrence friedman, total justice, 80-90 (1985) (describing the increased demands on the legal system to provide for fair procedure as the due process revolution). 2012] 539 florida tax review of credits and provisions that address topics and behavior far from revenue collection. 6 accordingly, the justification for exceptional treatment of the irs as lying outside administrative law norms becomes less compelling as the code takes on other roles beyond pure revenue collection.8 ' through the code, congress has tasked the irs with administering these benefitdelivering provisions; congress itself, however, has noted on some occasions that the traditional tolerance of absolute or near-absolute irs discretion, having its origins in the pressing need for unfettered access to revenues, is not a foregone conclusion just because the irs is involved in the 8administration of a statute. similarly, recent commentary has explored the 86. recent congressional testimony on the distribution of tax burdens has emphasized the growing use of the tax code to deliver social benefits see, e.g., scott a. hodge, president, tax foundation, is the distribution of tax burdens and tax benefits equitable?, hearing before the u.s. senate committee on finance, may 3, 2011, http://finance.senate.gov/imo/media/doc/testimony%20of%/ 20scott%20hodge.pdf . 87. to be sure, the code has for a long time played a key role in providing incentives through deductions, credits and exclusions that are removed from the exercise of determining the proper base of income in an income tax. yet, congress's penchant for tax credits, and refundable credits in particular, has had a significant complicating impact on the irs's job of administering the tax system. see nta 2010 ann. rep. vol. 1, supra note 55, at 15. 88. moreover, even when it comes to tax collection, congress has expressed its desire to ensure that the irs and courts consider the individual interests and minimize the potential for error and harm. perhaps most famously this congressional desire appears in the irs restructuring act of 1998 and, in particular, the collection due process within that legislation. see i.r.c. § 6330(c)(3)(c) (the basis for determination of levies will depend in part on "whether any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of the person that any collection action be no more intrusive than necessary."). the importance of individual rights is expressed in other areas where congress gave taxpayers increasing rights to hearings and explanation before the irs could take actions that it previously could do without worry of running afoul of statutory rights: see 26 u.s.c. § 6159(b)(5) the secretary may not take any action under paragraph (2), (3), 04 (4) unless (a) a notice of such action is provided to the taxpayer not later than the day 30 days before the date of such action, and (b) such notice includes an explanation why the secretary intends to take such action. i.r.c. § 6159(b)(5). see also i.r.c. § 7122(d)(3)(a) (providing that "an officer or employee of the internal revenue service shall not reject an offer-in-compromise from a low-income taxpayer solely on the basis of the amount of the offer."). it has also charged the irs to relieve taxpayers from liability to the extent that collection violates fairly undefined notions of fairness. see i.r.c. § 6015(f) (directing the court to take into consideration all the facts and circumstances, to determine whether it is inequitable 540 [vol. 12:7 paradigm for irs guidance applicability of the due process clause to the delivery of welfare benefits via the earned income tax credit.89 given the growing use of the tax code to deliver benefits and increasing congressional recognition that interests other than the government's warrant statutory protection, it is not surprising that there is a change and less acceptance of the irs as meriting a blanket exception to rules that apply to other agencies. while the irs still enjoys great powers, and while there is still resistance to even formally acknowledging its crucial non-revenue collecting mission, scholars and courts are reexamining means to ensure accountability. b. notice and comment rulemaking versus informal rulemaking in administrative law generally agencies issue guidance that can broadly be classified into one of three categories of "rules": legislative rules, non-legislative rules, and procedural rules. 90 legislative rules carry the force of law and must comport with apa notice and comment requirements. 91 non-legislative rules need not comport with apa requirements and merely clarify or define statutory language, a previous administrative rule, or a judicial or agency adjudicative decision.92 procedural rules govern internal agency policies, procedures for seeking agency adjudication, and procedures for the submission of comments on proposed regulations; while the apa explicitly mentions procedural rules to hold the individual liable for any unpaid tax or deficiency); 1.r.c. § 7122 (allowing offers on a third ground: effective tax administration). 89. see megan newman, the low-income tax gap: the hybrid nature of the earned income tax credit leads to its exclusion from due process protection, 64 tax law. 719 (2011). 1 have previously analyzed the relationship of constitutional procedural due process principles to issues of tax collection. see generally, book, the collection due process, supra note 59. 90. this is not to say that formal rulemaking is the only way regulations are promulgated. section 553 of the administrative procedure act applies only to agency rulemaking, but agencies may also promulgate rules through adjudication. see leslie book, a response to professor camp: the importance of oversight, 84 ind. l.j. supp. 63 (2009). 91. see 5 u.s.c. § 553(b); hickman, the need for mead, supra note 30, at 1543 n.23 ("the apa itself does not use the legislative term to describe rules subject to the notice and comment requirements. however, explanations of apa provisions in both preand post-apa literature and jurisprudence use the term in distinguishing such rules from interpretive rules."). 92. see michael asimow, nonlegislative rulemaking and regulatory reform, 1985 duke l.j. 381, 383 (1985) (discussing various types of non-legislative agency rulemaking activities). 2012] 541 florida tax review as exempt from notice and comment, courts remain divided on exactly what a procedural rule is.93 1. legislative rules and apa notice and comment requirements put simply, legislative rules are those that bind the public in some substantive and meaningful way. in american mining congress v. mine safety and health administration,9 4 the d.c. circuit announced the most widely used95 test for determining whether a rule is legislative, asking (1) whether there would be an adequate legislative basis for enforcement action or the conferral of benefits without the agency rule at issue; (2) whether the agency published the rule in the code of federal regulations; 96 (3) whether the agency explicitly invoked its general legislative authority; or (4) whether the rule effectively amends a prior legislative rule.97 if any single factor exists, the rule is legislative.98 apa formal procedural protections are only triggered if legislation calls for rules "to be made on the record after opportunity for agency hearing."99 if the rule is legislative but not required to be made on the record under section 553 of the apa, when promulgating rules an agency must do three things: publish a written notice of proposed rulemaking, offer parties a chance to comment and participate through the submission of written data, views, or arguments, and publish a statement of basis and purpose when promulgating final rules.100 taken together, these 93. see 5 u.s.c. § 553(c); see also, e.g., philips petroleum co. v. johnson, 22 f.3d 616, 620-21 (5th cir. 1994), modified, 36 f.3d 89 (5th cir. 1994) (addressing "substantial impact" of rule on regulated parties, focusing on burden imposed by rule rather than rule's language or appearance); jem broad. co., inc. v. fcc, 22 f.3d 320, 326 (d.c. cir. 1994) (considering whether regulation at issue encodes "substantive value judgment" or merely "alter[s] the manner in which the parties present themselves or their viewpoints to the agency." (internal quotations omitted)). 94. 995 f.2d 1106 (d.c. cir. 1993). 95. as of 2010, six circuits have adopted the american mining congress test. see richard j. pierce jr., administrative law treatise 454 (5th ed. 2010). 96. the d.c. circuit has since deemphasized this second factor, calling it only "a snippet of evidence of agency intent," and in the same case rejecting an argument that the contested regulation was legislative in nature solely by virtue of its publication in the cfr. see health ins. ass'n of am., inc. v. shalala, 23 f.3d 412, 423 (d.c. cir. 1994). 97. american mining congress, 995 f.2d at 1112. the ninth circuit would also ask whether a rule binds tribunals outside of the agency issuing the rule. see erringer v. thompson, 371 f.3d 625, 631 (9th cir. 2004). 98. 995 f.2d at 1112. 99. the administrative procedure act, 5 u.s.c. § 553(c). 100. 5 u.s.c. § 553 (b)-(d). [vol. 12:7542 paradigm for irs guidance requirements are referred to as the notice and comment rules. 101 the notice and comment regime reflects the quasi-legislative role that agencies play and attempts to inject democratic responsiveness and accountability in actions that unelected agency officials take when promulgating general rules. a foundational aspect of rulemaking under the apa is that agency guidance having the force of law must be subject to notice and comment rulemaking. this right of public participation reflects a delicate legislative balance whereby in the modem state agencies with expertise promulgate rules of general application but ensure input that contributes to collective wisdom and enhances legitimacy of state actions. 10 2 101. there were two main trends in last few decades as relates to informal rulemaking. first, in response to courts of appeals imposing additional requirements on agencies attempting to engage in informal rulemaking, in the famous case of vermont yankee nuclear power corp. v. natural res. def. council, inc., 435 u.s. 519 (1978), the supreme court held that it was up to congress, not the courts, to inject additional procedural requirements on agencies engaging in informal rulemaking. second, in response to vermont yankee, courts, congress and the executive branch have imposed obligations on agencies that have made the notice and comment regime of informal rulemaking increasingly burdensome. see david l. franklin, legislative rules, nonlegislative rules, and the perils of the short cut, 120 yale l.j. 276, 283 (2010) [hereinafter franklin, nonlegislative rules]. 102. see wallace-wells, cass sunstein, supra note 39 (examining sunstein's agency directive to improve public participation in the rulemaking process). "hardly anyone would isolate section 553 of the administrative procedure act . . . as the greatest invention of modem government . .. but i see it as having potential." id. see also arthur e. bonfield, state .administrative rule making at §§ 5.2.1, 5.2.2 & 5.2.3, at 144-50 (1986) (describing the benefits of rulemaking as promoting rules that are "lawful," "technically sound," and "politically responsible"); cary coglianese, heather kilmartin & evan mendelson, transparency and public participation in the rulemaking process 2-5 (july 2008) www.law.upenn.edu/academics/instiutes/regulation/transparencyreport.pdf (arguing that an "optimal" level of public participation can improve "legitimacy" and result in "more informed policy decisions"). 2012] 543 florida tax review 2. non-legislative rules: interpretive rules and procedural rules a second type of rulemaking exists outside the apa notice and comment regime in the form of non-legislative rules.'0 3 section 553 of the apa states that except when notice or hearing is required by statute, general notice of proposed rulemaking is not required for "rules of agency organization, procedure, or practice"; interpretative rules and general statements of policy; and rules as to which the agency has good cause to conclude that notice and comment would be "impracticable, unnecessary, or contrary to the public interest."' 04 although the apa expressly exempts these guidance documents or "non-legislative rules" from notice and comment, it does not define that category. the "working definitions" set forth in the 1947 attorney general's manual on the administrative procedure act say that legislative rules (the manual calls them "substantive 103. see franklin, nonlegislative rules supra note 101, at 282 (noting that 'informal rulemaking" is also referred to as "section 553 rulemaking" or "notice and comment rulemaking"). 104. 5 u.s.c. § (b)(3)(a)-(b). an agency may circumvent the apa's notice and comment requirement by asserting the "good cause" exception, which waives notice and comment where the process would be "impracticable, unnecessary, or contrary to the public interest." essentially an emergency procedure intended to allow immediate rulemaking where delay would do harm, an agency must meet a high burden in order to successfully assert the good cause exception. treasury's invocations of the good cause exception, however, typically occur in non-emergency circumstances, and it often fails to provide sufficient justification explaining why it is necessary to issue immediate guidance. see, e.g., t.d. 9158, 2004-2 cb 665 (asserting good cause where regulations provided guidance on treatment of certain contingent liabilities in acquisition of nuclear power assets where treasury had previously issued private letter rulings on issue in prior years); t.d. 9089, 2003-2 cb 906 (invoking good cause for regulations elaborating on consequences of supreme court decision two years prior). treasury has also relied on the good cause exception on at least one occasion to combat abusive tax shelters, though its ability under code section 7805(b) to retroactively apply final regulations may reduce the need for the good cause exception in this area. see, e.g., t.d. 9062, 2003-2 cb 46 (addressing ambiguities in code regarding transfer of certain liabilities along with property into partnership in exchange for interest in partnership, asserting good cause exception by arguing regulations were "necessary to prevent abusive transactions"). see hickman, coloring outside the lines, supra note 26, at 1786 (arguing that good cause exception may not be necessary to combat tax shelters where treasury may make final regulations retroactive to date of initial nprm). recent nontax cases have required a high burden for agencies to meet the good cause exception. see united states v. valverde, 628 f.3d 1159, 1166 (9th cir. 2010) (rejecting attorney general's invocation of good cause exception where attorney general offered merely conclusory statements that delay in issuing regulation would be "contrary to the public interest."). 544 [vol. 12:7 paradigm for irs guidance rules") are "issued by an agency pursuant to statutory authority and . . . implement the statute." 05lnterpretive rules, on the other hand, "advise the public of the agency's construction of the statutes and rules which it administers"; 106 and general statements of policy "advise the public prospectively of the manner in which the agency proposes to exercise a discretionary power."'0o in practice, the distinction between interpretive and legislative rules left courts "to struggle with the task of distinguishing legislative from nonlegislative rules."os courts have described the tests that govern these cases as "fuzzy," "tenuous," "blurred," "baffling," and "enshrouded in considerable smog." 0 9 two categories of exempt rules, interpretive rules and general statements of policy, are often labeled "guidance documents" or "onlegislative rules," to distinguish them from legally binding regulations, which are themselves often called "legislative rules.""10 these non-legislative guidance documents greatly outnumber regulations that are promulgated 105. attorney general's manual on the administrative procedure act at 39 (1947). 106. id. 107. id 108. franklin, nonlegislative rules, supra note 101, at 286. 109. professor franklin and others have also bemoaned the lack of clarity in distinguishing general statements of policy from legislative rules, with courts tending "to examine whether the rule is binding, either on the public or on the agency" . . . which has proven difficult for courts to apply. for one thing, the degree to which a rule is binding may be hard to judge in the absence of a well-developed record of enforcement. for another, challenged rules often contain disclaimers renouncing any binding effect. courts sometimes, however, hold these rules to be legislative nonetheless, depending on other language in the rule or the way in which the agency has invoked the rule in enforcement actions or litigation. franklin, nonlegislative rules, supra note 101, at 288 (footnotes omitted). the most common test employed in distinguishing legislative rules from interpretive rules was formulated by the d.c. circuit in am. mining cong. v. mine safety and health admin., 995 f.2d 1106 (d.c. cir. 1993). see text at supra note 95 page 33. six circuit courts of appeals have adopted the american mining congress test, though the tax court has only endorsed the test in a single concurring opinion. see intermountain ins. serv. of vail, llc v. commissioner, 134 t.c. 211, 226 (2010), (halpern and holmes, jj., concurring) rev 'd., intermountain ins. serv. of vail v. commissioner, 650 f.3d 691 (d.c. cir. 2011). 110. section 553 also exempts from the notice-and-comment process rules involving military and foreign affairs and "matter[s] relating to agency management or personnel or to public property, loans, grants, benefits, or contracts." 5 u.s.c. § 553(a)(1)-(2). 2012] 545 florida tax review through notice and comment."' federal agencies publish guidance that "set forth a policy on statutory, regulatory, or technical issue[s] or an interpretation of a statutory or regulatory issue." 1 l2 in other words, nonlegislative rules are usually not binding on the public but they are usually binding on the promulgating agency." 3 they come in a variety of names and forms (manuals, circulars, bulletins, etc.) and even in innovative formats, such as video, audio or web-based software."14 111. see sean croston, the petition is mightier than the sword: rediscovering an old weapon in the battles over "regulation through guidelines," 63 admin. l. rev. 381, 384 (2011) [hereinafter croston, petition] (describing the volume of guidance versus legislative rules). see also connor n. raso, strategic or sincere? analyzing agency use of guidance documents, 119 yale l.j. 782, 787 (2010) (suggesting that while guidance documents overwhelmingly out number legislative rule, agencies have not abused their power to issue it); peter l. strauss, publication rules in the rulemaking spectrum: assuring proper respect for an essential element, 53 admin. l. rev. 803, 805 (2001) (stating that "publication rules" greatly outnumber those that pass through notice and comment); m. elizabeth magill, agency choice of policymaking form, 71 u. chi. l. rev. 1383, 1411 (2004) (pointing to an increased use of informal guidance documents over time). 112. omb, final bulletin for agency good guidance practices, 72 fed. reg. 3432, 3434 (jan. 25, 2007) [hereinafter omb, final bulletin]. the omb definition is very similar to the apa definition of a rule, "mean[ing] the whole of part of an agency statement of general or particular applicable . . . designed to implement, interpret, or prescribe law or policy . . . of an agency . . . 5 u.s.c. § 551(4). for a discussion of the growing use of guidance outside notice and comments, see croston, petition supra note 111, at 388 (arguing that interested persons should seek the right to petition federal agencies for all forms of guidance). 113. see batterton v. marshall, 648 f.2d 694, 701-02 (d.c. cir. 1980). 114. omb, final bulletin supra note 112, at 3434. as sean croston and others have described, informal guidance can amount to essentially free legal advice for regulated parties who may be confronting a host of technical and complex statutory rules. see croston, petition, supra note 111, at 382-83 (asserting that one reason for increased use of informal guidance is to help those regulated comply with regulations). from an agency's perspective, non-legislative guidance allows the agency to reduce administrative burden as contrasted with individual requests for explanation and application to specific circumstances. see id. at 382-83 (reasoning that informal guidance upfront decreases the burden of responding to shareholder requests for interpretation after the fact). in addition, informal guidance allows agencies to avoid notice and comment requirements under the apa, thus allowing agencies to issue guidance more quickly than legislative rules and reducing the time that regulated parties and staff are uncertain about how to apply the law to individual circumstances. 546 [vol. 12:7 paradigm for irs guidance c. irs rulemaking and guidance: the tax-exceptional approach? as contemporary scholarship has recognized, treasury, the irs, and the tax bar generally take a "tax-exceptional" approach to administrative law in conducting rulemaking activities, particularly as regards the legislative/interpretive distinction in treasury regulations."' for example, a "legislative" tax regulation (one requiring compliance with apa notice and comment procedures) binds the public and is promulgated pursuant to a specific statutory grant of authority." 6 in contrast, an "interpretive" regulation (one not requiring compliance with apa notice and comment) theoretically does not bind the public"'7 and is promulgated pursuant to the general grant of rulemaking authority under code section 7805.118 the tax bar essentially concerns itself with where the rulemaking power comes from and avoids a substantive analysis of the regulation's effects, such as american mining congress would require."l9 importantly, while the treasury acknowledges that apa section 553 notice and comment rules govern its regulatory efforts, it contends that most of its regulations are exempt from these procedures either because of their interpretive nature or under the good cause exception.120 whether this assertion is correct, and many contend that it is not, treasury offers little or no explanation behind its assertion. 12 nonetheless, the treasury maintains that it generally follows apa rulemaking procedure, usually publishing notices of proposed 115. see hickman, coloring outside the lines, supra note 26, at 1761-62 (describing historical approach of tax bar and treasury and arguing such approach no longer comports with contemporary standards of administrative law practice). 116. see michael 1. saltzman, irs practice and procedure, 3.02[3j[a]-[b], at 3-12 to -14 (rev. ed. 2002) [hereinafter saltzman, irs practice]. 117. failure to comply with an "interpretive" treasury regulation, however, can result in the imposition of penalties. see i.r.c. § 6662 and accompanying regulations. 118. see john f. coverdale, court review of tax regulations and rulings in the chevron era, 64 geo. wash. l. rev. 35, 44 (1995). 119. see intermountain ins. serv. of vail, 134 t.c. at 240-42 (halpern and holmes, jj., concurring) (contrasting legislative/interpretive distinction in tax law and administrative law). 120. see reg. § 601.601(a)(2) (acknowledging that apa rules apply for promulgation of regulations). but see internal revenue manual §§ 32.1.3.3 and 32.1.5.4.7.5.1 (asserting that most treasury regulations are interpretive and therefore not subject to the apa provisions). 121. see hickman, coloring outside the lines, supra note 26, at 1759-89 (analyzing treasury's asserted apa exceptions and funding them lacking support). 2012] 547 florida tax review rulemaking ("nprm") in the federal register and soliciting public comments.122 as professor asimow pointed out, the two most important consequences of the distinction relate to the scope of judicial review and to the public participation requirements of the apa. traditionally, courts have given less scrutiny, or greater deference, to legislative rules as contrasted to interpretive rules. the scope of review, and the deference that the agency receives with respect to its promulgated rules, is somewhat less clear with respect to interpretive rules leading some courts to apply heightened deference to interpretive rules as well as legislative rules, and others less so.1 23 apa rulemaking provisions more directly turn on the distinction between legislative and interpretive rules, with the apa's public participation requirements triggered (unless an exception applies) for legislative rules. tax law has also struggled to distinguish between legislative rules and non-legislative guidance flowing from the irs. historically, there were many tax cases applying the legislative versus interpretive distinction in applying the deference given to the irs's interpretation.12 4 the landscape in this area changed radically after the decision in mayo foundation for medical research v. united states, where the supreme court clarified that courts are to apply the same chevron-type deference to regulations irrespective as to whether they were promulgated under treasury's general 122. see irm § 32.1.2.3. but see hickman, coloring outside the lines, supra note 26, at 1731 (asserting that "most if not all treasury regulations are legislative rather than interpretative"). in her study, hickman analyses 232 separate treasury regulatory projects for which treasury decisions (tds) or notice of proposed rulemaking were published in the federal register over the course of three years, finding that regardless of treasury procedures, approximately 40 percent did not follow apa procedures. id at 1748. hickman explains, that treasury typically issues legally binding temporary regulations, only collecting public comments after the fact and evaluating them in the final regulation issues sometime later. id. in these instances where tds were issued simultaneously with a notice of proposed rulemaking, the public typically is not afforded an opportunity to comment. id. at 1757. in some instances, treasury skipped the notice and comment process altogether. id. at 1749. 123. see mayo, 131 s.ct. 704, 712-13 (2011) (detailing the differing standards for interpretive agency guidance and ultimately deciding that treasury guidance should be afforded chevron deference). 124. see rowan companies, inc. v. united states, 452 u.s. 247, 253 (1981) (stating that the word "wages" as interpreted by the commissioner under § 7805(a) specific grant of authority, is subject only to inquiry relating to "whether the interpretation or method is within the delegation of authority"). 548 [vol. 12:7 paradigm for irs guidance section 7805(a) authority, or under specific grants of legislative authority within a substantive statute.12 5 while administrative law lawyers might take mayo as a natural progression in light of the changed landscape of administrative law, the historical tax practice of distinguishing interpretive and legislative regulations based upon whether treasury invoked general rather than specific statutory authority for purposes of calibrating the degree of deference to the agency for judicial review purposes had been entrenched in the tax world for decades. 126 mayo has clarified that for purposes of the scope and intensity of judicial review, the longstanding tax approach that focuses on the source of the regulatory adoption is obsolete. yet mayo does not directly speak to the other main consequence flowing from the distinction between legislative and interpretive rules, specifically to what extent the apa's participation requirements are triggered in tax matters. mayo's swipe 125. 131 s.ct. 704, at 707 (2011) (asserting that rowan and other cases giving greater deference to specific grants of authority have been outdated by the application of chevron deference to general grants of authority). the mayo court's dismantling of the tax exceptional approach is consistent with the court's approach in other cases such as dickinson v. zurko, 527 u.s. 150 (1999), where the supreme court held that decisions of the patent and trademark office must be reviewed in the same manner as other agency determinations. the court's rationale largely centered on the need for uniform regulation of administrative agencies. id at 154 (recognizing "the importance of maintaining a uniform approach to judicial review of administrative action). section 559 of the apa provides, in part, that the apa does "not limit or repeal additional requirements . . . recognized by law." before zurko reached the supreme court, the federal circuit, in an en banc opinion, held that this exception allowed for a separate clearly erroneous standard, as it was the practice under court review of the pto's predecessor at the time of apa's enactment, it amounted to a stricter standard than ordinary arbitrary and capricious agency review, and thus was an additional requirement under section 559 that trumped the section 706 standard of review. see in re zurko, 142 f.3d 1447 (1998) rev'd, dickinson v. zurko, 527 u.s. 150 (1999). reversing, the supreme court held that given the need for uniform regulation of agencies, to trigger the section 559 exception, the practice prior to the apa had to be clear, and in its view that was not the case. see zurko, 527 u.s. at 154. 126. for example, professor asimow, writing in 1991, referred to legislative history in 1921, four years after the predecessor to section 7805(a) was adopted, where several members of congress commented that the 1921 statute was the "first to take the daring step of providing for delegations of rulemaking power to the treasury in light of the complex character of the statutes under consideration" and how "tax authorities almost uniformly assume that regulations adopted pursuant to .. . section 7805(a) ... are interpretive and that rules adopted pursuant to specific grants of rulemaking authority are legislative." see asimow, public participation, supra note 21, at 358. see also lederman, the fight over "fighting regs," supra note 21 (tracing law on judicial deference to tax authorities over time). 5492012] florida tax review at tax exceptionalism undercuts the rationale behind the treasury view that the apa participation requirements are inapplicable to regulations promulgated under section 7805(a). as mayo did not speak to that issue precisely, it remains to be seen how the tax bar's exceptional approach to public participation will fare. in addition to regulations, treasury and the irs issue several important forms of informal guidance (otherwise known as "irb guidance") 127 while these rules technically do not bind the public and are not promulgated with notice and comment, they nonetheless often bind the public in some meaningful way, usually through the imposition of penalties for noncompliance.12 8 revenue rulings are interpretations made by the irs and published in the internal revenue bulletin (irb), which apply tax law to a particular set of facts.12 9 they are both intended to inform taxpayers of the likely outcome of their behavior and provide irs staffers with a format to apply the treasury position ensuring uniform application of the tax law.130 revenue procedures have a similar objective, setting forth procedure to allow employees to apply the tax law and assist taxpayers, promoting voluntary tax compliance.131 revenue procedures are issued principally by the associate chief counsel offices, are published in the rb, and cover a wide variety of procedural and administrative matters. when there is a need for quick and immediate guidance to ensure effective tax administration, the irs often uses notices and announcements as its delivery methods of choice. a notice is published in the irb and can cover a large array of topics ranging from changes in forms, solicitation of public comments, and to alert the public to proposed rulemaking.13 2 announcements, also published in the irb, usually contain information of short term value such as effective dates of temporary regulations, modification of form instructions or providing explanations for newly adopted policies or programs.'33 this brief list only scratches the surface of irs guidance which also includes various types of letter rulings, several forms of legal advice such as technical advice memoranda and chief 127. see hickman, irb guidance, supra note 28, at 240 (explaining the term "irb guidance" is given for the documents published in the internal revenue bulletin and cumulative bulletin). 128. see reg. § 1.6662-3(b)(2) (allowing for imposition of penalties for failure to comply with revenue rulings and notices); hickman, irb guidance, supra note 28, at 265 (noting that taxpayers and return preparers can be subject to penalties for failing to comply with facially non-binding irb guidance). .129. internal revenue manual § 32.2.2.3.1. 130. see korb, the four r's revisited, supra note 27, at 330-31 (describing history and purpose of revenue rulings). 131. see id. at 336. 132. see id. at 339-340 (listing topics covered by irs notices). 133. see id. at 340-41 (explaining short term guidance is more typically disseminated in the form of announcements). [vol. 12:7550 paradigm for irs guidance counsel notices, and notices of acquiescence.134 moreover, as with the schedule utp discussed above, much guidance the irs issues actually takes place in forms, schedules, and instructions, and increasingly in the form of posted questions on the irs web page. d. the impact of tax exceptionalisn on public participation regardless of whether treasury correctly exempts its irb guidance from the apa's notice and comment regime, the extension of irs guidance to issues relating to benefits and relief from liability also heightens the risk that administrative law scholars have emphasized regarding the impact of illsuited agency guidance directed at lower income individuals."' as substantive provisions reach issues relating to potentially the difference between poverty' 36 or a lifetime of tax debt, 37 leading to possibly devastating impact, the interest in crafting appropriate guidance the first time around becomes a necessity. moreover, less sophisticated taxpayers may be unwilling or not able to discern the difference between legally binding rules and others, effectively making the policy de facto binding.'3 1 while the irs may ask for public input or input from proxies such as the american bar association tax section when it publishes informal guidance, it is difficult for issues that do not have a natural constituency to generate informal or formal input. the big problem is the absence of possibility of private parties to be heard on proposed policy alternatives.'39 134. see generally korb, the four r's revisited, supra note 27, at 330-361 (discussing various forms of irs informal published guidance). 135. see bonfield, representation for the poor, supra note 64, at 511-12. 136. the most predominant credit used for low-income taxpayers is the earned income tax credit. see holt, the eitc at age 30, supra note 36 (surveying recent studies addressing eitc issues). for a somewhat different view of the topic, see also leonard burman, jon stewart's fake news on tax expenditures, forbes, may 10, 2011, http://blogs.forbes.com/leonardburman/2011/05/10/jonstewarts-fake-news-on-tax-expenditures/ (discussing the growing use of tax credits in the irc as a form of spending). 137. see i.r.c. § 6015(f), relief from joint and several liability on joint return. 138. see robert a. anthony, interpretive rules, policy statements, guidances, manuals, and the like should federal agencies use them to bind the public?, 41 duke l.j. 1311, 1328 (1992) (describing how interpretative rules have a practical bind effect if private parties are lead to believe that failure to conform will bring adverse consequences). 139. see id at 1329-30 (referring to lack of opportunity to be heard that is evident in non-legislative rules with binding effect). 2012] 551 florida tax review iv. critique of the foundational apa distinction between "legislative" and "interpretive" regulations applied to the irs when one surveys the literature and cases on the line between notice and comment rulemaking and informal guidance, i can make two broad conclusions that are directly relevant for the thesis in this paper: (1) courts and scholars are uncertain where the line should be drawn between rulemaking that requires notice and comment and rulemaking that need not go through the processl 4 0 and (2) there are also good reasons to not require all agency rulemaking to take place via notice and comment, such as the need for immediate guidance in some circumstances. 14 1 the rub for many administrative law scholars, and a question that is the topic of much administrative law scholarship, is how to draw the line, or as professor franklin states: [h]ow can courts strike the best balance between administrative efficiency and broad public participation in agency policymaking? interpret the exemptions from notice and comment too narrowly, and you drive agencies into a purely adjudicative mode that offers less notice and less opportunity for widespread participation. interpret them too broadly, and you allow agencies to dispense with public input at the pre-promulgation stage as a matter of course. 14 2 140. see, e.g., boeing co. v. united states, 537 u.s. 437, 447-48 (2003) ("even if we regard the challenged regulation as interpretive because it was promulgated under § 7805(a)'s general rulemaking grant . . . we must still treat the regulation with deference."); hosp. corp. of am. & subs. v. commissioner, 348 f.3d 136, 144 (6th cir. 2003) (noting that failure to comply with notice and comment does not necessarily have bearing on binding force of regulation); intermountain ins. serv. of vail, 134 t.c. 211, 240 (2010) (halpern and holmes, jj., concurring) (noting disagreement within tax court over where notice and comment requirements attach), rev'd, 650 f.3d 691 (d.c. cir. 2011); hickman, coloring outside the lines, supra note 26, at 1764 (discussing incompatibility of tax law conceptions of notice and comment requirements with administrative law generally). 141. see jessica mantel, procedural safeguards for agency guidance: a source of legitimacy for the administrative state, 61 admin. l. rev. 343, 346-47 (2009) [hereinafter mantel, procedural safeguards] (discussing policy justifications for excepting notice and comment requirements in some circumstances); korb, the four r's revisited, supra note 27, at 342 (discussing need for informal guidance in many cases). 142. franklin, nonlegislatvie rules, supra note 101, at 306. 552 [ vol. i12: 7 paradigm for irs guidance while administrative law scholars have spent considerable time exploring the balance between efficiency and participation in rulemaking, a substantial amount of scholarship also considers the formidable barriers to participation in the rulemaking process that individuals, and, in particular, lower income individuals face. effective and informed participation requires parties to both have the required background knowledge to make meaningful comments, and the financial and technical resources to do so. 14 3 the scheme in apa section 553 is meant to provide a mechanism for public participation. as summarized above, an agency must publish advance notice and take comments prior to finalizing a rule. courts impose a general obligation on agencies to explain their reasoning when they reject significant comments. 14 4 agency actions that are not reasoned or are arbitrary or capricious face the possibility that judges will vacate agency action. 14 5 administrative law scholars have noted that these requirements ensure that agencies remain "accountable for following the law (including implementing any critical value choices congress may have made in the authorizing statute) and for acting in a nonarbitrary fashion."i4 6 in theory, the apa scheme's approach to allow for direct involvement in agency process and agency explanation satisfies both a pluralist and civic republican view of democratic accountability. from a pluralist perspective, an agency decision is democratic "to the extent the agency hears directly from and considers a wide variety of interests."' 4 7 the apa requirements allowing for access to the agency, as well as the backstop of the right to challenge agency actions in court, is a mechanism to allow for individuals to provide input and ensure that agencies remain accountable for their actions. from a civic republican perspective, legitimacy of agency actions in a democratic state is grounded in agencies contributing to a dialogue where citizens provide their views and agencies and citizens alike are deliberative and open to considering differing perspectives.14 8 the apa's 143. see johnson, good guidance, supra note 45, at 735 (describing several barriers to effective participation). 144. see aclu v fcc, 823 f.2d 1554, 1581 (d.c. cir. 1987) (stating notice and comment rulemaking obligates agencies to respond to all significant comments). 145. 5 u.s.c. § 706 (defining scope of review). 146. mendelson, rulemaking, supra note 63, at 1356. 147. id. at 1350. see also stewart, reformation, supra note 80, at 1679, 1683 (stating that courts have asserted agencies must consider "all of the various interests affected by their decisions as an essential predicate" to determining the public interest). 148. see seidenfeld republican justification, supra note 80, at 1514 (defining the theory of civic republicanism). "civic republicanism promises democratic government that does not exclude or coerce citizens whose backgrounds and values differ from those of mainstream society." id. 2012] 553 florida tax review requirements to allow for participation, and the judicial gloss requirements that agencies explain their actions contribute to accountability in a civic republican sense. in practice, observers of agencies generally have noted that despite the pluralist and civic republican theories of rulemaking's legitimacy in a democratic state, there is a skewing of participation in the process toward business interest and away from a diffuse class of regulated beneficiaries.' 49 the main reason for this observation is that while the administrative law right to participate under apa section 553 is clear, it takes "resources to uncover the existence of a rulemaking, to understand the issues at stake, and to prepare persuasive comments."o compounding the issue is the collective action problem, meaning there are challenges associated with organizing those whose interests are widely diffused as compared to matters that relate to more concentrated groups. as a practical matter, business groups and others with significant resources tend to dominate the rulemaking process. for example, studies of agencies tend to show that regulated entities as contrasted with regulated beneficiaries predominantly provide comments to agencies. 52 as a counterweight to business interests, with many matters that are the subject of agency rulemaking (such as environmental issues) there are significant 149. see mendelson, rulemaking, supra note 63, at 1357-58 (stating that one reason big business groups dominate rulemaking participation is their availability of financial resources to do so); wendy wagner, administrative law, filter failure, and information capture, 59 duke l.j. 1321, 1382 (2010) [hereinafter wagner, administrative law] (asserting pre-nprm interest group communication is also likely to be extensive and influential); jason webb yackee & susan web yackee, a bias towards business? asessing interest group influence on the u.s. bureaucracy, 68 j. pol. 128, 133 (2006) [hereinafter yackee, bias towards business] (stating that rulemaking costs remain so high that individuals and public interest groups are disadvantaged). 150. see mendelson, rulemaking, supra note 63, at 1357-58. 151. id. at 116 (explaining that because of a free rider problem, groups with diffused interests have greater challenges organizing as opposed to small concentrated groups ); see also the politics of regulation, 357, 360 (james q. wilson, ed., 1980). 152. see wagner, administrative law, supra note 149, at 1334 n.40 (quoting colin s. diver, the optimal precision of administrative rules, 93 yale l.j. 65, 99 (1983) (stating "[w]idely dispersed costs or benefits are less effectively represented in policymaking than concentrated costs or benefits. thus we would expect error-correction to favor interests championed by enforcers and regulated firms and to undervalue interests of unorganized beneficiaries of government programs."); yackee, bias towards business, supra note 149, at 131, 133 (explaining that in a study of mid size rulemaking business groups submitted over 57 percent of comments while nonbusiness groups and public interest organizations contributed only 6 percent). [vol. 12:7554 paradigm for irs guidance public interest organizations that do participate in the process and help redress the imbalance. yet, the balance is still skewed toward business interests in the process generally. professor wagner has observed public interest groups face barriers to entry when pluralistic processes are undermined by a system that becomes oblivious to the costs imposed on participants in a meaningful way. 5 3 groups that already struggle against organizational and related collection action impediments to represent the public interest cannot keep up. wagner argues that resource rich participants engage in information capture by providing agencies with excess information that stretches agency staff so that the staff is overwhelmed. 15 4 moreover, wagner claims that limits on time, resources and expertise blunt the effectiveness of public interest groups, especially when regulated entities overwhelm the process. 155 v. good guidance requires a better balance between efficiency and participation irrespective of apa classification a. moving beyond current apa classification in the previous section, i discussed how existing rules within the apa are not likely to provide either the certainty or degree of input that the irs will need to administer its rules, especially as those rules relate to issues germane to lower-income or disadvantaged taxpayers. in addition, the tax law is in a state of flux when it comes to determining precisely when the notice and comment regime of the apa will be implicated. a possible approach at this point would be for courts to require the irs to issue more guidance subject to notice and comment, or at least require the irs to take more seriously the exceptions applicable to notice and comment rules under the apa. i do not recommend that approach as a blanket solution to the problem i have identified and worry that it would have unintended adverse consequences. at times, the public and irs employees need informal guidance, and as a practical matter the treasury and the irs cannot put all of its guidance in time consuming regulation projects.156 this point is consistent 153. see wagner, administrative law, supra note 149, at 1378 (discussing collective action impediments to meaningful participation in notice and comment process). 154. see id at 1352 (discussing coping strategies to avoid postpromulgation litigation as overwhelming understaffed and under-resourced agencies). 155. see id 156. see asimow, public participation, supra note 21, at 346 (describing practical reasons for the need to issue interim guidance after tax reform act of 1986). asimow uses the section 469 passive activity loss rules as an example, 2012] 555 florida tax review with a number of commentators in the broader administrative law literature who recognize that the apa's blurry distinction between legislative and interpretive rules led agencies and courts into a definitional morass, but who stating "this provision is exceptionally complex, involves very large revenue gains, contains vague and undefined phrases and applies (or might apply) to millions of taxpayers. thus, the preparation of regulations to provide guidance to taxpayers and the internal revenue service was a high priority." id. furthermore, asimow stresses that interpretative rules are an important part of agency guidance because subjecting all rules to notice and comment would not only be a time-consuming process, but would limit this type of pertinent guidance-disserving the interests of good government. id. at 352. the treasury maintains some forms of its guidance are exempt from the apa for a variety of reasons. this may be the case if (1) the regulations are interpretive, (2) they are temporary, (only some regulations are temporary) or (3) the apa's good cause exception applies because of the need for immediate public guidance. id. at 347. but see juan j. lavilla, the good cause exception to notice and comment rulemaking requirements under the administrative procedure act, 3 admin. l.j. 317 (1989) [hereinafter lavilla, good cause exception] (surveying agency good cause exception claims, asserting that the irs most frequently abuses this exception). some have argued that courts should calibrate deference to agency action based upon whether the guidance has gone through notice and comment. see also gersen, legislative rules revisited, 74 u. chi. l. rev. 1705, 1720 (2007) (emphasizing that greater procedure incorporating public input should/does receive greater deference upon judicial review); john f. manning, nonlegislative rules, 72 geo. wash. l. rev. 893 (2004) (arguing that courts are more likely to apply chevron deference to policy having undergone notice and comment); but see e. donald elliott, re-inventing rulemaking, 41 duke l.j. 1490, 1490 (1992) (asserting that the real purpose of notice and comment is not to obtain public participation, but only to create a record for judicial review). these commentators suggest that courts should treat rules that have gone through this procedure as having the force of law in agency enforcement actions. guidance that has not gone through notice and comment should be denied this treatment. professor franklin refers to this as a short cut, with a rule's "procedural provenenace [determining] its substantive effect" rather than the substance determining procedure as under current law. see franklin, nonlegislative rules, supra note 101, at 279 (arguing that the short cut carries with it far too many costs, including minimizing the benefits of front-end regulatee participation). in addition, the particularized difficulties associated with ensuring pre-enforcement judicial review of irs action (including the declaratory judgment act and anti injunction act) contribute to the possibility that ex post participation via court challenge is less viable in the tax context. id. at 310-11. see also hickman, a problem of remedy, supra note 5, at 1200 (explaining "jurisprudence stands almost unyieldingly against pre-enforcement challenges to treasury regulations promulgated in violation of apa procedural requirements"). [vol. 12:7556 paradigm for irs guidance fall short of recommending that there agencies adopt across the board rulemaking subject to existing notice and comment procedures.15 7 moreover, scholars and commentators looking at agencies have generally noted that focusing solely on the dividing point between legislative rules and other rules under the apa minimizes the role other informal guidance has as a practical matter both in the working lives of agency employees and broader sense of civic acceptance of agency action.' as professor jessica mantel notes: the success of our social contract depends first on those entrusted with governmental powers exercising their discretion for the benefit of "we the people," and second on citizens' acceptance of and obedience to the state's rules for organizing societal functioning and its allocation of public resources. process plays a fundamental role in reinforcing both obligations. in shaping agencies' decisionmaking, procedures promote the legitimacy of administrative policies 157. see franklin, nonlegislative rules, supra note 101, at 278 (explaining judicial difficulty in distinguishing legislative versus nonlegislative rules, and urging courts not to take a "short cut" by looking only to notice and comment to decide). congress, the president, and the courts have taken recent steps that make notice and comment more cumbersome, including statutes that require review for impact on specific interests like small business information collection and state and local governments. id at 283. as professor franklin identifies, this has made nonlegislative rulemaking more attractive. the three main benefits for agencies to engage in this form of rulemaking, all of which relate to administrative efficiency, are: (1) providing swift and accurate notice to the public; (2) informing lower level agency employees about changes or views to ensure bureaucratic uniformity; (3) avoiding opportunity costs by freeing up agency resources away from notice and comment process. id at 303-0)4. see also jacob gersen, legislative rules revisited, supra note 156, at 1721 (explaining that in terms of deference associated with formal versus informal rules, agencies will choose to put more controversial rules through formal procedure, informal procedures will be associated with less controversial agency interpretations). gersen argues that agencies have a clear choice; utilize formal procedure that take into account public input and receive greater deference, or use informal procedures and receive greater scrutiny thereafter. id. at 1722. 158. see johnson, good guidance, supra note 45, at 701 (asserting that nonlegislative rules enables agencies to give advance notice to the regulated community about the agencies interpretations and enables them to promote consistent decision-making and application of the law by their employees); mantel, procedural safeguards, supra note 141, at 351 (reiterating agency incentives to issue rule as guidance rather than through notice-and comment rulemaking). guidance documents also have a substantial impact on the behavior of regulated parties, beneficiaries of government programs and the public that can be just as significant as legislative rules. id. at 354. 2012] 557 florida tax review and protect against violations of the public trust by agency officials. social psychology also has shown that fair procedures that reinforce the legitimacy of the administrative state strengthen individuals' normative commitment to obey the law. for these reasons, the wholesale absence of process requirements for agencies' nonlegislative rulemaking cannot stand. agency guidance documents, carrying as they do the imprimatur of the state, must be legitimated through a process that comports with our ideas of fair government. 59 in light of her concerns, mantel provides that "agencies should be required to offer the public an opportunity to comment on guidance prior to its adoption or, when there is a compelling need for timely final guidance, after its adoption." i1o to encourage greater understanding, agencies also "should provide a concise statement of the legal and policy rationale for a nonlegislative rule when issued in final form."' 6' professor stephen johnson, in a recent article, argues that congress should amend the apa to require agencies "to the extent practicable, necessary and in the public interest, provide opportunities for timely and meaningful public participation in rule making, including the formulation of interpretive rules and general statements of policy."l 62 johnson, like mantel, seeks to dispense with the notion that only legislative rules warrant opportunities for public participation.163 the insights of professors johnson and mantel are important and allow for a consideration of the practical effect of non-legislative guidance as well as the difficulty agencies and courts have in classifying guidance under the apa in the first instance. as a model toward increasing participation, johnson points to the epa as effectively putting in place best practices to increase the likelihood that its guidance gets the benefit of public input.164 159. mantel, procedural safeguards, supra note 141, at 346-47. 160. id. at 348. 161. id. 162. johnson, good guidance, supra note 45, at 697. 163. see id. (arguing that greater procedural controls could lead to the same ossification that resulted in legislative rule making). 164. see id. at 736-37. to address the shortfalls of notice and comment, and as a model for improving public participation, johnson points to the epa's public involvement policy. see u.s. envil prot. agency, epa 233-b-03-022 public involvement policy of the u.s. environmental protection agency (2003) [hereinafter epa public involvement policy] http://www.epa.gov/ pubinvol/policy2003/finalpolich.pdf. the epa has been called "an innovative leader in collaborative governance" incorporating input from those affected by its rules to shape its policy. see carmen sirianni, investing in democracy: engaging citizens in collaborative -governance, 166 (2009) [hereinafter sirianni, [vol. 12:7558 paradigm for irs guidance some of those best practices include town hall meetings at a time and place convenient to those impacted by the agency's policy, increased access to proposed policy online in a user-friendly webpage, as well as developing contact lists to ensure that as new information is disseminated regarding the policy, it is distributed to those effected in a meaningful and understandable manner.16 5 as johnson asserts, public participation is a vital component of agency decision making. not only does it improves the quality of agency decision making, it also makes agencies "more likely to make rational, defensible decisions when they solicit input from a broad array of stakeholders, who can identify facts and issues that the agency might otherwise fail to consider adequately."166 furthermore, increased participation enhances agencies' legitimacy, making the public more apt to accept the policy and less likely to challenge it after the fact.167 b. applying the insight ofprofessors mantel and johnson to the irs both professors mantel and johnson, in criticizing the existing manner that the apa imposes participatory requirements, reflect an investing in democracy]. the goal of the policy is the ensure the epa "continue[s] to provide for meaningful public involvement in all its programs, and consistently look for new ways to enhance public input . . . [the] epa staff and manager should seek input reflecting all points of view [and] . . . should work to ensure that decision-making processes are open and accessible to all interested groups, including those with limited financial and technical resources. . . ." epa public involvement policy, supra, at 1. with increased public involvement, the agency seeks to "make it easier for the public to contribute to the agency's decisions, build public trust, and make it more likely that those who are most concerned with and affected by agency decisions will accept and implement them." id. at 1. in order to achieve its goals, the policy lists seven basic steps for effective public involvement: (1) plan and budget for public involvement activities, (2) identify the interested and affected public, (3) consider providing technical or financial assistance to facilitate involvement, (4) provide information and outreach, (5) conduct public consultation and involvement activities, (6) review and provide feedback, and (7) evaluate public involvement activities. id. accompanying each step are specific actions and methods agency staff can utilize in order to meet these goals. see also sirianni, investing in democracy, supra, at 155-223 (detailing epa success as "civic enabler") and (citing the epa public involvement policy at 207); lisa b. bingham, the next generation of administrative law: building the legal infrastructure for collaborative governance, 2010 wis. l. rev. 297, 330 (2010) (commending the epa's "collaborative governance"). 165. see epa public involvement policy, supra note 164, at 16 (identifying effective public outreach policies). 166. johnson, good guidance, supra note 45, at 735. 167. see id at 735-37 (describing public participation as a vital component of decisionmaking because if increases legitimacy of agency decisions). 2012] 559 florida tax review understanding that broader range of agency actions would benefit from additional input and agency explanation. like professors mantel and johnson, rather than pushing the irs to focus solely on notice and comment rulemaking in the context of guidance that is considered legislative under the apa, i propose that the irs reach out to the public and solicit participation when it issues a wide range of guidance, especially when the guidance relates to lower income taxpayers and issues related to either relief from liability or the delivery of benefits. this approach recognizes that public participation is crucial to the success of agency actions, irrespective of whether the agency's actions relate to nonlegislative rules or other types of agency guidance. it also recognizes that existing notice and comment procedure in and of itself is not a panacea. 168 even if agencies increasingly subjected their guidance to notice and comment, it would be insufficient to ensure participation due to barriers that limit the possibility of meaningful public involvement, especially when the issues implicate diffuse interests and relate to individuals who do not have the time, expertise or money necessary to understand and provide meaningful commentary.169 to be sure, a challenge would be calibrating the degree of participation and extent of public involvement, as well as the existence and amount of agency explanation of its actions. changes in technology, including the existence of social media siteso and greater internet 168. see donald elliott, re-inventing rulemaking, 41 duke l.j. 1490, 1490 (1992) (asserting that even if notice and comment is used, it rarely captures true public participation). elliott asserts that "notice-and-comment rulemaking is to public participation as japanese kabuki theater is to human passions a highly stylized process for displaying in a formal way the essence of something which in real life takes place in other venues." id. at 1492. if agencies truly wanted to get policy input, they would do so with "informal meetings with trade associations and other constituency groups, to roundtables, to floating trial balloons in speeches or leaks to the trade press, to the more formal techniques of advisory committees and negotiated rulemaking." id. at 1492-93. 169. see johnson, good guidance, supra note 45, at 735 (explaining barriers that inhibit effective public participation). even when the irs does solicit comments for its proposed rulemaking, these barriers often prevent taxpayers most significantly effected from commenting. for example, notice 98-61, 1998-2 c.b. 758, which set out the two year limitation for section 6015(f) received no comments regarding the change. see supra notes 5-11 and accompanying text for a more detailed discussion of the lack of public participation regarding the two year limitation. the litigation that amounted after its finalization, however, is a testament to its importance. see lantz v. commissioner, 132 t.c. 131 (2009) (holding the time period invalid), rev'd, lantz v. commissioner, 607 f.3d 479 (7th cir. 2010) (holding the time period valid); mannella v. commissioner, 631 f.3d 115 (3d cir. 2011) (holding the time period valid). 170. see mendelson, rulemaking, supra note 63, at 102 (explaining how the growth of technology and e-rulemaking has facilitated the receipt of comments 560 [vol. 12:7 paradigm for irs guidance accessibility across the board, provide additional opportunities for irs to reach out, and taxpayers to give input to the agency, and irs to explain its actions.17' the irs will need to spend resources to publicize its actions and from lay people relating mostly to values rather than technical expertise). mendelson explains the benefits of e-rulemaking and how it enhances participation. see also comm. on the status and future of fed. e-rulemaking, achieving the potential: the future of federal e-rulemaking, 7 (2008), http://ceri.law. comell.edu/documents/report-web-version.pdf (stating that e-rulemaking can "enhance public participation ... so as to foster better regulatory decisions ... [add] greater support for those decisions by more involved regulatory and beneficiary communities"). recent innovative use of social media by the obama administration suggests how transformative social media can be as a means of communicating to and receiving information from the public. see michael s. shear, obama takes questions from his tweeps, n.y. times, july 6, 2011 (recapping president obama's town hall twitter session where he accepted tweets from the public); katelyn sabochick, president obama @ twitter town hall: economy, jobs, deficit, and space exploration, the white house blog (jul. 07, 2011 at 9:38 am) (listing the tweets answered by the president) http//www.whitehouse.gov/blog/2011/077page=6. 171. see mendelson, rulemaking, supra note 63, at 102. on the one hand, increased public participation through the internet, particularly regulations.gov, can certainly broaden public participation and increase democracy, even going so far as to give rise to "political campaigns" about particularly controversial rulemaking activities. see peter l. strauss, implications of the internet for quasi-legislative instruments ofregulation, 28 windsor y.b. access. just. 377, 390 (2010) (noting that use of consolidated, computer-based records through unified system of regulations.gov can increase agency efficiency in rulemaking activities and allow easier access to entire record by interested parties); see also stuart j. shulman, the case against mass e-mails: perverse incentives and low quality public participation in u.s. federal rulemaking, 1(1) policy & internet, article 2 (2009), http://www.pso-commons.org/policy-and-internet/voll/issl/art2 (discussing computerized system for handling of mass email comments). on the other hand, scholars have expressed reservations about the increasing use of the internet and social media in the promulgation of administrative rules. particularly, scholars have criticized the unified, monolithic system of regulations.gov as unresponsive to the particular needs of a given agency and overly solicitous of low-quality, unhelpful, or politically-motivated comments from parties that would otherwise lack the incentive to participate in any meaningful way in a system that would require participants to set forth some minimal amount of effort. see, e.g., stuart m. benjamin, evaluating e-rulemaking: public participation and political institutions, 55 duke l.j. 893, 908, n.43 (2006) (noting in one particular fcc rulemaking activity open to public participation on regulations.gov that over one million comments were received, but none were "terribly helpful or influential"); gary coglianese, citizen participation in rulemaking: past, present, and future, 55 duke l.j. 943, 959 (2006) ("according to one recent study of about 500,000 comments submitted on an especially controversial epa rule, less than 1 percent . . . had anything original to say."); john m. de figueiredo, e-rulemaking: bringing data to theory at the federal communications commission, 55 duke l.j. 969 (2006) (finding only 2012] 561 florida tax review target its need for guidance and information to appropriate audiences. knowing who to ask, and where to reach out, are skills not likely part and parcel of irs guidance writers' training, though there is a significant segment of the irs involved in providing outreach to the community, and organizations within the irs (such as the taxpayer advocate service) have contacted listserves dedicated to low income practitioners, used town halls, youtube and other new media outlets to get their message across. in addition to helping the irs, should its position be challenged in court, its explanation of its choices in guidance should be more forthcoming. the irs has long guarded internal deliberations from public discovery,172 but marginal change in quality of fcc rulemaking after introduction of public participation through regulations.gov). further, an ever-present concern is the prospect of making rulemaking activities more time-consuming and costly for already understaffed or under-resourced agencies. see strauss, supra, at 391 (noting that increased volume of comments in record can expose agency to intrusive congressional oversight and judicial review if agency fails to adequately consider all comments, even comments ultimately lacking merit). as a remedy to these concerns about information overload through the unified system of regulations.gov, some third-party participation initiatives, such as the cornell electronic rulemaking initiative (ceri), have formed that aim to facilitate public participation in rulemaking, but at the same time synthesize and filter public comments before they reach the regulating agency. see strauss, supra, at 392 (citing ceri, http://www.lawschool.cornell.edu/research/ceri/index.cfn). in one example involving a proposed department of transportation (dot) regulation that would prohibit regulated truck drivers from texting while driving, ceri summarized the regulation on its website, solicited public participation on particular sections of the regulation on particular days, and developed a summary of the public comments that it subsequently submitted to dot. see id. (advocating for effectiveness of third party advocates such as ceri, arguing that such third-programs would not be necessary if agencies were free to create their own individualized websites to refine public participation). 172. there is a long history of litigation between the irs and publisher tax analysts regarding access to chief counsel writing. chief counsel training materials summarize as follows: "section 6110 of the internal revenue code codifies the outcome of several freedom of information act (foia) lawsuits, brought by tax analysts dating back to the early 1970s, to make available for public inspection certain work products produced, in relevant part, by the national office of chief counsel. denominated as "written determinations," these work products are letter rulings, technical advice, determination letters, and by virtue of the 1998 irs restructuring & reform act amendments chief counsel advice." there is still litigation regarding the scope this provision. see tax analysts finds examples of guidance of taxpayers in e-mails that irs chief counsel sent to field offices, tax analysts, apr. 10, 2008 http://www.taxanalysts.com/www/pressrel. nsf/releases/4b9f8de65do3a8e1852574270053d878?opendocument (citing examples of chief counsel advice found in irs emails that should have been made public). [vol. 12:7562 paradigm for irs guidance when the irs deliberates about issues that result in guidance, enhancing the public's acceptance of and the legitimacy of the agency actions itself are related to understanding why the agency acts.173 some decisions may be grounded in agency expedience, and others may reflect a weighing of other values, but all too often the public and the courts are left wondering why the agency has acted.174 explaining the rationale for an approach, in a manner that reflects the irs's consideration of comments, should be part of the irs checklist, irrespective of whether the guidance was subject to apa notice and comment, or the irs's version of notice and comment through the publication of nprm. amending the apa in the way professor johnson suggests, and subjecting the irs to its terms, would signal the importance of public participation in agency decision making processes. johnson's proposed amendment is intentionally open ended, allowing agencies to determine how much public participation is needed, and which procedures best facilitate "opportunities for timely and meaningful public participation."' johnson looks to the courts "to impose additional procedural requirements on agencies as courts fleshed out the meaning of 'to the extent practicable, necessary and in the public interest,"' and thus creating a body of common law for agencies to rely on when promulgating rules.17 6 it is not clear precisely how much a role courts would, or should have, in helping refine 173. the irs has also started to use social media outlets to provide the public insight into the agency interworking. see national taxpayer advocate twitter link, http://www.irs.gov/advocate/. the irs also holds a number of town hall meetings throughout the country focusing on a variety of taxpayer issues. see, e.g., california practitioner liason meeting and seminars, http://www.irs.gov/businesses/ small/article/0,,id=127814,00.html; irs provides guidance to louisiana, mississippi taxpayers dealing with casualty loss reimbursements, mar. 24, 2008, http://www.irs.gov/newsroom/article/0,,id=180322,00.html. the irs also hosts national webinars for practitioners. 174. the irs's failure to explain its reasoning for adoption of rules it seeks to have court apply may have adverse consequences under general administrative law doctrine. see sec v. chenery corp., 332 u.s. 194 (1947) (court not permitted to affirm agency decision on grounds not advanced by agency); shamik trivedi, after mayo, greater chance of taxpayer success against the irs, tax court judge says, 2011 tnt 120-2 (suggesting courts should apply the chenery rule in tax cases). 175. johnson, good guidance, supra note 45, at 738. 176. id. at 739. even with that discretion, i believe that one benefit of such an approach is that it will engender greater agency consideration to the need for involving the public and explaining its actions. to the extent that involvement and explanation provide too great a cost, the irs can offer a brief explanation why that is the case. see lavilla, good cause exception, supra note 156 (surveying agency good cause exception claims, asserting that the irs most frequently abuses this exception). 2012] 563 florida tax review procedural aspects of rulemaking.'7 7 there are unique issues associated with challenging the procedural validity of irs rulemaking,17 8 yet i believe that other institutional actors can play a complimentary role in enhancing these participatory values. irrespective of the precise role that courts or other actors should play, i believe the broader point is important, i.e, that there should be institutional pressure and leverage placed on the irs to increase participation and accommodate the views of differing constituencies. the paradigm i propose presupposes a more engaged irs willing to employ a broader degree of participatory measures to a greater number of issues. while i do not offer a one size fits all approach to how much process should be attached to each guidance project, a question that irs will need to consider when calibrating the degree of participation is precisely how much process to employ before formulating guidance. this balancing of values related to participation and efficiency is a familiar one; it animates the decision whether to put a rule through notice and comment or issue it in the form of informal guidance. not every issue will be subjected to multiple 177. see vermont yankee nuclear power corp. v. natural res. def. council, inc., 435 u.s. 519 (1978) (exemplifying supreme court reluctance to impose procedures on agencies). "[w]hile agencies are free to grant additional procedural rights in the exercise of their discretion, reviewing courts are generally not free to impose them if the agencies have not chosen to grant them . .. even apart from the apa, the formulation of procedures should basically be left within the discretion of the agencies to which congress has confided the responsibility for substantive judgments. id. at 520. 178. in particular, the declaratory judgment act and anti-injunction act limit the ability to challenge the procedural sufficiency of irs guidance outside traditional deficiency or refund litigation matters. see hickman, a problem of remedy, supra note 5, at 1164-65. but cf cohen v. u.s., 650 f.3d 717, 731, (d.c. cir. 2011) (holding in limited circumstances that section 702 waives sovereign immunity for procedural challenges under apa in the tax context as well as in other contexts). the litigation involved the irs's special refund scheme for a telephone excise tax that a number of circuit courts had previously concluded was illegally collected. after setting up a procedure in notice 2006-50 to allow for refunds, the taxpayer in cohen alleged that the irs failed to comply with notice and comment procedures applicable to agencies that issue legislative guidance under the apa. in a majority en banc opinion, the court read the dja prohibition on matters "with respect to federal taxes" as coterminous with the narrower language of the associated anti-injunction act prohibition on suits, which relates to the preclusion of injunctive relief, as "restraining the assessment or collection of any tax." i.r.c. § 742 1(a). as the taxpayers in cohen did not seek a restraint in the assessment or collection of taxes, and were rather disputing the process set forth in the notice, the majority held that neither the anti-injunction act nor the dja applied, and thus held in limited circumstances that section 702 waives sovereign immunity for procedural challenges to the notice under the apa. cohen, 650 f.3d at 724. [vol. 12:7564 paradigm for irs guidance town hall meetings and direct involvement of the commissioner in soliciting input, or warrant releasing a memo or explanation of its decision in adopting a particular approach. despite my reluctance to provide a tight fit and my desire to maintain agency discretion, i propose that the irs consider a number of factors to help determine just how much it should do to engage the public: * the number of taxpayers or third parties affected by the guidance, * the extent to which the issue requires a consideration of equitable factors, * the extent to which the issue gives the irs broad discretion, especially when the discretion relates to the granting of relief from liability or providing a benefit, * visibility of issues to external parties, * severity of burden the rules may impose on taxpayers or third parties, * extent to which taxpayer rights are impacted, * likelihood that the circumstances of those impacted by rules differs from the circumstances of the regulating agency, * extent that the issue has the attention of parties that are familiar with or involved in the informal process of influencing, * the administrative burden on the irs given other demands it faces, * the extent that the issue requires immediate guidance. 79 the benefit of this approach is that it requires the irs to consider the circumstances both for and against engaging the public. how much the scale should be tipped in any issue requires the judgment of the irs; yet, by at least considering the factors, the irs will weigh the merits associated with seeking guidance. for example, an issue that requires the agency to consider equitable factors in granting relief, or one that gives the irs broad discretion, would presumptively attract greater process. the presumption could be 179. these factors were adopted from nina olson's response to tigta report evaluating the tsa process used to identify potential systemic issues. see treasury inspector general for tax administration, the identification and evaluation of systemic advocacy projects designed to resolve broad-based taxpayer problems can be improved, jun. 27, 2011 http://www.treasury.gov/ tigta/auditreports/201 1reports/201110052fr.pdf the report stated that improvements can be made to tas's screening process used to identify these systemic issues. the national taxpayer advocate responded that tas has in fact developed a number of criteria that apply when evaluation potential impact of systemic issues and asserted that issues can only be evaluated based on an exercise of informed judgment. id at 17-19. 2012] 565 florida tax review rebutted, however, if there was an immediate need for guidance. 80 to assist with the important goal of educating the public as well as increasing the broader acceptance of the irs's actions, the irs should briefly explain the rationale for the process it chooses for any issue, and summarize the nature of meaningful comments and input it received during the procedures leading to the promulgation of the guidance it issues.' 81 a prominent place in the discussion should be the views of tas or tax clinics, as well as the justification for the adoption of a particular rule. in the next section, i discuss how strengthening the role of intermediaries such as the taxpayer advocate service and low income taxpayer clinics can assist the agency in addressing the challenges associated with underrepresentation. even if congress were to amend the apa, or the irs were to engage proactively to seek the input of all those it regulates, these intermediaries are necessary to overcome barriers such as time, public expertise, and technical knowledge, all of which limit involvement in the american political system among those that have the fewest resources. c. how the taxpayer advocate service and clinics can help ensure that lower income taxpayer's interests are served in the rulemaking process as described above, the irs can do more to seek out the voice of the underrepresented in the rulemaking process. even with an irs determined to seek input from groups underrepresented in the political process, however, it is likely that due to the characteristics of lower-income or underrepresented taxpayers that are the subject of irs guidance, there would be a shortage of meaningful input. accordingly, i propose an approach that would first, as described above, require the irs to take positive steps to reach out to seek input, and second, ensure that organized third parties are encouraged and incentivized to contribute to the irs's formation of rules. my idea is not novel; scholars outside the tax area have long noted how poorer americans are underrepresented in the political process, and that agencies often need to interact with organized intermediaries or proxies who can advance the interest of people who the agencies regulate. 182 180. the immediate need for guidance should not necessarily foreclose involvement; interim rules could be adopted, with guidance finalized after the agency had time to put in place the means for generating public participation. 181. while this is done as a matter of course in the preamble to regulations, it is not done in subregulatory guidance. 182. for example, see bonfield, representation for the poor, supra note 64, at 511 (urging "the sound operation of the federal administrative rulemaking system demands that all relevant interests and viewpoints be considered prior to the formulation and promulgation of its product."). bonfield asserts that agency rulemaking is more representative of middle and upper class americans who either [vol. 12:7566 paradigm for irs guidance commentators looking at agencies whose regulatory policies have significant impact on low income people have often shared a concern for ensuring more pluralistic engagement in the informal rulemaking process. one of the earlier commentators, arthur bonfield, argues that agencies fail to consider the needs of lower income citizens when developing policy because their public participation programs are both inadequate and inconsistently applied. 83 bonfield, as i do here, offered a two-pronged approach. initially, he asserts that agencies making rules seek to ascertain the views of the poor.'" bonfield, like johnson, proposed practical steps that agencies can do, such as holding formal hearings on proposed rules in close proximity to the poor people affected and holding informal town hall meeting in their own neighborhoods, to increase public participation. 8 5 in addition, even with those actions, bonfield felt that barriers among regulatees like poverty and limited time would blunt their effect. accordingly, he suggested an independent counsel to represent the interests of the poor in all federal rulemaking that substantially effects them, acting as an artificial representative for the poor.186 acting as an advocate, the group would be under the affirmative duty "to seek the advice and help of relevant sources of every kind, whether private or governmental, individual or organizational."18 7 other scholars and advocates have also considered the use of advocate agencies and ombudsmen to represent the interests of poor or directly or indirectly monitor agency activities, to the detriment of those who lack the resources to keep themselves informed. id at 511-12. see also susan lazarus & joseph onek, the regulators and the people, 57 va. l. rev. 1069 (1971) [hereinafter lazarus & onek, the regulators] (stating the central problem with regulatory agencies is their unresponsiveness to public concerns). lazarus and onek posit that "the mere fact that agencies perform efficiently does not insure that the agencies are properly fulfilling their functions." id at 1071. 183. bonfield, representation for the poor, supra note 64, at 514-16 (reasoning that not only do agencies fail to realize the substantial impact their programs have on the poor, the efforts used to solicit public participation are inadequate). 184. id. at 512, 522-23. 185. id. at 524. bonfield urges federal agencies to use special notice and hearing arrangements tailored to meet the problems of economically underprivileged persons in order to accurately obtain their views on regulations. an updated version of bonfield's proposal would most likely capture the vast social media networks to facilitate discussion and keep the public aware of agency decision making in real time. as applied to economically under privileged persons, access to this forum may still be limited, and thus agencies should also continue to structure their public participation policy to be accommodating to a particular group. 186. id at 530-31. 187. id. at 531. 2012] 567 florida tax review otherwise underrepresented parties. 18 in a recent essay, professors mcdonnell and schwarcz explore the role that regulatory contrarians can play in the regulatory process, with a focus on ensuring a more adaptive and responsive financial regulatory process.189 their essay describes ombudsman contrarians as one of the four types of regulatory contrarians that exist,190 with the ombuds term referring to an independent entity or person that is charged with responding to complaints. noting that the ombuds office within the irs, the taxpayer advocate service, is "[p]erhaps the most well-known ombudsman contrarian," mcdonnell and schwartz refer to its ability to improve the agency's relationship through persuasive force and soft powers, such as its congressional reporting power, and its participation within the academy (such as in research colloquium and conferences).' 9' tas also has the ability to "continually present the taxpayer point of view to other subcomponents within the agency as a balance, counterweight, or check to insular thinking and the enforcement mentality that often pervades inquisitorial systems."l 9 2 while mcdonnell and schwarcz describe tas and ombuds success generally in the context of encouraging agencies to act and combat the regulatory tendency toward delay, professor wendy wagner focuses more on the role that intermediaries such as ombuds can play once the agency has committed to act. professor wagner has called for the deployment of "government intermediaries" to redress a "pluralistic imbalance" that she believes is exacerbated by the ability of larger, better financed parties to engage in information capture, or the "excessive use of information and related information costs as a means of gaining control over regulatory decision-making in informal rulemakings."l 93 professor wagner writes 188. see wagner, administrative law, supra note 149, at 1414 (proposing that government intermediaries such as agency selected ombudsmen, advocates and advisory groups, stand in for underrepresented interest groups in order to redress pluralistic imbalances in rulemaking); stewart, reformation, supra note 80, at 1723, 1748 (asserting that specialized advocacy in the form of high-level government advocates may be a potential way to ensure diffused interests are represented in policy formation); lazarus & onek, the regulators, supra note 182, 1097-93 (stating that even when political power of public constituencies has proven powerful, like with consumer protection, it is usually ineffective at influencing administration of laws after their enactment). 189. see generally brett mcdonnell & daniel schwarcz, regulatory contrarians, 89 n.c. l. rev. 1629 (2011). 190. the other regulatory contrarians listed by mcdonnell and schwarcz are consumer representative, investigative, and research. id at 1653. 191. id. at 1655. 192. id. at 1655-56 n.108 (citing bryan camp, what good is the national taxpayer advocate?, 126 tax notes 1243 (mar. 8, 2010)). 193. see wagner, administrative law, supra note-149, at 1325, 1414. 568 [vol. 12:7 paradigm for irs guidance mostly about the potential for capture in the context of environmental rulemaking where, unlike in many of the tax issues relating to poorer taxpayers, there is a possibility that larger better financed voices can crowd out other less powerful voices with respect to particularized matters. in those matters, an agency such as the epa, balances differing interests of the regulated parties. professor wagner's (and others) concern is that powerful parties can control or capture the agency, through for example, the allure of employment prospects for agency employees or the ability to overload the agency with information in a way that distorts the process.194 when agencies seek to act and provide guidance in a variety of forms, parties with access and voice have opportunity to present and persuade the agency, and those without the ability to communicate will face an agency that is unaware of their needs. wagner suggests that agencies allow ombudsmen to participate in the formative rulemaking process so that agencies consider not just the costs of regulation, but also the health benefits with regard to "vulnerable populations."' 95 if the agency failed to consider the interests adequately in the formulation of rules, professor wagner proposes that the ombudsperson would be "required to file comments," thus building a record for review to be used by other regulatory participants and potentially in the context of judicial review of the agency's rulemaking.'96 for rulemakings that are highly technical, wagner suggests assembling an expert advisory committee that would allow for the agency to consider issues relating to "missing affected interests," i.e., interests that the agency may not otherwise consider (or even be adequately made aware of).197 194. id. at 1325. wagner also references other areas of agency regulations that have also been plagued by information capture. id at n. 18 (citing pete tridish & danielle redden, radio controlled: a media activist's guide to the fcc!, prometheus radio project, feb. 12, 2006 (referring to information capture and excessive information in fcc rulemaking)); troy a. paredes, blinded by the light: information overload and its consequences for securities regulation, 81 wash. u. l.q. 417, 449 (2003) (arguing that increased disclosure requirements can be problematic in light of inadequate filtering of information). 195. wagner, administrative law, supra note 149, at 1414. 196. see id at 1415 (reasoning that a paper trail of comments would be beneficial to judicial review). 197. in addition to improving the agency's rules ex ante, wagner's proposals have as a secondary objective creating a record so that parties challenging the agency's rulemaking in court may be able to point to inadequacies in the process or substance of the agency's rulemaking. as discussed above, in the tax context, limits to parties' ability to receive pre-enforcement judicial review combined with the trend of greater deference to irs rulemaking makes this secondary objective less relevant. likewise, professor wagner's suggested use of aljs to oversee a hybrid formal/informal rulemaking, in light of the relative absence of al's in the tax context make this portion of the proposal inapplicable to irs rulemaking. id 2012] 569 florida tax review professor wagner's policy prescription makes sense for the irs, and as professors mcdonnell and schwarcz identify, the irs already has in place a strong ombuds office that plays an active, though incomplete role in representing the voices of less powerful taxpayers. in tax matters, while there may not be the same clash between say polluters and environmental groups that professor wagner identifies, the effect may be the same. for example, the irs may not necessarily consider or weigh sufficiently the interests of poorer or underrepresented taxpayers in the context of rules relating to the delivery of benefits or to relief of liability because those taxpayers and their issues are less germane to the agency's core constituencies.19 non-tax and tax scholars looking at tas have praised its abilities to provide voice for the poor and for its influence tax administration. 99 yet, tas's role is incomplete because its recent success has much to do with its current charismatic and persistent leader nina olson, and it could benefit from administrative and legislative changes that would cement its role in the process even when she departs the scene. moreover, its statutory reporting powers are focused on alerting congress of problems and solutions, rather than directing tas to have a more direct and clear role in the formation of irs guidance. the following discusses the evolution of tas over the past few decades and proposes a more concrete role for the agency in the rulemaking process. 1. tas since its origin as the irs's problem resolution program (prp) of the 1970s,2 00 tas, the irs's ombuds, has grown in independence, responsibility and prestige. since 2001, it has been headed by nina olson, who, as national taxpayer advocate, has been a major voice in tax administration and has made significant steps to institutionalize the office's powers. the history of the office indicates its relatively modest beginnings, 20' and its increasing power and prestige over the years,202 to a 198. see colin s. diver, policymaking paradigms in administrative law, 95 harv. l. rev. 393 (1981); mark seidenfeld, cognitive loafing, social conformity, and judicial review of agency rulemaking, 87 cornell l. rev. 486 (2002). 199. see, e.g., bryan camp, what good is the national taxpayer advocate, 126 tax notes 1243 (mar. 8, 2010) [hereinafter camp, national taxpayer advocate]. 200. i am indebted to and borrow from the excellent discussion of the evolution of the prp program in camp, national taxpayer advocate, supra note 199. 201. in 1976, the irs implemented the problem resolution program (prp) to address taxpayer problems that were not promptly or timely resolved, or where the service had not been fully responsive to the needs of taxpayers. id. that program 570 [vol. 12:7 paradigm for irs guidance point now where it plays a significant, though incomplete, role in the formation of administrative policy.203 originated in large part due to the automated functions of irs adjudication procedures, and the concomitant need to have specialized irs employees to assist with taxpayers navigate problems. id. in 1979, the irs expanded the prp program and created a senior position, the taxpayer ombudsman, to both coordinate prp activity and to provide systemic advocacy by reviewing "[p]olicies and procedures and legislative proposals for unfair taxpayer burdens." id. at 27 (citing james w. quiggle and lipman redman, procedure before the internal revenue service, at 6 (6th ed. 1984)). the focus of prp was on assisting taxpayers when operations failed and providing a mechanism to elevate concerns to congress. the trend of increasing responsibilities continued in 1988 when congress enacted section 7811 as part of the taxpayer bill of rights which codified aspects of the prp program and allowed tas to issue taxpayer assistance orders (tao) to prevent the irs from taking certain administrative collection actions. see technical and miscellaneous revenue act of 1988, pub. l. 100-647, 102 stat. 3342. note that only the commissioner could overrule tao. see irm 13.1.20.5 (12-15-2007). 202. administrative changes in 1992, gave tas explicit authority to take positive actions in addition to ordering the release of levies with a tao (such as ordering the release of a taxpayer's refund). see i.r.s. deleg. order 239 (rescinded jan. 1, 2004); camp, inquisitorial, supra note 83 (explaining do gave taxpayer ombudsman authority to require positive acts, later incorporated onto tabor2). the 1996 taxpayer bill of rights 2 (tbor2) codified the changes and renamed the taxpayer ombudsman as the taxpayer advocate and there was a higher level of independence, authority and responsibility attached to this new position. see taxpayer bill of rights 2, pub. l. no. 104-168 stat. 1452. tbor 2 extended the scope of the tao by giving the taxpayer advocate broader authority in issuing a tao. tbor 2 also mandated that the taxpayer advocate present two annual reports to congress, with congress specifying what those reports should contain. see evolution of the office of the taxpayer advocate, i.r.s. publication http://www.irs.gov/pub/irs-utl/evolution-of the office of the taxpayers advocate .pdf. the move towards restructuring the service and the impetus for further reform led congress to establish the national commission on restructuring the internal revenue service in 1996. see treasury, postal services and general government appropriations act, 1996. 203. the restructuring commission report supported changes to "restore the public's faith in the american tax system," incorporate greater outside oversight, simplify the system and strengthen tas to allow for greater independence. national commission on restructuring the internal revenue service. a vision for a new irs, at 5 (june 25, 1997). specifically, it recommended, "to succeed, the advocate must be viewed, both in perception and reality, as an independent voice for the taxpayer within the irs." id. at 48. to mitigate those concerns, the commission called on tas to expand its reporting obligations by identifying the ten most litigated issues and providing solutions for mitigating disputes in those areas. see id. at 49. the commission proposed that "[t]o ensure the independence of the national taxpayer advocate, candidates for this position should have substantial experience representing taxpayers before the irs or with taxpayer 2012] 571 florida tax review following rra 98, tas increasingly played an important role in the development of legislation.2 04 its reports and the testimony of nina olson have had a substantial impact in terms of encouraging administrative and legislative sensitivity to issues and interests that are not necessarily championed by any organized group. in addition, tas has greatly expanded its capacity to address individualized problems that taxpayers have in navigating the system and had a role in a variety of issues that resulted in 205changes to irs guidance. how much of the influence of tas rests with the skills of the current national taxpayer advocate, as compared to the institutional powers of its office, however, remains unclear. in addition, its reporting role is directed to congress, and while it is responsible for informing congress, to ensure an even stronger role, and one that will last beyond the term of any one nta, congress and the irs itself can make changes that emphasize tas's role in assisting the irs and treasury develop rights issues. if the advocate is selected from the ranks of career irs employees, the selection also should be a person with substantial experience assisting taxpayers or with taxpayer rights issues, and the job description should stipulate that it will be the employee's final position within the agency." id. the commission also called for a more vigorous internal role in preventing problems before they occur, emphasizing a special relationship with the irs's outside board of directors. id. my proposals thus build on the commission's theme for ex post tas involvement. 204. see national taxpayer advocate, 2001 annual report to congress at 2 (voicing concern about differing definitions and complex rules surrounding "qualifying child" deductions, and calling for revision). the working families tax relief act of 2004 subsequently enacted this tas recommendation. pub. l. no. 108-311, 118 stat. 1169. 205. see, e.g., withdrawal of notice of federal tax lien after release, bsse-05-0611-037 (june 10, 2011) (setting forth new procedures for processing requests for withdrawal of notices of federal tax liens after the lien has been released and reflecting a victory for the nta). see also, national taxpayer advocate says irs not meeting needs of low-income taxpayer, 2010 tnt 51-41 (march 16, 2010) (tax analysts) (containing nina olson's testimony before the house ways and means oversight subcommittee regarding the need for nftl reform). the taxpayer advocate asserted that although nftls are powerful and effective collection tools, improperly applied, they may cause unnecessary hardship to taxpayers. id. therefore, the irs must balance the harm the lien may inflict and the revenue it is likely to generate. id as cases percolate through the taxpayer advocate service, it is uniquely situated to examine how these policies impact taxpayer interests. for example, if a taxpayer loses his job and he becomes delinquent on his taxes, an nftl may be applied. if it is applied, it is immediately recorded on the taxpayer's credit report. not only will this have long term damage on his credit score, it may also destroy his financial viability hampering employment opportunities and thus driving up a taxpayer's costs, and lowering the likelihood he will be able to pay their tax deficiency. even if the tax debt is settled and the lien released, the nftl will still appear on a taxpayer's credit report, potentially indefinitely, causing him long term financial repercussions. [vol. 12:7572 paradigm for irs guidance policies before problems arise, rather than in a reactive way through irs guidance that may adversely impact taxpayer interests. although tas is involved in proposing legislative changes to congress, little explicit statutory authority exists to empower tas to act in the rulemaking process. to supplement the powers of tas within the guidance process, the statute should reflect an affirmative role for commenting on proposed agency guidance as well as report on the effect of its involvement in rulemaking. moreover, the structure of the office should be modified to allow a statutorily based counsel to play a formal role in the rulemaking process. that approach is discussed below. a. enhancing the role of the taxpayer advocate congress has invested tas with several statutorily-designated "hard" powers and obligations, from which spring numerous informal "soft" powers.206 while these powers have led to an increased level of awareness of taxpayer issues at the irs, they essentially center on ex post solutions to taxpayer problems. that is, the current tas regime does not adequately involve tas in ex ante participation in irs rulemaking. one factor that has contributed to tas's soft power in the past decade is the skill and experience of the current nta. congress can take specific steps to enhance the statutory powers that tas has with respect to rulemaking, and, in particular, with respect to ensuring that the irs consider tas's perspective before the irs promulgates rules. this subsection proposes three additions to tas's "hard" powers aimed at increasing tas "soft" powers and involvement in ex ante rulemaking consideration. first, congress can create an office of independent counsel that will report to the nta and carve a defined role for that counsel in the rulemaking process. second, tas's reporting obligations to congress may be expanded to include the extent to which irs has considered issues that tas raises in the rulemaking process, including the extent to which irs has sufficiently engaged the interests of outside stakeholders and considered interests of individuals. third, congress may provide a mechanism for the irs to specifically identify comments of tas in the notice and comment process, using section 7805(f) as a model. using section 7805(f) as a model, i propose tas play a more vital role in the promulgation of agency guidance. responsibility for drafting 206. for example, tas has the "hard" powers to intervene in an ongoing taxpayer case before the irs and may issue a variety of administrative measures to delay irs actions and prompt additional agency consideration. as an outgrowth of these explicitly granted powers, as well as the skills and energy of the office, tas has also gained what i term "soft" powers, such as the ability to participate in the academy and colloquia. its prestige and influence undoubtedly contribute to irs taking into account its views prior to promulgating guidance: 2012] 573 florida tax review regulations rests with the assistant secretary of the treasury for tax policy and the office of tax legislative counsel. initial drafting of regulations is delegated to the commissioner and his or her legal advisors in the office of chief counsel.2 07 a fairly intense internal review process ensures that both treasury and irs are comfortable with regulations before promulgation. as mentioned above, the irs view is that regulations are generally exempt from the apa notice and comment regime, although it usually provides at least an informal mechanism for public comment outside the apa.208 the code also provides, under section 7805(f), that after publication of any proposed or temporary regulation, the irs is to submit the regulation to the chief counsel for advocacy of the small business administration for comment on the impact of the regulation on small businesses.209 the chief counsel then submits comments on the regulation, and the irs is statutorily required to consider those comments, discussing those more significant in the preamble of the final regulation. 21 0 this model presents a template that 207. saltzman, irs practice, supra note 116, at sec 3.002. see also, korb, the four r's revisited, supra note 27, at 324-25. 208. see hickman, coloring outside the lines, supra note 26 (describing treasury's view that most of its regulations are interpretive and therefor exempt from apa notice and comment procedure). for more in depth discussion of treasury's guidance see supra notes 115-34 and accompanying text. even when the irs maintains that it is exempt from apa notice and comment because its rule is either interpretive, temporary, or promulgated under the good cause exception, the treasury may still issue a notice of proposed rulemaking and solicit public comments, explicitly stating that it is doing so outside and not pursuant to apa rules. see, e.g., regulations prepared for irc section 469, passive activity loss, t.d. 8175, 1988-1 c.b. 191, 205 (inviting comments but explicitly stating its temporary, interpretive regulation was not subject to apa or rfa). 209. see review of impact of regulations on small business, irc § 7805(f), providing that: (1) after publication of a proposed regulation, it shall be submitted to the chief counsel for advocacy of the sba for comment on impact on small business; (2) in prescribing the final regulation which has been submitted to the chief counsel (a) the secretary shall consider the counsels comments, and, (b) discuss any response to them in the preamble of the final regulation. furthermore, (f)(3) if the final regulation does not supersede the proposed regulation, the secretary must again submit the regulation for sba comments and consider them in the preamble. initiated under, technical and miscellaneous revenue act of 1988, pub. l. no. 100-647, 102 stat. 3342. 210. see id. the regulatory flexibility act (rfa), which is applicable to all rules published pursuant to administrative procedures act section 553(b), requires an agency to prepare a regulatory flexibility analysis in its notice of proposed rulemaking that describes the impact of the proposed rule on small entities and any significant alternatives to the proposed rule. rfa, 5 u.s.c. §§ 603-04. because the treasury maintains that most of its regulations are exempt from the apa notice and comment requirement, either because they are nonlegislative [vol. 12:7574 paradigm for irs guidance congress should adopt to enhance the advocacy role of the national taxpayer advocate. amending section 7805 to provide that the irs is to submit regulations to counsel for the nta, and likewise require the irs to discuss any concerns that the counsel raises, would provide a record allowing the public (and courts) to evaluate the irs's decision-making process and further ensure that it considers the interests that tas represents. to effectuate this, legislation would be needed to grant statutory authority for an independent counsel2 1 hired by the nta that would report directly thereto (counsel to the nta).m to avoid the difficult task of limiting which issues tas should offer comments on, the legislation should clarify that the intent is to allow the irs to benefit from taxpayers whose perspectives may not typically be before the irs due to limited resources or sophistication, or other barriers. in addition, the intent should reflect that congress wishes all taxpayers, not just those with the resources and paid intermediaries, have their interests furthered in the rulemaking process. this would require the nta to select which regulations it comments on, and essentially give the nta discretion to comment, or not, depending upon the nature of the issue.213 to serve as a useful monitor of this new power and how the irs interpretive rules or under the good cause exception, it is not required to comply with the rfa. therefore, although section 7805(f) does not act as an exemption for treasury rules which are promulgated in accordance with the apa, it subjects nonlegislative "interpretive" rules to a lesser degree of analysis. 211. see s. rep. no. 105-174 (1998); h.r. rep. no. 105-599 (1998) (conf. rep.). the senate version of the rra98 suggesting legislative changes to tas provided in § 1102(a) that the nta had the authority to appoint a counsel in the office of the taxpayer advocate that reported directly to the nta, but this was dropped in conference. although there is not much in way of legislative history with respect to the functions that the senate had in mind for this position, it may have been an attempt to provide a statutory foundation to be more involved with the formation of policy within the irs in a manner consistent with the commission report. 212. after this article was written but before its publication, the nta made a similar proposal. see 2011 annual report to congress, http://www.taxpayer advocate.irs.gov/usersfiles/file/201 1_arclegislative%2orecommendations.pdf, at p. 577. 213. currently, nta has on her staff directorates providing staff services for a variety of areas. in addition, the office of chief counsel provides several legal advisors. see national taxpayer advocate background, appendix iii at 4, http://www.irs.gov/pub/irs-utl/tas03obj.pdf. these advisors, known as special counsel to the national taxpayer advocate (cnta), although assisting nta, report back to the office of chief counsel. irm 1.1.6.4 (07-29-2005). the cnta is responsible for matters that require interpretation of irc §§ 7803(c) and 7811, raise questions regarding the authority of the nta, and relate to the completion of legislative recommendations drafted for the nta's annual report to congress. id. this creates the possibility of aconflict when the chief counsel takes a legal 2012] 575 florida tax review overall responds, as part of its reporting responsibilities to congress, nta would describe the regulations it offered comments on, and to what extent the irs did or did not take those views into account in finalizing its rules. 214 b. subregulatory input from tas under current procedures, in addition to regulations, the assistant secretary of the treasury for tax policy makes "the final determination of the treasury department's position with respect to issues of tax policy arising in-connection with regulations, published revenue rulings and revenue procedures, and tax return forms and to determine the time, form and manner for the public communication of such position."215 before promulgation of a variety of forms of subregulatory guidance, the irs's office of chief counsel generally circulates "green" drafts of rule-making throughout all the offices within irs, including tas.2 16 if tas identifies a problem with this guidance, it may raise the concern to the assistant secretary but there is no formal sign-off or procedure to ensure tas comments are considered. although the creation of a counsel to the nta position that differs from the nta's. there are other attorneys who work with the nta, and who are housed in the attorney-advisory group. this group does not provide legal advice or advocacy to the nta, but does provide the nta access to skills such as researching tax law and assisting with report writing, thus providing both direct and indirect assistance with the nta's systemic advocacy function. see http://www.irs.gov/pub/irs-utl/nta2ollobjectivesfinal..pdf, at 75-77; http://www.tax payeradvocate.irs.gov/userfiles/file/20 11 arclegislative%20recommendations.p df, at p.577. 214. ignoring tas comments or failing to explain why irs acted in ignoring those comments might lead a court to find the regulations infirm. see sec. & exch. comm'n v. chenery corp., 318 u.s. 80, 87 (1943) ("the grounds upon which an administrative order must be judged are those upon which the record discloses that its action was based."); motor vehicle mfrs. ass'n v. state farm mut. auto. ins. co., 463 u.s. 29, 50 (1983) (stating "[i]t is well-established that an agency's action must be upheld, if at all, on the basis articulated by the agency itself"). moreover, requiring tas to report on the regulations it comments on, and highlight areas where irs has failed to take into account those comments, will provide requisite congressional attention to issues that may adversely impact taxpayers. 215. the signature authority of the assistant secretary arises under department of the treasury order 111-01 which effectively gives the office of tax policy veto power. http://www.treasury.gov/about/role-of-treasury/ordersdirectives/pages/tol l l-01.aspx. while the chief counsel for advocacy of the small business administration has section 7805(f) to ensure small business interest are considered in nonlegislative regulations, tas currently has no such avenue to assert low income taxpayer concerns. 216. email on file with author. [vol 12:7576 paradigm for irs guidance operating in manner similar to the chief counsel of advocacy for the sba would allow tas to have a stronger voice in regulatory guidance, this additional procedural step may result in irs relying on increased use of subregulatory guidance to bypass this requirement. as professor mantel and others identify, the same concerns with respect to ensuring that an agency considers the interests of parties in subregulatory as in regulatory guidance, a mechanism should be in place to allow for systemic tas input there as well. one approach would be to require guidance from the counsel to the nta, with regard to issues that could have significant effect on low income taxpayers, before the irs issues a notice, revenue ruling, or other forms of guidance. although the assistant secretary for tax policy would still have the final say as to whether the guidance is issued, the counsel to the nta would be given the opportunity to provide comments, and in the case of a disagreement, the nta would have the discretion to report such instances to congress. 2 17 the report should provide and explain any disagreement and, as with other recommendations contained in the tas annual report to congress, allow the irs the opportunity to respond. this procedure will thereby create a complete record for congress to determine whether there is proper consideration of the interests of low income taxpayers. this proposal would encourage understanding of the rationale behind irs policies, and provide systemic pressure on the irs to consider differing views before or close in time to using guidance. 2. clinics scholars have noted the role that organized public interest groups outside government can play in promoting the agenda of lower income or regulated individual interests.2 18 while there are general restrictions that 217. leaving discretion with the assistant secretary of tax policy will help ensure subregulatory guidance will not be bottlenecked by tas comments, but will also balance the interests of all parties. 218. well-financed public interest groups have the ability to lobby agencies in order to advance their views in the policy and regulations produced. see wagner, administrative law, supra note 149, at 1349 (using epa rulemaking as an example for interest groups to infiltrate policymaking). this public interest community has traditionally had little involvement with the formulation of irs guidance, with one major exception. one area where public interest advocates have greatly influenced irs policy is with respect to refund anticipation loans (rals). rals are short-term loans secured by a taxpayer's anticipated tax refund amount. in 2011, the irs effectively curtailed the practice by no longer revealing information about a potential lender's past due tax liabilities or other liabilities that the irs can satisfy with refunds. due to the high cost of those loans and questionable trade practices, the public interest community had a longstanding practice of attempting to convince irs 5772012] florida tax review apply to limit the lobbying activities of legal service organizations 219 and particular restrictions that apply to federally funded tax clinics, there is ample opportunity for the irs to capitalize on clinics involvement with low income taxpayers before the irs puts in place rules that may become the subject of resource intensive litigation if the rules are improper or unwise in the first instance.22 0 since 1998, tax clinics that meet certain criteria, including representing low-income 221 taxpayers or providing outreach to taxpayers who have limited english proficiency, receive matching federal funding.222 and congress to limit their availability. see danielle douglas, end of the rals?, the washington post, mar. 27, 2011, http://www.washingtonpost.com/ capital business/end-of-the-rals/2011/03/25/afnqjvkbstory.html. 219. see 45 c.f.r. pt. 1612. restrictions in lobbying and certain other activities (specifying which activities are prohibited for recipients are legal services corporation grant recipients). see also legal aid services of oregon v. legal services corp., 608 f.3d 1084 (9th cir. 2010). because not all clinics receive funding from legal services, they are not confined to these restrictions. id. 220. low income tax clinics (litcs) specifically are restricted from using any federal grant funds or matching grant funds to either directly or indirectly support, modify, or adopt any low, regulation or policy at any level of government. to clarify, the 2012 grant application packages outlines distinctions between permitted and prohibited activities. low income taxpayers clinic 2012 grant application and guidelines, irs publication 3319 (rev. 9-2011) [hereinafter grant application]. for example, grantees are prohibited from using federal grant funds and matching funds to "draft or assist in the drafting of legislation or provide comments on draft legislation." id. at 38. it is permissible, however, to use funds to educate the public or constituents on legislative issues, "so long as the education is not part of a broader effort to directly or indirectly . . . influence legislators on a specific piece of legislation or legislative issue." id. at 39, 67. see also 31 usc § 1352; 2 cfr pt. 230, 220; publicity and propaganda/appropriations laws restrictions; 2012 grant application supra at 40 (identifying these sources of guidance on lobbying activities and effect on litc activity). note that some tax clinics, including the benjamin cardozo school of law tax clinic, do not receive federal funding and would not be subject to these limits. 221. the term low-income taxpayer clinic means that a clinic: (i) does not charge more than a nominal fee for its services; and (ii) represents low-income taxpayers in controversies with the irs or operates programs to inform individuals for whom english is a second language about their rights and responsibilities. see i.r.c. § 7526(b)(1)(a). the statute does, however, give some room for up to 10 percent of cases in a given year to include taxpayers other than those defined as "low-income." see i.r.c. § 7526(b)(i) (at least 90 percent of taxpayers represented by the clinic must have incomes that do not exceed 250 percent of the poverty level). 222. i.r.c. § 7526(a) (stating that the secretary may make matching fund grants for qualified low-income taxpayer clinics). see also leslie book, tax clinics: past the tipping point and to the turning point, 34 exempt org. tax rev. 27 (2001); keith fogg, a brief history of low income tax clinics, aba section on [vol. 12:7578 paradigm for irs guidance clinics have grown significantly since the advent of federal funding,223 with many housed within traditional legal service organizations, others based in law or business schools under the supervision of a professor, and still others freestanding. the principal activity of tax clinics is the representation of individuals who have disputes before the irs or tax court, or who have tax 224liabilities and are unable to pay fully on those debts. in essence, clinics are a proxy for legal representation before the irs, playing a role necessitated in part by the explosion of the use of the tax system as a means for delivering benefits in the aftermath of welfare reform, ensuring irs focus on compliance among taxpayers claiming those benefits, and the traditional absence of tax work from general legal service organizations.2 25 traditionally, the number of clients that clinics represented has been a key factor in irs decisions to provide funding. 22 6 as such, while some clinics taxation 2010 joint fall cle meeting (sept. 25, 2010) (detailing history of lowincome taxpayer clinics from inception to present). although the majority of lowincome taxpayer clinics are funded through the federal grant program, there are other clinics in existence that operate separate from federal funding. 223. section 7526 authorizes the secretary to provide a matching grant up to $100,000 for qualified clinics. in 1999 grants were awarded to thirty-four clinics. as of 2011, 165 clinics have received funding through the litc programs. see grant application, supra note 220, at 10. 224. out of the 156 litcs currently operating within all fifty states, the district of columbia and puerto rico, eighteen provide esl services exclusively, fifty-two provide representation without esl support, and eighty-six provide both representation and esl. see http/www.irs.gov/pub/irs-pdf/p4134.pdf. 225. see leslie book, the irs's eitc compliance regime: taxpayers caught in the net, 81 or. l. rev. 351, 358-60 (2002) (describing that rights and benefits are often meaningless for low-income taxpayers who lack access to representation in the face of irs compliance actions). litcs not only provided representation, they deliver benefits in the form of increased confidence in the tax system and increased exposure of low income taxpayer issues that have in the past been underrepresented. id. at 414-16. see also janet spragens and nina e. olson, tax clinics: the new face of legal services, 2000 tnt, 181-101 (sept. 18, 1000) (describing how changes in welfare laws, the expansion of the earned income tax credit (eitc), and increased compliance efforts directed largely at low income taxpayers claiming the eitc converged to increase the need for free or low-cost tax representation to the nation's working poor). 226. low income tax clinics are part of the taxpayer advocate service. the irs created the litc program in 1998 as part of the rra '98, and in 2003 it was transferred from the irs wage and investment operating division to the tas, where the director of litc programs reports directly to the national taxpayer advocate. because clinics apply for grants and grant renewals through tas, tas is responsible for both setting guidelines for clinic activity and evaluating clinics effectiveness. furthermore, rra '98 provided that local taxpayer advocates be located in each state, whom area clinics report to, and to whom report directly to the national taxpayer advocate. see i.r.c. § 7803(c)(4). 2012] 579 florida tax review and directors of tax clinics have participated in commenting on proposed irs rules, either individually 2 27 or in the context of work within the american bar association tax section, 22 8 clinicians with limited time and resources 229 have had to allocate their time carefully lest they run the risk of cutting into their ability to handle cases. therefore, the primary focus has been on serving clients in the context of adjudication proceedings, rather than through participation in the rulemaking process. to be sure, since tas took over the responsibility of clinics from irs's wage and investment unit, 23 0 tas has recognized the valuable 227. see leslie book, unofficial transcript of irs hearing on proposed regulations: user fees for offer in compromise, 2003 tnt, 35-27 (feb. 13, 2003) (asserting that user fees as applied will discourage good-faith submissions of olcs by low income taxpayers). 228. see low income taxpayer committee panel website, http://apps. americanbar.org/dch/committee.cfn?com=tx330500 (providing resources for low income taxpayer representation, providing multilanguage eitc forms and publications, and pleading strategies for litc issues such as section 6015(f) innocent spouse to name a few). note that almost all guidance will have an litc clinician involved. see carlton m. smith, what's next? equitable tolling, judical deference and challenges to regulations, revenue rulings and revenue procedure in a post mayo foundation, lantz, and mannella era, aba tax sect. low income taxpayer comm. (2011) (describing from the view point of a clinician the implication of recent section 6015(f) litigation). 229. the issues of limited resources and ability of legal clinics to meet the needs of indigent clients with civil matters is something that is well known in the nontax literature. see quintin johnstone, law and policy issues concerning the provision of adequate legal services for the poor, 20 cornell j.l. & pub. pol'y 571, 575 (2011) (suggesting that growth in population and the number of laws that add to the problems that poor people encounter as the two most important ereasons for the increasing problem of limited access to civil legal representation among the poor); boston bar association task force on expanding the civil right to counsel, gideon's new trumpet: expanding the civil right to counsel in massachusetts (sept. 2008), 4, http://www.bostonbar.org/prs/nr 0809/gideonsnewtrumpet.pdf (describing the pressing need for legal services for the poor funded by federal and state government). see also anthony doniger, a civil right to counsel, 51 b. b.j., 2, 2 (sept./oct. 2007) (addressing how to provide counsel as a matter of right to lowincome persons in civil proceedings); gideon v. wainwright, 372 u.s. 335, 344-45 (1963). "the right to be heard would be, in many cases, of little avail if it did not comprehend the right to be heard by counsel. even the intelligent and educated layman has small and sometimes no skill in the science of law. ... he requires the guiding hand of counsel at every step in the proceedings against him. without it, though he be not guilty, he faces the danger of conviction because he does not know how to establish his innocence." (quoting powell v. alabama, 287 u.s. 45, 68-69 (1932)). 230. see grant application, supra note 220, at 10 (describing briefly the history of litcs). in 2003, the litc program office was transferred from the irs 580 [vol. 12:7 paradigm for irs guidance services some clinic provide in the form of scholarship addressing issues relevant to low-income taxpayers231 and has helped facilitate the flow of information to tas regarding systemic issues that clinics experience first232hand through their representative work. in addition, tas has recognized that clinics housed in law or business schools may have less ability to represent the same number of clients as nonacademic clinics 2 3 3 and has acknowledged that activities such as commenting on regulations and writing articles are also critical factors in assessing clinic performance. while wage and investment (w&i) operating division to the taxpayer advocate service (tas). the director of the litc program office reports directly to the national taxpayer advocate. id. 231. non-clinical scholars are recognizing the valuable role that scholars associated with tax clinics can play. see bryan t. camp, theory and practice in tax administration, 29 va. tax rev. 227, 269 (2009) (praising clinicians such as villanova tax clinic director keith fogg on his contribution to tax reform scholarship, specifically with regard to section 6672 trust fund recovery penalty). 232. for example, i am aware that in 2011, the irs had assembled a task force on issues relating to innocent spouse, and the task force that includes clinicians. the task force is considering a number of issues, including possible revision of the form 8857, request for innocent spouse relief, http://www.irs.gov/pub/irs-pdf/f8857.pdf. 233. the 2012 grant application addressed the unique situation of academic litcs. in academic clinics, fewer taxpayers are served than in nonacademic clinics because of the time involved in teaching and mentoring students. see grant application, supra note 220, at 67. clinical scholarship has provided insight 'from the trenches' on how tax policy affects low income taxpayers, providing tas with the needed information to suggest legislative changes and report the most pressing issue to congress in its annual report. see camp, theory and practice, supra note 60, at 274 (expressing the importance of litcs both in their ability to become a "lobbying voice" for low income taxpayers and a source of valuable tax administration proposals and articles from a nontraditional view from clinical professors). see, e.g., janet spragens & nancy abramowitz, low-income taxpayers and the modernized irs: a view from the trenches, 107 tax notes 140, (jun, 13, 2005) (detailing the effects of '98 reform and reorganization on low income taxpayers); nancy s. abramowitz, thinking about conflicting gravitational pulls litcs: the academy and the irs, 56 am. u. l. rev. 1127, 1133 (2007) [hereinafter abramowitz, gravitational pulls] (recognizing the "closeup scholarly examination of client-centered lawyering" that amounts from clinical professors). 234. see grant application, supra note 220, at 67 (providing program office evaluation measure specific to academic clinics). "[t]he litc program office will consider additional ways in which academic clinics can accomplish litc program goals (e.g., providing technical assistance, training, and mentoring to other litc programs, publishing articles about the litc program, commenting on proposed treasury regulations that affect low income or els taxpayers, and monitoring graduates to determine whether they perform pro bono work on behalf of or otherwise assist low-income taxpayers." id. even though the unique position of 2012] 581 florida tax review these efforts are valuable, congress and the irs can do more to encourage clinics to participate in agency rulemaking. as a legislative incentive, congress could amend section 7526(b)(1)(a) to provide that a permitted clinic activity includes work related to the submission of comments on regulations or other agency guidance provided that those comments are reflective of issues that are germane to their representation of low income taxpayers or people for whom english is a second language. 23 5 in addition, to further help identify the importance of this type of work, litcs should be required to report to tas on their commenting activity in annual reports it submits. moreover, congress may wish to provide a separate funding academic litcs was acknowledged in 2007, the new commenting criteria for evaluation did not appear in litc grant applications until 2012. see abramowitz, gravitational pulls, supra note 233, 1133 (voicing concerns shared by the litc community that litc program office may overemphasize the number of taxpayers served by a program, putting academic clinics at a disadvantage). concerns were met with response and the "national taxpayer advocate has recognized essential differences between academic and pro bono clinics and has extended a hand to academia to offer criteria for evaluating their programs." id at 1130. 235. amended the statute could read as follows (proposed change in italics): 1.r.c. § 7526(b)(1)(b) representation of low-income taxpayers. a clinic meets the requirements of subparagraph (a)(ii)(i) if(i) at least 90 percent of the taxpayers represented by the clinic have incomes which do not exceed 250 percent of the poverty level, as determined in accordance with criteria established by the director of the office of management and budget; and (ii) the amount in controversy for any taxable year generally does not exceed the amount specified in section 7463; and (iii) the clinic provides meaningful commentary to proposed treasury regulations substantially effecting low income taxpayers. (c) special rules and limitations.... (4) criteria for awards. in determining whether to make a grant under this section, the secretary shall consider (a) the numbers of taxpayers who will be served by the clinic, including the number of taxpayers in the geographical area for whom english is a second language; . (b) the existence of other low income taxpayer clinics serving the same population; (c) the quality of the program offered by the low-income taxpayer clinic. . (d) alternative funding sources available to the clinic.... (e) the contribution of meaningful commentary to proposed treasury regulations that will substantially affect low income taxpayers. alternatively, perhaps regulations under section 7526 could liberally define representational work to include participation in rulemaking with respect to matters that clinics are generally involved in. [vol. 12:7582 paradigm for irs guidance mechanism for clinics that engage principally in that activity or incentivize organizations to receive funding separate and distinct from money that is allocated specifically to representation or outreach work.236 the effect of these changes would be both symbolic and practical, as congress and the irs signal to the community that they take nonrepresentative work seriously and help clinic employees and directors who may otherwise feel compelled to allocate their limited resources to areas that are rewarded in the funding process. vi. conclusion reflecting similar concerns that this article raises, the 2011 taxpayer advocate annual report to congress, which came out after this article was originally drafted, makes an explicit legislative recommendation that would require the irs to submit proposed or temporary regulations prior to their publication to the nta for comment, and would also require that the irs address those comments in the preambles to the regulations. in addition, the 2011 annual report recommends allowing the nta to appoint an independent counsel, whose role would include directly providing legal advice to the nta.2 m the recommendations i make, as well as the specific legislative recommendation the nta herself makes, reflect an increased awareness that the irs plays one of the more prominent roles of all agencies in the lives of americans. congress has chosen to increase the irs's responsibilities beyond revenue collection, especially in the last twenty years with the explosion of the amount and size of refundable credits and the placement of nontax legislation (like health reform) within the internal revenue code. superimposed on these additions is an increasing codification of taxpayer rights in the collection process, an overall trend in american culture to expect more transparency in institutions and opportunities for public involvement. the irs in the time following the passage of the apa often received a free pass from provisions to ensure greater accountability and participation. that free pass rooted in tax exceptionalism is coming to an end. 236. this is not intended to exhaustively discuss the mechanism for such funding; rather, the focus here is that congress and tas can do more to ensure that there are proper incentives and certainly no disincentives associated with providing comments to the irs. 237. http://www.taxpayeradvocate.irs.gov/usersfiles/file/2011_arc_ legis lative %2o20recommendations.pdf at p.576. the 2011 report also urges that the nta be granted power to submit amicus curiae briefs and contemplates that the counsel assist the nta with that brief writing function, as well as the task of commenting on regulations. 2012] 583 florida tax review the irs will have an opportunity to consider ways in which its actions and guidance are reflective of participatory values that will help ensure its legitimacy and produce better formed rules that the public will be more receptive to following. the still crucial goal of revenue collection, essential for the modem nation state, need not be undercut by the agency performing functions beyond that still primary goal. the paradigm i propose reflects the reality of the irs's functions and provides an opportunity for it to remain responsive and accountable to the public it is serving. failing to consider its new position in the lives of americans carries with it great risks in that acceptance of the legitimacy of the agency is a likely powerful factor associated with tax law compliance. moreover, increased participation will enhance the wisdom of guidance that the irs adopts. the irs has advantages relative to other agencies in that it has tas and clinics, powerful intermediaries that would be willing partners to facilitate public involvement and serve as proxies when that involvement is not available or impractical. moreover, adopting a best practices approach to participation in the form of informal guidance that would be backstopped by irs explanation of its actions would allow it to serve as a model for other agencies. the irs, like other agencies, has many choices as to how it issues guidance to the public. it is not my intent that this article serve a call to limit the irs's discretion; rather, my hope is that it serves as a prompt for the irs (and congress) to consider as a matter of course the ways in which it can engage the public more meaningfully before it issues guidance that as a practical matter has great impact on the lives of ordinary americans. what of the two-year rule mentioned in the introduction? after about thirty judges ruled or heard argument on cases winding their way through courts of appeal and in tax court, the irs receiving congressional rebuke for its policy and the extraordinary efforts of commissioner shulman in instituting a high level review of the irs's policies, the irs reversed course. in july of 2011, the irs announced that it would be giving relief to taxpayers whose claims for equitable relief were denied because of the two-year rule in the past and offering relief to those who had yet applied.23 8 the reaction in the community of advocates and scholars was immediate. the national taxpayer advocate, in a press release, stated that: i am pleased the irs will be providing relief from the twoyear rule not merely to taxpayers who file future claims but also to most taxpayers whose claims were rejected in the past. i particularly want to commend commissioner shulman, who personally made the decision to change this policy. i also want to commend tas's local taxpayer 238. see notice 2011-70, 2011-32 i.r.b. 135; i.r.s., news release ir2011-80 (jul. 25, 2011). 584 [ vol. i 2: 7 paradigm for irs guidance advocates, who worked on many of these cases and advocated for change; the low income taxpayer clinics, who represented many taxpayers as this issue was winding its way through the courts; and the many members of congress who advocated for this result. this is a welcome occasion where everyone has emerged a winner.3 while the irs withdrawal is good policy, it would have been even better policy had the irs made more of an effort to get direct input on the rule before it issued its guidance. the efforts of local advocates and clinics singled out by the nta when the irs made its high profile withdrawal of the rule, should systematically be part of the ex ante guidance process. relying on clinics or the tas to work with aggrieved taxpayers or lobby congress for changes after the fact does not make for sound tax administration and engenders ill feelings between the irs, congress and, most importantly, among those very individuals who the provision was enacted to help. the paradigm i offer in this article reveals how the irs can provide a more inclusive and participatory way of governing. 239. see nina olson, taxpayer advocate commends irs for policy change on equitable innocent spouse relief 2011 tnt 4143-26 (jul. 25, 2011). 2012] 585 florida tax review volume 12 2012 number 7 the 2011 tannenwald writing competition winners first prize ($5.000): michael a. behrens university of california, los angeles, school of law citizens united, tax policy, and corporate governance faculty sponsor: prof. steven bank second prize (tied) ($2,500): jacob dean university of cincinnati college of law "do you have that new church app for your iphone?' making the case for a clearer and broader definition of church under the internal revenue code faculty sponsor: prof. stephanie hunter mcmahon second prize (tied) ($2,500): stas getmanenko southern methodist university consequences of carried interest reform for the private investment industry faculty sponsor: prof. christopher hanna honorable mention: tessa davis florida state university college of law repoducing value faculty sponsor: prof. curtis bridgeman jacob goldin yale law school libertarian paternalist meets tax policy: designing commodity taxes for inattentive consumers faculty sponsor: prof. yair listokin 587 microsoft word first 5 pages-new.doc florida tax review volume 9 2009 number 5 497 allocating business profits for tax purposes: a proposal to adopt a formulary profit split by reuven s. avi-yonah∗ kimberly a. clausing∗∗ michael c. durst∗∗∗ i. introduction ....................................................................................... 498 ii. the u.s. system of corporate taxation .................................... 499 a. why “arm’s length” prices do not successfully benchmark transactions within multinational companies ..................................... 501 iii. a proposal to adopt a formula-based profit split system of apportionment ........................................................ 507 a. how would a formulary profit split work? ........................... 508 b. five key advantages to a formula-based profit split ............ 510 iv. addressing the downsides of formulary apportionment: a practical statutory approach .................................................... 516 a. is formulary apportionment arbitrary? ........................................ 516 b. implementation ............................................................................... 517 1. statutory proposal .......................................................................... 517 2. interactions between countries with different tax systems .......... 519 3. defining the tax base .................................................................... 522 4. interaction with tax treaties ......................................................... 523 c. negative effects on some corporate stakeholders ........................ 524 v. conclusion ......................................................................................... 525 ∗ irwin i. cohn professor of law and director, international tax llm, the university of michigan. ** thurmund a. miller and walter mintz professor of economics, reed college. ∗∗∗ special counsel, steptoe & johnson llp, and former director, advance pricing agreements program, irs. 498 florida tax review [vol. 9:5 i. introduction1 the current system of taxing the income of multinational firms in the united states is flawed across multiple dimensions. the system provides an artificial tax incentive to earn income in low-tax countries, rewards aggressive tax planning, and is not compatible with any common metrics of efficiency. the u.s. system is also notoriously complex; observers are nearly unanimous in lamenting the heavy compliance burdens and the impracticality of coherent enforcement. further, despite a corporate tax rate one standard deviation above that of other oecd countries, the u.s. corporate tax system raises relatively little revenue, due in part to the shifting of income outside the u.s. tax base. in this proposal, we advocate moving to a system of formulary apportionment for taxing the corporate income of multinational firms. under our proposal, the u.s. tax base for multinational corporations would be calculated based on a fraction of their worldwide incomes. this fraction would be the sum of (1) a fixed return on their expenses in the united states and (2) the share of their worldwide sales that occur in the united states. this system is similar in significant respects to the current “residual profit split” method of the u.s. transfer pricing regulations and the oecd guidelines, as well as to the current method that u.s. states use to allocate national income across states.2 the state system arose due to the widespread belief that it was impractical to account separately for the economic activity supposedly earned in each state when states are highly integrated economically. similarly, in an increasingly global world economy, it is difficult to assign profits to individual countries, and attempts to do so are fraught with opportunities for tax avoidance. under our proposed apportionment system, firms would have far fewer incentives to shift income to low-tax locations. this would help protect the u.s. tax base while reducing the distortionary features of the current tax system. in addition, the complexity and administrative burden of the system would be reduced. the proposed system would be both better 1. parts of this paper incorporate reuven avi-yonah and kimberly clausing, reforming corporate taxation in a global economy: a proposal to adopt formulary apportionment, in path to prosperity: hamilton project ideas on income security, education, and taxes, furman and bordorff, eds. brookings institution (2008), pp319-44; also in 2007 tnt 114-38 (jun. 13, 2007), and michael durst, a statutory proposal for u.s. transfer pricing reform, tax notes int’l 1041 (june 4, 2007). the authors acknowledge valuable feedback from rosanne altshuler, mihir desai, jon talisman, michael knoll, reed shuldiner, chris sanchirico, joann weiner, diane ring, yariv brauner, joseph guttentag, philip west, and the hamilton project staff, especially peter orszag, jason bordoff, and michael deich. 2. we should note, however, that our proposal is significantly different from current state tax law, in ways discussed below. 2009] allocating business profits for tax purposes 499 suited to an integrated world economy and more compatible with the tax policy goals of efficiency, equity, and simplicity. the following section will discuss the current u.s. system and describe its flaws. section iii will describe our proposed formulary apportionment system, discuss its advantages, and clarify how the proposal addresses the flaws of the current system. section iv will address potential hurdles and problems associated with formulary apportionment, including implementation issues. section v will conclude, briefly contrasting this proposal with other reform suggestions. ii. the u.s. system of corporate taxation under the current tax system, multinational firms (both resident and non-resident) pay tax to the u.s. government based on the income that they report earning in the united states. as is typical, the united states employs a separate accounting (sa) system, under which firms account for income and expenses in each country separately. the current u.s. tax rate is 35%. figure 1a shows the evolution of corporate tax rates for oecd countries over the past quarter century. as is clear from this diagram, the u.s. statutory corporate tax rate has been increasing relative to other oecd countries over the previous 15 years, and it is now one standard deviation higher than the average oecd tax rate.3 the u.s. government taxes u.s. multinational firms on a residence basis, and thus u.s. resident firms incur taxation on income earned abroad as well as income earned in the united states. u.s. taxation is imposed only when income is repatriated by a foreign subsidiary to the u.s. parent via a dividend.4 thus, a subsidiary’s income can grow free of u.s. tax prior to repatriation, a process known as deferral. deferral provides strong incentives to earn income in low-tax countries. as an example, consider a u.s. based multinational firm that operates a subsidiary in ireland. assume that the u.s. corporate income tax rate is 35% while the irish corporate income tax rate is 12.5%. the irish subsidiary earns €800 and decides to repatriate €70 of the profits to the united states. (assume, for ease of computation only, a 1:1 exchange rate.) first, the irish affiliate pays €100 to the irish government on profits of €800. 3. the trends for average effective tax rates are similar. see figure 1, panel b. 4. the subpart f provisions of u.s. tax law prevent some firms from taking full advantage of deferral. under subpart f, certain foreign income of controlled foreign corporations is subject to immediate taxation. this includes income from passive investments. the subpart f rules, however, do not seek even to approach the goal of eliminating the shifting of income overseas, and in fact they permit massive levels of such shifting. 500 florida tax review [vol. 9:5 it then repatriates $70 to the united states, using the remaining profit (€630) to reinvest in its irish operations. the firm must pay u.s. tax on the repatriated income, but it is generally eligible for a tax credit of $100 (taxes paid) times 70/700 (the ratio of dividends to after-tax profits), or $10.5 owing to deferral, the remaining profits (€630) can grow abroad tax-free prior to repatriation. this system creates a clear incentive to earn profits in low-tax countries. firms may respond by locating real activities (jobs, assets, production) in low-tax countries. in addition, firms respond with various legal and accounting techniques to shift profits to low-tax locations, disproportionately to the scale of business activities in such locations. there are multiple such ways to shift income to subsidiaries in low-tax countries. for example, it may be advantageous for multinational firms to alter the debt/equity ratios of affiliated firms in high and low-tax countries in order to maximize interest deductions in high-tax countries and taxable profits in low-tax countries. further, multinational firms have an incentive to distort the prices on intrafirm transactions in order to shift income to low-tax locations. for example, firms can follow a strategy of under(over-) pricing intrafirm exports (imports) to (from) low-tax countries, following the opposite strategy with respect to high-tax countries. the most powerful of such techniques typically involve the transfer of interests in intangible property, such as patents, copyrights and trademarks as well as unpatented know-how, to subsidiaries in low-tax countries. in theory, firms should be limited in their ability to engage in taxmotivated transfer pricing by government enforcement of existing transfer pricing laws. governments generally employ an “arm’s length” standard, requiring multinational firms to price intrafirm transactions as if they were occurring at arm’s length. nonetheless, there is universal agreement that this standard leaves substantial room for uncertainty as to the “correct” transfer pricing, as arm’s length prices are often difficult to establish for many intermediate goods and services, and they are especially difficult, and probably impossible, to estimate in cases of licenses and other transfers of interests in unique intangible property such as a company’s “crown jewel” patents and copyrights. further, as argued below, the arm’s length standard has become administratively unworkable in its complexity. as a result, the arm’s length standard rarely provides useful guidance regarding economic value. 5. in general, under the u.s. tax system, when a non-u.s. subsidiary distributes income to a u.s. parent through a dividend, the u.s. parent is entitled to a credit, against u.s. taxes for taxes paid out of the distributed income to a foreign government. 2009] allocating business profits for tax purposes 501 a. why “arm’s length” prices do not successfully benchmark transactions within multinational companies at the heart of the sa system, with its reliance on estimated “arm’s length” prices, is the assumption that each affiliated company within the group transacts with the other members of the group in the same way that it would transact if the members were unrelated. that central assumption defies reality, and it is not surprising that a system of “arm’s length” pricing cannot yield sensible results. most fundamentally, the sa system ignores the fact that multinational groups of companies arise precisely in order to avoid the inefficiencies that arise when unrelated companies must transact with one another at arm’s length. multinational enterprises arise in large part due to organizational and internalization advantages relative to the efforts of unrelated, separate companies that seek to do business with one another. such advantages mean that within multinational enterprises, profit is generated in part by internalizing transactions within the firm. thus, for firms that are truly integrated across borders, holding related entities within the commonly controlled group to an “arms-length” standard for the pricing of intracompany transactions does not make sense, nor does allocating income and expenses on a country-by-country basis. in fact, a very similar logic was behind the use of formulary apportionment (fa) for u.s. state governments and among the canadian provinces; in an integrated economy, it does not make sense to attribute profits and expenses to individual jurisdictions using separate-entity accounting. second, as explained above, the porosity of current transfer pricing rules creates an artificial tax incentive to locate profits in low-tax countries, both by locating real economic activities in such countries and by shifting profits toward more lightly taxed locations. it is apparent that u.s. multinational firms book disproportionate amounts of profit in low-tax locations. for example, figure 2 shows the ten highest-profit locations for u.s. multinational firms in 2005, based on the share of worldwide (non-u.s.) profits earned in each location. while some of the countries are places with a large u.s. presence in terms of economic activity (the united kingdom, canada, germany, japan), seven of the top-ten profit countries are locations with very low effective tax rates. the literature has consistently found that multinational firms are sensitive to corporate tax rate differences across countries in their financial decisions. estimates from the literature suggest that the tax base responds to changes in the corporate tax rate with an average semi-elasticity of about -2; thus, countries with high corporate tax rates are likely to gain revenue by lowering their tax rate.6 one recent study suggests that corporate income tax 6. see de mooij (2005) for an overview of this literature. 502 florida tax review [vol. 9:5 revenues in the united states were approximately 35% lower due to income shifting in 2004.7 this problem has worsened as u.s. corporate rates have become increasingly out of line with those of other countries. in the past twenty years, most oecd countries have lowered their corporate income tax rates, whereas u.s. rates have been relatively constant. this increasing discrepancy between u.s. rates and foreign rates likely results in increasing amounts of lost revenue for the u.s. government due to strengthening income shifting incentives. also, the literature suggests a substantial responsiveness of real economic activities to tax rate differences among countries.8 these findings imply both less activity in united states and less tax revenue for the u.s. government. however, the tax responsiveness of real activity is less immediately apparent in the data. for example, figure 3 shows the top ten employment locations for u.s. multinational firms in 2005, based on the share of worldwide (non-u.s.) employment in each location. the high employment countries are the usual suspects – large economies with close economic ties to the united states. as the accompanying table indicates, tax rates are not particularly low for this set of countries. third, the current system is absurdly complex. as taylor (2005) notes, observers have described the system as “a cumbersome creation of stupefying complexity” with “rules that lack coherence and often work at cross purposes.” altshuler and ackerman (2005) note that observers testifying before the president’s advisory panel on federal tax reform found the system “deeply, deeply flawed,” noting that “it is difficult to overstate the crisis in the administration of the international tax system of the united states.” current transfer pricing rules have spawned a huge industry of lawyers, accountants and economists whose professional role is to assist multinational companies in their transfer pricing planning and compliance. fourth, particularly given the high u.s. corporate statutory tax rates, the u.s. corporate tax system raises relatively little revenue. figure 4 shows the evolution of government corporate tax revenues relative to gdp for oecd countries. for most oecd countries, revenues have increased as a share of gdp even as corporate tax rates have declined; the average oecd country receives about 3.25% of gdp from corporate tax revenue by the end of the sample. most observers attribute this trend to a broadening of the tax base for many oecd countries during this time period. for the united states, revenues are lower; although they fluctuate with the cyclical position of the economy, they tend to be closer to 2.25% of gdp. there are several 7. this estimate is from clausing (2008). the calculation is based on a regression of u.s. multinational firm affiliate profit rates on tax rate differences across countries. see appendix a for more details. 8. see de mooij (2005). 2009] allocating business profits for tax purposes 503 plausible reasons for the lower amount of u.s. revenue, including the increasingly aggressive use of corporate tax shelters, a narrower corporate tax base, and stronger incentives for tax avoidance, which tend to increase as the u.s. tax rate is high relative to other countries.9 finally, it is important to note that the problems with the current system derive not from rules at its periphery, but instead from a fallacy that lies at the system’s central core: namely, the belief that transactions among unrelated parties can be found that are sufficiently comparable to transactions among members of multinational groups that they can be used as meaningful benchmarks for tax compliance and enforcement.10 for example, if one wants to determine the “arm’s length” level of profitability of a u.s. distribution subsidiary of a foreign manufacturer of automobiles, one identifies one or more independent u.s. distributors of automobiles operating in economically, similar circumstances and uses the income of the independent distributor or distributors to benchmark the income of the u.s. subsidiary. such an approach might well have made sense eighty years ago, when the legislative language underlying today’s arm’s length standard for income tax purposes was first developed.11 at that time, although multinational groups existed, available transportation and communications technology did not permit close centralized management of geographically dispersed groups. therefore, members of multinational groups functioned largely as independent entities, and benchmarking their incomes or transactions based on uncontrolled comparables probably made good sense. 9. alan auerbach “why have corporate tax revenues declined? another look.” nber working paper no. 12463. cambridge, (aug. 2006); also notes that there is a declining ratio of nonfinancial c corporation profits, although he notes that this is offset by an increasing average tax rate due to the increasing importance of tax losses. 10. reuven avi-yonah “the rise and fall of arm’s length: a study in the evolution of u.s. international taxation.” finance and tax law review 9:310 (updated version of article from 1995 virginia tax rev. 15:80 (2006). this argument is presented in detail in e.g., stanley i. langbein “the unitary method and the myth of arm’s length.” tax notes 30:625 (1986), and michael c. durst & robert e. culbertson clearing away the sand: retrospective methods and prospective documentation in transfer pricing today.” tax law rev. 57. 37-84 (2003). 11. for historical summaries see, e.g., stanley i. langbein “the unitary method and the myth of arm’s length.” tax notes (1986), rueven avi-yonah “the rise and fall of arm’s length: a study in the evolution of u.s. international taxation.” (2006) and michael c.durst & robert e. culbertson “clearing away the sand: retrospective methods and prospoective documentation in transfer pricing today.”(2003) at 42-64. 504 florida tax review [vol. 9:5 that situation changed, however, with the technological changes precipitated by the second world war. today, it is possible to exercise close managerial control over multinational groups, and these groups develop in all industries and geographic market segments in which the efficiencies of common control pose significant economic advantages. moreover, in those industries and markets where common control poses advantages, it is typically economically infeasible to remain in the market using a noncommonly controlled structure (for example, by maintaining distributors that are economically independent of manufacturers). therefore, in those markets in which multinational groups operate – that is, in those markets in which transfer pricing issues arise – it is unlikely that reasonably close “uncontrolled comparables” can be found. for example, to our knowledge, there are no independently owned distributors of mass-market automobiles in the united states; all of the distributors are owned by their manufacturers.12 the same is true of virtually every other industry that is conducted on a large global scale. in sum, no matter how assiduously one performs “functional analyses” designed to identify “uncontrolled comparables” that are reasonably similar to members of multinational groups, one is rarely going to find them. certainly, such comparables will not be – and have not been – found with sufficient regularity to serve as the basis for a workable transfer pricing system. if the transfer pricing rules are going to be made tolerably administrable, congress will need to restate them on a basis other than that of reliance on uncontrolled comparables. the results of the current system, which assumes the availability of useful comparables in an economic environment where they are very unlikely to be found, are predictable: (i) companies and the government spend extraordinary sums each year on efforts at compliance and enforcement, largely through the preparation of “contemporaneous documentation”13 by taxpayers and attempts at comprehensive examinations by the irs involving some of the service’s most experienced and skilled personnel. 12. even some of the few apparent comparables that are found to exist often prove flawed. for example, often, such comparables arise in transitional situations in which, for example, an industry is entering a new market and operates temporarily through unrelated distributors, which after several years are acquired by the manufacturing company. prices charged in such situations are unlikely to be representative of those that would be charged among members of commonly controlled groups. similarly, one might find within a market independent distributors of small-volume “niche market” products within an industry, whereas the largevolume distributors will almost invariably be controlled by their manufacturers. see michael c.durst & robert e. culbertson “clearing away the sand: retrospective methods and prospoective documentation in transfer pricing today.”(2003) at 4748. 13. see treas. reg. § 1.6662-6. 2009] allocating business profits for tax purposes 505 (ii) despite the expense of compliance and enforcement, companies and the irs typically are dramatically far apart in their determinations of arm’s length pricing. controversies routinely involve hundreds of millions of dollars and are resolved at amounts that resemble neither the government’s nor the taxpayer’s positions, thereby casting grave doubt on the conceptual soundness of the underlying rules.14 (iii) the inability to predict whether their positions will be sustained leaves companies and their investors with large areas of uncertainty in their financial statements. (iv) the absence of clear standards for compliance, coupled with the ability under the arm’s length standard to apportion income to low-tax countries through legal arrangements governing the sitting of intangibles and (more recently) the bearing of risk, make it impossible for congress to predict with reasonable accuracy the actual amount of federal revenue that will be raised as a result of any particular corporate tax rate that congress believes it has enacted.15 14. a 1992 study by the general accounting office concluded that less than 30% of transfer pricing adjustments proposed by irs examiners ultimately were upheld in subsequent proceedings. gao (1992). similarly, in a recent multibillion dollar case settled out of court, the parties agreed on payment of 3.4 billion in settlement of pending transfer pricing claims; this represents concession of about 50% of the deficiency before the tax court, although since the settlement covered years in addition to those then pending before the court, the extent of irs concession appears to have been larger. overall, while results vary from case to case, the irs typically recovers at trial only a small proportion of transfer pricing deficiencies that it has asserted. the lament by judge gerber in one case gives a good idea of the atmosphere to be found in this field of law, despite attempts to project an image of statistical science: “once again, we are left stranded in a ‘sea of expertise’ and must navigate our own way through a complex record to decide what constitutes an appropriate arm’s-length consideration.” h group holding, inc. v. comm’r, t.c. memo 1999-334. the supply of very large, disputed transfer pricing adjustments does not seem likely to be exhausted soon. see nutt (2007). 15. revenue implications of a move from the current transfer pricing system are explored below. in connection with the potential revenue implications of the proposed transfer pricing reform, it is useful to consider the implications for transfer pricing reform proposals of the recently increased accounting scrutiny of companies’ uncertain tax positions following the reforms of the sarbanes-oxley act and, especially, the financial accounting standards board’s interpretation 48 (fin 48). the new accounting rules probably reduce companies’ expectations of financial statement benefit from taking what might be perceived as “aggressive” tax positions. therefore, some of the revenue gains that might otherwise be expected from the reform of transfer pricing rules (and from some other possible tax reforms) might occur even in the absence of the reform. the recent accounting changes therefore complicate the task of estimate revenue effects from reforms such as that proposed in this article. 506 florida tax review [vol. 9:5 (v) the fact that neither taxpayers nor enforcement authorities typically have clear standards for judging compliance means that issues involving very large amounts – billions of dollars – of federal revenue are resolved in examination, settled in appeals, resolved in negotiations under tax treaties with foreign governments, negotiated through advance pricing agreements, or settled by attorneys out-of-court after examination. in most cases, federal privacy laws require that this decision-making occur outside the public eye. in the authors’ experience, those involved in this process have served their roles with both integrity and skill. nevertheless, the resolution of issues involving such large amounts of money, without the benefit of clearly discernable decision-making standards and public scrutiny, is not healthy for the tax system. (vi) a related problem is that the uncertain results under current transfer pricing law degrade the quality of tax practice on the parts of both taxpayer and government representatives, regardless of the high standards of practice that both sides seek to maintain. both sides are tempted to state, as “starting points” for what is expected to be extended negotiation, positions that strain the edges of what most would consider reasonable. the resulting atmosphere contributes to a lessening of the publicly perceived credibility of both corporations and the government – a development that is seriously damaging to what will always remain a largely mixed economic system. (vii) the vulnerability of the current transfer pricing system to the shifting of income based on intangibles ownership and risk-bearing makes necessary numerous additional complexities in the international tax system. if the current transfer pricing regime were replaced by a more formulary approach such as that suggested below, congress could eliminate from the code many or all of the “base company” provisions of subpart f, retaining only those portions of subpart f dealing with passive investment income. the recent financial accounting changes, however, mitigate the problems of current transfer pricing rules only to a limited extent. although the accounting reforms might prevent some transactions in which difficult issues may have arisen, or have altered the pricing that companies have chosen to adopt in some circumstances, the reforms generally do not eliminate the uncertainty of current transfer pricing rules but shift some of the burden of dealing with it to financial auditors. moreover, much of the portability of income to lowor zero-tax jurisdictions under the current rules does not depend on positions that most would view as “aggressive,” but instead involve straightforward application of today’s transfer pricing principles. further, even if some arguably aggressive transactions or reporting positions are eliminated, current transfer pricing rules will continue to impose administrative burdens and uncertainties even with respect to entirely routine transactions with no hint of tax avoidance intent. thus, while the new accounting rules pose many benefits, including imposing some restraints on transactions arguably involving “aggressive” transfer pricing planning, they leave substantial need for reform of the transfer pricing tax rules themselves. 2009] allocating business profits for tax purposes 507 considerable complexity would, of course, be retained, but much would be eliminated. similarly, transfer pricing vulnerabilities probably constitute the most pressing argument against adoption of a territorial tax system.16 reforming transfer pricing rules could tip the policy-making balance in favor of adopting a territorial system, thereby permitting elimination of the grossly complex foreign tax credit system except as it relates to u.s. taxpayers’ passive investment income (which would remain subject to the u.s. tax jurisdiction and for which credit rules would need to be retained).17 the current transfer pricing system therefore can be seen as the tail that wags the dog of much unnecessary tax complexity. iii. a proposal to adopt a formula-based profit split system of apportionment our proposal would address most of the aforementioned flaws in the current system of international corporate taxation. under a formulary profit split, tax liabilities would reflect the economic reality of globally integrated businesses, and they would not vary among businesses based on their relative abilities to shift the ownership of intangible property. firms would have no incentive to shift income across countries through legal and accounting techniques, as tax liabilities would be based on total world income as well as the share of a firm’s sales that occur in each destination. moreover, since even the shifting of income involving legal and accounting techniques typically involves moving real activities to low-tax countries, the tax incentive to locate plant and equipment, as well as employment, in low-tax countries would also be reduced.18 eliminating companies’ ability to shift income would raise large amounts of federal revenue. in particular, if the proposal offered here were implemented in a revenue neutral fashion, it would enable a substantial cut in the corporate income tax rate. such a reduction would mean that many corporate actors benefit directly by a move to a formula-based system, 16. edward d. kleinbard “throw teritorial taxation from the train.” tax notes today, feb. 6, 2007.. 17. id. 18. under typical principles of tax law a multinational must be able to show tax examiners some “substance” in those countries in which they claim income. 508 florida tax review [vol. 9:5 thereby suggesting that the proposal might have a realistic chance of widespread political support.19 a. how would a formulary profit split work? the proposed approach will divide income from each business “activity” of a multinational group among the countries in which that activity is conducted. an “activity” will be defined as a group of functions related to the conduct of a particular trade or business to which two or more related parties contribute, determined at the largest level of aggregation of functions performed that will permit reliable identification of such related parties’ respective contributions to the functions comprising an activity. that activity is treated as a single taxpayer and its income is calculated by subtracting worldwide expenses from worldwide income, based on a global accounting system, without regard to legal distinctions among units. the resulting net income is apportioned among taxing jurisdictions based on a formula that takes into account various factors. each jurisdiction then applies its tax rate to the income apportioned to it by the formula and collects the amount of tax resulting from this calculation. following the pattern of one of the transfer pricing methods currently used by the united states and many other countries, the “residual profit split” method,20 the proposed system would (1) first assign to each country an estimated market return on the tax-deductible expenses incurred by the multinational group in that country (this element of income is typically called the “routine” income in current tax practice under the residual profit split method), and (2) would then divide any additional income (which, in current transfer pricing practice, typically is called the “residual” income and is seen as deriving from a multinational group’s 19. as both a political and economic matter, though, it should be recognized that a movement to a more formulary system, while permitting a lowering of corporate tax rates across-the-board, is unlikely to permit the lowering of rates to such an extent as compensate those companies that today make heavy use of deferral opportunities for the loss of those opportunities. therefore, for those companies, typically in “brick and mortar” industries, that have been unable to use current opportunities to shift income, a revenue-neutral implementation of a formulary approach would represent a significant tax cut, whereas those that have been able to shirt substantial income under the “arm’s length” system would experience an effective increase in tax. to mitigate this effect, it might be feasible to phase in the new system gradually, as described below; alternatively, it is sometimes suggested that measures to eliminate the tax advantages of deferral might be accompanied by a “one time” opportunity to repatriate deferred income on favorable terms, as has been offered in the past under the american jobs creation act of 2004. 20. see treas. reg. § 1.482-6; oecd guidelines, chapter 6. 2009] allocating business profits for tax purposes 509 intangible property) among the countries based on the group’s relative sales in each country. the particular formula used, with the “residual” apportioned according to sales, would provide a substantial improvement of the formulas typically used among the u.s. states. in the experience of the u.s. states, income has been allocated to state jurisdictions using a variety of formulas. historically, many u.s. states have used the so-called “massachusetts formula” which employs equal weights on property, payroll and sales. for example, under an equally-weighted formula apportionment system, tax liability to the u.s. government would be based on the u.s. tax rate times the fraction of worldwide profits that are attributed to the united states. this fraction would be based on how much of worldwide economic activity (an average of sales, assets, and payroll shares) occurs in the united states. observers have noted, however, that an fa system such as that used by the states creates an implicit tax on the factors used in the formula, thus discouraging assets and employment in high-tax locations. some of these concerns are also present here due to the reliance on expenses in calculating the normal return. still, we propose a simpler formula for assigning residual profit, which would only consider the fraction of sales in each location. sales would be determined on a destination-basis, based on the location of the customer rather than the location of production. we propose this destinationbasis sales formula for several reasons; alternative formulas are also discussed in appendix b. the key advantage of a sales-based formula is that sales are far less responsive to tax differences across markets than investment in plant, and employment, as the customers themselves are far less mobile than firm assets or employment. even in a high-tax country, firms have an incentive to sell as much as possible. in addition, if some countries adopt sales-based formulas for allocating residual profits, other countries will have an incentive to adopt sales based formulas as well in order to avoid losing payroll or assets to countries in which these factors are not part of the formula. the u.s. state experience reinforces the merits of this proposal. in recent years, many u.s. states have shifted to a formula that double-weights the sales factor. state incentives to move toward a sales-based formula are well documented. for example, edminston (2002) generates a model with this prediction, and omer and shelley (2004) document this trend empirically. goolsbee and maydew (2000) demonstrate that u.s. states that lower the weight on the payroll factor experience increases in manufacturing employment. according to weiner (2005), 23 states double-weight sales as of 2004, and seven others place an even larger weight on sales. some states 510 florida tax review [vol. 9:5 even use a sales-only formula (which was approved for iowa by the supreme court).21 in addition, a formula that relies relatively heavily on sales is likely to be conducive to international coordination of apportionment systems. because of the widespread belief that imposing taxes on imports and exempting exports boosts national competitiveness and reduces trade deficits, if a large trading country such as the united states were to adopt an apportionment that depends largely on sales, other countries are likely to perceive it in their interests to follow suit. it would also be in these countries’ economic interest to avoid the implicit tax on assets and payroll that is embedded in formula that relies excessively on those two factors.22 this built-in incentive for sales-based formulas would minimize the likelihood of over or under-taxation due to disparate formulas, an obstacle to adopting formulary apportionment. we should note that in spite of the factors that are likely to cause countries unilaterally to move toward coordination with a “first mover” in the implementation of a formulary system that weights sales heavily, it would be ideal to have international cooperation and consensus regarding both the adoption of a formulary approach and the choice of formula. we will discuss below the problems that arise if only the u.s. were to adopt fa, or if different countries use different formulas. although we do not believe that these problems justify delay in implementing the proposed approach under u.s. law, and we believe that it will be in the self-interest of most countries to follow the u.s. lead in this instance, the united states should seek as high a level of international coordination as is practical. the united states should not, however, state as a policy that it will implement a more formulary system only if international consensus can be achieved. such consensus will never be forthcoming – especially from those low-tax countries that profit from the current system – and waiting for such consensus will mean that meaningful reform can never be accomplished. b. five key advantages to a formula-based profit split the most important advantage of a formula-based profit split is summarized above: (i) the “arm’s length” system is based on a mistaken view of the operation of multinational groups, so that the search for 21. moorman mfg. co. v. bair, 437 u.s. 267 (1978). 22. in the last 50 years, over 100 countries have adopted the vat, and every single one of them (including all other members of the oecd) has adopted the destination principle (i.e. imposing vat on imports and rebating it on exports). the spread of destination-based vats around the world provides a good example of how tax innovations can spread without a coordinating supra-national agency or “world tax organization,” simply on the basis of countries’ perception of their self-interest. 2009] allocating business profits for tax purposes 511 “comparables” that the arm’s length system requires is incapable of producing useful results; and (ii) the resulting inability of either taxpayers or tax agencies to discern standards for enforcement means that enforcement is impossible. in the resulting uncertainty, firms find many ways to use accounting and legal techniques, particularly the licensing of intangibles, to shift income to zeroor low-tax countries in which the multinational groups perform little if any real economic activity. under the proposed system, tax liabilities are based on a multinational group’s global income, and the share that is taxed by a national jurisdiction depends on the fraction of the group’s observable economic activity that occurs in a particular country. there is no need for massive economic studies that try to “estimate” arm’s length prices in the absence of meaningful benchmarks. thus, while a truly precise definition and measurement of economic value is likely unattainable, the proposed system provides a reasonable, comparatively administrable, and conceptually satisfying compromise that suits the nature of the global economy.23 the second advantage associated with the proposal is that it eliminates the tax incentive to shift income through legal and accounting devices, such as licenses of patents and other intangible property, to subsidiaries in zeroor low-tax countries. as such income shifting incentives often entail the movement of employees and plants outside the united states in order to give “substance” to the income shifting that is achieved on paper, removing the incentive for shifting through licenses and the like will also result in less tax-distorted decisions regarding the location of economic activity. by eliminating the opportunity to shift income merely “on paper,” and thus also reducing incentives to move jobs and plants overseas, the proposed approach should eliminate the kinds of profit distortions that are so clearly visible in figure 2.24 by reducing the ability of “tax haven” countries to attract income from other countries’ tax bases, an approach like that proposed here should help governments around the world set their tax policies more independently. the wishes of voters in each government influence the ideal size of government, required revenue needs, and the allocation of the tax burden among subgroups within society. under the proposed approach, governments will be better able to choose their own corporate tax rates based on their 23. if a sales-based formula is adopted, both u.s. and foreign-based mnes would be able to locate their headquarters (which frequently produce positive externalities, such as those that flow from r&d) in the united states without substantially increasing their tax burdens. 24. a very similar pattern is apparent in other years. the bea data are discussed further in appendix a. 512 florida tax review [vol. 9:5 assessments of these sorts of policy goals, rather than the pressures of tax competition for an increasingly mobile capital income tax base. the third advantage associated with the proposal is the massive increase in simplicity that this would enable for the international tax system. if an approach such as that proposed here were adopted by our major trading partners, simplification gains would be particularly large, but simplification would still exist even if the approach was adopted unilaterally. to determine u.s. tax liability, there would be no need to allocate income or expenses among countries, resulting in far lighter compliance burden for firms. subpart f and the foreign tax credit, which are both hugely complicated and a major source of transaction costs for us-based mnes, can be greatly simplified, since there will be greatly reduced opportunities for deferral of business income under this system (which is essentially territorial and treats u.s.and foreign-based mnes alike). the likely administrative savings from abandoning the current cumbersome transfer pricing regime are huge. the current regime consumes a disproportionate share of both irs and private sector resources. for example, several recent ernst and young surveys of multinational firms have concluded that “transfer pricing continues to be, and will remain, the most important international tax issue facing mnes.” (ernst and young, 2006.) seventy percent of their respondents feel that transfer pricing documentation has become more important in recent years, and 63% of respondents report transfer pricing audit activity in the previous three years (ernst and young, 2005). a very recent ernst & young (2008) survey reports: “among nonu.s. owned organizations, by far the single most significant concern is with transfer pricing and its documentation.” for the government, audit costs are several (three to seven) times higher for federal transfer pricing cases than for state formula apportionment audits.25 judicial opinions in transfer pricing cases run to hundreds of pages each, and litigation can involve billions of dollars in proposed deficiencies, such as in the recently settled glaxo case ($9 billion in proposed deficiency, settled for $3.4 billion) and the aramco advantage cases (litigated and lost by the irs, which asserted deficiencies of over $9 billion). there is no indication that the 1994 regulations under irc section 482 have abated this trend (avi-yonah, 2006). the contemporaneous documentation rule adopted by congress, which requires taxpayers to develop documentation of their transfer pricing methods at the time the transactions are undertaken rather than when they are challenged on audit, as well as the complexity of the new sa methods (such as the comparable profits method, or cpm), have led the major accounting 25. see dan r. bucks and michael mazerov “the state solution to the federal government’s international transfer pricing problem.” nat’l tax j. (1993), 46(3), 385-92. 2009] allocating business profits for tax purposes 513 firms to develop huge databases and expertise in preparing transfer pricing documentation for clients. this imposes large costs on major u.s. multinational corporations (durst and culbertson, 2003). meanwhile, small and medium businesses, which cannot afford the major accounting firms, are left to fend for themselves. by contrast, the approach suggested here is relatively simple since it requires only (1) defining activities (discussed below) and (2) establishing the standard return on expenses and the destination of arm’s-length sales of goods or services. once these two elements are established, the resulting formula permits both taxpayers and the irs to determine the correct tax liability for each jurisdiction. for small and medium sized businesses in particular, the proposed approach will result in major cost savings as well as the potential for paying less tax (since such businesses are rarely in a position to take on the irs under the current system). for major multinational firms, the proposed approach also offers the prospect of avoiding the costs of contemporaneous documentation, and while some firms may pay more tax than before, many would welcome the opportunity of paying a single, low rate to each jurisdiction in which they do business (especially if the adoption of this proposal is coupled with a reduction in the corporate rate), instead of having to cope with the complexities and costs of separate accounting. of course, some firms – i.e., those that have had the greatest opportunity to shift income under the current system – will be hurt by the change in tax environment; these issues are discussed below, in section iv. the fourth advantage associated with the adoption of a formulary approach for the united states is that the new system would raise more revenue, enable a substantial rate reduction, or both. estimating how much revenue such a change would raise is a difficult and imprecise task, and the details of the implementing legislation and regulations would likely be influential in determining the ultimate effects of the proposed change. still, previous studies and some preliminary calculations suggest that such a change is likely to generate substantial additional u.s. government revenue. appendix a reviews several such calculations in more detail. for example, one simple approach is to assume that multinational firms will subsequently have u.s. income shares that are the same as their u.s. sales shares; this would imply an increase in u.s. corporate tax revenues of 36% in 2005. a second (and more complex) approach is to utilize regression analysis to relate profitability to tax rates, and then estimate resulting changes in revenues by removing such tax responses. this approach, taken by a recent study, finds that tax avoidance activities reduce corporate income earned in the united states by over $180 billion in 2004, resulting in corporate tax revenues that are about 35% lower. since our proposed formulary profit split approach would eliminate tax avoidance incentives, 514 florida tax review [vol. 9:5 one would expect it to raise revenues by a similar order of magnitude (although our proposal’s departure from a pure sales-based apportionment will mean some differences in results). a final approach is that taken by shackelford and slemrod (1998); they use accounting data in financial reports for 46 u.s.-based multinational corporations over the period 1989 to 1993 to estimate changes in revenue under a three-factor fa system. they find that u.s. government revenues from the corporate income tax would increase by 38%. this increase is not dependent on any particular factor, and they calculate that a single factor sales formula would increase revenues by 26%. given the changes in the international tax environment since the time period of their data, and in particular the increasing discrepancy between the u.s. corporate tax rate and those of other major countries, these estimates likely understate the potential u.s. revenue gain from a proposal such as that offered here. still, a recent attempt to replicate the results of shackelford and slemrod using more recent data found a smaller revenue effect; this surprising finding may be due to increased discrepancies between book and tax income in recent years; see appendix a for more details. table 1 shows illustrative statistics on the operations of u.s. multinational affiliates in 2005 for all countries where the bureau of economic analysis reports data and where affiliate operations are at least one-half of 1% of world-wide totals in either sales or income. column 1 shows the share of worldwide foreign affiliate sales that occur in each country, column 2 shows the share of worldwide affiliate net income earned in each country, column 3 shows the effective tax rate, and column 4 shows the percentage by which the income share exceeds or falls short of the sales share. countries are shown in descending order of values for column 4, and it is immediately apparent that those countries with income shares that vastly exceed their sales shares tend to be very low-tax countries, and those with sales shares that exceed their income shares are typically high-tax countries. thus, it appears quite likely that a sales-based formula apportionment system would increase revenues in comparatively high-tax countries, decreasing them in low-tax countries. as one plausible conjecture, if revenues increase by 35% with formula apportionment, one can also calculate the tax rate reduction that would be possible with a revenue-neutral implementation of the proposal suggested below. in that case, the implied new corporate tax rate would be 26%, nine percentage points lower than the current corporate tax rate of 35%. of course, one could also pursue an intermediate policy that allowed a smaller rate reduction and also increased revenues more modestly. appendix a provides more background on these calculations. therefore, adoption of fa can help address the four flaws in the current system of u.s. taxation that were discussed in section ii of the paper. there are also potential gains due to coordination with other taxes as well as 2009] allocating business profits for tax purposes 515 coordination among countries. consider first coordination with value added taxes. existing vats around the world depend on defining the destination of sales of goods and services. determining destination for goods is relatively easy because of customs enforcement. in fact, many jurisdictions use harmonized rules for customs, vat and income tax collection. determining destination for services is harder, but countries have developed significant expertise in it under vat.26 if the united states adopts a sales-based apportionment formula, it can learn from this experience even without adopting its own vat. if the u.s. subsequently adopts a vat, the rules for determining sales destination under fa can be coordinated with the vat rules. in addition, existing u.s. regulations already define destination and origin of goods for purposes of trade regimes, tax-based export subsidies, and under the base company rules of subpart f. this proposal also introduces the possibility of gains from coordination with other countries. the eu commission is actively working on defining a common tax base and apportioning it among member states by formula. we can learn from this effort (which itself learned from the u.s. state and canadian province experiences).27 also, if the united states and the european union both adopt formulary approaches, there is obvious potential for coordinating their efforts through the oecd. it may in fact be possible, given current discussions of fa within the eu, to reach agreement with the eu (and possibly with other oecd members) on the adoption of a new system before it is actually implemented. still, while an international agreement would be ideal, we do not, again, believe that reaching such an agreement should be a necessary prerequisite to the united states adopting a formulary-based profit split unilaterally. many significant advances in international taxation, such as the foreign tax credit and cfc regimes, as well as more problematic developments such as the current transfer pricing methods, resulted from unilateral action by the united states, which was followed by most other jurisdictions and by the oecd. the distortions and revenue losses of the current system are too serious to permit delay until the perhaps-impossible goal of international consensus can be achieved. 26. oecd, report: the application of consumption taxes to the trade in international services and intangibles, ctpa/cfa (oecd 2004); eu vat directive 2006/112/ec (eu 2006), as revised in eu 2007; oecd, applying vat/gst to cross-border trade in services and intangibles, emerging concepts for defining place of taxation (oecd 2008). 27. see joann martens weiner “formulary appointionment and group taxation in the european union: insights from the united states and canada.” european commission taxation working paper no 8. (mar. 2005). 516 florida tax review [vol. 9:5 iv. addressing the downsides of formulary apportionment: a practical statutory approach this section of the paper will consider the concerns that typically are raised with respect to adoption of a more formulary apportionment system, and will describe how the statutory language that is proposed here would address those concerns. the concerns fit into four broad categories. first, some critics argue that fa is inherently arbitrary. second, there are implementation issues associated with the definition of activities and the determination of the location of sales. third, there are problems associated with interactions between countries with incongruent corporate tax systems. there is a potential for zero or double taxation. accounting standards across countries are not uniform, and tax treaties may need modification. finally, the proposed system is likely to affect some stakeholders adversely, as some domestic industries and firms will find that their tax obligations will increase under the new system. a. is formulary apportionment arbitrary? some would consider basing the corporate income tax liability largely on a routine return to expenses and the extent of sales in a particular country to be arbitrary. still, it is not clear that the current sa regime is less arbitrary given the incentive to shift profits to low-tax jurisdictions. under the current regime, it is quite possible that a mne will not pay taxes either in the location of production (because of tax competition and production tax havens) or in the location of distribution (because it can avoid having a permanent establishment or minimize the profits attributable to the distribution function), while any tax due to its residence jurisdiction is subject to deferral or exemption. such a result is more arbitrary than consistently assigning profits to the market jurisdiction, especially if most countries adopt similar formulas. it is true that any formula can produce arbitrary results in a given industry. for example, the oil industry has long argued that it is unfair to tax it based on payroll, assets or sales because most of its profits result from the oil reserves themselves, which are not reflected in the formula (since they are typically not assets of the company for any length of time). however, while some industries will lose under the proposed formula, others (such as major u.s. exporters) will win, and most taxpayers would gain from the increased simplicity and transparency of the fa regime. if companies are willing to pay one level of tax and are only concerned about double taxation, they 2009] allocating business profits for tax purposes 517 should be willing to accept the fa option, which prevents double taxation but also double non-taxation.28 b. implementation 1. statutory proposal the statute below (appendix c) is modeled closely on the residual profit split method of the current u.s. transfer pricing regulations and the oecd guidelines. it has obvious “formulary” elements, but it avoids the problem of distorting international investment patterns by basing the apportionment of “residual” income on the international division of sales revenues, rather than “property” and “payroll.” (property and payroll figure indirectly in the apportionment of “routine” rather than “residual” income under the statute through their effects on a party’s expenses). most importantly, the statute avoids the two elements that have caused the current regulations and their predecessors to fail: namely (i) reliance on “uncontrolled comparables” and (ii) “functional analysis” based on the taxpayer’s facts and circumstances.29 a central challenge of implementing the proposed statute (or any statute with formulary elements) will be to deal effectively with the need to determine the geographic distribution of a party’s sales revenue. the need to distinguish sales for final use as opposed to storage or transshipment, and the difficulties of determining locations for sales of raw materials and intermediate goods, intangible property and certain services (e.g., financial 28. it can also be argued that “ignoring intangible property,” which is the source of most of the value added by mnes, is arbitrary under both our formula and the state formulas (that do not include intangibles in the property factor). but intangibles do not have a real location, and their value inheres in the whole mne, which is why they cannot be adequately addressed under sa. any formula that “ignores” intangibles in fact assigns their value to the entire mne (divided based on the other factors used in the formula), and we believe this result more accurately reflects the nature of intangibles. 29. the approach proposed below, which depends heavily on the geographic locations of various activities, can be applied only to apportionment of income among geographic areas, and cannot be used for apportionment of income within a single jurisdiction – for example, between related companies that do not file consolidated returns under a single country’s rules, or between related taxable and tax-exempt entities located in the same country. as indicated in the attached proposed statute, it is anticipated that an “arm’s length” approach will need to be retained for domestic use, although that system could be greatly simplified if it is used only for domestic apportionment purposes (e.g., by using safe harbors in lieu of comparables searches when determining markups in pricing the provision services). 518 florida tax review [vol. 9:5 services), will require toleration of some degree of reasonable estimation and generally will require some restraint in enforcement. in addition, owing to the wide range of situations in which sales can arise, regulations will need to be detailed, and a rulings process will be needed to provide flexibility for particularly difficult situations. the administrative challenges involved in determining the geographic distribution of sales revenue should be relatively limited compared to those posed by the virtually endless need for factfinding under current rules, but the challenges nevertheless should be understood and foreseen. a reformed transfer pricing system should provide many advantages, but it will not lead even remotely to perfection. the proposed statute incorporates provisions that are designed to address the following substantive and procedural issues: 30 (i) determining a reasonable “routine” rate of income without the need to search for comparables and engage in functional analyses; (ii) determining where, geographically, “sales” occur and “expenses” are incurred and protecting those determinations from artificial distortion; (iii) defining the group of activities to which the new method is to be applied; (iv) coordinating the new statute with existing income tax treaties; (v) coordinating the new statute with rules for apportioning interest expense; (vi) coordinating the new statute with rules governing withholding taxes on interest, royalties and dividends; (vii) providing simplified rules for small-business taxpayers; and (viii) providing for regulatory and other guidance, including private letter rulings to deal with difficulties in applying the various definitions that will be required under a revised statute.31 in addition to the text of the proposed statute, appendix __ to this article provides, both in footnotes and in the examples, explanatory language 30. overall, as internal revenue provisions go, the suggested statutory language is relatively (although certainly not unprecedentedly) complicated, but it is dramatically less complex than the regulations that have been issued and continue to be issued under § 482. 31. with respect to this final point, an aspect of the proposed statute that might prove controversial is that private letter rulings granted under the new system (for example, rulings determining how “revenues” will be defined in a particular instance) would be subject to the same degree of public disclosure as other private rulings (i.e., with taxpayer identifying information removed), thus effectively removing the special exceptions from disclosure that congress has provided for advance pricing agreements in §§ 6103(b)(2) and 6110(b)(1)(b) of the internal revenue code. 2009] allocating business profits for tax purposes 519 that might be suitable for inclusion in congressional committee reports and in regulations. a question in drafting any complex tax statute is the degree of specificity that should be set forth in the statute as opposed to being reserved for regulations. while the desire for flexibility in administration often favors reserving large areas for regulation, the following statute includes a good deal of detail in the statutory language itself. legislative drafters might well want to change this balance; in this article, however, we have retained significant specificity in the statute largely in an attempt to illustrate the nature of the issues that will need, one way or another, to be addressed in detail. 2. interactions between countries with different tax systems it would be ideal for most major countries to coordinate implementation of fa and to come to a joint agreement on the definition of the formula for apportioning global income. given that the european union (eu) is already pursuing the possibility of fa within europe, a natural forum for reaching international consensus on these issues would be the oecd. with international cooperation, the possibility of double or non-taxation would be reduced and there would be less room for multinational firms to respond strategically to variations in country formulas. even without formal cooperation, however, unilateral adoption by the united states of a reformed system for taxing international income would create a powerful incentive for other countries using separate accounting to adopt similar new systems. in a world with both formulary and separate accounting system countries, formulary countries will immediately appear as tax havens from a separate accounting country perspective. for example, a multinational firm operating in both separate accounting and formulary countries would have an incentive to book all their income in formulary countries, as the tax liability in such countries does not depend on the income booked there, but rather the fraction of a firm’s activities in that location. such responses would likely greatly reduce the tax revenues of remaining separate accounting countries. thus, separate accounting countries will have a strong incentive to adopt formulary approaches, particularly if large economies adopt formulary approaches. moreover, the experience of the u.s. states amending their formulas to emphasize the sales factor, and the experience of over 100 countries adopting the destination-based vat, and a number of other experiences in the development of international tax law, suggest that there is a significant likelihood that if the u.s. were to adopt a sales-based formula, other countries would be inclined to follow suit. the u.s. led the way in adopting the foreign tax credit (1918), subpart f (1962), and the current transfer pricing regulations (1968 and 1994), all of which were followed by most of 520 florida tax review [vol. 9:5 our major trading partners and recognized by the oecd. it is quite possible that if the u.s. adopted the proposed formulary split, this would be another innovation that is widely copied, with or without explicit coordination. still, if the united states adopts a formulary approach unilaterally and other countries do not follow suit (or follow suit much later), or if countries adopt different formulas, there is the potential for double or zero taxation. this is, arguably, the largest obstacle to unilateral adoption of a formulary system; but the significance of the obstacle should not be overstated. although situations of double taxation or double non-taxation could arise, it is not clear that a formulary approach would produce more double or non-taxation than the current regime. the notorious absence of clear standards under the current separate accounting system means that different countries routinely reach widely disparate divisions of income under the same facts. it is hard to imagine that a reformed system, which at least provides clear quantitative benchmarks, would lead to as many double taxation, or double non-taxation, disputes as the current system already produces. for example, the irs recently settled a major transfer pricing case with the british firm glaxo for $3.4 billion. this additional revenue resulted from shifting to the u.s. profits that glaxo claimed belonged in the uk.32 it is far from clear that the uk tax authorities would accept the result of this settlement: under the us-uk tax treaty, they are not required to do so. (art. 9 of the treaty only states that a country must make a “correlative adjustment” when profits are shifted by the other treaty partner if it agrees that the profit shift was justified.) the dispute resolution mechanism in most of our tax treaties does not provide for binding arbitration and therefore does not necessarily lead to a resolution. as justice brennan observed in the container case (approving california’s application of worldwide fa to usbased mnes), it is not clear which method (fa or sa) produces more over or under-taxation, even when some countries use fa and the others use sa, or when different formulas are used.33 in summary, with respect to the potential problem of double taxation, it must be remembered that the current system, which typically provides only wide ranges of potential “answers” to any given transfer pricing issue, often results in very divergent positions being taken by different countries, even when both countries ostensibly are applying the same “arm’s length” principles. therefore, as a starting point, it should not be thought that a revised section 482 would move us from a system without 32. for news reports describing the glaxo matter, see glaxo preparing to litigate transfer pricing “heritage product” dispute in united kingdom, daily tax report, mar. 7, 2007, at i-3; and glaxosmithkline to pay $3.4 billion to settle largest dispute in irs history, daily tax report, sept. 12, 2006 at gg-1. 33. container corp. v. franchise tax board, 463 u.s. 159 (1983). 2009] allocating business profits for tax purposes 521 substantial double taxation to a system with double taxation; in fact, it is not at all clear whether adoption of a statute like that below would lead to more or less danger of double taxation. of course, to the extent other countries, particularly those within the european union, develop formulary systems of their own, a formulary approach by the united states would fit well into an international system for avoidance of double taxation. 34 in order to evaluate the question of double taxation during the period when a u.s. formulary system might be mixed with arm’s length systems in other countries, it should be recognized that those multinational groups that have, to date, adopted tax-minimization structures involving transfer pricing typically have sought to minimize their taxable incomes in all high-tax countries in which they operate, not only the united states, and to shift income into lowor zero-tax countries. as a result, a unilateral move by the united states to a formulary system is not likely to increase disputes with other high-tax countries; rather, it is likely to increase disagreements with low-tax countries that have sought actively to attract income and business from the united states. it is not clear that avoidance of these kinds of tax disputes constitutes a valid reason to delay reform of the u.s. transfer pricing rules. it nevertheless needs to be recognized that a unilateral move to a formula-based approach is likely to result in political controversy with the low-tax countries,35 and because the interests of those countries will coincide with those of companies that seek to retain the subsidies implicit in the current system, those governments may find themselves in political alliance with multinational companies themselves. how to resolve the resulting controversy is a question that will need to be resolved by congress – but the 34. the support among many countries for the cctb suggests that political attitudes in some countries have changed substantially since the early 1990s when, as described in michael c. durst and robert e. culbertson “clearing away the sand: retrospective methods and prospetive documentation in transfer pricing today.” (2003) tax law review, 57. 37-84 at 80-81, international officials generally opposed actions that might lead to a more formulary transfer pricing system. today, dissatisfaction with current transfer pricing rules appears widely shared internationally, as evidenced by government officials’ expressions of concern with “restructurings” around the world. the oecd committee on fiscal affairs is now devoting substantial attention to problems posed by “restructurings.” see committee on fiscal affairs, organisation for economic cooperation and development, discussion draft on the transfer pricing aspects of business restructuring, sep. 19, 2008. 35. the government of ireland, for example, currently is opposing the cctb proposal within the european union. 522 florida tax review [vol. 9:5 controversy should be recognized as primarily political in nature.36 overall, it would not appear that concerns about “double taxation,” significant though they may be, should be sufficient to deter congress from taking action that could substantially improve the efficiency and apparent fairness of the u.s. international tax system. 3. defining the tax base it would, of course, be desirable for a u.s. move to a formulary system to be accompanied by international coordination of the tax base. a common definition of the tax base (as opposed to harmonized tax rates, which are unlikely as well as undesirable) is plausible to achieve because mnes already use uniform accounting for world-wide financial reporting purposes. thus, it is quite possible to use financial reporting as the starting point for calculating the global profit of the mne, to be allocated to jurisdictions based on the fa formula. while there are still differences in accounting among countries, those are diminishing due to the spread of international accounting standards, which have been adopted in the eu and japan. further, the u.s. securities and exchange commission announced in august 2008 that it would allow some large u.s. multinational firms to begin using international accounting standards as early as next year, and eventually require all american companies to do so. alternatively, it may be possible to let each mne use its home country’s accounting methods for calculating the global tax base (as suggested by the eu commission for inter-eu purposes).37 such changes would also have the advantage of more closely aligning book income and tax income. this could act a damper on both the underreporting of income for tax purposes as well as the overstatement of income for the purpose of signaling profitability to financial markets.38 36. a resolution of this political issue might be aided through transitional rules, for example rules permitting u.s. multinationals to receive foreign tax credits, for a limited period of time (perhaps with a phase-out) for taxes paid by affiliates to foreign governments, provided the taxes are imposed at statutory rates not exceeding a specified maximum (such as 15%) that would be based on the practices of particular low-tax countries. 37. see eu commission, company taxation in the internal market, com (2001) 582 final (2002), 13.1. 38. this is discussed in mihir desai “the degradation of reported corporate profits.” journal of economic perspectives, 19(4) 171-192 (fall 2005), where he recommends reconsideration of the dual-reporting system. desai (2003) reports an increasing divergence between book income and tax income, with more than half of the divergence not explained by conventional differences between the measures. for the united states in 1998, he estimates that this discrepancy amounts to about 34% of tax income (just over $150 billion), and he attributes these trends to increased tax sheltering activities. 2009] allocating business profits for tax purposes 523 however, if coordination of the tax base with accounting-based measures were unachievable or undesirable, the proposed formulary approach could also be implemented unilaterally by the u.s. using its definition of taxable income and applying it to the entire mne. u.s.-based mnes already have to calculate the earnings and profits of cfcs for purposes of subpart f and the foreign tax credit, so the additional information required for unilateral adoption would not be overly burdensome. for non-u.s. based mnes, the u.s. system could use financial reporting to shareholders (already required by the sec or by home country regulators) as the base for calculating worldwide income. while this would create a disparity between u.s. and non-u.s. based mnes, the disparity would probably be no more significant than it is under current transfer pricing regimes around the world, which often must operate from measures of income as determined under local accounting systems. concern is sometimes expressed that a transfer pricing system depending on application of an apportionment formula to global income will require the irs to gain access to information on both u.s. and foreign multinational groups’ operations outside the united states. current transfer pricing law, however, already requires access to such information, both in the application of the profit split method and in the course of examinations. indeed, current law requires both u.s. and foreign companies to retain and provide on request to the irs voluminous information on non-u.s. operations.39 there is no way to avoid offering national tax administrations access to information on activities in other jurisdictions. 4. interaction with tax treaties some have argued that tax treaties will need modification with adoption of formulary apportionment. however, it is not clear that existing u.s. tax treaties will have to be renegotiated, at least in the short term. transfer pricing is currently governed by article 9 of the treaties, which seems to assume the sa method because it addresses the commercial or financial relations between associated enterprises. in addition, article 7 of the treaties provides generally for the application of sa principles in apportioning income among branches of single corporations – a technically complex topic not directly addressed in this article, although it raises issues similar to those raised when dealing with apportionment among separate affiliates. there can be no question that historically, both article 7 and article 9 have been interpreted as incorporating “arm’s length” concepts such as resorting to supposed “comparables,” and the other accoutrements of 39. irc §§ 6038a and 6038c and regulations thereunder. 524 florida tax review [vol. 9:5 attempted transfer pricing administration under the sa regime. there is no reason, however, why the united states and its treaty partners could not agree, under the “competent authority” process contained in each treaty and discussed above, to interpret their treaties to accept the reformed apportionment approach as the closest feasible, and administrable, approximation to the “arm’s length” results envisioned in articles 9 and 7. except for low-tax, “tax haven” countries, one would expect many if not most u.s. tax treaty partners eagerly to accept such an approach, since these treaty partners face the same difficulties in enforcement and administration of transfer pricing rules that the united states faces. there may, to be sure, be some countries that will insist on retaining the current sa-based analysis in their treaty dealings with the united states. in such instances, case-by-case negotiation will be necessary in order to avoid double taxation – but such negotiations are required to an unacceptably large extent even under the current system, the vagueness of which leads to numerous conflicts among tax jurisdictions over particular cases. the attached proposed legislation includes provisions designed to ensure that u.s. negotiators have authority to interpret u.s. tax treaties as authorizing the proposed reformed transfer pricing methodology in double taxation negotiations with treaty partners.40 one can expect low-tax countries, as well as those multinational businesses that are favored under the current transfer pricing regime, to assert vigorously that the new regime is in violation of income tax treaties. such assertions will, however, reflect disagreement with the reformed system on policy grounds, rather than reflecting any serious impediment in the tax treaty system to the adoption of the new system. political opposition to the reform from low-tax countries and from businesses that will pay relatively larger shares of the corporate tax burden must be respected and dealt with – but such political opposition should be recognized for what it is. c. negative effects on some corporate stakeholders analysts have noted that adoption of fa would disproportionately affect some industries and firms negatively. for example, shackelford and slemrod (1998) find that fa raises tax liabilities for some industries and firms, lowering burdens for others. they estimate that the oil and gas industry would see an increase in tax liabilities of 81% under fa, compared with 29% for all other firms in their study. (the mean oil and gas company 40. this language, by manifesting congressional intent that the reformed system should be treated as acceptable under existing u.s. income tax treaties, should preclude successful invocation of treaties in judicial challenges to application of the new system. see nat’l westminster bank plc v. united states, 512 f.3d 1347 (fed. cir. 2008). 2009] allocating business profits for tax purposes 525 in their study reports 68% of assets in the united states, 70% of sales in the united states, and 78% of total compensation paid to u.s. employees, but such companies book 42% of pretax earnings in the united states.) the authors also estimate that some firms will experience a tax decrease, including boeing and procter and gamble. the update of clausing and lahav (2008) suggests a similar pattern, with tax increases for oil companies (e.g.) and tax decreases for boeing, procter and gamble, and intel. under our proposal, firms with a disproportionate amount of u.s. sales relative to u.s. income would see tax increases under fa, while those with relatively low u.s. sales compared to u.s. income (e.g., large exporters) would see tax decreases. in addition, firms that derive their income largely from high-value technological intangibles would likely be adversely affected by adoption of fa, as these firms have the greatest opportunities for lowering their tax burdens under the current system. indeed, clausing and lahav (2008) predict tax increases for some intangibleintensive firms like pfizer and johnson controls, but also tax decreases for others such as walt disney and 3m. also, negative impacts may be muted by several considerations. first, firms will benefit from reductions in complexity and compliance burdens. small and medium size businesses should be particularly appreciative of such benefits. second, accompanying the adoption of a more formulary system with a reduction in the corporate income tax rate would increase the number of firms benefiting from the adoption. a rate reduction would also appeal to those concerned that the u.s. is losing competitiveness because of the current rate disparity. v. conclusion our proposal for the adoption of a formula-based profit split for the u.s. taxation of corporate income responds to the reality of an increasingly global world. multinational firms have internationally integrated operations, and they are responsive to the incentives created by discrepancies among national tax policies. a separate accounting system generates an artificial need to assign income and expenses by location, and this creates ample opportunities for tax avoidance. the proposed system would greatly reduce the complexities associated with sourcing income and expenses across locations, and it would eliminate the incentive to use legal and accounting techniques to shift income to more lightly-taxed locations. further, because these legal and accounting techniques often involve moving jobs and plant overseas to support the “substance” of the techniques, eliminating the techniques would reduce taxmotivated shifts of employment and investment outside the united states. by eliminating opportunities to shift income from the united states, the proposed approach would increase u.s corporate tax revenues would 526 florida tax review [vol. 9:5 likely increase significantly. alternatively, the proposal could be implemented in a revenue neutral fashion, allowing for a dramatic reduction in the corporate tax rate. those who benefit from the current system are certain to proclaim, loudly, what will be described as terrible difficulties of moving to a reformed system, but on close analysis the obstacles to effective reform appear surmountable. perhaps the most significant objection to adoption of a reformed system is that such a step would entail conflict with some u.s. tax treaty partners. in all likelihood, however, such conflict would involve almost entirely those treaty partners that have chosen to adopt unusually low corporate income tax rates in an effort to attract investment from the united states and other non-haven countries. most other countries, which face difficulties in administering their own transfer pricing systems similar to the difficulties faced by the united states, are likely to cooperate in implementing and refining the new system. questions of international comity do not preclude serious reform of the transfer pricing system; if the united states has the political will for such reform, it can feasibly be accomplished. 2009] allocating business profits for tax purposes 527 figure 1, panel a: statutory corporate tax rates, oecd countries, 1979-200441 0.00 0.10 0.20 0.30 0.40 0.50 0.60 19 79 19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 average plus one st.dev. minus one st.dev. united states 41. statutory tax rate data are from pricewaterhousecoopers, corporate taxes: worldwide summaries. effective tax rate data are calculated as foreign income taxes paid relative to net (pre-tax) income for u.s. affiliates operating in a particular country. these data are from the bureau of economic analysis (bea); they are discussed further in appendix a. 528 florida tax review [vol. 9:5 panel b: average effective tax rates, oecd countries, 1982-2004 0.00 0.10 0.20 0.30 0.40 0.50 0.60 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 average plus one stdev. minus one stdev. 2009] allocating business profits for tax purposes 529 figure 2: where were the profits in 2005? (profits as a percentage of the worldwide total) 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% ne th . lu x. u. k. be rm ud a ire la nd sw itz . ca na da si ng ap or e u. k. is la nd s be lg iu m country effective tax rate netherlands 5.1% luxembourg 0.9% united kingdom 28.9% bermuda 0.9% ireland 5.9% switzerland 3.5% canada 21.4% singapore 3.2% u.k. islands 1.9% belgium 8.7% notes: in 2005, majority-owned affiliates of u.s. multinational firms earned $336 billion of net income. this figure shows percentages of the worldwide (non-u.s.) total net income occurring in each of the top-10 income countries. thus, each percentage point translates into approximately $3.4 billion of net income. effective tax rates are calculated as foreign income taxes paid relative to net (pre-tax) income. data are from the bureau of economic analysis (bea) web page; 2005 is the most recent year with revised data 530 florida tax review [vol. 9:5 available. the bureau of economic analysis conducts annual surveys of operations of u.s. parent companies and their foreign affiliates. these data are discussed in more detail in appendix a. figure 3: where were the jobs in 2005? (employment as a percentage of the worldwide total) 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% u. k. ca na da mex ico ger m an y fr an ce ch in a br az il au st ra lia ja pa n ita ly country effective tax rate united kingdom 28.9% canada 21.4% mexico 21.8% germany 26.2% france 21.3% china 14.8% brazil 18.1% australia 12.1% japan 34.7% italy 24.9% notes: in 2005, majority-owned affiliates of u.s. multinational firms employed 9.1 million employees. this figure shows percentages of the worldwide (non-u.s.) total employment occurring in each of the top-10 countries. thus, each percentage point translates into approximately 91,000 jobs. effective tax rates are calculated as foreign income taxes paid relative 2009] allocating business profits for tax purposes 531 to net (pre-tax) income. data are from the bureau of economic analysis (bea) web page; 2005 is the most recent year with revised data available. the bureau of economic analysis conducts annual surveys of operations of u.s. parent companies and their foreign affiliates. these data are discussed in more detail in appendix a. figure 4: central government corporate tax revenues relative to gdp oecd countries, 1982 to 2005 0 0.5 1 1.5 2 2.5 3 3.5 4 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 united states average note: data are from the oecd revenue statistics. 532 florida tax review [vol. 9:5 table 1: u.s. multinational firm operations in 2005 (for those countries with the largest u.s. affiliate operations) (1) share of sales (2) share of income (3) effective tax rate (4) excess income share (v. sales) luxembourg 0.4% 10.5% 1% 2688% u.k. islands 0.6% 3.2% 2% 428% bermuda 1.4% 7.2% 1% 408% austria 0.5% 1.5% 2% 202% netherlands 4.4% 13.0% 5% 194% denmark 0.4% 0.7% 18% 67% indonesia 0.4% 0.6% 35% 62% ireland 4.3% 7.0% 6% 62% switzerland 4.3% 6.7% 3% 57% venezuela 0.4% 0.6% 18% 51% belgium 2.3% 2.8% 9% 21% norway 0.9% 0.8% 52% -1% australia 2.5% 2.0% 12% -19% singapore 4.4% 3.3% 3% -25% hong kong 2.0% 1.3% 11% -34% china 2.0% 1.3% 15% -36% argentina 0.6% 0.4% 20% -38% united kingdom 13.6% 7.7% 29% -44% spain 2.0% 1.1% 17% -47% canada 12.4% 6.6% 21% -47% malaysia 1.1% 0.6% 18% -49% japan 4.7% 2.1% 35% -56% india 0.5% 0.2% 22% -57% korea, republic of 1.0% 0.4% 22% -57% thailand 0.9% 0.4% 30% -58% mexico 3.5% 1.4% 22% -60% poland 0.6% 0.2% 14% -62% italy 2.8% 1.1% 25% -63% south africa 0.5% 0.2% 51% -63% taiwan 0.9% 0.3% 18% -66% france 4.9% 1.6% 21% -68% sweden 1.4% 0.4% 16% -70% germany 7.3% 1.8% 26% -75% brazil 2.5% 0.5% 18% -80% 2009] allocating business profits for tax purposes 533 countries are selected for inclusion in this table if either their sales share or their income share exceeds one half of 1% of worldwide totals. data are from the bureau of economic analysis (bea) web page; 2005 is the most recent year with revised data available. the bureau of economic analysis conducts annual surveys of operations of u.s. parent companies and their foreign affiliates. these data are discussed in more detail in appendix a. 534 florida tax review [vol. 9:5 appendix a: estimates of revenue gain due to formula apportionment this appendix considers methods of estimating the revenue gain to the united states government due to formula apportionment. all of these methods rely on multiple assumptions and simplifications. the data are imperfect and incomplete. further, there are multiple margins under which this change would affect multinational firm behavior both in the united states and abroad, and there is substantial uncertainty regarding the net influence of these responses on government revenues. finally, the actual legislation and accompanying regulations implementing fa would matter a great deal in terms of ultimate effects on revenue. therefore, all of these estimates should be treated with a great deal of caution, as a mere starting point for thinking about this question. that said, estimates below paint a broadly consistent picture of large u.s. government revenue gains with the adoption of formula apportionment. 1. the simplest estimate of the revenue gain relies on inferences from the u.s. bureau of economic analysis (bea) data regarding the operations of u.s. multinational firms. according to 2005 data from the bea, u.s. multinational firms earn 52.4% of their worldwide net income in the united states. however, 67.2% of worldwide sales for these firms occurs in the united states. if the united states tax base were 67.2% of worldwide income, it would increase by $285 billion. with the increment taxed at the marginal tax rate of 35%, that would generate $99 billion in additional revenue. since revenues from the corporate income tax in 2005 were $278 billion, that represents an increase of 36%. the following table shows the results of the same calculations for the four most recent years with available data; 2002, however, was likely an usual year, as net income in the united states was abnormally low in comparison with other years. 2002 2003 2004 2005 fraction of world sales in united states 71.6% 69.6% 68.1% 67.2% fraction of world income in united states 8.2% 56.7% 51.5% 52.4% implied new revenue $79 b $52 b $82 b $99 b implied new tax revenue as share of same year’s federal corporate tax receipts 54% 40% 44% 36% 2009] allocating business profits for tax purposes 535 if one assumes instead that the increment were taxed at the average tax rate that was paid on corporate profits, then this increase would be smaller. yet in other ways, this estimate represents an underestimate of the revenue gain since it includes only u.s. multinational firms. foreign-owned multinational firms with affiliates in the united states would also face changes in their tax treatment that will increase revenues as long as the fraction of their worldwide sales in the united states exceeds the fraction of their worldwide income booked in the united states. while this is not possible to ascertain given the absence of bea data on foreign parent firms, profits do appear to be disproportionately low for these firms relative to their sales in the united states. for example, in 2005, net income of u.s. parent multinational firms is 8.5% of their u.s. sales, while net income for u.s. affiliates of foreign parent firms is 3.2% of their u.s. sales. a final issue concerning these calculations is the possibility of double-counting in the bea net income figures. these figures include “income from equity investments”, some of which may be counted more than once if there are tiers of holdings within the same country. unfortunately, from existing bea data, it is impossible to tell exactly how large this problem is, or how much this problem is correlated with the tax rate of the country in question.42 using an alternative data series from the bea on direct investment earnings, one can exclude all income from equity investments, but this too is conceptually inappropriate. still, i performed calculations that employed this series nonetheless. to make the data comparable to net income, i adjusted for the fact that direct investment earnings were pro-rated to reflect the ownership stake of the u.s. parent, assuming an average ownership stake of 68.6% for all firms. (this was the average ownership stake in 2003.) one finds a very similar fraction of worldwide income abroad, roughly 57% in both 2003 and 2004. estimates of revenue gain from fa are about a third smaller, due to some combination of a narrower definition of income as well as the elimination of any double-counting. 2. clausing (2008) undertakes estimates of the revenue lost to the united states due to income shifting by u.s. multinational firms. these are based on regressions that consider how profit rates (profit to sales ratios) depend on affiliate country tax rates. for the time 42. using german data, weichenrieder (2006) finds no relationship between the tax rates of host countries and more complicated ownership chains. however, other tax factors are important, including whether the investing country has a credit or exemption tax system. 536 florida tax review [vol. 9:5 period 1993 to 2004, the regression results indicate that a tax rate one percentage point higher (relative to the united states) is associated with an affiliate profit rate about .8 percentage points lower. this result is used, together with information regarding profits and sales for each country and year, to calculate how profits would be different absent tax influences, and thus how revenue would be different in the united states absent income shifting. by 2004, it is estimated that tax-motivated income shifting shifts over $180 billion in corporate income out of the united states, resulting in 35% lower corporate tax revenues; for the recent period 2001-2004, revenues are estimated to be 29% lower due to incomeshifting. some estimates are lower or higher; there are multiple assumptions that are embedded in the analysis that could cause the results to be underestimates or overestimates. for example, results depend on the specification of the tax parameter, the econometric specification employed, assumptions regarding the residual u.s. taxation of foreign income, the nature of foreign multinational firm behavior, and assumptions regarding the share of excess foreign income earned in low-tax countries that should be attributable to the united states. thus, the precise estimate should be viewed with caution. still, the nature of the main findings is robust: the sign and statistical significance of the tax coefficients are always as expected, and the consequences of tax avoidance grow dramatically over the previous decade. 3. other studies have generated estimates of a similar magnitude. the most thorough estimate is shackleford and slemrod (1998); they use accounting data in financial reports for 46 large u.s. based multinational corporations over the period 1989 to 1993 to estimate changes in revenue under a fa system. their estimates are based on firm financial statements and the related income tax footnotes. three certified public accountants interpreted each detailed disclosure. both domestic and foreign taxable income were estimated as the sum of the current relevant tax provisions and credits divided by the relevant statutory tax rate; worldwide income is then the sum of domestic and foreign income. the u.s. tax liability under formula apportionment is then calculated as the product of worldwide taxable income, the formula for the fraction of income allocated to the united states, and the u.s. tax rate. the authors find that fa raises tax liabilities for some industries and firms, lowering burdens for others. they estimate that the oil and gas industry would see an increase in tax liabilities of 81% under fa, compared with 29% for all other firms in their study. 2009] allocating business profits for tax purposes 537 they also estimate that some firms will experience a tax decrease, including boeing, procter and gamble, and dow chemical. overall, shackleford and slemrod (1998) find that revenues would increase by 38% under a three-factor fa system. this increase is not dependent on any particular factor, and they calculate that a single factor sales formula would increase revenues by 26%. given the changes in the international tax environment since the time period of their data, and in particular the increasing discrepancy between u.s. corporate tax rates and those of other major countries, these estimates likely understate the current u.s. revenue gain with fa adoption. still, clausing and lahav (2008) have work in progress that attempts to replicate the study of shackelford and slemrod, using nearly identical methods and data from the period 2005-2007. the sample is the fifty largest u.s. based multinational firms that have adequate reporting data. they find a smaller increase in revenue, of 22% in 2007 and 13% for the three year period. given the change in the tax environment since 1989-1993, this is a surprising finding. while more work is needed to clarify this result, it may stem from the use of financial reports, rather than tax data. while shackelford and slemrod also use financial reporting data, desai (2003, 2005) and others have noted increased discrepancies between book and tax income over this time period. any of these estimates can be used to generate an estimate of what corporate tax rate would be associated with a revenue neutral implementation of formula apportionment. taking as one baseline that tax revenues would increase by 35% with formula apportionment, this implies that the corporate tax rate could be lowered by 9 percentage points, to 26%. of course, one could also pursue an intermediate policy that lowered the corporate tax rate less but that also modestly increased tax revenue. note that all of the estimates discussed above are based on book income figures, not tax income. numbers (1) and (2) utilize data from the bea surveys on multinational firms; number (3) uses data from firm financial statements. it would be preferable to utilize data on tax income, which is also presumably more responsive to tax incentives; however, this is not possible absent access to treasury data. also note that none of these estimates address methods that firms utilize to lower their taxable income overall; the focus is instead on the sourcing of income. 538 florida tax review [vol. 9:5 appendix b: other formula choices section iii of the paper explains the merits of employing a salesbased formula rather than the traditional “massachusetts formula” which is an equal-weighted average of sales, payroll, and asset shares. a sales based formula has several advantages. first, firms have little ability to undertake tax avoidance strategies with a destination-based sales formula, since firms have no control over where customers are located.43 second, use of a salesbased formula lessens any implicit tax on payroll and assets, which can distort multinational firms’ investment and employment decisions. third, u.s. states have demonstrated a tendency to increase the sales weight over time, so adopting a sales based formula at the outset may encourage countries to adopt more uniform formulas. still, multiple factor formulas have some advantages. first, while the incidence of the corporate tax is a complex matter, beyond the scope of this paper, one advantage of the equal-weighted formula is that the incidence of the tax may be more desirable. for example, some argue that the asset portion of the formula is particularly compatible with the desire to have the corporate tax borne by capital. second, some argue that a three-factor formula more adequately captures the supply side of the process that generates profit. still, as was recognized as far back as marshall (1890), value has its roots in both supply and demand factors, and trying to separate them is as futile as trying to determine which blade of the scissors cuts. third, to the extent that firms are able to manipulate the destination of their sales (a problem that we think can be addressed to a large extent by careful statutory drafting; see text), a multiple factor formula would make that type of avoidance more difficult. finally, to the extent that some countries view a sales-based formula as not suited to their interests, a formula with several factors could be viewed as a useful compromise. in addition to a sales-based formula and an equally-weighted formula, some have suggested a formula with a double weight on sales. for example, eichner and runkel (2006) argue that such a formula would reduce the harmful effects of tax competition, as the fiscal externalities of corporate income taxation would be minimized. sorensen (2004) and agundez-garcia (2006) have discussed the possibility of using industry or macro-based weights in these formulas. thus, a firm’s tax liability in a particular country would not depend on its own share of worldwide activity in the country, but rather on the industry-wide average of these shares. if a firm is small relative to the industry, then its own decisions have little effect on where its tax liability is assigned. however, this method has the downside of separating a firm’s activities from 43. of course this assumes that the definition of activity is sufficient to prevent manipulation of the destination of sales. this issue is discussed in the paper. 2009] allocating business profits for tax purposes 539 the jurisdictions in which it incurs taxation, which would likely prove too arbitrary. in the extreme, if macro-weights were used, a firm’s tax liability in a given country would depend on, e.g., the size of that country in the world economy. so if the united states were one quarter of the world economy, any firm with nexus in the united states would have a u.s. tax base equal to one-quarter of their worldwide profits, even if the particular firm did 1% (or 99%) of its activity in the united states. this is unduly arbitrary. 540 florida tax review [vol. 9:5 appendix c: suggested statutory language section 482. allocation of income and deductions among taxpayers. (a) in general – in any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the united states, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.44 (b) income of related parties resident for income tax purposes in different countries – (1) in general – except as otherwise provided in this section or in regulations, if any party participates in an activity with one or more related parties, and if such party and such related parties are resident for income tax purposes in more than one country, the income of such party from such activity, for purposes of subsection (a), shall not be treated as resulting in evasion of taxes and shall be treated as clearly reflecting such income, provided that the net operating income or loss of all related parties participating in such activity is, taking into account all payments and other transactions among such related parties, divided among such related parties so that each earns the sum of – (a) an amount of operating income equal to a markup of 7.5% (or such other markup as the secretary may prescribe 44. the proposed revision eliminates what is now the second sentence of § 482, commonly called the “commensurate with income” or “superroyalty” rule: in the case of any transfer (or license) of intangible property (within the meaning of 936(h)(3)(b)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. under the proposed revision, the concern that gave rise to enactment of this rule – namely, that taxpayers would be able to assign the income from high-value intangibles to countries in which disproportionately little activity occurs – generally should not arise. if the propose revision is enacted, corresponding changes should be made to § 367(d), which incorporates a similar rule. 2009] allocating business profits for tax purposes 541 by regulation as described in subsection (d))45 on such related party’s expenses of such activity paid or incurred with respect to persons other than related parties; and (b) a proportionate share of any income from such activity remaining after application of subparagraph (a), equal to such party’s proportionate share of the revenues of all related parties that are derived from persons other than related parties from such activity. (2) exception if net operating income is below specified threshold or in case of operating loss from activity – if the combined income of all related parties from an activity described in paragraph (1) is greater than zero but is insufficient to provide all of such related parties with the level of operating income described in subparagraph (1)(a), or if the activity gives rises to a net operating loss, the income of any such related party will satisfy the requirement of paragraph (1) if the total operating income or the operating loss, as the case may be, of such related parties is shared among such related parties in proportion to their respective expenses of such activity. (3) accounting methods – except as otherwise provided in this section or in regulations, a party’s revenue, expenses, operating income and operating loss, if any, shall be determined according to the accounting methods by which such party ordinarily keeps its books and records. (4) rules applicable to related parties resident for income tax purposes in different countries except as otherwise provided in this section or in regulations, for purposes of this subsection — (a) revenues from the provision of services shall be treated as earned by the related party that is resident for income tax 45. the markup of 7.5% is prescribed based on the authors’ observation that tax practitioners in both private and government practice often consider such a markup to be within reasonable ranges for many kinds of activities, and it is slightly above the 7% markup set forth as the dividing line between “low margin” and other services in recently promulgated regulations. temp. reg. § 1.482-9t(b)(4)(ii). it is anticipated that the treasury will by regulation prescribe different markups for geographic locations, or particular industries, in which a markup of 7.5% does not constitute a reasonable estimate of a “routine” level of return based on prevailing market conditions. 542 florida tax review [vol. 9:5 purposes of the country in which the services are performed;46 (b) except as otherwise provided in subparagraph 4(c), revenues from the provision of tangible and intangible property shall be treated as earned by the related party that is resident for income tax purposes in the country in which the tangible property is consumed or placed in service for its intended use,47 and in which the intangible property is used;48 (c) revenues from the provision of tangible property that is to be incorporated into other tangible property, or otherwise transformed substantially, by manufacturing or other processes prior to sale to the user or consumer of such tangible property, and revenues from the provision of intangible property that is to be used in the manufacturing of products, shall be treated as earned as follows: (i) if the taxpayer establishes to the satisfaction of the secretary that the income from such 46. it is anticipated that regulations will provide for different treatment with respect to advertising services. regulations may, for example, provide that revenues from advertising in print media be apportioned based on the taxpayer’s best reasonably available estimates of circulation, from advertising in electronic media based on the taxpayer’s best reasonably available estimate of the distribution of viewers or listeners, or from internet advertising based on the taxpayer’s best reasonably available estimate of the distribution of website visits. 47. regulations should specify that taxpayers will be permitted to base determinations of where tangible property is consumed or placed in service for its intended use on reasonable and good faith inferences, including statistical inferences, based on information that is available to taxpayers in the ordinary course of business, such as shipping records, customs filings, market surveys and other regulatory filings (e.g., those dealing with food and drug laws or labeling requirements). the irs should challenge such determinations only if the taxpayer appears not to have exercised reasonable care and due diligence in making estimates, or if inaccuracies in a taxpayer’s determinations might materially affect the taxpayer’s income that is subject to u.s. taxation. 48. for example, if a u.s. corporation licenses a patent to an affiliate in ireland, the irish affiliate sublicenses the patent to an unrelated party in germany for use in the manufacture of products in germany, the resulting royalty revenue will be treated as earned in germany if the u.s. corporation has an affiliate in germany, or (see proposed § 482(b)(4)(i)), if the u.s. corporation has no affiliate in germany, the resulting royalty income will be apportioned among the members of the group according to their relative levels of expenses. 2009] allocating business profits for tax purposes 543 manufacturing or other processes is subject to an effective rate of income tax imposed by a foreign country greater than 90% of the maximum rate of tax specified in section 11, such revenues shall be treated as earned in such foreign country; (ii) if the taxpayer cannot establish that the income from such manufacturing or other processes is subject to an effective rate of taxation described in subparagraph (c)(i), but if the taxpayer can establish to the satisfaction of the secretary, with reasonably certainty, the countries in which such tangible property, following incorporation into other property or other transformation, or the property that is manufactured using such intangible property, is used or placed in service for its intended use,49 such revenues shall be treated as earned in such countries; and (iii) if the taxpayer cannot establish the conditions described in subparagraphs (c)(i) or (c)(ii), such revenues shall be treated as earned in the united states. (d) revenues from the provision of banking, insurance, brokerage, or other financial services, and revenues of a kind described in section 954(c) that are attributable to particular activities, shall be treated as earned by related parties in proportion to their expenses of such activities as determined pursuant to this subsection;50 (e) revenues from the provision of transportation described in section 863(c), space and ocean activities described in section 863(d), and international communications described in section 863(e) shall, respectively, be treated as derived by 49. see supra note 57. 50. it is anticipated that regulations will provide that revenues for the provision of banking, insurance, brokerage, or other financial services will be treated as earned by the related party that is resident for income tax purposes in the country in which such revenues can be identified, with reasonable certainty in view of the records and other information available to the taxpayer, with services provided to individuals resident, property located, or active business activities conducted within that country. 544 florida tax review [vol. 9:5 the related parties in a manner consistent with the principles employed by those provisions and the regulations thereunder in determining the sources of such income; (f) expenses incurred for the provision of services shall be treated as incurred by the related party that is resident for income tax purposes in the country where the services are performed; (g) expenses related to tangible property, including but not limited to expenses for depreciation and maintenance, shall be treated as incurred by the related party that is resident for income tax purposes in the country where the property is located; (h) expenses not otherwise described in this paragraph shall be treated as incurred by the related party that is resident for income tax purposes in the country where the benefit of such expenses is derived;51 (i) revenues or expenses that, under subparagraphs (a) through (h), are treated as earned or incurred in a country in which no related party participating in the activity is resident for income tax purposes shall be treated as earned or incurred, as the case may be, by all such related parties in proportion to their respective expenses (determined prior to the application of this subparagraph) that are related to the activity; and (j) if a related party incurs expenditures that benefit more than one activity described in paragraph (1), such expenditures shall be apportioned among such activities 51. regulations should provide that the benefit of royalties paid with respect to intangible property shall be treated as enjoyed in the jurisdiction in which property is manufactured or services are performed using such intangible property. 2009] allocating business profits for tax purposes 545 according to the relative benefits provided by such expenditures.52 (5) exception for activities involving only the provision of services by a related party. if, with respect to an activity described in paragraph (1), the only assistance or contribution provided by a related party to other related parties consists of the performance of personal services by employees or other persons (including the procurement of tangible or intangible property from unrelated persons for the benefit of a related party), then, at the election of the taxpayer, the rules for allocation and apportionment of paragraphs (1) through (5) shall not apply, and the income of any such related party from such activity, for purposes of subsection (a), shall not be treated as resulting in evasion of taxes and shall be treated as clearly reflecting such income, provided that such related party earns a markup on the expenses of performing such services equal to the markup described in subparagraph (b)(1)(a) (or such other markup as may be provided in regulations). (6) rule related to the use of trademarks, trade names, and similar marketing intangibles. except as otherwise provided in regulations, the use by a party in one country of a trademark, trade name, or similar marketing intangible that has previously been used by a related party in another country shall not in itself constitute participation by the related parties in an activity for purposes of this subsection, unless one such related party has incurred or reimbursed expenditures involving the advertisement or marketing of such trademark, trade name, or similar marketing intangible, and such advertising or marketing has, under standards prescribed in regulations, been directed at actual or potential customers of the other related party. (7) exception for small and mid-size taxpayers. notwithstanding any other provision of this section, and except as the secretary shall prescribe by regulation, if a taxpayer that is a related party has made a reasonable effort in good faith to comply with the provisions of this subsection, and if the combined gross income of the taxpayer 52. regulations should provide that the apportionment function prescribed in subparagraph (j) should follow the system of “apportionment keys” (e.g., apportionment by such factors as sales, payroll, headcount, or some other reasonable indicator of relative benefit) that is currently prescribed in the regulations under § 482 governing the pricing of services among related parties. 546 florida tax review [vol. 9:5 and of all related parties with respect to such taxpayer does not exceed $5 million dollars, then the secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such related parties under this section only if such related party, in establishing pricing for or otherwise arranging transactions among such related parties, had as a principal purpose avoiding taxes imposed by this chapter. (8) exception for interest expense. notwithstanding any other provision of this section, and except as provided in regulations, in determining whether the test of subsection (a) is met, expenses for interest shall not be treated as expenses but instead shall be apportioned among related parties (whether or not such related parties are engaged together in an activity described in this subsection) in a manner that is consistent with the rules for determining the source of such expenses in parts i and ii of subchapter n of this chapter and the regulations prescribed thereunder.53 (9) coordination with treaties. the secretary shall apply the rules of this subsection in determining, under any income tax treaty to which the united states is a party, whether a related party’s income is attributable to a permanent establishment, or whether conditions are made or imposed between two enterprises in their commercial or financial relations that differ from those that would be made between independent enterprises, or in applying any similar standard contained in any such income tax treaty, except that the competent authority may, pursuant to any such treaty, agree to a resolution of a matter that is not consistent with the rules of this subparagraph if the competent authority determines that such resolution is necessary to prevent double taxation and is consistent with sound tax administration. (10) treatment of payments among related parties. except as provided in regulations, payments made among related parties during a taxable year, other than contributions to capital or distributions 53. regulations may provide exceptions to the rule of this subparagraph for situations in which interest expense is identified with particular elements of a related party’s operations, or in which the amount of interest expense incurred by a related party or group of related parties is sufficiently small that an exception is warranted by considerations of sound tax administration. 2009] allocating business profits for tax purposes 547 with respect to a person’s ownership interest in a corporation, partnership or other entity, shall be treated as – (a) payments in compensation for services, to the extent of the markup described in subparagraph (b)(1)(a) (or such other markup as may be provided in regulations) on the payee’s direct and indirect expenses with respect to the services provided or reasonably apportionable to the payer; (b) payments for the purchase of tangible property, to the extent consistent with (i) the valuation of any tangible property transferred among such related parties for purposes of compliance with united states customs laws or other united states laws requiring valuation of such property; (ii) if no united states laws require valuation of such property, the valuation determined in good faith for purposes of the customs or other laws of another country; or (iii) if no laws of any country require valuation of such property, the valuation of such property determined in good faith by the taxpayer, with such valuation to be adjusted by the secretary for purposes of this subparagraph only if unreasonable; (c) payments for the purchase of stock or securities, other financial instruments, interests in real property, or other identifiable interests in property other than intangible property described in section 936(h)(3)(b), to the extent of the fair market value of such interests in property based on the valuation of such interests determined in good faith by the taxpayer, taking into account reasonably available information such as that provided by public securities exchanges, with such valuation to be adjusted by the secretary for purposes of this subparagraph only if unreasonable; (d) payments of interest, to the extent of interest on bona fide indebtedness determined at the applicable federal rate, or at a reasonably corresponding market rate of interest in the case of bona fide indebtedness that is denominated in a foreign currency; (e) payments for the purchase of intangible property described in section 936(h)(3)(b), provided that the transfer of such property constitutes a purchase rather than a license under this chapter, to the extent of the valuation of such 548 florida tax review [vol. 9:5 intangible property determined in good faith by the taxpayer, with such valuation to be adjusted by the secretary for purposes of this subparagraph only if unreasonable; and, to the extent not otherwise accounted for under this subparagraph, shall be treated as (f) royalties for the use of intangible property described in section 936(h)(3))(b). (11) definitions – for purposes of this subsection, except as otherwise provided in regulations – (a) activity – an “activity” shall mean a group of functions related to the conduct of a particular trade or business (or to a particular purpose described in subsections (1) and (2) of section 212), to which two or more related parties contribute, determined at the largest level of aggregation of functions performed that will permit reliable identification of such related parties’ respective contributions to the functions comprising an activity.54 the secretary may modify a taxpayer’s designation of an activity only if such modification is necessary to correct a significant failure reasonably to reflect related parties’ relative contributions to the functions comprising an activity.55 (b) participation in an activity – a related party shall be treated as participating in an activity if such related party performs services, engages in manufacturing, or otherwise engages in economic activity in support of the activity, except that such related party shall not be treated as participating in such activity if such related party’s contribution to the activity is of an insubstantial and incidental nature. the secretary shall prescribe regulations 54. regulations should specify that the boundaries of an “activity” can be determined in part by the geographic scope of the activity, in keeping with operational divisions maintained in the taxpayer’s business. 55. in general, a failure reasonably to reflect related parties’ relative contributions to the functions comprising an activity should be considered significant only if the taxpayer has not exercised due diligence and reasonable care in determining such relative contributions, or if the correction of the taxpayer’s determination will increase or decrease a party’s income subject to taxation by at least the greater of 1% of such income or $300,000. 2009] allocating business profits for tax purposes 549 specifying circumstances under which contributions will be treated as being of an insubstantial and incidental nature.56 (c) expenses – for purposes of this subsection, except as otherwise provided in regulations or in the second sentence of this subparagraph, expenses shall include (i) costs of a kind for which a deduction is allowed under section 16257 and (ii) allowances of depreciation and amortization. except as otherwise provided in regulations, amounts that are incurred in connection with the manufacture of property or the purchase of property for resale, which do not constitute either (i) the cost of tangible property purchased for resale, (ii) tangible property that is incorporated in or consumed in the process of manufacturing, or (iii) costs of property for which an allowance of depreciation or amortization is permitted, and that would be described in the preceding sentence except that they are capitalized in the cost of inventory, also shall be treated as expenses for purposes of this subsection.58 (d) party and related party – a “party” shall mean any organization, trade, or business as those terms are used in subsection (a), and a “related party” shall mean any of two or more such parties (whether or not incorporated, whether or not organized in the united states, and whether or not affiliated) owned or controlled directly or indirectly by the same interests. (e) resident for income tax purposes – except as otherwise provided in regulations, a person is resident for income tax 56. it is suggested that such regulations specify that a related party’s contribution to a particular activity will be treated as insubstantial and incidental if the expenses associated with the contribution do not exceed 2% of the related party’s total expenses. 57. thus, for example, the purchase price of stock or securities or other financial instruments acquired for any purpose generally will not constitute an “expense.” 58. for example, a distributor of washing machines may purchase the machines and also incur such expenses as depreciation on a warehouse in which the machines are stored, and overhead costs associated with the distribution activities, which under § 263a must be capitalized in the distributor’s inventory costs. the depreciation and overhead costs, but not the costs of purchasing the washing machines, are treated as “expenses” for purposes of this subsection. 550 florida tax review [vol. 9:5 purposes in a country in which its income is subject to taxation, under such country’s laws, by reason of such person’s residence in such country.59 (c) rules applicable to related parties resident for income tax purposes in the same country. – the secretary shall provide regulations governing the application of subsection (a) to the activities of related parties that are resident in the same country. 60 (d) rulings – the secretary may, in the secretary’s discretion, issue rulings to particular taxpayers setting forth, by agreement with such taxpayers, the manner in which compliance with the rules of this section shall be determined, including but not limited to how expenses or revenues shall be apportioned among activities, and which operations shall be included in a particular activity. any such rulings shall extend for specified terms not to exceed five years, although they may in the secretary’s discretion be renewed. such rulings and background file documents related to such rulings shall be open to public inspection subject to the rules of section 6110(a) and such limitations on public inspection as are provided under this chapter.61 (e) regulations – the secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section, including but not limited to regulations providing for modification of the factor described in subparagraph (b)(1)(a)(i) for use in connection with activities performed in particular industries or in particular geographic locations, to the extent the secretary believes such modification is necessary to adjust for 59. regulations should address the application of this subsection to parties that are resident for income tax purposes in more than one country. 60. this provision would be applicable, for example, with respect to the division of income between taxable and tax-exempt affiliates within the united states, and among members of affiliated groups filing consolidated returns (to the extent that their separate incomes may be relevant for federal income tax purposes). it is anticipated that regulations under this provision will, to the extent feasible, rely on principles similar to those prescribed with respect to related parties that are resident for income tax purposes in different countries. in particular, it is anticipated that such regulations will provide for the review of arrangements for the provision of services between related parties based on cost-based pricing methodologies. it also is anticipated that regulations will, to the greatest extent feasible, rely on the apportionments of income and expenses set forth in the taxpayer’s accounting records, provided those records follow generally accepted accounting principles and have not been compiled with a principal purpose of tax avoidance. 61. it is suggested that enactment of this language be accompanied by repeal of §§ 6103(b)(2) and 6110(b)(1)(b) (exempting advance pricing agreements from public inspection). 2009] allocating business profits for tax purposes 551 substantially differing expected returns on cost from business activities conducted in such industries or locations. examples: example 1 – parentco engages with subsidiaries in different countries in the manufacture and distribution of cars, light trucks, and heavy trucks, as well as parts for those vehicles. parentco and the subsidiaries all participate in research and development, manufacturing and distribution associated with the cars, light trucks, and heavy trucks. in general, the companies trade among themselves in intermediate goods and finished products relating to cars, light trucks, and heavy trucks, and make available to one another without charge the results of all research and development that they perform. parentco and its subsidiaries organize their books and records, establish research and development and marketing budgets, and organize reporting lines for their personnel by reference to two divisions, (i) cars and light trucks, and (ii) heavy trucks. in general, research and development activities performed by personnel assigned to the cars and light trucks division is expected to benefit the manufacture of both cars and light trucks but to provide only minor and incidental benefits with respect to the production of heavy trucks; and research and development performed by personnel assigned to the heavy trucks division is expected to provide only insubstantial and incidental benefits with respect to the production of cars and light trucks. the parentco group has been manufacturing and distributing cars and light trucks for many years, and sales in those product lines have been highly profitable. the group only recently, however, has begun the manufacture and distribution of heavy trucks and to date has incurred operating margins from the sales of heavy trucks significantly lower than the margins achieved from sales of cars and light trucks. in addition, the percentage of revenues derived from heavy trucks varies substantially from country to country. the management of the parentco group reasonably believes that accounting for the manufacture and distribution of cars and light trucks will permit will permit reliable identification of each group member’s respective contributions to the derivation of profits from those vehicles, whereas accounting on an aggregate basis for the manufacture and distribution of cars, light trucks and heavy trucks will overstate the apparent contributions of those entities that contribute disproportionately to the manufacture and sale of heavy trucks. the manufacture and sale of cars and light trucks and related parts, and the manufacture and sale of heavy trucks and related parts, will each be treated as separate “activities” for purposes of paragraph (b). 552 florida tax review [vol. 9:5 example 2 – the facts are the same as in example 1 except that in addition parentco organizes its distribution activities geographically and maintains separate distribution organizations, in both its car and light truck and heavy truck divisions, that are responsible for sales of each category of vehicle and related parts in three regions: (i) the americas, (ii) europe/middle east/africa, and (iii) rest of world. although a number of entities in parentco’s global group participate in the design, manufacture and sale of vehicles in two or all regions, some of such entities are engaged in operations relating only to particular regions. in general, parentco maintains accounting records for both its car and light truck and heavy truck divisions by geographic region. the manufacture and sale of (i) cars and light trucks, and (ii) heavy trucks, and of parts in each category, each will be treated as consisting of three different activities corresponding to the three regions according to which parentco organizes its operations. example 3 – techco engages with its subsidiaries in different countries in the manufacture and distribution of human pharmaceuticals, animal medications, and toiletries. techco and the subsidiaries all participate in research and development, manufacturing and distribution related to human pharmaceuticals and animal medications, and exchange technical results among themselves on a regular basis. no member of the group, however, engages in research and development relating to toiletries. members of the group do not trade with one another in tangible property. (that is, each group member arranges for the manufacture or purchase of all product that it sells.) techco and its subsidiaries organize their books and records, establish research and development and marketing budgets, and organize reporting lines for their personnel by reference to three divisions: (i) human pharmaceuticals, (ii) animal medications, and (iii) toiletries. separate research departments engage in research relating to human pharmaceuticals and animal medications. although on occasion a product developed for use in humans has proven useful with respect to animals, and vice versa, the research operations of the human pharmaceutical and animal medication divisions provide only insubstantial and incidental benefits to each other. profit margins on the three different categories of products manufactured by members of the techco group vary significantly, both among themselves and among countries; relative sales volumes of the different categories of products also vary significantly among countries. the management of the techco group reasonably believes that accounting for the manufacture and distribution of human pharmaceuticals, animal medications, and toiletries separately will permit reliable identification of each group member’s respective contributions to the derivation of profits from those product lines. the management of the 2009] allocating business profits for tax purposes 553 techco group considered whether different categories of human pharmaceuticals should be considered as separate activities for purposes of section 482(b), but reasonably determined that the pharmaceutical industry as a whole depends on the funding of a wide variety of research and development products, only a few of which are likely to be successful. the management of the techco group therefore reasonably concluded that measuring the profitability of a human pharmaceutical business generally requires reference to its success with respect to multiple categories of products, and that treating the manufacture and distribution of different categories of human pharmaceuticals as separate activities, for purposes of section 482(b), was likely to distort measurement of the contributions made by the different related parties to the success of the business. the manufacture and distribution of human pharmaceuticals, animal medications, and toiletries will be treated as separate activities (or separate groups of activities, if further geographic breakdown is appropriate) for purposes of section 482(b). example 4 – the investco group provides financial planning services to individuals, and also conducts brokerage operations, through a network of subsidiaries resident around the world. several of the subsidiaries conduct research operations. these include efforts by personnel to develop computerbased tools for predicting clients’ financial needs and developing financial plans for their use. although applicable laws governing, for example, retirement planning differ from country to country, and some development efforts are useful only in particular countries, the financial planning staffs located in different countries engage in significant exchanges of planning techniques. research operations also seek to identify improved techniques for computer-based trading of securities, and these operations benefit brokerage activities around the world. the relative revenues derived from brokerage activities and from financial planning services vary significantly from country to country. management of the investco group reasonably believes that accounting separately for brokerage and financial planning operations is necessary to permit reliable identification of each group member’s respective contributions to the derivation of profits from those two components of the group’s business. the brokerage and the financial planning operations will both be treated as “activities” for purposes of section 482(b) (or as separate groups of activities that are subdivided into activities along geographic lines). login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe 329 florida tax review volume 8 2007 number 3 taxing hot asset shifts by karen c. burke i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 ii. hot asset sale approach and revaluations . . . . . . . . . . . . 332 iii. relationship between §§ 734(b) and 751(b) . . . . . . . . . . . . . . 336 iv. liquidating distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341 v. nonliqudating distributions . . . . . . . . . . . . . . . . . . . . . . . . . . 346 a. distributions of excess hot assets . . . . . . . . . . . . . . . . . . . . 347 b. distributions of excess cold assets . . . . . . . . . . . . . . . . . . . 350 c. tension between § 704(c) approach and § 751(b) . . . . . . . . 356 vi. restoring conformity between §§ 751(a) and 751(b) . . . . 359 vii. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363 330 florida tax review [vol.8:3 * warren distinguished professor, university of san diego school of law. the author thanks professor william d. andrews for helpful comments and suggestions. the author has benefited from her participation in the aba section on taxation’s working group on i.r.s. notice 2006-14. the views expressed here are solely those of the author and should not be attributed to the aba or other participants in the working group. 1. see notice 2006-14, 2006-8 i.r.b. 498. the notice uses the term “hot assets” to refer to “unrealized receivables as defined in § 751(c) and substantially appreciated inventory as defined in § 751(b)(3) and (d).” 2. for recent commentary, see william d. andrews, comments on notice 2006-14 (nov. 28, 2006), bna daily tax report no. 230, at g-10 (nov. 30, 2006) [hereinafter andrews comments]; nysba tax section, report responding to notice 2006-14 relating to the treatment of partnership distributions under § 751(b) (nov. 28, 2006) [hereinafter nysba report], 2006 tnt 230-8. 3. since 1954, the definition of hot assets has been expanded to include items such as depreciation recapture. see irc § 751(c). 4. see reg. § 1.751-1(b). by contrast, the treasury has extensively revised the § 743 regulations to reflect § 704(c) allocations. see martin j. mcmahon, jr., optional partnership inside basis adjustments, 52 tax law. 35 (1998). 5. see william d. andrews, inside basis adjustments and hot asset exchanges in partnership distributions, 47 tax l. rev. 3, 46 (1991). taxing hot asset shifts by karen c. burke* i. introduction notice 2006-14 invites comments concerning proposals to simplify and rationalize the treatment of disproportionate distributions that rearrange the partners’ shares of unrealized appreciation in ordinary income and capital gain assets (“hot asset distributions”). specifically, the notice requests comments1 concerning whether to adopt the “hot asset sale” approach in lieu of the imputed exchange mechanism under the current section 751(b) regulations.2 upon a current nonprorata distribution, the hot asset sale approach would be coupled with a revaluation of partnership property and special allocations to preserve shares of built-in hot asset gain to the extent possible. although enacted in 1954, section 751(b) has remained largely unchanged. indeed, the3 regulations issued in 1956 have never been updated to reflect the modern concept of revaluations and section 704(c) allocations. while section 751(b)4 is sometimes viewed mainly as concerned with the character of income, it also has a significant impact on the timing of gain recognition.5 2007] taxing hot asset shifts 331 6. these provisions include §§ 731 and 732 (gain recognition and basis), 735 (character preservation), 734(b) and 743(b) (inside basis adjustments), 751(a)-(b) (collapsible partnership provisions) and 755 (basis allocation rules). 7. for an overview of the aba/ali proposals, see stanley s. surrey & william c. warren, the income tax project of the american law institute: partnerships, corporations, sale of a corporate business, trusts and estates, foreign income and foreign taxpayers, 66 harv. l. rev. 1161 (1953); j. paul jackson et al., a proposed revision of the federal income tax treatment of partnerships and partners – american law institute draft, 9 tax l. rev. 109 (1954). 8. see generally andrews, supra note 5. for recent proposals to repair § 734(b) adjustments, see howard e. abrams, the section 734(b) basis adjustment needs repair, 57 tax law. 343 (2004); karen c. burke, repairing inside basis adjustments, 58 tax law. 639 (2005). 9. although the 1954 reformers apparently never considered the possibility of reverse § 704(c) allocations for distributed property, they did thoroughly explore § 704(c) allocations for contributed property. see mark p. gergen, the story of subchapter k: mark h. johnson’s quest, in business tax stories 207, 214-16 (steven a. bank & kirk j. stark eds., 2005). 10. when partnership property is revalued, the partnership must allocate any built-in gain (or loss) in the revalued property in accordance with § 704(c) principles. see irc § 704(c)(1)(a); reg. §§ 1.704-1(b)(4)(i), 1.704-3(a)(2), and 1.704-3(a)(6). 11. see infra notes 33-60 and accompanying text. section 751(b) is only one of several provisions that are intended to prevent a distribution or sale of partnership interests from shifting built-in ordinary income or capital gain among partners. the collapsible partnership6 rules of sections 751(a) and 751(b) and the inside basis adjustment rules of sections 743(b) and 734(b) represented the culmination of intensive study by the american bar association (aba) and american law institute (ali) leading to the 1954 codification of subchapter k. while sections 743(b) and7 751(a) dealing with sales of partnership interests generally function relatively well, sections 734(b) and 751(b) are subject to important defects that impair their ability to prevent shifting of built-in gain. these defects stem mainly8 from congress’ failure to follow through on the 1954 ali proposals for treating a nonprorata current distribution as a partial liquidation of the distributee’s interest, coupled with mandatory inside basis adjustments. to avoid9 inadvertently undermining the purpose of section 751(b), the hot asset sale approach needs to be coordinated with section 734(b) adjustments. part ii of this commentary considers the general operation of the hot asset sale approach when partnership property is revalued. part iii considers10 the relationship between sections 734(b) and 751(b), focusing on the 1954 ali proposals and professor andrews’ more recent proposals to reform the treatment of hot asset distributions and inside basis adjustments. part iv11 explores the hot asset sale approach in the context of liquidating distributions 332 florida tax review [vol.8:3 12. see andrews, supra note 5, at 46 (stressing that § 751(b) has now come to play an important gain-recognition function under subchapter k). 13. see notice 2006-14, supra note 1. 14. if § 704(c) principles are taken into account in measuring hot asset shifts, “significantly fewer distributions would trigger § 751(b).” id. it is assumed throughout that a partnership revalues all of its assets immediately prior to the distribution. see reg. § 1.704-1(b)(2)(iv)(f) (election to revalue); see also reg. § 1.704-1(b)(2)(iv)(e)(1). 15. by comparison to current distributions, liquidating distributions are much simpler to handle under § 751(b), since the distributee is left with no outside basis, tax capital account, or share of inside basis. 16. this example is derived from notice 2006-14, supra note 1, example 1. that trigger section 734(b) because of insufficient shares of outside (or inside) basis. part v addresses nonprorata current distributions that reduce the distributee’s interest in the partnership, leaving the distributee with a retained interest that may be insufficient (by value) to support booked-up hot asset gain. part vi suggests the need to restore conformity between sections 751(a) and 751(b) by extending the hot asset sale approach to shifts of tepid asset gain. while the hot asset sale approach represents a significant improvement, this commentary concludes that section 751(b) should continue to play an essential gain-recognition function.12 ii. hot asset sale approach and revaluations under the hot asset sale approach, any partner whose share of hot assets is reduced (selling partner) would be treated as receiving the relinquished hot assets as a distribution and then selling them back to the partnership for fair market value. the basis of distributed (or retained) hot assets would be13 increased to reflect ordinary income recognized by the selling partner. thus, a current hot asset distribution would generally trigger section 751(b) only if the nondistributee partners were previously allocated a share of booked-up gain in distributed hot assets. the nondistributee partners whose predistribution share14 of hot asset gain is thereby reduced would be treated as the selling partners. on liquidation of a partner’s interest, the selling partners would be either the continuing partners or the distributee (but not both), depending on whether the distribution carries out more or less than the distributee’s predistribution share of hot asset gain. section 751(b) would often be inapplicable when a current15 distribution consists entirely of cash or other nonhot assets (cold assets), since a revaluation preserves the partners’ shares of ordinary income. example (1): the abc partnership purchases land for $210 which16 appreciates in value to $300. each partner has a basis of $120 in her partnership interest. when the partnership also has zero-basis receivables worth $90 and cash of $150, c receives a cash distribution of $90, reducing her interest in the 2007] taxing hot asset shifts 333 17. applying § 704(c) principles, c has a one-ninth share ($30/$270) and the nondistributee partners have an eight-ninths share ($240/270) of the basis of each retained asset. thus, c has the following share of inside basis, gain and value: assets basis gain value cash $6.67 $ 0 $6.67 receivables 0 30 30 land 23.33 30 53.33 total $30 $60 $ 90 since c’s share of hot asset gain ($30) and value ($30) are both unchanged, § 751(b) should not apply even under the existing regulations. 18. see monte a. jackel & avery i. stok, blissful ignorance: section 751(b) uncharted territory, tax notes 1557, 1577 (mar. 10, 2003); karen c. burke, partnership distributions: options for reform, 3 fla. tax rev. 677, 701 (1998). 19. see jackel & stok, supra note 18, at 1581; burke, supra note 18, at 703-04. 20. see notice 2006-14, supra note 1. partnership from one third to one fifth. immediately before the distribution, the partnership’s assets are restated to reflect fair market value and the partners’ capital accounts are increased to reflect their shares of unrealized appreciation in the partnership’s assets. accordingly, the abc partnership has the following post-distribution balance sheet: assets basis value capital tax book cash $ 60 $ 60 a $120 $180 receivables 0 90 b 120 180 land 210 300 c 30 90 total $270 $450 total $270 $450 since the book-up preserves each partner’s predistribution share of hot asset gain and value, section 751(b) does not apply. special allocations (so-called17 “reverse” section 704(c) allocations) would be necessary, however, to ensure proper allocation of the tax gain corresponding to the booked-up gain. when the partnership holds zero-basis hot assets, a revaluation may often avoid section 751(b) even under the existing regulations. under current18 law, however, a revaluation may fail to prevent a hot asset shift when the partnership holds non-zero basis hot assets and the distributee receives solely cold assets. even though a revaluation freezes the distributee’s share of hot19 asset gain, the distributee’s share of the gross value of hot assets will nevertheless be reduced, potentially triggering section 751(b). because disproportionality is measured in terms of shifts in the gross value of hot assets, section 751 may not even achieve its intended purpose of preventing shifts in ordinary income. notice 2006-14 would eliminate this underlying flaw in the20 334 florida tax review [vol.8:3 21. the § 751(b) regulations already require similar treatment for depreciable property subject to recapture. see reg. § 1.751-1(c)(5). 22. thus, the hot asset sale approach would avoid the need to determine a partner’s share of the gross value of partnership assets. similarly, a partner’s share of partnership liabilities would generally be irrelevant, except to the extent that a shift in liabilities may affect a partner’s share of hot asset gain. 23. s. rep. no. 1622, 83d cong., 2d sess. 99 (1954). 24. see andrews, supra note 5, at 45. 25. notice 2006-14, supra note 1, would apparently treat the selling partner as receiving cash directly from the partnership (rather than from the purchasing partners). by contrast, the method of computing gain under § 751(b) reflects a strict aggregate approach. see s. rep. no. 1622, 83d cong., 2d sess. 98-99 (1954). measurement of hot asset shifts by focusing on shifts in hot asset gain (rather than gross value). in effect, the hot asset sale approach treats a partnership’s section 751 property as consisting of (1) a zero-basis hot asset with a fair market value equal to the amount of potential hot asset gain and (2) a non-section 751 asset consisting of the rest of the property. for example, assume that a partnership’s21 section 751 property consists of inventory with a basis of $10 and a fair market value of $15. the section 751 property would be bifurcated into two assets: a hot asset (zero basis, $5 value) and a cold asset ($10 basis, $10 value). if hot asset gain is treated as separable from the basis portion of hot assets, a revaluation would often avoid section 751(b) even though a distribution reduces the distributee’s share of the basis (and hence gross value) of retained hot assets. treating hot asset gain as separable from the underlying hot assets is22 consistent with the legislative history of section 751(b), which emphasizes the “income rights” of the partners and suggests that such income rights may be treated as severable for purposes of taxing partners in a similar manner as individual entrepreneurs. 23 under the existing regulations, one of the chief sources of complexity is the need to identify specific cold assets deemed exchanged for an increased share of hot assets. the hot asset sale approach eliminates this problem, since24 the selling partners would be treated as selling hot assets for cash. for example, assume that a withdrawing partner receives a liquidating distribution consisting entirely of cold assets, thereby relinquishing a share of hot assets. the withdrawing partner would be treated as selling the relinquished hot assets to the partnership for cash and then recontributing the cash to the partnership.25 the deemed hot asset sale would trigger ordinary income to the selling partner and appropriate adjustments to inside basis and outside basis. the hot asset sale approach should be simplified by eliminating the fiction of a deemed distribution of relinquished hot assets to the selling partner and imputed cash consideration on the sale. this fiction is quite unnecessary 2007] taxing hot asset shifts 335 26. see andrews comments, supra note 2. 27. see nysba report, supra note 2, at 49 (recommending similar “deemed gain” approach); daryll k. jones, simplifying section 751(b): you can’t get there from here, 111 tax notes 99, 104 (apr. 3, 2006). 28. see andrews, supra note 5, at 46. 29. the hypothetical sale should take into account any special § 704(c) allocations and basis adjustments under §§ 734(b) and 743(b). see nysba report, supra note 2, at 40-43 (treating § 743(b) adjustments in the same manner as a share of common basis). 30. presumably, the net reduction in a partner’s share of hot asset gain should take into account built-in ordinary losses as well as built-in ordinary income. and may produce unintended results when an actual distribution of hot assets would trigger other partnership provisions. by analogy, section 704(c)(1)(b)26 already provides for deemed sale treatment on certain distributions, coupled with appropriate adjustments to inside and outside basis (the “section 704(c)(1)(b) approach”). the selling partners would be deemed to realize27 ordinary income equal to the net reduction in their share of hot asset gain. any recognized gain would trigger appropriate adjustments to inside and outside basis. the section 704(c)(1)(b) approach accomplishes the same result as notice 2006-14 without imputing a circular flow of cash from the partnership to the selling partner (as consideration on the sale) and from the selling partner back to the partnership (as a contribution). under the section 704(c)(1)(b) approach, the credit to the selling partner’s book capital account for the value of the relinquished hot assets substitutes for imputed cash consideration on the sale. it might be argued that the section 704(c)(1)(b) approach ignores the28 statutory language of section 751(b) which refers to a “sale or exchange.” since every disproportionate distribution is an implicit exchange of properties between the distributee and the nondistributee partners, however, the only relevant issue should be the extent to which the exchange is taxable to both parties. the hypothetical sale approach provides an accurate measurement of the partners’ shares of hot asset gain. indeed, a hypothetical sale approach is already applied under other partnership provisions, including sections 743(a), 751(a), and 755. a partner’s predistribution share of hot asset gain should29 equal the amount of such gain that would be allocated to the partner upon a hypothetical sale of the partnership’s assets. the net reduction in a partner’s share of hot asset gain would be determined by comparing the partner’s preand post-distribution shares of hot asset gain. a partner’s post-distribution30 share of hot asset gain should include any booked-up share of hot asset gain in retained partnership assets and any hot asset gain in distributed hot assets 336 florida tax review [vol.8:3 31. for purposes of determining hot asset gain in distributed assets, the distributee’s basis would initially be determined under the transferred basis rules of § 732. 32. see reg. § 1.751-1(b)(3)(ii)-(iii). consistent with the hot asset sale approach, any increase in the basis of retained partnership property should generally benefit the purchasing partners. 33. see surrey & warren, supra note 7, at 1174. the ali partnership proposals and explanation are contained in american law institute, federal income tax statute: february 1954 draft, vol. ii, 86-119, 353-411 (1954) [hereinafter 1954 ali draft]; see id. at 116-19, 408-11, § x761 (collapsible partnerships), and id. at 101-04, 392-95, § x757 (noncollapsible partnerships). 34. the ali proposals defined a current distribution as one other than upon winding up of the partnership or “as the result of a sale by the distributee of part or all of his interest in partnership property to the other partners.” see 1954 ali draft, supra note 33, at 97, § x754; cf. reg. § 1.761-1(d) (defining a current distribution as any distribution that does not completely terminate a partner’s interest). (determined before taking section 751(b) into account). both current and31 liquidating distributions would be treated in a similar manner, except that a liquidated partner has no continuing share of unrealized appreciation inside the partnership, thereby simplifying the mechanics of section 751(b). iii. relationship between §§ 734(b) and 751(b) when section 751(b) applies, the partnership receives a “cost” basis in purchased hot (or cold) assets, regardless of whether the partnership has a section 754 election in effect. indeed, sections 751(b) and 734(b) were both32 enacted in 1954 to address different facets of disproportionate distributions. under the 1954 ali proposals, the more complex rules of section 751(b) applied to distributions by partnerships with substantially appreciated hot assets, while section 734(b) governed all other distributions that reduced a partner’s interest in partnership profits. both provisions treated a distribution33 that redeems a portion of a partner’s interest as a partial liquidation. for34 example, a distribution that reduced a partner’s interest from one third to one fifth was treated as a complete liquidation of one half of the distributee’s interest; the distributee’s interest was bifurcated into a redeemed and a continuing interest. partial liquidation treatment was considered essential to preserve parity of treatment between sales of partnership interests and disproportionate distributions. following a distribution, section 734(b) basis adjustments serve a dual function: adjusting inside basis to reflect the “cost” of acquiring the distributee’s interest and preserving shares of unrealized appreciation for the 2007] taxing hot asset shifts 337 35. see andrews, supra note 5, at 18 (“in a sense, it is quite remarkable that a single adjustment, defined in one way, can serve two such distinct purposes as reflecting cost on a purchase and preserving taxability . . . in a nonrecognition disposition.”). 36. until recently, the main difference was that § 734(b) adjustments were entirely optional. since 2004, § 734(a) has provided that § 734(b) adjustments are mandatory if the partnership has a § 754 election in effect or “there is a substantial basis reduction.” see american jobs creation act of 2004, pub. l. no. 108-357, 118 stat. 1418, 1589, 1591-92 (2004) (amending §§ 734 and 743). the regulations under § 755 now permit “wrong-way” adjustments that increase the disparity between basis and fair market value to preserve shares of unrealized gain (or loss) for future taxation. see reg. § 1.755-1(c). 37. the collapsible partnership rules were needed to prevent conversion of ordinary income into capital gain through the “simple device of a disproportionate distribution.” surrey & warren, supra note 7, at 1172. 38. see id. at 1172-75. continuing partners. in the case of a cash liquidating distribution, section35 734(b) adjustments function in a manner similar to adjustments under section 743(b), the conceptually simpler provision relating to sales of partnership interests. since the continuing partners are in effect acquiring the distributee’s interest, the implicit purchase price should be reflected in their basis in the partnership’s assets. on a nonrecognition exchange, section 734(b) adjustments to common basis preserve the continuing partners’ shares of unrealized appreciation inherent in retained partnership property, analogous to other nonrecognition provisions. 36 the ali’s 1954 solution to the collapsible partnership problem was modeled closely on the basis adjustment provisions of section 734(b) for noncollapsible partnerships. to preserve the distributee and nondistributee37 partners’ shares of hot (and cold) asset gain following a disproportionate distribution, the ali looked to reallocation of inside basis between distributed and retained assets. accordingly, the distributee was treated as realizing any38 hot and cold asset gain attributable to the redeemed partnership interest (or portion thereof) as if the partnership had sold all of its assets immediately before the distribution. such realized gain was deferred, however, to the extent that the distributee received hot or cold assets of sufficient value to absorb any required basis adjustments. any increases or decreases to the basis of the partnership’s retained property affected both the distributee and nondistributee partners in proportion to their continuing interests in the partnership. gain (or loss) was triggered to the extent of any prevented basis adjustments. in 1954, the senate ultimately rejected the ali’s proposed collapsible partnership rule as excessively complex and substituted the flawed approach of 338 florida tax review [vol.8:3 39. in senate hearings in march 1954, the aba endorsed the ali’s approach to the collapsible partnership provision. see report hearings before the committee on finance, united states senate on h.r. 8300, 83d cong. 2d sess. (part i), at 476-77. the aba criticized the house proposals for failing to recognize that a nonprorata distribution “truly represents an exchange of the interests of the continuing partners in the distributed property for an interest of the distributee in the remaining partnership property.” id. at 476. 40. one objection was that the ali’s partial liquidation approach would have triggered mandatory § 734(b) adjustments whenever a nonprorata distribution altered the partners’ interests in the partnership. see s. rep. no. 1622, 83d cong., 2d sess. 39394 (1954). 41. see id. at 94-96. 42. under § 732(c), the basis of distributed hot assets can never be higher than the partnership’s basis in such assets. this basis limitation largely cured the problem of conversion of ordinary income into capital gain that arose under the house version of the distribution provisions. see id. at 95-96. 43. see andrews, supra note 5, at 8. 44. see id. at 12-13. the § 743(b) regulations already employ shares of inside basis to determine the amount of the purchaser’s adjustment following a sale of a partnership interest. see reg. § 1.743-1(d). a partner’s share of inside basis is equal to current section 751(b). it also rejected other key elements of the ali39 proposals, including mandatory section 734(b) adjustments and partial liquidation treatment when the distributee’s interest was reduced but not entirely eliminated. thus, section 751(b) was transformed into mainly a gain-40 recognition provision, while section 734(b) adjustments survived only as an elective means of adjusting the common basis of retained partnership assets following a non-section 751(b) distribution. moreover, the scope of section 734(b) was radically curtailed: distributions in partial liquidation of a partner’s interest were treated as current rather than liquidating distributions. under the41 transferred basis rule of section 732(a) applicable to current distributions, the distributee generally retains the partnership’s predistribution basis in distributed property, mooting any section 734(b) adjustments. thus, section42 734(b) adjustments are most likely to be triggered in connection with liquidating distributions when distributed property receives an exchanged basis determined, under section 732(b), by reference to the distributee’s outside basis. in 1992, professor andrews proposed thoroughgoing reforms that would essentially refine and perfect the treatment of partnership distributions as envisaged under the ali’s 1954 proposals. the andrews proposals start from the premise that section 734(b) is defective because it is (mostly) optional. even when it applies, section 734(b) often produces the wrong43 adjustment because is determined by reference to outside basis rather than shares of inside basis. under the andrews proposals, section 734(b)44 2007] taxing hot asset shifts 339 her share of previously-taxed capital plus her share of partnership liabilities. id. since partnership liabilities cancel out, the amount of the § 743(b) adjustment may be determined by comparing the amount of cash and the basis of property distributed with the distributee partner’s interest in partnership capital computed on a tax (rather than book) basis. see andrews, supra note 5, at 13 n.45. 45. see andrews, supra note 5, at 65-66 46. tepid assets would consist essentially of § 1250 real property. 47. see id. at 53-54. 48. section 751(b) would be modified to require each partner and the continuing partnership to make such basis adjustments as needed to preserve their respective predistribution shares of unrealized gain (or loss) in the partnership’s hot assets and other property. see andrews, supra note 5, at 55. 49. see id. at 37, 39. 50. see id. at 46-47. 51. see id at 46 (noting that § 751(b) imposes “a tax [on the purchasing partners] . . . whose purpose is wholly obscure.” indeed, this senseless capital-gain tax stems from the senate’s hasty attempt to convert essentially a basis reallocation adjustments would be mandatory and a distribution that redeems a portion of a partner’s interest would be treated as a partial liquidation. mandatory inside45 basis adjustments, coupled with partial liquidation treatment, would align the continuing partners’ (including the distributee’s) post-distribution shares of inside basis, gain and value. the andrews proposals would modify the imputed exchange mechanism of section 751(b) and expand the categories of section 751(b) property to include tepid asset gain. the method of allocating basis46 adjustments under section 755 would also be modified to prevent shifting of basis from cold to tepid assets.47 consistent with the ali’s 1954 proposals, the andrews proposals would reformulate section 751(b) to preserve the partners’ shares of unrealized gain through basis reallocation. gain (or loss) would be triggered only to the48 extent of any prevented basis adjustments. specifically, the andrews49 proposals would replace the imputed exchange mechanism of section 751(b) with a hot asset sale approach. the imputed exchange mechanism often50 needlessly triggers recognition of capital gain to those partners whose shares of hot asset gain increase as a result of a disproportionate distribution (the “purchasing” partners). taxing the purchasing partners immediately results51 340 florida tax review [vol.8:3 provision that preserved gain for future taxability into an imputed exchange that triggered immediate taxation to the purchasing and selling partners alike. 52. id. 53. the § 704(c) approach gives rise routinely to ceiling-rule problems that could conceivably be cured by complex remedial § 704(c) allocations. see id. at 63; reg. § 1.704-3(d). 54. see andrews, supra note 5, at 65. 55. see id. (“fortunately, inside basis adjustment under § 734 offers a much more satisfactory approach.”) 56. see id. at 75 (noting that proposals would allow “simple accounting . . . by maintaining proportionality between profit shares and shares of unrealized gain in the partnership,” without the need for complex § 704(c) allocations). 57. see id. at 46-47. “from following through relentlessly on the logic of an imputed exchange.”52 while the taxable exchange model is understandable in light of the legislative history of § 751(b), it is conceptually flawed. since subchapter k generally allows maximum deferral of gain on an exchange of cold assets, the imputed exchange may not serve any sensible tax policy. professor andrews recognized that shifting of unrealized appreciation could, in theory, be dealt with through partnership revaluations and extended section 704(c)-type allocations. nevertheless, he rejected such “spectral” section 704(c) allocations as extraordinarily cumbersome. when appreciated53 property leaves the partnership in a nonprorata distribution, reverse section 704(c) allocations would often require producing “gains for the nondistributee partners in excess of what partnership basis will permit at the partnership level.” thus, the section 704(c) approach is an “unwieldy way to deal with the54 problem” of preserving shares of unrealized appreciation. as under the 195455 ali proposals, basis reallocation and partial liquidation treatment represent the key to achieving simple partnership accounting for unrealized gain following a nonprorata distribution that alters the partners’ interests in the partnership.56 under the andrews proposals, the hot asset sale approach is intended to minimize recognition of capital gain and obviate the need to identify specific cold assets relinquished in the section 751(b) exchange. a hot asset shift would always be treated as a one-sided sale, triggering ordinary income to the selling partner. the two-sided exchange mechanism of section 751(b) would be57 eliminated, and the purchasing partners would be treated as if they had paid cash for their increased share of hot assets. while a one-sided sale of hot assets may leave a distributee with insufficient outside basis to absorb the increased inside basis of hot assets, professor andrews concluded that “this is not a convincing defense of the exchange rule, which imputes gain (or loss) in many cases where there is no problem of insufficient outside basis, and fails to 2007] taxing hot asset shifts 341 58. id. at 47. 59. cf. reg. § 1.755-1(c)(4) (deferring § 734(b) adjustment if partnership lacks property of the proper class or has insufficient basis). 60. see andrews, supra note 5, at 53; see id. at 37, 39 (allowing reduction to basis of “hotter” property to avoid immediate gain recognition). correct many other cases of insufficient outside basis.” rather, basis shortfalls58 would be handled by requiring gain recognition to the extent of any prevented basis adjustments. 59 under the andrews proposals, a distributee with insufficient outside basis to absorb the partnership’s basis in distributed hot assets would generally recognize capital gain immediately, unless the distributee elected to reduce the basis of distributed hot assets. such gain recognition would be the implicit60 cost to the distributee of retaining the partnership’s increased inside basis in distributed hot assets. by contrast, notice 2006-14 would not require gain recognition to remedy basis shortfalls even if the partnership has a section 754 election in effect. instead, the distributee could elect to recognize capital gain when necessary to preserve hot asset basis. moreover, nonliquidating distributions would continue to be treated as current distributions even if nearly all of the distributee’s interest in the partnership is redeemed. without some form of line-drawing between current and liquidating distributions, a distributee who receives excess cold assets might often be able to circumvent section 751(b) simply by retaining an insignificant interest (by value) in the partnership’s revalued hot assets. unless these problems are addressed, the hot asset sale approach may undermine the function of section 751(b) in curbing unwarranted deferral. iv. liquidating distributions following a liquidating distribution, a revaluation and reverse section 704(c) allocations cannot preserve the distributee’s predistribution share of hot asset gain in retained assets. similarly, any predistribution gain in distributed hot assets is shifted to the distributee. thus, a liquidating distribution may trigger recognition of hot asset gain to either the distributee or the continuing partners (but not both). notice 2006-14 illustrates the hot asset sale approach in two examples involving liquidating distributions of excess hot and cold assets that potentially trigger section 734(b) adjustments to retained partnership assets. the interaction between the section 734(b) adjustment and the hot asset sale approach may lead to surprising and unwarranted results. 342 florida tax review [vol.8:3 61. this example is derived from notice 2006-14, supra note 1, example 3. 62. the bc partnership has the following post-distribution balance sheet: assets basis value capital tax book hot asset $50 $50 b $25 $100 cold asset 0 150 c 25 100 total $50 $200 total $50 $200 63. see reg. § 1.751-1(b)(1)(iii) (applying rules of § 751(b) before the rules of §§ 731-736); jackel & stok, supra note 18, at 1579; id. at 1579 n.79 (noting that ordering rule may not reach the “correct [result] from a tax policy standpoint”). example (2): the abc partnership holds one hot asset and one cold61 asset, each with a basis of zero and value of $150. each partner has a zero basis in her partnership interest and a $50 share of both hot and cold asset gain, and the partnership has a section 754 election in effect. the abc partnership distributes two thirds of the hot asset (worth $100) to a in liquidation of a’s interest. prior to the distribution, the partnership’s assets are revalued and each partner’s restated book capital account is increased to $100. accordingly, the abc partnership has the following predistribution balance sheet: assets basis value capital tax book hot asset $0 $150 a $0 $100 cold asset 0 150 b 0 100 total $0 $300 c 0 100 total $0 $300 since their share of hot asset gain is reduced from $100 to $50, b and c are deemed to sell $50 worth of zero-basis hot assets. accordingly, b and c recognize total ordinary income of $50, increasing their total outside basis and the basis of the distributed portion of the hot asset to $50. under section 732(c), a’s basis in the distributed hot asset is limited to a’s outside basis (zero), or $50 less than the partnership’s predistribution basis. the distribution thus triggers a $50 upward section 734(b) adjustment to the partnership’s retained hot asset, potentially allowing the continuing partners to escape $50 of bookedup hot asset gain.62 under the statutory ordering rule, the section 734(b) adjustment arises only after the tax consequences of the deemed section 751(b) exchange are determined. if the hot asset shift is measured before the section 734(b)63 adjustment arises, b and c would apparently be treated as having retained a $50 share of hot asset gain pursuant to the book-up, even though the subsequent section 734(b) adjustment eliminates the corresponding tax gain. to prevent this unintended result, it would seem necessary to disallow the section 734(b) 2007] taxing hot asset shifts 343 64. the bc partnership would have the following post-distribution balance sheet: assets basis value capital tax book hot asset $ 0 $ 50 b $25 $100 cold asset 50 150 c 25 100 total $50 $200 total $50 $200 65. without a basis increase of $50 to the retained cold asset, the continuing partners’ share of cold asset gain would increase from $100 to $150 ($150 value of retained cold asset less zero basis), triggering a corresponding capital loss of $50 on liquidation. adjustment entirely or change the statutory ordering rule. without a section 734(b) adjustment to cold assets, however, the continuing partners would be improperly taxed on a’s share of cold asset gain remaining in the partnership. what is needed is a $50 upward basis adjustment to cold (not hot) assets to reflect the reduction in a’s share of cold asset gain. under the andrews proposals, the problem of basis insufficiency would be remedied generally by requiring gain recognition in the event of a prevented basis adjustment. a’s $50 share of cold asset gain cannot be preserved through basis adjustments, since a receives no cold assets whose basis can be reduced. thus, a would be required to recognize $50 of capital gain immediately, unless a elected to take a reduced basis in the distributed hot assets. a’s recognized gain would increase the partnership’s basis in retained cold assets and a’s outside basis. since a would have sufficient outside basis to absorb the stepped-up basis of the distributed hot asset, section 734(b) would not apply. notice 2006-14 suggests that a could elect, or be required, to recognize $50 of cold asset gain to preserve the stepped-up basis in the distributed hot asset. under the statutory authority of section 751(b), a should be required to recognize capital gain of $50 immediately, unless a elects to take a reduced basis in the distributed hot asset. a has relinquished a $50 share of cold asset gain in exchange for an increased interest in hot assets. the basis of the partnership’s retained cold asset would be adjusted upward by the amount of a’s recognized gain ($50) and the basis of the retained hot asset would remain zero. the continuing partners would have a $100 share of cold asset gain and64 a $50 share of hot asset gain inside the partnership. alternatively, if a65 foregoes a cost basis in the purchased portion of the partnership’s hot assets, a would have additional ordinary income of $50 outside the partnership, and the continuing partners could be allowed a $50 increase to the basis of retained cold assets. where problems of basis insufficiency do not arise, the hot asset sale approach works properly. for example, assume that the facts are the same as in example (2) except that the partnership owns an additional cold asset with 344 florida tax review [vol.8:3 66. the bc partnership would have the following post-distribution balance sheet: assets basis value capital tax book hot asset $ 0 $ 50 b $75 $150 cold asset #1 50 150 c 75 150 cold asset #2 100 100 total $150 $300 total $150 $300 67. in effect, a has relinquished a $50 interest in inside basis (a cold asset) in exchange for a $50 interest in cold asset gain (and value). 68. this example is derived from notice 2006-14, supra note 1, example 2. 69. the bc partnership would have the following post-distribution balance sheet: assets basis value capital tax book hot asset $50 $150 b $0 $100 cold asset 0 50 c 0 100 total $50 $200 total $0 $200 a basis of $150 and a fair market value of $150, and each partner has an outside basis ($50) equal to one third of the partnership’s inside basis. on the liquidating distribution, a again receives two thirds of the zero-basis hot asset (worth $100) and one third of the unappreciated cold asset (worth $50). b and c would again recognize hot asset gain of $50, and a would take a basis of $50 in the distributed hot asset, reducing a’s outside basis to zero. since a’s remaining outside basis (zero) is less than the inside basis of the distributed cold asset ($50), the partnership would be entitled to an upward section 734(b) basis adjustment, eliminating $50 of cold asset gain inside the partnership.66 the inside basis increase properly reflects the nondistributee partners’ cost of acquiring a’s former share of the partnership’s retained cold asset. a recognizes no capital gain immediately, since a’s $50 share of cold asset gain is preserved in the distributed cold asset whose basis is stepped down from $50 to zero in a’s hands.67 example (3): the facts are the same as in example (2), except that a68 receives a liquidating distribution of two thirds of the cold asset with a value of $100. since a’s share of hot asset gain is reduced to zero, a is deemed to sell $50 worth of zero-basis hot assets to b and c. accordingly, a recognizes $50 of ordinary income, increasing a’s outside basis and the partnership’s basis in the retained hot asset to $50. under section 732(b), the distributed cold asset takes a basis of $50 in a’s hands equal to a’s outside basis, triggering a downward section 734(b) basis adjustment to the partnership’s retained cold asset. the section 734(b) adjustment is suspended, however, because the partnership’s basis in the retained cold asset cannot be reduced below zero.69 thus, notice 2006-14 states that capital gain of $50 is “potentially eliminated 2007] taxing hot asset shifts 345 70. id. the nondistributee partners will eventually recognize capital gain of $50 on liquidation of the partnership or sale of their partnership interests. 71. the bc partnership would have the following post-distribution balance sheet: assets basis value capital tax book hot asset $50 $150 b $25 $100 cold asset 0 50 c 25 100 total $50 $200 total $50 $200 72. if the partnership’s retained cold assets had sufficient basis to absorb the required $50 downward adjustment, the continuing partners would not recognize capital gain. from the system.” of course, the capital gain does not actually disappear but70 rather is preserved in the nondistributee partners’ outside bases. in example (3), b and c should be required, under the authority of section 751(b), to recognize immediately capital gain of $50 equal to the amount of the prevented section 734(b) adjustment. prior to the distribution, the partnership’s basis in the distributed cold asset would thus be increased from zero to $50. since the inside basis of the distributed cold asset would be the same as a’s outside basis ($50), no section 734(b) adjustment would be triggered. b and c should not be permitted to enjoy the benefit of an increased basis in the retained hot asset, unless they recognize $50 of capital gain immediately. without such gain recognition, the continuing partners’ outside bases (zero) would be less than the inside basis of the retained hot asset ($50). immediate gain recognition restores parity between the continuing partners’ outside bases and shares of inside basis.71 although the relationships of the distributee and nondistributee partners are interchanged, examples (2) and (3) should produce similar results. in example (2), the distributee (a) receives excess hot assets and should recognize capital gain immediately to preserve a stepped-up basis in the distributed hot assets. in example (3), the nondistributee partners (b and c) retain excess hot assets and should also recognize capital gain immediately to preserve a stepped-up basis in the partnership’s retained hot assets. both72 examples represent exchanges of hot and cold asset gain and, under section 751(b), should be taxed accordingly. the tax consequences should not depend on the often purely formal distinction concerning the identity of the partners receiving or retaining assets. indeed, the transaction in example (3) could easily be rearranged so that b and c are the withdrawing partners who have insufficient outside bases to absorb the partnership’s increased basis in distributed hot assets. examples (2) and (3) both represent situations in which recognition of capital gain to the purchasing partners should be required as a condition of 346 florida tax review [vol.8:3 73. while the ali proposals were the forerunner of current § 751(b), they bore little relationship to the provision as enacted. cf. gergen, supra note 9, at 224 (attributing complexity of existing § 751(b) approach to ali proposals). 74. see s. rep. no. 1622, 83d cong., 2d sess. 401-02 (1954). 75. see, e.g., paul little, partnership distributions under the internal revenue code of 1954 (pts. 1 & 2), 10 tax l. rev. 161 & 335 (1955) (“with respect to . . . current distributions, it may well be that although the section seems to apply, the serious complexities and unreasonable tax results obtained under the section may outweigh the desirability of closing what seems to be a relatively minor tax loophole.” id. at 189). preserving a stepped-up basis in the partnership’s distributed or retained hot assets. under the existing regulations, section 751(b) often taxes capital gain unnecessarily to the purchasing partners. if shifts in hot asset gain are measured accurately, however, the capital-gain side of the transaction should be taxed whenever the distributee or continuing partners would otherwise wind up with insufficient basis to absorb their share of the stepped-up basis of the partnership’s hot assets. alternatively, the problem of basis insufficiency could be dealt with by requiring the purchasing partners to forego the benefit of a stepped-up basis in distributed or retained hot assets. v. nonliquidating distributions the goal of the 1954 ali proposals was to preserve unrealized gain (or loss) through mandatory reallocation of basis among distributed and retained assets, while triggering gain recognition only to the extent of any prevented basis adjustments. when congress rejected partial liquidation treatment, it73 removed one of the major assumptions underlying the operation of section 751(b) – namely, that the distributee had relinquished a “proportionate share” of partnership assets in exchange for distributed property. since it was74 virtually impossible to determine which assets were relinquished in a nonprorata current distribution, contemporaries quickly expressed doubt as to whether section 751(b) should even apply to current distributions. limiting75 section 751(b) to liquidating distributions would leave a wide gap in the collapsible partnership rules: a distribution of cash or appreciated cold assets that reduces a partner’s interest in the partnership from 99% to 1% would avoid section 751(b), even though such a distribution clearly represents a partial liquidation of the distributee’s interest. the modern concept of a revaluation makes it possible, in theory, to track precisely each partner’s preand post-distribution shares of hot and cold asset gain. without a revaluation, the partners’ respective shares of inside basis, gain and value would often be quite difficult to determine. thus, a revaluation allows tagging of predistribution hot (and cold) asset gain for later recognition. nevertheless, a revaluation of partnership property is not an adequate replacement for section 751(b), since a nonprorata current distribution of 2007] taxing hot asset shifts 347 76. as on a liquidating distribution, a current distribution of excess hot assets should trigger capital gain only to the extent of any basis shortfall. 77. see andrews comments, supra note 2. appreciated property alters the spread between inside basis and value. following the distribution, the value of the distributee’s retained interest may thus no longer be capable of supporting the distributee’s remaining share of inside basis and booked-up hot (and cold) asset gain. to the extent that the distributee receives a current distribution of excess hot assets, the hot asset sale approach generally works well. the nondistributee partners would recognize ordinary income equal to the net reduction in their share of hot asset gain, and a distributee with sufficient outside basis would receive the benefit of the partnership’s stepped-up basis in distributed hot assets. a current distribution of excess cold assets would76 generally not trigger section 751(b) because a revaluation preserves the partners’ shares of hot asset gain inside the partnership. if the distributee’s share of booked-up hot asset gain exceeds the value of the distributee’s retained partnership interest, however, section 751(b) should apply. following a current distribution that leaves the distributee with a retained partnership interest of insufficient value to support booked-up hot asset gain, section 704(c) special allocations cannot adequately substitute for immediate gain recognition under section 751(b).77 a. distributions of excess hot assets on a distribution of excess hot assets, the hot asset sale approach would greatly improve the operation of section 751(b). as illustrated by example (4) below, the one-sided sale of hot assets would trigger ordinary income to the nondistributee partners whose share of hot asset gain is reduced. absent a shortfall in outside basis, however, no capital-gain tax would be triggered to the distributee partner who receives excess hot assets. on a current distribution, a revaluation would thus serve to minimize any hot asset shift and corresponding gain recognition. example (4): assume that c receives a distribution of two thirds of the abc partnership’s hot asset ($20 basis, $80 value), when the abc partnership has the following predistribution balance sheet: assets basis value capital tax value cash $ 60 $ 60 a $ 90 $160 land 180 300 b 90 160 receivables 30 120 c 90 160 total $270 $480 total $270 $480 348 florida tax review [vol.8:3 78. since a distribution shifts any unrealized gain in distributed assets to the distributee, the § 704(b) regulations should generally treat such special allocations as in accordance with the partners’ interests in the partnership. see reg. § 1.704-1(b)(3). immediately before the distribution, the partnership’s assets are revalued. each partner is allocated one third ($40) of the partnership’s total cold asset gain and one third ($30) of the partnership’s total hot asset gain. since the hot asset gain inherent in the distributed property ($60) exceeds c’s total predistribution share of hot asset gain ($30), a revaluation cannot prevent a hot asset shift. thus, a and b should recognize ordinary income of $30, increasing the basis of the distributed hot asset from $20 to $50 and preserving c’s hot asset gain of $30 ($80 value less $50 basis). c recognizes no capital gain, since c has sufficient outside basis to absorb the increased basis of the distributed hot asset. the partnership has the following post-distribution balance sheet: assets basis value capital tax book cash $ 60 $ 60 a $105 $160 land 180 300 b 105 160 receivables 10 40 c 40 80 total $250 $400 total $250 $400 the book value of c’s retained interest ($80) equals c’s share of the partnership’s inside basis ($40) and booked-up cold asset gain ($40). c’s share of hot asset gain is reduced to zero. the book value of the nondistributee partners’ interest ($320) reflects their share of the partnership’s inside basis ($210) and booked-up hot ($30) and cold ($80) asset gain. the hot asset sale approach works properly in example (4). c should not be required to recognize capital gain, since c has essentially exchanged a share of inside basis ($30) for an increased interest in hot assets ($30). when the distributee has sufficient outside basis to absorb the partnership’s steppedup basis in hot assets, a single tax to the selling partners on their relinquished ordinary income is entirely appropriate. although the basis rules under section 732(a) seek to preserve the partnership’s predistribution basis in distributed property, the hot asset sale approach would leave the distributee with a steppedup basis in distributed hot assets that reflects the ordinary income recognized by the selling partners whose share of hot asset gain is reduced. thus, the distributee would, quite sensibly, obtain a fair market value basis in distributed hot assets reduced by the distributee’s preserved share of hot asset gain. in order to minimize the impact of section 751(b), the partnership should allocate booked-up gain in distributed hot assets disproportionately to the distributee. booking-up the gain in this manner generally reflects the economics of the transaction, since the distributee alone will be taxed on the hot asset gain shifted outside the partnership. the partners should be78 2007] taxing hot asset shifts 349 79. the abc partnership has the following predistribution balance sheet: assets basis value capital tax book cash $ 60 $ 60 a $ 90 $160 hot asset #1 180 300 b 90 160 hot asset #2 30 120 c 90 160 total $270 $480 total $270 $480 80. this result seems strange because the distribution alters the partners’ shares of inside basis and value; while the book-up locks in predistribution gain in the partners’ predistribution sharing ratios, any subsequent gain will be allocated in accordance with their post-distribution interests in partnership capital. 81. in effect, the abc partnership owns zero-basis hot assets with a value of $210 and cold assets with a basis and value of $270 ($60 cash plus $210 basis of other assets). 82. the abc partnership would have the following post-distribution balance sheet: assets basis value capital tax book cash $ 60 $ 60 a $110 $160 hot asset #1 180 300 b 110 160 hot asset #2 10 40 c 30 80 total $250 $400 total $250 $400 permitted flexibility in determining how to book-up hot asset gain attributable to particular partnership assets, as long as each partner’s share of total hot asset gain is preserved or recognized. thus, section 751(b) would generally apply to a distribution of hot assets only if the partnership fails to book up its assets or, alternatively, the partnership allocates booked-up gain in distributed hot assets to the nondistributee partners. assume that the abc partnership’s assets consist of $60 cash and two hot assets: asset #1 ($180 basis, $300 value) and asset #2 ($30 basis, $120 value), and the partnership allocates predistribution gain from each asset ratably among the partners. the partnership distributes two thirds of asset #2 ($2079 basis, $80 value) to c. before the distribution, a, b and c are each allocated $40 of book gain from asset #1 and $30 of book gain from asset #2. although not entirely clear, it appears that a, b, and c would each have a one third share of reverse section 704(c) gain in each retained asset following the distribution.80 thus, the distribution shifts $40 of the hot asset gain (two thirds of $60) in distributed asset #2 from a and b to c, reducing the nondistributee partners’ share of hot asset gain from $140 to $100. under the existing regulations, section 751(b) does not apply because the partnership has no cold assets. because the hot asset sale approach treats inside basis (like cash) as a cold asset, however, the distribution should be subject to section 751(b). a and b81 should immediately recognize ordinary income of $40 equal to the shifted hot asset gain, and c should be allowed a $40 increase in the basis of distributed asset #2, preserving c’s $20 share of hot asset gain ($80 less $60 basis).82 350 florida tax review [vol.8:3 c’s remaining share of inside basis ($30) and booked-up hot asset gain ($40 in retained asset #1 and $10 in retained asset #2) equals the value of c’s retained interest ($80). 83. in terms of the 1954 ali proposals, the reduction in the value of the distributee’s partnership interest clearly represents a partial liquidation, though it may be quite difficult in partnerships with varying profit-sharing ratios to determine precisely the portion of the distributee’s interest redeemed. see andrews, supra note 5, at 73-75. 84. thus, the abc partnership has the following predistribution balance sheet: assets basis value capital tax value cash $ 60 $ 60 a $ 90 $160 land 180 300 b 90 160 receivables 30 120 c 90 160 total $270 $480 total $270 $480 b. distributions of excess cold assets if reverse section 704(c) allocations trump the application of section 751(b), current distributions of cold assets would generally no longer trigger the collapsible partnership rules, regardless of the value of the distributee’s retained interest. notice 2006-14 requests comments concerning the83 application of the hot asset sale approach when the distributee’s share of booked-up hot asset gain exceeds the distributee’s post-distribution interest in partnership capital. the issue is not simply a technical one: it implicates the scope of the nonrecognition rules generally under subchapter k, as well as the relationship between sections 751(a) and 751(b) which were intended to parallel each other. as illustrated by example (5) below, there may be significant constraints on the treasury’s authority to revise the operation of a statutory provision that was conceived when revaluations were not prevalent. example (5): assume that c receives a distribution of one half of the abc partnership’s cold asset ($90 basis, $150 value), when the abc partnership has the same predistribution balance sheet as in example (4).84 immediately before the distribution, the partnership’s assets are revalued and each partner is allocated one third ($40) of the partnership’s total cold asset gain and one third ($30) of the partnership’s total hot asset gain. the abc partnership has the following post-distribution balance sheet: assets basis value capital tax book cash $ 60 $ 60 a $ 90 $160 land 90 150 b 90 160 receivables 30 120 c 0 10 total $180 $330 total $180 $330 ignoring section 751(b), c takes a transferred basis ($90) in the distributed cold asset, leaving c with cold asset gain of $60 outside the partnership ($20 more 2007] taxing hot asset shifts 351 85. see irc § 731(a). 86. see reg. § 1.751-1(a)(2). 87. see jackel & stok, supra note 18, at 1581 than c’s total predistribution share). c’s booked-up hot asset gain ($30) exceeds c’s post-distribution interest in partnership capital ($10). the nondistributee partners’ total share of booked-up cold asset gain ($80) also exceeds the actual tax gain ($60) inherent in the retained cold asset, giving rise to potential ceiling-rule problems. in example (5), c’s excess booked-up hot asset gain of $20 would apparently be recognized regardless of whether the partnership sells the retained assets or c sells her partnership interest. if the partnership sold its retained assets for their fair market value, each partner would be allocated one third of the partnership’s ordinary income ($30 each) and a and b should presumably be allocated the partnership’s entire cold asset gain ($60). on liquidation of the partnership, c would recognize a capital loss of $20 ($10 distribution less $30 outside basis) and a and b would recognize an offsetting capital gain of $20 ($320 distribution less $300 outside basis). similarly, if85 c sold her partnership interest for $10, c would recognize $30 of ordinary income under the section 751(a) regulations, and an offsetting capital loss of $20. rather than attempt to allocate a portion of the selling partner’s amount86 realized and adjusted basis to section 751(b) property, the section 751(a) regulations adopt a hypothetical sale approach under which c recognizes ordinary income as if the partnership sold its assets. under a literal interpretation of section 751(a), however, the actual amount realized on the sale of c’s interest ($10) arguably sets a cap on c’s realized ordinary income, potentially allowing hot asset gain of $20 to disappear. 87 given the parallel purpose of sections 751(a) and 751(b), it would clearly be inappropriate to interpret one provision in a manner that defeats the other. thus, if the section 751(b) regulations were to take the position that no hot asset shift occurs even though the distributee’s share of booked-up hot asset gain exceeds the value of the distributee’s retained interest, the section 751(a) regulations ought to require that any reverse section 704(c) allocations be taken into account upon a subsequent transfer of the distributee’s partnership interest. in light of the language of section 751(a), however, a court might nevertheless conclude that treasury’s exercise of its regulatory authority under section 751(a) was unreasonable. indeed, the government could very well be whipsawed: a distributee might fail to report ordinary income on a hot asset shift, while the purchasing partners could later claim that they were entitled to a stepped-up basis in purchased hot assets. in revising the section 751(a) regulations in 1999, the drafters could not have anticipated the full extent to which hot asset gain might be deferred through a revaluation without triggering 352 florida tax review [vol.8:3 88. according to the nysba, “there is not an obvious and principled way of defining a point at which reverse 704(c) concepts should no longer apply and § 751(b) should be triggered.” nysba report, supra note 2, at 33. 89. id. at 33. 90. see id. at 3 (recommending that congress repeal § 751(b) outright or revise the provision to function as an anti-abuse rule). 91. cf. dale e. anderson & melvin a. coffee, proposed revision of partner and partnership taxation: analysis of the report of the advisory group on subchapter k (pts. 1 & 2), 15 tax l. rev. 285 & 497 (1960) (“perhaps the reason the legislative history sheds no light on the proportionate share problem is that congress did not intend the collapsible rules to apply to a current distribution.” id. at 531). section 751(b). thus, the treasury’s interpretation of section 751(a) may need to be reevaluated in light of any changes to the section 751(b) regulations. the contrary view is that reverse section 704(c) allocations should override application of section 751(b) even though the distributee’s booked-up share of hot asset gain exceeds the distributee’s post-distribution interest in partnership capital. under this view, the section 751(a) regulations provide88 an adequate safeguard to ensure that the distributee cannot avoid booked-up ordinary income upon a subsequent sale of the distributee’s partnership interest. to the extent that any uncertainty exists, the treasury should clarify the operation of section 751(a) or provide bright-line rules so that taxpayers are aware of transactions subject to any special rules. such special rules would address the situation in which “a partner’s reverse section 704(c) hot asset gain vastly exceeds the partner’s interest in partnership capital” following a distribution. under this anti-abuse approach, section 751(b) would seldom (if89 ever) apply to a current distribution of excess cold assets, since even a lowvalue retained partnership interest would generally suffice to preserve the distributee’s booked-up share of hot asset gain. 90 the treasury should reject such an anti-abuse approach as fundamentally inconsistent with the language and purpose of section 751(b). despite early concerns about the application of section 751(b) in a nonliquidating situation, it has been well accepted for half a century that the provision applies to current as well as liquidating distributions. moreover,91 there are important policy reasons why section 751(b) should apply when the distributee’s retained interest in partnership capital is no longer consistent with the economic assumptions underlying the booked-up hot asset gain allocable to the distributee. given the myriad ways in which such excess built-in ordinary income may disappear on a subsequent nonrecognition transfer, the potential for tax-avoidance is quite high. for example, the distributee may transfer the low-value retained partnership interest to a controlled corporation, thereby deflecting ordinary income while relinquishing property of negligible value. since current distributions are defined expansively as any distribution that does 2007] taxing hot asset shifts 353 92. cf. nysba report, supra note 2, at 32 (suggesting that congress in 1954 was not concerned about deferral of hot asset gain). 93. see christopher h. hanna, partnership distributions: whatever happened to nonrecognition?, 82 ky. l.j. 465 (1993-94) (comparing the scope of nonrecognition under the 1954 provisions and current law). 94. h.r. 8300, 83d cong., 2d sess. § 751(b) (1954) (as amended by the senate). 95. see h.r. conf. rep. no. 2543, 83d cong., 2d sess. 65 (1954). since hot asset gain is simply the spread between basis and value, both basis and value should remain relevant in applying § 751(b). see andrews, supra note5, at 75 (“as in the treatment of § 751(b), the final key is to focus primarily neither on basis nor on value, but on the spread between the two or unrealized gain.”). 96. indeed, the distributee might be required to retain an interest in partnership capital in excess of this minimum amount. see andrews comments, supra note 2 (suggesting that some “considerable cushion” in excess of the distributee’s share of not terminate a partner’s interest (or the partnership), section 751(b) is necessary to limit deferral of gain when a partner’s interest is partially liquidated. recently, subchapter k has moved further in the direction of92 limiting the scope of the nonrecognition rules.93 while the treasury clearly has authority to update the section 751(b) regulations to reflect revaluations and section 704(c) allocations, it does not have carte blanche to rewrite the existing statute. the principle underlying section 751(b) is that a distribution in partial liquidation of the distributee’s interest is essentially an exchange of the continuing partners’ interests in the distributed property for the distributee’s interest in the remaining partnership property. because the language of section 751(b) focuses on an increase or decrease in a partner’s proportionate share of hot or cold assets, the hot asset sale approach cannot entirely ignore a reduction in the distributee’s interest in partnership capital, even if the goal is to minimize gain recognition. indeed, under the language of the 1954 senate bill, section 751(b) was triggered whenever a distributee received “more than his proportionate share of the value” of either hot or cold assets. thus, the senate bill introduced the94 concept of shifts in a partner’s proportionate share of hot or cold assets measured by the value of such assets. while the conference committee’s revised statutory language deleted the reference to value, this change was not intended to eliminate the proportionate share concept. 95 consistent with the statutory language and purpose, section 751(b) should apply when the distributee’s interest in partnership capital is no longer sufficient to support the distributee’s booked-up share of hot asset gain. to avoid triggering section 751(b), the distributee’s post-distribution book capital account should be at least equal to the distributee’s remaining share of inside basis plus the distributee’s booked-up hot asset gain. if a distribution of96 354 florida tax review [vol.8:3 inside basis plus booked-up hot asset gain might be required). the distributee’s share of inside basis would be determined net of liabilities. see note 44 supra. 97. “exhausted basis” distributions are precisely the type of distributions that ought to trigger § 734(b) adjustments. see andrews, supra note 5, at 56-57. 98. see reg. § 1.743-1(d). 99. see, e.g., irc §§ 351(b), 1031; see also andrews, supra note 5, at 67 (characterizing proportional gain recognition rule on a nonprorata current distribution as “mild by comparison” to other boot rules) 100. see irc § 731(a). 101. although c’s outside basis is increased by the recognized gain of $20, c’s basis in the distributed property is also increased by $20; thus, c’s outside basis (zero) equals c’s share of inside basis. excess cold assets exhausts the distributee’s share of inside basis, the distributee would recognize ordinary income equal to the “excess booked-up hot asset gain,” i.e., booked-up hot asset gain in excess of the book value of the distributee’s retained interest. in example (5), c would thus recognize $20 of97 hot asset gain immediately equal to the excess of c’s booked-up hot asset gain ($30) plus c’s remaining share of inside basis (zero) over the value of c’s retained interest ($10). immediate recognition of ordinary income of $20 eliminates the capital loss of $20 that c would otherwise recognize upon liquidation of the partnership. in effect, the built-in capital loss signifies that c has retained a share of inside basis and booked-up hot asset gain in excess of the value of c’s retained interest. ignoring section 751(b), the distribution in example (5) exhausts c’s share of outside basis ($90 outside basis less $90 transferred basis of land). the corollary of a zero outside basis should be a zero share of inside basis. in fact, c’s share of previously taxed capital is apparently negative $20, i.e., the book value of c’s retained interest ($10) less c’s booked-up hot asset gain ($30).98 outside subchapter k, gain recognition is routinely required to prevent negative basis. indeed, even subchapter k generally requires gain recognition99 when a cash distribution exceeds a partner’s entire outside basis, since the lurking gain can no longer be preserved. if c recognizes hot asset gain of100 $20, c’s share of inside basis is restored to zero ($10 book value less $10 remaining share of hot asset gain).101 the nondistributee partners (a and b) should also be required to recognize cold asset gain of $20, the amount of unrealized appreciation in the distributed cold asset in excess of c’s total predistribution share of cold asset gain. c has given up $20 worth of zero-basis hot assets and received, in exchange therefor, an additional $20 worth of zero-basis cold assets. the partnership’s stepped-up basis of $20 in the retained hot asset reflects the cost of acquiring c’s former share of hot asset gain (and value). while c could perhaps be deemed to sell $20 worth of hot assets to herself, it makes much better sense to treat the nondistributee partners (a and b) as the purchasing 2007] taxing hot asset shifts 355 102. if c is treated as selling the hot assets to herself, c’s remaining outside basis would be $20, and c’s basis in the distributed cold asset would be only $90; thus, c would apparently have a built-in loss of $20 in her partnership interest ($20 outside basis increased by $10 built-in gain less $10 value of interest). 103. accordingly, the partnership would have the following post-distribution balance sheet: assets basis value capital tax book cash $ 60 $ 60 a $100 $160 land 90 150 b 100 160 receivables 50 120 c 0 10 total $200 $330 total $200 $330 104. ignoring § 751(b), the partners would have the following shares of inside basis, gain and value following the distribution: partners, exactly as if they had paid cash for c’s share of hot asset gain. with102 respect to a and b, the result is the same as if they had sold their relinquished share of cold asset gain for cash. thus, c recognizes $20 of ordinary income and a and b together recognize $20 of capital gain. immediately prior to the distribution, the basis of the distributed cold asset is increased from $90 to $110. since c’s outside basis is also increased from $90 to $110, c takes a stepped-up basis of $110 in the distributed cold asset, preserving c’s $40 share of cold asset gain.103 following the distribution, the continuing partners’ shares of inside basis, gain and value are properly aligned: c a and b share of inside basis $0 $200 hot asset gain 10 60 cold asset gain 0 60 total $10 $320 by contrast, ignoring section 751(b) creates havoc under the partnership accounting rules, since the partners’ section 704(b) capital accounts no longer properly reflect their shares of inside basis and booked-up appreciation. the partnership’s balance sheet would “balance” only if c were treated as having a negative basis hot asset (negative $20 basis, zero value) and a and b were treated as having a mirroring positive basis cold asset ($20 basis, $20 value).104 356 florida tax review [vol.8:3 c a and b share of inside basis $ 0 $180 hot asset gain 30 60 cold asset gain 0 60 share of value (§ 704(c)) 30 300 negative/positive basis asset (20) 20 booked-up value (§ 704(b)) $10 $320 105. despite proposals to eliminate § 751(b), legislation introduced in 1960 retained the section virtually intact. see h.r. 9662, 86th cong., 2d sess. 27-30, 148-150 (1960); see also arthur b. willis, willis on partnership taxation 17-18 (1971) (discussing congress’ failure to enact proposed revisions). 106. see american law institute, federal income tax project: subchapter k, proposals on the taxation of partners 8, 30, 53 (1984). 107. see id. at 35, 45. 108. id. at 51. the imbalance in the partnership’s balance sheet reflects the failure to properly account for the shift of hot and cold asset gain (and value). c. tension between § 704(c) approach and § 751(b) allowing reverse section 704(c) allocations to support an unlimited amount of hot asset gain goes well beyond a simple “fix” to improve the measurement of hot assets shifts. except in the case of current distributions of excess hot assets and liquidating distributions, this approach would effectively nullify section 751(b). while earlier proposals have sought to limit section 751(b) to liquidating distributions or tax-avoidance situations, congress has thus far retained section 751(b). for example, the 1984 ali proposals105 advocated the repeal of section 751(b) and sought to limit application of section 751(b) concepts to cash liquidating distributions in which the distributee would be treated as if she had disposed of her share of the underlying partnership assets in a fully taxable sale. with respect to many common types of106 partnership distributions, the 1984 ali proposals resulted in substantially less than full fragmentation. thus, full fragmentation was not required for (1) any distribution of cash in partial liquidation of a partner’s partnership interest, or (2) any current or liquidating distribution in which the distributee received both cash and other cold assets (or solely cold assets).107 importantly, the 1984 ali proposals were directed toward legislative reform of section 751(b), not revision of the statute through treasury regulations. the 1984 ali proposals urged repeal of section 751(b) on the ground that “it is extraordinarily complex” and “produces too harsh a result for the policy that it is intended to enforce.” if the only purpose of making the108 section 751(b) exchange taxable was to prevent income-shifting, the ali reasoned that this purpose might have been accomplished by “tainting” the 2007] taxing hot asset shifts 357 109. see id. at 50. the ali proposals emphasized that “the purpose of [§ 751(b)] is not to impose a tax merely because a partner is exchanging an interest in one asset for an interest in another asset.” id. 110. see, e.g., william b. brannan, the subchapter k reform act of 1997, 75 tax notes 121, 135-36 (1997) (treating a disproportionate distribution as a taxable event only if it “significantly” shifted potential ordinary income and had a “principal purpose” of tax avoidance). 111. for an analysis of the clinton administration’s proposals to require partial liquidation treatment and mandatory § 734(b) adjustments, see karen c. burke, reassessing the administration’s proposals for reform of subchapter k, 86 tax notes 1423 (mar. 6, 2000); ernst & young llp, analysis of the administration’s partnership proposals, 84 tax notes 103 (july 5, 1999). 112. thus, the abc partnership has cash of $120 (rather than $60) and the following predistribution balance sheet: assets basis value capital tax value cash $120 $120 a $110 $180 land 180 300 b 110 180 receivables 30 120 c 110 180 total $330 $540 total $330 $540 distributed (or retained) property. during the 1990's, proposals again109 resurfaced to repeal section 751(b) outright or retain the provision only as an anti-abuse rule. these proposals contrast starkly with more fundamental110 reform of subchapter k, along the lines of the andrews proposals, that would require partial liquidation treatment and mandatory basis reallocation.111 the tension between reverse section 704(c) allocations and section 751(b) reflects the failure of subchapter k to treat a disproportionate distribution as a partial liquidation of the distributee’s interest, requiring either immediate gain recognition or reallocation of inside basis to preserve existing shares of unrealized appreciation. while section 704(c) is designed to deal with the problem of income-shifting on a contribution of partnership property, a distribution in partial liquidation of a partner’s interest removes both value and unrealized appreciation from the partnership. thus, preserving shares of unrealized appreciation may no longer be possible because the partnership’s retained assets lack sufficient unrealized appreciation or the distributee retains an insufficient interest in partnership capital. in these situations, the regulatory concept of reverse section 704(c) principles should give way to the specific statutory requirements of section 751(b). nevertheless, section 751(b) may appear to tax hot asset gain needlessly to a distributee who receives a current distribution of excess cold asset gain and retains a positive share of inside basis. in example (5), assume that, prior to the distribution of land to c, each partner’s tax capital account (and outside basis) is $110 (rather than $90) and the value of each partner’s interest is $180 (rather than $160). the unrealized hot and cold asset gain112 358 florida tax review [vol.8:3 113. the abc partnership would have the following post-distribution balance sheet: assets basis value capital tax book cash $120 $120 a $120 $180 land 90 150 b 120 180 receivables 30 120 c 0 30 total $240 $390 total $240 $390 114. if the cold asset shift does not trigger gain recognition to the nondistributee partners, c would be left with a $20 share of inside basis (and a $90 basis in the distributed land). thus, the book value of c’s retained interest ($30) would be insufficient to support c’s booked-up share of hot asset gain ($30) and share of inside basis ($20). 115. see note 36 supra. although congress retained electivity of § 734(b) basis adjustments in transactions not involving substantial built-in losses, the senate version of the 2004 legislation would have required mandatory § 734(b) basis adjustments in virtually all situations. see s. rep. no. 108-192, at 189-190 (2004) (rejecting electivity of basis adjustments as “anachronistic”). inherent in the partnership’s assets is unchanged, since total inside basis and value are increased by an equal amount. if the distribution of excess cold asset gain is treated as taxable to the nondistributee partners, there is no reason to tax c’s hot asset gain immediately. the basis of the distributed land would be increased from $90 to $110 in c’s hands to reflect the nondistributee partners’ recognized capital gain of $20. following the distribution, c’s share of inside basis would be reduced to zero ($110 less $110 basis of distributed property) and the value of c’s retained interest ($30) would equal c’s booked-up hot asset gain ($30). c’s share of hot assets would not be diminished, since c113 would be treated as having exchanged a $20 share of inside basis for an increased interest in cold assets worth $20. 114 when partnership property is revalued, retained partnership property may no longer suffice to produce actual tax gain corresponding to the nondistributee partners’ shares of booked-up cold asset gain. at a minimum, the partnership should be required to allocate booked-up cold asset gain in a manner that eliminates or reduces any shift in cold asset gain as a result of a nonprorata current distribution. while immediate taxation of cold asset shifts may appear startling, both sections 734(b) and 751(b) were expressly designed to prevent income-shifting through partial liquidation treatment and mandatory basis reallocation. although it has taken congress fifty years to recognize the need for (mostly) mandatory section 734(b) adjustments to inside basis,115 extending section 751(b) to cold asset shifts is long overdue. 2007] taxing hot asset shifts 359 116. see irc § 751(a). 117. see reg. § 1.1(h)-1(b)(2)(ii) and 3(ii), -1(c) (defining look-through capital gain). vi. restoring conformity between §§ 751(a) and 751(b) section 751(b) was originally intended to function as a backstop to section 751(a). nevertheless, section 751(a) has been amended to require full fragmentation regardless of whether the partnership’s inventory is substantially appreciated. thus, a selling partner generally recognizes the same amount of116 ordinary income on a sale of a partnership interest as if the partnership had disposed of its assets. even more significantly, section 751(a) applies a lookthrough approach when a partnership owns tepid assets, primarily unrecaptured section 1250 gain. the failure to extend section 751(b) to tepid asset shifts117 creates an important disparity between the operation of these two provisions. example (6): assume that the abc partnership has the same balance sheet as in examples (4) and (5), except that the partnership owns depreciated section 1250 property (rather than a hot asset) with unrecaptured section 1250 gain of $90. thus, the abc partnership has the following predistribution balance sheet: assets basis value capital tax value cash $ 60 $ 60 a $ 90 $160 land 180 300 b 90 160 § 1250 property 30 120 c 90 160 total $270 $480 total $270 $480 c receives a current distribution of one half of the land ($90 basis, $150 fair market value) and cash of $5. ignoring § 751(b), the partnership has the following post-distribution balance sheet: assets basis value capital tax book cash $55 $55 a $ 90 $160 land 90 150 b 90 160 § 1250 property 30 120 c 0 5 total $175 $325 total $180 $325 thus, c’s outside basis of $85 ($90 reduced by the $5 cash distribution) is no longer sufficient to preserve the partnership’s $90 basis in the distributed land. since the distribution carries out inside basis in excess of the distributee’s outside basis, it triggers an upward section 734(b) adjustment to the 360 florida tax review [vol.8:3 118. the upward § 734(b) adjustment is necessary to eliminate the disparity of $5 in the partnership’s basis in its assets and the continuing partners’ outside bases. 119. thus, the basis of the land would be increased by $2 ($60/$150 x $5) and the basis of the § 1250 property would be increased by $3 ($90/$150 x $5). 120. following a revaluation, an upward section 734(b) adjustment should arguably benefit exclusively the distributee partner who recognizes gain on a nonprorata distribution. see abrams, supra note 8, at 364-65. 121. an upward § 734(b) adjustment to depreciable property serves two functions: (1) it displaces gain inherent in the partnership’s retained assets and (2) it gives rise to future depreciation deductions. as a result, any § 734(b) adjustment should generally be shared for purposes of book depreciation in the same ratio as the partners’ post-distribution percentage interests. see burke, supra note 8, at 653. in accordance with § 704(c) principles, tax depreciation would be allocated in a manner that eliminates book-tax disparities. partnership’s retained cold assets. under the section 755 regulations, the118 inside basis adjustment ($5) is allocated to the land and section 1250 property in proportion to their unrealized appreciation. since the section 734(b)119 adjustment affects the common basis of the partnership’s property, it eliminates tax gain corresponding to previously booked-up gain. thus, it is not entirely clear how the remaining tax gain inherent in the partnership’s cold assets should be allocated. even though the section 734(b) adjustment eliminates120 tepid asset gain, section 751(b) does not apply. if the section 1250 property were instead section 1245 property, the section 751 regulations would treat the partnership as owning a hot asset to the extent of the depreciation recapture (zero basis, $90 value) and a residual cold asset ($30 basis, $30 value). the section 755 regulations would allocate the entire section 734(b) adjustment to the partnership’s only appreciated cold asset (the land), thereby preventing the inside basis adjustment from eliminating booked-up ordinary income or generating future depreciation deductions. under the section 755 regulations, an upward section 734(b) adjustment to section 1245 property is allowed only if the partnership’s section 1245 property has unrealized appreciation in excess of the total recapture amount or the upward section 734(b) adjustment exceeds the entire unrealized appreciation in the partnership’s retained cold assets.when a partnership owns depreciated section 1245 property, a current distribution of excess cold assets raises two problems: it is necessary to identify (1) the reduction in the distributee’s share of potential recapture income and (2) whether all of the continuing partners (including potentially the distributee) should benefit from any increase to the basis of the partnership’s retained section 1245 property. 121 the proper solution is to tax immediately the distributee’s excess booked-up hot asset gain (including recapture) and to allocate the benefit of any basis increase to section 1245 property to the nondistributee partners, who have effectively purchased the distributee’s relinquished share of hot asset gain. 2007] taxing hot asset shifts 361 122. c’s initial outside basis of $90 would be increased by $25 gain recognized and reduced by $5 cash and $110 basis of distributed property. 123. in the case of depreciable property, any reverse § 704(c) gain (including potential recapture) will be eliminated over time as the property is depreciated. see nysba report, supra note 2, at 33-34. 124. following the distribution, the continuing partners’ shares of inside basis, gain and value would be properly aligned: c a and b share of inside basis $0 $200 hot asset gain 5 60 cold asset gain 0 60 total $5 $320 125. on a subsequent sale of the § 1245 property, the amount of recapture income could be limited to avoid overstating the continuing partners’ ordinary income. because c’s share of booked-up hot asset gain is $30 and the value of c’s retained interest in only $5, c should be required to recognize ordinary income of $25 immediately, increasing c’s outside basis to $110 ($115 less $5 cash distributed). c should take a basis of $110 in the distributed land ($90 inside basis plus $20 capital gain recognized or deferred by nondistributee partners), preserving c’s share of cold asset gain ($40). c’s outside basis (and share of inside basis) would be reduced to zero, and c’s remaining share of hot asset gain would be reduced to $5.122 the purchasing partners (a and b) should generally enjoy the benefit of future depreciation deductions attributable to the $25 increase in the basis of the partnership’s section 1245 property. in effect, a and b have purchased $25 worth of c’s interest in the partnership’s section 1245 property in exchange for the shifted cold asset gain in the distributed land ($20) plus cash ($5). thus, if a and b recognize capital gain of $20 immediately, they should be entitled to the equivalent of a cost basis in the purchased portion of the section 1245 property. accordingly, the abc partnership would have the following post-123 distribution balance sheet:124 assets basis value capital tax book cash $55 $55 a $100 $ 160 land 90 150 b 100 160 § 1245 property 55 120 c 0 5 total $200 $325 total $200 $325 if a and b are instead permitted to defer recognition of capital gain, they should be denied a corresponding $20 upward adjustment to the basis of the partnership’s section 1245 property to avoid inflating depreciation deductions.125 362 florida tax review [vol.8:3 126. the sale of a partnership interest with a long-term holding period may result in a combination of ordinary income, collectibles gain (taxed at 28%), § 1250 capital gain (taxed at 25%), and long-term capital gain (taxed at 15%). see reg. § 1.1(h)-1(b)(2)(ii) and 3(ii), -1(c). 127. see william s. mckee et al., federal income taxation of partnerships and partners ¶ 16.02[1] (3d ed. 1997); reg. § 1.731-1(a)(3); see also nysba report, supra note 2, at 48-49 (noting that, by analogy to § 751(a), the treasury could permit or require recharacterization of gain under § 731(a)). example (6) reveals the flaw in the operation of section 751(b) when the distributee relinquishes a share of tepid asset gain: section 751(b) does not apply to unrecaptured section 1250 gain and the section 755 basis allocation rules permit reallocation of basis from distributed cold assets to retained tepid assets. the andrews proposals would fix both flaws: for purposes of both sections 751(b) and 755, tepid assets would be treated as belonging to an intermediate class on the continuum between hot and cold assets. under current law, sale of a partnership interest triggers tepid asset gain under rules similar to those applicable to hot asset gain. tepid asset gain is taxed as if the126 partnership sold the underlying assets and allocated such gain to the partners in accordance with their profit-sharing ratios. since sections 751(a) and 751(b) were intended to operate in tandem, there is no policy reason to carve out tepid asset gain solely for purposes of § 751(a). extending hot asset sale treatment to tepid assets is thus essential to restore parity between sections 751(a) and 751(b). example (7): assume that the equal ab partnership has cash of $100 and zero-basis section 1250 property worth $100, and each partner has an outside basis of $50. if a receives a cash distribution of $75, a recognizes capital gain of $25, triggering an upward section 734(b) adjustment. since a has effectively sold three-fourths of a’s partnership interest for cash, it might appear that section 751(a) – the provision governing sales of partnership interests would apply to tax a’s recognized capital gain of $25 at the rate applicable to unrecaptured section 1250 gain. nevertheless, the overall statutory scheme, historical background, and existing regulations make it clear that section 751(b) rather than section 751(a) is the controlling provision for recharacterizing gain on a partnership distribution (whether current or liquidating). but, unlike section 751(a), section 751(b) applies only to hot127 (not tepid) asset shifts. worse yet, the upward section 734(b) basis adjustment potentially eliminates $25 of tepid asset gain inside the partnership and generates future depreciation deductions. as a policy matter, a’s gain should be taxed in the same manner as if a had sold her interest in a portion of the partnership’s section 1250 property, regardless of whether section 751(a) or section 751(b) applies. indeed, it is quite clear that congress originally intended sections 751(a) and 751(b) to reach essentially the same result: a nonprorata current distribution that alters 2007] taxing hot asset shifts 363 128. see andrews, supra note 5, at 55 n.178. 129. see irc § 732(c). the partners’ percentage interests in the partnership is economically equivalent to a sale of a ratable portion of the distributee’s partnership interest to the continuing partners. since section 751(a) now requires section 1250 gain to be determined separately on sale of a partnership interest, however, the two provisions are not longer congruent. thus, unrecaptured section 1250 gain may be taxed more lightly on a cash distribution in liquidation (or partial liquidation) of a partner’s interest than on sale of a partnership interest. yet, the continuing partners receive the same beneficial treatment as a third-party purchaser to the extent that any upward section 734(b) adjustment eliminates section 1250 gain inside the partnership. in connection with revision of the section 751(b) regulations, the treasury should consider whether it has authority to expand the hot asset sale approach to shifts in tepid asset gain. indeed, a more far reaching proposal would be to dispense with section 751(b) entirely and instead specify gain (or loss) recognition and basis consequences entirely under sections 731 and 732. in terms of gain (or loss) recognition, the distributee and nondistributee128 partners would be required to recognize hot, cold, and tepid asset gain (or loss) to the extent that such gain (or loss) cannot be preserved for later recognition in distributed and retained property. because of administrative concerns based on valuation difficulties, congress in 1954 drafted the basis rules of section 732 to avoid the need to value distributed property. when partnership property is revalued, however, there is no longer any reason why a distributee’s basis in distributed property should not reflect the fair market value of such property less the distributee’s predistribution share of built-in gain (or loss) allocable to such property. thus, any distributed property should generally be assigned a fair market value basis in the distributee’s hands, less the distributee’s preserved share of hot, tepid, and cold asset gain or loss. indeed, congress has recently revised the basis allocation rules of section 732(c) to take into account discrepancies between basis and fair market value of distributed property.129 vii. conclusion the hot asset sale approach would remedy flaws under existing section 751(b), but only at the cost of substantially increased complexity under section 704(c). when the selling partner’s share of hot asset gain is reduced, the hot asset sale approach generally minimizes recognition of capital gain. nevertheless, the purchasing partners may be left with insufficient outside bases (or shares of inside basis) to absorb the stepped-up basis of distributed and retained hot assets. under the authority of section 751(b), the problem of basis insufficiency should be dealt with generally by requiring the purchasing 364 florida tax review [vol.8:3 130. whether the solution is perceived as requiring special allocations of basis or gain, the different approaches under §§ 743(b) and 751(b) are essentially interchangeable. thus, § 751(b) adjustments could be handled in the same manner as § 743(b) adjustments to the extent they reflect cost on a purchase. 131. a revaluation distorts the allocation of § 734(b) adjustments because the revaluation concept arbitrarily bifurcates preand post-distribution sharing of gains and losses; by contrast, the concept of § 734(b) adjustments to common basis is premised on partial liquidation treatment. see burke, supra note 8, at 650-51. 132. see nysba report, supra note 2, at 24. 133. see notes 53-56 supra and accompanying text. partners to recognize capital gain as the implicit cost of benefitting from a stepped-up basis in the partnership’s hot assets. a current distribution of excess cold assets would generally not trigger section 751(b), unless the distributee’s retained interest in partnership capital is insufficient to support booked-up hot asset gain. when built-in gain of the proper character can no longer be preserved, section 751(b) should continue to play an important gain-recognition function. the hot asset sale approach should be coordinated with basis adjustments under sections 734(b) and 743(b). when section 751(b) applies, the nondistributee partners are treated essentially as if they had acquired the distributee’s interest in retained partnership assets; thus, section 751(b) adjustments have much in common with section 743(b) adjustments that benefit exclusively the purchaser of a partnership interest. by contrast, section130 734(b) adjustments to common basis potentially benefit all partners (including the distributee whose interest is partially redeemed). while the hot asset sale approach may exacerbate defects inherent in the section 734(b) adjustment, the more fundamental problem is that the concept of a common-basis adjustment is quite difficult to reconcile with revaluations and reverse section 704(c) allocations. thus, when sections 734(b) and 751(b) apply, the treasury needs131 to provide guidance concerning the interaction between inside basis adjustments and the operation of reverse section 704(c) allocations.132 many of the problems that arise in connection with hot asset distributions can be traced directly to congress’ rejection of the 1954 ali proposals to require partial liquidation treatment and reallocation of inside basis to preserve unrealized shares of built-in gain. congress rejected those proposals essentially on grounds of complexity, and instead implemented the flawed approach of current section 751(b) and elective inside basis adjustments under section 734(b). as the andrews proposals suggest, however, partial liquidation treatment and mandatory inside basis adjustments may actually represent a simpler method of dealing with shifts in unrealized appreciation than revaluations and reverse section 704(c) allocations. even if a perfect133 solution to the problem of partnership distributions remains elusive, the hot asset sale approach represents much needed improvement of section 751(b). 2007] taxing hot asset shifts 365 perhaps subchapter k may yet evolve back toward the conceptually more straightforward treatment of partnership distributions that congress rejected in 1954. florida tax review florida tax review volume 14 2013 number 10 the internal revenue code and automobiles: a case study of taxpayer noncompliance by james alm* jay a. soled** over the last decade, the tax gap — the difference between what taxpayers owe in taxes and what they actually pay — has remained significantly large. a contributory factor to the tax gap’s size is the fact that many taxpayers mischaracterize the tax treatment of their automobile expenses and the receipt of other employer-provided fringe benefits. this analysis explores the reasons for this phenomenon and then proposes reforms that will make taxpayers more compliant, helping to reduce the tax gap’s size. although these reforms admittedly would not solve all of the nation’s tax noncompliance woes, they would help preserve the income tax base and minimize economic distortions. i. introduction ............................................................................. 420 ii. business and personal automobile expenses and their concomitant tax consequences ....................... 424 a. the demarcation line between business and personal automobile expenses ........................................................... 425 b. tax reporting of automobile expenses ............................... 431 iii. compliance oversight and its flaws ................................ 439 a. supposed rigor of the taxpayer compliance rules............ 440 b. flaws in the taxpayer compliance rules ........................... 442 iv. the receipt of taxable fringe benefits, noncompliance, and its implications .................................................................. 448 * james alm, professor of economics, tulane university. ** jay a. soled, professor, rutgers university business school; jd, university of michigan law school’ ll.m (taxation), new york university law school. the authors thank the participants of the 2012 critical tax conference for their thoughtful comments and suggestions. 420 florida tax review [vol. 14:10 v. reform measures that congress should institute ........ 453 a. simplify and clarify certain tax compliance rules ........ 453 b. mandate the submission of information returns for accountable plans ............................................................ 455 c. impose penalties upon derelict plan administrators and taxpayers .......................................................................... 457 d. capitalize upon technological changes .......................... 458 vi. conclusion...................................................................................... 460 i. introduction many taxpayers deduct all or a portion of their automobile expenses or exclude from income travel allowances and reimbursements related to the use of their automobiles. when incurred for ordinary and necessary business reasons, such deductions and exclusions are sanctioned under the internal revenue code (code);1 however, those automobile expenses incurred while commuting and for personal use reasons are not allowed as deductions and exclusions.2 unfortunately, many taxpayers intentionally or mistakenly mischaracterize their automobile expenses in a tax-favored fashion. anecdotal evidence of such practices abounds, and case law suggests the ubiquity of this phenomenon.3 1. see i.r.c. § 162(a)(2) (travel expenses incurred while away from home are deductible) & § 62(c) (expenses that are reimbursed under an “accountable plan” are not includable in a taxpayer’s income). 2. see i.r.c. § 262; reg. § 1.262-1(b)(5); see, e.g., cashman v. commissioner, 9 t.c. 761 (1947) (expenses such as bus, trolley, subway and taxi fares and the cost of operating an automobile between home and work are nondeductible personal expenses); chief couns. adv. 199948016 (dec. 3, 1999) (nondeductible expenses include mileage, tolls and parking fees incurred by employee driving from home to work). 3. in each of the following cases, for example, the taxpayers’ commuting expenses were held to be nondeductible: feistman v. commissioner, 63 t.c. 129 (1974), appeal dismissed, 587 f.2d 941 (9th cir. 1978); anderson v. commissioner, 60 t.c. 834 (1973); marot v. commissioner, 36 t.c. 238 (1961); donnelly v. commissioner, t.c. 1278 (1957), aff’d, 262 f.2d 411 (2d cir. 1959); bruton v. commissioner, 9 t.c. 882 (1947); washburn v. commissioner, 992 f.2d 321 (2d cir. 1993), aff’g t.c. memo. 1991-195, cert. denied, 510 u.s. 866 (1993); verbica v. commissioner, t.c. memo. 1990-584; clark v. commissioner, t.c. memo. 1989598, aff’d on another issue, 951 f.2d 1258 (10th cir. 1991); dickson v. commissioner, t.c. memo. 1986-182; brown v. commissioner, t.c. memo. 1983726; henderson v. commissioner, t.c. memo. 1983-372; taylor v. commissioner, t.c. memo. 1981-8; krambo v. commissioner, t.c. memo. 1980-425; alexander v. commissioner, t.c. memo. 1979-436; fisher v. commissioner, t.c. memo. 19792013] the internal revenue code and automobiles 421 taxpayer noncompliance with respect to automobile usage is not surprising. three bodies of tax literature offer compelling explanations for why noncompliance is commonplace. the first body of literature explains that distinguishing between deductible business expenses and nondeductible personal expenses sometimes engenders difficult line-drawing.4 when the line between the two is blurry — as is often the case with automobile usage 191; mckinley v. commissioner, t.c. memo. 1978-428; gudmundsson v commissioner, t.c. memo. 1978-299; clark v. commissioner, t.c. memo. 1978276; potenga v. commissioner, t.c. memo. 1976-151; patti v. commissioner, t.c. memo. 1975-107; beckley v. commissioner, t.c. memo. 1975-37; roberts v. commissioner, t.c. memo. 1971-282; pemberton v. commissioner, t.c. memo. 1970-194; crist v. commissioner, t.c. memo. 1970-115; hodgkinson v. commissioner, t.c. memo. 1968-176; kutchinski v. commissioner, t.c. memo. 1968-46; steinhort v. commissioner, 335 f.2d 496 (5th cir. 1964), aff’g t.c. memo. 1962-233; bodholdt v. commissioner, t.c. memo. 1961-87; steele v. commissioner, t.c. memo. 1960-181; walker v. commissioner, t.c. memo. 1959206; ranstead v. commissioner, 10 t.c. memo. 117 (1951); thompson v. commissioner, 15 t.c. 609 (1950), acq. in result, 1951-1 c.b. 3, nonacq,.1951-1 c.b. 4, rev’d, 193 f.2d 586 (10th cir. 1951); rogers v. commissioner, tc. summary op. 2001-188. commissioner, t.c. memo. 1979-436; fisher v. commissioner, t.c. memo. 1979-191; mckinley v. commissioner, t.c. memo. 1978-428; gudmundsson v commissioner, t.c. memo. 1978-299; clark v. commissioner, t.c. memo. 1978-276; potenga v. commissioner, t.c. memo. 1976151; patti v. commissioner, t.c. memo. 1975-107; beckley v. commissioner, t.c. memo. 1975-37; roberts v. commissioner, t.c. memo. 1971-282; pemberton v. commissioner, t.c. memo. 1970-194; crist v. commissioner, t.c. memo. 1970115; hodgkinson v. commissioner, t.c. memo. 1968-176; kutchinski v. commissioner, t.c. memo. 1968-46; steinhort v. commissioner, 335 f.2d 496 (5th cir. 1964), aff’g t.c. memo. 1962-233; bodholdt v. commissioner, t.c. memo. 1961-87; steele v. commissioner, t.c. memo. 1960-181; walker v. commissioner, t.c. memo. 1959-206; ranstead v. commissioner, 10 t.c. memo. 117 (1951); thompson v. commissioner, 15 t.c. 609 (1950), acq. in result, 1951-1 c.b. 3, nonacq,.1951-1 c.b. 4, rev’d, 193 f.2d 586 (10th cir. 1951); rogers v. commissioner, tc. summary op. 2001-188. 4. see, e.g., william a. klein, income taxation and commuting expenses: tax policy and the need for nonsimplistic analysis of “simple” problems, 54 cornell l. rev. 871, 878 (1969) (“the foregoing discussion should establish that the question of whether commuting expenses should be deductible is not an easy one and that the soundness of our present rules is not self-evident”); daniel i. halperin, business deduction for personal living expenses: a uniform approach to an unsolved problem, 122 u. pa. l. rev. 859 (1974) (sets forth an analysis to determine the sometimes hard-to-draw line between business and personal expenses). 422 florida tax review [vol. 14:10 — taxpayers tend to exploit the ambiguities in their favor.5 the second body of literature avers that the code purposefully recruits third parties, such as employers (who, for example, must annually issue a set of information returns to both their employees and to the government),6 to monitor taxpayer compliance.7 the success of this monitoring system, however, is predicated upon the third party acting in a self-interested fashion that precludes collusion between itself and the party that it is assigned to monitor.8 in the case of automobile usage, third parties and taxpayers often act in a collusive fashion rather than as adversaries, so taxpayer compliance suffers as a 5. perhaps this sentiment is best expressed by professor william a. klein in the following quotation: in other words, it is not reasonable to expect satisfactory results from simply asking taxpayers, “was your combination business and pleasure trip to florida worth anything to you personally, and if so how much?” even if a taxpayer could answer that question meaningfully, chances are his answer would be seriously distorted by the conscious or subconscious effect of self-interest. william a. klein, the deductibility of transportation expenses of a combination business and pleasure trip—a conceptual analysis, 18 stan. l. rev. 1099, 1103 (1966). 6. i.r.c. § 6041(a). 7. see leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stan. l. rev. 695, 697 (2007): this “information reporting,” like red light cameras, provides information to the government, and it is information that the taxpayer knows the government is receiving. moreover, in some situations, the payor, such as an employer, must also withhold taxes from the payment and remit those taxes to the government. withholding taxes, like speed bumps, constrain compliance with the law. 8. see, e.g., irs, irs releases new tax gap estimates; compliance rates remain statistically unchanged from previous study (jan. 6, 2012) (ir-2012-4) http://www.irs.gov/pub/irs-news/ir-12-004.pdf (“overall, compliance is highest where there is third-party information reporting and/or withholding. for example, most wages and salaries are reported by employers to the irs on forms w-2 and are subject to withholding. as a result, a net of only 1 percent of wage and salary income was misreported. but amounts subject to little or no information reporting had a 56 percent net misreporting rate in 2006”); karen setze, taxpayers honest when someone’s checking, say irs officials, 111 tax notes 1216, 1216 (2006) (“[r]esults from the recently completed individual reporting compliance study for 2001 . . . showed that only 1.2 percent of wage income was underreported, 57 percent of nonfarm proprietor income was misreported . . . and 72 percent of farm income was misreported”). 2013] the internal revenue code and automobiles 423 result.9 the third body of literature, grounded in economic theory, presents compelling evidence that indicates that there are strong financial incentives in terms of tax savings that drive taxpayer noncompliance.10 what is surprising is the congressional response to this phenomenon. congress has seemingly chosen to ignore how taxpayers mischaracterize their automobile usage and the receipt of other fringe benefits that do not fall within the scope of any statutory income exclusion. demonstrating the absence of congressional vigilance is the fact that, in the last quarter of a century, there are no comprehensive studies from reputable governmental oversight agencies such as the government accounting office, congressional research service, or treasury inspector general for tax administration detailing the level of taxpayer noncompliance in the realm of automobile usage. from a cynical perspective, one possible explanation is that the absence of such studies allows this noncompliance to persist, financially benefiting politicians and the wealthy campaign contributors who support them.11 alternatively, from a less cynical perspective, politicians may neither appreciate the severity of the problem nor have been presented with any practical compliance solutions. whatever one’s perspective, the prospects for enhanced taxpayer compliance appear slim. however, it is certainly possible for congress to address the mischaracterization of automobile expenses and the receipt of other taxable fringe benefits. historically, whenever the country has suffered a tax compliance problem, congress has crafted a solution. for example, when taxpayers were taking advantage of abusive tax shelters, congress instituted code section 469 to eliminate deductions for passive activity losses;12 and when taxpayers sought to manufacture fictitious losses, congress codified the economic substance doctrine now found in code section 7701(o).13 the list of meaningful fixes to strengthen taxpayer compliance problems is a long and growing one.14 in the not-too-distant future, congress could add to its 9. see infra section ii.b. (discussing why so-called accountable plans fall far short of ensuring taxpayer compliance). 10. the literature in this area of economic analysis abounds. for a comprehensive and recent review, see, e.g., james alm, measuring, explaining, and controlling tax evasion: lessons from theory, experiments, and field studies, 19 int’l tax and pub. fin. 54 (2012). 11. see infra section iv. 12. tax reform act of 1986, pub. l. no. 99-514, § 501, 100 stat. 2085 (1986). 13. health care and education reconciliation act of 2010, pub. l. no. 111-152, § 1409, 124 stat. 1029, 1067–68 (2010). 14. consider one of congress’s most recent efforts to enhance taxpayer compliance. in passing hiring incentives to restore employment act of 2010, pub. 424 florida tax review [vol. 14:10 list of successful compliance accomplishments the accurate tax reporting treatment of automobile usage. while the focus of this article is primarily on the mischaracterization of automobile expenses, automobile expenses are illustrative of many other taxpayer mischaracterizations such as for the personal use of cellular telephones, frequent flyer miles, and home internet service and their tax treatment as being business-related. accordingly, towards the end of our analysis, we expand our discussion to include reforms that address these items of potential abuse as well. this article proceeds as follows. section ii summarizes the distinctions between business and personal automobile expenses and then sets forth the concomitant consequences stemming from such determinations. section iii highlights the current oversight system and its flaws. section iv details how the tax treatment of automobile expenses is representative of a broad spectrum of taxpayer noncompliance problems and the implications associated with taxpayer noncompliance. section v offers viable solutions aimed at addressing and eradicating taxpayer noncompliance. finally, section vi offers a conclusion. ii. business and personal automobile expenses and their concomitant tax consequences under the code, the tax treatment of automobile expenses is intricate. there are several steps involved in ascertaining the correct tax treatment of such expenses as well as the manner in which such treatment should be reported. the sections below (a) delineate the demarcation line between those automobile expenses that are business in nature (and hence are deductible or, alternatively, the reimbursement for which is excludable from income) and those incurred for personal reasons (and hence are nondeductible or, alternatively, the reimbursement for which is nonexcludable from income) and (b) detail how the code instructs taxpayers to report automobile expenses. l. no. 111-147, 124 stat. 71, congress enacted the foreign account tax compliance act (fatca). this legislation requires foreign financial institutions to disclose specific information relating to their customers’ identities or else, for the first time in the code’s history, confront a withholding tax as a coercive enforcement mechanism. see generally melissa a. dizdarevic, the fatca provisions of the hire act: boldly going where no withholding has gone before, 79 fordham l. rev. 2967 (2011). 2013] the internal revenue code and automobiles 425 a. the demarcation line between business and personal automobile expenses the basic building blocks that underpin the tax treatment of automobile expenses can be found in two code sections: code section 162 states that all “ordinary and necessary” business expenses are deductible15 and code section 262 states that all personal expenses are nondeductible.16 in many instances, application of these two sections is fairly straightforward. for example, if an attorney drives from her office to the courthouse to argue a motion, the expenses that she incurs (e.g., gasoline) are deductible.17 this is a sensible result because one of the code’s fundamental precepts is that taxpayers should be taxed on their net profits and not upon their gross receipts.18 conversely, if an architect commutes from his suburban home to his urban office, the expenses that the architect incurs (e.g., the highway tolls) are nondeductible.19 this, too, is a sensible result because another fundamental precept underlying the code is that personal income is the sum of “the market value of rights exercised in consumption and the change in the value of the store of property rights.”20 here, because it is the taxpayer’s personal choice to live a considerable distance away from his place of work, the travel expenses that the taxpayer incurs constitute an item of consumption and, when determining taxable income, should not be deductible. the two scenarios just posited in the prior paragraph involving an attorney and architect present a fairly straightforward black-and-white picture of those automobile expenses that are considered business-oriented and those that are personal. however, there are four important exceptions to the general business-versus-personal rule just posited. these four exceptions imbue the otherwise black and white landscape with dark shades of gray. 15. i.r.c. § 162(a). 16. i.r.c. § 262(a). 17. see, e.g., el v. commissioner, t.c. memo. 1990-182, aff’d without op., 980 f.2d 723 (3d cir. 1990) (expenses of policeman who traveled between his primary and secondary jobs were not commuting expenses but rather deductible business expenses). 18. see, e.g., hantzis v. commissioner, 638 f.2d 248, 249 (1st cir. 1981) (“[a] fundamental principle of taxation [is] that a person’s taxable income should not include the cost of producing that income”). 19. fausner v. commissioner, 413 u.s. 838 (1973); commissioner v. flowers, 326 u.s. 465 (1946); feistman v. commissioner, 63 t.c. 129, 134 (1974). 20. henry c. simons, personal income taxation (1938); see also robert m. haig, the federal income tax (1921). 426 florida tax review [vol. 14:10 1. exceptions exception #1: the home office exception. this exception, judicially and administratively formulated,21 declares that expenses incurred traveling between a taxpayer’s residence and other business locations are deductible if the residence constitutes the taxpayer’s principal place of business. code section 280a(c)(1) sets forth the conditions determining when a taxpayer’s residence constitutes a principal place of business.22 if the taxpayer’s residence satisfies one of these conditions and thus constitutes the taxpayer’s principal place of business, automobile expenses that a taxpayer incurs traveling to other business locations are deductible.23 for example, if a dentist has a home office and periodically makes house calls, the travel expenses that she incurs while visiting patients are deductible.24 21. strohmaier v. commissioner, 113 t.c. 106, 113–14 (1999); wis. psychiatric servs. v. commissioner, 76 t.c. 839, 849 (1981); curphey v. commissioner, 73 t.c. 766, 777–78 (1980); see rev. rul. 99-7, 1999-1 c.b. 361, 362 (“if a taxpayer’s residence is the taxpayer’s principal place of business . . . , the taxpayer may deduct daily transportation expenses incurred in going between the residence and another work location”). 22. essentially, one of the following three conditions must be met: the residence must be used by the taxpayer (1) for the administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business; (2) as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business; or (3) in the case of a separate structure that is not attached to the dwelling unit, in connection with the taxpayer’s trade or business. i.r.c. § 280a(c)(1). 23. gosling v. commissioner, t.c. memo. 1999-148; dehr v. commissioner, t.c. memo. 1998-441; kahaku v. commissioner, t.c. memo. 199034; wicker v. commissioner, t.c. memo. 1986-1; adams v. commissioner, t.c. memo. 1982-223, aff’d, 732 f.2d 159 (7th cir. 1984); curphey v. commissioner, 73 t.c. 766 (1980). 24. conversely, if the taxpayer’s residence does not satisfy any of the conditions set forth in code section 280a (and is thus not his principal place of business), then commuting expenses to other business locations are deemed nondeductible personal expenses. see strohmaier v. commissioner 113 t.c. 106, 114 (1999) (“since petitioner’s residence was not his ‘principal place of business’, it follows that the expenses relating to the disallowed mileage for each year constitutes commuting expenses that are not deductible”); see also romer v. commissioner, t.c. memo. 2001-168 (holding that because the taxpayer’s residence did not qualify as his principal place of business under section 280a(c)(1)(a), he was not entitled to 2013] the internal revenue code and automobiles 427 exception #2: the temporary distant work site exception. this exception is encapsulated in a half-century-old revenue ruling stating that when an employee is employed for a strictly temporary (as distinguished from an indefinite) period on a construction project situated at a distance from the metropolitan area in which he is regularly employed, he may deduct … his actual expenses incurred for daily transportation between his principal or regular place of employment and such job.25 over the years, courts have refined this exception, providing that the qualification for this exception requires that the temporary work site has to be a meaningful distance from the area where the taxpayer lives and normally works.26 the rationale for permitting this exception is simple: “it is not reasonable to expect people to move to a distant location when a job is foreseeably of limited duration.”27 to illustrate, if a taxpayer is an accountant who lives and works in new york city and is sent on a twomonth assignment by her employer to audit a client in philadelphia, then she may categorize her travel expenses as business rather than personal (i.e., commuting) in nature.28 deduct travel expenses to and from his home); beale v. commissioner, t.c. memo. 2000-158 (same). 25. rev. rul. 190, 1953-2 c.b. 303. in revenue ruling 99-7, 1999-1 c.b. 361, the irs, too, added a further refinement to this exception, stating thus: “a taxpayer . . . may deduct daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work location outside the metropolitan area where the taxpayer lives and normally works.” the revenue ruling defines a temporary work location as one that “is realistically expected to last (and does in fact last) for 1 year or less.” 26. rev. rul. 190, 1953-2 c.b. 303. in revenue ruling 99-7, 1999-1 c.b. 361, the irs, too, added a further refinement to this exception, stating thus: “a taxpayer . . . may deduct daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work location outside the metropolitan area where the taxpayer lives and normally works.” the revenue ruling defines a temporary work location as one that “is realistically expected to last (and does in fact last) for 1 year or less.” 26. dahood v. united states, 747 f.2d 46, 48 (1st cir. 1984); kasun v. united states, 671 f.2d 1059, 1061 (7th cir. 1982); epperson v. commissioner, t.c. memo. 1985-382. 27. kasun, 671 f.2d at 1061. 28. see, e.g., daiz v. commissioner, t.c. memo. 2002-192 (taxpayer who lived and normally worked in stockton, california, and, for work, had to travel to 428 florida tax review [vol. 14:10 exception #3: the regular work location exception (one employer). this exception, rooted in revenue ruling 90-2329 and subsequently reformulated in revenue ruling 99-7,30 provides as follows: “if a taxpayer has one or more regular work locations away from the taxpayer’s residence, the taxpayer may deduct daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work location in the same trade or business, regardless of the distance.” revenue ruling 90-23 defines a “temporary” work location as one at which the taxpayer performs services on an irregular or short-term (i.e., generally a matter of days or weeks) basis.31 for example, a contractor who spends approximately 25 percent of his time at his office and, with respect to the balance of his time, regularly travels to various job sites from his residence may deduct the costs associated with the latter trips.32 exception #4: the regular work location exception (two or more employers). if a taxpayer works at two (or more) different places in a day, the courts have held that the taxpayer may deduct the costs of getting from one place to the other,33 and the irs generally concurs.34 for example, if a lawyer teaches at a law school and also maintains a private practice at a different location, the travel expenses that the lawyer incurs in going from the school to his private practice law office and vice versa are deemed business in nature. 2. confusion surrounding exceptions in theory, for tax purposes, the general rule coupled with these four exceptions constitutes a viable framework for taxpayers to account for how to treat their automobile expenses. but when taxpayers actually confront these exceptions, they get lost in their applications and mired in their subtleties. consider the confusion that each exception engenders. novato, napa, and yuba city — round-trip distances of 171, 141, and 174 miles, respectively — could treat such trips as noncommuting in nature). 29. rev. rul. 90-23, 1990-1 c.b. at 29. 30. rev. rul. 99-7, 1999-1 c.b. at 362. 31. rev. rul. 90-23, 1990-1 c.b. at 29. 32. see, e.g., priv. ltr. rul. 98-06-007 (exploring the tax consequences associated with a similar arrangement). 33. see, e.g., el v. commissioner, t.c. memo. 1990-182, aff’d without op., 980 f.2d 723 (3d cir. 1990) (travel expenses incurred by police officer traveling between his principal place of employment at the police department and his parttime security jobs at a hospital and a supermarket were business rather than personal in nature). 34. rev. rul. 55-109, 1955-1 c.b. 261; irs pub no. 463, at 14 (2009). 2013] the internal revenue code and automobiles 429 first, in this day and age, most taxpayers perform some work tasks from home.35 they regularly log on to their computers and/or use their smartphones to stay in constant touch with their offices. in other words, for many taxpayers, their homes have become an extension of their offices. what many of these same taxpayers do not realize is the fact that, although they do some work each day from home or even may work a whole day or two weekly from home, this activity does not transform their home into a principal place of business qualifying them for the first exception.36 second, as the global business environment becomes more competitive, it has become standard fare for taxpayers to go to temporary work sites to perform services. some of these work sites are in fairly close proximity to where taxpayers are currently employed; some are not. absent a clear definition of the term distant, taxpayers do not know exactly when the second exception applies and often benightedly think that once they leave their driveways, the automobile expenses that they incur are automatically business in nature.37 third, throughout a particular year, taxpayers may have jobs requiring that they be at two or more different locations at different times of the year. for example, during the winter months, a taxpayer might operate a horse-breeding farm in florida; during the summer months, the same taxpayer might operate a pool business in connecticut. are these different work locations temporary work locations as specified under the third exception? the irs says no because the third exception is not designed for taxpayers who regularly commute to the same work locations (e.g., a doctor who goes between the doctor’s residence and one or more offices, clinics, or hospitals at which the doctor works or performs services on a regular basis constitute nondeductible commuting expenses). however, many taxpayers may naively think that different work locations at different times of the year 35. see table 1-1. all workers, and workers who worked at home for the united states: 1960 to 2000, u.s. census 2000, working at home 2000 (oct. 20, 2004), http://www.census.gov/population/www/cen2000/briefs/phc-t35/tables/tab011.pdf (reflecting the fact that over the past two decades an increasing number of people work from home). 36. see lauren marini, “simplification” is not enough: an analysis of the home office tax deduction and the home office simplification act of 2009, 40 u. balt. l. rev. 107 (2010) (among other things, explaining the problems associated with the home office deduction). 37. see, e.g., wheir v. commissioner, t.c. summary op., 2004-117 (pointing out the difficulty associated with defining metropolitan area, resorting to webster’s third new international dictionary (1986), which defines metropolitan as follows: “relating to, or constituting a region including a city and the densely populated surrounding areas that are socially and economically integrated with it”). 430 florida tax review [vol. 14:10 count as temporary places of business and may accordingly try to deduct all of their automobile expenses they incur at both locations under the third exception.38 fourth, the incidence of taxpayers having multiple fulland parttime jobs has become increasingly common.39 taxpayers may travel to these jobs on different or the same days of the week. such taxpayers are accordingly likely to classify all of their automobile expenses (or at least those incurred during the workweek) as business oriented under the fourth exception.40 the confusion that surrounds the application of the general rule and these four exceptions no doubt contributes to taxpayer noncompliance. taxpayers are often at a loss to distinguish between those automobile expenses that are business in nature and those that are personal. also, as was previously pointed out, when the distinctions between business and personal expenses are especially difficult to discern, taxpayers are apt to err on the side of treating such expenses in a tax-favored fashion.41 the difficulties engendered in discerning the business-versus-personal nature of automobile expenses are bad enough, but, as the next section details, the manner in which the code instructs taxpayers to report business-oriented automobile expenses presents its own set of unique challenges. 38. the irs would argue that the automobile expenses the taxpayer incurred at each location are merely commuting expenses and, as such, nondeductible. in andrews v. commissioner, 931 f.2d 132 (1st cir. 1991), for example, the taxpayer had a horse-breeding business in florida and a pool construction business in connecticut at different times of the year, as described in the text. in analyzing the deductible expenses that the taxpayer incurred, the first circuit ruled that the taxpayer had a major and minor post of duty and that the expenses the taxpayer incurred while at the minor post of duty were deductible. the first circuit, however, failed to address whether the taxpayer’s automobile expenses incurred while commuting from his living quarters at the minor post of duty to the actual job location would be nondeductible or deductible. 39. see jim campbell, multiple jobholding in states in 2010, monthly labor review, sept. 2011, at 32, http://www.bls.gov/opub/mlr/2011/09/art3full.pdf (“the annual average national multiple jobholding rate in 2010 was 4.9 percent. . . .”). 40. see, e.g., lopkoff v. commissioner, t.c. memo. 1982-701 (holding that a taxpayer who had two jobs with two different employers was allowed to deduct the travel expenses she incurred in going between the two job locations even though the second of her two jobs was only a half-mile away from the taxpayer’s home). 41. see supra notes 4–5. 2013] the internal revenue code and automobiles 431 b. tax reporting of automobile expenses automobiles can serve dual purposes: they can be used as a means to produce income (e.g., a drug representative who must drive between locations to promote a drug manufacturer’s product), and they can be used for personal purposes (e.g., a drug representative who, along with his family, drives to various vacation destinations). this section of the analysis explores the methodology by which the code (1) accords deductions for the business use of automobiles and (2) requires income inclusion associated with the personal use of business-supplied automobiles. 1. deductions for the business use of automobiles automobiles can perhaps best be described as the platypus of tangible personal property — they defy easy categorization. for example, even when used strictly for business, depending upon how luxurious the model, automobiles may offer personal emoluments to their owners;42 the taxpayer seeking the deduction may have stellar record-keeping habits, or, alternatively, such habits may be lackluster; and the taxpayer seeking to deduct automobile expenses may either be an employee or the owner of a business enterprise. each one of the foregoing items — i.e., personal inurement, record keeping, and taxpayer status — plays a pivotal role in shaping the tax deductibility and reporting of business automobile expenses. for starters, to account for personal emoluments associated with the use of automobiles, the code caps the depreciation deductions normally associated with the use of passenger automobiles.43 more specifically, the code labels passenger automobiles as listed property44 and, as such, places 42. see h.r. rep. no. 98-432, pt. 2, at 1387 (1984) (expressing the view that beyond a certain level, “the extra expense of a luxury automobile operates as a tax-free personal emolument which the committee believes should not qualify for tax credits and deductions”). 43. the normal depreciation rule classifies automobiles as five-year property. i.r.c. § 168(e)(3)(b)(i). as such, the prescribed depreciation method is 200 percent declining balance method (and switching to straight-line when it produces a greater deduction (i.r.c. § 168(b)(1)) that ignores salvage value (§ 168(b)(4))) and is subject to the half-year convention. id. § 168(d)(1). 44. see i.r.c. § 280f(d)(5)(a) (the term passenger automobile is defined as “any 4-wheeled vehicle which is manufactured primarily for use on public streets, roads, and highways, and which is rated at 6,000 pounds unloaded gross vehicle weight or less”). 432 florida tax review [vol. 14:10 significant limitations on how much depreciation is annually allowable.45 for example, automobiles placed in service that cost $30,784 (the average cost of a new automobile in 2012)46 would take ten years to fully depreciate; but 45. i.r.c. § 280f(a). if the purchase price exceeds an annually adjusted monetary threshold, automobiles are subject to special depreciation limitations. id. § 280f(d)(4)(a)(i). here’s how the depreciation limitation applies: it caps the allowable depreciation amounts in accordance with annually published tables. id. § 280f(a)(1)(a). in 2012, for example, the amount of allowable depreciation for each year that an automobile remains in service is as follows: allowable depreciation first year $11,160 second year $ 5,100 third year $ 3,050 each succeeding year $ 1,875 see rev. proc. 2012-23, 2012-14 i.r.b. 1. note that in 2012, code section 168(k)(2)(f)(i) permits an additional $8,000 of depreciation deductions the first year that an automobile is placed into service. when it comes to depreciating tangible personal property, there are potential opportunities for enhanced depreciation deductions. that is, code section 179 permits taxpayers to take bonus depreciation deductions that, depending upon the tax year involved, can be quite significant. for example, the bonus depreciation figure for 2012 is $500,000. i.r.c. § 179(b)(1). code section 168(k) next permits an additional depreciation allowance. i.r.c. § 168(k)(1)(a). for example, in 2012, in addition to the normal deduction that a taxpayer may take, taxpayers can deduct 50 percent of the purchase price of tangible personal property placed into service, including the purchase of any new passenger automobile. id. the listed property restrictions found in code section 280f nullify the utility of these enhanced deductions. this is because code section 280f(d)(1) provides that the depreciation ceiling amounts apply even if a taxpayer elects to apply code section 179 bonus depreciation. furthermore, even though a taxpayer may not be able to fully utilize the code section 179 bonus depreciation, an automobile’s adjusted basis is nevertheless reduced by the full amount of the code section 179 allowance. reg. § 1.280f-2t(e), ex. 4. in succeeding years, this basis reduction will curtail the availability of future depreciation deductions. finally, taxpayers must reduce the tax basis of any business use automobile by the full amount of allowable depreciation deduction, even if a portion of the depreciation deduction is denied because of the taxpayer’s personal use of the automobile. i.r.c. § 280f(d)(2). 46. see, e.g., zach bowman, average price for a new car sales transaction hits $30,784, an all-time record, autoblog (april 11, 2012, 4:01 pm) (“according to truecar.com’s data, the average selling price of a new car sold here in the u.s. last month was $30,748, marking an all-time record (last year’s 2013] the internal revenue code and automobiles 433 more luxurious automobiles, say a $50,000 lexus, would take twenty years to fully depreciate. to circumvent the application of these depreciation deduction limitations, taxpayers cannot simply lease their automobiles; stringent deduction limitations also apply to automobile lease payments.47 aside from a restrictive depreciation regime, taxpayers seeking to deduct their business automobile expenses have a fundamental choice: they can deduct the actual expenses they incur, or, alternatively, they can deduct a standard rate based upon the business miles they travel. under the actual expense method, those taxpayers who wish to deduct the actual costs of operating their vehicle for business purposes must catalog such expenses.48 figure was just $28,771)”), http://www.autoblog.com/2012/04/11/average-price-ofnew-cars-hits-all-time-record. 47. taxpayers may deduct their lease payments (or, if less, the business use percentage of such lease payments). this percentage is found by dividing the mileage incurred that is qualified business use by the automobile’s total mileage. i.r.c. § 280f(d)(6)(a). as listed property, however, if the annual lease payments exceed a particular monetary threshold (which is adjusted each year for inflation), there is an income add-back feature associated with such lease payments. i.r.c. § 280f(c)(2). the purpose of this add-back — a sum referred to as an inclusion amount — is to ensure that taxpayers not avoid the depreciation deduction limitations that are set forth above. computation of the inclusion amount is a complex process that entails multiple steps and a familiarity with the automobile leasing process. computing the actual inclusion amount essentially engenders three steps: (1) the taxpayer must ascertain the automobile’s fair market value; (2) based upon the number determined in step (1) and using a table supplied by the irs, the taxpayer must determine the includable amount; and (3) the taxpayer must prorate over the number of days leased. reg. § 1.280f-7(a)(2). once this dollar figure is determined, the taxpayer must adjust it for the taxpayer’s percentage of business/investment use. reg. § 1.280f-7(a)(2)(iii). 48. the actual expense method requires taxpayers to distinguish between business and personal use of their automobiles. to assist in this bifurcation process, treasury regulations prescribe that taxpayers may use a mileage measurement test (reg. § 1.274-5t(b)(6)(i)(b)), albeit taxpayers are at liberty to use an alternative method to accomplish the same task as long as the method chosen is reasonable. h.r. conf. rep. no. 98-861, at 1028 (1984) (“[r]egulations could provide that if an automobile is used 5 days a week for business purposes and is available 2 days a week for personal purposes, in no event may the taxpayer consider more than fivesevenths of the use to be allocable to business purposes”). as listed property, distinctions drawn between business and personal use of automobiles are critical. by way of background, the code defines qualified business use to be “any use in a trade or business of the taxpayer.” i.r.c. § 280f(d)(6)(b). however, the ambit of qualified business use does not include investment activities under code section 212 (reg. § 1.280f-6(d)(2)(i)) and certain other delineated activities specified in code section 280f(d)(6)(c)(i). if the qualified business use of 434 florida tax review [vol. 14:10 such costs generally include items like gasoline, tolls, repairs, regular maintenance, and insurance. under the standard rate method (designed to alleviate the administrative burden of keeping accurate records of cash disbursements and computing their depreciation expenses), taxpayers are allowed instead to compute their business automobile expenses using a standard rate for the business miles they travel.49 for example, in 2013, this rate is 56.5 cents per mile;50 accordingly, a taxpayer who drives ten thousand miles related to business in 2013 may deduct $5,650 (i.e., 10,000 x 56.5 cents).51 there are, however, several rules that limit the availability of the standard mileage deduction.52 finally, deduction limitations may turn upon whether the taxpayer seeking an automobile expense deduction is an employee. subject to limitations,53 employee taxpayers who incur unreimbursed “ordinary and necessary” business expenses may deduct them,54 including business automobile expenses. because automobiles constitute listed property,55 an automobile is fifty percent or less, then the taxpayer must, on a going-forward basis, use the straight-line method of depreciation (i.r.c. § 280f(b)(2)(a)) and, furthermore, recapture in the current year as income the difference between the depreciation deductions the taxpayer was allowed in prior years versus what straightline depreciation would have yielded. i.r.c. § 280f(b)(2)(b). 49. reg. § 1.274-5(j)(2). 50. notice 2012-72, 2012-50 i.r.b. 673, § 2 (2013 rates), notice 2012-1, 2012-2 i.r.b. 260, § 2 (2012 rates); notice 2010-88, 2010-51 i.r.b. 882, § 2, as modified by ann. 2011-40, 2011-29 i.r.b. 56 (2011 rates): rev. proc. 2009-54, 2009-51 i.r.b. 930, § 5.01 (2010 rates). 51. a corollary to using the standard mileage rate is a deemed depreciation rule. application of this rule requires that the adjusted basis of the automobile used for business driving purposes be downwardly adjusted by multiplying each business mile by a standard rate. for example, in 2012, this deemed rate of depreciation is equal to 23 cents per mile; in 2011, this rate was 22 cents per mile; and in 2010, this rate was 23 cents per mile. notice 2012-1, supra note 50, § 3. in the prior illustration of the taxpayer who drove his automobile ten thousand miles for business in 2012, the taxpayer must downwardly adjust the tax basis he has in his automobile by $2,300 (i.e., 10,000 x .23). 52. for example, this method is not allowed if the taxpayer had claimed a code section 179 deduction, previously used a depreciation method other than straight-line, or had used or leased simultaneously five or more vehicles in business (such as fleet operations). rev. proc. 2010-51, 2010-51 i.r.b. 883, § 4.05. 53. see i.r.c. § 67(a) (limits miscellaneous deductions to the amount that exceeds two percent of the taxpayer’s adjusted gross income); i.r.c. § 68(a) (in certain instances, limits the amount of a taxpayer’s itemized deductions). 54. i.r.c. § 162(a). 55. see supra note 44. 2013] the internal revenue code and automobiles 435 however, the code disallows all depreciation and lease expenses associated with business automobile usage “unless such use is for the convenience of the employer and required as a condition of employment.”56 definitions for the phrases “the convenience of the employer” and “condition of employment” have the same meaning under the listed property limitations as they do under code section 119.57 application of this stringent test curtails the ability of most employee taxpayers to deduct their unreimbursed depreciation or lease expenses because, as practical matter, they cannot satisfy these conjunctive conditions. in sum, deductions are said to be the product of legislative grace.58 in the realm of business automobile expenses, congress has rightfully chosen to be circumspect because when it relates to their business automobile expenses, many taxpayers tend to be highly aggressive in taking tax deductions.59 2. personal use of business-supplied automobiles and its tax implications the starting point for tax implications associated with the personal use of a business-supplied automobile is code section 61, which essentially declares that all accretions to wealth are taxable.60 congress has decided, however, that certain enumerated fringe benefits should be excluded from income.61 in the subsections below, this analysis explores whether the personal use of a business-supplied automobile will result in either (a) income inclusion or (b) income exclusion. 56. i.r.c. § 280f(d)(3)(a). 57. reg. § 1.280f-6(a)(2)(i). 58. see new colonial ice co. v. helvering, 292 u.s. 435, 440 (1934) (“whether and to what extent deductions shall be allowed depends upon legislative grace. . . .”); helvering v. indep. life ins. co., 292 u.s. 371, 381 (1934) (“unquestionably congress has power to condition, limit, or deny deductions from gross income in order to arrive at the net that it chooses to tax”). see generally david i. walker, suitable for framing: business deductions in a net income tax system, 52 wm. & mary l. rev. 1247 (2011); erwin n. griswold, an argument against the doctrine that deductions should be narrowly construed as a matter of legislative grace, 56 harv. l. rev. 1142 (1943). 59. treasury’s temporary and proposed regulations relating to recordkeeping for automobiles and certain other property: hearings before the comm. on ways and means, 99th cong., 1st sess. 80-84, 87, 92 (1985). 60. i.r.c. § 61(a). 61. i.r.c. § 132(a). 436 florida tax review [vol. 14:10 a. income inclusion when taxpayers receive an accretion to wealth, including an in-kind fringe benefit secured as part of their employment, the item’s fair market value is includable in income.62 in the context of employer-supplied automobiles, ascertaining the fair market value of an automobile and its usage for non-business purposes is particularly challenging, involving a myriad of intertwining rules. elaborated below, applicable treasury regulations provide a general valuation rule coupled with three elective alternatives. under the general valuation rule, the amount includable in an employee’s income is equal to the amount that an “individual would have to pay in an arm’s-length transaction to lease the same or comparable vehicle on the same or comparable conditions in the geographic area in which the vehicle is available for use.”63 for example, if an employer supplies an employee with an automobile that has a lease value of $10,000 per year and one-quarter of the employee’s use is nonbusiness in nature, the employee would have to include $2,500 in gross income. in lieu of the general valuation rule, if one of four specified conditions is met,64 an employee can elect one of the three alternative valuation methods for purposes of computing the amount includable in an employee’s income:65 the annual lease rule,66 the cents-per-mile rule,67 or the commuting valuation rule.68 62. reg. § 1.61-21(b)(1). 63. reg. § 1.61-21(b)(4)(i). 64. these conditions are specified in reg. § 1.61-21(c)(3)(ii). they are as follows: (a) the employer treats the value of the benefit as wages for reporting purposes within the time for filing the returns for the taxable year (including extensions) in which the benefit is provided; (b) the employee includes the value of the benefit in income within the time for filing the returns for the taxable year (including extensions) in which the benefit is provided; (c) the employee is not a control employee as defined in paragraphs (f)(5) and (f)(6) of this section; or (d) the employer demonstrates a good faith effort to treat the benefit correctly for reporting purposes. 65. no notice of this election must be supplied to the irs. see reg. § 1.6121(c)(3)(i) (“neither the employer nor the employee must notify the internal revenue service of the election”). 66. when the annual lease value rule applies, it includes the costs of maintaining the automobile plus the costs of insuring it. reg. § 1.61-21(d)(3)(i). utilization of this valuation rule requires the application of a multistep process. 2013] the internal revenue code and automobiles 437 step 1 involves determining an automobile’s fair market value. the general rule is that an automobile’s fair market value is the amount an individual would pay locally to purchase a comparably equipped automobile. reg. § 1.61-21(d)(5)(i). in ascertaining an automobile’s value, there are several alternative methods available, including, in the case of a purchased automobile, the employer’s cost of purchase, reg. § 1.61-21(d)(5)(ii)(a); and in the case of a leased automobile, the manufacturer’s suggested retail price less eight percent (including sales tax, title, and other purchase expenses), reg. § 1.61-21(d)(5)(ii)(c). step 2 involves taking the fair market value established in step 1 and then using it and a table provided under the treasury regulations to ascertain the so-called annual lease value of the vehicle. reg. § 1.61-21(d)(2)(i)(b). the table itself is found in reg. § 1.61-21(d)(2)(iii). the final step involves taking the annual lease value and multiplying it by the ratio of the taxpayer’s annual personal mileage over the annual total mileage (i.e., business-related miles driven plus personal miles driven). reg. § 1.1325(b)(1)(i). special rules apply if the automobile is (i) available for less than the full calendar year (see reg. § 1.61-21(d)(4)(i) (the annual lease value is prorated, based on the ratio of use days to total days in the year) or continuously available to the taxpayer for less than thirty days (reg. id. § 1.61-21(d)(4)(iii)); (ii) used beyond a defined period of time (see reg. § 1.61-21(d)(2) (permitting a recalculation of the lease value if the taxpayer uses the automobile past december 31 of the fourth full calendar year that the automobile is placed into service); reg. § 1.61-21(d)(2)(v) (likewise permitting a recalculation of the lease value if the automobile is assigned to another employee (as long as the primary purpose of the switch was not tax motivated)); or (iii) is part of a larger fleet of employer-owned automobiles. see reg. § 1.61-21(d)(5)(v) (describing in elaborate detail how taxpayers who own twenty or more automobiles may use the average of the fair market values of each automobile in the fleet). if an employer also covers fuel expenses, such expenses must be independently accounted for. reg. § 1.61-21(d)(3)(ii)(a). as a rule of convenience, taxpayers can generally elect to value such fuel at 5.5 cents per mile. reg. § 1.6121(d)(3)(ii)(b). 67. this method permits employers to value an employee’s personal use of an automobile at a fixed rate (e.g., in 2012, 55.5 cents per mile (see supra note 50)). reg. § 1.61-21(e)(1). this monetary figure covers the entire use of an automobile, including its gas, maintenance, and insurance. reg. § 1.61-21(e)(3)(i). if an employer does not cover gasoline expenses, the stated monetary amount is reduced by 5.5 cents per mile. reg. § 1.61-21(e)(3)(iii)(a). for taxpayers to qualify to use this valuation method, two conditions must be met. first, the fair market value of the automobile cannot exceed a certain ceiling amount (e.g., in 2012, $15,900, see rev. proc. 2012-13 § 3.01, 2012-3 i.r.b. 295). see also reg. § 1.61-21(e)(1)(iii) (the fair market value of the automobile when it is first placed into service cannot exceed the sum of the maximum depreciation deduction allowance under code section 280f(a)(2) for the first five years of use). second, either the employer reasonably expects that the automobile will be regularly 438 florida tax review [vol. 14:10 b. income exclusion when an employer supplies an employee with the use of an automobile, the starting point of analysis is that the value of such use is fully taxable.69 however, the code provides that certain specified fringe benefits are excluded from income.70 among the many fringe benefits that the code excludes from income, the two with the most salience insofar as business automobile usage is concerned are those that qualify as working condition fringe benefits71 and de minimis fringe benefits.72 a working condition fringe benefit is a payment for property or a service that would have been deductible as an ordinary or necessary business used in its trade or business or the automobile is driven at least ten thousand miles in a calendar year and is used primarily by employees. reg. § 1.61-21(e)(1)(ii). 68. if several rigorous conditions are met, a taxpayer’s use of an employersupplied automobile for commuting purposes can be valued at $1.50 per one-way commute. reg. § 1.61-21(f)(3). all five of the following conditions must be met: (i) the vehicle is owned or leased by the employer and is provided to one or more employees for use in connection with the employer’s trade or business and is used in the employer’s trade or business; (ii) for bona fide noncompensatory business reasons, the employer requires the employee to commute to and/or from work in the vehicle; (iii) the employer has established a written policy under which neither the employee, nor any individual whose use would be taxable to the employee, may use the vehicle for personal purposes, other than for commuting or de minimis personal use (such as a stop for a personal errand on the way between a business delivery and the employee’s home); (iv) except for de minimis personal use, the employee does not use the vehicle for any personal purpose other than commuting; and (v) the employee required to use the vehicle for commuting is not a control employee of the employer (as defined in paragraphs (f)(5) and (6) of this section). reg. § 1.61-21(f)(1). due to the stringent nature of the conditions specified in the treasury regulations and the fact that an employer and an employee must both agree to adhere to this rule, reg. § 1.61-21(c)(2)(i), it is not frequently utilized. 69. i.r.c. § 61(a). 70. i.r.c. §132(a). 71. i.r.c. §132(d). 72. i.r.c. §132(e). 2013] the internal revenue code and automobiles 439 expense or would have been depreciable had the employee paid for it.73 for example, if an employer supplies an employee with an automobile to make deliveries, the value of the employee’s use of this automobile would be excluded from the employee’s gross income except to the extent that the employee used the automobile for personal purposes.74 the scope of the working condition exclusion is fairly broad. for example, there is a safe harbor from income for vehicles that are not used at all for personal purposes75 and another safe harbor for automobiles not available to employees for personal purposes other than commuting.76 a de minimis fringe benefit is “any property or service the value of which is (after taking into account the frequency with which similar fringes are provided by the employer to the employer’s employees) so small as to make accounting for it unreasonable or administratively impracticable.”77 frequency of the benefit being conferred on an employee is an important factor in determining whether a benefit qualifies under this exception.78 in terms of automobiles, the regulations specifically state that, if an employer provides an employee the use of a vehicle more than one day a month for commuting purposes, then its value would not be excludable from income under this exception.79 *** properly categorizing the correct tax treatment and reporting of business automobile expenses is challenging, as evidenced by the number of interwoven variables. many taxpayers and tax practitioners fail to understand the impact of these variables and their interrelationships. this leaves compliance outcomes in doubt. iii. compliance oversight and its flaws in theory, oversight of taxpayers’ accounting of their automobile expenses is rigorous. estimations of such expenses and business usage under the so-called cohan rule80 are eschewed in favor of documented 73. i.r.c. § 132(d). 74. reg. § 1.132-5(b)(1). 75. reg. § 1.132-5(e). to fall within the protections of this safe harbor, several stringent required conditions specified in reg. § 1.274-6t(a)(2) must be met. 76. reg. § 1.132-5(f). the stringent required conditions to meet this safe harbor are specified in reg. § 1.274-6t(a)(3). 77. reg. § 1.132-6(a). 78. reg. § 1.132-6(b). 79. reg. § 1.132-6(e)(2). 80. see cohan v. commissioner, 39 f.2d 540 (2d cir. 1930) (under certain circumstances, permitting taxpayers to estimate the amount of their expenses). see 440 florida tax review [vol. 14:10 substantiation that delineates the amount and nature of each expenditure, the date that each expenditure is incurred, and the business purpose underlying the expenditure.81 subsection a sets forth the supposed rigor of these rules is set forth; subsection b’s analysis explains why such rules fall far short of ensuring taxpayer compliance. a. supposed rigor of the taxpayer compliance rules as set forth in the treasury regulations, taxpayers should keep a set of records such as a diary, account book, trip sheet, or the like detailing the amount and business nature of each trip they take; such records are permitted to be recorded “at or near the time” when expenses are incurred.82 in addition, accompanying these records should be receipts for every out-ofpocket expense that under current law equals or exceeds seventy-five dollars.83 the legitimacy of taxpayers’ expenses is questioned if taxpayers’ records fall short of reaching these delineated benchmarks.84 to ease the record-keeping burdens associated with automobile usage, the treasury department has promulgated a series of regulations that permit several simplified record-keeping methods, including the use of the standard mileage rate.85 under the standard mileage rate, the taxpayer must generally jay a. soled, exploring and (re)defining the boundaries of the cohan rule, 79 temp. l. rev. 939 (2006). 81. temp. reg. § 1.274-5t(b)(6). 82. id. 83. reg. § 1.274-5(c)(2)(iii)(a)(2). 84. see, e.g., tyler v. commissioner, t.c. memo. 1982-160 (taxpayer’s reliance upon his own testimony together with summaries prepared by him during audit failed to meet the rigorous substantiation requirements of § 274(d)); rembusch v. commissioner, t.c. memo. 1979-73 (diaries verifying taxpayer’s expenditures prepared several years after the actual events occurred were held unreliable); silverton v. commissioner, t.c. memo. 1978-22 (failure to maintain an “account book, diary, statement of expense or similar record” resulted in the disallowance of taxpayer’s expenditures). 85. in lieu of the standard mileage rate, if an employer prefers, it can instead provide for a general mileage allowance. this allowance can equal the lesser of the following: (1) an amount the employer deems appropriate (a.k.a. mileage allowance) or (2) the standard mileage rate multiplied by the number of miles substantiated by the employee. rev. proc. 2010-51 § 7, 2010-51 i.r.b. 883. as an alternative to the general mileage allowance, employers can utilize a much more complex employee reimbursement method known as the fixed and variable rate (favr) allowance which, in certain instances, may more accurately compensate employees for the business use of their automobiles. albeit greatly oversimplified, under this method an employer determines what it considers to be a “standard” 2013] the internal revenue code and automobiles 441 substantiate the nature of the expense (i.e., the time, place, business purpose of the travel, and the amount of mileage traveled).86 once this is done, the taxpayer can then multiply the number of business miles traveled by the standard mileage rate in effect during the calendar year incurred (in 2013, 56.5 cents).87 use of this rule obviates the need for taxpayers to maintain actual receipts and records of their operating and fixed costs.88 in order to monitor whether taxpayers are fulfilling their compliance obligations, the code and treasury department permit two reporting methods: the first requires a tax return submission and the second requires the establishment of a so-called accountable plan. 1. return submissions application of the first method requires that taxpayers make information disclosures on certain designated forms. self-employed individuals are supposed to accompany their tax returns with a schedule c, enumerating in part iv the nature and extent of their automobile expenses.89 employees who choose to deduct their business automobile expenses may do so as an unreimbursed deduction on schedule a of their tax returns; these employees must also complete a form 2106 and enumerate the nature and extent of their business automobile expenses.90 finally, any taxpayer (including a proprietor, partner, or corporate entity) wishing to depreciate the automobiles that are owned must complete a form 4562; part v of this form asks many detailed questions regarding automobiles that are placed into service and their business percentage usage.91 automobile for its employees and then estimates the fixed costs (e.g., depreciation and insurance) and variable costs (e.g., gasoline and maintenance) associated with its use. based upon these estimates, an employer can then reimburse its employees based upon their business-use percentage of their automobiles. rev. proc. 2010-51, § 6. there are several significant limitations to the use of this method, including that it cannot be paid to control employees (as defined in reg. § 1.61-21(f)(5)), management employees cannot constitute a majority of the reimbursed employees, and at all times during the calendar year, at least ten employees must be covered. id. 86. reg. § 1.274-5(j)(2). 87. notice 2012-72, § 2, i.r.b. 2012-50 673 (2013 rates). 88. rev. proc. 2010-51, 2010-51 i.r.b. 883, § 4.02. 89. irs publication no. 17, at 187 (2011). 90. id. 91. irs publication no. 946, at 13–14 (2011). 442 florida tax review [vol. 14:10 2. accountable plans to fulfill their compliance obligations, taxpayers engaged in business are able to establish so-called “accountable plans.”92 payments under such plans are not includable in the participant’s income;93 furthermore, such plans obviate the need to make return submissions specified in the prior paragraph, including the need to provide information returns to those participating in the plan.94 to be considered an accountable plan, the plan must fulfill three requirements:95 (1) the expenses submitted to the plan for reimbursement have a “business connection” (i.e., the expenditures themselves would constitute deductible expenses under code section 162),96 (2) the business expenses incurred must be substantiated to the payor within a reasonable time of their occurrence,97 and (3) the employee must return to the payor within a reasonable period of time any amount paid under the arrangement in excess of the expenses substantiated.98 if a participant fails to meet any or all of the foregoing conditions, the plan is deemed to be a non-accountable plan,99 and payments under such a plan must be included in the participant’s income.100 b. flaws in the taxpayer compliance rules given the stringency of the rules specified above, the expectation might be that taxpayers will be compliant and that the irs can readily detect the derelictions of any taxpayer who is noncompliant. the reality is far different, however. this section reveals that (1) taxpayers are apt to be noncompliant, and (2) the irs has little or no ability to detect taxpayer noncompliance. 1. taxpayers’ proclivity to be noncompliant there are several reasons why taxpayers are apt to mischaracterize their automobile expenses in a tax-favored fashion. 92. i.r.c. § 62(a)(2)(a). 93. reg. § 1.62-2(c)(4). 94. reg. § 1.6041-3(b). 95. reg. § 1.62-2(c)(2). 96. reg. § 1.62-2(d). 97. reg. § 1.62-2(e). 98. reg. § 1.62-2(f). 99. reg. § 1.62-2(c)(3)(i). 100. reg. § 1.62-2(c)(5). 2013] the internal revenue code and automobiles 443 let us begin by examining the tacit endorsement of accountable plans (described in the prior section) under the code and treasury regulations.101 the reason underpinning this endorsement is clear: in theory, employers should be willing to reimburse only legitimate business expenses incurred by their employees. the code and treasury regulations both presume a zero-sum environment in which there is one less dollar of business profits for every dollar that an employer reimburses an employee. to illustrate, suppose that an employee incurs $100 of automobile expenses and submits the corresponding expense receipts to his employer for reimbursement. the employer will presumably verify the legitimacy of the $100 expense and its business connection lest the business enterprise accords undeserved remuneration to the employee, thereby having correspondingly less money available for other employees, working capital, and/or investors (e.g., shareholders). but the theory behind accountable plans does not match reality. in numerous business enterprises, a faustian bargain is struck between employees and employers in which both sides readily conspire against the government. the anatomy of the faustian bargain is as follows: employees “wash” personal expenses through accountable plans and bear no income tax; simultaneously, self-interested employers, in their quest to avoid paying employment taxes102 and to award their employees tax-free perks, honor these reimbursement requests. the employers then account for such expenses at the back end in the form of a salary or distribution reduction. the transformation of accountable plan reimbursement accounts into mini–tax shelters is not rocket science. to illustrate, suppose an employee travels on vacation for two weeks in maine and attends one business meeting while there. suppose further that the travel expenses incurred are $5,000 and that the employee’s annual compensation package is normally $100,000. even though the travel expenses under the code are nondeductible because they were not incurred primarily for business,103 the employee submits them for reimbursement. the employer honors this reimbursement request and correspondingly reduces the employee’s annual salary package by $5,000. admittedly, by 101. see ridgeley a. scott, reimbursed employee expenses: new tales from the grimm brothers, 28 willamette l. rev. 1, 25 (1991) (“treasury proposed a system to complete the bias in favor of reimbursed employee expenses”); see also supra notes 56–57 and accompanying text (delineating those rules that make it virtually impossible for individual employees to take deductions for their depreciation expenses or lease payments). 102. i.r.c. § 3111(a), (b). 103. reg. § 1.162-2(b). 444 florida tax review [vol. 14:10 orchestrating this salary reduction, this otherwise accountable plan is transformed into a non-accountable plan; nevertheless, if this arrangement goes unaudited, the employee is able to receive $5,000 of tax-free income (i.e., the employee avoids paying income taxes from this arrangement equal to his marginal tax rate times the value of his personal travel expenses), and the employer saves paying employment taxes on an equivalent dollar amount. both parties to this arrangement, namely, the employee and employer, are economic winners; the only slighted party is the one not invited to join in the arrangement at all, the government. aside from such deliberate violations, the lack of clear rules is another contributory factor in taxpayer noncompliance. a healthy number of taxpayers who commute to work and who must occasionally use their automobiles during the course of a workweek to perform necessary business tasks mistakenly (or purposefully) group many of their automobile expenditures under the deductible category. why would otherwise honest taxpayers benightedly delude themselves? in instances when tax dollars are at stake, taxpayers’ minds tend to play funny tricks.104 commuting to work, traveling from an office to a courtroom, visiting a patient in a local hospital, and framing a new house — all entail the exact same act of turning the ignition key or pushing a “start” button and doing something work-related. the synapses in many taxpayers’ brains apparently fire in a lockstep manner, causing them to group all such expenses as deductible.105 along these same lines is the fact that taxpayers are charged with the duty of deciding their own fate. more specifically, taxpayers are often the ones assigned the duty of deciding if their automobile usage is business or personal in nature, with little or no corresponding “paper trail” of transactions to document the usage. if, for example, the owner of a small business enterprise takes a family trip from new jersey to vacation in florida and visits a client or two along the way, the taxpayer must decide for himself whether the trip was primarily business or personal in nature. one does not have to be a psychology expert to guess that the taxpayer will probably decide this tax issue in his favor.106 this is common practice: study after study shows that when taxpayers are left to their own devices, they often do not wear halos, and tax compliance plummets.107 admittedly, the taxpayer generally bears the initial burden to 104. see supra note 5. 105. by way of contrast, when taxpayers incur other expenses, such as payments made to home landscapers to cut their lawns or to plumbers to fix their kitchen sinks, the same sense of ambiguity is nonexistent. the demarcation line is clear: such expenses are clearly not deductible. i.r.c. § 262. 106. see supra note 5. 107. see supra note 8. 2013] the internal revenue code and automobiles 445 present credible evidence of the deductible expenses he incurred,108 but if the taxpayer maintained a set of compliance records — albeit distorted — the irs is apt to have a difficult time challenging the veracity of the taxpayer’s claims. a final contributing factor to taxpayer noncompliance is that the stakes on a per-taxpayer basis are almost uniformly small. for many taxpayers, automobile expenditures are not major components of their overall tax returns. as such, taxpayers tend to deduct their automobile expenses in an aggressive fashion or use accountable plans to camouflage the nondeductible nature of such expenses because they believe they can get away with it (i.e., the dollar amounts are too small to attract an irs audit).109 2. the inability of the irs to detect noncompliance there are several reasons why the irs lacks the ability to detect taxpayers’ mischaracterizations of their automobile expenses. first, the irs lacks the funds and staffing to audit a large percentage of taxpayers’ returns;110 indeed, by historical standards, the irs’s audit rates continue to hover at fairly low levels.111 therefore, many taxpayers believe — and usually rightfully so — they can cheat on their taxes with impunity. one strong piece of evidence of the irs’s inability to rein in taxpayer noncompliance is that the tax gap (i.e., the difference between taxpayers owe 108. i.r.c. § 7491(a)(1). 109. in all likelihood, taxpayers also believe that even if they are audited, they can use the disallowance of their automobile expenses as a potential distraction to mask larger noncompliance concerns. 110. see, e.g., william hoffman, nearly 1 in 8 high-income taxpayers audited, irs reports, 134 tax notes 174 (2012) (“yet the irs started 2012 with about 3,000 fewer enforcement personnel than it had a year earlier, mainly because of hundreds of millions of dollars in budget cuts. . . . total enforcement staff is down from more than 52,000 in late 2010 to about 49,000 in 2012. . . .”). 111. see irs releases fiscal 2011 enforcement statistics, 2012 tax notes today 4-21 (depicting statistics that indicate that over the past decade the national audit rate averages approximately 1 percent of all tax returns); jim abrams, “historic collapse” of irs audit rates of big companies, seattle times apr. 14, 2008, http://seattletimes.nwsource.com/html/nationworld/2004346994_audits14. html (indicating a plunge in the audit rates of large companies); irs audit rates: rate for individual taxpayers has declined but effect on compliance is unknown, gao 01-484 (apr. 2001), www.gao.gov/new.items/d01484.pdf (showing a steep decline in the audit rate for individual taxpayers). 446 florida tax review [vol. 14:10 in taxes and what they actually pay) continues to be a sizable figure, roughly $450 billion in the most recent irs estimates.112 furthermore, automobile usage presents the irs with several unique microand macrochallenges. on the micro-level, there is no single form designed to address the deductibility of automobile expenses; instead, as previously pointed out,113 there is a series of different forms upon which taxpayers, depending upon their tax-filing status, are supposed to record their automobile expenses. likewise, when it comes to accountable plans, the irs has not designated a specific form that the taxpayer submits to the government. the absence of a designated form creates the impression that the government has adopted a laissez-faire approach to the tax treatment of expenses of this sort because there is no designated “toggle switch” designed to put the irs on notice that something may be amiss. on a macro-level, automobile usage compliance also presents the irs with challenges. unlike some audits that can be conducted automatically, monitoring taxpayer compliance with respect to automobile usage is a labor-intensive endeavor.114 the irs must examine the taxpayers’ actual books and records and determine their accuracy. apart from being labor–intensive, the revenue associated with the irs’s audit efforts will likely be small relative to other audit exercises.115 true, a key feature of accountable plans is that employers bear financial risk in the form of taxes, interest, and penalties if the irs successfully challenges such a plan’s bona fides.116 yet, the blade of this supposed sword of damocles is extraordinarily dull: if delinquent tax dollars must be paid, the same taxpayers who benefited from such misreporting (e.g., the taxpayer in the prior example who took his family to florida and deducted his travel expenses) will often be the very 112. irs estimates $450 billion gross tax gap for 2006, 2012 tax notes today 5-51. 113. see supra notes 89–91 and accompanying text. 114. see ridgeley a. scott, reimbursed employee expenses: new tales from the grimm brothers, 28 willamette l. rev. 1, 8 (1991) [hereinafter scott, reimbursed employee expenses] (explaining how time intensive irs audits involving travel and entertainment expenses tend to be). 115. u.s. gov’t accountability office, gao-08-620t, internal revenue service: assessment of the 2009 budget request 10 n.14 (2008), http://www.gao.gov/new.items/d08620t.pdf (“in fy 2007 correspondence audits took, on average, 1.4 hours to conduct compared to the 30.8-hour average for field audits done at taxpayers’ locations and the 7.8-hour average for field audits done at irs offices”). 116. see, e.g., peoples life ins. co. v. united states, 373 f.2d 924 (ct. cl. 1967) (employer has liability for its failure to withhold on taxable wages); acacia mut. life ins. co. v. united states, 272 f. supp. 188 (d. md. 1967) (same). 2013] the internal revenue code and automobiles 447 same people who bear the associated costs of the audit. more specifically, employers will pass the burden of the additional taxes resulting from the irs audit squarely upon those employees whom directly benefited from such mischaracterizations in the form of reduced salaries, bonuses, and the like. on a final note, with its limited budget, the irs must choose whom to audit, based at least in part on predicted revenue yields. more specifically, the irs uses the results of its previous experience with audited tax returns to devise a formula called the “discriminant index function” (dif) that determines which tax returns to audit based upon historical tax return reporting patterns.117 this formula estimates a “dif score” for each tax return, with a higher dif score indicative of a tax return with a higher likelihood of additional tax assessments in excess of audit costs. these dif scores lie behind the so-called “audit flags:” individuals who deviate from the average behavior of their assigned cohort indicate possible low compliance and suggest an audit response may be in order. the irs does not reveal the details of this audit rule, but many tax professionals routinely publish guides that provide information about which deductions (and other reporting strategies) they believe are allowed and which they think are likely to be challenged.118 irs audits based upon a tax return’s dif score generate significantly more additional assessments than purely random tax audits; 117. see u.s. gen. accounting office, how the internal revenue service selects individual income tax returns for audit. report to the joint committee on internal revenue taxation, congress of the united states (1976). 118. tax professionals have long recognized the broad outlines of the irs audit process. nearly every year, especially around april 15th, articles and books appear with titles such as “how to avoid a tax audit,” most arguing that taxpayers should try to avoid waving a red flag in front of the irs. for example, one professor argues that large deductions relative to income increase the likelihood of an audit, with over ninety percent of all audits triggered by the size of deductions relative to income. amir d. aczel, how to beat the i.r.s. at its own game: strategies to avoid–and fight–an audit (1995). professor aczel claims that his analysis shows that the audit probability goes up significantly when deductions are between thirty-five and forty-four percent of adjusted gross income and that a ratio in excess of forty-four percent is almost certain to trigger an audit. other, more specific flags identified by tax professionals include larger than typical medical deductions, mortgage interest deductions, travel and entertainment expenses, home office deductions, charitable donations, dependent exemptions, casualty losses, or tax shelter losses. websites are widely available that indicate the levels of itemized deductions or schedule c business expenses relative to income that make a taxpayer “unlikely,” “likely,” or “almost certain” to be flagged for an audit. the basic advice of these tax professionals is quite simple and easily summarized: “don’t be different.” see frederick w. daily, stand up to the irs (1999); julian block, julian block’s tax avoidance secrets (1996). 448 florida tax review [vol. 14:10 roughly one-half of all audited returns in the united states are now selected by this approach.119 unlike items such as robust charitable deductions and significant paper losses (i.e., commonplace “audit flags”), there is no data indicating that automobile expenses are major determinants of these dif scores. iv. the receipt of taxable fringe benefits, noncompliance, and its implications having explored why and how taxpayers mischaracterize their automobile expenses, it is important to realize that taxpayer noncompliance likely does not stop there. to the contrary, there is every reason to assume that if the same conditions are present (i.e., confusing rules, lack of thirdparty or irs oversight, and the absence of substantiation requirements), taxpayers will mischaracterize the receipt of other taxable fringe benefits as well. several decades ago many on-the-job benefits (aka fringe benefits) that employees received were generally considered nontaxable.120 however, as these benefits increasingly substituted for taxable income and the tax base was at risk of erosion,121 congress took note and decided to curb these practices.122 in 1984, congress enacted code section 132, which specifically delineated those fringe benefits that were exempt from tax;123 by default, all other non-designated fringe benefits were subject to income tax.124 119. see u.s. gen. accounting office, gao/ggd-98-40, tax admin.: irs’ use of random selection in choosing tax returns for audit. report to the honorable paul coverdell, u. s. senate 4–5 (1998); see also united states gen. accounting office, gao/ggd-99-30, tax admin.: irs’ return selection process. report to the chairman, committee on ways and means; and the chairman, subcommittee on oversight, committee on ways and means, house of representatives 2 (1999). 120. see, e.g., ira b. stechel, current planning for fringe benefits—an administrative shambles, 40 n.y.u. ann. inst. on fed. tax’n. 35-1 et seq. (1981) (describing the lack of clarity in then-existing state of the law). 121. richard l. doernberg, a workable flat rate consumption tax, 70 iowa l. rev. 425, 436–37 (1985) (“the advantages of fringe benefits relative to cash wages, combined with increasing marginal rate taxation, help explain the dramatic rise in fringe benefit use over the past fifty years. in 1929 fringe benefits accounted for 1.2% of total compensation; in 1981 the percentage was 16.3.”). 122. see rules for the federal tax treatment of fringe benefits: hearing on h.r. 3235 before the subcomm. on select revenue measures of the comm. on ways and means, 98th cong (1983). 123. pub. l. 98-369, §§ 531–32, 98 stat. 877-87 (1984). for a complete description of these rules and their effects, see wendy gerzog shaller, the new 2013] the internal revenue code and automobiles 449 when code section 132 became law, cellular telephones, frequent flyer mile awards, and home internet service were, for all intents and purposes, nonexistent. all three of these items, however, currently enjoy immense and growing popularity. thus, it is important to examine the tax treatment of these items. clearly, employer-provided cellular telephones, frequent flyer mileage awards, and home internet service fall squarely within the scope of being fringe benefits; since none of these items is specifically excluded from gross income, the personal use of these employer-provided items should give rise to taxable income,125 unless a specific fringe benefit exemption applies (e.g., they qualify as working condition or de minimis fringe benefits).126 notwithstanding the clarity of this obvious conclusion, irs rulings and pronouncements pertaining to the tax treatment of each of the foregoing employer-provided fringe benefits do not always follow this line of reasoning. in the case of cellular telephones, the most informative pronouncement to date is found in irs notice 2011-72.127 in this notice, the irs declared that employer-provided cellular telephones furnished for noncompensatory reasons are not taxable and that any personal use within this context would constitute a de minimis fringe benefit excludable from income. consistent with this notice, in irs publication 15-b, the irs states that employer-provided cellular telephones that are furnished for compensatory reasons and/or to establish goodwill constitute taxable income.128 in the case of employer-provided frequent flyer miles, the irs has adopted a more hands-off approach. in announcement 2002-18, the irs declared that it “will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel.”129 this declaration was made over a decade ago and, to date, the agency has not articulated any further refinements. with respect to the tax treatment of employer-provided home internet service, the irs has maintained complete silence. this silence is fringe benefit legislation: a codification of historical inequalities, 34 cath. u. l. rev. 425 (1985). 124. i.r.c. § 61(a)(1); reg. § 1.61-21(a)(1). 125. id. 126. i.r.c. § 132(d) & (e). 127. notice 2011-72, 2011-38 i.r.b. 407. 128. irs publlication 15-b (2012), http://www.irs.gov/pub/irs-pdf/p15b. pdf. 129. announcement 2002-18, 2002-1 c.b. 621. 450 florida tax review [vol. 14:10 particularly surprising given the fact that once internet service is in a taxpayer’s home, via computer routers, it can be shared with family members who reside at that same location. indeed, irs publication 15-b — the agency’s go-to guide on the taxability of fringe benefits — does not mention the phrase “internet service.” consider how the irs has responded to taxpayers misreporting the receipt of their taxable fringe benefits. with respect to automobile expenses, the irs has said and written a lot; however, with respect to employerprovided cellular telephones, frequent flyer miles, and home internet service, the agency has said little or nothing. in terms of enforcement efforts, the irs has made tepid attempts to stem taxpayer noncompliance insofar as the mischaracterization of automobile expenses is concerned;130 insofar as other taxable fringe benefits are concerned, however, irs enforcement efforts are virtually nonexistent. evidence for the latter point can be made only by negative inference: despite the widespread personal use of employerprovided cellular telephones, frequent flyer miles, and home internet service, there are no reported court cases pertaining to cell phones and frequent flyer miles and only one reported court case pertaining directly to the taxability of frequent flyer miles.131 unless virtually every one of the nation’s taxpayers is a saint, the absence of adjudicated court cases regarding the receipt of taxable fringe benefits does not suggest that there is a lack of tax mischaracterizations but rather that there is a lack of noncompliance oversight. taxpayer noncompliance results in revenue loss to the government. to counteract this loss, the government must raise taxes for other taxpayers, reduce government spending, borrow to make up for the shortfall, or some combination of the foregoing. when it comes to automobile expense mischaracterizations and the receipt of other fringe benefits that go misreported or unreported, the effects are often particularly pernicious and far-reaching. more specifically, if taxpayer noncompliance is pervasive in one area of the law, it likely has a corrosive effect upon other areas of taxpayer compliance.132 for example, if taxpayers routinely submit 130. see supra note 3. 131. charley v. commissioner, 91 f.3d 72 (9th cir. 1996) (frequent flyer miles transformed into cash are taxable). 132. see, e.g., ernst fehr & urs fischbacher, the economics of strong reciprocity, in moral sentiments & material interests: the foundations of cooperation in economic life 167 (herbert gintis ed. 2005) (“[i]f people believe that cheating on taxes, corruption, or abuses of the welfare state are widespread, they themselves are more likely to cheat on taxes, take bribes, or abuse welfare state institutions”). 2013] the internal revenue code and automobiles 451 illegitimate business automobile expenses for reimbursement to a supposed accountable plan and this process goes unchallenged, there is undoubtedly a two-fold effect. first, the perpetrator taxpayer will probably seek other illegitimate avenues in which to reduce his taxes; second, those taxpayers who cannot avail themselves of this tax-savings device will harbor contempt for the tax system, causing them to search for their own illegitimate taxsavings devices.133 in the case of the mischaracterization of automobile expenses and the receipt of taxable fringe benefits, there is an equity concern as well. the financial benefits associated with noncompliance of the sort expounded upon in this analysis are likely to inure more to those taxpayers who are generally in high-income brackets. that is, the taxpayers who are most apt to use and receive employer-provided automobiles, cellular telephones, frequent flyer miles, and home internet services are business owners and upper management; they are best situated to take advantage of their positions, and the tax benefit associated with such fringe benefits (regardless of whether such fringe benefits are legitimately business in nature or not) increases with the taxpayer’s marginal tax rate. for example, business owners and those taxpayers in the upper echelons of management likely have much more latitude in submitting questionable business expenses to accountable plans and reaping the corresponding purported tax savings. even if business owners, upper-echelon management, and the rank-and-file employees equally participate in the (mis)use of accountable plans, those whose incomes are subject to higher marginal tax rates will save more on a dollarfor-dollar basis than those taxpayers whose income is subject to lower marginal tax rates. consistent with the foregoing inequities, businesses that save employment taxes by utilizing accountable plans as a tax-saving device will likely use the savings that such plans achieve to award their already highly compensated employees with more remuneration rather than according such benefits to their rank-and-file employees. a direct effect of taxpayers mischaracterizing the receipt of their fringe benefits is that they enjoy an economic windfall, and certain industries are subsidized over others. for example, the mischaracterization of automobile expenses enables participating taxpayers to enjoy deep purchase 133. see, e.g., joshua d. rosenberg, the psychology of taxes: why they drive us crazy, and how we can make them sane, 16 va. tax rev. 155, 199 (1996) (theorizing that “when we hear about leona helmsley evading taxes and going to jail, some of us say to ourselves ‘we had better pay our taxes,’ but many others tend to engage in an internal dialogue that sounds more like ‘this rich woman evaded her taxes; from what i hear, most other rich people do, and probably i should or i’ll be losing out”’). 452 florida tax review [vol. 14:10 price discounts and simultaneously subsidizes the automobile and oil industries. to illustrate, assume that taxpayers who mischaracterize their automobile expenses are in the forty-percent marginal tax bracket (when state income taxes are taken into account). with respect to every automobile and gasoline purchase that participating taxpayers make, they enjoy a tremendous purchase price discount. translated into dollars and ignoring the tax value of money issues and depreciation deduction limitations, if the fair market value of an automobile is $50,000, the taxpayer will effectively pay $30,000 for it after receiving a $20,000 discount (0.40 x $50,000); similarly, if the price for gas is $4 per gallon, the taxpayer will effectively pay $2.40 per gallon after receiving a $1.60 discount (0.40 x $4). other factors being equal, simple laws of economics declare that the lower an item’s purchase price, the higher the demand.134 increasing the slope of the demand curve enables the automobile and oil industries to charge higher prices and, as a result, reap greater profits.135 as evidenced by this analysis, the implications associated with taxpayer noncompliance are grim not only in terms of the tax system but also in terms of the overall economic health of the united states. it is a problem that congress therefore must not ignore. section v proposes several reform measures that congress should institute. 134. see robert cooter & thomas ulen, law & econ. 31 (3d ed. 2000) (discussing the relationship between price and demand); see also harold j. leavitt, a note on some experimental findings about the meanings of price, 27 j. bus. 205, 205 (1954) (“conventional price analysis takes the generalized view that demand curves are negatively sloped. the purchase of a product is expected to decline as its price increases and to increase as its price declines—other factors being equal”). 135. an indirect effect of taxpayer noncompliance insofar as automobile expenses are concerned is that it likely is a contributing factor to global climate change. once again, in accordance with general principles of economics, if taxpayers are able to secure gasoline at deeply discounted prices, there will be an increase in this item’s use. admittedly, it is well beyond the scope of this analysis to delve into the whole issue of climate change supposedly caused by the use of fossil fuel by humans; however, scientists universally agree that there is a direct correlation between fossil fuel usage and airborne pollutants. for more on the issue of how the code’s structure may be a contributory factor in generating pollution, see roberta f. mann, on the road again: how tax policy drives transportation choice, 24 va. tax rev. 587 (2005). 2013] the internal revenue code and automobiles 453 v. reform measures that congress could institute in order to curtail the taxpayer noncompliance problem, congress could institute a series of reforms. the nature of these reforms varies: some attempt to simplify the system; others seek to provide the irs with a more strategic vantage point; some impose penalties upon plan administrators who fail to fulfill their oversight duties; still others impose a strict liability accuracy-related penalty upon taxpayers who lack substantiation of their business automobile expenses; and some try to capitalize upon new technologies. notwithstanding their differing natures, these reforms all share common goals, namely, to (1) simplify taxpayer compliance; (2) curtail taxpayers’ mischaracterizations of their business automobile expenses in order to preserve equity between and among taxpayers; (3) reduce the distortions in economic behavior that result from taxpayer noncompliance; and (4) ensure that taxpayer mischaracterizations of their automobile expenses (and their receipt of other taxable fringe benefits) do not further erode the income tax base. a. simplify and clarify certain tax compliance rules taxpayer confusion commonly reigns as to the correct tax treatment of automobile expenses and the receipt of other taxable fringe benefits. in light of this situation, based upon how the majority of taxpayers use their automobiles, cellular telephones, frequent flyer miles, and home internet service, congress should draft black-and-white rules that are easy to implement, understand, and monitor. first, consider taxpayers’ use of automobiles. the vast majority of taxpayers use their automobiles for personal use (i.e., commuting).136 in the face of this reality, congress should craft several hard-and-fast rules: (1) unless an automobile is used eighty percent or more in business, its cost should not be depreciable nor should any lease payments be deductible;137 136. see generally brian mckenzie & melanie rapino, u.s. census bureau, commuting in the united states: 2009 (sept. 2011), http://www.census .gov/prod/2011pubs/acs-15.pdf. 137. a common practice among many taxpayers who mischaracterize their automobile expenses is that they benightedly believe that that week days when they commute to work are deductible and weekend days when they use their automobiles for pleasure are nondeductible. the business-use percentage these taxpayers report is 71.4 percent (i.e., five work days divided by seven (number of days in the week)). raising the business use percentage threshold to eighty percent before depreciation and lease payments would be deductible would presumably eliminate this common taxpayer practice. 454 florida tax review [vol. 14:10 (2) with respect to those automobiles that are neither depreciable or whose lease payments are not deductible, deductible business automobile expenses should be limited to gas, tolls, and parking (and the standard mileage allowance should be limited corresponding to these items); and (3) in order to authenticate the business nature of their trips, audited taxpayers would have to substantiate their business miles driven by means of contemporaneous electronic data entries (see subsection d. infra). next, consider cellular telephone expenses. in those instances in which employees have both a personal and a business cellular telephone, the code should state that (a) in cases when the business cellular telephone and service are provided by the employer, taxpayers should have no income (i.e., there is no accretion to the taxpayer’s wealth because the business cellular telephone is not being used for personal consumption); and (b) in cases when the business cellular telephone and service costs are borne by the employee, employee taxpayers should be able to deduct the cost of the business cellular telephone and its associated service. in those instances when taxpayer employees have only one cellular telephone for both personal and business use, the code should impose a rigid rule, namely that (a) in cases when the cellular telephone and service are employer provided, fifty percent of the value of each be included in the taxpayer’s income; and (b) in cases when the cellular telephone and service costs are borne by the employee, the lesser of the business percentage use or fifty percent of the cost of each should be allowed as a deduction from the employee’s income. third, consider frequent flyer miles earned while on business travel. the rule should be that frequent flyer miles subsequently used for personal travel constitute income.138 taxing frequent flyer miles engenders timing and valuation issues, but these issues can be overcome: frequent flyer miles should not be taxed when earned but rather upon their personal use. additionally, the value of such frequent flyer miles should be set at a fixed, low-dollar amount (adjusted annually by the irs) to account for the typical limitations and restrictions associated with the use of such miles.139 138. see generally m. bernard aidinoff, frequent flyer bonuses: a tax compliance dilemma, 31 tax notes 1345 (1986); joseph m. dodge, how to tax frequent flyer bonuses, 48 tax notes 1301 (1990); jonathan barry forman, income tax consequences of frequent flyer programs, 26 tax notes 742 (1985); lee garsson, frequent flyer bonus programs: to tax or not to tax—is this the only question?, 52 j. air l. & com. 973 (1987); george guttman, irs moves slowly on frequent flyer issue, 38 tax notes 1309, 1309 (1988); lee a. sheppard, collecting the tax on frequent flyer benefits, 59 tax notes 1140 (1993). 139. see david lazarus, citibank deems frequent-flier miles taxable, but does the irs?, l.a. times (jan. 25, 2011), http://www.latimes.com/business/la-fi2013] the internal revenue code and automobiles 455 fourth, high-speed home internet service is fast becoming a ubiquitous feature of many u.s. households.140 in those cases in which this service is provided by the employer, it is probably fair to assume that a healthy percentage of the internet service will be for personal and family use, unless the employer’s internet policy specifically prohibits personal use. erring on the conservative side, in instances when employer-provided internet service is available for personal use, congress should mandate that fifty percent of its value be includable in the employee’s income. although these simplification and clarification measures would not entirely eliminate taxpayer confusion insofar the receipt of taxable fringe benefits are concerned, they would go a long way toward erasing the current latitude that taxpayers enjoy in gaming the system. these simplification and clarification measures thus constitute a positive step toward enhancing taxpayer compliance. b. mandate the submission of information returns for accountable plans as previously described, accountable plans generally do not live up to their moniker of being accountable.141 accordingly, congress should institute rules that make plan administrators truly accountable for the verification of employees’ putative business expenses. in theory, accountable plans appear to function efficaciously and as intended. consider employees who incur legitimate business expenses by traveling to client meetings. the employees submit their receipts to the plan administrator, who verifies the authenticity of these expenses and then issues reimbursements. with the business entity’s profitability at stake (and presumably the plan administrator’s job on the line as well), the plan administrator’s role as gatekeeper is important, and the irs can theoretically lazarus-20120124,0,1228880.column (for income tax purposes, citibank accorded each frequent flier mile it awarded a value of 2.5 cents); trivedi shamik, promotional frequent flier miles are taxable income, irs and citibank say, 2012 tax notes today 21-4 (jan. 31, 2012). 140. see, e.g., joelle tessler, u.s. broadband figures show 40 percent lack high-speed internet: study, huffington post (feb. 16, 2010), http://.huffingtontonpost.com/2010/02/16/us-broadband-figures-how_n_463849.html (“fcc chairman julius genachowski said . . . he wants 100 million u.s. households to have access to ultra high-speed internet connections, with speeds of 100 megabits per second, by 2020”). 141. see supra section iii.b. 456 florida tax review [vol. 14:10 rely upon her judgment to evaluate with disinterested accuracy the legitimacy of the purported business nature of the submitted expenses.142 but the code’s blind reliance on the plan administrator — as is currently the case — is misplaced. in particular, this compliance model suffers from a fundamental flaw, namely that the plan administrator is a neutral, disinterested party. in large business enterprises, a plan administrator is usually an employee who is beholden to her employer, aiming to secure employment stature and monetary gains. therefore, the plan administrator is apt to be acquiescent to upper management and owners, willing to kowtow to their demands and turn a blind eye to questionable business reimbursement submissions. in the closely held business enterprise context, the plan administrator and the business owner are often one and the same person. this alter ego relationship undermines the supposed disinterested, unbiased nature of the process of distinguishing between legitimate business and personal expense claims. under current law, accountable plans operate far below the radar screen of irs scrutiny. due to requests for reimbursement under these accountable plans, billions of dollars of putative business expense submissions are presumably made annually to plan administrators of such plans. notwithstanding the size and scope of these requests, plan administrators are not required to submit any concomitant documentation to the irs.143 absent an irs field audit, this absence of documentation leaves the agency in the dark about the inner workings of such plans and whether they are truly compliant with the requisites of the code and treasury regulations.144 to enable the irs to better monitor the bona fides of accountable plans and to determine whether plan administrators are adhering to their obligations as set forth in the treasury regulations, the status quo is unacceptable. the treasury department should instead promulgate regulations that mandate the submission of a dedicated accountable plan information return.145 this annual information return should be signed by the plan administrator, under penalty of perjury, that it is accurate and complete and should detail the business nature and amounts of all of the reimbursed expenses. in those instances when the reimbursement figures on the face of 142. see supra note 6. 143. see supra section iii.b.2. 144. id. 145. the use of such “third party” sources of information has proven immensely useful in ensuring compliance with income taxes and payroll taxes, even personal exemptions. joseph a. pechman, federal tax policy (5th ed. 1987). 2013] the internal revenue code and automobiles 457 this submitted return seem suspect or abnormally large, the irs could target its limited audit resources in a strategic fashion. 146 c. impose penalties upon derelict plan administrators and taxpayers under current law, third parties participating in the tax return filing process who are derelict in fulfilling their duties may be penalized. for example, tax practitioners who are negligent or reckless in preparing tax returns face stiff monetary penalties,147 censure, and possible suspension from practice.148 likewise, appraisers who negligently or recklessly prepare inaccurate appraisals face penalties of a similar nature.149 the goal underlying these third-party penalties is to make parties who participate in the tax return filing process more attentive in their responsibility to be accurate. accountable plan administrators currently do not bear the same risks as other third parties who participate in the tax return filing process. if plan administrators allow personal expenses to be reimbursed, even if they are negligent or reckless in allowing such expenses to pass supposed business muster, they face no downside risks. to illustrate, suppose a business owner takes a two-week vacation in hawaii and then submits these personal expenses for reimbursement to the plan administrator. if the plan administrator receives no verification that such a trip was business related but, nevertheless, reimburses these expenses from the plan, the code attaches no third-party culpability to the plan administrator’s actions. congress must reform the code and “deputize” plan administrators to be plan enforcers. in those instances when plan participants submit expenses that a plan administrator knows or should have known were personal in nature and permits them to be reimbursed, the plan administrator should be penalized. the penalty should be equal to a percentage (say, ten percent) of the reimbursed personal expense. to illustrate, if the hawaiian trip described in the prior paragraph cost $10,000, the corresponding penalty should be $1,000 (i.e., $10,000 x .10). correlating the amount of the penalty 146. irs agents are specifically instructed to look for “large, unusual, or questionable items.” irs, internal revenue manual: audit ¶ 4.90.8.2 (2012), http://www.irs.gov/irm/part4/irm_04-090-008.html (last visited september 20, 2013). 147. i.r.c. § 6694(a). 148. see 31 c.f.r. § 10.50 (2012) (detailing sanctions applicable to attorneys, certified public accountants, enrolled agents, and other persons who represent taxpayers before the irs and who fail to adhere to proscribed ethical standards). 149. i.r.c. § 6695a; 31 c.f.r. § 10.50(b) (2012). 458 florida tax review [vol. 14:10 to the size of the claimed business reimbursement amount makes sense: the larger the claim, the more circumspect the plan administrator should be in evaluating the legitimacy of the submitted expense amount. aside from plan administrators, taxpayers, also, must be held accountable for accurately report the business nature of their automobile expenses. if taxpayers have little or no downside risk to mischaracterizing such expenses, there is every reason to expect that taxpayers’ mischaracterization practices will continue unabated. congress should, therefore, resurrect its prior strict liability negligence penalty for taxpayers who fail to substantiate the business nature of their automobile expenses.150 imposing a strict liability penalty for automobile expense mischaracterizations would have two salutary effects. first, it would send a message to the general public that congress has no tolerance for those taxpayers who want to put their financial interests ahead of those of the general public. taxpayers must stand ready to present credible evidence regarding the business nature of their automobile expenses or risk being penalized. period. this would be another way of congress saying that it does not want to subsidize the purchasing power of those taxpayers who are business owners, professionals, and part of upper management who currently exploit the mischaracterizations of their automobile expenses (and the receipt of other fringe benefits) at the expense of compliant taxpayers. second, a strict liability penalty would give the irs the upper hand during audits. if taxpayers failed to produce substantiation of their business automobile expenses (i.e., a “paper trail”), then the audit process would reach a quick conclusion. the irs would no longer have to pour further resources into demonstrating that taxpayers were negligent or reckless. moreover, imposition of this proposed strictpenalty would deprive taxpayers of a key bargaining chip (i.e., a quick settlement in return for a penalty reduction). d. capitalize upon technological changes it is a vast understatement to say that over the past quarter century technology has changed at a lightning pace. in particular, computers have become faster, lighter, and more efficient. furthermore, internet usage has blossomed into a staple of most taxpayers’ lives. it is not a stretch to say that feats of technology, which were unimaginable just a decade or two ago (e.g., an electronic device that provides real-time destination instructions and traffic reports) have quickly become woven into the fabric of our society. such technological advancement provides the setting for congress to revisit the substantiation requirement it instituted in 1984 and then 150. pub. l. no. 98-369, § 179(b)(3), 98 stat. 464 (1984). 2013] the internal revenue code and automobiles 459 retroactively repealed. in 1984, congress passed legislation that would have required taxpayers to maintain a contemporaneous travel log documenting the business miles that a taxpayer traveled.151 this legislation gave rise to a popular uproar leading to the retroactive repeal of this legislation.152 in its place, congress left intact a requirement that taxpayers must be able to substantiate the business miles driven via an account book, diary, log, expense statement, or trip sheet,153 dropping the requirement that such documentation be recorded contemporaneously with the business travel. let us now fast-forward to the twenty-first century. this is a time period during which smartphones and gps systems have become commonplace in the business world. with the simple touch of a button, these devices enable taxpayers to readily track miles traveled with pinpoint accuracy in ways that were unthinkable a decade or two ago. in particular, taxpayers can now purchase smartphone applications that record when a taxpayer starts and stops a trip and can tag such a trip with a description. gone are the days when taxpayers would have to pull out a log book, review their mile odometers, and then provide a written description of their business trips. congress should capitalize upon the use of this technology.154 accordingly, it should reinstitute its 1984 requirement that taxpayers document their business automobile miles via contemporaneous electronic records. using available technology, taxpayers can collect important information (i.e., date of travel, location to which traveled, and exact mileage between locations), organize it, and readily transfer it to their tax returns. if and when the submitted returns are audited, taxpayers can present this information to the irs auditor. on the web, several existing companies currently advertise apps that permit users to track business miles for business purposes.155 to induce taxpayers to capitalize upon this technology, congress might also consider offering a tax credit to offset all or a portion of the purchase price of this technology. 151. pub. l. no. 98-369, § 179(b)(1), 98 stat. 464 (1984). 152. pub. l. no. 99-44, 99 stat. 77 (1985). 153. see supra note 82. 154. see generally jeremiah coder, securities basis reporting may signal more technology in tax administration, 2009 tax notes today 25-4 (discussing how technology is reshaping the process of tax administration). 155. see, e.g., taxbot, https://taxbot.com/z/2f14/ (last visited sep. 1, 2013) (promoting its ability to track business travel expenses); zone walker llc, http://www.zonewalker.com/acar (last visited sept. 1, 2013) (same). 460 florida tax review [vol. 14:10 vi. conclusion taxpayers’ mischaracterizations of their business automobile expenses are not limited to one or two renegade taxpayers. to the contrary, this article demonstrates such mischaracterizations are commonplace.156 further, this article illustrates that taxpayer mischaracterizations of fringe benefits are not confined to the realm of automobiles. rather, taxpayer mischaracterizations of automobile usage are emblematic of a larger noncompliance problem and constitute a useful case study of what congress should do to enhance overall taxpayer compliance. the effects of taxpayer noncompliance are far-reaching. not only does it erode the income tax base, it severely distorts economic choices. for example, in the case of taxpayers mischaracterizing the tax treatment of their automobile expenses the economic impact is seen in the form of purchase price discounts generally benefiting high-income taxpayers and windfall profits inuring to the automobile and oil industries. there is a time-honored adage that states, “if it isn’t broke, don’t fix it.” when it comes to automobile expenses and the receipt of other taxable fringe benefits, however, the system is in dire need of repair. the good news is that this is not a problem that lacks a solution. there are several possible reform measures congress could and should adopt that would enhance the code’s integrity, lessen economic distortions, and enable the irs to perform its oversight mission more prudently and proficiently. 156. see supra note 3. florida tax review volume 14 2013 number 10 a case study of taxpayer noncompliance by james alm0f* jay a. soled1f** over the last decade, the tax gap — the difference between what taxpayers owe in taxes and what they actually pay — has remained significantly large. a contributory factor to the tax gap’s size is the fact that many taxpayers mischaracterize the tax t... i. introduction many taxpayers deduct all or a portion of their automobile expenses or exclude from income travel allowances and reimbursements related to the use of their automobiles. when incurred for ordinary and necessary business reasons, such deductions and ex... a de minimis fringe benefit is “any property or service the value of which is (after taking into account the frequency with which similar fringes are provided by the employer to the employer’s employees) so small as to make accounting for it unreasona... florida tax review volume 8 2007 number 2 the de-gentrification of new markets tax credits by roger m groves introduction and scope .................................................................... 214 p a r t i ....................................................................................................... 2 17 a. nmtc background and regulatory structure ........................ 217 b. definitions as best evidence of congressional intent to primarily benefit low-income residents not high-income residents in low-income areas .................................................. 220 p a r t ii ...................................................................................................... 2 2 1 a. program in operation: gentrification and problematic purposed projects ................................................................. 221 p a r t iii ................................................................................................... 234 a. the gentrification alternative the properly purposed project developed through harmonious cde and q c b e ntities ................................................................................ 234 b. transactional end sum model ................................................ 235 p a r t iv ................................................................................................... 239 a. proposed amendments to close loopholes ............................ 239 1. the equity investment and its correlation with qualified active low-income community by business ("q cb ") ........................................................... 240 2. cde m ission clarity .................................................. 241 3. demanding an invitation to your own party through cde board influence ...................................... 242 4. the "qualified business" exclusion of project outside core interest and needs assessment ................. 245 5. "low-income community" clarification to match intent to primarily benefit "low-income residents" .... 247 6. increased accountability through recapture of the c redit ................................................................... 248 7. safeguards against over-leveraging the qcb ........... 249 8. implications for urban tax policy .............................. 252 c o nclusio n ........................................................................................... 255 florida tax review the de-gentrification of new markets tax credits by roger m groves' "i am concerned and i am frustrated because i don't know what the alternates are.. .it clearly isn't racist; its economics. the real question you have to ask yourself is: is this good or bad?" norman rice, former mayor of seattle on gentrification in that city.2 introduction and scope urban america is in a state of crisis. a huge pool of america's resources is increasingly disconnected from mainstream society.3 that pool is within the core of major cities and particularly includes african american and hispanic male youth.4 by way of illustration, more than half of all core city african american men do not finish high school. the correlation between drop-out rates, unemployment, and incarceration is profound. as of 2004, 72% of african american dropouts who are in their 20's are unemployed, up from 65% in 2000. s incarceration levels are at historic highs 1. roger m. groves is assistant professor at florida coastal school of law, former tax court judge and partner at howard & howard attorneys p.c, and counsel to lewis & munday. special thanks are in order for the contributions of law professors, beverly moran and susan mandiberg, research assistants kelly menjivar and troy nixon, administrative staff brienne carpenter and barbara homziuk. 2. blaine harden, http://www.washingtonpost.com/wpdyn/content/article/2006/06/1 8/ar2006061800605) (accessed jun. 19, 2006). 3. andrew sum, challenges & pol'y options: labor market conditions among 16-24 year-old young adults in maryland and the baltimore pmsa, johns hopkins university 2-3 (2001). the sum study found that black and hispanic youth in baltimore, maryland, are twice as likely to fall within the ethnographic definition of "disconnected" than white youth. the term "disconnected" refers to a quantified tendency to be out-of-school and out-of-work. 4. id. 5. eric eckholm, plight deepens for black men, studies warn, n.y. times al (mar. 20, 2006). eckholm was relying on data from a panel of experts at [vol. 8:2 the de-gentrification of new markets tax and increasing, where by their mid-30's, 6 in 10 of these high school drop outs have spent time in prison.6 that rate is four times higher than that of black men in south africa under the apartheid regime.7 seventy-five percent of african american males incarcerated in baltimore maryland did not graduate from high school. the infant mortality rate among all african americans is more than twice the national average, and is much worse among the poor in the core of urban america. 9 after the katrina floodwaters have receded, some see an opportunity to buy low and sell high. but the muted voices of the poor cry to keep what they had.' for them it was a katrina moment. for the urban core poor across the nation, it has been a katrina erosion over the decades from a series of unnatural disasters. despite this crisis in urban america, could it be that over $2 billion of us taxpayer dollars designed to alleviate that problem are being co-opted for the financially well-healed? with the aid of federal subsidies, are the wealthy gentrifying the low-income areas and marginalizing the low-income residents in the process? a long-time portland oregon resident observed: "the heart of the black community is gone."" seattle's first and only african american mayor in the 1990's observed the transition of welleducated and mostly white newcomers into the city's central district and said: "i am concerned and i am frustrated because i don't know what the alternates are.. .it clearly isn't racist; its economics. the real question you columbia, princeton, and harvard, who opined that the rate of disconnectedness is "far" greater for these african american males than comparable white and hispanic men. one factor of many is the reduced market for unskilled labor. 6. id. 7. dash t. douglas, a house divided: the social and economic underdevelopment of american's inner cities, 10 u. fla. j.l. & pub. pol'y 369, 381 (spring 1999), citing milton s. eisenhower foundation report, the millennium breach 1(1998). 8. sum, see supra note 2. the findings were from 1998. 9. center for disease control, http://www.cdc.gov/omh/amhlfactsheets/ infant.htm (accessed jun. 13, 2006). the national average is 6.9 deaths per 1,000 live births, but 14.1 among african americans. that is on par with the mortality of children from bulgaria, bosnia and herzegovina, see study involving the world health organization and the world bank (available at http://hdr.undp.org/reports/global/2003/indicator/indic_289.html) (accessed jun. 13, 2006). 10. query whether those core residents will experience economic discrimination through a reverse reconstruction. the civil war reconstruction was designed to increase the quality of life for former slaves and their decedents. it remains to be seen whether the well educated financially well healed will be the beneficiaries of the post katrina reconstruction of new orleans and other gulf coast communities. 11. harden, see supra note 2. 2007] florida tax review have to ask yourself is: is this good or bad?"'12 more to the point of this article, is the federal law, through the new markets tax credit program actually subsidizing the gentrification? the answer to the later question appears to be either an unequivocally "yes," or adding a drop of vacillation: "it certainly appears that way." metaphorically speaking, the proof is in the plumbing. as will be detailed below the nmtc program has been used to subsidize the development of performing arts centers for opera, ballet, symphony orchestras, hotels, high priced condominiums, theatres, mixed use commercial developments, and even convention centers.' 3 this author opines that as a matter of tax credit policy, the needs of the desperate should trump the wants of financially well-healed, and that the nmtc funds were not misappropriated, just misapplied in many significant respects a correctable error nonetheless. the thesis of this article is the following: if tax credits are used as part of the solution to urban ills, gentrified projects for the wealthy are not consistent with congressional intent or wise tax policy. the remedy is to close loopholes in the nmtc act that have allowed problematic use of governmental subsidies, and redirect those funds to ventures that more precisely benefit existing low-income residents who are the object of the nmtc program.14 consistent with this thesis, part 1 provides an overview of the regulatory structure of the tax credit, foundational definitions and intended operational scheme. this is to clarify that the intent of the legislation was to 12. id. one in four of the anticipated job growth in the seattle central city is high wage and highly skilled positions. 13. see the discussion in part ii regarding what i term "problematic purposed projects." 14. governmental corrections are only part of what is necessary to materially improve the quality of life among urban core residents. a larger component of urban revitalization is increasing private equity infusion from new sources. in a pending article, this author models a reconfigured substrata of the african american middle class that has peculiarly-crafted investment motivations (part profit, part philanthropic) that is aligned with self help investment techniques of prior generations and other ethnic groups that have successfully established economic enclaves (e.g. cubans in miami, west indians and koreans in boston). i term them "ethnivestors." the thesis is that such an investor group should receive tax credit subsidies over gentrified investors because ethnivestors provide projects more likely to be in the long term best interests of the urban core community, thereby reducing long term governmental dependence by those communities. ethnivestors can be accomplished through the race-neutral amendments proposed in this article. see revitalizing our urban core without marginalizing our core people: closing tax credit loopholes for the wealthy while generating ethnic entrepreneurial self help alternatives to subsidized gentrification. [vol 8:2 the de-gentrification of new markets tax benefit the low-income residents, not wealthy residents who come into lowincome areas. part ii provides a contextual framework for the competing models for how tax subsidies should be delivered to the urban community, i.e. models that allow for gentrified projects and those that do not. part iii contains proposed amendments to the legislation to close loopholes that have diverted funds away from the low-income residents of target communities. part i a. nmtc background and regulatory structure to stimulate the investment of private equity capital into low-income urban and rural america, the 106th congress in the waning years of the clinton administration amended the internal revenue code 5 to allow a tax credit in the amount of 39% of a taxpayer's equity investment over a 7-year period if that taxpayer invested in low-income communities.1 6 and it is not an unfunded mandate. in hopes of generating $15 billion of equity investments between 2002 and 2007, the federal treasury has authority to issue tax credit to investors equal to 39% of that sum ($5.85 billion dollars).1 7 the credits are distributed by rounds based on the size of equity commitments by qualified investor groups. already investments and corresponding tax credits are allocated through four of five anticipated rounds. 18 the treasury has delegated the responsibility for distribution and 15. on may 23, 2000, president clinton and speaker of the house dennis hastert publicly announced an agreed proposal that led to the introduction of the community renewal and new markets act of 2000. hr 4923, 106th cong. (2000). what emerged from the conference deliberations of both chambers was the bill entitled the community renewal tax relief act of 2000 ("crtra") h.r. 5662, 106th cong. (2000). despite its complexity and permutations, the bill was introduced dec. 14, 2000, and voted on and passed the same day. robert w. oast, jr., incentives for economic development in underserved communities and for affordable housing: a selective look at the legislative initiatives in the 106th congress, 33 urb. law. 793, 795 urban lawyer (summer 2001). the crtra was signed into law on dec. 21, 2000, tucked away into obscurity within the massive appropriations act. title i of the consolidated appropriations act of 2001, pub. l. no. 106-569, 114 stat. 2944 (2000) thus, it received little fan-fare or public attention beyond those already in the know. actual legislative history is equally obscure. 16. irc § 45d(a)(2)(a-b) (2004). these sections specifically provide for a credit of 5% of the equity investment for the first 3 years, followed by a 6% credit for the remaining years. 17. irc § 45d(f)(1)(a-d). 18. the 2002 round equity amount was $2.5 billion. the 2003 round amount was $3.5 billion. for 2005, the amount was $2 billion, and for 2006 the equity allocation was $3.5 billion. the 2007 equity to be raised is $3.5 billion. see 2007] florida tax review administration of the program to the community development fund institution ("cdfi"). 19 the focus of the nmtc is to benefit low-income communities by drawing equity capital into these target communities. 20 the "draw" is a tax credit. by reducing an investor's tax liability, the economic return on the investment in the low-income area is increased akin to the successful lowincome housing tax credit program.2' a byproduct of the equity investment is restored commerce within those communities.22 the general nmtc transaction can be described as follows: 1. an investor 23 must invest a qualified equity investment ("qei") into a qualified community development entity ("cde"); 2. the cde must then take the investor's qei and invest those sums into a low-income community project, either directly, or through a qualified community-based organization ("qcb") or other approved entities that serve the low-income area; 3. the credit is considered for the period commencing with the date the initial investment and each of the 6 anniversary dates thereafter.24 the credit is 5% for the initial three years, and 6% for the remaining 4 years, equating to a 39% credit over the total of 7 years.25 the statutory authority of irc § 45d(f)(1)(a-d) and the 2003 accountability report of the us department of treasury, cdfi fund available at http://www.cdfifund.gov/docs/2004/2003-annual-report.pdf. 19. 26 c.f.r. pts. 1, 602 (2004). original cite included fed reg. vol. 690, no. 248 (12-28-2004). 20. mulock, see supra note 12 at summary. available at http://www.ncseonline.org/nle/crsreports/economics/econ-73.cfmn?&cfid=1798 179847&cftoken=80276519# 1 1 (accessed nov. 3, 2005). 21. the low-income housing tax credit provides an approximate 9% tax credit for new construction or rehabilitation expenditures for low-income households over a 10-year period. see irc § 1437f. 22 . jennifer forbes, using economic development programs as tools for urban revitalization: a comparison of empowerment zones and new markets tax credits, 2006 u. i11. l. rev. 177, 188 (2006), citing statements of rep. rangel, 145 cong. rec. e1761 (daily ed. aug. 5, 1999). 23. also termed the "taxpayer" since that person is the recipient of the tax credits. 24. irc § 45 (a)(3)(a-b). 25. to illustrate the credit, assume an equity investment of $ 100,000 in year 1. for year 1, 2, and 3, the credit is $5,000 (5% of $100,000) for a total of $15,000. the 6% credit on the same 100,000 investment for the following four years is $6,000 each of the remaining four years for a total of $24,000. the combined credit is $39,000 ($15,000 plus $24,000). [vol. 8:2 the de-gentrification of new markets tax the anchor for the tax credit ship is the cde.26 the general scheme is that the cde receives the investor taxpayer's equity investment ("qei") 27 and redirects it (in the form of a qualified low-income community investment to a low-income community business (the qcb). it is the cde that funnels the credits to the investors. a cde must satisfy three requirements. first, its primary mission must be serving, or providing investment capital for lowincome communities or low-income persons.2 second, a cde must provide for low-income resident representation "on any governing board of the entity or on any advisory board to the entity., 29 third, the director of the cdfi must formally certify the community development entity.3" since the tax credit is only provided to investors in exchange for a "qualified" equity investment, the basis of qualification is important to the scheme. the cde must use substantially all of the cash for qualified lowincome community investments to qualify as an equity investment.31 in construing the requirement that "substantially all" of the qei must be for low-income community investments, the final regulations provide that 85% of the gross assets must be so directed, and that the requirement must be satisfied for each annual period in the 7 years available for the tax credit.32 procedurally, the program is administered through the community development financial institutions fund ("cdfi"). the application process requires a mini-business plan prior to certification of acceptance into the program.33 for an overview of the process and typical parties to a nmtc transaction see attached table a. 26. a qualified cde can be any domestic corporation or partnership. irc § 45d(6)(c)(1). an individual conducting business as a sole proprietor is excluded. 27. reg. § 1.45d-l(b). 28. irc § 45d(c)(1)(a). 29. irc § 45d(c)(1)(b). 30. irc § 45d(6)(c)(1)(c). 31. irc § 45d(b)(1)(b). the qei must be paid to a qualified community development entity ("cde"), irc § 45d(a)(1), acquired at its original issue (directly or through an underwriter) solely in exchange for cash, irc § 45d(b)(l)(a), and the cde must designate the investment as such on its books and records. reg. § 1.45d1 (c)(1)(iii). for a corporation, the type of authorized "equity investment" can include any stock, except certain preferred stock. excluded is nonqualified preferred stock as defined in § 351(g)(2) of the irc the taxpayer investor can be a limited liability company or business trust, which is taxed as a partnership for federal tax purposes. 32. reg. § 1.45d-1(c)(5). 33. procedurally, an application is filed and reviewed by the cdfi based specified criteria, including the extent of past assistance to disadvantaged businesses or communities irc § 45d(f)(2)(a). 2007] florida tax review b. definitions as best evidence of congressional intent to primarily benefit low-income residents not high-income residents in low-income areas the magnitude of the nmtc distribution begets the question: who are the real beneficiaries of the tax credit subsidy? it could be that congress intended to benefit whoever desired into move to the low-income areas, or rather the low-income residents and its existing businesses, or those equity investors who receive the tax credit. the answer could be all of the above. the plan could be designed for some and not for others. and the plan in operation could be at variance with the original intent. this sub-part concerns the original intent by congress. the next sub-part treats the program in operation. clearly, one intended beneficiary is the investor because she receives the tax credit. the nmtc mechanism allows investor groups of all types to provide the funds that serve the community. but the real issue is a matter of degree. among those various potential recipients, who is designed as the "primary" beneficiary of that subsidy? what if an investor's appetite for a high rate of return generates a project so expensive only the wealthy can afford it? a 10-story high priced condominium would be beyond the economic reach of a low-income resident. that core resident is perhaps unwittingly reclassified from a primary beneficiary to a residual beneficiary, where benefits are at best trickled down from the condo owner. for such projects, those existing low-income residents are left behind and financially unfed. if the primary beneficiary is the investor or wealthy new residents to the community, then the reduced benefit to the low-income residents is of little consequence the nmtc definitions provide sufficient, albeit imperfect, clarity as to the intended beneficiaries of the program through its definitions. qualified investments, by definition, are designed to benefit a "low-income community. 3 4 metropolitan low-income communities are defined as areas where the poverty rate is at least 20% of the statewide or area median family income, or where the median family income does not exceed 80% of that same state-wide or median income criterion. 35 the statute defines nonmetropolitan areas as low-income communities if the median family income does not exceed 80% of the statewide median family income.36 the statute also incorporates targeted populations, as defined by the riegle community 34. reg. § 1.45d-1(d)(1)(i) provide that the qualified equity investment is funneled through the cde into a low-income community project. 35. new markets tax credit, 26 u.s.c. § 45d(e)(1)(a) (2000). 36 id. § 45d(e)(1)(b)(ii). [vol 8:2 the de-gentrification of new markets tax development and regulatory improvement act of 1994, into the definition of low-income communities.37 importantly, the low-income definition captures not only financial poverty, but also the lack of access to capital a pervasive problem in perpetuating poverty.38 it is therefore clear that nmtc program envisions primary assistance to a "target population," and that target population is those who have suffered the effects of poverty. it is only that group within the community who has lacked historic access to capital. if congress had intended to target the financially well healed, it would have expanded the definition, instead of limiting it to those who have a lacked access to capital. beyond definitions of the target population, other indicia of intended beneficiaries are from examining the role of each party to the transaction. the requirement that the cde must have low-income residents on advisory boards, 9 that 85% of the gross assets of the cde must be devoted to lowincome communities,4° and a mechanism is in place to funnel the equity funds into an active low-income community business which derives its income or services from that community,41 are all prime indications that congress intended each party to the transaction is purposely designed as a mere conduit to the delivery of equity capital to existing low-income community residents, not new entrants without the economic need. part ii a. program in operation.: gentrification and problematic purposed projects "observers [of the nmtc industry] suggest that it is commercial real estate development driven, which raises questions about whether it will foster gentrification in the absence of careful community planning 42 37. id. see also, 12 u.s.c. 4702 (2000) defining targeted populations as low-income or "otherwise lack[ing] adequate access to loans or equity investments. 38. see generally daniel m. leibsohn, financial services innovation in community development, 8-wtr jahcdl 122 (1999) (describing the need for flexible, accessible capital in low-income communities). 39. irc § 45d(c)(1)(b). 40. reg. § 1.45d-1(c)(5). 41. irc § 45d(d)(2)(a)(i-iii). 42. susan r. jones, will new markets tax credits enhance community economic development, 8 j. small & emerging bus. l. 229, 237 (2004). indeed, those observers who questioned whether commercial real estate projects were the apple of investor's eye have an answer. according to cdfi's own statistics, "61% of the nmtc proceeds will be used to finance and support real estate projects..." (available at http://www.cdfifund.gov/awardees/2005/2005nmtc-faqs.pdf). 2007] florida tax review if congress truly intended the primary beneficiaries of the nmtc program to be the existing low-income residents, the question becomes is the program in operation fulfilling that intent? if, as depicted in the previous section, an investor can receive the tax credit subsidy for building a 10-story condominium at purchase prices beyond the economic reach of low-income residents, is the program too broad in operation? the model that permits the above-described project is, respectfully submitted, up-side-down. as advocated throughout this article, the type of project should be decided not based on what is most profitable to the investor, but what most meets the needs of the community. thus, i attempt an analytical construct for a tax credit policy that prioritizes those low-income residents, placing them in the front of the line with a chair at the tax planning table as full fledged participants in the nmtc program.43 the answer in my view does not start with my above conclusion, but rather with an analysis of the type of model actually used by those who administer the program, the cdfi. whether by design or fiat, the cdfi has at least two conceptual choices. as described below there is a "place-based" concept that targets people in a particular place, and a "pure people" concept, targeting people regardless of residency. congress has historically offered various forms of subsidy from tax revenues to eliminate urban blight. 44 enterprise zones and the nmtc program are both generally designed to reduce poverty in low-income areas through economic growth.45 but the methodology to accomplish that goal differs. the enterprise zones utilize a "place-based" policy, meaning the zones are designed to revitalize a place, i.e. the urban core communities, "in order to help local residents. 46 the underlying theory is that "people cannot be separated from place, and ... an antipoverty strategy needs to treat individuals in the context of their community. ' 47 the method of the empowerment zones and related programs 48 was to provide skill training and counseling to local residents so 43. this is not to say those who have significant financial resources from whatever residency source should be excluded from any role in urban revitalization. there are various private industry programs and other federal subsidies available for development in inner cities. but here elected federal representatives of the american taxpayers earmark public funds to be used to revitalize low-income areas and residents of those areas, who are more in need of dialysis machines than movie theatres, qualitative grocery stores than starbucks, and simply houses rather than opera houses. the model that follows is designed to more effectively use the nmtc subsidy to meet those needs. 44. harden, see supra note 2, at 5. 45. forbes, see supra note 22, at 177. 46. id. at 193. 47. id. at 193. 48. after fist and starts early in the reagan administration, congress passed legislation in 1987 and established 100 enterprise zones that remained largely [viol. 8:2 the de-gentrification of new markets tax they would "also benefit from the revitalization of the area through employment opportunities and improved social structures.49 the nmtc law,50 unlike enterprise zone legislation, is less clear and has fallen into a conceptual conundrum. the stated purpose of the nmtc is consistent with the goal of primarily benefiting the core lowincome residents. 51 notwithstanding the apparent congressional purpose, the nmtc program in operation appears to be designed to enhance economic development but not necessarily for the local residents. this is a policy for economic growth of a geographic area, even if the growth benefits primarily those who came in from outside that area. 2 as one commentator observed, the nmtc program "does not focus on the economic well-being of local residents as one of its primary goals.. .no incentives exist to target jobs or services towards local, low-income residents... instead the program looks to improve the economic well-being of individuals extending far beyond the defined area. 53 and most poignantly, nmtc scholars conclude that the nmtc has been focused on "targeting a geographic space and not necessarily the needs of the people within that space."'5 4 thus, the nmtc does not foretell economic mobility to low-income residents through job placement and fails to address other issues such as schools, job training, and housing that are key components in the attainment of long-term economic success." 55 this falls within the "pure people-oriented" strategy which advocates assistance to people regardless of where they live, thereby ineffective due to a lack of tax incentives until spurred into action after the los angeles riots of 1992 under the clinton administration. only then was emphasis placed on tax credits and coordinated federal resources through social services block grants. in 1993, clinton signed legislation that established nine enterprise zones and ninety-five enterprise communities. through a competitive bidding process additional rounds of zones were created in 1998 and 2001. see forbes, see supra note 22, at 183. 49. id. 194. 50. the law is codified in primarily two areas, statutorily in irc § 45d, and the accompanying regulations, reg. § 45d. 51. the statute states its purpose is to provide a "qualified equity investment" irc § 45d(b) for "target populations," irc § 45d(e)(2), within the "low-income community." (irc § 45d(e)(1)). the regulations generally state the purpose of the federal subsidy (tax credit) is to be an incentive for investors to provide equity capital into projects designed to serve the "low-income community" and "low-income residents." reg. § 1.45d-l(d). as this article reveals, the bedeviling issues of purpose and fulfillment thereof are in the details. 52. forbes, see supra note 22, at 177. 53. id. 54. id. 55. id at 194-195. 2007] florida tax review increasing human capital and mobility since the benefits would follow them regardless of where they relocate. 56 the two opposing models are illustrated below non-core beneficiary cin core area peo ple-oriented ppein](regardless of place) p0ae o0rilented the most fundamental difference between the two models, in my view, is in the intended beneficiaries. the people-oriented model that targets the space but not the core residents of that space allows the intended beneficiaries to be anyone, regardless of the relationship to the low-income community. if the nmtc program is flexible enough to allow projects that only high income people can afford, the intended beneficiaries become only those who can afford the projects developed, e.g. the earlier 10-story condominium illustration. as such, a model is in essence a subsidization of gentrification by another name, where the financially well healed can claim as its 'new market" a core urban area. i maintain that the people-oriented model, therefore, is ill-conceived as a means to primarily benefit low-income residents, as congress intended. the evidence of whether this model is operational in the nmtc program is shown by following the money. if the project's goal is to primarily benefit financially well healed new entrants to the community, and 56. id at 195 citing helen f. ladd, spacially targeted economic development strategies: do they work? 1 cityscape 193, 196 (1994). [vol. 8:2 the de-gentrification of new markets tax the nmtc program endorses that focus, upscaling projects can be authorized. if on the other hand, the intended beneficiaries are the existing low-income residents, then the only authorized projects are likely to be such projects as health care facilities for the ills most acute to the existing lowincome residents, affordable housing for the elderly and chronically financially distressed, innovative non-conforming loans and financial services for those who lack access to capital, and charter schools for local children. if the nmtc program allows both, it misses the mark if the mark is indeed to assist the core low-income residents. scholarly discussion of the historic and recurring failure of urban redevelopment points to this same root cause, where the conceptual model of redevelopment planners does not start with low-income residents as "clients" of the redevelopment. instead, the focus is on luring white citizenry back to the cities.57 it does not take sophisticated empirical analysis to predict that a revitalization plan for an area that does not make those residents the "client" does not appear well designed to solve the problem. to determine whether the cdfi authorizes the people-oriented gentrification model, i examined descriptions of award winning projects. i also examined websites of cdes that were given allocations. many entities that have received allocations have not declared a precise project.5 but of the identified projects in each round of nmtc awards, approximately $2 billion of tax credit subsidy has been allocated to projects that appear to be designed primarily for those already with the very access to capital that the low-income residents lack.59 it is worth reiterating that the "target population" for the tax subsidy program includes those who historically lacked access to capital.60 many projects, particularly those with mixed use project types, include movie theatres, performing art centers for opera, symphony and ballet, hotels like the marriott inn with connected convention 61centers, museums, upscale commercial office, retail outlets, and eventourist centers. i have designated these project types as "problematic 57. benjamin b. quinones, redevelopment redefined: revitalizing the central city with resident control, 27 u. mich. j. l. reform 689, 743 (1994). 58. this conclusion is derived from the author's review of cdfi documents through four rounds of allocations. 59. the statistics are from the cdfi's own profiles of the allocation award winners at http://www.cdfi.gov and the websites of the allocatees with press releases concerning the projects. 60. irc § 45d(e)(1). 61. for example, a nmtc subsidy of $15,263,157 was allocated in round iii (2005) for a project investment of $106 million. the awardee was louisville development bancorp, inc. the purpose is the construction of a 617-room convention center and hotel, (the marriott louisville downtown convention hotel). see http://www.morethanabankcom/new%20markets%2otax%20credit/winners. htm and the cdfi allocate profiles at http://www.cdfi.gov. 2007] florida tax review purposed projects" because they appear to be inconsistent with the congressional intent to primarily benefit the low-income target population as defined in the law. there have been four rounds of allocation awards of nmtc funds.62 a sampling of those problematic projects is described in amount and type segregated by round in the attached table b. listed below is a summary of the amount of tax credit subsidies provided to such projects to provide a sense of the cost to taxpayers for authorizing those types of projects.63 allocation year problematic project problematic project tax equity investment credit subsidy 2002 $1.6 billion $624 million 2003 $1.1 billion $429 million 2005 $744 million $290.1 million 2006 $1.9 billion $741 million total $5.3 billion $2 billion (rounded) these amounts are subject to adjustments due to the lack of clarity among cdes as to exactly how the funds would be used. many project descriptions include a mix of problematic and proper purposes, though the vast majority of project types and costs are associated with the problematic projects.' 4 are subsidized gentrification projects necessarily antithetical to assisting low-income residents? are "problematic purposed projects" a natural and predictable byproduct of gentrification? or conversely, are gentrified projects a primary benefit to low-income residents? the answer appears to depend on how gentrification is defined and characterized. two definitions of gentrification have come to the fore among scholarly literature. one that considers displacement of low-income residents as included in the definition, and one that excludes displacement. interestingly, those two definitions have their conceptual roots in the same two models discussed above for urban renewal through economic revitalization the "people62. the rounds were (1) in 2002-2003, (2) in 2003, (3) in 2004, and (4) in 2006. 63. these findings are from the author's review of the cdfi's profiles of allocatees. see supra note 60. 64. the amount is subject to a potentially large upward adjustment since a significant number of the cdfi profiles did not specify any project types. the larger projects include the hotels, convention centers, opera houses, etc. beyond the types of projects i consider to be properly purposed. a downward adjustment is also likely since it cannot be determined from the published materials the percentage mix between the gentrified projects and those truly designed for low-income residents. many projects have a combination of both. it appears the greatest dollar volume will be to build the largest projects, which again appear to be problematic. [vol. 8:2 the de-gentrification of new markets tax oriented regardless of place model, and "people in place" model. scholarly debate on whether gentrification is an adverse or a positive influence on the core residents breaks down philosophically on the basis of which urban revitalization model is employed. like the people in place model where the benefits inure to the core beneficiary in the core area, those who define gentrification as a displacement of low-income residents employ the theory of unity between the place and the existing residents, so the benefits to the place must also include benefiting primarily the people already "in place."65 under this view, the influx of new wealthy residents is viewed as adversely affecting those existing low-income residents." a contrary definition of gentrification excludes "displacement" as part of the definition, and instead refers to gentrification as a "process by which people of higher incomes move into lower income urban areas and seek to change its physical and social fabric to better meet their needs and preferences. 67 the needs and preferences targeted are those of any persons, not just those who are existing residents in place. this is conceptually aligned with the people-oriented model. that model targets anyone who can afford the market prices and it is their "needs and preferences" that are prioritized, not the poorer existing residents. the beneficiary under this definition can include anyone, including of course those new entrants to the community without having to tie the existing low-income residents already in place. under this theory, gentrification has a positive impact. this later theory does not ignore displacement but does not blame gentrification. the displacement culprit is the government, for its persistent failure to produce sufficient housing for the poor.68 the flaw of this non-displacement view is the same as the pure people model and other historic urban revitalization missteps discussed above. just as urban revitalization has lacked success for failing to prioritize the needs of the "client" urban residents over the wants of the wealthy who seek to rediscover this marketplace, gentrification definitions that exclude displacement similarly fail to prioritize the client the low-income resident. it is the client low*income resident that suffers the displacement. and to reassign blame to the government for the cause of the displacement could at best only add to the burden of government rather than the private sector. to date, that formula has not proven successful. as stated earlier, the 65. john a. powell & marguerite l. spencer, giving tern the old 'onetwo:' gentrification and the k.o. of impoverished urban dwellers of color, 46 howard l.j. 433-435 (2003). 66. id. 67. j. peter byme, two cheers for gentrification, 46 howard l. r. 405 (2003). 68. id. 2007] florida tax review redevelopment plan for the community that conceptually does not prioritize the existing community residents is not well designed to revitalize the area. one proponent of the non-displacement definition concludes that even if the target is low-income residents in place, gentrification is a net gain for the low-income residents.69 under his analysis, urban residents currently have better employment opportunities in the suburbs, so increased investment in new shops and services within the urban community provides more jobs within the urban core. in his view, the increased level of high end jobs also increases the supply of support jobs for which low-income residents can qualify.7° he also claims gentrification should improve retail and grocery shopping for low-income people, 71 though he fails to detail how that would occur if the majority of low-income residents cannot afford the products brought into the target community for the gentrifiers who have more leisure income to afford those products. that theory also fails for two principal reasons. first gentrification depends on trickle down economics. since problematic purposed projects appear designed to benefit the financially well healed new entrants to the area, low-income residents are merely incidental beneficiaries of the nmtc program. the benefits for low-income benefits must therefore be residual in nature, a morphed trickle down of benefits from the wealthy newcomers to the area. trickle down economics has not been a user friendly model for those at the lower rung of the ladder. by definition, the trickle down theory "assumes that by helping directly already-wealthy person x we will in fact help disadvantaged person y in a more sustainable manner than by helping person y directly."' 2 historical views by scholars of urban revitalization have well documented the failures of this theory in application.73 the conclusion is described as follows: "the net result is that a neighborhood of poor people is replaced by office towers, luxury hotels, or retail centers. the former low-income residents displaced by the bulldozer or an equally effective increase in rents, must relocate into another area they can perhaps afford., 74 this conclusion is arguably more normative than empirical. but the same can be said to a greater degree, with less empirical support, about the notion that greater investment will lead to significant job growth. as one study concluded the causal connection between capital investment and job growth among the low-income residents is "untested and usually 69. id at 406. 70. id at 419. 71. id at 420. 72. quinones, see supra note 59, at 724-751. 73. id at 741 and cited references therein. 74. id. [vol. 8.'2 the de-gentrification of new markets tax unproven.,75 and without sophisticated statistical analysis, can't we take the equivalent of judicial notice to observe that if the federal subsidy is used for a $500,000 condominium in new orleans, the displaced low-income resident of the 9th ward who could have used an affordable home project instead, has little or nothing as a trickle down benefit? isn't he certainly, something far less than an operational primary beneficiary? what is the quantified amount of tax benefits trickling down from a tax subsidy for a $100 million hilton inn and convention center when that same 9th ward used-to-be resident receives perhaps a $10,000 $20,000 job? no amount of fringe benefits or other multiplied extensions of benefits would elevate him to primary beneficiary status. conversely, there is ample empirical evidence that redevelopment project areas normally become "gentrifying markets" without material increase in the quality of life of the low-income residents.7 6 that notion is aligned with the author's definition of gentrification that is raised below. a second reason gentrification does not have a positive impact on low-income residents are because of marginalization or squeezing out of existing low-income residents. to illustrate the process of marginalization, assume a low-income resident is a renter, unable to afford to own a home. assume the owner of the apartment building faces higher taxes and insurance costs due to increased property values from new construction or renovations to accommodate gentrifiers. the landlord also believes there is an increasing market of higher income potential renters. he is likely to increase the rent to meet the higher debt service and maintain or improve profitability. the lowincome renter has to pay the higher rent charged by a landlord. assume too the low-income existing resident has static income. though she may not have to move out yet she nonetheless has been increasingly marginalized because she has less money for other living expenses due to the effect of gentrification. that rising rent scenario has been termed "secondary displacement" or "indirect displacement ' 77 as one study concludes, paying higher rent without a corresponding increase in personal welfare is a negative effect of gentrification. this assumes that the gentrifier wants are different than the core residents needs. while certainly there are some harmonious projects, there appear to be an alarming number of circumstances where subsidized projects designed for gentrifiers appear incompatible with the core resident needs and therefore at variance with the goals of the nmtc legislation. in sum, the likely failure of trickle down economics and the more likely marginalization of low-income residents stand as detriments and 75. id at 746, citing robert mier, job generation as a road to recovery in social justice and local development policy 34 (robert mier ed. 1993). 76. id at 748. 77. byrne, see supra note 69, at 414. 2007] florida tax review unintended consequences of gentrification that dwarf the above-claimed benefits to the low-income residents of the non-displacement definition of gentrification. since i believe a definition should incorporate the elements that give the term its character, or give attribution to what it affects, i define gentrification more broadly than either of the previously described definitions. this article views gentrification as having two definitional components. first there is an influx of new residents with resources significantly beyond the existing residents. second, and most importantly, the potential infusion of new residents must motivate landlords and commercial owners to upscale properties to accommodate the accoutrements of opulence of the new residents. this definition establishes a causal connection to a sustained displacement or marginalization of existing urban low-income residents. under this definition, it is the conversion of resources, not merely the infusion of people that is the cornerstone of gentrification.78 new residents could conceivably go to the same video stores, churches, and grocery stores as the existing residents without causing a displacement or marginalization of those existing residents. existing business owners could conceivably maintain affordable rents, menu prices, and the government could establish rent subsidies to minimize rising housing costs for the poor and elderly. it is only when landlords, owners of vacant and dilapidated housing, restaurant owners, and the like start what i will call "upscaling", so that the life style of the new residents becomes entrenched to the economic and quality of life detriment of the existing residents that gentrification becomes operational. the definition is also race neutral. no preference is provided based on race or ethnicity.79 under this definition therefore, new residents with wealth, regardless of race or ethnicity, could bring resources to the community and feed into the existing cultural lifestyle, maintain affordable housing, contribute to the charitable causes that improve the living quality of life of the existing residential base, and gentrification still has not occurred. but if the new infusion of residents also brings with them facilities to 78. one definition of gentrification is "the displacement of low-income individuals by young affluent homeowners as they 'discover' downtown residential areas, renovate homes, and thereby raise rents." quinones, see supra note 59, at 748. the essence of gentrification, in my view, is the conversion of the area, which has more of a genesis with those who owned and made the property available, than those who decide to move in. the starting point is not therefore with the affluent, young or not, who buy the property. rather it is those who increase the rents, or built the luxury condominiums who are more the proximate cause of the conversion. 79. constitutional issues could be raised, but is beyond the scope of this article. a brief discussion of race neutrality in the article's cdfi-required needs assessment is discussed at infra note 103. [vol. 8:2 the de-gentrification of new markets tax accommodate a standard not affordable or desired or of primary benefit of the existing community, gentrification is in process. under this article's gentrification definition, the failure to account for displacement allows the thwarting of congressional intent in passing the nmtc legislation and would ignore two fundamental principles that i assert are important in developing the revitalization model for tax credits: (1) prioritizing needs of the most needy over the wants of the wealthy and (2) identification of the intended versus incidental beneficiaries. if federal funds are intended to primarily meet the needs of poor urban residents, then the more such funds are used to instead accommodate the wants (accoutrements of opulence) of new entrants, there is a diversion of funds that pushes revitalization opportunities further away from those intended low-income residents hence a marginalization rather than mainstreaming of tax benefits.80 of course there is a continuum of project uses that may benefit the target populations and low-income communities at some level. low-income residents could potentially enjoy an opera or a visit an art gallery if they could afford the prices of the pieces, or taking in a movie during leisure time. and certainly some target low-income residents could benefit from commercial office space, if they could afford to rent an office and had a job to make it reasonable to occupy it.8' and a condominium would be wonderful if the low-income target population could afford the mortgage. and some jobs could flow from the new commerce created in the area. but such uses are not well designed as primarily for a community and population with third world health care, chronic unemployment and over 50% drop out rates among its male youth, unprecedented incarceration of up to 6 of every 10, substandard and overpriced grocery stores, and a lack of access to the capital to change the circumstance. the salient issue is whether the people's tax dollars are used to meet the needs of the low-income residents as earmarked by congress. these problematic purposed projects do not appear to meet that purpose. 80. id at 414-415, citing jacob l. vignor, does gentrification harm the poor?, brookings-wharton papers on urb. aff. 133, 167-168 (2002). it is important to note that gentrification is a group dynamic, descriptive of a group experience. so a single homeowner that benefits from appreciation on sale of the residence does not mean that gentrification is not occurring. it is rather a matter of degree. the extent of damages to the poor due to gentrification is beyond the scope of this article, as empirical proofs would be required. the issue treated in detail in other published materials. see powell, see supra note 67. 81. the office rents and condominium prices for a vast majority of the projects is unavailable as many projects have not released data or have yet to finalize plans in that regard. but from the data gathered to date, a multitude of projects are at least "problematic" and appear common sensical beyond the intended purpose of the nmtc program. 2007] florida tax review another unintended consequence of gentrified nmtc projects is no different fundamentally than what has been observed by urban demographers as the byproduct of other urban redevelopment programs opportunity costs.8 2 those costs are substantial and have been enumerated in prior studies.83 there are physical construction costs. this refers to actual construction that was ineffective at meeting resident needs, and thereby precluding construction that would have been better suited.84 in theory it is akin to the property appraisal concepts of the failure to build based on the "highest and best use" for the site. also prominent is the lost time and effort of governmental actors for misguided development projects. the staff time, including the huge resources associated with negotiating with private developers, creating and evaluating feasibility reports, holding public hearings and then analyzing and publishing materials there from are all costs for gentrified projects that miss the mark.8 5 there are also costs from the nationalization of project types, where the cookie cutter format of office buildings, high-tech developments, hotel-convention centers complexes, inter alia, have replicated themselves as a matter of policy. that policy also replicated and compounds the error since in many cases, the construction would have occurred in any event and the subsidies were not needed. 6 the more obvious and devastating personal costs are to the low-income residents themselves who suffer the inordinate risk of displacement or marginalization.87 will the gentrification and problematic purposed projects develop in areas devastated by hurricane katrina? in the most recent of the four rounds of allocations, $600 million is specifically allocated for use in such areas, defined as the hurricane katrina gulf opportunity zone ("go zone").88 from the inception of the program, there have been over 230 entities created under the internal revenue code to receive the subsidy to help the urban core. less than a handful of those entities are african american owned. 89 for 82. see quinones, see supra note 59, at 742-744. 83. id. at 724-751. 84. id. at 724. 85. id. at 742-743. 86. id. at 744. 87. id. at 750-751. 88. see the cdfi website at www.cdfi.gov. the $600 million of nmtc finds was authorized by the gulf opportunities act of 2005 for recovery and redevelopment of what was termed the hurricane katrina gulf opportunity zone ("go zone"). 89. two hundred thirty three cdes have received allocations as of june 29, 2006 according to cdfi announcements on its website at www.cdfi.gov. the cdfi published profiles describes 3 entities as being majority or 100% minority owned, although one of which is an llc, and the general partner is actually the award winner that may not be a minority concern. [vol. 8:2 the de-gentrification of new markets tax cities like new orleans where nearly 70% of the city and the vast majority of the displaced residents are african american, the entities receiving federal subsidies for reconstruction therefore do not include them.90 and though the majority of those entities with go zone awards have not identified specific projects, 91 many have included the same type of general descriptions that brought gentrified projects to other urban core residents in the prior 3 rounds.92 for example, the chevron nmtc fund llc received an allocation of $50 million for the go zone.93 the chevron plan is to use the federal subsidies to help construct "hotels, office space, retail, light industrial and mixed-use buildings" 94 who are they building the projects for? it is far from pure speculation to surmise that the hotels are not primarily for the displaced low-income residents. i suspect they will not be asked in homeland security fashion to be permanent hotel guests. i suspect they may receive janitorial jobs that trickle down from the multi-million dollar developments. but is the bulk of the $50 million likely to be used for affordable housing complex, replete with nearby grocery stores and health care facilities designed to meet the needs of the low-income residents the subsidy was designed to assist? not all cdes with katrina go allocations are problematic in purpose. a very few have described what i term properly purposed projects like capital link, inc.95 they received a $15 million allocation which they assert will be used to provide "federally qualified health centers" to the actual low-income residents and the uninsured. that is a dramatically different purpose and intended beneficiary than a hotel project, which by very definition is designed for the wealthy owners of the facility. the lowincome residents who likely cannot afford the occupancy rates have at best residual benefits. the focus of this article, however, is not confined to exposing misguided projects. the next part also presents an analytical construct to 90. u.s. census bureau, u.s. department of housing and urban development. a study based on the federal emergency management agency data concluded that katrina's effects were "disproportionately borne by the region's african american community, by people who rented their homes, and by the poor and unemployed." robert p. stoker & michael j. rich, lessons and limits: tax incentives and rebuilding the gulf coast after katrina 1 (brookings institut. 2006). 91. the conclusion is based on the author's review of cdfi profiles from the 2006 round that includes all go zone allocations. 92. id. 93. see the cdfi website at www.cdfi.gov. 94. id. jpmorgan chase & co. also received $50 million to develop commercial real estate ventures, presumably with a mix of other, but quite possibly lesser community-based facilities. 95. see fourth round-2006 new markets tax credit allocatees at www.cdfi.gov. 20071 florida tax review proliferate projects truly designed for the low-income communities and their corresponding target populations. such projects already exist within the nmtc program. they primarily involve community healthcare facilities, financing for non-profit community based organizations, child care, social service centers, community development real estate projects, senior centers, providing below market nonconventional unsecured commercial loans, and affordable housing for truly low-income residents. these project types are termed "properly purposed projects" because author believes are most precisely within the intent of congress when the nmtc legislation was passed. the nmtc legislation was also thoughtful enough to build into the program a monitoring and evaluation process.96 there are various actions that the cdfi can take to ensure that the allocations are properly made to appropriate entities. part iii of this article attempts to assist in that effort as the cdfi assesses the impact of the new markets credits on low-income communities. part hi a. the gentrification alternative the properly purposed project developed trough harmonious cde and qcb entities as noted above, some commentators argue that gentrification is a net gain for low-income residents. if that theory is true in all cases, then the use of nmtcs for such developments as opera houses, high priced condominiums, and convention centers would also benefit the urban poor. the reality, however, is more complicated. the extent of benefits to a lowincome community, some tangible, some intangible, are a matter of degree and difficult to quantify. and if it is just a matter of degree, then all projects have at least some level of indirect or residual benefit. assuming that to be the case, the precise question is whether the nmtc federal funding scheme mandates that the tax subsidy is only for those projects that make lowincome urban residents the primary beneficiaries. and if congress intended low-income residents to be primary beneficiaries, and problematic purposed projects as vehicles for gentrification create a mismatch, what regulatory amendments are necessary to match the program's operational reality with congressional intent? the answer to those questions starts with a conceptual model, a way of thoughtful problem solving, which is discussed in this section. specific proposed amendments follow in part iv. 96. not later than january 31 of 2004, 2007, and 2010, the comptroller general of the united states must report to congress, pursuant to an audit, on the nmtc program, including all qualified community development entities that receive an allocation under the credit. [vol 8:2 the de-gentrification of new markets tax b. transactional end sum model the nmtc purposes may well be served by first starting with identifying an achievable outcome, and then building the means to meet that end. a similar model already exists and has had significant measurable success in the bill and melinda gates foundation.97 in the nmtc context, the desired outcome is two-fold: identify a need in the community and a specific project designed to meet that need. the starting point in my model is a list of priorities for the types of projects that the target community needs most. there is a plethora of statistical data on the extent of disparity between the urban core cities and the general population, subdivided by health, employment, and virtually every other category that the united states census tracks.98 moreover, congress is fully capable of establishing a commission to perform a needs assessment so that it can state at the end of the day: "these are the needs, and these are the types of projects we believe are designed to meet those needs." 99 i term the needs list a "mall of needs" akin to a strip mall with various business types within it. the projects designed to meet those needs i term "properly purposed projects." the mall of needs is based on the premise that the low-income core urban residents would rather have quality grocery stores at affordable prices to feed their households than a starbucks. they, i will assume, prefer qualitative health care clinics specializing in the types of illness that disproportionately affect core community residents (e.g. sickle cell, kidney failure) to an upscale commercial office building.'00 it would be nice to have it all, but the priority assumed in this article is for the needs, subrogating the wants. 10 97. a more detailed discussion of the bill and melinda gates foundation is set forth in § 2 regarding social entrepreneurship. 98. u.s. census bureau, u.s. department of commerce, statistical abstract of the united states: 2001, the national databook, tables 660, 661, 662, 663 (2001) to name a few. 99. the substantive materials could be first established by congress, subject to the target community's localization (top-to-bottom) or first established by the communities (bottom-to-top). 100. see nancy krieger, painting a truer picture of us socioeconomic and racial/ethnic health inequalities: the public health disparities geocoding project, american journal of public health, vol. 95, no. 2, p. 312, 317 (2005), for findings that poor health among low-income communities is attributable to, inter alia, inadequate "public goods (e.g. supermarkets, health clinics) and environmental pollution." segregation has also increased health disparities. according to the krieger study, "also pharmacies in segregated neighborhoods are less likely to have adequate medication supplies, and hospitals in these neighborhoods are more likely to close." id. at 330. 101. interjecting into the cdfi criteria cultural connectivity or sensitivity to the particular needs of a community based on ethnic traits could raise constitutional questions. racial classifications imposed by the government are subject to strict 2007] florida tax review currently, the nmtc program has thoughtfully created criteria by which to evaluate fund applicants'0 2 but it has not publicly released such a needs assessment. nor has it published prioritized project types. that void allows latitude for gentrification projects that would not otherwise have been authorized if there was a template of needs and project types, and adherence to that standard in the certification process. if this paradigm shift occurs, it will be clear to nmtc applicants that the privilege attached to the credits scrutiny, and are only constitutional if narrowly drawn. grutter v bollinger, et al, 539 u.s. 306, 326 (2003). none of the amendments offered in this article (e.g. raising the minimum poverty rate) attempt to add a "racial" classification or preference. an ethnivestor can be of any race that has cultural connectivity with the low-income community. the low-income community may have a mix of ethnic groups, including immigrant enclaves. cultural sensitivity is not synonymous with a particular race. under all proposed amendments, any investor, cde or qcb can, for example, determine whether certain needs are unmet within the community. ethnivestors may be more attuned to the issues and provide a more culturally sensitive application to the cdfi. an ethnivestor may therefore be more likely to propose a properly purposed project. but no governmentally imposed classification or preference is given because of race. if a needs assessment must be performed, but without proscribing a governmental preference or establishing a racial classification, it should be considered "race neutral" in this author's view. the preferences should arise as a matter of course in the private marketplace of empirical research. in other words, if a regulation states: "the cde shall perform a good-faith needs assessment based on statistical data publicly available," and if there is no sickle cell treatment center for a community that has a high incidence of that disease, that need should be identified and included in the needs assessment. that does not necessarily mean that particular need must be the cde's designated project. but since the cdfi has a statutory duty to implement a program to assist low-income residents in their community, the cdfi should be within its authority to at least require all applicants, regardless of race, to determine what is needed. if the project fails to meet any identified need in the community, then the applicant should be provided the opportunity to receive the subsidy. even if proposed amendments are considered race conscious classifications, the language could be carefully crafted to be narrowly drawn to serve a compelling governmental purpose. nonetheless, determining what is or is not a race-conscious governmental provision is debatable and beyond the scope of this article. 102. the cde applicant is evaluated on the following four categories: business strategy, capitalization strategy, management capacity, and community impact. each category has a maximum of 25 points. there are additional "priority points" under the business strategy category if the applicant (1) already has a record of providing capital or technical assistance to disadvantaged businesses or communities or (2) intends to funnel substantially all of its cash investment to an unrelated low-income businesses. each applicant is then given a numeric score and ranked. see notice of allocation availability, 69 fed. reg. 49951-49952 (aug. 12, 2004). [vol. 8:2 the de-gentrification of new markets tax only inures to those who meet criteria consistent with a mall of needs for low-income residents rather than a mall of wants for gentrifiers. it is not enough to merely identify needs and conforming project types. it is also important to conceptually align the parties to the transaction. a business transactional approach is herein suggested because most fundamentally the program is about structuring transactions among various parties. investors deliver a particular product (i.e. equity capital) to a particular location (i.e. low-income areas) for particular beneficiaries (lowincome residents). as with any business transaction, each party has separate interests, and the success of the transaction depends on establishing a winwin environment for all those who participate in the transaction. that requires a comprehensive connecting of dots involving all the component parts and players in the program. a model that simply fulfills the investor's financial expectations but leaves the small business in ruins does not adequately incorporate and harmonize the interests of each part of the transaction. nor does it most effectively meet the goal of the subsidy. to harmonize the interests of each party to the transaction, this modeling involves two hybrid components: a "means-ends factor" and a "balancing of interests" factor. the means end factor is a process whereby the applicant is first provided the mall of needs and the list of properly purposed project types. 10 3 those combined items constitute the end sum interests. only with that end sum in focus is the transaction devised. the parties to the transaction, (the investor, cde, and the qcb) comprise a "means team" because they collectively are the means by which the "end" is achieved. that end is the properly purposed project for the target community. the concept is that if the means team is required to first focus on the end sum interests, there will be a natural weeding out of those parties that would otherwise attempt to establish gentrifier projects. the second component of the transactional model is the balancing of interests. that component has two aspects a balance internally among the means team, and externally between the means team and the target community. internally, each team member should balance its own profit motive with the philanthropic motive of assisting the target community. if the cde desires a rate of return at odds with the expectations or distribution of benefits to the small business (qcb), the discord could lead to severing the relationship. a failed venture also diminishes the value of the tax credit since the revitalization did not occur. to avoid a loss of benefits from the tax subsidy dollars, the cdfi should scrutinize the relationships for signs of 103. assuming the list is preliminary and subject to fine tuning, it nonetheless provides a starting point for aligning and harmonizing the potential parties to the transaction. 2007] florida tax review incongruence.'04 of course, projects can have a relative level of success without complete failure, and it is not necessarily an either/or proposition. but it is not a proper balance if the kind of projects that are authorized are conceptually upscaling without also reaching down to bring the community with it. external balance refers to the need to carefully weigh interests of the collective means team against the interests of the target community. a conceptual model that allows too heavy a weighting of benefits to the means team, e.g. an investor that expects an unrealistic return on an investment rather than the community interests is more likely to produce a project deliverable that is a problematic purposed project. a means team that intends to drain the resources of the small business that initially received the equity funds and then immediately sell the property at the conclusion of the tax credit period is not properly balanced transaction between the respective interests of the community and the means team. conversely if the model is too heavily weighted in favor of the community without sufficient financial attraction to the investor and other members of the means team, the equity supply could wither and die, without a nourishing vine to the community. a philosophical or investment disconnect between the means team and the target community is a prescription for potential failure. the balancing of interests is therefore vital to the "win-win" circumstance required to meet the congressional purpose. this transactional entity purpose model is therefore a hybrid approach between means-ends and balance of interests. the model is graphically illustrated below (means team) (ie s e d s in terets) i extemal between mepo n teai -,ad esi a--9g mean. teammembrs alanc.. o nterst 104. the cdfi can review operating agreements of llcs, which is the popular entity of choice for many operations, scan for oppressive terms, or unrealistic projections of earned income, unusual debt loads by the smaller entities, or any other contractual terms that appear problematic. [vol. 8:2 the de-gentrification of new markets tax the cdfi has a certification system that is rigorous in many respects. but if the balancing of interests and properly purposed projects are to be systematically part of the nmtc program, amendments to existing publications and regulations should be considered. the published advice from the cdfi on how to become a cde does not mandate how the cde, qcb and the target community relationships should be structured. 0 5 there are numerous possibilities, as it should be. however, with flexibility comes the opportunity for abuse or circumvention of intended purposes, particularly if the purposes themselves are ambiguously stated. the irs regulations exist to provide clarity and close unintended loopholes in determining tax liability and tax credits. they often include examples to elucidate its interpretation of the statutes. the nmtc statue it part of the internal revenue code, with regulations. consistent with this article's purpose of adding clarity and closing loopholes, the published materials and regulations should also provide models examples to guide investor taxpayers in clarifying the conditions under which the tax credit is availing. this model could be part of a suggested set of ways in which the three parties to the "transaction" can conceptualize how they are to relate to each other to develop a project. the regulations could also state that each applicant is expected to state how it intends to match the mall of needs with a properly purposed project and how each party to the transaction will contribute to that end. as with other recommendations within this article, this model is designed to narrow the qualified entities and investment vehicles to more precisely accomplish the statutory goal. part iv a. proposed amendments to close loopholes as noted in part ii, there are competing models for who are the intended beneficiaries of the nmtc program. one focuses on people in place within the target community, while the other benefits people regardless of the place of origin. this article maintains that the people to be primarily benefited fall within the former model so that the 'target population" is comprised of low-income residents in place within the low-income community. the support for that conclusion includes careful analysis of the transactions and related definitions. below are those transactional definitions, the how the structural process can be amended to close loopholes that have diverted funds away from the low-income residents of target communities. 105. the cdfi guidance on the cde certification is found on its website at http://www.cdfifund.gov. 20071 florida tax review 1. the equity investment and its correlation with qualified active low-income community business ("qcb') the importance of qualifying an equity investment is previously discussed. but it is not enough to merely have a qualifying equity investment. the cde must then invest that qei into a community project. though there are at least four different ways an investment can be structured (i.e. through loans, or loans in combination with cash, and to different types of entities), that investment must still be designed for low-income residents within a low-income community. one prime scenario is when an investment is made in an entity that provides financial services. the regulations provide that the services must specifically be to businesses located in and residents of low-income communities. 0 6 if the intent of the program was for the financially well healed there would have been no need for federally sponsored incentives to help them get back on their collective feet. the point is buttressed in the cdfi official announcements used to announce upcoming allocations. the criteria for awarding allocations includes the language: "an applicant will generally score well to the extent that it will deploy debt or investment capital in products or services which: (1) are designed to meet the needs of underserved markets... (2) focus on customers or partners that typically lack access to conventional sources of capital"'°7 the gentrifiers do not typically lack that access to capital, but have likely thrived because of it. a second confirmation that low-income residents are the primary beneficiaries is gleaned from the statutory framework for involving businesses within the low-income community. an investment can be made to a "qualified active low-income community business" ("qcb").'18 a qcb is defined as an entity that derives over 50% of its income from within the lowincome communities. it must also devote a substantial portion 0 9 of its property, or services from within the low-income community. 10 the 106. reg. § 1.45d-l(d)(1)(iii). 107. 69 fed. reg. 49951 (aug. 12, 2004). 108. reg. § 1.45d(d)(1)(a). 109. the "substantial portion" test for tangible property or services is satisfied if 40% of the property (owned or leased) or services is within the lowincome community. reg. § 1.45d(d)(1)(b). 110. the specific qcb requirements tied to low-income residents are that (1) at least 50% of the qcb's total gross income for the year must be derived from the active conduct of a qualified business within any low-income community irc § 45d(d)(2)(a)(i); (2) a substantial portion of the use of its tangible property, whether owned or leased, must be within any low-income community, irc § 45d(d)(2)(a)(ii); a substantial portion of the services performed for the entity by its employees must be performed in a low-income community, irc § 45d(d)(2)(a)(iii). [vol. 8:2 the de-gentrification of new markets tax investment is only qualified if services are performed and income is from within the target community. so it follows that congress intended the investment to flow to a small business that is an integral part of that community. since the target population is by definition low-income, the investment must primarily serve those low-income residents. it is the nexus with the low-income residents that provides the qualifying status, and should thus be the focus of the investment. that construction would weigh against an investment in a hotel-convention center complex, for example. it is difficult to conclude it is designed primarily for the low-income residents when attendees and occupants are non-residents. the loophole is that an investment in a low-income community business is only one of the types of qualified investments. other investments can occur without a required commitment to an enterprise like a qcb with the 50% community income, or other community services requirements. 1 ' that type of connectivity with the target community should be required of all entities seeking to qualify for the subsidy. the convention center would not qualify if the majority of its income were derived from visitors attending a convention. an opera house would not qualify if the bulk of the revenue was from outside the community. 2. cde mission clarity the current nmtc statute is ambiguous as to a cde's intended beneficiaries. as noted in the background section of this article, there are three requirements that must be met for a cde to be qualified under the nmtc program, two of which are vital to this discussion. first and most importantly, its primary mission must be serving, or providing investment capital for low-income communities or low-income persons.' 2 arguably the conjunctive "or" allows a construction that could mean a project for the lowincome "community" is broader than, and equal in status to, a project for low-income "persons." in other words, a project for an opera house could benefit a broader category of residents within the "community" like new entrants, who are not low-income. a doctor with income of $400,000 annually who works at an inner city hospital could be within the low-income community, but still not a low-income resident. conversely, if the only descriptive beneficiaries were "low-income persons", it would far more difficult for the doctor to be a primary beneficiary of the subsidy. as to entity types, the qcb can be a corporation, (including a non-profit), a partnership, or a sole proprietor. reg. § 1.45dl(d)(4)(i)(ii). 111. an investment is still qualified even if it is a loan to another cde, or purchase of a cde loan. irc § 45d(d)(1)(b)&(d). 112. irc § 45d(c)(i)(a). 20071 florida tax review to avoid ambiguity and to fulfill a goal of qualitative revitalization, this article recommends that the nmtc regulation simply delete "lowincome community." the benefit should be determined as of the date application for an allocation of funds from the cdfi is made. under such a definition, the loophole is closed. those persons not experiencing the adverse affects of a blighted condition would not have projects built primarily for their benefit. the cdfi could then clearly disallow an investment designed for a 10-story condominium unit where the minimum price for a one bedroom unit is $400,000.113 3. demanding an invitation to your own party through cde board influence the requirement that a cde must maintain accountability to residents of low-income communities also provides options that weaken its effectiveness. the accountability standard is confined to low-income resident representation "on any governing board of the entity or on any advisory board to the entity."' 1 4 again the conjunctive "or" allows for ambiguity or a broader interpretation that could weaken the participatory role of those residents. if a cde has the flexibility to relegate low-income persons from the target area to a mere advisory board, those residents can be marginalized by having only advisory powers. though such funds are designed specifically for their benefit, the advisory powers are essentially no more than a muffled voice and virtually no representation on how these important federal funds are used. it should also be remembered that these same lowincome residents are taxpayers too and it is also their money at stake. under the current regulatory language, a performing arts center could change its original diverse repertoire of performances to only ballet even if the majority of low-income persons within the low-income community vehemently object. if the advisory board language is stricken, the ambiguity and unintended consequences go away as well. allowing the target low-income residents a true voice in project decision-making also allows a fair chance for eliminating conflicts with gentrifiers before they arise. if the target residents sign off on projects, the cde and its investors will presumably only be able to construct projects the target population already considers acceptable. thus gentrifiers are not put in the position of being at odds with the target community. it is entirely possible that the targeted low-income community and gentrifiers actually agree on certain project types. this regulatory remedy has such potential to 113. id. 114. irc § 45d(c)(1)(b). the third requirement is that the cdfi must certify the cde. irc § 45d(6)(c)(1)(c). [vol. 8:2 the de-gentrification of new markets tax be curative, advisory board provisions should be afforded the same care in drafting as a nonprofit corporation's its board of directors." 5 arguably the question of relative influence of an advisory or even a mandatory board such language could be left to the parties of each transaction under the "contractarian" theory. under that theory the marketplace should be free to establish its own agreements and the nmtc statute and regulations should be relegated to a default role, applied only when the agreements of the parties to the transaction are silent on the relevant issue. 16 the current nmtc regulations and statute appear to operate under that model. the cde and the target residents are left to their own devices and relative influences on each other to determine just what role the low-income community shall have in decision making for the cde or the projects it undertakes. there is no statutory or regulatory mandate as to the extent of low-income community participation. but even when parties are left to their own devices, statutory and regulatory provisions have historically stepped in when parties use that contractual freedom to thwart the intent of the legislation or otherwise fail to do what is fair and equitable. 17 one analogous circumstance is the congressional action to curb abusive tax shelters. promoters of certain types of transactions took advantage of existing tax laws to create losses far in excess of the economic reality of the transaction (i.e. losses on paper, but without any potential financial loss). the use of huge deductions significantly reduced taxable income far beyond congressional intent.1"' to close the loophole and stop the abuse congress passed provisions both 115. upon election or appointment to a board of director position, a lowincome community resident would be imbued with a fraction of management powers of the cde, including but not limited to the right to participate in decisions pertaining to the cde mission, overall policy direction, types of projects that are consistent with that mission. see the virginia nonstock corporation act, code §§ 13.1-803 and stewart v. lady, 251 va. 106, 110 (1996). 116. also known as the nexus of contracts model, the theory is that a business organization is most fundamentally a "nexus of contracts" amongst those who generate goods and services, not a single entity created by statute. see robert w. hamilton & jonathan r. macey, cases and materials on corporations, including partnerships and limited liability companies (9th ed., thompson & west 2005) and david rosenberg, venture capital limited partnership: a study in freedom of contract, 2002 colum. bus. l. rev. 363, 367 (2002). 117. to protect kansas farmers from bogus investments (termed "a piece of blue sky") the kansas legislature passed a security statutory regulation. see paul g. mahoney, the origins of the blue-sky laws: a test of competing hypotheses, 46 j.l. econ. 229 (2003). 118. see discussion of abusive tax shelters in james j. freeland, daniel j. lathrope, stephen a. lind & richard b. stephens, fundamentals of federal income taxation 498-499 (11 th ed., foundation press 2000). 2007] florida tax review procedural and substantive." 9 included in the legislation was the creation of a concept of "potentially abusive tax shelters" where promoters of tax shelter transactions were required to keep lists of customers and register shelters with the internal revenue service. 12 the federal governmental interest in tax revenues particularly weighs against a pure contractarian model. an abuse of deductions or tax credits reduces the tax revenue otherwise owing to the treasury. that results in less revenue available for public services, inter alia, which therefore shortchanges the taxpayers. the federal government has the obligation to direct tax dollars to an intended purpose. in the case of the nmtc program, if over $2 billion of taxpayer funds are being used as incentives for the wealthy, rather than the low-income residents that congress intended as beneficiaries, that too is an abusive diversion of federal tax dollars. it leaves fewer funds for the intended purpose of inducing greater private equity into target communities. the lost funds have multiple adverse affects because those subsidies are also designed to reduce public fund dependence by those low-income communities. the subsidy is only a match to light private funds designed to increase the quality of life of the target populations. thus, the coopting of funds for a few who are without need increases the federal wasting of resources, diminishing the value of the taxpayer's contribution to the treasury. accordingly, certain disclosure requirements or restrictions could be infused into the nmtc regulation. akin to the tax shelter concept of protecting against potentially abusive shelters, the comparable term in this context is the identification of problematic purposed projects. based on certain criteria that red flag a potential abusive project type, the cdfi can be alerted to those cdes that escaped detection during the application and allocation process. one such red flag is when a board of low-income residents, be it advisory or governing, objects to a proposed gentrified upscale project. if, prior to construction of a real estate venture, the cde was required to submit objections that reach a majority vote to the cdfi , the disclosures could assist auditors in an investigation as to whether the project in operation violates the spirit or letter of the regulations or statute. another disclosure requirement could be a mandatory mall of needs compilation by low-income residents.' 2' the mall of needs for a target community would be whatever the community determines to be of greatest need, e.g. affordable housing, charter schools, pre-school educational facilities, health care clinics for the diseases most untreated or in particularly 119. substantively congress disallowed the artificial losses by capping losses from certain income producing activity or a trade or business to the amount the taxpayer had at risk, e.g. where taxpayer may be personally liable. irc § 465(a)(1). 120. irc § 6112(a)(b). 121. see table c, properly purposed projects. [vol. 8:2 the de-gentrification of new markets tax acute susceptibility among the residents. with a baseline so established, a project proposal that varies materially from the established needs would be subject to a higher level of scrutiny. the threat of losing those credits through required disclosures, meaningful penalties and enforcement could be an effective deterrent against the creation of problematic projects. even if legislation was not passed to mandate low-income residents on a board of directors, an advisory board with teeth is a viable alternative. the regulations are silent however on the following: 1. the number of advisory board members (or a corresponding percentage). 2. the criteria for selection of advisory board members. 3. the assurance that recommendations on material issues can be submitted to cde decision-makers. 4. good faith requirements on the cde to consider advisory board recommendations. 5. penalties to the cde and remedies to the residents if the cde fails to comply with provisions relating to the advisory board. since cde and investor decisions are easily based on profit motives and investment return there is also skepticism as to whether any significant community input will actually occur. 122 the regulations should accordingly incorporate best practices models for corporate advisory boards into the nmtc cde certification requirements, including those committed to principles of social entrepreneurship. 4. the "qualified business" exclusion of project types outside core interest and needs assessment as will be discussed below, congress specifically eliminated certain types of business ventures from being eligible or qualified for the nmtc subsidy. expanding those exclusions is recommended in this article. when congress defined a "qualified business" under the nmtc program, it excluded the establishment of residential rental units, i.e. housing projects. 23 also specifically excluded are businesses that hold intangibles for sale or license,124 or operate a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, or other gambling facility. 125 also 122. see forbes, see supra note 22, at 198, and dimitri pappas, a new approach to a familiar problem: the new markets tax credit, 10 j. affordable housing & community dev. 323, 325(2001). 123. irc § 45d(2)(c)(3)(a), reg. § 1.45d-l(d)(5)ii. 124. reg. § 1.45d-l(d)(5)(iii)(a). 125. reg. § 1.45d-l(d)(5)(iii)(b). 2007] florida tax review excluded are highly profitable farming operations. 26 in enumerating those exclusions congress expressed its intent to eliminate certain types of projects that may fall outside the low-income revitalization. if a type of business cannot be a qualified business it cannot be part of the chain of transactions that leads to a tax credit. so while rural low-income communities are certainly planned beneficiaries of tax credit investments, congress fashioned the law to protect against unintended beneficiaries such as farm businesses that already have assets in excess of a $500,000.00.127 that is obvious indicia of the intent to exclude those investors and cde's who primarily see dollar signs over help signs for low-income residents. similarly, golf courses, gambling facilities, and country clubs are excluded as a matter of congressional urban tax policy. it was congressional judgment that golf courses and country clubs are not truly designed for the target population of low-income residents. congressional judgment could also be used to eliminate other accoutrements of opulence venues for opera, ballet, and symphonies, high priced condominiums, art galleries, hotels, and convention centers all of which have received the nmtc federal subsidy. 128 to close the loophole for such problematic purposed projects, this regulation can either simply add those project types to the list of prohibited businesses and/or put a fair market value ceiling on the project as it did with farming projects. the existing business operation exclusion could be amended to incorporate the following language: "any trade or business where, unless decided otherwise by a mandatory community board, the principal activity is a venue for opera, ballet, symphony orchestras, art galleries, hotels, convention centers, mixed use condominiums, or substantially similar business operations where the aggregate fair market value of assets owned or leased for the project by the taxpayer at the close of the taxable year, or on average during the taxable year exceeds __ 129 126. id. the provision is that as of the close of the taxable year, the sum of the fair market value of the farming assets, and the taxpayer's aggregate value of leased assets exceeds $500,000. 127. id. 128. these findings are from the author's review of cdfi profiles through four rounds of allocations to cdes. 129. the ceiling amounts are not incalculable. congress already provided a ceiling for farming operations was $500,000. it can just as easily exercise its judgment in other categories. the cdfi may have enough project history within various low-income communities to establish fair market value amounts based on such factors as project size, target community income level, stated protect types and [vol. 8:2 the de-gentrification of new markets tax consistent with other regulatory amendments noted above, if such a prohibition was contained in the regulations, the cdfi would have a clearer basis for auditing and eliminating such problematic purposed projects. since the cdfi is required to monitor whether its award allocations are used for projects consistent with the congressional goals, amendatory language should be a valuable asset in carrying out its oversight function. 5 "low-income community" clarification to match intent to primarily benefit low-income residents as previously stated, the nmtc mandates that a cde must have a primary mission of serving or providing equity capital for "low-income communities or low-income persons." similar to the need for carefully drafted definitions of the entities that prevent unintended consequences, the definition of the low-income community should also be narrowly drawn. as noted above, the definition of low-income community could simply be synonymous with low-income residents or be deleted entirely. then there can be no doubt that the "community" truly means the existing low-income residents of the community rather than the new financially well healed entrants to that community. another amendment to close loopholes in the definition of the lowincome community is to tighten the census tract criteria. currently, a census tract with poverty rates of 20% qualifies as a "low-income community" in a metropolitan area. 130 if instead, the poverty rate with a census tract had a floor of 30% or 40% of the community, lower income residents would have to comprise a higher percentage of the tract to qualify.' 3' as an additional safeguard, the cdfi could hire demographers with the type of expertise used to analyze the fairness of federal congressional districts, pinpointing the percentages of various groups within a district when redistricting issues arise, to examine questionable circumstances within a census tract. if, as one goals from the target low-income residents through board of director statements, or otherwise. 130. irc § 45d(3)(e)(1)(a). 131. observers of the nmtc program in its infancy also recognized the issue. as a federal reserve bank of cleveland examiner stated: "poverty rates take into consideration the number of individuals in a family, whereas median family income does not. while lowor moderate-income tracts are more likely to have poverty rates over 20%, it is possible to have high poverty in a middle-income census tract. for that reason, new markets funds may be invested in areas with high poverty rates that are not necessarily lowor moderate-income communities." connie smith, new market tax credit investments: an examiner's perspective, community investment forum, the federal reserve bank of ccleveland, p. 5. (2003). 2007]1 florida tax review federal reserve bank examiner stated,132 there is a narrow segment of high poverty rates within an otherwise affluent area, this article suggests a case by case review to vary the general census tract criteria to avoid over inclusiveness. the nmtc statute could be amended to allow that flexibility in individual cases. 6. increased accountability through recapture of the credit the forgoing proposed amendments to the nmtc law are designed to change behavior of certain investors and entities, i.e. discourage federally sponsored gentrification. when changing behavior is the goal of amended language, it is more likely to be effective as a remedy if the failure to change behavior has adverse consequences for noncompliance in a word accountability. the primary tool in the existing nmtc law is a recapture (i.e. a retroactive forfeiting) of the tax credit.'33 the recapture currently occurs when any of the three following events occur: (1) the cde loses its status as such (2) the proceeds of the equity investment to the cde are improperly used outside of the required use for qualified investment purposes, or (3) the cde redeems (takes back) the equity investment for other qualified use. 34 thus, if a cde no longer has as its primary mission serving low-income persons or the low-income community or the cde fails to use a low-income resident advisory board, it could lose its status and the tax credits would be recaptured. if the prior suggested amendments were incorporated in the statute so low-income residents must be served primarily without community definitions expanding beyond them, and the boards truly allow decision making participation to those residents, then the recapture provides the accountability standards advocated in this article. similarly, if the qualified equity investment (qei) is only allowed for the "qualified business" that eliminates the problematic purposed projects, then only properly purposed projects would be qualified businesses. any investment in the hotels and convention centers, and other enumerated up-scaling projects of gentrification would be non-qualified, and the tax credit recapture hammer would fall on the investor. those provisions appear to be adequate deterrents to investing in outside of properly purposed projects. to provide a catch all provision, like a default and termination clause in commercial contracts, the recapture clause could simply state the failure of the cde to comply with provisions concerning properly purposed projects and the target community's needs assessment is cause for recapture 132. id. 133. irc § 45d(g). 134. irc § 45d(g)(3)(a)(b)(c). [vol 8:2 the de-gentrification of new markets tax of the tax credit (default) and unless cured within a specified time or by certain curing actions, the credit will be lost. the recapture has teeth built into the statute and appears loophole free, assuming the proposed amendments are made. the recapture occurs at any time in any tax year upon the happening of any of the triggering events. the amount of the credit recaptured increases the investor's tax, and no deduction is given for the recaptured interest. 3 5 7. safeguards against overleveraging the qcb since the qcb is the small business within the nmtc program that actually serves the target community, 136 its economic health is vital to efficient use of the federal tax credit subsidy and achieving the goal of revitalizing the community. like most typical small businesses, qcbs are financed with a combination of debt and equity.1 37 there are admittedly some positive aspects of incurring debt.' 38 proponents of debt financing as an incentive to efficiently manage the business have axioms that essentially state that the challenge of producing sufficient cash flows or default motivates owners to work harder than counterparts in less leveraged firms.1 39 this theory has been criticized as an oversimplification since it should not be assumed that owners or managers are predictably going to respond to this risk by working harder. 40 indeed, proponents of debt incentives admit "the manager or owner's fear of not meeting the debt service (falling through thin ice) does not always lead to superior 135. the credit recapture amount is the decrease in credits allowed for all taxable years as if the nmtc had not been granted, plus interest. irc § 45d(g)(1)(a)(b). 136. the qcb is required to derive over half of its income from and provide goods or services to the target community. reg. § 1.45d(d)(1). 137. as finance terms debt and equity are forms of "capital" used to fund the business enterprise. the principal distinction between the terms being that debt refers to borrowed funds, where fixed obligations must repaid with interest, while equity refers to amounts contributed by owners and investors (e.g. cash). debt is a fixed claim against the business assets that must be repaid, while equity is a residual claim against the company where the equity owner has a claim on what is left over after the fixed debt obligations have been paid. see hamilton & macey, see supra note 118, at 313-314. 138. see michael c. jensen, agency costs of free cash flow, corporate finance and takeovers, 76 am. econ. rev. 323 (1986), note 5 at 67. 139. george g. triantis, debt financing and motivation, 31 u. rich. l. rev. 1323 (dec. 1997), citing jensen, see supra note 140, at 323, and frank h. easterbrook, high-yield debt as an incentive device, 11 int'l rev. l. & econ. 183 (1991). 140. id. 2007] florida tax review performance; it may instead lead to a fatalistic sense that effort might be wasted in a futile cause.' ' 4 1 a prime illustration of the dangers of debt is found in the tantalizing quest for leverage. leverage is the ability of a borrower to earn more on the borrowed funds that the cost of the borrowing. 42 overleveraging at its core is the incurrence of debt beyond the capacity to pay it. empirical studies reveal that higher goals (e.g. an overly ambitious high cost real estate development), typically result in the owners carrying higher levels of debt ("debt service"). to meet that debt service, higher cash flow production is required. those cash flow demands can increase the risk of financial failure. and if goals are too difficult, perceived risks can in turn cause business owners to have a declining commitment to achieving those goals a downward spiral where the next project or financial issue is met with greater reluctance to accept similar goals and a lesser commitment that those goals can be achieved. 4 there is a growing body of literature that psychological cycles of failure result from such unrealized goals.44 a "falling through thin ice" syndrome is not uncommon. 45 this author's review of financing structures reveals great potential for overleveraged qcbs. many nmtc cdes require multi-million dollar thresholds for project size to justify the high transactional fees to law firms, accountants, and consultants in structuring the transactions. 46 based on a sampling of nmtc allocations established through the four rounds of awards to date, over 50% of the awards have been $50 millions or greater, with some as high as $150 million. 47 this author suspects most qcbs are not currently able to secure the requisite amount of equity financing to compete at that level, and must rely on debt to participate in the transaction, in many of the financing structures reviewed, the qcb is essentially a borrower rather than a full fledge equity partner in the transaction. some 141. 31 u. rich l. rev. 1328. specifically, overleveraging creates a "crisis atmosphere." jensen, see supra note 140, at 323, note 5 at 67. 142. hamilton & macey, see supra note 118, at 339. 143. 31 u. rich l. rev. 1336. 144. id. 145. id. at 1333, citing edwin a. locke, toward a theory of task motivation and incentives, 3 org. behavior and human performance, 157-89 (1968). of course, aggressive goal setting does not always lead to financial ruin. the practice can stimulate planning and strategy development, and that higher levels of management performance can occur when the challenges are perceived as "just manageable." id. at 1335-36. 146. id. at 1334, citing gilbert brim, ambition: how we manage success and failure throughout our lives 32 (1992). 147. the author sampled all cdfi profiles from round two (2003-2004) and round three (2005). http://www.cdfi.gov/what we do/overview.asp. in 2005, 64% of the awards for over $50 million, where in round two over 49% were in that range. [vol. 8:2 the de-gentrification of new markets tax transactions have even placed the qcb in the position of receiving a 100% loan, and no cash or other equity at all. 148 if the cde sets project size and cost goals beyond the capacity of the qcb, the qbc is a likely to overly rely on debt financing. that results in the overleveraging and consequential growing likelihood of not meeting the goals of paying the debt service with related psychological downturns in motivation and performance. if the qcb is overleveraged the owners are more likely to perceive an inability to meet that debt service, and as a result a declining commitment to the project. the outcome could obviously be a business failure. thus, a high debt structure could be anathema to the financial structure of a nmtc transaction. if failure occurs due to overleveraging, the overall loss is not just an economic loss of an enterprise, but also the loss of the value of the individuals to the community (personally and professionally). these "negative externalities" include the destructive effect of the firm failure on the future motivation and production of that qcb owner. 149 the nmtc target community also bears a loss of resource commitment. 50 thus, this potential loss of the qcb and the firm owners due to "motivational externalities" from overleveraging of debt should be discouraged "as a matter of public policy."' 51 as the nmtc program is a governmental program, funded with public dollars for a public benefit, it is therefore fair game for cdfi regulation. the cdfi can monitor debt ratios. it can publicly encourage nmtc applicants to carefully construct a financing model that does not jeopardize the qcb. the cdfi could even provide the ultimate incentive of including in its award criteria a review of the cde's proposed debt-equity mix. that would be consistent with also advising the applicants that favorable consideration would be given to properly purposed projects over problematic purposed projects. the underlying theory is that if the projects with the greatest benefit to the target community are smaller in financial scale, there should fewer overleveraged transactions for the qcb. if the structure appears to be overleveraging the qcb, the cde applicant should be viewed less favorably than a cde applicant that builds a financing model that minimizes the financial thin ice that unduly puts the qcb at risk of failure. 148. see the clearinghouse nmtc, llc transaction described at infra note 162. 149. id. at 1328. 150. id. 151. id. at 1329. 2007] florida tax review 8. implications for urban tax policy the united states tax system raises revenues from its citizenry in large part on the fundamental principle that those with a greater ability to pay must pay more than those of lesser resources. 152 that is why progressive tax rates were established, requiring those with greater taxable income to be in higher marginal rates, paying a greater percentage of taxable income than those with lesser taxable income.1 3 the corollary is that those in greater economic need are to pay less in federal income tax. if a federal subsidy is allowed to benefit those taxpayers who have the greater ability to pay, i.e. investors in gentrified projects who receive the tax credit subsidy, the real benefit flows not to those in greatest economic need, but those already with wealth and resources. and it is the average american taxpayer with lesser resources that picks up the tab for the gentrified multimillion dollar projects by paying for the billions of dollars in subsidy. that was not likely the intent of congress when placing the nmtc legislation in the internal revenue code, and it is inconsistent with long standing principles of federal taxation. our tax system does not use the internal revenue code for the singular purpose of raising revenues for the public good. the code is also a vehicle for encouraging certain congressionally approved behavior among taxpayers in accord with certain established values. congress, for example, wanted to encourage home ownership. homeowners receive a "subsidy" (i.e. deduction) for paying interest on home mortgages and for paying local property taxes on a home. 154 a renter could theoretically receive a deduction, but the value of renting was not considered as valuable an interest, and thus no deduction to encourage that activity. conversely, congress has decided that it will not provide tax benefits through deductions to those who are involved in personal "consumption" expenditures, like a self employed groundskeeper who may 152. see william a. klein, joseph bankman & daniel n. shaviro, federal income taxation, 6-7 (aspen publishers 2003). this "ability to pay" theory could arguably mean a mere convenience in paying where those with more liquid assets (cash) pay more than those invested in illiquid assets. under that theory, true wealth could more easily be disguised and misrepresented. the other notion is the ability to pay is more directly aligned with overall wealth and well-being. under that theory, those with greater resources, liquid or illiquid, pay more because the resources are greater, though it may be inconvenient to retrieve it. 153. the progressive income tax exists when the rates of taxation (percentage paid on certain ranges of income) rise as income rises. so the higher ones income the greater proportion of income is taxed. see id. 154. see irc § 163(h) for the deduction for interest paid on a principal residence. the tax reform act of 1986 eliminated deductions for interest paid on borrowed money for personal items such as vacations and automobiles. real property taxes are a personal itemized deduction under irc § 164(a)(1). [vol 8:2 the de-gentrification of new markets tax deduct expenses for mowing activities for a golf course client, but not for mowing his own lawn. 55 similar personal non-deductible consumption expenditures include the cost of gasoline to buy groceries for the household, or paying for the grooming of a pet, or paying interest on vacation loans or credit cards. 5 6 these are generally "wants" not needs. there are exceptions, but those are typically because congress determined that though an item was personal, there was also a higher value in society placed on the item as a "need", not merely a leisure or convenience activity generating the expenditure. a tax credit is a benefit even greater than many deductions.5 7 but if tax credits designed for low-income residents instead flow to wealthy investors from gentrified projects the primary beneficiaries will not statutory target population, but rather those of greater leisure, for their consumptive convenience and wants. that is also inconsistent with federal tax policy, as formulated historically and as applied in this context. and while it is arguable that the tax credit incentive could include gentrified projects to increase tax base and provide jobs, it is wiser policy to narrowly construe those items that draw down the federal treasury. it is well established that whether domestic programs are financed with direct expenditures or with tax expenditures in the form of exclusions, deductions, or credits, the effect on the federal budget is the same. 58 every credit and deduction takes money out of the treasury that would otherwise be used for roads, war efforts, and the handicapped. the more that funds are withdrawn, the greater the burden on the american taxpayer to provide additional replacement funding, and the greater the potential for a federal deficit, with the adverse economic consequences that could follow. another reason for narrowing the availability of credits from a tax policy perspective is that tax credits add to the complexity of tax law and can undermine fairness in the distribution of tax burdens. 159 another rationale for narrowing the tax credit is the evidence that financially well healed entities would make the investment even without the subsidy. the evidence is found in analogous tax incentives offered by states and municipalities. various state and local tax incentives (e.g. credits for employing local persons, exemptions, and abatements from property taxes), 155. for a discussion of the theory of consumption, see marvin a. chirelstein, federal income taxation, 184-190 (10th ed., foundation press 2005). 156. see irc § 163(a)&(h). 157. tax credits receive a full dollar for dollar value reduction in tax liability whereas various itemized deductions that have certain percentage floors or ceilings that reduce the benefit. see irc § 67 for miscellaneous deductions and § 68 for deduction examples, and tax credits like the nmtc at irc § 45d. 158. adele robinson, risky credit: tuition tax credits & issues of accountability & equity, 11 stan. l. & pol'y rev. 253, 254 (2000). 159. id. 2007] florida tax review like federal tax credits, are governmental tax benefits given to induce the business to invest and do business in a particular venue. economists, social scientists, and legal scholars have found only marginal links between a tax incentive and increased economic activity in the area by large corporations. 160 after nearly 30-years of research, the conventional wisdom is that various other economic factors have more impact on the investment decision by multistate corporations than the economic value of the tax benefit.161 a corporate executive has candidly admitted the tax benefits were merely "a little extra cream on top.' ' 162 skepticism abounds as to whether state tax incentives lure the wealthy corporations with tax incentives is cost effective for the state.' 63 the nmtc award winners for many of the gentrified problematic purposed projects are banks, or subsidiaries of banks. 64 in light of the above research, isn't it also likely that the nmtc cdes for problematic projects would also have made the investment in a multi-million dollar convention center without the tax credit? the same non-subsidy factors of other corporate executives, like quality of workforce, and regulatory environment may also be primary decision-making factors for the major cde. if lesser cost effectiveness exists among the cdes of problematic purposed projects, then offering the subsidy to such entities should be eliminated or minimized. that would free up the funds for either a reallocation to properly purposed projects or a reduction in the amount of subsidies. in either case, the efficiency of tax credits is increased. 165 160. peter d. enrich, saving the states from themselves: commerce clause constraints on state tax incentives for business, 110 harv. l. rev. 377, 391 (1996). 161. much of the study is codified in a new your legislative commission report. the report concluded that the quality of labor, proximity to markets and supplies, access to utilities, regulatory environment, quality of education, and the availability of housing are aggregate factors that have greater impact on whether to invest in a particular city or region. see 51 albany l. rev. 393 (1987). 162. enrich, see supra note 162, at 392. 163. see jerome r. hellerstein & walter hellerstein, state and local taxation: cases and materials, 28 (8th ed., thompson & west 2005) for various cited articles. 164. see supra note 63. the louisville development bancorp, inc., that was allocated funds for building a marriott hotel and convention center is just an example. 165. arguably, the non-subsidy factors are also primary for cdes of properly purposed projects. the reallocation to those cdes is still wiser tax policy because the funds are more carefully directed to the meet the purposes of the program. the only alternative would be to eliminate the tax credit, which is politically difficult to justify as an improvement in the quest to revitalize urban and rural low-income communities. [vol. 8:2 the de-gentrification of new markets tax conclusion the nmtc program has laudably used tax credit incentives to stimulate increased equity investment to benefit low-income residents. unintended loopholes have morphed properly purposed projects into more problematic venues for opera, ballet, symphony orchestras, hotel and convention center complexes, and high priced condominiums, in two words subsidized gentrification. this has occurred in part due to a lack of conceptual clarity on a required relationship between means team and end project, where each participant in the nmtc transaction is merely a conduit for delivery of a product primarily designed for the low-income residents, rather than the financially well healed migrants to that community. the lack of conceptual clarity led to statutory ambiguity as to the precise intended beneficiaries of the program. and as a result, the nmtc program continues to incur staggering opportunity costs and a wasting of resources within the community and the dollars earmarked to assist them.166 various amendments are proposed to provide the cdfi with additional transactional controls. principal recommendations include narrowing the type of projects authorized so only those well designed to meet established needs of the community receive the subsidy. a model that first establishes the two-pronged outcome (end sum interests, i.e. a mall of needs assessment, and a project to meet those needs) should systematically weed out the problematic purposed projects. there should also be increased accountability in capital structure to minimize potential overleveraging of the qcbs. that should also increase long term equity commitments and business operations beyond the 7 year tax credit haven. a model for revitalization should incorporate long term activity and this model is consistent with long term planning. these may be unprecedented ways to meet the urban crisis, but the crisis is reaching unprecedented levels. the status quo brings more of the same, and more of the same does not solve the urban core issues sought to be remedied through the nmtc program. if the federal government is to provide tax subsidies to influence investment behavior in urban america, it is wiser tax policy to retain fundamental tax principles, and refuse to provide tax benefits for the consumptive wants of gentrifiers, when needs of crisis proportions remain unmet. that diversion of funds and dilution of purpose only adds to the marginalization and ultimate cost to our society in lost social capital. a tax subsidy is a benefit paid for with taxpayers' dollars that comes with a price. that price for tax credit investors is the foregone opportunity to 166. see discussion of opportunity costs imposed on low-income residents from failed trickle down urban redevelopment, which is in effect gentrification, at part ii. 20071 256 florida tax review [vol. 8:2 maximize profits. that quest is best suited for purely private transaction with purely private funds in play. but the nmtc program involves public funds that therefore should tie primarily to a public purpose. the nmtc purpose is the revitalization of the low-income community. closing loopholes through amendments to the nmtc statute is recommended as a step in the right direction to accomplish that goal. the de-gentrification of new markets tax table a nmtc summary graphic* cdes must make qlicis within 12 months of receipt of investor qels odes must offer credits to investors within 5 years qei must stay invested for 7 years *figure taken from cdfi fund nmtc information session handout 2007] florida tax review table b representative sample of problematic purposed projects problematic problematic project project tax allocation cde proposed use equity credit award investment subsidy year (in millions) (in millions) received 6th largest allocation. center for the arts: transform the abandoned factory into museum space for its world-class contemporary art collection. following a $30 million rehabilitation, this 292,000 square-foot industrial steel, concrete and glass structure is now home to one of the world's foremost collections of works by major artists of the 1960s and 1970s, including andy warhol, joseph beuys, walter de maria and donald judd. hippodrome performing arts national center: restore three historic trust landmark buildings. the community distinctive exterior cornice and $127 $49.53 2002 investment marquee of the original corporation hippodrome theater will be recreated. the 2,250-seat center anticipates hosting 200 events a year, including the baltimore symphony orchestra and touring broadway production. portland telegram building: includes restoration of the fagade and clock tower and renovation of 33,000 square-feet of space for retail and office use. professional building: upper floor offices and ground floor retail. historic tennessee theatre: rehabilitation of the 'official state theatre of tennessee,' a [vol. 8:2 the de-gentrification of new markets tax problematic problematic project project tax allocation cde proposed use equity credit award investment subsidy year (in millions) (in millions) 1928 movie palace in downtown knoxville. american tobacco historic district: rehabilitation... into a mixed-use complex, and 4,000seat theatre. 123 new market 226-room hotel in downtown $13 $5.07 2002 investors, washington, d.c. llc redevelopment of broadway cinemas ... development of the louisville marriott convention development hotel.. .development of residence $8 $3.12 2005 bancorp, inc. inn downtown... construction of a new headquarters building for cw johnson xpress. phoenix community development a biotechnology campus. $170 $66.3 2002 and investment corporation iccf project-grand rapids: 5,000 square feet of commercial space. lot 9-kalamazoo: 113,000 square feet mixed-use building comprised of 10,000 square feet retail, 48,606 class a office and 16,800 square feet of residential housing. michigan pere marquette depot: $3.8 $60 $23.4 2005 magnet fund million building will be the regional tourism bureau center. 1 south division-grand rapids: 40,000 square feet of retail space and 149 public parking spaces. stadium project-lansing: mixeduse development with first floor retail/office use consisting of 25,000 square feet... 36 urban 2007] florida tax review problematic problematic project project tax allocation cde proposed use equity credit award investment subsidy year (in millions) (in millions) rental units... $800-$1,200 per month. 500 block-flint: $11 million 30,000 square foot restaurant and entertainment complex. eight loft apartments ... 1,500 sq. ft. to 3,000 sq. ft. rehabilitation of the old portland armory for the portland center stage. "intent is to transform portland's historic historic, but unused, armory rehabilitation building into a world-class $24 $9.36 2003fund i performing arts center. this allows portland center stage to move out of its current home into a performance space better suited to its goal of becoming a top american regional theater company." $4 million to fund a newly constructed office building, deer valley corporate center. johnson assist the stockyards restaurant, community a virtual living museum and local com nt landmark that commemorates and $52 $20.28 2003 development celebrates arizona's cattle company industry. loans have funded improvements for.. .world headquarters for a medical systems company. 60,000 square feet of retail space and 100 apartment units on a fouracre site.. .transforming high cmunity point from a blighted $20 $7.8 2006 coments concentration of low-income people into a new, ecologically sustainable, mixed-income community. [vol 8:2 the de-gentrification of new markets tax problematic problematic project project tax allocation cde proposed use equity credit award investment subsidy year (in millions) (in millions) urban research parks.. universities, research park colleges, hospitals, medical $50 $19.5 2006 cde, llc schools, and research parks. bring "real life" to a community. affirmative boston medical center to new markets, rehabilitate an historic building on $12 $4.68 2003 llc its campus.. .to house its information technology group. the association for theaterthe purchase and rehabilitation of $6 $2.34 2002 based theaters community development border communities office, industrial, tourist, capital commercial and residential $50 $19.5 2002 company, development projects llc cahaba community lofts.. .retail and office space, a $40 $15.6 2002 development, multi-story parking structure. llc campus large mixed-use facility partners for (including retail, office and $35 $13.65 community residential components as well as development parking facilities) $15 million shopping and cultural clearinghouse center in san diego called market $56 $10.14 2002 cdfi creek plaza. amphitheater for special events. 60,000 square-foot mixed-use real estate projects... saves historic mill.. .by rehabilitating and expanding the existing structure local into residential and commercial initiatives space. the project will house art support galleries... wine bar/coffee $10.8 $4.21 2002 corporation shop... also include 36 residential (lisc) lofts. another project: third floor ballroom will be used.. .for studio, office and performance space for 20071 florida tax review problematic problematic project project tax allocation cde proposed use equity credit award investment subsidy year (in millions) (in millions) itself and other puppet artists.. project begun 16 years ago when hobt renovated the avalon theatre. rehab of former industrial buildings in milwaukee suburb: high quality office building... 500,000 square-feet of office and parking space. retail and office space, theaters and performing arts centers. new 20,000 square-foot, 4-story office condominium building. mhic, llc high quality and attractive $25 $9.75 2002 commercial space and housing. performance center, office and retail space. lofts. greater jamaica local 14-story office building.. office $21 development space, ground floor retail. $8.19 2002 company, inc. impact commercial real estate projects. community 40% of its activities will be $40 $15.6 2002 capital cde, targeted to suburban areas. llc phoenix community retail development and hotel development proj ects... mixed-use commercial and facilities.. .a biotechnology investment campus. corporation 30,000 square-foot state-of-the-art manufacturing plant at the rei new presbyterian health foundation markets (phf) research park. $80 $31.2 2002 investment, llc cytovance biologics, inc. is a biopharmaceutical contract manufacturing company [vol 8.'2 the de-gentrification of new markets tax problematic problematic project project tax allocation cde proposed use equity credit award investment subsidy year (in millions) (in millions) specializing in the production of therapeutic proteins and antibodies from mammalian cell culture. southeast indiana hotel...theater.. .medical arts $1.17 2002 community center development gmri marine research/education coastal laboratory. enterprises, $64 $24.96 2003 inc. first-class commercial/office space. the housing and business infrastructure relating to the harbor development of an $800 million bankshares bio-tech park. $50 $19.5 2003 corporation a commercial loan fund to finance large scale mixed-use projects. restore historic retail center of hospitality portland's downtown for mixed$72.5 $28.28 2003 fund i use... premium hotel rooms. massachusetts housing office and retail space, theatres $90 $35.1 2003 investment and performing arts centers. corporation northeast enhance or improve upon the ohio current activity of the cleveland$47 $18.33 2003 fund, llc cuyahoga county port authority. community retail projects, prestamos, commercial/industrial cdfi, llc development.. .equity funding for $15 $5.85 2003 companies in the life sciences and technology industry. $15 million will go toward southside attracting national retailers to the development former mid city shopping $21 $8.19 2003 enterprises, center.. .attract office and llc commercial development to ... business park. 2007] florida tax review problematic problematic project project tax allocation cde proposed use equity credit award investment subsidy year (in millions) (in millions) wisconsin community finance construction of a ninedevelopment $100 $39 2003 legacy fund, story office building. inc. help finance development of a biotech 300,000 square foot life sciences research research facility next to the new $28 $10.92 2005 center, llc university of hawaii medical school. $65 million for mixed-use property that includes commercial space and 36 loft apartments. local initiatives sophisticated office $90 $35.1 2005 support complex.. .with 500,000 square corporation feet of office and parking spaces.. .many of the tenants will be in the high tech or medical services sectors. [vol. 8:2 the de-gentrification of new markets tax table c properly purposed project descriptions below is a sampling of project descriptions that are considered well designed for target community needs determinations and thus properly purposed projects. the term properly purposed projects is also an apt label. " "community healthcare centers" " "small business development" " "nontraditional financing to support businesses located in lowincome areas" " "child care, head start and other non-profit facilities" " "real estate financing to small businesses, non-profit community centers, day care centers, charter schools, food distributors, health and social service centers..." " "projects ... designed to be more affordable to end users, so that businesses can remain in the low-income communities" " "facilities enhance access for charter schools in distressed areas" " "economic development to hispanic latino communities.. .originate debt investments in ...nonprofit community organizations." " "working capital loans to community based housing developers, and operators of community facilities, ...and senior centers" [source: round two cdfi profiles] 2007] florida tax review florida tax review volume 15 2014 number 4 157 the movement to destroy the income tax and the irs: who is doing it and how they are succeeding by diane l. fahey * i. introduction ............................................................................ 158 ii. a government’s perceived legitimacy empowers it to tax ...................................................................................... 162 a. the lack of a taxing power threatens the early federal government ....................................................................... 162 b. early tax wars ................................................................. 164 iii. why do taxpayers comply with the tax laws? ............ 170 a. the role of sanctions in fostering a taxpaying ethos .... 170 b. creation of a taxpaying ethos in the united states ......... 175 1. early attempts to create a federal income tax . 175 2. the sixteenth amendment and the modern income tax .......................................................... 178 3. transition from a “class tax” to a “mass tax”.......................................................... 182 a. educating the american public about the income tax .................................................... 182 b. changing the taxpayer’s payment method .. 188 iv. the campaign to destroy tax ethos and the income tax ................................................................................. 191 a. the cabal ......................................................................... 191 b. philosophical foundation for reducing income tax rates ........................................................................... 195 c. ronald reagan, massive tax cuts: massive deficits ...... 200 d. more tax cuts and more debt ........................................ 204 e. grover norquist: tax cut enforcer .................................. 206 f. think tanks and media ..................................................... 212 g. the internal revenue service under attack ..................... 216 * associate professor of law at new york law school. j.d., clevelandmarshall college of law, and ll.m. in taxation, georgetown university law center. i am indebted to professor edward purcell for his extensive comments and discussions on an earlier draft, professor stephen j. ellmann for his insights about several key concepts, and professor richard c. beck for his encouragement. 158 florida tax review [vol. 15:4 1. 1998 senate and house hearings into alleged abuses .................................................................. 216 2. congressional restrictions on irs enforcement powers ................................................................. 221 3. erosion in taxpaying ethos .................................. 227 v. conclusion ................................................................................. 231 i. introduction the passage of the sixteenth amendment to the united states constitution 1 in 1913 2 enabled the federal government to enact a progressive federal income tax, 3 thereby acquiring a new source of funds, although the federal income tax initially was fairly limited in scope. from 1913 until 1941, when the united states entered world war ii, only a small number of americans paid the income tax. it was, in effect, a class tax only paid by those at the very top of the income brackets. when the united states entered world war ii the federal income tax was expanded so that most citizens paid something towards it and, after the cessation of hostilities, the federal income tax remained in place as a mass tax. not only did the general public pay the federal income tax, but taxpayers felt that the income tax system was fair. a gallup poll taken during world war ii revealed that eight out of ten americans felt that their taxes were fair. 4 further, as the tax was expanded it became a major source of revenue for the federal government during and after world war ii, thereby enabling the federal government to grow in size and power. however, from the time the income tax was enacted, there has been a movement to repeal or undermine the income tax by financial elites who not only stand to benefit enormously but who are personally and philosophically offended at the idea of being subject to an income tax and an 1. u.s. const. amend. xvi. 2. on february 3, 1913, delaware became the 36th state to ratify the 16th amendment to the u.s. constitution, which authorized the income tax. at the time there were 48 states in the u.s.; therefore, delaware’s ratification of the amendment provided the necessary 75 percent required. see len burman, happy birthday, income tax, tax pol’y center (feb. 5, 2013), http://taxvox.taxpolicycenter.org/ 2013/02/05/happy-birthday-income-tax/; sheldon d. pollack, origins of the modern income tax, 1894-1913, 66 tax law. 295, 320–24 (2013) [hereinafter pollack, modern income tax]. 3. congress added the income tax on individuals in section ii of the underwood tariff act of 1913. the act begins at chapter 16, 38 stat. 114 (1913). section ii begins at 38 stat. 166. section ii, parts a to f, address the obligations of individuals to pay the income tax. 4. robert borosage, talking taxes, the am. prospect (may 22, 2005) [hereinafter borosage, talking taxes], http://prospect.org/article/talking-taxes-0. 2014] the movement to destroy the income tax and the irs 159 expanded and powerful federal government. the wealthy who were dismayed by the federal government’s increasingly prominent role in the lives of ordinary americans recognized that removing, or at least reducing, the federal government’s access to funds would consequently reduce the federal government’s influence and power. these early opponents were careful to hide their agenda. from the beginning they had the common sense to present themselves as defenders of the united states constitution, and not as people looking out for their money. they use right-wing networks to spread their message and control political figures by providing or withholding campaign funds. they have lavishly funded think tanks which all say the same thing, producing an echo effect—all which is done to achieve their goal of eviscerating the power of the federal government to tax business and the wealthy. one way to destabilize and de-legitimize the federal government is to prevent it from acquiring funds. 5 this movement has used a severalpronged approach: (1) attack the legitimacy of the federal government itself, (2) attack the progressive income tax, and (3) attack the manner in which the tax is collected. if you can convince the public that the federal government is at best, incompetent and wasteful, and at worst, evil, then the public will object to funding that government. leading political figures have denounced the income tax as theft and the internal revenue service as an out-of-control, rogue agency. grover norquist, currently the most influential figure in conservative politics, has famously stated that he wants to reduce government to the size that it can be “drowned in a bathtub.” 6 however, our government represents our uniquely american way of life; to say that you wish to destroy this government is to say that you wish to destroy america. if taxpayers do not perceive the government as legitimate and the tax system as fair, then they will find ways to avoid complying with the tax system— which is exactly what the financial elites seek to accomplish. how did we get to the point as a nation that we have changed from viewing the fulfillment of our taxpaying obligations as a patriotic duty to holding our government and the federal income tax in contempt? how did we get to the point that we elect leaders who denounce the government they represent and serve? how did we get to the point that those leaders encourage noncompliance with the law and even violence? 7 5. see marjorie e. kornhauser, legitimacy and the right of revolution: the role of tax protests and anti-tax rhetoric in america, 50 buff. l. rev. 819, 820– 824 (2002). 6. see infra note 246 and accompanying text. 7. see the statement from don fierce, the 1993 director of strategic planning for the republican national committee: “washington is financially and morally bankrupt and because of that it is the glue that binds economic and social 160 florida tax review [vol. 15:4 part ii of this article reviews the united states government’s early struggles to obtain funding. a government unable to perform even basic functions such as defense will lose legitimacy. therefore, steady, reliable revenue is necessary for a government to survive. the articles of confederation, under which the united states operated during the revolutionary war, and for a period of time thereafter until the passage of the united states constitution, did not give the newly created central government the power to collect taxes directly to fund the war and other government operations, but rather the central government could only request that the individual states contribute to the national treasury. further, the articles of confederation only created a legislative branch; there was no provision for an executive or judicial branch. therefore, there was no government agency that could create a structure or system for tax collection and enforcement. without a steady, reliable source of revenue, the government could not directly fund the war effort, nor could it easily borrow funds from other countries. no one is eager to lend to an entity which does not have a determinable means for repayment. the government’s inability to levy or collect taxes almost destroyed our new nation at its inception. the government’s ability to levy and collect taxes and enforce the tax laws under the united states constitution and its ability to put down the early tax rebellions legitimized the federal government. part iii considers how a government can persuade the populace to comply with the tax laws. methods of duress, such as penalties, threats of imprisonment, and audits provide a backstop way of ensuring compliance from recalcitrant taxpayers, but are not effective or practical for a country conservatives. these are people that love their country but hate their federal government. where is the evil empire? the evil empire is in washington.” dan balz & ronald brownstein, storming the gates: protest politics and the republican revival 15 (1996) [hereinafter balz & brownstein, storming the gates]; see also eric kleefeld, bachmann: we’re not going to obey health care law—‘we don’t have to,’ tpm (mar. 15, 2010, 2:34 pm), http://talking pointsmemo.com/dc/bachmann-we-re-not-going-to-obey-health-care-law-we-don-thave-to-video (noting representative bachmann’s belief that using the “deem and pass” parliamentary procedure represents “taxation without representation,” and that, if used, would make an “illegitimate” law that the people could ignore and thus refuse to pay taxes); dana milbank, the republicans who stirred the tea, wash. post, mar. 22, 2010, at a1 (noting that numerous republican elected officials encouraged the raucous tea party protests outside of congress during the health care debate by themselves waiving protest signs and the gadsden “don’t tread on me” flag from the house balcony); ted barrett et al., protestors hurl slurs and spit at democrats, politicalticker (mar. 20, 2010), http://politicalticker.blogs.cnn.com/ 2010/03/20/protesters-hurl-slurs-and-spit-at-democrats/ (recounting how tea party activists protesting the health care bill on capitol hill repeatedly screamed epithets and spit on representatives john lewis, emanuel cleaver, and barney frank). 2014] the movement to destroy the income tax and the irs 161 with a large population and a representative form of government. taxpayers comply voluntarily with their obligations when they have internalized a taxpaying ethos. it was not until world war ii that average americans willingly accepted the imposition of the income tax on them. during world war ii, the general population developed a taxpaying ethos because they developed a sense of trust that the income tax was being fairly administered and that other taxpayers were complying with their taxpaying duties—a social contract basis for tax compliance. additionally, the general population developed a sense of trust that the federal government was using the tax revenues to provide social benefits—a quid pro quo basis for compliance. during world war ii, the federal government used the tax revenues to fund the war effort. subsequent to world war ii, the federal government continued to provide social benefits so that taxpayers continued to demonstrate a tax paying ethos. part iii recounts how the modern income tax became an accepted part of our tax system and explains the means that the federal government successfully employed to create a taxpaying ethos in the general population. however, not all americans supported the imposition of the income tax nor did they support the steadily increasing role the federal government played in the lives of average americans. from the time of franklin d. roosevelt’s presidency, this group has steadily worked to eviscerate the income tax, which would also have the effect of underfunding the federal government, thus reducing its power. part iv explores how a small group of financial elites have used think tanks, the media, and politicians to achieve their goals to undermine faith in the federal government in general, as well as faith in the fairness of the income tax system itself, particularly its administration. from the time of franklin d. roosevelt’s presidency, this group of financial elites has patiently and steadily worked to achieve these goals. their efforts finally began to bear fruit during the reagan administration, which passed the largest tax cuts in united states history, despite the fact that these tax cuts created huge deficits. just as importantly, these financial elites were able to market an anti-tax, anti-government philosophy that has at least superficial appeal and is an easily understood message. they have created distrust in the general population toward federal government and a sense of grievance that the tax system is unfair and that the internal revenue service is a rogue, out-of-control agency victimizing innocent taxpayers. as a result, the internal revenue service is now subject to restrictions that impede its ability effectively to administer the tax system, thereby further eroding the taxpaying ethos and compliance with the tax laws. the article concludes that if this erosion in compliance attitudes continues, it will reach a level of magnitude such that a tipping point will be reached and noncompliance will be an acceptable norm. 162 florida tax review [vol. 15:4 ii. a government’s perceived legitimacy empowers it to tax a. the lack of a taxing power threatens the early federal government without the ability of the federal government to both impose and collect taxes, the founding fathers might have failed in their quest to establish this new nation. a government needs a steady, reliable source of revenue in order to function and establish basic institutions such as a military to defend against a foreign enemy and protect the borders, a state department to negotiate trade treaties with other countries, and a treasury department to manage a currency. reasonable minds can differ as to the proper role and scope of the federal government, but even those of the libertarian persuasion concede that a federal government serves a valid purpose and must exist to provide basic functions. 8 great britain was one of the greatest powers at the time of our revolutionary war, and in order for our army to prevail, political fervor and a sense of justice might have been necessary, but not sufficient: an army needs guns, clothing, and food—all of which require money. the british were able to deploy 25,000 experienced, well-equipped troops 9 in the field while “the continental congress struggled to [maintain] an army of 10,000 men.” 10 under the articles of confederation, the continental congress could spend money but did not have the power to levy or collect taxes; instead, it had to rely on the individual states to send funds to the central government. 11 8. see the libertarian party platform as adopted at the convention of may 2012, at las vegas, nevada, wherein the libertarian party formally acknowledges the need for the government to provide a military (section 3.1 of statement of principles), a department of state (section 3.3 of statement of principles), and a judicial system to protect property and other rights (section 1.5 of statement of principles). libertarian party platform, libertarian party, http://www.lp.org/ platform (last visited oct. 22, 2013). 9. by the time of the american revolution, great britain already had an efficient tax collection system in place which enabled great britain to easily finance its war. see arthur j. cockfield, how tax law created the modern world, presentation at the university of baltimore annual meeting of the law and society association (july 8, 2006) [hereinafter cockfield, tax law] (unpublished draft for comments) (on file with author). 10. simon johnson & james kwak, white house burning 15–16 (2012) [hereinafter johnson & kwak, white house burning]. 11. id. at 21 (citing articles of confederation of 1781, art. viii (“congress could assess contributions to the ‘common treasury, which shall be supplied by the several states, in proportion to the value of all land within each state, granted to, or surveyed for, any person,’ but ‘the taxes for paying that 2014] the movement to destroy the income tax and the irs 163 without a reliable, steady source of revenue, the new nation faced tremendous difficulty in supplying the continental army. 12 in 1779, john jay, president of the second continental congress, 13 “exhorted” the states to contribute to the central government in support of the war: “recollect that it is the price of the liberty, the peace[,] and the safety of yourselves and posterity, that now is required.” 14 however, without an executive branch “the central government had no enforcement powers over the states and could not compel” the states to contribute. 15 to compensate for the shortfall in funds from the states, the continental congress issued paper money in order to pay the soldiers and to pay for supplies, but without funds backing up the continental currency, it fell in value. 16 due to a lack of basic supplies such as food, clothing, and shelter, “2,500 men died at valley forge,” and “[a]nger over irregular pay ... contribute[d] to the pennsylvania mutiny of 1783, which prompted congress to relocate from philadelphia to princeton, new jersey.” 17 not only could the central government not depend on tax revenues from the states, it could not easily borrow from other countries if repayment proportion shall be laid and levied by the authority and direction of the legislatures of the several states, within the time agreed upon by the united states, in congress assembled.’”)). the articles of confederation were created on november 15, 1777; however, the document was not ratified by the 13 founding states until march 1, 1781. nevertheless, between the dates of creation and ratification, the continental congresses acted as if the articles were controlling. 12. id. at 16. 13. the first continental congress met on september 5, 1774; the second continental congress met on may 10, 1775. after the articles were actually ratified on march 1, 1781, the term used to describe congress was the united states in congress assembled. the last president of the united states in congress assembled was cyrus griffin who resigned in november 1788—shortly before the united states constitution was ratified on march 4, 1789. 14. johnson & kwak, white house burning, supra note 10, at 21 (citing john jay, circular letter from congress of the united states of america to their constituents, september 13, 1779, in 15 journals of the continental congress, 1774-1779, at 1052, 1062 (1909)). 15. id. the articles of confederation only provided for a federal legislative body; no provision was made for an executive or judicial branch (the state courts were to hear any federal issues). in particular, the lack of an executive branch hampered the continental congress’s ability to meet the financial demands of the war. id. 16. the credit of the united states was so poor that in the 1780s, “some claims on the . . . government could be bought for less than 15 cents on the dollar.” id. at 15. 17. id. at 16. 164 florida tax review [vol. 15:4 from tax revenues could not be assured. 18 fortunately for the united states, france was contemporaneously embroiled in a power struggle with great britain, and therefore willing to lend the central government money (and also provided ships and troops), enabling the americans to ultimately prevail in their quest for independence. 19 the treaty of paris ended the war on september 3, 1783. 20 b. early tax wars however, defeating great britain did not ensure survival as a nation. history books are littered with examples to this present day of countries that succeeded in throwing off colonial rule only to founder when attempting to self-govern. not only did the united states have british sympathizers still within its borders, but the budding nation would also have to convince even those who had fought the british that this new government had the authority to rule, including the power to tax. some of the biggest challenges to the new government’s authority came from veterans of the american revolutionary war, particularly over the new government’s authority to levy and collect taxes. the two most significant, early threats to the new nation arose from shays’ rebellion and the whiskey rebellion. after the revolutionary war ended, the states had to pay not only their own debts, but also contribute to payment of the central government’s war debt. however, while parts of the country started to recover economically from the war, the rural regions of the country were struggling. merchants on the eastern seaboard were relatively prosperous, but farmers in remote areas survived on subsistence farming, and farmers, particularly in those areas, began to rebel against taxes imposed by the states to pay their debts. the most well-known rebellion was shays’ rebellion in massachusetts, named after its leader, daniel shays. 21 the massachusetts assembly “had taken an aggressive approach” to paying its war debts, which benefited the “few who held interest-bearing state notes.” 22 taxes in massachusetts were already high, and when the state 18. spain and the netherlands were also persuaded to lend money despite the high risk of nonpayment. id. 19. id. 20. the treaty of paris was signed at the hotel d’york (now 56 rue jacob) on september 3, 1783. john adams, benjamin franklin, and john jay signed on behalf of the united states; david hartley signed on behalf of great britain. the united states in congress assembled ratified the treaty on january 14, 1784. 21. see william hogeland, the whiskey rebellion 52–53 (2006) [hereinafter hogeland, whiskey rebellion]. daniel shays had been a captain in the continental army. cockfield, tax law, supra note 9, at 28. 22. hogeland, whiskey rebellion, supra note 21, at 53. the massachusetts assembly paid interest on the notes based on their face value, so that 2014] the movement to destroy the income tax and the irs 165 decided to pay off the war debt quickly, the taxes became even higher. those who could not pay the taxes, such as farmers and small businesses, saw their property sold at foreclosure. after petitions and meetings did not provide relief, the debtors staged a court riot at northampton in 1786 and attempted to seize a federal arsenal in springfield in 1787. 23 massachusetts repealed the onerous taxes, 24 but 14 of the participants were subsequently tried and sentenced to death for treason (although they were pardoned before execution). 25 at the same time, americans wanted to push west and develop the land. they hoped that the mississippi river would open up trade, but the states were not willing to invest in the infrastructure necessary to develop the west or the mississippi river, nor were the states able to stop the conflict between settlers and indians. 26 the central continental government did not have the financial means to accomplish the settlers’ goals either. furthermore, great britain was encouraging indians to attack the settlers. 27 as a result, settlers in ohio, kentucky, western virginia, and north carolina considered declaring themselves as independent or aligning with spain. 28 in an alarmed response, even those who had been deeply committed to state sovereignty and opposed a strong central government began to recognize that a federal government with the power to raise money through taxation was paramount to halting insurrection, assuring settlers’ safety in the west, and assisting in the development of trade. 29 state delegates met in philadelphia from may 14 to september 17, 1787, initially intending to amend the articles of confederation but ended up creating the constitution of the united states. one of the most contentious issues was whether the federal government or solely the individual states even if a $1 note, on which interest of 25 percent was to be paid, had depreciated in value to only $0.02, the note holder still received the $0.25 interest payment. the tax levied by the state to pay the interest on these notes was onerous enough, but massachusetts exacerbated the burden by deciding to pay off the principal amount of the notes raising taxes even more. farmers in particular felt victimized by the creditor class that held the notes and was being paid from the taxes. id. 23. id. 24. id. 25. cockfield, tax law, supra note 9, at 28 (citing treason trials in the united states, 46 alb. l.j. 345, 345 (1892)). 26. hogeland, whiskey rebellion, supra note 21, at 56–57. 27. id. at 57. 28. id. the idea of forming an alliance with spain was not so farfetched given that spain had provided some financial support during the revolutionary war. 29. id. at 56, 57–62. 166 florida tax review [vol. 15:4 would have the power to tax. 30 george washington was reluctant to serve as the new nation’s first president if the federal government did not have the power to tax but instead had to rely on the states to raise and send money to the federal government. in a letter to thomas jefferson, george washington stated that he was willing to accept “any tolerable compromise” except for the amendment preventing direct taxation. 31 as also noted by one of the participants, “[tax] connects with . . . almost all other powers and [tax] at least will in process of time draw all other[s] after it.” 32 in other words, the 30. cockfield, tax law, supra note 9, at 29 (citing calvin h. johnson, righteous anger at the wicked states: the meaning of the founders’ constitution 151 (2005)). 31. letter from george washington to thomas jefferson (aug. 31, 1788), in 30 the writings of george washington from the original manuscript sources, 1745-1799, at 79, 82–83 (john c. fitzpatrick ed., 1939) the merits and defects of the proposed constitution have been largely and ably discussed. for myself, i was ready to have embraced any tolerable compromise that was competent to save us from impending ruin; and i can say, there are scarcely any of the amendments which have been suggested, to which i have much objection, except that which goes to the prevention of direct taxation; and that, i presume, will be more strenuously advocated and insisted upon hereafter, than any other. id. 32. cockfield, tax law, supra note 9, at 30 (second and third alteration in original) (citing brutus i, new york journal (oct. 18, 1787), in 13 the documentary history of the ratification of the constitution 408 (merrill jensen et al. eds., 1976)). most historians believe that “brutus” was robert yates, who was a new york delegate at the constitutional convention held in philadelphia in 1787, and also a delegate to the new york state ratifying convention in poughkeepsie in 1788. he opposed the adoption and ratification of the constitution, in great part because he feared that a powerful federal government would overwhelm the power of the individual states. one of the federal powers that gave him grave concern was the proposed power to tax. his 16 essays in rebuttal to the federalist papers were published in the new york journal between 1787 and 1788. the essays were addressed to the citizens of the state of new york. see introduction to brutus i, new york journal (oct. 18, 1787), in 13 the documentary history of the ratification of the constitution 411 (john p. kaminski et al. eds., 1981). the legislative power is competent to lay taxes, duties, imposts, and excises;—there is no limitation to this power, unless it be said that the clause which directs the use to which those taxes, and duties shall be applied, may be said to be a limitation: but this is no restriction of the power at all, for by this clause they are to be applied to pay the debts and provide for the common defence and general welfare of the united states; but the legislature have authority to contract debts at their discretion; they are the sole judges of what is necessary to provide for the common defence, 2014] the movement to destroy the income tax and the irs 167 power over taxation was the foundation for all other government powers. while virginia debated whether to ratify the bill of rights, james madison’s source said that the opposition was reducible “to a single point, the power of direct taxation.” 33 nevertheless, the united states constitution was ratified on march 4, 1789, replacing the unsuccessful articles of confederation under which the new nation had been governed since 1776. 34 the new constitution gave and they only are to determine what is for the general welfare; this power therefore is neither more nor less, than a power to lay and collect taxes, imposts, and excises, at their pleasure; not only [is] the power to lay taxes unlimited, as to the amount they may require, but it is perfect and absolute to raise them in any mode they please. no state legislature, or any power in the state governments, have any more to do in carrying this into effect, than the authority of one state has to do with that of another. in the business therefore of laying and collecting taxes, the idea of confederation is totally lost, and that of one entire republic is embraced. it is proper here to remark, that the authority to lay and collect taxes is the most important of any power that can be granted; it connects with it almost all other powers, or at least will in process of time draw all other after it; it is the great mean of protection, security, and defence, in a good government, and the great engine of oppression and tyranny in a bad one. id. at 414–15. 33. james madison’s source was hardin burnley, a member of the virginia house of delegates. in a letter to james madison dated november 28, 1789, burnley advised madison regarding the problems in obtaining the virginia house’s approval of the bill of rights. burnley believed that at least some of the opposition to the bill of rights was really opposition to the u.s. constitution, in particular the power of congress to tax. in his letter to george washington on december 5, 1789, madison included portions of burnley’s letter. see 12 the papers of james madison 17891790, at 455–56, 458–59 (charles f. hobson et al. eds., 1979). 34. see robert n. clinton, a brief history of the adoption of the united states constitution, 75 iowa l. rev. 891 (1990) (providing a concise explanation of the ratification of the articles of confederation and then later the united states constitution). the new constitution also created executive and judicial branches in addition to the existing legislative branch. george s. boutwell, whom abraham lincoln appointed as the first commissioner of internal revenue during the civil war (and who later served as secretary of the treasury under ulysses s. grant), observed that if the articles of confederation had provided the federal government with the power to tax, the federal government might well have continued to operate under the articles. boutwell noted this in an essay he wrote in 1895 in which he criticized the u.s. supreme court’s decision to strike down the income tax of 1894 as unconstitutional. by the articles of confederation the general government had no power to levy taxes, and yet it had power to incur debts. at 168 florida tax review [vol. 15:4 congress the power “to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defence and general welfare,” and “to borrow money on the credit of the united states.” 35 when washington took the oath of office on april 30, 1789, the united states was in dire fiscal condition. 36 in 1790, the federal government owed $54 million, of which $12 million was owed to foreigners. in addition, the individual states had debts of $25 million. yet, between 1784 and 1789, the continental congress had been able to raise only $4.6 million, and half of that was borrowed. 37 the first tax that the federal government imposed was the tax on whiskey at a rate of 7 cents per gallon. 38 secretary of the treasury alexander hamilton presented the idea to congress as a tax on a luxury item, and congress liked the idea because it would not tax landowners. 39 congress might not have fully appreciated the fact that the whiskey tax was not simply a tax on a commodity that people bought and consumed as a luxury. many farmers, especially in the western areas of the country, had little access to hard cash but rather, relied on barter. landlords would take advantage of poor tenant-farmers and either demand astronomical amounts of crops or refuse to take crops at all in payment of rent. however, whiskey was as good as hard cash, and farmers could use whiskey to pay down debts, and laborers were often paid in whiskey rather than cash. 40 for these poor people, taxing whiskey was practically a tax on income. distillers in western pennsylvania in particular relied on the manufacture and sale of whiskey as their principal the end of ten years its insolvency was apparent, and its incapacity, as a government, had been demonstrated to the thoughtful men of the country. the downfall of the [articles of] confederation was due to its inability to levy taxes; and the constitution of the united states had its rise in that experience. with the power to levy taxes, even with all its other infirmities on its head, the [articles of] confederation might have outlasted, and it is probable that it would have outlasted, the eighteenth century. george s. boutwell, the income tax (pt. 1), 16 n. am. rev. 589, 590–91 (1895) [hereinafter boutwell, income tax]. 35. u.s. const. art. i, § 8. 36. johnson & kwak, white house burning, supra note 10, at 15. 37. id. (citing davis rich dewey, financial history of the united states 57 (2d ed. 1903)). 38. cockfield, tax law, supra note 9, at 29. 39. hogeland, whiskey rebellion, supra note 21, at 62–64. whiskey was the preferred, “cheap drink of the laboring classes.” id. at 63. 40. id. at 67. 2014] the movement to destroy the income tax and the irs 169 source of income. 41 therefore, the whiskey tax was a significant burden on small farmers and laborers and generated outrage as a result. in the fall of 1791, gangs on the western frontier began attacking the tax collectors, and over the course of the next two years, the attacks morphed from isolated, albeit vicious, attacks to an organized, regional movement that was determined to resist federal authority in general. 42 many of the perpetrators were war veterans who were farmers, laborers, and hunters who were expert marksmen. 43 the rebels were not necessarily opposed to taxation in general, and many had fought in the revolutionary war; however, they resented a system which seemed to redistribute wealth from small farms and businesses to a few wealthy federal bond holders. 44 for some, the rebellion had morphed into a “secessionist insurgency” against the united states itself. 45 in the fall of 1794, washington raised 13,000 federal troops and crushed the rebellion. 46 both george washington and alexander hamilton believed that suppressing the rebellions had unified the country and helped the nation to flourish financially. 47 in a letter to his sister-in-law about the whiskey rebellion, hamilton expressed his belief that “the insurrection will do us a great deal of good and add to the solidity of everything in this country.” 48 in a subsequent letter to her, hamilton boasts that, “our insurrection is most happily terminated. government has gained from it reputation and strength.” 49 the new federal government had proven that it could perform and was perceived by americans as having legitimacy. 41. cockfield, tax law, supra note 9, at 29. the best whiskey was produced by small distillers in the west, “especially from the forks of ohio, whose ‘monongahela rye’ possessed consistent strength and purity. the region achieved brand recognition. its whiskey was known by name in philadelphia and new orleans.” hogeland, whiskey rebellion, supra note 21, at 66. 42. hogeland, whiskey rebellion, supra note 21, at 7. 43. id. at 7–8. 44. id. at 8–9. 45. id. at 7. 46. id. of the original 35 rebels who were charged with treason, two men were convicted of treason: john mitchell and philip vigol; however, both men were pardoned by george washington. cockfield, tax law, supra note 9, at 29. 47. hogeland, whiskey rebellion, supra note 21, at 239–40. 48. id. at 276 (quoting letter from alexander hamilton to angelica church (oct. 23, 1794)). 49. id. (quoting letter from alexander hamilton to angelica church (dec. 8, 1794)). 170 florida tax review [vol. 15:4 iii. why do taxpayers comply with the tax laws? a. the role of sanctions in fostering a taxpaying ethos what motivates taxpayers to comply with their tax filing and payment responsibilities? one way to understand this is to consider three types of sanctions: symbolic, instrumental, and expressive. professor michael kirsch has examined the imposition of sanctions from an instrumental, expressive, and symbolic perspective in the context of taxmotivated expatriation, but which has broader implications and can be applied here. 50 symbolic sanctions do not seek to change or stop the target’s undesirable behavior; instead, the purpose of symbolic sanctions is to reassure the public that “something” is being done about the problem. 51 instrumental sanctions are intended to change the target’s behavior by changing the cost-benefit analysis. expressive sanctions are intended to change the target’s behavior by changing the target’s norms. 52 an example of a symbolic sanction is legislation banishing expatriates, which sends the signal that congress is cracking down on tax cheats. 53 expatriates are a small, yet visible and controversial group; enacting legislation designed to punish them provides the public with a sense of satisfaction that something has been accomplished regarding tax evasion, despite the fact that expatriation is a technique rarely used to avoid tax. 54 symbolic sanctions might buttress or reinforce existing taxpayer compliance norms and signal to other taxpayers that they are not “chumps” for fulfilling their tax obligations. however, the danger with symbolic sanctions is that they are only symbolic. if society in general, and the government in particular, merely engages in empty gestures designed to placate the public, eventually the public becomes cynical. no one likes to be played for a fool. instrumental sanctions attempt to modify behavior by changing the cost-benefit analysis. 55 for example, taxpayers who do not properly file and pay their taxes are subject to sanctions in the form of penalties, 56 audits, and 50. see michael s. kirsch, alternative sanctions and the federal tax law: symbols, shaming, and social norm management as a substitute for effective tax policy, 89 iowa l. rev. 863 (2004) [hereinafter kirsch, alternative sanctions]. 51. id. at 921. 52. id. 53. id. at 923–25. 54. id. at 876 (“more than 255,000,000 million [sic] individuals hold united states citizenship, yet, on average, fewer than 600, or 0.00023%, renounce or otherwise lose citizenship annually.”). id. 55. id. at 893–912. 56. these include penalties for failure to file, failure to pay, underpayment, civil fraud, and criminal fraud. 2014] the movement to destroy the income tax and the irs 171 incarceration. 57 (taxpayers who fail to pay what is owed must also pay interest on the underpayment, but that is not really punitive in nature; rather, the interest is intended to prevent the taxpayer from receiving an interest-free loan from the federal government during the period from when the payment is due until the payment is made.) therefore, a taxpayer who contemplates cheating on his taxes must weigh the benefit of not paying the tax against the costs associated with being audited or paying penalties. the cost-benefit analysis underlying instrumental sanctions assumes that taxpayers will always act as rational wealth maximizers. 58 in order to act in a manner that rationally maximizes wealth, taxpayers must have all the necessary and accurate information when deciding how to act. however, taxpayers do not. for example, taxpayers assume that the risk of being audited is much higher than it actually is. 59 (human beings tend to overemphasize information that comports with what they already believe and tend to dismiss information that does not.) 60 the audit rate was 0.49 percent in 2000 and 1.03 percent in 2007. 61 (of course, taxpayers are not a monolith, but represent people with very diverse backgrounds. the compliance rate for the self-employed is very low: sole proprietors report on 43 percent of their business income. 62 entrepreneurs also tend to be risk-takers. therefore, that group might well minimize the risk of being audited or not being able to talk their way out of any negative consequences.) however, even though taxpayers believe that the risk of being audited is much higher than it actually is, that misperception alone does not explain taxpayer compliance. 57. although the possibility of incarceration for criminal tax fraud is remote, several high profile cases, such as richard hatch from survivor and actor wesley snipes, perhaps create the impression that incarceration for criminal tax fraud is more common than it actually is. this article will focus more on penalties and audits, as they are the two most common instrumental sanctions. 58. richard lavoie, patriotism and taxation: the tax compliance implications of the tea party movement, 45 loy. l.a. l. rev. 39, 45–46 (2011) [hereinafter lavoie, patriotism and taxation]. 59. richard lavoie, flying above the law and below the radar: instilling a taxpayer ethos in those playing by their own rules, 29 pace l. rev. 637, 640– 42 (2009) [hereinafter lavoie, flying above the law]. tax protestors have begun to share this information with each other and some are now openly challenging the irs to take action against them in the confident belief that nothing will be done. 60. id. at 675 (citing clifford r. mynatt et al., confirmation bias in a simulated research environment: an experimental study of scientific inference, 29 q.j. experimental psychol. 85–95 (1977)). 61. id. at 641 note 20 (noting that “[o]f course the audit rate is somewhat understated as it omits errors detected by information matching and other computer screening techniques that are typically rectified through written correspondence only”). id. 62. 1 taxpayer advocate serv., national taxpayer advocate 2012 annual report to congress 7 (2012). 172 florida tax review [vol. 15:4 studies have revealed that the levels of risk aversion in taxpayers to being audited are not sufficiently high to account for compliance. 63 this is not to say that instrumental sanctions do not have their place or that they do not induce some measure of tax compliance. studies have demonstrated that tax compliance increases as penalties and enforcement activity escalate, at least up to a point. 64 in addition, the presence of instrumental sanctions might reinforce other norms that taxpayers hold that encourage them to comply. 65 furthermore, audits and penalties reassure compliant taxpayers that the government is monitoring the system and endeavoring to detect and punish cheaters. however, the government must walk a fine line when reassuring the public that cheaters are being punished. if the public perceives that tax evasion is rampant, then compliant taxpayers may well believe that they are fools to report their taxes accurately. there is evidence that the “publicity about taxpayer evasion and government efforts to stop evasion seem less likely to have pernicious effects on society when the government publicizes specific examples of noncompliance, as compared to general stories about rampant tax cheating.” 66 most importantly, the cost-benefit model does not fully explain the level of voluntary compliance in the united states because most people do not base every decision on pure economics or the potential for maximizing wealth. rather, people want and need to satisfy a myriad of values and goals. further, a tax system cannot be based solely on threats and coercion—at least not in a country of this size and with a democratic form of government. the government needs taxpayers to fulfill their obligations in a spirit of cooperation for tax administration to be effective. one way for the government to foster this cooperation is to create a tax morale that favors 63. see lavoie, flying above the law, supra note 59, at 642 (citing james andreoni, brian erard & jonathan feinstein, tax compliance, 36 j. econ. literature 818, 846 (1998) (noting that misperceptions of audit rate cannot explain observed compliance rate); benno torgler, tax compliance and tax morale: a theoretical and empirical analysis 4 (2007) (noting that estimated level of risk aversion in the united states would need to be much higher to explain the compliance rate)). 64. id. at 647. 65. see leandra lederman, the interplay between norms and enforcement in tax compliance, 64 ohio st. l.j. 1453 (2003) [hereinafter lederman, tax compliance] (demonstrating that enforcement sanctions such as auditing and penalties can buttress norms-based appeals for compliance). 66. leslie book, the poor and tax compliance: one size does not fit all, 51 u. kan. l. rev. 1145, 1150, note 18 (2003) (citing steven m. sheffrin & robert k. triest, can brute deterrence backfire, in perceptions and attitudes, in 2 taxpayer compliance 193, 210, 212–13 (“suggesting that general stories about the tax gap likely lowers morale and leads people to believe others are cheating, but that particularized stories are not likely to have a similar effect”)). 2014] the movement to destroy the income tax and the irs 173 compliance. tax morale represents a conglomeration of factors that have an impact, either positive or negative depending on the circumstances, on taxpaying attitudes. societies with high tax morale will have high voluntary compliance, and societies with low tax morale will have widespread evasion and cheating. high tax morale fills in the gap, so to speak, as to what explains taxpayer compliance in the united states to the extent that penalties and audits do not. society can create high tax morale through the use of expressive sanctions. expressive sanctions seek to change the target’s behavior by changing or altering norms. 67 the goal of the expressive form of sanctions is to encourage the target to internalize a new norm, thereby causing the target to consequently change its behavior. 68 robert mcadams’ esteem-based theory of norm development theorizes that the enactment of expressive legislation publicizes to the relevant community that a consensus on certain behavior exists. after individuals become aware of this consensus, they are more likely to experience a gain in esteem by complying with the norm (or alternatively lose esteem by failing to comply). for purposes of expressive sanctions, “the term ‘social norms’ means ‘informal social regularities that individuals feel obligated to follow because of an internalized sense of duty, because of a fear of external non-legal sanctions, or both.’” 69 simply put, if a sufficient number of people in a social group or community adopt a norm, those who comply with it gain esteem and those who violate the norm garner disapproval. 70 lavoie uses the term “tax ethos” to describe this social norm. tax ethos connotes a widely held social belief (an internalized norm) that one should not cheat on his or her taxes. 71 [a] taxpaying ethos represents a pervasive cultural norm that is internalized by members of the society and therefore strongly influences their behavior in favor of faithfully complying with the tax laws.” 72 stated another way, taxpaying ethos is a descriptive phrase identifying a cultural 67. kirsch, alternative sanctions, supra note 50, at 913. 68. see, e.g., diane l. fahey, can tax policy stop human trafficking?, 40 geo. j. int’l l. 345 (2009). 69. kirsch, alternative sanctions, supra note 50, at 913, n.219 (citing richard h. mcadams, the origin, development, and regulation of norms, 96 mich. l. rev. 338, 340 (1997)); see also id. (citing robert cooter, expressive law and economics, 27 j. legal stud. 585, 587 (1998) (stating that a social norm is “a consensus in a community concerning what people ought to do . . . [that] affects what people actually do”) (alteration by kirsch)). id. 70. id. at 917–18. 71. lavoie, flying above the law, supra note 59, at 642–43. 72. id. at 643. 174 florida tax review [vol. 15:4 dynamic that values adhering to (and disfavors disobeying) the tax laws, while tax morale refers to the various factors that may contribute to creating such a taxpaying ethos within a particular society. 73 as lavoie notes, tax ethos can be one of the factors that affects tax morale in that if there is a strong tax ethos in a society, tax morale should be correspondingly higher. we need a tax ethos because we cannot rely only on threats and the fear of punishment to compel compliance. not only would this require a much larger irs, but would also create an atmosphere that is unconducive for tax morale. two perceptions or beliefs can create the foundation for a taxpaying ethos among the general public if the beliefs are widely held: a social contract and quid pro quo. a social contract exists in a society when taxpayers not only perceive a tax as legitimate or fair and fairly collected (a type of trust in their government), but also that others are honestly reporting and paying their fair share of taxes (a type of trust in other members of society). quid pro quo exists when taxpayers believe that their taxes are being used to provide benefits to the taxpayer or to society in general— benefits that the taxpayer believes have value or worth (again, a type of trust in government). as noted by lavoie, “[t]axpayers’ willingness to pay taxes increases if they understand the implicit quid pro quo received in exchange for their taxes and they if [sic] perceive that others are reciprocating by paying their share of the tax burden as well.” 74 lavoie also states with regard to the quid pro quo aspect of tax ethos that this relationship continues to hold true even when the quid pro quo takes the form of “public goods,” which the government would provide to all citizens even if a particular taxpayer did not contribute toward them. thus, individuals perceive benefits and are willing to pay for government activities even if the benefits are amorphous with no direct link to the individuals, like government grants for pure scientific research. 75 as discussed infra, there is a deliberate campaign to destroy tax ethos with the purpose of destroying the progressive federal income tax. the social contract basis for taxpaying ethos can be eroded if taxpayers believe that others are not paying their fair share or if the nontaxpaying norm of a subgroup gains widespread acceptance. part iv of this article details how 73. id. 74. lavoie, patriotism and taxation, supra note 58, at 46. 75. id. 2014] the movement to destroy the income tax and the irs 175 there has been a deliberate campaign by a segment of society to destroy taxpayers’ belief in the social contract through both of the above-mentioned methods. this same small segment also seeks to create doubt in taxpayers that their government is using tax revenues responsibly. b. creation of a taxpaying ethos in the united states 1. early attempts to create a federal income tax prior to enactment of the modern federal income tax in 1913, 76 the federal government derived most of its revenues primarily from tariffs, customs duties on imports, from some internal excises taxes (for example on the sale of alcohol and tobacco), and from the sale of public lands. however, during times of crisis, such as war, the federal government had to find other sources of revenue in order to meet the expanded demands on the federal government. for example, during the war of 1812, revenues from tariffs dropped during the pre-war embargo against great britain and during the war itself. 77 secretary of the treasury alexander j. dallis suggested “enactment of an inheritance and income tax which he thought could ‘be easily made to produce $3 million.’ however, the war ended before the proposal could be enacted . . . .” 78 later, from 1861 to 1865, 79 the country was embroiled in a civil war, and the federal government’s expenditures rose from $67 million in 1861 to $1.3 billion by 1865. 80 the federal government could not raise such large sums from tariffs and excise taxes alone. therefore, the civil war saw the country’s enactment of the first income tax (at least in the north), 81 the rates of which were steadily raised during the war as the need for funds increased. 82 the general public tolerated the tax because it was perceived as 76. underwood tariff act, ch. 16, 38 stat. 114 (1913). 77. johnson & kwak, white house burning, supra note 10, at 6. 78. harold dubroff, the united states tax court: an historical analysis 2 (1979) [hereinafter dubroff, tax court]. 79. actual hostilities commenced when confederate forces attacked fort sumter in south carolina on april 12, 1861. robert e. lee surrendered at appomattox on april 9, 1865, and president andrew johnson issued a proclamation on may 9, 1865, proclaiming an end to hostilities. see david j. eicher, the longest night: a military history of the civil war 819 (2001); see also important proclamations, n.y. times (may 10, 1865), http://www.nytimes.com/ 1865/05/10/news/important-proclamations-belligerent-rights-rebels-end-all-nationswarned-against.html. 80. dubroff, tax court, supra note 78, at 2. 81. id. at 3 (citing act of aug. 5, 1861, ch. 45, § 49, 12 stat. 309). 82. initially, incomes below $600 were exempt from the tax; incomes between $600 and $10,000 were taxed at a rate of 3 percent; incomes above $10,000 176 florida tax review [vol. 15:4 a temporary measure required by the exigencies of war and because most of the burden was shouldered by the more affluent. this first federal income tax was not a significant source of government revenues; in 1866, at the tax’s height, it raised $73 million out of federal revenues totaling $559 million. 83 furthermore, within a few years of the war’s end the country had returned to a budget surplus, and, under pressure from banking and commercial interests in the northeast, the income tax was repealed, effective 1872. 84 the shortlived nature of the civil war-era income tax and its limited scope (both in terms of the amount of revenue generated and the number of taxpayers subject to it) were factors that were not conducive to creating a social contract or quid pro quo basis for compliance in the general public. 85 almost immediately after the repeal of the civil war’s income tax, the country experienced a severe recession and financial panic in 1873 which hit farmers in the south and midwest particularly hard because prices for their crops dropped, whereas the cost of feed, fuel, and other supplies did not. no sooner had the country begun to recover from the recession of 1873 when it was caught in the grip of a depression, which again hurt farmers and were taxed at a rate of 5 percent. id. (citing act of july 1, 1862, ch. 119, § 90, 12 stat. 473). as the war progressed and the federal government needed more funds, the rates were increased so that by 1865, incomes between $600 and $5,000 were taxed at a rate of 5 percent and incomes above $5,000 were taxed at a rate of 10 percent. id. (citing act of mar. 3, 1865, ch. 78, 13 stat. 479). 83. id. at 3. by 1872, when the tax was repealed, it raised $14 million out of federal revenues totaling $374 million. id. 84. id. at 3–4 (citing act of july 14, 1870, ch. 255, § 6, 16 stat. 257). prior to its repeal, the amount of income exempt from tax was steadily increased and the tax rates were reduced. see id. (citing act of mar. 2, 1867, ch. 169, § 13, 14 stat. 478; act of july 14, 1870, ch. 255, §§ 6, 8, 16 stat. 257, 258). merchants, in particular, preferred tariffs and excise taxes because these taxes made locally produced goods cheaper and more attractive to buyers than the imported goods on which these taxes were imposed. the republican party controlled congress for most of the late nineteenth century. industrial and manufacturing interests controlled the postwar republican party and these interests preferred “high import tariffs to protect themselves from foreign competition.” however, these tariffs increased the cost of consumer goods, which hurt lowerand middle-income people, “especially those in the south and west who did not benefit from protectionism.” as a result of these tariffs, the federal government had a “consistent budget surplus from the end of the war through 1893.” johnson & kwak, white house burning, supra note 10, at 35–36. 85. see bryan t. camp, tax administration as inquisitorial process and the partial paradigm shift in the irs restructuring and reform act of 1998, 56 fla. l. rev. 1, 37–44 (2004) [hereinafter camp, tax administration], (detailing the history of the unique collection problems associated with the civil war-era income tax). 2014] the movement to destroy the income tax and the irs 177 small businesses in particular. 86 the first attempt at a permanent income tax arose from a populist and agrarian movement rebelling against the government’s reliance on tariffs and internal excise taxes to fund its activities, as well as the regular presence of economic recessions and depressions. tariffs favored the merchant class because it made domestic goods more attractive over imported goods. however, tariffs tax consumption, and therefore, fall more heavily on lower-income people who must use a greater percent of their income to purchase goods (the same being true for internal excise taxes). in addition, economic power was increasingly concentrated in the hands of banks, railroads, and other industrial and financial interests. the populist movement wanted “cheap money, regulation or [break-up] of the monopolies, and the imposition of an income tax.” 87 out of this economic turmoil arose a coalition of populists, southern and western democrats, and some moderate republicans who joined together in 1894 to enact what was hoped to be the first permanent federal income tax. 88 this income tax was intended to reduce tariffs and compensate for the shortfall by taxing the wealthy (although it only taxed the wealthiest 2 percent of the population and at a rate of 2 percent, with an exemption of $4,000). 89 this first permanent income tax was unusual in that it arose because the public (at least, the less-affluent members of the public) demanded that the government impose the tax (a bottom-up demand, so to speak). previously, taxes were usually proposed by the government and then imposed on the public (a top-down demand, so to speak). true, even from the days in great britain dating back to 1100 with the charter of liberties 90 and from our country’s early history, the masses of citizens had demanded a say in the government’s imposition of a tax. however, this demand found expression in the populace wanting a voice or representation in the government which then devised and imposed the tax. conversely in this instance, the public itself generated the demand for the tax. it was the public, not the government, which was behind the demand for this tax. unsurprisingly, the wealthy denounced the tax as “socialism, communism and devilism” devised by “‘the professors with their books, the socialists with their schemes,’ and ‘the anarchists with their bombs.’” 91 86. dubroff, tax court, supra note 78, at 4. 87. id. 88. id. (citing act of aug. 27, 1894, ch. 349, § 27, 29 stat. 553). president grover cleveland, “who favored reduced tariffs but opposed . . . an income tax, allowed it to become law without his signature.” id.; see also pollack, modern income tax, supra note 2, at 301–06. 89. dubroff, tax court, supra note 78, at 4–5. 90. the british aristocracy began to demand that the king could not levy taxes without consulting them. see cockfield, tax law, supra note 9, at 6–7. 91. dubroff, tax court, supra note 78, at 5. “in a republic like ours, where all men are equal, this attempt to array the rich against the poor or the poor 178 florida tax review [vol. 15:4 almost immediately, the tax was challenged as unconstitutional in pollock v. farmers’ loan & trust co. 92 on three grounds as: (1) a direct tax instead of “apportioned among the states on the basis of population,” 93 (2) not uniform throughout the u.s. because it exempted incomes under $4,000, 94 and (3) “imping[ing] on the rights of state and local governments by taxing the interest on obligations issued by [those] bodies.” 95 the united states supreme court had held previously “that direct taxes included only land and capitation taxes, 96 and had upheld the constitutionality of the civil war income taxes.” 97 nevertheless, in pollock, the supreme court held that the federal government could not tax state and local obligations, that “taxes on income from real and personal property were direct taxes,” and that the law was “so infected with unconstitutionality” that the whole thing needed to be struck down. 98 2. the sixteenth amendment and the modern income tax for the poor, especially immigrants, economic conditions in the united states at the beginning of the twentieth century only worsened, so that most workers lived in extreme poverty while wealth became against the rich is socialism, communism, devilism . . . .” 26 cong. rec. 6695 (1894) (statement of sen. john sherman). the nonmigrating european feels a parental superiority and duty toward us. european professors announce to american professors, who publish and believe it, the birth of a brand new political economy for universal application. from the midst of their armed camps between the danube and the rhine, the professors with their books, the socialists with their schemes, the anarchists with their bombs, are all instructing the people of the united states in the organization of society, the doctrines of democracy, and the principles of taxation. little squads of anarchists, communists, and socialists cross the ocean and would have us learn of them. no wonder, if their preaching can find ears in the white house. 26 cong. rec. 3564 (1894) (statement of sen. david b. hill). 92. dubroff, tax court, supra note 78, at 5 (citing 157 u.s. 429, modified, 158 u.s. 601 (1895)). 93. id. (citing u.s. const. art. i, § 9). 94. id. (citing u.s. const. art. i, § 8, cl. 1). 95. id. (citing u.s. const. amend. x). 96. id. (citing hylton v. united states, 3 u.s. (3 dall.) 171, 174 (1796)). 97. id. (citing springer v. united states, 102 u.s. 586 (1880)). see also boutwell, income tax, supra note 34, (criticizing the supreme court’s reasoning in pollock that a tax on the rents from land and on income from stocks and bonds was a direct tax). 98. id. 2014] the movement to destroy the income tax and the irs 179 increasingly concentrated in the hands of monopolies. 99 additionally, in 1907, the country experienced another financial crisis with a run on the banks. only the efforts of j.p. morgan, who provided loans to threatened banks, prevented the financial system from collapsing. 100 although republicans controlled the white house, the senate, and the house of representatives, several midwestern republican senators again forged an alliance with democrats who were in favor of a progressive federal income tax. 101 in order to save the payne-aldrich-tariff bill, 102 the conservative republicans had to compromise with the coalition and agree to: (1) “amend the [united states] constitution to permit an income tax without 99. ahmed a. white, the crime of economic radicalism: criminal syndicalism laws and the industrial workers of the world, 1917-1927, 85 or. l. rev. 649, 673–74 (2006). the realities of industrial labor . . . were not only independent aspirations to protest. these conditions reflected themselves in a work-life that was, for many workers, nothing short of a living hell: unremunerative, physically dangerous, and devoid of any intrinsic meaning. in mines, mills, and factories throughout the country, workers toiled long hours for meager pay, often in places far too hot or cold, amid noisy machinery, suffused in noxious gasses and dust, in dank and darkness, and under the control of evermore rigorous and authoritarian structures of control. this reality was overlaid by more immediate causes of dissatisfaction with the lived experience of industrial capital: chronic poverty, which was often reflected in inadequate housing, malnutrition, and exposure to disease; disenfranchisement, ghettoization, and other forms of social exclusion; and, for many, a recognition that the social and legal order was designed not to uplift and enlighten them, but to facilitate their utter exploitation. id. at 673. see also laurie serafino, life cycles of american legal history through bob dylan’s eyes, 38 fordham urb. l.j. 1431, 1453–54 (2011). like african americans abused and misused by plantation owners, immigrants were discriminated against, exploited by industrial bosses, and neglected by politicians. sweatshops flourished; industrial accidents caused tragedies such as the triangle fire in 1911; and laws mandating a minimum wage, regulating maximum working hours regulations, and prohibiting child labor did not exist. workers had virtually no rights or protections, and working conditions were atrocious. id. at 1453. 100. simon johnson & james kwak, 13 bankers: the wall street takeover and the next financial meltdown 26–27 (2010). 101. dubroff, tax court, supra note 78, at 6–7. 102. id. at 7 (citing act of aug. 5, 1909, ch. 6, § 38, 36 stat. 112). 180 florida tax review [vol. 15:4 apportionment,” and (2) enact a corporate income tax. 103 by 1913, two-thirds of the states necessary for its ratification had approved the sixteenth amendment to the united states constitution, which provided that, “the congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” 104 in 1913, congress enacted the internal revenue act of 1913—the predecessor to the present federal income tax as now codified in title 26 of the united states code— and which president woodrow wilson signed into law. 105 the 1913 act was relatively modest in its scope with low rates and a “generous exemption,” so that out of a population of 97 million, only 358,000 individual income tax returns were filed for the 1913 tax year. 106 again, it is significant that the demands from the general public for the enactment of the modern income tax were not based on social contract or quid pro quo theories that “we are all in this together,” but rather, were based on a sense that a small segment of society was benefiting the most and, therefore, should contribute something to the federal fisc. a government agency was needed to administer this new tax system. in 1861 and 1862, when congress had enacted legislation temporarily creating an income tax to finance the civil war, 107 congress also created the bureau of internal revenue [hereinafter “the bureau”] to administer the income tax. 108 although the income tax was repealed after the civil war, the bureau remained in existence to administer what few internal revenue taxes remained—such as on alcohol and tobacco—and to perform certain miscellaneous duties, such as administering the bounty for united states 103. id. it was believed that the corporate income tax would not run afoul of the supreme court’s decision in pollock because it was described as an excise tax on the right to do business in the corporate form and was measured by the corporation’s income. the supreme court blessed the corporate income tax in flint v. stone tracy co., 220 u.s. 107 (1911). id.; see also pollack, modern income tax, supra note 2, at 316, n.129. 104. id. (citing u.s. const. amend. xvi); see also supra note 2. 105. underwood tariff act, ch. 16, 38 stat. 114 (1913); see also supra note 3. president theodore roosevelt had spoken up in favor of a progressive income tax during his administration, but took no action on that score. his successor, william howard taft, also made statements in support of a progressive income tax but also did not take personal action to further its enactment. dubroff, tax court, supra note 78, at 6. 106. dubroff, tax court, supra note 78, at 8. 107. see act of aug. 5, 1861, ch. 45, § 49, 12 stat 309; see also act of july 1, 1862, ch. 119, § 90, 12 stat. 473. 108. dubroff, tax court, supra note 78, at 13–14; see also camp, tax administration, supra note 85. 2014] the movement to destroy the income tax and the irs 181 sugar producers, certifying chinese laborers, and collecting the tax on opium and oleomargarine. 109 in 1914, world war i [hereinafter “wwi”] began in europe, and, although the united states would not officially enter the conflict until the spring of 1917, the united states immediately experienced financial repercussions from the war as a result of (1) reduced revenues from customs receipts due to trade reduction with europe, and (2) increased government expenditures as the united states made preparations to enter the conflict. 110 as a result, the federal government incurred a deficit of $400,000 in 1914, which increased to $13 billion by 1919. 111 in response, congress enacted the revenue acts of 1916, 112 1917, 113 and 1918 114 [hereinafter “the wwi revenue acts”]. 115 each one of these revenue measures increased the number of taxpayers who were required to file returns so that by 1917, 3.5 million individuals filed income tax returns and by 1920, the number had increased to 7 million, or 6.6 percent of the population. 116 nevertheless, the tax remained a “class tax” and was paid only by taxpayers in the upper economic strata. perhaps there was a rough justice to this, considering that the rich became richer from the war. 117 again, as with the civil war income tax, the federal government did not attempt to expand the tax to the general public with appeals to their sense of tax ethos via the social contract or quid pro quo. however, in contrast to the federal individual income tax imposed during the civil war, the individual income tax of 1913, the corporate income tax, and the excess profits tax were significant sources of federal revenues. for example, in 1920, federal revenues totaled $6.7 billion of which $3.9 billion, or 55 percent, was derived from the income and excise taxes. 118 after wwi ended and the federal government once again had revenue surpluses, congress was under pressure to reduce the income tax, and the revenue act of 1921 reduced the individual and corporate tax 109. dubroff, tax court, supra note 78, at 14. 110. id. at 8–9. on april 6, 1917, the united states congress declared war on the german empire. arthur s. link, woodrow wilson and the progressive era, 1910–1917, at 282 (1954). 111. dubroff, tax court, supra note 78, at 9. 112. revenue act of 1916, ch. 463, 39 stat. 756. 113. war revenue act of 1917, ch. 63, 40 stat. 300. 114. revenue act of 1918, ch. 18, 40 stat. 1057. 115. dubroff, tax court, supra note 78, at 9–10. 116. id. at 10–12; see also lawrence h. seltzer, the personal exemptions in the income tax 62 (1968) [hereinafter seltzer, personal exemptions]. 117. see liaquat ahamed, lords of finance 90–91 (2009). 118. dubroff, tax court, supra note 78, at 10. 182 florida tax review [vol. 15:4 rates. 119 however, the income tax was too firmly entrenched to be completely repealed. from 1918 to at least 1979, income and profits taxes have rarely yielded less than half of the annual government receipts, and in some years they have yielded considerably more than half. therefore, significantly reducing or eliminating the income tax would greatly reduce federal tax revenues and incapacitate the federal government. the sixteenth amendment and the subsequent income tax laws were approved because the less wealthy believed it would shift some of the tax burden onto the wealthy. there was an evolving perception among the less affluent that the income tax would increase fairness in the tax system. therefore, the idea of a federal income tax was not only accepted by the general public, but was embraced and demanded. however, the purpose of this early income tax (and who would pay it) was radically different from its purpose during world war ii and thereafter. initially, the purpose of the tax was to provide some relief for the less wealthy, as the government would be able to rely less on tariffs and excise taxes for revenue. furthermore, the majority of the public perceived that the wealthy and large corporations derived most of the economic benefit from this country and therefore should pay something. as described infra, the purpose, and thus the nature, of the income tax needed to change during world war ii in order for the tax to metamorphose from a class tax to a mass tax, and this change has persisted to the present day, but is increasingly under assault by segments of the wealthy once again. 3. transition from a “class tax” to a “mass tax” 120 a. educating the american public about the income tax the federal income tax changed within a relatively short period of time from a tax begrudgingly paid by only the wealthy to a tax also paid by cooperative middleand lower-income classes. world war ii enabled this transition as it allowed the government to create a taxpaying ethos in the majority of the citizenry—a tax ethos that remained in place for decades after the war ended. during world war ii, the government used tools such as the media, popular public figures, and appeals to american values such as patriotism to educate the public about this greatly expanded tax system and to persuade the public to accept their taxpaying obligations. these tools helped create the perception among the general public that everyone had a 119. see revenue act of 1921, ch. 136, 42 stat. 227. 120. see carolyn c. jones, class tax to mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685 (1989) [hereinafter jones, class tax to mass tax]. 2014] the movement to destroy the income tax and the irs 183 part to play in the war effort—a social contract basis for compliance—and the awareness that the tax revenues were providing the men on the front lines with guns, ammunition, planes, and other necessities—a quid pro quo basis for compliance. as demonstrated infra, within a relatively short period of time the general public’s perception of, and compliance with, the federal income tax underwent dramatic changes. between 1918 and 1932, an average of 5.6 percent of the population was covered by taxable returns, with the maximum coverage in 1920 of 11.4 percent and a low in 1931 of 2.5 percent. the low in 1931 was attributable to the great depression. 121 despite the economic hardship of the great depression, president franklin d. roosevelt did not seek to broaden the base of the federal income tax beyond the very wealthy, so that from 1933 to 1939, an average of 3.7 percent of the population was covered on taxable returns. 122 “as a result, the individual income tax accounted for a lower percentage of federal revenue during the pre-war period of roosevelt’s presidency than it had from 1925 to 1932.” 123 roosevelt did not seek to expand the scope of the income tax to include middleand lower-income class americans, in part because the continuing depression made such an expansion difficult, and perhaps partially for fear of triggering tax revolts, such as had occurred during 1932. 124 further, the federal income tax’s reputation was sullied by association with the tiny fraction of the american public whom roosevelt described as “a small, but powerful group which has fought the extension of [the] benefits of democracy, because it did not want to pay a fair share of their cost.” 125 the taxpaying classes’ reputation was not improved by the many loopholes the wealthy used to avoid their taxes. 126 by 1938, the public still supported the idea of taxing the wealthy, but did not support the idea of imposing the tax on low-income wage earners. 127 121. id. at 688 (citing seltzer, personal exemptions, supra note 116). 122. id. at 689 (citing seltzer, personal exemptions, supra note 116). 123. id. 124. id. (referring to violence in mississippi and kentucky, where sales tax protestors attempted to force their way into the governors’ offices, as well as threats of violence over taxes in new york and louisiana). 125. id. at 691 (alteration in original) (citing campaign address at worcester, massachusetts (oct. 1936), in 5 the public papers and addresses of franklin d. roosevelt 524–25 (s. rosenman ed., 1938)). 126. in 1937, congress held hearings detailing the tactics used by 67 wealthy families to evade taxation. “foreign and domestic personal holding companies, hobby losses, incorporated yachts and country estates, and personal service corporations” were among the devices used by the “well-to-do” to avoid taxation. id. at 691–92 (citing revenue act of 1937: hearings before the house committee on ways and means, 75th cong. (1937)). 127. id. at 693 (citing public opinion, 1935-1946, at 316 items 12 & 16, 317 items 20 & 22 (hadley cantril ed., 1951)). if inflation occurred, lower-income 184 florida tax review [vol. 15:4 however, by the fall of 1939, it was clear to treasury secretary henry morgenthau, jr. that the united states would become involved in the wars in europe and asia and that involvement would require the united states to change its income tax structure. 128 first, the war itself would need to be funded, and current government revenues were insufficient for the task. 129 second, the war would create both shortages of goods and increased consumer spending power so that there was a real risk of inflation as consumers competed for scarce goods and drove up prices. 130 the income tax could be both a source of funding for federal expenditures and also a way to tamping down consumer purchasing power. 131 however, the government faced the dilemma of how to get the public to accept the idea of an income tax on all economic classes as up to this time, the federal income tax was viewed as something only the very wealthy paid. 132 the government needed to find a way to justify the federal income tax and make it acceptable to the public. the problem faced by the franklin d. roosevelt administration [hereinafter “fdr administration”]was changing public perception of the income tax from a measure designed to curb the economic and political power of the wealthy, to a perception that everyone should sacrifice for the common good. as explained by professor jones: because income taxpayers had been portrayed as members of a despised class during the years before world war ii, there was little in the rationale for the income tax during the 1930’s that justified income taxation of average americans. further, efforts to redistribute wealth by tapping the resources of middle income taxpayers had proved taxpayers would be disadvantaged in their ability to afford goods at a time when they would be asked to contribute some of their income toward taxes. see id. at 724. 128. id. at 693. 129. “federal budget expenditures increased more than twelve times from 1940 to 1945.” id. at 686 (citing bureau of the census, u.s. dep’t of commerce, ser. y 605–37, historical statistics of america 1123–24 (1975)). “[t]he income tax rolls increased from about 7 million . . . in 1940 to more than 42 million in 1945.” id. (citing bureau of the census, u.s. dep’t of commerce, ser. y 402–411, historical statistics of america 1110 (1975)). 130. see id. at 724–25 (citing letter from james r. brackett to fred smith (aug. 4, 1943), treasury/correspondence; general records of assistant dirs. james rogers and william lewis, january to july 1943; records of the office of war info., record grp. 208 (available in national records center, suitland, md.)). 131. id. at 686. 132. id. at 736. 2014] the movement to destroy the income tax and the irs 185 unsuccessful during the 1930s and did not provide a promising justification for a mass income tax. 133 the wealthy paid the federal income tax because they had to and not because of either (1) a recognition that their lives were enhanced by the benefits the government provides (a quid pro quo basis for compliance) or (2) respect for the social contract that “we are in this together” and need to pay their fair share because others are doing so. as initially the idea of an income tax was tied to an economic measure against the “economic royalists,” the fdr administration” needed to find a way to make the tax “legitimate” in order to impose the tax on a mass scale. the fdr administration needed to find a philosophical basis or rationale that the general public would accept as a good reason for paying this newly imposed tax. in other words, franklin d. roosevelt was going to have to create a taxpaying ethos among the general population. professor jones posits that the fdr administration was able to do this because of the messages and structures that were created during the war. the fdr administration obtained citizen cooperation (1) through an intense education campaign as to why and how the tax should be paid changing the perception as to the nature of the income tax, and (2) by imposing withholding on wages at the source which meant that taxpayers were current on their payments as opposed to having to save up to pay the tax bill later. as a result of the revenue acts of 1940 and 1941, the number of taxable returns increased from 7.4 million to 27.6 million. 134 for the less wealthy, the income tax became a fact of life so that professors surrey and warren stated that the income tax had “changed its morning coat for overalls” and had “spread from the country club group district down the railroad tracks and then over to the other side of the tracks.” 135 the fdr administration was able to achieve this change mainly by tying the tax to the 133. id. at 733. in 1938, “only 10 percent of families had incomes of $3,200 or over. a subsistence . . . income for a family of four was variously set at between $800 and $2,000. [approximately] [s]eventy-four percent of american families earned less than $2,000.” id. at 690 (citing mark leff, the limits of symbolic reform 94 (1984)). congress at that time “increased surtaxes on those with incomes over $50,000, making a top bracket of 79 percent for income over $5 million.” id. at 690–91 (citing leff, supra, at 142). for three years after that, only john d. rockefeller qualified for this top bracket. id. at 691 (citing leff, supra, at 144–45). 134. id. at 694 (citing bureau of the census, u.s. dep’t of commerce, ser. y 402–11, historical statistics of america 1110 (1975)). the 1942 act also included a “victory tax” which was a 5 percent gross income tax on all income over $624. “taking the victory tax into account, the income tax rolls increased from 13 million to 50 million in one year.” id. at 695. 135. id. at 695 (citing randolph e. paul, taxation in the united states 318 (1954) [hereinafter paul, taxation]). 186 florida tax review [vol. 15:4 war effort and shared sacrifice (and not to the new deal economic programs). 136 one can understand how this appeal would be effective for the duration of the war, but many expected the tax to disappear for most americans once the war ended. one tool the fdr administration employed during the war to create a taxpaying ethos was using the media to disseminate information to the public as to how the funds were being used in the war effort and how to comply with their taxpaying obligations. the fdr administration made frequent use of media to “get the message out” that uncle sam needs your help. 137 during world war ii, americans owned 57 million radio sets that reached over 90 percent of the population. 138 the treasury department and the office of war information would broadcast their own programs, sometimes featuring treasury secretary morgenthau or other administration officials, who would explain and encourage tax compliance. 139 short advertisements and spot announcements during entertainment programming containing war messages such as, “join the wac,” or “pay your taxes” also proved effective. 140 other times, popular radio shows such as the roy rogers show and the great gildersleeve, and popular personalities such as the andrews sisters and burns and gracie would urge the public to support the war by paying their taxes. 141 encouraging the public to support the war contributed to americans’ feeling that they all had a part to play in the war effort and were “in this together”—the social contract basis for compliance. the fdr administration also used movies to encourage americans to pay their taxes. given that each week, “80 million americans—two-thirds 136. id. at 720. 137. see lavoie, patriotism and taxation, supra note 58, at 53–54. 138. jones, class tax to mass tax, supra note 120, at 709 (citing plans for the coordination of the government’s wartime use of radio 1941-42, in peter h. odegard papers (available in franklin d. roosevelt library, hyde park, n.y.); bureau of the census, u.s. dep’t of commerce, ser. r 93–105, ser. a 288– 319, historical statistics of america 796 (1975)). 139. id. at 709–10. 140. id. at 712 (citing allocation schedule for war information messages, week beginning february 21, 1944 (final), radio bureau allocations: records of the deputy director, records of the office of war information, record group 208, national records center, suitland, md.). 141. id. at 711–725. in the introduction to the burns and allen radio show that aired february 5, 1945, the announcer states early in the show: say, here’s a very important message. uncle sam is asking us to file our regular march fifteenth income tax returns early this year. the money is need[ed] for victory. if you have made more than five hundred dollars during 1944 you must file a return— regardless of withholding tax . . . . id. at 712. 2014] the movement to destroy the income tax and the irs 187 of the population—saw at least one movie,” it made sense to use such a popular media. 142 the treasury department commissioned disney to make an animated short, the new spirit, starring donald duck. 143 in the new spirit, donald duck fills out his tax forms after hearing a radio announcement that it is “your privilege, not just your duty, but your privilege to help your government by paying your tax and paying it promptly.” 144 donald then “races from hollywood to washington” to file his return and “the film shows how tax revenues are transmuted into guns, planes, and ships” while a narrator exhorts that, “taxes will keep democracy on the march.” 145 through popular movies and radio programs, taxpayers were shown how the government used tax revenues to create benefits such as the public defense—a quid pro quo basis for compliance. the fdr administration also made extensive use of written materials, such as pamphlets that were distributed to governors, mayors, town clerks, heads of education, and larger employers; posters that were sent for display in banks, department stores, libraries, post offices, and office buildings; newspaper cartoons and editorials; and magazines such as the magazine war guide. 146 these materials all emphasized the important role the average citizen could play in the war effort including “taxes to beat the axis.” 147 all this messaging and information helped create the impression that the tax was not coercive but rather a citizen’s choice or voluntary assumption in service to the country. 148 it also helped assuage the guilt of those who were not serving in the armed services by giving them a way to participate in the war effort. a taxpayer who complied with his or her taxpaying obligations felt as though he or she played an important role in the war effort and as though he or she was carrying a part of the load. in other words, this messaging promoted the notion that we are “all in this together”—part of the social contract. some americans served overseas; 142. id. at 716 (citing clayton r. koppes & gregory d. black, hollywood goes to war: how politics, profits and propaganda shaped world war ii movies 1 (1987)). 143. id. (citing the new spirit (disney 1942), u.s. government film collection, motion picture collection faa 188 (library of congress, washington, d.c.)). treasury secretary morgenthau was heard to exclaim that, “if we can get people to pay taxes with that god-awful mickey mouse, we will have arrived socially.” id. at 735 (citing group meeting (9:45 a.m., dec. 15, 1941), in 473 morgenthau diaries 28 (franklin d. roosevelt library, hyde park, n.y.)). mickey mouse was eventually replaced by donald duck in the film. id. note 271. 144. id. at 716 (quoting the new spirit, supra note 143). 145. id. 146. id. at 705–09. 147. id. at 723 (quoting the new spirit, supra note 143). 148. id. (noting that there were very few public announcements that mentioned penalties for failing to file or pay). id. note 265. 188 florida tax review [vol. 15:4 others contributed at home through economic support through war bonds and taxes. although appeals to patriotism during peacetime have not been particularly effective, appeals during wartime are. 149 this makes sense considering people react differently to threats to their safety and lives, as is natural during wartime. while americans on the mainland of the united states might not have felt physically threatened, they could identify with loved ones and friends who were serving in the european and pacific fronts and risking their lives. 150 the fdr administration also saw the income tax as a tool for fighting inflation. with the increased employment because of the war and shortages of consumer goods, the country faced a serious risk of inflation as americans competed for consumer goods, thereby driving up prices. the fdr administration attempted to explain the problem to the public in a second walt disney movie starring donald duck, the spirit of ’43, in which donald struggles with his conscience between being a “spendthrift [or] a scrooge.” 151 donald duck is reminded that “every dollar you spend for something you don’t need is a dollar—to help the axis.” 152 however, the government’s appeals to the public to exercise fiscal restraint were not particularly effective. 153 despite the fact that inflation affected the everyday lives of taxpayers, it was difficult to get the public to see the connection between such an abstract concept as inflation and their own behavior. this also explains why appeals to patriotism, at least for a period of time, can be effective. people understand the concept of physical danger and threats to safety when the threat is imminent. b. changing the taxpayer’s payment method the fdr administration also had to change the existing payment system for the income tax and then educate the mass of new taxpayers regarding the new payment system and tax forms. prior to 1943, federal income taxes were not collected at the source (e.g., by the employer withholding the tax from the employee’s wages), and were not paid in the current year when incurred, but rather were paid in quarterly installments in 149. id. at 722–23; see also steven a. bank et al., war and taxes (2008); joel slemrod, cheating ourselves: the economics of tax evasion, 21 j. econ. persp. 25, 39–40 (2007). 150. jones, class tax to mass tax, supra note 120, at 722. 151. id. at 726 (citing the spirit of ’43 (disney 1943), u.s. government film collection, motion picture collection faa 256 (library of congress, washington, d.c.)). 152. id. 153. id. at 725–26. 2014] the movement to destroy the income tax and the irs 189 the following year. 154 thus, the 1941 tax obligations based on salary income were paid in quarterly installments in 1942. lower-income taxpayers in particular struggled to make the quarterly payments because they often had not set aside funds for that purpose. thus, the lack of withholding at the source of income and the delay in payment until the year following the tax accrual made it impractical, if not impossible, for the federal government to collect the tax. the solution was to have employers withhold the estimated tax due from employees’ wages so that the tax was collected concurrently. however, this created a new problem as to how to transition to this system, as a “bunching” problem would be created during the first year the system was imposed. “under the existing tax system, year 1’s tax liability was paid in year 2. if, in year 2, the tax payments were made current, a taxpayer would be required to pay year 1’s and year 2’s taxes in year 2.” 155 in the current tax payment act of 1943, congress solved the problem by partially forgiving the lower of the 1942 or 1943 tax liability and “[u]nforgiven tax liabilities could be paid over the next two years.” 156 if it had not been for the exigencies of war, the government might not have been able to obtain the public’s willingness to struggle through the chaotic first year or two of the transition to this new tax and system of payment. the fdr administration again made use of the media to explain to the new taxpayers how to file and pay their taxes, assuring the public that the obligation was not unduly confusing or burdensome. taxpayers were reminded frequently in public service announcements over the radio as to the deadlines for filing taxes. these public service announcements sometimes used actors playing “ordinary” people such as factory workers or housewives who exclaimed how easy it was to fill out the new forms and how withholding relieved their worries about payment. the treasury department also recognized that the tax forms had to be simplified and explained if it were to obtain the public’s cooperation and compliance with their new tax obligations. the treasury department enlisted the services of judge clarence v. opper and judge marion j. harron of the tax court in creating and endorsing the new tax forms. 157 154. id. at 695 (citing paul, taxation, supra note 135, at 328–29, 332). 155. id. at 696. 156. id. at 697 (citing current tax payment act of 1943, pub. l. no. 78-68, § 6, 57 stat. 126, 145–49 (1943)). however, the tax returns for march 1944 included tax obligations from three different years: the first quarter estimated tax payments for 1944 on 1944 income, withholding and estimated tax payments for 1943 income, and the unforgiven portion of the 1942 taxes. id. at 698. 157. see id. at 730–32. in september 1943, some taxpayers were required to file an estimated tax declaration form as part of the transition to a system for the current payment of the tax. the september 15, 1943 declaration form proved to be particularly challenging. after it took treasury secretary morgenthau one and one190 florida tax review [vol. 15:4 the government also turned to the movies for assistance in explaining the new system and forms to the public. as discussed supra, the walt disney animated short, the new spirit, portrayed an initially irritated donald duck filling out his tax form and finding it easier than he had anticipated. not only does withholding tax at the source of the income solve the problem of having taxpayers find the funds to pay a tax bill at the end of the year, but also makes the tax payment less noticeable to taxpayers. 158 taxpayers are paying the tax with money they have never seen in their paychecks because it has been withheld from their gross income. it is less emotionally intrusive to have money withheld than to have to write a check and send the money in to the treasury department. withholding becomes a routine, unobtrusive way of paying one’s tax obligation, thereby increasing compliance. 159 the creation of these two foundations for tax compliance (social contract and quid pro quo) is one reason why the public did not demand that the federal income tax be repealed after the end of world war ii. despite world war ii ending, americans did not necessarily feel safe from outside threats—in particular from the soviet union and, to a lesser extent, china. during the truman, eisenhower, and kennedy administrations, americans worried that the soviet union would take over the united states, either through a direct attack or from the inside by communist infiltration. the cold war posed a common threat to all americans and bound the country together in a continued sense that we are all in this together—or, at least, we are facing annihilation together. a strong federal government could protect the country from attack. despite the fact that in 1953 the bureau of internal revenue was rocked with a corruption scandal by top administration officials, support for the income tax and overall faith in the tax system remained strong. 160 contemporaneously, the post-world war ii era continued to be a time during which americans could see the connection between their taxes and government benefits. for example, veterans attended college with assistance from the federal government. 161 the government also half hours and the assistance of two aides to complete the 55 computations the form required, he recognized that the form had to be simplified or the public would be outraged. id. at 731–32. 158. id. at 697. 159. id. 160. see camp, tax administration, supra note 85, at 87. in 1953, the house ways and means committee spent two years investigating allegations of misconduct and corruption at what was then called the bureau of internal revenue. a number of top officials were charged with crimes and the bureau of internal revenue was reorganized into the internal revenue service. id. at 89. 161. see servicemen’s readjustment act of 1944, pub. l. no. 78-346, § 400, 58 stat. 284, 287–90 (commonly referred to as the g.i. bill). as a result of the 2014] the movement to destroy the income tax and the irs 191 poured money into the space program and national defense, which generated employment. 162 iv. the campaign to destroy tax ethos and the income tax a. the cabal not everyone was in favor of roosevelt’s new deal, the increased power and size of the federal government, and the enactment of the federal income tax. the initially small, but very determined, cabal of men who wanted to eviscerate, if not outright repeal, the federal income tax and render the federal government impotent were businessmen and not politicians, although these businessmen would later recruit politicians, academics, and religious leaders to further the movement’s goals. 163 some of the names of the men and the corporations they ran are familiar; others are less well-known, but no less important to the movement. the early members included lemuel ricketts boulware, the head of general education benefits provided by the g.i. bill, 7.8 million veterans enrolled in education or training programs by the time the g.i. bill expired on july 25, 1956. the gi bill’s history, u. s. dep’t of veterans aff., http://gibil.va.gov/ benefits/history_timeline/index.html (last visited oct. 26, 2013). 162. see, e.g., robert b. reich, supercapitalism (2007). for example, in the 1970s, the federal government provided half of the funding for research and development of the nation’s telecommunications industry and 70 percent of the funding for the nation’s aircraft industry. id. at 59. 163. see kim phillips-fein, invisible hands: the making of the conservative movement from the new deal to reagan 6 (2009) [hereinafter phillips-fein, invisible hands]. the anti-new deal, anti-income tax movement began during the fdr administration and continued after world war ii, despite the fact that business and labor had worked together during wwii to defeat the axis. but at the same time, despite all these changes, it remained difficult for the men who had fought the new deal in the 1930s to let go of the battle. all they could see in the postwar order was a landscape of defeat. after all, from their perspective, the war had created a newly gargantuan federal government. in the late 1940s, top marginal income tax rates were about 90 percent, and corporate tax rates remained high as well. the government had steady revenue sources that it had never possessed before. nor were they comforted by the new ideology of keynesian consumerism, for it implied that the disposable income of workers, not the patient saving and canny investment of entrepreneurs and owners, mattered most for economic health. id. at 33. 192 florida tax review [vol. 15:4 electric who became famous for his union breaking tactics; 164 the three dupont brothers (irénée, lammot, and pierre) who made fortunes during the two world wars from their plastics which were used extensively by the military; 165 j. howard pew, president of sun oil; 166 sterling morton, head of the morton salt company; 167 leonard read, who with jasper crane 168 in 1946 founded the still highly influential foundation for economic education (“fee”); 169 and william j. baroody, who helped develop the american enterprise institute (“aei”), another leading political right-wing think tank, was an overseer for the hoover institute at stanford university, and was also involved in the center for strategic and international studies at georgetown university, both of which are influential conservative intellectual organizations. 170 sometime later on board was joseph coors, who, together 164. boulware became so effective at destroying labor unions that some of his tactics were later labeled as “boulwarism.” id. at 99–101. 165. id. at 3–5. in 1934, the dupont brothers founded the american liberty league, one of the first groups organized to overthrow the new deal. the name was carefully chosen to create the impression that the group’s concern was defending the u.s. constitution and not protecting the members’ wealth. id. at 10. 166. id. at 70. despite the rise of the fundamentalist religious movement in the country beginning in the 1930s, pew despaired of its efficacy to the conservative cause: “we can never hope to stop this country’s plunge toward totalitarianism until we have gotten the ministers’ thinking straight.” id. 167. in 1956, sterling morton sent a $500 check to the conservative manion forum (a weekly radio program expressing opposition to the federal income tax) with a note expressing his support for the repeal of the sixteenth amendment, which had allowed the creation of the federal income tax. id. at 85. 168. leonard read served as the general manager for the los angeles chamber of commerce; jasper crane was a retired dupont chemical vice president. id. at 16–19, 27. 169. jasper crane, one of the first trustees for the fee, believed it was essential that the movement clarify its goals and articulate its theoretical underpinnings. crane believed that appeals to emotion would be important later but that initially those who wished to undo the new deal and return to laissez-faire unfettered capitalism should be able to explain their principles. fee, which is located in irvington, new york, is still an important think tank today. id. at 27–30, 265. 170. id. at 62–67. “[h]e took a faltering organization, which he joined in 1954, and invested his tireless energy, his wisdom, his amazing intellectual capacity, and his boundless love for humanity and built it into a significant force in public policy research: the american enterprise institute for public policy research.” william j. baroody, sr. (introductory remarks), aei (dec. 11, 1980), http://www.aei.org/article/society-and-culture/william-j-baroody-sr-introductory-re remarks/tohttp://www.aei.org/article/society-and-culture/william-j-baroody-sr-intro ductory-remarks/. the papers of william j. baroody were given to the library of congress by his sons and span from 1943 to 1983. the bulk of the papers deals with the years 1954 to 1980 and documents his leadership role in the american enterprise 2014] the movement to destroy the income tax and the irs 193 with paul weyrich 171 formed the heritage foundation, probably the most influential think tank for the political right. 172 joseph coors also helped fund the federalist society, an organization of conservative law students and professors, 173 and paul weyrich founded the american legislative exchange institute. donna ellis et al., william j. baroody: a register of his papers in the library of congress 4 (manuscript div., library of cong. 2005). 171. paul weyrich was a staff member for senator gordon allott of colorado at the time. phillips-fein, invisible hands, supra note 163, at 171. 172. in addition to its research mission, the heritage foundation “runs a full-service media relations shop, ready to assist reporters, editors[,] and producers 365 days of the year.” the heritage foundation, about heritage, www.heritage.org /about. similarly, the heritage foundation also provides analysts who “help members of congress and their staff prepare for congressional hearings by providing valuable insight on foreign or domestic policy issues. congressional staffers come to heritage regularly to receive custom-tailored briefings on the latest heritage research related to their committee assignment or legislative priority.” id. the heritage foundation also helps broadcast research performed by other conservative activists. “the conservative movement includes a wide array of think tanks, scholars, public interest law groups, activists, philanthropists, film makers, and many others to spread the idea that liberty is the best way of governing society. we feature some of the best work being done by conservatives and pro-liberty activists around the world.” id. some of the early contributors to the heritage foundation were dow chemical, general motors, mobil, pfizer, chase manhattan bank, and richard mellon scaife. phillips-fein, invisible hands, supra note 163, at 172. 173. in 1980, steven calabresi, a student at yale law school; lee liberman otis; and david mcintosh, students at the university of chicago law school were dissatisfied with the liberal viewpoint of many of their professors and decided to organize. the federalist society’s first major event was a symposium held in april of 1982, which was financially underwritten in large part by the olin foundation. today, the federalist society has a membership of 45,000 lawyers and law students, 13,000 are dues-paying members. in 2010, the federalist society had revenues of $9,595,919. michael avery & danielle mclaughlin, the federalist society: how conservatives took the law back from liberals 1–3 (2013). not only are four u.s. supreme court justices members of the federalist society (antonin scalia, clarence thomas, samuel alito, and john roberts), but every federal judge appointed by george h.w. bush and george w. bush was either a member of or approved by the federalist society. those federal judges, in turn, hire federalist society members as law clerks. additionally, during the reagan administration and both bush administrations, federalist society members held key position in the white house and the department of justice. id. at 2, 7–8, 11, 22–27, 30–42. although it violated federal law, during george w. bush’s administration, department of justice officials used political ideology as a litmus test when hiring career attorneys and summer interns. law students and recent law school graduates who were federalist society members were given preference, while students and graduates who belonged to liberal organizations, such as the american constitution society were rejected. id. at 35–42. 194 florida tax review [vol. 15:4 council (“alec”) which promotes conservative ideas at the state level. 174 these organizations are funded and supported by a small group of ultra-rich sponsors. as explained by david c. johnson in his article on alleged tort reform (another pet project of the conservative movement): right-wing organizations in this network all receive major general operating support, project grants and coordinated strategic guidance from a core group of interlocking, ultraconservative foundations that has been working for nearly thirty years to alter public attitudes and move the national agenda to the right. this core group of right-wing foundations includes the scaife, castle rock (endowed by the adolph coors foundation in 1993), bradley, olin and koch foundations. 175 the movement faced an uphill battle, especially after world war ii because “the flexible hybrid of capitalism and the welfare state pioneered in the united states had proved capable of military triumph over germany, italy, and japan.” 176 further, the bitterness and violence between rich and poor, labor and capitalists that had marked the early twentieth century in this country had largely disappeared. it is beyond the scope of this article to discuss in great detail the reasons for the changing economic and political climate during the 1950s and 1960s; however, by the 1970s, the country experienced chronic economic problems in the form of “stagflation” 177 and an oil embargo by opec. 178 the economic downturn provided conservative economic ideas an opportunity to take root because these ideas were no longer competing against “good times.” 174. david c. johnson, commonweal. inst., the attack on trial lawyers and tort law 4 (2003), http://www.commonwealinstitute.org/cw/files /attacktriallawyerstortlaw.pdf [hereinafter johnson, tort law]. 175. id. see also people for the american way, buying a movement: right-wing foundations and american politics 32 (1996), http://www.pfaw. org/media-center/publications/buying-movement. http://pfaw.org/pfaw/general/default. aspx?oid=2052 lynde bradley, joseph coors, and fred koch all helped to create or fund the john birch society. the allegheny foundation is also a scaife-funded foundation. id. 176. phillips-fein, invisible hands, supra note 163, at 31. 177. “stagflation” is an unusual economic phenomenon wherein the country experienced both high unemployment and high prices. ordinarily, one would expect high prices when there is high employment and people have money to spend and compete for goods. 178. opec is an acronym for the organization of petroleum exporting countries. 2014] the movement to destroy the income tax and the irs 195 b. philosophical foundation for reducing income tax rates in 1974, professor robert mundell attended a conference sponsored by the american enterprise institute, at which he presented his economic theory which later became known as supply-side economics. 179 professor mundell argued that, among other things, tax cuts stimulate economic growth. 180 mundell theorized that tax cuts initially reduce tax revenues, but individuals and businesses, freed from the crippling restraint of taxation, will then invest more in businesses, which will in turn expand their operations, thus increasing the tax base and generating even greater tax revenues than before. jude wanniski, a journalist who sometimes wrote for the wall street journal, was inspired by professor mundell’s theory and wrote several commentaries about it, including the mundell-laffer hypothesis–a new view of the world economy which was published in the public interest quarterly, an academic journal edited by irving kristol. 181 this commentary contained a footnote written by mundell summarizing the tax-cut part of his economic theory and providing the intellectual foundation for the reagan-era tax cuts. 182 in this footnote, mundell explains that there is one ideal tax rate for maximizing government revenues. a rate that is too high reduces economic output and reduces government revenues. however, a rate that is too low, at least during times of less than full employment, has the effect of eventually raising output and the tax base, thereby increasing government revenues at least sufficiently enough to service the interest on any government bonds that were issued to finance the deficit. taxes should be cut and government spending maintained through deficit financing only when a special condition exists, a condition mundell and laffer say exists now. “there are always two tax rates that produce the same dollar revenues,” says laffer. “for example, when taxes are zero, revenues are zero. when taxes are 100 per cent, there is no production, and revenues are also zero. in between these extremes there is one tax rate that maximizes 179. robert mundell was a professor of economics at columbia university. 180. bruce bartlett, the origin of modern republican fiscal policy, n.y. times economix blog (mar. 20, 2012), http://economix.blogs.nytimes.com/2012/ 03/20/the-origin-of-modern-republican-fiscal-policy [hereinafter bartlett, modern republican]. 181. jude wanniski, the mundell-laffer hypothesis–a new view of the world economy, 39 pub. int. 31 (spring 1975). at the time, arthur laffer was a professor at the university of chicago’s graduate school of business. in his article, wanniski notes that there was no joint mundell-laffer paper, but rather mundell wrote the economic theory and laffer provided data support. id. at 32, note 1. 182. id. at 49–50, note 4. 196 florida tax review [vol. 15:4 government revenues.” any higher tax rate reduces total output and the tax base, and becomes counterproductive even for producing revenues. u.s. marginal tax rates are now, they argue, in this unproductive range and the economy is being “choked, asphyxiated by taxes, says mundell. tax rates have been put up inadvertently by the impact of inflation on the progressivity of the tax structure. if the tax rate were below the rate that maximizes revenues, tax cuts would reduce tax revenues at full employment. but a multiplier effect operates if the economy is at less than full employment, and the tax cut then raises output and the tax base, besides making the economy more efficient. even if a bigger deficit emerges, sufficient tax revenues will be recovered to pay the interest on the government bonds issued to finance the deficit. thus, future taxes would not have to be raised and there would be no subtraction from future output. tax cuts, therefore, actually can provide a means for servicing the public debt. 183 in 1976, wanniski made his most important contribution to supplyside economics by writing taxes and a two-santa theory. 184 as shall be explained infra, wanniski argued that democrats are the spending santa claus and republicans should be the tax-cut santa claus. 185 wanniski attributes the success of the democrats in winning elections to knowing “the first rule of successful politics is never shoot santa claus.” 186 reagan agreed and in 1980, ran on a platform that advocated tax cuts, with little emphasis on deficit reduction. despite the fact that the deficit increased markedly during his first term, he won reelection in 1984, which convinced 183. id. 184. the two-santas article was published on march 6, 1976, in the national observer, a weekly published by the dow jones. the national observer ceased publication after 1977 and as a result, it is impossible to obtain a copy from its archives. however, congressman jack kemp, discussed infra, kept the article alive by handing out copies. the article has been reproduced by bruce bartlett on his blog. see bruce bartlett, jude wanniski: taxes and a two-santa theory, capital gains and games blog (may 6, 2010), http://capitalgainsandgames.com/blog/ bruce-bartlett/1701/jude-wanniski-taxes-and-two-santa-theory [hereinafter wanniski, two santas]. 185. bartlett, modern republican, supra note 180. as bruce bartlett observes in his introduction to the two-santas article, irving kristol immediately recognized the political possibilities in wanniski’s proposal to turn the republicans to the party of tax-cuts as opposed to the party of balanced budgets. wanniski, two santas, supra note 184. 186. bartlett, modern republican, supra note 180. 2014] the movement to destroy the income tax and the irs 197 his fellow republicans that tax cuts were a winning position. 187 grover norquist, the republican enforcer of no tax increases, has claimed that he owes much of his tax pledge to wanniski’s two-santas theory. 188 wanniski initially states that we need both santas, and that the democrats are suited to be the spending santa, just as the republicans are meant to be the santa of tax cuts. however, as the article progresses, it becomes increasingly clear that tax-cut santa can and should destroy spending santa. in his rather short two-santas theory article, wanniski reviews the economic history of the united states from the coolidge administration beginning in the 1920s to the ford administration in 1976 and claims to prove that every time the government had cut tax rates, prosperity ensued, yet when the government raised tax rates, as a result of either economic difficulties or to balance the budget, the country suffered economic calamity. 189 the only factor wanniski considers is tax rates, ignoring any other possible explanations or factors to account for economic conditions. he singles out for particular praise and emulation presidents warren harding and calvin coolidge, as well as their secretary of the treasury, andrew mellon. the gop’s heyday was in the 1920s, when, acting on the advice of treasury secretary andrew mellon . . . the republicans cut tax rates no less than five times. mellon, the embodiment of the republican santa claus argued that a cut in tax rates would provide business an incentive to expand, increase prosperity, expand the tax base, and thereby provide more revenues to the government than would have accrued without a tax cut. 190 187. id. during reagan’s first term, the budget deficit rose from 2.7 percent of gross domestic product in 1980 to 6 percent by 1983. id. 188. id. interestingly, in a 2005 e-mail to ben bernanke, the then-chairman of the president bush’s council of economic advisors, wanniski wrote that “[t]he grover norquist idea of opposing all tax increases is dumb, and grover knows i believe that.” id. 189. arthur laffer continues to adhere to wanniski’s point of view regarding our country’s economic history, as evidenced by his recent comments on the radio in which he repeated portions of wanniski’s historical account and continued the narrative through the tax cuts of the george w. bush administration. the rich are taxed enough (npr, intelligence squared, broadcast mar. 3, 2013) (transcript), http://intelligencesquaredus.org/debates/past-debates/item/775-the-richare-taxed-enough. intelligence squared hosted a panel of four economists divided into two teams who debated the proposition that the rich are taxed enough: robert reich and mark sandy who opposed the proposition, and arthur laffer and glenn hubbard who supported it. 190. wanniski, two santas, supra note 184. 198 florida tax review [vol. 15:4 the country, euphoric over the good times, elected calvin coolidge in 1924 in a landslide victory. the new york times, at the time an enthusiastic supporter of mellon’s policies, predicted prosperity for america as had never been seen before. coolidge continued the policy of tax cuts, and according to wanniski, “[t]he next four years were as glorious as the times had forecast.” 191 franklin d. roosevelt then assumed the presidency and was “the prototype of the democratic spending santa claus.” 192 according to wanniski, roosevelt’s misguided tax and spend policies prolonged the great depression by eight years. 193 wanniski also found regrettable dwight d. eisenhower’s eight years in office during the 1950s, as president eisenhower listened to his economic advisors and rejected any consideration of tax cuts; instead, putting his efforts toward balancing the budget—as a result, economic stagnation ensued. 194 wanniski acknowledges that democrats at times play both santas, but, are temperamentally inclined to be spending santa, reluctantly cutting taxes only when politically expedient. to his great relief, wanniski believes that ford and reagan understood the potency of tax cuts. therefore, rather than kill spending santa quickly by shooting him, ford and reagan killed him slowly by expanding the private sector through tax cuts, thus eliminating the need for spending santa. both president ford and ronald reagan are inching toward the mellon approach. still[,] they each insist in one way or another that tax reduction be bound to spending cuts. this is an improvement on the straightforward demand that the spending santa be shot. but as the two-santa claus [t]heory holds that the republicans should concentrate on tax-rate reduction.[sic] as they succeed in expanding incentives to produce, they will move the economy back to full employment and thereby reduce social pressures for public spending. just as an increase in government spending inevitably means taxes must be raised, a cut in tax rates—by expanding the private sector—will diminish the relative size of the public sector. all the united states needs now to 191. id. 192. id. 193. id. 194. id. wanniski is correct that eisenhower believed firmly in balanced budgets, and although he did balance the federal budget, unemployment rose from 2.6 percent to 6.9 percent during his time in office. id. 2014] the movement to destroy the income tax and the irs 199 prosper is a coolidge in the white house, a mellon at treasury, and gop tax-cutting st. nick. 195 during world war ii, americans understood that they were paying the income tax because “uncle sam needs your help,” and “taxes to fight the axis.” these short, pithy slogans enabled americans to understand why paying taxes is patriotic. the anti-tax movement has been able to articulate a philosophy that appears to say that not paying taxes would be good for and would help america. 196 the right-wing has been very effective in creating and promoting a philosophy that is very understandable to voters. with regard to taxes, voters understand the message, “cut taxes, get government out of the way, and the economy will take off.” the anti-tax conservatives recognized that this is a much more attractive philosophy and message than, “we need to balance the budget and to do so we must cut services.” for the last 30 years, the anti-tax conservatives have trumpeted the wanniski-laffer-reagan tax cut philosophy embodied in the first message to great effect. it is difficult to think of a similar message from the left-wing since the reagan administration regarding taxes. during world war ii and the first few decades thereafter, americans might not have had a sophisticated grasp of the theory behind the progressive income tax, but they could see and understand the connection between paying taxes and benefits, and could understand the argument that everyone needs to chip in. between 1972 and 1999, conservatives created at least 60 new organizations with mission statements modeled after the heritage foundation, which emphasizes free enterprise, limited government, individual freedom, traditional american values, and a strong national defense. 197 in 2004, pollster celinda lake asked a group of white midwestern swing voters what conservatives stood for and most of the voters repeated the above 195. id. interestingly, when president bill clinton, a democrat, began his first term in 1992 facing enormous budget deficits, he put his social spending programs on hold; instead, president clinton cut spending and raised taxes in order to balance the budget, which he succeeded in doing, without hurting economic growth. johnson & kwak, white house burning, supra note 10, at 77. 196. during the 2008 presidential campaign, then vice-presidential candidate joe biden defended the democratic party’s proposal to raise taxes on individuals earning more than $250,000 by stating, “it’s time to be patriotic . . . . time to jump in. time to be part of the deal. time to help get america out of the rut.” republican vice-presidential candidate sarah palin rebuked biden saying, “[t]o the rest of america that’s not patriotism. . . . raising taxes is about killing jobs and hurting small businesses and making things worse.” michael falcone, on tax policy and patriotism, n.y. times, september 19, 2008, at a14. 197. ari berman, big $$ for progressive politics, the nation, oct. 16, 2006. 200 florida tax review [vol. 15:4 catchphrases. however, when the voters were asked what liberals stood for, half of them answered that they didn’t know. 198 c. ronald reagan, massive tax cuts: massive deficits president reagan became a firm believer in the efficacy of tax cuts and, in 1981, pushed through the biggest tax cut in united states history. 199 however, the economic boom did not materialize; the federal budget deficit ballooned and unemployment increased to 10 percent. 200 in fact, the tax cuts contributed to record peacetime deficits. 201 in 1982, the federal deficit was more than double that of 1981, and in 1983 it grew to $343 billion, almost three times larger from when reagan took office. as a result, the government was borrowing almost one dollar out of every three it spent. 202 republicans are fond of saying that tax revenues increased during these years. they did, but not because of increased productivity by business. as the government hemorrhaged red ink because of the tax cuts, the reagan administration and its congressional allies searched for new sources of revenue to pay for the operational expenses of the federal government. first, 198. id. 199. johnson & kwak, white house burning, supra note 10, at 88, note 118. the second or third largest tax cut in history (depending on how you measure it) was the economic growth and tax relief reconciliation act of 2001 (egtrra), pushed through by george w. bush, and discussed more fully infra. the largest as a share of gdp was the 1981 reagan tax cut; the second largest was the 1964 kennedy-johnson tax cut. in 2010, when fully phased in, egtrra was projected to reduce tax revenues by $176 billion, or 1.1 percent of gdp (as then projected by the cbo), making it larger than the revenue act of 1978. in real dollar terms, egtrra was the second-largest tax cut in modern history. we exclude the major tax cuts enacted as a result of the end of world war ii. id. (citing cong. budget office, pay-as-you-go estimate: h.r. 1836, economic growth and tax relief reconciliation act of 2001 (2001), http://www.cbo.gov/publication/13098 [hereinafter cbo, estimate]). 200. david cay johnston, perfectly legal: the covert campaign to rig our tax system to benefit the super rich—and cheat everybody else 123 (2003) [hereinafter johnston, perfectly legal]. 201. johnson & kwak, white house burning, supra note 10, at 68. government revenues fell from 19.6 percent of gdp in 1981 to 17.3 percent in 1984. they grew later on in the decade but never exceeded 18.4 percent of gdp. office of mgmt. & budget, exec. office of the president, historical tables, budget of the u.s. government, fiscal year 2012, at 24–25 table 1.2 (2011), http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assests/ hist.pdf. 202. johnson & kwak, white house burning, supra note 10, at 68. 2014] the movement to destroy the income tax and the irs 201 they raised excise taxes, such as the nickel-a-gallon tax on gasoline (which reagan referred to as revenue enhancers as opposed to calling them tax increases); 203 then increased the social security tax. the tax burden of both of these increases is felt more keenly by low and middle class income tax payers. 204 beginning in 1983, the white house began claiming that social security was in deep trouble and required additional funding in order to remain solvent. alan greenspan headed a commission that reported that in 31 years, social security would start operating in the red. critics of greenspan’s findings noted that economic growth and slightly less generous inflation increases would solve any potential funding problems. 205 senator daniel moynihan, a democratic senator from new york known for his expertise on social security, scoffed at the idea that social security was in trouble and labeled the calls for an increase in social security taxes as “thievery” designed to hide the pernicious effect of the reagan tax cuts on the economy and the government. 206 many americans might recognize that the federal government is incurring substantial debt, but might not be able to discern that the cause is the drop in the income tax rates nor recognize that the debt would be even higher were it not for the increased social security and excise taxes. nevertheless, social security tax rates and the wage ceiling were increased so that from 1984 to 2002, the government collected $1.7 trillion more in social security taxes than the agency paid out in benefits. 207 as noted by professor johnston: the rise in the maximum social security tax has been sharp. in 1970 the maximum tax was $327. three decades later the 203. id. 204. excise taxes on necessities, such as gasoline, hurt the poor more because the tax is a larger percent of their disposable income as opposed to wealthier individuals. consumers can try to curtail their need for the taxed items, but can do so by only so much. social security is also felt more keenly by lower and middle class income taxpayers. one reason is that wage income is subject to the tax, whereas investment income is not. second, social security is not paid on all wage income, but rather only up to a specific ceiling amount. in 2003, the ceiling was $87,000 and up to $116,800 by 2012. employees pay a tax of 6.2 percent on this wage income. however, once the ceiling is reached, any excess wages are free from the tax, enabling higher income wage earners to save more. employers are required to “match” this 6.2 percent tax, but most economists agree that the employee bears the burden because the employer figures in the matched amount when determining salaries. 205. johnston, perfectly legal, supra note 200, at 124. 206. id. 207. id. at 120, www.ssa.gov. 202 florida tax review [vol. 15:4 maximum was $4,724 or more than 14 times as much. in 2003 it was almost $5,400, an amount matched by the employer. for a married couple both earning the $87,000 maximum subject to the total tax, it comes to $21,576 or more than $400 paid to the government each week. 208 rather than tell the american people the truth, their leaders in congress assured the public that the extra money being paid into social security would go into a trust fund and would earn interest. of course, no such thing occurred. instead, the money was used to compensate for the shortfall in federal revenues caused by the reagan tax cuts for the wealthy. from 1983 to 2003, the government spent almost $5.4 trillion more than it took in from income, estate, gift, and excise taxes. however, the government debt grew by only $3.6 trillion because of the extra social security taxes that were paid in and used for the operational expenses of the federal government. 209 “in effect[,] the government took dollars from joe lunchpail so that the rich could stuff even more into their silk pockets.” 210 however, tax cuts are now the centerpiece of republican economic policy, regardless of how the economy is fairing. when economic times are good (an increasing rarity), then taxes should be reduced in order to return the money to its rightful owners. when the economy is bad, cutting taxes will create economic stimulation. most taxpayers do not have the time or ability to study in depth how the federal budget or the income tax system operates; therefore, taxpayers do not see how fallacious or circular the tax cut arguments are. the mantra is “cut taxes.” as the government incurs massive debt, taxpayers develop the impression that the federal government is irresponsible and out of control; therefore, it is throwing good money after bad to continue to fund the federal government with taxpayers’ hard-earned money. as the government continues to lose funding, it is then forced to cut services or borrow money to meet expenses. this service reduction and mounting debt further reinforces taxpayers’ belief that government is incompetent and cannot manage its affairs, leading to the argument that taxes should be cut even more. david stockman, former budget director to ronald reagan, expressed disgust with the tax cuts at all times philosophy, despite its detriment to the country: 208. id. at 126. 209. id. at 125. 210. id. at 126. these amounts were computed by jarrett murphy from national income and product accounts, bureau of economic analysis, commerce department. furthermore, from 1983 to 1986, taxes other than social security and medicare totaled less than half of all federal spending. 2014] the movement to destroy the income tax and the irs 203 [“]well, it’s become in a sense an absolute. something that can’t be questioned, something that’s gospel, something that’s sort of embedded into the catechism and so scratch the average republican today and he’ll say [‘]tax cuts, tax cuts, tax cuts,[’”] he explained. [“]it’s rank demagoguery,[”] he added. [“]we should call it for what it is. if these people were all put into a room on penalty of death to come up with how much they should cut, they couldn’t come up with $50 billion, when the problem is $1.3 trillion. so, to stand before the public and rub raw this anti-tax sentiment, the republican party, as much as it pains me to say this, should be ashamed of themselves.[”] 211 until the latter part of reagan’s second term, the republican party was still controlled by more moderate republicans such as then senate majority leader bob dole who believed in balanced budgets. 212 however, the antitax group continued to gain influence and power, led by newt gingrich who had been serving in the house of representatives since 1978. gingrich assembled a group of more radical antitax conservatives and by the end of george h.w. bush’s term as president, this group had gained control of the republican party. 213 although they occasionally pay lip service to the idea of balanced budgets, they are surprisingly frank in stating that their real agenda is cutting taxes. for example, former house majority leader dick armey stated that, “balancing the budget in my mind is the attention-getting device that enables me to reduce the size of government . . . . if you’re anxious about the deficit, then let me use your anxiety to cut the size of the government.” 214 grover norquist, the tax cut enforcer of the republican party, is also very open about the fact that he only cares about tax cuts, not the deficit. 215 211. see david stockman, 60 minutes (cbs television broadcast oct. 31, 2010). 212. johnson & kwak, white house burning, supra note 10, at 73. 213. id. at 73–78. see also balz & brownstein, storming the gates, supra note 7, at 117. 214. balz & brownstein, storming the gates, supra note 7, at 154. 215. in 2011, when congress was debating whether or not to raise the debt ceiling, norquist stated, “anyone who says we have a deficit problem is either a democrat who wants to raise taxes or a republican who’s dimwitted and doesn’t understand what he is talking about.” johnson & kwak, white house burning, supra note 10, at 79. 204 florida tax review [vol. 15:4 d. more tax cuts and more debt on august 10, 1993, president bill clinton signed legislation raising taxes, mostly on higher income taxpayers. 216 clinton was able to get his tax increase legislation passed by emphasizing fiscal responsibility and balanced budgets as opposed to ideological or policy arguments that the progressive income tax is fair. the tax increase passed without a single republican vote. 217 as a result, the federal government’s annual budget operated in the black and the deficit began to shrink. 218 as a result, in january of 2001, when george w. bush entered the white house, the congressional budget office was projecting budget surpluses for the next decade, including a surplus of $796 billion. 219 however, in 2010 the budget actually ran a deficit of $1.3 trillion—a difference of over $2 trillion. how did the federal government go from projected surpluses to deficits during the george w. bush administration? on june 7, 2001, bush signed his tax cut package into law and lowered rates on the rich, eliminated the estate tax for one year and gave more than half of the $1.3 trillion tax cut (to be spread over ten years) to the richest 1 percent. 220 the economic growth and tax relief reconciliation act of 2001 216. omnibus budget and reconciliation act of 1993, pub. l. no. 103-66, 107 stat. 312. 217. see u.s. senate roll call votes 103d congress – 1st session, u.s. senate, http://www.senate.gov/legislaive/lis/roll_call_lists/roll_call_vote_cfm.cfm ?congress=103&session=1&vote=00247#position. the roll call states that the 50 democratic senators voted for the tax increase and the 50 republican senators voted against it. vice president al gore voted in favor of the tax increase, breaking the tie votehttp://www.senate.gov./legislative/lis/roll_call_vote_vote. in the house of representatives, all 175 republican representatives voted against the tax increase. see u.s. house of representatives roll call votes 103d congress – 1st session, u.s. house of representatives, http://clerk.house.gov./evs/1993/roll199.xml.http:// www.house.gov/evs/1993/roll406.xml. 218. interestingly, bruce bartlett, a treasury official during the reagan administration acknowledged that clinton’s economic policies were praiseworthy, noting that clinton returned the federal budget to a surplus. see bruce bartlett, those were the days, n.y. times, (jul. 1, 2004), http://www.nytimes. com/2004/07/01/opinion/those-were-the-days.html (“bringing the federal budget into surplus is obviously an achievement. after inheriting a deficit of 4.7 percent of gross domestic product in 1992, mr. clinton turned this into a surplus of 2.4 percent of g.d.p. in 2000 . . . .”). 219. cong. budget office, the budget and economic outlook: fiscal years 2002 to 2011, at 2, table 1-1 (2001), http://www.cbo.gov /publication/12958. 220. pub. l. no. 107-16, 115 stat. 38. johnston, perfectly legal, supra note 200, at 129. the center on budget and policy priorities estimated that the 2001 tax cut would cost $4.1 trillion in its second decade from 2012 through 2021, 2014] the movement to destroy the income tax and the irs 205 (egtrra) was the second or third largest tax cut in modern history. 221 egtrra lowered tax rates for almost all taxpayers, increased deductions and exemptions for high-income households, and made it easier to shield retirement funds from taxation. 222 by 2003, the projected budget surpluses from the clinton administration were gone, but george w. bush argued that additional tax cuts would act as an economic stimulus and with republicans wavering under extreme pressure from organizations such as grover norquist’s americans for tax reform, discussed infra, congress passed the jobs and growth tax relief reconciliation act of 2003 (jgtrra). 223 this tax cut bill lowered the tax rate on capital gains and dividends and also accelerated some of the 2001 tax cuts that originally had been scheduled to begin years later. 224 this tax cut primarily benefited the wealthy whose investments generate capital gains and dividends. middle class taxpayers also have investments, but mostly in the form of the equity in their homes and their retirement savings which are largely shielded from taxation. these tax cuts were then extended through 2010 by the tax increase prevention and reconciliation act of 2005 (tipra). 225 in 2010, with the support of president barack obama, the tax cuts were extended again until 2012. 226 when fully phased in, 67 percent of the tax cuts went to the richest 20 percent of households. households making between $40,000 and $50,000 saw an average 2010 tax reduction of $962, but households making more than $1 million received an average reduction of $168,052. 227 exclusive of additional interest on the larger national debt. johnson & kwak, white house burning, supra note 10, at 90, n.125. 221. johnson & kwak, white house burning, supra note 10, at 88. 222. cbo, estimate, supra note 199. 223. pub. l. no. 108-27, 117 stat. 752. 224. id. 225. pub. l. no. 109-222, 120 stat. 345. the expiration date of these tax cuts in 2010 was due to the manner in which congress enacted the legislation. in the senate, most measures require 60 votes in order to end debate and move to a vote; a filibuster permits 41 senators to prevent a vote. however, the budget reconciliation process provides an exception to the filibuster rules for bills that change revenue and mandatory spending laws. the budget reconciliation process was created by the congressional budget and impoundment control act of 1974 and was intended to expedite budgetary legislation. pub. l. no. 93-344, 88 stat. 297. however, bills passed through this process sunset automatically after ten years. however, when the tax cuts are due to expire as a matter of course, the anti-tax group argues that allowing the cuts to expire is tantamount to a tax increase. 226. tax relief, unemployment insurance reauthorization, and job creation act of 2010, pub. l. no. 111-312, 124 stat. 3296. president obama signed the legislation on december 17, 2010. 227. tax policy center, individual income and estate tax provisions in the 2001–08 tax cuts with amt patch extended, distribution of federal tax change 206 florida tax review [vol. 15:4 in 2000, george w. bush had also pledged that he would not touch the excess social security taxes that were being collected, claiming that $2 trillion in social security revenues were safe in a lockbox. 228 just two months after he took the oath of office, he reiterated his promise that social security taxes would only be spent on social security and not for other programs. 229 by then the wall street journal had already concluded that [george w.] bush intended to pick the lock on the social security box. [george w.] bush’s economic plan, the journal reported, uses “all of the social security surpluses … to fund the government for the next two years, and to spend well over $100 billion of social security funds in each of the following three years.” 230 what makes the passage of these tax cuts all the more remarkable is that there was not much public support for them. most taxpayers preferred higher domestic spending over tax cuts and also favored tax cuts going to middle-income americans instead of high-income taxpayers. polls revealed that a slight majority of taxpayers favored tax cuts when the question was asked in the abstract, but when taxpayers were asked if they wanted the then surplus used for social security or medicare, support for the tax cuts became very low. 231 nevertheless, congress repeatedly enacted legislation giving tax cuts to the wealthy. the underlying reason behind this legislation is that members of congress are beholden to the special interest groups and lobbyists who fund their campaigns, as opposed to their constituents, who have difficulty grasping who actually benefits from this tax legislation. e. grover norquist: tax cut enforcer in 2012, george h.w. bush snapped, “who the hell is grover norquist, anyway?” 232 of course the former president knew who norquist by cash income level, 2010, brookings institution table t08–0156 (july 2, 2008), http://www.taxpolicycenter.org/numbers/displayatab.cfm?docid=1865.http://www. taxpolicycenter.org/numbers/displayatab.cfm?docid-1865&doctypeid=1. 228. johnston, perfectly legal, supra note 200, at 128. 229. id. at 127. 230. john d. mckinnon & shailagh murray, bush offers $2.13 trillion budget, launching era of deficit spending, wall st. j., feb. 5, 2002. 231. johnson & kwak, white house burning, supra note 10, at 88, n.115. 232. felicia sonmez, ‘who the hell is grover norquist, anyway?’ asks george h.w. bush, wash. post (july 13, 2012), http://www. washingtonpost.com/blogs/post-politics/post/who-the-hell-is-grover-norquist-asks2014] the movement to destroy the income tax and the irs 207 is, 233 but his point was that norquist is not an elected official, yet wields enormous political power. 234 the former president was referring to norquist’s threats to punish any republican member of congress who votes for a tax increase. norquist is president of americans for tax reform [hereinafter “atr”], an advocacy group which campaigns for lower taxes at the federal and state level. 235 but atr is not just any advocacy group; it is the well-funded, central clearinghouse for all far right-wing conservative causes. norquist has also built a solid working alliance with the fortune 500 corporate elite and its k street lobbyists. “what he’s managed to do is to chain the ideological conservatives together with the business guys, who have the money, and to put that money to work in the service of the conservative george-hw-bush/2012/07/13/gjqaezuviw_blog.html (reporting on an interview the former president gave to parade magazine). the 41st [p]resident . . . was asked how he feels about norquist’s anti-tax pledge, given his own retraction of his “no new taxes” pledge as president. “the rigidity of those pledges is something i don’t like,” bush responded. “the circumstances change and you can’t be wedded to some formula by grover norquist. it’s—who the hell is grover norquist, anyway?” 233. norquist claims credit for the former president’s presidential defeat when he ran for a second term in 1992. during his first successful campaign in 1988, bush had famously promised, “no new taxes.” however, when faced with a looming, large deficit, he realized that income taxes would have to be increased. an infuriated norquist claims that he punished george h.w. bush to send a message to other republican leaders not to stray from the commandment not to raise taxes. drake bennett, grover norquist, the enforcer, bloomberg businessweek, (may 26, 2011), http://www.businessweek.com/magazine/content/11_23/b423100668562 9.htm [hereinafter bennett, the enforcer]. as observed by alan brinkley, a columbia university historian, “i don’t know of anyone outside of government who has had this kind of influence on politics before . . . . he is sui generic, i think, not a politician, not visible very often in the media, but remarkably powerful.” id. 234. for example, white house visitor’s logs indicate that norquist visited the white house 74 times over a five year period during george w. bush’s presidency. alison fitzgerald, no-tax ‘zealot’ norquist emerges as biggest barrier to u.s. deficit deal, bloomberg, (may 24, 2011), http://www.bloomberg. com/news/2011-05-24/norquist-emerges-as-barrier-to-u-s-debt-deal.html [hereinafter fitzgerald, zealot]. 235. norquist has also compared the arguments for imposing the estate tax on the wealthiest americans to the morality of the holocaust. (“[t]he morality that says it’s ok to do something to a group because they’re a small percentage of the population is the morality that says that the holocaust is ok because they didn’t target everybody, just a small percentage.”) see fresh air (npr radio broadcast oct. 2, 2003), http://www.npr.org/templates/story/story.php?storyid=1452983. 208 florida tax review [vol. 15:4 movement,” says roger hickey of the campaign for america’s future, who’s repeatedly clashed with norquist. “and he picks big issues.” besides taxes, norquist is also the go-to-guy on virtually all of the right’s favorite agenda items, from privatization of social security and medicare to school vouchers and deregulation. 236 norquist got his start in 1986 when president reagan asked norquist to run an ad hoc group called americans for tax reform, then a white house in-house operation created to build support for reagan’s 1986 tax bill. 237 soon afterward, norquist took atr private and has run it ever since. 238 atr has received funding from rj reynolds, philip morris, microsoft, us tobacco, and aol timewarner, among others. 239 one of atr’s most effective tools in becoming indispensable to the far right-wing has been the well-known wednesday morning meetings. they began in 1993 with the purpose of rallying conservatives against then president clinton’s healthcare plan. 240 the meetings began initially with around a dozen attendees but now have grown to about 100. 241 the meetings are attended by representatives from the national rifle association, the christian coalition, the heritage foundation, republican national committee members, and house and senate leaders, together with conservative media reporters and editors. 242 236. robert dreyfuss, grover norquist: ‘field marshall’ of the bush plan, the nation, april 26, 2001 [hereinafter dreyfuss, field marshall]. 237. americans for tax reform, federal taxpayer protection pledge questions and answers, http://www.atr.org/federal-taxpayer-protection-questionsanswers-a6204. 238. dreyfuss, field marshall, supra note 236. 239. id. the most recent data available is from 1999 when atr received $7 million in funding. 240. id. see americans for tax reform, who is grover norquist?, http://www.atr.org/about-grover. 241. id. see john cassidy, wednesdays with grover, the new yorker, aug. 1, 2005 [hereinafter cassidy, wednesdays]; see also laura blumenfeld, sowing the seeds of gop domination, wash. post, jan. 12, 2004, at a01 [hereinafter blumenfeld, sowing the seeds]. 242. dreyfuss, field marshall, supra note 236. norquist has served on the ten-person executive council of the tax relief coalition, established by the national association of wholesaler-distributors, the national association of manufacturers, the national federation of independent businesses, and the u.s. chamber of commerce. more than 700 corporations and trade associations have joined the tax relief coalition with 80 of these corporations paying $5,000 each to be part of its steering committee. id. 2014] the movement to destroy the income tax and the irs 209 norquist is able to boast that, as of june 1, 2011, 236 u.s. house representatives and 41 u.s. senators from the 112th congress have signed his tax pledge in which they promise to never raise taxes. 243 he has also acquired, as of june 17, 2011, the signatures of 1,263 state legislators, in addition to 13 governors, five lieutenant governors, four attorney generals, three secretaries of state, three treasurers, one auditor, and one member of the board of equalization. 244 the tax pledge is not just a piece of paper; it is a weapon. woe to the politician who reneges on this promise or even shows signs of weakening. during the primary race for the republican presidential nomination in 1988, then frontrunner bob dole refused to sign the pledge and subsequently lost the republican presidential nomination to george h.w. bush, who had signed the pledge. 245 however, in 1990, faced with the large reagan-era budget deficits and debt, george h. w. bush raised taxes. 246 after george h.w. bush did so, norquist targeted bush for defeat when he ran for reelection in 1992. 247 in 1994, after republicans gained control of the house, some republicans protested the size of the tax cut proposed by the house leadership. norquist launched a direct mail attack against the group’s leader, forcing the group to back down. 248 norquist’s revenge is not confined to politicians at the federal level. he has sought to defeat republican legislators in primary elections who have voted to raise taxes in violation of the pledge. 249 when abel maldonado, a state senator 243. americans for tax reform, current list of taxpayer protection pledge signers for the 112th congress, http://www.atr.org/current-list-taxpayerprotection-pledge-signers-a5597. see also bennett, the enforcer, supra note 233. the taxpayer protection pledge for u.s. representatives recites as follows: “i, ______, pledge to the taxpayers of the _____________district of the state of ______________and all the people of this state that i will oppose and vote against any and all efforts to increase taxes.” americans for tax reform, taxpayer protection pledge, http://www.atr.org/userfiles/statepledge.pdf. 244. bennett, the enforcer, supra note 233. 245. id.; johnson & kwak, white house burning, supra note 10, at 79. 246. in his 1988 campaign for the presidency, george h.w. bush promised not to raise taxes, famously stating at the republican national convention, “read my lips: no new taxes.” george h.w. bush, 1988 republican national convention acceptance address (aug. 18, 1988), http://www.americanrhetoric.com/speeches/ georgehbush1988rnc.htmhttp://www.americanrhetoric.com/speeches/georgehbush19 88rnc.htm. however, in 1990, faced with increasing federal deficits and a weak economy, he negotiated a deal with the democrats and raised taxes. omnibus reconciliation act of 1990, pub. l. no. 101-508, 104 stat. 1388. grover norquist claims that he helped defeat george h.w. bush to punish him for this transgression. bennett, the enforcer, supra note 233. 247. bennett, the enforcer, supra note 233. 248. johnson & kwak, white house burning, supra note 10, at 80; bennett, the enforcer, supra note 233. 249. cassidy, wednesdays, supra note 241 210 florida tax review [vol. 15:4 from california, voted for a tax increase proposed by then republican governor arnold schwarzenegger, norquist successfully targeted maldonado for defeat when he ran for lieutenant governor. 250 norquist has spent the last 30 years building a powerful coalition of hardcore, far right-wing conservatives opposed to tax increases for any reason. 251 norquist’s ultimate goal is to reduce the government to the size it can be “drowned in a bathtub.” 252 he has not yet succeeded; however, he was instrumental in damaging the credit rating of the united states. the debtceiling standoff in congress in the summer of 2011 was due in large part to members’ of congress unwillingness to violate the tax pledge they had in the past few years, a lot of states and cities have been facing budget deficits, which they are legally obliged to close. you might think this justifies higher taxes, but norquist doesn’t. he’s just brutal to republican tax raisers. in virginia, for example, he’s getting involved in this year’s republican primaries and trying to unseat a number of legislators who voted for higher taxes. it’s a similar story in other states. id. for those who do not cooperate, norquist plays enforcer. democrats are “bad guys,” but errant republicans are “evil.”. . . . on the internet access tax vote, he targeted two republican [u.s. s]enators from tennessee and ohio: “we’re going to get [lamar] alexander and [george] voinovich to behave. ∙ ∙ ∙ when alabama gov. bob riley (r) tried to pass a state tax increase, norquist helped defeat it. “we’re going to keep him on life support,” he said. “we’ll put him in a freezer, as an example,” he gave the alabama state party chairman an award for opposing the hike. instead of a plaque, norquist sent him a sword with a steel blade. blumenfeld, sowing the seeds, supra note 241. 250. see fitzgerald, zealot, supra note 234. norquist issued a press release saying that because of maldonado, “california is closed for business.” id. norquist also distributed videos on youtube, and wrote opinion pieces in california newspapers and blogs. id. 251. he has also compared bipartisanship to “date rape.” see cassidy, wednesdays, supra note 241. http://www.newyorker.com/archive/2005/08/01/ 05081on_onlineonly01?printable=true 252. in the meantime, norquist has other goals as well. for example, he wants to dismantle and privatize state pension plans and the trillions of dollars of public funds held as investments for retirees. “just 115 control $1 trillion in these funds,” he says. “we want to take that power and destroy it.” dreyfuss, field marshall, supra note 236. in addition, destroying the democratic party appeals to him. “democrats used to anger him, norquist said. he’s past angry now. ‘do you get mad at cancer? we’ll defeat and crush their institutions, and the trial lawyers will go sell pizza.’” blumenfeld, sowing the seeds, supra note 241. 2014] the movement to destroy the income tax and the irs 211 signed, bringing the nation to the verge of a default. “‘congress was willing to cause severe economic damage to the entire population,’ marvels paul o’neill, george w. bush’s former treasury secretary, ‘simply because they were slaves to an idiot’s idea of how the world works.’” 253 although norquist’s wednesday morning meetings of far right-wing activists might be the most well-known, they are not unique. there were weekly wednesday night meetings for the under-30 crowd known as the third generation held at the heritage foundation, and there are monthly meetings of the federalist society in washington d.c.’s chinatown, and meeting of the saturday evening club at a french restaurant organized by r. emmett tyrrell of the american spectator (a far right-wing magazine) for leading conservative writers and pundits. there is also the annual national conservative political action committee meeting where hundreds of grassroots activists from around the country gather. 254 the right-wing also has singled out federal judges for special attention. the law & economic center at george mason university school of law treats federal judges to two-week seminars at resorts where they are educated in advanced legal and economic theories advocating a hands-off approach to the “free market.” as explained by the national committee for responsive philanthropy, moving a public policy agenda: the law and economics center mission is to educate judges in how to apply principles of economic analysis to the law. by 1991, the center had provided such training—with seminars held at resort locations to enhance their attractiveness—to over 40 [percent] of the federal judiciary. ∙∙∙ like the center for the study of market processes, the [law and economics center] is run independently of george mason, with corporate and foundation sponsors covering all travel, lodging, and meal expenses for the most powerful players in the legal system—judges. 255 253. tim dickinson, grover norquist: the billionaires’ best friend, rolling stone mag., aug. 5, 2012. 254. robert borosage, the mighty wurlitzer, the am. prospect, (may 5, 2002), http://prospect.org/cs/articles?article=the_mighty_wurlitzer [hereinafter borosage, wurlitzer]. 255. johnson, tort law, supra note 174, at 42. the law and economics centers founded by henry g. manne is not only at george mason but also at emory university and the university of miami. it receives funding from the sarah scaife foundation. id. george mason university foundation, inc., the george mason university, and george mason school of law also receives funding from the charles g. koch charitable foundation, john m. olin foundation, and the lynde 212 florida tax review [vol. 15:4 f. think tanks and media the right-wing has also turned to media to broadcast its message, and given its lavish funding and extensive, well-organized networks, the right-wing has a powerful machine with which to do so. with all that ideological money, institutional heft, coordination, and credentialing, the right has perfected what the cia used to call a “mighty wurlitzer”—a propaganda machine that can hone a fact or a lie, broadcast it, and have it echoed and recycled in fox news commentary, in washington times news stories, in wall street journal editorials, by myriad right-wing pundits, by heritage seminars and briefing papers, and in congressional hearings and speeches. privatization of social security, vouchers for school, vince foster’s supposed murder, hillary’s secret sex life—you name it—the right’s mighty wurlitzer can ensure that a message is broadcast across the country, echoed in national and local news, and reverberated in the speeches of respectable academics[,] as well as rabid politicians. 256 these organizations, through the media, put out the same message, creating a “multiplier” effect and give the impression that there is consensus and harry bradley foundation (according to records from 1989 to 2002). id. at 43– 44. 256. borosage, wurlitzer, supra note 254. by way of example of the echo and multiplier effect, so that some message becomes conventional wisdom or accepted fact, robert borosage uses david brock’s smearing of anita hill during the senate hearings to confirm clarence thomas as a justice for the united states supreme court. brock had denigrated professor hill as “a little slutty and a little nutty,” which was repeated by conservative pundits. with no factual basis, brock trashes hill—“a little slutty and a little nutty” was the quote chosen for effect —in the american spectator, with a circulation of 30,000. rush limbaugh then reads from the article on his radio show, broadcast to two million people. conservative pundits recycle the charges in columns and radio shows across the country. brock turns the article into a book at the free press, which gets george will to hype the book in a column. the wall street journal devotes virtually an entire editorial page to excerpts. that ensures that the book is treated seriously in the new york times book review and kindred publications. and so it goes. a biased, politically inspired hatchet job becomes a bestseller, clothed in the praise of conservative pundits. id. 2014] the movement to destroy the income tax and the irs 213 or widespread support for their opinions and policies, that “everyone thinks so.” the right’s organizations use sophisticated market methods to “translate”—packaging ideas to appeal to people’s deeper feelings and values—and disseminate messages designed to alter underlying public opinions to be supportive of their shared ideology. even single words or phrases, selected for their effectiveness, are shared by multiple voices to reinforce the right wing message. this in turn leads to public support for their organizations and ideology, puts public pressure on legislators to support their issues, and elects public officials who support their agenda and appoint judges and agency officials who carry out their policies. 257 the right-wing amplifies its message, creating the impression that diverse groups all think the same thing. very few people know that only a handful of the ultra-wealthy are behind this “diversity of opinion.” as a result, [l]ayer upon layer of seminars, studies, conferences, and interviews [can] do much to push along, if not create, the issues, which then become the national agenda of debate. . . . by multiplying the authorities to whom the media are prepared to give a friendly hearing, [conservative donations] have helped to create an illusion of diversity where none exists. the result can be an increasing number of one-sided debates in which the challengers are far outnumbered, if indeed they are heard at all. 258 talk show radio and cable news in particular have played an important role in broadcasting the anti-tax, anti-government message. rush limbaugh has been the top-rated radio host for the last 20 years, 259 and fox news has been the dominant cable news channel since 2002. 260 rush limbaugh is not alone, however. as of spring 2011, the top eight talk radio 257. johnson, tort law, supra note 174, at 10. 258. id. at 16 (quoting sally covington, the strategic philanthropy of conservative foundations, national committee for responsive philanthropy (1997)). http://www.mediatransparency.org/movement.htm 259. zev chafets, late-period limbaugh, n.y. times, july 6, 2008. 260. jacques steinberg, fox news, media elite, n.y. times, nov. 8, 2004; jacques steinberg, fox news finds its rival closing in, n.y. times, june 28, 2008. 214 florida tax review [vol. 15:4 shows featured conservative hosts. the top eight were: (1) rush limbaugh, (2) sean hannity, (3) michael savage, (4) glenn beck, (5) mark levin, (6) dave ramsey, (7) neal boortz, and (8) laura ingraham. 261 admittedly, there probably is a great deal of overlap in the listening audiences. every weekday, and sometimes on weekends, these conservative talk show hosts preach the anti-government, anti-tax message to their audience. a more recent tactic by the anti-tax movement has been to use a fake grass-roots organization to create the impression that average americans, fed up with taxes, have spontaneously organized and banded together to fight back: the tea party. historically, objections to taxes have tended to be lodged against specific taxes or the purpose for which they were used (e.g., war) but this new objection, as voiced by the tea party movement, is against taxation in general. 262 however, the tea party is organized and funded by freedomworks, an organization that, until recently, was run by dick armey, the former house majority leader for the republicans. freedomworks is funded by the same right-wing group of billionaires as the other organizations, such as heritage foundation and the manhattan institute. 263 during world war ii, the fdr administration made effective use of media, particularly radio, in communicating its message to the american people that paying the income tax was patriotic. even after the end of world war ii, television shows continued to portray the income tax, and the irs, in a positive light for several decades. although the taxpayers expressed fear of running afoul of the irs, most of the early episodes note the social contract basis for complying with taxpaying obligations and emphasize the benefits the public receives from the government’s use of their tax revenues. beginning in the 1940s, radio and television sitcoms began to air episodes (especially around march, which was the month in which the return date formerly fell, or april) in which taxpayers had to file their annual tax returns. 264 one notable change over the years is in the number of episodes: 15 in 1940, 25 in the 1950s, 12 in the 1960s, ten in the 1970s, eight in the 1980s, 17 in the 1990s, and four from 2000 to 2007. 265 the high number of episodes in the 1940s and 1950s reflects the fact that for many taxpayers, the 261. the top talk radio audiences, talkers mag., (spring 2011), http://talkers.com/top-talk-radio-audiences/. glenn beck and neal boortz are no longer hosting programs. boortz recently retired and glenn beck became so controversial that he was switched to cable television. 262. lavoie, patriotism and taxation, supra note 58, at 66, n.106 (describing the movement as astroturf). 263. paul krugman, tea parties forever, n.y. times, apr. 13, 2009, at a21. 264. lawrence zelenak, from the great gildersleeve to homer simpson: six decades of the federal income tax in sitcoms, 117 tax notes today 1265 (dec. 27, 2007). 265. id. 2014] the movement to destroy the income tax and the irs 215 federal income tax was a new experience. 266 the spike in the 1990s might well reflect the fact that congress was holding highly publicized hearings attacking the internal revenue service, discussed infra. 267 many of the episodes featured plots in which a taxpayer would have to decide whether or not to be truthful on his or her tax return. particularly in the earlier episodes, the taxpayer is anguished over either an honest mistake or a deliberate omission of some items of income (usually in relatively small amounts). although many of the taxpayers expressed fear that they will face prison, the internal revenue service agents were not portrayed unsympathetically and thanked the taxpayer for his or her honesty when he or she confesses to the understatement and corrects the return. many of the taxpayers expressed pride that “they did the right thing” and paid their fair share of tax because of all the benefits they receive from living in this country. 268 however, in some of the later episodes in the 1990s and 2000s, there is some evidence of decreasing respect for the income tax system. 269 266. burns and allen: income tax problems (radio broadcast mar. 1, 1950). in the show, george explains to gracie why the government needs the money: the government needs our tax money to run the country. part of it goes to pay the salaries of the president, the cabinet, and the congressmen. and the government needs the money to run the army and the navy. . . . . and don’t forget that our government is spending millions of dollars on european recovery. id. 267. see e.g., camp, tax administration, supra note 85, at 79–80; see also diane l. fahey, the tax court’s jurisdiction over due process collection appeals: is it constitutional? 55 baylor l. rev. 453, 457–58 (2003) [hereinafter fahey, collection appeals] (discussing the senate finance committee hearings that led to the enactment of the irs restructuring and reform act). 268. see lawrence zelenak, justice holmes, ralph kramden, and the civic virtues of a tax return filing requirement, 61 tax l. rev. 53, 62–63 (2007) (discussing the honeymooners: income tax (cbs television broadcast mar. 7, 1953)). ralph kramden finds that he owes $15 which he could pay by using the money he had saved for a new bowling ball. instead, he gives the money to a priest who stops by to ask for a donation for the poor. ralph decides he will work an extra shift to earn the money for the tax and tells his wife, alice: “i didn’t mean what i said before about income taxes. boy, we should give everything to the government. we’re living in a great country. this is the greatest country in the world. we’ve got parks for the kids. everybody’s free to say what they think and do and please. it’s a great place.” id. 269. lawrence zelenak, learning to love form 1040 (2013). for example, in an episode of the sitcom roseanne, the taxpayers cheat on their taxes and bitterly denounce the irs and the code to irs employees who are rude and sarcastic. roseanne and dan connor must determine whether they need to include $400 on their income tax return that roseanne earned selling magazine subscriptions. when one of their children asks whether the parents cheat on their 216 florida tax review [vol. 15:4 although no one would argue that sitcoms represent the reality of most viewers’ daily life, sitcoms do reflect or arise out of a society’s culture. viewers watch a program because in some way that sitcom speaks to them. despite the jokes in the earlier sitcoms about the irs and the complexity of the forms, most of the characters end up “doing the right thing” and paying their taxes. the later sitcoms where characters justify or laugh about noncompliance, might also well reflect a deteriorating tax ethos. thus, the earlier storylines reflected the taxpayer’s (1) recognition that our lives are enhanced by the benefits the government provides (a quid pro quo basis for compliance), and (2) respect for the social contract that “we are in this together” and need to pay our fair share because others are doing so. as discussed supra, threats are insufficient to obtain taxpayer compliance with their taxpaying obligations. as noted by lavoie, “taxpayers’ willingness to pay taxes increases if they understand the implicit quid pro quo received in exchange for their taxes and they if perceive [sic] that others are reciprocating by paying their share of the tax burden as well.” 270 g. the internal revenue service under attack 1. 1998 senate and house hearings into alleged abuses our tax system can only function if most taxpayers comply voluntarily with their reporting and payment responsibilities. as noted by professor camp: the tax determination process ultimately rests on taxpayers disclosing their financial affairs and paying what they owe taxes, roseanne says no, but then winks and nods simultaneously, indicating that she and her husband do, in fact, cheat. roseanne and dan then go visit an irs office for assistance, but the irs employee they encounter is sarcastic and rude. the employee explains that roseanne did not receive a form 1099 for the $400 because a form 1099 is not required for amounts less than $600. “the answer is there in writing. sorry there are no pictures.” roseanne responds angrily that “no human being can really understand these things, you know that. that’s why you've got to go get some $200 an hour lawyer to explain the crap to you, you know. and i can’t afford $200 an hour.” another irs employee then retorts, “we don’t write the stinking laws. you got a complaint, talk to the idiots in congress.” roseanne bitterly erupts that, “the poor people and us regular people, we’re paying more taxes than the rich people, ‘cause they’ve got all the lawyers to figure out all the loopholes.” the connors return home and complete their tax return, with the implication that they did not include the $400 in their income. id. at 92, 93–94, 112 (quoting roseanne: april fool’s day (abc television broadcast apr. 10, 1990). 270. lavoie, patriotism and taxation, supra note 58, at 46. 2014] the movement to destroy the income tax and the irs 217 through withholding or otherwise without overt government compulsion. . . . . it is each citizen’s self-enforcement of the legal duty that keeps . . .the tax. . .system running smoothly. with over 130 million individual tax returns and over 80 million other returns (not including information returns) filed in [the] calendar year 2001, the system depends on the veracity, if not the kindness, of taxpayers. 271 the irs obtains information about taxpayers through tax and information returns and audits; however, the irs employs these tools solely for the purpose of encouraging compliance. 272 it is through use of this information that the irs is able to monitor, verify, and enforce the law, stated otherwise, to require taxpayers to determine their correct tax liability and pay it. however, beginning particularly with ronald reagan, the antitax, anti-federal government cabal bitterly denounced the federal government in general and the irs in particular. many americans are familiar with ronald reagan’s words when he took the oath of office to serve as president of this country, “government is not the solution to the problem; government is the problem.” on other occasions, he had stated that the most dreaded words in the english language were, “i’m from the government and i’m here to help you.” he also famously denounced the federal income tax as “unamerican.” 273 reagan was not alone in his denouncements of our government and tax system. congressmen jack kemp also called for the abolishment of the income tax and the irs: the internal revenue service as it exists today is incompatible with a free society. it is intrusive and by its very nature, contrary to the fundamental rights of citizens …. [t]he abuses will continue as long as the present tax [c]ode and the irs remain …. to tax not only income, but also savings, investments, and assets, the government must 271. camp, tax administration, supra note 85, at 5–6. 272. i.r.m. 1.2.13.110 (“the primary objective in selecting returns for examination is to promote the highest degree of voluntary compliance on the part of taxpayers.”) the internal revenue manual, or i.r.m., is the penultimate guide for irs personnel. 273. president reagan’s remarks during tax bill signing ceremony (oct. 22, 1986) reprinted in 33 tax notes 413 (oct. 27, 1986) (“blatantly unfair, our tax code became a source of bitterness and discouragement for the average taxpayer. it wasn’t too much to call it ‘unamerican.’”). see also louis e. wolcher, senseless kindness: the politics of cost-benefit analysis, 25 law & ineq. 147, 184 (2007) (reagan remarked during a speech to the representatives of the future farmers of america on july 28, 1988, that “the 9 most terrifying words in the english language are, i’m from the government and i’m here to help.”). 218 florida tax review [vol. 15:4 be all-knowing, by definition, the fundamental rights of privacy and fairness must be violated. 274 this anti-government, anti-tax rhetoric eventually affects americans’ attitudes towards the tax system and the government that tax system funds and empowers. eventually, the public no longer believes that the government is fulfilling its social contract responsibility to administer the tax system fairly, and no longer believes that the government is fulfilling its quid pro quo responsibilities by using taxpayer money wisely for benefits. the constant denouncements of the irs by government officials and political leaders created a false impression that the irs and the federal government were exceeding their authorized powers and paved the way for the public to believe the false testimony given during the 1998 senate finance committee hearings concerning the irs. although the accusations leveled against the irs were soon debunked, the atmosphere created by the false testimony enabled congress to pass legislation restraining the irs’s ability to carry out its tax collection duties. this in turn has led to reduced tax morale and increased cheating. beginning in september of 1997, the senate finance committee held hearings in which former and current irs agents and taxpayers recounted horror stories of alleged agency abuse of innocent taxpayers. senator william roth of delaware was the force behind most of the hearings, which he arranged to be held in a senate committee room specifically designed for intelligence briefings with walls that supposedly are able to block electronic eavesdropping and also included posted guards who searched those who wished to enter the room. at one point, six irs agents testified from behind a black curtain, with their voices electronically distorted and their identities concealed, the way turncoat mobsters who feared [that] their godfathers would have them whacked were allowed to testify. at a time when some members of congress were describing government law enforcement agents as “jack-booted thugs,” the impression that the irs was a government mafia that could have you killed for breaking its code of silence was unmistakable .275 these anonymous agents and taxpayers recounted dramatic stories of armed irs agents bursting into the homes and businesses of innocent 274. richard w. rahn, the irs choice: tax reform or self-destruction, in the irs v. the people: time for real tax reform 31 (jack kemp & ken blackwell eds., 1999). 275. johnston, perfectly legal, supra note 200, at 147–48. 2014] the movement to destroy the income tax and the irs 219 taxpayers while making threats, and, in one instance, allegedly ordering a teenage girl to change her clothes while a male agent watched, and of agents issuing subpoenas solely to harass their enemies. 276 in april of 1998, senator roth and the senate finance committee held additional, yet equally sensational hearings, which led senators trent lott of mississippi and frank murkowski of alaska to denounce the irs’s “gestapo-like tactics.” 277 representative bill archer, chair of the house ways and means committee, thundered that “criminals have more rights in this country than taxpayers do. it shouldn’t be that way. that’s wrong and we’re going to fix it.” 278 in addition to denouncing the irs as an out-ofcontrol rogue agency, members of congress denounced the code as a monstrosity that no honest taxpayer could understand in order to determine honestly and accurately one’s correct tax liability. representative bill archer claimed that “income is a subjective term. no two people agree on precisely what is income for tax purposes.” 279 senator roth belittled the code as “a mine field [sic] for most americans, and even too complex to be efficiently and consistently administered by the internal revenue service.” 280 implicit in these statements is the belief that a taxpayer’s true liability cannot be determined with any degree of accuracy; therefore, any action on the part of the irs to collect the tax is unreasonable and an arbitrary exercise of government power. 281 if americans believe these congressional leaders as to what the problem with government is, americans are going to believe in their proposed solutions. 276. id. at 148. 277. id. at 149. see also david cay johnston, i.r.s. commissioner promises full inquiry, n.y. times, may 2, 1998. the committee heard about armed raids, corrupt audits of large corporations, a botched effort to frame former senator howard h. baker jr. on bogus tax charges and pervasive cover-ups by management, although democrats on the panel emphasized that they were hearing only one side of the story and should treat some of the testimony skeptically. id. 278. camp, tax administration, supra note 85, at 82 (citing representative bill archer, news conference (oct. 21, 1997) (transcript available on lexis in fdch political transcripts)). 279. camp, tax administration, supra note 85, at 83 (citing representative bill archer, news conference (sept. 30, 1997) (transcript available on lexis in fdch political transcript)). as noted by professor camp, “archer was trying to segue into his favorite reform: consumption tax. id. at 78 note 435. 280. camp, tax administration, supra note 85, at 84, (citing irs oversight, hearings before the senate comm. on finance, s. hrg., 105-598, at 2 (1998)). 281. richard h. mcadams, the origin, development, and regulation of norms, 96 mich. l. rev. 338, 400–07 (1997) [hereinafter mcadams, origin]. 220 florida tax review [vol. 15:4 however, virtually every accusation leveled against the irs was repudiated after thorough investigations by the general accounting office, justice william webster (a former fbi director who the senate finance committee appointed to investigate the accusations), the new york times, tax notes, and the wall street journal. 282 for example, david cay johnston, then an investigative reporter for the new york times found that “[m]ost of the crucial testimony in the 1997–98 hearings that preceded the new law, contending abuses by i.r.s. agents has proved to be unfounded, based on false or misleading testimony or disproved in subsequent court actions.” 283 judge weber also found the accusations leveled against the irs to be unfounded. “‘no evidence was found of systematic abuses by agents,’ judge webster reported, although his investigators did find ‘isolated and individual’ examples of misconduct. judge webster concluded that there was ‘no evidence in the use-of-force incidents to suggest that . . . agents are overly aggressive, use force unnecessarily, or are improperly trained.’” 284 even more significantly, the general accounting office’s investigation failed to find abuse of power by the irs: generally, we found no corroborating evidence that the criminal investigations described at the hearing were retaliatory against the specific taxpayer. in addition, we could not independently substantiate that irs employees had vendettas against these taxpayers. our investigation did find that decisions to initiate the investigations were reasonably based on the information available to the irs at the time and were documented in agency files when they were made. further, we found no evidence that irs employees had acted improperly in obtaining and executing search warrants. 285 282. johnston, perfectly legal, supra note 200, at 157–58. 283. camp, tax administration, supra note 85, at 81, n.428, (quoting david cay johnston, inquiries find little abuse by tax agents, n.y. times, aug. 15, 2000, at c1). 284. johnston, perfectly legal supra note 200, at 157–58. 285. general accounting office, report to the chairman, committee on finance, u.s. senate, tax administration: investigation of allegations of taxpayer abuse and employee misconduct ¶ 2 (1999) reprinted in 2000 tax notes today 80-13 (tax analysts doc. no. 2000-11630). however, despite the investigations debunking senator roth’s accusations against the irs, he co-authored a book in which he continued to denounce the irs as a rogue agency. see william v. roth, jr. & william h. nixon, the power to destroy 14 (1999) (describing the irs as an agency with “unchecked power” and having a “culture of isolation that protects it against interference and oversight”). 2014] the movement to destroy the income tax and the irs 221 it strains credulity to believe that the members of the senate finance committee could have spent a year gathering these stories and not been aware that they were fabrications. indeed, senator roth attempted to suppress the report of the general accounting office which disproved the accusations and only through the efforts of tax notes, using the freedom of information act, was the report released. 286 2. congressional restrictions on irs enforcement powers nevertheless, after the second round of hearings, the senate voted 97 to zero to pass the internal revenue service restructuring and reform act of 1998 [hereinafter “rra 98”]. 287 the house followed suit and president clinton signed the bill into law on july 22, 1998. rra 98 made a number of significant changes in the structure of the irs, many of which are beyond the scope of this article; 288 however, one provision in particular had the effect of handcuffing irs employees, making them fearful they could lose their jobs as a result of complaints by disgruntled or vindictive taxpayers. the provision is commonly referred to as the ten deadly sins. rra 98 mandated that irs employees would be fired if found to have engaged in any of ten acts, which included violating a taxpayer’s constitutional or civil rights, threatening an audit for personal gain, making a false statement under oath or falsifying or destroying documents to conceal mistakes. 289 certainly, 286. johnston, perfectly legal, supra note 200, at 156. 287. pub. l. no. 105-206, 112 stat. 6851. 288. see generally camp, tax administration, supra note 85; see also fahey, collection appeals, supra note 267. 289. the ten deadly sins contained in rra 98 are: (1) willful failure to obtain the required approval signatures on documents authorizing the seizure of a taxpayer’s home, personal belongings, or business assets; (2) providing a false statement under oath with respect to a material matter involving a taxpayer or taxpayer representative; (3) with respect to a taxpayer, taxpayer representative, or other employee of the internal revenue service, the violation of (a) any right under the constitution the united states; or (b) any civil right established under (i) tit. vi or vii of the civil rights act of 1964; (ii) tit. ix of the education amendments of 1972; (iii) the age discrimination employment act of 1967; (iv) the age discrimination act of 1975; (v) section 501 or 504 of the rehabilitation act of 1973; or (vi) tit. i of the americans with disability act of 1990; (4) falsifying or destroying documents to conceal mistakes made by any employee with respect to a matter involving a taxpayer or taxpayer representative; (5) assault or battery on a taxpayer, taxpayer representative, or other employee of the internal revenue service, but only if there is a criminal conviction, or a final judgment by a court in a civil case, with respect to the assault or battery; (6) violations of the internal revenue code of 1986, department of treasury regulations, or policies of the internal revenue service (including the internal revenue manual) for the purpose of retaliating against, or harassing, a taxpayer, taxpayer representative, or other 222 florida tax review [vol. 15:4 committing any of these acts would be egregious behavior on the part of an irs employee. however, irs employees feared being accused, even unjustly, and subjected to investigations by the department of the treasury’s inspector general for tax administration. 290 well-known tax protestors such as irwin schiff, who had served time in prison for tax fraud, began to hold seminars teaching people how to use the new law to evade taxes. 291 collection efforts by irs personnel immediately plummeted because of (1) concerns of being falsely accused under the ten deadly sins, and (2) the shift of irs personnel from enforcement to service. 292 levies on and seizures of taxpayer assets dropped from 3,669,090 in 1997 to 2,505,259 in 1998. 293 even more dramatically, levies and seizures dropped to 504,161 in 1999 to 220,174 in 2000. 294 taxpayers who had influence with their congressperson were able to use that influence to resolve cases in the taxpayers favor: in nashville, a revenue agent said anyone there could get a tax case resolved favorably if the taxpayer had enough influence to get a senator or congressperson to complain to the irs. “we just collapse,” the 14-year veteran said. “please don’t call us tax collectors in the newspaper,” one longtime revenue officer in new york said. “we don’t collect taxes anymore. we aren’t allowed to.” 295 employee of the internal revenue service; (7) willful misuse of the provisions of section 6103 of the internal revenue code of 1986 for the purpose of concealing information from a congressional inquiry; (8) willful failure to file any return of tax required under the internal revenue code of 1986 on or before the date prescribed therefore (including any extensions), unless such failure is due to reasonable cause and not to willful neglect; (9) willful understatement of federal tax liability, unless such understatement is due to reasonable cause and not to willful neglect; and (10) threatening to audit a taxpayer for the purpose of extracting personal gain or benefit. see internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, 112 stat. 685. 290. see e.g., amy hamilton, ten deadly sins: effective tool or invitation to employee harassment? 85 tax notes 1360 (1999); see also ann murphy & david higer, the ten deadly sins: a law with unintended consequences, 96 tax notes 871 (2002). 291. johnston, perfectly legal, supra note 200, at 152. 292. leandra lederman, tax compliance and the reformed irs, 51 u. kan. l. rev. 971, 982 (2003) [hereinafter lederman, tax compliance]. 293. id. at 984. 294. id. 295. johnston, perfectly legal, supra note 200, at 154. johnston also uncovered evidence suggesting that irs supervisors refused to support the conclusions of irs agents who were auditing big oil companies like unocal and chevron. id. at 254–55. similar accusations arose in 2004 relating to the irs’s audit 2014] the movement to destroy the income tax and the irs 223 if taxpayers are convinced that the irs is a rogue agency that abuses power, they are less likely to comply voluntarily with the civic duty and pay the proper tax. at first, tax cheats will abuse the system but as time goes on, honest taxpayers will develop a contempt for the law and fail to comply. donald alexander, the nixon administration tax commissioner, was astonished at what his party, the party of law and order, had done to breed disrespect for tax law enforcement. alexander, who had gone on to become a prominent washington tax lawyer, said he would have none of the fashionable republican view that law enforcement was good, audits were bad. and he believed that weakening the irs was an unprincipled way to restrain the growth of government because the benefits went to the sharpers at the expense of the honest. “it’s a dumb law,” alexander said of the reform act and its ten deadly sins. “when someone can fail to meet his or her tax obligations without a worry about having enforcement actions taken, then other creditors are going to come in first and get paid, and the deadbeat taxpayer wins.” ∙∙∙ [t]he decline in tax rates paid by the largest companies and the increased willingness of rich americans to hide income and to undervalue gifts were the predictable results of slashing the number of auditors and then handcuffing those that remained. . . . . “the fewer traffic policemen you have, the more chances people are going to take,” he said. “and as people find that their neighbors are not paying their fair share, they are encouraged to not pay their share, either.” 296 nevertheless, the irs, under the new commissioner, charles rossotti, did exactly that and cut the number of audits for all income levels of micrel, inc. see warren rojas, agent says irs used disclosure, circular referrals to block audit, 104 tax notes 687 (2004) (discussing irs agent accused of wrongdoing after making public allegations of collusion between corporation under examination and senior irs executives). 296. johnston, perfectly legal, supra note 200, at 155, 166. see also donald l. bartlett & james b. steele, the great american tax dodge: how spiraling fraud and avoidance are killing fairness, destroying the income tax, and costing you (2000) (discussing the rise in tax evasion and congress’ role in limiting irs enforcement of the tax laws). 224 florida tax review [vol. 15:4 except for poor taxpayers who received the earned income tax credit. 297 other than being audited in 1997, commissioner rossotti had no background in tax, although he was a successful entrepreneur who had founded american management systems, which contracted with government agencies to integrate technology and management. 298 in the fiscal year 2000, assigning irs personnel to customer service instead of examination of returns reduced examination programs by 605 staff years, and in the fiscal year 2001, the number of professional staff in audit and field collection was approximately 21 percent lower than before 1987. 299 under his watch, the audit rate for taxpayers making more than $100,000 fell so that the odds of being audited were one in 145. 300 the risk for s corporations, favored by doctors, lawyers, and other wealthy professionals fell to one in 233. additionally, audits of gift and estate tax returns also sharply dropped. in 1997, for gifts of $1 million or more, irs auditors had recommended more taxes in four out of five audited returns, with the average return understating the value of the gift by $303,000, a relatively large amount. 301 however, a provision in the 1997 taxpayer relief act required the irs to audit gift tax returns within three years or accept them as filed. prior to the change in the law, gift tax returns oftentimes were not audited until the donor had died and the estate tax return was filed. when the number of irs auditors was reduced to 78 agents, audits of these complicated gift tax returns were reduced to 31 minutes, creating an incentive for wealthy taxpayers to understate the value of gifts and avoid paying the proper amount of tax. 302 the taxpayers who saw their risk of being audited increase were recipients of the eitc. in fact, in 2000, the odds of being audited were one in 47, making them approximately three times more likely to be audited than the affluent. they were even somewhat more likely to be audited than 297. the earned income tax credit, [hereinafter “eitc”] is a welfare system for the working poor administered through the tax system. the eitc is a way of giving poor, but working, taxpayers money by means of a refundable tax credit, meaning that the taxpayer receives back more in taxes than the taxpayer actually paid. the amount of the refund rises as the taxpayer earns more up to a point and then begins to fall until it is phased out when income reaches a certain level. the amount of the credit is also dependent upon whether the taxpayer has one or two (and at times, three) children, although a small credit is provided for very poor working taxpayers with no children. 298. johnston, perfectly legal, supra note 200, at 159, 163. 299. lederman, tax compliance, supra note 292, at 982–83 (noting that a staff year consists of 2000 hours). 300. johnston, perfectly legal, supra note 200, at 166. 301. id. at 167. 302. id. at 168. 2014] the movement to destroy the income tax and the irs 225 businesses with assets between $1 million and $5 million, whose audit rate was only one in 49. 303 in more recent years, the situation has not improved. the net tax gap was $385 billion in 2006 (the most recent year the irs has been able to estimate). 304 given that there are 116 million households in the united states, this means that each household is paying a “surtax” of approximately $3,300 to subsidize noncompliance by others. 305 one would expect congress to take action and fund the irs so that it could effectively pursue noncompliant taxpayers. however, congress has actually reduced the irs’s budget in the last several years, 306 despite that that in 2012, the irs collected approximately $2.52 trillion on a budget of approximately $11.8 billion, which is a return on investment of approximately 214 to one. 307 in a letter to congress last year, former commissioner douglas h. shulman informed congress that the then proposed cuts to the irs budget would result in 303. id. at 169. congress was willing to provide the irs with $100 million in funds specifically earmarked for audits of eitc recipients. id. at 134. however, to reduce taxpayer complaints about long waits or unanswered phone calls, commissioner rossotti ordered auditors and tax collectors to staff the phones, contributing to the reduction in the number of audits of other taxpayers. id. at 166. 304. 1 taxpayer advocate service, 2012 annual report to congress 7 (2012) [hereinafter advocate, report]. the net tax gap reflects the amount by which tax liabilities exceed tax collection after accounting for late payments and enforced collections. the gross tax gap—the amount of tax due, but not paid timely, and before enforced collections—was estimated to be $450 billion. 305. id. 306. for purposes of appropriations, the irs is treated as a domestic discretionary program, generally subject to the same funding rules as all other such programs. id. at 35. although there has been discussion of the “program integrity cap adjustment” mechanism whereby new funding is appropriated for irs enforcement programs, the taxpayer advocate is concerned that this mechanism will actually have a deleterious effect on voluntary compliance. id. at 38. the irs’s budget was reduced from the fiscal year 2010 to the fiscal year 2011, and from the fiscal year 2011 to the fiscal year 2012, and faces the possibility of future cuts. id. at 35. see also alan fram, watchdog: growing irs workload causing problems, wash. times (jan. 11, 2012), http://www.washingtontimes.com/news/2012/jan/ 11/watchdog-growing-irs-workload-causing-problems/?page=all (“congress cut the irs budget to $11.8 billion this year. that is $300 million less than last year and $1.5 billion below the request by president barack obama, who argued that boosting the agency’s spending would fatten tax collections and provide better service for taxpayers.”). 307. advocate, report, supra note 304, at 35 (citing government accountability office, financial audit: irs’s fiscal years 2012 and 2011 financial statements 65 (2012), http://www.gao.gov/assets/650/649881.pdf; department of the treasury, fy 2013 budget in brief, http://www. trerasury.gov/about/budget-performance/budget-in-brief/documents/11.%20irs_50 8%20-%20passed.pdf. 226 florida tax review [vol. 15:4 reduced revenue collection seven times that of the cuts. 308 according to the taxpayer advocate, another way of looking at it is that for every dollar the irs spends, it is able to collect $7 in return. 309 the irs’s budget problems do not only affect its ability to pursue the collection of delinquent amounts. the irs is unable to respond effectively to taxpayers’ requests for assistance and information, which leads to further erosion in taxpayers’ willingness to comply voluntarily with their taxpaying obligations. despite the fact that of the 140 million individual taxpayers who filed tax returns for the fiscal year 2011, 59 percent paid preparers to prepare and file their returns and another 30 percent used tax software programs to assist them in preparing the returns themselves, 310 the irs has been inundated with phone calls and correspondence from taxpayers requesting information and assistance. in each of the last two fiscal years, the irs has received more than 115 million phone calls and has become increasingly unable to answer them. 311 furthermore, the irs’s ability to process taxpayer correspondence in a timely manner has also declined from the fiscal years 2004 to 2012. the irs receives more than 10 million letters from taxpayers each year in response to irs adjustment notices. 312 given its fiscal constraints and additional demands on its time, the irs now only audits one percent of individual taxpayers, and the majority of these audits are conducted by automated correspondence due to the high cost of face-to-face audits. almost three out of four audits of individual taxpayers are now limited to issue examinations conducted by mail. as a result, the 308. advocate, report, supra note 304 at 35, n.9 (referencing a letter from douglas h. shulman, commissioner of internal revenue, to the chairman and ranking members of the house committee on ways and means, its subcommittee on oversight, and the senate committee on finance). http://democrats. waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/media/pdf /112/rep_lewis_irs-letter.pdf. see also id. at 36 n.11 (citing charles o. rossotti, many unhappy returns: one man’s quest to turn around the most unpopular organization in america 278 (2005) (stating that the most difficult part of his job was dealing with the irs’s budget, much to the astonishment of his business associates. “when i talked to business friends about my job at the irs, they were always surprised when i said that the most intractable part of the job, by far, was dealing with the irs budget. the reaction was usually ‘why should that be a problem? if you need a little money to bring in a lot of money, why wouldn’t you be able to get it?’”). 309. advocate, report, supra note 304, at 35. 310. id. at 6. 311. id. at 9. for the taxpayers who are able to speak with someone at the irs, the time the taxpayers must wait on hold has increased from just over two and a half minutes in the fiscal year 2004 to nearly 17 minutes in the fiscal year 2012. id. 312. id. 2014] the movement to destroy the income tax and the irs 227 irs in the fiscal year 2011 only conducted traditional face-to-face audits for just one of every 360 taxpayers. 313 3. erosion in taxpaying ethos prior to the rra 98, the irs’s avowed mission was to collect the “true” tax liability owed by the taxpayer. similarly, prior to the rra 98, the irs mission statement was as follows: the purpose of the internal revenue service is to collect the proper amount of tax revenue at the least cost; serve the public by continually improving the quality of our products and services; and perform in a manner warranting the highest degree of public confidence in our integrity, and fairness. 314 underlying this mission statement was the belief that a taxpayer’s true tax liability could be determined and should be collected. however, certain members of congress used the rra 98 hearings to convince the public that a true tax liability could never be determined, hence painting the tax system arbitrary and therefore untrustworthy. 315 subsequent to the rra 98, the irs’s mission statement was changed to the following: “provide america’s taxpayers with top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all.” 316 clearly, the new mission statement makes no reference to determining the taxpayer’s correct liability or to its collection. however, to ensure continued taxpayer compliance, taxpayers must be convinced that others are paying their taxes and in the proper amounts. there has been an alarming decrease in taxpayers’ attitudes towards their taxpaying 313. id. at 35 (citing internal revenue service, fiscal year 2011 enforcement and service results (2011), http://www.irs.gov/pub/news room/fy_2011_enforcement_results_table.pdf). 314. see press release, internal revenue service, new irs mission statement emphasizes taxpayer service (sept. 24, 1998), http:// irs.gov/pub/irsnews/ir-98-59.pdf [hereinafter irs press release]. see also irs, the agency, its mission and statutory authority, http://wwwirs.gov/uac/the-agency,-its-missionand-statutory-authority (last visited oct. 23, 2013) [hereinafter irs, mission]. 315. mcadams, origin, supra note 281, at 400–07. 316. irs, mission, supra note 314, http://wwwirs.gov/uac/the-agency,-itsmission-and-statutory-authority. the new mission statement was mandated by rra 98 which required the irs “to review and restate its mission to place a greater emphasis on serving the public and meeting taxpayers’ needs.” press release, irs, supra note 314. 228 florida tax review [vol. 15:4 responsibilities which became quite obvious immediately after the rra 98 hearings. in 1999, 87 percent of respondents said that cheating on taxes was unacceptable; in 2001, only 76 percent. in 1999, 96 percent of respondents agreed that it is everyone’s duty to pay their fair share of taxes; in 2001, 91 percent. and in 2001, respondents were skeptical that cheaters would be caught. a plurality of respondents (37 percent) said that cheaters were less likely to be audited in 2001 than in the past. only one in three thought the odds of detection had increased. 317 this concern about the erosion in taxpayers’ attitudes towards compliance was echoed by the internal revenue service’s oversight board, which placed some of the blame on the decline in the irs’s monitoring activity. “the oversight board is concerned that broad decline in enforcement activity increases our reliance on voluntary compliance, and fears that the public’s attitudes towards voluntary compliance is beginning to erode.” 318 even more alarmingly, in her 2012 annual report to congress, taxpayer advocate nina olson reported that in a statistically representative national survey by the taxpayer advocate service, or tas, of over 3,300 taxpayers who operate businesses as sole proprietors, only 16 percent said that they believed the tax laws are fair. only 12 percent believed that taxpayers pay their fair share of taxes. 319 additionally, 73 percent of the surveyed taxpayers said that the “wealthy have ways of minimizing their federal taxes that are not available to the average taxpayer,” and only 12 317. camp, tax administration, supra note 85, at 8 (citing leonard e. burman, urban institute testimony on tax fraud, evasion, 2003 tax notes today 133-26 (july 11, 2003) (reporting the statement of leonard e. burman before the house committee on the budget)). 318. irs oversight bd., 2002 annual report 2, http://www.treasury.gov/irsob/board-reports_archive.shtml. see also leandra lederman & stephen w. mazza, addressing imperfections in the tax system: procedural or substantive reform?, 103 mich. l. rev. 1423, 1440 note 52 (2005) (citing irs oversight bd., 2004 annual report 11 (2004), http://www. treasury.gov/irsob/board-reports_archive.shtmlhttp://www.treas.govirsob/documents /2004_annual_report (reporting a continuing decrease in the percentage of americans who feel that it is not at all acceptable to cheat on their income taxes)). 319. advocate, report, supra note 304, at 3. the taxpayer advocate went on to state that she “finds this extraordinary lack of public trust in the method by which our government is funded profoundly disturbing.” id. 2014] the movement to destroy the income tax and the irs 229 percent said that “everyone pays their fair share of taxes.” 320 this survey reveals an alarming erosion in the taxpayer beliefs that (1) the income tax itself is fair, and (2) it is administered in a way that is fair. furthermore, according to a gallup poll in 1999 (shortly after the senate finance committee hearings on the irs), 49 percent of americans surveyed thought that their taxes were unfair, compared to 45 percent who called them fair. in comparison, during world war ii, gallup polls found that eight out of 10 americans believed their taxes were fair. 321 the taxpayer advocate also expressed great concern that the manner in which the irs is being funded will lead to further erosion of voluntary taxpayer compliance. the irs’s inability to respond to taxpayers requests for assistance and information in a timely manner ultimately will have a deleterious effect on taxpayers’ attitudes towards voluntary compliance. several appropriations acts in recent years have given the irs additional funding through the “program integrity cap adjustment” mechanism, whereby new funding can be appropriated for irs enforcement programs (but not for irs taxpayer assistance activities). the program integrity cap adjustment mechanism requires that the relevant agency show that the requested additional funding will generate a return on investment greater than 1:1. the irs is able to compute the dollars that can be collected from its examination, collection, and documents-matching functions, but cannot quantify the return on investment from additional taxpayer services. therefore, the irs can receive additional funding only for enforcement-type activities. 322 the taxpayer advocate believes that increased funding for collection and enforcement, but not assistance, will erode voluntary compliance in two ways. first, on the taxpayers’ end of compliance, the erosion will occur because taxpayer services are significant drivers of tax compliance. in order to promote voluntary compliance, the irs needs to be able to publish tax forms and instructions, as well as educate taxpayers, tax return preparers, and tax software manufacturers. 323 second, on the irs’s end of compliance, the erosion will occur because an enforcement only cap adjustment will force the irs to become more of a hardcore enforcement agency. 320. id. 321. borosage, talking taxes, supra note 4. http://prospect.org/cs/articles ?article=talking_taxesinterestingly, a gallup poll taken after the attacks on september 11, 2001, found that 61 percent of americans thought their taxes were fair, compared to 34 percent who said they were unfair. id. this lends further credibility to the theory that americans rally around their government when the country faces a threat. 322. advocate, report, supra note 304, at 38–39. 323. id. at 39. 230 florida tax review [vol. 15:4 however, for the fiscal year 2011, 98 percent of irs tax collections resulted from front-end voluntary compliance. two percent of total irs tax collections were the result of enforcement activity at the back-end of compliance. 324 as noted by the taxpayer advocate, “[i]n our effort to enforce the laws against noncompliant taxpayers, we must take care to avoid steps that may alienate compliant taxpayers and thereby jeopardize the existing tax base.” 325 although only two percent of tax collections are the result of enforcement activity, that activity is vital to ensuring that other taxpayers comply voluntarily. if compliant taxpayers believe that the irs is taking action against noncompliant taxpayers, they do not feel like “chumps” for voluntarily filing and paying. the danger presented by the unrelenting campaign to undermine the tax system is that a new norm might be established—that it is patriotic and moral not to fulfill one’s taxpaying duties. as noted by lederman: one model of tax compliance . . . suggests that a norm of compliance can gradually erode as enforcement decreases until the norm “tips” to one of noncompliance. once there is a norm of noncompliance, the psychic costs of evasion are lower, so authorities likely will have to increase enforcement above the previous level to restore the previous level of compliance. in other words, the model suggests that it is difficult for the government to disturb an existing equilibrium reflecting a norm of noncompliance but that it can be done with increased enforcement. 326 the danger that a new, noncompliance norm might become established is exacerbated by the fact that government officials, including members of congress, denounce not only the irs, but the income tax itself. professor cass sunstein observes that politicians can serve as potential norm entrepreneurs . . . alerting the public to the existence of a shared complaint and suggesting a collective solution. under certain circumstances, the enactment of legislation may lower the cost to individuals of expressing the new norms, resulting in a norm bandwagon that encourages an ever-increasing number of people to reject a previously popular norm. eventually, a tipping point is reached, where the new norm becomes generally accepted 324. id. 325. id. 326. lederman, tax compliance, supra note 292, at 1509–10. 2014] the movement to destroy the income tax and the irs 231 and adherence to the old norm produces social disapproval. 327 v. conclusion when the income tax required expansion to include most american households, the federal government deliberately created a taxpaying ethos by creating the widely accepted norm that one should fulfill his or her income tax obligation. to achieve voluntary compliance, the federal government recognized the importance of educating the public as to why the tax was necessary and how to comply with their taxpaying obligations. among the tools the government employed to educate the populace and reinforce the norm were written and broadcast media. in addition, the government emphasized the connection between the tax revenues and the concomitant benefits those revenues provided the american people. furthermore, the government created an effective enforcement system: the irs. as a result, the social contract and quid pro quo bases for compliance created a taxpaying ethos or norm. americans developed (1) a sense of trust in their fellow americans—that they were paying their fair share, and (2) a sense of trust in the tax system itself—that enforcement was fair and the government used the revenues appropriately. there is a deliberate campaign to destroy this trust, and a new norm of noncompliance is beginning to take root. the anti-tax financial elites have an easily understood philosophy: cut taxes and we all prosper. there is evidence to the contrary, but relatively few people have the resources to ferret out this truth. also, supporters of the income tax cannot point to a cogent, easily understood argument they have been offered in support of the income tax. americans do not see the connection between the tax cuts and the increased federal deficit because neither congressional leaders nor the media explains it to them. furthermore, the irs is so underfunded and understaffed that it cannot provide the education and assistance taxpayers need in order to comply with their taxpaying obligations. the anti-tax financial elites have been successful not only in convincing americans that their taxes are too high, but have also succeeded in developing strategies, networks, and funding to achieve their goals. the taxpaying ethos was created in a relatively short period of time during world war ii. similarly, once a tipping point is reached, a nontaxpaying ethos can quickly become the norm. 327. kirsch, alternative sanctions, supra note 50, at 916 (citing cass r. sunstein, social norms and social roles, 96 colum. l. rev. 903, 912 (1996)). login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe microsoft word mjm 1st 5 pages-11-17-10 new.doc florida tax review volume 10 2011 number 9 565 recent developments in federal income taxation: the year 2010 martin j. mcmahon, jr.* ira b. shepard** daniel l. simmons*** i. accounting ...................................................................................... 569 a. accounting methods ................................................................... 569 b. inventories ................................................................................... 571 c. installment method ..................................................................... 571 d. year of inclusion or deduction ................................................... 571 ii. business income and deductions ............................................... 571 a. income ......................................................................................... 571 b. deductible expenses versus capitalization ................................. 577 c. reasonable compensation .......................................................... 580 d. miscellaneous deductions .......................................................... 582 e. depreciation & amortization ...................................................... 587 f. credits ......................................................................................... 591 g. natural resources deductions & credits .................................... 597 h. loss transactions, bad debts, and nols ................................... 598 i. at-risk and passive activity losses .......................................... 599 iii. investment gain and income ...................................................... 607 a. gains and losses ......................................................................... 607 b. interest, dividends, and other current income ........................... 617 c. profit-seeking individual deductions ......................................... 617 d. section 121 .................................................................................. 617 e. section 1031 ................................................................................ 619 f. section 1033 ................................................................................ 622 g. section 1035 ................................................................................ 622 h. miscellaneous .............................................................................. 622 iv. compensation issues ..................................................................... 623 a. fringe benefits ............................................................................ 623 b. qualified deferred compensation plans ..................................... 629 * stephen c. o’connell professor of law, university of florida, fredric g. levin college of law. ** professor of law university of houston law center. *** profesor of law, university of california at davis, school of law. 566 florida tax review [vol. 10:9 c. nonqualified deferred compensation, section 83, and stock options ........................................................................................ 630 d. individual retirement accounts.................................................. 630 v. personal income and deductions ............................................. 631 a. rates ............................................................................................ 631 b. miscellaneous income ................................................................. 634 c. hobby losses and § 280a home office and vacation homes .. 638 d. deductions and credits for personal expenses ........................... 639 e. divorce tax issues ...................................................................... 648 f. education .................................................................................... 648 g. alternative minimum tax ........................................................... 649 vi. corporations .................................................................................. 650 a. entity and formation ................................................................... 650 b. distributions and redemptions ................................................... 650 c. liquidations................................................................................. 653 d. s corporations ............................................................................. 653 e. mergers, acquisitions and reorganizations ................................ 658 f. corporate divisions .................................................................... 661 g. affiliated corporations and consolidated returns ..................... 661 h. miscellaneous corporate issues .................................................. 661 vii. partnerships ................................................................................... 666 a. formation and taxable years ..................................................... 666 b. allocations of distributive share, partnership debt, and outside basis ............................................................................................ 666 c. distributions and transactions between the partnership and partners ........................................................................................ 667 d. sales of partnership interests, liquidations and mergers ........... 668 e. inside basis adjustments ............................................................ 668 f. partnership audit rules .............................................................. 668 g. miscellaneous .............................................................................. 676 viii.tax shelters .................................................................................. 678 a. tax shelter cases and rulings .................................................... 678 b. identified “tax avoidance transactions.” ...................................... 691 c. disclosure and settlement ........................................................... 698 d. tax shelter penalties, etc. .......................................................... 698 ix. exempt organizations and charitable giving .................... 699 a. exempt organizations ................................................................. 699 b. charitable giving ........................................................................ 701 x. tax procudure ............................................................................... 704 a. interest, penalties and prosecutions ............................................ 704 b. discovery: summonses and foia .............................................. 713 c. litigation costs ........................................................................... 715 d. statutory notice of deficiency .................................................... 716 e. statute of limitations .................................................................. 718 2011] recent developments in federal income taxation 567 f. liens and collections .................................................................. 727 g. innocent spouse .......................................................................... 730 h. miscellaneous .............................................................................. 738 xi. withholding and excise taxes.................................................. 747 a. employment taxes ...................................................................... 747 b. self-employment taxes .............................................................. 758 c. excise taxes................................................................................ 758 xii. tax legislation ............................................................................. 760 a. enacted ........................................................................................ 760 568 florida tax review [vol. 10:9 recent developments in federal income taxation: the year 2010 by martin j. mcmahon, jr. ira b. shepard daniel l. simmons this recent developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the year 2010 — and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted – unless one of us decides to go nuts and spend several pages writing it up. this is the reason that the outline is getting to be as long as it is. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide dan and marty the opportunity to mock our elected representatives; again, sometimes at least one of us goes nuts and writes up the most trivial of legislative changes. the outline focuses primarily on topics of broad general interest (to the three of us, at least) – income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. any mistakes in this outline are marty’s responsibility; any political bias or offensive language is ira’s; and any useful information is dan’s. 2011] recent developments in federal income taxation 569 i. accounting a. accounting methods 1. is the public company accounting oversight board in the intensive care unit? free enterprise fund v. pcaob, 537 f.3d 667 (d.c. cir. 8/22/08) (2-1), cert. granted, 129 s. ct. 2378 (5/18/09). judge rogers held that the article ii appointments clause was not violated by having members of the pcaob appointed by the sec commissioners, nor was the separation of powers doctrine violated by the for-cause limitation on removal of pcaob members. • judge kavanaugh dissented strongly, stating: the two constitutional flaws in the pcaob statute are not matters of mere etiquette or protocol. by restricting the president’s authority over the board, the act renders this executive branch agency unaccountable and divorced from presidential control to a degree not previously countenanced in our constitutional structure. this was not inadvertent; members of congress designed the pcaob to have “massive power, unchecked power.” 148 cong. rec. at s6334 (statement of sen. gramm). our constitutional structure is premised, however, on the notion that such unaccountable power is inconsistent with individual liberty. “the purpose of the separation and equilibration of powers in general, and of the unitary executive in particular, was not merely to assure effective government but to preserve individual freedom.” morrison, 487 u.s. at 727 (scalia, j., dissenting); see also clinton v. city of new york, 524 u.s. 417, 450 (1998) (kennedy, j., concurring) (“liberty is always at stake when one or more of the branches seek to transgress the separation of powers.”). the framers of our constitution took great care to ensure that power in our system was separated into three branches, not concentrated in the legislative branch; that there were checks and balances among the three branches; and that one individual would be ultimately responsible and accountable for the exercise of executive power. the pcaob contravenes those bedrock constitutional principles, as well as long-standing supreme court precedents, and it is therefore unconstitutional. a. affirmed in part, reversed in part, and remanded. there is less to this decision than meets the eye because the 570 florida tax review [vol. 10:9 pcaob continues to operate as before but its members may be removed without cause by the sec. 130 s. ct. 3138 (6/28/10) (5-4, with the usual liberals dissenting). the court held that the for-cause limitations on the removal of pcaob members contravene the constitution’s separation of powers but that the unconstitutional provisions are separable from the rest of the sarbanes-oxley act. the consequence is that the board may continue to function as before, but its members may be removed at will by the commission. 2. just because you might have to perform work in the future and incur future costs doesn’t necessarily mean you have a long-term contract eligible for deferred reporting of income. koch industries, inc. v. united states, 603 f.3d 816 (10th cir. 4/27/10). in connection with a contract to construct a highway for the state of new mexico, the taxpayer and new mexico entered into a “rehabilitation” contract under which the taxpayer provided a “pavement warranty” that required it to perform all work necessary to assure performance of the pavement for a period 21.5 years and a “structures warranty” to perform all work necessary to assure performance of the bridges, drainage, and erosion structures for 11.5 years, in consideration of a $62,000,000 payment. the taxpayer had no obligation to perform any work on the highway or structures unless and until the highway and/or structures failed to meet performance standards included in the warranty agreements. the taxpayer sought to use the percentage of completion method under § 460 to report the income, but the court agreed with the irs that the percentage of completion method was unavailable. neither warranty was a long-term contract under § 460 because under reg. § 1.460-1(b)(2)(i) “to be classified as a long-term contract, ‘manufacture, building, installation, or construction of property [must be] necessary for the taxpayer’s contractual obligations to be fulfilled,’” which “necessarily entails a fixed and definite obligation on the part of the contractor to provide specified construction services.” this standard was not met because even though it was virtually certain that some work would be performed at some point, the taxpayer “had no obligation to perform any work on the highway unless and until the highway and/or structures thereon failed to meet the performance standards included in the warranty agreements.” the contracts were “warranties” within the meaning of reg. § 1.460-1(d)(2), and thus the consideration was not eligible for reporting under the percentage of completion method. 3. new and improved automatic consent procedures for changes of accounting methods. rev. proc. 2011-14, 2011-4 i.r.b. 330 (1/11/11). this revenue procedure provides automatic consent procedures for a wide variety of accounting method changes. rev. proc. 97-27 clarified and 2011] recent developments in federal income taxation 571 modified. rev. procs. 2001-10, 2002-28 2004-34, and 2006-56 modified. rev. procs. 2008-52 and 2009-39 superseded, in part. b. inventories there were no significant developments regarding this topic during 2010. c. installment method there were no significant developments regarding this topic during 2010. d. year of inclusion or deduction 1. the long arm of § 267(a)(2). bosamia v. commissioner, t.c. memo. 2010-218 (10/7/10). section 267(a)(2) applies to the determination of the cost of goods sold when an accrual method taxpayer purchases from a related cash method taxpayer property that will be included in the purchaser’s inventory. thus, because the costs were not paid within two and one-half months after the close of the purchaser’s taxable year, the amounts could not be included in cogs. furthermore, because the adjustment was a change of accounting method, § 481 applied to eliminate from the cogs amounts previously included in that remained unpaid in the current year for goods purchased in years beyond the statute of limitations. ii. business income and deductions a. income 1. this looks pretty good, but at first a few serious questions were lurking. the 2009 arra, § 1231(a), added code § 108(i), which defers and then ratably includes income arising from business indebtedness discharged by the reacquisition of a debt instrument. this new provision allows a taxpayer to irrevocably elect to include cancellation of debt income realized in 2009 and 2010 ratably over five tax years, rather than in the year the discharge occurs, if the debt was issued in connection with the conduct of a trade or business or by a corporation. for partnerships and s corporations, the election is made by the partnership or corporation, not by the individual partners or shareholders. i.r.c. § 108(i)(5)(b)(iii). under the § 108(i) election, income from a debt cancellation in 2009 is recognized beginning in the fifth taxable year following the debt cancellation; the income is recognized ratably in each of 2014 through 2018. income from a debt cancellation in 2010 is recognized beginning in the 572 florida tax review [vol. 10:9 fourth taxable year following the debt cancellation; the income is recognized ratably in each of 2014 through 2018. if a taxpayer elects to defer debt cancellation income under § 108(i), the § 108(a) exclusions for bankruptcy, insolvency, qualified farm indebtedness, and qualified real property business indebtedness do not apply to the year of the election or any subsequent year. § 108(i)(5)(c). thus, the election cannot be used to move the year of inclusion to a year in which it is expected that one of the exceptions will apply. once the election is made, inclusion is inevitable; the statute requires acceleration of inclusion to the taxpayer’s final return in the event of the intervening death of an individual or liquidation or termination of the business of an entity. § 108(i)(5)(d). the acceleration rule also applies in the event of the sale or exchange or redemption of an interest in a partnership or s corporation by a partner or shareholder. • although the statute speaks in terms of cancellation of debt income arising from “reacquisition” of a “debt instrument,” the statutory definitions of “reacquisition” and “an applicable debt instrument,” respectively, are broad enough the provision applies to most situations in which the debt is cancelled. section 108(i)(3)(b) broadly defines “debt instrument” to include a bond, debenture, note, certificate, or any other instrument or contractual arrangement constituting indebtedness within the meaning of §1275(a)(1). section 108(i)(4)(b) defines “acquisition” to include (1) an acquisition of the debt instrument for cash, (2) the exchange of the debt instrument for another debt instrument, including an exchange resulting from a modification of the debt instrument (which includes a reduction of the principal amount of the debt), (3) the exchange of the debt instrument for corporate stock or a partnership interest, (4) the contribution of the debt instrument to capital, and (5) the complete forgiveness of the indebtedness by the holder of the debt instrument. • however, the statutory definition of “acquisition” appears to omit the cancellation of a debt in connection with a property transfer, for example, a deed in lieu of foreclosure, although the legislative history contains some indication that this type of debt cancellation is included. • query when and to what extent real estate ownership qualifies as a trade or business. a. many of the questions have been answered. rev. proc. 2009-37, 2009-36 i.r.b. 309 (8/17/09). this revenue procedure provides the exclusive procedure for taxpayers to make § 108(i) elections. debt cancellation in connection with a property transfer is included in § 108(i). section 4.04(3) permits partial elections, with the partnership permitted to determine “in any manner” the portion of the cod income that is the “deferred amount” and the portion of the cod income that is the “included amount” with respect to each partner. section 4.11 permits 2011] recent developments in federal income taxation 573 protective elections where the taxpayer concludes that a particular transaction does not generate cod income but fears that the irs may determine otherwise. a partner’s deferred § 752(b) amount, arising from a decrease in his share of partnership liabilities, will be treated as a current distribution of money in the year that the cod income is included. taxpayers are allowed an automatic one-year extension from the due date to make the election, and taxpayers who made elections before the issuance of the revenue procedure will be given until 11/16/09 to modify (but not revoke) their existing elections. corporate taxpayers making a § 108(i) election are required to increase earnings and profits for the year of the election. b. temporary regulations allocate deferred cancellation of debt income. t.d. 9498, application of section 108(i) to partnerships and s corporations, 75 f.r. 49380 (8/13/10). section 108(i) provides an election to include cancellation of indebtedness income resulting from a reacquisition (broadly defined in § 108(i)(4)) of a debt instrument, issued by a c corporation or other person engaged in a trade or business, ratably over five years beginning with the fifth year following reacquisition occurring in 2009, and the fourth year following reacquisition in 2010. under § 108(i)(5)(b)(iii) an election is made by the partnership, not the partners individually. section 108(i)(6) requires a partnership to allocate the cod income to partners according to partnership share on the day immediately preceding reacquisition and provides that the discharge will not trigger § 752(b) recognition under § 731 because of a reduction in a partner’s share of partnership liabilities. • temp. reg. § 1.108(i)-2t(d)(1) provides five safe harbors where debt instruments issued by a partnership or s corporation will be treated as issued in a trade or business: (1) the gross fair market value of the trade or business assets of the partnership or s corporation represent at least 80 percent of the fair market value of all of its assets on the date of issuance, (2) trade or business expenses of the partnership or s corporation represent at least 80 percent of all expenditures, (3) at least 95 percent of the interest paid on the debt instrument is allocable to trade or business expenditures under the interest allocation rules of temp. reg. § 1.1638t, (4) at least 95 percent of the proceeds from the debt instrument were used to acquire trade or business assets within six months of the issue of the debt, or (5) the partnership or s corporation issued the debt instrument to the seller of a trade or business to acquire the trade or business. absent anchoring in one of the safe harbors, qualification of a trade or business debt is a matter of facts and circumstances. • while § 108(i)(5)(b)(iii) requires the election to be made at the partnership level, temp. reg. § 1.108(i)-2t(b)(1) allows the partnership to allocate both deferred and included portions of cod 574 florida tax review [vol. 10:9 income to the partners. the temporary regulations first require that cod income be allocated to the partners in the partnership immediately before the reacquisition in the manner the income would be included in distributive shares under § 704, then the partnership must determine the amount of cod income from the applicable instrument that is the deferred amount includible in the partner’s share and the amount that is immediately includible. with respect to deferred cod income of an s corporation, the temp. reg. § 1.108(i)-2t(c)(1) requires that on an election by the s corporation, deferred income must be shared pro rata on the basis of stock ownership immediately prior to the reacquisition. • temp. reg. § 1.108(i)-2t(b)(2) provides that a partner’s basis is not adjusted under § 705(a) to account for the partner’s share of partnership deferred cod income until the deferred item is recognized by the partner. likewise, § 1.108(i)-2t(c)(2) provides that neither an s corporation shareholder’s basis under § 1367 nor the shareholder’s accumulated adjustment account is adjusted for deferred cod income until the shareholder recognizes the deferred cod income. • following the rules of rev. proc. 2009-37, and applying the rules of § 108(i)(6), temp. reg. § 1.108(i)-2t(b)(3) provides that reduction in a partner’s share of partnership liabilities is determined under § 752(b) when a debt instrument is reacquired, but that the reduction in liabilities is not treated as a distribution of money until deferred cod income is recognized by the partner. the temporary regulations provide additional rules for determining a partner’s deferred amounts where the partner would recognize § 731 gain in the year of the reacquisition. • partners’ capital accounts are adjusted as if no § 108(i) election were made. • temp. reg. § 1.108(i)-2t(d)(3) provides that gain attributable to a reduction in a partner’s or s corporation shareholder’s amount at-risk under § 465(e) will not be taken into account in the year of reacquisition and will be deferred to the date the cod income is recognized. • in the case of an acceleration event under § 108(i)(5)(d) that requires a partnership or s corporation to recognize deferred items, under temp. reg. § 1.108(i)-2t(c)(3) the partners or s corporation shareholders must account for deferred cod in the year that the accelerating event takes place. in addition, the temporary regulations described various circumstances in which a partner or s corporation shareholder terminates the interest in the entity that will require acceleration of deferred cod income, including death, liquidation, sale or exchange, redemption, or abandonment. 2011] recent developments in federal income taxation 575 • identical proposed regulations were issued simultaneously. reg-144762-09, application of section 108(i) to partnerships and s corporations, 75 f.r. 49427 (8/13/10). c. significant guidance on a soon to expire beneficial code section that leaves a nasty hangover. t.d. 9497, guidance regarding deferred discharge of indebtedness income of corporations and deferred original issue discount deductions, 75 f.r. 49394 (8/13/10). the irs and treasury have promulgated temp. reg. §§ 1.108(i)-0t through 1.108(i)-3t providing detailed rules for c corporations regarding the acceleration of deferred cod income and deferred oid deductions under § 108(i)(5)(d), and the calculation of earnings and profits as a result of an election under § 108(i). the regulations also provide rules applicable to all taxpayers regarding deferred oid deductions under § 108(i) as a result of a reacquisition of an applicable debt instrument by an issuer or related party. • identical proposed regulations were issued simultaneously. reg-142800-09, guidance regarding deferred discharge of indebtedness income of corporations and deferred original issue discount deductions, 75 f.r. 49428 (8/13/10). 2. rev. rul. 2010-10, 2010-13 i.r.b. 461 (3/29/10) provides standard industry fare level cents-per-mile rates and terminal charges for the first half of 2010 for determining the value of noncommercial flights on employer provided aircraft. 3. these winds blow in capital contributions. southern family insurance company v. united states, 106 a.f.t.r.2d 20107200 (m.d. fla. 12/1/10). following hurricane andrew, the state of florida created a joint underwriting association (jua) as a windstorm insurer of last resort. state legislation provided for a “takeout bonus” payable to private insurers for each risk they removed from the jua. the taxpayer was formed to provide residential insurance and participate in the jua takeout program. the taxpayer reported bonuses received from the jua as nonshareholder contributions that were excluded under § 118. following an “intent of the contributor test” that it derived from case law, the court found that the florida legislature intended the takeout bonuses to constitute a nonshareholder contribution to capital and excluded the payments from income under § 118. • the case did not discuss the treatment of the contributed capital under § 362(c). 4. but this claim of a tax-free contribution to capital goes down in flames. at&t, inc. v. united states, 107 a.f.t.r.2d 2011321 (5th cir. 1/3/111), aff’g at&t, inc. v. united states, 104 a.f.t.r.2d 576 florida tax review [vol. 10:9 2009-6036 (w.d. tex. 7/16/09). the court of appeals (judge dennis) affirmed a district court decision holding that payments from the federal government for universal telephone access are includible in income, and are not excluded under § 118 as contributions to capital. the payments were part of state and federally mandated programs funded by fees collected from telecommunications carriers based on revenues. payments are made to carriers with high cost obligations to provide universal access to telephone services. the district court followed the decision in united states v. coastal utilities, inc., 514 f.3d 1184 (11th cir. 2008). the court of appeals traced the history of the exclusion for contributions to the capital of a corporation, ending with the five characteristics of a nonshareholder contribution to capital set forth in united states v. chicago, burlington & quincy railroad co., 412 u.s. 401 (1973). [1] it certainly must become a permanent part of the transferee’s working capital structure. [2] it may not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee. [3] it must be bargained for. [4] the asset transferred foreseeably must result in benefit to the transferee in an amount commensurate with its value. and [5] the asset ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect. from the supreme court jurisprudence, the court derived “three principles.” (1) whether a payment to a corporation by a nonshareholder is income or a capital contribution is controlled by the intention or motive of the transferor. (2) when the transferor is a governmental entity, its intent may be manifested by the laws or regulations that authorize and effectuate its payment to the corporation. (3) also, a court can determine that a transfer was not a capital contribution if it does not possess each of the first four, and ordinarily the fifth, characteristics of capital contributions that the supreme court distilled from its jurisprudence in cb&q. applying these principles to the facts of the case, the court concluded that, “either by construing the controlling statutes and regulations or by applying the cb&q five-factor test, the governmental entities in making universal service payments to at&t did not intend to make capital contributions to at&t; and thus, that the payments were income to at&t.” under the statutes authorizing the payments, the administrative implementation in regulations, the payments 2011] recent developments in federal income taxation 577 “were not intended to be capital contributions to at&t, but to be supplements to at&t’s gross income to enable it to provide universal service programs while meeting competition ... .” the payments “were compensation to at&t for the specific and quantifiable services it performed for high-cost and lowerincome users as well as for developing and maintaining universal service ... .” furthermore, the payments did not become “a permanent part of at&t’s working capital structure, as is demanded by the first cb&q requirement.” b. deductible expenses versus capitalization 1. those fancy pyrex® and oneida® branded kitchen products are made by robinson knife manufacturing, which is required to capitalize license fees. robinson knife manufacturing co., inc. v. commissioner, t.c. memo. 2009-9 (1/14/09). the taxpayer designs and produces kitchen tools for sale to large retail chains. to enhance its marketing, the taxpayer paid license fees to corning for use of the pyrex trademark and oneida for use of the oneida trademark on kitchen tools designed and produced by the taxpayer. the taxpayer’s production of kitchen tools bearing the licensed trademarks was subject to review and quality control by corning or oneida. the irs asserted that the taxpayer’s licensing fees were subject to capitalization into inventory under § 263a under reg. § 1.263a-1(e)(3)(ii)(u), which expressly includes licensing and franchise fees as indirect costs that must be allocated to produced property. agreeing with the irs, the court (judge marvel) rejected the taxpayer’s argument that the licensing fees, incurred to enhance the marketability of its produced products, were deductible as marketing, selling, or advertising costs excluded from the capitalization requirements by reg. § 1.263a-1(e)(3)(iii)(a). the court noted that the design approval and quality control elements of the licensing agreements benefited the taxpayer in the development and production of kitchen tools marketed with the licensed trademarks. the court rejected the taxpayer’s argument that rev. rul. 2000-4, 2000-1 c.b. 331, which allowed a current deduction for costs incurred in obtaining iso 9000 certification as an assurance of quality processes in providing goods and services, was applicable to the quality control element of the license agreements. the court noted that although the trademarks permitted the taxpayer to produce kitchen tools that were more marketable than the taxpayer’s other products, the royalties directly benefited and/or were incurred by reason of the taxpayer’s production activities. the court also upheld the irs’s application of the simplified production method of reg. § 1.263a-2(b) to allocate the license fees between cost of goods sold and ending inventory as consistent with the taxpayer’s use of the simplified production method for allocating other indirect costs. 578 florida tax review [vol. 10:9 a. but the second circuit disagrees. robinson knife manufacturing co., inc. v. commissioner, 600 f.3d 121 (2d cir. 3/19/10). like the tax court, the court of appeals rejected robinson’s arguments that the royalty payments were deductible as marketing, selling, advertising or distribution costs under reg. § 1.263a-1(e)(3)(iii)(a), and that the royalty payments were deductible as not having been incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced under reg. § 1.263a-1(e)(3)(ii)(u). the court of appeals concluded, however, that “royalty payments which are (1) calculated as a percentage of sales revenue from certain inventory, and (2) incurred only upon sale of such inventory, are not required to be capitalized under the § 263a regulations.” the court held that the royalties were neither incurred in, nor directly benefited, the performance of production activities under reg. § 1.263a-1(e)(3)(i). unlike license agreements, the court concluded that robinson could have manufactured the products, and did, without paying the royalty costs. the royalties were not, therefore, incurred by reason of the production process. the court also concluded that since the royalties were incurred for kitchen tools that have been sold, “it is necessarily true that the royalty costs and the income from sale of the inventory items are incurred simultaneously.” the court noted further that had robinson’s licensing agreements provided for non-sales based royalties, then capitalization would have been required. b. proposed regulations make you wonder why the irs ever litigated robinson knife. reg-149335-08, sales-based royalties and vendor allowances, 75 f.r. 78940 (12/17/10). the irs has proposed regulations under § 263a that generally provide the taxpayerfavorable result reached by the second circuit in robinson knife. the proposed regulations provide that sales-based royalties must be capitalized, but also provide that sales-based royalties required to be capitalized are allocable only to property that a taxpayer has sold, rather than to closing inventory. the preamble asserts that the second circuit in robinson knife misconstrued the nature of costs required to be capitalized; according to the preamble, the costs of securing rights to use intellectual property directly benefit, or are incurred by reason of, production processes, which requires that the costs be capitalized, even if the costs are payable only on the basis of the number or units sold or as a percentage of revenue. nonetheless, the proposed regulations are consistent with the holding of robinson knife where they provide that sales-based royalties are related only to units that are sold during the taxable year. thus, prop. reg. § 1.263a-3(d)(3)(i)(c)(3) would provide that sales-based costs would not be included in ending inventory under § 471. • however, in light of the generous 2011] recent developments in federal income taxation 579 treatment of sales-based royalties, the proposed § 263a regulations, along with proposed amendments to reg. § 1.471-3(e), require that sales-based vendor allowances [which are rebates or discounts from a vendor as a result of selling the vendor’s merchandise] must be taken into account as an adjustment to the cost of merchandise sold, effectively requiring that such allowances be included in gross income immediately, and would not be taken into account in ending inventory. • the formulas allocating additional indirect costs to ending inventory under the simplified production and resale methods would be modified to remove capitalized sales based royalties and vendor allowances allocable to property that has been sold. 2. legal fees incurred resisting states’ attorney general challenges to the privatization of blue shield are capital expenses. wellpoint, inc. v. commissioner, 599 f.3d 641 (7th cir. 3/23/10). the taxpayer provides health insurance coverage through operating subsidiaries that are licensees of the blue cross and blue shield association and are a result of mergers with blue cross and blue shield organizations that were once characterized as tax-exempt charitable entities. several state attorneys general brought cy pres or charitable trust actions against the taxpayer claiming assets of the charitable organizations that were impressed with charitable trusts. the taxpayer made payments of nearly $114 million to settle these actions. the circuit court affirmed the tax court holding (t.c. memo. 2008-236) that the taxpayer’s legal fees and settlement payments were incurred in a dispute over the equitable ownership of assets allegedly impressed with charitable trust obligations, and that the fees and payments were thus required to be capitalized. judge posner described an expenditure as a capital expense “if its ‘utility ... survives the accounting period’ in which it is made” (citing sears oil co. v. commissioner, 359 f.2d 191, 197 (2d cir. 1966)) and added that “expense incurred to enhance the value of a capital asset must be capitalized, and thus amortized over the asset’s remaining life.” the court concluded that the settlement was based on claims involving wellpoint’s title to the assets acquired from the formerly tax-exempt entities. the court rejected the taxpayer’s argument that the payments were incurred to protect its business practices. 3. starting-up is cheaper. the small business jobs act of 2010 increases the amount of deductible § 195 start-up expenses for investigating or creating an active trade or business from $5,000 to $10,000 for expenses incurred in a year beginning in 2010. the phase out amount is also increased from $50,000 to $60,000. 4. a retail safe harbor for car dealers. rev. proc. 2010-44, 2010-49 i.r.b. 811 (11/11/10). section 263a(a) and reg. 580 florida tax review [vol. 10:9 § 1.263a-3(c) require a taxpayer who acquires property for resale to capitalize acquisition costs and other costs allocable to the property, including purchasing, handling, and storage costs. however, a reseller is not required to capitalize handling and storage costs incurred at a retail sales facility. under the safe harbor, a motor vehicle dealership may treat its entire sales facility from which it normally and routinely conducts on-site sales to retail customers, including any vehicle lot that is an integral part of its sales facility and that is routinely visited by retail customers, as a retail sales facility with respect to which the dealership is not required to capitalize handling and storage costs. a motor vehicle dealer without production activities may treat itself as a reseller under the revenue procedure. the costs of handling activities with respect to services performed on dealership owned vehicles and customer owned vehicles, other than the cost of parts, are not required to be capitalized. parts used in dealer-owned vehicles must be capitalized as acquisition cost of its vehicles. a motor vehicle dealership using the “reseller without production activities safe harbor method” may use the “simplified resale method” under § 1.263a-3(d) for its vehicles and other eligible property. adoption of the safe harbor is a change of accounting method subject to the automatic change in method under rev. proc. 2008-52, 2008-2 i.r.b. 587, clarified, modified, and superseded by rev. proc. 201114, 2011-4 i.r.b. 330 (1/11/11). 5. the compromise tax relief act of 2010, § 744, extends the election under code § 181 to expense up to $15 million qualified film and television production costs incurred in low-income or distressed communities through 2011. 6. the compromise tax relief act of 2010, § 745, extends the deduction under code § 198 of otherwise capitalized environmental remediation expenses incurred to abate or control hazardous substances at a qualified environmental site through 2011. 7. the cost of figuring out what kind of work you’re going to do isn’t deductible. forrest v. commissioner, t.c. memo. 2011004 (1/4/11). the court held that expenses incurred in a “fledgling effort” solo law practice by a lawyer who reported no income from her law practice, but which were incurred to make contacts and network in an effort to “figure out what kind of work ... [the taxpayer] was going to do,” were nondeductible start-up expenses under § 195. c. reasonable compensation 1. throwing the tarp over compensation of insurance executives even though they never received a tarp. the 2010 2011] recent developments in federal income taxation 581 health care act amended § 162(m) by adding subsection (m)(6) to limit deductions for compensation paid by health insurance providers, which is defined as any employer that is a health insurance issuer (as defined in § 9832(b)(2) of the act) not less than 25 percent of the gross premiums of which are received from providing health insurance coverage (as defined in § 9832(b)(1) of the act) “that is minimum essential coverage.” the deduction for compensation for services rendered in any year is limited to $500,000, regardless of whether the compensation is paid during the taxable year or in a subsequent taxable year. as under § 162(m)(5) for remuneration from tarp participants, there are no exceptions for performance based compensation or compensation under existing binding contracts. the limitation applies not only to all officers, directors, and employees, but also to any other service providers, such as consultants, performing services for or on behalf of a covered health insurance provider. the provision is effective for remuneration paid in taxable years beginning after 2012 with respect to services performed after 2009. • omg — does it apply to outside counsel? probably not. a. thank god! the legal fees are safe. notice 2011-2, 2011-2 i.r.b. 260 (12/23/10). the § 162(m)(6) limitation applies to remuneration for services performed in a “disqualified taxable year” beginning after 12/31/12 that is otherwise deductible by a covered health insurance provider in a taxable year beginning after 12/31/12. it also applies to deferred deduction remuneration attributable to services performed in a taxable year beginning after 12/31/09 and before 1/1/13 if the employer was a pre-2013 covered health insurance provider for the year in which services were performed and the employer is a post-2012 covered health insurance provider for the year in which the deferred deduction remuneration is otherwise deductible. the guidance also has a de minimis rule, as well as a definition of “applicable individual” that excludes an independent contractor who provides substantial services to “multiple unrelated customers.” 2. why was over $2 mil reasonable comp in one year, but the next year only about $1.3 mil was reasonable? multi-pak corporation v. commissioner, t.c. memo. 2010-139 (6/22/10). in this case appealable to the ninth circuit, the tax court (judge goeke) allowed deductions for the full $2,020,000 of compensation paid to the taxpayer’s sole shareholder/ceo and coo, for 2002, but reduced the allowable compensation deduction for 2003 from $2,058,000 to $1,284,104. both amounts were greater than the $655,000 and $660,000 amounts that the irs asserted as reasonable. the court applied the five factor test of elliotts, inc. v. commissioner, 716 f.2d 1241, 1243-1245 (9th cir. 1983): (1) the employee’s role in the company; (2) comparison with other companies; 582 florida tax review [vol. 10:9 (3) the character and condition of the company; (4) potential conflicts of interest; and (5) internal consistency in compensation. the court rejected the opinions of dueling experts, noting that neither expert looked to companies comparable to the taxpayer. the court also faulted the taxpayer’s expert for not performing the “analysis, required in the applicable case law, of whether an independent investor would have been satisfied by his or her return on investment.” noting that the court of appeals in elliotts found that a 20 percent return on equity would satisfy the hypothetical investor, the court indicated that the taxpayer’s 2.9 percent return in 2002 supported the salary in light of an impressive growth in sales, but the -15.8 percent return in 2003 called into question the amount of compensation paid in that year. finally, the court refused to apply a § 6662(a) accuracy penalty. d. miscellaneous deductions 1. standard mileage rate rules published in a revenue procedure while the amounts will be disclosed in a separate notice. rev. proc. 2010-51, 2010-51 i.r.b. 883 (12/3/10). the irs indicated that beginning in 2011 it will publish mileage rates in a separate annual notice. the revenue procedure indicated that a taxpayer may use the business standard mileage rate to substantiate expenses for business use of an automobile in lieu of fixed and variable costs. parking fees and tolls are deductible as separate items. the basis of an automobile used for business is reduced by a per-mile amount published in the annual notice. separate rates are provided both for charitable use of an automobile and medical and moving use of an automobile. the revenue procedure also provides details for treating as substantiated a fixed and variable rate allowance for expenses incurred by an employee in driving an automobile owned or leased by the employee in performing services for the employer a. standard mileage rates announced. notice 2010-88, 2010-51 i.r.b. 882 (12/3/10). standard mileage rates for 2011 are: (1) 51 cents per mile for business miles driven [up from 50 cents]; (2) 19 cents per mile driven for medical or moving purposes [up from 16.5 cents]; and (3) 14 cents per mile driven in service of charitable organizations [unchanged because the rate is statutory, § 170(i)]. 2. throw another log on the fire! loss of contemporaneous § 274(d) mileage log in a fire doesn’t cause loss of mileage deductions too. freeman v. commissioner, t.c. memo. 2009-213 (9/16/09). judge gustafson allowed the taxpayer a deduction, at mileage rates, for business use of his automobile on the basis of the taxpayer’s credible testimony regarding the route he drove in connection with his auto parts delivery business. the taxpayer had maintained and at one time 2011] recent developments in federal income taxation 583 possessed adequate documentation, in the form of a daily log, to comply with § 274(d), but his failure to produce that daily log was the result of an accidental fire that destroyed his house and the logbook. reg. § 1.2745t(c)(5) allows a taxpayer to “substantiate a deduction by reasonable reconstruction of his expenditures or use” when records are lost through circumstances beyond the taxpayer’s control, including a fire. a. but if you lose the mileage log books due to crs [misplacing them], or they’re just plain s****y [smudgy?], you’re out of luck. royster v. commissioner, t.c. memo. 2010-16 (2/1/10). the taxpayer was denied a deduction for claimed 2003 business mileage because he had “lost” his log books. but it probably didn’t matter. he was also denied any deductions for 2004 and 2005 business mileage because his log books recorded only the odometer readings at the beginning and end of each day and had no indications of the business purpose of the trips or the destinations. 3. restitution of insurance fraud proceeds is deductible. cheating wife produces business losses. cavaretta v. commissioner, t.c. memo. 2010-4 (1/5/10). the taxpayer dentist’s wife, who managed the billing for the taxpayer’s dental practice, billed an insurance company for work that had not been done. the dentist was unaware of his wife’s false claims, but unfortunately for her the insurance company figured it out. she subsequently pled guilty to criminal health-care fraud and received a prison sentence followed by supervised release. restitution was not ordered in the criminal proceeding, but the wife had agreed to repay $600,000 in civil restitution before sentencing and compliance with the restitution agreement was required as a condition for supervised release from prison. the repayment was made by the taxpayer over three taxable years. the tax court (judge holmes) held, first, that the restitution payments, which were made by the husband, were deductible because payment was compensatory, not punitive, and thus § 162(f) did not disallow the deduction. the court agreed with the taxpayer’s claim that the repayments were deductible as losses incurred in a trade or business under § 165(c)(1) and rejected the irs’s argument that the payments constituted restitution deductible as a loss in a transaction entered into for profit under § 165(c)(2), which is not eligible for carryback under § 172(d). the court refused to apply the holding of stephens v. commissioner, 905 f.2d 667 (2d cir. 1990), which states that a payment constituting “restitution” is never deductible under § 162 and only sometimes deductible under § 165. the court concluded that the “restitution” label does not make a repayment automatically ineligible for deduction as a business expense. the court distinguished stephens as involving restitution for criminal fraud and embezzlement without any connection to a separate trade or business. the 584 florida tax review [vol. 10:9 court also rejected the irs’s argument that because the payments were expenses of committing fraud they cannot be considered as business expenses. the court found that the repayment was an ordinary and necessary expense of the dental practice. 4. multi-employer life insurance plan too good to be true? yes, says the tax court. curcio v. commissioner, t.c. memo. 2010115 (5/27/10). this case consolidated irs assessments and penalties against three companies that had been involved in the benistar 419 plan and trust, established by daniel carpenter and promoted in a book entitled a professional’s guide to 419 plans. participating companies contributed money to a trust account which in turn acquired cash rich life insurance policies covering employees insured by the plan. benistar withdrew nine percent of the surrender value of the policies to cover its expenses. promotional materials promised unlimited deductions, contribution rates that are variable from year to year, benefits that could be provided to key employees on a selective basis, that contributions to the plan are not limited by qualified plan rules and will not interfere with qualified plans, funds inside the benistar trust accumulate tax free, death benefits are income and estate tax free, arrangements can be made for later tax-free distributions, and the funds are secure from creditors. section 419(a) provides that contributions to a welfare benefit fund are deductible, limited under § 419(b) to the plan’s qualified cost, but only if the contributions are otherwise deductible under chapter 1 of the code. section 419(f)(6) provides that contributions to a multi-employer plan are not subject to the limit of § 419(b). the court (judge cohen) held that contributions to the plans were not deductible under § 162 because the taxpayers had the right to receive the value reflected in the underlying insurance policies in the benistar plan, and that the taxpayers used the plan to funnel pretax business profits into cashladen life insurance policies over which they retained control. the court also held that contributions to the plan were constructive dividends rather than deductible expenses. the court found that the costs of insurance policies under the plans claimed as deductions far exceeded the costs of providing term life insurance to the covered employees, that the taxpayers treated the underlying policies as their own, and that the policies could be withdrawn from the plan without cost. • with respect to s corporation employee shareholders in one of the cases, the court pointed out that deductions claimed and denied for 2002 would properly increase income under § 1366 and basis under § 1367 which would offset subsequent distributions. with respect to the s corporation shareholder involved, since the corporation claimed a deduction in 2002, a year not before the court, and the actual contribution was paid in 2003, there was no increase in income in 2003 to create basis. absent 2011] recent developments in federal income taxation 585 evidence regarding basis at the end of 2002, the court presumed that the basis was zero. • the court also affirmed accuracy related penalties assessed under § 6662(a), rejecting both the taxpayers’ arguments that their positions were supported by substantial authority and that they reasonably relied on professionals. on the latter point the court found that the accountants on whom the taxpayers asserted reliance had no expertise in employee benefit rules and the insurance agents had no tax expertise on which reliance was reasonably warranted. a. and another one goes down. mcgehee family clinic, p.a. v. commissioner, t.c. memo. 2010-202 (9/15/10). same book, same plan, same judge (cohen, j.), different taxpayer, same result with penalties. 5. this mountain does not blossom into cost of goods. d.l. white construction, inc. v. commissioner, t.c memo. 2010141 (6/28/10). the taxpayer, a c corporation, purchased 80 acres in idaho with plans to construct four houses for sale to customers. unfortunately the access road to the property was owned by another who disputed in the idaho courts the taxpayer’s right to an easement. as a consequence the taxpayer claimed the purchased land was worthless and claimed the loss as a cost of goods sold. the tax court (judge marvel) rejected the taxpayer’s argument that the purchased land represented a cost of goods sold. the court noted that § 471 generally prohibits inventory accounting for property that is not merchandise and added that land is not merchandise. the court also rejected the taxpayer’s claim that it was entitled to a business loss under § 165(a), holding that the taxpayer’s claimed loss was not evidenced by a closed and completed transaction because the adjacent land owner’s lawsuit was not finally resolved. 6. have you documented that your own cell phone is used for business rather than personal purposes? tash v. commissioner, t.c. memo. 2008-120 (4/29/08). among the many deductions claimed by a lawyer that judge haines disallowed was the deduction claimed for his cellular telephone, because “[t]he record did not indicate whether petitioner used his cellular telephone for business and/or personal calls.” inasmuch as cell phones are listed property, reg. § 1.2745(c) and (f) require substantiation for the deduction. a. how do you steer the car? it might or might not be ok to drive while talking on your cell phone, but it is imperative to take notes in your log book while chatting on the phone. alami v. commissioner, t.c. memo. 2009-42 (2/23/09). judge vasquez 586 florida tax review [vol. 10:9 denied the taxpayer’s claimed business deductions for cellular telephone service because the taxpayer failed to establish the amount of time he used his cell phone for business and personal purposes. a cellular phone is “listed property” that is subject to the strict substantiation requirements of § 274(d) pursuant to § 280f(d)(4)(a)(v), and a taxpayer must establish the amount of business use and the amount of total use for the property to substantiate the amount of expenses for listed property. an alternative ground for denying the deduction was that the taxpayer’s employer did not require that he have a cell phone. • query whether there are employer reporting obligations with respect to cell phones furnished to employees who fail to keep records? b. but, simplified methods for reporting cell phone use are under consideration. notice 2009-46, 2009-23 i.r.b. 1068 (6/8/09). irs is considering methods to simplify treatment of employerprovided cell phones, including a (1) “minimal personal use method” (if the employee accounts to the employer that he has a personal cell phone for use during business hours); and (2) a safe harbor method under which an employer would treat 75 percent of each employee’s use of the cell phone as business usage. • in a letter to representative skelton, info 2009-0141 (7/8/09), the irs advised that it is seeking clarifying legislation from congress. 2009 tnt 216-62. c. and the prez says to congress “delist” cell phones. president obama’s fiscal year 2011 budget calls for congress to amend § 280f to remove cellular telephones from the category of listed property, thereby “effectively removing the requirement of strict substantiation and the limitation on depreciation deductions.” department of the treasury, general explanations of the administration’s fiscal year 2011 revenue proposals 26 (february 2010). the substantiation requirements are “burdensome for employers;” it is difficult to document the cost of cell phone calls, and “the cost of accounting for personal use often exceeds the amount of any resulting income.” the proposal specifically contemplates that “a cell phone (or other similar telecommunications equipment) provided primarily for business purposes would be excluded from gross income.” d. finally, there is no longer a need to keep a log book on the front seat of your car. section 2043 of the small business jobs act of 2010 removed “cellular telephones and similar telecommunications equipment” from the definition of “listed property” contained in § 280f(d)(4) for taxable years beginning after 12/31/09. this, in 2011] recent developments in federal income taxation 587 turn, eliminates the § 274(d) substantiation requirement for business cell phone use. 7. the courts really socked it to this cpa. the legal fees he paid in connection with defending a criminal charge arising from his kissing a client’s employee do not give rise to deductions in his accounting business. argyle v. commissioner, 106 a.f.t.r.2d 2010-6759 (3d cir. 10/14/10), aff’g t.c. memo. 2009-218. in a nonprecedential per curiam opinion the court upheld the tax court’s conclusion that a cpa could not deduct legal expenses incurred in a criminal simple assault case brought by the female employee of a client who the taxpayer kissed at her home. the court rejected the taxpayer’s assertion that the criminal action was brought because he had reprimanded the woman for misconduct in the client’s business and that the fees, therefore, arose out the cpa’s professional activities. the court concluded that the origin of the criminal complaint was the taxpayer’s personal activities. the court also upheld the tax court’s finding that the taxpayer was not entitled to claimed home office expense deductions. 8. non-salaried members of a religious organization are employees whose compensation is deductible by the tax-exempt organization. stahl v. united states, 626 f.3d 520 (9th cir. 11/29/10). the taxpayer was a member and president of the stahl hutterian brethren (shb), a § 501(d) religious or apostolic organization in which the members pooled their efforts in farming and selling produce. the organization paid no salaries but took care of the members’ personal needs such as food, shelter, and medical care. the members did not contribute to or collect social security benefits. under § 501(d) a religious or apostolic organization is exempt from tax if it maintains a common treasury and its members include in gross income their pro rata share of the entity income, whether or not distributed. the taxpayer claimed that he was an employee of shb so that his medical and meal expenses were deductible in determining the entity’s taxable income. reversing summary judgment in the district court, the court held that, applying the common law factors defining employment status, the members of shb were employed by the business, even though they have many other relationships among themselves and to the organization. e. depreciation & amortization 1. stimulate the economy, buy a new car, light truck or van and claim $100 more depreciation. rev. proc. 2010-18, 2010-9 i.r.b. 427 (2/16/10). the annual dollar limit on depreciation for passenger automobiles placed in service in 2010 is generally increased by $100 for the first year as follows: $3,060 for the placed in service year, 588 florida tax review [vol. 10:9 $4,900 for the second tax year, $2,950 for the third tax year, and $1,775 for each succeeding year. the limits for light trucks and vans are: $3,160 for the placed in service year, $5,100 for the second tax year, $3,050 for the third tax year, and $1,875 for each succeeding year. 2. now that’s a whole lotta expens’n goin’ on! for taxable years beginning in 2008 and 2009, the 2009 arra, § 2021, increases the § 179 maximum deductible amount to $250,000 and provides a phase-out threshold of $800,000. the maximum amount allowed to be deducted under § 179 is increased by another $35,000 for (a) qualified enterprise zone property, i.r.c. § 1397a(a)(1), and (b) qualified renewal community property acquired and placed in service after 2001 and before 2010. i.r.c. § 1400j. in addition, for both qualified enterprise zone property and qualified renewal community property, only fifty percent of the cost of property in excess of the threshold for the phase-out is taken into account. i.r.c. § 1397a(a)(2). i.r.c. § 179(e) increases the maximum amount allowed to be deducted under § 179 by $100,000, and increases the phase-out threshold by $600,000, for qualified disaster assistance property placed in service after 2007 (with respect to disasters declared after that date) and before 2010. the increased expensing and ceiling limits under the 2009 arra also affect the special expensing rules for enterprise zone property, renewal property, and for qualified disaster assistance property. thus, the maximum § 179 deduction for qualified enterprise zone and renewal property is $285,000 for 2008 and 2009 ($250,000 + $35,000). for qualified disaster assistance property in 2008 and 2009 the maximum deduction is $350,000 ($250,000 +$100,000), and the phase-out threshold is $1,400,000 ($800,000 + $600,000). a. and the tide of the expens’n rolls on. the 2010 hire act extended the increased $250,000 ceiling on deducting the cost of equipment under § 179, and the increased phase-out threshold of $800,000, through taxable years beginning before 2011. b. rev. proc. 2010-24, 2010-25 i.r.b. 764 (6/1/10), superseded by rev. proc. 2010-47, 2010-50 i.r.b. 827 (12/1/10). the revenue procedure modifies rev. proc. 2009-50, 2009-45 i.r.b. 617, to update inflation adjusted § 179 first year depreciation to reflect increases provided by the 2010 hire act increasing for taxable years beginning in 2010 the aggregate cost of § 179 property eligible for expensing to $250,000 and the amount above which the deduction is reduced to $800,000. after the small business jobs act of 2010 increased the § 179 increased the deductible amount to $500,000 for tax years beginning in 2010 or 2011, rev. proc. 2010-24 became irrelevant. 2011] recent developments in federal income taxation 589 c. the tide is growing into a tsunami. the small business jobs act of 2010 increases the § 179 increased the deductible amount to $500,000 for tax years beginning in 2010 or 2011 and increases the phase-out threshold to $2,000,000. d. and certain real property becomes eligible. the small business jobs act of 2010 extended the § 179 deduction to “qualified real property” as defined in § 179(f), through cross-reference to § 168(e). section 179(f) allows the deduction of up to $250,000 of capital expenditures for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. the qualified real property allowance is within the overall $500,000 expenditure limit of § 179 and is limited to depreciable real property used in the taxpayer’s trade or business. e. section 179 limits are extended again – is this becoming permanent like research credits? the compromise tax relief act of 2010, § 402, provides for code § 179 first year expensing for tax years beginning in 2012 in an amount not to exceed $125,000 with a phase-out amount beginning at $500,000. for tax years beginning after 2012 the maximum deduction drops to $25,000 with the phase-out beginning at $200,000 (at least until the business community makes sufficient campaign contributions to extend the higher numbers into later years). f. and applied to computer software for another year. the compromise tax relief act of 2010, § 402, extends eligibility as qualified code § 179 property to off-the-shelf computer software placed in service before 2013. 3. fifty percent bonus depreciation is extended for 2010. the small business jobs act of 2010 extends application of the 50 percent bonus depreciation allowance of § 168(k) for one year to property placed in service before 1/1/11. the 50 percent allowance is available for depreciable machinery and equipment and most other tangible personal property, and is available for computer software and certain leasehold improvements, the first use of which began with the taxpayer. a. but why worry about § 179 with bonus depreciation at 100% extended for 2011. the compromise tax relief act of 2010, § 401, increases first year bonus depreciation under code § 168(k) to 100% of the cost of qualified property placed in service after 9/8/10, and before 1/1/12. 590 florida tax review [vol. 10:9 4. certain real property is 15 year macrs property. the compromise tax relief act of 2010, § 737, extends application of code § 168(e)(3)(e) and (e)(8)(e), which allow 15 years macrs recovery for certain qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property, to property placed in service on or before 12/31/11. 5. nascar wins again. the compromise tax relief act of 2010, § 738, extends the 7-year cost recovery period for real property improvements at motor-sports facilities under code § 168(i)(15)(d) to property placed in service before 1/1/12. 6. ouch! fifteen year recovery period for a oneyear lived asset. covenant not to compete from a minority s corporation shareholder is a § 197 intangible. recovery group, inc. v. commissioner, t.c. memo. 2010-76 (4/15/10). the taxpayer s corporation paid a retiring 23 percent shareholder/employee $400,000 for a one-year covenant not to compete. the taxpayer asserted that the acquisition of a 23 percent interest was not “entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof” as provided in § 197(d)(1)(e), and claimed a full year’s deduction for the amount paid. the court (judge gustafson) upon a careful analysis of the statutory phrase concluded that the covenant was part of an acquisition of an interest in a trade or business, that the interest was “substantial,” and that in any event the term “thereof” in the statutory language does not modify “an interest,” which, therefore, need not be substantial. 7. fiat lux but only for seven years. street lights are not land improvements. here, it’s better not to be assigned an asset class. ppl corporation v. commissioner, 135 t.c. no. 8 (7/28/10). the taxpayer public utility company claimed that streetlights were depreciable over seven years, as property for which there is no assigned recovery period, while the irs asserted that the proper recovery period for the streetlights was 20 years, as electric utility transmission and distribution plant, or alternatively 15 years, as land improvements. the tax court (judge halpern) held that street lighting, including lamps, poles and wiring, owned and installed by an electric utility for public and private customers constituted property without a class life and were thus eligible for seven year macrs recovery under § 168(e)(2) & (3). judge halpern found that the streetlights were neither (1) electric utility transmission and distribution plant, because they were “‘primarily used’ to make light, not to distribute electricity,” and not used in the distribution of electricity for sale, nor (2) land improvements, because they were bolted to wood poles and buildings and not affixed to anything in an inherently permanent way. judge halpern applied the six 2011] recent developments in federal income taxation 591 factors of whiteco industries, inc. v. commissioner, 65 t.c. 664 (1975), which focus on the permanence of the depreciable property and the damage caused to it or to realty upon removal of the depreciable property: (1) “is the property capable of being moved, and has it in fact been moved?” (2) “is the property designed or constructed to remain permanently in place?” (3) “are there circumstances which tend to show the expected or intended length of affixation, i.e., are there circumstances which show that the property may or will have to be moved?” (4) “how substantial a job is removal of the property and how time-consuming is it? is it ‘readily removable’?” (5) “how much damage will the property sustain upon its removal?” and (6) “what is the manner of affixation of the property to the land?” every factor suggested that street lights, including poles bolted to concrete foundations, which were easily moved, were not land improvements. a. entergy corporation & affiliated subsidiaries v. commissioner, t.c .memo 2010-166 (7/28/10). this case follows ppl corp. v. commissioner, (7/28/10), on essentially similar facts. 8. oral leases don’t cut it if you want a § 179 deduction for the leased property. thomann v. commissioner, t.c. memo. 2010-241 (11/1/10). pursuant to § 179(d)(5)(b), a taxpayer (other than a corporation) who leases property to others may not deduct the cost of the leased property under § 179 unless the taxpayer meets a two-prong test: (1) the term of the lease, taking into account options to renew, must be less than 50 percent of the class life of the leased property, and (2) the taxpayer’s § 162 business expenses for the leased property during the initial 12-month period following the transfer of the property to the lessee must exceed 15 percent of the rental income from the property. in this case, the taxpayer leased property pursuant to an oral lease, the annual term of which was extended several times. judge kroupa held that the lease term was indefinite and that the statutory test thus was not met. the § 179 deduction was denied. f. credits 1. a credit for vinny gambini hiring disconnected “yutes.” the 2009 arra, § 1221, added two new categories of eligible employees for 2009 and 2010 under the existing code § 51 work opportunity tax credit: unemployed veterans and “disconnected youth.” to qualify as an unemployed veteran, the employee (1) must have been discharged from active duty in the military (after serving at least 180 days or being discharged for a service-connected disability) during the five-year period ending on the hiring date, and (2) must have received unemployment compensation for at least four weeks during the one-year period ending on the hiring date. a disconnected youth is an individual certified by the 592 florida tax review [vol. 10:9 designated local agency who is (1) at least age 16 but not yet age 25 on the hiring date, (2) not regularly attending any secondary, technical, or postsecondary school during the six-month period preceding the hiring date, (3) not regularly employed during the six-month period preceding the hiring date, and (4) not readily employable by reason of lacking a sufficient number of skills. a. disconnected yutes defined. notice 200928, 2009-24 i.r.b. 1082 (5/28/09). 2009 arra amended § 51 to add two new targeted groups for purposes of the § 51 work opportunity credit: unemployed veterans and disconnected youths who begin work for an employer during 2009 or 2010. this provides guidance on the definition of “disconnected youth.” it also provides transition relief for employers who hire unemployed veterans or disconnected youths after 12/31/08, and before 7/17/09. b. the irs is paying you not to fire newly hired people. code §§ 38(b) and 39, as amended by the 2010 hire act, provide a credit for retaining newly hired workers. the amount of the credit is the lesser of (1) $1,000 or (2) 6.2 percent of the wages paid to the worker during the 52 week period following the commencement of employment in a tax year ending after 3/18/10. the credit is not available unless the employee’s wages (as defined for income tax withholding in § 3401(a)) during the last 26 weeks of the period are at least 80 percent of the wages for the first 26 weeks of that period. the credit is allowed in the year in which the 52 week period ends. no portion of the unused business credit under § 38 for any tax year that is attributable to the increased credit under the 2010 hire act may be carried to a tax year beginning before 3/18/10. 2. the research credit is available for the whole boat. trinity industries, inc. v. united states, 691 f. supp. 2d 688 (n.d. tex. 1/29/10). for purposes of the § 41 research credit, substantially all of the research activities undertaken for the discovery of technological information must constitute elements of a process that relates to a new or improved function. the tests of § 41 are applied to each “business component” of the taxpayer, which is a product or process held for sale or used in the business. i.r.c. § 41(d)(2). a trinity subsidiary designed and built six prototype “first in class” ships. the court rejected the irs’s argument that the special order ships were not held for sale because they were not sold out of inventory. the court also refused to accept the assertion that because each ship consisted of numerous existing subassemblies incorporated into a ship design that the total development cost of each ship did not constitute a qualified research expense. citing reg. § 1.41-4(a)(6), the court held that as long as the taxpayer can demonstrate that 80 percent of 2011] recent developments in federal income taxation 593 a first-in-class ship was part of a process of experimentation, the entire cost is a research expenditure. the court also indicated that the taxpayer failed to offer evidence from which the court could determine the amount of research expenditure relating to any business component smaller than the entire ship. the court then found that 80 percent of the costs of two of the six projects for which the taxpayer claimed the research credit represented qualified experimentation. 3. who says congress doesn’t love small bidnesses? big bidnesses are required to buy health insurance for their employees and must pay excise taxes if they don’t; small bidnesses, which aren’t required to buy health insurance for their employees, get a tax credit if they do. new § 45r, added by the 2010 health care act, adds to the § 38 general business credit a credit for health insurance expenses of small business employers, effective for taxable years beginning in 2010. this provision is generally intended to encourage small employers, who are not required to provide health insurance to their employees under other provisions of the act, to provide health insurance benefits to their employees. some amount of the credit is available to a business employer with no more than 25 full-time equivalent employees (2,080 hours is an fte), if the employees have average annual full-time equivalent wages of no more than $50,000 (as adjusted for inflation after 2014). the full amount of the credit is available only to an employer with 10 or fewer full-time equivalent employees, whose employees have average annual full-time equivalent wages from the employer of less than $25,000 (as adjusted for inflation after 2014). seasonal workers are not taken into account. employer aggregation rules apply. self-employed individuals, including partners and sole proprietors, two percent shareholders of an s corporation, and five percent owners of the employer (as defined in § 416(i)(1)(b)(i)) are not treated as employees, and sole proprietors cannot claim the credit with respect to employees who are family members. the credit applies only to contributions under a plan that requires the employer to make a nonelective contribution on behalf of each employee who enrolls in certain defined qualifying health insurance offered to employees by the employer equal to a uniform percentage (not less than 50 percent) of the premium cost of the qualifying health plan. before the phase-out rules are applied, the amount of the credit equals the “applicable percentage” of the employer’s mandatory health insurance premium for each covered employee; amounts paid under a cafeteria plan are not taken into account. for 2010 through 2013, the applicable percentage is 35 percent; for years after 2013, the applicable percentage is 50 percent. however, the credit cannot exceed the applicable percentage multiplied by the contributions that the employer would have made during the taxable year if each employee had enrolled in coverage with a “small business benchmark premium” (as defined in the statute). the phase 594 florida tax review [vol. 10:9 out formula depends on (1) whether the employer has more than 10 employees, (2) whether the employees’ average wages exceed $25,000, (3) whether both (1) and (2) apply, and whether the year is claimed, i.e., the year after the taxable year with respect to which the credit is claimed, is 2011 through 2013 or after 2013. we will not provide the gory details. the credit is nonrefundable, but may offset amt liability. the employer’s § 162 deduction is reduced by the amount of the credit. a. healthy credits. rev. rul. 2010-13, 201021 i.r.b. 691 (5/3/10). section 45r enacted in the health care act, provides a credit to eligible small employers (fewer than 25 employees with average annual wages around $50,000), including tax exempt employers, who make nonelective contributions (contributions that are not part of a salary reduction agreement) towards employee health care based on a percentage of the lesser of (1) the amount of nonelective contributions paid by the small employer and (2) the amount of nonelective contributions the employer would have paid if employees were enrolled in a plan that required the average premium for the small group market in the state in which the employer is offering health care coverage. the ruling sets forth the average premiums for the small group market in each state for the 2010 taxable year. the tables include average premiums for both single coverage and family coverage. b. the irs tells employers how to count, and throws in some transition relief. notice 2010-44, 2010-22 i.r.b. 717 (5/17/10), amplified by notice 2010-82, 2010-51 i.r.b. 857 (12/4/10). these notices provides comprehensive (?) guidance regarding the § 45r credit for small employers that make nonelective contributions towards their employees’ health insurance premiums, including guidance for determining eligibility for the credit, calculating the credit, and claiming the credit. it explains how to determine the number of hours of service worked by employees during the taxable year and how to compute ftes. the credit is available for add-on dental and vision coverage as well as for traditional health insurance. because the § 45r credit applies to taxable years beginning in 2010, including the period in 2010 before its enactment, the notice provides transitional relief under which an employer will be deemed to satisfy the requirement that the employer pay a uniform percentage, not less than 50 percent, of the premium cost of the health insurance coverage. for taxable years beginning in 2010, this uniformity requirement will be deemed to have been met if the employer pays an amount equal to at least 50 percent of the premium for single (employee-only) coverage for each employee enrolled in coverage offered to employees by the employer, even if the employer does not pay the same percentage of the premium for each such employee. 2011] recent developments in federal income taxation 595 c. more guidance. notice 2010-82, 2010-51 i.r.b. 857 (12/4/10). this notice amplifies notice 2010-44, 2010-22 i.r.b. 717, to provide additional guidance regarding the § 45r credit for small employers that make nonelective contributions towards their employees’ health insurance premiums under a qualifying arrangement. among the issues addressed are (1) tax-exempt organizations that are not both described in § 501(c) and exempt from tax under § 501(a) are not eligible to claim the credit; (2) a household employer that otherwise satisfies the statutory requirements is eligible o claim the credit; (3) spouse of owners that are treated as employees even if employed by the business: (4) the treatment of leased employees; (5) determination of average annual wages, number of hours worked, and number of ftes; (6) hsas and self-insured plans, including hras and fsas, are not qualifying arrangements; (7) calculation of the credit, including the application of the average premium cap. 4. it will be difficult for alliantgroup to be retrospectively generating these new research credits for clients. section 48d, added by the 2010 health care act, provides a 50 percent nonrefundable investment tax credit for qualified investments in qualifying “therapeutic discovery projects,” which is a term with a complicated definition. the credit is available only to companies having 250 or fewer employees, and the right to claim the credit must be awarded by the treasury company-by-company, in consultation with hhs, to companies that apply. oh, yeah, only a total of $1 billion can be awarded. the many small details will probably bore you. a. the irs creates the program. notice 2010-45, 2010-23 i.r.b. 734 (5/22/10). this notice establishes the qualifying therapeutic discovery project program and provides the procedures under which an eligible taxpayer may apply for certification from the irs of a qualified investment with respect to a qualifying therapeutic discovery project as eligible for a credit, or for certain taxpayers, a grant under the program. 5. leveraging the new markets tax credit is ok! rev. rul. 2010-17, 2010-26 i.r.b. 769 (6/8/10). section 45d(b) provides that an equity investment in a qualified community development entity eligible for the new markets tax credit is a qualified equity investment in cash. the irs ruled that, consistent with the holding of rev. rul. 2003-20, 2003-1 c.b. 465, an equity investment by an llc which is funded with a nonrecourse loan to the llc qualifies for the new markets tax credit, an equity investment includes cash from a recourse loan obtained by an llc. 596 florida tax review [vol. 10:9 6. mid-audit cca changing the irs’s view doesn’t cut the mustard as authority to support an asserted deficiency. the proctor & gamble co. v. united states, 106 a.f.t.r.2d 2010-5433 (s.d. ohio 6/25/10). section 41(a)(1) allows a credit of 20 percent of the amount by which the taxpayer’s qualified research expenditures for the year exceed the taxpayer’s “base amount” of qualified research expenditures. generally speaking, the �base amount” is the company’s “fixed base percentage” — the percentage of the company’s gross receipts expended for research from 1984 through 1988 (subject to a 16 percent ceiling) — multiplied by the company’s average annual receipts for the preceding four years (but the base will not be less than 50 percent of the qualified research expenses for the credit year). section 41(f) provides that for purposes of computing the credit, all members of the same controlled group of corporations will be treated as a single corporation. reg. § 1.41-6(b), as well temp. reg. § 1.41-6t(b), which was the controlling regulation for the years in question, provides that “[t]he group credit is computed by applying all of the section 41 computational rules on an aggregate basis.” pursuant to § 41(f)(5), a “controlled group” is defined by a cross reference to § 1563(a), substituting 50 percent for 80 percent, and thus should include foreign group members. in computing its credit, p&g excluded receipts from intercompany transactions within its group, including transactions with foreign members, from gross receipts. this method was acceptable to the irs under cca 200233011, but during the course of the audit, the irs issued cca 200620023, which provided that only research expenditures and not gross receipts within a controlled group should be disregarded, the position that the government maintained in the litigation. the court held that p&g had properly computed the § 41 research credit by disregarding both research expenditures and gross receipts within its controlled group. the court rejected the government’s argument that deere & company v. commissioner, 133 t.c. 246 (2009), supported its position, concluding that deere was not relevant because specific statutory and regulatory language was controlling. 7. once enacted, credits never die. the compromise tax relief act of 2010, extends a number of expiring and expired credits. • the research credit of code § 41 was retroactively extended to apply to amounts paid or accrued before 1/1/12. act § 731. • the 20% credit under code § 45a for qualified wages and health benefits paid to enrolled indian tribe members was retroactively extended to amounts paid or incurred in tax years beginning before 1/1/12. act § 732. • the 5% credit under § 45d for investment in stock of a community development entity was retroactively extended through 2011. act § 733. 2011] recent developments in federal income taxation 597 • the 20% credit provided by § 45p for differential wages paid to employees called to active duty in the armed services was extended through 2011. act § 736. • the work opportunity credit of § 51 was extended to individuals who begin work before 1/1/12. the date was extended from 8/31/11. act § 757. a. but the paper manufacturers take a hit. the compromise tax relief act of 2010 retroactively eliminates the § code § 6426(d) alternative fuels credit eligibility for “black liquor” produced by paper milling processes for fuel sold or used after 12/31/09. act § 704. g. natural resources deductions & credits 1. hire tax credits explained. notice 2010-35, 2010-19 i.r.b. 660 (4/26/10). the hiring incentives to restore employment act provides for an irrevocable election to receive direct payment of otherwise allowable tax credits to holders of new clean renewable energy bonds (§ 54c), qualified energy conservation bonds (§ 54d), qualified zone academy bonds (§ 54e), and qualified school construction bonds (§ 54f) that are issued after 3/18/10. direct pay tax credit bonds provide a federal borrowing subsidy through payment of a refundable tax credit to issuers with respect to each interest payment. the credit is the lesser of (1) the amount of interest payable, or (2) 100 percent of the interest on school construction and qualified zone academy bonds and 70 percent of the interest on clean renewable energy bonds and qualified energy conservation bonds that would have been payable if the interest were determined at the tax credit bond rate under § 54a(b)(3). the notice describes requirements for qualifying an issue as a direct pay tax credit bonds and requires issuers to elect that status the day before issue. issuers are required to file a revised form 8038-cp to request payment of a refundable credit. the credit will be paid contemporaneously with the applicable interest payment date of fixed rate bonds. payments will be made quarterly with respect to variable interest rate bonds. the notice also specifies reporting requirements. 2. the compromise tax relief act of 2010, § 706, suspends the code § 613a limitation on percentage depletion for oil and gas from marginal wells for two years (to apply to tax years beginning before 1/1/12). a. under the compromise tax relief act of 2010, §§ 701-711, energy credits were reinstated and extended two years, including the biodiesel fuels credit, biodiesel mixtures excise tax credit, refined coal credit, alternative fuel tax credit, alternative fuel mixtures excise 598 florida tax review [vol. 10:9 tax credit, alcohol fuels credit, ethanol blenders credit, alcohol fuels excise tax credit, energy efficient appliances credit, and the alternative fuel vehicle refueling property credit. h. loss transactions, bad debts, and nols 1. carry me back to those long ago days of yore, when there were profits to be offset by today’s nol. the 2009 arra, § 1211(b), amended code § 172 to permit an “eligible small business” to elect to extend the carryback period for a net operating loss arising in 2008 to any number of years greater than two or fewer than six – i.e., the elected carryback period may be five, four, or three years. (absent an election the normal two year carryback rule still applies.) an “eligible small business” is defined in § 172(b)(1)(h)(v)(ii) (through cross references to § 172(b)(1)(f)(iii)) as a corporation, partnership, or sole proprietorship with average annual gross receipts of $15 million or less. an election under § 172(b)(1)(h) must be made by the due date (including extensions) for filing the taxpayer’s return for the year the net operating loss arose (i.e., 2008). if the taxpayer is on a fiscal year, the election can be made with respect to either the taxable year ending in 2008 or the taxable year beginning in 2008, but not with respect to both taxable years. i.r.c. § 172(b)(1)(h)(ii),(iii). the election is irrevocable. a. and here’s instructions on how to get back to those days of yore. rev. proc. 2009-19, 2009-14 irb 747 (3/16/09). this revenue procedure provides guidance under § 1211 of 2009 arra, which amended § 172(b)(1)(h) to allow a taxpayer that is an eligible small business to elect a 3-, 4-, or 5-year nol carryback for a taxable year ending after 2007. b. rev. proc. 2009-19 was modified and superseded by rev. proc. 2009-26. rev. proc. 2009-26, 2009-19 i.r.b. 935 (4/25/09). this revenue procedure was issued because many eligible small businesses inadvertently failed to make valid elections that complied with rev. proc. 2009-19. c. now the carryback is available to larger businesses as well. section 13 of the worker, homeownership, and business assistance act of 2009 (whaba) amends § 172 to permit larger businesses to make the 2008 and 2009 nol carryback election of up to five years (which in 2009 arra was allowed only for and “eligible small business”). the election applies with respect to nols incurred in either 2008 or 2009, but not both years. in addition, 2008 or 2009 nols can be used to offset only fifty percent of the taxable income earned in the fifth prior taxable year. 2011] recent developments in federal income taxation 599 this 50 percent limit does not apply to carrybacks of 2008 losses by “eligible small businesses.” in addition, an “eligible small business” may take advantage of the extended carryback rules with respect to both 2008 and 2009 losses, rather than the losses of only one of those years. generally, the extended nol carry back election is not available for tarp recipients or corporations that, at any time during 2008 or 2009 were a member of an affiliated group including a tarp recipient. • this provision also increases the use of nols to offset a corporation’s alternative minimum taxable income by the nols the taxpayer elects to carry back up to five taxable years and removes the 90 percent amt limit. d. more instructions. rev. proc. 2009-52, 2009-49 i.r.b. 744 (11/20/09). this revenue ruling provides guidance regarding procedures for making the election and its effect. the revenue procedure explains which business can elect the nol carry back periods provided by whaba. e. notice 2010-58, 2010-37 i.r.b. 326 (8/20/10). this notice provides guidance in q&a format regarding twenty particular issues that have arisen regarding the election to carryback nols for three, four, or five years under § 172(b)(1)(h), as amended by the worker, homeownership, and business assistance act of 2009. 2. amt nols are different. metro one telecommunications, inc. v. commissioner, 135 t.c. no. 28 (12/15/10). in computing amti, § 56(a)(4), allows a corporation to claim an amt nol in lieu of a regular nol deduction allowed under § 72. the taxpayer claimed an amt nol deduction for 2002 based on a carryback of an amt nol from 2004. analyzing a very complicated statutory pattern, judge paris held that § 56(a)(1) does not allow for an amt nol carryover to a prior year. i. at-risk and passive activity losses 1. limited liability partnership and limited liability company membership interests are not presumptively limited partnership interests under the passive activity loss rules. garnett v. commissioner, 132 t.c. 368 (6/30/09). the taxpayers held a number of direct and indirect interests in limited liability partnerships and llcs that were engaged in agribusiness. section 469(h)(2) provides that a limited partnership interest will not be treated as an interest with respect to which a taxpayer is a material participant, except as provided in regulations. temp. reg. § 1.469-5t(e)(2) provides that a limited partner materially participates in a partnership activity only if (1) the taxpayer devotes more than 500 hours 600 florida tax review [vol. 10:9 to the activity in the year, (2) the taxpayer materially participates in the activity for five of the preceding ten taxable years, or (3) the activity is a personal service activity in which the taxpayer materially participated for any three preceding years. temp. reg. § 1.469-5t(e)(2)(1), (5), (6). temp. reg. § 1.469-5t(e)(3) defines a limited partnership interest as an interest designated as a limited partner interest in a partnership agreement or an interest for which the partner has limited liability. temp. reg. § 1.4695t(e)(3)(ii) has an exception from the material participation rule for an interest of a limited partner who also holds a general partnership interest. the court (judge thornton) concluded that in the case of an interest in a limited liability partnership or a limited liability company, both of which the court described as different from a limited partnership, the interests are not to be treated as limited partnership interests under § 469(h)(2). holders of such interests are not barred by state law from materially participating in the affairs of the entity and thus hold their interests as general partners within the meaning of the temporary regulations. thus, whether or not the taxpayer is a material participant requires a full factual inquiry and an llc member can satisfy the material participation requirement under any of the seven tests in temp. reg. § 1.469-5t(a). a. the court of federal claims agrees. thompson v. united states, 87 fed. cl. 728 (7/20/09). the court (judge block) granted summary judgment treating the taxpayer member/manager of an llc as a material participant. the taxpayer’s degree of participation was stipulated and the only question was whether § 469(h)(2) precluded treating the taxpayer as a material participant in a texas llc. the court noted that § 469(h)(2) treats limited partners differently because of an assumption that limited partners do not materially participate in their limited partnerships. in an llc, on the other hand, all members have limited liability but members may participate in management. the court noted that temp. reg. § 1.4695t(e)(3) treats a partnership interest as a limited partner interest if the holder has limited liability “under the law of the state in which the partnership is organized.” the court held that the quoted language applies only to an entity that is a partnership under state law, which does not include an llc, which, although treated as a partnership for tax purposes, is a different type of entity under state law. the taxpayer was both a member and manager of the llc. unlike a limited partner, a member manager does not lose limited liability by participation in the management of the llc. the court also recognized that shareholders of an s corporation have limited liability as shareholders, but participate in management, and are not subject to being automatically treated as passive participants. the taxpayer, therefore, was able to demonstrate his material participation in the activity by using all seven of the temp. reg. § 1.469-5t(a) tests. 2011] recent developments in federal income taxation 601 b. ditto. hegarty v. commissioner, t.c. summ. op. 2009-153 (10/6/09), is to the same effect. c. ditto again. newell v. commissioner, t.c. memo. 2010-23 (2/16/10). relying on garnett v. commissioner, supra, judge marvel held that the interest of a managing member of a california llc was not a limited partnership interest for purposes of reg. § 1.4695t(c)(1). taxpayer’s losses were not passive activity losses because the irs conceded that the taxpayer met the “significant participation” test of temp. reg. § 1469-5t(a)(4). d. the irs acquiesces. aod 2010-02, 201014 i.r.b._(4/5/10). the irs acquiesces in the result in thompson. see also aod 2010-02, 2010 wl 2010483. 2. reporting self-help slicing, dicing, gluing, and pasting of passive activities. tell the irs about grouping trade or business activities. rev. proc. 2010-13, 2010-4 i.r.b. 329 (1/6/10). this revenue procedure requires taxpayers to report to the irs their groupings and regroupings of activities and the addition of activities within their existing groupings of activities under reg. § 1.469-4(c) for purposes of § 469. a written statement must be filed with the original income tax return for the first taxable year in which two or more trade or business activities or rental activities are originally grouped as a single activity. the statement must contain a declaration that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss under § 469. a similar statement must be filed with a return for the first taxable year of a regrouping or the taxable year in which a new trade or business activity or a rental activity is added to an existing grouping. a partnership or s corporation must disclose as required on the entity’s tax return and by separately stating the amounts of income and loss for each grouping, and a partner or shareholder is not required to make a separate disclosure unless the partner or shareholder (1) groups together any of the activities that the entity does not group together, (2) groups the entity’s activities with activities conducted directly by the partner or shareholder, or (3) groups the entity’s activities with activities conducted through other entities. • a taxpayer is not required to file a report of groupings in existence prior to the 1/25/10 effective date of the revenue procedure. a. contrary to jackie gleason, this was not a “good group.” grouping activities under § 469 requires an explicit election, not merely a reporting position. trask v. commissioner, t.c. memo. 2010-78 (4/15/10). the taxpayer failed to make an explicit election 602 florida tax review [vol. 10:9 on his return to aggregate rental real estate activities as required by reg. § 1.469-9(g). the tax court (judge goeke) held that merely aggregating real estate rental activity losses on his returns was not an effective election. thus, although the taxpayer established that he was a “real estate professional” as defined in § 469(c)(7), all of the claimed losses were disallowed because he failed to prove that he materially participated in any of the rental activities on an activity-by-activity basis. b. elect to aggregate, or be segregated. shiekh v. commissioner, t.c. memo. 2010-126 (6/10/10). on facts substantially similar to the facts in trask, the tax court (judge wells) reached a similar result. the taxpayer materially participated in the operation of rental properties in miami beach, florida, and owned additional properties including properties in ventura and culver city, california. the taxpayer did not file the election required by § 469(c) which would have allowed the taxpayer, as a real estate professional, to aggregate all of his real estate activities into a single activity for purposes of treating all of the real estate income and losses as active. the tax court (judge wells) held that aggregating properties on a return filed in the year the taxpayer claimed ordinary loss on the sale of his ventura property was not adequate notice of an election to aggregate properties under reg. § 1.469-9(g)(3). the taxpayer was found not to be a material participant with respect to his ventura and culver city properties. the taxpayer was allowed to reduce capital gain in the year he sold the ventura property by expenses incurred in the year of sale. 3. a song and a dance doesn’t make the law practice a professional real estate business, but renting your building to the law practice is active. langille v. commissioner, t.c. memo. 2010-49 (3/18/10). the taxpayer deanna langille, formerly known as deanna birdsong, worked long hours in her law practice and devoted somewhat less of her time to her rental real estate activities. unfortunately for the taxpayer she resigned from her law practice in lieu of disciplinary proceedings implemented for misappropriation of funds from her firm’s client trust accounts. to make matters worse, after an unsuccessful negotiation for the sale of her law practice, the potential buyer reported to the irs that the taxpayer maintained two sets of books for the practice, which resulted in a criminal investigation and a guilty plea to one count of a tax fraud indictment. in the civil tax matter the tax court (judge gustafson) found that the taxpayer willfully failed to report income from her law practice and residential real estate rental activities (from which she had no profit). the taxpayer was unable to establish the number of hours she worked on her residential real estate activities, and thus was unable to establish herself as a real estate professional under the 50 percent of all personal services 2011] recent developments in federal income taxation 603 requirement of § 469(c)(7)(b)(i), or to prove that she satisfied the 750 hour requirement of § 469(c)(7)(b)(ii). in addition, the court held that income from the taxpayer’s rental of office space to her law practice in which she was a material participant was not passive activity income under reg. § 1.469-2(f)(6). 4. an activity log that reflects work days in excess of 24 hours isn’t very credible (unless you were on an airplane to the west coast). goolsby v. commissioner, t.c. memo. 2010-64 (4/1/10). the taxpayers owned several rental real estate properties with respect to which they claimed net losses. the irs disallowed the losses as passive activity losses, and the taxpayers claimed that one of them spent more than 750 hours a year managing the properties and that under the § 469(c)(7)(b) real estate professional rule, the losses were treated as active business losses. judge wells rejected the taxpayers’ arguments. he found that the activity log purporting to document the hours of management activity was not credible. it was created after the taxpayers’ return was selected for audit and solely for purposes of the case in controversy. the taxpayers “presented no evidence of contemporaneous records, such as appointment books, calendars, or narrative summaries, that would credibly support the ... activity log. incredibly, the ... activity log lists days during which [the taxpayer] allegedly logged more than 24 hours of work.” 5. new market tax credits are not treated as passive activity credits. rev. rul. 2010-16, 2010-26 i.r.b. 769 (6/8/10). section 45d provides a new market credit for an equity investment in a qualified community development entity, an entity that invests in or loans money to a qualified active low-income community business, purchases loans from another qualified community development entity, provides financial counseling to residents of low-income communities, or loans money or makes an equity investment in a qualified community development entity. a qualified community development entity does not itself need to be engaged in a trade or business. thus, the ruling concludes that when an individual acquires an equity investment in a qualified community development entity that is not in connection with the conduct of a trade or business by the individual, § 45d credits are not passive activity credits under § 469(d)(2) because a passive activity is defined in § 469(c) as an activity that is a trade or business in which the taxpayer does not materially participate. the ruling also concludes that new market credits derived from acquisition of an equity interest in a qualified community development entity by a partnership that is not in connection with the partnership’s conduct of a trade or business are not passive activity credits. 604 florida tax review [vol. 10:9 6. here’s an example of why tax court summary opinions aren’t and shouldn’t be precedential. ajah v commissioner, t.c. summ. op. 2010-90 (7/8/10). this otherwise unremarkable summary opinion, denying the taxpayers’ claim that he rental real estate losses from two properties were not subject to the § 469 passive activity loss rules because mrs. ajah was real estate professional under § 469(c)(7) is notable only for a glaring error of law that likely did not affect the outcome, but demonstrates that some decided cases contain statements that are just flat out wrong and should be ignored. the taxpayers were held not to qualify because mrs. ajah’s “method of calculating her time spent participating in the rental activities constitutes an impermissible ‘ballpark guesstimate’” that under temp. reg. § 1.469-5t(f)(4) was not an acceptable method of establishing her participation. she had no records and simply testified that she worked at least 20 hours a week for 52 weeks on the two rental properties. not content to stop there, the judge continued by finding that the taxpayer had failed to properly aggregate the two rental properties into a single activity because merely aggregating items on schedule e is insufficient – a point on which he was correct – and then concluded that because the taxpayers had not aggregated the activities, to qualify as a real estate professional under § 469(c)(7)(b) mrs. ajah “would need to perform 750 hours of service for each rental real estate interest for a total of 1,500 hours to meet the test” – a conclusion that every kindergartner knows is not what is required by the statute. • section 469(c)(7)(b)(ii) requires that “such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.” this language clearly means that the 750 hours requirement refers to the aggregate number of hours in all real property trades or businesses in which the taxpayer materially participates and is not a property-by-property requirement. only material participation is determined on a property-byproperty basis, except with respect to those properties that are grouped. trask v. commissioner, t.c. memo. 2010-78 (4/15/10), which was cited in ajah as the basis for the errant holding, did not so hold. a careful reading of trask indicates that the taxpayer, who was able to prove that he devoted more than one-half of his time and more than 750 hours of total time to managing over thirty rental properties, was held to qualify as a real estate professional under § 469(c)(7)(b), but because he failed properly to elect to treat all of his rental properties as a single activity for purposes of § 469(c)(7)(a) and he “[did] not contend that he materially participated in each of his rental activities when viewed separately,” he did not qualify for the exception. section 469(c)(7) removes from the passive activity basket only those rental activities in which the real estate professional materially participates. 2011] recent developments in federal income taxation 605 7. estate of roberts v. commissioner, t.c. memo. 2010-156 (7/21/10). the deceased taxpayer was the sole owner of a leasing llc organized for the purpose of leasing trucking equipment to the taxpayer’s solely owned s corporation. the taxpayer “lent” the llc $425,000 for a promissory note. the llc issued a cashier’s check in the same amount which was used to fund a portion of the $1.4 million purchase price of a luxury rv. the court (judge goeke) found that the rv was not used by the llc in its leasing activity and therefore the taxpayer was not atrisk under § 465 for the contribution to the llc because the funds were not borrowed for use “in an activity” as required by § 465(b)(2). 8. estate of stangeland v. commissioner, t.c. memo. 2010-185 (8/16/10). the deceased taxpayer was an investor in numerous business enterprises, all of which were independently managed. one of the businesses, r&l air, l.l.c., was formed to own and lease two airplanes. the airplanes were managed by a third party under contract. the taxpayer also maintained a consulting business as a sole-proprietor to help manage his businesses. he worked approximately 50 hours per week for the consulting business. the taxpayer periodically leased the r&l airplanes for use in his consulting business and also used the airplanes in the course of charitable activities and in pursuit of private investment activities. the court (judge cohen) first held that the taxpayer’s consulting activities did not constitute a trade or business but described the consulting activities as being engaged to increase the value of the taxpayer’s numerous investments. the court thus disallowed deductions of expenses incurred in the consulting activities. the court also rejected the taxpayer’s argument that the consulting business should be combined with the airplane leasing business as a single activity in which the taxpayer participated for more than 500 hours. to combine the two activities under reg. § 1.469-4(c), both must be found to constitute a trade or business, a test which the consulting activity failed. the court also rejected the taxpayer’s argument that his participation in the two activities qualified under the significant participation test of reg. § 1.469-5t(a)(4), again because the consulting activity failed to qualify as a trade or business. however, for one of the three tax years at issue, the court found that the taxpayer participated in activities of various businesses for more than 500 hours and in the airplane leasing activity for at least 100 hours, and that the losses from the airplane leasing activity were not passive activity losses for that year. 9. homer simpson loses in the tax court. time off from the nuclear power plant is not being a real estate professional. moss v. commissioner, 135 t.c. no. 18 (9/20/10). the taxpayer, who worked full time as a maintenance planner at a nuclear power plant, owned several rental real estate properties. the taxpayer recorded the days, but not 606 florida tax review [vol. 10:9 the time worked in maintenance on the rental properties in a daily calendar. the taxpayer claimed that he worked a total of 645 hours on the rental properties (including travel time) and attempted to add time that he was “oncall” anytime he was not working at the power plant in order to satisfy the minimum 750 hour requirement of § 469(c)(7)(b)(ii) to qualify as a real estate professional. the court (judge wells) held that only time for services actually performed could be counted towards the 750 hour requirement, which did not include time while the taxpayer was on call. however, the court also found that the taxpayer actively participated in the rental real estate activities and was, therefore, entitled to the § 469(i) $25,000 allowance, but subject to being phased out to the extent the taxpayer’s income exceeded $100,000. the court also held that the taxpayer was subject to the § 6662 accuracy related penalty. 10. now here’s really bad grouping. dunn v. commissioner, t.c. memo. 2010-198 (9/13/10). the tax court (judge thornton) held that the taxpayer’s (1) medical practice conducted as an employee, (2) property management business conducted through an s corporation, and (3) airplane leasing conducted through an llc could not be grouped for purposes of applying § 469, because they did not constitute an “appropriate economic unit” within the meaning of reg. § 1.469-4(c)(2). the property management business and the airplane leasing activity were found to be passive activities. accuracy related penalties were imposed because the taxpayer, and not his advisors, made the decision to characterize the activities as passive or active, and the taxpayer acknowledged on brief that he was “highly educated and sophisticated and possesses extensive business experience” and conceded, “the standard of care that must have been exercised by the petitioner is a high one.” • the taxpayer’s tax advisor testified that “the client would tell us whether or not it was passive or nonpassive. … we would have to ask the client. we would have no way of knowing without. … if the client told us it was passive, fine. it was passive. if the client tells usyou know, we don’t know unless the client tells us.” • hum! circular 230 issue? 11. a real estate professional must materially participate in her real estate rental activities. perez v. commissioner, t.c. memo. 2010-232 (10/25/10). section 469(c)(2) provides that rental real estate activities are per se passive activities. however, § 469(c)(7) excludes rental real estate activities of a real estate professional from the per se rule. the taxpayer was a real estate sales person and broker who owned three residential rental properties. the taxpayer stipulated that she did not materially participate in those activities under the rules of temp. reg. § 1.469-5t. the court (judge haines) rejected the taxpayer’s argument that 2011] recent developments in federal income taxation 607 because she was a qualified real estate professional all of her real estate activities were not passive activities. the court pointed out that the taxpayer’s argument ignored the plain language of reg. § 1.469-9(e)(1), which provides that “a rental real estate activity of a qualifying [real estate professional] is a passive activity under section 469 for the taxable year unless the taxpayer materially participates in the activity.” the court also indicated that the taxpayer’s activity as a real estate loan agent and broker was separate from her activity as an owner of residential real estate properties, and the activities may not be aggregated. reg. § 1.469-9(e)(3)(i). the court also sustained § 6662 penalties. iii. investment gain and income a. gains and losses 1. new rules for determining basis in securities. the emergency economic stabilization act of 2008 [division b], act § 403, amends code § 1012 to create new rules for determining the basis of securities acquired after 12/31/10. the fifo or other conventions for determining the basis of securities when sold must be applied on an accountby-account basis. thus, with respect to a taxpayer who holds the same stock in more than one account, determining the basis of sold securities from any account will be determined solely with regard to the basis of securities in that account. in addition, § 1012(d) provides for averaging the basis of stock acquired in a dividend reinvestment plan. stock in a dividend reinvestment plan is treated as held in a separate account for purposes of determining basis. a. no more fooling the irs about basis. the emergency economic stabilization act of 2008 [division b], § 403, added code § 6045(g), which requires brokers to report their customers’ basis in a “covered security” and whether gain or loss is long-term or short-term, in addition to the existing requirement that the broker report gross sales proceeds. in general, the customer’s basis is to be reported on a first-in firstout method, unless an average basis method is permissible. covered securities include securities acquired through an account with the broker or transferred to the broker from another account on or after an applicable date. january 1, 2011, is the applicable date for stocks. january 1, 2012, is the applicable date for stocks under the average basis method. january 1, 2013, or such later date as specified by the irs, is the applicable date for any other security. under § 6045a, a taxpayer transferring securities to a broker after 1/1/11 is required to report information, as required by regulations, necessary to permit the broker to meet its reporting requirements. section 6045b 608 florida tax review [vol. 10:9 requires the issuer of any security to report information describing any organizational action that affects the basis of the security. b. and the irs begins to gear up. reg101896-09, basis reporting by securities brokers and basis determination for stock, 74 f.r. 67010 (12/17/09). these proposed regulations relate to reporting sales of securities by brokers (prop. reg. § 1.6045-1) and determining the basis of securities (prop. reg. § 1.1012-1). the proposed regulations reflect changes in the law made by the energy improvement and extension act of 2008 that require brokers when reporting the sale of securities to the irs to include the customer’s adjusted basis in the sold securities and to classify any gain or loss as long-term or short-term. the proposed regulations under § 1012 alter how taxpayers compute basis when averaging the basis of shares acquired at different prices and expand the ability of taxpayers to compute basis by averaging with respect to ric shares and shares specifically held in a dividend reinvestment plan. brokers must furnish information statements to customers by february 15th. the proposed regulations provide for the implementation of new reporting requirements imposed upon persons that transfer custody of stock and upon issuers of stock regarding organizational actions that affect the basis of the issued stock. other proposed regulations reflect changes in the law that alter how brokers report short sales of securities. c. transitional relief from reporting requirements. notice 2010-67, 2010-43 i.r.b. 529 (10/12/10). this notice provides transitional relief from the information reporting requirements in § 6045a that apply beginning in 2011 to transfers of securities by brokers and other custodians. the notice provides that, solely for transfers of stock in 2011 described in the notice, the irs will not assert penalties for failure to furnish a transfer statement under § 6045a and that the transferred stock may be treated as a noncovered security upon its subsequent sale or transfer. (“a noncovered security is any security that is not a covered security.”) the notice further provides: to enable brokers to meet the requirements of section 6045(g) for securities transferred between accounts, section 6045a provides that, beginning in 2011, a broker and any other person specified in treasury regulations that transfers custody of a covered security to a receiving broker must furnish to the receiving broker a written statement that allows the receiving broker to satisfy the basis reporting requirements of section 6045(g). except as provided by the [irs], the statement must be furnished to the receiving broker within fifteen days after the date of the transfer. a covered security remains a covered security if transferred, 2011] recent developments in federal income taxation 609 but only if the receiving broker receives a transfer statement for the transfer. d. final regulations on basis reporting and basis determination. t.d. 9504, basis reporting by securities brokers and basis determination for stock, 2010-47 i.r.b. 670 (11/22/10). these regulations adopt, with only minor changes, the regulations proposed in december 2009. they permit the use of the average basis method by regulated investment companies and dividend reinvestment plans. brokers must use either the specific identification method or the fifo method for securities sold from any particular account. • the final regulations also permit election of the fido method if the securities in any account consist predominantly of dogs. • to minimize the possibility of identification foot-faults, the creation of different accounts to hold securities acquired at different times is recommended. 2. question: when is the amount for which you could sell something much less than its value for determining a bargain purchase? answer: when it’s a whole life insurance policy sold from a pension plan to the insured plan participant. matthies v. commissioner, 134 t.c. no. 6 (2/22/10). pursuant to a prearranged plan, the taxpayer rolled over approximately $1.3 million from an ira to a profit sharing plan; the profit sharing plan then purchased a life insurance policy on the taxpayer for $1.3 million and sold the policy to the taxpayer for approximately $300,000; and the taxpayer transferred the life insurance policy to a trust for estate planning purposes. at the time of the sale of the policy from the profit sharing plan to the taxpayer, the life insurance policy had an “account value” of approximately $1.3 million, but was subject to a “surrender charge” of approximately $1 million, thereby reducing its cash surrender value to approximately $300,000. the surrender charge would diminish over time and be completely phased out after 20 years. the irs asserted that the taxpayer recognized $1 million of income on the bargain purchase because it was not an arm’s length transaction, and judge thornton agreed with the irs. first, he found that on the facts, the transaction was not arm’s length because the only trustees of the profit sharing plan were the taxpayer and his wife. turning to the valuation issue, judge thornton rejected the taxpayer’s argument that the value of the insurance policy was its cash surrender value, which was equal to the amount the taxpayer paid the profit sharing plan for the policy. he reached the same result as the irs, but via a slightly different road. judge thornton concluded that under §§ 402 and 72(e), the amount of a distribution in the form of a life insurance policy is the cash surrender value determined without any surrender charges, rather than the new surrender 610 florida tax review [vol. 10:9 value. finally, he concluded that the excess of the cash surrender value determined without any surrender charges, minus the amount paid by the taxpayer – approximately $1,000,000 – was gross income under § 61. 3. ex-post recharacterization is not an option for taxpayers. united states v. bergbauer, 602 f.3d 569 (4th cir. 4/16/10), cert. denied, 131 s. ct. 297 (10//10). the fourth circuit affirmed a summary judgment for the government in an erroneous refund suit. the taxpayer exchanged her partnership interest in ernst & young for stock of cap gemini, a corporation acquiring e&y’s consulting business, in a transaction that was not a statutory nonrecognition event; however, the stock was held in escrow to enforce a forfeiture provision if the seller-taxpayer failed to perform certain services as an employee of the acquiring corporation. the taxpayer initially reported that all of the cap gemini shares received vested in the year 2000 (the year of the exchange), but after the stock declined in value took the position that income was realized in 2000 only to the extent of cash received in that year and the remainder of the income was recognized in 2003 (when the stock was worth less than one-fifth of its 2000 value). the court held that if a taxpayer exchanges one property for a different property, the gain realized on the exchange must be recognized in the year the exchange occurs, even though the property received in the exchange is forfeitable if contractual provisions or representations in the contract for exchange are not subsequently satisfied and even though the property received in the exchange is held in escrow to assure enforcement of the forfeitability provisions. furthermore, the court refused to accept the taxpayer’s argument that the transaction could be recast into a form different than that which it had taken. to put it plainly, we have bound taxpayers to “the ‘form’ of their transaction” when they attempt to recharacterize an otherwise valid agreement bargained for in good faith. [citation omitted] we have also refused to entertain arguments “that the ‘substance’ of their transaction triggers different tax consequences.” [citation omitted] this precept not only maintains the vital public policy of enforcing otherwise valid contracts, but also assures the reliability of agreed tax consequences to the public fisc. … there is no “disparity” in allowing “the commissioner alone to pierce formal” agreements as “taxpayers have it within their own control to choose in the first place whatever arrangements they care to make.” [citation omitted] • earlier cases that reached the same result for other taxpayers involved in the same transaction include united states v. fletcher, 562 f.3d 839 (7th cir. 4/10/09); united states v. culp, 99 2011] recent developments in federal income taxation 611 a.f.t.r.2d 2007-618 (m.d. tenn. 12/29/06); and united states v. nackel, 105 a.f.t.r.2d 2010-474 (c.d. cal. 10/20/09). 4. when does a debt instrument that has in effect become a proprietary interest because the creditor is insolvent remain a debt instrument? reg–106750–10, notice of proposed rulemaking and notice of public hearing, modifications of debt instruments, 75 f.r. 31736 (6/4/10). the treasury department has proposed amendments to reg. § 1.1001-3, which deals with when a modification of a debt instrument results in an exchange for purposes of § 1001 (gain or loss realization by creditor) and § 61(a)(12) (realization of cod income by debtor). under reg. § 1.1001-3(e)(5), a modification of a debt instrument that results in an instrument or property right that is not debt for tax purposes is a significant modification. all of the factors relevant to the classification of the modified instrument as debt or equity immediately after an alteration or modification must be analyzed. however, prop. reg. § 1.1001-3(f)(7) would clarify that any deterioration in the financial condition of the issuer between the date the debt instrument was issued and the date it was altered or modified, insofar as it relates to the issuer’s ability to repay the debt instrument, will not be not taken into account in determining whether the instrument has been converted to another type of interest, unless there is a substitution of a new obligor or the addition or deletion of a co-obligor. thus, any decrease in the fair market value of a debt instrument (whether or not publicly traded) is not taken into account to the extent that the decrease in fair market value is attributable to the deterioration in the financial condition of the issuer, rather than to a modification of the terms of the instrument, but only for purposes of determining the nature of the instrument. according to the preamble, “[c]onsistent with this rule in the proposed regulations, if a debt instrument is significantly modified and the issue price of the modified debt instrument is determined under reg. § 1.1273-2(b) or (c) (relating to a fair market value issue price for publicly traded debt), then any increased yield on the modified debt instrument attributable to this issue price generally is not taken into account to determine whether the modified debt instrument is debt or some other property right for federal income tax purposes. however, any portion of the increased yield that is not attributable to deterioration in the financial condition of the issuer, such as a change in market interest rates, is taken into account.” • the provisions of prop. reg. § 1.1001-3(f)(7) will be effective upon finalization, but taxpayers may rely on paragraph (f)(7) of this section for alterations of the terms of a debt instrument occurring before that date. see prop. reg. § 1.1001-3(h)(2). 5. should the name of the promoter of this tax scam been “devious,” instead of “derivium?” calloway v. commissioner, 135 612 florida tax review [vol. 10:9 t.c. no. 3 (7/8/10) (reviewed). in 2001 the taxpayer entered into an agreement with derivium capital llc pursuant to which he transferred 990 shares of ibm common stock to derivium under its 90-percent-stock-loan program. the terms of the agreement characterized the transaction as a loan, with the ibm stock pledged as collateral. (derivium was not registered with the new york stock exchange or the national association of securities dealers/financial industry regulatory authority.) the purported loan was nonrecourse; interest accrued but was not payable until maturity; all dividends were applied against interest due; prepayment during the 3-year term of the purported loan was prohibited. the terms of the agreement allowed derivium to sell the stock and retain the proceeds, which it did immediately upon receipt, receiving $103,918.18. the taxpayer received $93,586.23 from derivium, the amount of the payment being determined, and payment being made, only after derivium had sold the stock. upon maturity of the “loan,” the taxpayer had the option of (1) paying the balance due and having an equivalent amount of ibm stock returned to him, (2) renewing the purported loan for an additional term, or (3) satisfying the “loan” by surrendering any right to receive ibm stock. at maturity in august 2004 the balance due was $124,429.09, which was $40,924.57 more than the then $83,318.40 value of the ibm stock. (derivium had credited against the accrued interest the amount of dividends that would have been received had the stock not been sold, but the taxpayer never received a form-1099-div or included any dividends in income.) the taxpayer elected to satisfy his purported loan by surrendering any right to receive ibm stock. the taxpayer never made any payments toward either principal or interest on the purported loan. citing commissioner v. court holding co., 324 u.s. 331 (1945), and gregory v. helvering, 293 u.s. 465 (1935), for the proposition that substance controls over form, the tax court, in a reviewed opinion by judge ruwe (with no dissents but judges halpern, wherry, and holmes concurring in result only), held that the 2001 transaction between taxpayer and derivium was a sale, not a loan, under the test factors set forth in grodt & mckay realty, inc. v. commissioner, 77 t.c. 1221 (1981). the taxpayer had transferred all the benefits and burdens of ownership of the stock to derivium. legal and equitable title, as well as possession and control of the stock were transferred in exchange for $93,586.23 with no obligation to repay that amount. “at best [the taxpayer] had an option to purchase an equivalent number of ibm shares after 3 years at a price equivalent to $93,586.23 plus ‘interest.’” the transaction was not a true loan because “[f]or a transaction to be a bona fide loan the parties must have actually intended to establish a debtor-creditor relationship at the time the funds were advanced.” there was no such intent. after the 2001 transaction the taxpayer never treated the transaction as a loan; in 2004 he did not report either a sale of the stock or cancellation of debt income, positions which were inconsistent with treating the transaction as loan. because derivium was not 2011] recent developments in federal income taxation 613 acting as a broker, the court also rejected the taxpayer’s argument that the transaction was analogous to the securities lending arrangement in rev. rul. 57-451, 1957-2 c.b. 295, which held that no sale occurred when the owner of stock deposited shares with a broker who could lend the securities until such time as the shareholder received from the broker property other than identical securities. nor was the transaction equivalent to a securities lending arrangement under § 1058, because the agreement did not meet the requirements of that provision, which under samueli v. commissioner, 132 t.c. 37 (2009), requires that the transferor of the stock retain “all of the benefits and burdens of ownership of the transferred securities” and the right to “be able to terminate the loan agreement upon demand.” because the taxpayer could not regain possession of the stock for three years, his opportunity for gain was diminished. • section 6662 accuracy related penalties were sustained. • judge halpern’s concurring opinion emphasized that the grodt & mckay realty, inc. test, while appropriate for determining whether there had been a sale of property that was not fungible, was not useful in the case of fungible property, such as corporate stock. it was enough for him that the taxpayer “gave derivium the right and authority to sell the ibm common stock in question for its own account, which derivium in fact did.” • holmes’s concurring opinion emphasized that the majority’s test for a sale was too broad and could be applied to treat too wide a range of collateralized nonrecourse loan arrangements as sales. he concluded that the majority erred in treating the taxpayer’s transfer of the stock to derivium and derivium’s subsequent sale of the stock as one integrated transaction, because derivium had represented to its customers that it would hold the stock and never told them of the quick sale. instead, he would have treated derivium’s sale of the stock as the event triggering recognition by the taxpayer, under the tufts principle that “when a nonrecourse liability is discharged by sale of collateral, the borrower must recognize income at that point – the amount realized is the amount of nonrecourse liability discharged as a result of the sale,” since reg. § 1.10012(a)(4)(i) provides that “the sale ... of property that secures a nonrecourse liability discharges the transferor from the liability.” he recognized that under his analysis, “the tax consequences to calloway would be remarkably similar to those flowing from the result reached by the majority.” • the tax court majority opinion noted in a footnote that other cases involving derivium transactions are pending in the tax court. from 1998 to 2002 derivium engaged in approximately 1,700 similar transactions involving approximately $1 billion. the government 614 florida tax review [vol. 10:9 estimated the total tax loss associated with derivium’s scheme to be approximately $235 million. • nagy v. united states, 104 a.f.t.r.2d 2009-7789 (d. s.c. 2009), and united states v. cathcart, 104 a.f.t.r.2d 2009-6625 (n.d. calif. 2009) held, in § 6700 penalty cases, that the 90-percent stockloan-program transactions offered by derivium were sales of securities, not bona fide loans. a. district court had enjoined derivium capital usa from promoting its 90 percent loan program. united states v. cathcart, 105 a.f.t.r.2d 2010-1293 (n.d. cal. 3/5/10). b. does this case make monty python “substantial authority”? shao v. commissioner, t.c. memo. 2010-189 (8/26/10). as in calloway v. commissioner, 135 t.c. no. 3 (7/8/10), the taxpayer in this case engaged in a transaction with derivium capital under its “90-percent-stock-loan program.” in this case, however, the taxpayer conceded that she had sold her stock and the only issue was whether the § 6662 accuracy related penalty the irs asserted would be upheld. the taxpayer asserted a reasonable cause and good faith defense to the penalty, and the tax court (judge holmes) agreed with the taxpayer. the court reasoned as follows. in shao’s case we don’t find the circumstances that led the court to penalize calloway – there is no evidence of a winkwink-nudge-nudge-say-no-more arrangement with derivium. see monty python’s flying circus: how to recognise different types of trees from quite a long way away (bbc1 television broadcast oct. 19, 1969). shao had legitimate, nontax motivations for wanting to structure her deal as a loan instead of a sale-she wanted to reduce risk and use some of the stocks’ value without selling her nest egg. her naivete, but not (we expressly find) her negligence, is especially prominent in her renewal of the loan at a steep price after three years. unlike calloway, shao treated her transaction like a loan throughout its existence, proving her good faith. 6. when all is said and done, the sum of the parts of the deal was really a current sale of stock. anschutz co. v. commissioner, 135 t.c. no. 5 (7/22/10). an s corporation, through a q-sub (tac) entered into transactions with donaldson, lufkin & jenrette securities (dlj) involving appreciated stock that it owned. the agreements were memorialized by a master stock purchase agreement (mspa) that included “prepaid variable forward contracts” (pvfcs) and share-lending 2011] recent developments in federal income taxation 615 agreements (slas) with respect to the shares subject to the pvfcs. the pvfcs required dlj to make an upfront payment to tac in exchange for a promise by tac to deliver a variable number of shares to dlj in ten years. the amount of the payment was 75 percent of the fair market value of the shares subject to the pvfcs. if the stock subject to the pvfcs appreciated over the term of the contract, tac was entitled to retain 50 percent of the appreciation, and the remainder accrued to dlj. tac pledged the shares of stock at issue in the pvfcs as collateral for the upfront payment and to guarantee tac’s performance under the pvfc. the pledged shares were delivered to a trustee. before each stock transaction dlj executed short sales of that stock in the open market. after tac lent shares to dlj pursuant to the slas, dlj used the shares to close out the short sales. tac received upfront payments under the pvfcs totaling $350,968,652 and $23,398,050 in prepaid lending fees under the slas. • the taxpayer claimed that tac executed two separate transactions— pvfcs and slas — and neither constituted a current sale for tax purposes, relying, in part, on § 1058. the tax court (judge goeke) agreed with the irs that the shares subject to the pvfcs and lent pursuant to the slas were sold for income tax purposes. the transaction consisted of two integrated legs, one of which called for share lending, but the two legs were clearly related and interdependent. analyzing the mspa as a whole, in exchange for valuable consideration tac transferred to dlj the benefits and burdens of ownership, including (1) legal title to the shares; (2) all risk of loss; (3) a major portion of the opportunity for gain; (4) the right to vote the stock; and (5) possession of the stock. although the slas provided that tac could terminate share loans and recall the shares, in reality any share recalls were really tac borrowing shares from dlj. because dlj closed out its original short sales with the lent shares, the shares later transferred to tac were in substance dlj borrowing shares from third parties and delivering them to tac. gain was recognized with respect to the upfront cash payments received in the transactions. the taxpayer’s reliance on § 1058 was rejected because it relied on the argument that the pvfcs were separate from the slas. the mspa violated the requirement of § 1058(b)(3) that the agreement not limit the lender’s risk of loss or opportunity for gain, because the agreements eliminated tac’s risk of loss with regard to the lent shares. • on the bright side ☺, judge goeke rejected the irs’s alternative argument that the transactions were also either a constructive short sale by tac under § 1259(c)(1)(a) or a constructive forward contract sale under§ 1259(c)(1)(c). tac did not enter into any short sale because dlj was acting as a principal and not as an agent in making the short sales. the transactions were not constructive forward contract sales because they were not forward contracts as defined in § 1259(d)(1) in that they did not provide for delivery of a substantially fixed amount of property for a substantially fixed price. 616 florida tax review [vol. 10:9 • the transactions in both calloway and anschutz co. occurred before the issuance of rev. rul. 2003-7, 2003-1 c.b. 363, in january 2003. that ruling offered a roadmap to avoidance of gain recognition although a collar around unrealized appreciation was achieved. 7. the small business act helps small business stock. gain realized on a sale or exchange of qualified small business stock under § 1202, which is acquired after the date of enactment of the 2010 small business jobs act (9/27/10) and before 1/1/11, is subject to 100 percent exclusion from gross income. the act also changed the period for exclusion of 75 percent of such gain from 2/17/09 to the date of enactment (previously the 75 percent rate would have applied up to 1/1/11). gain attributable to qualified small business stock acquired between 9/27/10 and 1/1/11 is not treated as an amt preference item. the exclusion is applicable to noncorporate shareholders who acquire stock at original issue and hold the stock for a minimum of five years. under the former 50 percent and 75 percent exclusions, included gain was subject to tax at the 28 percent capital gains rate. the amount of excluded gain attributable to any one corporation is limited to the greater of ten times the taxpayer’s basis in a corporation’s stock sold during the taxable year or $10 million reduced by gain attributable to the corporation stock excluded in prior years. qualified small business stock is stock issued by a c corporation engaged in the active conduct of a trade or business with gross assets (cash plus adjusted basis of assets) not in excess of $50 million. a. so you put off investing in that qualified business before 2011, fear not ye procrastinators. the compromise tax relief act of 2010, § 760, extends the 100% exclusion for gain on qualified small business stock under code § 1202 to stock acquired before 1/1/12. 8. rate extensions. the compromise tax relief act of 2010, § 102, extends the 15% rate under code § 1(h) on adjusted net capital gain for regular and alternative minimum tax purposes through 2012. for persons in the 25% or lower brackets, the tax rate on adjusted net capital gain remains at zero. unrecaptured § 1250 gain will be taxed at a 25% rate, and the rate applicable to collectables and § 1202 gain will remain at 28% through 2012. 9. the return of tax-free basis step-up (or down) at death — with a very interesting twist for george steinbrenner and others who followed the same tax planning technique. the compromise tax act, § 301(a), reinstated the § 1014 fair-market-value-at-death basis rule for taxable years after 2010. for estates of decedents dying in 2010, act § 301(c) provides a special rule that allows the executor to elect between (1) 2011] recent developments in federal income taxation 617 applying the rules enacted in 2001, i.e., no estate tax for 2010 coupled with the § 1022 carryover basis rules, or (2) paying an estate tax (applying the rates and exemptions provided in act § 302 for years after 2009) and applying the § 1014 fair-market-value-at-death basis rules. b. interest, dividends, and other current income 1. shelve the presentations updating the treatment of redemptions – dividends are taxed the same. the compromise tax relief act of 2010, § 101, extends the 15% rate on qualified dividend income, for both regular and alternative minimum tax purposes, through 2012. taxpayers in the 10% and 15% brackets pay a zero rate on dividend income through 2012. a. code § 163(d)(4)(b), which allows an election to treat qualified dividends as investment income but removes the dividends from the benefit of lower rates, is also extended by the compromise tax relief act of 2010, § 102, through the end of 2012. b. the compromise tax relief act of 2010, § 102, also extends the rule of code § 1(h)(11)(d)(ii) that loss on the sale or exchange of stock on which the taxpayer received an extraordinary dividend (generally more than 10% of basis, or 5% in the case of preferred stock) is treated as long-term capital loss. c. profit-seeking individual deductions 1. the irs still can’t figure out knight. notice 201032, 2010-16 i.r.b. 594 (4/1/10). this notice provides that pending further guidance, taxpayers are not required to determine the portion of a “bundled fiduciary fee” that is subject to the § 67 two-percent of agi floor on miscellaneous itemized deductions for any taxable year beginning before 1/1/10. taxpayers may deduct the full amount of the bundled fiduciary fee; payments by the fiduciary to third parties for expenses subject to the twopercent floor must be treated separately. it modifies and supersedes notice 2008-116, 2008-11 i.r.b. 593, which provided similar relief for years beginning before 1/1/09. d. section 121 1. “congress intended the terms ‘property’ and ‘principal residence’ to mean a house or other dwelling unit in which the taxpayer actually resided.” gates v. commissioner, 135 t.c. no. 1 (7/1/10) (reviewed, 8-5). the married taxpayers had owned and occupied a house as a principal residence for at least two years. they wanted to enlarge 618 florida tax review [vol. 10:9 and remodel the house but were advised by an architect that more stringent building and permit restrictions had been enacted since the house was built. in 1999, rather than remodel the house, they completely demolished it and constructed a new house on the property. the taxpayers never occupied the new house, and in 2000 they sold it for $1,100,000, realizing a gain of $591,406. they claimed that $500,000 of the gain was excludable under § 121, but the irs took the position that they did not qualify for the § 121 exclusion because they had never occupied the new structure and it thus never was their “principal residence,” even though it occupied land on which had been located their former principal residence. the irs’s argument interpreted “the term ‘property’ [in § 121(a)] to mean, or at least include, a dwelling that was owned and occupied by the taxpayer as his ‘principal residence’ for at least 2 of the 5 years immediately preceding the sale.” the taxpayers argued that the term “property” in § 121(a) includes not only the dwelling but also the land on which the dwelling is situated, and that the requirements of § 121(a) are satisfied if the taxpayer lived in any dwelling on the property for the required 2-year period, even if that dwelling is not the dwelling that was sold. under this theory, because they used the original house and the land on which it was situated as their principal residence for the required term, the land and building that were sold qualified as their principal residence. finding that the statute did not define the terms “property” and “principal residence,” the tax court in a divided (8-5) opinion by judge marvel looked to dictionaries and the legislative history for guidance. after examining the background of § 121, including its statutory predecessors, former § 1034 and its predecessor in the 1939 code, the majority held that: congress intended the term “principal residence” to mean the primary dwelling or house that a taxpayer occupied as his principal residence. ... although a principal residence may include land surrounding the dwelling, the legislative history supports a conclusion that congress intended the section 121 exclusion to apply only if the dwelling the taxpayer sells was actually used as his principal residence for the period required by section 121(a). • the majority found further support for its conclusion in the case law under former § 1034. • in a footnote the court’s opinion noted that reg. § 1.1211(b)(3), as currently in effect allows gain from the sale of land alone to qualify under § 121 if the taxpayer also sells “a ‘dwelling unit’ that meets the requirements under sec. 121 within 2 years before or after the sale of the land.” • a concurring opinion by judge cohen (in which 6 other members of the majority joined) noted that the taxpayers did not argue in the alternative for a partial exclusion of gain 2011] recent developments in federal income taxation 619 attributable to the sale of the land and did not introduce any evidence that would have permitted the court to allocate gain between the new house and the land. • the dissent by judge halpern would have allowed the exclusion, treating the demolition and reconstruction no differently from a renovation. it expressed concern that distinguishing between a “remodeling,” which presumably would not start the 2-year clock running anew and a “rebuilding,” which under the majority opinion does start the 2-year clock running anew is a difficult line to draw: “is there some level of remodeling that does (1) terminate the use of the home as the taxpayer’s principal residence, and (2) set the temporal clock to zero?” e. section 1031 1. don quixote tilted at the windmill and deflected only the penalty, not the deficiency. ocmulgee fields, inc. v. commissioner, 132 t.c. 105 (3/31/09). this opinion by judge halpern applied § 1031(f) to deny tax-free like-kind exchange treatment in the following situation: (1) the taxpayer transferred appreciated real property (wesleyan station) to a qualified intermediary; (2) an unrelated third party purchased the wesleyan station property from the qualified intermediary for cash; (3) a partnership related to the taxpayer sold like-kind property (barnes & noble corner) to the qualified intermediary for cash; and (4) the qualified intermediary transferred the like-kind barnes & noble corner property to the taxpayer. but for the application of § 1031(f)(4), the exchange with the qualified intermediary would have qualified for § 1031 nonrecognition. the taxpayer, who wanted the replacement property to be in the same general geographic area, i.e., middle georgia, as the surrendered property, argued that the reason for the acquisition of replacement property from a related person was that it was unable to locate a suitable replacement property within the time limits imposed on deferred like-kind exchanges by § 1031(a)(3) and reg. § 1.1031(k)-1(b). a careful reading of the facts, however, reveals that the taxpayer entered into the agreement to acquire the replacement property only five days after the relinquished property was sold and actually closed the purchase before the 45-day identification period had even lapsed. as argued by the commissioner, judge halpern held that § 1031(f)(4) required recognition because the taxpayer had “structured” the transaction “to avoid the purposes” of the rule of § 1031(f) denying non recognition for an exchange to a related person if the transferee sells the property within two years. based on the legislative history, he concluded that the “basis shifting” that resulted from the transaction “suppl[ied] the principal purpose of tax avoidance.” the basis shift effected an approximately $1.8 million reduction in taxable gain, because if the related party had acquired wesleyan station from the taxpayer in a like-kind 620 florida tax review [vol. 10:9 exchange for barnes & noble corner, the related party’s substituted basis in wesleyan station, which in the taxpayer’s hands was only around $716,164, would have been $2,554,901 (equal to the related party’s basis in barnes & noble corner). in addition, if § 1031 applied, the gain on the sale of wesleyan station would have been taxed at only 15 percent, the applicable rate for capital gains taxed to the partners of the related partnership, instead of the 34 percent rate that would have applied had the taxpayer sold the property. judge halpern further found the case to be substantially similar to teruya bros., ltd. v. commissioner, 124 t.c. 45 (2005), in which the taxpayer transferred properties to a qualified intermediary, who sold them to unrelated third parties and used the proceeds to purchase like-kind replacement property from a related party. in teruya bros., judge thornton held that the transactions were economically equivalent to direct exchanges between the taxpayer and related party, followed by the related party’s sale of the properties to unrelated third parties, and that they were structured to avoid the purposes of § 1031(f). the taxpayer argued that unlike the taxpayer in teruya bros., it did not have a prearranged plan to use property from a related person to complete a like-kind exchange, but judge halpern found that the presence of the prearranged plan in teruya bros. was not a critical element of the holding in that case. nevertheless, the taxpayer avoided the § 6662 negligence penalty because (1) the return reporting the transaction as a § 1031 like-kind exchange was prepared by an accountant with extensive experience in representing real estate developers, (2) the accountant was aware of all relevant facts, and (3) when the taxpayer filed its return, the tax court had not yet decided teruya bros., and while rev. rul. 2002-83, 20022 c.b. 927 (presaging the result in teruya bros.) had been issued, judge halpern did “not think that the ruling left the result free from doubt.” a. “congress enacted § 1031(f) because of its disapproval of taxpayers’ use of § 1031 to cash-in on a low-basis investment property, but to pay taxes as if it were cashing in on the high basis property; here, ocmulgee fields and treaty fields cashed in on the low-basis property, wesleyan station, but paid taxes only on the gains from treaty fields’ sale of the high-basis property, the barnes & noble corner.” ocmulgee fields, inc. v. commissioner, 613 f.3d 1360 (11th cir. 8/13/10). in an opinion by judge ebel, the eleventh circuit affirmed the tax court’s decision. the court characterized the taxpayer’s argument as being based on the proposition that neither it nor the related party “had any intent to circumvent the purposes of § 1031(f),” which it described as a challenge to the tax court’s fact finding that the taxpayer “engaged in a series of transactions structured to avoid the related party rules, cash in on its investment in wesleyan station, and avoid taxation,” and affirmed because the tax court’s finding was not clearly erroneous. the 2011] recent developments in federal income taxation 621 court found evidence of the taxpayer’s intent in the use of a qualified intermediary in a multi-cornered exchange, stating that, [w]e can look to the unneeded complexity in the series of transactions to help us in inferring ocmulgee fields’ intent. ... ocmulgee fields could have achieved the same result by simply engaging in a direct exchange of property with treaty fields, and treaty fields could have then sold wesleyan station ... . if ocmulgee fields had taken this approach, however, § 1031(f)(1) would have automatically disallowed nonrecognition treatment for the exchange because treaty fields disposed of wesleyan station within two years of the exchange. • the court rejected the taxpayer’s argument that the related party exchange was “merely a fall-back position,” because that argument was inconsistent with the fact that the taxpayer had examined only a small number of alternative properties and entered into the transaction after only six days. 2. i woulda completed my like-kind exchange, but the qi went belly-up. can you help me mr. commish? no; unfortunately, there is no relief which would allow the taxpayer to complete the § 1031 exchange. rev. proc. 2010-14, 2010-12 i.r.b. 456 (3/5/10). this revenue procedure provides a safe harbor method for reporting gain or loss by taxpayers who are unable to complete deferred like-kind exchanges solely because the qi has defaulted on its obligation to acquire and transfer replacement property as a result of the qi’s bankruptcy or receivership under federal or state law, provided three additional conditions have been met. the taxpayer must have: (1) transferred the relinquished property to a qi in accordance with reg. § 1.1031(k)-1(g)(4); (2) properly identified replacement property within the identification period (unless the qi’s default occurs during that period); and (3) not actually or constructively receive any proceeds from the disposition of the relinquished property (excluding the qi’s assumption of debts on the relinquished property) before the qi entered bankruptcy or receivership. under the safe-harbor, the taxpayer may report gain under a “safe harbor gross profit ratio method” provided in the revenue procedure, which is essentially the § 453 installment method. however, unlike normal § 453 installment reporting, § 1245 and § 1250 recapture gain may be reported under the “safe harbor gross profit ratio method;” however, depreciation recapture income is recognized before any § 1231 or capital gain is recognized. interest must be imputed under § 483 or § 1274, as appropriate. for this purpose, the taxpayer is treated as selling the relinquished property on the date of the confirmation of the bankruptcy plan or other court order that resolves the taxpayer’s claim against the qi. thus, if the only payment in full satisfaction of the taxpayer’s 622 florida tax review [vol. 10:9 claim is received by the taxpayer on or before the date that is six months after the safe harbor sale date, then no interest is imputed. if a loss is realized, the timing of a loss deduction is governed by normal § 165 principles. • we think this could result in open transaction treatment for loss recognition. 3. the april’s fool joke is on the taxpayer. goolsby v. commissioner, t.c. memo. 2010-64 (4/1/10). a residence acquired in an exchange was not property held for investment or for use in a trade or business and the exchange of the surrendered property did not qualify for nonrecognition under § 1031, even though the taxpayer made minimal efforts to rent out the property before taking up residence. the taxpayer moved into the property within months after acquiring it, and the residence was more than temporary. the contract for purchase was contingent upon the sale of the taxpayer’s prior principal residence. the taxpayer’s interaction with the qualified intermediary evidenced a lack of investment intent at the time of the exchange. before purchasing the property, the taxpayer sought advice regarding whether he could move into the property if renters could not be found, evidencing contemplation of use of the property as a personal residence. in addition, the taxpayer began preparations to improve the property as a personal residence within weeks of purchasing the property. f. section 1033 there were no significant developments regarding this topic during 2010. g. section 1035 there were no significant developments regarding this topic during 2010. h. miscellaneous 1. sorting out derivatives in this “major/minor” transaction. the treatment turns on the nuances of the definitions. summitt v. commissioner, 134 t.c. 248 (5/20/10). an s corporation of which the taxpayer was a shareholder acquired reciprocal put and call foreign currency options that exactly offset each other. subsequently, the corporation assigned a depreciated major currency (euro) call option and an appreciated minor currency (danish krone) call option to a charity pursuant to an agreement in which the charity was substituted with respect to the obligations under the call options. the taxpayer took the position that the depreciated major currency call option was a “foreign currency contract” 2011] recent developments in federal income taxation 623 subject to the mark-to-market rules of § 1256, which were triggered by § 1256(c) upon the disposition, but that the appreciated minor currency call option was not so treated. the taxpayer argued that there are no economically significant differences among foreign currency forwards, futures, and options. the tax court (judge haines) held that foreign currency options are not “foreign currency contracts” as defined in § 1256(b)(2) and (g)(2) and the mark-to-market rules of § 1256 thus do not apply. the only options subject to § 1256 are listed nonequity options, dealer equity options, and options on dealer securities futures, all of which are traded on a qualified board or exchange. an interbank market is not a qualified board or exchange, and because the options in question were purchased in an interbank market, they could not be “nonequity options” under § 1256. iv. compensation issues a. fringe benefits 1. involuntarily terminated employees will receive assistance with their cobra premiums for a while. the 2009 arra § 3001 (in title iii – premium assistance for cobra benefits) provided premium assistance for cobra benefits to the extent of 65 percent of the otherwise applicable cobra premium. eligibility for this benefit is more restrictive than eligibility for cobra, with elimination of the premium subsidy for high-income individuals as well as for those eligible for another form of medical coverage, e.g., retiree medical. the dol has provided a model notice to individuals pursuant to arra § 3001. • the premium subsidy is only provided with respect to involuntary terminations that occur on or after 9/1/08 and before 1/1/10. a. and for a while longer. h.r. 3326, § 1010, extended the cobra subsidy period from nine months to 15 months and extends the subsidy to terminations occurring in the first two months of 2010. notification requirements are provided for individuals who may have previously lost assistance but became eligible for the extended subsidy period. b. another cobra subsidy extension is provided, but no more extensions will be needed as president obama focuses with “laser-like intensity” on the jobs issue. the temporary extension act of 2010 extended the cobra subsidy for another month to cover terminations that took place from 9/1/08 through 3/31/10. 624 florida tax review [vol. 10:9 c. wrong again, moosebreath. the continuing extension act of 2010 extended the cobra subsidy to 5/31/10. d. a further extension of the cobra subsidy was included in the pending small business jobs tax relief bill of 2010, h.r. 5486, which passed the house on 6/15/10. this provision was not enacted. 2. new tax code rules permeate every nook and cranny of health care reform: american health benefit exchanges can’t work as substitutes for employer-provided health insurance without special tax rules. pursuant to § 10108 of the 2010 health care act, employers offering minimum essential health care coverage through an eligible employer-sponsored plan and paying a portion of that coverage must provide “qualified employees” with a voucher whose value can be applied to purchase a health plan through an american health benefit exchange established under § 1311 of the act. (an american health benefits exchange must be established by each state (the cost of the establishment of which is subsidized by the u.s. treasury) to facilitate the purchase of qualified health insurance plans.) “qualified employees” are employees (1) whose (a) required contribution for employer sponsored minimum essential coverage exceeds 8 percent, but does not exceed 9.5 percent of the employee’s household income for the taxable year, and (b) total household income does not exceed 400 percent of the poverty line for the family, and (2) who do not participate in the employer’s health plan. the value of a voucher equals the employer’s contribution to the employer’s health plan. vouchers can be used to purchase a qualified health plan in the exchange. if the value of the voucher exceeds the premium, the employee receives cash for the excess value. under new § 139d, added to the code by the 2010 health care act, the value of the voucher is not includable in gross income to the extent it is used for the purchase of a health plan. but any rebate received by the employee is includable in the employee’s gross income. if an individual receives a voucher, the individual is disqualified from receiving any tax credit or cost sharing credit for the purchase of a plan in the exchange. new § 162(g) allows the employer a deduction for the amount of the voucher. this provision is effective after 12/31/13. 3. a little added tax benefit to encourage the kids not to cut the apron strings. the health care and education reconciliation act of 2010 amended § 105(b) of the code to extend the exclusion for reimbursement of medical care expenses under an employer-provided accident or health plan to any child of an employee who has not attained age 27 by the close of the taxable year, without regard to whether the child is the taxpayer’s dependent. a similar amendment to § 162(l) allows self-employed taxpayers a deduction for any such children. similar amendments to §§ 401 2011] recent developments in federal income taxation 625 and 501 apply to vebas and qualified plans providing retiree health benefits. the new rules are effective as of the date of enactment. a. with a little leeway for the year the kid turns 26. notice 2010-38, 2010-20 i.r.b. 682 (4/27/10). this notice provides guidance on the exclusion from employees’ gross income under §§ 105 and 106 for employer-provided accident and health plan coverage for employees’ children under age 27, on the employment tax treatment of these benefits, and on the parallel amendments to § 401(h) for retiree health accounts in pension plans, § 501(c)(9) for vebas, and the deduction under § 162(1) for self-employed individuals. the value of any employer-provided health coverage for an employee’s child for the entire taxable year the child turns 26 may be excluded under § 105 if the coverage continues until the end of that taxable year. for example, if a child turns 26 in march, but stays on the plan past december 31st (the end of most individual’s taxable year), the health benefits up to december 31st are a tax-free fringe benefit. b. health insurance that covers dependent children is no longer a tax-free fringe benefit unless all of the employee’s kids under age 27 are covered. t.d. 9482, interim final rules for group health plans and health insurance issuers relating to dependent coverage of children to age 26 under the patient protection and affordable care act, 75 f.r. 27122 (5/13/10). the affordable care act amended the public health service act (phs act) to add § 2714, which requires group health plans and health insurance issuers that provide dependent coverage of children to continue to make such coverage available for an adult child until age 26. this requirement is incorporated by § 9815 of the code. these interim final regulations, reg. § 54.9815-2714t, provide that for a health insurance (or self-insured) plan that makes available dependent coverage of children to qualify under § 105, the plan may not deny or impose special requirements for coverage of either minor children or adult children under age 26. with respect to a child who has not attained age 26, a plan or issuer may not define dependent for purposes of eligibility for dependent coverage of children other than in terms of a relationship between a child and the participant. thus, for example, a plan or issuer may not deny or restrict coverage for a child who has not attained age 26 based on the presence or absence of the child’s financial dependency (upon the participant or any other person), residency with the participant or with any other person, student status, employment, or any combination of those factors. nothing in the regulations requires an employer’s plan to cover dependents as a condition for eligibility to be a tax-free fringe benefit. the regulation applies for plan years beginning on or after 9/23/10, and the regulation expires “on or before” 5/13/13. transition rules are provided. 626 florida tax review [vol. 10:9 4. how about a little consistency in tax-free drug use? the 2010 health care act added § 106(f), dealing with employer sponsored health flexible spending arrangements and health reimbursement arrangements, and amended § 223(d)(2), dealing with hsas (for individuals with high deductible health plans, whether through an employer or individually) and § 220(d)(2), dealing with individual archer msas, to disallow reimbursement under any such plan for the cost of overthe-counter medicines unless the medicine is prescribed by a physician. thus, reimbursement is allowed only if the medicine or drug is a prescribed drug, without regard to whether such drug is available without a prescription, or is insulin, which is the rule for deductibility of medicine as a medical expense under § 213. the new provisions are effective after 12/31/10. a. and the irs takes steps to make it more difficult to buy beer and cigs using health fsa and hra debit cards. notice 2010-59, 2010-39 i.r.b. 396 (9/3/10). current debit card systems are not capable of substantiating compliance with § 106(f) with respect to overthe-counter medicines or drugs because the systems are incapable of recognizing and substantiating that the medicines or drugs were prescribed. for expenses incurred on and after january 1, 2011, health fsa and hra debit cards may not be used to purchase over-the-counter medicines or drugs. nevertheless to facilitate the significant changes to existing systems necessary to reflect the statutory change, the irs will not challenge the use of health fsa and hra debit cards for expenses incurred through january 15, 2011 if the use of the debit cards complies with prior guidance. however, on and after january 16, 2011, over-the-counter medicine or drug purchases at all providers and merchants (whether or not they have an inventory information approval system (iias)) must be substantiated before reimbursement may be made. substantiation is accomplished by submitting the prescription (or a copy of the prescription or other documentation that a prescription has been issued) for the over-the-counter medicine or drug, and other information from an independent third party that satisfies the requirements under prop. reg. § 1.125-6(b)(3)(i). • sections 106(f), 220(d)(2) and § 223(d)(2)(a) do not apply to items that are not medicines or drugs, including equipment such as crutches, supplies such as bandages, and diagnostic devices such as blood sugar test kits; such items may qualify as medical care if they otherwise meet the definition of medical care in § 213(d)(1). b. notice 2010-59, 2010-39 i.r.b. 396 (9/3/10). to reflect the limitations in § 106(f), the irs has obsoleted rev. rul. 2003-102, 2003-2 c.b. 559, which had held that reimbursements by the employer of amounts expended for medicines or drugs available without a 2011] recent developments in federal income taxation 627 prescription are excludable from gross income under § 105(b). effective after 1/15/11. c. notice 2011-5, 2011-3 i.r.b. 314 (12/23/10), modifying notice 2010-59, 2010-39 i.r.b. 396. after 1/15/11, health fsa and hra debit cards may continue to be used to purchase overthe-counter medicines or drugs if a prescription is presented to the pharmacist and an rx number is assigned and retained in a manner that meets irs recordkeeping requirements. 5. no more deduction for spending tax-free government subsidies on drugs for retirees. however, companies that made required balance sheet adjustments became subject to congressional hazing because they made obama look bad. section 139a excludes from gross income federal subsidy payments, made pursuant to 42 usc § 1395w-132, to a sponsor of a qualified retiree prescription drug plan. the 2010 health care act amended § 139a to provide that for taxable years beginning after 12/31/12, the amount of any deduction allowable for retiree prescription drug expenses is reduced by the amount of the excludable subsidy payments received. 6. enlisting cafeteria plans in health insurance reform. a. congress forces employees to pay more of the health care costs with after-tax dollars to fight rising health care costs. the 2010 health care act amended § 125 by adding new § 125(i) (and renumbering former §§ 125(i) and (j) as §§ 125(j) and (k)) to limit allowable salary reduction contributions to a health flexible spending arrangement under a cafeteria plan to $2,500. the 2010 reconciliation act extended the effective date until years after 12/31/12. the $2,500 limitation is indexed for inflation after 2013. a plan that does not include the $2,500 ceiling does not qualify as a cafeteria plan under § 125. b. employers can’t easily duck the responsibility to pay a healthy chunk of health insurance premiums by putting the whole kit and caboodle into a cafeteria plan. section 125(f )(3), added by the 2010 health care act, restricts the ability of employers to provide reimbursement, or direct payment, under a cafeteria plan for the premiums for coverage under any qualified health plan offered through an american health benefits exchange. such a benefit qualifies only if the employer is a “qualified employer” as defined in § 1312(f)(2) of the act. a “qualified employer” is a small employer that elects to make all its full-time employees eligible for one or more qualified plans offered in the small group 628 florida tax review [vol. 10:9 market through an exchange. for this purpose, a “small employer” (defined in § 1304(b)(2) of the act) is an employer who employed an average of not more than 100 employees on business days during the preceding calendar year and who employs at least 1 employee on the first day of the plan year. unless it qualifies under § 125(f)(3), reimbursement (or direct payment) for the premiums for coverage under any qualified health plan offered through an exchange is not a qualified benefit under a cafeteria plan. thus, any employer that is not a qualified employer cannot offer to reimburse an employee for the premium for a qualified plan that the employee purchases through the individual market in an exchange as a health insurance coverage option under its cafeteria plan without disqualifying the plan. this provision applies to taxable years beginning after 12/31/13. c. to us, the new “simple cafeteria plan” rules appear to be just as complex as the old, still generally applicable cafeteria plan rules; others who actually represent small business clients think they are helpful. the 2010 health care act amended § 125 by adding new § 125(j) (and renumbering former §§ 125(j) and (k) as §§ 125(k) and (l)) to provide for “simple cafeteria plans” for “eligible small employers,” to which the otherwise generally applicable nondiscrimination requirements, for both the cafeteria plan itself and benefits under the plan (e.g., group term life insurance, self-insured medical expense reimbursement plan, and dependent care assistance program), do not apply. under the safe harbor, a cafeteria plan and the specified qualified benefits are treated as meeting the nondiscrimination rules if the cafeteria plan satisfies special (1) minimum eligibility and participation requirements and (2) minimum employer contribution requirements. the eligibility requirement is met only if (1) all employees (other than excludable employees) are eligible to participate, and (2) each eligible employee may elect any benefit available under the plan under terms and conditions applicable to all participants. excludable employees include employees who (1) have not attained the age of 21 before the close of a plan year, (2) have fewer than 1,000 hours of service for the preceding plan year, (3) have not completed one year of service with the employer as of any day during the plan year, or (4) are covered under a collective bargaining agreement if there is evidence that the benefits covered under the cafeteria plan were the subject of good faith bargaining. shorter service and younger age requirements can apply only if the shorter service or younger age applies to all employees. the minimum contribution requirement requires the employer to make a contribution for each nonhighly compensated employee (employee who is not a highly compensated employee (as defined in § 414(q)) or a key employee (as defined in § 416(i)) in addition to any salary reduction contributions made by the employee. the minimum contribution may be either a matching contribution or a “nonelective contribution,” but the same method must be used for calculating 2011] recent developments in federal income taxation 629 the minimum contribution for all nonhighly compensated employees. the minimum matching contribution is the lesser of (1) 100 percent of the salary reduction contribution made by the employee for the year or (2) six percent of the employee’s compensation for the year. matching contributions in excess of the minimum may be made only if matching contributions with respect to any highly compensated employee or key employee are not at a higher percentage than the matching contributions for any nonhighly compensated employee. under the nonelective contribution method the employer must contribute an amount equal to a uniform percentage (not less than two percent) of each eligible employee’s compensation for the year, whether or not the employee makes any salary reduction contribution. generally speaking, an eligible small employer is an employer who employed an average of 100 or fewer employees on business days during either of the two preceding years. if an employer was an eligible employer and maintained a simple cafeteria plan, but subsequently employs more than 100 employees, it remains an eligible small employer until the year after which it employs an average of 200 or more employees during the year. there are aggregation rules for controlled groups and special rules treating leased employees as employees. • the devil might be in the details that we have omitted in the name of quasi-brevity. 7. going green is hard to do. notice 2010-94, 201052 i.r.b. 927 (12/15/10). the irs has delayed to 1/1/12 the effective date of revenue ruling 2006-57, which provides guidance to employers regarding the use of smartcards, debit or credit cards, or other electronic media to provide qualified transportation fringes under §§ 132(a)(5) and 132(f). b. qualified deferred compensation plans 1. sacked from his job and socked with a premature withdrawal penalty. owusu v. commissioner, t.c. memo. 2010-186 (8/23/10). the taxpayer borrowed several thousand dollars from his qualified defined contribution plan, with repayment to be made through payroll withholding. as originally structured the loan qualified under reg. § 1.72(p)-1 and was not treated as a withdrawal. the loan was evidenced by a legally enforceable agreement; the amount did not exceed the permissible amount; the loan was to be repaid within 5 years and the loan had substantially level amortization over its term, with payments not less frequently than quarterly. when the taxpayer was suspended by his employer without pay, loan payment stopped. pursuant to the regulations, which provide that a deemed distribution will occur at the first time those requirements are not satisfied, either in form or in operation, cessation of loan repayment resulted in the entire outstanding loan balance being treated 630 florida tax review [vol. 10:9 as a distribution. because the taxpayer had not attained age 55, the 10 percent § 72(t) penalty applied. c. nonqualified deferred compensation, section 83, and stock options 1. section 409a added a new layer of rules for nonqualified deferred compensation. section 885 of the american jobs creation act of 2004 added new § 409a, which modifies the taxation of nonqualified deferred compensation plans for amounts deferred after 2004. section 409a has changed the tax law governing nonqualified deferred compensation by making it more difficult to avoid current inclusion in gross income of unfunded deferred compensation. nevertheless, § 409a has not completely supplanted prior law. the fundamental principles of prior law continue in force but have been modified in certain respects. a. notice 2008-113, 2008-2 c.b. 1305 (12/5/08) this notice provides procedures to obtain relief from the full application of the income inclusion and additional taxes requirements of § 409a with respect to certain operational failures to comply with the requirements of § 409a. comments were also requested on whether procedures for the correction of a failure of a plan to comply with the plan document requirements of § 1.409a-1(c) should be adopted. b. notice 2010-6, 2010-3 i.r.b. 275 (1/5/10). this notice provides relief and guidance on corrections of failures to comply with plan documentation requirements of § 409a. c. notice 2010-80, 2010-51 i.r.b. 853 (11/30/10). this notice expands the relief for nonqualified deferred compensation plans covered by § 409a by reason of both failure to comply with operational requirements and failure to comply with plan documentation requirements. d. individual retirement accounts 1. an employment tax penalty injury leads to an income tax insult. swanton v. commissioner, t.c. memo. 2010-140 (6/24/10). the tax court (judge wells) held that $289,017 seized from taxpayer’s ira by the irs in satisfaction of a § 6672 penalty tax liability constituted a distribution from the ira includable in gross income. 2. the compromise tax relief act of 2010, § 725, extended the code § 408 exclusion for tax-free distributions from iras for charitable purposes to years 2010 and 2011. 2011] recent developments in federal income taxation 631 v. personal income and deductions a. rates 1. the government isn’t mandating anybody have health insurance, it’s just raising your taxes if you don’t. beginning in january of 2014, new § 5000a (which all by itself constitutes new chapter 48 of the code), added by the 2010 health care act, imposes a penalty — that’s exactly the concise and elegant statutory language — on any individual who does not maintain minimum essential health insurance coverage, unless the individual is exempt. minimum essential health insurance coverage includes government sponsored programs, eligible employer-sponsored plans, plans in the individual market, grandfathered group health plans and other coverage as recognized by hhs in coordination with the treasury. the penalty is phased in over the period 2014-2016 and becomes fully effective in 2016. the penalty applies month-by-month, but there is a once a year exception for a coverage gap of less than three consecutive months. the monthly penalty is 1/12 of an annualized penalty amount. starting in 2016, the annualized penalty is the greater of: (1) 2.5 percent of the amount by which the taxpayer’s household income for the taxable year exceeds the threshold amount of income requiring an income tax return to be filed for that taxpayer, or (2) $695 per uninsured adult in the household (indexed for inflation after 2016). (household income is the sum of gross income (including all foreign earned income) and tax-exempt interest, minus trade and business deductions, allowable losses from sales of property, deductions attributable to rent and royalty income, and alimony. note that deductions for contributions to iras, archer msas, etc., are not allowed for this purpose.) the penalty for an uninsured individual under age 18 is one-half of the penalty for an adult. (if an individual without minimum essential health insurance coverage is a dependent of another taxpayer, the other taxpayer is liable for the penalty with respect to the individual.) during the phase-in, the flat sum adult penalty is $95 for 2014, and $325 for 2015; the household income penalty percentage is 1 percent for 2014 and 2 percent for 2015. the total household penalty may not exceed the lesser of (1) three times the adult penalty, or (2) the national average annual premium for bronze level health plans — exactly what is a bronze level health plan is way too difficult to explain here — offered through an american health benefits exchange that year for the taxpayer’s household size. (an american health benefits exchange must be established by each state (the cost of the establishment of which is subsidized by the u.s. treasury) to facilitate the purchase of qualified health insurance plans.) individuals who cannot afford coverage because their required contribution for employer sponsored coverage or the lowest cost bronze plan in the local american health benefits exchange exceeds eight percent (indexed after 2014 for increases in health insurance 632 florida tax review [vol. 10:9 premium costs) of household income for the year are exempt from the penalty. in years after 2014, the eight percent exemption is increased by the amount by which premium growth exceeds income growth. (members of a recognized religious sect exempt from self-employment taxes and members of indian tribes also are exempt, as are prisoners.) the penalty is due upon notice and demand, and is subject to normal assessment procedures. however, it cannot be collected by lien and levy. there are no criminal or civil penalties for failure to pay, and interest does not run on late payment. 2. even though it’s domiciled in new chapter 2a, and titled “unearned medicare contribution,” it feels like an income tax surtax on investment income. new code § 1411 of the code, added by the health care and education reconciliation act of 2010, imposes a 3.8 percent tax on investment income of individuals, estates, and trusts in taxable years beginning after 12/31/12. for individuals (except nonresident aliens), the tax applies only to the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (increased by net foreign earned income excluded under § 911(a)(1)) over a threshold amount. the threshold amount is $250,000 for spouses filing a joint return or a surviving spouse, $125,000 for married individuals filing separate returns, and $200,000 for single taxpayers (including heads of household). modified adjusted gross income is adjusted gross income increased by the amount excluded under § 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income). for estates and trusts, the tax is levied on the lesser of (1) undistributed net investment income, or (2) the excess of adjusted gross income (as defined in § 67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins. the tax does not apply to a trust that is tax-exempt under § 501, is a charitable remainder trust tax-exempt under § 664, or all of the interests of which are devoted to charitable purposes. net investment income is investment income reduced by the deductions allocable to that income. investment income is the sum of (1) gross income from interest, dividends, annuities, royalties, and rents (other than income derived from any trade or business to which the tax does not apply), (2) other gross income derived from any business to which the tax applies, and (3) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply. the § 1411 tax applies to trade or business income from (1) a passive activity, and (2) trading financial instruments or commodities (as defined in § 475(e)(2)). it does not apply to any other trade or business income. gain or loss from the disposition of a partnership interest or stock in an s corporation is taken into account only to the extent gain or loss would be taken into account by the partner or shareholder if the entity had sold all its properties for fair market value immediately before the disposition. thus, there is a 2011] recent developments in federal income taxation 633 deemed basis adjustment that results in taking into account only the net gain or loss attributable to the entity’s property that is not attributable to an active trade or business. however, all income, gain, or loss on working capital is subject to the tax. investment income does not include any distributions from a qualified retirement plan or any income subject to self-employment tax. unlike self-employment taxes, no part of the § 1411 tax is deductible in computing taxable income under chapter 1. 3. domestic partners = one; breeders = zero. plr 201021048 (5/5/10). registered california domestic partners must each report one-half of the combined income earned from the performance of personal services and one-half of the combined income derived from their community property assets. the resulting income is then taxed to each of the domestic partners at the more favorable § 1(c) single rates, as opposed to the higher rates paid by married couples. also, no federal gift tax is payable on the vesting of earnings of one partner in the other partner under california law. • see also, ilm 201021049 (5/6/10) (holding that the irs could consider the assets of taxpayer’s registered domestic partner when determining whether to accept an offer in compromise); and ilm 201021050 (5/5/10) (the treatment of a registered domestic partner who reported earned income in accordance with cca 200608038 in years beginning before 6/1/10). 4. tax rates stay low in anticipation of the next nationwide election cycle. the compromise tax relief act of 2010, § 101: • retains through 2012 the 10%, 15%, 25%, 28%, 33% and 35% tax rates scheduled to expire at the end of 2010. in addition, the size of the 15% bracket for joint returns and surviving spouses will continue to be 200% of the size of the bracket for unmarried individuals (marriage penalty relief) through 2012. • the tax relief extension also maintains the 25%, 28%, 33%, and 35% rate brackets applicable to estates and trusts through 2012. • under the compromise tax relief act of 2010 the withholding rate on gambling winnings will remain at 25% instead of rising to 28%. • the minimum withholding rate on supplemental wages under § 3402 will remain at 25%, and 35% for supplemental wages in excess of $1 million. • rates for voluntary withholding of federal payments such as social security under § 3402 remain at 7%, 10%, 15%, or 25%, instead of rising to 7%, 15%, 28%, or 31%. 634 florida tax review [vol. 10:9 • the standard deduction for married couples filing a joint return will be twice the standard deduction for single filers through 2012. • no pease. elimination of the overall limitation on itemized deductions of code § 68 (reducing itemized deductions by 3% of the amount of agi over a threshold amount, but allowing at least 80% of itemized deductions) was to sunset at the end of 2010, but was extended through 2012. • no pep. the phase-out of the personal exemption for taxpayers under code § 151(d)(3) of 2% for each $2,500 of adjusted gross income above a threshold amount is eliminated through 2012. b. miscellaneous income 1. police arrest procedures did not result in “physical injury.” stadnyk v. commissioner, t.c. memo. 2008-289 (12/22/08). the tax court (judge goeke) held that damages received on account of false imprisonment were not excludable under § 104(a)(2), even though the taxpayer was detained, handcuffed and searched, because she suffered no physical harm. the damages, received from the taxpayer’s bank in a settlement, compensated her for “the ordeal ... suffered as a result of her arrest, detention, and indictment” after her bank erroneously stamped a check “nsf,” when it had been stopped for “dissatisfied purchase.” the damages were “stated in terms of recovery for nonphysical personal injuries: emotional distress, mortification, humiliation, mental anguish, and damage to reputation.” judge goeke also rejected summarily the taxpayer’s claim that damages received for personal injuries are not gross income within the meaning of § 61(a) and that “section 104(a)(2) conflicts with section 61(a) and violates the sixteenth amendment to the extent that it taxes compensatory damages received for personal injuries.” a. the sixth circuit agrees that police arrest procedures did not result in “physical injury.” stadnyk v. commissioner, 105 a.f.t.r.2d 2010-1130 (6th cir. 2/26/10), aff’g t.c. memo. 2008-289 (12/22/08). in an nonprecedential opinion, the sixth circuit affirmed the tax court opinion (judge goeke) holding that damages received on account of false imprisonment were not excludable under § 104(a)(2), even though the taxpayer was detained, handcuffed and searched, because she suffered no physical harm. the tax court found that the damages received in the settlement compensated the taxpayer for “the ordeal ... suffered as a result of her arrest, detention, and indictment” resulting from her bank erroneously stamping a check “nsf,” when it had been stopped for “dissatisfied purchase.” the damages were “stated in terms 2011] recent developments in federal income taxation 635 of recovery for nonphysical personal injuries: emotional distress, mortification, humiliation, mental anguish, and damage to reputation.” the court of appeals declined “to create a per se rule that every false imprisonment claim necessarily involves a physical injury,” stating as follows: to be sure, a false imprisonment claim may cause a physical injury, such as an injured wrist as a result of being handcuffed. but the mere fact that false imprisonment involves a physical act—restraining the victim’s freedom— does not mean that the victim is necessarily physically injured as a result of that physical act. • section 104(a)(2) did not apply, because the taxpayer “unequivocally testified that she suffered no physical injuries as a result of her physical restraint.” thus, she had not suffered personal physical injuries or physical sickness. • the court of appeals also rejected as meritless the taxpayer’s claim that damages received for personal injuries are not gross income within the meaning of § 61(a) and that “§ 104(a)(2), as amended by congress in 1996, violates the sixteenth amendment to any extent that it purports to subject compensation for personal injuries to income tax.” • apparently the government did not cross appeal the tax court’s failure to impose penalties. in the tax court judge goeke had refused to uphold the penalties asserted by the irs because taxpayers had received “disinterested advice” that the damages were not includable in income. the advice came from taxpayer’s lawyer, the defendant’s lawyer, and the mediator who negotiated the settlement. he concluded that the taxpayers “acted reasonably and in good faith when following their advice and preparing their own return as they have done for over 40 years,” because “[a]lthough none of those individuals had specialized knowledge in tax law, they were experienced in personal injury lawsuits and settlements.” 2. it looks like damages for physical sickness caused by emotional distress can be excluded if they go beyond mere symptomatic manifestations of the underlying emotional distress. domeny v. commissioner, t.c. memo. 2010-9 (1/13/10). the taxpayer received approximately $33,000 in settlement of claims for wrongful termination of employment and violations of various civil rights statutes. the taxpayer’s former employer paid approximately $8,000 to her that was reflected on a form w-2 as employee compensation, $8,000 to the taxpayer’s lawyer, for which no information return was filed, and $17,000 to the taxpayer that was reflected on a form 1099-misc as “nonemployee compensation.” the tax court (judge gerber) held that the $8,000 paid directly to the taxpayer was includable wage compensation, and the remaining amount was excludable under § 104(a)(2) as damages for physical 636 florida tax review [vol. 10:9 injuries attributable to exacerbation of multiple sclerosis caused by a hostile work environment. the payor-former employer’s intent in settlement of the claim was evidenced by the issuance of separate checks and different information returns; these facts indicated that the former employer intended the amount in excess of wages due to be in settlement of tort claims for physical injuries attributable to the exacerbation of multiple sclerosis. • the legislative history indicates that physical manifestations of emotional distress, such as insomnia, headaches, and stomach disorders, are not to be treated as physical injuries. h.r. rep. no. 737, 104th cong., 2d sess. 143, n.56 (1996). 3. having a heart attack can improve your tax health. parkinson v. commissioner, t.c. memo. 2010-142 (6/28/10). the tax court (judge thornton) held that one-half of the amount received by the taxpayer in settlement of suit for intentional infliction of emotional distress was excludable under § 104(a)(2), because the payor intended it to be compensation for a heart attack suffered as a result of the emotional distress. he reasoned that “a heart attack and its physical aftereffects constitute physical injury or sickness rather than mere subjective sensations or symptoms of emotional distress.” the other one-half of the settlement was not excludable because it was compensation for the emotional distress itself. 4. the irs will treat innocent ex-cons better than innocent victims of sexual harassment. ilm 201045023, tax treatment of compensation to exonerated prisoners (11/4/10, released 11/12/10). an individual who was wrongfully convicted of a crime and was wrongfully incarcerated for several years may exclude from gross income under § 104(a)(2) the compensation he receives from the state where “[t]he individual suffered physical injuries and physical sickness while incarcerated.” it may have helped the result that one of the individuals involved, while meeting with irs officials, suffered a seizure and had to be carried out of the room by paramedics – apparently the result of head injuries sustained while in prison. • but see plr 200041022 (7/17/00), which required that a damage award for sexual harassment be allocated between (a) punitive damages and compensatory damages allocable to period before the first physical injury, and (b) damages allocable to the period after the first physical injury. 5. when the taxpayer lives in florida, the gross income tax a/k/a the amt doesn’t bite as hard. campbell v. commissioner, 134 t.c. 20 (1/21/10). the taxpayer recovered a gross award of $8.75 million as a relator in a qui tam action on behalf of the united states government against a military contractor, and paid $3.5 million of attorney’s 2011] recent developments in federal income taxation 637 fees, which amount was retained by the taxpayer’s attorney to whom the $8.75 million had been remitted; the taxpayer received only $5.25 million from his attorney. the tax court (judge wells) held that the entire gross award of $8.75 million was includable in gross income, and the $3.5 million of attorney’s fees was deductible as a miscellaneous itemized deduction. • “qui tam” is an abbreviation of the latin phrase “qui tam pro domino rege quam pro se ipso in hac parte sequitor,” which means “who pursues this action on our lord the king’s behalf as well as his own.” • the tax year involved in this case (2003) pre-dates the effective date of 2004 amendments to § 62(a), which now permits attorney’s fees in a false claims act case to be an above-the-line deduction. 6. protecting the tax-free treatment of indian medical care provided from casino profits. the 2010 health care act added new § 139d, which expressly excludes from gross income the value of certain indian tribe health care benefits. • these benefits might have been excludable in any event under the “common law” general welfare exclusion, but congress was concerned by statements of some irs officials to the effect that the general welfare exclusion might not apply universally to indian tribe health care benefits. although the exclusion extends only to specified benefits, it broadly covers most health insurance, medical benefits, and accident coverage. 7. bp is gonna have to send out a whole lot of form 1099s. this will result in some claimants having to file tax returns for the first time in their lives. ir-2010-078 (6/25/10), http://www.irs.gov/newsroom/article/0,,id=224886,00.html. the irs has published guidance for individuals and businesses affected by the oil spill in the gulf of mexico. (1) taxpayers must include in gross income payments received for lost business income, lost wages, and lost profits. (2) selfemployed individuals who receive a payment that represents compensation for lost income of the individual’s trade or business must include the amount of the payment in calculating the self-employment tax. (3) a payment to an individual to compensate for lost wages is subject to the social security tax and medicare taxes, but generally is not subject to income tax withholding, unless backup withholding applies. (4) a person making payments to an individual or partnership (including an llc) for lost business income, lost wages, or lost profits must report the payments on a form 1099-misc, miscellaneous income, if the payments aggregate $600 or more. the document also describes the standard rules regarding casualty loss 638 florida tax review [vol. 10:9 deductions and involuntary conversions, and the inclusion in gross income of damages for emotional distress. • the obvious remedy is for bp to gross up its payments for the taxes claimants would not have paid absent the oil spill. 8. it pays really big tax benefits to run your own church and give yourself two parsonage allowances. driscoll v. commissioner, 135 t.c. no. 27 (12/14/10) (reviewed). the taxpayer (phillip driscoll) received a parsonage allowance from mighty horn ministries, inc., later known as phil driscoll ministries, inc., that was applied to the acquisition and maintenance of not only a principal residence but also a second home — a vacation residence. the irs disallowed a § 107 exclusion for the portion of the parsonage allowance received with respect to the second home — for four years amounts totaled over $400,000 — on the grounds that § 107(a) refers to “a home” and that the legislative history limited the § 107 exclusion to only one home. the tax court majority, in an opinion by judge chiechi (in which four judges joined and with which two concurred), rejected the irs’s argument, stating “[w]e find nothing in section 107, its legislative history, or the regulations under section 107, which, as respondent points out, all use the phrase ‘a home,’ that allows, let alone requires, respondent, or us, to rewrite that phrase in section 107.” the opinion pointed to § 7701(p)(1) [(m)(1) for the years at issue], which refers to the definition in 1 u.s.c. § 1 that provides that in interpreting the united states code, the singular includes the plural, unless the context indicates otherwise. • judge gustafson, joined by five other judges, dissented, on the grounds that exclusions should be interpreted narrowly, and “[t]he chance that congress in 1954 thought it was permitting the exclusion of multiple parsonage allowances seems remote.” c. hobby losses and § 280a home office and vacation homes 1. she bet that the ball wouldn’t stop on § 183 and won the right to deduct gambling losses on schedule c instead of on schedule a. chow v. commissioner, t.c. memo. 2010-48 (3/18/10). judge cohen applied reg. § 1.183-2(b) to determine that the taxpayer’s gambling activity was engaged in for profit. accordingly, the taxpayer was a professional gambler, and her losses were deductible on schedule c, rather than as itemized deductions. nevertheless, pursuant to § 165(d), her losses were not deductible to the extent they exceeded her gambling winnings. 2011] recent developments in federal income taxation 639 2. really going broke helps prove that it wasn’t a hobby after all. dennis v. commissioner, t.c. memo. 2010-216 (10/5/10). judge paris held that a horse breeding activity conducted by the husband, who had no other source of income, was conducted for a profit even though the losses from the horse breeding activity were applied against his wife’s income from her cosmetology business on their joint return. the income from the cosmetology business would not have been enough to pay their living costs along with the expenses of the horse breeding activity, and the income from the wife’s business could not have absorbed the losses the husband’s horse breeding activity incurred while paying their living costs. thus, the taxpayer’s faced economic hardship because the losses were actual, not merely attributable to depreciation deductions, and depleted their available cash and savings. d. deductions and credits for personal expenses 1. helping entry-level homebuyers invest in the bear housing market. code § 36, added by the housing assistance tax act of 2008, provides a refundable credit for a “first-time homebuyer” who purchases a principal residence on or after 4/9/08, and before 1/1/09. the amount of the credit is the lesser of 10 percent of the purchase price or $7,500 ($3,750 in the case of a married individual filing a separate return). if two or more unmarried persons purchase a principal residence together, the total amount of the credit will be allocated among them as prescribed by the irs. the credit is phased out over the modified adjusted income range of $75,000 to $95,000 ($150,000 to $170,000 in the case of a joint return). a person qualifies as a “first-time homebuyer” if neither the person nor the person’s spouse (if any) owned a principal residence at any time during the three-year period ending on the date of purchase of the credit-generating residence. the credit is not available if the taxpayer purchased the property from a related person or acquired it by gift, or if the taxpayer’s basis in the property is determined under § 1014. (persons are related for this purpose if they are related for purposes of § 267 or § 707, except that the family of an individual under § 267(c)(4) is limited for this purpose to his spouse, ancestors, and lineal descendants.) the credit is also not available: (1) if a credit under § 1400c (relating to first-time homebuyers in the district of columbia) has ever been allowed to the taxpayer; (2) if the taxpayer’s financing is from tax-exempt mortgage revenue bonds; (3) if the taxpayer is a nonresident alien; or (4) if the taxpayer disposes of the residence or ceases to use it as his principal residence before the close of the taxable year. • the amount of the credit is recaptured ratably over the 15-year period beginning with the second taxable year following the taxable year in which the credit-generating purchase was made. for example, if a taxpayer properly claimed a credit of $7,500 for a 640 florida tax review [vol. 10:9 purchase in 2008, the recapture amount would be $500 in 2010, with another $500 recapture amount in each of the next 14 years. thus, the credit actually functions as an interest-free loan from the government to the taxpayer. if, prior to the end of the 15-year recapture period, a taxpayer disposes of the creditgenerating residence or ceases to use it as his principal residence, the recapture of any previously unrecaptured credit is accelerated. in the case of a sale of the principal residence to an unrelated person, the recapture amount is limited to the amount of gain (if any) on the sale. there is no recapture (either regular or accelerated) after the death of a taxpayer, and there is no accelerated recapture following an involuntary conversion of a residence if the taxpayer acquires a new principal residence within the next two years. if a credit-generating residence is transferred between spouses or incident to a divorce, in a transaction subject to § 1041, any remaining recapture obligation is imposed solely on the transferee. • although the credit is ordinarily allowed with respect to the year in which the credit-generating purchase occurred, a taxpayer purchasing a home in 2009 (before july 1) may elect to treat the purchase as having been made in 2008, for the purpose of claiming the credit on his 2008 tax return. if the election is made, the first year of the recapture period will be 2010, rather than 2011. a. the homebuyer credit started out as an interest-free loan, but now it’s outright free money from the federal government. section 1006 of the 2009 arra amended code § 36(h) to extend the life of the first-time homebuyer credit through november 30, 2009, and to increase the amount of the credit to $8,000 for 2009. it also amended § 36(f) to eliminate the recapture of the credit for a home purchased in 2009, unless the home is sold or ceases to be the taxpayer’s principal residence within 36 months of the date of purchase. b. the credit is extended and modified in the worker, homeownership, and business assistance act of 2009. section 11 of the whaba of 2009 amends code § 36 to extend the credit for homes purchased before 5/1/10 (before 7/1/10, if subject to a binding contract before 5/1/10). • an individual (and, if married, the individual’s spouse) who has maintained the same principal residence for any five-consecutive year period during the eight-year period ending on the date of the purchase of a subsequent principal residence is treated as a first-time homebuyer. the maximum allowable credit for such taxpayers is $6,500. this provision applies to residences purchased after 11/30/09. • there are, of course, income limitations for the credit, with phaseouts between $225,000 and $245,000 of agi, as well as a purchase price limit of $800,000. 2011] recent developments in federal income taxation 641 c. closing deadline extended to give banks (and congress) time to do the paperwork. the homebuyer assistance and improvement act of 2010 extended the closing deadline for the § 36 homebuyer’s credit from 6/30/10 to 9/30/10 for any eligible homebuyer who entered into a binding purchase contract on or before 4/30/10 to close on the purchase of the home on or before 6/30/10. the new law addresses concerns that many homebuyers might be unable to meet the original 6/30/10 closing deadline because of circumstances beyond their control. one of these circumstances is the failure of congress to provide for the extension of federal flood insurance after the former program expired. 2. the irs recedes from tax court victories on the scope of “home equity indebtedness.” ilm 200940030 (8/7/09). home mortgage indebtedness in excess of $1,000,000 may qualify as home equity indebtedness under § 163(h)(3)(c). the position taken in the memo is inconsistent with pau v. commissioner, t.c. memo. 1997-43, and catalano v. commissioner, t.c. memo. 2000-82, but it is consistent with the instructions in irs pub. no. 936, home mortgage interest deduction. • shouldn’t this position be stated in a published revenue ruling since tax court decisions are the law and instructions in irs publications are not the law? a. and the position is stated in a published revenue ruling. rev. rul. 2010-25, 2010-44 i.r.b. 571 (10/14/10). indebtedness that is incurred by a taxpayer to acquire, construct, or substantially improve a qualified residence can constitute “home equity indebtedness” (within the meaning of § 163(h)(3)(c)) to the extent it exceeds $1 million. 3. sex reassignment surgery is not nondeductible cosmetic surgery, but the boob job is. o’donnabhain v. commissioner, 134 t.c. no. 4 (2/2/10). the taxpayer was a genetic male who suffered from gender identity disorder, which is a condition recognized in medical reference texts, in which an individual experiences persistent psychological discomfort concerning his or her anatomical gender. pursuant to medical advice the taxpayer underwent sex reassignment surgery, including breast augmentation surgery, and claimed a § 213 medical expense deduction for the cost of the surgeries, feminizing hormones, and other related expenses. the irs disallowed the deductions. in a reviewed opinion by judge gale the majority (8 judges) held as follows: (1) gender identity disorder is a “disease” within the meaning § 213(d)(1)(a) and (9)(b); (2) the taxpayer’s hormone therapy and sex reassignment surgery were “for the ... treatment ... of” and “[treated]” disease within the meaning of § 213(d)(1)(a) and (9)(b); and (3) because they were for the treatment of disease, the procedures were 642 florida tax review [vol. 10:9 not “cosmetic surgery” that is excluded from the definition of “medical care” by § 213(d)(9)(a). however, the taxpayer’s breast augmentation surgery was “directed at improving ... [her] appearance,” because the taxpayer failed to prove that the breast augmentation surgery either “meaningfully [promoted] the proper function of the body” or “[treated] ... disease” within the meaning of § 213(d)(9)(b). thus, the breast augmentation surgery was “cosmetic surgery” that is excluded from the definition of deductible “medical care.” • judges halpern, goeke, and holmes concurred. • judge foley, joined by judges wells, vasquez, kroupa, and gustafson, concurred in disallowance of the deduction for the breast augmentation surgery and dissented with respect to allowing deductions for hormone therapy and sex reassignment. he reasoned that “the fact that a procedure treats a disease is not sufficient to exclude the procedure from the definition of ‘cosmetic surgery,’” because § 213(d)(9)(a) provides that the term “medical care” includes “cosmetic surgery or other similar procedures” only if the “surgery or procedure is necessary to ameliorate a deformity arising from, or directly related to,” a disfiguring disease. “to yield a deduction, an appearance-improving procedure must treat ‘disease’ (as opposed to treating a patient or a symptom).” • judge gustafson, joined by judges foley, wells, vasquez, and kroupa, concurred in disallowance of the deduction for the breast augmentation surgery and dissented with respect to allowing deductions for hormone therapy and sex reassignment. he reasoned as follows: a procedure that changes the patient’s healthy male body (in fact, that disables his healthy male body) and leaves his mind unchanged (i.e., with the continuing misperception that he is female) has not treated his mental disease. on the contrary, that procedure has given up on the mental disease, has capitulated to the mental disease, has arguably even changed sides and joined forces with the mental disease. in any event, the procedure did not (in the words of havey v. commissioner, 12 t.c. at 412) “bear directly on the *** condition in question,” did not “deal with” the disease (per webster’s), did not “treat” the mental disease that the therapist diagnosed. rather, the procedure changed only petitioner’s healthy body and undertook to “mitigat[e]” the effects of the mental disease. 4. the sun will never set on increased adoption credits, and the day gets permanently longer, unlike mere daylight savings time. the 2010 health care act amended § 23(b), now § 36c, to raise the ceiling on the adoption credit from $10,000 to $13,170 (and adjusting the inflation adjustment rules) and to make the credit refundable for 2011] recent developments in federal income taxation 643 taxable years after 12/31/09. the act also exempted all changes in § 23 adoption credit from the egtrra sunset rules. 5. reducing health care costs by discouraging health care spending. the 2010 health care act amended § 213 to increase the 7.5 percent of agi threshold for deducting unreimbursed medical expenses to 10 percent of agi for taxable years beginning after 12/31/12. however, the increased threshold does not apply for the years 2013 through 2016, if either the taxpayer or the taxpayer’s spouse turns 65 before the end of the year. the 10 percent of agi threshold for deducting medical expenses under the amt remains unchanged. 6. how about a little consistency in tax-free drug use? the 2010 health care act amended § 220(d)(2), dealing with individual archer msas, to disallow reimbursement from an archer msa for the cost of over-the-counter medicines unless the medicine is prescribed by a physician. reimbursement is allowed only if the medicine or drug is a prescribed drug, without regard to whether such drug is available without a prescription, or is insulin, which is the rule for deductibility of medicine as a medical expense under § 213. the new rule is effective after 12/31/10. a. notice 2010-59 2010-39 i.r.b. 396 (9/3/10). section 220(d)(2) does not apply to disallow items that are not medicines or drugs, including equipment such as crutches, supplies such as bandages, and diagnostic devices such as blood sugar test kits; such items may qualify as medical care if they otherwise meet the definition of medical care in § 213(d)(1). 7. making it little bit more difficult to use an archer msa to save for that vacation trip of a lifetime you dreamed is in your future. the 2010 health care act amended § 220(f)(4)(a), dealing with individual archer msas, and § 223(f)(4)(a), dealing with hsas (for individuals with high deductible health plans, whether through an employer or individually) to increase additional tax on distributions from an hsa or an archer msa that are not used for qualified medical expenses from 10 percent to 20 percent of the distribution. the new rule is effective after 12/31/10. 8. and now for the pièce de résistance — the tax code pays for health insurance for poor, and much of the middle class,1 1. some amount of the health insurance premium credit probably will be available to over one-half of all households, because the credit is not fully phased out until median household income is 400 percent of the federal poverty level, which in 644 florida tax review [vol. 10:9 but only as long as they are not getting abortions. section 36b, added by the 2010 health care act, provides a “premium assistance” credit for eligible individuals and families who purchase health insurance through an american health benefits exchange established under § 1311 of the act. (an american health benefits exchange must be established by each state (the cost of the establishment of which is subsidized by the u.s. treasury) to facilitate the purchase of qualified health insurance plans.) the credit is payable in advance directly to the insurer to subsidize the purchase of health insurance through an exchange. the individual then pays the difference between the premium tax credit amount and the total premium charged for the plan. (alternatively, an individual may elect to purchase health insurance out-of-pocket and apply to the irs for the credit at the end of the taxable year.) the amount of the reduction in premium is required to be included with each bill sent to the individual. for employed individuals who purchase health insurance through an exchange, the premiums are paid through payroll deductions. the premium assistance credit is available for individuals (single or joint filers) whose household income (as defined in the statute) is less than 400 percent of the federal poverty level for the family size involved and who do not received health insurance through an employer. the exact amount of the premium depends on household income, based on the percentage of income the cost of premiums represents. the baseline for the credit equals the full premium for a “second lowest cost silver plan” — whatever that might provide — but may be used to purchase any plan, including bronze, silver, gold and platinum level plans, through an exchange. (we will not pretend to understand the details of the different plans; we don’t even understand our own health insurance plans.) the credit is phased out on a sliding scale for households whose income is above the poverty level and is completely phased out at 400 percent of the poverty level. we will not attempt to amuse you with the details of the complicated phase-out formula, except to note that it is linear. married taxpayers must file a joint return to be eligible, and dependants are ineligible. an employee who is offered minimum essential coverage through an employer-provided health insurance plan is not eligible for the premium tax credit for health insurance purchased through an exchange. but an employee for whom offered coverage is unaffordable is eligible for the credit. an employee also is eligible for the credit if the employer’s plan benefits are less than 60 percent of the cost of insurance, and the employee declines the employee coverage and satisfies the other conditions for receiving the credit. (an employer will be notified if an employee is eligible for a premium assistance credit because the employer does not provide minimal essential coverage, or the employer does offer minimum essential coverage but it is not affordable; the notice many states, for many different size households, is an amount that exceeds median household income. 2011] recent developments in federal income taxation 645 will explain the employer may be liable for an “assessable payment” — q: is it an excise tax, a penalty, or merely an exaction? a: it’s an excise tax — under § 4980h.) individuals who apply for the credit must provide massive amounts of personal information to the american health benefits exchange, including copies of their last two tax returns. if the credit received through an advance payment exceeds the amount of credit to which the taxpayer is entitled, the excess is treated as an increased tax liability. for individuals whose household income is below 400% of the federal poverty level, the increased tax cannot exceed $400. if the advance payment credit is less than the amount of the credit to which the taxpayer is entitled, the shortfall reduces tax liability. premium assistance credits are not available for months in which an individual has a free choice voucher. premium assistance credits, or any amounts that are attributable to them, cannot be used to pay for abortions for which federal funding is prohibited. the provision is effective for taxable years ending after 12/31/13. • there’s oh so much more that could be explained, but we ran out of time and space and, most of all, patience to explain the mind-numbing complexity of it all. 9. finality safety. rev. proc. 2010-31, 2010-40 i.r.b. 413 (9/29/10). section 36c(e) provides that in the case of an adoption of a foreign child, no credit for qualified adoption expenses is allowed unless and until the adoption becomes final. this revenue procedure provides safe harbors for determining the finality of foreign adoptions governed by the hague convention on protection of children and co-operation in respect of intercountry adoption for purposes of the § 36c credit for qualified adoption expenses. 10. this revenue procedure refers to chinese drywall, but is too politically correct to call it by name. rev. proc. 201036, 2010-42 i.r.b. 439 (9/30/10). this revenue procedure provides guidance regarding the tax treatment of amounts paid to repair damages to personal residences resulting from “corrosive” drywall building materials (sometimes referred to as “certain imported drywall installed in homes between 2001 and 2008”). the reported consequences include the presence of “sulfur gas odors” that corrode copper electrical wiring. the procedure does not mention any alternative possibilities for the presence of “sulfur gas odors” in the home. • this revenue procedure permits the deduction of 100 percent of repair costs for damage to the residence and to household appliances as a casualty loss in the year of repayment provided that the taxpayer does not pursue reimbursement through property insurance, litigation, or otherwise; the loss deduction is 75 percent if the taxpayer makes a claim for reimbursement. both deductions are limited by the $100 floor 646 florida tax review [vol. 10:9 imposed by § 165(h)(1) and by the 10-percent-of-agi limitation imposed by § 165(h)(2). • contrast the so-called “chinese wall,” now permitted by the aba model rules of professional conduct, rule 1.10; there it is referred to as a “screen.” 11. tax stimulus for procreation. the code § 24 $1,000 child tax credit (scheduled to drop to $500 after 2010) is extended through 2012 under the compromise tax relief act of 2010, §§ 101, 103. • the credit remains available against both regular and alternative minimum taxable income. the credit is phased out by $50 for each $1,000 of modified agi above $110,000 for joint returns, $75,000 for unmarried individuals, and $55,000 for married filing separately. the credit remains refundable to the greater of 15% of taxable earned income above $3,000 or, for a taxpayer with three or more qualified children, the excess of social security taxes over the earned income credit for the taxable year. 12. earned income tax credits remain simplified, at least congress so thinks. the compromise tax relief act of 2010, § 103, extends through 2012 certain simplification provisions, originally enacted in the economic growth and tax relief reconciliation act of 2001 and scheduled to sunset after 2010, in calculating the refundable earned income tax credit of code § 32. • the definition of earned income includes only amounts includible in gross income for the taxable year. • the phase out of the earned income credit is based on adjusted gross income (rather than modified agi). • a child, to be a qualified child, must reside with the taxpayer for more than six months, descendants of step children are qualified children, and siblings, or step siblings are eligible children if the taxpayer cared for them. • a child is the qualifying child of the taxpayer under the rules of § 152(c) with respect to the dependency exemption except for the support requirement and the § 152(e) rules allowing a noncustodial parent to claim the dependency exemption. a qualifying child must have the same principal place of abode as the taxpayer for at least one-half of the year, and be under age 19, age 24 if a student, or permanently disabled. • the increased phase-out threshold for joint filers, $5,000 more than the threshold for other filers (plus inflation adjustments), is extended through 2012. 13. multiple individual credits are extended through 2012 by the compromise tax relief act of 2010 through 2012: 2011] recent developments in federal income taxation 647 a. the code § 21 dependent care credit remains at 35% of qualified expenses up to $3,000 for one qualifying dependent and up to $6,000 for two or more qualifying dependents. the 35% credit phases out by one percentage, going down to 20%, for each $2,000 of agi above $15,000. act § 101. b. expanded adoption credits, but not refundability, are extended. act § 101. c. the nonbusiness energy property credit of code § 25c is extended to property placed in service before 1/1/12, but at pre-2009 rates, 10% of the cost of energy efficient building envelope components plus $50 for each advanced main air circulating fan, $150 for each qualified heater, and $300 for each item of energy efficient building property. the lifetime limit for the credit is $500, or $200 for windows. also, standards for furnaces and boilers were returned to pre-2009 higher levels. act § 710. d. the $5,000 credit for a first time home buyer in the district of columbia, code § 1400c, is extended to homes purchased before 1/1/12. the credit phases out beginning at $70,000 of modified agi for single filers and at $110,000 of agi for a joint return. act § 754. 14. sales tax deductions extended to 2010 and 2011. the compromise tax relief act of 2010, act § 722, extends the election under code § 164 to deduct state and local sales taxes in lieu of state and local income taxes to the years 2010 and 2011. 15. singing ♬ “yankee doodle dandy”♪ supports some of the claimed deductions for which no records were available. zilberberg v. commissioner, t.c. memo. 2011-005 (1/5/11). judge wherry applied the cohan rule [cohan v. commissioner, 39 f.2d 540 (2d cir. 1930)] with respect to deductible personal expenses. the taxpayer was allowing $3,000 of a claimed $5,000 § 217 moving expense deduction, even though he had inadequate records, because he established that he had moved for employment purposes and that he had incurred some expenses. he was also allowed $15,500 of a claimed $36,250 § 165(c)(3) casualty loss deduction with respect to his residence, where his records were destroyed in the hurricane that gave rise to the casualty. 648 florida tax review [vol. 10:9 e. divorce tax issues 1. did the court really understand the regs? maes v. united states, 106 a.f.t.r.2d 2010-6752 (d. mont. 10/13/10). section 71(c)(2) provides that an amount is considered to be fixed for child support, and thus is not alimony, if the period over which it is payable is determined with reference to an event relating to a child. temp reg. § 1.71-1t(c), q&a18, provides that a date is presumed to be clearly associated with an event relating to a child only if (1) the date is within six months on either side of the child’s eighteenth or twenty-first birthday (or the age of majority under local law) or (2) payments are to be reduced on two or more dates that are within a year either side of the attaining of a certain age, between eighteen and twenty-four, by two or more children. notwithstanding these provisions, the court held that no part of payments the divorce agreement designated as alimony, but which were reduced from $109,000 to $91,000, and then to $25,000 in the same years that the two children attained age 20, respectively, was characterized as child support. the court found any presumption that the payments were not alimony was overcome by the facts that (1) the divorce decree made separate provision for child support, (2) the decree did not expressly link reduction of alimony to children attaining age 20; and (3) evidence established that the amount of the payments to the taxpayer were grossed-up in anticipation of taxpayer reporting the full amount as alimony and paying taxes thereon. under the relevant state law, the payments would have terminated upon the payee’s death. f. education 1. tax subsidies continue to help higher education increase tuition. the compromise tax relief act of 2010, act §§ 101, 103, extend multiple education tax expenditures through 2012. • the american opportunity tax credit, code § 25a, provides a tax credit of 100% of education expenses up to $2,000, plus 25% of the next $2,000, for a maximum credit of $2,500 per year for an eligible student. the credit phases out for taxpayers with a modified agi of $80,000 to $90,000 for single filers and $160,000 to $180,000 for joint returns. the alternative hope credit for the first two years of higher education provides a 100% credit for the first $1,200 of education expenses, plus 50% of the next $1,200 of education expenses, including tuition and related expenses. both are extended through 2012. • excludable scholarships under code § 117 include amounts paid for services by the national health service corps scholarship program and the f. edward gebert armed forces health professions scholarship and financial assistance program (armed forces scholarship program). 2011] recent developments in federal income taxation 649 • employer provided educational assistance is excluded under code § 127, even if the education is not job related. • higher phase-out ranges remain for above the line student loan interest deductions, between $60,000 and $75,000 for single filers and $120,000 to $150,000 for joint returns. • enhanced contributions to cloverdale education savings accounts remain at $2,000 per year through 2012 for beneficiaries under age 18 with phase out amounts based on modified agi between $95,000 and $110,000 for single filers and $190,000 to $220,000 for joint returns. 2. k-12 teacher deductions. the compromise tax relief act of 2010, § 721, extends the code § 62 deduction of up to $250 of “eligible educator expenses” for k-12 teachers to the years 2010 and 2011. g. alternative minimum tax 1. once again band-aids are applied to the individual amt. the compromise tax relief act of 2010, § 201(a), adopts perennial patches to the amt exemption for 2010 and 2011. the exemption amount under code § 55(d) for 2010 is $72,450 for joint returns and surviving spouses. the exemption phases out by 25% of amti exceeding $150,000, eliminating the exemption when amti is $439,800. for unmarried individuals in 2010 the exemption is $47,450, with a phase out of 25% of amti in excess $112,500 eliminating the exemption when amti is $302,300. the exemption amount for 2011 for joint returns and surviving spouses will be $74,450, with the 25% phase out beginning when amti exceeds $150,000, eliminating the exemption when amti is $447,800. for unmarried filers, the exemption will be $37,225 with the 25% phase-out beginning when amti exceeds $75,000 eliminating the exemption when amti is $223,900. • the exemption amounts for married individuals filing separately are 50% of the exemption for joint filers. • the code § 1(g) kiddie tax exemption for 2010 is the child’s earned income plus $6,700, and for 2011, earned income plus $6,800, but not more than the unmarried individual exemption amount. 2. individual nonrefundable personal credits offset amt. the compromise tax relief act of 2010, § 202, allows nonrefundable personal credits to offset both regular tax liability and amt liability. these include the credits listed in code §§ 21 through 25d. 650 florida tax review [vol. 10:9 vi. corporations a. entity and formation there were no significant developments regarding this top during 2010. b. distributions and redemptions 1. section 162(k)’s bite is as loud as its bark. ralston purina co. v. commissioner, 131 t.c. 29 (9/10/08). ralston purina claimed a deduction under § 404(k) for payments made to its esop in redemption of ralston purina preferred stock owned by the esop to fund distributions to employees terminating participation in the esop. the commissioner argued the redemption payments were not deductible under either § 404(k)(1) or (5), or alternatively that the deduction was barred by §162(k). the tax court, in a unanimous reviewed opinion by judge nims, held that because ralston purina’s payments were “in connection with the redemption of its own stock,” § 162(k) applied to disallow the deduction. the tax court refused to follow the contrary opinion on almost identical facts in boise cascade corp. v. united states, 329 f.3d 751 (9th cir. 2003). in boise cascade the ninth circuit interpreted the phrase “in connection with” to include only expenses that have their origin in a stock redemption transaction, excluding expenses that have their origin in a “separate, although related, transaction.” the tax court previously had rejected the ninth circuit’s narrow interpretation of the phrase “in connection with” in fort howard corp. v. commissioner, 103 t.c. 345 (1994), and did so again in ralston purina. the court rejected ralston purina’s argument that because the payments were an applicable dividend under § 404(k), the transaction was excepted from the application of § 162(k) under § 162(k)(2)(a)(ii). the tax court reasoned that the entire transaction potentially deductible as an applicable dividend under § 404(k) — payment from the corporation to the esop and the distribution to the esop participants — must also pass muster under § 162(k), and that the ‘otherwise allowable’ deduction was disallowed because the payment was ‘in connection with’ a repurchase of stock. a. and the third circuit agrees with the tax court, not with the ninth circuit. conopco, inc. v. united states, 572 f.3d 162 (3d cir. 7/13/09), aff’g 100 a.f.t.r.2d 2007-5296 (d. n.j. 7/18/07). the court held that assuming that conopco’s payments were applicable dividends under § 404(k)(1) — an issue that it did not reach — “where a corporation makes payment to an esop trust in redemption of its stock, the otherwise allowable § 404(k)(1) deduction for an applicable dividend inevitably involves an ‘amount paid or incurred by a corporation in 2011] recent developments in federal income taxation 651 connection with the reacquisition of its stock’ and is therefore barred by § 162(k)(1).” b. the dog food corporation precedent wasn’t the people’s food corporation’s best friend. general mills, inc. v. united states, 554 f.3d 727 (8th cir. 1/26/09). general mills claimed a deduction under § 404(k) for payments made to its esop in redemption of general mills stock owned by the esop to fund distributions to employees terminating participation in the esop. in a very brief opinion, the court (judge benton) held that §162(k) barred the deduction for the “applicable dividend” otherwise allowable under § 404(k). the court followed the tax court’s decision in ralston purina co. v. commissioner, 131 t.c. 29 (9/10/08), and refused to follow the contrary opinion in boise cascade corp. v. united states, 329 f.3d 751 (9th cir. 2003), because it disagreed with the reasoning of boise cascade. c. and the people food precedent comes around to bite the dog’s tail. nestle purina petcare co. v. commissioner, 594 f.3d 968 (8th cir. 2/9/10). following its holding in general mills the court affirmed the tax court holding in ralston purina co. v. commissioner, 131 t.c. 29 (9/10/08), that § 162(k)(1) barred a dividends paid deduction under § 404(k) where payments are made to redeem stock from the distributors esop. in the eighth circuit the taxpayer asserted, in an argument not extensively considered by the tax court, that its distribution constituted a dividend under § 561 (dividends paid in determining accumulated taxable income, undistributed personal holding company income, investment company taxable income and reit taxable income) that was subject to an exception from the limitation provided in § 162(k)(2)(a)(ii), allowing deductions for dividends paid within the meaning of § 561. the court rejected the argument pointing out that § 404(k) does not reference dividends paid under § 561 and that the plain language of the statute does not incorporate § 404(k) distributions within the meaning of dividends paid under § 561. 2. fool me once, fool me twice, but you’re not gonna fool me three times in a row. media space, inc. v. commissioner, 135 t.c. no. 21 (10/18/10). the taxpayer’s corporate charter granted its preferred shareholders the right to compel redemption of their stock on or after 9/30/03 if a majority of the holders of the specific series elected redemption. because state law could prohibit the redemption if it would impair the corporation’s capital or the corporation might otherwise fail to redeem the shares upon proper demand, the charter required it to pay interest, which increased from 4 percent per annum by 0.5 percent at the end of each 6-month period until paid in full, subject to a maximum rate of 9 percent. the corporation was 652 florida tax review [vol. 10:9 also required to continue paying the dividends on any shares it did not redeem. on 9/30/03, the taxpayer and the preferred shareholders entered into a forbearance agreement, under which the shareholders agreed to forbear from exercising their redemption rights until 9/30/04, and the corporation agreed to pay the shareholders a “forbearance amount” computed under an interest-like formula. the forbearance agreement was extended several times, with the latest one extending into 2010. the taxpayer deducted the forbearance amount payments as interest and the shareholders reported them as interest. the irs disallowed the deduction on the ground that the payments were not interest because they were not paid on any indebtedness. judge goeke upheld the irs’s determination that the payments were not interest, but allowed deductions under § 162 for the payments in all but one year. • regarding the reason the payments were not interest, judge goeke concluded as follows: the redemption right itself does not create the obligation to pay a principal sum (the redemption amount); rather the exercising of the redemption right by the shareholders’ written election creates the obligation to pay. without a written election, no obligation for payment existed. no redemption election was made during the years at issue. • he rejected the taxpayer’s argument that the irs elevated form over substance, reasoning as follows: comparing the results of the forbearance agreement and the results that would have occurred had a redemption election been made reveals a glaring difference: petitioner would not be legally bound to redeem the investors’ shares as a result of the forbearance agreement. if the investors had made a redemption election, petitioner would have been bound to redeem the shares pro rata as petitioner became financially able to redeem them. under the redemption election scenario the investors are entitled to redemption, but under the forbearance agreement the investors retain the choice of whether or not to have their shares redeemed. • he rejected the irs’s arguments that the payments were not deductible under § 162 as ordinary and necessary business expenses, or that if they were ordinary and necessary business expenses, § 162(k) applied to disallow the deduction on the theory that the expenses were incurred in connection with a redemption. the corporation probably could not have redeemed the stock even if the shareholders exercised the redemption right, and the shareholders had a previously agreed upon right to be paid compensation if they made a redemption election and the corporation 2011] recent developments in federal income taxation 653 was unable to redeem; the forbearance agreement was not in form or in substance a reacquisition of stock. • the irs’s argument that the payments were § 301 distributions was summarily rejected, because the corporation received valuable deferral rights in exchange therefor. • finally, the irs argued that the payments were required to be capitalized under reg. § 1.263(a)-4(d)(2)(i) because a financial interest was created or modified. judge goeke agreed with the irs that because the payments were made to modify the corporate charter with respect to the rights of the preferred stock, the payments were required to be capitalized under reg. § 1.263(a)-4(d)(2)(i). however, he also concluded that the exception to capitalization in reg. § 1.263(a)-4(f)(1) for payments the benefit of which does not extend beyond the earlier of (1) twelve months, or (2) the end of the following taxable year applied to the initial and first renewal payments, but that an exception to the exception, and thus § 263, applied to the renewal payments under the third extension. reg. § 1.263(a)-4(f)(5)(i) provides that “the duration of a right includes any renewal period if all of the facts and circumstances in existence during the taxable year in which the right is created indicate a reasonable expectancy of renewal.” because any two deferral periods considered together lasted longer than 12 months, if there was a reasonable expectancy of renewal (extension) of the forbearance agreement, the 12-month rule would not apply. applying the five-factor test of reg. § 1.263(a)-4(f)(5)(ii) to determine if there was a reasonable expectation of renewal – (1) renewal history, (2) economics of the transaction, (3) likelihood of renewal by the other party, (4) terms of renewal, and (5) terminations – in light of the corporation’s financial condition, judge goeke concluded that there was no reasonable expectation of renewal for the initial agreement and first renewal, but that there was such an expectation at the time of the second renewal agreement and the at the payments made under the second renewal agreement had to be capitalized. c. liquidations there were no significant developments regarding this topic during 2010. d. s corporations 1. disregarded qsub is still a bank subject to reduced interest deductions for interest incurred to carry tax-exempt obligations. vainisi v. commissioner, 132 t.c. 1 (1/15/09). sections 291(a)(3), (e)(1)(b), and 265(b)(3) disallow interest deductions of a financial institution incurred to carry tax-exempt obligations, but allow an 80 percent deduction for interest on tax-exempts acquired after 12/31/82, and before 8/7/86, and for certain qualified tax exempt obligations as defined in 654 florida tax review [vol. 10:9 § 265(b)(3)(b). section 1361 allows certain financial institutions to elect to be treated as an s corporation, and further allows an s corporation to treat a financial institution as a qualified s corporation subsidiary (qsub). under § 1361(b)(3)(a), a qsub is not treated as a separate corporation except as provided in regulations. reg. § 1.1361-4(a)(3) provides that in the case of a bank that is an s corporation or a qsub of an s corporation, any special rules applicable to banks will apply to an s corporation or a qsub that is a bank. the court (judge foley) held that under these provisions the limitations of § 291(a)(3) are applicable to interest deductions claimed by a parent s corporation for interest expense generated by the s corporation’s qsub bank. the court also held that reg. § 1.1361-4(a)(3) is consistent with the enactment of § 1361(b)(3)(a) and its legislative history. a. but in the seventh circuit judge posner sees things differently, as he often does, and s corporation banks in illinois, indiana, and wisconsin gain a competitive advantage over c corporation banks. vainisi v. commissioner, 599 f.3d 567 (7th cir. 3/17/10). the tax court’s decision was reversed on appeal. judge posner noted that by virtue of § 1363(b)(4), § 291 applies to an s corporation only if it had been a c corporation within three years preceding the taxable year in question. because the taxpayer’s s corporation had not been a c corporation within the preceding three taxable years, § 291 could not apply. nothing in reg. § 1.1361-4(a)(3) could change that result. he rejected the government’s argument that because § 291 was enacted before a bank could elect to be an s corporation or a qsub, congress did not intend § 1363(b)(4) to prevent the application of § 291 to a bank and that the treasury thus was authorized to rescind that application by regulation. instead, he concluded that the regulation “merely requires that the special banking rules be applied to banks that are s corporations or qsubs at the corporate level so that a bank’s s corporation status will not emasculate the rules. ... but nothing ... suggests that section 1363(b)(4) is to be overridden with regard to banks.” he went on to reject the government’s argument as follows: missing from the government’s analysis is recognition that the only s corporations to which section 291, the source of the special banking rule at issue in this case (the 80 percent rule), applies are s corporations that were c corporations in one of the three immediately preceding years. nothing in the regulation suggests a purpose to change that rule. ... of course, unless abrogated, the privilege conferred by section 1363(b)(4) will perpetuate a competitive advantage enjoyed by s or qsub banks that have never been c corporations or that converted from c to s earlier rather than later. later converters – not to mention all existing c 2011] recent developments in federal income taxation 655 corporation banks (the majority of all banks) – may be gnashing their teeth in fury at the additional interest deduction that many of their s or qsub bank competitors can take. but the difference in treatment, and whatever consequences flow from it, are built into section 1363(b)(4). • finally, judge posner concluded: the regulation was promulgated a decade ago and the treasury department has thus had ample time in which to decide whether the favored treatment of s and qsub banks is a bad idea. the internal revenue service thinks it a bad idea, the tax court thinks it a bad idea, but the institutions authorized to correct the favored treatment of these banks – congress by statute, and the treasury department (we are assuming without deciding), as congress’s delegate, by regulation – have thus far left it intact. • on the reasoning, its game, set, and match, we think. 2. a solomon-like valuation by judge wells. the ringgold telephone company v. commissioner, t.c. memo. 2010-103 (5/10/10). this case involved valuation of the taxpayer’s assets on the date it converted from c corporation status to s corporation status, for the purpose of computing the built-in gain tax under § 1374 upon the subsequent sale of its assets within 10 years of electing s corporation status. the only asset in question was a minority partnership interest in a partnership that itself held a minority interest in a lower tier partnership. the taxpayer valued the partnership interest at $2,600,000 on the effective date of its election, but it sold the partnership interest less than a year later for $5,220,423 to bell south, which indirectly controlled the lower tier partnership. judge wells found that the taxpayer’s expert witness’s testimony, which valued the interest at $2,980,000, based on averaging $3,243,000 using a “distribution yield analysis” and $2,718,000 using a business enterprise analysis with a 5% minority discount, to be more persuasive than the irs’s expert witness’s valuation of $5,155,000. however, he also concluded that while bell south had not paid a control premium for the partnership interest, the price paid by bell south was “probative, but not conclusive, evidence of the value of the [partnership] interest on the valuation date.” accordingly, he valued the partnership interest at $3,727,141, by weighing equally – that means averaging – (1) the $3,243,000 value using a “distribution yield analysis,” (2) the $2,718,000 value using a business enterprise analysis, and (3) the $5,220,423 paid by bell south. 656 florida tax review [vol. 10:9 3. gitlitz by analogy? “not,” says the tax court. nathel v. commissioner, 131 t.c. 262 (12/17/08). prior to 2001, the taxpayer had claimed losses passed-through from an s corporation in an amount that exceeded his stock basis but which were properly allowable under § 1366(d)(1)(b) because there were outstanding loans to the corporation from the taxpayer-shareholder. the taxpayer’s basis in the loans to the corporation was reduced under § 1367(a)(2)(a) to $112,547. in 2001 the corporation paid $649,775 on the loan, which exceeded the taxpayer’s $112,547 basis in the loan by $537,228. later in 2001, pursuant to a restructuring of the ownership of the s corporation and two other corporations owned by the taxpayer, his brother, and a third party (which left the taxpayer with no ownership in the corporation), the taxpayer made a capital contribution of $537,228 to the s corporation, which equaled the amount by which the loan repayment exceeded the taxpayer’s basis in the debt. the consideration for the contribution was the assumption by another shareholder of the taxpayer’s obligation on guarantees of loans from banks to the corporation. in calculating the gain realized upon receipt of the loan repayment, the taxpayer treated the capital contribution as income under § 1366(a)(1) to the s corporation, although excludable income under § 118, and therefore as restoring or increasing under § 1367(b)(2)(b) his bases in the outstanding loans before repayment (rather than increasing his stock basis), thus eliminating any gain. relying on gitlitz v. commissioner, 531 u.s. 206, 216 (2001), the taxpayer argued that because § 118 excludes capital contributions from the gross income of an s corporation, capital contributions are “permanently excludible” and are thus “tax-exempt income” under reg. § 1.1366-1(a)(2)(viii), and that as such it is included as an item of the s corporation’s income to for purposes of § 1366(a)(1) and the resulting § 1367 basis adjustments. the tax court (judge swift) rejected the taxpayer’s argument and upheld the deficiency. by attempting to treat petitioners’ capital contributions to [the corporation] as income to [the corporation], [taxpayers] in effect seek to undermine three cardinal and longstanding principles of the tax law: first, that a shareholder’s contributions to the capital of a corporation increase the basis of the shareholder’s stock in the corporation; ... sec. 1.118-1, income tax regs.; second, that equity (i.e., a shareholder’s contribution to the capital of a corporation) and debt (i.e., a shareholder’s loan to the corporation) are distinguishable and are treated differently by both the code and the courts; ... and third, that contributions to the capital of a corporation do not constitute income to the corporation; sec. 118; ... sec. 1.118-1, income tax regs. 2011] recent developments in federal income taxation 657 we do not believe that the gitlitz holding or the provisions of subchapter s, namely sections 1366(a)(1), 1367(a)(1)(a), and 1367(b)(2)(b), should be interpreted to override these three longstanding principles of tax law. • reg. § 1.118-1 provides that “if a corporation requires additional funds for conducting its business and obtains such funds through *** payments by its shareholders *** such amounts do not constitute income.” thus, shareholder capital contributions are not treated as items of income to an s corporation under § 1366(a)(1) and are not taken into account in calculating the “net increase” under § 1367(b)(2)(b) for the purpose of restoring or increasing a shareholder’s tax basis in loans a shareholder made to an s corporation. such capital contributions are not “tax-exempt income” under § 1366(a)(1) nor under reg. § 1.1366-1(a)(2)(viii) and do not restore or increase the bases in shareholder loans under § 1367(b)(2)(b). a. affirmed, after a trip down memory lane reviewing classic supreme court decisions on the parameters of gross income. nathel v. commissioner, 615 f.3d 83 (2d cir. 6/2/10). after a lengthy review of the classic case law dealing with the parameters of gross income, ranging from eisner v. macomber, 252 u.s. 189 (1920), through edwards v. cuba railroad, 268 u.s. 628 (1925), to commissioner v. glenshaw glass co., 348 u.s. 426 (1955), the second circuit (judge koeltl) held that capital contributions traditionally are not considered to be “income” and, therefore, should not be considered “items of income” under § 1366(a)(1)(a). furthermore, in enacting § 118, congress “has specifically recognized that capital contributions are not income” in that “the legislative history of § 118(a) indicates that the purpose of that section was to codify pre-1954 court decisions holding that certain payments to corporations by nonshareholders should be treated as capital contributions and not as income to the corporations, just as shareholder contributions were not treated as income to the corporations.” furthermore, reg. § 118-1, which provides that “‘voluntary pro rata payments’” to a corporation from its shareholders for the purposes of providing “‘additional funds for conducting [the corporation’s] business ... do not constitute income’” to the corporation,” is entitled to deference and “is fatal to the [taxpayer’s] position.” • the court rejected the taxpayers’ argument that based on the reasoning of gitlitz v. commissioner, 531 u.s. 206 (2001), there would be no reason for § 118 to exclude contributions to capital from gross income if they were not already included in gross income by § 118, concluding that the taxpayer’s view of § 118 was belied by its legislative history. the court also rejected other variations of the same argument. finally, the court rejected the taxpayers’ alternative argument that they should have been allowed to deduct their capital contributions to the s corporation under § 165(c)(2) as losses incurred in a transaction entered into for profit. the tax 658 florida tax review [vol. 10:9 court had found that the taxpayers had not made the contributions for the “‘sole purpose of being released from their guarantees on the bank loans’” and, as a result, it found that the contributions were not deductible pursuant to § 165(c)(2). the second circuit concluded that the tax court’s test was too stringent, holding instead that to be deductible as losses incurred in a transaction entered into for profit the capital contributions needed only to have been made for the primary purpose of obtaining the releases. nevertheless, the tax court’s error was harmless because the taxpayers failed to prove that the primary purpose of the contributions was to obtain the releases from the guarantees. 4. the lifetime of built-in gain gets shorter every year. the small business jobs act of 2010 shortened the holding period under § 1374 for recognizing unrealized built-in gain on conversion from a c corporation to an s corporation to five years preceding the corporation’s tax year beginning in 2011. before the change the holding period was ten years for sales or exchanges in tax years beginning before 2009, and seven years for tax years beginning in 2009 or 2010. e. mergers, acquisitions and reorganizations 1. q: what does the irs do when temporary regulations expire? a: allow taxpayers to rely on the identical proposed regulations. notice 2010-25, 2010-14 i.r.b. 527 (3/18/10). temp. reg. § 1.368-1t(e)(2), t.d. 9316, corporate reorganizations; guidance on the measurement of continuity of interest, 72 f.r. 12974 (3/20/07), dealing with continuity of interest in corporate reorganizations, expired on march 19, 2010, pursuant to § 7805(e)(2). this notice permits taxpayers to rely on prop. reg. § 1.368-1(e)(2) until new regulations are promulgated. however, “the target corporation, the issuing corporation, the controlling corporation of the acquiring corporation if stock thereof is provided as consideration in the transaction, and any direct or indirect transferee of transferred basis property from any of the foregoing, may not apply the provisions of the proposed regulations unless all such taxpayers elect to apply the provisions of such regulations. this requirement will be satisfied if none of the specified parties adopts treatment inconsistent with this election.” a. reg-146247-06, corporate reorganizations; guidance on the measurement of continuity of interest, 72 f.r. 13058 (3/20/07). prop. reg. § 1.368-1(e)(2) would amend reg. § 1.368-1(e), as promulgated in 2005. (the proposed regulations are identical to now expired temp. reg. § 1.368-1t.) under the 2005 regulations, the value of consideration received in a reorganization for purposes of determining whether shareholders received a sufficient proprietary interest in the 2011] recent developments in federal income taxation 659 acquiring corporation was to be determined as of the last business day before the contract is binding. the proposed regulations apply the signing date value only where the contract provides for a fixed consideration. the definition of fixed consideration is modified to provide that consideration is fixed where the contract specifies the number of shares of the issuing corporation to be exchanged for all or each proprietary interest in the target corporation. definitions referring to the percentage of proprietary interests are deleted. the regulations treat transactions that allow for shareholder elections as providing for fixed consideration regardless of whether the agreement specifies a maximum amount of money or a minimum amount of stock of the issuing corporation. (in any event the shareholders are subject to the economic fortunes of the issuing corporation as of the signing date.) the rule that modifications of the contract that increase the number of shares to be issued does not change the signing date is broadened to also state that a modification that decreases the amount of cash or other property to be issued also does not change the signing date. the regulations also tighten the contingent consideration rules by providing that a contract will not be treated as providing a fixed consideration if provisions for contingent consideration prevent the target shareholders from being subject to the economic benefits and burdens of ownership of the issuing corporation as of the signing date. finally the regulations provide that the signing date value must be adjusted to take into account the effect of any anti-dilution clause adjustments to reflect changes in the issuing corporation capital structure. 2. prepaid income is not recognized built-in gain. t.d. 9487, built-in gains and losses under section 382(h), 75 f.r. 33990 (6/16/10). reg. § 1.382-7 provides that for purposes of computing § 382 limitations following an ownership change, prepaid income is not recognized built-in gain. prepaid income is defined as “any amount received prior to the change date that is attributable to performance occurring on or after the change date.” examples include, but are not limited to, income received prior to the change date that is deferred under § 455, reg. § 1.451-5, or rev. proc. 2004-34, 2004-1 c.b. 991 (or any successor revenue procedure). this regulation applies to corporations that have undergone an ownership change on or after 6/11/10, but it merely mirrors former temp. reg. § 1.382-7t, which it replaced. 3. measuring owner shifts of loss corporations under § 382. notice 2010-50, 2010-27 i.r.b. 12 (6/11/10). this notice provides guidance under § 382 for measuring owner shifts of loss corporations that have more than one class of stock outstanding when the value of one class of stock fluctuates relative to another class of stock. the irs will accept use of the “full value methodology,” under which all shares are “marked to market” on each testing date. under this method, the 660 florida tax review [vol. 10:9 percentage of stock owned by any person is determined with reference to “the relative fair market value of the stock owned by such person to the total fair market value of the outstanding stock of the corporation. ... [c]hanges in percentage ownership as a result of fluctuations in value are taken into account if a testing date occurs, regardless of whether a particular shareholder actively participates or is otherwise party to the transaction that causes the testing date to occur ... .” the irs also will accept use of the “hold constant principle.” under this methodology, “the value of a share, relative to the value of all other stock of the corporation, is established on the date that share is acquired by a particular shareholder. on subsequent testing dates, the percentage interest represented by that share (the ‘tested share’) is then determined by factoring out fluctuations in the relative values of the loss corporation’s share classes that have occurred since the acquisition date of the tested share. thus, as applied, the hcp is individualized for each acquisition of stock by each shareholder.” the “hold constant principle” has several variations that the notice identifies as acceptable. an acquisition is not an event upon which the acquiring shareholder marks to fair market value other shares that it holds under any hcp variation. to be acceptable, whichever methodology is selected must measure the increased percentage ownership represented by a stock acquisition by dividing the fair market value of that stock on the acquisition date by the fair market value of all of the outstanding stock of the loss corporation on that date. any alternative treatment of an acquisition is inconsistent with §382(l)(3)(c) and is not acceptable. any method selected, whether the “full value methodology” or a particular variation of the “hold constant principle,” must be applied consistently to all testing dates in a “consistency period.” with respect to any testing date, the consistency period includes all prior testing dates, beginning with the latest of: (1) the first date on which the taxpayer had more than one class of stock; (2) the first day following an ownership change; or (3) the date six years before that testing date. 4. this district court decision, if followed, makes it much much more difficult ever to have personal goodwill as an employee-shareholder. howard v. united states, 106 a.f.t.r.2d 20105533 (e.d. wash. 7/30/10). the taxpayer was a dentist who practiced through a solely owned (before taking into account community property law) professional corporation until the practice was sold to a third party. he had an employment agreement with the corporation with a noncompetition clause that survived for three years after the termination of his stock ownership. the purchase and sale agreement allocated $47,100 to the corporation’s assets, $549,900 for the taxpayer-shareholder’s personal goodwill, and $16,000 in consideration of his covenant not to compete with the purchaser. the corporation did not “dissolve” until the end of the year following the sale. the taxpayer reported $320,358 as long-term capital gain income resulting 2011] recent developments in federal income taxation 661 from the sale of goodwill (the opinion does not explain how the remainder of the sales price was reported), but the irs recharacterized the goodwill as a corporate asset and treated the amount received by the taxpayer from the sale to the third party as a dividend from the taxpayer’s professional service corporation. because the sale occurred in 2002, when dividends were taxed at a higher rate than capital gains, a deficiency resulted. the government advanced three arguments in support of its position: (1) the goodwill was a corporate asset, because the taxpayer was a corporate employee with a covenant not to compete for three years after he no longer owned any stock; (2) the corporation earned the income, and correspondingly earned the goodwill; and (3) attributing the goodwill to the taxpayer-shareholder did not comport with the economic reality of his relationship with the corporation. after reviewing the principles of norwalk v. commissioner, t.c. memo. 1998-279 and martin ice cream co. v. commissioner, 110 t.c. 189 (1998), the court held that because the taxpayer was the corporation’s employee with a covenant not to compete with it, any goodwill generated during that time period was the corporation’s goodwill. the court also rested its holding that the goodwill was a corporate asset on its conclusions that (1) the income associated with the practice was earned by the corporation and (2) the covenant not to compete, which extended for three years after the taxpayer no longer owned stock in the corporation, rendered any personal goodwill “likely [of] little value.” • see solomon v. commissioner, t.c. memo. 2008-102, for an extended discussion of the issues underlying an attempted sale of individual goodwill. f. corporate divisions there were no significant developments regarding this topic during 2010. g. affiliated corporations and consolidated returns there were no significant developments regarding this topic during 2010. h. miscellaneous corporate issues 1. timing is everything to budget windows. under the corporate estimated tax shift act of 2009, as amended by the hire act and the health care and education reconciliation act of 2010, for corporations with at least $1 billion in assets, in determining the estimated tax otherwise due after 12/31/09, the percentages of estimated tax liability required by the tax increase prevention and reconciliation act of 2005 for 662 florida tax review [vol. 10:9 the third quarters of 2010 through 2013 do not apply. prior to enactment of the health care and education reconciliation act of 2010, payments due in july, august, or september, 2014, were increased to 157.75 percent of the payment otherwise due, and the next required payment was to be reduced accordingly. the health care and education reconciliation act of 2010 increases the required payment of estimated tax otherwise due in july, august, or september, 2014, by 15.75 percentage points. 2. they were “engineers” under the irc, even if not under state law. kraatz & craig surveying inc. v. commissioner, 134 t.c. no. 8 (4/13/10). the tax court (judge dawson) upheld the validity of temp. reg. § 1.448-1t(e)(4)(i), under which “engineering” includes surveying and mapping, even though the services were not required by state law to be performed by licensed engineers and were not performed by licensed engineers. whether a corporation is a qualified personal services corporation, as defined in § 448(d)(2), and thus subject to a flat 35 percent tax rate under § 11(b)(2), is determined under all of the facts and circumstances and is not controlled by state licensing laws. 3. textron, schmextron — the irs is going to just require taxpayers to rat out their uncertain positions on the return itself via schedule “come audit me.” this would even permit the irs to send a statutory notice without having to perform an audit. announcement 2010-9, 2010-7 i.r.b. 408 (1/26/10). the irs announced that it was developing a new schedule to be filed with form 1120, which would require corporations with more than $10 million in assets and one or more uncertain tax positions to disclose those positions. the schedule would require both (a) a concise description of each uncertain position for which the taxpayer has recorded a reserve in its financial statement [defined broadly to include some positions for which the taxpayer has not recorded a reserve because it expects to litigate the position or because the taxpayer has determined that the irs has a general administrative practice not to examine the position] and (b) the maximum amount of potential federal tax liability attributable to each uncertain position if it were disallowed in its entirety. • the taxpayer will not be required to disclose the taxpayer’s risk assessment or tax reserve amounts, although in the announcement the irs states that under united states v. arthur young, 465 u.s. 805 (1984), it can compel the production of that information through a summons. to be sufficient, the description must contain: 1. the code sections potentially implicated by the position; 2. a description of the taxable year or years to which the position relates; 2011] recent developments in federal income taxation 663 3. a statement that the position involves an item of income, gain, loss, deduction, or credit against tax; 4. a statement that the position involves a permanent inclusion or exclusion of any item, the timing of that item, or both; 5. a statement whether the position involves a determination of the value of any property or right; and 6. a statement whether the position involves a computation of basis. • a number of the above requirements were eliminated from the final schedule utp. a. draft schedule utp is released. announcement 2010-30, 2010-19 i.r.b. 668 (4/19/10). this announcement released draft schedule utp to form 1120, together with draft instructions. it requires that, beginning with returns filed for years beginning in 2010 and thereafter, the following taxpayers with both uncertain tax positions and assets equal to or exceeding $10 million will be required to file schedule utp if they or a related party issued audited financial statements: (1) corporations who are required to file a form 1120, u.s. corporation income tax return; (2) insurance companies who are required to file a form 1120 l, u.s. life insurance company income tax return or form 1120 pc, u.s. property and casualty insurance company income tax return; and (3) foreign corporations who are required to file form 1120 f, u.s. income tax return of a foreign corporation. • for 2010 tax years, the irs will not require a schedule utp from form 1120 series filers other than those identified above (such as real estate investment trusts or regulated investment companies), pass-through entities, or tax-exempt organizations. the irs stated that it will determine the timing of the requirement to file schedule utp for these entities after comments have been received and considered. • query whether disclosures on schedule utp can serve as substitutes for disclosures made on forms 8275 and 8275r? yes, the instructions so provide. b. proposed regulations authorizing schedule utp, requiring corporations to rat themselves out. reg119046-10, requirement of a statement disclosing uncertain tax positions, 75 f.r. 54802 (9/9/10). the treasury has published proposed amendments to reg. § 1.6012-2 to require corporations to attach a schedule utp, uncertain tax position statement (or any successor form) to their income tax returns in accordance with forms, instructions, or other appropriate guidance provided by the irs. according to the preamble, “[t]he irs intends to implement the 664 florida tax review [vol. 10:9 authority provided in this regulation initially by issuing a schedule and explanatory publication that require those corporations that prepare audited financial statements to file a schedule identifying and describing the uncertain tax positions, as described in fin 48 and other generally accepted accounting standards, that relate to the tax liability reported on the return.” when adopted as a final regulation, this rule will apply to returns filed for tax years beginning after december 15, 2009, and ending after the date of publication of these rules as final regulations. c. read all about it! schedule utp will be less onerous than originally proposed. announcement 2010-75, 2010-41 i.r.b. 428 (9/24/10). the irs announced changes to the proposed schedule utp and delayed implementation for all but the largest taxpayers. the major changes include the following: (1) for corporations with total assets under $100 million, there will be a phase-in of the reporting requirement based on a corporation’s asset size. corporations that have total assets equal to or exceeding $100 million must file schedule utp starting with 2010 tax years. the threshold will be reduced to $50 million starting with 2012 tax years and to $10 million starting with 2014 tax years. (the irs will consider whether to extend all or a portion of schedule utp reporting to other taxpayers for 2011 or later tax years, such as pass-through entities and tax-exempt entities.). (2) the proposed reporting of a maximum tax adjustment has been eliminated. instead, a corporation must rank all of the reported tax positions (including valuation positions) based on the federal income tax reserve (including interest and penalties) recorded for the position taken in the return, and must designate those tax positions for which the reserve exceeds 10 percent of the aggregate amount of the reserves for all of the tax positions reported on the schedule. (3) taxpayers will not be required to report the rationale and nature of uncertainty in the concise description of the position. instead, the schedule utp must provide a concise description of the tax position, including a description of the relevant facts affecting the tax treatment of the position and information that reasonably can be expected to inform the irs of the identity of the tax position and the nature of the issue. (4) the proposed requirement that a corporation report tax positions for which no reserve was recorded because the corporation determined it was the irs’s administrative practice not to raise the issue during an examination has been eliminated. d. irs modifies “policy of restraint” in connection with schedule utp preparation. announcement 2010-76, 2010-41 i.r.b. 432 (9/24/10). the irs modified its “policy of restraint,” which provides that, with certain exceptions, the irs will not assert during an examination that privilege has been waived by a disclosure when a document that was otherwise privileged under the attorney-client privilege, 2011] recent developments in federal income taxation 665 the tax advice privilege in § 7525, or the work product doctrine, was provided to an independent auditor as part of an audit of the taxpayer’s financial statements. see announcement 2002-63, 2002-2 c.b. 72; irm 4.10.20. under the revisions, taxpayers may redact certain information from any copies of tax reconciliation workpapers relating to the preparation of schedule utp it is asked to produce during examination: (a) working drafts, revisions, or comments concerning the concise description of tax positions reported on schedule utp; (b) the amount of any reserve related to a tax position reported on schedule utp; and (c) computations determining the ranking of tax positions to be reported on schedule utp or the designation of a tax position as a major tax position. other than requiring the disclosure of the information on the schedule, the requirement to file schedule utp does not affect the policy of restraint. e. final regulations authorizing schedule utp. t.d. 9510, requirement of a statement disclosing uncertain tax positions, 75 f.r. 78160 (12/15/10). the final regulations authorize the requirement of filing schedule utp, generally following the proposed regulations. they are silent as to the availability of any provision relating to the disclosure of privileged information. • the final regulations apply to tax returns filed only for years beginning after 12/15/09. 4. arra funds nonshareholder contributions? rev. proc. 2010-34, 2010-41 i.r.b. 426 (9/23/10). the american recovery and reinvestment act of 2009 (arra) appropriated $2.5 billion to the rural utilities service of the department of agriculture under the broadband initiatives program (bip) and the national telecommunications and information administration (ntia) of the department of commerce under the broadband technology opportunities program (btop) to expand broadband capabilities. grants under the various programs will be treated as nonshareholder contributions to capital under § 118(a) subject to the basis reduction requirements of § 362(c)(2). 5. miscellaneous and generally obsolete corporate tax rates are extended. the compromise tax relief act of 2010, § 102, which extended the 15% rate on dividends also extended through 2012 the 15% rate applicable to the accumulated earnings tax and the undistributed personal holding company income tax. otherwise the rates would have increased to 39.6%. see joint committee technical explanation, jcx-55-10 (12/10/10), at 26 fn. 29. 6. collapsibles remain collapsed for two more years. the compromise tax relief act of 2010, § 102, extends the repeal of 666 florida tax review [vol. 10:9 the collapsible corporation provisions through 2012. the collapsible corporation rules were originally repealed in 2002 but the repeal was scheduled to expire at the end of 2010. see joint committee technical explanation, jcx-55-10 (12/10/10), at 26 fn. 29. vii. partnerships a. formation and taxable years there were no significant developments regarding this topic during 2010. b. allocations of distributive share, partnership debt, and outside basis 1. expanded anti-abuse rules look at the tax attributes of indirect owners to test allocations of built-in gain or loss. t.d. 9485, contributed property, 75 f.r. 32659 (6/9/10). reg. § 1.7043(a)(10) provides that an allocation with respect to contributed built-in gain or loss property under § 704(c) (or a reverse allocation in the case of a bookup) is not reasonable if the contribution of property and the allocation is made with a view of shifting built-in gain or loss among partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability. the treasury has finalized amendments to reg. § 1.704-3 that adopt without substantial change the proposed regulations in reg-10079806, contributed property, 73 f.r. 28765 (5/19/08). as amended, the regulations provide that in testing for a reduction in aggregate tax liability, the tax consequence to both direct and indirect partners must be considered. indirect partners include the owners of an entity that is a partner and is a partnership, s corporation, estate, trust, or controlled foreign corporation that is a ten percent partner. indirect partners include the members of a consolidated group in which the partner is a member. furthermore, as amended, reg. § 1.704-3(a)(1) provides that the use of allocation methods with respect to built-in gain or loss property only apply to contributions to a partnership that “are otherwise respected.” even though an allocation may comply with the literal language of reg. § 1.704-3(b), (c), or (d) (traditional method, curative allocations, or remedial allocations), “the commissioner can recast the contribution as appropriate to avoid tax results inconsistent with the intent of subchapter k.” the regulations identify remedial allocations among related partners as one factor that may be considered. • effective date. the amendments to the regulations apply to taxable years beginning after 6/9/10, but the preamble specifically notes that “[n]o inference should be drawn from this effective date with respect to prior law.” 2011] recent developments in federal income taxation 667 2. family farm is a partnership. holdner v. commissioner, t.c. memo. 2010-175 (8/4/10). when his son randal expressed little interest in going to college, william holder, an accountant, invested in developing a small family farm for his son to operate with an agreement to divide the profits with an undefined equity interest in the property. as the farming operation expanded, father and son took title to property as tenants in common. on his returns william reported one-half of the income and claimed deductions for all operating expenses. the court (judge marvel) held that the arrangement was a partnership, rejecting the taxpayer’s arguments that they each operated as independent soleproprietors. the court noted that both william and randal contributed properties and labor to the venture which conducted business activities. the court also found that the taxpayers failed to rebut a presumption that the partners shared equal per capita interests in the partnership that applied to all items of income and expenditure and that differing capital contributions did not justify an allocation of all expenditures to william. the court sustained an accuracy related penalty under § 6662 finding that william failed to make a reasonable attempt to ascertain the correctness of his reporting positions. c. distributions and transactions between the partnership and partners 1. forfeitable for decades and thus not guaranteed payments as annually accrued, but 100 percent a guaranteed payment when received. wallis v. commissioner, t.c. memo. 2009-243 (10/27/09). the taxpayer (a tax lawyer) retired as an equity partner in holland & knight, and among other amounts received $240,000 in twelve $20,000 payments over four taxable years. the $240,000 represented accumulated amounts that had been awarded to him as an equity partner over many years, but which were neither currently distributable as awarded nor recorded in the partner’s capital account; rather, the amounts, which were determined annually without regard to partnership income, were payable over a period of time after the partner reached age 68, but were forfeitable if the partner left the firm before that date. the tax court (judge cohen) held that the payments were a guaranteed payment under § 707(c) and § 736(a), taxable as ordinary income, and were not received as distributions under § 731. a. affirmed. tax lawyers have a high standard of “good faith” and “reasonable cause.” wallis v. commissioner, 391 fed. appx. 826 (11th cir. 8/11/10). the tax court was affirmed in an unpublished per curiam opinion. there was sufficient evidence to support the tax court’s conclusion that the payments’ were § 707(c) guaranteed payments. the court also affirmed the imposition of a 668 florida tax review [vol. 10:9 § 6662(a) negligence penalty, rejecting the taxpayer’s “good faith” and “reasonable cause” argument, stating as follows: “given that donald wallis has 35 years of experience as a tax lawyer, the tax court reasonably could conclude that wallis should have been aware there were inconsistencies between (1) his not reporting the schedule c payments at all to the irs and (2) the income form 1099 he received from h&k.” d. sales of partnership interests, liquidations and mergers there were no significant developments regarding this topic during 2010. e. inside basis adjustments there were no significant developments regarding this topic during 2010. f. partnership audit rules 1. partner’s outside basis in a tax-shelter partnership is a partner item. napoliello v. commissioner, t.c. memo. 2009-104 (5/18/09). the taxpayer invested in a son-of-boss transaction involving digital foreign currency items. the irs issued an fpaa to the taxpayer as a notice partner. in the uncontested partnership proceeding it was determined that the partnership was a sham that lacked economic substance, that transactions entered into by the partnership should be treated as transacted directly by the partners, and that purported losses claimed on disposition of distributed property with an enhanced basis should be disallowed. the irs assessed a deficiency against the taxpayer based on the partnership items. the tax court previously had held in petaluma fx partners, llc v. commissioner, 131 t.c. 84 (2008), that the determination of whether a partnership was a sham that will be disregarded for federal tax purposes is a partnership item. in the instant case, the court (judge kroupa) agreed with the irs that the partner’s basis in distributed securities from the sham partnership is an affected item subject to determination in the partnership proceeding, and not subject to re-determination in the partnerlevel deficiency proceeding. because the amount of any loss with respect to the partner’s disposition of securities distributed from the partnership required a factual determination at the partner level, the court held that it had jurisdiction in the partner deficiency proceeding to proceed under normal deficiency procedures. the court thus proceeded to determine that the taxpayer claimed loss on the sale of the distributed securities was disallowed, that the taxpayer’s basis in the securities was their direct cost rather than an exchange basis from the partnership interest, and that the taxpayer was not allowed to deduct transaction costs attributable to the investment. the tax 2011] recent developments in federal income taxation 669 court also held that the fpaa gave the taxpayer fair notice of the irs claims. a. part of the tax court’s holding in petaluma fx partners retains its vitality, but not the part the tax court relied upon in napoliello. petaluma fx partners, llc v. commissioner, 591 f.3d 649 (d.c. cir. 1/12/10). the tax court in this son-of-boss tax shelter case determined that it had jurisdiction in a tefra partnership proceeding to determine that the partnership lacked economic substance and was a sham. since the partnership was disregarded, the tax court concluded that it had jurisdiction to determine that the partners’ outside basis in the partnership was zero. the tax court reasoned that a partner could not have a basis in a partnership interest that did not exist. (131 t.c. 84 (2008).) the court of appeals agreed that the tax court had jurisdiction in the partnership proceeding to determine that the partnership was a sham. temp. reg. § 301.6223-1t(a) expressly provides that, “[a]ny final partnership administrative adjustment or judicial determination ... may include a determination that the entity is not a partnership for such taxable year.” the court of appeals held that the regulation was explicitly authorized by § 6233. a partnership item is defined in § 6231(a)(3) as an item required to be taken into account in determining the partnership’s income under subtitle a of the code that is identified in regulations as an item more appropriately taken into account at the partnership level. the court indicated that, “logically, it makes perfect sense to determine whether a partnership is a sham at the partnership level. a partnership cannot be a sham with respect to one partner, but valid with respect to another.” however, the appeals court concluded that the partners’ bases were affected items, not partnership items, and that the tax court did not have jurisdiction to determine the partners’ bases in the partnership proceeding. the court rejected the irs argument that the tax court had jurisdiction in the partnership proceeding to determine the partners’ outside basis as an affected item whose elements are mainly determined from partnership items. the court held that resolution of the affected item requires a separate determination at the partner level even though the affected item could easily be determined in the partnership proceeding. finally, the court of appeals held that accuracy related penalties under § 6662(a) could not be determined without a determination of the partners’ outside basis in a partner level proceeding and vacated and remanded the tax court’s determination of penalty issues. b. on remand, the tax court disavowed jurisdiction over penalties in the partnership-level proceeding. petaluma fx partners, llc v. commissioner, 135 t. c. no. 29 (12/15/10). the court (judge goeke) held that in light of the court of appeals holding that determination of adjustments attributable to the partner’s outside basis is an 670 florida tax review [vol. 10:9 affected item properly addressed in individual partner level proceedings, any § 6662 penalties must also be determined at the partner-level proceeding and that the tax court had no jurisdiction to assess the penalties. the court rejected the irs argument that the penalties proceeded from the partner-level determination that the partnership was a sham, thereby providing jurisdiction for the tax court to determine the negligence penalty. the tax court held that if a penalty “does not relate directly to a numerical adjustment to a partnership item, it is beyond our jurisdiction. in this case there are no such adjustments to which a penalty can apply.” judge halpern dissented, asserting that the tax court could reconsider the penalty on grounds other than the partners’ outside bases under the court’s initial findings that the partnership was a sham and did not provide the basis increase claimed by the partners. a dissent by judge marvel (joined by three others) argued that the tax court has jurisdiction to determine the imposition of a penalty for negligence related to adjustment of a partnership item in the partnership level proceeding, but the amount of the individual penalty depends upon a computation at the partner level. 2. partnership audit rules extend the statute of limitations. curr-spec partners, l.p. v. commissioner, 579 f.3d 391 (5th cir. 8/11/09). section 6501(a) provides a three-year statute of limitations for assessing tax deficiencies. section 6229(a) provides that the period for assessing a deficiency attributable to a partnership item does not expire until three years after the later of the date of a partnership return or the due date for the partnership return. the irs issued an fpaa disallowing claimed partnership losses four years after the partnership return was filed, and assessed deficiencies against the partners for years into which the losses were carried forward. the assessment to individual losses disallowing the loss carryforwards were within the three-year statute of limitations applicable to the partners’ returns. the fifth circuit affirmed the tax court holding that § 6229(a) does not establish an independent three-year statute of limitations with respect to partnership items, but merely extends the limitations period of § 6501(a). thus, assessment of a deficiency against partner’s whose individual return remains open is not barred by any limitation period in § 6229(a). a. the tax court agrees. lvi investors, llc v. commissioner, t.c. memo. 2009-254 (11/9/09). the court (judge nims) followed its holding in curr-spec partners as affirmed by the fifth circuit. section 6501(a) provides a three year assessment period after an individual’s return is filed. section 6229(a) provides that the period for assessing any tax attributable to a partnership item or an affected item expires three years after the latter of the due date of the partnership return or the date the partnership return was filed.. the court held that § 6229 does not override § 6501 and 2011] recent developments in federal income taxation 671 instead sets a minimum limitations period that may extend the § 6501(a) period. b. as does the eastern district of texas. bemont investments, llc v. united states, 105 a.f.t.r2d 2010-1256 (e.d. tex. 3/5/10). on taxpayer’s motion for partial summary judgment on the statute of limitations, magistrate judge bush held that curr-spec partners required that the motion be denied. (1) in another motion decided on the same day, magistrate judge bush decided that taxpayer’s expert witness david weisbach may testify as to whether the tax opinions received complied with applicable tax opinion standards and whether they complied with circular 230, but not as to whether taxpayer’s actions were reasonable (which is a matter for the court). 3. krause v. united states, 105 a.f.t.r.2d 2010-1899 (w.d. tex. 1/22/10). partners who didn’t contest an fpaa were not permitted to raise partnership level defenses to § 6662(h) valuation misstatement penalties in a separate refund action. the taxpayer’s claim that a valuation misstatement penalty is not allowable with respect to a disallowed partnership deduction is a substantive defense that must be raised in the partnership proceeding. the assertion does not constitute a computational error or partner-level defense permitted in a refund action under § 6230(c). a. affirmed. krause v. united states, 106 a.f.t.r.2d 2010-6736 (5th cir. 10/12/10). the court held in a per curiam opinion that the penalties assessed in the fpaa were attributable to the “fraudulent” loss the partnership alleged it incurred when it sold high basis canadian currency, which passed thought to the taxpayer. thus, the penalties “related to basis, basis adjustments, and losses, all of which are considered partnership items under § 6231.” 4. the applicable statute of limitations is a partnership item, even on the second try. prati v. united states, 603 f.3d 1301 (fed. cir. 5/5/10). the taxpayers invested in tax shelters promoted by amcor in the mid-1980s. in a partnership audit procedure, following issuance of an fpaa, the tax court held rejected partnership assertions that the fpaa was barred by the statute of limitations. agri-cal venture associates v. commissioner, t.c. memo 2000-271. some of the 43 partnerships entered into a settlement agreement with the irs that allowed a percentage of ordinary deductions, but provided that the irs may assert additional tax liability against individual partners plus interest. subsequently 672 florida tax review [vol. 10:9 the irs assessed additional tax plus penalties against the taxpayers, which they paid in full. seventy-seven of 129 amcor partnership tax refund cases filed in the court of federal claims were identified as being factually similar raising claims that the statute of limitations had expired and that assessments of additional interest under § 6621(c) were improper because the transactions were not tax-motivated transactions. prati was selected as a representative case. the trial court dismissed the action accepting the irs assertion that the court lacked jurisdiction to consider the claims that represented partnership items that should have been challenged in the partnership level proceeding. ultimately 57 cases were appealed but stayed pending the court’s decision in keener v. united states, 551 f.3d 1358 (fed. cir. 1/8/09), which held that the statute of limitations is a partnership item as defined in § 6231(a), and that whether a partnership transaction is a sham is a partnership item for purposes of the additional interest provision. in keener the court rejected a claim that the fpaa was untimely under § 6229 (three years after the date a partnership return is filed or the last day for filing the partnership return), but did not address a separate assertion that the claim was barred by the general three year limitation of § 6501 (three years from the date an individual’s return is filed). notwithstanding representations by the taxpayers before keener was decided that the case would be determinative, the federal circuit considered the § 6501 argument, but reached the same result. the court concluded that the reasoning in keener was directed to statutes of limitation in general and was not limited to § 6229. the court also applied the reasoning of keener to the taxpayers’ § 6621(c) interest claim to hold that the characterization of partnership transactions is a partnership item. the court rejected the assertion that the taxpayers’ settlement agreements converted the items into non-partnership items. a. kercher v. united states, 106 a.f.t.r.2d 2010-7097 (e.d. tex. 11/16/10). in a proceeding involving a representative seven partnership level proceedings against tax shelter investors in 43 deals promoted by american agri-corp (amcor), the tax court rejected statute of limitations defenses raised by the partnerships in agri-cal venture associates v. commissioner, t.c. memo. 2000-271. each of the 43 partnerships stipulated it would be bound by the decision. in separate actions by individual partners, the district court (magistrate judge mazzant) held that under prati, the statute of limitations argument had been decided in partner level proceedings and that the individual partners were barred from asserting the argument in individual refund claims. the court also rejected the taxpayer’s argument that they were barred from raising the statute of limitations issue in the partnership proceeding. 5. tmp’s sole shareholder doesn’t get to file a separate tax court petition. devonian program v. commissioner, t.c. 2011] recent developments in federal income taxation 673 memo 2010-153 (7/19/10). the taxpayer was the sole shareholder of basin gas corp. which was designated as the tax matters partner in devonian program, a partnership. the devonian subscription agreement indicated that basin would receive a flat fee for its services and contribute $3,000 to devonian for a 17 percent interest in devonian’s revenues. after the irs issued an fppa to devonian, basin filed a petition with the tax court as the tax matters partner. subsequently, the taxpayer, the sole shareholder of basin, filed a second petition claiming that basin was only an agent and not a partner in devonian. the tax court (judge goeke) held that the court lacked jurisdiction to consider the second petition, finding that basin was a partner in the partnership and the designated tax matters partner. the court rejected the taxpayer’s argument that basin held only a contingent interest in the partnership, finding that basin could assign the interest and that basin’s interest in revenues was a partnership share rather than payment for services. the opinion does not indicate why basin’s sole shareholder independently sought to file a petition with the tax court. 6. son-of-boss – the shelter that keeps on taking. legal fees for creating a son-of-boss transaction are affected items. domulewicz v. commissioner, t.c. memo. 2010-177 (8/5/10). the taxpayers entered into a bdo seidman / jenkens & gilchrist son-of-boss transaction by creating a subchapter s corporation that held an interest in a partnership. the s corporation was owned by a grantor trust. the s corporation paid $1,053,400 of legal fees related to the transaction. under an fpaa issued to the partnership the irs determined that the partnership was a sham whose existence was disregarded. after the fpaa became final, the irs issued an affected item notice of deficiency to the individual investors disallowing deduction of the legal fees passed-through from the s corporation. the court (judge laro) rejected the taxpayers’ argument that the deficiency was barred by the statute of limitations because the fees, incurred by the s corporation, were not affected partnership items. citing thomas v. united states, 166 f.3d 825 (6th cir. 1999), the court held that the fees and the s corporation deduction were affected by the partnership item determination in that the fees were nondeductible given the lack of a profit or business motive flowing from the partnership level determination. the fact that the fees were not incurred or deducted by the partnership did not remove the fees from being treated as affected items. the court pointed out further that the relationship between the partnership, the fees, the s corporation, and the taxpayers could not have been determined at the partnership level but had to be determined at a partner level proceeding. therefore, the running of the statute of limitations was suspended under § 6229(d) until 60 days after the decision in the partnership proceeding became final. the fees were affected items because they were related to the transaction and were related to the partnership in that they were paid, at least in part, to form the partnership and 674 florida tax review [vol. 10:9 to effect the transaction as it related to the partnership. the fees were the type of affected item assessable only through the deficiency procedures, because they required partner-level determinations to ascertain the portion (if not all) of the fees related to the partnership and to the transaction and which were thus nondeductible. 7. the irs gets a second bite at this tefra apple even if the in-house rules were not followed. npr investments, llc v. united states, 106 a.f.t.r.2d 2010-5788 (e.d. tex. 8/10/10). npr was a partnership formed to execute a r.j. ruble, sidley austin, son of boss abusive tax shelter deal. the three partners were partners in a plaintiffs contingency fee law firm, and two of them were the taxpayers in klamath strategic investment fund, llc v. united states, 568 f.3d 537 (5th cir. 5/21/09). when the partners withdrew from npr, they transferred the inflated basis foreign currency from npr to their law firm partnership. on its tax return, npr indicated that it was not a partnership subject to tefra audit procedures, when in fact it was a tefra partnership. in the initial audit of npr’s returns, the irs applied normal partnership audit procedures and issued a final no adjustment notice to the partnership. rather than proposing adjustments to the npr return, the irs determined that it would deny loss deductions through the issue of notices of deficiency directly to the npr partners. in a higher level review, the irs determined that npr was a tefra partnership and that the deficiency action required issue of an fpaa to the npr partners adjusting npr partnership items. section 6223(f) provides that if the irs mails a final partnership administrative adjustment, it may not mail another notice in the absence of a showing of fraud, malfeasance, or misrepresentation of a material fact. the taxpayers argued that the second notice was invalid. the court (judge ward) found that the initial notice to npr met the statutory criteria for an fppa, even though it was sent through the normal audit process. the court indicated that there is nothing in statute or case law that affects the validity of an fppa by whether the irs followed proper internal procedures in issuing the notice. however, the court also found that the taxpayer’s misrepresentation of the tefra audit status on npr’s partnership return by failing to check the box indicating it was subject to the tefra provisions was a “misrepresentation of a material fact” invoking the exception in § 6223(f) that allows a second notice. • the court also held that the taxpayers reasonably relied on their tax advisors and declined to impose penalties under §§ 6662(b) and 6664(c)(1). 8. the $9,500 deposited was only $2.9 million short; that’s a reasonable mistake. kislev partners, l.p. v. united states, 84 fed. cl. 385 (8/13/08). the taxpayer, a non-tax matters partner, filed an action 2011] recent developments in federal income taxation 675 seeking review of a final partnership administrative adjustment for kislev partners, which claimed $140 million of losses in an abusive tax shelter known as a distressed asset/debt transaction (dad). in order to invoke jurisdiction in the court of federal claims, a filing partner is required under § 6226(e)(1) to make a deposit of the amount by which the taxpayer’s tax liability would be increased if the partner’s return were filed consistent with the treatment of partnership items in the fpaa. in this case the taxpayer made a deposit of $9,500 reflecting the taxpayer’s potential tax liability for the year in which the claimed losses were passed through from the partnership. the taxpayer did not calculate the deposit based on the taxpayer’s liability for years to which he carried over the losses. the correct amount of the deposit, including claimed tax reductions in the carryover years was $2,905,046, exclusive of penalties and interest. the court held that the deposit amount is to be calculated over multiple taxable years. however, the court was satisfied that the taxpayer made a good faith effort to determine the deposit under the statute and denied the government’s motion to dismiss, as long as the taxpayer has made the additional deposit within 60 days of the date of the opinion. a. go figure the deposit and come back. russian recovery fund ltd. v. united states, 90 fed. cl. 698 (12/14/09). section 6226(a) requires that in order to petition for a readjustment of a partnership item in the court of federal claims, the petitioning partner must provide a deposit of the amount by which the tax liability of the petitioning partner would be increased if the treatment of partnership items on the partner’s return were consistent with the fpaa. reg. § 301.6226(e)-1(a)(1) requires that if the petitioning partners is itself a partnership, the deposit must include the potential liability of each indirect partner. in an arrangement with losses flowing to partners through multiple partnerships, the court held that the deposit must be calculated by any downstream partner to include losses flowing through the chain of partnerships, and not just losses passing through a single filing partnership. the filing partner’s $50,000 actual deposit was increased to a required deposit of $8 million under this interpretation. rather than dismiss the case, however, the court allowed the taxpayer to show that she made a good faith effort to calculate the required deposit. b. different judge, the court of federal claims reaches a different result opening the jurisdictional door to easier entry. prestop holdings, llc v. united states, 106 a.f.t.r.2d 20107246 (fed. cl. 12/07/10). in both russian recovery fund, ltd. v. united states, 90 fed. cl. 698 (12/14/09) and kislev partners, l.p. v. united states, 84 fed. cl. 385 (8/13/08), the court interpreted § 6226(e)(1) as requiring a deposit based on the partner’s entire multi-year increase in tax liability. the taxpayer in prestop was a grantor trust partner that claimed losses from 676 florida tax review [vol. 10:9 partnership short sale transactions of approximately $2.6 million, most of which were carried over to later taxable years. rejecting the analysis of both russian recovery and kislev partners, the court (judge allegra) concluded that the specific language of § 6226 along with multiple indications throughout the tefra provisions indicated that the provisions applied to a single tax year under the annual accounting system. thus, the court held that the full payment requirement of § 6226(e)(1) applied only to the tax years for which the taxpayer was seeking a refund. as a result, the taxpayer’s $100 deposit was adequate to establish jurisdiction in the court to consider the taxpayer’s challenge to administrative adjustments in the partnership return for the year in which the full loss was passed to the taxpayer trust. g. miscellaneous 1. oops. no, no, i’m ok after all. rev. proc. 2010– 32, 2010-36 i.r.b. 320. (9/7/10). this procedure provides that if a foreign entity makes a check the box election to be a partnership, under the reasonable assumption that it has more than one owner, but then determines that it only had one owner, the original check the box election will be treated as an election to be a disregarded entity provided the requirements in the revenue procedure are satisfied. similarly, it also provides that if a foreign entity makes a check the box election to be disregarded entity, under the reasonable assumption that it has only one owner, but then determines it only had more than one owner, the original check the box election will be treated as an election to be a partnership provided the requirements in the revenue procedure are satisfied. 2. the irs gets serious about series. reg-11992109, series llcs and cell companies, 75 f.r. 55699 (9/14/10). proposed regulations would determine the entity status of series llcs with reference to current rules. several states have enacted statutes providing that llcs may establish “series,” which are generally not treated as separate entities for state law purposes and which do not generally cannot have members, although each series may have associated with it specified members, assets, obligations and investment purpose or business objectives. the state statutes provide a significant degree of separateness for individual series within a series llc but not all of the attributes of a typical state law entity. other statutes provide for chartering of a legal entity known as a protected cell company that establishes multiple accounts or cells, each with its own name and identified with a specific participant. the assets of each series or cell generally are protected from creditors of any other series or cell and from creditors of the series llc or cell company. a series organization would be defined as a juridical entity that establishes and maintains a series, including 2011] recent developments in federal income taxation 677 a series limited liability company, series partnership, series trust, protected cell company, segregated cell company, segregated portfolio company, or segregated account company. a series would be defined as a segregated group of assets and liabilities that is established pursuant to a series statute by agreement of a series organization. • the proposed regulations would recognize a series as an entity formed under local law and would provide that whether a series is a separate entity is determined under reg. § 301.7701-1 and general tax principles. • the proposed regulations would provide that a series would not cease to be treated as a separate entity if the series assets were not protected from creditors. • a series that is recognized as a separate entity would be classified under the rules of reg. § 301.7701-2. thus a series that meets the corporation definition under reg. § 301.7701-2(b)(1) through (8) would be treated as a corporation for federal tax purposes regardless of the classification of the series organization. • identity of the owners of a series would be determined under general tax principles that look to who bears the economic benefits and burdens of ownership. • generally, domestic series would be classified as separate local law entities based on the characteristics granted to them under the various series statutes. • the proposed regulations would not apply to a series formed under the laws of a foreign jurisdiction except that an entity that would be treated as an insurance business if it were a domestic insurance entity, would be treated as a separate entity under the proposed regulations. • if local law permits creditors to collect a liability attributable to a series from the series organization or other series of the organization, then the series organization will be considered the taxpayer from which taxes assessed against the series may be collected. • the proposed regulations do not address the application of employment taxes to employees of a series or the series organization. • the proposed regulations would be effective on the date of publication in the federal register, and may require reclassification of some series as of that date with the tax consequences of conversion determined under general tax principles. the proposed regulations include an exception for series established prior to publication of the proposed regulations that treat all series and the series organization as one entity. • the preamble requests comments on a list of specified questions. 678 florida tax review [vol. 10:9 viii. tax shelters a. tax shelter cases and rulings 1. sala. district court holds for the taxpayer on the merits in an options transaction for which r.j. ruble provided the tax opinion. sala v. united states, 552 f. supp. 2d 1167 (d. colo. 4/22/08). the district court (judge babcock) held that taxpayer was entitled to a $60 million ordinary loss on 24 long and short currency options entered into in november 2000 as part of a deerhurst program, in which the options were contributed to a partnership. the basis of that partnership interest was increased by the cost of the long options but was not reduced by the contingent liability on the short options under helmer v. commissioner, t.c. memo. 1975-160 (1975). this was based upon judge babcock’s finding of fact that the long and short options were separate instruments for tax purposes. the court found that the regulations issued in 2003, reg. § 1.7526, retroactive to october 1999, which contained an “exception to the exception” for transactions described in notice 2000-44, exceeded treasury’s authority. judge babcock held that the regulations were not legislative because the “exception to the exception” was not comparable to the rules for corporations described in § 358(h). judge babcock concluded that the corporate rules were only “to prevent acceleration or duplication of losses,” which were not involved in the transactions described in notice 2000-44. he refused to follow cemco investors, llc v. united states, 515 f.3d 749 (7th cir. 2008). • judge babcock analyzed the complex transaction under the step transaction doctrine and found the doctrine inapplicable. • he found the losses deductible under § 165(c)(2) because they were incurred in a transaction entered into for profit, which was to be determined at the time taxpayer entered into the transaction, and not in hindsight. in this, judge babcock credited sala’s testimony that “he expected his investment in deerhurst to be profitable above and beyond the expected tax loss . . . .” • he found the taxpayer was “an extremely cautious investor who invested a great deal of time and energy carefully researching and choosing his investments” and that he had a business purpose other than tax avoidance for structuring his investment as he did. • judge babcock further held that sala’s amended return filed on 11/18/03 was a “qualified amended return” because kpmg had not been contacted regarding deerhurst prior to that date, although it had been previously contacted regarding transactions similar to deerhurst. 2011] recent developments in federal income taxation 679 a. government motion on 6/10/08 for new trial based upon affidavit given in connection with decision not to prosecute investment manager. andrew j. krieger, a key witness for the taxpayer, stated in an affidavit dated 5/22/08 that a portion of the testimony he gave at deposition was false, in that there was no “test period” for an “investment program” but merely an effort to obtain tax savings. 2008 tnt 114-15. the motion was opposed by the taxpayer because krieger gave his affidavit only after the government granted him immunity from prosecution by executing a non-prosecution cooperation agreement in connection with a criminal investigation unrelated to this case, i.e., the coplan criminal case pending in the southern district of new york. 2008 tnt 130-62, 7/1/08. b. government motion for new trial denied. 251 f.r.d. 614, 102 a.f.t.r.2d 2008-5292 (7/18/08). judge babcock denied the motion, holding that the evidence submitted by the government was not new. he stated, “rather than implying diligence, the timing of this ‘new’ evidence instead implies a deliberate attempt on the part of the government to further delay and derail this case for tactical gain.” c. tenth circuit reverses judge babcock for his sala’d days. sala v. united states, 106 a.f.t.r.2d 2010-5406 (10th cir. 7/23/10). the tenth circuit (judge murphy) reverses judge babcock’s ruling in favor of sala on all issues by severing the year-2000 tax loss from the post-2000 deerhurst program and finding that the 2000 transaction lacked economic substance because “the economic substance doctrine requires ‘disregarding, for tax purposes, transactions that comply with the literal terms of the tax code but lack economic reality.’” • judge murphy observed: indeed, rather than suffering any actual financial loss through deerhurst gp, sala actually profited from the transaction. sala does not contest that the loss is fictional, but rather protests that the rule from helmer should control. this argument does not, however, address the claimed loss’s absence of economic reality. the absence of economic reality is the hallmark of a transaction lacking economic substance. ... additionally, while the district court found the long and short options had a potential to earn profits of $550,000 over the course of one year, the expected tax benefit was nearly $24 million. that expected tax benefit dwarfs any potential gain from his participation in deerhurst gp such that “the economic realities of [the] transaction are insignificant in relation to the tax benefits of the transaction.” ... the existence of some potential profit is 680 florida tax review [vol. 10:9 “insufficient to impute substance into an otherwise sham transaction” where a “common-sense examination of the evidence as a whole” indicates the transaction lacked economic substance. 2. wells fargo. “the silo transactions here are offensive to the court on many levels.” wells fargo & co. v. united states, 91 fed. cl. 35 (1/8/10). wells fargo engaged in 26 silo transactions, five of which were tried in this refund case in the court of federal claims. seventeen of the silos involved domestic transit agencies and nine involved qualified technological equipment. the trial dealt with four silos involving public transit agencies, and one involving cellular telecommunications equipment. the parties agreed that the court’s ruling with respect to the five transactions would guide the resolution of the remainder. the court’s fact findings are synopsized in the following passage from the opinion by judge wheeler: in each transaction, the parties employed equity and debt “defeasance accounts,” which are types of escrow accounts intended to minimize the risks of non-payment. during the lease-back period, a return is generated from the equity defeasance account investments. the value of the equity defeasance account is expected to grow so that the taxexempt entity can exercise the buy-out option at the end of the lease-back period without using any of its own funds. however, the equity defeasance account return is more than offset by the other costs of the transaction, including wells fargo’s cost of funds to engage in the transaction. the end result is that the trial transactions produce an overall loss without the tax benefits, and no rational person would engage in these transactions absent the tax benefits. this conclusion is borne out by wells fargo’s cessation of silo transactions after the irs began disallowing silo tax deductions. moreover, the profitable portion of the transactions could be realized simply by investing in the same portfolio as the equity defeasance account. the only reason to create the elaborate array of agreements comprising a silo transaction is for wells fargo to obtain the tax benefits at minimal risk, and with complete assurance of the desired long-term outcome. • the essence the court’s ultimate holding is captured in the following passages from the opinion: the court finds that wells fargo is not entitled to the claimed tax deductions on the five trial transactions. the silo transactions did not grant to wells fargo the burdens 2011] recent developments in federal income taxation 681 and benefits of property ownership. the transactions lack economic substance, and were intended only to reduce wells fargo’s federal taxes by millions of dollars. although well disguised in a sea of paper and complexity, the silo transactions essentially amount to wells fargo’s purchase of tax benefits for a fee from a tax-exempt entity that cannot use the deductions. the transactions are designed to minimize risk and assure a desired outcome to wells fargo, regardless of how the value of the property may fluctuate during the term of the transactions. indeed, nothing of any substance changes in the tax-exempt entity’s operation and ownership of the assets. the only money that changes hands is wells fargo’s up-front fee to the tax-exempt entity, and wells fargo’s payments to those who have participated in or created the intricate agreements. the equity and debt “loop” transactions simply are offsetting accounting entries not involving actual payments, or pools of money eventually returned to the original holder. if the court were to approve of these silo schemes, the big losers would be the internal revenue service (“irs”), deprived of millions in taxes rightfully due from a financial giant, and the taxpaying public, forced to bear the burden of the taxes avoided by wells fargo. ... the heart of these transactions is that wells fargo paid a fee to tax-exempt entities to acquire valuable tax deductions that the tax-exempt entities could not use. wells fargo also invested an amount with an equity undertaker that it could have done directly, without involving any taxexempt entities or their equipment. aside from these two elements, the circular flow of funds adds nothing to the transaction, except to eliminate any risk to wells fargo and to produce more claimed tax deductions. the involvement of lenders like aig, appraisers like ernst & young, and law firms like king & spalding is “window dressing” serving only to generate fees and lengthy documents to give the silos an appearance of validity. the indiana district court hit the mark when it described the silo as a “blatantly abusive tax shelter” that is “rotten to the core.” hoosier energy rural elec. coop., inc. v. john hancock life ins. co., 588 f.supp.2d 919, 921, 928 (s.d. ind. 2008), aff’d 582 f.3d 721 (7th cir. 2009). • after first holding that wells fargo was not entitled to depreciation deductions because it never obtained the benefits and burdens of ownership, and was not entitled to interest deductions, 682 florida tax review [vol. 10:9 because the loop nonrecourse debt was not genuine indebtedness — “the lenders did not relinquish the use of the money except for the brief one-day loop ... [and neither] wells fargo nor the tax-exempt entity ever had the use of the funds” — the court held alternatively that the transactions lacked economic substance under the standards of coltec industries v. united states, 454 f.3d 1340 (f3d. cir. 2006), cert. denied, 549 u.s. 1206 (2007). the transactions lacked objective economic substance because the source of the non-tax economic benefit to wells fargo, when the silos terminated, was merely the return of its investment, plus the interest earned. ... wells fargo could have realized this same return simply by investing in the portfolio of the equity defeasance arrangement, without involving the [counter-parties] ... in any way. ... ... though the mountains of paper defy comprehension without careful study, the bottom line is that the silos provide no reasonable possibility of profit at all, absent a claim for the tax deductions. wells fargo’s cost of funds alone turns the silos into a losing proposition. wells fargo’s witness ... agreed that the cash-on-cash, non-tax return calculated is less than wells fargo’s cost of funds for its leasing business. ... ... [w]hen all transactional and funding costs are considered, the non-tax return is negative. thus, if not for the tax deductions, no rational business entity would seriously contemplate a silo transaction. • the transactions failed the subjective branch of the economic substance test because they had no non-tax business purpose. ... without the claimed tax benefits, and without the company’s tax capacity to use the claimed tax benefits, wells fargo would not have entered into the silo transactions. ... the motivating reason for the wells fargo silos was the desire to reduce the company’s taxes as much as possible. there were no non-tax reasons that would justify wells fargo’s entering into these transactions. the lack of any arms’ length negotiations of many substantive terms is a further indication of a questionable transaction. the key terms of the silos were determined by tax considerations, and wells fargo’s constraints to eliminate risk. the transaction terms were more the product of a software model, than any negotiations or commercial realities. • the court distinguished consolidated edison co. of new york v. united states, 90 fed. cl. 228, 104 a.f.t.r.2d 2011] recent developments in federal income taxation 683 2009-6966 (2009), as a “distinctly unique” case, and found the transactions in wells fargo to be like those in awg leasing trust v. united states, 592 f. supp. 2d (n.d. ohio 2008), and bb&t corp. v. united states, 523 f.3d 461 (4th cir. 2008), aff’g 99 a.f.t.r.2d 2007-376 (m.d. n.c. 2007), in which deductions from lilo transactions were disallowed. 3. confining the frank lyon co. result to its facts as understood by the supreme court. “the court [in frank lyon co.] also emphasized, in contrast to this case the transaction did not create any tax deductions, because lyon and worthen paid taxes at the same rate.” altria group, inc. v. united states, 694 f. supp. 2d. 259 (s.d. n.y. 3/16/10). in a refund suit involving several silo and lilo tax shelters with respect to infrastructure originally owned by tax indifferent parties, a jury rendered a verdict for the government, finding that the transactions lacked economic substance. on the taxpayer’s motion for judgment as a matter of law and, alternatively, for a new trial, judge holwell ruled in favor of the government. he generically described the four transactions as follows: in each transaction, altria immediately leased the asset back to its original owner using agreements with a number of unusual features, including complete defeasance (prepayment, in essence) of the lessee’s rent and an owner’s option to repurchase the asset. altria then claimed depreciation, amortization, interest expense, and transaction expense deductions on its 1996 and 1997 corporate tax return based on its newly acquired assets, even though (i) its purchase money immediately was invested in securities that the nominal lessees could not access without providing substitute collateral, and (ii) the lessees could reacquire the assets without incurring any out-of-pocket costs. • in the course of extensive discussion of the import of frank lyon co. v. united states, 435 u.s. 561 (1978), judge holwell deftly confined that case to its facts as understood by the supreme court, stating, “the court also emphasized, in contrast to this case the transaction did not create any tax deductions, because lyon and worthen paid taxes at the same rate.” referring again to the supreme court’s frank lyon decision, he observed: “the supreme court, however, has expressly indicated that a transaction’s effect on the u.s. treasury must inform a federal court’s analysis of whether a transactional form chosen selected by a taxpayer should be respected for federal tax purposes.” judge holwell went on to discuss of the application of a flexible economic substance doctrine test under second circuit precedent, but he described it all as “dicta” in light of the jury’s verdict. he described second circuit law as requiring “an analysis under which the fact finder must consider both aspects of the economic substance inquiry, and may (but need not) find against the taxpayer if a transaction lacks either a legitimate 684 florida tax review [vol. 10:9 business purpose or an economic effect.” on this basis, the court rejected altria’s argument that because the facts established that it expected to receive a nontax-based return of 2.5% to 3.8% from the transactions it was entitled to judgment as a matter of law. “[t]he jury’s finding that altria lacked a legitimate business purpose for entering the transactions, even if at the limits of what present doctrine allows, was sufficient to support its economic substance verdict.” • note that under new § 7701(o), if a court applies the economic substance doctrine to transactions entered into after 3/30/10, it must apply a conjunctive test under which the claimed tax benefits must be disallowed unless (1) the transaction changes the taxpayer’s economic position in a meaningful way apart from federal income tax effects and (2) the taxpayer has a substantial business purpose, apart from federal income tax effects, for entering into such transaction. 4. partnership anti-abuse rules are applied to eliminate losses in a transaction that lacked economic substance. did this court initiate the use of reg. § 1.701-2? nevada partners fund, llc v. united states, 714 f. supp. 2d. 598 (s.d. miss. 4/30/10). the district court upheld the irs recharacterization of a tax shelter strategy involving kpmg, called the family office customized strategy (focus) in eleven separate actions challenging final partnership administrative adjustments (fpaas). the court agreed with the irs that the transactions were subject to recharacterization under the anti abuse rules of reg. § 1.701-2. the tax matters partner in all of the proceedings was james kelly williams who had substantial gains in tax years 2001 and 2002. the transaction developed by kpmg utilized a multiple tier structure, the creation of a fund of funds llc, an alternative investment fund llc and a third tier llc that invested in collared long and short currency futures with credit suisse first boston. gains on long positions were invested in cds with credit suisse, suspended losses on short positions remained in the investment funds. the tax shelter investor then purchased the funds to acquire the suspended losses with a capital contribution, in the form of debt guarantees with credit suisse, to establish basis. the transaction was blessed with opinions from the arnold & porter firm. the court recognized these transactions as artificial high basis transactions described in notice 2000-44, 2000-36 i.r.b. 255 (boss and son of boss type transactions). while noting that the boss type transactions had been challenged by the irs, the court also indicated that kpmg hoped that the focus strategy was structured in a way that would avoid irs scrutiny and did not register the deal as an abusive tax shelter. the court found that “the central point in 2001 of following the strategy being promoted by kpmg was to ameliorate williams’ tax situation, regardless of williams’ investment activity.” after a lengthy analysis of economic substance cases, the court stated that “the focus steps were a series of 2011] recent developments in federal income taxation 685 transactions lacking economic substance and comprising an abusive tax shelter designed to permit an investor such as james kelley williams to purchase losses embedded in a tiered partnership structure and to reduce substantially, if not entirely, his federal tax liability for the 2001 tax year in a manner inconsistent with the intent of subchapter k.” the court also refused to conflate the focus generated losses with subsequent successful investments with the hedge fund, the ncr bricolage companies, that managed the investments. thus, the court held that the irs appropriately recast the transaction under reg. § 1.701-2 to deny the losses. with regard to the irs assertion of penalties, the court held that james kelly williams was required to raise any reasonable cause and good faith defenses in a separate partner level refund action. the court sustained imposition of 20 percent understatement of income and 20 percent negligence penalties (which are not stacked) on the partnerships and rejected the partnerships’ assertions that the focus positions were supported by substantial authority and that the partnerships could have reasonably relied on the advice of professionals. a. different district court, same result. fidelity international currency advisor a fund, llc v. united states, 105 a.f.t.r.2d 2010-2403 (d. mass. 5/17/10). richard egan (a former ambassador to ireland) was one of the founders of emc corporation, a large publically traded entity that developed computer storage devices. in order to avoid tax on $200 million capital gain resulting from sales of emc stock, egan entered into paired options arrangements through partnership investments devised by kpmg, with opinions from sidley, austin, brown & wood, with fidelity international currency advisors and fidelity high tech advisor a fund as general partners (son-of boss type transactions), and a separate transaction designed to offset ordinary gains described as a financial derivatives strategy designed to generate u.s. losses offset with offshore gains attributed to a non-us taxpayer. in an opinion in excess of 350 pages, finding that the transactions were shams lacking economic substance the court (judge saylor) described the transactions as “entirely irrational; they were unnecessarily and extravagantly expensive, and did not hedge the purported risks effectively (or at all). . . . the transactions were designed and intended to lose money, and in fact did so.” with respect to the taxpayer’s argument that § 752 allowed a basis increase for the long option positions while not treating the short positions as liabilities, the court stated that, “if the tax system depended entirely on form over substance, the argument might well pass muster. but tax liabilities are not so easy to dodge. it would be absurd to consider offsetting options – purchased and sold at the same time, and with the same counterparties – as separate items, and to act as if the one item existed and the other did not. that is particularly true where (as here) the individual option positions were gigantic, and might bankrupt the taxpayer or the options dealer if no offset were in place.” rejecting the 686 florida tax review [vol. 10:9 taxpayers’ claim of reasonable reliance on tax opinions, the court described the opinions as “fraudulent” and indicated that “[t]he egans knew that the opinion letters were simply part of the tax shelter scheme, and did not for a moment believe that they were receiving independent legal advice after a full disclosure of all underlying facts.” the court ultimately held, among other things, that neither transaction had business purpose and both lacked economic substance, that the intermediate steps of the transactions should be disregarded under the step transaction doctrines and that the transaction should be treated as a single integrated transaction, and that the partnerships would be disregarded under the anti-abuse regulation § 1.701-2. although the court found that there were no grounds to assert reasonable reliance defenses to penalties, the court indicated that it lacked jurisdiction to determine whether specific penalties, determined in individual partners’ proceedings, should be assessed against members or partners. 5. the court of federal claims denied retroactive application of the regulations, but slammed the door on the digital options strategy on economic substance grounds and upholds penalties. stobie creek investments, llc v. united states, 82 fed. cl. 636 (7/31/08). the welles family recognized substantial capital gain on disposition of 50 percent of the family residential entry door business for $455 million. prior to sale the family transferred their stock holdings in the family corporation, therma-tru, to a family investment partnership, stobie creek. the partnership, through single member llcs, participated in the jenkens & gilchrist digital options strategy, to no avail according to the court of federal claims. in an extraordinarily detailed and lengthy opinion, the court held: • helmer v. commissioner, t.c. memo. 1975-160, establishes that the contingent nature of the short sold position in foreign currency prevents a reduction in basis for a reduction in partnership liabilities on distribution of property from the partnership. thus the potential liability on the open currency option did not reduce the taxpayers’ basis in distributed therma-tru stock, whose basis was increased by the purchase price of the short options. • retroactive application of reg. § 1.752-6 is not justified by § 309 of the community renewal tax relief act of 2000, pub. l. no. 106-554, § 309, 114 stat. 2763a-587, -638. that provision was aimed at corporate transactions and is focused on the use of contingent liabilities to accelerate or duplicate losses. the court opined that, “the transfers of the contingent liabilities in the cases at bar resulted in increasing each partner’s outside basis, but did not cause any acceleration or duplication of losses.” • judge miller held that the long and short digital options were two options, not one as contended by the government. 2011] recent developments in federal income taxation 687 • judge miller dismissed notice 200044, which was issued in august 2000, after the transactions occurred but before they were reported by taxpayers in 2001, as follows: [the government’s] argument misunderstands the import of irs notices. as a general proposition, irs notices are press releases stating the irs’s position on a particular issue and informing the public of its intentions; such notices do not constitute legal authority. …. whether [taxpayers] had “notice” that their transactions would be subject to scrutiny has no bearing on whether a treasury regulation, seeking retroactively to effect a change in the law, can serve to disallow [taxpayers’] reporting position. • nonetheless, under coltec industries, inc. v. united states, 454 f.3d 1340 (fed. cir. 2006), the partnership transaction in options lacked economic substance. the court indicated that in coltec, “the federal circuit thus adopted a disjunctive test for determining whether a transaction should be disregarded as an economic sham: the doctrine should apply and a transaction should be disregarded either if the transaction lacks objective economic substance or if it is subjectively shaped solely by tax avoidance motivations.” after an exhaustive analysis of conflicting expert opinions, the court found that, “the weight of the evidence overwhelms plaintiffs’ claim that the transactions were investments motivated by a business purpose to return a profit.” the court also interpreted coltec as holding that, “if a transaction was shaped solely by a tax-avoidance purpose, the fact that the transaction may have some objective economic reality cannot save it from being disregarded as an economic sham.” as to the taxpayers’ subjective purpose, the court found that, “plaintiffs’ limited evidence of non-tax avoidance subjective motivation does not imbue the transactions with economic substance.” • the court also applied the step transaction doctrine to deny the claimed tax benefits. the court stated, “trial established that, under either the interdependence test or the end result test, the step transaction doctrine applies to plaintiffs’ transactions. accordingly, the tax consequences must turn on the substance of the transaction and not on the form by which plaintiffs engaged in it. in disregarding the predetermined steps of the j&g strategy, stobie creek is unable to claim a basis increase in the thermatru stock, and the capital gains must be taxed according to the reality of the transaction.” • the court upheld accuracy and negligence penalties and rejected the taxpayers’ claims that they reasonably relied on the advice of counsel. the court concluded that because of the built-in conflict of interest of the lawyers promoting the transaction that was known to the taxpayers, reliance on the legal opinions was not reasonable. 688 florida tax review [vol. 10:9 a. affirmed, 105 a.f.t.r.2d 2010-2848 (fed. cir. 6/11/10). the federal circuit (judge prost) affirmed the court of federal claims on both the merits and on the penalty issue. the court found that the offsetting options, while separate transactions for tax purposes (under “a literal application of the tax code at that time”), were to be “properly treated as a single, unified transaction” for economic substance (“economic reality”) purposes. this led to the conclusion that “they similarly should not be separate for the purpose of calculating the taxpayers’ basis in stobie creek,” and the taxpayers’ claimed basis of $204,575,000 was disregarded “as lacking economic reality.” • the key paragraphs of the opinion relating to penalties are: similarly, the evidence supports the trial court’s conclusion that jeffrey welles knew or should have known that slk was an agent of j & g, and thus could not reasonably rely on slk’s advice. slk’s agency relationship was apparent from the beginning. waterman referred the welleses to j & g, presented the strategy at the vero beach meeting, and recommended the strategy. as was true for j & g, slk’s fee agreement made clear that slk had a financial stake in the outcome, again tying compensation to the sheltered gain. slk also helped implement the strategy by drafting and backdating documents for the different corporate entities. in-deed, slk openly acknowledged its role in a letter to the welleses. the letter stated that the lower taxable gain that would be reported on stobie creek’s return was “produced by the tax strategy that was developed by [j & g] and implemented with our [slk’s] help earlier this year.” the trial court found that jeffrey welles received this letter. based on that and other evidence presented at trial, it was reasonable for the trial court to infer that jeffrey welles (and thus stobie creek) knew or should have known about the conflicts of interest for j & g and slk. it was not objectively reasonable for jeffrey welles to ignore evidence of these conflicts and continue to rely on the advice, regardless of the welleses’ longstanding relationship with slk or the reputations of both firms. even if jeffrey welles had not known about the conflicts of interest, his reliance on the advice of slk and j & g was still unreasonable. based on jeffrey welles’s education and experience, as well as the reason the welleses pursued the j & g strategy, the trial court found that jeffrey welles should have known that the j & g strategy was “too 2011] recent developments in federal income taxation 689 good to be true.” cf. neonatology, 299 f.3d at 234. this determination is not clearly erroneous. jeffrey welles was a highly educated professional with extensive experience in finance, having worked as an investment banker and as the manager of his family’s complex finances. stobie creek, 82 fed. cl. at 715. in that managerial role, he had helped implement a number of sophisticated tax-planning strategies, giving him sufficient knowledge and experience to know when a tax-planning strategy was likely “too good to be true.” jeffrey welles knew that the j & g strategy was marketed as a “basis enhancing derivatives structure” and that the purpose of the strategy was to boost the basis in capital assets, “generating a reduced gain for tax purposes.” moreover, jeffrey welles sought out and selected the j & g strategy because of a desire to avoid taxes that would otherwise be owed on the therma-tru deal, not because he wanted to structure the deal itself to minimize taxes. 6. even this tax court judge’s gullibility has limits. a “should” opinion by pwc that the transaction was not a disguised sale isn’t worth the paper it was printed on, which resulted in a penalty of $36,691,796. reliance on an opinion issued by an advisor who was actively involved in developing and structuring a transaction was unreasonable because the advisor faced an inherent conflict of interest. canal corp. v. commissioner, 135 t.c. no. 9 (8/5/10). in 1999, a member of the taxpayer’s consolidated group that manufactured tissues, wisco, contributed substantially all of its assets to an llc in exchange for a 5percent interest in the llc, which assumed most of wisco’s liabilities and which simultaneously distributed $755 million of cash to wisco. the remaining 95 percent interest in the llc was owned by georgia pacific. the $755 million was obtained through a bank loan to the llc guaranteed by georgia pacific, for which wisco provided a circumscribed indemnity regarding the principal, but not the interest (which required georgia pacific first to look to the llc’s assets and which also provided wisco an increased interest in the llc if it paid the indemnity). wisco used the cash to pay a $151 million dividend to canal and repay intercompany loans. wisco’s only assets thereafter were a $151 note from canal and a $6 million corporate jet. subsequently, the llc borrowed funds from a subsidiary of georgia pacific to retire the bank loan. the taxpayer received a “should” opinion from pwc that the 1999 transaction would not be treated as an asset sale and gain would be deferred, for which it paid flat fee of $800,000. the fee was due only if the opinion was a “should” opinion, and only upon the closing of the joint venture transaction. in 2001, wisco sold its llc interest to georgia pacific for $1 million, and georgia pacific then 690 florida tax review [vol. 10:9 sold the entire interest in the llc to an unrelated party. the taxpayer treated the 1999 transaction as a contribution to the llc and the receipt of a “debtfinanced transfer of consideration,” for which reg. § 1.707-5(b) provides an exception to the disguised sale rules to the extent the distribution does not exceed the distributee partner’s share of the partnership liabilities under § 752. (however, for financial accounting purposes taxpayer reported the transaction as a sale.) the irs asserted that the 1999 transaction was a disguised sale under § 707(a)(2)(b), because wisco did not have any allocable share of the liability. the taxpayer argued that wisco’s indemnity of georgia pacific’s guaranty imposed the economic risk of loss for the llc debt on wisco, and thus wisco’s share of the debt equaled the distribution. the irs asserted that wisco’s indemnity agreement should be disregarded under the anti-abuse rule for allocation of partnership debt: reg. § 1.752-2(j)(1) and (3) provides that a partner’s obligation to make a payment may be disregarded if (1) the facts and circumstances indicate that a principal purpose of the arrangement between the parties is to eliminate the partner’s risk of loss or to create a facade of the partner’s bearing the economic risk of loss with respect to the obligation, or (2) the facts and circumstances of the transaction evidence a plan to circumvent or avoid the obligation. the tax court (judge kroupa) agreed with the irs that the transactions had to be viewed together and they constituted a disguised sale under § 707(a)(2)(b) rather than a tax-free contribution to a partnership under § 721. taking into account all of the facts, including the facts that (1) georgia pacific did not require the indemnity, but it was included because the taxpayer’s tax advisor concluded that it was necessary in order to avoid the disguised sale rules, (2) the indemnity’s provisions minimized the likelihood that it would ever be invoked, and (3) the taxpayer’s representations to moody’s and standard & poor’s that the only risk associated with the transaction was the tax risk, judge kroupa found that the indemnity agreement was crafted to limit any potential liability to wisco’s assets, which were insufficient to cover more than a small fraction of the indemnity. accordingly, the indemnity agreement was disregarded, and the distribution of cash to wisco was not protected by the debt-financed transfer exception to the disguised sale rules. the 1999 transaction was a sale of wisco’s assets. the court said, “chesapeake [taxpayer’s predecessor] used the indemnity to create the appearance that wisco bore the economic risk of loss for the llc debt when in substance the risk was borne by gp.” among the circumstances considered by the court was that chesapeake represented that its only risk on the transaction was the tax risk. • judge kroupa also upheld the imposition of a substantial understatement penalty under § 6662(a) in the amount of $36,691,796. even though the taxpayer received a “should” opinion from pwc that the 1999 transaction would not be treated as an asset sale and gain would be deferred, the reasonable cause exception of § 6664(c)(1) did not 2011] recent developments in federal income taxation 691 apply, because (1) “the opinion was riddled with questionable conclusions and unreasonable assumptions,” and (2) pwc was actively involved in planning the transaction and its opinion was tainted by a conflict of interest, which caused it have “crossed over the line from trusted adviser for prior accounting purposes to advocate for a position with no authority that was based on an opinion with a high price tag—$800,000.” she described the opinion as “littered with typographical errors, disorganized and incomplete.” judge kroupa concluded that pwc’s opinion was based on the size of its fee, rather than on legal reasoning, stating as follows: we are also nonplused by mr. miller’s failure to give an understandable response when asked at trial how pwc could issue a “should” opinion if no authority on point existed. he demurred that it was what chesapeake requested. the only explanation that makes sense to the court is that no lesser level of comfort would have commanded the $800,000 fixed fee that chesapeake paid for the opinion. • judge kroupa found that the taxpayer “essentially bought an insurance policy as to the taxability of the transaction,” and continued to conclude as follows: pwc’s opinion looks more like a quid pro quo arrangement than a true tax advisory opinion. if we were to bless the closeness of the relationship, we would be providing carte blanche to promoters to provide a tax opinion as part and parcel of a promotion. independence of advisers is sacrosanct to good faith reliance. we find that pwc lacked the independence necessary for chesapeake to establish good faith reliance. we further find that chesapeake did not act with reasonable cause or in good faith in relying on pwc’s opinion. b. identified “tax avoidance transactions.” 1. now let me get this straight. i followed the code and regs meticulously, claimed my loss deduction, but it was disallowed because i really had no possibility of actually making money on the deal and all i was looking for was a nice tax loss, and even though i’ve got this letter from my lawyer saying the deduction is 100% legal, i’m still looking at a 40 percent penalty on the deficiency. but my neighbor who deducted the cost of his kid’s college education as a business expense, which every kindergartner knows you can’t do, doesn’t have to pay any penalty because he’s dumb and his dumb, but probably honest, cpa said it was ok. say what!? well, we don’t have to “know it when we see it” because congress has defined it for us. the 2010 health care 692 florida tax review [vol. 10:9 reconciliation act added new code § 7701(o), codifying the economic substance doctrine, which has been applied by the courts for several decades as a judicial interpretive doctrine to disallow tax benefits otherwise available under a literal reading of the code and regulations. • background — codification of the economic substance doctrine has been on the legislative agenda many times since early in the first decade of this century, or for the past ten years (for those of us still hung up on y2k). the move for codification was motivated in part by the insistence of not a few tax practitioners that the economic substance doctrine simply was not actually a legitimate element of the tax doctrine, notwithstanding its application by the courts in many cases over several decades. this argument was based on the assertion that the supreme court had never actually applied the economic substance doctrine to deny a taxpayer any tax benefits, ignoring the supreme court’s decision in knetsch v. united states, 364 u.s. 361 (1960), and instead focusing on the supreme court’s subsequent decisions in cottage savings ass’n v. commissioner, 499 u.s. 554 (1991), and frank lyon co. v. united states, 435 u.s. 561 (1978), in which a transaction that on the facts showed the total lack of “economic substance” was upheld. congressional concern was intensified by the decision of the court of federal claims in coltec industries, inc. v. united states, 62 fed. cl. 716 (2004), vacated and remanded, 454 f.3d 1340 (fed. cir. 2006), cert. denied, 127 s. ct. 1261 (2007), which questioned the continuing viability of the doctrine, stating that “the use of the ‘economic substance’ doctrine to trump ‘mere compliance with the code’ would violate the separation of powers.” see staff of the joint committee on taxation, technical explanation of the revenue provisions of the “reconciliation act of 2010,” as amended, in combination with the “patient protection and affordable care act,” 144 (jcx-18-10 3/21/10). however, in that case the trial court found that the particular transaction at issue in the case did not lack economic substance, and thus the trial court did not actually rule on its validity, and on appeal, the court of appeals for the federal circuit vacated the court of federal claims decision and, reiterating the validity of the economic substance doctrine and, in the opinion of some, expanding it greatly, held that transaction in question lacked economic substance. although the economic substance doctrine has been articulated in a number of different manners by different courts over the years, its purpose is aptly described by the court of appeals for the federal circuit in coltec industries v. united states, supra. the economic substance doctrine represents a judicial effort to enforce the statutory purpose of the tax code. from its inception, the economic substance doctrine has been used to prevent taxpayers from subverting the legislative purpose of the tax code by engaging in transactions that are fictitious or lack economic reality simply to reap a tax benefit. in this regard, the economic 2011] recent developments in federal income taxation 693 substance doctrine is not unlike other canons of construction that are employed in circumstances where the literal terms of a statute can undermine the ultimate purpose of the statute. • the modern articulation of the doctrine traces its roots back to frank lyon co. v. united states, 435 u.s. 561 (1978), where the court upheld the taxpayer’s treatment of an early version of a silo, stating as follows: [w]here, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax avoidance features that have meaningless labels attached, the government should honor the allocation of rights and duties effectuated by the parties. • this passage – which sets forth a statement as to what was sufficient for economic substance, but which was subsequently interpreted to be a statement as to what was necessary for economic substance2 – has led courts to two different formulations of the economic substance doctrine. one, the so-called “conjunctive test” requires that a transaction have both (1) economic substance and (2) a non-tax business purpose in order to be respected for tax purposes. see, e.g., klamath strategic investment fund v. united states, 568 f.3d 537 (5th cir. 2009); pasternak v. commissioner, 990 f.2d 893, 898 (6th cir. 1993); james v. commissioner, 899 f.2d 905 (10th cir. 1990); new phoenix sunrise corp. v. commissioner, 132 t.c. no. 9 (2009); coltec, supra. under the other formulation, the so called “disjunctive test,” represented principally by ies industries v. united states, 253 f.3d 350, 358 (8th cir. 2001), and rice’s toyota world, inc. v. commissioner, 752 f.2d 89 (4th cir. 1985), a transaction would be respected for tax purposes if it had either (1) economic substance and (2) a non-tax business purpose. yet a third articulation appeared in acm partnership v. commissioner, 157 f.3d 231 (3d cir. 1998), cert. denied, 526 u.s. 1017 (1999), where the court concluded that, that “these distinct aspects of the economic sham inquiry do not constitute discrete prongs of a ‘rigid two-step analysis,’ but rather represent related factors both of which inform the analysis of whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes.” the courts also have differed with respect to the nature of the non-tax economic benefit a taxpayer is required to establish to demonstrate that a transaction has economic substance. some 2. ira believes that the interpretation contains an error in logic which takes a statement from the frank lyon case as to what is “sufficient” for economic substance and construes it as a statement as to what is “necessary” for economic substance. marty and dan do not so believe, or think that the alleged error is irrelevant. 694 florida tax review [vol. 10:9 courts required a potential economic profit. see, e.g., knetsch v. united states, 364 u.s. 361 (1960); goldstein v. commissioner, 364 f.2d 734 (2d cir. 1966), cert. denied, 385 u.s. 1005 (1967). other courts have applied the economic substance doctrine to disallow tax benefits where – even though the taxpayer was exposed to risk and the transaction had a profit potential – compared to the tax benefits, the economic risks and profit potential were insignificant. sheldon v. commissioner, 94 t.c. 738 (1990); goldstein, supra. yet other courts have asked whether a stated business benefit – for example, cost reduction, as opposed to profit-seeking – of a particular transaction was actually obtained through the transaction in question. see coltec industries, inc. v. united states, 454 f.3d 1340 (fed. cir. 2006), cert. denied, 127 s. ct. 1261 (2007). finally, notwithstanding that several courts have rejected the bootstrap argument that an improved financial accounting result — derived from tax benefits increasing after-tax profitability — served the valid business purpose requirement, see, e.g., american electric power, inc. v. united states, 136 f. supp. 2d 762, aff’d, 326 f.3d.737 (6th cir. 2003); wells fargo & company v. united states, 91 fed. cl. 35 (2010), taxpayers continued to press such claims. • the codified economic substance doctrine — the codification of the economic substance doctrine in new § 7701(o) clarifies and standardizes some applications of the economic substance doctrine when it is applied, but does not establish any rules for determining when the doctrine should be applied. according to the legislative history, “the provision [i.r.c. § 7701(o)(5)(c)] does not change present law standards in determining when to utilize an economic substance analysis.” see staff of the joint committee on taxation, technical explanation of the revenue provisions of the “reconciliation act of 2010,” as amended, in combination with the “patient protection and affordable care act,” 152 (jcx-18-10 3/21/10). thus, “the fact that a transaction meets the requirements for specific treatment under any provision of the code is not determinative of whether a transaction or series of transactions of which it is a part has economic substance.” id. at 153. codification of the economic substance doctrine was not intended to alter or supplant any other judicial interpretive doctrines, such as the business purpose, substance over form, and step transaction doctrines, any similar rule in the code, regulations, or guidance thereunder; § 7701(o) is intended merely (merely?) to supplement all the other rules. id. at 155. • conjunctive analysis of objective and subjective prongs — one of the most important aspects of new § 7701(o) is that it requires a conjunctive analysis under which a transaction has economic substance only if (1) the transaction changes the taxpayer’s economic position in a meaningful way apart from federal income tax effects and (2) the taxpayer has a substantial business purpose, apart from federal income tax effects, for entering into such transaction. (the second prong of most versions of the codified economic substance doctrine introduced in earlier congresses added 2011] recent developments in federal income taxation 695 “and the transaction is a reasonable means of accomplishing such purpose.” see, e.g., h.r. 2345, 110th cong, 1st sess. (2007); h.r. 2, 108th cong., 1st sess. (2003). it is not clear what difference in application was intended by adoption of the different final statutory language.) this conjunctive test resolves the split between the circuits (and between the tax court and certain circuits) by rejecting the view of those courts that find the economic substance doctrine to have been satisfied if there is either (1) a change in taxpayer’s economic position or (2) a nontax business purpose, see, e.g., rice’s toyota world v. commissioner, 752 f.2d 89 (4th cir. 1985); ies industries, inc. v. united states, 253 f.3d 350, 353 (8th cir. 2001). section 7701(o)(5)(d) allows the economic substance doctrine to be applied to a single transaction or to a series of transactions. the staff of the joint committee report indicates that the provision “does not alter the court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the doctrine,” and gives as an example the courts’ ability “to bifurcate a transaction in which independent activities with non-tax objectives are combined with an unrelated item having only tax-avoidance objectives in order to disallow those tax-motivated benefits.” • claim of profit potential — section 7701(o)(2) does not require that the taxpayer establish profit potential in order to prove that a transaction results in a meaningful change in the taxpayer’s economic position or that the taxpayer has a substantial non-federal-income-tax purpose. nor does it specify a threshold required return if the taxpayer relies on the profit potential to try to establish economic substance. (in this respect the enacted version differs from earlier proposals that would have required the reasonably expected pre-tax profit from the transaction to exceed a risk-free rate of return. see, e.g., h.r. 2345, 110th cong, 1st sess. (2007); h.r. 2, 108th cong., 1st sess. (2003).) but if the taxpayer does rely on a profit potential claim, then the profit potential requires a present value analysis: the potential for profit of a transaction shall be taken into account in determining whether the requirements of [the § 7701(o) test for economic substance] are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. • thus the analysis of profit potential by the court of federal claims in consolidated edison co. of new york v. united states, 90 fed. cl. 228 (2009), which appears not to have thoroughly taken into account present value analysis, would not stand muster under the new provision. in all events, transaction costs must be taken into account in determining pre-tax profits, and the statute authorizes regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases. any state or local income tax effect that is related to a 696 florida tax review [vol. 10:9 federal income tax effect is treated in the same manner as a federal income tax effect. thus, state tax savings that piggy-back on federal income tax savings cannot provide either a profit potential or a business purpose. similarly, a financial accounting benefit cannot satisfy the business purpose requirement if the financial accounting benefit originates in a reduction of federal income tax. • don’t worry, be happy! [?] — section 7701(o)(5)(b) specifically provides that the statutory modifications and clarifications apply to an individual only with respect to “transactions entered into in connection with a trade or business or an activity engaged in for the production of income.” (we wonder what else anybody would have thought they might apply to? the home mortgage interest deduction? charitable contributions of appreciated property? how about a son of boss transaction where there is no possibility for profit?) more importantly, according to staff of the joint committee on taxation, technical explanation of the revenue provisions of the “reconciliation act of 2010,” as amended, in combination with the “patient protection and affordable care act,” 152-153 (jcx-18-10 3/21/10), “[t]he provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.” the list of transactions and decisions intended to be immunized for the application of the economic substance doctrine includes: (1) the choice between capitalizing a business enterprise with debt or equity; (2) a u.s. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter c; and (4) the choice to utilize a related-party entity in a transaction, provided that the arm’s length standard of section 482 and other applicable concepts are satisfied. • leasing transactions will continue to be scrutinized based on all of the facts and circumstances. • jettisoned along the way — many earlier versions of the codification of economic substance doctrine, some of which were adopted by the house, also provided special rules for applying what was essentially a per se lack of economic substance in transactions with tax indifferent parties that involved financing, and artificial income and basis shifting. see, e.g., h.r. 2345, 110th cong, 1st sess. (2007); h.r. 2, 108th cong., 1st sess. (2003). these rules did not make it into the enacted version. special statutory rules for determining the profitability of leasing transactions also did not find their way into the final statutory enactment. 2011] recent developments in federal income taxation 697 • penalties, oh what penalties! — new §§ 6662(b)(6), in conjunction with new § 6664(c)(2), imposes a strict liability 20 percent penalty for an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance, within the meaning of new § 7701(o), “or failing to meet the requirements of any similar rule of law.” (does that extend to substance versus form in a silo? how about business purpose in a purported tax-free reorganization?) the penalty is increased to 40 percent if the taxpayer does not adequately disclose the relevant facts on the original return or an amended return filed before the taxpayer has been contacted for audit — an amended return filed after the initial contact cannot cure original sin. i.r.c. § 6664(i). because the § 6664(c) “reasonable cause” exception is unavailable, outside (or in-house) analysis and opinions of counsel or other tax advisors will not insulate a taxpayer from the penalty if a transaction is found to lack economic substance. likewise, new § 6664(d)(2) precludes a reasonable cause defense to imposition of the § 6662a reportable transaction understatement penalty for a transaction that lacks economic substance. (section 6662a(e)(2) has been amended to provide that the § 6662a penalty with respect to a reportable transaction understatement does not apply to a transaction that lacks economic substance if a 40 percent penalty is imposed under § 6662(i)). a similar no-fault penalty regime applies to excessive erroneous refund claims that are denied on the ground that the transaction on which the refund claim was based lacked economic substance. § 6676(c). however, under the “every dark cloud has a silver lining” maxim, the §§ 6662(b)(6) and 6664(c)(2) penalty regime does not apply to any portion of an underpayment on which the § 6663 fraud penalty is imposed. • effective date — section 7701(o) and the revised penalty rules applies to transactions entered into after the date of enactment and to underpayments, understatements, and refunds and credits attributable to transactions entered into after 3/30/10. a. better than a sharp stick in the eye, but not much better. the irs is catching conjunctivitis, weighing in on the conjunctive test. notice 2010-62, 2010-40 i.r.b. 411 (9/13/10). the irs indicates that it will rely on relevant case law in applying the two-pronged conjunctive test for economic substance. thus, both in determining whether a transactions meets both of the requirements of the conjunctive test, the irs will apply cases under the common law economic substance doctrine to determine whether tax benefits are allowable because a transaction satisfies the economic substance prong of the economic substance doctrine and to determine whether a transaction has a sufficient nontax purpose to satisfy the requirement that the tax benefits of a transaction are not allowable because the taxpayer lacks a business purpose. the irs adds that it will challenge taxpayers who seek to rely on case law that a transaction will be treated as 698 florida tax review [vol. 10:9 having economic substance merely because it satisfies either of the tests. the irs also indicates that it anticipates that the law of economic substance will continue to evolve and that it “does not intend to issue general administrative guidance regarding the types of transactions to which the economic substance doctrine either applies or does not apply.” • the notice also indicates that, except for reportable transactions, disclosure for purposes of the additional penalty of § 6621(i) will be adequate if the taxpayer adequately discloses on a timely filed original return, or a qualified amended return the relevant facts affecting the tax treatment of the transaction. a disclosure that would be deemed adequate under § 6662(d)(2)(b) will be treated as adequate for purposes of § 6662(i). the disclosure should be made on a form 8275 or 8275-r. c. disclosure and settlement there were no significant developments regarding this topic during 2010. d. tax shelter penalties, etc. 1. magistrate judge bush decided that valuation misstatement penalties are inapplicable in a son of boss tax shelter case in which the irs determined that the transaction were shams that lacked economic substance. bemont investments llc v. united states, 105 a.f.t.r.2d 2010-1338 (e.d. tex. 3/9/10). magistrate judge bush based his decision on weiner v. united states, 389 f.3d 152 (5th cir. 2004), which cited with approval a line of cases that held that valuation penalties are not applicable if the irs’s disallowance of tax benefits is not “attributable to” a valuation misstatement. 2. the irs states that it will suspend the collection of penalties under § 6707a from small businesses that “inadvertently” invested in listed tax shelters. 2009 tnt 128-15 (7/6/09). letter from commissioner shulman, which reads in part, “given your indication of a commitment to enact legislation to address this issue, and to provide the congress that opportunity, we will not undertake any collection enforcement action through september 30, 2009, on cases where the annual tax benefit from the transaction is less than $100,000 for individuals or $200,000 for other taxpayers per year.” a. the irs agreed to extend the moratorium through the end of 2009. letter from commissioner shulman. 2009 tnt 184-23 (8/24/09). 2011] recent developments in federal income taxation 699 b. and again, to extend the moratorium through 4/1/10. 2009 tnt 245-1 (12/23/09). c. yet another extension to 6/1/10. 2010 tnt 42-2 (4/3/10). d. relief from tax shelter penalties under § 6707a for small businesses. the § 6707a penalty is limited to 75 percent of the decrease in tax shown for any reportable transaction. under § 2041 of the small business jobs act of 2010, the § 6707a penalty is limited to 75 percent of the decrease in tax shown for any listed or reportable transaction. formerly, penalty imposed for failure to include information on a listed transaction by a taxpayer other than a natural person was $200,000 regardless of how small the claimed benefits from the transaction happened to be. the limitation applies to penalties assessed after 12/31/06. 3. if the tax advisor’s fee is big enough, it’s not a reliable opinion! murfam farms, llc v. united states, 94 fed. cl. 235 (8/16/10). the taxpayers conceded that their son-of-boss tax shelters lacked economic substance, and the only issue was whether the 40 percent accuracy related penalty was properly assessable. the court held that the taxpayers had not established that acted with reasonable cause or in good faith, and that the penalty wa0s properly assessed. reliance on the advice of e&y was not reasonable: “because e&y had a financial interest in having the murphys participate in cobra, the firm had an inherent conflict of interest in advising on the legitimacy of that transaction.” furthermore, “[t]hat conflict of interest was exacerbated by the fee structure,” under which e&y’s fee would be a percentage of the taxpayer’s desired tax loss. “the murphys knew that e&y stood to earn millions by advising them to participate in cobra, and they therefore knew or should have known that e&y’s advice lacked the trustworthiness of an impartial opinion.” judge damich also had a host of other reasons for finding that the taxpayers’ reliance was not reasonable or in good faith. ix. exempt organizations and charitable giving a. exempt organizations 1. the irs gives small exempt organizations until 10/15/10 to comply with filing requirements. ir-2010-87 (7/26/10). the irs has granted relief to small exempt organizations that failed to file required returns for 2007, 2008 and 2009 by extending to 10/15/10 the deadline for complying with filing requirements in order to keep tax exempt status. the information release provides for late electronic filing of the form 700 florida tax review [vol. 10:9 990-n, electronic notice (e-postcard) and for a voluntary compliance program to file the form 990-ez. 2. tax blues for bluetooth. bluetooth sig, inc. v. united states, 611 f.3d 617 (9th cir. 7/8/10). the taxpayer sought tax exempt status under § 501(c)(6) as a “business league.” the corporation (1) develops, refines, and adapts the bluetooth specification, (2) engages in marketing, public relations, and other promotional activities designed to influence the acceptance, understanding, and use of bluetooth enabled products, (3) enforces its trademark both by ensuring that its members conform to the “bluetooth brand book” and by detecting unauthorized use of the bluetooth trademark, and (4) operates a certification and listing program. the taxpayer had 4,148 members, all of which independent businesses. it had three membership classes: adopters, associates, and promoters. adopters pay no annual fee, but pay a listing fee of $10,000 per product. associates pay an annual fee of either $7,500 or $35,000 depending on the size of the manufacturer. they pay a reduced listing fee of $5,000 per product and have the right to participate in the continuing development of the bluetooth specification. they receive certain marketing and promotional opportunities that may not be available to adopters. promoters pay no annual fee but enjoy the same benefits as associates, plus a seat on the board of directors. each of the original five companies involved with the technology has promoter status. the court affirmed the district court’s summary judgment that the taxpayer did not qualify for tax exempt status, because it activities were activities ordinarily conducted for profit, which is not permitted under reg. § 1.501(c)(6)-1. further, the taxpayer’s activities were not directed to the improvement of business conditions of one or more lines of business as distinguished from the performance of particular services for individual persons. a benefit to nonmembers is a key characteristic of business leagues, but the taxpayer did not benefit nonmembers. rather, the taxpayer engaged in particular services for particular member-manufacturers. 3. the exclusivity of a gated parking lot for the neighborhood beach club has a tax price. ocean pines association v. commissioner, 135 t.c. no. 13 (8/30/10). the taxpayer was a homeowners association that was tax-exempt under § 501(c)(4) as a not-for-profit organized to promote community welfare. in addition to enforcing zoning and providing roads and recreational facilities within ocean pines, funded by members’ dues (but which were open to both members and nonmembers), it operated a beach club and parking lots eight miles from the area (ocean pines) in which its members lived. the primary beach club facilities (e.g., pool, locker room, etc.) and parking lots were accessible only to the association’s members and their guests, but the snack bar, restaurant, and beach itself were open to the public. the taxpayer charged its members a 2011] recent developments in federal income taxation 701 separate fee for parking permits, and maintained a parking permit system and guards. it also leased the parking lots to third-party businesses at night and in the off season. the taxpayer did not report any of the income as subject to the unrelated business income tax (ubit). the irs issued a deficiency notice determining that the net income from the parking lots and beach club facilities was subject to ubit, because their operation was not substantially related to the promotion of community welfare. the tax court (judge morrison) upheld the deficiency. the court concluded that the operation of the beach club and the parking lots did not promote community welfare because they were not accessible to nonmembers, i.e., the general public. therefore, unless an exception applied, the income was subject to ubit. finally, the court held that the § 512(b)(3)(a)(i) exception for rents from real property did not apply, because reg. § 1.512(b)-1(c)(5) provides that income from the operation of a parking lot is not rent from real property. b. charitable giving 1. a “gotcha” for the irs! the tax court just says “no” to deductions for contributions of conservation easements on mortgaged properties. kaufman v. commissioner, 134 t.c. no. 9 (4/26/10). the tax court (judge halpern) held that as a matter of law no charitable contribution deduction is allowable for the conveyance of an otherwise qualifying conveyance of a facade conservation easement if the property is subject to a mortgage and the mortgagee has a prior claim to condemnation and insurance proceeds. because the mortgage has priority over the easement, the easement is not protected in perpetuity – which is required by § 170(h)(5)(a). the deduction cannot be salvaged by proof that the taxpayer likely would satisfy the debt secured by the mortgage. 2. a personal sperm bank can’t qualify as a tax exempt organization. was this foundation founder thinking he could get a tax deduction for producing sperm? free fertility foundation v. commissioner, 135 t.c. no. 2 (7/7/10). a not-for-profit corporation established for the sole purpose of providing the founder’s sperm free of charge to women seeking to become pregnant through artificial insemination or in vitro fertilization was held not to promote health for the benefit of the community, and thus did not operate for exempt purposes and did not qualify for an exemption under § 501(c)(3). the founder and his father were the only board members and decided in their sole discretion who would receive the founder’s sperm. 3. both their house and their claimed charitable contribution deduction went up in smoke. district court denies deduction for about-to-be-demolished house to local fire department on 702 florida tax review [vol. 10:9 “qualified appraisal” and “contemporaneous written acknowledgment” grounds, but ducks the issue of whether taxpayers could claim a deduction for this type of donation. hendrix v. united states, 106 a.f.t.r.2d 2010-5373 (s.d. ohio 7/21/10). when the taxpayers found it would cost $10,000 to demolish their house so they could build a new house on the land, in 2004 they entered into a transaction under which the local fire department could use their house for training and return the cleared land to the taxpayers. they claimed a charitable contribution deduction of $287,400 – based upon an appraisal of $520,000 for the property. the district court (judge frost) denied the deduction on failure to obtain a “qualified appraisal” as required by § 170(f)(11)(a) and failure to obtain a “contemporaneous written acknowledgment” as required by § 170(f)(8). while judge frost did not answer the question of whether “taxpayers may be able to claim a deduction for the type of donation involved in this case” if a qualified appraisal and written acknowledgment had been obtained, he did include in his opinion that deloitte & touche had advised the taxpayers that “[d]onation of property to a fire department is aggressive and not explicitly sanctioned by the internal revenue code.” a. now the tax court holds that the gambit does not work at all. rolfs v. commissioner, 135 t.c. no. 24 (11/4/10). the taxpayers donated a home, but not the underlying land, to the local volunteer fire department to be burned down in a training exercise. the fire department could not use the house for any purpose other than destruction by fire in training exercises. the taxpayers claimed a charitable contribution deduction of $76,000 based on a “before and after” valuation, comparing the value of the parcel with the building intact and the value of the parcel after demolition of the building; they complied with all record keeping and substantiation requirements. the tax court (judge gale) upheld the irs’s denial of the deduction. first, based on expert testimony, he found that the taxpayers received a quid-pro-quo in the amount of $10,000, which was the value of the demolition services provided to them by the donee fire department. second, he found that the building, with ownership severed from the land and burdened by the condition that it be removed, i.e., in this case demolished, had no value. the lack of value was established by the expert testimony of home movers, who testified that considering the costs of removal to another site, the modest nature of the home, and the value of nearby land, no one would purchase the home for more than a nominal amount, between $100 and $1,000, sufficient to render the contract enforceable. applying the principles of hernandez v. commissioner, 490 u.s. 680 (1989), and united states v. american bar foundation, 477 u.s. 105 (1986), judge gale held that because they consideration received by the taxpayers exceeded the value of the transferred property, there was no charitable contribution. he rejected application of the “before and after” 2011] recent developments in federal income taxation 703 valuation method, because that method did not take into account the restrictions that would have affected the marketability of the structure severed from the land. 4. no mardi gras beads from the tax court for this taxpayer. whitehouse hotel limited partnership v. commissioner, 131 t.c. 112 (10/30/08). the tax court (judge halpern) held that, as a precondition to using the replacement cost approach to valuing real estate, the taxpayer must show that the property is unusual in nature and other methods of valuation, such as comparable sales or income capitalization, are not applicable. the income approach to valuation is favored only where comparable market sales are absent. on the facts, the value of the contribution of a conservation facade easement for an historic structure on the edge of the french quarter in new orleans was overstated. the accuracy-related penalty for gross overvaluation was proper because there was no good faith investigation into the value. a. regardless of which valuation method is used, it still must relate to the property’s “highest and best use.” whitehouse hotel limited partnership v. commissioner, 615 f.3d 321 (5th cir. 8/10/10). in an opinion by judge barksdale, the fifth circuit vacated the tax court’s decision and remanded the case for a determination of the easement’s value, although it rejected the taxpayer’s arguments that the irs’s expert was unqualified and that his report was unreliable and should not have been admitted. but the court of appeals agreed with the taxpayers’ argument that the tax court “miscomprehended the highest and best use” of the building subjected to the conservation easement, and thereby undervalued the easement. in sum, the tax court erred in declining to consider the maison blanche and kress buildings’ highest and best use in the light of both the reasonable and probable condominium regime and the reasonable and probable combination of those buildings into a single functional unit, both of which foreclosed the realistic possibility, for valuation purposes, that the kress and maison blanche buildings could come under separate ownership. this combination affected the buildings’ fair market value. • as result the court did not reach the tax court’s holding that the income and replacement-cost methods of valuation were inapplicable and directed the tax court to consider those methods, in addition to comparable sales method on remand. because the holding on the valuation was vacated, the tax court’s holding that the gross overvaluation penalty also was vacated. 704 florida tax review [vol. 10:9 5. “praise the lord, [but] pass the ammunition.” or, is it that the judge was hypertechnical? lord v. commissioner, t.c. memo. 2010-196 (9/8/10). a charitable contribution deduction for a conservation easement was denied because the appraisal in the amount of $242,000 submitted to comply with reg. 1.170a-13(c)(2)(i)(a) was not a “qualified appraisal.” the tax court (judge foley) held that this was because the appraisal itself did not include: (1) the easement contribution date; (2) the date the appraisal was performed; or (3) the appraised fair market value of the easement contribution on the contribution date. judge foley further held that the doctrine of substantial compliance was not applicable because significant information was omitted from the appraisal. • the background facts were that taxpayer granted a deed of conservation easement to the land preservation trust on 12/30/99; that the paige appraisal company produced an appraisal report [stating the fair market value of the easement] with an effective date of 12/31/99; and that the report date was 1/4/00. a. retrospective “as of” appraisals don’t cut the mustard. evans v. commissioner, t.c. memo. 2010-207 (9/22/10). judge wherry disallowed the taxpayers’ deduction for the contribution of a conservation facade easement due to inadequate substantiation. the appraisal introduced at trial was not a qualified appraisal because it was prepared almost four years after the date of the donation, and the appraiser testified that she was unfamiliar with the standards for a qualified appraisal. qualified appraisals by qualified appraisers, upon which taxpayer relied in preparing the return were not introduced into evidence because the appraisers did not testify at trial. however, an asserted § 6662 accuracy related penalty was not sustained because in preparing the return the taxpayer reasonably relied on qualified appraisals by the qualified appraisers. x. tax procedure a. interest, penalties and prosecutions 1. no free trade agreement for ssns. t.d. 9437, amendments to the section 7216 regulations – disclosure or use of information by preparers of returns, 73 f.r. 76216 (12/16/08). this treasury decision amends reg. § 301.7216-3(b)(4) to permit disclosure by a tax return preparer of a taxpayer’s ssn to another tax return preparer located outside the united states only with the taxpayer’s consent. the amended regulation applies to disclosures of tax return information occurring on or after 1/1/09. 2011] recent developments in federal income taxation 705 a. but there is some freedom for preparers to use taxpayer return information to increase their own profitability. t.d. 9478, amendments to the section 7216 regulations – disclosure or use of information by preparers of returns, 75 f.r. 48 (12/29/09). temp. reg., § 301.7216-2t(n) allows preparers to compile, maintain, and use a list containing solely the names, addresses, e-mail addresses, phone numbers, taxpayer entity classification, and income tax return form numbers of taxpayers whose tax returns the tax return preparer has prepared, if the list is used only to contact the taxpayers on the list either (1) to provide tax, general business, or economic information for educational purposes, or (2) for soliciting additional tax return preparation services. temp. reg. § 301.72162t(p) allows return preparers to disclose return information without penalty for the purpose of a quality or peer review, but only to the extent necessary to accomplish the review. the information also may be used to perform a conflict of interest check. identical proposed regulations were published simultaneously. reg-131028-09, amendments to the section 7216 regulations – disclosure or use of information by preparers of returns, 75 f.r. 94 (12/29/09). (1) rev. rul. 2010-5, 2010-4 i.r.b. 312 (12/30/09). this revenue ruling provides further guidance and allows disclosure of return information to a return preparer’s malpractice carrier to the extent necessary to obtain insurance or to defend against claims; to defend claims, the tax return itself may be disclosed and it may be disclosed to attorneys engaged to defend against the claim. (2) rev. rul. 2010-4, 2010-4 i.r.b. 309 (12/30/09). this revenue ruling provides further guidance and details circumstances that justify use of lists to contact clients and allowing disclosure of information to a third-party provider who prepares the mailings. 2. the instructions for the new fbar are fubar. ir-2009-58 and announcement 2009-51, 2009-25 i.r.b. 1105 (6/5/09). the irs announced that for the reports of foreign bank and financial accounts (fbars) due on 6/30/09, filers of form td f 90-22.1 (rev. 10-2008) need not comply with the new instruction relating to the definition of a united states person, i.e.: united states person. the term “united states person” means a citizen or resident of the united states, or a person in and doing business in the united states. see 31 c.f.r. 103.11(z) for a complete definition of ‘person.’ the united states includes the states, territories and possessions of the united states. see the definition of united states at 31 c.f.r. 103.11(nn) for a complete definition of united states. 706 florida tax review [vol. 10:9 a foreign subsidiary of a united states person is not required to file this report, although its united states parent corporation may be required to do so. a branch of a foreign entity that is doing business in the united states is required to file this report even if not separately incorporated under u.s. law. • instead, for this year, taxpayers and others can rely on the definition of a united states person included in the instruction to the prior form (7-2000): united states person. the term “united states person” means: (1) a citizen or resident of the united states; (2) a domestic partnership; (3) a domestic corporation; or (4) a domestic estate or trust. a. notice 2009-62, 2009-35 i.r.b. 260 (8/7/09). by this notice, the irs extended the filing deadline until 6/30/10 to report foreign financial accounts on form td f 90-22.1 for persons with signature authority over (but no financial interest in) a foreign financial account and persons with signature authority over, or financial interests in, a foreign commingled fund. b. still clear as mud: new definitions and instructions. rin 1506-ab08, financial crimes enforcement network; amendment to the bank secrecy act regulations – reports of foreign financial accounts, 75 f.r. 8844 (2/26/10). this proposed rule would include a definition of “united states person” and definitions of “bank account,” “securities account,” and “other financial account,” as well as of “foreign country.” it also includes draft instructions to form td f 90-22.1 (fbar). (1) notice 2010-23, 2010-11 i.r.b. 441 (2/26/10). provided administrative relief to certain person who may be required to file and fbar for the 2009 and earlier calendar years by extending the filing deadline until 6/30/11 for persons with signature authority, but no financial interest in, a foreign financial account for which an fbar would have otherwise been due on 6/30/10. it also provides relief with respect to mutual funds. (2) announcement 2010-16, 2010-11 i.r.b. 450 (2/26/10). the irs suspended, for person who are not u.s. citizens, u.s. residents, or domestic entities, the requirement to file an fbar for the 2009 and earlier calendar years. 2011] recent developments in federal income taxation 707 3. meeting five out of six criteria for being a “responsible person” buys a 100% penalty. erwin v. united states, 591 f3d 313 (4th cir. 1/13/10). the fourth circuit, in a majority opinion by judge motz, upheld the district court’s finding on summary judgment that the taxpayer was liable for the § 6672 failure to withhold and pay-over penalty. to determine whether a particular individual is a “responsible person” liable for the § 6672 failure to withhold and pay-over penalty, the fourth circuit will examine whether he: (1) served as an officer or director of the company; (2) controlled the company’s payroll; (3) determined which creditors to pay and when to pay them; (4) participated in the corporation’s day-to-day management; (5) had the ability to hire and fire employees; and (6) possessed the power to write checks. undisputed facts established that the taxpayer met the first five criteria, even though he delegated some responsibilities to others. considering “the totality of the circumstances,” he was a responsible person even though he did not have check-writing authority. • judge hamilton dissented, concluding that a “reasonable fact-finder, viewing the evidence in the light most favorable to erwin and drawing all reasonable inferences from such evidence in his favor, could find that he was not a responsible person ... ”, even though he did not believe that as a matter of law erwin could not be a responsible person. judge hamilton thought that only the first factor cut in favor of the government, and he would have vacated and remanded for a trial, because it was a “close case.” 4. the district court needs to justify home imprisonment in lieu of time in the big house for criminal tax evasion. united states v. engle, 592 f.3d 495 (4th cir. 1/13/10). the defendant pled guilty to tax evasion for 2004. although he was charged with tax evasion only for 2004, the information alleged that he had evaded taxes for 16 years between 1984 and 2002 and owed taxes on more than $600,000 – when interest and penalties were tacked on the amount exceeded $2 million. the district court sentenced engle to four years probation, conditioned on 18 months of home detention, with work release and international travel privileges. the district judge reasoned that it was more important that the back taxes be paid than that engle be imprisoned and that if engel were imprisoned he would be deprived of his livelihood and hence be unable to pay the taxes that he had evaded. the fourth circuit (judge traxler) vacated the sentence because the district court did not adequately explain its decision to vary significantly from the 18 u.s.c. § 3553(a) u.s. sentencing guidelines’ recommendations in imposing the lenient sentence that did not include prison time. judge traxler noted, after requiring that further proceedings be in front of a different judge: 708 florida tax review [vol. 10:9 the district judge in this case [judge mullin] also presided over the tax evasion trials and sentencings in [other] cases that, though not formally consolidated with this case, were argued before this court seriatim with this appeal. in the sentencing hearing for [another criminal defendant], the district judge, who has taken senior status, stated that he no longer intended to handle criminal matters. 5. yip[e]! united states v. yip, 592 f.3d 1035 (9th cir. 1/13/10). the ninth circuit held that under u.s.s.g. § 3c1.1, “[o]bstruction during an irs audit justifies enhancing a defendant’s sentence for obstruction ‘during the course of the investigation.’” 6. the defendant was a little bit too “cheeky”3 for his own good; instead, he should have turned the other cheek(s). united states v. phipps, 595 f.3d 243 (5th cir. 1/25/10). the defendant’s conviction for tax evasion was upheld. his claim of good faith belief that he was not required to pay taxes on proceeds from a pyramid marketed tax evasion scheme was belied by his receipt of prior notice from the irs regarding his tax liability coupled with his advice to participants in the scheme to plan a “reliance defense” based “on the advice of income tax professionals and other credible sources that could be used to convince a jury that the participant sincerely believed he or she was not liable for federal or state income tax.” because he was advising others to employ calculated tactics to avoid paying income taxes ... a rational jury reasonably could have found that [he] ... willfully evaded paying income tax.” 7. “abatement” is all or nothing. “reduction” is not a lesser included option. it couldn’t have happened to a nicer union. service employees international union v. united states, 598 f.3d 1110 (9th cir. 3/17/10). seiu filed its information return late and the irs assessed a $50,000 penalty under § 6652(c)(1)(a). on appeal from an adverse cdp determination, the district court (which at the time had jurisdiction) concluded that there was no “reasonable cause” for the late filing, but nevertheless held that in its discretion the irs should have reduced the penalty and entered judgment in favor of the irs for only 25% of the $50,000 penalty. the court of appeals reversed. the penalty under § 6652(c)(1)(a) is “‘either fully enforceable or fully unenforceable,’” citing in re sanford, 979 f.2d 1511, 1513 (11th cir. 1992). section 6652(c)(4), providing for abatement of the penalty if there was “reasonable cause” for the late filing, is mandatory, not discretionary. “if a nonprofit fails to file the 3. cheek v. united states, 498 u.s. 192 (1991), held that court held that a good-faith belief as to the law need not be objectively reasonable to be a defense to criminal tax fraud. 2011] recent developments in federal income taxation 709 informational return on time for reasonable cause, the irs has no discretion whether to impose or reduce the penalty; it is flatly prohibited from imposing any penalty at all.” neither the irs nor any reviewing court has discretion to reduce, rather than to abate for “reasonable cause,” a § 6652(c)(1)(a) penalty for late filing of an informational return. 8. the “turbotax got it wrong for me just like wikipedia says it did for timothy geithner” defense doesn’t cut the mustard. lam v. commissioner, t.c. memo. 2010-82 (4/19/10). based on a stipulation, the tax court (judge wherry) upheld a deficiency determined by the irs based on the application of § 280a to disallow claimed rental real estate losses and recharacterization of claimed ordinary losses as capital losses. the court also upheld accuracy related penalties, finding that there was no substantial authority for the taxpayer’s positions and that the reasonable cause exception did not apply. the taxpayers argued that they consistently filled out their tax returns using turbotax and that they confused capital gains and losses with ordinary income and expenses. even though judge wherry believed that the errors were made in good faith, he held that they did not behave in a manner consistent with that of a prudent person. they did not consult a tax professional or visit the irs’s web site for instructions on filing the schedule c. he did not accept their misuse of turbotax, even if unintentional or accidental, as a defense to the penalties, because they did not attempt to show a reasonable cause for their underpayment of taxes. rather, they analogized their situation to that of the secretary of the treasury, timothy geithner. citing a wikipedia article, ms. lam essentially argues that, like secretary geithner, she used turbotax, resulting in mistakes on her taxes. in short, it was not a flaw in the turbotax software which caused petitioners’ tax deficiencies. “tax preparation software is only as good as the information one inputs into it.” [citation omitted]. because petitioners have not “shown that any of the conceded issues were anything but the result of [their] own negligence or disregard of regulations,” they are liable for the section 6662(a) penalties. a. another case on turbotax. the case does not reflect whether the irs was ashamed, but it was undeterred in seeking penalties for conduct unpenalized with respect to the secretary of treasury. parker v. commissioner, t.c. summ. op. 2010-78 (6/21/10). the tax court (judge chiechi) held that the taxpayer’s compensation from the international monetary fund was subject to self-employment taxes. accuracy-related penalties were imposed despite taxpayer’s argument that he relied on his tax return preparation software. 710 florida tax review [vol. 10:9 b. ouch! the tax court again rejected taxpayers’ use of the “geithner defense” and held that blaming h&r block tax preparation software for errors on their return did not excuse them from penalties. au v. commissioner, t.c. memo. 2010-247 (11/10/10). in this pro se case, the court (judge cohen) upheld the imposition of the accuracy related penalty on taxpayers who deducted gambling losses in the absence of any gambling winnings, stating: petitioners contend that they followed the instructions on the [h&r block tax cut] tax preparation software that they used in preparing their 2006 tax return, asserting that the software was “approved by the irs.” they indicate that they were unaware of the provisions of the code and that they did not consult any internal revenue service (irs) publications or professional tax advisers before claiming deductions equaling almost half of their reported income in 2006. the software instructions are not in the record, so we cannot determine how the error occurred. we doubt that the instructions, if correctly followed, permitted a result contrary to the express language of the code. petitioners may have acted in good faith but made a mistake. in the absence of evidence of a mistake in the instructions or a more thorough effort by petitioners to determine their correct tax liability, we cannot conclude that they have shown reasonable cause for the underpayment of tax on their 2006 return. 9. t.d. 9488, interest and penalty suspension provisions under section 6404(g) of the internal revenue code, 75 f.r. 33992 (6/16/10). final reg. § 1.6404-4(b)(5), replacing temp. reg. § 1.6404-4t(b)(5), provides guidance regarding the exception for any listed transaction as defined in § 6707a(c) or any undisclosed reportable transaction from the general rule of suspension of any interest under § 6404(g)(1) if the irs does not contact the taxpayer regarding adjustments within the requisite period of time, generally 36 months after the later of the due date or the return filing date. 10. he might have played a dc cop in “murder at 1600,” but now he’ll be a convict for real at an fci thanks to 1111 constitution ave. united states v. snipes, 106 a.f.t.r.2d 2010-5256 (11th cir. 7/16/10). snipes earned more than $27 million dollars in gross income from 1999 to 2004, but he did not file individual federal income tax returns for any of those years. snipes was involved with co-defendant eddie ray kahn’s organization, american rights litigators (arl), which purported to 2011] recent developments in federal income taxation 711 assist customers in resisting the irs. arl employees, including codefendant douglas rosile, and arl members, including snipes, sent voluminous letters to the irs, challenging the irs’s authority to collect taxes. the centerpiece of this resistance was the “861 argument” that the domestic earnings of individual americans are not income subject to tax. snipes personal arguments to the irs over the curse of several years were described by the court, in part, as follows: snipes’s correspondence with the irs advanced several arguments justifying his failure to file his personal tax returns, including that he was a “non-resident alien to the united states,” that earned income must come from “sources wholly outside the united states,” that “a taxpayer is defined by law as one who operates a distilled spirit plant,” and that the internal revenue code’s taxing authority “is limited to the district of columbia and insular possessions of the united states, exclusive of the 50 states of the union.” snipes also claimed that as a “fiduciary of god, who is a ‘nontaxpayer,’” he was a “foreign diplomat” who was not obliged to pay taxes. when snipes consulted his long-time tax attorneys about his resistance to paying federal income taxes, they advised him that his position was contrary to the law and that he was required to file tax returns. the firm terminated snipes as a client when snipes refused to file his tax returns. • snipes also integrated the alr tax “teachings” into the accounting methodology of his film production companies. after june 2000, his companies stopped deducting payroll and income taxes from employees’ salary checks. snipes began to proselytize this theory of tax resistance. not surprisingly, the eleventh circuit upheld wesley snipes’s conviction of willful failure to file tax returns and the imposition of a 36-month prison sentence. 11. cheatin’ tax advisor blinded by his own brilliance. united states v. jewell, 614 f.3d 911 (8th cir. 7/30/10). the defendant was a tax attorney who concocted a scheme to assist his clients in underreporting several million dollars of income and was convicted of aiding and abetting tax evasion. among the many issues he raised on appeal was that his clients ultimately had settled the tax deficiency with the irs. the court of appeals affirmed the conviction. the court held that the fact that the taxpayer whose taxes were evaded eventually paid those taxes is not a defense to aiding and abetting tax evasion if the advisor had the intent to assist the taxpayer with evading taxes in the taxable year in question and at the time taxes were due for the year in question there was a deficiency. 712 florida tax review [vol. 10:9 12. “sorry, i spent it all” not only doesn’t vitiate willfully not paying, but helps to prove willfulness. united states v. blanchard, 618 f.3d 562 (6th cir. 8/30/10). the defendant was convicted under § 7202 of failure to pay over to the irs employee’s withheld taxes. the sixth circuit held that inability to pay over to trust fund is pertinent to whether the defendant willfully failed to pay, but ability to pay over the taxes is not an element of the offense that the government must prove beyond a reasonable doubt. evidence of the taxpayer’s discretionary expenditures, including gambling losses, vacation trips, jewelry purchases, and leases of multiple cadillacs, in lieu of the defendant meting his tax obligations was “probative” of his guilt. 13. let the sunshine in. rev. proc. 2011-13, 2011-3 irb 318 (12/29/10). this revenue identifies circumstances under which the disclosure on a taxpayer’s income tax return with respect to an item or a position is adequate for the purpose of reducing the understatement of income tax under § 6662(d), relating to the substantial understatement accuracy-related penalty, and for the purpose of avoiding the tax return preparer penalty under § 6694(a) (relating to understatements due to unreasonable positions) with respect to income tax returns for any income tax return filed on a 2010 tax form for a taxable year beginning in 2010, and to any income tax return filed on a 2010 tax form in 2011 for a short taxable year beginning in 2011. it does not apply with respect to any other penalty provisions (including the disregard provisions of the § 6662(b)(1) accuracyrelated penalty, the § 6662(i) increased accuracy-related penalty for undisclosed noneconomic substance transactions, and the § 6662(j) increased accuracy-related penalty in the case of undisclosed foreign financial asset understatements. 14. literal compliance with the tax laws in a transaction that lacks economic substance results in a valid indictment of a tax advisor. united states v. daugerdas, 106 a.f.t.r.2d 2010-7432 (12/23/10 s.d.n.y.). the district court (judge pauley) denied the defendants motion to dismiss over twenty counts of an indictment for aiding and abetting tax evasion in connection with the design, marketing, and implementation of four tax shelters: the short sale, short options strategy (“sos”), swaps, and homer tax shelters. all of the shelters were based on the tax court’s decision in helmer v. commissioner, t.c. memo. 75-160. the defendant’s argued that the indictment failed to allege willfulness for three reasons: “(1) a transaction’s economic effect is measured by whether it subjects the taxpayer to market risk, not whether it provides a realistic possibility of profit; (2) even if the possibility-of-profit test is proper, there was no known legal duty to account for fees when measuring a transaction’s profit potential; and (3) helmer-based tax strategies were not outlawed by 2011] recent developments in federal income taxation 713 the irs until after defendants executed the transactions at issue.” the court rejected all three arguments. as the first argument, the court concluded, “defendants mistakenly assert that the economic effect component of the economic substance doctrine asks only whether a transaction subjects the taxpayer to market risk. ‘the nature of the economic substance analysis is flexible.’” as to the second argument the court concluded, “because the indictment alleges that the all-in fee was integral to the tax shelters, such a formulation is particularly appropriate. indeed, ignoring fees associated with a tax shelter conflicts with rational decision making—absent tax benefits, no rational investor would entertain an investment where the total costs exceeded any potential return. finally, as to the third argument, the court concluded, “while the indictment describes transactions apparently modeled on helmer, its center of gravity focuses on the shelters as a whole and the fact that in the aggregate they were shams. thus, defendants’ technical adherence to the contingent liability rule articulated in helmer is irrelevant. the economic substance doctrine is designed to ferret out improper conduct ‘despite literal compliance’ with tax laws. b. discovery: summonses and foia 1. reversed by a divided first circuit in an en banc rehearing. the first follows the fifth to el paso. united states v. textron inc., 577 f.3d 21 (1st cir. 8/13/09) (3-2), cert. denied, 130 s. ct. 3320 (5/24/10). the majority (judge boudin) held that the work product privilege protects only work done for litigation purposes (the “prepared for” test or the “primary purpose” test), and abandoned the prior first circuit “because of” test, encompassing work done in preparing financial statements that also is prepared in contemplation of litigation. the majority followed united states v. el paso co., 682 f.2d 530 (5th cir. 1982). judge boudin concluded: textron apparently thinks it is “unfair” for the government to have access to its spreadsheets, but tax collection is not a game. underpaying taxes threatens the essential public interest in revenue collection. if a blueprint to textron’s possible improper deductions can be found in textron’s files, it is properly available to the government unless privileged. virtually all discovery against a party aims at securing information that may assist an opponent in uncovering the truth. unprivileged irs information is equally subject to discovery. the practical problems confronting the irs in discovering under-reporting of corporate taxes, which is likely endemic, are serious. textron’s return is massive – constituting more than 4,000 pages – and the irs requested the work papers only after finding a specific type of 714 florida tax review [vol. 10:9 transaction that had been shown to be abused by taxpayers. it is because the collection of revenues is essential to government that administrative discovery, along with many other comparatively unusual tools, are furnished to the irs. as bentham explained, all privileges limit access to the truth in aid of other objectives, 8 wigmore, evidence § 2291 (mcnaughton rev. 1961), but virtually all privileges are restricted – either (as here) by definition or (in many cases) through explicit exceptions – by countervailing limitations. the fifth amendment privilege against selfincrimination is qualified, among other doctrines, by the required records exception, and the attorney client privilege, along with other limitations, by the crime-fraud exception. to sum up, the work product privilege is aimed at protecting work done for litigation, not in preparing financial statements. textron’s work papers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected; and irs access serves the legitimate, and important, function of detecting and disallowing abusive tax shelters. [footnote and internal citations omitted] a. even after textron, the government is still not home free when it wants to run barefoot through tax audit workpapers and tax opinions, and to run roughshod over work product protections. the d.c. circuit accepted that dual-purpose documents could be covered by the work product doctrine, and it refused to find that disclosure to the auditing cpa firm constituted waiver of work product protection. united states v. deloitte llp, 610 f.3d 129 (d.c. cir. 6/29/10). the government sought discovery of three documents in the possession of deloitte, dow chemical’s independent auditor, that the taxpayer, claimed were attorney work product. one document was a draft memorandum prepared by deloitte that summarized a meeting between dow employees, dow’s outside counsel, and deloitte employees about the possibility of litigation over a partnership in which dow was a member and the necessity of accounting for such a possibility in an ongoing audit. the district court had concluded that, although the document was created by deloitte, it was nonetheless dow’s work product because “its contents record the thoughts of dow’s counsel regarding the prospect of litigation.” the second document was a memorandum and flow chart prepared by two dow employees, an accountant and an in-house attorney. the third was a tax opinion prepared by dow’s outside counsel. the district court held that all three documents were protected under the work-product doctrine. on appeal, 2011] recent developments in federal income taxation 715 the government contends that the deloitte memorandum was not work product because it was prepared by deloitte during the audit process. it conceded that the other two documents were work product, but argued that dow waived work-product protection when it disclosed them to deloitte. • the court of appeals (judge sentelle) vacated the district court’s decision that the memorandum prepared by deloitte was work product and remand for in camera review to determine whether it is entirely work product. it affirmed the district court’s holding that dow did not waive work-product protection when it disclosed the other two documents to deloitte. in analyzing whether the deloitte memorandum could be work product, the court of appeals applied the “‘because of’ test, asking ‘whether, in light of the nature of the document and the factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of the prospect of litigation.’” it rejected the government’s argument that the memorandum was not protected work product under united states v. el paso co., 682 f.22 530 (1982), reasoning that el paso was decided under the “primary motivating purpose test,” which is a different test than the “because of” test, as well as the government’s argument that united states v. textron inc., 577 f.3d 21 (1st cir. 2009), supported its position, reasoning that the holding in textron was fact specific. in rejecting the government’s argument that the deloitte memorandum could not be work product because it was prepared in the course of a financial audit, the court of appeals held that a document can contain protected work-product material even though it serves multiple purposes, so long as the protected material was prepared because of the prospect of litigation. • however, having determined that the deloitte memorandum could be work product, when it turned to whether it was work product, the court of appeals concluded that the district court lacked a sufficient evidentiary foundation for its holding that the memorandum was purely work product and remanded for further consideration. turning to waiver issue with respect to the other two documents, the court of appeals held that there was no waiver. deloitte was neither a potential adversary in the matter with respect to which the documents had been prepared nor a conduit to other adversaries — the only relevant adversary was the irs. “dow had a reasonable expectation of confidentiality because deloitte, as an independent auditor, has an obligation to refrain from disclosing confidential client information.” • we note that one left coast tax professor vented on this case so vehemently that a casual observer might fear that he would burst a ventricle. 2010 tnt 125-1. c. litigation costs 1. the irs position can’t be “unreasonable” when a “novel” issue of law is involved. bale chevrolet co. v. united states, 620 716 florida tax review [vol. 10:9 f.3d 868 (8th cir. 9/2/10). the eighth circuit held that even though the irs eventually settled the taxpayer’s case and rescinded a $100,000 penalty under § 6721(e) for failure to comply with § 6050i, the government’s administrative and litigating positions were substantially justified because the “case involve[d] a novel issue apparently not yet addressed by any court of appeals.” the issue whether a company that fails to adopt an adequate reporting system after acknowledging that its current system is deficient is subject to intentional disregard penalties pursuant to § 6721(e). 2. a lawyer doesn’t pay himself attorneys fees that can be recovered. united states v. hudson, 106 a.f.t.r.2d 7017 (2d cir. 11/10/10). the second circuit affirmed a district court decision holding that a prevailing taxpayer who appears pro se cannot recover under § 7430 an amount representing the value of his own time expended in presenting his case, but can recover out-of-pocket litigation costs, including court filing fees, postage and delivery charges, transportation (mileage), and parking. d. statutory notice of deficiency 1. if you pay without a statutory notice, you can’t get a refund. bush v. united states, 599 f.3d 1352 (fed. cir. 3/31/10). during the pendency of a partnership level proceeding, the taxpayers entered into closing agreements with the irs with respect to their § 465 at-risk amounts in the partnership. the closing agreements did not waive the right to a deficiency notice. subsequently, the irs issued notices of adjustment, without issuing any deficiency notices, based on the application of the agreed upon at-risk amount in the closing agreements. the taxpayers paid the assessed taxes and sought a refund. a deficiency notice is not required if a tax liability issue has been resolved in a partnership-level proceeding. in that case any additional tax due is assessed as a computational adjustment, § 6230(a)(1), which § 6231(a)(6) defines for this purpose as the “change in the tax liability of a partner which properly reflects the treatment under this subchapter of a partnership item.” but a deficiency notice is required if the additional tax asserted by the irs to be due does not involve such a “computational adjustment.” thus, a deficiency notice is required if the deficiency is attributable to “affected items which require partner level determinations.” i.r.c. § 6230(a)(2)(a)(i). the court (judge dyk), held for the government, concluding that on the facts of the case, the irs’s failure to issue a deficiency notice was harmless error. after first concluding that § 6213(a) “does not broadly provide for a refund of amounts paid by the taxpayer after assessment or provide for a refund where the taxpayer voluntarily pays the assessment before collection proceedings are initiated,” the court continued as follows: 2011] recent developments in federal income taxation 717 the irs did not issue a demand for payment (which is a predicate to collection, see i.r.c. § 6303) or initiate collection proceedings. the taxpayers do not ... seek repayment of funds improperly collected. rather, the taxpayers paid the assessments and then sued for a refund, alleging that they are entitled to a refund simply because the irs failed to issue the requisite notice, without regard to whether the tax was in fact owed, and without any showing that the taxpayers were prejudiced by litigating the tax issue in the refund proceedings rather than in the tax court. nothing in the language of the statute confers such a refund right on the taxpayer, and the failure in the statute to provide for a refund under such circumstances strongly suggests that no such automatic refund was intended. • finally, the court explained that despite the taxpayers not having received a deficiency notice, had they not voluntarily paid the tax, they could have had their day in tax court simply by not paying and seeking collection due process relief under § 6330 when the irs subsequently took actions to collect the assessed taxes. a. decision withdrawn and en banc hearing granted. (fed. cir. 10/29/10). 2. the tax court loves its jurisdiction. winter v. commissioner, 135 t.c. no. 12 (8/25/10). the taxpayer reported passedthrough losses from an s corporation in which he was a shareholder in excess of the amount reported on his schedule k-1. rather that treat the adjustment resulting from the inconsistency as correction of a mathematical error, as provided by § 6037, subject to summary assessment under § 6213(b), the irs issued a deficiency notice with respect to both the adjustment resulting from disallowing the excess loss and the inclusion of unreported interest, dividends, and gambling income. the irs issued a summary assessment based on the mathematical error only after the taxpayer had filed the tax court petition. the principal issue was whether the tax court had jurisdiction over the adjustment to the taxpayer’s distributive share of s corporation income or whether the irs was required to assess the tax related to the adjustment as a math error under § 6213(b), precluding the inclusion in the notice of deficiency of the increase in tax relating to that adjustment. both the taxpayer and irs argued that the court had jurisdiction, but the court nevertheless addressed the question, and in a reviewed opinion (10-1-1) by judge goeke, the tax court held that it had jurisdiction to consider the taxpayer’s claim that his income from the s corporation was less than the amount reported on the schedule k-1 he received from it. the decision was based on two alternative grounds; first, the taxpayer assigned error to the 718 florida tax review [vol. 10:9 entire deficiency and the alleged unreported income was one of the irs’s adjustments contributing to that deficiency; second, pursuant to the tax court’s overpayment jurisdiction (which the taxpayer had invoked), the tax court has “authority to decide all the issues necessary to determine the correct amount of income tax for the taxable year in issue,” which even includes amounts that cannot be assessed because the statute of limitations on assessment and collection has expired. • judge holmes, in a long4 and lonely dissent, argued that the tax court lacked jurisdiction to review the deficiency attributable to the inconsistency between the taxpayer’s return and the s corporation’s schedule k-1 with respect to the taxpayer. he reasoned that even though the irs did issue a deficiency notice, it had no power to do so because § 6037 required that the irs treat the inconsistency solely as a mathematical error. that treatment would leave the taxpayer in the position of being required to pay the assessed amount and seek a refund. 3. if you really owe the tax and have already paid it you can’t it get it back on an irs procedural foot-fault. principal life insurance company v. united states, 106 a.f.t.r.2d 2010-7034 (fed. cl. 11/12/10). an assessment is necessary only for the irs to collect taxes that have not been paid. a tax liability paid before the deadline for payment will not be subject to refund merely because the irs fails to timely assess the tax or assesses it beyond the statute of limitations. e. statute of limitations 1. the courts hold that overstating basis is not the same as understating gross income, but the treasury department ultimately plays its trump card by promulgating regulations. section 6501(e)(1) extends the normal three-year period of limitations to six years if the taxpayer omits from gross income an amount in excess of 25 percent of the gross income stated in the return. section 6229(c)(2) provides a similar extension of the statute of limitations under § 6229(a) for assessments arising out of tefra partnership proceedings. a critical question is whether the six year statute of limitations applies if the taxpayer overstates basis and as a consequence understates gross income. a. the tax court says overstating basis is not the same as understating gross income. bakersfield energy partners, lp v. commissioner, 128 t.c. 207 (6/14/07). the taxpayer overstated basis, resulting in an understatement of § 1231 gain. looking to supreme court 4. the dissent was 43 typewritten pages, while the majority opinion was only 14 pages long. 2011] recent developments in federal income taxation 719 precedent under the statutory predecessor of § 6501(e) in the 1939 code (colony, inc. v. commissioner, 357 u.s. 28 (1958)), from which the six-year statute of limitations in § 6229(c)(2) is derived and to which it is analogous, the tax court concluded that this understated gain was not an omission of “gross income” that would invoke the six year statute of limitations under § 6229(c)(2) applicable to partnership audits. b. the ninth circuit likes the way the tax court thinks: bakersfield energy partners is affirmed. bakersfield energy partners, lp v. commissioner, 568 f.3d 767 (9th cir. 6/17/09). the ninth circuit affirmed the tax court on the grounds that the language at issue in the instant case was the same as the statutory language interpreted in colony. the court noted, however, that “the irs’s interpretation of § 6501(e)(1)(a) is reasonable.” c. and a judge of the court of federal claims agrees. grapevine imports, ltd v. united states, 77 fed. cl. 505 (7/17/07). in a tefra partnership tax shelter case, the court of federal claims (judge allegra) held that the § 6501(e) 6-year statute of limitations does not apply to basis overstatements, citing colony, inc. v. commissioner, 357 u.s. 28 (1958). section 6501(e), rather than § 6229(c)(2) as in bakersfield energy partners, lp, applied because in earlier proceedings in the instant case (71 fed. cl. 324 (2006)), the court had held that § 6229 did not create an independent statute of limitations, but instead only provides a minimum period for assessment for partnership items that could extend the § 6501 statute of limitations, and because the fpaa was sent within this sixyear statute of limitations under § 6229(d) the statute of limitations with respect to the partners was suspended. d. but a district court in florida disagrees. brandon ridge partners v. united states, 100 a.f.t.r.2d 2007-5347 (m.d. fla. 7/30/07). the court refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) 6-year statute of limitations does apply to basis overstatements. the court reasoned that as a result of subsequent amendments to the relevant code sections, the application of colony, inc. v. commissioner, 357 u.s. 28 (1958) is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or services. [“in the case of a trade or business, the term “gross income” means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.”] the court reasoned that to conclude otherwise would render § 6501(e)(1)(a)(i) superfluous. because the transaction at issue was the partnership’s sale of stock, which was not a business sale of goods or services, the gross receipts 720 florida tax review [vol. 10:9 test did not apply. on the facts, the partners and partnership returns (and statements attached thereto), taken together “failed to adequately apprise the irs of the true amount of gain on the sale of the ... stock.” thus, the partnership did not show that the extended limitations period was inapplicable. e. and a different judge of the court of federal claims agrees with the district court in florida and disagrees with the prior court of federal claims opinion by a different judge in grapevine imports. salman ranch ltd. v. united states, 79 fed. cl. 189 (11/9/07). the court (judge miller) refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) 6-year statute of limitations does apply to basis overstatements. judge miller reasoned that an understatement of “gain” is an omission of gross income, and that omission can result from a basis overstatement as well as from an understatement of the amount realized. like the brandon ridge partners court, judge miller concluded that the application of colony, inc. v. commissioner, 357 u.s. 28 (1958), is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or services. (“in the case of a trade or business, the term ‘gross income’ means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.”) because the transaction at issue was the partnership’s sale of a ranch, which was not a business sale of goods or services, the gross receipts test did not apply. on the facts, the partners’ and partnership returns failed to adequately apprise the irs of the amount of gain in a variant of the son-ofboss tax shelter. accordingly, the partnership did not show that the extended limitations period was inapplicable. the amended order certified an interlocutory appeal and stayed the case pending further court order, because of the split of opinion between salman ranch, on the one hand, and bakersfield energy partners and brandon ridge partners, on the other hand. f. and the pro-government opinion by judge miller is slapped down by the federal circuit. salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09). following colony, inc. v. commissioner, 357 u.s. 28 (1958), the federal circuit (judge schall, 2-1) held that “omits from gross income an amount properly includable therein” in § 6501(e)(1)(a) does not include an overstatement of basis. accordingly, the six-year statute of limitations on assessment did not apply – the normal three-year period of limitations applied. judge newman dissented. g. but a second district court sees it the government’s way. home concrete & supply, llc v. united states, 599 f. supp. 2d 678 (e.d. n.c. 10/21/08). the court held that §6501(e) extends the 2011] recent developments in federal income taxation 721 statute of limitations for deficiencies attributable to basis overstatements that result in omitted gross income exceeding 25 percent of the gross income reported on the return. the court refused to follow the tax court’s decisions in bakersfield energy partners and grapevine imports, because it concluded that those cases were erroneously decided. h. a hiccup from judge goeke in the tax court: overstated basis in an abusive tax shelter is a substantial omission from gross income that extends the statute of limitations. highwood partners v. commissioner, 133 t.c. no. 1 (8/13/09). the taxpayers invested through partnerships in foreign currency digital options contracts designed to increase partnership basis and generate losses marketed by jenkens & gilchrist (son of boss and miscellaneous other names). after expiration of the three-year statute of limitations, the irs issued an fpaa to the partnership based on the six-year statute of §6501(e)(1) applicable if there was a greater than 25 percent omission of gross income on each partner’s or the partnership’s return. the court (judge goeke) held that the digital options contracts produced § 988 exchange gain on foreign currency transactions, which, under the regulations, are required to be separately stated. the long and short positions of the options contracts were treated as separate transactions. thus, failure to report the gain on the short position, not offset by losses on the accompanying stock sale, represented an omission of gross income. the court also rejected the taxpayer’s argument that because the irs asserted that the options transactions should be disregarded in full, there can be no omission of gross income from the disregarded short position. finally, the court refused to apply the adequate disclosure safe harbor of § 6501(e)(1)(a)(ii) because the taxpayer’s netting of the gain and loss from the long and short positions was intended to mislead and hide the existence of the gain and did not apprise the irs of the existence of the gain. i. but judge haines follows the tax court orthodoxy. beard v. commissioner, t.c. memo. 2009-184 (8/11/09), rev’d, 107 a.f.t.r.2d 2011-552 (7th cir. 1/26/11). in a basis offset deal involving contributions of long and short positions in treasury notes contributed to s corporations, the court (judge haines) granted summary judgment to the taxpayer holding that the basis overstatement attributable to the short sale was not an a substantial omission of gross income. because the transaction involved treasury notes, there were no § 988 issues involved. this holding is consistent with bakersfield energy partners v. commissioner, 568 f.3d 767 (9th cir. 6/17/09), and salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09). j. and the irs loses again in the tax court. intermountain insurance service of vail v. commissioner, t.c. memo. 722 florida tax review [vol. 10:9 2009-195 (9/1/09). the court (judge wherry), again following bakersfield energy partners lp v. commissioner, 128 t.c. 207 (2007), granted summary judgment to the taxpayer holding that a basis overstatement is not a substantial omission from gross income that triggers the six year extended statute of limitations under § 6229. k. finally, the irs gets the upper hand with temporary regulations. t.d. 9466, definition of omission from gross income, 74 f.r. 49321 (9/24/09). temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)-1t both provide that for purposes of determining whether there is a substantial omission of gross income, gross income as it relates to a trade or business includes the total amount received from the sale of goods or services, without reduction for the cost of goods sold, gross income otherwise has the same meaning as under § 61(a). the regulations add that, “[i]n the case of amounts received or accrued that relate to the disposition of property, and except as provided in paragraph (a)(1)(ii) of this section, gross income means the excess of the amount realized from the disposition of the property over the unrecovered cost or other basis of the property. consequently, except as provided in paragraph (a)(1)(ii) of this section, an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of section 6229(c)(2).” l. but the irs still suffers from a hangover in cases on which the extended statute had run before the effective date of the regulations. utam, ltd v. commissioner, t.c. memo. 2009-253 (11/9/09). judge kroupa followed bakersfield energy partners to hold that the statute of limitations is not extended to six years pursuant to § 6229(c)(2) or § 6501(e)(1)(a) as a result of a basis overstatement that causes gross income to be understated by more than 25 percent. • although the date of the decision was after the effective date of temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)1t, the result was dictated by prior law effective when the fpaa was issued in 1999. m. judge wherry shoves it up the commissioner all the way to his “colon(-y)” in a reviewed tax court decision that holds the temporary regulations invalid. intermountain insurance service of vail v. commissioner, 134 t.c. no. 11 (5/6/10) (reviewed, 7-0-6), supplementing t.c. memo. 2009-195 (9/1/09) (granting summary judgment to the taxpayer, holding that a basis overstatement is not a substantial omission from gross income that triggers the six year extended statute of limitations under § 6229). on irs motions to reconsider and vacate in light of temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)-1t, the tax 2011] recent developments in federal income taxation 723 court (judge wherry) held that the supreme court’s opinion in colony, inc. v. commissioner, 357 u.s. 28 (1958), “’unambiguously forecloses the [irs] interpretation’ … and displaces [the] temporary regulations.” the first ground was that the temporary regulations were specifically limited their application to “taxable years with respect to which the applicable period for assessing tax did not expire before september 24, 2009,” and in this case that period was not open as of that date. the second ground was that the supreme court had held in colony that the statute was unambiguous in light of its legislative history, and foreclosed temporary regulations to the contrary. • judges halpern and holmes concurred in the result. they stated that they were not persuaded by either of the majority’s analyses, but that the temporary regulations should be invalidated on procedural grounds for failure to comply with the administrative procedure act’s notice-and-comment requirement. n. “tax court, we’ll see ya at high noon in front of the courts of appeals,” says the irs. t.d. 9511, definition of gross income, 75 f.r. 78897 (12/17/10). the irs and treasury have finalized amendments to regs. §§ 301.6229(c)(2)-1 and 301.6501(e)-1, replacing temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)-1t, t.d. 9466, definition of omission from gross income, 74 f.r. 49321 (9/24/09). the final regulations are identical to the temporary regulations in providing that for purposes of determining whether there is a substantial omission of gross income, gross income as it relates to a trade or business includes the total amount received from the sale of goods or services, without reduction for the cost of goods sold, gross income otherwise has the same meaning as under § 61(a). • the irs and treasury declared in the preamble that they believed that the tax court’s decision in intermountain insurance service of vail v. commissioner, 134 t.c. no. 11 (5/6/10), invalidating the temporary regulations, was erroneous: the treasury department and the internal revenue service disagree with intermountain. the supreme court stated in colony that the statutory phrase ‘‘omits from gross income’’ is ambiguous, meaning that it is susceptible to more than one reasonable interpretation. the interpretation adopted by the supreme court in colony represented that court’s interpretation of the phrase but not the only permissible interpretation of it. under the authority of nat’l cable & telecomms. ass’n v. brand x internet servs., 545 u.s. 967, 982–83 (2005), the treasury department and the internal revenue service are permitted to adopt another reasonable interpretation of ‘‘omits from gross income,’’ particularly as it is used in a new statutory setting. 724 florida tax review [vol. 10:9 • according to the preamble, the final regulations have been clarified to emphasize that they only apply to open tax years, and do not reopen closed tax years. however, the preamble states: the tax court’s majority in intermountain erroneously interpreted the applicability provisions of the temporary and proposed regulations, which provided that the regulations applied to taxable years with respect to which ‘the applicable period for assessing tax did not expire before september 24, 2009.” the internal revenue service will continue to adhere to the position that “the applicable period” of limitations is not the “‘general”’ three-year limitations period. ... consistent with that position, the final regulations apply to taxable years with respect to which the six-year period for assessing tax under section 6229(c)(2) or 6501(e)(1) was open on or after september 24, 2009. the supreme court’s decision in mayo foundation for medical education and research v. united states, 131 s. ct. 704 (1/11/11), see part xi.a.1.h. of this outline, holding that treasury regulations are entitled to deference under chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), could affect whether the irs will win this shoot-out. o. and government wins a big shoot-out in the seventh circuit, without any help from the temporary regulations. beard v. commissioner, 107 a.f.t.r.2d 2011-552 (7th cir. 1/26/11), rev’g t.c. memo 2009-184 (8/11/09). the seventh circuit, in an opinion by judge evans, reversed the tax court’s decision and held that an overstatement of basis results in an omission of gross income that triggers the six year statute of limitations under § 6501(e)(1)(a). in a very carefully reasoned opinion, the court concluded that the supreme court’s decision in colony, inc. v. commissioner, 357 u.s. 28 (1958), was not controlling. the seventh circuit reasoned that colony was both factually different — colony involved an overstatement of the basis of lots held by a real estate developer for sale to customers in the ordinary course of business, while the instant case involved an overstatement of basis in a partnership interest in a son-of-boss tax shelter transaction — and legally different because of changes between 1939 code § 275(c), which was interpreted in colony and 1954 code § 6501(e). the court held that “colony’s holding is inherently qualified by the facts of the case before the court, facts which differ from our case, where the beards’ omission was not in the course of trade or business.” applying principles of statutory interpretation, the court focused on the impact of the addition of § 6501(e)(1)(b)(ii) in the 1954 code, which provides that “in determining the amount omitted from gross income, there shall not be taken into account any amount which is omitted from gross income stated in the return if such amount is disclosed in the return, or in a statement attached to 2011] recent developments in federal income taxation 725 the return, in a manner adequate to apprise the secretary of the nature and amount of such item.” quoting phinney v. chambers, 392 f.2d 680 (5th cir. 1968), the court stated “[w]e conclude that the enactment of subsection (ii) of section 6501(e)(1)[(b)] makes it apparent that the six year statute is intended to apply where there is either a complete omission of an item of income of the requisite amount or misstating of the nature of an item of income which places the “commissioner ... at a special disadvantage in detecting errors.” (emphasis supplied). even though it distinguished colony and concluded that it was “left without precedential authority,” the court nevertheless concluded that because the language of § 6501(e)(1)(a) at issue in the case was identical to the language of § 275(c) interpreted in colony, it was required to interpret § 6501(e)(1)(a) in light of colony. however, it also reasoned that it must “bear in mind” that congress did add subsections (i) and (ii) to § 6501(e)(1)(b) and that “the section as a whole should be read as a gestalt.” in analyzing colony, the court noted that the supreme court had found § 275(c) to be ambiguous, but was more persuaded by the taxpayer’s argument that focused on the word “omits.” the seventh circuit noted that an issue that colony “does not address in depth is ‘gross income’” which is defined generally in section 61 of the code as ‘all income from whatever source derived,’ ” but which is not defined in § 6501(e) except for the special definition in § 6501(e)(1)(b)(i) that applies to trade or business income. the court then went on to hold: using these definitions and applying standard rules of statutory construction to give equal weight to each term and avoid rendering parts of the language superfluous, we find that a plain reading of section 6501(e)(1)(a) would include an inflation of basis as an omission of gross income in nontrade or business situations. ... it seems to us that an improper inflation of basis is definitively a “leav[ing] out” from “any income from whatever source derived” of a quantitative “amount” properly includible. there is an amount-the difference between the inflated and actual basiswhich has been left unmentioned on the face of the tax return as a candidate for inclusion in gross income. the court was reenforced in its conclusion by the existence of § 6501(e)(1)(b)(i), reasoning that “[i] the omissions from gross income contemplated section 6501(e)(1)(a) were only specific items such as receipts and accruals, then the special definition in subsection (i) would be, if not superfluous, certainly diminished. the addition of this subsection suggests that the definition of gross income for the purposes of section 6501(e)(1)(a) is meant to encompass more than the types of specific items contemplated by the colony holding.” the seventh circuit considered bakersfield energy partners v. commissioner, 568 f.3d 767 (9th cir. 6/17/09), and salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 726 florida tax review [vol. 10:9 7/30/09), to have been erroneously decided. finally, the court addressed the parties’ arguments regarding the impact of temp. reg. § 301.6501(e)1t(a)(1)(a). rather than ruling on the validity of the regulation, however, the court stated that because it did not find colony controlling and reached its decision that the six-year statute of limitations applied on the face of the code section, it would not reach the validity of the regulation. however, in dictum, the court stated that it would be inclined to grant deference to temp. reg. § 301.6501(e)-1t(a)(1)(a), even though it was issued without notice and comment, citing barnhart v. walton, 535 u.s. 212 (2002), for the proposition that “the absence of notice-and-comment procedures is not dispositive to the finding of chevron deference.” 2. the statute of limitations remains open for any tax return in connection with which required information about foreign transfers is not reported to the irs. section 513 of the 2010 hire act amended i.r.c. § 6501(c)(8) by providing that the statute of limitations remains open for any tax return relating to which information about foreign transfers is not furnished to the irs and treasury. the statute of limitations remains open until three years after the required information is furnished. section 511 and 512 of the 2010 hire act also provide for extended limitations for tax returns that are not fully compliant with respect to foreign assets. 3. a refund of fraudulently reported withholding results in an underpayment. feller v. commissioner, 135 t.c. no. 25 (11/8/10) (reviewed). the taxpayer, who controlled the corporation by which he was employed, fraudulently overstated withholding tax credits on his income tax returns and on the forms w-2 issued to him for tax years 1992 through 1997. the irs assessed tax and fraud penalties in 2006, on the theory that there was fraudulent underpayment and that, therefore, pursuant to § 6501(c)(1) the statute of limitations did not bar the assessment. the taxpayer argued that reg. § 1.6664-2(c)(1) and (g), ex. (3), which provide that overstated prepayment credits (e.g., overstated withholding) result in underpayments of tax within the meaning of § 6664, was invalid. in a reviewed opinion by judge haines (joined by ten other judges), the tax court, applying the chevron test (because the case was appealable to the sixth circuit, which applies the chevron test to treasury regulations), upheld the validity of reg. § 1.6664-2(c)(1) and (g), ex. (3). the assessments were upheld. • judges wherry and gustafson (joined by judge halpern) dissented and would have invalidated the regulations as an impermissible construction of the statute. 2011] recent developments in federal income taxation 727 f. liens and collections 1. in this much-discussed case, taxpayer’s poverty trumps a proposed levy. vinatieri v. commissioner, 133 t.c. no. 16 (12/21/09). the taxpayer submitted a settlement offer for delinquent taxes, but the irs determined to levy on the taxpayer’s wages and car. even though the irs concluded that the levy would create an economic hardship, the settlement officer determined collection alternatives to the levy, including an installment agreement, an offer-in-compromise, and reporting the account as currently not collectible, were not available because the taxpayer had not filed returns for several years. in a review of a § 6330 cdp hearing, judge dawson held that it was unreasonable and an abuse of discretion for the irs to proceed to levy on the taxpayer’s wages and car, because a levy would have left the taxpayer impoverished. section 6343(a)(1) requires that the irs must release a levy upon all, or part of, a taxpayer’s property if it determines that the levy creates an economic hardship due to the taxpayer’s financial condition. reg. § 301.6343-1(b)(4) provides that a levy creates an economic hardship due to the financial condition of an individual taxpayer and must be released “if satisfaction of the levy in whole or in part will cause an individual taxpayer to be unable to pay his or her reasonable basic living expenses.” because the taxpayer had demonstrated that a levy would render her unable to pay her reasonable basic living expenses, the irs was barred from levying. judge dawson rejected the irs’s argument that because the taxpayer was not in compliance with the filing requirements for all required tax returns, its determination to levy was not unreasonable. • the requirement that taxpayer be currently in compliance with his or her obligations to the irs under its “currently not collectible” (“cnc”) program does not apply to relief under § 6343. a. appeals must address credible claims of economic hardship. chief counsel notice cc-2011-005 (12/22/10). in response to the vinatieri case, the chief counsel now requires appeals to address credible claims of economic hardship. 2. you only imagined that a discharge in bankruptcy from personal liability for back income taxes really got you off the hook. wadleigh v. commissioner, 134 t.c. no. 14 (6/15/10). this case involved a review of the irs’s determination in a § 6330 cdp hearing not to release a levy on the taxpayer’s pension. the tax lien had not been perfected by filing a notice of federal tax lien, and prior to the irs issuing its notice of intent to levy, the taxpayer’s personal liability for the income taxes in question had been discharged in bankruptcy. the tax court (judge marvel) held that because the taxpayer’s pension was an excluded asset 728 florida tax review [vol. 10:9 under 11 u.s.c. § 541(c)(2) that was never part of the bankruptcy estate – in contrast to an exempt asset, which initially is part of the bankruptcy estate but which is unavailable to satisfy creditor’s claims – the § 6231 unperfected tax lien on the taxpayer’s pension survived his bankruptcy and could be enforced notwithstanding his personal discharge. however, the lien was not enforceable until the pension entered payout status. nevertheless, judge marvel remanded the case to the appeals division, but retained jurisdiction, because the record was inadequate to determine whether the irs abused its discretion in levying on the taxpayer’s retirement income, in the face of the taxpayer’s claim that the levy would result in economic hardship by leaving him destitute. 3. just because the irs thinks it’s not worth trying to levy on it doesn’t necessarily mean it’s not a fraudulent conveyance if you give it away. rubenstein v. commissioner, 134 t.c. no. 13 (6/7/10). the taxpayer’s father, who was insolvent and had substantial unpaid income tax liabilities of which the taxpayer was aware, transferred to the taxpayer for little or no consideration the condominium in which they both resided, which was worth approximately $44,000. in the course of evaluating an offer in compromise previously submitted by the father, but which was rejected, the irs had determined that the net realizable equity value in the condominium was zero. after the transfer, the irs asserted transferee liability equal to the condominium’s fair market value on the date of the transfer on the ground that the transfer was constructively fraudulent under florida’s uniform fraudulent transfer act (fufta). under florida law the condominium was the father’s homestead, and thus was generally exempt from creditor’s claims under nonbankruptcy law. however, the fufta excludes from the definition of “assets” property that is “generally exempt under nonbankruptcy law.” on this basis the taxpayer argued that the condominium was not an “asset” for purposes of the fufta and its transfer to him thus was not avoidable. the tax court (judge thornton) held that because a homestead property is reachable by the united states through judicial process to enforce collection of unpaid income tax liabilities, even if it is exempt from the claims of other creditors under state law, the homestead condominium was not “generally exempt under nonbankruptcy law” within the meaning of the fufta. thus, the condominium was an “asset” for purposes of the irs’s claim under the fufta. furthermore, because the care that the taxpayer had provided for his father was not bargained for, but was provided out of love and respect, it did not constitute “reasonably equivalent value” for the condominium within the meaning of the fufta. accordingly, the transfer was fraudulent. finally, the irs was not equitably estopped from asserting transferee liability by virtue of having previously determined that the condominium had zero net equity value. 2011] recent developments in federal income taxation 729 4. here’s a case in which a partner’s draw is “salary or wages,” much to his dismay. united states v. moskowitz, passman & edleman, 603 f.3d 162 (2d cir. 4/29/10). the second circuit held that a continuing levy on “salary” under § 6331(e) reached a partner’s “near-weekly” draw against the law firm’s profits. reg. § 301.6331-1(b)(1) defines “salary or wages” to “‘include[] compensation for services paid in the form of fees, commissions, bonuses, and similar items.’” (emphasis supplied by the court). because the partner’s draw was “compensation for services,” the court concluded that it was within the sweep of the regulation, and thus § 6331(e). the court rejected the law firm’s argument that payments of partnership draw to the partner were not “salary or wages” under § 6331(e) at the time of the levy because “‘a partner only realizes income on the last day of the partnership’s taxable year.’” 5. no need for actuarial values to decide how much of the entirety the tax-deadbeat hubby owned. united states v. barr, 106 a.f.t.r.2d 2010-5590 (6th cir. 8/4/10). in an opinion by judge rogers, the sixth circuit held that to satisfy a husband’s separate tax liability, the government could levy on his one-half interest in a house owned with his wife in tenancy by the entirety under michigan law. the taxpayer’s wife was entitled to only one-half of the sales proceeds, despite her longer life expectancy. 6. just because you gave it away to a trust for your kids doesn’t mean you still really own it. dalton v. commissioner, 135 t.c. no. 20 (9/23/10). the tax court (judge wells) held that the irs abused its discretion in rejecting the taxpayer’s offer in compromise. the irs treated property that had been deeded to the taxpayer’s father before a tax lien arose, and which subsequently was transferred by the taxpayer’s father to a trust for the benefit of the taxpayer’s children, as held by the trust as a nominee for the taxpayer. on this basis, the irs treated the trust’s assets as available for the payment of taxpayer’s tax liability. after examining both state law and federal tax principles, judge wells concluded that the trust did not hold the property as a nominee for the taxpayer. 7. ya gotta tell the court ya want a speedy trial. thompson v. united states, 106 a.f.t.r.2d 2010-6464 (n.d. ill. 9/29/10). the failure of the district court to review a jeopardy assessment within 20 days, as required by § 7429(b)(2) is not alone grounds for entering judgment for the taxpayer. the taxpayer bears the responsibility for informing the district court of the statutory time deadline. the taxpayer failed to do so. 730 florida tax review [vol. 10:9 g. innocent spouse 1. that regulation ain’t got no equity and it ain’t got no empathy, so it’s invalid. the tax court majority responds to “the sound of [congressional] silence.” lantz v. commissioner, 132 t.c. no. 8 (4/7/09) (reviewed, 12-4). the taxpayer sought equitable relief from joint income tax liability under § 6015(f), but the irs denied relief on the ground that she had not requested relief within two years from the irs’s first collection action, as required by reg. § 1.6015-5(b)(1). consequently, the irs did not reach the substantive issues of the claim. in a reviewed opinion by judge goeke, joined by eleven judges, with four dissents, the tax court held reg. § 1.6015-5(b)(1) to be invalid as applied to § 6015(f) relief. (following the golsen rule, the tax court applied chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), because the seventh circuit held in bankers life & cas. co. v. united states,142 f.3d 973, 979 (7th cir. 1998), that regulations issued under general or specific authority of the irs to promulgate necessary rules are entitled to chevron deference; reg. § 1.6015-5 was issued under both a general grant of authority under § 7805 and a specific grant of authority in § 6015(h).) the court focused on the explicit inclusion of a two-year deadline in both § 6015(b) and § 6015(c), in contrast to the absence of any deadline in § 6015(f), to find that the regulation was not a reasonable interpretation of the statute under the chevron standard. “‘it is generally presumed that congress acts intentionally and purposely’ when it ‘includes particular language in one section of a statute but omits it in another.’” ... we find that by explicitly creating a 2-year limitation in subsections (b) and (c) but not subsection (f), congress has “spoken” by its audible silence. because the regulation imposes a limitation that congress explicitly incorporated into subsections (b) and (c) but omitted from subsection (f), it fails the first prong of chevron. ... had congress intended a 2-year period of limitations for equitable relief, then of course it could have easily included in subsection (f) what it included in subsections (b) and (c). however, congress imposed no deadline, yet the secretary prescribed a period of limitations identical to the limitations congress imposed under section 6015(b) and (c). • as a result, the irs abused its discretion in failing to consider all facts and circumstances in the taxpayer’s case. further proceedings are required to fully determine the taxpayer’s liability. 2011] recent developments in federal income taxation 731 a. you don’t have to actually know the irs denied § 6015(b) relief for the statute of limitations on seeking review to have expired, but you can always turn to § 6015(f), which for now appears to have an open-ended period for review. mannella v. commissioner, 132 t.c. no. 10 (4/13/09), rev’d, 107 a.f.t.r.2d 2011-519 (3d cir 1/19/11). the irs sent the taxpayer a notice of intent to levy and notice of the right to a § 6330 cdp hearing on 6/4/04. on 11/1/06, more than two years later, the taxpayer requested § 6015 relief from joint and several liability, which the irs denied on the grounds that the request was untimely. the taxpayer claimed that she did not receive her notice of intent to levy because her former husband received the notices, signed the certified mail receipts, and failed to deliver of inform her of the notices. judge haines held that actual receipt of the notice of intent to levy or of the notice of the right to request relief from joint and several liability is not required for the 2-year period in which to request relief under §§ 6015(b) and (c) to begin. the taxpayer’s request for relief under §§ 6015(b) and (c) was not timely. however, the taxpayer’s claim for relief under § 6015(f), was timely because lantz v. commissioner, 132 t.c. no. 8 (4/7/09), held that reg. § 1.60155(b)(1), requiring a request for relief within two years from the irs’s first collection action, is invalid as applied to § 6015(f) relief. b. but the irs will fight this one to the bitter end! cc-2010-005, designation for litigation: validity of two-year deadline for section 6015(f) claims under treas. reg. § 1.6015-5(b)(1) (3/12/10). this chief counsel notice states that because the issue of the validity of the two-year deadline in reg. § 1.6015-5(b)(1) for filing a claim for § 6015(f) relief, which was held to be an invalid regulation in lantz v. commissioner, 132 t.c. no. 8 (2009), has been designated for litigation by the office of chief counsel, the irs will continue to deny claims for relief under § 6015(f) as untimely and will not settle or concede this issue. however, depending on the facts of the case, the merits of the § 6015(f) claim might be conceded. c. and the irs’s bitter-end fight to validate the regulation ended up in the seventh circuit, where judge posner denied the existence of “audible silence.” lantz v. commissioner, 607 f.3d 479 (7th cir. 6/8/10). the taxpayer was described as “a financially unsophisticated woman whose husband, a dentist, was arrested for medicare fraud in 2000, convicted and imprisoned. they had been married for only six years when he was arrested and there is no suggestion that she was aware of, let alone complicit in, his fraud.” she received a packet that included a notice of a proposed levy on her in 2003, but did not respond because her estranged husband told her “he’d deal with the matter.” he asked the irs to be sent the application form for seeking innocent-spouse relief, explaining that his wife 732 florida tax review [vol. 10:9 was an “innocent spouse,” but he died before filing it. in 2006, the irs applied taxpayer’s $3,230 income tax refund for 2005 to her joint and several liability for 1999 of more than $1.3 million. “unemployed and impecunious, she applied for innocent-spouse relief but the irs turned her down because she’d missed the two year-deadline ….” the seventh circuit (judge posner), sustained the regulation and agreed with the irs’s denial of relief, stating, “… any statute of limitations will cut off some, and often a great many, meritorious claims.” • judge posner denied the existence of “audible silence” in the following words: but even if our review of statutory interpretations by the tax court were deferential, we would not accept “audible silence” as a reliable guide to congressional meaning. “audible silence,” like milton’s “darkness visible” or the zen koan “the sound of one hand clapping,” requires rather than guides interpretation. lantz’s brief translates “audible silence” as “plain language,” and adds (mysticism must be catching) that “congress intended the plain language of the language used in the statute.” • in sustaining the regulation judge posner reasoned as follows; agencies ... are not bashful about making up their own deadlines[,] ... and because it is as likely that congress knows this as that it knows that courts like to borrow a statute of limitations when congress doesn’t specify one, the fact that congress designated a deadline in two provisions of the same statute and not in a third is not a compelling argument that congress meant to preclude the treasury department from imposing a deadline applicable to cases governed by that third provision;” if there is no deadline in subsection (f), the two-year deadlines in subsections (b) and (c) will be set largely at naught because the substantive criteria of those sections are virtually the same as those of (f). ... we must also not overlook the introductory phrase in subsection (f)—“under procedures prescribed by the [treasury department]”—or the further delegation in 26 u.s.c § 6015(h) to the treasury to “prescribe such regulations as are necessary to carry out the provisions of” section 6015. in related contexts such a delegation has been held to authorize an agency to establish deadlines for applications for discretionary relief. 2011] recent developments in federal income taxation 733 • the opinion concludes with the hope that the irs would grant taxpayer relief under § 6343 from its levy on taxpayer by declaring the taxes “currently not collectible” as follows: ironically, the service declared the taxes owed by lantz’s husband – the crooked dentist – “currently not collectible.” she is entitled a fortiori to such relief, and there is no deadline for seeking it. we can at least hope that the irs knows better than to try to squeeze water out of a stone.5 d. and the tax court responds with a big “raspberry” to judge posner. hall v commissioner, 135 t.c. no. 19 (9/22/10). in a reviewed opinion by judge goeke, in which seven judges joined, the tax court adhered to its position in lantz, supra, that reg. § 1.6015-5(b)(1) imposing a two-year statute of limitations on claims for relief under § 6015(f) is invalid, notwithstanding the reversal of its decision in lantz by the seventh circuit. five judges dissented. e. the third circuit likes the way judge posner thinks and gives a big “raspberry’ to the tax court. mannella v. commissioner, 107 a.f.t.r.2d 2011-519 (3d cir. 2011), rev’g 132 t.c. no.10 (4/13/09). in a 2-1 decision written by judge greenberg, the third circuit reversed the tax court and upheld the two-year statute of limitations on taxpayers seeking § 6015(e) equitable relief provided in reg. § 1.60155(b)(1). according to judge greenberg’s opinion, “[w]e cannot say that section 6015, in terms, requires that we embrace any particular view of congress’s intent with respect to a subsection (f) filing deadline, and “the absence of a statutory filing deadline in subsection (f) similar to those in subsections (b) and (c) does not require us to conclude that the secretary cannot impose a two-year deadline by regulation.” in the course of applying step one of its chevron analysis, the court stated “[w]e agree with the court of appeals for the seventh circuit that this silence is not made audible by the presence of deadlines in subsections (b) and (c).” turning to step two of its chevron analysis, the court acknowledged that the taxpayer’s argument that the legislative history of § 66(c), which provides relief similar to § 6015(e) relief for taxpayers in community property states who do not file a joint return and which was enacted at the same time as § 6015(e), suggested that there should not be a rigid statute of limitations on seeking § 6015(e) equitable relief, “lends some support to [the taxpayer’s] position, but concluded that “it fails to overcome the deference that we must give to treasury regulation § 1.6015-5(b)(1) under chevron and it does not clearly demonstrate that congress intended that requests for relief under subsection 6015(f) not be subject to a two-year filing deadline.” additionally, the court 5. but cf., exodus 17:1-7 and numbers 20:1-13. 734 florida tax review [vol. 10:9 likewise rejected the taxpayer’s argument that “the inclusion of deadline periods in subsections (b) and (c) but omission of such a period in subsection (f) “demonstrates congressional intent that requests for equitable relief not be subject to a bright-line time limitation, but rather allow the taxpayer to request relief during the 10-year collection period of 26 u.s.c. § 6502.” however, the court of appeals remanded the case to the tax court to determine whether the statute of limitations in reg. § 1.6015-5(b)(1) is subject to equitable tolling and, if so, whether the taxpayer met the standards for equitable tolling. • judge ambro dissented. he agreed with the majority, and disagreed with the tax court, on the question of whether congress had spoken directly on the issue of the time frame in which the taxpayer must seek § 6015(e) relief, but would have invalidated reg. § 1.6015-5(b)(1) in step two of the chevron analysis on the ground that in promulgating the regulation, “the irs has not advanced any reasoning for its decision to impose a two-year limitations period on taxpayers seeking relief under subsection (f), leaving us no basis to conduct the analysis mandated by chevron step two.” he reasoned that “it is ... a necessary corollary of the deference owed to agencies-that courts may not supplement deficient agency reasoning,” and did not find judge posner’s reasoning in lantz v. commissioner, 607 f.3d 479 (7th cir. 6/8/10), to be convincing. 2. one spouse pays and the other spouse doesn’t, and no one is innocent. one is just more cooperative with the irs. jordan v. commissioner, 134 t.c. no. 1 (1/11/10). the tax court (judge wells) held that spouses may separately agree to a waiver of the 10-year period of limitations on collections for a year with respect to which they filed a joint return. the waiver may be effective with respect to one spouse, but not with respect to the other spouse if the other spouse did not also execute the waiver or has the right to repudiate it. 3. the statute might not have correctly articulated the statutory cross reference, but the tax court got the drift of congressional intent anyway. adkison v. commissioner, 129 t.c. 97 (10/16/07). the tax court does not have jurisdiction to review a claim for apportioned liability relief under § 6015(c) when the tax liability in question relates to partnership income and the deficiency notice on which the jurisdiction was asserted to be based is invalid because the partnership items are subject to determination in a tefra partnership level proceeding that has not yet been resolved. section 6230(a)(3)(a), which still refers to former § 6013(e), the statutory predecessor of § 6015, evidences congressional intent that the spouse of a partner can initiate a claim for innocent spouse relief with respect to a deficiency attributable to an adjustment of a partnership item only after the irs issues a notice of computational 2011] recent developments in federal income taxation 735 adjustment following the completion of the partnership-level proceeding. judge cohen concluded that congress simply overlooked the need to correct the cross references in § 6230 when it replaced § 6013(e) with § 6015. a. affirmed on other grounds: the tax court had jurisdiction, but cannot grant any relief until the tefra proceeding is concluded. adkison v. commissioner, 592 f.3d 1050 (9th cir. 1/21/10). judge bybee’s opinion for the ninth circuit described the tax court’s holding as “dismiss[ing] for lack of jurisdiction, reasoning that because a separate partnership proceeding involving the transaction from which the deficiency arose was already pending, the commissioner did not “assert” a deficiency against adkison within the meaning of [§ 6015(e)(1)(a)].” however, judge bybee concluded that the tax court did have jurisdiction, because nothing in § 6320 divests the tax court of jurisdiction under § 6015. he found that “the commissioner, joined by the tax court, has confused the availability of a remedy with the question of the tax court’s jurisdiction.” however, he continued to conclude that: although ... the tax court has jurisdiction over adkison’s § 6015 petition, the tax court’s instincts were correct: in light of the ... tefra proceeding ..., there is no “appropriate relief available” to adkison.” tefra plainly contemplates that when a partnership proceeding is pending, the commissioner will not assert a deficiency against a taxpayer-partner until the partnership proceeding determines the liability of the partnership, and consequently, the partners. ... once the tefra proceeding is concluded, the partners are entitled to a “final partnership administrative adjustment,” id. § 6223(a)(2), their tax deficiency is determined, and at that point, the spouse of a partner may file a petition for relief under § 6015. • thus, the judgment was affirmed on the grounds that no remedy was available, even though there was jurisdiction. • we think judge bybee was confused by the phrase “in the case of an individual against whom a deficiency has been asserted” in § 6015(e) and concluded that the tax court has jurisdiction even though the deficiency notice is invalid. a long line of case law holds that the tax court does not have jurisdiction in every case in which a “deficiency is asserted,” to use judge bybee’s phrase, but only in those cases in which a valid deficiency notice has been issued. if the deficiency notice was issued prematurely, it was not valid, and if the deficiency notice is not valid, although the tax court has no jurisdiction to “redetermine” the asserted deficiency, the irs nevertheless is barred from assessing the tax. 736 florida tax review [vol. 10:9 4. the widow inherits the ability to make a standalone § 6015(c) election, even though § 6015(b) and § 6015(f) relief were foreclosed by the pleadings in the prior deficiency case. deihl v. commissioner, 134 t.c. no. 7 (2/23/10). the taxpayer and her late husband had contested deficiencies for 1996, 1997, and 1998 in tax court proceedings in 2004. the petition in that proceeding had raised the issue of § 6105 relief for 1996, but not for 1997 or 1998; however, in the stipulation of facts for the consolidated cases, the claim for relief from joint and several liability was withdrawn. only the taxpayer’s husband signed the petition in the deficiency proceeding. the taxpayer did not (1) sign any court documents in the case, (2) review the petitions or the stipulations of facts, or (3) agree to any of the stipulations. her husband and their (his) lawyer did not discuss the documents with the taxpayer, and she saw them for the first time at trial in the instant case. the taxpayer did not meet with any irs personnel, participate in any settlement negotiations with the irs, or sit in on any such meetings between her attorneys and the irs during the litigation in the earlier case, although she was called as a witness and testified briefly. the taxpayer’s husband died after the trial but before a final order was entered. after the decision was entered, the taxpayer filed an administrative claim for relief from joint and several liability for all three years, which the irs denied on the ground that the claim was barred by res judicata under § 6015(g)(2). the tax court (judge vasquez) held that § 6015(g)(2) applied because the tax court entered final decisions for 1996 through 1998. however, because § 6015 relief was raised only in the pleadings for 1996, § 6015 relief for 1997 and 1998 was not an issue in the prior proceeding, and because the taxpayer did not meaningfully participate in the prior preceding, the exception in § 6015(g)(2) applied for 1997 and 1998 and the taxpayer was not barred from seeking relief for those years. furthermore, because the petition in the 2004 proceeding did not specifically invoke § 6015(c), and the taxpayer was ineligible to make a § 6015 election at the time because her husband was alive, a § 6015(c) election was not an issue in the prior proceeding, the taxpayer was not barred from seeking § 6015(c) apportioned liability for 1996. however, relief from joint and several liability for 1996 was raised by the petition and thus was at issue in the earlier proceeding, and § 6015(g)(2) barred the taxpayer from claiming relief from joint and several liability under § 6015(b) and (f) for 1996. 5. pyrrhic victory on the meaning of “no reason to know.” greer v. commissioner, 595 f.3d 338 (6th cir. 2/17/10). the taxpayer sought § 6015(b) relief with respect to a deficiency attributable to her husband’s disallowed tax shelter deductions and credits. in the tax court, judge goeke found that “rather than having ‘“no reason to know’ of the tax understatement, as required for relief, she ‘chose not to know,’” and denied relief. in affirming, the sixth circuit, in an opinion by judge moore, 2011] recent developments in federal income taxation 737 adopted the test of price v. commissioner, 887 f2d 959 (9th cir. 1989), under which “in erroneous-deduction cases, ‘[a] spouse has “reason to know” of the substantial understatement if a reasonably prudent taxpayer in her position at the time she signed the return could be expected to know that the return contained the substantial understatement.’” the court rejected application of the knowledge of the transaction test, which applies to income omission cases, on the following reasoning. the knowledge-of-the-transaction test leaves room for a taxpayer to claim innocent-spouse relief in omitted-income claims, because the understatement arises in such cases from information being left off a return, and the spouse otherwise may not have known or had reason to know that information. in erroneous-deduction cases, the understatement arises from information being included on the return, so a spouse who signs a tax return necessarily learns of the transaction. the knowledge-of-the-transaction test writes the innocent-spouse provision out of the law in such cases. a more nuanced approach is thus required, especially given that an understatement arising from a deduction usually is not obvious from the face of a tax return. a taxpayer who knows how much money the family earned will know that tax has been understated if income is omitted from the return, as it is common knowledge that income is taxable. ... by contrast, a taxpayer who is aware of an investment may or may not know that tax benefits claimed on its basis are impermissible, depending on that taxpayer’s level of sophistication and how much he or she knows about the investment. .... the price test takes account of this difference. • nevertheless, relief was denied because the tax court did not clearly err. “[t]he low level of taxes owed relative to the income reported ... should have given mrs. greer pause.” section 6015(f) equitable relief also was denied, on the ground that the taxpayer failed to demonstrate economic hardship. • note that current reg. §1 .60153(c)(2)(i)(b)(1), which was effective for the year in which the taxpayer sought relief but which was not cited by the court, expressly provides: “in the case of an erroneous deduction or credit, knowledge of the item means knowledge of the facts that made the item not allowable as a deduction or credit.” 6. it’s tough to get back money you never paid the irs, even if you might be an innocent spouse. kaufman v. commissioner, t.c. memo. 2010-89 (4/27/10). the tax court held that – assuming for the sake of argument that the surviving spouse would be entitled to § 6015(f) 738 florida tax review [vol. 10:9 relief – no relief was available because she was seeking a refund of amounts paid by her husband’s estate, not amounts paid by her. h. miscellaneous 1. claims for a method for hedging risk in commodities trading are held not to concern patent-eligible subject matter. this leads to the possible conclusion that tax strategies are not patentable. however, the federal circuit did not overrule the state street case and the supreme court has granted certiorari in this case. in re bilski, 545 f.3d 943 (fed. cir. 10/30/08) (9-3), cert. granted sub nom. bilski v. doll, 129 s. ct. 2735 (6/1/09). the federal circuit (judge michel) affirmed a decision of the board of patent appeals and interferences that claims for a method for managing (hedging) the risks in commodities trading did not constitute a patent-eligible subject matter. the meaning of a patentable “process” under 35 u.s.c. § 101 [“whoever invents or discovers any new and useful process, machine [etc.] … may obtain a patent therefore … .] includes only the transformation of a physical object or substance, or an electronic signal representative of a physical object or substance.” a. federal circuit is affirmed, in that the hedging method did not constitute a patent-eligible subject matter, but the supreme court’s long-awaited opinion leaves the law farkockteh [utterly messed up] and leaves tax practitioners farblonjet [completely confused]. bilski v. kappos, 130 s. ct. 3218 (6/28/10). tax method patents appear to be permissible under the court’s opinion if they constitute a process related to a machine (and that test is not the exclusive test). moreover, business method patents are not categorically excluded from patentability. there is much more, but it is patent law and not of interest to non-masochistic tax practitioners. 2. burton kanter got in trouble. investment research associates, ltd. v. commissioner, t.c. memo. 1999-407 (12/15/99). in a 600-page opinion, burton kanter was held liable for the § 6653 fraud penalty by reason of his being “the architect who planned and executed the elaborate scheme with respect to … kickback income payments . . . .” a. for a detailed outline of developments in this matter between 2000 and december 2009, please see mcmahon, shepard & simmons, recent developments in federal income taxation: the year 2009, 10 florida tax review, 79, 249 – 254 (2010). b. a former member of the university of chicago law school faculty, members of which took a pro-kanter stand 2011] recent developments in federal income taxation 739 during the entire litigation because the school was getting big bucks from kanter and/or his estate, decided the last appeal in this matter in favor of burton kanter’s estate. result: the late burton kanter = 1; the irs = zero; the tax court = minus 1. did we mention that the former faculty member was married to a current member of the faculty? kanter v. commissioner, 590 f.3d 410 (7th cir. 12/1/09). the seventh circuit reversed, vacated and remanded t.c. memo. 2007-21 (2/1/07), with instructions to “enter an order approving and adopting the stj’s report as the decision of the tax court.” judge wood found that the stj’s findings were not “clearly erroneous” but “freely acknowledge[d] that a rational person could just as easily have come to the opposite conclusion on this record.” • on his federal income tax returns for the years 1979 through 1989, burton kanter reported that he had no income tax liability. that return position has been vindicated. so it goes. c. chutzpah on steroids by this influential chicago family. according to tax analysts, the kanter family has called for removal of several tax court judges. “taxes, taxes, we don’t have to pay no steenking income taxes.” 2010 tnt 44-1 (3/8/10). “as attorneys for the kanter family, we call on the president, who has the power to remove a tax court judge, to immediately institute an investigation on whether such removal is justified,” lanny j. davis of mcdermott will & emery told tax analysts. “we also call on the committees of congress that have oversight of the tax court to institute an investigation of judge dawson and other tax court judges who appear to have been at least complicit in knowing about judge dawson’s pattern of deception and not reporting him to senior authorities or, even worse, participated in a cover-up of his deception in the summer of 2005 after the supreme court forced the disclosure of judge couvillion’s original opinion.” • the kanter family is also upset because the irs is auditing burton kanter’s estate tax return. why on earth would the irs do something like that? 3. when the irs says it’s going negative on a private letter ruling you better withdraw it the way the rev. proc says to. does this taxpayer really think that captioning the case as “anonymous v. commissioner” will help hide from the irs? anonymous v. commissioner, 134 t.c. no. 2 (1/19/10). the tax court (judge goeke) held that it lacked jurisdiction to enjoin the issuance of a private letter ruling after the taxpayer failed to withdraw the request following notification that the ruling would be adverse. (the tax court does have jurisdiction to determine whether certain items in a private letter ruling must be redacted prior to publication.) judge goeke summarized taxpayer’s argument (before rejecting it) as follows: 740 florida tax review [vol. 10:9 petitioner . . . argues that the [administrative procedure act] provides this court with the authority to order respondent not to disclose the plr at issue because the plr was arbitrary, capricious, and an abuse of discretion. petitioner alleges section 6110(f)(3) grants the court the express authority to review written determinations open to public inspection like plrs. petitioner contends that the contents of the plr are contrary to law and thus respondent acted arbitrarily, capriciously, and in bad faith in issuing it. petitioner further argues that for the same reason the plr should not be disclosed to department of the treasury officials. 4. “the whistleblower talks twice.” chief council notice cc-2010-004 (2/17/10). this chief counsel notice clarifies the limitations on contacts between irs employees and informants, including informants who have filed claims under § 7623, by permitting more than one contact with informants [including those informants who are current employees of the taxpayer]. there are safeguards to prevent the informant from becoming an instrument or agent of the government, as well as a prohibition on accepting any information from an informant who is the taxpayer’s representative in any administrative matter pending before the irs. 5. congress discovers that corporations as well as unincorporated businesses might cheat less if payors rat them out to the irs. the 2010 health care act amended § 6041 to extend to payments to corporations the information reporting requirement for all payments by a business to any single payee (other than a payee that is a tax exempt corporation) aggregating $600 or more in a calendar year for amounts paid in consideration for property or services. however, the expanded rule does not override other specific code provisions that except payments from reporting, for example, securities or broker transactions as defined under § 6045(a) and the regulations thereunder. the new rule is effective for payments made after 12/31/11. • there is a move in congress to repeal this provision in exchange for tax increases on multinational corporations. 6. reporting, reporting, there’s lots of health care reporting. a. employer reporting, act 1. the 2010 health care act amended § 6051 of the code to require reporting on each employee’s annual form w-2 the value of the employee’s health insurance 2011] recent developments in federal income taxation 741 coverage sponsored by the employer for taxable years beginning after 12/31/10. b. employer reporting, act 2. the 2010 health care act added new § 6056 to the code and amended § 6724(d) to impose health insurance reporting requirements on employers. applicable large employers subject to the employer responsibility provisions of new § 4980h, and other employers who offer minimum essential coverage to their employees under an employer-sponsored plan and pay premiums in excess of 8 percent of employee wages, must report specified health insurance coverage information to both its full-time employees and to the irs. an employer who fails to comply with these new reporting requirements is subject to the penalties for failure to file an information return and failure to furnish payee statements, respectively. the new rules are effective for calendar years beginning after 2013. c. insurer reporting. the 2010 health care act added new § 6055 to the code and amended § 6724(d). insurers, including employers who self-insure, that provide minimum essential coverage to any individual must report certain health insurance coverage information to both the individual and to the irs. an insurer who fails to comply with these new reporting requirements is subject to the penalties for failure to file an information return and failure to furnish payee statements, respectively. the new rules are effective for calendar years beginning after 2013. 7. disclosure of return information is ok if the purpose is to verify eligibility / ineligibility for cost-sharing benefits and an advance § 36b premium credit through an american health benefits exchange. the 2010 health care act amended § 6103 to the code to allow the irs to disclose to hhs certain return information of any taxpayer whose income is relevant in determining the amount of the tax credit or cost-sharing reduction, or eligibility for participation in the specified state health subsidy programs (i.e., a state medicaid program under title xix of the social security act, a state’s children’s health insurance program under title xxi of such act, or a basic health program under § 2228 of such act). 8. irs releases recommendations that paid tax return preparers would be required to register. ir-2010-1, 2010 tnt 2-1 (1/4/10). the irs released a list of recommendations that would require that individuals who sign a tax return as a paid preparer pay a user fee to register online with the irs and obtain a preparer tax identification number [ptin]. all preparers – except attorneys, cpas and enrolled agents – would have to pass competency exams and complete 15 hours of annual cpe in federal tax 742 florida tax review [vol. 10:9 law topics. the irs proposes to expand circular 230 to cover all signing and nonsigning return preparers. registered preparers would be listed on a publicly-searchable data base and would be required to have ptins in 2011. a. we wish we had karen’s confidence in accenture. the irs office of professional responsibility is not at all concerned with the task of registering paid tax preparers. that is because accenture will be the vendor to establish a system for on-line registration, with a target date of 9/1/10. accenture will undoubtedly bring to this task the same thoughtful foresight and judgment it used when it selected tiger woods as its leading spokesperson. 2010 tnt 85-24 (5/4/10). the irs announced that accenture national security services, llc, will be the vendor to establish a system for on-line registration of paid tax return preparers. “the vendor will develop and maintain the registration application system and address related questions.” karen hawkins, director of the irs office of professional responsibility recently stated that she was not worried about registration of paid preparers because accenture would take care of it completely. b. some of us learned about the concept of “fee simple” in school but these will not be “simple fees”; instead there will be multiple fees – some of which will be raked off by accenture. reg-139343-08, user fees relating to enrollment and preparer tax identification numbers, 75 f.r. 43110 (7/23/10). registration for an identifying number, together with a $50 fee will be required for all tax return preparers who prepare all, or substantially all, of a return or claim for refund of tax after 12/31/10. accenture may charge a “reasonable fee” that is independent of the $50 user fee. • the irs later confirmed that the user fee for the first year of registration will be $64.25; the excess $14.25 will permit accenture to “wet its beak.” c. the irs issued proposed regulations which would regulate tax return preparers, and establish a new class of practitioner – a “registered tax return preparer” – whose qualifications obviously exceed those of any other class of practitioner. reg-13863707, regulations governing practice before the internal revenue service, 75 f.r. 51713 (8/19/10). these proposed regulations would amend circular 230 to apply to all paid return preparers and identify exactly which preparers have a registration obligation. they would also change the general circular standard of contact from “more likely than not” to “reasonable basis” [sic]. specifically, the proposed regulations establish "registered tax return preparers," as a new class of practitioners. sections 10.3 through 10.6 of the proposed regulations 2011] recent developments in federal income taxation 743 describe the process for becoming a registered tax return preparer and the limitations on a registered tax return preparer’s practice before the irs. in general, practice by registered tax return preparers is limited to preparing tax returns, claims for refund, and other documents for submission to the irs. a registered tax return preparer may prepare all or substantially all of a tax return or claim for refund, and sign a tax return or claim for refund, commensurate with the registered tax return preparer’s level of competence as demonstrated by written examination. the proposed regulations also revise section 10.30 regarding solicitation, section 10.36 regarding procedures to ensure compliance, and section 10.51 regarding incompetence and disreputable conduct. proposed regulations under section 6109 of the code (reg-134235-08) published in the federal register (75 fr 14539) on march 26, 2010, also implement certain recommendations in the report. the proposed regulations under section 6109 provide that, for returns or claims for refund filed after december 31, 2010, the identifying number of a tax return preparer is the individual’s preparer tax identification number (ptin) or such other number prescribed by the irs in forms, instructions, or other appropriate guidance. the proposed regulations under section 6109 provide that the irs is authorized to require through other guidance (as well as in forms and instructions) that tax return preparers apply for a ptin or other prescribed identifying number, the regular renewal of ptins or other prescribed identifying number, and the payment of user fees. d. proposed amendments to circular 230. reg-138637-07, rules governing practice before the internal revenue service, 2010-44 i.r.b. 581 (8/19/10). these proposed regulations contain standards with respect to tax returns under § 10.34, as well as new rules governing the oversight of tax return preparers under §§ 10.3 through 10.6. there are also proposed revisions to § 10.30 regarding solicitation, § 10.36 regarding procedures to ensure compliance, and § 10.51 regarding incompetence and disreputable conduct. e. final § 6109 regulations. t.d. 9501, furnishing identifying number of tax return preparer, 75 f.r. 60309 (9/28/10). final regulations amending § 1.6109-2 explaining how the irs will define those required to obtain a ptin as a return preparer, with four examples. 744 florida tax review [vol. 10:9 f. david williams is to be given “broad responsibility.” ir-2010-107 (10/26/10). in a speech to the aicpa fall meeting, irs commissioner shulman announced the creation of a return preparer office under david r. williams at the irs itself, which office is to have “broad responsibility” for the return preparer initiative. the office will complement the work of the irs office of professional responsibility under karen hawkins. g. register those staff members as “supervised preparers”! notice 2011-6, 2011-3 i.r.b. 315 (12/30/10). this notice provides guidance on the new regulations § 1.6901-2 governing tax return preparers, including the exemption from continuing education requirements and competency exams for non-signing supervised staff members employed and supervised by an attorney, cpa or enrolled agent; however, these “supervised preparers” must obtain ptins and pass the mandatory tax compliance and suitability checks [and pay the $64.25 annual fee]. the notice also contains a list of forms that do not require that their preparer have a ptin, as well as interim rules that permit individuals to obtain provisional ptins before the first offering of competency examinations, which ptins may be renewed until the end of 2013. 9. this whistleblower gets a chance to let the tax court decide whether or not he was whistling in the dark. cooper v. commissioner, 135 t.c. no. 4 (7/8/10). the tax court (judge kroupa) held that it has jurisdiction under § 7623(b)(4) to review the denial of a claim for a whistleblower award. the court rejected irs’s argument that the tax court’s jurisdiction is limited to appeals of a determination of the amount of the award. 10. might this case lead to doma becoming the twenty eighth amendment? gill v. office of personnel management, 106 a.f.t.r.2d 2018-5184 (d. mass. 7/8/10). district court judge tauro held that § 3 of the defense of marriage act, 1 u.s.c. § 7, which limits the meaning of the word “marriage” to “a legal union between one man and one woman as husband and wife,” and provides that “the word ‘spouse’ refers only to a person of the opposite sex who is a husband or wife” for purposes of all federal laws is an unconstitutional denial of equal protection in violation the equal protection principles embodied in the due process clause of the fifth amendment. joint return filing status under the code was one of the issues addressed in the case; also addressed were government benefits available to married individuals, e.g., employee health benefits, social security benefits. 2011] recent developments in federal income taxation 745 11. the constitution does not require appeals officers for cdp hearings to be appointed by the president. tucker v. commissioner, 135 t.c. no. 6 (7/26/10). the taxpayer requested a cdp hearing after the irs issued a notice of filing of a tax lien. after the settlement officer had upheld the tax lien notice, the taxpayer requested a remand for a hearing to be heard by an officer appointed by the president or the secretary of the treasury, in compliance with the appointments clause of u.s. const., art. ii, sec. 2, cl. 2. judge gustafson held that an “officer or employee” or an “appeals officer” under § 6320 or § 6330 is not an “inferior officer of the united states” for purposes of the appointments clause. they are instead properly hired, pursuant to § 7804(a), under the authority of the commissioner of internal revenue. the taxpayer’s motion to remand was denied. 12. “sorry, you can’t cite the other guy’s plr to support your argument,” but this case involved rulings with respect to the same liability issued to the seller which the buyer attempted to use.6 amergen energy co., llc v. united states, 94 fed. cl. 413 (9/1/10). the court of federal claims (judge bush) held that private letter rulings issued to the seller of a business relating to the treatment of certain operating expenditures were not precedential or relevant evidence in buyer’s case regarding the same issue. the irs was not bound by the private letter rulings. • the rulings issued to the seller purportedly concluded that the nuclear decommissioning liabilities were “fixed and reasonably determinable.” the buyer attempted to use the ibm case. judge bush stated: the court notes that plaintiff relies extensively on int’l bus. machs. corp. v. united states, 343 f.2d 914, 170 ct. cl. 357 (ct. cl. 1965) (ibm), a case with thirty negative citing references on westlaw, and omits any reference to the precedential limitation of the holding of that case to its facts. see, e.g., fla. power & light co. v. united states, 375 f.3d 1119, 1124 (fed. cir. 2004) (“we need not decide whether the appellant would be entitled to relief under ibm, however, because the decision in ibm was effectively limited to its facts by subsequent decisions of the court of claims . . . .”) (citations and footnote omitted). plaintiff perhaps believes that this case falls within the fact pattern of ibm. nonetheless, plaintiff should have alerted the court to the binding precedent limiting the scope of the holding of 6. the rulings were ten years old. “. . . but that was in another country, and besides, the wench is dead.” eliot (quoting jonson). 746 florida tax review [vol. 10:9 ibm, so that the weight to be accorded ibm was clear. see, e.g., jewelpak corp. v. united states, 297 f.3d 1326, 1333 n.6 (fed. cir. 2002) (stating that “officers of our court have an unfailing duty to bring to our attention the most relevant precedent that bears on the case at hand—both good and bad—of which they are aware”) (citations omitted). plaintiff could not have been unaware of this binding precedent, because another case upon which plaintiff greatly relies discussed, at length, the limits placed on the holding of ibm. see vons cos. v. united states, 51 fed. cl. 1, 10 & nn. 9-10 (2001), modified in part by vons cos. v. united states, no. 00-234t, 2001 u.s. claims lexis 241, 2001 wl 1555306 (fed. cl. nov. 30, 2001). the court, in the context of this discovery dispute over plrs, need not reach the issue of whether plaintiff, as a purchaser of nuclear power plants, is “similarly-situated” to sellers of nuclear power plants, in regards to the tax treatment of assumed decommissioning liability. 13. another court tells the irs it can’t pretend it doesn’t know it has the wrong address for the taxpayer. terrell v. commissioner, 625 f.3d 254 (5th cir. 11/1/10). the tax court dismissed the taxpayer’s petition for innocent spouse relief because she failed to file within 90 days from the date irs first mailed its determination not to grant relief, had been mailed to the same address shown on prior tax returns that the irs had used for multiple prior mailings that had been returned as undeliverable by the usps. however, the taxpayer timely filed petition within 90 days of date irs re-sent the notice of determination to the new address on her tax return filed between the date the most recent earlier notice of determination had been mailed and the date it had been returned as undeliverable. reg. § 1.6212-2 provides that a taxpayer’s last known address 1s the address that appears on the taxpayer’s most recently filed and properly processed federal tax return, unless the taxpayer has given the irs clear and concise notification of a different address. the fifth circuit reversed the tax court’s decision and remanded the case. the court (judge prado) held that even if the irs has not received “clear and concise notification” of the taxpayer’s change of address, “the irs must use ‘reasonable diligence’ to determine the taxpayer’s address in light of all relevant circumstances.” if the irs knows or should have known at the time of mailing a notice that the taxpayer’s address on file might no longer be valid, “reasonable diligence” requires further investigation. the irs may not rely on a lack of notification once it is on notice that its address on file is incorrect. because three separate prior mailings to taxpayer’s address on file with irs had been returned as 2011] recent developments in federal income taxation 747 undeliverable, the irs should have known that taxpayer’s address on the earlier filed tax return was incorrect. 14. soon there will no paper trail for anything, but digital trails might be even longer. t.d. 9507, electronic funds transfer of depository taxes, 75 f.r.75897 (12/2/10). the treasury and irs have promulgated regulations (reg. §§ 1.1461-1; 1.6302-1; 1.6302-2; 1.6302-3; 1.6302-4; 31.6071(a)-1; 31.6302-1; 31.6302(c)-3; and 301.6302-1) requiring all federal tax depositors to use electronic funds transfers for all federal tax deposits. the rules regarding federal tax deposit coupons have been eliminated. xi. withholding and excise taxes a. employment taxes 1. wisdom from the mount. medical residents may be students for fica taxes. united states v. mount sinai medical center of florida, inc., 486 f.3d 1248 (11th cir. 5/18/07). section 3121(b)(10) provides that employment taxes are not payable with respect to services performed in the employ of a college or university by a student who is enrolled and regularly attending classes. the government argued that legislative history with respect to the repeal of an exemption for medical interns in 1965 (former § 3121(b)(13)) established as a matter of law that medical residents are subject to employment taxes. the eleventh circuit concluded that § 3121(b)(10) is unambiguous in its application to students and that the statute requires a factual determination whether the hospital is a “school, college, or university” and whether the residents are “students.” a. this is no april fool. the minnesota district court also finds that medical residents at the university of minnesota are students. regents of the university of minnesota v. united states, 101 a.f.t.r.2d 2008-1532 (d. minn. 4/1/08). the university’s summary judgment motion was granted by the district court, which held that medical residents at the university of minnesota are not subject to employment taxes under the student exclusion of § 3121(b)(10). the court reiterated its conclusion that the full-time employee exception in reg. § 31.3121(b)(10)-2(d), as amended in 2004, is invalid. b. the district court finds that the mount sinai medical center is a school and the residents are students. united states v. mount sinai medical center of florida, inc., 102 a.f.t.r.2d 20085373 (s.d. fla. 7/28/08). after the decision in minnesota v. apfel, 151 f.3d 742 (8th cir. 1998), mount sinai medical center obtained refunds for fica 748 florida tax review [vol. 10:9 taxes paid in 1996-1997. the united states filed suit against the medical center for erroneous refunds. following the eleventh circuit’s direction to make a factual determination whether the program qualifies for the § 3101(b)(10) exception, the district court found that the medical center’s residency programs were operated as a “school, college, or university,” that residents were present for training in patient care, which was an intrinsic and mandatory component of the training, and that the residents were “students” who were regularly enrolled and attending classes. the court also found that the students’ performance of patient care services was incident to their course of study. c. south dakota medical residents are also students. center for family medicine v. united states, 102 a.f.t.r.2d 2008-5623 (d. s.d. 8/6/08). following minnesota v. apfel, 151 f.3d 742 (8th cir. 1998), the south dakota district court held that medical residents in the center for family medicine (cfm) and university of south dakota school of medicine residency program (usdsmrp) were eligible for the student exception to the definition of employment under § 3101(b)(10). the court rejected the government’s assertion that cfm was not a school, college or university because cfm was affiliated with a non-profit hospital. the court found that cfm’s work includes teaching its medical residents the skills required to practice in their chosen profession. the court also concluded that the students were “enrolled” in the institution and that their attendance at noon conferences and medical rounds established that the students regularly attended classes. tossing a small bone to the government, the court held that chief residents in the programs, who are essentially coordinators for the residency programs, were not students. d. residents in chicago are also students. university of chicago hospitals v. united states, 545 f.3d 564 (7th cir. 9/23/08). the court affirmed the district court’s denial of the government’s motion for summary judgment based on the government argument that medical residents are per se ineligible for the student exemption from employment taxes under § 3121(b)(10). the court indicates that a case-bycase analysis is required to determine whether medical residents qualify for the statutory exemption. e. and ditto for medical residents in detroit. united states v. detroit medical center, 557 f.3d 412 (6th cir. 2/26/09). reversing the district court’s summary judgment, the sixth circuit joins the lineup holding that medical residents at the seven detroit area hospitals operated by the detroit medical center in a joint program with wayne state university, which provides graduate medical education, may be students entitled to exemption from employment taxes under § 3121(b)(10). the court 2011] recent developments in federal income taxation 749 remanded the case for further development of the record regarding the nature of the residents’ relationship to the hospitals and the education program. the court indicated that further development of the record would not preclude deciding the matter on summary judgment. the sixth circuit also affirmed summary judgment that the stipends paid to medical residents were not scholarships or fellowships excludible from income under § 117. the court found both that the stipends were received in exchange for services and that the medical residents were not candidates for a degree as required for exclusion under the terms of § 117. f. and ditto again for sloan-kettering. united states v. memorial sloan-kettering cancer center, 563 f.3d 19 (2d cir. 3/25/09). following similar decisions in the sixth, seventh, eighth, and eleventh circuits, the second circuit court of appeal reversed summary judgment for the united states holding that the district courts for the northern and southern districts of new york erred in holding as a matter of law that medical residents at the albany medical center and the hospitals of the memorial sloan-kettering cancer center were not eligible for exclusion from employment taxes under § 3121(b)(10). the cases were remanded to the trial courts for factual determinations whether the residents were students and whether the hospitals were schools. g. but the tide turns against the mayo clinic; however, the supreme court granted certiorari to the eighth circuit. mayo clinic residents may or may not be students, the supreme court will decide. mayo foundation for medical education and research v. united states, 568 f.3d 675 (8th cir. 6/12/09), cert. granted, 130 s. ct. 3353 (6/10/10). for purposes of the student exclusion from fica taxes under § 3121(b)(10), reg. § 31.3121(b)(10)-2(c) and (d), limit the definition of a school, college, or university to entities whose “primary function is the presentation of formal instruction.” reg. § 31.3121(b)(10)-2(d) provides that to qualify as a “student” rather than be classified as an employee, any services rendered must be “incident to and for the purpose of pursuing a course of study” at the institution for which the student provides the services. furthermore, under the regulation, a person whose work schedule is 40 hours or more per week is a full-time employee rather than a student. the district court, in granting refunds of employment taxes, declared the regulation invalid. applying the deference standard of chevron u.s.a. inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), the eighth circuit reversed and remanded the case for entry of judgment for the united states. the court concluded that application of the exemption only to students pursuing a course of study who are not full time employees is a reasonable interpretation of the statute. the court declined to consider whether the portion of the regulation limiting the definition of a school or college is valid 750 florida tax review [vol. 10:9 because the medical residents were not students under the regulation in any event. h. the supremes spread mayo all over the code. national muffler is dead: long live chevron. mayo foundation for medical education and research v. united states, 131 s. ct. 704 (1/11/11). in a unanimous decision, written by chief justice roberts, the supreme court affirmed the court of appeals in what undoubtedly will be one of the most far reaching tax decisions ever rendered by the court. the court applied the two part test of chevron, u.s.a., inc. v. natural resources. defense council, inc., 467 u.s. 837 (1984), to test the validity of the regulation and upheld it. under chevron, the first question is whether congress has directly spoken to the precise question at issue. if the statute has “directly addressed the precise question at issue” the regulation must follow the unambiguously expressed intent of congress. if the statute is silent or ambiguous with respect to the specific issue, the second question is whether the agency’s answer is based on a permissible construction of the statute. in this second step, according to the supreme court, a court “may not disturb an agency rule unless it is ‘arbitrary or capricious in substance, or manifestly contrary to the statute.’” thus, a court may not substitute its own construction for the reasonable interpretation of an agency. in mayo, the supreme court held that “[t]he principles underlying our decision in chevron apply with full force in the tax context.” in applying chevron, the court unambiguously overruled its prior decision in national muffler dealers association v. united states, 440 us 472, 477 (1979), rendering the national muffler standards irrelevant in all future cases. under national muffler the inquiry was as follows: in determining whether a particular regulation carries out the congressional mandate in a proper manner, we look to see whether the regulation harmonizes with the plain language of the statute, its origin, and its purpose. a regulation may have particular force if it is a substantially contemporaneous construction of the statute by those presumed to have been aware of congressional intent. if the regulation dates from a later period, the manner in which it evolved merits inquiry. other relevant considerations are the length of time the regulation has been in effect, the reliance placed on it, the consistency of the commissioner’s interpretation, and the degree of scrutiny congress has devoted to the regulation during subsequent re-enactments of the statute. in overruling national muffler, the court unequivocally stated that “an agency’s interpretation of an ambiguous statute does not turn on such considerations.” the court specifically stated that “[a]gency inconsistency is not a basis for declining to analyze the agency’s interpretation under the 2011] recent developments in federal income taxation 751 chevron framework.” quoting its earlier decision in bob jones university v. united states, 461 u.s. 574, 596 (1983), the court stated, “[i]n an area as complex as the tax system, the agency congress vests with administrative responsibility must be able to exercise its authority to meet changing conditions and new problems.” the court also rejected the taxpayer’s argument that a regulation, like the one question, promulgated under the general authority of § 7805(a) was entitled to less deference than one “‘issued under a specific grant of authority to define a statutory term or prescribe a method of executing a statutory provision,’” and in so doing overruled its prior decisions in rowan cos. v. united states, 452 u.s. 247, 253 (1981), and united states v. vogel fertilizer co., 455 u.s. 16 (1982), which had so held, stating that the court’s inquiry does not turn on whether congress’s delegation of authority was general or specific. furthermore, the court held that “it is immaterial to our analysis that a ‘regulation was prompted by litigation,’” noting that in united dominion industries, inc. v. united states, 532 u.s. 822 (2001), it had “expressly invited the treasury department to ‘amend its regulations’ if troubled by the consequences of our resolution of the case.” thus, the supreme court has unambiguously stated that as along as a regulation can withstand chevron analysis, a treasury regulation can reverse case law. finally, however, in upholding the validity of the regulation, the court emphasized that the regulation was promulgated after notice and comment, thus leaving open the possibility that mayo/chevron deference might not apply to a temporary regulation issued without notice and comment. i. and the irs throws in the towel on refund claims for fica taxes paid before april fools’ day, 2005. i.r. 2010-25 (3/2/10). the irs has decided to accept the position that medical residents are exempt from fica taxes under the student exception and will issue refunds to hospitals, universities, and medical residents who have filed claims for refunds of fica taxes paid before 4/1/05, which is the effective date of amendments to reg. § 31.3121(b)(10)-2 providing that employees who work 40 hours or more during a week are not eligible for the student exception. 2. reg-137036-08. section 3504 agent employment tax liability, 75 f.r. 1735 (1/12/10). proposed regulations include federal unemployment tax act (futa) withholding taxes within the scope of current regulatory authority that allows employers to meet their fica tax obligations for domestic in-home services through an agent as provided in § 3401. the agent files a single return for multiple employers using the agent’s employer identification number. 752 florida tax review [vol. 10:9 3. the gamble doesn’t pay off and this tribe sings the blues. blue lake rancheria v. united states, 105 a.f.t.r.2d 2010-638 (n.d. calif. 1/8/10). section 3306(c) excludes from employment for futa purposes “service performed . . . in the employ of an indian tribe, or any instrumentality” thereof. section 3309 also allows indian tribes to opt out of paying state unemployment taxes if the tribe reimburses the state for actual costs of providing unemployment benefits to the tribe’s employees. mainstay is in the business for providing leased employees. it provides over 39,000 employees to business in three states. mainstay is controlled by blue lake rancheria economic development corporation, a tribal corporation. (the tribe has 53 members.) mainstay sought refund of over $2 million of futa taxes claiming that its employees were the employees of an indian tribe. the court concluded that the tribal exception operates to eliminate the existence of statutory employment “where services performed in a common law relationship between an employer and employee would normally lead to the existence of “employment.” the court then reasoned that “’employment’ must be defined by reference to the common law employer, and that the statutory employer must be liable.” the court holds, “that the exception to the definition of ‘employment’ for ‘services performed ... in the employ of an indian tribe, or any instrumentality’ thereof, § 3306(c)(7), is only available when an indian tribe is the common law employer of the employees in question. when an indian tribe is merely the statutory employer, the applicability of this exception depends upon the employee’s relationship with his or her common law employer. where the common law employer is not an indian tribe, and where no other exemption under § 3306(c) applies, the statutory employer will be liable under futa.” the court also rejected the taxpayer’s argument that the indian tribe was not a common law employer of the leased employees and the exemption therefore did not apply. 4. we don’t need no steenking payroll taxes! new code § 3111(d)(1), added by the 2010 hire act, excuses employers from paying the employer’s share of oasdi taxes from 3/19/10 — sort of, see below — through 12/31/10 for wages paid to newly hired previously unemployed workers. however, unless employer elects out of the payroll tax holiday, wages paid to a qualified individual do not qualify for the § 51 work opportunity credit during the one-year period beginning on the date that the qualified employer hired the employee. • a “qualified” employee is an individual who (1) starts employment after 2/3/10 and before 1/1/11; (2) provides an affidavit, under penalties of perjury, certifying that he has not been employed for more than 40 hours during the 60-day period ending on the date his employment begins; (3) has not been hired to replace another employee who was discharged without cause; (4) is not related to the employer or a more than 50 percent owner of the stock of a corporate employer, in a manner that 2011] recent developments in federal income taxation 753 would disqualify him for the work opportunity credit under § 51(i)(1), i.e., a long list of relatives, including, inter alia, all ancestors and descendants, brothers and sisters, nieces and nephews, and close in-laws; however aunts, uncles, cousins and outlaws appear to be ok. • wages paid during the first calendar quarter of 2010, i.e., between 3/19/10 and 3/31/10, do not actually qualify for complete forgiveness of the oasdi tax. rather, the amount by which the oasdi tax for wages paid during the first calendar quarter of 2010 would have been reduced if the tax holiday had been in effect for that quarter is treated as a payment against the employer’s oasdi tax on other employees in the second calendar quarter of 2010. • the tax waiver applies only to nongovernmental employers except that it also applies to a public institution of higher education. the tax waiver ends on 12/31/10. 5. funding health care by making the hi tax more progressive. section 1301, as amended by the 2010 health care act, increases the employee portion of the hi tax is increased by an additional tax of 0.9 percent on wages in excess of a threshold amount. the threshold amount is $250,000 of the combined wages of both spouses on a joint return ($125,000 for a married individual filing a separate return. the threshold is $200,000 for all other individuals. the employer must withhold the additional hi tax, but in determining the employer’s withholding requirement and liability for the tax, only wages that the employee receives from the employer in excess of $200,000 for a year are taken into account, and the employer disregards the employee’s spouse’s wages. i.r.c. § 3102(f). the employee is liable for the additional 0.9 percent hi tax to the extent the tax is not withheld by the employer. section 1402(b), as amended, imposes an additional tax of 0.9 percent self-employment income above the same thresholds, the threshold amount is reduced (but not below zero) by the amount of wages taken into account in determining the fica tax with respect to the taxpayer. no deduction under § 164(f) for the additional seca tax, and the alternative deduction under § 1402(a)(12) is determined without regard to the additional seca tax rate. the additional tax applies to wages received in taxable years after 12/31/12. 6. united states v. quality stores, inc., 424 b.r. 237, 105 a.f.t.r.2d 2010-1110 (w.d. mich. 2/23/10). severance payments made to pre-petition and post-petition employees who were involuntarily terminated were treated as wage-replacement social benefits rather than taxable remuneration and wages subject to fica tax. the court concluded that under § 3402(o) (which treats supplemental unemployment compensation benefits as wages for withholding) supplemental 754 florida tax review [vol. 10:9 unemployment compensation was not “wages” and therefore was not taxable for purposes of fica. • the result is contrary to the holding in csx corp. v. united states, 518 f.3d 1328 (fed. cir. 2008). 7. s corporation “john edwards gambit” dividends may be treated as wages. david e. watson, p.c. v. united states, 714 f. supp. 2d 954 (s.d. iowa 5/27/10). using a common tax reduction device, david watson formed an s corporation that was a member of watson’s accounting firm. the s corporation contracted with the accounting firm to provide services. watson was paid a salary of $24,000 as an employee of the s corporation, on which the s corporation paid employment taxes. the remainder of the s corporation income, approximately $200,000 per year, was distributed to watson as a dividend, not subject to employee taxes. the irs recharacterized the dividends as wages. the s corporation paid an assessment and brought a refund action. in a motion for summary judgment the s corporation asserted that its intent controls whether amounts paid are wages and that it intended to pay dividends in the amount of cash on hand after the payment of wages. citing a long line of authorities in support of its position, the district court held that the s corporation’s “self proclaimed intent” to pay salary does not limit the government’s ability to recharacterize dividends as wages. the court indicated that whether amounts paid to watson were remuneration for services is a question of fact. • the court’s opinion concluded with the following passage: in support of its motion for summary judgment, plaintiff points the court to the following oft-cited statement of judge learned hand: over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as law as possible. everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. to demand more in the name of morals is mere cant. see pl.’s reply br. at 5 n. 2 (quoting commissioner of internal revenue v. newman, 159 f.2d 848, 850-51 (2d cir.1947) (l. hand, j., dissenting)). while the court agrees fully with judge learned hand, it would remind plaintiff of justice oliver wendell holmes’ succinct, yet equally eloquent statement in compania general de tabacos de 2011] recent developments in federal income taxation 755 filipinas v. collector of internal revenue: “taxes are what we pay for civilized society.” 275 u.s. 87, 100 (1927) (holmes, j., dissenting). indeed, “the greatness of our nation is in no small part due to the willingness of our citizens to honestly and fairly participate in our tax collection system.” manley v. commissioner of internal revenue, t.c. memo 1983-558 (sept. 12, 1983). thus, while plaintiff is free to structure its financial affairs in such a way as to avoid paying “more [taxes] than the law demands,” plaintiff is not free to structure its financial affairs in a way that avoids paying those taxes demanded by the law. in this case, the law demands that plaintiff pay employment taxes on “all remuneration for employment,” and there is clearly a genuine issue of material fact as to whether the funds paid to watson, in actuality, qualify as such. a. since the judge gave the irs everything it asked for, will the irs go for the whole kit and caboodle the next time. david e. watson, p.c. v. united states, 107 a.f.t.r.2d 2011-321 (s.d. iowa 12/23/10. on the merits, judge pratt rejected the taxpayer’s claim that the wages subject to employment tax were limited to the $24,000 salary formally paid to the sole shareholder/sole employee. in addition to the “salary” in each of the years in question, the corporation distributed approximately $175,000 of “profits,” pursuant to a corporate resolution authorizing “payment to watson of ‘dividends in the amount of available cash on hand after payment of compensation and other expenses of the corporation.’” citing joseph radtke, s.c. v. united states, 712 f. supp. 2d 143 (e.d. wis. 1989), spicer accounting, inc. v. united states, 918 f.3d 90 (9th cir. 1990), and veterinary surgical consultants v. commissioner, 117 t.c. 141 (2001), as particularly persuasive, the court concluded that “‘characterization of funds disbursed by an s corporation to its employees or shareholders turns on an analysis of whether the payments at issue were made ... as remuneration for services performed.’” after examining the facts, the court concluded that the reasonable amount of watson’s compensation for each of the years at issue was $91,044, increasing the $24,000 salary amount by the full amount of the $67,044 that the corporation claimed was a § 1368 distribution, thus upholding in full the government’s position. 8. contract workers are employees, and taxpayer gets no help from § 530 of the revenue act of 1978. bruecher foundation services, inc v. united states, 383 fed. appx. 381 (5th cir. 6/18/10). in 1999-2000 the taxpayer employed 13-16 workers as contractors in its foundation repair, landscaping and grading business. the taxpayer claimed deductions for the workers’ compensation as “contract workers” but filed no 756 florida tax review [vol. 10:9 form 1099s for the workers. the irs initiated an audit of employment tax liabilities without notifying the taxpayer and without informing the taxpayer of the § 530 safe harbor (pub. l. no. 95-600, § 530, 92 stat. 2763, 2885-86) as required by the statute. when the taxpayer was notified of the audit the taxpayer filed a form 1099 for each of the workers. section 530 bars reclassification of workers as employees if (1) the worker was not treated as an employee for any period, (2) the employer filed all returns, including information returns, in a manner consistent with treating the worker as an independent contractor, and (3) the employer had a reasonable basis under common law standards for treating the worker as an independent contractor. the court rejected the taxpayer’s assertion that it complied with the § 530 requirement that it filed returns consistent treating the employees as independent contractors. although the court was not willing to go as far as the irs argument that timely forms were always required, the court indicated that the taxpayer’s strategic filing of the required returns after the irs assessed the tax was not compliance with the statute. the court also held that the irs’s failure to give early notice of its audit and the availability of § 530 did not shift the burden of proof to the government. finally, the court accepted the irs position that the workers were employees under common law standards. 9. the tax court follows the sixth and second circuits to hold that pre-2009 employment tax liability of a disregarded llc must be paid by the sole-member. medical practice solutions, llc v. commissioner, 132 t.c. 125 (3/31/09). following the decisions in littriello v. united states, 484 f.3d 372 (6th cir. 2007), and mcnamee v. dept. of the treasury, 488 f.3d 100 (2d cir. 2007) [both of which upheld the validity of the “check-the-box” regulations in the same context, applying chevron u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984)], the tax court (judge cohen) held that the check-the-box regulations treating a single member entity that does not elect to be treated as a corporation as a disregarded entity, reg. § 301.7701-3(b), are valid and as a result the sole member of a disregarded limited liability company is responsible for the llc’s unpaid employment taxes. after 1/1/09, under reg. § 301.7701-2(c)(2)(iv), a disregarded entity is treated as a corporation for purposes of employment tax reporting and liability. the court rejected the taxpayer’s argument that the amendment to the regulations, which reverses the prior rule, demonstrates that the prior regulation imposing employment tax liability on the sole-member of the disregarded entity was unreasonable. the court stated that, “in light of the emergence of limited liability companies and their hybrid nature, and the continuing silence of the code on the proper tax treatment of such companies in the decade since the present regulations became effective, we cannot conclude that the above treasury 2011] recent developments in federal income taxation 757 regulations, providing a flexible response to a novel business form, are arbitrary, capricious, or unreasonable.” a. the first circuit agrees. britton v. shulman, 106 a.f.t.r.2d 2010-6048 (1st cir. 8/24/10). in a one-paragraph memorandum opinion, the first circuit finds no error or abuse of discretion in the tax court opinion in medical practice solutions, llc v. commissioner. 10. independence massages away employment taxes. mayfield therapy center v. commissioner, t.c. memo. 2010-239 (10/28/10). the taxpayer rented booth space to massage therapists, cosmetologists and nail technicians for $80 base rent or 25 percent of the service provider’s gross revenue. the service providers set their own hours, their appointments were made by a receptionist at taxpayer’s facility, they were free to charge prices that differed from posted prices, they provided their own supplies, and in some cases they individually decorated their own space, but occasionally shared space. each provider was a separately licensed professional. payments were collected centrally and divided in accord with the amount paid by each provider’s individual client. applying the 20 factors of rev. rul. 87-41, 1987-1 c.b. 296 (which one of us had a hand in drafting as a professor-in-residence in the office of chief council), the court (judge thornton) concluded that – although the financial arrangement represented payment by the taxpayer to the service providers – the weekly rent arrangement and compensation to the service providers on a commission basis with no guaranteed return favored independent contractor status. the court also pointed to the fact that the workers provided their own expenses, bore the risk of losses, that they could increase their income by working longer hours, and were not directed in providing services to clients as supporting independent contractor status. while indicating that the case was close, the court decided that factors indicating the service provider’s autonomy predominate over factors indicating the taxpayer’s control and concluded that the service providers were independent contractors for whom the taxpayer was not liable for employment taxes. 11. social security is cheaper for 2011, but the deficits grow. the compromise tax relief act of 2010, § 601, reduces the employee portion of the old-age, survivors, and disability insurance tax (oasdi) from 6.2% to 4.2% for calendar year 2011. • the 4.2% rate also applies to the railroad retirement tax. 758 florida tax review [vol. 10:9 b. self-employment taxes 1. self employment taxes reduced. the compromise tax relief act of 2010, § 601, reduces self employment taxes from 12.4% to 10.4% for calendar year 2011. c. excise taxes 1. employers who aren’t willing to pay health insurance premiums on their employees must pay uncle sam a very healthy nondeductible excise tax. under § 4980h, added by the 2010 health care act and effective after 12/31/13, an applicable large employer, i.e., an employer that employed an average of at least 50 full-time employees during the preceding calendar year, that fails to offer its full-time employees and their dependents the opportunity to enroll in minimum essential coverage under an employer sponsored health insurance plan is subject to an assessable excise tax if (1) there is a waiting period, or (2) any of its employees are certified to the employer as having enrolled in health insurance coverage purchased through an american health benefits exchange with respect to which a premium tax credit or cost-sharing reduction is allowed or paid to such employee or employees. (an employee is eligible for the premium credit if the employer does not offer health insurance for all its full-time employees, it offers minimum essential coverage that is unaffordable (“unaffordable” means a premium required to be paid by the employee that is more than 9.5 percent of the employee’s household income), or it offers minimum essential coverage under which the plan’s share of the total allowed cost of benefits is less than 60 percent.) for an employer not offering coverage, the amount of the excise tax amount for any month equals the number by which full-time employees exceeds 30employees (regardless of how many employees are receiving a premium tax credit or cost-sharing reduction) multiplied by $166.67 (one-twelfth of $2,000). the amount is nothing to sneeze at. staff of the joint committee on taxation, technical explanation of the revenue provisions of the “reconciliation act of 2010,” as amended, in combination with the “patient protection and affordable care act,” 39-40 (jcx-18-10 3/21/10) gives the following example: for example, in 2014, employer a fails to offer minimum essential coverage and has 100 full-time employees, ten of whom receive a tax credit for the year for enrolling in a state exchange-offered plan. for each employee over the 30employee threshold, the employer owes $2,000, for a total penalty of $140,000 ($2,000 multiplied by 70 ((100-30)). this penalty is assessed on a monthly basis. 2011] recent developments in federal income taxation 759 • for each full-time employee receiving a premium tax credit or cost-sharing subsidy through an american health benefits exchange for any month, the monthly excise tax equals onetwelfth of $3,000. the tax is capped, however, by the amount that would have been the excise tax if the employer had provided no coverage. staff of the joint committee on taxation, technical explanation of the revenue provisions of the “reconciliation act of 2010,” as amended, in combination with the “patient protection and affordable care act,” 39-40 (jcx-18-10 3/21/10) gives the following example: for example, in 2014, employer a offers health coverage and has 100 full-time employees, 20 of whom receive a tax credit for the year for enrolling in a state exchange offered plan. for each employee receiving a tax credit, the employer owes $3,000, for a total penalty of $60,000. the maximum penalty for this employer is capped at the amount of the penalty that it would have been assessed for a failure to provide coverage, or $140,000 ($2,000 multiplied by 70 ((100-30)). since the calculated penalty of $60,000 is less than the maximum amount, employer a pays the $60,000 calculated penalty. this penalty is assessed on a monthly basis. • the excise tax is not deductible as a business expense under § 162. the restrictions on assessment under § 6213 do not apply. 2. did congress call them fees, instead of excise taxes, because there are no percentages in the formulae or because they are earmarked to fund pcortf? new § 4375, added by the 2010 health care act, imposes a fee on each health insurance policy, to be paid by the insurer, of $2 ($1 for years ending in u.s. fiscal year 2013) multiplied by the average number of lives covered under the policy, and new § 4376 imposes a like fee on self-insured health plans, to be paid by the employer. the fees are earmarked to fund the patient centered outcomes research trust fund (pcortf), to carry out provisions in the act relating to comparative effectiveness research. 3. that’s not a “nice healthy” tan, it’s a “dangerous pre-cancer glow.” new § 5000b of the code imposes a 10 percent sales tax on the amount paid for indoor tanning services. the tax is collected by the service provider and remitted to the irs quarterly. the tax kicks in on 6/1/10, just in time for the summer tanning season. 4. a nondeductible tax on cadillacs, and we’re not talking about any g.m. cars here. new § 4980i, added by the 2010 health 760 florida tax review [vol. 10:9 care act, imposes an excise tax on insurers if the aggregate value of employer-sponsored health insurance coverage and health benefits (except separate dental and optic coverage) for an employee (including former employees, surviving spouses and any other primary insured individuals) exceeds a threshold amount. the amount of the tax is 40 percent of the aggregate value that exceeds the threshold amount. for 2018, the threshold amount is $10,200 for individual coverage and $27,500 for family coverage, multiplied by the health cost adjustment percentage (a multiplier designed to increase the thresholds if the actual growth in health care between 2010 and 2018 exceeds the projected growth for that period), increased by an age and gender adjusted excess premium amount. the threshold amounts are increased for individuals who have attained age of 55 who are non-medicare eligible and receiving employer-sponsored retiree health coverage or who are covered by a plan sponsored by an employer the majority of whose employees covered by the plan are engaged in a certain high risk professions. for a self-insured group health plan, a health fsa or an hra, the excise tax is paid by the entity that administers the plan. if the employer acts as the plan administrator, the excise tax is paid by the employer. employer-sponsored health insurance coverage includes both insured and self-insured health coverage excludable from the employee’s gross income; for a self-employed individual, the coverage for any portion of which a deduction is allowable under § 162(l). if an employer reports to insurers, plan administrators, and the irs a lower amount of insurance cost subject to the excise tax than required, the employer is subject to a penalty equal to the sum of any additional excise tax that each such insurer and administrator would have owed if the employer had reported correctly and interest attributable to that additional excise tax. the excise tax is not deductible under the income tax. • although the staff of the joint committee on taxation did not score this provision for revenue effects, because its effective date is outside the 5-year window for scoring revenue effects, despite being in the “revenue provisions” of the act, congress does not really intend that provision raise much revenue. it intends to discourage employers from providing high cost, i.e., cadillac, health plans. xii. tax legislation a. enacted 1. h.r. 4462, p.l. 111-126, was signed by president obama on 1/22/10. the law permits donors who itemize deductions on their 2009 tax returns to deduct on their 2009 returns any charitable contributions for the relief of victims of the haitian earthquake made in cash after 1/11/10 and before 3/1/10. 2011] recent developments in federal income taxation 761 2. h.r. 4691, the temporary extension act of 2010, p.l. 111-144, was signed by president obama on 3/2/10. the signing ceremony consisted of a “tea party” at which the president was tea-bagged, i.e., tea bags were thrown at him. 3. the hiring incentives to restore employment (“hire act”), p.l. 111-147, was signed by president obama on 3/18/10. it is a $17.6-billion “jobs package.” 4. h.r. 3590, the patient protection and affordable care act (“ppaca” – pronounced “pee-pac-a”), p.l.111-148, was signed by president obama on 3/23/10. 5. h.r. 4872, the health care and education reconciliation act of 2010 (“2010 health care act” or “2010 reconciliation act”), p.l. 111-152, was signed by president obama on 3/30/10. 6. the continuing extension act of 2010, p.l. 111157, was signed by president obama on 4/15/10. it extends the cobra subsidy to may 31, 2010. 7. hr 3962, the preservation of access to care for medicare beneficiaries and pension relief act of 2010, p.l. 111-192, was signed by president obama on 6/25/10. 8. the homebuyer assistance and improvement act of 2010, p.l. 111-198, was signed by president obama on 7/2/10. 9. the small business jobs act of 2010, p.l. 111240, was signed by president obama on 9/27/10. this act will create millions upon millions of good paying jobs. the tax relief, unemployment insurance reauthorization, and job creation act of 2010 (“the compromise tax relief act of 2010”), p.l. 111-312, was signed by president obama on 12/17/10. it was a compromise arrived at between president obama and republican congressional leaders, and was based in part upon s. 3793, the job creation and tax cuts bill of 2010, which was introduced on 9/16/10 by sen. baucus. the act extends individual tax reductions (the so-called “bush tax cuts”) for two years, contains economic stimulus incentives, and provides energy related tax breaks and disaster relief. many provisions of the act renewed various expiring and expired tax benefits for individuals and businesses, and they are thus sometimes referred to as the “jimmy johnson” provisions. the act, §§ 301-304, also included estate, gift and generation-skipping transfer tax 762 florida tax review [vol. 10:9 relief for the years 2011 and 2012, including “portability” of the marital deduction. it is the great post-election compromise of 2010. * assistant professor, pace university school of law. b.a. yale university 1991. j.d. university of pennsylvania law school 1996. i gratefully acknowledge the input and guidance of jonathan g. blattmachr, david n. cassuto, don l. doernberg, derek b. dorn, james j. fishman, mitchell m. gans, bennett l. gershman, lissa griffin, anthony c. infanti, ronald h . jensen, janet a. johnson, darryll k. jones, jeffrey g. m iller, nanette morrison and darren rosenblum. b. brian brittingham, rebecca l. juice and william a. onofry provided able research assistance. 757 florida tax review volume 6 2004 number 8 one flesh, two taxpayers: a new approach to marriage and wealth transfer taxation bridget j. crawford* introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 759 i. the two shall become one: the history of the estate and gift tax marital deduction . . . . . . . . . . . . . . . . . . . . . . . . 762 a. income tax consequences of community property and common law property rules . . . . . . . . . . . . . . . . . . . . . . . . . 762 b. horizontal equity, joint income tax returns and the wealth transfer tax marital deduction . . . . . . . . . . . . . . . . . . . . . . . 764 c. triumph of substance over form . . . . . . . . . . . . . . . . . . . . . 768 d. the incipient one flesh, one taxpayer theory of wealth transfer taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 769 e. vertical equity and the full marital deduction . . . . . . . . . . 773 ii. current tax treat men t of marital wealth transfers . . 775 a. the unlimited marital deduction, or “what’s mine is yours” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 775 1. the terminable interest rule . . . . . . . . . . . . . . . . . . 776 2. the economic importance of the estate and gift tax marital deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 779 b. gift-splitting by spouses, or “what’s mine is ours” . . . . . . 780 c. disclaimers by spouses and others, or “what was theirs is now yours” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 781 iii. why marital wealth transfers should be taxed . . . . . . 784 a. the current tax rules reinforce traditional gender roles 784 1. coverture, legal personhood and taxation . . . . . . . 784 2. women should pay more tax . . . . . . . . . . . . . . . . . . 787 b. the current tax rules disregard economic unity . . . . . . . . 792 1. under-inclusivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 792 2. heterosexual privilege . . . . . . . . . . . . . . . . . . . . . . . 794 758 florida tax review [vol. 6:8 iv. the one flesh, two taxpayer solution . . . . . . . . . . . . . . . . 797 a. overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 797 b. a $10 million exemption from wealth transfer taxation . . 797 c. increased tax revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 799 d. tax simplicity and neutrality . . . . . . . . . . . . . . . . . . . . . . . . 800 e. theoretical implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 1. taxation and legal personhood . . . . . . . . . . . . . . . . 800 2. all taxpayers are created equal . . . . . . . . . . . . . . . 801 f. impact on geographic equality . . . . . . . . . . . . . . . . . . . . . . . 803 conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 805 2004 one flesh, two taxpayers 759 1. see irc §§ 2056 (estate tax marital deduction) and 2523 (gift tax marital deduction). unless otherwise spec ified all references to the internal revenue code (hereinafter the “code”) refer to the internal revenue code of 1986, as amended. special rules limit the types of property interests eligible for the marital deduction. see irc §§ 2056(b)(1) (no deduction disallowed where spousal interest will terminate, inter alia , on lapse of time) and 2523(f) (in case of property passing to spouse in trust, spouse must be entitled to all income from the property, payable at least annually). note that the code limits the marital deduction for transfers to a spouse who is not a united states citizen. see irc §§ 2056(d) (disallowance of estate tax marital deduction except for property in a passing in a qualified domestic trust) and 2523(i) (denying gift tax marital deduction for transfers to non-citizen spouse, but permitting annual exclusion gifts of up to $100,000 to non-citizen spouse). 2. see discussion infra part ii.a.2. 3. see discussion infra part ii.a. as the surviving spouse may use and even consume the first decedent’s entire estate (including any amount that would have been used to pay estate taxes, if any had been due upon the death of the first spouse to die), the surviving spouse benefits from the property during the survivor’s lifetime, and the successor beneficiaries generally receive a lower tax bill on the combined estates of both spouses. 4. see kathryn g. henkel, estate planning & wealth preservation: strategies & solutions ¶¶ 4.01, 4.03 (2004); jeffrey n. pennell, estate tax marital deduction § a-1 (bna 2002). 5. as used herein, the phrase “wealth transfer taxation” refers to the estate and gift taxes. the same phrase often includes generation-skipping transfer taxes, as well, but these taxes are outside the scope of this article. for discussion of generationskipping transfers, see, e.g., jonathan g. blattmachr, t he complete guide to wealth preservation and estate planning 238-44 (1999). 6. see, e.g., genesis 2:25 (“[a] man leaves his father and his mother and cleaves to his wife, and they become one flesh.”); mark 10:7-10 (“‘[a] man shall leave his father and mother and be joined to his wife, and the two shall become one flesh.’ so they are no longer two but one flesh. what therefore god has joined together, let not man put asunder.”). introduction marriage is an excellent estate planning strategy. generally speaking one spouse can transfer assets to the other during life and at death without adverse estate or gift tax consequences.1 this has two principal economic advantages. first the tax-free status of marital transfers allows a comparatively wealthy husband or wife to shift assets to his or her less wealthy spouse so that each may take maximum advantage of all available tax deductions, exemptions, exclusions, special valuation rules, credits and lower tax rates.2 second the taxfree status of marital transfers allows a married couple to postpone the payment of estate tax until the death of the second spouse.3 for these reasons property transfers between spouses form the cornerstone of the vast majority of married couples’ estate plans.4 in permitting tax-free transfers during life and at death, the federal wealth transfer tax5 system treats a married couple as a single taxpayer. just as marriage causes a man and woman to “become one flesh”6 for biblical purposes, it causes them to become one taxpayer for federal estate and gift tax 760 florida tax review [vol. 6:8 7. the phrase “marital wealth transfers” refers to transfers of property by one spouse to another during life or at death. 8. see discussion infra part iii.b. 9. see discussion infra part iii.b. 10. see discussion infra part iii.b. 11. but see generally joseph m. dodge, a feminist perspective on the qtip trust and the unlimited m arital deduction, 76 n.c. l. rev. 1729, 1729 (1998) (suggesting that feminist legal scholarship on the estate and gift tax marital deduction has failed to “come up with a plausible solution” to gender bias in the code); lawrence zelenak, symposium: taking critical tax theory seriously, 76 n.c. l. rev. 1521, 1524 (1998) (“the most serious problem [with critical tax scholarship] is the failure to think through proposed solutions with sufficient care.”) 12. even in the proposed one flesh, two taxpayer system, one spouse could make gifts to the other under the protection of the annual exclusion. see irc § 2503(b). 13. see discussion infra parts iv.b and c . the one flesh, two taxpayer rule does not contemplate any change to the tax rules applicable to charitable transfers. see irc §§ 170(c), 2055(c) and 2522(a). 14.“[t]he 1948 statutory principle of equal taxes for equal income married couples has been ‘almost universally accepted’ by tax theorists.” boris i. bittker, federal income taxation and the family, 27 stan. l. rev. 1389, 1395 (1975) (citation omitted). professor lily kahng suggests that the construction of husbands and wives as one person for tax purposes is “difficult to challenge because of its status as a first principle. those who object to the harms inflicted on women by the fiction bear the burden of establishing that these harms are serious enough to require abandoning this fiction that masquerades as a first principle.” lily kahng, fiction in tax, in taxing america 25, 38 (karen b. brown & mary louise fellows eds., 1996). purposes. the tax law embraces a “one flesh, one taxpayer” approach to marital wealth transfers.7 the “one flesh, one taxpayer” rules are undesirable because they are based on gender stereotypes and because they deny estate and gift tax benefits to socially important non-marital relationships. legislative history cites economic unity as the rationale for the estate and gift tax marital deduction, but unmarried taxpayers who in fact are economically unified are ineligible for the deduction. the one flesh, one taxpayer rules thus penalize those who do not want to marry, but could marry (such as cohabitating heterosexual partners),8 those who want to marry, but cannot marry (such as some same-sex partners)9 and those who do not want to marry and cannot in any case (such as elderly cohabitating siblings or an adult child who cares for an elderly parent).10 congress should eliminate the estate and gift tax marital deduction and adopt a “one flesh, two taxpayer rule” for marital wealth transfers.11 gratuitous transfers between spouses should be fully taxable,12 but each taxpayer should have a large credit against the tax, so that, in effect, the wealth transfer tax system will be inapplicable to the vast majority of taxpayers. by increasing the estate and gift tax unified credit to a sufficiently high number, such as 10 million dollars, legislators can simplify the administration of the tax system and, somewhat counterintuitively, increase overall tax revenue.13 although the construction of husband and wife as a single economic unit seems ingrained in estate and gift tax jurisprudence,14 married couples have not always enjoyed special tax status. part i of this article traces the historic development of the “one flesh, one taxpayer” approach to wealth transfer taxation. in 1948 congress used federal tax law to cure the economic impact of 2004 one flesh, two taxpayers 761 15. see discussion infra part i. the marital deduction initially was limited to one-half of a decedent’s adjusted gross estate tax and one-half of lifetime gifts. see pennell, supra note 4, at a-2. as part of the tax reform act of 1976, pub. l. no. 94455, § 2002(a), 90 stat. 1520 (1976), congress considered expanding the marital deduction to 100 % of a decedent’s gross estate, but instead expanded the marital deduction to the greater of $250,000 or one-half of the adjusted gross estate. see discussion infra part i.d. as part of the economic recovery tax act of 1981, pub. l. no. 97-34, § 403(a), 95 stat. 172 (1981) (hereinafter “ert a”), congress removed the percentage limitation on the marital deduction and radically relaxed the rules on the types of spousal property interests that qualify for the marital deduction. 16. see discussion infra part i.e. 17. see supra text accompanying note 4. 18. see discussion infra in part iii.a. 19. in effect, the applicable exclusion amount is the cumulative amount that any taxpayer may transfer tax-free during lifetime or at death. see irc § 2010. differences in married couples’ property rights under state law. over a period of more than thirty years, the marital deduction then evolved from a tool for achieving jurisdictional uniformity15 into an institution based on an unreal and idealized story of proper gender roles for men and women and the economic significance of marriage.16 part ii of this article details the benefits of marriage under present wealth transfer tax laws. apart from the estate and gift tax marital deduction,17 a married couple may “split” lifetime gifts to achieve a low (or no) tax bill. unique among beneficiaries, a surviving spouse can disclaim property to a trust for his or her own benefit without adverse tax consequences. part iii analyzes the jurisprudential implications of the “one flesh, one taxpayer” approach to wealth transfer taxation. notwithstanding the law’s gender neutrality, the current estate and gift tax approach to marriage is a vestige of the common law rule of coverture that suspended a woman’s legal identity during marriage.18 furthermore, in departure from important tax policy goals, federal wealth transfer tax laws privilege heterosexual marital relationships over other socially important relationships with economic or emotional characteristics similar to marriage. by failing to recognize the economic unity of taxpayers who may be opposite-sex unmarried domestic partners, same-sex domestic partners or adult children who support elderly parents, the one flesh, one taxpayer rule discourages relationships that benefit society as a whole. part iv proposes the elimination of the marital deduction in favor of a “one flesh, two taxpayer” approach to marriage that would cause all gratuitous transfers to be subject to taxation, regardless of the identity of the recipient. at the same time, the wealth transfer taxation system should accommodate a dramatically increased applicable exclusion amount. that way, even though all transfers will be subject to taxation, the vast majority of transfers will not result in actual payment of tax.19 this part illustrates how increasing the exemption amount will increase federal tax revenue and enhance the vitality of common law and community property systems. the article concludes by connecting the estate and gift tax treatment of marriage to the larger issue of estate tax repeal and reform. 762 florida tax review [vol. 6:8 20. see, e.g., kahng, supra note 14, at 26-28. prior legislation provided for limited joint filing by spouses. see edward j. mccaffery, taxing women: how the marriage tax penalty affects your taxes 30-31 (1997); marjorie e. kornhauser, love, money and the irs: family, income-sharing, and the joint income tax return, 45 hastings l.j. 63 (1993); angela v. langlotz, tying the knot: the tax consequences of marriage, 54 tax law. 329, 329 (2001). 21. kahng, supra note 14, at 26-28. 22. the app licable federal income tax statutes imposed a tax on “income derived from salaries, wages, or compensation for personal services,” among other items. revenue act of 1918, pub. l. no. 254, § 213(a), 40 stat. 1057, 1065 (1919); revenue act of 1921 , pub. l. no. 67-98, ch. 136, 42 stat. 227, 238 (1921). 23. lucas v. earl, 281 u.s. 111, 114-115 (1930). i. two shall become one: the history of the estate and gift tax marital deduction a. income tax consequences of community property and common law property rules the current estate and gift tax treatment of intra-spousal transfers derives historically from related income tax rules. prior to 1948 joint income tax returns were unknown for the most part.20 each taxpayer filed a separate return, regardless of marital status.21 for that reason, married couples developed strategies designed to shift income from high-income spouse to the lowerincome (or no-income) spouse in order to take advantage of exemptions available to each individual taxpayer. as an example, guy c. earl entered into an agreement with his wife pursuant to which each spouse agreed that any property acquired by either of them, including salaries, would be treated as their joint property. for several years mr. earl, an attorney, earned legal fees. pursuant to their agreement, mr. and mrs. earl each owned one-half of these fees. mr. and mrs. earl each filed an individual income tax return reporting income for the relevant tax years in the amount of one-half of the legal fees earned by mr. earl that year.22 the earls reasoned that because the property ownership was divided equally between them, their taxable income should be as well. in 1930 the united states supreme court rejected the taxpayers’ argument in lucas v. earl: there is no doubt that the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. that seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.23 2004 one flesh, two taxpayers 763 24. “the validity of the [earls’] contract is not questioned, and we assume it to be unquestionable under the law of the state of california, in which the parties lived.” earl 281 u.s. at 114. 25. 282 u .s. 101 (1930). 26. william a. reppy, jr. & cynthia a. samuel, community property in the united states 1-11 (6th ed. 2004). the court assumed, and the government did not contest, that for property law purposes, the earls’ contract was valid.24 the court acknowledged that spouses could fix property rights as between the two of them, causing property earned by one of them to be owned legally by both of them (thus dividing “fruit” from “tree”). but the court held that such a contract had no impact for federal income tax purposes. in other words, spouses could contract for property law results but not for tax results. private property contracts could not change a tax system that precluded joint income tax returns. approximately eight months after the decision in lucas v. earl, the supreme court held in poe v. seaborn25 that state property laws accomplished what private contracts did not – a change in the default federal income tax rules. the poe court held that for spouses residing in community property jurisdictions, federal income tax liability followed state law property ownership. in other words, because each spouse in a community property jurisdiction owned one-half of all property earned or held by the other,26 each spouse was taxable for federal income tax purposes on one-half of the community income, regardless of which spouse earned the income. thus if spouse 1 earned a salary and spouse 2 did not work outside the home, each spouse could file a federal income tax return and pay tax on one-half of spouse 1’s salary. by using the exemptions allotted to each taxpayer, the two spouses together could shelter greater income from taxation than either one of them could alone. the income might even escape taxation entirely. the impact of state property law rules on federal income taxation can be illustrated by a simple example. assume that spouse 1 and spouse 2 are married. spouse 1 earns $100,000 per year for paid labor, but has no income from any other source. spouse 2 has no income at all. assume further that the hypothetical tax system does not permit joint filing, but exempts from taxation the first $20,000 of any individual’s income. any amounts over $20,000 are taxed at a rate of 50%. disregarding the impact of other available exemptions or deductions, the combined federal income tax liability of spouse 1 and spouse 2 will depend on how applicable state property law treats the $100,000. if the couple resides in a common law jurisdiction, spouse 1 owns the $100,000 and must report it on his or her individual income tax return. spouse 1’s hypothetical tax liability will be $40,000 (50% of the amount by which $100,000 exceeds $20,000). because spouse 2 has no income, spouse 2 will not file a tax return and owes no tax. taken together, the couple’s combined income tax liability is $40,000. in contrast, after the decision in poe and before the creation of the joint return in 1948, if spouse 1 and spouse 2 resided in a community property jurisdiction, then regardless of who actually earned the income, one-half of $100,000, or $50,000, was attributed to each spouse. spouse 1 would have income tax liability of $15,000 (50% of the amount by which $50,000 exceeds $20,000). spouse 2, who owned one-half of the community’s income, also 764 florida tax review [vol. 6:8 27. the community property jurisdictions in 1948 were arizona, california, hawaii, idaho, louisiana, michigan, nebraska, nevada, new mexico, oklahoma, oregon, texas, washington and w isconsin. pennsylvania’s community property statute had been declared unconstitutional. today, the states with community-property or quasicommunity property rules are alaska, arizona, california, idaho, louisiana, nevada, new mexico, texas, washington and wisconsin. see s. rep. no. 1013, at 302 (1948). most notably, alaska permits married residents and married non-residents to elect community property treatment for some or all of their assets. alaska stat. §§ 34.77.010 995 (michie 2003). in order to create alaska community property, a married couple not resident in alaska must transfer assets to a trust meeting certain requirements, including that one of the trustees must be an individual who is domiciled in alaska, or a bank or trust company organized under alaska law and having its principal place of business in alaska. alaska stat. § 34.77.100(a). for general discussion of alaska’s elective community property law, see jonathan g . blattmachr et al., tax planning w ith consensual community property, 33 real prop. prob. & tr. j. 615 (1999); alan newman, incorporating the partnership theory of marriage into elective-share law, 49 emory l.j. 487 (2000); david g. shaftel & stephen greer, obtaining a full steppedup basis under alaska’s new community property system, 23 est. plan. 109 (1999); http://www.alaskatrust.com/www/homepg2.html (last visited july 28, 2004). 28. s. rep. no. 80-1013, at 1 (“equalization is provided for the tax burdens of married couples in common-law and community-property states. the bill corrects existing inequalities under the estate and gift taxes, as well as the individual income tax”). both in 1948 and now, in states such as california, each spouse legally owns onehalf of the community property, regardless of the form in which the property is held. state law accomplishes this division of property without any adverse tax consequences. see boris i. bittker et al., federal estate and gift taxation 236-237 (8th ed. 2000); carolyn c. jones, split income and separate spheres: tax law and g ender roles in the 1940s, 6 law & hist. rev. 259, 266, 273-74; kahng, supra note 14, at 28; pennell supra note 4, at a-2. furthermore, in community property jurisdictions, at death, the first spouse to die may dispose of only his or her share of the community property. only the first decedent’s share of the community property is subject to estate tax, with the other half escaping taxation until the second decedent’s death. see poe v. seaborn, 282 u.s. 101, 111 (1930) (“[i]t is clear that income of community property is owned by the community and that husband and wife have each a present vested one-half interest therein”.); bittker et al. at 237; reppy & samuel, supra note 26, at 13-21. post-poe, state property rules had important consequences for not only income taxes, but for wealth transfer taxes as well. assume for example that spouse 1 and spouse 2 resided in a common law jurisdiction prior to 1948, and that spouse 1 died with a gross estate of $100,000 passing entirely to spouse 2. assuming a 50% rate of would have income tax liability of $15,000 (again, 50% of the amount by which $50,000 exceeds $20,000). taken together, couple’s combined income tax liability would be $30,000, or $10,000 less than the common law couple’s. the poe decision confirmed that state community property law accomplished spousal income splitting without gift tax consequences. for that reason, community property resident spouses enjoyed favorable tax treatment compared with their common law counterparts27 from 1930 until 1948, when congress authorized income splitting by means of the joint income tax return. b. horizontal equity, joint income tax returns and the wealth transfer tax marital deduction in 1948 congress altered the income, estate and gift tax laws in response to the poe court’s exposure of the disparities in the federal tax treatment of married couples in common law and community property jurisdictions.28 in its report accompanying the revenue act of 1948,29 the 2004 one flesh, two taxpayers 765 taxation, spouse 1’s estate would owe $50,000 in estate tax (50% of $100,000). if, however, same couple resided in a community property jurisdiction where the $100,000 was a community asset, spouse 1’s gross estate would be one-half of $100,000, or $50,000. even if spouse 1 held the $100,000 in a bank account titled in spouse 1’s sole name, by operation of state law, spouse 1 legally owned (and could dispose of at his death) only $50,000. the other $50,000 already belonged to spouse 2. again assuming an estate tax rate of 50% , spouse 1’s estate would owe $25 ,000 (50% of $50,000). this is one-half of the tax imposed if spouse 1 had resided in a common law jurisdiction ($50,000). compare as follows: common law jurisdiction community property jurisdiction spouse 1 spouse 2 spouse 1 spouse 2 assets at death $100,000 $0 $50,000 $50,000 estate taxes (50%) (50,000) (25,000) 0 net estate 50,000 25,000 50,000 bequest to spouse 2 (50,000) 50,000 (25,000) 25,000 net assets 0 $50,000 $75,000 to achieve a $50,000 gross estate, common law resident spouse 1 would have needed to consume or give away a portion of the $100,000 to spouse 2 or to others. prior to the institution of the marital deduction, any lifetime gifts by spouse 1 would be subject to gift tax. if the gift tax rate were, say, 50%, common law residing spouse 1 with assets $100,000 could make a taxable gift of $33,333. spouse 1 then would pay a gift tax of $16,667 (rounded) (50% of $33,333). spouse 1 would then have a remaining gross estate of $50,000 ($100,000 minus $33,333 minus $16,667) and estate tax bill of $25,000 (50% of the remaining gross estate). spouse 2 would have total assets of $58,333 ($33,333 received during spouse 1’s lifetime plus $50,000 upon spouse 1’s death). note that community property resident spouse 1 did not have to make any lifetime taxable transfers to achieve the gross estate of $50,000; state law effected spouse 2’s ownership of $50,000. at death, spouse 1 would transfer $50,000 net to spouse 2. spouse 2 would have total assets of $75,000 . compare as follows: common law jurisdiction community property jurisdiction spouse 1 spouse 2 spouse 1 spouse 2 assets at inception $100,000 $0 $50,000 $50,000 lifetime transfers (33,333) 33,333 gift taxes (50%) (16,667) 0 gross assets at death 50,000 50,000 estate taxes (50%) (25,000) (25,000) 0 net estate 25,000 25,000 50,000 bequest to spouse 2 (25,000) 25,000 (25,000) 25,000 net assets 0 $58,333 0 $75,000 29. pub. l. no. 80-471, 62 stat. 110, reprinted in 1948-1 c.b. 211. senate finance committee acknowledged the likelihood that several states would convert to community property systems so that their citizens would experience no financial disadvantage: 766 florida tax review [vol. 6:8 30. s. rep. no. 1013, at 302-03. 31. id. at 302. 32. daniel q. posin & donald b. tobin, principles of federal income taxation 26 (6th ed. 2003). see generally walter j. blum & harry kalven, jr., the uneasy case for progressive taxation, 19 u . chi. l. rev. 417 (1952); walter j. blum, revisiting the uneasy case for progressive taxation, 60 taxes 16 (1982). 33. s. rep. no. 1013, at 302. uniformity is a constitutional requirement: “[a]ll duties, imposts, and excised shall be uniform throughout the united states.” u.s. const. art. i, § 8, cl. 2. 34. revenue act of 1948, pub. l. 80-471, § 372, 62 stat. 110, 125-27, reprinted in 1948-1 c.b. 211, 223-24; s. rep. no. 1013, at 303-06. for further discussion of the history of the wealth transfer tax marital deduction, see, e.g., richard b. stephens et al., federal estate & gift taxation ¶ 5.06[1] (8th ed. 2002). 35. irc § 2513 (1948). 36. e.g., bittker et al., supra note 28, at 337-38. [t]he fact which makes action at the present session imperative is the potential rapid extension of community property to a large number of common-law states. the adoption of community property has been advocated widely in spite of a growing awareness of the substantial differences between community property and common law which make a transition to one system extremely difficult . . . . [t]here is a lively fear that the tax advantages of community property will produce a migration of the relatively well-to-do taxpayers [from common law states] . . . . if the necessary action is not taken, there will be a flood of state legislation . . . which has the most unfortunate consequences, not only for the taxpayers involved, but also for the persons who must use or administer the property laws of the states which rush into the communityproperty system.30 the finance committee predicted a “difficult transition” as common law states moved to community property31 and created mass confusion and administrative nightmares. even if the potential wave of state property law change and confusion was not strictly a federal problem, congress addressed it with a federal solution. as legislators framed the issue, if similarly situated spouses were taxed differently because of differences in state property law, federal tax law, not state law, should change. in the congressional view, geographic differences meant that federal tax law failed to achieve its important policy goal of horizontal equity, the principle that “people with about the same income should pay about the same tax.”32 geographic equalization then became the rallying cry behind the enactment of the joint income tax return in 1948.33 in addition to the joint income tax return, congress saw gift-splitting and the estate and gift tax marital deduction as primary equalizing vehicles.34 with the enactment of irc § 2513,35 spouses could agree to have any transfer made by either of them treated as made one-half by each spouse. the marital deduction itself initially was limited to one-half of a decedent’s gross estate or one-half of any lifetime transfer by gift.36 this new tax rule achieved for common law resident spouses the same tax treatment of gifts made by 2004 one flesh, two taxpayers 767 37. precise geographic equalization remained somewhat elusive, for technical reasons relating mostly to the tax treatment of spousal joint tenancies. see, e.g., s. rep. no. 1013, at 304 (in its report, the senate finance committee noted that “the widespread use of life tenancies in common-law states” presented particular challenges). for a detailed discussion of the tax treatment of joint tenancies, see stephens et al., supra note 34, ¶ 5.06[3][d]. 38. pub. l. no. 591-736, § 2056, 68a stat. 1, at a318 (1948). for a general explanation of the relaxed terminable interest rule, see s. rep. no. 1013, at 335-36; s. rep. 1622, at 125 (1948). 39. in a broad sense, a general power of appointment is “[o]ne exercisab le in favor of any person the donee may select.” black’s law dictionary 685 (6th ed. 1990). for federal estate and gift tax purposes, however, in order for a trust to qualify for the marital deduction under irc § 2056(b)(5), the spouse must have the power to appoint all or a specific portion of the trust property in favor of the surviving spouse or his or her estate, whether or not the power is exercisable in favor of others, and with no power in any other person to appoint any part of the trust to any person other than the surviving spouse. irc § 2056(b)(5). cf. irc § 2041 (general power of appointment is a power exercisable in favor of the taxpayer himself, herself, his or her estate and the creditors of his or her estate, except in certain circumstances). 40. in 1954, the marital deduction rules were relaxed to permit explicitly a life estate to qualify for the marital deduction. see h.r. rep. no. 1337, at 91-92 (1954). 41. kahng, supra note 14, at 33-35. 42. charles looker, the impact of estate and g ift taxes on property disposition, 38 cal. l. rev. 44, 62 (1950). 43. id. at 67. community property resident spouses. with the deduction, a common law resident spouse could transfer all property to his or her spouse at death, but owe estate tax only on half of the estate (as one-half did not qualify for the marital deduction). for most practical purposes, then, the new rules achieved the desired geographic parity between common law and community property resident spouses.37 under the estate and gift tax laws enacted in 1948, a limited category of transfers apart from outright gifts and bequests qualified for the marital deduction. the new laws generally prohibited deductions for terminable interests,38 or interests subject to the spouse’s divestiture, although the law allowed a deduction for a spouse’s income interest in a trust over which the spouse had a specific type of general power of appointment.39 in recognizing this limited exception to the terminable interest rule, congress treated a life estate coupled with a general power as equivalent for transfer tax purposes to outright ownership even though the spouse lacked full ownership rights over the property.40 the construction of substantively different property interests as equivalent for tax purposes played an important role in the estate and gift tax marital deduction from its inception. this equivalency theme recurred prominently in later congressional debates over the marital deduction. contemporary commentators reacted unfavorably to the level of control by a surviving spouse that was required to qualify transfers for the marital deduction.41 outright ownership or a general power of appointment enabled a widow to “cut off the objects of [the husband’s] bounty and leave his estate to a gigolo second husband,”42 or “cut off” a husband’s intended beneficiaries ‘by the stroke of a mother’s pen.”43 even if husbands and wives were theoretical economic partners, that partnership lasted only as long as they (or their 768 florida tax review [vol. 6:8 44. s. rep. no. 1599, at 1-6 (1966). 45. irc § 2056(d). 46. id. 47. see supra note 30 and accompanying. 48. h.r. rep. no. 1513, at 2-7 (1966). 49. id. 50. id. 51. in stating its rationale for supporting the legislative change, the senate finance committee employed language substantially similar to the house ways and means committee’s: marriage) did. truly equal spousal ownership of property was problematic because women were too weak (and thus prey for “a gigolo second husband”) or too strong (capricious evil-doers who cut off beneficiaries with a “stroke of a mother’s pen”). c. triumph of substance over form in 1966, almost twenty years after the enactment of the provisions authorizing the joint income tax return and the estate and gift tax marital deduction, congress amended the marital deduction provisions to address perceived “inequities and discrimination”44 in the transfer tax treatment of disclaimed property. in particular, legislators saw economic discrimination in the non-recognition for transfer tax purposes of disclaimers by persons other than a surviving spouse.45 to illustrate, if an unrelated third party disclaimed a testamentary bequest, even if the disclaimed property passed to the decedent’s surviving spouse, the transfer would not qualify for the estate tax marital deduction.46 in the case of disclaimed property, tax results depended on the process by which a surviving spouse received property, not its receipt alone. thus for transfer tax purposes prior to 1966, form vanquished substance. echoing congress’s 1948 dismay at the “unfortunate” conversion of common law jurisdictions to community property systems,47 the house ways and means committee labeled the pre-1966 disclaimer rules as “unfortunate”48 for causing estate tax consequences to deviate from underlying substantive property ownership. in most of these “unfortunate” disclaimer cases, the committee observed, “the failure to make provision for the marital deduction stemmed from an absence of knowledge concerning estate tax law by the decedent.”49 “this is an area of the law which, of necessity, contains complexities and frequently is not understood by an individual preparing his own will.”50 in the face of complex and confusing laws, congress believed that taxpayers should be saved from their own mistakes, and that wealth transfer taxation rules should be flexible where possible in granting the marital deduction. in 1966 congress ratified revised disclaimer rules. under the new transfer tax rules, whether a surviving spouse received property became more important than how he or she received it. in other words, a bequest directly to a surviving spouse was equivalent for tax purposes to an indirect transfer to the surviving spouse via disclaimer. in either case, the surviving spouse became entitled to the property. congress again showed preference for tax rules that tracked economic or beneficial ownership of property.51 2004 one flesh, two taxpayers 769 where the beneficiary d isclaims his right to receive property and, as a result, the property is received by the surviving spouse, it is difficult to see why a larger tax should be recovered from the estate than would be true where the property goes directly to the surviving spouse (rather than indirectly as a result of a d isclaimer). in bo th cases the economic effect of the transaction is the same. moreover, frequently the failure to make provision for the marital deduction in the first instance stems from an absence of knowledge concerning estate tax law by the decedent. this is an area of the law which, of necessity, contains complexities and frequently is not fully understood by an individual preparing his own will. s. rep. no. 1599, at 1-6 (1966). 52. tax reform act of 1976 pub. l. 94-455, 90 stat. 1520 (1976). for discussion of the impact on estate planning by the 1976 tra’s important changes to the federal tax system, see, e.g., jonathan g. blattmachr & thomas j. mcgrath, carryover basis under the 1976 tax reform act (1977); joseph m. dodge, generation-skipping transfers after the tax reform act of 1976, 125 u. pa. l. rev. 1265 (1977). 53. as ronald d. aucutt explains, the tax reform act of 1976 partially ‘unified’ the gift and estate taxes by making the estate tax cumulative with the gift tax through the concepts of ‘adjusted taxable gifts’ and a ‘unified credit,’ with the same stated ra tes. the act repealed the former specific exemptions of $30,000 for gift tax purposes and $60,000 for estate tax purposes. ronald d. aucutt, the statute of limitations and disclosure rules for gifts, sj073 ali-aba 1345, 1348 (citations omitted). for further discussion of the unification of the wealth transfer tax system, see, e.g., paul r. mcd aniel et al., federal wealth transfer taxation 8-9 (5th ed. 2003). 54. a generation-skipping transfer occurs when, for example, a taxpayer makes a gift to a trust for the benefit of his or her child, with remainder to the grantor’s grandchild. see irc §§ 2515, 2602-2603, 2611-2613, 2621-2623, 2631, 2641-2642, 2651-2653; treas. reg. §§ 26.2601-1(a), (b), 26.2611-12, 26.2612-1, 26.2613-1, 26.2642-2(a)(1), (2), 26.2652(a)(1)-(4). the provisions of the 1976 tra relating to the generation-skipping transfer tax were repealed retroactively in 1986 and a new generation-skipping transfer tax system was enacted. see stephanie j. willbanks, federal taxation of wealth transfers 6 (2004). for a superb analysis of the generation-skipping transfer tax, see carol a. harrington et al., generation-skipping transfer tax (2d ed. 2001). 55. tax reform act of 1976, pub. l. 94-455, § 2002(a), 90 stat. 1520 (1976). see generally pennell, supra note 4, at a-3. d. the incipient one flesh, one taxpayer theory of wealth transfer taxation the next significant development in the history of the estate and gift tax treatment of marital transfers occurred in 1976. the tax reform act of 1976 (“1976 tra”)52 is landmark legislation best known for substantially unifying the estate and gift tax systems.53 less well known is that the 1976 tra implemented (albeit temporarily and ineffectively) the nation’s first generation-skipping transfer tax.54 furthermore, in connection with the 1976 tra’s increase of the marital deduction to the greater of $250,000 or one-half of a decedent’s adjusted gross estate,55 congress considered, but did not pass, an increase in the marital deduction to 100% of a decedent’s estate for transfers 770 florida tax review [vol. 6:8 56. see generally pennell, supra note 4, at a-3. 57. congress did increase the estate tax marital deduction from one-half of the decedent’s adjusted gross estate to the greater of (a) $250,000 or (b) one half of the decedent’s adjusted gross estate. the increased gift tax marital deduction was unlimited with respect to the first $100,000 and 50% of lifetime transfers in excess of $200,000. pub. l. 97-34, § 339, 95 stat. 172 (1981). 58. see supra note 6 and accompanying test. 59. in this context, horizontal equity refers to the idea that all married couples, regardless of their state of residence, should be subject to the same level of wealth transfer taxation. for further discussion of the role of horizontal equity in taxation, see generally michael a. livingston, taxation law, planning & policy xxv-xxxvi (2003). see also christopher t. nixon, should congress revise the tax code to extend the same tax benefits to same-sex couples as are currently granted to married couples? an analysis in light of horizontal equity, 23 s. ill. u. l.j. 41 (1998) (comparing tax treatment of same-sex couples to tax treatment of opposite-sex married couples). 60. here vertical equity refers to the idea that all married couples, regardless of their level of wealth, should be sub ject to the same level of wealth transfer taxation. for further discussion of the role of vertical equity in taxation, see generally livingston, supra note 59; philip d. oliver, tax policy 1-4 (2d ed. 2004). 61. in the tax reform studies and proposals published jointly by the house ways and m eans committee and the senate finance committee, the treasury department explained that wealthy married taxpayers typically exploited lower gift tax rates to make lifetime instead of death time transfers to the less wealthy spouse. joint comm. on tax ref., tax reform studies and proposals 257-259 (1969). at death, regardless of estate size, and the entire value of property for transfers by lifetime gift.56 although lawmakers ultimately did not agree in 1976 to increase the marital deduction to the full value of the decedent’s gross estate,57 in considering the possibility congress laid the foundation for the “one flesh, one taxpayer” approach to marriage and wealth transfer taxation.58 close analysis of the legislative history and supporting materials, including the studies and proposals of the treasury department, the house and senate committee reports and testimony before congressional committees, reveals a shift in policy focus. congress moved away from the horizontal equity59 concerns of 1948 toward a new goal of vertical equity in taxation.60 specifically, lawmakers focused on the supposed ability of wealthy couples to avoid estate tax entirely (albeit through lifetime taxable gifts) and the expansion of this “right” to married couples of all levels of wealth.61 in arguing for an increased estate and gift tax marital deduction, the bill’s supporters construed marriage as a unique economic partnership that deserved special tax treatment. four particular themes emerge from the legislative history. first, according to congress, husbands and wives treat all assets belonging to either of them as belonging to both of them. [m]any families regard their property as being generated by their combined efforts and, thus, “ours” rather than “his” and “hers” . . . . [t]hey often transfer property from separate ownership to joint ownership or community property without paying much attention to the legal change in ownership. there is a serious question whether it is appropriate to tax such 2004 one flesh, two taxpayers 771 62. tax reform (administration and public witnesses): public hearings before the house comm. on ways and means, 94th cong., 2d sess. part 2, 1187 (m ar. 22, 1976) (testimony of treasury secretary william e. simon). for an analysis of the partnership approach, see m arjorie e. kornhauser, deconstructing the t axable unit: intrahousehold allocations and the dilemma of the joint return, 16 n.y.l. sch. j. hum. rts. 140 (1999). kornhauser asks, “if marriage is a partnership, why do only 10% of married women use a name other than their husband’s?” id. at 150. 63. tax reform studies and proposals, supra note 61, at 258. 64. viviana a. zelizer, the social meaning of money: pin money, paychecks and other currency 43-66 (1994). 65. id. at 68-69. 66. arlene f. saluter & t erry a. lugaila, current population reports, p o p u l a t i o n c h a r a c te r i s t i c s p 2 0 4 9 6 ( m a r . 9 8 ) , a v a i l a b l e a t http://www.census.gov/prod/3/98pubs/p20-496.pdf. 67. howard n fullerton, jr., labor force participation: 75 years of change, 1950-98 and 1998-2025, 122 monthly lab. rev. 3 (1999), available at http://www.bls.gov/opub/mlr/1999/12/art1full.pdf. 68. average population per household and family: 1940 to present, u.s. bureau of the census, at http://www.census.gov/population/socdemo/hh-fam/tabhh6.xls (last modified june 11, 2003). 69. tax reform studies and proposals, supra note 61, at 258. 70. id. at 199. transfers that are basically just incidents in the common management of the family’s pooled resources.62 congress viewed the legal form of marital property ownership as less important than how spouses themselves approach the property. in support of the assertion that most married couples treat property owned by either of them as “‘ours’ from the time of its acquisition since it was acquired with family funds,”63 lawmakers in 1976 entertained little direct testimony about taxpayers’ attitudes toward marital property. sociologists now would suggest that congress was mistaken in its assertions. historically husbands have controlled marital finances,64 and even today in a couple where both spouses frequently engage in paid labor, a wife frequently regards her earnings as “for personal frills” and husbands “are still more likely than their wives to retain personal spending money.”65 the second theme that emerges from the 1976 legislative history is that economic dependents deserve special insulation from the negative impact of the estate tax. statistically speaking, in 1976 the majority of adult taxpayers were married.66 most married women did not work outside the home67 and the average family had more than one minor child.68 these data help explain the treasury department’s emphasis on the “especially difficult burden [that] may be imposed by the [estate] tax when property passes to a widow, particularly if there are minor children.”69 through images of bereft widows and orphans, advocates appealed for legislative sympathy for those who were unable to provide financially for themselves. a third theme of the 1976 legislative history is that taxation of wealth transfers should be postponed until the death of the second spouse. “it does not appear . . . that transfers between husband and wife are appropriate occasions for imposing tax,” asserted the treasury department.70 “[t]he [full marital 772 florida tax review [vol. 6:8 71. id. at 260. 72. see supra note 54 and accompanying text. 73. tax reform studies and proposals, supra note 61, at 260. 74. id. 75. w ith respect to the legislative history of erta, kahng, supra note 14, at 32-34, makes a similar point. kahng does not address the legislative history of the 1976 tra, however. 76. tax reform studies and proposals, supra note 61, at 259. deduction] proposal is designed to provide that property of a married couple will be taxed once as it passes to the next generation.”71 note that the proposed tax law did not contemplate an exemption for wealth transfers between unmarried members of the same generation (although generational differences between taxpayers formed the backbone of the ill-fated generation-skipping transfer tax provisions of 1976).72 the proposed full deduction applied only to transfers between spouses, regardless of any age difference between them. thus the marital unit itself took on greater importance than the characteristics of either member of the couple. this focus on the marital unit itself grew out the joint income tax return. if married couples filed one return for income tax purposes, the logical extension of that argument was that they should, in effect, file one estate tax return (or at least pay only one estate tax). even if a full martial deduction meant lost federal revenue, advocates insisted that it would facilitate smooth administration of the wealth transfer tax system.73 building on the notion of a merged husband and wife taxpayer, the fourth theme from the debate over the marital deduction is the relationship among substance, form and tax results. specifically, congress considered revising the terminable interest rule to provide that a mere life estate in a surviving spouse without a general power of appointment qualified for the marital deduction. turning a blind eye to the limited rights of a life beneficiary, the treasury department asserted that “whether the husband or wife makes provision as to who gets the property ultimately” was insignificant to the federal government “so long as it is agreed that the property will be taxed on the death of the spouse.”74 limiting the federal interest in this way accorded generally with the previously articulated viewpoint that a married couple, not an individual taxpayer, was the appropriate taxable unit for estate and gift tax purposes. yet the claim that the federal interest was limited to the eventual taxation of property masked an entirely different agenda. specifically the estate and gift tax rules forced men to relinquish too much control over their property in order to qualify their transfers for the martial deduction.75 under present law, the bequest [of a terminable interest] only qualifies for the marital deduction if the spouse has control over the property underlying her income interest that is considered her property (and taxable at her death). a husband may want to leave the income from his property to his wife but ensure that the property goes on her death to his children. ordinarily . . . the bequest would not qualify under present law for the marital deduction.76 2004 one flesh, two taxpayers 773 77. id. 78. table 2-1, estimated number of divorces and annulments and rates, with percent changes from preceding year; united states 1920-1976, vital statistics of the united states 1976, vol. iii marriage and divorce, available at http://www.cdc.gov/nchs/data/vsus/mgdv76_3.pdf (june 10, 2004). in 1976, the rate of marriage was 10 per 1,000 population. id. at table 1-1. in 2001, the divorce rate was 4.0 per 1,000 total population; the marriage rate was 8.4 per 1,000 total population. births, marriages, divorces and deaths: provisional data for 2001, national vital s t a t i s t i c s r e p o r t ( s e p t . 1 1 , 2 0 0 2 ) , a v a i l a b l e a t http://www.cdc.gov/nchs/data/nvsr/nvsr50/nvsr50_14.pdf. 79. economic recovery tax act of 1984, pub. l. no. 97 34, as stat. 172 (1981). 80. treasury department’s general and technical explanation of h.r. 3849: administration’s economic recovery tax act of 1981, 97th cong., 1st sess., at 39 (june 23, 1981). 81. see supra note 69 and accompanying text. in a certain sense, the two arguments in favor of a naked life estate’s qualification for the marital deduction contradicted each other. if husband and wife had identical or substantially identical economic interests, they arguably deserved recognition as one person for transfer tax purposes. the male half of the taxable “person” (and the legislative history indeed contemplates a male taxpayer77) would require no control over the ultimate disposition of the property, if the female half of the taxable “person” exercised her general power of appointment on her subsequent death in a manner consistent with the male’s intentions. the real concern behind the strict qualifications for marital property, however, was that husband and wife were not economic alter egos of each other. at a time when the national divorce rate was 5.0 per 1,000 total population,78 spouses frequently had divergent dispositive interests. e. vertical equity and the full marital deduction the economic recovery tax act of 1981 (“erta”)79 finally codified the one flesh, one taxpayer approach to marital wealth transfers that had been developing since 1948. erta made two substantial refinements to the marital deduction. first lawmakers increased the marital deduction so that a decedent’s entire estate and the full value of any lifetime denotive transfer could qualify for the marital deduction. second the prohibition on terminable interests was relaxed, so that the first spouse to die could retain substantial control over a trust for the surviving spouse’s benefit, without sacrificing eligibility for the marital deduction. the successful arguments made in 1981 in favor of an unlimited marital deduction resounded the themes of 1976. in language borrowed directly from the legislative history of the 1976 tra, the treasury department opined: “many couples view their property as ‘ours’ rather than ‘his’ or ‘hers,’ especially if the property is purchased with ‘family’ funds.”80 the house ways and means committee also claimed that economic dependents deserved special insulation from the negative impact of the estate tax. in an appeal to legislative sympathy, the committee report called the estate tax the “widow’s tax,” because it “falls most heavily on widows,” an echo of the sentiments of 1976.81 the senate finance committee emphasized the proper time for imposition of 774 florida tax review [vol. 6:8 82. see s. rep. no. 97-144, at 127 (1981). 83. id. 84. id.; h.r. rep. no. 97-201, at 158 (1981). 85. treasury department’s general and technical explanation, supra note 80, at 39. 86. several scholars aptly critique the contribution of the qtip provisions to a simplified tax system. see, e.g., wendy c. gerzog, the m arital deduction qt ip provisions: illogical and degrading to women, 5 ucla w omen’s j.l. 301 (1995). 87. irc § 2056(b)(7)(b)(i)(i). 88. see id. 89. compare h.r. rep. no. 1337, at 91-92. 90. see generally kahng, supra note 14. 91. h.r. rep. no. 97-201, at 160. 92. 127 cong. rec. s:8346 (daily ed. july 24, 1981) (remarks of sen. boren). 93. see generally kahng, supra note 14. the estate tax as well as the complex relationship among substance, form and tax result.82 congress intended the increased marital deduction to implement the vision of “husband and wife as a single economic unit for transfer tax purposes, as they are generally treated for income tax purposes.”83 advocates of tax reform emphasized the urgent need for simplification of the marital deduction, citing overwhelming difficulty in determining ownership of marital property,84 and “the pressure to engage in complex estate planning.”85 yet in adopting relaxed terminable interest rules in connection with the full marital deduction, congress in fact complicated tax administration and estate planning.86 the enactment of the qualified terminable interest rules of section 2056(b)(7)87 represented the ultimate triumph of form over substance. by allowing sharply circumscribed property interests, such as an income interest in a trust without any power of appointment, to qualify for the marital deduction, federal tax jurisprudence turned full circle from its 1948 position that the substance of state law community property rights should control federal tax results. congress permitted a decedent’s estate to take a deduction for the full value of property passing to a trust for the benefit of a surviving spouse, even though the actuarial value of the spouse’s interest, depending on the spouse’s age and other factors, could be far less than the value of the entire property.88 with erta, lawmakers reasoned that a mere income interest was equivalent, for transfer tax purposes, to outright ownership.89 this equivalency argument was crucial to preserving the (typically male) testator’s ultimate control over property.90 erta’s adoption of the modified qualified terminable interest (“qtip”) rules in 1981 exposes the ultimate hollowness of the one flesh, one taxpayer approach to marital wealth transfers. under the pre-1981 marital deduction rules, only outright ownership or a life estate coupled with a general power could qualify for the marital deduction. the law required a taxpayer who sought to qualify a transfer for a full estate tax marital deduction to choose “between surrendering control of the entire estate to avoid imposition of the estate tax at his death or reducing his tax benefit at his death to insure inheritance by the children.”91 congressional recognition of this “difficult”92 choice amounted to an acknowledgment that the construction of husbands and wives as one taxpayer was legal fiction,93 or at least inconsistent with human 2004 one flesh, two taxpayers 775 94. in 1980, approximately 147,000 estate tax returns were filed. internal revenue service, statistics of income winter 2003-2004 bulletin, table 22, selected returns and forms filed or to be filed by type during specified calendar years 1975-2004 (may, 2004), available at http://www.irs.gov/pub/irs-soi/04al22sr.xls (last visited aug. 9, 2004). the federal government collected an estimated $6,282,247 in estate taxes for that year. internal revenue service data book fiscal year 2003 , table 7 – internal revenue gross collections, by type of tax, fiscal years 1973-2003, available at http://www.irs.gov/pub/irs-soi/03db07co.xls (last visited oct. 5, 2004). 95. except in the case of transfers to a spouse who is not a united sta tes citizen, the gift tax marital deduction is unlimited. irc § 2523(i)(1) (marital deduction disallowed where spouse is not a citizen of the united states). a donor may transfer up to a certain statutory amount to his or her non-citizen spouse each year. however, irc § 2523(i)(2) states that when the spouse of the donor is not a united states citizen that irc § 2503(b) applies to gifts and the deduction allowable. in 2004, that amount was $114,000. rev. proc. 2003-85, 2003-49 i.r.b. 1184. 96. in the estate tax context, irc § 2001 imposes a tax on the “taxable estate” of every citizen or resident of the united states. irc § 2001(a). a decedent’s taxable estate is defined in irc § 2051 as his or her gross estate (as further defined in irc § 2031(a)) minus certain deductions. permissible deductions include expenses, indebtedness and taxes under irc § 2053, losses under irc § 2054, charitable bequests, legacies, devises or transfers under irc § 2055, and most significant for purposes of this discussion, under irc § 2056, “the value of any interest in property which passes or has passed from the decedent to his or her surviving spouse, but only to the extent such interest is included in determining the value of the gross estate.” irc § 2056(a). similarly, in the gift tax context, irc § 2501 imposes a tax on all property transferred by gift during a calendar year by any individual. irc § 2501(a)(1). in essence, the gift tax is imposed on all “taxable gifts.” under irc § 2503(a), “taxable gifts” are the total amount of gifts made during the calendar year, other than annual exclusion gifts made pursuant to irc § 250 3(b), less the deductions permitted by subchapter c of chapter 12 of the code (irc §§ 2522-2524). irc § 2503(b). the nature. the surviving spouse could not be relied upon to serve as a dispositive extension of the first spouse to die, either because the spouses had different objects of their bounty or because the survivor’s needs and wishes changed over his or her ongoing life. yet instead of honoring the principle that tax results should follow from substantive property ownership, congress indulged anxieties about a transferor-spouse’s loss of control by changing the tax law. tangled in the construction of husbands and wives as one economic unit, in 1981 congress enacted the qtip rules to permit the first spouse to die to control the disposition of the transferred property upon the surviving spouse’s subsequent death. husbands and wives might be one taxpayer, when convenient, but the construction strained in the face of a surviving spouse’s potential outright ownership of all marital property.94 ii. current tax treat men t of marital wealth transfers a. the unlimited marital deduction, or “what’s mine is yours” since the enactment of erta in 1981, a married person generally may transfer an unlimited amount of property to his or her spouse without triggering the imposition of an estate or gift tax,95 provided that the property is in a qualified form.96 the favorable wealth transfer tax treatment of transfers 776 florida tax review [vol. 6:8 taxpayer may exclude from the calculation of his or her taxable gifts transfers that qualify for the annual exclusion under irc § 2503(b)(1). in 2004, the annual exclusion is $11,000. rev. proc. 2003-85, 2003-49 i.r.b. 1184. the annual exclusion is indexed for inflation each year. irc § 2503(b)(2). deductions for gift tax purposes include transfers to or for the use of charity and transfers to a spouse. irc §§ 2522 (charity), 2523(a) (spouse). the recipient must be the donor’s spouse at the time of the gift. 97. willbanks, supra note 54, at 457. see irc §§2056(a), 2523(a); treas. reg. §§ 20.2056(a)-1, 25.2523(a)-1. certain decedents or donors not subject to estate tax. see, e.g., irc §§ 2101 , 2106 (no estate tax imposed on an individual who is not a citizen or resident of the united states if he or she does not own property situated in the united states). 98. irc §§ 2056(a), 2523(a); treas. reg. §§ 20.2056(a)-1, 25.2523(a)-1. professor willbanks describes survivorship in the estate tax context as a separate requirement. willbanks, supra note 54, at 457-58. 99. willbanks, supra note 54, at 459. see also irc §§ 2056(a); treas. reg. § 20.2056(a)-1. 100. willbanks, supra note 54, at 459. t his rule “limits the amount of the marital deduction to the net value of the property received by the surviving spouse.” id. see also irc 2056(b)(4) (calculation of amount of property passing to surviving spouse must take into account the net property interest passing to the spouse). 101. the double negative is statutory. irc §§ 2056(b)(1), (b)(7), 2523(f)(1) and (f)(2). see willbanks, supra note 54, at 464, 467-68, 473-92. 102. see, e.g., priv. ltr. rul. 92-42-006 (jul. 15 , 1992) (transfer of life estate in art qualifies as qtip property). private letter rulings are binding only on the requesting taxpayer and may not be relied on as precedent. irc § 6110(k)(3). between spouses is accomplished by means of a tax deduction. in calculating the amount of total taxable gifts, a decedent’s executor or a living taxpayer, as the case may be, may deduct all transfers to a surviving spouse (for estate tax purposes) or a current spouse (for gift tax purposes), provided that certain requirements are met. the five requirements are: (1) the gross estate of the decedent includes the property with respect to which the marital deduction is sought.97 (2) the recipient of the property must be a surviving spouse or a current spouse.98 (3) in the case of transfers at death, the property must be included in the decedent’s gross estate for federal estate tax purposes.99 (4) the property must “pass” from the decedent/transferor to the surviving spouse or the current spouse.100 (5) the interest may not be a non-deductible terminable interest.101 the last of these, the prohibition on non-deductible terminable interests, is the source of many significant estate and gift tax controversies.102 1. the terminable interest rule – in lay terms the terminable interest rule provides that only an outright transfer or its very near equivalent will qualify for the wealth transfer tax marital deduction. in technical terms a terminable interest is one “which will terminate or fail on the lapse of time or 2004 one flesh, two taxpayers 777 103. treas. reg. § 20.2056(b)-1(b). see also irc § 2056(b)(1) (“where, on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur, an interest passing to the surviving spouse will terminate or fail, no deduction shall be allowed.”). 104. irc §§ 2056(b)(1), 2523(b)(1) (no deduction for interests that expire upon lapse of time). 105. this assumes that wife is a united states citizen. see irc § 2523(i) (disallowance of marital deduction in the case of transfers to a non-citizen spouse). 106. the examples in this part i.a.1. illustrate two separate transfers to which the reciprocal trust doctrine would not apply. see united states v. grace’s estate, 395 u.s. 316 (1969); lehman v. commissioner, 109 f.2d 99 (2d cir. 1940), cert. denied, 310 u.s. 637 (1940). in grace, the court ruled that the value of a trust created by wife is includible in husband’s gross estate under irc § 2036(a)(1) where husband and wife created “crossed” trusts in which “the trusts [are] interrelated, and . . . the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been in had they created the trusts naming themselves as life beneficiaries.” 395 u.s. at 324. in a recent private letter ruling the internal revenue service offered further guidance on the circumstances in which the reciprocal trust doctrine will apply. see priv. ltr. rul. 2004-26-008 (june 25, 2004) (ruling that life insurance trusts created by each of husband and wife for the other were not interrelated and therefore not subject to the reciprocal trust doctrine). private letter rulings are binding only on the requesting taxpayer and may not be relied on as precedent. irc § 6110(k)(3). nevertheless, private letter rulings may provide insight into the internal revenue service’s approach to a particular issue. for further analysis of the reciprocal trust doctrine, see elena marty-nelson, taxing reciprocal trusts, 75 n.c. l. rev. 1781 (1997); timothy p. o’sullivan & stewart t. weaver, using two trusts w ith reciprocal spousal general powers of appointment, 30 est. plan. 283 (june, 2003). 107. irc §§ 2056(b)(1), 2523(b)(1) (no deduction for interests that terminate upon a certain event or contingency). other terminable interests include annuities, patents and copyrights. treas. reg. §§ 20.2056(b)-1(b), 25.2523(b)-1(a)(3). on the occurrence or the failure to occur of some contingency.”103 conversely a non-terminable interest is one, like outright ownership, that will not terminate or fail on the lapse of time or on the occurrence or the failure to occur of some contingency. two examples illustrate this rule. first assume that husband transfers to wife a life estate in blackacre. because wife’s interest in the life estate expires upon her death, husband’s transfer does not qualify for the gift tax marital deduction.104 if husband transfers blackacre to wife outright, however, the transfer does qualify for the marital deduction.105 unlike a life estate, outright ownership does not expire upon wife’s death, insofar as she may transfer blackacre to designated beneficiaries or heirs at her death. a term of years is a second example of a terminable interest that does not qualify for the marital deduction. assume that wife transfers greenacre to husband to use and enjoy until daughter attains the age of twenty-one or sooner dies. if daughter dies before her twenty-first birthday, greenacre will be transferred to son. if daughter survives to her twenty-first birthday, greenacre will be transferred to daughter.106 wife’s transfer of time-limited use and enjoyment of greenacre to husband does not qualify for the marital deduction because husband’s interest will be defeated at daughter’s twentyfirst birthday or earlier death.107 in contrast, if wife gives greenacre to husband outright, the transfer qualifies for the marital deduction. an outright ownership 778 florida tax review [vol. 6:8 108. treas. reg. § 20.2056(b)-1(b). see also irc § 2056(b)(1) (“where, on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur, an interest passing to the surviving spouse will terminate or fail, no deduction shall be allowed.”). 109. irc §§ 2056(b)(7)(a), 2523(f)(1). 110. irc § 2056(b)(7)(b)(i)(i). 111. irc § 2523(f)(2)(a). 112. irc §§ 2056(b)(7)(b)(i)(iii), 2523(f)(2)(c). 113. irc §§ 2056(b)(7)(b)(i)(ii), (ii)(i), 2523(f)(2)(b). the surviving spouse must have the authority to demand that the trust property be made productive. treas. reg. § 20.2056(b)-7(h) example 2. 114. irc §§ 2056(b)(7)(b)(i)(ii), (ii)(ii), 2523(f)(2)(b). a typical qtip transfer is made by means of a trust that requires the trustee to pay all income at least annually to the spouse for life, with discretionary ab ility to invade principal for the benefit of the spouse alone. see, e.g., james s. sligar & bridget j. crawford, form 7, in david westphall & george mair, estate planning law and taxation a-61(4th ed. 2003). the beneficiary-spouse of a qt ip trust has the right to demand that the trust property be made productive (or sold and reinvested in productive property). treas. reg. § 20.2056(b)-7(h) example 2. although there is no case or ruling that indicates the minimum amount of interest that trust property must earn to be productive, the threshold probably is as little as 3% per annum. cf. treas. reg. § 1.643(b)-1 (definition of income interest for purposes of subparts a, b, c and d of part i of subchapter j of the code governing income taxation of estates and trusts). under this regulation, a 3% unitrust payment may constitute an “income” interest for purposes of determining whether a trust will be treated as a “simple” (pay all income) or “complex” (no requirement to pay all income) trust for income tax purposes. id. such a unitrust interest should qualify as a sufficient “income” interest for purposes of the martial deduction. irc §§ 2056(b)(8), 2523(g); treas. reg. §§ 20.2056(b)-8, 25.2523(g)-1. see jonathan g. blattmachr & mitchell m. gans, the final “income” regulations: their meaning and importance, 103 tax notes 891 (may 17, 2004). to qualify for qtip treatment and the marital deduction, the beneficiaryspouse need not have a power of appointment over the trust property. if the spouse does have both the requisite income interest and a general power of appointment over the transferred property, the transfer will qualify for the marital deduction under irc § 2056(b)(5) (estate tax) or irc § 2523(e) (gift tax). by dispositive provisions of the governing instrument, the trust’s grantor (or the testator under whose will the qtip trust interest does not “fail on the lapse of time or on the occurrence or the failure to occur of some contingency.”108 while mere life estates (without a general power of appointment) and terms of years, as examples, do not qualify for the marital deduction, one special form of terminable interest does qualify. if property meets four specific conditions, it will be treated as “qualified terminable interest property”109 (“qtip”) that is deductible for wealth transfer tax purposes. first, the property must pass from the transferor to the surviving spouse, in the case of testamentary transfers,110 or the current spouse, in the case of lifetime transfers.111 second, the transferor or the transferor’s executor affirmatively must elect qtip treatment for the transfer, or it will not qualify for the marital deduction and will be subject to taxation.112 third, the spouse must be entitled to all income from the transferred property, payable at least annually.113 fourth, no person may have the power to transfer any portion of the transferred property to any person other than the spouse.114 2004 one flesh, two taxpayers 779 is created) can control the disposition of the property upon the beneficiary-spouse’s death without jeopardizing the trust’s qtip treatment. 115. see text accompanying note 114. 116. irc §§ 2001, 2010(a). the unified credit is also known as the applicable credit. under the economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, 115 stat. 70 (2001) (hereinafter “egtrra”), “to the extent not used with respect to lifetime taxable gifts, the unified credit allowed under section 2010 of the code may protect $1,000,000 of assets in 2003 (and years after 2010); $1,500,000 in 2004 and 2005; $2,000,000 in 2006 through 2008; and $3,500,000 in 2009. under egtrra, the federal estate tax is repealed for 2010.” sligar & crawford, supra note 114, at a-42 n.1. see also jonathan g. blattmachr & lauren y. detzel, estate planning changes in the 2001 tax act – more than you can count,, 95 j. of tax’n 74 (aug. 2001) (discussion of changes under egtrra); jonathan g. blattmachr & mitchell m. gans, wealth transfer tax repeal: some thoughts on policy and planning, 90 tax notes 393 (jan. 15, 2001) (analysis of estate and gift tax planning opportunities under egt rra). 117. irc § 2010. the term “applicable exclusion amount” refers to the amount that may be protected from tax (starting with the lowest tax bracket) by reason of the unified credit under irc § 2010. see irc § 2010(c). in effect, the qtip rules allow a taxpayer to obtain tax-advantaged treatment for transfers of property to his or her spouse, even though the beneficiary-spouse has a limited interest in (and possibly no control over) the property. by way of illustration, assume that husband’s will directs that his entire estate be held qtip trust for the benefit of second wife for her life, remainder to pass on wife’s death to husband’s children from his marriage to first wife. husband could name third party as trustee with sole and absolute discretion to pay trust principal to second wife. husband also could prohibit third party from invading trust principal for second wife’s benefit. for tax purposes, it is irrelevant that third party may be an ally of husband’s children from his marriage to first wife (and hostile to second wife) or that second wife has no ability to control the disposition of the trust property at her death. second wife’s mere authority to cause the trustee to make the trust property productive means that she has a qualifying income interest115 and husband’s transfer to the trust will be eligible for the marital deduction. 2. the economic importance of the estate and gift tax marital deduction – whether a person is motivated by love, affection or tax law, transferring assets to a spouse has positive estate tax consequences. because the marital deduction allows one spouse to transfer assets to the other without adverse tax consequences, it is a powerful estate planning tool. unless each spouse separately owns assets equal to or in excess of the amount that can be protected by the unified credit,116 the credit will be “wasted” in a tax sense. in other words, if any taxpayer may transfer up to $x without attracting transfer tax, a taxpayer who does not have $x cannot use his or her exemption. because the exemption is not transferable to another taxpayer, it will never be used. consider a scenario in which the applicable exclusion117 for wealth transfer taxes is $1,000,000: assume that a and b are married, a owns $2 million, and b owns nothing. if a dies first, she can leave $1 million to a trust 780 florida tax review [vol. 6:8 118. stephanie j. w illbanks, federal estate and gift taxation: an analysis and critique ¶ 13.05 (3rd ed. 2004) (citations omitted). note that at the time this example was written, the applicable exclusion amount was $1,000,000. 119. see, e.g., irc § 2010 (unified credit against estate tax). 120. irc § 2513. 121. irc § 2513(a). gift-splitting is available only with respect to transfers by spouses who both are citizens or residents of the united states at the time of the transfer. irc § 2513(a)(1). 122. the regulations set forth the manner and time of signifying consent. treas. reg. §§ 25.2513-1 , 25.2512-2. 123. under irc § 2503(b), the first $10,000 of gifts by a donor to any person in a taxable year is exempt from gift tax. for 2004, this amount has been indexed for inflation to $11,000. rev. proc. 2003-85, 2003-49 i.r.b. 1184. [that does not qualify for the marital deduction] to pay the income to b for life with remainder to the children. this trust will not qualify for the marital deduction . . . . the remainder of the property can be left outright to b or in a trust that qualifies for the marital deduction . . . a ends up with a taxable estate of $1million but pays no estate tax because of the applicable credit. if, however, b dies first, a ends up with a $2 million taxable estate . . . . this tax could have been avoided had a given b $1 million during b’s life. b could then have bequeathed this $1 million . . . . as long as the [bequest via a] trust does not qualify for the marital deduction, it will remain in b’s taxable estate and be sheltered from tax by the applicable credit.118 a comparatively wealthy spouse can transfer assets to a less wealthy spouse so that each spouse’s estate will be of sufficient size to take maximum advantage of all available tax deductions, exemptions, exclusions, special valuation rules, credits and lower tax rates.119 tax-advantaged inter vivos gifts, then, form a key part of wise estate planning. b. gift-splitting by spouses, or “what’s mine is ours” married couples benefit from not only the marital deduction, but also from the ability to “split” gifts. under section 2513,120 spouses may agree to have any gratuitous transfer by one spouse to a third party treated for gift tax purposes as made one-half by each spouse.121 one-half of a taxpayer’s gifts will be attributed to the non-donor spouse if the non-donor spouse indicates his or her consent on the donor’s timely filed gift tax return.122 gift-splitting can minimize (or even eliminate) gift tax liability, especially when applied in connection with a series of annual exclusion gifts under section 2503(b).123 to illustrate, assume that wife gives each of her three children a gift of $22,000 cash. if husband consents to split the gifts, wife is treated for tax purposes as making three gifts of $11,000 each and husband is treated as making three gifts of $11,000 each. because each $11,000 transfer is made under the protection of the annual exclusion, neither wife nor husband will owe any gift tax, and 2004 one flesh, two taxpayers 781 124. irc § 2518(a) (“for purposes of this subtitle, if a person makes a qualified disclaimer with respect to any interest in property, this subtitle shall apply with respect to such interest as if the interest had never been transferred to such person.”) 125. irc § 2518(b)(1). 126. irc § 2518(b)(2)(a), (b). 127. irc § 2518(b)(3). 128. where one person makes a written transfer of his or her entire interest in property to a person who would have received the property had the disclaimer been “qualified” for federal wealth transfer tax purposes, the transfer will be treated as a qualified disclaimer for purposes of irc § 2518. irc § 2518(c)(3). 129. irc§ 2518(b)(4)(a), (b). 130. stephens et al., supra note 34, ¶ 10.07. 131. e.g., irc §§ 2056 (marital deduction), 2055 (charitable deduction). wife can diminishes her taxable estate. if wife had not “split” the gifts with husband, one-half of each transfer would have been subject to taxation. gift-splitting is consistent with the treatment of a married couple as a single economic unit for wealth transfer tax purposes theoretically the identity of the actual transferor is immaterial if all property held by either spouse is treated for wealth transfer tax purposes as belonging equally to both. if both spouses agree, the transferor-spouse acts for tax purposes as a quasi-agent, and the gratuitous transfer is treated as made one-half by each taxpayer. c. disclaimers by spouses and others, or “what was theirs is now yours” as a matter of property law, an intended recipient may disclaim, or refuse to take ownership of, a gratuitous transfer. in the estate administration context, disclaimers commonly are used for tax planning purposes. this is because a disclaimer that is “qualified” for federal wealth transfer tax purposes causes the disclaimed property to be treated as passing directly from the decedent/donor to the alternate named beneficiary or a statutory taker in default, as the case may be.124 generally speaking, for a disclaimer to be “qualified” for federal transfer tax purposes, the disclaimer must be made in writing125 no later than nine months after the transfer creating the interest (or the purported transferee’s twenty-first birthday, if later);126 the disclaimant must not accept the property or any of its benefits;127 and the interest must pass without any direction on the part of the disclaimant128 to either the decedent’s spouse or a person other than the disclaimant himself or herself.129 if a disclaimer does not meet all of these criteria, then for transfer tax purposes, the disclaimant, not the decedent/donor, is the transferor for tax purposes.130 in the estate tax context, whether a disclaimer is qualified for tax purposes has important estate tax consequences. if a testamentary gift, devise or bequest to an intended beneficiary ordinarily would qualify for an estate tax deduction,131 for example, but the intended beneficiary makes a qualified disclaimer, the estate’s anticipated tax bill may change depending on the identity of the person who succeeds to the property by reason of the disclaimer. the transfer resulting from the disclaimer may or may not be eligible for the 782 florida tax review [vol. 6:8 132. to illustrate the important tax implications of the disclaimer rules, consider a scenario in which father dies, leaving a will with the following bequest: i give and bequeath the amount of one hundred thousand dollars ($100,000) to my adult daughter, daughter, if she survives me, or, if she does not survive me, or if she shall effectively disclaim all or any portion of this bequest, i give and bequeath all of such property, or the portion so disclaimed, as the case may be, to charity, if at the time of such disposition it is an organization described in and meeting the requirements of irc §§ 170(c) and 2055(a). “charity” is used in this example as a generic stand-in for the class of beneficiaries transfers to which qualify for the estate tax charitable deduction. an actual w ill typically would contain the specific name of an organization described in and meeting the requirements of irc §§ 170(c) (income tax charitable deduction) and 2055(a) (estate tax charitable deduction). if, within nine months of father’s date of death, daughter delivers to father’s executor an irrevocable written refusal to accept the $100,000 bequest, the property passes to charity. note that the bequest passes to charity pursuant to the terms of father’s will, without direction on daughter’s part and without daughter’s having accepted any portion of the bequest. assuming she has accepted no benefits from the offered legacy (such as interest earned by it), then for federal transfer tax purposes d aughter’s disclaimer is “qualified.” irc § 2518(a). the property is treated as passing directly from father to charity. id. father’s estate will be entitled to an estate tax charitable deduction. irc § 2518(a). if daughter’s disclaimer is not “qualified” for estate tax purposes, the tax consequences to father’s estate change. assume the same facts as above, but that five months after father’s death, daughter requests and receives payment of the $100,000 bequest. daughter spends $5,000 of the bequest on a luxurious vacation but then decides she does not want any of the money. assume that daughter is independently wealthy. daughter then wants to disclaim the bequest, causing the money to pass to charity. before the ninth month after father’s death, daughter reimburses the estate from her own funds for the entire $100,000 bequest. daughter also delivers to father’s executor an irrevocable written refusal to accept the bequest. pursuant to the terms of father’s will, the executor pays $100,000 to charity. as before, for estate tax purposes, the bequest passes to charity. yet in this case, daughter first accepted the benefit of the bequest by spending part of it on a luxurious vacation and then decided to disclaim it. even though charity ultimately receives $100,000, father’s estate will not be eligible for the deduction under irc § 2055(a) for transfers to charity. daughter’s disclaimer is not “qualified” for transfer tax purposes, and daughter, not father’s estate, will be treated as the transferor of the property. irc § 2055. the tax law gives daughter an opportunity to accept the property (and fix the tax consequences to father’s estate), but once she has decided to accept it, she may not change her mind (for tax purposes, at least). note, however, that because daughter’s disclaimer is not qualified for transfer tax purposes, she may be eligible for an income tax charitable deduction with respect to all or a portion of the bequest passing to charity. irc § 170(a). in any event she would not incur any gift tax on the transfer to charity. irc § 2522(a). same tax treatment. if the disclaimed amount is sizeable, the change could be significant.132 disclaimers by a surviving spouse are subject to rules that are different from those that apply to disclaimers by other persons. a disclaimer by a spouse or surviving spouse that otherwise meets the requirements of a qualified 2004 one flesh, two taxpayers 783 133. irc § 2518(b); treas. reg. § 25.2518-2(a). for the requirements of a qualified disclaimer, see discussion supra part i.c. 134. this is especially true for estates of married couples having modest wealth. so that neither spouse will “waste” the unified credit available under irc § 2001, each spouse’s will typically provides for an outright bequest of the entire estate to the surviving spouse. at the survivor’s election (i.e., upon effective disclaimer of all or a por tion of the decedent’s estate), a trust that does not qualify for the marital deduction is created for the benefit of the decedent’s surviving spouse and descendants. such a flexible estate plan allows the surviving spouse to take into account all circumstances at the time of the decedent’s death and the nine months after death. irc §§ 2031 (valuation at time of death), 2032 (alternate valuation date). if the surviving spouse does not anticipate needing all of the assets bequeathed outright, the surviving spouse will disclaim an amount equal to the decedent’s unused applicable exclusion amount. because the entire estate then qualifies for either the estate tax marital deduction under irc § 2056 or will be covered by the unified credit under irc § 2010, no estate tax should be owed upon the death of the first spouse to die. see irc §§ 2001, 2010. 135. a disclaimer typically funds such a trust with an amount equal to the testator’s unused applicable exclusion amount, or the maximum amount that the testator can transfer without incurring an estate tax. irc § 2010. estate planners frequently refer to this type of trust as a by-pass or credit shelter trust. see, e.g., henkel, supra note 4, at ¶ 4.04. 136. ordinarily if an intended beneficiary accepts a disclaimed property interest or derives any benefit from it, the disclaimer will not be “qualified” and the intended beneficiary, not the decedent’s estate, will be treated as the property’s transferor of the disclaimed property for wealth transfer tax purposes. yet where the intended beneficiary is the decedent’s surviving spouse, if all other requirements of a qualified disclaimer are met, the surviving spouse’s disclaimer will remain qualified for tax purposes, even if the surviving spouse derives benefit from the disclaimed property. see discussion supra part i.c. 137. see irc § 2010. disclaimer133 will not lose its tax-favored status if the spouse accepts or receives benefits from the disclaimed property. in fact many sound estate plans rely on disclaimers by a surviving spouse for post-mortem estate tax planning.134 a testator may give his or her entire estate to the surviving spouse, but typically provides that if the surviving spouse disclaims all or any portion of such property, the property so disclaimed will be held in a trust, such as a discretionary trust for the benefit of the testator’s surviving spouse and descendants that intentionally does not qualify for the marital deduction.135 in such a case the spouse’s potential or actual benefit from the trust property does not render the disclaimer “unqualified” for estate tax purposes. the decedent remains the transferor for estate tax purposes136 and the unused unified credit137 applies to “cover” the transfer to the discretionary trust, resulting in a nontaxable estate. by allowing the surviving spouse to disclaim to a trust for his or her benefit, the tax law does not force the surviving spouse to make the all-ornothing choice faced by other disclaimants. instead the tax law treats the surviving spouse as an extension of the decedent himself or herself, by granting the surviving spouse the ability to control, to a certain extent, the estate tax consequences of the decedent’s death, without forfeiting the benefit of the 784 florida tax review [vol. 6:8 138. coverture is an antiquated way to define “[t]he condition of being a married woman.” b lack’s law dictionary (8th ed. 2004). for a discussion of the role of coverture in the development of american law, see generally hendrik hartog, man and wife in america: a history (2000); sarah barringer gordon, the mormon question: polygamy and constitutional conflict in nineteenth-century america (2002). 139. see, e.g., s. rep. no. 80-013 (1948), reprinted in 1948 u.s.c.c.a.n. 1163; h.r. rep. no. 83-1337 (1954), reprinted in 1954 u.s.c.c.a.n. 4017. 140. norma basch, in the eyes of the law: women, marriage, and p roperty in nineteenth century new york 19-23 (1982); see also hartog, supra note 138, at 43. 141. id. disclaimed property. in this sense, a husband and wife are treated as one tax planner for wealth transfer purposes. iii. why marital wealth transfers should be taxed the one flesh, one taxpayer rules are undesirable because they reinforce traditional gender roles and because they fail to recognize nonmarital, economically unified couples. the estate and gift tax rules may favor marriage, but they generally hurt women by invigorating antiquated jurisprudence that denies women legal personhood. the marital deduction rules in particular prevent a less wealthy spouse (typically the wife) from achieving economic autonomy. in disregarding the importance of many non-marital relationships, the law of wealth transfer taxation encourages dependence on the state. this part describes how current tax rules hurt women and explains why women and others should want to pay more taxes. a. the current tax rules reinforce traditional gender roles 1. coverture, legal personhood and taxation – the persistent appeal of the one flesh, one taxpayer approach to wealth transfer taxation is based in part on its gender neutrality and in part on its familiarity. legal unity of married couples is a common law tradition. marital unity formed the backbone of the system of coverture that dominated english and american jurisprudence well into the nineteenth century.138 although the tax legislative history contains no reference to coverture,139 many legislators would have been aware that treatment of a married couple as one person was not unique to tax law. the historic context of coverture and critiques of that institution illuminate the problems that result from the tax law’s embrace of it. a. historical background from as early as perhaps the tenth century, a married woman at english common law was a feme covert.140 her legal identity was “covered” or subsumed by her husband’s.141 a wife had no legal authority to act independently from her husband except in limited circumstances. as one nineteenth century commentator explained, “by marriage, the husband and wife are one person in law: that is, the very being or legal existence of the woman is suspended during the marriage, or at least is incorporated and consolidated into that of husband: under whose wing, protection, and cover, she performs 2004 one flesh, two taxpayers 785 142. 1 william blackstone, commentaries on the laws of england 430, 442. as blackstone explains, “[a] man canno t grant any thing to his wife, or enter into covenant with her; for the grant would be to suppose her separate existence; and to covenant with her would be only to covenant with himself.” id. 143. basch, supra note 140, at 22. 144. see genesis 2:24 (rsv ). new testament writers echoed this language in their teachings on marriage and divorce. see, e.g., mark 10:7-10 (rsv). (“‘[a] man shall leave his father and mother and be joined to his wife, and the two shall become one flesh.’ so they are no longer two but one flesh. what therefore god has joined together, let not man put asunder.”). 145. historian hendrik hartog explains that coverture (a legal status) and unity of the flesh (a religious status) were interrelated. in his excellent discussion of men’s and women’s experiences with coverture, hartog describes one eighteenth century woman’s philosophy of marriage. “when abigail bailey thought of herself as a wife, she did not think in terms of merger, of ‘one flesh,’ of an obliteration of a prior self. instead, she thought of a self ‘covered’ by her husband during marriage. submission was not a denial of her self. on the contrary, it constituted the central test of her se lf and of the strength of her religious identity. . . . to abigail bailey, [coverture] suggested the task for a lifetime, a way of establishing credentials as a worthy christian. coverture was hard but necessary work for a distinctively female self that would realize salvation through submission.” hartog, supra note 138, at 43-44. 146. blackstone, supra note 142, at 442. 147. the meeting at seneca falls typically is considered to mark the formal commencement of the woman suffrage movement. see, e.g., aileen kraditor, ideas of the woman suffrage movement 1890-1920 1 (1965). everything.”142 marriage traditionally caused a woman to lose her legal identity for at least as long as the marriage lasted. historian norma basch links the legal concept of marital unity to the judeo-christian religious tradition. coverture, she explains, arose from the biblical “doctrine of the unity of the flesh.”143 according to the book of genesis, upon marriage “a man leaves his father and his mother and cleaves to his wife, and they become one flesh.”144 if marriage were a merger of spiritual identities,145 then it was not surprising that it resulted in a merger of legal identities, too. but coverture went beyond mere merger. in blackstone’s words, “husband and wife are one person in law,”146 and that person was the husband. b. early critiques of coverture nineteenth century women’s rights advocates vigorously critiqued women’s legal subordination. at a political gathering at seneca falls, new york in 1848,147 attendees adopted a “declaration of sentiments” that was drafted principally by elizabeth cady stanton. stanton modeled her declaration on the declaration of independence. she boldly asserted that the “history of mankind is a history of repeated injuries and usurpations on the part of man toward woman.” stanton objected strongly to women’s exclusion from civic affairs and their inability to vote. she railed against coverture for rendering a married woman “in the eye of the law, civilly dead . . . . in the covenant of marriage, she is compelled to promise obedience to her husband, he becoming, to all intents and purposes, her master – the law giving him the power to 786 florida tax review [vol. 6:8 148. i history of woman suffrage, 70 (elizabeth cady stanton et al., eds., 1881-1922, reprint ed . 1985). 149. id. at 71. for further discussion of the nineteenth century critiques of the relationship between women’s exclusion from politics and religion, see elizabeth b. clark, religion, rights, and d ifference in the early woman’s rights movement, 3 w is. women’s l.j. 29 (1987); elizabeth b. clark, self-ownership and the political theory of elizabeth cady stanton, 21 conn. l. rev. 905 (1989). 150. “[i]n view of this entire disenfranchisement of one-half the people of this country . . . in view of the unjust laws above mentioned, and because women do feel themselves aggrieved, oppressed, and fraudulently deprived of their most sacred rights, we insist that they have immediate admission to all the rights and privileges which belong to them as citizens of the united states.” i history of woman suffrage , supra note 148, at 71. 151. see john phillip reid, constitutional history of the american revolution: the authority to tax 271-79 (1987). 152. see supra text accompanying note. 153. in 1848, new york state became the first state to accord significant rights to married women. see generally, richard h. chused, married women’s property law: 1800-1850, 71 geo. l.j. 1359-1425 (1983); elizabeth bowles w arbasse, the changing legal rights of married women, 1800-1861 (1987). known as the m arried women’s property acts, these laws were designed to limit a husband’s “right to and control of his wife’s property which the common law gave him. the purpose of those acts was to protect married women against unkind, thriftless, or profligate husbands, by securing to them the separate and independent control of all their own property.” coleman v. burr, 93 n.y. 17, 24 (1883). 154. see discussion infra part ii.a. deprive her of her liberty, and to administer chastisement.”148 similarly stanton claimed that in religious affairs, men “usurped the prerogative of jehovah himself” by excluding women from participation in church life and religious governance.149 stanton framed women’s loss of legal personhood and religious subordination as loss of liberty and utter abridgement of the freedoms and responsibilities of citizenship.150 like the signers of the declaration of independence,151 stanton used emotionally charged arguments to stir her audience. c. coverture and the qtip rules insofar as the internal revenue code is gender neutral, the one flesh, one taxpayer approach to marital wealth transfers resembles the nineteenth century construction of marriage as a spiritual “merger”152 more than coverture. in contrast to coverture, which recognized only a husband’s legal identity, the one flesh, one taxpayer approach advocates recognition of the marital unit itself as the appropriate taxable entity. far from a pro-women’s rights theory of taxation, however, the one flesh, one taxpayer approach to wealth transfer taxation responded to destabilization in women’s legal identities in the years following the seneca falls convention. between the seneca falls convention of 1848 and the implementation of the joint income tax return in 1948, married women gained unprecedented legal rights.153 recall that lawmakers explained the 1948 tax reforms as a response to the possible widespread conversion by states to community property law systems.154 although they framed the rationale as concern for 2004 one flesh, two taxpayers 787 155. see supra text accompanying note 30. 156. see, e.g., reva b. siegel, the modernization of marital status law: adjudicating wives’ rights to earnings, 1860-1930, 82 geo. l. j. 2127 (1994) 157. kahng, supra note 14, at 32-36. 158. see generally, chused, supra note 153; warbasse, supra note 153. 159. see discussion supra part ii.a. 160. irc § 2001(a). 161. irc § 2501(a)(1). 162. see irc §§ 2056(b), 2523(f); regs. §§ 20.2056(b)-7, 25.2523(f)-1(b) (definition of qualified terminable interested property). 163. “formal equality is a principle of equal treatment: individuals who are alike should be treated alike, according to their actual characteristics rather than assumptions about them based on stereotypes . . . . what makes an issue one of formal equality is that the claim is limited to treatment in relation to another, similarly situated individual or group and does not extent to a demand for some particular, substantive treatment.” katharine bartlett et. al., gender and law: t heory, doctrine and equality 117 (3d ed. 2002). administrative costs,155 lawmakers’ likely motivation for tax reform was preventing further erosion of male property interests in an era of expanding women’s rights through the married women’s property acts,156 for example. the prospect of nation-wide equal property ownership by husbands and wives was too far-reaching for many legislators. federal tax law therefore was used to limit the expansion of women’s property rights. if common law resident husbands and wives could be construed as one for tax purposes, then residents of common law jurisdictions likely would not demand conversion to community property.157 husbands stood to gain nothing – and lose control over one-half of their property – from conversion to a community property law system.158 at least initially the one flesh, one taxpayer rules required one spouse to grant the other spouse meaningful rights over transferred property in order to qualify transfers for the marital deduction.159 the 1981 qtip rules, however, practically embraced legal suspension of the transferee spouse’s property rights. by allowing a marital deduction for property over which a spouse had little control, the qtip rules marked the elevation of the transferor spouse’s legal personhood and property rights over the transferee spouse’s. 2. women should pay more tax – unlike coverture, the tax rules do not discriminate on the basis of gender. estate tax is imposed on “the taxable estate of every decedent who is a citizen or resident of the united states,”160 without regard to gender. similarly, gift tax is imposed “on the transfer of property by gift,”161 without regard to the gender of the donor or recipient. both men and women can avail themselves of the marital deduction, gift-splitting and special disclaimer rules. regardless of whether a property transferor is a husband or a wife, the same rules apply.162 in every sense men and women are treated as formal equals for wealth transfer tax purposes.163 although the one flesh, one taxpayer approach to wealth transfer taxation violates no constitutional principles, those committed to gender equality nevertheless have reason to regard it with suspicion. the estate and gift tax rules constitute a quasi-coverture system in which one spouse’s “right” to control the disposition of property trumps the other’s. although this may not 788 florida tax review [vol. 6:8 164. in an unrelated context, professor david cassuto suggests “that the inherent contingency of language renders it impossible to define harm or injury without acknowledging the systemic perspective from which the concepts are viewed.” david n. cassuto, the law of words: standing, environment, and other contested terms, 28 harv. envtl. l. rev. 79, 79 (2004). 165. gerzog, supra note 86, at 320. see also wendy c. gerzog, the illogical and sexist qtip provisions: i just can’t say it ain’t so, 76 n.c. l. rev. 1597 (1998). 166. gerzog, supra note 86, at 321. 167. david cay johnston argues that there is a direct correlation between wealth and political influence: “politicians insist[ ] that no one bought their vote with their donation and that was true. but what donations did buy, every politician acknowledged, was access. that access meant that every senator and representative was listening primarily to the concerns and ideas of the super rich, of the political donor class.” david cay johnston, perfectly legal: the secret campaign to rig our tax system to benefit the super-rich and cheat everybody else 41-42 (2003). 168. kahng, supra note 14, at 39-40. constitute recognizable legal “harm,” it has negative social, political and economic implications for women.164 the qtip rules hurt women: the qtip provisions . . . were enacted to enable men to control the ultimate disposition of property but nonetheless the provisions qualify qtip transfers for a marital deduction. the framers of this new exception to the terminable interest rule further degraded women because they assumed that widows would be content with receiving only one of the indicia of property ownership, e.g., current beneficial enjoyment, and would not protest against the enactment of such a provision.165 if enhanced social and legal rights for women depend on increasing women’s financial power, women “would be better served by requiring husbands to make outright transfers of property to their wives.”166 by implication, through greater wealth, women will have greater social and political clout.167 the qtip rules are a primary stumbling block in women’s advancement. in treating partial interests in trusts, for one, as equivalent to outright ownership, the estate and gift tax rules preclude accurate assessment of women’s economic position. [t]he qtip rules, along with other estate tax provisions built upon the fiction of marital unity, undermine the prospect of women’s achieving equal status with men as wealth holders. . . . the idea that women are increasingly wealthy has permeated the popular press. the data, however, are misleading. they obscure the true wealth holdings of men and women because they are based on estate tax returns. on these returns, qtip property is now included in [a widow’s] estate and accounted for as her wealth. the effect of this decision is to inflate the wealth holdings of women artificially. . . through the qtip trust, the fiction has created an illusory class of women wealth holders.168 2004 one flesh, two taxpayers 789 169. id. at 38-41. 170. see, e .g., reed v. reed, 404 u.s. 71 (1971) (statutory rule for the appointment of an administrator of an intestate estate is invalid because of preference for males among persons otherwise equally entitled to appointment as administrator), frontiero v. richardson, 411 u.s. 677 (1973) (unconstitutional to require female member of military is to prove dependency of her spouse in order to obtain certain benefits, where male member of the military is not so required). 171. craig v. boren, 429 u .s. 190, 197 (1976). this approach, commonly referred to as “intermediate” scrutiny, has been applied to invalidate laws that “have the effect of invidiously relegating the entire class of females to inferior legal status without regard to the actual capabilities of its individual members.” frontiero, 411 u.s. at 687. see also orr v. orr, 440 u.s. 268 (1979) (invalidating state statute that required husbands but not wives to pay alimony). 172. see, e.g., mary louise fellows, wills and trusts: the kingdom of the fathers, 10 law & ineq. 137 (1991); gerzog, supra note 86; carolyn c. jones, dollars and selves: women’s tax criticism and resistance in the 1870s, 1994 u. ill. l. rev. 265 (1994); kahng, supra note 14; edward j. mccaffery, taxation and the family: a fresh look at behavioral gender biases in the code, 40 ucla l. rev. 983 (1993). 173. see discussion supra part ii.a. the “legal fiction” of merged marital identity portrays marriage as an economic partnership when, in fact, men are far more powerful financially than women.169 in this sense, then, the real harm of the one flesh, one taxpayer rule is its obscuring effect. women’s apparent wealth diminishes the need for unbiased empirical investigation into men’s and women’s comparative financial and economic positions. the tenacity of the “fiction” of marital unity is, in some sense, a legacy of the feminist movement itself. beginning in the 1970’s lawyers successfully challenged a wide range of laws as discriminatory on the basis of gender.170 thereafter, for a law to be non-discriminatory, it must be gender neutral on its face or, if not, serve “important governmental objectives” and be “substantially related to achievement of those objectives.”171 because the estate and gift tax rules are gender neutral on their face, they seemingly do not violate any constitutional right. tax statutes appear to conform to the goal of treating men and women equally under the law. in at least one sense, however, criticism of the estate and gift tax rules172 does not go to the tax laws’ legality per se. instead it attempts to identify how the estate and gift tax treatment of marital wealth transfers makes women’s economic, social and political advancement more difficult. but at the same time, criticism of the estate and gift tax rules makes a theoretical claim, too. it demands consistency in tax jurisprudence. the 1948 tax rules established a framework in which the estate and gift taxation of marital transfers followed from the economic substance of the transferee spouse’s property rights.173 only outright ownership or its very near equivalent qualified for the marital deduction in 1948. the current tax system should take the same approach. the one flesh, one taxpayer system of wealth transfer taxation is pernicious because it emphasizes the marital unit over an individual’s legal personhood. traditionally feminist activists and scholars have criticized aspects of marriage and the family that tend to de-emphasize a woman’s 790 florida tax review [vol. 6:8 174. in connection with her 1855 marriage to henry blackwell, antislavery and women’s rights advocate lucy stone insisted that “[a] wife should no more take her husband’s name than he should hers. my name is my identity and must not be lost.” as part of the larger campaign for women’s rights, activists brought litigation in 1881 to guarantee the “right of married women to use their own surnames with state and federal agencies.” omi morgenstern leissner, the name of the maiden, 12 wis. women’s l.j. 253, 255 (1997). 175. see, e .g., 1 forbush v. wallace, 341 f . supp. 217 (m .d. ala. 1971) (unsuccessful litigation challenging requirement that a married woman use her husband’s surname on state driver’s license). 176. see, e.g., 29 u.s.c. § 206(d) (1994) (equal pay act of 1963); 42 u.s.c. § 2000e (1994) (t itle vii of civil rights act of 1964). 177. see, e.g., planned parenthood v. danforth, 428 u.s. 52 (1976) (invalidating missouri law requiring spousal consent to abortion). 178. patricia j. williams, the alchemy of race and rights 146-47 (1991). 179. id. at 147. 180. id. at 148. individuality.174 feminists have insisted on a woman’s right to retain her birth name after marriage,175 to be free from discrimination in employment,176 and to make decisions about her own health and well-being.177 the tax law may be gender neutral, but it submerges each spouse’s individual identity in the couple and should be subject to great scrutiny. many commentators have explored the law’s role in conferring privilege and status. professor patricia williams has described the experiences she and a colleague had in searching separately for an apartment in a new city.178 when peter, her white male colleague, finds an apartment for himself, he concluded the transaction with a handshake and a large cash deposit. in contrast, williams, who is african-american, signed a detailed written agreement with her new landlord: in my rush to show good faith and trustworthiness, i signed a detailed, lengthily negotiated, finely printed lease firmly establishing me as the ideal arm’s-length transactor. . . . [peter and i] could not reconcile our very different relations to the tonalities of law. peter, for example, appeared to be extremely self-conscious of his power potential (either real or imagistic) as white or male or lawyer authority figure. he seemed, therefore, to go to some lengths to overcome the wall that image might impose. . . . on the other hand, i was raised to be acutely conscious of the likelihood that no matter what degree of professional i am, people will greet and dismiss my black femaleness as unreliable, untrustworthy, hostile, angry, powerless, irrational, and probably destitute. . . . [t]o show that i can speak the language of lease is my way of enhancing trust of me in my business affairs.179 williams explained her and peter’s different approaches to law as a function of experience: “on a semantic level, peter’s language of . . . informality . . . sounded dangerously like the language of oppression to someone like me who was looking for freedom through the establishment of identity. . . .”180 the 2004 one flesh, two taxpayers 791 181. see id. 182. id. 183. see discussion supra part iii.a. 184. women were not permitted to vote in national elections, for example, until 1920. see, e.g., u.s. const. amend. xix § 1 (“the right of citizens of the united states to vote shall not be denied or abridged by the united states or by any state on account of sex.”); minor v. happersett, 88 u.s. (21 wall.) 162 (1874) (denying women’s right to vote). for a history of the woman suffrage movement, see generally nancy f. cott, the grounding of modern feminism (1987); ellen carol dubois, feminism and suffrage: the emergence of an independent women’s movement in america, 1848-1869 (1978); linda k. kerber, no constitutional right to be ladies: women and the obligations of citizenship (1998). 185. see, e.g., hartog, supra note 138, at 161-64 (description of husband’s superior rights over marital property in 1830’s). 186. see, e.g., bradwell v. the state, 83 u.s. (16 wall.) 130 (1872). in denying myra bradwell’s claim that women had a constitutional right to become lawyers, the supreme court stated, “the harmony, not to say identity, of interests and views which belong, or should belong, to the family institution is repugnant to the idea of a woman adopting a distinct and independent career from that of her husband.” id. at 141. 187. women were not admitted to the forerunner of the university of pennsylvania law school, for example, until 1883. see, e.g., bridget j. crawford, “daughter of liberty wedded to law:” gender and legal education at the university of pennsylvania department of law 1870-1900, 6 j. gender race & just., 131, 131-32 (2002). the school had formal instruction for almost 100 years before the first woman was admitted. see hampton l. carson, an historical sketch of the law department of the university of pennsylvania 9-12 (oct. 10, 1882) (speech delivered at university of pennsylvania describing formal instruction in law beginning in 1790). 188. at her sentencing in 1873 for violating the law by voting, susan b. anthony demanded that she be subject to full legal consequences. “[f]ailing to get . . . justice – failing, even, to get a trial by jury not of my peers – i ask not for leniency at your hands – but rather the full rigors of the law.” ii history of woman suffrage , supra note 148, at 700. importance of legalities and law depend significantly on one’s race and gender, williams explained.181 for this reason, “stranger-stranger” (formal) interactions are preferable to “stranger-chattel” (informal) ones.182 as a member of an historically disadvantaged group, williams intentionally invoked law and became subject to it. this was her way of asserting equality. if becoming subject to the law asserts a rights claim, then the one flesh, one taxpayer theory disadvantages both women and men. in treating husbands and wives as one, the tax law diminishes the importance of each (or at least one) spouse’s individual identity.183 as suggested by the apartment-hunting experiences of professor williams and her colleague, being free from (or invisible to) the law may be positive for someone with “power potential” but “oppression” for someone else. women historically have not had significant “power potential” compared to men. women have had fewer political rights,184 property rights,185 employment prospects,186 and educational opportunities187 than men have had. for that reason especially, women should be skeptical of the individual’s relative invisibility in the wealth transfer taxation of marriage.188 undoubtedly the suggestion that women should want more estate and gift taxation is counterintuitive. most taxpayers do not relish tax bills; yet paying taxes, in a certain sense, is foundational to the claims of citizenship and equality. in advocating for woman suffrage, elizabeth cady stanton highlighted 792 florida tax review [vol. 6:8 189. i history of woman suffrage, supra note 148, at 595. 190. see also jones, supra note 172, at 265-66. 191 . see supra notes 52-78 and accompanying text. 192. see discussion supra part ii.a. 193. see discussion supra part ii.b. 194. see discussion supra part ii.c. 195. 1 u.s.c. § 7 (2000). pursuant to the defense of marriage act, pub. l. no. 104-199, 110 stat. 2419 (1996) (hereinafter doma) signed by president clinton in 1996, for federal law purposes, “the word ‘marriage’ means only a legal union between one man and one woman as husband and wife, and the word ‘spouse’ refers only to a person of the opposite sex who is a husband or a wife.” id. accordingly, even if two same-sex taxpayers are treated as married for state law purposes, they would not be considered married for federal tax purposes. see id. several commentators have questioned doma’s constitutionality. see, e.g., m ark strasser, t he privileges of national citizenship: on saenz, same-sex couples, and the right to travel, 52 rutgers l. rev. 553 (2000); evan wolfson & michael f. melcher, the supreme court’s decision in romer v. evans and its implications for the defense of marriage act, 16 quinnipiac l. rev. 217 (1996); litigating the defense of marriage act: the next battleground for same-sex marriage note, 117 harv. l. rev. 2684 (2004). 196. it is certainly true that some married couples structure their finances so that all assets bear the label “ours” instead of “mine” and “yours,” but not all married couples share their assets in this fashion. see supra text accompanying note 62. even among those who do, the degree to which property is “ours” may vary from marriage to marriage and from time to time during the marriage. the estate and gift tax laws’ presumption that all husbands and wives are economic units missteps theoretically in its essentialism. in feminist legal theory, essentialism refers to the propensity for scholars to “focus only on what all women have in common: their subordination to men” and to ignore that “men are never just men . . . not all men have equal access to ‘male’ power.” katharine t. bartlett et al., supra note 163, at 1193. marjorie kornhauser questions the extent to which husbands’ and wives’ beliefs about their shared financial management matches reality. kornhauser, supra note 20, at 80-84. a couple may choose to organize finances at any point on a spectrum that has complete resource sharing at one end and to tal financial separation at the other end. women’s financial contribution to government in the form of taxes. women are “property-holders, taxpayers; yet we are denied the exercise of our right to the elective franchise. we support ourselves, and, in part, your schools, colleges, churches, your poor-houses . . . and yet we have no vote in your councils,” she asserted.189 in stanton’s reasoning, because women were subject to the same tax laws as men, women have a claim of right to civic participation.190 b. the current tax rules disregard economic unity 1. under-inclusivity – the one flesh, one taxpayer approach to wealth transfer taxation is based on the assertion that husband and wife are a “single economic unit,”191 but married couples need not show actual economic unity to qualify property transfers for the marital deduction,192 gift-splitting,193 and special disclaimer rules.194 marriage alone between a man and a woman195 entitles these taxpayers to special tax treatment regardless of the couple’s resources, consumption patterns, or allocation of responsibility for financial management.196 under present law taxpayers who are not married (or who 2004 one flesh, two taxpayers 793 many couples likely fall somewhere in between and may vary their location on the spectrum at different times in their relationship. 197. see 1 u.s.c. § 7 (2000). for a critical perspective on the tax laws, see generally anthony c. infanti, the internal revenue code as sodomy statute, 44 santa clara l. rev. 763 (2004) (describing the internal revenue code as “another weapon for discrimination and oppression in society’s already well-stocked arsenal.” id at 768). 198. see supra note 116. 199. the massachusetts supreme court has invalidated the state’s prohibition on same-sex marriage. goodridge v. dep’t. of public health, 798 n.e.2d 941, 948 (mass. 2003). 200. same-sex couples may register their domestic partnership in vermont. vt. stat. ann. tit. 15, § 1202 (2004). 201. see 1 u .s.c. § 7 (2000). cannot marry at least for federal purposes)197 are not eligible for transfer tax benefits even if they demonstrate that they function as a single economic unit. consider the following scenarios: (a) man and woman live together as husband and wife. although they equally share all financial resources and responsibilities, man and woman are not married. assume that applicable state law would not recognize their relationship as a common law marriage. (b) man 1 and man 2 live together as spouses, but their state and local government do not recognize domestic partnerships or samesex marriage. they are not married under the laws of any other state. man 1 works full-time outside the home. man 2 is a full-time parent to the couple’s minor child. (c) sister and sister are elderly, unmarried siblings who live together in order to save costs. each has a small amount of retirement income, but neither is able to support herself on her individual income alone. the sisters live modestly and share all costs evenly. (d) elderly parent lives with adult child. elderly parent has no assets or income, except what adult child provides. adult child is elderly parent’s sole source of financial support. the taxpayers in these scenarios economically resemble the married couple of the one flesh, one taxpayer rule. yet none of these taxpayers may transfer assets tax-free to the other member of the “couple.” if man from example (a) above leaves all of his property to woman, assuming that his estate exceeds the minimum threshold for the imposition of estate tax,198 man’s estate will be taxable. this couple presumably could have married, but chose not to do so. man and woman are not “one flesh” and therefore are not one taxpayer for present wealth transfer tax purposes. similarly, if man 1 from example (b) above leaves a large estate to man 2 or to their minor child, man 1’s estate would be taxable. this couple is not married199 or recognized as domestic partners200 by the state of their domicile. federal tax law does not recognize same-sex partnerships as marriage.201 for the couples in examples (c) and (d) above, the sisters and elderly parent living with adult child, marriage is 794 florida tax review [vol. 6:8 202. see, e.g., n.y. dom. rel. law § 5 (mckinney 2004) (prohib iting incestuous marriages between ancestor and descendant; siblings; uncle and niece; or aunt and nephew). 203. see supra note 116. 204 . see supra note 32 and accompanying text. 205. see, e.g., 8 wigmore, evidence §§ 2332-2341 (mcnaughton rev. 1961) (spousal privilege). 206. 142 cong. rec. s10,068 (daily ed. sept. 9, 1996) (remarks by senator helms). 207. id. 208. william c. duncan, law and culture: the state interests in marriage, 2 ave maria l. rev. 153, 154 (2004). 209. singer v. hara, 522 p.2d 1187, 1195 (wash. ct. app. 1974) (discussed in duncan, supra note 208, at 154-156). 210. baehr v. miike, no. 91-1394, 1996 w l 694235, at *3, (h aw. cir. ct. dec. 3, 1996) (from defendant’s memorandum). see, e.g., brad k. gushiken comment, the fine line between love and the law: hawaii’s attempt to resolve the same-sex marriage issue, 22 u. haw. l. rev. 149, 160 (2000). 211. duncan, supra note 208, at 160 quoting defendants’ brief at 30, lewis v. harris, no. mer-l-15-03, 2003 w l 23191114 (n.j. super. ct. law div., nov. 5, 2003). 212. adams v. howerton, 673 f.2d 1036 (9th cir. 1982) (discussed in duncan, supra note 208, at 161). prohibited (and likely not desired in any case).202 any of these taxpayers’ estates, if above a certain size,203 will be taxable at death. regardless of economic showing, then, wealth transfer taxation benefits inure only to opposite-sex married couples. this is unfair from a policy perspective because taxpayers who economically are similarly situated are taxed differently.204 the estate and gift tax law’s encouragement and support for marriage comports with the state’s asserted interest in marriage.205 the present national debate on same-sex marriage has made commonplace proclamations about the “sacred institutions of marriage and the family.”206 apart from media-friendly sound bites, though, the focus on the legality of same-sex marriage has required proponents of traditional marriage to articulate precisely why marriage is a “sacred institution.”207 one scholar summarizes the state’s interests in marriage as one or more of procreation, child rearing, tradition, and interstate uniformity.208 a washington state court succinctly proclaimed, “[m]arriage exists as a protected legal institution primarily because of societal values associated with the propagation of the human race.”209 in a litigation to defend the state of hawaii’s denial of a marriage license to a same-sex couple, lawyers for the state declared that, “all things being equal, it is best for a child that it be raised in a single home by its parents, or at least by a married male and female.”210 in the view of the state’s lawyers, any significant change to marriage laws, such as the recognition of gay marriage, might “disrupt long-settled expectations and deeply-held beliefs” of citizens.211 on the question of interstate uniformity, the ninth circuit has recognized a governmental interest in minimizing uncertainty surrounding the obligation of one state to recognize a marriage conducted in another state.212 2004 one flesh, two taxpayers 795 213. discussion of the relative strengths of these claims is beyond the scope of this article. for a constitutional law analysis, see, e.g., deborah a. batts, repeal doma, 30 hum. rts. 2 (sum. 2003); brett p. ryan, love and let love: same-sex marriage, past, present, and future, and the constitutionality of dom a, 22 u. haw. l. rev. 185 (2000); mark strasser, dom a and the two faces of federalism, 32 creighton l. rev. 457 (1998); anita y . woudenberg, note, giving doma some credit: the validity of applying defense of marriage acts to civil unions under the full faith and credit clause, 38 val. u. l. rev. 1509 (2004). 214. see discussion supra part iii.b.1. 215. professor carolyn jones suggests that “stereotypical notions of family relationships as hierarchical” provided the basis for legal and popular opposition to the partnership theory of marriage, and, by extension, community property. jones, supra note 28, at 265-68, 274-80. philosopher carole pateman suggests that the traditional view of marriage as a bilateral contract mischaracterizes the relationship: freedom of contract (proper contract) demands that no account is taken of substantive attributes – such as sex. if marriage is to be truly contractual, sexual difference must become irrelevant to the marriage contract; “husband” and “wife” must no longer be sexually determined .” indeed, from the standpoint of contract, “men” and “women” would disappear. there can be no predetermined limits on contract, so none can be imposed by specifying the sex of the parties. in contrast, the fact of being a man or a woman is irrelevant. in a proper marriage contract two “individuals” would agree on whatever terms were advantageous to both. the parties to such a contract would not be a “man” and a “woman” but two owners of property in their persons who have come to an agreement about their property to their mutual advantage. carole pateman, the sexual contract 167 (1988). instead, pateman sees marriage as an instrument of a patriarchal social system in which women trade access to their bodies in return for physical safety and satisfaction of material needs. id. at 57. 216. feminist theorist catharine mackinnon suggests that law’s emphasis on heterosexuality is a form of subordination of women. [s]ex inequality takes the form of gender; moving as a relation between people, it takes the form of sexuality. gender emerges as the congealed form of the sexualization of inequality between men and women. so long as this is socially the case, the feelings or acts or 2. heterosexual privilege – regardless of the state interest in marriage,213 according tax benefits exclusively to married heterosexuals is unjustified and unfair. the economic rationale has limited validity if married taxpayers who offer no proof of economic unity receive tax benefits, but unmarried taxpayers who can prove economic unity never receive tax benefits.214 the one flesh, one taxpayer theory functions not as a needs-based benefit, then, but as a glorification of relationships that conform to traditional male-female relations.215 men and women are expected to marry each other (not members of the same gender) and form traditional, two-parent households. the law of wealth transfer taxation devalues non-conforming affinity or economic unions such as heterosexual partners who could marry but do not; same-sex couples who cannot marry; elderly siblings who cohabitate for economy; and an adult child who supports an elderly parent.216 796 florida tax review [vol. 6:8 desires of particular individuals notwithstanding, gender inequality will divide their society into two communities of interest. the male centrally features hierarchy of control. catharine a. mackinnon, feminism unmodified: discourses on life and law 6 (1985). if gender is “sexualized inequality,” then heterosexual marriage is a formalization of that inequality. by providing benefits exclusively to heterosexual married taxpayers, the transfer tax system reinforces the metaphoric and literal value of traditional male-female relationships. the tax law further entrenches marriage and therefore perpetuates inequality between men and women. 217. in professor robin west’s view, women are not essentially, necessarily, inevitably, invariably, always, and forever separate from other human beings: women, distinctively, are quite clearly “connected” to another human life when pregnant. . . . the potential for material connection with the other defines women’s subjective, phenomenological and existential state, just as surely as the inevitability of material separation from the other defines men’s existential state. robin west, jurisprudence and gender, 55 u. chi. l. rev. 1, 2, 14 (1988). west’s “connection thesis” posits “four recurrent and critical material experiences” of women: pregnancy, heterosexual intercourse, menstruation and breast-feeding. id. at 2-3. 218. cf. mary becker, patriarchy and inequality: towards a substantive feminism, 1999 u. chi. legal f. 21, 22 (critical of strands of feminist theory advocating that women “adopt traditionally feminine attributes and repress masculine ones”). 219. martha albertson fineman, cracking the foundational myths: independence, autonomy, and self-sufficiency, 8 am. u. j. gender soc. pol’y & l. 13, 20, (1999). 220. id. two urgencies pressed by feminist jurisprudence are recognition of women’s connectedness to others217 and support for women’s traditional caretaking roles.218 professor martha fineman, for one, asserts that women, more so than men, are responsible for care-taking of children, the elderly, and the sick.219 she advances a theory of the “derivative dependency” of care-takers: “[t]hose who care for others are themselves dependent on resources in order to undertake that care. caretakers have a need for monetary or material resources. they also need recourse to institutional supports and accommodation, a need for structural arrangements that facilitate caretaking.”220 estate and gift tax reform admittedly is not at the forefront of the feminist agenda. yet applying fineman’s thesis revisions to the tax law would be at the forefront of the feminist agenda. the tax law can support and accommodate women’s care-taking relationships by extending marital-type transfer tax benefits to an adult child who provides an elderly parent’s sole financial support. tax breaks for caregivers would lead to lessened economic dependency. by way of illustration, assume that adult child from example (d) above predeceases her elderly parent. if adult child could make tax-free transfers at her death to elderly parent, adult child’s full estate will be available to support elderly parent. the more assets that are available to elderly parent, the less likely that elderly parent will become a ward of the state. conversely, if adult child’s estate is fully taxable, less will be available to support elderly parent. if adult child’s estate, after payment of taxes, is 2004 one flesh, two taxpayers 797 221. the term “state” refers here to the government generally. the complex relationship between wealth transfer tax revenue and publicly-funded support for the elderly is beyond the scope of this discussion. suffice to say for purposes of this article that if an individual state loses significant tax revenue on account of the phase-out of the state death tax credit, then that state’s funded programs for the elderly could be impacted negatively. see generally blattmachr & detzel, supra note 116 (discussion of the phase out of the state death tax credit). 222. but see generally joseph m. dodge, a feminist perspective on the qtip trust and the unlimited marital deduction, 76 n.c. l. rev. 1729, 1729 (1998) (suggesting that feminist legal scholarship on the estate and gift tax marital deduction has failed to “come up with a plausible solution” to gender bias in the code); lawrence zelenak, taking critica l tax theory seriously, 76 n.c. l. rev. 1521, 1524 (1998) (“the most serious problem [with critical tax scholarship] is the failure to think through the proposed solutions with sufficient care.”). 223. even in a one flesh, two taxpayer system, one spouse could make gifts to the other under the protection of the annual exclusion. see irc § 2503(b). 224. see, e.g., irc § 2010. 225. william gates, sr. and chuck collins believe that wealth in excess of $15 million “has moved beyond the point of meeting its needs and aspirations of itself and its heirs.” william h. gates, sr. & chuck collins, wealth and our commonwealth: why america should tax accumulated fortunes 17 (beacon press 2002). inadequate for elderly parent’s care, then elderly parent will need support from the state. elderly parent’s care may cost the state more than the tax revenue generated by adult child’s estate.221 even if the cost of elderly parent’s care does not exceed the estate tax revenue, the state could be in a negative fiscal posture depending on the administrative costs associated with the tax collection process. iv. the one flesh, two taxpayer solution a. overview legislators should revise the wealth transfer tax laws to implement a one flesh, two taxpayer rule for marital wealth transfers.222 treating husbands and wives as separate taxpayers for estate and gift tax purposes will make large gratuitous transfers between spouses fully taxable.223 no longer will estate or gift tax treatment depend on the relationship between the transferor and transferee. this proposal contemplates some adjustments to state law in order to minimize any new geographic inequality between spouses in common law and community property jurisdictions. b. a $10 million exemption from wealth transfer taxation a key feature of the proposed one flesh, two taxpayer system is a significant increase in the amount that any taxpayer may transfer free from estate or gift tax.224 this exemption should be high enough so that the wealth transfer tax laws will apply to only a small minority of taxpayers, but low enough that taxpayers cannot transfer excessive wealth without paying tax. what constitutes “excessive wealth” necessarily is a subjective determination.225 what one taxpayer may consider minimally necessary, another 798 florida tax review [vol. 6:8 226. see id. 227 . see t able 1, estate tax returns filed in 2002: gross estate by type of property, deductions, taxable estate, estate tax and tax credits, by size of gross estate, irs statistics of income division, unpublished d ata (july 2004), available at http://www.irs.gov/pub/irs-soi/02es01ge.pdf. the one flesh, two taxpayer rule does not contemplate any change to the tax rules applicable to charitable transfers. see irc §§ 170(c), 2055(c) and 2522(a). see also gates & collins, supra note 225, at 17, and accompanying text (“[t]he amassing of great wealth, above a certain point, becomes an accumulation of social and political power.”). 228. see table 1, estate tax returns filed in 2002: gross estate by type of property, deductions, taxable estate, estate t ax and t ax credits by size of gross estate, supra note 227. 229. id. 230. id. 231. during the 2000 presidential campaign, a spokesman for george w. bush said, “the death tax assaults families, it creates a disincentive for hard work and savings and it is fundamentally unfair and all americans should be concerned about an unfair tax that penalizes families that build a business or farm with all their energies, efforts and savings.” matthew i. pinzur, estate tax seldom an issue for most, fla. timesunion, sept. 20, 2000, at b1 (quoting tucker eskew). 232. glenn kessler, estate tax repeal bill delivered; democrats assail gop measure as a giveaway to the rich, wash. post, aug. 25, 2000, at a4. may consider luxurious. in any case, a $10 million wealth transfer tax exemption would allow almost all taxpayers to provide very comfortably for themselves and their families. a $10 million wealth transfer tax exemption would greatly simplify tax administration. with the exclusion set at $10 million, only the wealthiest taxpayers226 will owe tax on account of gratuitous transfers made during life or at death. if such an exemption had been in place in 2002, the internal revenue service would have received far fewer estate tax returns.227 the internal revenue service estimates that of the 98,359 estate tax returns filed in 2002, only 1.9% came from gross estates valued at $10 million or more.228 approximately one-third of those gross estates valued at $10 million or more were non-taxable.229 the other two-thirds of the estates contributed more than 36% of the total estate tax revenue for 2002.230 in other words 1.9% of estates paid 36% of the estate taxes. the new one flesh, two taxpayer proposal addresses, although partially and incompletely, the claim by some critics that the wealth transfer tax penalizes success.231 these critics especially target the estate tax: “the threat of having a tax like [estate tax] takes away all incentive of growing your business.”232 in the critics’ view the estate tax is “unfair double taxation since taxpayers are taxed twice – once when the money is earned and again when you 2004 one flesh, two taxpayers 799 233. advertisement, african american business leaders call for an end to the estate tax, n.y. times, apr. 4, 2001, at c3. 234. the origins of the phrase “death tax” are not entirely clear: california congressman christopher cox (r-calif.), a lead sponsor of repeal legislation, notes that there were many references to “death taxes” in professional tax journals dating back to the 1970s. californians, who repealed their state inheritance tax in 1982, deployed the “death tax” phrase throughout the campaign. president reagan first used the term in a minnesota speech in 1982. gates & collins, supra note 225, at 57 (citations omitted). 235 . id. at xi. 236. progressivity in taxation generally refers to the concept that those who are able to pay more should. see, e.g., marvin a. chirelstein, federal income taxation 4-5 (9th ed. foundation press 2002); posin & tobin, supra note 32, at ¶ 1.02 (in a progressive income tax system, “the higher income individual not only pays more but pays a higher percentage of his income in tax. the effective rate is higher on the higher income individual. with a progressive system, the tax system is serving, to one degree or another, to redistribute the wealth.”). 237 . id. at xi. 238. see irc § 2057. for simplicity purposes, this example assumes unrealistically that the estate is not eligible for any other exemption, deductions or credits. [sic] die.”233 the so-called “death tax”234 represents to opponents of the estate tax the worst possible overreaching by the federal government. the imposition of a tax on transfers in excess of $10 million will make the one flesh, two taxpayer system unacceptable to advocates of complete repeal of the estate tax. the present proposal insists on taxation of the wealthiest taxpayers on philosophical grounds: americans who possess great wealth have a special obligation to pay back a debt to society. we live in a society that has enabled a wide variety of people to attain wealth and comfort. and those who accumulate great wealth – $10 million, $50 million, $500 million, and more – are people who have benefitted disproportionately from the system of public investment that we together, as taxpayers and givers to charity, have put in place in our society.235 the one flesh, two taxpayer system embraces the notion that progressive236 wealth transfer tax is an appropriate price for “a society enhanced by public investments that have been made over the centuries.”237 c. increased tax revenue eliminating the marital deduction and increasing the applicable exclusion amount to $10 million necessarily will impact federal revenue. that impact should be determined with greater precision than is possible here. it would appear, however, that the one flesh, two taxpayer system will increase tax revenue. consider the example of a $100 million estate that qualifies for the full marital deduction under the existing estate tax rules.238 the entire estate of 800 florida tax review [vol. 6:8 239. maudie celia hopkins, age 89, has outlived her husband by 70 years. ms. hopkins is believed to be the oldest living widow of a confederate soldier who served in the united states civil war. see melissa nelson, civil war widow provides link to history, monterey county (ark.) herald, june 20, 2004, at a17. also if surviving spouse left his or her entire estate to charity, no estate tax would be due. see irc §§ 170, 2055. 240. this assumes that first decedent had used none of his or her unified credit during life. 241. according to the 2000 census, the median income for nonfamily households in the united states was $25,705 in 1999. the mean income for the same year was $36,609. u .s. census bureau, qt-p32, income distribution in 1999 of households and families: 2000. 242. see discussion supra part i.c. first decedent passes outright or in qualified form to his or her surviving spouse. under present law no estate tax is due until surviving spouse’s subsequent death. assuming a tax rate of 55% (and absent consumption of the bequest from first decedent), surviving spouse’s estate will owe $55 million in estate tax at his or her subsequent death. the government may wait many years to receive the $55 million, depending on surviving spouse’s age, health and other factors.239 furthermore if surviving spouse consumes any portion of the $100 million bequest, the government will receive far less than $55 million in estate tax (and conceivably nothing at all). under the present one flesh, one taxpayer system, the couple’s combined wealth transfer tax liability is $55 million. under the proposed one flesh, two taxpayer system, a $100 million estate will generate immediate revenue and greater revenue overall. first decedent again may transfer $10 million240 to surviving spouse tax-free. the remaining $90 million passing to surviving spouse will be subject to taxation at a rate of 55%. first decedent’s estate therefore will owe $49.5 million in estate tax. the net $40.5 million will pass to surviving spouse, giving surviving spouse a total gross estate of $50.5 million. assume that surviving spouse does not consume any of this property. upon surviving spouse’s subsequent death, the first $10 million will pass tax-free to any designated beneficiaries. the remaining $40.5 million will be subject to taxation at a rate of 55%. surviving spouse’s estate therefore will owe $22,275,000 in estate tax. under the proposed one flesh, two taxpayer system, the couple’s combined estate tax liability is $71,775,000. d. tax simplicity and neutrality eliminating the favorable treatment of marital wealth transfers will have salutary practical and theoretical consequences. perhaps most significantly, the vast majority of american taxpayers will be able to make dispositive decisions free from tax considerations.241 in this sense, the one flesh, two taxpayer approach is more consistent with the stated goals of the marital deduction than the present marital deduction itself. when congress revised the law in 1966 to recognize for tax purposes disclaimers made by persons other than the surviving spouse,242 the house ways and means committee lamented the tax law’s complexity and emphasized the need to save taxpayers from their 2004 one flesh, two taxpayers 801 243. see discussion supra part i.c. 244. h.r. rep. no. 97-201 , at 160 (1981). 245. in 1950, professor stanley surrey called the marital deduction rules a “sorry mess.” stanley s. surrey, an introduction to revision of the federal estate and gift taxes, 38 cal. l. rev. 1, 14 (1950). 246. see, e.g,, lauren b. epstein, the qtip t rust and the elective share trust: are they really parallel?, 53 fla. l. rev. 965 (2001); julia b. fisher, maximizing the tax effectiveness of the qtip trust: pre-mortem and post-mortem planning strategies, sf17 a.l.i.-a.b.a. 349 (2000). 247. see discussion supra part i.a.1. 248. see irc §§ 2001, 2501(a)(1). 249. see id. 250. surrey, supra note 245, at 14. 251. see discussion supra part i.d. own mistakes.243 in 1981 the same committee supported the qtip rules on the grounds that “tax laws should be neutral and . . . tax consequences should not control an individual’s disposition of property.”244 the existing estate and gift tax rules are neither simple nor neutral, however. if anything, they complicate the tax system245 and now dominate estate planning.246 e. theoretical implications 1. taxation and legal personhood – on a theoretical level eliminating favorable treatment for marital wealth transfers affirms each spouse’s legal personhood. the one flesh, two taxpayer system will not permit the disparity between tax result and property ownership that is allowed under the current qtip rules.247 all completed transfers of the exemption threshold by one spouse to another will be subject to taxation.248 gift-splitting is based on an unproven notion that husbands and wives are a single economic unit and will not be allowed. the special disclaimer rules also should be eliminated because they will not be necessary in a system without a marital deduction. with an increased applicable exclusion amount of $10 million, however, most spouses in fact will not owe any transfer tax, even if they give away all of their property.249 there will be minimal (if any) incentive to engage in tax-strategic behavior. the one flesh, two taxpayer system will simplify estate planning and tax administration. eliminating the estate and gift tax marital deduction removes a powerful incentive for spousal transfers. under current law if a spouse fears “releasing his hand from the control of the property on his wife’s death and the risk that when she dies some alien hand will be guiding her actions,”250 the spouse typically creates a testamentary qtip trust that entitles the surviving spouse to a lifetime income interest, but little else.251 note that with the one flesh, two taxpayer system’s generous applicable exclusion amount, the qtip trust is unnecessary. practically speaking this means that the first spouse to die could leave his or her entire testamentary estate to children from a prior marriage. if so, the surviving spouse would have a limited legal remedy, i.e., his or her state property law right to elect against the decedent’s will. whether the 802 florida tax review [vol. 6:8 252. in most jurisdictions, a surviving spouse may elect against the w ill to receive a statutory share of the decedent’s estate. see, e.g., restatement (third) of prop.: wills & other donotive transfers, § 9.1 cmt. d (2003); restatement (second) of prop. donative transvers, § 34.1 reporter’s note 15 (1992); lawrence w. waggoner, the uniform probate c ode’s elective share: time for a reassessment, 37 u. mich. j.l. reform 1 (2003). 253. see discussion supra part iii.b. 254. id. 255. the present code provides for an income tax exemption amount with respect to each dependent of a taxpayer. irc § 151(c). for income tax purposes, a dependent is any member of a spec ified class over half of whose support, for the calendar year in which the taxable year of the taxpayer begins, is received or is treated as received from the taxpayer. irc § 152(a). the specified class is comprised of the following members: (1) a son or daughter of the taxpayer, or a descendant of either, (2) a stepson or stepdaughter of the taxpayer; (3) a brother, sister, stepbrother or stepsister elective share is fair or adequate252 is open to question, but it is a question that should be answered by state law, not federal estate and gift tax law. 2. all taxpayers are created equal – in the one flesh, two taxpayer system, all gratuitous transfers above the exemption threshold will be subject to taxation, regardless of the relationship between the donor and the donee. as described in part iii.b.1, transfers between members of the hypothetical “couples” described in that section would be fully taxable in the new system. regardless of any showing of economic unity, a tax would be imposed if, say, unmarried man makes a gift to his opposite sex partner, woman; or if man 1 sets up a discretionary trust for his same-sex partner, man 2; or if one elderly sister devises property to the other sister at death; or if adult child predeceases elderly parent and leaves her entire estate to elderly parent in trust.253 whether those transfers will result in the payment of any transfer tax, however, will depend on the size of the transfer and whether the transferor has used some or all of his or her $10 million applicable exclusion amount. the one flesh, two taxpayer system embraces the similarity among the many relationships that people form but rejects special treatment for dependency relationships. the tax results of a transfer by one person to another should not depend on the existence of a legalized sexual relationship between a man and a woman. women in particular may develop affinity relationships on account of their roles as care-takers, and there is no logical reason to treat these economic relationships any different from marriage.254 these relationships should not be treated as “better” than traditional marriage but should not be treated any worse, either. note the similarities among a married couple (as envisioned by the current code) and the hypothetical taxpaying couples described in part iii.b.1. all the couples arguably could demonstrate economic unity. recall, however, that tax results in the new one flesh, two taxpayer system do not depend on either the identity of the donor and the donee or the presence or absence of an economic unity of interest. although an argument could be made for the nontaxation of transfers to economic dependents, such an exemption is undesirable. it would complicate and increase the costs of administration of the tax system. furthermore a dependency exemption would necessitate a factual inquiry into personal relationships that would be unwelcome by many taxpayers.255 the 2004 one flesh, two taxpayers 803 of the taxpayer, (4) the father or mother of the taxpayer, or an ancestor of either, (5) a stepfather or stepmother of the taxpayer, (6) a son or daughter of a brother or sister of the taxpayer, (7) a brother or sister of the father or mother of the taxpayer, (8) a son-inlaw, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in law of the taxpayer, (9) or an individual [other than the taxpayer’s spouse] who, for the taxable year of the taxpayer, has as his principal place of abode the home of the taxpayer and is a member of the taxpayer’s household. irc § 152(a)(1)-(9). 256. minimal or no expectation of financial support may motivate children of wealthy taxpayers to undertake full-time employment. see, e.g., david rockefeller, memoirs 73 (random house 2002) (self-description of the motivations of the youngest son of businessman and philanthropist john d. rockefeller, jr., and grandson of standard oil founder john d. rockefeller, for a long and productive career with the chase manhattan bank). 257. see discussion supra part ii.b. 258. id. 259 . see d iscussion supra part ii and accompanying text. number of dependency exemptions theoretically available to a taxpayer could not be limited, absent a normative judgment about appropriate family configurations. furthermore there might be an undesired “daisy chain” effect if taxpayer 1 can transfer assets tax-free to taxpayer 2 upon a showing of economic dependency, and then taxpayer 2 can transfer assets tax-free to taxpayer 3 upon a showing of economic dependency, and so on. finally, a dependency exemption would provide a negative incentive for a taxpayer’s spouse and children to become self-supporting, productive members of society.256 f. impact on geographic equality notwithstanding the positive revenue effect of the proposed one flesh, two taxpayer system, the new rules admittedly would disrupt the geographic equality created by the marital deduction.257 under the proposed system, gratuitous transfers in excess of $10 million by a common law resident husband or wife to his or her spouse would be subject to taxation. in community property jurisdictions, most “transfers” between spouses would continue to be accomplished by operation of state law (and therefore would not be subject to wealth transfer taxation).258 in a one flesh, two taxpayer federal wealth transfer tax system, community property states should not be expected to change their laws so that wealthy residents of those states would be subject to just as much taxation as common law residents. therefore any state law response to the recreated geographic inequality likely would occur in common law states. legislators in common law states might choose to adopt community property laws in whole or in part. comprehensive change could be administratively prohibitive, however, and could lead to years of uncertainty (and litigation) over property rights.259 legislators might contain the administrative costs of converting to a community property system by limiting its application to taxpayers who earn or accrue more than $10 million during lifetime. such a system might raise accounting questions, however, in the absence of specific, simple and fair rules to determine what assets “count” toward the $10 million limit. a third option would be for legislators in common law jurisdictions to enact a voluntary 804 florida tax review [vol. 6:8 260. alaska stat. §§ 34.77.010 to 995 (michie 2003). in reality many common law states have de facto community property rules that provide for the equal or nearly equal division of marital assets upon divorce. see, e.g., n.j. stat. ann. § 2a: 34-23.1 (2004); 23 pa. cons. stat. § 3502 (2004). a court may look at a variety of factors in making an equitable distribution upon dissolution of a marriage. t he new jersey statute provides that a court shall examine: a. the duration of the marriage; b. the age and physical and emotional health of the parties; c. the income or property brought to the marriage by each party; d. the standard of living established during the marriage; e. any written agreement made by the parties before or during the marriage concerning an arrangement of property distribution; f. the economic circumstances of each party at the time the division of property becomes effective; g. the income and earning capacity of each party, including educational background, training, employment skills, work experience, length of absence from the job market, custodial responsibilities for children, and the time and expense necessary to acquire sufficient education or training to enable the party to become self-supporting at a standard of living reasonably comparable to that enjoyed during the marriage; h. the contribution by each party to the education, training or earning power of the other; i. the contribution of each party to the acquisition, dissipation, preservation, depreciation or appreciation in the amount or value of the marital property, as well as the contribution of a party as a homemaker; j. the tax consequences of the proposed distribution to each party; k. the present value of the property; l. the need of a parent who has physical custody of a child to own or occupy the marital residence and to use or own the household effects; m. the debts and liabilities of the parties; n. the need for creation, now or in the future, of a trust fund to secure reasonably foreseeable medical or educational costs for a spouse or children; o. the extent to which a party deferred achieving their career goals; and p. any other factors which the court may deem relevant n.j. stat. ann. § 2a:34-23.1 (2004). 261. alaska stat. §§ 34.77.010 to 995 (michie 2003). see generally blattmachr et al., supra note 27; newman, supra note 27; shaftel & greer, supra note 27. some commentators are critical of the alaska statute, among other state laws, as responding too directly to federal tax law. see, e.g., ira mark bloom, how federal transfer taxes affect the development of property law, 48 clev. st. l. rev. 661, 671 (2000); mitchell m. gans, federal transfer taxation and the role of state law: does the marital deduction strike the proper balance?, 48 emory l.j. 871, 877 (1999). however, this criticism appears to go to the desirability – not the legality or effectiveness – of alaska’s elective community property law. community property system similar to alaska’s community property trust act.260 alaska law permits spouses in any jurisdiction to elect community property treatment for property transferred to a trust, provided that certain conditions are met.261 in the absence of a special federal exemption, however, 2004 one flesh, two taxpayers 805 262 . an elective community property trust would allow wealthy taxpayers to secure some of the estate tax benefits of community property, most notably the double step-up in basis upon the death of the first spouse to die under irc § 1041. 263. cf. gans, supra note 261, at 876-83 (raising concerns about overemphasis in federal transfer tax jurisprudence on state law property rights). 264. see supra notes 225-26, 241. 265. monica davey, missourians back amendment barring gay marriage, n.y. times, aug. 4, 2004, at a13. 266 see, e .g., martin vaughan, as estate tax repeal emerges as pivotal budget issue, congress daily, mar. 8, 2004. a taxpayer with over $10 million in assets could be subject to gift tax if he or she elects into a community property system.262 ultimately if substantive state law differences cause very wealthy spouses in common law and community property jurisdictions to be treated differently, principles of federalism would suggest that the appropriate remedy lies not with federal tax law.263 at worst, legislators in common law states may take no action in response to the federal tax changes. geographic inequality would exist, but would not be widespread because the vast majority of taxpayers will never have, let alone transfer, $10 million.264 but the specter of geographic inequality in taxation, however minimal, should be avoided if possible. hopefully, the implementation of a one flesh, two taxpayer federal tax rule would cause citizens and state lawmakers to confront state property laws and evaluate their fairness with respect to all taxpayers. conclusion the one flesh, two taxpayer system implicates two ongoing political debates. at the same time that voters, legislators, and courts in every state consider the legal and moral validity of same-sex marriage,265 national leaders contest the importance of estate tax repeal.266 the current tax treatment of marital wealth transfers frequently diverges from the underlying economic substance of property transfers. treating husband and wife – or any two taxpayers – as a single economic unit is inconsistent with the privileges and responsibilities of citizenship as they have evolved over time. the one flesh, two taxpayer system proposes an increase in the applicable exclusion amount so that any taxpayer, regardless of marital status, can transfer up to $10 million tax-free. the new rule will shrink the administrative costs associated with estate and gift tax assessment and collection, overall tax revenue will increase, and the tax burden will be shifted more effectively to those who are most able to pay. former commissioner of the internal revenue service sheldon cohen famously said that “[i]f you know the position a person takes on taxes, you can tell their whole philosophy. the tax code, once you get to know it, embodies all the essence of life: greed, politics, power, goodness, charity. everything’s in 806 florida tax review [vol. 6:8 267. jeffrey h. birnbaum & alan s. murray, showdown at gucci gulch: lawyers, lobbyists, and the unlikely triumph of tax reform 289 (1987). (quoting sheldon s. cohen). 268. the “fundamental tax policy objectives,” according to one treasury department official, are fairness, efficiency, and simplicity. leslie b. samuels, remarks of leslie b. samuels, assistant treasury secretary for tax policy, federal bar association section of taxation report 11 (spring 1995). scholars traditionally consider adam smith to have articulated these goals and several related variations. see adam smith, an inquiry into the nature and causes of the wealth of nations (e. cannan ed., 1937). see also edward j. mccaffery, the holy grail of tax simplification, 1990 wis. l. rev. 1267, 1312 (1990); m. scotland morris, reframing the flat tax debate: three not-so-easy steps for evaluating radical tax reform proposals, 48 fla. l. rev. 159, 178 (1976). there.”267 the one flesh, two taxpayer proposal is no exception. its greatest hope is a wealth transfer tax system that is just, simple and progressive.268 page 1 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 page 16 page 17 page 18 page 19 page 20 page 21 page 22 page 23 page 24 page 25 page 26 page 27 page 28 page 29 page 30 page 31 page 32 page 33 page 34 page 35 page 36 page 37 page 38 page 39 page 40 page 41 page 42 page 43 page 44 page 45 page 46 page 47 page 48 page 49 page 50 page 51 page 52 page 53 page 54 florida tax review volume 13 2012 number 3 florida tax review articles it’s not a rule: a better way to understand the definition of income alice g. abreu richard k. greenstein university of florida college of law florida tax review volume 13 2012 number 3 articles it’s not a rule: a better way to understand the definition of income alice g. abreu richard k. greenstein 101 florida tax review volume 13 2012 number3 the florida tax review is a publication of the graduate tax program of the university of florida college of law. each volume consists of ten issues published by tax analysts. the subscription rate, payable in advance, is $125.00 per volume in the united states and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: customer service dept., tax analysts, 400 s. maple ave, suite 400, falls church, va 22048. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify tax analysts of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352)273-0904 or email ftr@law.ufl.edu. copyright © 2012 by the university of florida florida tax review volume 13 2012 number 3 editor-in-chief martin j. mcmahon, jr. stephen c. o‟connell professor of law university of florida associate editors university of florida yariv brauner professor of law dennis a. calfee professor of law patricia e. dilley professor of law michael k. friel professor of law david m. hudson professor of law charlene luke associate professor of law omri marian professor of law yolanda jameson visiting assistant professor samuel c. ullman adjunct professor of law lawrence a. lokken emeritus culverhouse eminent scholar board of advisors hugh j. ault boston college j. martin burke university of montana charlotte crane northwestern university jasper l. cummings jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina reed shuldiner university of pennsylvania theodore s. sims boston university graduate editors rachel barlow ashley haskins justin hoyle grant marshall isabelle taylor suzie ward gary williams seth williams executive assistant trudi m. reid florida tax review volume 13 2012 number 3 information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: ―articles,‖ ―commentaries,‖ and ―book reviews.‖ the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in either word perfect or microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manuel. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. manuscripts selected for publication as articles generally are expected to be published within three months after acceptance. all tax law and policy positions presented are solely those of the authors. the editors, the university of florida college of law and tax analysts do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 13 2012 number 3 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 13 2012 number 3 101 it’s not a rule: a better way to understand the definition of income by alice g. abreu * richard k. greenstein * i. introduction ............................................................................. 101 ii. applying an income-as-standard approach .................... 107 a. the doctor and the lawyer .............................................. 109 b. the father and son ........................................................... 114 c. pooling labor: joint activities and common goals ........ 115 1. the roommates, the urban gardeners, and the young parents: dividing responsibilities ..... 115 2. child care, nursery school, and home school... 119 3. the handy shoe salesman and the chess master professor .................................................. 122 iii. income-as-rule or income-as-standard ........................... 124 iv. conclusion ................................................................................. 130 i. introduction in a recent article, professor douglas kahn explores a particular dissonance between the positive and very broad definition of income that includes all realized accessions to wealth, and what the government can, and * alice g. abreu is james e. beasley professor of law, and richard k. greenstein is professor of law at temple university‘s beasley school of law. we are grateful for the very detailed and thoughtful comments offered by our temple colleagues, jane baron, greg mandel, and andrea monroe, and we also thank professor douglas kahn of the university of michigan school of law for writing an article that inspired a close read and this response. we could not have completed this project without our exemplary research assistant, ashley rivera, temple 2013, who took tax as an elective in her first year of law school and whose love of the subject, dedication, reliability, attention to detail, and professionalism will be missed when she graduates. a summer research stipend from temple also assisted our work. all errors, omissions and deficiencies remain ours. 102 florida tax review [vol. 13:3 actually does attempt to tax. 1 at the beginning of his article, professor kahn summarizes the problem he seeks to resolve: when cash is received for services, it typically will constitute gross income to the recipient. but what if the payments are made in a noncommercial setting such as the payment by a parent to a child for mowing the lawn or performing household chores? as discussed later in this essay, there are reasons to conclude that such payments do not constitute income. the problem of how to treat receipts from a noncommercial activity frequently arises in the context of an exchange of services. a similar problem arises when services are provided by several persons pursuant to a pooling of labor to accomplish a common noncommercial goal. 2 professor kahn then offers two limiting principles, which he posits operate as exclusions, thus eradicating the gap. specifically, he suggests that the apparent dissonance vanishes if we understand that ―the income tax operates only on commercial transactions‖ 3 and, as a corollary, that ―joint efforts should not be treated as an exchange of services but rather as a jointly conducted activity,‖ 4 which does not produce income ―[w]hen the common goal has no business connection.‖ 5 for professor kahn, these two principles explain why a number of items that would seem to come within the broad positive definition of income are not in fact subject to tax despite the absence of a statutory exclusion. we will refer to these principles collectively as the ―commercial/noncommercial distinction‖ or the ―commercial/ noncommercial rule.‖ we understand the deep dissatisfaction with the positive definition of income that led professor kahn to develop the commercial/noncommercial distinction he explores in his article. indeed, we have shared it, as have others before us, including professors zelenak and mcmahon, who struggled to provide a theoretical justification for not treating as income the value of a 1. see generally douglas a. kahn, exclusion from income of compensation for services and pooling of labor occurring in a noncommercial setting, 11 fla. tax rev. 683 (2011) [hereinafter kahn, exclusion from income]. in commissioner v. glenshaw glass co., 348 u.s. 426, 431 (1955), the supreme court defined income as ―undeniable accessions to wealth, and over which the taxpayers have complete dominion.‖ 2. kahn, exclusion from income, supra note 1, at 683 (footnote omitted). 3. id. at 686. 4. id. at 691. 5. id. although it is unclear, there may be an additional corollary principle having to do with whether the services exchanged are ―similar.‖ see infra part ii.c.1. 2012] the definition of income 103 record-breaking baseball caught by a lucky fan at a game. 6 that same desire for theoretical tidiness prompted scholars years ago to search for a comprehensive tax base (―ctb‖). 7 in our earlier article, defining income, we argued that the desire for theoretical precision has led to a long tradition of interpreting the definition of income — whether in the haig-simons or glenshaw glass 8 formulation — as a rule. 9 we proposed as an alternative that the definition of income be thought of as a standard — specifically, that questions about whether a particular accession to wealth constituted income be answered by employing an all-things-considered inquiry based on the values relevant to federal income tax. our claim was that treating income as a standard effectively addressed the puzzling gap between what the broad definition that glenshaw glass would seem to include in the tax base and what is actually included. child support, government welfare payments, and many other categories of ―accessions to wealth, clearly realized, and over which the taxpayers have complete dominion‖ 10 are routinely excluded from income, despite the absence of any statutory basis for their exclusion. to account for this, we began to explore the role of values — particularly non-economic values — in determining the contours of the tax law. we posited that what explains the inconsistency . . . is that economics — at least haig-simons economics — is not everything. although the glenshaw glass definition of income is largely consistent with the haig-simons definition, and thus with economics, it fails to take into account other values that count for the people who are subject to the tax and must buy into it, at least to some degree, for the tax to be administrable. 11 6. see lawrence a. zelenak & martin j. mcmahon, jr., taxing baseballs and other found property, 84 tax notes 1299 (aug. 30, 1999) [hereinafter zelenack & mcmahon, taxing baseballs]. professor dodge also addressed this issue, but came to a different conclusion. see joseph m. dodge, accessions to wealth, realization of gross income, and dominion and control: applying the “claim of right doctrine” to found objects, including record-setting baseballs, 4 fla. tax rev. 685, 691 (2000) [hereinafter dodge, accessions to wealth]. 7. see, e.g., boris i. bittker, a “comprehensive tax base” as a goal of income tax reform, 80 harv. l. rev. 925 (1967) [hereinafter bittker, ctb as a goal]. 8. commissioner v. glenshaw glass co. 348 u.s. 426 (1955). 9. alice g. abreu & richard k. greenstein, defining income, 11 fla. tax rev. 295 (2011) [hereinafter abreu & greenstein, defining income]. 10. glenshaw glass, 348 u.s. at 431. 11. abreu & greenstein, defining income, supra note 9, at 299 (footnotes omitted). 104 florida tax review [vol. 13:3 accordingly, we proposed ―that the definition of income be acknowledged to be a standard that should be interpreted in light of the values — including noneconomic values — that animate the field of income taxation.‖ 12 in proposing that income be understood as a standard, we were returning to an approach that characterized the early days of federal income tax scholarship. writing in the mid-1950s, professors stanley surrey and william warren understood the importance of values and therefore urged that foundational concepts such as income be defined by reference to standards. 13 standards are inherently flexible and allow for consideration of various factors with multiple, and possibly conflicting values. as surrey and warren explained: in the income tax, as in other complex legislation, the need is for a standard which will project our present aims into the future and serve as the vehicle for solving the unforeseen cases as they arise. the legislative function is not denied or thwarted when other branches of the government are relied upon by congress to perform substantial tasks in the application of statutes. administration and judicial interpretation are necessary parts of the overall process of legislation. the income tax is no exception. 14 surrey and warren‘s call for the acceptance of standards and for not treating tax law as exceptional went unheeded despite having been contained in an otherwise influential american law institute study which appeared in a 12. id. at 346. 13. see stanley s. surrey & william c. warren, the income tax project of the american law institute: gross income, deductions, accounting, gains and losses, cancellation of indebtedness, 66 harv. l. rev. 761, 771–72 (1953) [hereinafter surrey & warren, tax project]. the supreme court also understood the importance of values, noting in duberstein that [t]he nontechnical nature of the statutory standard, the close relationship of it to the data of practical human experience, and the multiplicity of relevant factual elements, with their various combinations, creating the necessity of ascribing the proper force to each, confirm us in our conclusion that primary weight in this area must be given to the conclusions of the trier of fact. commissioner v. duberstein, 363 u.s. 278, 289 (1960). the duberstein court took its cue from justice cardozo, quoting his observation that ―[t]he standard set up by the statute is not a rule of law; it is rather a way of life. life in all its fullness must supply the answer to the riddle.‖ id. at 288 n.9 (quoting welch v. helvering, 290 u.s. 111, 115 (1933)). 14. surrey & warren, tax project, supra note 13, at 775. 2012] the definition of income 105 leading scholarly publication, the harvard law review. another scholar of like stature, professor boris bittker, echoed surrey and warren‘s recognition of the central role of values in tax law when he opposed the call for a ctb (a tax system free of loopholes and base erosions and, by necessary implication, free of any role for non-economic values) on the ground that a ―neutral, scientific measure of . . . income is a mirage.‖ 15 however, bittker‘s views were roundly criticized by very prominent scholars from both economics and law, who accused him of misunderstanding haig-simons, adopting an ―untenable position,‖ and doing no more than ―suggesting ad hoc settlements.‖ 16 to his enduring credit, bittker remained undaunted, choosing instead to use his rapier wit to mock the comprehensive tax base as ―an encompassing verity‖ and asserting that failure to find that verity would not produce the ―‗dank, miasmic, myxomycetous sump‘ that [his detractors] would probably like to call ‗bittker‘s quagmire.‘‖ 17 despite also being a formidable technician who wrote several treatises and casebooks — including federal income taxation of corporations and shareholders, a tome of near-biblical authority coauthored with james s. eustice, bittker advocated a nuanced, multifaceted analysis and interpretation of tax law. 18 in his detractor‘s quagmire he saw a boundless fertility. 15. bittker, ctb as a goal, supra note 7, at 925. like bittker, professor ernest brown — also a noted and influential scholar — embraced a view of the income tax where standards that were influenced by values play a substantial role. see ernest j. brown, the growing “common law” of taxation, 34 s. cal. l. rev. 235, 239–40 (1961). 16. see, e.g., charles o. galvin, more on boris bittker and the comprehensive tax base: the practicalities of tax reform and the aba‟s cstr, 81 harv. l. rev. 1016, 1019 (1968) [hereinafter galvin, more on bittker] (accusing professor bittker of doing no more than suggesting ―ad hoc settlements‖); richard a. musgrave, in defense of an income concept, 81 harv. l. rev. 44, 45 (1967); joseph a. pechman, comprehensive income taxation: a comment, 81 harv. l. rev. 63, 65 (1967) (accusing professor bittker of misunderstanding haig-simons). 17. boris i. bittker, comprehensive income taxation: a response, 81 harv. l. rev. 1032, 1041 (1968) [hereinafter bittker, ctb response] (quoting galvin, more on bittker, supra note 16, at 1019). 18. perhaps this is attributable at least in part to professor bittker‘s profound interest in constitutional law, a field in which the role of values is patent. after taking emeritus status, bittker‘s scholarly production turned to constitutional law. c.f. boris i. bittker & brannon denning, bittker on the regulation of interstate and foreign commerce (1999); boris i. bittker, constitutional limits on the taxing power of the federal government, 41 tax law. 3 (1987); boris i. bittker, the bicentennial of the jurisprudence of original intent: the recent past, 77 calif. l. rev. 235 (1989); boris i. bittker, the world war ii german saboteurs‟ case and writs of certiorari before judgment by the court of appeals: a tale of nunc pro tunc jurisdiction, 14 const. comment. 431 (1997). 106 florida tax review [vol. 13:3 however, the standard-based approach recommended by surrey, warren, and bittker has been supplanted by, as we have said, a tradition of thinking about tax law, generally, and income, particularly, in terms of rules. 19 the approach that professor kahn takes in his article lies squarely in this tradition. he sees the commercial/noncommercial distinction as signaling a rule, 20 namely ―that the income tax applies only to commercial activities and that income produced from noncommercial activities is not taxable.‖ 21 in this article we propose a thought experiment: what if we were to think about the problems professor kahn poses from the perspective of income-as-standard? doing so will allow us to explore the utility of such an approach in a concrete way. professor kahn develops the commercial/noncommercial distinction by working through a series of interesting hypothetical scenarios, and we use these scenarios as the foundation of our thought experiment. in part ii, which follows this introduction, we examine those scenarios using the income-as-standard approach. in part iii we compare the application of rule-based and standardbased approaches to the general issue raised by professor kahn and, having concretely contrasted the two approaches, return to the conclusion we reached in defining income: standards have important virtues that make them superior to rules for resolving some fundamental questions in federal income tax law. we conclude in part iv by summarizing the virtues of regarding the definition of income as a standard and pointing toward future scholarship that will apply a standard-based framework to other fundamental questions in tax law. our exploration of the definition of income has shown us that contemporary tax analysis often assumes that all tax formulations are rules. we believe that while many are, income is not. 19. in many ways this is not surprising given the widely acknowledged advantages of rules as providers of clarity and certainty. see generally colin s. diver, the optimal precision of administrative rules, 93 yale l.j. 65 (1983); isaac ehrlich & richard a. posner, an economic analysis of legal rulemaking, 3 j. legal stud. 257 (1974); louis kaplow, rules versus standards: an economic analysis, 42 duke l.j. 557 (1992); cass r. sunstein, problems with rules, 83 calif. l. rev. 953 (1995). nevertheless, some contemporary scholars are once again looking to standards to explain and understand particularly thorny problems. see, e.g., steven a. dean, neither rules nor standards, 87 notre dame l. rev. 537 (2011) (providing a critique of efforts to replace standards with rules in the international tax regime); the delicate balance: tax, discretion and the law (chris evans et al. eds., 2011). 20. indeed, professor kahn explicitly identifies what he is doing as developing a ―proposed rule excluding income from noncommercial activity.‖ kahn, exclusion from income, supra note 1, at 697. 21. id. at 686. 2012] the definition of income 107 ii. applying an income-as-standard approach to explore the problem of compensation for, and exchange of, services in ―noncommercial‖ settings, professor kahn examines seven hypothetical scenarios, along with some variations on a couple of these settings. in addition to the scenarios, professor kahn examines barter clubs for child care, cooperative nursery schools, and cooperative home schooling. in this part we examine these various situations from the perspective of income-as-standard. this endeavor requires an all-things-considered analysis informed by the relevant tax values. thus, the first order of business is to identify those values: the things we care about when deciding whether an accession to wealth should be treated as income. professor kahn‘s article is very helpful in this endeavor, as he identifies various ―policies‖ that support his conclusions regarding when compensation for services, exchanges of services, and pooling of labor should and should not count as income. for instance, focusing on exchanges of services within a ―marital community,‖ he identifies the importance of administrability: one consideration is that taxing an exchange of services performed in a marital community would pose huge administrative difficulties, and avoidance of that administrative burden is likely one factor in the decision not to impose a tax. in addition to difficult valuation issues, it would not be easy to discover the events where one spouse performed a service for the other; and many of the services performed will be of a highly personal nature. 22 another important consideration identified by professor kahn is privacy: a tax regime that would require the discovery of services performed within the marital community would constitute an invasion of privacy and an intrusion into an individual‘s private noncommercial life, and that would be unacceptable in a free society. even when identification and valuation of marital services does not pose a problem, the value of these services nevertheless will be excluded from income. the personal private lives of individuals should not be subjected to disclosure by the government unless there is a compelling public reason to require it. 23 22. id. at 687. 23. id. at 687–88. 108 florida tax review [vol. 13:3 in addition to administrability and privacy, professor kahn worries about creating undesirable incentives that undermine private improvement of living standards: not taxing services performed in a family setting is analogous to not taxing imputed income from the services one performs for himself. an individual is not taxed on the wealth produced by cooking his own meal, shaving himself, mowing his own lawn, building a bookcase for his own use, etc. . . . a tax on such imputed income would pose difficult valuation and identification problems and would constitute an invasion of privacy and an intrusion into an individual‘s private life. moreover, it would be undesirable to have the tax law deter an individual from using his own labor to improve his household, himself, or his family. if such imputed income were taxable, an individual might choose not to shave or have his wife cut his hair or make household improvements and repairs. that is not to say that a person would necessarily refrain from such actions, but the imposition of a tax liability would be a factor to be weighed in determining whether the net benefit to be gained is worth the effort. while there is no statutory provision excluding imputed income from taxation, it is excluded under the common law. for some limited purposes (but certainly not for all purposes) members of a family are treated as a single unit. therefore, services performed for the family by an individual member can be seen as services performed by the family unit for its own benefit and thus excluded from tax as imputed income. 24 this concern about incentives to promote improved well-being leads professor kahn to identify the importance of social cooperation: ―as a matter of societal policy, the tax law should not operate to deter the formation of cooperative ventures in which people pool their labor for a common personal goal.‖ 25 we agree with professor kahn‘s assessment of the importance of administrability, privacy, and social cooperation as social policies and believe that by invoking them, he is identifying what we refer to as values. his article begins to create a taxonomy of relevant values, and in doing so, 24. id. at 688–89 (footnote omitted). 25. id. at 693. 2012] the definition of income 109 he has helped us to refine our own thinking. we fully agree with professor kahn that the values he identifies are important and must be considered when deciding what to include in the tax base. we differ with respect to where our respect for those values takes us. for each of the scenarios and variations, professor kahn‘s analysis requires a determination of whether the setting is commercial or noncommercial. our thought experiment requires instead that we treat the definition of income as a standard, the application of which depends on the relevant values. in this case the values are those which professor kahn identifies — administrability, privacy, improvement of living standards, and cooperation — along with others that are implied in his discussions of specific scenarios. when we do that, the important facts in the scenarios, now illuminated by the values, become apparent. but the income-as-standard analysis that we advocate in defining income, and which our thought experiment applies here, does not stop with an identification of the relevant values. identification cannot suffice when some of the relevant values collide with other relevant values. indeed, it is precisely because of such collisions that a standard-like, rather than a rulelike formulation is apt in defining income. 26 colliding values require choosing which values will prevail in any given case, and as we will discuss in part iii, that is something that can only be accomplished by deploying a standard. professor kahn‘s scenarios are especially helpful in illustrating this collision of values, so we turn to them now as we pursue our thought experiment to illustrate the operation the income-as-standard approach. for ease of identification and recollection, we will refer to the scenarios by the roles that their protagonists play. a. the doctor and the lawyer professor kahn begins his analysis by describing an example of an exchange of services which he believes — and we agree — produces income for both parties. the exchange that so clearly produces income is that described in the first iteration of the first scenario, which involves a doctor (the doctor) and a lawyer (the lawyer). if the doctor performs surgery for the lawyer in explicit exchange for her representing him in a divorce, both have income in the amount of the fair market value of their services, which are presumably equal under these circumstances. an explicit, bargained-for exchange of services like this constitutes income because the regulations provide that ―if a taxpayer receives services from another as payment for 26. see generally abreu & greenstein, defining income, supra note 9, at 321–44 (exploring the concept of aptness more fully). 110 florida tax review [vol. 13:3 services rendered by the taxpayer, each party will realize gross income equal to the value of the services received from the other.‖ 27 this first scenario is an easy case because both an income-as-rule and an income-as-standard analysis produce the same result. if the definition of income articulated by the supreme court in glenshaw glass — that gross income is all ―accessions to wealth, clearly realized, over which the taxpayers have complete dominion‖ 28 — is a rule, both the doctor and the lawyer have income. the receipt of legal services and surgery, respectively, without a diminution in resources to pay therefor, has made each better off. the transaction described is equivalent to one where the lawyer pays the doctor for his services in cash and the doctor takes that cash and uses it to pay the lawyer; neither the lawyer nor the doctor has any more or less cash as a result of the two transactions, and each has received services from the other. however, both the doctor and the lawyer have realized accessions to their respective wealth when they receive cash in exchange for the services they perform, and the fact that they use that cash to pay for a service does not remove the realization of income upon receipt. when a transaction in which cash is paid is economically the same as one in which no cash is exchanged, a view of income-as-rule must tax both transactions equally. a view of income-as-standard produces the same result. the value of horizontal equity supports taxation of both the doctor and the lawyer because it supports taxing economically equivalent transactions equivalently. while other values, such as administrability, might point to a different conclusion and create a potential collision of values in this case, the administrability problems are relatively minor. ascertaining the value of the services exchanged is not difficult since there is an active market for both. other important values, such as privacy, do not pose grave concerns because of the public nature of the services. neither the receipt of surgery nor of legal representation in a divorce proceeding are private events. both the doctor and the lawyer would probably have paid for the services elsewhere if the exchange had not been possible, so social cooperation is not diminished. horizontal equity requires taxing a bargained-for exchange that produces the same result as an arms-length transaction between strangers for cash in the same way in which the cash transaction would have been taxed; in the absence of strong countervailing values, it carries the day. 29 most cases 27. kahn, exclusion from income, supra note 1, at 683 (citing reg. § 1.612(d)(1)). 28. glenshaw glass, 348 u.s. at 431. 29. horizontal equity, which is largely an economic value because it seeks to tax economically equivalent transactions equivalently (it is also a specific instance of the value of justice), outweighs administrability in this case as well as in many others in which the principal value pushing against taxation is administrability. we note, however, that when administrability is joined by other, noneconomic values, 2012] the definition of income 111 involving bargained-for exchanges are of this sort, and the income-as-rule and the income-as-standard approaches produce identical results. since the income-as-rule approach is both much easier to apply and consistent with the tax-as-rules reflex, it is hardly surprising that income is so often thought to be a rule. the possibility that prompts our thought experiment — that income might actually be more effectively analyzed as a standard — does not appear until we encounter more difficult cases. quite usefully, professor kahn‘s scenarios provide us with such cases. the first variation of the doctor/lawyer scenario is also easy. in that variation the doctor and the lawyer have been friends since childhood. the lawyer retains the doctor‘s services, but, after the doctor performs the surgery, he tells the lawyer that he won‘t charge her because of their friendship. in this case, both the income-as-rule and the income-as-standard approaches again produce the same result again. the lawyer would not have income because the doctor has made the lawyer a gift and section 102 excludes gifts from income. 30 under an income-as-standard approach, the values of encouraging and respecting kindness and cooperation among friends, as well as the privacy of those personal relations, would suggest non like cooperation, privacy, education, or even a love of baseball, the strength of the other values often tips the balance, and non-taxation is the result. this observation explains professors zelenak and mcmahon‘s suggestion that for tax purposes, income is paradigmatically about cash; that noncash transactions (e.g., bartering) are taxed when necessary to prevent ―wholesale tax avoidance,‖ but that ―nontax benefits . . . that involve no transaction‖ should not be taxed. zelenak & mcmahon, taxing baseballs, supra note 6, at 1304–05 (emphasis removed). we see their point about taxing certain nontax transactions to be the preservation of horizontal equity and their suggestion as saying that in those cases where horizontal equity meets only administrability, horizontal equity should triumph. but where administrability has other allies (as in the case of imputed income, the caught baseball, big game trophies, or caught fish), horizontal equity should not necessarily carry the day. as we note in the text, it seems to us that professor kahn‘s commercial/noncommercial distinction proceeds from the same intuition regarding the power of other, noneconomic values. the situations that he labels ―commercial‖ implicate principally the economic value of horizontal equity; thus administrability takes a back seat to horizontal equity and taxation ensues. in the situations he labels ―noncommercial,‖ other values are prominent, and they tip the scale to non-taxation. in the two situations in which we disagree with professor kahn, the difference may be in the weight each of us places on the noneconomic values involved. it appears to us that in proposing the noncommercial exclusion, professor kahn is implicitly agreeing with one of our conclusions in defining income: ―[e]conomics is not everything.‖ abreu & greenstein, defining income, supra note 9, at 299, 348. 30. i.r.c. § 102(a). 112 florida tax review [vol. 13:3 taxation to the lawyer. under that view, section 102 simply serves to make the importance of those values patent and to make the conclusion explicit. 31 the difficult variation is the next one. in that variation the doctor also gratuitously performs the lawyer‘s surgery but several years thereafter, the doctor finds that he needs a divorce lawyer and asks the lawyer to represent him. the lawyer does so and wants to charge the doctor but decides not to because the doctor had not charged her for the surgery. in explaining his conclusion that the doctor has income in this situation, professor kahn reasons that since the lawyer did not refrain from charging out of ―detached and disinterested generosity‖ as required by the supreme court to find a gift, the doctor should have income. 32 in other words, professor kahn finds income and can conclude that there is no income only if the gift exclusion applies. an income-as-standard approach suggests a different result. the same values that resulted in no income to the lawyer in the previous variation of this scenario (the clear gift) would apply here. the values of encouraging and respecting kindness and cooperation among friends, as well as the privacy of those personal relations, suggest non-taxation to the doctor. additionally, in this case there is the additional value of preventing intrusion into an individual‘s thoughts, coupled with the administrative impossibility of so doing in most cases. absent the knowledge of the lawyer‘s secret desire to charge, this scenario would look just like the prior one. under an income-as-standard approach, the value of personal privacy would preclude consideration of that desire, and the result would be the same as it would be without the secret desire. this standard-based approach is supported by the supreme court‘s decision in duberstein. when it announced the ―detached and disinterested generosity‖ test, the supreme court quite clearly and explicitly stated that the existence of detached and disinterested generosity was to be determined objectively. 33 justice brennan, writing for the court, asserted that it was ―plain that the donor‘s characterization of his action is not determinative — that there must be an objective inquiry as to whether what is called a gift amounts to it in reality.‖ 34 based on this language, the question is not simply whether the lawyer would have liked to charge the doctor for her services in the absence of other considerations. duberstein could easily be read to require that the question of the lawyer‘s intent ―must be based ultimately on 31. just as in the case of section 501(c)(3), the statutory exclusion confirms the importance of the value, but the exclusion is a structural part of the tax system — not a tax expenditure. 32. kahn, exclusion from income, supra note 1, at 685 (quoting commissioner v. duberstein, 363 u.s. 278, 285 (1960)). 33. commissioner v. duberstein, 363 u.s. 278, 286 (1960). 34. id. 2012] the definition of income 113 the application of the fact-finding tribunal‘s experience with the mainsprings of human conduct to the totality of the facts of each case.‖ 35 as the court acknowledged in duberstein, ―[t]he nontechnical nature of the statutory standard, the close relationship of it to the data of practical human experience, and the multiplicity of relevant factual elements, with their various combinations, creating the necessity of ascribing the proper force to each, combine to require a consideration of multiple factors.‖ 36 although professor kahn acknowledges that ―[t]here is a substantial question as to whether the moral constraint that prevented [the lawyer] from charging [the doctor] precludes gift treatment,‖ he concludes that it does because ―[h]er transfer was not motivated by affection or a concern for [the doctor].‖ 37 however, extending our thought experiment and treating the definition of a gift as a standard, a trier of fact could reasonably conclude that although the lawyer might have wanted to charge the doctor, her decision not to charge meant that she put her friendship with him above her desire for additional money. whether characterized as a ―moral constraint‖ or ―affection or a concern for the doctor,‖ some aspect of the value the lawyer placed on her relationship with the doctor caused her to decide not to charge him. a trier of fact could justifiably conclude that the lawyer‘s legal services were given out of ―detached and disinterested generosity‖ and were, therefore, a gift. extending the thought experiment that contrasts the rule-based and standard-based approaches to the supreme court‘s definition of a gift as proceeding from the donor‘s ―detached and disinterested generosity‖ highlights the differences between the two approaches. rules narrow the factual focus of analysis, and in this case cause a focus on only one fact (the lawyer‘s desire to charge the doctor), resulting in a finding that the rule is unsatisfied, which leads to the conclusion that there is no gift. the standardbased approach is different. if the detached and disinterested generosity requirement sets forth a standard to be informed by an all-things-considered analysis, the inquiry involves consideration of the value that the lawyer places on her relationship with the doctor, and perhaps with others, who might think badly of her if she charges the doctor, and the value she places on compliance with social mores or reciprocity. in other words, a standardbased approach requires consideration of what the lawyer actually did, rather than what she might have wanted to do if no other factors were considered. that broader consideration can quite easily lead to the conclusion that the standard is satisfied. affection for the doctor and a desire to preserve his friendship triumphed over competing values, such as the desire for money. the importance of respecting the values that caused the 35. id. at 289. 36. id. (emphasis added). 37. kahn, exclusion from income, supra note 1, at 685 n.4. 114 florida tax review [vol. 13:3 lawyer‘s decision, as well as the values of administrability and privacy, supports a conclusion of non-taxation. such a nuanced, multifaceted analysis might be precisely what the duberstein court intended when it referred to the ―nontechnical nature of the statutory standard,‖ 38 and what led it to reject the government‘s request to adopt a single-factor, rule-like test under which gifts would ―be defined as transfers of property made for personal as distinguished from business reasons.‖ 39 an odd consequence of the rule-based analysis is that the doctor‘s surgery is excluded from income as a gift to the lawyer, but the lawyer‘s legal representation is gross income to the doctor. if instead the lawyer‘s action is treated as a gift, as it would be under a standard-based analysis, there is no asymmetry. but eliminating asymmetry is not our goal, and our desire to explore the application of a standard-based analysis is broader than a critique of an interpretation of the duberstein test as a rule. an income-asstandard analysis reveals that neither the doctor nor the lawyer has income when the definition of income is analyzed as a multifaceted standard informed by multiple values, including the values of friendship, affection, reciprocity, privacy, and the mores of social interaction that suggest that friends do things for one another even when they would prefer not to. later, we‘ll discuss why we think this analysis is the better one. b. the father and son in the first variation in this scenario, a father (the father) pays his son (the son) a $20 weekly allowance while the son ―performs chores as his share of household responsibilities.‖ 40 in this variation, the allowance can be characterized as a gift and not taxable, presumably because of the lack of explicit connection between the allowance and the chores. in the second variation the father pays his son $20 in specific return for the son‘s performance of chores because the father wants ―to instill work habits in [his son] for earning his living later in life.‖ 41 in this variation there does not appear to be a gift because the payment of $20 explicitly exchanged for the performance of chores cannot be characterized as proceeding from detached and disinterested generosity. it is in this variation that professor kahn develops the commercial/non-commercial distinction that his article advocates. he takes the position that although it is not a gift, this payment should be excluded from income because the transaction occurs in a noncommercial zone. this approach takes a rule — the definition of income 38. duberstein, 363 u.s. at 289. 39. id. at 284 n.6. 40. kahn, exclusion from income, supra note 1, at 689. 41. id. 2012] the definition of income 115 — and creates another rule — the noncommercial zone exclusion — to arrive at what we agree is the correct result of no income. an income-as-standard analysis arrives at the same conclusion in this case but does so by a different path. that path does not involve applying a rule and then creating another rule, which operates as an exception, but rather involves only applying a standard. as before, applying the standard requires a consideration of the relevant values. those values include horizontal equity, which would point toward taxation because it requires that all individuals who receive compensation for services be treated alike; thus, if the chore is mowing the lawn and a landscaper who receives $20 for mowing the lawn has income, then the child who receives a similar amount for performing the same service should have income as well. but in this case, unlike in the case of the landscaper, there are competing values. those competing values include the value of family and the value of the parent‘s freedom to raise his child by demonstrating the rewards of industry, as well as the privacy that should attend intra-family transactions, the kind of social cooperation that families generally represent, and the difficulty of administering a different conclusion. the strength of the competing values supports a no-income result. this scenario is particularly helpful in illustrating the differences in the two approaches because it reveals that both approaches rely on the importance of values other than horizontal equity. the difference is not whether the approaches involve a consideration of values, but is what analytical role the consideration of values plays. professor kahn‘s application of the rule-based approach makes it clear that the commercial/noncommercial rule was crafted in response to the same values we employ in our standard-based approach. in the standard-based approach, no additional category is created and nothing else needs to be defined. we believe that the transparency of the standard-based approach, with its direct resort to a consideration of values (as opposed to considering values only as a step in the creation of another rule which must itself be construed), makes it an attractive alternative. c. pooling labor: joint activities and common goals 1. the roommates, the urban gardeners, and the young parents: dividing responsibilities a number of the scenarios professor kahn analyzes involve situations where services are exchanged in pursuit of a common goal. these goals involve housekeeping in shared living quarters, reciprocal tending of gardens, and reciprocal caring for children in their parent‘s absence (i.e. babysitting). in the first of these scenarios, two roommates (the roommates) divide household chores. the income-as-rule approach, now supplemented 116 florida tax review [vol. 13:3 by the noncommercial zone exception, produces the conclusion that the exchange of services between the roommates is not income to either of the roommates. however, in this case, professor kahn describes a ―corollary principle‖ to the noncommercial zone exception — that an exchange of services should not produce income if the exchange occurs in pursuit of a common goal. in another scenario, two individuals who live separately in manhattan each want to have a vegetable garden (the gardners), a goal they accomplish by purchasing neighboring plots of land on long island, planting their gardens, and then agreeing that each will travel to the plots twice a week to tend to both gardens rather than four times a week to each tend to his own garden. the income-as-rule approach, now supplemented by the noncommercial zone exception and the corollary principle of the common goal, produces the conclusion that the exchange of services between the gardeners is not income to either. 42 yet another scenario involves two couples (the parents), each of whom have young children. when one couple needs a babysitter on short notice, the other couple agrees to provide that service, and in return, the first couple agrees to care for the other couple‘s son. again, the income-as-rule approach, supplemented by the noncommercial zone exception and the corollary principle of the common goal, produces the conclusion that the exchange of babysitting services between the parents is not income to either couple. in this case, however, there is a further rule-like refinement that produces a ―joint activity exception.‖ 43 reaching a no-income approach in this scenario under an income-as-rule approach, thus, requires the application of one rule, one exception, and one corollary principle which in turn produces yet another exception. all three of these scenarios can be seen as examples of what professor kahn calls ―pooled labor.‖ 44 he explains that ―[s]everal persons can join together to pool their labor to accomplish a common goal‖ and 42. id. at 693. 43. id. at 694. we confess that it is a bit difficult to ascertain the parameters of the ―common goal‖ and the ―joint activity.‖ in discussing the gardeners scenario, professor kahn states that the gardeners ―should be treated as pooling their labor to accomplish a common goal,‖ id. at 693, but later, in discussing the parents scenario, he states that ―exchange of services comes within the joint activity exception described above in connection with the tending of the vegetable gardens. the parents are tending children instead of vegetables, but the same principle applies.‖ id. at 694. the two concepts — common goal and joint activity — are obviously related, but the references to a ―corollary principle‖ of a common goal and the ―joint activity exception,‖ which later is applied to the same situation first governed by the common goal corollary principle, make the nature of the relationship between them somewhat opaque. 44. id. at 691. 2012] the definition of income 117 concludes: ―when the common goal has no business connection, the exclusion of joint activity services from income can be seen as a corollary to the proposed principle that income arising out of a noncommercial activity is not taxable.‖ 45 this in turn requires a test ―for determining what constitutes a ‗common goal.‘‖ 46 in setting out that test, professor kahn follows the kind of all-things-considered approach characteristic of a standard. in his words: the common goal must be the product of a single activity that is regarded as such by the public. the services involved must be so related that they are commonly regarded as in furtherance of that activity. the limitation on the breadth of a common goal rests on a common sense approach to whether the public would consider that goal to be the purpose of conducting an activity as contrasted to stretching the concept to incorporate the services in question. the limitation of the concept rests on a factual issue as to what is commonly regarded as a single activity. 47 although the development of this ―common goal‖ formulation started from a construction of income-as-rule, it appears to us that the formulation itself (as explained in the foregoing paragraph) differs little from an income-as-standard approach that openly relies on values, and justice cardozo‘s exhortation that ‗life in all its fullness‘ must provide the answer. values seem to guide the ―common goal‖ analysis because, as professor kahn explains: as a matter of societal policy, the tax law should not operate to deter the formation of cooperative ventures in which people pool their labor for a common personal goal. the tax law expressly provides for such pooling of labor and property for business purposes in its rules for dealing with partnerships. the partners‘ exchange of services does not cause them to recognize income. the same treatment 45. id. consistent with our analysis, while we agree with professor kahn that the joint efforts of individuals who pool their labor to accomplish a common goal — which occurs in nearly all business activities that involve multiple individuals, whether organized as partnerships or corporations — do not generate income, we do not agree that this conclusion proceeds from an ―exclusion of joint activity services from income.‖ id. our claim is that the pooling, or exchange, does not produce income. and hence nothing needs to be excluded. 46. id. at 691. 47. id. at 692. 118 florida tax review [vol. 13:3 should be accorded to the pooling of labor in a joint activity that is not connected with a business. 48 invocation of business partnerships strongly suggests that in the construction of the common goal the relevant point is not whether the activity is commercial or noncommercial (because business partnerships are obviously commercial), and yet the existence of a common goal precludes a finding of income for the partners who benefit from each other‘s services. 49 it seems that the value of fostering cooperation guides the creation of the common goal principle. the value of cooperation is also central to the conclusion that follows from application of the income-as-standard approach. under that approach cooperation is a value to be considered along with other values in determining whether something should be treated as income. the income-asstandard approach dispenses with the devices of ―noncommercial zone[s],‖ ―common goals,‖ and ―joint activities.‖ instead, it directly considers the various values at stake. the income-as-standard approach produces the same result as the income-as-rule approach without resort to exceptions and corollary principles. in the scenario involving the roommates the relevant values emerge from the discussion that produces the common goal principle. hence, administrability strongly suggests non-taxation since, as professor kahn points out, the difficulties in both discovering and valuing a bartered exchange of services in a domestic cohabitation context would be enormous. 50 privacy and the correlative concern with intrusiveness are also considerations, although their strength may have to do with the precise nature of the roommates‘ relationship. finally, the value of social cooperation — what professor kahn describes as ―the formation of cooperative ventures in which people pool their labor for a common personal goal‖ 51 — is directly relevant. here, the roommates cooperate to improve their well-being by maintaining a clean and orderly household. against these considerations are different tax-related values: revenue raising and horizontal equity (someone providing household cleaning services as a business would have income when paid for those services). under an income-as-standard approach we believe that the values of cooperation, privacy, and administrability, all of which point to the conclusion of no income, push against the values that point to a different conclusion and hence account for the no-income result. 48. id. at 693 (footnotes omitted). 49. id. 50. see id. at 687. 51. id. at 693. 2012] the definition of income 119 in the case of the gardeners and the parents, healthy eating and the care of children, like the roommates‘ maintenance of a functional household, are social goods, and as professor kahn himself argues, the tax law should not discourage the kind of social cooperation necessary to produce such goods. moreover, informal arrangements like these among neighbors, friends, and relatives cannot be easily identified and evaluated without an objectionable degree of government intrusion, implicating both administrability and privacy concerns. as with the roommates, the values that suggest non-taxation are countered by concerns for revenue raising and horizontal equity given that vendors of gardening and child care services would have gross income if paid for their work. application of income-asstandard requires directly deciding which values should be preferred in this context. in all three of these scenarios there is likely widespread agreement that the sharing of household chores or gardening or child-care services among friends or acquaintances should not generate gross income. if pressed, those holding this view would likely explain their conclusion by invoking values; the values invoked would include privacy, social cooperation, wellbeing, administrability, and horizontal equity; and the widely shared conclusion would be that these various values taken together favor nontaxation. both the income-as-rule and the income-as-standard approaches produce that result. for us, the question is which one does so most directly and transparently. 2. child care, nursery school, and home school in his article, professor kahn also examines the existence of income in the case of larger-membership barter clubs for child care, cooperative nursery schools, and cooperative home schooling. in general, barter clubs, which individuals join to exchange disparate services and for which points are earned or spent, will generate gross income. 52 however, professor kahn distinguishes cooperative barter clubs organized by parents for child care and concludes that such clubs do not produce income to the members who receive child-care services. professor kahn cites two reasons in support of this conclusion. one, mentioned in passing, is that the paradigmatic barter club is a ―commercial 52. as professor kahn points out, the service has issued several rulings on the income tax consequences of barter clubs and their attendant information reporting obligations, all of which make clear that transactions occurring within such clubs produce the same tax consequences as regular marketplace exchanges involving cash. kahn, exclusion from income, supra note 1, at 691 and accompanying text; see also rev. rul. 85-101, 1985-2 c.b. 301; rev. rul. 83-163, 1983-2 c.b. 26; rev. rul. 80-52, 1980-1 c.b. 100; rev. rul. 79-24, 1979-1 c.b. 60. 120 florida tax review [vol. 13:3 enterprise from which a proprietor derives a profit.‖ 53 it seems that applying an income-as-rule approach, as limited by the noncommercial exception, produces this result. the second reason for distinguishing cooperative barter clubs for child care from others is this: a significant difference between the child-care barter clubs and other barter clubs is that the services that are obtained through the club are all of the same type and serve the same function. the only service obtained is babysitting for a young child. in other types of clubs, a member might choose to get legal services from another member or he could choose to obtain an entirely different type of service. consequently, in contrast to other barter clubs, a child-care barter club can be seen to be a cooperative joint venture to engage in a single activity — that is, the tending to young children. 54 applying an income-as-rule approach as limited by the noncommercial exception produces a similar result in the case of cooperative nursery schools and cooperative home schooling. professor kahn ―concludes that the cooperative nursery does not constitute a taxable exchange of services but rather is a pooling of labor to accomplish a common goal.‖ 55 in the case of cooperative home schooling, no income is generated because ―[t]he parents pool their services to achieve the common goal of educating their children.‖ 56 the same analysis extends to the exchange of teaching services involving just two different subjects, which professor kahn describes in a scenario involving teachers (the teachers). in that scenario one teacher teaches latin to the child of another teacher who teaches french to the first teacher‘s child. 57 applying the income-as-rule approach limited by the noncommercial zone exception, further enhanced by the common goal corollary principle and the common goal exception, leads to the conclusion that this exchange does not result in income to either of the teachers. under this approach, ―[t]he common goal could be to teach a foreign language or more broadly to educate the children. in [professor kahn‘s] view, neither goal is too broad to serve for this purpose; and so the exchange is not taxable.‖ 58 53. kahn, exclusion from income, supra note 1, at 695. 54. id. 55. id. at 696. 56. id. 57. id. 58. id. 2012] the definition of income 121 the income-as-standard approach operates differently, although it produces the same result. rather than ask whether the setting is ―commercial‖ or the services exchanged by the members of the child-care barter club are ―all of the same type‖ or serve a ―common goal,‖ that approach asks what is valued in this type of setting. the answer is that social cooperation to care for and educate children is an important value, as is education, 59 and public outrage would likely accompany any effort to tax the 59. that education is a relevant tax value is easily demonstrated by considering that section 501(c)(3) exempts revenue received by nonprofit educational organizations from federal income taxation. as the staff of the congressional joint committee on taxation (―joint committee‖) has consistently made clear, the tax exemption for these organizations is not a tax expenditure. see, e.g., staff of joint comm. on taxation, 112th cong., estimates of federal tax expenditures for fiscal years 2011–2015, at 9–10 (comm. print 2012) [hereinafter joint comm. on taxation, 2011–2015 tax expenditures]. prior joint committee reports and other government estimates consistently reach the same result. see, e.g., office of mgmt. & budget, special analyses, budget of the united states government fiscal year 1976, at 108 (1975). although it is beyond the scope of our current effort to discuss it further, there is a rich literature on the nature of the exemption for certain organizations and a number of theoretical bases on which to support it, but the conception of the exemption as structural and not as a tax expenditure has been consistent. see, e.g., boris i. bittker and george k. rahdert, the exemption of nonprofit organizations from federal income taxation, 85 yale l.j. 299, 304–05 (1976) (analyzing the genesis of the exemption and arguing that the failure to treat the exemption as a tax expenditure ―can properly be regarded as [a] routine aspect[] of the income tax structure rather than as [a] digression[] from an as yet undefined comprehensive tax base‖); evelyn brody, of sovereignty and subsidy: conceptualizing the charity tax exemption, 23 j. corp. l. 585, 585–86 (1998) (analyzing whether the tax exemption for charities ―is, on the one hand, a ‗subsidy‘ or, on the other, an acknowledgement that charitable activity falls outside the ‗right‘ tax base‖ and suggesting a ―sovereignty‖ view that both explains the non-taxation of charitable organizations while also accounting for the form of executing the nontaxation (exemption rather than direct subsidy). see generally rob atkinson, altruism in nonprofit organizations, 31 b. c. l. rev. 501 (1990) (examining the role of altruism in the rationale for the tax exemption of nonprofit organizations as a supplement to traditional economic analysis). that is, the exemption is a structural part of the system, it is not a subsidy, and revenue received by 501(c)(3) educational organizations is not income at all — precisely the result that an income-as-standard analysis produces. as the joint committee on taxation explains, the legislative history of the budget act indicates that tax expenditures are to be defined with reference to a normal income tax structure (referred to here as ―normal income tax law‖). the determination of whether a provision is a tax expenditure is made on the basis of a broad concept of income that is larger in scope than ―income‖ as defined under general u.s. income tax 122 florida tax review [vol. 13:3 teachers for teaching each other‘s children. hence, the values of administrability, which requires some degree of acceptance by those being taxed, social cooperation, and education suggest non-taxation in this case. interestingly, the income-as-standard and the income-as-rule approaches produce the same results in the child-care barter club, cooperative nursery school, and cooperative home schooling contexts. as before, the difference is in the directness and transparency of the analysis. we believe the income-as-standard approach provides a more direct route. both approaches are rooted in the same concern for respecting and promoting the values of cooperation, administrability, and education, but the income-as-standard approach exposes those values directly, whereas the income-as-rule approach requires the creation of exceptions, corollary principles, and further exceptions to reach the result. 3. the handy shoe salesman and the chess master professor following the joint activity discussion professor kahn proceeds to consider what he labels ―non-marital exchange of services not connected with a trade or business‖ and offers a scenario in which a shoe salesman (the salesman), who is handy with home repairs, and a college professor with a master‘s ranking in chess (the professor), but no talent for home repairs, exchange services. thus, when a window in the professor‘s house is broken by a storm, the salesman offers to fix it. the professor accepts the salesman‘s offer and suggests that he give chess lessons to the salesman‘s daughter in return. the income-as-rule approach produces income even though neither the professor nor the salesman is providing services connected with their businesses. professor kahn explains that ―the exchange of services can be seen as occurring in a commercial zone‖ because the professor and the salesman each could have charged for their services. 60 he then concludes that there is no common goal, and the transaction cannot be characterized as a pooling of services. consequently, ―a proper application of the tax law would tax the exchange.‖ 61 in this scenario the income-as-standard approach would produce a different result, and the reason for that is contained in an aside offered by professor kahn: principles. the joint committee staff has used its judgment in distinguishing between those income tax provisions (and regulations) that can be viewed as a part of normal income tax law and those special provisions that result in tax expenditures. joint comm. on taxation, 2011–2015 tax expenditures, supra, at 3. 60. kahn, exclusion from income, supra note 1, at 694. 61. id. 2012] the definition of income 123 given the isolated aspect of this exchange (i.e., it was not part of a pattern of exchanging services), the administrative costs of taxing it are such that the government might be better advised to ignore it. nevertheless, a proper application of the tax law would tax the exchange. the exchanged services were not provided to achieve a common goal. it just may not be worth the government‘s effort to enforce the tax. 62 substituting the words ―an income-as-rule‖ for ―a proper‖ in the foregoing paragraph explains the difference. an income-as-standard approach produces precisely the result professor kahn prefers without resort to either exceptions or corollary principles and avoids the assertion of apparent impropriety. 63 although the income-as-standard approach would result in the same counsel to the government, the difference is that counsel based on an income-as-standard approach produces a result of no-income, not just non-enforcement. in suggesting non-enforcement, professor kahn is not alone. courts have recognized the administrative agency‘s ability to deploy its resources as it deems appropriate and have relied on that power to explain the irs‘s position that unsolicited samples are not income unless a taxpayer attempts to claim a deduction for donating them to charity. 64 but that reasoning 62. id. (emphasis added). 63. we should add that it is not clear that considerations of horizontal equity press in favor of finding income in the scenario involving the salesman and the professor. here, a useful comparison is the first version of the doctor/lawyer exchange of services in the first scenario examined. see supra part ii.a. as professor kahn sets up the facts, the lawyer needed surgery and the doctor needed a divorce lawyer. each would have purchased the services on the open market if the other had not offered to provide them. the value of horizontal equity requires that transactions that would have taken place on the open market through the exchange of money for services be taxed similarly even when no money changes hands. however, in the scenario involving the salesman and the professor there is no certainty that either of those transactions would have taken place in the marketplace. the salesman may not have been willing to pay (with after-tax dollars) for his daughter to take chess lessons from a master, or at all, and the professor may have been happy attempting the repair himself, simply tacking a piece of wood to the broken window, or otherwise making do. the exchange is not a clear substitute for a market transaction (which the value of horizontal equity requires us to tax), and that allows other values, like the values of cooperation and administrability, to carry the day. 64. see haverly v. united states, 513 f.2d 224, 227 (1975), discussed in defining income, supra note 9, where we quoted the court‘s observation that [t]he internal revenue service has apparently made an administrative decision to be concerned with the taxation of 124 florida tax review [vol. 13:3 implicates a concept akin to prosecutorial discretion, which assumes that an item is income (or a crime) although the relevant administrator has decided not to assert that position. we believe that an interpretation which posits that an administrative agency can use its discretion to interpret a standard and, in this case, to interpret the bare receipt of an unsolicited sample as not constituting income under that standard, offers a more satisfactory explanation of the agency‘s observed decision. iii. income-as-rule or income-as-standard what has our thought experiment demonstrated? one thing it has shown is that the standard-based approach supports the same results as a rule-based approach in most of the cases that professor kahn considers in his article. in addition, a standard-based approach explains why those results seem appropriate by revealing how the relevant tax values apply to the various sets of facts. usually, that would not be enough to recommend income-as-standard over income-as-rule. but in this case there is more. among the presumed advantages of rules over standards is that they are more efficient and promise predictability, certainty, uniformity, and administrability. 65 these advantages should be realized if the rule is determinate in the great run of cases; if it is, it makes sense to reach predictable results through the efficient application of that rule and not worry about the underlying reasons. the situations at the margins can be addressed as they arise. in the case of the definition of income, though, it turns out that treating the definition of income as a rule actually leads to a high degree of indeterminacy, not just indeterminacy at the margins. professor kahn‘s commercial/noncommercial distinction offers a good illustration. in professor kahn‘s formulation, the rule is that ―the income tax applies only to commercial activities and . . . income produced from noncommercial activities is not taxable.‖ 66 for this rule to have the predictive power associated with rules, the meaning of ―commercial‖ and ―noncommercial‖ must be reasonably clear. but consider professor kahn‘s central examples of what he classifies as noncommercial activities in which exchanges should not produce income. those examples involve the father and the son, and the roommates. in both cases, professor kahn concludes that the exchanges of money for services (in the case of the father and the son), and of pure unsolicited samples only when failure to tax those samples would provide taxpayers with double tax benefits. it is not for the courts to quarrel with an agency‘s rational allocation of its administrative resources. 65. see supra note 18. 66. kahn, exclusion from income, supra note 1, at 686. 2012] the definition of income 125 services (in the case of the roommates), is not income to either of them because the exchange occurs within a noncommercial zone. the problem is articulating what makes the zone noncommercial. it cannot be that there is no money exchanged since no money was exchanged when the doctor exchanged surgery for legal services, or when the salesman exchanged repairs for chess lessons, both of which professor kahn treats as commercial exchanges that generate income. it cannot be the absence of a quid pro quo since in some scenarios the division is deliberate: one roommate cooks in exchange for the other‘s doing the dishes, and the son does the chores in exchange for the money the father gives him, making precisely the association that the father seeks to underscore. 67 it cannot be because the services were not sold for a profit since any compensation for labor by definition produces a profit. 68 it cannot be because the services were not 67. professor kahn acknowledges that the noncommercial determination is not affected by the existence of explicit bargaining, citing the example of a couple who deliberately divide chores so that they are equivalently distributed and no one is receiving a bargain or undue burden, concluding that even in such an extreme example the zone remains noncommercial. id. at 687. 68. the tax system does not assign any basis to human capital, which is why the exchange of human capital for money — working for a salary — always produces income in the full amount of the compensation received. the d.c. circuit faced the issue of human capital in murphy v. i.r.s., 460 f.3d 79, 88 (d.c. cir. 2006), finding that compensation for harm caused to an individual‘s reputation and emotional well-being must be included in income unless a taxpayer‘s basis in such human capital exceeds the amount received. much to the chagrin of the tax community and its contrary general consensus, the decision implied that it would be possible to have basis in human capital. see joseph m. dodge, murphy and the sixteenth amendment in relation to the taxation of non-excludable personal injury awards, 8 fla. tax rev. 369, 420 (2007) (―human capital simply does not possess basis as a matter of law.‖); deborah a. geier murphy and the evolustion of „basis,‟ 113 tax notes 576, 582 (nov. 6, 2006) (―because murphy had no basis in her human capital, the entirety of the cash she received was gross income . . . .‖); allen kenney, murphy a boon for protesters, critics say, 112 tax notes 832, 832 (sept. 4, 2006) (―[critics] expressed concern that the decision could be read as a validation of the popular antitax argument that wages paid for an individual‘s labor are not taxable‖); lee a. sheppard, murphy‘s law: tax provision declared unconstitutional, 112 tax notes 825, 830 (sept. 4, 2006) (―human capital is taxable‖); sheryl stratton, experts ponder murphy decision‟s many flaws, 112 tax notes 822, 823 (sept. 4, 2006) (―[u]ntil this opinion, it has been widely accepted that taxpayers have no basis in their labor . . . .‖). bowing to the scathing criticism, the opinion was subsequently vacated and a new one issued in murphy v. i.r.s., 493 f.3d 170, 184–86 (d.c. cir. 2007), this time finding that the taxpayer had gross income even if the amounts were characterized as a recovery of human capital. for related analyses of human capital in the context of the cost of education, see generally jennifer j.s. brooks, taxation and human capital, 13 am. j. tax pol‘y 189 (1996); david s. davenport, education and human capital: pursuing an 126 florida tax review [vol. 13:3 provided as part of an established business because in the scenario involving the salesman and the professor, the services exchanged were not a part of either the salesman‘s or the professor‘s established business and professor kahn nevertheless found that the exchange of window-fixing for chess lessons occurred ―in a commercial zone.‖ 69 it also cannot be because each party to the exchange could have charged for his work. like home repairs and chess lessons, the housekeeping chores exchanged by the roommates, gardening chores exchanged by the gardeners, the babysitting exchanged by the parents, and teaching exchanged by the home schooling language teachers all involve services for which a commercial market exists. since we can point to no aspect of the various transactions that explains why the zones in which they occur are commercial in some cases but not in others, and professor kahn offers no definition or explanation of the term, we are drawn to the conclusion that the commercial/noncommercial rule does not help us understand those results. the promise of determinacy offered by the crafting of a rule is unfulfilled. our more general point is that no single rule can determine the existence of income across the great run of human activity. any rule would fail to explain the result in great swaths of human exchanges. indeed, professor kahn‘s attempt to craft such a rule vividly demonstrates that, as even the commercial/noncommercial distinction is insufficient to explain the result in the various exchanges he posits without the aid of a corollary principle and an additional exception. our thought experiment thus lends support to the claim we made in defining income: the definition of income is most aptly analyzed not as a rule but as a standard. as we have suggested, transparency alone might not suffice to make an income-as-standard superior if the indeterminacy produced by the rule existed only at the margins. and the types of situations addressed in professor kahn‘s scenarios might be thought to lie at the margins. after all, many non-tax scholars might ask: who really wonders whether a kid has income when his dad pays him to do chores, or whether neighbors who exchange babysitting or gardening or even do disparate things for one another (fix a window, teach chess), have income? only a tax geek would think that such questions even existed. but it is precisely because the no-income answer is so obvious to so many people, and so troubling to tax scholars, 70 that the income-as-standard ideal income tax and a sensible tax policy, 42 case w. res. l. rev. 793 (1992); joseph m. dodge, taxing human capital acquisition costs—or why costs of higher education should not be deducted or amortized, 54 ohio st. l. j. 927 (1993). 69. kahn, exclusion from income, supra note 1, at 694. 70. the fact that very highly respected tax scholars are troubled by these issues is evidenced by professor kahn‘s article as well as by the efforts of other 2012] the definition of income 127 approach is apt. the types of exchanges represented by the scenarios in which professor kahn finds no income are the norm in civil society, not the exception. people do things for one another all the time, and they do those things not necessarily out of detached and disinterested generosity but out of social convention and expectation. observance of norms makes us better off and thus arguably constitutes an accession to our wealth, but it should not be taxed. the problem for tax scholars is that a tax law that defines income as ―accessions to wealth, clearly realized, and over which the taxpayers have complete dominion,‖ 71 would have to treat such accessions as gross income if that definition were interpreted as a rule. like the first-year law student who suddenly sees torts everywhere when she takes torts, the law student first exposed to the concept of income as defined in glenshaw glass can see income everywhere too. the torts student comes to understand that not every instance of preventable harm represents an actionable tort because she comes to understand that due care, or its converse, negligence, is a standard. the tax student has no similarly clarifying explanation. she assumes that the definition of income is a rule not only because it is framed as a rule but because so much of the tax law is composed of rules. why would there be a 10,000-plus page statute if not to set forth all the rules? and of course there are many, many rules in tax. but a view of the tax law as consisting exclusively and uniformly of rules creates a situation in which there is no theoretically satisfactory way of arriving at a no-income result in the scenarios in which professor kahn arrives at such a result save for the creation of more rules. as we have seen with professor kahn‘s attempt at creating the commercial/non-commercial rule, defining income as a rule only begets more rules or exceptions thereto without necessarily producing more determinacy at the end. 72 noted scholars who have addressed similar questions, particularly when they involved home-run breaking baseballs. zelenak & mcmahon, taxing baseballs, supra note 6, at 1300–01; dodge, accessions to wealth, supra note 6, at 691–92. 71. glenshaw glass, 348 u.s. at 431. 72. although this is not the vehicle in which to engage in an extended discussion of tax pedagogy, the one of us who teaches the introductory tax course regularly and has been doing so for over twenty-five years can attest to the illuminating power of even suggesting that the definition of income is a standard. the suggestion has the potential to answer many of the questions tax professors often get when teaching glenshaw glass, such as why an individual will not have income when a companion pays for an expensive dinner even if the individual clearly understands the expectation, that as a result, sexual advances will not be rebuffed. indeed, determining whether a formulation is a rule or a standard before proceeding with further analysis can illuminate the application of many fundamental tax concepts. some are obvious, such as the supreme court‘s definition of capital expenditure in indopco. indopco, inc. v. commissioner, 503 u.s. 79, 85–87 128 florida tax review [vol. 13:3 the disconnect between the very large number of exchanges that would seem to produce income if the definition thereof were a rule and our real world understanding that many of these exchanges do not produce income (and that treating them as such would be unadministrable), led professor kahn to attempt an explanation by developing the commercial/noncommercial distinction. putting aside the technical problem of finding the authority to craft an exception to a rule, income-as-rule is seriously indeterminate. the reason is that rules are determinate when they reflect clear value preferences. 73 but the question of what counts as income in an income tax system implicates an unusually large number and variety of relevant values. some of these are economic (e.g., efficiency); some are about design of an effective system (e.g., administrability); and some are about the fundamental legal value of justice (e.g., horizontal and vertical equity). moreover since an income tax system concerns nothing less than the whole of public welfare, all public welfare values — economic and noneconomic alike — are potential candidates for application to questions of income. finally, there is no consensus that certain values should consistently predominate over others in determining what should be taxed. indeed, there is little consensus on whether there should be an income tax at all. in short, there are too many values and too little agreement for a rule like professor kahn‘s to work. yet because rules seem so desirable in tax, the temptation is to provide determinacy by refining the rule. professor kahn does this by qualifying the commercial/noncommercial rule with exceptions and corollary principles. we might even pursue this further by adding a subrule that payments or exchanges between cohabitants do not generate income. but that will not do. if someone patronizes a particular store (1992). when understood as a standard, the treasury department implemented through the promulgation of detailed rules containing safe harbors and rules of convenience designed to foster administrability, regs. §§ 1.263(a)-4 to -5, the definition loses the apparently constricting force that threatened to make every ceo‘s salary nondeductible. it also explains the treasury‘s position in the regulations as an administratively driven interpretation thereof and not simply as an illegitimate giveaway to the taxpayer community. see roger jones & andrew roberson, to what extent can treasury abandon or overrule indopco?, 127 tax notes 547, 547–49 (may 3, 2010). understanding the word ‗reorganization‘ in the predecessor of section 368 as a standard explains not only gregory v. helvering, 293 u.s. 465 (1935), and its progeny but also the pervasiveness of judicial doctrines of substance over form more generally. understanding the section 318 attribution rules as rules that promote administrability explains the service‘s (and most courts‘) stubborn unwillingness to countenance arguments of family hostility. engaging in the rule/standard determination as part of the analysis of a tax provision can illuminate the application of that provision, but further development of this point must await another day. 73. abreu & greenstein, defining income, supra note 9, at 330–31. 2012] the definition of income 129 primarily because it is owned by her roommate and purchases items for the price charged to the public, those transactions generate gross income. so maybe the rule should be that only transactions among cohabitants for the benefit of the household do not generate gross income. but as the rules regarding income thus become more and more refined to work properly, they become more and more numerous and more and more narrow — sliding inexorably towards the all-things-considered approach of a standard. on the other hand, the consideration of the relevant values is often easy as a practical matter, as it is in many of the cases reflected in professor kahn‘s scenarios, where the irs has never attempted to assert the existence of income (the father paying the son for chores, the roommates sharing housekeeping, and the like). when it is more difficult, and the irs takes a position that does not reflect widely shared values, as it did when a spokesperson suggested that a fan who caught a record-breaking baseball at a game had income, public opinion, congress, or the courts can correct it. sometimes the irs even completely changes its position. 74 but this very fluidity is the law‘s strength. it reflects values, and as those change, so does the law, if imperfectly and sometimes belatedly but, at its best, in a way that reflects changing societal values. 74. a recent example is the service‘s change of position on the application of a two-year statute of limitations to claims for equitable relief in innocent spouse cases, which came despite victories in two federal courts of appeal following congressional communication with the commissioner. see sen. max baucus et al., senators request withdrawal of equitable innocent spouse relief limitations period, 2011 tnt 75–27 (apr. 19, 2011); rep. fortney pete stark et al., representatives request withdrawal of equitable innocent spouse relief limitations period, 2011 tnt 75–28 (apr. 19, 2011). see also douglas h. shulman, shulman says irs is reviewing innocent spouse relief rules, 2011 tnt 86–34 (may 4, 2011); david van den berg, irs gives in on innocent spouse, 134 tax notes 38 (jan. 2, 2012). in notice 2011-70, 2011-32 i.r.b. 135 (july 25, 2011), the service announced that despite its victories in the courts of appeals, the section 6015 regulations would be revised so that the two-year limitations period no longer applied to claims for equitable relief. in addition, the notice provided generous transition relief, specifying that pending requests for equitable relief would be considered if submitted after the two-year period, requests that were denied solely because of failure to comply with the two-year period and that were not litigated would be treated as claims for refund, any such requests that were in litigation would be the subject of action consistent with the notice without further action on the taxpayer‘s part, and in cases where the litigation had been final the irs would cease further collection action. the only way the irs‘s change of heart could have been more complete is if it had offered refunds of any taxes collected from individuals who had sought equitable relief, but it is impossible to know whether any such taxes were ever collected and thus whether any refunds could even have been possible. 130 florida tax review [vol. 13:3 iv. conclusion professor kahn‘s article makes an important contribution to the understanding of the definition of income by explicitly identifying some of the values that should animate it. the scenarios he uses to explore the contours of the definition of income allow useful comparisons and contrasts; working with these scenarios has helped us refine the ideas about the definition of income that we first proposed in defining income. in defining income, we demonstrated that numerous results, like the non-taxation of support, the value of dinners and other entertainment provided to clients by lawyers and other professionals, travel provided by a prospective employer to a prospective employee or investor, record-breaking baseballs caught by fans or fish caught by amateurs and professionals alike, or even big game trophies collected by hunters and donated to charity, were best explained by an analysis that treats the definition of income as a standard, the application of which is informed by multiple values. working with professor kahn‘s scenarios has reinforced our conclusion that the traditional difficulty of reconciling the definition of income with such results stems from the unexamined assumption that the definition of income is to be interpreted as a rule. once we consider the possibility that the definition of income is not a rule but a standard, both the source of the difficulty and its resolution become clear. analyzing the definition of income as a standard illuminates the treatment of the vast majority of exchanges that occur in human interaction. those exchanges create wealth but implicate important non-economic values too vast and varied for any rule to capture. a standard, however, is apt. in the case of pornography, justice stewart famously acknowledged the futility of creating a rule or even a highly articulated standard and refused to attempt it. instead he captured the essence of the concept by simply asserting that he knew it when he saw it. 75 in the case of income the supreme 75. in jacobellis v. ohio, 378 u.s. 184 (1964), the court used the formulation it had developed in roth v. united states, 354 u.s. 476, 489 (1957), ―whether to the average person, applying contemporary community standards, the dominant theme of the material taken as a whole appeals to prurient interest,‖ acknowledging it to be a standard. id. at 191. concurring in jacobellis, however, justice stewart acknowledged the difficulty of ―trying to define what may be indefinable,‖ and wished to go no further than stating that criminal laws could only constitutionally proscribe pornography and ―i shall not today attempt further to define the kinds of material i understand to be embraced within that shorthand description; and perhaps i could never succeed in intelligibly doing so. but i know it when i see it, and the motion picture involved in this case is not that.‖ id. at 197. the reception to justice stewart‘s most prominent observation has been mixed. for a 2012] the definition of income 131 court has not been so candid about the difficulty of the definitional task. but at their core, the definitions of both income and pornography are best analyzed as standards, informed, as standards must be, by contemporary values. acknowledging that the definition of income is best interpreted as a standard does not render it lawless any more than any legal formulation that is interpreted as a standard is lawless. neither does such acknowledgment deny that many tax formulations are rules. there are many, many rules in tax, but that does not mean that every tax formulation must be interpreted as a rule. section 61 suggests as much by defining income by reference to itself. 76 an income-as-standard approach has the advantage of being more satisfying than an income-as-rule approach because it provides a theoretical explanation for the observed definition of income, which excludes myriad wealth-enhancing accessions taxpayers receive every day, and does so directly, without resort to exceptions that need to be defined and further qualified. because the number of exchanges that would inappropriately produce gross income if the definition of income were a rule is so vast, it is important to articulate the theoretical basis for their non-inclusion. that is what professor kahn was trying to do in his article. we hope to have shown that an income-as-standard approach achieves that objective transparently and efficiently, invoking directly the values that the judgments of noninclusion reflect. an income-as-standard approach provides the theoretical space for engaging in the nuanced consideration required in an area as valueladen as the income tax. 77 the benefits that flow from the income-as-standard approach remind us that all law —whether formulated as rules, standards, or hybrids — is animated by values and that the road to resolving seemingly intractable legal puzzles sometimes begins with recalling those values. in the case of income in tax law, the relevant values include the familiar concerns of equity, efficiency, and administrability, but go on to embrace a host of often contestable economic and noneconomic social welfare values. with so much discussion of and response to justice stewart‘s critics, see paul gewirtz, on “i know it when i see it,” 105 yale l.j. 1023 (1996). 76. section 61 defines gross income as ―all income from whatever source derived,‖ thereby unhelpfully defining gross income as income. although the provision does include an illustrative list, it is explicit in stating that gross income includes, but is ―not limited to‖ those items. if the definition of income were a rule, it would be reasonable for the statute to define it, but saying that gross income is income does not define income. for the united states supreme court‘s efforts to define income in glenshaw glass, see supra note 1 and accompanying text. 77. as professor boris bittker observed long ago, ―when we turn to the field of income taxation . . . we do not begin with a consensus on the meaning of income, but with a myriad of arguments about what should be taxed, when and to whom.‖ bittker, ctb as a goal, supra note 7, at 985. 132 florida tax review [vol. 13:3 at stake it seems especially important to remember bittker‘s warning a half century ago that a ―neutral, scientific measure of . . . income is a mirage‖ 78 and to revive surrey and warren‘s call ―for a standard which will project our present aims into the future and serve as the vehicle for solving the unforeseen cases as they arise.‖ 79 in the decades since bittker, surrey, and warren offered those observations the income tax has grown into a daunting array of complex statutory provisions with not only sections, subsections, paragraphs, and subparagraphs, but complex, detailed regulations, and a mind-numbing number of revenue rulings, revenue procedures, notices, directives, forms, schedules, instructions, and publications. 80 it is not surprising that in the unrelenting deluge of apparent commandments many tax scholars and other professionals have come to assume that all of the tax law is composed of rules. our broad claim is that it is not, and our specific claim is that the definition of income is not a rule. in future work we expect to develop our broad claim, but professor kahn‘s article has provided us with an opportunity to test our specific claim, and we believe the test has made our claim stronger. the definition of income is not a rule; it is a standard, and that explains what is taxed and what is not. 78. id. at 925 (article abstract). professor bittker also observed pointedly that ―[a] truly ‗comprehensive‘ base . . . would be a disaster.‖ id. at 982. 79. surrey & warren, tax project, supra note 13, at 775. 80. the growth in the code alone is notable. for example, the cch standard federal tax reporter weighed in at a hefty 73,608 pages of tax law in 2012 — approximately 13,000 more pages than in 2004. federal tax law keeps piling up, cch inc. (2012), http://www.cch.com/wbot2012/wbot_taxlawpileup_ (23)_f.pdf. while this calculation includes more than income tax laws, it nonetheless illustrates the growth in the number of formulations that are easily assumed to be rules because they are contained in a highly articulated statute. in addition, the growth in population, the economy, and technology, have led to significant automation of the tax collection process, and that requires rules, for it is much easier for a machine to determine compliance with a rule than with a standard. for an examination of the effect of using technology in tax administration, see 2 national taxpayer advocate, from tax collector to fiscal automation: demographic history of federal income tax administration , annual report to congress, http://www.irs.gov/pub/irs-utl/irs_tas_arc_2011_vol_2.pdf. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 14 2013 number 4 the de novo doctrine: irrelevant to relevancy in civil tax litigation by michael kummer* 1. introduction ................................... ....... 1 16 ii. the weak precedential underpinnings of the denovo doctrine as a relevancy concept ............ 120 a. origins of the de novo doctrine in tax court................. 120 1. barry v. commissioner........... ........ 121 2. greenberg's express inc. v. commissioner......... 123 b. origins of the de novo doctrine in district courts and the court of federal claims....................... 127 iii. courts struggle to coherently apply the denovo doctrine .............................. ......... 129 a. lpciminelli interests, inc. v. united states .... ...... 130 b. other cases ...................... ............ 132 c. cook v. united states ......................... 133 iv. additional pitfalls with the denovo doctrine as a relevancy standard .......................... 135 a. the de novo doctrine violates well-settled discovery and evidentiary rules ............. ................ 135 b. the de novo doctrine enables the service to withhold from taxpayers materials it has gathered from third parties and deemed relevant to taxpayers' examinations ............................... 138 c. what occurred during the examination, and the service's thoughts, procedures, conclusions, reasoning, or factual findings is often the central issue to be decided .......................... 140 1. estoppel ....................... ..... 141 2. variance ....................... ..... 141 3. shifting the burden ofproof as to factual matters ............................. 142 * associate, bingham mccutchen llp. i am indebted to david curtin for sparking my interest in this topic and thank will nelson and saul mezei for their comments. any errors are mine. 115 florida tax review d. the de novo doctrine as a standard of relevancy is inimical to well-established notions of fundamental fairness. ........................ 144 e. courts are regularly asked to, and increasingly do, decide cases based on deference to the service's thoughts, procedures, conclusions, reasoning, or factual findings ....................... ..... 146 v. conclusion . ...................................... ...... 1 50 i. introduction "a tax case is a de novo proceeding and the thoughts, procedures, conclusions, reasoning, or factual findings of internal revenue service employees about a taxpayer's liability are irrelevant." any attorney who has handled a tax case on a taxpayer's behalf has likely heard this argument, or a variation of it, during the discovery process, during motion practice, or even in the courtroom when attempting to introduce evidence.' many attorneys from the internal revenue service 1. see, e.g., r.e. dietz corp. v. united states, 939 f.2d 1, 4 (2d cir. 1991) ("the factual and legal analysis employed by the commissioner is of no consequence to the district court." (citing nat'l right to work legal def. & educ. found. v. united states, 487 f. supp. 801, 805 (e.d.n.c. 1979))); lpciminelli interests, inc. v. united states, 2012-2 u.s. tax cas. (cch) 50,671, 110 a.f.t.r.2d (ria) 2012-6631, 6633 (w.d.n.y. 2012) ("[t]he factual considerations and legal analysis employed by the audit team during their examination . .. must be deemed 'of no consequence' to the de novo review required in this refund action . . ."); united states v. nordberg, 96-1 u.s. tax cas. (cch) 50,295 at 84,085, 77 a.f.t.r.2d (ria) 96-2158, 96-2160 (d. mass. 1996) ("in light of the principle that a challenge to a tax determination results in a trial de novo rather than a review by this court of an existing administrative record, the defendants' discovery requests fail to satisfy the mandate of fed. r. civ. p. 26(b) that information sought to be discovered by relevant or 'reasonably calculated to lead to the discovery of admissible evidence." (citations omitted)); garity v. united states, 81-2 u.s. tax cas. (cch) 1 9599 at 88,005-06, 46 a.f.t.r.2d (p-h) 80-5143, 80-5145 (e.d. mich. 1980) ("the court holds that the opinions, impressions, conclusions and reasoning of irs agents are irrelevant to the validity of the assessment against plaintiff."); vons companies, inc. v. united states, 51 fed. cl. 1, 5-6 (fed. cl. 2001) ("we begin with the axiomatic principle that tax refund cases are de novo proceedings. . . . as such, this court's determination of plaintiffs tax liability must be based upon the facts and merits presented to the court and does not require (or even ordinarily permit) this court to review findings or a record previously developed at the administrative level." (citation omitted)); int'l paper co. v. united states, 36 fed. cl. 313, 320 116 [vol. 14:4 the de novo doctrine ("service") or department of justice who defend or bring tax cases on the government's behalf have likely asserted some version of the "de novo doctrine." indeed, the service and department of justice commonly raise the de novo doctrine in an attempt to defeat taxpayers' requests to discover or introduce into evidence information about the service's audit or facts and information gathered by the service and contained in its audit file.2 the asserted ground for withholding such information from taxpayers is that none of it is relevant to the court's inquiry, which is to determine the merits of taxpayers' liabilities. if successful, in this context the de novo doctrine is a powerful and broad tool. it is powerful because, if it applies, the de novo doctrine thwarts taxpayers' discovery requests on relevancy grounds, and allows the government to withhold from its adversaries in tax litigation information to which the government has access. the de novo doctrine is broad because, unlike the attorney-client privilege and work product doctrines, courts often apply the de novo doctrine to shield from discovery purely factual information, as well as information that should not typically be discoverable, such as analysis, reasoning, or the service's motives for initiating an examination.3 moreover, because relevant evidence under the discovery and (fed. cl. 1996) ("[t]he factual findings, if any, underlying the commissioner's determination of tax liability are irrelevant and entitled to no evidentiary weight. this position is, of course, fully consistent with the de novo nature of tax refund proceedings in the court of federal claims (as well as in the district courts). . ."); flamingo fishing corp. v. united states, 31 fed. cl. 655, 658 (fed. cl. 1994) ('the opinions, conclusions and reasoning of government officials are not subject to discovery.' ... 'the opinions, impressions, conclusions, and reasoning of irs agents are irrelevant. . . ."' (quotations omitted)). 2. see, e.g., defendant united states of america's motion in limine to exclude certain witness testimony, certain exhibits and all deposition testimony designations as evidence at 3, lpciminelli interests, inc. v. united states, 2012-2 u.s. tax cas. (cch) 1 50,671, 110 a.f.t.r.2d (ria) 2012-6631 (w.d.n.y. 2012) (no. 09-cv-274) [hereinafter motion in limine] ("'the factual and legal analysis employed by the commissioner [in the examination of a taxpayer's return and the assessment of tax] is of no consequence to the district court.' as a result, any witness testimony or documentary evidence which the plaintiff seeks to introduce concerning the actions of the irs during the examination of its tax return and the assessment of tax are not relevant to the fact finder." (citation omitted)); response of the united states to panasonic's motion to compel (§ 6103) at 4-5, panasonic commc'n corp. v. united states, 99 fed. cl. 422 (fed. cl. 2011) (no. 09-793t). 3. see, e.g., r.e. dietz corp., 939 f.2d at 4 ("the factual and legal analysis employed by the commissioner is of no consequence to the district court." (citing nat'l right to work legal def. & educ. found. v. united states, 487 f.supp. 801, 805 (e.d.n.c. 1979))); isi corp. v. united states, 503 f.2d 558, 558 n.3 (9th cir. 1974) (noting the district court refused to require service's agent to answer purely factual questions in deposition, such as "[d]id you make any independent 2013] 117 florida tax review evidentiary rules is defined broadly, any weapon that exempts material from the scope of relevancy can, by its nature, preclude inquiry into a wide range of facts and information. despite the doctrine's advantages, breadth, and the fact that it is regularly asserted, the de novo doctrine has received little discussion among practitioners and scholars. the goal of this article is to help fill this void by examining the de novo doctrine's origins, merits, and vitality as a doctrine of relevancy in tax litigation. as it turns out, courts often struggle to apply the de novo doctrine in a coherent manner and often shield from discovery or introduction factual material that would be otherwise discoverable under any established definition of relevancy. courts fail to distinguish taxpayers genuinely hunting for information that can prove or disprove the merits of the service's determination from recalcitrant taxpayers who seek information about the service's motives or judgment behind initiating an audit or making an adjustment. moreover, the current articulation of the de novo doctrine as a doctrine of relevancy has weak historical and precedential footing. the de novo doctrine arose in cases that expanded, rather than restricted, the scope of inquiry in tax cases. the first opinions to articulate the de novo doctrine did not do so in the relevancy context but, rather, simply explained that in tax cases courts review the merits of the service's determination, rather than its motives or judgment. at some point, however, what had historically been a well-established and uncontroversial standard of review mutated into a standard of relevancy that shields from discovery or introduction into evidence facts and information that might prove or disprove the merits of the service's determination. as explained below, the de novo doctrine's underlying premise that relevancy adequately supports withholding from a taxpayer or a court information the service has itself deemed relevant to the taxpayer's examination is suspect given the broad definitions of relevancy under applicable legal rules, the instances where information in the service's files is directly relevant to issues in tax cases, and well-established notions of fundamental fairness. finally, the de novo doctrine's continued vitality is further undercut by the deference the service and department of justice are increasingly seeking and receiving in tax litigation today. if the service argues that courts should defer to the service's thoughts, procedures, conclusions, reasoning, or factual findings about a taxpayer's liability, perhaps taxpayers and courts should have the opportunity to examine in detail those thoughts, procedures, conclusions, reasoning, or factual findings determination of your own whether the personal property of $300,000 as allocated in the agreement, was in fact worth $300,000 at the date of purchase" and "[a]t any time did you review the contract between isi and miller for the sale of the personal property, the leasehold and the investor records"). 118 [vol. 14:4 the de novo doctrine as applied on a case-by-case basis. at the very least, the de novo doctrine should not preclude such an examination on relevancy grounds. to be clear, this article does not suggest that taxpayers or courts should be given wholesale access to materials and information gathered by the service during an audit or during the pendency of a tax case. the service and the department of justice have in their quivers other privileges to defeat unwarranted disclosures, such as the deliberative process privilege, the attorney-client privilege, and the work product doctrine, each of which stand on stronger precedential and policy footings than the de novo doctrine as a relevancy standard.4 nor does this article suggest that the government or courts should be bound by materials and information gathered or created by the service during an audit, or by statements made by the service during an audit.5 rather, this article concludes that articulating the de novo doctrine as a doctrine of relevancy is misguided based on the cases in which the doctrine arose, well-established evidentiary and discovery principles, and the current state of affairs in tax litigation. in other words, the de novo doctrine is not relevant to relevancy. 4. see, e.g., procter & gamble co. v. united states, 2010-1 u.s. tax cas. 50,146, 105 a.f.t.r.2d 2010-330 (s.d. ohio 2009) (determining that documents related to the service's appraisals of artwork and intellectual property were relevant under fed. r. civ. p. 26(b)(1) over the department of justice's de novo objection, but analyzing deliberative process). 5. see, e.g., boulez v. commissioner, 810 f.2d 209 (d.c. cir. 1987) (refusing to bind the service to an oral compromise agreement between the taxpayer and the service's director of international operations); herbert v. united states, 662 f. supp. 573, 583 (s.d.n.y.1987) (stating that the government is not "bound or estopped by a position taken . . . by one of its employees or agents" (citing heckler v. cmty. health serv., 467 u.s. 51, 59-61 (1984); schweiker v. hansen, 450 u.s. 785, 788-89 (1981) (per curiam))); louderback v. united states, 500 f. supp. 575, 579 (d. colo. 1980) ("[a]n internal revenue service agent does not have authority to make a final determination binding on the government. . . ."); order of dismissal for lack of jurisdiction at 2,_maser v. commissioner, no. 19497-l ls (nov. 29, 2011) ("the law is clear that erroneous legal advice rendered by employees of the irs generally is not binding on the commissioner." (citing dixon v. united states, 381 u.s. 68, 72-73 (1965); schuster v. commissioner, 312 f.2d 311 (9th cir. 1962); fortugno v. commissioner, 41 t.c. 316 (1963), affd 353 f.2d 429 (3d cir. 1965))). see also greene v. commissioner, 55 t.c. memo (cch) 1374, 1376, t.c. memo (p-h) t 88,331 at 88-1640 (1988) ("it is well settled that, where a taxpayer relies to his detriment on an internal revenue service publication, the contents of the publication do not bar respondent from collecting tax lawfully due. while petitioner did not point out the specific language he relied on in the publications, to the extent the publications may have been misleading, authoritative tax law is contained in statutes, regulations, and judicial decisions and not in information publication. internal revenue service publications are merely guides published by the service to aid taxpayers." (citations omitted)). 2013] 119 florida tax review part 1i of this article describes the origins of the de novo doctrine in tax court and in federal district courts and the court of federal claims, which suggest it is unwarranted to apply the doctrine to preclude discovery or introduction of facts and information that might prove the merits of a tax case. part iii of this article examines several recent contexts in which courts have struggled to apply the de novo doctrine in a coherent, justifiable manner to discovery or evidentiary disputes. part iv introduces other problems with applying the de novo doctrine as a doctrine of relevancy that courts have not addressed, including how to reconcile the doctrine with instances in which the service asks courts to defer to its litigating position or when the service assumes a litigating stance that is contrary to the position it took during audit. part v of this article concludes that courts should return to the de novo doctrine's origins and scrap the doctrine as a standard of relevancy in the discovery or evidentiary contexts. an alternative is to establish a principled approach to the de novo doctrine as a relevancy standard that avoids the confusion recent cases have engendered. doing so could prevent costly discovery and evidentiary battles but raises other questions courts should answer. ii. the weak precedential underpinnings of the denovo doctrine as a relevancy concept the de novo doctrine was first articulated as a standard of review whereby courts committed to analyzing anew all of the evidence that illustrated the merits of a taxpayer's tax liability. in the tax court, the federal district courts, and court of federal claims, the doctrine was initially unmoored to any concept of relevancy as a discovery or evidentiary matter and arose in cases that expanded, rather than restricted, the scope of inquiry. a. origins of the de novo doctrine in tax court less than six months after it was created, the board of tax appeals (the predecessor to the tax court) issued what is perhaps its earliest articulation of the de novo doctrine.6 6. the board of tax appeals was created under the revenue act of 1924. see camilla e. watson & brookes d. billman, jr., federal tax practice and procedure: cases, materials and problems 67 (2004) [hereinafter watson & billman, federal tax]. the first members of the board of tax appeals, then an independent agency of the executive branch, were sworn in on july 16, 1924. harold dubroff, the united states tax court: an historical analysis 80 (1979) [hereinafter dubroff, historical analysis]. 120 [vol. 14:4 the de novo doctrine 1. barry v. commissioner in barry v. commissioner, the board overruled the service's objection and enabled a taxpayer to raise for the first time an argument the taxpayer did not raise at the administrative level.' the board stated: when a taxpayer brings his case before the board he proceeds by trial de novo. the record of the case made in the internal revenue bureau is not before the board except in so far as it may be properly placed in evidence by the taxpayer or by the commissioner. the board must decide each case upon the record made at the hearing before it, and, in order that it may properly do so, the taxpayer must be permitted to fully present any questions relating to his tax liability which may be necessary to a correct determination of the deficiency. to say that the taxpayer who brings his case before the board is limited to questions presented before the commissioner, and that the board in its determination of the case is restricted to a decision of issues raised in the internal revenue bureau would be to deny the taxpayer a full and complete hearing and an open and neutral consideration of his case. thus, the de novo doctrine encompasses the idea that courts in deficiency cases do not sit in judgment of the record established by and before the service.9 rather, courts determine taxpayers' liabilities anew based on the evidence introduced by the parties and the merits of the case. ironically, in direct opposition to the government's current articulations of the de novo doctrine as a standard of relevancy, in barry the service argued that the only items germane to the board's determination 7. barry v. commissioner, 1 b.t.a. 156 (1924). 8. id. at 157. 9. in certain non-deficiency cases, however, the tax court's review may be limited to the administrative record established by and before the service. see, e.g., robinette v. commissioner, 439 f.3d 455 (8th cir. 2006) (holding that the tax court erred in deciding that it could consider evidence not in the administrative record in its review of a collection due process hearing); murphy v. commissioner, 469 f.3d 27 (1st cir. 2006) (holding that tax court properly excluded evidence not in the administrative record in its review of a collection due process hearing). but see wilson v. commissioner, ill a.f.t.r.2d (p-h) 2013-522, 531 (9th cir. 2013) ("the text structure, and legislative history of § 6015(e) direct the tax court to proceed de novo when determining whether a taxpayer is eligible for relief under § 6015(f). the tax court therefore did not err in holding a trial de novo and applying a de novo standard of review in this case."). 2013] 121 florida tax review were those considered at the administrative level. the board rejected that argument, but barry does not stand for the converse: that facts and materials developed at the administrative level are never germane to the board's decisions. rather, like other contemporaneous articulations of the de novo doctrine, barry expands the scope of inquiry, rather than contracts it.'0 barry also makes clear that notions of fundamental fairness play a role, as a broad inquiry is necessary to ensure the taxpayer obtains "a full and complete hearing and an open and neutral consideration of his case."" most importantly, barry's creation of the de novo doctrine was entirely independent of any notion of relevancy as an evidentiary or discovery concept. this makes sense, in part because barry articulated the de novo doctrine as a standard of review in tax cases, and standards of review are questions of law distinct from evidentiary and discovery rules. but it also makes sense because the board, which congress renamed the tax court in 1942 and designated as an article i court in 1969,12 had no formal pretrial discovery procedures until 1974, and thus presumably had limited occasion to grapple with relevancy questions in the discovery context.13 however, shortly after the tax court adopted its formal pretrial discovery procedures, it articulated what is today arguably its most widely cited iteration of the de novo doctrine. 10. see also wisconsin butter & cheese co. v. commissioner, 10 b.t.a. 852, 854 (1928) ("on many occasions the board and its members have had occasion, in decisions and otherwise, to point out that the proceeding before it is de novo and that we have before us only such evidence as the parties submit."); martin wunderlich co. v. commissioner, p-h 1952 b.t.a. mem. dec. (p-h) t 52,029, at 52-96 (1952) ("the court admitted into evidence, over objection of respondent, certain documents which petitioner contends represent a binding agreement between the government and petitioners as to the use of the completed contract basis of accounting. this court is given jurisdiction to determine de novo excessive profits, if any, realized by a contractor. being a de novo proceeding, we are not restricted to a review of the administrative steps taken below." (internal citations omitted)); caplan v. commissioner, b.t.a. mem. dec. (p-h) t 40,028 (1940) (quoting barry, 1 b.t.a. at 157). 11. barry, 1 b.t.a. at 157. 12. in 1942, the board changed its name to the tax court of the united states, but maintained a similar jurisdiction and its position as an independent agency within the executive branch. see watson & billman, federal tax, supra note 6, at 67. in 1969, the board "became an article i (united states constitution, article 1, § 8) legislative court of record within the federal judicial system, redesignated the united states tax court." id. 13. see dubroff, historical analysis, supra note 6, at 297-305. 122 [vol. 14:4 the de novo doctrine 2. greenberg's express inc. v. commissioner in greenberg's express inc. v. commissioner,14 the tax court stated: as a general rule, this court will not look behind a deficiency notice to examine the evidence used or the propriety of respondent's motives or of the administrative policy or procedure involved in making his determinations. . . . the underlying rationale for the foregoing is the fact that a trial before the tax court is a proceeding de novo; our determination as to a petitioner's tax liability must be based on the merits of the case and not any previous record developed at the administrative level." greenberg's express cited the de novo doctrine to support its holding that it would decide the validity of the service's determination on the merits, rather than vitiating the determination based on the petitioners' "allegations of discrimination in their selection as objects of an otherwise legitimate tax audit."16 the passage above is consistent with the notions espoused in barry and similar cases: each expresses the de novo doctrine as a standard of review whereby the tax court will itself determine a taxpayer's liability. but, without elaboration, subsequent cases have cited the aforementioned passage to deny on relevancy grounds taxpayers' discovery requests or attempts to introduce evidence.17 these cases confuse distinct 14. greenberg's express inc., v. commissioner, 62 t.c. 324 (1974). 15. id. at 328. 16. id. at 327. the tax court in greenberg's express stated that it "has on occasion recognized an exception to the rule of not looking behind the deficiency notice when there is substantial evidence of unconstitutional conduct on respondent's part and the integrity of our judicial process would be impugned if we were to let respondent benefit from such conduct." id. at 328. 17. see, e.g., united states v. nordberg, 96-1 u.s. tax cas. (cch) 50,295 at 84,085, 77 a.f.t.r.2d (ria) 96-2158, 2160 (d. mass. 1996) ("in light of the principle that a challenge to a tax determination results in a trial de novo rather than a review by this court of an existing administrative record, the defendants' discovery requests fail to satisfy the mandate of fed. r. civ. p. 26(b) that information sought to be discovered by relevant or 'reasonably calculated to lead to the discovery of admissible evidence." (citing lewis v. reynolds, 284 u.s. 281, 283 (1932); ruth v. united states, 823 f.2d 1091, 1094 (7th cir. 1987); greenberg's express, inc. v. commissioner, 62 t.c. at 328)); avedisian v. commissioner, 53 t.c.m. (cch) 503, 505, t.c.m. (p-h) 87,176 at 87-839 (1987); ramsey v. commissioner, 51 t.c.m. (cch) 1247, 1250, t.c.m. (p-h) 86,252 at 86-1073 to 86-1074 (1986) ("specifically, petitioners contend that respondent has not completely disclosed the file compiled by the inspection division in connection with its criminal investigation of petitioner's bribe of agent west nor has he disclosed 2013] 123 florida tax review aspects of the tax court's opinion in greenberg's express, which, in addition to reiterating a commitment to judging the service's determinations on their merits, also denied the petitioners' request for an order impounding documents with the tax court.18 however, a close examination of greenberg's express reveals nothing that supports relevancy objections. the petitioners in greenberg's express were the sons of carlo gambino, an alleged organized crime boss, and several affiliated entities. they alleged that the service discriminatorily selected their returns for examination and, to gather evidence to help prove these claims, moved the tax court under tax court rule 103(a)(10)' 9 to order the service to gather and deliver a number of documents to the court. this was not an ordinary discovery request for specific items in the service's administrative file. rather, the petitioners requested all documents, whether in custody of the service, the department of the treasury, or the attorney general, and their agents, relating to the audit of the petitioners' tax returns or to any investigation of thomas and joseph gambino by the department of justice, the service, or the federal strike force against organized crime in new york city.20 the tax court denied this request. it was unnecessary to issue an impounding order under rule 103(a)(10) because "[t]he custodians of the documents which petitioners seek are already, by virtue of their offices, obligated to preserve any evidence that they know may be relevant to these cases." 21 the court also explained that the petitioners chose the wrong mechanism for their documentary request. the tax court refused to sanction impoundment as "a device for obtaining access to documents which [taxpayers] might be able to obtain by some other available procedures for the production of documents," such as a request for production or subpoena duces tecum.22 after refusing to grant the petitioners' "blanket coverage" discovery request, the tax court also held that, even if such documents revealed certain receipts, memoranda and cancelled checks relied on by agent stephens to prepare his examination report. petitioners contend that this evidence is necessary to establish the basis for respondent's notice of deficiency. for the reasons stated above, however, this court will not look behind respondent's deficiency notice, and, therefore, any evidence concerning the basis for respondent's determination is not relevant to the disposition of the instant case."). 18. greenberg's express, 62 t.c. at 325-27. 19. according to the tax court in greenberg's express, "rule 103(a)(10) permits the issuance of an order, 'that documents or records be impounded by the court to insure their availability for purposes of review by the parties prior to trial and use at the trial."' id. at 326 n.3. 20. id. at 325-26. 21. id. at 326. 22. id. at 327. 124 [vol. 14:4 the de novo doctrine discriminatory selection of petitioners' returns for audit, the tax court would not have been justified in declaring the service's determination null and void.23 rather, it would examine the merits of the determination. it was in this specific context that greenberg's express reaffirmed the tax court's commitment to deciding tax liabilities de novo. however, subsequent courts have confused the two aspects of the opinion in greenberg's express and cite the de novo standard of review as support for denying narrow discovery requests on relevancy grounds. there are several flaws in such an extension of greenberg's express. first, in greenberg's express, the tax court did not refuse to issue the impounding order based on relevance. in fact, the converse is true. the court refused to grant the order because (1) the government was otherwise "obligated to preserve any evidence which [it] know[s] may be relevant to these cases,"24 and (2) the taxpayers should have requested such evidence by other (recently established) pretrial discovery procedures as opposed to a draconian impounding order.2 5 the tax court presumed the agencies from which the petitioners sought documents had at least some evidence in their files relevant to the determination of the petitioners' tax liabilities and noted that evidence should be preserved even if it might be relevant to those determinations. moreover, perhaps to facilitate future information gathering, the tax court even advised taxpayers to "give careful attention to developing a more precise description of the materials which they may seek."26 second, as noted above, greenberg's express was decided shortly after the tax court adopted its first set of formal, pretrial discovery procedures, which, although not as broad as discovery under the federal rules of civil procedure, defined relevancy broadly and, according to the tax court, liberally. 27 it would have been incongruous for the court to enact 23. id. 24. id. at 326. 25. id. at 326-27. 26. id. at 327. in fairness, by characterizing the scope of petitioners' requested order "blanket coverage," the court suggested (but did not decide) that some evidence gathered by the various investigative agencies from which the petitioners sought documents would be irrelevant to determining petitioners' tax liabilities for the years at issue. id. this makes sense, however, because the scope of the requested documents included "any investigation of petitioners thomas gambino and joseph gambino by the department of justice, the internal revenue service, or the federal strike force against organized crime operating in new york city." id. at 32526. it is hard, if not impossible, to imagine how some of the information gathered by these agencies would be relevant to tax liabilities of these and other individuals and affiliated entities for three, specific federal income tax years. 27. zaentz v. commissioner, 73 t.c. 469, 471-72 (1979) ("for purposes of discovery, the standard of relevancy is liberal. rule 70(b) permits discovery of 2013] 125 florida tax review a liberal standard of relevancy and then immediately curtail that standard in a case where relevancy objections were not at issue. indeed, relevancy objections were at issue in a case decided the same year as greenberg's express, and there the tax court reaffirmed the breadth of relevancy in the pretrial discovery context.28 third, greenberg's express fits comfortably within the tax court's prior and well-settled articulations of the de novo standard of review, beginning with barry. for greenberg's express (and barry), the de novo doctrine holds that courts in tax cases do not sit in judgment of the record established administratively by the service but, instead, apply a merit-based determination of taxpayers' liabilities based on the evidence introduced by the parties. distinguishing between the proper mechanism for obtaining evidence to prove a proper tax liability, on the one hand, and the de novo doctrine, on the other, is consistent with earlier cases whose articulations of this standard of review are distinct from any notion of relevancy or other discovery or evidentiary concepts. moreover, by suggesting that the service or the taxpayer can place some materials in the service's administrative files into evidence, greenberg's express and the tax court's earlier cases consistently presume that such materials can be relevant to cases before the court.2 9 reading greenberg's express as a drastic departure from this lineage, as modem cases have, is going too far. information relevant not only to the issues of the pending case, but to the entire 'subject matter' of the case. we have previously ruled that material which would aid the discovering party in understanding relevant material, or which would lead to admissible evidence, is within the scope of rule 70(b)."). but see estate of woodward v. commissioner, 64 t.c. 457, 459 (1975) ("discovery in the tax court is new and, although many of our rules were adopted from the federal rules of civil procedure, discovery is not as broad in the tax court as it is in the federal district courts. for example, discovery depositions are not available in the tax court."). 28. p.t. & l. constr. co. v. commissioner, 63 t.c. 404, 413-14 (1974) ("some of the material respondent has objected to, such as the table of contents to the special agent's report, while not directly relevant to any fact that may be established at trial, would aid the reader in understanding the material that we hold is subject to discovery. as such, it is relevant, albeit in a derivative sense.. . . finally, we emphasize most strongly that the basic purpose of discovery is to reduce surprise by providing a means for the parties to obtain knowledge of all the relevant facts. what is relevant is the factual information which may either reveal evidence that will be admissible at the trial or lead to the discovery of such evidence."). 29. see caplan v. commissioner, b.t.a. mem. dec. (p-h) 40,028 (1940) ("the record of the case made in the internal revenue bureau is not before the board except insofar as it may be properly placed in evidence by the taxpayer or by the commissioner."). 126 [vol. 14:4 the de novo doctrine b. origins of the de novo doctrine in district courts and the court of federal claims in federal district courts and the court of federal claims, the de novo doctrine appears to have its roots in lewis v. reynolds,3 0 a seminal 1932 supreme court opinion. however, while lewis is the earliest case these courts commonly cite when discussing the de novo doctrine,3 lewis does not stand for the proposition that the discovery of, or introduction of, evidence should be restricted. in fact, like barry, lewis expanded the scope of review, rather than restricted it, and said nothing about relevancy in the evidentiary or discovery context. at issue in lewis was whether the service could offset a refund, on which the statute of limitations had not expired, with a deficiency from the same year, on which the statute of limitations had expired. in lewis, the service audited the final tax return of a decedent's estate, disallowed certain deductions, and assessed a $7,297.16 deficiency. the decedent's estate paid the assessed deficiency and requested a refund. nearly three years later, the service refused payment, citing other improper deductions for the same year that, if they had been disallowed in the first instance, would have caused an even bigger deficiency. in a concise opinion which upheld the service's refusal to issue a refund, lewis established the rule that: an overpayment must appear before a refund is authorized. although the statute of limitations may have barred the 30. 284 u.s. 281 (1932). 31. see, e.g., gen. motors corp. v. united states, 75 fed. r. serv. 3d 828 (e.d. mich. 2009) ("tax refund cases are de novo proceedings." (citing lewis, 284 u.s. at 283)); united states v. nordberg, 96-1 u.s. tax cas. (cch) t 50,295 at 84,085, 77 a.f.t.r.2d (ria) 96-2158, 96-2160 (d. mass. 1996) ("in light of the principle that a challenge to a tax determination results in a trial de novo rather than a review by this court of an existing administrative record, the defendants' discovery requests fail to satisfy the mandate of fed. r. civ. p. 26(b) that information sought to be discovered by relevant or 'reasonably calculated to lead to the discovery of admissible evidence." (citing lewis, 284 u.s. at 283 (1932))); armtek corp. v. united states, 78 a.f.t.r.2d 96-5266, 96-5268 (w.d.n.y. 1996) ("it is the government's position that the opinions and conclusions of the irs are not relevant to the court's de novo determination of the applicable tax. (citing lewis, 284 u.s. at 283)); fowler v. united states, 89 a.f.t.r.2d (ria) 2002-2736 (fed. cl. 2002); vons companies, inc. v. commissioner, 51 fed. cl. 1, 6 (fed. cl. 2001) ("we begin with the axiomatic principle that tax refund cases are de novo proceedings." (citing lewis v. reynolds, 284 u.s. 281, 283 (1932))). see also r.e. dietz corp. v. united states, 939 f.2d 1 (2d cir. 1991); litman v. united states, 78 fed. cl. 90, 107 (fed. cl. 2007); cook v. united states, 46 fed. cl. 110, 116 (fed. cl. 2000). 2013] 127 florida tax review assessment and collection of any additional sum, it does not obliterate the right of the united states to retain payments already received when they do not exceed the amount which might have been properly assessed and demanded.32 courts regularly cite lewis for the well-established proposition that a plaintiff seeking a refund of taxes has the burden of proving that she is in fact entitled to a refund (e.g., that an overpayment actually exists in a given tax year).33 however, in the discovery or evidentiary context, some courts have cited lewis for the proposition that facts developed by the service are irrelevant in de novo proceedings.34 such an extension of lewis is unwarranted for several reasons. first, lewis expanded the scope of relevant facts in trials of refund actions. under lewis, courts must look at all of the items in a taxpayer's tax year even those for which adjustments are barred by the statute of limitations to determine whether a refund is justified. second, lewis held nothing about relevancy as a discovery or evidentiary matter. lewis simply established a standard of review in refund actions, much like barry and greenberg's express did in deficiency cases. relying on the case to support decisions about relevancy in the discovery or evidentiary context is misguided. finally, lewis' only reference to evidence was to a letter from the service to the petitioners that stated additional deductions had been improperly allowed and provided a revised computation of the petitioners' tax liability for the year at issue. the supreme court noted that the letter was "introduced in evidence by [petitioners]," noted that the lower courts upheld the service's determination reflected in the letter, and affirmed the lower courts' decisions. lewis itself thus relied on facts and conclusions that were developed and established at the administrative level and introduced into the evidentiary record. citing the case to preclude the discovery or introduction of such facts is incongruous. the historical origins of the de novo doctrine in the tax court and the federal district courts and the court of federal claims illustrates the weaknesses in applying the de novo doctrine to enable the service and department of justice to withhold information from taxpayers on relevancy grounds. in addition to, and perhaps because of, the de novo doctrine's weak precedential underpinnings in the evidentiary and discovery context, courts 32. lewis, 284 u.s. at 283. 33. see, e.g., williams-russel & johnson, inc. v. united states, 371 f.3d 1350 (11th cir. 1994); decker v. korth, 219 f.2d 732 (10th cir. 1955); bachner v. commissioner, 109 t.c. 125 (1998). 34. see supra note 31. 35. lewis, 284 u.s. at 282. [vol. 14:4128 the de novo doctrine often apply the doctrine inconsistently in those arenas, a problem to which this article now turns. iii. courts struggle to coherently apply the de novo doctrine as noted above, the de novo doctrine arose as a standard of review courts apply when determining taxpayers' tax liabilities. specifically, it embodies the idea that courts must base their determinations on all of the facts pertinent to taxpayers' liabilities for the year at issue, rather than "looking behind" the adjustment to miscellaneous factors such as the service's motives or reasons for initiating an audit or making an adjustment." in contrast to facts surrounding the service's deficiency determination, these miscellaneous factors do not bear on the merits of taxpayers' tax liabilities. at some point, however, courts began citing the doctrine in the discovery or evidentiary context for the proposition that the factual findings, thoughts, procedures, conclusions, or reasoning of service employees about a taxpayer's liability are irrelevant.37 to say that facts, thoughts, reasoning, or conclusions obtained or reached by the service are privileged and not discoverable is one thing. to say that such information is irrelevant is an entirely different matter, especially because the standard of review in tax cases is distinct from other legal questions such as the discovery or admissibility of evidence. as noted below, courts often fail to draw these distinctions and, as a result, apply the de novo doctrine inconsistently. 36. it is worth noting that even this well-established rule has exceptions. see clapp v. commissioner, 875 f.2d 1396, 1402 (9th cir. 1989) ("only where the notice of deficiency reveals on its face that the commissioner failed to make a determination is the commissioner required to prove that he did in fact make a determination." (citing campbell v. commissioner, 90 t.c. 110 (1988))); scar v. commissioner, 814 f.2d 1363 (9th cir. 1987); frazier v. commissioner, 91 t.c. 1, 9-10 (1988) ("where, however, there is substantial evidence of unconstitutional conduct by respondent in connection with the deficiency determined, we have, as an exception on occasion, 'looked behind the notice of deficiency."' (citations omitted)). 37. see, e.g., r.e. dietz corp. v. united states, 939 f.2d 1, 4 (2d cir. 1991) ("the factual and legal analysis employed by the commissioner is of no consequence to the district court." (citing nat'l right to work legal def. & educ. found. v. united states, 487 f.supp. 801, 805 (e.d.n.c. 1979))); united states v. nordberg, 96-1 u.s. tax cas. (cch) 50,295, 77 a.f.t.r.2d (ria) 96-2158 (d. mass. 1996); katz v. united states, no. 91-5623, 1992 u.s. dist. lexis 7394, at *2-3 (e.d. pa. may 6, 1992); garity v. united states, 81-2 u.s. tax cas. (cch) 1 9599, 46 a.f.t.r.2d (p-h) 80-5143 (e.d. mich. 1980); flamingo fishing corp. v. united states, 22 cl. ct. 625, 629 (1991). 2013] 129 florida tax review a. lpciminelli interests, inc. v. united states lpciminelli interests, inc. v. united states,38 a 2012 decision of the federal district court for the western district of new york, illustrates the difficulties courts face in applying the de novo doctrine. in lpciminelli, the service examined a corporation's 2004 consolidated income tax return for compliance with the consolidated return rules' excess loss account ("ela") provisions and with the code's cancellation of indebtedness ("cod") provisions. during the audit, the service found the corporation complied with the ela provisions but found that the corporation had $3.5 million of unreported cod income.39 after lpciminelli paid the additional tax and sued for a refund, the department of justice determined that the service's position was erroneous, conceded that the corporation had no cod income, and argued that lpciminelli failed to report an equivalent amount of income from its ela.40 during litigation, lpciminelli deposed david throm, one of the service's agents, and obtained several emails, draft notices of proposed adjustments, "and other documents pertaining to the facts considered and matters pursued by the audit team, which included mr. throm's supervisor kathleen oswald and irs attorney matthew root."4a when lpciminelli sought to introduce pieces of this evidence at trial, the service filed a motion in limine to preclude such evidence arguing that "any testimony or documentary evidence concerning the actions of irs employees involved in the audit is of no relevance to the court in its role as the finder of fact as to the propriety of the tax assessment." 42 the court agreed with the service, holding that "[t]he factual and legal analysis employed by the commissioner is of no consequence to the district court"43 and that "trial courts called upon to conduct de novo review of the commissioner's assessment of tax liability have declined, on relevance grounds, to consider evidence regarding irs agents' underlying opinions, impressions, conclusions, and reasoning for their administrative 38. lpciminelli interests, inc. v. united states, 2012-2 u.s. tax cas. (cch) 150,671, 110 a.f.t.r.2d (ria) 2012-6631 (w.d.n.y. 2012). 39. id. 2012-2 u.s. tax cas. (cch) at 87,220, 110 a.f.t.r.2d (ria) at 6633. 40. id. 2012-2 u.s. tax cas. (cch) at 87,220-2 1, 110 a.f.t.r.2d (ria) at 6633. 41. id. 2012-2 u.s. tax cas, (cch) at 87,221, 110 a.f.t.r.2s (ria) at 6633. 42. id. 2012-2 u.s. tax cas. (cch) at 87,221, 110 a.f.t.r.2d (ria) at 6633-34. 43. id. 2012-2 u.s. tax cas. (cch) at 87,222, 110 a.f.t.r.2d (ria) at 6634. 130 [vol. 14:4 the de novo doctrine determinations."44the court granted the service's motion in limine on relevancy grounds and refused to consider "the factual considerations and legal analysis employed by the audit team. . .. to determine the merits of the case, however, the court relied heavily on a document "which was prepared by the irs [in] connection with the audit of lpciminelli's 2004 tax return, [and provided] an accurate summary of [lpciminelli's subsidiary's] assets, liabilities, income, and expenses during the period from 1999 through 2 0 0 3 .'a6 this document was not subject to the service's motion in limine, despite the fact that it contained the service's underlying factual and legal analysis.47 moreover, in support of its conclusion that lpciminelli did not violate the ela anti-avoidance rule or recognize ela income, the court stated "the irs examined the matter and chose not to assess tax based on any realized ela income. instead, the irs directed lpciminelli to pay tax on cod income for tax year 2004."48 thus, at the same time the court was rejecting evidence as irrelevant because it included factual considerations and legal analysis employed by the audit team, the court was accepting as relevant and relying on factual considerations and legal analysis employed by the audit team. lpciminelli is devoid of any apparent legal justification for such a distinction. additionally, the court and parties considered the factual considerations and legal analysis employed by the audit team relevant for purposes of discovery, as lpciminelli deposed the service's agent assigned to the case and obtained emails, draft notices, and other documents from the service's audit team. but the court did not distinguish relevancy for purposes of federal rules of civil procedure 26(b)(1) ("frcp"), which governs discovery, from relevancy for purposes of federal rules of evidence 401, which governs trial 44. id. 2012-2 u.s. tax cas. (cch) at 87,222, 110 a.f.t.r.2d (ria) at 6634. 45. id. 2012-2 u.s. tax cas. (cch) at 87,222, 110 a.f.t.r.2d (ria) at 6634. 46. id. 2012-2 u.s. tax cas. (cch) at 87,224, 110 a.f.t.r.2d (ria) at 6636. 47. the service and lpciminelli apparently stipulated that the document and its factual and legal analysis were admissible. see id. however, "it is axiomatic that the litigants cannot stipulate the court into error" with respect to evidentiary matters. see exxon corp. v. united states, 45 fed. cl. 581, 692 (fed. cl. 1999). see also kaminer constr. corp. v. united states, 488 f.2d 980, 988 (ct. cl. 1973); dillon, read & co., inc. v. united states, 875 f.2d 293, 300 (fed. cir. 1989). thus, the fact that the parties stipulated the document was relevant (and admissible) does not control whether it was in fact. the court's reliance on the document in lpciminelli suggests it determined the document was relevant and otherwise admissible. 48. lpciminelli interests, inc., 2012-2 u.s. tax cas. (cch) at 87,225, 110 a.f.t.r.2d (ria) at 6637. 2013] 131 florida tax review admissibility. moreover, for better or worse, courts have applied the de novo doctrine as a doctrine of relevancy for both discovery and evidentiary 49 purposes, so lpciminelli's application appears to be a misapplication of a misguided doctrine. b. other cases lpciminelli is not alone in its confusing application of the de novo doctrine as a relevancy standard. other cases inconsistently apply the de novo doctrine when faced with discovery or evidentiary disputes. some cases deny on relevancy grounds taxpayers' attempts to discoverso or introduces" factual materials in addition to materials containing the service's thoughts, impressions, or opinions. other cases, however, have allowed taxpayers to discover52 or introduce53 materials contained in the service's administrative file. 49. see infra notes 50-51. 50. see, e.g., isi corp. v. united states, 503 f.2d 558 (9th cir. 1974) (noting that district court may have erred in refusing to require service's agent to answer purely factual questions in deposition); united states v. nordberg, 96-1 u.s. tax cas. (cch) t 50,295, 77 a.f.t.r.2d (ria) 96-2158 (d. mass. 1996); garity v. united states, 81-2 u.s. tax cas. (cch) 9599 at 88,005; 46 a.f.t.r.2d (p-h) 805143, 5145 (e.d. mich. 1980) (refusing to require production of "documents relating to the assessment or collection of federal withholding taxes;" although taxpayer argued that the reasoning of the service was relevant to whether the assessment was an abuse of discretion, the court did not address the fact that the documents may have contained factual data relevant to the amount of the assessment itself); flamingo fishing corp. v. united states, 22 cl. ct. 625, 629 (1991). 51. see, e.g., katz v. united states, no. 91-5623, 1992 u.s. dist. lexis 7394, at *2-3 (e.d. pa. may 6, 1992). 52. see, e.g., big ernie's inc. v. united states, 104 a.f.t.r.2d (ria) 20096218 (e.d. va. 2009); beresford v. united states, 123 f.r.d. 232, 235 (e.d. mich. 1988) ("[i]nformation relied upon by the government in making its valuation is directly relevant to plaintiffs ability to challenge that valuation in this proceeding."); simons-eastern co. v. united states, 55 f.r.d. 88 (n.d. ga. 1972); timken roller bearing co. v. united states, 38 f.r.d. 57, 62 (n.d. ohio 1964) (holding that the discovery rules permit "discovery of a defensive claim as well; the requested items may relate to the defense which the government may offer"); memorandum for counsel, black and decker corp. v. united states, 219 f.r.d. 87 (d. md. 2004) (no. wdq-02-2070) (enabling depositions of two service officials because the service took a position allegedly inconsistent with public pronouncements it made); jade trading, llc v. united states, 65 fed. cl. 487 (fed. cl. 2005). 53. see, e.g., hudspeth v. commissioner, 914 f.2d 1207, 1214 (9th cir. 1990) (holding that tax court's determination that service's agent's data was irrelevant was erroneous; evidence was relevant and admissible to show bias); d'angelo v. united states, 2009-1 u.s. tax. cas. (cch) 50,273, 103 a.f.t.r.2d 132 [vol. 14:4 the de novo doctrine still other cases discuss the de novo doctrine in a manner that closely adheres to the doctrine's origins; these cases are difficult to reconcile with other modem views of the doctrine as a relevancy standard.54 c. cook v. united states for instance, in cook v. united states, the service lost all but select portions of the taxpayer's administrative file.55 regarding the standard of review it should apply to the service's assessment, the court stated that "[i]n tax refund suits, factual issues are tried de novo in this court, with no weight given to subsidiary factual findings made by the service in its internal administrative proceedings."5 6 it is worth noting that cook's precise language that factual findings made by the service are given no weight by trial courts is separate from a comment on the discoverability or admissibility of such factual findings." a fundamental precept of evidentiary rules is that the weight of evidence is distinct from the admissibility of that evidence.58 thus, cook's recitation of the de novo doctrine says nothing about whether the court would admit into the trial record the service's administrative factual findings. in fact, cook suggests that the service's administrative files are generally subject to discovery on relevancy grounds. the court admonished (ria) 2009-1296 (s.d. fla. 2009) (denying motion in limine to preclude calling service witnesses at trial to question their administrative determination); haag v. commissioner, 88 t.c. 604, 622 n.14 (1987) (admitting into evidence over the service's objection a thirty day letter and revenue agent's report to identify the basis for the service's deficiency determination), aff'd, 855 f.2d 855 (8th cir. 1988); order: the court directs the parties to confer and attempt to reach agreement regarding the form of a judgment consistent with the determinations in this order and trinity 1, trinity indus., inc. v. united states, no. 3:06-cv-00726, at 6 n.2 (n.d. tex. may 11, 2012) ("it appears to the court that the rar is admissible evidence under the party opponent exception to the hearsay rule. thus, while certainly not binding on the government, the rar statement is competent evidence and the court has considered it as such."). 54. see, e.g., litman v. united states, 78 fed. cl. 90, 107 (fed. cl. 2008); cook v. united states, 46 fed. cl. 110 (fed. cl. 2000). 55. cook, 46 fed. cl. at 110. 56. id. at 113. 57. see, e.g., builders steel co. v. commissioner, 179 f.2d 377, 380 (8th cir. 1950) (reversing tax court's opinion for failure to allow evidence and noting "[w]e think that the trial judge in this case confused the question of the admissibility of evidence with its weight. evidence as to value may be admissible, although of little weight."); gilford v. commissioner, 88 t.c. 38, 54 n.18 (1987) ("the facts presented by these documents go to the weight of the evidence, not its admissibility."). see also ziskie v. mineta, 547 f.3d 220, 225-26 (4th cir. 2008). 58. see supra note 57. 2013] 133 florida tax review the service for its inability to locate the taxpayer's administrative file, and stated "this court believes that the service has a particular responsibility to ensure that files needed for litigation are preserved and timely made available to the justice department and, upon proper discovery request, to plaintiffs." 9 although relevancy was not at issue in cook, the court, like barry, greenberg's express, and lewis, implied that documents in the service's administrative file would be responsive to a taxpayer's discovery request. the distinctions between these cases do not appear to be founded on a principled, or even an identifiable, application of a relevancy standard to each case's unique circumstances. nor do these cases routinely distinguish facts the service has gathered from taxpayers and third parties that might support or contradict the service's assessment, from materials that purely reflect the service's thoughts, impressions, opinions, or motives for beginning an examination or making an adjustment.60 trial courts, tasked with judging the merits of deficiencies de novo, generally do not consider the latter, which might also be shielded from discovery on grounds such as work product, attorney-client privilege, or deliberative-process privilege. it is difficult to see how the former, however, would be irrelevant under even the most restrictive definition of relevancy in the discovery and evidentiary contexts. the inconsistent manner in which courts have applied the de novo doctrine as a standard of relevancy suggests that courts should either dispose of the de novo doctrine as a relevancy standard or articulate a more principled, clear, and uniform approach. either option would help eliminate costly discovery and evidentiary battles and facilitate the speedy, inexpensive, and extrajudicial determination of tax controversies, which are goals of courts' discovery rules to begin with.6 ' either way, courts should be mindful of several additional problems with the de novo doctrine as a standard of relevancy. 59. cook, 46 fed. cl. at 120. 60. but see big ernie's, 104 a.f.t.r.2d at 2009-6218; armtek corp. v. united states, 78 a.f.t.r.2d 96-5266, 5267-68 (w.d.n.y. 1996); simons-eastem co. v. united states, 55 f.r.d. 88 (n.d. ga. 1972). 61. tax ct. r. 1(d) ("the court's rules shall be construed to secure the just, speedy, and inexpensive determination of every case."); fed. r. civ. p. 1 ("[these rules] should be construed and administered to secure the just, speedy, and inexpensive determination of every action and proceeding."). 134 [vol. 14:4 the de novo doctrine iv. additional pitfalls with the de novo doctrine as a relevancy standard part ii discussed the fundamental problem with articulating the de novo doctrine as a relevancy standard: such an articulation has no apparent legal justification. none of the cases to first articulate the de novo doctrine were cases in which relevancy was at issue, and they either expanded the scope of inquiry or presumed information obtained by the service or other government agencies was relevant to the issues at hand. part iii explained that courts inconsistently apply the de novo doctrine as a relevancy concept and have failed to draw important, principled distinctions that might facilitate extrajudicial resolution of future discovery disputes. as noted below, there are other problems with reading the de novo doctrine as a standard of relevancy such as a fundamental inconsistency with the broad scope of relevancy in the discovery and evidentiary context. a. the de novo doctrine violates well-settled discovery and evidentiary rules frcp 26(b)(1) establishes the scope of discovery for tax refund suits in district courts. under frcp 26(b)(1), unless otherwise limited by a court order: parties may obtain discovery regarding any nonprivileged matter that is relevant to any party's claim or defense including the existence, description, nature, custody, condition, and location of any documents or other tangible things and the identity and location of persons who know of any discoverable matter. for good cause, the court may order discovery of any matter relevant to the subject matter involved in the action. relevant information need not be admissible at the trial if the discovery appears reasonably calculated to lead to the discovery of admissible evidence.62 although the 2000 amendments to frcp 26(b)(1) narrowed the scope of discovery from its prior focus on relevance to the subject matter of the suit to encompass material relevant to the claims or defense of any 62. fed. r. clv. p. 26(b)(1) (emphasis added). the corollary in the rules of the united states court of federal claims, r. ct. fed. cl. 26(b)(1), parallels the structure and content of frcp 26(b)(1). see r. ct. fed. cl. 26(b)(1); r. ct. fed. cl. 26 rules committee notes, 2002 revision. 2013] 135 florida tax review party,63 federal district courts still "must employ a liberal discovery standard in keeping with the spirit and purpose of the discovery rules," 64 which are to be "construed and administered to secure the just, speedy, and inexpensive determination of every action and proceeding."65 unlike the frcp, the tax court's rules enable discovery of any information relevant to the subject matter of the case. tax court rule 70(b) states that: the information or response sought through discovery may concern any matter not privileged and which is relevant to the subject matter involved in the pending case. it is not ground for objection that the information or response sought will be inadmissible at the trial, if that information or response appears reasonably calculated to lead to discovery of admissible evidence, regardless of the burden of proof involved. if the information or response sought is otherwise proper, it is not objectionable merely because the information or response involves an opinion or contention that relates to fact or to the application of law to fact.66 under frcp 26(b)(1) and tax court rule 70(b), the basic purpose of discovery is to reduce surprise and enable the parties to evaluate and resolve their dispute by providing a means for the parties to obtain 67knowledge of all the relevant facts. in determining whether evidence is relevant, which party bears the burden of proof in the matter is of no consequence, since parties may obtain discovery of matters relating to any party's claim or defense.6' hence, a claim that factual material obtained by 63. see 6 james wm. moore et al., moore's federal practice 26.41(6)(c) (3d ed. 1999). 64. wrangen v. pa. lumbermans mut. ins. co., 593 f. supp. 2d 1273, 1278 (s.d. fla. 2008) (citing graham v. casey's gen. stores, 206 f.r.d. 251, 253 (s.d. ind. 2002); white v. kenneth warren & son, ltd., 203 f.r.d. 364, 366 (n.d. ill. 2001)). 65. fed. r. civ. p. 1. 66. tax ct. r. 70(b). 67. erskine v. consol. rail corp., 814 f.2d 266, 272 (6th cir. 1987); nutt v. black hills stage lines, inc., 452 f.2d 480, 483 (8th cir. 1971) ("the federal discovery rules were designed to provide each party with the fullest pre-trial knowledge of the facts and to clarify and narrow the issues to be tried."); p.t. & l. construction co. v. commissioner, 63 t.c. 404 (1974) (discussing discovery under tax court rule 70(b)). see also 6 moore et al., supra note 63, at 1 26.02. 68. fed. r. civ. p. 26(b)(1). see also tax ct. r. 70(b)(1) ("it is not ground for objection that the information or response sought will be inadmissible at the trial, 136 [vol. 14:4 the de novo doctrine the service is irrelevant because taxpayers must prove the service's determination is incorrect or prove their entitlement to a refund is unfounded. nor is information irrelevant for discovery because it would be inadmissible at trial.69 thus, information may be discoverable even if, under the federal rules of evidence, it would be cumulative, would waste time or might mislead the jury,7 0 is hearsay,n describes compromise offers or 72 7negotiations, is evidence of insurance against liability, cannot be authenticated,74 or is irrelevant under the federal rules of evidence. like its counterpart in the discovery rules, the definition of relevancy under evidentiary rules is itself a broad standard. the federal rules of evidence govern the admissibility, rather than the discovery, of evidence in federal civil trials and in the tax court. under federal rule of evidence 401: evidence is relevant if: (a) it has any tendency to make a fact more or less probable than it would be without the evidence; and (b) the fact is of consequence in determining the action.7 in tax cases, trial courts are given significant discretion to determine the scope of relevancy, and regularly interpret the term broadly. if that information or response appears reasonably calculated to lead to discovery of admissible evidence, regardless of the burden ofproof involved." (emphasis added)). 69. fed. r. civ. p. 26(b)(1); tax ct. r. 70(b)(1). 70. see fed. r. evid. 403. 71. see fed. r. evid. 802. 72. see fed. r. evid. 408(a). 73. see fed. r. evid. 411. 74. see fed. r. evid. 901. 75. the tax court follows the federal rules of evidence as adopted by the u.s. district court for the district of columbia for non-jury trials. tax ct. r. 143(a); i.r.c. § 7453. 76. fed. r. evid. 401 (emphasis added). 77. see, e.g., kalo v. commissioner, 98-2 u.s. tax cas. t 50,514, 85,14243, 81 a.f.t.r.2d 98-2266, 2269-71 (6th cir. 1998); robinette v. commissioner, 123 t.c. 85, 103-04 (2004), rev'd, 439 f.3d 455 (8th cir. 2006); estate of gilford v. commissioner, 88 t.c. 38, 53-54 (1987); karme v. commissioner, 73 t.c. 1163, 1178-80 (1980). see also procter & gamble co. v. united states, 2010-1 u.s. tax cas. 50,146, 83,196, 105 a.f.t.r.2d 2010-330, 332 (s.d. ohio 2009) (construing fed. r. civ. p. 26(b)(1)); vons cos., inc. v. united states, 51 fed. cl. 1, 19 (2001) ("indeed, the language establishing what is 'relevant evidence' under the federal rules of evidence is quite different and certainly much broader than the 'directly related' language in section 6103(h)(4)(b) a difference which the legislative history of the latter provision indicates should not be overlooked."). 2013] 137 florida tax review however, in contravention of the broad scope of relevancy under these rules, applying the de novo doctrine as a standard of relevancy potentially exempts from discovery or introduction into evidence a wide range of facts gathered and developed by the service. such an application of the de novo doctrine also contravenes the tax court's rules, which, in addition to purely factual information, allow discovery of information that "involves an opinion or contention that relates to fact or to the application of law to fact."78 as noted below, the service regularly obtains such information from sources other than the taxpayer, and discovery requests are often the quickest and least expensive way for taxpayers to obtain such information. b. the de novo doctrine enables the service to withhold from taxpayers materials it has gathered from third parties and deemed relevant to taxpayers' examinations the service regularly contacts and obtains information from third parties as part of its examination process, both informally and using the summons process.79 taxpayers are generally entitled to notice of this information gathering when summons are issued,80 and in the third-party contact context, when the contact: "(1) is initiated by [a service] employee; (2) is made to a person other than the taxpayer; (3) is made with respect to the determination or collection of [a] tax liability of [the] taxpayer; (4) discloses the [taxpayer's] identity . . .; and (5) discloses the association of the [service] employee with the [service]."8 in other contexts, however, taxpayers are not entitled to notice that the service has gathered materials from third parties to assist the service in its examination.82 in addition, the service occasionally gathers or obtains information about other taxpayers to be used as evidence that might prove or disprove issues to be decided in the 83 taxpayer's case. 78. tax ct. r. 70(b). 79. see i.r.c. § 7602; irm 4.11.57 (jan. 15, 2005). 80. i.r.c. § 7609(a)(1). 81. reg. § 301.7602-2(b). 82. for instance, the service is not required to give notice to the taxpayer if its third-party contacts are outside of any of the four criteria noted above. see reg. § 301.7602-2(b). the service also need not give notice to any contacts authorized by the taxpayer "if the [service] determines for good cause . . . that such notice would jeopardize collection of any tax" or "involve reprisal against any person," or "with respect to pending . . . criminal investigation[s]." see i.r.c. § 7602(c)(3). the service also need not provide taxpayers with notice of its service of third-party summonses in various instances. see i.r.c. § 7609(c)(2). 83. see, e.g., i.r.c. § 7491(b) (allocating to the service the burden of proof with respect to individuals' incomes that are reconstructed by the service "solely 138 [vol 14:4 the de novo doctrine use of the summons or examination process itself is contingent on the information sought by the service being "relevant or material to such inquiry."84 additionally, in the context of maintaining taxpayer confidentiality, the code defines taxpayer "return information" to encompass any information received by, collected by, or furnished to the service "with respect to the determination of the existence, or possible existence, of [the taxpayer's] liability."85 thus, in each of these situations, the material the service's third-party inquiries yield is relevant to the service's examination of the taxpayer. to then argue that, under the de novo doctrine, such facts and information are not relevant because they were gathered by (and found relevant by) the service makes no sense, especially because the de novo doctrine's origins provide no justification for doing so. moreover, in some instances a discovery request might be the only reasonable manner in which the taxpayer can access the facts and information gathered by the service." in the third-party contact context, the regulations typically entitle taxpayers to pre-contact notice of potential third party contacts and post-contact reports of the individuals contacted, but not to information "such as the nature of the inquiry or the content of the third party's response."8 in other instances, taxpayers are not entitled to notice that the service has gathered materials from third parties. absent a discovery request in these instances, it could be nearly impossible for the taxpayer to obtain information that might be used to support or rebut its position at trial. through the use of statistical information on unrelated taxpayers"); i.r.s. legal mem. 2012-50-020 (dec. 14, 2012) ("[p]attern evidence from other participants showing that all the arrangements were designed, implemented, and operated identically can be used to demonstrate that the arrangement was not designed with a specific taxpayer's business needs in mind and therefore lacked a bona fide business purpose other than tax benefits."). 84. i.r.c. § 7602(a)(l)-(3). notably, the standard of relevancy in the summons context is also relaxed, as documents are generally considered relevant if they "have the potential to shed some light on any aspect of [a taxpayer's] income." 2121 arlington heights corp. v. i.r.s., 109 f.3d 1221, 1224 (7th cir. 1997) (citing united states v. arthur young & co., 465 u.s. 805, 814-15 (1984)). 85. i.r.c. § 6103(b)(2). 86. see vons cos., inc. v. united states, 51 fed. cl. 1 (2001) ("indeed, the language establishing what is 'relevant evidence' under the federal rules of evidence is quite different and certainly much broader than the 'directly related' language in section 6103(h)(4)(b) a difference which the legislative history of the latter provision indicates should not be overlooked."). 87. while taxpayers can submit freedom of information act requests for materials gathered by the service, such requests are cumbersome and impose time, monetary, and administrative burdens on both the taxpayer and the service that simple, direct discovery requests do not. see 5 u.s.c. § 552; 5 u.s.c. § 552a; reg. § 601.702. see also 1.r.c. § 6110(a). 88. reg. § 301.7602-2(e)(2)(i). 2013] 139 florida tax review indeed, the discovery process provides a means for obtaining helpful and harmful facts and materials gathered by the service during the examination, which narrows issues for trial and encourages a quick and inexpensive resolution of litigated matters. applying the de novo doctrine as a restrictive standard of relevancy thwarts these purposes. c. what occurred during the examination, and the service's thoughts, procedures, conclusions, reasoning, or factual findings is often the central issue to be decided another problem with applying the de novo doctrine as a standard of relevancy in tax cases is that in many instances when the service or taxpayer might argue estoppel or when the service might argue the doctrine of variance, for example the service's thoughts, procedures, conclusions, reasoning, or factual findings are directly at issue. as a practical and policy matter, the strength of the de novo doctrine as a discovery or evidentiary concept is undercut by the various instances where it should not apply.8 9 89. the examples below are only several that might commonly occur. there are other instances when the service's thoughts, procedures, conclusions, reasoning, or factual findings might be directly at issue in a given case. see, e.g., united states v. powell, 379 u.s. 48, 57-58 (1964) (holding that, to defeat a petition to quash a summons or to enforce a summons, the government must establish that (1) "the investigation will be conducted [for] a legitimate purpose," (2) the material being sought is relevant to that purpose, (3) "the information sought is not already in the [service's] possession," and (4) the service complied with all the administrative steps required by the code); william bryen co. v. commissioner, 89 t.c. 689, 707 (1987) ("respondent may rely on a particular theory [at trial] if he has provided petitioner with 'fair warning' of his intention to proceed under that theory." (citing schuster's express, inc. v. commissioner, 66 t.c. 588, 593 (1976); rubin v. commissioner, 56 t.c. 1155, 1163 (1971)). cases in which the service attempts to penalize taxpayers pose an especially thorny issue because reasonable cause and good faith based on "all the facts and circumstances, including the uncertain state of the law," is a defense to penalties. see, e.g., patel v. commissioner, 138 t.c. no. 23, 39 (2012) ("given all the facts and circumstances, including the uncertain state of the law, we find that petitioners acted with reasonable cause and in good faith. therefore, we hold that they are not liable for any penalty under section 6662."). arguably, the service's views on the state of the law and the service's treatment of other similarly situated taxpayers might be relevant to whether a taxpayer acted reasonably in a given case. see allison v. united states, 80 fed. cl. 568, 582 (2008) ("there is no record showing whether the commissioner at all investigated the actions of each individual taxpayer or any explanation about the standard of care expected and the reason each taxpayer was found to fall short of this standard. . .. as a consequence, the taxpayers are in the position of needing to prove that they were not negligent without the benefit of knowing why the commissioner thought that they were."). 140 [vol. 14:4 the de novo doctrine 1. estoppel claims of estoppel by or against the service generally require that (1) there be a false representation or wrongful misleading silence, (2) the error originate in a statement of fact and not in an opinion or statement of law, (3) the person claiming the benefit of estoppel must be ignorant of the true facts, and (4) the aggrieved party must be adversely affected by the acts or statements of the person against whom estoppel is claimed.o as noted above, relevant evidence is that which is relevant to the claim or defense of any party.91 thus, in instances where the service alleges the taxpayer should be estopped, the service's detrimental reliance and ignorance of the true facts are directly at issue and can only be proven or disproven by the service's thoughts, conclusions, reasoning, and factual findings. conversely, in instances where the taxpayer alleges the service should be estopped, whether the service made a false representation or was wrongfully silent, and whether the error arose out of a statement of fact and not opinion or law are directly at issue and can only be proven or disproven by the service's thoughts, conclusions, reasoning, and factual findings. the de novo doctrine should not apply to claims of estoppel because, if it did, taxpayers would be unable to access the evidence to prove or disprove such a claim or defense. 2. variance in tax refund actions, the doctrine of variance prevents taxpayers from raising issues at trial that vary from those it asserted in its administrative refund claim.92 a well-established exception to the doctrine of variance, however, states that: 90. see whitney v. united states, 826 f.2d 896 (9th cir. 1987) (citing lignos v. united states, 439 f.2d 1365 (2d cir. 1971)); stair v. united states, 516 f.2d 560 (2d cir. 1975); van antwerp v. united states, 92 f.2d 871, 875 (9th cir. 1937) (citing united states v. f.s. scott & sons, 69 f.2d 728 (1st cir. 1934)). see also botany worsted mills v. united states, 278 u.s. 282, 288 (1929) (holding that an agreement which does not comply with the statutory requirements for compromises cannot be binding on the taxpayer or the service). 91. see supra notes 62, 66. the tax court's rules apply a slightly broader rule, enabling discovery of information "relevant to the subject matter involved in the pending case." supra note 66. 92. union pac. r.r. co. v. united states, 389 f.2d 437 (ct. cl. 1968) (citing united states v. felt & tarrant mfg. co., 283 u.s. 269 (1931); real estateland title & trust co. v. united states, 309 u.s. 13, 17-18 (1940); int'l curtis marine turbine co. v. united states, 56 f.2d 708 (ct. cl. 1932); the midvale co. v. united states, 138 f. supp. 269 (ct. cl. 1956); williamson v. united states 292 f.2d 524 (ct. cl. 1961)). variance stems from section 7422, which states that suits for recovery of taxes cannot be maintained in any court until a claim for refund or 2013] 141 florida tax review [a]n item raised in litigation but not specifically adverted to in the claim might be permitted if it is found that the taxpayer adequately alerted the service to the fact that the item is a ground for refund, or that the commissioner considered that unspecified ground in reaching his decision on the items for which a refund was requested. thus, what the service knew and considered with respect to the items for which a refund was requested are relevant to whether variance applies to issues raised in litigation that a claim for refund did not expressly include.94 moreover, the purpose of the variance doctrine is to "prevent surprise and to give adequate notice to the service of the nature of the claim and the specific facts upon which it is predicated, thereby permitting an administrative investigation and determination."95 whether the service undertook an administrative investigation and determination with respect to the claim and its underlying facts is directly relevant to whether the defense applies. the de novo doctrine should not apply when variance might be at issue because, if it did, taxpayers would be unable to access the evidence to disprove such a claim or defense. 3. shifting the burden ofproofas to factual matters finally, the taxpayer's cooperation with the service's reasonable requests during its examination is a statutory prerequisite to shifting from the taxpayer to the service the burden of proof on certain factual issues in tax litigation. under section 7491(a), if the taxpayer introduces credible evidence with respect to any factual issue in any court proceeding, the service will bear the burden of proof on that factual issue, but only if the credit has been duly filed, and from regulations which require a refund claim to "set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the commissioner of the exact basis thereof." i.r.c. § 7422(a); reg. § 301.6402-2(b)(1). 93. union pac., 389 f.2d at 442 (citing cases). see also herrington v. united states, 416 f.2d 1029, 1032 (10th cir. 1969) ("thus, if the claim fairly apprises the service of the ground on which recovery is sought or if the service actually considers the ground later sought to be raised the claim will be held adequate for ... bringing suit under § 7422."); garvey, inc. v. united states, 1 cl. ct. 108 (1983). 94. see computervision corp. v. united states, 445 f.3d 1355, 1370 (fed. cir. 2006); dillon, read & co., inc. v. united states, 15 cl. ct. 246, 251-52 (1988), vacated, 875 f.2d 293 (fed. cir. 1989). 95. union pac., 389 f.2d at 442. 96. i.r.c. § 749 1(a)(2)(b). 142 [vol. 14:4 the de novo doctrine taxpayer meets certain conditions, including cooperating with the service's examination.97 the legislative history to section 7491(a) states: [t]he taxpayer must cooperate with reasonable requests by the secretary for meetings, interviews, witnesses, information, and documents (including providing, within a reasonable period of time, access to and inspection of witnesses, information, and documents within the control of the taxpayer, as reasonably requested by the secretary). cooperation also includes providing reasonable assistance to the secretary in obtaining access to and inspection of witnesses, information, or documents not within the control of the taxpayer (including any witnesses, information, or documents located in foreign countries). a necessary element of cooperating with the secretary is that the taxpayer must exhaust his or her administrative remedies (including any appeal rights provided by the irs). the taxpayer is not required to agree to extend the statute of limitations to be considered to have cooperated with the secretary. cooperating also means that the taxpayer must establish the applicability of any privilege.98 section 7491(a) places directly at issue facts the service requested and received, and events that occurred, at the administrative level, and whether those facts and circumstances were reasonable. courts "consider all the surrounding facts and circumstances of [a] case in deciding whether [the service's] request for witnesses, information, documents, meetings, and interviews is reasonable."99 moreover, "[w]hether the taxpayer cooperated with reasonable requests by the commissioner for witnesses, information, documents, meetings, and interviews is based on all the surrounding facts and circumstances of the case."100 broadly applying the de novo doctrine as a standard of relevancy contradicts section 7491(a), which itself places at issue the facts gathered by 97. i.r.c. § 7491(a). 98. s. rep. no. 105-174, at 45 (1998) (internal footnotes omitted). 99. polone v. commissioner, 86 t.c. memo. (cch) 698, 707, t.c. memo. (ria) t 2003-339, 1957 (2003), af'd on other issue, 449 f.3d 1041 (9th cir. 2006). see also long term capital holdings v. united states, 330 f. supp. 2d 122 (d. conn. 2004), aff'd on other issue, 150 f. app'x 40 (2d cir. 2005); southgate master fund, l.l.c. v. united states, 651 f. supp. 2d 596 (n.d. tex. 2009), aff'd on other issue, 659 f.3d 466 (5th cir. 2011). 100. polone, 86 t.c. memo. (cch) at 707, t.c. memo. (ria) at 1957. 2013] 143 florida tax review the service and the general nature of its examination. of course, one could argue that taxpayers have access to facts that prove whether or not they cooperated with the service's examination, so the application of the de novo doctrine as a relevancy standard would do them no harm. but purely internal statements of service employees regarding the audit and the taxpayer's and service's conduct would also tend to prove whether or not the taxpayer cooperated with the service and applying the de novo doctrine as a relevancy standard would preclude access to that information. noting a few examples where the service's thoughts, procedures, conclusions, reasoning, or factual findings are directly at issue does not, by itself, doom the de novo doctrine's vitality as a standard of relevancy in other contexts. however, these examples illustrate the standard is not unconditional and generally undercut the doctrine's vitality as a relevancy standard. they also illustrate the broader implications of applying the de novo doctrine as a standard of relevancy in an unprincipled manner. specifically, they raise the specter that the service could seek to apply the de novo doctrine in a manner that enables it to withhold information harmful to the service's claims or defenses, but disclose information beneficial to the service's claims or defenses or harmful to taxpayers' claims or defenses, a matter of fairness to which this article now turns. d. the de novo doctrine as a standard of relevancy is inimical to well-established notions offundamental fairness in the tax realm, considerations of fundamental fairness are central to the government's mission.o0 fundamental fairness is also central to the discovery and evidentiary rules discussed above,'0 2 so courts hold fairness 101. see the irs mission, http://www.irs.gov/uac/the-agency,-itsmission-and-statutory-authority (last updated aug. 2, 2012) (stating that the service's mission is to "[p]rovide america's taxpayers top quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all"); united states department of justice tax division, mission statement, http://www.justice.gov/tax/ (last visited jan. 9, 2012) ("the tax division's mission is to enforce the nation's tax laws fully, fairly, and consistently, through both criminal and civil litigation, in order to promote voluntary compliance with the tax laws, maintain public confidence in the integrity of the tax system, and promote the sound development of the law."). 102. see, e.g., fed. r. civ. p. 1 ("[these rules] should be construed and administered to secure the just, speedy, and inexpensive determination of every action and proceeding." (emphasis added)); tax ct. r. 1(d) ("the court's rules shall be construed to secure the just, speedy, and inexpensive determination of every case." (emphasis added)); campbell jr. v. eastland, 307 f.2d 478, 485 (5th cir. 1962) ("it ought not to be necessary to resort to discovery against the government . . . [t]he government litigates with its citizens and ought to be frank and fair and 144 [vol. 14:4 the de novo doctrine plays a role in disputes between taxpayers and the service regarding the applicability of those rules.103 indeed, with respect to the discovery rules in tax cases, the service is often "treated like any other litigant." 0 4 however, reading the de novo doctrine as a standard of relevancy contradicts these principles and violates well-established notions of fundamental fairness. the service and department of justice regularly call as witnesses or deponents service employees, including examining agents. on the other hand, and sometimes in the same cases,'0 o the service and department of disclose all facts." (quoting statement of william d. mitchell, federal rules of civil procedure, proceedings of the institute at washington, d.c., oct. 6, 7, 8, 1938 and of the symposium at new york city oct. 17, 18, 19, 1938 (edward h. hammond ed., 1939)). 103. see angelus milling co. v. commissioner, 325 u.s. 293, 297 (1945) ("even tax administration does not as a matter of principle preclude considerations of fairness."); eastland, 307 f.2d at 485 ("usually, when the taxpayer is seeking a refund or resisting payment of a tax deficiency assessed against him the united states is just another litigant. in such cases we start with the feeling that fundamental fairness to both sides the government starts with a great advantage in investigative resources requires recognition of the taxpayer's right to pre-trial discovery of the reports of the internal revenue agents who examined the taxpayer's books and records."); beresford v. united states, 123 f.r.d. 232, 233 (e.d. mich. 1988) ("[i]t is apparent that congress enacted [section 6103] as a shield to protect taxpayers from improper disclosure by the government of the information they were required to provide to it by law. the government now seeks to use this statute as a sword to avoid telling the taxpayer seeking a refund the information utilized in determining the tax. . . . while the government may not be able to introduce the return information at trial absent disclosure, it has already received the advantage of that information."); peterson v. united states, 52 f.r.d. 317, 321-22 (s.d. ill. 1971) ("the government, through its objections to interrogatories nos. 6 and 8, is seeking a favored position under the discovery rules. in a tax refund case, however, it should be treated as any other litigant."); frazier v. phinney, 24 f.r.d. 406, 410 (s.d. tex. 1959) (requiring the service to produce various materials in its administrative files because "there is a sufficient necessity for the production of these documents and that denial of production would unduly prejudice the preparation of plaintiffs' case. . . . plaintiffs are entitled to know what defendant's claims and contentions may be"). 104. peterson, 52 f.r.d. at 321-22. see also eastland, 307 f.2d at 485; barry v. commissioner, 1 b.t.a. 156, 157 (1924) ("to say that the taxpayer who brings his case before the board is limited to questions presented before the commissioner, and that the board in its determination of the case is restricted to a decision of issues raised in the internal revenue bureau would be to deny the taxpayer a full and complete hearing and an open and neutral consideration of his case."). 105. see, e.g., isi corp. v. united states, 503 f.2d 558 (9th cir. 1974); lpciminelli interests, inc. v. united states, 2012-2 u.s. tax cas. (cch) t 50,671, 110 a.f.t.r.2d (ria) 2012-6631 (w.d.n.y. 2012); panasonic communications 2013] 145 florida tax review justice often invoke the de novo doctrine and argue they (or their witnesses or deponents) may withhold from taxpayers or courts, on relevancy grounds, facts the service gathered and analyzed during an examination. in these cases, the de novo doctrine can apply to prevent disclosure of information that the service has already obtained the advantage of reviewing in contravention of the fundamental premise that litigants be fairly treated for discovery purposes absent a countervailing privilege.' 0 6moreover, this type of selective disclosure of information is precluded in other discovery and evidentiary contexts such as when litigants attempt to use privileges as a "shield and a sword."10' fairness suggests that facts and analysis the service deems relevant to the examination of a taxpayer should likewise be relevant when the taxpayer seeks to challenge the merits of the service's adjustments in litigation. at a minimum, fairness should play a role when courts are asked to decide whether to give taxpayers access to facts and analysis used by the service in making a determination. unfortunately, courts that articulate the de novo doctrine as a standard of relevancy have not analyzed the impact their articulations of the doctrine have on notions of fundamental fairness. but these notions should have a role and be considered when the service asks courts to withhold information from its adversaries in litigation. while there may be countervailing concerns that would favor maintaining the de novo doctrine as a standard of relevancy despite its impact on fundamental fairness, courts should articulate such concerns and principles so that they too can become as ingrained in the discovery process as notions of fairness. e. courts are regularly asked to, and increasingly do, decide cases based on deference to the service's thoughts, procedures, conclusions, reasoning, or factual findings courts have long deferred to agencies when deciding cases, assuming the agency's determination is reasonable. broadly, deferring to agency decisions is justified by principles of encouraging uniformity and consistency in regulation, facilitating efficient administration of industry corp. v. united states, 99 fed. cl. 422 (fed. cl. 2011), vacated sup nom. in re united states, 669 f.3d 1333 (fed. cir. 2012). 106. see beresford, 123 f.r.d. at 233 (requiring production where, "[w]hile the government may not be able to introduce the return information at trial absent disclosure, it has already received the advantage of that information" (emphasis added)). 107. see, e.g., new phoenix sunrise corp. v. commissioner, 408 fed.app'x 908, 919 (6th cir. 2010) (quoting in re lott, 424 f.3d 446, 454 (6th cir. 2005)). see also glenmede trust co. v. thompson, 56 f.3d 476, 486 (3d cir. 1995); in re g-i holdings, inc., 218 f.r.d. 428, 433 (d.n.j. 2003). 146 [vol. 14:4 the de novo doctrine developments, and agency expertise.'0o typically, courts apply such deference to the service's regulations'0 9 although courts have deferred to the positions the service takes in its revenue rulings"o and even in its litigation briefs with respect to individual taxpayers."' a recent case from the second circuit illustrates that the service has increasingly been seeking and receiving deference from courts with respect to its expertise. in union carbide corp. v. commissioner, the service challenged union carbide's entitlement to research and development tax credits for supplies union carbide used in the conduct of qualified research." 2 at issue was whether union carbide's costs for the supplies used during the research, which would have been used in union carbide's manufacturing process regardless of any research, were "amount[s] paid or incurred for" supplies used in the conduct of qualified research."' in its appellate brief, the service argued that supply costs are not eligible for the credit if they would have been incurred regardless of any research activities.'1 4 the second circuit agreed, stating that: we ordinarily give deference to an agency's interpretation of its own ambiguous regulations, even if that interpretation appears in a legal brief. the interpretation advanced here does not fall into any of the enunciated categories where we would withhold such deference as it is not "plainly erroneous or inconsistent with the regulation," does not "conflict with prior interpretation" of the same regulation, and is not merely a "convenient litigating position" or a 108. see, e.g., michael hall, from muffler to mayo: the supreme court's decision to apply chevron to treasury regulations and its impact on taxpayers, 65 tax law. 695, 702-06 (2012). 109. see, e.g., mayo found. for med. educ. & research v. united states, 131 s. ct. 704 (2011). i10. see, e.g., bob jones univ. v. united states, 461 u.s. 574 (1983). 111. see, e.g., union carbide corp. v. commissioner, 697 f.3d 104, 109 (2d cir. 2012) ("we ordinarily give deference to an agency's interpretation of its own ambiguous regulations, even if that interpretation appears in a legal brief." (citing auer v. robbins, 519 u.s. 452, 461-62 (1997))); dewees v. commissioner, 870 f.2d 21 (1st cir. 1989) ("for one thing, the tax court was obligated to give some deference to the commissioner's view of the application of the sham in substance doctrine, and the 'for profit' language, to the facts of this case." (citing cases)). 112. union cabride, 697 f.3d at 105. 113. id. at 106 (quoting i.r.c. § 41(b)(2)(a)(ii)). 114. id. at 108-09. 2013] 147 florida tax review "post hoc rationalization advanced by an agency seeking to defend past agency action against attack."' as union carbide suggests, in deciding whether to defer to the service's interpretation during litigation of its own ambiguous regulation, courts engage in an examination of the facts surrounding the interpretation itself. whether the service's position is merely a "convenient litigating position" or a "post hoc rationalization" requires a detailed comparison of the service's institutional, administrative position with respect to an issue to the service's articulation of its position on the facts of a given case." 6 more broadly, whether the service's position is reasonable requires an analysis of the facts and circumstances of the service's interpretation."' the service's thoughts, procedures, conclusions, reasoning, or factual findings are relevant to such an inquiry because courts regularly cite them in upholding or overturning the service's actions. applying the de novo doctrine as a standard of relevancy to preclude consideration of the service's thoughts, procedures, conclusions, reasoning, or factual findings ignores these issues, especially in cases where the service claims its position with respect to a specific taxpayer in litigation is entitled to deference." 8 these considerations acquire additional significance when the government in litigation seeks to use the de novo doctrine as a relevancy standard to distance itself from a contrary position the service took 115. id. (citations omitted). 116. see christopher v. smithkline beecham corp., 132 s. ct. 2156, 216669 (2012) (citing cases). 117. see mayo found. for med. educ. & research v. united states, 131 s.ct. 704, 714-16 (2011). 118. moreover, the service's thoughts, procedures, conclusions, reasoning, or factual findings are relevant to whether deference to the service's position with respect to a specific taxpayer is supported by the policy rationale for deference in the first instance. a key reason why courts defer to agencies is because agencies are presumed to have "a body of experience and informed judgment to which courts and litigants may properly resort for guidance." skidmore v. swift & co., 323 u.s. 134, 140 (1944). as the supreme court stated: "[t]he judgments about the way the real world works that [inform an agency's] policy are precisely the kind that agencies are better equipped to make than are courts. this practical agency expertise is one of the principal justifications behind chevron deference." pension benefit guar. corp. v. ltv corp., 496 u.s. 633, 651-52 (1990). if the service's judgment the informed thoughts, procedures, and reasoning its employees have developed over time is relevant to whether a court should defer to that judgment as it is applied to all taxpayers through regulations, the service's judgment might also be relevant to whether a court should defer to that judgment as it is applied to individual taxpayers on a case-by-case basis. nonetheless, a strict application of the de novo doctrine as a relevancy standard would preclude an informed inquiry into such judgment. 148 [vol. 14:4 the de novo doctrine administratively while examining the taxpayer. for instance, in lpciminelli, the department of justice argued that: while the united states agrees that the irs agents came to that conclusion, it asserts in this refund suit proceeding that the irs agents were wrong. the united states contends in this motion that the fact that irs agents came to an incorrect conclusion is irrelevant within the meaning of fed. r. evid. 402 and that therefore the proposed testimony and documents are inadmissible.1 1 9 the lpciminelli opinion noted that "the notice of tax deficiency carries a presumption of correctness, requiring the taxpayer to demonstrate that the deficiency is incorrect,"l 2 0 despite the fact that the department of justice argued in the same case that the service's stated ground for claiming a deficiency was incorrect. lpciminelli and union carbide raise two interesting questions that bear on the de novo doctrine as a relevancy standard. first, if courts should defer to the service's institutional expertise or litigating position on a caseby-case basis, why not provide support for such expertise to the taxpayers whose liabilities are being decided? and second, if the service's institutional expertise is correct in some instances but erroneous in others, how should the de novo doctrine as a relevancy standard apply when both instances allegedly occur at different phases of the same case? a full discussion of how deference should apply in these circumstances is beyond the scope of this article (and is a briar patch lpciminelli did not enter). nonetheless, applying the de novo doctrine as a relevancy standard to preclude consideration of the service's factual findings, thoughts, reasoning, and conclusions conflicts with arguing courts should rely on those factual findings, thoughts, reasoning, and conclusions to decide cases. moreover, situations like lpciminelli, in which the government assumes a litigating stance contrary to a prior agency determination in the same case and then argues that a court should not rely on the service's factual findings, thoughts, reasoning, and conclusions, highlight this problem.121 119. motion in limine, supra note 2, at 2-3 120. lpciminelli interests, inc., 2012-2 u.s. tax cas. (cch) 50,671, at 87,221, 110 a.f.t.r.2d (ria) 2012-6631, 6634 (w.d.n.y. 2012), (quoting r.e. dietz corp. v. united states, 939 f.2d 1, 4 (2d cir.1991)). 121. this might especially be true when penalties are at issue, and courts must grapple with questions of whether substantial authority or a reasonable basis exists for a position or whether a taxpayer acted with reasonable cause and good faith. see i.r.c. § 6662(d)(2)(b)(i)-(ii)(ii); reg. § 1.6664-4(b)(1). in other words, 2013] 149 florida tax review unfortunately, however, courts that articulate the de novo doctrine as a standard of relevancy have not examined the impact their articulations of the doctrine might have on the deference the service increasingly requests and receives. nor have they examined how the de novo doctrine should operate in situations when the service requests deference, but only to its litigating position and not to an allegedly erroneous position advanced during its examination of the taxpayer. v. conclusion historically, the de novo doctrine was not a standard of relevancy in the discovery or evidentiary context. it merely encompassed the idea that courts decide tax cases on the merits of taxpayers' liabilities for the year at issue, rather than on miscellaneous factors such as the service's motives or reasons for initiating an audit or making an adjustment. today, however, the doctrine is commonly and unjustifiably cited for the proposition that the service may withhold from taxpayers on relevancy grounds information the service gathered during its examination, even though the cases in which the doctrine arose do not stand for such a proposition. moreover, recent cases that have applied the doctrine have done so inconsistently, which encourages additional costly discovery and evidentiary disputes. contemporary courts also fail to draw clear distinctions between taxpayers who genuinely seek factual and other information that might prove the merits of a tax case from intransigent litigants who merely want to argue that the service's motives or reasons for initiating an audit or making an adjustment are improper. applying the de novo doctrine as a standard of relevancy also contrasts with the broad scope of relevancy in the discovery and evidentiary contexts, is hostile to notions of fundamental fairness, fails to account for instances in which information in the service's administrative files is directly relevant to claims or defenses of the parties, and raises thorny policy issues regarding deference in today's litigating environment. all of these factors suggest the de novo doctrine is not relevant to relevancy. courts should dispense with the de novo doctrine as a relevancy concept and return to the doctrine's simple, uncontroversial roots. concerns that doing so would give litigants free access to the service's administrative files are unjustified because well-established privileges attorney-client privilege, work product, and deliberative process would continue to apply to prohibit unwarranted disclosures. alternatively, courts could articulate a principled, uniform approach to the doctrine as a relevancy standard that litigants can easily apply without court intervention. in so doing, however, the fact that the service examined but did not adjust an item might be relevant to whether a taxpayer should be penalized if the service reverses course and makes an adjustment during litigation. 150 [vol. 14:4 2013] the de novo doctrine 151 courts should address the additional concerns mentioned above, which have escaped judicial analysis to date. volume 14213nme5 florida tax review article was blackstone's initial public offering too good to be true?: a case study in closing loopholes in the partnership tax allocation rules emily cauble university of florida levin college of law 0hnanailsts 2013 number5 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe congressional unilateral tax treaty overrides: 699 florida tax review volume 9 2009 number 7 congressional unilateral tax treaty overrides: the “latter in time doctrine” is out of time!  professor mark j. wolff 1 i. introduction………………………………………………700 ii. international tax policy…………...……..……….….704 iii. comparison of treaty ratification and domestic tax law enactment……………………..........................705 iv. treaty overrides defined……………………………...709 v. the impact of the supremacy clause………………..710 vi. treaty overrides and the internal revenue code ……………………………………………..731 vii. conclusion…..…………………………………………….748  all citations herein are to the 2006 internal revenue code, 26 u.s.c. §§ 1-9833 (2006) (unless otherwise indicated). 1. professor wolff currently enjoys the rank of tenured full professor of law at st. thomas university school of law, and over the past twenty-one academic years has specialized in teaching courses in various areas of federal income taxation, comparative international taxation, tax policy, agency and partnership, corporations, corporate taxation, and contracts, as well as advanced jurisprudence seminars related to the united nations, international monetary fund, world bank, world trade organization, financing for development and international tax cooperation. 700 florida tax review [vol. 9:7 i. introduction the current form of globalization has resulted in greater global economic integration and liberalization, political openness, and cultural and social acceptance. as the world economy continues to weaken national economic orders, and as nations become more dependent upon international trade, good relations between nations may provide greater global wealth and political stability. 2 global integration requires a “cooperative multilateralist” approach, encouraging international alliances, partnerships and institutions. 3 the current global shift, however, finds the united states in a period of protectionism. as a result of 9/11, the united states has begun a strategy of preemption, one triggered at creating measures aimed at preventing substantial casualties to the u.s., whether military or economic. 4 the actions taken in furtherance of this strategy, such as the invasion of iraq without the consent of the security council, altered the perception of the united states around the world. 5 furthermore, these actions were in direct contradiction of 2. richard n. haas, the age of nonpolarity: what will follow u.s. dominance, foreign affairs, 44 may/june 2008. “trade can be a powerful tool of integration. it gives states a stake in avoiding conflict because instability interrupts beneficial commercial arrangements that provide greater wealth and strengthen the foundations of domestic political order. trade also facilitates development, thereby decreasing the chance of state failure and alienation among citizens.” id. at 54. 3. id. “encouraging a greater degree of global integration will help promote stability. establishing a core group of governments and others committed to cooperative multilateralism would be a great step forward.” id. at 56. 4. david hendrickson, the curious case of american hegemony: imperial aspirations and national decline, world policy journal, 1, 2005. the united states “broke from the cold world doctrines of containment and deterrence, arguing that the threat posed by terrorists and rogue states justified a strategy of preventive war, which it called the strategy of preemption.” id. 5. robert kagan, america’s crisis of legitimacy, foreign affairs, mar./apr. 2004. the global situation is now inverted, “where once the united states risked its own safety to defend the vital interests of a threatened europe, a threatened united states was now looking out for itself in apparent, and sometimes genuine, disregard for what many europeans perceived to be their moral, political and security interests.” id. “europeans objected to the u.s.’s willingness to go to war without the security council’s approval – that is, without europe’s approval – challenged both europe’s world view and its ability to exercise even a modicum of influence in the new unipolar system.” id. see also michael cox, empire by denial: the strange case of the united states, international affairs, volume 81, 2005. the world has been led into an “age of unparalleled u.s. dominance and global terror, where it looks as if the united states has now arrogated to itself the international role of setting standards, determining threats, using force and meting out justice. define it as unilateralism, call it necessary response to new threats: it still looks like imperialism and empire.” id. 2009] congressional unilateral tax treaty overrides 701 secretary of state condoleezza rice’s pledge to “support and uphold the system of international rules and treaties that allow us to take advantage of our freedom.” 6 international tax treaties are a vital instrument in developing and stimulating economies throughout the world. 7 countries enter into tax treaties to promote investment, growth, and commerce by avoiding double taxation and preventing tax evasion. 8 unilateral actions, such as congress amending the tax code to override an international tax treaty, bear significant negative impacts upon the potential development of economies and the political relationship between the nations. 9 congress’ ability to override 6. hendrickson, supra note 4. note that pre-9/11 the government still retained protectionist views. john bolton stated in 1999, “it is a big mistake for us to grant any validity to international law even when it may seem in our short-term interest to do so – because, over the long term, the goal of those who think that international law really means anything are those who want to constrict the united states.” id. 7. see generally, pending income tax agreements: hearing before the s. comm. on foreign relations, 109th cong. 1 (2006). (testimony of patricia a. brown, deputy international tax counsel (treaty affairs), united states department of the treasury). opening statement for hearing on tax treaties: bangladesh, france and sweden 109th cong. 1, (2006) (opening statement of richard g. lugar, chairman, s. comm. on foreign relations, (testimony of the staff, j. comm. on taxation), the ratification of an income tax treaty and various protocols before the senate committee on foreign relations 109th cong. 1 2006) (testimony of william a. reinsch, president, national foreign trade council), renato ruggiero, the high stakes of world trade, wall st. j., apr. 28, 1999, at a18. 8. william h. newton, iii, international income tax and estate planning, 405 (west 2nd ed. 2004). “double taxation occurs when two jurisdictions, due to overlapping authority, tax the same income or assets. the effect discourages investment and creates artificial barriers to the free flow of commerce. both international cooperation and goodwill are correspondingly undermined.” id. “tax treaties also limit fiscal evasion by authorizing close administrative coordination and mutual exchange of information between contracting jurisdictions.” id. at 405-6 (citations omitted). another form of tax evasion occurs through treaty shopping. “[t]reaty shopping is the practice of rerouting income through one or more artificial entities in different countries for the main or sole purpose of obtaining treaty benefits that are not directly available to the true earner of income.” simone m. haug, the united states policy of stringent anti-treaty shopping provisions: a comparative analysis, 29 vand. j. transnat’l l. 191, 205 (1996). 9. richard l. doernberg, overriding tax treaties: the u.s. perspective, 9 emory int’l l. rev. 71, 71 (1997) such actions have caused treaty partners to come to expect that the united states will breach its treaty obligations because the later-intime doctrine causes domestic tax law to supersede prior agreements without due regard for prior treaty obligations. 702 florida tax review [vol. 9:7 these treaties negates the “anti-imperial” design of the constitution and creates negative consequences for economic development and commerce. 10 in spite of this, treaties are often partially or completely abrogated in a unilateral fashion. it is vital for the united states to adhere to treaties into which it enters and pay heed to the reliance of other nations on these treaties. the united states “retains more capacity than any other actor to improve the quality of the international system, so the question is whether it will continue to possess such capacity.” 11 the determination of this question appears to depend on how the nation develops its’ international relations under the new leadership of president barack obama. 12 president obama believes “it is illegal and unwise for the president to disregard international human rights treaties that have been ratified by the united states senate,” yet, the question remains whether he feels the same about overriding international tax treaties. 13 president obama stated the united states is in need of repairing relationships with other nations, whereby strengthening its economic alliances and garnering the support for the united states to compete on a global scale. 14 10. bill emmott, 20:21 vision: twentieth century lessons for the twentyfirst century, 2003. america’s constitutional domestic law has primacy over international treaties…congress can alter the terms of any international treaty entered into by the administration, and all treaties need to be implemented through domestic laws. not only is it wrong to imagine that america is a single, unified actor, it is also the case that the constitution was expressly designed by the founding fathers to prevent such a single actor from emerging… in international affairs that makes america especially difficult to deal with, since countries are accustomed to dealing with each other as sovereign governments, empowered to negotiate. the american system does its best to prevent the white house from being able to negotiate freely. id. 11. haas, supra note 2 at 53. 12 the question was of great importance in the 2008 presidential election and presented to senator, former presidential candidate, john mccain. senator mccain was quoted saying: “if there is a treaty that the congress has ratified, we have chosen to make it the law of the land, and it must be obeyed under the terms that it was ratified.” questionnaire on executive power, boston globe, dec. 20, 2007. senator mccain further pointed out that “demanding unilateral changes and threatening to abrogate an agreement that has increased trade and prosperity is nothing more than retreating behind protectionist walls.” mark murray, mccain’s day in canada, jun. 20, 2008. http://firstread.msnbc.msn.com/archive/2008/06/20/1158780.aspx. 13. boston globe, supra note 12. 14. barack obama, renewing american leadership, foreign affairs, http://firstread.msnbc.msn.com/archive/2008/06/20/1158780.aspx 2009] congressional unilateral tax treaty overrides 703 due to president obama’s overwhelming dedication to international policy, 15 it seems inevitable the question will be answered sooner than expected, especially considering the historic lack of urgency to address this matter. this article examines the questionable jurisprudence allowing the united states to override treaties unilaterally, freely negotiated between two sovereign nations, through the later-in-time doctrine. through the perspective of tax conventions, this article provides an overview of the historical development and context of unilateral treaty overrides. the following analysis will demonstrate the flawed reasoning behind the enactment of the later-in-time doctrine; the necessity to distinguish between indian and sovereign nations; the contravention of the executive branch’s treaty powers; the flawed interpretations of the supremacy clause; and the growing requirement to fulfill international obligations. the analysis provides a plausible solution by applying a heightened scrutiny to domestic tax statutes attempting to override prior-in-time treaties. the call for heightened scrutiny is to be applied before potential overrides are granted; it is not meant to displace congress’ power to override international tax treaties by way of the tax code. in the case that an override jul./aug., 2007. senator obama stated “to renew american leadership in the world, i intend to rebuild the alliances, partnerships, and institutions necessary to confront common threats and enhance common security. needed reform of these alliances and institutions will not come by bullying other countries to ratify changes we hatch in isolation. it will come when we convince other governments and people that they, too, have a stake in effective partnerships… our essential challenge is to build a relationship that broadens cooperation while strengthening our ability to compete.” id. 15. stop tax haven abuse act, s. 681, 110th congress (2007). president obama was a leading promoter of this bill aimed at the eradication of tax havens, which has substantial impact on the international economy. not only does the definition of tax havens vary, so does the estimated impact of tax havens on the world’s economy. certain analysts suggest that more than 50% of the world’s money goes through tax havens. nick kochan, cleaning up by cleaning up, euromoney, april 1991, at 73-77; marcel cassard, the role of offshore centers in international financial intermediation (int’l monetary fund working paper wp/94/107, 1994). it is estimated that around 20% of total private wealth and around 22% of banks’ external assets are invested offshore. id. see also, diamond, walter h. and dorothy b. diamond, tax havens of the world, 1, newark, nj: matthew bender books (2002). additionally, walter and dorthy diamond estimate the current total assets located in tax havens at $5.1 trillion. id. regardless of the scholar or the estimated impact, it is indisputable that tax havens have become an emerging consequence of today’s ever globalizing economy. president obama’s next steps at restoring the united states’ international relations, while trying to regulate them, is going to be of great importance to the united states’ economy and overall well-being. 704 florida tax review [vol. 9:7 is allowed, the void left from the unfulfilled obligations should spur the united states to make restitution to the parties injured. ii. international tax policy because our ever-globalizing economies are becoming dependent on international trade, each country’s tax policy is important. each country’s tax specialists and tax advisors need to be totally aware of the other countries’ tax policies to negotiate international tax treaties presenting a hospitable environment for foreign investors and also to protect their revenue base. 16 the tax policy is supposed to equalize taxes in cross-border transactions in which many small and medium size companies, as well as large companies, are now engaged. 17 the relationship between tax treaties and domestic tax legislation is complex in many countries. the basic principle is the treaty should prevail in the event of a conflict between the provisions of domestic law and a treaty. 18 one of the most important issues for many countries in international treaties is the risk to taxpayers of international double taxation. 19 international tax extends beyond the income tax. it may include estate taxes, gift taxes, inheritance taxes, general wealth taxes, sales taxes, customs duties, and a variety of special levies. 20 the goals of international tax treaties should be to get the country’s fair share of revenue from cross-border transactions, promote fairness, enhance the competitiveness of the domestic economy, and to neutralize capital-exports and capital imports. 21 the list of u.s. tax treaties with 16. brian j. arnold & michael j. mcintyre, international tax primer, 1 (kluwer law internat’l, 2d ed. 2002). 17. id. at 7. almost all modern income tax treaties are based on the oecd model treaty and the un model treaty. id. the oecd model treaty has been revised over 8 times, as late as 2002. id. at 107. the un model treaty was first published in 1980, revised in 2001, and is usually used by developing countries. id. at 109. 18. id. at 104. 19. id. at 2. there are three types of double taxation that arise from conflicts over tax jurisdiction: source-source conflicts, residence-residence conflicts and residence-source conflicts, which is the most common because most countries tax on the basis of both the residence status of the taxpayer and the source of income. id. at 27. 20. id. at 4. 21. id. at 5. three methods are commonly used for providing relief from double taxation: the deduction method, which is generally taxable at a higher effective rate, and the exemption and the credit methods, which usually give equivalent results. id. at 31. on tax policy grounds, the credit method is supposed to be the best method for eliminating international double taxation. id. at 37. but the debate about which method is better is often vigorous and emotional. id. at 44. 2009] congressional unilateral tax treaty overrides 705 developing countries is growing rapidly. although tax incentives have some supporters in the political arena, they are impossible to justify on the basis of tax policy principles. the costs of tax incentives are typically large, the benefits are uncertain, and very rarely do the benefits justify the likely costs. 22 the challenge for future governments is to achieve a proper balance of cooperation and competition among taxing regimes. governments have been reluctant to act on a multilateral basis because they do not want to lose sovereignty over their tax policy. globalization is a real threat to sovereignty. in the global economy, a unilateral approach to tax policy is obsolete, counterproductive, and ineffective. some forms of cooperation are now necessary for governments to achieve their traditional tax policy objectives, and some forms of competition are helpful in promoting the best taxing practices. 23 iii. comparison of treaty ratification and domestic tax law enactment overriding a tax treaty is heavily influenced by the processes through which the treaties are ratified and domestic tax laws are enacted. the levels of influence of the two differ, due to the united states constitution’s prescribed roles for the three branches of the government. 24 the executive treaty relief is very important because it usually is more generous and it usually constrains a country’s ability to amend its domestic law to withdraw the double taxation relief afforded to nonresidents. id. at 47. 22. id. at 52. 23. id. at 143-144. 24. the constitution confers the power to enact domestic tax laws on the house of representatives, part of the legislative branch of the united states government. u.s. const. art. i, § 7, cl.1. (“all bills for raising revenue shall originate in the house of representatives; but the senate may propose or concur with amendments as on other bills.”). the constitution places the power to enter into treaties on the president and executive branch, subject to two-thirds ratification by the senate. u.s. const. art. ii, § 2, cl. 2. (“he shall have power, by and with the advice and consent of the senate, to make treaties, provided two thirds of the senators present concur . . .”). when the house of representatives enacts a domestic law that directly conflicts with a treaty provision, under current u.s. jurisprudence the domestic law overrides the treaty provision and therefore, the house of representatives is impinging upon the executive’s treaty powers. this procedure has been exasperated since the amendment to the language of the 1954 code. the language as amended allows congress to give due regard to any treat obligation and still tax an item that is exempt from taxation under the treaty. also, in 1988, the house of representatives amended § 7852(d)(1) providing that “[f]or purposes of determining the relationship between a provision of a treaty and any law of the 706 florida tax review [vol. 9:7 branch vests the power to create treaties whereby the process begins with negotiations between representatives of the president and the delegation of the other nation. 25 after an agreement is reached, representatives from both sides sign the proposed treaty and the president forwards it to the senate for its advice and consent. the senate foreign relations committee debates the merits of the proposed treaty and votes to accept or reject. during this debate, the foreign relations committee seeks advice from the tax-writing committees in the house of representatives and the senate, despite them having no official jurisdiction. 26 after consent is given by the senate, the treaty is sent back to the executive branch which decides whether to ratify. 27 the executive branch maintains the ability to deny the treaty’s ratification if conditions relevant to the proposal have changed. 28 united states affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law.” this latter provision reflects the u.s. rule that the “later in time” of either the treaty or the applicable statute controls. under the u.s. constitution, u.s. treaties and federal statutes have equal status as the supreme law of the land. u.s. const. art. vi, cl. 2. consequently, when a conflict exists between the treaty and the statute, the later in time prevails. see restatement (third) of the foreign relations law of the united states § 115 (1986). for well over 100 years the united states has allowed this lack of uniformity and certainty to hinder the united states’ international relations. however, this impinging upon the executive’s treaty powers, whether intended or not, is inevitable due to the current domestic and international treaty enactment processes. see also irc § 894(a) which provides “the provisions of this title shall be applied to any taxpayer with due regard to any treaty obligation of the united states which applies to such taxpayer.” (emphasis added). 25. u.s. const. art. ii, § 2, cl. 2: he shall have power, by and with the advice and consent of the senate, to make treaties, provided two thirds of the senators present concur; and he shall nominate, and by and with the advice and consent of the senate, shall appoint ambassadors, other public ministers and consuls, judges of the supreme court, and all other officers of the united states, whose appointments are not herein otherwise provided for, and which shall be established by law: but the congress may by law vest the appointment of such inferior officers, as they think proper, in the president alone, in the courts of law, or in the heads of departments. 26. overriding tax treaties, supra note 9, at 77. the tax-writing committee in the house of representatives is the only component of the house of representatives which has input into the treaty making process. such miniscule input helps explain the lack of comity among domestic and international tax legislation. 27. u.s. const. art. i § 7. 28. transcript of senate foreign relations hearing on tax treaties, 93 tnt 225-23, nov. 2, 1993: in 1981, the senate gave its advice and consent to a treaty and protocol with israel. the treaty was signed in 1975 and the protocol in 2009] congressional unilateral tax treaty overrides 707 the process for creating domestic tax laws and their influence upon tax treaties differs from the process of ratifying a treaty. while all revenue bills are initiated in the house of representatives, the senate may exert its influence by amending tax legislation and voting to approve legislation originating in the house. 29 the executive branch creates tax bills which originate usually in the department of treasury or directly from the president. these bills, whether originating in congress or the executive branch, must be screened by the house and senate before being vetoed or signed into law by the president. if the president vetoes the bill, it may still be passed into law if two-thirds of congress overrides the veto. 30 the most significant difference between the enactment of domestic tax laws and the treaty ratification process is the absence of an official role for the house of representatives. one reason for the house’s exclusion is the senate is expected to have an expertise in foreign politics, 31 while the 1980. israel objected, however, to the final terms of the treaty and failed to ratify it. in 1986, israel changed its views and asked whether the united states would be prepared to exchange instruments of ratification. in the meantime, the united states had adopted an anti-treaty shopping policy that was not reflected in the treaty. consequently, the treasury refused to exchange instruments of ratification until a new protocol was negotiated... 29. u.s. const. art. 1, § 7, cl. 1. (“all bills for raising revenue shall originate in the house of representatives; but the senate may propose or concur with amendments as on other bills.”); overriding tax treaties, supra note 9, at 7476 (providing a thorough examination of the enactment process for a domestic tax statute which differs greatly from the international treaty enactment process). 30. u.s. const. art. 1, § 7, cl. 2. every bill which shall have passed the house of representatives and the senate, shall, before it become a law, be presented to the president of the united states; if he approves he shall sign it, but if not he shall return it, with his objections to that house in which it shall have originated, who shall . . . proceed to reconsider it. if after such reconsideration two thirds of . . . [congress] . . . shall agree to pass the bill, . . . it shall become a law. 31. the federalist no. 64, at 432 (john jay) (jacob e. cooke ed., 1961). the framers of the constitution thought: [t]he power of making treaties is an important one, especially as it relates to war, peace and commerce; and it should not be delegated but in such a mode, and with such precautions, as will afford the highest security, that it will be exercised by men the best qualified for the purpose, and in the manner most conducive to the public good. alexander hamilton did not think that these qualities existed in the house of representatives. the fluctuating, and taking its future increase into the account, the multitudinous composition 708 florida tax review [vol. 9:7 founding forefathers intended for the house of representatives to be the voice of the people and have power over domestic revenue laws. 32 as the voice of the people, the house of representatives has the primary role in enacting domestic tax laws and are answerable to their voters in their respective states. 33 the senate, on the other hand, which is not subject to re of . . . [the house of representatives] . . . forbid us to expect in it those qualities which are essential to the proper execution of . . . [treaty powers]. accurate and comprehensive knowledge of foreign politics; a steady and systematic adherence to the same views; a nice and uniform sensibility to national character, decision, secrecy and dispatch; are incompatible with the genius of a body so variable and so numerous. the federalist no. 75, at 506-07 (alexander hamilton) (jacob e. cooke ed., 1961). however, it was believed that these qualities are found in senators, as the age restrictions imposed on their offices should produce candidates of “whom the people have had time to form a judgment, and with respect to whom they will not be liable to be deceived by those brilliant appearances of genius and patriotism, which like transient meteors sometimes mislead as well as dazzle. thus, ‘the president and senators . . . will always be of the number of those who best understand our national interests . . . and whose reputation for integrity inspires and merits confidence. with such men the power of making treaties may be safely lodged.’ the federalist no. 64, at 433 (john jay) (jacob e. cooke ed., 1961). 32. u.s. const. art. 1, § 2, cl. 1 (“the house of representatives shall be composed of members chosen every second year by the people of the several states . . . .”). in light of the fact that a representative is subject to re-election every two years by popular vote, if he or she is not relaying the “people’s voice,” he or she will likely not remain in office for a subsequent term. the house has been called “a popular assembly whose members are ‘constantly coming and going in quick succession’ and, therefore, do not continue in office for ‘sufficient time to become perfectly acquainted with our national concerns, and to form and introduce a system for the management of them.’” the federalist no. 64, at 432 (john jay) (jacob e. cooke ed., 1961). however, such an assessment of the capabilities of the members of the house of representatives, made in 1961, should not be set in stone, just as the internal revenue code should not be set in stone. rather, the internal revenue code should adapt to the growing concerns of the united states to ensure our nation will prosper in our globalizing economy. 33. another reason the house of representatives is considered the voice of the people is the number of representatives a state has is dependent upon the population within each state and each voting district. u.s. const. art. 1, § 2, cl. 3. in comparison, originally, “[t]he senate of the united states shall be composed of two senators from each state, chosen by the legislature thereof, for six years . . . .” u.s. const. art. 1, § 3, cl. 1. however, since the enactment of the seventeenth amendment, “[t]he senate of the united states shall be . . . elected by the people thereof, for six years . . . .” u.s. const. amend. 17. 2009] congressional unilateral tax treaty overrides 709 election every two years, is not as directly answerable to the public as is the house. this allows the senate to act with independent judgment as to what is best for the nation as a whole rather than for his or her particular state. iv. treaty overrides defined a treaty override is the implementation of a domestic law that directly conflicts with a treaty provision. 34 for example, the united states and country b enter into a treaty granting country b a most-favored-nation status for products exported to the united states. 35 the united states subsequently enacts a domestic law taxing imported cotton at $40 per ton from every country except country c. country c is taxed at $25 per ton of cotton it exports to the united states. 36 under current u.s. jurisprudence, the domestic law enacted after the treaty would supersede the treaty obligation, and obligate country b to pay a tax of $40 per ton of cotton it exports to the united states while country c pay $25 per ton; country b is no longer the most-favored-nation. this contradiction arises out of country b no longer having a most-favored-nation status with all exports to the united states, as specifically noted in the treaty. however, despite finding a direct conflict between the treaty and the domestic law, a court would likely find the resulting conflict was intended by congress and its ensuing consequences are to be accepted. 37 to delve further into the intricacies of tax treaty overrides, we must analyze the structure of the united states constitution, separation of powers and the theories of monism and dualism. 34. id. at 74. under the current § 7852(d), the code gives deference to the domestic law regardless of whether the treaty was prior in time. such practice results in the united states breaching its treaty obligations and placing it in violation of international law. this result may not be anticipated by congress prior to the change in domestic law. 35. see taylor v. morton, 23 f. cas. 784 (curtis, circuit justice, c.c.d. mass. 1855); see also infra, pp. 3-6 (examining the processes by which domestic law is enacted and the treaty ratification process). reuven s. avi-yonah, international tax as international law, 57 taxlr 483 (2004) (examining the processes by which international law differs from international tax law). 36. see morton, 23 f. cas. at 785. 37. see id. at 788; see also cook v. united states, 288 u.s. 102, 120 (1933) (holding that “[a] treaty will not be deemed to have been abrogated or modified by a later statute unless such purpose on the part of congress has clearly been expressed.”); trans world airlines v. franklin mint corp., 466 u.s. 243, 252 (1984). it has been conceded by congress that such conflict cannot always be anticipated. id. 710 florida tax review [vol. 9:7 v. the impact of the supremacy clause the supremacy clause in the united states constitution has been interpreted, and further emphasized in marbury v. madison, to place domestic federal statutes on equal status with treaties. 38 the supremacy clause states: [t]his constitution, and the laws of the united states which shall be made in pursuance thereof; and all treaties made, or which shall be made, under the authority of the united states, shall be the supreme law of the land; and the judges in every state shall be bound thereby, any thing in the constitution or laws of any state to the contrary notwithstanding. 39 an ambiguity is found in the complications arising from the constitution’s allocation of power and enforcement. the ambiguity is whether a treaty and a domestic law of the united states carry the same level of authority. pursuant to constitution, the president has the power to create treaties 40 subject to the senate’s consent, and congress has the power to lay 38. in marbury v. madison 5 u.s. at 180, the supreme court determined, in light of the language of the supremacy clause, that the constitution was the supreme law of the land. specifically, justice marshall stated that [i]t is also not entirely unworthy of observation, that in declaring what shall be the supreme law of the land, the constitution itself is first mentioned; and not the laws of the united states generally, but those only which shall be made in pursuance of the constitution, have that rank. thus the particular phraseology of the constitution of the united states confirms and strengthens the principle, supposed to be essential to all written constitutions, that a law repugnant to the constitution is void; and that courts, as well as other departments, are bound by that instrument. id. (marshall, j.) notably absent from this opinion is any mention of “treaty.” yet, marbury v. madison has subsequently been relied on in holding that while that the constitution is supreme to statutes, statutes and treaties must be of equal status. however, this overlooks the fact that unlike statutes, treaties are formed as the result of negotiations between two sovereign nations, each ceding some of its sovereignty in return for a benefit, and the fact that the international obligation remains after the domestic override. see jordan j. paust, international law as law of the united states 277 n.547 (1996). 39. u.s. const. art. vi, § 2, cl. 2. 40. u.s. const. art. ii, § 2, cl. 2 (giving the executive branch treaty powers, subject to senate consent). 2009] congressional unilateral tax treaty overrides 711 and collect taxes. 41 yet, when a conflict arises between domestic tax legislation and an international treaty, how should the conflict be resolved? this question has been in debate since 1855; however, with the advent of globalization and the call for stronger economic foreign policy, should the united states continue to follow the later-in-time rule? current law dictates that, when there is a conflict between a domestic law and a treaty provision, whichever was enacted later-in-time triumphs. has policy and law become solely an issue of preemptive planning and strategic timing? to investigate the later-in-time doctrine further, it is important to consider how the supreme court originally interpreted the character of an international treaty. in the amiable isabella case, 42 a 1795 treaty between the united states and spain led the court to question the construction of treaties. the 1795 treaty contained a provision allowing either nation to “sail from any port to those of a country which may be at war with either or both nations, and may go to neutral places, or to other enemy ports; and that every article on board, except contraband, to whomsoever belonging, shall be free.” 43 if a ship did not have a passport, it could be captured and claimed as a war prize. 44 the isabella had a passport, but the captors claimed the document was not issued by a competent authority because the spanish king was required to authorize such passports; therefore, it was invalid and cause for the isabella’s seizure. 45 the treaty required passports to be issued by the 41. u.s. const. art. i, § 8, cl. 1 (giving congress the power to lay and collect taxes). specifically, the constitution gives the house of representatives the power to create domestic tax laws. u.s. const. art. 1, § 7, cl. 1 (“all bills for raising revenue shall originate in the house of representatives; but the senate may propose or concur with amendments as on other bills.”). 42. in re the amiable isabella, 19 u.s. 1, 4 (1821). a spanish ship, sailing from havana, cuba, under the protection of the british navy, leaving such protection off the coast of florida, allegedly setting course for london, was “captured by the privateer ship roger, and carried into wilmington, north carolina, for adjudication.” the captured ship, the amiable isabella, claimed that it had free passage because the administrator general of the royal revenues for the port of havana, cuba granted such authority, in the form of a passport. the passport gave the isabella permission to sail from cuba to hamburg, germany, for the purposes of trading and it gave permission for the return trip. 43. id. at 14. the treaty further provided that ships “shall be furnished with a passport expressing her national character, and with certificates to show, that the cargo is not contraband.” the passport was to have conclusive effect. 44. 19 u.s. at 21 (“[w]ithout which requisites they [the cargo and ship] may be sent to one of the ports of the other contracting party, and adjudged by the competent tribunal . . . [as] legal prizes . . . .”). 45. 19 u.s., at 18. 712 florida tax review [vol. 9:7 magistrate of the place from which the vessel sails. 46 therefore, cuba could not issue the passport because the isabella was a spanish vessel. 47 however, the court examined the treaty provision and found it did not proscribe any specific form for the passport. 48 specifically, the supreme court held “the obligations of the treaty could not be changed or varied but by the same formalities with which they were introduced; or at least by some act of as high an import, and of as unequivocal an authority.” 49 in the amiable isabella case, justice story stated: [this] court does not possess any treaty-making power. that power belongs by the constitution to another department of the government; and to alter, amend, or add to any treaty, by inserting any clause, whether small or great, important or trivial, would be on our part an usurpation of power, and not an exercise of judicial functions. it would be to make, and not to construe a treaty. 50 (emphasis added) justice story further held: [t]he parties who formed this treaty, and they alone, have a right to annex the form of the passport. it is a high act of sovereignty, as high as the formation of any other stipulation of the treaty. it is a matter of negotiation between the governments. the treaty does not leave it to the discretion of either party to annex the form of the passport; it requires it to be the joint act of both; and that act is to be expressed by both parties in the only manner known between independent nations – by a solemn compact through agents specially delegated, and by a formal ratification. 51 46. id. at 18 47. id. 48. id. at 23. 49. this was decided thirty-four years before the taylor v. morton, 23 f. cas. 784, 786-87 (curtis, circuit justice, c.c.d. mass. 1855). justice story wrote the opinion in which the following justices concurred: chief justice marshall, justice livingston, justice washington, justice todd, and justice duvall; justice johnson provided the sole dissenting opinion. the amiable isabella, 19 u.s. at 25. justice johnson dissented because he thought the passport provision applied and that any form substantially complying with the provision should be acceptable. id. at 111-12 (johnson, j., dissenting). 50. the amiable isabella, 19 u.s. at 22. 51. id. at 22. 2009] congressional unilateral tax treaty overrides 713 the amiable isabella distinguishes the character of treaties and their authority to domestic law. the court states a treaty requires, not just the cooperation of the united states, but the cooperation of another country, and it is not the place of any branch of government to circumvent their obligation under a treaty without first approaching the other country. the true progenitor of the later-in-time doctrine was supreme court justice benjamin curtis, sitting alone on circuit court as trial judge in the case of taylor v. morton. 52 in 1832, the united states entered into a treaty with russia, in which the united states granted russia most-favored-nation treatment with respect to imports. 53 the tariff act of 1842 lowered the tax on bombay hemp to $25 per ton, while keeping the same tax on russian hemp at $40 per ton. 54 russia brought action against the boston port 52. 23 f. cas. 784, 786-87 (curtis, circuit justice, c.c.d. mass. 1855). see also david sachs, is the 19th century doctrine of treaty override good law for modern day tax treaties?, 47 tax law. 867, 869 (1994). in dred scott v. sandford, 60 u.s. 393 (1857), curtis, in a dissenting opinion, had an opportunity to further profess the later-in-time doctrine. curtis showed his resentment at the idea the legislature could be constrained by a treaty. dred scott, 60 u.s. at 629 (curtis, j., dissenting). he thought the powers of the government must be unimpaired. id. curtis completely rejected the idea that the united states ceded any sovereignty when it entered into the treaty: [t]he responsibility of the government to a foreign nation, for the exercise of those powers, is quite another matter. that responsibility is to be met, and justified to the foreign nation, according to the requirements of the rules of public law; but never upon the assumption that the united states had parted with or restricted any power of acting according to its own free will, governed solely by its own appreciation of its duty. id. (curtis, j., dissenting). curtis further stated: “[t]his constitution, and the laws of the united states which shall be made in pursuance thereof, and all treaties made or which shall be made under the authority of the united states, shall be the supreme law of the land.” this has made treaties part of our municipal law; but it has not assigned to them any particular degree of authority, nor declared that laws so enacted shall be irrepealable. no supremacy is assigned to treaties over acts of congress. that they are not perpetual, and must be in some way repealable, all will agree. id. (curtis, j., dissenting). 53. taylor, 23 f. cas. at 784. 54. the domestic statute imposed a tax of forty dollars per ton on all hemp except hemp imported from manila and suera, and on other hemps from india, on which a tax of twenty-five dollars was levied. id. at 784-85. 714 florida tax review [vol. 9:7 collector of customs seeking repayments for the difference between the two rates. 55 judge curtis acknowledged the supremacy clause, but reasoned it was not dispositive of the issue. he believed when a treaty and domestic law conflicted, “the solution of the question was [to be] found, by considering the nature and objects of each species of law, the authority from which each emanated, and the consequences of allowing or denying the paramount effect of the constitution.” 56 judge curtis recognized “[t]he foreign sovereign between whom and the united states a treaty has been made, has a right to expect and require its stipulations to be kept with scrupulous good faith . . . .;” 57 yet, relying on article i, section 8 of the constitution, he found the statute overrode the treaty. 58 he expressly rejected the idea that the house of representatives’ power to lay taxes had to be exercised in conformity with treaties, as this would deeply affect the independence and sovereignty of the united states. 59 judge curtis found the tax statute was within the house’s powers and because a treaty was equivalent to a law, there was nothing that could prevent the house from repealing the treaty since it could repeal laws. 60 in addition, judge curtis stated domestic statutes should receive deference as opposed to treaties, because the creation of domestic laws involves three bodies of government (the house of representatives, the senate, and the president), while treaty ratification involves only two (the president and the senate). 61 judge curtis’s opinion wholly ignores and disregards the amiable isabella case. finally, judge curtis held certain questions such as whether a treaty had been violated, whether the nations under the treaty were still required to fulfill their obligations, and whether a treaty override was justified, were not 55. id. at 784. 56. id. at 785. 57. id. 58. id. 59. id. at 786. this reasoning overlooks the fact that by entering a treaty, each country cedes sovereignty in return for a benefit. see paust, supra note 38, at 277 n.547. 60. taylor, 23 f. cas. at 784-6. judge curtis explicitly rejected the idea that the president and the senate exclusively held the power to modify or repeal treaty provisions. id. he reasoned that because when congress makes a declaration of war, it has the effect of repealing all “treaties with the hostile nation, inconsistent with a state of war[,]” there is nothing that requires the same government body that enacts the treaty to be the same body that that repeals it. id. at 786. congress could override a treaty, because if it could not, no one could, and “the power to do so, is prerogative, of which no nation can be deprived, without deeply affecting its independence.” id. 61. taylor, 23 f. cas. at 786. 2009] congressional unilateral tax treaty overrides 715 questions for judicial review, 62 were questions for the executive and legislative departments of the government. 63 the supreme court addressed statutory overrides of treaties, in the context of “domestic dependent nations,” in the cherokee tobacco case. 64 62. thus judge curtis found that a court could not determine whether a treaty had been violated because it was a political question. see generally baker v. carr, 369 u.s. 186 (1962), in which a court decided that a right was justiciable before the supreme court as arising basically out of their jurisdiction directly under the constitution. 63. taylor, 23, f.cas. at 786-87. curtis thought the remedy was to be found in diplomacy and legislation, not through the administration of existing laws: is it a judicial question, whether a treaty with a foreign sovereign has been violated by him; whether the consideration of a particular stipulation in a treaty, has been voluntarily withdrawn by one party, so that it is no longer obligatory on the other; whether the views and acts of a foreign sovereign, manifested through his representative have given just occasion to the political departments of our government to withhold the execution of a promise contained in a treaty, or to act in direct contravention of such promise? i apprehend not. these powers have not been confided by the people to the judiciary, which has no suitable means to exercise them; but to the executive and the legislative departments of our government. they belong to diplomacy and legislation, and not to the administration of existing laws. id. at 787. 64. the cherokee tobacco, 78 u.s. 616 (1870). this was a split decision, the opinion was delivered by justice swayne, in which justice strong, justice clifford, and justice miller concurred; chief justice chase, justice nelson, and justice field did not hear the argument; and justice bradley and justice davis concurred in dissent. in cherokee nation v. georgia, 30 u.s. 1, 17 (1831). justice marshall referred to indian nations as domestic dependent nations and described the relationship between indian nations and the united states as one similar to a ward and guardian. 30 u.s. 1, 17 (1831) (marshall, j.). though the indians are acknowledged to have an unquestionable, and, heretofore, unquestioned right to the lands they occupy, until that right shall be extinguished by a voluntary cession to our government; yet it may well be doubted whether those tribes which reside within the acknowledged boundaries of the united states can, with strict accuracy, be denominated foreign nations. they may, more correctly, perhaps, be denominated domestic dependent nations. they occupy a territory to which we assert a title independent of their will, which must take effect in point of possession when their right of possession ceases. meanwhile they 716 florida tax review [vol. 9:7 the cherokee nation argued an internal revenue act, enacted in 1868, 65 which taxed liquor and tobacco products, did not apply to the nation due to a treaty it had with the united states. 66 under the treaty, the cherokee nation did not have to pay federal taxes on goods produced within the nation. 67 the are in a state of pupilage. their relation to the united states resembles that of a ward to his guardian. id. marshall also relied on the commerce clause in holding that congress had the power to regulate trade with indian nations. id. at 43 (marshall, j.). article i, § 8 of the constitution gives congress the power “[t]o regulate commerce with foreign nations, and among the several states, and with the indian tribes.” u.s. const. art. i, § 8, cl. 3. in johnson v. m’intosh, 21 u.s. 543, 586, 592 (1823) (marshall, j.) decided eight years earlier, marshall found indian nations were subject to the sovereignty of the united states and noted that indian nations did not have absolute title to their lands, the united states having the power to extinguish it. the indian nations were first conquered by great britain, spain, and france, but through the civil war, a treaty with spain, and the louisiana purchase, the united states acquired absolute title to the lands occupied by the conquered indian nations and therefore the indian nations were subject to the sovereignty of the united states, the conqueror. id. at 583-88 (marshall, j.). nine years later, marshall had another opportunity to describe the relationship between the united states and indian nations, and the lack of sovereignty on the part of the indian nations. worcester v. georgia, 31 u.s. 515, 580 (1832) (marshall, j.). at no time has the sovereignty of the country been recognized as existing in the indians, but they have been always admitted to possess many of the attributes of sovereignty. all the rights which belong to self government have been recognized as vested in them. their right of occupancy has never been questioned, but the fee in the soil has been considered in the government. this may be called the right to the ultimate domain, but the indians have a present right of possession. 31 u.s. at 580 (1832) (marshall, j.). marshall stated the indian nations were dependent upon the united states for their protection and for the supply of their essential wants. id. at 555 (marshall, j.). marshall again noted congress had power over indian nations pursuant to the commerce clause in the constitution. id. at 559 (marshall, j.). 65. internal revenue act of 1868 § 107. 66. the internal revenue act taxed “distilled spirits, fermented liquors, tobacco, snuff, and cigars . . . produced anywhere within the exterior boundaries of the united states, whether the same shall be within a collection district or not.” the cherokee tobacco, 78 u.s. at 618. 67. under the treaty, “[e]very cherokee indian and freed person residing in the cherokee nation shall have the right to sell any products of his farm . . . or any merchandise or manufactured products . . . without . . . paying any tax thereon . . . .” id. 2009] congressional unilateral tax treaty overrides 717 government argued the code provision applied to the cherokee, as it did in all other territories, and the relevant provisions of the treaty were annulled. 68 justice swayne, much like judge curtis, 69 believed the constitution did not address the issue of when treaties and acts of congress conflict. 70 justice swayne ultimately held the internal revenue statute to supersede the treaty with the cherokee nation, despite being enacted later-in-time. 71 he believed the consequences of the treaty override were merely political questions outside “the sphere of judicial cognizance.” 72 the supreme court’s decision which enacted the first-in-time rule was reflective of the reasoning of that time. 73 indirectly, the court found it inconceivable, in its deliberations, that a treaty could in some way impair or supersede the authority or independence of the united states. 74 68. id. 69. see taylor v. morton, 23 f. cas. at 785. 70. worcester v. georgia, 31 u.s. at 621. 71. the cherokee tobacco, 78 u.s. at 621. drawing from the language in taylor v. morton, the court stated that “[in] the case under consideration the act of congress must prevail as if the treaty were not an element to be considered.” id. justice bradley, in his dissenting opinion, stated that he did not think it was “the intention of congress to extent [sic] the internal revenue law to the indian territory [because] . . . [t]hat is an exempt jurisdiction.” id. at 622 (bradley, j., dissenting). bradley reasoned that because congress did not expressly state that the cherokee nation, a jurisdiction exempt from u.s. taxation pursuant to numerous treaties, was to be subject to the domestic legislation, it should not have to pay the tax. id. at 622-23 (bradley, j., dissenting). 72. the court held that any injuries resulting from the domestic statute overriding the treaty, “the power of redress is with congress, not with the judiciary, and that body, upon being applied to, it is presumed, will promptly give the proper relief.” id. at 621. 73. this is reflective of justice marshall’s view expressed in johnson v. m’intosh, 21 u.s. 543, 586, 592 (1823), where justice marshal found that the native americans, although in the united states first, ceded their sovereignty to the united states who came later-in-time. this case involved a “domestic dependent nation” and, at this time, the u.s. already had a history of poorly treating indian nations and disregarding treaty obligations. cherokee tobacco, supra note 63. the indian removal act of 1830 gave president andrew jackson the power to enter into treaty agreements with indians, seeking relocation of native americans. the “trail of tears,” a product of this relocation plan in which indian nations were relocated to indian territories at gunpoint, resulted in the deaths of over four thousand native americans mostly due to disease, malnutrition, and violence. essentially, this resulted in the forced relocation of indian nations onto reservations. 74. see the cherokee tobacco, 78 u.s. at 621. the u.s. was still expanding westward, developing such states like california and arizona which were admitted as states in 1850 and 1912. 718 florida tax review [vol. 9:7 in 1884, the supreme court had the occasion to revisit the issue of treaty overrides in two separate cases, decided in the context of congress’ immigration powers. 75 in the head money cases, a consolidation of several 75. chew heong v. united states, 112 u.s. 536 (1884); the head money, 112 u.s. 580 (1884). these cases were decided on the same day, chew heong first and the head money cases second, with the court reaching different results on very similar facts involving congress’ power over immigration. while the head money cases had a unanimous decision, chew heong was not. 112 u.s. at 580, 600; chew heong, 112 u.s. at 538, 560. in chew heong, the majority held that there was no treaty override because congress did not intend for the domestic law, which required chinese laborers returning to the united states to possess a certificate to be readmitted into the country, to apply to those already covered by the earlier treaty, which allowed chinese laborers to freely leave and return to the united states. chew heong, 112 u.s. at 542, 560. the majority consisted of the following justices: chief justice waite, justice harlan, justice miller, justice woods, justice matthews, justice gray, and justice blatchford; justice field and justice bradley provided separate dissenting opinions. chew heong, 112 u.s. at 538, 560; see united states supreme court, http://www.supremecourtus.gov/about/members.pdf (last visited jun. 23, 2008). justice field, in his dissenting opinion, thought that congress had intended for the domestic law to apply to chinese laborers despite the treaty. chew heong, 112 u.s. at 561. citing taylor v. morton, field reaffirmed some of the concerns about sovereignty and independence and stated that a treaty, like any other legislation, may be modified or revoked by a subsequent act of congress. id. at 56263 (field, j., dissenting) (“if the treaty relates to a subject within the powers of congress and operates by its own force, it can only be regarded by the courts as equivalent to a legislative act. congress may, as with an ordinary statute, modify its provisions, or supersede them altogether.”). field stated that treaty overrides were not a matter for judicial review, [i]f the nation with which the treaty is made objects to the legislation it may complain to the executive head of our government, and take such measures as it may deem advisable for its interests. but whether it has just cause of complaint, or whether, in view of its action, adverse legislation on our part be or be not justified, is not a matter for judicial cognizance or consideration. 112 u.s. at 562 (field, j., dissenting). in support for the domestic law overriding the treaty provision, just as justice curtis reasoned in taylor v. morton, field reasoned that the supremacy clause placed treaties and federal law on equal footing and did not give paramount authority to either over the other, therefore the last expression of the sovereign will must control. id. (field, j., dissenting); taylor v. morton, 23 f. cas. 784, 785 (curtis, circuit justice, c.c.d. mass. 1855). field also based his reasoning that the domestic law override the treaty on congress’ powers over immigration; he stated that “[t]he immigration of foreigners to this country, and the conditions upon which they shall be permitted to come or remain, are proper subjects both of legislation and of treaty stipulation. the power of 2009] congressional unilateral tax treaty overrides 719 lower court opinions, debated a fifty-cent tariff imposed on all non-u.s. passengers arriving aboard ships in the united states. 76 the fifty-cent tax, part of a congressional act known as the act to regulate immigration, conflicted with a pre-existing treaty with russia. relying on the cherokee tobacco and taylor v. morton, the court held if a provision of an act is in conflict with any treaty with a foreign nation, the act must prevail in the courts. the court, reasoning that the constitution gave treaties no “superior sanctity,” likened it to a statute, and therefore determined that nothing made a treaty “irrepealable” or “unchangeable.” 77 several years later, in whitney v. robinson, 78 the supreme court for the first time clearly enunciated the later-in-time rule. 79 relying primarily on congress, however, over the subject can neither be taken away nor impaired by any treaty.” chew heong, 112 u.s. at 563 (field, j., dissenting). 76. the head money cases, 112 u.s. at 586. the suit is brought to recover from robertson the sum of money received by him, as collector of the port of new york, from plaintiffs, on account of their landing in that port passengers from foreign ports, not citizens of the united states at a rate of 50 cents for each such passengers, under the act of congress of aug. 3, 1882, entitled ‘an act to regulate immigration.’ id. 77. id. at 598-99. a treaty, then, is a law of the land as an act of congress is, whenever its provisions prescribe a rule by which the rights of the private citizen or subject may be determined. and when such rights are of a nature to be enforced in a court of justice, that court resorts to the treaty for a rule of decision for the case before it as it would to a statute. but even in this aspect of the case there is nothing in this law which makes it irrepealable or unchangeable. the constitution gives it no superiority over an act of congress in this respect, which may be repealed or modified by an act of a later date. nor is there anything in its essential character, or in the branches of the government by which the treaty is made, which gives it this superior sanctity. id. 78. whitney v. robinson, 124 u.s. 190 (1888) 79. id. the whitney court, which rendered a unanimous decision, had almost an identical composition as the chew heong and the head money court, consisted of chief justice waite, justice miller, justice field, justice bradley, justice harlan, justice matthews, justice gray, justice blatchford, and justice lamar. see id.; chew heong, 112 u.s. at 536; the head money cases, 112 u.s. at 580; see also united states supreme court, supra note 61. in this case, the importers of sugar from the island of santo domingo protested the collection of taxes on those items. they argued that since the united 720 florida tax review [vol. 9:7 taylor v. morton, but also citing the head money cases, justice field held whenever a conflict exists between a treaty provision and a domestic tax law, the later enacted provision would control: 80 by the constitution a treaty is placed on the same footing, and made of like obligation, with an act of legislation. both are declared by that instrument to be the supreme law of the land, and no superior efficacy is given to either over the other. when the two relate to the same subject, the courts will always endeavor to construe them so as to give effect to both, if that can be done without violating the language of either; but if the two are inconsistent, the one last in date will control the other, provided always the stipulation of the treaty on the subject is self-executing. 81 following whitney was the chinese exclusion case. 82 it dealt with a conflict between a treaty with the united states and china, permitting states had a treaty with the kingdom of hawaii that exacted on taxes on the same items, and because the united states’ treaty with the dominican republic had a clause precluding any “higher or other duty” it should not have to pay those taxes either. id. the supreme court rejected this argument because congress had subsequently passed a law requiring taxation on the importation of certain items covered by the u.s.-santo domingo treaty, notwithstanding the treaty’s provisions. the court found that treaties and statutes were of equal status and when there is an un-resolvable conflict, the last one passed will control. id. at 194. 80. whitney, 124 u.s. at 194 81. id. at 195. as the analysis of this article is confined to treaty overrides in the context of tax conventions, it is important to note that tax treaties are self-executing – no domestic legislation is required to incorporate them into domestic law. overriding tax treaties, supra note 7, at 78 (citing columbia marine services, inc. v. reffet ltd., 861 f.2d 18 (2d cir. 1988); united states v. schooner peggy, 5 u.s. 103 (1801)). 82. chae chan ping v. united states, 130 u.s. 581 (1889) [hereinafter ping]. plaintiff was a chinese laborer living in united states until 1887, when he returned to china. upon returning to the u.s., he presented his certificate allowing him to enter the country when he was taken into custody by the collector of customs. during ping’s trip to china, congress had enacted legislation, which became effective in 1888, that denied chinese laborers passage into the united states, this legislation became effective several days before ping returned to the u.s. id. at 431; ping, 130 u.s. at 593-94. the new legislation was claimed to be for the common good and protection of the nation. the discovery of gold in california in 1848 caused an influx of chinese immigrants into the united states and as a result, there was a fear that california “would be overrun by them unless prompt action was taken to restrict their immigration.” ping, 130 u.s. at 595. an 1880, u.s.-china 2009] congressional unilateral tax treaty overrides 721 chinese immigrants to freely return to the united states, and a subsequently enacted statute which placed restrictions on the return of chinese immigrants. 83 justice field delivered the unanimous opinion which held, “congress has the power to control immigration because such power, although not enumerated in the constitution, is inherent in the sovereignty and nationhood of the united states.” 84 secondly, relying on taylor v. treaty allowed chinese to freely return to the united states with a certificate issued by the collector of customs. id. at 589. the supreme court had an identical composition as the whitney court, which consisted of chief justice waite, justice miller, justice field, justice bradley, justice harlan, justice matthews, justice gray, justice blatchford, and justice lamar. see id. at 581; whitney, 124 u.s. 90. 83. this treaty was not a self-executing treaty, but in 1882, an act of congress made the treaty effective. ping, 130 u.s. at 597. to resolve the conflict between the treaty and subsequently enacted statute, the court applied the rule enunciated in whitney, that a treaty which is not self-executing can be overridden by another congressional act. id. at 600. after applying this rule, the court went even further and held that “in either case [the treaty being self-executing or not] the last expression of the sovereign will must control. id. at 600. distinguishing this case from chew heong, was congress’ express intent for the override. see id. at 598-99; chew heong v. united states, 112 u.s. 536, 542 (1884); see supra note 61. in the chinese exclusion case, congress had specifically amended the domestic law at issue in chew heong to make it “unlawful for any chinese laborer who shall at any time heretofore have been, or who may now or hereafter be, a resident within the united states, and who shall have departed, or shall depart therefrom, and shall not have returned before the passage of this act, to return to, or remain in, the united states” and “every certificate heretofore issued in pursuance thereof is hereby declared void and of no effect, and the chinese laborer claiming admission by virtue thereof shall not be permitted to enter the united states.” ping, 130 u.s. at 599. 84. ping, 130 u.s. at 603-04. justice field found that control over immigration is a right that belongs to every sovereign state and that this right is inherent in state independence and sovereignty. ping, 130 u.s. at 605-06 (field, j.). in the head money cases, which dealt with the imposition of a tax of fiftycents per immigrant, found that congress had the power to impose this under its authority to regulate commerce with foreign nations. 112 u.s. 580, 591 (1884). however, in 1884, immigration was more of a matter of personal choice and not foreign commerce; also, the notion that foreign commerce includes the importation of persons conjures thoughts of the slave trade and was demeaning to immigrants to be thought of in this way. ping, 130 u.s. at 603-04. but, in the chinese exclusion case, even though power over immigration is not expressly granted to the federal government in the constitution, the court found support for congress’ power to control immigration in the sovereignty and independence inherently belonging to the united states. see id. at 857. in united states v. curtiss-wright export corp., justice 722 florida tax review [vol. 9:7 morton, justice field stated “the constitution does not prohibit congress from enacting laws inconsistent with the international obligations of the united states and that the courts will give effect to an act of congress inconsistent with provisions in an earlier treaty.” 85 the court held treaties and statutes to be of equal status under the supremacy clause and found that when in conflict, whichever was enacted later-in-time would triumph. 86 the court noted that despite the resemblance of treaties as contracts between nations, the court found them to be just like statutes, able to be repealed or modified by a subsequent congressional act. 87 despite the recognition by the court that an override may leave international obligations unfulfilled, relying on taylor and notions of inherent sovereignty, the court found that “[t]he validity of this legislative release from the stipulations of the treaties was of course not a matter for judicial cognizance.” 88 historically, courts have addressed conflicts between treaty provisions and statutes, and have ruled that not every provision of a treaty must be dominated by a domestic law. the starting point with cases proclaiming this reasoning began with murray v. the schooner charming betsy. 89 in this case, the supreme court declared “an act of congress ought never to be construed to violate the law of nations if any other possible construction remains . . .” 90 this rule of construction has also been applied sutherland expounded the doctrine that the powers of external sovereignty did not derive from the constitution. these powers, he said, were lodged in the united states, rather than in the individual states, before the constitution was adopted and remained there – and therefore in the federal government – under the constitution. id. at 858 (citing united states v. curtiss-wright export corp., 299 u.s. 304, 316-18 (1936)). it should be noted that this interpretation would seem to be precluded by the 10th amendment, which states that “[t]he powers not delegated to the united states by the constitution, nor prohibited by it to the states, are reserved to the states respectively, or to the people.” u.s. const. amend. x. 85. ping, 130 u.s. at 602). 86. id. 87. id. 88. id. (“the question whether our government is justified in disregarding its engagements with another nation is not one for the determination of the courts.”). 89. 6 u.s. 64, 81 (1808). this was a unanimous decision delivered by chief justice marshall; also sitting on the court at this time were justice cushing, justice chase, justice washington, justice johnson, justice livingston, and justice todd. id. at 64. 90. the charming betsy, 6 u.s. at 118. here, a domestic statute prohibited trade with france and authorized the seizure of any vessel bound for french ports. the court noted that “the building of vessels in the united states for sale to neutrals, in the islands, is, during war, a profitable business, which congress cannot be intended to have prohibited, unless that intent be manifested by express words or a 2009] congressional unilateral tax treaty overrides 723 to treaties. therefore, a court should attempt to construe a domestic statute against a treaty provision to prevent conflict. for example, in chew heong v. united states, involving a chinese laborer working in the united states, the supreme court held that congress did not intend for the domestic law to apply to those covered by a preexisting treaty. 91 in 1880, the united states and china signed a treaty allowing chinese laborers already in the united states “to go and come of their own free will.” 92 in 1881, chew left for the hawaiian kingdom and, upon attempting to return to the united states in 1884, was denied admission because he did not possess a certificate required of all chinese laborers entering the country. 93 congress passed the certificate requirement as part of the chinese restriction act of 1882. 94 the supreme court held that when congress enacted the certificate provision, it did not intend for it to apply to chinese laborers already covered by the earlier treaty provisions. 95 the inference drawn from this holding is congress may override an existing treaty, only if there is a clear expression of congressional intent such result was intended. 96 in cook v. united states, the supreme court addressed a potential override of a treaty with the united kingdom. 97 in 1930, pursuant to the tariff act of 1930, a u.s. coast guard stopped the british vessel mazel tov, eleven and one-half miles from the united states coast. 98 the tariff act very plain and necessary implication.” captain murray, of the united states navy, captured a vessel, the charming schooner betsy, and sold in 1800 pursuant to the statute. the former owner challenged the sale because he was a united states citizen and the current owner, born in connecticut, swore an oath to denmark in 1797. chief justice marshall declared the proper construction of the statute was that a citizen must own the vessel, “not at the time of the passage of the law, but at the time when the act of forfeiture shall be committed.” since the current owner was not a united states citizen at the time of forfeiture, the domestic law did not apply and the forfeiture was illegal. under this construction, the statute did not violate the naturalization and citizenship laws of the danish crown. 91. 112 u.s. 536 (1884). 92. id. at 542. 93. id. at 539. 94. id. at 538. 95. id. at 560. 96. id.; sachs, supra note 51, at 870. 97. 288 u.s. 102 (1933). justice brandeis delivered the unanimous opinion of the court, which also consisted of chief justice hughes, justice mcreynolds, justice sutherland, justice stone, justice roberts, justice cardozo, justice van devanter, and justice butler. see id. at 102. 98. cook, 288 u.s. at 107. the collector of customs seized the ship and searched cook’s cargo, discovering intoxicating liquor, and charged cook a penalty for failing to disclose the illegal cargo. id. cook claimed that his cargo, which was 724 florida tax review [vol. 9:7 allowed the coast guard to stop and inspect any ship coming within twelve miles of the u.s. coast. cook argued the stop was unjustified because the treaty between the united states and great britain only permitted the stopping and inspecting of any ship within three nautical miles of shore. 99 the tariff act of 1922 contained language which the subsequent treaty with britain sought to address and found relevant in this case. 100 however, when congress amended the tariff act in 1930, they left that specific portion unchanged. 101 while not addressing cook v. u.s., justice being transported from a french colony, was destined for the bahamas, a british colony, and that his ship was intercepted outside the legal limit of the tariff act. id. 99. from 1918 until 1933, under the 18th amendment, the manufacture, sale, and transportation of alcohol were prohibited in united states. u.s. const. amend. xviii, repealed by u.s. const. amend. xxi; see wikipedia, http://en.wikipedia.org/wiki/prohibition#prohibition_in_the_united_states (last visited jun. 23, 2008). this is reflected in the u.s.-britain treaty, which provided that the high contracting parties should declare “their firm intention to uphold the principle that three marine miles measured from low water mark constitute the proper limits of territorial waters” . . . . moreover, the arrangement . . . was to be limited specifically to intoxicating liquors; and no reciprocal rights were to be conferred. cook, 288 u.s. at 117-18 (citations omitted). it was specifically noted that [t]he need of the united states was to be met by providing that his britannic majesty ‘will raise no objection to the boarding,” etc., outside the territorial waters at no “greater distance from the coast of the united states than can be traversed in one hour by the vessel suspected of” smuggling. the need of great britain was to be met by our allowing “british vessels voyaging to or from the ports or passing through the waters of the united states to have on board alcoholic liquors listed as sea stores or as cargo destined for a foreign port, provided that such liquor is kept under seal while within the jurisdiction of the united states.” id. 100. id. 101. shortly after the treaty took effect, the treasury department issued amended instructions for the coast guard which pointed out, after reciting the provisions . . . [the tariff act], that “in cases of special treaties, the provisions of those treaties shall be complied with;” and called attention particularly to the recent treaties dealing with the smuggling of intoxicating liquors. the commandant of the coast guard, moreover, was informed in 1927, as the solicitor general states, that all seizures of british vessels captured in the rum-smuggling trade should be within the terms of the treaty and that seizing officers should be instructed to produce evidence, not that the vessel was found within the four2009] congressional unilateral tax treaty overrides 725 brandeis cited chew heong and held the amendments to the tariff act of 1930 did not have a clear expression of congressional intent to abrogate and modify the treaty between the united states and great britain. 102 specifically, justice brandeis stated, “[a] treaty will not be deemed to have been abrogated or modified by a later statute unless such purpose on the part of congress has been clearly expressed.” 103 distinguishing cook, the supreme court in trans world airlines v. franklin mint corp. 104 held a domestic statute did not override a treaty provision because there was no clear expression of congressional intent for such effect. 105 the court was asked to determine the extent of trans world airlines’ (“twa”) liability for losing cargo belonging to franklin mint. 106 the district court followed the warsaw convention, an international air carriage treaty into which the united states entered in 1934, which limited twa’s liability to a sum of 250 francs per kilogram; the french franc consisted of “65 1/2 milligrams of gold at the standard of fineness of nine hundred thousandths.” 107 franklin mint argued that the repeal of the par league limit, but that she was apprehended within one hour’s sailing distance from the coast. id. at 119. 102. id. at 119-20. 103. id. at 120. 104. 466 u.s. 243, 251 (1984). 105. trans world airlines, inc. v. franklin mint corp., 466 u.s. 243, 251 (1984). 106. franklin mint, 466 u.s. at 245-46. the cargo consisted of four packages of numismatic materials that, in total, weighed 714 pounds and was shipped on twa from philadelphia to london. id. franklin mint did not declare the value of the cargo, but declared damages of $250,000 for the subsequently lost packages. id. at 246. the district court ruled that under article 22 of the warsaw convention, twa’s liability was limited to $6,475.98. id. 107. id. justice o’connor noted that “[t]he [warsaw] convention was drafted at international conferences in paris in 1925, and in warsaw in 1929. the united states became a signatory in 1934. more than 120 nations now adhere to it. the convention creates internationally uniform rules governing the air carriage of passengers, baggage, and cargo.” id. at 246-47. article 18 of the convention holds carriers liable for the loss of cargo. see convention for the unification of certain rules relating to international carriage by air, ch. iii, art. 18, oct. 12, 1929, available at http://www.jus.uio.no/lm/air.carriage.warsaw.convention.1929/18 (last visited on jun. 24, 2008). (“the carrier is liable for damage sustained in the event of the destruction or loss of, or of damage to, any registered luggage or any goods . . . .”). article 22 sets the amount of liability equal “to a sum of 250 francs per kilogram, unless the consignor has made . . . a special declaration of the value at delivery[,] . . . [then] the carrier will be liable to pay a sum not exceeding the declared sum, unless he proves that that sum is greater than the actual value to the consignor at delivery.” 726 florida tax review [vol. 9:7 value modification act, which had the effect of abandoning the gold standard, rendered the liability limitation in article 22 of the warsaw convention unenforceable in the united states. 108 the court of appeals agreed, as it held the “enforcement of the [warsaw] convention requires a factor for converting the liability limit into dollars and . . . there is no united states legislation specifying a factor to be used by the united states courts.” 109 the supreme court disagreed with this reasoning. 110 the court did not cite to the charming betsy or chew heong; instead, the court relied on cook v. united states and held “[a] treaty will not be deemed to have been abrogated or modified by a later statute unless such purpose on the part of congress has been clearly expressed.” 111 therefore, the abandonment of the gold standard and the enactment of legislation repealing the par value modification act did not terminate the united states’ obligation to follow convention for the unification of certain rules relating to international carriage by air, ch. iii, art , oct. 12, 1929. 22, available at http://www.jus.uio.no/lm/air.carriage. warsaw.convention.1929/22 (last visited jun. 24, 2008). article 22 also states that the french franc consists “of 65 milligrams gold of millesimal fineness 900” and provides that the “sums may be converted into any national currency in round figures.” id. in 1945, the united states became a member of the international monetary fund (“imf”) and agreed to “maintain a ‘par value’ for the dollar and to buy and sell gold at the official price in exchange for balances of dollars officially held by other imf nations.” franklin mint, 466 u.s. at 248. in 1945, a price of $35 per ounce of gold was established, which, under article 22 of the warsaw convention, equaled a cargo limit of $7.50 per pound. id. at 248-49. this changed in 1978 with the abandonment of the gold standard and the repeal of the par value modification act. id. at 249. in 1968, the central banks of most western nations “instituted a ‘two-tier’ gold standard in 1968[,] the gold-based international monetary system began to collapse” and gold transactions took place at a free market price. id. in 1971, the united states passed the par value modification act, which set a standard value for gold; eventually the exchange rate was set at $42.22 per ounce. id. (citing aeronautics and space, 14 c.f.r. § 221.176 (1975)). “in 1976, congress passed legislation to . . . [repeal] the par value modification act effective apr. 1, 1978.” franklin mint, 466 u.s. at 249. 108. id. at 251. 109. id. at 251, 254 n.25. 110. 466 u.s. at 251, 254 n.25. trans world airlines, inc. v. franklin mint corp. was not a unanimous decision, justice o’connor wrote the majority opinion, in which chief justice burger, justice powell, justice brennan, justice white, justice marshall, justice blackmun, and justice rehnquist joined. id. at 244. justice stevens was the sole dissenter. id. 111. id. at 252 (quoting cook v. united states, 288 u.s. 102, 120 (1933)). 2009] congressional unilateral tax treaty overrides 727 the warsaw pact. 112 thus, the court construed the domestic law and treaty so as not to be in conflict. in our view congress has not abandoned any “unit of conversion specified by the convention” – the convention specifies liability limits in terms of gold francs and provides no unit of conversion whatsoever. to the contrary, the convention invites signatories to make the conversion into national currencies for themselves. in the united states the cab has been delegated the power to make the conversion, and has exercised the power most recently in order 74-1-16. we are not called upon to “[substitute] a new term,” but merely to determine whether the cab’s order is inconsistent with the convention. that determination does not engage the “political question” doctrine. 113 justice stevens, in his dissenting opinion, found article 22 of the warsaw convention and the legislation to be in direct conflict with each other. 114 according to stevens, article 22 required “that the liability limits be determined by reference to the value of ‘gold at the standard of fineness of nine hundred thousandths’ and then converted into our ‘national currency in round figures.’” 115 justice stevens believed the majority held the liability limitation to be unenforceable and the limitation set by the civil aeronautics board (“cab”) as enforceable thus effectively rewriting the treaty. 116 under stevens’ reasoning, article 22 set the standard for the value of gold in terms 112. id. at 253. 113. id. at 254. under the order by the civil aeronautics board (“cab”), twa’s liability was limited to $9.07 per pound. id. cab order 4-1-16, issued in 1974, set the minimum acceptable figure for liability limits applicable to ‘international carriage at $9.07 per pound of cargo. id. at 251. because article 22 was not found to be in conflict with the legislation repealing the par value modification act, the supreme court held that twa’s liability was limited to $9.07 per pound. 114. id. at 261-62 (stevens, j, dissenting). 115. id. at 261 (stevens, j., dissenting) (citing convention for the unification of certain rules relating to international carriage by air, ch. iii, art. 22, oct. 12, 1929, available at http://www.jus.uio.no/lm/air.carriage.warsaw. convention.1929/22) (last visited jun. 24, 2008). 116. id. (stevens, j., dissenting). stevens thought that the majority had rewritten the treaty and had acted outside the scope of the judicial branch’s constitutional powers, as the treaty making power belongs to the executive branch. id. at 263 (stevens, j., dissenting) (citing the amiable isabella, 19 u.s. 1, 71-73 (1821)). 728 florida tax review [vol. 9:7 of a stated fineness, and then allowed for this sum to be converted into national currencies in round figures. 117 stevens believed the economic climate changed dramatically since the warsaw convention, 118 and in light of the abandonment of the gold standard and the repeal of the par value modification act, “[t]he rate at which a domestic currency exchanges for gold was and is the only ‘conversion’ permitted or anticipated by the [warsaw] convention. that figure is the liability limitation of the warsaw convention[,]” not the amount set by cab. 119 while the charming betsy, cook, chew heong, and trans world airlines require a clear expression of congressional intent in for a domestic law to override a treaty, the united states v. palestine liberation organization 120 illustrates that even when congressional intent is clear, courts may still construe a treaty and a statute so as not to conflict. 121 the issue was whether the palestine liberation organization (hereinafter the “plo”) could maintain its office, as a permanent observer, at the united nations’ headquarters in new york. 122 the plo was asked to be an observer 117. id. at 265-66 (stevens, j., dissenting). 118. id. at 274-75 (stevens, j., dissenting). when the warsaw convention was entered into, aviation was very dangerous; it was considered an unbelievable feat when charles lindbergh flew the spirit of st. louis from new york to paris. id. (stevens, j., dissenting). article 22 was intended to calm fears of losing one’s cargo or life in the event of a disaster and to stimulate travel and shipment by airlines. id. at 264-65. three years after the united states entered the warsaw convention, the crash of the hindenburg occurred in 1937, furthering fears of traveling or shipping on airlines. id. at 265. stevens noted “[a]ir travel is among the safest forms of transportation and the fledging venture of a half century ago is a major, established international industry today. id. at 273. 119. id. at 275. 120. 695 f.supp. 1456 (s.d.n.y. 1988). 121. the schooner charming betsy, 6 u.s. 64, 81 (1808); cook, 288 u.s. at 120 (1933); chew heong, 112 u.s. 536, 560 (1884); trans world airlines, inc., 466 u.s. 243, 251 (1984); palestine liberation organization, 695 f. supp. at 146568. 122. palestine liberation organization, 695 f. supp. at 1458. the court referred to the headquarters agreement, in which the united states extended an invitation to the united nations to establish a seat within the u.s. id. (citing h.r. con. res. 75, 79th cong., (1st sess. 1945)). the united nations has invited nonmember nations, consisting of intergovernmental organizations and other organizations to maintain “permanent observer missions” in new york. id. the plo is one of the “other organizations” asked to become an observer at the u.n. id. (citing headquarters agreement, § 11, 61 stat. 756 (1947)); see united nations, available at http://www.un.org/overview/missions.htm#iga (last visited jun. 24, 2008). 2009] congressional unilateral tax treaty overrides 729 to the united nations in 1974 and maintain a permanent observer mission in the u.n.’s new york headquarters. 123 in 1986, congress asked the u.s. state department to close the plo mission office in new york. 124 the request was unsuccessful and gave rise to the anti-terrorism act of 1987 (hereinafter the “ata”). 125 under the ata, the plo was “stated to be ‘a terrorist organization and a threat to the interests of the united states, its allies, and international law, and it should not benefit from operating in the united states.’” 126 the ata prohibited “the establishment or maintenance of ‘an office, headquarters, premises, or other facilities or establishments within the jurisdiction of the united states at the behest or direction of, or with funds provided by’ the plo, if the purpose is to further the plo’s interests.” 127 the ata was clearly and expressly aimed at removing the plo from the u.n. headquarters in new york. 128 the court held the statute did not override the treaty, and cited the charming betsy, cook, chew heong, the head money cases, and trans world airlines, when it stated a court is under a duty to interpret statutes in a manner consistent with existing treaty obligations, and a domestic statute enacted later-in-time should not override a treaty provision unless congress clearly and unequivocally expressed their intent to override the treaty. 129 123. palestine liberation organization, 695 f. supp. at 1459. the “observer” status conferred the right upon the representatives of the plo to admission to the united states and access to the united nations. id. at 1459, 1465 (citing 61 stat. 756) (“section 11 of the headquarters agreement reads . . . [t]he federal, state or local authorities of the united states shall not impose any impediments to transit to or from the headquarters district of: (1) representatives of members . . ., (5) other persons invited to the headquarters district by the united nations . . . on official business.”). further, “[s]ection 12 requires that the provisions of § 11 be applicable ‘irrespective of the relations existing between the governments of the persons referred to in that section and the government of the united states.’” id. (citing 61 stat. 756). the right to access into the united states, granted under the headquarters agreement, was unsuccessfully challenged in the eastern district of new york and the plo’s right to access was upheld. id. 124. id. (citing anti-plo terrorism act of 1987, h.r. 2211, 100th cong., (1st sess. 1987)). 125. id. at 1459-60. 126. id. at 1460 (citing 22 u.s.c. § 5201(b)). 127. id. (citing 22 u.s.c. § 5202(3)). the ata also prohibited the spending of plo funds and proscribed the plo from receiving, in new york, anything of value except material information from the plo. id. (citing 22 u.s.c. §§ 5202(1)-(2)). 128. palestine liberation organization, 695 f. supp. at 1465. 129. id. at 1465. the plo argued that application of the ata would violate the headquarters agreement. the district court agreed and held that the ata was 730 florida tax review [vol. 9:7 in reaching their decision, the district court analyzed the language of both the headquarters agreement and the ata. it referred to the united states’ past practice regarding the headquarters agreement and the interpretation each party gave to such agreement. 130 the district court reasoned congress did not clearly express its intention to abrogate the headquarters agreement because neither the mission nor the headquarters agreement was mentioned in the ata. it stated, “[s]uch an inclusion would have left no doubt as to congress’ intent on the matter which had been raised repeatedly with respect to this act, and its absence here reflects equivocation and avoidance, leaving the court without clear interpretive guidance in the language of the act.” 131 palestine liberation organization is a glaring illustration of the efforts a court will exert to harmonize a treaty with the subsequent enactment of a statute, without applying the later-in-time rule to override the treaty. 132 up to this point, this article has examined statutory overrides of treaty provisions in the context of “domestic dependent nations,” commerce with indian nations, immigration, and trade with foreign nations. 133 “inapplicable to the plo mission to the united nations.” id. at 1466-68. 130. id. at 1466-68, 1471. the district court noted that in the forty years since the united states had accepted the headquarters agreement, it had taken numerous “actions consistent with its recognition of a duty to refrain from impeding the functions of observer missions to the united nations.” id. at 1466. further, after the plo was asked to establish a permanent observer mission, the department of state took the position that it was required to grant access to the united nations by the plo. id. (citations omitted). the district court reasoned that the ata’s language that it should apply “notwithstanding any provision of law to the contrary[,]” did not apply “notwithstanding any treaty.” id. at 1468. the district court also thought it was important that the department of state, part of the executive branch, took the position that the headquarters agreement should remain effective when petitioned by congress to remove the plo from the u.n. headquarters in new york. id. at 1466. 131. id. at 1468. 132. see generally curtis a. bradley, the charming betsy canon and separation of powers: rethinking the interpretive role of international law, 86 geo. l.j. 479 (1998) (providing a thorough examination the charming betsy doctrine). 133. taylor v. morton, 23 f. cas. 784 (curtis, circuit justice, c.c.d. mass. 1855) (involving the domestic override of a treaty in the context of congress’ power to regulate commerce with foreign nations); the cherokee tobacco, 78 u.s. 616 (1870) (involving the statutory override of a treaty with a “domestic dependent nation” and pursuant to congress’ power to regulate commerce with indian nations); chew heong v. united states, 112 u.s. 536 (1884) (involving congress’ power over immigration); edye v. robertson, 112 u.s. 580 (1884) (involving congress’ power over immigration); whitney v. robinson, 124 u.s. 190 (1888) (involving congress’ power to regulate commerce with foreign nations); chae chan ping v. united states, 2009] congressional unilateral tax treaty overrides 731 however, the issue of domestic law overriding treaty provisions also arises in the context of the internal revenue code and tax conventions. vi. treaty overrides and the internal revenue code 134 initially, the code declared treaty obligations prevailed over domestic tax laws; “[i]ncome of any kind, to the extent required by any treaty obligation of the united states, shall not be included in gross income and shall be exempt from taxation under this subtitle.” 135 however, in the 1962 revenue act, congress changed how treaty obligations would be treated for domestic tax purposes when it provided that “[s]ection 7852(d) of the internal revenue code of 1954 (relating to treaty obligations) shall not apply in respect to any amendment made by this act.” 136 at this time, the united states had an estate tax treaty with greece which included a real estate exemption provision that was in conflict with the 1962 revenue act. 137 the conflict never became an issue because the effective date of the domestic tax law was deferred for two years, allowing for the renegotiation of the treaty. 138 the code further gave treaties preference over domestic law through the foreign investors tax act of 1966; “[n]o amendment made by this title shall apply in any case where its application would be contrary to any treaty obligation of the united states.” 139 however, favorable treatment was short 130 u.s. 581 (1889) (involving congress’ power over immigration). 134. hereinafter referred to as the “code.” 135. irc §§ 894(a), 7852(d) (1954) (“no provision of this title shall apply in any case where its application would be contrary to any treaty obligation of the united states in effect on the date of enactment of this title.”). the code’s former treatment of treaty obligations should be contrasted with how the internal revenue service currently views such obligations; now the code applies “to any taxpayer with due regard to any treaty obligation . . . which applies to such taxpayer.” irc § 894(a). the 1954 language was changed in 1988, and allows congress to give due regard to any treaty obligation and still tax an item that is exempt from taxation under the treaty. also in 1988, the house of representatives amended § 7852(d) and officially adopted the later-in-time doctrine therein. overriding tax treaties, supra note 7, at 80-81; § 7852(d) (1988) (“for purposes of determining the relationship between a provision of a treaty and any law of the united states affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law.”). 136. the revenue act of 1962, pub. l. no. 87-834 § 31, 76 stat. 960, 1069 (1962). 137. h.r. rep. no. 2508, 87th cong., 2d sess. 48 (1962), reprinted in 1962 u.s.c.c.a.n. 3732, 3771; sachs, supra note 51, at 870-71. 138. id. 139. foreign investors tax act of 1966, pub. l. no. 89-809 § 110, 80 stat. 732 florida tax review [vol. 9:7 lived. the tax reduction act of 1975 reduced the amount of credit to income arising from foreign oil and gas. 140 this act failed to state whether it was to apply notwithstanding any conflicting treaty obligations. the house and the senate failed to provide for such application in the legislative history, but the service ruled that these changes would override any conflicting treaty provisions. 141 furthermore, the tax reform act of 1976 gave preference to domestic tax laws over treaty obligations. 142 1539, 1575 (1966). 140. tax reduction act of 1975, pub. l. no. 94-12 § 601, 89 stat. 26, 5458 (1975). section 907(a) provided for a reduction in the amount of credit allowed under § 901, which gives a credit to foreign oil and gas income. id at § 601(d)(1)– (2). during this time period, the unemployment rate was rising and the economy was declining. id. at § 501. the purpose of this amendment was, inter alia, to counteract the aforementioned negative factors by stimulating the economy, while creating jobs. id. 141. sachs, supra note 51, at 871; rev. rul. 80-223, 1980 c.b. 217 (1980) (“§§ 901(f) and 907 of the code by the 1975 act supersede inconsistent provisions of all income tax treaties, those in effect on the date of the enactment of the 1954 code as well as those in effect after this date.”). 142. tax reform act of 1976, pub. l. no. 94-455 § 1031, 90 stat. 1520, 1620-24 (1976); sachs, supra note 51, at 871. the service took the position that § 1031 of the tax reform act of 1976, which amended code § 904(a) to provide that the limitation on the foreign tax credit shall be computed using only the overall method, overrides the foreign tax credit per-country limitation provided in united states income tax treaties. rev. rul. 80-201, 1980-2 c.b. 221 (1980); sachs, supra note 51, at 872. [t]he method for determining the limitation on foreign tax credits has taken a variety of forms over the years, having been computed based on a taxpayer’s overall foreign source income when first enacted in 1921, limited to the lesser of an overall or per-country amount in the 1930’s, 1940’s, and early 1950’s, and computed country by country in the latter half of the 1950’s. beginning in 1960, taxpayers were given the option of an overall or per country limitation until 1976 when the per country limitation was repealed and the law returned to its 1921 shape. there it rested until 1986 when today’s system, which categorizes various types of income into so-called baskets for purposes of calculating the foreign tax limitation, came into effect. whenever the limitation has changed, congress has expressed concern with protecting the u.s. tax on u.s. source income from erosion. michael j. graetz, taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 26 brook. j. int’l l. 1357, 1359-60 (2001) (citations omitted). 2009] congressional unilateral tax treaty overrides 733 throughout the last several decades, congress promulgated a number of treaty overrides. 143 a. congressional treaty overrides 144 the following is an exhaustive list of treaty overrides enacted during the past 45 years: a) revenue act of 1962 – section 27. treaties. senate amendment no. 203: the bill as passed by the house provided section 7852(d) of the code, relating to treaty obligations, was not to apply in respect of any amendment made by the revenue act of 1962. senate amendment no. 203 provides no provision of this act will apply in any case where its application would be contrary to any treaty obligation of the united states; 145 b) foreign investors tax act of 1966 – section 110. treaty obligations. the section provides no amendment made by this title shall apply in any case where its application would be contrary to any treaty obligation of the united states. however, granting a benefit provided by an amendment made by this bill is not to be considered to be contrary to a treaty obligation. thus, even though a nonresident alien or foreign corporation has a permanent establishment in the united states, income which is not effectively connected with this business is to be taxed at the applicable treaty rate rather than at the regular individual or corporate rate; 146 c) tax reduction act of 1975 – section 601. limitations on foreign tax credit for taxes paid in connection with foreign oil and gas income. the act was to amend the internal revenue code of 1954 to provide for a refund of 1974 individual income taxes, to increase the low income allowance and the percentage standard deduction, to provide a credit for personal exemptions and a credit for certain earned 143. overriding tax treaties, supra note 7, at 83. prior to the 1980s, statutory overrides of tax treaties were rare. harry g. gourevitch, tax treaties: the legislative override problem, 93 tax notes int’l 172-15 (1993). 144. see anthony c. infanti, curtailing tax treaty overrides: a call to action, 62 u. pitt. l. rev. 677, 682-683 (2001). this article contributed general information and citations for this list. 145. see revenue act of 1962, supra note 137. 146. see foreign investors tax act of 1966, supra note 135. 734 florida tax review [vol. 9:7 income, to increase the investment credit and the surtax exemption, to reduce percentage depletion for oil and gas, and for other purposes; 147 d) tax reform act of 1976 – section 1031. requirement that foreign tax credit be determined on overall basis. the senate finance committee provided it was the committee’s understanding that the per-country limitation was not required under the provisions of any recent income tax treaty between a foreign country and the united states. it was the committee’s intent for consistent application of all existing treaties with this amendment by using the overall limitation in computing the allowable foreign tax credit. the committee further intends that, as was the case with other recent legislation modifying the foreign tax credit. the amendments made by the committee’s bill are to be used in computing the credit allowed under all treaties; 148 e) foreign investment in real property tax act of 1980 – section 1445 concerning disposition of united states real property interest. – gains, profits, and income from the disposition of a united states real property interest (as defined in section 897 (c)). section 1125 (c). special rule for treaties. except as provided in paragraph (2), after december 31, 1984 nothing in section 894(a) or 7852(d) of the internal revenue code of 1954 or in any other provision of law shall be treated as requiring, by reason of any treaty obligation of the united states, an exemption from (or reduction of) any tax imposed by section 871 or 882 of such code on a gain described in section 897 of such code; 149 f) tax reform act of 1984 – section 127 repeal of 30% tax on portfolio interest paid to foreign persons. payments of passive income (interest, dividends, royalties, etc.) to foreign persons generally are subject to a 30% u.s. withholding tax if the payments are not effectively connected with a u.s. trade or business conducted by the foreign person. exemptions from the tax are provided in certain situations. some u.s. tax treaties reduce the tax. some treaties eliminate the tax. the conference agreement generally repeals the 30% withholding tax on interest paid on portfolio indebtedness by u.s. borrowers to nonresident alien individuals and foreign corporations; 150 147. see tax reduction act of 1975, supra note 139. 148. see tax reform act of 1976, supra note 141. 149. see foreign investment in real property tax act of 1980, infra note 157. 150. see tax reform act of 1984, infra note 161. 2009] congressional unilateral tax treaty overrides 735 g) tax reform act of 1986 – section 1241 branch-level interest tax. this section states any interest paid by a branch’s u.s. trade or business is u.s. source and subject to u.s. withholding tax of 30%, unless the tax is reduced or eliminated by a specific code or treaty provision. for purposes of determining whether the tax on the excess interest is to be reduced or eliminated by treaty, the applicable treaty generally is any income tax treaty between the united states and the country of the corporation’s home office. however, any treaty benefits available in this case are subject to the agreement’s prohibition against treaty shopping. the conference agreement generally follows the senate amendment in providing that existing u.s. income tax treaties may modify, reduce, or eliminate the branch profits tax, the second-level withholding tax on dividends, or the branch-level tax on interest except in cases of treaty shopping; 151 h) technical and miscellaneous revenue act of 1988 – section 1012 (aa). coordination with treaties. (2) certain amendments to apply notwithstanding treaties. this section provides in part the following amendments made by the reform act “apply notwithstanding any treaty obligation of the united states in effect on the date of the enactment of the reform act. (a) the amendments made by section 1201 of the reform act, and (b) the amendments made by title vii of the reform act to the extent such amendments relate to the alternative minimum tax foreign tax credit;” 152 i) omnibus budget reconciliation act of 1989 – section 7210. the earnings stripping rules. section 7403. information with respect to certain foreign-owned corporations. (a) 25% foreign-owned corporations required to report. section 7815(d)(14). the estate tax marital deduction for non-citizen spouses; 153 j) omnibus budget reconciliation act of 1993 – section 13238. authorizing the promulgation of regulations re-characterizing multiple-party financing transactions; 154 151. see tax reform act of 1986, infra note 167. 152. technical and miscellaneous revenue act of 1988, pub l no 100-647 § 1012, 102 stat. 3342, 3531 (1988). see tamra infra note 171. 153. see omnibus budget reconciliation act of 1989, infra note 194. 154. see omnibus budget reconciliation act of 1993, infra note 195. 736 florida tax review [vol. 9:7 k) health insurance portability and accountability act of 1996 – section 511. taxation of expatriates; 155 l) taxpayer relief act of 1997 – section 1054(a). denial of treaty benefits for certain payments through hybrid entities. a foreign person shall not be entitled under any income tax treaty of the united states with a foreign country to any reduced rate of any withholding tax imposed by this title on an item of income derived through an entity which is treated as a partnership for purposes of this title if – (a), (b), & (c) of the title are raised; 156 m) american jobs creation act of 2004 – section 801(a). anti-inversion provision. section 804. taxation of expatriates. 157 the foreign investments in real property tax act of 1980 (hereinafter “firpta”) authorized the united states to tax non-residents on the sale of u.s. real property, and on the gain from the sale of shares in certain u.s. real property holding corporations. 158 notably, most treaties entered into with the united states specifically exempted foreigners from gain on domestic stock. 159 however, firpta expressly provided, 155. see health insurance portability and accountability act, infra note 199. 156. see taxpayer relief act of 1997, infra note 202. 157. american jobs creation act of 2004, pub l no 108-357 § 804, 118 stat. 1418, 1565, 1569-73 (2004). see also supra note 172. 158. foreign investment in real property tax act of 1980, pub. l. no. 96499, § 1121, 96 stat. 2682 § 1121, 94 stat. 2599 (1980). section 1122 of firpta amended the 1954 code to include a new section, § 897. id. section 897 taxes nonresident aliens or foreign corporations on the gains upon the dispositions of direct or indirect interests in united states real property. id. a report from the senate finance committee is instructed on the act’s purpose, noting that the finance committee believes that it is essential to establish equity of tax treatment in u.s. real property between foreign and domestic investors. the committee does not intend by the provisions of this bill to impose a penalty on foreign investors or to discourage foreign investors from investing in the united states. however, the committee believes that the united states should not continue to provide an inducement through the tax laws for foreign investment in u.s. real property which affords the foreign investor a number of mechanisms to minimize or eliminate his tax on income from the property while at the same time effectively exempting him from u.s. tax on the gain realized on disposition of the property. s. rep. no. 96-499, at 8-9 (1979). 159. doernberg, super note 7, at 83. 2009] congressional unilateral tax treaty overrides 737 nothing in section 894(a) or 7852(d) of the internal revenue code of 1954 or in any other provision of law shall be treated as requiring, by reason of any treaty obligation of the united states, an exemption from (or any reduction of) any tax imposed by section 871 or 882 of such code on a gain described in section 897 of such code. 160 firpta had a clear expression of congressional intent to override any prior inconsistent treaty provisions. however, a five year delayed effective date allowed the treasury department to renegotiate treaties containing conflicting tax-exemption provisions. 161 section 269b was enacted with the passage of the tax reform act of 1984. 162 under section 269b, the stock of a foreign corporation was “stapled” to the stock of a domestic corporation because a shareholder could not buy or sell the stock of one corporation without buying or selling the stock of the other. 163 section 269b superseded tax treaty provisions which conferred tax-exempt status, under domestic law, on corporations from the partner nation of the treaty. 164 moreover, section 904(g), added by section 121(a) of the act, re-characterizes “the source of certain united statesowned foreign corporations.” 165 section 7701(b), also enacted as part of the act, orders an alien individual to be taxed as a u.s. resident, under certain 160. foreign investment in real property tax act of 1980, pub. l. no. 96499, § 1125(c), 94 stat. 2690 (1980). recall that § 894(a) and § 7852(d) of the 1954 code mandated that treaty obligations shall prevail over domestic tax laws. irc §§ 894(a); 7852(d) (1954); supra note 124. 161. gourevitch, supra note 142, at 2; overriding tax treaties, supra note 7, at 83. 162. tax reform act of 1984, pub. l. no. 98-369, 98 stat. 494 (1984); gourevitch, supra note 142, at n.2. 163. pub. l. 98-369 § 136, 98 stat. 669–72 (1984). 164. gourevitch, supra note 142, at 2; § 269b(d); deficit reduction act of 1984, pub. l. no. 98-369, 98 stat. 1175 (1984). if the foreign corporation has a permanent establishment in the united states, it would then be subject to u.s. taxation. 165. sachs, supra note 51, at 872. section 904(g), “provided that interest, dividends and certain other payments by a u.s. owned foreign corporation are to be treated in the hands of the recipient as u.s. source rather than foreign source income to the extent the payments are attributable to income of the u.s. owned foreign corporations from u.s. sources.” gourevitch, supra note 142. following enactment, it was not clear whether § 904(g) was to prevail over inconsistent treat provisions; however, this was resolved “in the tax reform act of 1986 and related senate finance committee report which retroactively expressed a congressional intent that [the] initially inadvertent statutory changes [of §§ 904(g) and 7701(b)] were to override inconsistent tax treaties.” id. 738 florida tax review [vol. 9:7 circumstances, thus conflicting with definitions of what constitutes a u.s. resident under the terms of a treaty. 166 congress still determined these conflicting treaty provisions should triumph over the domestic law definition. 167 additionally, the tax reform act of 1986 contained further provisions affecting international commerce. 168 the act added code section 865, which taxes a nonresident maintaining an office or other fixed place of business in the united states, on “any sale of personal property (including inventory property) attributable to such office or other fixed place of business . . .” 169 if the nonresident does not maintain an office or other fixed place of business in the u.s., the taxpayer is not subject to u.s. taxation because the source of his or her income is the country of residence. 170 section 904(d) increased “the number of separate categories of foreign source income for purposes of the foreign tax credit limitation.” 171 this expansion conflicts directly with tax treaties; however, there is no congressional expression as to whether domestic law or the conflicting treaty provisions are to prevail in the event of a conflict. 172 in 2004, as part of the american jobs creation act, congress amended section 904(d), 173 limiting 166. gourevitch, supra note 142. 167. see staff of joint committee on taxation, 98th cong., general explanation of the revenue provisions of the deficit reduction act of 1984, at 468 (comm. print 1985) (“[a]n alien who is a resident of the united states under the new statutory definition but who is a resident of a treaty partner of the united states (and not a resident of the united states) under a u.s. income tax treaty is eligible for the benefits that the treaty extends to residents of the treaty partner.”) 168. irc § 1, 11, 38, 46-48 (1986). “the 1986 act lowered individual and corporate income tax rates, and reduced total expected tax payments from individuals while increasing those from corporations. familiar features of the internal revenue code like the investment tax credit and full deductibility of contributions into individual retirement accounts (iras) disappeared. many new provisions appeared, such as the passive loss limitation rule aimed at curbing tax shelters.” richard l. doernberg & fred s. mcchesney, doing good or doing well? congress and the tax reform act of 1986, 62 n.y.u. l. rev. 891, 891 (1987). (citations omitted) 169. irc § 865(e)(2)(a). 170. id. 171. gourevitch, supra note 142. 172. id. congress enacted the technical and miscellaneous revenue act of 1988, pub. l. no. 100-647, 102 stat. 3342 (1988(, (hereinafter tamra) to retroactively express its intent that the changes made to § 904(d) in the tax reform act of 1986 were to override inconsistent treaties. gourevitch, supra note 142 (citing h.r. rep. no. 100-1104 at 204-206 (1988) (conf. rep.) the tax reform act of 1986 “also limited the alternative minimum foreign tax credit to 90% of the tentative u.s. alternative minimum tax.” gourevitch, supra note 142. 173. p.l. 108-357, §404(a), 118 stat. 1418, 1494 (2004) (hereinafter 2009] congressional unilateral tax treaty overrides 739 foreign source categories to either the passive income category or the general income category. despite the re-characterization of the categories, the definition of “passive category income” as contained in section 904(d)(2), 174 may still conflict with international treaty provisions. internal revenue code sections 884(a) and (f), known as the branch profits tax, were also enacted as part of the tax reform act of 1986. 175 the american jobs creation act]. 174. passive income “means any income received or accrued by any person which is of a kind which would be a foreign personal holding company income (as defined in § 954(c)). irc § 904(d)(2)(b)(i). 175. pub. l. no. 99-514, § 1241(a), 100 stat. 2285, 2576 (1986). before the branch profits tax, a foreign corporation owned by foreign investors and doing business in the united states was taxed at the corporate level under the regular graduated corporate rates on income effectively connected with a u.s. trade or business. if the foreign investors operated in the united states through a domestic corporation, the outcome was the same. differences in treatment arose when the corporation distributed its corporate earnings to foreign investorowners. doernberg, supra note 7, at 84. (citations omitted). at this time, dividends paid by foreign corporations to foreign investors were rarely subject to u.s. taxation because many treaties exempted such dividends paid by foreign corporations to non-u.s. residents. id. at 84-85. in contrast, dividends paid by domestic corporations to nonu.s. residents were subject to a 30% tax. see §§ 871(a)(1) (withholding tax on nonresident alien individuals) 881(a) (withholding tax on non resident alien corporations). the resulting effect was that domestic corporations were subject to two levels of taxation while foreign corporations were subject to only one level of taxation. irc § 884(a), the branch profits tax on earnings, imposes “on any foreign corporation a tax equal to 30% of the dividend equivalent amount for the taxable year.”). section 884(f)(1), the branch profits tax on interest provides: in the case of the foreign corporation engaged in a trade or business in the united states (or having gross income treated as effectively connected with the conduct of a trade or business in the united states), for purposes of the subtitle – (a) any interest paid by such trade or business in the united states shall be treated as if it were paid by a domestic corporation, and (b) to the extent that allocable interest exceeds the interest described in subparagraph (a), such foreign corporation shall be liable for tax under § 881(a) in the same manner as if such excess were interest paid to such foreign corporation by a wholly owned domestive corporation on the last day of such foreign corporation’s taxable year. the amount of interest allowable as a deduction under § 882 in computing the effectively connected taxable income of such foreign corporation 740 florida tax review [vol. 9:7 branch profits tax has specific provisions dealing with treaty obligations. section 884(e) limits the effect of an income tax treaty provision, “[n]o treaty between the united states and a foreign country shall exempt any foreign corporation from the tax imposed by subsection (a) (or reduce the amount thereof) unless . . . such treaty is an income tax treaty, and . . . such foreign corporation is a qualified resident of such foreign country.” 176 a similar exceeds the interest described in subparagraph (a), such foreign corporation shall be liable for tax under § 881(a) in the same manner as if such excess were interest paid to such foreign corporation by a wholly owned domestic corporation on the last day of such foreign corporation’s taxable year. see doernberg, supra note 7, at 85 (providing a comprehensive analysis of the branch profits tax on interest). the purpose of the branch profits tax is to subject foreign corporations to two levels of taxation, just as domestic corporations are taxed at two levels – the corporate level (with a maximum rate of 35%) and the shareholder level (with a maximum rate of 35%). see id. under the branch profits scheme, the foreign corporation’s income is taxed at the corporate rate when it is earned and then the foreign corporation is taxed again, the branch profits tax, when the income is repatriated by the foreign corporation. id. the effect is to treat foreign corporations equally as domestic corporations. id. however, the branch profits tax is levied solely upon the corporation and not the shareholder. there are special rules for when a domestic corporation makes a distribution to a non-u.s. resident and foreign corporation. dividends received by non-resident shareholders are subject to a 30% tax. sections 871(a)(1) (imposing “a tax of 30% of the amount received from sources within the united states by a nonresident alien individual”); § 881(a) (imposing “a tax of 30% of the amount received from sources within the united states by a foreign corporation”). section 1441(a) lays out the general withholding rule: all persons, in whatever capacity acting (including lessees or mortgagors of real or personal property, fiduciaries, employers, and all officers and employees of the united states) having the control, receipt, custody, disposal, or payment of any of the items of income specified in subsection (b) (to the extent that any of such items constitutes gross income from sources within the united states), of any nonresident alien individual or of any foreign partnership shall . . . deduct and withhold from such items a tax equal to 30% thereof, except that in the case of any item of income specified in the second sentence of subsection (b), the tax shall be equal to 14% of such item. section 1441(b) covers items such as interest, “dividends, rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable annual or periodical gains, profits, and income . . .” section 1442(a) states that “[i]n the case of foreign corporations subject to taxation under this subtitle, there shall be deducted and withheld at the source in the same manner and on the same items of income as is provided in § 1441 a tax equal to 30% thereof.” 176. for § 884(e)(1) purposes, “qualified resident” means, with respect to any foreign country, any foreign 2009] congressional unilateral tax treaty overrides 741 requirement in section 884(f)(3) states “no benefit under any treaty between the united states and the foreign country of which such corporation is a resident shall apply unless . . . such treaty is an income tax treaty, and . . . such foreign corporation is a qualified resident of such foreign country.” however, there is an exception to these two provisions, making them inapplicable where a foreign corporation is engaged in treaty shopping. 177 despite seeming to pay respect to treaty obligations in regards to tax treaties and qualified residents, the branch profits tax, in fact, overrides other provisions. 178 one such provision is the non-discrimination requirement, requiring foreign entities to receive the same tax treatment as domestic entities engaged in the same activities. 179 domestic corporations do not pay a branch profits tax rather, they are taxed at the corporate level when they earn income, and shareholders are taxed in their individual brackets when they receive distributions. 180 in contrast, foreign corporations are taxed at the corporate level when they earn income and are taxed again, with the branch profits tax, on distributions to foreign shareholders. 181 therefore, nondiscrimination provisions are violated because foreign corporations receive corporation which is a resident of such foreign country unless (1) 50% or more (by value) of the stock of such foreign corporation is owned . . . by individuals who are not residents of such foreign country and who are not united states citizens or resident aliens, or (ii) 50% or more of its income is used (directly or indirectly) to meet liabilities to persons who are not residents of such foreign country or citizens or residents of the united states. irc § 884(e)(4)(a). it is important to note that the term “qualified resident” is defined under u.s. domestic law and not under the negotiated terms of the treaty. 177. section 884(e)(4)(d). gourevitch, supra note 142. the definition of “qualified resident” in § 884(e) “prevents non-treaty country foreign investors from treaty shopping by capitalizing a treaty corporation with a large amount of debt while residents of the treaty country hold shares of the corporation having little or no value.” section 884(e)(4)(a) (1986); overriding tax treaties, supra note 7, at 90. to fall under the terms of that definition, a foreign treaty corporation must use 50% or less of “its income . . . to meet liabilities to persons who are not residents of the treaty country or the united states.” section 884(e)(4)(a)(ii) (1986). 178. see doernberg, supra note 7, at 88-90. 179. id., at 88 (explaining and applying the non-discrimination provision). 180. see irc § 11 (relating to subchapter c corporate tax rates); 301 (relating to taxation of subchapter c corporate shareholders upon corporate distributions). 181. section 884(a) imposes a 30% tax on the “dividend equivalent amount.” section 884(b) defines “dividend equivalent” amount as the foreign corporation’s effectively connected earnings and profits, with some u.s. net equity adjustments. therefore, if a foreign owned corporation pulls profits out of its u.s. business they will incur the branch profits tax. 742 florida tax review [vol. 9:7 unfavorable tax treatment in comparison to domestic corporations. congress, however, does not believe that foreign corporations are taxed unfavorably because foreign corporations and their shareholders are taxed “no worse than u.s. corporations and their shareholders . . . .” 182 the technical and miscellaneous revenue act of 1988 (“tamra”) continued the code’s trend of placing domestic law in a superior position to treaty obligations. 183 first, tamra was expressly provided to apply, notwithstanding any treaty obligation of the united states. 184 tamra also codified the later-in-time doctrine by amending section 7852(d) to read, “[f]or purposes of determining the relationship between a provision of a treaty and any law of the united states affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or a law.” 185 an equally significant change commanded by tamra, was the amendment of section 894(a) to read “[t]he provisions of this title shall be applied to any taxpayer with due regard to any treaty obligation of the united states which applies to such taxpayer.” 186 prior to 1988 and tamra, section 894(a) gave preference to treaty obligations over domestic tax laws. 187 tamra also added section 6114, which required a taxpayer to disclose on his tax return his reliance on a treaty provision superseding a domestic tax statute. 188 182. id. (citing staff of j. comm. on tax’n, 99th cong., general explanation of the tax reform act of 1986, at 1038 (comm. print 1987); tim n. vettel, branch-level tax and treaty overrides, 35 tax notes 632, 633 (1987)). “[s]ince u.s. corporations are taxed on their earnings, and u.s. shareholders of such corporations are taxed on dividend distributions, it is not discriminatory to subject foreign corporations and their shareholders to two taxes – one on a corporation’s earnings and the other on the repatriation of those earnings.” overriding tax treaties, supra note 7, at 89 (providing an analysis of the non-discrimination provisions found in many treaties and their relationship with the branch profits tax). 183. tamra, supra note 171. 184. pub. l. no. 100-647, § 1012, 102 stat. 3531 (1988). 185. irc § 7852(d) (1988). the senate noted that the amendment to § 7852(d) was intended to codify the judicial doctrine of the later-in-time rule and was not meant “to alter the initial presumption of harmony between . . . earlier treaties and later statutes.” overriding tax treaties, supra note 7, at 80. s. rep. no. 445 at 376-77 (1988), as reprinted in u.s.c.c.a.n. 4515, 4829-33. prior to tamra, § 7852(d) gave preference to treaty obligations over domestic tax statutes, “[n]o provision of this title shall apply in any case where its application would be contrary to any treaty obligation of the united states in effect on the date of enactment of this title.” section 7852(d) (1954). 186. irc § 894(a) (1988) (emphasis added). 187. irc § 894(a) (1954). before tamra, § 894(a) read, “[i]ncome of any kind, to the extent required by any treaty obligation of the united states, shall not be included in gross income and shall be exempt from taxation under this subtitle.” 188. tamra, supra note 171 at § 1012(aa)(3). section 6114 requires: 2009] congressional unilateral tax treaty overrides 743 in 1989, treaty obligations further lost ground to domestic tax statutes within the code. the omnibus budge reconciliation act of 1989 continued the trend, as seen by firpta, the tax reform acts of 1984 and 1986, and tamra, by amending section 6038a to require foreign-owned domestic corporations to file reports with the secretary of the treasury. 189 the revenue reconciliation act of 1989 enacted section 163(j), the earnings stripping provision. 190 this section denies a corporation an interest deduction for interest payments made to a related tax-exempt entity. the deduction is denied only if the corporation has an “excess interest expense” 191 at the end of the year. 192 the earnings stripping provision [e]ach taxpayer who, with respect to any tax imposed by this title, takes the position that a treaty of the united states overrules (or otherwise modifies) an internal revenue law of the united states shall disclose (in such manner as the secretary may prescribe) such position . . . on the return of tax for such tax (or any statement attached to such return), or . . . if no return of tax is required to be filed, in such form as the secretary may prescribe. irc § 6114(a) (1988). 189. omnibus budget reconciliation act of 1989, pub. l. no. 101-239, § 7403, 103 stat. 2106, 2358-61 (1989). according to the senate report, § 6038a “should not violate any treaty, but if it did, the statutory provision should prevail.” sachs, supra note 51, at 874. 190. irc § 163(j) (1989). 191. excess interest expense is defined as the excess of the corporation’s net interest expense less the sum of 50% of the adjusted taxable income of the corporation plus any excess limitation carry forward (as defined by irc § 163(j)(2)(b)(ii). 192. section 163(j) (1989); see overriding tax treaties, supra note 7, at 9295 (providing a comprehensive examination of § 163(j)). before the earnings stripping provision, a corporation could limit its tax liability by borrowing from a related foreign lender; thus generating interest deductions on a transaction which, economically, is otherwise a wash. overriding tax treaties, supra note 7, at 92. congress was concerned that taxable u.s. corporations were limiting their tax liabilities by taking interest deductions for payments to lenders who were exempt from u.s. taxation. the provision [§ 163(j)] is aimed primarily at interest payments from u.s. subsidiaries to foreign parent corporations when such parent corporations are not subject to u.s. taxation on the interest received, because the interest is not income effectively connected with a u.s. trade or business. code § 163(j) also applies to interest payments from corporations related to u.s. tax-exempt corporations, such as charitable foundations. id. (citing irc § 882 (1998)). under most treaties, in regards to receiving interest payments, exclusive taxing jurisdiction is given to the country in which the lender resides. 744 florida tax review [vol. 9:7 seemingly violates non-discrimination provisions in treaties by allowing certain interest payments to related u.s. lenders, while denying the same payments to foreign lenders. 193 congress naturally takes the position that the earnings stripping provision does not violate non-discrimination provisions found in treaties. 194 section 163(j) operates, under certain circumstances, to deny an interest deduction for interest payments made to a related tax-exempt party. irc § 163(j) (1989). it is known as the earnings stripping provision “because it prevents shareholders from using deductible interest payments to ‘strip’ a corporation of its earnings.” julie a. roin, adding insult to injury: the “enhancement” of § 163(j) and the tax treatment of foreign investors in the united states, 49 tax l. rev. 269, 270 (1994). a related tax-exempt party includes: [a]n individual and a corporation more than 50% in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; . . . [t]wo corporations which are members of the same controlled group; . . . [a] person and an organization to which § 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual; . . . [a] corporation and a partnership if the same persons own . . . more than 50% in value of the outstanding stock of the corporation, and . . . more than 50% of the capital interest, or the profits interest, in the partnership . . . . irc § 267(b) (1989). 193. irc § 163(j)(3); richard l. doernberg & kees van raad, the legality of the earnings stripping provision under u.s. income tax treaties, 35 tax notes 793 (1987). within a non-discrimination clause, there are typically two provisions, “[t]he first provides that a treaty partner shall not impose more burdensome taxes on a company controlled by residents of the other treaty country than are imposed on other domestic companies” and “[t]he other provides that interest and other payments by a domestic corporation to a corporation resident in the other treaty country shall be deductible under the same conditions as if they had been made to another domestic corporation.” gourevitch, supra note 142, at 4 (citations omitted). the earnings stripping provision violates the deductibility clause, the second provision; foreign corporations are denied a deduction for certain interest payments made to related parties while domestic corporations are allowed the deduction for the same payment made to a domestic lender. id., overriding tax treaties, supra note 7, at 93. 194. h.r. conf. rep. to the omnibus budget reconciliation act of 1989, cited in [1995 binder] 953 stand. fed. tax. rep. (cch) ¶ 9102 at 23,528; gourevitch, supra note 142 (citing 136 cong. rec. s. 15629 (1990)). according to congress, the earnings stripping provision does not discriminate because it treats “similarly situated persons similarly.” overriding tax treaties, supra note 7, at 101 (citing h.r. conf. rep. to the omnibus budget reconciliation act of 1989, cited in [1995 binder] 953 stand. fed. tax. rep. (cch) ¶ 9102 at 23,528). however, the deductibility portion of non-discrimination provisions require “interest and other 2009] congressional unilateral tax treaty overrides 745 once again, in line with the code’s discriminatory treatment of treaty obligations, the omnibus budget reconciliation act of 1993 (“obra 1993”) provided for the statutory override of such obligations with its amendment to section 7701(l). 195 following obra 1993, section 7701(l) provides that “[t]he secretary may prescribe regulations re-characterizing any multiple-party financing transaction as a transaction directly among any 2 or more of such parties where the secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by this title.” 196 this allows the service to deny treaty benefits to the nominal recipient of a payment who “is not the ‘beneficial owner.” 197 obra 1993 also amended section 163(j)(3)(b) to deny an interest deduction, under section 163, for interest payments made by a domestic corporate borrower to an unrelated lender if the loan repayment was guaranteed by a foreign party related to the borrower. 198 payments by a [foreign-owned] domestic corporation to a corporation resident in the other treaty country shall be deductible under the same conditions as if they had been made to another domestic corporation.” gourevitch, supra note 142, at 4 (citations omitted). therefore, the non-discrimination provision is not satisfied in light of congress’ reasoning that there is no discrimination because the § 163(j) treats similarly situated persons similarly. h.r. conf. rep. to the omnibus budget reconciliation act of 1989, cited in [1995 binder] 953 stand. fed. tax. rep. (cch) ¶ 9102 at 23,528). if, in analyzing for discriminatory treatment one compares the same lender, only changing its country of residence, the earnings stripping provision violates a non-discrimination provision. id. at 97. if one compares a tax-exempt entity in the united states to a tax-exempt entity in a foreign country, as congress seemingly does, there is no discrimination. id. at 97, 101 (citing h.r. conf. rep. to the omnibus budget reconciliation act of 1989, cited in [1995 binder] 953 stand. fed. tax. rep. (cch) ¶ 9102 at 23,528); gourevitch, supra note 142, at 4 (citing 136 cong. rec. s. 15629 (1990)). 195. omnibus budget reconciliation act of 1993, pub. l. no. 103-66, 107 stat. 508 (1993). before obra 1993, there was an omnibus budget reconciliation act of 1990, which added § 6038c to the code. omnibus budget reconciliation act of 1990, pub. l. no. 101-508, § 11315(a), 104 stat. 1388, 1456-58 (1990). congress expressed an opinion that this act did not override any treaty positions and failed to indicate the consequences if such a conflict were to exist. sachs, supra note 51, at 874 (citing h.r. rep. no. 101-881 at 325-26 (1990)). 196. irc § 7701(l) (1993). 197. overriding tax treaties, supra note 7, at 111, n. 144. 198. irc § 163(j)(3)(b) (1993). prior to this amendment, a corporation could deduct interest payments to an unrelated tax-exempt lender for a loan which is guaranteed by a third party that is related to the borrower. overriding tax treaties, supra note 7, at 102. corporations would take advantage of this loop-hole and take 746 florida tax review [vol. 9:7 the health insurance portability and accountability act of 1996 followed suit by amending its expatriation tax provisions to expand and substantially strengthen the present-law provisions targeting u.s. citizens who lose their citizenship for tax avoidance purposes. 199 the house bill affirmed that “it is intended that the purpose of the expatriation tax interest deductions by having the u.s. subsidiary finance through an unrelated lender with the foreign parent corporation guaranteeing the loan. for example, usco, a u.s. corporation, borrows money from forbank, a foreign bank unrelated to usco. interest payments from usco to forbank are not subject to code § 163(j). suppose, instead, that usco’s foreign parent, forco guarantees the loan from forbank. prior to obra 1993, as long as usco paid interest to forbank, the interest would have been deductible. id. at 102-03. the obra 1993 amendment to § 163(j)(3)(b) intended to end this type of behavior. id. congress determined that “[a]lthough the interest on guaranteed debt is paid to an unrelated lender, the debt serves as a substitute for a direct related party loan to the extent that money is fungible.” id. (quoting committee on ways and means, fiscal year 1994 budget reconciliation recommendations of the committee on ways and means, wmcp doc. no. 11, 103d cong., 1st sess. 244-45 (may 18, 1993)). congress reasoned “[a]n affiliated group requires funding for all of its activities and assets, and has flexibility as to the source and use of its funds. even money borrowed for a specific purpose frees up funds for other purposes.” id. (quoting committee on ways and means, fiscal year 1994 budget reconciliation recommendations of the committee on ways and means, wmcp doc. no. 11, 103d cong., 1st sess. 244-45 (may 18, 1993)). 199. health insurance portability and accountability act, h.r. conf. rep. 104-736, 1996 u.s.c.c.a.n. 1990, 2136. first, the house bill extends the expatriation tax provisions to apply not only to u.s. citizens who lose their citizenship but also to certain long-term residents of the united states whose u.s. residency is terminated. second, the house bill subjects certain individuals to the expatriation tax provisions without inquiry as to their motive for losing their u.s. citizenship or residency, but allows certain categories of citizens to show an absence of taxavoidance motive if they request a ruling from the secretary of the treasury as to whether the loss of citizenship had a principal purpose of tax avoidance. third, the house bill expands the categories of income and gains that are treated as u.s. source (and therefore subject to u.s. income tax under § 877) if earned by an individual who is subject to the expatriation tax provisions and includes provisions designed to eliminate the ability to engage in certain transactions that under current law partially or completely circumvent the 10-year reach of § 877. fourth, the house bill provides relief from double taxation in circumstances where another country imposes tax on items that would be subject to u.s. tax under the expatriation tax provisions. id. 2009] congressional unilateral tax treaty overrides 747 provisions, as amended, not be defeated by any treaty provision.” 200 however, “beginning on the tenth anniversary of the enactment of the house bill, any conflicting treaty provisions that remain in force would take precedence over the expatriation tax provisions as revised.” 201 the taxpayer relief act of 1997 was a denial of treaty benefits for certain payments through hybrid entities. regarding the application to certain payments, it stated, a foreign person shall not be entitled under any income tax treaty of the united states with a foreign country to any reduced rate of any withholding tax imposed by this title on an item of income derived through an entity which is treated as a partnership (or is otherwise treated as fiscally transparent) for purposes of this title if (a) “such item is not treated for purposes of the taxation laws of such foreign country as an item of income of such person, (b) the treaty does not contain a provision addressing the applicability of the treaty in the case of an item of income derived through a partnership. 202 26 usca section 894 (relating to income affected by treaty) is amended by inserting subsection (c) which states “the foreign country does not impose tax on a distribution of such item of income from such entity to such person.” 203 200. id. at 2142. 201. id. 202. taxpayer relief act of 1997, 111 stat 788, 943 (1997). 203. id. the section also added a regulations subsection. (2) regulations. – the secretary shall prescribe such regulations as may be necessary or appropriate to determine the extent to which a taxpayer to which paragraph (1) does not apply shall not be entitled to benefits under any income tax treaty of the united states with respect to any payment received by, or income attributable to any activities of, an entity organized in any jurisdiction (including the united states) that is treated as a partnership or is otherwise treated as fiscally transparent for purposes of this title (including a common investment trust under § 584, a grantor trust, or an entity that is disregarded for purposes of this title) and is treated as fiscally nontransparent for purposes of the tax laws of the jurisdiction of residence of the taxpayer. id. at 943, 944. 748 florida tax review [vol. 9:7 as one can see, not only is case law filled with statutory overrides of treaty provisions, but the code also contains numerous overrides. 204 the justification and flawed analysis allowing for such effect stems from several poorly analyzed cases from the mid-nineteenth and early-twentieth centuries, all of which can easily be distinguished from each other. 205 vii. conclusion although the united states champions globalization, its conflicting priorities are evidenced by the treaty enactment process. the inherent tension regarding the later-in-time doctrine among the senate and the house of representatives is not conducive to developing and sustaining the united states’ foreign relations. while globalization is one of the united states’ main priorities, the u.s. still favors its domestic economy with protectionist actions. 206 commitment to globalization may be seen through united states’ membership in several international organizations: the united nations (un); the world trade organization (wto); the world bank; and the international monetary fund. these organizations promote the idea of trade liberalization as a means to eradicate poverty, achieve sustained economic growth, and promote a sustainable development that will eventually lead to a fully inclusive and equitable global economic system. 207 as a member of these organizations, the united states is expected to fulfill the obligations it assumes in good faith so that all participating nations may benefit from their membership. 208 204. see richard l. doernberg, hi ho silver! congress rides, or rather overrides, again: the proposed tax on capital gains of foreign shareholders, 2 tax notes int’l 464 (1990) (providing an examination of proposed code amendments which would override existing treaty provisions); overriding tax treaties, supra note 7, at 105-09 (examining proposed code legislation that would override existing treaty provisions). 205. taylor, 23 f. cas. at 784; the cherokee tobacco, 78 u.s. at 616; chew heong, 112 u.s. at 536; edye, 112 u.s. at 580; whitney, 124 u.s. 190); chae chan ping, 130 u.s. at 581. 206. developed countries want to protect their declining industries and gain market access for their expanding industries. however the declining industries are declining largely because of competitive pressures from the developing countries. therefore, the sectors that they are most interested in protecting are precisely the sectors that are of the greatest concern to the developing world. protection elicits concerns about equity and social justice within the developed countries – but the failure to extend these concerns to developing countries shows a particularly narrow vision which is out of step with economic globalization. 207. the monterrey consensus on financing for development, mar. 2002. 208. charter of the united nations and statute of the international court of justice, chapter 1, purposes and principles, article ii, sec 2. 2009] congressional unilateral tax treaty overrides 749 as previously stated, the twin aims of tax treaties are the avoidance of double taxation and the prevention of tax evasion, which have the effect of promoting investment, growth, and commerce. 209 there are a number of incidental effects and benefits outside of these aims. for example, if taxes imposed on foreign investors are kept to a minimum, foreign firms will have a greater profit margin after taxes have been assessed. of course, any change in tax rates, or a reclassification of taxable income that changes the original terms of the tax treaty relied upon, 210 lowers the profit margin that foreign investors expect. another consequence of congress’ conflicting priorities is the alteration of domestic tax law leading to overrides of existing treaty obligations and increases in the amount of taxes foreign corporations and nonresident investors pay on income derived from their foreign investments. this action reduces profit for a wealthy individual purchasing investment properties within the united states, and reduces the appeal of the united states for potential treaty partners. for example, when a property is sold, the gross profit will be reduced by income taxes paid on that profit. for foreign corporations, the allowable tax credit limitations will also have a similar reduction on gross profits. the world bank, through various empirical studies, has found that increasing corporate taxes has a substantial adverse effect on investments, entrepreneurship, and foreign direct investment. 211 congress’ decision to 209. newman, supra note 8. “double taxation occurs when two jurisdictions, due to overlapping authority, tax the same income or assets. the effect discourages investment and creates artificial barriers to the free flow of commerce. both international cooperation and goodwill are correspondingly undermined.” id. “tax treaties also limit fiscal evasion by authorizing close administrative coordination and mutual exchange of information between contracting jurisdictions.” id. at 1004. another form of tax evasion occurs through treaty shopping. “[t]reaty shopping is the practice of rerouting income through one or more artificial entities in different countries for the main or sole purpose of obtaining treaty benefits that are not directly available to the true earner of income.” haug, supra note 8. 210. such as in the tax reduction act of 1975, which provided a reduction in the tax credit allowed; tax reform act of 1976, which changed the method of computing the foreign tax credit; the foreign investment in real property act of 1980, which taxed foreign corporations and non resident individuals on the disposition of direct or indirect interests in the u.s. real property; and the omnibus budget reconciliation act of 1993, which allowed for the secretary to prescribe regulations to re-characterize any financing transactions in order to prevent the avoidance of taxes. 211. the effect of corporate taxes on investments and entrepreneurship, available at http://www.doingbusiness.org/documents/aej-manuscript.pdf. the doing business project of the world bank established through their extensive research that raising the first year effective tax rate by 10% points reduces the 750 florida tax review [vol. 9:7 increase u.s. tax revenues by overriding tax treaties that provide tax credits to foreign investors and by excluding certain forms of income substantially reduces foreign investments. such effects are thought to have fueled the united states’ great depression during the 1930’s and quite conceivably contributed to the frictions ultimately helping to ignite world war ii. 212 this is very alarming considering the current recession which has striking similarities to the u.s. economy of the 1930’s. on october 29, 1929, the stock market crashed and black tuesday became synonymous with the great depression. in june, 1930, the senate passed the smoot-hawley tariff act, 213 of which president herbert hoover announced his support. the tariff act was designed to raise tariffs on over 20,000 imported goods to a tax rate of 60%. two days after the announcement, the dow jones industrial average sank 8% 214 as a direct response of the senate’s passage of the act. the protectionist measures taken by the act, ultimately had the effect of radically decreasing international trade and retaliatory tariffs, causing the world economy to contract and investment rate by 2.2 percentage points and the foreign direct investment rate (fdi) by 2.3 percentage points. this paper presents basic statistical relationships between corporate taxes, investment and entrepreneurship using two new data sets. the first data set computes effective 1st year and 5 year corporate income tax rates for 85 countries, using a survey of price waterhouse coopers’ local offices. the second data set, collected from national statistical offices, presents official registration rates by new firms in 62 countries. the research ultimately suggests that government regulatory and tax policies may have large consequences for the business environment as well as for economic development. id. at 24-25. 212. foreign capital: friend or foe? william h peterson paraphrases french economist frederic bastiat: when goods – and capital – can’t cross frontiers, armies will. 213. the smoot-hawley tariff act was signed into law on jun. 17, 1930, and raised u.s. tariffs on over 20,000 imported goods to record levels, and, in the opinion of most economists, worsened the great depression. smoot-hawley imposed an effected tax rate of 60% on more than 3,200 products and materials imported into the u.s. quadrupling previous tariff rates. the act was the successor of the fordney-mccumber tariff act, which was intended to increase the market share of domestic firms. the weakening labor markets in 1927 prompted the need for another round of tariff hikes. although the tariff act was passed after the stock market crash of 1929, many economic historians consider the political discussion leading up to the passing of the act as a factor in causing the crash and/or recession that began in 1929, and its eventual passage led to the deepening of the great depression. unemployment after the act was passed jumped from 7.8% in 1930, to 16.3% in 1931, 24% in 1932, and 25% in 1933. 214. pat toomey, economist against protectionism, the wall street journal, aug. 1, 2007. 2009] congressional unilateral tax treaty overrides 751 unemployment to sky rocket. the international trade war 215 continued to drive the market down until the dow hit a 41 low on july 8, 1932. it took the dow jones 25 years to recover its 1929 peak. in comparison to actions taken by congress in response to the great depression, the united states is currently in the process of eradicating tariffs on u.s. exports to colombia. 216 congress, with the great depression in mind, has realized the important role that taxes play with regard to foreign countries and their contribution to our economy, resulting in economic growth. congress’ realization and actions taken in furtherance of this awareness, signifies the necessity for binding tax law and encouraging foreign investment in our country. this also exemplifies the problems associated with the instability of tax treaty overrides and their effect on deterring foreign relations. over the past fifty years, the united states increased its public national debt to over eleven trillion dollars. 217 this amount is not expected to decrease due to projected deficits. 218 this debt is composed of money the united states government owes itself, private investors, and foreign investors. in 2007, 46% of the national debt was held by foreign nations. 219 this form of external debt has the effect of directly reducing the available lifetime consumption of the individual taxpayer and reducing his disposable income, savings, and thus, capital stock. 220 at best, the effect of this national debt will reduce the amount of money americans could invest in business, 215. id. 216. department of commerce, http://www.commerce.gov/ (last visited jun. 9, 2008). 217. treasury direct, monthly statement of the public debt of the united states (2009), http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds052009.pdf. see also, recovery.gov, http://www.recovery.gov/?q=content/act. (last visited jun. 9, 2009) which provides a summary of the american recovery and reinvestment act of 2009. to view the recovery act in its’ entirety, visit http://www.treasurydirect.gov/recovery.htm, which provides access to act in pdf format. 218. historical tables, office of management and budget, budget of the united states government, fiscal year 2009, available at http://www. whitehouse.gov/omb/budget/fy2009/pdf/hist.pdf. 219. the top ten nations holding the u.s. national debt are japan ($571 billion), china ($405 billion), uk ($299 billion), brazil ($128 billion), oil exporters (including ecuador, venezuela, indonesia, bahrain, iran, iraq, kuwait, etc.) ($126 billion), caribbean banking centers (including the bahamas, bermuda, cayman islands, netherlands antilles, and panama)($81 billion), luxembourg ($76 billion), hong kong ($54 billion), taiwan ($51 billion) and korea ($45 billion). 220. peter a. diamond, national debt in a neoclassical growth model, 1. a national debt of 9 trillion dollars equates to about $79,000 on average for each american taxpayer. 752 florida tax review [vol. 9:7 resulting in an economic slow down, which could then end in a recession. at worst, the united states could lose its international power, allowing for other economically thriving countries to take the lead. these issues are of greater concern than ever before as the united states’ recession has developed into a full fledge depression. 221 overriding tax treaties may deter foreign countries from financing our national debt, since these countries have rightfully come to expect that the tax benefits promised to them by the united states in international treaty agreements may possibly be extinguished. in 2006, foreign investors spent $184 billion investing in u.s. business and real estate. foreign direct investment creates new jobs, 222 boosts wages, 223 strengthens u.s. manufacturing, 224 brings new research and technology, 225 increases u.s. productivity, 226 contributes to tax revenues, 227 keeps interest rates low, 228 and can help u.s. companies penetrate foreign markets and increase u.s. exports. 229 the united states is unique in its status 221. an independent streak, the economist, jan. 26, 2008. this threat of american recession hits close to home for the middle-class elements of the country as one of the principal concerns arising from the recession is the major hit taken by the housing market, causing a huge “mortgage mess” and “great financial losses.” a long slog, the economist, jan. 12, 2008. 222. u.s. department of state, fact sheet, mar. 13, 2006, http://www.state.gov/r/pa/prs/ps/2006/63041.htm. bureau of economic analysis (bea), u.s. department of commerce: u.s. affiliates of foreign companies employ 5.5 million u.s. workers, or 4.7% of private industry employment. 223. id., national bureau of economic research – robert lipsey working paper 9293: u.s. affiliates of foreign companies tend to pay higher wages than u.s. companies. foreign companies support an annual u.s. payroll of $318 billion, with an average annual compensation per employee of over $60,000. average foreign companies pay up to 15% more than wages paid by u.s. companies. 224. id., bea: 41% of the jobs related to u.s. affiliate of foreign companies are in the manufacturing sector. 225. id., bea: affiliates of foreign companies spent $30 billion on research and development in 2003 and $109 billion on plants and equipment. 226. id., bureau of economic and business affairs, u.s. department of state: the increased investment and competition from fdi leads to higher productivity growth, a key ingredient that increases u.s. competitiveness abroad and raises living standards at home. 227. id., internal revenue service: in 2002, foreign affiliates paid $17.8 billion in taxes, representing 12% of u.s. corporate tax revenue and in 2004 paid $44 billion in taxes. 228. id., bureau of economic and business affairs, u.s. department of state: the inflow of foreign capital also decreases the cost of borrowing money for domestic entrepreneurs, especially in the small to medium sized enterprise sector. 229. id., bea: u.s. companies can use multinationals’ distribution networks and knowledge about foreign tastes to export into new markets. 2009] congressional unilateral tax treaty overrides 753 as the largest foreign direct investor in the world and the largest recipient of foreign direct investment. this dual role signifies globalization’s prominent role in the u.s. economy. 230 by overriding tax treaties, the united states places an unnecessary strain on its international relations without realizing the significance of those relationships to its economic well being. as stated above, overriding tax treaties causes an unexpected fluctuation in profit margins to foreign investors. consequently, this changes the investment climate which can lead to a decrease in overall foreign direct investment. if there are no tax incentives, security, or stability in the tax legislation for foreign investors in the united states, the $184 billion will be lost to more attractive investment climates. “capital is not free, nor permanent; it must be nurtured and it is highly sensitive in that it is at once risk-tolerant and risk adverse. it can be sullied and bullied, but not for long. it can flee to safer climes.” 231 on march 7, 2007, the investment trade administration (ita) announced it would undertake a new invest in america initiative 232 aimed at attracting foreign direct investment. ita’s main concern was if the united states does not play an active role in promoting inward investment, its investment climate is in danger of being perceived around the world only by its growing difficulties. 233 with a current recession, and our economy continuing to weaken while facing a growing national debt and national widespread inflation, foreign direct investment seems to be our only hope for surviving the impending depression. the dramatic increases of real estate foreclosures, surges in oil prices, sky rocketing levels of unemployment, and increases in commodity goods, are further causing fear and apprehension in the u.s. in approximately 21% of all u.s. exports come from u.s. subsidiaries of foreign companies. 230. crs report for congress; foreign direct investment: current issues, apr. 27, 2007. 231. foreign capital: friend or foe, quote by william h. peterson, member of california state assembly 2nd district. http://www.theadvocates.org/ freeman/8901pete.html. 232. lavin, frank l., role of foreign investment in u.s. economic growth, mar. 7, 2007. the initiative will have 3 key responsibilities: (1) outreach to the international investment community, (2) serve as an ombudsman in washington d.c. for the concerns of the international investment community as well as work on policy issues that affect the attractiveness of the united states in foreign investments, and (3) supporting state and local governments engaged in foreign investment promotions. 233. lavin, frank l., role of foreign investment in us economic growth, mar. 7, 2007, p. 1. http://trade.gov/press/speaches/lavin_030707.asp. 754 florida tax review [vol. 9:7 today’s u.s. economy, much like in 1929, people are being forced to drastically cut expenditures to keep up with their payments, ultimately resulting in an economic slow down. as businesses are failing, construction work and factory orders plunge. u.s. banks are claiming huge losses, as debtors default on their debts. this pattern is identical to the great depression, save the fact that in the late 1920’s, foreign direct investment was not a dominating force in the united states. research conducted by the nbre finds that direct investors, chiefly those who operate manufacturing facilities in foreign countries, are much more likely to ride out economic squalls than those involved in foreign bonds, equities, bank loans, and other forms of investments. 234 direct investment is bound up in enterprises that, in times of instability, can redirect sales from the country’s local markets to export markets. the drop in the currency value of a troubled country makes national products cheaper to foreign buyers and easier to export. this may allow for a host country to maintain levels of sustainable employment. it may ease the riding out of the economic storm. with so much to gain from foreign direct investment, it is difficult to rationalize why the united states is willing to bite the hand that feeds it. it is inevitable that foreign countries must pay taxes. however, how and what should be taxed should be established by the tax treaties negotiated between the united states and the foreign country. congress’ position that the laterin-time rule applies to tax treaties that contradict the tax code is not conducive to foreign direct investments, international relations, or to globalization as a whole. congress needs to act pragmatically by reinstating section 7852(d) of the 1939 tax code which respected treaty obligations and declared that treaty obligations prevailed over domestic tax laws. 234. foreign direct investors in three financial crises, mathew davis, available at http://www.nber.org/digest/jun01/w8084.html. florida tax review volume 11 2011 number 7 an equity-based, multilateral approach for sourcing income among nations by fred b. brown* i. introduction .......................................... ....... 567 ii. current source rules: description, principles, and problems .................................................. 570 a. description of current source rules .................... 570 1. interest and dividends ................................... 570 2. rent and royalties. ......................... ..... 571 3. service income. ................................. 572 4. property gains................................ 572 b. principles underlying the current source rules...... ...... 574 1. connection to governmental benefits/economic nexus.......... 574 2. expectation that another country will be taxing the income. ...................................... 576 3. national interests unrelated to traditional tax policy goals........... .................. ...... 577 4. principles reflected in treaties ...................... 578 5. administrability.......................... 579 c. problems with the current source rules ................. 579 1. lack of coherence ........................ ...... 579 2. variation in source rules used worldwide.... ......... 582 * associate professor of law and director of the graduate tax program, university of baltimore school of law; b.s. with high honors 1982, rutgers university; j.d. summa cum laude 1985, georgetown university; ll.m. 1986, new york university. i thank deborah schenk, walter schwidetzky, michael mcintyre, and diane ring for reviewing and providing very helpful comments on a draft of this article, as well as michael knoll for providing his very helpful insight. i also thank participants at the 2010 annual law and society meeting for their helpful comments. i am grateful to elizabeth cowan and michael spencer for their excellent research assistance. any errors are solely the responsibility of the author. 565 florida tax review iii. equity-based standard for devising source rules ........... 586 a. overview, basic assumptions, and preliminary matters............... 586 b. appropriate principles for sourcing income..... .......... 589 1. the benefits principle............................ 589 2. effect of the ability to pay principle ..................... 595 3. administrability.................... ............ 598 4. inappropriate principles in developing the source standard ....................... ................ 599 a. capital export neutrality and capital import neutrality... 600 b. expectation that another country will be taxing the income ................. ............... 604 c. national interests ................................ 604 c. standard for sourcing income................ ............ 607 1. categorizing and describing governmental benefits that relate to income ................................. 608 a. countries where taxpayer conducts activities ................. 608 b. countries in which taxpayer provides property, capital, or services ..................... ........ 608 c. country where taxpayer resides ........... ...... 611 2. unifying the activities, destination, and residence approaches for sourcing income............ ............ 612 a. the benefits principle and the propriety of split sourcing ......................... ........ 612 b. defending the residence country source problem............615 c. less stress on characterization.........................620 3. addressing administrative and coordination concerns.........623 a. an allocation scheme that avoids administrative difficulties...................................623 b. market access and enforcement concerns... ..... 628 c. the need for international agreement..........629 iv. using the standard to devise source rules. ........... 630 a. interest........................................631 b. income from corporate stock..................633 1. dividends....................................633 2. stock gains...................................635 c. service income....................................635 d. income from intangibles.............................637 1. royalties......................................637 2. intangible gains.................. ............. 638 e. income from the sale ofinventory......................640 v. conclusion................................................. 641 [yol. 11:7566 sourcing income among nations i. introduction the source of income rules used in the united states and elsewhere in large part establish the contours of income tax jurisdiction that is exercised by countries.' source rules do this by allocating a taxpayer's income for purposes of assigning countries their rights to tax such income. thus, source rules are of critical importance in the functioning of the income tax rules that apply to cross-border business and investment activities. the source rules play a vital role in the foreign tax credit system applicable to u.s. persons with foreign investment or business activities. this is because a u.s. taxpayer is subject to an annual foreign tax credit limitation, which is generally equal to the taxpayer's average u.s. tax rate multiplied by the taxpayer's foreign source income as determined under the source rules. the source rules also play a central role in the united states' exercise of taxation over foreign persons with u.s. businesses or investments. for the most part, only u.s. source income is subject to tax under the u.s. tax regimes that apply to foreign persons. moreover, if the united states were to move to a full or partial territorial system for taxing u.s. persons, the source rules would assume even greater importance given that they would determine whether the united states would impose any tax (as opposed to a residual tax) on the income of u.s. persons from crossborder activities.' other countries likewise use source rules or their 1. see hugh j. ault & david f. bradford, taxing international income: an analysis of the u.s. system and its economic premises, in national bureau of economic research, taxation in the global economy 11, 13 (assaf razin & joel slemrod, eds., 1990) ("the source rules are central to the taxing jurisdiction asserted over both u.s. and foreign persons."); stephen e. shay, j. clifton fleming, jr. & robert j. peroni, "what's source got to do with it?" source rules and us. international tax, 56 tax l. rev. 81, 83 (2002) [hereinafter, shay, fleming & peroni, source rules] (noting that "the concept of 'source' is at the heart of international taxation"). 2. compare this to the use of the arm's length method for allocating income among commonly controlled entities. see, e.g., i.r.c. § 482. thus, whereas the arm's length method is used to allocate income among taxpayers, the source rules are used to allocate income within a particular taxpayer. 3. see i.r.c. § 904(a), (d). 4. see i.r.c. §§ 871(a), (b), 881(a), 882(a), 864(c). 5. see j. clifton fleming, jr. & robert j. peroni, exploring the contours of a proposed u.s. exemption (territorial tax system), 41 tax notes int'l 217, 226-227 (2006); cf hugh j. ault & brian j. arnold, comparative income taxation: a structural analysis 447-48 (2010) (pointing out that in countries using territorial systems, great pressure is placed on source rules because treating income as foreign source may result in the income not being taxed anywhere if countries use different source rules). 2011] 567 florida tax review equivalent in applying foreign tax credit or territorial systems to their residents and exercising source taxation over nonresidents. the current approach for sourcing income suffers from two related problems. first, the source rules lack coherence in that they fail to advance a consistent normative tax policy.7 while the u.s. rules are generally based on the notion of sourcing income according to the location of economic activities that generate the income, they also promote other policy concerns, such as taxing income that is not likely to be taxed by foreign countries and encouraging u.s. export activities. more fundamentally, the source rules used by the united states and other countries fail to reflect the consistent application of the key principle appropriate for allocating nations' primary taxing rights namely, the benefits principle, under which income should be sourced to the country that provides the taxpayer with significant governmental benefits related to the derivation of the income.9 the connection to governmental benefits should be the guidepost for designing source of income rules, because the source rules define the scope of source taxation and source taxation is justified by governmental benefits provided to a nonresident by the host country.'o furthermore, even where the source rules attempt to implement an economic approach for sourcing income an approach that can be consistent with the benefits principle the rules in the united states and elsewhere often produce distorted binary results: that is, generally all of the income from a transaction is either domestic or foreign source even though the relevant economic factors suggest that a division of the income is warranted." the results produced by these "single" source rules at times are arbitrary.12 the second problem is the variation in the source rules used worldwide.' 3 this may produce double taxation two or more countries taxing the same income, a result that would impede the free flow of business and investment capital. or alternatively, differences in countries' sourcing approaches can lead to non-taxation no country taxing the particular income, which may encourage tax motivated transactions. this article addresses both of these problems by offering an approach for sourcing income that has the potential for being adopted by countries on a multilateral basis. the article develops an equity-based standard for sourcing that would allow for the derivation of source rules for various types of income. the core idea underlying the proposed sourcing 6. see ault & arnold, supra note 5, at 454-57, 498-502, 506-15. 7. see infra notes 84-106 and accompanying text. 8. see infra notes 60-61, 68 and accompanying text. 9. see infra notes 144-48 and accompanying text. 10. see infra notes 144-48 and accompanying text. 11. see infra notes 53-59, 94-96 and accompanying text. 12. see infra notes 97-100 and accompanying text. 13. see infra part ii.c.2. [vol. 11:7568 sourcing income among nations standard is the benefits principle, which calls for the sourcing of income on the basis of related government benefits. to an extent, the proposed approach is somewhat consistent with source rules currently used in the united states and elsewhere. however, unlike the u.s. rules and those of some other countries, the proposed approach would not take into account other policy concerns, with the exception of administrability. moreover, the suggested approach would divide the income between geographical sources where more than one country provides significant governmental benefits that contribute to the earning or enjoyment of the income, whereas the current rules typically assign income to a single geographical source. by basing the source rules on a benefits principle-based standard that allows source to be divided when appropriate, this article seeks to rationalize and harmonize the provisions used to source income for purposes of taxing cross-border investment and business activities. this article differs from prior work in this area in two important respects. first, it offers a multilateral approach for sourcing income, whereas earlier studies of significance have taken a national approach, evaluating for reform the source rules of the united states.14 second, unlike other scholarship devoted to the source rules, the article develops a single standard for sourcing income that promotes equity by dividing the income tax jurisdiction of countries based on the provision of government benefits that relate to the income. thus, the article is important in that it develops an equity-based standard for sourcing income that may gain international acceptance.' 5 part ii of the article briefly describes source rules used in the united states and other countries, reviews the principles underlying the current source rules, and describes the significant problems caused by the current approach. part iii develops a standard for devising source rules, first by identifying the benefits principle and administrability as the appropriate principles for developing the standard for sourcing income. this part then formulates a standard that would devise source rules by evaluating the source of income on the basis of three factors: the destination of the services, property, or capital giving rise to income; the location(s) of the activities giving rise to income; and the residence of the person receiving income. 14. see am. law inst., federal income tax project: international aspects of united states income taxation: proposals of the american law institute on united states taxation of foreign persons and of the foreign income of united states persons (1987) (ali project 1); shay, fleming & peroni, source rules, supra note 1. 15. this would be analogous to the international acceptance of the arm's length principles to allocate income among commonly controlled entities. see, e.g., oecd model tax convention on income and on capital art. 9 (2010) [hereinafter oecd model] (calling for the use of arm's length principles to allocate income among associated enterprises). 2011] 569 florida tax review based on this evaluation, the rule for a given type of income may divide the source of the income among multiple locations. part iv then illustrates the use of this standard by suggesting revised source rules for several types of income. part v concludes the article. ii. current source rules: description, principles, and problems this part proceeds by briefly describing source rules used in the united states and other countries. this is followed by a review of the principles underlying the current source rules, and then a description of the significant problems caused by the current approach. a. description of current source rules the current approach used in the united states and other countries for sourcing income is to provide separate source rules for particular types of income. thus, there are different rules for several categories of income, such as interest, dividends, service income, rents, royalties, and various types of property gains. in addition, while technically not source rules, statutes and treaties have provisions that limit or eliminate countries' exercise of source taxation. what follows is a brief description of these rules. 1. interest and dividends interest income is typically sourced based on the residence or place of incorporation of the borrower.' 7 this rule is usually overlaid with exceptions for business-related interest, under which interest that is associated with a business that is conducted outside the borrower's country of residence or incorporation is sourced according to the actual or presumed 16. this article will not address the related subject of sourcing deductions, that is, linking expense deductions to income from different sources. for purposes of both source and residence taxation, it is often necessary to determine the net income from different sources. see, e.g., i.r.c. §§ 871(b), 882 (a), 904(a). this requires that deductions be allocated and apportioned to income from different sources. under the u.s. rules, deductions are generally matched to gross income based on the factual relationship between the deductions and income. see regs. §§ 1.861-8, 8t. there are also special allocation and apportionment rules for interest expense and research and development costs. see regs. §§ 1.861-9, 9t, 10t, 17. while determining appropriate rules for sourcing deductions is certainly important in crafting harmonized source rules, this issue will be left for a future endeavor. 17. see, e.g., i.r.c. § 861(a)(1); oecd model, supra note 15, at art. 11, para. 5; see also ault & arnold, supra note 5, at 510 (stating that interest is generally sourced where the payer is resident). [vol. 11:7570 sourcing income among nations location of that business." similar to interest, dividends are generally sourced according to the place of incorporation of the corporation paying the dividend,'9 with exceptions for situations where the corporation derives a significant portion of its income outside its country of incorporation.2 0 while the source rule for interest would indicate that the borrower's country of residence would generally have taxing rights over the interest payments, in most cases source taxation is prevented. many countries have statutes that provide tax exemptions for domestic source interest received by foreign persons.2 ' in addition, income tax treaties between countries usually give the country where the interest recipient resides the exclusive right to tax interest income.22 for dividends, treaties typically reduce source taxation by limiting the source country tax rates on dividends to either fifteen or five percent.2 3 2. rents and royalties rental income from the leasing of tangible property is traditionally sourced at the location of the leased property.2 4 royalty income from licensing intangible property is sourced using a similar, property destinationtype approach, but there are differences among countries in carrying out this approach. under u.s. law, the source of royalty income is determined according to the place where the intangible is used.25 the place of use is typically the country that is providing the legal protections that relate to the 18. see, e.g., i.r.c. § 861(a)(1)(a), (b); oecd model, supra note 15, at art. 11, para. 5. under u.s. law prior to 2011, interest paid by a u.s. corporation or resident alien was generally treated as foreign source interest in its entirety if the payer met the 80 percent foreign business requirements contained in section 861(c) (so called 80/20 companies rule). see i.r.c. § 861(a)(1)(a) (prior to 2011). for taxable years beginning after 2010, the 80/20 source rule has been repealed, although a similar rule applies to exempt from u.s. source taxation interest (as well as dividends) paid by "existing 80/20 companies" (as defined in section 871(1)(1)). see i.r.c. § 871(i)(2)(b), (1), 881(d). 19. see, e.g., i.r.c. § 861(a)(2); oecd model, supra note 15, at art. 10. 20. see, e.g., i.r.c. § 861(a)(2)(b). 21. see am. law inst., federal income tax project: international aspects of united states income taxation ii: proposals of the american law institute on united states income tax treaties 194 (1992) (ali project ii); see, e.g., i.r.c. §§ 871(h), 881(c) (portfolio interest exemption); i.r.c. §§ 871(i)(2)(a), 881(d) (bank deposit interest exemption). 22. see, e.g., u.s. model income tax convention of november 15, 2006, art. 11, para. i [hereinafter u.s. model]. 23. see, e.g., oecd model, supra note 15, at art. 10, para. 2. 24. see, e.g., i.r.c. § 861(a)(4). 25. see id. 2011] 571 florida tax review intangible.26 in other countries, royalties are often sourced based on the residence of the payer or the country from which payment is made.2 despite the source rules for royalties, income tax treaties typically prevent the source country from taxing royalty income that is received by residents of the other treaty country.28 3. service income a few approaches have emerged for sourcing income from the performance of services. some countries, including the united states, source service income according to where the services are performed.29 other countries apply a service destination approach and focus instead on the country in which the services are utilized.30 some countries use both approaches and determine a domestic source for service income if the services are either preformed or utilized in the particular country. 4. property gains there are several approaches for sourcing gains from the disposition of property, with the particular approach based on type of property that is involved. for sales of inventory property that is purchased by the taxpayer (as opposed to being produced by the taxpayer), the united states generally sources the income on the basis of where beneficial ownership and risk of loss pass to the buyer the so-called title passage rule. other countries appear to focus on the country where the sales activities giving rise to the income takes place. for sales of inventory property that is produced by the 26. see stephen e. shay, et al., report of the task force on international tax reform, 59 tax law. 649, 773 (2006) [hereinafter shay, et al., task force]. 27. ali project ii, supra note 21 at 199; see ault & arnold, supra note 5 at 513 (discussing the implicit source rule under the australian non-resident withholding tax, which effectively treats royalties as well as interest and dividends paid by residents as australian source income). 28. see, e.g., oecd model, supra note 15, at art. 12, para. 1. 29. see, e.g., i.r.c. § 861(a)(3). 30. ali project i, supra note 14, at 57; see ali project il, supra note 21, at 7; ault & arnold, supra note 5, at 506. 31. see ali project i, supra note 14, at 57. 32. see i.r.c. § 861(a)(6); reg. § 1.861-7(c). 33. see ault & arnold, supra note 5, at 456 (discussing the source rule for export sales of inventory used by japan for purposes of its foreign tax credit limitation, which treats income from such sales as foreign source only if effected through a foreign branch or in other circumstances that subject the income to a foreign tax). the united states uses this approach in treating income as u.s. source where the income is derived by nonresidents from sales of property that are attributable to a u.s. fixed place of business. see i.r.c. § 865(e)(2). 572 [vol. 11:7 sourcing income among nations taxpayer, the united states generally sources 50 percent of the income to the country that is the situs of the production activities and 50 percent of the income to the country where title to the goods passes to the buyer.34 other countries similarly divide the source of the income between production and sales activities, but they may use different methods for determining the amount of income that is attributable to the production and sales activities. although technically not source rules, u.s. statutory and regulatory provisions prevent the exercise of source taxation over inventory income unless the nonresident is conducting a trade or business in the united states.36 similarly, treaties condition the exercise of source taxation over inventory income and other forms of business profits on the existence of a permanent establishment in the source country by the nonresident,3 7 which is generally a fixed place of business through which the business is conducted. the united states generally sources gain on the sale of other types of property based on the residence of the seller. under this rule, gain from the sale of a financial asset, such as corporate stock, by a foreign person would generally be foreign source.40 most other countries also generally source investment gains based on the residence of the seller.4 1 however, several countries, contrary to the u.s. rule, do impose a source tax on gains realized by a nonresident on the sale of stock in a resident corporation.4 2 under the 34. see reg. § 1.863-3. 35. see ali project ii, supra note 21, at 8. in addition, other countries would probably focus on the location of the sales activities as opposed to where title passes in sourcing the sales portion of such income. 36. see i.r.c. §§ 871(a), (b), 881(a), 882(a), 864(b); reg. § 1.1441-2(b) (excluding most gains from the definition of fdap income, which is the base of the u.s. gross basis source tax regime). 37. see, e.g., oecd model, supra note 15, at art. 7. 38. see, e.g., oecd model, supra note 15, at art. 5. 39. see i.r.c. § 865(a). 40. see i.r.c. §§ 865(a), 865(g). there are other limitations on the source taxation of gains from sales of stocks or securities. under u.s. law, the trading of stocks or securities is generally not considered to be a u.s. trade or business for purposes of u.s. net basis source taxation, and stock or security gains are generally not subject to u.s. gross basis source taxation. see i.r.c. §§ 864(b)(2), 871(a), (b), 881(a), 882(a); reg. § 1.1441-2(b). in addition, treaties generally prevent the source taxation of stock or security gains. see, e.g., u.s. model, supra note 22, at art. 13, para. 6. 41. see ali project ii, supra note 21, at 202. 42. see id.; joseph l. andrus, determining the source of income in a changing world, 75 taxes 839, 844 (1997); ault & arnold, supra note 5, at 49798, 509; kimberly s. blanchard, cross-border tax problems of investment funds, 60 tax law. 583, 585 (2007) (stating that many countries tax nonresidents on stock 2011] 573 florida tax review u.s. rule, gain on the sale of an intangible would generally be sourced according to the residence of seller.4 3 an exception exists for contingent payment sales, in which case the gain is sourced under the royalty rule discussed above." gains from sales of real property are sourced in the country in which the real property is located.45 in the united states, u.s. source treatment also applies to gains from indirect holdings of u.s. realty through u.s. corporations whose principal assets are u.s. real estate.46 b. principles underlying the current source rules a comprehensive rationale has never been offered for the source rules that exist in the united states and other countries.4 7 instead, the current rules are a product of balancing a complex set of conflicting principles, considerations, and claims as they apply to particular income types.48 1. connection to governmental benefits/economic nexus an important principle used in formulating source rules is the view that income should be sourced to the country that provides governmental services and protections that are used in deriving the income.49 in practice, this policy is usually carried out by associating income with a geographic source based on an economic nexus between the income and a particular gains with respect to "local corporations, at least where such corporations are not publicly traded and locally listed"). 43. see i.r.c. § 865(a). 44. see i.r.c. § 865(d)(1); supra notes 25-26 and accompanying text. 45. ali project i, supra note 14, at 37; see, e.g., i.r.c. §§ 861(a)(5), 897(c). 46. see i.r.c. §§ 861(a)(5), 897(c). 47. see ali project i, supra note 14, at 18; andrew walker, exceptions in search of a rule: the source and taxability of "none of the above" income 4 (columbia law school tax policy colloquium, 2009), http://www.law.columbia. edu/null/download?&exclusive=filemgr.download&file id=153762 (stating that there is no obvious unifying principle that explains the existing u.s. source rules). 48. see ali project i, supra note 14, at 18; walker, supra note, 47 at 5; cf staff of the joint comm. on taxation, description and analysis of present-law rules relating to international taxation, jcx-40-99 (1999) (stating that various factors determine the source of income for u.s. purposes, including the location or nationality of the payer and recipient, and the location of the activities and assets that generate income). 49. see, e.g., ali project i, supra note 14, at 18; lawrence lokken, what is this thing called source? 3-5 (miami law research paper series, 2011), http://ssrn.com/abstract-1795265 [hereinafter lokken, source] (stating that several source rules can be explained by a principle that sources income based on the location of governmental services and protections utilized in earning income). 574 [vol. 11: 7 sourcing income among nations country.50 thus, in determining the source of income from activities, the focus is typically on the country in which income-producing activities occur." likewise, the source of income derived from property or capital is often determined to be the country where the property or capital is used.52 income may well have an economic nexus to two or more countries. for example, a bank may perform lending activities in one country in connection with a loan made to a borrower who resides in another country; in this case, there would be a conflict between the activities and utilization bases for sourcing income.53 or the conflict could involve the activities basis alone, for example, where two selling branches participate in one sales transaction. in most cases, the source rules resolve such conflicts by sourcing the income to one of the countries involved.54 this is often determined by deciding which country has the stronger source claim,55 based either on the country with the aspects of the transaction that have the greatest economic significance56 or the country that is providing the most important public benefits related to the derivation of the income.57 sometimes conflicting source claims are resolved by determining whether one of the competing countries is likely to tax the income, a principle that is discussed below. 8 in some cases, however, source conflicts are resolved by dividing the income between two countries; for example, this approach is used to source inventory income where the inventory is produced in one country and sold in another.59 50. see, e.g., u. s. treas. dept, the president's tax proposals to the congress for fairness, growth, and simplicity 399 (1985) [hereinafter treasury ii] (stating that appropriate source rules "should reflect the location of the economic activity generating the income and the source of legal protections facilitating the earning of that income"); ali project i, supra note 14, at 19; cf michael j. mcintyre, the international income tax rules of the united states 3-67 to 3-68 (1996) [hereinafter mcintyre, tax rules] ("to the extent possible, income should be sourced in a country where it has some economic nexus."). as discussed below, economic nexus is an incomplete surrogate for the benefits principle. see infra note 152 and accompanying text. 51. see, e.g., ali project i, supra note, 14 at 19. 52. see id. 53. see id. 54. see, e.g., i.r.c. §§ 861(a)(4), 865(e)(2). 55. see ali project i, supra note 14, at 19. 56. see id. at 45. 57. see lawrence lokken, the sources of income from international uses and dispositions of intellectual property, 36 tax l. rev. 233, 239-40 (1981) [hereinafter lokken, intellectual property]. 58. see infra part ii.b.2. 59. see supra notes 34-35 and accompanying text. 5752011] florida tax review 2. expectation that another country will be taxing the income another principle that is sometimes used to source income is whether it is expected that other countries will be taxing the income.60 the united states uses this principle in sourcing several types of income for purposes of the foreign tax credit limitation.6 ' the concern underlying this principle is international under taxation. that is, if income is included in calculating a residence country's foreign tax credit limitation, but the income is not taxed by another country, the taxpayer would be able to cross-credit excess foreign tax credits on other foreign income against the pre-credit residence country tax on the income, thus resulting in effectively no tax or a 62reduced tax on the income. similarly, if the residence country uses a territorial system, exempting income that is not taxed by another country would mean that no country is taxing the income. to prevent this, a residence country can use the expected-to-tax principle to treat income as domestic source, thus removing it from either the foreign tax credit limitation or foreign income exemption. when used, this principle may serve as a tiebreaker in determining source where the income has an economic connection to two or more countries, but only one of the countries is expected to tax the income.6 ' because of a concern that the expected-to-tax principle still allows for substantial cross-crediting opportunities, some commentators go further and call for an investigation of whether it is feasible to treat income as foreign source for foreign tax credit limitation purposes only where a foreign country imposes a significant tax on the income."4 in this regard, some countries use a subject-to-tax requirement for exempting foreign income under territorial tax systems. 60. see staff of the joint comm. on taxation, 99th cong., general explanation of the tax reform act of 1986, at 917-18, 933 (1987) [hereinafter 1986 bluebook]; andrus, supra note 42, at 843-44. 61. see 1986 bluebook, supra note 60, at 917-18, 932-33 (sales of personal property; income from space and certain ocean activities). 62. see id. at 917-18. 63. cf mcintyre, tax rules, supra note 50, at 3-68 to 3-69 ("to the extent feasible, income with an economic nexus in more than one country should be sourced in a country that is inclined to subject the income to taxation."). 64. see shay, fleming & peroni, source rules, supra note 1, at 151-52; see also robert j. peroni, a hitchhiker's guide to reform of the foreign tax credit limitation, 56 smu l. rev. 391, 396 (2003). these commentators acknowledge the administrative difficulties of such an approach. 65. see shay, fleming & peroni, source rules, supra note 1, at 150; see also i.r.c. § 865(e)(1) (personal property gains of u.s. residents otherwise subject to residence-based sourcing are treated as foreign source where the sale of the personal property is attributable to an office or fixed place of business maintained by the u.s. resident in a foreign country, provided that at least a ten percent income tax is actually paid to a foreign country with respect to the gain). [vol. 11:7576 sourcing income among nations 3. national interests unrelated to traditional tax policy goals a country's national interests unrelated to traditional tax policy goals may also affect the design of source rules. for example, the united states uses the source rules in order to provide export incentives. in 1986 the united states generally repealed the title passage rule for sourcing personal property gains because it did not want u.s. taxpayers to be able to generate foreign source income on sales that were not likely to be subject to a foreign tax (an application of the expected-to-tax principle discussed above). such low or non-taxed foreign income could be used to absorb excess foreign tax credits on high-taxed foreign income. however, the united states retained the title passage rule for sales of inventory out of a concern that the repeal of this rule for inventory sales would create difficulties for u.s. businesses competing in international commerce, especially given the substantial u.s. trade deficit at that time. 8 thus, the united states' continued use of the title passage rule for inventory sales is a form of export incentive. in addition, as mentioned above, many countries, including the united states, generally provide tax exemptions for domestic source interest income received by nonresidents.6 9 the purpose for the portfolio interest exemption is to allow domestic borrowers unrestricted access to the eurobond market, where debt securities are generally free of taxes withheld at source and where the issuer would generally be required to pay interest net of any source tax. 70 to the extent that a source withholding tax is imposed, a borrower in the eurobond market would generally have to gross up the interest payment to cover the tax.7 1 the exemptions for interest promote national, non-tax policy objectives by allowing less costly borrowings by domestic persons, as well by encouraging non-residents to lend money to residents of a particular country.72 66. see 1986 bluebook, supra note 60, at 918. 67. see id. 68. see id. 69. see supra note 21 and accompanying text. 70. see staff of the joint comm. on taxation, 98th cong., general explanation of the revenue provisions of the deficit reduction act of 1984, at 388-89 (1984). 71. see id. 72. see ali project ii, supra note 21, at 195 (stating that the u.s. tax exemptions for interest reflect a policy judgment that it is critical to stimulate or preserve the willingness of non-residents to lend to u.s. borrowers); yoram keinan, the case for residency-based taxation of financial transactions in developing countries, 9 fla. tax rev. 1, 26 ("the portfolio-interest exception is perhaps the purest example of enlightened self-interest and realism in attracting foreign capital." (quoting from dan r. mastromarco & lawrence a. hunter, the u.s. anti-savings directive, 2002 tnt 247-28)). similarly, the u.s. rules that generally treat the 2011] 577 florida tax review 4. principles reflected in treaties as noted above, treaties typically limit a country's exercise of source taxation by reducing or eliminating the withholding tax on investment income such as interest, dividends, and royalties. an important reason for the reduction of withholding taxes on investment income is to avoid excessive taxation by the source country.7 4 gross basis withholding taxes that take no account of expenses associated with the income can result in a very high rate of tax on the net income from a transaction. the quintessential example is interest income derived by a financial institutional upon relending funds that are borrowed from others; in this situation, a significant gross basis tax may be confiscatory in that it could exceed the amount of net income from the transaction. another, apparent reason for treaty provisions that reduce or eliminate source taxation on investment income is the notion that the source country's claim to tax such income may be considered to be relatively weak. the fact that the general elimination of the source tax on interest applies not only to financial institutions but also to other interest recipients suggests that another principle is at work besides preventing excessive source taxation." likewise, the treaty rate on dividends, typically fifteen percent, seems lower than necessary to address concerns of a high rate of source tax on net income, given the degree of associated expenses usually incurred in connection with portfolio investments. trading of stocks or securities as not constituting a u.s. trade or business were enacted to encourage foreign persons to invest in u.s. capital markets. see id at 54. 73. see supra notes 22-23, 28 and accompanying text. 74. see ali project ii, supra note 21, at 9. 75. see id. 76. see id. at 194 (referring to this as a possible basis for the general treaty elimination of source taxation of interest income); michael j. graetz & itai grinberg, taxing international portfolio income, 56 tax l. rev. 537, 569 (2003) (stating that the source country's claim to tax portfolio income is more attenuated than its claim to tax business income and that the claims of the residence country seem to deserve priority in the inter-nation allocation of tax jurisdiction over portfolio income; pointing out that primary allocation of taxing rights over portfolio income reflects this priority). 77. see ali project ii, supra note 21, at 193-94. 78. cf oecd model tax convention on income and on capital art. 10 cmt. (2008) [hereinafter oecd model 2008] (stating that the 15 percent treaty rate on dividends appears to be a reasonable maximum rate given that the source country can already tax the corporation's profits); but see ali project ii, supra note 21, at 184 (stating that the object of treaty provisions that limit the source country rate on dividends seems to be keep the rate low enough so that in many cases the source tax will not exceed the net basis tax that would be imposed in the residence country). [vol. 11:7578 sourcing income among nations 5. administrability administrability is an important consideration in devising source rules.79 although more than one country may be connected to the derivation of income, the current source rules usually determine a single source apparently because of a concern that a multi-source approach would be overly complex.so source rules also attempt to avoid detailed factual inquiries. in this regard, both the title passage rule8 ' and the 50-50 source rules used by the united states in a few contexts8 2 allow for bright line determinations of source. simplicity is especially desirable for the source rules that are used to determine withholding obligations,8 such as those for interest, dividends, and royalties. c. problems with the current source rules the current approach for sourcing income suffers from two fundamental and related problems. first, the source rules lack coherence in that they fail to advance a consistent normative tax policy. in particular, the rules fail to reflect the consistent application of the key principle appropriate for allocating nations' primary taxing rights namely, the benefits principle. and second, because of a lack of coherence, there may be considerable variation in the source rules used worldwide, thus increasing the likelihood of double taxation and non-taxation. 1. lack of coherence the current sources rules employed in the united states and elsewhere fail to advance a consistent normative tax policy.84 this leads to 79. see ali project i, supra note 14, at 19; mcintyre, tax rules, supra note 50, at 3-66. 80. see allison christians, samuel a. donaldson & philip f. postlewaite, united states international taxation 20-21 (2008). 81. see supra note 32 and accompanying text. 82. see i.r.c. §§ 863(c), 863(e); treas. reg. § 1.863-3. 83. see mcintyre, tax rules, supra note 50, at 3-66. 84. see shay, fleming & peroni, source rules, supra note 1, at 83-84 ("because no clear economic or equitable principles guide the formulation of rules to divide income and expense by geographic origin, the construction of these rules has been a significantly arbitrary exercise.") & n.3 ("[t]he claimed rationale for most source rules has a substantial element of arbitrariness."); ruth mason, tax expenditures and global labor mobility, 84 n.y.u. l. rev. 1540, 1591 (2009) (stating that the source rules have long be criticized for their arbitrariness); michael j. graetz, a multilateral solution for the income tax treatment ofinterest expenses, 62 bull. int'l tax'n 486, 489 (2008) [hereinafter graetz, multilateral solution] 2011] 579 florida tax review different sourcing approaches for economically similar types of income.85 for example, dividends are generally sourced based on the country of incorporation of the corporation paying the dividend. 6 in contrast, as a result of the expected-to-tax principle, stock gains are generally sourced under the u.s. rules according to the residence of the seller. yet, in substance the two items are quite similar given that stock gains represent a market capitalization of future earnings.89 the different source consequences on the sale versus license of a patent are also a result of basing source rules on different principles.90 similarly, the source tax exemption that generally applies to interest, which is to allow domestic borrowers unrestricted access (stating that it is well known that "the 'source' of income is not well grounded economically, nor is it conceptually straightforward," that in many instances "archaic rules and distinctions prevail," and that it may be that the "current sourcing rules seem arbitrary and archaic"); edward d. kleinbard, the lessons of stateless income 56 (usc legal studies research paper no. 11-7, 2011), http://ssrn.com/abstract-1791783 [hereinafter kleinbard, lessons) ("[tlhe global tax norms that define the geographic source of income or expense are largely artificial constructs, difficult to administer and often devoid of any conceptual foundation."); ilan benshalom, the new poor at our gates: global justice implications for international trade and tax law, 85 n.y.u. l. rev. 1, 76 (2010) (arguing that "the notorious complexity of source rules is due primarily to a lack of normative comprehension as to what they are expected to achieve"); cf arthur j. cockfield, the rise of the oecd as informal "world tax organization" through national responses to e-commerce challenges, 8 yale j. l. & tech. 136, 175 (2006) (referring to observations that international tax policy suffers from a degree of arbitrariness because of a lack of agreement on guiding principles). 85. see shay, fleming & peroni, source rules, supra note 1, at n.3 (providing an example of the often capricious nature of the source rules that involves the title passage rule for sales of inventory); cf willard b. taylor & diana l. wollman, why can't we all just get along: finding consistent solutions to the treatment of derivatives and other problems, 53 tax law. 95, 95, 113-18 (1999) (pointing out the differences in the source rules applying to several types of derivative financial instruments and the lack of a seeming purpose for such; suggesting that there could be a single rule for sourcing derivative gains and losses). 86. see supra notes 19-20 and accompanying text. 87. see supra notes 60-63 and accompanying text. 88. see supra notes 39-40 and accompanying text. it should be noted that the expected-to-tax principle is problematic in some cases, in that a determination that other countries are not imposing a source tax on a particular type of income may not always be correct. see andrus, supra note 42 (pointing out that the united states' application of residence based sourcing of gains from the disposition of foreign corporate stock pursuant to the expected-to-tax principle can result in double taxation because a significant number of countries do tax nonresidents on such gains). 89. see shay, fleming & peroni, source rules, supra note 1, at 122. 90. see infra notes 105-106 and accompanying text. [vol. 11:7580 sourcing income among nations to the eurobond market,9' is inconsistent with the general source taxation of other types of investment income, such as dividends, rents, and royalties. 9 2 more fundamentally, the rules fail to reflect the consistent application of the key principle appropriate for allocating nations' primary taxing rights namely, the benefits principle. as developed more fully in the next part, the connection to governmental benefits should be the guidepost for designing source of income rules, because the source rules define the scope of source taxation and source taxation is justified by governmental benefits provided to a nonresident by the host country. in this regard, equity supports host country taxation of nonresidents who benefit from host country governmental services so that the costs of these services are not borne solely by residents of that country. while the economic nexus principle can function to a degree as a surrogate for focusing on governmental benefits, 94 the general binary nature of the source rules results in a failure to appropriately allocate primary tax jurisdiction in accordance with the provision of government benefits. as discussed above, the current source rules often assign all of the income to a single geographic source even though relevant economic activities occur in more than one country.9 s although administrative considerations counsel against a sourcing approach that would take into account all countries that might have some connection to the income, 6 one certainly should question the soundness of the current approach that usually ignores all but one of the connected countries. moreover, the decision to choose a particular country as the most important either in terms of economic contribution or provision of public benefits often is arbitrary.97 for example, where an intangible is produced in one country and licensed for use in another country, is it so clear that the latter country is the most important in the derivation of the income? 98 91. see supra notes 21, 70-72 and accompanying text. 92. see supra notes 19-20, 24-27 and accompanying text. 93. see infra part iii.b.1. 94. see infra notes 149-52 and accompanying text. 95. see supra notes 53-59 and accompanying text. 96. see supra notes 79-83 and accompanying text. 97. see mason, supra note 84, at 1591 n.195 (noting different possible bases for sourcing sales income (where title passes, place of sale, or place of consumption) and interest income (including the residence of the borrower, where the principal is either made available or used, or where interest payments are made)); cf michael j. graetz, taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 54 tax l. rev. 261, 317 (2001) [hereinafter graetz, inadequate principles] (stating that the source rules "should be overhauled to be better linked to the location of real economic activity, the location of customers, workers, or assets"). 98. under section 861(a)(4), the royalty income will be sourced where the intangible is being used. 2011] 581 florida tax review and when compared to a similar situation involving services performed in one country that are utilized in another country, the u.s. source rules appear inconsistent, given that the source of the service income typically will be in the country in which the services are performed. 99 (as mentioned above, some countries use a service destination approach for sourcing service income.10) the arbitrary and inconsistent results of single source rules are exacerbated by the need to characterize transactions.'o' characterization is particularly necessary and often problematic in the case of transactions involving intangibles and electronic commerce, where the income from a given transaction may take the form of royalties, compensation, or property gains based on the specific facts and circumstances. 0 2 and because the single source rules produce very different results depending on the ty e of income involved,'03 a great deal turns on how income is characterized.' for example, where a u.s. resident develops an invention in the united states, obtains a foreign patent on the invention, and then sells the foreign patent for a lump sum amount, all of the gain will be u.s. source;'s however, if instead of selling the patent the taxpayer licenses the patent in exchange for a lump sum royalty for a period that is slightly less than the patent's remaining life, all of the income would be foreign source.' 06 despite the similarity in the substance of these two alternatives, the source results are quite different. 2. variation in source rules used worldwide because of a lack of coherence, there may be considerable variation in the source rules used worldwide.' 07 this raises the concern of double 99. i.r.c. § 861(a)(3). 100. see supra notes 30-31 and accompanying text. 101. see mason, supra note 84, at 1591 (referring to disputes about how to classify income). 102. see ali project i, supra note 14, at 43; andrus, supra note 42, at 855-56; david g. noren, commentary, the u.s. national interest in international tax policy, 54 tax l. rev. 337, 345 (2001) (pointing out that many electronic commerce activities can plausibly be analogized to any of these categories). 103. see supra part h.a. 104. see noren, supra note 102, at 345. 105. i.r.c. §§ 865(a), 865(g)(1). this assumes that the sale was not attributable to a foreign office maintained by the u.s. resident and subject to foreign tax of at least ten percent. see i.r.c. § 865(e)(1). 106. i.r.c. §§ 861(a)(4), 862(a)(4). 107. see ali project 1, supra note 14, at 14 (stating that "the rules defining the source of income may vary considerably from country to country"); ault & arnold, supra note 5, at 498-502, 506-09 (discussing differences in countries' approaches for attributing income to domestic branches, determining the source of employment income, and exercising source taxation over gains derived by [vol. 11:7582 sourcing income among nations taxation that two or more countries are taxing the same income, a result that would impede the free flow of business and investment capital.'s or alternatively, differences in countries' sourcing approaches can lead to nontaxation that no country is taxing the particular income, which may encourage inefficient, tax-motivated transactions.' 09 where more than one country has a connection to an income item (which is often the case), the single source approach requires that the income be sourced to only one of the countries. in this regard, nations may come to a different conclusion as to the appropriate country, thus creating differences in source rules."o for example, some countries source service income based on where the services are performed, while others focus on where the services are utilized' or a mixture of the place of performance, the place of contract, and place of payment.112 likewise, countries choose the single source differently with respect to royalty income, with some countries using the location of the payer or place of payment, while other countries focus on where the intangible is being used." in addition, countries use substantially nonresidents from disposing of substantial shareholdings in domestic corporations); technical advisory group on monitoring the application of existing treaty norms for taxing business profits, oecd, are the current treaty rules for taxing business profits appropriate for e-commerce? final report 26, http://www.oecd.org/dataoecd/58/53/35869032.pdf [hereinafter oecd, ecommerce] (pointing out that even developed countries have different approaches for determining source taxation of business profits); oleksandr pastukhov, going where no taxman has gone before: preliminary conclusions and recommendations drawn from a decade of debate on the international taxation of e-commerce, 36 rutgers computer & tech. l.j. 1, 6-7 (2009) (pointing out that the lack of uniformity among nations in taxing electronic commerce leads to taxing authorities being perplexed over the country that should have taxing rights). 108. see mcintyre, tax rules, supra note 50, at 1-3 to 1-4; graetz, multilateral solution, supra note 84, at 489. 109. see mcintyre, tax rules, supra note 50, at 1-4; graetz, multilateral solution, supra note 84, at 489. 110. see michael j. mcintyre, the use of combined reporting by nationstates, in the taxation of business profits under tax treaties, ch. 8 (brian j. arnold, jacques sasseville & eric m. zolt, eds.) 263 (2003) ("because the source of income is not obvious in many cases, the source rules adopted by various countries sometimes conflict."). 111. see supra notes 29-31 and accompanying text. 112. see ault & arnold, supra note 5, at 506-07 (discussing the australian approach for sourcing employment income for purposes of exercising source taxation over nonresidents). 113. see supra notes 25-27 and accompanying text. while countries generally source interest income based on the residence of the borrower (see supra notes 17-18 and accompanying text), for purposes of its foreign tax credit limitation, australia sources interest that is not subject to a foreign tax based on the where the 2011] 583 florida tax review different approaches in attributing income to domestic branches of nonresidents for purposes of exercising source taxation.1 4 in this regard, some countries focus on the economic connection between income items and the branch, while other countries use "force of attraction" approaches that attribute domestic source income to the branch regardless of an actual economic connection, with source determined based on an independent set of source rules." 5 the details of the approaches for sourcing branch income tend to be relatively undeveloped for example, the source rules are sometimes from judge-made law that operate on a facts-and-circumstances or similar basis." 6 moreover, even if countries decided their single source rules in the same way, there could still be differences in source results where countries characterized income items differently."' assume that another country has the same source rules as the united states with respect to service income and royalties, but uses different rules for characterizing transactions as either the performance of services or the licensing of an intangible. under these circumstances, the united states and the other country would source a given cross-border transaction differently if the united states characterized the transaction as the performance of services while the other country viewed it as the licensing of an intangible. not surprisingly, the use of different principles for devising source rules can lead to different source rules. for example, based on the expectedto-tax principle,"8 the united states generally sources stock gains based on the residence of the seller." 9 however, several countries impose a source tax on gains realized by a nonresident on the sale of stock in a resident corporation,120 presumably on the basis of the economic nexus principle.121 funds are made available, which may be the place where the funds are advanced or where the contract was executed. see ault and arnold, supra note 5, at 457. 114. see ault & arnold, supra note 5, at 498. 115. see id. at 499. 116. see id. at 500 (discussing the australian facts-and-circumstances approach for business income, which appears to source sales income where the contract is made; discussing the canadian approach under which income is treated as domestic source if it may be allocated in a reasonable manner to a nonresident's canadian branch). 117. see ali project i, supra note 14, at 37, n.46 (noting the problem of conflicting characterizations of transactions by countries); ali project ii, supra note 21, at 235 (discussing the potential for double taxation or under taxation where countries characterize transactions differently); andrus, supra note 42, at 856 (same). 118. see supra notes 60-63 and accompanying text. 119. see supra notes 39-40 and accompanying text. 120. see supra note 42 and accompanying text. 121. see supra notes 49-52 and accompanying text. 584 [vol. 11: 7 sourcing income among nations this difference in treatment can lead to double taxation where a u.s. resident sells stock in a foreign corporation that results in a source tax in the corporation's home country. 2 in situations where countries use different domestic source rules, bilateral income tax treaties may resolve conflicts in source rules. u.s. treaties typically provide that for the purposes of the u.s. foreign tax credit limitation, income that may be taxed by the other country under the treaty will be sourced in that country.12 3 sometimes treaties even provide explicit source rules in separate articles.124 thus, for example, treaties may prevent double taxation in the situation where a u.s. resident is subject to a source tax on the sale of foreign corporate stock.12 5 however, existing treaties fail to comprehensively deal with potential conflicts in domestic source rules. in this regard, treaties often lack specific details with regard to attributing business profits to permanent establishments, 26 and countries may interpret such provisions differently.127 moreover, in limiting source taxation and guaranteeing that countries use foreign tax credit or exemption systems, treaties aim to avoid double taxation, and thus do not prevent the nontaxation of cross-border income that results when countries' varying source rules create under lapping tax jurisdiction.12 8 furthermore, a bilateral treatybased solution to the problem of double taxation or non-taxation stemming from source rule conflicts is an incomplete solution, because treaties between countries may not always exist.129 122. see andrus, supra note 42, at 844. 123. see u.s. model, supra note 22, at art. 23, para. 3; ali project ii, supra note 21 at 233-34. 124. see ali project ii, supra note 21, at 234. 125. see, e.g., convention between the u.s. and spain for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, feb. 22, 1990, art. 13, para. 4, http://www.irs.gov/pub/irs-trty/spain.pdf; andrus, supra note 42, at 844. 126. see u.s. model, supra note 22, at art. 7. 127. see jessica l. katz, charles t. plambeck & diane m. ring, taxation of foreign persons' u.s. income, 908-2nd t.m. (bna), at v.c.3.b(2) (stating that most u.s. treaty partners, along with the oecd, take the position that article 7(2) of the oecd model treaty requires the recognition of interbranch interest expense of a bank, whereas the united states traditionally disagreed with this interpretation of the oecd treaty). 128. cf peroni, supra note 64, at 396 (pointing out that the current u.s. source rules often allow income that is not subject to foreign taxation (for example, by reason of a u.s. income tax treaty) to be treated as foreign source income and thus inflate a taxpayer's foreign tax credit limitation). 129. see andrus, supra note 42, at 844. 2011] 585 florida tax review iii. equity-based standard for devising source rules a. overview, basic assumptions, and preliminary matters to address the problems identified above, this part develops a benefits principles-based standard for devising source rules that has the potential to be adopted on a multilateral basis.130 an internationally harmonized approach to sourcing income that is based on the connection to governmental benefits should result in a fair allocation of taxing jurisdiction among nations; this could replace the current patchwork of rules, which often produce incoherent and arbitrary results."' and a principled standard that is considered fair by a critical mass of countries could lead to internationally harmonized source rules.1 32 in this regard, an important goal is that the allocation of tax jurisdiction via source rules or their equivalent be mutually agreeable, 33 so that source taxation does not result in either double taxation or non-taxation.134 this part proceeds in two steps: first by establishing the case for using the benefits principle along with administrability as the appropriate principles for designing source rules, and second by formulating a standard for devising source rules that is based on the appropriate principles. before doing so, a few assumptions and preliminary matters are in order. first, it is assumed that countries will continue to exercise source taxation, as opposed to abandoning such in favor of exclusive residence 130. cf id. at 856 (concluding that "to address the tax issues created by the changing economy, international consensus must be developed with regard to characterizations issues as well as source rules"). 131. cf mcintyre, tax rules, supra note 50, at 3-65 to 3-66 (pointing out that each country should receive a reasonable share of the global tax base pursuant to a fair negotiating process). 132. see peggy b. musgrave, sovereignty, entitlement, and cooperation in international taxation, 26 brooklyn j. int'l l. 1335, 1345 (2001) (calling for the adoption of a formula via mutual international agreement that "generally is acceptable for reasons of fairness" in order to achieve international cooperation in the sharing of the tax base); cf benshalom, supra note 84, at 79 (stating that effective tax cooperation among nations can be facilitated where "it involves an organizing principle that all parties consider fair"); rifat azam, e-commerce taxation and cyberspace law: the integrative adaptation model, 12 va. j.l. & tech. 5 (viewing an approach for taxing electronic commerce that divides the tax pie fairly as having the potential to gain international acceptance). 133. see mcintyre, tax rules, supra note 50, at 3-65 to 3-66 (stating that a goal of model source rules should be the allocation of taxing jurisdiction in some mutually agreeable manner); cf andrus, supra note 42, at 856 (calling for international consensus on source rules to address sourcing issues created by electronic commerce and other aspects of the changing economy). 134. see mcintyre, tax rules, supra note 50, at 3-65 to 3-66. 586 [vol. 11: 7 sourcing income among nations taxation. second, it is assumed that countries will continue to adhere to the "single tax principle" subjecting cross-border income to one tax and thus attempt to avoid double taxation and non-taxation by employing either foreign tax credit or territorial systems.'35 third, it is assumed that in allocating taxing rights over cross-border business and investment income, countries will continue to use the separate transactions method (source and transfer pricing rules), rather than applying formulary apportionment methods to a taxpayer's aggregate net income. 36 135. see reuven s. avi-yonah, international taxation of electronic commerce, 52 tax l. rev. 507, 517 (1997) [hereinafter avi-yonah, electronic commerce]. the single tax principle has been justified "on both theoretical and practical grounds." reuven s. avi-yonah, tax competition, tax arbitrage and the international tax regime, 61 bull. int'l tax'n 130, 134 (2007). with regard to theory, a heavier tax on cross-border income as compared to domestic income would create an inefficient incentive to invest domestically; a lighter tax on cross-border income would create an inefficient incentive to invest abroad. id. in addition, the non-taxation of cross-border income when compared to the taxation of domestic labor income can violate both horizontal and vertical equity. see id. from a practical perspective, double taxation of cross-border income would tend to stifle international investment, while non-taxation of such income can lead to the avoidance of domestic taxation by investing internationally, thereby eroding the national tax base. id. 136. recently, several notable commentators on international taxation have proposed using formulary apportionment to allocate tax jurisdiction over the income of related multi-national corporations. see, e.g., reuven s. avi-yonah, kimberly a. clausing & michael c. durst, allocating business profits for tax purposes: a proposal to adopt a formulary profit split, 9 fla. tax rev. 497, 498 (2009). while it is conceivable, it is not likely that formulary apportionment will replace the current system in the foreseeable future. see james j. tobin, barbara m. angus, & david j. canale, preserving and protecting the arm's-length standard, int'l tax mon., july 19, 2010 (asserting that the arm's-length standard should continue to be at the center of the international tax system); see also kleinbard, lessons, supra note 84, at 66 (pointing out that without some form of multilateral cooperation, formulary apportionment poses a substantial risk of over or under taxation; concluding that "[i]t is difficult to imagine how a multilateral global formulary apportionment system can come to pass); rosanne altshuler & harry grubert, formula apportionment: is it better than the current system and are there better alternatives?, 63 nat'l tax j. 1145, 1182-83 (2010) (concluding that formula apportionment and separate accounts distort behavior along different margins and that simulations indicate that the former has no clear advantages over the latter); susan c. morse, revisiting global formulary apportionment, 29 va. tax rev. 593 (2010) (questioning the benefits of the unilateral u.s. adoption of a destination sales-based formulary apportionment method for dividing global jurisdiction to tax corporate income). consequently, this article assumes the continued use of source and transfer pricing rules to allocate taxing rights over income among nations. 2011] 587 florida tax review the harmonized source rules developed under the sourcing standard should be the same for countries' taxation of both in-bound transactions by nonresidents and out-bound transactions by residents.' where countries use uniform source rules, but the rules for in-bound and out-bound transactions differ, either double taxation or non-taxation will result.'3 ' for example, assume that all countries adopted a rule that sourced service income based on the location of the recipient of the services for in-bound transactions and on the place of performing services for out-bound transactions. a country a resident performs services in country a for a company that is located in country b. under the in-bound source rule, the country a resident would have country b source income that is subject to tax in county b because the recipient of the services was located there. however, under the out-bound source rule, country a would treat the income as domestic source for purposes of calculating its resident's allowable foreign tax credit (assuming it uses a foreign tax credit system that includes a limitation based on the amount of foreign source income), because the services were performed in country a. consequently, the country a resident may be prohibited from receiving a foreign tax credit against her country a tax liability for the country b tax, thus potentially resulting in double taxation. if the source rules were reversed, it could be that neither country would be taxing the income. finally, the standard should be used to devise source rules that form the basis for countries' exercise of taxing jurisdiction.13 9 thus, income that is 137. see ali project i supra note 14, at 348-49 (stating that "presumptively at least, the 'inbound' and 'outbound' source rules should be the same"); peter a. harris, corporate/shareholder income taxation and allocating taxing rights between countries, 445-446 (1996) (stating that the only reference point in evaluating whether countries appropriately tax international income "is the symmetry of their own tax system"). some commentators disagree with this, but they are approaching the issue of sourcing from the perspective of enhancing the welfare of u.s. individuals. see shay, fleming & peroni, source rules, supra note 1, at 150-51. as mentioned above, the objective of this article is to develop a sourcing standard that can be adopted multilaterally, which thus should refrain from taking into account particular countries' national interests. see infra note 223-225 and accompanying text. 138. see andrus, supra note 42, at 843 (source rules that do not treat u.s. and foreign taxpayers the same will inevitably lead to double taxation or nontaxation). 139. nevertheless, as under current law, certain countries, generally referred to as tax havens, may impose little or no tax on income over which they have jurisdiction to tax. consequently, it is assumed that countries may continue to employ mechanisms designed to prevent their residents from avoiding current taxes on certain income that is allocated to tax haven corporations, such as the antideferral regimes used in the united states (subpart f rules (i.r.c. §§ 951-965)) and the pfic rules (i.r.c. §§ 1291-1298)). in addition, with the proposed sourcing 588 [ vol. 11: 7 sourcing income among nations treated as domestic source with respect to a particular country would be subject to tax in the hands of a nonresident of that country;14 0 unlike current u.s. law,141 operative tax provisions will not prevent the taxation of income that is treated as domestic source. likewise, income that is treated as foreign source would be nontaxable to a nonresident.142 similarly, it is contemplated that since there will be multilateral agreement on source via harmonized domestic rules, treaties would not generally alter the taxing rights of countries, although treaties may still affect to some degree the tax rates that apply to particular types of income.143 b. appropriate principles for sourcing income 1. the benefits principle as discussed earlier,'" the source rules are used to determine the contours of countries' exercise of source taxation, that is, the taxation by a host country over nonresidents. source rules also affect the scope of countries' exercise of residence taxation the taxation by a country of its residents.14 5 this effect, however, is derivative of source taxation. countries that mitigate double taxation through foreign tax credit systems cede primary tax jurisdiction with respect to their residents over income that is viewed as properly subject to source taxation by host countries. countries that use territorial systems that exempt foreign source income cede all tax jurisdiction over such income. because the source rules define the scope of source approach, countries also may want to exercise residual tax jurisdiction over the foreign source portion of income derived by nonresidents from domestic activities. see infra note 287 and accompanying text. 140. cf ali project part i, supra note 14, at 115 (recommending that u.s. source income generally be subject to either u.s. net basis or gross basis taxation, although providing exceptions for certain items, including portfolio interest). 141. see, e.g., i.r.c. §§ 871(h), 881(c) (portfolio interest exemption). 142. under current u.s. law, it is possible for a foreign person to be taxable on foreign source income. see i.r.c. §§ 864(c)(4), 882(a). 143. this may be warranted in order to ameliorate the excessive burdens of gross basis taxes where a taxpayer is likely to incur significant expenses in earning income for example, interest income earned by a nonresident bank. see supra notes 73-75 and accompanying text. of course, this could also be done through harmonized domestic legislation, but there may be reasons why countries may find the treaty process more appropriate for such provisions. see ali project ii, supra note 21, at 12-13 (stating that a source country may not want to forgo taxing income that is received by a resident of a tax haven country). with regard to the permanent establishment requirement for subjecting business income to source taxation, it may be advisable to retain the requirement, albeit in modified form. see infra note 342. 144. see supra notes 3-6 and accompanying text. 145. see supra notes 3-6 and accompanying text. 2011] 589 florida tax review taxation, the principles that form the basis for source taxation should be used in formulating source rules. it is widely accepted that source taxation is grounded on the benefits principle: a host country should have the right to tax a nonresident on income that benefits from host country government services, with the tax serving as a charge, of sorts, for these benefits.'" a nonresident with investments or business activities in the host country benefits from numerous government activities, including those that give rise to infrastructure (physical, economic, 146. see ali project i, supra note 14, at 18; lokken, intellectual property, supra note 57 at 239; shay, fleming & peroni, source rules, supra note 1, at 90; peggy b. musgrave, interjurisdictional equrry in company taxation: principles and applications to the european union, in taxing capital income in the european union 46, 52-53 (sjibren cnossen ed., 2000), reprinted in michael j. graetz, foundations of international income taxation 6 (2003); avi-yonah, electronic commerce, supra note 135, at 521; graetz & grinberg, supra note 76, at 569; michael s. kirsch, the role ofphysical presence in the taxation of cross-border personal services, 51 b.c. l. rev. 993, 1040 (2010) [hereinafter kirsch, services]; mason, supra note 84, at 1553-54; carlo garbarino, a study of the international tax policy process: defining the rules for sourcing income from isolated sales of goods, 29 harv. int'l l.j. 393, 394 (1988); william b. barker, an international tax system for emerging economies, tax sparing, and development: it is all about source!, 29 u. pa. j. int'l l. 349, 369-70 (2007); benshalom, supra note 84, at 75; steven a. dean, more cooperation, less uniformity: tax deharmonization and the future of the international tax regime, 84 tul. l. rev. 125, 161 & n.163 (2009) (referring to the benefits principle, used to assign tax jurisdiction, as being in some respects "the cornerstone of the modern income tax regime"); kim brooks, inter-nation equity: the development of an important but underappreciated international tax policy objective, in tax reform in the 21st century 471, 492 (john g. head & richard krever, eds., 2009); lokken, source, supra note 49 at 3; jeffrey m. col6n, financial products and source basis taxation: us. international tax policy at the crossroads, 1999 u. ill. l. rev. 775, 781; edward a. zelinsky, citizenship and worldwide taxation: citizenship as an administrable proxy for domicile, 96 iowa l. rev. 1289, 129394 (2011) (viewing source taxation as justified by the benefits principle on a theoretical level); cf oecd, e-commerce supra note 107, at 12, (referring to the benefits principle as a justification for source taxation; stating that source taxation may also serve to prevent nonresidents from capturing all of the economic rent derived from exploiting the host country's resources); mitchell a. kane, risk and redistribution in open and closed economies, 92 va. l. rev. 867, 904-05 (2006) (stating that source taxation is typically grounded either upon the benefits principle or a theory of economic rents). for a recent discussion of the benefits principle for taxation in general, see james r. repetti, democracy and opportunity: a new paradigm in tax equity, 61 vand. l. rev. 1129, 1135-38 (2008). 590 [vol. 11: 7 sourcing income among nations and legal), public safety, national security, and a skilled workforce.14 7 consequently, a key principle in determining whether an item of income should be sourced to a particular country is whether that country provides the taxpayer with governmental benefits that relate to the income.14 8 closely aligned with the benefits principle basis for sourcing is the view that income should be sourced according to the location of the economic activities that give rise to the income.'49 the economic nexus basis for sourcing is best understood as a surrogate for the benefits principle that is, the location of economic activities is where the taxpayer receives government benefits that justify a source tax. 50 indeed, authorities referring to the economic nexus basis for sourcing income usually also refer to the place of legal protections as a basis for sourcing,'5 thus suggesting that it is the connection to government benefits that underlies the focus on economic activities. importantly, economic nexus is an incomplete surrogate for the benefits principle in that by focusing on the location of economic activities conducted by taxpayer, it ignores government benefits provided by the taxpayer's country of residence that relate to the earning and enjoyment of income by the taxpayer. 5 2 147. see shay, fleming & peroni, source rules, supra note 1, at 90; mason, supra note 84, at 1553-54. for a more detailed discussion of these public benefits, see infra part iii.c. 1. 148. see col6n, supra note 146, at 781 ("a designation of an item of income as u.s. (or foreign) source indicates that the united states (or a foreign country) is the country that has provided the primary benefits resulting in the earning of such income and therefore has primary tax jurisdiction."); lokken, source, supra note 49 at 3-4 (proposing a conceptual framework for source determinations that "apportions a taxpayer's ability to pay among jurisdictions in a way that reflects the governmental services and protections available to the taxpayer in profit-seeking activities"); cf oecd, e-commerce, supra note 107, at 14 n.20 (noting that the benefits principle, which provides a justification for source taxation, "can also be put forward as a principle for determining the source of the business profits"). 149. see supra notes 50-52 and accompanying text. 150. see dean, supra note 146, at 162 & n. 164 (indicating that the benefits principle underlies the recognized right of a country to tax income derived from economic activity occurring within its borders). 151. see treasury ii, supra note 50, at 399. 152. cf dean, supra note 146, at 161 n.162 (stating that the benefits principle also describes the relationship between a country and its residents and citing peggie brewer richman, taxation of foreign investment income: an economic analysis 23 (1963) for the proposition that a country has the right to tax the income and wealth of its residents based on the protection and services provided by the country). these residence country benefits are more fully described below. see infra notes 249-52 and accompanying text. it should be noted that professor lokken, in proposing a conceptual framework for source determinations that relies on the benefits principle, would not take into account consumer benefits received by 5912011] florida tax review source taxation may also be justified by the right of a host country to exact a charge for economic rents, or super-normal returns, realized by nonresidents through the use of a country's resources.153 this basis for source taxation, however, should properly be viewed as merely a supplement to the benefits principle basis, as it would only permit a host country to tax super-normal returns. in both theory and practice, it is widely acknowledged that source taxation extends to all income that bears a sufficient economic connection to the host country, not just super-normal returns.15 4 at its core, the benefits principle underlying source taxation is an equitable principle. nonresidents who earn income that profits from a country's government activities should be subject to source taxation on such income; otherwise, the burden for these government activities that benefit individuals that do not directly relate to the production of income. see lokken, source, supra note 49 at 3. 153. see oecd, e-commerce, supra note 107, at 12; robert a. green, the future of sourced-based taxation of the income of multinational enterprises, 79 cornell l. rev. 18, 30 (1993); charles e. mclure, jr., substituting consumptionbased direct taxation for income taxes as the international norm, 45 nat'l tax j. 145, 148 (1992); kane, supra note 140, at 904-05. 154. see green, supra note 153, at 30 (stating that this argument does not justify source-based corporate income taxes); but see mclure, supra note 153, at 149 (considering the adoption of consumption-based direct taxation as the international norm, the effect of which would be source taxation of only economic rents for the most part). the power of governments to impose source taxes, or force majeure, is another explanation given for source taxation. see green, supra note, 153 at 31-32. even if force majeure were an explanation, it would apparently not provide a principle for designing source rules suitable for worldwide adoption. one commentator has offered a pragmatic justification for source taxation that the source country is generally in the best position to enforce a tax on cross-border income. see id. arguably, this possible justification for source taxation could provide a basis for designing sources rules, under which income could be sourced to the country that is able to monitor transnational income by requiring local firms and financial intermediaries to report and withhold on payments they make to nonresidents. however, basing source taxation and implementing source rules on a country's enforcement capabilities appears to go too far, in that tax collection can be protected even without source taxation of cross-border income by requiring the country in the better position to monitor cross-border income to report such income to the recipient's country of residence or to withhold tax subject to refunds upon demonstration that a residence country tax has been paid. cf gary clyde hufbauer, u.s. taxation of international income: blueprint for reform 68-71 (1992) (recommending similar measures for a system that imposes residenceonly taxation of portfolio income). consequently, countries' enforcement capabilities should not provide the primary basis for designing multilateral source rules, although enforcement concerns should be a factor is formulating particular source rules. see infra part iii.c.3.b for a discussion of this latter point. [vol. 11:7592 sourcing income among nations nonresidents would be borne by residents of that country alone. 1ss thus, an equitable sharing of the cost of government activities between nonresidents and residents is at the root of source taxation. the equity basis underlying source taxation can be described as a form of inter-individual equity, because it requires the fair treatment of taxpayers residents and nonresidents who receive governmental benefits from a particular country. 56 it can also be described as inter-nation equity, a term that usually refers to the equitable sharing among nations of the taxation of cross-border business and investment income.' 57 in any event, the normative basis for inter-nation equity, if any, would appear to rest on the theoretical foundation for inter-individual equity, since it is individuals that ultimately pay taxes. 58 155. see shay, fleming & peroni, source rules, supra note 1, at 96-97 ("domestic fairness requires that the costs of the u.s. government be borne both by (1) residents on the basis of ability to pay, and (2) nonresidents on the basis of an appropriate charge for the privilege of exploiting the u.s. market. to the extent that abandonment of source taxation relieves nonresidents of their charge, the tax burden belonging to nonresidents inevitably will shift to u.s. residents. a failure of nonresidents to contribute to the costs of government, would therefore, diminish, not enhance, domestic tax fairness."); see nancy h. kaufman, fairness and the taxation of international income, 29 law & pol'y int'l bus. 145, 153 (1998) (referring to the conclusion of other commentators that under the benefit theory for source taxation "individuals who benefit equally from government, including nonresidents, should contribute to the host country's cost of government"). 156. see kaufman, supra note 155 at 153 (stating that most scholarship on residence and source taxation internationalizes inter-individual equity). 157. see id at 153-54 (citing to writings by peggy musgrave and richard musgrave describing inter-nation equity in various ways: "an 'equitable international distribution of the tax base,' "'an equitable division of the tax revenue between countries,"' "an equitable 'allocation of national gain and loss,"' "'[t]he problem of tax shares in international business,"' and "an equitable division of the 'tax pie . .. among the treasuries of the various countries"'). 158. in examining whether tax competition among nations should be reconsidered in order to promote inter-nation equity, professor ring evaluated the normative basis for inter-nation equity in terms of inter-individual equity ("because it is the individuals for whom we are ultimately concerned") and concluded that "to fit inter-nation equity into the current framework of inter-individual equity (premised on a legitimate nation-state and community) we can only endorse the 'inter-nation version' of inter-individual equity if in fact all of these individuals are members of a single community under one government a global state." diane ring, democracy, sovereignty and tax competition: the role of tax sovereignty in shaping tax cooperation, 9 fla. tax rev. 555, 587 (2009). professor ring does leave open the possibility in the future for a normative basis for inter-nation equity standing alone, based on an accepted theory of duty and obligations owed to others globally. see id. at 585, 587, 590. 2011] 593 florida tax review the equity basis for source taxation may be complicated by the fact that some residents of a given country will be investing or doing business in other countries. thus, it may be contended that one country's failure to tax a nonresident for the receipt of governmental benefits can be "offset" by the failure of the nonresident's country to tax the other country's residents when they receive host country governmental benefits. one response is that taxpayers with purely domestic business and investment activities would not benefit from another country's lack of source taxation: such taxpayers would bear the cost of home country governmental benefits received by nonresidents but would not take advantage of tax-free governmental benefits provided by other countries. nonetheless, a further contention may be that resident taxpayers with purely domestic activities would not suffer from their home country's lack of source taxation over nonresidents because other home country residents with foreign income that is free of source taxation would then bear a greater residence country tax burden. this is because without the imposition of source taxation, there would be no occasion nor need for a home country to provide its residents with foreign tax credits or foreign income exclusions, respectively. 159 thus, a home country would be taxing its residents with foreign income effectively as surrogates for the nonresidents receiving governmental benefits from the particular country. however, this argument assumes equal capital flows between countries, which would never be the case. if a given country's amount of nonresident investment or business activity exceeds the amount of foreign investment or business activity conducted by its residents, i.e., is a net capital importer, then its residents with purely domestic activities would not experience a sufficient tax offset for its country's failure to exercise source taxation over nonresidents. notions of perceived equity bolster the equity basis for source taxation. recently, some leading commentators on international taxation have put forth what they term as a new principle for structuring source taxation the parity principle.160 in applying this principle to u.s. source taxation, they assert that the u.s. income tax should treat businesses owned by foreign taxpayers no more favorably than comparably situated u.s.owned businesses. 161 the basis for the parity principle is that residence taxation will lose legitimacy and efficacy if residents perceive that they are being more heavily taxed than nonresidents with equal amounts of income 159. see green, supra note 153, at 80 (pointing out that with international agreement on a residence-based tax system, the united states would collect more tax revenue from its residents with foreign source income because it would no longer yield to other countries the primary right to tax such income). 160. see shay, fleming & peroni, source rules, supra note 1, at 110-11. 161. id. at 111. 594 [vol. 11:7 sourcing income among nations from the residence country;162 thus, this principle rests on perceptional equity concerns (along with real equity concerns).'63 in applying the parity principle in examining a few source rules, the commentators refer to the access to the u.s. market, which they see as a product of government activities, as well as u.s. legal protections,'6 indicating that the benefits principle is at the core of their parity principle. consequently, their work suggests that both real and perceptional equity concerns support the benefits-principle basis for source taxation. 2. effect of the ability to pay principle in contrast to source taxation, residence taxation rests on a different equity basis than source taxation, this being the notion of a taxpayer's ability to pay.165 under residence taxation, the tax burden is allocated among taxpayers in a manner that reflects their relative abilities to pay.16 6 because a taxpayer's worldwide income is usually considered the proper gauge for measuring a taxpayer's ability to pay, and because the ability to pay principle suggests that tax rates should be progressive, residence taxation is generally implemented by imposing a progressive tax on a taxpayer's worldwide income.16 7 although it may seem as though source taxation and residence taxation are quite distinct, this is not the case. first, source taxation, while founded on the benefits principle, can be viewed as having ability-to-pay attributes.' 68 the source tax, similar to the residence tax, is determined by applying tax rates to a nonresident's domestic source income. thus, no effort is made to approximate the value of the benefits received by the nonresident from the host country's government activities that relate to the nonresident's income, no doubt because it would be impossible to do so with any degree of 162. see id. 163. other scholars have pointed out the importance of perceptional equity. see, e.g., nodl b. cunningham & deborah h. schenk, the case for a capital gains preference, 48 tax l. rev. 319, 368-69 (1993). 164. see shay, fleming & peroni, source rules, supra note 1, at 91-92, 142-43. 165. see j. clifton fleming, jr., robert j. peroni & stephen e. shay, fairness in international taxation: the ability-to-pay case for taxing worldwide income, 5 fla. tax rev. 299, 306-08 (2001) [hereinafter fleming, peroni & shay, fairness]. besides equity, other considerations that are important in residence taxation include economic efficiency and administrability. see id. at 306-08 & n. 14. 166. see green, supra note 153, at 29. 167. see id. 168. see lokken, intellectual property, supra note 57, at 239-40. 2011] 595 florida tax review accuracy.169 instead, the amount of tax that is imposed on a nonresident's domestic source income appears to reflect the host country's determination of a fair allocation of the tax burden based on the relative abilities to pay of all taxpayers, with nonresidents judged only on the basis of their domestic source income.' 70 this view is buttressed by the fact that the rates that apply to a nonresident's domestic source business income are often progressive in nature.17' thus, while the benefits principle forms the basis for, and defines the scope of, source taxation, the ability to pay principle appears to provide some role, at least in practice, in determining the amount of tax that is imposed on a nonresident's domestic source income.17 2 in addition, and of significance in determining principles for sourcing income, source taxation and residence taxation are related in that source taxation frustrates to an extent the ability to pay principle underlying residence taxation. it is standard practice, as well as an assumption of this article,17 3 that with source taxation, countries will relieve international double taxation either by allowing their residents a foreign tax credit or exempting certain foreign income from residence taxation. where a foreign tax credit is allowed, the residence tax is reduced by the amount of the credit, whereas from the strict standpoint of measuring ability to pay, there should only be a deduction for foreign taxes, as is the case with other expenses of earning income.17 4 and where a residence country employs an exemption system to relieve double taxation, the residence country ignores completely the exempt foreign income in measuring the resident's ability to pay. consequently, source taxation effectively diminishes the ability of a 169. see mason, supra note 84, at 1585 (stating that it would be impossible to determine precisely the amount of government benefits received by taxpayers); barker, supra note 146, at 370 (stating that there is no way to measure directly the benefit received; instead one should develop a tax base that reflects the benefit received). 170. see lokken, intellectual property, supra note 57, at 239-40. 171. see, e.g., i.r.c. §§ 871(b), 882(a). 172. see lokken, intellectual property, supra note 57, at 239-40. whether this is correct as a normative matter is another issue. some commentators are of the view that ability-to-pay considerations should not be used in connection with source taxation. their reason is that ability to pay should be measured by reference to a taxpayer's total income and not just that income over which a country exercises taxing jurisdiction. see shay, fleming & peroni, source rules, supra note 1, at 9495. nevertheless, these commentators endorse the determination of a nonresident's source tax liability by imposing graduated tax rates on a nonresident's domestic source, because it is a reasonable and practical measure of the host country government benefits received and it treats nonresidents in a nondiscriminatory manner versus residents. see id. at 95, 104. 173. see supra note 135 and accompanying text. 174. see fleming, peroni & shay, fairness, supra note 165, at 328; ault & bradford, supra note 1, at 41. 596 [vol. 11:7 sourcing income among nations residence country to equitably allocate the costs of government activities among its residents on their respective abilities to pay.17 5 based on this reason, some commentators call for an end to source taxation in favor of exclusive residence taxation.176 other commentators advocate for a modified source taxation approach under which passive income would be subject to exclusive residence taxation, but active income would continue to be subject to source taxation.17 7 those supporting the modified source taxation approach justify the passive/active income distinction by pointing to the fact that international passive income is often earned by individuals, for whom ability to pay taxation is geared, whereas international active income tends to be earned by corporations, for which the ability to pay principle is less relevant.'7 8 because these proposals call for a reduction (or even elimination) of source taxation, they would obviously greatly affect the formulation of source rules. the appropriateness of eliminating or reducing source taxation should be decided on the basis of the equitable principles involved. source taxation promotes an equitable sharing of the costs of government among residents and nonresidents. residence taxation advances the equitable allocation of the costs of government among residents based on their relative abilities to pay. because source taxation frustrates residence taxation to an extent, the issue is which approach strikes the appropriate balance between these two competing types of equity. exclusive residence taxation simply goes too far in favor of abilityto-pay equity, by ignoring completely the benefits provided to nonresidents by the host country. 7 9 in addition, because exclusive residence taxation would result in more tax revenue for developed countries and less for 175. see shay, fleming & peroni, source rules, supra note 1, at 97. some commentators appear to take the position that source taxation is objectionable under the ability-to-pay criterion not necessarily because it interferes with residence taxation, but because source taxation is itself a poor way to measure ability to pay as it only taxes a portion of a taxpayer's worldwide income and sometimes uses gross basis withholding taxes. see graetz and grinberg, supra note 76, at 570; green, supra note 153, at 29. 176. see green, supra note 153, at 29, 32. 177. see reuven s. avi-yonah, the structure ofinternational taxation: a proposal for simplification, 74 tex. l. rev. 1301 (1996) [hereinafter avi-yonah, simphiication]. 178. see id. at 1310-17. 179. see michael j. graetz, foundations of international income taxation 67-68 (2003) [hereinafter graetz, foundations]; cf avi-yonah, simplification, supra note 177 at 1311 (stating that the ability-to-pay argument for exclusive residence taxation does not explain why the home country should have the only claim to tax cross-border income and that based on economic allegiance, both countries should have taxing rights). 2011] 597 florida tax review developing countries, the latter would likely refuse to cooperate in such a system.so in any event, this article assumes that countries will continue to exercise source taxation. 81 while an approach that eliminates source taxation of passive income at least strikes a balance between the equitable principles involved, is it an appropriate one? equitable determinations are fraught with value judgments,182 and the same is true in deciding between competing notions of equity. there appears to be no correct answer here. the remainder of the article assumes that countries will generally agree that the equitable notions underlying the benefits principle are more important than those supporting ability-to-pay taxation where these equitable notions conflict, and that the benefits principle should generally dictate the scope of source taxation for both passive and active income. however, under the proposed sourcing standard (which is discussed in the next section' 83 ), it would be possible to take ability-to-pay equity into account to some extent in determining the source of income; 8 4 this can be done by increasing the portion of income that is sourced to the country of residence due to ability-to-pay equity considerations.18 5 3. administrability another principle that should guide the development of a sourcing standard is administrability.' 8 6 it is important for source rules to operate in a clear fashion and refrain from requiring difficult factual determinations on a case-by-case basis.' 87 both taxpayers and tax administrators need clarity and 180. see avi-yonah, simplification, supra note 177 at 1313-14. 181. see supra text accompanying note 135. 182. indeed, some would assert that for purposes of the ability-to-pay criterion, a resident of a country who has income from foreign sources is not similarly situated to a resident with income only from domestic sources. see ault & bradford, supra note 1, at 41 (referring to these assertions). 183. see infra part iii.c. 184. cf julie roin, competition and evasion: another perspective on international tax competition, 89 geo. l.j. 543, 588-89 (2001) (in arguing for a system where the united states exempts foreign income from taxation, contending that the united states may be justified in imposing some tax on such income because of the government benefits provided by the united states to u.s. corporations with respect to such income, along with the notion that "u.s. corporations may be expected to contribute to the redistributional social benefits decided upon by the nation's electorate"). 185. see infra note 312 and accompanying text. 186. see ali project i, supra note 14, at 19; treasury ii, supra note 50, at 399; mcintyre, tax rules, supra note 50, at 3-66 to 3-67. 187. treasury ii, supra note 50, at 399; see mcintyre, tax rules, supra note 50, at 3-66; andrus, supra note 42, at 842. 598 [vol. 11:7 sourcing income among nations minimal uncertainty in performing their respective compliance and enforcement tasks. this is particularly so where the source of income determines whether a payer of an item is required to withhold in order to collect tax on an in-bound transaction.1 to this end, the sourcing standard, and the rules devised thereunder, should avoid overly refined approaches aimed at absolute precision. in particular, while the sourcing standard (discussed in the next section) will call for the division of an item of income among different sources where appropriate,' 89 this will generally be done using a bright line approach in order to provide clear and predictable source rules.' 90 such an approach is further supported by the equity basis that underlies the benefits principle, which, as noted above, is somewhat imprecise given the value judgments involved.191 an aspect of administrability is that a source tax must be enforceable. 19 2 it would make little sense in designating income as domestic source for purposes of a country's exercise of source taxation over nonresidents if the tax cannot be enforced because the nonresidents are not physically present in the host country and collection of the tax through withholding would not be feasible. accordingly, enforcement should be an important consideration under the standard for devising source rules.'93 4. inappropriate principles in developing the sourcing standard the preceding subsections have determined that connection to government benefits and administrability are principles that should guide the development of a standard for sourcing income. this subsection demonstrates why other principles should not be used in developing the sourcing standard, because they either do not appropriately relate to sourcing income or are not suitable for crafting source rules intended for multilateral adoption.' 94 188. see mcintyre, tax rules, supra note 50, at 3-66; cf ali project i, supra note 14, at 36 (referring to withholding complications as a reason for not dividing the source of rental income where a taxpayer had produced the leased property). 189. see infra notes 267-70 and accompanying text. 190. cf andrus, supra note 42, at 842 (noting the administrative benefits of source rules that rely on line drawing). 191. see supra notes 155-56, 182 and accompanying text. 192. see shay, fleming & peroni, source rules, supra note 1, at 115. 193. see walker, supra note 47, at 6, 30. 194. in this regard, the principles underlying treaty provisions that reduce or eliminate source taxation on investment income can be viewed as either consistent with, or supplemental to, an approach for sourcing income that focuses on the countries that provide the taxpayer with public benefits relating to the income. to 2011] 599 florida tax review a. capital export neutrality and capital import neutrality capital export neutrality (cen) and capital import neutrality (cin) should be examined for their potential for providing principles for sourcing. while these are the key neutrality policies generally thought to govern the structure of cross-border taxation,' they apparently have little to offer in developing the sourcing standard. 19 6 cen is satisfied when a resident pays the same total of resident country and foreign taxes regardless of whether the income is earned within or without the country of residence.19 7 in this situation, a resident's decision to invest in the residence country or abroad is unaffected by the tax consequences in the residence and foreign countries.'98 instead, the decision is dictated by pre-tax returns. 99 because the location of investments is not affected by the income taxes, economists generally view cen as essential for worldwide economic efficiency.2 00 whether cen is achieved does not depend on the method used for dividing tax jurisdiction among countries. for example, cen would be satisfied if all countries used residence taxation exclusively. 201 alternatively, cen would exist with source taxation, provided that residence countries taxed domestic and foreign income the same and allowed for an unlimited and refundable foreign tax credit.202 (it should be noted that apparently no the extent that these treaty provisions reflect the view that the source country's claim to tax investment income is relatively weak (see supra notes 76-78 and accompanying text), they are conceptually consistent with the benefits principle; nevertheless, an evaluation of the related public benefits under the standard proposed in this article may lead to different allocations of tax jurisdiction than that currently provided in treaties. to the extent that the treaty limitations on taxing investment income aim to prevent excessive source taxation, this principle can co-exist with harmonized source rules founded primarily on the benefits principle, by allowing for treaties to continue reducing the source tax rate on certain income where appropriate to achieve this objective. see supra notes 74-75 and accompanying text. 195. see graetz, inadequate principles, supra note 97, at 270-71. 196. see oecd, e-commerce, supra note 107, at 13 (concluding that the policies of cen or cin do not depend in practice on whether a country should have source taxation rights over particular income); shay, fleming & peroni, source rules, supra note 1, at 108-10 (stating that cen and cin apply without regard to the division of tax revenue between source and residence countries; concluding that the efficiency criterion offer little help in the design of source taxation). 197. see charles h. gustafson, robert j. peroni & richard crawford pugh, taxation of international transactions 20 (2011). 198. see id. 199. see id. 200. see graetz, inadequate principles, supra note 97, at 270. 201. see shay, fleming & peroni, source rules, supra note 1, at 108. 202. see id. 600 [vol. 11:7 sourcing income among nations country allows for an unlimited foreign tax credie 03 ). on the other hand, cen is not satisfied where a residence country uses a territorial system that exempts foreign income (assuming that foreign tax rate differs from the rate applied by the residence country on domestic source income), and this would be true regardless of how income is sourced for these purposes. thus, with source taxation, whether or not cen is satisfied depends primarily on methods used by resident countries for mitigating double taxation.2 04 nevertheless, cen does support measures to reduce opportunities for crosscrediting, so that taxpayers will not have a tax incentive to invest in activities generating low-taxed foreign income as opposed to domestic income.205 and, as discussed above,206 a way of combating cross-crediting is to treat income as domestic source where a foreign country is not expected to tax the income. however, as pointed out below, 2 07 this expected-to-tax principle is not relevant in designing source rules intended for multilateral adoption by countries.208 cin exists when the total tax that is paid on income earned in a country is determined without regard to the residence of the taxpayer.2 09 thus, cin requires that all firms operating in a particular country be taxed at the same rate, whether the firms are domestically or foreign owned.21 o where cin holds, the worldwide allocation of savings is efficient because all savers receive the same after-tax returns.2 1' upon initial examination, it would seem that similar to cen, cin is concerned only with the overall structure of international taxation. thus, it is often stated that cin would exist where countries employed territorial tax regimes that exempted foreign source income.212 under such a structure, only the source country would be taxing income from activities or investments within a given country, thus resulting in the same level of taxation for all taxpayers with income from that country. on closer inspection, however, cin does have something to say about the design of source rules. for cin to exist, source countries and residence countries must apply the same source rules in determining the 203. see id; graetz, foundations, supra note 179, at 27. 204. see shay, fleming & peroni, source rules, supra note 1, at 109. 205. see graetz, inadequate principles, supra note 97, at 271. 206. see supra notes 60-63 and accompanying text. 207. see infra part iii.b.4.b. 208. moreover, cross-crediting can also be addressed by having separate foreign tax credit limitations for different categories of foreign source income, as contained in section 904(d). see gustafson, peroni & pugh, supra note 197, at 41323. 209. see id. at 21. 210. see id. 211. see graetz, inadequate principles, supra note 97, at 271. 212. see id. 2011] 601 florida tax review income to tax and exempt, respectively. moreover, even with the uniform source rules, cin would be violated if residence-based source rules were used. for example, assume that all countries sourced income from electronic commerce according to the residence of the taxpayer rather than the location of the sales activity or the destination of the items sold. under this rule, sales by e--commerce sellers would be treated as domestic source for purposes of residence country taxation and exempt income for purposes of source taxation. further assume that country a imposes a 40 percent tax, country b imposes a 30 percent tax, and country c imposes a 20 percent tax. in these circumstances, a resident of country c who is selling goods electronically into country c would be taxed at 20 percent (the country c rate), whereas a country b resident performing the same activity would be taxed at 30 percent (the country b rate). assume that for both sellers all activities related to these electronic sales (such as maintaining a web site) occur in country a. thus, cin is violated because the two sellers are not subject to the same tax on income that is earned through performing electronic sales activities in country a and accessing the country c market.2 13 consequently, cin dictates that residence-based methods not be used to source income. however, as to whether the income should be sourced according to the location of the seller's activities or the location of the market (or a combination of both), cin provides no guidance: as long as all countries apply the same source rule, taxpayers resident in different countries will be subject to the same rate of taxation with respect to operations in the same country or countries. while cin does provide some guidance for designing source rules, cin is not the generally accepted neutrality standard2 14 and consequently does not seem to be an appropriate guide for crafting source rules intended for multilateral adoption by countries.21 economists generally favor cen over cin because distortions in the investment locations are considered to be more costly than distortions in the savings allocation216 (and it is practically 213. see infra note 244-48 and accompanying text for a discussion of sourcing income based on accessing a country's market. 214. see jane g. gravelle, cong. research serv., reform of us. international taxation: alternatives 7 (2010) (concluding that "capital import 'neutrality' is not neutral at all"). 215. moreover, commentators have asserted that cin has little or no relevance to the taxation of portfolio income, because taxing such income has no effect on the abilities of companies from different nations to compete against one another in a particular country. see graetz & grinberg, supra note 76, at 558-59. 216. see graetz, inadequate principles, supra note 97, at 272. moreover, as a practical matter, cin is often rejected as an objective compared to cen and national neutrality, given that many national policies of individual countries affect the return to savings. see james r. hines, jr., reconsidering the taxation offoreign income, 62 tax l. rev. 269, 273-74 (2009). nevertheless, economists may still 602 [vol. 11:7 sourcing income among nations impossible to achieve cen and cin simultaneously).217 consequently, it is unlikely that countries would generally agree to adhere to cin, which would be necessary for them to want to use it as a principle for designing source rules. for these reasons, cin should not inform the development of the sourcing standard.2 18 advocate territorial taxation based on a "second best" efficiency argument, as well as asserted simplicity and revenue raising benefits. see gravelle, supra note 214, at 1314 (referring to proposals advancing these arguments, but not subscribing to such views). 217. to do so would require uniform income tax bases and tax rates for all countries, or a worldwide government. see graetz, inadequate principles, supra note 97, at 272. 218. capital ownership neutrality (con), a relatively recent neutrality policy, should also be considered for providing principles for developing the sourcing standard. con requires that international tax rules not distort the identities of the owners of capital. see gustafson, peroni & pugh, supra note 197, at 22 (citing to mihir a. desai & james r. hines, jr., evaluating international tax reform, 56 nat'l tax j. 487 (2003)). according to its proponents, con can be achieved if all countries adopted territorial tax systems. see kleinbard, lessons, supra note 84, at 8 & n.4; gustafson, peroni & pugh, supra note 197, at 22. alternatively, con can be met if all countries adopted worldwide tax systems with foreign tax mechanisms. see kleinbard, lessons, supra note 84, at 8 n.4; gustafson, peroni & pugh, supra note 197, at 22. in short, con calls for conformity among countries in the method of double tax relief. see gustafson, peroni & pugh, supra note 197, at 22; cf. mitchell a. kane, ownership neutrality, ownership distortion, and international tax welfare benchmarks, 26 va. tax rev. 53, 73-78 (2006) [hereinafter kane, ownership] (characterizing the prescription of con in this fashion but not agreeing that non-mixed systems for providing double tax relief necessarily result in ownership efficiency). con would appear to offer no principles for the design of multilateral source rules for use in either worldwide or territorial tax systems. this is because with worldwide tax systems coupled with foreign tax credit mechanisms, con should be satisfied regardless of particular source rules. with territorial tax systems, con should be satisfied as long as countries use uniform source rules. and, unlike the case for achieving cin, it should not matter that such source rules employ residence-based sourcing approaches, as the key in achieving con is the global consensus in the form of double tax relief moreover, even if con did provide principles for developing multilateral source rules, like cin, con does not appear to be the generally accepted neutrality standard. see gravelle, supra note 214, at 10 ("in light of the many ways in which the efficiency costs of capital ownership non-neutrality are unlikely to be significant compared to location distortions, it seems questionable to use meeting this standard of neutrality to evaluate tax reform changes."); kane, ownership, supra, at 56 (arguing that con is not an appropriate benchmark for determining international tax policy given the many factors that distort ownership patterns). 2011] 603 florida tax review b. expectation that another country will be taxing the income as mentioned previously, another principle that is sometimes used to source income is whether it is expected that other countries will be taxing the income.219 the concern underlying this principle is international under taxation. that is, if income is included in calculating a residence country's foreign tax credit limitation, but the income is not taxed by another country, the taxpayer would be able to cross-credit excess foreign tax credits on other foreign income against the pre-credit residence country tax on the income, thus effectively resulting in no or reduced overall tax on the income.220 similarly, if the residence country uses a territorial system, exempting income that is not taxed by another country would mean that no country is taxing the income. the expected-to-tax principle is simply not relevant to the design of source rules in light of the following objectives of this article that the sourcing standard should produce source rules that are the same for countries' taxation of both in-bound transactions by nonresidents and outbound transactions by residents, and that the source rules form the basis for countries' exercise of taxing jurisdiction. with the same source rules being applied by countries for taxing inbound and outbound transactions, the concern that underlies the expected-to-tax principle should not be present: income that is treated as foreign source for purposes of a taxpayer's home country foreign tax credit will be treated as domestic source and thereby be taxable by the host country. 2 2 1 consequently, the expected-to-tax principle should be discarded in the design of multilateral source rules.22 2 c. national interests finally, the national interests of particular countries should not be considered as relevant factors in developing the sourcing standard. in this 219. see supra notes 60-65 and accompanying text. 220. see supra note 62 and accompanying text. 221. of course, even with the general adoption of the sourcing scheme proposed by this article, there will always be outlier countries. however, assuming that they are in the distinct minority, then in the vast majority of cases the concern underlying the expected-to-tax principle would not be present (because the vast majority of countries will be using consistent rules), and thus this principle need not be used in formulating source rules. if the proposed sourcing approach is not generally adopted, then it should not be used because of the high degree of double taxation and non-taxation that is likely to result. see infra notes 333-35 and accompanying text. 222. see supra note 88 for problems under current law with source rules based on this principle. 604 [vol. 11:7 sourcing income among nations regard, some prominent commentators assert that u.s. national interests should dictate the structure of u.s. international income tax rules.223 fostering national interests may be a proper consideration in contexts where it is not critical whether countries use harmonized approaches for taxing international income. for example, it would appear that no great harm results where some countries tax their residents on the basis of worldwide income subject to the allowance of foreign tax credits, while other countries employ exemptions systems under which certain foreign income is excluded from home country taxation. consequently, in deciding among these overall structures for taxing international income, it would appear that countries may appropriately take into account national concerns such as the economic wellbeing of their own residents. however, where source rules vary among countries, there is the potential for double or under taxation. for this reason, this article seeks to develop rules that are suitable for international acceptance,224 and universal agreement will likely not be reached on source rules that are designed to serve the national interests of one or more 225nations. accordingly, source rules suitable for multilateral adoption should avoid features aimed at promoting national interests, such as the title passage rule for inventory sales226 and the portfolio interest exemption.227 it may be 223. see graetz, inadequate principles, supra note 97, at 277-82 (framing the inquiry as what international income tax rules will enhance the economic wellbeing of u.s. citizens and residents); graetz & grinberg, supra note 76, at 538 (asking what income tax policy for taxing foreign portfolio investments serves the united states' interest); shay, fleming & peroni, source rules, supra note 1, at 9798 (in evaluating the structure of u.s. source taxation, asserting that "the primary obligation of u.s. tax policy is to improve the well-being .. . of u.s. individuals"). 224. see musgrave, supra note 132, at 1344 (calling for cooperative rules among nations for the division of the tax base and tax rates); oecd, e-commerce, supra note 107, at 25 (stressing the need for universal agreement of rules for allocating taxing rights over business profits in order to prevent double taxation or non-taxation). 225. cf musgrave, supra note 132, at 1348 (noting that the national interests of countries may conflict with each other). 226. see supra note 32 and accompanying text. in this regard, commentators assert that the foreign tax credit and the source rules used for purposes of limiting the credit should be focused on mitigating the double taxation of foreign income and "should not be designed to subsidize foreign investment, favor or disfavor particular types of investment, or serve nonrevenue raising foreign policy objectives." see shay, fleming & peroni, source rules, supra note 1, at 149. commentators have used tax expenditure analysis to demonstrate that the title passage rule as applied to u.s. export sales is an inappropriate and ineffective subsidy for such sales activities; these commentators accordingly recommend that the title passage rule for export sales be repealed, and that the source of income from export sales be determined using an approach that more clearly reflects the location 6052011] florida tax review contended that such deviations from the benefits principle whereby countries give up tax revenue228 in order to promote national interests are benign from the standpoint of achieving universal agreement: countries not employing such features may simply not care because the effect would be undertaxation borne by another country as opposed to potential double taxation of a country's residents. however, other countries may object because such measures may harm their own national interests for example, the title passage rule may provide a u.s. exporter with a competitive advantage vis a vis companies operating in the importing country. similarly, while the portfolio interest exemption stimulates the provision of foreign capital,229 capital-importing countries, in particular developing nations, stand to lose tax revenue to capital-exporting countries (i.e., developed nations) from source tax exemptions for interest and other types of portfolio income.2 30 of the underlying economic activities. see j. clifton fleming, jr. & robert j. peroni, reinvigorating tax expenditure analysis and its international dimension, 27 va. tax rev. 437, 551-61 (2008). 227. see supra note 21 and accompanying text. other commentators also have proposed repealing the portfolio interest exemption, albeit for reasons that differ from those advanced in this article. see reuven s. avi-yonah, memo to congress: it's time to repeal the u.s. portfolio interest exemption, 17 tax notes int'l 1817 (1998) (proposing that congress repeal the portfolio interest exemption and instead enact a high withholding tax "on interest and other deductible payments to nonresidents" that would "be completely refundable on proof that the income ... has been reported to the tax authorities" in the beneficial owner's country of residence; basing this proposal on the assertion that the factors that led to the enactment of the portfolio interest exemption no longer exist and that the exemption has led to the situation where most cross-border portfolio income is not being taxed by any jurisdiction, which is "unacceptable from an efficiency [or] equity perspective"); michael j. mcintyre, guidelines for taxing international capital flows: the legal perspective, 46 nat'l tax j. 315, 317 (1993) [hereinafter mcintyre, guidelines] (recommending that countries harmonize their withholding taxes on capital income at some positive rate and that the united states should take the first step towards this end by imposing a low-rate withholding tax on all interest payments; basing this proposal on the need to mitigate competitive pressures that undermine countries' imposition of income taxes and to raise revenue). 228. with the title passage rule, the united states is surrendering some residence taxation; with the portfolio interest exemptions, countries are surrendering some source taxation. 229. see supra notes 70-72 and accompanying text. cf peter r. merrill, et al, tax treaties in a global economy: the case for zero withholding on direct dividends, 5 tax notes int'l 1387, 1388-89 (1992) ("[i]t generally is in every country's self interest to seek reciprocal elimination of withholding taxes."). 230. see michael j. graetz & michael m. o'hear, the "original intent" of u.s. international taxation, 46 duke l.j. 1021, 1033-34 (1997) ("capitalexporting and capital-importing nations have conflicting financial interests: capital [vol. 11:7606 sourcing income among nations and developing nations usually struggle between their tax revenue and foreign capital needs.2 3 1 thus, countries not favoring source exemptions for portfolio income may well object if the sourcing standard permits such exemptions, because these countries would then be at a competitive disadvantage in attracting foreign capital if they were to impose a source tax on portfolio income.23 2 moreover, permitting deviations from the benefits principle sets a precedent whereby countries may feel justified in varying their source rules where it suits their national interests, and some such measures may indeed result in instances of double taxation, thereby frustrating the goals of a universal sourcing standard.2 33 c standard for sourcing income the previous section has determined that the sourcing standard should be developed according to the following two principles: (i) sourcing income based on the countries that provide the taxpayer with public benefits importers have the most to gain from taxation at source, capital exporters from taxation of residents."). 231. keinan, supra note 72, at 66; see reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1639-48 (2000) [hereinafter avi-yonah, globalization]. in this regard, commentators have warned that "[t]he resulting fiscal sacrifice [by developing countries from source tax exemptions] is likely to exceed by far the potential benefits resulting from new investment capital." lee a. sheppard, news analysis: revenge of the source countries, part iii: source as fiction, 40 tax notes int'l 219, 224 (2005) (quoting from a report given by angel schindel and adolfo atchabahian at the september 12-16, 2005, international fiscal association world congress in buenos aires, argentina). consequently, there is "a growing awareness that the sensible approach for developing countries is to withhold" tax on payments of portfolio income to foreign investors. id; see cockfield, supra note 84, at 176 (pointing out that many developing nations prefer the provisions contained in the united nations model tax treaty, which enhance source taxation); cf oecd model 2008, supra note 78, at positions on article 10 (dividends) and its commentary, positions on article 11 (interest) and its commentary, positions on article 12 (royalties) and its commentary (several developing countries reserving their positions on deviating from the oecd treaty rates for dividends, interest, and royalties); but cf keinan, supra note 72, at 676 (contending that although residency taxation of financial transaction income "would shift revenue from developing countries to developed countries in the short-run," it would benefit developing countries in the long-run). 232. with only some countries taxing portfolio income, it can be expected that most of the tax would be shifted to the borrower in the form of higher interest payments. see mcintyre, guidelines, supra note 227, at 317. 233. for example, a country that wants to curb imports may enact a source rule that results in more domestic source income than that prescribed by the multilateral sourcing standard. 2011] 607 florida tax review that relate to the income and (ii) administrability. this section uses these principles to develop a standard that can be used to derive particular source rules. as a first step in developing the standard, it is important to describe in some detail the types of public benefits that countries provide. 1. categorizing and describing governmental benefits that relate to income taxpayers receive numerous governmental benefits that relate to their earning and enjoyment of income. the locations where such governmental benefits are provided can be grouped into three categories: the situs of the activities giving rise to income; the destination of the property, capital, or services giving rise to income; and the residence of the person receiving income. each of these is examined below. a. countries where taxpayer conducts activities numerous public benefits arise from government services that are provided in countries where taxpayers conduct income-producing activities. included among these public benefits are physical infrastructure (e.g., roads and telecommunications), economic infrastructure (e.g., banking systems), legal infrastructure (e.g., court systems and regulatory agencies), public safety, national security, and a skilled workforce.234 these products of government activities are either essential for, or contribute greatly to, the capacity of taxpayers to carry on activities in the particular country. as discussed previously, 2 3 5 the receipt of these government benefits justifies a source tax, and thus the location of these benefits should serve as a basis for sourcing income. indeed, several of the current source rules determine the source of income based on the location of the economic activities giving rise to the income, which can be viewed as a surrogate for the location of the public benefits provided; these include the rules for sourcing service income236 and manufacturing income.23 7 b. countries in which taxpayer provides property, capital, or services where a taxpayer provides property, capital, or services into a country, the country of destination is providing the taxpayer with governmental benefits that relate to the earning of income. this is most 234. see shay, fleming & peroni, source rules, supra note 1, at 90. 235. see supra part 11i.b.1. 236. see supra note 29 and accompanying text. 237. see supra note 34 and accompanying text. 608 [vol. 11:7 sourcing income among nations easily understood in the form of legal protections provided by a destination country to a taxpayer in connection with royalties received for licensing patents, copyrights, or other intangibles for use in that country.23 8 in this regard, the source rules typically source royalty income based on the location of the legal protections.239 destination countries provide other public benefits to taxpayers as well. for example, when a taxpayer is providing capital to a corporation, both the country (or countries) where the corporation conducts activities as well as the country under whose laws the corporation is formed are providing benefits that contribute to the taxpayer's ability to receive dividend income and stock gains; the former country provides benefits in support of the corporation's activities and the latter country provides the legal infrastructure that protects and regulates the taxpayer's investment in the corporation.240 current u.s. law recognizes both types of public benefits in sourcing dividend income, with dividends generally sourced according to the corporation's country of incorporation, but with exceptions that look to the place of substantial business activity conducted by the company.2 4 1 similarly, a taxpayer who loans money indirectly profits from the public benefits received by the borrower in connection with the borrower's incomeproducing activities, which provide the borrower with funds to pay interest to the taxpayer.24 2 the current u.s. source rule is generally in accord with this view, as it sources interest income based on the residence (in the case of noncorporate borrowers) or country of incorporation (in the case of corporate borrowers) of the debtor, unless the debtor has substantial business activities or a banking branch outside its country of residence or incorporation. 2 43 in addition, the country of destination provides significant public benefits by performing the governmental services essential for establishing a market for a taxpayer's goods and services. 2 44 the market in any country 238. see ali project i, supra note 14, at 45; shay, fleming & peroni, source rules, supra note 1, at 143; lokken, intellectual property, supra note 57, at 240-41. 239. see supra notes 25-26 and accompanying text. 240. see ali project i, supra note 14, at 63. 241. see supra notes 19-20 and accompanying text. 242. cf lokken, source, supra note 49, at 7 (stating that under a benefitsbased model for sourcing income, "interest originates where the borrower utilizes the borrowed funds because governmental services and protections at that location are central to the success of the borrower's venture, which generates the capacity to pay interest on the loan"); ali project i, supra note 14, at 67 (stating that the general principle under the current source rules for interest appears to be that the interest is sourced in the country that is reasonably presumed to be the place where the borrower derives the income or wealth that funds the interest payments). 243. see supra notes 17-18 and accompanying text. 244. see shay, fleming & peroni, source rules, supra note 1, at 91; aviyonah, electronic commerce, supra note 135, at 540; cf ali project i, supra note 6092011] florida tax review could not exist without the necessary physical, economic, and legal infrastructure, and this is largely a result of governmental functions.2 45 and by accessing a country's market through the sale of goods and services, a taxpayer is benefiting from these governmental activities, thus justifying a source tax to some degree on the income earned. while current u.s. law does not appear to recognize market access as a basis for sourcing income,24 6 several leading commentators advocate that the united states should tax nonresidents as a charge for exploiting the u.s. market,2 47 and other notable analysts view market access as a legitimate basis for exercising source taxation in general.248 14, at 20 (stating that it might be appropriate to source income from the sale of inventory in the country in which the purchaser is located, because it is the country that "has provided the market for the property sold"). 245. see shay, fleming & peroni, source rules, supra note 1, at 91; cf oecd, e-commerce, supra note 107, at 14 (some members of the technical advisory group studying the taxation of electronic commerce concluding that source taxation of a supplier not physically present in a market country is justified because the business profits derive partly from the use of the country's infrastructure, such as "means of transportation (such as roads), public safety, a legal system that ensure the protection of property rights and a financial infrastructure"). 246. an exception to this may be the source rule for international communications income that is earned by u.s. persons, which treats 50 percent of such income as foreign source, possibly because the u.s. person is viewed as having accessed a foreign country's market by transmitting communications or data to that country. see i.r.c. § 863(e). while not based on the market access rationale, the title passage rule that applies under u.s. law for inventory sales can produce a source designation that is consistent with a market access approach. for example, where inventory is sold into a foreign country with title passing to the buyer in that country, the income will be foreign source. of course, sales into the foreign country can also generate u.s. income if title to the goods passes in the united states. in any event, simply selling inventory into a country is not likely to result in a source tax in the absence of some other business activity in that country (and possibly a fixed place of business if a treaty applies). see supra notes 36-38 and accompanying text. 247. see shay, fleming & peroni, source rules, supra note 1, at 91. 248. see avi-yonah, electronic commerce, supra note 135, at 540; cf graetz, inadequate principles, supra note 97, at 299 (stating that countries that supply only a market for goods and services may have a basis for exercising source taxation). in this regard, the oecd technical advisory group that was established to address the taxation of electronic commerce could not reach an agreement as to whether or not a supplier that is not physically present in a country may be viewed as using that country's economic and legal infrastructure so as to justify source taxation of a portion of the enterprise's profits. see oecd, e-commerce, supra note 107, at 14. 610 [vol. 11:7 sourcing income among nations c. country where taxpayer resides the taxpayer's country of residence provides public benefits that relate to the taxpayer's earning and enjoyment of income. specifically, the residence country contributes to the ability of a taxpayer to acquire and protect the wealth arising from income by providing a legal system that governs rights and obligations. 249 these public benefits include the creation of a court system and the regulation of financial markets and commercial activity. moreover, through military protection and agencies that are responsible for relationships with other nations, a country is providing services that protect its residents' financial interests in other countries. 2 50 for income that is consumed by individuals, the residence country provides important governmental benefits to the individual that relate to consumption; 25 1 one would be unable to spend and consume income within a given country in the absence of the governmental services that support physical, legal, and economic infrastructure as well as public safety.25 2 249. see mason, supra note 84, at 1554 (noting property protection among the governmental benefits provided by a country to its residents); reuven s. aviyonah, the case against taxing citizens 7 (univ. of michigan law school pub. law & legal theory working paper series, paper no. 190, 2010), http://ssm.com/abstract-1578272 [hereinafter avi-yonah, case against] (pointing out that u.s. residents benefit from the rule of law and government protection, among other government benefits); mclure, supra note 153, at 149 (finding it more appropriate that the residence country rather than the source country should have the right to tax the normal return to capital because "the residence country creates the economic climate favorable to the creation of portfolio capital by practicing public fiscal virtue and by nourishing private thrift" (quoting from gary clyde hufbauer, u.s. taxation of international income: blueprint for reform 67 (1992)); cf zelinsky, supra note 146, at 1316 (concluding that the extensive civil and social rights of u.s. residents may justify taxing their worldwide incomes under a benefit theory). 250. see roin, supra note 184, at 588-89 (pointing out that countries may assist their residents in the event of military or political instability as well as trade disputes); michael s. kirsch, taxing citizens in a global economy, 82 n.y.u. l. rev. 443, 472-73 (2007) [hereinafter kirsch, taxing citizens]. more specifically, the united states has entered into dozens of bilateral investment treaties, which provide u.s. citizens and corporations basic protection for their business operations and investments in other countries. id. at 473. 251. see harris, supra note 137, at 447; cf graetz & grinberg, supra note 76, at 569 (noting that because countries fund government services that provide for the well-being of their residents, countries seem to deserve priority in taxing the foreign portfolio income of their residents). 252. see jefferson vanderwolk, the deferral debate and the benefits theory, 20 tax notes int'l 1469, 1470 (2000) [hereinafter vanderwolk, benefits theory] (stating that the residence country provides consumption-related services that support individuals' ability to enjoy income); cf avi-yonah, case against, 2011] 611 florida tax review to an extent, current law appears to recognize the benefits provided by the residence country in assigning jurisdiction to tax. for example, although the u.s. rules generally source interest income according to the residence of the borrower,253 most interest paid by u.s. persons to nonresidents is exempt from u.s. tax under the portfolio interest exemption.254 while the stated reason for this exemption is to allow u.s. borrowers the opportunity to participate in the eurobond market,255 the notion that the resident country has a greater right to tax such interest may also play a role.256 more generally, treaties usually assign the right to tax interest and royalties to the residence country25 7 and significantly reduce the rate of source taxation on dividends. 25 8 again, although the prevention of excessive source taxation is an important reason for these treaty provisions, 259 they also seem to reflect a determination that the residence country has the greater taxing rights over these types of income,260 or that at least tax jurisdiction should be shared between the residence and source countries. 2. unifying the activities, destination, and residence approaches for sourcing income a. the benefits principle and the propriety of split sourcing as discussed above, several countries may be providing governmental benefits to a taxpayer that relate to the taxpayer's income, with these countries grouped into three categories location of activities; supra note 249, at 7 (pointing out the u.s. residents benefit from the "many opportunities of a free market economy"). 253. see i.r.c. § 861(a)(1). 254. see i.r.c. §§ 871(h), 881(c). many developed countries likewise exempt interest paid to nonresidents. see ali project ii, supra note 21, at 194. 255. see supra notes 70-72 and accompanying text. 256. see ali project ii, supra note 21 at 194 (providing as a possible explanation for the portfolio interest exemption that the source country's claim to tax interest received by a nonresident may be considered to be weak); graetz & grinberg, supra note 76, at 569 (stating that the source country's claim to tax portfolio income is more attenuated than its claim to tax business income and that the claims of the residence country seem to deserve priority in the inter-nation allocation of tax jurisdiction over portfolio income; pointing out that primary allocation of taxing rights over portfolio income reflects this priority). 257. see supra notes 22, 28 and accompanying text. 258. see supra note 23 and accompanying text. 259. see supra notes 74-75 and accompanying text. 260. see supra notes 76-78. [yol. 11:7612 sourcing income among nations destination of property, capital, or services; and country of residence. in many situations, more than one country in different categories may provide benefits. for example, a taxpayer who resides in one country may receive dividends from a corporation that is incorporated and does business in another country. in this situation, there are governmental benefits relating to the income provided by both the residence country (where the taxpayer resides) and the destination country (where the corporation is incorporated and does business, which is the destination of the taxpayer's invested capital). in fact, for a given item of income, countries in all three categories may provide benefits. for example, a taxpayer who resides in one country may develop an intangible in another country and license the intangible for use in a third country. here, the taxpayer is receiving public benefits from the residence country, the activities country (where the intangible is developed), and the destination country (where the intangible is being used). current law addresses such situations by sourcing all of the income to one of the countries involved. 26 ' thus, in the first situation, all of the dividends are sourced to the country of destination despite the public benefits that are also provided in the residence country.262 and in the second situation, all of the royalties are sourced to the destination country even though all three countries are benefiting the taxpayer.26 3 the current approach apparently is to choose the country to which the income primarily relates. 2 6 however, this can sometime lead to arbitrary determinations;265 it is not always clear which of the countries is the greatest contributor to the income in question. more fundamentally, the current "single source" approach is inappropriate given that often more than one country is providing significant public benefits. furthermore, an approach that seeks to determine the primary country that is providing public benefits can lead to disagreements among nations,26 6 and thus does not appear suitable for multilateral adoption. instead, a unified approach is called for, one that recognizes those countries that provide significant public benefits that relate to the income. accordingly, this article proposes that multilateral source rules be devised pursuant to a standard that evaluates income for sourcing on the basis of three factors: the destination of the services, property, or capital giving rise 261. see, e.g., supra notes 19-20, 25-27 and accompanying text. 262. see supra notes 19-20 and accompanying text. 263. see supra notes 25-27 and accompanying text. 264. see lokken, intellectual property, supra note 57, at 242-43; ali project i, supra note 14, at 18 (stating that the current source rules used in the united states and elsewhere are result of a process that seems "to require a balancing of the strength of conflicting claims and considerations as they apply to particular types of income"). 265. see mason, supra note 84, at 1591. 266. see supra notes 110-16 and accompanying text. 2011] 613 florida tax review to income; the location(s) of the activities giving rise to income; and the residence of the person receiving income. 267 each of these countries has the potential for contributing significantly to the earning and enjoyment of income, as demonstrated above2 6 8 and as reflected in the current source rules.269 under this standard, a given item of income may have its source 267. cf azam, supra note 132, at 30-31 (proposing that source rules for taxing electronic commerce be developed by taking into account the locations of producers, consumers, and other physical facilities and components that contribute to e-commerce income, so that the tax pie can be divided fairly among countries). these factors, and the bases for them, are conceptually consistent with the idea of economic allegiance for determining the tax jurisdiction of countries that was developed by four prominent economists in their seminal report for the league of nations. see economic and financial commission, league of nations, report on double taxation submitted to the financial committee by professors bruins, einaudi, seligman, and sir josiah stamp, league of nations doc. e.f.s.73f.19 (1923). in determining the meaning of economic allegiance, the report identified four fundamental considerations: (i) the acquisition of wealth, (ii) the location of wealth, (iii) the enforceability of the rights to wealth, and (iv) the consumption of wealth. id. at 22-23. corresponding to these considerations are four points that are significant in determining the appropriate place of taxation: (i) the place of origin of wealth, (ii) the situs of wealth, (iii) the place of enforcement of the rights to wealth, and (iv) residence or domicile. id at 23. the report concludes that of the four, the place of wealth origin and residence or domicile of the taxpayer are the most important, with the other two factors mostly significant in reinforcing the tax claims of the country of origin or domicile. id. at 25. in examining the origin of wealth with respect to the human relations that help create wealth, the report discusses the places where activities such as management occur as well as "[t]he selling end, that is, the place where agents for selling ply their calling and where the actual markets are to be found." id. at 24. and in applying the economic allegiance criteria to real estate mortgages, the report views the place of wealth origin as where the land is located, apparently embracing an approach that determines origin in this context based on the destination of the loaned capital. see id. at 34-35; but cf id. at 36 (in evaluating the origin of income on corporate shares, the report favors the place where the owners of the corporation, i.e., the shareholders, reside, as opposed to the place where the corporation earns the dividends, especially because determining the location of the underlying corporate earnings would be complicated where the corporation has production, sales, or a chief office in more than one country). thus, similar to the factors identified in this article, the league of nations report focuses on where the taxpayer resides and where wealth is produced, with the latter apparently taking into account both the activities giving rise to income along with the destination of the products or capital in some cases. 268. see supra notes 234-35, 238, 240, 242, 244-45, 249-52 and accompanying text. 269. see supra notes 236-37, 239, 241, 243, 253-58 and accompanying text; cf avi-yonah, globalization, supra note 231, at 1586-87 (pointing out that three types of jurisdictions may, under current rules, impose a tax on cross-border sales of goods or provision of services: both the supply and demand jurisdictions 614 [vol. 11:7 sourcing income among nations divided among multiple locations. 27 0 thus, in the second example above,2 71 a portion of the royalty income would be sourced to the residence country, the activities country, and the destination country. subsection 3, below, discusses the specifics of assigning income portions.272 b. defending the residence country source portion for the most part, commentators appear to view a split-sourcing approach as appropriate from the standpoint of the benefits principle.273 the may impose a source tax, and the residence jurisdiction may impose residual tax that is not taxed by the supply or demand jurisdictions). 270. cf kevin a. bell, indian official says source country should have greater taxing rights, int'l tax mon., feb. 26, 2008 (indian official quoted as stating that the source country and residence country should each have the right to tax one half of certain income that originates in india). 271. see supra text accompanying note 261. 272. as voiced by a leading commentator, a concern with the functioning of source rules is the potential for taxpayers to erode completely their effect in a given jurisdiction by making deductible payments to related parties located in a second, low tax jurisdiction. see edward d. kleinbard, stateless income 62-63 (usc legal studies research paper no. 11-6, 2011), http://ssm.com/abstract-1791769 ("even if a multinational enterprise's income is sourced in the first instance by every country according to some economically rational set of agreed-upon principles, stateless income tax planning simply extracts the income from the source country (for example, through deductible interest, royalty, or fee payments) and deposits it in a tax-friendlier locale."). this concern is based on the assumption that the deductible payments in the first jurisdiction are not subject to a source tax in that jurisdiction. see id. at 15. under the proposed sourcing standard, this should not be the case if, as the commentator assumes (see id at 62-63), the first jurisdiction is the destination of services or an intangible and is not a tax haven in these circumstances, a portion of the deductible payments would be sourced and taxed in the first jurisdiction. 273. see, e.g., ali project i, supra note 14, at 35-36, 48 (stating that it seems anomalous to assign all of the rental income from leasing tangible property produced by the taxpayer to the country of use; noting that conceptually royalty payments received on the license of intangible property developed by the taxpayer represent income generated by both the creation and exploitation of the intangible); lokken, intellectual property, supra note 57, at 242 (acknowledging that with regard to royalty income received from the license of intangible property developed by the taxpayer, both the country that was the situs of development activities and the country where the intangible is used provide important services and protections); christians, donaldson & postlewaite, supra note 80, at 20-21 (stating that a highly analytical approach for determining the source of service income might attribute the income to one or more jurisdictions, each of the contacts with which provides an economically defensible basis for determining source). 2011] 615 florida tax review major concerns with such an approach are administration27 4 and coordination among countries,275 which are addressed in the next subsection. however, some leading commentators would probably take issue with sourcing a portion of income to the country of residence. with regard to u.s. source taxation, they assert that where a nonresident is doing business in the united states (or possibly accessing the u.s. market), the public benefits provided by the united states to the nonresident are quite similar to the public benefits provided to residents, thus justifying a source tax that is equivalent to that imposed on u.s. residents. these commentators also are concerned that u.s. residents would perceive a lower tax for nonresidents as inequitable, and thus damage the legitimacy and efficacy of the residence tax.277 the commentators specifically disagree with other analysts,278 who argue that nonresidents should pay a lower tax than residents on income earned in a particular country because the nonresidents are receiving fewer public benefits from that country.279 274. see, e.g., ali project 1, supra note 14, at 36, 48 (pointing out administrative difficulties of splitting the source of rental income received from leasing tangible property produced by the taxpayer; pointing out administrative difficulties of splitting the source of royalty income received from licensing intangible property developed by the taxpayer); lokken, intellectual property, supra note 57, at 242-43 (pointing out administrative difficulties of splitting the source of royalty income received from licensing intangible property developed by the taxpayer); cf christians, donaldson & postlewaite, supra note 80, at 21 (stating that the u.s. source rule for service income, which looks to the place where services are performed, is probably based primarily on administrative considerations). 275. see, e.g., ali project i, supra note 14, at 37, 48 (stating that no case has been found in which a country divides the source of rental income between the place where the leased property was produced and the place where it is being used; noting that few if any countries divide the source of royalty income between the place where the licensed property was developed and the place where it is being used). 276. see shay, fleming & peroni, source rules, supra note 1, at 90-91; cf lokken, intellectual property, supra note 57, at 239 (asserting that consumer benefits received by individuals are not related to the issue of source of income). 277. see shay, fleming & peroni, source rules, supra note 1, at 110-11. 278. see id at 90-91. 279. see harris, supra note 137, at 457 (the rate of tax on nonresidents with domestic income should be less than that on residents with domestic income, "because nonresidents deriving domestic income receive less government services than residents deriving such income, i.e., they are not in receipt of residence or consumption services from the domestic government"); vanderwolk, benefits theory, supra note 252, at 1470 (arguing that the taxation of foreign-source business income should be divided more or less equally between the residence country and the source country because of the governmental services provided by each country); jefferson vanderwolk, direct taxation in the internet age: a fundamentalist approach, bull. for int'l fiscal documentation, apr. 2000, at 173, 179 616 [vol. 11:7 sourcing income among nations this criticism is not warranted. first and foremost, assigning a portion of income to the residence country is in accord with the benefits principle.2 80 because a resident benefits from home country government activities with respect to income that is either accumulated or consumed, the residence country should have a primary right to tax at least a portion of income that is derived from activities or market access that occurs outside of that country. 281' this in turn should reduce the income over which the countries of activities and destination should have a right to tax.282 to support this proposition, consider the case of an individual who resides in (proposing an approach under which the tax rate on the local-source income of nonresidents is lower than the rate on residents' income, because nonresidents receive less governmental benefits than residents nonresidents "receive only production services, not consumption services"); cf roin, supra note 184, at 591 (stating that "[a] case may be made for imposing a lower tax on the u.s. income of foreign corporations than on the u.s. income of domestic corporations," because foreign corporations are receiving less benefits from the united states as compared to domestic corporations); avi-yonah, case against, supra note 249, at 7 (in arguing against the united states taxing nonresidents citizens on their worldwide income, pointing out that nonresident citizens do not receive certain significant benefits that are received by u.s. residents or only receive them in a substantially weaker form). 280. several commentators agree with this proposition. see supra note 279. 281. see vanderwolk, benefits theory, supra note 252, at 1470 (arguing that the taxation of foreign-source business income should be divided more or less equally between the residence country and the source country because of the governmental services provided by each country); harris, supra note 137, at 462-63 (proposing that residents deriving foreign income should be taxed by the residence country on their worldwide taxable income at the full residence income tax rate, "but should receive a tax credit with respect to their foreign income at the source income tax rate," with the source tax rate being lower than the residence tax rate; this will result in residents with foreign income contributing to the cost of the "government services they receive, i.e., consumption services"); roin, supra note 184 at 588-89 (in arguing for a system where the united states exempts foreign income from taxation, contending that the government benefits provided by the united states to u.s. corporations with respect to foreign income "may be substantial enough to justify some home country tax" on such income); cf mclure, supra note 153, at 149 (finding it more appropriate that the residence country rather than the source country should have the right to tax the normal return to capital because "the residence country creates the economic climate favorable to the creation of portfolio capital by practicing public fiscal virtue and by nourishing private thrift" (quoting from gary clyde hufbauer, u.s. taxation of international income: blueprint for reform 67 (1992)). 282. see roin, supra note 184, at 591 ("exactly the same factors that justify the imposition of an add-on tax imposed with respect to the foreign income of a u.s. corporation, then, justify a corresponding downward adjustment in the rate of corporate tax payable on the domestic income of foreign corporations."). 6172011] florida tax review country a but who derives all of her income from country b, which has a tax rate that exceeds the country a tax rate, thus precluding any residual tax by country a even if it employed a foreign tax credit system as opposed to an exemption system. the individual consumes all of her income in country a, and uses the banking and financial system of country a to protect the wealth that accumulates from the income. furthermore, the government activities of country a, through its military and state department, protect her property rights in country b. if the individual's income were sourced only on the basis of activities and destination, she would pay no tax to country a, despite the public benefits that she receives from country a. to prevent this, at least a portion of the taxpayer's income should be assigned to country a for primary taxation purposes in order for the taxpayer to shoulder some of the burden of country a governmental costs from which the taxpayer clearly benefits. as far as the perceived inequity of a country taxing nonresidents less heavily than residents (which would occur where a portion of the income is sourced to the residence country), residents may well not feel that they are being unfairly treated given that nonresidents are receiving fewer benefits in particular, a lack of public benefits relating to personal consumption. indeed, an argument can be made that if nonresidents are subject to the same taxes as residents despite receiving fewer public benefits from the host country, the nonresidents may be the ones who feel that they are being treated unfairly. this could result in less compliance by nonresidents as well as steps taken to reduce their exposure to source taxation for example, by avoiding a presence in the host country and instead carrying out host country activities remotely. the difference in benefits provided to residents and nonresidents may also mitigate or eliminate any concerns that nonresidents would have an advantage in competing with residents in the particular country. a lower source tax on nonresidents would only present this concern where the difference in tax burden is not being made up by tax liability in the residence country on the portion of the income sourced to it. with substantially harmonized source rules (the end-product of this article's endeavor), there would likely be a lack of a significant residence tax only where the residence country is not providing important benefits to its individuals and corporations, such as stable legal protections. 28 in this regard, investors in a tax haven corporation would likely have a higher degree of legal risk than 283. see roin, supra note 184, at 588-89; kirsch, taxing citizens, supra note 250, at 473. 284. cf roin, supra note 184, at 589 (differences in the tax rates imposed by countries often reflect differences in the level of governmental benefits provided) 618 [vol. 11: 7 sourcing income among nations investors in a corporation from a developed country.285 given this tradeoff, nonresidents may well not have a competitive advantage over residents even if the nonresidents faced lower overall tax liability. 28 6 nevertheless, host countries could always remove any perceived advantage by subjecting the residence country source portion of income to a form of residual source taxation that is, a host country could impose a tax on the entire portion of a nonresident's income that is derived from the host country, subject to a credit for any residence country taxes that are imposed on the portion of the income that is sourced to the residence country.287 an additional reason for assigning a portion of income to the residence country is to have a reasonable allocation of tax jurisdiction that can be agreed to by nations on a multilateral basis. under the destination component of the proposed standard, where a taxpayer earns income by accessing a country's market, a portion of the income should be assigned to that country even without the taxpayer's actual presence in the country, which is not the case under current law.288 similarly, the proposed standard will assign taxing rights over a portion of interest and royalty income to the destination country, thereby altering the typical rights of residence countries to tax such income in its entirety.289 these features of the standard thus expand the reach of source taxation. allowing residence countries a primary right to tax a portion of income is an appropriate and fair counterbalance to these features, and a measure that is more likely to bring about international accord on a sourcing standard.290 285. cf kleinbard, lessons, supra note 84, at 77 n. 172 (noting that despite the clear tax advantages of using a foreign corporation, it is difficult to find examples of successful new public firms that have been organized by u.s. entrepreneurs as foreign firms). 286. cf roin, supra note 184, at 588-91 (contending that the proposed structure, which generally exempts u.s. corporations' foreign income but considers the imposition of an add-on tax on such, and considers taxing foreign corporations on u.s. income at a lower rate than that applied to the u.s. income of u.s. corporations, adheres rather closely to capital export neutrality, with neutrality "expanded to include governmental benefits"). 287. this would be similar to the tax imposed under section 877, under which a nonresident alien who is treated as having expatriated to avoid u.s. tax is subject to u.s. tax on u.s. source income, as expanded under the provision, but with a credit for foreign taxes on income that is taxable solely as a result of section 877. see i.r.c. § 877(a), (b), (d). 288. see supra notes 36-38 and accompanying text. 289. see supra notes 21-22, 28 and accompanying text. 290. notwithstanding the conceptual basis for residence-based sourcing, there is a concern over determining the residence of corporations, which of course is necessary in deciding where to source the residence-based portion of income earned by corporations. cf andrus, supra note 42, at 848 (pointing out that residence-based source rules will place tremendous pressure on the residence definition). under u.s. 2011] 619 florida tax review c. less stress on characterization in addition to doing a better job of effectuating the benefits principle, the proposed standard would also reduce or possibly eliminate the current stress that is placed on characterizing income items for purposes of applying source rules. as mentioned previously, under the current source rules, a great deal turns on how income is characterized.2 91 this is because the current single source rules result in very different results depending on the type of income involved. for example, under the u.s. rules, royalties received on a license of a patent are sourced where the patent derives its legal protection,292 whereas gain on the sale of a patent for a fixed price is sourced where the law, corporate residency is based on the country of incorporation. see i.r.c. § 7701(a)(4), (5). as a consequence, a publicly traded corporation can avoid being subject to u.s. tax on its worldwide income, as well as being subject to subpart f on foreign income, simply by being incorporated outside the united states. see shay et al., task force, supra note 26, at 746-47. this concern has prompted some commentators to advocate tests for determining corporate residency that focus on what are arguably more meaningful factors than the place of incorporation. see id. at 749-55 (evaluating alternative tests and concluding that the place of incorporation should be retained); kleinbard, lessons, supra note 84, at 76 (stating that the current u.s. corporate residence test can be modernized to look to a corporation's "mind and management," a u.k. concept). recently, bills have been proposed in congress that would enact a new section 7701(p), which would treat any large or publicly-traded foreign-organized corporation as a domestic corporation for u.s. tax purposes if the management and control of the corporation occurs primarily in the united states. see international tax competitiveness act of 2011, h.r. 62, 112th cong.; international tax competitiveness act of 2010, h.r. 5328, 111th cong.; see also stop tax haven abuse act, h.r. 1265, 111th cong. (2009); stop tax haven abuse act, s. 506, 111th cong. (2009); jim brown et al., new york state bar association, report on the management and control provision of the "international tax competitiveness act of 2011" (2011) (providing comments on this legislative proposal). while determining corporate residency is important in crafting harmonized source rules that use residence-based sourcing, this issue will need to be left for a future endeavor. for now it may be useful to point out that one basis for sourcing a portion of income to the residence country, the legal protections provided by that country, may support a corporate residence test that looks to the country of incorporation; nevertheless, the fact that a country also provides pubic benefits, such as infrastructure, that make possible the domestic management activities of a company may also support a residence test that looks to the place of management and control. if it is appropriate to focus on factors beyond the place of incorporation, in addition to the currently proposed legislation, several alternative tests have been suggested for determining corporate residency for purposes of residence taxation. see shay et al., task force, supra note 26, at 749-5 5. 291. see supra notes 102-06 and accompanying text. 292. see supra notes 25-26 and accompanying text. 620 [vol. 11: 7 sourcing income among nations seller resides.293 characterization is particularly problematic in the case of transactions involving intangibles and electronic commerce, where the income from a given transaction may take the form of royalties, compensation, or property gains based on the specific facts and circumstances.294 as a consequence, the current approach often leads to a great deal of uncertainty, as well as the potential for double taxation or non-taxation, because countries may be characterizing an item differently (even if they used similar source rules).295 more fundamentally, the current rules are flawed in that they produce different source results for transactions that are economically similar.296 this in turn creates planning opportunities for taxpayers, with the attendant concerns of manipulation, compliance, and enforcement.29 7 to restate an illustration provided earlier,29 8 where a u.s. resident develops an invention in the united states, obtains a foreign patent on the invention, and then sells the foreign patent for a lump sum, all of the gain will be u.s. source;299 however, if instead of selling the patent the taxpayer licenses the patent in exchange for a lump sum royalty for a period that is slightly less than the patent's remaining life, all of the income would be foreign source.3 00 despite the similarity in the substance of these two alternatives, the source results are quite different. under the proposed standard, there would be similar source results regardless of how a transaction is characterized. because the sourcing standard calls for rules that would divide the source of income among the countries of activities, destination, and residence, economically similar transactions would have the same or similar source results. specifically, in the case of an intangible developed by the taxpayer, the standard would support a rule that allocates the source of royalty income among the country 293. see supra notes 43-44 and accompanying text. 294. see supra note 102. 295. see supra note 117 and accompanying text. 296. see harry grubert, tax credits, source rules, trade, and electronic commerce: behavioral margins and the design of international tax systems, 58 tax l. rev. 149, 188 (2005) (pointing out that "the current distinction in the u.s. source rules between a sale of a good, a royalty, and a service is highly artificial and serves no policy objective;" stating that the current treasury regulations for sourcing income from computer software exemplifies this confusion given that different types of transactions involving software are highly substitutable from the developer's point of view). 297. see noren, supra note 102, at 345 (pointing out that distinguishing ecommerce income among existing source categories appears to be highly prone to manipulation). 298. see supra notes 105-06 and accompanying text. 299. see supra note 105. 300. see supra note 106. 2011] 621 florida tax review where the intangible was developed, the country where the intangible is being used, and country where the taxpayer resides.30 the same rule should be appropriate for gain from the sale of an intangible developed by the taxpayer.302 consequently, the different source results in the example above would no longer hold true. because the sourcing standard recognizes the public benefits of the different countries involved, and the location of these benefits relates to the economic substance of a transaction, rules developed pursuant to the standard should produce similar sourcing results for transactions with similar economic substance. this would reduce the uncertainty and potential for taxpayer manipulation that plague current law. it would also avoid the need for harmonized characterization rules for nations, which would be necessary if multilateral source rules continued to use a single source approach with different rules based on the type of income involved. although there are single source rule options for reducing uncertainty and manipulation, such as residence-based303 or destination-based sourcing'0 for all service and intangible income, these approaches would be distortive in light of the benefits principle and may well not be acceptable internationally. 305 301. see infra notes 370-73 and accompanying text. 302. see infra notes 374-76 and accompanying text. 303. see andrus, supra note 42, at 856. 304. see ali project i, supra note 14, at 49-50, 57; noren, supra note 102, at 345 (suggesting that source rules for e-commerce income focus on the location of the consumer in order to avoid the difficult classification issues that arise under current law). 305. see andrus, supra note 42 at 856. an additional benefit of the proposed sourcing standard is that there would generally be less opportunity under foreign tax credit limitations for cross-crediting (see supra note 62 and accompanying text), given that there would be a greater likelihood that income treated as foreign source would be subject to a significant tax by a foreign country. for example, under current u.s. law, portfolio income is typically sourced based on the destination of capital or property, yet the destination country typically imposes little or no tax on most types of such income. see supra notes 17-28 and accompanying text. under the proposed sourcing standard, only a portion of portfolio income would be sourced to the country of destination (see supra notes 267-272 and accompanying text), and the destination country would generally be imposing a tax at a significant rate on that portion (see supra note 139-143). consequently, the proposed sourcing standard should reduce the pressure placed on the strictness of foreign tax credit limitations. see ali project i, supra note 14, at 348 (pointing out the inverse relationship between the foreign tax credit basket limitations and the restrictiveness of the source rules for u.s. persons); shay, fleming & peroni, source rules, supra note 1, at 152-53 (same). 622 [vol. 11:7 sourcing income among nations 3. addressing administrative and coordination concerns a. an allocation scheme that avoids administrative difficulties commentators who agree that the current source rules are arbitrary because they typically choose the primary country that provides related public benefits, while ignoring other countries that are also providing benefits, view the current approach as necessary.306 that is, while in a given situation there may be connections to several different countries, an approach that attempted to attribute income to each of the countries involved would be overly complex and administratively difficult. 0 7 while taking into account all benefit-providing nations would be unworkable, the proposed standard eschews such an approach in favor of one that limits the source inquiry to the countries that are likely to provide significant public benefits that relate to the income in question. thus, certain less significant connections, such as the residence of the payer or the place where payment is made, are ignored because it is administratively impossible to allocate income to every country with some connection to the transaction. in applying the standard to devise rules, certain additional lines should be drawn to promote administrability. for example, service income should be sourced without regard to where the taxpayer was educated or developed her skills. although the development of human capital is related to earning compensation income and could fall within the activity component of the proposed sourcing standard, 08 taking this into account appears too difficult administratively; moreover, human capital development would likely occur at the place where services are performed,309 and under the standard a portion of the income will be sourced there in any event. in the same vein, source rules devised pursuant to the standard should use reasonably certain indicia for the place of activities or destination. for example, in determining the destination of goods or services, the rules should use well-developed factors such as the "use, consumption, or disposition" concept that is currently used under u.s. law.31 o similarly, it would be 306. see, e.g., christians, donaldson & postlewaite, supra note 80, at 2021. 307. see id. at 20. 308. cf shay, fleming & peroni, source rules, supra note 1, at 140 (arguing that the country where a service provider's extensive human capital was developed would seem to have a claim to tax a portion of the service income). 309. see graetz & grinberg, supra note 76, at 569. 310. see reg., § 1.864-6(b)(3)(ii). nevertheless, with the potential for split sourcing of income between activities and destination countries, there will be the need for more factual determinations than under current law's single source approaches. 2011] 623 florida tax review advisable for the location of taxpayer activities to be limited to those jurisdictions where taxpayers engage in significant activities involving manufacturing, sales, development, or services that relate to the income in question. the most important administrative issue with the proposed sourcing standard is determining the portions of income that should be assigned to the different components. that is, once it is decided that an item of income should be divided among the standard's components, what method should be used to make the allocation? for many situations, there would not be a precise basis for making allocations. for example, it would be nearly impossible to value the public benefits provided by the residence country in order to determine an allocation for the residence country component, assuming that the allocation of income based on the relative amount of public benefits provided by jurisdictions is considered appropriate.3 11 likewise, where income is allocated to the destination country because a taxpayer has accessed that country's market by selling goods or services into the country, the value of the public benefits provided by the destination country appears to be indeterminable. in some cases, arm's length pricing principles may provide a basis for making allocations, but these principles would only be helpful in assigning income to business-related activities and transactions. thus, the arm's length method would not be able to determine the portion of portfolio income that should be allocated to a residence country, or the appropriate allocation of income between the country of sales activities and the country of destination. yet, some allocation is appropriate in light of the public benefits provided at the different locations. to address these difficulties, allocations among the components of the sourcing standard generally should be made using fixed percentages that are mutually agreed upon by countries. 312 an inexact allocation using fixed percentages is the only practical approach for split sourcing where it is not possible to determine with any degree of precision the relative value of 311. in this regard, several leading commentators have expressed their opposition to an approach that would partially exempt international income from the tax bases of the source and residence countries based on the view that international income receives fewer governmental benefits than income earned within a taxing country by its residents. see fleming, peroni & shay, fairness, supra note 165, at 334-37. the commentators object to this approach in part because the approximate cost of the government benefits provided by the countries involved is not capable of being measured. see id. at 336-37. 312. the determination of these percentages should generally be made based on a rough evaluation of the amount of public benefits provided by the residence, activities, and destination countries. however, as mentioned previously, it may be appropriate also to take into account equity considerations underlying ability-to-pay taxation in determining the portion of the income that is sourced to the country of residence. see supra notes 183-85 and accompanying text. 624 [vol. 11:7 sourcing income among nations government benefits provided by countries. and such an approach is superior to no allocation at all because it at least recognizes that more than one country is providing significant government benefits that relate to the income. 3 as an illustration of this approach, countries may decide that service income should be allocated by assigning one third of the income to each of the countries where the services are performed, where the services are used or consumed, and where the taxpayer resides.314 the use of fixed percentage allocations to source income has support under current law. for income that is attributable to transportation that either begins or ends in the united states, the current u.s. rules treat 50 percent of the gross income as u.s. source and 50 percent as foreign source. 31s the u.s. rules also use a 50-50 method to source international communications income that is earned by u.s. persons.1 similarly, income from the manufacture and sale of inventory is generally sourced by allocating 50 percent of income to the place of manufacturing and 50 percent of the income to the place of sales.317 furthermore, the apportionment formulas used by u.s. states provide analogous support for using fixed percentages in sourcing income. these formulas typically apportion income among states by using fixed percentage factors for example, an equally weighted threefactor formula that takes into account the location of sales, payroll costs, and 318assets. recently, some commentators have proposed using similar formula apportionment schemes in lieu of transfer pricing to allocate income among affiliated corporations. 3 19 these measures reflect a judgment that where more precise allocations are unavailable or too difficult, a reasonable allocation of tax jurisdiction based on fixed percentages is superior to no allocation whatsoever. as alluded to above, it would be appropriate to use arm's length pricing principles to allocate income within the activities component. for example, in lieu of the 50-50 method generally used under u.s. law to 313. moreover, an inexact method of allocating income should not be viewed as inappropriate given that the benefits principle's equity basis for sourcing is somewhat imprecise in light of the value judgments involved. see supra notes 155-157, 182 and accompanying text. 314. cf bell, supra note 270 (indian official quoted as stating that giving the residence and source countries the rights to tax one half of certain income that originates in india "would be an amicable resolution of the problem"). 315. see i.r.c. § 863(c). 316. see i.r.c. § 863(e). 317. see reg. § 1.863-3. 318. see charles e. mcclure, jr., legislative, judicial, soft law, and cooperative approaches to harmonizing corporate income taxes in the us and the eu, 14 colum. j. eur. l. 377, 420-21 (2008) (describing the formulary methods used by u.s. states to apportion business income). 319. see, e.g., avi-yonah, clausing & durst, supra note 136. 6252011] florida tax review allocate income between manufacturing activities and sales activities, it would be advisable to base such allocations on the arm's length method.3 20 this would allow for a determination that takes into account the economic income attributable to these activities, which should serve as a reasonable proxy for the relative amount of government benefits provided at these locations. the use of arm's length principles to allocate income among a taxpayer's activities would also promote the neutral treatment of activities conducted through branches and subsidiaries, given the use of the arm's length method to allocate income where activities are conducted through affiliated corporations. 32 1 for the same reasons, it would be appropriate to use arm's length principles to allocate income within the activities component in other situations, such as in the case of global dealing operations involving financial products.3 22 the use of arm's length principles in these and other similar situations is generally consistent with the functional separate entity method that is authorized by the oecd model treaty as well as by some recent u.s. treaties. in theory, arm's length principles can also be used in certain situations to allocate income between the activities component and the destination component of the sourcing standard. for example, where a bank incorporated in country a makes a loan to a resident of country b, with all of the loan activities done at a branch located in country c, it may be possible to divide the interest income received by the bank between the activities and destination components by determining an arm's length charge for the banking services performed by the country c branch. this may provide an economically justifiable way of determining the portion of the interest that represents compensation for the banking services and the portion that represents compensation for the use of money. (a portion would still need to be assigned to country a, the residence country). however, a 320. see ali project i, supra note 14, at 29-33 (recommending that the source of income from the production and sale of tangible personal property be determined by apportioning the income between the countries of production activities and sales activities using arm's length principles). 321. see fred b. brown, federal income taxation of us. branches of foreign corporations: separate entity or separate rules?, 49 tax l. rev. 133, 193-95 (1993); ali project i, supra note 14, at 33. nevertheless, the results under the sourcing standard for subsidiary versus branch operations will differ where parent and subsidiary corporations have different residences, in light of the residence component of the standard. 322. proposed treasury regulations are in accord with this approach. see prop. reg. § 1.482-8. 323. see, e.g., oecd model, supra note 15, at art. 7; u.s. model, supra note 22, at art. 7. unlike the treaty separate entity method, however, the proposed standard would source a portion of the income based on the residence of the taxpayer. 626 [ vol. 11: 7 sourcing income among nations problem with using arm's length principles to make this allocation is that since the interest would be received over time, it would be necessary to apportion each payment of interest between the banking services element and use of money element, which would require the use of present value concepts to achieve a degree of accuracy. moreover, given the uncertainty in determining an arm's length charge for the banking services at the country c branch, using this method would severely complicate the application of a withholding tax on the interest in country b, although procedures could be created that would allow the bank to claim a refund for over-withholding by demonstrating the amount of interest that is properly assignable to the country c banking branch.324 even more troublesome would be using arm's length principles to allocate royalty income between a taxpayer's development activities in one country and the use of the intangible in another country. in theory, such income could be economically divided by determining the value of the intangible and then using this value to allocate the royalties between the portion that represents a return of the value of the intellectual property and the portion that represents a return on the intellectual property.3" however, in addition to the problems discussed above, there is a great deal of uncertainty in valuing intangibles.326 moreover, even after determining the value of the intangible, in the case of contingent royalties there would be the added difficulties of determining the extent to which the royalties represent a return of this value, given that the time period that the intangible would be productive can only be roughly estimated and the annual royalties will typically vary over the life of the intangible.327 because of these problems, the american law institute decided to forgo any allocation to the place of development activities, and instead source royalties in their entirety to the location where the intangible is used.3 28 without delving into the details, other commentators, however, appear to suggest that an allocation between the locations where an intangible is developed and used should at least be considered.329 because of these difficulties, fixed percentages should be used to allocate income between the activities and destination components of the sourcing standard, with the particular percentages determined by 324. cf ali project i, supra note 14, at 36 (discussing similar administrative problems with an approach that would use arm's length principles to divide the source of income from the production and lease of tangible property). 325. see id. at 48. 326. see id. at 49; see lokken, intellectual property, supra note 57, at 243. 327. see lokken, intellectual property, supra note 57, at 243. 328. see ali project i, supra note 14, at 48-49. a leading commentator on international taxation also came to the same conclusion. see lokken, intellectual property, supra note 57, at 242-43. 329. see shay, fleming & peroni, source rules, supra note 1, at 143. 6272011] florida tax review international agreement. the same approach should be used for other activities-destination allocations. the use of arm's length principles for this purpose is too difficult administratively, but an allocation is warranted in light of the government benefits received in each location. thus, as stated previously, where other methods are not available, a reasonable, fixed percentage allocation is superior to no allocation at all. and the fact that the percentages would need to be agreed upon internationally should ensure that they are reasonable.33 0 b. market access and enforcement concerns where a nonresident generates income by accessing the market of another country, a portion of the income should in principle be sourced to this country under the destination component of the sourcing standard due to the governmental benefits provided to the taxpayer by the country whose market is penetrated.33 thus, where a wholesaler who resides in one country sells goods from a branch in that country to an independent retailer located in another country, the destination country should have the right to tax the wholesaler on a portion of the income on the sale. and it should be feasible for the destination country to collect the tax by requiring the retailer to withhold. however, if the sale by the nonresident seller were directly to consumers in the destination country through electronic commerce or other remote selling techniques, the collection of the tax would be more problematic, given that consumers may not be reliable withholding agents.332 while there may be ways to create an enforcement structure for these situations,333 the important point is that in devising source rules, the allocation of income under the destination component would be dependent on addressing enforcement concerns for taxing electronic commerce and other types of remote selling. 330. while this article does not address the subject of sourcing deductions (see supra note 16), it should be noted that the proposed approach's potential for split sourcing of income items will further complicate the allocation and apportionment of deductions to income from different sources. this should not be overly burdensome for taxpayers and tax authorities, as deductions allocated to split sourced income could be apportioned to the income from different sources based on the relative amounts of such income. cf reg. § 1.863-3(d) (using this method to allocate and apportion deductions to income from the manufacture of sale of inventory where the 50-50 method is used to determine the source of such income). 331. see supra notes 244-48 and accompanying text. 332. see kirsch, services, supra note 146, at 1053 & n.264. 333. see infra note 364. 628 [vol. 11:7 sourcing income among nations c. the need for international agreement that there be substantial international agreement on the sourcing standard and the rules developed thereunder is critical to the success of this article's endeavor.334 in the absence of such agreement, there would likely be an unacceptable amount of double taxation and non-taxation. this is because the proposed split sourcing approach is inconsistent with the current single source approaches that are typically used by countries. thus, if some countries use the proposed standard to devise source rules, but many other countries did not, there would be a great amount of inconsistency in the source rules used by nations probably considerably more so than under current law. this article recommends that the united states should take the lead in advocating the international acceptance of the proposed sourcing standard.3 the key would be having the support of the oecd, 3 which could then work to turn the sourcing standard into source rules that can be adopted by at least a substantial majority of countries. international agreement may well be attainable. in particular, it is certainly possible that countries could agree to share tax jurisdiction by agreeing to the fixed percentages that would generally be used to allocate income among the activities, destination, and residence countries. the fact 334. cf oecd, e-commerce, supra note 107, at 25 (stressing the need for universal agreement on rules for allocating taxing rights over business profits in order to prevent double taxation or non-taxation). 335. cf fleming, peroni & shay, fairness, supra note 165, at 339 (pointing out that the unilateral adoption of an approach that fractionally apportioned international income between the source and residence countries would result in double taxation probably being overor under-mitigated in most cases). 336. this would be similar to the united states having taken the lead in promoting the international adoption of the arm's length method for allocating income among commonly controlled corporations. see barbara angus, tom neubig, eric solomon & mark weinberger, the u.s. international tax system at a crossroads, 127 tax notes 45, 64 (2010). 337. cf graetz, multilateral solution, supra note 84, at 493 (suggesting that the oecd and european commission might lead the way in achieving a multilateral agreement for the treatment of interest expense that is based on worldwide allocation). 338. cf reuven s. avi-yonah & ilan benshalom, formulary apportionment myths and prospects: promoting better international tax policy by utilizing the misunderstood and under-theorized formulary alternative 26 (univ. of michigan pub. law & legal theory working paper series, paper no. 221, 2010), http://ssrn.com/abstract-1693105 (claiming that for a hybrid arm'slength/formulary apportionment regime to be operative, it would be sufficient if a "critical mass of countries that includes some major developed and emerging economies [adopts] such a regime"). 2011] 629 florida tax review that countries entering into tax treaties typically use identical provisions to reduce or eliminate source taxation on passive income demonstrates that such agreement is possible. 39 and beyond the split-sourcing aspect of the standard, the proposed approach is not at all radical: rather than introducing a new basis for allocating tax jurisdiction, the standard unifies into a splitsourcing approach the concepts that are currently used separately in single source rules.340 iv. using the standard to devise source rules this part uses the standard developed in the preceding part to suggest source rules for several types of income. the objective here is not to propose a comprehensive and detailed set of source rules that should be adopted on a multilateral basis. instead, it is to illustrate how the standard can be used to formulate certain source rules in order to provide a foundation for future efforts in this area. 339. see supra notes 22-23, 28 and accompanying text. 340. see supra part i1i.c.2. international agreement on this article's sourcing approach should be considerably less difficult than the multilateral adoption of formulary apportionment to allocate tax jurisdiction over the income of related multi-national corporations, a concept advocated recently by several notable commentators (see supra note 136). first, unlike the proposed sourcing approach, many nations may be quite reluctant to adopt formulary apportionment in lieu of arm's-length transfer pricing, given the lack of experience with large-scale formulary apportionment and the unknowns that it presents. see kleinbard, lessons, supra note 84, at 66 (referring to the susceptibility of formulary apportionment to gaming as an important unknown; concluding that "[i]t is difficult to imagine how a multilateral global formulary apportionment system can come to pass"). second, as compared to the adoption of uniform source rules, multilateral agreement on territorial taxation with formulary apportionment would involve greater tax stakes in that countries would exercise tax jurisdiction only over that income that is apportioned to them pursuant to the formula; with uniform source rules, countries would still have the option of exercising residual tax jurisdiction over their residents via foreign tax credit systems, as well as retain the ability to employ mechanisms designed to prevent their residents from avoiding current taxes on certain income that is allocated to tax haven corporations (see supra note 139). with lower tax stakes, international agreement on source rules should be more feasible. finally, a multilateral formulary apportionment system would require agreement on not only apportionment factors, but also on the tax base that would be subject to apportionment, the latter appearing quite unlikely given the differences in countries' tax bases and the value that countries attach to their particular tax regimes. see aviyonah & benshalom, supra note 338, at 15 (stating that "any attempt to form a comprehensive corporate tax base in the near future suffers from high failure probabilities"). harmonized source rules would not require multilateral agreement on a common tax base. 630 [vol. 11: 7 sourcing income among nations to recap, under the sourcing standard, the source of income should be evaluated on the basis of three factors: the destination of the services, property, or capital giving rise to income; the location(s) of the activities giving rise to income; and the residence of the person receiving income. based on this evaluation, a given item of income may have its source divided among multiple locations. below this standard is applied to suggest source rules for the following types of income: interest, dividends and stock 341 342gains, service income, income from intangibles, and inventory income. a. interest in using the standard to devise source rules for interest income, there should be separate treatment for interest received by passive investors and interest received by active lenders, such as banks and other financial businesses. for passive investors, the source of interest income should be 341. source rules developed pursuant to the standard would also need to address income from financial derivatives such as interest rate and equity swaps. one commentator has argued that because of the difficulty in subjecting equity swaps to u.s. source taxation, the united states should consider exempting u.s. source portfolio dividends (and perhaps all other u.s. source non-business income) earned by foreign persons from treaty countries. see col6n, supra note 146, at 780. recently, congress has gone in the opposite direction, and enacted a provision that sources payments pursuant to equity swaps involving u.s. source dividends (and other dividend equivalents involving u.s. source dividends) as if they were actual u.s. source dividends. see i.r.c. § 871(m). 342. as mentioned previously, since it is contemplated that there will be multilateral agreement on source via harmonized domestic rules, treaties would not generally alter the taxing rights of countries, although treaties may still affect to some degree the tax rates that apply to particular types of income. see supra 143 and accompanying text. with regard to the permanent establishment threshold for subjecting business income to source taxation, for administrative reasons it may be advisable to modify the threshold rather than eliminate it entirely. the current threshold, which relies on physical presence (see supra notes 37-38 and accompanying text), should not be used; it would prevent source taxation of income from remote activities that would be sourced to the destination country pursuant to the proposed sourcing standard. however, subjecting remote sellers or service providers to the tax jurisdiction of destination countries in all situations could be administratively burdensome for taxpayers and tax authorities. accordingly, it may be sensible to retain the permanent establishment threshold, but modify it so that a taxpayer would not be subject to source taxation on business income where there are a de minimis amount of sales into a country. other commentators have made similar recommendations. see, e.g., avi-yonah, globalization, supra note 231, at 1671. of course, modifying the permanent establishment threshold to remove the physical presence requirement raises enforcement concerns in taxing remote sellers and the like, which would need to be addressed in devising source rules. see supra part iii.c.3.b. 6312011] florida tax review divided between the residence country of the interest recipient and the destination country of the funds that are loaned. because a passive investor will have performed minimal activities in making the loan, none of the interest should be sourced under the activities component of the standard. the division of the interest income between the residence and destination countries should be based on a fixed percentage that is agreed to internationally. there are several possibilities for determining the destination of the loaned funds, considering the public benefits that relate to the interest income. one option would be to source the destination component according to the residence of the borrower. this is based on the view that the borrower's country of residence is presumably where the borrower derives the income or wealth that fund the interest payments, and that the public benefits provided by this country thus indirectly benefit the interest recipient.343 a more refined approach in this regard would be to focus on specific factors that indicate the location of the borrower's economic activities; for this urpose, the relevant activities could be those of the borrower in general or those that relate to funding the particular interest payments.3 45 a third option would be to combine the first two options: the destination of the loaned funds would presumptively be the residence of the borrower unless there are clear indicia that the borrower was conducting relevant economic activities at another location. this third option appears the most appropriate as it strikes a reasonable balance between the benefits principle and administrabilty. it is also similar to the approach under current 343. cf lokken, source, supra note 49, at 28 (stating that under a benefitsbased model for sourcing income, "interest originates where the borrower utilizes the borrowed funds because governmental services and protections at that location are central to the success of the borrower's venture, which generates the capacity to pay interest on the loan;" concluding that the current source rule for interest, which generally assigns all interest income to the obligor's country of residence, is probably the best available approximation given the practical difficulties of a more refined approach and the fact that most obligors locate their activities and investments predominantly in their countries of residence); ali project i, supra note 14, at 67-68 (stating that the general principle underlying the source rules for interest appears to be that interest should be sourced in the country that is reasonably presumed to be the place where the borrower derives the income or wealth from which the interest is paid; stating that a fair presumption is that in most cases the borrower's country of residence or domicile is where the borrower's economic interests are centered). 344. cf ali project i, supra note 14, at 68 (pointing out that in certain circumstances, current u.s. law disregards the borrower's residence or domicile and sources interest based on the geographic composition of the borrower's income). 345. cf id. at 69-70 (recommending an approach for sourcing interest that in part focuses on the location of real estate or a business that the interest relates to). 632 [vol. 11:7 sourcing income among nations u.s. law,346 except that the u.s. rule applies to source the entire amount of interest, as opposed to just the destination component. where the interest recipient is a bank or other financial entity, the source results should be the same as above except that a portion of the interest income would also be assigned to the country (or countries) where the taxpayer conducts significant activities that relate to the lending transaction. as discussed previously, the portion sourced to the activities component should be based on a fixed percentage agreed to internationally. this portion may be further apportioned between two or more countries where significant activities related to the transaction occur at multiple countries; such apportionment could be done either based on the ratio of arm's length charges for the lending activities at the different locations or by using fixed percentages. b. income from corporate stock 1. dividends dividend income should be sourced in a manner that is similar to the sourcing of interest income. that is, for passive investors a portion of the dividends should be allocated to the shareholder's residence country and a portion should be allocated to the destination country of the invested capital, with the portions determined on the basis of a fixed percentage. as with interest received by passive investors, none of the dividend income should be sourced based on the activities component of the standard; this is because the shareholder's activities in connection with earning the dividends are likely to be minimal. similar to sourcing interest income, there are several options in determining the destination country of the shareholder's invested capital. one possibility would be to look to the country of incorporation based on the view that this country is providing the shareholder with public benefits through its legal system that protects and regulates the shareholder's investment in the corporation.34 7 alternatively, the destination country could be considered the country or countries where the corporation is engaged in significant business activities.34 8 this is because such countries provide 346. see supra notes 17-18 and accompanying text. 347. cf ali project i, supra note 14, at 62-63 (stating that the traditional rule, which sources dividends to the country of the distributing corporation's domicile, gives controlling weight to the fact that the distributing corporation derives its legal capacity from its country of domicile). 348. cf id. at 63 (referring to this approach as alternative way of sourcing dividends). whether activities in a country are considered significant for this purpose could be based on a certain threshold percentage of the corporation's gross income. see, e.g., i.r.c. § 861(a)(2)(b) (using a threshold of 25 percent of a foreign 2011] 633 florida tax review public benefits that relate to the corporate earnings that in turn are the economic source of the dividends;349 in other words, the countries where the corporation conducts activities provide indirect public benefits to the shareholders. a third option would be to take into account both the corporation's country of incorporation and significant activities countries by apportioning the destination portion of the dividend among these countries; if this is done, a fixed percentage should be used for this purpose. if all or a portion of the destination portion of the dividend is sourced according to the location of the corporation's significant business activities, it would be advisable to base this determination on the composition by source of the 350corporation's gross income. determining the source of dividend income based on the income composition of a corporation raises complications in imposing a source tax that is collected through withholding.3 ' for this reason,352 in lieu of a secondary dividend tax, the united states and some other countries exact a second level of tax on the domestic earnings of foreign corporations by imposing a branch profits tax on such corporations. assuming that the destination portion of dividends will not be sourced exclusively on the basis of the corporation's country of incorporation, countries should continue to have the option of using a branch profits tax as a surrogate for taxing a portion of dividends. where the dividend recipient is a securities dealer or otherwise holding corporate stock in the conduct of an active business, it seems appropriate to modify the source results by assigning a portion of the dividend to the country (or countries) where the taxpayer conducts significant activities that relate to the acquisition of the stock. if this is done, corporation's gross income being u.s. effectively connected income to determine whether a portion of dividends paid by the corporation is sourced to the united states). 349. see ali project i, supra note 14, at 63; lokken, source, supra note 49, at 27. 350. to illustrate, if the third option were used, a fixed percentage of the destination portion of the dividend would be assigned to both the corporation's country of incorporation and the country (or countries) where the corporation conducts economic activities; where the corporation has significant activities in more than one country, the latter portion would be further apportioned according to the percentages of corporate income derived from each country. 351. see 1986 bluebook, supra note 60, at 1036-37; ali project i, supra note 14, at 141; fred b. brown, reforming the branch profits tax to achieve neutrality, 25 va. tax rev. 1219, 1225 (2006) [hereinafter brown, branch profits tax]. 352. see 1986 bluebook, supra note 60, at 1037; brown, branch profits tax, supra note 351, at 1225. 353. see, e.g., i.r.c. § 884; see also ault & arnold, supra note 5, at 51617. 634 [vol. 11:7 sourcing income among nations the portion sourced to the activities component should be based on a fixed percentage agreed to internationally. this portion may be further apportioned between two or more countries where significant activities related to the transaction occur at multiple countries; such apportionment could be done either based on the ratio of arm's length charges for the activities at the different locations or by using fixed percentages. 2. stock gains the gain on the sale of stock by assive investors should be sourced in the same way as dividend income. 4 economically, a stock gain is essentially a market capitalization of a corporation's future earnings."' consequently, the same reasons that support the rights of the residence and destination countries to tax portions of the dividend should apply with equal force to stock gains.3 ss in particular, the country or countries where the corporation is incorporated and/or doing business are providing the selling shareholder with important public benefits that contribute to the value of the stock investment, both directly through legal protection and indirectly through benefits provided to the corporation. while current law usually sources stock gains realized by investors exclusively to the taxpayer's country of residence,35 7 this treatment appears to be mainly due to perceived administrative and enforcement concerns of imposing a source tax on such gains.358 as has been pointed out by other commentators, these concerns can be addressed by applying withholding procedures similar to those that apply under u.s. law for taxing foreign persons on sales of stock in u.s. real property holding corporations.359 c. service income income received for performing services should be sourced by dividing the income among the country where the service provider resides, the country (or countries) where the services are performed, and the country where the services are either used or consumed. fixed percentages should be used for making these allocations. where services are performed in more 354. stock gains realized by dealers should be sourced according to the rules for inventory. see infra part iv.e. 355. see shay, fleming & peroni, source rules, supra note 1, at 122. 356. id. (stating that if the market access rationale supports a source tax on dividends, it should also support a source tax on stock gains). 357. see supra notes 39-42 and accompanying text. 358. see shay, fleming & peroni, source rules, supra note 1, at 122. 359. see cynthia blum, how the united states should tax foreign shareholders, 7 va. tax rev. 583, 643-51 (1988); shay, fleming & peroni, source rules, supra note 1, at 145. 6352011] florida tax review than one country, the place of performance portion should be further apportioned between two or more countries based on either the time spent or payroll costs incurred in each of the countries in performing the services. under this rule, where services are performed in one country for use or consumption in another country, both countries, in addition to the service provider's country of residence, would have the primary right to tax a portion of the income. while current u.s. law focuses exclusively on where the services are performed, some countries use a destination approach for sourcing service income,3 60 and a few commentators view market access as a justification for imposing a source tax on services performed remotely.3 61 indeed, a recent article emphasizes that the continued reliance on a service provider's physical presence in sourcing service income will become increasing untenable with the prevalence of remote services in the modem economy.3 2 while not inconsistent with these views, this article calls for an approach that divides the source of service income in recognition of the public benefits provided at each of the relevant locations. an important caveat to the suggested rule for sourcing service income is the ability of the destination country to enforce a source tax on services performed remotely. while withholding by the service recipient should be feasible where the recipient is a business, difficulties will be encountered where services are rendered remotely to a broad range of individual consumers, such as in the case of electronic commerce.36 3 enforcement mechanisms must be developed before the implementation of a rule that sources a portion of service income to the destination of remotely performed consumer services. in this regard, commentators have suggested possible enforcement structures for taxing electronic commerce. 360. see supra notes 29-31 and accompanying text. 361. see avi-yonah, electronic commerce, supra note 135, at 537-40; kirsch, services, supra note 146, at 1040-41 & n.211, 1066. in a similar vein, another commentator has proposed a market state approach to the sourcing of service receipts for dividing the business income of multistate enterprises under uditpa for state corporate income tax purposes. see john a. swain, reforming the state corporate income tax: a market state approach to the sourcing of service receipts, 83 tul. l. rev. 285, 346-53 (2008). 362. see kirsch, services, supra note 146, at 1073. 363. see id. at 1053. 364. see shay, fleming & peroni, source rules, supra note 1, at 145-46 (stating that because electronic commerce involves "credit or debit charges, or electronic cash payment facilities, it may be possible to rely on these payors in some fashion to structure a viable enforcement mechanism in the future"); avi-yonah, electronic commerce, supra note 135, at 537-38 (proposing a gross withholding tax that would be imposed "by the demand jurisdiction unilaterally by forbidding merchants from selling goods to its residents unless procedures for withholding the tax are in place"). 636 [vol. 11:7 sourcing income among nations d. income from intangibles 1. royalties in using the standard to devise a source rule for royalties, it is important to distinguish between situations where the taxpayer purchased the intangible that is licensed and where the taxpayer developed the licensed intangible. in the former situation, the source of royalty income should be divided between the licensor's country of residence and the country where the intangible is used. this assumes that the taxpayer is not engaged in an active business of licensing intangibles, and thus none of the royalty income should be sourced based on the activities component of the standard because the taxpayer's activities would seem to be relatively insignificant to the economics of the transaction.6 if the transaction occurs in the active conduct of a licensing business, it should be appropriate to allocate a portion of the royalties to the country or countries where the licensing activities take place. 66 as in other situations, the division of the royalty income should be based on fixed percentages. the place of use should typically be the country that provides the legal protections that relate to the intangible.3 6' this country should have the right to tax a portion of the royalties because through its laws and legal system the destination country provides the taxpayer with the public benefits that permit the earning of the royalty income.368 the destination country also provides the taxpayer with indirect benefits that relate to the royalty income by providing public benefits to the taxpayer's licensee that contribute to the licensee's ability to earn income that is typically shared with the licensor via contingent royalty payments.369 365. see ali project i, supra note 14, at 45; lokken, intellectual property, supra note 57, at 240. 366. current u.s. law provides some support for sourcing a portion of royalties to the place where a taxpayer performs significant licensing activities in connection with an active business. under section 864(c), foreign source royalties received by a foreign person are subject to u.s. net basis taxation where the royalties are derived in the active conduct of a u.s. business and attributable to the foreign person's u.s. office. see i.r.c. § 864(c)(4)(a) and (b), (c)(5). of course, under this provision, the united states has tax jurisdiction over the entire amount of the royalties, not just a portion. 367. see shay et al., task force, supra note 26, at 773. as under current law, complications would arise in determining the place of use where the intangible provides protection in more than one country. see ali project i, supra note 14, at 50-52; lokken, intellectual property, supra note 57, at 277-86. 368. see ali project i, supra note 14, at 45; lokken, intellectual property, supra note 57, at 240-41. 369. see ali project i, supra note 14, at 45 2011] 637 florida tax review where the taxpayer developed the licensed intangible, the source of the royalty income should be divided among the taxpayer's country of residence, the country (or possibly countries") where significant development activities took place, and the country where the intangible is used; again, fixed percentages should be used to divide the income."' the country where significant development activities occur provides important public benefits in support of such activities and thus should have the right to tax a portion of the royalty income.372 and using a fixed percentage to assign a portion of the royalties to the development country should remove the administrative concerns regarding such allocations that have been voiced by commentators.7 while this allocation approach is imprecise, it is superior to ignoring the development country in assigning source in light of the public benefits provided there. 2. intangible gains gain on the sale of an intangible should be sourced in the same manner as royalties.374 thus, for purchased intangibles, the source of the gain should be divided between the taxpayer's country of residence and the country where the intangible will be used; for developed intangibles, the 370. where the taxpayer conducts significant development activities in two or more countries, it may be advisable to further apportion the portion of the royalties assigned to development activities; this should probably be done using fixed percentages because of difficulties in valuing the relative contributions of different development activities. 371. this assumes that the licensing transaction is not in connection with an active business. if it were, it would be appropriate to source a portion of the royalties to the location of the licensing activities. see supra note 366 and accompanying text. 372. see supra note 234 and accompanying text; cf lokken, intellectual property, supra note 57, at 242 (acknowledging that with regard to royalty income received from the license of intangible property developed by the taxpayer, both the country that was the situs of development activities and the country where the intangible is used provide important services and protections). 373. in this regard, commentators have recognized the conceptual basis for dividing the source of such royalty income between the country of development and country of use, but declined to do so mainly for administrative reasons. see ali project i, supra note 14, at 48; lokken, intellectual property, supra note 57, at 242-43. 374. other commentators have also proposed using the same rule to source both royalties and intangible gains. see ali project i, supra note 14, at 47-50; lokken, intellectual property, supra note 57, at 244. unlike the proposal here, these commentators would use the place of use rule to source both items. see id. under current u.s. law, intangible gains are sourced the same as royalties only where the gains are contingent on the productivity, use or disposition of the intangible. see i.r.c. § 865(d)(1). 638 [vol. 11:7 sourcing income among nations source of the gain should be divided among the taxpayer's country of residence, the country (or possibly countries375 ) where the development activities took place, and the country where the intangible will be used.176 again, fixed percentages should be used to divide the income. the same reasons that support this approach for royalties also apply with respect to intangible gains. a taxpayer who realizes gain on the sale of an intangible receives public benefits from the country from which the intangible derives its legal protection; without this protection, which is a product of the laws and legal system of the country providing it, the intangible would lack value and the gain would not be realized.377 and where the taxpayer has developed the intangible, whether the intangible is licensed or sold, the country where significant development activities take place provides important public benefits that relate to the taxpayer's ability to earn the income. 7 an additional reason for applying the same source rule for royalties and intangible gains is that this approach will avoid the difficult issue of determining whether a transfer of an intangible should be characterized as a license or a sale. 379 indeed, with the proposed rule for service income, the same or similar source rules would apply to royalties, intangible gains, and service income, putting considerably less stress on property/service characterization issues. 375. see supra note 370. 376. this assumes that the sales transaction is not in connection with an active business. if it were, it would be appropriate to source a portion of the gain to the location of the sales activities. 377. see lokken, intellectual property, supra note 57, at 244 (in proposing that intangible gains should be sourced based on where the intangible will be used, pointing out the importance of the services and protections provided by the country in which the intangible is exploited). 378. see id. (in considering but ultimately rejecting an approach dividing intangible gain between the country of development and country of the sale, noting that the services and protections provided by the country that is the location of development activities can be viewed as significant factors in creating the intangible). 379. see ali project i, supra note 14, at 47. 380. cf id. at 53-57 (discussing these difficulties). in this regard, the treasury has issued regulations that attempt to address these characterization issues in the context of transactions involving computer programs. see reg. § 1.861-18. 2011] 639 florida tax review e. income from the sale ofinventory in using the standard to devise a source rule for income from the sale of inventory, it is important to distinguish between situations where the taxpayer purchased the inventory and where the taxpayer produced the inventory. for purchased inventory, the source of the inventory income should be divided among the taxpayer's country of residence, the country or countries where significant sales activities take place, and the country in which the inventory is used or consumed. fixed percentages should be used to divide the income. the portion assigned to the location of sales activities should be further apportioned between two or more countries where significant sales activities related to the transaction occur in multiple countries;"' such apportionment should probably be done based on the ratio of arm's length charges for the activities at the different locations, although the use of fixed percentages may be an acceptable alternative. this source rule recognizes the related public benefits provided to the taxpayer by each of the residence, activities, and destination countries.382 where the taxpayer produced the inventory, the source of the inventory income should be divided among the taxpayer's country of residence, the country (or countries) where significant production activities take place, the country (or countries) where significant sales activities take place, and the country in which the inventory is used or consumed. in this situation, portions of the inventory income would be assigned to two different types of activities production and sales. fixed percentages should be used to allocate the inventory income among the three categories of countries: that is, a certain percentage of the income should be assigned to the residence country, a certain percentage of the income should be assigned to the destination country, and a certain percentage of the income should be assigned to the countries where production and sales activities occur. it would then be necessary to further divide the portion of the income assigned to production and sales activities. as mentioned previously, it would be 381. this can occur where one branch is performing a wholesaling function and another is performing a retail selling function; it can also occur where the taxpayer is either a wholesaler or a retailer, but different functions are performed at different branches for example, storage and shipping at one branch with solicitation and negotiation at another branch. 382. in this regard, the american law institute found that it may be appropriate for inventory income to be sourced in either the activities country or the destination country in light of the related public benefits provided by each of these countries. see all project i, supra note 14, at 20. ultimately, the ali settled on a recommended rule that focuses primarily on the country where the sales activities take place, but gives weight to the destination country in certain situations. see id. at 23. 640 [vol. 11:7 sourcing income among nations advisable to do so based on the ratio of arm's length charges for the production and sales activities. as previously discussed,3" the destination country should have the right to tax a portion of the inventory income because the taxpayer accesses this country's market by selling goods to consumers and businesses located therein. since a country's market is in large part a product of government activities, the destination country is providing the taxpayer with important public benefits that justify source taxation. and this holds true even when the taxpayer has no physical presence in the destination country. nevertheless, it may be difficult for the destination country to enforce a source tax where goods are sold remotely to individual consumers, such as in the case of electronic commerce. consequently, as with remote services, applying the destination component of the source rule to remote sales of consumer goods would need to be conditioned on the creation of adequate mechanisms for enforcing a source tax. 5 v. conclusion the current source of income rules used in the united states and other countries are crucial to the functioning of the international tax rules because they essentially establish the contours of tax jurisdiction that is exercised by countries. however, the current approach for sourcing income suffers from a lack of coherence and international conformity. this article addresses both of these problems by offering an equity-based approach for . sourcing income that has the potential for being adopted by countries on a multilateral basis. by basing the source rules on a benefits principle-based standard that allows income source to be divided when appropriate, this article seeks to rationalize and harmonize the provisions used to source income for purposes of taxing cross-border investment and business activities. 383. where production activities occur at more than one location, the portion assigned to production activities should be further divided. an asset-based apportionment method could be used for this purpose. see reg. § 1.863-3(c) (employing this approach under current u.s. law). 384. see supra notes 244-48 and accompanying text. 385. see supra note 364 and accompanying text. 6412011] login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review florida tax review volume 14 2013 number 8 319 startup ltd.: tax planning and initial incorporation location by susan c. morse* i. introduction ............................................................................. 320 ii. why startups’ place of incorporation matters for tax ........................................................................................ 322 a. being a us-parented mnc ............................................... 322 b. being a non-us-parented mnc ....................................... 326 iii. us incorporation: a dominant structure with exceptions .................................................................................. 329 a. us-based startups generally incorporate in the us ....... 329 b. exceptions ......................................................................... 334 iv. explaining the dominant structure ....................................... 337 a. limited tax benefits of a non-us-parent structure ........ 337 b. legal benefits of a us-parent structure........................... 339 c. liquidity and other resource constraints ....................... 342 d. considering future law changes .................................... 349 v. theorizing the exceptions: what facilitates a non-us parent structure? ................................................... 354 a. tax factors ....................................................................... 354 b. nontax legal factors ....................................................... 356 * assistant professor, university of texas school of law. this project was largely completed while the author served as associate professor of law at uc hastings college of the law, and the uc hastings summer research stipend program provided funding. many thanks for helpful comments to participants at the university of florida levin college of law eighth annual international tax law symposium and at the 2013 critical tax conference; to eric allen, william dodge, victor fleischer, and stephen shay; and to participants in workshops and colloquia at uc hastings, santa clara university school of law, sturm college of law at the university of denver, boston college school of law, and the school of taxation and business law at the university of new south wales. 320 florida tax review [vol. 14:8 c. liquidity and other resource constraints ....................... 357 d. investor preferences ......................................................... 358 vi. conclusion ................................................................................. 359 i. introduction do startup firms consider taxes when they decide where to organize? this article analyzes the incorporation decisions of relatively new, us-based private business enterprises with global ambitions. such startup firms generally organize as us corporations. this article theorizes this dominant structure and its exceptions, drawing from prior literature and illustrating with informal interview results. it identifies explanatory factors including limited tax benefits of non-us incorporation, legal benefits of us incorporation, startups’ liquidity and other resource constraints, and investor preferences. part ii explains the different treatment of usand non-us-parented multinational corporations (mncs) under us federal income tax law. some non-us-parented mnc structures have tax advantages compared to usparented mnc structures. this prompts the hypothesis that us-based startup corporations may incorporate outside the united states,1 for example in a tax haven jurisdiction, if the non-tax costs of a non-us incorporation decision are sufficiently low.2 part iii reports that available empirical work shows few examples of startup corporations headquartered in the united states and incorporated in tax haven jurisdictions.3 prior work4 and informal interviews reported here 1. see, e.g., mihir a. desai & dhammika dharmapala, do strong fences make strong neighbors?, 63 nat’l tax j. 723, 724 (2010) [hereinafter desai & dharmapala, strong fences] (noting incentive for new firms with global business plans to use a non-us parent corporation). 2. see daniel shaviro, the david r. tillinghast lecture the rising taxelectivity of u.s. corporate residence, 64 tax l. rev. 377, 383–84 (2011) [hereinafter shaviro, rising tax-electivity of u.s. corporate residence] (noting that the degree of electivity turns on “nontax consequences”). 3. see, e.g., eric j. allen & susan c. morse, tax-haven incorporation for u.s.-headquartered firms: no exodus yet, 66 nat’l tax j. 395, 395 (2013) [hereinafter allen & morse, tax-haven incorporation for u.s.-headquartered firms] (reporting twenty-seven instances of tax haven incorporation among 918 identified us-headquartered multinational ipo firms). 4. this analysis builds on work that has considered the puzzle of the typical startup’s decision to organize as a corporation and not as an entity taxed as a partnership. see, e.g., joseph bankman, the structure of silicon valley start-ups, 41 ucla l. rev. 1737 (1994) [hereinafter bankman, the structure of silicon valley 2013] tax planning and initial incorporation location 321 support the conclusion that venture-backed silicon valley startups generally organize in the united states, form corporations rather than partnerships or llcs, and prefer the state of delaware as an incorporation jurisdiction. available examples, drawn in large part from initial public offering (ipo) evidence, corroborate the conclusion that delaware incorporation is the norm. the evidence also reveals exceptions to the general rule of us incorporation concentrated in particular industries, such as insurance and marine transportation. part iii also identifies several additional examples of us-based, non-us-incorporated firms, scattered among different industries. part iv explores several possible reasons for the dominant structure of us incorporation for startup firms. one reason is the limited relative tax advantages of non-us incorporation. for example, us-parented mncs can often obtain low tax rates on non-us income, sometimes access offshore cash without onerous us tax results, and erode their us taxable income base to some extent. another reason is that a us-parented structure can provide corporate governance and other non-tax legal advantages. in addition, because us incorporation is a familiar “cookie cutter” structure for startups, it requires fewer monetary and other startup company resources. this is important to startups with liquidity constraints. investor preference, or at least investor familiarity with the delaware corporate form, also plays a role. market participants share the perception that venture capital (vc) firms, an important source of financing for startup companies, favor investments in us corporations, although venture capitalists describe portfolios that include investments that take a range of organizational forms. even if current us tax laws do not provide a significant incentive for a typical startup corporation to incorporate outside the united states, congress could change these laws in the future so as to greatly increase the tax burden placed on us-parented multinationals. yet the possibility of future change in us tax law does not appear to affect most startups’ incorporation location decisions. startups have reason to discount the possibility of future changes in us tax law adverse to us-parented mncs because of the strength and diversity of corporate lobbying efforts. startups and their advisors may conversely worry more about the possibility of start-ups]; victor fleischer, the rational exuberance of structuring venture capital start-ups, 57 tax l. rev. 137 (2003) [hereinafter fleischer, the rational exuberance of structuring venture capital]; daniel s. goldberg, choice of entity for a venture capital start-up: the myth of incorporation, 55 tax law. 923 (2002) [hereinafter goldberg, choice of entity for a venture capital start-up]; calvin h. johnson, why do venture capital funds burn research and development deductions, 29 va. tax rev. 29 (2009) [hereinafter johnson, why do venture capital funds burn research and development deductions]; eric j. allen & sharat raghavan, the impact of non-tax costs on tax-efficiency of venture capital investments (april 16, 2013) [hereinafter allen & raghavan, the impact of non-tax costs on tax-efficiency] (available at ssrn.com) (manuscript on file with the author). 322 florida tax review [vol. 14:8 changes adverse to non-us-parented mncs because they perceive a higher likelihood of such changes inside or outside the united states. they also likely face a higher degree of uncertainty about the possibility of adverse changes applicable to non-us-parented firms. part v theorizes the noted exceptions to the dominant trend of us incorporation for us-based startups. it suggests that tax factors may drive some non-us incorporation decisions. for example, a favorable set of tax rules supports a bermuda incorporation decision for certain insurance companies that cover us risks. in addition, nontax legal factors play a role in encouraging some firms to incorporate outside the united states. a number of tax and nontax legal factors facilitate marine transportation firms’ non-us incorporation decisions, for example. online gambling provides another example of an industry in which regulatory factors have supported a non-us incorporation decision. additional anecdotal examples of us-based, tax-haven-incorporated firms also suggest that resource constraints and investor preferences influence non-us incorporation decisions. with respect to resource constraints, several us-based, non-us incorporated firms received funding from deep-pocketed sources other than venture capital funds. in each of these cases, one or more wealthy individuals, a large corporation or a private equity firm made an up-front investment in a custom, tax-haven-parented structure. with respect to investor preferences, founder or investor links with an incorporation jurisdiction might lead to a preference for non-us incorporation. an investor preference for non-us incorporation might proceed from current tax and non-tax legal considerations specific to the investor, or simply from greater familiarity with non-us law on the part of the investor or the investor’s advisors. separately, the investor might believe that non-us incorporation would further the goal of positioning the startup firm as a more attractive acquisition candidate. ii. why startups’ place of incorporation matters for tax a. being a us-parented mnc us law uses a brittle place-of-incorporation rule to determine corporate tax residence.5 a firm incorporated in delaware that lacks any corporate functions in the united states must still pay us corporate income tax. a firm incorporated in bermuda and headquartered in and managed 5. see i.r.c. § 7701(a)(4). 2013] tax planning and initial incorporation location 323 from the united states does not automatically pay us corporate income tax by reason of corporate residence.6 a typical us-parented mnc structure features a us corporate parent that owns non-us operating subsidiaries through intermediate low-tax holding corporations.7 because the us rules treat separately incorporated affiliates as separate taxpayers,8 non-us corporate subsidiaries of a us parent are not automatically required to pay us federal income tax on all of their income. under applicable anti-deferral and other rules, a us-parented mnc must currently pay tax on the income of its foreign subsidiaries to the extent such income falls into the definition of “subpart f income”9 or is distributed as dividend income, in each case subject to the reduction of us tax under applicable foreign tax credit provisions.10 us-parented mncs use transfer pricing, deduction allocation, income source and subpart f planning to allocate profits to low-tax subsidiaries and use foreign tax credit planning, treaty planning, base erosion strategies, and borrowing to minimize non-us taxes and the residual us federal income tax due upon repatriation.11 as a result, the non-us income 6. see shaviro, rising tax-electivity of u.s. corporate residence, supra note 2, at 377–78 (2011) (noting the difference in us tax results that turns on place of incorporation). 7. edward d. kleinbard, stateless income, 11 fla. tax rev. 699, 706–09 (2011) [hereinafter kleinbard, stateless income] (giving google structure as an example). 8. see commissioner v. bollinger, 485 u.s. 340 (1988); moline properties inc. v. commissioner, 319 u.s. 436 (1943). 9. i.r.c. § 951(a). subpart f is intended to impose current tax on mobile and passive income. see, e.g., lawrence lokken, whatever happened to subpart f? u.s. cfc legislation after the check-the-box regulations, 7 fla. tax rev. 185, 192 (2005) (noting that subpart f does not target active business income); stephen e. shay, exploring alternatives to subpart f, 82 taxes 29, 29–30 (2004) (referring to subpart f’s targeting of passive and base company income). 10. see i.r.c. § 901 (granting foreign tax credit); § 902 (providing for deemed paid foreign tax credit when foreign corporations distribute dividends to certain us corporate shareholders); § 904 (providing foreign tax credit limitation rules). 11. see j. clifton fleming, jr., robert j. peroni & stephen e. shay, worse than exemption, 59 emory l. j. 79, 85 (2009) (noting “overly generous” tax benefits enjoyed by us corporations); kleinbard, stateless income, supra note 7, at 715–26 (arguing that the us international corporate tax system is an “ersatz territorial” system); lawrence lokken, territorial taxation: why some u.s. multinationals may be less than enthusiastic about the idea (and some ideas they really dislike), 59 smu l. rev. 751, 759 (2006) (explaining that “refined” tax planning permits many us-parented mncs to pay less under current rules than they would under a territorial system). with respect to the important technology industry strategy of offshoring intangibles at advantageous valuations, see yariv brauner, 324 florida tax review [vol. 14:8 earned by us-parented mncs often enjoys both a low foreign effective tax rate and a low us effective tax rate.12 for example, it is estimated that the us income tax burden on non-us business income earned by non-us subsidiaries in mnc groups is perhaps between 3 and 6 percent.13 us-parented mncs may also may seek ways to allocate income related to us operations to low-taxed non-us affiliates, and conversely to allocate deductions away from low-taxed non-us affiliates and to us operations.14 the ability of firms to erode the us tax base through such planning has led some to conclude that the current us system raises less tax revenue than would a “territorial” system that refrained from taxing non-us value in the eye of the beholder: the valuation of intangibles for transfer pricing purposes, 28 va. tax rev. 79, 85–95 (2008). 12. see harry grubert, foreign taxes and the growing share of u.s. multinational company income abroad: profits, not sales, are being globalized, 65 nat’l tax j. 247, 281 (2012) (reporting a decline in the average effective foreign tax rate for non-us subsidiaries of us parent corporations from about 21 percent in 1996 to about 16 percent in 2004). see also aba tax’n sec. task force, report of the task force on international tax reform, 59 tax law. 649, 655–56 (2006) (“the effective rate of us and foreign income taxation of foreign income is understood to be materially lower than the effective rate on domestic income.”). 13. see melissa costa & jennifer gravelle, taxing multinational corporations: average tax rates, 65 tax l. rev. 391, 403–04 (2012) (reporting based on 2007 treasury tax return data an annual us tax on adjusted foreign-source book income of about $18 billion, representing 3.3 percent of such income); see also harry grubert & john mutti, taxing international business income: dividend exemption versus the current system 31-32 (2001) (reporting a 3.3 percent estimate for the overall burden of a dividend repatriation tax assuming an excess limitation foreign tax credit position and a non-us effective tax rate below 10 percent); rosanne altshuler & harry grubert, where will they go if we go territorial? dividend exemption and the location decisions of u.s. multinational corporations, 54 nat’l tax j. 787, 797 (2001) (calculating a rate of 5.4 percent based on certain assumptions including a 1.7 percent “excess burden” measure and the us taxation of royalties from intangible assets). 14. see, e.g., kimberly a. clausing, multinational firm tax avoidance and tax policy, 62 nat’l tax j. 703, 711, 717 (2009) (estimating “financial” incomeshifting and “real” productive asset location-shifting responses to higher us tax rates and concluding that the financial effects, producing lost tax revenue of about $87 billion in 2002, were more than double the real effects). the oecd base erosion and profit shifting, or beps, project lists as one of its headline goals “limit[ing] base erosion via interest deductions and other financial payments.” organisation for economic cooperation and development, action plan on base erosion and profit shifting 17 (2013). 2013] tax planning and initial incorporation location 325 business income,15 although the revenue estimate depends on the details of such a territorial system.16 once a firm has chosen a us-parented structure, it is difficult to change to a non-us parented structure. applicable rules require gain recognition (but prevent loss recognition) upon such an inversion.17 moreover, under an anti-inversion statute enacted in 2004,18 a mnc is still treated as a us-parented firm even after acquisition by a foreign corporation if (i) at least 80 percent of the foreign corporation’s stock is owned by former owners of the us parent (by reason of their former ownership of the us parent) and (ii) the firm lacks substantial business activities in the country in which the new foreign parent is incorporated.19 the anti-inversion statute and related regulations leave room for us corporations to invert in connection with an acquisition transaction, but severely limit options for stand-alone inversion transactions.20 policymakers may take an interest in 15. see supra note 11. 16. see, e.g., harry grubert, enacting dividend exemption and tax revenue, 54 nat’l tax j. 811, 814 (2001) (providing a static revenue gain estimate of $9 billion based on 1996 treasury data and evaluating possible behavioral responses to territoriality adoption including “adjustments to overhead expenses and royalty payments”). 17. see i.r.c. § 367; u.s. treasury office of tax policy, corporate inversion transactions: tax policy implications (2002). 18. see i.r.c. § 7874. 19. see jefferson p. vanderwolk, inversions under section 7874 of the internal revenue code: flawed legislation, flawed guidance, 30 nw. j. int’l l. & bus. 699, 699 (2010). section 7874 also imposes other inversion restrictions, such as a gain recognition requirement triggered by a lower ownership overlap threshold. 20. after the initial passage of section 7874, some firms took advantage of a facts-and-circumstances “substantial business activities” test and expatriated to create structures with parents in ireland, switzerland, and the uk. see stuart webber, inverted u.s. firms relocate headquarters to europe, 64 tax notes int’l 589, 591 (nov. 21, 2011) [hereinafter webber, inverted u.s. firms relocate] (providing summary chart); bret wells, cant and the inconvenient truth about corporate inversions, 136 tax notes 429, 430–36 (july 23, 2012) [hereinafter wells, cant and the inconvenient truth about corporate inversions] (describing different forms of acquisition and stand-alone inversion transactions). recent temporary and proposed treasury regulations substantially curtail stand-alone transactions by imposing a 25 percent threshold for sales, property, and employees with respect to the substantial business activities requirement. see temp. reg. § 1.7874-3t; kevin m. cunningham, the new section 7874 substantial business activity exception regulations: closing the door, 67 tax notes int’l 961, 962 (sept. 3, 2012) (explaining the change from a facts-and-circumstances rule); eric solomon, corporate inversions: a symptom of larger tax system problems, 136 tax notes 1449, 1454–55 (sept. 17, 2012) [hereinafter solomon, corporate inversions: a symptom of larger tax system problems] (stating that inversion can 326 florida tax review [vol. 14:8 whether startups’ habit of incorporating in the united states will change under reform alternatives that increase the tax burden placed on us-parented multinational corporations (mncs). in particular, they may worry that such reforms might drive us-based startups to incorporate outside the united states instead, taking economic activity with them.21 b. being a non-us-parented mnc an alternative structure features an mnc headquartered in the united states, but whose parent is incorporated in a non-us country. the non-us parent might be incorporated in a tax haven that imposes a very low, often zero, rate of corporate income tax,22 and treats foreign subsidiaries and income favorably, for example through a territorial system that only taxes domestic income exempts dividends distributed from foreign subsidiaries to domestic parents.23 the non-us parent would typically own a us subsidiary that houses the us management and us business operations, as well as other subsidiaries incorporated in non-us jurisdictions.24 tax treaty planning constitutes an important element of a non-usparented, us-headquartered mnc structure. a treaty relationship between the non-us parent and the us subsidiary would substantially reduce the continue via merger and acquisition transactions after the revised § 7874 regulations). 21. see, e.g. senate finance committee staff, tax reform options for discussion: international competitiveness 4 (may 9, 2013) (expressing concern about us tax incentives for multinationals “to be foreign-based”); see also desai & dharmapala, strong fences, supra note 1, at 724 (“in a global setting in which formal corporate residence is increasingly elective, new firms that anticipate generating significant amounts of non-us income will have an incentive to incorporate their parent firm outside the united states.”); roger h. gordon, discussion, in fundamental tax reform: issues, choices, and implications 365-67 (john w. diamond & george r. zodrow eds., 2008) (expressing the concern that worldwide consolidation would encourage mncs owned by us investors to incorporate outside the united states and would encourage us investors to invest in non-us corporations instead of us corporations). 22. see, e.g., mihir a. desai, the decentering of the global firm, 32 world econ. 1271, 1276–77 (2009) (giving example of an mnc parented by a tax haven-incorporated firm and with “decentered” financial, legal and managerial homes). 23. see, e.g., webber, inverted u.s. firms relocate, supra note 20, at 591 (providing recent examples of expatriation to european parent structures); bret wells, cant and the inconvenient truth about corporate inversions, supra note 20, at 430–36 (same). 24. office of tax policy, department of the treasury, corporate inversion transactions: tax policy implications 12-13 (2002) (explaining post-inversion tax treatment). 2013] tax planning and initial incorporation location 327 parent’s chance of exposure to us tax because a treaty relationship increases the threshold for business taxation from the us statutory “effectively connected income” standard to the treaty-based “permanent establishment” standard.25 a treaty relationship also reduces withholding taxes that would apply, for example with respect to interest, dividend, and royalty payments from the us subsidiary to the parent.26 because direct tax treaties between tax havens and the united states generally do not exist, any treaty planning for a us-parented structure with a tax-haven-incorporated parent would typically rely upon intermediate affiliates with excellent treaty networks.27 25. see, e.g., new york state bar association tax section, report on outbound inversion transactions 42-43 (2002), http://www.nysba.org/ content/contentfolders20/taxlawsection/taxreports/1014report.pdf [hereinafter nysba, outbound inversion transactions report] (outlining analysis in support of bermuda parent treatment as engaged in a us trade or business and/or having a us permanent establishment). see generally lawrence lokken, income connected with u.s. trade or business: a survey and appraisal, 86 taxes, mar. 2008, at 61. in one case, the tax court held that a foreign parent provided brokerage services through its us subsidiary and therefore was engaged in a us trade or business. see inverworld, inc., et al v. commissioner, 71 t.c.m. (cch) 3231 (1996), t.c.m. (ria) ¶ 1996-301, at 2104–12, reconsideration denied, 73 t.c.m. (cch) 2777, t.c.m. (ria) ¶ 1997-226. 26. see, e.g., office of tax policy, department of the treasury, corporate inversion transactions: tax policy implications 24 (2002) (noting that a 30 percent withholding tax applies to “related party” interest payments from us subsidiary to non-us parent in the absence of a treaty relationship). 27. tax-haven parents with indirect us subsidiaries have used barbados and luxembourg as intermediate treaty countries, for example. see nysba, outbound inversion transactions report, supra note 25, at 6, 19-20 (reporting intermediate barbados affiliate in 1994 bermuda-parented helen of troy structure and intermediate luxembourg affiliate in 2001 bermuda-parented accenture structure). public disclosures typically do not make such intermediate structures clear. for example, michael kors did not disclose an effectively connected income, branch profits, or permanent establishment risk. its list of subsidiaries includes a swiss “holdings” affiliate that might serve an intermediate treaty planning role between the british virgin islands parent and the us indirect subsidiary. see michael kors holdings ltd., registration statement (form f-1) ex. 21.1 (dec. 2, 2011), http://www.sec.gov/archives/edgar/data/1530721/000119312511328487/ d232021dex211.htm (listing subsidiaries). freescale semiconductor also does not disclose such risks, although it does disclose that a shareholder’s tax results might be different if that shareholder received dividends or gains related to a us trade or business of the shareholder. see freescale semiconductor holdings i, ltd., registration statement (form s-1a) 180 (may 20, 2011), http://www.sec.gov/ archives/edgar/data/1392522/000119312511146916/ds1a.htm. freescale, like helen of troy and accenture, has a bermuda parent. however, its list of subsidiaries does not include an intermediate barbados or luxembourg holding company or another company whose name suggests that it is used as a treaty intermediate between 328 florida tax review [vol. 14:8 because the us rule for corporate tax residence turns on incorporation location, not on management and control, a non-us-parented mnc avoids exposure to us federal income tax on subpart f income earned by non-us subsidiaries, so long as 10 percent-or-more-shareholders that are us persons do not own more than 50 percent of the non-us parent.28 in addition, a non-us-parented mnc can use base erosion or earnings-stripping strategies, under which a us subsidiary makes deductible interest or other payments to its non-us parent, to reduce the amount of income subject to us tax.29 research on non-us-parented structures resulting from inversion transactions undertaken prior to the enactment of the 2004 anti-inversion rules suggests that the tax savings provided by such structures depends in significant part on the success of earnings-stripping strategies. one study shows no systematic increase in company valuation following the announcement of an inversion.30 but another concludes that markets exhibit more positive reactions to inversions in the presence of greater leverage.31 this is consistent with evidence that earnings stripping results in lower post bermuda and the us. a swiss company appears to serve as an intermediate for indirect european subsidiaries and a british virgin islands company as an intermediate for several asian subsidiaries. see freescale semiconductor holdings i, ltd., registration statement (form s-1a) exhibit 21.1 (may 20, 2011), http://www.sec.gov/archives/edgar/data/1392522/000119312511032381/dex211.ht m (listing subsidiaries). interwave provides a counterexample of an ipo firm that discloses an effectively connected income risk. see interwave communications int’l ltd., registration statement (form f-1a) 81 (jan. 28, 2000), http://www.sec.gov/archives/edgar/data/1095478/000091205700002759/000091205 7-00-002759.txt. 28. see mihir a. desai & james r. hines jr., expectations and expatriations: tracing the causes and consequences of corporate inversions, 55 nat’l tax j. 409, 421 (2002) [hereinafter desai & hines, expectations and expatriations] (citing avoidance of subpart f as the frequently articulated reason for corporate inversions). 29. see, e.g., office of tax policy, department of the treasury, corporate inversion transactions: tax policy implications 13 (2002) (discussing deductible payments resulting from intercompany debt and reinsurance). 30. see c. bryan cloyd, lillian f. mills & connie d. weaver, firm valuation effects of the expatriation of u.s. corporations to tax-haven countries, 25 j. am. tax’n ass’n 87 (2002). 31. see desai & hines, expectations and expatriations, supra note 28, at 435 (reporting correlation between higher leverage and favorable stock price reactions upon inversion transaction announcement). 2013] tax planning and initial incorporation location 329 inversion effective tax rates for inverted firms compared to a control sample.32 iii. us incorporation: a dominant structure with exceptions a. us-based startups generally incorporate in the us a “startup,” for purposes of this article, is a relatively new private business enterprise with global ambitions. this article focuses on initial incorporation decisions of “relatively new” firms and not on later changes in a firm’s place of incorporation, for example as a result of a standalone inversion transaction, strategic acquisition, or private equity or other financial acquisition. a “us-based” firm has a preponderance of ties to the united states. in the ipo study cited in this article, my co-author eric allen and i used a definition of more than 50 percent us revenue, employees, or identified real property to identify us-headquartered firms.33 some of the material presented in this article, including the informal interviews, draws heavily from venture capital experience, although the definition of “startup” used here is not limited to venture-backed firms. other sources of initial outside capital could include individuals, corporations, governments, or investment groups other than venture capital firms. the availability of data and prior work constitutes one reason for the focus on venture capital experience. in addition, many venture-backed portfolio companies happen to fall within the startup definition adopted for purposes of this article, since such companies often have or expect to develop global components in their respective business plans. prior work that investigates the choice of organizational form by usbased startups backed by us venture firms observes that us incorporation, particularly delaware incorporation, is the market norm.34 venture capital 32. see jim a. seida & william f. wempe, effective tax rate changes and earnings stripping following corporate inversions, 57 nat’l tax j. 805, 825 (2004) (finding an 11.6 percentage point post-inversion tax rate reduction). 33. see allen & morse, tax-haven incorporation for u.s.-headquartered firms, supra note 3, at 403. this article does not consider inversion transactions undertaken by mature firms, including transactions prior to or after the 2004 passage of anti-inversion legislation and transactions in connection with a cross-border acquisition. compare, e.g., wells, cant and the inconvenient truth about corporate inversions, supra note 20. 34. see, e.g., bankman, the structure of silicon valley start-ups, supra note 4, at 1739–40 (“in almost all cases, the [portfolio firm] will be structured as a corporation.”); johnson, why do venture capital funds burn research and development deductions, supra note 4, at 50–51 (noting that corporate investors, which could use losses if a startup firm had a pass-through structure, generally do 330 florida tax review [vol. 14:8 investments generally use standard contract structures, including a c corporation organizational form and a capital structure featuring preferred and common stock.35 lawyers maintain these contract structures and influence them, just as lawyers have been shown to significantly affect a new corporation’s choice of domicile36 and client firms’ choice of takeover defenses or other structures over time.37 several interviews reported here support and add color to the observation that that us incorporation is the norm for us-based startups.38 one law firm partner said that “9.5 out of 10” startups used a delaware corporation;39 the others used limited liability company (llc) or california corporation structures. another said that “most vcs don’t want to invest except into a delaware corporation.”40 entrepreneurs agreed. one characterized the vc expectation of delaware corporate organization as “cookie-cutter.”41 another entrepreneur reported that incorporation was an not invest in venture capital funds); allen & raghavan, the impact of non-tax costs on tax-efficiency, supra note 4, at 39 (finding that only seventeen out of 995 firms in a sample of venture-backed ipo firms from 1996-2008 had llc status at the time of ipo). 35. convertible preferred stock provides an attractive tradeoff between venture capitalists’ goal of claiming a control stake in a portfolio company and their goal of accessing maximum returns on their investment, for example in the event of an ipo. the use of preferred stock also permits the use of tax-advantaged equity compensation strategies for portfolio company employees. see ronald j. gilson, engineering a venture capital market: lessons from the american experience, 55 stan. l. rev. 1067 (2003) [hereinafter gilson, engineering a venture capital market]; ronald j. gilson & david m. schizer, understanding venture capital structure: a tax explanation for convertible preferred stock, 116 harv. l. rev. 874 (2003) (presenting tax explanation). 36. see, e.g., robert daines, the incorporation choices of ipo firms, 77 n.y.u. l. rev. 1559 (2002) [hereinafter daines, the incorporation choices of ipo firms]. 37. see john c. coates iv, explaining variation in takeover defenses: blame the lawyers, 89 cal. l. rev. 1301 (2001) [hereinafter coates, explaining variation in takeover defenses]. see also victor fleischer & nancy c. staudt, the supercharged ipo, 67 vand. l. rev. ____ [hereinafter fleischer & staudt, the supercharged ipo] (forthcoming 2014) (presenting evidence of the impact of professional networks on firms’ use of a specific planning strategy). 38. consistent with commitments made to interviewees, interviews cited in this article omit identifying details. no person was interviewed twice, and the citations to different interviews therefore reference conversations with unique individuals. 39. telephone interview with san francisco law firm partner (jan. 28, 2013). 40. telephone interview with san francisco law firm partner (feb. 16, 2013). 41. telephone interview with san francisco entrepreneur (feb. 16, 2013). 2013] tax planning and initial incorporation location 331 “absolute requirement” at the time of his company’s first venture funding and that his company reorganized from an llc to a delaware corporation at that time.42 and an entrepreneur who had organized his firm as an llc and who was fully aware of the tax ramifications of different organizational decisions reported that one reason he had avoided venture funding was to avoid “dogma” including the heuristic of delaware incorporation.43 as discussed further below, vcs do invest in portfolio firms not organized as delaware corporations. nevertheless, these comments reflect perceptions of an industry norm. the choice of delaware incorporation involves three subsidiary decisions. first, delaware incorporation rejects the alternative choice of home-state, for example california, organization. second, it rejects the option of organizing as an llc taxed as a flow-through for us tax purposes. third, and most important for purposes of this article, it rejects the option of incorporating outside the united states. with respect to the question of delaware or home-state incorporation, literature in the corporate governance area demonstrates that us-based firms (or their lawyers) frame the incorporation location decision largely as a binary choice between home-state and delaware incorporation.44 cited reasons for delaware incorporation include the quality of courts, the substance of corporate governance law, and the habits of advisors. with respect to the question of organization as an llc or corporation, an llc would permit investors to benefit from one layer of tax rather than two in the event of a profitable startup, or to use the passedthrough losses more often generated by a startup.45 the losses “burned” as a result of venture capitalists’ choice of a corporate form46 are estimated to be worth “billions”47 and wasting them may seem “hard to reconcile with any 42. telephone interview with silicon valley entrepreneur (jan. 30, 2013). a california corporation, like a delaware corporation, forms the foundation for a future structure as a us-parented mnc. 43. telephone interview with silicon valley entrepreneur (feb. 11, 2013). 44. see lucian arye bebchuk & alma cohen, firms’ decisions where to incorporate, 46 j.l. & econ. 383 (2003); daines, the incorporation choices of ipo firms, supra note 36; jens dammann & matthias schundein, the incorporation choices of privately held corporations, 27 j.l. econ. & org. 79 (2011). 45. see, e.g., goldberg, choice of entity for a venture capital start-up, supra note 4. 46. johnson, why do venture capital funds burn research and development deductions, supra note 4, at 53. 47. allen & raghavan, the impact of non-tax costs on tax-efficiency, supra note 4, at 3 (estimating lower bounds for the value tax benefit value of foregone losses at $1.4 billion – $4.4 billion based on ipo evidence from 19962011). 332 florida tax review [vol. 14:8 strong form of efficient market hypothesis.”48 yet contemporaneous work shows that out of 995 venture-backed firms that conducted ipos on us markets between 1996 and 2008, only forty-eight firms initially organized as llcs, and only seventeen retained llc status until the ipo. the few firms that organized as llcs were more profitable than those that did not.49 prior literature also considers the possible impact of factors that may favor incorporation despite the tax advantages of llc organization, including limited ability to use tax losses among existing investors in venture capital firms and reduced transaction costs that result from the relative simplicity of c corporation organization.50 the question of us or non-us incorporation, which is the focus of this article, adds to the delaware-versus-home state and llc-versuscorporation elements of a startup’s organization decision. available empirical evidence shows that us incorporation is the dominant organizational decision for us-based startup firms with global ambitions. in particular, initial public offering data from 1997 through 2010 reveals that fewer than 3 percent of identified us-based multinational corporations in the data set incorporated in tax havens. in addition, fewer than 2 percent of such firms incorporated in non-tax-haven, non-us jurisdictions.51 informal interview evidence corroborates the view that us incorporation is the norm for us-based startups with global ambitions. one entrepreneur, for example, characterized us organization as the undisputed default rule, even, for example, for a startup that anticipated that the most significant market for its product would be in europe.52 one lawyer 48. bankman, the structure of silicon valley start-ups, supra note 4, at 1767 (raising the possibility of a gambler’s mentality). 49. allen & raghavan, the impact of non-tax costs on tax-efficiency, supra note 4, at 2. 50. see bankman, the structure of silicon valley start-ups, supra note 4, at 1767–68 (considering reduced transaction costs and venture capitalists’ collective action problem); fleischer, the rational exuberance of structuring venture capital, supra note 4, at 139–40 (adding that venture capitalists generally would not benefit from startup losses and that loss limitations prevent typical investors in venture funds from taking full current advantage of losses produced by pass-through portfolio companies). 51. see allen & morse, tax-haven incorporation for u.s.-headquartered firms, supra note 3, at 407. the ipo data set excludes firms that stay private and those that only list on non-us exchanges. it includes firms that were not “relatively new” at the time of ipo, for example because a firm may have gone public for a second time after a taking-private transaction conducted by a financial investor. in addition, data as of the ipo date typically lags incorporation. see id. at 401–02. nevertheless, the study provides some support for the conclusion that delaware incorporation is the market norm for us-based startup firms. 52. telephone interview with silicon valley entrepreneur (jan. 30, 2013). 2013] tax planning and initial incorporation location 333 responded to the question of whether the global elements of a client’s plan influenced advice on the place of incorporation for a firm. “no,” he said. “they have no money.”53 startups that are not us-based, on the other hand, may well incorporate outside the united states, even if they receive funding from usbased venture capital firms. some firms that originate outside the united states and initially organize as non-us corporations may keep their non-us status after they move to the united states. israeli-parented firms, for example, comprise about 1 percent of the firms that conducted us-based ipos between 1997 and 2010.54 one lawyer recalled instances of such firms retaining an israeli-parented structure and establishing us subsidiaries, even though the lawyer thought such an approach tended to produce inefficiencies since two sets of lawyers were required rather than one.55 another mentioned israeli and uk firms as examples of non-us-incorporated structures that tended to survive the migration to the us venture capital market.56 this contrasts with another reported approach, in which a non-us firm that wants to access the us market reorganizes into a us-parented structure.57 similarly, some venture capital firms maintain non-us offices or assign certain partners to oversee non-us-based portfolio companies. these portfolio companies may be organized under non-us law rather than us law.58 examples of foreign office locations include israel, india, and china. 53. telephone interview with san francisco entrepreneur (feb. 16, 2013). 54. see allen & morse, tax-haven incorporation for u.s.-headquartered firms, supra note 3, at 407. 55. telephone interview with san francisco law firm partner (jan. 28, 2013). 56. telephone interview with silicon valley law firm partner (feb. 27, 2013). 57. e.g., telephone interview with san francisco law firm partner (feb. 16, 2013). 58. for example, sequoia capital manages portfolios of companies based in india, see sequoia capital, http://www.sequoiacap.com/india (last visited june 3, 2013), and china, see sequoia capital, http://www.sequoiacap.cn/en/ (last visited june 3, 2013). the website of bessemer venture partners lists dozens of portfolio companies based in india, israel and europe, some of which can be identified as non-us companies by their “ltd.” suffix. see bessemer venture partners, http://www.bvp.com/portfolio (last visited june 3, 2013) (sort by europe, india and israel geographies). 334 florida tax review [vol. 14:8 b. exceptions the dominant structure of us incorporation for us-based startups is subject to several important exceptions. this small set of examples of usbased startups that incorporate outside the united states, and in particular in tax havens, adds context to the default rule of us incorporation. the below discussion covers exceptions in the insurance, marine transportation, and online gambling industries. it also includes several other examples of firms that do not follow industry lines. of nearly 3,000 firms in a dataset of ipos on us markets between 1997 and 2010, only forty-seven were us-based, tax-haven-incorporated firms. of these, thirteen were insurance carriers, which generally insure us risks.59 the structure of such an insurance company typically features a bermuda parent and a us subsidiary. the us subsidiary sources and services the insurance policies covering us risks, while premiums paid to the us subsidiary are substantially eroded by means of deductible reinsurance payments made to a bermuda affiliate.60 as described in part iv, a collection of rules, primarily tax rules, facilitates insurance firms’ decision to incorporate in bermuda. marine transportation is the second industrial category identified as a typical candidate for a us-based, tax-haven-incorporated firm structure in the study of us ipo data. four firms out of the forty-seven identified in the ipo study were marine transportation firms.61 each of the four firms identified in the data set engages in commercial shipping, but other 59. see allen & morse, tax-haven incorporation for u.s.-headquartered firms, supra note 3, at 413–15. some of the bermuda-parented insurance firms in the ipo dataset fit the definition of startup used in this article. as an example, validus holdings re, which went public in july 2007, disclosed that it was “formed in october 2005” with the sponsorship of a set of private equity funds. see validus holdings ltd., registration statement (form s-1a) 2 (july 19, 2007), http://www.sec.gov/archives/edgar/data/1348259/000095012307010068/e28184a6s v1za.htm. 60. see nysba outbound inversion transactions report, supra note 25, at 27–29 (describing bermuda-parented insurance company structure). 61. see allen & morse, tax-haven incorporation for u.s.-headquartered firms, supra note 3, at 413–15. some of the tax-haven-parented marine transportation firms in the ipo dataset fit the definition of startup used in this article. as an example, general maritime corporation, a marshall islands corporation which went public in june 2001, disclosed that it was “newly formed” and would assemble vessels and support services assets from three different sources. see general maritime corporation, registration statement (form s-1a) 3–4 (june 12, 2001), http://www.sec.gov/archives/edgar/data/1127269/00009120570151949/ a2051255zs-1a.txt. 2013] tax planning and initial incorporation location 335 international marine transportation businesses, such as passenger cruise lines, also use tax haven parents.62 online gambling provides another example of an industry in which firms that target the us market have used tax-haven-parented structures. for example, one leading company incorporated in gibraltar conducted an ipo on the london stock exchange in 2005 using a proxy statement that reportedly disclosed that 90 percent of its customers were us.63 as further discussed in part iv, industry-specific reasons encourage the use of taxhaven-parented structures for us-based firms in the insurance, marine transportation and online gambling examples. other examples of tax-haven-parented, us-based startup firms resist categorization along industry lines. because of the small sample size and inconsistency of data in publicly available disclosures, these examples also resist statistical analysis. they include firms with less restrictive resource constraints and/or non-us investors that own a significant percentage of stock. firms with less restrictive resource constraints, including an absence of dependence on deferred law firm fee arrangements or post-incorporation venture capital financing, include several funded by established public corporations such as motorola,64 sun65 and tyco international.66 in one other 62. carnival, for example, incorporated in panama in 1972 and operates as a dual listed company with carnival plc, a uk company organized in 2000. see carnival corporation annual report (form 10-k) 3 (jan. 30, 2011), http://www.sec.gov/archives/edgar/data/815097/000119312511018320/d10k.htm. royal caribbean reports that it “was founded in 1968 as a partnership. its corporate structure evolved over the years and the current parent corporation, royal caribbean cruises ltd., was incorporated on july 23, 1985 in the republic of liberia . . . .” see royal caribbean cruises ltd., annual report (form 10-k) 1 (feb. 25, 2013), http://www.sec.gov/archives/edgar/data/884887/000104746913001567/a2213132z1 0-k.htm. 63. see christine hurt, regulating public morals and private markets: online securities trading, internet gambling, and the speculation paradox, 86 b.u. l. rev. 371, 415 (2006) [hereinafter hurt, regulating public morals] (reporting partygaming ipo). 64. see iridium world communications ltd., registration statement, (form s-1a) 99 (june 10, 1997), http://www.sec.gov/archives/edgar/data/ 948421/0000950133-97-002150.txt (disclosing approximately 28 percent ownership by motorola, inc.). 65. see opentv corp., registration statement (form f-1a) 3 (nov. 19, 1999), http://www.sec.gov/archives/edgar/data/1096958/0000950013099006648/00 00950130-99-006648.txt (disclosing that opentv began as a joint venture between thomson multimedia s.a. and sun microsystems). 66. see tycom ltd., registration statement (form s-1a) 2, f-6 (july 24, 2000), http://www.sec.gov/archives/edgar/data/1108511/0000950013000004016/ 0000950130-00-004016.txt (explaining that the registrant formed as a wholly-owned 336 florida tax review [vol. 14:8 case, a private equity investment fund sponsored a capital-intensive startup.67 a broad group of equity partners together with current profits apparently funded accenture’s startup phase.68 wealthy individuals sponsored firms including rsl communications.69 in addition, some us-based, tax-haven-parented startup firms have major founders or shareholders with non-us connections. some firms appear to have started doing business outside the united states.70 others had major non-us shareholders at the time of ipo, including corporate investors71 and subsidiary of tyco international ltd., which would continue to own 89 percent of the stock post-ipo). 67. see aircastle ltd., registration statement (form s-1a) 50 (aug. 2, 2006), http://www.sec.gov/archives/edgar/data/1362988/000095013606006258/ file1.htm (“we were formed in october 2004 with a capital commitment of $400 million from funds managed by fortress for the purpose of investing in aviation assets.”). 68. see accenture ltd., registration statement (form s-1a) 62–63, 73 (july 18, 2001). http://www.sec.gov/archives/edgar/data/1134538/0000950130 01503127/ds1a.htm (showing that no shareholder owned more than 5 percent of any class of accenture ltd. shares, that its partners owned 82 percent of the voting equity, and annualized after-tax profits exceeding $1.5 billion for each year of operation following separation from arthur andersen). 69. ralph lauder funded rsl communications. see rsl communications ltd, registration statement (form s-1a) 101 (mar. 20, 1998), http://www.sec. gov/archives/edgar/data/1036297/0000889812-98-000682.txt (stating that lauder owned about 43 percent of the registrant’s common stock prior to ipo). see also kerry a. dolan, srpska calling, forbes (nov. 2, 1998, 12:00am), http://www.forbes.com/forbes/1998/1102/6210141a.html (describing rsl’s “deep pockets”). 70. see garmin ltd., registration statement (form s-1a) 36 (dec. 6, 2000), http://www.sec.gov/archives/edgar/data/1121788/000095013100006701/000 0950131-00-006701.txt (disclosing that garmin “formed in taiwan”); vistaprint ltd., registration statement (form s-1a) 35 (sept. 26, 2005), http://www.sec.gov/archives/edgar/data/1262976/000119312505190875/ds1a.htm (noting that business initially commenced in france, then moved to the us, where it was conducted by a us corporation, which later amalgamated with a new bermuda company). 71. see interwave communications international ltd., registration statement (form f-1a) 75 (jan. 28, 2000), http://www.sec.gov/archives/edgar/ data/1095478/000091205700002759/0000912057-00-002759.txt (listing nortel networks corp. as 22 percent shareholder pre-ipo); iridium world communications ltd., (form s-1a) 99 (june 6, 1997), http://www.sec.gov/archives/edgar/data/ 948421/0000950133-97-002129.txt (disclosing approximately 11 percent ownership by a japanese-based consortium and 9 percent ownership by a german-based investor pre-ipo); opentv corp., registration statement (form f-1a) 3 (nov. 19, 1999), http://www.sec.gov/archives/edgar/data/1096958000095013099006648/000 2013] tax planning and initial incorporation location 337 also including michael kors, which received most of its funding prior to its 2011 ipo from two non-us individual investors through their jointly held investment vehicle.72 iv. explaining the dominant structure a. limited tax benefits of a non-us-parent structure the tax benefits of a non-us-parented structure derive from three possible factors. first, a non-us-parented structure may reduce the current tax paid by a mnc with respect to non-us income. second, it may reduce the tax paid upon the repatriation of income from subsidiaries to the mnc parent. third, it may reduce the current tax paid by an mnc with respect to us income. the tax-efficient structures of many us-parented mncs initially suggest that a startup has little to gain from a non-us-parented structure. the effective rate of us income tax collected on non-us income earned under us-parented structures is already very low.73 even if a non-us-parented structure brings the rate of current us taxation on non-us income closer to zero, it may not result in significant cost savings. a non-us-parented structure might also permit the tax-efficient repatriation of profits to the parent company, for example for the purpose of dividend distributions to ultimate shareholders. under the currently dominant us-parented mnc structure, a firm pays us income tax less foreign tax credits, in addition to withholding taxes, when the mnc repatriates profits from a foreign subsidiary to the us parent. some firms, in particular technology firms, can achieve very low rates of non-us tax rate on non-us income. as a result, they may have less ability to use foreign tax credits to shelter us income tax upon the repatriation of profits.74 0950130-99-006648.txt (disclosing that opentv began as a joint venture between thomson multimedia s.a. and sun microsystems). 72. see michael kors holdings ltd., registration statement (form f-1) 87– 88 (dec. 2, 2011), http://www.sec.gov/archives/edgar/data/1530721/0001193 12511328487/d232021df1.htm (disclosing approximately 52 percent pre-ipo beneficial ownership by silas k.f. chou, a hong kong individual, and lawrence s. stroll, a canadian individual). 73. see supra note 13 and accompanying text (reviewing data on us taxation of non-us income of us-parented mncs). 74. see rosanne altshuler & harry grubert, repatriation taxes, repatriation strategies and multinational financial policy, 87 j. pub. econ. 73, 74–75 (2002) (noting the connection between lower foreign tax rates and higher incentives to avoid repatriation). it is possible for a us parent to benefit from offshore cash without a taxable repatriation in some circumstances, as high-profile cases illustrate. see, e.g., peter burrows, apple avoids $9.2 billion in taxes with 338 florida tax review [vol. 14:8 many us-parented firms have substantial profits that remain offshore, in part because of the residual tax expense of repatriation.75 a nonus-parented structure would remove this residual us tax obstacle to repatriation from a us subsidiary to a foreign parent. such a non-usparented structure presents other planning challenges, however, including the challenge of how to avoid withholding taxes on such a repatriation payment. withholding taxes are generally charged at rates as high as 30 percent on related party interest or dividends paid by a us firm and on royalties paid for the use of us intellectual property,76 and treaty planning is presumably necessary to reduce these taxes.77 the possible reduction in tax on us income as a result of a non-usparented structure also deserves consideration. evidence from inversion transactions suggests that the main benefit of transforming from a usparented to a tax-haven-parented corporation lies in the reduction of tax on us income, not in the reduction of tax on non-us income. inverted companies erode the tax base of their us operating subsidiaries through strategies such as intercompany leverage, which results in deductible payments from us subsidiaries to non-us parents. empirical evidence indicates that the benefit of an inverted transaction to a firm correlates with the availability of such base erosion strategies, although base erosion can also feature in us-parented structures.78 importantly, all three of these advantages — reduction of tax on nonus income, reduced tax upon repatriation, and reduction of tax on us income — will benefit a mature and profitable firm more than a loss-making, newly-formed startup corporation. for example, in order to take advantage of a non-us-parented structure to reduce tax on us income, a firm needs taxable income and the capacity to establish intercompany agreements that support deductible payments from the us to the non-us parent. many startups have neither. finally, a startup incorporated outside the united states that has us shareholders faces the risk of categorization as a passive foreign investment company, or pfic. a foreign corporation is a pfic if passive income makes debt deal, bloomberg, may 3, 2013, http://www.bloomberg.com/news/2013-0502/apple-avoids-9-2-billion-in-taxes-with-debt-deal.html. 75. see susan c. morse, a corporate offshore profits transition tax, 91 n.c. l. rev. 549, 550 (2013) (referencing estimate of $1 trillion to $2 trillion of untaxed offshore earnings). 76. see, e.g., i.r.c. §§ 861 (providing source rules), 881 (taxing non-us corporations on the receipt of certain us-source income). 77. see supra notes 25–27 (discussing tax treaty planning in the context of non-us-parented firms’ access to permanent establishment rules). 78. see supra notes 14–15 and accompanying text and 29–32 and accompanying text (reviewing base erosion strategies of us-parented and inverted firms). 2013] tax planning and initial incorporation location 339 up at least 75 percent of its gross income or assets held to produce passive income make up at least 50 percent of its total asset value.79 concern about a startup’s pfic status can result from current operating losses together with investment income produced by working capital, including working capital attributable to ipo proceeds. pfic status imposes unattractive tax results on us shareholders.80 registration statements for non-us-parented mncs that go public typically disclose the possibility of pfic status,81 and pfic status presents a concern for shareholders of private companies as well, despite a limited start-up company exception.82 b. legal benefits of a us-parent structure a us-parent structure, meanwhile, provides non-tax legal benefits. us incorporation provides the benefit of access to delaware corporate governance law, for example, and non-us incorporation does not.83 startup advisors also perceive an advantage to us incorporation for purposes of the protection of intellectual property and other property rights. the corporate governance advantages of us incorporation include access to relatively investor-friendly and highly reliable delaware or other state corporate governance law.84 the 2011 registration statement for michael kors, incorporated in the british virgin islands, lists risk factors related to the difficulty of initiating shareholder derivative actions, enforcing 79. see i.r.c. § 1297. 80. these results include the possible imposition of the maximum ordinary income tax rate on “excess distributions” including gain on sale of stock, together with an interest charge. i.r.c. § 1291. 81. see, e.g., freescale semiconductor holdings i, ltd., registration statement (form s-1a) 179 (may 20, 2011), http://www.sec.gov/archives/ edgar/data/1392522/000119312511146916/ds1a.htm; michael kors holdings ltd., registration statement (form f-1) 114 (dec. 2, 2011), http://www.sec.gov/ archives/edgar/data/1530721/000119312511328487/d232021df1.htm. see also aircastle ltd., registration statement (form s-1a) 36 (aug. 2, 2006), http://www.sec.gov/archives/edgar/data/1362988/000095013606006258/file1.htm (disclosing that the firm expected to be categorized as a pfic and as a cfc). 82. see i.r.c. § 1298(b)(2). 83. see mitchell a. kane & edward b. rock, corporate taxation and international charter competition, 106 mich. l. rev. 1229, 1239–40 (2008) (contrasting “corporate surplus” and “tax surplus”). 84. id. at 1255–58 (arguing that the first-best solution to the problem of corporate tax consequences influencing corporate governance choices is to segregate them so that tax results follow from a “real seat” rule while corporate governance results follow from a “place of incorporation” rule). 340 florida tax review [vol. 14:8 judgments against officers and directors, and pursuing minority or other shareholder rights.85 related research that investigates companies that cross-list on different securities markets indicates that cross-listed firms trade at a premium because their willingness to comply with stricter accounting, disclosure, and other rules serves as a “bonding” signal that encourages investors to invest.86 structures subject to less regulatory oversight may permit more rent extraction by corporate managers, particularly in widely held corporations;87 or make transparent reporting of earnings more elusive.88 even if non-us incorporation saves corporate governance costs, for example by reducing compliance costs produced by sarbanes-oxley and other us regulatory requirements,89 investors may experience the absence of tighter corporate governance regulation as a net disadvantage. informal interview results corroborate some of these corporate governance concerns with non-us incorporation. one lawyer explained that using a delaware corporation ensured that an investor would be protected under us law, for example because board and/or shareholder votes would be required for certain corporate actions and because investors could limit the amount of capital exposed to non-us law, for example through contract limitations on how much of the investors’ cash could be transferred to a foreign subsidiary of a us parent.90 one venture capitalist explained that it was generally not advisable for vcs to invest in a firm formed outside the us, because of the risk that non-us governments might take over a company 85. see michael kors holdings limited, registration statement (form f-1) 25–26 (dec. 2, 2011), http://www.sec.gov/archives/edgar/data/1530721/00011 9312511328487/d232021df1.htm (listing risk factors related to corporate governance). 86. see, e.g., john c. coffee jr., racing toward the top?: the impact of cross-listings and stock market competition on international corporate governance, 102 colum. l. rev. 1757 (2002). 87. see mihir a. desai & dhammika dharmapala, earnings management, corporate tax shelters, and book-tax alignment, 62 nat’l tax j. 169 (2009); mihir a. desai & dhammika dharmapala, corporate tax avoidance and firm value, 91 rev. econ. stat. 537 (2009) (finding a correlation between institutional ownership and tax avoidance); michelle hanlon & joel slemrod, what does tax aggressiveness signal? evidence from stock price reactions to news about tax shelter involvement, 93 j. pub. econ. 126 (2009) (finding smaller stock price declines for firms with good governance). 88. see victor fleischer, regulatory arbitrage, 89 tex. l. rev. 227, 263– 64 (2010) (discussing “opacity costs”). 89. see kate litvak, the effect of the sarbanes-oxley act on non-u.s. companies cross-listed in the u.s., 13 j. corp. fin. 195 (2007). 90. telephone interview with silicon valley law firm partner (feb. 4, 2013). 2013] tax planning and initial incorporation location 341 or otherwise unilaterally reduce the value of an investment.91 another venture capitalist whose firm’s portfolio included non-us-parented companies said that such non-us investments were more common in a transaction in which the investment firms owned a controlling interest in the portfolio company, in which case corporate governance concerns might have less importance.92 the importance of corporate governance is also suggested by the exceptions to the rule of us incorporation for us-based startups. one lawyer explained that a startup with an israeli or uk parent would often keep its offshore parent instead of migrating to a us-parented structure when entering the us market.93 one venture capitalist cited europe as an exception to the rule of the strong preference for delaware incorporation because of a higher level of comfort with european law.94 property protection may provide another reason to choose a usparented structure for a startup.95 one lawyer said flatly with respect to ip development, “i want them to do it in the us, to be honest.” but this preference had more nuance. the lawyer had discomfort with the idea of a development team or ip ownership in india or china, but accepted the idea that ip might be developed or owned in switzerland.96 another lawyer emphasized a remedies advantage of us court jurisdiction over delaware corporations, which the lawyer said ensured the ability to sue and recover damages if successful in the event of a controversy.97 this focus on local 91. telephone interview with silicon valley venture fund partner (feb. 8, 2013). 92. telephone interview with silicon valley venture/private equity fund partner (feb. 22, 2013). 93. telephone interview with silicon valley law firm partner (feb. 27, 2013). other lawyers also mentioned an exception for israeli firms. see, e.g., telephone interview with san francisco law firm partner (jan. 28, 2013). 94. telephone interview with silicon valley venture fund partner (feb. 8, 2013). 95. formal legal rules generally do not sanction different ip protection by one country if the ip is held by a firm incorporated in a different country. international intellectual property conventions include anti-discrimination requirements. see robert p. merges, pete s. menell & mark a. lemley, intellectual property in the new technological age 55 (6th ed. 2012). nevertheless, the prospect of defending intellectual property rights in a jurisdiction other than the jurisdiction of incorporation may increase uncertainty for reasons including concern about de facto differences in the application of the law. see, e.g., rama lakshmi, india rejects novartis drug patent, wash. post, apr. 1, 2013, http://www.washingtonpost.com/world/asia-pacific (reporting on indian supreme court case denying protection for an improved form of a pre-existing compound and suggesting that the case might discourage foreign pharma investment in india). 96. telephone interview, san francisco law firm partner (feb. 16, 2013). 97. telephone interview, silicon valley law firm partner (feb. 4, 2013). 342 florida tax review [vol. 14:8 presence appears to derive in part from legal realism concerns. an investor with an office in india, for example, may have higher confidence as a practical matter about its ability to get a hearing and a remedy in indian court.98 c. liquidity and other resource constraints as prior literature observes, business frictions can interfere with taxmotivated planning.99 even if a structure with a parent in a low-tax jurisdiction offered tax advantages that clearly outweighed corporate governance and other legal disadvantages, certain business frictions, primarily liquidity and other resource constraints, would likely prompt many startups to continue to choose delaware incorporation. liquidity constraints partly explain the premium placed on simplicity in the default startup structure. declining to search for an optimal organizational structure and instead accepting the “satisfactory solutio[n]” provided by the dominant heuristic of delaware incorporation also saves non-cash resources.100 other work has noted the importance of cash conservation and the up-front and ongoing expense of nonstandard structures for startup firms.101 interview evidence also supports the conclusion that many startups have severe liquidity constraints. one entrepreneur admitted that he and his cofounder were “very cheap” and simply “never brought in outside legal counsel” until financing.102 another explained that “you want to defer expense as far as possible.”103 one lawyer reported that startups often had 98. telephone interview, silicon valley law firm partner (feb. 4, 2013). 99. see generally david m. schizer, frictions as a constraint on tax planning, 101 colum. l. rev. 1312, 1323–35 (2001) (evaluating impact of behavioral distortions on tax planning choices); david a. weisbach, line drawing, doctrine, and efficiency in the tax law, 84 cornell l. rev. 1627, 1665–68 (1999) (same). 100. herbert a. simon, rational decision making in business organizations, 69 am. econ. rev. 493, 498 (1979). see generally daniel kahneman, thinking fast and slow (2011) (distinguishing between automatic and heuristics-based “system 1” decisions and energy-demanding “system 2” decisions). 101. see, e.g., bankman, the structure of silicon valley start-ups, supra note 4, at 1749–50 (noting the often-mentioned reason for incorporation of minimizing legal and organizational costs). planning related to non-us income may account for a substantial part of the total cost of us-parented firms’ tax compliance. see marsha blumenthal & joel b. slemrod, the compliance cost of taxing foreign-source income: its magnitude, determinants, and policy implications, 2 int’l tax & pub. fin. 37 (1995). 102. telephone interview with silicon valley entrepreneur (jan. 30, 2013). 103. telephone interview with silicon valley entrepreneur (feb. 11, 2013). 2013] tax planning and initial incorporation location 343 difficulty meeting costs in the thousand-dollar range prior to venture investment. a good startup attorney, he said, “understands the need to conserve cash.”104 one venture capitalist could not think of an example where an early globalization strategy requiring significant up-front capital investment had improved a startup’s valuation. such plans “take a lot of money,” and when “the music stops,” for example prior to the company achieving self-sufficiency through a revenue stream, the capital is gone.105 reluctance to slow down business plan implementation may limit startups’ focus on legal issues generally. one entrepreneur reported that “legal is the last thing on my mind;” when a prospective strategic acquirer asked him “how many compliance people” he had, he was struck by the fact that the acquirer had “the luxury of asking that question.”106 another entrepreneur explained that even though unfavorable customer agreements had required renegotiation at the time of acquisition, costing time and money, the company would not necessarily have invested in legal review of the agreements even with the benefit of hindsight, since such review would have slowed down sales.107 startup lawyers triage the legal issues they recommend that their clients address. issues like intellectual property ownership and a clean capitalization table take precedence over organization decisions.108 startup lawyers readily give examples of startups that have stumbled over ip ownership or “founder in the woodwork”109 problems. in contrast, they generally do not see evidence that organizing as anything other than a delaware c corporation changes the startup firm’s chances of a successful exit or the likely valuation of that exit.110 resource constraints encourage startups to prefer the simplest organizational structure: the delaware c corporation. this organizational choice is simple in part because of path dependence; it is the “cookie-cutter” structure,111 the “pre-approved” package,112 the “gold standard,”113 104. telephone interview with silicon valley law firm partner (feb. 4, 2013). 105. telephone interview with silicon valley venture fund partner (feb. 8, 2013). 106. telephone interview with san francisco entrepreneur (feb. 16, 2013). 107. telephone interview with silicon valley entrepreneur (feb. 30, 2013). 108. e.g., telephone interview with san francisco law firm partner (jan. 28, 2013) (explaining the importance of “buddy” issues relating to co-developed ip and emphasizing the importance of focusing on “the most high level issues”). 109. telephone interview with silicon valley venture fund partner (feb. 8, 2013). 110. e.g. telephone interview with san francisco law firm partner (feb. 16, 2013) (“i don’t think there’s any example of people getting extra money for [an offshore structure].”). 111. telephone interview with san francisco entrepreneur (feb. 16, 2013). 344 florida tax review [vol. 14:8 “dogma,”114 the “generally accepted norm.”115 under current practice, delaware corporations are simpler than llcs or partnerships and also simpler than us-based non-us corporations. important examples of delaware corporation simplicity identified in the corporation-versus-llc literature include employee options, corporate governance, and exit strategy,116 although it would surely be possible to optimize and simplify a different structure if it were widely used.117 similarly, delaware organization is simpler than non-us organization for us-based startups. the addition of non-us entities to the mix adds more complexity because the relevance of different laws requires more than one set of legal and other advisors.118 managing multiple corporate entities and related agreements between them complicates the project of running the company.119 available resources for efficient corporation formation services for startups lean toward a delaware corporate structure, especially the resources provided by law firms. a founder looking for online advice about how to organize a startup will soon find legalzoom, which provides form documents for llcs as well as s and c corporations.120 however, the online 112. telephone interview with silicon valley law firm partner (feb. 4, 2013). 113. telephone interview with silicon valley venture fund partner (feb. 22, 2013). 114. telephone interview with silicon valley entrepreneur (feb. 11, 2013). 115. telephone interview with silicon valley law firm partner (feb. 4, 2013). 116. see fleischer, the rational exuberance of structuring venture capital, supra note 4, at 167–84 (explaining reasons why venture capitalists may stick with the “devil they know”). 117. see bankman, the structure of silicon valley start-ups, supra note 4, at 1767–68 (considering venture capitalists’ collective action problem). 118. telephone interview with san francisco law firm partner (jan. 28, 2013). 119. telephone interview with san francisco law firm partner (feb. 16, 2013) (characterizing the use of an offshore intellectual property holding company subsidiary as “very expensive” tax planning that “completely breaks the idea of simplicity”); telephone interview with silicon valley entrepreneur (jan. 30, 2013) (explaining that setting up places of business in different global locations was “much more difficult than we anticipated,” due to issues like local bank account and office requirements). 120. legal zoom provides a choice among the us states for jurisdiction of organization but does not mention the possibility of offshore incorporation. see legal zoom, http://www.legalzoom.com/ (last visited july 11, 2013). 2013] tax planning and initial incorporation location 345 term sheet generators supported by large silicon valley law firms assume a c corporation structure.121 law firms have standardized and made cost-effective the formation of a startup as a delaware corporation. more than one lawyer put the current cost of the “thirty-plus” documents needed to form a company, ranging from articles of incorporation to employee option plans, at $2000-$3000.122 uniform questionnaires facilitate the process, as do, at least in some cases, law firm outposts located in low-cost locations.123 in contrast, documents for a firm that organizes as an llc might cost $10,000 and forming a bermuda corporation, perhaps $30,000.124 the dominance of the delaware corporate form permits not only upfront cost savings, but also lower diligence costs in the event of later transactions. one lawyer explained the approach of organizing each startup firm with the same number of shares of authorized common stock and a similarly sized option pool. the uniform approach permitted the easy conversion of financing terms to a preferred stock price, and the expression of most preferred stock pricing as a figure in the range of twenty-five cents to one dollar for each share of preferred stock. since this approach is similar to other firms’ approach, it makes negotiating more straightforward and diligence less expensive.125 a cost difference in the thousands of dollars may seem an insufficient reason to choose one organizational approach over another for a corporation that might be worth billions of dollars someday. yet this cost differential is important for a startup firm that makes its organizational decision before it obtains outside financing. for example, it may make the decision in connection with a preliminary round of financing in which it seeks smaller investments from friends and family or from angel investors. startups may also begin work on their business plan without significant 121. for example, the “series seed” documents developed by a fenwick & west lawyer assume a delaware corporation. see series seed financing documents, http://www.seriesseed.com/posts/documents.html (last visited july 11, 2013). see also wilson sonsini, term sheet generator, http://www.wsgr.com/ wsgr/display.aspx?sectionname=practice/termsheet.htm (last visited july 11, 2013) (giving jurisdiction options of delaware, california or “other” and assuming as the next step the issuance of preferred stock). 122. telephone interview with san francisco law firm partner (feb. 16, 2013); see also telephone interview with silicon valley law firm partner (feb. 4, 2013). 123. telephone interview with san francisco law firm partner (feb. 16, 2013). 124. telephone interview with silicon valley law firm partner (feb. 4, 2013). 125. telephone interview with silicon valley law firm partner (feb. 4, 2013). 346 florida tax review [vol. 14:8 venture capital financing in particular in areas that require little capital investment, such as the development of mobile or cloud software applications.126 in some cases, law firms’ willingness to defer startups’ obligation to pay legal fees contributes to lawyers’ reluctance to recommend “exotic” structures.127 the fee deferral limit might range from $15,000128 to $25,000129 and accordingly will not cover the expense of offshore incorporation. the limit puts the attorneys at risk for the amount of the deferred fees in the event the startup fails to achieve financing, and lawyers may not consider the investment worthwhile. one lawyer said that he would be happy to implement a complex structure if he were paid “full freight,” but not “on a deferred fee basis.”130 the reluctance to spend resources on a nonstandard corporate structure is consistent with the view that venture capital firms do not place any value on such a structure. prior research suggests that venture capitalists insist on a delaware corporate structure for their portfolio companies.131 however, three venture capitalists informally interviewed did not go so far and instead denied that they filtered out corporations that were organized as other than delaware corporations. the investors generally acknowledged 126. telephone interview with silicon valley law firm partner (jan. 28, 2013) (noting the emergence of low-capital business models). 127. telephone interview with silicon valley law firm partner (feb. 27, 2013). 128. telephone interview with silicon valley law firm partner (feb. 27, 2013). 129. telephone interview with silicon valley law firm partner (feb. 4, 2013). 130. telephone interview with san francisco law firm partner (feb. 16, 2013). 131. see bankman, the structure of silicon valley start-ups, supra note 4, at 1767–68 (attributing corporate structure decisions to venture capitalists); gilson, engineering a venture capital market, supra note 35 (same); johnson, why do venture capital funds burn research and development deductions, supra note 4, at 89 (same). researchers have similarly reported that private equity ownership of portfolio firms correlates with tax planning. see, e.g., brad a. badertscher, sharon p. katz & sonja o. rego, the separation of ownership and control and tax avoidance, 56 j. acct’g & econ. 228, 242 (2013) (reporting that portfolio companies controlled by private equity firms had higher tax avoidance measures than management-owned companies); steven n. kaplan & per strömberg, leveraged buyouts and private equity, 23 j. econ. persp. 121, 134-35 (2009) (noting tax benefits of additional leverage in private equity-owned portfolio companies). 2013] tax planning and initial incorporation location 347 their preference for delaware incorporation, but also expressed the view that “the lawyers” overstated this preference.132 one venture capitalist cited portfolio companies that were incorporated in various us states as well as outside the united states and in llc form.133 another said that organizational form was not something the firm sought to “optimize.”134 firms may rely on the judgment of earlier investors in a portfolio company or on the judgment of co-investors and to accept their planning with respect to organizational form.135 some venture firms have investment fund segments that specifically target non-us portfolio companies, which are typically organized as non-us firms.136 the norm of us incorporation may derive less from venture capital preference and more from the involvement of lawyers that advise startup firms.137 lawyers have developed an out-of-the-box structure for startup firms that is easy and cheap to implement because it is so frequently replicated. the lawyer’s interests and the startup’s issues are generally closely aligned with respect to the goal of conserving cash and other resources, particularly if the lawyer has agreed to defer fees. as one lawyer explained, if startups have “no revenue,” and “no product,” they have “no future,”138 and cannot pay their legal bills. other work demonstrates that lawyers can significantly influence client legal decisions, including state of incorporation,139 use of takeover defenses,140 and aggressive structures to permit founder liquidity.141 132. telephone interview with silicon valley venture fund partner (feb. 8, 2013) (stating that the california code was “stable” and “good enough” and that llc formation “can be fixed later,” when “institutional investors” are involved). 133. telephone interview with san francisco entrepreneur (feb. 16, 2013). contemporaneous examination of venture-backed ipo evidence also finds some evidence of a small number of venture-backed llcs. allen & raghavan, the impact of non-tax costs on tax-efficiency, supra note 4. 134. telephone interview with silicon valley venture fund partner (mar. 8, 2013). 135. telephone interview with san francisco entrepreneur (feb. 16, 2013); telephone interview with silicon valley venture fund partner (mar. 8, 2013). 136. see supra note 58 (giving examples drawn from sequoia capital and bessemer partners portfolios). 137. cf. reinier h. kraakman, gatekeepers: the anatomy of a third-party enforcement strategy, 2 j.l. econ & org. 53 (1986). 138. telephone interview with silicon valley law firm partner (feb. 16, 2013). 139. see, e.g., daines, the incorporation choices of ipo firms, supra note 36. 140. see coates, explaining variation in takeover defenses, supra note 37. 141. see fleischer & staudt, the supercharged ipo, supra note 37 (presenting evidence of the impact of professional networks on firms’ use of a specific planning strategy). 348 florida tax review [vol. 14:8 in the corporation-versus-llc context, the overwhelming adherence of startups to the standard delaware corporation organization advice offered by lawyers and other gatekeepers has raised the question of whether the default corporation approach is a rational or irrational habit.142 the corporation-versus-llc question raises this issue because there are known net tax costs presented by the corporate organizational form, whether it is the loss of the benefit of tax losses or the cost of double taxation in the event of profit.143 in the us-versus-non-us incorporation case, however, the rationality question is not broadly presented, because the choice of us incorporation instead of non-us incorporation does not clearly result in net tax costs for a typical startup and its investors.144 nevertheless, the influence of advisors over startups’ us-versusnon-us organization decision is important. for example, it influences the analysis of what might happen in the event the us did (contrary to predictions discussed below based on legislative process and interest group constraints) increase the tax burden of us-parented mncs relative to nonus-parented mncs. in the absence of a mediating group of advisors and in the absence of a standard market norm for a startup’s organizational structure, an increase in the tax burden of us-parented mncs should marginally increase the frequency of us-based startups that incorporate outside the us based on each individual startup’s cost-benefit analysis. however, if mediated by gatekeepers such as venture capitalists and lawyers, the possible adoption of non-us-parented mnc startup structures in response to a change in law is more complicated. one issue is agency costs. the existing default delaware incorporation structure optimizes various 142. compare bankman, the structure of silicon valley start-ups, supra note 4, at 1767 (acknowledging transaction costs and loss limitations but also suggesting various “irrational” possible reasons for corporate startup structure including the possibility that “individual investors are irrationally attracted by the remote possibility of enormous return”) and johnson, why do venture capital funds burn research and development deductions, supra note 4, at 89 (“the explanations offered on why the funds accept such high taxes do not justify or explain the destruction of the tax benefits. the results cannot be justified by drafting habits in a billion dollar fund because the stakes are too high to be justified by inertia.”) with fleischer, the rational exuberance of structuring venture capital, supra note 4, at 139–140 (placing greater weight on transaction costs and loss limitations including the fact that venture capitalists generally would not benefit from startup losses). 143. allen & raghavan, the impact of non-tax costs on tax-efficiency, supra note 4. 144. see, e.g., shaviro, rising tax-electivity of u.s. corporate residence, supra note 2, at 383–84 (2011) (noting that the degree of electivity turns on a comparison between tax advantages and “nontax consequences” such as corporate governance). 2013] tax planning and initial incorporation location 349 venture capital goals. its widespread use may also reflect lawyers’ aversion to taking on the professional risk of recommending an untested structure.145 another issue is collective action, since developing a new startup structure norm might be worthwhile only if the new structure could be used for a large number of clients.146 both the agency cost issue and the collective action issue suggest that significant path-dependent obstacles would block the development of a new norm of non-us incorporation of us-based startups in reaction to a tightening of us tax law applicable to us-parented mncs. this applies in particular to venture-backed startups because the advisor community that serves these firms shows a strong commitment to a us-incorporation norm for us-based firms. gatekeeper network effects would influence any change to the prevailing norm, including a change from a default of us incorporation to a default of non-us incorporation.147 d. considering future law changes in the future, congress could impose onerous tax rules on usparented mncs.148 it also could impose onerous non-tax rules on us 145. see gilson, engineering a venture capital market, supra note 35. cf. ruth mason, delegating up: state conformity with the federal tax base, 62 duke l.j. 1267, 1323–24 (2013) (referencing other literature on the “stickiness” of contract default terms). 146. see bankman, the structure of silicon valley start-ups, supra note 4, at 1767–68 (considering reduced transaction costs and venture capitalists’ collective action problem). see generally mancur olson, the logic of collective action (1965). 147. see marcel kahan & michael klausner, standardization and innovation in corporate contracting (or “the economics of boilerplate”), 83 va. l. rev. 713, 729 (1997) (contending that “learning and network benefits” encourage boilerplate and “path dependence”). cf. robert cooter, do good laws make good citizens? an economic analysis of internalized norms, 86 va. l. rev. 1577, 1585– 87 (2000) (noting that social norms present the possibility of multiple equilibria in part because of “fixed costs and network effects”). 148. courts have held that the constitution does not prevent congress from imposing a full current tax on all of the income earned by non-us subsidiaries of us parents. see, e.g., garlock inc. v. commissioner, 489 f.2d 197, 202-03 (2d cir. 1973) (holding subpart f’s current taxation of us shareholders constitutional) (citing heiner v. mellon, 304 u.s. 271, 281 (1938) (holding constitutional the taxation of a partner on partnership distributive share regardless of “the fact that it may not be currently distributable as a matter of state law”)), cert. denied, 417 u.s. 911 (1974). see also cook v. tait, 265 u.s. 47 (1924) (rejecting the contention that substantive due process concerns blocked the united state’s ability to tax noncitizen individuals); flint v stone tracy co., 220 u.s. 107, 151-52 (1911) (holding a 350 florida tax review [vol. 14:8 parented mncs. but available data does not suggest that startups place importance on the possibility of future changes in us tax law that would be adverse to us-parented mnc structures when they consider how to organize. several possible reasons may support this lack of concern. legislative process obstacles and interest group lobbying may block us legal changes adverse to us-parented mncs. similar considerations may not produce similarly formidable obstacles to legal change adverse to non-usparented mncs, whether under us or non-us law. in addition, the experience of us-based startups and their advisors with us law and legal change may provide a greater degree of certainty about the low likelihood of change in the united states, particularly with respect to change applicable to us-parented structures. us-based advisors have good reasons based on a significant body of data to believe that legal changes adverse to a us-parented mnc structure are unlikely. legislators may hotly criticize mnc tax planning in public hearings.149 but congressional policy goals also explicitly include corporate income tax constitutional because of its nature as an excise tax, not a “direct” tax subject to apportionment). several proposals for international corporate tax reform could, depending on the details, increase the tax burden of us-parented multinationals. one option is worldwide consolidation. see, e.g., kleinbard, stateless income, supra note 7, at 152–55 (listing advantages of worldwide consolidation, including satisfaction of capital export neutrality, solution to the problem of “stateless income,” and finessing of the “otherwise intractable” problems of transfer pricing and expense allocation). another is the imposition of a minimum tax on non-us subsidiaries’ income. see white house & dep’t of treasury, the president’s framework for business tax reform 14 (2012). a third option is territoriality, or dividend exemption. see jane g. gravelle, cong. research. serv., r42624, moving to a territorial income tax: options and challenges (2012). this approach would permanently exempt an mnc’s non-us business income from us income tax. territoriality is generally presented as a business-friendly reform. however, its adoption could produce increased taxes on us-parented multinationals depending on the details, including choices about the disallowance of deductions such as overhead expense allocable to non-tax business income and the inclusion of royalty income paid by non-us subsidiaries to us parents. see cong budget office, options for taxing u.s. multinational corporations 22 (2013) (citing expense allocation and royalty taxation as possible sources of increased revenue). the current taxation of low-taxed foreign income under territoriality or dividend exemption presents another open question. see j. clifton fleming, jr., robert j. peroni & stephen e. shay, designing a u.s. exemption system for foreign income when the treasury is empty, 13 fla. tax rev. 397 (2012). 149. see, e.g., nelson d. schwartz & charles duhigg, apple’s web of tax shelters saved it billions, panel finds, n.y. times, may 20, 2013, at a1 (reporting on senate permanent subcommittee on investigations hearing featuring apple ceo tim cook and senator carl levin). 2013] tax planning and initial incorporation location 351 “increas[ing] us competitiveness” and “reduc[ing] tax incentives for multinationals to be foreign-based.”150 in addition, the us legislative process presents sequential hurdles to enactment and therefore favors the status quo.151 in the area of corporate tax law reform, agency costs further hamper change. for example, managers face an incentive to favor policies like accelerated depreciation that provide targeted incentives for new corporate investment, even though shareholders prefer policies that also enrich existing investment.152 moreover, the heterogeneity of interests among different corporations may strengthen the importance of interest group influence in the area of corporate tax policy. this is because there is an incentive for corporations that disproportionately benefit from a certain tax break to lobby energetically to keep that tax break rather than supporting more general reform proposals.153 while overall tax reform adverse to corporate interests is possible, it is unusual.154 and when broad reform does occur, it faces the prospect of later erosion.155 startup lawyers, venture capitalists and entrepreneurs may be more concerned about future law changes applicable to non-us parented mncs. some future law changes that could affect non-us-parented structures would arise under non-us law. in the informal interviews conducted, some concern about the uncertain application of non-us law was expressed. it is possible that startups and their advisors place a higher likelihood on the possibility of such adverse non-us law change. they might do so because they perceive 150. senate finance committee staff, tax reform options for discussion: international competitiveness 4 (may 9, 2013). 151. see, e.g., william n. eskridge, jr., philip p. frickey & elizabeth garrett, legislation and statutory interpretation 70 (2d ed. 2006) (“the most salient aspect of the modern legislative process is that it is filled with a complex set of hurdles that proponents of a new policy must overcome before their bill becomes law.”). 152. see jennifer arlen & deborah m. weiss, a political theory of corporate taxation, 105 yale l.j. 325, 336–38 (1995) (arguing that managers have incentives to favor policies that encourage additional investment or otherwise make possible increases to individual returns such as salaries). 153. see michael doran, managers, shareholders and the corporate double tax, 95 va. l. rev. 517, 536–42 (2009) (citing “unevenness resulting from the different use of corporate tax preferences, interest deductions, and tax shelters”). see also martin sullivan, corporate tax reform: taxing profits in the 21st century (2011) (explaining some interest group and other concerns that make reform unlikely). 154. see, e.g., daniel shaviro, beyond public choice and public interest: a study of the legislative process as illustrated by tax legislation in the 1980s, 139 u. pa. l. rev. 1 (1990). 155. see, e.g., edward j. mccaffery & linda r. cohen, shakedown at gucci gulch: the new logic of collective action, 84 n.c. l. rev. 1159 (2006). 352 florida tax review [vol. 14:8 relatively lower legislative process constraints outside the united states, where fewer legislative process obstacles to change may exist, for example in parliamentary systems. other future law changes that could affect non-us-parented mncs would arise under us law. in the tax area, the anti-inversion rule of section 7874 provides a prominent example of a us statute that targets a non-usparented structure. under this statute, a standalone firm with a parent incorporated in the united states generally cannot invert into a non-usparented structure respected as such for us tax purposes absent substantial business activities in the country where the new parent is incorporated.156 other proposals could tighten earnings-stripping rules and limit the ability of us subsidiaries of non-us parents to erode us tax bases via deductible payments such as interest and royalties;157 impose a mind-and-management residence rule to replace the current place-of-incorporation rule;158 or impose a higher rate on dividends paid to us shareholders from non-us corporations compared to dividends from us corporations.159 if non-us-parented mncs are less effective than us-parented mncs at lobbying congress, antiforeign-corporation proposals like these may have a greater chance of enactment relative to proposals that impose more onerous requirements on us-parented firms. 160 another possibility is that uncertainty aversion causes a higher level of concern about the possibility of change adverse to a non-us-parented 156. see supra notes 18–20 and accompanying text (analyzing i.r.c. § 7874). 157. a series of administration proposals made by both the bush and obama administrations would significantly limit the deductibility of interest expense paid by us subsidiaries to foreign parents established in an inversion transaction. see solomon, corporate inversions: a symptom of larger tax system problems, supra note 20, at 1451–52. 158. one example is legislation that would change the corporate tax residence rule from place-of-incorporation to place of management and control or place of listing. see omri y. marian, jurisdiction to tax corporations, 54 b.c. l. rev. __ (forthcoming 2013), manuscript at 45 (identifying proposals to change us corporate residence rule), 51–53 (advocating us residence status for corporations managed and controlled in the united states or listed on a us exchange). 159. currently, dividends from “qualified foreign corporations,” meaning dividends on publicly traded stock or dividends from corporations eligible for the benefits of a satisfactory comprehensive income tax treaty, are taxed at the preferential rate under section 1(h) that also applies to dividends from us corporations. i.r.c. § 1(h)(11)(c). 160. see, e.g., david rogers, capital climate discomfits multinationals – business frauds, patriotic fever dominate debates on offshore havens, tax breaks, wall st. j., july 25, 2002, at a4 (reporting the issue of anti-inversion legislation in the wake of stanley works’ effort to reincorporate in bermuda as an potent congressional campaign issue). 2013] tax planning and initial incorporation location 353 structure.161 there are numerous data points related to the possibility of congressional change adverse to us-parented mncs. us-based advisors have access to fewer data points related to the possibility of either us or non-us change adverse to non-us parented mncs. for example, us advisors may be able to predict likely congressional action related to the repeated renewal of specific tax breaks. “look-through” rules for payments between related controlled foreign corporations and the subpart f active financing exception provide two current examples of provisions that us-parented mncs regularly lobby to preserve to ensure that their treatment under the existing set of rules does not worsen.162 the repeated renewal of such tax breaks provides ample opportunity to observe corporate interest groups’ ability to lobby and influence legislation and to support a conclusion on the part of advisors and 161. uncertainty aversion describes a preference for avoiding situations in which the chances of different possible outcomes are unknown. see david schmeidler, subjective probability and expected utility without additivity, 57 econometrica 571 (1989); see also larry g. epstein, a definition of uncertainty aversion, 66 rev. econ. stud. 579 (1999). uncertainty aversion can be analyzed separately from risk aversion, which refers to a preference for avoiding situations in which the outcome is not known, but the chances of different possible outcomes are known. see frank h. knight, risk, uncertainty & profit part iii ch viii (1921) (using “risk” to mean a measurable or mathematical uncertainty like that faced in a game of chance and “uncertainty” to mean an unmeasurable uncertainty). see also kenneth j. arrow, aspects of the theory of risk-bearing (1965) (providing risk aversion model); sarah b. lawsky, modeling uncertainty in tax law, 65 stan. l. rev. 241, 259–61 (2013) (citing daniel ellsberg, risk, ambiguity, and the savage axioms, 75 q.j. econ. 643 (1961)). the impact of uncertainty about future law changes has been considered broadly. see, e.g., guy halfteck, legislative threats, 61 stan. l. rev. 629 (2008). some tax research has focused on uncertainty under steady-state policies. for example, sarah lawsky has pointed out that a taxpayer’s uncertainty aversion may function as a built-in penalty. sarah b. lawsky, probably? understanding tax law’s uncertainty, 157 u. pa. l. rev. 1017, 1073 (2009) (“[t]heoretical models of tax compliance may benefit from taking into account an additional aspect of deterrence: the built-in penalty that is uncertainty.”). others have considered the interaction between penalties and uncertainty aversion. see mark p. gergen, uncertainty and tax enforcement: a case for moderate fault-based penalties, 64 tax l. rev. 453, 472 (2011) (considering solutions to the problem that a penalty may overdeter particularly uncertainty-averse taxpayers and underdeter others); kyle d. logue, optimal tax compliance and penalties when the law is uncertain, 27 va. tax rev. 241, 293–96 (2007) (analyzing strict liability and faultbased tax penalty structures assuming legal uncertainty). 162. see, e.g., press release, nat’l foreign trade council, nftc urges congress to pass tax extenders legislation, (march 15, 2012) (urging renewal of both provisions on competitiveness grounds). 354 florida tax review [vol. 14:8 investors that a change adverse to the interests of us-parented mncs is certainly unlikely. advisors likely face a higher degree of uncertainty related to the possibility of laws penalizing non-us-parented mncs. in the united states, there are few data points related to proposed laws targeting non-us-parented firms. in addition, us-based advisors may know less about likely future changes in law in other jurisdictions. if so, higher uncertainty about the likely changes to laws affecting non-us mncs could discourage use of the non-us mnc structure even if such a structure were advantageous from a tax perspective. v. theorizing the exceptions: what facilitates a non-us parent structure? a. tax factors because more mature and profitable firms are likely to benefit more from a non-us-parented structure, tax factors in general will present more advantages for some firms as opposed to others. the structure used by bermuda-parented corporations that primarily insure us risks provides an example of the potential power of tax factors to encourage non-us incorporation.163 the bermuda parent of a us insurance subsidiary must skirt several sets of rules to ensure that it will not be subject to us income tax on insurance or re-insurance premiums it receives.164 first, it must avoid the us rules that tax non-us persons on net income “effectively connected with a us business.”165 second, it must avoid the us rules that tax non-us persons by imposing a 30 percent withholding tax on gross “fixed or determinable, annual or periodic,” or fdap, income.166 bermuda-parented mncs that insure us risks achieve the first goal, related to avoiding effectively connected income treatment, with the help of a us-bermuda tax treaty that provides a taxpayer favorable “permanent 163. nontax regulatory factors, such as the opportunity to take advantage of less stringent investment standards, may also encourage tax-haven incorporation. see thomas st.g. bissell, a comparison of the u.s. tax rules for u.s. and offshore insurance products, 32 tax mgmt. int’l j. 14 (2003). 164. it must also avoid treatment as a passive foreign investment company, or “pfic.” this is accomplished by application of the active insurance exception to the pfic rules. see i.r.c. § 1297(b)(2)(a) and (b); david s. miller, how u.s. tax law encourages investment through tax havens, tax notes 167, 173–75 (apr. 11, 2011) (explaining application of pfic exception to offshore insurance companies and listing twenty-one publicly traded offshore reinsurance companies). 165. see i.r.c. § 882. 166. see i.r.c. §§ 881(a) (imposing 30 percent tax on fdap), 1441 (imposing withholding obligation). 2013] tax planning and initial incorporation location 355 establishment” provision.167 permanent establishment rules in treaties allow taxpayers from one treaty jurisdiction (here, bermuda) to establish more of a presence in the other treaty jurisdiction (here, the us) before the other treaty jurisdiction is permitted to impose income tax.168 the bermuda-us tax treaty provides among other things that the maintenance of a regular place of business “solely for the purpose of . . . collecting information, for the enterprise of insurance; or . . . advertising [or] for the supply of information, . . . for the enterprise” will not constitute a permanent establishment, even if carried on by a wholly-owned subsidiary, so long as the subsidiary is compensated on an arm’s length basis.169 this does not diverge substantially from the usual permanent establishment definitions in bilateral tax treaties, but it fails to acknowledge that the elements of the insurance business other than the giving and receiving of information can be carried on more easily from afar compared to many other businesses. in addition, it is unusual for the us and a tax haven jurisdiction like bermuda to conclude a tax treaty that includes a permanent establishment or “business income” provision. bermuda-parented mncs avoid fdap taxation despite the fact that the applicable statute includes us-source “premiums” in the list of items to be taxed;170 and premiums paid to insure us risks are us source income. a revenue ruling states that an excise tax applicable to premiums paid to a foreign insurer supersedes the fdap tax, and that the fdap tax substitutes for the collection of income tax.171 the excise tax charges four percent of property and casualty premiums and one percent of reinsurance, life insurance and other policy type premiums.172 the prevalence of the bermuda-parented insurance structure suggests that the premium excise tax produces a lighter tax burden than the imposition of us corporate income tax on net income would. a 1990 treasury study used a model to confirm this result.173 a key element of the 167. see william p. elliott, a guide to captive insurance companies, 16 j. int’l tax’n 22 (2005). 168. see joseph isenbergh, international taxation (3d ed. 2010). 169. u.s.a-bermuda insurance income tax convention act art. 3, aug. 29, 1986. 170. see i.r.c. §§ 881(a) (imposing 30 percent tax on fdap), 1441 (imposing withholding obligation). 171. see rev. rul. 89-91, 1989-2 c.b. 129. 172. see i.r.c. § 4371. 173. see u.s. treasury, report to congress on the effect on u.s. reinsurance corporations of the waiver by treaty of the excise tax on certain reinsurance premiums (apr. 2, 1990) tables 3, 4, 5 (showing top profitability in no-tax jurisdiction under almost all sets of assumptions under any of a 0 percent, 1 percent or 4 percent premium excise tax). 356 florida tax review [vol. 14:8 advantaged bermuda-parented insurance structure is that investment income resulting from invested premiums is not subject to tax.174 b. nontax legal factors nontax legal factors also help explain why some non-us incorporation locations may be more favored than others. marine transportation firms that are headquartered in the united states and incorporated outside the united states provide an example of an industry whose non-us organization decisions appear to be driven by various tax and nontax legal factors. online gaming provides another example of an industry influenced by nontax legal factors. us law exempts income derived from the international operation of a ship if it is earned by a foreign corporation resident in a country that declines to tax similar income earned by us corporations.175 in addition, although some commerce, such as “coastwise” shipping between two us ports, is limited to us-flagged vessels,176 the use of non-us flagships in international commerce including calls at us ports is permitted and provides several nontax regulatory advantages. these include the ability to use a nonus shipyard for vessel construction as well as the possible avoidance of applicable labor regulations, union contracts,177 and a choice of law doctrine that may require a us forum in the event of worker injury.178 online gambling firms may have had even stronger reasons to incorporate offshore. there is not yet a regulatory framework for online gambling in the united states and for some time its legality was in question in the united states, for example because of potential liability under the wire 174. see nysba, outbound inversion transactions report, supra note 25, at 28. 175. see i.r.c. § 883(a)(1); peter a. glicklich & michael j. miller, u.s. taxation of international shipping and air transport activities, 954 tax mgmt. (bloomberg/bna) portfolio 945 (2012). 176. see timothy semenoro, the state of our seafaring nation: what course has congress laid for the u.s. maritime industry?, 25 tul. mar. l.j. 355, 358 (2000). 177. id. at 368–69. 178. see grant gilmore & charles lund black, jr., the law of admiralty (2d ed. 1975). leading flag jurisdictions such as liberia and panama undertake to both provide satisfactory vessel safety and inspection requirements and also facilitate more cost-effective construction and operation. see, e.g., brad berman, does the unctad convention on the registration of ships need amending?, http://www.itfglobal.org/seafarers/icons-site/images/120_berman.pdf (emphasizing liberian commitment to safety standards). 2013] tax planning and initial incorporation location 357 act and the unlawful internet gaming enforcement act of 2006.179 one leading company incorporated in gibraltar conducted an ipo on the london stock exchange in 2005 using a proxy statement that reportedly disclosed that 90 percent of its customers were us.180 in 2011, the justice department provided guidance that permits states to legalize online gaming.181 this raises the question of whether online gaming companies will continue to organize outside the united states.182 c. liquidity and other resource constraints the description in part iv of startups’ reasons for incorporating in delaware under the default approach emphasized liquidity and other resource constraints. this suggests that if a startup had plentiful cash and other resources and did not need to depend upon venture capital financing, it would be more likely to depart from the default delaware corporation structure. the presence of corporateand individual-funded startups in the ipo data set, as discussed above, is consistent with this suggestion.183 similarly, one startup lawyer said that non-us incorporation might follow if a founder was a serial entrepreneur who had had the prior experience of a significant tax hit on a previous investment and who was confident about the availability of financing.184 another lawyer explained that he would not set such a structure up on a deferred fee basis, but would do so if the client paid “full freight.”185 a desire to access capital markets in the future might prompt organization as a non-us firm in order to make a future acquisition transaction attractive to a strategic acquirer who preferred to use offshore 179. see nelson rose & rebecca bolin, game on for internet gambling: with federal approval, states line up to place their bets, 45 conn. l. rev. 653, 657–69 (2012) [hereinafter rose & bolin, game on for internet gambling] (explaining historic legal landscape). 180. see hurt, regulating public morals, supra note 63, at 415 (reporting on partygaming ipo). 181. see rose & bolin, game on for internet gambling, supra note 179, at 674–84 (outlining likely state action regarding licensing of online gambling). 182. cf. matthew garrahan, us states make play for global gaming, fin. times, mar. 25, 2013, at 15 (reporting that states may enter into international regulatory compacts with respect to the regulation of online gambling). 183. see supra notes 64-69 and accompanying text. 184. telephone interview with silicon valley law firm partner (feb. 4, 2013). one founder reported refusing venture capital funding for a second startup, organizing it as an llc, and considering a non-us parent structure. telephone interview with silicon valley entrepreneur (feb. 11, 2013). 185. telephone interview with san francisco law firm partner (feb. 16, 2013). 358 florida tax review [vol. 14:8 cash. the results of informal interviews did not suggest that this factor is thought to affect startup company valuation.186 however, it arguably has affected valuation in some acquisitions. skype provides a good example, although it is not a pure startup example.187 microsoft bought skype, an mnc with a corporate parent resident in luxembourg, where the corporate tax is 0.4 percent, from a private equity consortium including silver lake partners and from ebay in 2011.188 the price was $8.5 billion. microsoft’s ability to forecast a low tax rate for skype profits and its ability to use offshore cash for the acquisition without paying any residual repatriation tax may have enabled it to pay much more than it would have been able to pay otherwise.189 d. investor preferences a number of tax-haven-incorporated firms in the ipo data set had investors or founders with links to a non-us jurisdiction. some tax factors correlate with this result. for example, a non-us investor does not face any pfic risk as a result of holding non-us company stock. in addition, the laws applicable in the non-us investor’s country and the country of incorporation will determine outcomes including treaty benefits such as withholding tax relief, and tax reporting requirements. these may be more favorable than those prescribed by us law. 186. e.g., telephone interview with silicon valley entrepreneur (feb. 11, 2013) (remarking that pharmaceutical companies really care about the technology); telephone interview with san francisco law firm partner (feb. 16, 2013) (expressing doubt that an offshore structure would affect valuation). 187. a similar example is provided by the 1994 acquisition of syntex, a silicon valley firm, by roche holdings ltd. see milt freudenheim, roche set to acquire syntex, n.y. times, may 3, 1994, at d1, d6 (reporting that syntex was based in palo alto and incorporated in panama). roche holdings ltd. was a swiss corporation; it owned a non-resident canadian corporation, which owned the acquiring company, a panama corporation. see syntex corp., tender offer statement (schedule 14d-1a) (sept. 9, 1994), http://www.sec.gov/archives/edgar/data/96000/0000950103-94-003492.txt. 188. see richard waters, tim bradshaw & maija palmer, microsoft in $8.5bn skype deal, fin. times, may 10, 2011, at 1 (reporting profit of $5 billion for the investors who had purchased 70 percent of skype eighteen months before the announcement of the microsoft deal). 189. see ronald barusch, microsoft’s brilliant, legal tax dodge, wall st. j. dealpolitik (may 11, 2011, 2:59 pm), http://blogs.wsj.com/deals/2011/05/11/dealpolitik-lesson-from-microsoftskypecongress-must-fix-corporate-tax-law/ (estimating deal price of $5.5 billion if skype “had been a delaware corporation run out of silicon valley” and microsoft had used offshore cash). 2013] tax planning and initial incorporation location 359 non-us connections also mitigate some of the risks presented by a non-us incorporation structure. venture firms that focus on particular nonus sectors often use non-us incorporation jurisdictions in those sectors, for example. their local presence may reduce legal risks, for example those related to the ability to pursue court remedies in the event of controversy. in addition, non-us connections support easier access to local, nonus attorneys, which can reverse the gatekeeper effects that cause us lawyers to recommend delaware incorporation. a local indian or israeli lawyer, for example, is likely to recommend indian or israeli incorporation. a local chinese lawyer may recommend that a firm follow a familiar structure that uses a parent company incorporated in the british virgin islands.190 vi. conclusion this article, consistent with previous literature and with the support of additional informal interview results, presents the default norm of us incorporation, in particular delaware incorporation, for us-based startups. the us incorporation structure dominates. however, there are exceptions to the general rule, for example in the insurance, marine transportation and online gambling industries and in isolated cases where resources permit and investors prefer a non-us incorporation structure. this article theorizes the dominant structure. it explains that usparented mncs can often achieve tax-advantaged structures and may obtain other valued corporate governance and other legal advantages. in addition, liquidity and other resource constraints support us incorporation for many startups. the dominant structure is particularly entrenched because advisors to startup firms, in particular lawyers, firmly embrace it. this article also theorizes the exceptions to the dominant structure. some us-based, non-us incorporated firms, including insurance firms, may make their organizational choice because of the tax advantages of non-us incorporation. other us-based, non-us incorporated firms, including marine 190. historically, legislative restrictions relating to foreign ownership of chinese firms, shareholder and creditor rights and listing approval made non-us ownership relatively attractive. see nicholas calcina howson & vikramaditya s. khanna, the development of modern corporate governance in china and india, in china, india and the international economic order 513, 542-45 (muthucumaraswamy sornarajah & jiangyu wang eds. 2010). tax havens may have provided corporate governance advantages as well as tax advantages. see dhammika dharmapala & james r. hines, jr., which countries become tax havens, 93 j. pub. econ. 1058 (2009). finally, substantial foreign direct investment tax incentives existed until 2007 and were available if investment was made through a non-chinese corporation. see jinyan li, the rise and fall of chinese tax incentives and implications for international tax debates, 8 fla. tax rev. 669 (2007). 360 florida tax review [vol. 14:8 transportation and online gambling firms, may make their organizational choice because of non-tax legal advantages of non-us incorporation, as well as any tax advantages. lower resource constraints and investor preference for non-us incorporation, for example because of independent sources of capital and/or business links to the jurisdiction of incorporation, also facilitate the incorporation of a us-based firm in a non-us jurisdiction. ii. why startups’ place of incorporation matters for tax b. being a non-us-parented mnc iii. us incorporation: a dominant structure with exceptions a. us-based startups generally incorporate in the us a “startup,” for purposes of this article, is a relatively new private business enterprise with global ambitions. this article focuses on initial incorporation decisions of “relatively new” firms and not on later changes in a firm’s place of incorpora... some of the material presented in this article, including the informal interviews, draws heavily from venture capital experience, although the definition of “startup” used here is not limited to venture-backed firms. other sources of initial outside c... prior work that investigates the choice of organizational form by us-based startups backed by us venture firms observes that us incorporation, particularly delaware incorporation, is the market norm.34f venture capital investments generally use stand... b. exceptions iv. explaining the dominant structure a. limited tax benefits of a non-us-parent structure c. liquidity and other resource constraints d. considering future law changes a. tax factors b. nontax legal factors c. liquidity and other resource constraints d. investor preferences login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe tcharity really does begin at home: florida tax review volume 10 2010 number 5 345 call for the gradual phase-out of all paper tax information statements by jay a. soled* for nearly a century, tax information statements such as form w-2s and forms 1099 have dominated the tax administration process, ensuring taxpayer compliance and providing a mechanism for irs oversight. the technological age of the internet, however, has fundamentally transformed the availability of information, including critical tax data, to make it more readily accessible. on the basis of this accessibility, this analysis calls for the phase-out of paper tax information statements. instead, tax data would be available at a secure irs website that, with a few keystrokes, taxpayers could conveniently use to prepare their tax returns. adoption of this proposal promises to create tremendous administrative efficiencies and greatly simplify the tax return preparation process. i. introduction .................................................................................. 347 ii. information statement issuance and its role in the tax administration process ......................................... 349 a. history of information statement/return issuance .............. 350 b. overview of how the current information statement/return system operates ....................................... 352 iii. technology gradually eclipsing need for paper information statement issuance .......................................... 356 iv. benefits flowing from the phase-out of paper information statement issuance ........................................ 361 a. taxpayers .............................................................................. 361 b. third-party information issuers ........................................ 363 c. tax return preparers............................................................ 364 d. government ........................................................................... 366 * professor, rutgers university business school. j.d. 1988, university of michigan law school. ll.m. (taxation), new york university school of law. the author thanks tax guru professor joseph bankman, tax historian joseph j. thorndike, and computer specialist george michaels for their assistance in offering valuable comments and insights. any errors or omissions contained in the analysis, however, are entirely of the author’s own doing. all rights reserved. 346 florida tax review [vol. 10:5 v. raising and addressing potential problems associated ....... with the phase-out of paper information statements ................................................................................. 370 vi. conclusion...................................................................................... 373 2010] phase-out of paper tax information statements 347 [the information return] is regarded as the most important blank form in the whole process of collecting income tax. it will involve an almost endless amount of labor on the part of many thousands of employers throughout the country. . . .1 i. introduction for nearly a century, the issuance of tax information statements/returns such as form w-2s and form 1099s, furnished annually to taxpayers, has played a vital role in the administration of our nation’s income tax system and in bolstering compliance. study after study shows robust evidence for this proposition: when information statements are issued, taxpayer compliance is high; conversely, in the absence of information statement issuance, taxpayer compliance plummets.2 there is little doubt that information statement issuance, coupled with the irs’s information return matching program, probably constitutes the single most important compliance mechanism ever devised to ensure the viability of the internal revenue code (code). nevertheless, the time has come for congress to phase out its existing information statement issuance requirement over the next several years. at first glance, calling for the phase-out of the information statement issuance requirement appears to be nothing short of a backhanded means to 1. see income blanks distributed, wall st. j., jan. 25, 1918, at 9 (bemoaning the introduction of information returns to the tax administrative compliance process). 2. see u.s. gov’t accountability office, gao-08-266, tax administration: costs and uses of third-party information returns (2007), available at http://www.gao.gov/new.items/d08266.pdf (reflecting the effectiveness of information returns in ensuring taxpayer compliance); irs fact sheet fs-2006-24 (aug. 2006), available at http://www.irs.gov/newsroom/article/0,,id=161511,00.html (“[e]xperience shows that taxpayers are much more likely to report their income when they receive third-party notification of payments they received.”); u.s. gen. accounting office, gao/ggd-94-123, tax gap: many actions taken, but a cohesive compliance strategy needed, at 5 (may 1994), available at http://archive.gao.gov/t2pbat3/151585.pdf (“information returns are a proven way to promote compliance and help irs find noncompliance.”); michael c. durst, report of the second invitational conference on income tax compliance, 42 tax law. 705, 707 (1989) (“computer-based enforcement techniques, relying largely on information returns filed by payers of wages, interest, dividends, and other items, have provided valuable benefits by virtually eliminating noncompliance with respect to important categories of income.”); see also leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stan. l. rev. 695, 695 (2007) (“[t]hird parties are routinely used by the tax system to verify the bona fides of taxpayer claims in diverse contexts involving reimbursed amounts and other receipts.”). 348 florida tax review [vol. 10:5 subvert the code and its administrability. but the truth is that while information statements have served an admirable purpose, they are a relic of the past. instead, consistent with the existing state of technology, accurate and timely tax information should be delivered electronically, supplanting our anachronistic delivery system of paper tax information statements. in a nutshell, when the government capitalizes upon existing technologies, here is a glimpse of what the future will undoubtedly look like: on or before january 31 following the end of a calendar year, responsible third parties that have traditionally issued paper information statements will instead electronically send pertinent tax information (e.g., employees’ wages, withholding data, interest payments, and the amount of recognized gains and losses on marketable securities) to the irs. the irs will then store this information, encrypt it, and post it on the internet. from a secure irs website, using a personal identification number or pin, taxpayers will access this information, review it, and then download it instantaneously onto their income tax returns.3 clerical errors would become virtually nonexistent because transcription mistakes and information entry in the wrong return fields would be minimized. while data aggregation of the sort envisioned here would not generate a tax compliance utopia, it would be a tremendous step in the right direction. in the parts that follow, this analysis outlines the specific details of this vision, its viability, and its salutary benefits relative to maintaining the status quo. in part ii, this analysis provides a short historical sketch of tax 3. congressman bill foster has recently introduced legislation that, in many respects, mirrors this proposal. congressman foster’s proposed legislation, labeled the autofill act of 2010, would require the irs to allow taxpayers to visit the irs website and gain electronic access to their personal tax data. see h.r. 5036, 111th cong. (2010). in addition, the government has an analogue of this proposal already in place known as the electronic federal tax payment system (eftps). as described in testimony for the irs oversight board, “eftps enables businesses, including clients of such agents, to view their tax account online via secure internet connection. clients can confirm that tax payments have been received by the irs and posted to their account as soon as the day after the tax deposit due date.” streamlining tax administration: how the irs can streamline its own processes and decrease taxpayer burden (feb. 1, 2005) (statement of tony tullo, director, federal compliance for automatic data processing, inc., on behalf of the national payroll reporting consortium), available at http://www.treas.gov/irsob/meetings/201-05/statement-nprc.pdf. in lieu of the proposal to eliminate paper information statements, several commentators have suggested that congress adopt a “pay as you earn” system that relies on a series of withholding taxes to obviate the need for many taxpayers to file tax returns. see william j. turnier, paye as an alternative to an alternative tax system, 23 va. tax rev. 205 (2003). pay as you earn tax systems are commonplace in many other countries. william g. gale & janet holtzblatt, on the possibility of a no-return tax system, 50 nat’l tax j. 475 (1997). 2010] phase-out of paper tax information statements 349 information statement issuance and the important role it has played to ensure taxpayer compliance. part iii explores the viability of electronic tax data aggregation and how it is poised to eclipse the world of paper tax information statement issuance. part iv sets forth numerous benefits that would flow both administratively and financially were the tax statement information process to move in this direction. part v raises and addresses potential problems associated with the congressional adoption of this proposal. finally, part vi offers conclusions. ii. information statement issuance and its role in the tax administration process one of the most important mechanisms to ensure tax compliance under the code has been the issuance of information statements combined with the issuance of information returns:4 the former are furnished to taxpayers to facilitate their tax return preparation process, informing them of wages produced, income earned, interest that is deductible, and gains and losses experienced; the latter contains the identical information but are submitted instead to the government, enabling it to cross-check the accuracy of taxpayers’ tax return entries.5 the reason that the combination of information statement/return issuance is so effective is that taxpayers know that the government has a road map to their reported income, making attempts to mask or omit such earnings virtually impossible. by way of analogy, in ancient egypt tax collectors used to measure the level of the nile to determine the amount of taxes owed by farmers.6 this public measurement put farmers on notice that the 4. see, e.g., jane g. gravelle & pamela j. jackson, crs report for congress: major tax issues in the 111th congress (2009): the percentage of individual income tax that was underreported varied significantly depending on the degree of information reporting and whether or not withholding was required. for example, only 1.2% of the sum of wages, salaries, and tips was underreported, but 57.1% of nonfarm proprietor income was underreported. these data suggest that increased information reporting and withholding would reduce the tax gap. 5. see irs data book, 2009, publ’n 55b, tbl.14, at 37 (mar. 2010) (for fiscal year 2009, the irs received approximately three billion information returns, less than 2% of which were filed in a paper format). 6. aristide théodoridès, the concept of law in ancient egypt, in the legacy of egypt 291, 292 (j.r. harris ed., 1971); see also leandra lederman, reducing information gaps to reduce the tax gap: when is information reporting warranted?, 78 fordham l. rev. 1733, 1736 (2010) (“with information reporting, the government obtains information about the taxpayer’s tax situation from a third 350 florida tax review [vol. 10:5 government knew with a fair degree of accuracy what that year’s harvest had yielded and, therefore, the annual tax the government could levy.7 in the subparts below, this analysis (a) summarizes the history of information statement/return issuance and (b) provides an overview of how the tax information reporting system currently operates. a. history of information statement/return issuance before attempting to revamp the existing information statement/return system, it is worthwhile to try to understand its historical origins and how congress, over the past century, has shaped and expanded this system. congressional institution of information return reporting commenced in 1917 and applied to a broad array of payments, including interest, rent, salaries, wages, premiums, annuities, compensation, remuneration, emoluments or other fixed or determinable gains, profits, and income of $800 or more paid during the course of any taxable year.8 at the time, the commissioner instructed payers to use form 1099 to report the delivery of such payments9 (with respect to wages, form w-2 did not come into existence until 1943 when congress instituted a broad withholding system).10 at least one newspaper, the wall street journal, greeted the introduction of this administrative taxpayer burden with a chilly reception.11 presumably finding that third-party wage reporting was a good mechanism to help ensure taxpayer compliance, congress decided to capitalize upon the success of this nascent initiative. in the revenue act of 1921, congress expanded the existing information return system to include brokers.12 this new legislation required that, upon request, every broker must disclose to the government “such details as to the profits, losses, or party and—equally important—the taxpayer knows that the government has the information.”). 7. said somewhat differently, the entire process is reminiscent of the christmas spirit and santa claus: with information returns in hand, the irs knows exactly who’s been “naughty” and who’s been “nice.” 8. war revenue act, pub. l. no. 65-50, ch. 63, § 1211, § 28, 40 stat. 300, 337 (1917). see richard l. doernberg, the case against withholding, 61 tex. l. rev. 595, 599–603 (1982) (detailing the history of information returns and statements). 9. see supra note 1 (“the commissioner of internal revenue has begun the distribution of 20,000,000 income blanks known as ‘form 1099.’”). 10. current tax payment act of 1943, pub. l. no. 78-68, ch. 120, 57 stat. 126. 11. see supra note 1. 12. revenue act of 1921, pub. l. no. 67-98, ch. 36, § 255, 42 stat. 227, 269. 2010] phase-out of paper tax information statements 351 other information . . . as to each of such customers, as will enable the commissioner to determine whether all income tax due on profits or gains of such customers has been paid.”13 in 1943 congress added another wrinkle to information statement/return issuance. beginning in that year, congress instituted a wage withholding system.14 this new withholding system added another dimension of complexity to information statement/return issuance. more specifically, on a going-forward basis, congress required employers to delineate the amount of wages withheld on the newly minted so-called form w-2.15 notwithstanding the initial flurry of activity surrounding information statement/return reporting, for the next four decades its scope and application remained relatively constant. however, in 1982 congress took measures to greatly expand information reporting. in the tax equity and fiscal responsibility act of 1982 (tefra), congress required brokers to delineate on information statements/returns the gross proceeds generated from all securities and commodities transactions.16 in the last few years, congress has again taken several important steps to expand the scope of information reporting. in 2008 it passed legislation embodied in code section 6045(g) that required taxpayers to track investors’ tax basis in so-called “covered securities” and, upon the disposition of such securities, report taxpayers’ corresponding gains and losses.17 in 2010, it passed legislation embodied in code section 6041(h) that requires businesses that pay any amount greater than $600 during the year to 13. id. 14. see supra note 10; see generally carolyn c. jones, class tax to mass tax: the role of propaganda in the expansion of the income tax during world war ii, 37 buff. l. rev. 685 (1988/89) (explaining how the current withholding system allowed congress to greatly expand the number of taxpayers subject to the income tax). 15. see employer duty in withholding tax explained, chi. daily trib., june 12, 1943, at 23 (“employers must provide each employé [sic] annually with a ‘statement of income tax withheld on wages.’ this is form w-2, and must be delivered to employés [sic] on or before jan. 31 of the next year.”). 16. pub. l. no. 97-248, § 311, 96 stat. 324, 600-01; see joint comm. on taxation, general explanation of the revenue provisions of the tax equity and fiscal responsibility act of 1982 (1982). 17. see emergency economic stabilization act of 2008, pub. l. no. 110343, § 403, 122 stat. 3765, 3854–56 (beginning in 2011, requiring security basis reporting). 352 florida tax review [vol. 10:5 corporate providers of property and services to file an information report with each provider and with the irs.18 when formulating tax policy pertaining to information reporting, congress has taken technological advancements and innovations into account. for example, approximately a decade ago, congress enacted legislation that sanctioned the voluntary use of electronic tax information statement issuance.19 payers required to furnish form w-2 are now authorized to do so electronically with respect to consenting payees,20 as can payers required to furnish statements under code sections 6041 through 6050t, such as form 1099-div.21 to ensure that unwilling payees are not forced to accept the receipt of their information statements electronically, both treasury department regulations and irs administrative notices have set forth detailed rules to safeguard against unscrupulous payers mandating that payees accept receipt of their information statements electronically rather than in paper form.22 b. overview of how the current information statement/return system operates tax information statements/returns come in many varieties. some relate to the receipt of wages (i.e., form w-2); others relate to the receipt of investment returns such as interest (i.e., form 1099-int) and dividends (i.e., form 1099-div). as pointed out in the prior subpart, the variety of tax information statements/returns that the government requires taxpayers to disseminate and to file has grown exponentially.23 indeed, as congress tries to close the “tax gap”—the difference between what taxpayers owe and what 18. see patient protection and affordable care act, pub. l. no. 111-148, § 9006, 124 stat. 119, 855 (2010) (beginning in 2012, greatly expanding the scope of information reporting). 19. job creation and worker assistance act of 2002, pub. l. no. 107-147, § 401, 116 stat. 21, 40. 20. reg. § 31.6051-1(j)(1). 21. general instructions to form 1099 pt. h (2005); irs notice 2004-10, 2004-1 c.b. 433. 22. for example: the consent requirement . . . is not satisfied if the recipient withdraws the consent and the withdrawal takes effect before the statement is furnished. the furnisher may provide that a withdrawal of consent takes effect either on the date it is received by the furnisher or on a subsequent date. the furnisher may also provide that a request for a paper statement be treated as a withdrawal of consent. reg. § 31.6051-1(j)(2)(ii). 23. see supra part ii.a. 2010] phase-out of paper tax information statements 353 they actually pay24—taxpayers can anticipate that tax information statement/return reporting will become more robust because politicians will seek to generate additional revenue without having to raise tax rates or broaden the tax base.25 the time period by which taxpayers must issue tax information statements/returns varies. to enable taxpayers to complete their tax returns in a timely fashion (e.g., march 15 in the case of calendar year corporate taxpayers and april 15 in the case of individual taxpayers),26 most forms of tax information statements must be issued to payees by january 31.27 to enable the irs to monitor taxpayer compliance, tax information returns are generally due to the agency by february 28 if submitted in paper form28 or by march 31 if submitted electronically.29 to ensure compliance with the foregoing rules, congress has instituted an elaborate penalty system pertaining to the issuance of timely and accurate information statements to payees and tax information returns to the government. one set of penalties applies to payers, financial institutions, and brokers, requiring them to furnish on a timely basis accurate tax information statements to payees and clients; another set of penalties applies to payers, financial institutions, and brokers, requiring them to submit 24. the irs estimates that the tax gap for 2001 (the latest year in which such an analysis was conducted) was $290 billion. irs news release ir-2006-28 (feb. 14, 2006), available at http://www.irs.gov/newsroom/article/0,,id=154496, 00.html. 25. the fiscal year 2008 and 2009 budgets both contained provisions that would expand the use of information reporting. james m. bickley, crs report for congress: tax gap and tax enforcement (2008); fy 2009 irs budget: written testimony before the h. comm. on ways & means (2008) (statement of douglas h. shulman, commissioner of internal revenue). in recent congressional testimony, the irs commissioner targeted six new areas of information reporting: require information reporting for private separate accounts of life insurance companies; require information reporting on payments for services to corporations; require a certified taxpayer identification number (tin) from contractors; require increased information reporting on certain government payments; increase information return penalties; and require information reporting on expense payments relating to rental property. filing season and fy 2011 budget request: written testimony before the h. comm. on ways & means (2010) (statement of douglas h. shulman, commissioner of internal revenue) [hereinafter shulman testimony 2010]. 26. irc § 6072(a), (b). 27. see, e.g., irc § 6049(c)(2) (requiring the issuance of form 1099-int by january 31 to the payee). 28. see, e.g., reg. § 1.6049-4(g) (requiring the submission of form 1099int by february 28 to the irs). 29. irc § 6071(b). 354 florida tax review [vol. 10:5 accurate tax information returns on a timely basis to the government. the next two paragraphs identify the nature of each set of these penalties. 1. penalties for failing to furnish timely and accurate tax information statements to payees on or before january 31 following the end of a calendar year, payers, financial institutions, and brokers are generally required to furnish tax information statements to payees and clients.30 a payer, financial institution, or broker that fails to meet this requirement or, alternatively, fails to include correct information (or omits required information) is generally subject to a penalty of $50 per statement, up to a maximum of $100,000 in any calendar year.31 even more severe penalties apply if the failure to comply with the foregoing furnishing rules is due to a payer’s, financial institution’s, or broker’s intentional disregard of these rules.32 due to the importance associated with taxpayers having timely receipt of and accurate information on these statements, neither the making of prompt corrections nor the commission of de minimis mistakes excuses or eliminates the imposition of penalties connected with the furnishing of incorrect tax information statements.33 2. penalties for failing to supply timely and accurate tax information returns to the government in general, on or before february 28 (or march 31, if filed electronically), payers, financial institutions, and brokers must submit information returns to the government.34 a payer, financial institution, or broker that fails to meet this requirement or, alternatively, fails to include correct information (or omits required information) is generally subject to a 30. an important exception to this rule pertains to partnerships and the issuance of schedule k-1s to partners. these schedules are due on or before the day on which the partnership return for that taxable year must be filed (with extensions). reg. § 1.6031(b)-1t(b). 31. irc § 6722(a), (b). 32. the penalty is $100 per statement or, if greater, (i) 10% of the aggregate dollar amount of items required to be reported (other than under code §§ 6045(b), 6041a(e), 6050h(d), 6050j(e), 6050k(b), or 6050l(c)); or (ii) 5% of the amounts required to be reported under code §§ 6045(b), 6050k(b), and 6050l(c). irc § 6722(c)(1). 33. h.r. rep. no. 101-247, at 1385 (1989) (expressing congressional concern that taxpayers need accurate information statements if they are to complete their tax returns in a timely fashion). 34. see, e.g., irc § 6071. 2010] phase-out of paper tax information statements 355 penalty of $50 per return, up to a maximum of $250,000 per calendar year.35 if payers, financial institutions, or brokers inadvertently submit incorrect information returns, the code provides a set of reduced penalties for prompt corrections.36 furthermore, if timely corrected (usually on or before august 1 of the calendar year in which the return is required to be filed), errors or omissions on a de minimis number of returns will not generate penalty imposition.37 evident from the emergence of the current compliance system, grounded heavily upon the submission and the matching of tax information statements/returns, is the government’s extraordinary reliance upon it and its proven ability to bolster taxpayer compliance.38 the government recognizes the pivotal importance of this system and has been willing to make significant investments to promote its modernization. consider that the irs has instituted the modernized e-file (mef) system. this system provides “a single method for filing all irs tax returns, information returns, forms, and schedules via the internet.”39 a key component of the mef system is the modernized tax return database (mtrdb), which is “the authoritative store of accepted returns and extensions submitted through the mef system.”40 the key reasons for the institution of these two interrelated systems are simple: [t]o allow the irs to collect more tax documents electronically and reduce the costs associated with the inefficiencies of paper documents and manual processing, while enhancing customer service and increasing availability of taxpayer information. internet-based filing directly supports the goal of revolutionizing how taxpayers transact and communicate with the irs.41 35. irc § 6721(a). 36. irc § 6721(b). for example, if a payer corrects the error or omission within thirty days after the due date, the amount of the penalty is $15 per return, up to a maximum of $75,000 in a calendar year. irc § 6721(b)(1). 37. irc § 6721(c). 38. see supra note 2. 39. see treasury inspector gen. for tax admin., 2009-20-026, the internal revenue service deployed the modernized e-file system with known security vulnerabilities, at 1 (2008), available at http://www.treas.gov/tigta/auditreports/ 2009reports/200920026fr.pdf. 40. id. 41. id. 356 florida tax review [vol. 10:5 to develop, operate, and maintain the mef system, the projected costs are $673 million.42 there is little doubt that the mef system constitutes a worthwhile investment; however, it addresses only one-half of the information statement/return equation, leaving untouched the part that pertains to the issuance of paper information statements.43 additional dollars should clearly be devoted to develop the mef system not only to accept and store information returns but also to use similar technology to allow taxpayers access to this stored data. enabling taxpayers to gain access to this stored data would obliterate the need for third parties to issue paper tax information statements. in the next part, this analysis documents how existing technology provides a sufficient platform to phase out the issuance of tax information statements in a paper medium. iii. technology gradually eclipsing need for paper information statement issuance over the last several decades, massive strides have been made in the field of technology. compared to their predecessors of only a generation ago, computers can operate at much faster speeds and store much more information on their hard drives. indeed, a contemporary computer can now complete in a matter of split seconds a process that may have taken several minutes a decade ago.44 along with a car and a telephone, a personal computer has become one of the most important durable items found in the average person’s home. 42. id. 43. through its electronic tax administration advisory committee, the irs seems to be exploring ways to expand the use of computer applications to the tax filing process. nevertheless, there are apparently no plans to make tax data available to taxpayers electronically such that they could complete the submission of their tax returns on a timely basis. irs publ’n 3415, elec. tax admin. advisory comm., annual report to congress (2010), available at http://www.irs.gov/pub/irspdf/p3415.pdf. on at least one occasion, however, the irs did consider providing taxpayers with access to collected tax data, but this effort was subsequently abandoned. see treasury inspector gen. for tax admin., 2009-20-102, changing strategies led to the termination of the my irs account project (2009), available at http://www.treas.gov/tigta/auditreports/2009reports/200920102fr.pdf (“the intent of the project was to develop a project that would provide taxpayers a means to securely view their tax account and return information online, as well as provide tools for self-service assistance.”). 44. see, e.g., gordon moore, cramming more components onto integrated circuits, 38 electronics 8 (1965) (“the complexity for minimum component costs has increased at a rate of roughly a factor of two per year.”). 2010] phase-out of paper tax information statements 357 corresponding to these massive strides in the technology field has been the spiraling popularity of internet usage. although the internet celebrates no exact birth date, in 1969 the u.s. department of defense developed a small network of computers that could communicate with each other in the case of an emergency.45 this intercomputer communication ultimately led to the genesis of the internet.46 initially, the development of the internet proceeded slowly as standards developed in message formats.47 by the early 1990s, once these standards were developed, internet usage grew at lightning speeds.48 today, its usage has become a staple of american culture.49 people constantly turn to it for information and to communicate. simply put, its presence has single-handedly reshaped how people conduct their businesses and orchestrate their personal lives. the impact of technology and the power of the internet can be readily seen and felt in the sphere of tax administration. most significantly, taxpayers consider computers central to the tax return preparation and filing processes. and this is for good reason. by 2008, over 80% of households possessed a personal computer.50 many taxpayers use their personal computers to prepare their own tax returns using tax return preparation software51 and to submit their returns electronically.52 when taxpayers turn to professionals to prepare their returns, in the vast majority of cases, these professionals likewise use tax preparation software and submit the prepared tax returns electronically.53 45. see generally janet abbate, inventing the internet (1999). 46. id. ch. 1. 47. id. ch. 5. 48. id. ch. 6. 49. wade rowland, spirit of the web, ch. 32 (2006). 50. over 57 percent of american homes have access to high-speed internet service, articlet, http://articlet.com/article791.html (last visited sept. 13, 2010) (“the pc penetration in american homes has increased to 80.6% in 2008 from 77.9% the year earlier.”); patrick seitz, personal computer still eludes a fifth of u.s. households; cost remains biggest factor, investor’s bus. daily, jan. 9, 2004. 51. see u.s. gov’t accountability office, gao-09-297, tax administration: many taxpayers rely on tax software and irs needs to assess associated risks (2009) (“individual taxpayers used commercial tax software to prepare over 39 million tax returns in 2007. . . .”). 52. see u.s. gov’t accountability office, gao-09-640, tax administration: interim results of irs’s 2009 filing season (2009) (reporting for the 2009 tax return filing season that 72% of returns were filed electronically); irs data book, supra note 5, tbl.4, at 9 (reflecting the fact that the majority of individual, corporate, and partnership tax returns are now filed electronically). 53. john l. guyton, adam k. korobow, peter s. lee & eric j. toder, the effects of tax software and paid preparers on compliance costs 2, available at 358 florida tax review [vol. 10:5 for reasons relating to efficiency, this reliance upon tax preparation software is understandable. companies producing this tax preparation software can readily keep such software up-to-date and debug any programming issues. indeed, more than ever, necessary changes are being conducted over the internet rather than via deliverable media such as cdroms.54 the power and speed of today’s computers combined with the availability of the internet’s information has made the need for paper records increasingly obsolete. evidence for this proposition abounds. consider the fact that around tax season, most public libraries traditionally stocked irs publications and tax returns for their patrons to use.55 no longer: these staples in public libraries have all but disappeared. consider, too, that the irs would historically mail copies of income tax returns beginning in midjanuary for individual taxpayers to complete. now, in an attempt to save resources and to cut costs, the irs only mails hard copies of the form 1040 to those taxpayers who have not previously filed their returns electronically.56 consider, too, that the availability of online documents combined with the speed and low cost of advanced networks has fundamentally changed the way we store documents. two primary technologies allow businesses and individuals such easy access to information. the first is the advent of the “intranet,” which allows documents to be stored centrally but still be accessible to all granted appropriate access.57 the second is the http://www.urban.org/uploadedpdf/1000802.pdf (last visited sept. 10, 2010) (“over 85% of tax returns were prepared on a computer in 2003—97% of the 62% of returns paid by preparers and 66% of the 38% of returns prepared by taxpayers.”). 54. curt finch, the benefits of the software-as-a-service model, computerworld (jan. 2, 2006), available at http://www.computerworld.com/s/article /107276/the_benefits_of_the_software_as_a_service_model. 55. see, e.g., rev. proc. 86-35, 1986-2 c.b. 596 (“no charge will be made to a bank, post office, public library or other organization for any quantity of forms and instructions intended for the convenience and use of the taxpayer, so long as such organization is not engaged in the preparation of tax returns for private gain.”). 56. see, e.g., shulman testimony 2010, supra note 25, at 13 (“the irs will generate savings by eliminating the non-mandated notice inserts; the automatic mailing of form 1040, u.s. individual tax return, tax packages; and the automatic mailing of business tax products.”); ed o’keefe, irs to stop mailing income tax forms, washington post (sept. 27, 2010) available at http://www.washingtonpost.com/wp-dyn/content/article/2010/09/27/ar2010092705 058.html (the irs will stop mailing instructions and paper forms, saving the agency $10 million annually). 57. see, e.g., mohd daud norzaidi, siong choy chong & mohamed intan salwani, intranet usage, managerial satisfaction and performance impact: an empirical analysis, 3 int’l j. bus. & sys. res. 481 (2009). 2010] phase-out of paper tax information statements 359 standardization of the pdf file as the electronic format of choice.58 with these two technologies in place, it has become commonplace for all computer users (particularly working for the same employer) to think of documents as easy to find and ready to transport. the one element of tax administration that has stubbornly bucked the paperless trend is the issuance of paper tax information statements. if left unchecked, not only will paper tax information statement issuance continue into the foreseeable future, all indications are that the issuance of paper tax information returns will skyrocket.59 both recently passed legislation and proposed legislation call for more tax information statement issuance.60 in practical terms, what does this mean? taxpayers will remain anchored in their traditional ways when meeting with their tax return preparers, continuing to bring their old “shoeboxes” filled with a wide assortment of paper tax information statements. by way of comparison, consider the fundamental transformation that has occurred in the sphere of business tax return completion. many businesses now use business software packages such as quickbooks that 58. int’l org. for standardization, pdf format becomes iso standard (july 2, 2008), www.iso.org/iso/pressrelease.htm?refid=ref1141. 59. see supra note 25; see also, e.g., u.s. dep’t treasury, general explanations of the administration’s fiscal year 2010 revenue proposals (2009) (“any u.s. person, or any qualified intermediary, that forms or acquires a foreign entity on behalf of a u.s. individual . . . would be required to file an information return with the irs regarding the foreign entity that is formed or acquired.”); u.s. gov’t accountability office, gao-09-238, tax gap: irs could do more to promote compliance by third parties with miscellaneous income reporting requirements 37 (2009) (“to simplify the burden that the corporate exemption places on payers to distinguish payee’s business status and also provide greater information reporting, congress should consider requiring payers to report payments to corporations on the form 1099 misc. . . .”); sam goldfarb, shulman calls for increased information reporting, 2009 tax notes today 89-44 (may 12, 2008) (“irs commissioner douglas shulman on may 9 said he is ‘philosophically’ supportive of more information reporting, specifically mentioning a controversial plan to require banks to report credit and debit card transactions.”). 60. see, e.g., housing assistance tax act of 2008, pub. l. no. 110-289, §§ 3000, 3091, 122 stat. 2654, 2877, 2908 (introducing code section 6050w, which requires that the gross amount of payment card and third-party network transactions be reported annually to participating merchants and the irs). in recently released proposed regulations, the irs details the information that must be included on the newly designated form 1099-k. information reporting for payments made in settlement for payment card and third party network transactions, prop. regs. §§ 1.6041-1, 1.6050w-1, 31.3406(b)(3)-5, 31.3406(a)-2, 31.3406(d)-1, 31.3406(g)-1, 31.6051-4, 301.6721-1, 301.6722-1, 74 fed. reg. 225 (proposed nov. 24, 2009); amy s. elliot, long-awaited proposed credit card reporting regs released, 125 tax notes 961 (2009). 360 florida tax review [vol. 10:5 enable them, at the end of each year, to readily download information onto their business tax returns without the presence of actual paper records. this data downloading process is far easier, less time-consuming, and more accurate than reliance upon paper records, which are readily misplaced or from which the data is inaccurately transcribed onto the submitted tax return. the good news for the tax administration process is that tremendous strides have been made in the sphere of mass data storage and data aggregation. these strides should enable taxpayers and the government to replicate what is already being done in other areas of data storage and apply these advancements to individual taxpayer return compliance.61 (this trend is being further propelled by the fact that mass electronic data storage is “green,” galvanizing political momentum, particularly among environmentalists.)62 three examples of successful data aggregation immediately come to mind. the first, cited in the prior paragraph, is the ability of off-the-shelf software packages to gather pertinent data entries and to file these entries exactly where the business taxpayer instructs. a second example of data aggregation pertains specifically to tax information: even today, many financial institutions and brokerage firms post taxpayer data, pertinent to their individual clients, on their websites; using a pin, taxpayers/clients can readily download this personal tax information directly onto their individual income tax returns.63 a third and final example of data aggregation is the m-trdb system (described in part ii.b), which currently stores all accepted returns and extensions.64 in terms of tax administration, what the foregoing advancements indicate is that the government, in terms of technology, does not need to 61. see mike ashenfelder et al., ndiipp models for mass data transmission and storage, 57 libr. trends 541 (winter 2009). 62. u.s. dep’t treasury, treasury goes green, saves green (apr. 19, 2010), http://www.treas.gov/press/releases/tg644.htm (“with americans poised to celebrate the 40th anniversary of earth day this week, the u.s. department of the treasury today announced a broad new initiative to dramatically increase the number of electronic transactions that involve treasury and millions of citizens and businesses, a move that is expected to save more than $400 million and 12 million pounds of paper in the first five years alone.”); dennis mccafferty, government goes green—political pressure, shrinking budgets force agencies to be energyefficient, varbusiness (sept. 29, 2008), at g6. 63. see, e.g., american century investments, turbotax and turbotax for the web, https://www.americancentury.com/customer_service/turbotax_help.jsp (“turbotax software and turbotax for the web include the instant data entry feature, that enables the automated import of 1099-div, 1099-b and 1099-r tax data directly from american century investments for your retirement and non-retirement accounts. once imported, you can download this information directly into your turbotax return.”). 64. see text accompanying supra note 40. 2010] phase-out of paper tax information statements 361 break new ground. that is, once the government gathers all the data sent electronically to it by third parties, it should house this information on one central website. the government would then grant taxpayers direct electronic access to this data warehouse, limited to their particular “storeroom” (i.e., where tax data pertinent to the completion of their personal tax returns would be housed). with a few keystrokes, taxpayers accessing this website would then be able to download this tax data directly onto their tax returns. iv. benefits flowing from the phase-out of paper information statement issuance if congress were to phase out tax information statement issuance and to call for the availability of this same information electronically via an irs website, numerous administrative benefits would arise. in terms of money, resources, and time, these administrative benefits would result in tremendous savings. in the subparts below, this analysis sets forth the benefits that would inure to (a) taxpayers, (b) third-party information statement issuers, (c) tax return preparers, and (d) the government. a. taxpayers by way of background, taxpayers who receive information statements such as form w-2s and form 1099s are often flummoxed and overwhelmed by the data such information statements contain. consider the face of form w-2: it encompasses spaces for over twenty numerical entries. for the nontax professional, the receipt of form w-2 can be a beguiling experience: a seemingly official document, arriving typically by mail, contains a broad array of numbers, some coded and some not coded. for those taxpayers who willingly undertake the challenge and complete their own tax returns, most find it difficult to know exactly where each numerical entry of the form w-2 should be transcribed on their paper form 1040 or exactly when (and if) their tax preparation software will prod them to enter the information proffered on the information statement. likewise, when it comes to using the information contained on form 1099, the same sense of uncertainty usually besets taxpayers, in particular regarding where certain numerical entries, such as qualified dividends, belong on their tax returns. aside from numeric complications surrounding the tax return preparation process, taxpayers harbor numerous other concerns as well. do they have all of their information statements? are the dollar figures and codes contained on their information statements correct? will they be able to enter the data contained on these information statements correctly on their tax returns? will turning over these information statements to their tax return 362 florida tax review [vol. 10:5 preparers jeopardize their privacy and possibly facilitate identity theft?65 if they pay a tax return preparer to prepare their tax returns and to enter this data, how expensive will the concomitant fee be? many, if not all, of the taxpayers’ fears and concerns articulated in the prior two paragraphs would be allayed if the data contained on paper information statements were available electronically on a secure irs website. for starters, taxpayers would have new confidence that the numbers and codes that previously appeared on their paper information statements and are now made available electronically on the irs website could be handled in a more comprehensive fashion. that is, the irs website could allow taxpayers to double click data entries to prompt a substantive explanation of the dollar figure and/or code in question.66 furthermore, with the push of another key, the irs website could presumably enable taxpayers to eliminate tax return guesswork by transferring relevant data directly onto their tax returns to the exact location where such data should be recorded. use of a secure irs website would help address other taxpayers’ concerns as well. for example, taxpayers could have confidence that their information statements would not be mailed to the wrong address, opened by unscrupulous mailroom personnel, or lost subsequent to their receipt. on their computer screens, taxpayers could view all tax data relevant to their tax returns. if taxpayers noticed that the information from a particular third-party information issuer was missing, they could contact the third-party information issuer in question; alternatively, if there was a putative mistake made by that third party, taxpayers likewise could contact the third party to request a correction of the erroneous information. adoption of this proposal would also probably alter the relationship that taxpayers share with their tax return preparer. right now, for reasons of cost efficiencies, data entry for a significant number of paid-preparer tax returns is conducted overseas.67 not only does the transference of personal 65. see david j. roberts, why is your social security number on those information returns?, 2010 tax notes today 36-9 (feb. 24, 2010) (stressing the dangers associated with having taxpayers’ social security numbers posted on the face of information statements). 66. indeed, the irs website could have a series of pop-ups to remind taxpayers that all income must be reported, including income earned in the form of cash. on the one hand, such pop-ups could be a tremendous taxpayer compliance tool; on the other hand, taxpayers may consider the use of such pop-ups too reminiscent of orwell’s 1984. see wendy m. moe, should we wait to promote?: the effect of timing on response to pop-up promotions (apr. 2003), available at http://interruptions.net/literature/moe-ms-submitted.pdf (drawing inconclusive conclusions on the effectiveness of pop-ups). 67. jay a. soled, outsourcing tax return preparation and its implications, cpa j., mar. 2005, at 14–15; see also tax advisor shortage: us returns prepared in india, rediff india abroad, nov. 24, 2006, http://www.rediff.com/money/2006/ 2010] phase-out of paper tax information statements 363 taxpayer data overseas raise privacy concerns,68 it contributes to the u.s. trade imbalance.69 by eliminating the data entry element of tax return preparation, privacy concerns would be minimized and the trade imbalance between the united states and other countries lessened. a related salutary effect of eliminating the menial and costly chore of manual data transferences is that taxpayers who rely on paid tax return preparers would likely experience a fee decrease as tax return preparation work would be a far less labor-intensive enterprise. b. third-party information issuers as explained in part ii, third-party information issuers have a broad array of filing obligations to fulfill lest they be subject to a series of fairly onerous penalties.70 as part of their responsibilities, third-party information issuers must undertake a two-step process. step 1 is that by january 31 of every year, each information provider must distribute paper information statements such as form w-2s to the taxpayers it employs and form 1099s to taxpayers who perform independent contractor services or utilize its investment services (e.g., banks).71 step 2 is that by mandated dates, thirdparty information issuers must file this same information with the government.72 in order to fulfill this second step, taxpayers typically use what is known as the filing information returns electronically (fire) 2006/nov/24bpo.htm (“[a] report prepared by pune-based valuenotes, a leading provider of business intelligence and research . . . ‘says that at least 1.6 million returns will be prepared in india by 2011, but adds that this estimate is quite conservative and the potential is much larger at 22 million returns per year by 2011.’”). 68. see, e.g., rachel konrad, foreign accountants do us tax returns, usa today, feb. 23, 2004, http://www.usatoday.com/money/perfi/taxes/2004-0223-overseas-outsourcing_x.htm (“although firms have yet to report identity theft or fraud stemming from outsourcing, privacy advocates cringe at the notion of scanning and transmitting w2 forms—along with their social security numbers and salary information—across a dozen or so time zones.”). 69. see, e.g., peter s. goodman, despite signs of recovery, chronic joblessness rises, n.y. times, feb. 21, 2010, at a1 (“factory work and even whitecollar jobs have moved in recent years to low-cost countries in asia and latin america.”). 70. see supra part ii.b. 71. see supra note 27 and accompanying text. 72. see supra notes 28–29 and accompanying text. 364 florida tax review [vol. 10:5 system.73 the fire system is the electronic repository/database of all information return submissions.74 adoption of the proposed electronic submission process would eliminate this two-step process and coalesce it into one step. by the end of every january, using the fire system, third-party information issuers would have to submit the relevant information electronically to the irs.75 it would then be the irs’s responsibility to transfer the submitted data onto its website, directing and separating such data in a fashion that enables taxpayers using specialized pins to have immediate access to this data. in an ideal world, this direction and separation process would take fourteen days or less, enabling taxpayers’ access to this critical information by february 15. from the prospective of third-party information issuers, the cost savings associated with the adoption of this proposal would be enormous. for example, no longer would these third parties endure burdensome postage, paper, and toner costs. in those cases in which these third-party information issuers employed the services of another party to produce these tax information statements, the fees associated with the production of these statements would likely drop dramatically. finally, if these third-party information providers committed errors in producing these tax information statements, they could quickly and efficiently remedy these errors electronically rather than having to issue new paper statements. c. tax return preparers adoption of this proposal would probably enjoy popularity with seasoned tax accountants. in general, few tax accountants relish the menial chore of manual data entry. instead, anecdotal evidence suggests that most seasoned tax accountants would prefer to focus their energies and mental acumen on the intellectual task of rendering exceptional tax advice. the 73. see rev. proc. 2009-30, 2009-27 i.r.b. 27 (sets forth in elaborate detail how participating taxpayers should electronically submit information to the fire system). 74. id. 75. under current law, the code requires magnetic-tape filing only if an employer or other payer is submitting at least 250 information returns. irc § 6011(e)(2)(a). that being the case, instituting this electronic mandate will carry with it an additional burden upon those taxpayers who still submit paper information returns. see u.s. dep’t treasury, report to congress on return-free tax systems: tax simplification is a prerequisite 39, n.46 (2003) (pointing out that in 2000, approximately 3% of information returns submitted to the irs were on paper). after december 31, 2008, the treasury department has discontinued the use of magnetic tapes, supplanted entirely by the use of electronic submissions. see irs data book, supra note 5, tbl.14, n.2. 2010] phase-out of paper tax information statements 365 congressional institution of this data aggregation proposal would provide this opportunity. (needless to say, ordinary tax return preparers who generate a large proportion of their fees via information return data entry might be far less thrilled about congressional adoption of this proposal.) depending upon the nature of their businesses, some tax accounting practices may experience enhanced profitability due to adoption of this proposal. more specifically, were congress to adopt this proposal, many tax accounting firms would be far less inclined to outsource their tax work overseas.76 as a practical matter, by keeping all of the tax work under their roofs, these accounting firms would hopefully experience a corresponding increase in their profits. one other item to keep in mind is that menial data entry is an area ripe for mistakes. while making monotonous data entries, tax return preparers are prone to strike incorrect keys, transpose numbers, and inadvertently omit entries, resulting in the production of flawed tax returns.77 upon discovery, accounting firms that commit such mistakes can fix them, presumably at their own expense, advising their clients to file amended returns.78 other times, when these mistakes are discovered upon audit, accounting firms risk malpractice suits and the subsequent payment of damages.79 while the adoption of the data aggregation proposal would not guarantee the production of flawless tax returns, it would certainly lessen the opportunities for mistakes. by lessening the prospects for mistakes, tax preparation and accounting firms might experience fewer costs in the form of fewer labor hours spent amending returns and possibly a concomitant reduction in their malpractice premiums as a result of fewer claims being made. 76. see supra note 67 and accompanying text. 77. see irs data book, supra note 5, at 38 tbl.15 (delineating the numerous number of math errors that individual taxpayers commit on their tax returns). 78. see regs. §§ 1.451-1(a), 1.461-1(a)(3) (stating that upon error or omission discovery involving an understatement of income or an overstatement of deductions, a taxpayer “should” file an amended tax return and pay any tax due); circular 230 instructs tax practitioners who know of an error or an omission on a client’s tax return to promptly notify the client and advise the client of the consequences that such an error or omission engenders under both the code and regulations. 31 c.f.r. § 10.21 (2002). the aicpa’s statement on tax services no. 6 sets forth a very similar directive applicable to certified public accountants. aicpa, statement on tax services no. 6, knowledge of error: return preparation and administrative proceedings (2010). 79. see jay a. soled & leonard goodman, tax return preparation mistakes: how to avoid or mitigate professional liability, j. acct., june 2010, at 62. 366 florida tax review [vol. 10:5 d. government aside from taxpayers, the single biggest benefactor of this proposal’s adoption would likely be the government. the administrative ease that this proposal engenders could bolster tax compliance, thereby boosting the collection of tax revenue.80 by way of background, most taxpayers generally have very few direct interactions with the federal government. tax preparation is one of the few exceptions to this rule because there is a direct interface between the federal government and taxpayers. if tax return preparation generates a perception that the government is inefficient, it produces an image of governmental incompetence, breeding contempt. conversely, if the tax return preparation process generates a perception that the government is efficient, it produces an image of competency, generating respect. tax return preparation is thus a pivotal opportunity for the government to put forward its best face, galvanizing support for its political efforts, fostering civic pride in its abilities, and bolstering camaraderie among its citizens.81 by instituting the data aggregation proposal, congress would be taking a meaningful step to promote the notion that the nation’s tax system operates efficiently. taxpayers who experience this efficiency would likely tend to be more compliant, fearful that the “efficient” irs could detect their derelictions. a serendipitous benefit associated with the enhancement of taxpayer compliance is that more revenue will likely flow into the government’s coffers. why? the reason is simple: noncompliant taxpayers rarely overpay their tax obligations; to the contrary, they usually underpay.82 if, therefore, the data aggregation could increase taxpayer compliance by a significant percentage, the government could anticipate the flow of a lot more revenue into its coffers. another feature of data aggregation is that the irs staff previously dedicated to transforming paper tax returns into electronic entries would 80. but see infra the second-to-last paragraph in part v, casting some doubt about whether compliance would actually be enhanced. 81. see lawrence zelenak, justice holmes, ralph kramden, and the civic virtues of a tax return filing requirement, 61 tax l. rev. 53 (2007) (expounding the civic virtues associated with the process of taxpayers fulfilling their obligations under the code and submitting their tax returns to the government). 82. see, e.g., stephen j. dubner & steven d. levitt, filling in the tax gap, n.y. times mag., apr. 2, 2006, at 26 (as part of the national research project, the irs conducted a three-year study and found that the difference between taxes owed and taxes paid represented approximately one-fifth of all taxes collected by the irs). 2010] phase-out of paper tax information statements 367 have to make far fewer manual tax data entries,83 liberating staff members to conduct more in-depth taxpayer audits. were the audit rate to increase, taxpayer compliance would likely increase as well.84 consider, too, that most irs audits are so-called “correspondence audits” currently conducted through what is known as the automated underreporter program, a program that detects flawed tax returns in which taxpayers either inadvertently omitted tax data or erred in reporting such data.85 because electronic data propagation of tax returns could eliminate the vast majority of these mistakes and omissions,86 the irs could save billions of dollars in administrative costs as the number of correspondence audits it conducts would significantly dwindle. all of this is not to say that the government would not confront challenges in implementing the data aggregation proposal. in particular, the irs has made clear that the processing and correction of information returns is not as simple as it might initially appear:87 it “begins with the receipt and input of information documents, includes several different error checks, and 83. see u.s. gen. accounting office, gao-02-205, tax administration: electronic filing’s past and future impact on processing costs dependent on several factors 4 (2002), available at http://www.gao.gov/new.items/d02205.pdf: in response to a question raised by the house appropriations committee in 2001, irs estimated that 50 million individual income tax returns would be filed electronically in fiscal year 2002. irs estimated that it would need 3,150 more full-time equivalent staff years if none of those returns were filed electronically. at irs’ estimate of $36,300 per staff year, that would be a cost avoidance of $114.3 million. 84. see charles o. rossotti, modernizing america’s tax agency, 83 tax notes 1191, 1195 (1999) (“historically, the irs placed great emphasis on direct enforcement revenue, in part because it is precisely measurable and in part because it showed an indirect deterrent effect that increases compliance.”). 85. see, e.g., gerard h. schreiber, jr., the irs underreporter initiative, 40 tax adviser 49 (2009) (“the automated underreporter program, which affects 4–5 million taxpayers annually, starts with third-party information returns filed with the irs by employers, banks, and brokers. the service matches the amounts reported on the individual and the information returns and creates an inventory of the resulting mismatches.”). 86. see, e.g., joint econ. comm., free e-filing makes sense for both taxpayers and the irs 1 (2008) (“the irs finds roughly 1 error in every 100 returns filed electronically (regardless of whether the return was prepared professionally or self-prepared by the taxpayer), compared to about 1 error in every 5 paper returns.”); arik hesseldahl, is e-file efficient?, forbes.com, mar. 12, 2002, http://www.forbes.com/2002/03/12/0312efile.html (error rates with e-filers are much lower compared to taxpayers who file paper returns (1% vs. 18%)). 87. u.s. dep’t treasury, internal revenue serv., current feasibility of a return-free tax system 10–16 (1987). 368 florida tax review [vol. 10:5 ends with the correction of any errors detected.”88 were this proposal instituted, the irs would either have to conduct this process over a muchabridged time period or, rather than delay the process, accept all information returns, whether erroneous or not. notwithstanding these challenges, the benefits that this analysis enumerates with the availability of data aggregation extend not only to the federal government but also to every state government that has instituted an income tax.89 virtually every state government that has instituted an income tax system has generally experienced less-than-stellar tax compliance.90 congressional adoption of the data aggregation proposal could thus do double duty: in availing themselves of electronic tax data in order to complete their federal tax returns, taxpayers could do the same in completing their state income tax returns. in other words, all the administrative benefits associated with the adoption of this proposal that inure to taxpayers, thirdparty issuers, tax return preparers, and the government at the federal level would similarly inure at the state level. in an effort at full disclosure, adoption of this proposal would no doubt engender additional up-front costs on the government’s part. either the irs or treasury department would have to develop sophisticated software to process the data it electronically receives, manipulate it into separate accounts, and then make it available to individual taxpayers to download. in the past, when the government has attempted to modernize its computer systems, such efforts have been plagued with problems.91 the adoption of 88. robert a. boisture, albert g. lauber & holly o. paz, policy analysis of “return-free” tax system 16 (2006), available at http://www.ccianet.org/ccia/ files/cclibraryfiles/filename/000000000087/return-free%20wp.pdf. 89. only seven states do not have an income tax: alaska, florida, nevada, south dakota, texas, washington, and wyoming. mary beth franklin, taxfriendly places to retire, kiplinger’s personal finance, oct. 1, 2009, at 56. for an interesting perspective of why those states that do not have an income tax or sales tax should have both taxes, see herwig schlunk, why every state should have an income tax (and a retail sales tax, too), 78 miss. l.j. 637 (2009). 90. for example, a report issued by the california franchise board estimated the board’s annual tax gap to be approximately $6.5 billion annually. franchise tax board, tax gap plan: a strategic approach to reducing california’s tax gap 4 (2006), available at http://www.ftb.ca.gov/aboutftb/taxgapstratplan.pdf. taxgapstratplan.pdf. 91. irs oversight board, annual report to congress 2008, at 4 (2009) (imploring the irs to update its information technology to keep pace with existing technology trends); michael phillips, additional actions are needed to effectively address the tax gap 2 (2008), available at http://treasury.gov/tigta/auditreports/2008 reports/200830094fr.pdf (the fiscal year 2009 budget decreased irs funding for modernization and improving technology); memorandum from the treasury inspector gen. for tax admin. to sec’y paulson, management and performance 2010] phase-out of paper tax information statements 369 this proposal would leave very little room for error: the last thing the government would want is a website that crashes, thereby risking the loss of critical data and taxpayers’ access to it.92 that being the case, the government must develop a website that can handle a tremendous amount of taxpayer volume and have a backup plan in place in case of catastrophic failure. another item that the government must consider is that, at least at inception, it must undertake a significant taxpayer and tax return preparer education campaign,93 inculcating exactly how the availability of electronic tax data information would operate. finally, from a legislative perspective, adoption of this proposal would not necessitate a congressional overhaul of the existing penalty structure. third-party information issuers would still have to complete their submissions in a timely fashion lest they be subject to late penalties,94 and such information would still have to be correct lest they be subject to accuracy-related penalties.95 in other words, in instituting this electronic data aggregation proposal, congress could focus its attention primarily upon detailing the irs’s augmented responsibilities and funding the agency to enable it to meet this administrative challenge; left undisturbed would be the basic responsibilities of taxpayers, tax return preparers, and third-party information issuers. aside from its administrative benefits and cost savings, adoption of this data aggregation proposal is politically viable. notwithstanding party affiliation, all members of congress should find this proposal politically attractive for several reasons. first, there is nothing in this proposal that suggests a tax increase, generally anathema in today’s political climate. second, a proposal such as this can be readily framed as a tax-simplification measure that will save taxpayers money, resources, and time. third, tax preparation software companies such as intuit, which, in the past, have sought to obstruct taxsimplification efforts fearing that such efforts might challenges facing the internal revenue service for fiscal year 2009, at 1 (oct. 15, 2008), available at http://www.treas.gov/tigta/management/management_fy2009.pdf (identifying the irs modernization program, security, and tax compliance initiatives as the irs’s top three challenges). 92. see, e.g., irs oversight board, supra note 91, at 20 (“the irs business systems modernization (bsm) program has been designated by the gao as an area of high risk since 1995. the gao made this determination because it believed that the irs relied on obsolete automated systems for key operational and financial management functions.”). 93. see, e.g., susan cleary morse, using salience and influence to narrow the tax gap, 40 loy. u. chi. l.j. 483 (2009) (explaining the positive correlation between tax education and enhanced tax compliance). 94. see supra note 35 and accompanying text. 95. see supra notes 35–36 and accompanying text. 370 florida tax review [vol. 10:5 subvert their business opportunities,96 will likely find this proposal attractive insofar as it will probably increase their client base because more taxpayers will likely prepare their own individual income tax returns. another reason that this data aggregation proposal should enjoy political popularity is that its implementation can be instituted in a gradual fashion. more specifically, this proposal does not have to be foisted upon taxpayers on a take-it-or-leave-it basis. to the contrary, taxpayers could “elect” to use the availability of this information on the web. more specifically, during a transition stage,97 third-party issuers would continue to issue paper information statements. taxpayers wishing to have their tax returns propagated electronically could visit the irs website, download pertinent tax information, and blithely destroy their paper information statements in the shredding machine. those taxpayers not wishing to “go” electronic could continue to prepare their tax returns the old-fashioned way. v. raising and addressing potential problems associated with the phase-out of paper information statements like any proposal, the phase-out of paper information statements coupled with the electronic propagation of tax returns engenders potential problems. nevertheless, these potential problems are just that—potential; and all of them can, in a timely fashion, be addressed and overcome. troubling some commentators is the fact that institution of this proposal will greatly facilitate the tax return preparation and filing processes. yes, you just read the last sentence correctly: there are some commentators who earnestly believe that making the tax administration process too easy camouflages from ordinary taxpayers the burdens associated with the imposition of taxes.98 they will therefore attack this proposal’s adoption, fearing that taxpayers who too readily complete their tax returns will be 96. jim sanders, tax-return bill dies in assembly, sacramento bee, june 2, 2006, at a4. 97. compare michael j. graetz, legal transitions: the case of retroactivity in income tax revision, 126 u. pa. l. rev. 47 (1977) (arguing that congress does not have a duty to provide transition relief to taxpayers who suffer economically as a result of tax reform), with kyle d. logue, tax transitions, opportunistic retroactivity, and the benefits of government precommitment, 94 mich. l. rev. 1129 (1996) (“[e]fficient transition policy [sometimes] entails full transition relief in the form of guaranteed grandfathering. . . .”). 98. see, e.g., president’s advisory panel on federal tax reform, transcript of ninth meeting 119–21 (may 17, 2005) (testimony of grover norquist), available at http://govinfo.library.unt.edu/meetings/docs/transcript_05172005.doc (in arguing against the institution of a return-free system and the administrative ease it would offer, mr. norquist made the following assertion: “[t]he present system . . . is at least citizen-based and focuses taxpayers on what they’re paying.”). 2010] phase-out of paper tax information statements 371 ignorant of the tax process just as drivers who pay tolls electronically often are not cognizant of the burdens that the government imposes on them with respect to their driving. the legitimacy of these commentators’ complaint is questionable; indeed, there appear far better ways to educate taxpayers about their tax burdens than to subject them to pointless costs and waste their time with unnecessary tasks such as making manual data entries. another potential problem with this proposal’s adoption is that not all taxpayers have internet access. if this proposal is to be fully effective, this is a fair criticism and one that congress will have to address. even now, however, this argument lacks saliency. why? throughout the united states, various studies indicate that the internet is almost universally available.99 in those instances when internet availability is problematic, the irs could make the internet accessible at its walk-in facilities or, alternatively, offer mobile vans—stocked with computers—that could traverse those rural, suburban, and urban areas where, due to technical and socioeconomic reasons, there may be limited internet access. privacy and identity theft are also concerns that cannot be readily dismissed. indeed, privacy and identity theft issues are endemic internet problems,100 and, to date, the irs has had a lackluster record addressing these issues.101 nevertheless, over the last few years the government has taken several steps that manifest its ability to prevent taxpayers’ private information from falling into the wrong hands.102 these steps, along with 99. see, e.g., donna gordon blankinship, study: third of americans use library computers, boston globe, mar. 25, 2010, www.boston.com/news/nation/ nation/articles/2010/03/25/study_third_of_americans_use_library_computers/ (“a third of americans 14 and older—about 77 million people—use public library computers to look for jobs, connect with friends, do their homework and improve their lives, according to a new study. . . .”); internet world stats, united states of america internet usage and broadband usage report, http://www.internetworldstats.com/am/us.htm (demonstrating that in 2009, 74.1% of the u.s. population was internet users and showing an upward usage trend in the future). 100. admittedly, no website system is ever completely impenetrable to security breaches. see, e.g., malcolm moore & nicola woolcock, tax website suspended after security breach, daily telegraph, may 31, 2002. 101. see treasury inspector gen. for tax admin., supra note 39, at 3 (“[o]ur review of available test documents provided by the irs showed that the mef system was deployed with known security vulnerabilities.”); u.s. gen. accounting office, gao-01-306, information security: irs electronic filing systems 14 (2001), available at http://www.gao.gov/new.items/d01306.pdf (acknowledging that there are “[a] number of serious control weaknesses in irs’ electronic filing systems”). 102. see jose e. serrano, house appropriations committee releases report for fiscal 2010 financial services spending bill, h.r. rep. no. 111-202, at 26 (2009): 372 florida tax review [vol. 10:5 other information safeguards it plans to implement,103 indicate that the government is ready to tackle the privacy and identity theft issues associated with this proposal’s adoption. a final potential problem associated with the institution of this proposal is that it may weaken taxpayer compliance. more specifically, after downloading tax data from the irs website, taxpayers will undoubtedly familiarize themselves with what information the government possesses (and, by default, what information it lacks); as a result of this knowledge, some dishonest taxpayers will be tempted not to report income beyond what the government “knows” about. of all the potential problems associated with the adoption of this proposal, this one has the most merit and requires congressional vigilance and attention.104 while this analysis would not the irs has taken several important steps to protect taxpayer data. for example, as tigta notes, it has established a security services and privacy executive steering committee to serve as the primary governance body for all matters relating to security and privacy issues in the irs. it has made steady progress each year in complying with the requirements of the federal information security management act. in addition, irs has established an office of privacy, information protection and data security to: (1) improve public, preparer and external stakeholder awareness of privacy policies, procedures, and general information, and (2) improve the irs response to taxpayers and practitioners who fall victim to data loss incidents, identity theft, or online fraud. see also u.s. gov’t accountability office, gao-10-355, information security: irs needs to continue to address significant weaknesses 5 (2010), available at http://cryptome.org/gao-10-355.pdf (“during fiscal year 2009, irs has made progress toward correcting previously reported information security control weaknesses and information security program deficiencies at its three computing centers, another facility, and enterprisewide.”). 103. see h.r. rep. no. 111-102 (2009); u.s. gov’t accountability office, supra note 102. 104. this is the virtually identical complaint initially lodged against the readyreturn program instituted in california. see joseph bankman, simple filing for average citizens: the california readyreturn, 107 tax notes 1431 (2005) (providing a complete overview of how the readyreturn program is designed to operate). the readyreturn program involved the state of california completing and disseminating state income tax returns to california residents who met certain criteria (e.g., those who did not itemize and had wage income only). recipients of these returns could ignore them, adjust them, or sign and submit them. despite the fear that california taxpayers who earned income beyond that which was reflected on the proposed state income tax return would not be forthcoming about the receipt of other income, in the vast majority of cases, the legislature’s compliance fears proved unfounded. see california franchise tax board, readyreturn service— frequently asked questions 3 (2007), available at www.ftb.gov/readyreturn/faq_ 2010] phase-out of paper tax information statements 373 anticipate a significant decline in taxpayer compliance, there might be a core of dishonest taxpayers who fail to report income beyond that downloadable from the irs website. there are, of course, several ways to combat this compliance challenge: expand those occasions upon which information returns are required to be issued,105 increase the number of audits that the irs conducts,106 and/or raise applicable noncompliance penalties.107 these proposed redresses are not mutually exclusive: congress can adopt one or more of these tactics at the same time and thereby strengthen taxpayer compliance and rein in taxpayer derelictions. every proposal has blemishes, and this proposal does not violate this axiom. however, none of the shortcomings just mentioned are insurmountable. to the contrary, in the vast majority of cases, the potential problems that this analysis raises are fairly easy to remedy. and, since this proposal is designed to be gradually phased in,108 it allows ample time to address these issues and others that may crop up as electronic propagation becomes the next major advancement in tax return preparation. vi. conclusion for a moment, think about the redundancy engendered by the issuance of paper information statements. as required under the code, by the end of every january, third parties must issue paper information statements to taxpayers and subsequently submit tax information returns to the irs, the vast majority of the latter of which are in electronic form and contain about.shtml (“we found that 99.9 percent of the income readyreturn participants reported to the irs was also reported to the ftb. . . . [t]hese findings suggest a minimal negative tax effect due to readyreturn (less than $3 per return).”); california franchise tax board, report to the legislature (apr. 23, 2009), available at http://www.ftb.ca.gov/readyreturn/readyreturnreport2009.pdf (in this report, there is no mention that taxpayer compliance suffered as a result of this program being instituted). 105. see supra note 25. 106. see, e.g., james alm et al., deterrence and beyond: towards a kinder, gentler irs, in why people pay taxes, 311, 322–23 (joel slemrod ed., 1992) (“[c]ompliance . . . rises when the audit rate increases.”); alan h. plumley, the impact of the irs on voluntary tax compliance: preliminary empirical results 8– 10 (2002) (finding that if the audit rate were 1% higher in 1991, the general population would have voluntarily reported an additional $56 billion of tax). 107. see michael doran, tax penalties and tax compliance, 46 harv. j. on legis. 111 (2009) (explaining various theories on the relationship between penalty imposition and enhanced tax compliance); alex raskolnikov, crime and punishment in taxation: deceit, deterrence, and the self-adjusting penalty, 106 colum. l. rev. 569 (2006) (identifying and analyzing similar issues). 108. see supra note 97. 374 florida tax review [vol. 10:5 identical information sent to taxpayers. in order to e-file their returns,109 taxpayers must then take the tax data they received in paper form and, like most third-party issuers, transform such data into an electronic format. the duplication of effort by third parties and taxpayers to transform tax data into an electronic format is nonsensical. to any casual observer, the issuance of paper information statements clearly constitutes an unnecessary, duplicative step that congress should immediately seek to phase out. years ago, the state of technology admittedly necessitated the issuance of paper information statements. but the technological age of the internet has fundamentally transformed the availability of information and its ease of storage, making it much more readily accessible electronically. by tapping into the power of the internet, the benefits inuring to taxpayers, third-party issuers, tax return preparers, and the government would be enormous. furthermore, in the case of the government, aside from administrative savings associated with the adoption of this proposal, the government could expect to generate additional tax revenue as the accuracy of taxpayers’ returns dramatically increases and the costs associated with the processing of these returns dramatically decreases. most proposals that are as revolutionary as this one suffer from one or more significant shortcomings. for example, they are expensive to implement, technologically infeasible, or politically untenable. this proposal shares none of these deficiencies. it stands far apart from other such revolutionary proposals because it entails virtually no palpable weaknesses. from this analysis, the message that members of congress and their staff should take away is that the time to act is now. the path to the promised land of enhanced tax compliance is ready to be pioneered. it is a path on which the vast majority of income tax returns can, with the push of a few keys that download the taxpayer’s pertinent tax information, be completed in a matter of a few minutes. 109. see irs news release ir-2010-35 (mar. 23, 2010) (“more than 82% of the 69 million returns received this year [(i.e., 2009 tax year)] have come in via efile.”); shulman testimony 2010, supra note 25, at 3 (referring to the 2009 tax filing season, the commissioner commented that “e-file as a percentage of total individual returns is up from 80% to 83%—continuing a very positive trend”). n:\expense\draft29\new thesis 3 professor of law, university of illinois college of law, b.a., stanford* university, j.d., southwestern university school of law, ll.m. (taxation), new york university school of law. i would like to thank both the southern methodist university school of law and the university of illinois college of law for their research resources and financial support. i would also like to thank my research assistants grant gulovsen, michelle herzog, mita patel, lee garsson and rick stamps, and to give special thanks to michelle herzog, mita patel, and zack mason, for their assistance with the development of the spreadsheet models used to generate the tables and figures herein. 467 florida tax review volume 5 2002 number 7 normative capital cost recovery for a realization-based income tax charles t. terry* i. introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469 ii. the financial characteristics of various cost recovery methods under the u.s. income tax. . . . . . . . 476 a. economic cost recovery. . . . . . . . . . . . . . . . . . . . . . . . . 477 b. accelerated cost recovery. . . . . . . . . . . . . . . . . . . . . . . . 480 c. year-end expensing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483 d. theoretical instantaneous expensing. . . . . . . . . . . . . . . 485 e. expensing-equivalent cost recovery. . . . . . . . . . . . . . . . 488 f. a preliminary comparative analysis: net present value, internal rate of return and financial effective tax rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491 iii. comparative capital income taxation principles. . . . 495 a. accretion-measured income tax (amit). . . . . . . . . . . . . 495 b. cash flow income tax (cfit). . . . . . . . . . . . . . . . . . . . 496 c. realization-based income tax (rbit). . . . . . . . . . . . . . . 498 1. general tax base principles.. . . . . . . . . . . . . . . 498 2. the role of asset basis. . . . . . . . . . . . . . . . . . . . 499 3. rbit capital income taxation principles. . . . . 500 4. the role of cost recovery deductions. . . . . . . . 501 d. defining the criteria for normative rbit base cost recovery. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503 iv. capital formation and capital cost recovery in a realization-based income tax. . . . . . . . . . . . . . . . . . . 504 a. the effect of cost recovery methods on loss offsets and capital investment. . . . . . . . . . . . . . . . . . . . . . . . . . 504 b. cost recovery methods and the maximum capital investment from earnings in a rbit base. . . . . . . . . . . . 506 v. normative criterion #1: recovering the full financial cost of investment. . . . . . . . . . . . . . . . . . . . . . . 510 a. the cary brown analysis.. . . . . . . . . . . . . . . . . . . . . . . . 510 468 florida tax review [vol. 5:7 b. modern analysis of net financial cost. . . . . . . . . . . . . . 514 vi. normative criterion #2: appropriately measuring net realized income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515 a. measuring net economic income in an amit base. . . . 516 1. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 516 2. internal rate of return, net present value and effective tax rates. . . . . . . . . . . . . . . . . . . . 518 3. hurdle rates and the effect of increased yield rates on irr etr and npv etr. . . . . . . . . . . . 519 4. the effect of variable tax rates on npv etr. . 523 5. summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524 b. cash flow accounting in a cfit base. . . . . . . . . . . . . . 525 1. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 525 2. cfit accounting: financial accuracy and proportionality. . . . . . . . . . . . . . . . . . . . . . . 527 c. measuring net realized income in a rbit base. . . . . . . 530 1. irr effective tax rates. . . . . . . . . . . . . . . . . . . . 530 2. npv effective tax rates. . . . . . . . . . . . . . . . . . . 532 3. hurdle rates and the financial accuracy of capital cost recovery methods. . . . . . . . . . . . . 535 4. summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537 vii. final arguments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538 a. empirical summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538 b. economic cost recovery is not the normative capital cost recovery method for a rbit base. . . . . . . . . . . . . . 541 c. capital expensing is the normative capital cost recovery method for a rbit base. . . . . . . . . . . . . . . . . . 542 viii. conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544 2002] normative capital cost recovery 469 1. briefly, the former base taxes all net increases in wealth, including appreciation in value of accumulated wealth, while the latter base only taxes wealth when and as devoted to consumption. for the two works that defined income as a tax base, see robert m. haig, the concept of income—economic and legal aspects, in the federal income tax 1, 6-7, 27 (robert m. haig ed., 1921); henry simons, personal income taxation 103 (1938). see also richard b. goode, the individual income tax 59-99 (1986). for a seminal article on the practical design of a consumption tax base, see william andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113 (1974) [hereinafter andrews, cash flow]. for a detailed discussion of the mechanics involved in implementing these two types of tax bases, see u.s. dep’t of the treasury, blueprints for basic tax reform (1977) [hereinafter blueprints]. see also deborah schenk, the plethora of consumption tax proposals: putting the value added tax, flat tax, retail sales tax, and usa tax into perspective, 33 san diego l. rev. 1281 (1996). 2. this article consistently uses a calendar year as the taxable period regardless of the tax base under discussion. cf. jeff strnad, perodicity and accretion taxation: norms and implementation, 99 yale l.j. 1817, 1820 (1990) (emphasizing the importance of defining the appropriate period to the structure of an income tax). 3. see thomas l. evans, the taxation of multi-period projects: an analysis of competing models, 69 tex. l. rev. 1109, 1111 (1991). see also brown & bulow, the definition of taxable business income, in comprehensive income taxation 241, 242-43 (j. pechman ed., 1977). 4. this convention has been in almost universal use since publication of andrews, cash flow, supra note 1, at 1113. for a proposal adopting this convention, see blueprints, supra note 1, at 111, 113-15, 130. 5. for a description and critique of the assumptions underlying the “mapping” between traditional tax base accounting approaches and traditional structural concepts of income and consumption tax bases, see jeff strnad, taxation of income from capital: a theoretical reappraisal, 37 stan. l. rev. 1023 (1985) (arguing that a cash flow income tax base accounting method implements the haig-simon income tax base i. introduction tax policy makers and academics in the united states traditionally focus on tax systems based on income and consumption. as a necessary1 adjunct to these fundamental tax base structural principles, these commentators have adopted complementary accounting principles in order to identify and compute the amounts of income and consumption to be taxed during a designated taxable period. for example, most economists and tax policy2 commentators assert that an accretion-measured income tax comprehensively and accurately measures economic income. most commentators also accept the3 proposition that a tax based on income but measured only by cash flows (a cash flow income tax) is a practical surrogate for a theoretical consumption tax.4 following these traditions, this article assumes that an accretion-measured income tax (amit), and a cash-flow measured income tax (cfit) are pure tax base paradigms in which the paired tax base structural and accounting principles theoretically complement each other.5 470 florida tax review [vol. 5:7 structural ideal more correctly than traditional accretionary income tax base accounting with respect to the net present value of investment and borrowing transactions) [hereinafter strnad, reappraisal]. for criticism of professor strnad’s methodology, analysis or conclusions, see louis kaplow & alvin c. warren, jr., an income tax by any other name–a reply to professor strnad, 38 stan. l. rev. 399 (1986); william d. popkin, tax ideals in the real world: a comment on professor strnad’s approach to tax fairness, 62 ind. l.j. 63 (1986). for rebuttals of those criticisms, see jeff strnad, the bankruptcy of conventional tax timing wisdom is deeper than semantics: a rejoinder to professors kaplow and warren, 39 stan. l. rev. 389 (1987); jeff strnad, tax timing and the haig-simons ideal: a rejoinder to professor popkin, 62 ind. l.j. 73 (1986). see discussion at infra note 111 and accompanying text. 6. congress has enacted limited exceptions to the non-accretion principle in recent years in the form of “mark-to-market” rules which require certain taxpayers to use unrealized gains and losses in computing taxable income. see irc §§ 1256 (gains and losses on regulated futures, foreign currency, and other contracts are recognized annually in amounts determined as though contracts held on the last day of the taxable year were sold at their fair market value); 475 (similar rule applied to dealers in securities). see generally, edward d. kleinbard & thomas l. evans, the role of markto-market accounting in a realization-based tax system, 97 taxes 788 (1997); david a. weisbach, a partial mark-to-market tax system, 53 tax l. rev. 95 (1999). 7. the u.s. income tax allows the use of both the cash and accrual methods of accounting as a general rule, as well as any other reasonable method of accounting that clearly reflects income. see irc § 446 (2000). congress only mandates the use of the cash accounting method in certain circumstances where the use of the accrual method could possibly facilitate the operation of tax shelters. the u.s. income tax base, however, employs structural and accounting principles that differ from both the amit and cfit base paradigms. like an amit base, the u.s. income tax purports to tax “income” as opposed to “consumption;” but unlike an amit base, it does not as a general rule employ accretion accounting in order to measure “income.” similarly, unlike a tax on6 consumption that is measured by cash flows, the u.s. income tax is not fundamentally structured to tax consumption; nor does it use cash flow accounting as the primary means of measuring the “income” that it taxes.7 with respect to capital income taxation in general, the u.s. income tax base may be characterized as a realization-based income tax (rbit) because it uses the principle of realization to define and measure capital income. overall, three major structural and accounting principles distinguish a rbit from either the amit or cfit capital income taxation paradigm. all of these principles have important capital income taxation policy implications. however, this article focuses on those principles in the context of short-lived completely wasting income-producing assets because their application is fairly clear in this context. in addition, an analysis of these assets allows this article to highlight and isolate the important issue of rbit cost recovery policy. first, under the realization principle per se, the “income” that a rbit base taxes, does not include mere increases or decreases in wealth (i.e., the net 2002] normative capital cost recovery 471 8. it has long been established that gain or loss in the value of property is taken into account for income tax purposes only if and when the gain or loss is “realized,” that is, when it is tied to a realization event, such as the sale, exchange or other disposition of the property. mere variation in value– the routine ups and down of the marketplace– do not in themselves have income tax consequences. this is fundamental in income tax law. cottage savings assn., 499 u.s. 554, 111 s. ct 1519, 1520 (1991) (blackmun, j., dissenting)., cf. supra note 6. 9. regs. § 1.1001-1(a). the u.s. supreme court decided in 1991 that a swap of functionally identical mortgage pools between institutions met the standard under this regulation. see cottage sav. ass’n v. commissioner, 499 u.s. 554, 556 (1991). because of intervening increases in interest rates, both parties deducted losses on the exchange. five years later, the treasury department issued new regulations classifying “debt modifications” as realization events only if those modifications were “significant.” see regs. § 1.1001-3. 10. the term capital is used here to describe the amounts available to rbit base taxpayers after tax has been paid on all concurrent realized income. this is a critical issue in this article. in the real world, of course, all rbit base investment, even earnings-financed investment, is not necessarily financed from capital. however, capital is a normative rbit base structural principle, and, with realization, is one of the structural principles that most distinguishes a rbit from an amit or cfit base. therefore, this article assumes that an analysis of normative cost recovery policy should begin in and with the economic context of capital-financed investment. value of taxpayer assets). instead, such increases and decreases in value enter8 the tax base only when “realized” by conversion of those assets into money or other assets differing materially either in kind or extent from the asset converted.9 second, because a rbit (like an amit) taxes earnings even if they are invested, in theory earnings-financed investment should only be made with after-tax dollars or “capital” in the tax sense of the word. this article calls this10 the capital formation principle. the realization principle and the capital formation principle interact in the following manner. because the purchase of an asset does not generally cause a realization of income, and because any subsequent changes in value cannot enter the tax base until the asset undergoes a realization event, assets must be assigned an amount at the time of their acquisition that quantifies the amount of tax “capital” invested in them. this amount measures and accounts for the invested capital in order to avoid taxing that capital again when the terminal value of the asset is subsequently realized and the amount of net realized income or loss is determined. the tax accounting convention that measures the investment of capital in a given asset is called basis, and only to the extent that an amount realized from the subsequent disposition of an asset exceeds its 472 florida tax review [vol. 5:7 11. see irc § 1001(a). similarly, if the amount so realized is less than the previous capital investment, the difference may be deducted, which results in the taxfree recovery of the amount invested in either event. id. see irc § 1016(a) for a list of the items that require or allow an adjustment to be made to an asset’s basis. 12. the closest analogy in either tax system is an amit base which taxes and accounts for the difference between an asset’s initial and terminal values, but measures and taxes that difference periodically despite the intervening lack of realization. see discussion at infra part iii.c.1. 13. in the case of other assets, only the un-recovered amount of that cost remaining at realization should offset any amount realized at that time in order to quantify the gain or loss realized, and therefore the net effect on the taxpayer’s tax base. see irc §§ 1016(a)(2); 1001(a). 14. see michael graetz, federal income taxation: principles and policies 34751 (1985). see also report to the congress on depreciation recovery periods and methods (treasury department, july 28, 2000) [hereinafter treasury department report]. the assumption that economic depreciation is the normative depreciation method for the u.s. income tax base runs throughout this study. see id. at 3 (replacing the current depreciation structure, “with a system more closely related to economic depreciation is sometimes advocated as the ideal reform”); id. at 27 (evaluation of the current cost recovery system “focuses on how closely current law cost recovery allowances reflect allowances based on economic depreciation; how deviations from economic depreciation affect the level and distribution of taxes on capital income; and justifications for any current law deviations from economic depreciation”). adjusted basis does the net amount enter a rbit base. neither amit nor a11 cfit base employs a counterpart to these unique structural and accounting features of a rbit base.12 a third principle of rbit base capital income taxation applies if an asset is physically or economically self-exhausting. such an asset’s complete decline in value or utility over time does not reduce the tax base directly, because unrealized changes in asset value are not included in a rbit base. instead, in order to measure and tax only net realized income, at some point in time the tax base must be reduced by means of one or more deductions in order to restore the amount of the capital invested in the asset to the taxpayer. otherwise, capital would be taxed again as the asset converted itself completely into income and wasted away. this structural principle is called the capital recovery principle. cost recovery is a particular rbit base accounting technique by which the capital cost of such a self-exhausting asset is recovered tax-free from otherwise taxable income prior to any realization of the asset’s terminal value at the time of its disposition. this treatment is particularly appropriate where the terminal realized value of the asset is likely to be little or nothing.13 u.s. tax policy with respect to cost recovery for short-lived completely wasting assets is at a watershed. on one hand, many policy makers assume or seem to conclude that economic depreciation properly measures income in the u.s. tax base. in addition, there is a growing trend among commentators to see14 2002] normative capital cost recovery 473 15. for an excellent summary of these works and cites thereto, see deborah h. schenk, a realization-based income tax and the taxation of capital, 53 nat’l tax j. 109 (2000) and works cited therein. 16. see discussion infra part ii.e. the types of tangible short-lived real assets discussed in this article are generally subject to both the accelerated cost recovery system of irc § 168 (accelerated cost recovery system), but also to irc § 179 (election to expense certain depreciable business assets) at the election of the taxpayer under certain conditions. the former system has been “expensing-equivalent” at certain times. id. the realization principle as an aberration that should be corrected or compensated for in the area of capital income taxation. both of these positions15 suggest that the u.s. rbit base should be made to more closely resemble an amit base. on the other hand, since the early 1980’s congressional cost recovery policy has clearly shifted toward expensing, which makes the u.s. tax base more closely resemble a consumption tax base.16 this article takes a middle ground and asks whether a rbit base has intrinsic or normative structural and accounting principles that indicate a third direction for u.s. cost recovery policy to take. in the context of capitalfinanced, short-lived, and completely wasting assets this article answers that question in the affirmative. this article assumes that normative capital cost recovery principles for a realization-based income tax base may be determined by extrapolating from a deep analysis of the capital formation, capital recovery and realization principles just described. this article does not treat these principles merely as practical deviations from a haig-simons income tax, but as the normative structural and accounting features of a unique and functionally discrete tax base. rather than attempting to correct or adjust the u.s. rbit in order to emulate or replicate the financial or economic characteristics of an amit, this article shows how a particular object of rbit capital income taxation policy – capital cost recovery for short-lived completely wasting assets – can be structured using these normative principles. this article adopts three major analytical assumptions. first, normative rbit base structural and accounting principles can be best understood through a comparative analysis of those principles and their functional equivalents in amit and cfit bases. therefore, this article adopts a comparative approach to analyzing rbit base capital income taxation policy in general and cost recovery policy in particular. second, rbit base cost recovery methods themselves should be analyzed in a comparative manner, and such an analysis must necessarily take place in a common economic context. capital-financed investment was chosen for this context because capital formation is a central structural principle of a rbit base and this context allows cost recovery methods to be comparatively analyzed independently of many other tax policy 474 florida tax review [vol. 5:7 17. for example, this article restricts its analysis to capital-financed, shortlived, completely wasting assets. analyzing longer-lived, incompletely-wasting or debtfinanced assets would require consideration of a much broader range of issues. this article is designed to elucidate only the most fundamental principles of normative rbit based cost recovery. 18. the term “depreciable assets” is used generically in this context. this article uses the term depreciation to refer to the tax base structural and accounting principle applied to “depreciable assets” in an amit base, and the term “cost recovery” to refer to the similar but also different principle applied to “depreciable assets” in a rbit base. 19. outside of this context, cost recovery methods per se cannot be compared in a consistent tax base structural context. see discussion at infra part iv.a. 20. “earnings” in this context refers to net taxable income from all sources other than the investment being analyzed, but is otherwise determined in the usual manner. any first year cost recovery deductions that are allowed under a given cost recovery method are also treated in the usual manner, even if they offset “earnings” and further reduce taxable income. “capital” is the amount of after-tax dollars remaining after tax is paid on net taxable income after all cost recovery deductions offsets are allowed. issues. third, this article financially analyzes cost recovery methods because17 most cost recovery methods employed in the u.s. are multi-period phenomena, and only a comparative financial analysis can meaningfully distinguish the tax policy effects of these methods from each other. starting with the third assumption, part ii of this article first analyzes the financial effects produced by the three major rbit base cost recovery methods – economic cost recovery, accelerated cost recovery, and expensing – on the transactional level. in the process, this part introduces the investment model and some of the financial analytical criteria used to evaluate not only rbit base cost recovery methods but also the taxation of this type of depreciable asset in all three of the tax bases considered. part iii then analyzes18 and compares the structural and accounting principles employed in each of these tax bases, going into the most detail with respect to a realization-based income tax. this part ends by defining the two criteria that are used to identify a normative rbit base capital cost recovery method: recovering the full cost of capital investment financially, and appropriately measuring net realized income financially. for this purpose, “appropriately” means in a manner consistent with the fundamental rbit base structural and accounting principles described above. before applying these criteria, however, part iv takes a deep look at the dynamics of capital formation, capital investment and capital cost recovery in a rbit base. this article defines the term “capital cost recovery” as the tax-free recovery of the cost of investment that is financed exclusively with capital, or previously taxed dollars. part iv develops a formula by which the maximum19 amount that can be invested in a rbit base from capital under any cost recovery method can be expressed as a percentage of net current earnings and as a variable of the tax rate. at or below this fairly high capital formation20 2002] normative capital cost recovery 475 21. see discussion, infra note 134 and accompanying text. 22. this analytical framework is very different from that used in many other works which assume that all investment is funded from pre-tax earnings, and which therefore reach very different conclusions. e.g., calvin h. johnson, soft money investing under the income tax, 1989 u. ill. l. rev. 1019 [hereinafter johnson, soft money]. 23. e. cary brown, business-income taxation and investment incentives, in income, employment and public policy: essays in honor of alvin h. hansen 300 (1948). threshold, all earnings-financed investment is capital investment regardless of21 the cost recovery method employed, and all cost recovery is therefore capital cost recovery. capital cost recovery precludes consumption tax treatment22 within a rbit base, even if expensing is used as a cost recovery method, and allows rbit base cost recovery methods to be analyzed consistently and exclusively in relation to all three of the normative rbit base structural and accounting principles described above – capital formation, cost recovery, and realization. part v then shows that capital expensing is the only capital cost recovery method that fully restores invested capital financially and thus meets the first criterion for a normative rbit capital cost recovery method. because other cost recovery methods restore capital through deductions over time but only restore the nominal amount invested, they cannot fully compensate taxpayers for the use of their capital in present value terms. as e. cary brown pointed out over fifty years ago, only expensing among rbit base cost23 recovery methods provides investors with an after-tax return on after-tax investment equal to the original amount invested. thus, the after-tax present value of a taxpayer’s invested capital is not impaired by the time value of money and is fully restored financially. part vi then examines the second criterion for a normative capital cost recovery method – the appropriate financial measurement of capital income. this part shows that economic depreciation appropriately and accurately aids an amit base in financially measuring net unrealized income. similarly, this part shows that unlimited expensing appropriately and accurately measures the taxable economic output of short-lived productive assets in a cfit base financially. both of these analyses utilize the financial criteria of net present value, internal rate of return and financial hurdle rates. these same financial criteria show that a rbit base measures realized income accurately across a wide range of financial circumstances only when capital expensing is employed as a capital cost recovery method. based on the foregoing analysis, part vii concludes the article with the following summary arguments. an accretion-measured income tax includes any net increases in the value of depreciable assets in the tax base when and as those increases accrue. during the holding period of a depreciable asset, net accretions to wealth occur to the extent that the economic yield or output 476 florida tax review [vol. 5:7 produced by the asset exceeds the asset’s unrealized decline in value. economic depreciation is designed to measure those unrealized declines in value as an aid to determining net unrealized (or “economic”) income. the taxation of depreciable assets in a rbit base, however, is structurally independent of a depreciable asset’s value prior to realization. as just noted, economic depreciation is designed specifically to measure accrued and unrealized changes in the value of depreciable assets within an amit base. as such, it is structurally inappropriate for a rbit base because it would combine accounting for realized income (the asset’s yield) with an accounting for unrealized decreases in the asset’s value in an improper attempt to measure net realized income. on the other hand, despite its mechanical similarities, rbit base capital expensing is not identical to cfit base cash flow accounting because a capital expensing deduction only recovers after-tax capital tax-free rather than pre-tax income. capital expensing as a cost recovery method is appropriate for a rbit base because it functionally separates the accounting for capital restoration from the accounting for realized investment yield. as a result it allows the full amount of invested capital to be restored tax-free and the full amount of the realized yield to be taxed as income financially. therefore, the article concludes, capital expensing is the only normative capital cost recovery method for a realization-based income tax. ii. the financial characteristics of various cost recovery methods under the u.s. income tax the timing, rather than the amount, of deductions distinguishes one rbit base cost recovery method from another. this part introduces an investment model that allows rbit base cost recovery methods to be analyzed on the basis of the relative financial value they provide to taxpayers after tax, and the relative percentages of an asset’s financial value received by taxpayers and government after tax. this part also introduces the financial benchmarks that allow the financial characteristics of various cost recovery methods to be compared to each other. those same benchmarks and others will be used in later parts of this article to compare the treatment of short-lived completely wasting assets in the three tax bases. 2002] normative capital cost recovery 477 24. e.g., strnad, reappraisal, supra note 5, at 1027-28. see also discussion at infra part iii.a. 25. see paul a. samuelson, tax deductibility of economic depreciation to insure invariant valuations, 72 j. pol. econ. 604 (1964). see also discussion, infra note 37 and accompanying text. 26. see marvin a. chirelstein, federal income taxation 145-49 (7th ed. 1994). 27. the financial conditions are as follows: the decrease in value of the asset during each year is measured by comparing the discounted present value of the remaining income stream at the beginning and end of each taxable year using the pre-tax yield rate as the discount rate. for example, assuming a 10% yield rate as the discounting rate and compounding annually, the values of the income stream produced by the asset portrayed in table 1 at the time placed in service (day 1 of year 1) and on the first day of each subsequent time period, and the decrease in value during each taxable year are as follows: begin: tot remain income: pv remain income: pv decrease during year: econ deprec. deduction: year 1 126.20 100.00 (100.00 78.44) 21.56 year 2 94.65 78.44 (78.44 54.74) 23.70 year 3 63.10 54.74 (54.74 28.68) 26.06 year 4 31.55 28.68 (28.68 0.00) 28.68 the sequence of depreciation deductions represented by the last column, “decrease during year,” represents a crude, but accepted, baseline for comparison of depreciation methods which at least some commentators have termed “economic depreciation.” id. at 149. see john p. steines, income tax allowances for cost recovery, 40 tax l. rev. 483, 491 (1985) [hereinafter steines, cost recovery]; martin j. mcmahon jr., reforming cost recovery allowances for debt financed depreciable property, 29 st. louis u. l.j. 1029, 1039 n.50, 1059 (1985) [hereinafter mcmahon, reforming]. a. economic cost recovery economic depreciation is an integral and normative feature of a tax based on economic income and measured by accretion (an amit base). the24 term “economic depreciation” has also become synonymous with a rbit base cost recovery method (“economic cost recovery”) that produces the same financial consequences as economic depreciation but within a rbit base. economist paul samuelsen characterized economic depreciation as a depreciation method that reduced the investor’s annual rate of return by the nominal tax rate and thereby ensured that depreciation deductions represented “putative decline in economic value.” subsequently, and as a practical matter,25 many tax commentators adopted a financial convention for portraying and analyzing this type of economic depreciation that was popularized by professor marvin chirelstein. this convention defined economic depreciation as the26 annual decrease in the present value of the future income stream to be produced by an asset each year during the useful life of that asset. thus, the “chirelstein27 convention” portrayal of “samuelson economic depreciation” is a simplified but 478 florida tax review [vol. 5:7 28. see sources cited supra note 27. see also charles t. terry, leveragefinanced tax arbitrage: a structural and accounting analysis, 7 am. j. tax pol’y 109 (1988). 29. the transactional tables used in this article owe their underlying structure and organization to those utilized by professor martin j. mcmahon, jr. in mcmahon, reforming, supra note 27. 30. annual accounting is shown in the horizontal rows corresponding to years 1 through 4. cumulative accounting is shown in the vertical columns. widely-used technique for quantitatively representing economic depreciation in an amit base (and economic cost recovery in a rbit base) under financial equilibrium conditions, and is used for that purpose herein.28 an example of a $100 investment using the chirelstein economic depreciation convention is portrayed in table 1 below. since it is the first of29 many tables of this kind in this article, a detailed explanation follows it. table 1: $100 investment subject to economic depreciation year g.i. rcvry t.i. ptcf tax atcf 1 31.55 21.55 10.00 31.55 5.00 26.55 2 31.55 23.70 7.85 31.55 3.92 27.62 3 31.55 26.07 5.48 31.55 2.74 28.81 4 31.55 28.68 2.87 31.55 1.43 30.11 tot 126.20 100.00 26.20 126.20 13.10 113.10 1pv 100.00 78.35 21.65 100.00 10.82 89.18 2pv 111.86 88.14 23.73 111.86 11.86 100.00 irr 10.00% 5.00% table 1, like most of the tables in the text, shows both a cash flow accounting and a tax accounting. this facilitates both an economic and a financial analysis of cost recovery methods and capital income taxation regimes. the cash flow accounting in table 1 is represented by the formula: pre-tax cash flow (ptcf) minus tax equals after-tax cash flow (atcf). these amounts are shown in the ptcf, tax, and atcf columns on both an annual and a cumulative basis. the tax accounting is represented by the formula: gross30 income (g.i.) minus recovery (rcvry) equals taxable income (t.i.), again on both an annual and cumulative basis. using a 50% tax rate for simplicity, the tax column equals 50% of the taxable income column. the nominal total of each column for years 1 through 4 is shown in the horizontal total (tot) row. the items described to this point determine the nominal or economic consequences of the transaction portrayed in table 1 and all of the tables used in this article. for the purpose of determining a transaction’s financial consequences, this article assumes, unless stated otherwise, that all investment and items 2002] normative capital cost recovery 479 31. in table 1 all of the tax and financial events other than the time 0 investment (which is not shown) occur on the last day of taxable years 1 through 4. this includes receipts, payments, and non-cash items such as recovery deductions. when time 0 events are later introduced into the analysis, all time 0 events will be shown as such in an additional row labeled “0” for time 0. e.g., infra table 5. 32. a last day convention for all income tax base events facilitates portraying an accretion or cash flow-measured tax base that is sensitive to the time value of money. within a cash flow-measured tax base such as a cfit, time 0 is the appropriate time to measure all initial cash flows, including investment. a first day (time 0) convention for expensed recovery within an hit base also seems appropriate for this cash flowequivalent tax treatment of investment expenditures. therefore, this article uses a last day convention when accounting for all true income tax events and for all events within any tax base that are determinative of financial consequences before or after tax. however, the article uses a first day of year 1 (or time 0) convention to account for both true expensing within a cfit base and expensing as a generic income tax recovery method within either an amit or hit base. 33. since the yield rate produced by the investment equals the pre-tax discount 1rate of 10%, both the g.i. and ptcf columns have pv ’s of $100. this indicates that the pre-tax present value of both the tax and economic income streams produced by the asset equal the amount invested. in classical financial texts, the pre-tax discount rate is usually less than the real or projected yield rate, allowing the financial analyst to evaluate investments or potential profitability on the basis of their positive net present value. e.g., richard brealey & stewart myers, principles of corporate finance 10-12 (1981). for simplification purposes and because this article focuses on the relative financial differences among recovery methods, the pre-tax yield rate is assumed to equal the pre-tax discount rate (10%) throughout this article unless stated otherwise. this is the most common scenario employed in the literature and is called a break-even transaction in this article. 34. this discount rate measures how much a given series of tax or accounting flows is worth or costs on the assumption that each year’s amount either makes or costs the taxpayer money (whether directly or indirectly), and that each year’s amount earns a 10% pre-tax yield which is taxed at a 50% rate, leaving the net yield or cost of that directly related to investment occur on the first day of year 1 (or time 0) and that all items of income and deduction take place simultaneously on the last day of each taxable year. this assumption consistently determines the present value of all tax-significant items in all tax base analyses as of time 0 (or first day of year 1). for the same reason, throughout this article all other items relating to the determination of the financial and economic consequences of the transactions described are presumed to occur simultaneously on the last day of taxable years 1 through 4. these timing conventions provide accounting31 consistency within and among the three tax bases.32 four items portray the financial consequences of economic cost 1recovery in table 1. first, the pv row shows the pre-tax present value of each column, using a 10% discount rate, compounded annually. since the tax rate33 2is assumed to be 50%, the pv row shows the after-tax present value of each column using a 5% discount rate compounded annually. the irr row shows34 480 florida tax review [vol. 5:7 series of amounts after tax to be measured at a 5% discount rate compounded annually. 35. this financial characteristic measures the constant discount rate that, applied to the sequence of cash flows in years 0 through 4, yields the amount of any equity invested at time or year 0 of the transaction. see brealey & myers, supra note 33, at 70-72. for example, in table 3, since the asset yield rate is 10%, the irr of the ptcf is also 10%. 36. the irr effective tax rate is determined by dividing the irr of the pre-tax cash flow minus the irr of the after-tax cash flow by the irr of the pre-tax cash flow. the formula can be expressed as: (irr ptcf irr atcf)/irr ptcf = etr. 37. this ratio satisfies the samuelson definition of economic depreciation. samuelson, supra note 25. note that the timing conventions explained earlier play a critical role in defining economic depreciation. if, for example, annual tax and cash flow events were treated as occurring on the first, rather than the last day of each taxable year, the irr of the atcf would become 8.54%, and the irr etr would become (10.0 8.54)/10.0 = 14.6%. under those circumstances, table 3 would no longer demonstrate economic depreciation. 38. see treasury department report, supra note 14, at 27, 32. the statement in the text is particularly true for short-lived assets but is dependent upon asset types and inflation rates. 39. e.g., kopits, tax provisions to boost capital formation vary widely in industrial nations, 11 tax notes 955 (february 17, 1980). this study was done before the combination of acrs and the investment tax credit (itc) was enacted. that combination was designed to approximately equal expensing (in after-tax present value terms). see infra note 70 and following text. see also kopits, industrial countries increase their use of tax incentives to stimulate investment, 12 tax notes 1083 (1981); see generally, office of federal tax services, arthur andersen & co., comparison of present value of cost recovery allowances permitted in various countries, 27 tax notes 1507 (june 24, 1985). the internal rate of return implicit in the pre-tax and after-tax cash flow columns, respectively. the fourth item is the irr effective tax rate. table 135 36 illustrates samuelsen economic depreciation because the irr of the atcf (5%) is exactly 50% of the irr of the ptcf (10%) which demonstrates that the irr effective tax rate or irr etr is exactly 50%. samuelsen economic depreciation only exists when the irr etr matches the nominal tax rate.37 b. accelerated cost recovery modern statutory cost recovery schedules seldom reflect the true ongoing diminution in economic value of the assets whose cost is being recovered. instead they tend to allow cost recovery much “faster” than the economic exhaustion of those assets actually occurs. thus, like the capital38 recovery allowances available to taxpayers in many other countries, the present value of the series of recovery deductions available to u.s. income taxpayers with respect to many assets exceeds the present value of economic depreciation as defined earlier. the financial value produced by such accelerated cost39 2002] normative capital cost recovery 481 40. the recovery deduction stream is based on that prescribed for 3-year recovery property by irc § 168(b) (1981). 241. the pv of the taxable income decreases from $23.73 in table 1 to $21.64 in table 2, a difference of $2.09. 42. the investment in table 1, which is economically depreciated, is worth 1$100 financially both before tax (as measured by the $100 pv of the ptcf) and after 2tax (as measured by the $100 pv of the atcf). this is appropriate not because the after-tax discount rate is exactly 50% of the pre-tax discount rate (which it also is in table 2), but because only the economic cost recovery method in table 1 produces an effective (or financial) tax rate that exactly equals the nominal tax rate. recovery methods after tax can be considerably greater than that produced by economic cost recovery. for example, table 2 below portrays a $100 investment in a depreciable asset with a 10% yield over 4 years that is identical to the investment portrayed in table 1 other than the fact that the acrs recovery method, rather than economic depreciation, is used for tax accounting purposes.40 table 2: $100 investment subject to acrs recovery year g.i. rcvry t.i. ptcf tax atcf 1 31.55 25.00 6.55 31.55 3.27 28.27 2 31.55 38.00 -6.45 31.55 -3.23 34.77 3 31.55 37.00 -5.45 31.55 -2.73 34.27 4 31.55 0.00 31.55 31.55 15.77 15.77 tot 126.20 100.00 26.20 126.20 13.10 113.10 1pv 100.00 81.93 18.07 100.00 9.03 90.97 2pv 111.87 90.24 21.64 111.87 10.80 101.04 irr 10.00% 5.48% 2because the after-tax present value (pv ) of the recovery deduction stream ($90.24) exceeds the comparable present value of the economic cost 2recovery deduction stream in table 1 ($88.14) by $2.10, the pv of the taxable income is reduced by approximately the same amount. conversely, because41 2the taxable income in table 2 has a $2.09 lower pv than the t.i. in table 1, the 2after-tax cash flow has a $1.04 higher pv . this relationship is appropriate 2since the tax rate is 50%. more importantly, the pv of the atcf in table 2 1($101.04) exceeds the pv of the ptcf ($100.00) by $1.04. this shows that a break-even investment in an asset subject to acrs recovery is more valuable financially after tax than it is before tax, whereas an economically depreciated asset break-even investment is worth the same amount financially before and after tax.42 to further illustrate this point table 3 below shows a $100 investment in an asset producing a 10% yield over four years which is subject to the 482 florida tax review [vol. 5:7 43. the recovery deduction stream in table 3 is based on the macrs system as enacted in the tax reform act of 1986, pub. l. 99-514, § 201(a), 100 stat. 2085, 2122 (codified in irc § 168(b). 44. $20.91 compared to $23.73 for a reduction of $2.82. see supra text, part ii.a., at 484 (table 1). 45. typically, alternative investment decisions are evaluated by comparing the net present values of the after tax return from alternative investments. the net present value in each case represents the excess of the present value of the return from a proposed investment over the present value of a minimum risk non-investment savings alternative, such as government bonds or certificates of deposit or other instruments of similar duration to the proposed investment. e.g., brealey & myers, supra note 33, at 12. modified accelerated cost recovery system (macrs) an even more accelerated cost recovery method than acrs under these circumstances.43 table 3: $100 investment subject to macrs recovery year g.i. rcvry t.i. ptcf tax atcf 1 31.55 33.33 -1.78 31.55 -.89 32.44 2 31.55 44.45 -12.90 31.55 -6.45 38.00 3 31.55 14.81 16.74 31.55 8.37 23.18 4 31.55 7.41 24.14 31.55 12.07 19.48 tot 126.20 100.00 26.20 126.20 13.10 113.10 1pv 100.00 83.22 16.78 100.00 8.39 91.61 2pv 111.87 90.95 20.91 111.87 10.46 101.41 irr 10.00% 5.67% 2now, the pv of the recovery deduction stream ($90.95) exceeds that of economic depreciation ($88.14) by $2.81. again, the higher after-tax present value of the recovery deduction stream leads to a lower present value of the 2taxable income stream, and ultimately a higher after-tax present value (pv )44 2for the after-tax cash flow ($101.41). again the pv of the atcf exceeds the 1pre-tax present value (pv ) of the pre-tax cash flow ($100.00), but now by $1.41 instead of $1.04. taken together, table 1, table 2 and table 3 show that the “faster” a recovery method is, the more it increases the net after-tax present value of the after-tax cash flow produced by a given amount of investment. thus, for45 2example, the net pv s of the atcfs in table 1 (economic depreciation), table 2 (acrs) and table 3 (macrs) are $0.00, $1.04 and $1.41, respectively. the higher the present value of an income tax recovery method, the higher the net present value of an investment in that asset is relative to alternative investments, 2002] normative capital cost recovery 483 46. the net present values of the after-tax cash flows are computed by 2subtracting from the pv of the atcf in each case the initial $100 cost of each investment. 47. thus, in table 1 through table 5, total g.i. = $126.20, total recovery = $100.00, total t.i. = $26.20, total tax = $13.10 and total atcf = $113.10. 48. this result shows that because only the cost recovery methods differ from 2one investment to another, and because the pv of the atcf under economic depreciation is $100, accelerated recovery methods are the only reason for the positive 2financial value of the investment after tax as measured by the pv of the atcf in table 2 and table 3. 49. see supra note 36 and accompanying text. 50. applying the etr formula from supra note 36 to table 2 produces an irr etr of 45.2%. in the macrs case, the application produces an irr etr of 43.3%. 51. see discussion, supra notes 31-32 and accompanying text. 52. this simplifying assumption ignores the impact of interim income and deductions on the amount of quarterly estimated tax payments for which many taxpayers are responsible. e.g., irc §§ 6654 (individuals), 6655 (corporations). it also ignores the fact that the tax liability for a taxable year is not payable in full until well after the close of the taxable year. see irc §§ 6072 (due dates for calendar year corporate and non-corporate income tax returns are march 15 and april 15 of the following calendar year, respectively), 6151 (tax payment is due with returns on date required for filing of returns). and the greater the financial attractiveness of investing in that asset. note,46 however, that these increments in financial value are solely a function of the recovery methods employed. under all of these recovery methods, all of the nominal or economic results are identical, and the pre-tax present value of the47 investment always equals $100.00.48 table 2 and table 3 also illustrate two other indicia of the financial value of accelerated recovery methods. under economic depreciation, as portrayed in table 1, for example, the irr of the after-tax cash flow (5%) was exactly 50% of the irr of the pre-tax cash flow (10%). this relationship demonstrated that the irr effective tax rate matched the nominal tax rate of 50%. acrs depreciation increased the irr of the atcf to 5.48%, and49 macrs increased it even more to 5.67%, thus reducing the irr effective tax rates to 45.2% and 43.3%, respectively.50 c. year-end expensing in the “real world,” an expensed asset may be purchased at any point in time between the first day of year 1, which is when investment in assets is generally deemed to occur for purposes of this article, and the last day of year 1, which is when gross income, recovery deductions and all other financial and tax events are accounted for under the conventions used in this article and under the tax accounting rules prescribed in the internal revenue code. thus,51 it can be argued that expensing deductions take effect at the same time (the end of year 1) as deductions under the cost recovery methods already discussed.52 484 florida tax review [vol. 5:7 53. in year 1, the $100 expensing deduction offsets the $31.55 of gross income produced by the asset, and the negative $68.45 of asset taxable income is presumed to offset an equal amount of non-asset gross income. this deduction produces tax savings of $34.23 (50% of $68.45). the atcf of $65.78 consists of the sum of the $31.55 ptcf produced by the asset and those tax savings. 54. at the same time, the expensing in table 4 is substantially “slower” financially than theoretical instantaneous expensing. 255. cf. the pv of the recovery deduction columns in table 2 (acrs), which is $90.24, and table 3 (macrs), which is $90.95, a difference of $5.00 and $4.29, respectively. 256. cf. the atcf pv figures from table 1 (economic depreciation), $100.00, table 2 (acrs), $101.04, and table 3 (macrs), $101.41. since all these investments have a 10% pre-tax yield rate and use a 10% pre-tax discount rate, none of them have 1any net present value before tax. all of the ptcf pv s equal zero. as pre-tax investment is subjected to faster and faster recovery methods, its after-tax net present table 4 below illustrates the expensing of an asset purchased on day 1 of year 1 using a “last day” convention. this approach to expensing is consistent with the structural and timing assumptions that were used with the other income tax recovery methods just described. table 4: asset purchase on first day & expensing on last day of year 1 year g.i. rcvry ded t.i. ptcf tax atcf 1 31.55 100.00 -68.45 31.55 -34.23 65.78 2 31.55 0.00 31.55 31.55 15.78 15.78 3 31.55 0.00 31.55 31.55 15.78 15.78 4 31.55 0.00 31.55 31.55 15.78 15.78 tot 126.20 100.00 26.20 126.20 13.10 113.10 1pv 100.00 90.91 9.10 100.00 4.56 95.48 2pv 111.87 95.24 16.64 111.87 8.33 103.57 irr 10.00% 7.11% the expensing cost recovery method in table 4 expensing differs from the accelerated cost recovery methods already discussed only in that much more of the recovery deduction “stream” offsets income other than that produced by the investment itself because all cost recovery occurs in year 1. however, the53 expensing demonstrated in table 4 is substantially “faster” financially than any other form of cost recovery analyzed so far when applied to identical amounts of investment. for example, the after-tax present value of “last day” expensing54 ($95.24) exceeds that of economic depreciation ($88.14) by $7.10 under identical economic and financial circumstances. its present value also exceeds those of acrs and macrs, although by lesser amounts. second, the55 expensing in table 4 produces an after-tax cash flow with an after-tax net present value of $3.57, which is much greater than that produced by the other cost recovery methods. third, the internal rate of return (irr) of the after-56 2002] normative capital cost recovery 485 2value (cost atcf pv ’s) increases. see supra notes 45-48 and accompanying text. 57. this conclusion is dependent upon the timing assumptions used in this article. for example, if one assumes that both the $100 investment in the asset and recovery are made on the last day of year 1, the irr of the ptcf and atcf each become 18.14% instead of 10%. on the other hand, if one treats all recovery deductions as occurring on the first day of each taxable year, one expenses the first year recovery deduction under all recovery methods, as well as the real world expensing deduction portrayed in table 4. this is apparently the method employed in alan j. auerbach, the new economics of accelerated depreciation, 23 b.c. l. rev. 1327, 1346-47 (1982) [hereinafter auerbach, auerbach convention] (treating all recovery deductions as being effective on the first day of each taxable year). see infra note 60. under neither alternative are the results even close to those in table 4. 58. see alvin c. warren, jr., accelerated capital recovery, debt, and tax arbitrage, 38 tax law 549, 555 (1985) [hereinafter warren, arbitrage]. 59. id. at 555 (emphasis added). tax cash flow increases to 7.11% and therefore reduces the irr effective tax rate to only 28.9%. the expensing in table 4 is clearly the “fastest” of any cost recovery method yet considered under the circumstances used in comparing all cost recovery methods so far. note, however, that the nominal amounts of57 taxable income ($26.20), tax paid ($13.10) and after-tax cash flow ($113.10) in table 4 are identical to those in table 1 (economic depreciation), table 2 (acrs) and table 3 (macrs), respectively. under the assumptions employed so far, expensing as a cost recovery method clearly affects only the financial effects of a given asset investment rather than the economic effects. d. theoretical instantaneous expensing in theory and purely from a tax base accounting standpoint, expensing can be viewed as a recovery method that differs only in timing from other cost recovery methods. for example, according to professor warren, “expensing and economic depreciation can be regarded as points along a continuum, with depreciation systems that are accelerated relative to economic depreciation fallin between these two points.” as warren further notes, “[e]xpensing can58 thus be characterized as extremely accelerated, or . . .‘instantaneous’ depreciation.” this section of the article constructs a model of theoretical59 instantaneous expensing. given the timing assumptions used in this article’s analytical model, instantaneously expensing the cost of an asset financially requires deducting that cost at the exact moment of the asset’s acquisition. in constructing a basic model of theoretical instantaneous expensing as a rbit base cost recovery method, this article assumes that expensing takes effect precisely at the time of 486 florida tax review [vol. 5:7 60. alternative conventions could be applied. e.g., auerbach, auerbach convention, supra note 57, at 1346-47 (treating investment and all recovery deductions as being effective on the first day of each taxable year). 61. compare supra note 52, where the impact of expensing on estimated tax liability was ignored for purposes of analyzing “year end” expensing. 62. by necessity, the analysis temporarily begs, for the moment, the question of how much economic investment can be made under an expensing regime within a hit base. this subject is discussed in infra part iv.b., when the question is considered in the context of earnings-financed investment. 63. e.g., steines, cost recovery, supra note 27, at 508 n.54. 64. all tax and financial events (other than time 0 investment and the expensing deduction) in the cycle: earnings tax = investment x yield rate = yield tax = atcf occur on the last day of taxable years 1 through 4. this includes receipts, payments, and non-cash items such as recovery deductions. see supra notes 31-32 and accompanying text. 65. the real world situation most closely approximating these theoretical conditions would be the purchase and expensing of an asset on the very last day of one taxable year followed by four subsequent calendar years of income production. in that event, the expensing deduction would be accounted for in the first year, while the asset would produce a four-year income stream similar to that used in these tables. see table 5. however, it is unlikely that even this situation would exactly replicate the financial characteristics of theoretical instantaneous expensing because tax liabilities, and therefore savings, do not become fixed legally until some time after investment in an asset occurs, even if that investment occurs on the last day of a taxable year. see supra note 52 and accompanying text. 66. as noted earlier, this article uses a last day convention when accounting for all generic income tax base events and a first day of year 1 (or last day of year 0) or simply “time 0” convention to account for both true expensing and expensing as a nominal income tax base recovery method. see supra notes 31-32 and accompanying text. a last day convention for all income tax base events is also consistent with the timing of filing determinations and requirements and facilitates an analysis which is sensitive to the time value of money, whereas a time 0 deduction seems appropriate for this essentially consumption tax treatment of investment. another important argument investment, which is called time 0. an argument can be made that this60 convention has a real-world counterpart since placing an expensed asset in service causes an immediate anticipated reduction in the investor’s estimated tax liability that can be valued in present value terms from that point in time.61 in order to compare the financial effects of theoretical instantaneous expensing to those of other income tax recovery methods, this article continues to assume that the amount invested is $100. thus, the expensing deduction has62 a present value measured at time 0 of $100. this article also continues to63 assume that all other items of income and deduction take place on the last day of the taxable year. this allows us to continue determining the present value of all tax and financial events as of time 0 (or beginning of year 1). this64 scenario is not designed to replicate real world conditions, but to provide a65 consistent framework for theoretical comparative analysis.66 2002] normative capital cost recovery 487 for an exception in the form of a first day convention for expensed recovery deductions is that such timing is necessary in order to create the financial and economic consequences attributed to theoretical expensing in the traditional literature. 67. table 5 shows net present values, while tables 1 through 4 used present values. infra part ii.f., conducts a closer examination of net present value and compares all of the cost recovery methods examined so far using that criterion. that examination will not change the results of or conclusions drawn from tables 1 through 5 at this point. 68. for a definition of irr effective tax rate, see supra note 36. applying the foregoing timing assumptions, table 5 below presents a $100 investment that is subject to theoretical instantaneous expensing. table 5: $100 investment subject to theoretical instantaneous expensing year g.i. rcvry t.i. ptcf tax atcf 0 0.00 100.00 -100.00 -100.00 -50.00 -50.00 1 31.55 0.00 31.55 31.55 15.78 15.78 2 31.55 0.00 31.55 31.55 15.78 15.78 3 31.55 0.00 31.55 31.55 15.78 15.78 4 31.55 0.00 31.55 31.55 15.78 15.78 tot 126.20 100.00 26.20 26.20 13.10 13.10 1npv 100.00 100.00 0.00 0.00 0.00 0.00 2npv 111.87 100.00 11.86 11.86 5.93 5.93 irr 10.00% 10.00% the economic consequences shown for “year 0” reflect the expensing deduction of $100 at time 0. this deduction reduces taxable income by $100, which in turn reduces tax by (or creates tax savings of) $50, leaving a positive after-tax cash flow of $50. during years 1 through 4, the asset produces the same gross income and pre-tax cash flow streams as in tables 1 through 4, but gross income in those years is not reduced by any cost recovery deductions, so annual t.i. equals both g.i. and ptcf ($31.55), and atcf is exactly 50% of that amount ($15.775). 2financially, the after-tax present value (pv ) of the “recovery deduction stream” in table 5 at time 0 ($100.00) now equals the amount invested. that 2pv also exceeds the comparable present value of the economic depreciation 2deduction stream in table 1 ($88.14) by $11.86. the npv of the atcf 1($5.93) now exceeds the npv of the pre-tax cash flow ($0.00) by half of that amount, or $5.93. table 5 also shows that the internal rates of return on the67 investment are the same both before and after tax (10%) and that the investment is therefore subject to a 0% irr effective tax rate.68 488 florida tax review [vol. 5:7 69. see s. rep. no. 97-494, at 122, reprinted in 1982 u.s.c.c.a.n. 781, 88689; staff of the joint comm. on taxation, 97th cong., analysis of proposals for depreciation and investment tax credit revisions, part i: overview 12 (comm. print 1981). 70. see alan j. auerbach & david raboy, 10-5-3 versus first year recovery: a depreciation debate, 12 tax notes 899, 906 (1981); auerbach, auerbach convention, supra note 57, at 1346; calvin h. johnson, tax shelter gain: the mismatch of debt and supply side depreciation, 61 tex. l. rev. 1013, 1022-25 (1983) [hereinafter johnson, mismatch]. 71. pub. l. no. 97-248, § 206 (1982). see senate comm. on finance, report on tax equity and fiscal responsibility act of 1982, s. rep. no. 494, 97th cong., 2d sess. 122, 122-23; johnson, mismatch, supra note 70, at 1022-23. 72. i.e., with an after-tax present value of recovery that equals or exceeds that of total nominal investment in the asset. 73. pub. l. no. 97-34, § 201(a), 95 stat. 172, 203-19 (1981). 74. see steines, cost recovery, supra note 27, at 537-38; see also auerbach, 2auerbach convention, supra note 57, at 1346-47. in table 6, for example, the pv of recovery, $101.67, exceeds the amount of the investment, $100.00. e. expensing-equivalent cost recovery congress made a more or less conscious decision in 1981 to implement a statutory approximation of expensing as a capital income tax recovery policy for the kinds of depreciable assets discussed in this article. the original69 combination of acrs and the investment tax credit (itc) was designed to produce an overall cost recovery allowance with an after-tax present value equal to the amount invested for most classes of personal property under then prevailing conditions, and is usually referred to as expensing-equivalent by commentators. because the conservative discount rate assumptions implicit70 in the original scheme made it more generous than expensing as interest rates subsequently rose, as part of the tax equity and fiscal responsibility act of 1982 (tefra), congress adjusted the statutory scheme in order to reduce the interest rate at which expensing-equivalence would exist.71 although cost recovery schedules that meet congress’s financial criterion are characterized as “expensing equivalent” or even beyond, these72 schedules can produce results that differ from those produced by theoretical simultaneous expensing. for example, table 6 below represents an investment subject to acrs and itc cost recovery under the economic recovery tax act of 1981 as originally enacted. this combination of recovery allowances has73 been described as expensing equivalent because the after-tax present value of tax-free recovery under this method equals or exceeds the amount of the nominal investment. table 6 converts the 6% itc, for which 3-year recovery74 property was eligible after erta, into an equivalent deduction of $12 in year 1 based on the 50% tax rate used in our investment model. thus, the recovery deduction for year 1 in table 6 is $37, which is the sum of a first year acrs 2002] normative capital cost recovery 489 75. the conditions required to produce expensing-equivalence under the prevailing definition depends on the after-tax discount rate, the applicable tax rate and the timing conventions used. auerbach gives the first year depreciation deduction a present value equal to nominal value. under the timing conventions used in this article, that is the equivalent of expensing the first year recovery deduction under every cost recovery method. thus, acrs recovery for three year property in auerbach’s discussion has a present value of .8842. see auerbach, auerbach convention, supra note 57, at 1340 n.102, 1346. employing the last day convention used by this article, the first year recovery deduction is not expensed and the same recovery method has a present value of only .7895. similarly, if the itc-equivalent deduction is treated as 2occurring at time 0, the pv of the atcf becomes $7.04, and the irr of the atcf becomes 8.4%. the choice of timing conventions, however, should only affect the discount rate at which a given “recovery method” becomes “expensing-equivalent.” cf. id. at 1347 (expensing equivalence for 3-year recovery property at 12% after-tax discount rate); supra table 6 (expensing equivalence for 3-year recovery property at 5% after-tax discount rate). for a formula and a complete set of tables presenting the combination of tax rate and after-tax discount rate at which this result pertains based on the auerbach convention, see johnson, mismatch, supra note 70, at 1021-25. 76. note that total nominal recovery deductions ($112.00) exceed nominal investment ($100.00). this is because the 6% ($6.00) itc is the equivalent of a $12.00 deduction in year 1 given a 50% tax rate, and this increases the year 1 recovery deduction in table 6 from $25.00 to $37.00 and the total recovery deductions from $100.00 to $112.00. this also causes total nominal after-tax cash flow ($119.10) to exceed the after-tax cash flow produced by all true recovery methods ($113.10) by recovery deduction of $25 and an itc-equivalent deduction of $12. that deduction is computed as occurring on the last day of year 1.75 table 6: acrs/itc expensing-equivalent cost recovery year g.i. rcvry t.i. ptcf due atcf 0 $ 0.00 $ 0.00 $ 0.00 ($100.00) $ 0.00 ($100.00) 1 31.55 37.00 -5.45 31.55 -2.73 34.28 2 31.55 38.00 -6.45 31.55 -3.23 34.78 3 31.55 37.00 -5.45 31.55 -2.73 34.28 4 31.55 0.00 31.55 31.55 15.78 15.78 tot 126.20 112.00 14.20 126.20 7.09 119.12 1pv 100.00 92.84 7.17 100.00 3.58 96.44 2pv 111.87 101.67 10.21 111.87 5.09 106.79 irr 10.00% 8.18% table 6 demonstrates three points. first, the combination of itc and acrs is not a true “recovery” method at all, but true cost recovery combined with a nominal tax subsidy. second, this “recovery” method produces greater76 490 florida tax review [vol. 5:7 $6.00 (due to the 50% tax rate). compare table 1 and table 5 supra, which show economic depreciation and theoretical expensing as a recovery method, respectively. both show nominal atcfs of $13.10. 77. in nominal dollar terms, this structure’s after-tax benefits exceed those provided by theoretical instantaneous expensing as a recovery method since the total net after-tax cash flow in table 6 ($19.12) exceeds the total after-tax cash flow in table 5 ($13.10). compare supra table 1 (economic depreciation), table 2 (acrs), table 3 (macrs), and table 4 (year end expensing) all of which have net after-tax cash flows of $13.10. 78. the present value of the net after-tax cash flow of $6.79 in table 6 exceeds that of the $5.93 generated by instantaneous expensing as a recovery method in table 5. this is caused by the duplicate recovery of a portion of the asset’s basis through the combination of the itc and acrs. however, the irr of the after-tax cash flow in table 6 (8.18%) is less than that of the pre-tax cash flow (10.00%). since the irr of the atcf is less than 10%, a positive effective tax rate is being applied to the income produced by the investment in present value terms. that tax rate is the ptcf irr (10.00) minus the atcf irr (8.18) or approximately 18.2%. expensing as a recovery method, on the other hand, produces a zero irr effective tax rate because under similar circumstances the irr of both the pre-tax and after-tax cash flows was 10%. see supra table 5 and text accompanying supra note 68. 79. for example, if the itc were reduced to 5.13% the npv of the atcf would equal $5.93, which matches the npv of the theoretical expensing transaction portrayed in table 5. however, the irr of the atcf would still only equal 7.77%. thus, the transaction would still not be totally “expensing equivalent.” 80. a process of iteration shows that the net present value of the after-tax cash flow would be $5.92 (approximately the same amount as in table 5) at an after-tax discount rate of 5.38%. however, the irr of the after-tax cash flow would remain unchanged. 81. the “cary brown hypothesis,” employed only one discount rate for both before and after-tax financial measurements. see supra note 23 for full citation and infra part v.a. for a full discussion and analysis. this differs from table 6, in which the after-tax, but not the pre-tax, present value of the recovery/itc stream equals the amount invested. economic tax benefits than expensing as an income tax recovery method.77 third, this “recovery” method produces financial tax benefits that are greater than those produced by expensing in terms of the net present value of the after-tax cash flow, but that are less than those produced by expensing in terms of the internal rate of return of the after-tax cash flow.78 based upon analysis of the figures in table 5 and table 6, the only way to achieve “expensing equivalence” in present value terms is to either adjust the itc amount while the discount rate remains constant, or for the real world79 discount rate to coincidentally match the specific rate that will create “expensing equivalence” for a given itc amount. without an itc, the only80 way to make multi-period “cost recovery” deductions the true equivalent of immediate expensing is to provide sufficient additional cost recovery deductions during the course of the investment for the after-tax present value of those deductions to equal the amount invested. this is also the underlying81 2002] normative capital cost recovery 491 82. see blueprints, supra note 1, at 123-24; michael j. graetz, implementing a progressive consumption tax, 92 harv. l. rev. 1575, 1598-1611 (1979) [hereinafter graetz, implementing]. 83. rounding errors create the small discrepancies among the amounts in the 2total pv column. 284. cumulative rounding errors cause the total pv s to deviate slightly from the average of $11.86. structural and accounting principle of capital income taxation in a cash flow consumption tax.82 f. a preliminary comparative analysis: net present value, internal rate of return and financial effective tax rates 2accelerated recovery methods reduce the pv of the tax burden attributable to the income produced by a given amount of investment relative 2to economic cost recovery, and simultaneously increase the pv of the after-tax 2cash flow (atcf). the sum of the pv of the tax paid and the atcf, however, remains constant. the following table illustrates this by totaling the 2pv of the tax paid and after-tax cash flow columns portrayed in table 1 through table 5, respectively.83 2table 7: relative impact of recovery methods upon pv of atcf and tax paid 2 2 2 recovery method pv tax paid net pv atcf total pv s 1-economic 11.86 0.00 11.86 2-acrs 10.80 1.04 11.84 3-macrs 10.46 1.41 11.87 5-real world exp 8.33 3.57 11.90 4-theory exp 5.93 5.93 11.86 2in table 1 (economic depreciation), the pv of tax paid was $11.86, 2 2but the pv of the atcf was $0.00. under acrs and macrs, the pv of tax 2paid decreased relative to economic depreciation, but the pv of the after-tax cash flow increased by the amount of that decrease. thus, the sum of both 2amounts remained fixed at approximately $11.86. finally, in table 5, the pv84 of the tax paid decreased from $11.86 to $5.93 relative to economic depreciation, and the atcf increased from $0.00 to $5.93, again preserving the total of $11.86. thus, the decrease in the after-tax present value of tax paid by a given amount of investment in a rbit base as depreciation accelerates from 492 florida tax review [vol. 5:7 85. see e.g., johnson, soft money, supra note 22, at 1019. 86. see the fifth column in infra table 8. 87. from left to right, the columns contain the following information about each of those recovery methods: (1) name of recovery method; (2) pre-tax net present 1value of the pre-tax cash flow (npv ptcf); (3) after-tax net present value of the pre2 2tax cash flow (npv atcf); (4) net after-tax present value of the tax paid (npv 2tax); and (5) after-tax present value of the after-tax cash flow (npv atcf). columns 2 and 3 show that there is a fixed difference of $11.86 between the pre-tax and after-tax net present values of the pre-tax cash flow. those net present values are computed using 10% and 5% discount rates, respectively. columns 4 and 5 show that 2the npv of the tax paid and the after-tax cash flow vary inversely to each other, but 2 2always total $11.86. column 6 computes the “npv effective tax rate” (npv etr). the last three columns contain the following information for each cost recovery method: 1(7) internal rate of return of the ptcf (irr ptcf or irr ); (8) internal rate of 2return of the atcf (irr atcf or irr ); and (9) the “irr effective tax rate” (irr etr). see discussions of these financial criteria, text accompanying supra notes 33-37 and 45-50. economic to expensing ($11.86 to $5.93) is exactly offset by a corresponding increase in the present value of the after-tax cash flow ($0.00 to $5.93). modern financial analysis focuses on the relative ability of accelerated cost recovery methods to increase the net present value of the after-tax cash 2flow (npv atcf) produced by investments using an after-tax discount rate.85 modern analysis also focuses on the impact accelerated cost recovery methods 2have on the internal rate of return of the after-tax cash flow (irr atcf) produced by similar investments. each financial criterion allows the computation of an effective tax rate (etr) that can differ substantially from the nominal tax rate. a comparative analysis of these effective tax rates adds considerably to our understanding of the financial effects produced by various cost recovery methods. table 8 below shows the elements that go into the computation of financial effective tax rates for each of the rbit cost recovery methods examined so far. this table ranks the rbit base recovery methods analyzed in part ii from the slowest to the fastest in order of the increasing 2amounts of the npv of their atcfs.86 table 8: modern financial analysis: after-tax financial yield87 recovery m ethod 1npv ptcf 2npv ptcf 2npv tax 2npv atcf 2npv etr irr ptcf irr atcf irr etr econ 0.00 11.86 11.86 0.00 100% 10.0% 5.0% 50.0% acrs 0.00 11.86 10.80 1.04 91.2% 10.0% 5.48% 45.2% m acrs 0.00 11.86 10.46 1.41 88.1% 10.0% 5.67% 43.3% yr end exp 0.00 11.86 8.33 3.57 69.9% 10.0% 7.11% 28.9% theory exp 0.00 11.86 5.93 5.93 50% 10.0% 10.0% 0.0% 2002] normative capital cost recovery 493 88. see text accompanying infra notes 149-52. the fact that economic depreciation and expensing lie at opposite ends of a spectrum of recovery methods as warren predicted can be seen in many ways. for example, a modern financial analysis of the income tax recovery methods examined so far would rank them from the “slowest” (economic) to the “fastest” (expensing) according to: (1) the increasing order of the net after-tax 2present value of the after-tax cash flow (npv atcf); (2) the increasing order of the irr of the atcf; and (3) the decreasing order of the effective tax rate (etr) as measured by both methods. not present value (npv) and internal rate of return (irr) are very different indicators of effective tax rates. for example, the irr of the atcf for economic depreciation in table 8 is exactly 5%. because the irr of the pretax cash flow (ptcf) is 10%, economic depreciation produces an irr effective tax rate (irr etr) that is exactly equal to the nominal tax rate of 50%. in other words, the rate of financial return before tax (10%) is reduced exactly by the tax rate in order to produce the appropriately reduced rate of financial return on this investment after tax (5%).88 effective tax rates that are computed by using net present value tell a 2different story. the key elements in computing npv etr are: (1) the npv of 2 2the ptcf; (2) the npv of tax paid; and (3) the npv of the atcf. npv etr is computed by using the formula: 2npv etr = npv tax 2 2 npv tax + npv atcf. as table 8 shows, in the context of a financially break-even investment, element 1 always equals the sum of elements 2 and 3, regardless of the cost recovery method employed, so the denominator can be simplified and re-written as: 2npv etr = npv tax 2 npv ptcf. when using npv etr under financially ideal conditions, the basic criterion of accuracy is the extent to which the npv effective tax rate produced by a given cost recovery method coincides with the nominal tax rate. therefore, 2if one begins with the npv of the ptcf ($11.86), and computes the fraction 2 2npv tax/npv ptcf, one quickly sees that economic depreciation causes 100% of the after-tax net present value of the after-tax cash flow to be paid in tax, producing an npv etr of 100%. 2as cost recovery methods accelerate, the npv of the atcf increases 2while the npv of the ptcf remains constant. as a result, the npv etr 494 florida tax review [vol. 5:7 2 2 289. as npv atcf increases, npv tax must decrease, so the fraction npv 2tax/npv ptcf must decrease as well. 90. this occurs because the formula for irr etr is irr atcf/irr ptcf 2 1(irr /irr ). 91. for a very accessible explanation of some of the issues involved in the computation of nominal effective tax rates, see seymour fiekowsky, pitfalls in the computation of “effective tax rates” paid by corporations, office of tax analysis paper 23 (july 1977), reprinted in ota papers: compilation of ota papers, volume 1 (1978). 92. for an equally lucid explanation of the process involved in computing financial effective tax rates, see jane gravelle, the economic effects of taxing capital income, appendix b, 287-89 (1994). 93. see brealey & myers, supra note 33, at 101-08. 94. see johnson, soft money, supra note 22, at 1041, n.85 (pointing out the serious limitations of irr analysis on investment return comparisons); michael s. knoll, the ucla tax policy conference: designing a hybrid income–consumption tax, 41 ucla l. rev. 1791, 1799, n.29 (1994) (pointing out four reasons why net present value should be used instead of irr in comparing capital income taxation regimes). overall, this article performs an extensive npv analysis comparing income and consumption tax treatment of capital income. 2decreases. under expensing, the npv of the atcf is maximized at $5.93;89 and this produces an npv etr of 50%. similarly, as cost recovery methods accelerate, the irr of the atcf increases relative to the irr of the ptcf, and therefore, the irr effective tax rate decreases. as a result, under expensing,90 the irr of the atcf matches the irr of the ptcf at 10%; therefore, the effective rate of tax using irr becomes 0% because the pre-tax financial rate of return is not decreased at all by taxation. the tax literature historically uses actual nominal tax liabilities in computing effective, as opposed to statutory, tax rates. the same literature91 tends to use internal rate of return when using effective tax rate as a financial analytical tool. however, the finance literature largely views net present92 value as a more accurate comparative financial indicator than internal rate of return for purposes of evaluating competing comparable investment opportunities, and some tax literature has begun to follow suit. these two93 94 financial indicators serve different purposes in measuring and conveying various types of financial information. this article uses both indicators in its comparative analysis of the three tax bases – amit, cfit and rbit – as well as in its comparative analysis of rbit base cost recovery methods. additional financial indicators will also be used as the need arises during the course of those comparative analyses. overall, the conclusions in this article are based on the financial evaluative factors that seem to be most appropriate and accurate for each analytical context. 2002] normative capital cost recovery 495 95. see simons, supra note 1, at 50. 96. bargain purchases could produce an increase in economic wealth, and the use of below-market financing could produce an increase in financial wealth. the breakeven investments used in this article, however, produce no change in economic or financial wealth. iii. comparative capital income taxation principles with respect to the taxation of capital income, amit, cfit and rbit structural and accounting principles address three common issues: first, whether and how to tax the source of investment; second, whether and how to tax the economic yield from investment; and third, whether and how to allow tax-free recovery of investment. within a given tax base the answers to these questions should be consistent with each other and with the fundamental structural and accounting principles of that particular tax base. a. accretion-measured income tax (amit) the structure of an amit base is defined by the equation i = c + dw, where i equals income, c equals consumption, and dw equals change in wealth. the purpose of the formula is to measure the increased capacity for95 consumption created by positive changes in net wealth, and the decreased capacity for consumption created by negative changes in net wealth. theoretically, the consumption of wealth per se is also includible in the tax base, but as a practical matter this inclusion produces no net change in the tax base because any current increase in consumption causes an equal and offsetting decrease in wealth. ultimately, the amit base consists of net accretions or decreases in wealth. “income” is simply the source (and therefore the sum) of both consumption and accretions to wealth. an amit base taxes the source of investment as well as the economic yield produced by investment because both create increases in wealth. however, an amit base does not allow tax-free recovery of investment. thus, in an amit base neither the acquisition nor disposition of an asset is given structural or accounting significance as such unless the taxpayer’s total store of wealth is changed as a result. for example, the acquisition of a depreciable asset financed with equity creates no change in the investor’s net economic or financial wealth if the investment is a break-even investment. if savings are used, the96 investment simply represents a new form of the previous wealth. if current year earnings are used, the increase in wealth represented by those earnings is transformed into the depreciable asset, but the amount of the initial increase in wealth is neither increased nor decreased by the change in form of that wealth. therefore, the tax base is increased by virtue of the earnings, but it is not reduced because those earnings were invested. this feature of an amit base 496 florida tax review [vol. 5:7 97. john stuart mill first called the income tax a “double tax on savings.” john s. mill, principles of political economy 814 (sir william ashley ed., augustus m. kelley publishers 1973) (1848). 98. under an amit base, the purpose of economic depreciation is not to directly measure the net capital income produced by specific assets, although it plays an important role in that process. 99. the chirelstein convention is a simplified theoretical way to measure the decline in value of real depreciable assets with the kinds of relatively predictable income streams that are associated with most financial assets. produces what is often referred to as a “double tax” on investment. for97 example, if an amit taxpayer earns $200 in year 0, the maximum amount that the taxpayer can invest from those earnings is the amount remaining after those earnings are subject to tax. if the tax rate is 50%, an amit taxpayer can only invest $100 after tax. during the holding period of a depreciable asset within an amit base, the gross economic yield produced by the asset increases wealth, while the decline in the asset’s value decreases wealth. the net yield produced by the asset may either increase or decrease net wealth relative to the initial value of the asset, or net wealth may remain unchanged. the primary purpose of economic depreciation in an amit base is not to recover the cost of an asset tax-free, but to assist in periodically measuring the overall dw factor in the haig-simons definition of income. in the case of a self-exhausting asset,98 annual economic depreciation deductions represent the actual decline in the asset’s value during each successive taxable period. if, as in table 1, the99 investment is a break-even investment because the asset’s yield rate equals the pre-tax discount rate, that investment has a npv of 0 before tax using the pretax discount rate, and an npv of 0 after-tax using the after-tax discount rate. both figures are appropriate and correct for an amit base. because no net wealth is created before tax, either at acquisition or during the holding period of the asset, no net wealth is created after tax. economic depreciation is the only type of depreciation accounting that produces this structurally correct result in an amit base. b. cash flow income tax (cfit) while an amit base is structured to tax consumption and the ability to consume and can be accounted for through a balance sheet approach, a cfit base is structured to tax actual consumption and can be accounted for through a cash flow statement approach. in other words, a cfit base can be expressed as the formula tax base = consumption rather than tax base = consumption + dw. consumption, in turn, can be expressed as earnings – investment if all non-invested or non-saved earnings are deemed to be consumed. a cfit base is a simplified type of consumption tax base and is basically structured to tax earnings – investment. as a result, it has been said that a consumption tax is a 2002] normative capital cost recovery 497 100. see alvin c. warren, jr., fairness and a consumption–type or cash flow personal income tax, 88 harv. l. rev. 931, 938-41 (1975); cf. william andrews, fairness and the personal income tax: a reply to professor warren, 88 harv. l. rev. 947 (1975). 101. traditionally, two versions of a cash flow consumption tax have been proposed with respect to the taxation of the income from depreciable assets. the first version is a straightforward cash flow accounting approach in which investment in real assets is deducted from the tax base and all investment yield is included in the tax base. the second version is often called yield exemption and operates by taxing investment in an asset (like an amit base) but exempting the yield produced by the asset from tax. the two versions produce the same present value of tax paid, but the second version potentially allocates all windfall gains to taxpayers. in its last major study of tax base reform, the treasury department prohibited this treatment for real business assets, both for concern about this allocation and the difficulty of distinguishing return to capital from income from services, in the context of small businesses. see blueprints, supra note 1, at 115-17. 102. on the other hand, to mix structural metaphors, one could characterize not taxing the source of investment as a form of ex ante tax-free cost recovery. tax on earnings but not on investment, while an income tax is a tax on both earnings and investment.100 under one of its two major approaches to capital income taxation, a cfit base does not tax the source of investment but completely taxes investment yield. because the source of investment (earnings for example) is101 not taxed, there is no after tax cost to recover tax-free subsequent to the act of investing.102 under this version of cfit base capital income taxation, the act of investing in a real exhausting asset is simply accounted for as a negative cash flow. structurally, investment is treated as a reduction of funds available for consumption, and therefore, as a reduction in the tax base for the relevant period. conversely, the yield stream produced by that real asset is accounted for solely as a positive cash flow, and structurally as an increase in funds available for consumption, and therefore, as an increase in the tax base. thus, for capital income taxation purposes, none of the funds used to make the initial investment are taxed, but all the income produced by the investment is taxed – unless additional investment is made with that income. this approach to tax base accounting completely separates the accounting for investment in a depreciable asset from accounting for the income produced by that asset. after the investment is accounted for as a tax base reduction, no further tax base structural or accounting significance is given to that asset. its value is not accounted for periodically, as in an amit base, and its original cost and value become irrelevant. if an asset is disposed of for value, the entire amount received for the asset is included in the tax base for that taxable period unless and to the extent the disposition proceeds are reinvested. 498 florida tax review [vol. 5:7 103. in addition to the realization requirement that is applied to the dw element in a rbit base formula, the historical non-taxation of imputed income from consumption of taxpayer-owned assets or self-provided services in the u.s. rbit implies that a realization requirement applies to the consumption element as well. e.g., thomas chancellor, imputed income and the ideal income tax, 67 or. l. rev. 561 (1988); richard goode, imputed rent of owner-occupied dwellings under the income tax, 15 j. fin. 504 (1960). 104. cf., edward a. zelinsky, for realization: income taxation, sectoral accretionism, and the virtue of attainable virtues, 19 cardozo l. rev. 861 (1997), and david j. shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. 1111 (1986). because the source of investment is not taxed in this type of cfit base, the maximum amount of earnings that can be invested in a cfit base is greater than the maximum amount that can be invested in an amit base. the wellknown ratio between the maximum amounts of investment in an amit and a cfit base, respectively, given the same amount of earnings, is expressed as amit investment x 1/1-t = cfit investment, where t, the tax rate, is the same in both tax bases. for example, given $200 of earnings in a taxable period, an amit investor, as noted above, can invest a maximum of $100 after all $200 of earnings are taxed because the tax base equals consumption + dw, and the earnings constitute an increase in wealth. a cfit investor on the other hand can invest the entire amount of earnings and owe no tax because the tax base equals earnings – investment. thus the maximum amit base investment ($100) x 1/1-t (1/.5) equals the maximum cfit base investment ($200). c. realization-based income tax (rbit) 1. general tax base principles.—the basic formula for a realizationbased income tax is identical to that of an accretion-measured income tax except that both consumption and dw must be realized in order to enter the tax rbase. in formula 1 below, represents the realization requirement.103 r r rformula 1: i = c + dw realization basically refers to the tangible receipt of wealth or consumption rather than a mere increase in the value of those items. realized changes of wealth are usually evidenced by a conversion of an asset into money or other property differing materially in kind or extent from the asset itself. the reasons usually given for the realization requirement are founded in tax policy and administration concerns. the reasons most frequently mentioned include: (1) the cost and difficulty of performing and resolving disputes over annual valuations of each taxpayer’s complete portfolio; and (2) the possibility that taxpayers might lack the ability to pay tax on accrued increases in value without being forced to partially liquidate their portfolios. the realization requirement104 2002] normative capital cost recovery 499 105. “[o]ne does not subject himself to income tax by the mere purchase of property, even if at less than its true value, and that taxable gain does not accrue to him before he sells or otherwise disposes of it.” palmer v. commissioner, 302 u.s. 63, 69 (1937). exceptions exist under the u.s. income tax. for example, in the compensatory context, the bargain element of a purchase has been traditionally taxed to the purchaser. see regs. § 1.61-2(d). 106. exceptions exist here, too. see supra note 6 and accompanying text. 107. in part iv., this article shows that rbit base investment may come from pre-tax dollars as well, and explains how the threshold between after-tax (or capital) and pre-tax dollar investment varies with the cost recovery method employed and the tax rate imposed. ultimately, however, the comparative analysis undertaken by this article is confined to capital-financed investment. helps to solve these problems by providing reliable evidence of value and causing the incidence of taxation to coincide with the ability to pay the tax. although realization may seem like a mere tax base accounting convention, it has substantial structural implications. unlike an amit base, any bargain element present in an asset acquisition does not enter a rbit base because any difference in value between the wealth used to obtain the asset and the newly acquired asset is generally not a realized change in wealth.105 similarly, during the asset’s holding period, the interim asset values have no tax structural or accounting significance because those asset value changes are not realized until the asset’s disposition. and finally, the amount realized from106 a disposition may differ from the asset’s terminal value. therefore, the realization principle may cause significant differences in the amount as well as the timing of income or loss taken into account in a rbit base in comparison to an amit base. 2. the role of asset basis.—the realization requirement alters some, but not all, of the structural and accounting features of an amit base. a rbit is still an “income” tax rather than a consumption tax. therefore, in a manner similar to amit base treatment but in contrast to cfit base treatment, investing earnings does not structurally decrease a rbit base. as a result, investment must come from after-tax or already-taxed dollars. however, in107 contrast to the way that an amit base accounts for and taxes all value fluctuations between the time of an asset’s acquisition and disposition, a rbit base only accounts for and taxes the difference between the initial amount invested and the terminal realized asset value. in other words, instead of beginning the tax base accounting process with the initial value of an asset at acquisition, a prototypical rbit begins with the asset’s after tax cost or other after-tax investment in the asset, using a tax accounting item and amount called basis. asset cost basis in a rbit base is somewhat analogous to initial asset value in an amit base: both are the tax accounting starting point for measuring subsequent changes in wealth. the difference is that those future changes must 500 florida tax review [vol. 5:7 108. cf. supra note 105 and accompanying text. 109. see irc § 7701(a), paragraphs 43 (transferred basis property), and 44 (exchanged basis property). both are examples of what § 7701(a)(42) defines as substituted basis property. 110. see irc § 1016. be realized in a rbit base but not in an amit base. administrative and evidentiary concerns justify the substitution of cost in a rbit base for initial value in an amit base for the same reasons that they support the substitution of realization for incremental and terminal asset valuation as an accounting principle. cost usually provides fairly reliable evidence of initial value but has a lower evidentiary threshold; and is a more easily administrable starting point than initial asset value. structurally, it is appropriate because any initial disparity between cost and initial value is generally not a realization event and a bargain purchase does not generally impact a rbit base.108 at the time of the asset’s disposition, the realization doctrine finally requires the taxpayer to account for the difference between the initial cost or other basis of the asset and the realized terminal value. however, if a disposition, though causing realization, is one which congress has decided warrants deferral of tax, then that gain or loss is not then “recognized” by the tax system. instead, the basis in the disposed asset is exchanged for identical basis in a new asset, or the old basis is transferred to a new taxpayer along with the asset. as an asset (or its successor) moves through the tax system, its tax109 basis moves along with it as an ongoing measure of the continuing amount of after-tax (or already-taxed) dollars invested in the asset. when a taxable disposition occurs (one in which gain or loss is both realized and recognized), the difference between the original basis (plus or minus any adjustments to that basis allowed for certain intervening events) and the amount realized110 produces either an increase or a decrease in the taxable income of the taxpayer disposing of the asset at that time. 3. rbit capital income taxation principles.—as a result of the tax base accounting element of asset basis, a transactional method of accounting for the taxation of capital income from depreciable assets in a rbit must address two possible components of that income: a self-exhausting income-producing asset, and the realized income produced by that asset. unlike an amit, unrealized declines in an asset’s value during its period of productivity need not and should not be accounted for as decreases in the tax base. this is why tax policy makers should not assume that economic depreciation as a cost recovery method is the tax base structural or accounting paradigm for measuring and taxing capital income within the u.s. rbit base. on the other hand, unlike a cfit base, the u.s. rbit measures neither capital investment nor capital income simply on the basis of cash flows. because unlimited expensing is a 2002] normative capital cost recovery 501 111. strnad argues that cash flow accounting, which has the same financial and economic effects as expensing, measures dw within a haig-simons amit base better than economic depreciation. this assertion has been hotly disputed by professors warren, kaplow, and popkin. see discussion supra note 5. this article takes the position that expensing more accurately measures capital income within a cfit base than economic depreciation, but does not consider expensing’s impact on the measurement of dw to be the reason. 112. in other words, a realization-based income tax is not an excise tax on investment coupled with an income tax on both earnings and capital income. surrogate for cash flow accounting, policy makers should not assume that it is the correct paradigm either.111 rather, the fundamental feature of capital income taxation under the u.s. rbit base is that of tax-free capital cost recovery. because a rbit base, like an amit base, taxes invested earnings, it is necessary to recoup or recover those taxed invested earnings at some point in time from otherwise taxable realized income. otherwise, a rbit would tax invested earnings twice, an amit once, and a cfit not at all. like an amit, a rbit is a tax on net increases in wealth, not a tax on capital (or after-tax wealth) per se. however,112 unlike an amit, which measures and taxes all changes in wealth between acquisition and disposition, rbit income is measured by the difference between already-taxed dollars invested in an asset at the time of its acquisition, as measured by an asset’s basis, and the terminal realized value (amount realized) of the asset at the time of its disposition or other realization event. basis in a rbit is somewhat analogous to the initial value of an acquired asset in an amit. if the asset produces net cumulative income or appreciates in value, the initial value (or basis) of the asset is not taxed again – only the difference between the initial value (or basis) and the asset’s terminal (realized) value enters the tax base. under the broadest articulation of this paradigm, a rbit base taxpayer is normatively entitled to completely recover his or her after-tax dollar investment in a real asset from otherwise taxable gross income through the medium of some form of tax base reduction equal in amount to the after-tax dollar investment in the asset at some point in time. 4. the role of cost recovery deductions.—within the u.s. rbit, cost recovery deductions further the dual purpose of accounting for both the wasting investment in a productive asset and the net income produced by the asset. this is in contrast to both an amit, which uses economic depreciation solely to account for fluctuations in value of the underlying asset, and a cfit, which uses offsetting cash flows to separately account for the initial investment (tax base decrease) and the subsequent economic yield (tax base increase) produced by a productive asset. 502 florida tax review [vol. 5:7 113. see schenk, supra note 15, and works cited therein. 114. see graetz, supra note 14; henry j. lischer, depreciation policy: whither thou goest?, 32 sw. l.j. 545, 546, 555 (1978). if an asset has an indeterminate economic life, such as corporate stock, a rbit base accounting for the difference between the initial cost and the terminal realized value cannot take place until disposition of the asset, at which time the full unreduced cost basis is utilized as an offset against the amount realized. this is appropriate structural treatment for such assets because a rbit does not take into account interim unrealized fluctuations in asset value. however, the deferral of the tax base accounting for gain or loss caused by the realization requirement creates a well-recognized financial distortion when compared to an amit base that measures and taxes those interim fluctuations prior to disposition.113 on the other hand, if an asset is self-exhausting (physically or economically) and has a reasonably known and limited economic life, deferring all cost recovery until abandonment or disposition of the asset causes a similar financial distortion in the tax base that is not a product of the realization requirement. the issue is not when and how to account for the diminution in value of the asset but how to provide for the tax-free recovery of its capital cost through an offset against the tax base. in addition to being theoretically proper, it is not administratively impractical to allow an appropriate portion of the cost basis to be recovered tax-free through the medium of cost-recovery deductions prior to realization of the asset’s terminal value through disposition or abandonment. such treatment is particularly apt if that terminal value will approximate zero because there may be insufficient taxable income in the year of disposition to offset the deduction, resulting in incomplete recovery of capital. logically, there are three ways that rbit base accounting could approach capital cost recovery. as already mentioned, it could wait until disposition or abandonment of the asset, at which time a loss would be realized if the unadjusted basis account was treated as an offset against the tax base. second, it could allocate a portion of the initial cost to each period of the anticipated economic life of the asset, allow a deduction for each year’s cost allocation, and adjust the unrecovered cost account (basis) downward to reflect cost recovery deductions that take place prior to disposition. third, it could recover the cost at the time of the asset’s acquisition by allowing a deduction for the full cost of such an asset at that time and essentially reducing the basis of the asset to zero at the same time. throughout the history of the u.s. rbit, the second method has dominated tax law and policy. that history began with an initial policy notion to simulate economic depreciation in an amit base by utilizing “economic depreciation” deductions in the rbit base. as appreciation of the financial114 effects of cost recovery systems grew, congress began to enact accelerated cost 2002] normative capital cost recovery 503 115. e.g., s. rep. no. 97-144, at 47-48 (1981) (tax policy rationale for short acrs recovery periods was to stimulate investment). 116. see simon v. commissioner, 103 t.c. 247, 248 (1994) (en banc), aff’d, 68 f.3d 41 (2d cir. 1995); liddle v. commissioner, 103 t.c. 285, aff’d, 65 f.3d 329 (3d cir. 1995) (both cases allowing professional violinists to use acrs cost recovery deductions with respect to instruments that were collector’s items and had no ascertainable useful life). see also irc § 197 (allowing amortization of previously unamortizable intangible assets that have no ascertainable useful life). see generally alton a. murakami, “useful life” has outlived its useful life: tax depreciation after simon and liddle, 72 n.y.u. l. rev. 1211 (1997); anthony p. polito, fiddlers on the tax: depreciation of antique instruments invites reexamination of broader tax policy, 13 am. j. tax pol’y 87 (1996). 117. see simon, 103 t.c. at 252. 118. e.g., invest more in america act, s. 76, 105th cong. (increasing the § 179 expensing limitation from $25,000 to $250,000); s. 3225, 102nd cong. (increasing the § 179 expensing limitation to $100,000); economic assistance and workers security act of 2001 (h.r. 3529, december 20, 2001) (increasing the § 179 limitation to $35,000 and granting a temporary expensing deduction under § 167(a) for many assets with less than a 20-year recovery period equal to 30% of the asset’s adjusted basis if acquired after september 11, 2001 and before september 11, 2004). 119. see generally supra part iii.a. see also supra note 112 and accompanying text. 120. compare the formulas for amit and rbit bases on one hand to that of a cfit base on the other. both income and consumption bases tax consumption, but the recovery methods. ultimately, congress began to cast rbit base cost recovery policy adrift from its moorings in amit-based economic deprecation rationales. both congress and the courts, for example, have allowed tax-free115 cost recovery with respect to assets with no ascertainably finite or measurable economic lives, and the tax court has even allowed accelerated cost recovery116 deductions with respect to possibly appreciating assets. in recent years, the117 third type of cost recovery – immediate expensing – has received increasing legislative support, especially for tangible, self-exhausting assets with relatively short economic lives.118 d. defining the criteria for normative rbit base cost recovery in choosing a normative rbit base cost recovery method for the types of depreciable assets discussed in this article, two related normative policy criteria should be satisfied. first, taxpayers should recover the entire cost of their capital investments tax-free in financial terms. the rationale for this criterion is that a normative capital cost recovery method should distinguish capital from income, and tax only the latter. a rbit base is a variant of an amit base, and as noted earlier, the consumption of capital per se is not generally subject to tax in an amit base. this is in contrast to a cfit base,119 which taxes the consumption of either new or old wealth. nothing about the120 504 florida tax review [vol. 5:7 reciprocal impact on the dw factor in an income tax base negates the inclusion of consumption in an amit. the additional realization requirement applied to consumption in a rbit base removes even more consumption from the tax base. 121. this definition is probably stricter than necessary. in the broadest sense, asset basis, and therefore cost recovery deductions, may correspond to previously taxed dollars and not necessarily or exclusively to after-tax dollars. for example, a taxpayer’s basis in property purchased for less than its fair market value in a compensatory context includes both the amount paid and the amount taxed to the taxpayer upon receipt (the excess of the asset’s fair market value over the amount paid for it). see regs. § 1.612(d)(2). in other words, the meaning of “capital” within a rbit base includes taxed dollars as well as after-tax dollars. see generally glen a. kohl, the identification theory of basis, 40 tax l. rev. 623 (1985). realization requirement, which only creates a subset of the consumption and dw factors in the amit base formula, should alter this principle of income taxation in a rbit. to the extent that a cost recovery method does not fully recover capital costs, either at acquisition, during the holding period of the asset, or at disposition, a rbit will tax capital again as opposed to taxing income. this is structurally inappropriate for either an amit or a rbit base. this leads directly to the articulation of the second criterion: a normative capital cost recovery method should cause income to be taxed appropriately in relation to the tax base structural and accounting principles that underlie a rbit. therefore, only net realized income should be taxed. the use of accretion or cash flow accounting, or the recognition of imputed income is inconsistent with the structural or accounting principles of a rbit base. as noted earlier, an amit base taxes invested earnings at the time of their investment (which distinguishes it from a cfit base), and should only tax accrued changes in the value of that after-tax wealth thereafter. a rbit base should operate in a similar fashion at the time of investment but only subsequent realized rather than accrued accessions to wealth should be taxed thereafter. iv. capital formation and capital cost recovery in a realization-based income tax a. the effect of cost recovery methods on loss offsets and capital investment in order to focus exclusively on comparative cost recovery method issues, this article assumes that all rbit base investments herein are cashfinanced and are purchased with capital, which is defined for purposes of this article as actual after-tax dollars. this sort of investment can arise in at least121 two situations: savings-financed investment and investment financed from contemporaneous after-tax earnings. 2002] normative capital cost recovery 505 each cost recovery method, ranging in speed from economic to expensing, involves a trade-off between the amount of earnings that is offset and the amount of asset yield that is offset during the asset’s holding period. for example, table 9 below shows that the spectrum runs from economic cost recovery, which recovers no cost from earnings and all from asset yield, to expensing, which recovers all cost from earnings and none from asset yield. this table also shows that when both earnings and asset yield are taken into account, every rbit base cost recovery method creates the same net amount of taxable income, tax and after-tax cash flow over the total life of the combined earning and investment cycle. table 9: comparative non-asset income offsets for rbit base cost recovery methods recovery method non-asset t.i. asset t.i. total t.i. tax atcf economic 100 – 0 = 100 126.20-100=26.20 126.20 63.10 63.10 acrs 100-11.90=88.10 126.20-88.10=38.10 126.20 63.10 63.10 m acrs 100-14.68=85.32 126.20-85.32=40.88 126.20 63.10 63.10 yr end expensing 100-68.45=31.55 126.20-31.55=94.65 126.20 63.10 63.10 theoretical expg 100 – 100 = 0 126 0 = 126 126.20 63.10 63.10 however, the amount of the initial investment that can be financed from after-tax earnings depends upon the amount of loss offset and consequent tax savings created by a given cost recovery method in the year earnings are invested. because different amounts of loss offset and tax savings are produced by various cost recovery methods in the year of investment, each cost recovery method permits a different amount of after-tax investment to be made from a given amount of earnings. this insight is borne out by table 10 below, which shows the effect of investing $100 from $200 of current earnings in a rbit base using the same spectrum of cost recovery methods that were analyzed in part ii and table 9 above. this analysis produces different results because acrs and macrs, while offsetting non-asset earnings in years 2 and 3, offset little or no earnings in year 1. 506 florida tax review [vol. 5:7 122. deduction against non-asset t.i. in year 1 only. 123. earnings minus loss offset. 124. earnings minus investment minus tax paid. 125. (earnings loss offset) x (l – t). see discussion in next part iv.b. 126. this situation is also necessitated by the fact that the first criterion for a normative cost recovery method requires the ability to identify and measure the amount of capital invested, and the second criterion requires the ability to distinguish the recovery of capital from realized income. table 10: comparative loss offset and after-tax investment for rbit cost recovery methods recovery m ethod earnings investment loss offset122 t.i. tax paid atcf after-tax123 124 investment125 econom ic 200.00 100.00 0.00 200.00 100.00 0.00 100.00 acrs 200.00 100.00 0.00 200.00 100.00 0.00 100.00 m acrs 200.00 100.00 1.78 198.22 99.11 0..89 99.55 yr end exp 200.00 100.00 68.45 131.55 65.78 34.22 65.78 theor expg 200.00 100.00 100.00 100.00 50.00 50.00 50.00 table 10 shows that the amount of after-tax dollar (or capital) investment that can occur in a rbit base in the year a fixed amount of earnings is invested depends directly on the cost recovery method employed. for a given amount of investment, economic cost recovery produces the most investment from capital (e.g., $100 in table 10), and expensing produces the least (e.g., $50 in table 10). these results stem from the fact that economic cost recovery produces no loss offset in the year earnings are invested, while expensing produces a loss offset equal to the entire amount invested. the various accelerated cost recovery methods create amounts of capital investment that fall in between the extremes of economic cost recovery and expensing. thus, there is an inverse relationship between loss offset and capital generation: the greater the loss offset a cost recovery method produces the less capital that cost recovery method allows to be invested in an asset of a given cost. b. cost recovery methods and the maximum capital investment from earnings in a rbit base in order to comparatively analyze capital cost recovery methods as such relative to the two criteria for a normative rbit capital cost recovery method described above, the analysis must be restricted to situations where only capital is invested, regardless of the cost recovery method employed. as table 10126 showed, expensing as a cost recovery method produces the least relative amount of capital in the year of investment among all cost recovery methods. therefore, 2002] normative capital cost recovery 507 127. earnings equal $200 in every case, and taxable income equals earnings minus the loss offset. cost recovery deductions must exceed any income produced by the asset in the year of investment in order to produce a loss offset. see supra table 10. 128. it appears to be rbit taxation to the extent of the $50 of capital invested and recovered tax-free, and cfit taxation to the extent of the $50 balance of untaxed earnings created by the expensing deduction and loss offset. most commentators to date have assumed that expensing deductions offset untaxed earnings exclusively when the comparative analysis of capital cost recovery methods in parts v and vi should be restricted to investments of that relative amount, regardless of the cost recovery method employed. that amount can be expressed both as a nominal amount and as a percentage relative to earnings. in reviewing the dynamics of table 10, we can see that each cost recovery method produces capital (after-tax investment) from earnings according to the following formula: formula 2: capital = (earnings – loss offset) x (1 – t) where t equals the tax rate. practically speaking, capital in this context consists of after-tax dollars – the amount remaining after tax has been paid on taxable income. where a cost recovery method creates a loss offset against earnings127 in the year of investment, the amounts of both taxable income and capital are reduced by the loss offset. economic cost recovery produces no loss offset and therefore no reduction in the capital produced from earnings per se. under economic cost recovery in table 10, capital equals ($200 earnings $0 loss offset) x (1 – t), or $100. as cost recovery methods become accelerated, however, and cost recovery deductions begin to offset earnings in the year of investment or thereafter, taxable income is reduced along with after-tax capital. in the extreme case, expensing produces capital from earnings according to the following formula, which is a variation of formula 2: formula 3: capital = (earnings – investment) x (1 – t) as table 10 showed, the loss offset amount for expensing is the entire amount invested, so the term investment in formula 3 can be substituted for the term loss offset in formula 2. for example, in table 10 the after-tax investment in the case of the expensed investment is only $50 because the entire amount invested ($100) is allowed to offset otherwise taxable income. since expensing as a cost recovery method only allows the production of $50 of capital after tax, the amount invested ($100) exceeds the amount of after-tax dollars generated and the capital available for investment from earnings. thus, the entire investment is not financed by after-tax dollars, or capital. this is not normative rbit base taxation. it is part normative rbit base taxation and part normative cfit base taxation.128 508 florida tax review [vol. 5:7 comparing economic cost recovery to expensing or in commenting on the effects of expensing in a rbit base in general. see johnson, soft money, supra note 22, at 102427; warren, arbitrage, supra note 58, at 551-55. this assumption depends on investing all pre-tax earnings produced in the year of investment. preliminary research suggests that u.s. equity-financed equipment purchases more likely than not offset after-tax capital rather than pre-tax earnings. see infra note 134 and accompanying text. 129. [earnings ($300)] – loss offset ($0) x (1 – t) = $300 x .5 = $150. economically, the taxpayer allocates $150 of the earnings to tax and $150 to purchase the asset. tax free recovery of the capital invested in the asset takes places entirely during the holding period of the asset through economic cost recovery deductions. 130. [earnings ($300)] – loss offset ($100) x (1 – t) = $200 x .5 = $100. economically, the taxpayer allocates $100 of the earnings to tax, $100 of earnings to the investment, and keeps $100 as an immediate return of the capital invested in the expensed asset. in order to determine the maximum amount of after-tax dollar investment that expensing allows to be produced from a given amount of earnings at a given tax rate, we must set up and solve the following equation for maxmaximum investment (i ). maxformula 4: i = (e – i) (1 – t) solution: maxi = e – et – i + it 2i – it = e – et i(2 – t)= e(1 – t) divide both sides by 2-t, and the result is: maxformula 5: i = e(1 – t)/(2 – t) maxfor example, if e equals $300 and t = 50%, i = $300(.5)/(2-.5) or $150/1.5, which equals $100. each cost recovery method produces a unique natural capital formation threshold, below which all rbit base investment subject to that recovery method must be capital investment. given $300 of current earnings, for example, the maximum amount of after-tax dollar investment possible in an amit base or rbit base that uses economic cost recovery is $150, but the maximum amount of after-tax dollar investment that is possible129 in a rbit that uses expensing is only $100. because expensing allows the130 maxformation of the least amount of capital, i is also the maximum amount of capital that can be invested from earnings under every cost recovery method in max maxa rbit. in other words, i equals capital investment , the maximum amount of capital that can be invested from earnings in a rbit regardless of the cost recovery method employed. all of the investments analyzed from this point forward are made with maxcapital investment or less. this amount represents the overall natural capital 2002] normative capital cost recovery 509 131. neither analysis standing alone is sufficient to analyze a rbit base universally. this article focuses on capital cost recovery in a rbit base, which necessarily excludes pre-tax investment. the traditional analysis makes no distinction between pre-tax and after-tax investment in a rbit base, but implicitly assumes that all investment is (or can be) pre-tax investment. when a rbit base taxes earnings in a normative fashion and capital cost recovery is examined under circumstances where it cannot limit the normative operation of capital formation, insights into the normative capital cost recovery method for a rbit base are much more likely to emerge. once the normative treatment of capital cost recovery is understood, it is more likely that the normative treatment of non-capital cost recovery or capital formation and capital cost recovery can be re-examined fruitfully. max132. proof: i = [earnings ($300) – investment ($112.50)] x (1 – t) = $187.50 x .6 = $112.50, which equals 37.5% of earnings. max133. proof: i = [earnings ($300) – investment ($133.33)] x (1 – t) = $166.67 x .8 = $133.33, which equals 44.4% of earnings. formation threshold for a rbit base, at or below which all investment is capital investment regardless of the cost recovery method employed. at or below this threshold, no pre-tax income can be offset under any rbit base recovery method, including expensing, and only capital cost recovery methods can be analyzed. commentators have often noted a related but different phenomenon related to rbit expensing. the maximum amount of overall possible investment in a rbit base that allows full-offset expensing equals the maximum amount that can be invested in an amit base that uses economic depreciation divided by 1 – t, where t equals the tax rate. in the above example, $150 is the maximum amount of investment that is possible in an amit base beginning with $300 of earnings, because an amit base must tax invested earnings and must use economic depreciation. if the capital investment condition that this article uses is relaxed, however, and pre-tax earnings are allowed to be invested with full loss offset, the maximum amount of investment that is possible from $300 of earnings in a rbit base that allows expensing becomes $300, or $150/1– t where t equals 50%. the difference between the traditional analysis and the analysis undertaken in this article is that this article focuses exclusively on the maximum amount of capital investment that is possible within a rbit base under any cost recovery method, while the traditional analysis focuses exclusively on the maximum amount of pre-tax dollar investment that is possible in a rbit base under various cost recovery methods.131 three other points should be noted here. first, the natural capital formation threshold for a rbit base increases in inverse relationship to the tax maxrate. for example, if earnings were $300 but the tax rate were 40%, i and maxcapital investment would increase to $112.50; and if the tax rate were132 20%, both thresholds would increase to $133.33. under current tax rates,133 therefore, the natural capital formation threshold ranges from approximately 510 florida tax review [vol. 5:7 134. see, e.g., statistical snapshot of the 1995 construction industry annual financial survey, in journal of lending and credit risk management 57, 59 (1996) (survey respondents finance between 37% and 68% of equipment purchases from current cash flows.). it is difficult, however, to estimate what percentage the amounts u.s. corporations spend on equipment purchases is of corporate taxable income in order to determine how much equipment investment is financed from rbit base tax capital. note, however, that the total amount of cost recovery deductions taken by profitable u.s. corporations with taxable years ending between july 1997 and june 1998 ($413 billion) is less than the amount of “tax capital” available to those corporations based on an analysis of statistical information from their income tax returns and applying formula 4 in the text ($658 billion). see irs pub. no. 1053, income tax returns of active corporations with accounting periods ended july 1977 through june 1998 in corporation source book of statistics of income 245 (all industries returns with net income) (march 3, 2000). if one assumes that annual corporate expenditures for equipment do not exceed the annual amount of cost recovery deductions allowed for all assets, than equipment purchases must be supported by, if not financed from, capital. 135. see e.g., supra note 17 and accompanying text, and infra part viii. 136. see brown, supra note 23. 37% to 45% of net earnings (prior to any cost recovery deductions). second, given that fairly high capital formation threshold, it is reasonable to assume that a substantial amount of capital-financed investment in short-lived depreciable assets takes place in the u.s. tax base. third, expensing of investment in134 excess of the minimum amount of capital that can be produced from current earnings under any cost recovery method raises a broad range of capital formation and cost recovery policy issues that are beyond the scope of this article.135 this article will continue to examine the comparative effects of rbit base cost recovery methods on investments in short-lived self-exhausting assets, with the understanding that all of the investments analyzed hereafter consist of amounts that fall below the natural rbit base capital formation threshold. v. normative criterion #1: recovering the full financial cost of investment a. the cary brown analysis expensing as a theoretical yardstick of capital income taxation policy in the u.s. began with a now-famous 1948 comparative analysis of business asset income taxation by e. cary brown. brown’s article analyzed the effect136 of income tax depreciation or cost recovery methods on the net cost of investment for the purpose of comparing the value of various recovery methods as investment incentives. he used a cost vs. benefit analysis that measured and ranked recovery methods by the excess of the present value of the cost of depreciable assets over the present value of the future receipts from those assets. 2002] normative capital cost recovery 511 137. table 11 and table 12 represent only the items and amounts employed in brown’s actual analysis and thus differ from the tables used earlier in this article. see brown, supra note 23, at 304. 138. brown used only one discount rate in his analysis, which is treated as the equivalent of the pre-tax discount rate used in the other tables used in this article. brown justified this treatment by assuming that interest earnings were nontaxable and interest payments were nondeductible. therefore, it cost the taxpayer no more to borrow after tax than before, and benefitted the taxpayer no more to lend after tax than before. this simplifying assumption eliminates the necessity to use different discount rates to measure the financial benefit or cost of tax or economic flows before and after tax. id. at 303, n.4. 139. for a definition and example of economic depreciation, see discussion at supra notes 24-37 and accompanying text. for the present, it should be noted that the depreciation of a 5-year $100 annual income stream at $80 per year is not economic specifically, brown analyzed and compared the net “after-tax” cost of investment (initial cost minus the present value of tax reduction due to depreciation deductions) with the present value of the net after-tax yield from that investment (pre-tax cash flow minus tax). on one end of the spectrum of cost recovery methods, brown concluded that economically depreciating the cost of an investment caused the net after-tax cost of making such an investment to exceed its net after-tax yield in present value terms. table 11 below duplicates brown’s original example of economic depreciation. in table 11, g.i. represents gross income; deprec137 represents depreciation; t.i. represents taxable income, atcf represents aftertax cash flow; and pv represents present value.138 table 11: cary brown example of economic depreciation year g.i. deprec t.i. tax atcf 1 100 80 20 10 90 2 100 80 20 10 90 3 100 80 20 10 90 4 100 80 20 10 90 5 100 80 20 10 90 tot 500 400 100 50 450 pv 400 320 80 40 360 brown used the following basic analysis: an asset that cost $400 produces a 5-year income stream of $500 at $100 annually. at a discount rate of 8%, the present value of the asset’s pre-tax yield ($400) exactly equals its cost. assuming a 50% tax is imposed, and economic depreciation of $80 per year is allowed in computing taxable income, $10 per year of tax is paid (50%139 512 florida tax review [vol. 5:7 depreciation, but straight line. the error is not fatal to an introduction to brown’s basic concept of expensing or to his analysis. of $20 taxable income) and the present value of the asset’s net yield after-tax becomes $360 ($90 x 5 years discounted at 8%). thus, the present value of the cost of the asset ($400) exceeds its net yield after tax by $40. alternatively, brown explained this $40 difference by reducing the $400 cost of the asset by the present value of the tax savings generated by the depreciation deduction stream ($80 x 50% = $40 x 5 years discounted at 8% = $160), thus arriving at a net cost after tax of $240 ($400 $160). this net cost after tax exceeded the net yield after tax, which he computed by discounting 50% of the pre-tax income stream at 8% ($100 x 50% = $50 x 5 years discounted at 8% = $200). again the excess of net after-tax cost over net after-tax yield was $40. on the other end of the spectrum of recovery methods, brown concluded that immediately expensing the cost of the same investment “neutralized” the tax as an investment decision factor by making the present value of the net after-tax cost equal to the present value of the net after-tax yield. table 12 below demonstrates the application of expensing to the investment portrayed in table 11. year 0 represents time 0, the moment at which the asset is acquired and its cost expensed. time 0 is also the point from which net present value determinations are made in both table 11 and 12. table 12: cary brown example of expensing year g.i. deprec t.i. tax atcf 1 100 400 -400 -200 +200 2 100 0 100 50 50 3 100 0 100 50 50 4 100 0 100 50 50 5 100 0 100 50 50 tot 500 400 100 50 450 npv 400 400 0 0 400 expensing the $400 pre-tax cost of the asset at time 0 produces a $200 negative tax, which produces an after-tax cash flow of $200. during years 2 through 5, the $100 annual yield is taxed at the rate of 50%, and $50 tax is paid annually. however, the net present values of taxable income and tax are zero, because the positive and negative present values of those items cancel each 2002] normative capital cost recovery 513 140. in each case, the negative present value of the year 1 amount is exactly offset by an equal positive present value of the year 2 through 5 amounts, although the nominal totals of the positive amounts for those years exceeds the initial nominal negative amount. for example, the -400 nominal taxable income in year 0 is exactly offset by the 400 present value of the 500 of nominal positive taxable income in years 1 through 5. this explains why the net present value of taxable income is zero. 141. brown, supra note 23, at 309-310. 142. theoretically, this may stem from brown’s decision to treat interest income as nontaxable and payment as nondeductible. see supra note 138. this convention may also be a sign of the undeveloped state of financial analysis of recovery methods at the time. 143. “both types of adjustment are theoretically necessary, and they cannot be viewed as alternatives.” brown, supra note 136, at 310. other out. this happens because the pv of the depreciation column ($400)140 now equals the pv of the g.i. column. in addition, because the pv of tax paid is 0, the pv of the atcf equals the pv of the ptcf. using the method of analysis just applied to economic depreciation, the $400 cost of the asset minus the $400 present value of the expensing recovery deduction yields the same amount as the present net value of the taxable income stream ($0) less the present value of tax paid ($0). under brown’s alternative analysis, the $400 cost of the asset reduced by the present value of the tax savings generated by the depreciation deduction stream ($400 x 50% = $200) equals $200, which is the same amount as the net yield after tax, computed by discounting 50% of the pre-tax income stream by 8% ($100 x 50% = $50 x 5 years discounted at 8% = $200). as brown explained, under expensing the present value of the cost of the asset after tax no longer exceeds the present value of its cash flow after tax. instead, the net present value of the cost of the asset after-tax equals the net present value of the yield from the asset after tax, which restores the investment to the same financial value that it had before tax. thus, expensing, according141 to brown’s analysis, is the only cost recovery method that completely restores the full financial cost of a depreciable investment to the taxpayer. in summary, the cary brown analysis focuses on the net financial cost of assets relative to their net financial return. it deals with the present values of cost and returns, and uses pre-tax present values exclusively. it accurately142 predicts that any recovery method slower than expensing fails to reduce the cost of an investment proportionately to its yield in present value terms. only if expensing as a recovery method is coupled with immediate full loss offsets,143 can it reduce the cost of an investment in proportion to the tax in present value terms and therefore equalize the present values of the investment’s after-tax cost and its after-tax yield. 514 florida tax review [vol. 5:7 1144. the pre-tax present value (pv ) of the pre-tax cash flow in table 1 through table 5 is consistently $100.00, which equals the cost of the investment. 2145. this is shown by the fact that the net pv of the atcf under the economic cost recovery method in table 13 equals $0.00. also note that in table 1, 1which portrays economic cost recovery, the slowest of the recovery methods, the pv 2of the pre-tax cash flow and the pv of the after-tax cash flow both equal $100, which is the cost of the asset. b. a modern analysis of net financial cost modern comparative financial analysis focuses on the same issues but provides fuller insights than brown’s analysis. for example, the information provided earlier by table 1 through table 5 can be used to compute the “net financial tax cost” imposed on the break-even transactions therein under various cost recovery regimes within a rbit base. in order to do this, the after-tax 2present value of the after-tax cash flow (pv atcf) is simply subtracted from the after-tax present value of the tax paid on the income produced by the 2transaction (pv tax). the resulting amount simply isolates the net after-tax present value of the transaction in question under various recovery methods, including expensing. table 13 below correlates these recovery methods with their corresponding net financial tax cost. table 13: net financial tax cost under various recovery methods 2 2rcvry m eth pv tax paid net pv atcf net final tax cost 1-economic 11.86 0.00 11.86 2-acrs 10.80 1.04 9.76 3-m acrs 10.46 1.41 9.05 4-end yr exp 8.33 3.57 4.76 5-theory exp 5.93 5.93 0.00 the analysis in table 13 is similar to the cary brown financial cost analysis, but it is more accurate because it uses after-tax discount rates in its computations. all of the investments break even financially before tax, and144 even the slowest recovery method, economic depreciation, causes the transaction to break even financially after tax as well. however, each of the145 accelerated recovery methods does better than break even financially after-tax 2as shown by the net pv atcf column, which progresses from $0.00 to $5.93. as a result, the net financial tax cost is reduced from $11.86 to $0.00. under 2expensing the net after-tax financial gain in the form of the pv of the atcf 2($5.93) is enough to exactly offset the financial burden of the pv of the tax paid ($5.93), creating a net financial tax cost of zero. 2002] normative capital cost recovery 515 146. in table 1 through table 5, all of which portray $100.00 investments in depreciable assets, total gross income, taxable income, tax paid, and after-tax cash flow are consistently $126.20, $26.20, $13.10, and $113.10, respectively. as discussed in part iv. above, this article’s analysis is limited to economic situations where true capital is invested. at this point, certain preliminary conclusions can be stated. if equal amounts of capital are invested, all recovery methods will produce the same amount of economic (or nominal) taxable income, tax paid, and after-tax cash flow. overall, none of them does any worse than break even, financially after146 tax. but only with theoretical expensing is the net financial return to the taxpayer after tax unreduced by the financial cost of the tax imposed on the transaction. in other words, in a state of financial equilibrium, only with expensing does the financial return to capital provided by the federal government’s cost recovery system “pay for” the financial cost of the tax imposed on depreciable asset investments by that same government. thus, only under expensing is the full financial value of invested capital returned to investing taxpayers after tax; and only capital expensing satisfies the first criterion for a normative capital cost recovery method in a realization-based income tax. vi. normative criterion #2: appropriately measuring net realized income the analysis in part v only required a comparative analysis of cost recovery methods within a rbit base. determining whether any cost recovery method satisfies the second criterion for a normative rbit base recovery method requires a broader analysis than that used with respect to the first criterion for the following reasons. on the transactional accounting level, economic cost recovery in a rbit base is technically identical to economic depreciation in an amit base, and cash flow accounting in a cfit base is technically identical to expensing in a rbit base. therefore, in order to fully understand how those recovery methods relate to the structural and accounting principles of a rbit base, part vi of this article must distinguish those principles from those employed in amit and cfit bases. this part first examines the structural and accounting principles of an amit base as they relate to the taxation of short-lived fully depreciable assets, and then examines cfit base principles as they relate to taxation of the same type of assets. in the last section of this part, the article reexamines rbit base recovery methods using a deeper analysis of the structural and accounting principles of a rbit base. this part concludes that capital expensing is the only capital cost recovery method that measures net realized income financially in a manner entirely consistent with rbit base structural and accounting principles. 516 florida tax review [vol. 5:7 147. this table allows us to compute the net nominal, net pre-tax present value, and net after-tax present value of the following amounts for time 0 through year 4: (1) the gross income and/or gross receipts stream; (2) the economic depreciation deduction stream; (3) taxable income; (4) the ptcf; (5) the tax paid; and (6) the atcf. in addition, this table provides the irr and npv effective tax rates. the first three columns represent the tax accounting for these investments (g.i. – recovery = t.i.), and the last three columns represent the economic accounting (ptcf – tax = atcf). this table also shows the effective tax rate based on net present value (100%) and the effective tax rate based on internal rule of return (50%). a. measuring net economic income in an amit base 1. introduction.—table 14 below contains the essential financial information needed to evaluate the normative method of measuring income from depreciable assets in an amit base. this table combines a summary of the relevant information from the investment in table 1 during years 1– 4 with the tax and economic effects of making that investment at time 0. the purpose of this table is to examine the net economic and financial consequences of a combined investment and investment yield transaction in an amit base. table 14: net financial characteristics of $100 investment subject to economic depreciation147 g.i. deprec = t.i. ptcf tax = atc f etr time 0 -100.00 -100.00 +tot y rs 1-4 126.10 100.00 26.20 126.20 13.10 113.10 =n et to t y rs 0-4 126.10 100.00 26.20 26.20 13.10 13.10 1npv @ 10% 100.00 78.35 21.65 0.00 10.82 -10.82 2npv @ 5% 111.86 88.14 23.73 11.86 11.86 0.00 100% irr 10.00% 5.00% 50% as stated earlier, the central structural approach of an amit base with respect to the taxation of capital income is to tax both invested earnings and the net investment yield produced by invested earnings. the central accounting focus of an amit base is on periodic net wealth valuation, which translates into net asset valuation in the context of investments in individual income-producing depreciable assets. economic depreciation implements that periodic valuation process appropriately for an amit base. for example, table 14 depicts the following sequence of events: first, $100 of wealth in the form of cash is converted into the same amount of wealth in the form of a depreciable asset. second, that asset produces a pre-tax yield with a pre-tax present value of $100. 1this fact is proven by the $100 pv of the asset’s ptcf at the time it is 1acquired. this gives the investment a pre-tax net present value (npv ) of 2002] normative capital cost recovery 517 1148. see the npv of the ptcf, which equals $0.00. 149. the following summary is taken from jane g. gravelle, tax neutrality and capital cost recovery in the economic effects of taxing capital income 101-02 (1994). 150. for example, the cumulative present value of investing the economic recovery deductions from table 1 at 10% compounded annually would be the following amount: $21.55 x (1.10) plus $23.70 x (1.10) plus $26.07 x (1.10) plus $28.68 x 1.104 3 2 = $31.55 + $31.55 + $31.55 + $31.55 = $126.20. as table 1 shows, the after-tax present value of that income stream is $100, the original amount invested. 151. see supra note 27. this important point is not clear from an examination of break-even investments in which the yield and pre-tax discount rates are the same; but the rule is used in computing economic depreciation throughout this article to $0.00. third, by the end of the investment’s useful life, the asset will be148 worthless, but the taxpayer will have converted the asset back into cash with an after-tax present value of $100, as measured at the time of the asset’s acquisition. overall, the entire transaction, as measured at the time of the asset’s acquisition, consists of converting $100 of after-tax earnings into an asset with a value of $100 and thence into $100 of after-tax investment yield, which gives the entire three-step transaction a net present value of zero – both before and after tax. the net present value of the investment in table 14 before tax is zero because the initial value of the investment is the present value of the asset’s future pre-tax cash flow; and here, the asset’s yield rate (y) equals the pre-tax 1discount rate (d ) that is used to measure the financial value of the yield stream before tax. both rates are 10% in the financial break-even model used in this article. economic depreciation uniquely insures that the net present value of the taxpayer’s investment after-tax also equals zero. this is appropriate for a breakeven investment in an amit base, because it equates the after-tax financial value of the investment to its pre-tax financial value. the use of any other depreciation method would be inappropriate in an amit base because, as table 8 showed, those methods would increase the net present value of the asset after tax above zero, thus destroying the pre-tax/after-tax valuation equality. table 14 also allows us to reference the following four characteristics that are often attributed to economic depreciation. first, the nominal sum of149 the depreciation deductions equals the amount invested ($100). second, if reinvested constantly, it would maintain the value of the asset. if, for example, each year’s depreciation deduction were invested at time 0 and allowed to grow at the after-tax discount rate until the year the deduction took place, the sum of the present values of the amounts on hand at each of the taxable periods would equal the amount invested. third, it is measured by the change in the present150 value of the asset. this was previously explained in the introduction to table 1, and means simply that economic depreciation is the reduction in the present value of an asset between the beginning and end of a taxable period as measured by the decrease in the yield stream’s present value using the yield rate as the discount rate for that purpose. fourth, it preserves an invariant relationship151 518 florida tax review [vol. 5:7 produce economic depreciation or cost recovery models which consistently satisfy the other three principles. see also, chirelstein, supra note 26; samuelsen, supra note 25; figure 6 and accompanying text in infra part vi.c.1. 152. pre-tax rate of return equals the yield rate. after-tax rate of return equals the yield rate x (1 – the tax rate) or y x (1 – t). 153. this irr can be computed by positing a $100 deposit that produces an income stream identical to the economic depreciation deduction stream for a $100 investment. 154. see discussion at supra part ii.f. between pre-tax and after-tax rates of return in exact proportion to the nominal tax rate. as a result, the irr etr always equals the nominal tax rate.152 2. internal rate of return, net present value and effective tax rates.—irr analysis reveals the key role that economic depreciation plays in producing the financial parameters of a break-even investment in an amit base. for example, the irr of the gross receipts and ptcf streams in table 14 is 10%, while the irr of the economic depreciation deduction stream is 0%.153 since taxable income is computed as gross receipts minus depreciation, the 1net pre-tax irr (irr ) is 10% minus 0%. appropriately, the irr of the atcf 2 1stream (irr ) is 5%, which equals irr x (1 t). as a result, the irr etr (50%) shows that the rate of return on investment is reduced exactly in proportion to the nominal tax rate. net present value (npv) analysis also allows us to make significant observations about the role economic depreciation plays in amit base 1accounting. first, notice in table 14 that the npv of taxable income ($21.65) 1equals the difference between the npv of the g.i. and ptcf streams ($100) 1and the pv of the economic depreciation deduction stream ($78.35). similarly, 2 2the npv of taxable income ($23.73) equals the difference between the npv 2of the g.i. and ptcf streams ($100) and the pv of the economic depreciation deduction stream ($88.14). this shows that financial taxable income, as measured by npv, is computed in the same manner as nominal taxable income. second, the net financial value of the after-tax cash flow equals zero because the financial value of economic depreciation produces exactly the financial value of taxable income necessary to produce that zero net present 2value. in table 14, for example, the npv of the ptcf ($11.86) equals the 2npv of the tax paid on the transaction. this shows that the financial return from the investment measured by the after-tax discount rate is used exclusively to pay the tax due on the transaction. as a result, none of the after-tax present 2value of the transaction inures to the benefit of the taxpayer, and the npv of the atcf is zero. this also produces a 100% npv effective tax rate.154 economic depreciation causes the entire after-tax financial return from a break-even financial investment to be paid as tax and therefore provides no net financial benefit to the taxpayer/investor after tax. this is appropriate in a 2002] normative capital cost recovery 519 155. e.g., summers, investment incentives and the discounting of depreciation allowances (nat’l bureau of econ. research, working paper no. 1941, 1986) (empirical survey of 200 major corporations suggests that most companies use high discount rates for prospective depreciation allowances, calling into question assumptions about cost recovery design, and suggesting that incentives providing immediate reduction in tax liabilities are more useful than multi-period incentives.). 156. the hurdle rate analysis in this article borrows generally from knoll, supra note 94, at 1803-05. 157. in our investment model, this discount rate is presumed to be 10%. 1 1158. this is shown by the fact that the pv of the ptcf is always zero if d equals 10% and the yield equals 10%. see supra table 1 through table 5. tax system that taxes and measures only net change in pre-tax asset values because no change in pre-tax asset value occurs when this type of break-even investment takes place. although economic depreciation does not cause the present value of the taxpayer’s depreciation deductions to equal the amount invested, it does cause the present value of the taxpayer’s after-tax cash flow to equal the amount invested. therefore the transaction has a zero net present value to an amit base taxpayer both before and after tax. the combined irr and npv analyses show that economic depreciation, in addition to providing appropriate rates of return, as measured by irr, also produces appropriate financial values for financial break-even investments in depreciable assets in an amit base, as measured by npv. 3. hurdle rates and the effect of increased yield rates on irr etr and npv etr.—investments rarely occur in the real world unless their projected net present value exceeds their cost. such a situation only exists where an asset’s projected yield rate exceeds a baseline discount rate used by the relevant financial decision makers. this article calls the rate of return that an155 investment must earn in order to produce a positive net present value a “hurdle rate.” in a no-tax world, the hurdle rate would simply be the baseline discount156 rate. for example, the $100 investment model we have used so far would have a hurdle rate of 10% because the pre-tax (or no-tax) discount rate is set at 10%. like npv etr and irr etr, financial hurdle rates provide a useful tool for analyzing the financial characteristics of the tax accounting treatment of depreciable assets in various tax bases. in a no-tax environment, the financial hurdle rate is the same as the baseline discount rate. in the context of our157 investment model, the tax base under all three systems is or begins with the investment’s pre-tax cash flow. therefore, the pre-tax hurdle rate for all investments based on this model should be the same as the pre-tax discount rate. indeed, in all of the rbit, amit and cfit base investments analyzed in this article so far, the pre-tax discount rate has been the hurdle rate for investments 1in depreciable assets before tax, because the yield rate must exceed d for the investment to have a positive npv before tax.158 520 florida tax review [vol. 5:7 2 1159. in table 14, the npv of the atcf is zero when the yield rate equals d . 2the yield rate must be greater than 10% in order for the npv atcf to have a positive 1 2net present value. thus the yield rate must exceed d to produce a positive npv atcf. 1the after-tax hurdle rate, therefore, is d . in an amit base, the after-tax hurdle rate 2 2actually equals the after-tax discount rate divided by 1 minus the tax rate. (h = d /1-t). 2this formula equals the pre-tax discount rate. thus where d equals 5%, the after-tax hurdle rate is .05/1-.5 or .05/.5, which equals 10%, the pre-tax discount rate. given an after-tax discount rate of 5%, therefore, an economically depreciated asset subject to a 50% tax rate must earn more than 10% (the pre-tax discount rate) before tax in order to produce a positive net present value after tax. 1160. twenty percent actually represents h , the rate at which the taxpayer’s atcf has a net present value of zero using the pre-tax discount rate. just as 2 2/1-t 1h = d , h1 = d /1 – t. the after-tax cash flow for all of these investments has two relevant 1present values. the pre-tax present value of the after-tax cash flow (pv atcf) measures the present value of the investment after-tax using the pre-tax discount 2rate. similarly, the after-tax present value of the after-tax cash flow (pv atcf) measures the present value of the investment after tax using the after-tax discount rate. under perfect financial circumstances, the after-tax discount rate equals the pre-tax discount rate times one minus the tax rate. in other words, 2 1d = d x (1 – t). in a taxed environment, only the after-tax cash flow has practical financial significance for tax-paying investors. therefore, the relevant “pre-tax hurdle rate” for a taxpayer is the rate that first creates an after-tax cash 1flow with a positive present value using the pre-tax discount rate (pv atcf 1$0). this hurdle rate will be called h . the relevant “after-tax hurdle rate” for a taxpayer is the rate that first creates an after-tax cash flow with a positive 2present value after tax using the after-tax discount rate (pv atcf $0.). this 2hurdle rate will be called h . comparing investments at and above the taxpayer after-tax hurdle rate 2(h ) allows us to determine how persistent are the financial characteristics of economic depreciation at increasing yield rates. such a comparative analysis also allows us to better understand the dynamics of amit base taxation and economic depreciation. for example, table 14 shows that the after-tax hurdle rate for a break-even investment in an economically depreciated asset in an 1 2 1amit base is the pre-tax discount rate (d ), so that h = d .159 table 15 below shows the financial changes that occur to a depreciable asset investment transaction as the yield rate increases from 10% to 20%. by focusing on the financial changes that occur as a result of this yield increase, this table allows us to better understand the financial operation and impact of economic depreciation. table 15 contains most of the same information contained in table 14 but for two different yield rates: 10% (the after-tax hurdle rate) and 20%, or twice that yield. again, the tax accounting is represented160 by the columns gr – depreciation = taxable income, while the cash flow accounting is represented by the columns ptcf – tax = atcf. 2002] normative capital cost recovery 521 2 2161. the first row shows the pv or npv of each tax and financial accounting element of an economically depreciated investment with a 10% yield. cf., table 1 and table 14. the second row shows the same information for an investment with a 20% yield. the third row shows the change between the two. 162. see supra notes 149-52 and accompanying text. 2 2163. at 10% yield, npv etr = 100% because pv tax/pv ptcf = 1 2 2(11.86/11.86). at 20% yield, npv etr = 67% because pv tax /pv ptcf = .67 (24.65/36.98). 2 2 2 2164. npv tax/npv tax + npv atcf = $24.65/$36.98 = 67%. npv tax 2 2+ npv atcf also = npv ptcf. table 15: net changes to financial characteristics of $100 investment subject to economic depreciation at various yield rates161 yield rate/net change gr/ptcf deprec t.i. tax atcf irr etr npv etr 10% yield 2 2pv / npv 111.86 88.14 23.72 11.86 0.00 50% 100% 20% yield 2 2pv /npv 136.98 87.67 49.31 24.65 12.33 50% 67% net change 2 2pv /npv +25.612 .47 25.59 +12.79 +12.33 0% -33% although the yield rate in table 15 increases to 20%, the irr etr 1 2remains at 50%, because irr is the same as the yield rate (20%) and irr equals y x (1 – t) or 10%. this is the fourth traditional financial characteristic of economic depreciation described above, above, and probably its most 2recognized. however, the npv of the atcf is now positive ($12.33) instead162 of $0.00 because the yield rate of 20% now greatly exceeds the after-tax hurdle rate of 10%. in addition, while the irr etr remains constant at 50%, the npv etr decreases from 100% at the after-tax hurdle rate (10% yield) to only 67% as the yield rate increases to 20%.163 while table 15 shows that the investment produces an npv etr of only 67% at the increased yield rate, it fails to show that the npv etr on the164 increased portion of the yield is only 50.9%. the following table completes the 2analysis by showing only the increases to and the changed ratios of the pv ’s of tax paid and after-tax cash flow at yields of 10% and 20%, respectively. the result is a decrease in the overall npv etr. 522 florida tax review [vol. 5:7 165. see supra table 14. 2166. the minor difference is caused by the allocation of the pv of the 2 2decrease in depreciation to the pv t.i. but not to the pv ptcf. 2 2 2167. npv tax increase/npv tot npv ’s increase = $12.79/$25.12 = 50.9%. 168. the pre-tax discount rate equals an amit taxpayer’s after-tax hurdle rate. table 16: changes in the allocation of the elements of npv etr due to yield rate increase yield rate: 10% change 20% 2npv tax 11.86 +12.79 24.65 2npv atcf 0.00 +12.33 12.33 2tot npv ’s 11.86 +25.12 36.98 npv etr 100% 50.9% 67% these changes in npv and npv etr show that once the after-tax hurdle rate is exceeded, the npv etr with respect to the financial return in excess of the after-tax hurdle rate becomes approximately equal to the nominal tax rate. to illustrate this point, notice that the npv etr on the first 10% of the 220% yield in table 16 is 100%. this occurs because the entire npv of the ptcf is paid as tax. however, as table 16 also shows, the npv etr for the165 next 10% of yield is almost exactly identical to the nominal tax rate (50.9%).166 thus economic depreciation produces approximately a 50% npv etr on the portion of the yield between 10% and 20%, and the overall npv etr on the167 20% yield is a blended rate of 67%. two points emerge from this analysis. first, to the extent the financial yield produced by an economically depreciated asset in an amit base equals the pre-tax discount rate, all financial yield is allocated exclusively to tax168 payment, as measured by npv etr. second, the financial yield in excess of the after-tax hurdle rate is taxed financially at approximately the nominal tax rate, also as measured by the npv etr. what is the reason for the exclusive allocation of the first 10% of the after-tax financial yield to the payment of tax? in the context of this investment model, an amit base only measures and taxes changes in pre-tax financial wealth, and no such increase exists as long as the yield rate of an investment is equal to or less than the pre-tax discount rate. however, once the yield rate exceeds the pre-tax discount rate (the taxpayer after-tax hurdle rate), an economically depreciated asset produces both a positive pre-tax change in wealth to tax and a positive net present value after-tax. however, because the first level of the financial yield (to the extent of 1d ) is taxed at a 100% effective rate, the npv etr for an economically depreciated asset in an amit base never exactly equals the applicable nominal 1tax rate, even though yield in excess of d is taxed almost at nominal rates 2002] normative capital cost recovery 523 financially. to confirm this point, figure 1 below plots the npv etr for an economically depreciated $100 investment that is subject to a 50% tax rate and that produces a yield rate ranging from 10% to 90%. nominal etr’s are also plotted for those tax rates to serve as a reference point. figure 1: npv etr at variable yield rates as shown earlier, at a 20% yield the first 10% of yield is taxed at an npv effective rate of 100%, and the second 10% at 50.9%, producing an overall npv etr of 67%. as the amount of yield in excess of the after-tax hurdle rate increases, the overall effective tax rate decreases as more and more yield (and a greater percentage of yield) becomes subject to an effective tax rate of approximately 50%. even at a yield rate of 90%, however, some of the 1original distortion created by taxing d (the first 10% of yield) at 100% remains. at that tax rate, the npv etr for a $100 investment subject to a 50% tax rate and utilizing economic depreciation is 53%. figure 1 shows that the same failure to reach nominal effective rates applies to an economically depreciated asset that is subject to a 30% tax rate, so this financial behavior is not dependent upon the nominal tax-rate. in addition to illustrating the dynamics of amit base income measurement, the above analysis strongly suggests two broader conclusions: first, npv is an appropriate measure of effective tax rates in an amit base; and second, the normative taxation of depreciable asset income in an amit base includes both the complete confiscation as tax of any financial yield up to the pre-tax discount rate, and the approximately proportionate taxation of the financial yield in excess of that rate. 4. the effect of variable tax rates on npv etr.—the after-tax present value of economically depreciated assets varies with the nominal tax 2rate for all yield rates except the after-tax hurdle rate (h ). at that rate, the 2npv of economically depreciated assets at all tax rates is zero. as the first line 524 florida tax review [vol. 5:7 2169. as the tax rate, t, increases, the after-tax discount rate, d , decreases, and 2 2the npv of the ptcf increases. on the other hand, the npv tax increases both 2 2because t increases and because d decreases. at low tax rates, the npv increase is due 2 2mostly to changes in d , while at high tax rates the npv tax increase is due mostly to changes in t. the “bow” in the plot of npv etr for economic depreciation occurs 2where the impact of the decreases in d and the increase in t combine for the most effect. in figure 2 below also shows, this causes the npv effective tax rate for breakeven investments to equal 100% regardless of the nominal tax rate. figure 2: npv etr at variable tax rates 2at all yield rates above h , however, after-tax npv and npv etr vary with the tax rate. as figure 2 shows, npv etr always exceeds the nominal etr, with the excess being greater for low yield assets than for high yield assets. this occurs because the effect of taxing the first portion of the yield (up 1to d ) at 100% and yield in excess of that rate at near nominal effective tax rates becomes attenuated at increased yield rates. the “bow” in the trend lines for a given tax rate result from the interplay between the after-tax discount rates for a given tax rate and the tax rate itself. overall, figure 2 simply shows another169 aspect of the phenomenon illustrated in figure 1. 5. summary.—in summary, economic depreciation always allocates the before and after-tax irr’s of depreciable asset investments in proportion to the nominal tax rate. this is normative treatment for an amit base, which measures value decay through the use of economic depreciation. since, in a sinking fund model, value is measured by the present value of future pre-tax and after-tax cash flows, irr etr’s that correspond to nominal tax rates are evidence that economic depreciation causes normative taxation in an accretionmeasured income tax. 2002] normative capital cost recovery 525 170. see discussion in infra part vi.c. 171. this table contains the same informational elements as table 14 (economic depreciation in an amit base), except that no cost recovery deductions are employed so taxable income equals the ptcf. the balance of the information is derived from table 5, supra, which contains a detailed analysis of theoretical instantaneous expensing. the result is a technically identical stand-in for cash flow accounting and the normative taxation of capital income from short-lived completely wasting assets in a pure cfit base. to the extent that yield rates exceed the pre-tax discount rate (and after2tax hurdle rate), economic depreciation causes a similar allocation of the npv of those same investments based on npv effective tax rates. as the above discussion shows, however, economic depreciation never completely succeeds in allocating the after-tax net present value of investments in proportion to nominal tax rates, regardless of the yield or tax rate. this appears to be a necessary by-product of the role of economic depreciation in measuring income defined as changes in net financial value, because financial value is measured against the benchmark of the pre-tax discount rate. despite this anomaly, economic depreciation overall is an appropriate means of measuring income in the form of net accretions in financial value in an amit base. whether this is also the normative way to measure income in a rbit base remains to be seen.170 b. cash flow accounting in a cfit base 1. introduction.—structurally, a cfit does not tax invested earnings but does tax investment yield unless that yield is reinvested. the formula for this version of a consumption tax is essentially earnings – investment. cash flow accounting is the central means of effectuating these structural principles in the context of investment in short-lived tangible assets. in the context of this article’s common investment model, as shown in table 17 below, a $100171 investment at time 0 in a cfit base produces a tax base reduction of $100. because this is a break-even investment, the yield rate of the investment equals 1the pre-tax discount rate. therefore, the pv of the investment’s pre-tax cash flow, which is treated as an increase in the tax base, also equals $100. as a result, the pre-tax present values of the sequential tax base reduction and tax base increase offset each other exactly. and, because taxable income is a perfect reflection of the investment and yield cash flows, its pre-tax net present value is $0.00. consequently, the pre-tax present values of tax paid and the taxpayer’s after-tax cash flow are also $0.00. 526 florida tax review [vol. 5:7 table 17: financial characteristics of $100 investment subject to expensing in a cfit base ptcf t.i. tax atcf etr time 0 -100.00 -100.00 -50.00 -50.00 tot yrs 1-4 126.20 126.20 63.10 63.10 net yrs 0 – 4 26.20 26.20 13.10 13.10 1npv @ 10% 0.00 0.00 0.00 0.00 2npv @ 5% 11.86 11.86 5.93 5.93 50% irr 10.00% 10.00% 0% notwithstanding this exact pre-tax financial offset, in contrast to an 2amit base the pv of the taxpayer’s atcf in a cfit base is a positive amount, $5.93. here is how that amount is derived. initially, the after-tax net 2present value of the pre-tax cash flow (npv ptcf) is $11.86. this is the excess of the present value of the yield stream (111.86) over the amount invested ($100) using the after-tax discount rate (5%). this suggests that the taxpayer’s after-tax return on the pre-tax cash flow is financially correct because it equals the pre-tax return times 1 minus the tax rate (10% x [1-.5]). indeed, this financial amount is produced by all of the $100 financial break-even investments in this article, regardless of the tax base or cost recovery method employed, because if is a characteristic of the pre-tax cash flow in the financial break-even model used in this article. uniquely though, cash flow accounting produces a tax treatment of both investment and investment yield that is completely proportional to the tax rate both economically and financially. commentators often use a co-investment theoretical model to explain the dynamics of a cfit base that produces such results. under this model, because a $100 investment in a cfit base is made with pre-tax dollars, it theoretically becomes a co-investment of the taxpayer and the government based on the ratio of the tax rate. the taxpayer’s portion of the investment comes from the amount of the initial investment times 1 minus the tax rate (i x [1 – t]). similarly, the taxpayer’s portion of the investment yield becomes (i x y) times (1 minus the tax rate) or ([i x y] x [1 – t]). therefore, the taxpayer’s portion of both investment and investment yield equals 50% (1 – t), and this ratio persists throughout the nominal and financial results in terms of both pre-tax and after-tax net present values. thus, the after-tax net present 2 2value of the after-tax cash flow (npv atcf) is $5.93, or 50% of the npv of 2 the pre-tax cash flow (npv ptcf), which is $11.86. from the government’s standpoint, the $50 tax savings produced by expensing (investment x t) can be viewed as a co-investment in the asset by the government in the form of foregone tax revenue. this hypothetical co2002] normative capital cost recovery 527 172. these facts are also the basis for the frequently stated assertions that expensing causes a rbit base to emulate a cfit base and exempts the income produced by expensed assets from taxation, both in nominal and financial terms. the nominal (or economic) exemption stems from the fact that the return on after-tax investment of $50, both in economic and financial terms, is 10% compounded over 4 years, despite a 50% tax rate. see discussion supra note 128 and accompanying text. the financial exemption stems from the fact that the pre-tax and after-tax irr’s are identical – 10%. investment yields the same type of nominal and financial return as the taxpayer’s after-tax investment. since the government’s portion of the financial results comes from the amount of the initial investment times the tax rate (i x t), the government’s portion of the investment yield is equal to (i x y) x t, or ptcf x t. in a state of financial equilibrium, where the yield rate equals the pretax discount rate, both parties’ investment and yield equations offset each other in pre-tax present value terms. so, for example, the taxpayer essentially invests $100 before tax and earns a 10% return on that investment, which gives the investment a npv of zero using the pre-tax discount rate of 10%. but, the taxpayer only invests $50 after tax, and earns a 10% return on that amount, which has a npv of $5.93 using the after-tax discount rate of 5%, or y x (1 – t). in other words, the formula for the pre-tax equilibrium is: invest = invest x y while the formula for the after-tax equilibrium is: invest x (1 – t) = [invest x (1 – t)] x y(1 – t) the two formulas are identical if the factor (1 t) is factored out of the second formula. this interpretation is supported by the fact that both the ptcf and the atcf have an irr of 10%. in a financial sense, cfit base accounting172 reflects parallel but identical pre-tax and after-tax dynamics that are related by the difference between the yield rate and the yield rate times one minus t (y x [1 – t]). 2 . c f i t a c c o u n t i n g : f i n a n c i a l a c c u r a c y a n d proportionality.—because cfit base structural and accounting principles ignore asset value and do not require keeping an investment cost account such as basis in order to recover capital tax-free, the entire tax accounting consists of a cash flow accounting. as a result, the tax consequences of cfit base investments mirror the financial consequences of those investments. for 1example, table 17 above shows that the taxpayer pre-tax hurdle rate (h ) in a 1 1cfit base equals the pre-tax discount rate (d ) because the npv of the atcf 528 florida tax review [vol. 5:7 173. at yield rates below the after-tax discount rate, the after-tax present value of the ptcf (and t.i.) becomes a negative amount. that negative amount is also allocated between tax paid and atcf in the ratio of the tax rate. 1 1 in that table equals zero. the equivalence of h and d suggests that the after2 2 1tax hurdle rate (h ) should equal the after-tax discount rate (d ), or d x 1 – t. as table 18 below shows, this is true in the context of the investment model where the tax rate is 50%, because when the yield rate is reduced to 5% 2 2(d ), the npv of the atcf does indeed become $0.00. because both hurdle173 rates coincide with the relevant discount rate (pre-tax and after-tax), cfit base taxable income coincides exactly with financial income, and the financial characteristics of investments after-tax coincide with the financial characteristics of those investments before tax. table 18: $100 investment subject to expensing in a cfit base at after-tax hurdle rate (5%) ptcf t.i. tax atcf etr time 0 -100.00 -100.00 -50.00 -50.00 tot yrs 1-4 112.80 112.80 56.40 56.40 net yrs 0 – 4 12.80 12.80 6.40 6.40 1npv @ 10% 10.61 89.39 -5.30 -5.30 2npv @ 5% 0.00 0.00 0.00 0.00 0% irr 5.00% 5.00% 0% the perfect proportionality of cfit base accounting also suggests that npv effective tax rates should coincide with nominal tax rates at tax rates other than 50% or at yield rates greater than the pre-tax hurdle rate. figure 3 below confirms the first point, and figure 4 below confirms the second. 2002] normative capital cost recovery 529 figure 3: npv etr at various yield rates as figure 3 shows, the effective tax rate based on net present value (npv etr) always equals the nominal tax rate, regardless of the yield rate produced by a short-lived “depreciable” asset. this occurs because both nominal and financial etr’s are proportional to the nominal tax rate in a cfit base. figure 4: npv etr at variable tax rates as figure 4 shows, exact proportionality also persists throughout the range of tax rates. in figure 4, the npv etr for two investments with widely variant yields (10% and 50%) coincide exactly with the nominal tax rate, no matter what that tax rate is. as a result, neither variance in yield rates nor tax rates distorts the npv etr. this is in marked contrast to the performance of an 530 florida tax review [vol. 5:7 174. see supra notes 157-58 and accompanying text. see also discussion, infra part vi.c.3. (text accompanying figure 9) (discussing a similar effect in a rbit base that uses economic cost recovery). amit base, where the hurdle rate varies widely with the tax rate, and where174 only yield rates in excess of the after-tax hurdle rate are taxed even approximately at the nominal statutory rates financially. cfit base cash flow accounting creates a wonderfully neutral and direct capital income taxation regime which contrasts sharply with the indirect measurement and taxation of capital income that is based on and measured by changes in net asset value under an amit base. cfit base accounting is not structurally appropriate for an amit base because it ignores both asset value and changes in that value, but it clearly measures the cash flow “income” produced by short-lived depreciable assets accurately financially. c. measuring net realized income in a rbit base this section of part vi will apply the tools of irr etr, npv etr, and hurdle rate analysis to this article’s investment model using various rbit base capital cost recovery methods. this analysis will measure the financial information provided by each of these tools against the normative structural and accounting principles of a rbit base. the goal will be to identify the capital cost recovery method that best accommodates those structural and accounting principles based on these comparative analyses, both individually and collectively. 1. irr effective tax rates.—this section first compares the impact of various capital cost recovery methods on the irr effective tax rates produced by identical investments in a rbit base. for the purpose of comparing these impacts, figure 5 below shows the irr etr produced by the three major cost recovery methods across a range of yield rates using our investment model. the yield rate ranges from 7%, which is 30% below the pre-tax discount rate of 10%, to 13%, which is 30% above it. 2002] normative capital cost recovery 531 figure 5: irr etr for variable yield rates if irr etr is the proper benchmark for comparing cost recovery methods, then economic cost recovery appears to be the normative cost recovery method for a rbit because its irr etr tracks the nominal tax rate exactly at all yield rates. under this rationale, macrs would be the next most accurate because it produces a constant irr etr of 44%, and expensing would be the least accurate because it produces a constant irr etr of 0%. in figure 5, the nominal tax rate was kept constant at 50% to show the effect of variable yields on irr etr. figure 6 below is designed to analyze the impact of the three major cost recovery methods on irr etr across a range of tax rates. therefore, in figure 6, the yield rate is kept constant at 10%, while the tax rate varies from 20% to 80%. figure 6: irr etr for variable tax rates it is clear again that economic cost recovery always creates a certain relationship between the pre-tax irr and the after-tax irr of break-even investments. the after-tax irr is always equal to the pre-tax irr x 1 minus the 532 florida tax review [vol. 5:7 175. for example, when the tax rate is 40% and the yield rate is 10%, the irr etr is 40%. see supra figure 6. when the tax rate is 50% and the yield rate is 12%, the irr etr is 50%. see supra figure 5. 176. as noted earlier, npv is deemed to be a more accurate financial indicator than irr in general, so it should actually be more persuasive in evaluating the financial accuracy of cost recovery methods as they relate to capital income measurement. see supra note 93 and accompanying text. as with irr etr, it is also possible to use npv etr to compare the taxation of capital income in all three major tax bases. 1 2 1tax rate. thus, the irr etr, which is based on the formula (irr irr )/irr , always equals the nominal tax rate, regardless of the tax rate, and regardless of the yield rate involved. economic cost recovery always produces what seems175 to be the ideal irr etr, at least in the context of a financial asset-based investment model. however, this only happens because economic cost recovery is computed by annually discounting the future yield stream by the yield rate and annually deducting the resulting decrease in the yield stream’s present value. because the difference between the discounting factors for the pre-tax and after2 1tax yield streams is the tax rate (so that y = y x 1 – t), the irr’s of the pre-tax and after-tax cash flows always bear the same ratio, and the irr etr always equals the nominal tax rate. expensing, on the other hand, does not start with one investment amount and discount the yield stream by two different discount rates that are related to each other by the tax rate. instead, expensing involves two different investment amounts, the taxpayer’s pre-tax investment and the taxpayer’s aftertax investment, both of which produce a yield stream. both the amounts of the investments and the yield streams are related to each other by the tax rate. because pre-tax investment (i) produces yield (y), and because after-tax investment [i x (1 – t)] produces yield of [(i x y) x (1 – t)], the yield streams, although produced by different investment amounts, have identical rates of return, and that rate is (y). thus expensed assets produce a 0% irr etr 2 1because y /y = 1. all told, analysis based on irr etr cannot establish that any rbit base cost recovery method is the normative cost recovery method for a rbit base. the irr etr criterion illustrates the different ways in which capital cost recovery methods impact a rbit base financially, but ultimately, this criterion is insufficient to determine which of the cost recovery methods best accommodates rbit base structural and accounting principles. 2. npv effective tax rates.—the use of npv effective tax rates seems to support the normative status of capital expensing. for example, figure 7176 below shows the npv etr produced by each cost recovery method across a range of yield rates using our baseline investment model. as in figure 5, the tax rate is 50%, but the yield rates now range from 14% to 26%. 2002] normative capital cost recovery 533 177. the general slope of the economic cost recovery line is the same 1regardless of the range of yield rates if at least some of the yield rates exceed d . although this phenomenon is diluted at higher yield rates, figure 7 shows a range of 1yield rates that center around h , the taxpayer pre-tax hurdle rate. all investments 2portrayed in figure 7 produce a positive npv of the atcf, and all those over 20% 1yield show a positive npv of the atcf. figure 7: npv etr for variable yield rates theoretical expensing, rather than economic cost recovery, now creates a normative financial effective tax rate at every yield rate shown, thus staking its claim to be the normative capital cost recovery method in a rbit base. as shown earlier, economic cost recovery uses the pre-tax discount rate as a 1baseline and taxes yield to the extent of d at a 100% npv etr. as a result, although economic (and to a lesser extent accelerated) cost recovery causes 1yield in excess of d to be taxed almost at the ideal npv etr, the total npv etr never quite reaches the nominal tax rate. these npv etr’s show that177 the intrinsic function of economic cost recovery is to measure asset value instead of realized income, thus proving its invalidity as a device for normatively measuring realized capital income taxation in a rbit base. capital expensing is clearly the only cost recovery method that seems to cause normative capital income taxation of short-lived depreciable assets using npv etr as a financial criterion, at least under the circumstances shown in figure 7. 534 florida tax review [vol. 5:7 178. as explained earlier, the “bow” in the plot line for economic cost recovery 2is due to the interaction of d and the tax rate as the latter increases. see supra note 167 and accompanying text. 179. this occurs to a lesser extent with accelerated cost recovery, but occurs nonetheless. figure 8: npv etr for variable tax rates at 20% yield while figure 7 shows that the economic and accelerated cost recovery methods overstate and thus overtax capital income financially across a range of yield rates, figure 8 shows that those same two cost recovery methods also overstate capital income financially across a range of tax rates. while the npv etr for expensing in figure 8 always remains identical to the nominal tax rate, the npv etr’s for economic and accelerated cost recovery are always greater than the nominal tax rate.178 the reasons for this financial over-taxation again stems from the fact that the yield rate, to the extent of the pre-tax discount rate, is taxed financially at a 100% effective tax rate, thus making the overall npv etr always exceed the nominal etr at yield rates above the pre-tax discount rate. in other179 words, the financial characteristics of economic cost recovery in a rbit base are identical to the financial characteristics of economic depreciation in an amit base. although economic cost recovery does not purport to measure net unrealized income, it produces the same financial results as a capital income taxation regime that does exactly that, albeit in a different tax base. based on npv etr, therefore, expensing seems to be the only cost recovery method that taxes capital income normatively in a rbit base. essentially, economic cost recovery seems to measure rbit base income nonnormatively because it measures unrealized income. and, accelerated cost recovery is non-normative because it is an artificial schedule of deductions that 2is simply designed to be “faster” (create a higher npv atcf) than economic cost recovery. as such, accelerated cost recovery has no intrinsic relationship 2002] normative capital cost recovery 535 180. the taxpayer hurdle rates refer to the discount rates that are necessary to 1create an atcf with a positive present value using the pre-tax discount rate (for h ) and 2after-tax discount rates (for h ), respectively. see discussion supra part vi.a.3. 181. it no longer seems necessary to continue to include accelerated cost recovery in the analysis. it has already failed to produce arguably normative financial characteristics under either the irr etr or npv etr benchmarks. to the financial structure or dynamics of any investment – or to the structural and accounting principles of a rbit base. although the results of the irr etr analysis are inconclusive, and the results of the npv etr analysis appear to confer normative status on capital expensing, the next section of the article evaluates the structural appropriateness of economic cost recovery and capital expensing using hurdle rate analysis. the final section of this part will integrate and summarize all three of these analyses and apply them to rbit base structural and accounting principles. 3. hurdle rates and the financial accuracy of capital cost recovery methods.—an appropriate way to understand the relationship between financial accounting and the tax accounting created by a given cost recovery method is 1 1to compare a taxpayer’s pre-tax hurdle rate (h ) to the pre-tax discount rate (d ) when that cost recovery method is employed. and, a useful way to evaluate the financial impact of a cost recovery method on the taxation of realized income 2is to compare a taxpayer’s after-tax hurdle rate (h ) to the after-tax discount rate 2(d ). figure 9 below plots both the taxpayer pre-tax and the taxpayer after-tax180 hurdle rates for economic cost recovery and expensing at various tax rates.181 the pre-tax discount rate remains constant at 10% per year for all investments. figure 9: taxpayer hurdle rates for economic cost recovery and capital expensing 536 florida tax review [vol. 5:7 182. ten percent divided by .9 equals 11.11%. 183. this has already been shown with respect to economic depreciation in an amit base. see supra part vi.a.3. 184. see supra note 170 and accompanying text. as suggested in the earlier analysis of hurdle rates in the context of cfit base taxation, expensing causes rbit base investments to have a taxpayer 1 1 1pre-tax hurdle rate (h ) equal to the pre-tax discount rate (d ). thus h for the 1expensed assets in figure 9 always equals d , or 10%. this suggests that expensing is financially neutral as a cost recovery method because it does not affect the criterion by which investment decisions would be made in the absence 2of tax. the after-tax discount rate (d ) in a rbit base in the context of our 1 2model equals the pre-tax discount rate times 1-t, or d x (1 – t). thus, d bears an inverse relationship to the tax rate. as figure 9 shows, the after-tax hurdle 2 2rate for expensed assets (h ) is identical to the after-tax discount rate (d ), and 2 1bears the same inverse relationship to the tax rate as d does to d . thus, both 2 2d and h for expensed assets range from 9% for an asset subject to a 10% tax rate (10% x 90%) to 1% for an asset subject to a 90% tax rate (10% x 10%). economic cost recovery, on the other hand, requires a taxpayer pre-tax 1hurdle rate equal to the pre-tax discount rate divided by 1 – t or d /(1 – t). thus, for example, an asset subject to a 10% tax rate must produce a yield of at least 11.11% in order to produce a positive net present value after-tax using a 10% pre-tax discount rate. similarly, as figure 9 shows, an asset subject to a 50%182 tax rate must produce a yield of at least 20% to achieve the taxpayer pre-tax 1hurdle rate because d /(1 – t) = .10/.5, which equals 20%. and finally, an asset 1subject to an 80% tax rate must produce a yield of at least 50% to reach h 1because d /(1 – t) = .10/.2, which equals 50%. on the other hand, a taxpayer’s 2after-tax hurdle rate for assets depreciated using economic cost recovery (h ) 1always equals the pre-tax discount rate (d ) in figure 9. from that observation, 2 1one can infer that h always equals d if economic cost recovery is used in a rbit base.183 the argument that expensing measures capital income normatively financially relates to the perfect coincidence of both taxpayer hurdle rates with the two financial discount rates in a taxed environment. when capital expensing is employed, rbit base accounting is transparent with respect to the financial characteristics of investments (i.e., mirrors those characteristics exactly). the argument against expensing is that the taxpayer hurdle rates (both of which apply to after-tax cash flow) would not be identical to the discount rates if income produced by the asset were actually being taxed.184 the argument against economic cost recovery is that it is not financially neutral because the taxpayer pre-tax hurdle rate always deviates from the pretax discount rate and increases in relationship to the tax rate. thus, the higher an investor’s tax rate, the greater the investment yield that must be obtained in order for an investment to produce a positive net present that value after tax 2002] normative capital cost recovery 537 185. cf. knoll, supra note 94, at 1801-05 (income tax) and 1808 (consumption tax). 186. thus, the pre-tax hurdle rates are determined by grossing up that discount 1 1rate to arrive at a pre-tax hurdle rate. the gross up formula is h = d /1-t. 2187. thus, for example, no net financial income is created after tax (npv atcf >0), given a 50% tax rate, unless the yield rate exceeds 20%, which equals 1d /1-t. see supra figure 9 and accompanying text. using the pre-tax discount rate. the counterargument would be that the pre-185 tax discount rate is the logical floor for taxpayers to use when initially determining whether a given investment will produce net income, whether realized or not. since both the taxpayer pre-tax hurdle rate and the taxpayer after-tax hurdle rate apply to the after-tax cash flow, it is logical that neither 1 2hurdle rate would coincide with the discount rates, but exceed d and d by the reciprocal of 1 – t, as they do. 4. summary.—ultimately, both npv etr and hurdle rate analysis show how and why the differences between economic cost recovery and expensing in a rbit base reflect their different functions within their native tax bases. economic cost recovery causes a rbit base investment to emulate the taxation of depreciable assets in a normative amit base. under this cost recovery method, the very existence of income from investment is dependent upon and is measured relative to the pre-tax discount rate. this is because no net increase in wealth is created in an amit base, or in a rbit base using economic cost 2recovery, unless and to the extent the taxpayer’s after-tax yield rate (h ) equals 1or exceeds the pre-tax discount rate (d ). the pre-tax discount rate (which186 equals the taxpayer’s after-tax hurdle rate) serves as a floor for determining the existence and amount of net increases in wealth after tax. this causes non-187 normative taxation of investment yield based on both npv etr and hurdle rate analysis. on the other hand, capital expensing in a rbit base, like cfit base cash flow accounting, ignores the relative value of the underlying asset and basically uses the after-tax discount rate as the floor for determining the existence and amount of income produced by a given investment. while no net value, and therefore no accretion-measured income, may be created by an 1investment return not in excess of d , realized income may be and is produced under those circumstances. expensed investments produce a positive net present 2value after tax as long as they have an after-tax yield rate (h ) in excess of the 2applicable after-tax discount rate (d ). in addition, the npv etr’s produced by expensing coincide with the nominal tax rate at all yield and tax rates. thus, two of the three financial criteria employed in this analysis – npv etr and hurdle rate analysis – suggest that capital expensing normatively taxes the rbit base capital income produced by short-lived fully-depreciating assets. in addition, by meeting these financial criteria, expensing makes the financial characteristics 538 florida tax review [vol. 5:7 188. those circumstances include variable yield, tax and discount rates. a subsequent article will examine the impact of variable inflation rates on the financial characteristics of rbit base cost recovery methods. 189. the information in table 19 comes from the previous discussions in supra part vi. see e.g., supra part vi.a. for a discussion of amit base taxation; supra part vi.b., for a discussion of cfit base taxation; and supra part vi.c., for a discussion of rbit base taxation. where a financial characteristic such as npv etr varies in relation to a range of external financial circumstances, such as yield, discount or tax rates, the formula given in table 19 describes the range of values that particular financial characteristic exhibits across the range of financial circumstances examined in part vi. for example, the npv effective tax rate of an asset subject to economic cost recovery in a rbit base ranges from 100% where the yield rate equals the pre-tax discount rate (regardless of the tax rate) to slightly more than the nominal tax rate, t, at very high yield rates (regardless of the tax rate). see supra figure 1, and accompanying text. thus, the formula in the third column of the fourth row shows that the npv etr of an investment in a rbit base that is subject to economic cost recovery ranges from “100% ...>t.” of short-lived depreciable assets in a rbit base consistent with the underlying non-tax financial characteristics of those investments. vii. final arguments a. empirical summary table 19 below summarizes all of the financial consequences produced by the taxation of short-lived completely wasting assets not only in a rbit base using various cost recovery regimes, but also in amit and cfit bases. this table contains formulas that summarize the financial consequences of taxing these investments across the complete range of financial circumstances that this article has examined. 188 table 19: summary of tax-related financial consequences for all investments189 1 2irr/etr npv/etr h h 1 2am it base t 100%.....> t d /1-t d /1-t 1 2cfit base 0 t d d 1 2rbit with econ cost recovery t 100%....> t d /1-t d /1-t rbit with accel cost recovery > 0 < t 1<100%....> t > d 1< d /1-t 2> d 2< d /1-t 1 2rbit with capital expensing 0 t d d 2002] normative capital cost recovery 539 190. see supra note 148 and text accompanying notes 145-48. cf. supra figure 5 and figure 6 and accompanying text (characteristics of economic cost recovery in a rbit base). 191. see supra note 185 and accompanying text. 192. see supra part vi.c.3. see especially, supra figure 9 and accompanying text and text accompanying supra notes 178-79. 193. see generally, supra part vi.b. see also supra table 17 and accompanying text. for the invariance of npv etr at variable yield and tax rates, see supra figure 3 and figure 4, respectively. for the invariance of irr etr see supra figures 5 and 6 (characteristics of theoretical expensing in a rbit base). for an analysis of hurdle rates in relation to cfit taxation see supra part vi.b.2. 194. see supra table 19, second row and second column. with respect to an amit base, the formula for the irr etr of an economically depreciated asset always equals t, the tax rate. cf. supra table 19, third row and third column. the formula for the npv etr of an expensed asset in a cfit base is also equals t, the tax rate, across a wide range of financial circumstances. 195. see the financial characteristics of cfit base taxation in the third row of supra table 19. as this article has shown and as the first row in table 19 reiterates, an amit base that normatively utilizes economic depreciation always produces an irr/etr equal to t, the tax rate, no matter what the surrounding financial circumstances may be. on the other hand, an amit base always produces an190 npv/etr that is greater than t. indeed, where the yield rate equals the pre-tax discount rate, the npv etr is 100%. finally, as shown earlier, the taxpayer191 hurdle rates in an amit base always equal the relevant discount rate divided by 1 – t.192 as reiterated in the second row of table 19, this article has also shown that a cfit base always produces an irr/etr of zero, an npv/etr equal to t, the tax rate, and hurdle rates that exactly equal the relevant discount rates under all of the financial circumstances analyzed in this article.193 an amit base and a cfit base share the characteristics of financial conformity and consistency. in both tax systems, at least one financial characteristic of an investment always equals the nominal tax rate, t, no matter what external financial circumstances apply to the transaction. in an amit base, it is the irr/etr, while in a cfit base, it is the npv/etr. the194 qualities of financial conformity and consistency show that by at least one financial measure, the tax is applied exactly and uniformly to capital income across a wide range of financial circumstances. in some respects, a cfit base shows superior qualities of financial conformity and consistency in comparison to an amit base in that none of the mathematical formulas that define the financial characteristics of cfit base taxation vary in response to external financial circumstances. the irr etr is always zero, the npv etr always equals the nominal tax rate, and the taxpayer hurdle rates are always identical to the discount rates. in an amit base, the195 npv etr varies between 100% and a rate greater than t depending upon the 540 florida tax review [vol. 5:7 196. see the financial characteristics of amit base taxation in the second row of supra table 19. 197. the irr etr for accelerated cost recovery ranges between percentages greater than zero and those less than the nominal tax rate. these percentages always fall between the percentages for economic cost recovery and expensing, but never coincide with either one. as a result, they achieve neither conformity with the nominal tax rate nor consistency across any range of financial circumstances. see supra figures 5 and 6. similarly, the npv etr for the macrs accelerated cost recovery method ranges between percentages less than 100% and those greater than t, showing a different aspect of non-conformity and inconsistency. see supra figures 7 and 8. 198. the range of taxpayer hurdle rates for assets subject to accelerated cost recoveery can be inferred from the other analyses in this article. the range of financial characteristics produced by the accelerated cost recovery method consistently falls between the characteristics for economic cost recovery and expensing. see e.g., tables 7 and 8 in supra part ii.f. see also supra figures 5, 6, 7 and 8 and supra part vi.c.3. external financial circumstances affecting the transaction, and the hurdle rates, while maintaining a constant relationship to prevailing discount rates, differ from them in inverse ratio to one minus the tax rate and therefore change as the tax rate changes.196 the financial characteristics of rbit base taxation depend on the cost recovery method employed. for example, in a rbit base that utilizes accelerated cost recovery, as shown in the fourth row of table 19, the irr/etr and the npv/etr vary according to external financial circumstances, and neither financial criterion ever equals the nominal tax rate. nor do the197 taxpayer hurdle rates ever bear any logical or steady relationship to the prevailing discount rates. a rbit base that employs accelerated cost recovery198 completely lacks the characteristics of financial conformity and consistency. if one assumes that some form of financial conformity and consistency is a hallmark of a normative capital income taxation regime, then no accelerated cost recovery can function as a normative cost recovery method for a realization-based income tax. the choice of normative capital cost recovery method, for a rbit base, therefore, appears to be between economic cost recovery and capital expensing. at this point, the financial characteristics of the two capital income taxation regimes standing alone provide an insufficient basis upon which to make a persuasive decision. because the financial characteristics of economic cost recovery and capital expensing duplicate the financial characteristics of amit base and cfit base taxation, respectively, one needs to incorporate a broader non-financial frame of reference into the analysis. in addition to evaluating each of the remaining two cost recovery methods for financial conformity and consistency, one must also evaluate each method for conformity and consistency with the fundamental structural and accounting principles of a realization-based income tax. 2002] normative capital cost recovery 541 199. see discussion supra part vi.a.2. b. economic cost recovery is not the normative capital cost recovery method for a rbit base the major structural principles of a rbit base are: (1) to tax realized invested earnings (capital creation); (2) to restore invested capital tax-free (capital cost recovery); and (3) to tax net realized investment yield (gross realized yield in excess of capital recovery). the major accounting principles of a rbit base are to: (1) allow the tax-free return of capital through cost recovery deductions; and (2) to otherwise tax all net realized investment income. in the context of our investment model, this means that the tax base accounting dynamic is similar to that of an amit base: nominal income produced by a productive asset is included in the tax base but is at least partially offset by a deduction (or tax base reduction) associated with the asset. in a normative rbit, however, the offsetting deduction should reflect the cost of capital invested in the asset rather than the declining value of the productive asset itself. economic cost recovery (cost recovery based on the financial characteristics of economic depreciation) fails to facilitate the second and third structural principles described in the previous paragraph or either of the accounting principles. first, economic cost recovery fails to implement the structural and accounting principle providing for the tax-free return of capital. because cost recovery based on economic depreciation requires deferred cost recovery, the present value of economic cost recovery is less than the present value of the asset yield stream. the difference becomes taxable income, and the result is the financial under-recovery of asset cost and the financial overtaxation of asset yield.199 second, economic cost recovery negates the realization requirement because it is based on an accretion or accrual accounting technique that measures unrealized decreases in an asset’s value. using such a cost recovery method to measure capital income is inconsistent with a rbit base both as a structural and accounting matter. the overall structural problem caused by economic cost recovery is that it causes realized income (asset yield) to be netted against cost recovery based on unrealized changes in wealth; and neither asset yield treatment nor asset cost recovery treatment should violate the realization requirement in a normative rbit base. third, economic cost recovery is appropriate for measuring unrealized changes in asset value, because those are determined by the relationship 1between d , the pre-tax discount rate, and a depreciable asset’s yield rate. however, it is inappropriate for purposes of measuring net realized income. for example, the 100% financial tax rate imposed on the present value of a depreciable asset’s yield stream (y) to the extent it equals (or is less than) the 1pre-tax discount rate (d ), creates a persistent distortion in effective tax rates as 542 florida tax review [vol. 5:7 measured by net present value (npv etr). the correct financial tax rate is only imposed on yield in excess of that threshold, but even then, economic cost recovery continues to distort the overall npv etr. this is normative treatment for an amit base that measures value relative to the pre-tax discount rate, but it is inappropriate for a tax base accounting principle that requires measuring net realized income rather than inter-period asset value fluctuations and indirectly net unrealized income. c. capital expensing is the normative capital cost recovery method for a rbit base on the other hand, capital expensing as a cost recovery method provides normative structural treatment for short-lived depreciable assets in a rbit base because it does not combine realization accounting for yield and non-realization accounting for cost recovery deductions in an effort to account for net realized income. as a result, capital expensing allows rbit base accounting to focus properly and exclusively on measuring net realized income and to ignore unrealized changes in asset value, which is the sine qua non of amit base accounting. capital expensing as a rbit base capital cost recovery method is also structurally distinguishable from cash flow accounting for cfit base investment. the former provides tax-free recovery of already-taxed dollars, while the latter causes the pre-tax investment of untaxed dollars. in both cases, the economic and financial yield produced by the investment asset is fully taxed – in a cfit base because it is a positive cash flow, and in a rbit base because it is realized income. in terms of rbit base accounting principles, capital expensing is the only rbit base cost recovery method that provides full cost recovery financially, as shown in part v. as a result, only true net financial income is taxed, and not disparities between the present values of realized gross income and financially insufficient cost recovery. overall, expensing produces financial results that are completely consistent with the underlying financial characteristics and dynamics of an investment. for example, the pre-tax hurdle 1rate of an expensed asset is d , the pre-tax discount rate; and the after-tax hurdle 2, rate is d the after-tax discount rate. furthermore, investment yield is taxed proportionately at all yield rates, including the extent to which the yield rate, y, 1. equals the pre-tax discount rate, d unlike investments subject to economic cost recovery, there is no yield rate threshold equal to the pre-tax discount rate, below which all financial income is taxed at a 100% effective rate. as a result all realized income in excess of full capital recovery is taxed proportionally. the major structural criticism of expensing per se as a cost recovery method in a rbit base stems from its ability to shield pre-tax income from tax and to that extent cause a rbit base to emulate a cfit base, rather than an amit base. this emulation includes what commentators call the economic 2002] normative capital cost recovery 543 200. see supra note 170 and accompanying text. 201. see discussion supra part vi.b.1. 202. see discussion supra part iv.b. 203. id. 204. see supra note 130 and accompanying text. and/or financial exemption from tax of invested earnings, and is explained200 through the metaphor of a taxpayer-government investment partnership. as201 discussed earlier, however, a rbit does not exempt pre-tax earnings from tax202 to the extent that the amount invested does not exceed the natural rbit base capital formation threshold. nor does it emulate a cfit base to the extent that investment equals (but does not exceed) that threshold. beyond that point, the cfit base emulation criticisms are true, but up to that point they are not.203 under these circumstances, therefore, capital expensing does not violate the normative structural principle of a rbit base that allows cost recovery deductions only with respect to previously-taxed capital. it is important to distinguish the “pre-tax dollar” investment dynamics involved in a cfit base globally (and a rbit base partially) on one hand, from the “after-tax capital formation” dynamics involved in a rbit base that allows only invested capital to be expensed on the other. in a cfit base, the taxpayer’s pre-tax investment equals investment, but her after-tax investment equals investment x (1 – t) because the investment offsets pre-tax dollars. subsequently, her after-tax return on investment equals (investment x y) x (1 – t). for example, in the cfit base investment shown in table 17, the aftertax investment of $50 produces a net financial return with a net after-tax present value of $5.93, which is approximately a 10% return on that after-tax investment. literally, the tax has not reduced the return on after-tax investment. on the other hand, because the rbit base investments in our model are already made with after-tax dollars, a true cfit-like taxpayer-government partnership is not involved. nor are any earnings shielded from taxation by virtue of the expensing deduction, either economically or in financial terms.204 instead, structurally, the transaction resembles a “tax margin loan” in which the taxpayer does not need or use the tax savings in order to make the after-tax investment but implicitly borrows (investment x t) from the government in the form of tax savings, repays the government with (investment x y) x t, and keeps (investment x y) x (1 – t) for herself. as long as the amount of investment is below the rbit base natural capital formation threshold, the taxpayer’s aftertax economic investment still equals investment (instead of investment x (1 – t)), and the taxpayer’s after-tax return equals (investment x y) x (1 – t). therefore, for example, an after-tax dollar investment of $100 that is expensed in a rbit base produces the same net return of $5.93 after tax as a cfit base after-tax investment of $50. that $5.93, however, represents only the correct net 5% return on the rbit base investment of $100 of after-tax capital. formulaically: (investment x y) x (1 – t) = ($100 x 10%) x (1 50%). 544 florida tax review [vol. 5:7 in addition to being consistent with its structural norms and distinguishable from a cfit base, a rbit base that allows capital expensing produces financially correct results that are distinguishable from an amit base. the same net after-tax financial return of $5.93 that is structurally consistent with a normative rbit base also provides a financial result that is correct from a normative tax base accounting perspective. as we learned earlier, economic 1cost recovery creates such a high hurdle rate that yield to the extent of d is subject to a 100% effective tax rate as measured by npv etr. the result is an 2investment with a npv of zero, although it produces a 10% yield rate. this is not the case where asset cost is expensed because the taxpayer hurdle rates equal the discount rates. as a result, an expensed asset in a rbit base with a 10% yield produces a financially logical and consistent result (5% net financial return after tax) that correctly measures all realized income (rather the asset’s net financial value) and completely returns the initial amount of the taxpayer’s capital investment tax-free as rbit base structure requires. viii. conclusion three major structural and accounting principles distinguish capital income taxation in a realization-based income tax (rbit) from its counterparts in either an accretion-measured income tax (amit) or a cash flow income tax (cfit). those principles are capital formation, capital recovery, and realization. at or below the natural rbit base capital formation threshold, all cash-financed investment is capital investment. when capital-financed investment is made in assets that are short-lived, self-exhausting, and likely to be worthless at the end of their useful lives, the capital formation principle is satisfied by definition, and capital cost recovery policy only requires consistency with the second and third principles. this article has shown that only immediate capital expensing is completely consistent with those principles. thus, capital expensing, not economic depreciation, is the normative capital cost recovery method for a realization-based income tax. if this conclusion is correct, u.s. cost recovery policy makers should take heed. the quest to implement economic depreciation will not convert the u.s. income tax into a true amit but will create an even more structurally inconsistent tax base that allows capital formation but does not allow full capital recovery, while measuring and taxing a mixture of realized and unrealized net income. the quest to implement unlimited expensing is also structurally inconsistent with a rbit base. although it would ostensibly measure and tax realized income, it would partially prevent the formation of true capital and partially allow the tax-free recovery of untaxed income. it would not completely implement a consumption tax base, but it would preclude the normative operation of the rbit base currently in place. before policy makers implement either one of these sets of distortions, the assumption that either amit or cfit base capital income taxation 2002] normative capital cost recovery 545 principles are normative or optimal for u.s. capital income taxation policy should be subjected to further questioning, and the initial normative rbit base principles described in this article should be fleshed out. some of the questions that should be asked include: what is the normative treatment of non-capital financed investment in a rbit base? what is the normative treatment of nondepreciable or long-lived depreciable assets? what is the normative treatment of debt and debt-financed assets in a rbit? and finally, does the normative treatment of capital income with respect to any or all of these issues define the optimal tax policy with respect to these issues for the u.s. income tax? this article has applied a limited range of normative rbit base capital income taxation principles to one type of capital income in one particular economic context, but hopefully it has also suggested a new approach to resolving some or these broader tax policy issues in the future. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review florida tax review volume 13 2013 number 10 503 recent developments in federal income taxation: the year 2012 martin j. mcmahon, jr. * ira b. shepard ** daniel l. simmons *** * stephen c. o‘connell professor of law, university of florida fredric g. levin college of law. ** professor emeritus, university of houston law center. *** professor of law emeritus, university of california davis school of law. this recent developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the most recent twelve months — and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted – unless one of us decides to go nuts and spend several pages writing one up. this is the reason that the outline is getting to be as long as it is. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide dan and marty the opportunity to mock our elected representatives; again, sometimes at least one of us goes nuts and writes up the most trivial of legislative changes. the outline focuses primarily on topics of broad general interest (to the three of us, at least) – income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. any mistakes in this outline are marty’s responsibility; any political bias or offensive language is ira’s; and dan is just irresponsible. 504 florida tax review [vol. 13:10 i. accounting ............................................................................... 506 a. accounting methods ...................................................................... 506 b. inventories...................................................................................... 506 c. installment method ........................................................................ 506 d. year of inclusion or deduction ...................................................... 506 ii. busness income and deductions ........................................... 508 a. income ........................................................................................... 508 b. deductible expenses versus capitalization ................................... 512 c. reasonable compensation ............................................................. 524 d. miscellaneous deductions ............................................................. 526 e. depreciation & amortization ........................................................ 535 f. credits .......................................................................................... 545 g. natural resources deductions & credits ...................................... 548 h. loss transactions, bad debts, and nols ..................................... 549 i. at-risk and passive activity losses ............................................. 550 iii. investment gain and income ................................................. 555 a. gains and losses............................................................................ 555 b. interest, dividends, and other current income ............................. 569 c. profit-seeking individual deductions ............................................ 572 d. section 121..................................................................................... 572 e. section 1031................................................................................... 572 f. section 1033................................................................................... 573 g. section 1035................................................................................... 573 h. miscellaneous ................................................................................ 573 iv. compensation issues ................................................................ 575 a. fringe benefits ............................................................................... 575 b. qualified deferred compensation plans ........................................ 577 c. nonqualified deferred compensation, section 83, and stock options .......................................................................................... 578 d. individual retirement accounts .................................................... 580 v. personal income and deductions ........................................ 581 a. rates ............................................................................................... 581 b. miscellaneous income ................................................................... 587 c. hobby losses and § 280a home office and vacation homes .......................................................................................... 591 d. deductions and credits for personal expenses .............................. 592 e. divorce tax issues ......................................................................... 599 f. education ....................................................................................... 600 g. alternative minimum tax ............................................................. 601 vi. corporations ............................................................................ 602 a. entity and formation ..................................................................... 602 b. distributions and redemptions ...................................................... 602 c. liquidations ................................................................................... 602 2013] recent developments in federal income taxation 505 d. s corporations ............................................................................... 602 e. mergers, acquisitions and reorganizations .................................. 610 f. corporate divisions ....................................................................... 617 g. affiliated corporations and consolidated returns ........................ 617 h. miscellaneous corporate issues ..................................................... 618 vii. partnerships .............................................................................. 618 a. formation and taxable years ........................................................ 618 b. allocations of distributive share, partnership debt, and outside basis ................................................................................. 627 c. distributions and transactions between the partnership and partners .......................................................................................... 630 d. sales of partnership interests, liquidations and mergers .............. 630 e. inside basis adjustments ............................................................... 630 f. partnership audit rules ................................................................. 630 g. miscellaneous ................................................................................ 640 viii. tax shelters .............................................................................. 642 a. tax shelter cases and rulings....................................................... 642 b. identified ―tax avoidance transactions‖ ......................................... 649 c. disclosure and settlement .............................................................. 649 d. tax shelter penalties, etc. .............................................................. 650 ix. exempt oganizations and charitable giving ................. 650 a. exempt organizations .................................................................... 650 b. charitable giving ........................................................................... 652 x. tax procedure .......................................................................... 667 a. interest, penalties and prosecutions ............................................... 667 b. discovery: summonses and foia ................................................. 675 c. litigation costs .............................................................................. 676 d. statutory notice of deficiency ...................................................... 676 e. statute of limitations ..................................................................... 677 f. liens and collections ..................................................................... 693 g. innocent spouse ............................................................................. 695 h. miscellaneous ................................................................................ 697 xi. withholding and excise taxes ............................................ 707 a. employment taxes ........................................................................ 707 b. self-employment taxes ................................................................. 715 c. excise taxes .................................................................................. 717 xii. tax legislation ........................................................................ 718 a. enacted .......................................................................................... 718 506 florida tax review [vol. 13:10 i. accounting a. accounting methods 1. rev. proc. 2012-39, 2012-41 i.r.b. 470 (9/4/12). the irs announced a change in its policy on automatic accounting method changes in corporate reorganizations. taxpayers that engage in a tax-free reorganization or liquidation under § 381(a) after 8/31/11 will be allowed to make automatic accounting method changes in the tax year they engage in the transaction. this revenue procedure clarifies and modifies (i) rev. proc. 2011-14, 2011-1 c.b. 330; and (ii) rev. proc. 97-27, 1997-1 c.b. 680, as amplified and modified by rev. proc. 2002-19, 2002-1 c.b. 696, as amplified and clarified by rev. proc. 2002-54, 2002-2 c.b. 432, as modified by rev. proc. 2007-67, 2007-2 c.b. 1072, as clarified and modified by rev. proc. 2009-39, 2009-2 c.b. 371, and as clarified and modified by rev. proc. 2011-14. b. inventories there were no significant developments regarding this topic during 2012. c. installment method there were no significant developments regarding this topic during 2012. d. year of inclusion or deduction 1. ―one potato, two potato, three potato, four ….‖ to have spudded or not to have spudded, that is the question. caltex oil venture v. commissioner, 138 t.c. 18 (1/12/12). the taxpayer, which was on the accrual method, entered into a turnkey contract under which it paid $5,172,666 by cash and note in december 1999 for the drilling of two oil and gas wells. some site preparation required under the contract occurred in 1999, but drilling was not commenced within ninety days after the end of 1999. the taxpayer deducted the full amount as intangible drilling and development costs (idc) under § 263(c) in 1999 and the irs disallowed the deduction on the ground that the economic performance requirement of § 461(h) was not satisfied. the tax court (judge gustafson) held that for purposes of the special rules in § 461(i)(2)(a), which provide ninety days leeway after the close of the year for economic performance to occur with respect to drilling oil and gas wells, ―drilling of the well commences‖ when there is ―actual penetration‖ of the ground surface in the act of drilling for 2013] recent developments in federal income taxation 507 purposes of spudding a well. mere site preparation is insufficient. he emphasized that the title of the provision refers to ―spudding,‖ which webster‘s third new international dictionary 2212 (2002) defines as ―to begin to drill (an oil well) by alternately raising and releasing a spudding bit with the drilling rig.‖ thus, the taxpayer did not qualify under the special rule. furthermore, the 3-1/2-month rule of reg. § 1.461-4(d)(6)(ii), which allows a taxpayer to treat a liability as having been economically performed at the time of payment if that taxpayer ―reasonably expect[ed] the . . . [provider of services] to provide the services ... within 3 ½ months after the date of payment,‖ did not apply ―because, in the case of an undifferentiated, non-severable contract, the 3-1/2-month rule contemplates that all of the services called for must be provided within 3-1/2 months of payment.‖ moreover, even if the 3-1/2-month rule applied to treat some of the services due under the contract as having been economically performed in 1999, the deductions allowed under the 3-1/2-month rule were limited to payments of cash or cash equivalents and did not include payments made by notes. finally, judge gustafson held that a trial was warranted on how much of the idc was actually incurred in 1999 and could be deducted under the general economic performance rule of § 461(h). 2. you‘ll learn more about insurance company taxation than income tax accounting reading this case. massachusetts mutual life insurance co. v. united states, 103 fed. cl. 111 (fed. cl. 1/30/12). the court of federal claims (judge horn) held that the taxpayer, an accrual method mutual life insurance company could deduct guaranteed minimum policyholder dividends in the year that the board of directors passed a resolution to pay the dividends during the following year. all events fixing liability had occurred and the obligation to pay out at least a minimum amount established both the fact of liability and that the liability could be determined with reasonable accuracy. pursuant to § 461(h)(3) and reg. § 1.461-5 because policyholder dividends were in the nature of return of premium, and they qualified under reg. § 1.461-4(g)(3) as ―rebates or refunds,‖ and thereby satisfied both the matching requirement and the recurring item exceptions to the economic performance rule. further, the court rejected the government‘s argument that the economic substance doctrine applied to prevent the taxpayer from accounting for dividends in guarantee years; the taxpayer ―did not engage in a typical transaction with an investment followed by a deduction. instead, as plaintiff notes, plaintiff‘s payment of policyholder dividends was not designed to generate a tax benefit, rather ‗the payment of policyholder dividends is central to plaintiff‘s business and that of the mutual life insurance industry as a whole,‘ and to the benefit of the policyholder.‖ 508 florida tax review [vol. 13:10 ii. business income and deductions a. income 1. the dentist‘s income is taxable to the dentist, just like his lawyer‘s income is taxable to the lawyer. walker v. commissioner, t.c. memo. 2012-5 (1/9/12). the taxpayer dentist practiced through an llc, owned 1 percent by the taxpayer and 99 percent by a partnership that included the dentist‘s children. the arrangement was patterned on entities created by scott and darren cole to avoid income and employment on their law practice and rejected in cole v. commissioner, 637 f.3d 767 (7th cir. 2011). the tax court (judge cohen) held that the arrangement represented an anticipatory assignment of income that was taxable to the taxpayer. the only distinction between the taxpayer and the taxpayers in cole was the practice of dentistry versus law, a distinction that did not make a difference. 2. assignment of income principles are alive and well, sort of. owen v. commissioner, t.c. memo. 2012-21 (1/19/12). the taxpayers, john and laura owen incorporated a personal services company, j&l owen, inc., in which they were the sole shareholders. in 1997, john owen and two others formed two companies, family first insurance services companies (ffis) and ffeap, which sold insurance related and financial products. john was both an officer/employee and an independent contractor salesman. laura was employed by ffis as an executive. in 2002, john sold his 50 percent interest in the two companies for $7.5 million, $3.8 million of which was paid in the form of a cashier‘s check. the taxpayer reported $1.9 million on the sale of ffis as capital gain and attempted to roll over $1.9 million of gain on the sale of ffeap into a jewelry business under § 1045 (rollover of an investment of one small business corporation into another small business corporation). in each of january and december 2003 the purchaser paid an additional $1.5 million into the owen family trust. the taxpayers‘ accountant mistakenly omitted the second payment from the taxpayers‘ 2003 return. an employment agreement retained john as president of ffis and vice-president of ffeap. various compensation and incentive payments pursuant to the agreement and amendments signed by john in his role as president of ffis were made to j&l owen, inc. in 2002 j&l owen, inc. reported $910,454 of wages to john and $225,000 to laura on forms w-2, which wages were deducted by the corporation. the tax court (judge wherry) held that payments to john for his sales activity in his capacity as an independent contractor for the insurance companies were under the control of j&l owen, inc., and were thus income of the corporation. the court indicated that, as an independent contractor, an 2013] recent developments in federal income taxation 509 individual has control over earned income, which includes the right to choose to do business as a corporation. after a factual inquiry into the nature of other payments, the court held that payments to john for consulting and sales promotion activities were made in his capacity as an officer of the insurance companies and therefore not subject to assignment to the personal service corporation. the court rejected the taxpayers‘ assertion that they over-reported their income for 2002 in the amount reported as compensation from the personal services corporation, stating that the taxpayers failed to meet their burden of showing that they did not receive the amounts reported on w-2s from the personal services corporation. (the irs also conceded that amounts includable in the taxpayers‘ income for 2002 under assignment of income principles had been included in the w-2s from the personal services corporation.) the court also noted that while a taxpayer may conduct business in whatever form the taxpayer chooses, the taxpayer must also accept the result.  with respect to the capital gain the taxpayer attempted to roll over under § 1045, the court held that the jewelry business into which the taxpayer invested proceeds from the sale of ffeap was not an active trade or business and thus not a qualified small business for § 1045 purposes.  the court imposed § 6662 accuracy related penalties, holding that the taxpayer did not reasonably rely on the tax advice of the accounting firm that structured the various transactions. 3. f. lee bailey defends himself in the tax court, as they say about the client of the (disbarred) lawyer who represents himself . . . . bailey v. commissioner, t.c. memo. 2012-96 (4/2/12). to facilitate an incarcerated marijuana dealer‘s forfeiture plan, f. lee bailey entered into an unwritten agreement with the justice department to deposit $5.9 million of biochem pharma stock in his investment account at credit suisse bank that was provided by the client. the purpose of the arrangement was to facilitate repatriation and forfeiture of the client‘s assets to the u.s. government as part of a deal to reduce the client‘s sentence. mr. bailey sold some of the stock and borrowed $3 million from credit suisse posting the stock as security. mr. bailey used the proceeds to make payments on behalf of his client and deposited a portion of the proceeds in personal accounts. when the drug dealer client replaced mr. bailey with a different lawyer, the u.s. district court ordered mr. bailey to return the stock to the court. unfortunately, he was unable to do so because the bank refused to release the collateral until the loan was paid. as a consequence, mr. bailey was held in contempt by the district court and incarcerated for a period of 44 days. after mr. bailey was able to raise capital to repay the credit suisse loan and transfer the stock, he was released. mr. bailey was reimbursed for out-ofpocket expenses that he paid on behalf of the client but was not paid any fee 510 florida tax review [vol. 13:10 for his services. in a deficiency notice the irs asserted that mr. bailey had unfettered dominion and control over the stock and therefore recognized as income the full value of the stock at the time it was deposited in his credit suisse account. alternatively, the irs asserted that if the full value of the stock was not includable in mr. bailey‘s income, at least the value of the stock that he used as collateral for the $3 million loan represented gross income. in a 143-page opinion addressing multiple issues, the tax court (judge gustafson) held that, based on findings in mr. bailey‘s litigation over the right to retain the stock (bailey v. united states, 54 fed. cl. 459 (2002)), to which collateral estoppel applied, mr. bailey held the biochem pharma stock in trust for the u.s. government. mr. bailey was not therefore taxable on the stock‘s value. however, the court also held that bailey realized income of approximately $425,000 when he transferred proceeds from sale of some biochem pharma stock to his personal accounts in a departure from his fiduciary role. the court also rejected the irs‘s assertion that bailey realized income on the use of $12 million of the appreciated biochem pharma stock as collateral for the $3 million loan from credit suisse. the irs argued that bailey had misappropriated the value of the stock used as collateral for the loan. the court found that bailey was personally liable for repayment of the credit suisse loan and that the loan was a bona fide indebtedness for which there was a consensual recognition of mr. bailey‘s obligation to repay. thus, the receipt of the loan proceeds was not includible in income.  the court rejected bailey‘s argument that due process barred the government from including in his income $1.6 million in fees that were attached by the government and used to satisfy a portion of the indebtedness to credit suisse in order to release the biochem pharma stock from the credit suisse security, holding that payments made to a third party on behalf of the taxpayer are nonetheless included in income.  the court rejected bailey‘s argument that the burden of proof with regard to substantiation of expenses shifted to the government after he had notified the government that he was disposing of records stored in an aircraft hangar and provided access to those records to auditing agents prior to their destruction. the court observed that taxpayers are required to maintain records, there is no provision that imposes a recordkeeping requirement on the irs, and the fact that he offered to let the irs review and copy records before discarding them does not absolve bailey of the recordkeeping requirement nor shift the burden of proof.  the court held that bailey‘s yacht renovation and rental activity was not an activity engaged in for profit, but that an aircraft renovation activity was a profit seeking activity.  finally, bailey was found liable for negligence penalties. 2013] recent developments in federal income taxation 511 4. the irs cuts an illegal drug dealer a break not warranted on the face of the statute. olive v. commissioner, 139 t.c. no. 2 (8/2/12). the taxpayer operated a medical marijuana business that sold medical marijuana at retail under the california compassionate use act of 1996. the tax court (judge kroupa) upheld the irs‘s determination that the taxpayer underreported his gross receipts and that § 280e precluded his deduction of business related expenses. the irs conceded that § 280e did not bar a deduction from gross receipts for costs of goods sold but argued that the taxpayer‘s ledger entries were inadequate substantiation and that as a factual matter cost of goods sold should be zero. judge kroupa sustained the irs‘s position that the journal entries were unreliable, but applied cohan v. commissioner, 39 f.2d 540 (2d cir. 1930) to find, based on expert witness testimony, that the cost of goods sold was approximately 75 percent of the gross receipts and adjusted that amount to account for marijuana that was given away to customers and staff. judge kroupa rejected the taxpayer‘s argument that the expenses should be deductible based on californians helping to alleviate medical problems, inc. v. commissioner, 128 t.c. 173 (2007), in which the tax court held that the corporation‘s care-giving activities for terminally ill patients were a separate trade or business from its medical marijuana delivery and that expenses allocable to the care-giving activity were deductible as ordinary and necessary business expenses. in the instant case, unlike in californians helping to alleviate medical problems, based on the facts and circumstances there were not two separate and distinct activities. in this case the taxpayer operated a single business of dispensing medical marijuana, with all other services being provided as part of that business.  judge kroupa upheld accuracy-related penalties on the deficiency resulting from unsubstantiated expenses, but not with respect to expenses that were substantiated but disallowed under § 280e, reasoning that the application of § 280e to the medical marijuana industry was decided after the years at issue.  a straightforward reading of § 280e and the last sentence of § 263a(a)(2) in concert clearly denies the recovery of cost of goods sold for the marijuana in this case. prior to the enactment of the last sentence of § 263a(a)(2), however, § 280e alone did not deny drug dealers taxfree recovery of the cost of goods sold. see, e.g., franklin v. commissioner, t.c. memo. 93-184. in californians helping to alleviate medical problems, inc. v. commissioner, 128 t.c. 173 (2007), the irs, based on that outdated case law conceded — erroneously in our opinion — that § 280e did not operate to deny as matter of law the cost of goods sold to a taxpayer that purchased and resold marijuana. that mistake was repeated in this case. 5. abracadabra: a creditor‘s bad debt does not necessarily create debtor‘s cod income. abarca v. commissioner, t.c. 512 florida tax review [vol. 13:10 memo. 2012-245 (8/27/12). the tax court (judge goeke) held that no cancellation of debt income was realized by a taxpayer where the only evidence that the debt was discharged was a letter stating that the loan had been ―charged off,‖ but also stated that the taxpayer ―still remain[ed] obligated for the repayment of the debt,‖ and no form 1099-c was introduced into evidence. 6. the fabled plotkin diamond always comes with a curse — mr. plotkin. plotkin v. commissioner, 110 a.f.t.r.2d 2012-6752 (11th cir. 11/27/12). taxpayer received an economics degree from the university of pennsylvania‘s wharton school, class of 1963, and a law degree from st. louis university, class of 1972, before he purchased a controlling interest in a nursing home empire from the father of his ex-wife in 1980. as the result of a complex series of financial machinations and fund diversions through his girlfriend(s) during the years 1991, 1992, and 1993, he was convicted on three counts of willfully making and subscribing false income tax returns under § 7206(1) in 1999 and sentenced to five years of probation. the commissioner determined that he failed to report in excess of $1.5 million of schedule c self-employment income during the years 1991 through 1995. in this unpublished per curiam opinion, the eleventh circuit affirmed a tax court decision upholding the commissioner‘s determination, finding taxpayer‘s argument that he received non-taxable partnership distributions not supported by the facts because taxpayer deliberately chose not to be a partner in the entity from which he received financial benefits. b. deductible expenses versus capitalization 1. temporary and proposed regulations provide extensive rules for the acquisition, production, or improvement of tangible personal property. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11), and reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81128 (12/27/11). the treasury department has promulgated temporary regulations, generally effective for tax years beginning on or after 1/1/12, addressing capitalization requirements for expenditures to acquire and improve tangible property. the temporary regulations adopt provisions of regulations proposed in 2008 (reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 73 f.r. 12838 (3/10/08)), which were in turn based on a 2006 proposal that was substantially modified by the 2008 proposed regulations (reg-16874503, guidance regarding deduction and capitalization of expenditures related to tangible property, 71 f.r. 48590 (8/21/06)). the temporary 2013] recent developments in federal income taxation 513 regulations provide detailed capitalization rules and several bright-line standards under §§ 162(a) and 263(a) regarding the acquisition, improvement, or repair of tangible real and personal property. the temporary regulations also revise rules under § 168 regarding disposition and maintenance of general asset accounts for macrs property. in general, the regulations adopt the provisions of the 2008 proposed regulations, but with multiple modifications. temp. reg. § 1.263(a)-2t provides rules for amounts paid for the acquisition or production of tangible property, and § 1.263(a)-3t provides rules for amounts paid for the improvement of tangible property. however, these new proposed regulations provide many additional rules. the temporary regulations define material and supplies to treat as deductible (1) the cost of any property with a useful life that does not exceed one year and (2) any item that cost not more than $100. they add a book-conformity de minimis rule, a safe-harbor for routine maintenance, and an optional simplified method for regulated taxpayers. the temporary regulations contain provisions defining a unit of property as a key concept and address capitalization of expenditures that improve or restore a unit of property. the regulations do not provide for a detailed repair allowance rule, but do provide for future i.r.b. guidance regarding industry-specific repair allowance methods.  acquisition and production costs. temp. reg. § 1.263(a)-2 provides that a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property (as determined under temp. reg. § 1.263(a)-3t(d)(2)), including leasehold improvement property, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. amounts paid to create intangible interests in land are treated as capital expenditures. amounts paid for work performed on a unit of property prior to the date the property is placed in service must also be capitalized. temp. reg. § 1.263(a)-2t(d)(1). transaction costs to facilitate the acquisition of property are expressly required to be capitalized, temp. reg. § 1.263(a)-2t(f), but facilitative expenditures do not include employee compensation or overhead unless the taxpayer elects to capitalize such expenditures. expenditures to defend or protect title must be capitalized. temp. reg. § 1.263(a)-2t(e).  selling expenses. temp. reg. § 1.263(a)1t(d) provides for the capitalization of selling expenses as an offset against sales proceeds (except in the case of dealers).  materials and supplies. as under the prior rules, temp. reg. § 1.162-3t allows a deduction for incidental material and supplies in the year an expenditure is made. materials and supplies are incidental when they are carried on hand and for which no record of consumption is maintained or when not carried in inventory. a deduction for non-incidental materials and supplies is allowed in the year the property is consumed. materials and supplies include tangible property that is (1) a 514 florida tax review [vol. 13:10 component acquired to repair or improve a unit of tangible property that is not acquired as part of a unit of property, (2) fuel, lubricants, water and similar items that are reasonably expected to be consumed within 12 months, and (3) tangible property that is a unit of property with (a) an economic useful life to the taxpayer of not more than 12-months, or (b) that costs not more than $100 (an embedded de minimis rule). temp. reg. § 1.162-3t(c). taxpayers may elect to capitalize the cost of each item of material or supply. items used in the production of other property remain subject to the uniform capitalization rules of § 263a. temp. reg. § 1.263a-1t(b). on sale or disposition, materials and supplies are not treated as capital assets. temp. reg. § 1.162-3t(g).  rotable spare parts. rotable spare parts are components treated as materials and supplies that are installed in a unit of property, are removable from the unit of property, and are generally repaired and improved for installation in a unit of property or stored for later use. the cost of rotable spare parts is deductible in the year of the disposition of the part. temp. reg. § 1.162-3t(a)(3). temp. reg. § 1.162-3t(e) provides an elective optional method of accounting for the treatment of rotable and temporary spare parts under which (1) the taxpayer deducts the amount paid for the part in the year the part is first installed on a unit of property, (2) in each year the part is removed from a unit of property the taxpayer includes the fair market value of the part in gross income, (3) includes in the basis of the part the value taken into income plus amounts paid to remove the part, (4) includes in the basis of the part any amounts expended to maintain the part, (5) then deducts the basis and any cost incurred to reinstall the part in a unit of property, and finally (6) deducts the basis of the part on final disposition.  financial accounting de minimis rules. temp. reg. § 1.263(a)-2(g) allows a taxpayer to deduct expenditures to acquire or produce property (other than property produced for resale) if the taxpayer expenses the cost on a certified audited financial statement (including audited financial statements prepared by an independent cpa and used for non-tax purposes and certain financial statements filed with regulatory agencies) pursuant to a written accounting procedure adopted by the taxpayer that treats as expenses amounts paid for property costing less than a specified dollar amount, as long as the amounts deducted under the de minims rule do not exceed the lesser of 0.1 percent of the taxpayer‘s gross receipts or 2 percent of the taxpayer‘s total depreciation and amortization expense reflected in its financial statement. (the temporary regulations remove a provision in the 2008 proposed regulations that the aggregate amount deducted do not materially distort the taxpayer‘s income for purposes of § 446.) property subject to the de minimis rule cannot be treated on sale or other disposition as a capital or § 1231 asset. a taxpayer may elect to apply the de minimis rule of temp. reg. § 1.263(a)-2t(g) to materials and supplies, including rotable spare parts, which 2013] recent developments in federal income taxation 515 are then not treated as materials or supplies under temp. reg. § 1.162-3t. temp. reg. § 1.162-3t(f).  unit of property. temp. reg. § 1.263(a)3t(e). the unit of property concept is central to the proposed regulations‘ requirement that improvements to a unit of property must be capitalized.  temp. reg. § 1.263(a)-3t(e)(2) provides that a building and its structural components (as defined in reg. § 1.48-1(e)(2)) are treated as a unit of property. 1 however, the improvement rules must be separately applied to components of a building including heating, ventilation and air conditioning systems, plumbing systems, electrical systems, elevators and escalators, fire protection and security systems, gas distributions systems, and other systems identified in published guidance. condominium units and cooperative units are each treated for the owner as a unit of property. similarly, a leasehold interest in a portion of a building is treated as a unit of property.  temp. reg. § 1.263(a)-3t(e)(2) defines a unit of property for property other than buildings as including all the components that are functionally interdependent. components of property are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component. however, a component that is recorded on the taxpayer‘s books as having a different economic useful life or which is in a different class of property for macrs depreciation would be treated as separate unit of property. thus, for example, all of the component parts of a railroad locomotive constitute a single unit of property, as does a truck trailer and its tires (unless the taxpayer‘s financial statements treat them as separate property). a special rule applies to ―plant property,‖ which is a functionally integrated collection of equipment and machinery used to perform an industrial process; each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent machinery or equipment constitutes a separate unit of property. determinations of a unit of property with respect to network assets are based on the taxpayer‘s facts and circumstances unless otherwise provided in published guidance. network assets include property such as railroad tracks, oil, gas, water and sewage pipelines, power transmission lines, and cable and telephone lines that are owned or leased by taxpayers in those industries. 1. under reg. § 1.48-1(e)(2), structural components of a building include such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefor such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building. 516 florida tax review [vol. 13:10  capitalization of improvements. expenditures to improve a unit of property must be capitalized. temp. reg. § 1.263(a)-3t(d). amounts expended for repairs and maintenance of tangible property are deductible if they are not required to be capitalized under temp. reg. § 1.263(a)-3t. temp. reg. § 1.162-4t. expenditures that improve tangible property and that are required to be capitalized include expenditures that: ºresult in a ―betterment‖ to a unit of property (replacing the term ―material increase in value‖ used in the original proposal); ºrestore a unit of property; or ºadapt the unit of property to a new or different use. temp. reg. § 1.263(a)-3t(f) provides special rules requiring a lessee to capitalize expenditures for improvements to a unit of leased property. a lessor is required to capitalize the cost of improvements to leased property paid directly or through a construction allowance to the lessee. (the preamble to the regulations states that the recovery period for an improvement or addition to the ―underlying property‖ begins on the placedin-service date of the improvement or addition. see § 168(i)(6); temp. reg. § 1.168(i)-8t(c)(4)(ii)(e).)  betterment. temp. reg. § 1.263(a)-3t(h). an expenditure results in a betterment of a unit of property if it (1) ameliorates a material condition or defect that existed prior to acquisition of the property or arose during production of the property, (2) results in a material addition to a unit of property, or (3) results in a material increase in capacity. determination of whether an expenditure results in a betterment is factual and requires a comparison of the condition of the property immediately prior to the circumstance necessitating the expenditure (or the condition of property the last time the taxpayer corrected for normal wear and tear) with the condition of the property after the expenditure. an expenditure that results in a betterment of a component of a building is treated as a betterment to the unit of property consisting of the building and its structural components.  restoration. temp. reg. § 1.263(a)-3t(i). an expenditure is capitalized as a restoration if it (1) replaces a component for which the taxpayer has deducted a loss, (2) replaces a component the adjusted basis of which has been accounted for in realizing gain or loss on a sale or exchange of the component, (3) repairs damage for which the taxpayer has deducted a casualty loss under § 165, (4) returns the property to its ordinary operating condition after the property has fallen into a state of disrepair and is no longer functional, (5) results in rebuilding the property to a like-new condition at the end of its class life under the § 168(g) alternative depreciation system, or (6) is for the replacement of a major component or structural part of 2013] recent developments in federal income taxation 517 the unit of property. whether there is a replacement of a major component or structural part is determined under the facts and circumstances and includes replacement of a major component or structural part that comprises a large portion of the physical structure of the unit of property or that performs a discrete and critical function in the operation of the unit of property. (the 50 percent of replacement cost test of the proposed regulations was eliminated.) again, the restoration of a component of a building is treated as a restoration of the unit of property consisting of the building and its structural components.  new use. temp. reg. § 1.263(a)-3t(j). a unit of property is treated as adapted to a new or different use if the adaptation is not consistent with the taxpayer‘s ―intended ordinary use of the unit of property at the time originally placed in service by the taxpayer.‖ an expenditure to adapt a component of a building to a new use must be capitalized as an expenditure to adapt the unit of property consisting of the building and its structural components to a new use.  rehabilitation doctrine is no more. temp. reg. § 1.263(a)-3t(f)(3) eliminates the judicially created rehabilitation doctrine by providing that, ―[i]ndirect costs that do not directly benefit and are not incurred by reason of an improvement are not required to be capitalized under section 263(a), regardless of whether they are made at the same time as an improvement.‖ but the regulations provide that if otherwise deductible repairs benefit or are incurred by reason of an improvement, the cost of the repairs must be capitalized under § 263a.  routine maintenance safe harbor. temp. reg. § 1.263(a)-3t(g) provides a safe harbor from the capitalization requirement for ―the recurring activities that a taxpayer expects to perform as a result of the taxpayer‘s use of the unit of property to keep the unit of property in its ordinarily efficient operating condition.‖ the safe harbor applies to activities that the taxpayer reasonably expects to perform more than once during the class life of the property, as determined under the macrs alternative depreciation schedule of § 168(g). routine maintenance includes maintenance with respect to and the use of rotable spare parts. routine maintenance excludes activities that follow a basis recovery event similar to the items that are described as restorations.  repairs. temp. reg. § 1.162-4t allows as a deductible repair expense any costs that are not required to be capitalized under temp. reg. § 1.263(a)-3t.  repair allowance. the regulations do not provide for a repair allowance, but temp. reg. § 1.263(a)-3t(l) permits taxpayers to use a repair allowance method that is authorized by published guidance in the federal register or the internal revenue bulletin, suggesting that such rules will be forthcoming. 518 florida tax review [vol. 13:10  examples. the regulations are full of examples that seem to cover most of the litigated cases and rulings addressing capitalization versus repair. the examples are necessary to understand the substantive provisions, which, although intended to provide clarity, are not so clearly applied. a. irs specifies the procedures for adopting new accounting methods under the temporary regulations. rev. proc. 2012-19, 2012-14 i.r.b. 689 (3/7/12), modifying rev. proc. 2011-14, 2011-1 c.b. 330. the irs has provided lengthy and detailed rules regarding automatic changes in methods of accounting under temp. reg. §§ 1.162-3t and -4t (materials and supplies), 1.263(a)-1t (capital expenditures in general), 1.263(a)-2t (transaction costs), and 1.263(a)-3t (improvements), all added by t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11). these changes are for taxable years beginning on or after january 1, 2012. b. lb&i provides guidance under rev. proc. 2012-19. lb&i-4-0312-004 (3/15/12). this directive to the field applies to taxpayers who adopted a method of accounting relating to the conversion of capitalized assets to repair expense under § 263(a). c. have your clients been wasting time trying to comply with the temporary regulations in 2012? yes, they have. further guidance announcing that pending final regulations will apply only in years beginning in 2014 and thereafter. notice 2012-73, 2012-51 i.r.b. 713 (11/20/12). the irs announced that pending final regulations will apply to taxable years beginning on or after 1/1/14, but that taxpayers will be permitted to apply the final regulations to taxable years beginning on or after 1/1/12. the notice also indicates that the temporary regulations may be revised with respect to the de minimis rule of § 1.263(a)2t(g); dispositions under §§ 1.168(i)-1t and 1.168(i)-8t; and the safe harbor for routine maintenance under § 1.263(a)-3t(g). d. technical amendments so revise the temporary regulations. more important, the effective date of the 12/27/11 temporary regulations is delayed to years beginning on or after 1/1/14, with optional retroactive applicability. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 77 f.r. 74583 (12/17/12). these include the following explanation: . . . [t]he irs and the treasury are concerned that taxpayers are expending resources to comply with temporary 2013] recent developments in federal income taxation 519 regulations that may not be consistent with forthcoming final regulations. e. this announcement amends — really!!?? announcement 2013-7, 2013-3 i.r.b. 308 (1/14/13). an announcement amending regulations — the temporary regulations (t.d. 9564), regarding the deduction and capitalization of expenditures under §§ 162(a) and 263(a) relating to tangible property to apply to taxable years beginning on or after 1/1/14, while permitting taxpayers to apply the temporary regulations for taxable years beginning on or after 1/1/12, and before the applicability date of the final regulations. 2. just because state law requires you to make the payment doesn‘t mean it‘s an ordinary and necessary business expense. zweifel v. commissioner, t.c. memo. 2012-93 (3/28/12). citing sebring v. commissioner, 93 t.c. 220, 227 (1989); firetag v. commissioner, t.c. memo. 1999-355, aff’d without published opinion, 232 f.3d. 887 (4th cir. 2000); and rankin v. commissioner, t.c. memo. 1996-350, aff’d, 138 f.3d 1286 (9th cir. 1998), the tax court (judge paris) held that payments to a ―build up fund account‖ into which a bail bondsman is required under state law to make deposits to reimburse insurers for losses on bail bonds underwritten by the bail bondsman are not deductible in the year of the contribution to the account, because the expense for which the account was created has not yet arisen.  as a condition of doing business, taxpayer bail bond agent was required by state law to maintain a ―build-up fund‖ of 1 percent of bonds executed as an agent of national surety services (the underwriter) for the purpose of establishing an indemnity to protect the insuring company from loss through the posting of bonds by the agent. the taxpayer had legal title to the funds, was taxable on interest, and was entitled to return of the funds on termination of the contract with the insurer and discharge of remaining open bonds. judge paris rejected the taxpayer‘s argument that the payments were in the nature of insurance premiums paid to financially protect the taxpayer. the court indicated that the payments are specific payments tied to an individual bond and are not a general contract to protect against unforeseen losses. the court held that the payments are deductible when amounts are paid out of the build-up fund to the insurer.  the court sustained penalties for failure to timely file and indicated with respect to negligence penalties that, although the taxpayer presented ―well-thought-out arguments‖ to distinguish prior case law with respect to the claimed deductions, the taxpayer‘s failure to timely file indicates that the taxpayer did not act in good faith or with reasonable cause. 520 florida tax review [vol. 13:10 3. avoided interest attributable to associated property taken out of service requires capitalization under chevrontested regulations that barely survive. dominion resources, inc. v. united states, 97 fed. cl. 239 (2/25/11). the taxpayer, an electric utility, removed boilers from service to replace burners. reg. § 1.263a-11(e)(1)(ii)(b) requires that the capitalized cost of improvements under § 263a include both direct expenditures and the capitalized cost of interest (under the avoided cost rules) attributable to the basis of property temporarily removed from service in order to complete the improvements. the court (judge lettow) rejected the taxpayer‘s arguments that (1) the associated property rule of reg. § 1.263a-11(e)(1)(ii)(b) is invalid as inconsistent with § 263a, and (2) it was adopted in contravention of the requirements of the administrative procedure act. under the test of chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), the taxpayer argued that the regulation was inconsistent with § 263a(f)(2)(a)(ii), which provides that for purposes of determining production period interest ―with respect to any property . . . interest on any . . . indebtedness [not directly attributable to production expenditures] shall be assigned to such property to the extent that the taxpayer‘s interest costs could have been reduced if production expenditures . . . had not been incurred.‖ the taxpayer asserted that ―property‖ for this purpose under the statutory language can include only the improvement itself, which is separately depreciable, and cannot, therefore be expanded to include associated property as provided in the regulation. the taxpayer also argued that the production costs were incurred with respect to the replacement burners, and not with respect to the boilers themselves. while the court was not completely happy with the irs‘s argument that the property can be separated for depreciation purposes while considered as a unit for purposes of the interest allocation, the court concluded that the statute was sufficiently ambiguous under the first prong of the chevron test that the regulation could be tested under the second prong of chevron, which asks whether the regulation is a permissible construction of the statute. here the court indicated that, ―it is stretching the statute quite far to say that the associated-property rule ‗is a reasonable interpretation of the enacted text‘ [of section 263a].‖ the court added that the irs‘s rationales ―are not very satisfying.‖ the court then concluded, however, that ―it is not this court‘s province to be making such policy choices. in this very close case, the court cannot say that treasury overstepped the latitude granted by the statute to adopt regulations prescribing the calculation of interest to be capitalized in connection with an improvement to existing property used by the taxpayer to produce income‖ and held that the regulation therefore survived the taxpayer‘s challenge. with respect to the taxpayer‘s challenge under the administrative procedure act, the court again found that ―it is a stretch to conclude that treasury ‗cogently explain[ed] why it has exercised its https://checkpoint.riag.com/getdoc?docid=iaftrinc:123421.1&pinpnt= 2013] recent developments in federal income taxation 521 discretion in a given manner,‘‖ but added that ―[t]he ‗path‘ that treasury was taking in the rulemaking proceedings can be ‗discerned,‘ albeit somewhat murkily‖ and upheld the regulation. finally, the court rejected retroactive application of a de minimis rule of reg. § 1.263a-11(e)(2) to the taxpayer, and denied the irs‘s counterclaim for capitalization of additional interest.  no pretzel in existence has as many twists and bends as does this opinion. a. but the regulation does not survive chevron analysis on appeal. dominion resources, inc. v. united states, 681 f.3d 1313 (fed. cir. 5/31/12). the court of appeals for the federal circuit (in an opinion by judge rader) reversed the court of federal claims decision upholding reg. § 1.263a-11(e)(1)(ii)(b), which requires that the capitalized cost of improvements under § 263a include both direct expenditures and the capitalized cost of interest (under the avoided cost rules) attributable to the basis of property temporarily removed from service in order to complete the improvements, by invalidating the regulation under step two of the chevron analysis. the majority of the federal circuit panel held that ―the regulation is unreasonable in defining ‗production expenditures‘ to include the adjusted basis of the entire unit,‖ because ―[t]he regulation directly contradicts the avoided-cost rule that congress intended the statute to implement.‖ the opinion illustrated the problem with the following example. for example, let‘s say an owner purchased real property for $100,000 by a loan with a 3% interest rate. a few years later, she made an improvement that cost $5,000. if she had used that $5,000 toward the debt instead of the improvement, she would have avoided accruing $150 in interest ($5,000 multiplied by 3%). the avoided-cost rule requires her to capitalize that $150 in interest. the treasury regulation, however, requires her to capitalize $3,150 in interest ($100,000 + $5,000 then multiplied by 3%). that result makes no sense, because there is no way that she could have avoided accruing $3,150 in interest by not making the improvement, as she did not expend or incur an amount equal to $105,000 when making the improvement.  the court went on to point out that ―[t]he only way that an amount equal to the adjusted basis could potentially satisfy the avoided-cost method is by assuming that the property owner would have sold the unit and used the sale proceeds to pay down the debt.‖ based on this analysis the court of appeals concluded that the court of federal claims erred by concluding that the regulation reflected a ―policy choice‖ by the agency and was thus permissible. 522 florida tax review [vol. 13:10  the majority also invalidated the regulation, as did the concurring opinion of judge clevenger, on the basis that it violated the requirement imposed by the supreme court in motor vehicle mfrs. ass’n of the united states, inc. v. state farm mut. auto. ins. co., 463 u.s. 29 (1983), that the agency must provide a reasoned explanation for adopting a regulation. ―state farm requires that the treasury ‗articulate a satisfactory explanation for its action, including a rational connection between the facts found and the choice made.‘‖ neither the preamble to the proposed regulations nor the preamble to the final regulations (nor notice 88-99, 1988-2 c.b. 422) provided any rationale for adopting the rule in the regulations; there was ―no explanation for the way that use of an adjusted basis implements the avoidedcost rule.‖ 4. proposed regulations restrict negative numbers in allocating indirect costs under the complicated ―simplified methods rules.‖ reg-126770-06, allocation of costs under the simplified methods, 77 f.r. 54482 (9/5/12). section 263a requires capitalization of all direct and indirect costs into goods produced during the year and inventory, so-called § 471 costs that must be included in inventory. section 263a costs may be allocated on a facts and circumstances basis, or the taxpayer may use the simplified resale or simplified production methods provided in reg. §§ 1.263a-2(b) and 1.263a-3(d) to allocate costs to eligible property produced or held for resale in lieu of a facts-and-circumstances allocation method. under the simplified method a pool of additional capitalized § 263a costs (indirect costs not otherwise includible in inventory under the taxpayer‘s method of accounting) may be allocated among ending inventory and costs of goods sold based on an ―absorption ratio‖ of such costs to the taxpayer‘s total § 471 inventory costs. in some circumstances the simplified method will produce negative amounts that cause distortions in inventory accounting, generally when a taxpayer capitalized a cost as an inventory cost that is greater than the amount required to be capitalized for tax purposes. proposed reg. § 1.263a-2(b) would, with certain exceptions, prevent taxpayers from using negative amounts in determining additional § 263a costs. producers with average annual gross receipts of less than $10,000,000 would be allowed to continue to include negative amounts in additional § 263a costs. retailers who use the simplified resale method would be permitted to remove inventory costs that are not required to be capitalized for tax purposes from ending inventory by treating them as negative additional § 263a costs.  the proposed regulations include a modified simplified production method that would allow producers to separately determine the allocation of preproduction related additional § 263a 2013] recent developments in federal income taxation 523 costs using a preproduction cost absorption ratio applied to capitalized inventory costs for raw materials.  as a sop for simplification, the proposed regulations would redefine a taxpayer‘s ―additional § 263a costs‖ for purposes of the simplified methods as costs, other than interest, that a taxpayer capitalized to its inventory in its financial statements. the definition would provide, however, that a taxpayer must include all direct costs in its § 471 costs regardless of the taxpayer‘s treatment of the costs in its financial statements. 5. tax expenditures for movies and television. the compromise tax relief act of 2010, § 744, extends the election under code § 181 to expense up to $15 million of qualified film and television production costs if 75 percent of total compensation is for services performed in the u.s. the limit is $20 million for production costs incurred in lowincome or distressed communities through 2011. a. final regulations come out just in time for the expiration date of the statute. t.d. 9551, deduction for qualified film and television production costs, 76 f.r. 60721 (9/30/11). section 181 provides for an election to deduct qualified film or television production costs incurred in productions commenced prior to 1/1/12, as an expense not chargeable to capital account in an amount up to $15 million for each production, or $20 million for production expenses incurred in certain low income or distressed county areas. a production qualifies for the election if at least 75 percent of the total compensation for the production is for services performed in the united states by actors, directors, producers, and production personnel. final regulations §§ 1.181-1 through -6, replacing temporary and proposed regulations, clarify the owner of production costs, the definition of aggregate production costs for purposes of the election and limitations, and provisions applicable to participations and residuals. b. temporary and proposed regulations update the rules. reg-146297-09, deduction for qualified film and television production costs, 76 f.r. 64879 (10/19/11). the temporary (temp. reg. §§ 1.181-0t, 1.181-1t) and proposed regulations clarify that the $15 million (or $20 million) limitation under amendments to § 181 applies to limit the aggregate deduction for production costs paid or incurred by all owners of a qualified film or television production for each qualified production, rather than limit the aggregate production costs. c. and now, ―final‖ final regulations after the provision expired. t.d. 9603, deduction for qualified film and television production costs, 77 f.r. 72923 (12/7/12). the final regulations (reg. §§ 1.181-0, 1.181-1) remove the temporary regulations, and provide 524 florida tax review [vol. 13:10 that whether production costs qualify for preor post-1/1/08 limitations, compensation to actors is allocated to first unit principal photography. d. thank dodd that special expensing rules for film and television productions were extended to 2012 and 2013. the 2012 taxpayer relief (and not so grand compromise) tax act, § 317, extends through the end of 2013 the election under code § 181 to expense up to $15 million of qualified film and television production costs if 75 percent of total compensation is for services performed in the u.s.  the limit is $20 million for production costs incurred in low-income or distressed communities; are any members of the film crew residents of those communities? c. reasonable compensation 1. non-limit limitations on excessive compensation to corporate officers. reg-137125-08, certain employee remuneration in excess of $1,000,000 under internal revenue code section 162(m), 76 f.r. 37034 (6/24/11). section 162(m) limits deductions for compensation to top corporate officers of publicly traded corporations to $1 million with an exception to performance-based compensation attributable to stock options and stock appreciation rights. proposed regulation § 1.162-27(e)(2)(iv) would require that performance-based compensation plans designate the maximum number of shares with respect to which options or rights may be granted to an individual employee during a specified period. the preamble to the proposed regulations indicates that the irs rejects assertions that specifying a limit is not necessary because such plans require shareholder approval as contrary to its interpretation of legislative history as requiring an objective formula for determining the maximum amount of compensation an employee could receive if the employee‘s performance goal is met. a. performance-based compensation is based in part on performance. rev. rul. 2012-19, 2012-28 i.r.b. 16 (6/25/12). the limitation of § 162(m) on deduction of employee compensation to an applicable employee by a publically held company to $1,000,000 does not apply to performance-based compensation. the irs rules that a corporate plan to pay dividends and dividend equivalents on restricted stock granted to an employee that vests on meeting performance goals is performance based compensation. however, dividends and dividend equivalents payable on restricted stock regardless of whether the employee meets performance goals does not qualify as performance-based compensation. the ruling cites reg. § 1.162-27(e)(2), which provides that performance-based compensation must be paid solely on account of pre2013] recent developments in federal income taxation 525 established performance goals based on an objective standard, on a grant-bygrant basis. 2. every time a reasonable compensation case is appealable to the seventh circuit, it seems that whoever the judge is, after doing the exacto bit to satisfy judge posner, he or she adds something like, ―and in any event it wasn‘t deductible because it wasn‘t intended to be compensation.‖ mulcahy, pauritsch, salvador & co. v. commissioner, t.c. memo. 2011-74 (3/31/11). the taxpayer, an accounting and consulting firm operating as a c corporation, made payments to three related entities owned by the three named principals of the corporation that essentially resulted in zeroing out the taxpayer‘s income for the year. the related entities performed no services for the taxpayer, and at trial the taxpayer claimed that the payments were deductible as compensation to the named principals, who did perform services for the taxpayer. the court (judge morrison) held that even if the payments were viewed as compensation to the named principals, the payments were not deductible. applying the ―hypothetical independent investor‖ test of exacto spring corp. v. commissioner, 196 f.3d 833 (7th cir. 1999), because the case was appealable to the seventh circuit, judge morrison found that the rate of return on the firm‘s equity was ―too low to create a presumption that the amounts claimed as ‗consulting fees‘ were reasonable compensation for the [principals‘] services.‖ because the taxpayer presented no other relevant evidence that the payments were reasonable in amount, the deduction was disallowed. judge morrison added that besides being reasonable in amount, to be deductible the payment must be intended to be compensation, and the payments in question were not intended to be compensation. [the firm] intended for the payments to the related entities to distribute profits, not to compensate for services. . . . salvador chose the amount to pay each year so that the payments distributed all (or nearly all) accumulated profit for the year. he did this for tax planning purposes. each [principal‘s] percentage of the payments to the related entities was tied to hours worked, but the firm‘s intent in making the payments was to eliminate all taxable income. the firm did not intend to compensate for services.  accuracy related penalties were upheld, with judge morrison taking special note of the fact that the taxpayer was an accounting firm. a. and judge posner agrees adding ―[t]hat an accounting firm should so screw up its taxes is the most remarkable feature of the case.‖ mulcahy, pauritsch, salvador & co. v. commissioner, 680 f.3d 867 (7th cir. 5/17/12). the seventh circuit (judge posner) 526 florida tax review [vol. 13:10 affirmed the tax court, holding that the consulting fee payments to the three related entities owned by the three named principals of the c corporation, did not constitute deductible compensation but, instead, constituted a return on invested capital, i.e., dividends. this is because the taxpayer corporation was not ―a pane of glass‖ between the billings of a typical small professional services firm and the salaries of its professionals where the amount of capital invested is negligible. here, the taxpayer corporation had 40 employees in multiple branches, so the amount of invested capital was relatively large, and the consulting fees constituted a return on that invested capital. judge posner noted that treating the consulting fees as salary expenses, which reduced the firm‘s return to equity to zero even though the firm was ―doing fine,‖ flunked the independent-investor test.  during the course of the opinion, judge posner managed to chide taxpayer‘s lawyers for ―appear[ing] not to understand the difference between compensation for services and compensation for capital.‖ he also chided taxpayer‘s expert witness for using ―firm income per partner‖ of comparable accounting firms without ―divid[ing] firm income per partner into salary and dividend components,‖ which rendered his testimony ―irrelevant.‖  judge posner noted his ―puzzlement‖ that the firm did not organize as a pass-through entity, but noted that it had to accept the consequences of its entity choice, ―that in this case include[d] a large tax deficiency and a hefty penalty.‖  see pediatric surgical assocs., p.c. v. commissioner, t.c. memo. 2001-81 (relating to the non-deductibility of compensation paid to shareholder employees derived from earnings resulting from the efforts of non-shareholder professionals).  shades of charles mccandless tile service v. united states, 191 ct. cl. 108, 422 f.2d 1336 (ct. cl. 1970). it held that 15 percent of profits (before stockholders‘ salaries) should be considered as a dividend, and should reduce the deduction for salaries paid accordingly. that case aroused a great deal of interest when it first came out, and led to all sorts of closely held corporations paying out dividends of about $1,000 per year to establish a history of paying dividends. d. miscellaneous deductions 1. standard mileage rate rules published in a revenue procedure while the amounts will be disclosed in a separate notice. rev. proc. 2010-51, 2010-51 i.r.b. 883 (12/3/10). the irs indicated that beginning in 2011 it will publish mileage rates in a separate annual notice. the revenue procedure indicated that a taxpayer may use the business standard mileage rate to substantiate expenses for business use of an 2013] recent developments in federal income taxation 527 automobile in lieu of fixed and variable costs. parking fees and tolls are deductible as separate items. the basis of an automobile used for business is reduced by a per-mile amount published in the annual notice. separate rates are provided both for charitable use of an automobile and medical and moving use of an automobile. the revenue procedure also provides details for treating as substantiated a fixed and variable rate allowance for expenses incurred by an employee in driving an automobile owned or leased by the employee in performing services for the employer. a. standard mileage rates for 2012. notice 2012-1, 2012-2 i.r.b. 260 (12/9/11). the standard mileage rate for rolling the tires after 1/1/12 remains at 55.5 cents (23 cents representing depreciation). the mileage rate for charitable service is 14 cents, and for medical care or moving expenses the rate is slightly down to 23 cents. the maximum standard automobile cost for computing the allowance under a fixed and variable rate (favr) plan is $28,000 for automobiles and $29,300 for trucks and vans. b. add one cent per mile for 2013 (except for charitable service). notice 2012-72, 2012-50 i.r.b. 613 (11/21/12). the standard mileage rate for business miles in 2013 goes up to 56.5 cents per mile (with 23 cents representing depreciation), and the medical/moving rate goes up to 24 cents per mile. the charitable mileage rate remains fixed by § 170(i) at 14 cents. c. the irs announces per diem rates for travel away from home. notice 2012-63, 2012-42 i.r.b. 496 (9/26/12). per diem reimbursement rates in lieu of substantiated expenses under rev. proc. 2011-47, 2011-42 i.r.b. 520, effective for travel after 10/1/12, are unchanged from 2011. one revision, however, removes transportation expenses between points, lodging and meals, and mailing expense for travel vouchers from incidental expenses, so that these items may be separately reimbursed for travelers using the per diem method. per diem rates are as follows:  the special meals and incidental rates for the transportation industry are $59 within conus and $64 oconus.  incidental expense deduction for any location is $5 per day (the irs believes in cheap tippers).  rates for travel within conus are $242 per day for high cost localities (listed in the notice) and $163 for all others. the portion allowed for meals is $65 in a high-cost locality and $52 for others. d. rev. rul. 2012-27, 2012-41 i.r.b. 435 (10/4/12). the irs has provided standard industry fare level cents-per-mile 528 florida tax review [vol. 13:10 and terminal charges for the second half of 2012 for determining the value of non-commercial flights on employer provided aircraft. under reg. § 1.6121(g) the value of a non-commercial flight is determined by multiplying the standard industry fare cents-per-mile rate by the applicable aircraft multiple and adding the applicable terminal charge. 2. the empire strikes back against the ―millennium plan.‖ goyak v. commissioner, t.c. memo. 2012-13 (1/11/12). the individual husband and wife taxpayers‘ wholly owned corporation, goyak & associates, contributed $1.4 million to a purported § 419a(f)(6) employee welfare benefit plan, known as the ―millennium plan,‖ of which the taxpayer husband was the sole beneficiary with respect to goyak & associates, and goyak & associates claimed a § 162 deduction. the tax court (judge goeke) held that the amount was a constructive dividend to mr. goyak, rather than a deductible ordinary and necessary business expense. the covered employee, i.e., mr. goyak, in the plan was able to (1) freely void his participation in the plan and have the life insurance policy maintained by the plan distributed to him, or (2) receive life benefits at a time of his choosing by ―timing‖ a severance event. a 20 percent § 6662 accuracy-related penalty was upheld. 3. reimbursement insurance is really a deposit. f.w. services, inc. v. commissioner, 459 fed. appx. 389 (5th cir. 1/25/12). the taxpayer, a temporary personnel agency, purchased insurance policies to cover workers compensation and employer‘s liability. the policies required the taxpayer to reimburse the insurer up to $500,000 for each claim. to provide evidence of financial responsibility to the insurer, the taxpayer entered into a second ―insurance‖ contract to cover the reimbursement obligation. the second contract provided for an estimated premium of $3.9 million. the actual premium would be determined at the end of the policy year and provided for an increase or decrease in the amount owed depending upon experience. the taxpayer claimed a § 162 deduction for the full premium. upholding the tax court, the circuit court agreed with the irs position that the premium paid was a non-deductible deposit on the taxpayer‘s potential reimbursement liability under the first policy. the court added that funds set aside for future reimbursement did not constitute insurance as there was no shift in the risk of loss. 4. family commune farm provides deductible meals and medical care to its members. stahl v. united states, 861 f. supp. 2d 1226 (e.d. wash. 3/20/12), on remand from 626 f.3d 520 (9th cir. 2010). the stahl family (consisting of eight siblings and spouses plus children numbering 65 people) maintains a hutterite colony engaged in farming on 2013] recent developments in federal income taxation 529 30,000 acres selling potatoes and dairy products. as participants in a § 501(d) nonprofit apostolic corporation, each member pays personal income tax on the member‘s pro rata share of the corporation‘s income, determined after allowable deductions. in a claim for refund the taxpayers asserted that their share of the corporate income should be reduced by deductions for the cost of meals and payments for a health plan maintained by the corporation. on remand from the ninth circuit determination that the taxpayers were employees of the corporation, the district court upheld the taxpayers‘ assertion that the corporate income of the colony is reduced by deductions for meals and the health plan. the court noted that it was necessary within the meaning of § 162 to maintain employees on the farm around the clock to maintain the dairy herd and found that food and medical care represented compensation to the employee family members who performed the work of the farm. the court stated that it was appropriate to treat the food and medical care as a form of ―other compensation‖ deductible within the meaning of § 162(a)(1). the court also held that the medical insurance purchased by the corporation was a health plan within the meaning of reg. § 1.106-1, excludable from income of the employee and deductible under reg. § 1.162-10. the court rejected the irs‘s argument that the food and health care were not deductible as personal expenses. 5. don draper likely would have tried to take advantage of this rule had it been around when he was renting hotel rooms in nyc. reg–137589–07, local lodging expenses, 77 f.r. 24657 (4/25/12). prop. reg. § 1.162-31 would allow a deduction for local lodging, i.e., lodging while the taxpayer is not away from home, in carrying on a taxpayer‘s trade or business (whether or not as an employee) under a ―facts and circumstances‖ test. one factor is whether the taxpayer incurs the expense because of a bona fide condition or requirement of employment imposed by the taxpayer‘s employer. (for employees the question usually is whether the employer-paid lodging is a working condition fringe benefit.) the proposed regulations provide a safe harbor for local lodging at business meetings and conferences. the examples indicate that there must be a bona fide business reason for the overnight stay, and, if provided by an employer, there must be a substantial noncompensatory reason. the regulations will be effective upon final publication, but pending finalization, taxpayers may rely on the proposed regulations.  we foresee a deluge of future tax court cases involving deductions claimed for nights (or mid-day stays) at a host of no-tell motels. 6. flying is entertainment, at least in the corporate aircraft. t.d. 9597, 77 f.r. 45480 (8/1/12), corrected, 77 f.r. 50373 (8/21/12). the treasury department has promulgated final regulations 530 florida tax review [vol. 13:10 revising reg. § 1.61-21(g)(14) and adding reg. §§ 1.274-9 and 1.274-10, in addressing the disallowance of expenses under § 274(a) incurred in the use of taxpayer owned aircraft for entertainment. under the regulations both fixed and variable expenses, including depreciation and interest expense, attributable to the use of taxpayer owned aircraft for entertainment are disallowed. expenses are allocated on the basis of occupied seat miles or hours for entertainment travel relative to total seat miles or hours of aircraft use, or on a flight-by-flight basis. expenses attributable to deadhead flights returning empty from an entertainment flight are included in the calculation. the treasury department rejected suggestions that expenses be determined on the basis of the primary purpose of a specific flight. depreciation for the purpose of determining entertainment expenses may be calculated on a straight-line basis regardless of the depreciation method used by the taxpayer for other purposes. aircraft with similar cost profiles that have the same type and number of engines can be aggregated in determining expenses allocable to use of the aircraft for entertainment. the regulations do not permit aggregation of the costs of all aircraft operated by the taxpayer. expenses incurred for entertainment flights of specified employees (officers, directors, 10 percent owners) are excepted from disallowance under § 274(e)(2) only to the extent included in income as compensation by the recipient. expenses in excess of the amounts included in income are disallowed. also, expenses incurred to provide entertainment flights in taxpayer owned business aircraft to meet security concerns (which are excludable from the recipient‘s income as a fringe benefit) remain disallowed as deductions under § 274(a). the loss disallowance rules do not apply to expenses incurred by a commercial airline providing entertainment flights to ―specified individuals‖ on a regularly scheduled flight on which 90 percent of the seats are offered for sale to the general public to the extent the entertainment flight is includable in the gross income of the specified individual. 7. the one who eats the food may not get the haircut: proposed regulations allocate the § 274(n) limitations with respect to reimbursed meals. reg-101812-07, reimbursed entertainment expenses, 77 f.r. 45520 (8/1/12). section 274(n) limits otherwise allowable deductions for meals and entertainment to 50 percent of the expense. in the case of reimbursed meal or entertainment expenses that are not treated as income to the payor, § 274(e)(3) applies the limitation to the person claiming a deduction for the reimbursement. in transport labor contract/leasing, inc. v. commissioner, 461 f.3d 1030 (8th cir. 2006), the court held that in a three-party reimbursement arrangement the § 274 limitation applied to the client who reimbursed an employee leasing company for meal expenses paid by the leasing company employer to contract truck drivers who were leased to a trucking company. the eighth circuit‘s opinion defined reimbursement 2013] recent developments in federal income taxation 531 arrangements by reference to definitions of an employer‘s accountable plan under § 62(a)(2)(a) and reg. § 1.62-2. the proposed regulations would provide an independent definition of a reimbursement or expense allowance arrangement independent of the rules of § 62(a)(2)(a) and (c). prop. reg. § 1.274-2(f)(2)(iv)(a)(d) would define a reimbursement arrangement as one under which an employee or independent contractor receives an advance, allowance, or reimbursement from an employer, client, or contractor for expenses incurred by the recipient. a reimbursement plan involving payments to an independent contractor would have to be memorialized in a written agreement that identifies the party subject to the § 274 limitations.  in the case of an employer, the limitations of § 274 apply to the employer‘s deduction of reimbursed expenses, except to the extent that the employer treats the reimbursement or other payment as compensation paid to the employee and wages for withholding purposes.  in case of reimbursements to an independent contractor, the limitations apply to the independent contractor to the extent that the independent contractor does not account to the client or customer for meals and entertainment expenses under the substantiation rules of § 274(d). where the independent contractor accounts for meal and entertainment expenses, the limitations are applicable to the client or customer. the person responsible for the § 274 limitations can be specified in a written agreement between the parties.  the preamble to the proposed regulations and proposed examples indicate that in a multiple party arrangement each relationship will be treated as a two-party relationship subject to the independent contractor rules, which thus would impose the § 274 limitations upon the party that reimburses expenses substantiated to it by another party. again, persons in multiparty reimbursement arrangements would be permitted to specify by agreement which party is subject to the § 274 limitations. 8. cincinnati is one big metropolitan area. saunders v. commissioner, t.c. memo. 2012-200 (7/17/12). the taxpayer worked for a single employer, had no principal place of business, and travelled directly from home to temporary work sites located between 74 and 96 miles away. the taxpayer lived in manchester, ohio [more than 70 miles away from cincinnati], and indicated that his ―main area‖ was cincinnati. the tax court (judge thornton) refused to allow the taxpayer‘s claimed deductions for travel away from home as expenses incurred for travel outside the metropolitan area where the taxpayer lives and normally works. the court noted that the term ―metropolitan area‖ is ill defined, but concluded under the facts and circumstances that the taxpayer failed to establish that any of the temporary worksites to which the taxpayer travelled were outside of the cincinnati metropolitan area; the two worksites identified in the opinion were 20 and 31 miles away from downtown cincinnati, but were located 532 florida tax review [vol. 13:10 within the cincinnati-middletown, oh-ky-in metropolitan statistical area as defined in omb bulletin no. 08-01 (nov. 20, 2007). 9. the tax court strikes a blow to the travel expense of two-earner couples. noz v. commissioner, t.c. memo 2012272 (9/24/12). the court (judge morrison) disallowed travel expense deductions to married taxpayers who worked as university professors, one in new york, one in stockholm. although the married taxpayers collaborated with each other on articles and books, the court held, ―on the basis of the frequency of travel, the personal relationship between the petitioners, and the petitioners‘ failure to offer any evidence, beyond broad generalities, of how the trips advanced any stated business purpose, we find that the new yorkstockholm trips were motivated primarily by personal concerns.‖ 10. selling insurance is a service business not allowed a cost of goods sold, even to a former irs agent. perry v. commissioner, t.c. memo. 2012-237 (8/16/12). along with denying unsubstantiated travel and business expenses (including $3,000 to an airline employee to be designated her ―travel companion‖ for discounted airfare), the tax court (judge kroupa) held that the taxpayer‘s business of selling insurance was not the sale of a material product to which direct cost may be allocated to reduce gross receipts as cost of goods sold. 11. irs tries to put a lid on wages recharacterized as reimbursements. rev. rul. 2012-25, 2012-37 i.r.b. 337 (9/10/12). the irs ruled that certain employer arrangements that substitute reimbursement for tools, travel, supplies and the like under a purported ―accountable plan‖ for compensation for services do not meet the business connection requirement of § 62(c) and therefore fail as accountable plans. the irs noted that such plans are intended to avoid the two-percent limitation on deduction of employee business expenses and payment of employment taxes on wages that are recharacterized as reimbursements. citing reg. § 1.62-2(d), the ruling indicates with three factual situations that the business connection requirement is not met where hourly compensation is reduced and replaced with a reimbursement arrangement that pays the same gross amount to the employee regardless of whether the employee incurs deductible business expenses. the ruling states that the fact that the employee actually incurs a deductible expense in connection with employment does not cure the wage recharacterization. second, a plan that pays the same amount of reimbursement to employees who have not actually incurred deductible expenses in connection with the employer‘s business fails the business connection requirement. in situation 4 of the ruling, the irs indicates that a plan that reduces hourly compensation, but only reimburses employees who 2013] recent developments in federal income taxation 533 incur expenses in connection with the employer‘s business and who are required to substantiate expenses, qualifies as a reimbursement plan notwithstanding substitution for the reimbursement plan for a portion of the hourly compensation. 12. texas professors denied bad debt deductions for related entity loans. herrera v. commissioner, t.c. memo. 2012-308 (11/5/12). the tax court (judge wherry) denied business bad debt deductions under § 166 for advances by one llc to its sister, both of which were owned by two university of texas el paso engineering professors who used the llcs for consulting and metal fabrication activities. citing the 13 factors identified by the fifth circuit in texas farm bureau v. united states, 725 f.2d 307 (5th cir. 1984), the court found that advances were not bona fide debt, stressing the lack of a promissory note, the lack of a definitive maturity date, the lack of a repayment schedule, de facto subordination of the debt to other creditors, the absence of a requirement for security, and the fact that the source of payment was tied to the fortunes of the business. the court stressed the fact that no interest was paid as being particularly important. 13. friends from the cheers bar don‘t provide business bad debt deductions until all hope is gone. alioto v. commissioner, 699 f.3d 948 (6th cir. 11/7/12). after the taxpayer hired john ratzenberger (famous for his role in cheers) he entered into a business venture with ratzenberger to use celebrity talent in short form media to be sold as internet advertising. the taxpayer contended that he expected to be fully reimbursed for advances of his own money to the venture. affirming the tax court (t.c. memo. 2011-151), the sixth circuit (judge moore) denied business bad debt deductions because the taxpayer failed to meet his burden of proof that his losses were no longer subject to a reasonable prospect of recovery. the court rejected the taxpayer‘s testimony that he had received an e-mail from ratzenberger‘s agent notifying the taxpayer that no further reimbursement would be forthcoming as insufficient proof, nor did the court accept the fact that the taxpayer filed bankruptcy as evidence that the debt was not recoverable. the court also denied the taxpayer‘s claim for a theft loss on the ground that there was no proof that ratzenberger‘s actions amounted to larceny under massachusetts law. 14. the ceo and sole shareholder of a janitorial corporation used cocaine as a chick magnet, but can the corporation deduct the cleanup costs? held, the price paid for the cocaine overdose death of the boss‘s girlfriend is not a deductible corporate business expense. cavanaugh v. commissioner, t.c. memo. 2012-324 (11/26/12). james cavanaugh the ceo and sole shareholder of jani-king international took a holiday trip to the cavanaugh‘s villa in st. maarten with his 27 year534 florida tax review [vol. 13:10 old girlfriend, a body guard, and another female jani-king employee. unfortunately the girlfriend died from an overdose of cocaine. the girlfriend‘s mother sued the individuals and the corporation for wrongful death. the taxpayer‘s s corporation paid the full amount of the settlement, including a $250,000 reimbursement to cavanaugh and claimed a business expense deduction. the tax court (judge holmes) began its opinion in this case submitted under tax court rule 122 2 as follows: twenty-seven-year-old colony anne (claire) robinson left texas in november 2002 for a thanksgiving vacation in the caribbean with her boyfriend, his bodyguard, and another employee of the company that he had spent decades building. she did not return home alive. the coroner‘s report showed a massive amount of illegal drugs in her body and concluded that they were the likely cause of her death. robinson‘s mother sued the boyfriend and his company for wrongful death. the parties settled. the company paid most of the $2.3 million settlement directly; the boyfriend contributed $250,000, which the company then reimbursed.  siding with the irs, judge holmes looked to the origin of the claim, which the court held to be applicable to the corporation‘s payment in settlement of the wrongful death claim. the court concluded that although the claim related to the conduct of the three corporate employees, the conduct was not related to the corporate business, i.e., its profitseeking activities. the court also rejected the taxpayer‘s theory that the bodyguard supplied cocaine in the course of his employment as a bodyguard and enabler for the ceo. further, the court rejected the taxpayer‘s argument that reimbursement of the taxpayer‘s contribution to the settlement was contractually required under a corporate indemnity agreement. in addition, the court found that the payment was not deductible under the theory that it was 2. rule 122. submission without trial (a) general: any case not requiring a trial for the submission of evidence (as, for example, where sufficient facts have been admitted, stipulated, established by deposition, or included in the record in some other way) may be submitted at any time after joinder of issue (see rule 38) by motion of the parties filed with the court. the parties need not wait for the case to be calendared for trial and need not appear in court. (b) burden of proof: the fact of submission of a case, under paragraph (a) of this rule, does not alter the burden of proof, or the requirements otherwise applicable with respect to adducing proof, or the effect of failure of proof. 2013] recent developments in federal income taxation 535 made to protect the corporation‘s business reputation because there was no evidence that underlay that theory. 15. puerto rico may not be a state, but it‘s part of the u.s.a. for § 199 domestic production purposes. the 2012 taxpayer relief (and not so grand compromise) tax act, § 318, extends inclusion of manufacturing and production activities in puerto rico as domestic production activities for purposes of the § 199 domestic production activities deduction for the first eight years of a taxpayer beginning after 12/31/05 and before 1/1/14. previously § 199 applied to the first six years of a taxpayer beginning after 12/31/05 and before 1/1/12. 16. extended power to empowerment zones. the 2012 taxpayer relief (and not so grand compromise) tax act, § 327, extends designations of empowerment zones through 12/31/13. the designations, which were set to expire on 12/31/11, extends a 20 percent wage credit under § 1396, additional $35,000 of first year expensing under §179, tax-exempt bond financing under § 1394, and capital gains deferral on replacement of qualified assets under § 1397b. e. depreciation & amortization 1. no chickening out of the allocation agreement in an applicable asset acquisition — even after a cost segregation study. peco foods, inc. v. commissioner, t.c. memo. 2012-18 (1/17/12). the taxpayer entered into an agreement with the sellers of two poultry processing plants that allocated a large portion of the purchase price to processing plants on which the taxpayer claimed depreciation deductions as nonresidential real property with a macrs life of 39 years. the agreements separately listed an agreed upon price for machinery and equipment. subsequently, after a cost segregation study, the taxpayer attempted to change its method of accounting to separate out components of the plants as equipment and machinery and claim accelerated depreciation on the basis of shorter macrs recovery periods. the tax court (judge laro) held that under commissioner v. danielson, 378 f.2d 771, 775 (3d cir. 1967) and § 1060, unless the taxpayer could show fraud, undue influence, duress, etc., the taxpayer was bound by the purchase price allocation agreement. the court rejected the taxpayer‘s argument that nothing in § 1060 precluded the taxpayer from segregating components of assets broadly described as a production plant into components consisting of the real property and related equipment and machinery. the court also refused to accept the taxpayer‘s assertion that the agreements with the sellers should be disregarded because the use of the terms ―processing plant building‖ and ―real property improvements‖ were ambiguous. finally the court agreed with the irs that the irs did not abuse 536 florida tax review [vol. 13:10 its discretion in prohibiting the taxpayer from adopting depreciation schedules that were inconsistent with the terms of the purchase agreements. 2. new accounting and disposition rules for macrs property. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11), and reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81128 (12/27/11). the capitalization and repair regulations (discussed above) provide significant new rules for the maintenance of multiple asset accounts and disposition of property from macrs single and multiple asset accounts.  accounting for macrs property. consistent with prior rules under reg. § 1.167-7, temp. reg. § 1.168(i)-7t allows taxpayers to account for macrs property in a single asset account or by combining multiple assets in a multiple asset account. assets in a multiple asset account must have been placed in service in the same taxable year, and have the same recovery period and convention. assets that are subject to different recovery rules or special limitations, such as automobiles, assets subject to additional first year recovery, or property used partly for personal purposes, may not be combined with assets subject to different recovery provisions. assets with the same recovery periods and conventions may be combined in a multiple asset account even if the assets have different uses. in addition, the taxpayer is permitted to use as many single and multiple asset accounts as the taxpayer may choose.  dispositions. temp. reg. § 1.168(i)8t(d) defines a disposition of macrs property as occurring when the asset is transferred or permanently withdrawn from use in the taxpayer‘s trade or business or from the production of income. thus, a disposition includes the sale, exchange, retirement, abandonment, or destruction of an asset. significantly, the definition of disposition is expanded in the temporary regulation to include the retirement of a structural component of a building.  gain or loss. gain or loss on the sale, exchange or conversion of an asset is determined under applicable tax principles. loss on abandonment is determined from the ―adjusted depreciable basis‖ of the asset (basis adjusted for depreciation). temp. reg. § 1.168(i)8t(d). recognized loss on other dispositions is the excess of the adjusted depreciable basis of the asset over fair market value. identification of the asset disposed of from a multiple asset account, and its basis, is generally determined from the taxpayer‘s records. temp. reg. § 1.168(i)-8t(e) & (f). the temporary regulations provide rules for identifying assets if the taxpayer‘s records do not do so; a first-in first-out method, a modified fifo method, a mortality dispersion table method, or any other method designated by the irs. the asset cannot be larger than a unit of property. in case of a disposition of a structural 2013] recent developments in federal income taxation 537 component of a building, the structural component is the asset disposed of. an improvement placed in service after the asset is treated as a separate asset provided that it is not larger than the unit of property. temp. reg. § 1.168(i)8t(c)(4)(ii)(e). disposition of an asset in a single asset account terminates depreciation for the asset as of the time of the disposition. disposition of an asset in a multiple asset account removes the asset from the account as of the beginning of the year of disposition, requires separate depreciation for the asset in the year of disposition, and reduction of the depreciation reserve of the multiple asset account by the unadjusted basis of the disposed asset as of the first day of the taxable year of the disposition. temp. reg. § 1.168(i)-8t(g).  general asset accounts. consistent with prior reg. § 1.168(i)-1, the temporary regulations provide for an election to group assets into one or more general asset accounts. temp. reg. § 1.168(i)1t(c)(2) provides for grouping assets in a general asset account as long as the assets have been placed in service in the same taxable year and have the same recovery period and convention. assets that are subject to different recovery rules or special limitations, such as automobiles, assets subject to first year recovery, or property used partly for personal purposes, may not be combined with assets subject to different recovery provisions. the temporary regulations do not include the requirement of prior regulations that general asset accounts include only assets in the same asset class. assets eligible for additional first year depreciation deductions must be grouped with assets eligible for the same first year depreciation deductions and may not be grouped with assets not eligible for additional first year depreciation. temp. reg. § 1.168(i)1t(c)(2)(ii)(d) & (e). the temporary regulations expand existing rules for dispositions of assets from a general asset account to encompass as a disposition the retirement of a structural component of a building. as under existing rules, the temporary regulations treat the basis of any asset disposed of from a general asset account as zero, and any amount realized results in ordinary gain. the taxpayer continues to deprecate assets in the general asset account as if no disposition occurred. temp. reg. § 1.168(i)-1t(e)(2). however, consistent with existing regulations, the temporary regulations allow a taxpayer to elect to terminate general asset account treatment on disposition of an asset in a qualifying disposition, in which case gain or loss is recognized under the rules of temp. reg. § 1.168(i)-8t. the list of qualifying dispositions is expanded generally to include any disposition. temp. reg. § 1.168(i)1t(e)(3). in addition, general asset accounts are terminated in certain nonrecognition dispositions and on termination of a partnership under § 708(b)(1)(b). gain or loss may also be recognized on disposition of all of the assets, or the last asset, in a general asset account. temp. reg. § 1.168(i)1t(e)(3)(ii). a. irs specifies the procedures for adopting new accounting methods under the temporary regulations relating to 538 florida tax review [vol. 13:10 depreciation of tangible property. rev. proc. 2012-20, 2012-14 i.r.b. 700 (3/7/12), modifying rev. proc. 2011-14, 2011-1 c.b. 330. the irs has provided lengthy and detailed rules regarding automatic changes in methods of accounting under temp. reg. §§ 1.167(a)-4t (amortizing or depreciating leasehold improvements), 1.168(i)-1t (rules for general asset accounts), 1.168(i)-7t (accounting for macrs property), and 1.168(i)-8t (dispositions of macrs property), all added by t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11). the automatic change of accounting method of rev. proc. 2011-14, 2011-1 c.b. 330, is applicable to property placed in service in a taxable year ending after 12/29/03. with respect to assets placed in service in a taxable year ending before 12/30/03, adopting the methods of the temporary regulations requires an amended return for open years including the placed-in-service years and all subsequent years. no § 481 adjustment is required or permitted with respect to the amended returns. b. lb&i provides guidance under rev. proc. 2012-20. lb&i-4-0312-004 (3/15/12). this directive to the field applies to taxpayers who adopted a method of accounting relating to the conversion of capitalized assets to repair expense under § 263(a). c. have your clients been wasting time trying to comply with the temporary regulations in 2012? yes, they have. further guidance announcing that pending final regulations will apply only in years beginning in 2014 and thereafter. notice 2012-73, 2012-51 i.r.b. 713 (11/20/12). the irs announced that pending final regulations will apply to taxable years beginning on or after 1/1/14, but that taxpayers will be permitted to apply the final regulations to taxable years beginning on or after 1/1/12. the notice also indicates that the temporary regulations may be revised with respect to the de minimis rule of § 1.263(a)2t(g); dispositions under §§ 1.168(i)-1t and 1.168(i)-8t; and the safe harbor for routine maintenance under § 1.263(a)-3t(g). d. technical amendments to revise the temporary regulations. more important, the effective date of the 12/27/11 temporary regulations is delayed to years beginning on or after 1/1/14, with optional retroactive applicability. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 77 f.r. 74583 (12/17/12). e. this announcement amends regulations — really!!?? announcement 2013-7, 2013-3 i.r.b. 308 (1/14/13). an announcement amending regulations — the temporary regulations (t.d. 2013] recent developments in federal income taxation 539 9564), regarding the deduction and capitalization of expenditures under §§ 162(a) and 263(a) relating to tangible property to apply to taxable years beginning on or after 1/1/14, while permitting taxpayers to apply the temporary regulations for taxable years beginning on or after 1/1/12, and before the applicability date of the final regulations. 3. more trouble for cost segregation studies in an opinion from a self-described ―high plains drifter‖ (in which judge holmes does to the taxpayer something like what the stranger did to callie travers). should the determination be made by comparison with a typical apartment building, or should it be made by comparison with a generic shell building? amerisouth xxxii, ltd. v. commissioner, t.c. memo. 2012-67 (3/12/12). the tax court (judge holmes) rejected the taxpayer‘s attempt to use a cost segregation study to break down an apartment building and office complex into numerous components subject to macrs cost recovery other than the 27.5 year straight line recovery attributable to residential real estate, in the process describing himself as a lone rider over the ―llano estacado.‖ the court described the property as ―apartment buildings with over a thousand pieces of tangible personal property that just happen to be attached.‖ following a renovation, the taxpayer‘s cost segregation study broke down the property into several categories including site preparation and earthwork; water-distribution system; sanitary-sewer system; gas line; site electric; special hvac; special plumbing; special electric; finish carpentry; millwork; interior windows and mirrors; and special painting. the court rejected the irs‘s argument that the taxpayer did not own a depreciable interest in the water and electric utility lines and gas distribution systems crossing the property in utility owned easements, but agreed with the irs that the taxpayer did not have a depreciable ownership interest in the sewer lines on the property. the court rejected the taxpayer‘s assertion that site preparation costs were segregated depreciable assets subject to 15 year recovery saying that the taxpayer failed to overcome the presumption that the irs correctly determined that the site preparation costs were non-depreciable improvements to land. the taxpayer failed to provide evidence that some of the costs were attributable to depreciable sidewalks, parking and driveways. after a lengthy analysis of rulings and case law, the court concluded that costs of installing water, gas, and electrical distribution systems between utility mains and the numerous buildings in the apartment complex constituted structural components of the buildings and thus were not subject to shorter macrs recovery. turning to the building itself, judge holmes rejected the taxpayer‘s argument that the baseline for distinguishing structural components of the building from tangible personal property was an unfinished building shell suitable for being finished for a variety of purposes, instead agreeing with the irs that the baseline was a typical apartment building. applying this standard, judge 540 florida tax review [vol. 13:10 homes found that the only tangible personal property was the garbage disposals, dryer-dedicated venting having no connection to the general ventilation system, 220 amp power outlets dedicated to stoves, and 110 amp power outlets dedicated to refrigerators. all of the following were structural components of the buildings: venting connected to apartment stove hoods and hvac systems, connecting plumbing, sinks, plastic wash tubs, laundry room drains, and gas lines (excepting individual gas line connectors to dryers and stoves), recessed lights, paddle fans with recessed lights, and wall outlets, finish carpentry (shelves, paneling, molding and the like), interior windows and mirrors, and special painting. in reaching all of these conclusions, the court refused to apply the holding in hospital corp. of america v. commissioner, 109 t.c 21 (1997), which allowed segregation of certain rapidly depreciable tangible personal property that was not an inherently permanent structural component from the structural components of the hospital buildings in question in that case.  some have suggested that the precedential value of this decision might be limited because of the procedural aspects described by the court as follows: amerisouth sold garden house about the time the case was tried, and stopped responding to communications from the court, the commissioner, and even its own counsel. we suspended briefing in an attempt to figure out what was going on and ended up ordering amerisouth to show cause why its attorneys should not be allowed to withdraw from its case. without any response to the court, we granted the attorneys‘ motion to withdraw and so amerisouth has been left representing itself. the court then ordered amerisouth to file a posttrial brief, which it never did. because the court ordered a posttrial brief and amerisouth didn‘t file one, we could dismiss this case entirely. …. despite amerisouth‘s lack of response and mysterious disappearance, however, we will not do so. we will, though, deem any factual matters not otherwise contested to be conceded.  on the other hand, it is a decided tax court case, and according to rumor, this case presages further tax court interest in the cost segregation studies area. 4. shockwave‘s shocking mechanical defects fail to hook go zone bonus depreciation. blakeney v. commissioner, t.c. memo. 2012-289 (10/15/12). in february 2006 the taxpayer took possession of a new $3.9 million charter fishing yacht, shockwave, to be based in https://checkpoint.riag.com/app/main/doclinknew?usid=684591fd06d&docid=i05c413d4331911dda252c7f8ee2eaa77&srcdocid=t0newsltr%3a612431.1dr7&feature=tnews&lastcpreqid=1723821 2013] recent developments in federal income taxation 541 orange beach, alabama, a city within the gulf opportunity zone. unfortunately multiple mechanical difficulties forced the boat to be tied up for repairs in the caribbean until october 2006 when it was delivered to orange beach. unfortunately, the fishing season ended in september so that the etaxpayer was not able to charter the boat in orange beach during the remainder of 2006. the taxpayer did, however, manage to charter the boat in the caribbean for 43 days between repairs. the 50 percent bonus depreciation deduction of § 1400n is available for property placed in service after 8/28/05, substantially all of the use of which in the active conduct of a trade or business is in the gulf opportunity zone. the court (judge vasquez) held that the 74 days during which the boat was available for charter in orange beach constituted use within the go zone, even though the boat was not hired for charter during that period. the court also held that the boat was not available for use during the time it was laid up for repairs. however, the court treated the 43 days of charter service in the caribbean as use outside of the go zone and held that the 63 percent use (74/117) within the go zone was not substantially all under § 1400n(d)(2)(a)(ii). the court indicated that it was not necessary to address whether the 80 percent use requirement of notice 2006-77, 2006-2 c.b. 590, was entitled to deference under skidmore v. swift & co., 323 u.s. 134 (1944). 5. first year bonus depreciation extended for one year by the 2012 taxpayer relief (and not so grand compromise) tax act. the first year bonus depreciation of 50 percent of adjusted basis of property with a macrs recovery period of 20 years or less is extended to property placed in service before 1/1/14 and to certain transportation property placed in service before 1/1/15. the 50 percent allowance is available for depreciable machinery and equipment and most other tangible personal property, and is available for computer software and certain leasehold improvements, the first use of which began with the taxpayer. the 2012 act also extends the provisions in § 168(e)(3)(e) treating qualified leasehold improvement property and qualified restaurant property as 15 year property, also eligible for the first year bonus depreciation. 6. section 179 limits are extended again — is this becoming permanent like research credits? the 2012 taxpayer relief act, § 315(a) retroactively extended, the code § 179 first year expensing for tax years beginning in 2012 and 2013 in an amount not to exceed $500,000 with a phase-out amount beginning at $2,000,000. for tax years beginning after 2014 the maximum deduction drops to $25,000 with the phase-out beginning at $200,000 (at least until the business community again makes sufficient campaign contributions to extend the higher numbers into later years). 542 florida tax review [vol. 13:10 a. the sunny side of inflation. rev. proc. 2011-52, 2011-45 i.r.b. 701, § 3.20 (11/7/11). as adjusted for inflation and before extension by the 2012 act, as provided in § 179(b)(6), the 2012 ceiling for expensing machinery and equipment and certain other § 1231 property was $139,000, and the phase-out threshold was $560,000. the retroactive application of the 2012 extension to tax years beginning in 2012 provided a windfall to taxpayers who exceeded the 2012 thresholds. b. section 179 is applied to computer software for another year. the 2012 taxpayer relief act, extends for another year eligibility as qualified code § 179 property to off-the-shelf computer software placed in service before 2014. 7. mine safety equipment eligible for 50 percent expensing. the 2012 act, § 316, extends the election under § 179e to expense 50 percent of mine safety equipment to apply to property placed in service on or before 12/31/2013. 8. 2012 depreciation tables for business autos, light trucks, and vans are to be increased by the 2012 tax relief act with an additional $8,000 of first year recovery. rev. proc. 2012-23, 2012-14 i.r.b. 712 (3/2/12). the irs published depreciation tables with the depreciation limits for business use of small vehicles: passenger automobiles with § 168(k) first year recovery, 1st tax year $11,160 2nd tax year $5,100 3rd tax year $3,050 each succeeding year $1,875 2013] recent developments in federal income taxation 543 trucks and vans with § 168(k) first year recovery, 1st tax year $11,360 2nd tax year $5,300 3rd tax year $3,150 each succeeding year $1,875 section 168(k), as extended by the 2012 act to property placed in service by 12/31/13, provides an additional $8,000 first year recovery passenger automobiles not eligible for § 168(k) first year recovery, 1st tax year $3,160 2nd tax year $5,100 3rd tax year $3,050 each succeeding year $1,875 trucks and vans not eligible for § 168(k) first year recovery, 1st tax year $3,360 2nd tax year $5,300 3rd tax year $3,150 each succeeding year $1,875  the revenue procedure also has tables for leased vehicles. 9. the irs identifies property eligible for 100 percent depreciation, including the unintended consequences for business autos. rev. proc. 2011-26, 2011-16 i.r.b. 664 (3/29/11). 2010 tax acts extended the placed-in-service date for property to be eligible for the § 168(k)(1) 50 percent first year depreciation allowance to property placed in service before 2013 (2014 in the case of certain property described in § 168(k)(2)(b) and (c)) and adopted § 168(k)(5) to allow a 100 percent depreciation deduction for qualified property acquired after 9/8/10 and before 1/1/12, and placed in service before 1/1/12. the revenue procedure sets out several rules for the application of these provisions.  reg. § 1.168(k)-1(b)(4)(iii)(c)(1) and (2) provide that if the larger part of self-constructed property commences before the applicable dates for the 50 percent depreciation deduction, components selfconstructed after the effective date are also ineligible for the accelerated deduction. if the construction of the larger part of self-constructed property begins before 9/9/10, but the qualified property otherwise qualifies for the 50 percent depreciation deduction, self-constructed components after 9/9/10, that 544 florida tax review [vol. 13:10 are qualified property may be subject to an election to claim 100 percent depreciation deductions with respect to the component.  section 168(k)(2)(d)(iii) provides an election not to claim first year depreciation with respect to a ―class of property‖ placed in service during the taxable year. reg. § 1.168(k)-1(e)(2)(i) applies the election to each class of property described in § 168(e). the revenue procedure allows an election to claim 50 percent first year depreciation rather than 100 percent depreciation for a class of property. a. the passenger automobile anomaly. the additional first year depreciation allowance is limited to $8,000 for passenger automobiles and light trucks subject to the § 280f limitations ($3,060, $4,900, $2,950 in years one through three respectively, and $1,775 in years four through six). thus the first year depreciation allowance in year one is $11,060 ($3,060 plus $8,000). this allowance is treated as the 100 percent depreciation deduction. under § 280f(a)(1)(b)(i), unrecovered passenger automobile basis is treated as a deductible expense (up to $1,775) in each year after the sixth year. unless the taxpayer elects to forego 100 percent depreciation recovery with respect to a passenger automobile, the taxpayer would be treated as claiming 100 percent depreciation in year one, with no further deductions allowable in years two through six. the revenue procedure provides a safe harbor method of accounting that the taxpayer is deemed to apply by deducting depreciation of the passenger automobile for the first taxable year succeeding the placed-in-service year. in effect, the revenue procedure continues to treat passenger automobile and light truck depreciation as if the first year deduction were 50 percent depreciation. b. the 2012 act extends the eligibility to property placed in service before 1/1/14. 10. not all self-created intangibles are nonamortizable. fitch v. commissioner, t.c. memo. 2012-358 (12/26/12). the taxpayer sold his cpa practice to another accountant for $900,000 after suffering severe medical problems that led to brain surgery. approximately 4-1/2 months after the sale, the purchaser suffered a seizure and was hospitalized. five days later, the purchaser sold the practice back to the taxpayer for $900,000. the taxpayer claimed § 197 amortization deductions with respect to the cost of intangibles reflected in the $900,000 repurchase price, and the irs denied the deductions. the irs position was based on alternative arguments that (1) ―‗the alleged sales agreements petitioners submitted are untrustworthy and the alleged sales did not take place,‘‖ (2) that the original transaction was rescinded, and (3) that the taxpayer reacquired self-created intangibles in a series of related transactions. the tax 2013] recent developments in federal income taxation 545 court (judge vasquez) found that in light of the circumstances leading to each transaction, the two sales and purchase transactions were unrelated and genuine. furthermore, the second transaction was not a mere rescission. thus, the exception to the prohibition on amortization of certain self-created intangibles in reg. § 1.197-2(d)(2)(iii)(c), which allows amortization if a taxpayer disposes of a self-created intangible and subsequently reacquires the intangible from a seller (in whose hands the intangible is amortizable) in an unrelated transaction, applied. 11. tax incentives for ―first peoples‖ — accelerated depreciation for property on indian reservations is extended. the 2012 tax relief act, extends the shortened recovery periods of § 168(j) to property placed in service on indian reservations before 12/31/13. f. credits 1. save energy, save taxes. notice 2012-26, 2012-17 i.r.b. 847 (3/28/12). perpetually extended § 179d (through 2014 in the last iteration) allows a deduction of up to $1.80 per square foot for the cost of installing energy saving components if the total energy and power costs of a building are reduced by more than 50 percent compared to a reference building. a partial deduction is allowed for energy systems that do not meet the 50 percent threshold but satisfy a specified lowered requirement. the notice revises the percentage reductions figures of prior notices for the partial deduction for heating, cooling, ventilation, and hot water systems from 16 to 15 percent, from 16 to 25 percent for interior lighting, and from 16 to 10 percent for reductions attributable to the building envelope. thus, the required percentage reductions in energy consumption for the partial deduction that are provided in the notice are 15 percent for hvac systems, 25 percent for lighting, and 10 percent for the building envelope. 2. the tax court just says ―no‖ to r&d credits claimed with 20/20 hindsight provided by alliantgroup. shami v. commissioner, t.c. memo. 2012-78 (3/21/12). the taxpayer‘s s corporation hired alliantgroup to conduct § 41 research tax credit studies covering the years in question. the research and development department staff ranged from 18 to 27 and included chemists, technicians, and a vice president of research and development who supervised the department. the alliantgroup concluded that the corporation was entitled to claim the § 41 research credit based in part on wages paid to two individuals who were, respectively, its chairman of the board, chief executive officer, president, and secretary (shami), and its executive vice president and the sole member of its sales and marketing committee (mccall), neither of whom had formal education or training in any physical or biological science or engineering. the only issue 546 florida tax review [vol. 13:10 in the case involved credits based on wages paid to the two executives. the taxpayers ―failed to provide any documentation that establishe[d] how much time, if any, mr. shami or mr. mccall spent performing research and development services during the relevant years,‖ but argued that the court ―must estimate the amount of wages allocable to qualified services if [it found] either mr. shami or mr. mccall performed qualified services.‖ the tax court (judge kroupa) rejected the taxpayer‘s argument, on the basis that the cohan rule (cohan v. commissioner, 39 f.2d 540, 543-544 (2d cir. 1930)) applies only if there is a reasonable basis on which the court can make an estimate, and that in this case the taxpayer failed to satisfy the court that there was sufficient evidence to estimate the appropriate allocation of wages between qualified services and nonqualified services. judge kroupa found united states v. mcferrin, 570 f.3d 672 (5th cir. 2009), which did apply the cohan rule in determining the § 41 research credit, to be inapposite, stating that in mcferrin ―the court of appeals for the fifth circuit did not overrule, or even address, the basic requirement under cohan that a court must have a reasonable basis upon which to make an estimate.‖ 3. you can‘t consume your supplies in research and sell them too. union carbide corp. v. commissioner, 697 f.3d 104 (2d cir. 9/7/12) affirming the tax court, t.c. memo. 2009-50, the second circuit (judge pooler) held that raw materials used in three discontinued research products that were ultimately converted to products sold by the taxpayer were not eligible for inclusion as part of qualified research expenditures for the 20 percent research credit of § 41(a). the court specifically held that the costs of supplies used during research projects that would have been used in the course of the taxpayer‘s manufacturing process regardless of the research do not qualify under §§ 41(b)(2)(a)(ii) and 41(h)(1)(b) as ―an amount paid or incurred for supplies used in the conduct of qualified research.‖ the court, not willing to make ―a fortress out of the dictionary,‖ determined that the phrase ―used in the conduct of qualified research‖ encompassed only supplies purchased for the purpose of conducting research, although supplies consumed in the normal manufacturing process were necessary to the research focused on more efficient methods of converting the raw materials to finished product. the court also noted that any ambiguity in the statute could be resolved by giving deference to the agency interpretation of the statute ―even if that interpretation appears in a legal brief.‖ the court found that the irs‘s interpretation of the statute was consistent with the purpose of the research credit. in a concurring opinion judge pooler observed that if congress had intended the supplies at issue to be creditable, it would have so provided in precise terms on a subject of industry lobbying. 2013] recent developments in federal income taxation 547 4. gross receipts are not defined by the narrow definition of black‘s law dictionary, the regulations provide better guidance. hewlett-packard company v. commissioner, 139 t.c. no. 8 (9/24/12). for the tax years at issue the taxpayer elected the alternative incremental research credit (airc) method of computing the § 41 research credit, which provided a credit equal to the sum of: (i) 2.65% (1.65% for 1999) of so much of the qualified research expenditures (qre) from the tax year as exceeded 1% of annual adjusted gross receipts (aagr), but did not exceed 1.5% of those aagr; (ii) 3.2% (2.2% for 1999) of so much of the qre from the tax year as exceeded 1.5% of aagr, but did not exceed 2% of those aagr; and (iii) 3.75% (2.75% for 1999) of so much of the qre from the tax year as exceeded 2% of aagr. in 1999 treasury proposed regulations to provide that adjusted gross receipts for this purpose include in addition to sales receipts (as adjusted for returns and allowances) other sources of gross income such as interest, dividends and rents. the final regulations adopted the provision but with an effective date for tax years beginning after the date of the final regulations, 1/3/01. for its tax years 1999 through 2001 the taxpayer calculated its credit on the basis of adjusted gross receipts that did not include income other than sales income. the tax court (judge goeke) concluded that the final regulations were a proper interpretation of the statutory language and legislative intent and that the treasury‘s logic in embracing a definition of gross receipts as articulated in the preamble to the proposed regulations applies to taxable years preceding the effective date of the regulations. thus the court adopted a definition of gross receipts that includes the total amount derived by a taxpayer from all activities and sources. the court rejected the taxpayer‘s argument that by adopting § 41(c)(4) (excluding ―returns and allowances‖ from gross receipts), congress indicated an intent to limit the concept of gross receipts for § 41 purposes to sales receipts. the court also refused to adopt a narrow ―common law meaning‖ of gross receipts from black‘s law dictionary as undermined by numerous statutory authorities using the term. further, the court indicated that the maximum ―expressio unius est exclusio alterius‖ applies to indicate that congressional enumeration of specific exceptions to gross receipts means that other exceptions are not to be implied. 5. business tax credits extended and liberalized by the 2012 taxpayer relief (and not so grand compromise) tax act. the business tax credits extended include: a. research credit of § 41 for 20 percent of research expenditures over a base amount, 20 percent of basic research payments to universities and 20 percent of qualified energy research by an energy consortium is retroactively extended for two years to cover research expenditures incurred before 1/1/14. the new law also provides that the 548 florida tax review [vol. 13:10 acquirer of a trade or business, or of a substantial portion of a business unit, may include certain qualified research expenditures of the predecessor and must include the gross receipts of the predecessor in calculating credits available to the acquirer. for controlled corporations, under § 41(f) all of the members are treated as a single taxpayer and the research credit and the credit allowable to each member is to be determined in proportion to its share of research expenditures. b. railroad track maintenance. the 2012 act, § 306, extends the 50 percent credit of § 45g for qualified railroad track maintenance expenditures of up to $3500 per mile incurred by a qualified railroad owner to tax years beginning before 1/1/14. c. mine rescue training. the 2012 act, § 307, extends the 20 percent credit of § 45n for costs of training qualified mine rescue employees to taxable years beginning before 12/31/13. g. natural resources deductions & credits 1. business energy related tax credits extended by the 2012 taxpayer relief (and not so grand compromise) tax act. the tax credits extended include: a. alternative vehicle fuel property. section 402 of the act extends the code § 30c alternative fuel vehicle refueling property 30 percent credit, limited to $30,000 for depreciable property and $1,000 for other property, to property placed in service before 1/1/14. b. electric vehicles. section 403 of the act extends the code § 30d credit for two or three wheel electric vehicles of $2,500 to $5,000 depending on battery power to vehicles acquired before 1/1/14. c. plant gas. section 404 of the act extends the per gallon credit for alcohol used as fuel to production before 1/1/14, and provides rules for using algae as qualified feedstock for fuel produced after 1/2/13 [the date of enactment]. in addition, § 410(b) of the act extends the additional 50 percent depreciation allowance of code § 168(l)(2) for biofuel plant property placed in service before 1/1/14. d. biodiesel, i.e., the timing of the iowa primary; even al gore has given up on ethanol. section 405 of the act 2013] recent developments in federal income taxation 549 extends the code § 40a $1.00 per gallon credit for biodiesel mixtures to fuel sold or used before 1/1/14. e. indian coal. section 406 of the act extends the $2 per ton additional renewable energy credit under § 45(e)(10) for coal produced at an indian coal production facility and sold by the taxpayer during an eight year period beginning on 1/1/06. f. energy efficient homes. section 407 of the act extends the code § 45l credit to contractors of $2,000 (or $1,000 in the case of certain manufactured homes) that are certified as energy efficient to homes acquired from the contractor for use as a residence on or before 12/31/13. g. refrigerators, dishwashers and washing machines. section 409 of the act retroactively extends for two years the credit under code § 45m to energy efficient appliances manufactured in 2012 and 2013. h. transmission line sales. section 411 of the act extends the code § 451(i) eight year amortization of gain recognized on sales of transmission lines by a qualified vertically integrated electric utility to an independent transmission company to sales before 1/1/14. i. alternative fuel excise tax credit. section 412 of the act retroactively extends through 2013 the excise tax credits of code § 6426 for alternative fuels and fuels mixtures. h. loss transactions, bad debts, and nols 1. unless you think you have a cert — no it‘s neither a breath nor a candy mint — or a ceril, don‘t punish yourself by reading these proposed regulations just for fun. reg–140668–07, regulations regarding the application of section 172(h) including consolidated groups, 77 f.r. 57452 (9/17/12). the corporate equity reduction transaction (cert) rules of § 172(b)(1)(e) and (h) were enacted in 1989 to limit a corporation‘s ability to obtain tax refunds as the result of the carryback of nols that were attributable to interest deductions allocable to leveraged buyout transactions. sections 72(b)(1)(e) and (h) limit the carryback of the portion of an nol that constitutes a ―corporate equity reduction interest loss‖ (ceril) of an ―applicable corporation‖ in any ―loss limitation year.‖ prop. reg. §§ 172(h)-0 through -5 provide general rules addressing whether a cert has occurred, the computation of a ceril, and the treatment of successor corporations. 550 florida tax review [vol. 13:10 2. atnold is not a breath mint to relieve your amt problems. metro one telecommunications inc. v. commissioner, 135 t.c. 573 (12/15/10). in computing amti, § 56(a)(4) allows a corporation to claim an amt nol in lieu of a regular nol deduction allowed under § 72. the taxpayer claimed an amt nol deduction for 2002 based on a carryback of an amt nol from 2004. analyzing a very complicated statutory pattern, judge paris held that § 56(a)(1) does not allow for an amt nol carryover to a prior year. a. on appeal, the ninth circuit affirms and holds that a ―carryover‖ is a ―carryforward,‖ but not a ―carryback.‖ metro one telecommunications, inc. v. commissioner, 704 f.3d 1057 (9th cir. 12/19/12). for tax years 2002 through 2009 the relief rule of § 56(d)(1) allowed taxpayers to offset 100 percent of amti by an alternative tax net operating loss deduction (atnold) which consisted of nols that were (1) ―carryovers‖ to the 2001 and 2002 tax years or (2) carried back from 2001 or 2002 tax years to a prior year. the ninth circuit (judge n.r. smith) ruled that metro one was precluded from carrying back net operating losses from 2004 to offset 100 percent of 2002 amti, but was limited to offsetting 90 percent of the 2002 amt under former § 56(d)(1)a)(i)(ii). the court indicated that the ―plain meaning‖ of the term ―carryovers‖ in the relief rule prevents taxpayers from using nols that are carried back from a later tax year. the use of the term ―carryover‖ in § 172 is synonymous with ―carryforward.‖ i. at-risk and passive activity losses 1. ya gotta keep time records. vandegrift v. commissioner, t.c. memo. 2012-14 (1/12/12). the taxpayer, who was employed as a salesman, invested in nine rental properties. six of the properties were rented. the taxpayer acquired three properties for rental after renovations were completed, but sold the properties before they were rented. the tax court (judge goeke) held that the taxpayer failed to establish that he was a real estate professional under § 469(c)(7), because the taxpayer was unable to provide contemporaneous verification of the time he devoted to the real estate activity. the court also held that the taxpayer‘s rental real estate activity was a passive trade or business that included all nine properties. thus, the taxpayer was permitted to offset losses from the rental properties against the capital gain recognized on the sale of three properties. the court rejected the irs‘s argument that since the three properties that produced short-term capital gain were never rented the gain could not be offset by the losses. 2013] recent developments in federal income taxation 551 2. yeah, it‘s true – ya really do gotta keep records of hours worked. iversen v. commissioner, t.c. memo. 2012-19 (1/18/12). the tax court (judge swift) held that the taxpayer failed to prove he had satisfied the 500 hour participation test of reg. § 1.469-5t(a)(1) in the operation of a rocky mountain cattle ranch that was principally run by a resident manager. evidence of eleven trips (along with his children) to the ranch (which had a 20,000 square foot lodge) in a private plane funded by the taxpayer‘s successful medical supplies business and telephone conversations with the ranch manager did not convince the court that the taxpayer was a material participant. in addition, the court concluded that much of the taxpayer‘s activities were in the capacity of an investor, which do not qualify as participation under reg. § 1.469-5t(f)(2)(ii)(a) and (b). the court did not sustain accuracy related penalties on the ground that the taxpayer reasonably relied on his accountant to prepare the returns. 3. self-rent to the taxpayer‘s business was not passive income. samarasinghe v. commissioner, t.c. memo. 2012-23 (1/19/12). applying reg. § 1.469-2(f)(6), the tax court (judge marvel) held that income from the taxpayer‘s rental of a building owned by the taxpayer, which was used in the taxpayer‘s medical practice was not passive activity income that could be offset with the taxpayer‘s losses from passive activities. the court also held that, under new jersey state law, the original lease for the medical building entered into in 1980 was not subject to the transitional rule of reg. § 1.469-2(f)(6), which is not applicable to binding contracts entered into before 1988. the court determined that the original lease had been ignored by the parties and not followed in the 2004 through 2009 time period at issue in the case. the court refused to impose § 6662 penalties because it found that the taxpayers reasonably relied on their tax advisor with respect to the treatment of the lease payments. 4. when good at-risk notes go bad there are tax consequences to the maker. zeluck v. commissioner, t.c. memo. 2012-98 (4/3/12). in 2001, the taxpayer invested in an oil and gas partnership, investing $310,000 – $110,000 of cash and $200,000 in the form of a subscription recourse promissory note. he was initially at risk for $310,000, because the debt obligation was ―genuine‖ through 2002, but by 2003, when the partnership terminated, his at-risk amount had been reduced to zero as a result of receiving passed-through losses and distributions totaling $310,000. after he had reduced his at-risk amount to zero, upon the termination of the partnership in 2003 his liability for the $200,000 note became ―nongenuine.‖ no principal payments had been made to the partnership and there was no evidence that the note was transferred or distributed to anyone upon dissolution of the partnership. after the termination of the partnership, there was no person or entity to which the taxpayer was liable for payment on the 552 florida tax review [vol. 13:10 subscription note. he never received any written notification of the balance due on the subscription note, made no inquiry regarding the balance due, and has made no arrangements to pay the balance due. no demand for payment was made by any party as a result of the subscription notes, even after the due date. the taxpayer never signed an extension of the subscription note or otherwise pushed back the maturity date. as a result of the note becoming nongenuine, under § 465(b)(2) the taxpayer‘s at-risk amount was reduced to negative $200,000 in 2003. thus, the tax court (judge goeke) decided that the taxpayer recognized a $200,000 gain for 2003 pursuant to § 465(e).  the 20 percent accuracy-related penalty under § 6662(a), imposed for taxpayer‘s negligence in failing to reduce his amount at risk, was upheld by the court. 5. the tax court shines some light on passive solar energy installations. wilson v. commissioner, t.c. memo. 2012-101 (4/10/12); uyemura v. commissioner, t.c. memo. 2012-102 (4/10/12); lum v. commissioner, t.c. memo. 2012-103 (4/10/12). in three nearly identical opinions the tax court (judge cohen) held that losses from a micro-utility activity involving purchase and rental of solar equipment were passive activity losses. the taxpayers each purchased photovoltaic systems from a company doing business in hawaii as mercury solar. under the program, the taxpayer also acquired an investment solar system that was installed at the residence of a ratepayer, who paid a monthly fee to purchase the energy produced by the investment system. each taxpayer acquired a single investment system that was installed in the residence of the ―ratepayer.‖ the system was installed at the ratepayer‘s residence by mercury solar. the taxpayer contracted with another company to collect the monthly payments on behalf of the taxpayer as the equipment owner. the collection company maintained records and made payments on the taxpayers‘ loans to acquire the equipment. the court rejected the taxpayers‘ assertions that they qualified as material participants as the persons engaged in substantially all of the participation in the activity and held that that the taxpayers failed to meet their burden of proving that they participated in the activity for more than 100 hours, which was not less than the participation of any other individual. see temp. reg. § 1.469-5t(b)(2). the court noted that the participation of mercury solar and the collection company were also substantial. in the absence of material participation by the taxpayers in the three cases, the court did not need to consider whether the activity was a rental activity. in addition to disallowing deductions for losses under § 469, in uyemura and lum the court disallowed the taxpayers‘ claims for the § 48 business energy credit not subject to the passive activity loss limitation because the taxpayers had no tax liability with respect to the micro-utility and because no § 38 general 2013] recent developments in federal income taxation 553 business credits are allowable with respect to property for which a § 179 election to expense business assets is made. 6. the taxpayer loses, but not as badly as he would have had the irs properly argued the case. veriha v. commissioner, 139 t.c. no. 3 (8/8/12). the taxpayer was the sole owner of jvt, a c corporation that conduced a trucking business in which he actively participated. jvt leased the tractors and trailers used in its business from tri, an s corporation in which the taxpayer owned 99 percent of the stock, and jrv, a single-member llc wholly owned by the taxpayer and thus a disregarded entity. each lease of a tractor or trailer was governed by a separate contract. during the year in issue, tri realized net income and jrv realized a net loss. the taxpayer treated the net income from tri as passive income and treated the net loss from jrv as a passive loss. the irs determined that pursuant to reg. § 1.469-2(f)(6) — the self-rental recharacterization rule — each tractor and each trailer should be considered a separate ―item of property‖ and that the income the taxpayer received from tri should be recharacterized as nonpassive income, while the net loss realized by jrv remained a passive activity loss. reg. § 1.469-2(f)(6) provides as follows: ―an amount of the taxpayer‘s gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property— (i) is rented for use in a trade or business activity . . . in which the taxpayer materially participates . . . .‖ the tax court (judge wells) rejected the taxpayer‘s argument that all of the tractors and trailers collectively were one ―item of property,‖ and looking to webster’s third new international dictionary 1203 (2002) for the definition of the term ―item‖ held that for purposes of applying reg. § 1.469-2(f)(6), each individual tractor or trailer was an ―item of property,‖ and the income received from tri was subject to recharacterization. however, because the irs had not contested the taxpayer‘s netting of gains and losses within tri, only tri‘s net income was recharacterized as nonpassive income that could not be offset by losses from jrv.  judge wells noted that the result was more favorable to the taxpayer than the result would have been if the irs had taken the position — which was consistent with judge well‘s analysis of the meaning of the regulations — that the income from each tractor or trailer within tri and jrv should have been recharacterized as nonpassive. 7. cell tower rentals escape the self-rental rule. dirico v. commissioner, 139 t.c. no. 16 (11/13/12). the taxpayer‘s wholly owned s corporation was engaged in the business of operating specialized mobile radio services (smr, a precursor to cellular services) which included numerous antenna towers. the taxpayer individually leased towers to the s 554 florida tax review [vol. 13:10 corporation, which in turn leased space on the towers to cellular companies. the s corporation reported all of its income from its combined activities as ordinary business income. the irs recharacterized the taxpayer‘s rental income from profitable tower leases as non-passive activity income under the self-rental rule of reg. § 1.469-2(f)(6), which applies to rental income from property rented for use in a trade or business in which the taxpayer is a material participant. (the irs characterized losses from unprofitable leases as passive.) the tax court (judge halpern) rejected the irs argument that the s corporation rented cell tower space to third parties as part of its smr business. the court concluded that the minimal services provided by the s corporation to third-party lessees such as painting the towers, making sure the lights worked, and removing snow, meant that the leasing of towers and land to unrelated parties was a rental activity within the meaning of § 469(j)(8) and temp. reg. § 1.469-1t(e)(3)(i). the rental activity complemented, but was not part of the smr business. the court also rejected the irs argument that the s corporation‘s grouping of the rental income with ordinary business income was proper and binding on the taxpayer even though the taxpayer had the same proportionate ownership in the s corporation business and the rental property under reg. § 1.4694(d)(1)(i)(c). the court indicated that no portion of the s corporation‘s use of the towers in its smr business was rental and thus its rental of towers to third parties produced only rental income. thus, the corporation‘s use of the towers for rental did not produce trade or business income supporting application of the self-rental to the taxpayer that could properly be combined into a single economic activity. because the taxpayer derived his rental income from the s corporation as a lessor to the corporation, and not as its shareholder, the court held that the erroneous grouping of activities by the corporation was not binding on the taxpayer under the last sentence of reg. § 1.469-4(d)(5)(i) (―a shareholder *** may not treat activities grouped together by a section 469 entity as separate activities‖). the court concluded that while reg. § 1.469-4(e)(1) ―prohibits only the regrouping of activities by ―the taxpayer‖ (in this case, [the corporation]) and, therefore, constitutes a limitation on the manner in which the taxpayer (i.e., [the corporation]) reports its income for purposes of section 469. it does not affect petitioner‘s reporting of [the corporation‘s] rental payments to him.‖  the irs also classified land rental income as non-passive under temp. reg. § 1.469-2t(f)(3), which provides that if less than 30 percent of the unadjusted basis of rental property is subject to depreciation under § 167 net passive activity income from the property will be treated as non-passive income. the regulation converts rental income from raw land to non-passive income. the court agreed with the irs that under reg. § 1.469-4(d)(2) an activity involving the rental of real property and an activity involving the rental personal property cannot be combined into a single activity. 2013] recent developments in federal income taxation 555 thus, the unadjusted basis of the towers and land could not be combined with the basis of raw land for purposes of the 30-percent rule.  the court further rejected the taxpayer‘s argument that the irs assertion of the 30-percent rule should be rejected because it was first raised on brief. while the court agreed that the irs‘s raising the argument was not timely, causing an element of surprise, the court found that the taxpayer was not prejudiced by the argument since all of the evidence necessary to resolve the issue was presented at trial. 8. ill bank president is not a real estate professional. harnett v. commissioner, t.c. memo. 2011-191 (8/11/11). the taxpayer founded a savings and loan association to provide financing to customers of his real estate development company. in 2003 the taxpayer suffered a heart attack and other health problems. he resigned as ceo of the bank in 2005, but continued to work as a consultant to the bank and served as chairman of the board. after 2003 the taxpayer had stopped renting his real estate properties and had begun trying to sell them. the real estate was managed partly by the taxpayer‘s son, his wife, and his former bank secretary. the court (judge thornton) found that the taxpayer‘s unsubstantiated testimony did not meet the burden of proof required to establish that the taxpayer had performed more than 750 hours of service during the tax years at issue and thus failed to qualify as a real estate professional for purposes of § 469(c)(7). the taxpayer‘s real estate losses were, therefore, passive activity losses not deductible against active income sources. the court found that the taxpayer‘s statement that he spent most of his time on real estate activities and only 10 hours a month at the bank strained credibility since ―for most of this period he was both chairman of the board and ceo of the bank, with wide-ranging responsibilities and six-figure compensation‖ and added that the court saw no reason to think that managing the taxpayer‘s dormant real estate holdings required him to spend anywhere near 750 hours each year. a. affirmed per curiam. harrnett v. commissioner, 110 a.f.t.r.2d 2012-6628 (11th cir. 11/14/12) (unpublished opinion.) iii. investment gain and income a. gains and losses 1. section 1221(a)(1) says ―to customers in the ordinary course of business‖ (emphasis added), not ―to a customer.‖ bennett v. commissioner, t.c. memo. 2012-193 (7/12/12). the taxpayer was a ―serial entrepreneur‖ who constructed a single residence for purposes of resale at profit, but which he sold at a substantial loss after five years. the 556 florida tax review [vol. 13:10 tax court (judge wherry) upheld the irs‘s determination that the residence was a capital asset, not property held for sale to customers in the ordinary course of business described in § 1221(a)(1), thereby denying ordinary loss treatment and subjecting the loss to § 1211 limitations. the taxpayer was not a real estate broker, had never before (or after) dealt in real estate, and did not have a contract to sell the property in place when he commenced construction. he did not meet the burden of showing that the real estate activity was a trade or business rather than an investment. 2. the taxpayer lost his claim that a qui tam relator‘s reward for ratting out hca for medicare fraud was a capital asset, while in the meanwhile the alleged mastermind of the hca medicare fraud scheme won the florida gubernatorial race. alderson v. united states, 686 f.3d 791 (9th cir. 7/18/12). the taxpayer was a qui tam relator who filed a refund claim based on the argument that his share of the government‘s recovery (16 percent of $631 million) from the hospital corporation of america, inc. (and several medical providers related to hca) for medicare fraud was capital gain rather than ordinary income. when alderson, who was the cfo of an hca related corporation (quorum), was asked to prepare two sets of books, one for the hospital's financial auditors and one to serve as the basis for the hospital‘s medicare cost reports, he refused to prepare separate books and was fired. using information obtained during discovery in his wrongful termination suit, alderson filed a qui tam suit against quorum, hca, and affiliated companies under the false claims act (31 u.s.c. §§ 3729 et seq.). alderson made available to the united states the documents he had received during discovery, and eventually the government intervened in the suit. the ninth circuit (judge fletcher) affirmed the district court‘s holding for the government. first, the court rejected the taxpayer‘s claim that he ―‗exchanged his documents, information and know-how[ ] and . . . received cash, thus consummating a sale or exchange . . .,‘‖ reasoning that the taxpayer ―did not ‗sell‘ or ‗exchange‘ his information.‖ his right to a relator‘s share for pursuing his qui tam suit that was conferred by the fca was subject to a statutory precondition that he share his information with the government. second, the information regarding hca and its affiliates was not the taxpayer‘s ―property.‖ the taxpayer had no legal right to exclude others from use of the information, the information was known to other officials in the companies, and the taxpayer had no right to prevent those officials from providing the information to others. the court also rejected the taxpayer‘s argument that his relator‘s share, which he argued appreciated in value from the time he filed his suit until he received payment, was the relevant capital asset. the taxpayer had no ―underlying investment of capital,‖ and the increase in value ―did not ‗reflect an accretion in value over cost to [the] underlying asset.‘‖ the 2013] recent developments in federal income taxation 557 taxpayer ―was not an investor who bought and held an asset that increased in value during the holding period,‖ but ―worked intensively . . . to increase the likelihood that his qui tam suit would be successful.‖ finally, the court summarily dismissed the taxpayer‘s argument that the increase in value of the claim was a capital asset under § 1234a, on the grounds that § 1234a only applies with respect to assets that are capital assets to start with. 3. be still open transaction doctrine! let‘s fight over the proper basis apportionment method. dorrance v. united states, 877 f. supp. 2d 827 (d. ariz. 7/9/12). the taxpayers, who originally had purchased life insurance from a mutual life insurance company, received stock when the life insurance company demutualized; they retained the life insurance policies. the form 1099-b that the taxpayers received, consistent with irs policy, listed the basis in the stock as zero. when the taxpayers sold the stock, they reported it as having a zero basis and filed a refund claim seeking summary judgment based on the argument that the open transaction doctrine applied to the demutualization and that the basis in the life insurance policies resulting from the payment of premiums should be allocated to the stock with the result that all of the proceeds from the stock sale were a return of capital and they thus owed no tax. the government sought summary judgment on the theory that no part of the insurance premiums was paid to acquire the mutual rights under the policy, and that the entire premium was paid to purchase the policy, with the result that the stock received in exchange for the mutual rights had a zero basis. the district court denied both motions, holding, first, that the open transaction doctrine did not apply, rejecting the court of federal claims decision in fisher v. united states, 82 fed. cl. 780 (fed. cl. 2008), which accepted the taxpayer‘s argument that the open transaction doctrine applied, allowing the taxpayer to treat all of the premium payments he had made during the course of the policy as capital investment where the taxpayer received a cash payment in exchange for his mutual rights during the demutualization of a life insurance company. the court noted that if the taxpayer was ―allowed to use the open transaction doctrine in the context of stock received during demutualization, he ‗is getting a windfall, because all of the basis may be allocated to the assets that will be sold, while the asset that does not require basis has had its basis reduced.‘‖ the court also rejected the government‘s position, finding that the value of both the mutual rights and the policy itself at the time of demutualization could be determined. however, neither party had presented evidence from which the court could equitably apportion the premiums paid before demutualization as basis in the mutual rights and basis in the policies themselves. the court instructed the parties to bring forward arguments for choosing between two different valuation methods: (1) compare the cost of the policies to the cost of comparable policies issued by non-mutual insurance companies at the time of issuance; or (2) comparing the market 558 florida tax review [vol. 13:10 value of the policy and the stock at the time of demutualization, and applying that ratio to the premium payments. 4. should the name of the promoter of this tax scam have been ―devious,‖ instead of ―derivium?‖ calloway v. commissioner, 135 t.c. 26 (7/8/10) (reviewed). in 2001 the taxpayer entered into an agreement with derivium capital llc pursuant to which he transferred 990 shares of ibm common stock to derivium under its 90-percent-stock-loan program. the terms of the agreement characterized the transaction as a loan, with the ibm stock pledged as collateral. (derivium was not registered with the new york stock exchange or the national association of securities dealers/financial industry regulatory authority.) the purported loan was nonrecourse; interest accrued but was not payable until maturity; all dividends were applied against interest due; prepayment during the 3-year term of the purported loan was prohibited. the terms of the agreement allowed derivium to sell the stock and retain the proceeds, which it did immediately upon receipt, receiving $103,918.18. the taxpayer received $93,586.23 from derivium, the amount of the payment being determined, and payment being made, only after derivium had sold the stock. upon maturity of the ―loan,‖ the taxpayer had the option of (1) paying the balance due and having an equivalent amount of ibm stock returned to him, (2) renewing the purported loan for an additional term, or (3) satisfying the ―loan‖ by surrendering any right to receive ibm stock. at maturity in august 2004 the balance due was $124,429.09, which was $40,924.57 more than the then $83,318.40 value of the ibm stock. (derivium had credited against the accrued interest the amount of dividends that would have been received had the stock not been sold, but the taxpayer never received a form-1099-div or included any dividends in income.) the taxpayer elected to satisfy his purported loan by surrendering any right to receive ibm stock. the taxpayer never made any payments toward either principal or interest on the purported loan. citing commissioner v. court holding co., 324 u.s. 331 (1945), and gregory v. helvering, 293 u.s. 465 (1935), for the proposition that substance controls over form, the tax court, in a reviewed opinion by judge ruwe (with no dissents but with judges halpern, wherry, and holmes concurring in result only), held that the 2001 transaction between taxpayer and derivium was a sale, not a loan, under the test factors set forth in grodt & mckay realty, inc. v. commissioner, 77 t.c. 1221 (1981). the taxpayer had transferred all the benefits and burdens of ownership of the stock to derivium. legal and equitable title, as well as possession and control of the stock were transferred in exchange for $93,586.23 with no obligation to repay that amount. ―at best [the taxpayer] had an option to purchase an equivalent number of ibm shares after 3 years at a price equivalent to $93,586.23 plus ‗interest.‘‖ the transaction was not a true loan because 2013] recent developments in federal income taxation 559 ―[f]or a transaction to be a bona fide loan the parties must have actually intended to establish a debtor-creditor relationship at the time the funds were advanced.‖ there was no such intent. after the 2001 transaction the taxpayer never treated the transaction as a loan; in 2004 he did not report either a sale of the stock or cancellation of debt income, positions which were inconsistent with treating the transaction as a loan. because derivium was not acting as a broker, the court also rejected the taxpayer‘s argument that the transaction was analogous to the securities lending arrangement in rev. rul. 57-451, 1957-2 c.b. 295, which held that no sale occurred when the owner of stock deposited shares with a broker who could lend the securities until such time as the shareholder received from the broker property other than identical securities. nor was the transaction equivalent to a securities lending arrangement under § 1058, because the agreement did not meet the requirements of that provision, which under samueli v. commissioner, 132 t.c. 37 (2009), requires that the transferor of the stock retain ―all of the benefits and burdens of ownership of the transferred securities‖ and the right to ―be able to terminate the loan agreement upon demand.‖ because the taxpayer could not regain possession of the stock for three years, his opportunity for gain was diminished.  section 6662 accuracy-related penalties were sustained.  judge halpern‘s concurring opinion emphasized that the grodt & mckay test, while appropriate for determining whether there had been a sale of property that was not fungible, was not useful in the determination of whether there had been a sale of fungible property, such as corporate stock. it was enough for him that the taxpayer ―gave derivium the right and authority to sell the ibm common stock in question for its own account, which derivium in fact did.‖  judge holmes‘s concurring opinion emphasized that the majority‘s test for a sale was too broad and could be applied to treat too wide a range of collateralized nonrecourse loan arrangements as sales. he concluded that the majority erred in treating the taxpayer‘s transfer of the stock to derivium and derivium‘s subsequent sale of the stock as one integrated transaction, because derivium had represented to its customers that it would hold the stock and never told them of the quick sale. instead, he would have treated derivium‘s sale of the stock as the event triggering recognition by the taxpayer, under the tufts principle that ―when a nonrecourse liability is discharged by sale of collateral, the borrower must recognize income at that point — the amount realized is the amount of nonrecourse liability discharged as a result of the sale,‖ since reg. § 1.10012(a)(4)(i) provides that ―the sale . . . of property that secures a nonrecourse liability discharges the transferor from the liability.‖ he recognized that under his analysis, ―the tax consequences to calloway would be remarkably similar to those flowing from the result reached by the majority.‖ 560 florida tax review [vol. 13:10  the tax court majority opinion noted in a footnote that other cases involving derivium transactions are pending in the tax court. from 1998 to 2002 derivium engaged in approximately 1,700 similar transactions involving approximately $1 billion. the government estimated the total tax loss associated with derivium‘s scheme to be approximately $235 million.  nagy v. united states, 104 a.f.t.r.2d 2009-7789, 2010-1 u.s.t.c. ¶ 50,177 (d. s.c. 2009), and united states v. cathcart, 104 a.f.t.r.2d 2009-6625, 2009-2 u.s.t.c. ¶ 50,658 (n.d. calif. 2009) held, in § 6700 penalty cases, that the 90-percent stockloan-program transactions offered by derivium were sales of securities, not bona fide loans.  district court had enjoined derivium capital usa from promoting its 90 percent loan program. united states v. cathcart, 105 a.f.t.r.2d 2010-1293 (n.d. calif. 3/5/10). a. and the eleventh circuit teaches even more about how to distinguish sales from loans in affirming the tax court. calloway v. commissioner, 691 f.3d 1315 (11th cir. 8/23/12). in an opinion by judge ripple, the eleventh circuit affirmed the tax court‘s decision, essentially following the rationale of the tax court‘s majority opinion. like the tax court, the court of appeals considered the grodt & mckay factors to determine whether there had been a transfer of the benefits and burdens of ownership, which would thereby constitute a ―sale,‖ while pointing out that ―‗[n]one of these factors is necessarily controlling; the incidence of ownership, rather, depends upon all the facts and circumstances,‘‖ citing h.j. heinz co. & subsidiaries v. united states, 76 fed. cl. 570, 582 (2007). the court of appeals also considered the somewhat overlapping factors applied by the tax court in dunne v. commissioner, t.c. memo 2008-63 specifically with respect to ownership of stock: (1) whether the person has legal title or a contractual right to obtain legal title in the future; (2) whether the person has the right to receive consideration from the transferee of the stock; (3) whether the person enjoys the economic benefits and burdens of being a shareholder; (4) whether the person has the power to control the company; (5) whether the person has the right to attend shareholder meetings; (6) whether the person has the ability to vote the shares; (7) whether the stock certificates are in the person‘s possession or are being held in escrow for the benefit of that person; (8) whether the corporation lists the person as a shareholder on its tax returns; 2013] recent developments in federal income taxation 561 (9) whether the person lists himself as a shareholder on his individual tax return; (10) whether the person has been compensated for the amount of income taxes due by reason of the person‘s shareholder status; (11) whether the person has access to the corporate books; and (12) whether the person shows by his overt acts that he believes he is the owner of the stock.  applying the grodt & mckay factors, as ―refined‖ by dunne, the court concluded that the most relevant factors ―firmly‖ established that the transaction was a sale. notwithstanding their labels, the agreements as a whole made it clear that during the period of time covered by the ―loan,‖ derivium owned the stock. the court looked to its precedents under which ―‗the characteristics typically associated with ―stock‖ are that it grants ‗the right to receive dividends contingent upon an apportionment of profits‘; is negotiable; grants ‗the ability to be pledged or hypothecated‘; ‗confer[s][ ] voting rights in proportion to the number of shares owned‘; and has ‗the capacity to appreciate in value.‘‖ when the taxpayer transferred the stock to derivium pursuant to the agreements, ―he ceded these rights of stock ownership to derivium.‖ other grodt & mckay benefits and burdens test factors also led to the conclusion that the transaction was a sale. the agreements granted ―derivium the right to possess the stock, the equity in the stock, and the right to receive the profits from either holding or disposing of the stock;‖ that the loan was nonrecourse assured that the risk of loss was shifted entirely to derivium.  the court of appeals rejected the approach taken by judge halpern in his concurring opinion, concluding that ―judge halpern‘s approach risk[ed] transforming, for income tax purposes, all interests secured by stock into sales of stock.‖ it also rejected the approach taken by judge holmes in his concurring opinion, concluding that ―judge holmes‘s test could result in understatements of income when taxpayers have absolutely no way to determine that a taxable event has occurred.‖ b. devious derivium strikes again. raifman v. commissioner, t.c. memo. 2012-228 (8/7/12). the taxpayer transferred stock to derivium under its infamous ―90% stock loan‖ program. following calloway v. commissioner, 135 t.c. 26 (2010), the tax court (judge wells) granted the irs‘s motion for summary judgment that the transactions were sales and not loans, but denied the irs‘s motion for summary judgment on the taxpayer‘s claim for a theft loss deduction, concluding that genuine issues of material fact remained regarding whether the taxpayer was entitled to a theft loss deduction for the amount of the value of the options they purchased from derivium. the taxpayer‘s affidavit alleged that derivium misrepresented the nature of the transaction because derivium never engaged in a plausible hedging strategy, but rather appeared to be massively betting that the price of all of its clients‘ stocks would fall, ―hedged‖ only by a ponzi 562 florida tax review [vol. 13:10 scheme, and that the taxpayer relied on derivium‘s misrepresentations when he entered into the 90% stock loan program by which he was defrauded. the instant case is distinguishable from prior derivium cases in that none of the prior cases considered the taxpayer‘s attempt to exercise the rights to a return of the collateral after the maturity dates. 5. this case disproves the old adage ―you can‘t lose for trying.‖ sollberger v. commissioner, 691 f.3d 1119 (9th cir. 8/16/12). the taxpayer entered into an agreement with optech pursuant to which he transferred floating rate notes (frns) worth approximately $1 million to optech in return for a nonrecourse loan of 90 percent of the value of the frns. under the agreement optech had the right to receive all dividends and interest on the frns, and the right to sell the frns during the loan term without sollberger‘s consent. optech did not hold the frns as collateral for the loan, but immediately sold the frns and transferred 90 percent of the proceeds to the taxpayer. the taxpayer treated the transaction as a loan rather than as a sale. the ninth circuit (judge smith) affirmed the tax court‘s holding (t.c. memo. 2011-78) that the transaction was a sale. the court stated: although the transaction took the form of a loan, sollberger transferred the frns to optech, and gave optech the right to sell the frns (which optech promptly exercised), to transfer the registration of the frns into its own name, and to keep all interest due from the frns. sollberger would not be personally liable if he did not make payments on the loan since it was nonrecourse. . . . nonrecourse financing, which is sometimes viewed as an ―indicator of a sham transaction,‖ sacks v. comm’r, 69 f.3d 982, 988 (9th cir. 1995), placed sollberger more in the position of a seller than a debtor. nowhere in the master agreement or the loan schedule did sollberger promise to repay the money ―lent‖ to him. instead, optech merely agreed to return the frns if sollberger repaid the loan at the end of the seven-year loan term, thereby giving sollberger the option of repurchasing the frns in seven years, but not requiring him to do so. thus, the transaction was more akin to an option contract, whereunder the frns were sold, but the seller retained a call option to reacquire them after seven years, if he elected to do so, than a true loan. . . . sollberger‘s and optech‘s conduct also confirms our conclusion that the transaction was, in substance, a sale. although interest accrued on the loan, sollberger stopped receiving account statements and making interest payments 2013] recent developments in federal income taxation 563 after the first quarter of 2005, less than one year into the seven-year loan term. thus, neither sollberger nor optech maintained the appearance that a genuine debt existed for long. the total amount that sollberger paid to optech was de minimis compared to the size of the loan. the frns were also sold before sollberger received the loan from optech, which suggests that optech funded the majority of the ―loan amount‖ with the proceeds received from the sale of the frns. the apparent lack of any ability or intention by optech to hold the frns as collateral to secure repayment of the loan further buttresses our conclusion that the transaction was merely a sale in the false garb of a loan.  the court also rejected the taxpayer‘s argument that the transaction came within the § 1058 safe harbor for securities lending transactions because the requirements of that section clearly had not been met. 6. the cap gemini exchange cases: a. gain is recognized on an exchange even if the taxpayer didn‘t yet have what she got and she might not have gotten to keep it. united states v. culp, 99 a.f.t.r.2d 2007-618 (m.d. tenn. 12/29/06). the government was granted summary judgment in an erroneous refund suit. the taxpayer exchanged her partnership interest in ernst & young for stock of a corporation acquiring e&y‘s consulting business, in a transaction that was not a statutory nonrecognition event; however, the stock was held in escrow to enforce a forfeiture provision if the seller-taxpayer failed to perform certain services as an employee of the acquiring corporation. the court held that the open transaction doctrine was not applicable. if a taxpayer exchanges one property for a different property, the gain realized on the exchange must be recognized in the year the exchange occurs, even though the property received in the exchange is forfeitable if contractual provisions or representations in the contract for exchange are not subsequently satisfied and even though the property received in the exchange is held in escrow to assure enforcement of the forfeitability provisions. b. the seventh circuit affirmed taxable exchange treatment for an e&y consulting partner in a capgemini exchange. united states v. fletcher, 562 f.3d 839 (7th cir. 4/10/09), aff’g 101 a.f.t.r.2d 2008-588 (n.d. ill. 1/15/08). in this 2000 exchange of taxpayer‘s partnership interest in e&y for restricted stock of capgemini, the seventh circuit (judge easterbrook) affirmed the summary judgment award to the government in this erroneous refund suit, and in the process 564 florida tax review [vol. 13:10 ―fletcherized‖ 3 the e&y consulting partner involved because she initially took the position of the parties to the transaction that all of the capgemini shares received vested in the year 2000 [the year of the exchange], but after the stock declined in value took the position that she received income in 2000 only to the extent of cash she received in that year and the remainder of her income was recognized in 2003 [when the stock was worth less than onefifth of its 2000 value].  judge easterbrook did not appreciate the argument that she signed the ―consulting partner transaction agreement‖ [which provided for taxable gain in 2000] only because she was afraid she would be fired if she did not do so. both the district court and the seventh circuit held that under either commissioner v. danielson, 378 f.2d 771 (3d cir. 1967), or the alternative ―strong proof‖ test, taxpayer was bound by the agreement she signed. he stated that: fletcher argues that she didn‘t ―really‖ agree to the structure that ernst & young and cap gemini (and most of her partners) wanted in 2000. if she had voted no and refused to sign, she maintains, she would have been excluded from the economic benefits and might have been fired. if this is so, then she had a difficult choice to make; it does not relieve her of the choice‘s consequences. hard choices may be gut-wrenching, but they are choices nonetheless. even naïve people baffled by the fine print in contracts are held to their terms; a sophisticated business consultant who agrees to a multi-million-dollar transaction is not entitled to demand the deal‘s benefits while avoiding its detriments. the argument that fletcher can avoid the terms as a matter of contract law is frivolous. all that matters now are the tax consequences of the contracts she signed.  judge easterbrook concluded: the more likely it is that the conditions will be satisfied, and all restrictions lifted, the more sensible it is to treat all of the stock as constructively received when deposited in the account. to see this, suppose that the parties had wanted to defer the recognition of income and had put $2.5 million in each partner‘s account, with the condition that the whole amount would be forfeited if the temperature in barrow, alaska, exceeded 80 [degrees] f on january 1, 2005. would the remote possibility of an arctic heat wave enable the partners to defer paying taxes? surely not. see 3. horace fletcher (1849–1919), a health food faddist, argued that food should be chewed thirty-two times before being swallowed. “nature will castigate those who don’t masticate.” 2013] recent developments in federal income taxation 565 cemco investors, llc v. united states, 515 f.3d 749 (7th cir. 2008). if, on the other hand, the parties agreed that the ex-partners would receive $ 2.5 million only if the temperature in barrow on january 1, 2005, exceeded 80 [degrees] f, then none of the partners would constructively receive income in 2000; everything would depend on events in 2005. the sort of contingencies that could lead to forfeitures were within the ex-partners‘ control. that implies taxability in 2000, for control is a form of constructive possession. and the agreement to discount the stock by only 5% tells us that the parties deemed forfeitures unlikely. fletcher‘s acknowledgment that the risk of forfeiture was small shows that the conditions of constructive receipt in 2000 have been satisfied. thus although we agree with fletcher that the expartners are entitled to contest the tax treatment called for by the 2000 contracts, we hold that the shares are taxable in 2000 at their value on the date of deposit to the accounts at merrill lynch. income was constructively received in that year not because the contract said that everyone would report it so to the irs, but because the parties were right to think that this transaction‘s actual provisions made the income attributable to 2000. that the price of capgemini stock dropped in 2001 and later does not entitle the parties to defer the recognition of income. fletcher must repay the refund (and amend her returns for later years to reflect receipt of the income in 2000). c. ex-post recharacterization is not an option for taxpayers. united states v. bergbauer, 602 f.3d 569 (4th cir. 4/16/10). the fourth circuit affirmed a summary judgment for the government in an erroneous refund suit. the taxpayer exchanged her partnership interest in ernst & young for stock of cap gemini, a corporation acquiring e&y‘s consulting business, in a transaction that was not a statutory nonrecognition event; however, the stock was held in escrow to enforce a forfeiture provision if the seller-taxpayer failed to perform certain services as an employee of the acquiring corporation. the taxpayer initially reported that all of the cap gemini shares received vested in the year 2000 (the year of the exchange), but after the stock declined in value took the position that income was realized in 2000 only to the extent of cash received in that year and the remainder of the income was recognized in 2003 (when the stock was worth less than one-fifth of its 2000 value). the court held that if a taxpayer exchanges one property for a different property, the gain 566 florida tax review [vol. 13:10 realized on the exchange must be recognized in the year the exchange occurs, even though the property received in the exchange is forfeitable if contractual provisions or representations in the contract for exchange are not subsequently satisfied and even though the property received in the exchange is held in escrow to assure enforcement of the forfeitability provisions. furthermore, the court refused to accept the taxpayer‘s argument that the transaction could be recast into a form different than that which it had taken. to put it plainly, we have bound taxpayers to ―the ‗form‘ of their transaction‖ when they attempt to recharacterize an otherwise valid agreement bargained for in good faith. [citation omitted] we have also refused to entertain arguments ―that the ‗substance‘ of their transaction triggers different tax consequences.‖ [citation omitted] this precept not only maintains the vital public policy of enforcing otherwise valid contracts, but also assures the reliability of agreed tax consequences to the public fisc. . . . there is no ―disparity‖ in allowing ―the commissioner alone to pierce formal‖ agreements as ―taxpayers have it within their own control to choose in the first place whatever arrangements they care to make.‖ [citation omitted]  earlier cases that reached the same result for other taxpayers involved in the same transaction include united states v. fletcher, 562 f.3d 839 (7th cir. 4/10/09); united states v. culp, 99 a.f.t.r.2d 2007-618, 2007-1 u.s.t.c. ¶50,399 (m.d. tenn. 12/29/06); and united states v. nackel, 105 a.f.t.r.2d 2010-474 (c.d. cal. 10/20/09). d. judge dyk stuck his finger into the cap gemini pie and pulled out a constructive receipt plum. hartman v. united states, 694 f.3d 96 (fed. cir. 9/10/12). this cap gemini case was decided in favor of the government, as were all of the other cap gemini cases. the federal circuit (judge dyk) rejected the government‘s argument that taxpayer was bound under commissioner v. danielson, 378 f.2d 771 (3d cir. 1967), by his agreement to recognize for federal income tax purposes in the year 2000 all the shares of cap gemini that were placed in escrow for him in that year because danielson was limited to situations where ―a taxpayer challenges express allocations of monetary consideration.‖ instead, judge dyk found that taxpayer was in constructive receipt of all the cap gemini stock that was received for him in exchange for his e&y partnership interest even though the stock was placed into an escrow account and he could not receive the stock until subsequent years — subject to the risk of forfeiture should he sooner voluntarily terminate his employment with cap gemini. 2013] recent developments in federal income taxation 567 7. extended tax-free capital gains for ―small‖ c corporation stock. who is going to rush out and form a c corporation to grab this benefit? the 2012 taxpayer relief (and not so grand compromise) tax act extends help to qualified small business stock. gain realized on a sale or exchange of qualified small business stock under § 1202, which was acquired after the date of enactment of the 2010 small business act [9/27/10] and before 1/1/11 [subsequently extended to ―before 1/1/12‖], was subject to 100 percent exclusion from gross income. the 2012 act, § 324(b), extends the 100 percent exclusion to stock acquired before 1/1/12 to before 1/1/14. gain attributable to qualified small business stock acquired between 9/27/10 and 1/1/14 is not treated as an amt preference item. the exclusion is applicable to noncorporate shareholders who acquire stock at original issue and hold the stock for a minimum of five years. under the former 50 percent and 75 percent exclusions, included gain was subject to tax at the 28 percent capital gains rates. the amount of excluded gain attributable to any one corporation is limited to the greater of ten times the taxpayer‘s basis in a corporation‘s stock sold during the taxable year or $10 million reduced by gain attributable to the corporation stock excluded in prior years. qualified small business stock is stock issued by a c corporation engaged in the active conduct of a trade or business with gross assets (cash plus adjusted basis of assets) not in excess of $50 million. 8. application of the step transaction doctrine obviates the need to apply a statutory anti-abuse rule. g.d. parker, inc. v. commissioner, t.c. memo. 2012-327 (11/27/12). a panamanian corporation (vicmar) owned a minority interest in a peruvian telecommunications corporation (tele2000). the stock had a built-in loss of over $12 million. in march 2004, bellsouth, the owner, though a subsidiary of the majority interest, agreed to sell its stock of tele2000 to telefonica (a spanish corporation). telefonica‘s announced plan was to purchase 100 percent of tele2000. during the period between march 2004 and december 21, 2004, vicmar took steps to transfer its stock of tele2000 to the taxpayer, g.d. parker, inc. on december 16, the parties, including the taxpayer, entered into a share transfer and settlement agreement, and the sale was finalized on december 21, 2004. the taxpayer was made a party to the share transfer agreement at the last minute after the sole shareholder of vicmar represented to bell south and telefonica that the taxpayer was the owner of the tele2000 shares. before the last-minute representation, bellsouth‘s representative was unaware of the taxpayer‘s existence. applying the end result version of the step transaction doctrine, the tax court (judge haines) held that vicmar, the panamanian corporation, not the taxpayer u.s. corporation, was the true seller of the stock and disallowed the taxpayer‘s loss deduction. [i]t is clear from the record that, from the start, the acquisition of the tele2000 shares by petitioner and the 568 florida tax review [vol. 13:10 subsequent sale to telefonica were really steps of a single transaction intended to be taken for the purpose of reaching the ultimate result. those steps constituted part of a prearranged plan to have telefonica obtain the tele2000 shares while having the capital loss shifted to petitioner. had telefonica acquired the shares directly from vilanova, this shift in the capital loss would not have occurred, and petitioner would have been obligated to report a capital gain rather than a capital loss that it could carry back to prior years. petitioner may not avoid this result by employing mere formalisms thinly disguised to mask its true intentions. . . . hence under the end-result test petitioner‘s ownership of the tele2000 shares must be ignored, with telefonica being viewed as having acquired the shares from vilanova.  the irs also argued that § 362(e), which would have reduced the taxpayer‘s basis in the stock to fair market value, applied, but judge haines concluded that there was no need to reach a decision with respect to § 362(e) because under the step transaction doctrine there was no transfer of the stock from vicmar to the taxpayer for income tax purposes. 9. the taxpayer passed the benefits and burdens of ownership to his wholly owned corporation, so he sold the property and recognized a gain. gaggero v. commissioner, t.c. memo. 2012-331 (11/29/12). in the early 1990s, the taxpayer bought, for $3 million, and moved into a rundown beach house in malibu that was renovated into a splendid mansion while he lived in it as his primary residence. before renovations began, in 1991 he entered into a land contract purchase and sale agreement and a development contract (bcc), a real estate development corporation that was wholly owned by the taxpayer. the essence of the deal was that bcc would provide the development services and bcc would receive an equal share in any increase in the property‘s value between the time the contract was signed and the time the property was sold to a third party, even though the taxpayer would pay most of the costs of the project. bbc would receive its interest if it completed its work. the project was completed in 1997 and the residence was sold for $9.6 million. the taxpayer reported a receipt of $6.6 million, but claimed that pursuant to former § 1034 none of it was recognizable because he purchased a new residence for $6.7 million. bbc reported ordinary income of $3 million. the irs contended that the taxpayer never sold any interest in the residence to bbc and that he realized $9 million on its sale and should have reported a $2.9 million gain. the tax court (judge holmes) engaged in an extensive factual inquiry of whether the benefits and burdens of ownership in a partial interest in the residence had passed to bbc prior to the sale to the ultimate 2013] recent developments in federal income taxation 569 purchaser, and concluded that because benefits and burdens of ownership had been transferred, a partial ownership had passed from the taxpayer to bbc prior to the sale to the ultimate purchaser. that the taxpayer continued to maintain the property as his primary residence did not alter that fact. accordingly, a sale had occurred. however, the sale from the taxpayer to bbc occurred in 1997, when bbc‘s interest vested, and the amount realized on that sale was $3 million; the remaining $6.6 million was realized by the taxpayer on the sale of the remaining interest. since he realized $9.6 million of the sale of his residence and purchased a replacement residence for only $6.7 million, he should have recognized a gain of $2.9 million. however, the court did not uphold penalties, finding that the taxpayer relied in good faith on his tax advisor. b. interest, dividends, and other current income 1. the statute might read ―state or local bond‖ but it means ―state or local obligation.‖ denaples v. commissioner, 674 f.3d 172 (3d cir. 3/19/12). the third circuit (judge fuentes) held that the § 103 exclusion for state and local bond interest applied to interest on an obligation issued by a state government that provided for deferred payments, with interest, to compensate the taxpayers for condemned land. even though § 103 refers to ―bond[s],‖ it applies to any ―obligation‖ of a state that is incurred ―under the borrowing power.‖ however, it does not to apply when a government‘s obligation to pay interest arises by operation of law. in this case the state‘s obligation to pay interest arose from voluntary bargaining in which the state invoked its borrowing power. 2. what does ―traded on an established securities market‖ mean in the internet era? reg-131947-10, property traded on an established market, 76 f.r. 1101 (1/7/11). under the oid rules, if a debt instrument is issued for stock or other debt instruments (or other property) that is traded on an established securities market (often referred to as ―publicly traded‖), the issue price of the debt instrument is the fair market value of the stock or other property. similarly, if a debt instrument issued for property, such as another debt instrument, is traded on an established securities market, the issue price of the debt instrument is the fair market value of the debt instrument. see reg. § 1.1273-2(c). among other issues, a debt-for-debt exchange (including a significant modification of existing debt) in the context of a work-out may result in a reduced issue price for the new debt, which generally would produce (1) cod income for the issuer (i.e., debtor), (2) a loss to a holder (i.e., creditor) whose basis is greater than the issue price of the new debt, and (3) oid that must be accounted for by both the issuer and the holder of the new debt. the treasury has published proposed regulations that are intended to simplify and clarify the 570 florida tax review [vol. 13:10 determination of when property is traded on an established market. prop. reg. § 1.1273-2(f)(1) would identify four ways for property to be traded on an established market: (1) the property is publicly traded on an exchange (as defined), which is relatively unusual for debt instruments other than corporate bonds; (2) a sales price for the property is reasonably available — it appears in a medium that is made available to persons that regularly purchase or sell debt instruments, or persons that broker purchases or sales of debt instruments‖ (―a sale that is reported electronically at any time in the 31-day time period, such as in the trade reporting and compliance engine (―trace‖) database maintained by the financial industry regulatory authority, would cause the instrument to be publicly traded, as would other pricing services and trading platforms that report prices of executed sales on a general basis or to subscribers‖); (3) if a firm price quote to buy or sell the property is available; or (4) a price quote (other than a firm quote) that meets certain standards set forth in the regulations is provided by a dealer, a broker, or a pricing service (an indicative quote). in all four cases, the time for determining whether the property is publicly traded is the 31-day period ending fifteen days after the issue date of the debt instrument. there would be an exception for ―small debt issues — those below $50 million. the regulations will apply to debt instruments that have an issue date on or after the promulgation of final regulations. a. finalized with some important changes. t.d. 9599, property traded on an established market, 77 f.r. 56533 (9/13/12). final reg. § 1.1273-2(f)(1) substantially follows the framework of the proposed regulations but provides only three rules for determining that property is traded on an established market. reg. § 1.1273-2(f)(1) provides that property is traded on an established market if at any time in the 31-day time period ending 15 days after the issue date of a debt instrument: (1) a sales price for the property is reasonably available — it appears in a medium that is made available to persons that regularly purchase or sell debt instruments, or persons that broker purchases or sales of debt instruments (a sale that is reported electronically such as in the trade reporting and compliance engine (trace) database maintained by the financial industry regulatory authority, would cause the instrument to be publicly traded, as would other pricing services and trading platforms that report prices of executed sales on a general basis or to subscribers); (2) a firm price quote to buy or sell the property is available; or (3) a price quote (other than a firm quote) that meets certain standards set forth in the regulations, is provided by a dealer, a broker, or a pricing service (an ―indicative quote‖). very significantly, reg. § 1.1273-2(f)(6) provides that a debt instrument will not be treated as traded on an established market if at the time the determination is made the outstanding stated principal amount of the issue that includes the 2013] recent developments in federal income taxation 571 debt instrument does not exceed $100 million (rather than $50 million as provided in the proposed regulations). the other significant change made in the final regulations is to require that the issue price be reported consistently by issuers and holders.  the regulations generally apply to a debt instrument issued on or after 11/13/12.  according to the preamble: the final regulations dispense with the category of exchange listed property because the small amount of debt that is listed rarely actually trades over the exchange. moreover, although stock, commodities, and similar property are commonly listed on and traded over a board or exchange, such property typically will be the subject of frequent sales or quotes and would be covered in a separate category of publicly traded property. a debt instrument that is issued for stock, commodities, or similar exchange traded property is therefore tested under the rule for property where there is a sales price or quote within the 31-day period ending 15 days after the issue date of the debt instrument. eliminating the category of property listed on an exchange also eliminates the need for the de minimis trading exception in the proposed regulations, which was intended to exclude property that is listed on an exchange but trades in a negligible quantity. 3. ouch! he got nothing in pocket, but his realized income was $29,093.30. brown v. commissioner, 693 f.3d 765 (7th cir. 9/11/12). the taxpayer owned an insurance policy on which he had borrowed money in excess of the cash surrender value. at the time that the policy was cancelled by the insurance company, the taxpayer had paid $44,205.00 in premiums, but the insurance company had applied $31,063.30 of policy dividends to the purchase of additional insurance above the $100,000 face value of the policy, and $4,869.94 of dividends had been applied to pay premiums and repay policy loans. the additional paid up life insurance had been surrendered for its cash value to repay policy loans prior to the cancellation of the base $100,000 policy. the seventh circuit (judge posner) affirmed a tax court decision holding that the taxpayer‘s investment in the contract had been reduced from $44,205.00 to $8,271.76 as a result of the application of $35,933.24 of dividends as described. accordingly, because the cash surrender value of the policy, which was applied against policy loans when it was cancelled was $37,365.06, taxpayer realized income of $29,093.30 ($37,365.06 $8,271.76). 572 florida tax review [vol. 13:10 4. exempt financing for new york liberty zone bonds extended. the 2012 taxpayer relief act, § 328, extends the issue date for exempt new york liberty bonds to bonds issued before january 1, 2014. c. profit-seeking individual deductions there were no significant developments regarding this topic during 2012. d. section 121 there were no significant developments regarding this topic during 2012. e. section 1031 1. judge goeke lets the taxpayer get away with a like-kind exchange claim where the replacement property was used as taxpayer‘s principal residence. reesink v. commissioner, t.c. memo. 2012-118 (4/23/12). the taxpayer disposed of an undivided one-half interest in an apartment building (along with his estranged brother) and acquired a single family home (the laurel lane property), which was originally acquired as investment or rental property, but into which the taxpayer and his family moved, as their principal residence, eight months after the acquisition. according to the tax court (judge goeke), the only issue in the case relating to whether the acquisition and disposition of the two properties qualified as a like kind-exchange was whether the taxpayer held the acquired property ―with investment intent at the time of the exchange.‖ based on a number of factors, including the taxpayer‘s efforts to rent the acquired property, that he did not sell his principal residence in another city until six months after the acquisition, and the testimony of the taxpayer‘s estranged brother that the taxpayer did not plan to relocate until his son was finished with high-school, which he was not at the time of the transaction, judge goeke held that the taxpayer had acquired the property for investment. 2. rental property occupied by the taxpayer‘s son was investment property, not personal-use property. adams v. commissioner, t.c. memo. 2013-7 (1/10/13). the taxpayer engaged in a deferred like-kind exchange through an intermediary in which he surrendered a property held for rental and acquired a new residential property that was dilapidated and in need of rehabilitation. the taxpayer and his son entered into an agreement whereby the son and his family could live in the new 2013] recent developments in federal income taxation 573 house after renovations. the son and his family worked on the house an aggregate of 60 hours per week for three months before moving in. the son and his family bore all of the rehabilitation expenses; their services were worth $3,600. after three months of work, the son‘s family moved-in, resided in the house for three years, and paid rent that was a few hundred dollars per month less than the fair rental value. the irs took the position that the transaction was not a § 1031 like-kind exchange because the taxpayer acquired the new house for personal purposes — i.e., ―with the intention of letting his son and family live there at below market rent‖ — and that the taxpayer thus must recognize gain on the sale. the tax court (judge morrison) found that the taxpayer had acquired the new house for investment purposes and that the transaction thus qualified as a § 1031 like-kind exchange. furthermore, the limitations on deductions imposed by § 280a did not apply to the new house rented to the son. pursuant to § 280a(d)(2), a taxpayer is treated as using a dwelling unit during the taxable year as a residence if the taxpayer rents the dwelling unit to a family member, unless the taxpayer rents the dwelling unit to the family member ―at a fair rental‖ and for use as that family member‘s principal residence. the son used the residence as his principal residence and, although the $1,200 per month cash rent was slightly below market, it was fair rent considering the work that the son had performed with respect to the house. thus the § 280a(a) prohibition of deductions for dwelling units used as residences did not apply. f. section 1033 there were no significant developments regarding this topic during 2012. g. section 1035 there were no significant developments regarding this topic during 2012. h. miscellaneous 1. it takes a paper trail to prove that stock is ―qualified small business stock,‖ but a bribery attempt by taxpayer‘s representative [an enrolled agent] during the audit was not sufficient to support a fraud penalty. holmes v. commissioner, t.c. memo. 2012-251 (8/30/12). section 1045 provides for elective nonrecognition of capital gain on the sale of ―qualified small business stock,‖ as defined in § 1202, if the stock has been held for more than six months, and if the taxpayer purchases replacement qualified small business stock within 60 days of the date of the sale. the taxpayer‘s efforts to defer gain on the sale of stock in this case 574 florida tax review [vol. 13:10 failed. the tax court (judge halpern) held that § 1045 did not apply because, among other reasons, the taxpayer failed to prove that (1) as required by § 1202(c)(1)(b), he acquired the stock at its original issue in exchange for money, or (2) as required by § 1202(d)(1)(a) and (b), the corporation‘s aggregate gross assets immediately after the stock issuance did not exceed $50 million. the taxpayer offered no documentary evidence, such as stock certificates or book entries from the corporation, indicating from whom he acquired the stock. nor did the taxpayer introduce into evidence corporate balance sheets or other financial statements showing the amount of cash and property held by the corporation before and immediately after each date he acquired stock.  even though the taxpayer‘s return preparer/representative during the audit, an enrolled agent, attempted to bribe the revenue agent conducting the audit, behavior that judge halpern described as ―highly inappropriate,‖ such behavior was not sufficient to support imposition of a fraud penalty, because, among other facts, the record was ―devoid of evidence indicating that mr. afshar‘s actions towards agent mahamoud, while highly inappropriate, were part of petitioner‘s scheme of tax evasion initiated at the time of filing the subject tax returns. as we have stated above, it seems more likely that mr. afshar‘s actions were a continuation of his attempt at mitigating the tax preparation errors.‖  compare: the taxpayer‘s conduct was not fraudulent, but maybe he wasn‘t an innocent babe in the woods either. the return was fraudulent even though the taxpayer did not know it. allen v. commissioner, 128 t.c. 37 (3/5/07). judge kroupa held that the statute of limitations for a fraudulent return is extended under § 6501(c)(1), even though it was solely the return preparer, rather than the taxpayer, who had the intent to evade tax. the taxpayer was a truck driver who filed timely returns for the years at issue. he gave his form w-2, 401(k) statement, mortgage interest statement, and other relevant documents to his return preparer (goosby) who prepared the returns and filed them. as prepared by goosby, the returns claimed false and fraudulent itemized deductions for charitable contributions, meals and entertainment, and pager and computer expenses, as well as various other expenses. the taxpayer received complete copies of the returns for the years at issue after they had been filed, but he did not file any amended tax returns. judge kroupa reasoned as follows: we do not find it unduly burdensome for taxpayers to review their returns for items that are obviously false or incorrect. it is every taxpayer's obligation. petitioner cannot hide behind an agent‘s fraudulent preparation of his returns and escape paying tax if the government is unable to investigate fully the fraud within the limitations period. 2013] recent developments in federal income taxation 575  she further noted that the irs was seeking to collect only the deficiency (and interest) from the taxpayer. iv. compensation issues a. fringe benefits 1. the irs modifies guidance on reporting of employer-provided healthcare coverage despite the fact that the amounts reported have no relevance whatsoever to anyone‘s taxes. notice 2012-9; 2012-4 i.r.b. 315 (1/3/12), superseding notice 2011-28, 2011-16 i.r.b. 656. the irs has issued interim guidance on informational reporting to employees of the cost of their group health insurance coverage under § 6051(a)(14). the notice includes the following statement: ―this reporting to employees is for their information only. the reporting is intended to inform them of the cost of their health care coverage, and does not cause excludable employer-provided health care coverage to become taxable. nothing in § 6051(a)(14), this notice, or the additional guidance that is contemplated under § 6051(a)(14), causes or will cause otherwise excludable employer-provided health care coverage to become taxable.‖ 2. the irs began ramping up for the patient protection and affordable care act even before the supreme court upheld it. notice 2012-17, 2012-9 i.r.b. 430 (2/9/12). the irs (along with the labor department and department of health and human services) has issued guidance in q-&-a format that is intended to identify likely direction and scope of future regulations and other published guidance addressing provisions of the patient protection and affordable care act that become effective beginning in 2014. the guidance explains (1) automatic enrollment of new full-time employees where employer has more than 200 full-time employees; (2) employer shared responsibility and assessable payment; and, (3) 90-day limitation on waiting period. 3. the value of those corporate jets that some people want to tax. rev. rul. 2012-10, 2012-14 i.r.b. 614 (3/29/12). the irs has announced the cents-per-mile and terminal charges for calculating the value of noncommercial flights on employer-provided aircraft as a fringe benefit for the period january 1 through june 30, 2012. the cents-per-mile is multiplied by the aircraft multiple (based on size) in reg. § 1.61-21(g)(7), then increased by the terminal charge. the mileage rates are, up to 500 miles, $0.2455 per mile; 501-1500 miles, $0.1872 per mile; and over 1500 miles, $0.1800 per mile. the terminal charge is $44.88. 576 florida tax review [vol. 13:10 4. this one hits parents of special needs children the hardest. wouldn‘t it just be easier to have a government-run national health care program? then we could have rationing by queue. notice 2012-40, 2012-26 i.r.b. 1046 (5/30/12). this notice provides guidance on the limits in § 125(i) on salary reduction contributions to health flexible spending arrangements, effective for cafeteria plan years beginning after 12/31/12, and requests comments on possible modification to the ―use-orlose‖ rule in the proposed § 125 regulations. the notice provides that the $2,500 limit does not apply for plan years that begin before 2013 and plans may adopt the required amendments to reflect the $2,500 limit at any time through the end of calendar year 2014. (indexing of the $2,500 limit applies to plan years beginning after 12/31/13.) for plans providing a grace period (which may be up to two months and 15 days), unused salary reduction contributions to the health fsa for plan years beginning in 2012 or later that are carried over into the grace period for that plan year will not count against the $2,500 limit for the subsequent plan year. 5. did the tax court really mean to deny a deduction for a taxable fringe benefit? dkd enterprises, inc. v. commissioner, t.c. memo. 2011-29 (1/31/11). the tax court (judge chiechi) upheld the irs‘s denial of the corporation‘s deduction of the cost of medical insurance premiums for a policy covering its employee/sole shareholder because the corporation ―failed to carry its burden of establishing that it had in effect during any of the years at issue a sickness, hospitalization, medical expense, or similar benefit plan for employees.‖ for that same reason, the individual shareholder/employee was not entitled to exclude the amount of the premiums under either § 105 or § 106.  notably, the court did not expressly recharacterize the premium payment as a constructive dividend. a. and the eighth circuit also seems to be smoking suspicious substances in analyzing this issue. dkd enterprises, inc. v. commissioner, 685 f.3d 730 (8th cir. 7/17/12). the eighth circuit, in an opinion by judge riley, affirmed ―[b]ecause the tax court permissibly found dkd failed to prove the payments were made pursuant to a predetermined plan for the benefit of employees.‖ although acknowledging that under reg. § 1.105-5, ―a plan may cover a single employee or limited class of employees; need not be in writing; and need not be enforceable by the employee,‖ the court held that there was no ―plan‖ because while the taxpayer ―testified dkd ‗paid [her] quarterly medical insurance,‘ paying approximately the same amount for her insurance in 2003, 2004, and 2005,‖ she ―did not testify these payments were made according to a pre-determined ‗plan‘ intended to benefit employees.‖ 2013] recent developments in federal income taxation 577  we wonder whether the court‘s reasoning indicates that it thought twelve consecutive payments for medical insurance were made by accident. ―plan‖ versus ―accident;‖ are there any other alternatives? 6. premiums for corporate welfare benefit plans for principal owners fail the smell test, with penalties. curcio v. commissioner, 689 f.3d 217 (2d cir. 8/9/12). in consolidated cases involving three different subchapter s corporations, judge chin upheld the tax court‘s denial of deductions for premiums paid to maintain welfare benefit plans consisting of individual life insurance policies for selected employees, the so-called benistar 419 plan, a multi-employer welfare benefit trust. the plan allowed the policy beneficiaries to withdraw the life insurance policies from the plan and obtain the net surrender value. in each case the court found that the life insurance policies were provided to key employees (shareholders) for the personal benefit of the employees (to fund a buy/sell agreement, to provide retirement planning, and to divert business profits). while the court acknowledged that contributions to a welfare benefit plan may be deductible, in these cases the court indicated that the tax court did not err in finding that the contributions were not helpful for the development of the taxpayers‘ businesses and were made instead for the personal benefit of the s corporation shareholders. the court observed that the plan was designed to benefit the owners and their families, not the respective business entities. in addition to upholding tax deficiencies representing increased pass-through income to the taxpayers, the court upheld § 6662(a) accuracyrelated penalties, again indicating that the tax court did not err in concluding that the taxpayers were negligent and acted in disregard of the tax rules and regulations. the court further rejected the taxpayer‘s assertion that they relied on the advice of their accountants noting that there was little reason for the taxpayers to believe that their accountants were experts in the tax treatment of welfare benefit plan contributions or that the accountants had sufficiently researched the issue. 7. putin might be fighting american adoptions, but congress likes adoptions. the 2012 taxpayer relief (and not so grand compromise) tax act, § 104, made permanent the code § 137 exclusion for employer-provided adoption assistance. the maximum exclusion is $12,170 (adjusted for inflation), and the phase-out range is $182,520 to $222,520 (adjusted for inflation). b. qualified deferred compensation plans 1. rev. proc. 2013-12, 2013-4 i.r.b. 313 (12/31/12), modifying and superseding rev. proc. 2008-50, 2008-2 c.b. 464. this 578 florida tax review [vol. 13:10 revenue procedure updates the comprehensive system of correction programs for sponsors of retirement plans that are intended to satisfy the requirements of §§ 401(a), 403(a), 403(b), 408(k), or 408(p) of the code, but that have not met these requirements for a period of time. this system, the employee plans compliance resolution system (―epcrs‖), permits plan sponsors to correct these failures and thereby continue to provide their employees with retirement benefits on a tax-favored basis. the components of epcrs are the self-correction program (―scp‖), the voluntary correction program (―vcp‖), and the audit closing agreement program (―audit cap‖). c. nonqualified deferred compensation, section 83, and stock options 1. a sad story involving non-qualified stock options, with a different twist. mclaine v. commissioner, 138 t.c. no. 10 (3/13/12). in this review of a cdp proceeding, the tax court, in a reviewed opinion by judge colvin, sustained the irs‘s determination to proceed with a levy against the taxpayer to collect unpaid taxes resulting from his exercise of non-qualified stock options. the taxpayer argued that in the cdp proceeding the irs wrongly denied him a § 31 credit for a third-party payment by a successor to his former employer of the taxes that should have been withheld from the stock proceeds but which the taxpayer claimed were paid in the year after the year in which he filed his tax return. judge colvin found that there was no evidence that any such payment occurred.  judge halpern (joined by judge holmes) concurred, but would have held that as a matter of law, even if the successor company paid the non-withheld taxes associated with the option exercise in a later year, the taxpayer would not have been entitled to a § 31(a) credit for the payment. he wrote: i believe the law is clear that an employer‘s (or former employer‘s) payment to the internal revenue service (irs) of taxes that should have been, but were not, withheld in a prior year does not entitle the employee to a section 31(a) credit for that payment. under those circumstances we have a duty not to mislead taxpayers by perpetuating a case . . . that may very well encourage needless litigation. therefore, we should hold, in the alternative, that, as a matter of law, the vartec payment alleged by petitioner, even if proven, would not entitle him to a section 31(a) credit therefor. 2. 20/20 hindsight doesn‘t change the value of stock purchased through stock options. sheedy v. commissioner, t.c. memo. 2012-69 (3/14/12). in june 2006, the taxpayer exercised nonstatutory stock 2013] recent developments in federal income taxation 579 options in his employer, which six months later was bankrupt. the stock was not publicly traded but was bought and sold through an investment bank that maintained a trading desk with the ability to facilitate secondary trading among and between accredited investors and qualified institutional buyers; the investment bank did not set these prices but reported prices resulting from a bid-ask process in which it acted as the market maker. between january 11, 2005, and february 22, 2007, the price per share ranged between $1.50 and $10.25. at the time the taxpayer exercised the options, and for several months thereafter, the investment bank sold several blocks of stock for $3 per share. the taxpayer received a w-2 showing $744,466.25 in gross income — the difference between the $750,000 fair market value of the stock (at $3 per share) on the exercise date and the $5,533.75 the taxpayer paid for the stock. nevertheless, the taxpayer argued that the stock was worthless on the date of exercise and that he therefore realized no income. the tax court (judge laro) rejected that argument. citing first national bank of kenosha v. united states, 763 f.2d 891, 894 (7th cir. 1985) as controlling authority, the court held that ―subsequent events should not be used to determine fair market value, except to the extent that they were reasonably foreseeable on the valuation date.‖ on the record, the bankruptcy and the worthlessness of the stock were not reasonably foreseeable events on the exercise date. following the principle that ―price of stock in a liquid market is presumptively the one to use in judicial proceedings,‖ the court accepted the irs‘s valuation of $3 per share. the taxpayer was required to include $744,466.25 in gross income — the difference between the $750,000 fair market value of the stock on the exercise date and the $5,533.75 that he paid for the stock. 3. tightening the meaning of ―substantial risk of forfeiture.‖ reg–141075–09, property transferred in connection with the performance of services under section 83, 77 f.r. 31783 (5/30/12). the treasury department has proposed amendments to reg. § 1.83-3 to clarify the meaning of ―substantial risk of forfeiture.‖ under the proposed amendments, a substantial risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer. when determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered. in addition, the proposed amendments clarify that except as specifically provided in § 83(c)(3) and reg. § 1.83–3(j) and (k), transfer restrictions do not create a substantial risk of forfeiture, including transfer restrictions which carry the potential for forfeiture or disgorgement of some or all of the property, or other penalties, if the restriction is violated. the proposed amendments would add two additional examples to reg. § 1.83–3(c)(4) illustrating that a substantial risk of 580 florida tax review [vol. 13:10 forfeiture is not created solely as a result of potential liability under rule 10b–5 of the securities exchange act of 1934 or a lock-up agreement. (this change incorporates the holding of rev. rul. 2005-48, 2005-2 c.b. 259, holding that if an employee exercises a nonstatutory option more than six months after grant, and thus outside the period covered by § 16 of the securities exchange act of 1934, but is subject to restrictions on his ability to sell the stock obtained through exercise of the option under rule 10b-5 under the securities exchange act of 1934 and ―lock-up‖ contractual provisions imposed by the employer in connection with a public offering, the employee is required to recognize income under § 83 at the time of the exercise of the option because full enjoyment of the shares is not conditioned on any obligation to provide future services.)  the proposed amendments are proposed to apply to property transferred on or after 1/1/13. taxpayers may rely on the proposed regulations for property transferred after 5/30/12. 4. the irs provides help to avoid messing up your § 83(b) election, but you still have to remember to file it on time, i.e., within 30 days. rev. proc. 2012-29, 2012-28 i.r.b. 49 (6/27/12). this revenue procedure provides sample language that may be used, but is not required to be used, for making a § 83(b) election. it also provides several examples of the consequences of making a § 83(b) election. d. individual retirement accounts 1. the ―use a c corporation to increase ira contributions‖ scam is struck down. repetto v. commissioner, t.c. memo. 2012-168 (6/14/12). the tax court (judge marvel) imposed the 6 percent excess contribution tax under § 4973 for a scheme established by the taxpayers‘ cpa. the taxpayers formed two corporations, most of the stock of which was held by the taxpayers‘ newly formed iras. one of the two corporations was intended to provide office and support services, and the other to provide marketing and business development services to the taxpayers‘ construction and rental property businesses operated through an s corporation and llc. the court indicated that the preponderance of the evidence supported a finding that the service agreements and the payments to the roth ira owned corporations ―were nothing more than a mechanism for transferring value to the ira.‖ the court stated that the service agreements did not change the identity of the person providing services to the construction businesses, the taxpayers continued to do the work as they had done before the arrangement was structured, and the taxpayers provided no written documentation of the services provided. the court‘s conclusion was bolstered by the language of the engagement letter with the cpa, which 2013] recent developments in federal income taxation 581 supported the finding that payment of dividends to the roth iras was the primary goal of the support agreements. the court determined that the amount contributed to the roth ira and the amount of excess contributions should be determined based on the fair market value of the roth ira at year end. the court rejected the irs approach that would have treated payments to the corporations as distributions to the taxpayers who subsequently contributed the amounts to the roth iras.  in the consolidated cases the court also held that amounts distributed by the taxpayers‘ s corporation were to be treated as wages rather than distributions.  amounts paid for medical plans that benefited the taxpayers by the ira-owned c corporations were disallowed as deductions by the corporations because the employment relationship with mrs. repetto was a sham.  the taxpayers were liable for a 5 percent penalty for failure to file form 5329 reporting excess contributions to their iras and that the taxpayers‘ reliance on the tax professionals who promoted the scheme was not reasonable.  the taxpayers were liable for the 20 percent penalty of § 6662a incurred for an understatement attributable to a reportable transaction. the transaction was substantially similar to the listed transaction described in notice 2004-8, 2007-1 c.b. 333, promulgated before the taxpayers filed returns involving the transaction. in addition, the taxpayers were held liable for the increased 30 percent penalty of § 6662a(c) for failing to file a disclosure of their participation in a listed transaction. again the court found that taxpayers did not reasonably rely on the advice of independent tax professionals.  the court revised the irs computation of the understatement subject to penalties by holding that understatements attributable to wages paid by the taxpayers‘ s corporation and the disallowance of medical expense deductions were not related to the listed transaction. v. personal income and deductions a. rates 1. doma could be on its way to the supreme court. on the other hand, might this case lead to doma becoming the twenty-eighth amendment? not likely, unless it was left to the bigoted voters. massachusetts v. united states dept. of health and human services, 682 f.3d 1 (1st cir. 5/31/12), aff’g gill v. office of personnel management, 699 f. supp. 2d 374 (d. mass. 7/8/10). in an opinion by judge boudin, the first circuit held that § 3 of the defense of marriage act, 1 u.s.c. § 7, 582 florida tax review [vol. 13:10 which limits the meaning of the word ―marriage‖ to ―a legal union between one man and one woman as husband and wife,‖ and provides that ―the word ‗spouse‘ refers only to a person of the opposite sex who is a husband or wife‖ for purposes of all federal laws is an unconstitutional denial of equal protection in violation the equal protection principles embodied in the due process clause of the fifth amendment. joint return filing status under the code was one of the issues addressed in the case, as well as government benefits available to married individuals, e.g., employee health benefits, social security benefits. the court further ordered: anticipating that certiorari will be sought and that supreme court review of doma is highly likely, the mandate is stayed, maintaining the district court‘s stay of its injunctive judgment, pending further order of this court. a. the second circuit agrees in a split decision. windsor v. united states, 699 f.3d 169 (2d cir. 10/18/12) (2-1), cert. granted, 184 l. ed. 2d 527 (12/7/12). in an appeal from a grant of summary judgment in a tax refund suit by the district court for the southern district of new york, the second circuit (chief judge dennis jacobs) affirmed the grant of summary judgment to the surviving spouse of a samesex couple that was married in canada in 2007 and resided in new york at the time of her spouse‘s death in 2009 who was denied the benefit of the § 2056 marital deduction for federal estate tax on the ground that § 7 of the defense of marriage act violated the equal protection clause for want of a rational basis.  the court concluded that review of § 7 required heightened scrutiny because (a) homosexuals as a group have historically endured persecution and discrimination; (b) homosexuality has no relation to aptitude or ability to contribute to society; (c) homosexuals are a discernible group with non-obvious distinguishing characteristics, especially in the subset of those who enter same-sex marriages; and (d) the class remains a politically weakened minority. the circuit court further concluded that the class was quasi-suspect (rather than suspect) based on the weight of the factors and on analogy to the classifications recognized as suspect and quasi-suspect. the circuit court held that the rationale premised on uniformity was not an exceedingly persuasive justification for doma, and that doma was not substantially related to the important government interest of protecting the fisc.  judge straub dissented on the following basic ground: the majority holds doma unconstitutional, a federal law which formalizes the understanding of marriage in the federal context extant in the congress, the presidency, and the judiciary at the time of doma‘s enactment and, i 2013] recent developments in federal income taxation 583 daresay, throughout our nation‘s history. if this understanding is to be changed, i believe it is for the american people to do so. . . . at bottom, the issue here is marriage at the federal level for federal purposes, and not other legitimate interests. the congress and the president formalized in doma, for federal purposes, the basic human condition of joining a man and a woman in a long-term relationship and the only one which is inherently capable of producing another generation of humanity. whether that understanding is to continue is for the american people to decide via their choices in electing the congress and the president. it is not for the judiciary to search for new standards by which to negate a rational expression of the nation via the congress. 2. net investment income tax of 3.8 percent. 4 section 1411 of the code, added by the health care and education reconciliation act of 2010, imposes a 3.8 percent tax on the net investment income of individuals, estates, and trusts in taxable years beginning after 12/31/12. for individuals (except nonresident aliens), the tax applies only to the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over a threshold amount. i.r.c. § 1411(a)(1). the threshold amount is $250,000 for spouses filing a joint return or a surviving spouse, $125,000 for married individuals filing separate returns, and $200,000 for single taxpayers (including heads of household). i.r.c. § 1411(b). these threshold amounts for individuals are not adjusted for inflation. modified adjusted gross income is adjusted gross income increased by the amount of foreign earned income excluded under § 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income). i.r.c. § 1411(d). for estates and trusts, the tax is levied on the lesser of (1) undistributed net investment income, or (2) the excess of adjusted gross income (as defined in § 67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins for the tax year ($11,950 for 2013). i.r.c. § 1411(a)(2). the tax does not apply to a trust that is tax-exempt under § 501, is a charitable remainder trust tax-exempt under § 664, or all of the unexpired interests of which are devoted to charitable purposes. net investment income is investment income reduced by the deductions properly allocable to that income. investment income is the sum of (1) gross income from interest, dividends, annuities, royalties, and rents (other than income derived from any trade or business to which the tax does not apply), (2) other gross income derived from any trade or business to 4. we thank professor bruce mcgovern, south texas college of law for contributing this description of § 1411 and the regulations thereunder. 584 florida tax review [vol. 13:10 which the tax applies, and (3) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply. i.r.c. § 1411(c)(1). the § 1411 tax applies to trade or business income from (1) a passive activity, and (2) trading financial instruments or commodities (as defined in § 475(e)(2)). i.r.c. § 1411(c)(2). it does not apply to any other trade or business income. however, income on the investment of working capital is not treated as derived from a trade or business and is subject to tax under § 1411. i.r.c. § 1411(c)(3). gain or loss from the disposition of a partnership interest or stock in an s corporation is taken into account only to the extent gain or loss would be taken into account by the partner or shareholder if the entity had sold all its properties for fair market value immediately before the disposition. i.r.c. § 1411(c)(4). thus there is a deemed basis adjustment that results in taking into account only the net gain or loss attributable to the entity‘s property that is not attributable to an active trade or business. investment income does not include any distributions from a qualified retirement plan or any income subject to self-employment tax. i.r.c. § 1411(c)(5)-(6). unlike self-employment taxes, no part of the § 1411 tax is deductible in computing taxable income under chapter 1. the tax on net investment income is subject to the estimated tax provisions. i.r.c. § 6654(a). a. proposed regulations provide extensive guidance on the tax on net investment income. on 11/30/12, the treasury department issued proposed regulations regarding the § 1411 tax on net investment income. reg-130507-11, net investment income tax, 77 f.r. 72612 (12/05/12). the proposed regulations generally are proposed to be effective for tax years beginning after 12/31/13. the treasury department intends to issue final regulations during 2013. however, § 1411 is effective for tax years beginning after 12/31/12. taxpayers may rely on the proposed regulations for purposes of complying with § 1411 until the effective date of the final regulations.  general provisions. section 1411 is the only provision in chapter 2a of subtitle a of the code. chapter 2a does not contain any other operational or definitional provisions. the proposed regulations provide that, except as otherwise provided, all code provisions that apply for purposes of chapter 1 in determining taxable income as defined in § 63(a) also apply in determining the tax imposed by § 1411. prop. reg. § 1.1411-1(a).  application to estates and trusts. the proposed regulations provide as a general rule that the § 1411 tax applies to all estates and trusts that are subject to the provisions of part i of subchapter j of chapter 1 of subtitle a of the code. prop. reg. § 1.1411-3(a)(1)(i). 2013] recent developments in federal income taxation 585 accordingly, the § 1411 tax does not apply to trusts that are not classified as trusts under the check-the-box regulations (such as business trusts). it also does not apply to trusts that are exempt from taxes imposed by subtitle a of the code. prop. reg. § 1.1411-3(b)(2)-(4). this is true even if the trust is subject to tax on its unrelated business taxable income. the proposed regulations clarify that grantor trusts are not subject to the tax. the grantor or other person who takes into account the grantor trust‘s income and deductions is treated as receiving and paying those items directly for purposes of calculating that person‘s liability for the § 1411 tax. prop. reg. § 1.1411-3(b)(5). special computational rules apply to electing small business trusts and charitable remainder trusts. prop. reg. § 1.1411-3(c)(2). although charitable remainder trusts are not subject to the tax, annuity and unitrust distributions may be net investment income to the non-charitable beneficiary who receives them. the proposed regulations provide detailed rules regarding the calculation of an estate or trust‘s undistributed net investment income. prop. reg. § 1.14113(c)(e). generally, the rules for calculating undistributed net investment income are guided by the subchapter j concept of distributable net income, which apportions income between the trust and its beneficiaries.  net investment income. because trade or business income from a passive activity is net investment income, the status of activities as passive and the grouping of activities for purposes of the passive activity loss rules are significant. the proposed regulations provide taxpayers with a fresh start to regroup activities in the first tax year that begins after 12/31/13 in which § 1411 would apply to the taxpayer. prop. reg. § 1.46911(b)(3)(iv). net investment income, which is investment income reduced by the deductions properly allocable to that income, cannot be less than zero. deductions that exceed investment income can be carried forward only to the extent provided in chapter 1 of the code. prop. reg. § 1.1411-4(f)(1)(ii). deductions carried over to a tax year because they were suspended or disallowed by other provisions, such as the investment interest, basis, at-risk or passive activity loss limitations, and allowed for that year in determining adjusted gross income are also allowed in determining net investment income. this is true regardless of whether the taxable year from which the deductions are carried precedes the effective date of § 1411. if items of net investment income (including the properly allocable deductions) pass through to an individual, estate, or trust from a partnership or s corporation, the allocation of the items must be separately stated under § 702 or § 1366. the proposed regulations provide detailed guidance on determining the net investment income arising from the disposition of interests in partnerships or s corporations. prop. reg. § 1.1411-7.  international issues. under § 951(a), united states shareholders who own stock in a controlled foreign corporation on the last day of the corporation‘s taxable year must include in gross income their pro rata share of the cfc‘s subpart f income. similarly, united states 586 florida tax review [vol. 13:10 persons who hold stock of a passive foreign investment company and elect to treat the pfic as a qualified electing fund must include in gross income currently under § 1293 a pro rata share of the pfic‘s earnings and profits. when the cfc or pfic later distributes its earnings, the shareholders can exclude the distributions from gross income to the extent they previously were taxed on them. these income inclusions and exclusions result in positive and negative stock basis adjustments. because these income inclusions are not treated as dividends unless expressly provided for in the code, the proposed regulations do not treat the income inclusions as net investment income for purposes of § 1411. instead, cfc shareholders and pfic shareholders who have made a qualified electing fund election must treat actual distributions of previously taxed earnings as net investment income. prop. reg. § 1.141110(c)(2)(i). one effect of this rule is that a cfc or pfic shareholder can have one stock basis for purposes of chapter 1 of the code and a different stock basis for purposes of the § 1411 tax. to avoid these complexities, the proposed regulations allow a taxpayer to elect to treat the income inclusions required by § 951(a) and § 1293 as net investment income. prop. reg. § 1.1411-10(g). the election can be revoked only with the service‘s consent. although the proposed regulations do not address the issue, it appears that the § 1411 tax cannot be reduced with foreign tax credits because foreign tax credits reduce taxes imposed by chapter 1 of the code, and § 1411 is located in chapter 2a.  see also, faqs on the net investment income tax, released by the irs on 11/29/12, 2012 tnt 232-47. 3. ―middle class‖ tax rates extended ―permanently‖ by the 2012 taxpayer relief (and not so grand compromise) tax act, but the ―rich‖ must pay more. these changes made by act §§ 101 and 102 include:  individual income tax rates. the 10%, 15%, 25%, 28%, 33%, and 35% tax rates enacted in 2001 have been made permanent (including the expansion of the 15% bracket to mitigate the ―marriage penalty‖). however, the 39.6% rate from pre-2001 act law has been restored for taxable incomes in excess of the following amounts: (1) $450,000 for married couples filing jointly and surviving spouses; (2) $425,000 for headof-households; (3) $400,000 for single taxpayers; (4) $225,000 for married taxpayers filing separately. for tax years after 2013, these highest bracket threshold amounts are adjusted for inflation with 2012 as the base year. (for trusts and estates the brackets are 15%, 25%, 28%, 33% and, for income in excess of $11,950, 39.6%; there is no 35% rate bracket.)  capital gains and dividends. taxing qualified dividends at the same rate as long-term capital gains has been made permanent, but the maximum rate has been increased. the maximum rates are as follows: 20% for income otherwise in the 39.6% bracket, 15% for income 2013] recent developments in federal income taxation 587 otherwise in the 25% or higher bracket (but below the 39.6%), and zero for income otherwise in the 10% or 15% bracket.  the above rates are in addition to the affordable care act investment income tax. beginning in 2013, the 3.8% net investment income tax under code § 1411 applies to taxpayers whose modified adjusted gross income exceeds (1) $250,000 for joint returns and surviving spouses; (2) $125,000 for separate returns, and (3) $200,000 for all other taxpayers. thus, for qualified dividends and most capital gains, the overall rate for taxpayers in the 39.6% rate bracket will be 23.8%. for taxpayers who are subject to a 25%-or-greater rate on ordinary income, but whose income is below the 39.6% rate threshold and are subject to the net investment income tax, the rate will be 18.8%. b. miscellaneous income 1. the treasury department uses regulations to reverse a principle established in a supreme court decision that the government won. do mayo doubters think that the treasury exceeds its powers when it issues regulations giving away government victories in the supreme court? t.d. 9573, damages received on account of personal physical injuries or physical sickness, 77 f.r. 3106 (1/23/12). the treasury department has finalized proposed amendments (reg-127270-06, damages received on account of personal physical injuries or physical sickness, 74 f.r. 47152 (9/15/09)) to reg. § 1.104-1(c) under § 104(a)(2) to reflect amendments to § 104 and certain judicial decisions. the amended regulations provide that the § 104(a)(2) exclusion applies to personal physical injuries or physical sickness. emotional distress is not considered to be a physical injury or physical sickness. however, the regulations provide that damages for emotional distress attributable to a physical injury or physical sickness are excludable under § 104(a)(2). the regulations do not address loss of consortium or emotional distress from witnessing physical injury to another person. under the amended regulations, the term ―damages‖ means an amount received (other than workers‘ compensation) through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution. notably, the amended regulations eliminate the requirement in the prior regulations that to be excludable under § 104(a)(2) the damages must have been ―based upon tort or tort type rights.‖ thus, damages for physical injuries may qualify for exclusion under § 104(a)(2) even though the injury giving rise to the damages is not defined as a tort under state or common law. the reason for the change was the treasury department‘s concern that the supreme court‘s interpretation of the tort type rights test in united states v. burke, 504 u.s. 229 (1992), limiting the § 104(a)(2) exclusion to damages for personal injuries for which the full range of tort-type remedies is available, could 588 florida tax review [vol. 13:10 preclude an exclusion under § 104(a)(2) for redress of physical personal injuries under a ―no-fault‖ statute that does not provide traditional tort-type remedies.  taxpayers may apply the amended regulations to amounts paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after 9/13/95 and received after 8/20/96. 2. compensation to victims of human trafficking is tax-free. the irs would have been pilloried if it had ruled the other way. notice 2012-12, 2012-6 i.r.b. 365 (1/19/12). mandatory restitution payments awarded under 18 u.s.c. § 1593, which criminalizes (1) holding a person to a condition of peonage; (2) kidnapping or carrying away a person to sell the person into involuntary servitude or to be held as a slave, (3) providing or obtaining a person‘s services or labor by actual or threatened use of certain means including force, physical restraint, serious harm, and abuse of legal process, and (4) sex trafficking of children or by force, fraud, or coercion, are excluded from gross income. 3. it pays really big tax benefits to run your own church and give yourself two parsonage allowances. driscoll v. commissioner, 135 t.c. 557 (12/14/10) (reviewed, 4-4-6). the taxpayer (phillip driscoll) received a parsonage allowance from mighty horn ministries, inc., later known as phil driscoll ministries, inc., that was applied to the acquisition and maintenance of not only a principal residence but also a second home — a vacation residence. the irs disallowed a § 107 exclusion for the portion of the parsonage allowance received with respect to the second home — for four years amounts totaled over $400,000 — on the grounds that § 107(a) refers to ―a home‖ and that the legislative history limited the § 107 exclusion to only one home. the tax court majority, in an opinion by judge chiechi (in which four judges joined), with four concurrences, rejected the irs‘s argument, stating ―[w]e find nothing in section 107, its legislative history, or the regulations under section 107, which, as respondent points out, all use the phrase ‗a home,‘ that allows, let alone requires, respondent, or us, to rewrite that phrase in section 107.‖ the opinion pointed to § 7701(p)(1) [(m)(1) for the years at issue)], which refers to the definition in 1 u.s.c. § 1 that provides that in interpreting the united states code, the singular includes the plural, unless the context indicates otherwise.  judge gustafson, joined by five other judges, dissented, on the grounds that exclusions should be interpreted narrowly, and ―[t]he chance that congress in 1954 thought it was permitting the exclusion of multiple parsonage allowances seems remote.‖ 2013] recent developments in federal income taxation 589 a. reversed and remanded. a home means only one home. commissioner v. driscoll, 669 f.3d 1309 (11th cir. 2/8/12). in a per curiam opinion, the eleventh circuit held that the rental allowance taxpayers received for their second house was not excluded from income under § 107(2) because the proposition that singular terms also include their plural terms, contained in the dictionary act, 1 u.s.c. 1, does not apply if ―‗the context indicates otherwise‘‖ and the use of ―home‖ in § 107(2) ―has decidedly singular connotations.‖ 4. ―home‖ means where the taxpayer actually resides, not just any old house the taxpayer owns. stromme v. commissioner, 138 t.c. no. 9 (3/13/12). section 131 provides an exclusion for certain amounts paid by a state or local government (or a ―qualified foster care placement agency‖) to a ―foster care provider for caring for a qualified foster individual in the foster care provider‘s home,‖ or which is a ―difficulty of care payment.‖ the taxpayers cared for several developmentally disabled adults at a home they owned and in which they worked, but in which they did not reside and received several hundred thousand dollars from the local government. the tax court (judge colvin) held that § 131 did not apply to exclude payments from the local government to provide foster care, because § 131 applies only if the care is provided in the home in which the taxpayer actually resides. 5. who ever heard of a local real property tax appraisal that was anywhere near accurate? shepherd v. commissioner, t.c. memo. 2012-212 (7/24/12). the taxpayers compromised a consumer credit card debt for $4,412 less than the balance and claimed that pursuant to § 108(a)(1)(b) none of the cod income should be recognized because they were insolvent. the irs and taxpayers agreed on the amount of the taxpayers‘ debts and the value of all of their property with three exceptions: (1) the value of their principal residence, (2) the value of a beach house, and (3) whether a pension was an asset to be included in the determination of insolvency. the tax court (judge ruwe) held that taxpayers were not able to demonstrate insolvency because they failed to establish the value of the residences. local tax assessments introduced by the taxpayers were insufficient evidence of value because ―a value placed upon property for local taxation purposes is not determinative of fair market value of the property for federal income tax purposes in the absence of evidence of the method used in arriving at that valuation.‖ appraisals introduced into evidence were based on ―comparable‖ sales more than two years after the date of discharge, and thus were not probative of the value of the homes at the time of the debt cancellation. the portion of the pension that could have been withdrawn (or borrowed), but not the excess thereover, was included in 590 florida tax review [vol. 13:10 the value of assets, because ―the word ‗assets‘ as used in the definition of the term ‗insolvent‘ for section 108(d)(3) includes ‗assets exempt from the claims of creditors under applicable state law‘‖ citing carlson v. commissioner, 116 t.c. 87, 105 (2001). the taxpayers were not insolvent, and the cod income was includible in income. 6. if you take the fifth in front of a senate investigating committee, you may become a martyr, but if you take the fifth in front of the tax court, you lose. a cicero, illinois politician fraudulently underreported income by omitting conversion of $350,000 campaign funds to personal use, but that‘s small potatoes compared to the more than $10 million insurance fraud scheme for which she spent time in the federal slammer. there may well be a falcon mixed up in here as well, but no sign of it appears in the tax court opinion. lorenmaltese v. commissioner, t.c. memo. 2012-214 (7/30/12). the taxpayer, betty loren-maltese, was the president of cicero, illinois — ―a suburb of chicago that sits on its western hip like a well-holstered gun, and that has a colorful history that reaches back into the 1920s when al capone took refuge there‖ — and the republican committeeman of cicero township in 1994. she also served as cicero‘s deputy liquor commissioner, a position to which she was appointed by her husband, a ―prominent cicero politician who confessed to being a mob bookmaker and pleaded guilty to a federal gambling charge,‖ when the previous deputy liquor commissioner resigned during an fbi investigation into his practice of taking bribes and skimming money off liquor-license renewal fees. in 2002, loren-maltese was convicted of conspiracy to defraud cicero through a pattern of racketeering via multiple acts of bribery, money laundering, mail and wire fraud, official misconduct, and interstate transportation of stolen property. the conviction ended her political career, and she was sentenced to eight years in prison. the government tried her separately on criminal tax fraud charges, but the trial ended in a hung jury, and the government decided not to try her again. in the instant case, the irs asserted a deficiency for unreported income and civil fraud penalties based on loren-maltese‘s purchase of a 1993 classic black cadillac allante convertible for her personal use and her investment in a luxury golf course and clubhouse with checks totaling more than $350,000 drawn on her ―committeeman fund‖ account. (for the year in question, illinois law allowed public officials, who like loren-maltese, were also political-party officials, to raise money from donors in their capacity as party officials, in amounts that they could keep secret. the evidence established that cicero‘s town attorney explained to loren-maltese that she could supplement her salary by taking money from the committeeman fund to buy something for herself or to make an investment for her own personal benefit, but the money would be personal income to her and she would owe tax on it 2013] recent developments in federal income taxation 591 in the year that she took it.) the tax court (judge holmes) found that both items should have been included in loren-maltese‘s income and that her failure to do so was due to fraud. importantly, loren-maltese was mostly silent during her trial, relying on her attorney‘s advice to take shelter under the fifth amendment. judge holmes found that loren-maltese‘s valid invocation of the fifth amendment nevertheless allowed the court to draw a negative inference from her refusal to answer question where the irs produced some additional supporting evidence. similarly, he drew inferences from loren-maltese‘s silence where, under the circumstances, it would have been natural for her to object. 7. it looks like-the home mortgage crisis continues, so the mortgage cod exclusion continues. the 2012 taxpayer relief act, § 202, extends the exclusion from income of discharged principal residence indebtedness under § 108(a)(1)(e) to indebtedness discharged before 1/1/14. 8. excludible mass transit and parking fringe benefits are brought to sweet harmony. for 2012, employees were allowed to exclude $240 per month for parking but only $125 for employer-provided mass-transit and vanpool benefits. congress came to the rescue in the 2012 taxpayer relief act to provide the same benefit (indexed to $245) through 2013. congress did not explain how the benefit will apply retroactively in 2012. perhaps the irs can figure it out. c. hobby losses and § 280a home office and vacation homes 1. this space cadet didn‘t get a secret decoder ring. he might have succeeded had he had limited himself to saying ―to the moon!‖ barker v. commissioner, t.c. memo. 2012-77 (3/20/12). the tax court (judge goeke) sustained the irs‘s disallowance of deductions claimed by the taxpayer, an experienced nasa scientist, relating to planning the exploration of mars, including ―ways to actually live off the land once people have arrived on mars as opposed to taking all supplies along on the flight.‖ judge goeke held that the taxpayer was not engaged in an active trade or business because under the factors in reg. § 1.183-2(b), the taxpayer did not conduct his activities with the intention of earning a profit. furthermore, his nascent business had not yet begun to function as a going concern; at most he was merely researching or investigating a potential business, which is insufficient to demonstrate that a taxpayer is engaged in a trade or business. 2. only a doctor could think he could win this case. verrett v. commissioner, t.c. memo. 2012-223 (8/2/12). the taxpayer was 592 florida tax review [vol. 13:10 a physician who had an annual salary as such of approximately $120,000 in each of the three years at issue. he claimed losses from a construction business run from his home for which he had no license and had never showed a profit in 17 years. most of his services during the years at issue involved uncompensated projects for his family and his church. obviously, the losses were disallowed under § 183. d. deductions and credits for personal expenses 1. only in the irc can ―first-time‖ mean not within the past three years, but these taxpayers still weren‘t ―property virgins.‖ foster v. commissioner, 138 t.c. 51 (1/30/12). the taxpayers bought a home on july 28, 2009 and claimed the temporary, then-in-effect § 36 firsttime homebuyer credit. they had listed their previously-owned house for sale in february 2006 and spent ―considerable time‖ at one of their parents‘ house; the taxpayers sold their old house on june 6, 2007 and rented an apartment that month. the tax court (judge foley) held that the taxpayers did not qualify for the credit. under § 36(c)(1), a ―first-time homebuyer‖ is any individual who has not owned a principal residence for three years prior to the date of purchase of a new principal residence. thus, the taxpayers could have qualified if they had not owned a principal residence after july 27, 2006, and before july 28, 2009 (i.e., the period three years prior to the purchase of their new house). although the taxpayers owned the old house until june 6, 2007, they argued that they ceased using it as their principal residence in february 2006. judge foley found that the taxpayers‘ original home remained their principal residence through at least july, 2006 — a date within the three years preceding the purchase of the new home — because until it was sold the original home was fully furnished, and taxpayers maintained utility services, frequently stayed overnight, hosted family holiday gatherings, kept personal belongings, accessed the internet, and received bills and correspondence at that home, as well as listing it as the address for renewing a driver‘s license and filing federal income tax returns. 2. two unmarried male cohabitants holding residences in joint ownership were not entitled to double the § 163(h)(3) limits, but were instead restricted to mortgage interest deductions on only $1.1 million of loans. sophy v. commissioner, 138 t.c. no. 8 (3/5/12). the tax court (judge cohen) decided that the $1.1 million § 163(h)(3) limitations on qualified residence indebtedness should be applied on both a per taxpayer and a per-residence basis with respect to residence owners who are not married to each other, rather than solely on the per-taxpayer basis argued for by the unmarried taxpayers who jointly owned the residence in question on which the purchase money mortgage exceeded $1.1 million. 2013] recent developments in federal income taxation 593 thus, each of the two taxpayers was limited to deducting interest on only $500,000 of acquisition debt on their two residences and $50,000 of home equity indebtedness on their principal residence. the decision was based upon congressional intent, as shown by the statute‘s repeated use of phrases ―with respect to any qualified residence‖ and ―with respect to such residence,‖ which would have been superfluous had congress intended that the limitations be applied on a per-taxpayer basis. 3. married filing separately status can put a big dent in the home mortgage interest deduction. bronstein v. commissioner, 138 t.c. no. 21 (5/17/12). the taxpayer, who was married, purchased a residence as joint tenants with rights of survivorship together with her father-in-law. the taxpayer and her husband resided in the home, and her father-in-law did not. the amount of the mortgage exceeded $1.3 million, and the taxpayer made all of the payments on the mortgage. the taxpayer, who filed separately, deducted interest on $1.1 million of the mortgage. the tax court (judge goeke) applied § 163(h)(3)(b)(ii), which provides that a married individual filing a separate return is limited to a deduction for interest paid on $500,000 of home acquisition indebtedness, and § 163(h)(3)(c)(ii), which provides that a married individual filing a separate return is limited to a deduction for interest paid on $50,000 of home equity indebtedness, which limits the taxpayer‘s total deduction to interest on $550,000 of mortgage debt. section 6662 accuracy-related penalties were upheld, even though the taxpayer claimed to have relied on her tax advisor in taking her return position, because ―she . . . made no attempt to establish that the reliance was reasonable.‖  interestingly, the same tax advisor who prepared her return also represented her in the tax court litigation. 4. no dependency or child credits for nonresident, noncitizen children. carlebach v. commissioner, 139 t.c. no. 1 (7/19/12). this case involved whether the taxpayers were allowed § 151 dependency exemption deductions and § 21 and § 24 child-related credits, which require that the children satisfy the same statutory test, for non-resident, non-citizen children. one of the married taxpayers was a u.s. citizen and the other an israeli, and they lived in israel; the children were born in, and lived in israel. the tax court (judge halpern) applied § 152(b)(3)(a), which provides that ―[t]he term ‗dependent‘ does not include an individual who is not a citizen or national of the united states unless such individual is a resident of the united states or a country contiguous to the united states,‖ and reg. § 1.152-2(a)(1), which provides that ―to qualify as a dependent an individual must be a citizen or resident of the united states . . . at some time during the calendar year in which the taxable year of the taxpayer begins‖ to deny the deductions and credits. he rejected the taxpayers‘ argument that because the 594 florida tax review [vol. 13:10 children were citizens in the year (2007) in which returns were filed, they qualified as dependents for the years at issue (2004 through 2006). he also rejected the taxpayers‘ argument that the children had ―derivative citizenship‖ under 8 u.s.c. § 1433, because such citizenship is not automatic, but requires an application and naturalization, which had not occurred during the years in question. finally, he rejected the taxpayers argument that because § 152(b)(3)(a) does not require citizenship during the year in question, reg. § 1.152-2(a)(1), which does require citizenship during the year in question, was invalid. the regulation was a reasonable interpretation of § 152(b)(3)(a), which he interpreted ―in the context of subtitle a of the internal revenue code, which deals with income taxes, and in which the concept of an annual accounting system is deeply embedded.‖ section 6662 accuracy related penalties were upheld. 5. an incomplete effort to collect on a homeowner‘s insurance policy is all that‘s necessary to secure a casualty loss deduction. ambrose v. united states, 106 fed. cl. 152 (8/3/12). the taxpayers‘ home was destroyed in a fire, and the next day they filed a timely claim with their homeowner‘s insurance company. however, they failed to file a timely ―proof of loss‖ as required by the insurance policy; they sued the insurance company in state court and lost. the irs applied § 165(h)(5)(e) to deny the taxpayer‘s claim for a casualty loss deduction. section 165(h)(5)(e) provides that ―[a]ny loss of an individual described in subsection (c)(3) to the extent covered by insurance shall be taken into account under this section only if the individual files a timely insurance claim with respect to such loss.‖ the court of federal claims (judge allegra) upheld the taxpayers‘ refund claim, allowing the casualty loss deduction, on the ground that § 165(h)(5)(e) does not apply to a taxpayer who files a timely claim but whose claim is rejected by the insurance company when the taxpayer fails to timely file a ―proof of loss‖ as required by the insurance policy. reading from webster‘s dictionary to divine the meaning of the terms ―file‖ and ―claim‖ in § 165(h)(5)(e), judge alegra concluded that there is a ―distinction between the filing of a claim, i.e. the ‗deliver[y] . . . to the proper officer‘ of a ‗demand for something due or believed to be due‘ and the subsequent submission of proof of the validity of that claim,‖ and that in enacting § 165(h)(5)(e), congress intended to require only the former. he rejected the government‘s argument that ―an insurance ‗claim‘ [includes fulfilling] all of the conditions on recovery found in a given policy.‖ 6. if you don‘t plead the right theory, you lose — even though had you pled the correct theory, you might have won. halata v. commissioner, t.c. memo. 2012-351 (12/19/12). in 2007, the 2013] recent developments in federal income taxation 595 taxpayer was suckered into paying $180,000 in a scam ―bank guarantee transaction‖ that promised a return of $2.5 million, with the first installment to be received only a few weeks after the payment was made. the ―opportunity‖ was presented through one montgomery, a california lawyer, who provided the taxpayer with documents memorializing the transaction. no funds ever were received. the taxpayer hired a lawyer to attempt to recover the funds. montgomery insisted that the purported bank-guaranty transaction was a legitimate transaction, but that he was merely a facilitator of the transaction, received no money, and had no information about how the transaction worked or the identities and roles of the parties to the transaction. in 2009, the taxpayer‘s lawyer advised her that a suit against montgomery likely would be fruitless. the taxpayer did not claim a theft deduction on her 2007 tax return and did not file a 2008 tax return. the irs audited her for 2007 and 2008 and proposed deficiencies. in the tax court, the taxpayer argued that she suffered a theft loss in 2007 and 2008 that would offset her otherwise unreported income. the tax court (judge morrison) agreed with the taxpayer that a theft had occurred under the relevant state law and that montgomery most likely was the thief, but denied a deduction for the year before the court because the loss was not sustained until 2009. based on all of the facts, prior to 2009, she had a reasonable prospect of recovery. furthermore, the taxpayer never filed a pleading asserting her theory that there was a net-operating loss for 2009 that should be carried back to prior years. 7. one p&s, one loan, one property — all residence. norman v. commissioner, t.c. memo. 2012-360 (12/27/12). the taxpayers purchased a principal residence on 8.875 acres of land for $1.8 million. the land was zoned for 1/4 acre lots, and the taxpayers hired a civil engineering firm to study the feasibility of development. however, the purchase contract did not allocate the price between the residence with a limited amount of acres and remaining acreage, and the taxpayers obtained a single mortgage of $1,860,000. the land was never subdivided. the taxpayers deducted all of the interest on the mortgage, but the irs allowed only the interest on $1.1 million as qualified home mortgage interest, rejecting the taxpayer‘s claim that they paid $1 million was for the dwelling unit plus three acres and $800,000 for ―investment property‖ consisting of the other 6.875 acres. the tax court (judge thornton) upheld the deficiency, largely on the grounds that the purchase contract did not allocate the price between the residence and the acreage that was purportedly investment property and the acquisition was financed with a single loan, which included not only the purchase price, but also a line of credit for renovations to the house. 8. the validity and effect of an admittedly executed form 8332 is beyond question. george v. commissioner, 139 t.c. no. 19 596 florida tax review [vol. 13:10 (12/19/12). the taxpayer, who was the custodial spouse following a divorce, in compliance with a state court order, executed a form 8332 (release of claim to exemption for child of divorced or separated parents), which stated that ―i agree not to claim an exemption for‖ her daughter as a dependent for the years at issue. however, the taxpayer believed that the state court order was improper, because she thought that court lacked jurisdiction to issue such an order and because any such order should have taken into account her former husband‘s past arrears in child support before enabling him to obtain the dependency exemption. as a result, she nevertheless claimed a dependency exemption and a child tax credit for the child. the taxpayer‘s former spouse also claimed the child as a dependent for those years and attached the executed form 8332 to his tax returns. the tax court (judge gustafson), held that the taxpayer was not entitled to the dependency exemption. the executed form 8332 was not rendered invalid by any error in the state court order requiring it or by the fact that the taxpayer signed the form 8332 under the compulsion of that state court order. the release of the claim to the exemption was valid. likewise the child credit was disallowed. 9. if an ex-spouse disobeys a court order to sign form 8332, the noncustodial spouse still loses. what‘s a guy gotta do? armstrong v. commissioner, 139 t.c. no. 18 (12/19/12). the taxpayer and his wife divorced, and his ex-wife had custody of their son. a state court order provided that the taxpayer would be entitled to the dependency exemption and explicitly required his ex-wife to execute in his favor a form 8332, ―release of claim to exemption for child of divorced or separated parents‖) provided that the taxpayer met child support obligations. the taxpayer met his child support obligations, but his ex-wife failed to provide the executed form 8332. the irs disallowed the taxpayer‘s claimed dependency exemption, even though he appended to his tax return the court order and provided the irs evidence that he had met his support obligations. in a reviewed opinion (12-3) by judge gustafson, the tax court upheld the denial of the exemption. the state court order, even though countersigned by the taxpayer‘s ex-wife was not a substitute for a form 8332 because it failed to unconditionally declare that the ex-wife ―will not claim such child as a dependent‖ for the year at issue. that defect is not cured by the noncustodial parent‘s proof that he has fulfilled support conditions beyond those in the statute. likewise the child credit was disallowed.  judge holmes wrote a very, very lengthy dissent, in which judges halpern and vasquez joined. the essence of the dissent was that the statutory requirement to ―attach‖ the waiver to the tax return properly requires only that it be ―associated with‖ or ―connected to by attribution‖ to the return. thus, all relevant documents should be considered to 2013] recent developments in federal income taxation 597 be ―attached‖ to a taxpayer‘s return, without regard to the point in time those documents are provided to the irs. 10. miscellaneous not-so-permanent extensions through 2013. the 2012 taxpayer relief (and not so grand compromise) tax act extends multiple expiring individual deductions, but only through 2013, so congress can be sure it has some work to do next year. these include extenders for: a. teachers. section 201 of the act extends the § 62(a)(d) above-the-line deduction for up to $250 of classroom related expenditures of elementary and secondary school teachers for expenses incurred in taxable years beginning in 2012 and 2013. and who says that the federal government doesn‘t abundantly support quality education for children? b. mortgage insurance. section 204 of the act extends the code § 164(b)(5) deduction as qualified residence interest provided for mortgage insurance premiums incurred in connection with acquisition indebtedness for a qualified residence that are paid or accrued before 1/1/14. c. state and local taxes: a not-so-permanent extension of the election to deduct state sales taxes. section 205 extends the code § 164(b)(5) election to deduct state and local sales and use taxes in lieu of state and local income taxes to tax years beginning before 1/1/14.  thank you! professor shepard (texas) and professor mcmahon (florida) thank congress and the president for their solicitude on this issue. for professor simmons (california), this provision is irrelevant. 11. standard deduction marriage penalty relief is now permanent. the 2012 taxpayer relief (and not so grand compromise) tax act made permanent the provisions in code § 63 providing a basic standard deduction for a married couple filing a joint return double the basic standard deduction for single individuals. the basic standard deduction for married taxpayers filing separately is the same as the basic standard deduction for single taxpayers. 12. pep and pease zombie-like arise from the grave. a. pep. the 2012 taxpayer relief (and not so grand compromise) tax act permanently revived the phase-out of personal 598 florida tax review [vol. 13:10 exemptions for high-income taxpayers for years beginning after 2012. the phase-out kicks in the following agi levels: (1) $300,000 for joint returns or surviving spouses; (2) $150,000; and for married taxpayers filing separately; (3) $275,000 for heads of household; and (4) $250,000 for single taxpayers. after 2013, the threshold amounts are adjusted for inflation. the amount of the phase-out, as previously, is 2% of the exemption amount for each $2,500 ($1,500 for married taxpayers filing separate returns), or portion thereof, by which agi exceeds the phase-out threshold. b. pease the act also permanently revived for years beginning after 2012 the limitation on itemized deductions. like pep, the phase-out begins at the following agi levels: (1) $300,000 for joint returns filers or surviving spouses; (2) $150,000; and for married taxpayers filing separately; (3) $275,000 for heads of household; and (4) $250,000 for single taxpayers. after 2013, the threshold amounts are adjusted for inflation. the amount of the phase-out, as previously, is 3% of the excess of certain itemized deductions over the threshold amount, but not by more than 80% of the itemized deductions subject to the limitation. (as previously, the limitation does not apply to medical expenses, investment interest, casualty and theft losses, and wagering losses.) 13. making children permanently cheaper. the taxpayer relief (and not so grand compromise) tax act extended permanently the increase of the § 24 child credit for taxpayers having children under age 17 to $1,000. (no inflation adjustment has been added.) the refundability of the credit to the extent of 15% of the taxpayer‘s earned income in excess of $3,000 (unindexed) has been extended only through 2017. 14. send the kids to day care, get a tax break. the taxpayer relief (and not so grand compromise) tax act extended permanently the increases to the § 21 dependent care credit in the egtrra 2001. the credit is 35% of up to $3,000 of eligible expenses (maximum $1,050) for one qualifying dependent, and 35% of up to $6,000 of eligible expenses (maximum $2,100) for two or more qualifying dependents. the 35% credit rate is reduced, but not below 20%, by one percentage point for each $2,000 (or fraction thereof) of agi above $15,000. 15. it‘s tax-smart to adopt rather than to procreate. the taxpayer relief (and not so grand compromise) tax act extended permanently the egtrra code § 23 credit for adoption expenses, but not the changes in the credit in the patient protection and affordable health care act. as a result: (1) the maximum per-child credit is $10,000 (inflation 2013] recent developments in federal income taxation 599 adjusted) for all adoptions; (2) the credit begins to phase-out at a modified agi of $150,000 (inflation adjusted); (3) for special needs adoptions, the credit is $10,000 regardless of actual expenses; and (4) the credit is allowed against the amt. the credit remains nonrefundable. for 2013 the maximum credit is expected to be approximately $12,770 and the phase-out is expected to begin at approximately $189,710, after inflation adjustments. 16. eitc 2001 simplification and expansion is made permanent and 2009 expansion is extended five years. the taxpayer relief (and not so grand compromise) tax act made permanent the 2001 simplifying revisions to the code § 32 earned income tax credit, as amended by the 2003 jobs and growth tax relief reconciliation act and the 2004 working families tax relief act, and also extended the 2009 increases in the earned income credit for taxpayers with three or more qualifying children through 2017. through 2017, the phase-out threshold for married taxpayers filing joint returns will be $5,000 (inflation adjusted) higher than for other taxpayers, and starting in 2018 the phase-out threshold for married taxpayers filing joint returns will be $5,000 (inflation adjusted) higher than for other taxpayers. e. divorce tax issues 1. the test for whether it‘s ―alimony‖ is objective, not subjective. rood v. commissioner, t.c. memo. 2012-122 (4/25/12). the taxpayer was obligated under florida law to pay his former spouse a ―lump sum alimony‖ award of $300,000 payable over 60 months in $5,000 payments. the tax court (judge goeke) held that the payments were not deductible as ―alimony‖ because under florida law the taxpayer‘s obligation did not terminate upon his former wife‘s death. the court declined to consider extrinsic evidence in determining the nature of the payments: ―the intent of the parties is irrelevant in determining whether such an obligation would terminate at death.‖ even though the purpose of the requirement of § 71(b)(1)(d) that the payment terminate upon death is to prevent deductions of amounts that are attributable to support of the payee, the relevant inquiry is entirely objective; the intent of the parties regarding the purpose of the payments is irrelevant. 2. a qdro can‘t lend tax-free disability payment status to a substitute payee. fernandez v. commissioner, 138 t.c. no. 20 (5/14/12). the tax court (judge wherry) held that § 104(a)(1) does not apply to exclude disability payments paid to the disabled worker‘s former spouse pursuant to a § 414(p) qualified domestic relations order (qdro). section 402(a) provides that amounts distributed from employee trusts are taxable to the distributee ―except as 600 florida tax review [vol. 13:10 otherwise provided in this section‖, and section 72 provides that ―except as otherwise provided in this chapter gross income includes any amount received as an annuity *** under an *** endowment, or life insurance contract.‖ nowhere in section 402(a) or section 72 is section 104(a) mentioned. section 402(e)(1)(a) explicitly provides: ―for purposes of subsection (a) [of section 402] and section 72, an alternate payee who is the spouse or former spouse of the participant shall be treated as the distributee of any distribution or payment made to the alternate payee under a qualified domestic relations order.‖ if congress had included section 104 in this portion of the statute, the result in this case might be different. however, without congressional approval we decline to expand the reach of section 402(e)(1)(a) beyond the sections specifically referred to in its text. 3. counting to six distinguishes child support from alimony. schilling v. commissioner, t.c. memo. 2012-256 (9/5/12). the tax court (judge swift) applied § 71(c) and temp. reg. § 1.71-1t(c), q&a 18, to hold that the amount by which payments received pursuant to a divorce decree were reduced on dates that corresponded to taxpayer‘s children attaining age 18 or starting college were child support. however, an amount by which payments were reduced to zero on a fourth date, in the sixth post-separation year was treated as alimony. although the complete termination of payments occurred within six months of one child‘s twentyfirst birthday, which ordinarily would be treated as related to a contingency relating to a child under § 71(c)(2)(b), temp. reg. § 1.71-1t(c), q&a 18, expressly provides that complete cessation of support payments during the sixth post-separation year does not qualify as a contingency relating to a child. f. education 1. congress encourages universities to raise tuition even more in the next five years. the taxpayer relief (and not so grand compromise) tax act extended the 2009 expansion of the code § 25a american opportunity tax credit (formerly known as the hope scholarship credit) through 2017. a. doubling down on encouraging universities to raise tuition even more in the next five years. section 207 of the taxpayer relief (and not so grand compromise) tax act reinstates and 2013] recent developments in federal income taxation 601 extends the above-the-line deduction of higher education expenses provided in code § 222(d) for expenses incurred in taxable years 2012 and 2013. previously § 222(d) applied only to expenses incurred before 12/31/11. 2. helping banks keep student loan interest rates higher. the 2012 tax act made permanent the egtrra changes to the code § 221 above-the-line deduction for qualified higher education student loan interest. 3. helping banks market education iras. the 2012 tax act made permanent the many egtrra changes to the coverdell education savings account (―coverdell esa,‖ or ―cesa,‖ formerly called an ―education ira‖) rules (§§ 25a, 530). the 2001 changes that have been extended permanently are extensive and since they have been in place for twelve years, we won‘t bore you with them. 4. encouraging employers to pay for employee‘s education. the 2012 tax act made permanent the code § 127 tax-free fringe benefit for up to $5,250 annually for amounts paid or expenses incurred by the employer in providing educational assistance to employees under an educational assistance program (including graduate courses). g. alternative minimum tax 1. finally — permanent amt relief!!! the 2012 taxpayer relief (and not so grand compromise) tax act, § 104, has provided permanent amt relief. beginning in 2012, the amt exemption amount has been increased to: (1) $78,750 for married couples filing jointly and surviving spouses; (2) $39,375 for married individuals filing separate returns; and (3) $50,600 for single taxpayers. these amounts are subject to automatic adjustment for inflation after 2012 using 2011 as the base year. the amt exemption is phased out by an amount equal to 25% of the amount by which amt exceeds the following thresholds: (1) $150,000 for married couples filing jointly and surviving spouses; (2) $75,000 for married individuals filing separate returns; and (3) $112,500 for single taxpayers. the phase-out thresholds are likewise subject to inflation adjustments. (the 2012 act did not change the $22,500 exemption amount for estates and trusts.) the 2012 act also provides permanent 0%, 15%, and 20% (for taxpayers otherwise in the 39.6% bracket for ordinary income) amt rates for longterm capital gains and qualified dividends. the rule under code § 26(a)(2) allowing various nonrefundable personal credits to offset amt has been made permanent. finally, by an amendment to code § 26, the § 24 refundable child credit offset of amt has been made permanent. 602 florida tax review [vol. 13:10 vi. corporations a. entity and formation there were no significant developments regarding this topic during 2012. b. distributions and redemptions 1. the cat‘s out of the bag! dkd enterprises, inc. v. commissioner, 685 f.3d 730 (8th cir. 7/17/12), aff’g t.c. memo. 2011-29 (1/31/11). the eighth circuit, in an opinion by judge riley, held that expenses incurred by a corporation to operate a cattery, the deductions for which were disallowed because the cattery was not operated with a genuine profit-seeking motive, constituted constructive dividends to the corporation‘s sole shareholder because the corporation operated the cattery ―for the personal pleasure of . . . its sole stockholder, and that during each of those years that activity was incident to [her] personal hobby.‖ because the corporation did not have ―a legitimate business purpose to operate the cattery,‖ the expenditures to operate constituted a constructive dividend ―even though this activity conferred no tangible economic benefit on [the shareholder].‖ 2. is section 306 like the human appendix — a vestige of something that might have once served a purpose? the 2012 taxpayer relief (and not so grand compromise) tax act made permanent the treatment as qualified dividend income of ordinary income realized under code § 306. the only effect of § 306 now is to affect basis recovery. c. liquidations 1. adios collapsible corporations. but how will tax professors be able to torture their students now? the 2012 taxpayer relief (and not so grand compromise) tax act permanently repealed the infamous code § 341. d. s corporations 1. poison pill warrants issued in an s corporation tax shelter scheme turn truly poisonous to s corporation status. santa clara valley housing group, inc. v. united states, 108 a.f.t.r.2d 20116361 (n.d. cal. 9/21/11). the stock of santa clara valley housing group, inc. (scvhg) originally was held by a husband and wife and their children. 2013] recent developments in federal income taxation 603 to implement a kpmg tax shelter product known as the s corporation charitable contribution strategy (sc2), scvhg recapitalized itself so as to have 100 shares of voting stock and 900 shares of nonvoting stock. scvhg also issued to each shareholder a warrant to purchase ten shares of nonvoting stock for each share of voting stock (which was tax-free under § 305(a)). the warrants were issued solely to protect the original shareholders‘ interest in scvhg while they engaged in the sc2 strategy. (the warrants protected against the possibility that the donee charity would refuse to sell its stock back to the original shareholders after the agreed-upon length of time, because if the warrants were exercised, the warrants would dilute the stock held by the charity to such an extent that the original shareholders would end up owning approximately 90 percent of the outstanding shares.) thereafter, the shareholders transferred all of the nonvoting stock to the city of los angeles safety members pension plan (clasmpp), a tax-exempt entity as a ―donation,‖ with the understanding that clasmpp would sell the shares back after a certain period of time. while clasmpp held the stock, scvhg reported over $114 million of income, of which more than $100 million was passed through to clasmpp, but clasmpp received distributions of only $202,500, representing .02 percent of the income allocated to clasmpp. after four years, clasmpp sold the 900 shares of stock back to the original shareholders for $1,645,002, and the warrants were cancelled. the irs concluded that the transaction was an abusive tax shelter. the irs concluded that under reg. § 1.1361-1(l)(4)(ii) the warrants constituted a second class of stock in scvhg and scvhg‘s status as an s corporation was terminated and issued a deficiency notice based upon treating scvhg as a c corporation. the district court agreed with the irs. the warrants ―constitute equity,‖ and were intended to prevent clasmpp ―from enjoying the rights of distribution or liquidation that ordinarily would come with ownership of the majority of a successful company‘s shares.‖ thus the warrants were a second class stock and scvhg‘s s corporation status was terminated. however, the warrants were not a second class of stock under reg. § 1.13611(l)(4)(iii), which provides that options are a second class if, under the facts and circumstances, (1) the option is substantially certain to be exercised and (2) has an exercise price substantially below the fair market value of the underlying stock on the date the option is issued. in this case it was never intended that the options be exercised; they were a ―poison pill.‖ a. reconsidered. santa clara valley housing group, inc. v. united states, 109 a.f.t.r.2d 2012-554 (n.d. cal. 1/18/12). on reconsideration of its summary judgment, the court determined that there is a triable issue of fact whether the warrants are protected from being treated as a second class of stock under the safe harbor of reg. § 1.13611(f)(4)(iii)(c), which provides that a call option will not be treated as a second class of stock if the strike price is at least 90 percent of the fair 604 florida tax review [vol. 13:10 market value of the underlying stock on the date the option is issued, transferred to an ineligible shareholder, or materially modified. the regulation also directs that a good faith determination of value will be respected unless it can be shown that the valuation was substantially in error and the determination was not made with reasonable diligence. the court indicated that there is conflicting evidence regarding the value of the stock at the time the warrants were issued. 2. qsub status is a property right of the qsub. in re the majestic star casino, llc, 109 a.f.t.r.2d 2012-698 (bankr. d. del. 1/24/12). a debtor qsub, but not its parent s corporation, was in bankruptcy. the court held that the parent corporation‘s post-bankruptcy petition revocation of its s corporation status, which under § 1361(b)(3)(c) automatically terminated the debtor-subsidiary‘s qsub status, converting it into a c corporation, was an avoidable transfer of estate property in violation of bankruptcy code § 549. the debtor‘s qsub status was property of the bankruptcy estate, and as a result of the loss of that status was required to, and did, pay state income taxes it would not otherwise have been required to pay. (the corporation had not paid any federal income taxes, but the irs‘s claim for any deficiency would be affected, so the irs opposed the debtor‘s argument that its qsub status was property of the bankruptcy estate.) accordingly, the revocation of the parent‘s status as an s corporation and the termination of the debtor‘s status as a qsub were held to be ―void and of no effect.‖  in re prudential lines, inc., 107 b.r. 832 (bankr. s.d.n.y. 1989), aff'd, 928 f.2d 565 (2d cir. 1991), followed. 3. roth ira is not an eligible s corporation shareholder. taproot administrative services, inc. v. commissioner, 133 t.c. 202 (9/29/09) (reviewed, 12-4). the taxpayer corporation‘s sole shareholder was a custodial roth ira account. eligible s corporation shareholders as defined in § 1361 include individuals, estates, certain specifically designated trusts and certain exempt organizations. with an effective date after the year involved in this case, § 1361(c)(2)(a)(vi) was enacted to allow a bank whose stock is held by an ira or roth ira to elect s corporation status. reg. § 1.1361-1(e)(1) provides that a person for whom s corporation stock is held by a nominee, guardian, custodian, or agent is deemed to be the s corporation shareholder. however, in rev. rul. 92-73, 1992-2 c.b. 224, the irs ruled that a trust that qualifies as an ira is not a permitted s corporation shareholder. declaring the issue as one of first impression, and indicating that under skidmore deference to revenue rulings depends upon their persuasiveness, the tax court (judge wherry) agreed with the irs‘s rationale in the ruling that iras are not eligible s corporation https://www.lexis.com/research/buttontflink?_m=8029299dc07c8f002df7af53f4ca76b1&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b226%20b.r.%20227%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=29&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b928%20f.2d%20565%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=1&_startdoc=1&wchp=dglzvzt-zskab&_md5=f81092c7ecb7bf58f1cc7be9c8eb6ef8 2013] recent developments in federal income taxation 605 shareholders because the beneficiary of the ira is not taxed currently on the trust‘s share of corporate income unlike the beneficiary of a custodial account or the grantor of a grantor trust who is subject to tax on the passthrough corporate income. (the income of the corporation owned by a roth ira would never be subject to tax.)  judge holmes dissented in a beautifullyreasoned opinion which made the point that an ira account is owned by a custodian for the benefit of an individual, who is to be treated as the shareholder, and any unwarranted tax benefits would not accrue because the income of the ira would be taxed under § 511 as ubit. his opinion concluded: this case is a reminder that tax law does not cascade into the real world through a single channel. it meanders instead through a vast delta, and any general principles tugged along by its current are just as likely to sink in the braided and rebraided rivulets of specific code provisions and the murk of regulations as they are to survive and be useful in deciding real cases. taproot thinks it found a course through the confluence of the subchapter s and ira rules that it could successfully navigate. its route would be new, but the stakes are not that great, and the sky will remain standing if we had just read and applied the regulation as it is. a. yes, it would be too good to be true, so a roth ira isn‘t an eligible shareholder. taproot administrative services, inc. v. commissioner, 679 f.3d 1109 (9th cir. 3/21/12). the court of appeals affirmed the tax court‘s holding that a roth ira is not an eligible shareholder for an s corporation, and that the taxpayer corporation thus was a c corporation. although the court of appeals ―adopt[ed] the tax court‘s reasoning,‖ it concluded that ―the analysis requires further elaboration,‖ because the tax court‘s focus ―fail[ed] ... to squarely address taproot‘s alternative argument for eligibility as the legal owner of the individual shares of stock comprising the ira.‖ the taxpayer argued that ―both forms of iras – trusts and custodial accounts – lack the essential attributes of a separate tax-paying entity and consequently should be treated as legally indistinguishable from their individual owners.‖ but the court of appeals concluded that the reasoning behind revenue ruling 92-73, 1992-2 c.b. 224, ―unequivocally supports the opposite result.‖ furthermore, the legislative history of subchapter s favors limited eligibility, and ―[a]ccording to the legislative history of the esop eligibility amendment, ... congress did not envision iras as permissible shareholders at the time of enactment.‖ the court also rejected the taxpayer‘s argument that the language of reg. § 1.1361-1(e), which provides guidance regarding determining the number of shareholders of a corporation statute, stating that ―[t]he person for whom 606 florida tax review [vol. 13:10 stock of a corporation is held by a nominee, guardian, custodian, or an agent is considered to be the shareholder ... directly authorizes ownership of s corporation stock by iras and roth iras created as custodial accounts.‖ rather, the court agreed with the irs‘s argument that ―the language of the regulation requires consideration of who ultimately bears the tax responsibility from its application,‖ and concluded that ―[a]pplying this logic, custodial iras and roth iras are different in kind and therefore distinguishable from other custodial accounts, such as those involving minors or disabled individuals.‖ the court emphasized that ―[t]o adopt the position taproot urges, this court must conclude that congress consciously crafted a legislative scheme enabling shareholders to employ roth iras to perpetually avoid any taxation on s corporation profits. the legislative history and regulatory record foreclose this conclusion.‖ 4. s corporation shareholders aren‘t allowed to just make up their own basis adjustment rules. barnes v. commissioner, t.c. memo. 2012-80 (3/21/12) the tax court (judge morrison) agreed with the irs in holding — unsurprisingly — that there is no upward stock basis adjustment under § 1367 for amounts that are erroneously reported by the shareholder as § 1366 pass through income but that do not correspond to, but exceed, the shareholder‘s actual pro rata share of pass through income. likewise, § 1367(a)(2)(b) requires an s corporation shareholder to reduce stock basis by any losses that the shareholder is required to take into account under § 1366(a)(1)(a), even if the shareholder does not actually claim the pass through losses on the shareholder‘s return. because the taxpayer had reported gain rather than loss in a prior year in which a very large loss had been passed through, the shareholder had no basis to support passed-through losses in the year in question. 5. an s corporation is not an individual, even if an irs employee said so. trugman v. commissioner, 138 t.c. no. 22 (5/21/12). the taxpayers moved from california to nevada to avoid state income taxes. they acquired a principal residence in henderson, nevada through their wholly owned s corporation, which held rental properties in missouri, texas, and california. the taxpayers claimed the $8,000 first time homebuyer‘s credit under now-expired § 36, which was available to an ―individual‖ who had no present ownership interest in a principal residence during the three year period ending on the date of the purchase. the tax court (judge kroupa), in a case of first impression, held that a corporation is not an individual for purposes of § 36, and election of subchapter s status does not change that characterization. the pass-through nature of the credit did not alter the fact that the corporation purchased the property. the court pointed out that individuals can have a principal residence, but a corporation 2013] recent developments in federal income taxation 607 has a principal place of business. the court also was unsympathetic to the taxpayer‘s request for leniency on the grounds that an irs representative advised them that they could claim the credit if the residence was purchased through an s corporation. the court pointed out that the commissioner is not bound by the erroneous legal advice of irs employees.  even though an s corporation is taxed like an individual (with four enumerated exceptions) under § 1363(b), an s corporation is still not an individual. 6. paper is substance. corporate resolutions and ledger entries create an ―economic outlay.‖ — no kidding, they really do, says judge ruwe. maguire v. commissioner, t.c. memo. 2012-160 (6/6/12). the taxpayers in these consolidated cases owned two s corporations with related businesses — one was an auto dealership, and the other a finance company that purchased customer notes from the auto dealership. the finance company operated at a profit and the dealership operated at a loss. apart from the transactions at issue, the taxpayers did not have sufficient basis in the dealership to deduct losses, but had substantial basis in the finance company. the finance company owned substantial accounts receivable due from the dealership. at the end of each year, through journal entries, the finance company distributed accounts receivable to the taxpayers, who in turn contributed them to the related dealership to increase the basis in the dealership sufficiently to avoid the § 1366(d) limitation on the deduction of passed through losses. the irs disallowed the claimed loss deductions on the grounds that the transactions did not increase the taxpayers‘ basis in the dealership because the taxpayers had not made an ―an economic outlay.‖ the irs argued that the corporate ―resolutions and adjusting journal entries made to the books of the related companies were devoid of any economic reality and did not alter the economic positions of the parties.‖ the tax court (judge ruwe) rejected the irs‘s position and held for the taxpayer, finding that the ―distributions and contributions did have real consequences that altered the positions of petitioners individually and those of their businesses.‖ thus, the transactions did result in the taxpayer making the required ―economic outlay.‖ [t]he distributions and contributions created actual economic consequences for the parties, because the accounts receivable had real value in that they were legitimate debts that auto acceptance owed to cnac and thus were legitimate assets of cnac. petitioners‘ contribution of the accounts receivable resulted in their being poorer in a material sense in that the accounts receivable were no longer collectible by them individually.  judge ruwe added that he saw ―no reason why shareholders in two related s corporations should be prohibited 608 florida tax review [vol. 13:10 from taking distributions of assets from one of their s corporations and investing those assets into another of their s corporations, in order to increase their bases in the latter. the effect is to decrease the shareholders‘ bases in the s corporation making the distribution, thereby reducing the shareholders‘ potential future tax-free distributions from the distributing s corporation, while increasing the shareholders‘ bases in the s corporation to which the contribution is made.‖ furthermore, ―[t]he fact that the two s corporations have a synergistic business relationship and are owned by the same shareholders should make no difference so long as the underlying distributions and contributions actually occurred.‖  but for the fact that the shareholders‘ ownership of the two corporations was not congruent, this issue could have been avoided by having the two operating corporations organized as subsidiary qsubs of an s corporation holding company. 7. the treasury department proposes major surgery on the rules for determining an s corporation shareholder‘s basis limitation for passed-through losses under § 1366(d). reg-13404207, basis of indebtedness of s corporations to their shareholders, 77 f.r. 34884 (6/12/12). the treasury department has proposed amendments to reg. § 1.1366-2 that would deal with determination of an s corporation shareholder‘s basis in any debt of the s corporation, which principally affects the limitation on the pass-through of losses under § 1366(d). the proposed regulations expressly provide that the basis of any indebtedness of the s corporation to the shareholder means the shareholder‘s adjusted basis (as defined in reg. § 1.1011-1 and as provided in § 1367(b)(2)) in any ―bona fide indebtedness of the s corporation that runs directly to the shareholder.‖ whether indebtedness is ―bona fide indebtedness‖ to a shareholder is determined under general tax principles and depends on ―all of the facts and circumstances.‖ prop. reg. § 1.1366-2(a)(2)(i). furthermore, the proposed regulations expressly provide that: a shareholder does not obtain basis of indebtedness in the s corporation merely by guaranteeing a loan or acting as a surety, accommodation party, or in any similar capacity relating to a loan. when a shareholder makes a payment on bona fide indebtedness for which the shareholder has acted as guarantor or in a similar capacity, based on the facts and circumstances, the shareholder may increase its basis of indebtedness to the extent of that payment.  the preamble states that ―[u]nder these proposed regulations, an incorporated pocketbook transaction [see, e.g., yates v. commissioner, t.c. memo. 2001-280; culnen v. commissioner, t.c. memo. 2000-139] increases basis of indebtedness only where the transaction creates a 2013] recent developments in federal income taxation 609 bona fide creditor-debtor relationship between the shareholder and the borrowing s corporation.‖  prop. reg. § 1.1366-2(a)(2)(ii), example (3) in the proposed regulation blesses a basis increase resulting from a back-toback loan in which one s corporation lends money to the shareholder who in turn lends the loan proceeds to a second s corporation, if the loan to the second s corporation ―constitutes bona fide indebtedness‖ from the borrower s corporation to the shareholder. example (4) in the proposed regulation blesses a basis increase resulting from a distribution of a note from one s corporation (s2) to another s corporation (s1) if after the distribution s2 is indebted to the shareholder and ―the note constitutes bona fide indebtedness‖ from s2 to the shareholder.  the proposed regulations do not attempt to clarify the meaning of ―bona fide indebtedness,‖ or provide any examples of relevant facts and circumstances, but rely on ―general federal tax principles.‖ this may portend that the voluminous debt versus equity jurisprudence might replace the ―actual economic outlay‖ by the shareholder test for creating basis of indebtedness, applied in cases such as maloof v. commissioner, 456 f.3d 645 (6th cir. 2006); spencer v. commissioner, 110 t.c. 62, 78-79 (1998), aff’d without published opinion, 194 f.3d 1324 (11th cir. 1999); hitchins v. commissioner, 103 t.c. 711 (1994); and perry v. commissioner, 54 t.c. 1293 (1970). the preamble refers to knetsch v. united states, 364 u.s. 361 (1960) (disallowing interest deductions for lack of actual indebtedness); geftman v. commissioner, 154 f.3d 61 (3d cir. 1998); estate of mixon v. u.s., 464 f.2d 394 (5th cir. 1972); and litton business systems, inc. v. commissioner, 61 t.c. 367 (1973), as relevant authorities.  the proposed regulations do not address how to determine the basis of the shareholder‘s stock in the s corporation. rev. rul. 81-187, 1981-2 c.b. 167, provides that a shareholder of an s corporation does not increase basis in stock for purposes of § 1366(d)(1)(a) by contributing the shareholder‘s own unsecured demand promissory note to the corporation. in the preamble, the treasury department and the irs have requested comments concerning the propriety of basis calculations in the s corporation and partnership context, similar to the one currently in reg. § 1.7041(b)(2)(iv)(d)(2), which provides that a partner‘s capital account is increased with respect to non-readily tradable partner notes only (i) when there is a taxable disposition of such note by the partnership, or (ii) when the partner makes principal payments on such note.  the proposed regulations will apply to loan transactions entered into on or after the date of publication of final regulations. 610 florida tax review [vol. 13:10 8. shareholder consent to an s election constitutes consideration paid to the s corporation for cash distributions. — say what! in re kenrob information technology solutions, inc., 110 a.f.t.r.2d 2012-5190 (bankr. e.d. va. 7/10/12). kenrob was an s corporation in bankruptcy. pursuant to a long-standing pre-existing agreement between the corporation and the shareholders, the corporation had paid directly to the irs the personal income taxes attributable to the shareholders‘ passed-through income. the trustee asserted that the payments were fraudulent conveyance because they were made without consideration by the corporation. the bankruptcy court rejected the trustee‘s argument, holding that the consideration received by the corporation was the shareholders‘ ―election‖ — the court should have said ―consent‖ to have the corporation be taxed as an s corporation — as long as the corporation paid the resulting personal income tax liability. the benefit to the corporation was the § 11 taxes that it would not have had to pay had it not made the s election. 9. the lifetime of built-in gain gets shorter every year. the small business jobs act of 2010 shortened the holding period under § 1374 for recognizing unrealized built-in gain on conversion from a c corporation to an s corporation to five years preceding the corporation‘s tax year beginning in 2011. before the change the holding period was ten years for sales or exchanges in tax years beginning before 2009, and seven years for tax years beginning in 2009 or 2010. a. and again. the 2012 taxpayer relief act, § 326(a)(2), extends the code § 1374 five-year holding period reduction to five years for recognized built-in gain in 2012 and 2013. 10. s corporation charitable contributions favored with reduced basis deductions. the 2012 taxpayer relief act, § 325, extended code § 1367(a)(2), enacted in 2006, which provides that shareholders of an s corporation reduce stock basis by the adjusted basis of property contributed to a charity, even though the full fair market value of the contributed property is passed through to the shareholder as a charitable contribution. prior law applied to contributions made in tax years beginning before 1/1/12. the two-year extension applies to contributions made in tax years beginning before 1/1/14. e. mergers, acquisitions and reorganizations 1. corporate shareholders knew what midcoast‘s midco deal was all about. transferee liability imposed. feldman v. commissioner, t.c. memo. 2011-297 (12/27/11). the tax court (judge 2013] recent developments in federal income taxation 611 swift) upheld transferee liability against the shareholders of a corporation who sold the stock of the corporation engaged in a purported stock sale to a midco (the infamous midcoast) to avoid recognition of gain from earlier sale of the corporation‘s assets. the transaction was structured as a stock redemption for cash after the asset sale, with the remainder of the stock being sold in the same taxable year of the corporation to a midco that purported to shelter the gains with losses from purported distressed debt tax shelter transactions. the purported stock sale ―lack[ed] both business purpose and economic substance― and was disregarded for federal income tax purposes. ―the substance of the transaction was a liquidation [of the corporation] and a fee payment to midcoast for its role in facilitating the sham.‖ the court specifically noted that the taxpayers took no actions to ensure that the corporate income tax liability triggered by the asset sale would be paid, and that it remained unpaid. a. a different tax court judge sees a somewhat differently structured midcoast deal as immune from transferee liability. frank sawyer trust of may 1992 v. commissioner, t.c. memo. 2011-298 (12/27/11). the tax court (judge goeke) refused to uphold transferee liability against the shareholders of a corporation who sold the stock of the corporation engaged to a midco (fortrend), which was brought into the deal by the infamous midcoast to provide financing) after an asset sale. he found that the shareholders knew little about the mechanics of the transaction and exercised due diligence. the trust representatives believed fortrend‘s attorneys to be from prestigious and reputable law firms. they assumed that fortrend must have had some method of offsetting the taxable gains within the corporations. they performed due diligence with respect to fortrend to ensure that fortrend was not a scam operation and that fortrend had the financial capacity to purchase the stock. the trust representatives believed fortrend assumed the risk of overpaying for the taxi corporations if they did not have a legal way for offsetting or reducing the tax liabilities.  judge goeke applied state fraudulent conveyance law to determine whether the transactions should be collapsed and concluded that they should not, because the irs, which has the burden of proof in transferee liability cases, did not prove that ―the purported transferee had either actual or constructive knowledge of the entire scheme.‖ because in this case the transaction was structured in such a manner that the corporation never made any payments to the shareholders, there was no actual or constructive fraudulent transfer to the shareholders. finally, turning to federal tax law, judge goeke held that ―substance over form and its related doctrines [were] not applicable,‖ because the transaction was an arm‘s length stock sale between the 612 florida tax review [vol. 13:10 shareholders and a purchaser in which the parties agreed that the purchaser would be responsible for reporting and paying the corporation‘s income taxes. ―there was no preconceived plan to avoid taxation . . . .‖ judge goeke distinguished feldman v. commissioner, t.c. memo. 2011-297 (12/27/11), supra, because in that case ―[i]t was ‗absolutely clear‘ that the taxpayer was aware the stock purchaser had no intention of ever paying the tax liabilities [and] the taxpayer did not conduct thorough due diligence of the stock purchaser . . . .‖ b. and yet another shareholder escapes transferee liability after yet another midcoast midco transaction. slone v. commissioner, t.c. memo. 2012-57 (3/1/12). the taxpayer‘s familyowned corporation sold all of its assets for cash, resulting in a gain of over $38 million and an estimated combined federal and state income tax liability of over $15 million. none of the proceeds had been distributed at the time fortrend and midcoast made an unsolicited offer to purchase the stock of the corporation, which ultimately was accepted, at a purchase price of $35,753,000, plus assumption of the corporation‘s federal and state income taxes owed as of the closing date. not unsurprisingly, the taxes were never paid and the irs asserted transferee liability against the shareholders. because the asset sale and stock sale were independent of each other and the shareholders ―had no reason to believe that fortrend‘s methods were illegal or inappropriate, . . . [n]either the substance over form doctrine nor any related doctrines appl[ied] to recast the stock sale as a liquidating distribution.‖ thus, because the irs‘s transferee liability theory was grounded on recasting the stock sale as a liquidation, the irs lost. c. and the irs loses yet again on similar facts but with different ―bad guys.‖ salus mundi foundation v. commissioner, t.c. memo. 2012-61 (3/6/12). judge goeke found that the case was similar to frank sawyer trust and sloane, supra, and unlike feldman, supra. actually, the facts here were even better for the taxpayer — the stock sale preceded the asset sale to the unrelated schemer, so there was no corporate tax liability at the time the stock was sold. d. and the irs‘s batting average continues to sag. starnes v. commissioner, 680 f.3d 417 (4th cir. 5/31/12), aff’g t.c. memo. 2011-63. the fourth circuit refused to apply transferee liability under § 6901 against the shareholders of a corporation (tarcon) who sold the stock of a corporation to midcoast after an asset sale, even though the corporation had nothing but cash, which pursuant to the contractual provisions was transferred to midcoast by wire transfer contemporaneously with the closing of the stock sale and purchase, even though the purchase 2013] recent developments in federal income taxation 613 price was substantially less than the cash holdings of the corporation. the court of appeals held that under commissioner v. stern, 357 u.s. 39 (1958), whether a ―person is the ‗transferee‘ of a taxpayer‘s assets, the ‗existence and extent‘ of that transferee‘s liability for unpaid taxes the taxpayer owed prior to the transfer is determined by state law, not federal law.‖ (it failed to consider the impact of the federal debt collection act, which postdates stern.) the court also held that stern forecloses the application of federal tax law principles to recast of the actual transactions under federal law before applying state law to the set of transactions: ―an alleged transferee‘s substantive liability for another taxpayer‘s unpaid taxes is purely a question of state law, without an antecedent federal-law recasting of the disputed transactions.‖  a cogent dissent by judge wynn would have imposed transferee liability.  judge wynn would have followed bb&t corp. v. united states, 523 f.3d 461, 472 (4th cir. 2008) – ―[i]n applying the doctrine of substance over form, we ‗look to the objective economic realities of a transaction rather than to the particular form the parties employed‘‖ (quoting frank lyon, 435 u.s. at 573 (alteration omitted)) to recast the transaction because ―the ‗objective economic realities‘ establish that the former shareholders effectively wound up tarcon and received liquidating distributions of its cash as a result of the stock sale to midcoast.‖ judge wynn reasoned that the sale to midcoast was not a true sale of stock. rather, the ―substance‖ of the transaction was merely a cash-for-cash swap and because cash is fungible, the transaction in substance was a receipt by the former shareholders of distributions of tarcon‘s cash. finally, because the stock sales agreement did not require that tarcon get anything in return for its cash, this transfer was clearly fraudulent under the relevant state law. 2. the treasury proposes what is essentially elective location of e&p following asset-acquisition reorganizations. reg–141268–11, allocation of earnings and profits in tax-free transfers from one corporation to another, 77 f.r. 22515 (4/16/12). the treasury department has published proposed amendments to reg. § 1.312-11(a) that would provide that in a transfer described in § 381 – which applies to taxfree § 368 asset-acquisitions and § 332 liquidations – only the acquiring corporation, as defined in reg. § 1.381(a)–1(b)(2), succeeds to the earnings and profits of the distributor or transferor corporation unless the second transfer also is described in § 381(a). thus, if following an asset-acquisition reorganization all of the target‘s assets are dropped to a subsidiary of the acquiring corporation, the earnings and profits move to the subsidiary; but if the acquiring corporation retains any assets, then it retains all of the earnings and profits. amended reg. § 1.312-11(a) will not apply if reg. § 1.312-10 applies in the case of a § 355 distribution. 614 florida tax review [vol. 13:10 3. this district court decision, if followed, makes it much much more difficult ever to have personal goodwill as an employee-shareholder. howard v. united states, 106 a.f.t.r.2d 20105533 (e.d. wash. 7/30/10). the taxpayer was a dentist who practiced through a solely owned (before taking into account community property law) professional corporation until the practice was sold to a third party. he had an employment agreement with the corporation including a noncompetition clause that survived for three years after the termination of his stock ownership. the purchase and sale agreement allocated $47,100 to the corporation‘s assets, $549,900 for the taxpayer-shareholder‘s personal goodwill, and $16,000 in consideration of his covenant not to compete with the purchaser. the corporation did not ―dissolve‖ until the end of the year following the sale. the taxpayer reported $320,358 as long-term capital gain income resulting from the sale of goodwill (the opinion does not explain how the remainder of the sales price was reported, but the irs recharacterized the goodwill as a corporate asset and treated the amount received by the taxpayer from the sale to the third party as a dividend from the taxpayer‘s professional service corporation. because the sale occurred in 2002, when dividends were taxed at higher rate than capital gains, a deficiency resulted. the government‘s position was based on three main reasons: (1) the goodwill was a corporate asset because the taxpayer was a corporate employee with a covenant not to compete for three years after he no longer owned any stock; (2) the corporation earned the income, and correspondingly earned the goodwill; and (3) attributing the goodwill to the taxpayer-shareholder did not comport with the economic reality of his relationship with the corporation. after reviewing the principles of norwalk v. commissioner, t.c. memo. 1998-279, and martin ice cream co. v. commissioner, 110 t.c. 189 (1998), the court held that because the taxpayer was the corporation‘s employee with a covenant not to compete with it, any goodwill generated during that time period was the corporation‘s goodwill. the court also rested its holding that the goodwill was a corporate asset on its conclusions that the income associated with the practice was earned by the corporation and the covenant not to compete, which extended for three years after the taxpayer no longer owned stock in the corporation, rendered any personal goodwill ―likely [of] little value.‖  see solomon v. commissioner, t.c. memo. 2008-102, for an extended discussion of the issues underlying an attempted sale of individual goodwill. a. affirmed — ―dr. howard has offered no compelling reason why he should be let out of the corporate structure he chose for his dental practice.‖ 448 fed. appx. 752 (9th cir. 8/29/11). the 2013] recent developments in federal income taxation 615 ninth circuit affirmed the district court in an opinion that contains an elegantly concise summary of the current state of the law. goodwill ―is the sum total of those imponderable qualities which attract the custom of a business, — what brings patronage to the business.‖ grace brothers v. comm’r, 173 f.2d 170, 175-76 (9th cir. 1949). for purposes of federal income taxation, the goodwill of a professional practice may attach to both the professional as well as the practice. see, e.g., schilbach v. comm’r, 62 t.c.m. (cch) 1201 (1991). where the success of the venture depends entirely upon the personal relationships of the practitioner, the practice does not generally accumulate goodwill. see martin ice cream co. v. comm’r, 110 t.c. 189 at 207–08 (1998). the professional may, however, transfer his or her goodwill to the practice by entering into an employment contract or covenant not to compete with the business. see, e.g., norwalk v. comm’r, 76 t.c.m. (cch) 208, *7 (1998) (finding that there is no corporate goodwill where ―the business of a corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation‖) (emphasis added); martin ice cream co., 110 t.c. at 207-08 (finding that ―personal relationships ... are not corporate assets when the employee has no employment contract [or covenant not to compete] with the corporation‖) (emphasis added); macdonald v. comm’r, 3 t.c. 720, 727 (1944) (finding ―no authority which holds that an individual‘s personal ability is part of the assets of a corporation ... where ... the corporation does not have a right by contract or otherwise to the future services of that individual‖) (emphasis added). in determining whether goodwill has been transferred to a professional practice, we are especially mindful that ―each case depends upon particular facts. and in arriving at a particular conclusion ... we ... take into consideration all the circumstances ... [of] the case and draw from them such legitimate inferences as the occasion warrants.‖ grace brothers v. comm’r, 173 f.2d 170, 176 (9th cir. 1949).  looking at the facts as found by the district court, the ninth circuit concluded that ―while the relationships that dr. howard developed with his patients may be accurately described as personal, the economic value of those relationships did not belong to him, because he had conveyed control of them to the howard corporation.‖ furthermore, the court 616 florida tax review [vol. 13:10 rejected the taxpayer‘s argument that the purchase and sale agreement impliedly terminated both the employment contract and the non-competition agreement, thereby transferring the accumulated goodwill of the practice back to dr. howard, the court added that even if it accepted that argument, ―such a release would constitute a dividend payment, the value of which would be equivalent to the price paid for the goodwill of the dental practice.‖ b. has judge holmes breathed new vitality into martin ice cream? h&m, inc. v. commissioner, t.c. memo. 2012290 (10/15/12). h&m, inc. conducted a small town insurance agency business for many years. in the years before it sold its business it paid schmeets, its principal employee/sole shareholder, an annual salary of approximately $29,000. in an integrated transaction, a bank bought h&m, inc.‘s insurance business for $20,000 and entered into an employment agreement with schmeets pursuant to which he was paid total compensation of over $600,000 over a six-year period for continuing to run the insurance business on behalf of the bank that purchased the insurance agency. schmeets kept h&m, inc. alive and converted its business to (unsuccessfully) exploiting patents developed by its sole shareholder. the irs asserted a deficiency against h&m, inc. based on the ―substance over form‖ theory that a significant portion of the compensation paid to schmeets by the bank under the employment agreement actually was a payment to h&m, inc. for the sale of the insurance business, and that h&m, inc. thus realized significant capital gains and interest income over the period the compensation was paid to schmeets. the irs‘s argued that all of the compensation that was fixed in amount actually was part of the purchase price and that only the portion of the compensation that varied (the greater of $50,000 or 45% of ―net adjusted income‖ for the year) was actually compensation. the tax court (judge holmes) rejected the irs‘s argument completely. applying martin ice cream co. v. commissioner, 110 t.c. 189 (1998), and macdonald v. commissioner, 3 t.c. 720 (1944), judge holmes concluded that payments by a purchaser of a corporate business to a controlling shareholder for that shareholder‘s customer relationships were not taxable to the corporation ―where the business of a corporation depends on the personal relationships of a key individual [i.e., the controlling shareholder], unless he transfers his goodwill to the corporation by entering into a covenant not to compete or other agreement so that his relationships become property of the corporation.‖ judge holmes found the instant case to be like macdonald and martin ice cream co. the insurance business was ―‗extremely personal,‘ and the development of [the] business before the sale was due to schmeets‘s ability to form relationships with customers and keep big insurance companies interested in a small insurance market.‖ 2013] recent developments in federal income taxation 617 furthermore, the compensation paid to schmeets was reasonable, and there were no other intangibles to be accounted for in the purchase price.  the irs won on a whole raft of run-ofthe-mill other issues, typically found in closely held corporations, none of which are particularly interesting. f. corporate divisions there were no significant developments regarding this topic during 2012. g. affiliated corporations and consolidated returns 1. the ela was triggered in a closed year. lpciminelli interests, inc. v. united states, 110 a.f.t.r.2d 2012-6631 (w.d.n.y. 11/13/12). the irs asserted a deficiency against the taxpayer‘s consolidated group on the grounds that an inactive subsidiary realized cod income in 2004. the taxpayer paid the deficiency and sought a refund. in the refund proceedings, the government conceded that cod issue but asserted that pursuant to reg. § 1.1504-19, the taxpayer recognized gain from the subsidiary‘s excess loss account (ela) upon the worthlessness of the subsidiary‘s stock in 2004. the taxpayer proved that between 1999 and the end of 2003, the subsidiary‘s assets declined from more than $8.2 million to $4,128, and that under the pre-2008 version of reg. § 1.1504-19, the subsidiary‘s stock was worthless by the end of 2003 — a year beyond the statute of limitations — because the subsidiary had disposed of substantially all of its assets. accordingly, the court held that the income was not realized in 2004. the government further asserted that even if the subsidiary had disposed of substantially all of its assets prior to 2004, the ela was properly included in 2004 under the ―anti-avoidance rule‖ of reg. § 1.1502-19(e), which provides: ―if any person acts with a principal purpose contrary to the purposes of this section, to avoid the effect of the rules of this section or apply the rules of this section to avoid the effect of any other provision of the consolidated return regulations, adjustments must be made as necessary to carry out the purposes of this section.‖ the government‘s theory was based on the argument that the taxpayer ―acted with the purpose of avoiding the regulations by not reporting [the subsidiary] as an inactive subsidiary prior filing its consolidated return for tax year 2004, and by failing to file an amended return for the year (or years) during which the income from [the subsidiary‘s] ela was actually realized.‖ the court rejected this argument for two reasons. first, the taxpayer had fully disclosed the facts to the irs during the audit and had offered to extend the statute of limitations for 20012003 on the issue, and while the limitations periods from 2001–2003 were open, the irs examined the matter and chose not to assess tax based on any 618 florida tax review [vol. 13:10 realized ela income. second, there is no obligation to file an amended return. h. miscellaneous corporate issues 1. have you thought about the personal holding company or accumulated earnings taxes recently? bet not! the 2012 taxpayer relief (and not so grand compromise) tax act permanently increased from 15% and set at 20% the § 531 accumulated earnings tax and the § 541 personal holding company tax. vii. partnerships a. formation and taxable years 1. the castle harbour saga. will it ever end? the second circuit twice reverses a taxpayer victory in a self-liquidating partnership note transaction, in which the lion‘s share of income was allocated to a tax-indifferent party, on the ground that the taxindifferent dutch banks were not really equity partners. tifd iii-e, inc. v. united states, 342 f. supp. 2d 94 (d. conn. 11/1/04), rev’d, 459 f.3d 220 (2d cir. 8/3/06), on remand, 660 f. supp. 2d 367 (d. conn. 10/7/09), as amended, 2009 u.s. dist. lexis 98884 (d. conn. 10/23/09), rev’d, 666 f.3d 836 (2d cir. 1/24/12). a. castle harbour i: district court holds for the taxpayer. the court found that the creation of castle harbour, a nevada llc, by general electric capital corp. subsidiaries was not designed solely to avoid taxes, but to spread the risk of their investment in fully-depreciated commercial airplanes used in their leasing operations. gecc subsidiaries put the following assets into castle harbour: $530 million worth of fullydepreciated aircraft subject to a $258 million non-recourse debt; $22 million of rents receivable; $296 million of cash; and all the stock of another gecc subsidiary that had a value of $0. two tax-indifferent dutch banks invested $117.5 million in castle harbour. under the llc agreement, the taxindifferent partner was allocated 98 percent of the book income and 98 percent of the tax income.  the book income was net of depreciation, and the tax income did not take depreciation into account (because the airplanes were fully depreciated for tax purposes). depreciation deductions for book purposes were on the order of 60 percent of the rental income for any given year. 2013] recent developments in federal income taxation 619  scheduled distributions in excess of book income would have resulted in the liquidation of the investment of the dutch banks in eight years, with the dutch banks receiving a return of approximately nine percent, with some ―economically substantial‖ upside and some downside risk. castle harbour was terminated after five years because of a threatened change in u.s. tax law, but during that period about $310 million of income was shifted to the dutch banks for a tax saving to the gecc subsidiaries of about $62 million.  query whether § 704(b) was properly applied to this transaction?  this appears to be a lease-stripping transaction in which the income from the lease was assigned to foreign entities while the benefits of ownership were left with a domestic entity.  the court (judge underhill) held that satisfaction of the mechanical rules of the regulations under § 704(b) transcended both an intent to avoid tax and the avoidance of significant tax through agreed upon partnership allocations. in this partnership, 2 percent of both operating and taxable income was allocated to gecc, a united states partner, and 98 percent of both book and taxable income was allocated to partners who were dutch banks. the dutch banks were foreign partners who were not liable for united states taxes and thus were indifferent to the u.s. tax consequences of their participation in the partnership. because the partnership had very large book depreciation deductions and no tax depreciation, most of the partnership‘s taxable operating income, which was substantially in excess of book taxable income, was allocated to the tax-indifferent foreign partners, even though a large portion of the cash receipts reflected in that income was devoted to repaying the principal of loans secured by property that gecc had contributed to the partnership. the overall partnership transaction saved gecc approximately $62 million in income taxes, and the court found that ―it appears likely that one of gecc‘s principal motivations in entering into this transaction — though certainly not its only motivation — was to avoid that substantial tax burden.‖ the court understood the effects of the allocations and concluded that ―by allocating 98% of the income from fully tax-depreciated aircraft to the dutch banks, gecc avoided an enormous tax burden, while shifting very little book income.‖ put another way, by allocating income less depreciation to taxneutral parties, gecc was able to ―re-depreciate‖ the assets for tax purposes. the tax-neutrals absorbed the tax consequences of all the income allocated to them, but actually received only the income in excess of book depreciation. nevertheless, the court upheld the allocations. ―the tax benefits of the . . . transaction were the result of the allocation of large amounts of book income to a tax-neutral entity, offset by a large depreciation expense, with a corresponding allocation of a large amount of taxable income, but no corresponding allocation 620 florida tax review [vol. 13:10 of depreciation deductions. this resulted in an enormous tax savings, but the simple allocation of a large percentage of income violates no rule. the government does not – and cannot – dispute that partners may allocate their partnership‘s income as they choose. neither does the government dispute that the taxable income allocated to the dutch banks could not be offset by the allocation of non-existent depreciation deductions to the banks. and . . . the bare allocation of a large interest in income does not violate the overall tax effect rule.‖  judge underhill concluded: the government is understandably concerned that the castle harbour transaction deprived the public fisc of some $62 million in tax revenue. moreover, it appears likely that one of gecc‘s principal motivations in entering into this transaction — though certainly not its only motivation — was to avoid that substantial tax burden. nevertheless, the castle harbour transaction was an economically real transaction, undertaken, at least in part, for a non-tax business purpose; the transaction resulted in the creation of a true partnership with all participants holding valid partnership interests; and the income was allocated among the partners in accordance with the internal revenue code and treasury regulations. in short, the transaction, though it sheltered a great deal of income from taxes, was legally permissible. under such circumstances, the i.r.s. should address its concerns to those who write the tax laws. b. castle harbour ii: second circuit reverses. 459 f.3d 220 (2d cir. 8/3/06). the second circuit, in an opinion by judge leval, held that the dutch banks were not partners because their risks and rewards were closer to those of creditors than partners. he used the facts-and-circumstances test of commissioner v. culbertson, 337 u.s. 733 (1949), to determine whether the banks‘ interest was more in the nature of debt or equity and found that their interest was overwhelmingly in the nature of a secured lender‘s interest, ―which would neither be harmed by poor performance of the partnership nor significantly enhanced by extraordinary profits.‖  in acm (colgate), judge laro wrote a 100+ page analysis to find that there was no economic substance to the arrangement. the next contingent payment installment sale case in the tax court was asa investerings (allied signal), in which judge foley wrote a much shorter opinion finding that the dutch bank was not a partner; the d.c. circuit affirmed on judge foley‘s holding that the dutch bank was not a partner. the irs began to pick up this lack-of-partnership argument and began 2013] recent developments in federal income taxation 621 to use it on examinations. later, the tax court (judge nims) used the economic substance argument in saba (brunswick), which the dc circuit remanded based on asa investerings to give taxpayer the opportunity to argue that there was a valid partnership, which it could not do, as judge nims found on remand. even later, the d.c. circuit reversed the district court‘s boca (wyeth or american home products) case based upon this lack-of-partnership argument – even though cravath planned boca carefully so that if the dutch bank was knocked out, there would still be a partnership – based upon its asa investerings and saba findings on appeal that there was no partnership. now the second circuit has adopted the lack-of-partnership argument. c. castle harbour iii. judge underhill still likes ge. on remand in castle harbour, the district court found a valid partnership to have existed under § 704(e) because the heading does not alter the clear language of a statute. a valid family partnership is found in the absence of a family. additionally, in his contingent penalty findings, judge underhill stated that his 2004 taxpayer-favorable decision ipso facto means that the taxpayer‘s reporting position was based upon substantial authority. 660 f. supp. 2d 367 (d. conn. 10/7/09), as amended, 2009 u.s. dist. lexis 98884 (d. conn. 10/23/09). in a carefully-written 5 opinion, judge underhill held that, while the second circuit opinion decided that the partnership did not meet the culbertson totality-of-the-circumstances test (―whether . . . the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise‖), it did not address the § 704(e)(1) issue. he held that the dutch banks did satisfy the requirements of that paragraph, which reads: (e) family partnerships. (1) recognition of interest created by purchase or gift. – a person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person.  in so holding, he relied upon well-settled law that the title of a statute cannot limit the plain meaning of the text, and that the title is of use only when it sheds light on some ambiguous word or phrase. see also i.r.c. § 7806(b).  it is worth noting that although evans v. commissioner, 447 f.2d 547 (7th cir. 1971), aff’g 54 t.c. 40 (1970), which 5. we do not all share the opinion that the opinion is “carefully-written,” but ira thinks so. ira’s college classmate [judge] pierre leval characterized the district court’s analysis as “thorough and thoughtful.” 622 florida tax review [vol. 13:10 judge underhill relied upon extensively to reach his conclusion, held that the application of § 704(e)(1) was not limited to the context of family partnerships, evans involved the question who, between two different persons — the original partner or an assignee of the original partner‘s economic interest—was the partner who should be taxed on a distributive share of the partnership‘s income. although in the family context § 704(e) frequently has been applied to determine whether a partnership exists in the first place, judge underhill‘s decision in castle harbour iii is the first case to ―discover‖ that § 704(e)(1) applies to determine whether an arrangement between two (or more) otherwise unrelated business entities or unrelated individuals constituted a partnership.  it has sometimes been adduced that the fact that a court of applicable jurisdiction subsequently upholds the tax treatment of a transaction should be a strong argument for the proposition that such tax treatment was based upon substantial authority. with respect to whether the applicability of penalties should he be reversed on appeal, judge underhill stated: to a large extent, my holding in castle harbour i in favor of the taxpayer demonstrates the substantial authority for the partnership‘s tax treatment of the dutch banks, as does my discussion above of the dutch banks‘ interest in castle harbour under section 704(e)(1). in addition, the government‘s arguments against the substantial authority defense are unavailing.  judge underhill also sought to place the application of the penalty provisions in a temporal context when he stated: the government argues that culbertson and second circuit cases like slifka and dyer that interpreted culbertson cannot provide substantial authority for the partnership‘s tax position because the second circuit held in castle harbour ii that the dutch banks were not partners under culbertson. the government, however, has not pointed to any second circuit case or other authority, prior to 1997 and 1998 when the castle harbour partners took the tax positions at issue, where the parties‘ good faith intention or valid business purpose in forming a partnership was not sufficient to support a conclusion of partnership status for tax purposes.  in the context of the previous two bullet points, it is worth noting that judge underhill‘s observations in the immediately preceding bullet point appears to be consistent with reg. § 1.66624(d)(3)(iv)(c), which provides that whether a position was supported by substantial authority must be determined with reference to authorities in existence at the time. but judge underhill‘s observations in the second preceding bullet point appear to be inconsistent with both reg. § 1.66622013] recent developments in federal income taxation 623 4(d)(3)(iv)(c) and observations in the immediately preceding bullet. however, we are not all in agreement with what judge underhill intended the observations in the second preceding bullet point to mean. d. castle harbour iv: the second circuit smacks down the district court again in an opinion that leaves you wondering why it ever remanded the case in the first place. 666 f.3d 836 (2d cir. 1/24/12). in another opinion by judge leval, the second circuit again reversed judge underhill and held that the enactment of § 704(e)(1), which recognizes as a partner one who owns a ―capital interest in a partnership,‖ did not ―change[] the law so that a holding of debt (or of an interest overwhelmingly in the nature of debt) could qualify as a partnership interest.‖ notwithstanding that they tend to favor the government‘s position, the governing statute and regulation leave some ambiguity as to whether the holder of partnership debt (or an interest overwhelmingly in the nature of debt) shall be recognized as a partner. therefore, we may consult the legislative history to see whether it sheds light on their interpretation. . . . the reports of the house and the senate accompanying the passage of § 704(e) make clear that the provision did not intend to broaden the character of interests in partnerships that qualify for treatment as a partnership interest to include partnership debt. the purpose of the statute was to address an altogether different question. the concern of § 704(e)(1) was whether it matters, for the determination of whether a person is a partner for tax purposes, that the person‘s purported partnership interest arose through an intrafamily transfer. the section was passed to reject court opinions that refused to recognize for tax purposes transfers of partnership interests because the transfers were effectuated by intrafamilial gift, as opposed to arm‘s length purchase. its focus is not on the nature of the investment in a partnership, but rather on who should be recognized for tax purposes as the owner of the interest.  the second circuit went on to describe the district court as having found that the banks incurred ―real risk‖ that might require them to restore negative capital accounts, and thus having concluded ―that the banks‘ interest was therefore an ‗interest in the assets of the partnership‘ distributable to them upon liquidation.‖ the second circuit then described the district court‘s finding that the banks‘ interest qualified as a capital interest as having been ―premised entirely on the significance it accorded to the possibility that the banks would be required to bear 1% of 624 florida tax review [vol. 13:10 partnership losses exceeding $7 million, or 100% of partnership losses exceeding $541 million.‖ but the second circuit disagreed, holding that there was a mere appearance of risk, rather than any real risk, which did not justify treating the banks‘ interest as a capital, or equity, interest, noting that it had reached the same conclusion in its earlier opinion. the second circuit then suggested that ―[t]he district court was perhaps reading § 704(e)(1) to mean that the addition to a debt interest of any possibility that the holder‘s ultimate entitlement will vary, based on the debtor‘s performance, from pure reimbursement plus a previously fixed rate of return will qualify that interest as a partnership interest, no matter how economically insignificant the potential deviation and how improbable its occurrence.‖ the second circuit ―disagree[d] with any such reading of the statute. no such interpretation is compelled by the plain language of § 704(e)(1). and the fact that the statute was intended to serve an altogether different purpose is confirmed by the legislative reports.‖ the second circuit continued: in explaining our conclusion that the banks‘ interest was not a genuine equity interest, we repeatedly emphasized that, as a practical matter, the structure of the partnership agreement confined the banks‘ return to the applicable rate regardless of the performance of castle harbour. . . . the banks‘ interest was therefore necessarily not a ―capital interest‖ . . . . because the banks‘ interest was for all practical purposes a fixed obligation, requiring reimbursement of their investment at a set rate of return in all but the most unlikely of scenarios, their interest rather represented a liability of the partnership. . . . accordingly, for the same reasons that the evidence compels the conclusion that the banks‘ interest was not bona fide equity participation, it also compels the conclusion that their interest was not a capital interest within the meaning of § 704(e)(1).  turning to the § 6662 penalty issue, the second circuit again trashed judge underhill‘s opinion and reversed, reinstating the penalties, stating that judge underhill had ―mistakenly concluded that several of our decisions supported treatment of the banks as partners in castle harbour.‖ 2. frack the corporate tax for this waste removal partnership. ltr. rul. 201227002 (3/1/12, released 7/6/12). the irs concluded in this private letter ruling that income from the removal, treatment, recycling and disposal of waste products from fracturing processes in oil and gas production is qualifying gross income under § 7704(d)(1)(e), 2013] recent developments in federal income taxation 625 permitting a publicly traded partnership to avoid being taxed as an association under § 7704. 3. section 47 historic rehabilitation credits were allowed to an llc (taxed as a partnership) in which pitney bowes was a 99.9 percent member despite an irs challenge under the anti-abuse provisions of reg. § 1.701-2, but it was too late to keep the miss america pageant in atlantic city. historic boardwalk hall, llc v. commissioner, 136 t.c. 1 (1/3/11). the tax court (judge goeke) held that the ownership interest on the historic east hall of the atlantic city boardwalk hall under a 35-year lease belonging to the new jersey sports and exposition authority could be transferred to historic boardwalk hall, llc, in which pitney bowes (through a subsidiary and an llc) was the 99.9 percent member (and the njsea was the 0.1 percent member). along with ownership went the § 47 federal tax credit of 20 percent of the qualified rehabilitation expenditures incurred in transforming the run-down east hall from a flatfloor convention space to a ―special events facility‖ that could host concerts, sporting events, and other civic events. pitney bowes became the 99.9 percent member of historic boardwalk hall, llc, following an offering memorandum sent to nineteen large corporations, which described the transaction as a ―sale‖ of tax credits (although that description was not repeated in any of the subsequent documents relating to the transaction). njsea lent about $57 million to historic boardwalk hall, and pitney bowes made capital contributions of more than $18 million to that llc, as well as an investor loan of about $1.2 million. in that offering memorandum, losses were projected over the first decade of operation of east hall. the irs argued that the bulk of the pitney bowes contributions were paid out to njsea as a ―development fee‖ and that the entire transaction was a sham because njsea was going to develop east hall regardless of whether pitney bowes made its capital contributions and loan.  judge goeke held that one of the purposes of § 47 was ―to encourage taxpayers to participate in what would otherwise be an unprofitable activity,‖ and the rehabilitation of east hall was a success, leading to the conclusion that historic boardwalk had objective economic substance. he also held that ―pitney bowes and njsea, in good faith and acting with a business purpose, intended to join together in the present conduct of a business enterprise‖ and that while the offering memorandum used the term ―sale,‖ ―it was used in the context of describing an investment transaction.‖ finally, judge goeke used reg. § 1.701-2(d), example (6), involving two high-bracket taxpayers who joined with a corporation to form a partnership to own and operate a building that qualifies for § 42 low-income housing credits, to conclude that reg. § 1.701-2 did not apply to the historic boardwalk transaction because that regulation ―clearly contemplate[s] a 626 florida tax review [vol. 13:10 situation in which a partnership is used to transfer valuable tax attributes from an entity that cannot use them . . . to [a taxpayer] who can . . . .‖  query whether ―economic substance‖ requirements are applicable when the tax benefits take the form of tax credits enacted to encourage specific types of investments? a. ―‗[t]he sharp eyes of the law‘ require more from parties than just putting on the ‗habiliments of a partnership whenever it advantages them to be treated as partners underneath.‘ . . . indeed, culbertson requires that a partner ‗really and truly intend[] to . . . shar[e] in the profits and losses‘ of the enterprise. ... and, after looking to the substance of the interests at play in this case, we conclude that, because [pitney bowes] lacked a meaningful stake in either the success or failure of [historic boardwalk hall], it was not a bona fide partner.‖ historic boardwalk hall llc v. commissioner, 694 f.3d 425 (3d cir. 8/27/12) in a unanimous opinion by judge jordan, the third circuit reversed the tax court and held that pitney bowes was not a bona fide partner in historic boardwalk hall llc. the court‘s reasoning was based on the culbertson test [commissioner v. culbertson, 337 u.s. 733 (1949)], as applied by the second circuit in tifd iii-e, inc. v. united states, 459 f.3d 220, 232 (2d cir. 2006) (castle harbour ii), to find that the dutch banks were not partners, and the reasoning of the fourth circuit in virginia historic tax credit fund 2001 lp v. commissioner, 639 f.3d 129 (4th cir. 2011), to find that the investors who acquired the virginia historic rehabilitation credits through the partnership bore no ―true entrepreneurial risk,‖ which the third circuit concluded was a characteristic of a true partner under the culbertson test. the third circuit concluded that pitney bowes was not a partner because, based on an analysis of the facts, as the transaction was structured, (1) pitney bowes ―had no meaningful downside risk because it was, for all intents and purposes, certain to recoup the contributions it had made to hbh and to receive the primary benefit it sought — the hrtcs or their cash equivalent,‖ and (2) pitney bowes‘s ―avoidance of all meaningful downside risk in hbh was accompanied by a dearth of any meaningful upside potential.‖ the analysis was highly factual and based on substance over form. as for downside risk, the court of appeals reversed as clearly erroneous the tax court‘s finding that pitney bowes bore a risk because it might not receive an agreed upon 3% preferred return on its contributions to hbh. referring to virginia historic tax credit fund, the third circuit treated the 3% preferred return as a ―return on investment‖ that was not a ―share in partnership profits,‖ which pointed to the conclusion that pitney bowes did not face any true entrepreneurial risk. as for upside potential, applying the substance over form doctrine, the court concluded that ―although in form pb had the potential to receive the fair 2013] recent developments in federal income taxation 627 market value of its interest . . . in reality, pb could never expect to share in any upside.‖ the court noted that it was mindful ―of congress‘s goal of encouraging rehabilitation of historic buildings,‖ and that its holding might ―jeopardize the viability of future historic rehabilitation projects,‖ but the court observed that it was not the tax credit provision itself that was under attack, but rather the particular transaction transferring the benefits of the credit in the manner that it had.  the opinion makes it very clear that the decision was based on applying the ―substance over form‖ doctrine rather than the ―economic substance‖ doctrine to determine that pitney bowes was not a partner. 4. deathbed estate planning with intended contributions creates a texas style family limited partnership. keller v. united states, 637 f.3d 238 (5th cir. 9/25/12). on may 10, the decedent met in her hospital bed with advisors to structure estate planning ab trusts as partners with an llc in a family limited partnership. the decedent executed partnership agreements and indicated that she intended to fund the partnership with community property bonds. the decedent also wrote a check to the partnership which was never cashed. the decedent died on may 15. after attending a cle conference, the taxpayer‘s advisors re-thought the estate‘s estate tax payment and claimed a $147 million refund of estate taxes on the basis of a valuation discount attributable to the assets in the family limited partnership. the irs asserted that the partnership was never funded. the court, affirming findings by the district court, held that under ―[w]ellestablished principles of texas law‖ the decedent‘s intent to make an asset partnership property caused the bonds to be equitably owned by the partnership. thus the estate was entitled to the valuation discount for the partnership property. b. allocations of distributive share, partnership debt, and outside basis 1. de minimis partners become substantial under proposed regulations. reg-109564-10, partner‘s distributive share, 76 f.r. 66012 (10/25/11). the economic effect of a partnership allocation is not substantial under reg. § 1.704-1(b)(2)(iii)(a) if, at the time the allocation (or allocations) becomes part of the partnership agreement: (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the 628 florida tax review [vol. 13:10 partnership agreement. reg. § 1.704-1(b)(2)(iii)(e) provides that the tax attributes of a de minimis partner (a partner who owns less than 10 percent of partnership capital or profits) need not be taken into account in applying the substantiality tests. the proposed regulation would remove the de minimis partner rule ―in order to prevent unintended tax consequences.‖ the preamble to the proposed regulation indicates that the de minimis partner rule was ―not intended to allow partnerships to entirely avoid the application of the substantiality regulations if the partnership is owned by partners each of whom owns less than 10 percent of the capital or profits, and who are allocated less than 10 percent of each partnership item of income, gain, loss, deduction, and credit.‖ the regulations will be effective when finalized. a. de minimis partners are still partners under the substantiality test. t.d. 9607, partner‘s distributive share, 77 f.r. 76380 (12/28/12). reg. § 1.704-1(b)(2)(iii)(e) is amended to remove the de minimis rule that provided that in determining whether the economic effect of a partnership allocation is substantial under reg. § 1.704-1(b)(2)(iii) the tax consequences to a less than 10 percent partner could be ignored. the final regulation is applicable to allocations that become part of a partnership agreement after 12/28/12, and is applicable for all partnership taxable years beginning on or after 12/28/12, regardless of when an allocation became part of the partnership agreement. 2. only in tax law could insolvency result from debts you don‘t really have to repay. rev. rul. 2012-14, 2012-24 i.r.b. 1012 (5/25/12). section 108(a)(1)(b) excludes cod from gross income if the cancellation occurs when the taxpayer is insolvent; § 108(a)(3) limits the amount of cod income excluded by § 108 to the amount by which the taxpayer is insolvent. rev. rul. 92-53, 1992-2 c.b. 48, provides that the amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt (―excess nonrecourse debt‖) is treated as a liability in determining insolvency for purposes of § 108 to the extent that the excess nonrecourse debt is discharged. revenue ruling 2012-14 holds that for purposes of measuring a partner‘s insolvency under § 108(d)(3), each partner treats as a liability an amount of the partnership‘s discharged ―excess nonrecourse debt‖ that is based upon the allocation of cod income to such partner under § 704(b) and the regulations thereunder. 3. retention of an economic interest is not a liquidation. brennan v. commissioner, t.c. memo. 2012-209 (7/23/12). ashland and brennan were members of the cutler & company llc, which managed asset portfolios for high-income individuals. (another cutler case is discussed under the partnership audit rules at vii.f.7., below.) ashland 2013] recent developments in federal income taxation 629 was the ceo of cutler. cutler was restructured in 2002 because of ―turmoil‖ among the members. cutler sold certain institutional accounts under an agreement entered into in 2002, with payments made in 2003 and 2004. sales proceeds were used to satisfy cutler liabilities and obligations. at the time of the sale brennan ceased to be a member of cutler, but continued to hold ―an economic interest‖ which conferred a continuing interest in income and loss items. ashland reported capital gain from the sale in 2003, but none in 2004. brennan reported no capital gain from the cutler sale. the irs asserted inconsistent deficiencies against both ashland and brennan in order to avoid a whipsaw, asserting that ashland was responsible for reporting all of the capital gains recognized in 2003 and 2004 and that brennan was responsible for reporting his 45 percent distributive share of the capital gains. the tax court (judge kroupa) rejected brennan‘s claim that his partnership interest terminated in 2002, holding that a retiring partner remains a partner for tax purposes until the partner‘s interest has been completely liquidated. thus, the court held that brennan was responsible for reporting his share of partnership capital gain derived in 2003 and 2004. ashland was responsible for reporting her share of the capital gain as set forth in the 2002 restructuring agreement. 4. family farm is a partnership. holdner v. commissioner, t.c. memo. 2010-175 (8/4/10). when his son randal expressed little interest in going to college, william holder, an accountant, invested in developing a small family farm for his son to operate with an agreement to divide the profits with an undefined equity interest in the property. as the farming operation expanding, father and son took title to property as tenants in common. on his returns, william reported one-half of the income and claimed deductions for all operating expenses. the tax court (judge marvel) held that the arrangement was a partnership, rejecting the taxpayer‘s arguments that they each operated as independent sole proprietors. judge marvel noted that both william and randal contributed properties and labor to the venture, which conducted business activities. she also found that the taxpayers failed to rebut a presumption that the partners shared equal capital interests in the partnership that applied to all items of income and expenditure, and that differing capital contributions did not justify an allocation of all expenditures to william. the court sustained an accuracy related penalty under § 6662 finding that william failed to make a reasonable attempt to ascertain the correctness of his reporting positions. a. not clearly erroneous says the ninth circuit. holdner v. commissioner, 483 fed. appx. 383 (9th cir. 10/12/12). affirming the tax court in an unpublished opinion, the ninth circuit upheld judge marvel‘s conclusion that the farming operation was a 50-50 partnership, as opposed to a mere co-ownership of property. it also rejected 630 florida tax review [vol. 13:10 the taxpayer‘s argument that the notice of deficiency was not adequate because it failed to inform the taxpayer of what would be relevant at trial. c. distributions and transactions between the partnership and partners there were no significant developments regarding this topic during 2012. d. sales of partnership interests, liquidations and mergers there were no significant developments regarding this topic during 2012. e. inside basis adjustments there were no significant developments regarding this topic during 2012. f. partnership audit rules 1. partner‘s outside basis in a tax-shelter partnership is a partner item. napoliello v. commissioner, t.c. memo. 2009-104 (5/18/09). the taxpayer invested in a son-of-boss transaction involving digital foreign currency items. the irs issued an fpaa to the taxpayer as a notice partner. in the uncontested partnership proceeding, it was determined that the partnership was a sham that lacked economic substance, that transactions entered into by the partnership should be treated as transacted directly by the partners, and that purported losses claimed on disposition of distributed property with an enhanced basis should be disallowed. the irs assessed a deficiency against the taxpayer based on the partnership items. the tax court previously held in petaluma fx partners, llc v. commissioner, 131 t.c. 84 (2008), that the determination of whether a partnership was a sham that will be disregarded for federal tax purposes is a partnership item. in the instant case, the court (judge kroupa) agreed with the irs that the partner‘s basis in distributed securities from the sham partnership is an affected item subject to determination in the partnership proceeding, and not subject to re-determination in the partner-level deficiency proceeding. because the amount of any loss with respect to the partner‘s disposition of securities distributed from the partnership required a factual determination at the partner level, the court held that it had jurisdiction in the partner deficiency proceeding to proceed under normal deficiency procedures. the court thus proceeded to determine that the 2013] recent developments in federal income taxation 631 taxpayer‘s claimed loss on the sale of the distributed securities was disallowed, that the taxpayer‘s basis in the securities was their direct cost rather than an exchange basis from the partnership interest, and that the taxpayer was not allowed to deduct transaction costs attributable to the investment. the tax court also held that the fpaa gave the taxpayer fair notice of the irs claims. a. part of the tax court‘s holding in petaluma fx partners retains its vitality, but not the part the tax court relied upon in napoliello. petaluma fx partners, llc v. commissioner, 591 f.3d 649 (d.c. cir. 1/12/10). the tax court in this son-of-boss tax shelter case determined that it had jurisdiction in a tefra partnership proceeding to determine that the partnership lacked economic substance and was a sham. since the partnership was disregarded, the tax court concluded that it had jurisdiction to determine that the partners‘ outside basis in the partnership was zero. the tax court reasoned that a partner could not have a basis in a partnership interest that did not exist. (131 t.c. 84 (2008)) the court of appeals agreed that the tax court had jurisdiction in the partnership proceeding to determine that the partnership was a sham. temp. reg. § 301.6233-1t(a) expressly provides that ―[a]ny final partnership administrative adjustment or judicial determination ... may include a determination that the entity is not a partnership for such taxable year.‖ the court of appeals held that the regulation was explicitly authorized by § 6233. a partnership item is defined in § 6231(a)(3) as an item required to be taken into account in determining the partnership‘s income under subtitle a of the code that is identified in regulations as an item more appropriately taken into account at the partnership level. the court indicated that, ―[l]ogically, it makes perfect sense to determine whether a partnership is a sham at the partnership level. a partnership cannot be a sham with respect to one partner, but valid with respect to another.‖ however, the court of appeals concluded that the partners‘ bases were affected items, not partnership items, and that the tax court did not have jurisdiction to determine the partners‘ bases in the partnership proceeding. the court rejected the irs argument that the tax court had jurisdiction in the partnership proceeding to determine the partners‘ outside basis as an affected item whose elements are mainly determined from partnership items. the court held that resolution of the affected item requires a separate determination at the partner level even though the affected item could easily be determined in the partnership proceeding. finally, the court of appeals held that accuracy related penalties under § 6662(a) could not be determined without a determination of the partners‘ outside basis in a partner level proceeding and vacated and remanded the tax court‘s determination of penalty issues. https://checkpoint.riag.com/getdoc?docid=t0advaftr:12675.1&pinpnt= 632 florida tax review [vol. 13:10 b. on remand, the tax court disavowed jurisdiction over penalties in the partnership-level proceeding. petaluma fx partners, llc v. commissioner, 135 t.c. 581 (12/15/10). the court (judge goeke) held that in light of the court of appeals holding that determination of adjustments attributable to the partner‘s outside basis is an affected item properly addressed in individual partner level proceedings, any § 6662 penalties must also be determined at the partner-level proceeding and that the tax court had no jurisdiction to assess the penalties. the court rejected the irs argument that the penalties proceeded from the partner-level determination that the partnership was a sham, thereby providing jurisdiction for the tax court to determine the negligence penalty. the tax court held that if a penalty ―does not relate directly to a numerical adjustment to a partnership item, it is beyond our jurisdiction. in this case there are no such adjustments to which a penalty can apply.‖ judge halpern dissented, asserting that the tax court could reconsider the penalty on grounds other than the partners‘ outside bases under the court‘s initial findings that the partnership was a sham and did not provide the basis increase claimed by the partners. a dissent by judge marvel (joined by three others) argued that the tax court has jurisdiction to determine the imposition of a penalty for negligence related to adjustment of a partnership item in the partnership level proceeding, but the amount of the individual penalty depends upon a computation at the partner level. c. partner‘s outside basis in a tax-shelter partnership is a partner item. napoliello v. commissioner, 655 f.3d 1060 (9th cir. 8/23/11). the taxpayer invested in a son-of-boss transaction involving digital foreign currency items. the irs issued an fpaa to the taxpayer as a notice partner. in the uncontested partnership proceeding it was determined that the partnership was a sham that lacked economic substance, that transactions entered into by the partnership should be treated as transacted directly by the partners, and that purported losses claimed on disposition of distributed property with an enhanced basis should be disallowed. the irs assessed a deficiency against the taxpayer based on the partnership items. upholding the tax court, the ninth circuit joined the d.c and eighth circuits, in petaluma fx partners, llc v. commissioner, 591 f.3d 649 (d.c. cir. 2010), and rjt invs. x v. commissioner, 491 f.3d 732 (8th cir. 2007), respectively, holding that the determination of whether a partnership was a sham that will be disregarded for federal tax purposes is a partnership item. the ninth circuit also agreed with the tax court that the partner‘s basis in distributed securities from the sham partnership is an affected item subject to determination in the partnership proceeding, and not subject to re-determination in the partner-level deficiency proceeding. because the amount of any loss with respect to the partner‘s disposition of 2013] recent developments in federal income taxation 633 securities distributed from the partnership required a factual determination at the partner level, the court held that the tax court had jurisdiction in the partner deficiency proceeding to proceed under normal deficiency procedures. thus, the tax court could determine that the taxpayer‘s claimed loss on the sale of the distributed securities was disallowed, that the taxpayer‘s basis in the securities was their direct cost rather than an exchange basis from the partnership interest, and that the taxpayer was not allowed to deduct transaction costs attributable to the investment. d. disregarded tax-shelter partnership is still a partnership for purposes of the tefra audit rules. tigers eye trading llc v. commissioner, 138 t.c. 67 (2/13/12) (reviewed, court opinion joined by fiver judges, three judges concurred and four dissented). in this son-of-boss tax shelter matter, the parties stipulated that the tax shelter partnership should be disregarded, the basis of distributed property should be reduced to zero, and upheld accuracy related penalties. the partnership filed a motion to revise the stipulated decision after the d.c. circuit‘s decision in petaluma fx partners, llc v. commissioner, 591 f.3d 649 (d.c. cir. 2010), which held that a partner‘s outside basis is not a partnership item subject to the court‘s jurisdiction in a partnership-level proceeding and thus not subject to a penalty determination in the partnership proceeding. in an opinion joined by only judges colvin, halpern (who also wrote a separate concurring opinion), cohen, and goeke, the tax court (judge beghe) held that it has jurisdiction in a partnership-level proceeding against an entity that filed a partnership return to determine whether the entity should be disregarded as a partnership and to determine all items of the entity that would be partnership items if the entity had been a partnership, citing §§ 6233 and 6226(f) and temp. reg. § 301.6226(f)-1t. under § 6233, if a partnership return is filed for a taxable year but it is determined that no partnership exists, the tefra procedures apply to the partnership, partnership items, and to persons holding an interest in the entity. the court specifically noted that a holding that an entity does not exist under temp. reg. § 301.6233-1t(a) ―will serve as a basis for a computational adjustment reflecting the disallowance of any loss or credit claimed by a purported partner with respect to that entity.‖ the court indicated that petaluma fx partners was decided on the basis of a government concession that outside basis was not a partnership item. the court held that under mayo foundation for med. educ. & research v. united states, 131 s. ct. 704 (2011), decided after petaluma fx partners, it was required to defer to the regulations. the court then interpreted the basis rules of subchapter k and reg. § 301.6231(a)(3)-1(a) to require that determination of outside basis is a partnership item: determination of the partners‘ outside bases in their interests in a partnership that is recognized for federal 634 florida tax review [vol. 13:10 income tax purposes requires complex determinations of not only the amounts of partnership items that are elements of outside basis but also the partners‘ shares of those amounts, which are also partnership items. those complex determinations must be made in the partnership proceeding, and most often there are no other factors to be determined at the partner level.  with respect to its jurisdiction to assess penalties, unlike the d.c. circuit in petaluma fx partners, the court indicated that, based on its holding that the partners‘ outside bases were subject to determination in the partnership-level proceeding, the court had jurisdiction to impose the 40-percent basis misstatement penalty at the partnership level.  judge wherry wrote a concurring opinion. judges gale and paris concurred in the result only, without opinions. judge marvel wrote a dissent, which was joined in part by judges thornton and kroupa. judge foley dissented without opinion, and judges vasquez, gustafson, and morrison did not participate.  since this case is appealable to the d.c. circuit, the tax court‘s lengthy opinion is not likely to be the last word. e. partnership items are in the eye of the beholder. petaluma fx partners, llc v. commissioner, t.c. memo. 2012142 (5/17/12). on its own motion, the d.c. circuit again remanded this case back to the tax court to reassess the tax court‘s holding in petaluma iii (135 t.c. 581) that it lacked jurisdiction to determine the partner‘s outside basis in the partnership proceeding because it is an affected item in light of the court‘s majority decision in tigers eye trading llc v. commissioner, 138 t.c. 67 (2/13/12), that it had jurisdiction in the partnership level proceeding to determine the partner‘s outside bases and assess penalties. petaluma fx partners, llc v. commissioner, 109 a.f.t.r. 2d 2012-2238 (d.c. cir. 2/27/12). the court of appeals cited the lone dissent by judge holmes where he stated that ―[o]ur decision today overrules petaluma iii‖. in its supplemental memorandum decision, the tax court (judge goeke) indicated that the decision on remand in petaluma was based on the ―narrow‖ instruction on remand from the d.c. circuit which established the law of the case and further stated that its decision on remand was ―thoroughly imbued with the legal reasoning and logic provided by the d.c. circuit in its earlier decision.‖ the court also stated that the language from judge holmes‘s dissent in tigers eye that was cited in the d.c. circuit‘s remand does not represent the position of the court and indicated that no part of the opinion in tigers eye ―purported to explicitly alter or overrule the decision in this case or to revise the language of the court‘s opinion in petaluma iii.‖ 2013] recent developments in federal income taxation 635 2. who settled with whom and when? mathia v. commissioner, 669 f.3d 1080 (10th cir. 1/5/12). the taxpayer‘s deceased husband was a partner in a swanton coal partnership that the irs challenged with an fpaa. in 1991 the law firm representing the tax matters partner entered into a settlement agreement in principle, but which required further negotiation with the irs to determine the settlement amount. in 1995 the irs sent a stipulation of settlement agreement to the partnership that was signed by the partnership but not by the irs. an identical agreement was signed by both parties in 2001 and entered as a final judgment by the tax court. within the one year allowed from the date of final judgment under § 6225(a), the irs issued a deficiency assessment against the taxpayer, who asserted that the earlier settlements represented a settlement with individual partners that reclassified the claimed partnership losses as nonpartnership items under § 6231(b)(1)(c), which then required an assessment within one year of the settlement. the court held that even if the 1991 agreement in principle and the subsequent settlement were binding agreements, the agreements dealt only with partnership items and not settlement agreements with individual partners. thus, the taxpayer was not dismissed from the partnership level proceeding, and the assessment within one year of the final tax court judgment was timely. 3. keep those addresses up to date. international strategic partners, llc v. commissioner, 455 fed. appx. 91 (2d cir. 1/19/12). by summary order, the second circuit affirmed the tax court‘s dismissal of a petition filed more than 150 days after the irs mailed an fpaa. the court held that the irs met the § 6223(a) notice requirements by mailing the notices to the llc at the address shown on its tax return and to the partners at the addresses shown on accompanying schedules k-1. the irs was not required to do more when the llc failed to provide the irs with additional information. the taxpayer is responsible for updating contact information under § 6223(c)(2) and reg. § 301-6223(c)-1. 4. the tefra audit rules create a mess with tiered partnerships. rawls trading, l.p. v. commissioner, 138 t.c no. 12 (3/26/12). the ultimate taxpayer, jerry rawls, entered into son-o-boss transactions using a tiered partnership structure. the proceeds of short sales of treasury notes were contributed to lower-tier partnerships by various trust entities (referred to by the court as source partnerships). in turn, the partnership interests in the lower-tier partnerships with inflated basis were contributed to middle partnerships (referred to by the court as interim partnerships). the interim partnership passed through losses generated by transactions using the inflated basis of the source partnerships. the ―contrived losses‖ eventually inured to the tax benefit of rawls. the irs 636 florida tax review [vol. 13:10 issued fpaa‘s to both the source and interim partnerships. the court (judge vasquez) ultimately concluded that since any determination of a deficiency in the interim partnership required resolution of the fpaa issued to the source partnership, such a deficiency was based on a computational adjustment to the interim partnership as a partner, or on resolution of an affected item. in either case, the court held that it lacked jurisdiction to consider the fpaa issued to the interim partnership and dismissed the fpaa. the court rejected the irs request to stay the proceeding with respect to the interim partnership as premature until the issues in the source partnership proceeding were resolved. the court indicated that since it had no jurisdiction to consider the fpaa issued to the interim partnership, it had no jurisdiction to stay the proceeding. the court also addressed the irs‘s assertion that it would be barred from issuing a second fpaa to the interim partnership by the no-second-notice rule of § 6223(f) by pointing out that the court‘s jurisdiction is conferred by statute and that it had no option to grant the stay. the court suggested, however, that to the extent that adjudication of the shelter issues in the fpaa issued to the source partnership results in a computational adjustment, the irs could make a direct assessment against rawls as an indirect partner (§ 6231(a)(2)) without the need for an fpaa against the interim partnership. 5. tefra audit rules bar tax court consideration of a guaranteed payment of a small partnership with a pass-through member. brennan v. commissioner, t.c. memo. 2012-187 (7/9/12). in consolidated cases, the tax court (judge kroupa) determined that it lacked jurisdiction under the tefra audit rules to determine whether the taxpayers were entitled to flow-through losses attributable to guaranteed payments. the involved parties were members of the cutler & company llc, which managed asset portfolios for high-income individuals. ashland was the ceo of cutler. ashland and brennan transferred their cutler interests to a general partnership, airport plaza (ap), which was to dissolve under its own terms at the end of 2001. the cutler operating agreement in 2002 identifies ap as a cutler member. cutler was restructured in 2002 because of ―turmoil‖ among the members. ap‘s 2002 partnership return claimed a partnership loss for 2002 attributable to a guaranteed payments to brennan of $4,785,616 and joseph furey, a former cutler member, of $485,000. ashland claimed her share of the loss from ap on her 2002 return. in a petition contesting the irs disallowance of the loss, ashland asserted in an amended petition to the court that the guaranteed payments were in fact made by cutler and that ashland was entitled to a pass-through loss from cutler for the payments. the cutler 2002 partnership return, signed by ashland as ceo, reported the payments as guaranteed payments to brennan and furey. the court agreed with the irs that cutler was a tefra partnership so that the status of 2013] recent developments in federal income taxation 637 guaranteed payments by cutler was a partnership item, determinable only in a tefra proceeding. a petition for administrative adjustment of cutler‘s 2002 return was barred by the statute of limitations. the court rejected the taxpayer‘s assertion that cutler was a small partnership (fewer than ten members) because the small partnership exception does not apply under § 6231(a)(9) to a partnership that has a pass-through entity as a member. the court did not allow ashland to disregard her chosen form of operating ap as a partnership and reporting partnership returns. in addition the court found that ap was treated a member of cutler in spite of ashland‘s argument that cutler membership interests were never formally transferred to ap because of stipulations by ashland to the contrary and the cutler operating agreement unambiguously including ap as a member. 6. a notice of deficiency relating to the partner level loss limitation rules need not wait for an fpaa. meruelo v. commissioner, 691 f.3d 1108 (9th cir. 8/16/12, as amend3ed 11/14/12). the taxpayer reported losses from a single-member llc (disregarded entity) that was a partner in intervest, which reported losses from foreign currency transactions. neither the intervest returns nor the taxpayer‘s individual returns identified the status of the disregarded llc. although the irs was investigating intervest for fraud, and there was a related grand jury proceeding, the irs did not notify intervest that it would begin an audit, nor did it issue an fpaa for the year at issue. the irs issued a notice of deficiency to the taxpayers shortly before the three-year statute of limitations would have expired with respect to their individual returns. affirming the tax court, 132 t.c. 355 (2009), the court of appeals (judge n.r. smith) held that even though application to a partner of the loss limitation rules of §§ 704(d) and 465 are affected items that require a partner-level determination, a notice of deficiency to a partner based on the application of the loss limitation rules of §§ 704(d) and 465 was not issued prematurely and was valid. the tax court had jurisdiction over the petition. while the tefra audit rules require completion of partnership proceedings when a partnership item or a related item is involved before issuing a notice of deficiency to partners, the court held that tefra does not limit the issuance of a notice of deficiency when no partnership proceeding is pending and no notice of deficiency has been sent. the court also stated that although § 6225(a) provides that ―‗no assessment of a deficiency attributable to any partnership item may be made . . . before‘ 150 days after the date a notice of fpaa is mailed or a proceeding in tax court has been finalized[,]‖ [a]ssessment of a deficiency is not equivalent to providing notice of a deficiency.‖ the court also rejected the taxpayer‘s argument that the notice of deficiency was improper when issued because the irs was considering a criminal investigation that might have found fraud. the court held that the irs‘s contemplation of initiating future proceedings is irrelevant and that 638 florida tax review [vol. 13:10 requiring the irs to prove that it had no interest in future partnership-level proceedings would serve no purpose. 7. asset management joint venture is not a partnership, so take that ordinary income. rigas v united states, 107 a.f.t.r.2d 2011-2046 (s.d. tex. 5/2/11). hydrocarbon capital, llc, which held a number of oil and gas industry financial assets, entered into a loan management and servicing agreement (specifically stating the arrangement was not a partnership) with odyssey energy capital i, lp, formed by five individual limited partners with an llc general partner. the management agreement provided for a performance fee representing 20 percent of profits after provisions for disposition of income realized on the asset portfolio designed to recoup hydrocarbon‘s expenses, the capital value of the portfolio, and a 10 percent preferred return. in a claim for refund, the taxpayer, one of odyssey‘s limited partners, claimed pass-through capital gain treatment on gains from disposition of the managed assets. the district court (judge ellison) agreed with the irs determination that the income to the odyssey partners was ordinary income as a service fee rather than passthrough partnership income from a joint venture with hydrocarbon. the court indicated that notwithstanding the unambiguous text of the management agreement eschewing partnership status, it may still look to the conduct of the parties to determine whether the arrangement was a partnership. the court indicated that the odyssey partners contributed both capital and services to the relationship with hydrocarbon, and the arrangement provided for a profit sharing and some risk of loss for the odyssey partners, which supported treating the arrangement as a partnership. odyssey maintained significant management responsibility for the hydrocarbon assets, but it did not have authority to withdraw funds from hydrocarbon bank accounts, it could not increase hydrocarbon‘s capital commitment to a particular asset, it could not enter into binding agreements in hydrocarbon‘s name, and it could not dispose of an asset without hydrocarbon‘s written approval. odyssey did not share control over bank accounts that corresponded to companies in the asset portfolio, nor could it disburse funds from the accounts, and thus lacked control over the assets and income of the venture. finally, the court pointed to the fact that neither hydrocarbon nor odyssey filed tax returns treating the arrangement as a partnership. thus, the court found that the irs established by a preponderance of the evidence that a partnership did not exist.  the court also held that it had jurisdiction to consider the taxpayer‘s refund claim under tefra as a partner item based on its holding that the taxpayers‘ amended returns qualified as a partner administrative adjustment request as being in substantial compliance with the https://checkpoint.riag.com/getdoc?docid=ia293511dd5d24e6de4b2cb625f083713&pinpnt= https://checkpoint.riag.com/getdoc?docid=ia293511dd5d24e6de4b2cb625f083713&pinpnt= 2013] recent developments in federal income taxation 639 requirements of reg. § 301.6227(d)-1, notwithstanding the absence of a timely filed form 8802 as required by the regulations. a. the fifth circuit reverses the district court but the taxpayer still loses. this case proves that the tefra audit rules are ridiculously complicated and result in a catch-22. rigas v. united states, 486 fed. appx. 491 (5th cir. 8/21/12). the taxpayer was one of five limited partners in odyssey energy capital i, lp (odyssey), which entered into a loan management and servicing agreement with hydrocarbon capital, llc. the agreement provided for a performance fee representing 20 percent of profits after provisions for disposition of income realized on the asset portfolio designed to recoup hydrocarbon‘s expenses, the capital value of the portfolio and a 10 percent preferred return. the agreement specifically stated that the arrangement was not a partnership. in 2004 hydrocarbon recognized approximately $110 million of gain on disposition of assets and paid a performance fee to odyssey of approximately $20 million. odyssey originally reported the $20 million as a management fee constituting ordinary income, and the odyssey partners reported their share of the ordinary income on individual returns. subsequently odyssey filed an amended return claiming it was in a partnership with hydrocarbon and its $20 million share of proceeds was capital gain. the partners filed amended individual returns claiming refunds. apparently the irs allowed refunds to four partners, but denied rigas‘s claim. in rigas‘s refund suit, the district court held that there was no partnership between odyssey and hydrocarbon and the fees paid to odyssey were properly treated as ordinary income. rigas v united states, 107 a.f.t.r.2d 2011-2046 (s.d. tex. 5/2/11). the district court also held that it had jurisdiction to consider the taxpayers‘ refund claims under tefra as a partner item based on its holding that the taxpayers‘ amended returns qualified as a partner administrative adjustment request as being in substantial compliance with the requirements of reg. § 301.6227(d)-1, notwithstanding the absence of a timely filed form 8802 as required by the regulations. with a complicated meander through the limitations on filing refund actions by partners under tefra, the fifth circuit in a lengthy per curiam opinion reversed the district court‘s holding that it had jurisdiction to hear the refund action, denied the taxpayer‘s claim that he was entitled to consideration of whether the partnership item was capital gain, held that the district court had jurisdiction to determine whether the taxpayer was given inconsistent settlement treatment, but alas concluded that there was no settlement.  section 7422(h) bars jurisdiction to consider a refund claim by a partner attributable to partnership items except as provided in §§ 6228(b) or 6230(c). section 6228(b) allows a refund suit attributable to partnership items if the irs responds to a partner‘s administrative adjustment request (aar), filed as provided in § 6227(d), by https://checkpoint.riag.com/getdoc?docid=ia293511dd5d24e6de4b2cb625f083713&pinpnt= 640 florida tax review [vol. 13:10 mailing a notice indicating that partnership items will be treated as nonpartnership items, or if the irs fails to allow the aar and no notice is mailed. section 6230(c) provides for claims arising from erroneous computations and was not at issue in the case. the court of appeals rejected the district court holding that the taxpayer‘s filing an amended return was substantial compliance with the aar requirement. the court held that the requirement of reg. § 301.6627(d)-1 that the taxpayer file a specific form (form 8082) is a procedural requirement that may be met with substantial compliance, but that the requirement that the taxpayer provide a detailed explanation of the claim is a substantive requirement that must be satisfied so that the irs can properly decide whether to allow the aar. the court held that rigas‘ amended return failed to meet the substantive requirements because it had not been filed in the service center where the partnership return had been filed, and it did not provide a detailed explanation of the claim for refund.  the court held that a partner‘s claim to settlement terms consistent with the terms of a settlement between the irs and another partner under § 6224(c)(2) is an item that depends upon whether the particular partner has been properly offered consistent settlement terms and is, therefore, not a partnership item. thus, the court has jurisdiction to consider a refund claim on that basis. however, the court concluded that as a matter of law the irs‘s payments of refunds to the other odyssey partners were not settlement agreements under § 6224 because there was no partnership-level administrative proceeding.  finally, the court rejected the taxpayers alternate claim that since the character of the income was adjusted at the partnership level in the partnership amended return, the taxpayer is entitled to tax treatment consistent with the treatment of the partnership item. the court held that the district court lacked jurisdiction to consider a refund claim on this basis under § 7422(h) because when the taxpayer ―claim that the performance fee was recharacterized as capital gains instead of ordinary income at the partnership level and that they are entitled to a refund based on a similar characterization at the partner level, their claim is attributable to a partnership item.‖ the court noted in support of its finding that the item is a partnership item that characterization of the performance fee at the partnership level affects both the partnership‘s reporting and the reporting of the other partners. g. miscellaneous 1. electronic k-1s. rev. proc. 2012-17, 2012-10 i.rb. 453 (2/13/12). the irs has provided procedures for furnishing schedule k1s to persons to whom a partnership is required to provide the form in an electronic format. the rev. proc. notes that the recipient entitled to a k-1 2013] recent developments in federal income taxation 641 must affirmatively consent to receive the form in electronically, and that the consent may be conveyed electronically. 2. hiding abusive shelter transactions behind disregarded entities makes the indirect partner an unidentified partner for statute of limitations purposes. gaughf properties, l.p. v. commissioner, 139 t.c. no. 7 (9/10/12). the taxpayers invested in kpmg/jenkens & gilchrist currency options tax shelters through a partnership consisting of two disregarded llcs and a wholly owned corporation. after the irs caught up with the taxpayers from information obtained through john doe summons issued to jenkens & gilchrist, the irs asserted that the statute of limitations remained open with respect to the taxpayers under § 6229(e), which extends the limitation period for one year after the name and address of a partner is furnished to the irs where (1) the name, address, and tin of the partner is not ―furnished‖ on the partnership return, and the irs has sent notice of an fpaa within the statute of limitations, or (2) the taxpayer has taken an inconsistent position and fails to provide the notice required by § 6222(b). the tax court (judge goeke) held that the statute remained open under both provisions. following the holding in costello v. united states, 765 f. supp. 1003 (c.d. cal. 1991), the court held that, although schedule k-1s are required only for direct partners, an indirect partner who is not identified on a partnership return remains an ―unidentified partner‖ for purposes of § 6229(e)(1). the court rejected the taxpayer‘s argument that because the irs was in possession of identifying information from applications for taxpayer identification numbers for the disregarded entities (forms ss-4) and information from jenkens & gilchrist and kpmg‘s john doe summons more than one year before issuing assessment notices. the court upheld the validity of requirements in temp. reg. § 301.6223(c)-1t that information be ―filed‖ with the irs at the service center where the taxpayer‘s returns are filed and that the identifying information be specific. the court interpreted § 6229(e)‘s use of term ―furnished‖ as sufficiently close to the filing requirement of the temporary regulations to indicate that the regulation was a valid exercise of administrative authority under chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984) and § 7805(a).  the court also held that the taxpayer took an inconsistent position on returns reporting the partnership transactions because of the way the partnership netted contributions of long and short options which the taxpayer reported separately in claiming basis increases. as a result, the taxpayer was found to have failed to provide the statement required by § 6222(b), thereby extending the statute of limitations under § 6229(e)(2).  the court also rejected the taxpayer‘s arguments that the irs was estopped from assessing a deficiency (1) because of irs delays in issuing notice 2000-44, 2000-2 c.b. 255 (notifying taxpayers of 642 florida tax review [vol. 13:10 the issues raised by the shelter transaction); (2) because of the long period before the irs issued an fpaa to the taxpayer‘s partnership; or (3) because the irs had withheld and destroyed evidence or placed witnesses beyond the reach of the taxpayer because of criminal investigations. vii. tax shelters a. tax shelter cases and rulings 1. yet another investor in a kpmg opis tax shelter gets devoured by the economic substance doctrine. blum v. commissioner, t.c. memo. 2012-16 (1/17/12).the taxpayer‘s bogus $45 million loss claimed from a kpmg opis tax shelter was disallowed. the taxpayers did not contest that their loss was ―fictional.‖ section 6662 accuracy-related penalties for gross valuation misstatements and negligence were upheld. 2. had this opinion been issued on october 25th, the taxpayer might have had a chance. however, the opinion was issued on march 14th, so success was not in the cards. crispin v. commissioner, t.c. memo. 2012-70 (3/14/12), on appeal to the third circuit. the taxpayer, an experienced cpa, entered into a cards transaction in 2001 to shield about $7 million of shared fees (ordinary) income from his wholly owned s corporation that engaged in a business related to a pool of collateralized mortgage obligations. the promoter was a longtime friend who did not charge the taxpayer any fee to participate in the cards transaction. the tax court (judge kroupa) held that the transaction lacked economic substance because it lacked business purpose and profit expectation, stating, ―[w]e have consistently held that cards transactions lack economic substance,‖ and noting that an appeal in this case lies in the third circuit, which decided acm p’ship v. commissioner, 157 f.3d 231 (3d cir. 1998).  judge kroupa also upheld the 40 percent gross valuation misstatement accuracy-related penalty. the tax opinion the taxpayer received from his advisors relied on ―false representations [the taxpayer] made,‖ including that he had a business purpose for entering into the cards transaction and that he anticipated earning a profit, absent tax benefits, from the cards transaction, which were ―material to the conclusions reached in the tax opinion.‖ furthermore, the taxpayer had not actually relied on the opinion. 3. just another generic tax shelter that lacks economic substance — taxpayer, ―you lose.‖ reddam v. commissioner, t.c. memo. 2012-106 (4/11/12). the taxpayer invested in an opis tax 2013] recent developments in federal income taxation 643 shelter peddled by kpmg. the tax court (judge goeke) found that the ―‗pretax profit‘ potential of the transaction was so remote as to render disingenuous any suggestion that the transaction was economically viable.‖ [the taxpayer] knew little to nothing about the details of the opis transaction. the extent of his knowledge was limited to an understanding that the opis transaction was a ―formula or a recipe‖ that would provide him with a substantial capital loss. despite the fact that petitioner and his closest advisers were ignorant as to the function and design of the investment, petitioner never investigated the transaction further, relying instead on the opinion letters provided by or on behalf of kpmg. petitioner's lack of due diligence in researching the opis transaction indicates that he knew he was purchasing a tax loss rather than entering into a legitimate investment.  accordingly, the losses claimed by the taxpayer were denied on the grounds that the transaction lacked economic substance. amazingly, the opinion makes no reference to accuracy related penalties — did the irs forget to assess penalties? 4. you better hope that your h-p computer works better than h-p‘s tax planning strategies. hewlett-packard co. v. commissioner, t.c. memo. 2012-135 (5/14/12). in a complicated transaction designed by aig-financial products to generate foreign tax credits, hewlett-packard purchased a preferred stock interest in a foreign entity called foppingadreef (fop) that was to engage in a u.s.-dollar linked netherlands guilder stepped coupon contingent note transaction which took advantage of asymmetric treatment of contingent interest in the u.s. and the netherlands. the common stock of fop was held by the dutch bank, abn, which also provided capital to fop through transactions structured as a loan to an aig subsidiary which in turn transferred the dutch guilder proceeds to fop along with an obligation on the part of fop to pay contingent interest back to abn. hewlett packard treated fop as a controlled foreign corporation through its ownership of the preferred stock and warrants to acquire additional stock and claimed foreign tax credits for dutch taxes. the transaction was structured to terminate in 2003 through the exercise of put options to transfer hewlett-packard‘s stock interest back to abn for a price that resulted in a loss to hewlett-packard. the tax court (judge goeke), applying the multiple factors used to distinguish debt from equity, found that the structure of the transaction resulted in a fixed repayment of hewlettpackard‘s investment on a fixed date and treated the investment as a loan rather than an equity interest in fop, thereby disallowing claimed foreign tax credits. the court also disallowed hewlett-packard‘s claimed § 165 loss on the difference between its initial investment and the price it received on the 644 florida tax review [vol. 13:10 termination date. the court agreed with the irs‘s assertion that hewlettpackard‘s claimed $15.5 million loss on termination of the transaction was in effect a fee paid to aig in order to participate in a tax shelter. the court held that fees spent for the generation of artificial tax losses are not deductible as payments incurred in a transaction that lacked economic substance citing enrici v. commissioner, 813 f.2d 293, 296 (9th cir. 1987), and new phoenix sunrise corp. v. commissioner, 132 t.c. 161, 186 (2009), aff’d 408 fed. appx. 908 (6th cir. 2010). the court also noted that hewlett-packard failed to meet its burden of proof regarding the proper timing of the deduction. 5. ―a [contingent liability section 351] transaction that would let [the taxpayer] deduct an approximately $38 million tax loss on the sale of $11,000 in securities which had just recently been purchased for the same amount ... would clearly appear to be too good to be true,‖ said judge marvel in a decision rendered nine years after the trial. at long last, this is the first case to apply § 351(g). gerdau macsteel, inc. v. commissioner, 139 t.c. no. 5 (8/30/12). to shelter capital gains of over $41 million recognized on the sale of two subsidiary corporations in 1997, the taxpayer (quanex), which was the parent in a consolidated group, entered into a tax shelter transaction devised and recommended by deloitte & touche that was intended to create an artificial short-term capital loss of approximately $38 million to offset the capital gains, called the ―double deducting environmental and other contingent liabilities‖ (ddcl). the loss was to be created in a series of transactions involving quanex‘s liabilities under for its medical plan benefits (mpbs). in simplified form, the transaction involved the following steps using two of quanex‘s inactive subsidiaries (qs and qhmc): (1) quanex caused qhmc to be recapitalized to have multiple classes of stock, including class b and class c voting preferred stock, (a) each with ―an assumed $100 issue price,‖ (b) cumulative dividends of 9.5%, payable quarterly, providing quanex or qhmc with rights to call the preferred stock after five years and providing the class c shareholders with rights to put the preferred stock after seven years, and (c) providing for a liquidation value for the class c stock in amount equal to the greater of $125 or an amount equal to the lesser of a percent of any cumulative cost savings in mpbs or of qhmc‘s book net equity; (2) quanex transferred $38,000,000 to qs, which assumed quanex‘s contingent liability to pay mpbs under quanex‘s benefits plan which were treated as being in the amount of $37,989,000; (3) qs transferred $38 million to qhmc, which in turn assumed the liability to pay quanex‘s mpbs, in exchange for newly issued class c stock; and (4) qs sold its class c preferred stock to a former employee of a q subsidiary for $11,000. the taxpayer took the position that the transfers of $38 million and the assumptions of liability were § 351 nonrecognition transactions and that 2013] recent developments in federal income taxation 645 pursuant to § 358(a)(2) and rev. rul. 95-74, 1995-2 c.b. 36, qs‘s basis in the qhmc stock was $38 million unreduced by the $37,989,000 of mpbs that were not deductible until paid. the taxpayer claimed a $37,989,000 loss recognized on the sale of the class c stock that was used to offset the capital gains on the sales of the other subsidiaries. the tax court (judge marvel) found as facts that the transactions were structured in such a way that it was highly likely when the class c stock was issued that the class c stock would be redeemed within the fiveand seven-year periods and that the redemption payment would be $125 per share. judge marvel further found that after the transactions, quanex continued to process claims for mpbs, and its handling of the claims transferred to qhmc was the same as the handling of claims with respect to individuals whose mpbs were not transferred to qhmc. qhmc‘s reimbursements to quanex for claims were made through intercompany entries recorded on quanex‘s books as a receivable due from qhmc and on qhmc‘s books as a payable. qhmc lent the $38 million to an affiliated corporation, and qhmc eventually reimbursed quanex for the mpbs when qhmc received payments on the loan. based on the fact finding, judge marvel disallowed the loss deduction on two grounds.  first, she held that because the class c stock ―‗does not participate in corporate growth to any significant extent‘ within the meaning of i.r.c. sec. 351(g)(3)(a),‖ it was nonqualifed preferred stock (nqps) as defined in § 351(g). the taxpayer and irs had stipulated that if the class c stock was found to be nqps the claimed loss was not allowable. (the opinion does not explain the reason that the claimed loss was not allowable if the class c stock was nqps; however, § 351(g)(1)(a) provides that when nqps is the only stock received, § 351(a) [and § 358] shall not apply to the transaction, and pursuant to §§ 1001 and 1012, the basis of the stock is equal to its fair market value.)  the loss also was also disallowed under the economic substance doctrine, as was a § 162 deduction for $352,251 of fees incurred to effect the transactions. judge marvel found no business reason for assumption by qhmc of the mpb liabilities, the sale of the class c stock, or any other aspect of the transactions; the transactions were all entirely tax motivated, for the purpose of generating an artificial loss. the court also upheld a § 6662(a) 20 percent accuracy penalty (and alternatively a substantial understatement penalty). [a] transaction that would let petitioners deduct an approximately $38 million tax loss on the sale of $11,000 in securities which had just recently been purchased for the same amount, and that this result, to a savvy, experienced businessman ... would clearly appear to be too good to be true.  thus, the reasonable cause exception of § 6664(c) was not available despite subsequent trial court decisions (later 646 florida tax review [vol. 13:10 reversed on appeal) upholding tax plans similar to this one. but applying the golsen rule, the court followed the fifth circuit‘s precedents in heasly v. commissioner, 902 f.2d 380 (5th cir. 1990), rev’g t.c. memo. 1988-408, and todd v. commissioner, 862 f.2d 540 (5th cir. 1988), aff’g 89 t.c. 912 (1987), in declining to sustain a 40 percent penalty asserted by the irs, because the grounds underlying the court‘s disallowance of the capital loss deduction were not directly related to the taxpayer‘s valuation of the class c stock or to the reporting of the proper basis therein. 6. even though this d&t ddcl worked for a few years, double deductions are a ―no no!‖ thrifty oil co. v. commissioner, 139 t.c. no. 6 (8/30/12). thrifty was the common parent of a consolidated group for the relevant years (fiscal years ending 9/30/96 through 9/30/02), but only the years ending in 2000 through 2002 were at issue. during the fiscal year ending in 1996, thrifty had generated and claimed a capital loss by causing a subsidiary (gw) to transfer a $29,100,000 note from another subsidiary (b) to yet another preexisting subsidiary (em), which had assumed contingent environmental liabilities in transaction in exchange for 90 shares em stock; this was done upon the advice of deloitte & touche. the taxpayer took the position that the transfer of the $29,100,000 note and the assumption of the $29,070,000 of contingent environmental remediation liabilities was a § 351 nonrecognition transaction and that pursuant to § 358(a)(2) and rev. rul. 95-74, 1995-2 c.b. 36, gw‘s basis in the em stock was the $29,100,000 face value of the b note, without reducing the stock basis by the $29,070,000 of contingent environmental remediation liabilities em assumed, which were not deductible until paid. three days later (9/30/96), gw sold its em stock for $25,200 and claimed a capital loss of $29,074,800. the taxpayer deducted a total of $18,347,205 of the capital loss on its 1996 through 1999 tax returns, years which were beyond the statute of limitations at the time the dispute in the case arose. the taxpayer claimed deductions for the remaining $10,727,595 of the capital loss on its 2000 through 2002 income tax returns, and those carryforwards were disallowed by the irs. the sale of the 90 shares of em stock had not broken em‘s affiliation with the consolidated group, and in the years 2000 through 2002, the thrifty group claimed § 162 deductions for $11,109,962 of environmental remediation expenses that were accruable in those years. the irs disallowed the deductions. after stipulations — the taxpayer conceded the capital loss issue and the irs conceded the deduction for environmental remediation expenses that had not previously been deducted in closed years as capital losses, as well as any penalties — the only issue for the court was the deductibility of the $11,109,962 of environmental remediation expenses from 2000 through 2002. the tax court (judge wherry) applied charles ilfeld co. v. hernandez, 292 u.s. 62 (1934), and its progeny to disallow the 2013] recent developments in federal income taxation 647 deductions as ―double deductions‖ that had been previously claimed as capital losses in the closed years 1996 through 1999. the court reasoned that under its applicable precedents and the applicable precedents in the ninth circuit, to which the case was appealable, ―[i]f the deductions represent the same economic loss to [the taxpayer] and [the taxpayer] cannot point to a specific provision demonstrating congress‘ [sic] intent to allow the double deductions, then the claimed environmental remediation expense deductions must be disallowed.‖ factually, there was a ―double deduction‖ because ―the capital loss arose not as a result of how basis was calculated but as a result of the contingent environmental remediation liabilities being taken into account in calculating the amount realized (or fair market value) but not in calculating basis.‖ furthermore, § 162, a general deduction provision, does not reflect a ―clear declaration of intent‖ to allow a double deduction. moreover, under ninth circuit precedent in stewart v. united states, 739 f.2d 411 (9th cir. 1984), as well as cases from other courts, it was immaterial to the application of charles ilfeld co. whether the earlier deduction was proper or erroneous but not timely challenged by the irs. 7. district court upholds blips tax shelter on taxpayer‘s partial summary judgment motion. klamath strategic investment fund, llc v. united states, 440 f. supp. 2d 608 (e.d. tex. 7/20/06). the court (judge ward) held that the premium portion of the loans received from the bank in connection with the funding of the instruments contributed to a partnership was a contingent obligation, and not a fixed and determined liability for purposes of § 752. the transaction was entered into prior to the release of notice 2000-44, 2000-2 c.b. 255, which related to son-of-boss transactions. judge ward held that a regulation to the contrary, reg. § 1.752-6 (see t.d. 9062), was not effective retroactively, and was therefore invalid as applied to these transactions. judge ward held that there was clear authority existing at the time of the transaction that the premium portion of the loan did not reduce taxpayer‘s basis in the partnership. a. klamath on the merits: it does not work because it lacks economic substance, but no penalties. the authorities discussed in the holland & hart and olson lemons opinions provide ―substantial authority.‖ klamath strategic investment fund, llc v. united states, 472 f. supp. 2d 885 (e.d. tex. 1/31/07). the transactions lacked economic substance because the loans would not be used to provide leverage for foreign currency transactions, but no penalties were applicable because taxpayers passed on a 1999 investment, they thought they were investing in foreign currencies, and the tax opinions they received that relied on relevant authorities set forth in the court‘s earlier opinion provided ―substantial authority‖ for the taxpayers‘ treatment of their basis in their partnerships. 648 florida tax review [vol. 13:10 b. on government motions, judge ward refuses to vacate partial summary judgment decision on the retroactivity of the regulations under § 752, and he permits the deduction of operational expenses — despite his earlier finding that the transactions lacked economic substance — because the taxpayers had profit motives. klamath strategic investment fund, llc v. united states, 99 a.f.t.r.2d 2007-2001 (e.d. tex. 4/3/07). first, judge ward held that even though the loans lacked economic substance, they still existed, and thus the partial summary judgment on the non-retroactivity of the regulations under § 752 was not premised on invalid factual assumptions. second, he held that the existence of profit motive for deduction of operational expenses was based on the purposes of nix and patterson — and not on the motives of presidio, the managing partner of the partnership. c. affirmed in part, vacated in part, and remanded, klamath strategic investment fund, llc v. united states, 568 f.3d 537 (5th cir. 5/21/09). in ruling unfavorably on the taxpayers‘ crossappeal of the holding that the transaction lacked economic substance, the fifth circuit (judge garza) followed the majority rule, which ―is that a lack of economic substance is sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax avoidance.‖ he stated, ―[t]hus, if a transaction lacks economic substance compelled by business or regulatory realities, the transaction must be disregarded even if the taxpayers profess a genuine business purpose without tax-avoidance motivations.‖  in ruling unfavorably on the government‘s appeal of the non-imposition of penalties, judge garza stated: the district court found that patterson and nix sought legal advice from qualified accountants and tax attorneys concerning the legal implications of their investments and the resulting tax deductions. they hired attorneys to write a detailed tax opinion, providing the attorneys with access to all relevant transactional documents. this tax opinion concluded that the tax treatment at issue complied with reasonable interpretations of the tax laws. at trial, the partnerships‘ tax expert [stuart smith] concluded that the opinion complied with standards established by treasury circular 230, which addresses conduct of practitioners who provide tax opinions. overall, the district court found that the partnerships proved by a preponderance of the evidence that they relied in good faith on the advice of qualified accountants and tax lawyers. 2013] recent developments in federal income taxation 649 d. a small lagniappe to the taxpayers in a tax shelter. klamath strategic investment fund, llc v. united states, 110 a.f.t.r.2d 2012-6021 (e.d. tex. 9/24/12). on appeal, the fifth circuit court of appeals disallowed losses generated by a blips tax shelter investment which was held to lack economic substance. klamath strategic investment fund v. united states, 568 f.3d 537 (5th cir. 2009). the court of appeals remanded the case to the district court to determine whether partnership operational expenses of $903,000 and fees for investment advice to the partner investors were deductible under § 212. based on findings by the trial court, the court of appeals indicated that although the transaction lacked economic substance, the profit motive of the individual investors would permit the deduction of their economic outlays if the investors effectively controlled the partnership activities so that their profit motive would be attributable to the partnership. (the managing partners were held to have lacked the necessary profit motive to support the deductions.) the district court (judge gilstrap) found that the partnerships were formed to effect an investment strategy selected by the investors, the managing partners were the managing partners ―only because [the investors] made it so,‖ the managing partners were confined to the investment strategy directed by the investors ―who could shut down the whole process by withdrawing from the partnerships they had created.‖ the court thus held that the investors were the parties having effective control over the partnerships. the court also held that $250,000 of investment fees paid to investment advisors who provided guidance with respect to the partnerships‘ foreign currency investments were deductible. the court concluded from its reading of the court of appeals remand that it had jurisdiction to order the refund in the partnership proceeding notwithstanding the fact that the expenses were not paid or incurred by the partnerships. b. identified ―tax avoidance transactions‖ there were no significant developments regarding this topic during 2012. c. disclosure and settlement 1. not all losses are tax shelter losses. rev. proc. 2013-11, 2013-2 i.r.b. 269 (12/06/12). this revenue procedure provides that certain losses are not taken into account in determining whether a transaction is a reportable transaction for purposes of the disclosure rules under reg. § 1.6011-4(b)(5). however, these transactions may be reportable transactions for purposes of the disclosure rules under reg. § 1.6011-4(b)(2), (b)(3), (b)(4), (b)(6), or (b)(7). among the losses not subject to § 6011 are losses (1) with respect to the sale or exchange of property where the basis was 650 florida tax review [vol. 13:10 determined with respect to cash paid by the taxpayer, or under §§ 358, 1014, 1015, or 1031(d); (2) from fire, storm, shipwreck, or other casualty, or from theft, as those terms are defined for purposes of § 165(c)(3); (3) from compulsory or involuntary conversions as described in § 1231(a)(3)(a)(ii) and (a)(4)(b); (4) to which § 475(a) or § 1256(a) applies; (5) arising from hedging transactions described in § 1221(b), if the taxpayer properly identifies the transaction as a hedging transaction, or from a mixed straddle account under reg. § 1.1092(b)-4t; (6) attributable to the abandonment of depreciable tangible property that was used by the taxpayer in a trade or business and that has a basis determined in clause (1), supra; (7) arising from the bulk sale of inventory if the basis of the inventory is determined under § 263a; and (8) that are equal to, and determined solely by reference to, a payment of cash by the taxpayer. d. tax shelter penalties, etc. there were no significant developments regarding this topic during 2012. ix. exempt organizations and charitable giving a. exempt organizations 1. the exclusivity of a gated parking lot for the neighborhood beach club has a tax price. ocean pines association, inc. v. commissioner, 135 t.c. 276 (8/30/10). the taxpayer was a homeowners association that was tax-exempt under § 501(c)(4) as a not-for-profit organized to promote community welfare. in addition to enforcing zoning and providing roads and recreational facilities within ocean pines, funded by members‘ dues (but which were open to both members and nonmembers), it operated a beach club and parking lots eight miles from the area (ocean pines) in which its members lived. the primary beach club facilities (e.g., pool, locker room, etc.) and parking lots were accessible only to the association‘s members and their guests, but the snack bar, restaurant, and beach itself were open to the public. the taxpayer charged its members a separate fee for parking permits, and maintained a parking permit system and guards. it also leased the parking lots to third-party businesses at night and in the off season. the taxpayer did not report any of the income as subject to the unrelated business income tax (ubit). the irs issued a deficiency notice determining that the net income from the parking lots and beach club facilities was subject to ubit, because their operation was not substantially related to the promotion of community welfare. the tax court (judge morrison) upheld the deficiency. the court concluded that the operation of 2013] recent developments in federal income taxation 651 the beach club and the parking lots did not promote community welfare because they were not accessible to nonmembers, i.e., the general public. therefore, unless an exception applied, the income was subject to ubit. finally, the court held that the § 512(b)(3)(a)(i) exception for rents from real property did not apply because reg. § 1.512(b)-1(c)(5) provides that income from the operation of a parking lot is not rent from real property. a. affirmed — parking lots and a beach club that benefit only those who own property in a private community and their guests that provide ―a private refuge for those who would live apart,‖ do not promote social welfare. ocean pines association, inc. v. commissioner, 672 f.3d 284 (4th cir. 3/2/12). the fourth circuit (in an opinion by judge motz) affirmed the tax court‘s decision in favor of the government. the court of appeals made three key points. first, ―facilities that do not permit access to the general public – like the parking lots and beach club – simply do not promote ‗social welfare.‘‖ second, the court rejected the taxpayer‘s argument that ―‗social welfare‘ must be interpreted through the lens of the association‘s charter, which aims to promote the community welfare of the association’s members rather than that of the general public,‖ holding that ―[n]otwithstanding the association‘s charter, the purpose that constitutes the basis of the association‘s exemption under § 501(c)(4) is its promotion of ‗social welfare‘ as defined by the statute and regulations.‖ (emphasis added by the court) third, the court rejected the taxpayer‘s argument that ―congress‘s purpose in enacting the unrelated business income tax was to avoid unfair competition with private enterprise, and that a rule requiring a business operated by a 501(c)(4) organization to be open to the general public in order to avoid taxation would frustrate that purpose.‖ rather, the court held that ―[t]he plain language of the statute and regulations speak with . . . clarity ... . [t]he only question . . . is whether the parking lots and beach club are ‗substantially related‘ to the association‘s tax-exempt purpose,‖ which they were not. thus, the income was subject to ubit. 2. proposed regulations on program-related investments. reg-144267-11, examples of program-related investments, 77 f.r. 23429 (4/19/12). the proposed regulations add nine examples depicting a wider range of investments that qualify as program-related investments. the new examples demonstrate that a program-related investment may accomplish a variety of charitable purposes, such as advancing science, combating environmental deterioration, and promoting the arts. several examples also show that an investment funding activities in one or more foreign countries, including investments that alleviate the impact of a natural disaster or that fund educational programs for poor individuals, 652 florida tax review [vol. 13:10 may further the accomplishment of charitable purposes and qualify as a program-related investment. b. charitable giving 1. conditionally revocable conservation easements are no-good. carpenter v. commissioner, t.c. memo. 2012-1 (1/3/12). conservation easements that could be extinguished by the mutual consent of the donor taxpayer and the donee organization failed as a matter of law to comply with the enforceability in perpetuity requirements under reg. § 1.170a-14(g). the easements were not protected in perpetuity and thus were not qualified conservation contributions under § 170(h)(1). 2. both their house and their claimed charitable contribution deduction went up in smoke. rolfs v. commissioner, 135 t.c. 471 (11/4/10). the taxpayers donated a home, but not the underlying land, to the local volunteer fire department to be burned down in a training exercise. the fire department could not use the house for any purpose other than destruction by fire in training exercises. the taxpayers claimed a charitable contribution deduction of $76,000 based on a ―before and after‖ valuation, comparing the value of the parcel with the building intact and the value of the parcel after demolition of the building; they complied with all record keeping and substantiation requirements. the tax court (judge gale) upheld the irs‘s denial of the deduction. first, based on expert testimony, he found that the taxpayers received a quid-pro-quo in the amount of $10,000, which was the value of the demolition services provided to them by the donee fire department. second, he found that the building, with ownership severed from the land and burdened by the condition that it be removed, i.e., in this case demolished, had no value. the lack of value was established by the expert testimony of home movers, who testified that considering the costs of removal to another site, the modest nature of the home, and the value of nearby land, no one would purchase the home for more than a nominal amount, between $100 and $1,000, sufficient to render the contract enforceable. applying the principles of hernandez v. commissioner, 490 u.s. 680 (1989), and united states v. american bar endowment, 477 u.s. 105 (1986), judge gale held that because the consideration received by the taxpayers exceeded the value of the transferred property, there was no charitable contribution. he rejected application of the ―before and after‖ valuation method, because that method did not take into account the restrictions that would have affected the marketability of the structure severed from the land. 2013] recent developments in federal income taxation 653 a. while the tax court opinion is very fact specific, the court of appeals affirmance looks to establish a broader principle. rolfs v. commissioner, 668 f.3d 888 (7th cir. 2/8/12). in an opinion by judge hamilton, the seventh circuit affirmed the tax court‘s decision. the seventh circuit concluded that ―proper consideration of the economic effect of the condition that the house be destroyed reduces the fair market value of the gift so much that no net value is ever likely to be available for a deduction, and certainly not here.‖ the appellate court reasoned that ―the fair market valuation of donated property must take into account conditions on the donation that affect the market value of the donated property,‖ and that the tax court properly rejected the before-and-after method for valuing a donation of property conditioned on the destruction of the property. the valuation must take into account any reduction in fair market value that results from the condition. moving and salvage, under which the house had no actual value, were analogous situations reasonably approximated the actual facts. the before-and-after valuation method proffered by the taxpayer was not appropriate, because the facts were not analogous to conservation easements, where that method typically is used; in this case the donation destroyed the residential value rather than transferring it. b. another burning house charitable contribution deduction goes up in smoke. patel v. commissioner, 138 t.c. no. 23 (6/27/12). in 2006 the taxpayers purchased residential property with the intention to demolish the house and construct a new one on the site. shortly after purchasing the property, the taxpayers obtained a demolition permit and executed documents granting the local fire department the right to conduct training exercises on the property and to destroy the house by burning during the exercises. soon thereafter live fire training exercises were conducted, and the house was destroyed. the taxpayers claimed a noncash charitable contribution of $339,504 for the donation of the house to the fire department, but the irs disallowed the deduction on the ground that the donation was a contribution of a partial interest in property, a deduction for which is denied by § 170(f)(3). in a reviewed opinion by judge dawson, the tax court granted summary judgment for the irs and upheld the denial of the deduction. the court reasoned that under the controlling (virginia) state law, the taxpayers had merely granted the fire department a license to conduct training exercises on the property and to destroy the building, which did not convey any interest in the building to the fire department. in doing so, they conveyed only a partial interest in the land. section 170(f)(3) thus denies any charitable contribution deduction for the donation of the use of the property regardless of the value of that use. however, the taxpayers acted with reasonable cause and in good faith and were not liable for any accuracyrelated penalty under §§ 6662(a) or (h), because at the time they filed their return, scharf v. commissioner, t.c. memo. 1973-265, which held that a 654 florida tax review [vol. 13:10 charitable contribution deduction was available for the donation of a building to a volunteer fire department for demolition in firefighter training exercises, was the only relevant case law.  an appendix explained that a license does not convey an interest in the property under the common law in any state or the district of columbia.  judges colvin, cohen, vasquez, thornton, marvel, gustafson, and morrison joined in the opinion of the court. judge paris concurred in the result only.  judge gale, in an opinion joined by judges halpern, foley, goeke, wherry, kroupa, and holmes, dissented. the dissent reasoned that the taxpayers had not merely granted a license, but ―by virtue of the fire department‘s severance and destruction of the house, petitioners in substance ceded all substantial property interests they held in the structure to the department.‖ citing rolfs v. commissioner, 668 f.3d at 888 (7th cir. 2012), aff’g 135 t.c. 471 (2010), in which judge gale wrote the tax court opinion, the dissent noted that to be entitled to a charitable contribution deduction, the taxpayers ―must show that the value of the house, taking into account the conditions on its donation, exceeded the value of the benefit they received from the fire department in the form of demolition services.‖ thus the dissenters would have denied the motion for summary judgment and proceeded to trial on that fact question.  judge kerrigan dissented but did not join in judge gale‘s dissent or write separately. 3. mining is not the highest and best use for land that no one actually wants to mine. esgar corp. v. commissioner, t.c. memo. 2012-35 (2/6/12). the taxpayers granted conservation easements in certain land that was zoned irrigated, agricultural, and which had historically been used as irrigated and unirrigated farmland. the land was not permitted for any mining, but absent the donations it was likely that the necessary permits to mine (gravel) could have been obtained. the terms of the conservation easements provided the donee organization perpetual rights to preserve the natural and open space conditions and protect the wildlife, ecological, and environmental values and water quality characteristics of the property. the conservation easements specifically prohibited the mining or extraction of sand, gravel, rock, or any other mineral. the taxpayers valued the easement donation under the ―before and after method,‖ treating the highest and best use before the donation as gravel mining. the tax court (judge wherry) held that the before highest and best use was agricultural, not mining. where . . . an asserted highest and best use differs from current use, the use must be reasonably probable and 2013] recent developments in federal income taxation 655 have real market value. . . . ―any suggested use higher than current use requires both ‗closeness in time‘ and ‗reasonable probability‘‖. hilborn v. commissioner, [85 t.c. 677, 689 (1985)]. any proposed uses that ―depend upon events or combinations of occurrences which, while within the realm of possibility, are not fairly shown to be reasonably probable‖ are to be excluded from consideration. olson v. united states, 292 u.s. 246, 257 (1934). where the asserted highest and best use of property is the extraction of minerals, the presence of the mineral in a commercially exploitable amount and the existence of a market ―that would justify its extraction in the reasonably foreseeable future‖ must be shown. united states v. 69.1 acres of land, [942 f.2d 290, 292 (4th cir. 1991)]. ―there must be some objective support for the future demand, including volume and duration. mere physical adaptability to a use does not establish a market.‖  based on detailed examination of the facts and expert witness reports, the evidence did not prove that a hypothetical willing buyer in the year of the donation would have considered the land as the site for construction of a gravel mine. ―while it would have been physically possible to mine the properties in 2004 (or in the future), there was no unfilled demand and there was no unmet market.‖ instead, judge wherry found that there were comparable sales upon which a before valuation of the contribution could be based. however, judge wherry declined to uphold the § 6662(b)(3) substantial valuation penalty asserted by the irs because he found that the taxpayers relied in good faith on the appraisers and the accounting firm they hired as advisors. 4. judge wells analyzed in detail the expert testimony concerning four donated conservation easements in the columbus, georgia area. butler v. commissioner, t.c. memo. 2012-72 (3/19/12). taxpayers claimed about $10 million of charitable contribution deductions for four donated easements on large tracts of rural land located in the direction of the expansion of the city of columbus, georgia. the tax court (judge wells) allowed deductions totaling about $6.5 million. he analyzed in detail the reports and testimony of the appraisers for both taxpayers and the irs in a lengthy opinion, including a consideration of the various appraisal methods used, particularly the discounted cash flow method, the comparable sales method and the so-called ―comparable easements‖ method. it also deals with the difference between the last two methods, the latter of which arrives at a percentage diminution in value caused by the donated easement. 656 florida tax review [vol. 13:10  as an initial matter, the tax court (judge wells) concluded that the taxpayer had produced credible evidence as required by § 7491(a) with respect to the factual issues regarding whether their conservation easements satisfied the requirements of § 170(h), thus shifting the burden of proof to the irs. the purposes of the easements were to provide a significant wildlife resource for the region and enhance the natural aesthetics of the area; the site offered forage, nesting habitat, and shelter; the public would be benefitted by cleaner air and water, plentiful game for hunting, and natural beauty in the area. among the uses prohibited by the conservation easements were mineral exploitation, ―commercial or industrial facilities (other than those necessary in the operation or uses of the property expressly permitted by the easement), dumping, billboards, commercial towers, and mobile homes or recreational vehicles.‖ the conservation deeds did not permit the general public to access the properties. the conservation deeds reserved numerous rights for the taxpayer. the taxpayer (or future owners) could partition one of the properties into smaller tracts averaging 36 acres, each of which would include a 2-acre building site on which a home and a garage could be constructed and could build on one two-acre building site on the other property. roads or driveways could be constructed to access the buildings. the taxpayer (or future landowners) could operate small-scale farms and could use agrichemicals to eliminate ―noxious weeds‖ subject only to the exhortation that they ―minimiz[e] the impact upon non-noxious foliage and vegetation.‖ they could construct dams to create ponds for recreation or irrigation, and they could construct docks, gazebos, and ―related recreational structures.‖ they could clear timber for agricultural uses, clear brush and remove trees for ―aesthetic‖ purposes, and plant nonnative species of trees or other plants. the conservation deeds also permitted a wide variety of other uses provided that those uses do not result in ―demonstrable degradation to the conservation values,‖ including the construction of fences, the construction of other roads besides those that access the building sites, the construction of an unlimited number of barns and sheds for agricultural or recreational use on any portion of the property (not just the two-acre building sites), and commercial timber harvesting pursuant to an approved timber management plan. the donee had the right to determine whether such uses would result in degradation to the conservation values. judge wells held that these reserved rights were not inconsistent with the conservation purpose and allowed the deduction. even if fully exercised, the rights would not destroy the habitats and high-quality ecosystems on the property.  judge wells refused to uphold substantial understatement penalties because taxpayers throughout the process had had ―reasonable cause and acted in good faith‖ by relying on their long-term attorney and accountant. the attorney also helped taxpayers in selecting conservation advisors, l.l.c., a real estate firm specializing in conservation conveyances, which in turn helped them select qualified and experienced 2013] recent developments in federal income taxation 657 appraisers who ―had access to sufficient information to value the conservation easements.‖ 5. the old adage ―better late than never‖ didn‘t save the taxpayer‘s deduction for a conservation easement on mortgaged property. mitchell v. commissioner, 138 t.c. no. 16 (4/3/12). in 2003, the taxpayer contributed a conservation easement over 180 acres of unimproved land to a qualified organization. the property was subject to a mortgage, but the mortgagee did not subordinate the mortgage to the conservation easement deed until 2005. the taxpayer claimed a charitable contribution deduction on her 2003 federal income tax return, which the irs disallowed. the taxpayer argued that she had met the requirement of reg. § 1.170a-14(g)(2) requiring subordination of a mortgage to the conservation easement because reg. § 1.170a-14(g)(3) should apply to determine whether the requirements of reg. § 1.170a-14(g)(2) had been satisfied. reg. § 1.170a-14(g)(3) provides that a deduction will not be disallowed merely because on the date of the gift there is the possibility that the interest will be defeated so long as on that date the possibility of defeat is so remote as to be negligible. the taxpayer argued that the probability of her defaulting on the mortgage was so remote as to be negligible, and that the possibility should be disregarded under the soremote-as-to-be-negligible standard in determining whether the conservation easement is enforceable in perpetuity. the tax court (judge haines) held that the so-remote-as-to-be-negligible standard of reg. § 1.170a-14(g)(3) does not apply to determine whether the requirements of reg. § 1.170a14(g)(2), requiring subordination of a mortgage to the conservation easement have been satisfied, citing kaufman v. commissioner, 136 t.c. 294 (2011), kaufman v. commissioner, 134 t.c. 182 (2010), carpenter v. commissioner, t.c. memo. 2012-1, and distinguishing simmons v. commissioner, t.c. memo. 2009-208, aff’d, 646 f.3d 6 (d.c. cir. 2011). thus, the taxpayer did not meet the requirements of reg. § 1.170a-14(g)(2), and the deduction was denied. however, the taxpayer was not liable for a § 6662 accuracy related penalty. she ―attempted to comply with the requirements for making a charitable contribution of a conservation easement,‖ she hired an accountant and an appraiser, but she ―inadvertently failed to obtain a subordination agreement‖ and ―upon being made aware of the need for a subordination agreement she promptly obtained one.‖ she acted with reasonable cause and in good faith. 6. a ―gotcha‖ for the irs! the tax court just says ―no‖ to deductions for contributions of conservation easements on mortgaged properties. kaufman v. commissioner, 134 t.c. 182 (4/26/10). the tax court (judge halpern) held that as a matter of law no charitable contribution deduction is allowable for the conveyance of an otherwise qualifying conveyance of a facade conservation easement if the property is 658 florida tax review [vol. 13:10 subject to a mortgage and the mortgagee has a prior claim to condemnation and insurance proceeds. because the mortgage has priority over the easement, the easement is not protected in perpetuity – which is required by § 170(h)(5)(a). the deduction cannot be salvaged by proof that the taxpayer likely would satisfy the debt secured by the mortgage. a. plea for a mulligan is rejected! kaufman v. commissioner, 136 t.c. 294 (4/4/11). on the taxpayers‘ motion for reconsideration, the tax court (judge halpern) in a lengthy and thorough opinion reaffirmed its earlier decision that the conservation easement failed the perpetuity requirement in reg. § 1.170a-14(g)(6), because under the loan documents, the bank that held the mortgage on the property expressly retained a ―‗prior claim‘ to all insurance proceeds as a result of any casualty, hazard, or accident occurring to or about the property and all proceeds of condemnation,‖ and agreement also provided that ―the bank was entitled to those proceeds ‗in preference‘ to [the donee organization] until the mortgage was satisfied and discharged.‖ the court also disallowed a deduction in 2003, but allowed the deduction in 2004, for a cash contribution to the donee of the conservation easement in 2003 because the amount of the cash payment was subject to refund if the appraised value of the easement was zero, and the appraisal was not determined until 2004. the court also rejected the irs‘s argument that the taxpayers received a quid pro quo for the cash contribution in the form of the donee organization accepting and processing their application, providing them with a form preservation restriction agreement, undertaking to obtain approvals from the necessary government authorities, securing the lender agreement from the bank, giving the taxpayers basic tax advice, and providing them with a list of approved appraisers. the facts in evidence did not demonstrate a quid pro quo, because, among other things, many of the tasks had been undertaken by the organization before the check was received.  finally, the court declined to uphold the § 6662 accuracy related penalties asserted by the irs for the taxpayers‘ overstatement of the amount of the contribution for the conservation easement, but sustained the negligence penalty for the 2003 deduction for the cash payment. because the issue of whether any deduction was allowed for the easement, regardless of its value, was a matter of law decided in the case as a matter of first impression, the taxpayers were not negligent, had reasonable cause, and acted in good faith. b. the taxpayer wins the battle in the court of appeals with an excellent discussion of charitable contributions of easements on mortgaged property, but still might lose the war. kaufman v. commissioner, 687 f.3d 21 (1st cir. 7/19/12). the first circuit, however, 2013] recent developments in federal income taxation 659 in an opinion by judge boudin, disagreed with the tax court, holding that a mortgagee‘s right to satisfy the mortgage lien before the donee of the conservation easement is entitled to any amount from the sales or condemnation proceeds from the property does not necessarily defeat the charitable contribution deduction. judge boudin‘s opinion noted that ―the kaufmans had no power to make the mortgage-holding bank give up its own protection against fire or condemnation and, more striking, no power to defeat tax liens that the city might use to reach the same insurance proceeds – tax liens being superior to most prior claims, 1 powell on real property § 10b.06[6] (michael allan wolf ed., matthew bender & co. 2012), including in massachusetts the claims of the mortgage holder.‖ 6 the opinion continued by observing that [g]iven the ubiquity of super-priority for tax liens, the irs‘s reading of its regulation would appear to doom practically all donations of easements, which is surely contrary to the purpose of congress. we normally defer to an agency‘s reasonable reading of its own regulations, e.g., united states v. cleveland indians baseball co., 532 u.s. 200, 220 (2001), but cannot find reasonable an impromptu reading that is not compelled and would defeat the purpose of the statute, as we think is the case here. thus, the first circuit rejected the tax court‘s requirement that the donee of the conservation easement have ―an absolute right‖ (136 t.c. at 313), holding that a ―grant that is absolute against the owner-donor‖ is sufficient ―and almost the same as an absolute one where third-party claims (here, the bank‘s or the city‘s) are contingent and unlikely.‖  the first circuit went on to reject the irs‘s argument that contribution also failed to qualify for a charitable contribution deduction because a provision in the agreement between the kaufmans and the donee trust stated that ―nothing herein contained shall be construed to limit the [trust‘s] right to give its consent (e.g., to changes in the façade) or to abandon some or all of its rights hereunder,‖ citing commissioner v. simmons, 646 f.3d 6 (d.c. cir. 2011), which reasoned that such clauses permitting consent and abandonment ―‗have no discrete effect upon the perpetuity of the easements: any donee might fail to enforce a conservation easement, with or without a clause stating it may consent to a change or abandon its rights, and a tax-exempt organization would do so at its peril.‘‖ (quoting 646 f.3d at 10).  the court also rejected various scattershot irs arguments that the substantiation rules had not been met. 6. we include the citation to powell on real property in the quotation because michael allan wolf is a colleague of professor mcmahon’s, and the uf dean rewards faculty members based, in part, on their citation count. 660 florida tax review [vol. 13:10  however, the court of appeals did not necessarily hand the taxpayers a final victory. it remanded the case to the tax court on the valuation issue. when the kaufmans donated the easement, their home was already subject to south end landmark district rules that severely restrict the alterations that property owners can make to the exteriors of historic buildings in the neighborhood. these rules provide that ―[a]ll proposed changes or alterations‖ to ―all elements of [the] facade, ... the front yard ... and the portions of roofs that are visible from public streets‖ will be ―subject to review‖ by the local landmark district commission. under the standards and criteria, property owners of south end buildings have an obligation to retain and repair the original steps, stairs, railings, balustrades, balconies, entryways, transoms, sidelights, exterior walls, windows, roofs, and front-yard fences (along with certain ―other features‖); and, when the damaged elements are beyond repair, property owners may only replace them with elements that look like the originals. given these preexisting legal obligations the tax court might well find on remand that the kaufmans‘ easement was worth little or nothing.  the court took note of the fact that in persuading the kaufmans to grant the easement, ―a trust representative told the kaufmans that experience showed that such easements did not reduce resale value, and this could easily be the irs‘s opening argument in a valuation trial.‖ 7. but the tax court sticks by its guns on the mortgaged property conservation easement issue. minnick v. commissioner, t.c. memo. 2012-345 (12/17/12). once again, the tax court (judge morrison) has held that pursuant to reg. § 1.170a-14(g)(2), no charitable contribution deduction is allowable for the donation of a conservation easement where a mortgage encumbering the property has not been subordinated to the interest of the donee of the easement. the court emphasized its holding in mitchell v commissioner, 138 t.c. 324 (2012), that the unlikelihood of default is irrelevant. 8. if the donee messes up on the written acknowledgement, your only recourse is to have the chaplain punch your tare sugar chit [tango sierra chit, if you were in the military after the 1950s] because judge cohen won‘t help you. durden v. commissioner, t.c. memo. 2012-140 (5/17/12). a letter from taxpayers‘ 2013] recent developments in federal income taxation 661 church, dated 1/10/08, acknowledged numerous contributions during 2007, mostly in amounts of $250 or more, totaling $22,517; however the letter lacked a statement that no goods or services were provided to taxpayers in exchange for their contributions. a second letter from the church contained that statement but was dated 6/21/09 — after the irs sent a notice of deficiency disallowing most of the claimed charitable contribution deductions. the tax court (judge cohen) held that the second letter was untimely and the first letter was insufficient, so the taxpayers‘ charitable contributions of $250 or more were disallowed under § 170(f)(8).  unless there are damning facts not reflected in the opinion, shouldn‘t there have been a better way for the irs to have handled this matter? 9. you can‘t be your own appraiser, even if you might be qualified! ―a taxpayer relies on his private interpretation of a tax form at his own risk.‖ mohamed v. commissioner, t.c. memo. 2012152 (5/29/12). the taxpayer, a real-estate broker and certified real-estate appraiser, donated five real estate properties worth millions of dollars to a charitable trust. the taxpayer prepared his own tax return, including the form 8283, noncash charitable contributions, claiming charitable contribution deductions of over $3,000,000, even though the properties were worth over $15,000,000. the taxpayer left blank the declaration of appraiser because it stated, ―i declare that i am not the donor, the donee, a party to the transaction,‖ and he recognized that he was the donor (and the donee, since he was trustee of the trust), but he did sign the donee acknowledgment saying that the trust was a qualified organization under § 170(c) and that the trust had actually received the claimed donations. the taxpayer also attached two statements to the tax return. the first was captioned ―statement of explanation for entry on line 6 of schedule a,‖ and gave the addresses of the properties, more detailed descriptions of their size and improvements, and values for the properties. the second one, titled ―appraised market values,‖ elaborated on the appraisal. he signed the second document, and under his signature indicated that his title was ―real estate broker/appraiser.‖ in the course of an audit over valuation, the taxpayer hired an independent appraiser whose valuations were relatively consistent with the taxpayer‘s valuations, but the irs thereupon asserted that no deduction was allowable for failure to comply with the reg. § 1.170a13(c) substantiation requirements, which among other things require a ―qualified appraisal,‖ which under the regulations cannot be the donor or taxpayer claiming the deduction or the donee of the property. the taxpayer thus was not a qualified appraiser, and his attachments to the tax return did not qualify as the required appraisal summary that must be attached to the return because they failed to include information about several of the required categories on forms 8283 and the attached statements. the tax 662 florida tax review [vol. 13:10 court (judge holmes) granted summary judgment to the irs, upholding the validity of the regulations — no surprise — and finding that the taxpayer had failed to satisfy the ―substantial compliance‖ doctrine, because ―[t]he cases make clear that substantial compliance requires a qualified appraisal,‖ but excuses certain other minor deviations from the regulations requirements. lastly, judge holmes rejected the taxpayer‘s ―last-ditch effort‖ to save the deductions by arguing that form 8283 for the years in question did not indicate that a taxpayer had to get an independent appraisal for contributions worth more than $5,000 and presented conflicting messages about what could be filled out by the taxpayer and what required an appraiser‘s signature. ―we can‘t hold the form‘s failings against the commissioner here, because ‗the authoritative sources of federal tax law are in the statutes, regulations, and judicial decisions and not in such informal publications.‘‖ 10. according to judge wells, you can write your own acknowledgment of the donee‘s receipt of your charitable contribution. averyt v. commissioner, t.c. memo. 2012-198 (7/16/12). the tax court (judge wells) held that a conservation easement deed reciting that the easement had been conveyed for ―no consideration‖ satisfied the requirements of § 170(f)(8), even though the letter from the donee organization acknowledging the contribution did not satisfy § 170(f)(8) because it failed to state that no goods or services were received in exchange for the contribution. the letter recited that the taxpayer‘s sons had received ―pens and pencils,‖ which it was stipulated never had been received, but the letter nevertheless did not qualify, even though the pens and pencils would have had only nominal value, because the letters did not comply with the requirements of rev. proc. 90-12, § 2.05, 1990-1 c.b. 471, 472 (because the contribution was not pursuant to a fund-raising campaign).  section 170(f)(8)(b) provides that the contemporaneous written acknowledgment must include the following information: (i) the amount of cash and a description (but not value) of any property other than cash contributed; (ii) whether the donee organization provided any goods or services in consideration, in whole or in part, for any property described in clause (i); (iii) a description and good faith estimate of the value of any goods or services referred to in clause (ii). section 170(f)(8)(c) defines a ―contemporaneous‖ acknowledgment as one received on or before the earlier of: (i) the date on which the taxpayer files a return for the year when the contribution was made; or (ii) the due date for that return, including any extensions. 11. another case allowing the taxpayer to write the receipt. you just have to remember to get it countersigned by the donee. rp golf, llc v. commissioner, t.c. memo. 2012-282 (10/3/12). the tax 2013] recent developments in federal income taxation 663 court (judge paris) held that a conservation deed signed by donee trust‘s representative, as well as by donor, satisfied the § 170(f)(8) written acknowledgment requirement. the deed provided detailed description of property and easement, and was contemporaneous with donation. the deed ―stated that the conservation easement was an unconditional gift, recited no consideration received in exchange for it, and stipulated that it constituted the entire agreement between the parties with respect to the contribution of the conservation easement.‖ accordingly, the ―deed, taken as a whole, stated that no goods or services were received in exchange for the contribution.‖ 12. maybe it‘s time for the irs to stop trying to deny conservation easement deductions due to imaginary foot faults. irby v. commissioner, 139 t.c. no. 14 (10/25/12). the tax court (judge jacobs) allowed a charitable contribution deduction for the contribution to a qualified organization, via a bargain sale, of conservation easements that placed on the use of property a variety of limitations that served to protect the relatively natural habitat for fish, wildlife, and plants and to preserve open space and agricultural resources. although the donee was required to reimburse the government agencies that funded the bargain purchase price in the event it received proceeds if the land to which the easements related was condemned and the easements were extinguished, the conservation purpose for the easements was protected in perpetuity. the donee would have received its full share of the condemnation proceeds vis-a-vis the donor taxpayers, and there was no risk that the donors would reap a windfall in the event of condemnation. while the donee was required to reimburse the funding governments, the requirement of reg. § 1.170a-14(g)(6)(i) that all of the extinguishment proceeds would be used by donee in a manner consistent with the conservation purposes of the original contribution was met because the reimbursement under the terms of the conservation deeds would enhance the ability of the funding governmental agencies to conserve and protect more land, since the reimbursed funds would be used for that purpose. judge jacobs rejected the irs‘s argument that the deduction should be denied on the ground that the taxpayer‘s appraisal report was not a ―qualified appraisal‖ because the report did not include explicit statements that the appraisal was prepared for income tax purposes. [t]he appraisal report in this case included all of the required information either in the appraisal or in the appraisal summaries attached to petitioners‘ respective returns—it included a discussion of the purpose of the transaction (i.e., that the purpose of the appraisal was to value the donation of a conservation easement pursuant to the terms of section 170(h)) . . . ; it stated that fair market valuation was to be used in determining the value of the property; and form 8283 was properly filed with petitioners‘ 664 florida tax review [vol. 13:10 respective returns. the irs has not provided to the public a specific form for the tax purpose statement, and respondent has not proffered any instance where a suboptimal tax purpose statement, by itself, invalidated an otherwise qualified appraisal.  finally, judge jacobs rebuffed the irs‘s argument that the deduction should be disallowed on the ground that the taxpayers did not obtain contemporaneous written acknowledgments from the donee indicating the amount of goods or services that received for the contribution. he concluded that collectively (1) the option agreement between the donors and the donee, (2) the forms 8283 attached to the taxpayers‘ tax returns, (3) letters from the donee to the donors states that it was a qualified § 170(h) organization and would receive and hold the conservation deeds with respect to the parcels, (4) the settlement statements prepared by the title company in the transaction, which list the amounts paid as part of the bargain sale, and (5) the conservation deeds, which stated the source of funding for the bargain purchase, described the donated property, and listed the responsibilities and rights that the donors and donees had regarding the enforcement of the easement — all of which were prepared before the taxpayers income tax returns were filed — contained sufficient information to constitute a contemporaneous written acknowledgment despite the absence of any statement that no services were received by the donors (because goods were received by the donors in their bargain sales). 13. contributions to a disregarded entity owned by a charity. notice 2012-52, 2012-35 i.r.b. 317 (7/31/12). this notice holds that the irs will treat a contribution to a disregarded single member llc that is wholly owned and controlled by a u.s. charity as a charitable contribution to a branch or division of the u.s. charity. 14. no mardi gras beads from the tax court for this taxpayer. whitehouse hotel limited partnership v. commissioner, 131 t.c. 112 (10/30/08). the tax court (judge halpern) held that, as a precondition to using the replacement cost approach to valuing real estate, the taxpayer must show that the property is unusual in nature and other methods of valuation, such as comparable sales or income capitalization, are not applicable. the income approach to valuation is favored only where comparable market sales are absent. on the facts, the value of the contribution of a conservation facade easement for an historic structure on the edge of the french quarter in new orleans was overstated. the accuracy-related penalty for gross overvaluation was proper because there was no good faith investigation into the value. 2013] recent developments in federal income taxation 665 a. regardless of which valuation method is used, it still must relate to the property‘s ―highest and best use.‖ whitehouse hotel limited partnership v. commissioner, 615 f.3d 321 (5th cir. 8/10/10). in an opinion by judge barksdale, the fifth circuit vacated the tax court‘s decision and remanded the case for a determination of the easement‘s value, although it rejected the taxpayer‘s arguments that the irs‘s expert was unqualified and that his report was unreliable and should not have been admitted. but the court of appeals agreed with the taxpayers‘ argument that the tax court ―miscomprehended the highest and best use‖ of the building subjected to the conservation easement, and thereby undervalued the easement. in sum, the tax court erred in declining to consider the maison blanche and kress buildings‘ highest and best use in the light of both the reasonable and probable condominium regime and the reasonable and probable combination of those buildings into a single functional unit, both of which foreclosed the realistic possibility, for valuation purposes, that the kress and maison blanche buildings could come under separate ownership. this combination affected the buildings‘ fair market value.  as result the court did not reach the tax court‘s holding that the income and replacement-cost methods of valuation were inapplicable and directed the tax court to consider those methods, in addition to comparable sales method on remand. because the holding on the valuation was vacated, the tax court‘s holding that the gross overvaluation penalty also was vacated. b. judge halpern reconsiders the whole case in light of the fifth circuit decision and increases the allowable deduction by only $65,415, from $1,792,301 to $1,857,716. whitehouse hotel limited partnership v. commissioner, 139 t.c. no. 13 (10/23/12). on remand, judge halpern elaborated at length on the proper valuation method to be used to value the building under the ―before and after‖ method, and once again accepted the irs‘s argument that the value of the property should be determined using a comparable-sales method. the comparable-sales method applied by judge halpern was based on the sales of buildings suitable for conversion into hotels based primarily on local sales data, rejecting the taxpayer‘s argument that non-local sales data should be taken into account. he again rejected both the taxpayer‘s reproduction-cost method and income method to valuation. judge halpern explained that ―[t]he reproduction cost of an historic building usually bears little relationship to its present economic value. such cost is usually far in excess of the cost of construction of a similarly sized modern structure, and may reflect the price of materials and workmanship that are no longer readily available.‖ because 666 florida tax review [vol. 13:10 reconstruction of the maison blanche building, if destroyed, would not have been a reasonable business venture, there was no probative correlation between the taxpayer‘s expert‘s estimate of the reproduction cost of the maison blanche building and the fair market value of the property. judge halpern rejected the income valuation method because in this case, where there was no ongoing business, it was based on too many contingencies, was inadequately developed, and thus was too speculative, particularly where the value could be established by comparable sales. he did not reject the income method of valuation as a matter of law. he stated: ―we have no difficulty with the process. where we have difficulty is with petitioner‘s call to trust on their face [the taxpayer‘s expert‘s] judgments as to values to be input to his model.‖ judge halpern also again found that the easement conveyance did not deprive the partnership or any subsequent owner of the ability to add stories to the top of the kress building or blocking views of the maison blanche facade. however, in light of the fifth circuit‘s directive, judge halpern determined the value of the facade conservation easement based on the beforeand after-restriction values of the combined maison blanche and kress building property. he concluded that the value of the easement was approximately $1.86 million, rather than $1.79 million as determined in his first opinion. responding to the fifth circuit‘s determination that he had misapprehended the properties highest and best use, judge halpern reasoned that ―although the highest and best use of property may determine a ceiling on how much a willing buyer would pay for the property, it does not necessarily determine a floor on how little a willing seller would accept. . . . [t]he hypothetical willing buyer and the hypothetical willing seller who populate our standard definition of fair market value will not invariably conclude their negotiation over price at a price reflecting the value of the property at its highest and best use.‖ he turned to auction price theory to conclude that in determining the fair market value of the property, which is the relevant benchmark, ―the equilibrium price at which the willing buyer and the willing seller would meet would be somewhere between the value of the property taking into account its most productive use (i.e., its highest and best use) and the value of the property taking into account its second most profitable use.‖ accordingly, he rejected the taxpayer‘s argument that the valuation should be based on the use of the buildings as the shell of a luxury hotel, there being no scarcity of buildings in new orleans suitable for development as luxury hotels. ―only if there were sufficient scarcity would the partnership . . . capture a piece of the economic return to luxury hotel development of the building‘s shell.‖ finally, based on the $1.86 million value, the claimed value of the exceeded 400 percent of the actual value and the § 6662(h) gross valuation misstatement penalty applied. the § 6664(c) reasonable cause and good-faith exceptions did not apply, because 2013] recent developments in federal income taxation 667 whitehouse failed to make a good-faith investigation of the value of the easement and did not reasonably rely on an appraisal. 15. congress wants old folks to give their iras to charity. the 2012 taxpayer relief (and not so grand compromise) tax act, § 208(b)(2), retroactively extends the allowance of code § 408(d)(8) that permits taxpayers 70½ years or older to take a $100,000 ira distribution and contribute it to charity without recognizing income and without affecting the charitable contribution limitation of § 170 to contributed distributions made in tax years before 1/1/14. in addition, taxpayers may elect to treat distributions made in january 2013 as made on 12/31/12. taxpayers are also allowed to elect to treat any distribution in december 2012 as a qualified charitable distribution if the distribution was transferred in cash to a charitable organization by 1/31/13. 16. let‘s go green for a few more years; contributions of conservation easements. the 2012 taxpayer relief (and not so grand compromise) tax act, § 206, extended through 2013 the provisions of code § 170 allowing a deduction for a qualified conservation contribution made by an individual or corporate farmer or rancher in tax years beginning after 12/31/05 of up to 100% of the taxpayer‘s taxable income. the limits under code § 170(e) are 50% of the taxpayer‘s charitable conservation base over other allowable charitable contributions, 100% for farmers and ranchers, with a fifteen year carryforward. x. tax procedure a. interest, penalties, and prosecutions 1. the instructions for the new fbar are fubar. ir-2009-58 and announcement 2009-51, 2009-1 c.b. 1105 (6/5/09). the irs announced that for the reports of foreign bank and financial accounts (fbars) due on 6/30/09, filers of form td f 90-22.1 (rev. 10-2008) need not comply with the new instruction relating to the definition of a united states person, i.e.: united states person. the term ―united states person‖ means a citizen or resident of the united states, or a person in and doing business in the united states. see 31 c.f.r. 103.11(z) for a complete definition of ‗person.‘ the united states includes the states, territories and possessions of the united states. see the definition of united states at 31 c.f.r. 103.11(nn) for a complete definition of united states. a foreign subsidiary of a united states person is not required to file this report, although its united states parent 668 florida tax review [vol. 13:10 corporation may be required to do so. a branch of a foreign entity that is doing business in the united states is required to file this report even if not separately incorporated under u.s. law.  instead, for this year, taxpayers and others can rely on the definition of a united states person included in the instruction to the prior form (7-2000): united states person. the term ―united states person‖ means: (1) a citizen or resident of the united states; (2) a domestic partnership; (3) a domestic corporation; or (4) a domestic estate or trust. a. notice 2009-62, 2009-2 c.b. 260 (8/7/09). by this notice, the irs extended the filing deadline until 6/30/10 to report foreign financial accounts on form td f 90-22.1 for persons with signature authority over (but no financial interest in) a foreign financial account and persons with signature authority over, or financial interests in, a foreign commingled fund. b. still clear as mud: new definitions and instructions. rin 1506-ab08, financial crimes enforcement network; amendment to the bank secrecy act regulations – reports of foreign financial accounts, 75 f.r. 8844 (2/26/10). this proposed rule would include a definition of ―united states person‖ and definitions of ―bank account,‖ ―securities account,‖ and ―other financial account,‖ as well as of ―foreign country.‖ it also includes draft instructions to form td f 90-22.1 (fbar). (1) notice 2010-23, 2010-1 c.b. 441 (2/26/10). provided administrative relief to certain person who may be required to file an fbar for the 2009 and earlier calendar years by extending the filing deadline until 6/30/11 for persons with signature authority, but no financial interest in, a foreign financial account for which an fbar would have otherwise been due on 6/30/10. it also provides relief with respect to mutual funds. (2) announcement 2010-16, 20101c.b. 450 (2/26/10). the irs suspended, for persons who are not u.s. citizens, u.s. residents, or domestic entities, the requirement to file an fbar for the 2009 and earlier calendar years. c. second (or, is it the third?) special voluntary disclosure initiative available through 8/31/11. ir-2011-14 (2/8/11). the 2011 offshore voluntary disclosure initiative is similar to the 2009 offshore voluntary disclosure program with a 25-percent penalty and 2013] recent developments in federal income taxation 669 an 8-year look-back requirement (both slightly-increased from 2009). there are lower penalties in some limited situations (5 percent), and where offshore accounts do not surpass $75,000 (12.5 percent). all original and amended tax returns must be filed and payment of all taxes, interest, and penalties must be made by the 8/31/11 deadline.  subsequent q&as offer the possibility of a 90-day extension to complete the voluntary disclosure where total compliance had not been made by the deadline despite good faith attempts. see q&a 25.1. d. additional relief for persons with signature authority. notice 2011-54, 2011-29 i.r.b. 53 (6/16/11). provides additional relief to persons whose requirement to file form td-f 90-22.1, report of foreign bank and financial accounts (fbar), for calendar year 2009 or earlier calendar years was based solely upon signature authority. their deadline is now 11/1/11. the deadline for reporting signature authority over, or a financial interest in, foreign financial accounts for the 2010 calendar year was 6/30/11.  reporting problems occur for former employees, as well as with respect to foreign accounts that give signature authority to ―all officers.― e. complying with fatca may cause tax return preparers to become confused. ir-2011-117 (12/14/11). an information return on form 8938 must be filed by individuals with more than the threshold amount for foreign financial assets. it will serve as a check on foreign financial institutions providing form 1099 with respect to income from such assets. f. and the proposed fatca regulations place an unwanted burden on foreign financial institutions to the point that many of them refuse to open accounts for u.s. citizens. reg121647-10, regulations relating to information reporting by foreign financial institutions and withholding on certain payments to foreign financial institutions and other foreign entities, 77 f.r. 9022 (2/15/12). the treasury department has published proposed regulations under §§ 1471 through 1474, regarding information reporting by foreign financial institutions (ffis) with respect to u.s. accounts and withholding on certain payments to ffis and other foreign entities. these regulations affect persons making certain u.s.-related payments to ffis and other foreign entities and payments by ffis to other persons. g. ♪♫ ―this is a song that doesn‘t end. / it goes on and on, my friend ….‖ ♫♪ third (or fourth) voluntary disclosure program is announced. ir-2012-5 (1/9/12). the irs has 670 florida tax review [vol. 13:10 announced the reopening of the offshore voluntary disclosure program (ovdp) following the closure of the 2011 and 2009 programs. there is no set deadline within which to apply, but the program could be changed or terminated at any time. the penalty structure for the program will be similar to the 2011 program except the highest penalty will be 27.5 percent instead of 25 percent. details are available on the irs website. 2. a careful reading of this criminal tax fraud case should put the fear of god, or at least of the cid and doj, in the hearts of many tax shelter investors. united states v. rozin, 664 f.3d 1052 (6th cir. 1/6/12). the sixth circuit, in an opinion by judge rogers, upheld the defendant‘s conviction for criminal tax fraud. the defendant had claimed business and individual tax deductions for the cost of so-called ―loss of income‖ (loi) insurance policies, although the insurance aspect of the policies was questionable, and the policies allegedly permitted the defendant to reclaim or maintain control of the amount paid as premiums. the loi policies insured against loss of income due to certain circumstances, including corporate downsizing, changes in technology, or employee layoffs arising within one year from the date the policy was issued, but did not cover the following: death; disability; voluntary termination; self-inflicted injuries; proven criminal acts; negligent or willful misconduct; substance abuse; dishonesty or fraud; insubordination, incompetence, or inefficiency; conflict of interest; or breach of employment contract. in conjunction with the loi insurance policy, the defendant also purchased from the same ―return of premium‖ (rop) riders. if no claim was filed on the loi policy, under the rider the loi premium would be invested for the policy owner and would be distributed to the owner after ten years or at age sixty-five. according to the promotional materials, the loi premium payments (but not the rider) were deductible. in convicting the defendant of tax evasion and conspiracy to defraud the irs, the district court noted: (1) the lack of a ―true business purpose for purchasing the various loi policies,‖ (2) the ―dubious nature‖ of the policies, including the high premium to coverage ratio, as well as the practice of backdating, (3) rozin‘s access to and control over the funds, (4) rozin‘s descriptions of the policies to [friends to whom he recommended the scheme] as ―tax-savings product[s],‖ and (5) the differences between the policies rozin bought and those that were advertised in [the insurance broker‘s] promotional materials. the district court held that ―rozin did not have a good faith reliance defense because he withheld relevant information and had reason to suspect the motives of the individuals on whom he supposedly relied.‖ in upholding the conviction, the court of appeals made the following points: 2013] recent developments in federal income taxation 671 (1) ―though peddled as ‗insurance,‘ . . . the covered risks — corporate downsizing, employee layoffs, and technological obsolescence – were unlikely to happen to rozin because he was an owner of a carpet company. many of the most obvious causes of loss of income, such as death, disability, voluntary termination, and breach of contract, were not covered, and rozin, inc. was not under any immediate threat of bankruptcy.‖ in addition, unlike other legitimate insurance policies, rozin maintained control of the funds; when pitching the loi policies to potential buyers, rozin described them as ―a way to lower your taxes‖ while also receiving ―a large percentage of that money back.‖ (2) ―[b]ackdating the loi policies showed willfulness, because there was no reason for such backdating other than to claim the improper tax deductions.‖ (3) ―when selling the loi policies to friends, rozin stated outright that about eighty-five percent of the money would ‗come back and be held in a trust‘ that the individual would ‗have control over.‘ evidence that rozin knew that he would have access to most of his money, while reaping the benefits of a large tax deduction, would permit a rational trier of fact to find that he willfully utilized the loi policies in order to evade taxes.‖ (4) ―because rozin either did not provide full information to those he supposedly relied upon, or he had reason to believe that the advice provided by these individuals was incorrect, the district court correctly held that rozin could not mount a credible good faith reliance defense.‖ (5) ―because [the cpa who prepared the tax returns] was not aware of the full facts regarding the loi policies, rozin cannot claim that he relied on [his] advice in good faith.‖ (6) ―rozin did not rely on cohen, let alone rely on cohen in good faith. . . . cohen also told rozin that if the irs did ‗challenge the deduction,‘ the worst thing that rozin would have to do would be to pay the taxes owed plus interest. noting the possibility that the irs could challenge the deduction should have raised a red flag for rozin, giving him reason to suspect that the information cohen provided him was incorrect. in addition . . . cohen‘s motivations were at least suspect because he received commissions from the sale of the loi policies.‖  if those ―factors‖ don‘t describe a lot of tax shelter investors to a ―t,‖ we don‘t know what does! 3. hiding funds to try to cheat creditors isn‘t the same as hiding them to try to cheat the irs, even if the effect is the same. avenell v. commissioner, t.c. memo. 2012-32 (2/2/12). the taxpayer diverted funds from the corporation (tacon) of which he was the president and a 96 percent shareholder. the primary issue in the case was not whether he was liable for income taxes on the diverted funds, but whether he was liable for the civil tax fraud penalty. the taxpayer, represented by larry 672 florida tax review [vol. 13:10 sherlock of the chamberlain hrdlicka firm, argued that he did not divert the funds with intent to evade tax but rather to hide the funds from a judgment creditor of the corporation. even though part of the taxpayer‘s behavior included the use of a cayman island bank account, judge kroupa held that the irs had failed to prove fraud by clear and convincing evidence. she reasoned that ―he did not understand that tacon was a separate entity and that tacon‘s funds were different and separate from his own. . . . [s]pending company funds for personal use is not per se fraudulent. . . . [p]etitioner‘s actions stemmed from an intent to avoid judgment collection coupled with a lack of sophistication about and attention to legal obligations and financial details.‖ 4. inconsistent forms 1099 from year to year for the same payment give rise to a ―reasonable cause‖ defense to accuracy related penalties. sewards v. commissioner, 138 t.c. no. 15 (4/2/12). the taxpayer, who had been a policeman until he retired following a service related injury, was eligible for two types of retirement plans: (1) a service retirement based on his length of service (service retirement) and (2) a service-connected disability retirement based on his service-connected injuries (scd retirement). under the scd plan, a policeman was eligible for a benefit equal to the greater of (1) one-half of final salary, or (2) the service retirement benefit. one-half of the taxpayer‘s salary was $7,046 annually while the service benefit was $12,861. the taxpayer originally received 2001 and 2002 forms 1099-r indicating that his service retirement payments were fully taxable. after his scd retirement became effective, he received amended 2001 and 2002 forms 1099-r indicating that the taxable amount was not determined. he subsequently received 2003, 2004, and 2005 forms 1099-r also indicating that the taxable amount was not determined. a letter dated december 20, 2006, notified the taxpayer that beginning in 2006 benefits equal to 50 percent of his final compensation would be reported as taxable, and he received a 2006 form 1099-r indicating a portion of his scd retirement payments was taxable, but the taxpayer did not report any of his benefits as taxable income. the tax court (judge foley) held that an amount equal to the minimum payment under the scd retirement plan — one-half of final salary — was excludable under § 104(a)(1) as an amount received pursuant to a workmen‘s compensation act or a statute in the nature of a workmen‘s compensation act. but the remaining benefit was not excludable because it was determined by reference to the employee‘s age or length of service, citing reg. § 1.104-1(b). however, judge foley declined to uphold the § 6662 accuracy-related penalties imposed by the irs. he held that the taxpayer had reasonable cause because over the course of several years the forms 1099 varied. 2013] recent developments in federal income taxation 673 5. filing a false return or aiding and abetting the filing of a false return by a lawful permanent resident alien carries a really stiff penalty. bye-bye america! kawashima v. holder, 132 s. ct. 1166 (2/21/12). in a 6-3 decision written by justice thomas, the supreme court held that a lawful permanent resident alien could be deported as a result of conviction of willfully making and subscribing a false (not necessarily fraudulent) tax return, which is a criminal offense under § 7206(1), or a conviction for aiding and assisting in the preparation of a false tax return, which is a criminal offense under § 7206(2). the convictions qualified as crimes involving fraud or deceit under 8 u.s.c. § 1101(a)(43)(m)(i) (clause (i)) and thus were aggravated felonies for which the taxpayers could be deported under 8 u.s.c.§ 1227(a)(2)(a)(iii).  justice ginsburg‘s dissenting opinion makes a great deal of sense. 6. the steve martin excuse 7 doesn‘t work in the seventh circuit. failure to file for nearly twenty years isn‘t mere negligence. united states v. collins, 685 f.3d 651 (7th cir. 7/6/12). the defendant, who failed to file income tax returns for almost twenty years, was convicted of tax evasion. on appeal, he argued that the use of the seventh circuit pattern jury instructions for tax evasion was erroneous because they did not distinguish the crime of tax evasion from a ―mere negligent failure to file a tax return.‖ the court of appeals (judge sykes) affirmed, stating that ―it‘s not remotely plausible to attribute a tax delinquency of almost two decades to mere negligence.‖ a jury does not need to ―be specifically instructed that ‗willful‘ tax evasion requires more than a mere negligent failure to file a return.‖ 7. the irs tells you how to apologize for filing a frivolous return and get the penalty reduced, but only once. rev. proc. 2012-43, 2012-49 i.r.b. 643 (11/5/12). this revenue procedure describes the limited circumstances in which a person may be eligible for a one-time reduction of any unpaid § 6702 frivolous return penalty. if a person satisfies all eligibility criteria, including filing all tax returns and paying all outstanding taxes, penalties (other than under § 6702), and related interest, the irs will reduce all unpaid § 6702 penalties assessed against that person to $500. 8. instructions on how to rat yourself out. rev. proc. 2012-51, 2012-51 i.r.b. 719 (11/26/12). this revenue procedure updates rev. proc. 2012-15, 2012-7 i.r.b. 369 and identifies circumstances under which the disclosure on a taxpayer‘s income tax return with respect to an 7. “i forgot.” 674 florida tax review [vol. 13:10 item or a position is adequate for the purpose of reducing the understatement of income tax under § 6662(d), relating to the substantial understatement aspect of the accuracy-related penalty, and for the purpose of avoiding the tax return preparer penalty under § 6694(a), relating to understatements due to unreasonable positions). there have been no substantive changes. the revenue procedure does not apply with respect to any other penalty provisions, including § 6662(b)(1) accuracy-related penalties. if this revenue procedure does not include an item, disclosure is adequate with respect to that item only if made on a properly completed form 8275 or 8275–r, as appropriate, attached to the return for the year or to a qualified amended return. 9. freedom for preparers to use taxpayer return information to increase their own profitability. t.d. 9608, disclosure or use of information by preparers of returns, 77 f.r. 76400 (12/28/12). the treasury has finalized prop. reg. §§ 301.7216-2(n) through 301.7216-2(p) (reg-131028-09, amendments to the section 7216 regulations — disclosure or use of information by preparers of returns), replacing temp. reg. §§ 301.7216-2t(n) through 301.7216-2t(p). 75 f.r. 94 (1/04/10). reg. § 301.7216-2(n) allows preparers to compile, maintain, and use a list containing solely the names, addresses, e-mail addresses, phone numbers, taxpayer entity classification, and income tax return form numbers of taxpayers whose tax returns the tax return preparer has prepared, if the list is used only to contact the taxpayers on the list either (1) to provide tax, general business, or economic information for educational purposes, or (2) for soliciting additional tax return preparation services. reg. § 301.7216-2(o) allows return preparers to use tax return information, subject to limitations to produce a statistical compilation of data described in reg. § 301.72161(b)(3)(i)(b) for a purpose relating directly to the internal management or support of the tax return preparer‘s tax return preparation business, or to bona fide research or public policy discussions concerning state or federal taxation; disclosure of the statistical compilation must be anonymous as to taxpayer identity, and may not disclose an aggregate figure containing data from fewer than ten tax returns. reg. § 301.7216-2(p) allows return preparers to disclose return information without penalty for the purpose of a quality or peer review, but only to the extent necessary to accomplish the review. the information also may be used to perform a conflict of interest check. 2013] recent developments in federal income taxation 675 b. discovery: summonses and foia 1. you can‘t hide your foreign bank account records behind the fifth amendment. in re m.h., 648 f.3d 1067 (9th cir. 8/19/11), cert. denied, 133 s.ct. 26 (6/25/12). m.h. was the target of a grand jury investigation seeking to determine whether he used secret swiss bank accounts to evade paying federal taxes. the district court granted a motion to compel his compliance with a grand jury subpoena duces tecum demanding that he produce certain records related to his foreign bank accounts. the district court declined to condition its order compelling production upon a grant of limited immunity and, pursuant to the recalcitrant witness statute, 28 u.s.c. § 1826, held him in contempt for refusing to comply. the ninth circuit upheld the district court order. the court of appeals held that ―[b]ecause the records sought through the subpoena fall under the required records doctrine, the fifth amendment privilege against self-incrimination is inapplicable, and m.h. may not invoke it to resist compliance with the subpoena‘s command.‖ the records were required to be kept pursuant to the predecessor of 31 c.f.r. § 1010.420. a. when the government asks, ya gotta pony up the name(s) on your foreign bank accounts, the account numbers, the name and address of the banks, the type of account, and the maximum value of each such account during each year. in re special february 20111 grand jury subpoena dated september 12, 2011, 691 f.3d 903 (7th cir. 8/27/12). in an opinion by judge bauer, the seventh circuit held that the compulsory production of foreign bank account records required to be maintained under the bank secrecy act of 1970 does not violate a taxpayer‘s fifth amendment privilege against self-incrimination. the required records doctrine overrode any act of production privilege. a grand jury subpoena seeking his bank records issued in connection with an investigation into whether he used secret offshore bank accounts to evade his federal income taxes was enforced. b. a third decision going the same way. in re grand jury subpoena, 696 f.3d 428 (5th cir. 9/21/12). the fifth circuit (judge dennis), in reversing a district court, declined to create a circuit split and held that the required records doctrine applied; the individual was required to produce foreign bank records subpoenaed in the irs‘s investigation into whether he used secret swiss bank accounts [with ubs] to evade his federal income taxes. the court‘s reasoning was that the bank secrecy act‘s record-keeping requirement is ―essentially regulatory,‖ the records sought are of a kind ―customarily kept‖ by account holders, and the records have assumed ―public aspects‖; this is so even though one purpose of 676 florida tax review [vol. 13:10 the bsa was to aid law enforcement officials in pursuing criminal investigations. c. litigation costs 1. shades of the nineteenth century. a written opinion in a case with $71 dollars at stake. dale v. commissioner, t.c. memo. 2012-146 (5/22/12). in a case in which the irs conceded that the taxpayer was entitled to attorney‘s fees under § 7430, judge kroupa held that a taxpayer may not recover ―costs for secretarial and clerical work performed by a secretary ($37.50), an assistant ($23) and a ‗staff‘ member ($10.50) (collectively, fees at issue)‖ that were not subsumed in the attorney‘s hourly rate. d. statutory notice of deficiency 1. the eleventh circuit reverses the tax court by reading webster‘s third new international dictionary. shockley v. commissioner, 686 f.3d 1228 (11th cir. 7/11/12). the court of appeals for the eleventh circuit (judge hull) reversed a tax court decision, t.c. memo. 2011-96, in which the tax court held that if it determines that the deficiency notice with respect to which the petition was filed is invalid, then the period of limitations is not suspended. the court of appeals reasoned that the proposition that limiting this holding to only petitions filed in response to a valid deficiency notice ―cannot be found on the face of the suspension statute, nor can it be squared with the plain language of the statute.‖ here, the breadth of § 6503(a)(1)‘s plain language indicates the 2005 petition qualifies as a ―proceeding in respect of the [scc] deficiency.‖ first, the proceeding need only be ―in respect of‖ the deficiency, not seeking ―a redetermination of‖ the deficiency. the phrase ―in respect of‖ is particularly comprehensive, with one dictionary ascribing a definition of ―as to; as regards; insofar as concerns; [or] with respect to.‖ webster’s third new international dictionary 1934 (1993); cf. kosak v. united states, 465 u.s. 848, 854, 104 s. ct. 1519, 1523 (1984) (describing the phrase ―arising in respect of‖ in a section of the federal tort claims act, 28 u.s.c. § 2680(c), as ―encompassing‖). this choice of phrase is in contrast to a closely related statute, § 6213(a), where congress selected the more specific phrase ―redetermination of‖ the deficiency. in our view, the phrase ―in respect of‖ in § 6503(a)(1) 2013] recent developments in federal income taxation 677 requires only that the substance of the proceeding concern the deficiency.  presumably, the tax court will continue to follow its own precedent in future cases that are not appealable to the eleventh circuit. e. statute of limitations 1. the courts hold that overstating basis is not the same as understating gross income, but the treasury department ultimately plays its trump card by promulgating regulations. section 6501(e)(1) extends the normal three-year period of limitations to six years if the taxpayer omits from gross income an amount in excess of 25 percent of the gross income stated in the return. section 6229(c)(2) provides a similar extension of the statute of limitations under § 6229(a) for assessments arising out of tefra partnership proceedings. a critical question is whether the six year statute of limitations applies if the taxpayer overstates basis and as a consequence understates gross income. a. the tax court says overstating basis is not the same as understating gross income. bakersfield energy partners, lp v. commissioner, 128 t.c. 207 (6/14/07). the taxpayer overstated basis, resulting in an understatement of § 1231 gain. looking to supreme court precedent under the statutory predecessor of § 6501(e) in the 1939 code (colony, inc. v. commissioner, 357 u.s. 28 (1958)), from which the six-year statute of limitations in § 6229(c)(2) is derived and to which it is analogous, the tax court concluded that this understated gain was not an omission of ―gross income‖ that would invoke the six-year statute of limitations under § 6229(c)(2) applicable to partnership audits. b. the ninth circuit likes the way the tax court thinks: bakersfield energy partners is affirmed. bakersfield energy partners, lp v. commissioner, 568 f.3d 767 (9th cir. 6/17/09). the ninth circuit affirmed the tax court on the grounds that the language at issue in the instant case was the same as the statutory language interpreted in colony. the court noted, however, that ―[t]he irs‘s interpretation of § 6501(e)(1)(a) is reasonable.‖ c. and a judge of the court of federal claims agrees. grapevine imports, ltd v. united states, 77 fed. cl. 505 (7/17/07), rev’d, 636 f.3d 1368 (fed. cir. 3/11/11). in a tefra partnership tax shelter case, the court of federal claims (judge allegra) held that the § 6501(e) six-year statute of limitations does not apply to basis overstatements, citing colony, inc. v. commissioner, 357 u.s. 28 (1958). 678 florida tax review [vol. 13:10 section 6501(e), rather than § 6229(c)(2) as in bakersfield energy partners, lp, applied because in earlier proceedings in the instant case (71 fed. cl. 324 (2006)), the court had held that § 6229 did not create an independent statute of limitations, but instead only provides a minimum period for assessment for partnership items that could extend the § 6501 statute of limitations, and because the fpaa was sent within this six-year statute of limitations under § 6229(d) the statute of limitations with respect to the partners was suspended. d. but a district court in florida disagrees. brandon ridge partners v. united states, 100 a.f.t.r.2d 2007-5347 (m.d. fla. 7/30/07). the court refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) 6-year statute of limitations does apply to basis overstatements. the court reasoned that as a result of subsequent amendments to the relevant code sections, the application of colony, inc. v. commissioner, 357 u.s. 28 (1958), is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or services. [―in the case of a trade or business, the term ‗gross income‘ means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.‖] the court reasoned that to conclude otherwise would render § 6501(e)(1)(a)(i) superfluous. because the transaction at issue was the partnership‘s sale of stock, which was not a business sale of goods or services, the gross receipts test did not apply. on the facts, the partners and partnership returns (and statements attached thereto), taken together ―failed to adequately apprise the irs of the true amount of gain on the sale of the ... stock.‖ thus, the partnership did not show that the extended limitations period was inapplicable. e. and a different judge of the court of federal claims agrees with the district court in florida and disagrees with the prior court of federal claims opinion by a different judge in grapevine imports. salman ranch ltd. v. united states, 79 fed. cl. 189 (11/9/07). the court (judge miller) refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) six-year statute of limitations does apply to basis overstatements. judge miller reasoned that an understatement of ―gain‖ is an omission of gross income, and that omission can result from a basis overstatement as well as from an understatement of the amount realized. like the brandon ridge partners court, judge miller concluded that the application of colony, inc. v. commissioner, 357 u.s. 28 (1958), is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or 2013] recent developments in federal income taxation 679 services. (―in the case of a trade or business, the term ‗gross income‘ means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.‖) because the transaction at issue was the partnership‘s sale of a ranch, which was not a business sale of goods or services, the gross receipts test did not apply. on the facts, the partners‘ and partnership returns failed to adequately apprise the irs of the amount of gain in a variant of the son-of-boss tax shelter. accordingly, the partnership did not show that the extended limitations period was inapplicable. the amended order certified an interlocutory appeal and stayed the case pending further court order, because of the split of opinion between salman ranch, on the one hand, and bakersfield energy partners and brandon ridge partners, on the other hand. f. and the pro-government opinion by judge miller is slapped down by the federal circuit. salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09). following colony, inc. v. commissioner, 357 u.s. 28 (1958), the federal circuit (judge schall, 2-1) held that ―omits from gross income an amount properly includible therein‖ in § 6501(e)(1)(a) does not include an overstatement of basis. accordingly, the six-year statute of limitations on assessment did not apply – the normal three-year period of limitations applied. judge newman dissented. g. but a second district court sees it the government‘s way. home concrete & supply, llc v. united states, 599 f. supp. 2d 678 (e.d.n.c. 10/21/08), rev’d, 634 f.3d 249 (4 th cir. 2/7/11), aff’d, 132 s. ct. 1836 (4/25/12). the court held that §6501(e) extends the statute of limitations for deficiencies attributable to basis overstatements that result in omitted gross income exceeding 25 percent of the gross income reported on the return. the court refused to follow the tax court‘s decisions in bakersfield energy partners and grapevine imports, because it concluded that those cases were erroneously decided. h. a hiccup from judge goeke in the tax court: overstated basis in an abusive tax shelter is a substantial omission from gross income that extends the statute of limitations. highwood partners v. commissioner, 133 t.c. 1 (8/13/09). the taxpayers invested through partnerships in foreign currency digital options contracts designed to increase partnership basis and generate losses marketed by jenkens & gilchrist (son-of-boss and miscellaneous other names). after expiration of the three-year statute of limitations, the irs issued an fpaa to the partnership based on the six-year statute of §6501(e)(1) applicable if there was a greater than 25 percent omission of gross income on each partner‘s or the partnership‘s return. the court (judge goeke) held that the 680 florida tax review [vol. 13:10 digital options contracts produced § 988 exchange gain on foreign currency transactions, which, under the regulations, are required to be separately stated. the long and short positions of the options contracts were treated as separate transactions. thus, failure to report the gain on the short position, not offset by losses on the accompanying stock sale, represented an omission of gross income. the court also rejected the taxpayer‘s argument that because the irs asserted that the options transactions should be disregarded in full, there can be no omission of gross income from the disregarded short position. finally, the court refused to apply the adequate disclosure safe harbor of § 6501(e)(1)(a)(ii) because the taxpayer‘s netting of the gain and loss from the long and short positions was intended to mislead and hide the existence of the gain and did not apprise the irs of the existence of the gain. i. but judge haines follows the tax court orthodoxy. beard v. commissioner, t.c. memo. 2009-184 (8/11/09), rev’d, 633 f.3d 616 (7th cir. 1/26/11). in a basis offset deal involving contributions of long and short positions in treasury notes contributed to s corporations, the court (judge haines) granted summary judgment to the taxpayer holding that the basis overstatement attributable to the short sale was not a substantial omission of gross income. because the transaction involved treasury notes, there were no § 988 issues involved. this holding is consistent with bakersfield energy partners v. commissioner, 568 f.3d 767 (9th cir. 6/17/09), and salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09). j. and the irs loses again in the tax court. intermountain insurance service of vail v. commissioner, t.c. memo. 2009-195 (9/1/09). the court (judge wherry), again following bakersfield energy partners lp v. commissioner, 128 t.c. 207 (2007), granted summary judgment to the taxpayer holding that a basis overstatement is not a substantial omission from gross income that triggers the six-year extended statute of limitations under § 6229. k. finally, the irs gets the upper hand with temporary regulations. t.d. 9466, definition of omission from gross income, 74 f.r. 49321 (9/28/09). temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)-1t both provide that for purposes of determining whether there is a substantial omission of gross income, gross income as it relates to a trade or business includes the total amount received from the sale of goods or services, without reduction for the cost of goods sold; gross income otherwise has the same meaning as under § 61(a). the regulations add that, ―[i]n the case of amounts received or accrued that relate to the disposition of property, and except as provided in paragraph (a)(1)(ii) of this section, gross 2013] recent developments in federal income taxation 681 income means the excess of the amount realized from the disposition of the property over the unrecovered cost or other basis of the property. consequently, except as provided in paragraph (a)(1)(ii) of this section, an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of section 6229(c)(2).‖ l. but the irs still suffers from a hangover in cases on which the extended statute had run before the effective date of the regulations. utam, ltd v. commissioner, t.c. memo. 2009-253 (11/9/09), rev’d, 645 f.3d 415 (d.c. cir. 6/21/11). judge kroupa followed bakersfield energy partners to hold that the statute of limitations is not extended to six years pursuant to § 6229(c)(2) or § 6501(e)(1)(a) as a result of a basis overstatement that causes gross income to be understated by more than 25 percent.  although the date of the decision was after the effective date of temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)1t, the result was dictated by prior law effective when the fpaa was issued in 1999. m. judge wherry shoves it up the commissioner all the way to his ―colon(-y)‖ in a reviewed tax court decision that holds the temporary regulations invalid. intermountain insurance service of vail v. commissioner, 134 t.c. 211 (5/6/10) (reviewed, 7-0-6), supplementing t.c. memo. 2009-195 (9/1/09) (granting summary judgment to the taxpayer, holding that a basis overstatement is not a substantial omission from gross income that triggers the six year extended statute of limitations under § 6229), rev’d, 650 f.3d 691 (d.c. cir. 6/21/11). on the irs‘s motions to reconsider and vacate in light of temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)-1t, the tax court (judge wherry) held that the supreme court‘s opinion in colony, inc. v. commissioner, 357 u.s. 28 (1958), ―‗unambiguously forecloses the [irs‘s] interpretation‘ . . . and displaces [the] temporary regulations.‖ the first ground was that the temporary regulations were specifically limited their application to ―taxable years with respect to which the applicable period for assessing tax did not expire before september 24, 2009,‖ and in this case that period was not open as of that date. the second ground was that the supreme court had held in colony that the statute was unambiguous in light of its legislative history and foreclosed temporary regulations to the contrary.  judges halpern and holmes concurred in the result. they stated that they were not persuaded by either of the majority‘s analyses, but that the temporary regulations should be invalidated on procedural grounds for failure to comply with the administrative procedure act‘s noticeand-comment requirement. 682 florida tax review [vol. 13:10 n. ―tax court, we‘ll see ya at high noon in front of the courts of appeals,‖ says the irs. t.d. 9511, definition of omission from gross income, 75 f.r. 78897 (12/17/10). the irs and treasury have finalized amendments to regs. §§ 301.6229(c)(2)-1 and 301.6501(e)-1, replacing temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)1t, t.d. 9466, definition of omission from gross income, 74 f.r. 49321 (9/28/09). the final regulations are identical to the temporary regulations in providing that for purposes of determining whether there is a substantial omission of gross income, gross income as it relates to a trade or business includes the total amount received from the sale of goods or services, without reduction for the cost of goods sold; gross income otherwise has the same meaning as under § 61(a).  the irs and treasury declared in the preamble that they believed that the tax court‘s decision in intermountain insurance service of vail v. commissioner, 134 t.c. 211 (5/6/10), invalidating the temporary regulations, was erroneous: the treasury department and the internal revenue service disagree with intermountain. the supreme court stated in colony that the statutory phrase ‗‗omits from gross income‘‘ is ambiguous, meaning that it is susceptible to more than one reasonable interpretation. the interpretation adopted by the supreme court in colony represented that court‘s interpretation of the phrase but not the only permissible interpretation of it. under the authority of nat‘l cable & telecomms. ass‘n v. brand x internet servs., 545 u.s. 967, 982–83 (2005), the treasury department and the internal revenue service are permitted to adopt another reasonable interpretation of ‗‗omits from gross income,‘‘ particularly as it is used in a new statutory setting.  according to the preamble, the final regulations have been clarified to emphasize that they only apply to open tax years and do not reopen closed tax years. however, the preamble states: the tax court‘s majority in intermountain erroneously interpreted the applicability provisions of the temporary and proposed regulations, which provided that the regulations applied to taxable years with respect to which ―the applicable period for assessing tax did not expire before september 24, 2009.‖ the internal revenue service will continue to adhere to the position that ―the applicable period‖ of limitations is not the ―general‖ three-year limitations period. . . . consistent with that position, the final regulations apply to taxable years with respect to which the 2013] recent developments in federal income taxation 683 six-year period for assessing tax under section 6229(c)(2) or 6501(e)(1) was open on or after september 24, 2009. o. and the government wins in the seventh circuit, without any help from the temporary regulations. beard v. commissioner, 633 f.3d 616 (7th cir. 1/26/11), rev’g t.c. memo 2009-184 (8/11/09). the seventh circuit, in an opinion by judge evans, reversed the tax court‘s decision that an overstatement of basis results in an omission of gross income that triggers the six year statute of limitations under § 6501(e)(1)(a). in a very carefully reasoned opinion, (but see the burks case, below) the court concluded that the supreme court‘s decision in colony, inc. v. commissioner, 357 u.s. 28 (1958) was not controlling. the seventh circuit reasoned that colony was both factually different – colony involved an overstatement of the basis of lots held by a real estate developer for sale to customers in the ordinary course of business, while the instant case involved an overstatement of basis in a partnership interest in a son-ofboss tax shelter transaction – and legally different because of changes between the 1939 code § 275(c), which was interpreted in colony and 1954 code § 6501(e). the court held that ―colony‘s holding is inherently qualified by the facts of the case before the court, facts which differ from our case, where the beards‘ omission was not in the course of trade or business.‖ from the perspective of statutory interpretation, the court focused on the impact of the addition of § 6501(e)(1)(b)(ii) in the 1954 code, which provides that ―in determining the amount omitted from gross income, there shall not be taken into account any amount which is omitted from gross income stated in the return if such amount is disclosed in the return, or in a statement attached to the return, in a manner adequate to apprise the secretary of the nature and amount of such item.‖ quoting phinney v. chambers, 392 f.2d 680 (5th cir. 1968), the court stated ―[w]e conclude that the enactment of subsection (ii) . . . of section 6501(e)(1)[(b)] makes it apparent that the six year statute is intended to apply where there is either a complete omission of an item of income of the requisite amount or misstating of the nature of an item of income which places the ―commissioner ... at a special disadvantage in detecting errors.‖ (emphasis supplied in original). even though it distinguished colony and concluded that it was ―left without precedential authority,‖ the court nevertheless concluded that because the language of § 6501(e)(1)(a) at issue in the case was identical to the language of § 275(c) interpreted in colony, it was required to interpret § 6501(e)(1)(a) in light of colony. however, it also reasoned that it must ―bear in mind‖ that congress did add subsections (i) and (ii) to § 6501(e)(1)(b) and that ―the section as a whole should be read as a gestalt.‖ in analyzing colony, the court noted that the supreme court had found § 275(c) to be ambiguous, but was more persuaded by the taxpayer‘s argument that focused on the word ―omits.‖ the seventh circuit noted that what colony ―does not address in depth is ‗gross 684 florida tax review [vol. 13:10 income‘ which is defined generally in section 61 of the code as ‗all income from whatever source derived,‘‖ but which is not defined in § 6501(e) except for the special definition in § 6501(e)(1)(b)(i) that applies to trade or business income. the court then went on to hold: using these definitions and applying standard rules of statutory construction to give equal weight to each term and avoid rendering parts of the language superfluous, we find that a plain reading of section 6501(e)(1)(a) would include an inflation of basis as an omission of gross income in non-trade or business situations. . . . it seems to us that an improper inflation of basis is definitively a ―leav[ing]out‖ from ―any income from whatever source derived‖ of a quantitative ―amount‖ properly includible. there is an amount — the difference between the inflated and actual basis — which has been left unmentioned on the face of the tax return as a candidate for inclusion in gross income.  the court was reinforced in its conclusion by the existence of § 6501(e)(1)(b)(i), reasoning that ―[i]f the omissions from gross income contemplated section 6501(e)(1)(a) were only specific items such as receipts and accruals, then the special definition in subsection (i) would be, if not superfluous, certainly diminished. the addition of this subsection suggests that the definition of gross income for the purposes of section 6501(e)(1)(a) is meant to encompass more than the types of specific items contemplated by the colony holding.‖ the seventh circuit considered bakersfield energy partners v. commissioner, 568 f.3d 767 (9th cir. 6/17/09), and salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09), to have been erroneously decided. finally, the court addressed the parties‘ arguments regarding the impact of temp. reg. § 301.6501(e)-1t(a)(1)(a). rather than ruling on the validity of the regulation, however, the court stated that because it did not find colony controlling and reached its decision that the six-year statute of limitations applied on the face of the code section, it would not reach the validity of the regulation. however, in dictum, the court stated that it would be inclined to grant deference to temp. reg. § 301.6501(e)1t(a)(1)(a), even though it was issued without notice and comment, citing barnhart v. walton, 535 u.s. 212 (2002), for the proposition that ―the absence of notice-and-comment procedures is not dispositive to the finding of chevron deference.‖ p. but the fourth circuit relied on colony to find for the taxpayer. home concrete & supply, llc v. united states, 634 f.3d 249 (4th cir. 2/7/11), aff’d, 132 s. ct. 1836 (4/25/12). the fourth circuit (judge wynn) held that colony decided that 1954 code § 6501(e)(1)(a) was unambiguous and that an overstated basis in property is 2013] recent developments in federal income taxation 685 not an omission from gross income that extends the limitations period. it further held that reg. § 301.6501(e)-1(e) by its plain terms did not apply to the tax year in this case because the six-year limitations period had expired before the regulation was issued. judge wynn stated: like the ninth and federal circuits, we hold that the supreme court in colony straightforwardly construed the phrase ―omits from gross income,‖ unhinged from any dependency on the taxpayer‘s identity as a trade or business selling goods or services. there is, therefore, no ground to conclude that the holding in colony is limited to cases involving a trade or business selling goods or services. . . . further, the supreme court‘s discussion of the legislative history behind former § 275(c) is equally compelling with regard to current § 6501(e)(1)(a). the language the court construed in former § 275(c) — ―omits from gross income an amount properly includable therein‖ — is identical to the language at issue in § 6501(e)(1)(a). because there has been no material change between former § 275(c) and current § 6501(e)(1)(a), and no change at all to the most pertinent language, we are not free to construe an omission from gross income as something other than a failure to report ―some income receipt or accrual.‖ . . . thus, we join the ninth and federal circuits and conclude that colony forecloses the argument that home concrete‘s overstated basis in its reporting of the short sale proceeds resulted in an omission from its reported gross income.  judge wynn concluded that the regulation was ―not entitled to deference.‖ q. as did the fifth circuit, which chided the seventh circuit for misinterpreting a fifth circuit case on which it relied in beard. burks v. united states, 633 f.3d 347 (5th cir. 2/9/11). the fifth circuit (judge demoss) also held that an overstatement of basis is not an omission from gross income for purposes of § 6501(e)(1)(a). judge demoss disagreed with the seventh circuit‘s interpretation of phinney v. chambers, 392 f.2d 680 (5th cir. 1968), as limiting colony, stating that ―the seventh circuit failed to note the distinct factual pattern presented in phinney, where the taxpayers had misstated the very nature of the item so that the irs would not have had any reasonable way of detecting the error on the tax return. that is not the case here.‖  in its final footnote, the court stated: although we hold that § 6501(e)(1)(a) is unambiguous and its meaning is controlled by the supreme court‘s decision in colony, we note that even if the statute 686 florida tax review [vol. 13:10 was ambiguous and colony was inapplicable, it is unclear whether the regulations would be entitled to chevron deference under mayo foundation for medical research v. united states, 131 s. ct. 704, 711 (2011). see, e.g., home concrete & supply, llc v. united states, [634 f.3d 249] (4th cir. feb. 7, 2011) (declining to afford the regulations chevron deference because the statute is unambiguous as recognized by the supreme court in colony). in mayo, the court held that the principles underlying its decision in chevron ―apply with full force in the tax context‖ and applied chevron to treasury regulations issued pursuant to 26 u.s.c. § 7805(a). id. at 707. significantly, in mayo the supreme court was not faced with a situation where, during the pendency of the suit, the treasury promulgated determinative, retroactive regulations following prior adverse judicial decisions on the identical legal issue. ―deference to what appears to be nothing more than an agency‘s convenient litigating position‖ is ―entirely inappropriate.‖ bowen v. georgetown univ. hosp., 488 u.s. 204, 213 (1988). the commissioner ―may not take advantage of his power to promulgate retroactive regulations during the course of a litigation for the purpose of providing himself with a defense based on the presumption of validity accorded to such regulations.‖ chock full o’ nuts corp. v. united states, 453 f.2d 300, 303 (2d cir. 1971). moreover, mayo emphasized that the regulations at issue had been promulgated following notice and comment procedures, ―a consideration identified . . . as a significant sign that a rule merits chevron deference.‖ 131 s. ct. at 714. legislative regulations are generally subject to notice and comment procedure pursuant to the administrative procedure act. see 5 u.s.c. § 553(b)(a). here, the government issued the temporary regulations without subjecting them to notice and comment procedures. this is a practice that the treasury apparently employs regularly. see kristin e. hickman, a problem of remedy: responding to treasury’s (lack of) compliance with administrative procedure act rulemaking requirements, 76 geo. wash. l. rev. 1153, 1158-60 (2008) (noting that the treasury frequently issues purportedly binding temporary regulations open to notice and comment only after promulgation and often denies the applicability of the notice and comment procedure when issuing its regulations because that 2013] recent developments in federal income taxation 687 requirement does not apply to regulations that are not a significant regulatory action, while continuing to assert that the regulations are entitled to legislative regulation level deference before the courts). that the government allowed for notice and comment after the final regulations were enacted is not an acceptable substitute for prepromulgation notice and comment. see u.s. steel corp. v. u.s. epa, 595 f.2d 207, 214-15 (5th cir. 1979). r. finally, a court that read colony very very carefully and understands what colony really said and what it really did not say. grapevine imports, ltd. v. united states, 636 f.3d 1368 (fed. cir. 3/11/11), rev’g 77 fed. cl. 505 (2007). the federal circuit, in a unanimous panel opinion by judge prost, reversed the court of federal claims holding that the six-year statute of limitations does not apply to an understatement of gross income attributable to a basis overstatement. the court of federal claims had relied on the supreme court‘s decision in colony, inc. v. commissioner, 357 u.s. 28 (1958). however, the court of appeals for the federal circuit applied reg. § 301.6229(c)(2)-1 and reg. § 301.6501(e)-1, after first concluding that the supreme court‘s opinion in mayo foundation for medical education and research v. united states, 131 s. ct. 704 (2011), unambiguously held that a subsequently promulgated treasury regulation could overrule a prior judicial decision (including a supreme court decision), as long as the regulation was valid under the standards of chevron, usa, inc. v. natural resources defense council, inc., 467 u.s. 837 (1984). preliminarily the court found that the regulations, ―state that colony did not conclusively resolve the statutory interpretation issue, and that overstatement of basis (outside the trade or business context) can trigger the extended limitations period.‖ a critical point in the court‘s reasoning was that the decision in colony did not hold that the language in question, which is the language that § 6501(e)(1) has in common with § 275(c) of the 1939 code that was at issue in colony, was unambiguous. [t]he supreme court expressly found the predecessor statute ambiguous, and turned to the legislative history to resolve the question. [colony, inc., 357 u.s. at 33] (―[i]t cannot be said that the language [of the statute] is unambiguous.‖). and while it is true that the court later referred to the updated § 6501(e)(1)(a) as ―unambiguous,‖ it did not rely or elaborate on that statement, nor was the updated statute at issue in that case. . . . further, in colony the taxpayer was in the business of land sales, so § 6501(e)(1)(a)(i)‘s test for income ―in the case of a trade or business‖ expressly applied. that is not the case here. the ambiguity concerns what to do outside the trade and business context, and the 688 florida tax review [vol. 13:10 only language in § 6501(e)(1)(a) applicable outside the trade or business context is the same language from the predecessor statute, ―omits from gross income an amount.‖ the supreme court previously noted that this term was ambiguous as to whether it encompassed an overstated basis. we therefore find colony no bar to our finding that the text of the relevant statutes, standing alone, is ambiguous as to the disposition of this issue.  turning to chevron step one analysis, the court of appeals concluded that §§ 6229(c)(2) and 6501(e) are ambiguous, and that the treasury thus ―is entitled to promulgate its own interpretation of these statutes, and to have that interpretation given deference by the courts so long as it is within the bounds of reason.‖ [t]he tax code‘s use of the term ―omits‖ suggests that the section is primarily addressed to the return where the taxpayer has ―fail[ed] to include or mention‖ or ―le[ft] out‖ some item rather than misrepresenting it (as by an overstatement of basis). . . . but without looking beyond the text itself, we cannot say that the statute forecloses the possibility that a taxpayer‘s overstated basis might constitute an omission from gross income.  turning to the second step of the chevron analysis, which asks whether the regulations constitute ―a reasonable policy choice for the agency to make,‖ the court concluded that the regulations are reasonable, even though they depart from the judicial interpretation of colony and salman ranch, ltd. v. united states, 573 f.3d 1362 (fed. cir. 2009). next, the court rejected the taxpayer‘s arguments that the regulations were invalid because they were ―retroactive,‖ noting that in automobile club of michigan v. commissioner, 353 u.s. 180 (1957), the supreme court confirmed that § 7805(b) authorizes retroactive regulations. the court also rejected an argument by the taxpayer – one which we confess not to understand – that the statute of limitation expired upon the entry of judgment by the court of federal claims, notwithstanding rules tolling the period of limitations during a pending appeal. finally, based on supreme court precedent, the court rejected the taxpayer‘s claim that the treasury did not have the power to affect the outcome of the appeal by promulgating regulations after the trial court decision and before the appeal was heard. s. did anyone really expect the tax court to roll over and play dead just because the irs promulgates regulations that say it wins? carpenter family investments, llc v. commissioner, 136 t.c. 373 (4/25/11). in a reviewed opinion by judge wherry, in which only four other judges joined, but with a number of concurrences and no dissents, 2013] recent developments in federal income taxation 689 the tax court once again held that the six year statute of limitations under §§ 6501(e) and 6229(c)(2) do not apply to understatements of gross income attributable to basis overstatements. in doing so the court held that final reg. §§ 301.6501(e)-1t and 301.6229(c)(2)-1t are invalid, just as it had held in intermountain insurance service of vail v. commissioner, 134 t.c. 211 (5/6/10), that temp. reg. §§ 301.6501(e)-1t and 301.6229(c)(2)-1t were invalid. noting that the case was appealable to the ninth circuit, in which bakersfield energy partners, lp v. commissioner, 568 f.3d 767 (9th cir. 6/17/09), is the controlling precedent, the tax court followed the line of reasoning previously applied by it, bakersfield energy partners, and some other courts, that the supreme court‘s decision in colony, inc. v. commissioner, 357 u.s. 28 (1958), was not limited to situations involving a trade or business and that it controlled the interpretation of § 6501(e)(1)(a). the court then turned to whether reg. §§ 301.6501(e)-1t and 301.6229(c)(2)-1t were entitled to deference under chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), and mayo foundation for medical research v. united states, 131 s. ct. 704, 711 (1/11/11), and determined that they were not entitled to deference. in this context the court observed that mayo ―focuses exclusively on the statutory text at chevron step one and suggests (by negative implication) a disfavor of using legislative history at that stage. we are not persuaded, however, that after mayo, any judicial construction that examines legislative history is automatically relegated to a chevron step two holding by that fact alone.‖ in proceeding to analyze whether under the authority of nat’l cable & telecomms. ass’n v. brand x internet servs., 545 u.s. 967 (2005), the treasury department and the irs have the power to promulgate regulations overturning prior court decision, the court appears first to have concluded that ―only if an ‗unwise judicial construction‘ represents a policy choice, must it yield to ‗the wisdom of the agency‘s policy.‘‖ in the end, however, the court appears also to have grounded its decision on what it perceived to be ambiguities in the preamble of t.d. 9511, which promulgated the regulations at issue and which the court infers did not strongly enough invoke a power under brand x as the basis for promulgating the regulations. the final passage of its reasoning as follows: even if we read the supreme court‘s recent mayo opinion as a license to categorize most judicial constructions that discuss legislative history as chevron step two decisions, respondent has yet to unabashedly accept the court of appeals for the ninth circuit‘s invitation and issue regulations that unequivocally repudiate the colony holding. unless and until he does so, his hands must remain tied.  judge thornton‘s concurring opinion, with which judges cohen, halpern, holmes, and paris agreed, would have decided the case solely on the grounds that the result ―follows from the 690 florida tax review [vol. 13:10 unambiguous terms of the statute,‖ and there is no compelling reason for the tax court to abandon its precedents.  judges halpern and holmes joined in another concurring opinion discussing the scope and meaning of chevron and brand x. t. and the tenth circuit also likes the way the irs thinks. salman ranch, ltd. v. commissioner, 647 f.3d 929 (10th cir. 5/31/11). in a case involving a different tax year for the taxpayer, the federal circuit held, (see e. and f., above) that the extended statute of limitations did not apply to this partnership for its 1999 year. subsequently, in grapevine imports, ltd. v. united states, 636 f.3d 1368 (fed. cir. 3/11/11) (see r., above) the federal circuit overruled its pro-partnership decision in the 1999 salman ranch case. in this separate case for this partnership‘s 2001 and 2002 years, the tax court had held collateral estoppel required summary judgment be granted for the partnership. the tenth circuit (judge seymour) reversed and remanded, holding that collateral estoppel was inapplicable because of an intervening change in law, i.e., the final regulations (see n., above). judge seymour based his decision that the final regulations were entitled to chevron deference based upon the supreme court‘s holdings in mayo foundation for medical education and research v. united states, 131 s. ct. 713 (1/11/11), and refused to follow contrary authority among the cases discussed above. u. and the government chalks up another victory in front of a panel that really understands the proposition for which colony stands and the propositions for which it really does not stand [or, does it?]. intermountain insurance service of vail v. commissioner, 650 f.3d 691 (d.c. cir. 6/21/11). after a thorough examination of the history of § 275(c) of the 1939 code, the pre-colony litigation, the colony decision itself, the enactment of § 6501(e), the relevant changes from § 275(c), and the recent cases on the issue, and the promulgation of reg. §§ 301.6501(e)-1t(a)(iii) and 301.6229(c)(-1t)(a)(iii), the court of appeals for the district of columbia, in an opinion by judge tatel, reversed the tax court and, with a healthy spread of mayo upheld the regulations, and dismissed the taxpayer‘s [tautological, in our opinion] argument, which was accepted by the tax court (and a few other courts) that the regulations by the terms of their effective date were inapplicable to the transaction in question. the court‘s opinion carefully explains the source of the statutory ambiguity and why colony did not state that the relevant language was unambiguous, rejecting the less well reasoned opinions of those courts that found colony to have held that the statutory provision was unambiguous. going a step further, the court concluded that colony simply 2013] recent developments in federal income taxation 691 did not apply to either § 6501(e) or § 6229(c)(2), and that under chevron it was an easy call to uphold the substance of the regulations, while under mayo there were no procedural problems with the manner in which the regulations were promulgated. however, the court of appeals remanded the case to the tax court to consider intermountain‘s alternative argument that intermountain avoided triggering the extended statute of limitations by ―adequately disclos[ing] to the irs the basis amount it applied in connection with the transaction at issue.‖ v. let‘s play that tune again. utam, ltd v. commissioner, 645 f.3d 415 (d.c. cir. 6/21/11). the court of appeals for the district of columbia, in a very brief opinion by judge randolph, reversed the tax court decision (see l., above) on the basis of the court‘s holding in intermountain insurance service of vail v. commissioner, 650 f.3d 691 (d.c. cir. 6/21/11). although the tax court did not reach the issue of whether § 6229(c) suspends the individual partner‘s § 6501 limitations period when that period is open on the date the irs mailed the fpaa, the court of appeals found that a remand on this issue would not serve a useful purpose. under d.c. circuit‘s opinion in andantech, l.l.c. v. commissioner, 331 f.3d 972 (d.c. cir. 2003), the assessment period suspended by § 6229(d) is the partner‘s open assessment period under § 6501. thus, the statute of limitations had not run. w. the fifth circuit stands by its burks holding, and the government is ready to talk to the supreme court. r and j partners v. commissioner, 441 fed. appx. 271 (5th cir. 9/19/11). in a per curiam opinion, the fifth circuit followed burks v. united states, 633 f.3d 347 (5th cir. 2011), to hold that the six year statute of limitations of § 6501(e) does not apply to basis overstatements and that reg. § 301.6501(e)-1 is invalid.  the court noted that ―[t]he commissioner agrees that burks controls the law in the circuit on that question and that the tax court correctly applied that law, but took this protective appeal in an effort to obtain a review by the supreme court.‖ however, the supreme court did not grant certiorari in this case. x. and now the supremes will sing †♬♪ ―nothing but heartaches‖ ♬♪! but will the song be dedicated to the taxpayer or the government? the supreme court granted certiorari to the fourth circuit in home concrete & supply, llc v. united states, 634 f.3d 249 (4th cir. 2/7/11), cert. granted, 132 s. ct. 71 (9/27/11). it declined invitations from the government to consider cases from the fifth and seventh circuits. 692 florida tax review [vol. 13:10 y. taxpayer wins in the supreme court, 41-4. united states v. home concrete and supply, llc, 132 s. ct. 1836 (4/25/12). in an opinion by justice breyer, a former law professor in the administrative law area, the supreme court held that there is no extension of the three-year statute of limitations under § 6501(e)(1)(a) ―when the taxpayer overstates his basis in the property that he has sold, thereby understating the gain that he received from its sale.‖ justice breyer rested this conclusion on the precedential value of colony, inc. v. commissioner, 357 u.s. 28 (1958), which construed identical operative language in the 1939 code counterpart to current § 6501(e)(1)(a), and concluded that the statute‘s scope is limited ―to situations in which specific receipts or accruals of income are left out of the computation of gross income,‖ and that the word ―omits‖ (unlike, say, ―reduces‖ or ―understates‖) means ―‗[t]o leave out or unmentioned; not to insert, include, or name.‘‖ he rebutted the government argument that because the colony opinion stated ―it cannot be said that the language is unambiguous,‖ there is room for a regulation that is a ―permissible construction,‖ stating: we do not accept this argument. in our view, colony has already interpreted the statute, and there is no longer any different construction that is consistent with colony and available for adoption by the agency.  the test stated in the plurality opinion – justice scalia did not join the court‘s opinion on this point – was whether congress delegated ―gap-filling authority‖ to the agency. justice breyer‘s opinion stated that the colony opinion, including its examination of the legislative history to the statute, concluded that congress ―had decided the question definitively, leaving no room for the agency to reach a contrary result.‖  justice scalia‘s concurring opinion would have overruled the national cable & telecommunications assn. v. brand x internet services, 545 u.s. 967 (2005), holding that ―a ‗prior judicial construction,‘ unless reflecting an ‗unambiguous‘ statute, does not trump a different agency construction of that statute.‖  four justices dissented in an opinion by justice kennedy on the ground that the 1954 code amendments to the statute created inferences that would have permitted the treasury to promulgate its contrary regulations. justice breyer dismissed this position in part by stating that to rely on one of these changes ―is like hoping that a new batboy will change the outcome of the world series.‖  has the court cut the hair of brand x and mayo? in invalidating the regulations, the court held that a regulation can validly trump a prior judicial interpretation of a statute only if the ―statute‘s silence or ambiguity as to a particular issue means that congress has not 2013] recent developments in federal income taxation 693 ‗directly addressed the precise question at issue‘ (thus likely delegating gapfilling power to the agency).‖ the court noted that in chevron it stated that ―[i]f a court, employing traditional tools of statutory construction, ascertains that congress had an intention on the precise question at issue, that intention is the law and must be given effect.‖ this logic in logic in home concrete is somewhat tautological because it presumes that it is for agencies, through regulations — not courts, through judicial decisions — to fill gaps in the statute, but then states that if a court has already interpreted the statute in the absence of a regulation, then the court, per force, has ascertained congressional intent, and there is no gap in the statute remaining to be filled by regulations. moreover, the court‘s opinion is ambiguous with respect to which court‘s prior decision cannot be overturned by regulations — does this principle apply only to supreme court decisions, or dos it extend to lower courts decisions as well? are courts of appeals decisions different than trial court decisions? what about tax court, or even district court, decisions? even more troubling is how this principle applies to splits between lower courts; for example, if the irs prevails in the tax court but the decision is reversed on appeal, what are the limits on the treasury department‘s power to enshrine its tax court victory in regulations. 2. tolling is personal; it can‘t be inherited. murdock v. united states, 103 fed. cl. 389 (2/9/12). the trustee of a deceased taxpayer‘s trust filed tax returns for the deceased taxpayer for the years 2001-2006, for which the taxpayer, who had died on may 4, 2006, had not filed returns. the trustee did not discover that no returns had been filed until january 2009, and did not file the returns until september 2009. taxes had been withheld by the government on pension payments. in an attempt to avoid the limitations of § 6511(b)(2), the trustee argued that the tolling of the period of limitations on refunds under § 6511 applied because the taxpayer‘s failure to file returns was ―attributable to his advanced age, medical ailments, and alcoholism.‖ the court (judge lettow) rejected the trustee‘s claim, holding that § 6511(h) tolls the period of limitations only during the taxpayer‘s lifetime; ―if the financially disabled taxpayer is no longer alive, subsection 6511(h) can no longer apply and the statutory clock must begin to run.‖ thus, the three year look-back period had expired in may 2009. f. liens and collections 1. you can‘t tell the filing period deadline without a scorecard. gray v. commissioner, 138 t.c. no. 13 (3/28/12). the tax court (judge gale) followed raymond v. commissioner, 119 t.c. 191 (2002), holding that where a taxpayer raises § 6015 relief in a § 6330 cdp hearing, and the notice of determination included a determination that the taxpayer was not entitled to § 6015 relief, a tax court petition, filed more 694 florida tax review [vol. 13:10 than 30 days, but within 90 days, after the issuance of the notice of determination, was timely for purposes of conferring jurisdiction on the tax court to determine the appropriate § 6015 relief. however, barnes v. commissioner, 130 t.c. 248 (2008), held that a second request for § 6015(f) relief from an underpayment that was essentially duplicative of an earlier request for which a final determination had been issued did not confer jurisdiction on the tax court under § 6015(e)(1)(a). on the basis of the record developed in this case, the court was unable to determine whether the claim for § 6015 relief that the taxpayer raised at her cdp hearing is ―sufficiently dissimilar‖ from the claim for which she received an earlier final determination, and further proceedings were necessary to determine whether jurisdiction exists. on a second issue, the court held that the petition was timely for purposes of conferring jurisdiction under § 6404(h)(1) to determine whether the irs‘s determination not to abate interest, which was requested by the taxpayer in the cdp hearing, was an abuse of discretion. the notice and petition conferred jurisdiction under § 6404(h) that was independent of § 6330. insofar as the petition sought review under § 6404(h) of the irs‘s failure to abate interest, it was timely because it was filed within 180 days of the final determination not to abate interest. 2. ca-ching! the irs collects twice. weber v. commissioner, 138 t.c. no. 18 (5/7/12). in 2007 the taxpayer filed an income tax return for 2006 reporting an overpayment and elected to have it applied to his 2007 estimated income tax. however, the irs had determined that the taxpayer was liable for a § 6672 penalty and instead applied the income tax overpayment to that penalty liability. in 2008 the trust fund tax liability was satisfied by third-party payments, and when thereafter the taxpayer filed his 2007 income tax return, he claimed a credit for the overpaid 2006 income tax, thereby reporting a 2007 income tax overpayment, and elected to have that asserted 2007 overpayment applied to his 2008 estimated income tax. the irs adjusted the 2007 credits downward to eliminate the claimed 2006 income tax overpayment, thereby eliminating the overpayment for 2007, resulting in a balance due. this pattern was repeated when the taxpayer filed his 2008 income tax return in 2009, when he again claimed a credit for earlier overpaid income tax. when the taxpayer did not pay the balance due, the irs issued a notice of proposed levy, and the taxpayer requested a cdp hearing. at the cdp hearing the taxpayer argued that the § 6672 penalty had been overpaid and that his income tax liability would be satisfied if that overpayment were applied to his income tax liability. the irs rejected his argument and determined to proceed with the levy. the tax court (judge gustafson) held that the taxpayer was not entitled to apply the earlier income tax overpayment to his later income tax liability, because after application of the income tax overpayment to the 2013] recent developments in federal income taxation 695 § 6672 penalty liability, there was no 2006 overpayment available. furthermore, in reviewing the cdp hearing, the tax court lacked jurisdiction to adjudicate the taxpayer‘s claim of a § 6672 penalty overpayment. section 6330 — the statute conferring cdp jurisdiction on the tax court — has no provision conferring and delimiting any overpayment jurisdiction. finally, the opinion described the many administrative problems that would arise from allowing a person against whom a § 6672 penalty had been assessed and collected to seek a credit (or refund) based on the assertion that the penalty had been ―over-collected.‖ 3. the whole is greater than the sum of the parts. lewis v. commissioner, t.c. memo. 2012-138 (5/16/12). in this review of an irs cdp determination to proceed with a levy, judge paris held that the irs had abused its discretion. ―while each individual defect on its own may be insufficient to support a holding that [the irs] abused [its] discretion, the cumulative effect of such defects demonstrates that [the irs] acted both arbitrarily and capriciously in rendering [its] determination.‖ the irs‘s argument sought ―to quilt together a string of exceptions to account for [the] deviation from what one would consider a thorough review of [the taxpayer‘s] case. . . . accordingly, the court holds that the [irs] abused [its] discretion in sustaining the proposed levy.‖ 4. cdp hearings raising the issue of liability for tax at a cdp doesn‘t require antique common law pleading by the taxpayer. fielder v. commissioner, t.c. memo. 2012-284 (10/4/12). the tax court (judge laro) rejected the irs‘s argument that a taxpayer was precluded from challenging his liability for taxes in a cdp hearing because he did not raise the issue in the form 12153 hearing request. neither the statute nor tax court case law requires a taxpayer to raise the liability issue in the request for a cdp hearing. the statutory rule only limits the taxpayer‘s ability to contest the underlying tax liability at the cdp hearing if the taxpayer did not receive a notice of deficiency or otherwise had a prior opportunity to dispute the tax liability. the statute does not specify the time for raising the issue. the underlying liability should be considered if a taxpayer raises it at any time during a cdp hearing. g. innocent spouse 1. the irs is attempting to be more equitable in granting innocent spouse relief. notice 2012-8, 2012-4 i.r.b. 309 (1/6/12). this notice provides a proposed revenue procedure that will supersede rev. proc. 2003-61, 2003-2 c.b. 296, which provides guidance regarding § 6015(f) relief from joint and several liability. the factors used in making § 6015(f) innocent spouse relief determinations will be revised ―to ensure 696 florida tax review [vol. 13:10 that requests for innocent spouse relief are granted under section 6015(f) when the facts and circumstances warrant and that, when appropriate, requests are granted in the initial stage of the administrative process.‖ the revenue procedure expands how the irs will take into account abuse and financial control by the nonrequesting spouse in determining whether equitable relief is warranted, because when a requesting spouse has been abused by the nonrequesting spouse, the requesting spouse may not have been able to challenge the treatment of any items on the joint return, question the payment of the taxes reported as due on the joint return, or challenge the nonrequesting spouse‘s assurance regarding the payment of the taxes. furthermore, a lack of financial control may have a similar impact on the requesting spouse‘s ability to satisfy joint tax liabilities. thus, the proposed revenue procedure provides that abuse or lack of financial control may mitigate other factors that might otherwise weigh against granting § 6015(f) equitable relief. the proposed revenue procedure also provides for certain streamlined case determinations; new guidance on the potential impact of economic hardship; and the weight to be accorded to certain factual circumstances in determining equitable relief.  until the revenue procedure is finalized, the irs will apply the provisions in the proposed revenue procedure instead of rev. proc. 2003-61 in evaluating claims for equitable relief. but if a taxpayer would receive more favorable treatment under one or more of the factors provided in rev. proc. 2003-61 and so advises the irs, the irs will apply those factors from rev. proc. 2003-61, until the new revenue procedure is finalized. a. the tax court tells the irs that even if it wants to make a taxpayer favorable change to a revenue procedure, it needs to finalize it, not just publish a proposed revenue procedure. deihl v. commissioner, t.c. memo. 2012-176 (6/21/12). the tax court (judge marvel) declined to apply the provisions of the proposed revenue procedure set forth in notice 2012-8, 2012-4 i.r.b. 309, in determining whether the taxpayer was entitled to equitable relief under § 6015(f) and instead applied rev. proc. 2003-61, 2003-2 c.b. 296, ―in view of the fact that the proposed revenue procedure is not final and because the comment period under the notice only recently closed.‖ it did however note ―where appropriate how the analysis used in rev. proc. 2003-61 . . . would change if the proposed revenue procedure in notice 2012-8 . . . had actually been finalized.‖ but on the facts the proposed changes did not affect the conclusion that relief was not warranted. 2. an irs levy on a joint account doesn‘t trump a spouse‘s right to seek § 6015(g) relief. minihan v. commissioner, 138 t.c. 1 (1/11/12). at the time the taxpayer was seeking tax court review of the 2013] recent developments in federal income taxation 697 irs‘s denial of § 6015(g) relief, the irs levied on a joint bank account owned by the taxpayer‘s husband and the taxpayer to satisfy the tax liability. at that time collection against the taxpayer was suspended pursuant to § 6015(e)(1)(b). judge gustafson held that because under state law the taxpayer owned one-half of the funds in the bank account, she was not precluded from seeking a refund of one-half of the funds in the account if she prevailed on the § 6015(f) relief issue. while a taxpayer who is relieved from joint and several liability under § 6015(f) in a tax court proceeding is not entitled to a refund under § 6015(g)(1), unless the taxpayer made an overpayment, if the taxpayer prevailed, the levy on her one-half of the bank account funds would constitute an overpayment as defined in § 6402(a). although united states v. nat’l bank of commerce, 472 u.s. 713 (1985), held that the irs can lawfully levy on a joint bank account to satisfy one account holder‘s individual tax liability, that levy is conditional, and it does not extinguish a third party‘s rights in levied property. the court then concluded that the rights of an ―innocent spouse‖ who claims a refund under § 6015(g)(1) survive post-levy in the same way that the rights of a § 7426 or § 6343(b) wrongful levy claimant survive. accordingly, the irs was denied summary judgment, and whether mrs. minihan deserved § 6015(f) relief was a matter for trial. h. miscellaneous 1. the whistleblower made no noise, and kept his (?) identity secret. whistleblower 14106-10w v. commissioner, 137 t.c. no. 15 (12/8/11). in a reviewed opinion by judge thornton, the tax court granted summary judgment for the irs in this case in which a whistleblower appealed the irs‘s denial of a reward. the irs filed the affidavit of a chief counsel attorney ―declaring, on the basis of his review of respondent‘s administrative and legal files and on the basis of conversations with relevant irs personnel, that the information petitioner provided resulted in respondent‘s taking no administrative or judicial action against x or collecting from x any amounts of tax, interest, or penalty,‖ and the whistleblower did ―not set forth, by affidavits or otherwise, any specific facts showing that there [was] a genuine issue for trial.‖ the court granted the whistleblower‘s request for anonymity and redaction from the record of any identifying information because the potential harm from disclosing the whistleblower‘s identity as a confidential informant outweighed the public interest in knowing the whistleblower‘s identity in a case decided on summary judgment for the irs denying an award. because granting the request for anonymity and redaction adequately protected the whistleblower‘s privacy interests as a confidential informant, the motion to seal the record was denied. 698 florida tax review [vol. 13:10 a. calculating collected proceeds in calculating whistleblower awards. t.d. 9580, rewards and awards for information relating to violations of internal revenue laws, 77 f.r. 10370 (2/22/12). the treasury department promulgated final regulations relating to the payment of rewards under § 7623(a) for detecting underpayments or violations of the internal revenue laws and whistleblower awards under § 7623(b) that amend reg. § 301.7623-1. the amendments clarify the definitions of proceeds of amounts collected and collected proceeds and provide that the provisions of reg. § 301.7623-1(a) concerning refund prevention claims are applicable to claims under § 7623(a) and (b). ―[b]oth proceeds of amounts collected and collected proceeds include: tax, penalties, interest, additions to tax, and additional amounts collected by reason of the information provided; amounts collected prior to receipt of the information if the information provided results in the denial of a claim for refund that otherwise would have been paid; and a reduction of an overpayment credit balance used to satisfy a tax liability incurred because of the information provided.‖ b. you could be the next one to strike it rich by ratting out your employer. irs summary award report, 9/11/12. the irs whistleblower office recommended a payment of $104 million to former ubs banker bradley birkenfeld based on his 2009 claim under § 7623(b). the non-redacted portion of the recommendation read: birkenfeld provided information on taxpayer behavior that the irs had been unable to detect, provided exceptional cooperation, identified connections between parties to transactions (and the methods used by ubs ag), and the information led to substantial changes in ubs ag business practices and commitment to future compliance. the actions against ubs ag and the attendant publicity also contributed to other compliance programs. each of these factors could support an increase in the award percentage above the statutory minimum. the comprehensive information provided by the whistleblower was exceptional in both its breadth and depth. while the irs was aware of tax compliance issues related to secret bank accounts in switzerland and elsewhere, the information provided by the whistleblower formed the basis for unprecedented actions against ubs ag, with collateral impact on other enforcement activities and a continuing impact on future compliance by ubs ag. 2013] recent developments in federal income taxation 699 c. no relief for an uncompensated whistleblower when the irs closes its ears to the whistle. cohen v. commissioner, 139 t.c. no. 12 (10/9/12). in a case of first impression, the tax court (judge kroupa) held that no relief is available to a whistleblower under § 7623(b) when the irs denies a claim without initiating an administrative or judicial action or collecting proceeds. the taxpayer‘s argument that the irs abused its discretion by not acting on his information was rejected. d. more comprehensive proposed regulations on how to get rich ratting out tax cheats. reg–141066–09, awards for information relating to detecting underpayments of tax or violations of the internal revenue laws, 77 f.r. 74798 (12/18/12). the treasury department has published detailed comprehensive proposed regulations regarding whistleblower awards under section § 7623 to replace the current final regulations that are only slightly more than one year old. the proposed regulations provide guidance on eligibility and submitting information to the irs and filing claims for award with the whistleblower office that are intended to clarify the process individuals should follow to be eligible to receive whistleblower awards; the proposed regulations in large part, track the existing regulations. a claimant must provide the name of the taxpayer and specific facts and documents to support the claim. the proposed regulations reaffirm the practice of treasury and the irs to safeguard the identity of whistleblowers whenever possible. the definitions of proceeds of amounts collected and collected proceeds in the proposed regulations build on the definitions in the existing regulations, but some definitions, such as ―related actions,‖ are new. the definition of ―collected proceeds‖ restates the rule from those final regulations that collected proceeds include: tax, penalties, interest, additions to tax, and additional amounts collected because of the information provided; amounts collected prior to receipt of the information provided if the information results in the denial of a claim for refund that otherwise would have been paid; and a reduction of an overpayment credit balance used to satisfy a tax liability incurred because of the information provided. prop. reg. § 301.7623–3 describes the administrative proceedings applicable to claims whistleblower awards. prop. reg. § 301.7623-4 provides the framework and criteria that the whistleblower office will use in exercising its discretion to make awards. the proposed regulations are consistent with, and build on, the award determination provisions provided in the internal revenue manual. the proposed regulations will be effective upon finalization. 2. new tax court proposed rules (12/28/11). in december of 2011, the united states tax court proposed amendments to its 700 florida tax review [vol. 13:10 rules of practice and procedure. comments in writing were due by 2/27/12. the proposals include: (1) amending rule 23 to: (a) reduce the number of copies required for papers filed with the court, (b) delete the nonproportional font requirement for papers filed with the court, and (c) revise the language regarding the court‘s return of documents; (2) deleting rule 175, as the number of copies required for papers filed with the court in small tax cases would be the same as in all other cases; (3) amending rule 26 to require electronic filing by most attorneys; (4) amending rules 70 and 143 to conform the court‘s rules to rule 26(a)(2)(b) of the federal rules of civil procedure, regarding the contents of expert witness reports, rule 26(b)(3) of the federal rules of civil procedure, regarding work product protections, and revisions to rule 26(b)(4) of the federal rules of civil procedure, limiting discovery of draft expert witness reports and trial preparation communications and materials; (5) amending rule 121, summary judgment, to conform the rule with revisions to rule 56 of the federal rules of civil procedure; (6) amending rule 155 to clarify that computations may be filed in conjunction with dispositive orders; (7) amending rule 241, commencement of partnership actions, so that its notice provisions are consistent with those of reg. § 301.6223(g)-1(b)(3); (8) adopting new rule 345 to provide privacy protections in whistleblower cases; (9) amending various rules to make conforming changes; and (10) providing new form 18 in recognition of 28 u.s.c. sec. 1746, which allows an unsworn declaration to substitute for an affidavit. a. the proposed rules were adopted effective 7/6/12. 3. just because the case was an s case doesn‘t entitle the taxpayer to a mulligan. or, in other words, if you don‘t want an adverse decision in an s case, which would be res judicata, hire john w. davis to represent you in the s case. koprowski v. commissioner, 138 t.c. 54 (2/6/12). in a reviewed decision by judge gustafson, the tax court held (with no dissents) that res judicata attaches to final decisions in a small tax case and bars relitigation of a liability determined in such a case. in this 2013] recent developments in federal income taxation 701 case the taxpayer was not allowed to relitigate a clam for innocent spouse relief that could have been raised in earlier small case regarding the deficiency.  in a concurring opinion, judge holmes noted that ―the same result will certainly follow when the [tax] court finally addresses the question of whether decisions in s cases collaterally estop losing parties from relitigating the same issues in later cases.‖ 4. updating the ―independence‖ of appeals. rev. proc. 2012-18, 2012-10 i.r.b. 455 (2/15/12). this revenue procedure provides comprehensive guidance in narrative format regarding ex parte communications between appeals and other irs functions. rev. proc. 200043, 200-2 c.b. 404 was amplified, modified and superseded. 5. irs provides ―fresh start‖ penalty relief for the faltering self-employed and the unemployed. ir-2012-31 (3/7/12). relief for the failure-to-pay penalty of 0.5 percent per month (up to a maximum of 25 percent) is provided for otherwise compliant taxpayers who are either wage earners who have been unemployed for at least 30 days during 2011 and 2012 (up to the 4/17/12 filing deadline) or self-employed people who experienced a 25 percent or greater reduction in business income due to the economy. the announcement also doubles the dollar threshold for tax balance due amount that qualifies for the streamlined installment agreement program from $25,000 to $50,000 and raises the term for such agreements from five years to six years; these programs can be set up on the irs website without the filing of form 433-a or form 433-f financial statements. a. the irs announces more flexible offerin-compromise terms. ir-2012-53 (5/21/12). the irs announced an expansion of its ―fresh start‖ initiative that would enable taxpayers to revise their tax problems in as little as two years (compared to the four or five years in the past). the changes include: (1) revising the calculation for the taxpayer‘s future income; (2) allowing taxpayers to repay their student loans; (3) allowing taxpayers to pay state and local delinquent taxes; and (4) expanding the allowable living expense allowance category and amount. 6. no evidence of this, no evidence of that, no memory of anything — how in the world did this taxpayer expect to prove that it actually had filed a refund claim? maine medical center v. united states, 675 f.3d 110 (1st cir. 3/30/12). the issue in this case was whether an administrative refund claim had been timely filed. no one could locate a certified mail receipt or return receipt. no agent of the taxpayer had a specific memory of mailing the claim, and no one was aware of the identity 702 florida tax review [vol. 13:10 of the postal service employee who would have dealt with the mailing of the claim. the irs asserted that it has no record of ever receiving the claim. the first circuit (judge stahl) held that reg. § 301.7502-1(e), promulgated in 2011, forecloses the use of extrinsic evidence – not that there really could have been any such evidence after all of the things about which there was no evidence had been ascertained – as a means of proving a timely postmark. thus there was no jurisdiction to hear a refund suit. the court acknowledged that in cases decided before the promulgation of reg. § 301.7502-1(e), see anderson v. united states, 966 f.2d 487 (9th cir. 1992); estate of wood v. commissioner, 909 f.2d. 1155 (8th cir. 1990), other circuits had held that a taxpayer was entitled to prove via extrinsic evidence that its refund claim had a timely postmark, but described the holding in those cases as limited to allowing the extrinsic evidence to give rise to the common law presumption of delivery in a § 7502 context and were thus not applicable because there was no evidence that the irs ever received the refund claim. 7. a zero return is a nothing. waltner v. united states, 679 f.3d 1329 (fed. cir. 4/19/12). the federal circuit (judge prost) held that amended returns showing zeros for all income items and income taxes withheld were not a valid tax returns, and hence not valid administrative refund claims. thus there was no jurisdiction to hear a refund suit. 8. the constitution does not require appeals officers for cdp hearings to be appointed by the president. tucker v. commissioner, 676 f.3d 1129 (d.c. cir. 4/20/12), aff’g 135 t.c. 114 (7/26/10). the taxpayer requested a cdp hearing after the irs issued a notice of filing of a tax lien. after the settlement officer had upheld the tax lien notice, the taxpayer requested a remand for a hearing to be heard by an officer appointed by the president or the secretary of the treasury, in compliance with the appointments clause of u.s. const., art. ii, sec. 2, cl. 2. the tax court (judge gustafson) held that an ―officer or employee‖ or an ―appeals officer‖ under § 6320 or § 6330 is not an ―inferior officer of the united states‖ for purposes of the appointments clause. they are instead properly hired, pursuant to § 7804(a), under the authority of the commissioner of internal revenue. the taxpayer‘s motion to remand was denied. in an opinion by judge williams, the court of appeals for the district of columbia affirmed the tax court‘s decision. ―[t]o be an ‗officer of the united states‘ covered by article ii, a person must ‗exercis[e] significant authority pursuant to the laws of the united states.‘‖ however, ―appeals employees‘ discretion is highly constrained. . . . [t]he significance and discretion involved in the decisions seem well below the level necessary to require an ‗officer.‘‖ 2013] recent developments in federal income taxation 703 9. just as a taxpayer is not required to file an amended return, the irs is not required to accept and process an amended return. roberts v. commissioner, t.c. memo. 2012-144 (5/21/12). the taxpayer filed a return for 2007 reporting zero taxable income and $6,000 of withheld taxes. the irs processed the return and applied the $6,000 overpayment to the taxpayer‘s unpaid 1983 tax liability. subsequently, the taxpayer filed an amended return for 2007 reporting nearly $59,000 of taxable income, but the irs did not process the amended return. instead the irs sent a deficiency notice with respect to the same amounts reported on the amended return, and did not credit the $6,000 withholding against the 2007 taxes. the taxpayer argued that was improper for the irs to apply the overpayment claimed on his original 2007 return to a prior year tax liability, but the tax court (judge foley) was unimpressed by the argument. petitioner further contends that respondent was required to treat his amended 2007 return as superseding the original 2007 return. we disagree. taxpayers are permitted to submit amended returns, but the commissioner is ―not statutorily required to *** [accept an amended return], or to treat an amended return as superseding an original return.‖ fayeghi v. commissioner, 211 f.3d 504, 507 (9th cir. 2000), aff‘g t.c. memo. 1998-297. 10. you can remove those mindless disclaimers from your emails when these proposed regulations become final (but not before). 8 reg-13867-06, regulations governing practice before the 8. chicago lawyer sheldon i. banoff suggests consideration of the following language at the end of emails until the proposed regulations become final: circular 230 disclosure, non-disclosure and disclosure of non-disclosure: in accordance with treasury regulations circular 230, any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the internal revenue code or (ii) promoting, marketing or recommending to another party any tax-related matter addressed herein (together, the ―prohibited purposes‖). in september 2012 treasury proposed elimination of the requirement of the aforementioned circular 230 disclosure, to be effective prospectively only (upon adoption in final form and publication of the revised circular 230 in the federal register). until that time, our emails shall continue to include the aforementioned circular 230 disclosure. at such time as we are no longer required to include the aforementioned circular 230 disclosure, we shall no longer do so; however, we recognize that those handful of you 704 florida tax review [vol. 13:10 internal revenue service, 77 f.r. 57055 (9/17/12). in the course of a comprehensive revision of the requirements for tax opinions, these proposed circular 230 regulations include the following:  the rigid covered opinion rules in current § 10.35 (which require that the written opinion contain a description of the relevant facts, the application of the law to those facts, and the practitioner‘s conclusion with respect to the law and the facts) are removed; these rules are replaced with a single standard for all written tax advice under proposed § 10.37. this standard requires that the practitioner must: (i) base the written advice on reasonable factual and legal assumptions; (ii) reasonably consider all the relevant facts that the practitioner knows or should know; (iii) use reasonable efforts to identify and ascertain the facts relevant on each federal tax who previously have bothered to read our circular 230 disclosure will at that time wonder whether the elimination of our circular 230 disclosure was due to oversight or, worse yet, that the email being sent by us to you is in fact ―intended or written to be used,‖ and can be used, for the prohibited purposes. such inference is not intended (except in those extremely rare cases where it is intended, i.e., where you really would be entitled to so use our emails for the prohibited purposes). therefore, effective as of the moment that the revised treasury regulations circular 230 is published in the federal register, which should only happen in our lifetimes, the following disclosure shall become operative without any further action on our part: ―treasury regulations circular 230 was recently amended to eliminate the requirement that we disclose to you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the internal revenue code or (ii) promoting, marketing or recommending to another party any tax-related matter addressed herein (the ―prohibited purposes‖). therefore, as of this moment you should not consider this email to be a circular 230 disclosure. however, no inference is intended, and none should be taken, that our failure to make a circular 230 disclosure to you from this moment forward shall entitle you to rely on any tax advice herein for any prohibited purpose. further, in the event any person who is a member of, employed by or affiliated with this firm should continue to include a circular 230 disclaimer on any email after the amendment of circular 230 becomes effective, no negative inference should be taken that the emails of any others who are members of, employed by or affiliated with our firm whose emails do not contain the circular 230 disclosure but which contain any tax advice can be used for the prohibited purposes, without the express written consent of an authorized representative of the firm.‖ 2013] recent developments in federal income taxation 705 matter; (iv) not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) if reliance on them would be unreasonable; and (v) not take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit. the determination of whether a practitioner has failed to comply with these requirements is based on all the facts and circumstances, not on whether each requirement is addressed in the written advice.  proposed § 10.35 provides that a practitioner must exercise competence when engaged in practice before the irs (including providing written opinions), which includes the required knowledge, skill, thoroughness, and preparation necessary for the matter for which he is engaged. this complements the provision in § 10.51 that a practitioner can be sanctioned for incompetent conduct.  proposed § 10.36 conforms the ―procedures to ensure compliance‖ with the removal of the covered opinion rules in current § 10.35, but expands these ―procedures to ensure compliance‖ to include all of the provisions of circular 230.  proposed § 10.1 provides that the office of professional responsibility – as opposed to the irs return preparer office – would have exclusive responsibility for matters related to practitioner discipline.  proposed § 10.82 extends the expedited disciplinary procedures for immediate suspension, but limits it to practitioners who have engaged in a pattern of willful disreputable conduct by failing to make an annual federal tax return during four of five tax years immediately before the institution of the expedited suspension proceeding, provided that the practitioner is also noncompliant at the time the notice of suspension is served.  proposed § 10.31 forbids practitioners from negotiating any taxpayer refunds, which specifically adds manipulation of any electronic refund process. 11. not just any old express mail service cuts the mustard when you wait until the last minute to file a tax court petition. scaggs v. commissioner, t.c. memo. 2012-258 (9/10/12). tax court special trial judge armen held that a tax court petition received more than 90 days after the date of a deficiency notice but which was sent via fedex ―express saver third business day‖ within the 90-day period, was not timely filed. notice 2004–83, 2004–2 c.b. 1030, which lists the private delivery serves that qualify for the same ―mailbox‖ treatment as shipment via the u.s. postal service pursuant to § 7502(f), does not list fedex ―express saver third business day.‖ 706 florida tax review [vol. 13:10 12. if the statute requires appeals to consult with chief counsel, it‘s not a prohibited ex parte communication. hinerfeld v. commissioner, 139 t.c. no. 10 (9/27/12). the taxpayer‘s proposed offer in compromise was rejected and he sought review in the tax court. among the taxpayer‘s arguments was that the appeals officer had an improper ex parte consultation with chief counsel‘s office, violating the internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, § 1001(a)(4), 112 stat. at 689, and rev. proc. 2000-43, 2000-2 c.b. 404, which provides guidelines in question and answer format that are designed to distinguish prohibited and permissible ex parte communications between appeals and other irs employees during an administrative appeal. the tax court (judge gale) rejected the taxpayer‘s argument. the appeals officer had consulted chief counsel‘s office to seek an opinion as to whether the taxpayer had made a fraudulent conveyance. there was no evidence of improper communications, and review by counsel was mandated by § 7122(b), which, when the irs is to compromise any unpaid tax assessed of $50,000 or more, requires an opinion of the chief counsel to be filed with the irs. 13. the irs can‘t disclose knowingly false taxpayer information just because it could have disclosed true information. aloe vera of america, inc. v. united states, 699 f.3d 1153 (9th cir. 11/15/12). the statute of limitations under § 7431(d) on a claim for wrongful disclosure of a tax return begins to run when the taxpayer knows or reasonably should know of the government‘s allegedly unauthorized disclosures. on the facts of the case, the statute of limitations did not begin to run when the taxpayer became aware of a pending general investigation that would involve disclosures, but only later when they knew or should have known of the specific disclosures at issue. under § 6103(k)(4), return information may be disclosed to a foreign government that has a tax treaty with the united states, if such information as is pertinent to carrying out the provisions of the treaty or preventing fraud or fiscal evasion in relation to the taxes which are the subject of the treaty. but the disclosure of knowingly false information to a foreign tax authority in a proposal for a simultaneous tax examination is not protected as ―pertinent‖ information. there was a genuine issue of material fact as to whether the government knowingly disclosed false information, and the district court‘s grant of summary judgment for the government was vacated and the issue remanded. 14. prison tax returns. the 2012 taxpayer relief act, § 209, expands the list of persons to whom false prisoner tax returns may be disclosed by the irs under code § 6103(k)(10) to include officers and employees of the federal bureau of prisons, state agencies charged with 2013] recent developments in federal income taxation 707 prison administration, and contractors responsible for operating a federal or state prison. xi. withholding and excise taxes a. employment taxes 1. social security is cheaper for 2011, but the deficits grow. the compromise tax relief act of 2010, § 601, reduces the employee portion of the old-age, survivors, and disability insurance tax (oasdi) from 6.2 percent to 4.2 percent for calendar year 2011.  the 4.2 percent rate also applies to the railroad retirement tax. a. congress giveth a little and taketh some of it back. ir-2011-124 (12/23/11). this news release highlights the two month reduction in payroll withholding for social security taxes from 6.2 percent to 4.2 percent and the complimentary reduction in self-employment taxes for the first two months of 2012 under the temporary payroll tax cut continuation act of 2011. the news release indicates that employers should implement the new payroll rate as soon as possible, but in any event no later than march 31, 2012. the news release also highlights the recapture tax that is imposed on employees who receive more than $18,350 in wages during the two-month extension period in the amount of an additional 2 percent income tax on wages in excess of $18,350 received during the two-month extension. b. the recapture tax was repealed. the middle class tax relief and job creation act of 2012 repealed the twopercent recapture tax included in the december 2011 legislation that effectively capped at $18,350 the amount of wages eligible for the payroll tax cut. as a result, the now-repealed recapture tax does not apply 2. attorneys are employees of their professional corporation law firm. donald g. cave a prof. law corp. v. commissioner, t.c. memo 2011-48 (2/28/11), aff’d, 476 fed. appx. 424 (5th cir. 3/22/12). the court (judge marvel) held that donald cave, the principal attorney for the taxpayer s corporation engaged in law practice, associates of the firm, and a law clerk were employees for employment tax purposes. donald cave was the corporation‘s president, made corporate decisions, and received a percentage of legal fees. the court held that cave‘s management services in the capacity of the corporation‘s president were not provided as an independent contractor. numerous factors supported employment status for associate attorneys, hired by cave in his purported activity as an ―an attorney 708 florida tax review [vol. 13:10 incubator‖; they were found to be sufficiently under the control of the corporation, the corporation provided facilities, while the associates‘ compensation was on a percentage basis, they bore no risk of loss, the relationship was ―continuous, permanent, and exclusive,‖ there was no evidence that the associate attorneys provided services to anyone else, and the associate attorneys provided everyday professional tasks in the corporation‘s business. the court also denied independent contractor status under the safe harbor of § 530 of the 1978 revenue act finding no reasonable basis for the corporation to have treated the attorneys as independent contractors. the corporation was also required to pay failure to deposit tax penalties under § 6656. a. affirmed on control and non-exposure to losses issues. donald g. cave, a prof. law corp. v. commissioner, 476 fed. appx. 424 (5th cir. 3/22/12). the fifth circuit, in affirming the tax court, emphasized the factors of potential control by the firm of its associate attorneys and law clerk, as well as their non-exposure to losses. judge haynes concurred to note that, while the law clerk was ―free‖ to do work for other attorneys outside the firm, ―almost no evidence about [the clerk‘s] other work [was presented],‖ and continued, ―we need not address here the tax treatment of a person who truly performs piece work for numerous business entities.‖ 3. the forms are in the mail doesn‘t establish delivery. martinez v. united states, 101 fed. cl. 686 (1/5/12). the taxpayer employed drivers as independent contractors in his sole-proprietorship trucking company. the taxpayer claimed relief from employment taxes for misclassified workers under § 530 of the revenue act of 1978, which requires that the taxpayer consistently treat workers as independent contractors and file appropriate tax returns. the taxpayer asserted that the required forms 1099 were delivered to the irs asserting that the timely delivery date can be established under the common-law mailbox rule, which provides that proof of timely mailing creates a presumption of delivery. the court noted that under § 7502(a) and (c) the only exceptions to requirements that returns be delivered are that a return will be deemed delivered on the date of the postmark, or on the date the mailing is registered [extended by regulation to certified mail]. the court added that even if the taxpayer could invoke a common-law mailbox rule, the evidence was not sufficient to prove a timely and proper mailing. 4. employment tax liability depends upon which form you can use. laflamme v. commissioner, t.c. memo. 2012-36 (2/6/12). the taxpayer, a self-employed individual, deducted her 2013] recent developments in federal income taxation 709 contributions to her qualified defined benefit pension plan on her schedule c, rather than on line 26 of her form 1040 and claimed that her income from self-employment for purposes of employment tax liability was thereby reduced by the allowable § 162 deduction. section 404(a)(8) allows a selfemployed individual to deduct contributions to qualified plans under §§ 162 or 212. section 1402 defines net income from self-employment subject to the self-employment tax of § 1401 as gross income ―from any trade or business‖ less the deductions allowed by subtitle a ―which are attributable to such trade or business.‖ the court (judge vasquez) agreed with the irs that that the taxpayer‘s pension contribution is ―not attributable to her trade or business.‖ the court also indicated that the special rule of § 404(a)(8) does not apply outside of the context of that section. thus, the taxpayer‘s pension contribution was not allowed as a deduction on her schedule c in computing business income. the court declined to impose penalties under § 6662 finding that the taxpayer acted in good faith in the mistaken belief that she was entitled to deduct the pension contribution on her schedule c. 5. s corporation ―john edwards gambit‖ dividends may be treated as wages. david e. watson, p.c. v. united states, 714 f. supp. 2d 954 (s.d. iowa 5/27/10). using a common tax reduction device, david watson formed an s corporation that was a member of watson‘s accounting firm. the s corporation contracted with the accounting firm to provide services. watson was paid a salary of $24,000 as an employee of the s corporation, on which the s corporation paid employment taxes. the remainder of the s corporation income, approximately $200,000 per year, was distributed to watson as a dividend, not subject to employee taxes. the irs recharacterized the dividends as wages. the s corporation paid an assessment and brought a refund action. in a motion for summary judgment the s corporation asserted that its intent controls whether amounts paid are wages and that it intended to pay dividends in the amount of cash on hand after the payment of wages. citing a long line of authorities in support of its position, the district court held that the s corporation‘s ―self-proclaimed intent‖ to pay salary does not limit the government‘s ability to recharacterize dividends as wages. the court indicated that whether amounts paid to watson were remuneration for services is a question of fact.  the court‘s opinion concluded with the following passage: in support of its motion for summary judgment, plaintiff points the court to the following oft-cited statement of judge learned hand: over and over again courts have said that there is nothing sinister in so arranging one‘s affairs as to keep taxes as low as possible. everybody does so, rich or poor; and all do right, for nobody owes https://checkpoint.riag.com/getdoc?docid=t0advaftr:13270.1&pinpnt= https://checkpoint.riag.com/getdoc?docid=t0advaftr:13270.1&pinpnt= 710 florida tax review [vol. 13:10 any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. to demand more in the name of morals is mere cant. see pl.‘s reply br. at 5 n. 2 (quoting commissioner of internal revenue v. newman, 159 f.2d 848, 850-51 (2d cir.1947) (l. hand, j., dissenting)). while the court agrees fully with judge learned hand, it would remind plaintiff of justice oliver wendell holmes‘ succinct, yet equally eloquent statement in compania general de tabacos de filipinas v. collector of internal revenue: ―taxes are what we pay for civilized society.‖ 275 u.s. 87, 100 (1927) (holmes, j., dissenting). indeed, ―the greatness of our nation is in no small part due to the willingness of our citizens to honestly and fairly participate in our tax collection system.‖ manley v. commissioner of internal revenue, t.c. memo 1983-558 (sept. 12, 1983). thus, while plaintiff is free to structure its financial affairs in such a way as to avoid paying ―more [taxes] than the law demands,‖ plaintiff is not free to structure its financial affairs in a way that avoids paying those taxes demanded by the law. in this case, the law demands that plaintiff pay employment taxes on ―all remuneration for employment,‖ and there is clearly a genuine issue of material fact as to whether the funds paid to watson, in actuality, qualify as such. a. since the judge gave the irs everything it asked for, will the irs go for the whole kit and caboodle the next time? david e. watson, p.c. v. united states, 757 f. supp. 2d 877 (s.d. iowa 12/23/10). on the merits, judge pratt rejected the taxpayer‘s claim that the wages subject to employment tax were limited to the $24,000 salary formally paid to the sole shareholder/sole employee. in addition to the ―salary‖ in each of the years in question, the corporation distributed approximately $175,000 of ―profits,‖ pursuant to a corporate resolution authorizing ―payment to watson of ‗dividends in the amount of available cash on hand after payment of compensation and other expenses of the corporation.‘‖ citing joseph radtke, s.c. v. united states, 712 f. supp. 143 (e.d. wisc. 1989), spicer accounting, inc. v. united states, 918 f.2d 90 (9th cir. 1990), and veterinary surgical consultants v. commissioner, 117 t.c. 141 (2001), as particularly persuasive, the court concluded that ―characterization of funds disbursed by an s corporation to its employees or shareholders turns on an analysis of whether the ‗payments at issue were made . . . as remuneration for services performed.‘‖ after examining the facts, the court concluded that 2013] recent developments in federal income taxation 711 the reasonable amount of watson‘s compensation for each of the years at issue was $91,044, increasing the $24,000 salary amount by the full amount of the $67,044 that the corporation claimed was a § 1368 distribution, thus upholding in full the government‘s position. b. reasonable compensation can go up as well as down. david e. watson, p.c. v. united states, 668 f.3d 1008 (8th cir. 2/21/12), cert. denied, 10/1/12. in affirming the district court, the court of appeals agreed with the irs that the factors used by courts to assess reasonable compensation in the context of deductions are applicable to determine whether payments are in fact remuneration for fica purposes. the court indicated that ―in light of all the facts and circumstances of the case, scrutinizing compensation for its reasonableness may guide a court in characterizing payments for fica tax purposes.‖ assessing the facts, the court of appeals concluded that the district court did not clearly err in treating additional payments to the taxpayers as remuneration for services. the court also rejected the taxpayer‘s argument that under pediatric surgical assocs., p.c. v. commissioner, t.c. memo. 2001-81, the intent of the payor is controlling, noting that pediatric surgical did not involve a question of reasonableness. 6. the story line is just a rerun: nols do not reduce self-employment income. decrescenzo v. commissioner, t.c. memo. 2012-51 (2/27/12). the taxpayer was assessed deficiencies when he failed to file a return of income from self-employment as an accountant. the tax court (judge marvel) held – yet again — that § 1402(a)(4) prohibits a taxpayer from offsetting net earnings from self-employment with an nol carryforward or carryback. 7. tax-exempt employer is not subject to excise tax on qualified plan reversions. research corporation v. commissioner, 138 t.c. 192 (2/29/12). section 4980(a) imposes a 20 percent tax on the amount of any reversion to the employer from a qualified plan. however, § 4980(c)(1) excludes from the definition of a qualified plan, a plan ―maintained by an employer if such employer has, at all times, been exempt from tax under subtitle a.‖ research corporation received a reversion from its qualified plan in the amount of $4,411,395, but reported a taxable reversion under § 4980 of only $14,055 asserting that the reported amount reflected the portion of its income that was subject to the unrelated business income tax. in a case of first impression, the tax court (judge haines) rejected the irs assertion that, because the tax-exempt corporation was subject to tax on unrelated business income, it was not at all times exempt from tax under subtitle a. the court cited the language of § 501(b), which provides that a § 501(c)(3) organization that is subject to the unrelated 712 florida tax review [vol. 13:10 business income tax ―shall be considered an organization exempt from income taxes for the purpose of any law which refers to organizations exempt from income taxes.‖ thus the court held that research corporation was to be treated as exempt from tax at all times for purposes of § 4980(c)(1). the court also concluded that research corporation overpaid its taxes on the portion that it treated as a reversion, but that the court lacked jurisdiction to order a refund. 8. full-time resident horse farm workers don‘t have enough independence from the horse-mistress. twin rivers farm, inc. v. commissioner, t.c. memo. 2012-184 (7/2/12). the tax court (judge ruwe) denied the subchapter s corporation‘s petition for redetermination of the irs‘s determination of employment status for two farm workers on the taxpayer‘s tennessee horse farm. in spite of assertions by the taxpayer‘s sole shareholder that she did not exercise control over the two workers, the court noted that to maintain the requisite degree of control to establish employee status the principal need not directly control the worker; it is sufficient that the principal has the right to do so. the court indicated that by the nature of the work relationship, it was likely that the shareholder had the right to exercise control. the workers were using the taxpayer‘s equipment, caring for the corporation‘s principal assets, and living full time in a trailer on the taxpayer‘s property. the court pointed out that if the workers were not exercising their duties appropriately that the shareholder would certainly have intervened with direction. the court also pointed to the fact that the workers were receiving a regular weekly salary for their services and were long-term employees who resided on the farm. in addition, the taxpayer maintained workers compensation insurance and covered the workers‘ necessary job-related expenditures. the court also held the taxpayer liable for penalties under § 6651(a)(1) for failure to file the required form 943 for employers of agricultural workers and penalties under § 6656 for failure to make timely employment tax deposits. 9. skilled pieceworkers were employees even though the employer did not ―stand over them‖ to control them. atlantic coast masonry, inc. v. commissioner, t.c. memo 2012-233 (8/13/12). in spite of the fact that construction masons and laborers were paid in cash by the taxpayer on a piece-work basis, the workers were held to be employees by judge jacobs. the tax court noted that the workers were skilled craftsmen who did not require direct supervision. nonetheless, instruction from the taxpayer on the nature of the work and requirements for completion constituted control over the workers. ―an employer need not ‗stand over‘ the employee to control an employee.‖ the court also indicated that the workers did not share in profits and losses notwithstanding the piece-work nature of 2013] recent developments in federal income taxation 713 the workers‘ compensation, and that the factor supported employee status. section 530 relief was denied because the taxpayer failed to file forms 1099 with respect to the workers. the taxpayer was also held liable for § 6651 penalties for failure to file required employment tax returns and § 6656 penalties for failure to pay required employment tax deposits. the court held that the taxpayer failed to demonstrate reasonable cause for the absence of filings. 10. tax refunds in a bad economy set up another deference conflict among the circuits. in re quality stores, inc., 693 f.3d 605 (6th cir. 9/7/12). in november 2001 quality stores closed 63 stores and 9 distribution centers and terminated the employment of all employees in the course of chapter 11 bankruptcy cases. quality stores adopted plans providing severance pay to terminated employees. the company reported the severance pay as wages for withholding and employment tax purposes then filed claims for refund of fica and futa taxes claiming that the severance pay represented supplemental unemployment compensation benefits (subs) that are not wages for employment tax purposes. disagreeing with the contrary holding by the federal circuit in csx corp. v. united states, 518 f.3d 1328 (fed. cir. 2008), the sixth circuit held that the subs were exempt from employment taxes. the court examined the language and legislative history of § 3402(o)(1), which provides that sub payments ―shall be treated as if it were a payment of wages‖ for withholding purposes, to conclude that, by treating sub payments as wages for withholding, congress recognized that sub payments were not otherwise subject to withholding because they did not constitute ―wages.‖ then, under rowan cos. v. united states, 452 u.s. 247, 255 (1981), the court concluded that the term ―wages‖ must carry the same meaning for withholding and employment tax purposes. thus, if subs are not wages under the withholding provision (because the must be treated as wages by statutory directive), the subs are not wages for employment tax purposes. the court also rejected the irs‘s position in rev. rul. 90-72, 1990-2 c.b. 211, that to be excluded from employment taxes subs must be part of a plan that is designed to supplement the receipt of state unemployment compensation. the court declined to follow the federal circuit‘s holding in csx corp., which adopted the eight part test of rev. rul. 90-72, stating that, ―we decline to imbue the irs revenue rulings and private letter rulings with greater significance than the congressional intent expressed in the applicable statutes and legislative histories.‖ the court also stated that it could not conclude that the opinion in mayo foundation for medical education & research v. united states, 131 s. ct. 704 (2011), eroded the holding of rowan cos. v. united states, which compelled the court to interpret the meaning of ―wages‖ the same for withholding and employment tax purposes. 714 florida tax review [vol. 13:10  will the disagreement between the federal and sixth circuits once again invite the supreme court to enter the deference fray? 11. the district court for the eastern district of new york gets the message. recoveries in age discrimination suit are wages. gerstenbluth v. credit suisse securities (usa) llc, 110 a.f.t.r.2d 2012-6238 (e.d.n.y. 9/28/12). the district court for the eastern district of new york (judge seybert) granted summary judgment to defendants in a claim for refund against the employer and the irs for employment taxes withheld by the employer on damages paid to the taxpayer in a successful claim for age discrimination. the court ruled that money paid to settle employment discrimination claims constitute wages where the money represents back pay or front pay. although the settlement agreement with credit suisse did not explicitly describe the payment as wages, the court concluded that the payment represented wages based on the employer‘s characterization of the payment as wages in reporting the settlement as compensation on form w-2. a. as does the northern district. back and front pay in a title vii wrongful discharge recovery are wages. noel v. new york state office of mental health central new york psychiatric center, 697 f.3d 209 (2d cir. 8/31/12). the plaintiff in a title vii wrongful discharge case recovered damages for back and front pay in a jury trial. the state office of the controller withheld employment taxes from its payment of the judgment. the district court for the northern district of new york ordered the controller to pay the full amount of the judgment. in an appeal filed by the controller, joined by the tax division of the justice department as amicus, the court of appeals held that the front and back pay constituted wages subject to withholding. the court noted that both front and back pay constitute remuneration paid to compensate for what the employee would have earned had the employee not been a victim of discrimination. thus, the court concluded that, ―[t]hese amounts are ‗wages‘ because they constitute ‗remuneration‘ for services during an employee-employer relationship.‖ 12. funding health care by making the hi tax more progressive. section 1401, as amended by the 2010 health care act, increases the employee portion of the hi tax is increased by an additional tax of 0.9 percent on wages in excess of a threshold amount. the threshold amount is $250,000 of the combined wages of both spouses on a joint return ($125,000 for a married individual filing a separate return). the threshold is $200,000 for all other individuals. the employer must withhold the additional hi tax, but in determining the employer‘s withholding 2013] recent developments in federal income taxation 715 requirement and liability for the tax, only wages that the employee receives from the employer in excess of $200,000 for a year are taken into account, and the employer disregards the employee‘s spouse‘s wages. i.r.c. § 3102(f). the employee is liable for the additional 0.9 percent hi tax to the extent the tax is not withheld by the employer. section 1402(b), as amended, imposes an additional tax of 0.9 percent on self-employment income above the same thresholds. the threshold amount is reduced (but not below zero) by the amount of wages taken into account in determining the fica tax with respect to the taxpayer. no deduction under § 164(f) is allowed for the additional seca tax, and the alternative deduction under § 1402(a)(12) is determined without regard to the additional seca tax rate. the additional tax applies to wages received in taxable years after 12/31/12. a. proposed regulations relating to the additional medicare tax. reg-130074-11, rules relating to additional medicare tax, 77 f.r. 72268 (12/05/12). proposed regulations under §§ 1401, 3101, and 3102, relating to additional hospital insurance tax on income above threshold amounts (―additional medicare tax‖), as added by the affordable care act. specifically, these proposed regulations provide guidance for employers and individuals relating to the implementation of additional medicare tax. this document also contains proposed regulations relating to the requirement to file a return reporting additional medicare tax, the employer process for making adjustments of underpayments and overpayments of additional medicare tax, and the employer and employee processes for filing a claim for refund for an overpayment of additional medicare tax.  the changes to §§ 1401 and 3102 are effective for tax years beginning after 12/31/12, and taxpayers may rely on the proposed regulations for purposes of complying with these section until the effective date of the final regulations, which are expected to be made final during 2013 and will be applicable to tax years beginning after 12/31/13.  faqs to the additional medicare tax were released by the irs on 11/30/12, 2012-tnt 232-48. b. self-employment taxes 1. llc guaranteed payments are subject to selfemployment tax; the members are held to their reporting positions. howell v. commissioner, t.c. memo. 2012-303 (11/1/12). mr. howell and mr. bruzee formed a limited liability company to develop medical technology. mrs. howell (the taxpayer), however was named as a 60 percent member of the llc instead of mr. howell because she had a better credit rating and the parties intended to use her personal credit card for llc expenditures. the llc members were compensated with payments deducted 716 florida tax review [vol. 13:10 by the llc as guaranteed payments. under § 1402(a)(13) a limited partner‘s distributive share of partnership income is excluded from wages for selfemployment tax purposes except for guaranteed payments under § 707(c) for services rendered to the partnership. the tax court (judge marvel) rejected the taxpayer‘s argument that the payments were distributions of partnership share not subject to employment tax. the court held that the taxpayer was bound by the characterization of the payments on the partnership returns, which she signed, noting that taxpayers are free to organize their affairs as they choose, but that a taxpayer ―may not enjoy the benefit of some other route he might have chosen to follow but did not.‖ the court also observed that the taxpayer introduced no evidence to prove that the payments to mrs. howell were not in substance guaranteed payments. the court indicated that although mrs. howell‘s services were minimal in contrast to the management services of her husband pursuant to a contract signed by mrs. howell on behalf of the partnership, mrs. howell provided marketing advice, signed documents, entered into contracts on behalf of the llc, and allowed the llc to use her credit card and credit rating. the court thus found that mrs. howell was not merely a passive investor in the llc. the guaranteed payments were not, therefore, excluded from wages. 2. good preaching at home does not avoid selfemployment tax for this carpenter. good v. commissioner, t.c. memo 2012-323 (11/20/12). the taxpayer‘s claimed ministry for prepare the way ministries, formed based on various books about churches and taxes, did not exempt the taxpayer‘s income from various services from self-employment tax under the minister exception of § 1402(c)(4). taxpayer‘s receipts were also otherwise includible in gross income. the tax court (judge marvel) concluded that the taxpayer failed to provide any credible evidence that he was a minister of a church and held the taxpayer liable for fraud penalties. 3. local police officers working off-duty security jobs are independent contractors. specks v. commissioner, t.c. memo. 2012-343 (12/11/12). the taxpayer, a houston police officer, provided offduty security services in uniform for private companies. the private companies reported the remuneration on forms 1099. the tax court (judge kroupa) determined that the taxpayer was an independent contractor subject to self-employment tax. the private parties did not train, supply, or equip the taxpayer in performing the security service, which was performed on an atwill basis. the court concluded that the absence of evidence of control over the taxpayer was to be given greater weight over other factors indicating employee status.  the court sustained § 6662(a) accuracyrelated penalties and indicated that the taxpayer failed to establish under 2013] recent developments in federal income taxation 717 § 664(c) reasonable reliance on a return preparer who was a competent professional with significant expertise and provided all of the relevant information. c. excise taxes 1. the price of a tan goes up even in disregard of the hazard from which the owner is protected. t.d. 9596, disregarded entities and the indoor tanning services excise tax, 77 f.r. 37806 (6/25/12). temp. and prop. reg. § 1.1361-4t(a)(8)(iii) adds the 10 percent excise tax on indoor tanning services of § 5000b is added to the list of excise taxes for which disregarded entities (qsub or single owner business entity) that are treated as separate entities. 2. roll your own, inhale, and pay the tax. section 100122 of the transportation act would amend code § 5702(d) to add to the tobacco excise tax any person who for commercial purposes makes available to the consumer a machine that rolls cigarettes, cigars, or other tobacco products. previously the tax only applied to manufacturers of cigarettes and cigars who actually rolled the product, but did not apply to consumers who rolled their own. this change would add to the tobacco excise tax establishments that provided access to commercial grade rolling equipment to consumers who purchased the tobacco and paper from the retailer and fed it into the machine provided by the retailer, obtaining cigarettes at much lower cost free of the excise tax. 3. the irs rejects a (former) court of claims limitation on retroactive application of rulings. aod 2012002 (9/12/12). the irs announced its nonacquiescence in international business machines corp. v. united states, 343 f.2d 914 (ct. cl. 1965), which held that the irs could not apply a changed position on an excise tax issue prospectively from the date of revocation to a taxpayer whose erroneous favorable ruling was revoked, but retroactively as to another taxpayer. the court of claims in ibm held that it was an abuse of discretion to treat two competitors differently with respect to excise taxes on the same type of equipment. 4. final regulations for the medical device excise tax. t.d. 9604, taxable medical devices, 77 f.r. 72924 (12/7/12). final reg. §§ 48.4191-1 and -2 provide guidance on the excise tax imposed on the sale of certain medical devices, enacted by the health care and education reconciliation act of 2010 in conjunction with the patient protection and affordable care act. they define ―taxable medical device‖ and provide for the imposition of the tax at a 2.3 percent rate on manufacturers, producers and importers making sales of such devices. https://checkpoint.riag.com/app/main/doclinknew?usid=684598a089&docid=iea03806637f7c857a8dfa3ed1427e053&srcdocid=t0newsltr%3a624826.1dr7&feature=tnews&lastcpreqid=1243697&pinpnt=tregs%3a114406.2&d=d#tregs:114406.2 718 florida tax review [vol. 13:10  the tax is applicable to sales on and after 1/1/13. a. notice 2012-77, 2012-52 i.r.b. 781 (12/5/12). the irs has provided guidance regarding the § 4191 excise tax imposed on the sale of certain medical devises by domestic and foreign manufactures. the notice spells out a methodology for determining a constructive sales price applicable to manufacturers who sell through multiple distribution channels. the notice also exempts the sale price of domestically produced connivance kits for practitioners who install the medical device. foreign produced convenience kits are subject to the excise tax only to the extent of the value of included taxable medical devices.  faqs to the excise tax were released by the irs on 12/6/12, 2012-tnt 235-22. xii. tax legislation a. enacted 1. the patient protection and affordable care act (―ppaca‖ – pronounced ―pee-pac-a‖ or ―obamacare‖), p.l.111-148, was signed by president obama on 3/23/10, and h.r. 4872, the health care and education reconciliation act of 2010 (―2010 health care act‖ or ―2010 reconciliation act‖), p.l. 111-152, was signed by president obama on 3/30/10. a. the 2010 health care act is constitutional, but the ―penalty‖ is not a ―tax.‖ thomas more law center v. obama, 651 f.3d 529 (6th cir. 6/29/11) (2-1). the sixth circuit court of appeals, in an opinion by judge martin, upheld the constitutionality of the patient protection and affordable care act, pub. l. no. 111-148, 124 stat. 119 (2010), amended by the health care and education reconciliation act of 2010, pub. l. no. 111-152, 124 stat. 1029. the majority opinion upheld the act under the commerce clause. judge sutton‘s concurring opinion also concluded that the act was constitutional under the commerce clause, but held that the act was not an exercise of the taxing power – the penalty for not purchasing health insurance was not a tax. an opinion by senior district judge graham, concurring in part and dissenting in part, also held that the act was not an exercise of the taxing power but would have held the act unconstitutional as beyond congress‘s power to regulate commerce. b. but, on the other hand, the eleventh circuit holds that the individual mandate is unconstitutional. florida v. 2013] recent developments in federal income taxation 719 u.s. department of health & human services, 648 f.3d 1235 (11th cir. 8/12/11) (2-1). the eleventh circuit held that congress exceeded its authority by requiring americans to buy coverage, but also ruled that the rest of the wide-ranging law could remain in effect. the case stems from a challenge by twenty-six states which had argued the individual mandate, set to go into effect in 2014, was unconstitutional because congress could not force americans to buy health insurance or face the prospect of a penalty. the majority stated: this economic mandate represents a wholly novel and potentially unbounded assertion of congressional authority: the ability to compel americans to purchase an expensive health insurance product they have elected not to buy, and to make them re-purchase that insurance product every month for their entire lives. c. does anyone really care what d.c. circuit thinks when the issue is already up on certiorari? seven-sky v. holder, 661 f.3d 1 (d.c. cir. 11/8/11). the court of appeals for the district of columbia (2-1) upheld the constitutionality of the minimum essential health care coverage requirement of § 1501 of the 2010 patient protection and affordable health care act, codified at code § 5000a as an exercise of congress‘s power under the commerce clause. the suit was not barred by the anti-injunction act because the suit involved a penalty unconnected to a tax liability. judge kavanaugh dissented as to jurisdiction because he would have held that the aia barred the suit. d. when president obama said that the ―individual mandate‖ was not a tax, justices kennedy, scalia, thomas, and alito thought he was being serious, but the chief justice and justices ginsburg, breyer, sotomayor, and kagan knew that, as usual, he was just fooling with us. national federation of independent business v. sebelius, 132 s. ct. 2566 (6/28/12). on certiorari to the eleventh circuit, the chief justice delivered the opinion for the court which held: (1) that the suit to declare the individual mandate unconstitutional was not barred by the anti-injunction act because congress indicated that it did not want it to be so barred (9-0); (2) that the individual mandate was unconstitutional as an exercise of congressional power under the commerce clause (5-4); and (3) that the individual mandate was valid as a tax – but not a direct tax – under the taxing clause (5-4). with respect to the direct tax clause, the chief justice stated: a tax on going without health insurance does not fall within any recognized category of direct tax. it is not a capitation. capitations are taxes paid by every person, ―without regard to property, profession, or any other 720 florida tax review [vol. 13:10 circumstance.‖ hylton, supra, at 175 (opinion of chase, j.) (emphasis altered). the whole point of the shared responsibility payment is that it is triggered by specific circumstances — earning a certain amount of income but not obtaining health insurance. the payment is also plainly not a tax on the ownership of land or personal property. the shared responsibility payment is thus not a direct tax that must be apportioned among the several states.  there was some more stuff about congress lacking the power to force states to expand medicaid upon pain of denial of all federal aid to states for medicaid, which was decided 7-2. 2. the middle class tax relief and job creation act of 2012, p.l. 112-96, was signed by president obama on 2/22/12. the new law also repeals the two-percent recapture tax included in the december 2011 legislation that effectively capped at $18,350 the amount of wages eligible for the payroll tax cut. as a result, the now-repealed recapture tax does not apply. 3. the moving ahead for progress in the 21st century act (the ―transportation act‖), p.l. 112-141, was signed by president obama on 7/6/12. section 100122 of the transportation act amends code § 5702(d) to add to the tobacco excise tax any person who for commercial purposes makes available to the consumer a machine that rolls cigarettes, cigars, or other tobacco products. 4. the american jobs act of 2011 was orally signed by president obama on 9/8/11. it will reduce the unemployment rate to 4 percent, cause the oceans to recede and cure cancer. lacking are a written bill (because the congressional budget office perversely refuses to score speeches) and the trivial detail of congressional voting (rendered irrelevant by president obama‘s multiple repetitions of the necessity of immediate passage of the yet-unwritten bill, which congress perversely failed to do on 9/9/11). a. his directing that this fiscal cliff bill be ―signed‖ with an autopen, instead of signing it himself, confirms that obama acted arrogantly throughout this entire process. the lion‘s share of the act consists of so-called ―jimmy johnson‖ provisions. the american taxpayer relief act of 2012 (―the 2012 taxpayer relief (and not so grand compromise) act‖ or ―the act‖), p.l. 112-240, was ―signed‖ by president obama‘s autopen on 1/2/13. 2013] recent developments in federal income taxation 721  according to a white house press secretary statement, it ―makes permanent the temporary rates on taxable income at or below $400,000 for individual filers and $450,000 for married individuals filing jointly; permanently indexes the alternative minimum tax exemption amount to the consumer price index; extends emergency unemployment compensation benefits and federal funding for extended benefits for unemployed workers for one year; continues current law medicare payment rates for physicians‘ services furnished through december 31, 2013; extends farm bill policies and programs through september 30, 2013; and provides a postponement of the budget control act‘s sequester for two months. 722 florida tax review [vol. 13:10 florida tax review florida tax review volume 15 2014 number 5 233 recent developments in federal income taxation: the year 2013 “recent developments are just like ancient history, except they happened less long ago.” martin j. mcmahon, jr. * ira b. shepard ** daniel l. simmons *** * james j. freeland eminent scholar in taxation and professor of law, university of florida fredric g. levin college of law. ** professor emeritus, university of houston law center. *** professor of law emeritus, university of california davis school of law. this recent developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the most recent twelve months — and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted – unless one of us decides to go nuts and spend several pages writing one up. this is the reason that the outline is getting to be as long as it is. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide dan and marty the opportunity to mock our elected representatives; again, sometimes at least one of us goes nuts and writes up the most trivial of legislative changes. the outline focuses primarily on topics of broad general interest (to us, at least) – income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. any mistakes in this outline are marty’s responsibility; any political bias or offensive language is ira’s; and dan is just irresponsible. bruce a. mcgovern, vice president, associate dean, and professor of law, south texas college of law, contributed to this article. bruce’s contribution is (relative) youth. 234 florida tax review [vol. 15:5 i. accounting ................................................................................ 236 a. accounting methods ......................................................... 236 b. inventories ........................................................................ 236 c. installment method ........................................................... 236 d. year of inclusion or deduction ......................................... 236 ii. business income and deductions ......................................... 238 a. income .............................................................................. 238 b. deductible expenses versus capitalization ...................... 243 c. reasonable compensation ................................................ 258 d. miscellaneous deductions ................................................ 261 e. depreciation & amortization ........................................... 268 f. credits ............................................................................... 275 g. natural resources deductions & credits ......................... 277 h. loss transactions, bad debts, and nols ........................ 277 i. at-risk and passive activity losses ................................ 280 iii. investment gain and income ................................................. 284 a. gains and losses .............................................................. 284 b. interest, dividends, and other current income ................ 286 c. profit-seeking individual deductions ............................... 287 d. section 121 ....................................................................... 287 e. section 1031 ..................................................................... 287 f. section 1033 ..................................................................... 290 g. section 1035 ..................................................................... 291 h. miscellaneous ................................................................... 291 iv. compensation issues ................................................................ 291 a. fringe benefits .................................................................. 291 b. qualified deferred compensation plans........................... 295 c. nonqualified deferred compensation, section 83, 293and stock options ....................................................... 295 d. individual retirement accounts ....................................... 298 v. personal income and deductions ....................................... 301 a. rates.................................................................................. 301 b. miscellaneous income ...................................................... 312 c. hobby losses and § 280a home office and vacation homes ................................................................ 318 d. deductions and credits for personal expenses ................. 320 e. divorce tax issues ............................................................ 324 f. education .......................................................................... 324 g. alternative minimum tax ................................................ 324 vi. corporations ............................................................................ 325 a. entity and formation ........................................................ 325 b. distributions and redemptions ......................................... 327 c. liquidations ...................................................................... 328 2014] recent developments in federal income taxation 235 d. s corporations .................................................................. 329 e. mergers, acquisitions and reorganizations ..................... 333 f. corporate divisions .......................................................... 333 g. affiliated corporations and consolidated returns ........... 333 h. miscellaneous corporate issues ........................................ 340 vii. partnerships .............................................................................. 341 a. formation and taxable years ........................................... 341 b. allocations of distributive share, partnership debt, and outside basis .............................................................. 348 c. distributions and transactions between the partnership and partners ................................................... 352 d. sales of partnership interests, liquidations and mergers ............................................................................. 357 e. inside basis adjustments .................................................. 358 f. partnership audit rules .................................................... 358 g. miscellaneous ................................................................... 365 viii. tax shelters .............................................................................. 367 a. tax shelter cases and rulings ......................................... 367 b. identified “tax avoidance transactions” ............................ 378 c. disclosure and settlement ................................................. 378 d. tax shelter penalties, etc. ................................................. 379 ix. exempt organizations and chartiable giving ............... 384 a. exempt organizations ....................................................... 384 b. charitable giving .............................................................. 393 x. tax procedure .......................................................................... 405 a. interest, penalties, and prosecutions ................................. 405 b. discovery: summonses and foia .................................... 413 c. litigation costs ................................................................. 417 d. statutory notice of deficiency ......................................... 418 e. statute of limitations ........................................................ 419 f. liens and collections ........................................................ 423 g. innocent spouse ................................................................ 429 h. miscellaneous ................................................................... 434 xi. withholding and excise taxes ............................................ 436 a. employment taxes ........................................................... 436 b. self-employment taxes .................................................... 443 c. excise taxes ..................................................................... 443 xii. tax legislation ........................................................................ 444 a. enacted .................................................................................... 444 236 florida tax review [vol. 15:5 i. accounting a. accounting methods 1. yes, but when is the income recognized when, as often happens, the customer never redeems the gift card? rev. proc. 2013-29, 2013-33 i.r.b. 141 (7/24/13). this revenue procedure allows a taxpayer to defer recognizing in gross income certain advance payments received from the sale of gift cards that are redeemable for goods or services by an unrelated entity. where a gift card is redeemable by an entity whose financial results are not included in the taxpayer’s applicable financial statement, the taxpayer will recognize the payment in income to the extent the gift card is redeemed. for a taxpayer without an applicable financial statement, the taxpayer will recognize the payment in income when it is earned, which, in this situation, is when the gift card is redeemed. any payment received by the taxpayer that is not recognized in income in the year of receipt, must be recognized in the subsequent year. the revenue procedure modifies and clarifies rev. proc. 2011-18, 2011-5 i.r.b. 443, modifying and clarifying rev. proc. 2004-34, 2004-1 c.b. 991. it is effective for taxable years ending on or after 12/31/10. b. inventories there were no significant developments regarding this topic during 2013. c. installment method there were no significant developments regarding this topic during 2013. d. year of inclusion or deduction 1. does this case stand for the proposition that if you care enough about the treatment of a deduction item to try to change your accounting method regarding the year of deduction it’s “material” for tax purposes even if it’s not “material” for financial accounting purposes? veco corp. v. commissioner, 141 t.c. no. 14 (11/20/13). the accrual method taxpayer claimed current expense deductions for a variety of liabilities under a number of contracts performance under which straddled taxable years. on its gaap financial it accrued the deductions over more than one year. the tax court (judge marvel) first held that the mere execution of the contract does not necessarily establish the fact of liability. however, the terms of the agreements are relevant in deciding whether and 2014] recent developments in federal income taxation 237 when the liabilities became fixed under the all events test. where the taxpayer had not by the end of its year requested that services be performed and amounts were not unconditionally due, the fact of the liability had not been established. furthermore, the economic performance requirement of § 461(h) foreclosed certain deductions. the taxpayer conceded that it had not satisfied the 3½-month rule of reg. § 1.461-4(d)(6)(ii) for any of the deductions in issue. turning to the recurring item exception in § 461(h)(3), the irs argued that the taxpayer failed to satisfy the economic performance requirement and the materiality or matching requirement of the recurring item exception for all of the disputed deductions. the taxpayer’s position was that economic performance with respect to each expense item occurred within 8½ months after the close of its taxable year, as required by § 461(h)(3)(a)(ii)(ii), and that each expense item was not material within the meaning of § 461(h)(3)(a)(iv)(i). (the taxpayer conceded that, with one exception, it had not satisfied the matching requirement for any of the disputed deductions.) section 461(h)(3)(b) provides that the treatment of an item on financial statements should be taken into account in determining if an item is “material.” an example in the conference report, h.r. conf. rept. no. 98-861, at 874 (1984), 1984-3 c.b. (vol. 2) 1, 128, explains that if a calendar-year taxpayer enters into a one-year maintenance contract on july 1, 1985, and the amount of the expense is prorated between 1985 and 1986 for financial statement purposes, it also should be prorated for tax purposes. but if the full amount is deducted in 1985 for financial statement purposes because it is not material under generally accepted accounting principles, it may (or may not) be considered an immaterial item for purposes of the exception. drawing on this example, judge marvel concluded that the liabilities giving rise to the disputed deductions were “material” because the taxpayer prorated the liabilities between two years on its financial statements and took an inconsistent position with respect to the liabilities for financial statement and tax reporting purposes. furthermore, even if the amount of the liabilities was immaterial for financial statement purposes, under reg. § 1.461-5(b)(4)(iii) “[a] liability that is immaterial for financial statement purposes under generally accepted accounting principles may be material” for purposes of the recurring item exception. “the disputed items resulted from a change of accounting method, which was disclosed on petitioner’s financial statement, and the disputed items were treated inconsistently for financial accounting and tax reporting purposes. in addition, the liabilities giving rise to the deductions were accrued over more than one taxable year. under these circumstances, the liabilities generating the accelerated deductions were material for tax purposes.” 2. the irs continues successfully to flex the awesome power of § 461(h). suriel v. commissioner, 141 t.c. no. 16 (12/4/13). the taxpayer was the sole shareholder of an accrual method s 238 florida tax review [vol. 15:5 corporation that was a cigarette importer. the corporation settled tobacco related claims with 46 states, the district of columbia, the commonwealth of puerto rico, and 4 u.s. territories by entering into the tobacco master settlement agreement (msa). it agreed to pay $242,314,534 in 12 annual instalments from 2005 through 2016. even though none of the amount was paid, the corporation took the entire amount into account in computing the cost of goods sold. it also deducted $4,661,190 as interest owed on its obligation; none of the interest was paid. the irs disallowed the $242,314,534 deduction on the grounds that economic performance had not yet occurred. the irs’s position was that because the payments were to a qualified settlement fund (qsf), based on § 468b(a) economic performance therefore did not occur until the payments were made. (section 468b(a) specifically provides: “for purposes of section 461(h), economic performance shall be deemed to occur as qualified payments are made by the taxpayer to a designated settlement fund.” see also reg. § 1.468b-3(c)(1).) the taxpayer argued that the obligation arose from the provision of cigarettes to the taxpayer by the manufacturer and that pursuant to § 461(h)(2)(a)(ii) economic performance therefore occurred as the manufacturer provided the cigarettes to the taxpayer. the tax court (judge goeke) agreed with the irs. as far as the interest deduction was concerned, judge goeke held that where the interest is owed to a qsf, the more specific timing rule in § 468b(a) took precedence over the more general timing rules in §§ 163(a) and 461(a) and disallowed the deduction. ii. business income and deductions a. income 1. el niño has not yet won a major, but he claims a partial victory in the tax court. garcia v. commissioner, 140 t.c. 141 (3/14/13). professional golfer sergio garcia, a resident of switzerland, derived income from an endorsement agreement with taylormade golf co. the agreement required garcia to “exclusively wear and use golf products produced by taylormade and associated brands (taylormade products), and taylormade . . . receive[d] the right to use [garcia’s] image, likeness, signature, voice, and any other symbols associated with his identity to promote taylormade products.” garcia also was required to make a specified number of personal appearances and to play in a specified number of tournaments each year. an amendment to the endorsement agreement allocated 85 percent of garcia’s compensation to royalties for use of his image rights and 15 percent to his personal services. the government argued that the vast majority of garcia’s income was attributable to his personal services. the tax court (judge goeke) considered expert reports submitted 2014] recent developments in federal income taxation 239 by the parties and judicial precedent, including a prior decision of the tax court on the same issue in connection with golfer retief goosen’s endorsement agreement with taylormade, goosen v. commissioner, 136 t.c. 547 (2011) (where judge kroupa found a 50%-50% split). the court concluded that 65 percent of garcia’s compensation was royalties and 35percent was compensation for personal services. the court also held that garcia’s royalty income was not, as the government argued, income derived as an entertainer and therefore taxable in the united states under article 17 of the u.s.-swiss tax treaty, but rather was royalty income that is not taxable in the united states under article 12 of the treaty. the court held that all of garcia’s u.s.-source personal service income was taxable in the united states and rejected as untimely garcia’s argument, raised for the first time in a post-trial brief, that a portion of his service income was not taxable in the united states. 2. cash value life-insurance through off-shore insurance companies and llcs don’t produce deductible premiums. salty brine 1, ltd. v. united states, 111 a.f.t.r.2d, 2013-2308 (n.d. tex. 5/16/13). in a marketed insurance tax shelter arrangement that even jenkens & gilchrist would not bless with an opinion, the court denied § 162 deductions for premiums paid for business protection insurance issued by off-shore affiliates of fidelity and citadel insurance companies. the policies included cash value life insurance and related annuities that the court found did not protect the business from risk and merely represented an attempt to funnel cash from the businesses to families of the owners. section 6662 penalties were upheld. 3. pay me now or pay me later. the 2009 arra, § 1231(a), added code § 108(i), which defers and then ratably includes income arising from business indebtedness discharged by the reacquisition of a debt instrument. this provision allows a taxpayer to irrevocably elect to include cancellation of debt income realized in 2009 and 2010 ratably over five tax years, rather than in the year the discharge occurs, if the debt was issued in connection with the conduct of a trade or business or by a corporation. for partnerships and s corporations, the election is made by the partnership or corporation, not by the individual partners or shareholders. i.r.c. § 108(i)(5)(b)(iii). under the § 108(i) election, income from a debt cancellation in 2009 is recognized beginning in the fifth taxable year following the debt cancellation; the income is recognized ratably in each of 2014 through 2018. income from a debt cancellation in 2010 is recognized beginning in the fourth taxable year following the debt cancellation; the income is recognized ratably in each of 2014 through 2018. if a taxpayer elects to defer debt cancellation income under § 108(i), the § 108(a) exclusions for bankruptcy, insolvency, qualified farm indebtedness, and 240 florida tax review [vol. 15:5 qualified real property business indebtedness do not apply to the year of the election or any subsequent year. i.r.c. § 108(i)(5)(c). thus, the election cannot be used to move the year of inclusion to a year in which it is expected that one of the exceptions will apply. once the election is made, inclusion is inevitable; the statute requires acceleration of inclusion to the taxpayer’s final return in the event of the intervening death of an individual or liquidation or termination of the business of an entity. § 108(i)(5)(d). the acceleration rule also applies in the event of the sale or exchange or redemption of an interest in a partnership or s corporation by a partner or shareholder. a. many of the questions have been answered. rev. proc. 2009-37, 2009-36 i.r.b. 309 (8/17/09). this revenue procedure provides the exclusive procedure for taxpayers to make § 108(i) elections. debt cancellation in connection with a property transfer is included in § 108(i). section 4.04(3) permits partial elections, with the partnership permitted to determine “in any manner” the portion of the cod income that is the “deferred amount” and the portion of the cod income that is the “included amount” with respect to each partner. section 4.11 permits protective elections where the taxpayer concludes that a particular transaction does not generate cod income but fears that the irs may determine otherwise. a partner’s deferred § 752(b) amount, arising from a decrease in his share of partnership liabilities, will be treated as a current distribution of money in the year that the cod income is included. taxpayers are allowed an automatic one-year extension from the due date to make the election, and taxpayers who made elections before the issuance of the revenue procedure will be given until 11/16/09 to modify (but not revoke) their existing elections. corporate taxpayers making a § 108(i) election are required to increase earnings and profits for the year of the election. b. temporary regulations allocate deferred cancellation of debt income. t.d. 9498, application of section 108(i) to partnerships and s corporations, 75 f.r. 49380 (8/13/10). section 108(i) provides an election to include cancellation of indebtedness income resulting from a reacquisition (broadly defined in § 108(i)(4)) of a debt instrument, issued by a c corporation or other person engaged in a trade or business, ratably over five years beginning with the fifth year following reacquisition occurring in 2009, and the fourth year following reacquisition in 2010. under § 108(i)(5)(b)(iii) an election is made by the partnership, not the partners individually. section 108(i)(6) requires a partnership to allocate the cod income to partners according to partnership share on the day immediately preceding reacquisition and provides that the discharge will not trigger 2014] recent developments in federal income taxation 241 § 752(b) recognition under § 731 because of a reduction in a partner’s share of partnership liabilities.  temp. reg. § 1.108(i)-2t(d)(1) provides five safe harbors where debt instruments issued by a partnership or s corporation will be treated as issued in a trade or business: (1) the gross fair market value of the trade or business assets of the partnership or s corporation represent at least 80 percent of the fair market value of all of its assets on the date of issuance, (2) trade or business expenses of the partnership or s corporation represent at least 80 percent of all expenditures, (3) at least 95 percent of the interest paid on the debt instrument is allocable to trade or business expenditures under the interest allocation rules of temp. reg. § 1.163-8t, (4) at least 95 percent of the proceeds from the debt instrument were used to acquire trade or business assets within six months of the issue of the debt, or (5) the partnership or s corporation issued the debt instrument to the seller of a trade or business to acquire the trade or business. absent anchoring in one of the safe harbors, qualification of a trade or business debt is a matter of facts and circumstances.  while § 108(i)(5)(b)(iii) requires the election to be made at the partnership level, temp. reg. § 1.108(i)-2t(b)(1) allows the partnership to allocate both deferred and included portions of cod income to the partners. the temporary regulations first require that cod income be allocated to the partners in the partnership immediately before the reacquisition in the manner the income would be included in distributive shares under § 704, then the partnership must determine the amount of cod income from the applicable instrument that is the deferred amount includible in the partner’s share and the amount that is immediately includible. with respect to deferred cod income of an s corporation, temp. reg. § 1.108(i)-2t(c)(1) requires that on an election by the s corporation, deferred income must be shared pro rata on the basis of stock ownership immediately prior to the reacquisition.  temp. reg. § 1.108(i)-2t(b)(2) provides that a partner’s basis is not adjusted under § 705(a) to account for the partner’s share of partnership deferred cod income until the deferred item is recognized by the partner. likewise, temp. reg. § 1.108(i)-2t(c)(2) provides that neither an s corporation shareholder’s basis under § 1367 nor the shareholder’s accumulated adjustment account is adjusted for deferred cod income until the shareholder recognizes the deferred cod income.  following the rules of rev. proc. 2009 37, and applying the rules of § 108(i)(6), temp. reg. § 1.108(i)-2t(b)(3) provides that reduction in a partner’s share of partnership liabilities is determined under § 752(b) when a debt instrument is reacquired, but that the reduction in liabilities is not treated as a distribution of money until deferred cod income is recognized by the partner. the temporary regulations 242 florida tax review [vol. 15:5 provide additional rules for determining a partner’s deferred amounts where the partner would recognize § 731 gain in the year of the reacquisition.  partners’ capital accounts are adjusted as if no § 108(i) election were made.  temp. reg. § 1.108(i)-2t(d)(3) provides that gain attributable to a reduction in a partner’s or s corporation shareholder’s amount at-risk under § 465(e) will not be taken into account in the year of reacquisition and will be deferred to the date the cod income is recognized.  in the case of an acceleration event under § 108(i)(5)(d) that requires a partnership or s corporation to recognize deferred items, under temp. reg. § 1.108(i)-2t(c)(3) the partners or s corporation shareholders must account for deferred cod income in the year that the accelerating event takes place. in addition, the temporary regulations describe various circumstances in which a partner or s corporation shareholder terminates the interest in the entity that will require acceleration of deferred cod income, including death, liquidation, sale or exchange, redemption, or abandonment.  identical proposed regulations were issued simultaneously. reg-144762-09, application of section 108(i) to partnerships and s corporations, 75 f.r. 49427 (8/13/10). c. significant guidance on a soon to expire beneficial code section that leaves a nasty hangover. t.d. 9497, guidance regarding deferred discharge of indebtedness income of corporations and deferred original issue discount deductions, 75 f.r. 49394 (8/13/10). the irs and treasury have promulgated temp. reg. §§ 1.108(i)-0t through 1.108(i)-3t providing detailed rules for c corporations regarding the acceleration of deferred cod income and deferred oid deductions under § 108(i)(5)(d), and the calculation of earnings and profits as a result of an election under § 108(i). the regulations also provide rules applicable to all taxpayers regarding deferred oid deductions under § 108(i) as a result of a reacquisition of an applicable debt instrument by an issuer or related party.  identical proposed regulations were issued simultaneously. reg-142800-09, guidance regarding deferred discharge of indebtedness income of corporations and deferred original issue discount deductions, 75 f.r. 49428 (8/13/10). d. final guidance on an expired code section. t.d. 9622, guidance regarding deferred discharge of indebtedness income of corporations and deferred original issue discount deductions, 78 f.r. 39984 (7/2/13). the treasury department has finalized the proposed regulations (reg-142800-09, 75 f.r. 49428 (8/13/10)) regarding deferred 2014] recent developments in federal income taxation 243 cod income of corporations and deferred oid deductions and replaced the temporary regulations promulgated in t.d. 9497, 75 f.r. 49394 (8/13/10), without significant changes. e. more final guidance on an expired code section. t.d. 9623; application of section 108(i) to partnerships and s corporations 78 f.r. 39973 (7/2/13). the treasury department has finalized the proposed regulations (reg-144762-09, 75 f.r. 49427 (8/13/10)) regarding application of § 108(i) to partnerships and s corporations, and has replaced the temporary regulations promulgated in t.d. 9498, 75 f.r. 49380 (8/13/10), with some changes. b. deductible expenses versus capitalization 1. temporary and proposed regulations provide extensive rules for the acquisition, production, or improvement of tangible personal property. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11), and reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81128 (12/27/11). the treasury department has promulgated temporary regulations, generally effective for tax years beginning on or after 1/1/12, addressing capitalization requirements for expenditures to acquire and improve tangible property. a. irs specifies the procedures for adopting new accounting methods under the temporary regulations. rev. proc. 2012-19, 2012-14 i.r.b. 689 (3/7/12), modifying rev. proc. 2011-14, 2011-1 c.b. 330. the irs has provided lengthy and detailed rules regarding automatic changes in methods of accounting under temp reg. §§ 1.162-3t and 4t (materials and supplies), 1.263(a)-1t (capital expenditures in general), 1.263(a)-2t (transaction costs), and 1.263(a)-3t (improvements), all added by t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11). these changes are for taxable years beginning on or after january 1, 2012. b. lb&i provides guidance under rev. proc. 2012-19. lb&i-4-0312-004 (3/15/12). this directive to the field applies to taxpayers who adopted a method of accounting relating to the conversion of capitalized assets to repair expense under § 263(a). c. have your clients been wasting time trying to comply with the temporary regulations in 2012? yes, they have. further guidance announcing that pending final regulations will 244 florida tax review [vol. 15:5 apply only in years beginning in 2014 and thereafter. notice 2012-73, 2012-51 i.r.b. 713 (11/20/12). the irs announced that pending final regulations will apply to taxable years beginning on or after 1/1/14, but that taxpayers will be permitted to apply the final regulations to taxable years beginning on or after 1/1/12. the notice also indicates that the temporary regulations may be revised with respect to the de minimis rule of § 1.263(a)2t(g); dispositions under §§ 1.168(i)-1t and 1.168(i)-8t; and the safe harbor for routine maintenance under § 1.263(a)-3t(g). d. technical amendments to revise the temporary regulations. more important, the effective date of the 12/27/11 temporary regulations is delayed to years beginning on or after 1/1/14, with optional retroactive applicability. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 77 f.r. 74583 (12/17/12). these include the following explanation: “[t]he irs and the treasury are concerned that taxpayers are expending resources to comply with temporary regulations that may not be consistent with forthcoming final regulations.” e. an announcement amending regulations — really!!?? announcement 2013-7, 2013-3 i.r.b. 308 (1/14/13). this announcement amends the temporary regulations (t.d. 9564), regarding the deduction and capitalization of expenditures under §§ 162(a) and 263(a) relating to tangible property to apply the temporary regulations to taxable years beginning on or after 1/1/14, while permitting taxpayers to apply the temporary regulations for taxable years beginning on or after 1/1/12, and before the applicability date of the final regulations. f. a minor fix. announcement 2013-4, 20134 i.r.b. 440 (1/18/13). the irs corrected the temporary regulations to provide in § 1.168(i)-l(l)(2) rules for making general asset account elections on form 4562. the amendment corrects paragraph numbering mistakes. g. finally, final regulations providing extensive rules regarding capitalization of expenses for the acquisition, production, or improvement of tangible personal property, and brightline distinction of deductible repairs. t.d. 9636, guidance regarding deduction and capitalization of expenditures related to tangible property, 78 f.r. 57686 (9/19/13). the treasury department and irs have promulgated final regulations under § 263(a) addressing capitalization requirements for expenditures to acquire and improve tangible property that were proposed in reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81128 2014] recent developments in federal income taxation 245 (12/27/11), and replacing the temporary regulations promulgated in t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11). 1 the temporary regulations originally were to be effective for tax years beginning on or after 1/1/12, with an expiration date of 12/23/14, but t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 77 f.r. 74583 (12/17/12), delayed the effective date to years beginning on or after 1/1/14, with optional retroactive applicability to taxable years beginning on or after 1/1/12. the final regulations generally are effective for taxable years beginning on or after january 1, 2014. the § 263(a) regulations provide detailed capitalization rules and several brightline standards under §§ 162(a) and 263(a) regarding the acquisition, improvement or repair of tangible real and personal property. the 2011 temporary regulations also revised rules under § 168 regarding disposition of and maintenance of general asset accounts for macrs property. except for reg. § 1.168(i)-7, dealing with multiple asset accounts, these provisions of the temporary regulations (temp. regs. §§ 1.168(i)-1t, 1.168(i)-8t), have not been finalized and are still in force. in general, the § 263(a) regulations adopt the provisions of the 2011 and 2008 proposed regulations, but with multiple modifications, including not insignificant redesignation of subsections. reg. § 1.263(a)-2 provides rules for amounts paid for the acquisition or production of tangible property, and § 1.263(a)-3 provides rules for amounts paid for the improvement of tangible property. however, these new regulations provide many additional rules. the final regulations define material and supplies to treat as deductible (1) the cost of any property with a useful life that does not exceed one year and (2) any item that costs not more than $200 (the temporary regulations had a $100 ceiling). they add a book-conformity de minimis rule, a safe-harbor for routine maintenance, and an optional simplified method for regulated taxpayers. the regulations contain provisions defining a unit of property as a key concept and address capitalization of expenditures that improve or restore a unit of property. the final regulations do not provide for or authorize a detailed repair allowance rule, and unlike the temporary regulations do not provide for future i.r.b. guidance regarding industry-specific repair allowance methods. 1. the temporary regulations adopt provisions of regulations proposed in 2008 (reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 73 f.r. 12838 (3/7/08)), which were in turn based on a 2006 proposal that was substantially modified by the 2008 proposed regulations (reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 71 f.r. 48590 (8/21/06)). 246 florida tax review [vol. 15:5  acquisition and production costs. reg. § 1.263(a)-2 provides that a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property (as determined under reg. § 1.263(a)-3(e)), including leasehold improvement property, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. amounts paid to create intangible interests in land are treated as capital expenditures. reg. § 1.263(a)-1(d)(5). amounts paid for work performed on a unit of property prior to the date the property is placed in service must also be capitalized. reg. § 1.263(a)-2(d)(1). transaction costs to facilitate the acquisition of property are expressly required to be capitalized, reg. § 1.263(a)2(f), but facilitative expenditures do not include employee compensation or overhead unless the taxpayer elects to capitalize such expenditures or if capitalization is required under § 263a. expenditures to defend or protect title must be capitalized. reg. § 1.263(a)-2(e).  selling expenses. reg. § 1.263(a)-1(e) provides for the capitalization of selling expenses as an offset against sales proceeds (except in the case of dealers).  materials and supplies. as under the prior rules, reg. § 1.162-3 allows a deduction for incidental material and supplies in the year an expenditure is made. materials and supplies are incidental when they are carried on hand and for which no record of consumption is maintained or when not carried in inventory. a deduction for non-incidental materials and supplies is allowed in the year the property is consumed. materials and supplies include tangible property that is (1) a component acquired to repair or improve a unit of tangible property that is not acquired as part of a unit of property, (2) fuel, lubricants, water and similar items that are reasonably expected to be consumed within 12 months, (3) tangible property that is a unit of property with (a) an economic useful life to the taxpayer of not more than 12-months, or (b) that costs not more than $200 (an embedded de minimis rule), and (4) certain rotable spare parts. reg. § 1.162-3(c). unlike the temporary regulations, which allowed taxpayers to elect to capitalize the cost of each item of material or supply, the final regulations allow an election to capitalize only rotable, standby, or temporary spare parts (as defined). items used in the production of other property remain subject to the uniform capitalization rules of § 263a. reg. § 1.263a-1(b). on sale or disposition, materials and supplies are not treated as capital assets. reg. § 1.162-3(g).  rotable spare parts. rotable spare parts are components treated as materials and supplies that are installed in a unit of property, are removable from the unit of property, and are generally repaired and improved for installation in a unit of property or stored for later use. the cost of rotable spare parts is deductible in the year of the disposition of the part. reg. § 1.162-3(a)(3). reg. § 1.162-3(e) provides an elective optional 2014] recent developments in federal income taxation 247 method of accounting for the treatment of rotable and temporary spare parts under which (1) the taxpayer deducts the amount paid for the part in the year the part is first installed on a unit of property, (2) in each year the part is removed from a unit of property the taxpayer includes the fair market value of the part in gross income, (3) includes in the basis of the part the value taken into income plus amounts paid to remove the part, (4) includes in the basis of the part any amounts expended to maintain the part, (5) then deducts the basis and any cost incurred to reinstall the part in a unit of property, and finally (6) deducts the basis of the part on final disposition.  financial accounting de minimis rules. reg. § 1.263(a)-1(f)(1) allows a taxpayer to elect to deduct expenditures to acquire or produce property (other than land or property produced for resale) if the taxpayer expenses the cost on a certified audited financial statement (including audited financial statements prepared by an independent cpa and used for non-tax purposes and certain financial statements filed with regulatory agencies) pursuant to a written accounting procedure adopted by the taxpayer that treats as expenses amounts paid for (1) property costing less than a specified dollar amount, or (2) property that has an economic useful life of 12 months or less, as long as the amount per invoice (or item) does not exceed $5,000. 2 notwithstanding these de minimis rules, any amounts paid for property that is, or is intended to be, incorporated into inventory, or that will be used to manufacture inventory, must be capitalized pursuant to § 263a. property subject to the de minimis rules cannot be treated on sale or other disposition as a capital or § 1231 asset. a taxpayer who elects to apply the de minimis rule of reg. § 1.263(a)-1(f) must apply the same de minimis rule to materials and supplies, including rotable spare parts, which are then not treated as materials or supplies under reg. § 1.162-3.  unit of property. reg. § 1.263(a)-3(e). the unit of property concept is central to the proposed regulations’ requirement that improvements to a unit of property must be capitalized.  reg. § 1.263(a)-3(e)(2) provides that a building and its structural components (as defined in reg. § 1.48-1(e)(2)) are treated as a unit of property. 3 however, the improvement rules must be 2. the $5,000 limit replaces the limit in the 2011 temporary regulations, which was an aggregate amount that did not exceed the lesser of 0.1 percent of the taxpayer’s gross receipts or 2 percent of the taxpayer’s total depreciation and amortization expense reflected in its financial statement; the 2011 temporary regulations removed a provision in the 2008 proposed regulations requiring that the aggregate amount deducted not materially distort the taxpayer’s income for purposes of § 446. 3. under reg. § 1.48-1(e)(2), structural components of a building include such parts of a building as walls, partitions, floors, and ceilings, as well as any 248 florida tax review [vol. 15:5 separately applied to components of a building including heating, ventilation and air conditioning systems, plumbing systems, electrical systems, elevators and escalators, fire protection and security systems, gas distributions systems, and other systems identified in published guidance. condominium units and cooperative units are each treated for the owner as a unit of property. similarly, a leasehold interest in a portion of a building is treated as a unit of property.  reg. § 1.263(a)-3(e)(1) defines a unit of property for property other than buildings as including all the components that are functionally interdependent. components of property are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component. however, a component that is recorded on the taxpayer’s books as having a different economic useful life or which is in a different class of property for macrs depreciation would be treated as a separate unit of property. thus, for example, all of the component parts of a railroad locomotive constitute a single unit of property, as does a truck trailer and its tires (unless the taxpayer’s financial statements treat them as separate property). a special rule applies to “plant property,” which is a functionally integrated collection of equipment and machinery used to perform an industrial process; each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent machinery or equipment constitutes a separate unit of property. determinations of a unit of property with respect to network assets are based on the taxpayer’s facts and circumstances unless otherwise provided in published guidance. network assets include property such as railroad tracks, oil, gas, water and sewage pipelines, power transmission lines, and cable and telephone lines that are owned or leased by taxpayers in those industries.  capitalization of improvements. expenditures to improve a unit of property must be capitalized. reg. § 1.263(a)-3(d). amounts expended for repairs and maintenance of tangible property are deductible if they are not required to be capitalized under reg. § 1.263(a)-3. reg. § 1.162-4. expenditures that improve tangible property and that are required to be capitalized include expenditures that: permanent coverings therefor such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building. 2014] recent developments in federal income taxation 249 (1) result in a “betterment” to a unit of property; (2) restore a unit of property; or (3) adapt the unit of property to a new or different use. reg. § 1.263(a)-3(f) provides special rules requiring a lessee to capitalize expenditures for improvements to a unit of leased property. a lessor is required to capitalize the cost of improvements to leased property paid directly or through a construction allowance to the lessee. (the preamble to the 2011 temporary regulations states that the recovery period for an improvement or addition to the “underlying property” begins on the placedin-service date of the improvement or addition. see i.r.c. § 168(i)(6); temp. reg. § 1.168(i)-8t(c)(4)(ii)(e).)  betterment. reg. § 1.263(a)-3(j). an expenditure must be capitalized if it results in the “betterment” of a unit of property. an expenditure meets this standard only if it — (1) “[a]meliorates a material condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property ... ,” (2) “[r]esults in a material addition ... to the unit of property,” or (3) “[i]s reasonably expected to materially increase the productivity, efficiency, strength, quality or output of the unit of property.” 4 determination of whether an expenditure results in a betterment is factual and requires a comparison of the condition of the property immediately prior to the circumstance necessitating the expenditure (or the condition of property the last time the taxpayer corrected for normal wear and tear) with the condition of the property after the expenditure. an expenditure that results in a betterment of a component of a building is treated as a betterment to the unit of property consisting of the building and its structural components. if an expenditure is made to counter the effects of normal wear and tear, the betterment determination is made by comparing the condition of the property immediately after the expenditure with its condition after the last time the taxpayer corrected the effects of normal wear and tear, or with its condition when placed in service by the taxpayer (if the taxpayer has not previously corrected the effects of wear and tear). reg. § 1.263(a)-3(j)(3)(iii)(b). if an expenditure is made in response to a particular event that damaged the property, the betterment determination is made by comparing the condition of the property immediately after the expenditure with its condition immediately before the particular event. reg. § 1.263(a)-3(j)(3)(iii)(c). although the 2011 temporary regulations provided 4. former temp. reg. § 1.263(a)-3(h)(iii) applied a different standard for the third criterion, finding a betterment if the expenditure “[r]esults in a material increase in capacity ..., productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property.” 250 florida tax review [vol. 15:5 that the betterment determination was to be made on the basis of “all the facts and circumstances, including, but not limited to, the purpose of the expenditure, the physical nature of the work performed, the effect of the expenditure on the unit of property, and the taxpayer’s treatment of the expenditure on its applicable financial statement,” former temp. reg. § 1.263(a)-3t(h)(3)(i), this provision was eliminated in the final regulations; nevertheless the preamble states that the “irs and the treasury department believe that an analysis of a taxpayer’s particular facts and circumstances is implicit in the application of all the final regulations governing improvements and need not be specifically provided in the application of the betterment rules.”  restoration. reg. § 1.263(a)-3(k). an expenditure must be capitalized as a restoration if it (1) replaces a component for which the taxpayer has deducted a loss, (2) replaces a component the adjusted basis of which has been accounted for in realizing gain or loss on a sale or exchange of the component, (3) repairs damage for which the taxpayer has deducted a casualty loss under § 165, (4) returns the property to its ordinary operating condition after the property has fallen into a state of disrepair and is no longer functional, (5) results in rebuilding the property to a like-new condition at the end of its class life under the § 168(g) alternative depreciation system, or (6) is for the replacement of a major component or structural part of the unit of property. expenditures to repair damage to a unit of property for which the taxpayer has claimed a casualty loss for the damage must be capitalized only to the extent that (1) the basis of the property for which a loss deduction was allowed exceeds (2) the amounts paid that represent an improvement to the property measured by its condition prior to the casualty. reg. § 1.263(a)-3(k)(4). in other words, repair costs in excess of the casualty loss deduction that merely restore the property to its pre-casualty condition are deductible, but repair costs equal to the casualty loss must be capitalized. 5 see reg. § 1.263(a)-3(k)(7), exs. 3-5. whether there has been a replacement of a major component or structural part is determined under the facts and circumstances and includes replacement of a major component or structural part that comprises a large portion of the physical structure of the unit of property or that performs a discrete and critical function in the operation of the unit of property. again, the restoration of a component of a building is treated as a restoration of the unit of property consisting of the building and its structural components.  new use. reg. § 1.263(a)-3(l). a unit of property is treated as adapted to a new or different use if the adaptation is not consistent with the taxpayer’s “ordinary use of the unit of property at the 5. this differs from the temporary regulations under which the full amount of the casualty restoration costs would have been subject to capitalization. 2014] recent developments in federal income taxation 251 time originally placed in service by the taxpayer.” an expenditure to adapt a building system to a new use must be capitalized.  removal costs. the 2011 temporary regulations treated component removal costs as an indirect cost that had to be capitalized if the removal costs directly benefited or were incurred by reason of an improvement. the final regulations have changed this rule. reg. § 1.263(a)-3(g)(2) provides that if a taxpayer disposes of a depreciable asset (including a partial disposition under prop. reg. § 1.168(i)-1(e)(2)(ix) or prop. reg. § 1.168(i)-8(d)) and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, the costs of removing the asset or component are not required to be capitalized. if a taxpayer disposes of a component of a unit of property and the disposal is not a disposition for tax purposes, then the taxpayer must deduct or capitalize the costs of removing the component based on whether the removal costs directly benefit or are incurred by reason of a repair to the unit of property or an improvement to the unit of property.  rehabilitation doctrine is no more. reg. § 1.263(a)-3(g)(1) eliminates the judicially created rehabilitation doctrine by providing that, “[i]ndirect costs that do not directly benefit or are not incurred by reason of an improvement are not required to be capitalized under section 263(a), regardless of whether they are made at the same time as an improvement.” although the temporary regulations specifically provided that if otherwise deductible repairs benefit or are incurred by reason of an improvement, the cost of the repairs had to be capitalized under § 263a, the final regulations omit this sentence. however, some added examples illustrate when § 263a requires capitalization.  routine maintenance safe harbor. reg. § 1.263(a)-3(i)(1) provides safe harbor rules for routine maintenance of a unit of property that is not treated as improving the property. for property other than a building or a structural component of a building, routine maintenance is defined as “the recurring activities that a taxpayer expects to perform as a result of the taxpayer’s use of the unit of property to keep the unit of property in its ordinarily efficient operating condition.” reg. § 1.263(a)-3(i)(1)(ii). examples include inspection, cleaning, and testing of the unit, and replacement of parts of the unit. the safe harbor applies to activities that the taxpayer reasonably expects to perform more than once during the class life of the property, as determined under the macrs alternative depreciation schedule of § 168(g). routine maintenance includes maintenance with respect to and the use of rotable spare parts. routine maintenance excludes activities that follow a basis recovery event similar to the items that are described as restorations.  routine maintenance safe harbor for buildings. the 2011 temporary regulations did not provide a routine 252 florida tax review [vol. 15:5 maintenance safe harbor for buildings, but the 2013 final regulations provide two safe harbors for buildings. for buildings and structural components of building, routine maintenance is defined as “the recurring activities that a taxpayer expects to perform as a result of the taxpayer’s use of any of the properties ... to keep the building structure or each building system in its ordinarily efficient operating condition.” reg. § 1.263(a)-3(i)(1)(ii). examples include the inspection, cleaning, and testing of the building structure or each building system, and the replacement of damaged or worn parts with comparable and commercially available replacement parts. however, the activities are routine only if the taxpayer reasonably expects to perform the activities more than once during the 10-year period beginning at the time the building structure or the building system upon which the routine maintenance is performed is placed in service. reg. § 1.263(a)-3(i)(1)(ii).  routine maintenance safe harbor for buildings of “qualifying small taxpayers.” the 2013 final regulations also provide an additional safe harbor election for building property held by taxpayers with gross receipts of $10,000,000 or less (“a qualifying small taxpayer”). reg. § 1.263(a)-3(h). a qualifying small taxpayer may elect to not apply the improvement rules to an eligible building if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities with respect to the building does not exceed the lesser of $10,000 or two percent of the unadjusted basis of the building. eligible building property includes a building that is owned or leased by the qualifying taxpayer, provided the unadjusted basis of the property is $1,000,000 or less.  repairs. reg. § 1.162-4 allows as a deductible repair expense any costs that are not required to be capitalized under reg. § 1.263(a)-3. the final regulations do not provide for a repair allowance. temp. reg. § 1.263(a)-3t(l) provided that taxpayers would be permitted to use a repair allowance method authorized by published guidance in the federal register or the internal revenue bulletin. this provision was deleted in finalizing the regulations.  examples. the regulations are full of examples that seem to cover most of the litigated cases and rulings addressing capitalization versus repair. the examples are necessary to understand the substantive provisions, which, although intended to provide clarity, are not so clearly applied.  effective dates. in general, the final regulations apply to taxable years beginning on or after 1/1/14. however, certain rules apply only to amounts paid or incurred in taxable years beginning on or after 1/1/14. the various effective dates are in regs. §§ 1.162-3(j), 1.162-4(c), 1.162-11(b)(2), 1.165-2(d), 1.167(a)-4(b), 2014] recent developments in federal income taxation 253 1.167(a)-7(f), 1.167(a)-8(h), 1.168(i)-7(e), 1.263(a)-1(h), 1.263(a)-2(j), 1.263(a)-3(r), 1.263(a)-6(c), 1.263a-1(l), and 1.1016-3(j). 2. electricity and hot air — the irs defines unit of property for generators of steam and electricity. rev. proc. 2013-24, 2013-21 i.r.b. 1142 (4/30/13). under temp. reg. § 1.263(a)-3t, which requires capitalization of expenditures to improve, better, or restore a unit of property, interdependent major components are treated as a part of a unit of property. temp. reg. § 1.162-4t allows as a deductible repair expense any costs that are not required to be capitalized under temp. reg. § 1.263(a)-3t. in the case of power plants generating steam or electricity, the revenue procedure provides a list of properties that will be treated, at the taxpayer’s election, as separate units of property within a power station and identifies major components of the units of property. the revenue procedure adds that a taxpayer’s method for determining whether an expenditure must be capitalized or is deductible, including the taxpayer’s definitions of a unit of property or major components of a unit of property, is a method of accounting under § 446 and will be subject to § 481 adjustments and the automatic consent rules for adopting the unit of property definitions provided in appendix a of the revenue procedure. in general, the appendix lists numerous systems within a generating facility (such as turbines) as separate units of property and identifies major components of the units of property. the definitions of rev. proc. 2013-24 are limited to determinations for purposes of the capitalization/repair rules and may not be used for other purposes such as depreciation. 3. law firm advances of litigation expenses were loans, not deductible expenses. humphrey, farrington & mcclain v. commissioner, t.c. memo. 2013-23 (1/17/13). the cash method taxpayer plaintiff’s law firm maintained a classification system for litigation costs advanced to clients in contingent fee cases. if the firm considered the likelihood of reimbursement to be high, the advanced costs were capitalized. in riskier cases where the firm considered the likelihood of reimbursement to be low, the firm deducted the advanced expenses, and reported reimbursement as income as advances were repaid. the tax court (judge morrison) held that the advanced litigation costs were loans in all cases, even if eventual recovery of the advances was contingent, and disallowed the deductions. the court found that there was a significant possibility of reimbursement, a factor that supported treating the advances as loans. the court also agreed with the irs that the treatment of the advances as loans was a change in the taxpayer’s method of accounting, which did not clearly reflect income, and, therefore, allowed adjustments under § 481 with respect to prior years. nonetheless, the court found that the taxpayer’s classification method was a reasonable attempt to ascertain the tax treatment of advanced https://checkpoint.riag.com/app/main/doclinknew?docid=i1320e00def6d64fbb109eb0bb346c19a&srcdocid=t0newsltr%3a650544.1dr7&feature=tnews&lastcpreqid=3129040 254 florida tax review [vol. 15:5 expenses which qualified for the reasonable cause exception to § 6662 penalties. 4. protecting directors from cement shoes in a shareholder class-action arising from a merger subject to capitalization. why apply modern regulations when old case law will do the trick? ash grove cement company v. united states, 111 a.f.t.r.2d 2013-767 (d. kan. 2/6/13). the taxpayer settled a class action lawsuit by minority shareholders against itself and its directors arising out the acquisition of another corporation in a reorganization. the district court (judge murguia) granted summary judgment for the government, holding that both the settlement payment and litigation expenses incurred by the taxpayer in resolving the class action lawsuit were capital expenditures under § 263. the origin of the claim for which the taxpayer incurred the expenses arose from a capital transaction. even though the payments related to the taxpayer’s 2005 return, the court applied the case law based “origin of the claim” test, e.g., woodward v. commissioner, 397 u.s. 572 (1970), rather than reg. § 1.263(a)-5, which was promulgated in 2003. the court held that the litigation expenses arose out of the acquisition transactions and were thus capital expenses under the origin of the claim test. the court rejected the taxpayer’s argument that expenses incurred to indemnify directors from legal claims were deductible. the court pointed out that under the taxpayer’s approach, “companies could always deduct litigation expense any time a director acting in good faith is sued in connection with a capital transaction so long as the company has an indemnity obligation.” 5. with global warming these plants are growing faster. notice 2013-18, 2013-14 i.r.b. 742 (2/19/13); rev. proc. 2013-20, 2013-14 i.r.b. 744 (2/19/13). the irs has revised the categories of “berries” as plants that do not have a pre-productive growth period in excess of two years to segregate blueberry, blackberry, and raspberry plants, and removed papaya plants from the list. under § 263a(d)(1) and reg. § 1.263a-4(d) farmers who are not required to use the accrual method of accounting (and who are not tax shelters) are not required to capitalize the costs of raising animals or the costs of producing plants with a pre-productive period of two years or less. the irs maintains a list of qualifying plants based on the nationwide pre-productive period for plants. the accompanying revenue procedure provides procedures for a taxpayer to obtain automatic consent to not apply § 263a to the production of plants removed from the list of plants that have a nationwide weighted average pre-production period in excess of two years. 2014] recent developments in federal income taxation 255 6. research to eliminate uncertainty is deductible under proposed regulations. what about the uncertainty of tax advice? reg-124148-05, research expenditures, 78 f.r. 54796 (9/6/13). section 174 allows either deduction or 60 month amortization of research and experimental expenditures, but under § 174(c) the § 174 deduction is not applicable to expenditures for the acquisition or improvement of land or depreciable property. reg. § 1.174-2(a)(1) defines research and experimental expenditures as expenditures that represent “research and development costs in the experimental or laboratory sense” and provides in § 1.174-2(b)(1) that depreciation allowances on depreciable property used in research are § 174 expenditures. the proposed regulations would provide that expenditures may qualify under § 174 regardless of whether a resulting product is sold or used in the taxpayer’s trade or business and that the depreciable property rule is an application of the general definition of research and experimental expenditures.  prop. reg. § 1.174-2(a)(1) would provide that the ultimate success, failure, sale or use of a product is not relevant to a determination of eligibility of expenditures as research or experimental expenditures under § 174.  as an application of the general definition of research expenditures, the depreciable property rule should not be applied to exclude otherwise eligible expenditures.  under reg. § 1.174-(a)(2) research expenditures to develop a product include development of a pilot model. prop. reg. § 1.174-2(a)(4) would define a pilot model as “any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product.”  the proposed regulations would amend reg. § 1.174-2(a)(1) to “clarify” that production costs after uncertainty is eliminated are not eligible under § 174 by providing that “[c]osts may be eligible under section 174 if paid or incurred after production begins but before uncertainty concerning the development or improvement of the product is eliminated.”  prop. reg. § 1.174-2(a)(5) would adopt a “shrinking back rule” that would provide that research and experimental expenditures for the improvement of a component of a larger design may be eligible under § 174, but uncertainty with respect to a component does not necessarily indicate uncertainty with respect to the product as a whole.  although the proposed regulations will be effective on publication of final regulations in the federal register, the proposed regulations indicate that the irs will not challenge expenditures that conform to the proposed regulations. 256 florida tax review [vol. 15:5 7. custom homes are no different from spec houses, both are subject to the uniform cost capitalization rules. frontier custom builders, inc. v. commissioner, t.c. memo. 2013-231 (9/30/13). the taxpayer corporation constructed custom homes. it argued that its business model was centered around sales and marketing rather than production related services and asserted that employee salaries and other indirect expenses were not subject to capitalization under § 263a. the tax court (judge goeke) disagreed. the court stated that the taxpayer’s creative design of homes “is ancillary to the physical work and is as much a part of a development project as digging a foundation or completing a structure’s frame.” thus the court found that the taxpayer was a producer of property subject to § 263a’s capitalization requirements. the court also held that the irs did not abuse its discretion by treating the taxpayer’s deduction of production expenses as an accounting method and requiring the taxpayer to adopt the simplified production and simplified service cost methods of accounting under reg. §§ 1.263a-2(b)(1) and 1.363a-1(h)(1). the court required an allocation of salaries, bonuses and other expense items between indirect expenses subject to capitalization and operating expenses currently deductible. 8. tax expenditures for movies and television. the compromise tax relief act of 2010, § 744, extends the election under code § 181 to expense up to $15 million of qualified film and television production costs if 75 percent of total compensation is for services performed in the u.s. the limit is $20 million for production costs incurred in lowincome or distressed communities through 2011. a. final regulations come out just in time for the expiration date of the statute. t.d. 9551, deduction for qualified film and television production costs, 76 f.r. 60721 (9/30/11). section 181 provides for an election to deduct qualified film or television production costs incurred in productions commenced prior to 1/1/12, as an expense not chargeable to capital account in an amount up to $15 million for each production, or $20 million for production expenses incurred in certain low income or distressed county areas. a production qualifies for the election if at least 75 percent of the total compensation for the production is for services performed in the united states by actors, directors, producers, and production personnel. final regulations §§ 1.181-1 through -6, replacing temporary and proposed regulations, clarify the owner of production costs, the definition of aggregate production costs for purposes of the election and limitations, and provisions applicable to participations and residuals. 2014] recent developments in federal income taxation 257 b. temporary and proposed regulations update the rules. reg-146297-09, deduction for qualified film and television production costs, 76 f.r. 64879 (10/19/11). the temporary (temp. regs. §§ 1.181-0t, 1.181-1t) and proposed regulations clarify that the $15 million (or $20 million) limitation under amendments to § 181 applies to limit the aggregate deduction for production costs paid or incurred by all owners of a qualified film or television production for each qualified production, rather than limit the aggregate production costs. c. and now, “final” final regulations after the provision expired. t.d. 9603, deduction for qualified film and television production costs, 77 f.r. 72923 (12/7/12). the final regulations (reg. §§ 1.181-0, 1.181-1) remove the temporary regulations, and provide that whether production costs qualify for preor post-1/1/08 limitations, compensation to actors is allocated to first unit principal photography. d. thank dodd that special expensing rules for film and television productions were extended to 2012 and 2013. the 2012 taxpayer relief (and not so grand compromise) tax act, § 317, extends through the end of 2013 the election under code § 181 to expense up to $15 million of qualified film and television production costs if 75 percent of total compensation is for services performed in the u.s.  the limit is $20 million for production costs incurred in low-income or distressed communities. are any members of the film crew residents of those communities? e. no deduction under this terminated provision without a proper election. staples v. commissioner, t.c. memo 2013-262 (11/18/13). section 181 allowed a current deduction of otherwise capital expenses incurred for u.s. production of movie or television programing pursuant to an election in the form specified by the irs. the provision applies to production expenses incurred before 12/31/13. the taxpayer, an attorney, deducted research expenses incurred in developing a series on u.s. history by claiming the expenses on schedule c, but failed to file the form 3115 required by temp. reg. § 1.181-2t(c)(1). although the court (judge wherry) was willing to consider the doctrine of substantial compliance in attempting to make the § 181 election, the court indicated that since the taxpayer had not begun principal photography in the years at issue, the taxpayer was not entitled to the deduction in any event. 9. “candy, cigarettes, and . . . . ?” city line candy & tobacco corp. v. commissioner, 141 t.c. no. 13 (11/19/13). section 263a(b)(2)(b) provides a small reseller exception to the § 263a uniform capitalization rules, which applies to businesses acquiring goods for resale if 258 florida tax review [vol. 15:5 the firm’s average annual gross receipts for the three-year period immediately preceding the taxable year do not exceed $10 million. the tax court (judge marvel) held that for purposes of determining eligibility for the § 263a(b)(2)(b) small reseller exception the gross receipts of a cigarette wholesaler was required to include the entire sale proceeds from the sale of cigarettes, including the costs of the state cigarette tax stamps the wholesaler was required to purchase. as a result, the wholesaler’s gross receipts exceeded the $10 million ceiling. the cigarette stamp tax costs were indirect costs under reg. § 1.263a-1(e)(3)(i), properly characterized as handling costs, not selling expenses, which reg. § 1.263a-1(e)(3)(iii)(a) exempts from the capitalization requirement. c. reasonable compensation 1. you can save the failing nursing home, but don’t pay yourself too much. thousand oaks residential care home i, inc. v. commissioner, t.c. memo. 2013-10 (1/14/13). the husband and wife shareholders (the fletchers) took over a failing retirement home and turned it into a profitable operation. in the years at issue the fletchers each received approximately $200,000 of compensation plus contributions to a defined benefit plan for each of approximately $191,000 for services respectively as the overall manager and head nurse. the tax court (judge wherry) agreed that the compensation to the taxpayers was catch-up compensation for years when the corporation provided little compensation, that the compensation levels were below national norms, that the corporation’s cash-flow was marginally sufficient to pay its bills including acquisition indebtedness, but that the fletchers as the shareholders used all of the profits to pay salaries and never received a dividend. the deciding factor for the court’s holding that the compensation was unreasonable was that independent investors would have demanded at least a 10 percent return on their investment and that the compensation packages “did not leave enough of the corporation’s assets to be paid back to the hypothetical investor as a return on investment.” the court also held that compensation paid to the fletchers’ daughter was unreasonable. the court further declined the irs’s invitation to impose additions to tax under § 6651 and § 6662 accuracy related penalties, finding that the taxpayer reasonably relied on the advice of its accountant (with the exception of penalties related to the compensation paid to the fletchers’ daughter). a. and don’t press your luck by seeking costs as a prevailing party. thousand oaks residential care home i, inc. v. commissioner, t.c. memo. 2013-156 (6/20/13). the taxpayers moved for reasonable administrative and litigation costs pursuant to § 7430, which 2014] recent developments in federal income taxation 259 permits the award of such costs to a prevailing party. the irs “conceded that . . . petitioners ha[d] ‘substantially prevailed with respect to the most significant issues or set of issues in . . . [their] case[s] . . . .’” nevertheless, the court (judge wherry) denied the taxpayers’ motion on the ground that the position of the irs in the case was reasonable and substantially justified. “the testimony of [the irs’s] expert, the numerous factual issues surrounding the decision, and the total disallowance of all compensation paid to the owner-employees’ daughter ... demonstrate that [the irs] acted reasonably given the facts and circumstances.” therefore § 7430(c)(4)(b) precluded awarding attorney’s fees. 2. irs experts prevail on reasonable compensation issues – surprise! and the court found taxpayer’s position on equitable recoupment to be somewhere between “dalm and dahmer.” k&k veterinary supply, inc. v. commissioner, t.c. memo. 2013-84 (3/25/13). the taxpayer, a wholesaler of animal health products, was wholly owned by john lipsmeyer, who was employed as its chief executive and worked as a principal sales representative. the taxpayer employed john’s wife, melissa, as vice president, secretary and assistant financial officer, john’s brother david as senior vice president of sales, co-chief executive officer and cochief operative officer who also handled 50 accounts, and david’s daughter jennifer as the chief financial officer. accepting the irs expert’s evaluation, the tax court (judge cohen) reduced the corporation’s deductions for compensation paid to the sole shareholder/employee and related parties. the court considered nine factors in evaluating reasonable compensation. among those factors, the court determined that although john and david had significant experience with the corporation’s operations and were important to its success, the record did not establish that either of them was the primary reason for the taxpayer’s growth. the court acknowledged jennifer’s importance to the corporation’s success, but stated that the record fell short of establishing that she was exceptionally qualified or the primary reason for the corporation’s growth. the court also stated that the record fell “far short” of establishing martha’s exceptional qualification or contribution to growth. rejecting the taxpayer’s expert analysis, the court accepted the prevailing salary comparison figures offered by the irs expert and the irs expert’s conclusion of reasonable compensation from comparable companies at the 75th percentile.  the court also rejected the taxpayer’s assertion of an “equitable recoupment” to reduce the corporation’s tax liability by the amount of lower taxes payable by shareholders if the excess compensation had been distributed to the shareholder as a dividend rather than reported by them as compensation income. the court listed four elements required for equitable recoupment to apply: “(1) the overpayment or deficiency for which recoupment is sought by way of offset is barred by an expired period 260 florida tax review [vol. 15:5 of limitation; (2) the time-barred overpayment or deficiency arose out of the same transaction, item, or taxable event as the overpayment or deficiency before the court; (3) the transaction, item, or taxable event has been inconsistently subjected to two taxes; and (4) if the transaction, item, or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.” united states v. dalm, 494 u.s. 596 (1990). the court held that equitable recoupment was not available to the corporation because the denial of the corporate level deduction and the tax on dividends involved two or more taxpayers with insufficient identity of interest to be treated as a single taxpayer. the court observed that a corporation formed for legitimate business purposes and its shareholders are separate entities. 3. increasing the value of the company deserves some bonus, but not all of it. aries communications, inc. v. commissioner, t.c. memo. 2013-97 (4/10/13). in another case appealable to the ninth circuit, the tax court (judge wherry) applied the five factors of elliotts, inc. v. commissioner, 716 f.2d 1241 (9th cir. 1983), plus additional consideration of whether an independent investor would compensate the employee at the claimed amount, to reduce the taxpayer’s corporate deduction for compensation to its sole shareholder. the taxpayer sold its radio stations in the year at issue for a price that was $6 million higher than an initial offer. the taxpayer’s development of the stations and the higher purchase price were attributable to the efforts of the shareholder/ceo, arthur astor, who received annual compensation plus a bonus totaling approximately $6.9 million.  the court concluded that astor was the most important employee of the taxpayer and agreed that compensation attributable to prior years’ service as catch-up compensation allowed compensation that need not be reasonable in the year paid. the fact that astor played a pivotal role in both operating the taxpayer and negotiating the higher price for the sale of assets functioning as an employee of the taxpayer was a factor favoring the taxpayer’s deduction of the compensation.  the court considered the linear regression analysis of dueling experts regarding comparison with salaries of similar companies, but had difficulty with applying comparisons with publically held companies. the court ultimately concluded that a bonus equivalent to one-third of the negotiated increased sales price was reasonable.  the court described the character of the company as a large asset-laden complex business with a negative net income and bleak financial picture, a factor that favored the irs evaluation of reasonable compensation. 2014] recent developments in federal income taxation 261  the court indicated that astor’s conflict of interest in protecting the company as a going concern and his interest as owner in garnering the highest price for the assets and receiving the reward as deductible salary favored the irs.  the corporation’s internal inconsistency in treatment of payments to employees as bonuses at the end of the year when it could predict profits and potential federal income tax liability favored the irs.  finally, as a factor added to the elliotts list, the court determined that since the corporation retained sufficient earnings to satisfy an independent investor at 20 percent compound annual return on equity, the independent investor test supported the corporation’s level of compensation.  at the end of the day, the court determined, based on the experts’ testimony that astor’s fixed compensation was underpaid but the bonus was unreasonable and allowed a deduction of $2,660,889. the court also imposed an accuracy related penalty under § 6662(a) finding that the astor’s conversation with the corporation’s accountants was not reasonable reliance on a tax professional. d. miscellaneous deductions 1. irs values noncommercial flight. rev. rul. 201320, 2013-40 i.r.b. 272 (9/26/13). the value of noncommercial flights on employer owned aircraft is determined by multiplying the cents-per-mile for the applicable period by the appropriate aircraft multiple and adding the applicable terminal charge. the mileage rates for the second half of 2013 are $0.2654 per mile up to 500 miles, $0.2024 for 501-1500 miles, then $0.1946 over 1500 miles. the terminal charge for the second half of 2013 is $48.53. these are little changed from the rates for the first half of 2013: $0.2655 per mile up to 500 miles, $0.2024 for 501-1500 miles, then $0.1946 over 1500 miles. the terminal charge for the first half of 2013 was $48.54. 2. really bad timing in the real estate appraisal business does not the debt make bad. bishop v. commissioner, t.c. memo. 2013-98 (4/10/13). in april 2006, shortly before leaving his position as president of impac mortgage holdings, inc., where he bought and sold pools of loans, the taxpayer advanced $300,000 (which he borrowed from a commercial lender) to landmark equities group to assist in developing a public offering of landmark. landmark had developed an “automated valuation model” product designed to quickly value mortgage loans for investment banks by aggregating title insurance information. the written note required monthly interest payments and was due in april 2007. landmark failed to make payments on the note when due in 2006. the 262 florida tax review [vol. 15:5 taxpayer indicated in testimony that he reviewed the financial health of landmark and concluded that it should have been able to pay the interest, even though the real estate market was showing signs of trouble in 2006, but that landmark would not be able to pay principal in 2006 if the taxpayer had invoked an acceleration clause in the note on default of the interest payments. judge laro concluded that the note was a bona fide indebtedness rejecting the irs assertion that the advance was not a bona fide debt because the note was unsecured, landmark was unable to borrow from a commercial lender, and the taxpayer did not demand payment in full when landmark defaulted on interest payments. the court determined, however, that the taxpayer’s unsubstantiated testimony regarding landmark’s financial health was insufficient to carry the burden of proof that the loan became worthless in 2006. because landmark remained a going concern into 2007, the court indicated that some evidence of landmark’s ability or inability to turn the business around and generate income to pay the note was crucial. the court also sustained the irs assertion of § 6662(a) penalties indicating that the taxpayer’s failure to provide documentary evidence of landmark’s financial health to the taxpayer’s cpa who prepared the return claiming the deduction prevented the taxpayer’s reasonable reliance on the tax professional. 3. the threat of impending death does not reduce substantiation requirements. striefel v. commissioner, t.c. memo. 2013102 (4/11/13). the taxpayer worked as an independent contractor performing field engineering services for an engineering company. the taxpayer’s work required travel away from home. the taxpayer received a “traumatic medical diagnosis” and was told that he would likely die soon. on his release from the hospital the taxpayer destroyed all of his old business records that he kept in a file cabinet. while expressing some sympathy regarding the hospitalization, the tax court (judge kerrigan) refused to accept the taxpayer’s testimony and limited bank records as substantiation for automobile travel, meal, and lodging expenses. the court did allow deductions for some lodging expenses where the taxpayer’s bank records matched his calendar entries and allowed deduction of per diem for meals on those dates. the court also sustained a § 6662(a) accuracy penalty stating that, “[a]lthough petitioner was understandably upset at the time, his actions were not justifiable, reasonable, or prudent under the circumstances. we find that petitioner acted negligently.”  query whether his doctor told him to stop buying green bananas, or merely to stop taking out multi-year magazine subscriptions?  query whether taxpayer may recover for physician malpractice? 2014] recent developments in federal income taxation 263 4. stock valuation settlement produces imputed interest. colorcon, inc. v. united states, 110 fed. cl. 650 (4/30/13). to push out a minority shareholder, db trust, the taxpayer undertook a short-form merger of an 84 percent owned subsidiary under pennsylvania law, which did not require a shareholder vote. after offering the minority interest holder an $82 million promissory note in 1999 at the time of the merger, the taxpayer in 2002 settled a suit claiming dissenter’s rights and other claims with a payment of $191 million. the taxpayer filed a refund claim asserting that $31 million of the payment was deductible as imputed interest under § 483. section 483 requires a taxpayer to impute unstated interest on account of a sale or exchange of property under a contract under which some or all of the payments are due more than one year after the sale or exchange. the irs conceded that the 1999 merger was a sale or exchange. the irs argued, however, that the payment was made pursuant to the 2002 settlement agreement in an action that sought to rescind that 1999 merger transaction, rather than payment for the stock in 1999. looking to pennsylvania law, the court of federal claims (judge firestone) held that the 1999 short-form merger transaction transferred property as a matter of law and that at least a part of the $191 million settlement was paid for the shares. granting summary judgment to the taxpayer, the court also held that the irs did not raise a genuine factual dispute as to whether any portion of the $191 million payment was attributable to other claims. 5. a judge lets the jury decide how much of $126,796,262 of a $385,147,334 settlement payment under the false claims act is compensatory and how much is a nondeductible penalty. fresenius medical care holdings, inc. v. united states, 111 a.f.t.r.2d 2013-1938 (d. mass. 5/9/13). the taxpayer deducted the full amount of a $385,147,334 settlement with the government under the false claims act (for medicare and medicaid fraud), which provides for a penalty of not less than $5,000 and not more than $10,000 plus three times the amount of damages the government sustains. the settlement agreement was silent regarding the allocation of the payment between compensatory and punitive amounts, although it did allocate $65,800,555 to qui tam relators’ awards. the agreement expressly disclaimed any resolution of the tax treatment of the payment. the irs allowed a portion of the deduction but disallowed as a fine or similar penalty, which is nondeductible under § 162(f), $126,796,262 of the claimed deduction. the district court denied cross motions for summary judgment because “real disputes remained about the purpose of the payments,” and on a motion for entry of judgment held that the jury properly determined that $95,000,000 of the disputed amount of the settlement paid to the government was compensatory and therefore deductible. the court explained that “a manifest agreement is not necessary for [the taxpayer] to establish that all or some portion of the payments at issue were made in 264 florida tax review [vol. 15:5 settlement of non-punitive fca liability.” it concluded that “to determine whether the payments made by [the taxpayer] to the government in excess of the amount already deemed deductible by the irs were compensatory damages, it was necessary to consider both the language of the settlement agreements and non-contractual evidence regarding the purpose and application of the payments.” 6. its quest for § 199 deductions was not to be harried by the irs. houdini seals a wine bottle in a basket and escapes with domestic production deductions. united states v. dean, 945 f. supp. 2d 1110 (c.d. cal. 5/7/13). the court granted summary judgment to the taxpayer in the irs’s § 7405 suit to recover amounts erroneously refunded. the irs had granted refunds to the taxpayer shareholders of an s corporation claiming § 199 deductions for domestic production activities. the s corporation, houdini, inc. (“houdini”) packages and markets gift baskets with wine and food items. houdini purchases baskets manufactured to its specifications in china, plus fill materials and wine and food items from various suppliers. houdini designs and packages gift baskets in its facilities in california. section 199 provided a deduction for qualified production activities income of 3 percent for the years at issue and provides a deduction of 9 percent currently. “qualified production activities income” is defined in § 199(c)(1) as the taxpayer’s “domestic production gross receipts” (“dpgr”) minus the related cost of goods sold and other expenses, losses, or deductions. dpgr is defined, in relevant part, as the taxpayer’s gross receipts derived from “any lease, rental, license, sale, exchange, or other disposition of ... qualifying production property which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the united states.” reg. § 1.199-3(e)(1) defines manufacturing, etc. as “manufacturing, producing, growing, extracting, installing, developing, improving, and creating [qualified production property (“qpp”)]; making qpp out of scrap, salvage, or junk material as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles,” but reg. § 1.199-3(e)(1) adds that if a taxpayer “performs minor assembly of qpp and the taxpayer engages in no other mpge [manufactured, produced, grown, or extracted] activity with respect to that qpp [qualified production property], the taxpayer’s packaging, repackaging, labeling, or minor assembly does not qualify as mpge with respect to that qpp.” the district court (judge selna) rejected the irs’s argument that houdini’s assembling gift baskets was merely assembly or packaging activity by noting that, “houdini makes products suitable for use as gifts using machinery, according to an organized plan and with division of labor. therefore, houdini’s production process may qualify as manufacturing or producing.” also noting that houdini’s 2014] recent developments in federal income taxation 265 activities may also qualify as packaging the court stated that, houdini’s “complex production process relies on both assembly line workers and machines. the final products, gift baskets and gift towers, are distinct in form and purpose from the individual items inside. the individual items would typically be purchased by consumers as ordinary groceries. but after houdini’s production process, they are transformed into a gift that is usually given during the holiday season.” the court refused to interpret reg. § 1.199-3(e), ex. 6, indicating that customizing automobiles with purchased parts is not a manufacturing or production activity, as barring houdini’s § 199 deduction. a. direct mail is not manufacturing, just a pain in the mailbox. advo, inc. v. commissioner, 141 t.c. no. 9 (10/24/13). the issue before the court was the application of the § 199 domestic production deduction to materials manufactured through agreements with contract manufacturers. the taxpayer distributed advertising material both prepared by clients and developed by the taxpayer. taxpayer developed material was printed for the taxpayer by third party printers. the taxpayer claimed the § 199 domestic production deduction for paper and printing supplies that were manufactured in the united states. the tax court (judge wherry) agreed with the irs that the taxpayer’s gross receipts attributable to its printed direct mail advertising did not qualify as domestic production gross receipts. citing reg. § 1.199-3(f) the court held that where one taxpayer performs qualifying u.s. production activity with another taxpayer, only the taxpayer that has the “benefits and burdens” of the ownership of qualifying production property may claim the deduction. applying a multifactor test to identify who had ownership of the qualifying property based on case law and with reference to standards under § 936 the court concluded, among other things, that title to the manufactured paper remained with the printers during the printing process, the contract called for “manufacturing” by the printers, the printers had possession of the manufactured material before delivery to the taxpayer (even though the taxpayer controlled the process through its supply of pdf and color files to the printer), the printers bore the risk of damage before delivery of the printed material to the taxpayer, and the printers bore the economic gain or loss on the fixed-price printing contracts. thus, the printers, and not the purchaser of the printed material, were the taxpayers entitled to the § 199 deduction. 7. these fees are in the bag for the taxpayer who is in the trade or business of being a whistleblower. bagley v. united states, 112 a.f.t.r.2d 2013-5602 (c.d. cal. 8/5/13). the taxpayer was awarded $27,244,000 plus statutory attorney’s fees of $9,407,295 as a relator in a false claims act prosecution of trw that ultimately resulted in the recovery of $111 million by the u.s. government. in the taxpayer’s refund 266 florida tax review [vol. 15:5 suit the court concluded that the taxpayer was engaged in a trade or business of prosecuting the litigation and that the attorney’s fees were deductible as ordinary and necessary business expenses under § 162(a). the taxpayer was actively involved with his attorneys in pursuing the claim from 1993 (when the taxpayer was laid off by trw) and 2003, the year of the award. the court accepted the taxpayer’s assertion that he performed the services in order to obtain the award and thus had a good faith expectation of profit from the venture. the taxpayer was said to conduct himself in much the same manner as a lawyer prosecuting a lawsuit and the taxpayer’s expertise as an accountant with knowledge of trw’s systems, procedures, and where the bodies were buried, plus his expertise with federal acquisition regulations, were critical to the government’s recovery. the court observed the size and amount of the fca award to the taxpayer “makes it clear that it found his expertise vital to the prosecution of these claims.” the fact that the taxpayer knew about the fraudulent claims because he participated in them before he was laid off provided him with the knowledge and skills relevant to the subsequent trade or business. the court further observed that the taxpayer devoted significant time and effort to the activity that did not have recreational or personal aspects, which evidenced an intent to derive a profit. the court indicated that devoting effort to an opportunity to earn a single substantial profit (without a history of similar profit and loss activity) can constitute a trade or business. finally, the court concluded that the taxpayer’s activities were regular and continuous in pursuit of profit. [i]t is indisputable that bagley’s activity as a relator occurred over a substantial period of time, and during that time period, bagley devoted much of his time and energy to the tasks and responsibilities of investigating and litigating the fca lawsuit. he pursued the fca lawsuit “full time, in good faith, and with regularity,” by performing a multitude of tasks: attending meetings, reviewing documents that had been produced, creating and revising documents (memoranda, summaries, and court filings), doing damage calculations, and generally assisting his attorneys and the government in understanding the nature of the fraudulent claims and where they could find the documents and witnesses necessary to effectively litigate the case. this was not a hobby or an activity bagley engaged in for pleasure or amusement.  the court also rejected the irs’s assertion that under the origin of the claim test the taxpayer’s award had its origin in the taxpayer’s role as an informer whose contribution to the qui tam action is no different from other types of informants. the court concluded that 2014] recent developments in federal income taxation 267 the origin of the qui tam action is fraud against the government and indicated that the relator “acts as an agent or private attorney general for the government, and is provided an award for the ‘information and services’ provided while prosecuting that claim” and that the taxpayer’s services had the indicia of a business enterprise. 8. standard mileage rate rules published in a revenue procedure while the amounts will be disclosed in a separate notice. rev. proc. 2010-51, 2010-51 i.r.b. 883 (12/3/10). the irs indicated that beginning in 2011 it will publish mileage rates in a separate annual notice. the revenue procedure indicated that a taxpayer may use the business standard mileage rate to substantiate expenses for business use of an automobile in lieu of fixed and variable costs. parking fees and tolls are deductible as separate items. the basis of an automobile used for business is reduced by a per-mile amount published in the annual notice. separate rates are provided both for charitable use of an automobile and medical and moving use of an automobile. the revenue procedure also provides details for treating as substantiated a fixed and variable rate allowance for expenses incurred by an employee in driving an automobile owned or leased by the employee in performing services for the employer. a. add one cent per mile from 2012 for 2013 (except for charitable service). notice 2012-72, 2012-50 i.r.b. 673 (11/21/12). the standard mileage rate for business miles in 2013 goes up to 56.5 cents per mile and the medical/moving rate goes up to 24 cents per mile. the charitable mileage rate remains fixed by § 170(i) at 14 cents. b. and subtract one-half cent per mile from 2013 for 2014 (except for charitable service). notice 2013-80, 2013-52 i.r.b. 821 (12/6/13). the standard mileage rate for business miles in 2014 goes down to 56 cents per mile and the medical/moving rate goes down to 23½ cents per mile. of that business mileage amount, 22 cents is treated as depreciation for purposes of reducing basis. the standard automobile cost for purposes of computing allowances under a fixed and variable rate (favr) plan will be $28,200, and for trucks and vans, $30,400. the charitable mileage rate remains fixed by § 170(i) at 14 cents. 268 florida tax review [vol. 15:5 e. depreciation & amortization 1. guidance on expensing qualified real property under § 179 – things would be much simpler if congress enacted legislation in a timely manner instead of applying rules retroactively. notice 2013-59, 2013-40 i.r.b. 297 (9/10/13). section 179(f) permits a taxpayer to treat “qualified real property” as § 179 property. accordingly, taxpayers can deduct the cost of qualified real property in the year it is placed in service, subject to applicable limits. the american taxpayer (and not so grand compromise) relief act of 2012 extended the application of § 179(f) from qualified real property placed in service during any taxable year beginning in 2010 or 2011 to qualified real property placed in service during any taxable year beginning in 2010, 2011, 2012 or 2013. although the maximum cost of § 179 property that a taxpayer can deduct in each of these years is $500,000 under § 179(b)(1), not more than $250,000 of the taxpayer’s deductions in each year can be attributable to qualified real property. prior to enactment of the atra of 2012, § 179(f)(4) provided that any portion of a taxpayer’s § 179 deduction attributable to qualified real property that was disallowed by the taxable income limitation of § 179(b)(3) could not be carried over to any taxable year beginning after 2011 and required that any disallowed portion remaining after 2011 be treated as property placed in service on the first day of the taxpayer’s last taxable year beginning in 2011 for purposes of computing depreciation. the atra of 2012 amended § 179(f)(4) to provide that any portion of a taxpayer’s § 179 deduction attributable to qualified real property that is disallowed by the taxable income limitation of § 179(b)(3) cannot be carried over to any taxable year beginning after 2013. thus, taxpayers may be entitled to carry over to taxable years beginning in 2012 or 2013 § 179 deductions attributable to qualified real property that were previously disallowed and that the taxpayer is currently depreciating.  the notice provides that taxpayers can elect to deduct the cost of qualified real property for any taxable year beginning in 2010, 2011, 2012 or 2013 by filing an original or amended return in accordance with procedures similar to those in reg. § 1.179-5(c)(2) and section 7 of rev. proc. 2008-54, 2008-2 c.b. 722, 725, and can increase a deduction previously taken in those years by filing an amended return. an increase in a deduction taken for a prior tax year is not deemed to be a revocation of the taxpayer’s § 179 election for that year.  with respect to § 179 deductions attributable to qualified real property that were disallowed by the taxable income limitation of § 179(b)(3) and that a taxpayer currently is depreciating, the notice provides that the taxpayer can continue the current treatment. alternatively, a taxpayer can amend the return for the last taxable year beginning in 2011 to carry over the disallowed deductions to taxable years 2014] recent developments in federal income taxation 269 beginning in 2012 or 2013, provided that the period of limitations on assessment is still open for the year of amendment and all affected succeeding years.  the notice provides guidance on allocating disallowed deductions that are carried over between qualified real property and other § 179 property, and on the tax consequences of dispositions and other transfers of qualified real property, including permitted methodologies for determining the extent to which gain is treated as ordinary income under § 1245. 2. new accounting and disposition rules for macrs property. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11), and reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81128 (12/27/11). the capitalization and repair regulations (discussed above) provide significant new rules for the maintenance of multiple asset accounts and disposition of property from macrs single and multiple asset accounts.  accounting for macrs property. consistent with prior rules under reg. § 1.167-7, temp. reg. § 1.168(i)-7t allows taxpayers to account for macrs property in a single asset account or by combining multiple assets in a multiple asset account. assets in a multiple asset account must have been placed in service in the same taxable year, have the same recovery period and convention. assets that are subject to different recovery rules or special limitations, such as automobiles, assets subject to additional first year recovery, or property used partly for personal purposes, may not be combined with assets subject to different recovery provisions. assets with the same recovery periods and conventions may be combined in a multiple asset account even if the assets have different uses. in addition, the taxpayer is permitted to use as many single and multiple asset accounts as the taxpayer may choose.  dispositions. temp. reg. § 1.168(i)8t(d) defines a disposition of macrs property as occurring when the asset is transferred or permanently withdrawn from use in the taxpayer’s trade or business or from the production of income. thus, a disposition includes the sale, exchange, retirement, abandonment, or destruction of an asset. significantly, the definition of disposition is expanded in the temporary regulation to include the retirement of a structural component of a building.  gain or loss. gain or loss on the sale, exchange or conversion of an asset is determined under applicable tax principles. loss on abandonment is determined from the “adjusted depreciable basis” of the asset (basis adjusted for depreciation). temp. reg. § 1.168(i)8t(d). recognized loss on other dispositions is the excess of the adjusted 270 florida tax review [vol. 15:5 depreciable basis of the asset over fair market value. identification of the asset disposed of from a multiple asset account, and its basis, is generally determined from the taxpayer’s records. temp. reg. § 1.168(i)-8t(e) and (f). the temporary regulations provide rules for identifying assets if the taxpayer’s records do not do so; a first-in first-out method, a modified fifo method, a mortality dispersion table method, or any other method designated by the irs. the asset cannot be larger than a unit of property. in case of a disposition of a structural component of a building, the structural component is the asset disposed of. an improvement placed in service after the asset is treated as a separate asset provided that it is not larger than the unit of property. temp. reg. § 1.168(i)-8t(c)(4)(ii)(e). disposition of an asset in a single asset account terminates depreciation for the asset as of the time of the disposition. disposition of an asset in a multiple asset account removes the asset from the account as of the beginning of the year of disposition, requires separate depreciation for the asset in the year of disposition, and reduction of the depreciation reserve of the multiple asset account by the unadjusted basis of the disposed asset as of the first day of the taxable year of the disposition. temp. reg. § 1.168(i)-8t(g).  general asset accounts. consistent with prior reg. § 1.168(i)-1, the temporary regulations provide for an election to group assets into one or more general asset accounts. temp. reg. § 1.168(i)1t(c)(2) provides for grouping assets in a general asset account as long as the assets have been placed in service in the same taxable year and have the same recovery period and convention. assets that are subject to different recovery rules or special limitations, such as automobiles, assets subject to first year recovery, or property used partly for personal purposes, may not be combined with assets subject to different recovery provisions. the temporary regulations do not include the requirement of prior regulations that general asset accounts include only assets in the same asset class. assets eligible for additional first year depreciation deductions must be grouped with assets eligible for the same first year depreciation deductions and may not be grouped with assets not eligible for additional first year depreciation. temp. reg. § 1.168(i)1t(c)(2)(ii)(d) and (e). the temporary regulations expand existing rules for dispositions of assets from a general asset account to encompass as a disposition the retirement of a structural component of a building. as under existing rules, the temporary regulations treat the basis of any asset disposed of from a general asset account as zero, and any amount realized results in ordinary gain. the taxpayer continues to deprecate assets in the general asset account as if no disposition occurred. temp. reg. § 1.168(i)-1t(e)(2). however, consistent with existing regulations, the temporary regulations allow a taxpayer to elect to terminate general asset account treatment on disposition of an asset in a qualifying disposition, in which case gain or loss is recognized under the rules of temp. reg. § 1.168(i)-8t. the list of qualifying dispositions 2014] recent developments in federal income taxation 271 is expanded generally to include any disposition. temp. reg. § 1.168(i)1t(e)(3). in addition, general asset accounts are terminated in certain nonrecognition dispositions and on termination of a partnership under § 708(b)(1)(b). gain or loss may also be recognized on disposition of all of the assets, or the last asset, in a general asset account. temp. reg. § 1.168(i)1t(e)(3)(ii). a. irs specifies the procedures for adopting new accounting methods under the temporary regulations relating to depreciation of tangible property. rev. proc. 2012-20, 2012-14 i.r.b. 700 (3/7/12), modifying rev. proc. 2011-14, 2011-1 c.b. 330. the irs has provided lengthy and detailed rules regarding automatic changes in methods of accounting under temp. reg. §§ 1.167(a)-4t (amortizing or depreciating leasehold improvements), 1.168(i)-1t (rules for general asset accounts), 1.168(i)-7t (accounting for macrs property), and 1.168(i)-8t (dispositions of macrs property), all added by t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11). the automatic change of accounting method of rev. proc. 2011-14, 2011-1 c.b. 330, is applicable to property placed in service in a taxable year ending after 12/29/03. with respect to assets placed in service in a taxable year ending before 12/30/03, adopting the methods of the temporary regulations requires an amended return for open years including the placed in service years and all subsequent years. no § 481 adjustment is required or permitted with respect to the amended returns. b. lb&i provides guidance under rev. proc. 2012-20. lb&i-4-0312-004 (3/15/12). this directive to the field applies to taxpayers who adopted a method of accounting relating to the conversion of capitalized assets to repair expense under § 263(a). c. have your clients been wasting time trying to comply with the temporary regulations in 2012? yes, they have. further guidance announcing that pending final regulations will apply only in years beginning in 2014 and thereafter. notice 2012-73, 2012-51 i.r.b. 713 (11/20/12). the irs announced that pending final regulations will apply to taxable years beginning on or after 1/1/14, but that taxpayers will be permitted to apply the final regulations to taxable years beginning on or after 1/1/12. the notice also indicates that the temporary regulations may be revised with respect to the de minimis rule of § 1.263(a)2t(g); dispositions under §§ 1.168(i)-1t and 1.168(i)-8t; and the safe harbor for routine maintenance under § 1.263(a)-3t(g). d. technical amendments so revise the temporary regulations. more important, the effective date of the 272 florida tax review [vol. 15:5 12/27/11 temporary regulations is delayed to years beginning on or after 1/1/14, with optional retroactive applicability. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 77 f.r. 74583 (12/17/12). e. new, new rules relating to accounting for macrs property. t.d. 9636, guidance regarding deduction and capitalization of expenditures related to tangible property, 78 f.r. 57686 (9/19/13). the treasury department and irs have promulgated final regulations under § 168 for the maintenance of multiple asset accounts that were proposed in reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81128 (12/27/11), and replacing the temporary regulations promulgated in t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11). consistent with prior rules under reg. § 1.167-7, and temp. reg. § 1.168(i)-7t, final reg. § 1.168(i)-7 allows taxpayers to account for macrs property in a single asset account or by combining multiple assets in a multiple asset account. assets in a multiple asset account must have been placed in service in the same taxable year, and have the same recovery period and convention. assets that are subject to different recovery rules or special limitations, such as automobiles, assets subject to additional first year recovery, or property used partly for personal purposes, may not be combined with assets subject to different recovery provisions. assets with the same recovery periods and conventions may be combined in a multiple asset account even if the assets have different uses. in addition, the taxpayer is permitted to use as many single and multiple asset accounts as the taxpayer may choose. the new provisions are effective for years beginning after 1/1/14 with an election to apply them retroactively to years beginning on or after 1//1/12. a taxpayer may choose to apply temp. reg. § 1.168(i)-7t to taxable years beginning on or after 1/1/12, and before 1/1/14.  temp. reg. § 1.168(i)-1t(c), dealing with general asset accounts and temp. reg. § 1.168(i)-8t(d), dealing with dispositions, both of which were promulgated in t.d. 9564 (12/27/11), and proposed in reg-168745-03 (12/27/11) have not been replaced by final regulations. 3. no chickening out of the allocation agreement in an applicable asset acquisition — even after a cost segregation study. peco foods, inc. v. commissioner, t.c. memo. 2012-18 (1/17/12). the taxpayer entered into an agreement with the sellers of two poultry processing plants that allocated a large portion of the purchase price to processing plants on which the taxpayer claimed depreciation deductions as nonresidential real 2014] recent developments in federal income taxation 273 property with a macrs life of 39 years. the agreements separately listed agreed-upon prices for land, buildings, and machinery and equipment. subsequently, after a cost segregation study, the taxpayer attempted to change its method of accounting to separate out components of the buildings as equipment and machinery and claim accelerated depreciation on the basis of shorter macrs recovery periods. the tax court (judge laro) held that under commissioner v. danielson, 378 f.2d 771, 775 (3d cir. 1967), and § 1060, unless the taxpayer could show fraud, undue influence, duress, etc., the taxpayer was bound by the purchase price allocation agreement. the court rejected the taxpayer’s argument that nothing in § 1060 precluded the taxpayer from segregating components of assets broadly described as a production plant into components consisting of the real property and related equipment and machinery. the court also refused to accept the taxpayer’s assertion that the agreements with the sellers should be disregarded because the use of the terms “processing plant building” and “real property improvements” were ambiguous. finally the court agreed with the irs that the irs did not abuse its discretion in prohibiting the taxpayer from adopting depreciation schedules that were inconsistent with the terms of the purchase agreements. a. and the court of appeals plucks the taxpayer too. peco foods, inc. v. commissioner, 522 fed. appx. 840 (11th cir. 7/2/13). in a decision by judge hill, the eleventh circuit affirmed the tax court’s decision. the court of appeals noted that (1) “both agreements contain the statement that the original allocation shall be used ‘for all purposes (including financial accounting and tax purposes),’” (2) “[t]he parties allocated the purchase price among three assets: ‘real property: land,’ ‘real property: improvements,’ and ‘machinery, equipment, furnitures [sic] and fixtures,’” (3) peco intended “processing plant building” to be treated as a single asset when it entered into the agreement, and (4) the term “processing plant building” in the agreements was unambiguous. 4. the taxpayer’s basis in the three mile island nuclear power plant is melted away by the china syndrome; nuclear decommissioning liabilities are not included in the purchaser’s basis until there is economic performance. amergen energy co. v. united states, 113 fed. cl. 52 (10/8/13). the taxpayer purchased three nuclear power plants and assumed liability for decommissioning costs in future years. in each transaction, the taxpayer received decommissioning trust funds. in one case the cash purchase price was approximately $23,000,000 (plus $77,000,000 in five annual installments for nuclear fuel) and the liabilities exceeded $530,000,000; the decommissioning trust fund was approximately $331,000,000. in a second transaction, the cash price was 274 florida tax review [vol. 15:5 approximately $20,000,000 and the liabilities exceeded $600,000,000; the decommissioning trust fund was approximately $235,000,000. in the third transaction, the cash price was $10,000,000 and the liabilities exceeded $550,000,000; the decommissioning trust fund was approximately $437,000,000. the only issue was whether amergen could include a portion of the decommissioning costs to be paid in the future in the depreciable cost basis of the nuclear power plants. the irs had previously refused to give amergen a private letter ruling that it could take into account in computing the depreciable cost basis of the nuclear power plants the decommissioning costs to be paid in the future. amergen argued that only § 1012 was relevant and that the liabilities could be taken into account in basis immediately. the government argued that the all events test of § 461 and the “economic performance” test of § 461(h) controlled the date on which the liabilities could be taken into account. on summary judgment, the court of federal claims (judge bush) held for the government. the court reasoned that the plain language of § 461(h) does not limit its application to deductions, but provides that it applies to “any item.” thus, § 461(h) “is of general applicability,” and applies to determine when liabilities are incurred for the purpose of cost basis calculations. the court’s conclusion was reinforced by its reading of the legislative history of § 461(h) in h.r. rep. no. 98-432, pt. 2, at 1254–55 (1984), which included a reference to “capital items,” that the court concluded “show[ed] congress’ concern with the time value of money and revenue losses due to attempts by taxpayers to claim the premature accrual of liabilities, as well as with the administrative challenges of providing a system for the discounted valuation of liabilities that will be satisfied in the future. second, and more importantly, congress understood that these concerns were present not only in the timing of deductions for expenses but also in the timing of the accounting of liabilities relevant to capital items.” furthermore, the court held that the matrix of applicable regulations under §§ 263, 446, and 461 – particularly reg. § 1.461-1(a)(2)(i), which requires economic performance before an item is includable in basis – were entitled to deference under chevron u.s.a., inc. v. natural resources defense council, inc., 467 u.s. 837 (1984), and clearly applied the threepronged test of § 461 to assumed liabilities for purposes of determining § 1012 cost basis. finally, the court rejected amergen’s last ditch argument that economic performance had occurred at the time the plants were purchased because the sellers had “provided property” to it and indicated that economic performance of decommissioning costs does not occur before the nuclear plants are shut down and decommissioning costs are incurred.  reg. § 1.263(a)-1(c)(1), as amended in 2013, provides that “in the case of a taxpayer using an accrual method of accounting, the terms amount paid and payment mean a liability incurred (within the meaning of § 1.446-1(c)(1)(ii)). a liability may not be taken into 2014] recent developments in federal income taxation 275 account under this section prior to the taxable year during which the liability is incurred.” reg. § 1.446-1(c)(1)(ii) provides that “a liability is incurred, and generally is taken into account for federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.” f. credits 1. fifty ways to determine when construction begins. notice 2013-29, 2013-20 i.r.b. 1085 (4/15/13). the american taxpayer (and not so grand compromise) relief act of 2012 extended the renewable electricity production tax credit of § 45 and the elective § 48 alternative investment tax credit for electricity produced at a qualified facility if construction of the facility is commenced before 1/1/14. qualified facilities include wind facilities, closed-loop biomass facilities, open-loop biomass facilities, geothermal facilities, landfill gas facilities, trash facilities, hydropower facilities, and marine and hydrokinetic facilities. the notice provides that a taxpayer can demonstrate that construction has commenced by establishing that “physical work of a significant nature” is undertaken, or by meeting a safe harbor that five percent of the cost of a project is incurred before 1/1/14. the irs may determine that construction has not commenced if the taxpayer does not maintain a continuous program of work. significant physical work includes excavating foundations and the manufacture of components under a binding written contract that are not components held in inventory by the vendor. significant physical work includes work on component parts of multiple facilities that will be treated as single project that are integral to the project, such as roads, but not fences or buildings. significant physical work does not include preliminary work such as planning, design or licensing activities. the safe harbor is available if the taxpayer incurs five percent or more of the total cost of a facility before 1/1/14, and the taxpayer makes continuous progress towards completion of the facility as indicated by relevant facts and circumstances specified in the notice.  woe to the taxpayer who incurs cost overruns so that the pre-1/1/14 expenses do not amount to the requisite five percent. the safe harbor is not satisfied if total costs of the facility cause the amount incurred before 1/1/14, to be less than five percent of total cost. however, the credits may be claimed on some but not all of the facilities constituting a single project. 2. funded versus unfunded research for the § 41 credit. geosyntec consultants, inc. v. united states, 112 a.f.t.r.2d 20135488 (s.d. fla. 4/15/13). a magistrate judge granted summary judgment to 276 florida tax review [vol. 15:5 the taxpayer and irs on issues relating to whether research was funded or unfunded for purposes of the § 41 20 percent credit for increased research expenditures. under § 41(d)(4)(h) the research credit is not available to a taxpayer if another party has funded otherwise qualifying research. reg. § 1.41-4a(d) provides that, “amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research (see § 1.41-2(e)(2)) are not treated as funding. ...” reg. § 1.41-4a(d)(1)(iii) provides that an expense is incurred for qualified research under an agreement with third parties only if the agreement requires the taxpayer to bear the expense even if the research is not successful. fairchild industries, inc. v. u.s., 71 f.3d 868, 870 (fed. cir. 1995), interprets these regulations to allocate “the tax credit to the person that bears the financial risk of failure of the research to produce the desired product or result.” the magistrate judge held that research expenditures incurred under the taxpayer’s fixed price contracts were eligible for the research credit, and that the research was not subject to funded contracts. under those contracts the taxpayer was obligated to perform environmental clean-up activities for a fixed price subject to approval of the client. the court observed that, “the nature of fixed-price contracts makes them inherently risky to contractors. under these types of contracts, to the extent a contractor’s performance is unsuccessful, the contractor must remedy the performance without additional compensation. thus, these contracts generally place maximum economic risk on contractors who ultimately bear responsibility for all costs and resulting profit or loss.” the magistrate judge also held that research performed under “capped” contracts was funded research. the capped contracts provided for reimbursement of costs up to a capped amount. the court indicated that, “a distinctive feature of the capped contracts at issue is that each one obligates the client to reimburse [taxpayer] for pre-defined tasks at pre-defined rates in accordance with a detailed project budget.” the magistrate judge indicated that the capped contracts were similar to cost plus contracts that placed the risk of failed research on the client, and thus were funded contracts that did not cause the taxpayer to incur research expenditures eligible for the credit. 3. and the irs gets ready to start administering national health care. reg-113792-13, tax credit for employee health insurance expenses of small employers, 78 f.r. 52719 (8/26/13). the irs and treasury have published prop reg. §§ 1.45r-1 through 1.45r-5, which provide comprehensive guidance regarding the § 45r credit, enacted as part of the patient protection and affordable care act, available to certain small employers that offer health insurance coverage to their employees. the regulations are proposed to be effective for years beginning after 12/31/13. 2014] recent developments in federal income taxation 277 however, employers may rely on the proposed regulations for years beginning after 12/31/13, and before 12/31/14. g. natural resources deductions & credits 1. hurry to get in line for qualified advanced energy project credits. notice 2013-12, 2013-10 i.r.b. 543 (2/7/13). the irs has announced that phase ii of § 48c credits for establishing a manufacturing facility to produce advanced energy property will provide an allocation of $150,228,397 of credits. section 48c(a) provides a 30 percent credit for investment in the taxable year in a qualifying advanced energy project certified by the irs on recommendation by the department of energy. the maximum credit for any project is $30 million. a concept paper must be submitted to doe (electronically) by 4/9/13. if invited by doe, the § 48c application must be submitted by 7/23/13. the doe will rank applications. the highest ranked application will receive the full $30 million credit, down the list until the amount of available credits is exhausted. h. loss transactions, bad debts, and nols 1. should the irs tighten banks’ bad debt deductions? notice 2013-35, 2013-24 i.r.b. 1240 (5/20/13). the irs is asking for comments about whether the conclusive presumptions of reg. § 1.166-2(d) regarding worthless bad debts should be revised in light of changes in banking regulation. reg. §§ 1.166-2(d)(1) and (3) provide conclusive presumptions that bank’s bad debts are worthless if either (1) a bank or other regulated corporation charges off a debt in obedience to a specific order or in conformity with established polices of the regulatory authority which confirms the charge-off, or (2) under the book conformity method a bank applies loan loss classification standards that are consistent with regulatory loan loss classification standards of the bank regulator. the conclusive presumptions are based on a policy that there is sufficient similarity between tax standards for the deduction and regulatory standards used to identify a loan that should be charged off. however, in 2004 bank regulators, relying on fasb pronouncements, determined that a security is deemed impaired if its fair value is less than its amortized costs and allowing a charge-off if the difference is other than temporary. in addition, under 2009 fasb guidance, with respect to debt held to maturity the portion of loss related to credit loss is recognized on the income statement while loss attributable to other factors is reported directly on the balance sheet. among other things, the notice requests comments on whether the bank regulatory standards are sufficiently similar to worthless bad debt standards under § 166 and whether the conclusive presumption standards should be modified or replaced. 278 florida tax review [vol. 15:5 2. to successfully call it a loan, ya gotta prove that ya expected to be repaid. shaw v. commissioner, t.c. memo. 2013-170 (7/24/13). the taxpayer was the bookkeeper and chief financial officer of a family corporation owned by herself, her mother, and her siblings. she loaned the corporation over $800,000 under a revolving line of credit, evidenced by an unsecured promissory note, with adequate interest and a specified due date. the funds were to be used to develop a real estate project. at the time the line of credit was established and the funds were advanced, the corporation was encountering financial difficulties, cash flow was tight, and not all creditors could be paid. by the end of the year in which the funds had been advanced, the development project had been “cancelled.” the tax court (judge lauber) sustained the irs’s denial of a worthless debt deduction, finding that there was no bona fide debt; the advances either constituted equity or were gifts to the other family-member shareholders. the taxpayer (1) presented no documentary evidence of the corporation’s creditworthiness, (2) did not request collateral despite the corporation’s “questionable financial status,” and (3) did not insist on financial covenants that would condition future line-of-credit advances on the corporation’s adherence to specified income, net worth, or debt-to-equity benchmarks. the taxpayer’s “behavior over the course of 2009 was likewise inconsistent with what one would expect from a third-party lender.” as the corporation’s “finances became more precarious ... rather than moderate her advances, [the taxpayer] left the spigot open.” finally, the taxpayer made no serious effort to obtain repayment of the advances — “she did not send a letter demanding payment; she did not contact an attorney; and she did not file suit. ... [a] creditor with a genuine expectation of repayment would have acted more aggressively.” finally, assuming arguendo that the advances were a loan, the taxpayer introduced no evidence of identifiable events indicating worthlessness. 3. texas professors denied bad debt deductions for related entity loans. herrera v. commissioner, t.c. memo. 2012-308 (11/5/12). the tax court (judge wherry) denied business bad debt deductions under § 166 for advances by one llc (hsa) to its sister (mti), both of which were owned by two university of texas el paso engineering professors who used the llcs for consulting and metal fabrication activities. the llc independently borrowed funds in its own name that were transferred to its related manufacturing entity to pay down a letter of credit originally entered into by both entities. citing the 13 factors identified by the fifth circuit in texas farm bureau v. united states, 725 f.2d 307 (5th cir. 1984), the court found that advances were not bona fide debt, stressing the lack of a promissory note, the lack of a definitive maturity date, the lack of a repayment schedule, de facto subordination of the debt to other creditors, the 2014] recent developments in federal income taxation 279 absence of a requirement for security, and the fact that the source of payment was tied to the fortunes of the business. the court stressed the fact that no interest was paid as being particularly important. a. the fifth circuit affirmed. herrera v. commissioner, 112 a.f.t.r.2d 2013-6858 (5th cir. 11/11/13). the court rejected the taxpayer’s additional argument, which was not addressed by the tax court, that hsa had agreed to substitute its own note for that of its sister entity and payment of the debt was deductible as a business bad debt under reg. § 1.166-9(e)(2), which provides that payment as a guarantor or indemnitor under a right of subrogation constitutes a business bad debt. reiterating the findings of the tax court, the court indicated that there was no enforceable duty on the taxpayer to make the payment and that hsa’s payments were on its own loan. 4. it’s now impossible as a matter of law to abandon a capital asset. w(h)ither the “sale or exchange” requirement. pilgrim’s pride corp. v. commissioner, 141 t.c. no. 17 (12/11/13). in 1999, the taxpayer purchased certain stock and securities issued by southern states cooperative for $98.6 million. in 2004, southern states offered to redeem the stock and securities for less than the taxpayer had paid for them. the taxpayer wanted approximately $39 million, but southern states was willing to pay only $20 million. the negotiations ended without an agreement and the taxpayer “abandoned” the securities and claimed a $98.6 million ordinary loss deduction. the irs disallowed the ordinary loss deduction and treated the loss as capital. the tax court (judge dawson) upheld the irs’s position. the stock and securities were capital assets and § 1234a required that the loss be treated as capital. section 1234a provides that: gain or loss attributable to the cancellation, lapse, expiration, or other termination of— (1) a right or obligation (other than a securities futures contract, as defined in section 1234b) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or (2) a section 1256 contract (as defined in section 1256) not described in paragraph (1) which is a capital asset in the hands of the taxpayer, shall be treated as gain or loss from the sale of a capital asset. the preceding sentence shall not apply to the retirement of any debt instrument (whether or not through a trust or other participation arrangement). 280 florida tax review [vol. 15:5  judge dawson reasoned that “[s]hares of stock are intangible interests or rights that the owner has in the management, profits, and assets of a corporation, while the certificate of stock is tangible evidence of the stock ownership of the person designated therein and of the rights and liabilities resulting from such ownership,” and that congress intended “section 1234a to [apply to] terminations of all rights and obligations with respect to property that is a capital asset in the hands of the taxpayer or would be if acquired by the taxpayer, including not only derivative contract rights but also property rights arising from the ownership of the property.”  the court rejected the taxpayer’s argument that an ordinary loss was allowable under reg. § 1.165-2(a), because reg. § 1.165-2(b) disallowed the loss as the surrender of the stock and securities was deemed to be a loss from a sale or exchange of a capital asset pursuant to section 1234a. it also noted that rev. rul. 93-80, 1993-2 c.b. 239, which allowed an ordinary loss deduction upon the abandonment of a partnership interest in a partnership that had no debt, was issued four years before § 1234a was amended in 1997 to apply to all property that is (or would be if acquired) a capital asset in the hands of the taxpayer, and thus it did not carry any weight. i. at-risk and passive activity losses 1. section 183 is a more powerful sword for the irs than § 469. disallowance is more powerful than basketing. pederson v. commissioner, t.c. memo. 2013-54 (2/20/13). the tax court (judge goeke) upheld the irs’s application of § 183 to disallow losses claimed with respect to an investment in a marketed horse breeding “program” in which the taxpayer had no direct involvement. the taxpayer did not have a goodfaith belief that the horse breeding activity would turn an overall profit; the amount invested was based principally on the amount necessary to produce the desired tax losses; and participation in the breeding program was almost entirely motivated by tax benefits purportedly available to the taxpayer through such participation. 2. judge morrison finds an honest taxpayer. montgomery v. commissioner, t.c. memo. 2013-151 (6/17/13). temp. reg. § 1.469-5t(f)(4) provides that the extent of an individual’s participation in an activity may be established by any reasonable means. “‘reasonable means’ ... include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” however, “contemporaneous daily time reports, logs, or similar documents are not required if the extent of such 2014] recent developments in federal income taxation 281 participation may be established by other reasonable means.” in the instant case, however, judge morrison held that material participation had been established without any such documentary evidence being introduced. the taxpayers established material participation by their credible testimony providing details of the nature of the activities they conducted in starting and managing a business. they founded the company, negotiated contracts, hired 250 employees, and conducted daily business, “work[ing] on the business ‘day in and day out.’”  this case is notable because in most cases claims of material participation without written documentation fall on deaf ears in the courts. see, e.g., bailey v. commissioner, t.c. memo. 2001-296 (2001) (log book of visits to rental real estate that did not include contemporaneous record of hours devoted to real estate activity was not sufficient to substantiate that taxpayer devoted requisite number of hours to real estate business; uncorroborated estimates of hours required to perform activities were unreliable because they were prepared years later in anticipation of litigation); d’avanzo v. united states, 67 fed. cl. 39 (2005) (taxpayer did not offer contemporaneous written record of number of hours he spent performing personal services with respect to rental properties; noncontemporaneous log book of hours claimed to have been devoted to real estate activities and testimony at trial, alone, are inadequate evidence to establish that taxpayer devoted requisite number of hours to real estate business activities), aff’d by order, 215 fed. appx. 996 (fed. cir. 2007); lee v. commissioner, t.c. memo. 2006-193 (2006) (full-time physician and full-time irs employee could not establish that they worked more than one half of their time in their real estate partnership business; noncontemporaneous time logs submitted at trial that more than doubled hours in log books submitted during audit were not credible); goolsby v. commissioner, t.c. memo. 2010-64 (2010) (activity log purporting to document hours of management activity was not credible; it was created after taxpayer’s return was selected for audit and solely for purposes of the case; taxpayer had no contemporaneous records, such as appointment books, calendars, or narrative summaries to support activity log; “[i]ncredibly, the ... activity log lists days during which [the taxpayer] allegedly logged more than 24 hours of work”). a. a “ballpark guesstimate” doesn’t let you sing ♬♪ yankee doodle dandy♬♪. merino v. commissioner, t.c. memo. 2013-167 (7/16/13). the tax court (judge wherry) held that the taxpayer failed to prove that he was a real estate professional who materially participated in a real property rental activity, thereby escaping the passive activity loss limitations by way of § 469(c)(7). the taxpayer’s only evidence was his own “summary of hours” that was prepared “using his estimates and his memory as to how much time he spent on certain tasks with respect to the real estate rental activity.” it “was not created from contemporaneous 282 florida tax review [vol. 15:5 documentation, but rather it [was] a postevent reconstruction from memory,” that was “less of an approximation and more of a ‘ballpark guesstimate.’” b. the tax court continues to be hardnosed regarding contemporaneous records of hours devoted to activities to avoid section 469. bartlett v. commissioner, t.c. memo 2013-182 (8/8/13). the tax court (judge kerrigan) rejected a “guesstimate” of hours worked on a ranch. the lack of any contemporaneous records or other records and documentation regarding what the taxpayer specifically did dayto-day and how much time he spent on matters relating to the activity was not cured by estimates made years after the fact in writing or by testimony. 3. borrowed funds contributed to s corporation cellular company were neither at-risk nor did they create basis for loss deductions. broz v. commissioner, 137 t.c. 46 (9/1/11). in a structure typical for the industry, the taxpayer was the shareholder of two s corporations, rfb and alpine, that held fcc licenses to operate cellular networks in rural areas. rfb held licenses directly and was the original business. alpine and alpine llc, a single member llc owned by the taxpayer, were formed to expand the business. additional licenses were obtained and held by a number of llcs (partnerships) that were owned 99 percent by the taxpayer and 1 percent by his brother. alpine and the llcs were formed at the insistence of creditors to isolate the liabilities of the thinly capitalized expansion. rfb owned and operated all of the equipment. alpine and the llcs owned only licenses, and rfb allocated some of its income to alpine for use of the licenses. rfb obtained financing to construct cellular equipment and for working capital, and re-lent some of the loan proceeds to alpine. alpine and the taxpayer documented the loans from rfb to alpine as shareholder loans. the taxpayer pledged rfb stock for the loans, but did not guarantee the loans, which were also secured by corporate assets.  first, for purposes of determining the taxpayer’s basis in alpine, for purposes of applying the § 1366(d) limitation on passed-through losses, the court (judge kroupa) held that (1) the taxpayer had not established that he had borrowed money from the bank that he personally re-lent to alpine because rfb did not advance the funds to alpine on the taxpayer’s behalf, i.e., the loan ran directly from rfb to alpine; and (2) the taxpayer had not made any “economic outlay.” thus, the loans were not included in the shareholder’s basis to support loss deductions.  second, for purposes of determining the taxpayer’s at-risk amount with respect to alpine, in what was described as an issue of first impression, the court held that the rfb stock pledged for the loans represented pledged property used in the business not eligible to be treated as an amount at-risk by virtue of § 465(b)(2)(a). since alpine was formed to expand 2014] recent developments in federal income taxation 283 rfb’s cellular networks, the pledged rfb stock was related to alpine’s business. thus, because the shareholder did not guarantee the loans to alpine, the shareholder was not economically or actually at-risk with respect to his involvement with alpine.  third, the court held that alpine could not deduct interest, expenses, and depreciation during the years at issue because it was not yet engaged in an active trade or business utilizing the licenses it held. the court rejected the taxpayer’s argument that operation of cellular networks by rfb could be attributed to alpine. acquisition of licenses and related equipment was not sufficient to establish alpine as engaged in the active conduct of a trade or business. alpine failed to attach the required statement to the return for the taxable year to claim § 195 amortization of start-up expenses [which it could not have deducted even if it had attached the form because it had not yet commenced business operations].  fourth, in another issue that the court described as one of first impression, the court concluded that deductions under § 197 for amortization of the costs of fcc licenses were not available in years in which the taxpayers was not yet engaged in a trade or business. the court concluded that the language of § 197 that provides the deduction “in connection with the conduct of a trade or business” requires that the intangibles “must be used in connection with a business that is being conducted.” a. “losses are not tested under the at-risk rules until the shareholder has sufficient basis to deduct them.” broz v. commissioner, 727 f.3d 621 (6th cir. 8/23/13). the sixth circuit, in an opinion by judge rogers, affirmed, holding that the tax court correctly determined that the taxpayer did not have sufficient basis in alpine to support the claimed passed-through losses. the court also upheld denial of the claimed § 162 expenses and § 197 amortization deductions for the license-holding entities because those entities were not engaged in an active trade or business. the court did not reach the at-risk issue.  with respect to the § 1366(d) loss limitation issue, the sixth circuit found that there was no evidence that at the time the loan to alpine was made the debt was intended to run directly from alpine to either broz or his wholly owned llc. it was intended to run from alpine to rfb. “after-the-fact reclassification cannot satisfy the requirement that the debt run directly from the s corporation to the taxpayer/shareholder.” because broz had insufficient basis to support any passed-through loss deductions, the court did not reach the § 465 at-risk issue, stating that “losses are not tested under the at-risk rules until the shareholder has sufficient basis to deduct them.” in dictum that followed, the court noted that “the at-risk limit in § 465 and the basis limit in § 1366(d) are functionally almost identical in the s corporation context.” 284 florida tax review [vol. 15:5  turning to the § 162 expense deductions, the court held that “each entity’s activity must be evaluated individually and not in conjunction with any other entity.” thus, alpine’s and the llc’s activities could not be amalgamated with rfb’s activities. viewed individually, neither alpine nor the llcs conducted any business during the year. broz chose to employ separate entities for a business reason and could not have “‘the best of both worlds’ by having the alpine entities treated as separate for purposes of avoiding or distinguishing liabilities, but treated as one entity together with rfb for tax purposes.”  finally, turning to the § 197 amortization deductions, the court held that amortization deductions “do not begin upon acquisition of the intangible asset if the intangible asset is not yet held in connection with the conduct of a trade or business, because the assets are in that case not eligible as ‘amortizable section 197 intangibles.’” the court noted that although § 197(a) provides that the deduction is calculated beginning with the month in which the intangible asset is acquired, it allows the deduction only for “amortizable section 197 intangibles,” which are defined in § 197(c) as intangible assets “held in connection with the conduct of a trade or business.” because the alpine license-holding entities never actually leased the licenses to broz’s other businesses, the licenses were never held in connection with a trade or business that was actually being conducted. thus, the licenses did not qualify as “amortizable section 197 intangibles,” and were ineligible for amortization deductions. iii. investment gain and income a. gains and losses 1. what! you mean my money market fund might lose money — a proposed de minimis exception from de mickeymouse wash sale rules for money market fund losses. notice 2013-48, 2013-31 i.r.b. 120 (7/3/13). this notice proposes a revenue procedure that would provide a de minimis exception to the § 1091 wash sale rules for certain redemptions of shares of money market funds that, under regulations proposed by the sec, would no longer maintain a constant share price. under the proposed revenue procedure, if a taxpayer realizes a loss upon a redemption of shares in such a fund, and the amount of the loss is not more than 0.5 percent of the taxpayer’s basis in the shares, the irs will treat the loss as not subject to § 1091. the purpose of the de minimis rules is to mitigate tax compliance burdens that may result from the changes in money market fund redemption prices. if the sec does not adopt its proposed rules in substantially the same form as they have been proposed, the revenue 2014] recent developments in federal income taxation 285 procedure proposed by the notice might not be adopted or might be adopted in a materially modified form. 2. caught in the zero basis trap for lack of adequate records of stock purchase price. this case is too bad to be true. united states v. youngquist, 111 a.f.t.r.2d 2013-2293 (magistrate d. or. 4/17/13), adopted by the court, 111 a.f.t.r.2d 2013-2467 (d. ore. 6/21/13). the district court (judge brown) adopted magistrate judge papak’s findings and recommendations and held that a taxpayer’s basis in stock sold through one of his brokerage accounts was zero because the taxpayer introduced no evidence of the cost of any particular block of shares sold, citing coloman v. commissioner, 540 f.2d 427 (9th cir. 1976). the taxpayer’s evidence of the amount deposited as the opening cash balance of the brokerage account did not suffice to prove the basis of any block of stock. cohan v. commissioner, 39 f.2d 540 (2d cir. 1930), did not apply to allow an estimate of the basis of any of the shares because no authority supported an “aggregate theory of proving basis.”  taxpayer began his day trading in the brokerage account in question on november 5, 1996 and closed the account on december 20, 1996; nevertheless the irs found, and the court concluded, that he had $1,456,076 of income from the account during that period. 3. section 1014 means what it says. lower estate tax today may mean higher income tax tomorrow. van alen v. commissioner, t.c. memo. 2013-235 (10/21/13). the taxpayers were the beneficiaries of a trust that was the residuary beneficiary of a decedent’s estate. the estate made a special farm use valuation election under § 2032a. section 1014 provides fair market value at the time of the decedent’s death for heirs and beneficiaries, but § 1014(b)(3)(a) requires use of the estate tax value in the case of a special farm use valuation election under § 2032a, which values the land at its then current use as agricultural land. reg. § 1.1014-3(a) provides that the value of property at the date of death will be the value as appraised for purposes of the federal estate tax or the alternate value, whichever is applicable. on the sale of a conservation easement on the inherited ranch land by the trust, the tax court (judge holmes) required the taxpayers to compute their distributive shares of the gain using as basis the lower estate tax value reported under the § 2032a election. the court held that the taxpayers had a “duty of consistency,” because as residuary beneficiaries of the trust, they had an economic interest in the lower estate tax valuation and benefitted from the lower estate tax valuation. he rejected their argument that the lower estate tax valuation should not be used because it was erroneous and because the taxpayers did not understand the implications of the reporting position. in addition, the taxpayers’ inconsistency led to accuracy related penalties. 286 florida tax review [vol. 15:5 4. you can’t have your cake and eat it too. moore v. commissioner, t.c. memo. 2013-249 (10/30/13). in a somewhat convoluted transaction, the taxpayer purchased some stock of his employer s corporation from another shareholder and paid for the stock with a promissory note for approximately $5.8 million. the taxpayer agreed to the purchase price on the basis of information that the corporation had provided to him and the corporation’s promise that it would lend him the funds for the purchase price. to settle a suit to rescind the loan agreement because of a mutual mistake as to the value of the shares, the corporation reduced the debt to $1,000,000. when the taxpayer subsequently sold the shares for $3 million, the question was the taxpayer’s initial stock basis, before taking into account § 1367 adjustments (which were to be left to rule 155 computation). the taxpayer reported a loss of approximately $1.5 million and the irs asserted a deficiency based on a $2 million gain. the tax court (judge thornton) sustained the irs’s position. judge thornton concluded that there was no “absolute indebtedness.” the economic reality of the transactions in question, viewed in their totality, was that mr. moore agreed to purchase mr. baker’s ats shares as an accommodation to ats, with an understanding that ats’ funds would be used to pay the nominal purchase price. according to mr. moore’s own allegations in his subsequent lawsuit against ats, there was no expectation that he should pay out of his own funds more than the true economic value of the shares, which both he and ats ultimately agreed was only $1 million.  judge thornton noted that this result was consistent with the irs’s conclusion in the course of auditing the taxpayer’s return for the year the debt was reduced to $1 million that the taxpayer had not realized any cod income. the holding regarding basis in the year of the sale produced symmetry with the earlier year.  a § 6662 penalty was not upheld because the court found that the taxpayer had reasonably and in good faith relied on his tax advisors in taking the return position. b. interest, dividends, and other current income there were no significant developments regarding this topic during 2013. 2014] recent developments in federal income taxation 287 c. profit-seeking individual deductions there were no significant developments regarding this topic during 2013. d. section 121 there were no significant developments regarding this topic during 2013. e. section 1031 1. rental property occupied by the taxpayer’s son was investment property, not personal-use property. adams v. commissioner, t.c. memo. 2013-7 (1/10/13). the taxpayer engaged in a deferred like-kind exchange through an intermediary in which he surrendered a property held for rental and acquired a new residential property that was dilapidated and in need of rehabilitation. the taxpayer and his son entered into an agreement whereby the son and his family could live in the new house after renovations. the son and his family worked on the house an aggregate of 60 hours per week for three months before moving in. the son and his family bore all of the rehabilitation expenses; their services were worth $3,600. after three months of work, the son’s family moved in, resided in the house for three years, and paid rent that was a few hundred dollars per month less than the fair rental value. the irs took the position that the transaction was not a § 1031 like-kind exchange because the taxpayer acquired the new house for personal purposes – i.e., “with the intention of letting his son and family live there at below market rent” – and that the taxpayer thus must recognize gain on the sale. the tax court (judge morrison) found that the taxpayer had acquired the new house for investment purposes and that the transaction thus qualified as a § 1031 like-kind exchange. furthermore, the limitations on deductions imposed by § 280a did not apply to the new house rented to the son. pursuant to § 280a(d)(2), a taxpayer is treated as using a dwelling unit during the taxable year as a residence if the taxpayer rents the dwelling unit to a family member, unless the taxpayer rents the dwelling unit to the family member “at a fair rental” and for use as that family member’s principal residence. the son used the residence as his principal residence and, although the $1,200 per month cash rent was slightly below market, it was fair rent considering the work that the son had performed with respect to the house. thus the § 280a(a) prohibition of deductions for dwelling units used as residences did not apply. 288 florida tax review [vol. 15:5 2. swapping both a personal residence and business property for a new personal residence and business property invokes both § 1031 and § 121 and provides a computational challenge. yates iii v. commissioner, t.c. memo 2013-28 (1/24/13). through a qualified intermediary, the taxpayers exchanged a property that qualified as a principal residence under § 121 and a business property for a new principal residence and two business properties. the issues in the case dealt mainly with the proper valuations of the properties, which determined the amount of gain realized that was not sheltered by § 1031; and there is nothing noteworthy about the valuation determinations. the important point of the case is that the tax court (judge goeke) applied reg. § 1.1031(j)-1(a)(1), which provides that where multiple properties are transferred in a like-kind exchange, the properties are separated and arranged for analysis into “exchange groups” based on shared characteristics. a “residual group” is created if the aggregate fair market value of the properties transferred in all of the exchange groups qualifying for § 1031 treatment differs from the aggregate fair market value of the properties received in all the exchange groups. both residences were treated as part of the residual group, with the new residence treated as boot, but § 121 applied to provide nonrecognition (for up to $500,000) of gain on the exchange of the old personal residence for a new one. the exact computations were left to be made under rule 155. 3. tax ain’t horseshoes: when the regulations say thirty years, they don’t mean 21 years and 4 months. vip’s industries inc. v. commissioner, t.c. memo 2013-157 (6/24/13). through a qi, the taxpayer exchanged a leasehold with 21 years and 4 months remaining for a fee interest in other real estate. the only significant issue was whether the leasehold and fee interests were like-kind under reg. § 1.1031-1(c), which states that § 1031 nonrecognition can apply to an exchange of a leasehold with 30 years or more to run for a fee interest. applying may department stores co. v. commissioner, 16 t.c. 547 (1951), which held that a 20-year leasehold was not like-kind to a fee interest, judge marvel held that the exchange of a leasehold with 21 years and 4 months remaining for a fee interest in other real estate did not qualify as a like kind exchange. 4. that the residual method of valuing goodwill was the proper method was a slam dunk for the government, but its valuation amount bounced off the rim when the facts were analyzed by the court. deseret management corp. v. united states, 112 fed. cl. 438 (8/22/13). the taxpayer exchanged a highly appreciated radio station in los angeles (kzla) for several radio stations in st. louis and reported that pursuant to § 1031 no gain had been recognized. the government asserted that the taxpayer was required to recognize gain with respect to the exchange 2014] recent developments in federal income taxation 289 of kzla’s goodwill because reg. § 1.1031(a)-2(c)(2) provides that “[t]he good will or going concern value of a business is not of a like kind to the goodwill or going concern value of another business.” the taxpayer took the positions that (1) as a matter of law goodwill never attached to the business of a broadcast radio station, and (2) if goodwill could attach to the business of a broadcast radio station, on the facts the value of the goodwill of kzla was zero. the parties agreed that the aggregate value of the exchanged property was $185 million and stipulated that the value of all tangible assets of kzla was $3,384,637, and that the value of all intangible assets of kzla, apart from its fcc license and any goodwill, was $4,858,317. the taxpayer took the position that the value of the fcc license was the $176,757,046 that remained after accounting for those other assets, leaving nothing to be assigned to goodwill under the residual method. first, the court of federal claims (judge allegra) rejected the taxpayer’s argument that as a matter of law goodwill never attached to the business of a broadcast radio station. the taxpayer argued that a radio station can never possess goodwill because audience loyalty is a matter of format and online personalities. judge allegra responded that listeners might flee a station that suddenly changes its format or on-air personalities, however, does not prove plaintiff’s point—any more than it would be true to say that other types of businesses cannot have goodwill because they would lose their customers if they fundamentally changed their business plan. can it be that nationally-recognized restaurant chains lack goodwill because their customers might flee if they radically changed their menus; or that sporting goods stores lack goodwill because they might decide to sell only flowers; or that familiar chains of coffee purveyors lack good will because they would lose their current business if they sold only soda? one would think not. ... put another way, whether goodwill exists as part of the assets acquired in a transaction cannot depend upon whether the buyer concludes that it is in its best interests to sustain the prior business model—that the prior goodwill must be accounted for if the prior business model is maintained, but not if that model is modified.  turning next to the factual valuation issue, judge allegra handed the taxpayer a complete victory, based not on the taxpayer’s expert’s report and analysis, which he had rejected but by using the government’s expert’s methodology, modified to correct what he found to be errors in the methodology. in the end, applying the residual valuation method, judge allegra concluded that the value of the fcc license, determining by discounting the expected net cash flow from the license as if it belonged to a 290 florida tax review [vol. 15:5 start-up company, was at least $176,757,046, leaving nothing to be assigned to goodwill. 5. the magistrate judge wasn’t fooled by the disguised related party exchange. north central rental & leasing, llc v. united states, 112 a.f.t.r.2d 2013-7045 (d. n.d. 9/3/13). north central was an llc taxed as a partnership owned 99 percent by butler machinery corporation and 1 percent by mr. butler personally. butler machinery was a dealer in heavy equipment and north central engaged in equipment leasing. north central and butler machinery engaged in almost 400 transactions that it claimed were entitled to § 1031 like-kind exchange nonrecognition, but the irs and government took the position that pursuant to the § 1031(f) relatedparty rules, § 1031 treatment was not available. each of the transactions followed essentially the same format. north central desired to dispose of equipment that it had rented out for a number of years (and which had a fair market value in excess of adjusted basis). north central conveyed the equipment to a qi. the qi sold the truck to the unrelated third-party customer. butler bought the replacement equipment from caterpillar under a 180 day payment plan. the qi used the cash from the sale of the equipment to purchase the replacement property from butler and transferred the replacement property to north central. north central then paid any excess of the cost of the replacement property over the sales price of the relinquished property to butler through adjustment of an intercompany note between butler and north central. as structured, the transaction permitted butler to hold the cash for up to six months until the due date of the caterpillar invoice for the replacement property. magistrate judge klein held that the transactions allowed the related taxpayers to “cash out” – albeit only for six months – low basis property through basis shifting and that they were structured to avoid the limitations of § 1031(f). she rejected north central’s claims that there were nontax business reasons for the structure of the transactions. accordingly, because § 1031(f)(4) disqualifies from nonrecognition “any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of [§ 1031(f)],” the transactions were all taxable. f. section 1033 there were no significant developments regarding this topic during 2013. 2014] recent developments in federal income taxation 291 g. section 1035 there were no significant developments regarding this topic during 2013. h. miscellaneous 1. making the straddle rules even more complicated — retroactively for twelve years. t.d. 9635, debt that is a position in personal property that is part of a straddle, 78 f.r. 54568 (9/5/13). the treasury has promulgated temporary regulations to provide guidance under § 1092 regarding when an issuer’s obligation under a debt instrument may be a position in actively traded personal property and, therefore, may be part of a straddle. temp. reg. § 1.1092(d)-1t(d) provides that if a taxpayer is the obligor under a debt instrument one or more payments on which are linked to the value of personal property or a position with respect to personal property, then the taxpayer’s obligation under the debt instrument is a position with respect to personal property and may be part of a straddle. the provision applies to straddles established on or after 1/17/01.  the twelve year retroactivity is based on the fact that the treasury decision adopted prop. reg. § 1.1092(d)-1(d) in the form proposed on 1/18/01, (reg-105801-00). iv. compensation issues a. fringe benefits 1. this ruling is expressly for new mothers. announcement 2011-14, 2011-9 i.r.b. 532 (2/10/11). this announcement held that breast pumps and supplies that assist lactation are medical care under § 213(d) because “they are for the purpose of affecting a structure of the body of the lactating woman.” the announcement did not refer at all to the health of the baby. a. making what was recently held to be a deductible medical expense into a mandatory freebee. a new mandate under obamacare makes all this stuff mandatory for group plans, as well as miraculously free for the insureds. t.d. 9541, group health plans and health insurance issuers relating to coverage of preventive services under the patient protection and affordable care act, 76 f.r. 46621 (8/3/11). temp. reg. § 54.9815-2713t(a)(1)(iv) requires coverage by all group plans of contraceptive, breast-feeding and many other services for women without co-pays and without deductibles. reg-120391-10, group 292 florida tax review [vol. 15:5 health plans and health insurance issuers relating to coverage of preventive services under the patient protection and affordable care act, 76 f.r. 46677 (8/3/11), promulgates identical proposed regulations. the effective date is 8/1/12. b. “[obama says that] your little [republican] friends are wrong. . . . yes, virginia, there is a santa claus.” 6 reg-120391, coverage of certain preventive services under the 6. “dear editor: i am 8 years old. “some of my little friends say there is no santa claus. “papa says, ‘if you see it in the sun it’s so.’ “please tell me the truth; is there a santa claus? “virginia o’hanlon. “115 west ninety-fifth street.” virginia, your little friends are wrong. they have been affected by the skepticism of a skeptical age. they do not believe except they see. they think that nothing can be which is not comprehensible by their little minds. all minds, virginia, whether they be men’s or children’s, are little. in this great universe of ours man is a mere insect, an ant, in his intellect, as compared with the boundless world about him, as measured by the intelligence capable of grasping the whole of truth and knowledge. yes, virginia, there is a santa claus. he exists as certainly as love and generosity and devotion exist, and you know that they abound and give to your life its highest beauty and joy. alas! how dreary would be the world if there were no santa claus. it would be as dreary as if there were no virginias. there would be no childlike faith then, no poetry, no romance to make tolerable this existence. we should have no enjoyment, except in sense and sight. the eternal light with which childhood fills the world would be extinguished. not believe in santa claus! you might as well not believe in fairies! you might get your papa to hire men to watch in all the chimneys on christmas eve to catch santa claus, but even if they did not see santa claus coming down, what would that prove? nobody sees santa claus, but that is no sign that there is no santa claus. the most real things in the world are those that neither children nor men can see. did you ever see fairies dancing on the lawn? of course not, but that’s no proof that they are not there. nobody can conceive or imagine all the wonders there are unseen and unseeable in the world. you may tear apart the baby’s rattle and see what makes the noise inside, but there is a veil covering the unseen world which not the strongest man, nor even the united strength of all the strongest men that ever lived, could tear apart. only faith, fancy, poetry, love, romance, can push aside that curtain and view and picture the supernal beauty and glory beyond. is it all real? ah, virginia, in all this world there is nothing else real and abiding. 2014] recent developments in federal income taxation 293 affordable care act, 78 f.r. 8456 (2/6/13). these proposed regulations would require that insurance companies for tax-exempt religious organizations, including hospitals, universities and schools, provide free contraceptive services to all women insured by them (including students at universities), but would provide that the insurance companies will be reimbursed for the costs of individual contraceptive-only policies by the government. however, hhs secretary sibelius stated that the taxpayers would not pay for these reimbursements either. thus, services that cost $18,000 per woman would become free under obamacare.  such is the magic power of compound interest. c. the supreme court will consider the legality under the religious freedom restoration act of the application of obamacare’s contraceptive mandate to closely held businesses owned by persons who claim their christian beliefs would be violated by compliance with that mandate. hobby lobby stores, inc. v. sibelius, 723 f.3d 1114 (10th cir. 6/27/13) (en banc), cert. granted, 134 s. ct. 678 (11/26/13). the tenth circuit (judge tymkovich) held that the religious freedom restoration act (p.l. 103-141) protects closely held family businesses operated in corporate form from violating their owners’ christian principles by complying with a regulation under the ppaca (obamacare) that requires them to provide drugs and devices that they believe are abortifacients as part of their employer-sponsored health care plans. d. “white house suspends [individual] mandate penalty for those with cancelled health plans.” individuals whose health insurance plans were canceled by insurers because they did not meet the requirements of the affordable care act will be eligible for an exemption from the individual mandate penalty under § 5000a that takes effect in 2014, the department of health and human services said late december 19. (2013 tnt 246-5, 12/19/13). the mandate requires everyone to have health insurance or face a tax penalty, the greater of $95 or 1 percent of income in 2014. the administration will also allow those consumers to sign up for catastrophic coverage. those bare-bones plans are available to people who are under 30 or qualify for a “hardship exemption.” hhs secretary kathleen sebelius said in a letter to sen. mark warner, d-va., that the administration is granting a “hardship exemption” to americans whose no santa claus! thank god! he lives, and he lives forever. a thousand years from now, virginia, nay, ten times ten thousand years from now, he will continue to make glad the heart of childhood. (the [new york] sun, 9/21/1897, p. 1, unsigned, by francis pharcellus church). 294 florida tax review [vol. 15:5 plans were canceled and “might be having difficulty” paying for standard coverage. 2. you may have trouble with these proposed regulations if you don’t know the meaning of mv, ehb, has, hra, fpl, and “metal level.” reg-125398-12, minimum value of eligible employer-sponsored plans and other rules regarding the health insurance premium tax credit. 78 f.r. 25909 (5/3/13). the irs has issued proposed regulations on the § 36b health insurance premium tax credit that provide guidance on determining whether health coverage under an eligible employer-sponsored plan provides minimum value. 3. the irs provides guidance on the application of the affordable care act’s market reforms to hras, epps, fsas, and eaps—it’s the bee’s knees! notice 2013-54, 2013-40 i.r.b. 287 (9/13/13). the patient protection and affordable care act amended the public health service act to implement certain market reforms for group health plans, including requirements that: (1) group health plans not establish any annual limit on the dollar amount of benefits for any individual, and (2) nongrandfathered group health plans provide certain preventive services without imposing any cost-sharing requirements for the services. the notice provides guidance, in q&a format, on the application of these market reforms to: (1) health reimbursement arrangements (including hras integrated with group health plans), (2) group health plans under which employers reimburse employees for premium expenses incurred for an individual health insurance policy (referred to in the notice as “employer payment plans”), and (3) health flexible spending arrangements. the notice also provides guidance on employee assistance programs and on § 125(f)(3), which generally provides that a qualified health plan offered through a health insurance exchange established under the affordable care act is not a qualified benefit that can be offered through a cafeteria plan. the notice applies for plan years beginning on and after 1/1/14, but taxpayers can apply the guidance provided in the notice for all prior periods. the department of labor has issued guidance in substantially identical form (technical release 2013-03) and the department of health and human services is issuing guidance indicating that it concurs. 2014] recent developments in federal income taxation 295 b. qualified deferred compensation plans 1. some inflation adjusted numbers for 2014. i.r. 2013-86 (10/31/13).  elective deferral in §§ 401(k), 403(b), and 457 plans, remains at $17,500 with a catch up provision for employees aged 50 or older of $5,500.  the limit on contributions to an ira will be unchanged at $5,500. the agi phase out range for employees covered by a workplace retirement plan is increased to $96,000 and to $115,000 for employees not covered by a workplace retirement plan. the phase-out range for contributions to a roth ira is $181,000 to $191,000 for married couples filing jointly, and $114,000 to $129,000 for singles and heads of household.  the annual benefit from a defined benefit plan under § 415 is increased to $210,000.  the limit for defined contributions plans is increased to $52,000.  the amount of compensation that may be taken into account for various plans is increased to $260,000, and $385,000 for government plans. 2. notice 2014-5, 2014-2 i.r.b. 276 (12/13/13). this notice provides temporary nondiscrimination relief for certain “closed” defined benefit pension plans (i.e., those that provide ongoing accruals but that have been amended to limit those accruals to some or all of the employees who participated in the plan on a specified date). typically, new hires are offered only a defined contribution plan, and the closed defined benefit plan has an increased proportion of highly compensated employees. c. nonqualified deferred compensation, section 83, and stock options 1. the ninth circuit shows the irs no deference in its interpretation of its own regulations. schwab v. commissioner, 715 f.3d 1169 (9th cir. 4/24/13). the court of appeals, in an opinion by judge m. smith, affirmed the tax court’s decision, rejecting the government’s argument that “because section 72 contemplates the ‘cash value’ of a nonannuity ‘without regard to any surrender charge,’ i.r.c. § 72(e)(3)(a)(i), then section 402(b)(2) must also apply without regard to any surrender charge.” in addition to being an erroneous interpretation of § 72(e)(3)(a), the government’s interpretation of § 402(b)(2) would “read[] the phrase ‘amount actually distributed or made available’ entirely out of section 402(b)(2).” the court of appeals also refused to defer to the government’s interpretation of 296 florida tax review [vol. 15:5 reg. § 1.402(b)-1(c) as prohibiting the consideration of surrender charges in valuing a life insurance policy for purposes of § 402(b)(2). the court also rejected the government’s argument that surrender charges could not be considered under § 402(b) because in matthies v. commissioner, 134 t.c. 141 (2010), the tax court concluded that, under the pre-2005 regulations, surrender charges should not be considered when valuing a life insurance policy under § 402(a). the tax court decided matthies based on the regulation’s requirement to account for the “entire cash value” of the policy, while the regulation interpreting § 402(b)(2) contains no such language. accordingly, the tax court “correctly equated the ‘amount’ in section 402(b)(2) with the fair market value of the policies that were actually distributed.” finally, the tax court did not err in the determination of the fair market value of the policies after taking into account the surrender charges. 2. substance over form determines that an option to purchase shares of the taxpayer’s employer was granted to him by the corporation, not by his ex-wife to whom he transferred the shares in a divorce. davis v. commissioner, 716 f.3d 560 (11th cir. 5/16/13), aff’g t.c. memo. 2011-286. in connection with the taxpayer’s divorce, he transferred one-half of his shares of a family corporation of which he was a shareholder and key employee to his ex-wife, who granted him an option to purchase those shares. contemporaneously, the corporation agreed to grant him an option to purchase additional stock in the corporation as an inducement for him to continue his employment. however, instead of granting him the option, as contemplated by the parties all along, the corporation redeemed the shares transferred to the taxpayer’s ex-wife and assumed the obligation under the option from the ex-wife to permit the taxpayer to purchase the shares from the corporation. subsequently, that option was modified in several significant respects before it ultimately was exercised. the taxpayer did not report income under § 83(a) upon exercise of the option, but the corporation claimed a deduction under § 83(h). the eleventh circuit, in an opinion by judge ripple, affirmed the tax court’s decision that the taxpayer was required to recognize income under § 83 and that the corporation was entitled to a deduction. the court rejected the taxpayer’s argument that because the option originally was granted to him by his ex-wife incident to their divorce, his exercise of it was shielded from recognition by § 1041, holding instead that it was granted to him in connection with his performance of services. a key fact supporting the holding was that the revised option from the corporation imposed the requirement that the taxpayer notify the corporation in writing if he chose to make a § 83(b) election. applying substance over form, the court held that the corporation was the true counter-party to the option granted by the exwife and that the option from the corporation, with substantially different 2014] recent developments in federal income taxation 297 rights than those granted by the ex-wife’s option, was a different option, despite being termed an “amendment” of the option from the ex-wife. furthermore, the court added that had the taxpayer exercised the option granted by the ex-wife, its exercise would not have been governed by § 1041, because § 1041 applied only to the initial transfer of stock and the grant of the option; it does not apply to subsequent dispositions of property received in the divorce. the court went on to state that the exercise in that case still would have produced ordinary income. that final conclusion puzzles us, because apart from § 83, the exercise of an option to purchase property, even at a bargain, is not a realization event. but not to worry, the court’s faux pas was dictum. 3. a requirement to sell employer stock back at a discount if the employee is sacked for “[f]ailure or refusal by employee ... to cure by faithfully and diligently performing the usual and customary duties of his employment” is a substantial risk of forfeiture. austin v. commissioner, 141 t.c. no. 18 (12/16/13). the taxpayers received stock in a corporation in a § 351 transaction and entered into employment agreement and restricted stock agreements with the newly formed corporation. the taxpayers received 95 percent of the stock of the corporation and an esop acquired 5 percent of the stock for a promissory note. (the transactions occurred before the enactment of § 409(p) in 2004 and the tax years at issue were 2000-2003.) the taxpayers collectively were the entire board of directors of the corporation. the corporation made an s election. the employment agreements provided that upon termination of employment, they would receive less than the full fair market value of their s shares if they were terminated “for cause” during the initial term of the employment agreement; otherwise on termination of employment the taxpayers would receive in exchange for their stock 100 percent of the fair market value, determined by formula. the employment agreements defined termination “for cause” to include not only termination for “[d]ishonesty, fraud, embezzlement, alcohol or substance abuse,” but also termination upon “[f]ailure or refusal by employee ... to cure by faithfully and diligently performing the usual and customary duties of his employment.” the stock certificates were legended as restricted stock. the taxpayers took the position that their stock was not fully vested and that pursuant to reg. § 1.83-1(a)(1) they were not shareholders, with the result that all of the s corporation’s income passed through to the esop and none passed through to them. the irs asserted deficiencies based on the ground that the stock was not subject to forfeiture because reg. § 1.83-3(c)(2) provides that a requirement that stock be forfeited “if the employee is discharged for cause or for committing a crime will not be considered to result in a substantial risk of forfeiture.” the irs moved for summary judgment that the stock was not subject to a risk of forfeiture, but the tax court (judge lauber) denied the irs’s motion. 298 florida tax review [vol. 15:5 the court held that the restricted stock agreement and employment agreement together constituted “an earnout restriction that may give rise to a ‘substantial risk of forfeiture.’” (emphasis added). although the contractual provision addressed termination “for cause,” “termination upon ‘[f]ailure or refusal by employee ... to cure by faithfully and diligently performing the usual and customary duties of his employment’ falls outside the scope of discharge ‘for cause or for committing a crime’ within the meaning of [reg. § 1.83-3(c)(2)].” judge lauber reasoned that “an employee’s inability or disinclination to work for the agreed-upon term of his employment contract is not a ‘remote’ event that is unlikely to occur.” moreover, a finding that reg. § 1.83-3(c)(2) “precludes an earnout restriction from creating a ‘substantial risk of forfeiture’ would make that subparagraph of the regulation inconsistent with the statute.”  the irs’s other arguments, including that the taxpayer’s stock was “substantially vested” because as the sole directors of the corporation they could “remove at will any ownership restrictions to which their stock was subject, so that the forfeiture conditions were unlikely to be enforced,” presented issues for trial. d. individual retirement accounts 1. their iras got flecked by a prohibited transaction, which piqued the interest of the irs. peek v. commissioner, 140 t.c. no. 12 (5/9/13). two unrelated taxpayers, peek and fleck, established self-directed iras to purchase a business. the iras were funded with rollovers from other iras and 401(k) accounts. the purchase was accomplished by (1) peek and fleck forming a new corporation the stock of which was issued to their iras for the cash that had been rolled into the iras, and (2) the corporation purchasing the business assets from the seller for cash received from the iras, proceeds from a bank loan, and the corporation’s promissory note, which was guaranteed by peek and fleck. the iras subsequently sold the stock of the corporation, and the irs asserted deficiencies against peek and fleck on the grounds that the iras had failed to qualify under § 408 because the loan guarantees were prohibited transactions under § 4975. section 408(e)(2)(a) provides that an account ceases to qualify as an ira if “the individual for whose benefit any individual retirement account is established ... engages in any transaction prohibited by section 4975.” section 4975(c)(1)(b) prohibits “any direct or indirect ... lending of money or other extension of credit between a [retirement] plan and a disqualified person.” the taxpayers argued that the prohibition applies only to an extension of credit that, whether direct (like a loan) or indirect (like a loan guaranty), is “between a plan and a disqualified person,” and that the loan guaranties at issue were between disqualified 2014] recent developments in federal income taxation 299 persons (mr. fleck and mr. peek) and an entity other than the plans, i.e., the corporation that was owned by the iras, rather than the iras themselves. the tax court (judge gustafson) rejected the taxpayer’s argument and upheld the deficiency. [the taxpayers’] reading of the statute, however, would rob it of its intended breadth. section 4975(c)(1)(b) prohibits “any direct or indirect *** extension of credit between a plan and a disqualified person”. ... the supreme court has observed that when congress used the phrase “any direct or indirect” in section 4975(c)(1), it thereby employed “broad language” and showed an obvious intention to “prohibit[] something more” than would be reached without it. commissioner v. keystone consol. indus., inc., 508 u.s. 152, 159-160 (1993). as the commissioner points out, if the statute prohibited only a loan or loan guaranty between a disqualified person and the ira itself, then the prohibition could be easily and abusively avoided simply by having the ira create a shell subsidiary to whom the disqualified person could then make a loan. that, however, is an obvious evasion that congress intended to prevent by using the word “indirect”. the language of section 4975(c)(1)(b), when given its obvious and intended meaning, prohibited mr. fleck and mr. peek from making loans or loan guaranties either directly to their iras or indirectly to their iras by way of the entity owned by the iras.  accuracy related penalties were upheld. 2. “[t]his is precisely the kind of self-dealing that section 4975 was enacted to prevent.” ellis v. commissioner, t.c. memo. 2013-245 (10/29/13). the taxpayer rolled-over from his 401(k) account to a self-directed ira approximately $320,000. the $320,000 was promptly invested in a newly-formed llc (which made a check-the-box election to be taxed as a corporation) in which it obtained a 98 percent interest, with an unrelated party holding the remaining 2 percent interest. during the remainder of the year, the llc, which was engaged in the used car business, paid the taxpayer approximately $10,000 as compensation for managing the llc. the used-car llc also paid rent to another llc owned by the taxpayer and his family that owned the property on which the used car business was conducted. the tax court (judge paris) upheld that irs’s determination that the taxpayer had engaged in a transaction with his ira that was prohibited under § 4975. section 4975(c) prohibited transactions include any direct or indirect: (1) sale or exchange, or leasing, of any property between a plan and a disqualified person; (2) lending of money or 300 florida tax review [vol. 15:5 other extension of credit between a plan and a disqualified person; (3) furnishing of goods, services, or facilities between a plan and a disqualified person; (4) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; (5) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or (6) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. because the taxpayer exercised control over the ira, he was a disqualified person as defined in § 4975(e). although the initial investment in the llc was not a prohibited transaction because it had no outstanding owners or ownership interests before the initial capital contribution and therefore could not be a disqualified person at the time of the investment, the taxpayer did engage in a prohibited transaction when he caused the llc to pay him compensation. as a result, pursuant to § 408(e)(2)(a), the ira ceased to be qualified as of the first day of the taxable year and pursuant to § 408(e)(2)(b) the entire amount was treated as distributed and includable in gross income. because the taxpayer was not 59½ as of the first day of the year, the 10 percent § 72(t) penalty applied. and for good measure, a 20 percent § 6662(a) negligence penalty was sustained as well. 3. honey, i shrunk the iras! divorce is bad enough without learning that your iras have been depleted through forged withdrawals and that the irs is asserting a deficiency. roberts v. commissioner, 141 t.c. no. 19 (12/30/13). the taxpayer and his wife permanently separated in january 2009 and were later divorced. the taxpayer maintained two iras. during 2008, a total of approximately $37,000 was distributed from the iras. the distributions were made pursuant to forged withdrawal requests and the checks representing those distributions were endorsed with forged signatures and deposited in a checking account that the taxpayer owned jointly with his wife, but which was used exclusively by his wife. the taxpayer did not know about or authorize the ira withdrawals at the time they occurred and first learned of them in 2009, when he received forms 1099-r. the tax court (judge marvel), considering an issue of first impression, held that the distributions were not includible in the taxpayer’s gross income under § 408(d)(1), which provides that the “payee or distributee” must include in gross income in the manner provided under § 72 any amount paid or distributed out of an individual retirement plan. the court rejected the government’s argument that the taxpayer was a payee or distributee under bunney v. commissioner, 114 t.c. 259 (2000), in which the court held that the payee or distributee of an ira distribution generally is “the participant or beneficiary who, under 2014] recent developments in federal income taxation 301 the plan, is entitled to receive the distribution.” the court reasoned that the taxpayer was not a payee or distributee within the meaning of § 408(d)(1) because “he did not request, receive, or benefit from the ira distributions.” (the court found that the taxpayer’s wife received and spent the funds.) the court also rejected the government’s argument that the taxpayer was a payee or distributee because the taxpayer ratified or acquiesced in the ira withdrawals by: (1) failing to report the forged signatures to the financial institutions in a timely manner or make a claim based on those signatures, and (2) benefitting from the withdrawals in the divorce proceedings, in which the division of assets took into account that the funds went to the taxpayer’s wife. any ratification or acquiescence, the court reasoned, did not take place until 2009 at the earliest, and therefore could not affect whether the taxpayer was a payee or distributee in 2008, the year for which the deficiency was determined. because the taxpayer was not subject to tax on the distributions, he also was not subject to the 10% penalty tax imposed on early withdrawals by § 72(t). the court imposed the § 6662(a) accuracyrelated penalty based on the taxpayer’s failure to report interest income unrelated to the iras, his underreporting of wage income, and his filing of a return for 2008 as a single taxpayer despite the fact that he was married. the 2008 return, which the taxpayer never saw, was prepared and filed by his wife. v. personal income and deductions a. rates 1. doma could be on its way to the supreme court. on the other hand, might this case lead to doma becoming the twenty-eighth amendment? massachusetts v. united states dept. of health and human services, 682 f.3d 1 (1st cir. 5/31/12), aff’g gill v. office of personnel management, 699 f. supp. 2d 374 (d. mass. 7/8/10). in an opinion by judge boudin, the first circuit held that § 3 of the defense of marriage act, 1 u.s.c. § 7, which limits the meaning of the word “marriage” to “a legal union between one man and one woman as husband and wife,” and provides that “the word ‘spouse’ refers only to a person of the opposite sex who is a husband or wife” for purposes of all federal laws is an unconstitutional denial of equal protection in violation the equal protection principles embodied in the due process clause of the fifth amendment. joint return filing status under the code was one of the issues addressed in the case, as well as government benefits available to married individuals, e.g., employee health benefits, social security benefits. the court further ordered: 302 florida tax review [vol. 15:5 anticipating that certiorari will be sought and that supreme court review of doma is highly likely, the mandate is stayed, maintaining the district court’s stay of its injunctive judgment, pending further order of this court. a. the second circuit agrees in a split decision. windsor v. united states, 699 f.3d 169 (2d cir. 10/18/12) (2-1), cert. granted, 133 s. ct. 786 (12/7/12). in an appeal from a grant of summary judgment in a tax refund suit by the district court for the southern district of new york, the second circuit (chief judge dennis jacobs) affirmed the grant of summary judgment to the surviving spouse of a same-sex couple that was married in canada in 2007 and resided in new york at the time of her spouse’s death in 2009 who was denied the benefit of the § 2056 marital deduction for federal estate tax on the ground that the defense of marriage act violated the equal protection clause for want of a rational basis.  the court concluded that review of § 7 required heightened scrutiny because (a) homosexuals as a group have historically endured persecution and discrimination; (b) homosexuality has no relation to aptitude or ability to contribute to society; (c) homosexuals are a discernible group with non-obvious distinguishing characteristics, especially in the subset of those who enter same-sex marriages; and (d) the class remains a politically weakened minority. the circuit court further concluded that the class was quasi-suspect (rather than suspect) based on the weight of the factors and on analogy to the classifications recognized as suspect and quasi-suspect. the circuit court held that the rationale premised on uniformity was not an exceedingly persuasive justification for doma, and that doma was not substantially related to the important government interest of protecting the fisc.  judge straub dissented on the following basic ground: the majority holds doma unconstitutional, a federal law which formalizes the understanding of marriage in the federal context extant in the congress, the presidency, and the judiciary at the time of doma’s enactment and, i daresay, throughout our nation’s history. if this understanding is to be changed, i believe it is for the american people to do so. . . . at bottom, the issue here is marriage at the federal level for federal purposes, and not other legitimate interests. the congress and the president formalized in doma, for federal purposes, the basic human condition of joining a man and a woman in a long-term relationship and the only one which is inherently capable of producing another generation 2014] recent developments in federal income taxation 303 of humanity. whether that understanding is to continue is for the american people to decide via their choices in electing the congress and the president. it is not for the judiciary to search for new standards by which to negate a rational expression of the nation via the congress. b. same-sex spouses in valid marriages now get to share in marriage penalties and marriage bonuses when filing income tax returns because “the principal purpose and the necessary effect of [doma] are to demean those persons who are in a lawful samesex marriage.” united states v. windsor, 133 s. ct. 2675 (6/26/13). the defense of marriage act (doma), pub. l. no. 104–199, 110 stat. 2419 (1996), defines “marriage” in any act of congress, which (of course) includes the code, as a legal union “between one man and one woman” as husband and wife. doma also defines the word “spouse” to mean only a person of the “opposite sex” who is a husband or wife. this case involved whether the § 2056 estate tax marital deduction was allowable with respect to a bequest to a same-sex spouse whose marriage to the decedent was recognized under local law. the supreme court held that § 3 of doma — the provision that limits the meaning of the word “marriage” to “a legal union between one man and one woman as husband and wife,” and provides that “the word ‘spouse’ refers only to a person of the opposite sex who is a husband or wife” — is an unconstitutional denial of equal protection in violation of the due process clause of the fifth amendment. as a result, the § 2056 estate tax marital deduction was allowable. it follows that for income tax purposes same-sex married couples whose marriages are recognized by local law are eligible to file a joint return and if they do not file a joint return must file as married filing separately.  whether this result applies to a same sex married couple that has moved from a state that recognizes same sex marriage to a state that does not recognize same sex marriage is not entirely clear. the windsor court limited its holding to the definition of marriage in § 3 of doma and did not address § 2, which allows states to refuse to recognize same-sex marriages from other states. section 2 was not challenged in windsor. some clue to future guidance might be found in rev. rul. 58-66, rev. rul. 58-66, 1958-1 c.b. 60, in which the irs ruled that taxpayers who entered into a common-law marriage in a state that recognized common law marriage would be treated as married for tax purposes even if they later moved to a state in which a ceremony is required to initiate the marital relationship.  other questions for a future time include whether same sex spouses can toggle into and out of marriages when they change residence and whether domestic partnerships in some states that are not called marriage will be treated as marriage under federal law. 304 florida tax review [vol. 15:5 c. shakespeare called it “the merry wives of windsor.” and the irs interprets windsor broadly – a same-sex marriage celebrated under the laws of one state is a federal tax “marriage” in every state. rev. rul. 2013-17, 2013-38 i.r.b. 201 (8/29/13). in the wake of united states v. windsor, 133 s. ct. 2675 (2013), the irs ruled that the marital status of individuals of the same-sex who are lawfully married under the laws of a state that recognizes such marriages will be recognized for all purposes. the ruling held that for federal tax purposes (1) the terms “spouse,” “husband and wife,” “husband,” and “wife” include an individual married to a person of the same sex if the individuals are lawfully married under state law, and the term “marriage” includes such a marriage between individuals of the same sex; and (2) a marriage of samesex individuals that was validly entered into in a state whose laws authorize the marriage of two individuals of the same sex will be recognized even if the married couple is domiciled in a state that does not recognize the validity of same-sex marriages. however the terms “spouse,” “husband and wife,” “husband,” and “wife” do not include individuals (whether of the opposite sex or the same sex) who have entered into a registered domestic partnership, civil union, or other similar formal relationship recognized under state law that is not denominated as a marriage under the laws of that state, and the term “marriage” does not include such formal relationships.  taxpayers may file amended returns, adjusted returns, or claims for credit or refund for any overpayment of tax resulting from this ruling if the statute of limitations is open. the ruling applies retroactively with respect to any employee benefit plan or arrangement or any benefit provided thereunder for purposes of filing original returns, amended returns, adjusted returns, or claims for credit or refund of an overpayment of tax concerning employment tax and income tax with respect to employer-provided health coverage benefits or fringe benefits that were provided by the employer and are excludable from income under §§ 106, 117(d), 119, 129, or 132 based on an individual’s marital status. d. correcting overpayments of fica taxes and income tax withholding resulting from the windsor decision and rev. rul. 2013-17 just got a little easier. notice 2013-61, 2013-44 i.r.b. 432 (9/23/13). in the wake of united states v. windsor, 133 s. ct. 2675 (2013), the irs issued rev. rul. 2013-17, 2013-38 i.r.b. 201 (8/29/13), discussed in section v.a. of this outline, in which it ruled that same-sex couples who are lawfully married under the laws of a state or foreign jurisdiction will be recognized as married for federal tax purposes. rev. rul. 2013-17 permits taxpayers to file amended returns, adjusted returns, or claims for credit or refund for any overpayment of tax resulting from the ruling if the statute of limitations is open. the notice provides guidance for 2014] recent developments in federal income taxation 305 employers and employees to make claims for refunds or adjustments of overpayments of fica taxes and federal income tax withholding with respect to: (1) health coverage benefits or fringe benefits provided by an employer to a same-sex spouse that are excludable from income under §§ 106, 117(d), 119, 129, or 132 based on an individual’s marital status, and (2) remuneration for services performed in the employ of an individual’s spouse that are excepted from fica tax under § 3121(b)(3)(b). to correct overpayments of fica taxes, employers can use the regular procedures for doing so or special, simplified administrative procedures provided in the notice for correcting overpayments made in 2013 or in prior years. if an employer corrects overpayments of fica taxes for prior years, the usual requirements apply, including the filing of form w-2c, corrected wage and tax statement. employers cannot correct overpayments of withheld income tax after the end of a calendar year unless the overpayment is attributable to administrative error. accordingly, an employer can use the special administrative procedures to correct overpayments of income tax withholding only for 2013 and only by repaying or reimbursing the employee during 2013 for the over-collected income tax. e. same sex marriage fringe benefits. notice 2014-1 2014-2 i.r.b. 270 (12/17/13). this notice provides guidance in q&a format regarding the application of § 125 cafeteria plans, including health and dependent care flexible spending arrangements (fsas), and § 223, relating to health savings accounts (hsas), to same-sex spouses following united states v. windsor, 570 u.s. ___, 133 s. ct. 2675 (2013), and rev. rul. 2013-17, 2013-38 i.r.b. 201. 2. and the irs starts administering national health care. t.d. 9632, shared responsibility payment for not maintaining minimum essential coverage, 78 f.r. 53646 (8/30/13). the irs and treasury have promulgated reg. §§ 1.5000a-0 through 1.5000a-5 providing comprehensive guidance regarding the requirement to maintain minimum essential coverage under § 5000a, which was enacted by the patient protection and affordable care act and the health care and education reconciliation act of 2010, as amended by the tricare affirmation act and public law 111–173. the regulations provide guidance to individual taxpayers on their liability under § 5000a for the shared responsibility payment for not maintaining minimum essential coverage. the t.d. largely finalizes the rules in reg–148500–12, 78 f.r. 7314 (2/1/13). the regulations are effective on 8/30/13. 3. net investment income tax of 3.8 percent. section 1411 of the code, added by the health care and education reconciliation act of 2010, imposes a 3.8 percent tax on the net investment income of 306 florida tax review [vol. 15:5 individuals, estates, and trusts in taxable years beginning after 12/31/12. for individuals (except nonresident aliens), the tax applies only to the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over a threshold amount. i.r.c. § 1411(a)(1). the threshold amount is $250,000 for spouses filing a joint return or a surviving spouse, $125,000 for married individuals filing separate returns, and $200,000 for single taxpayers (including heads of household). i.r.c. § 1411(b). these threshold amounts for individuals are not adjusted for inflation. modified adjusted gross income is adjusted gross income increased by the amount of foreign earned income excluded under § 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income). i.r.c. § 1411(d). for estates and trusts, the tax is levied on the lesser of (1) undistributed net investment income, or (2) the excess of adjusted gross income (as defined in § 67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins for the tax year ($11,950 for 2013). i.r.c. § 1411(a)(2). the tax does not apply to a trust that is tax-exempt under § 501, is a charitable remainder trust tax-exempt under § 664, or all of the unexpired interests of which are devoted to charitable purposes. net investment income is investment income reduced by the deductions properly allocable to that income. investment income is the sum of (1) gross income from interest, dividends, annuities, royalties, and rents (other than income derived from any trade or business to which the tax does not apply), (2) other gross income derived from any trade or business to which the tax applies, and (3) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply. i.r.c. § 1411(c)(1). the § 1411 tax applies to trade or business income from (1) a passive activity, and (2) trading financial instruments or commodities (as defined in § 475(e)(2)). i.r.c. § 1411(c)(2). it does not apply to any other trade or business income. however, income on the investment of working capital is not treated as derived from a trade or business and is subject to tax under § 1411. i.r.c. § 1411(c)(3). gain or loss from the disposition of a partnership interest or stock in an s corporation is taken into account only to the extent gain or loss would be taken into account by the partner or shareholder if the entity had sold all its properties for fair market value immediately before the disposition. i.r.c. § 1411(c)(4). thus the transferor partner or shareholder takes into account only the net gain or loss attributable to the entity’s property that is not attributable to an active trade or business. investment income does not include any distributions from a qualified retirement plan or any income subject to self-employment tax. i.r.c. § 1411(c)(5) and(6). unlike self-employment taxes, no part of the § 1411 tax is deductible in computing taxable income under chapter 1. the tax on net 2014] recent developments in federal income taxation 307 investment income is subject to the estimated tax provisions. i.r.c. § 6654(a). a. final regulations provide extensive guidance on the § 1411 tax on net investment income. t.d. 9644, net investment income tax, 78 f.r. 72394 (12/2/13). the treasury department and irs have issued final regulations under § 1411 regarding the 3.8 percent tax on net investment income. the final regulations generally follow, but make some important changes to, the regulations that were proposed in reg-130507-11, net investment income tax, 77 f.r. 72612 (12/5/12). the final regulations generally are effective for tax years beginning after 12/31/13. however, § 1411 is effective for tax years beginning after 12/31/12. for tax years beginning before the effective date of the final regulations, taxpayers may rely on either the proposed regulations or the final regulations for purposes of complying with § 1411. however, to the extent taxpayers take a position inconsistent with the final regulations that affects the treatment of an item in a taxable year beginning after 12/31/13, they must make reasonable adjustments to ensure that their liability for the § 1411 tax in the later year is not inappropriately distorted. such adjustments might be required, for example, to ensure that an item of income or deduction is taken into account only once in determining net investment income.  general provisions. section 1411 is the only provision in chapter 2a of subtitle a of the code. chapter 2a does not contain any other operational or definitional provisions. except as otherwise provided, all code provisions that apply for purposes of chapter 1 in determining taxable income as defined in § 63(a) also apply in determining the tax imposed by § 1411. reg. § 1.1411-1(a).  application to individuals. section 1411 applies to individuals but does not apply to nonresident aliens. the regulations provide that dual resident taxpayers (as defined in reg. § 301.7701(b)-7(a)(1)) who determine that they are residents of a foreign country and therefore entitled to treaty benefits are nonresident aliens for purposes of the § 1411 tax. reg. § 1.1411-2(a)(2)(i). dual status individuals who are nonresident aliens for a portion of the taxable year are not subject to the § 1411 tax for the portion of the year during which they are nonresident aliens. only income received during the portion of the year that they are residents of the u.s. is subject to the tax. reg. § 1.1411-2(a)(2)(ii). special rules apply to a u.s. citizen or resident who is married to a nonresident alien. reg. § 1.1411-2(a)(2)(iii).  application to estates and trusts. as a general rule, the § 1411 tax applies to all estates and trusts that are subject to the provisions of part i of subchapter j of chapter 1 of subtitle a of the code. reg. § 1.1411-3(a)(1)(i). accordingly, the § 1411 tax does not apply to trusts that are not classified as trusts under the check-the-box regulations (such as business 308 florida tax review [vol. 15:5 trusts). in response to comments on the proposed regulations, the final regulations expand the list of estates and trusts that are specifically exempted from the § 1411 tax. trusts or estates, all of the unexpired interests of which are devoted to charitable purposes, are not subject to the § 1411 tax. reg. § 1.14113(b)(1)(i). the tax also does not apply to trusts that are exempt from taxes imposed by subtitle a of the code. reg. § 1.1411-3(b)(1)(ii)-(iv). this is true even if the trust is subject to tax on its unrelated business taxable income. the regulations clarify that grantor trusts are not subject to the tax. the grantor or other person who takes into account the grantor trust’s income and deductions is treated as receiving and paying those items directly for purposes of calculating that person’s liability for the § 1411 tax. reg. § 1.1411-3(b)(1)(v). the § 1411 tax does not apply to cemetery perpetual care funds subject to § 642(i), alaska native settlement trusts that have made an election under § 646, or foreign estates or trusts, but special rules apply to distributions from foreign estates or trusts to u.s. beneficiaries. reg. § 1.1411-3(b)(1)(vi)-(ix). special computational rules apply to electing small business trusts. reg. § 1.1411-3(c). although charitable remainder trusts are not subject to the tax, annuity and unitrust distributions may be net investment income to the noncharitable beneficiary who receives them. reg. § 1.1411-3(d).  the regulations provide detailed rules regarding the calculation of an estate or trust’s undistributed net investment income. reg. § 1.1411-3(e). generally, the rules for calculating undistributed net investment income are guided by the subchapter j concept of distributable net income, which apportions income between the trust and its beneficiaries.  the treasury department and the irs reserved two issues related to estates and trusts for further study and have requested comments on both issues. the first is how the § 1411 tax should apply to distributions by foreign trusts of net investment income that was accumulated for the benefit of u.s. beneficiaries. the second issue is the appropriate method of determining whether an estate or trust materially participates in an activity. this issue may be the subject of a separate guidance project under § 469.  net investment income. net investment income is investment income reduced by the deductions properly allocable to that income. the regulations provide an exclusive list of deductions that may be properly allocable deductions and provide authority for the identification of additional deductions in published guidance. reg. § 1.1411-4(f). in response to comments on the proposed regulations, the final regulations permit taxpayers to treat a portion of a net operating loss deduction as a properly allocable deduction. reg. § 1.1411-4(f)(2)(iv), (h). net investment income cannot be less than zero. deductions that exceed investment income can be carried forward only to the extent provided in chapter 1 of the code. reg. § 1.1411-4(f)(1)(ii). deductions carried over to a tax year because they were suspended or 2014] recent developments in federal income taxation 309 disallowed by other provisions, such as the investment interest, basis, at-risk, or passive activity loss limitations, and allowed for that year in determining adjusted gross income are also allowed in determining net investment income. this is true regardless of whether the taxable year from which the deductions are carried precedes the effective date of § 1411. the treasury department and the irs have issued proposed regulations that address issues related to the treatment of capital loss carryforwards. reg-130843-13, net investment income tax, 78 f.r. 72451 (12/2/13).  if items of net investment income (including the properly allocable deductions) pass through to an individual, estate, or trust from a partnership or s corporation, the allocation of the items must be separately stated under § 702 or § 1366. although the proposed regulations provided detailed guidance on determining the net investment income arising from the disposition of interests in partnerships or s corporations, the treasury department and the irs did not finalize this guidance and instead issued a new proposed regulation that addresses the issue. reg-130843-13, net investment income tax, 78 f.r. 72451 (12/2/13).  because trade or business income from a passive activity is net investment income, the status of activities as passive and the grouping of activities for purposes of the passive activity loss rules are significant. the regulations provide individuals, estates, and trusts with a fresh start to regroup activities in the first tax year that begins after 12/31/13 in which § 1411 would apply to the taxpayer. reg. § 1.469-11(b)(3)(iv). regrouping is permitted on an original return or on an amended return if changes on the amended return cause the taxpayer to become subject to the § 1411 tax. conversely, if a taxpayer regroups activities and it is subsequently determined that the taxpayer is not subject to the § 1411 tax for the year during which regrouping occurred, the regrouping is void and, subject to limited exceptions, has no effect for that year and all future years. despite comments on the proposed regulations that requested the change, the treasury department and the irs declined to allow partnerships and s corporations to regroup activities.  the regulations provide a safe harbor for real estate professionals as defined in § 469(c)(7)(b) who participate in rental real estate activities. if a real estate professional participates in rental real estate activities for more than 500 hours during the year (or has participated in such activities for more than 500 hours in any five of the last ten taxable years), then gross rental income from the rental activity and gain or loss from the disposition of property used in the rental activity is deemed to be derived in the ordinary course of a trade or business. reg. § 1.1411-4(g)(7). a real estate professional who meets the 500 hour threshold would be treated as materially participating in the rental real estate activity under reg. § 1.469-5t(a)(1), (5). accordingly, the effect of the safe harbor is that the real estate professional’s gross rental income and gain or loss from the disposition of property is not included in net investment income and therefore is not subject to the § 1411 tax. a real estate 310 florida tax review [vol. 15:5 professional who fails to satisfy the safe harbor is not precluded from establishing that gross rental income and gain or loss from disposition of property is not included in net investment income.  international issues. under § 951(a), united states shareholders who own stock in a controlled foreign corporation on the last day of the corporation’s taxable year must include in gross income their pro rata share of the cfc’s subpart f income. similarly, united states persons who hold stock of a passive foreign investment company and elect to treat the pfic as a qualified electing fund must include in gross income currently under § 1293 a pro rata share of the pfic’s earnings and profits. when the cfc or pfic later distributes its earnings, the shareholders can exclude the distributions from gross income to the extent they previously were taxed on them. these income inclusions and exclusions result in positive and negative stock basis adjustments. because these income inclusions are not treated as dividends unless expressly provided for in the code, the regulations do not treat the income inclusions as net investment income for purposes of § 1411. instead, cfc shareholders and pfic shareholders who have made a qualified electing fund election must treat actual distributions of previously taxed earnings as net investment income. reg. § 1.1411-10(c)(2)(i). one effect of this rule is that a cfc or pfic shareholder can have one stock basis for purposes of chapter 1 of the code and a different stock basis for purposes of the § 1411 tax. to avoid these complexities, the regulations allow a taxpayer to elect to treat the income inclusions required by § 951(a) and § 1293 as net investment income. reg. § 1.1411-10(g). in response to comments on the proposed regulations, the final regulations allow taxpayers to make the election on an entity-by-entity basis. the proposed regulations had required the election to apply to all cfcs and pfics held by the taxpayer, even if acquired subsequent to the election. once made, the election is irrevocable.  the § 1411 tax cannot be reduced with foreign tax credits because foreign tax credits reduce taxes imposed by chapter 1 of the code, and § 1411 is located in chapter 2a. reg. § 1.1411-1(e).  see also, faqs on the net investment income tax, originally released by the irs on 11/29/12, 2012 tnt 232-47, and subsequently updated on the irs web site. b. proposed regulations address specific issues related to the tax on net investment income. on 11/26/13, the treasury department issued proposed regulations regarding the § 1411 tax on net investment income. reg-130843-13, net investment income tax, 78 f.r. 72451 (12/2/13). the proposed regulations address discrete issues left open in the final regulations issued on the same day. t.d. 9644, net investment income tax, 78 f.r. 72394 (12/2/13). the proposed regulations generally are proposed to be effective for tax years beginning after 12/31/13. 2014] recent developments in federal income taxation 311 however, § 1411 is effective for tax years beginning after 12/31/12. taxpayers may rely on the proposed regulations for purposes of complying with § 1411 until they are issued as final regulations. some of the significant topics addressed by the proposed regulations are:  gain or loss from dispositions of interests in partnerships and s corporations. gain or loss from the disposition of a partnership interest or stock in an s corporation is treated as net investment income only to the extent gain or loss would be taken into account by the partner or shareholder if the entity had sold all its properties for fair market value immediately before the disposition. i.r.c. 1411(c)(4). the proposed regulations provide detailed rules for determining the transferor partner or shareholder’s net investment income from the disposition. prop. reg. § 1.14117. generally, if the transferor realizes a gain from the disposition, the gain subject to the § 1411 tax is the lesser of the transferor’s recognized gain or the transferor’s allocable share of net gain from a deemed sale by the partnership or s corporation of property that would give rise to gain or loss includable in determining the transferor’s net investment income. the proposed regulations also provide an optional, simplified reporting method that transferors who meet certain eligibility requirements can use instead of the normal calculation. generally, the optional, simplified method relies on historic distributive share amounts that the transferor has received from the partnership or s corporation to determine a percentage of the firm’s assets that are passive with respect to the transferor and therefore would give rise to net investment income.  partnership payments to partners. the proposed regulations provide guidance on the treatment of certain payments from partnerships to partners. the treatment of guaranteed payments under § 707(c) depends on whether the payments are for services or the use of capital. guaranteed payments for the use of capital are included in net investment income; guaranteed payments for services are not included in net investment income regardless of whether the payments are subject to self-employment tax. prop. reg. § 1.1411-4(g)(10). the treatment of payments to a retiring partner or to a deceased partner’s successor in interest in liquidation of the partner’s entire interest in the partnership is governed by how such payments are categorized under § 736. thus, payments that are treated under § 736(b) as distributions that give rise to gain or loss from the sale or exchange of a partnership interest are analyzed for purposes of § 1411 as gain or loss from the disposition of a partnership interest. payments that are treated under § 736(a)(1) as a distributive share of income to the partner are analyzed for purposes of § 1411 in the same manner as a partner’s distributive share of income, and payments that are treated under § 736(a)(2) as guaranteed payments are analyzed for purposes of § 1411 as guaranteed payments. prop. reg. § 1.1411-4(g)(11).  capital loss carryforwards. when a taxpayer determines net investment income for a taxable year, some capital losses are taken into account in determining net investment income and others 312 florida tax review [vol. 15:5 are not. capital losses that are not taken into account in determining a taxpayer’s net investment income include: (1) capital losses arising from the sale or disposition of property used in a trade or business in which the taxpayer materially participates, and (2) capital losses from sales or dispositions of partnership interests or s corporation stock to the extent that the rules as to such sales or dispositions do not treat the losses as part of net investment income. accordingly, when a taxpayer carries forward capital losses to a later year, the taxpayer must identify what portion of the capital loss carryforward should not be taken into account in determining net investment income in the later year. the proposed regulations impose this requirement and provide examples to illustrate it. prop. reg. § 1.1411-4(d)(4)(iii).  charitable remainder trusts. the proposed regulations provide charitable remainder trusts with an optional, simplified method of tracking a beneficiary’s net investment income. prop. reg. § 1.1411-4(d)(3). they also provide guidance for charitable remainder trusts that have income from a cfc or from a pfic that is treated as a qualified electing fund. prop. reg. § 1.1411-4(d)(2)(ii). b. miscellaneous income 1. no cod from collateralized welfare benefit fund borrowing. pinn v. commissioner, t.c. memo. 2013-45 (2/11/13). the taxpayer brothers were sole-shareholders and employees of their home construction company. the taxpayers caused the corporation to appoint local 707 of the national production workers union (of which four office employees became members) to facilitate the creation of an employee death benefit arrangement in which the taxpayers as owner/employees were allowed to participate. the union set up the american fund as a voluntary employees beneficiary association (veba) which provided a trust for guaranteed death benefits. the trust funded several million dollars of death benefits by purchasing life insurance policies. the cost was paid with deductible expenses by the taxpayers’ corporation. each of the taxpayers then borrowed $500,000 as a hardship loan, justified by them because of unexpected taxes. the loans were repayable with annual $50,000 quarterly payments plus interest, or as a reduction in death benefits. no payments were made. at the insistence of its independent accountant, the trust reported the loans in 2002 on a schedule to its form 5500 as in default or uncollectable. the tax court (judge holmes) rejected the irs assertion that the taxpayers recognized cod income in 2002. the court concluded that the loans remained collectable from the taxpayers’ death benefits with the insurance policies provided as collateral. the court rejected the irs argument that the insurance policies were insufficient because they were owned by the trust, not the taxpayers. the court observed that, “it follows that if a reduction in 2014] recent developments in federal income taxation 313 the pinns’ death benefits or capture of insurance proceeds owed (in some way) to them is an adequate alternative form of repayment, there should be no cod income just because the pinns failed to make their quarterly payments—any more than we would find cod income only because a homeowner stopped making payments on a $50,000 mortgage secured by a house worth a million.” the court held further that, when a debt is collectible and fully secured (where the fair market value of the collateral exceeds the loan balance), default alone will not result in cod income. the court also observed that the trust could collect the full value of the loans with a reduction in the taxpayers’ death benefits. 2. the irs says that a cut scrape or bruise is all you need for 100 percent exclusion under § 104(a)(2). private letter ruling 201311006 (released 3/15/13). this ruling dealt with the scope of the exclusion for damages for physical personal injury under § 104 that were paid out of a qualified settlement fund. it involved damages paid to victims of a fire and close relatives and estates of deceased victims. each of the victims received damages because he or she either suffered a cut, scrape, bruise, or other physical injury in the incident, or inhaled thick smoke and, as a result, suffered smoke inhalation during the fire. with no further explanation than “each of the victims suffered a personal physical injury or physical sickness as a result of the incident,” the irs ruled that 100 percent of the damages were excludable. the ruling made no effort to separate damages for the physical injuries and emotional injuries suffered by the survivors, and it does not mention punitive damages. a. settling an unfiled workers’ comp claim is very taxing. simpson v. commissioner, 141 t.c. no. 10 (10/28/13). the taxpayer, who had been discharged by her employer, settled a suit against the employer and received $262,500 – $12,500 for lost wages and employment benefits, $98,000 for “emotional distress, physical and mental disability,” which was based on the amount she could have received as workers’ compensation benefits (as well as an additional 25% penalty that could be imposed on the employer for failing to advise her of potential workers’ compensation eligibility and benefits) if she had filed such a claim, and $152,000 of attorney’s fees and costs. the taxpayer never filed a workers’ compensation claim, and the settlement agreement was not submitted to the california workers’ compensation appeals board (wcab) for the approval required under the california labor code. the tax court (judge laro) rejected the taxpayer’s argument that $250,000 of the settlement should be excluded under § 104(a)(1) as worker’s compensation, reasoning that “[t]he intent of the parties to a settlement of a workers’ compensation claim does not necessarily mean that the payment is excludable under section 104(a)(1).” because the settlement agreement failed to meet the express 314 florida tax review [vol. 15:5 requirement of california’s workers’ compensation laws that approval from the wcab be obtained, payments received under the agreement could not have been received under or pursuant to the state’s workers’ compensation act. rather, the payments were received under a private contract. turning to the taxpayer’s claim that § 104(a)(2) applied to provide an exclusion, the court concluded that the settlement was intended to compensate the taxpayer for both “physical personal injuries and sickness” and emotional distress. it took a guess, using its best judgment, at how much was attributable to personal physical injuries and sickness; because the record “[was] not susceptible of any precisely accurate determination” of the extent to which the settlement was attributable to personal physical injuries and sickness, it found that 10 percent of the $98,000 was on account of those physical injuries and physical sickness (other than emotional distress). finally, the court allowed the taxpayer to deduct the full $152,000 of attorney’s fees and court costs as an above the line deduction under § 62(a)(20) because the suit that was settled originally had been brought as a suit for employment discrimination on the basis of gender, age, and harassment in violation of california law.  compare: it looks like damages for physical sickness caused by emotional distress can be excluded if they go beyond mere symptomatic manifestations of the underlying emotional distress. domeny v. commissioner, t.c. memo. 2010-9 (1/13/10). the taxpayer received approximately $33,000 in settlement of claims for wrongful termination of employment and violations of various civil rights statutes. the taxpayer’s former employer paid approximately $8,000 to her that was reflected on a form w-2 as employee compensation, $8,000 to the taxpayer’s lawyer, for which no information return was filed, and $17,000 to the taxpayer that was reflected on a form 1099-misc as “nonemployee compensation.” the tax court (judge gerber) held that the $8,000 paid directly to the taxpayer was includable wage compensation, and the remaining amount was excludable under § 104(a)(2) as damages for physical injuries attributable to exacerbation of multiple sclerosis caused by a hostile work environment. the payor-former employer’s intent in settlement of the claim was evidenced by the issuance of separate checks and different information returns; these facts indicated that the former employer intended amount in excess of wages due to be in settlement of tort claims for physical injuries attributable to the exacerbation of multiple sclerosis.  the legislative history indicates that physical manifestations of emotional distress, such as insomnia, headaches, and stomach disorders, are not to be treated as physical injuries. h.r. rep. no. 737, 104th cong., 2d sess. 143, n.56 (1996).  compare: having a heart attack can improve your tax health. parkinson v. commissioner, t.c. memo. 2010-142 2014] recent developments in federal income taxation 315 (6/28/10). the tax court (judge thornton) held that one-half of the amount received by the taxpayer in settlement of suit for intentional infliction of emotional distress was excludable under § 104(a)(2), because the payor intended it to be compensation for a heart attack suffered as a result of the emotional distress. he reasoned that “a heart attack and its physical aftereffects constitute physical injury or sickness rather than mere subjective sensations or symptoms of emotional distress.” the other one-half of the settlement was not excludable because it was compensation for the emotional distress itself.  compare: the irs will treat innocent ex-cons better than innocent victims of sexual harassment. ilm 201045023, tax treatment of compensation to exonerated prisoners (11/4/10, released 11/12/10). an individual who was wrongfully convicted of a crime and was wrongfully incarcerated for several years may exclude from gross income under § 104(a)(2) the compensation he receives from the state where “[t]he individual suffered physical injuries and physical sickness while incarcerated.” it may have helped the result that one of the individuals involved, while meeting with irs officials, suffered a seizure and had to be carried out of the room by paramedics – apparently the result of head injuries sustained while in prison.  compare: compensation to victims of human trafficking is tax-free. the irs would have been pilloried if it had ruled the other way. notice 2012-12, 2012-6 i.r.b. 365 (1/19/12). mandatory restitution payments awarded under 18 u.s.c. § 1593, which criminalizes (1) holding a person to a condition of peonage; (2) kidnapping or carrying away a person to sell the person into involuntary servitude or to be held as a slave, (3) providing or obtaining a person’s services or labor by actual or threatened use of certain means including force, physical restraint, serious harm, and abuse of legal process, and (4) sex trafficking of children or by force, fraud, or coercion, are excluded from gross income.  but see p.l.r. 200041022 (7/17/00), which required that a damage award be allocated between (a) damages awarded for the period of sexual harassment without observable injury and (b) damages awarded for the period after an incident of sexual harassment that resulted in physical injury occurred. 3. “neither a borrower nor a lender be, for loan oft loses both itself and friend,” and a loan gives rise to excludable cod income, not compensation income. mcallister v. commissioner, t.c. memo. 2013-96 (4/8/13). during 2005, the taxpayer borrowed a total of $78,849 from his employer and executed promissory notes in favor of the employer. the promissory notes, which did not have repayment dates and did not require interest payments, required the taxpayer to repay the loans from bonuses he earned through incentive plans that formed part of his compensation. the taxpayer’s employment ended in 2007 when his employer encountered financial difficulties. the taxpayer did not report any 316 florida tax review [vol. 15:5 portion of the $78,849 as income on his return for 2007, which he timely filed in march 2008. the employer was acquired by a corporation that issued to the taxpayer in may 2008 a form 1099-misc that reported $78,849 as nonemployee compensation for 2007. the tax court (judge morrison) rejected the government’s contention that the taxpayer’s employer paid to the taxpayer in 2007 a constructive bonus, which the taxpayer used to repay the loans. instead, the court concluded that the taxpayer had $78,849 of cancellation of indebtedness income in 2007 because the form 1099-misc memorialized the decision of the corporation that acquired the employer to forgive the debt. the fact that the form 1099-misc classified the income as nonemployee compensation was “a bookkeeping error.” the court also concluded that, immediately before the discharge of indebtedness, the taxpayer was insolvent in the amount of $22,641 and therefore could exclude this portion of the income under § 108(a)(1)(b). the court declined to impose the accuracy-related penalty for a substantial understatement of income tax imposed by § 6662(a) and (b)(2). the court concluded that the taxpayer had reasonable cause for and acted in good faith with respect to the underpayment and therefore was not liable for the accuracy-related penalty pursuant to § 6664(c)(1). 4. equal tax rights for nonresident alien gamblers who lose. park v. commissioner, 722 f.3d 384 (d.c. cir. 7/9/13), rev’g 136 t.c. 569 (2011). in an opinion by judge kavanaugh, the d.c. circuit held that a nonresident alien who has gambling winnings in the united states should be treated the same as a u.s. citizen and should be allowed to subtract losses from their wins within a gambling session to arrive at per-session wins or losses. the court rejected the irs’s argument that for purposes of § 871, which taxes non-resident aliens for all “interest . . ., dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income” received from sources in the united states, gambling winnings are computed on a per bet rule. the court quoted irs office of chief counsel memorandum am2008-11 (2008) [cca 2008-011]: “‘we think that the fluctuating wins and losses left in play are not accessions to wealth until the taxpayer redeems her tokens and can definitively calculate’ her net gains. ... because gain or loss may be calculated over a series of wagers, a ‘taxpayer who plays the slot machines[] recognizes a wagering gain or loss at the time she redeems her tokens.’ ... therefore, u.s. citizens do not ‘treat every play or wager as a taxable event.’ ... the result is that u.s. citizens can measure their gambling winnings and losses on a per-session basis.” the court cited shollenberger v. commissioner, t.c. memo. 2009-306, for that same proposition. 2014] recent developments in federal income taxation 317  the tax court (judge cohen) had reasoned that a nonresident alien cannot “deduct or offset gambling losses against gambling winnings,” in part because for a u.s. citizen, the deduction for gambling losses is an itemized deduction. “thus, a nonresident alien who is not engaged in gambling as a business within the united states is subject to tax under section 871(a)(1) on gross income from gambling without a deduction for gambling losses.” the tax court opinion did not address the reasoning of irs office of chief counsel memorandum am2008-11, 4 (2008). 5. the tax court instructs you how not to word discrimination suit settlement agreements. molina v. commissioner, t.c. memo. 2013-226 (9/23/13). in the course of holding that no portion of the proceeds received from settling a discrimination claim against the taxpayer’s former employer were excluded under § 104(a)(2), the tax court (judge wells) observed that “the nature of underlying claims cannot be determined from a general release that is broad and inclusive,” and “all settlement proceeds are included in gross income where there is a general release but no allocation of settlement proceeds among various claims.” 6. atheists unite! freedom from religion foundation, inc. v. lew, 112 a.f.t.r.2d 2013-7103 (w.d. wisc. 11/21/13). the district court for the western district of wisconsin (judge crabb) held that § 107(2), which excludes from gross income a minister’s “rental allowance paid to him as part of his compensation” violates the establishment clause of the first amendment. the court held that the plaintiff lacked standing to challenge the constitutionality of 107(1), which excludes the rental value of a parsonage provided in kind.  stay tuned. this certainly isn’t the end of the story. 7. national mortgage settlement payments to homeowners who got screwed by their lender might or might not be taxable. rev. rul. 2014-2, 2014-2 i.r.b. 255 (12/18/13). this revenue ruling deals with the tax treatment of payments received by homeowners under the national mortgage settlement (nms) between the government and bank mortgage servicers regarding mortgage loan servicing and foreclosure abuses. it addresses several different situations. first, a taxpayer who receives an nms payment as a result of foreclosure on the taxpayer’s principal residence must include the payment in the amount realized on the foreclosure, but the taxpayer may exclude any resulting gain from gross income to the extent allowed under § 121. second, if the property contained one or more additional dwelling units that were not used as the taxpayer’s principal residence, the entire nms payment is allocable to the portion of the 318 florida tax review [vol. 15:5 property that the taxpayer used as a principal residence. third, a taxpayer who receives any portion of a deceased borrower’s nms payment stands in the shoes of the borrower to determine the taxable portion, if any, of the nms payment. any taxable amount is income in respect of a decedent (ird) under § 691(a). c. hobby losses and § 280a home office and vacation homes 1. computing the home office deduction just got easier, but qualifying for it still remains as difficult as ever. this revenue procedure is inadvisable unless the client lives in dogpatch, arkansas, or (more generally), if the client can afford your fees, the deduction will easily exceed $1,500. rev. proc. 2013-13, 2013-6 i.r.b. 478 (1/15/13). this revenue procedure provides an optional safe harbor method that taxpayers may use to determine the amount of expenses deductible under § 280a for business use of a portion of a personal residence, i.e., the “home office deduction,” in lieu of calculating, allocating, and substantiating of actual expenses. taxpayers using the safe harbor method must satisfy all requirements of § 280a for determining eligibility to claim a deduction. under the revenue procedure, in lieu of depreciation, and allocable repairs, utilities, and insurance, a taxpayer may deduct $5 per square foot for up to 300 square feet (i.e., a maximum of $1,500 per year) for the portion of the residence used exclusively for business as required by § 280a. a taxpayer electing the safe harbor method for a taxable year cannot deduct any actual expenses related to the qualified business use of that home, but may deduct all of the qualified home mortgage interest and real estate taxes, as well as any allowable casualty losses, as itemized deductions. (depreciation for the year is treated as zero.) a taxpayer using the safe harbor method may deduct allowable trade or business expenses unrelated to the qualified business use of the home, such as advertising, wages, and supplies. an election for any taxable year is irrevocable, but the election is year-by-year, and changing from the safe harbor method in one year to actual expenses in a succeeding taxable year, or vice-versa, is not a change of accounting method. the safe harbor method does not apply to an employee with a home office if the employee receives from an employer advances, allowances, or reimbursements for expenses for the business use of the employee’s home. there are other details and several examples.  for one of the gotchas that still remains, see hamacher v. commissioner, 94 t.c. 348 (1990). 2. what the taxpayer says his tax lawyer said is a “fair” price is not probative evidence. didonato v. commissioner, t.c. 2014] recent developments in federal income taxation 319 memo. 2013-11 (1/14/13). among the many issues in this case, virtually all of which went disastrously for the taxpayer, was the applicability of the § 280a limitation on deductions for personal residences used for mixed business and personal purposes. the taxpayer rented a property to his father as the father’s principal residence for the entire year in question. notwithstanding the general rule in § 280a(d) that a family member’s use of a dwelling unit is treated as personal by the taxpayer, § 280(d)(3) provides that a taxpayer is not treated as using the property for personal purposes for any period for which the dwelling unit is rented to the family member for use as the family member’s principal residence at a fair rent. the tax court (judge laro) held that the taxpayer failed to prove that the rent was “fair” because the taxpayer “offered no evidence at trial as to the fair rental value of the ... property other than [his own] testimony that the amount of rent to be charged was set by his tax attorney and, in [his own] view, the rent was fair by virtue of his belief that the property was in “deplorable shape.” that testimony alone was unpersuasive, because the legislative history makes clear that the fairness component be determined on the basis of comparable rents in the area. see h.r. rept. no. 97-404, at 8 (1981).  see an earlier opinion in this case. didonato v. commissioner, t.c. memo. 2011-153 (6/29/11). the tax court (judge laro) denied a 2004 charitable contribution deduction on grounds of lack of substantiation under § 170(f)(8). the alleged donation was memorialized by a 2004 contract between taxpayer and the charitable recipient but the formal transfer did not occur until 2006, when the donation was acknowledged. the 2006 acknowledgment was too late to substantiate a 2004 deduction because it was received by taxpayer after his 2004 federal income tax return was filed. 3. section 183 “does not apply only to wealthy taxpayers who engage in unprofitable activities to create ‘paper’ losses to offset against unrelated income.” rodriguez v. commissioner, t.c. memo. 2013-221 (9/18/13). the facts and ultimate holding of this § 183 hobby loss case involving a horse breeding activity conducted by two partners that spanned 15 years without showing a profit were unremarkable. (because the purported partnership was a “small partnership” that did not elect to have tefra apply, the tax court had jurisdiction to review in individual deficiency cases items otherwise subject to partnership-level proceedings, including the disputed losses from the horse-breeding activity.) every one of the nine factors of reg. § 1.183-2(b) favored the irs. however, two aspects of the case stand out. first, the court (judge laro) reiterated that § 183 “does not apply only to wealthy taxpayers who engage in unprofitable activities to create ‘paper’ losses to offset against unrelated income.” (this case involved middle-income wage earners.) the analysis simply “compares the income generated by an activity with the taxpayer’s taxable income from 320 florida tax review [vol. 15:5 sources other than the activity and quer[ies] whether the taxpayer’s ability to earn income elsewhere allows her to finance an otherwise unprofitable activity from which she derives some personal or tax benefits.” between 1993 and 2008, the taxpayers together had a combined wage income of $1.2 million. the horse breeding activity over that period was less than $15,000, but it incurred more than $1.6 million in expenses. the taxpayers financed these expenses using their wage income, life insurance proceeds, a home equity loan, and personal savings. “the income and funds from these other sources thus enabled petitioners to engage in their horse-breeding activity that ... ha[d] strong personal elements.” the second significant aspect of the case is the court’s observations about witnesses’ credibility and uncontradicted testimony, with respect to which the court stated as follows: we determine the credibility of each witness, weigh each piece of evidence, draw appropriate inferences, and choose between conflicting inferences in finding the facts of a case. the mere fact that one party presents unopposed testimony does not necessarily mean that the elicited testimony will result in a finding of fact in that party’s favor. we will not accept a witness’ testimony on its face if we find that our impression of the witness coupled with our review of the credible facts at hand conveys to us an understanding contrary to the spoken word.  one witness’s testimony was “ambiguous, equivocal, and sometimes evasive,” and the other’s, while “credible” was “unhelpful and unreliable.” d. deductions and credits for personal expenses 1. is this a casualty loss in limbo? alphonso v. commissioner, 136 t.c. 247 (3/16/11). the taxpayer owned stock in a n.y. cooperative housing corporation from which she rented an apartment as her personal residence. when a retaining wall on the grounds of the apartment complex collapsed, the corporation levied an assessment for the cost of repairs, and the taxpayer paid $26,390, with respect to which she claimed a casualty loss deduction of $23,188 (reflecting computational limitations in § 163(h)). the irs disallowed the deduction, and the tax court (judge chiechi) upheld the disallowance. judge chiechi reasoned that under the relevant state law and controlling legal instruments, the taxpayer had no property interest in the retaining wall, which was part of the common grounds — nothing in the lease, the corporation charter and by-laws, or any other governing documents indicated that the taxpayer possessed a leasehold interest, an easement, or any other property interest in the common grounds. 2014] recent developments in federal income taxation 321 finally, judge chiechi rejected the taxpayer’s argument that § 216, which allows cooperative apartment owners to deduct their shares of the real estate taxes and mortgage interest paid by the cooperative corporation, should be extended by judicial interpretation to casualty losses. although judge chiechi rejected the irs’s argument that the absence of a reference to casualty losses in § 216 conclusively determined that it did not apply to casualty losses, after examining the legislative history she concluded that congress intended § 216 to apply only to interest and real estate taxes. a. no, it’s not in limbo; the loss is allowed by the second circuit. alphonso v. commissioner, 708 f.3d 344 (2d cir 2/6/13), rev’g 136 t.c. 247 (2011). the second circuit, in an opinion by judge kearse, reversed the tax court’s decision. the court of appeals concluded that the right of a stockholder in a cooperative housing corporation to use the grounds and to exclude persons who are not tenants or the guests of tenants, coupled with obligations as a tenant stockholder under the cooperative lease, constituted a property interest in the land sufficient to entitle the taxpayer to the claimed casualty loss deduction. 2. home mortgage interest is deductible only if you actually pay it. smoker v. commissioner, t.c. memo. 2013-56 (2/21/13). for the years in question, the taxpayer paid over $40,000 of home mortgage interest and approximately $28,000 of home mortgage interest was deferred and capitalized into the principal amount. although the statutory language of § 163(h)(3) allows a deduction for qualified residence interest that is “paid or accrued” during the taxable year, the tax court (judge laro) upheld the denial of a deduction for the accrued but unpaid interest, because the taxpayer was an individual on the cash method — which is the method applicable to all individuals with respect to personal expenses. under wellestablished precedents, a cash method taxpayer may deduct in any taxable year only interest actually paid during that taxable year. the accrued but unpaid qualified residence interest would not be deductible until actually paid. inasmuch as no evidence was introduced to show that taxpayer relied on professionals in preparation of his tax return, the accuracy-related penalty was upheld. a. see here, mr. & mrs. hargreaves! hargreaves v. commissioner, t.c. summ. op. 2013-37 (5/15/13). taxpayers purchased a home in california with a “negative amortization loan” from a bank. for the year 2007, they received a substitute form 1098, which characterized interest as (1) gross interest paid of $59,554; (2) interest shortage of $33,288; and (3) net interest paid of $26,266, with the interest shortage added to the balance of the loan. in their self-prepared federal income tax return for 2007, they deducted the gross interest amount. the tax 322 florida tax review [vol. 15:5 court (judge haines) in this s case held that only the net interest was deductible, but did not uphold the accuracy-related penalty because taxpayer husband “credibly testified that he reported the interest deduction using what he thought the form 1098 stated.” 3. the court of federal claims rejects as a “shibboleth” 7 the proposition that whether a “theft” has occurred, for purposes of § 165(c)(3) depends upon whether a theft has occurred under state law. goeller v. united states, 109 fed. cl. 534 (3/20/13). the court of federal claims (judge allegra) denied both the taxpayers’ and the government’s cross-motions for summary judgment in a refund suit involving whether the taxpayers suffered a theft loss deductible under § 165(c)(3) as result of a failed investment in a real estate business. the court observed that both the taxpayers and the government accepted, and cited authority for, the proposition that whether a “theft” has occurred, for purposes of § 165(c)(3) depends upon whether a theft has occurred under state law, but disputed whether the controlling law is that of ohio or of california. however, in denying the motions on the ground that there were material factual issues to be resolved by trial, the court unequivocally rejected the proposition that whether a “theft” has occurred, for purposes of § 165(c)(3) depends upon whether a theft has occurred under state law. rather, the court held that there was a federal tax law concept of theft based on “a long-standing and well-accepted meaning” of the term theft found in black’s law dictionary, which “defines that term as ‘[t]he fraudulent taking of corporeal personal property belonging to another, from his possession, or from the possession of some person holding the same for him, without his consent, with intent to deprive the owner of the value of the same, and to appropriate it to the use or benefit of the person taking.’” the court also observed that “by the time the 1954 [internal revenue] code was enacted, it also was well-accepted, based on black’s law dictionary that the definition of ‘theft’ includes a crime in which one ‘obtains possession of property by lawful means and thereafter appropriates the property to the taker’s own use.’” furthermore, “these definitions of ‘theft’ are largely indistinguishable from that employed in the model penal code, which defines a ‘theft’ as occurring where a person ‘unlawfully takes, or exercises unlawful control over, movable property of another with purpose to deprive him thereof.’ ... this is relevant because the model code’s provisions have often been 7. [5] the gileadites captured the fords of the jordan leading to ephraim, and whenever a survivor of ephraim said, “let me cross over,” the men of gilead asked him, “are you an ephraimite?” if he replied, “no,” [6] they said, “all right, say ‘shibboleth.’” if he said, “sibboleth,” because he could not pronounce the word correctly, they seized him and killed him at the fords of the jordan. forty-two thousand ephraimites were killed at that time. (judges 12:5-6 (niv).) 2014] recent developments in federal income taxation 323 employed in determining the scope of an offense referenced in a federal statute.” these “well-accepted definitions of ‘theft’” thus render reference to state law unnecessary. the court concluded that “where a federal statute uses a common-law term of established meaning without otherwise defining it, the practice is to give that term its common meaning,” and saw “no reason why this rule ought not apply to section 165(c)(3).” nothing in the statutory language, its legislative history, or the relevant regulations suggested otherwise.  for authorities holding that to claim a theft loss, the taxpayer must prove that a theft occurred under the applicable state law, see, e.g., citron v. commissioner, 97 t.c. 200 (1991) (mere refusal to return property was not equivalent of embezzlement under state law); paine v. commissioner, 63 t.c. 736 (1975), aff’d by order, 523 f.2d 1053 (5th cir.1975) (denying a loss deduction under § 165(c)(3) to an investor who purchased publicly traded stock at a price that was inflated by fraudulent financial statements; no “theft” had occurred under state law because the taxpayer failed to prove a causal connection between the misrepresentations and the loss); alioto v. commissioner, 699 f.3d 948 (6th cir. 2012) (taxpayer failed to demonstrate that investment loss was due to false statements that would constitute theft under relevant state law); estate of meriano v. commissioner, 142 f.3d 651 (3d cir. 1998) (estate was entitled to theft loss for attorney’s failure to return excessive amounts withdrawn from the estate because a theft occurred under state law; extensive analysis of relevant state law); bellis v. commissioner, 540 f.2d 448 (9th cir. 1976) (denying a theft loss deduction because under relevant state law no theft had occurred). 4. another case where married filing separately significantly changes the ground rules. field v. commissioner, t.c. memo. 2013-111 (4/18/13). married taxpayers must file a joint return in order to claim the § 26 credit for adoption expenses. the tax court (judge thornton) held that the joint filing requirement does not violate the constitutional right to equal protection even though the married taxpayer who filed separately had adopted a child alone, without her husband also adopting the child. 5. standard deduction for 2014. rev. proc., 2013-35, 2013-47 i.r.b. 537 (10/31/13). the standard deduction for 2014 will be $12,400 for joint returns and surviving spouses, $6,200 for unmarried individuals and heads of households, and $6,200 for married individuals filing separately. 6. long distance to a remote work site is not travel away from home. cor v. commissioner, t.c. memo. 2013-240 (10/22/13). 324 florida tax review [vol. 15:5 the taxpayer was required to commute daily from his home in las vegas to a remote test site in the nevada desert not served by public transportation. the tax court (judge cohen) rejected the taxpayer’s argument that the extraordinary commuting expense should be allowable as a deduction because of the exceptional nature of the commute compared to ordinary commuting. the court cited the general principle that travel expenses going to or from work on a daily basis are not ordinary business expenses. e. divorce tax issues 1. here’s how to shift taxation of child support payments to the custodial spouse if state law allows it. delong v. commissioner, t.c. memo. 2013-70 (3/11/13). the tax court (judge kroupa) held that an unallocated family support allowance that under california law was intended to provide both spousal and child support that terminated entirely upon the death of the custodial payee spouse, but was not by its terms reduced upon emancipation of the children, was entirely alimony. 2. dueling lawyers’ letters do not a divorce or separation instrument make. faylor v. commissioner, t.c. memo. 2013143 (6/5/13). the tax court (judge vasquez) held that a series of letters between divorcing spouses’ lawyers regarding temporary support prior to the entry of a divorce decree did not constitute a divorce or separation agreement where neither spouse signed two proposed temporary support agreements. accordingly, payments by the husband to the wife during the pendency of the divorce were not deductible as alimony. f. education there were no significant developments regarding this topic during 2013. g. alternative minimum tax there were no significant developments regarding this topic during 2013. 2014] recent developments in federal income taxation 325 vi. corporations a. entity and formation 1. saving the world from double deductions. the details emerge only nine years after congress acted. t.d. 9633, limitations on duplication of net built-in losses, 78 f.r. 54156 (9/3/13). the treasury department has promulgated final regulations, reg. § 1.362-4, under § 362(e)(2), which was enacted in 2004, with only minor clarifying changes from the proposed regulations (71 f.r. 62067), which were published in 2006. section 362(e)(2) prevents taxpayers from transmuting a single economic loss into two (or more) tax losses by taking advantage of the dual application of the substituted basis rules in § 358 for stock received in a § 351 transaction and in § 362 for assets transferred to a corporation in a § 351 transaction. if the aggregate basis of the property transferred to a corporation in a § 351 transaction exceeds the aggregate fair market value, the aggregate basis of the property must be reduced to its fair market value. the final regulations include examples illustrating the application of § 362(e)(2) to transactions qualifying as both § 351 transactions and reorganizations, as well as an example illustrating the nonapplicability of § 362(e)(2) to triangular reorganizations that do not include a transfer to which § 362(a) applies. the regulations provide two exceptions to the application of § 362(e)(2). first, a transaction will not be subject to § 362(e)(2) to the extent that the transferor distributes the stock received in the transaction and, in the distribution, no gain or loss is recognized and no person takes the stock or other property with a basis determined by reference to the transferor’s basis in the distributed stock. this exception applies principally to distributions subject to § 355(a). in this situation there is no duplicated loss that could be recognized by any taxpayer. second, a transaction will not be subject to § 362(e)(2) if the transaction is between persons not connected to the united states, the transaction does not become relevant for federal tax purposes within two years of the transfer, and the transaction is not undertaken pursuant to a plan to reduce or avoid federal taxes. this exception relates to transfers between foreign subsidiaries. the assumption of a transferor’s liabilities by the transferee generally does not affect the application of § 362(e). however, if a § 362(e)(2)(c) election is made, the reduction to stock basis is limited to the amount that the transferee would otherwise reduce its basis in the transferred assets. this prevents the reduction of stock basis attributable to contingent liabilities associated with a trade or business, for which basis is specifically preserved under § 358(h)(2)(a). furthermore, when the property transferred is an interest in a partnership with liabilities, the final regulations provide that the value of a partnership interest is the sum of cash that the transferee would receive for such interest, increased by any reg. § 1.752-1 liabilities (as defined in reg. 326 florida tax review [vol. 15:5 § 1.752-1(a)(4)) of the partnership that are allocated to the transferee with regard to such transferred interest under § 752. see reg. § 1.362-4(h), ex. 8(ii). finally, reg. § 1.362-4(d) provides details on how to make the § 362(h)(2)(c) election to reduce the transferor’s stock basis in lieu of the corporation reducing asset basis; the regulations generally adopt the rules set forth in notice 2005-70, 2005-2 c.b. 694, and the proposed regulations, but expand those rules significantly. a § 362(e)(2)(c) election is irrevocable. it may be made protectively and will have no effect to the extent it is determined that § 362(e)(2) does not apply. for an election to be effective, (1) prior to filing “a section 362(e)(2)(c) statement” the transferor and transferee must enter into a written, binding agreement to elect to apply § 362(e)(2)(c, and (2) detailed requirements for filing the “section 362(e)(2)(c) statement,” which is required to contain extraordinarily detailed information about the transfer, must be followed. if the transferor is a person required to file a u.s. return for the year of the transfer, the transferor must include the “section 362(e)(2)(c) statement” on or with its timely filed (including extensions) original return for the taxable year in which the transfer occurred. there is a long list of the persons required to file the statement if the transferor is not required to file a u.s. return for the year of the transfer. 2. built-in losses cannot be “imported” either from offshore or from a u.s. tax-exempt. reg-161948-05, limitations on the importation of net built-in losses, 78 f.r. 54971 (9/9/13). the treasury department and irs have published proposed regulations under §§ 334(b)(1)(b) and 362(e)(1), dealing with the importation of built-in losses in § 332 subsidiary liquidations and § 351 transfers. (these regulations do not deal with § 362(e)(2); reg. § 1.362-4 deals with § 362(e)(2).) section 362(e)(1) applies property-by-property to assign each transferred property a fair market value basis rather than the normal § 362(a) transferred basis, if (1) there is net built-in loss in the aggregate transferred properties and (2) gain or loss realized by the transferor with respect to the property was not subject to u.s. income tax immediately prior to the transfer. if a controlled subsidiary is liquidated and (1) there is net built-in loss in the aggregate transferred properties and (2) gain or loss realized by the transferor with respect to the property was not subject to u.s. income tax immediately prior to the transfer, § 334(b)(1)(b) provides the parent with a fair market value basis in properties received in the liquidation.  prop. reg. § 1.362-3 terms the transactions to which § 362(e)(1) applies “loss importation transactions,” and the property to which it applies “loss importation property.” the proposed regulations use a hypothetical sale analysis to identify loss importation property. the proposed regulations clarify that § 362(e)(1) applies to transfers 2014] recent developments in federal income taxation 327 by u.s. tax-exempt organizations as well as transfers by foreign persons. the proposed regulations also provide a look-through rule for transfers by grantor trusts, partnerships, and s corporations, and in certain “tax-avoidance” transactions, as well as rules dealing with tiered entities. the proposed regulations clarify that whether a transaction is a loss importation transaction is determined with respect to the aggregate amount of built-in gain and built-in loss in all importation property acquired from all transferors in the transaction, unlike the transferor-by-transferor approach of § 362(e)(2). detailed basis calculation rules are specified. the proposed regulations are illustrated by nine examples. the rules in prop. reg.§ 1.362-3 will apply to any transaction occurring on or after the date these regulations are finalized, unless effected pursuant to a binding agreement that was in effect prior to that date and at all times thereafter. taxpayers may apply the proposed regulations to transactions occurring after 10/22/04 – almost 9 years retroactively.  proposed amendments to reg. § 1.3341(b) apply similar rules to “loss importation transactions,” and “loss importation property” in § 332 liquidations. all of the examples deal with the liquidation of a foreign subsidiary by a u.s. parent. b. distributions and redemptions 1. leona helmsley, eat your heart out! welle v. commissioner, 140 t.c. no. 19 (6/27/13). the taxpayer was the sole shareholder of terry welle construction, inc. (twc). he used twc to facilitate the construction of a new home for himself and his wife. to keep track of material and other construction costs, the taxpayer caused twc to open a “cost plus” job account on its books, but he personally acted as the general contractor during construction. the taxpayer personally hired the subcontractors and ordered building supplies from the vendors in twc’s name. twc kept track of construction costs and twc’s framing crew framed the home. the taxpayer reimbursed twc for its costs, including overhead, but did not pay twc an amount equal to the profit margin of 6 to 7 percent that twc normally charged its customers. the irs asserted that the taxpayer received a constructive dividend from twc in an amount equal to twc’s forgone profit. the irs’s theory was that magnon v. commissioner, 73 t.c. 980 (1980), which held that a shareholder of a corporation received a constructive dividend when the corporation performed electrical contracting services on the shareholder’s personal property primarily for the shareholder’s own benefit and without any expectation of repayment, stood for the proposition that the amount of the dividend included not only the costs incurred by the corporation, but also an amount equal to the corporation’s customary profit margin. the tax court (judge marvel) rejected the irs’s claim, stating that in magnon “we did not hold, and the commissioner did not assert, that the constructive dividend the 328 florida tax review [vol. 15:5 shareholder received included an amount corresponding to the corporation’s forgone profit.” judge marvel held that there was no constructive dividend because “[a] finding that a shareholder received a constructive dividend from a corporation is only appropriate where ‘corporate assets are diverted to or for the benefit of a shareholder,’” and that did not occur in this case. judge marvel concluded that melvin v. commissioner, 88 t.c. 63 (1987), aff’d on other grounds, 894 f.2d 1072 (9th cir.1990), in which the rental by a corporation to its shareholders for personal purposes at a rental equal to the corporation’s costs with respect to the vehicles resulted in a dividend equal to the amount by which the fair rental values of the automobiles exceeded the reimbursements paid to the corporation, was distinguishable. judge marvel’s reasoning was as follows: twc maintained its corporate infrastructure and workforce for business purposes. mr. welle’s use of twc during the construction of petitioners’ lakefront home was at most incidental to those purposes. the most that can be said about mr. welle’s use of twc is that he used the corporation as a conduit in paying subcontractors and vendors and that he obtained some limited services from corporate employees. mr. welle fully reimbursed the corporation for all costs, including overhead, associated with those services, and twc did not divert actual value otherwise available to it by failing to apply its customary profit margin in determining the amount mr. welle had to reimburse the corporation. we therefore conclude that this arrangement did not operate as a vehicle for the distribution of twc’s current or accumulated earnings and profits within the meaning of section 316(a).  we think the result in this case turns on the fact that, except possibly with respect to the use of twc’s framing crew by the taxpayer, nothing in the facts indicates that the taxpayer’s use of twc’s services resulted in twc forgoing profits that could have been earned from transactions with third parties had twc not been used by the taxpayer to facilitate construction of his personal residence in the manner he did. in other words, twc incurred no opportunity costs. had twc incurred opportunity costs, the result very well might have been different. c. liquidations there were no significant developments regarding this topic during 2013. 2014] recent developments in federal income taxation 329 d. s corporations 1. realized but unrecognized gain is not tax-exempt income. ball v. commissioner, t.c. memo. 2013-39 (2/6/13). the taxpayers owned stock of an s corporation that had a wholly-owned subsidiary for which it made a qsub election. they argued that the basis of their s corporation stock had been increased by the amount of built-in gain on the stock of the qsub that went unrecognized pursuant to § 332 as a result of the qsub election, and that the increased basis supported claimed passedthrough loss. their position was based on the argument that the unrecognized gain was tax-exempt income that resulted in a basis increase under § 1367(a)(1)(a). the tax court (judge kerrigan) rejected the taxpayer’s argument, and held that unrecognized gain resulting from a qsub election does not create an item of income or tax-exempt income pursuant to § 1366(a)(1)(a). the court reasoned that nonrecognition rules do not exempt income from taxation but merely defer recognition through substituted basis rules. 2. s corporation shareholders aren’t allowed to just make up their own basis adjustment rules. barnes v. commissioner, t.c. memo. 2012-80 (3/21/12). the tax court (judge morrison) agreed with the irs in holding — unsurprisingly — that there is no upward stock basis adjustment under § 1367 for amounts that are erroneously reported by the shareholder as § 1366 pass-through income but that do not correspond to, but exceed, the shareholder’s actual pro rata share of pass-through income. likewise, § 1367(a)(2)(b) requires an s corporation shareholder to reduce stock basis by any losses that the shareholder is required to take into account under § 1366(a)(1)(a), even if the shareholder does not actually claim the pass-through losses on the shareholder’s return. because the taxpayer had reported gain rather than loss in a prior year in which a very large loss had been passed through, the shareholder had no basis to support passed-through losses in the year in question. a. and the d.c. circuit sees it the same way — “the barneses paid more in taxes than they owed. but so it goes.” barnes v. commissioner, 712 f.3d 581 (d.c. cir. 4/5/13). the court of appeals affirmed. nothing in [sections 1366 and 1367] suggests that a shareholder’s basis is not reduced if the shareholder fails to take a deduction for the corporation’s losses. indeed, the fact that the code explicitly provides that a shareholder’s basis is increased by corporate income “only to the extent such amount is included in the shareholder’s gross income on his 330 florida tax review [vol. 15:5 return,” ... but provides no similar exception for corporate losses, militates against the barneses’ preferred reading. see russello v. united states, 464 u.s. 16, 23 (1983) (“[w]here congress includes particular language in one section of a statute but omits it in another section of the same act, it is generally presumed that congress acts intentionally and purposely in the disparate inclusion or exclusion.” (internal quotation marks omitted)). this difference makes sense. although congress had every reason to prevent taxpayers from reaping a double benefit by failing to report income while still being credited with an increased basis, it had no reason to permit them to indefinitely delay the realization of losses. 3. the third circuit says that qsub status isn’t “property” under the bankruptcy code and tells the ninth circuit that it was all wrong when it held that s corporation status was “property” under the bankruptcy code. in re the majestic star casino, llc, 716 f.3d 736 (3d cir. 5/21/13), rev’g 466 b.r. 666 (bankr. d. del. 1/24/12). a debtor qsub, but not its parent s corporation, was in bankruptcy. after the bankruptcy petition was filed the parent corporation revoked its s corporation status, which under § 1361(b)(3)(c) automatically terminated the debtor-subsidiary’s qsub status, converting it into a c corporation. the bankruptcy court held that the parent corporation’s action that terminated pass-through tax benefits that the debtor subsidiary had enjoyed was a voidable transfer of estate property in violation of bankruptcy code § 549. the debtor’s qsub status was property of the bankruptcy estate, and as a result of the loss of that status the bankruptcy estate was required to, and did, pay state income taxes it would not otherwise have been required to pay. (the corporation had not paid any federal income taxes, but the irs’s claim for any deficiency would be affected, so the irs opposed the debtor’s argument that its qsub status was property of the bankruptcy estate.) accordingly, the revocation of the parent’s status as an s corporation and the termination of the debtor’s status as a qsub were held to be “void and of no effect.” the bankruptcy court relied on in re prudential lines, inc., 107 b.r. 832 (bankr. s.d.n.y. 1989), aff’d, 928 f.2d 565 (2d cir. 1991), which held that a subsidiary’s nol carryforward was property of the subsidiary’s bankruptcy estate and that the parent’s plan to claim a worthless stock deduction, which would have eliminated the nol would violate the automatic stay, and its progeny holding that s corporation status is “property” and that the termination of an s election can be a voidable transfer. see in re bakersfield westar, 226 b.r. 227 (b.a.p. 9th cir. 1998); in re frank funaro inc., 263 b.r. 892 (b.a.p. 8th cir. 2001); in re trans2014] recent developments in federal income taxation 331 lines w., inc., 203 b.r. 653 (bankr. e.d. tenn. 1996); in re cumberland farms, inc., 162 b.r. 62 (bankr. d. mass. 1993).  the third circuit in an opinion by judge jordan, reversed, first finding based on nuances of the bankruptcy code, that the internal revenue code, rather than state law, governs whether an entity’s tax status is a property interest for purposes of the bankruptcy code. the court of appeals concluded that the extension of prudential lines, by in re translines west, inc., 203 b.r. 653 (bankr. e.d. tenn. 1996), and a series of cases that followed it, which held that a corporation’s revocation of its s corporation status prior to filing for bankruptcy was a prepetition transfer of property avoidable by the trustee pursuant to bankruptcy code § 548 was “untenable.” first, nols are not contingent at all; a bankrupt corporate debtor has a specific amount of nol at the time of the bankruptcy filing that are a function of the debtor’s operations prior to bankruptcy; the nols “are not subject either to revocation by the shareholders or termination by the irs.” in contrast, under § 1362, the shareholders of an s corporation can terminate its status at will, “regardless of how long it has been an s-corp and whatever its pre-bankruptcy operating history has been”; “the tax status of the entity is entirely contingent on the will of the shareholders.” second, nols have a readily determinable value that is available to the bankruptcy estate, either as a carryback or a carryforward against future earnings, while the value of the s corporation election is dependent on it not being revoked and the amount and timing of future earnings. nol carryforwards may be monetized while s corporation status cannot. third, s corporation status cannot be a property interest because s corporation status can be automatically terminated in a variety of manners by which the corporation can become ineligible to be an s corporation. fourth, even if s corporation status had some value to the estate, because it allows the debtor corporation to “place its tax liabilities on a non-debtor” shareholder, a “tax classification over which the debtor has no control is not a ‘legal or equitable interest[] of the debtor in property’ for purposes of § 541 [of the bankruptcy code].” finally, to allow all of the debtor corporation’s profits to remain in the bankruptcy estate while transferring the tax liability to the nondebtor shareholders would be inequitable. after so reasoning that s corporation status was not “property” under the bankruptcy code, the court of appeals found that “qsub status is an a fortiori case.” a qsub’s continuing status as such is contingent on a number of factors entirely outside of the qsub’s control, and a qsub cannot “transfer or otherwise dispose of its qsub status.” thus, qsub status cannot be “property.” furthermore, even if qsub status is property, it could not be property of the bankruptcy estate; it would be property of the subsidiary’s s corporation parent. for tax purposes a qsub does not exist. finally, the court added the coup-de-grâce: moreover, allowing qsub status to be treated as the property of the debtor subsidiary rather than the non-debtor parent, as 332 florida tax review [vol. 15:5 the bankruptcy court did in this case, places remarkable restrictions on the rights of the parent, restrictions that have no foundation in either the i.r.c. or the code. first, the corporate parent loses not only the statutory right to terminate its subsidiary’s qsub election, see i.r.c. § 1361(b)(3)(b), (d), but also its right to terminate its own scorp election, see id. § 1361(d). second, the corporate parent loses the ability to sell the subsidiary’s shares to any purchaser other than an s-corp, and would then be required to sell 100 percent of the shares, because any other sale would trigger the loss of the subsidiary’s qsub status. see id. § 1361(b)(3)(b). third, the s-corp parent and its shareholders lose the ability to sell the parent to a ccorporation, partnership, or other non-s-corp entity, to a non-resident alien, or to more than 100 shareholders, because any of those transactions would also trigger the loss of the subsidiary’s qsub status. see id., § 1361(b)(1)(b), (c), (a). filing a bankruptcy petition is not supposed to “expand or change a debtor’s interest in an asset; it merely changes the party who holds that interest.” in re saunders, 969 f.2d 591, 593 (7th cir. 1992). but under the bankruptcy court’s holding in this case, a qsub in bankruptcy can stymie legitimate transactions of its parent as unauthorized transfers of property of the estate, even though the qsub would have had no right to interfere with any of those transactions prior to filing for bankruptcy. 4. another taxpayer fails in the never-ending quest for s corporation debt basis without an economic outlay. montgomery v. commissioner, t.c. memo. 2013-151 (6/17/13). in 2006, the taxpayer guaranteed a loan to an s corporation in which he was a shareholder. the corporation passed through losses to the taxpayer for 2007 in excess of the taxpayer’s basis in the stock and loans the taxpayer had made to the corporation. the taxpayer claimed that because the corporation defaulted on the loan in 2008, he defaulted on the guarantee in that year, and in 2009 the creditor obtained a judgment against the taxpayer for $435,169.54, he should have had a basis increase in that amount for the corporation’s debt that he obtained through subordination. judge morrison was unimpressed by the argument. “[i]t is the payment by the guarantor of the guaranteed obligation that gives rise to indebtedness on the part of the debtor to the guarantor. the mere fact that the debtor 2014] recent developments in federal income taxation 333 defaults and thereby renders the guarantor liable is not sufficient.” [quoting from underwood v. commissioner, 63 t.c. 468, 476 (1975), aff’d, 535 f.2d 309 (5th cir. 1976)]. patrick montgomery did not make any payments on the suntrust bank loan during 2007. therefore his guarantee of the suntrust bank loan did not give rise to a debt to him from utility design, inc., during 2007.  in partial solace for the taxpayer, at least no § 6662 accuracy-related penalties were assessed by the irs. 5. rev. proc. spells relief for late elections. rev. proc. 2013-30, 2013-36 i.r.b. 173 (8/14/13). the irs has consolidated multiple rulings into a single procedure for requesting relief from late s corporation, qsst and qsub elections. in general the procedure requires that a requesting entity has reasonable cause for making a late election and has acted diligently to correct the mistake upon its discovery. the request must be made within 3 years and 75 days of the effective date of the election. e. mergers, acquisitions and reorganizations there were no significant developments regarding this topic during 2013. f. corporate divisions there were no significant developments regarding this topic during 2013. g. affiliated corporations and consolidated returns 1. twenty-seven years after the authorizing statute was enacted, the treasury and irs finalize regulations to prevent triple taxation resulting from sales, exchanges, and distributions of corporate stock resulting from general utilities repeal. t.d. 9619, regulations enabling elections for certain transactions under section 336(e), 78 f.r. 28467 (5/15/13). the irs published regulations under § 336(e). section 336(e), enacted as part of the tra 1986 repealing the general utilities doctrine, authorizes regulations allowing a corporation that sells, exchanges, or distributes stock in another corporation (target) meeting the requirements of § 1504(a)(2) to elect to treat the disposition as a sale of all of target’s underlying assets in lieu of treating it as sale, exchange, or distribution of stock, as under § 338(h)(10). the purpose of a § 336(e) election is to prevent creation of a triple layer of taxation — one at the controlled corporation 334 florida tax review [vol. 15:5 level, one at the distributing corporation level and, ultimately, one at the shareholder level. reg. §§ 1.336-0 through 1.336-5 provide the requirements and mechanics for, and consequences of, treating a stock sale, exchange, or distribution that would not otherwise be eligible for a § 338 election, as an asset sale under § 336(e). under the regulations, the results of a § 336(e) election generally are the same (with certain exceptions) as those of a § 338(h)(10) election. the structure of the regulations resembles that of the § 338(h)(10) regulations regarding the allocation of consideration, application of the asset and stock consistency rules, treatment of minority shareholders, and the availability of the § 453 installment method, although certain definitions and concepts differ to reflect differences between § 336 and § 338(h)(10). unlike under § 338(h)(10), however, a § 336(e) election is a unilateral election by the seller. a transaction that meets the definition of both a qualified stock disposition and a qualified stock purchase under § 338(d)(3) generally will be treated only as a qualified stock purchase and does not qualify for a § 336(e) election. reg. § 1.336-1(b)(6)(ii).  general rules. a qualified stock disposition for which a § 336(e) election may be made is any transaction or series of transactions in which stock meeting the requirements of § 1504(a)(2) (80 percent of voting and value) of a domestic corporation is either sold, exchanged, or distributed, or any combination thereof, by another domestic corporation or the shareholders of an s corporation in a disposition (as defined in reg. § 1.336-1(b)(5)), during the 12-month disposition period (as defined in reg. § 1.336-1(b)(7)). (all members of a consolidated group are treated as a single transferor. reg. § 1.336-2(g)(2)). stock transferred to a related party (determined after the transfer) is not considered in determining whether there has been a qualified stock disposition. reg. §§ 1.336-1(b)(5)(i)(c) and 1.3361(b)(6)(i). a section 336(e) election is available for qualifying dispositions of target stock to non-corporate transferees, as well as to corporate transferees. reg.§ 1.336-1(b)(2)  because the regulations require only that stock meeting the requirements of § 1504(a)(2) be transferred, the transferor (or a member of its consolidated group) may retain a portion of the target stock. reg. §§ 1.336-2(b)(1)(v) and 1.336-2(b)(2)(iv). furthermore, the regulations allow amounts of target stock transferred to different transferees, in different types of transactions to be aggregated in determining whether there has been a qualified stock disposition. for example, the sale of 50 percent of target’s stock to an unrelated person and a distribution of another 30 percent to its unrelated shareholders (who might or might not be the purchasers of the 50 percent that was sold) within a 12-month period would constitute a qualified stock disposition. reg. § 1.336-1(b)(5).  election. the election is made by the seller and the target by entering into a binding written agreement before the due 2014] recent developments in federal income taxation 335 date of the tax return for the year of the stock disposition and filing a required statement of election with the tax return for the appropriate year. the consent of both seller and the target (on behalf of the buyer) are required to avoid surprises to the buyer. an election for an s corporation target requires a binding written agreement between the target s corporation and all of the s corporation shareholders, including shareholders who do not sell stock, before the due date of the tax return for the year of the stock disposition and an election statement attached to the return for the year of the disposition. in both cases, the target must retain a copy of the written agreement. if the seller and target are members of a consolidated group, the seller and target must enter into a binding written agreement, retained by the parent of the consolidated group, and the common parent of the group must attach an election statement to the consolidated return for the year of the disposition. reg. § 1.336-2(h).  sales or exchanges of target stock. in general, if a seller sells or exchanges target stock in a qualified stock disposition, the treatment of old target, seller, and purchaser are similar to the treatment of old target (old t), s, and p under § 338(h)(10). if a § 336(e) election is made, the sale or exchange of target stock is disregarded. instead, target (old target) is treated as selling all of its assets to an unrelated corporation in a single transaction at the close of the disposition date (the deemed asset disposition). old target recognizes the deemed disposition tax consequences from the deemed asset disposition on the disposition date while it is a subsidiary of seller. in the case of a deemed asset sale by a subchapter s corporation, the tax consequences of the deemed asset sale pass through to the s corporation shareholders. see reg. § 1.336-2(b)(1)(a). old target is then treated as liquidating into seller which in most cases will be treated as a § 332 liquidation to which § 337 (or § 336) applies. additionally, the deemed purchase of the assets of old target by new target constitutes a deemed purchase of any subsidiary stock owned by target, and a § 336(e) election may be made for the deemed purchase of the stock of a target subsidiary if it constitutes a qualified stock disposition. a § 336(e) election generally does not affect the tax consequences, e.g., stock basis, to a purchaser of target stock.  distributions of target stock not subject to § 355. a § 336(e) election can be made for a taxable distribution of target stock (e.g., dividend, redemption, liquidation), but the election does not affect the tax treatment of the shareholders. special rules assure that the tax consequences to a distributee are the same as if no § 336(e) election was made. if a distribution is a qualified stock disposition, the distributing corporation is treated as purchasing from new target (immediately after the deemed liquidation of old target) the amount of stock distributed and to have distributed the new target stock to its shareholders. the distributing corporation recognizes no gain or loss on the distribution (old target having recognized gain on the deemed asset sale). reg. § 1.336-2(b)(1)(iv). if the distribution is a § 301 distribution, the portion that is a dividend may be affected by the difference 336 florida tax review [vol. 15:5 between (1) the § 311 gain, and thus e&p, that would have been recognized on a stock distribution and (2) the gain, and thus e&p, that results from the deemed asset disposition and liquidation of target. see reg. § 1.336-2(c). realized losses on the deemed asset disposition are allowed to offset realized gains, reg. § 1.336-2(b)(1)(i)(b)(2)(i). however, the regulations disallow a net loss recognized on the deemed asset disposition in proportion to the amount of stock disposed of by the seller in one or more distributions during the 12-month disposition period. reg. § 1.336-2(b)(1)(i)(b)(2)(ii).  section 355 distributions. the regulations allow a corporation that would otherwise recognize gain with respect to a qualified stock disposition resulting, in whole or in part, from a disposition described in § 355(d)(2) or (e)(2) to make a § 336(e) election. however, to preserve the e&p allocation consequences of a § 355 distribution under reg. § 1.312-10, the regulations provide special rules. old target is not deemed to liquidate into the distributing corporation, but is treated as acquiring all of its assets from an unrelated person and the distributing corporation is treated as distributing the stock of the controlled corporation (old target) to its shareholders. reg. § 1.336-2(b)(2)(i)(a). because the controlled corporation (old target) is not treated as liquidated, it will retain its tax attributes despite the § 336(e) election. furthermore, the controlled corporation will take into account the effects of the deemed asset disposition to adjust its e&p immediately before allocating e&p pursuant to reg. § 1.312-10. reg. § 1.336-2(b)(2)(vi). net losses from the deemed asset sale will be recognized only in relation to the amount of stock sold or exchanged in the qualified stock disposition during the 12-month disposition period. reg. §§ 1.336-2(b)(2)(i)(b)(2)(iii). however, if the controlled corporation (old target) has any subsidiaries for which a § 336(e) election is made, the general deemed asset disposition methodology shall apply. this prevents taxpayers from effectively electing whether the attributes of the lower tier subsidiary become those of target, by doing an actual sale of target subsidiary’s assets followed by a liquidation of target subsidiary, or remain with target subsidiary, by making a § 336(e) election for target subsidiary.  intragroup transfers prior to external dispositions. if target stock is transferred within an affiliated group and is then transferred outside the affiliated group, a § 336(e) election is not available for the intragroup transfer (because a qualified stock disposition may not be made between related sellers and purchasers). even if a § 336(e) election is made for the transfer outside of the group, the affiliated group would recognize gain both on target’s assets and the target stock. to solve this problem the final regulations modify reg. § 1.1502-13(f)(5)(ii)(c) to allow a § 1.1502-13(f)(5) election to treat the deemed liquidation of target into the seller as a taxable liquidation in order to provide the consolidated group with a stock loss to offset some, if not all, of the intragroup seller’s stock gain from the intragroup transaction. reg. § 1.366-2(b)(2)(i)(a)(2) also provides that in the case of a 2014] recent developments in federal income taxation 337 § 355(d)(2) or (e)(2) transaction that is preceded by an intragroup transaction, for purposes of the § 1.1502-13(f)(5) election, immediately after the deemed asset disposition of target’s assets, target is deemed to liquidate into seller, which provides seller with a stock loss that can offset some or all of the group’s intercompany gain on the transfer of target stock.  aggregate deemed asset disposition price (adadp) and adjusted grossed up basis (agub). to calculate old target’s gain under a § 336(e) election, the regulations define a new term, “aggregate deemed asset disposition price” (adadp). new target’s asset basis is determined with reference to adjusted grossed up basis (agub), as used in § 338 and reg. § 1.338-5. under reg. §§ 1.336-3 and 1.336-4, adadp and agub are determined similarly to the way adsp and agub are determined under the § 338 regulations. the regulations account for the lack of an actual amount realized on a stock distribution by treating the grossed-up amount realized as including in the amount realized the fair market value of distributed target stock on the date of distribution. reg. § 1.336-3(c)(1)(i)(b). in addition, because in the case of a § 336(e) election (unlike in the case of a § 338 election, where there is only one purchasing corporation and it is relatively easy to determine the purchaser’s basis in nonrecently purchased stock in order to determine agub), there can be multiple purchasers or distributees who acquired target stock prior to the 12-month disposition period, the regulations provide that “nonrecently disposed stock,” which has a similar meaning to the term “nonrecently purchased stock” in § 338(b)(6)(b), includes only stock in a target corporation held by a purchaser (or a related person) who owns (with § 318(a) attribution, except §318(a)(4)), at least 10 percent of the total voting power or value of the stock of target that is not recently disposed stock. reg. § 1.336-1(b)(18).  new target is treated as acquiring all of its assets from an unrelated person in a single transaction at the close of the disposition date, but before the deemed liquidation (or, in the case of a § 355 distribution, before the distribution) in exchange for an amount equal to the agub. with certain modifications, reg. § 1.336-4 generally resembles reg. § 1.338-5 to determine target’s agub. new target allocates agub among its assets in the same manner as in reg. §§ 1.338-6 and 1.338-7. reg. §§ 1.3362(b)(1)(ii) and 1.336-2(b)(2)(ii).  any stock retained by a seller (or a member of its consolidated group) or an s corporation shareholder is treated as acquired by the seller on the day after the disposition date at its fair market value, which is a proportionate amount of the grossed-up amount realized on the transfer under the § 336(e) election. reg. §§ 1.336-2(b)(1)(v) and 1.3362(b)(2)(iv). a continuing minority shareholder is generally unaffected by the § 336(e) election. reg. § 1.336-2(d). 338 florida tax review [vol. 15:5  a holder of nonrecently disposed stock may irrevocably elect (similarly to under § 338) to treat the nonrecently disposed stock as being sold on the disposition date. reg. § 1.336-4(c). the gain recognition election is mandatory if a purchaser owns (after applying § 318(a), other than § 318(a)(4)) 80 percent or more of the voting power or value of target stock. reg. §§ 1.336-1(b)(15) and 1.336-4(c).  a taxpayer will be allowed to make a protective § 336(e) election if it is unsure whether a transaction constitutes a qualified stock disposition, e.g. the disposition date is the first day of the 12month disposition period that may span two taxable years. a protective election will have no effect if the transaction does not constitute a qualified stock disposition, but it will otherwise be binding and irrevocable. reg. § 1.336-2(j).  correction to reg. § 1.338-5. reg. § 1.338-5(d)(3)(ii) is corrected to use the grossed-up basis of recently purchased stock in determining the basis amount, rather than the non-grossed-up basis.  effective date. the regulations apply to any qualified stock disposition for which the disposition date is on or after may 15, 2013. 2. the eleventh circuit interprets a tax sharing agreement. you don’t often see cases like this. zucker v. fdic, 727 f.3d 1100 (11th cir. 8/15/13). this case involved the interpretation of a tax sharing agreement (tsa) among members of a consolidated group. the tsa provided that although the parent holding company would file the group’s tax return, a bank subsidiary would pay all income taxes for the group and receive contributions from other members of the group and the bank would pay any member of the group that member’s share of any refund. the day after the bank was closed and the fdic appointed its receiver, the holding company filed for bankruptcy act chapter 11 protection. subsequently, the holding company received a refund, which it treated as part of the bankruptcy estate rather than paying it to the fdic (as the bank’s successor) for distribution pursuant to the tsa. the eleventh circuit, in an opinion by judge tjoflat, reversed the bankruptcy court and held that the refund was not part of the holding company’s bankruptcy estate; the refund was to be paid over to the fdic for distribution to the group’s members in accordance with the tsa. interpreting the tsa contract under the controlling delaware law, the court found that although the tsa did not contain a provision expressly requiring the holding company to forward the tax refunds to the bank, that was what the parties intended. thus, the court concluded: the relationship between the holding company and the bank is not a debtor-creditor relationship. when the holding company received the tax refunds, it held the funds intact— 2014] recent developments in federal income taxation 339 as if in escrow—for the benefit of the bank and thus the remaining members of the consolidated group. the parties intended that the holding company would promptly forward the refunds to the bank so that the bank could, in turn, forward them on to the group’s members. in the bank’s hands, the tax refunds occupied the same status as they did in the holding company’s hands—they were tax refunds for distribution in accordance with the tsa. 3. the tax court invokes a “common law” doctrine to disallow a double deduction for the same economic loss. duquesne light holdings, inc. v. commissioner, t.c. memo. 2013-216 (9/11/13). duquesne was the common parent of a consolidated group of corporations. duquesne held 1.2 million shares of aquasource, which until 2001 was a wholly-owned member of the group. in 2001, duquesne sold 50,000 shares of aquasource, in which it claimed to have a basis of $206,402,100 to lehman brothers—remember them—for $4,000,000 and claimed a $202,402,100 capital loss. duquesne filed an application for tentative refund, in which it carried back from 2001 $161,640,702 to year 2000, $135,267,183 of which was attributable to the 2001 stock loss in question, and the irs paid a tentative refund. subsequently, aquasource, while still a member of the group, sold various assets resulting in aggregate recognized losses exceeding $235,000,000, which were claimed on duquesne’s consolidated return, which were carried back to 2000. the irs determined that the 2001 loss on the disposition of 50,000 shares of aquasource stock (approximately 4 percent of the stock) recognized by the common parent was a loss attributable to the fact that there was built-in loss in the underlying assets of aquasource, and that under the doctrine of charles ilfeld co. v. hernandez, 292 u.s. 62 (1934), the group was not permitted to take the duplicative losses upon the subsequent sale of the underlying assets that were sold in 2002. the tax court (judge chiechi) upheld the irs’s determination, relying in part on thrifty oil v. commissioner, 139 t.c. 198 (2012). in doing so, it held that charles ilfeld co. continues to be “a vital canon of statutory construction in tax law,” even after the implementation of former reg. § 1.1502-32. the court rejected the taxpayer’s argument that rite aid corp. v. united states, 255 f.3d 1357 (fed. cir. 2001), supported allowing the deduction, and that the disallowance of double deductions could be effected only through the promulgation of valid regulations. although the court acknowledged that former temp. reg. § 1.1502-35t, which was in effect for the years in question, did not disallow the losses, nothing prohibited the court from disallowing duplicate deductions for the same economic loss under charles ilfeld co. finally, the court held that even though the statute of limitations had expired for 2000 – the year to which losses had been carried 340 florida tax review [vol. 15:5 back – the period was still open pursuant to § 6501(h) and § 6501(k), thereby allowing the tentative refund to be assessable. h. miscellaneous corporate issues 1. there goes corporate letter ruling practice! rev. proc. 2013-32, 2013-28 i.r.b. 55 (6/25/13), modifying rev. proc. 2013-1, 2013-1 i.r.b. 116. the irs will no longer rule on whether a transaction qualifies for nonrecognition treatment under §§ 332, 351, 355, or 1036, or on whether a transaction constitutes a reorganization within the meaning of § 368, regardless of whether the transaction presents a significant issue and regardless of whether the transaction is an integral part of a larger transaction that involves other issues upon which the irs will rule. however, the irs will rule on one or more issues under those sections to the extent that such issue or issues are significant. there is no limit on the number of significant issues that may be the subject of a single letter ruling. a “significant issue is an issue of law the resolution of which is not essentially free from doubt and that is germane to determining the tax consequences of the transaction.” 2. “[a]doption of these exceptions [to § 382(g)] is appropriate because these transactions do not introduce new capital into the loss corporation and because direct or indirect ownership of the loss corporation becomes less concentrated, thus diminishing the opportunity for loss trafficking.” t.d. 9638, application of the segregation rules to small shareholders, 78 f.r. 62418 (10/22/13). the treasury department has promulgated amendments to reg. § 1.382-3 (proposed in reg–149625–10, application of the segregation rules to small shareholders, 76 f.r. 72362 (11/23/11)). the amendments to reg. § 1.382-3 reduce the complexity of applying § 382 in tracking transactions involving small amounts of stock of a loss corporation. reg. § 1.382-3 provides that all shareholders who do not individually own 5 percent of a loss corporation are grouped together and treated as a single “public group” 5-percent shareholder. however, temp. reg. § 1.382-2t segregates into two or more public groups any public group of less than 5 percent stockholders that can be separately identified as having acquired their stock in a particular transaction. the amendments to the regulations provide that the segregation rule does not apply to transfers of a loss corporation’s stock to non-5-percent shareholders by 5-percent shareholders, or entities that directly or indirectly own at least 5 percent of a loss corporation whose owners (excluding those who are 5-percent shareholders of a loss corporation) own, in the aggregate, 5 percent or more of a loss corporation. the amendments to the regulations also provide that the segregation rules do not apply to transfers of ownership interests in 5-percent entities to shareholders who are not themselves 52014] recent developments in federal income taxation 341 percent shareholders. the proposed regulations also provide a special exception under which a loss corporation may annually redeem 10 percent of the value of its stock, or 10 percent of the shares of a particular class of stock, without triggering the segregation rules and the creation of new 5 percent groups. this redemption rule also applies to redemptions of not more than 10 percent of the value (or class of stock) of an entity that is a 5-percent owner of the loss corporation. the amendments also extend the 10-percent limitation for the application of the small issuance exception to issuances of stock by a 5-percent entity, calculated by reference to the value of the stock of the issuing entity. transactions that under the prior version of the regulations resulted in the creation of a new public group, and thus a possible owner shift, now are simply folded into the existing public groups, thereby reducing the chance of an ownership change. the amendments also add an anti-abuse rule to the small issuance (issuance of stock that does not exceed 10 percent of the total value (or 10 percent of the class) of the corporation’s outstanding stock at the beginning of the taxable year) exception. the effective dates for various amendments vary, with some effective as early as 11/4/92, and others effective 10/22/13. vii. partnerships a. formation and taxable years 1. final regulations cover noncompensatory options on partnership interests. t.d. 9612, noncompensatory partnership options, 78 f.r. 7997 (2/5/13). final regulations under § 721 generally provide for nonrecognition of gain or loss to the partnership or option holder on the exercise of a noncompensatory stock option that grants the holder the right to acquire an interest in the issuer (defined as an option not issued in connection with the performance of services) on the transfer of money or property to the partnership. the regulations also address the maintenance of partnership capital accounts and the determination of partners’ distributive shares. as a brief and horribly incomplete summary of the lengthy regulation−  the regulations provide that § 721 does not apply to the transfer of property in exchange for an option or the satisfaction of a partnership obligation by issuance of an option. the transfer or satisfaction will result in recognition of gain or loss to the option recipient and open transaction treatment with respect to the partnership. the regulations do provide for § 721 treatment for the receipt of convertible equity in exchange for property.  section 721 does not apply to the issuance of an option for accrued but unpaid interest, interest on convertible debt, rent, or royalties. 342 florida tax review [vol. 15:5  the nonrecognition rule of § 721 does not apply to the exercise of a noncompensatory option issued by a disregarded entity that would become a partnership if the option were exercised.  the investment partnership rules of § 721(b) apply to cause recognition if the partnership would be treated as an investment company.  cash settlement of a noncompensatory option is treated as a sale or exchange of the option under § 1234 rather than as a contribution to a partnership.  lapse of a noncompensatory option is treated as recognition of gain to the partnership and a loss to the option holder to the extent of the option premium. for this purpose, proposed regulations under § 1234 would treat partnership interests as securities for purposes of § 1234 (reg-106918-08, treatment of grantor of an option on a partnership interest, 78 f.r. 8060 (2/5/13)).  redemption of an interest following exercise of a noncompensatory option may be treated as a disguised sale. in addition, general tax principles will apply to determine the nature of the transaction if the exercise price of a noncompensatory option exceeds the capital account received by the option holder.  the regulations permit revaluation of partnership capital accounts on issuance of a noncompensatory option and provide further that any revaluation of partnership capital accounts must take into account the fair market value of any outstanding noncompensatory options. the value of partnership property must be adjusted to reflect the difference (if any) between the value of outstanding noncompensatory options and the amount paid by the option holder as consideration for the option.  the regulations require corrective allocations to account for any shift in partners’ capital accounts that results from capital account reallocations pursuant to exercise of a noncompensatory option. corrective allocations to the option holder can only include items properly allocable to a partner who suffered a capital account reduction.  noncompensatory options are generally not characterized as partnership equity. however, an option holder will be treated as a partner if the option holder’s rights are “substantially similar” to rights afforded to a partner, and there is a strong likelihood that the failure to treat the option holder as a partner would result in a substantial reduction in the present value of the partners’ and option holder’s aggregate federal tax liabilities under the facts and circumstances. the relevant facts and circumstances include the likelihood that the option would be exercised. the regulations contain a couple of safe harbors indicating that an option is not reasonably expected to be recognized (exercisable more than 24 months after the measurement date with a strike price equal to or greater than 110 percent of 2014] recent developments in federal income taxation 343 the value of the interest, or the strike price is equal to or greater than fair market value of the interest on the exercise date). the facts and circumstances determination whether an option holder has partner attributes includes whether the option holder has managerial rights in the partnership and rights to share in partnership profits through current and liquidating distributions, and has partnership obligations. 2. even the used car salesman has to provide evidence of partnership status. azimzadeh v. commissioner, t.c. memo. 2013-169 (7/23/13). the tax court (judge holmes) rejected the taxpayer’s assertion that his small california used car business was a partnership with a person called barghi, who also was in the automobile sales business. the court indicated that partnership status was a question of federal tax law, regardless of whether the taxpayers formed a separate state law entity, and applied the eight factors of luna v. commissioner, 42 t.c. 1067 (1964), to answer the ultimate test of commissioner v. culbertson, 337 u.s. 733 (1949), described as “whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise.” looking to the luna factors the court determined that the absence of a partnership agreement weighed against partnership status, the lack of proof regarding mutual contributions to the venture was neutral, barghi’s authority to write checks as control over income favored partnership status, that proof of the nature of the relationship with barghi as a co-proprietor or suppler “left only the muddiest of tracks,” the absence of k-1s and other partnership return filings, the absence of partnership books indicating barghi’s interest in the enterprise, weighed against partnership status, and the absence of evidence of barghi’s joint control other than signature authority on the checking account was a neutral factor. thus, only one of the luna factors supported partnership status while the rest were negative or neutral. the partnership went down by the count. the court also affirmed the irs’s reconstruction of the taxpayer’s income from bank deposits and the irs’s denial of cost of goods sold and other claims. 3. you can be partners without realizing you are. and if it turns out to be to your benefit, you can change your tune in the course of litigation. jimastowlo oil, llc v. commissioner, t.c. memo. 2013-195 (8/26/13). the taxpayer llcs purchased percentage working interests in oil and gas leaseholds operated by energytec on a cooperative basis—i.e., as an economic activity collectively owned and cooperatively exploited) for the working interest owners—but there was no formal written joint operating agreement executed by the working interest owners. to carry out the actual operation of the wells energytec employed another company. the operating company was supposed to collect oil from the wells in tanks, sell the collected oil, offset operating expenses against sale proceeds, and 344 florida tax review [vol. 15:5 apportion what remained among the working interest owners in proportion to their percentage interests. no working interest owner could take in kind or sell on its own its share of any oil production. when energytec subsequently presented the llcs and the other working interest owners in the leaseholds with draft joint operating agreements formally designating its wholly owned subsidiary as operator of the wells, many of the leasehold owners, including the llcs, would not execute the draft agreements. in actual operation most of the working interest owners, including the llcs, initially received recurring payments that did not vary with production, oil and gas prices, or operating expenses. eventually, energytec notified the working interest owners that the recurring payments had exceeded the net revenue that was due to them and that subsequent revenue distributions would be applied against the outstanding balance due to energytec. alternatively, the affected working interest owners could “pay the outstanding balance due energytec and subsequently receive revenue distributions based upon actual revenues less applicable lease operating expenses.” the llcs opted to pay the amount due to energytec. the issue before the tax court (judge halpern) was whether the informal joint operating agreement was a partnership. if so, fpaas to the llcs denying deductions and treating reported losses as passive activity losses under § 469 were invalid because no fpaas had been issued with respect to the joint venture. the principle ... that [the tax court] lack[s] jurisdiction to redetermine affected items attributable to a source partnership before the source partnership-level proceedings have been completed, applies even when the members of the source partnership have failed to recognize that they have created a separate entity (i.e., a partnership) for federal income tax purposes and have not, therefore, filed a partnership return on its behalf, and the commissioner has neither conducted a source partnership-level audit nor issued an fpaa to it. judge halpern held that the joint operating agreement constituted a partnership under § 761(a) and that fpaas issued to the llcs were invalid. to exploit the working interests, the co-owners cooperated, with energytec acting as common agent operating the wells for the working interest owners. no owner could take his share of production in kind or sell it independently of the other owners, and they were not merely sharing expenses. they were jointly carrying on a trade or business and dividing the proceeds therefrom. thus, the working interest owners “jointly carried on a trade or business, dividing the proceeds therefrom among themselves, each trade or business constituted for federal tax purposes an entity separate from the co-owners of 2014] recent developments in federal income taxation 345 the appurtenant working interest.” because there was no argument that the resulting entity should be classified as a trust (or otherwise specially classified), the entity must have been classified as either a partnership or a corporation under reg. § 301.7701-2(a), and because it was a domestic business entity with more than two members that was not a per se corporation (and did not elect to be classified as a corporation), it was, by default, a partnership pursuant to reg. § 301.7701-3(a) and (b)(1). 4. section 47 historic rehabilitation credits were allowed to an llc (taxed as a partnership) in which pitney bowes was a 99.9 percent member despite an irs challenge under the anti-abuse provisions of reg. § 1.701-2, but it was too late to keep the miss america pageant in atlantic city. historic boardwalk hall, llc v. commissioner, 136 t.c. 1 (1/3/11). the tax court (judge goeke) held that the ownership interest on the historic east hall of the atlantic city boardwalk hall under a 35-year lease belonging to the new jersey sports and exposition authority could be transferred to historic boardwalk hall, llc, in which pitney bowes (through a subsidiary and an llc) was the 99.9 percent member (and the njsea was the 0.1 percent member). along with ownership went the § 47 federal tax credit of 20 percent of the qualified rehabilitation expenditures incurred in transforming the run-down east hall from a flatfloor convention space to a “special events facility” that could host concerts, sporting events, and other civic events. pitney bowes became the 99.9 percent member of historic boardwalk hall, llc, following an offering memorandum sent to nineteen large corporations, which described the transaction as a “sale” of tax credits (although that description was not repeated in any of the subsequent documents relating to the transaction). njsea lent about $57 million to historic boardwalk hall. and pitney bowes made capital contributions of more than $18 million to that llc, as well as an investor loan of about $1.2 million. in that offering memorandum, losses were projected over the first decade of operation of east hall. the irs argued that the bulk of the pitney bowes contributions were paid out to njsea as a “development fee” and that the entire transaction was a sham because njsea was going to develop east hall regardless of whether pitney bowes made its capital contributions and loan.  judge goeke held that one of the purposes of § 47 was “to encourage taxpayers to participate in what would otherwise be an unprofitable activity,” and the rehabilitation of east hall was a success, leading to the conclusion that historic boardwalk had objective economic substance. he also held that “pitney bowes and njsea, in good faith and acting with a business purpose, intended to join together in the present conduct of a business enterprise” and that while the offering memorandum used the term “sale,” “it was used in the context of describing an investment transaction.” finally, judge goeke used reg. § 1.701-2(d), example (6), 346 florida tax review [vol. 15:5 involving two high-bracket taxpayers who joined with a corporation to form a partnership to own and operate a building that qualifies for § 42 low-income housing credits, to conclude that reg. § 1.701-2 did not apply to the historic boardwalk transaction because that regulation “clearly contemplate[s] a situation in which a partnership is used to transfer valuable tax attributes from an entity that cannot use them . . . to [a taxpayer] who can . . . .”  query whether “economic substance” requirements are applicable when the tax benefits take the form of tax credits enacted to encourage specific types of investments? a. “‘[t]he sharp eyes of the law’ require more from parties than just putting on the ‘habiliments of a partnership whenever it advantages them to be treated as partners underneath.’ ... indeed, culbertson requires that a partner ‘really and truly intend[] to … shar[e] in the profits and losses’ of the enterprise. ... and, after looking to the substance of the interests at play in this case, we conclude that, because pitney bowes lacked a meaningful stake in either the success or failure of historic boardwalk hall, it was not a bona fide partner.” historic boardwalk hall llc v. commissioner, 694 f.3d 425 (3d cir. 8/27/12), cert. denied, 5/28/13. in a unanimous opinion by judge jordan, the third circuit reversed the tax court and held that pitney bowes was not a bona fide partner in historic boardwalk hall llc. the court’s reasoning was based on the culbertson test [commissioner v. culbertson, 337 u.s. 733 (1949)], as applied by the second circuit in tifd iii-e, inc. v. united states, 459 f.3d 220, 232 (2d cir. 2006) (castle harbour ii), to find that the dutch banks were not partners, and the reasoning of the fourth circuit in virginia historic tax credit fund 2001 lp v. commissioner, 639 f.3d 129 (4th cir. 2011), to find that the investors who acquired the virginia historic rehabilitation credits through the partnership bore no “true entrepreneurial risk,” which the third circuit concluded was a characteristic of a true partner under the culbertson test. the third circuit concluded that pitney bowes was not a partner because, based on an analysis of the facts, as the transaction was structured, (1) pitney bowes “had no meaningful downside risk because it was, for all intents and purposes, certain to recoup the contributions it had made to hbh and to receive the primary benefit it sought — the hrtcs or their cash equivalent,” and (2) pitney bowes’s “avoidance of all meaningful downside risk in hbh was accompanied by a dearth of any meaningful upside potential.” the analysis was highly factual and based on substance over form. as for downside risk, the court of appeals reversed as clearly erroneous the tax court’s finding that pitney bowes bore a risk because it might not receive an agreed upon 3 percent preferred return on its contributions to hbh. referring to virginia historic tax credit fund, the third circuit treated the 3 percent preferred return as a 2014] recent developments in federal income taxation 347 “return on investment” that was not a “share in partnership profits,” which pointed to the conclusion that pitney bowes did not face any true entrepreneurial risk. as for upside potential, applying the substance over form doctrine, the court concluded that “although in form pb had the potential to receive the fair market value of its interest . . . in reality, pb could never expect to share in any upside.” the court noted that it was mindful “of congress’s goal of encouraging rehabilitation of historic buildings,” and that its holding might “jeopardize the viability of future historic rehabilitation projects,” but the court observed that it was not the tax credit provision itself that was under attack, but rather the particular transaction transferring the benefits of the credit in the manner that it had.  the opinion makes it very clear that the decision was based on applying the “substance over form” doctrine rather than the “economic substance” doctrine to determine that pitney bowes was not a partner. b. the irs is gilding the lily of its historic boardwalk victory. faa 20124002f, 2013 tnt 41-18 (dated 8/30/12; released 10/5/12). this field attorney advice dealt with whether a taxpayer was a partner in a partnership that generated § 47 historic rehabilitation tax credits. the faa held that under the culbertson doctrine, as applied in castle harbour, the taxpayer was not a partner. the taxpayer had no meaningful downside risk in that it is assured of receiving the benefit of its bargain, and it had no upside potential. all it could receive was it specified priority return. alternatively, the purported partnership was a sham; it served no business purpose. its only purpose was to effect a sale of the rehabilitation tax credits to the taxpayer. sacks v. commissioner, 69 f.3d 982 (9th cir. 1995), which held that a sale-leaseback transaction involving solar energy equipment had economic substance even though the investment had a negative rate of return before taking into account tax benefits, was distinguished on the ground that the transaction at issue in sacks otherwise had economic substance in terms of risk and reward. in reaching the conclusion, the faa states as follows: in any event, the notion that a court may consider tax benefits in evaluating the economic substance of a transaction involving — or of a purported partnership engaged in — tax-favored activity finds no support apart from sacks. two circuits, in analyzing the economic substance of american depository receipts (adr) transactions, determined that it was inappropriate to deduct the cost of foreseeable foreign taxes imposed on the transaction in determining the expected pre-tax profit of the transaction. see compaq computer corp. v. commissioner, 348 florida tax review [vol. 15:5 277 f.3d 778 (5th cir. 2001) and ies industries, inc. v. united states, 253 f.3d 350 (8th cir. 2001). these holdings address the calculation of pre-tax profit to be used in determining whether transactions resulted in pre-tax economic losses; they do not stand for the proposition that united states tax credits may serve as a substitute for economic profit. as such, these cases do not adopt the court’s holding in sacks that a court may consider tax benefits in evaluating the economic substance of a transaction involving — or of a purported partnership engaged in — tax-favored activity.  this position is absurd because the purpose of tax credits is to encourage taxpayers to engage in otherwise unprofitable activities. a holding that an activity that is unprofitable before taking tax credits into consideration lacks economic substance defeats that purpose. c. the irs now provides a safe harbor under which it will not use its historic boardwalk victory to challenge allocations of § 47 rehabilitation credits to investor partners. rev. proc. 2014-12, 2014-3 i.r.b. 415 (12/31/13). this revenue procedure specifies the conditions under which the irs will not challenge partnership allocations of § 47 rehabilitation credits. section 4 of the revenue procedure contains the requirements for the safe harbor. it defines investors as partnership partners (other than principals) (§4.01); provides for an investor’s minimum partnership interest (§4.02); provides for an investor’s minimum unconditional contribution of 20 percent of the investor’s total expected capital contribution before the date the building is placed in service (§4.03); and requires that at least 75 percent of the investor’s total expected capital contribution be fixed in amount before the building is placed in service (§4.04). b. allocations of distributive share, partnership debt, and outside basis 1. consistency for small minds – allocations to foreign partners, withholding at one rate, taxable at another. ann. 201330, 2013-21 i.r.b. 1134 (4/24/13). partnership income effectively connected to a u.s. trade or business allocable to a foreign partner is subject to withholding at the highest rate specified in §§ 1 or 11. fiscal year partnerships for a year beginning in 2012 must withhold at rates in effect for 2012. foreign partners who include partnership income for a partnership year 2014] recent developments in federal income taxation 349 ending in 2013, however, are subject to tax at the 2013 rates as increased by the american taxpayer (and not so grand compromise) relief act of 2012. 2. “this appears to be an issue of first impression as no case has specifically decided whether the transferor or the transferee of a nonvested partnership capital interest must include in gross income the undistributed partnership profit or loss allocations attributable to the partnership capital interest.” crescent holdings, llc v. commissioner, 141 t.c. no. 15 (12/2/13). this tefra partnership case addressed the treatment of partnership income recognized while a partner held a two percent restricted membership interest received for services that was forfeitable, and thus not vested, and for which no § 83(b) election had been made. an individual (fields) received a two percent capital interest in a partnership (crescent holdings llc) as compensation for entering into a contract to provide services to a lower-tier entity (crescent resources llc). field’s membership interest in crescent holdings would be forfeited if he terminated his employment with crescent resources before three years after the formation of crescent holdings. his interest was nontransferable until the forfeiture restrictions lapsed. he was entitled to the same distributions as other holders of member interests and that any distributions he received were not subject to forfeiture. no § 83(b) election was made. crescent holdings issued schedules k-1 allocating $423,611 of ordinary business income to fields for 2006 and $3,608,218 for 2007 as his § 702 distributive share of the partnership’s income. no distributions were made. fields did not believe that the schedules k-1 were proper because he did not believe that he was a partner for tax purposes. fields argued that § 83 applied to his interest in crescent holdings and because his right to the interest never vested, he was not the owner of the interest under reg. § 1.83-1(a)(1) and should not be allocated any partnership profits or losses attributable to the interest for the years at issue. the partnership argued that § 83 did not apply to fields’ interest because it was a profits-only interest and that under rev. proc. 9327, 1993-2 c.b. 343, fields was liable for tax on his share of the undistributed profits of crescent holdings for the years at issue. alternatively, the partnership argued that if rev. proc. 93-27 did not apply, then reg. § 1.721-1(b)(1) controlled and fields thus was the owner of the interest. the irs argued that rev. proc. 93-27 and rev. proc. 2001-43, 2001-2 c.b. 191, apply only to partnership profits interests and are inapplicable to a partnership capital interest, and that fields’ interest in crescent holdings was a capital interest. the irs’s position was that field’s capital interest was subject to § 83 and that because under reg. § 1.831(a)(1) he was not the owner of the interest, no profit or loss should have been allocated to him for the years at issue. the tax court (judge ruwe) held for fields and the irs on all counts. 350 florida tax review [vol. 15:5  first, the court held that fields’ interest was a capital interest, not a profits interest. under rev. proc. 93-27, a capital interest is “an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.” under the contractual terms of the crescent holding llc agreement, absent “priority capital contributions,” of which there were none, the llc members were entitled to receive liquidating distributions equal to their percentage interests. thus, the fact that fields did not have any initial capital account did not mean that he did not have a capital interest. if crescent holdings had liquidated immediately after fields received his interest, he would have received a share of the proceeds. thus, rev. proc. 2001-43 and rev. proc. 93-27 were not applicable.  second, the court held that a partnership capital interest is “property” for purposes of § 83, citing larson v. commissioner, t.c. memo. 1988-387 and campbell v. commissioner, t.c. memo. 1990-162, aff’d in part, rev’d in part on other grounds, 943 f.2d 815 (8th cir. 1991), and reg. § 1.83-1(a)(1) applied to fields’ interest in crescent holdings. reg. § 1.83-1(a)(1) provides that “[u]ntil such property becomes substantially vested, the transferor shall be regarded as the owner of such property.” the court rejected the argument that the absence of a reference to partnership interests in the legislative history of § 83 indicated that congress did not intend § 83 to apply to partnership interests.  third, the court held that although neither § 83 nor reg. § 1.83-1(a)(1) specifically addressed the issue, the transferee of a nonvested partnership capital interest does not recognize in income the undistributed partnership profit or loss allocations attributable to that interest. in this case fields’ right to receive the undistributed income allocations attributable to the interest was subject to the same substantial risk of forfeiture as his right to the partnership interest itself; if he forfeited his right to the interest, then he would also forfeit his right to receive any benefit from the undistributed income allocations. the undistributed income allocations were subject to the same substantial risk of forfeiture as the two percent interest in crescent holdings. the court noted that had fields continued his employment until the interest vested, the fair market value of the interest includable in gross income at that time would have included the undistributed income.  fourth, the court held that under reg. § 1.83-1(a)(1) undistributed partnership allocations attributable to a nonvested partnership capital interest are included in the gross income of the transferor. based on the contractual provisions regarding the formation of the two llcs, crescent holdings was the transferor. accordingly, the profits and losses attributable to the forfeitable two percent interest should be allocated to the other llc members (partners) in accordance with their distributive shares (which in this case were pro rata to their percentage interests). 2014] recent developments in federal income taxation 351 3. proposed regulations allocate liabilities among multiple parties and among related parties. reg-136984-12, section 752 and related party rules, 78 f.r. 76092 (12/16/13). the irs has proposed regulations to address allocation of the risk of economic loss for purposes of allocating partnership liabilities to a partner’s basis. under reg. § 1.752-2(a) a partner is allocated a share of recourse liability to the extent that the partner or a related person bears the economic risk of loss. a liability is nonrecourse when no partner or related person bears an economic risk of loss.  multiple parties under prop. reg. § 1.752-2(a)(2) where multiple partners bear the economic risk of loss with respect to the same liability, the amount of the liability will be taken into account only once, and if the total amount of liability borne by the partners exceeds the amount of the liability, the economic risk of loss to be borne by each partner would be determined by multiplying the amount of the liability by a fraction determined by dividing the amount of the economic risk of loss of a partner over the sum of the amount of loss borne by all partners. thus, as illustrated by an example in the proposed regulations, where partner a guarantees the full $1,000 of a bank loan to the ab partnership and partner b guarantees $500 of the liability, the amount of the liability allocable to a is $667 ($1,000 × $1,000/$1,500) and the amount of the liability allocable to b is $333 ($1,000 × $500/$1,500). prop. reg. § 1.752-2(i) would be amended to provide that where a liability of a lower-tier partnership is allocated both to the upper-tier partnership and to a partner who bears economic risk of loss as a partner in both the upper-tier and lower-tier partnerships, the basis resulting from such a liability will be allocated directly to the partner of the lower-tier partnership rather than to the upper-tier partnership.  related persons under reg. § 1.7044(b)(1) an individual and a corporation are treated as related persons if the individual is an 80 percent or greater shareholder. where the corporation is a lender to a partnership or has a payment obligation with respect to a partnership liability, prop. reg. § 1.752-4(b)(1)(iv) would disregard the application of § 267(c)(1) that provides that stock owned by a partnership is treated as owned proportionately by its partners. as a result, a partner in a partnership that owns 80 percent of the stock of the corporate lender will not be treated as related to the corporation that bears the economic risk of loss. prop. reg. § 1.752-4(b)(2) would provide that if a person who is a lender or has a payment obligation for a partnership liability is related to more than one partner, the liability will be shared equally among the related partners. this rule revises the existing provision that allocates the liability to the partner with the highest percentage of related ownership. in addition, the rule of reg. § 1.752-4(b)(2)(iii), which provides that persons owning interests in the same partnership are not treated as related persons for purposes of determining economic risk for partnership liabilities would be modified to apply only to persons who bear the economic 352 florida tax review [vol. 15:5 risk for a liability as a lender or have a payment obligation for the partnership liability.  the proposed regulations are to be effective on the date final regulations are published in the federal register. c. distributions and transactions between the partnership and partners 1. dad follows the son of boss into the tax shelter abyss. superior trading, llc v. commissioner, 137 t.c. 70 (9/1/11). this case involved a so-called distressed asset/debt (dad) tax shelter structure created by john rogers, tax lawyer and purported international finance expert. the tax court (judge wherry) described the structure by noting that, “true to the poet’s sentiment that ‘the child is father of the man’, the dad deal seems to be considerably more attenuated in its scope, and far less brazen in its reach, than the son of boss transaction.” at the top of rogers’ pyramid, warwick trading, llc acquired uncollectable receivables from a bankrupt brazilian retailer under a contribution arrangement. warwick claimed a transferred basis in the receivables equal to their face value under § 723. the receivables were then contributed through multiple tiers of trading companies, interests in which were sold to individual investors. not long after the contribution transaction, the interest of the brazilian retailer in warwick was redeemed, but no § 754 election to adjust basis under § 743(b) was made. ultimately the individual investors claimed loss deductions though their interests in the trading company partnerships as the receivables were liquidated at their depreciated value through an accommodating party. these transactions occurred before the october 2004 revisions to §§ 704(c), 734 and 743 (requiring allocations of built-in loss only to the contributing party, limiting basis to fmv at the time of contribution, and requiring mandatory basis adjustments on distributions involving substantial basis reductions). the court found multiple grounds on which to undo these transactions.  first, the court held that the original contribution of the receivables was not a partnership transaction under § 721 with § 723 transferred basis, but was instead a sale. the court concluded that the brazilian retailer was never a partner in a partnership with a joint-profit motive, and thus the transfer of the receivables in the initial transaction was not a § 721 contribution to a partnership.  the brazilian retailer’s receipt of money within two years of the transfer of the receivables supported recharacterization of the transaction as a sale under § 707(a)(2)(b). https://checkpoint.riag.com/getdoc?docid=iadvtcr:322.1&pinpnt= 2014] recent developments in federal income taxation 353  from the brazilian retailer’s financial statements the court found that the receivables had a zero basis at the time of the contribution in any event.  and if that was not enough, the court collapsed the transaction under the step-transaction doctrine into a single transaction that consisted of a sale of the receivables for the amount of cash payments eventually made to the brazilian retailer on redemption of its interest. thus, warwick’s basis in the receivables was no higher than the cash payment, which the taxpayer failed to substantiate, resulting in a zero basis.  interestingly, the court concluded that it was not necessary to address the broad judicial economic substance doctrine that other courts had used to disallow the tax benefits of the son-of-boss cases. the court said that, “because of a dad deal’s comparatively modest grab and highly stylized garb, we can safely address its sought-after tax characterization without resorting to sweeping economic substance arguments” and added that, “we need only look at the substance lurking behind the posited form, and where appropriate, step together artificially separated transactions, to get to the proper tax characterization.”  all of that was followed by an accuracyrelated penalty under § 6662. a. the seventh circuit goes back to the generic economic substance doctrine and addresses the penalties. superior trading, llc v. commissioner, 728 f.3d 676 (7th cir. 8/26/13). rather than focus on the technical application of the partnership provisions, with a generic tax shelter analysis, judge posner stated flat out that the partnership was a sham and said that, “if the only aim and effect are to beat taxes, the partnership is disregarded for tax purposes.” the court’s opinion is interesting for its holding on the § 6662 40 percent gross valuation misstatement penalty. the seventh circuit joined the majority view that “a taxpayer who overstates basis and participates in sham transactions, as in this case, should be punished at least as severely as one who does only the former.” the minority view was that the gross valuation penalty applied only applicable to an overstatement of value and thus was not applicable to deficiencies attributable to transactions that lack economic substance. as discussed in section viii.d. of this outline, in woods v. united states, 134 s. ct. 557 (12/3/130), rev’g 471 fed. appx. 320 (5th cir. 6/6/12), the supreme court resolved the conflict among the circuits.  in a warning that might be applicable to our headlines, judge posner also chided the tax court by saying in a parenthetical, “we note with disapproval the loquacity of, and lame attempts at humor in, the tax court’s opinion, which include making fun of rogers’ name, as in the section title ‘mr. rogers’ neighborhood.’” 354 florida tax review [vol. 15:5 b. and the money hidden in mr. rogers’ house is taxable to him. rogers v. commissioner, 728 f.3d 673 (7th cir. 8/26/13). john rogers, the promoter of the dad shelter in superior trading, was the sole shareholder of an s corporation, portfolio properties, inc. (ppi), which received $2.4 million in payments from investors in the dad shelter. of that money, $1.2 million was transferred to the llc that was the general partner in the shelter as the purchase price for the depreciated receivables used in the shelter. rogers argued that the full $2.4 million was held in trust for the shelter partnership, warwick. the seventh circuit (judge posner) agreed that the money actually transferred to warwick was received by ppi impressed with a fiduciary obligation and therefore not taxable to ppi. however, the court stated that the tax court was not required to believe rogers’ testimony that the funds not transferred to warwick were held in trust. the tax court’s conclusion was bolstered by the fact that a portion of the funds was distributed to rogers. judge posner also remarked on the “minuteness” of the $500 § 6662 penalty imposed on rogers’ $269,107 tax deficiency. c. the tax court again finds a disguised sale in the dad transaction. buyuk l.l.c. v. commissioner, t.c. memo. 2013-253 (11/6/13). judge laro held that the dad (distressed debt structure) marketed by bdo seidman failed to provide its promised basis step up under alternative holdings that the acquisition of high–basis, low-value receivables was a disguised sale under § 707(a)(2)(b), the transaction was in substance an installment sale of the receivables, and the transaction lacked economic substance. under the dad structure a russian utility company, saratov, transferred distressed receivables to an llc formed with gramercy advisors llc in exchange for a partnership interest in the llc. this master llc then transferred its interest in the receivables to a second llc in exchange for a membership interest in the second llc. gramercy was a one percent member of the second llc. the tax shelter investor would acquire a 90 percent interest in the second llc for cash. after the cash contribution the russian company was redeemed from the master llc for cash. the second level llc would transfer the receivables to a third level llc for a 99 percent interest in that entity. the third level llc would then exchange the receivables for interests in other gramercy assets and claim a loss, which was passed through to the tax shelter investor.  section 707(a)(2)(b). as it held in superior trading llc v. commissioner, 137 t.c. 70 (2011), aff’d, 728 f.3d 676 (7th cir. 8/26/13), the court concluded that the transfer of receivables by the russian company to the master llc was a transfer of property followed by the related distribution of cash treated as a disguised sale under § 707(a)(2)(b). this resulted in a basis for the receivables in the llc equivalent to the cash 2014] recent developments in federal income taxation 355 distributed to the russian company rather than the company’s higher basis. the court cited the two-year presumption of reg. § 1.707-3(c), which the taxpayer failed to overcome. the court also indicated that the contribution and cash distribution were “reciprocal transfers.” further, the court found that the receivables were not at risk in the master llc and the cash transfers to the russian company bore no relationship to the entrepreneurial risks of the partnership operations. the court also pointed out that the collection of the receivables was reassigned to the russian company so that gramercy’s lack of due diligence with respect to the collectability of the receivables indicated that gramercy was never serious about collecting in order to derive a joint profit on the transaction. rather than conducting a detailed analysis of the 10 facts and circumstances enumerated in reg. § 1.707-3(f), the court stated that, “the crucial and common theme to be gleaned from the 10 facts and circumstances in the regulations and their examples is that if, at the time of the earlier transfer, it was reasonably certain that the transferor would receive cash or other consideration for the property transferred of an amount determinable with reasonably certainty, the related transfers will be reclassified as a sale.”  substance over form and step transaction. using a similar analysis the court held that the substance of the whole transaction, including the contribution and distribution of cash, was an installment sale of the receivables. the court stated, “[t]he amount of cash saratov would receive was already determined at the time of the initial transfer. it was virtually certain from the outset that bdo would be able to collect sufficient money from buyers interested in the tax attributes of the receivables to fund the promised consideration to saratov. thus, the overall transaction was in substance an installment sale of the receivables.” the court found that the various steps could be collapsed into a single transaction under the end result test and the interdependence test.  economic substance. consistent with the seventh circuit’s holding in superior trading, the court concluded that the transaction lacked economic substance under both the objective test (a transaction has economic substance for federal income tax purposes if the transaction offers a reasonable opportunity for pretax profit) and the subjective test (whether the taxpayer has subjective nontax reasons for entering into the transaction and whether the taxpayer has a legitimate profit motive for doing so). based on testimony of expert witnesses the court held that there was no realistic possibility for the transaction to break even absent tax benefits. in addition, the court held that the taxpayers did not show any valid business purpose for engaging in the transaction, based in part on the absence of any due diligence with respect to collecting the receivables and transferring the funds to the u.s. master llc.  the court sustained § 6662(a) and (b) accuracy and substantial valuation misstatement penalties. 356 florida tax review [vol. 15:5 2. it’s difficult to claim you are not a partner when you agree in writing to receive a k-1. cahill v. commissioner, t.c. memo. 2013-220 (9/18/13). the taxpayer entered into a convoluted memorandum agreement with a partnership (fc) that provided the taxpayer with cash payments — termed a “drawdown”— aggregating to $175,000. the agreement required the taxpayer to repay the “drawdown” out of future income of the venture that was allocated to him and that outstanding balances would bear interest, while also specifically providing that fc, which changed its name to cfc, would report any draws on a schedule k-1, partner’s share of income, deductions, credits, etc., or a form 1099-misc, miscellaneous income. however, under a formula provided by the terms of the agreement, $125,000 of the drawdown was not subject to repayment. cfc reported the $175,000 paid to the taxpayer as a guaranteed payment to a partner and issued a schedule k-1 reporting a guaranteed payment of $175,000. eventually, the relationship soured and the taxpayer refused to sign a formal partnership agreement. the taxpayer did not report any of the $175,000, and the irs asserted a deficiency. the tax court (judge kerrigan) upheld the deficiency, rejecting the taxpayer’s arguments that he was not partner and that the $175,000 was received as a loan. even though the taxpayer never signed the formal partnership agreement, the memorandum provided the mechanism under which he would share in the profits of fc/cfc and specifically provided that fc/cfc would issue petitioner a form 1099-misc or a schedule k-1 with respect to any money he received, and there was no evidence that he ever objected to receiving a schedule k-1 on the grounds that he was not a partner. finally, that fc changed its name to cfc evidenced that he was a partner (the other partners’ names being christie and friemann). of the $175,000, $125,000 was unquestionably a § 707(c) guaranteed payment because under the terms of the agreement, that amount would have been paid to the taxpayer even if had been an employee; that amount was earned by fc/cfc pursuant to a flat fee (plus expenses) contract with a third-party that called for the taxpayer’s services and under the terms of the fc/cfc agreement the gross amount of the fee was to be allocated directly to the taxpayer. the remaining $50,000 was not a loan because no agreement provided any definite date of repayment or a manner of repayment other than from future fc/cfc income allocated to the taxpayer. furthermore, the memorandum agreement expressly stated that any draws would be considered income to the taxpayer. the taxpayer also lost on a variety of other issues, none of which presented any interesting points. a § 6662(a) negligence penalty was upheld. 2014] recent developments in federal income taxation 357 d. sales of partnership interests, liquidations and mergers 1. no bingo for mingo! former pwc consultant was required to recognize ordinary income attributable to her interest in partnership unrealized receivables on her receipt of convertible promissory notes in connection with the sale of the pwc consulting business to ibm. mingo v. commissioner, t.c. memo. 2013-149 (6/12/13). the taxpayer was a partner in the management consulting and technology services business (consulting business) of pwc until pwc sold its consulting business to ibm. the sale was structured by pwc transferring its consulting business to a newly formed partnership, pwcc, the partners of which were subsidiaries of pwc. among the assets pwc transferred to pwcc were its consulting business’ uncollected accounts receivable for services it had previously rendered (unrealized receivables). pwc then transferred to each of the 417 consulting partners an interest in pwcc and cash in exchange for the partner’s interest in pwc. the taxpayer was one of the partners who received a partnership interest in pwcc and cash from pwc in exchange for her partnership interest in pwc. then the pwc subsidiaries sold their interests in pwcc to ibm, and the 417 consulting partners sold their interests in pwcc to ibm in exchange for convertible promissory notes. the value of the taxpayer’s partnership interest in pwcc was $832,090, of which $126,240 was attributable to her interest in partnership unrealized receivables, which were uncollected accounts receivable for services. the taxpayer reported her entire gain on the sale under the § 453 installment method, but the irs asserted a deficiency on the ground that the gain on the § 751(c) unrealized receivables was not eligible for installment reporting. the tax court (judge paris) held that § 453 installment reporting is not available for gains attributable to § 751(c) unrealized receivables that represent uncollected cash-method accounts receivable for services. the court relied on sorensen v. commissioner, 22 t.c. 321 (1954), which held that installment reporting was not available with respect to the sale of options to purchase stock that had been granted as compensation for the taxpayer’s services, because “[t]he provisions of section [453] relate only to the reporting of income arising from the sale of property on the installment basis. those provisions do not in anywise purport to relate to the reporting of income arising by way of compensation for services.”  furthermore, the irs’s determination that the gain attributable to the unrealized receivables was not eligible for § 453 installment sale reporting, after the taxpayer had reported on the installment method, was a change of accounting method subject to § 481(a). as a result the court sustained the irs’s adjustment for the year 2003, the year the irs initiated the change, even though the gain properly was reportable in 2002, the 358 florida tax review [vol. 15:5 year of the sale. the court cited bosamia v. commissioner, 661 f.3d 250 (5th cir. 2011), aff’g t.c. memo. 2010-218, for the principle that a § 481(a) adjustment may include amounts attributable to tax years outside the statute of limitations on assessments.  finally, because the taxpayer was required to recognize $126,240 of ordinary income relating to partnership unrealized receivables in 2003, the taxpayer was entitled to increase the basis of the note by that amount, which reduced the reported long-term capital gain for the year in which the note was satisfied by conversion into ibm stock. 2. a partnership termination is only a termination for some purposes. reg-126285-12. partnerships; start-up expenditures; organization and syndication fees, 78 f.r. 73753 (12/9/13). proposed amendments to reg. §§ 1.195-2(a), 1.708-1(b)(6), and 1.709-1(b)(3) would provide that on a technical termination of a partnership under § 708(b)(1)(b) caused by a sale or exchange of 50 percent or more of partnership interests within a 12-month period, the new partnership deemed to be formed as a continuation of the terminated partnership under reg. § 1.708-1(b)(4), would continue to amortize § 195 start-up expenses and § 709 organization expenses using the same amortization period adopted by the terminated partnership. the proposed regulation clarifies that the terminated partnership may not claim a § 165 loss deduction for any unamortized start-up or organization expenses. the irs reasoned in the preamble that the technical termination of a partnership under § 708(b)(1)(b) is not a cessation of the trade or business to which the start-up and organizational expenses relate. the preamble also points out that this treatment is consistent with the amortization of § 197 intangibles to the extent of the transferor’s adjusted basis, which continues in the new partnership over the remainder of the transferor’s 15-year amortization period. when final, the regulations will be applied to technical terminations that occur after 12/9/13. e. inside basis adjustments there were no significant developments regarding this topic during 2013. f. partnership audit rules 1. penalties assessed on outside basis adjustments are not a partnership item. arbitrage trading, llc v. united states, 108 fed. cl. 588 (1/30/13). following petaluma fx partners, and tigers eye trading llc, the court of federal claims held in this son of boss tefra proceeding that the court lacked jurisdiction to consider the application 2014] recent developments in federal income taxation 359 § 6662 accuracy related penalties on adjustments to the taxpayer’s outside basis, which is an affected item in the partnership proceeding. the court further held that it had jurisdiction to consider accuracy related penalties related to adjustment of the disregarded partnership’s losses and other deductions. 2. rely on the irs for legal advice, you lose. kearney partners fund, llc v. united states, 111 a.f.t.r.2d 2013-1408 (m.d. fla. 3/27/13), reconsideration denied, 111 a.f.t.r.2d 2013-2043 (m.d. fla. 5/20/13). the taxpayer invested in a tax shelter scheme called “family office customized” (focus) program” by acquiring a direct interest in an llc called nebraska partners, which included indirect interests in lincoln partners llc owned 99% by nebraska, and kearney partners llc, owned 99% by lincoln. on initiation of a tefra audit procedure (which the court referred to as “terfa”), the irs mailed the required notice of beginning of administrative proceedings (nbap) to the partnerships but not to the partners. section 6223(a) requires notice of initiation of an audit at least 120 days before issuance of a final partnership administrative adjustments (fpaa) to partners whose names and addresses are furnished to the irs. section 6223(e) allows a partner who was not provided a required notice to opt-out of the partnership proceeding. in issuing its fpaa to kearney partners, the irs attached a cover letter indicating that since the taxpayer had not been issued an nbap the taxpayer was entitled to opt-out of the partnership proceeding, which he elected to do. however, shortly after the taxpayer notified the irs of his election to optout, the irs sent a letter to the taxpayer indicating that it erred in informing the taxpayer of an election to opt-out because the taxpayer was not directly entitled to an nbap in the first instance. the taxpayer’s petition to the tax court following a separately issued notice of deficiency was dismissed for lack of jurisdiction but the basis for the decision was not specified. the district court rejected the taxpayer’s motion that the court lacked jurisdiction over the taxpayer in the partnership proceeding because of the taxpayer’s election to opt-out. first, the court rejected the taxpayer’s argument that the irs was collaterally estopped from asserting jurisdiction in the partnership proceeding. the court concluded that since the basis for the tax court’s determination that it lacked jurisdiction over the notice of deficiency issued to the taxpayer was not clear, the issue was not fully litigated in the tax court and, therefore, collateral estoppel did not apply. the court then found that the taxpayer was not initially entitled to receive an nbap because the partnership failed either to provide the names and addresses of partners on a partnership return or by separate statement as required by § 6223(c). further, the court held that the irs is not required to search its records for other information that may be available to it that identifies the names and addresses of partners. that applies even if the irs is 360 florida tax review [vol. 15:5 aware of the partner’s identity. finally, the court indicated that, “while the agency’s error (subsequently rescinded) is regrettable to the extent it muddied the waters, it does not alter the fact that there was no legal obligation to provide the nbap to [the taxpayer] in the first place and the letter to the contrary does not change that circumstance.” a. strike two, same partner, different argument. kearney partners fund, llc v. united states, 111 a.f.t.r.2d 2013-1789 (m.d. fla. 4/25/13). in this action the court denied summary judgment motions by the partnerships and the 99 percent partner challenging irs assertions that the focus investment lacked economic substance so that all of the gains and losses emanating from the tax shelter should be disregarded and alternatively that if the losses allocated to the partner are respected then under the step transaction doctrine gains recognized before the partner acquired his interest should also be allocated to the partner. the transaction involved offsetting straddle gains allocated to one owner (and eliminated on the owner’s return) and losses, allocated to the later acquiring partner. the court noted that both irs positions are predicated on the conclusion that focus is an abusive tax shelter and observed that both the economic substance doctrine and the step transaction theory have been applied to give effect to both the cost and income functions of a transaction or to neither. the court concluded that the irs offered sufficient evidence to create a material issue over whether the 99 percent partner intended to benefit from the inception of the transaction and that the losses were generated through an interrelated series of transactions. further, citing the partnership anti-abuse rule of reg. § 1.701-2 as a complement to the economic substance doctrine, the court indicated that the irs may disregard the entire transaction. b. and a win for the taxpayer in another court on an earlier date. kearney partners fund, llc v. united states, 111 a.f.t.r.2d 2013-1780 (n.j. 7/13/12). a magistrate judge denied the irs’s motion to compel production of documents reflecting communications between the 99 percent partner and rabner, allcorn, baumgart & ben-asher, p.c. the court concluded that the documents were protected by the attorneyclient privilege and rejected the irs’s argument that the firm was providing financial advice after an in camera review. the court found that the attorney was providing legal and tax advice. the court also held that even if the partner were a party in the florida tefra litigation, the partner did not waive the attorney-client privilege by intending to call the attorney as a witness in that matter because the partner would not rely on the attorney’s advice in that case. the court also held that the documents were prepared in 2014] recent developments in federal income taxation 361 anticipation of litigation because of the aggressive nature of the tax shelter program. c. and a partial loss and partial win for the taxpayer who seems to have unlimited attorney fee resources for pretrial motions. kearney partners fund, llc v. united states, 111 a.f.t.r.2d 2013-1963 (m.d. fla. 5/10/13). in this round the court denied the taxpayer’s objection to a magistrate’s ruling that certain documents sought by the taxpayer from the irs were protected under the “deliberative process privilege.” the privilege attaches to documents that precede an agency’s final determination or outcome on a policy or legal matter and which reflect the give-and-take of the consultative process that is antecedent to final agency action. after in in camera review of the requested documents, the court found that all of the documents, except one, were subject to the privilege reflecting inter-agency opinions and recommendations of irs investigators, examiners and counsel at the office of chief counsel that preceded the irs’s final determination of the taxpayer’s tax obligations concerning the focus partnerships and application of accuracy related penalties. the court rejected the taxpayer’s argument that lower-level determinations relating to tax-return examinations were not subject to the privilege, noting that the entire body of work of auditors are subject to the deliberative process privilege. however, a legal memorandum written by debra butler, associate chief counsel procedure and administration, in response to a request for assistance as to whether accuracy related penalties could be imposed on taxpayers notwithstanding their disclosure of participation in the focus partnerships, was described by the court as the type of legal document relied upon by recipients as statements of law and public policy that are not pre-decisional and therefore not subject to the privilege. the court cited tax analysts v. internal revenue service, 117 f.3d 607 (d.c. cir. 1997) holding that field service advice memoranda could not be viewed as pre-decisional because the documents represented statements of the agency’s legal position. the court described the document as follows: similarly, the memorandum here reflects the office of the chief counsel’s statements of law and assessments of plaintiffs’ tax obligations. the opinion appears to be in its final form, with no visible marks or edits. the tone of the document is impersonal with distinct conclusion, facts, and law and analysis sections. although the memorandum indicates that it may not be used or cited as precedent, the document is a representation of the irs’s legal position in this case. and even if the document precedes the irs’s final 362 florida tax review [vol. 15:5 decisions in plaintiffs’ case, there is no indication that it precedes the agency’s final legal position.  the court also found that although the memorandum was subject to the attorney-client privilege, it should be produced because it reflects the irs’s final legal position regarding the taxpayer’s tax obligations. the court also upheld the magistrate’s ruling that other documents from an attorney in the office of chief counsel advising revenue agents were not protected by the attorney-client privilege and subject to disclosure. the court indicated that it was unable to ascertain whether the attorney conducted factual and legal analysis as counsel to the revenue agents or as one of the revenue agents, and that the irs thus failed to meet its burden of identifying the underlying facts demonstrating the existence of the privilege. d. and the waiver of penalties raises issues that may or may not be considered in the partnership proceeding. kearney partners fund, llc v. united states, 946 f. supp. 2d 1302 (m.d. fla. 5/22/13). in this decision the court determined that it had jurisdiction to determine under ann. 2002-2, 2002-1 c.b. 304, whether voluntary disclosure filed by the partner entitled him to waiver of accuracy related penalties under the terms of the announcement. the court held that since the announcement consists of an agency directive designed to confer important benefits to taxpayers who disclose their involvement in tax shelters in exchange for the waiver of penalties, the thrust of the announcement was to provide a benefit to taxpayers, not to internally regulate irs affairs. in addition, the specific procedures and requirements enumerated in the announcement provided the necessary law to evaluate the taxpayer’s eligibility for penalty waiver. thus, the court determined that it may review whether the taxpayer’s voluntary disclosure satisfied the announcement’s requirements. in addition, however, the court considered whether the penalty provisions were subject to review in the partnership level proceeding, or whether it lacked subject matter jurisdiction to determine the penalty as a partner item. that question turned on whether the partner who provided the disclosure had authority under the llc agreements to disclose on behalf of the partnership so that the disclosure was a partnership matter. the court determined that question depended on a showing of facts not in the record on summary judgment and thus denied summary judgment on the penalty issue.  the court also held that it did not have jurisdiction to review whether the irs followed its own internal procedures for reviewing penalty waivers, as the irs internal memorandum requiring approval of the director of field operations for penalties, which were determined at the office of chief counsel instead, represented internal general statements of policy and rules governing internal agency operations that do not have the force of law and, therefore, are not binding on the agency. 2014] recent developments in federal income taxation 363 3. wise guys respond to the wrong notice, it’s their problem even though the irs made the mistake. wise guys holdings, llc v. commissioner, 140 t.c. 193 (4/22/13). the irs mailed a fpaa to the tax matters partner from one office, and nine months later sent a second notice from a different office. the first and second fpaas were similar in content, set forth the same adjustments, but contained different contact information for the irs. after the deadline for challenging the first fpaa had expired, the taxpayer filed a petition in response to the second fpaa. too bad says the court (judge thornton). section 6223(f) provides that, “if the secretary mails a notice of final partnership administrative adjustment for a partnership taxable year with respect to a partner, the secretary may not mail another such notice to such partner with respect to the same taxable year of the same partnership in the absence of a showing of fraud, malfeasance, or misrepresentation of a material fact.” thus, concluded the court, the second fpaa is invalid and the taxpayer failed to file a timely petition in response to the first fpaa. reasoning from cases considering a statutory notice of deficiency, the court indicated that the tax court’s jurisdiction proceeds from a valid petition, which must be filed from a valid statutory notice (citing stamm int’l corp. v. commissioner, 84 t.c. 248, 252 (1985)). the court also indicated that it does not have authority to apply equitable principles such as estoppel to acquire jurisdiction. 4. the irs doesn’t have to search for the addresses of notice partners. taurus fx partners, llc v. commissioner, t.c. memo. 2013-168 (7/22/13). bricolage capital, llc was the tax matters partner (tmp) and fx trading co., llc was a notice partner of taurus fx partners llc. richard postma was the sole member of fx trading co., which was thereby a disregarded entity. the irs sent both the notice of beginning of administrative proceeding and the notice of final partnership administrative adjustment (fpaa) to the tax matters partner and the notice partner, plus postma, to the addresses shown on the partnership’s 2000 return, the year under review. postma filed a petition with the tax court as a partner other than the tmp after the 150 day period for filing had expired. the court (judge buch) rejected postma’s assertion that the fpaa was invalid because the irs did not mail the notices to the addresses shown on the partnership’s 2001 return, the partner’s last known address, which was different than the addresses on the 2000 return subject to the audit. section 6223(c)(1) provides that the irs “shall use the names, addresses, and profits interest shown on the partnership return” and § 6223(c)(2) provides that the irs shall use such additional information furnished to it under regulations. temp. reg. § 301.6223(c)-1t(a) required a written statement to the service center where the partnership return was filed that identified the partners, the years involved, and provided addresses. the court held that in the absence of the 364 florida tax review [vol. 15:5 notice required by the regulations, it was sufficient for the irs to mail the fpaa to the tax matters partner and the notice partner at the addresses shown on the partnership’s 2000 return, notwithstanding the fact that the partnership’s 2001 return had different addresses. the court stated that, “[a]lthough the commissioner may use other information in its possession, he is not obligated to search his records for information that is not expressly furnished on the 2000 return or pursuant to the regulations,” citing temp. reg. § 301.6223(c)-1t(f). the court also rejected postma’s argument that he should have received a copy of the fpaa as a notice partner. the court indicated that postma was not identified as an indirect partner in a statement to the irs as required by temp. reg. § 301.6623(c)-1t, even though postma was named on the schedule k-1 as the contact person for fx trading, the disregarded entity in which postma was the sole member. the court indicated that the language of temp. reg. § 301.6223(c)-1t(f), which provides that the irs “may use other information in its possession,” does not create an obligation on the irs to search its records for information not expressly provided under the regulations. the court ultimately held that the fpaa was valid and that the court lacked jurisdiction to hear the case because postma’s petition was filed more than 150 days after the fpaa was issued to the tmp. 5. the grantor of a trust is not a partner under tefra audit rules. sugarloaf fund, llc, jetstream business limited v. commissioner, 141 t.c. no. 4 (9/5/13). this tefra audit case is an offshoot of the john rogers depreciated asset/debt (dad) tax shelter rejected by the courts in superior trading (discussed in part c of this section). in the dad shelter, sugarloaf llc transferred depressed brazilian receivables to main trust (an illinois common law business trust) which in turn allocated the receivables to a sub-trust. the taxpayer elmes (who was represented by rogers) transferred cash to the main trust for the entire interest in sub-trust. elmes claimed a § 166 bad debt deduction for the receivables. the deduction depended upon the transferred basis of the receivables from sugarloaf. the tax court (judge wherry) rejected elmes’s assertion that he was a partner in sugarloaf because his basis in the receivables was dependent on sugarloaf’s basis. for purposes of participating in a tefra proceeding, a partner is defined in § 6231(a)(2) as “any other person whose income tax liability *** is determined in whole or in part by taking into account directly or indirectly partnership items of the partnership.” partners also include indirect partners, defined by § 6231(a)(10) to include “person[s] holding an interest in a partnership through 1 or more pass-thru partners.” the court concluded that elmes’s sub-trust had no interest in the sugarloaf partnership. the court also concluded that a trust is not necessarily a partner merely because the trust 2014] recent developments in federal income taxation 365 received assets from the partnership. the court indicated that the fact that assets were transferred to the trusts did not depend upon any legal relationship among elmes, the trusts and the partnership. the court distinguished the relationship of other investors in the dad shelter, noting that in other cases before the court each of those investors owned an interest in a trading company through one or more pass-through partners. 6. thirty years after investing in a tax shelter, the taxpayers find no help from the courts. acute care specialists ii v. united states, 727 f.3d 802 (7th cir. 8/22/13). in the mid-1980’s the taxpayers invested in tax shelters created by american agri-corp. which were found by the tax court in a partnership proceeding to lack economic substance and amount to nothing more than tax-avoidance schemes, with appropriate penalties. the taxpayers filed suit in the district court challenging deficiency assessments resulting from the partnership proceeding. the court affirmed district court holdings that it lacked subject matter jurisdiction because the taxpayers’ assertions regarding statutes of limitations and penalties were partnership-level determinations. g. miscellaneous 1. the first circuit intrudes on tax law in an erisa case between private litigants and may resolve carried interest issues. sun capital partners iii, l.p. v. new england teamsters and trucking industry pension fund, 724 f.3d 129 (1st cir. 7/24/13). in an erisa case two private equity funds organized as limited partnerships sought to withdraw from liability for contributions to the teamsters multi-employer plans on the grounds that the funds were merely passive investors in a bankrupt company owned by one of the funds. in a decision that could have implications for application of tax principles, the court affirmed summary judgment that at least one of the funds was not merely a passive investor in the bankrupt portfolio company. under the multiemployer pension plan amendment act of 1990 (29 u.s.c. § 1381 et. seq.) (mpaa) all employees of trades or businesses that are under common control are treated as employed by a single employer that becomes liable for obligations under defined benefit plans. applying the principles of commissioner v. groetzinger, 480 u.s. 23 (1987), the court concluded that the private equity fund was in the trade or business of developing companies and selling them at a profit. along the way the court rejected the equity funds’ argument that investing was not a trade or business under either higgins v. commissioner, 312 u.s. 212 (1941), or whipple v. commissioner, 373 u.s. 193 (1963). the court distinguished higgins by indicating that the taxpayer in that case was not engaged in the management of the companies represented in the taxpayer’s investment portfolio. the court concluded that whipple did not 366 florida tax review [vol. 15:5 bar trade or business status because, paraphrasing the language of whipple, the funds “did not simply devote time or energy to [the bankrupt company] ‘without more.’ rather they were able to funnel management and consulting fees to [the fund’s] general partner and its subsidiary.” quoting from rosenthal, “taxing private equity funds as corporate developers,” tax notes, jan. 21, 2013 at 361, the court stated that, “[p]rivate equity funds are active enough to be in a trade or business.”  while the court was clear that it based its opinion on its independent interpretation of the mpaa, the court deferred under the standard of skidmore v. swift, 323 u.s. 134 (1944) (the weight of the agency opinion depends upon its thoroughness and validity of its reasoning), to a 2007 pbgc letter concluding that an equity fund was engaged in a trade or business under the groetzinger two-part test based on findings that the fund was engaged in an activity with the primary purpose of income or profit and that it conducted that activity with continuity and regularity. the ppgc letter indicated that the size of the fund involved in the ruling, the size of its profits, and the management fees paid to the general partner of the fund established the requisite continuity and regularity.  the court rejected the equity funds’ assertion that the phrase “trade or business” must have a uniform interpretation across federal statutes in the context of the application of higgins and whipple. nonetheless, the court found no inconsistency in its interpretation of trade or business under those cases and groetzinger, which leaves wide open the possibility that fees and the profits interests of an equity fund represent ordinary income derived from services in the trade or business of acquiring and managing business operations. 2. hiding abusive shelter transactions behind disregarded entities makes the indirect partner an unidentified partner for statute of limitations purposes. gaughf properties l.p. v. commissioner, 139 t.c. 219 (9/10/12). the taxpayers invested in kpmg/jenkens & gilchrist currency options tax shelters through a partnership consisting of two disregarded llcs and a wholly owned corporation. after the irs caught up with the taxpayers from information obtained through a john doe summons issued to jenkens & gilchrist, the irs asserted that the statute of limitations remained open with respect to the taxpayers under § 6229(e), which extends the limitation period for one year after the name and address of a partner is furnished to the irs where (1) the name address and tin of the partner is not “furnished” on the partnership return and the irs has sent notice of an fpaa within the statute of limitations, or (2) the taxpayer has taken an inconsistent position and fails to provide the notice required by § 6222(b). the tax court (judge goeke) held that the statute remained open under both provisions. following the holding 2014] recent developments in federal income taxation 367 in costello v. united states, 765 f. supp. 1003 (c.d. cal. 1991), the court held that, although schedule k-1s are required only for direct partners, an indirect partner who is not identified on a partnership return remains an “unidentified partner” for purposes of § 6229(e)(1). the court rejected the taxpayer’s argument that because the irs was in possession of identifying information from applications for taxpayer identification numbers for the disregarded entities (forms ss-4) and information from jenkens and gilchrist and kpmg john doe summonses more than one year before issuing assessment notices. the court upheld the validity of requirements in temp. reg. § 301.6223(c)-1t that information be “filed” with the irs at the service center where the taxpayer’s returns are filed and that the identifying information be specific. the court interpreted § 6229(e)’s use of term “furnished” as sufficiently close to the filing requirement of the temporary regulations to indicate that the regulation was a valid exercise of administrative authority under chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984) and § 7805(a).  the court also held that the taxpayer took an inconsistent position on returns reporting the partnership transactions because of the way the partnership netted contributions of long and short options which the taxpayer reported separately in claiming basis increases. as a result, the taxpayer was found to have failed to provide the statement required by § 6222(b) thereby extending the statute of limitations under § 6229(e)(2).  the court also rejected the taxpayer’s arguments that the irs was estopped from assessing a deficiency because of (1) irs delays in issuing notice 2000-44, 2000-2 c.b. 255 (notifying taxpayers of the issues raised by the shelter transaction); (2) because of the long period before the irs issued an fpaa to the taxpayer’s partnership; or (3) because the irs had withheld and destroyed evidence or placed witnesses beyond the reach of the taxpayer because of criminal investigations. a. affirmed by the d.c. circuit. gaughf properties l.p. v. commissioner, 738 f.3d 415 (d.c. cir. 12/27/13), aff’g 139 t.c. 219 (9/10/12). in an interlocutory appeal, the d.c. circuit (judge henderson) affirmed the tax court and held that the gaughfs were “unidentified partners” who took positions on their own tax returns that were inconsistent with those of the partnership in its returns. viii. tax shelters a. tax shelter cases and rulings 1. had this opinion been issued on october 25th, the taxpayer might have had a chance. however, the opinion was issued on march 14th, so success was not in the cards. crispin v. 368 florida tax review [vol. 15:5 commissioner, t.c. memo. 2012-70 (3/14/12), on appeal to the third circuit. the taxpayer, an experienced cpa, entered into a cards transaction in 2001 to shield about $7 million of shared fees (ordinary) income from his wholly owned s corporation that engaged in a business related to a pool of collateralized mortgage obligations. the promoter was a longtime friend who did not charge the taxpayer any fee to participate in the cards transaction. the tax court (judge kroupa) held that the transaction lacked economic substance because it lacked business purpose and profit expectation, stating, “[w]e have consistently held that cards transactions lack economic substance,” and noting that an appeal in this case lies in the third circuit, which decided acm p’ship v. commissioner, 157 f.3d 231 (3d cir. 1998).  judge kroupa also upheld the 40 percent gross valuation misstatement accuracy-related penalty. the tax opinion the taxpayer received from his advisors relied on “false representations [the taxpayer] made,” including that he had a business purpose for entering into the cards transaction and that he anticipated earning a profit, absent tax benefits, from the cards transaction, which were “material to the conclusions reached in the tax opinion.” furthermore, the taxpayer had not actually relied on the opinion. a. this opinion was issued on february 25th and amended on march 19th so the taxpayer was again out of luck. crispin v. commissioner, 708 f.3d 507 (3d cir. 2/25/13), amended by 2013 u.s. app. lexis 5341 (3d cir. 3/19/13). the third circuit (judge jordan) upheld the tax court determination that the cards transaction failed both the objective and subjective tests for economic substance. the third circuit further found that the tax court did not abuse its discretion in deciding not to credit either taxpayer’s evidence as to business purpose [in that he approached the lender to substitute aircraft for cash as collateral] or the expert opinion by taxpayer’s expert [in that potential profit could be generated by using the cards loan proceeds to purchase aircraft]. the penalty issue was decided against taxpayer, following gustashaw v. commissioner, 696 f.3d 1124 (11th cir. 9/28/12).  judge jordan concluded: “when, as here, a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril.” neonatology assocs., 299 f.3d at 234. crispin gambled at cards and lost, and he is liable for both the underpayment of his taxes and the accuracy-related penalty as determined by the commissioner. 2014] recent developments in federal income taxation 369 2. taxpayer victory in the court of federal claims in a lease-in, lease-out (lilo) transaction with a dutch utility. on appeal, the taxpayer is likely to hit a dutch wall, i.e., a [timothy] dyk. consolidated edison co. of new york v. united states, 90 fed. cl. 228 (10/21/09). the court of federal claims (judge horn), in a long and detailed opinion, held that, under the particular facts of this case, the lilo transaction taxpayer entered into with a dutch utility had economic substance, i.e., that no decision as to whether particular options would be exercised was “pre-ordained” and that taxpayer “bore the burdens and benefits of ownership.” in finding that taxpayer had shown that the transaction was a true lease and should be respected, she distinguished factually other lilo cases decided for the government, such as bb & t corporation v. united states, 523 f.3d 461 (4th cir. 2008), and awg leasing trust v. united states, 592 f. supp. 2d 953 (n.d. ohio 2008).  a large portion of the opinion consists of judge horn’s analysis of the expert evidence, with pointed criticism of one expert who “failed to conduct in-depth studies of the … [t]ransaction and gave almost automatic and generalized conclusions on the flaws of lilo and silo transactions for tax purposes.”  alleged “spoliation of evidence” in 2000 by reason of a switch in e-mail systems without preserving all of the thenexisting e-mails, and the desire to protect 1997 memoranda as work product, came into conflict with a bad result for the credibility of an in-house lawyer. (“he was considered by the court an unreliable witness, perhaps willing to write or say whatever he thought would assist his then current assignment.”) the court found that litigation was not reasonably anticipated until 2002 at the earliest because negotiations in connection with the irs audit were ongoing until at least that year. the 1997 memoranda were ordered disclosed. a. and, indeed, as expected, the shelter crashes against the dutch wall in the form of judge timothy dyk! consolidated edison co. of new york, inc. v. united states, 703 f.3d 1367 (fed. cir. 1/9/13). in an opinion by judge dyk, the federal circuit reversed judge horn. the court applied the substance-over-form doctrine under its decision in wells fargo & co. v. united states, 641 f.3d 1319 (fed. cir. 2011), to disallow coned’s claimed deductions for rent and interest. because there was a reasonable likelihood that the tax-indifferent entity in the lilo transaction (the lessor of the master lease) would exercise its purchase option at the conclusion of the coned sublease, the master lease was illusory. therefore, the lilo transaction did not constitute a true lease and coned’s rent deductions were disallowed. the interest deductions were disallowed because the loan proceeds effectively remained in an account to satisfy coned’s loan obligation to the lender; coned did not have the use of the funds. therefore, there was no genuine indebtedness. the case was 370 florida tax review [vol. 15:5 remanded to the court of federal claims for the limited purpose of determining only the refund of previously paid interest coned might be entitled to receive.  while judge horn failed to stick her finger into the dike belonging to the dutch utility, judge dyk shoved his thumb all the way into judge horn. in so doing, he also trashed the deloitte & touche appraisal report relied upon by coned. 3. a tax court judge sees a midcoast deal as immune from transferee liability. frank sawyer trust of may 1992 v. commissioner, t.c. memo. 2011-298 (12/27/11). the tax court (judge goeke) refused to uphold transferee liability against the shareholders of a corporation who sold the stock of the corporation engaged to a midco (fortrend, which was brought into the deal by the infamous midcoast to provide financing) after an asset sale. he found that the shareholders knew little about the mechanics of the transaction and exercised due diligence. the trust representatives believed fortrend’s attorneys to be from prestigious and reputable law firms. they assumed that fortrend must have had some method of offsetting the taxable gains within the corporations. they performed due diligence with respect to fortrend to ensure that fortrend was not a scam operation and that fortrend had the financial capacity to purchase the stock. the trust representatives believed fortrend assumed the risk of overpaying for the taxi corporations if they did not have a legal way for offsetting or reducing the tax liabilities.  judge goeke applied state fraudulent conveyance law to determine whether the transactions should be collapsed and concluded that they should not, because the irs, which has the burden of proof in transferee liability cases, did not prove that “the purported transferee had either actual or constructive knowledge of the entire scheme.” because in this case the transaction was structured in such a manner that the corporation never made any payments to the shareholders, there was no actual or constructive fraudulent transfer to the shareholders. finally, turning to federal tax law, judge goeke held that “substance over form and its related doctrines [were] not applicable,” because the transaction was an arm’s length stock sale between the shareholders and a purchaser in which the parties agreed that the purchaser would be responsible for reporting and paying the corporation’s income taxes. “there was no preconceived plan to avoid taxation ... .” judge goeke distinguished feldman v. commissioner, t.c. memo. 2011-297 (2011), because in that case “[i]t was ‘absolutely clear’ that the taxpayer was aware the stock purchaser had no intention of ever paying the tax liabilities [and] the taxpayer did not conduct thorough due diligence of the stock purchaser ... .” 2014] recent developments in federal income taxation 371 a. but the first circuit says judge goeke misunderstood massachusetts law and tells him to try a different analysis. frank sawyer trust of may 1992 v. commissioner, 712 f.3d 597 (3/29/13). the first circuit, in an opinion by judge lynch, vacated and remanded the tax court’s decision. the court of appeals held that the tax court correctly looked to massachusetts law to determine whether the trust could be held liable for the corporations’ taxes and penalties, rejecting the irs’s argument that the tax court should have applied the federal tax substance-over-form doctrine to determine whether the trust should be considered a “transferee” of the four corporations’ assets. however, the court of appeals held that the tax court erred in construing massachusetts fraudulent transfer law (which is the uniform fraudulent transfer act) to require, as a prerequisite for the trust’s liability, either (1) that the trust knew of the new shareholders’ scheme or (2) that the corporations transferred assets directly to the trust. the irs had presented evidence of fraudulent transfers from the four corporations to the midco entities, and the midco entities purchased the four corporations from the trust. the court of appeals concluded that if on remand the tax court were to find that at the time of the purchases, the assets of these midco entities were unreasonably small in light of their liabilities and that the midco entities did not receive reasonably equivalent value in exchange for the purchase prices, then the trust could be held liable for taxes and penalties assessed upon the four corporations regardless of whether it had any knowledge of the new shareholders’ scheme. b. uh oh, it’s midco! the second circuit says taxpayers can’t act like the three monkeys. diebold foundation, inc. commissioner, 736 f.3d 172 (2d cir. 11/14/13), vacating and remanding salus mundi foundation v. commissioner, t.c. memo. 2012-61. the second circuit, in an opinion by judge poller, vacated a tax court decision holding that the shareholders of a corporation, and a transferee of a shareholder, that sold stock in a midco transaction were subject to § 6901 transferee liability for the corporate level taxes that were avoided. as an initial matter, the second circuit overruled its holding in bausch & lomb inc. v. commissioner, 933 f.2d 1084 (2d cir. 1991) that mixed questions of law and fact are reviewed under a clearly erroneous standard when reviewing a tax court decision, and held that tax court fact findings are reviewed for clear error, “but that mixed questions of law and fact are reviewed de novo, to the extent that the alleged error is in the misunderstanding of a legal standard.” the tax court had held that because there was no conveyance from the corporation to the shareholders, under the relevant state fraudulent conveyance law (new york, nyufca) there was no state law liability in law or equity, and thus the successor foundations were not liable as transferees. the tax court did not address federal law, but concluded that 372 florida tax review [vol. 15:5 because there was no state law liability, it was immaterial to the outcome of the case if the shareholder was a transferee under the terms of § 6901. the second circuit concluded that the two prongs of § 6901 are independent and that the tax court did not err by only addressing the liability prong. section 6901 exists only if: (1) the party is a transferee under § 6901, and (2) the party is subject to liability at law or in equity. federal tax law controls the first prong, while the second prong is determined by the applicable state law. if there was not a “conveyance” under state law, it did not matter whether or not the selling shareholder was a “transferee” as defined by § 6901(h). but then the second circuit differed with the tax court and held that state law transferee liability might have existed. under the nyufca “[i]t is well established that multilateral transactions may under appropriate circumstances be ’collapsed’” and treated as phases of a single transaction for analysis.” under new york law, a transaction can be collapsed if (1) the consideration received from the first transferee [is] “reconveyed by the [party owing the liability] for less than fair consideration or with an actual intent to defraud creditors,” and “the transferee in the leg of the transaction sought to be voided [has] actual or constructive knowledge of the entire scheme that renders her exchange with the debtor fraudulent.” the second circuit found that it was clear that the first element had been met and that the crucial issue was whether the shareholders had “actual or constructive knowledge of the entire scheme that renders [the] exchange ... fraudulent.” in this respect the second circuit held that the shareholders had such constructive knowledge. [w]e must now assess whether the shareholders had actual or constructive knowledge of the entire scheme. the tax court concluded they did not. this assessment is a mixed question of law and fact, assessing whether based upon the facts as determined by the tax court, the shareholders had constructive or actual knowledge as a matter of law. therefore, we review de novo the tax court’s determination that the shareholders did not have constructive knowledge, but review for clear error the factual findings that underpin the determination. concluding that a party had constructive knowledge does not require a showing that the party had actual knowledge of a scheme; rather, it is sufficient if, based upon the surrounding circumstances, they “should have known” about the entire scheme. hbe leasing, 48 f.3d at 636 (internal quotation marks omitted). constructive knowledge in this context also includes “inquiry knowledge”—that is, where transferees “were aware of circumstances that should 2014] recent developments in federal income taxation 373 have led them to inquire further into the circumstances of the transaction, but ... failed to make such inquiry. . . . the tax court did not sufficiently address the totality of the circumstances from all of the facts, which that court had already laid out itself. ... [i]t is of great import that the shareholders recognized the “problem” of the tax liability arising from the built-in gains on the assets ... . the shareholders specifically sought out parties that could help them avoid the tax liability inherent in a c corp holding appreciated assets. ... the parties to this transaction were extremely sophisticated actors, deploying a stable of tax attorneys from two different firms in order to limit their tax liabilities. ... considering their sophistication, their negotiations with multiple partners to structure the deal, their recognition of the fact that the amount of money they would ultimately receive for an asset or stock sale would be reduced based on the need to pay the c corp tax liability, and the huge amount of money involved, among other things, it is obvious that the parties knew, or at least should have known but for active avoidance, that the entire scheme was fraudulent and would have left double d unable to pay its tax liability. . . . to conclude that these circumstances did not constitute constructive knowledge would do away with the distinction between actual and constructive knowledge, and, at times, the tax court’s opinion seems to directly make this mistake. the facts in this case strongly suggest that the parties actually knew that tax liability would be illegitimately avoided, and in any event, as a matter of law, plainly demonstrate that the parties “should have known” that this was a fraudulent scheme, designed to let both buyer of the assets and seller of the stock avoid the tax liability inherent in a c corp holding appreciated assets and leave the former shell of the corporation, now held by a midco, without assets to satisfy that liability.  because the tax court had determined that there was no state law liability, it did not consider the other questions determinative to the case. accordingly, the second circuit remanded to the tax court to determine whether the shareholders were transferees under § 6901 and to resolve other procedural issues. 4. welfare for tax litigators — another generic tax shelter litigated to the bitter end. nevada partners fund, l.l.c. v. united states, 720 f.3d 594 (5th cir. 6/24/13), vacated and remanded for 374 florida tax review [vol. 15:5 reconsideration, 134 s. ct. 903 (2014). the fifth circuit in an opinion by judge dennis, affirmed a district court decision, 714 f. supp. 2d 598 (s.d. miss. 2010), denying the taxpayer’s deduction for losses purportedly generated by a kpmg focus tax shelter transaction. the shelter involved three tiers of partnerships and foreign currency transaction straddles that produced offsetting economic gains and losses. a transitory partner would recognize the gains while the taxpayer would recognize the losses through an inflated partnership basis. the transaction was substantially similar to the listed transaction described in notice 2000-44, 2000-2 c.b. 255. the court of appeals concluded that the district court “did not err legally or factually in determining that the partnerships failed to meet their burden of proving that the transactions giving rise to the $18 million tax loss in question had economic substance.” the district court correctly held that the transactions “served no other purpose than to provide the structure through which williams could enjoy the reduction of his tax burden for that year.” that in subsequent years the taxpayer made significant profits from currency transactions and other investments effected through the tax shelter promoter was not relevant; the later year’s transactions were separate transactions. a § 6662 negligence penalty was upheld notwithstanding that arnold & porter had issued an opinion that the losses “more likely than not” would be allowable. the taxpayer, williams, was not a partner at the time the opinion letter was issued. furthermore, “the partnerships could not reasonably rely on arnold & porter’s tax opinions in good faith because williams and the partnerships failed to prove by a preponderance of the evidence that they supplied the professional with all pertinent information necessary to assess the purpose and elements of the transactions at issue as they were actually effectuated.” 5. you say silo/lilo, but the courts keep singing bye-bye tax benefits. john hancock life insurance company v. commissioner, 141 t.c. no. 1 (8/5/13). this case was the first silo/lilo transaction to come before the tax court. after detailed fact findings and an examination of the various courts of appeals opinions in earlier silo/lilo cases, the tax court (judge haines) held for the irs. in each of four different transactions, the substance of the transaction was not consistent with its form. there was only de minimis risk to the taxpayer and the terms of the agreements assured that the taxpayer would receive its expected return on its equity investments. the tax court stated: this guaranteed return is not indicative of a leasehold or ownership interest. rather, it is reflective of what is better described as a very intricate loan from john hancock to the lessee counterparties. 2014] recent developments in federal income taxation 375  thus – even though the court did find that the transactions had economic substance – because the taxpayer was in substance a lender, its claimed deductions for rent, interest and depreciation were disallowed. 6. another tax shelter strategy bites the dust − isn’t it about time for frivolous litigation penalties to start being assessed against big corporations for this detritus (a more polite word than some of us would use)? wfc holdings corp. v. united states, 728 f.3d 736 (8th cir. 8/22/13). the court affirmed a district court ruling that a kpmg contingent liability tax reduction strategy sold to wells fargo bank failed to produce claimed capital loss deductions because the transaction lacked economic substance. 7. the stars are blacked out by the economic substance doctrine. bank of new york mellon corp. v. commissioner, 140 t.c. 15 (2/11/13). in a case described as a case of first impression in the tax court, the court (judge kroupa) denied the taxpayer’s claimed foreign tax credits and other tax benefits artificially generated through a “stars” taxshelter transaction developed and marketed by kpmg. the transaction that generated the purported foreign tax credit lacked economic substance. the taxpayer’s control and management over the transferred assets did not materially change as a result of the transaction and the stars structure had no effect on the income stream generated by the assets; the assets would have generated the same income regardless of being transferred. “thus, income from the stars assets was not an incremental benefit of stars.” the court rejected the taxpayer’s argument that the stars structure was security for a loan from barclays bank, finding that the loan proceeds were not used to purchase the stars assets and that the loan was adequately secured by other assets. thus the loan was a separate transaction from the stars transaction, which standing by itself lacked economic substance. furthermore, the stars transaction still lacked economic substance even if the stars structure and the loan were evaluated as an integrated transaction. the stars transaction was a complicated scheme centered around arbitraging domestic and foreign tax law inconsistencies. the u.k. taxes at issue did not arise from any substantive foreign activity. indeed, they were produced through pre-arranged circular flows from assets held, controlled and managed within the united states. we conclude that congress did not intend to provide foreign tax credits for transactions such as stars. 376 florida tax review [vol. 15:5  finally, the claimed transactional expenses, the zero coupon swap interest expense, and the u.k. taxes that were incurred in furtherance of the stars transaction were not deductible. “expenses incurred in furtherance of a transaction that is disregarded for a lack of economic substance are not deductible.” a. but on reconsideration, the taxpayer wins a skirmish after the major battle is over. bank of new york mellon corp. v. commissioner, t.c. memo. 2013-225 (9/23/13). the tax court (judge kroupa) granted the taxpayer’s motion for reconsideration of its decision, 140 t.c. 15 (2/11/13), which disallowed the taxpayer’s claimed stars tax shelter deductions, but only with respect to the disallowance in the earlier decision of interest deductions with respect to a loan incurred as part of the stars transaction. in the earlier proceeding the taxpayer maintained that it did not deduct interest on the loan because it argued that the loan interest and the spread should be treated as though they were paid under an integrated contract. the tax court bifurcated the stars transaction into the loan and the stars structure, and found that the loan proceeds were available for the taxpayer’s use throughout the stars transaction. based on this finding the taxpayer argued that an interest deduction should be allowed, reasoning that the loan was not necessary for the stars structure to produce the disallowed foreign tax credits, and thus loan served a purpose beyond the creation of tax benefits. the court agreed with this argument and allowed the deduction. b. another stars deal is rejected completely. salem financial, inc. v. united states, 112 fed. cl. 543 (9/20/13). the court of federal claims (judge wheeler) – in a very loooong opinion – concluded that “[n]o aspect of the stars transaction has any economic reality.” furthermore, because the taxpayer “was engaged in an economically meaningless tax shelter ... the negligence accuracy-related penalty of § 6662(b)(1) and the substantial understatement accuracy-related penalty of § 6662(b)(2) apply, and that the defenses of reasonable basis, substantial authority, and reasonable cause and good faith are not available [to the taxpayer].” c. but a different court – with a judge of irish descent – sees the stars deal and grants partial summary judgment for the taxpayer; only the shadow [and the first circuit] knows what comes next. santander holdings u.s.a. v. united states, 112 a.f.t.r.2d 2013-6530 (d. mass. 10/17/13). a key element in whether a stars transaction has a reasonable prospect for profit, and thus might not run afoul of the economic substance doctrine, is whether the payment from barclays 2014] recent developments in federal income taxation 377 (the counterparty) to the taxpayer of an amount equal to one-half of the u.k. taxes paid by the taxpayer effectively reduced the taxpayer’s payment of the u.k. taxes as a rebate. (we will not go into the details of the economic analysis.) suffice it to say that the government’s position was that “the barclays payment was not ‘in substance’ a payment by barclays at all, but rather it was ‘effectively’ a rebate of taxes originating from the u.k. tax authorities. the theory is that barclays was only able to make the payment because of the tax credits it had received from the u.k.” the district court (judge o’toole) found the government’s argument on this point “wholly unconvincing,” and held that the barclays payment was not in any way a rebate to the taxpayer of u.k. taxes, citing. reg. § 1.901-2(f)(2), which provides: “tax is considered paid by the taxpayer even if another party to a direct or indirect transaction with the taxpayer agrees, as a part of the transaction, to assume the taxpayer’s foreign tax liability.” accordingly, he ruled that the barclays payment to the taxpayer “should be accounted for as revenue to [the taxpayer] in assessing whether [the taxpayer] had a reasonable prospect of profit in the transaction.” he also rejected the government’s argument that the entire transaction was a “sham” “concocted to manufacture a bogus foreign tax credit,” because he found that argument to be foreclosed by his finding that “[i]f the barclays payment is included in the calculation of pre-tax profitability, then there was a reasonable prospect of profit as to the trust transaction, giving it economic substance.” finally, judge o’toole concluded that under first circuit precedent, if a transaction that had “objective economic substance,” the economic substance doctrine could not be applied to deny the tax benefits of the transaction on “subjective” grounds, although he acknowledged that the first circuit might revisit the issue and “would perhaps move a bit away from a rigid ‘objective only’ test to one that is primarily objective but has room for consideration of subjective factors where necessary or appropriate.” 8. the mighty sword of economic substance strikes down yet another tax shelter. this is getting to be really old news. blum v. commissioner, 737 f.3d 1303 (10th cir. 12/18/13). the taxpayer sold a business and recognized a capital gain of approximately $45 million. kpmg, which had already been preparing the taxpayer’s tax returns for a few years, then sold him an opis tax shelter to reduce his taxes. the tenth circuit was unconcerned with the technical mechanics of the transaction and described the deal as follows: the opis shelter is designed to create large, artificial losses for taxpayers by allowing them to claim a large basis in certain assets. these artificial losses offset actual capital gains, reducing the tax liability of the participating taxpayer. ... there are technical rules that allow certain related parties 378 florida tax review [vol. 15:5 in a financial transaction to claim a basis that, in reality, does not reflect the amount that the party paid for the asset. in fact, the party might not have actually purchased the asset at all. opis took advantage of this technical rule to allow clients to pay a relatively small amount of money in order to claim a disproportionately large basis and to use that basis to shelter their own otherwise taxable income. see generally staff of s. comm. on gov’t affairs, permanent subcomm. on investigations, 108th cong., rep. on u.s. tax shelter industry 5-10, 28 (comm. print 2003) [hereinafter senate report]. individual components of this transaction presented the possibility of profit. no one, however, argues that profits were likely. indeed, while the parties dispute the method used to calculate the likelihood of profit, both agree profits were unlikely. rather, according to mr. blum, the small chance of huge profits justified the risk of such an investment.  the court concluded as follows: we are unconvinced [that mr. blum lacked the subjective motivation to generate a profit from opis] and find ourselves arriving at the same conclusion arrived at by the irs, the u.s. senate committee on governmental affairs, and the tax court. the opis transaction in this case was a sham designed to reduce mr. blum’s tax liability, and it lacked any reasonable probability of generating a profit.  a gross misvaluation penalty, as well as a negligence penalty, was upheld. “mr. blum still relied on a company that was not independent, he signed an opinion letter that he knew or should have known contained a material misrepresentation, and he claims to have relied on advice that he didn’t receive until after he filed his taxes.” b. identified “tax avoidance transactions” there were no significant developments regarding this topic during 2013. c. disclosure and settlement there were no significant developments regarding this topic during 2013. 2014] recent developments in federal income taxation 379 d. tax shelter penalties, etc. 1. the tax court now agrees with the majority of circuits on the 40 percent gross valuation overstatement penalty, leaving the fifth and ninth circuits standing alone together. ahg investments llc v. commissioner, 140 t.c. 73 (3/14/13). in a unanimous reviewed opinion by judge goeke, the tax court overruled its prior decisions in todd v. commissioner, 89 t.c. 912 (1987), aff’d, 862 f.2d 540 (5th cir. 1988), and mccrary v. commissioner, 92 t.c. 827 (1989), and held that a taxpayer may not avoid a 40 percent gross valuation misstatement penalty under § 6662(h) by conceding a deduction or credit on grounds unrelated to value or basis of property. the tax court was persuaded that in its earlier cases it had misinterpreted a passage in the general explanation of the economic recovery tax act of 1981, which stated “the portion of a tax underpayment that is attributable to a valuation overstatement will be determined after taking into account any other proper adjustments to tax liability. thus, the underpayment resulting from a valuation overstatement will be determined by comparing the taxpayer’s (1) actual tax liability (i.e., the tax liability that results from a proper valuation and which takes into account any other proper adjustments) with (2) actual tax liability as reduced by taking into account the valuation overstatement. the difference between these two amounts will be the underpayment that is attributable to the valuation overstatement.” upon reconsidering the issue in ahg investments, the tax court quoted with approval the federal circuit opinion in alpha i, l.p. v. united states, 682 f.3d 1009 (fed. cir. 2012), which stated: the blue book, in sum, offers the unremarkable proposition that, when the irs disallows two different deductions, but only one disallowance is based on a valuation misstatement, the valuation misstatement penalty should apply only to the deduction taken on the valuation misstatement, not the other deduction, which is unrelated to valuation misstatement. the court in todd mistakenly applied that simple rule to a situation in which the same deduction is disallowed based on both valuation misstatement-and non-valuationmisstatement theories.  the tax court holding in ahg investments follows the rule adopted by the majority of the circuit courts of appeal. see, e.g., fidelity international currency advisor a fund llc v. united states, 661 f.3d 667 (1st cir. 2011); alpha i lp v. united states, 682 f.3d 1009 (fed. cir. 2012); and gustashaw v. commissioner, 696 f.3d 1124 (11th cir. 2012). the fifth circuit and ninth circuit follow the rule that the tax court established in todd but repudiated in ahg investments llc. see 380 florida tax review [vol. 15:5 todd v. commissioner, 862 f.2d 540 (5th cir. 1988); gainer v. commissioner, 893 f.2d 225 (9th cir. 1990). a. the supreme court will take up the conflict between the fifth and ninth circuits, on the one hand, and the tax court and the other circuits, on the other hand. woods v. united states, 471 fed. appx. 320 (5th cir. 6/6/12), rev’d, 134 s. ct. 557 (12/3/13). this case presented the issue of the applicability of the valuation overstatement penalty, more specifically whether tax underpayments are “attributable to” overstatements of basis when the inflated basis claim has been disallowed based on a finding that the underlying transactions lacked economic substance. the fifth circuit in a per curiam opinion held that the issue was well-settled and required no discussion in light of bemont invs., l.l.c. v. united states, 679 f.3d 339 (5th cir. 4/26/12); heasley v. commissioner, 902 f.2d 382 (5th cir. 1990); and todd v. commissioner, 862 f.2d 540 (5th cir. 1988). the court also added a second question for the parties to brief: “whether the district court had jurisdiction in this case under 26 u.s.c. § 6226 to consider the substantial valuation misstatement penalty.” this issue involves the general question under tefra of which issues are to be resolved in a partner-level proceeding and which should be resolved at the partnership level.  any supreme court resolution of the 40percent-penalty issue will be less important for years governed by § 7701(o), which provides for a 40-percent penalty on transactions lacking economic substance. b. the seventh circuit joins the majority. superior trading, llc v. commissioner, 728 f.3d 676 (7th cir. 8/26/13). in an opinion by judge posner the seventh circuit applied the 40 percent gross valuation misstatement penalty to a partnership tax shelter disregarded under the economic substance doctrine. the court opined that “a taxpayer who overstates basis and participates in sham transactions, as in this case, should be punished at least as severely as one who does only the former.” 2. the supreme court [unnecessarily?] addresses an issue of statutory interpretation that has implications far beyond the specific context of the case. united states v. woods, 134 s. ct. 557 (12/3/13). in a unanimous opinion by justice scalia, the court held (1) that pursuant to § 6226(f), which provides that a court in partnership-level tefra proceeding has jurisdiction to determine “the applicability of any penalty . . . which relates to an adjustment to a partnership item,” the applicability of the § 6662(b)(3) valuation overstatement penalty could be determined at the partnership level, and (2) that the § 6662(b)(3) valuation 2014] recent developments in federal income taxation 381 overstatement penalty applies to an underpayment resulting from a basisinflating transaction that is disregarded for lack of economic substance.  on the jurisdictional issue, the court noted that the tefra partnership-level determination maybe be provisional, stating that: tefra gives courts in partnership-level proceedings jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if imposing the penalty would also require determining affected or non-partnership items such as outside basis. the partnership level applicability determination, we stress, is provisional: the court may decide only whether adjustments properly made at the partnership level have the potential to trigger the penalty. each partner remains free to raise, in subsequent, partner-level proceedings, any reasons why the penalty may not be imposed on him specifically.  turning to the substantive issue, justice scalia wrote that “[t]he penalty’s plain language makes it applicable here.” for the year at issue, § 6662(e)(1)(a) provides that “there is a substantial valuation misstatement under chapter 1 if . . . the value of any property (or the adjusted basis of any property) claimed on any return of tax imposed by chapter 1 is 200 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis (as the case may be).” (section 6662(e)(1)(a) now has a 150 percent threshold.) [t]he cobra transactions were designed to generate losses by enabling the partners to claim a high outside basis in the partnerships. but once the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim an outside basis greater than zero. accordingly, if a partner used an outside basis figure greater than zero to claim losses on his tax return, and if deducting those losses caused the partner to underpay his taxes, then the resulting underpayment would be “attributable to” the partner’s having claimed an “adjusted basis” in the partnerships that exceeded “the correct amount of such . . . adjusted basis.”  justice scalia rejected the taxpayer’s argument that the valuation misstatement had to be a “factual” one that excluded threshold legal determinations, and held that “the valuationmisstatement penalty encompasses legal as well as factual misstatements of adjusted basis.” he noted that the holding did not render superfluous the § 6662(b)(6) penalty for transactions lacking in economic substance that was enacted in 2010. “the new penalty covers all sham transactions, including those 382 florida tax review [vol. 15:5 that do not cause the taxpayer to misrepresent value or basis; thus, it can apply in situations where the valuation misstatement penalty cannot.”  finally, justice scalia went out of his way to trash the taxpayer’s reliance on the bluebook for the economic recovery tax act of 1981, which explained in part the scope of the valuation misstatement penalty. although he found the particular language in the bluebook to which the taxpayer had pointed to be unpersuasive, he generally disparaged reliance on the bluebook for anything more than its persuasive power. blue books are prepared by the staff of the joint committee on taxation as commentaries on recently passed tax laws. they are “written after passage of the legislation and therefore d[o] not inform the decisions of the members of congress who vot[e] in favor of the [law].” flood v. united states, 33 f.3d 1174, 1178 (ca9 1994). we have held that such “[p]ost-enactment legislative history (a contradiction in terms) is not a legitimate tool of statutory interpretation.” bruesewitz v. wyeth llc, 562 u. s. ___, ___ (2011) (slip op. at 17-18); accord, federal nat. mortgage assn. v. united states, 379 f.3d 1303, 1309 (ca fed. 2004) (dismissing blue book as “a post-enactment explanation”). while we have relied on similar documents in the past, see fpc v. memphis light, gas & water div., 411 u.s. 458, 471-472 (1973), our more recent precedents disapprove of that practice. of course the blue book, like a law review article, may be relevant to the extent it is persuasive. but the passage at issue here does not persuade. it concerns a situation quite different from the one we confront: two separate, non overlapping underpayments, only one of which is attributable to a valuation misstatement.  this discussion of the bluebook in the text of the opinion is particularly notable because justice scalia dismissed in a footnote the taxpayer’s arguments based on legislative history. “whether or not legislative history is ever relevant, it need not be consulted when, as here, the statutory text is unambiguous.” 3. a total loss for this taxpayer was in the cards. kerman v. commissioner, 713 f.3d 849 (6th cir. 4/8/13), cert. denied, 2014 wl 102428, (1/13/14). the sixth circuit (judge ludington) decided the substantive issues in favor of the government, and the 40 percent valuation overstatement penalty was applied. 2014] recent developments in federal income taxation 383 4. even if krause is sour, partners are still liable for increased interest on substantial underpayments attributable to tax motivated transactions. bush v. united states, 717 f.3d 920 (fed. cir. 5/30/13). in an opinion by judge newman, the court of appeals affirmed the court of federal claims, which dismissed the suit under § 7422(h) on the basis that it lacked jurisdiction under the tefra audit rules. bush v. united states, 101 fed. cl. 791 (11/14/11). the taxpayers, who were partners of the denver-based dillon oil technology partnership, challenged the irs’s assessment of enhanced interest for tax years 1983 and 1984 pursuant to former § 6621(c). former § 6621(c) imposed an increased rate of interest “with respect to any substantial underpayment attributable to tax motivated transactions.” the irs had issued fpaas to dillon oil for tax years 1983 and 1984 and to other similarly situated denver-based partnerships disallowing losses of the partnerships. dillon oil and the other partnerships filed petitions in the tax court. the tax court proceedings were stayed pending resolution of krause v. commissioner, 99 t.c. 132 (1992), which was a test case for over 2,000 related cases. in krause, the tax court disallowed losses of the partnerships under § 183 because the partnerships’ activities lacked profit objectives and upheld the imposition of increased interest under former § 6621(c). after the krause decision, several partnerships in the tax court proceeding involving dillon oil moved to compel the irs to settle based on terms to which the irs had agreed in some cases prior to the krause decision. these terms allowed the partnerships to take deductions up to the amount of cash invested and imposed no penalties other than increased interest under former § 6621(c) (or its predecessor provision). (after krause, the irs settled by disallowing all deductions and imposing increased interest.) the tax court denied these motions and noted that it previously had concluded that partners who had not settled with the irs prior to krause were bound by the krause decision. vulcan oil tech. partners v. commissioner, 110 t.c. 153, 154-55 (1998). the tax court proceedings involving dillon oil ultimately were dismissed for lack of prosecution, and the dillon oil partners did not appeal the dismissal. the irs later sent form 4549a to the dillon oil partners informing them that they would be assessed increased interest under former § 6621(c). the dillon oil partners paid the interest and brought a refund action in the court of federal claims, in which they argued that the krause decision was “wrong as a matter of law” and that they were not bound by it. they noted that the fifth circuit, in a separate proceeding involving other partnerships, had held (contrary to other circuits) that the tax court in krause had erred in imposing increased interest pursuant to former § 6621(c) because the regulations under that provision permitted increased interest when losses were “disallowed for any period under section 183,” and the deductions in krause were not in fact disallowed under § 183, which by its terms applies to activities engaged in by individuals and s corporations. copeland v. 384 florida tax review [vol. 15:5 commissioner, 290 f.3d 326 (5th cir. 2002). the federal circuit rejected the taxpayers’ arguments and agreed with the court of federal claims that the dillon oil partners were bound by the krause decision, including its conclusion regarding the imposition of increased interest under former § 6621(c). the court reasoned that the dillon oil partners lost their opportunity to challenge krause when their tax court proceeding was dismissed for lack of prosecution. to set aside the irs’s imposition of increased interest for tax motivated transactions, the court stated, would require relitigating the tax court’s decision to bind dillon oil to the krause decision. the court concluded that whether the dillon oil partnership is bound by krause is a partnership level issue that must be determined at the partnership level rather than at the partner level. ix. exempt organizations and charitable giving a. exempt organizations 1. hock mir nicht kein chna! 8 reg-10649912, community health needs assessments for charitable hospitals, 78 f.r. 20523 (4/5/13). these proposed amendments to reg. §§ 1.509(r)-1 through 7 provide detailed guidance to charitable hospital organizations on the community health needs assessment (chna) requirements, and related excise tax and reporting obligations, enacted as part of the patient protection and affordable care act of 2010.  each § 501(c)(3) hospital organization is required to meet four general requirements on a facility-by-facility basis: -establish written financial assistance and emergency medical care policies; -limit amounts charged for emergency or other medically necessary care to individuals eligible for assistance under the hospital’s financial assistance policy; -make reasonable efforts to determine whether an individual is eligible for assistance under the hospital’s financial assistance policy before engaging in extraordinary collection actions against the individual; and -conduct a community health needs assessment (chna) and adopt an implementation strategy at least once every three years. (these chna requirements are effective for tax years beginning after 3/23/12.) 8. or, chinik. literally, “don’t knock my teakettle!” or, “stop bothering me!” 2014] recent developments in federal income taxation 385 2. the aba loses another tax case. aba retirement funds v. united states, 111 a.f.t.r.2d 2013-1815 (n.d. ill. 4/25/13). the district court held that the aba retirement funds (formerly known as the american bar retirement association), a not-for-profit corporation that creates and maintains irs-approved master tax-qualified retirement plans for adoption by lawyers and law firms, does not qualify as a tax-exempt “business league” under § 501(c)(6). to be a tax exempt business league, reg. § 1.501(c)(6)-1 requires that an organization be (1) of persons having a common business interest; (2) whose purpose is to promote the common business interest; (3) not organized for profit; (4) that does not engage in a regular business of a kind ordinarily conducted for profit; (5) whose activities are directed to the improvement of business conditions at one or more lines of a business as distinguished from the performance of particular services for individual persons; and (6) of the same general class as a chamber of commerce or a board of trade. the court found that aba retirement funds was engaged in a business generally carried on for profit. it competed with other retirement funds, and it “sought market share, not market welfare.” the fees for its services were paid by individuals in proportion to the benefits they derived from those services. most significantly, the court found that its activities were directed principally to individual lawyers and law firms rather than to promoting the well-being of the legal profession generally: “the requirement to promote the welfare of the general industry surely demands more than offering goods or services that may enhance the individual practices of the attorneys who purchase them.”  although the aba lost in the supreme court, united states v. american bar endowment, 477 u.s. 105 (1986) (american bar endowment’s income from life insurance policy dividends retained represent profits from the insurance program rather than charitable donations from your members. the court further stated that if the members were given a choice between allowing the american bar endowment to retain the dividends and having the dividends refunded to them, then the dividends retained might constitute charitable donations rather than unrelated business income.), it changed its insurance arrangements to achieve the same result by permitting cash refunds to policyholders who claimed them in writing each year, p.l.r. 8725056 (3/25/87). 3. will superman 9 arrive in time to share an aperitif with lois lerner? not before she took the entire fifth for herself. irs official admitted to using political criteria to target certain applicants for § 501(c)(4) status, and stated that this was known to upper-level officials in 2011. lois lerner is now on paid administrative leave, having reportedly 9. the person from the planet krypton. 386 florida tax review [vol. 15:5 refused to resign from the irs. under questioning by congress in 2012, commissioner douglas shulman denied that political criteria were used to target certain applications, even though he attended 157 (or more, or fewer) easter egg rolls at the white house during his term as commissioner of internal revenue. a tigta report on this practice was released.  in a prepared statement dated 5/21/13 for testimony before the senate finance committee on the following day, the treasury inspector general for tax administration, j. russell george, concluded that the irs has still not satisfactorily resolved the problems identified in the report: irs’s response to our recommendations tigta made nine recommendations to provide more assurance that applications are processed in a fair and impartial manner in the future without unreasonable delay. the irs agreed to seven of our nine recommendations and proposed alternative corrective actions for two of our recommendations. however, we do not agree that the alternative corrective actions will accomplish the intent of the recommendations. one of these recommendations was that the irs should clearly document the reason applications are chosen for further review for potential political campaign intervention. the second was that the irs should develop specific guidance for specialists processing potential political cases and publish the guidance on the internet. further, the irs’s response also states that issues discussed in the report have been resolved. we disagree with this assertion. until all of our recommendations are fully implemented and the numerous applications that were open as of december 2012 are closed, we do not consider the concerns in this report to be resolved. in addition, as part of our mission, tigta will also determine whether any criminal activity or administrative misconduct occurred during this process. the attached tigta report includes additional information on all nine recommendations and the irs’s planned corrective actions and completion dates.  superman, using treasury secretary lew as a conduit, asked acting commissioner of internal revenue steven miller to resign, and daniel werfel was appointed as acting commissioner effective 5/22/13. although he is a lawyer and worked in the department of justice civil rights division, werfel has absolutely no prior tax experience.  included among the “two rogue agents in cincinnati” are holly paz (acting director of rulings and agreements at the irs's tax-exempt and government entities division, fired; replaced 6/10/13 as 2014] recent developments in federal income taxation 387 acting director by karen schiller, who was director for exam planning and delivery at the irs small business/self-employed division), carter hull (washington irs lawyer who was overruled by washington superiors when he recommended making decisions on § 501(c)(4) applications without additional scrutiny, retiring), sarah hall ingram (who always seemed to be doing something other than work her title called for), and joseph grant (commissioner of tax exempt and government entities division and lois lerner’s boss, retired on 6/3/13). a. the only scandal at the irs is that it appears to be knuckling under to pressure and declining to enforce the law, and no one can force it to do what’s right. fs-2013-8 (6/24/13). the irs announced that it is offering certain organizations that have applied for § 501(c)(4) status an optional fast-track method to obtain tax-exempt status. the irs will offer the expedited option to groups that have had their applications pending for more than 120 days and involve possible political campaign intervention or issue advocacy.” this “safe-harbor” option will provide certain groups an approved determination letter granting them 501(c)(4) status within two weeks if they certify they devote 60 percent or more of both their spending and time on activities that promote social welfare as defined by section 501(c)(4). at the same time, they must certify that political campaign intervention involves 40 percent or less of both their spending and time. these thresholds apply for past, current and future years of operation. solely for the purpose of determining eligibility for the expedited procedure, an organization must count, among other things, any public communication identifying a candidate that occurred within 60 days prior to a general election or 30 days prior to a primary as political campaign intervention. (emphasis added)  section 501(c)(4) allows tax-exempt status for “[c]ivic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare … .” in a bit of orwellian logic, reg. § 1.501(c)(4)-1(a)(2)(i), redefines “exclusively” as “primarily,” but it really is doubtful that the language of the regulation was intended to allow any political activities. it most likely was intended to preserve tax-exempt status for organizations subject to ubit. see ellen aprill, the irs’s tea party tax row: how ‘exclusively’ became ‘primarily’, http://www.psmag.com/politics/theirss-tea-party-tax-row-how-exclusively-became-primarily-59451/. at least 388 florida tax review [vol. 15:5 some of us 10 believe that if the irs had done so at the outset – years ago – it could have said zero, nada political activities allowed under the code and regulations language. b. these allegations are unanswerable. van hollen v. internal revenue service (d. d.c., no. 1:13-cv-01276, filed 8/21/13). representative chris van hollen (d.-md) and three nonprofit organizations filed a complaint in a district court for the district of columbia seeking declaratory, injunctive, and mandamus relief against the irs and treasury department for allowing tax-exempt organizations to expend substantial sums on electoral activity, claiming it is contrary to the plain meaning of § 501(c)(4). the introduction to the complaint summarizes the cause of action as follows: 1. plaintiffs chris van hollen, democracy 21, campaign legal center, and public citizen bring this action under the administrative procedure act (apa), 5 u.s.c. §§ 702, 703, 704, and 706(1) & (2)(a), to compel agency action unlawfully withheld and unreasonably delayed, and to set aside agency action that is contrary to law. defendant internal revenue service (irs) has for many years violated the internal revenue code (irc) by allowing tax-exempt social welfare organizations to expend substantial sums on electoral activity. the irc provides that tax-exempt social welfare organizations must be “exclusively” engaged in “promotion of social welfare.” irc § 501(c)(4). the irs’s implementing regulation recognizes that electoral activity does not fall within the scope of activity promoting social welfare. treasury regulation (tr) § 1.501(c)(4)-1(a)(2)(ii). but the irs’s regulation also purports to provide that an organization operates “exclusively” to promote social welfare as long as it is operated “primarily” for social 10. guess which two. ira still believes what celia roady said when she said that lois lerner did not plant her question at the aba tax section meeting because ellen aprill vouched for celia’s credibility. he still believes jay carney when he echoed lois lerner’s conclusion that the entire so-called scandal consisted in the actions of a couple of rogue agents in cincinnati. he believes everything that lois lerner and holly paz said, and sees no need to question either one further. he continues to believe elijah cummings and sander levin when they said that progressive groups were treated as badly as (or worse than) tea party groups, and that darryl issa is blowing up the so-called scandal beyond all proportion because nothing wrong happened. inasmuch as none of these organizations were entitled to § 501(c)(4) status, what difference does it make? 2014] recent developments in federal income taxation 389 welfare purposes. id. § 1.501(c)(4)-1(a)(2)(i). by redefining “exclusively” as “primarily” in violation of the clear terms of its governing statutes, the irs permits tax-exempt social welfare organizations to engage in substantial electoral activities in contravention of the law and court decisions interpreting it. 2. instead of amending its rules to conform to the requirements of irc section 501(c)(4), the irs has recently taken action with precisely the opposite effect: it has issued a directive providing a “safe harbor” for certain organizations seeking exemption under section 501(c)(4) if they spend no more than 40% of their time and expenditures on electoral campaign activities and stating that even organizations that expend more than this percentage on electoral campaign intervention may qualify for tax-exempt status under section 501(c)(4) because the irs may consider them to be “primarily” engaged in social welfare activities. the irs’s new directive confirms that the irs interprets its regulation to allow substantial electoral campaign intervention by section 501(c)(4) organizations - intervention up to and in some circumstances exceeding 40% of their activity -despite the statutory requirement that they be exclusively engaged in social welfare activities. the irs’s action thus makes the extent of the conflict between its regulation and the statute even more explicit and will injure the plaintiffs by fostering increased electoral campaign spending without donor disclosure by ostensible section 501(c)(4) organizations. the plaintiffs therefore request that the court declare the irs’s new “safe harbor” directive unlawful insofar as it permits section 501(c)(4) organizations to spend amounts up to and exceeding 40% of their time and money on electoral campaign intervention. c. the taxpayer advocate weighs in. national taxpayer advocate, special report to congress, political activity and the rights of applicants for tax-exempt status, www.taxpayeradvocate.irs.gov/2014objectivesreport (6/30/13). the taxpayer advocate identified several categories of problems including, among others: (1) the legal standard under the statute that a § 501(c)(4) exclusively engage in promoting social welfare, interpreted as “primarily” engaged in promoting the common good is ambiguous, and there is no guidance as to the degree of permissible political activity, (2) unlike the case where an application for § 501(c)(3) status is rejected, there is no process for 390 florida tax review [vol. 15:5 judicial review that might provide guidance, (3) the irs as a tax agency may not be the most qualified governmental agency to make inherently controversial determinations about political activity, (4) the form 1024 application for recognition of exempt status does not include questions to identify excessive political activity, which is difficult to assess before operations have commenced, (5) eo failed to publically disclose its procedures and there are no checks and balances with regard to taxpayer rights, and (6) eo management failed to install an adequate inventory management system and failed to ensure that requests for guidance received a timely response. d. proposed regulations to exclude conservative organizations from § 501(c)(4) status, while leaving relatively undisturbed the many liberal organizations whose applications sailed through while a couple of rogue irs agents in cincinnati were playing games with applications from conservative organizations seeking such status. reg-134417-13, guidance for taxexempt social welfare organizations on candidate-related political activities, 78 f.r. 71535 (11/29/13). the proposed regulations would revise reg. § 1.501(c)(4)-1(a)(2)(ii) to state that “[t]he promotion of social welfare does not include direct or indirect candidate-related political activity.” they state that communications which expressly support a clearly identified candidate of a political party would be considered candidate-related political activity, as would communications that are made within 60 days of a general election (or within 30 days of a primary contest) and that clearly identify a candidate or party. contributions reportable under campaign finance laws and grants to § 527 political organizations and other exempt entities that are politically active also would be considered political, as would voter registration and get-out-the-vote drives, distribution of materials prepared by or for candidates or by a § 527 organization, preparation or distribution of voter guides that refer to candidates (or to parties in a general election), and events a candidate attends that are held within 60 days of an election or within 30 days of a primary.  the preamble to the proposed regulations says: the treasury department and the irs are considering whether the current section 501(c)(4) regulations should be modified in this regard and, if the “primarily” standard is retained, whether the standard should be defined with more precision or revised to mirror the standard under the section 501(c)(3) regulations. given the potential impact on organizations currently recognized as described in section 2014] recent developments in federal income taxation 391 501(c)(4) of any change in the “primarily” standard, the treasury department and the irs wish to receive comments from a broad range of organizations before deciding how to proceed. accordingly, the treasury department and the irs invite comments from the public on what proportion of an organization's activities must promote social welfare for an organization to qualify under section 501(c)(4) and whether additional limits should be imposed on any or all activities that do not further social welfare. the treasury department and the irs also request comments on how to measure the activities of organizations seeking to qualify as section 501(c)(4) social welfare organizations for these purposes.  see, also, b., above, in which there is a description of a lawsuit to force the irs to adopt regulations to prohibit § 501(c)(4) organizations from engaging in any political activity. on 12/6/13, the plaintiffs announced that they were dropping their unanswerable lawsuit. 4. it was really a partner of the home sellers, not a charitable partner. partners in charity, inc. v. commissioner, 141 t.c. no. 2 (8/26/13). pic was established as a nonprofit corporation under state law and received a determination that it was a § 501(c)(3) organization based on its claim its primary activity was to provide down-payment assistance grants to home buyers. pic’s “down payment assistance” program provided home buyers with funds to use for down payments for home purchases. in practice, however, pic obtained those funds (along with a fee) from home sellers. pic provided down-payment assistance grants where the seller was not reimbursing the down payment and paying pic’s fee in only two-tenths of 1% of its transactions. the irs retroactively revoked pic’s tax-exempt status on the ground that pic was not operated exclusively for a charitable purpose. the tax court (judge gustafson) upheld that revocation and held further that the irs did not abuse its discretion in retroactively revoking its determination that pic was a § 501(c)(3) organization. in its operation, pic failed to serve a charitable class, and a substantial amount of its activity did not further a charitable purpose, but rather furthered instead an unrelated business. pic did not limit its grants to low-income home buyers. pic engaged in two overlapping but distinct forms of activities: (1) activities that ultimately benefited the buyers — grants and homeowner education, and (2) activities that ultimately benefited the sellers — providing ready buyers, and promoting faster sales at generally higher prices. pic’s transactions with sellers generated revenues of over $28 million in 2002 and $32 million in 2003 and were clearly substantial. even if pic’s buyer-benefitting activities served an exempt purpose, pic’s seller-benefitting activities failed to further an exempt purpose and defeated the argument that pic was operated exclusively for a charitable purpose. “pic’s primary purpose was to broker 392 florida tax review [vol. 15:5 as many transactions as possible and thus to generate significant net profits, regardless of whether the transactions achieved a charitable end.” 5. the gymnastics booster club suffered the tax equivalent of a fall from the balance beam. capital gymnastics booster club, inc. v. commissioner, t.c. memo. 2013-193 (8/26/13). capital gymnastics booster club, inc. was formed to support the activities of young athletes from approximately 240 families. its members were the parents of the young athletes. the athletes were all on teams from one local private gym, to which each family individually paid tuition and other fees. these teams competed in meets, which required substantial additional funds that capital gymnastics collected and administered. parents of athletes who wanted to participate on the teams that were operated out of that private gym were required to be members of capital gymnastics. each family paid an annual assessment to cover the entry fees to compete in the meets and to offset the estimated expenditures for the coaches’ travel. a family could satisfy its assessment either by paying cash or by participating in capital gymnastics fund-raising program. the amount that a family raised was credited against the assessment. fund-raising-generated net profits reduced the assessment between 50% and 70% for the families that fund-raised. families that did not fund-raise paid the full assessment. in the taxpayer’s suit for a declaratory judgment that it was a § 501(c)(3) organization, the tax court (judge gustafson) upheld the irs’s determination that capital gymnastics was not operated exclusively for exempt purposes. its net earnings inured to the benefit of its fund-raising parent members, and it conferred substantial private benefit on children of those fund-raising families. 6. vexatious litigation for personal purposes does not serve charitable purposes, as established by multiple irs requests for information. although he was entitled to a review of the irs denial of § 501(c)(3) status – unlike seekers of § 501(c)(4) status – mr. huggins lost in the tax court. council for education v. commissioner, t.c. memo. 2013-283 (12/16/13). following his failure to graduate from the university of california santa barbara, between 1993 and 2002 harold huggins initiated a series of claims and lawsuits against the university, its academic senate (which one of us twice chaired), the california student aid commission, and the western association of schools and colleges, alleging that the defendants coerced him into withdrawing from ucsb, extorted students loans through grade fraud and intimidation and violated rico and the false claims act. the tax court (special trial judge guy) pointed out that all of these claims were dismissed and that mr. huggins was declared by the federal district court to be a vexatious litigant. in 2006 mr. huggins 2014] recent developments in federal income taxation 393 organized the petitioner as a nonprofit mutual benefit corporation to investigate academic fraud with the specific purpose to investigate and report fraudulent activities relating to student loan programs, advocate for student loan recipients, and enforce department of education accreditation standards for all students regardless of race or ethnicity. in 2008, the petitioner sought recognition of the organization as a charitable organization under § 501(c)(3). petitioner continued to file claims similar to mr. huggins prior actions, and formed a “special committee 1868” to gather evidence that former uc regent ward connerly (who was a leading advocate of california’s proposition 209 that prohibited race and gender based discrimination in public employment, education, and contracting) was an unregistered foreign agent, abused his position as a regent and had personal financial interest in matters before the uc board of regents and had organized so-called civil rights organizations to deceive california voters. following multiple administrative inquiries for information regarding petitioner’s activities, the irs denied the claim for exemption. the court affirmed the denial. the court recognized that an organization may qualify for charitable status where in carrying out its primary purpose the organization advocates social or civic changes or presents opinions on controversial issues. the court also observed that the irs recognizes that organizations that provide legal services or engage in litigation may serve a charitable purpose. however, the court noted that where an individual creates and controls the affairs of an organization without an independent board of directors “there is an obvious opportunity for abuse.” the court stated that “[p]rominent among petitioner’s shortcomings are the lack of a formal business plan and an independent board of directors to provide operational guidance and oversight.” the court further indicated that mr. huggins, acting as petitioner’s sole officer, director, and employee, did not demonstrate the skills to conduct petitioner’s operations to achieve its charitable purpose to further the public good. indeed, the court indicated that it “would be hard pressed to say that petitioner’s operations do not more than incidentally further mr. huggins’ private interests.” b. charitable giving 1. what part of “perpetuity” don’t you understand?! belk v. commissioner, 140 t.c. 1 (1/28/13). the taxpayers claimed a charitable contribution deduction for the grant of a conservation easement on 184.627 acres of a golf course to a qualified organization. specifically, they agreed not to develop the golf course. however, the conservation easement agreement permitted the taxpayers, with the donee’s consent, to remove portions of the golf course from the easement and replace them with property not theretofore subject to the conservation easement. the irs disallowed the deduction, and the tax court (judge vasquez) upheld the 394 florida tax review [vol. 15:5 irs’s disallowance of the deduction. section 170(h)(1)(a) requires the contribution of a “qualified” real property interest, and to be a “qualified” real property interest, § 170(h)(2)(c) requires that the conservation easement limit in perpetuity the use that may be made of the property. section 170(h)(2)(c) precluded the deduction because the taxpayers did not donate an interest in real property subject to a use restriction granted in perpetuity. because the conservation easement agreement allowed the parties to change the property subject to the conservation easement, it did not meet the perpetuity requirement. the court rejected the taxpayers’ argument the deduction nevertheless should be allowed because the substitution clause permitted only substitutions that would not harm the conservation purposes of the conservation easement. the court reasoned that the § 170(h)(5) requirement that the conservation purpose be protected in perpetuity is separate and distinct from the § 170(h)(2)(c) requirement that there be real property subject to a use restriction in perpetuity, and the taxpayers’ conveyance failed to satisfy § 170(h)(2)(c). satisfying § 170(h)(5) does not necessarily affect whether there is a qualified real property interest. furthermore, it was argued that any substitution required the donee’s consent: “there is nothing in the code, the regulations, or the legislative history to suggest that section 170(h)(2)(c) is to be read to require that the interest in property donated be a restriction on the use of the real property granted in perpetuity unless the parties agree otherwise. the requirements of section 170(h) apply even if taxpayers and qualified organizations wish to agree otherwise.”  the irs was represented in this case by one of professor mcmahon’s former research assistants. the tax court judge was one of professor shepard’s former research assistants. [so there, marty!] a. reconsideration denied. belk v. commissioner, t.c. memo. 2013-154 (6/19/13). judge vasquez denied the taxpayer’s motion for reconsideration. first, the taxpayer argued that the original opinion misinterpreted § 170(h)(2)(c), arguing that the code and regulations do “not require the donation of an interest in ‘an identifiable, unchanging, static piece of real property.’” the taxpayer argued that as long as it “agree[d] not to develop 184.627 acres of land, the court (and the internal revenue service (irs)) should not be concerned with what land actually comprises those 184.627 acres.” judge vasquez reiterated that the court had “rejected the notion of such ‘floating easements’ ... and found that section 170(h)(2)(c) requires that taxpayers donate an interest in an identifiable, specific piece of real property.” not being bound by any rule that arguments had to be consistent, the taxpayer’s second argument was that because the taxpayer had intended to obtain a deduction for granting the conservation easement the court had misinterpreted the conveyance and 2014] recent developments in federal income taxation 395 applicable state law as permitting a substitution. this argument also fell on deaf ears: “our interpretation of the parties’ intention is governed by what the parties actually included in the conservation easement agreement. it is well settled that a taxpayer’s expectations and hopes as to the tax treatment of his conduct in themselves are not determinative.” finally, the taxpayer argued that the original opinion “fail[ed] to consider that an element of trust and confidence is placed in a qualified organization that it will continue to carry out its mission to protect and conserve property.” judge vasquez responded, “because the parties have agreed petitioners are able to substitute land, there is no restriction on the golf course in perpetuity that we can trust smnlt to enforce.” 2. a “gotcha” for the irs! the tax court just says “no” to deductions for contributions of conservation easements on mortgaged properties. kaufman v. commissioner, 134 t.c. 182 (4/26/10). the tax court (judge halpern) held that as a matter of law no charitable contribution deduction is allowable for the conveyance of an otherwise qualifying conveyance of a facade conservation easement if the property is subject to a mortgage and the mortgagee has a prior claim to condemnation and insurance proceeds. because the mortgage has priority over the easement, the easement is not protected in perpetuity – which is required by § 170(h)(5)(a). the deduction cannot be salvaged by proof that the taxpayer likely would satisfy the debt secured by the mortgage. b. plea for a mulligan is rejected! kaufman v. commissioner, 136 t.c. 294 (4/4/11). on the taxpayers’ motion for reconsideration, the tax court (judge halpern) in a lengthy and thorough opinion reaffirmed its earlier decision that the conservation easement failed the perpetuity requirement in reg. § 1.170a-14(g)(6), because under the loan documents, the bank that held the mortgage on the property expressly retained a “‘prior claim’ to all insurance proceeds as a result of any casualty, hazard, or accident occurring to or about the property and all proceeds of condemnation,” and agreement also provided that “the bank was entitled to those proceeds ‘in preference’ to [the donee organization] until the mortgage was satisfied and discharged.” the court also disallowed a deduction in 2003, but allowed the deduction in 2004, for a cash contribution to the donee of the conservation easement in 2003 because the amount of the cash payment was subject to refund if the appraised value of the easement was zero, and the appraisal was not determined until 2004. the court also rejected the irs’s argument that the taxpayers received a quid pro quo for the cash contribution in the form of the donee organization accepting and processing their application, providing them with a form preservation restriction agreement, undertaking to obtain approvals from the necessary government authorities, securing the lender agreement from the bank, giving 396 florida tax review [vol. 15:5 the taxpayers basic tax advice, and providing them with a list of approved appraisers. the facts in evidence did not demonstrate a quid pro quo, because, among other things, many of the tasks had been undertaken by the organization before the check was received.  finally, the court declined to uphold the § 6662 accuracy related penalties asserted by the irs for the taxpayers’ overstatement of the amount of the contribution for the conservation easement, but sustained the negligence penalty for the 2003 deduction for the cash payment. because the issue of whether any deduction was allowed for the easement, regardless of its value, was a matter of law decided in the case as a matter of first impression, the taxpayers were not negligent, had reasonable cause, and acted in good faith. c. the taxpayer wins the battle in the court of appeals with an excellent discussion of charitable contributions of easements on mortgaged property, but still might lose the war. kaufman v. shulman, 687 f.3d 21 (1st cir. 7/19/12). the first circuit, however, in an opinion by judge boudin, disagreed with the tax court, holding that a mortgagee’s right to satisfy the mortgage lien before the donee of the conservation easement is entitled to any amount from the sales or condemnation proceeds from the property does not necessarily defeat the charitable contribution deduction. judge boudin’s opinion noted that “the kaufmans had no power to make the mortgage-holding bank give up its own protection against fire or condemnation and, more striking, no power to defeat tax liens that the city might use to reach the same insurance proceeds – tax liens being superior to most prior claims, 1 powell on real property § 10b.06[6] (michael allan wolf ed., matthew bender & co. 2012), including in massachusetts the claims of the mortgage holder.” 11 the opinion continued by observing that [g]iven the ubiquity of super-priority for tax liens, the irs’s reading of its regulation would appear to doom practically all donations of easements, which is surely contrary to the purpose of congress. we normally defer to an agency’s reasonable reading of its own regulations, e.g., united states v. cleveland indians baseball co., 532 u.s. 200, 220 (2001), but cannot find reasonable an impromptu reading that is not compelled and would defeat the purpose of the statute, as we think is the case here. 11. we include the citation to powell on real property in the quotation because michael allan wolf is a colleague of professor mcmahon’s, and the uf dean rewards faculty members based, in part, on their citation count. 2014] recent developments in federal income taxation 397 thus, the first circuit rejected the tax court’s requirement that the donee of the conservation easement have “an absolute right” (136 t.c. at 313), holding that a “grant that is absolute against the owner-donor” is sufficient “and almost the same as an absolute one where third-party claims (here, the bank’s or the city’s) are contingent and unlikely.”  the first circuit went on to reject the irs’s argument that contribution also failed to qualify for a charitable contribution deduction because a provision in the agreement between the kaufmans and the donee trust stated that “nothing herein contained shall be construed to limit the [trust’s] right to give its consent (e.g., to changes in the façade) or to abandon some or all of its rights hereunder,” citing commissioner v. simmons, 646 f.3d 6 (d.c. cir. 2011), which reasoned that such clauses permitting consent and abandonment “‘have no discrete effect upon the perpetuity of the easements: any donee might fail to enforce a conservation easement, with or without a clause stating it may consent to a change or abandon its rights, and a tax-exempt organization would do so at its peril.’” (quoting 646 f.3d at 10).  the court also rejected various scattershot irs arguments that the substantiation rules had not been met.  however, the court of appeals did not necessarily hand the taxpayers a final victory. it remanded the case to the tax court on the valuation issue. when the kaufmans donated the easement, their home was already subject to south end landmark district rules that severely restrict the alterations that property owners can make to the exteriors of historic buildings in the neighborhood. these rules provide that “[a]ll proposed changes or alterations” to “all elements of [the] facade, ... the front yard ... and the portions of roofs that are visible from public streets” will be “subject to review” by the local landmark district commission. under the standards and criteria, property owners of south end buildings have an obligation to retain and repair the original steps, stairs, railings, balustrades, balconies, entryways, transoms, sidelights, exterior walls, windows, roofs, and front-yard fences (along with certain “other features”); and, when the damaged elements are beyond repair, property owners may only replace them with elements that look like the originals. given these preexisting legal obligations the tax court might well find on remand that the kaufmans’ easement was worth little or nothing. 398 florida tax review [vol. 15:5  the court took note of the fact that in persuading the kaufmans to grant the easement, “a trust representative told the kaufmans that experience showed that such easements did not reduce resale value, and this could easily be the irs’s opening argument in a valuation trial.” 3. the old adage “better late than never” didn’t save the taxpayer’s deduction for a conservation easement on mortgaged property. mitchell v. commissioner, 138 t.c. 324 (4/3/12). in 2003, the taxpayer contributed a conservation easement on over 180 acres of unimproved land to a qualified organization. the property was subject to a mortgage, but the mortgagee did not subordinate the mortgage to the conservation easement deed until 2005. the taxpayer claimed a charitable contribution deduction on her 2003 federal income tax return, which the irs disallowed. the taxpayer argued that she had met the requirement of reg. § 1.170a-14(g)(2) requiring subordination of a mortgage to the conservation easement because reg. § 1.170a-14(g)(3) should apply to determine whether the requirements of reg. § 1.170a-14(g)(2) had been satisfied. reg. § 1.170a-14(g)(3) provides that a deduction will not be disallowed merely because on the date of the gift there is the possibility that the interest will be defeated so long as on that date the possibility of defeat is so remote as to be negligible. the taxpayer argued that the probability of her defaulting on the mortgage was so remote as to be negligible, and that the possibility should be disregarded under the so-remote-as-to-be-negligible standard in determining whether the conservation easement is enforceable in perpetuity. the tax court (judge haines) held that the so-remote-as-to-be-negligible standard of reg. § 1.170a-14(g)(3) does not apply to determine whether the requirements of reg. § 1.170a-14(g)(2), requiring subordination of a mortgage to the conservation easement, have been satisfied, citing kaufman v. commissioner, 136 t.c. 294 (2011), kaufman v. commissioner, 134 t.c. 182 (2010), carpenter v. commissioner, t.c. memo. 2012-1, and distinguishing simmons v. commissioner, t.c. memo. 2009-208, aff’d, 646 f.3d 6 (d.c. cir. 2011). thus, the taxpayer did not meet the requirements of reg. § 1.170a-14(g)(2), and the deduction was denied. however, the taxpayer was not liable for a § 6662 accuracy related penalty. she “attempted to comply with the requirements for making a charitable contribution of a conservation easement,” she hired an accountant and an appraiser, but she “inadvertently failed to obtain[] a subordination agreement” and “upon being made aware of the need for a subordination agreement she promptly obtained one.” she acted with reasonable cause and in good faith. a. and the subsequent first circuit decision in kaufman doesn’t change the result. mitchell v. commissioner, t.c. memo. 2013-204 (8/29/13). in a supplemental memorandum opinion, the 2014] recent developments in federal income taxation 399 tax court (judge haines) denied the taxpayer’s motion for reconsideration. the taxpayer argued that the tax court erred in relying on kaufman v. commissioner, 136 t.c. 294 (2011) (kaufman ii), which was affirmed in part, vacated in part, and remanded in part by the first circuit in kaufman v. shulman, 687 f.3d 21 (1st cir. 2012) (kaufman iii), because kaufman iii was an intervening change in the law. in rejecting the taxpayer’s argument judge haines concluded that kaufman iii addressed different issues from mitchell. kaufman iii addressed the proper interpretation of the proceeds requirement in reg. § 1.170a-14(g)(6), in particular, the breadth of the donee organization’s entitlement to proceeds from the sale, exchange, or involuntary conversion of property following the judicial extinguishment of a perpetual conservation restriction burdening the property. but kaufman iii did not state a general rule that protecting the proceeds from an extinguishment of a conservation easement would satisfy the in-perpetuity requirements of reg. § 1.170a-14(g), which was the basis on which mitchell was decided. b. the tax court sticks by its guns on the mortgaged property conservation easement issue. minnick v. commissioner, t.c. memo. 2012-345 (12/17/12). once again, the tax court (judge morrison) held that pursuant to reg. § 1.170a-14(g)(2), no charitable contribution deduction is allowable for the donation of a conservation easement where a mortgage encumbering the property has not been subordinated to the interest of the donee of the easement. the court emphasized its holding in mitchell v commissioner, 138 t.c. 324 (4/3/12), that the unlikelihood of default is irrelevant. 4. no “take backs” allowed if you want an allowable charitable contribution. graev v. commissioner, 140 t.c. no. 17 (6/24/13). the taxpayers contributed a facade conservation easement on property to the national architectural trust (nat), a qualified charitable organization, along with a cash contribution. the conservation deed stated that “nothing herein contained shall be constructed to limit the grantee’s right to give its consent (e.g., to changes in a protected facade(s)) or to abandon some or all of its rights hereunder” [emphasis added by the court], and nat gave the taxpayers a letter stating: “in the event the irs disallows the tax deductions in their entirety, we will promptly refund your entire cash endowment contribution and join with you to immediately remove the facade conservation easement from the property’s title.” prior to the taxpayers making the donation, their accountants had advised them that in notice 2004-41, 2004-2 c.b. 31, the irs had announced increased scrutiny of deductions for conservation easement donations, and the taxpayers asked for and received from nat assurance that their donation would be deductible. however, the year after the donation was made nat sent the taxpayers a 400 florida tax review [vol. 15:5 letter, which they had taken deliberate steps to obtain, stating that “[i]t has recently been brought to our attention by our attorney that this offer of a refund may adversely affect the deductibility of the cash contribution as a charitable gift.” subsequently, the irs disallowed the deductions of the facade easement and the cash as conditional gifts, and the tax court (judge gustafson) upheld the disallowance of the deductions. under reg. § 1.170a1(e), a contribution that might be defeated by a subsequent event will be considered to have been “made” only if at the time of the contribution the possibility that it will be defeated is “so remote as to be negligible.” taking into account all of the facts and circumstances, including the enforceability of the side-agreement letter, the likelihood it would be honored by nat even if it were unenforceable, the wording of the deed, and the various grounds on which the irs might disallow a deduction for the contribution wholly apart from its conditionality, judge gustafson found that the likelihood that the condition would occur was not so remote as to be negligible at the time of the contribution. the court found that notice 2004-41 made it clear that the contribution “would be subject to heightened scrutiny and that if any of the graevs’ positions were susceptible to challenge, the commissioner would likely enforce a contrary position,” and the taxpayers’ communications with nat, which stated that his accountants “have advised [him] to be very cautious” reflected their understanding of this possibility. because the condition requiring return was enforceable and nat would act as promised in the letter, the contribution was conditional and the deductions were disallowed. a. conditionally revocable conservation easements are no-good. carpenter v. commissioner, t.c. memo. 2012-1 (1/3/12). conservation easements that could be extinguished by the mutual consent of the donor taxpayer and the donee organization failed as a matter of law to comply with the enforceability in perpetuity requirements under reg. § 1.170a-14(g). the easements were not protected in perpetuity and thus were not qualified conservation contributions under § 170(h)(1). b. and the subsequent first circuit decision in kaufman doesn’t change the result. carpenter v. commissioner, t.c. memo. 2013-172 (7/25/13). judge haines denied the taxpayer’s motion for reconsideration. the taxpayer argued that in its earlier opinion the tax court had erred in relying on kaufman v. commissioner, 136 t.c. 294 (2011) (kaufman ii), which was affirmed in part, vacated in part, and remanded in part by the court of appeals for the first circuit in kaufman v. commissioner, 687 f.3d 21 (1st cir. 2012) (kaufman iii). specifically, the taxpayer argued that the first circuit’s emphasis on the destination of proceeds upon extinguishment of a conservation easement in kaufman iii, 2014] recent developments in federal income taxation 401 required the tax court to “take an overall approach in analyzing the inperpetuity requirement of section 170(h)(5)(a) and section 1.170a-14(g), income tax regs., and focus on any proceeds resulting from an extinguishment of the conservation easements.” judge haines concluded, however, that kaufman iii did not support the taxpayer’s argument that “putting into the hands of the parties to a conservation agreement the authority to determine when to extinguish the conservation easement so long as the donee organization gets its share of the proceeds of a subsequent sale,” because in kaufman iii the first circuit limited its holding to situations in which the easement is extinguished by judicial proceeding. 5. you need an appraisal of the right property – here stock, and not real estate. estate of evenchik v. commissioner, t.c. memo. 2013-34 (2/4/13). the taxpayer donated shares of stock in a corporation to a charity. the donated shares constituted approximately 72 percent of the outstanding stock. the corporation’s only assets were two apartment buildings. they attached appraisals for each building to their tax return, but never had obtained an appraisal of the stock. the tax court (judge holmes) upheld the denial of a charitable contribution deduction because the appraisals failed to comply with the qualified appraisal requirement in reg. § 1.170a-13(c)(3)(ii). the appraisals valued the wrong property. the stock was the property that had to have been appraised. furthermore the appraisals did not take into account the effect that the contribution of less than all of the stock might have had on value of the donated property. in addition, the appraisals failed to (1) provide a sufficient description of the property or (2) state the date or expected date of the contribution and the value of the property on those dates. finally, the substantial compliance doctrine could not save the deduction. “this is not a case where the taxpayers provided most of the information but left out one insignificant datum. . . . this is a case where the appraisals had gaping holes of required information.” 6. quid-pro-quo can be in the favorable governmental action. pollard v. commissioner, t.c. memo. 2013-38 (2/6/13). the tax court (judge jacobs) upheld the denial of a charitable contribution deduction for the conveyance to the county government of two conservation easements with respect to a 67 acre farm property that the taxpayer owned. the granting of the conservation easements to the county was part of a quid pro quo exchange for the county approving the taxpayer’s subdivision exemption request that would allow him to build a second home on the property. statements of the county commissioners during the course of public hearings indicated that the subdivision exemption would not have been approved if the taxpayer had not granted a conservation easement to the county. the approval of the subdivision exemption request was a substantial 402 florida tax review [vol. 15:5 benefit to the taxpayer. he did not convey the conservation easements “for detached and disinterested motives but rather to secure a personal benefit.” 7. typos don’t render a contemporaneous written acknowledgment defective. crimi v. commissioner, t.c. memo. 2013-51 (2/14/13). the taxpayer conveyed a conservation easement to a qualified donee though a bargain purchase. after first dissecting all of the experts’ reports to expose their errors, the tax court (judge laro) determined the value of the contribution. turning to the question of whether the requirements of a contemporaneous written acknowledgment required by § 170(f)(8) and a qualified appraisal required by § 170(f)(11) had been met, the court found for the taxpayer despite imperfect documentation. the court rejected the irs’s argument that the written acknowledgment had not been signed by a representative of the donee, finding that the signer was an agent of the donee. the court rejected the irs’s contention that a typographical error in the description of the property was grounds for denying the deduction in light of the fact that the appraisal and the form 8283 attached to the return provided the accurate description of the contributed property. the court rejected the irs’s assertion that the contemporaneous written acknowledgment was defective because although it stated that the easement was valued at $2,950,000, in consideration for which the donee provided a cash consideration of $1,550,000, leaving a charitable contribution of $1.4 million, it failed to state whether the donee organization provided other goods, services, or valuable consideration. finally, the court applied the substantial compliance doctrine to determine that the qualified appraisal requirement had been met despite the fact that the appraisal was for an earlier year because the taxpayer relied on a long-time cpa and tax advisor and had no reason to doubt them when they told him that an updated appraisal would not provide a different value. that a subsequent valuation prepared by the taxpayer’s expert produced a value much higher than the earlier appraisal indicated that it was reasonable for the taxpayer to believe the earlier appraisal “was not stale in substance and thus a good appraisal.” 8. if you are both the contributor and the president of the charity, you must send yourself a contemporaneous written acknowledgment. note how our attention has been shifted from ferals to ferrets. villareale v. commissioner, t.c. memo. 2013-74 (3/12/13). the taxpayer was a co-founder of ndm ferret rescue & sanctuary, inc. (ndm), an animal rescue organization that specializes in rescuing ferrets. during the year in issue, when she was ndm’s president, she contributed $10,022 to ndm by electronic funds transfers. twenty-seven contributions (totaling $2,393) were for less than $250 and 17 (totaling $7,629) were for $250 or more. the dates and amounts of the transfers were reflected in the taxpayer’s 2014] recent developments in federal income taxation 403 and ndm’s bank statements, but ndm never provided the taxpayer with a contemporaneous written acknowledgment containing a description of any property contributed, a statement as to whether any goods or services were provided in consideration, and a description and good-faith estimate of the value of any goods or services provided in consideration as required by § 170(f)(8). accordingly, the tax court (judge vasquez) upheld the irs’s denial of the $7,629 of contributions that were for $250 or more. the court found it “immaterial” that taxpayer was on both sides of the transaction and rejected her contention that as the president of ndm “‘it would have been futile to issue herself a statement that expressly provided that no goods or services were provided in exchange for her contributions.’” the deduction for the $2,393 of contribution that were in individual amounts of less than $250 was allowed.  do you remember? a touch of cohan [?], with a cap, for the cat woman’s unreimbursed charitable volunteer expenses. van dusen v. commissioner, 136 t.c. 515 (2011). the taxpayer claimed charitable contribution deductions for out-of-pocket expenses incurred in caring for “foster cats” as a volunteer on behalf of fix our ferals, a § 501(c)(3) organization. the tax court (judge morrison) applied the “substantial compliance doctrine” to allow a deduction for expenses incurred by a volunteer providing services to a charitable organization, even though the taxpayer’s records did not strictly meet the specific requirements of reg. § 170a-13(a)(1). the taxpayer’s documents were “legitimate substitutes for canceled checks,” because they contained all of the information that would have been on a canceled check — the name of the payee, the date of the payment, and the amount of the payment. although the regulation requiring substantiation records to reflect the name of the donee was not written with unreimbursed volunteer expenses in mind, because the amounts expended exceeded $250 and the taxpayer failed to satisfy requirements of § 170(f)(8)(a) and reg. § 1.170a-13(f)(1) for substantiation in the form of a contemporaneous written acknowledgment from the charitable organization, the deductible amount for each separate expenditure was limited to $250.  query whether prudent planning in the future should be: “if it flies or floats, don’t own – rent; if it barks or meows, don’t adopt – foster.” 9. quid pro quo can be very intangible. boone operations co., l.l.c. v. commissioner, t.c. memo. 2013-101 (4/11/13). the taxpayer transferred fill dirt to the city of tucson in a bargain sale and claimed a charitable contribution deduction for the difference between the appraised fair market value of the fill dirt and the cash purchase price. the fill dirt was used in the process of closing a city of tucson landfill that was adjacent to the landfill operated by the taxpayer. the tax court (judge marvel) upheld denial of the deduction on almost every conceivable ground. 404 florida tax review [vol. 15:5 first, the substantiation requirements of § 170(f)(8)(b) had not been met. although the written agreement between the taxpayer and the city of tucson stated the amount of cash tucson agreed to pay for the fill, it also stated that tucson provided goods and services in exchange for the contribution of fill, but lacked a good-faith estimate of the value of those goods and services. furthermore, the forms 8283 did not refer to any benefits received by the taxpayer in addition to the cash sale price. second, the appraisal was not a qualified appraisal because, among other deficiencies, it used the wrong comparables and was based on the fair market value of delivered fill dirt, including transportation, but the taxpayer had deducted the transportation, which was the major component of the value of delivered fill dirt, as a business expense. third, in addition to the cash price, the taxpayer received valuable consideration in the form of (1) a nonconforming use permit for the continued operation of its landfill, (2) the dismissal of a pending civil suit, (3) the city of tucson’s agreement not to pursue any criminal charges, and (4) indirect benefits from the city of tucson closing its landfill and maintaining and monitoring the methane gas system on the taxpayer’s landfill. accordingly, the taxpayer failed to prove that the fill dirt was sold to the city of tucson at a bargain price. 10. if at first you don’t succeed try again. if the tax court got reversed in another case appealable to the same circuit, it just might work. friedberg v. commissioner, t.c. memo. 2013-224 (9/23/13). the tax court (judge wells) granted the taxpayer’s motion to reconsider the court’s prior decision holding that the appraisal the taxpayer obtained and submitted in connection with a claimed deduction for the contribution was not a qualified appraisal, t.c. memo. 2011-238, and granted summary judgment that the appraisal was a qualified appraisal within the meaning of reg. § 1.170a-13(c)(3). the earlier decision was based in part on scheidelman v. commissioner, t.c. memo. 2010-151, vacated and remanded, 682 f.3d 189 (2d cir. 2012). in scheidelman, and in the earlier decision involving the taxpayer, the tax court held that the mechanical application of a percentage diminution to the fair market value before donation of a facade easement does not constitute a proper valuation method under reg. § 1.170a-13(c)(3). but in vacating the tax court’s decision in scheidelman, the second circuit held that reg. § 1.170a-13(c)(3)(ii)(k) does not require a specific method of valuation be used in the appraisal or that the irs must believe it to be reliable; the regulation’s requirement is fulfilled if the appraiser’s analysis is present, even if the irs and the court finds it to be unconvincing. because this case is appealable to the second circuit, applying golsen v. commissioner, 54 t.c. 742 (1970), the decision of the second circuit in scheidelman was an intervening change in the law. because the appraisal included a specific basis for the appraiser’s valuation 2014] recent developments in federal income taxation 405 as required by reg. § 1.170a-13(c)(3)(ii)(k), it was a qualified appraisal. under the second circuit’s opinion in scheidelman, an appraisal’s “accuracy and reliability” while relevant to the court’s analysis of valuation, are irrelevant as to whether the appraisal is “qualified” under reg. § 1.170a13(c)(3). 11. the facade, the whole facade, and nothing but the facade. 61 york acquisition, llc v. commissioner, t.c. memo. 2013266 (11/19/13). the partnership contributed to a qualified organization a facade easement covering the portion of a building that it owned. the partnership did not own the entire building. the tax court (judge laro) upheld the disallowance of a charitable contribution deduction because § 170(h)(4)(b) provides that to qualify for a deduction a facade easement must “include[] a restriction which preserves the entire exterior of the building (including the front, sides, rear, and height of the building).” (emphasis added.) the partnership could not, and did not, grant a valid easement restricting the entire exterior of the building when the partnership did not own the entire exterior. x. tax procedure a. interest, penalties, and prosecutions 1. did owen fiore fraudulently “welch” on his taxes? judge holmes said “yes.” fiore v. commissioner, t.c. memo. 2013-21 (1/17/13). the tax court (judge holmes) found that former estate planning lawyer owen fiore filed fraudulent 1996 and 1997 income tax returns; fiore had pleaded guilty to evasion of 1999 taxes but claimed that he did not owe fraud penalties for the earlier years. fiore had total control of the finances of his law firm and did not delegate even the most mundane tasks, e.g., preparation of checks for signature, to anyone else, but claimed that he simply was “a horrible recordkeeper.” in a detailed and analytic opinion, judge holmes decided the issue on the grounds that fiore was short of cash during the 1996-1997 period and admittedly engaged in “willful blindness” to the possibility that he was underreporting his income; he also repeatedly stalled during the irs examination of his tax returns. his opinion concludes: and with particular weight given to this willful blindness we find that the commissioner has met his burden of proving by clear and convincing evidence that fiore filed fraudulent returns. we cannot accept that a person of fiore’s intelligence, training, and experience was not aware when he filed his returns for 1996 and 1997 —at a time when he knew his need for cash was ballooning — that there was a 406 florida tax review [vol. 15:5 high probability that he was underreporting his income. and we find that he deliberately avoided steps that would have confirmed that underreporting, since all he had to do was read his monthly bank statements to verify the accuracy of his estimates of taxable income that he put on his returns.  from the website of owen g. fiore, jd: for over four decades, owen fiore was a tax and estate planning lawyer in california, representing families and business entities in developing and implementing tax sensitive wealth succession, preservation and management plans, including using flps, llcs, corporations and trusts in planning. he also had an active practice in tax controversies, especially those involving gift and estate taxes, evidenced by being lead counsel in a number of tax court cases, such as cristofani, schauerhamer and fontana. as the result of a personal income tax case leading to a plea agreement-based conviction and subsequent 14 months incarceration, owen now is involved as a nonlawyer consultant to professional advisors and their clients in tax and estate planning matters. *** owen lives in syringa, id with his wife, mary ann, enjoying being on the middle fork of idaho’s wild and scenic clearwater river.  section 10.24(a) of circular 230 provides that “a practitioner may not, knowingly and directly or indirectly: (a) accept assistance from or assist any person who is under disbarment or suspension from practice before the internal revenue service if the assistance relates to a matter or matters constituting practice before the internal revenue service.” 2. a sole shareholder gets 87 months of room and board from the federal government for fraudulently treating as independent contractors workers who were really employees. united states v. deleon, 704 f.3d 189 (1st cir. 1/11/13). the first circuit, in an opinion by judge stahl, affirmed the fraud conviction under § 7206(2), and various other criminal statutes, of a corporation’s sole shareholder. the corporation paid most of its workers directly with checks and did not withhold payroll taxes from their wages or report or remit such taxes to the irs. the shareholder told the tax preparers that the unreported payroll workers were independent contractors for whom she was not required to remit payroll taxes. the tax return preparers recorded the checks to individuals on the unreported payroll as a business expense and issued a form 1099 to each of those workers. the shareholder will get room and board from the federal government for 87 months. 2014] recent developments in federal income taxation 407 3. taxpayer’s reliance on his cpa, who did a little ($1.2 million) embezzling on the side, was reasonable; therefore, no penalties for underreporting income were imposed. thomas v. commissioner, t.c. memo. 2013-60 (2/26/13). the tax court (judge gerber) stated the considerations for reasonable cause penalty avoidance based upon reliance upon a tax professional as follows: to establish reasonable cause through reliance on the advice of a tax adviser, the taxpayer must meet the following threeprong test, laid out in neonatology assocs., p.a. v. commissioner, 115 t.c. at 98-99: (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer relied in good faith on the adviser’s judgment. finally, petitioner bears the burden of proof with respect to the defenses to the accuracy-related penalties. see higbee v. commissioner, 116 t.c. 438, 447 (2001). petitioner met and became familiar with steeves, his tax preparer, during 2003 when they began working together in a real estate investment business. after working with steeves for some time, petitioner began his own businesses, which involved the same type of business activity in which he had worked with steeves. steeves was a certified public accountant and had seven years of experience in the same type of businesses as petitioner. petitioner, having worked with steeves and being aware of his professional background and experience, exclusively relied upon him to maintain his records, handle his business financial matters, and prepare his returns. under these circumstances we find that it was reasonable for petitioner to perceive steeves as a competent professional and to rely on him. petitioner was reasonable in his reliance upon steeves to correctly and accurately prepare his books. petitioner understood that those books were used in the preparation of his 2006 and 2007 income tax returns. in addition, petitioners provided steeves with all other information steeves requested that was necessary to complete their returns, including the amounts of mortgage interest and interest income and forms w-2. accordingly, petitioner was satisfied that steeves had all necessary and accurate information needed to correctly prepare petitioners’ 408 florida tax review [vol. 15:5 income tax returns. we find that petitioner’s efforts were sufficient to ensure his return preparer had adequate and accurate information. finally, we consider whether petitioner relied in good faith upon steeves’ judgment. in the setting of this case, there came a time when petitioner had doubts about the accuracy and quality of steeves’ recordkeeping. ultimately, petitioner believed that steeves was guilty of theft, fraud, and misappropriation of his money. however, his doubts about steeves’ ability or honesty did not arise until sometime after the 2006 and 2007 income tax returns were filed and respondent was conducting an audit examination of the returns. at the outset of that examination, petitioner continued to believe in and rely upon steeves, to whom petitioner gave a power of attorney to represent him before the irs. under these circumstances we hold that petitioner has carried his burden of showing reasonable reliance on the advice of a professional as a defense to the accuracy-related penalties for 2006 and 2007. accordingly, petitioner is not liable for an accuracy-related penalty on any underpayment for 2006 or 2007. 4. cpa’s incorrect advice about an estate return extended filing deadline does not excuse the late filing penalty imposed on the executor. knappe v. united states, 713 f.3d 1164 (9th cir. 4/4/13). the ninth circuit (judge paez) held that reasonable cause did not exist to abate a late filing penalty where the cpa mistakenly told the executor that he had secured a twelve-month extension of both the filing and payment deadlines. the extended payment deadline was correct, but an extension of the filing deadline is limited to six months – unless the executor was out of the country, an exception that did not apply here. judge paez followed united states v. boyle, 469 u.s. 241 (1985), which held that advice about a filing deadline was “nonsubstantive advice” which does not constitute reasonable cause for relying upon his tax advisor’s determination of the extended filing deadline date. he quoted boyle as follows: reliance by a lay person on a lawyer is of course common; but that reliance cannot function as a substitute for compliance with an unambiguous statute. . . . it requires no special training or effort to ascertain a deadline and make sure that it is met. the failure to make a timely filing of a tax return is not excused by the taxpayer’s reliance on an agent, 2014] recent developments in federal income taxation 409 and such reliance is not “reasonable cause” for a late filing under § 6651(a)(1).  judge paez used a second rationale to justify his holding: we acknowledge that the result today imposes a heavy burden on executors, who will affirmatively have to ensure that their agents’ interpretations of filing and payment deadlines are accurate if they want to avoid penalties. this burden is justified by the government’s substantial interest in ensuring that returns are timely filed. see boyle, 469 u.s. at 249. moreover, any other result would reward collusion between culpable executors and their agents. in cases like this one, lawyers and accountants would be incentivized to claim that they gave erroneous advice to the executor whether or not they did in fact. the agent who fell on his sword would risk nothing, because the waiver of the penalty would leave the executor without damages. even in cases in which executors and their agents did not actively collude to propound a contrived misrepresentation defense, negligent agents would be unilaterally incentivized to persist in giving erroneous advice to their clients, even if they realized their error.  note that boyle contains strong language permitting a taxpayer to rely on his tax advisor’s substantive advice, and does not require the taxpayer to obtain a “second opinion” 5. sometimes actual receipt is necessary, mailing of a notice by the irs is not game, set, match. lepore v. commissioner, t.c. memo. 2013-135 (5/30/13). in this cdp review, judge morrison held that the irs improperly denied the taxpayer an opportunity to contest his liability for § 6672 trust fund penalty taxes at the cdp hearing, finding that the taxpayer had never had a previous opportunity to contest the liability because he had never actually received a letter 1153. the taxpayer testified that he never saw the letter 1153 or knew that it had arrived at his home, but the irs argued that the determination by the appeals office was based on the legal conclusion that receipt by the taxpayer’s son of the letter 1153, for which he signed, mailed to the taxpayer’s house constituted receipt by the taxpayer. judge morrison found the taxpayer’s testimony credible, as was the taxpayer’s son’s testimony that he “did not give the letter 1153 to his father personally and that he instead ‘threw’ the letter 1153 ‘somewhere’ in the basement.” 410 florida tax review [vol. 15:5  although the opinion notes that if the irs mails the letter 1153 to the taxpayer’s last known address (i.r.c. § 6212(b)), the notification requirement is satisfied even if the person did not actually receive the notice. i.r.c. § 6672(b)(1). mason v. commissioner, 132 t.c. 301 (2009), held that unless the taxpayer deliberately refuses to accept its delivery, a letter 1153 will be considered as having provided a prior opportunity to dispute liability for the underlying trust fund recovery penalty only if it is actually received. thus, even though the letter not only was mailed certified mail by the irs to the taxpayer’s last known address and was delivered there and signed for by his son, actual receipt was necessary. in essence, § 6672(b) is not relevant in the cdp context. 12 in mason, the irs mailed the form 1153 by certified mail to the taxpayer’s last known address, but the letter was returned to the irs undelivered and marked “unclaimed.” nevertheless, in mason the tax court allowed the taxpayer to challenge the merits of the § 6672 penalty liability. it held: “a section 6672(b)(1) notice that was not received, but not deliberately refused, by a taxpayer does not constitute an opportunity to dispute that taxpayer’s liability [for cdp purposes].” that sounds like an “actual receipt” rule. the facts of lepore were a step closer to actual receipt by the taxpayer than the facts of mason. nonetheless, the lepore facts fall short of actual receipt. a. but deliberately avoiding receipt of a letter 1153 is game, set, and match for the irs. giaquinto v. commissioner, t.c. memo. 2013-150 (6/12/13). the irs mailed a letter 1153 and form 2751, proposed assessment of trust fund recovery penalty, to the taxpayer’s last known address. the letter was returned as unclaimed. subsequently, the irs sent by certified mail to the taxpayer’s residence forms 3552, notice of tax due on federal tax return. the letter was returned as unclaimed. subsequently, the irs sent by certified mail to the taxpayer’s residence a letter 3172, notice of federal tax lien filing and your right to a hearing under irc 6320 (lien notice). the letter was delivered to petitioner. the taxpayer asked for a cdp hearing, but at the hearing was denied any opportunity to contest liability because he had a prior opportunity to dispute it. the taxpayer sought review of the determination sustaining the levy. the tax court (judge marvel) upheld the irs’s determination, holding that the taxpayer had a prior opportunity to dispute the underlying liability. the taxpayer argued that he was entitled to contest his liability for the § 6672 trust fund recovery penalties in the cdp hearing because he never received the letter 1153 sent to him by certified mail. mason v. commissioner, 132 t.c. 301 (2009), was inapplicable because on the facts in this case, the taxpayer’s failure to claim delivery of the certified 12. we are indebted to professor steve johnson of florida state university school of law for helping us with the analysis that follows. 2014] recent developments in federal income taxation 411 mail was deliberate. the taxpayer was fully aware that the irs was considering whether to assert § 6672 trust fund recovery penalties against him, and either ignored or failed to claim at least one, and possibly two, usps forms 3849 that the mail carrier left for him with respect to the notices sent to him by certified mail. 6. you gotta get your whole act together before filing a tax court petition. there’s no second act in a court of claims refund suit. the cheesecake factory, inc. v. united states, 111 fed. cl. 686 (7/3/13). the taxpayer sought a refund of interest and late payment penalties assessed for 2005. it previously had received a deficiency notice that did not reference the late payment penalty, and the 2005 year had been litigated and settled in the tax court. in the court of federal claims, the taxpayer argued that § 6512(a), which bars a suit for a refund or credit of income tax for a taxable year with respect to which the taxpayer has filed a petition in the tax court in response to a notice of deficiency, did not apply in this case because the deficiency notice “had nothing to do with either of the interest and penalty assessments.” the court of federal claims (judge hewitt) held that the suit was barred by § 6512(a) because, once invoked, the tax court’s jurisdiction “extends to the entire subject of the correct tax for the particular year. … it is immaterial whether ‘the commissioner issue[d] a notice of deficiency with respect to the penalties [and interest] . . . which are the subject of this complaint.’” 7. this accountant forgot the old maxim: “if someone has to go to jail, it better be the client.” united states v. favato, 533 fed. appx. 127 (3d cir. 8/5/13). the court of appeals upheld the conviction of a bdo accountant under § 7212(a) for obstructing tax law administration by knowingly preparing for a client returns that claimed depreciation on a yacht held for personal use and that claimed false charitable contribution deductions. 8. negligence penalty is based on the amount the taxpayer actually underpaid. snow v. commissioner, 141 t.c. no. 6 (9/19/13), supplementing t.c. memo. 2013-114 (4/22/13). in the earlier proceeding a deficiency was determined and a § 6662(a) negligence penalty was sustained. the instant proceeding involved a disputed rule 155 computation that turned on the computation of the “underpayment” as defined by § 6664(a) and reg. § 1.6664-2 on which the penalty would be computed. based on his return, the taxpayer had received a refund of $16,684.65 that included $5,567 of claimed withheld income tax that was never actually withheld. the earlier proceeding determined that his tax liability properly was $12,968. the tax court (judge ruwe) held that the underpayment as defined in reg. § 1.6664-2(a) is equal to the true amount 412 florida tax review [vol. 15:5 the government was deprived of as a result of the taxpayer’s return. accordingly, the § 6662 penalty was imposed on an “underpayment” of $18,535 — the $12,968 tax liability plus the $5,567 that was improperly refunded as a result of the taxpayer’s erroneous return. 9. surprising news – a deficiency is not the same thing as an underpayment. and fraudulently claimed refundable credits avoid a § 6662 accuracy related penalty. rand v. commissioner, 141 t.c. no. 12 (11/17/13). the husband and wife taxpayers filed an income tax return correctly reporting taxable income of zero, $144 of self-employment taxes due, and claiming refundable eitc of $4,824, refundable child credit of $1,447, and a recovery rebate credit of $1,200. they claimed and received a refund of $7,327. in the course of audit and the tax court litigation, the taxpayers conceded that they were not entitled to any credits. the only issue was whether there was an “underpayment” on which § 6662 accuracy-related adjustments could be computed. “underpayment” as defined by § 6664(a) is determined with reference to: (1) the “tax imposed;” (2) “the amount shown as the tax by the taxpayer on his return;” (3) “amounts not so shown previously assessed (or collected without assessment);” and (4) “the amount of rebates made.” the parties agreed that the “tax imposed” was zero, the “amounts not so shown previously assessed” was zero, and “the amount of rebates made” was zero. the point of contention was what was “the amount shown as the tax.” the irs argued that reg. § 1.6664-2(c) should be interpreted to mean that claims for the refundable credits should be included in the computation of the amount shown as tax on their return, which would result in a negative tax liability of $7,327. the taxpayer’s argued that credits claimed on a return are excluded from the computation of the amount of tax shown on the return, and that as a result the tax shown on the return was $144. alternatively, the taxpayers argued that while the three types of credits they claimed are part of the amount shown as tax on the return when calculating an underpayment, the tax shown on a return cannot be negative when calculating an underpayment because congress expressly failed to incorporate a provision like § 6211(b) in the definition of an underpayment. (this position also was advanced in an amicus brief by the cardozo tax clinic.) in a reviewed opinion (10-5) by judge buch, the tax court accepted the taxpayer’s alternative argument. after first deciding that credits can reduce the amount shown as tax on the return, it then went on to hold that for purposes of § 6664, unlike under § 6211(b), any excess of the refundable credits claimed as compared to the amount to which the taxpayer was entitled is not treated as a negative tax. accordingly, the underpayment was limited to the amount of the taxpayers’ self-employment tax that was offset by the refundable credits. in so doing, the court refused to defer to the irs’s interpretation of its regulations, although it noted that “our conclusion breaks 2014] recent developments in federal income taxation 413 the historical link between the definitions of a deficiency and an underpayment.” judge buch wrote that the court’s decision was further supported by the “rule of lenity,” under which “statutes that impose a penalty are to be construed in favor of the more lenient punishment.”  judge gustafson (joined by judges halpern and goeke) dissented, concluding that no penalty should have been imposed because the “tax” shown on the return should not be reduced by the credits. the dissent concluded that no “underpayment” results from offsetting the tax due as shown on the return with refundable credits. under this view, there is no § 6662 penalty for claiming credits to which the taxpayer is not entitled.  judge morrison (joined by judge colvin) would have found an underpayment in the full amount of the refundable credits. this dissent concluded that the majority’s interpretation of ambiguous statutes left an unwarranted gap in the penalty system that did not reflect congressional intent. the purpose of the section 6662 penalty is to deter taxpayers from taking questionable tax return positions that they hope that the irs will not discover. . . . in the case of refundable credits, the claimants hope that the irs will write them a refund check (as the irs did for rand and klugman). false claims of credits on returns are as difficult for the irs to detect as falsely reported items of gross income or deductions. treating a false claim of credits as part of the “tax shown” on the return, and treating a false claim to refundable credits as potentially a report of negative tax, are consistent with the purpose of section 6662. b. discovery: summonses and foia 1. taws for utps — some protected, some not. wells fargo & co. v. united states, 112 a.f.t.r.2d 2013-5380 (d. minn. 6/4/13). the irs issued summonses to obtain information from wells fargo and kpmg related to wells fargo’s financial reporting and its undisclosed tax positions. wells fargo turned over some information, but filed a petition to quash the summons issued to kpmg on a variety of grounds, including that information was protected by the work product doctrine and was subject to attorney-client privilege. the court (judge tunheim) held that the irs had established a legitimate purpose in seeking wells fargo’s tax accrual workpapers. wells fargo’s tax returns and utps were complex and “wells fargo ha[d] claimed tax benefits from listed transactions and engaged in other questionable tax practices in the past.” wells fargo failed to establish that the schedule m-3 and form 8886 would allow the irs to identify all transactions related to the utps, and the irs did not have to prove that the 414 florida tax review [vol. 15:5 tax accrual workpapers were “critical” to its ability to discover wells fargo’s tax positions. turning to the work product issues, the court first held that wells fargo’s identification of utps around the time it entered into business transactions was not a task prepared in anticipation of litigation but rather an event that occurred in the ordinary course of business. thus, the identity of the utps, and the process for identifying them, was not protected. however, after reviewing the taws relating to the utps, the court concluded that the recognition and measurement analysis reflected in its taws was prepared in anticipation of litigation, and thus was protected. the court further held that wells fargo’s state and local taws were not relevant to its federal tax liability and thus quashed the summonses with respect to those documents. 2. the irs is allowed a do-over in examining the taxpayer’s documents. action recycling, inc. v. united states, 721 f.3d 1142 (9th cir. 7/9/13). in declining to quash a summons as unnecessarily repetitive under § 7605(b), the ninth circuit rejected the taxpayer’s argument that the irs already “possessed” the summonsed information simply because a revenue agent had previously reviewed the documents. 3. lb&i directive contains new mandatory information document request (“idr”) enforcement procedures. lb&i-04-1113-009 (11/4/13). when a taxpayer does not timely respond to an idr that (1) is issue focused, (2) has been discussed with the taxpayer, and (3) contains a response date that has been discussed with the taxpayer (and, in most instances, had been mutually agreed upon), then a mandatory procedure (with no exceptions) must follow, including (1) a delinquency notice, (2) a pre-summons letter, and (3) a summons.  these procedures take effect 1/2/14, but examiners will not issue delinquency notices before 2/3/14.  the advantage of this procedure to the taxpayer is that the specific issues under consideration must be discussed before idrs are issued. the disadvantage is that there are extremely short mandatory time limits which are triggered once the examining agent determines that the taxpayer has not timely responded to an idr. 4. you can’t hide your foreign bank account records behind the fifth amendment. m.h. v. united states, 648 f.3d 1067 (9th cir. 8/19/11), cert. denied (6/25/12). m.h. was the target of a grand jury investigation seeking to determine whether he used secret swiss bank accounts to evade paying federal taxes. the district court granted a motion to compel his compliance with a grand jury subpoena duces tecum demanding that he produce certain records related to his foreign bank accounts. the district court declined to condition its order compelling 2014] recent developments in federal income taxation 415 production upon a grant of limited immunity and, pursuant to the recalcitrant witness statute, 28 u.s.c. § 1826, held him in contempt for refusing to comply. the ninth circuit upheld the district court order. the court of appeals held that “[b]ecause the records sought through the subpoena fall under the required records doctrine, the fifth amendment privilege against self-incrimination is inapplicable, and m.h. may not invoke it to resist compliance with the subpoena’s command.” the records were required to be kept pursuant to the predecessor of 31 c.f.r. § 1010.420.  the opinion stated: there is nothing inherently illegal about having or being a beneficiary of an offshore foreign banking account. according to the government, § 1010.420 applies to “hundreds of thousands of foreign bank accounts—over half a million in 2009.” nothing about having a foreign bank account on its own suggests a person is engaged in illegal activity. that fact distinguishes this case from marchetti and grosso, where the activity being regulated—gambling—was almost universally illegal, so that paying a tax on gambling wagers necessarily implicated a person in criminal activity. admitting to having a foreign bank account carries no such risk. that the information contained in the required record may ultimately lead to criminal charges does not convert an essentially regulatory regulation into a criminal one. a. when the government asks, ya gotta pony up the name(s) on your foreign bank accounts, the account numbers, the name and address of the banks, the type of account, and the maximum value of each such account during each year. in re: special february 2011-1 grand jury subpoena dated september 12, 2011, 691 f.3d 903 (7th cir. 8/27/12), cert. denied, 133 s. ct. 2338 (5/13/13). in an opinion by judge bauer, the seventh circuit held that the compulsory production of foreign bank account records required to be maintained under the bank secrecy act of 1970 does not violate a taxpayer’s fifth amendment privilege against self-incrimination. the required records doctrine overrode any act of production privilege. a grand jury subpoena seeking the taxpayer’s bank records issued in connection with an investigation into whether he used secret offshore bank accounts to evade his federal income taxes was enforced. b. a third decision going the same way. in re: grand jury subpoena, 696 f.3d 428 (5th cir. 9/21/12). the fifth circuit (judge dennis), in reversing a district court, declined to create a circuit split and held that the required records doctrine applied; the individual was 416 florida tax review [vol. 15:5 required to produce foreign bank records subpoenaed in the irs’s investigation into whether he used secret swiss bank accounts [with ubs] to evade his federal income taxes. the court’s reasoning was that the bank secrecy act’s record-keeping requirement is “essentially regulatory,” the records sought are of a kind “customarily kept” by account holders, and the records have assumed “public aspects”; this is so even though one purpose of the bsa was to aid law enforcement officials in pursuing criminal investigations. c. the second circuit held that owners of secret offshore foreign bank accounts are not “inherently suspect” of tax evasion or of anything else illegal. united states v. john doe, 2013 wl 6670733 (2d cir. 12/19/13). the second circuit (judge wesley) held that the required records exception to the fifth amendment applied, and that production of foreign bank records was required. judge wesley stated: the record keeping regulation at issue here, 31 c.f.r. section 1010.420, targets those engaged in the lawful activity of owning a foreign bank account. “there is nothing inherently illegal about having or being a beneficiary of an offshore foreign bank account.” m.h., 648 f.3d at 1074. doe’s protestations notwithstanding, owners of these accounts are not “inherently suspect” and the statute is “essentially regulatory.” doe’s argument that the statute is criminally focused has some force. the bsa [bank secrecy act] declares that its purpose is “to require certain reports or records where they have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings, or in the conduct of intelligence or counterintelligence activities, including analysis, to protect against international terrorism.” 31 u.s.c. section 5311. it does list “criminal investigations” first, but this multifaceted statute clearly contributes to civil and intelligence efforts wholly unrelated to any criminal purpose. although portions of the statute’s legislative history support doe’s characterization of the bsa as focused on criminal activity, “[t]he supreme court has already considered and rejected these arguments as they relate to the bsa generally.” m.h., 648 f.3d at 1074 (citing cal. bankers’ ass’n v. shultz, 416 u.s. 21, 76-77 (1974)). moreover, “the question is not whether congress was subjectively concerned about crime when enacting the http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=63&_butinline=1&_butinfo=31%20cfr%201010.420&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=e4afb0bc6c8c19fecae31e16a525b708 http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=63&_butinline=1&_butinfo=31%20cfr%201010.420&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=e4afb0bc6c8c19fecae31e16a525b708 http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=64&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b648%20f.3d%201067%2cat%201074%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=a72dbbfc443fc19ac6a696f1c2e990dd http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=65&_butinline=1&_butinfo=31%20usc%205311&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=152d9c87a4f3091f3fd6650cbb4c77bb http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=65&_butinline=1&_butinfo=31%20usc%205311&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=152d9c87a4f3091f3fd6650cbb4c77bb http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=67&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b648%20f.3d%201067%2cat%201074%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=d4190e9ef0a8efd1f438b1e6bff44961 http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=68&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b416%20u.s.%2021%2cat%2076%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=487e2fce8e8856feb9ee5e5ea1a0ce7d http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=68&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b416%20u.s.%2021%2cat%2076%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=487e2fce8e8856feb9ee5e5ea1a0ce7d 2014] recent developments in federal income taxation 417 bsa’s recordkeeping and reporting provisions, but rather whether these requirements apply exclusively or almost exclusively to people engaged in criminal activity.” grand jury proceedings, no. 4-10, 707 f.3d at 1271; accord grand jury subpoena, 696 f.3d at 434. looking beyond “congressional subjective intent” -if there could be such a thing -the bsa has considerable regulatory utility outside of the criminal justice context. the question becomes whether a statute with mixed criminal and civil purposes can be “essentially regulatory” with respect to the required records exception. we agree with our sister circuits: the fact “[t]hat a statute relates both to criminal law and to civil regulatory matters does not strip the statute of its status as ‘essentially regulatory.’” grand jury proceedings, no. 4-10, 707 f.3d at 1270. because people owning foreign bank accounts are not inherently guilty of criminal activity, the bsa’s applicable recordkeeping requirement, designed to facilitate “criminal, tax, or regulatory investigations or proceedings, or [] the conduct of intelligence or counterintelligence activities,” 31 u.s.c. section 5311, is still essentially regulatory. (footnote omitted)  these were records that were routinely maintained and made available to government agents upon request by those german jews who held secret accounts in swiss banks during the 1930s and 1940s. d. no circuit conflicts yet; the fifth case was from the fourth circuit. united states v. under seal, 737 f.3d 330 (4th cir. 12/13/13). the fourth circuit (judge agee) agreed with the other circuits that have dealt with this issue, and held that the required records doctrine overrode the fifth amendment privilege against self-incrimination of a couple who held an account (successively) in two swiss private banks. c. litigation costs 1. when the irs cuts the taxpayer a break in settling a case, the taxpayer is not a “prevailing party.” knudsen v. commissioner, t.c. memo. 2013-87 (4/1/13). on 5/14/09, the irs denied the taxpayer’shamilton request for § 6015(f) relief on the ground that she had failed to seek relief within the two year period required by reg. § 1.60155(b)(1). the taxpayer sought review in the tax court and on 3/15/11 the irs stipulated that the taxpayer qualified for complete relief under § 6015(f) for all subject years if the two-year deadline was invalid. on 7/25/11 “the irs http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=69&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b707%20f.3d%201262%2cat%201271%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=1bd2cc58611d0232ad70fc624d43e146 http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=69&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b707%20f.3d%201262%2cat%201271%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=1bd2cc58611d0232ad70fc624d43e146 http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=70&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b696%20f.3d%20428%2cat%20434%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=61dae827cfa9c88f968d3d72f27180ba http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=70&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b696%20f.3d%20428%2cat%20434%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=61dae827cfa9c88f968d3d72f27180ba http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=71&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b707%20f.3d%201262%2cat%201270%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=07afbaa1ebd74404c12b091156ee4105 http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=71&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b707%20f.3d%201262%2cat%201270%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=07afbaa1ebd74404c12b091156ee4105 http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=72&_butinline=1&_butinfo=31%20usc%205311&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=eb10511dcd448c795a82e447c53a0125 http://www.lexis.com/research/buttontflink?_m=f7909cb72ed837b12ee72b9b173278a2&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2013%20tnt%20245-10%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=72&_butinline=1&_butinfo=31%20usc%205311&_fmtstr=full&docnum=5&_startdoc=1&wchp=dglzvzt-zskab&_md5=eb10511dcd448c795a82e447c53a0125 418 florida tax review [vol. 15:5 announced as a policy directive that the department of the treasury would expand the two-year deadline ‘in the interest of tax administration and *** not reflective of any doubt concerning the authority of the service to impose the two-year deadline’ and that the two-year deadline would no longer be enforced in cases docketed in [the tax court].” see chief counsel notice cc-2011-017 (july 25, 2011); notice 2011-70, 2011-32 i.r.b. 135. in august 2011 the irs conceded that the taxpayer was entitled to relief. thereafter, the taxpayer sought attorney’s fees under § 7430, but the tax court (judge thornton) denied the taxpayer’s motion for attorney’s fees because she was not a “prevailing party” as required by the statute. section 7430 provides that a taxpayer qualifies as a prevailing party only if either (1) the taxpayer has made a “qualified offer” or (2) the irs’s position is not substantially justified, but the taxpayer relied on only the qualified offer rule. however, the qualified offer rule does not apply where the judgment is issued pursuant to a settlement, § 7430(c)(4)(e)(ii)(i), and the court held that the judgment in this case was based on a “settlement.” d. statutory notice of deficiency 1. are you “outside of the united states” if you live in another country but are visiting the united states when a deficiency notice is sent to your u.s. post office box? smith v. commissioner, 140 t.c. 48 (2/28/13). section 6213(a) gives the taxpayer 90 days, or if the notice is addressed to a person outside the united states, 150 days, after the mailing of a deficiency notice to file a tax court petition. prior to august 2007, the taxpayer lived in san francisco. in 2007, the taxpayer moved from san francisco to canada and became a permanent resident of canada. however, she continued to own a home and maintained a post office box in san francisco. in late december 2007, the taxpayer returned to san francisco briefly to complete moving her furniture to canada. while she was in san francisco, the irs mailed a deficiency notice relating to the year 2000 to her san francisco post office box. the respondent stated that the taxpayer had until march 26, 2008 (i.e., 90 days), to file a tax court petition. the taxpayer failed to pick up the notice before returning to canada on 1/8/08. on 5/2/08, the taxpayer received a copy of the deficiency notice, and on 5/23/08, she filed a tax court petition. the irs filed a motion to dismiss for lack of jurisdiction, contending that the petition was not timely filed. the taxpayer objected and contended that, pursuant to § 6213(a), she was entitled to 150, rather than 90, days to file a petition. in a reviewed opinion (7-1-5) by judge foley, the tax court held that the 150-day period applied to the taxpayer because at the time the deficiency notice was sent she was a permanent resident of canada. the majority cited hamilton v. commissioner, 13 t.c. 747 (1949), which held that “the 150-day period 2014] recent developments in federal income taxation 419 applies to a taxpayer who regularly resides outside the united states but who through fortuitous circumstance happened to be physically in one of the states of the union on the particular day the deficiency notice was mailed to him.  judge halpern, in a dissent joined by three other judges, would have held that the petition was not timely. the dissent reasoned that the taxpayer “was present in the united states for a two-week period bracketing both the mailing and delivery of the notice to her address (a u.s. address) last known to the commissioner, and, in the light of the words actually used by congress and the relevant case law, that is sufficient for me to conclude that the notice was not addressed to a person outside the united states.” the dissent concluded that “the 150-day rule applies either when the taxpayer is out of the country or when the address on the notice is a foreign address,” and that “out of the country means ‘physically located outside the united states’” under this reasoning “residence” is irrelevant. “absence from the united states, resulting in delay, is what matters.” 2. a website reference is as good as the address and phone number the statute requires on a deficiency notice. the statute is sooo 20th century. john c. hom and associates, inc. v. commissioner, 140 t.c. no. 11 (5/7/13). section 6212(a) requires that a deficiency notice inform the taxpayer of the taxpayer’s right to contact a local office of the national taxpayer advocate and provide the location and phone number of the appropriate office. the taxpayer argued that a deficiency notice was invalid because the inclusion of a web-site address where the address and telephone number of the local office of the national taxpayer advocate may be found did not comply with the statutory requirement. the tax court (judge cohen) held that the deficiency notice was valid. section 6212 does not provide that a deficiency notice sent without the specified information is invalid. the taxpayer was not prejudiced by the form of the deficiency notice because the information described in § 6212(a) was made available, “although in a manner that may not be sufficient for a taxpayer without access to a computer or knowledge of how to access a web site.” but the notice was not misleading, and the taxpayer was able to file, and did file, a timely tax court petition. e. statute of limitations 1. don’t screw up your certified mail customer receipt. stocker v. united states, 705 f.3d 225 (6th cir. 1/17/13). on 10/15/07, the taxpayers mailed an amended return requesting a refund for 2003; their 2003 tax return had been timely mailed on 10/15/04. the irs acknowledged that it received the amended return on 10/25/07, but rejected the refund claim on the ground that the request was untimely under § 420 florida tax review [vol. 15:5 6511(a), asserting that the envelope was postmarked october 19 — four days late. the taxpayers could not avail themselves of the timely mailed, timely filed rule of § 7502(a) because they could not produce a postmarked envelope; this was because the irs, by its own admission, had not retained the envelope in which the return had been received. nor could they present the customer copies of a certified mail receipts, because although they claimed to have sent the amended return by certified mail, they had — in a tragic comedy or errors — failed to present to the post office the customers’ copy of the certified mail receipt to get them date-stamped. the sixth circuit, in an opinion by judge rosen, held that the taxpayers were not entitled to introduce extrinsic evidence of timely mailing of the refund request. the court followed the decisions of other courts holding that the exceptions provided by § 7502 are “exclusive and complete.” see, e.g. deutsch v. commissioner, 599 f.2d 44 (2d cir. 1979), and other cases cited therein. the court noted that in any event, the extrinsic evidence put forward by the taxpayers did “not purport to establish the fact of significance under § 7502(a)(1) — namely, the ‘date of the united states postmark’ on their amended 2003 return — but instead is directed at the separate factual question of when they presented this return to the post office for mailing.” thus, the denial of the refund was upheld. 2. you must react quickly to a jeopardy assessment if you want judicial review. abraitis v. united states, 709 f.3d 641 (6th cir. 3/4/13). the sixth circuit, in an opinion by judge cook, held that the availability of judicial review under § 7429(b) requires that the taxpayer either have made a timely request for administrative review or exhausted administrative remedies prior to seeking judicial review of the jeopardy assessment. (the statute permits the taxpayer to seek judicial review within 90 days after either (1) the sixteenth day after the taxpayer’s request to the irs for administrative review or (2) the day the irs notifies the taxpayer of its determination on administrative review.) furthermore, the court held that the requirement in § 7429(a)(2) that the taxpayer’s request for administrative review must be filed within 30 days after receiving the written statement from the irs explaining the jeopardy assessment is not subject to equitable tolling. 3. a sad story about employee misclassification. karagozian v. commissioner, t.c. memo. 2013-164 (7/8/13). the taxpayer’s employer mischaracterized him as an independent contractor from 2002 through 2008. the taxpayer filed tax returns as an independent contractor, paying self-employment tax. after the taxpayer filed an amended return for 2008, treating himself as an employee, the irs assessed liability for the employer’s share of unpaid fica taxes for 2008 against the taxpayer. 2014] recent developments in federal income taxation 421 in a cdp review, the tax court (judge kerrigan) held that the taxpayer could not invoke equitable recoupment to reduce the 2008 liability for unpaid fica taxes by overpaid fica taxes for earlier years, when he filed tax returns as an independent contractor. although the fica taxes “paid in the time-barred years were paid on the same type of transaction (i.e., compensation ...) as in 2008, ... the overpaid fica taxes from 2002 through 2007 are separate transactions, separate items, and separate taxable events from [the taxpayer’s] 2008 tax deficiency.” 4. the pro se taxpayer won on the jurisdictional issue but lost on the merits. boeri v. united states, 724 f.3d 1367 (fed. cir. 7/31/13). the federal circuit, in an opinion by judge clevenger, held that the three-year “look-back” period of § 6511(b)(2)(a) limiting the amount of credit or refund is not a “statutory time limitation[]” but rather a “substantive limitation[] on the amount of recovery.” the look-back provision is not jurisdictional and does not preclude the court from hearing the taxpayer’s claim. the taxpayer lost on the merits. 5. there was no statute of limitations because the return was fraudulent, even though the taxpayer didn’t know it. city wide transit, inc. v. commissioner, 709 f.3d 102 (2d cir. 3/1/13), rev’g t.c. memo. 2011-279. the second circuit, in an opinion by judge wesley, held that the § 6501(c) extended period of limitations for assessing taxes due to a willful attempt to defeat or evade tax applied where the corporation’s accountant, who had been given a power of attorney, filed fraudulent employment tax returns to further his embezzlement scheme. (the scheme itself is not worth explaining.) the court explained: “the statute is agnostic as to the attendant motivations for submitting a fraudulent return and only requires that the commissioner prove a fraudulent return was filed with an intent to evade, that is avoid, paying a tax otherwise due.”  in the tax court proceeding, judge vasquez had found that the irs had not proved by clear and convincing evidence that the accountant’s filing of the employment tax returns was “conduct intended to defeat or evade [the] taxes” rather than “an incidental consequence or secondary effect of his embezzlement scheme.” he accepted the taxpayer’s argument that the accountant “intended only to cover up his embezzlement scheme and not defeat or evade petitioner's taxes.”  in an earlier case, allen v. commissioner, 128 t.c. 37 (2007), the tax court held that under § 6501(c)(1), the limitations period remained open indefinitely regardless of whether it was the taxpayer or the taxpayer's tax return preparer who had the intent to evade tax. a. but the court of federal claims says “nuts” to the second circuit and tax court. basr partnership v. united 422 florida tax review [vol. 15:5 states, 113 fed. cl. 181 (9/30/13). the irs issued an fpaa after the §§ 6501(a)/6229 period of limitation had expired. the government asserted that the extended period for assessment under § 6501(c)(1) for fraud applied by reason of the fraudulent intent of the taxpayer’s advisors who designed a tax shelter transaction and one of whom prepared the return. the government relied on city wide transit, inc. v. commissioner, 709 f.3d 102 (2d cir. 2013), and allen v. commissioner, 128 t.c. 37 (2007) in support of its argument. in city wide transit, the second circuit held that the fraudulent intent required to extend the statute of limitations under § 6501(c)(1) is not limited to the taxpayer. in that case the tax preparer’s fraudulent intent triggered the extended period in § 6501(c)(1), even though the preparer's primary motive was his own benefit rather than the taxpayer’s. the tax court reached the same conclusion in allen, where it stated: “nothing in the plain meaning of the statute suggests the limitations period is extended only in the case of the taxpayer’s fraud. the statute keys the extension to the fraudulent nature of the return, not to the identity of the perpetrator of the fraud.” however, in the instant case, without reaching the question of whether the taxpayer’s advisors harbored fraudulent intent, the court of federal claims rejected that proposition and held that even though there was no question that “basr’s partnership return included false or fraudulent items,” the extended statute of limitations did not apply. judge barden concluded that “the meaning of ‘intent to evade tax,’ as that text is used in i.r.c. § 6501(c), is limited to instances in which the taxpayer has the requisite intent to commit fraud.” referring to the second circuit’s decision in city wide transit and the tax court’s decision in allen, she said, “these cases, however, are not binding upon this court.” because the government conceded that the taxpayers in this case did not have fraudulent intent, the § 6501(a) three-year period for assessment applied and the fpaa was time barred. 6. what was i thinking, signing as the tmp!? an ostensible tmp who executed consents to extend the period of limitations on assessment of partnership items may not, in fact, have been the tmp, but the consents were valid because he was authorized to sign them. peking investment fund, llc v. commissioner, t.c. memo. 2013-288 (12/23/13). as the tax matters partner (tmp) of peking investment fund, llc (pif), an llc taxed as a partnership, an individual named li chien tsai executed forms 872-p, consents to extend the time to assess tax attributable to partnership items, which extended until december 31, 2008, the § 6229(a) period of limitations on assessment with respect to partnership items for certain taxable years. on december 30, 2008, the irs sent a notice of final partnership administrative adjustment (fpaa) denying loss deductions claimed by pif. among other issues in the case, the 2014] recent developments in federal income taxation 423 tax court (judge halpern) considered whether mr. tsai’s execution of the forms 872-p effectively extended the period of limitations on assessment pursuant to § 6229(b)(1)(b), which provides that the period of limitations can be extended “with respect to all partners, by an agreement entered into by the secretary and the tax matters partner (or any other person authorized by the partnership in writing to enter into such an agreement).” mr. tsai, who was granted leave to participate in the case in an earlier proceeding, asserted that the forms 872-p he executed were invalid and did not effectively extend the period of limitations on assessment because: (1) he was ineligible to be pif’s tmp when he signed them because he had no direct ownership interest in pif and therefore was not a general partner or member-manager of pif, and (2) he was not otherwise authorized to sign them. the government challenged only the second assertion. the court concluded that a letter to the irs from pif’s former tmp, who was the member-manager of pif, was sufficient authorization within the meaning of § 6229(b)(1)(b). in that letter, the former tmp resigned and appointed mr. tsai as tmp. the court reasoned that, although the letter might not have been effective to appoint mr. tsai as tmp, it nevertheless expressed the former tmp’s (and therefore pif’s) intent to authorize mr. tsai to exercise the same authority as the former tmp, including the authority to execute the form 872-p consents. in reaching this conclusion, the court examined an analogous situation involving a limited partnership in investment engineers, ltd. v. commissioner, t.c. memo. 1994-255. based on the former tmp’s resignation and its holding out of mr. tsai as the tmp, the court also concluded that pif was “estopped from denying his authority as pif's ostensible tmp to execute the form 872-p consents for the years in issue.” f. liens and collections 1. does this case portend that most single-member llcs are mere nominee owners on behalf of their single member? berkshire bank v. town of ludlow, 708 f.3d 249 (1st cir. 1/11/13). the first circuit, in an opinion by judge stahl, affirmed a district court decision holding that a tax lien against the owner of a single-member llc (which was a disregarded entity) filed in 2009 was superior to a judgment lien on land owned by the llc arising in 2010. on the facts the llc was a mere nominee for its owner: (1) the owner transferred the property to the llc for no consideration, (2) no one else had any interest in the llc, made decisions for it, or benefitted from its income, (3) the llc operated out of its owner’s home, (4) the owner exercised total control over the llc’s property and its development, (5) the owner had complete use and enjoyment of the property, as evidenced by his formulation and execution of the plan to subdivide the property and sell off the lots, (6) the llc did not interfere with the owner’s use of the property, (7) the owner used 10 to 15 percent of the revenue from 424 florida tax review [vol. 15:5 the llc to pay his personal expenses; (8) the owner of the llc treated the property as if it belonged to him, (9) the owner testified that he set up the llc and transferred title to the property solely to avoid legal liability “in case somebody got hurt on the property,” and (10) the llc’s bank account was not in its own name, but in the owner’s name. 2. the obligation to pay income taxes has priority over a religious obligation to tithe. thompson v. commissioner, 140 t.c. 173 (3/4/13). in reviewing a cdp hearing, the tax court (judge ruwe) held that it was not an abuse of discretion for the settlement officer to reject the taxpayer’s contention that his (1) monthly tithing to his (the mormon) church and (2) monthly payments for his children’s college expenses should be excluded from the monthly amount available to satisfy his unpaid tax liabilities. the court rejected the argument that failure to allow tithing as a necessary expense violated the taxpayer’s first amendment right to religious freedom and the religious freedom and restoration act of 1993. the commissioner’s interest in expeditiously collecting taxes is especially compelling given the specific facts of this case. petitioner has a long history of not paying his income tax liabilities. as of the date of trial petitioner still had not paid his income tax liabilities for the taxable years 1992, 1995, 1996, 1999, and 2000. additionally, respondent has assessed trust fund recovery penalties under section 6672 against petitioner for seven different tax periods. 3. blips and bankruptcy: hiding assets after learning losses may be disallowed can make the subsequent tax liability non-dischargeable. vaughn v. united states, 111 a.f.t.r.2d 2013-1481 (d. colo. 3/29/13). the taxpayer used losses from a kpmg blips tax shelter to offset gain from the 1999 sale of his interest in a cable company. after being informed by kpmg of the release of notice 2000-44, 2000-2 c.b. 255, which identified losses in blips-type tax shelters as nondeductible, and learning that the irs was auditing the cable company’s former cfo, who also had used blips losses to offset gain, the taxpayer purchased a $1.7 million home titled in his fiancée’s name. after kpmg advised the taxpayer to disclose his blips investment, but before he disclosed it, the taxpayer funded a $1.5 million trust for his stepdaughter. he also spent significant amounts on jewelry and home furnishings. the taxpayer later filed a chapter 11 bankruptcy petition and the irs filed a proof of claim in that proceeding in the amount of $14,359,592. under 11 u.s.c. § 523(a)(1)(c), a tax debt is not dischargeable in bankruptcy if the debtor either made a fraudulent return or willfully attempted to evade or defeat the 2014] recent developments in federal income taxation 425 tax. the bankruptcy court held that the taxpayer’s tax liability was nondischargeable on both grounds. the district court affirmed the bankruptcy court’s determination solely on the ground that the taxpayer had willfully attempted to evade or defeat tax. the district court rejected the taxpayer’s contention that he could not have willfully attempted to evade or defeat tax because there had been no assessment or quantification of his tax liability when he depleted his assets. 4. a good reason not to be the fiduciary of any estates or trusts that you represent. united states v. tyler, 528 fed. appx. 193 (3d cir. 6/11/13). the court of appeals, in an opinion by judge jordan, held that 31 u.s.c. § 3713 imposes personal liability on an executor who distributes all of the funds from an estate thereby rendering the estate unable to pay the taxes due from the estate (including unpaid tax liabilities of the decedent), even though such a distribution “is not, strictly speaking, the payment of a debt,” to which the statute refers. the court relied on united states v. coppola, 85 f.3d 1015 (2d cir. 1996), which reached the same result.  to avoid this problem, executors should consider filing form 4810, request for prompt assessment, and form 5495, request for discharge from personal liabilities. 5. who says the income tax is uniform throughout the country. sometimes state law determines from whom the irs can collect. fourth investments, lp v. united states, 720 f.3d 1058 (9th cir. 6/13/13). the court of appeals, in an opinion by judge m. smith, affirmed a district court in favor of the government in a quiet title action in which the plaintiff partnerships sought to remove a tax lien on properties to which the partnerships held title. the lien was for back taxes of married individuals from whom partnerships had received properties without consideration. the court rejected the government’s argument that nominee status was to be determined under federal common law, and held that the relevant state law controlled the determination of whether title to the property was held as a nominee. nevertheless, the court concluded that the partnerships held the properties as nominees of the taxpayers under california law, which was the controlling state law.  as for the controlling law, a similar result has been reached by other circuits that have addressed the issue. see berkshire bank v. town of ludlow, 708 f.3d 249 (1st cir. 2013) (clarifying that state law, rather than federal law, provides the “substantive rules” of nominee doctrine); holman v. united states, 505 f.3d 1060 (10th cir. 2007) (rejecting the government’s argument that a “uniform federal rule should ... govern whether the nominee theory is to apply,” and remanding for application of utah law); spotts v. united states, 429 f.3d 248 (6th cir. 2005) (“because there is no 426 florida tax review [vol. 15:5 indication that the district court applied [state] law before determining the scope of the federal tax lien we must reverse.”). 6. unremitted withholding determined in criminal tax fraud trial was credible for determining civil tax liability. dixon v. commissioner, t.c. memo. 2013-207 (9/3/13). in reviewing an irs cdp determination, the tax court (judge holmes) held that the dixons were entitled to a credit against their 1992 through 1995 income tax liability for $510,896 determined in their criminal tax fraud trial to have been withheld by their corporate employer (which they controlled) but not remitted. the withholding had been determined as part of the tax-loss computation from the then-still-extant books and records, even though many records subsequently disappeared before the cdp hearing. as part of their sentencing the taxpayers agreed to pay that sum to the corporation in 1999 and 2000, and the corporation remitted the funds to the irs with a designation that the funds be applied to the corporation’s employment taxes for the years in question with respect to the taxpayers as representing withheld taxes. a. an employer can designate which employee’s withholding taxes it has paid. dixon v. commissioner, 141 t.c. no. 3 (9/3/13). in a related case reviewing the same cdp determination, the tax court, in a reviewed opinion by judge lauber (11-1-3), held that “when an employer pays in a later year the nonwithheld income tax of an employee for an earlier year, the employee as a matter of law is not entitled to a credit under section 31.” that did not, however, resolve the matter. in 1999 and 2000 the dixons had remitted to the employer corporation $91,233 to be applied to their 1992 through 1995 income tax liabilities – the amount of their income tax liabilities in excess the amounts for which the court in the related tax court memorandum opinion held that the corporation had withheld (but not remitted). the corporation remitted the funds to the irs with a designation that they be applied to the corporation’s employment taxes for the years in question with respect to the taxpayers as representing withheld taxes. but the payment was outside the period prescribed by § 6205(a)(1) for making a “proper adjustment” to under-withholding. the irs applied the payment to other corporate tax liabilities. nevertheless, the court held that the taxpayers should have received a credit of $91,223 against their 1992 through 1995 income tax liabilities by virtue of the corporation’s designated payments. it rejected the irs’s argument that “there is no legal basis for insisting that the irs honor the designation of a delinquent employment tax payment toward the income tax liability of a specific employee.” however, the taxpayer’s remained liable for interest and penalties attributable to the late payment. 2014] recent developments in federal income taxation 427  judges holmes, buch, and halpern dissented, and would have held that the relevant statutory scheme does not allow the corporation to designate a payment for its own benefit and also for the benefit of the employees. 7. it’s going to cost more to apply not to pay the taxes you rightfully owe. reg–144990–12, user fees for processing installment agreements and offers in compromise, 78 f.r. 53702 (8/30/13). proposed amendments to reg. § 300.1(b) would increase the fee for entering into an installment agreement. the fee before 1/1/14 is $105. the fee for entering into an installment agreement on or after 1/1/14 would be $120. proposed amendments to reg. § 300.2(b) would increase the fee for restructuring or reinstating an installment agreement. before 1/1/14 the fees is $45. the fee for entering into an installment agreement on or after 1/1/14 would be $50. proposed amendments to reg. § 300.3(b) would increase the fee for processing an offer in compromise. before 1/1/14 the fee is $150. the fee for processing an offer in compromise on or after 1/1/14 would be $186. 8. no late mandatory mulligan on an unprocessable oic. reed v. commissioner, 141 t.c. no. 7 (9/23/13). in a case of first impression, the tax court (judge kroupa), in reviewing a cdp determination, held that the irs cannot be required to reopen in a cdp hearing an offer-in-compromise (oic) based on doubt as to collectability when the oic was rejected as unprocessable years before the cdp hearing commenced. there was no abuse of discretion. 9. “our review of the overall record leaves us with a firm sense that petitioner has not been treated in a fair and rational manner.” szekely v. commissioner, t.c. memo. 2013-227 (9/24/13). this case was a review of a cdp determination to file a tax lien. the selfemployed taxpayer filed tax returns for 2006 through 2010 reporting his income but making no payments. beginning in 2011 he began making estimated tax payments. in that year he also contacted the taxpayer advocate service to seek advice on making an offer in compromise. when the irs contacted him to advise him of his right to a cdp hearing, he submitted irs form 12153, request for a collection due process or equivalent hearing, and attached to his letter his previous communications with tas, as well as copies of checks and payment vouchers for his estimated tax payments for 2011 in an effort to persuade the irs to resolve his tax liabilities for prior years. by a letter dated feb. 3, 2012 the irs appeals office notified the taxpayer that a cdp hearing had been scheduled and that he needed to complete and submit a form 433-a together with supporting documentation and three months of bank statements. the letter form the irs stated that collection alternatives would not be considered 428 florida tax review [vol. 15:5 unless the documents were received within 14 days from the date of the letter. the taxpayer complied. during the cdp hearing the appeals officer informed the taxpayer that he needed to submit a form 656, offer in compromise, and another form 433-a—this time, form 433-a (oic)— before a collection alternative could be considered. on feb. 28, 2012, the appeals officer sent the taxpayer a follow-up letter with the forms, asking the taxpayer to complete and submit these forms, with supporting documentation and the required payments by march 13, 2012. unlike the earlier letter, the february 28 letter did not warn the taxpayer of any negative consequences if he failed to submit all of the required information by march 13. when the taxpayer had not submitted the forms and documentation by march 13, the appeals officer concluded that the filing of the lien should be sustained and the irs sent a determination letter. the tax court (judge lauber) remanded the case for a supplemental cdp hearing to consider the taxpayer’s oic. he noted that although the tax court has approved allowing a taxpayer only 14 days to submit documentation in cdp, a 14-day deadline must be applied using a rule of reason. the so [appeals officer] knew that petitioner’s liabilities were properly reported; that he had previously worked with tas to receive assistance; that he was eager to work out a compromise of his tax liabilities; that he was current on his 2011 tax liability; and that he had responded timely to her previous requests for documents and information. armed with this knowledge, the so should not have lightly assumed, when petitioner’s oic package did not arrive on march 13, that he had decided to walk away from his efforts to secure a compromise. ... all that was required was a twominute phone call to inquire whether petitioner needed a little more time. 10. when the u.s.p.s. form 3877 isn’t properly completed, it’s not enough to prove that the irs sent the deficiency notice. meyer v. commissioner, t.c. memo. 2013-268 (11/25/13). this case was a review of a cdp determination to proceed with a levy. the taxpayer had not filed a tax return and the irs prepared a substitute for return. the taxpayer claimed that he never received a deficiency notice. the irs could not produce a copy of the deficiency notice, but the appeals officer conducting the hearing relied on a form 4340, certificate of assessments, payments, and other specified matters, to verify that the commissioner had properly assessed the tax, and a u.s.p.s. form 3877 that listed, along with others, the taxpayer’s name and address to verify that the deficiency notice had been properly mailed. the taxpayer argued that this determination was 2014] recent developments in federal income taxation 429 an abuse of discretion, because the appeals officer did not meet his obligation to verify that the irs properly issued and mailed a notice of deficiency to him. citing hoyle v. commissioner, 131 t.c. 197 (2008), the tax court (judge holmes) held that “the appeals officer could not rely on ‘computerized records’ like the form 4340, ... but ‘[t]he appeals officer may be required to examine underlying documents.” examining the form 3877 was a step in the right direction according to judge holmes, but because the existence of the deficiency notice was in dispute and as a factual matter the form 3877 itself appeared not to have been properly completed, in this case that one additional step did not suffice. because the administrative record did not show that the appeals officer relied on anything else to verify proper mailing, the case was remanded to the appeals officer to independently verify that a deficiency notice was properly issued and mailed. g. innocent spouse 1. the significant benefit of getting to own your home free and clear of a mortgage lien precludes equitable relief. haggerty v. commissioner, 505 fed. appx. 335 (5th cir. 1/3/13). the taxpayer sought § 6015(f) equitable relief for taxes due with respect to her late husband’s premature ira withdrawal that was reported on their joint return for the year of his death. she had no knowledge of the withdrawal and the use of the funds to pay off a second mortgage lien on their home, which as a result of his death she owned outright, until after her husband’s death. in a per curiam opinion, the fifth circuit upheld denial of relief. because the taxpayer signed and filed the return after her husband’s death and the income tax liability was properly reported but not paid, she knew that her husband would not pay the tax liability. the key to the holding, however, was that the taxpayer received a significant economic benefit when her husband paid off the second mortgage against their home. 2. apa, schmay pa! the tax court’s review of § 6015(f) relief denial is de novo and new evidence is admissible. wilson v. commissioner, 705 f.3d 980 (9th cir. 1/15/13). the ninth circuit in a divided opinion (2-1) by judge thomas, held that, in reviewing the irs’s denial of § 6015 innocent spouse relief, the tax court properly considered new evidence outside the administrative record and correctly applied a de novo standard of review in determining the taxpayer’s eligibility for § 6015(f) equitable relief. the court reasoned as follows: section 6015(e)’s jurisdictional grant to determine whether equitable relief is warranted in a § 6015(f) case must be read alongside subsection (f)’s mandate to consider the totality of the circumstances before making an equitable relief 430 florida tax review [vol. 15:5 determination. “taking into account all the facts and circumstances” is not possible if the tax court can review only the evidence available at the time of the commissioner’s prior determination.  the majority also rejected the irs’s argument that the administrative procedure act applied to limit the tax court’s review. the court reasoned that the “extensive legislative history of [§§ 6015(e) and (f)] demonstrates that the special procedures enacted by congress displace application of the apa in innocent spouse tax relief cases, and the apa does not apply.” the court emphasized that at no time prior to the tax court proceeding is there a formal administrative procedure at which the taxpayer can present the case before an administrative law judge; and at no time during the administrative process is the taxpayer afforded the right to conduct discovery, present live testimony under oath, subpoena witnesses for trial, or conduct cross-examination. these procedures are available only in the tax court. finally, the ninth circuit acknowledged that “a de novo scope of evidentiary review is incompatible with an abuse of discretion standard,” but concluded that “the nature of equitable relief ... favors de novo review.” the tax court must be able to compile a de novo record if it is to consider “all the facts and circumstances” when deciding whether a taxpayer is entitled to relief from joint liability under § 6015(f), but it is pointless to do so if it can only review the commissioner’s denial of equitable relief for an abuse of discretion. the only way for the tax court to proceed de novo when hearing petitions for relief under § 6015(f) is by applying both a de novo standard and scope of review.  accordingly, the ninth circuit affirmed the tax court’s decision granting relief.  judge bybee dissented, arguing that the administrative procedure act applied, and the tax court as a reviewing court is limited to the administrative record and a review for abuse of discretion by the irs.  in commissioner v. neal, 557 f.3d 1262 (11th cir. 2009), the eleventh circuit, the only other circuit that has considered the scope of the tax court’s review in § 6015(f) cases, reached the same conclusion as the ninth circuit majority. a. the irs throws in the towel on another innocent spouse procedural rule. cc-2013-011 (6/7/13). this chief counsel notice provides that irs attorneys will no longer argue (1) that the 2014] recent developments in federal income taxation 431 tax court should limit its review of § 6015(f) determinations to abuse of discretion or (2) the tax court should limit its review to evidence in the administrative record.  this reflects the irs’s acquiescence in wilson v. commissioner, 705 f.3d 980 (9th cir. 2013), aff’g t.c. memo. 2010134, in aod 2012-07; 2013-25 i.r.b. i. 3. innocent spouses have longer to seek equity than to prove their innocence. reg-132251-11, relief from joint and several liability, 78 f.r. 49242 (8/12/13). the treasury department has published proposed amendments to reg. §§ 1.66-4 and 1.6015-5 that would enshrine in the regulations the relief provided by notice 2011-70, 2011-32 i.r.b. 125, providing that the otherwise applicable two-year deadline for seeking § 6015 relief (or the equivalent under § 66(c) with respect to income from community property) does not apply to equitable relief under § 6015(f) (or the equivalent under § 66(c)). prop. reg. § 1.6015-5(b)(2) provides that if a requesting spouse files a request for equitable relief under reg. § 1.6015-4 within the period of limitations on collection, the irs will consider the request, but any relief in the form of a tax credit or refund depends on whether the limitation period for credit or refund was also open as of the date the claim for relief was filed and the other requirements relating to credits or refunds are satisfied. in cases in which the limitation period for credit or refund is the longer of the two periods and is open when a request for equitable relief is filed, the request can be considered for a potential refund or credit of any amounts collected or otherwise paid by the requesting spouse during the applicable look-back period of § 6511(b)(2), even if the collection period is closed. if a request for equitable relief is filed after the expiration of the period of limitations for collection of a joint tax liability, the irs is barred from collecting any remaining unpaid tax from the requesting spouse. similarly, if a request for equitable relief under reg. § 1.6015-4 is filed after the expiration of the limitation period for a credit or refund, § 6511(b)(1) bars the irs from allowing, and a taxpayer from receiving, a credit or refund. the irs will not consider an individual’s request to be equitably relieved from a tax that is no longer legally collectible. the proposed regulations have no effect on the two-year deadline to elect relief under § 6015(b) (and reg. § 1.6015-2) or § 6015(c) (and reg. § 1.6015-3). 4. the irs is attempting to be more equitable in granting innocent spouse relief. notice 2012-8, 2012-4 i.r.b. 309 (1/6/12). this notice provides a proposed revenue procedure that will supersede rev. proc. 2003-61, 2003-2 c.b. 296, which provides guidance regarding § 6015(f) relief from joint and several liability. the factors used in making § 6015(f) innocent spouse relief determinations will be revised “to ensure that requests for innocent spouse relief are granted under section 6015(f) 432 florida tax review [vol. 15:5 when the facts and circumstances warrant and that, when appropriate, requests are granted in the initial stage of the administrative process.” the revenue procedure expands how the irs will take into account abuse and financial control by the nonrequesting spouse in determining whether equitable relief is warranted, because when a requesting spouse has been abused by the nonrequesting spouse, the requesting spouse may not have been able to challenge the treatment of any items on the joint return, question the payment of the taxes reported as due on the joint return, or challenge the nonrequesting spouse’s assurance regarding the payment of the taxes. furthermore, a lack of financial control may have a similar impact on the requesting spouse’s ability to satisfy joint tax liabilities. thus, the proposed revenue procedure provides that abuse or lack of financial control may mitigate other factors that might otherwise weigh against granting § 6015(f) equitable relief. the proposed revenue procedure also provides for certain streamlined case determinations; new guidance on the potential impact of economic hardship; and the weight to be accorded to certain factual circumstances in determining equitable relief.  until the revenue procedure is finalized, the irs will apply the provisions in the proposed revenue procedure instead of rev. proc. 2003-61 in evaluating claims for equitable relief. but if a taxpayer would receive more favorable treatment under one or more of the factors provided in rev. proc. 2003-61 and so advises the irs, the irs will apply those factors from rev. proc. 2003-61, until the new revenue procedure is finalized. a. the tax court tells the irs that even if it wants to make a taxpayer favorable change to a revenue procedure, it needs to finalize it, not just publish a proposed revenue procedure. deihl v. commissioner, t.c. memo. 2012-176 (6/21/12). the tax court (judge marvel) declined to apply the provisions of the proposed revenue procedure set forth in notice 2012-8, 2012-4 i.r.b. 309, in determining whether the taxpayer was entitled to equitable relief under § 6015(f) and instead applied rev. proc. 2003-61, 2003-2 c.b. 296, “in view of the fact that the proposed revenue procedure is not final and because the comment period under the notice only recently closed.” it did, however, note “how the analysis used in rev. proc. 2003-61 ... would change if the proposed revenue procedure in notice 2012-8 ... had actually been finalized.” but on the facts the proposed changes did not affect the conclusion that relief was not warranted. b. more equitable and streamlined equitable relief is finally here! rev. proc. 2013-34, 2013-43 i.r.b. 397 (9/16/13). the irs has finalized, with some changes, the revenue procedure proposed in notice 2012-8, 2012-4 i.r.b. 309 to modify and supersede rev. proc. 20032014] recent developments in federal income taxation 433 61, 2003-2 c.b. 296, to provide guidance regarding equitable relief under (1) § 6015(f) from joint and several liability, and (2) § 66(c) from income tax liability resulting from the operation of community property law to taxpayers domiciled in a community property state who do not file a joint return. the factors used in making the determinations have been revised “to ensure that requests for innocent spouse relief are granted under section 6015(f) when the facts and circumstances warrant and that, when appropriate, requests are granted in the initial stage of the administrative process.” the revenue procedure expands how the irs will take into account abuse and financial control by the nonrequesting spouse in determining whether equitable relief is warranted, because when a requesting spouse has been abused by the nonrequesting spouse, the requesting spouse may not have been able to challenge the treatment of any items on the joint return, question the payment of the taxes reported as due on the joint return, or challenge the nonrequesting spouse’s assurance regarding the payment of the taxes. furthermore, a lack of financial control may have a similar impact on the requesting spouse’s ability to satisfy joint tax liabilities. thus, the revenue procedure provides that abuse or lack of financial control may mitigate other factors that might otherwise weigh against granting § 6015(f) equitable relief. the revenue procedure also provides for certain streamlined case determinations for both understatement, as well as underpayments, of tax; new guidance on the potential impact of economic hardship; and the weight to be accorded to certain factual circumstances in determining equitable relief. very significantly, any significant benefit a requesting spouse may have received from the unpaid tax or understatement will not weigh against relief (will be neutral) if the nonrequesting spouse abused the requesting spouse or maintained financial control and made the decisions regarding living a more lavish lifestyle. a request for equitable relief under § 6015(f) or § 66(c) must be filed before the expiration of the period of limitation for collection under § 6502 to the extent the taxpayer seeks relief from an outstanding liability, or before the expiration of the period of limitation for credit or refund under § 6511 to the extent the taxpayer seeks a refund of taxes paid.  rev. proc. 2013-34 is effective for requests for relief filed on or after 9/16/13. it also is effective for requests for equitable relief pending on 9/16/13 with the irs, appeals, or in a docketed case.  notice 2012-8 provided that until the revenue procedure was finalized, the irs would apply the provisions in the proposed revenue procedure instead of rev. proc. 2003-61 in evaluating claims for equitable relief. but if a taxpayer would have received more favorable treatment under one or more of the factors provided in rev. proc. 2003-61 and so advised the irs, the irs would apply those factors from rev. proc. 2003-61, until the new revenue procedure was finalized. 434 florida tax review [vol. 15:5 h. miscellaneous 1. this case is just like loving v. virginia, 388 u.s. 1 (1967), except that, instead of freeing interracial same sex couples from discriminatory marriage laws, it is about freeing marginal tax return preparers from discriminatory competence testing. loving v. irs, 917 f. supp. 2d 67 (d.d.c. 1/18/13). the district court (obama appointee judge boasberg) enjoined the irs from regulating otherwise unregulated “taxreturn preparers” because they are not “representatives” and do not “practice” before the irs and are not covered under 31 u.s.c. § 330(a) (authorizing the regulation of “the practice of representatives of persons before the [irs]”). the regulation of tax-return preparers under circular 230, including registration, payment of fees, passing a qualifying exam, and completing continuing education courses annually, fails the chevron step one test because preparation of tax returns does not require that a “representative demonstrate … (d) competency to advise and assist persons in presenting their cases,” 31 u.s.c. § 330(a)(2)(d), on the ground that “[a]t the time of filing, the taxpayer has no dispute with the irs; there is no ‘case’ to present.” judge boasberg also noted that the “unstructured independence by the irs [under circular 230] would trample the specific and tightly controlled penalty scheme in title 26” (emphasis added).  note that there is neither privilege nor work product protection for communications to a tax return preparer, which arises only when there is a realistic possibility of “controversy.” a. the injunction is modified, but not stayed. loving v. irs, 920 f. supp. 2d 108 (d.d.c. 2/1/13). on the irs’s motion to stay the injunction, judge boasberg – while refusing to stay the injunction – modified it to make clear that its requirements were less burdensome than the irs claimed. the requirement that each tax return preparer obtain a ptin (and pay related fees) is authorized under § 6109(a)(4), so it may continue, except that the “irs may no longer condition ptin eligibility on being ‘authorized to practice’ under 31 u.s.c. section 330.” therefore, “the requirements that tax return preparers (who are not attorneys, cpas, enrolled agents, or enrolled actuaries) must pay fees unrelated to the ptin, pass a qualifying exam, and complete annual continuing-education requirements” continue to be enjoined. b. government’s motion for a stay pending appeal was denied summarily. loving v. irs, 111 a.f.t.r.2d 2013-1384 (d.c. cir. 3/27/13). the irs appealed these two opinions and orders to the circuit court for the district of columbia circuit, 2/20/13. that court 2014] recent developments in federal income taxation 435 refused to stay the district court’s injunction on the ground that the irs failed to satisfy “the stringent requirements for a stay pending appeal.” c. and the d.c. circuit affirms the freedom of marginal tax return preparers to ply their trade free from discriminatory competence testing. loving v. i.r.s., ___ fed ___, 2014 wl 519224 (d.c. cir. 2/11/14). 2. ryan loses its constitutional challenge to circular 230’s contingent fee rule. ryan, llc v. lew, 934 f. supp. 2d 159 (d. d.c. 3/29/13). the plaintiffs challenged § 10.27 of circular 230 that generally limits the use of contingent fee arrangements in connection with the preparation and filing of refund claims with the irs. more specifically, they mounted three distinct attacks against circular 230: (1) ryan, llc and mr. ryan argued that circular 230 violates their rights under the petition clause of the first amendment (count i); (2) mr. ryan argued that circular 230 violates his fifth amendment due process rights (count ii); and (3) mr. ridgely brought suit under the administrative procedure act (“apa”), 5 u.s.c. §§ 701, et seq., arguing that the irs exceeded its statutory authority in promulgating circular 230 (count iii). plaintiffs sought a declaratory judgment that circular 230’s restrictions of contingent fee arrangements in the context of “ordinary refund claims” is unconstitutional and exceeds the scope of the irs’s authorizing statute, and they sought a permanent injunction barring the enforcement of circular 230’s restrictions on the use of contingent fee arrangements for “ordinary refund claims.” the district court (judge wilkins) dismissed counts i and ii on the grounds that: count i failed to state a claim upon which relief may be granted, and mr. ryan lacked standing under count ii to pursue a due process claim so that claim lacked jurisdiction.  with respect to an issue he didn’t address, judge wilkins stated: in pressing for the dismissal of plaintiffs’ claim, the government first argues that the petition clause does not protect “a taxpayer’s right to file an administrative claim for refund” with the irs. (defs.’ reply at 7). the court finds this proposition dubious. not only has the supreme court explicitly held that petition clause guarantees citizens the ability to seek relief with courts, but it has also made clear that these protections extend to “other forums established by the government for the resolution of legal disputes.” borough of duryea, 131 s. ct. at 2494. the court has also explained that “[t]he same philosophy governs the approach of citizens or groups of them to administrative agencies 436 florida tax review [vol. 15:5 (which are both creatures of the legislature, and arms of the executive) and to courts, the third branch of government.” cal. motor transport co. v. trucking unlimited, 404 u.s. 508, 510 (1972) (“certainly the right to petition extends to all departments of the government. the right of access to the courts is indeed but one aspect of the right of petition.”). insofar as the internal revenue service is an administrative agency established by the government, the court believes that the petition clause would protect citizens’ rights to file claims with the irs, as plaintiffs suggest. on balance, however, the court need not directly pass on this issue because, even assuming that the right to file a refund claim with the irs does fall within the ambit of the petition clause’s protections, plaintiffs fail to allege any constitutionally cognizable violation or impingement of such a right. 3. new nationwide rollout of fast track settlement (“fts”) program for small businesses and self-employed individuals (“sb/se”) means settlement opportunities for taxpayers. ir-2013-88, 2013 tnt 216-10 (11/6/13). fts uses alternative dispute resolution techniques to help taxpayers save time, so audit issues can usually be resolved within 60 days – and, taxpayers who choose this option do not forfeit their appeal rights if the fts process is unsuccessful. normally, the appeals representative acts as mediator between the taxpayer and representatives from sb/se’s examination division.  any time the irs initiates a new program, those administering the program want to see it work. therefore, taxpayers who utilize the program in its early days have settlement opportunities unavailable elsewhere. compare “decisions in aid of jurisdiction” in the court of federal claims. xi. withholding and excise taxes a. employment taxes 1. tax refunds in a bad economy set up another deference conflict among the circuits. in re quality stores, inc., 693 f.3d 605 (6th cir. 9/7/12), cert. granted, 134 s. ct. 49 (10/1/13). in november 2001 quality stores closed 63 stores and 9 distribution centers and terminated the employment of all employees in the course of chapter 11 bankruptcy cases. quality stores adopted plans providing severance pay to terminated employees. the company reported the severance pay as wages for 2014] recent developments in federal income taxation 437 withholding and employment tax purposes then filed claims for refund of fica and futa taxes claiming that the severance pay represented supplemental unemployment compensation benefits (subs) that are not wages for employment tax purposes. disagreeing with the contrary holding by the federal circuit in csx corp. v. united states, 518 f.3d 1328 (fed. cir. 2008), the sixth circuit held that the subs were exempt from employment taxes. the court examined the language and legislative history of § 3402(o)(1), which provides that sub payments “shall be treated as if it were a payment of wages” for withholding purposes, to conclude that by treating sub payments as wages for withholding, congress recognized that sub payments were not otherwise subject to withholding because they did not constitute “wages.” then, under rowan cos. v. united states, 452 u.s. 247, 255 (1981), the court concluded that the term “wages” must carry the same meaning for withholding and employment tax purposes. thus, if subs are not wages under the withholding provision (because they must be treated as wages by statutory directive), the subs are not wages for employment tax purposes. the court also rejected the irs’s position in rev. rul. 90-72, 1990-2 c.b. 211, that to be excluded from employment taxes subs must be part of a plan that is designed to supplement the receipt of state unemployment compensation. the court declined to follow the federal circuit’s holding in csx corp., which adopted the eight part test of rev. rul. 90-72, stating that, “we decline to imbue the irs revenue rulings and private letter rulings with greater significance than the congressional intent expressed in the applicable statutes and legislative histories.” the court also stated that it could not conclude that the opinion in mayo foundation for medical education & research v. united states, 131 s. ct. 704 (2011), eroded the holding of rowan cos. v. united states, which compelled the court to interpret the meaning of “wages” the same for withholding and employment tax purposes. 2. proposed regulations define employment tax liabilities of agents designated by an employer to pay employment taxes. reg-102966-10. designation of payor as agent to perform acts required of an employer, 78 f.r. 6056 (1/29/13). proposed regulations under § 3405 would provide rules regarding obligations for all employment tax under an agreement between an employer and a third party payor that is designated as an agent to perform the acts of the employer. the proposed regulations would provide that all provisions of the law, including penalties, are applicable to the payor, and that the employer for which the payor is designated as agent also remains liable for all provisions of the employment tax. the preamble indicates that consistent with the irs position on administering the § 6672 trust fund penalty, the employment tax liability of an employer will be collected only once whether from the payor or the employer. the agency designation does not apply to (1) a payor that is itself 438 florida tax review [vol. 15:5 the common law employer of a person performing services for a client, (2) a payor that has legal control over the payment of wages under § 3401(d)(1) (and is thus the liable employer), and (2) a payor who is a payroll service provider that reports employment taxes under the employer’s ein. 3. advances to keep employees are wages. the vancouver clinic, inc. v. united states, 111 a.f.t.r.2d 2013-1571 (w.d. wash. 4/9/13). the clinic provided “advances” to newly hired physicians that were subject to repayment if the physician did not continue to work for the clinic for a period of five years. the advances were not reported on form w-2. instead, the clinic reported on form 1099 the subsequent forgiveness of the advances. the court granted summary judgment to the irs on the clinic’s suit for refund after paying employment taxes assessed by the irs. the court rejected the clinic’s assertion that the advances were loans principally on the finding that at the time the arrangements were entered into neither the clinic nor the physicians intended that the advances would be repaid. the court characterized the repayment obligation as liquidated damages payable by the physicians on breach of a contractual obligation to remain at the clinic for five years compelling the conclusion that the advances were compensation for services and thus subject to employment taxes and wage withholding. 4. “the self-employment tax provisions are construed broadly in favor of treating income as earnings from selfemployment.” old mcdonald had a farm and on his farm he collected federal subsidies that were self-employment income. morehouse v. commissioner ̧140 t.c. no. 16 (6/18/13). in a reviewed opinion (15-0-0), the tax court (judge marvel) overruled its prior decision in wuebker v. commissioner, 110 t.c. 431 (1998), rev’d, 205 f.3d 897 (6th cir. 2000), and held that payments under the u.s. department of agriculture (usda) conservation reserve program (crp) are self-employment income subject to self-employment taxes. the taxpayer owned farm land in south dakota, which he had rented to tenant farmers. the taxpayer entered into a crp contract with the usda under which in exchange for annual payments the taxpayer agreed to (1) maintain already established grass and legume cover for the life of the contract; (2) “[e]stablish perennial vegetative cover on land temporarily removed from agricultural production”, including pubescent or intermediate wheatgrass, alfalfa, and sweet clover; and (3) engage in “pest control and pesticide management” for the life of the contract. the taxpayer hired a former tenant farmer to carry out most of the work, but the taxpayer supervised the operation, purchased materials needed to implement the conservation plans, gathered documentation necessary to the crp payments, arranged for individuals to hunt on some of the properties, and visited the properties several times during the tax years involved. the court held that https://checkpoint.riag.com/app/main/doclinknew?docid=ibe11787ecd80c46dca4cb61370cbca47&srcdocid=t0newsltr%3a659323.1dr6&feature=tnews&lastcpreqid=4143495 2014] recent developments in federal income taxation 439 these activities were sufficient to constitute a trade or business carried on by the taxpayer the income from which was subject to self-employment taxes under § 1402(a)(1). the court indicated that regardless of whether the taxpayer’s activities qualified as farming, the taxpayer was directly and through his agent “engaged in the business of participating in the crp and that he enrolled, maintained, and managed multiple properties subject to crp contracts with the primary intent of making a profit.”  the court indicated that the analysis in a proposed revenue ruling published in notice 2006-108, 2006-2 c.b. 118, that would have treated crp payments as self-employment income, while not controlling, was nevertheless well-grounded and consistent with the court’s holding in the case.  the court also held that the crp payments were not rental income excluded from self-employment tax by § 1402(a)(1). although the payments were described as rental in the contract, the court found that the payments were not received in exchange for use or occupancy of the land by the usda. 5. s corporation distributions to sole shareholder sole employee were wages. glass blocks unlimited v. commissioner, t.c. memo. 2013-180 (8/7/13). the irs classified an s corporation as the employer of frederick blodgett, who was its sole shareholder and president. blodgett advanced funds to the corporation to cover operating expenses during years of financial difficulty. in each of 2007 and 2008 the corporation distributed $31,000 to blodgett as repayment of loans. the corporation paid no salary to its shareholder/employee. the tax court (judge halpern) sustained the irs’s deficiency for employment taxes payable on the distributions. the s corporation did not object to the irs’s characterization of the shareholder as an employee and thus the court held that, “[b]ecause mr. blodgett was petitioner’s employee for the periods at issue and performed substantial services for it yet it did not pay him a salary, its distributions to him are deemed wages and thus are subject to federal employment taxes.” the court rejected the taxpayer’s argument that the advances from the shareholder were loans citing the absence of notes or other instruments, the taxpayer’s failure to treat the transfers as loans, and the absence of any interest payments. the court also rejected for lack of evidence the s corporation’s assertion that treating the distributions as wages would result in unreasonable compensation to the shareholder. finally, the court sustained penalties under §§ 6651(a) and 6656 for failure to file employment tax forms and make required deposits. a. this lengthy summary opinion determines reasonable compensation for an s corporation shareholder. sean mcalary ltd. v. commissioner, t.c. summary opinion 2013-62 (8/12/13). mcalary was the sole shareholder and employee of a moderately 440 florida tax review [vol. 15:5 sized real estate brokerage operated as an s corporation. mcalary and the corporation entered into a compensation contract providing for a $24,000 annual salary. most of the corporation’s gross receipts were attributable to commissions generated by mcalary. the corporation did not issue a w-2 to mcalary nor claim deductions for salary paid to him. the corporation did, however, distribute $240,000 to mcalary. the irs expert determined, based on a statistical evaluation of similar sized real estate brokerages that mcalary should earn $48.44 per hour and assessed employment taxes on an annual compensation of $100,755, which reduced the corporation’s profit margin to slightly in excess of the industry average and represented 19.4 percent of the corporation’s gross receipts, again close to industry averages. the court (special trial judge guy) rejected the contract between the corporation and mcalary as controlling because mcalary sat on both sides of the table during the negotiation. the court also was not persuaded by the irs expert’s statistical analysis noting that reasonable compensation depended on the facts and circumstances identified though a multifactor analysis. ultimately the court concluded that $40 per hour was reasonable compensation and assessed employment taxes on the basis of $83,200. the court also sustained additions to tax under §§ 6651(a)(1) and 6656 for failure to file and pay employment taxes. the court rejected the taxpayer’s assertion of reasonable reliance on a tax professional, indicating that the taxpayer failed to present evidence that he investigated the background or qualifications of his return preparer/advisor to confirm that the advisor was a competent professional. 6. the minister of his own church under a vow of poverty must still file the right forms. rogers v. commissioner, t.c. memo. 2013-177 (8/1/13). the taxpayer performed ministerial duties for a church he formed. as compensation the church paid the taxpayer’s home mortgage (although the taxpayer deducted home mortgage interest against other income), personal credit card bills, and utility payments. the tax court (judge paris) held that the payments were income includible under § 61 and wages subject to employment tax. the taxpayer was ineligible to claim exemption from employment taxes under § 1402(c)(4) due to his failure to timely file the mandatory exemption certificate required by § 1402(e)(3). the taxpayer was also not allowed to exclude mortgage payments as a rental allowance under § 107 because of the absence of an employment agreement designating payment of a rental allowance as remuneration for services. finally the court rejected the taxpayer’s argument that the payments were not includible under the taxpayer’s vow of poverty. 7. squeezing blood from a turnip? the taxpayer is enjoined to pay taxes and follow the law. united states v. petrie & sons, 2014] recent developments in federal income taxation 441 inc., 112 a.f.t.r.2d 2013-5760 (e.d. wash. 8/7/13). on findings that the taxpayer failed to file employment tax returns, pay employment taxes, lacked sufficient assets to satisfy outstanding tax liabilities of more than $750,000, the irs was likely to prevail on the merits, and would suffer irreparable harm in the absence of preliminary relief, the taxpayer was enjoined from hindering tax law enforcement and specifically to withhold from employee wages as required by law, deposit withholdings in a bank within 72 hours, and was further enjoined from making any other payments or property transfers until it made payments to the irs. in addition, the taxpayer was ordered to inform employees with check writing authority of the injunction and each such employee was required to provide a written acknowledgment to the irs.  we have not seen such an action in the years we’ve been doing this outline and we wonder whether an injunction to follow the law will change the taxpayer’s behavior (especially the one of us who is related to a deceased tax protestor). 8. employed and self-employed at the same time. this status exists for all u.s. citizens working for foreign consulates in the united states. rosenfeld v. commissioner, t.c. memo 2011-110 (5/23/11), aff’d, 112 a.f.t.r.2d 2013-5638 (9th cir. 8/8/13) (unpublished opinion). the taxpayer, who maintained a consulting business advising clients on marketing, accepted a three year full-time appointment with the british consulate general (bcg) to perform services similar to those provided by the taxpayer to private clients. the tax court (judge dean) held that the taxpayer was an employee of the consulate for withholding purposes and not entitled to separately report income from the engagement on a schedule c. the court found employee status based on the facts that the taxpayer worked under the control of the bcg, the taxpayer received a fixed salary for his services, and the taxpayer’s services furthered bcg’s goals. the court described as “neutral” the facts that, although bcg provided an office (whether or not the taxpayer used the office was irrelevant) the taxpayer incurred many costs associated with his work, the taxpayer’s three year contract was not defined as long term, and either party could terminate the relationship without cause. the court also rejected the taxpayer’s arguments that he was self-employed because the parties defined the relationship as an independent contractor relationship that specifically provided that the bcg would not withhold taxes, and the taxpayer received no employee benefits and concluded that the taxpayer was a common law employee of bcg. 9. husband and wife in a community property state are liable for self-employment tax on their separate activities. fitch v. commissioner, t.c. memo. 2013-244 (10/28/13). donald and barbara fitch 442 florida tax review [vol. 15:5 were married taxpayers in california, a community property state. donald worked as a cpa and reported net losses from his accounting practice on a schedule c. barbara worked as a real estate agent and reported her income on a separate schedule c. in a rule 151 computation from a prior tax court case, fitch v. commissioner, t.c. memo. 2012-358, the irs separately calculated self-employment tax liability for donald as zero, and calculated positive self-employment tax liability for barbara based on her real estate business income. in a supplemental opinion, the tax court (judge vasquez) agreed with the irs that the taxpayers were not permitted to net the individual self-employment income to determine the combined selfemployment tax due on their joint return. section 1402(a)(5)(a) provides that in a community property state income derived from a trade or business that is community property is treated as the gross income (and deductions) of the spouse carrying on the trade or business. the provision adds that if the trade or business in jointly operated, the gross income and deductions are treated as the gross income and deductions of each spouse on the basis of their respective shares of gross income and deductions. the court found that the real estate business was conducted by barbara alone and that donald was not a participant in the business. the court also rejected the taxpayers’ assertion that under reg. § 1.1402(a)-8(a) gross income from a business in a community property state is treated as the income of the husband, pointing out that the regulation pre-dates the 2004 enactment of § 1402(a)(5)(a) and had not been updated to reflect the revised statutory language. 10. t.d.9649, section 3504 agent employment tax liability, 78 f.r. 75471 (12/12/13). final regulations include federal unemployment tax act (futa) withholding taxes within the scope of current regulatory authority that allows employers to meet their fica tax obligations for domestic in-home services through an agent as provided in § 3401. the agent files a single return for multiple employers using the agent’s employer identification number. a. rev. proc. 2013-39, 2013-52 i.r.b. 830 (12/12/13). the irs has described and updated procedures for filing form 2678 for an employer of a provider of domestic in-home services to designate an agent under reg. § 31.3504-1(a) to file employment taxes. 2014] recent developments in federal income taxation 443 b. self-employment taxes there were no significant developments regarding this topic during 2013. c. excise taxes 1. the price of a tan goes up even in disregard of the hazard from which the owner is protected. t.d. 9596, disregarded entities and the indoor tanning services excise tax, 77 f.r. 37806 (6/25/12). temp. and prop. reg. § 1.1361-4t(a)(8)(iii) adds the 10 percent excise tax on indoor tanning services of § 5000b to the list of excise taxes for which disregarded entities (qsub or single owner business entity) are treated as separate entities. a. the price of skin cancer is increased by the excise tax on tanning services. t.d. 9621, indoor tanning services; excise tax, 78 f.r. 34874 (6/11/13). final regulations § 49.5000b-1 are promulgated for collection of the 10 percent excise tax on indoor tanning facilities under § 5000b enacted as part of the affordable health care act. the tax is imposed on amounts paid for indoor tanning services. the final regulations generally adopt provisions in the proposed and temporary regulations. the regulations include an exemption for qualified physical fitness facilities, the predominant business or activity of which is to serve as a physical fitness facility that does not charge separately for indoor tanning services available at the facility. for other purveyors of indoor tanning, the tax applies to amounts actually paid for indoor tanning services that are provided at a reduced rate. the tax does not apply to services that are obtained by redemption of points through a loyalty program. where tanning services are bundled with other goods and services, the final regulations set out a formula to determine the amount reasonably attributable to indoor tanning services. with respect to gift cards, the tax is imposed when the card is redeemed specifically to pay for indoor tanning services and not when the card is purchased. the tax is also imposed on prepaid monthly membership and enrollment fees regardless of the services actually provided. 2. the medical devices excise tax sticks to the manufacturer. chemence medical products, inc. v. medline industries, inc., 112 a.f.t.r.2d 2013-7245 (n.d. ga. 12/5/13). in a declaratory relief action, the court held that the 2.3 percent tax on medical devices imposed under § 4191(a), enacted as part of the affordable care act, falls on the manufacturer rather than the distributor. before enactment of the aca, chemence medical products entered into a contract to supply adhesives to medline, a distributor of medical supplies. chemence sought declaratory https://checkpoint.riag.com/app/main/doclinknew?usid=684598a089&docid=iea03806637f7c857a8dfa3ed1427e053&srcdocid=t0newsltr%3a624826.1dr7&feature=tnews&lastcpreqid=1243697&pinpnt=tregs%3a114406.2&d=d#tregs:114406.2 444 florida tax review [vol. 15:5 relief that it could pass the tax onto the supplier as a price increase, notwithstanding the fact that price increases were limited under the agreement between chemence and medline. the court found that the language of § 4191 and reg. § 48.4191-1(c) are clear that the incidence of the tax falls on the manufacturer when the manufacturer is taxable. the court rejected arguments by the manufacturer that language in the statute imposing the tax at the highest wholesale price, imposing the tax on distributors when the manufacturer, producer, or importer is “untaxable”, or that pass-through provisions in the statute indicate the ultimate burden of the tax should fall on the entity that bears the tax permit shifting the tax from the manufacturer. the court also found that provisions in the sales agreement prohibited chemence from passing the tax to medline as a price increase. xii. tax legislation a. enacted 1. for this he needs an act of congress? h.r. 3458, the fallen firefighters assistance tax clarification act of 2013, p.l. 113-63 was signed by president obama on 12/20/13. this act exempts from income payments from public charities under §§ 509(a)(1) and (2) to firefighters [formerly, firemen] injured in a 12/24/12 ambush, or to the spouses or dependents of firefighters who were killed, when responding to a fire in webster, ny. payments between 12/24/12 and 1/19/14 will qualify for the exemption. the three parties in the race to the bottom: host governments, home governments and multin 151 florida tax review volume 7 2005 number 3 the three parties in the race to the bottom: host governments, home governments and multinational companies by rosanne altshuler harry grubert abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152 i. the u.s. rules for taxing foreign income and the new planning structures . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 ii. data sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 iii. country average effective tax rates, 1980-2000 . . . . . . . . 158 iv. tax planning and changes in firm level effective tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 v. evidence on the growth of income shifting at the subsidiary level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 vi. evidence on the location of income and real capital . . 166 vii. evidence on tax planning in the bea data . . . . . . . . . . . . . 166 viii. the double counting problem . . . . . . . . . . . . . . . . . . . . . . . 167 ix. implications of the growth of equity income from foreign affiliations . . . . . . . . . . . . . . . . . . . . . . . . . . . 168 x. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 152 florida tax review [vol.7:3 * associate professor of economics, rutgers university. ** economist in the office of tax analysis, u.s. treasury. nothing in this paper should be construed as reflecting the views and policy of the u.s. treasury department. we are grateful for comments from paul mcdaniel, jack mintz, andrew lyon and william randolph. we thank raymond mataloni for help with the department of commerce data and gordon wilson for help with the tax return data. the three parties in the race to the bottom: host governments, home governments and multinational companies by rosanne altshuler* harry grubert** abstract most studies of tax competition and the race to the bottom focus on potential host countries competing for mobile capital, neglecting the role of corporate tax planning and of home governments that facilitate this planning. this neglect in part reflects the narrow view frequently taken of the policy instruments that countries have available in tax competition. for example, hightax host governments can permit income to be shifted out to tax havens as a way of attracting mobile companies. home countries will cooperate in this shift if they think the benefit to their companies is greater than any reduction in the domestic tax base. we use various types of u.s. data, including firm level tax files, to identify the role of the three parties (host governments, home governments and multinational companies) in the evolution of tax burdens on u.s. companies abroad from 1992 to 2002. this period is of particular interest because the united states introduced regulations in 1997 that greatly simplified the use of more aggressive tax planning techniques. the evidence indicates that from 1992 to 1998 the decline in effective tax rates on u.s. companies was driven largely by host governments defending their market share. but after 1998, tax avoidance behavior seems much more important. effective tax rates on u.s. companies had a much weaker link with local statutory tax rates. furthermore, the disparity in the reported profitability of subsidiaries in high-tax and low-tax jurisdictions grew substantially. after 1997, there was a very large growth in intercompany payments and a parallel growth of holding company income. we attempt to estimate how much of these payments were deductible in the host country, and conclude that by 2002 the companies were saving about $7.0 billion per year by using the 2005] the three parties in the race to the bottom 153 1. for a discussion on how to construct measures of effective tax rates that reflect opportunities for various multilateral strategies, see grubert, harry, 2004, “the tax burden on cross-border investment: company strategies and country responses,” in: measuring the tax burden on labor and capital, edited by peter birch sorensen. cambridge, massachusetts: mit press (cesifo seminar series): 129-170, [hereinafter grubert (2004)]. more aggressive planning strategies. this amounts to about 4% of foreign direct investment income and about 15% of their foreign tax burden. i. introduction the tax competition literature generally focuses on potential host countries competing for mobile capital. but there are two other participants that are important to the evolution of tax burdens: multinational companies (mncs) that engage in various tax planning strategies and home governments that can facilitate the use of these strategies in order to bolster their companies’ competitiveness. discussions of tax competition tend to focus only on a narrow range of policy instruments that governments can use to attract companies, as reflected in effective tax rates that embody statutory tax rates, accelerated depreciation and investment credits. but host governments can use other inducements as well, such as lax thin capitalization rules that permit multinational companies to take large deductions for interest paid to affiliates offshore. at the same time home countries can cooperate in this strategy by allowing the use of tax haven finance affiliates for the receipt of this interest. this example illustrates the fact that tax competition cannot be gauged by straightforward bilateral effective tax rates because some subset of the participants can cooperate in the shifting of income to a third country.1 this paper uses data on the operations of u.s. companies abroad to illustrate the role of each of the actors in the reduction of corporate tax burdens. the period covered is from 1992 to 2002, with special emphasis on the period after 1996. in 1997, the u.s. treasury issued regulations which were initially targeted on purely domestic businesses but had important international implications because they greatly simplified the use of more aggressive tax planning strategies. indeed, we will see that the driving force behind the fall in effective tax rates on u.s. companies changed after 1996. prior to then, there seemed to be pressure on countries that had lost market share to lower their effective tax rates. after 1996, the role of company tax saving strategies was much more evident. the paper proceeds as follows: first, the basics of the u.s. system for taxing foreign direct investment income will be described including the significance of the rules introduced in 1997. this provides the context for the various tax planning strategies that have become commonplace. reviewing the details of the tax rules is necessary in order to make an accurate assessment of 154 florida tax review [vol.7:3 the tax burdens on cross-border investment. the incentives of host and home countries in the tax competition process will also be examined. the empirical analysis looks at the issues from several angles using different types of data because tax strategies can use alternative structures that reveal themselves in a variety of ways. no single data set gives the complete picture. we begin with the evolution of the average effective tax rates (aetrs) on the net income earned by u.s. manufacturing companies in approximately 60 countries from 1992 to 2000. this analysis provides suggestive evidence on the respective roles of the players. but country rates are not completely definitive because income in the form of interest or royalties could have been shifted to holding companies or finance affiliates in tax havens. this would not be captured in the country average effective tax rates for manufacturing subsidiaries. but data on foreign direct investment income and country affiliate income provided by the bureau of economic analysis (bea) in the u.s. commerce department allow us to estimate the growth of deductible payments paid to low-tax entities. in addition, treasury tax data shows the growth of income in companies incorporated in low-tax countries. these tax haven corporations also record a large growth in plant and equipment, which must in fact be located in operations somewhere else, presumably in a high-tax country. this is facilitated by the new planning strategies described below, in which one subsidiary can invest in another but one of them can “disappear” into a combined entity for u.s. tax purposes. the comparison of subsidiary-level treasury data for 1996 and 2000 adds further insight into the sources of the declines in foreign tax burdens. these data permit an examination of the relationship between subsidiary effective tax rates and country statutory rates and whether it changed in 2000 compared to 1996 because of the new tax planning opportunities. we also attempt to see whether a greater share of income has been shifted to companies in low-tax countries. the results indicate that all three parties have played important roles in the decline in effective tax burdens since 1992. from 1992 to 1998, countries appeared to react to their past success, or the lack of it, in attracting u.s. investment. the countries that had lost market share cut their effective tax rates more. also small countries, which would face the most elastic supply of foreign capital, continued to reduce their effective tax rates. the new opportunities for tax avoidance introduced in 1997 seemed to be a much more important force from 1998 onward. changes in market share were no longer significant determinants of effective tax rates and small countries were not the leading tax cutters. a country’s initial statutory tax rate, which indicates the benefits to the company of shifting income out, became more important between 1998 and 2000. the role of the companies and the cooperation, or nonresistance, of home and host countries is confirmed in the subsidiary-level data for 1996 and 2000. controlled foreign corporation (cfc) effective tax rates in 2000 were much less closely correlated with the local 2005] the three parties in the race to the bottom 155 statutory corporate tax rate than in 1996, suggesting that some profitable companies in high-tax locations were in a position to engage in “self-help” by taking advantage of the new planning opportunities. furthermore the disparity of cfc profitability between high-tax and low-tax countries widened substantially in 2000 compared to 1996. this might have happened, for example, if a highly profitable operation formerly incorporated in a high-tax location disappeared into a low-tax sibling that had stripped income out of it. (this planning technique is described below.) the surveys of direct investors by the bureau of economic analysis in the u.s. commerce department show a very large increase in intercompany payments and in the income of holding companies abroad after 1997. this presumably resulted from the new planning structures facilitated by the 1997 treasury department regulations. but in interpreting this growth in intercompany income it is important to distinguish between deductible payments like interest and nondeductible payment like dividends paid out of after-tax income. using two different bea series, we conclude that approximately 40% of the growth of intercompany income was in the form of payments deductible in the host country (and presumably not taxable in the receiving country). we therefore estimate that the multinational corporations saved about $7 billion in taxes in 2002 compared to what they would have paid if they continued to behave the same way as in 1997. this is about 4% of foreign direct investment income and more than 15% of total host country tax burdens. this shows that a large component of the falling burdens on mobile capital can be missed if the tax planning by the companies and the home and host country policies that permit this planning are ignored. ii. the u.s. rules for taxing foreign income and the new planning structures the united states imposes the corporate tax on all repatriated foreign income, which includes not only dividends but also interest, royalties and other foreign payments such as compensation for services performed abroad. the tentative u.s. tax can be reduced because of credits granted for foreign income taxes paid, including the underlying corporate tax paid on direct investment abroad, but the credit is limited to what the u.s. tax would have been on the foreign income. the repatriation of net active business income can be deferred but this deferral privilege is not extended to certain types of “tainted” income under what are generally referred to as controlled foreign corporation (cfc) rules. this tainted income includes passive portfolio income and the payment of interest, dividends and royalties from one cfc to a cfc in another jurisdiction. prior to 1997, u.s. companies could not therefore benefit from a tax haven finance subsidiary. in that scheme, equity is injected into a tax haven company which then lends to a high-tax subsidiary. the high-tax subsidiary then pays 156 florida tax review [vol.7:3 2. another way in which home countries increase the competitiveness of their companies is by not requiring them to allocate overhead expenses to foreign income. thus a company can borrow at home and invest equity in a low-tax jurisdiction, thereby receiving a tax deduction for the interest while paying little or no tax on its earnings. among the oecd countries, only the united states makes a serious effort to require interest allocations, and that is incomplete because it operates only through the foreign tax credit limitation. interest which is deductible against local taxable income to its tax haven affiliate. the 1997 regulations introduced “hybrid entities” which allowed u.s. companies to avoid the current tax under the cfc rules on intercompany payments like interest and royalties. (these regulations are sometimes referred to as “check-the-box” because they gave companies the freedom to either identify an entity as a separate corporation or to “disregard” it as the unincorporated branch of another corporation by simply checking the box on a tax form.) hybrid entities are business operations that are regarded as corporations by one country while being an unincorporated branch to another. in the tax haven finance affiliate example, the mnc could report to the u.s. treasury that the high-tax affiliate is really an unincorporated branch of the tax haven company from which it has borrowed. the affiliate is still regarded as a corporation by the high-tax host country which grants a deduction for the interest going to the tax haven but the transaction is invisible to the u.s. treasury which regards the combined tax haven-high-tax operation as one consolidated corporation. the interest payment therefore escapes the cfc rules and the company can defer the income in the tax haven. the interest is not taxed anywhere. this example illustrates that “standard” host country effective tax rates do not convey the complete picture in any analysis of the race to the bottom. what makes the use of these new planning structures difficult to identify in the data is that the mnc can elect to have either the high-tax corporation or its tax haven sibling disappear. in its reports to the treasury, the surviving consolidated corporation can be listed as incorporated in either the high-tax location or the tax haven. it will therefore be necessary to piece together different types of data to get a more comprehensive picture. why would a home country allow this kind of method of stripping income from a high-tax location to a tax haven? it depends on its judgment on the consequences of lowering the tax burden on its companies in the high-tax location. if its home-based companies now shift to the high-tax location from foreign low-tax locations, from ireland to germany for example, both the world and the home country are better off. capital has moved to a location with a higher pre-tax return.2 the high-tax host country could resist this income stripping strategy by enforcing “thin capitalization” rules which limit the extent to which a company can leverage itself up, particularly when the interest is paid to related parties 2005] the three parties in the race to the bottom 157 offshore. but it may not choose to do so as a way of discriminating in favor of internationally mobile companies that can take advantage of these income shifting strategies. this example also illustrates that tax competition can operate along many dimensions, not just in the lowering of statutory corporate tax rates or the granting of investment credits that tend to get the most attention. hybrid entities can also be used to route dividends to a holding company in a country with a favorable holding company regime, one that exempts dividends and has an extensive tax treaty network assuring low withholding taxes on dividends. multinational corporations frequently find it convenient to organize their foreign investments through holding companies. inter-affiliate dividends can also be used to reduce the u.s. residual tax on repatriations from low-tax countries (see altshuler and grubert 2003). without the use of a hybrid entity, the intercompany dividends would generally be subject to current u.s. tax. hybrid entities make them invisible to the u.s. treasury. hybrids can thus be used to make either intercompany payments like interest and royalties that are deductible from host company taxable income, or dividends paid out of after-tax equity income. as a result, these payments can have differing implications for the tax burden on foreign investment. distinguishing between the two will become an issue when we attempt to interpret the significance of the growth in intercompany payments documented in the bureau of economic analysis surveys. (these differ from the treasury data in that they keep the two entities that are combined in the treasury data as separate affiliates.) a further use of hybrid entities is to shift income from intellectual property like patents to tax havens by making the intercompany payment of royalties invisible. the tax haven entity can engage in a cost sharing agreement whereby it pays for part of the parent’s r&d project. this gives it the right to license the resulting technology to other foreign subsidiaries in exchange for royalty payments. because the appropriate cost sharing payments and royalties are very uncertain, the mnc can attempt to underprice the former and overprice the latter, leaving a large amount of income in the tax haven. the royalty payments by the high-tax affiliate are not subject to the anti-abuse cfc rules because the tax haven entity and the high-tax affiliate can be declared as one consolidated incorporated subsidiary. hybrid securities are another planning device that can sometimes achieve the same results as hybrid entities. these are instruments that are regarded as debt by the host country and equity by the country to which income payments are made. they exploit the difficulties that tax authorities have in determining the distinction between tax deductible debt and taxable equity. these hybrid securities are particularly effective in saving taxes when the receiving country employs a dividend exemption or a “territorial” system as it is sometimes referred to. examples are the netherlands, france and canada which exempt dividends paid from an active direct investment abroad. thus a canadian company can capitalize an operating subsidiary in the united states 158 florida tax review [vol.7:3 with a hybrid security and receive payments that are deductible in the united states but exempt at home. once again the income completely escapes taxation at the corporate level. hybrid securities can be combined with hybrid entities to ensure a deduction in the paying host country, no tax in the receiving foreign country and no tax by the united states. grubert (2004) addresses the issue of how company and government behavior can impact effective tax rates. he shows that some of the most important features of a home country tax system for determining the tax burden on cross-border investment are rules that either limit or accentuate the ability of firms to use self-help techniques to lower their tax burdens. for example, grubert’s work demonstrates that whether companies can use tax haven finance subsidiaries or other aggressive planning schemes can have a profound impact on effective tax rates for investments abroad. these rules are shown to have a much larger impact on tax burdens for foreign investment than those relating to whether foreign income is exempt from home country taxation, for example. iii. data sources the principal data source for this paper is the treasury tax files for u.s. multinational corporations, in particular the form 5471 which every u.s. parent company has to file for each of its controlled foreign corporations. this form provides information on the cfc’s country of incorporation, and its sales, assets and inter-company transactions with related parties. it also contains information on foreign income taxes paid and a measure of net income defined in the internal revenue code, referred to as earnings and profits, which approximates book income, not local taxable income. it is therefore possible to compute a consistent effective tax rate measure both for the country as a whole or for the individual subsidiary. in addition the basic corporate tax return, form 1120, is used for various parent characteristics such as r&d intensity. the surveys of foreign direct investment published by the bureau of economic analysis in the commerce department are an alternative data source for studying mnc behavior. they are a useful supplement to the treasury data because they define foreign affiliate income earned in a particular location in a different, and sometimes more convenient, way. iv. country average effective tax rates, 1980-2000 table 1 presents the means and standard deviations of average effective tax rates for u.s. manufacturing subsidiaries in 58 countries. host country average effective tax rates are calculated by dividing the total income taxes paid by u.s. cfcs in the manufacturing sector by their total earnings and profits (only cfcs with positive earnings and profits are included in the totals). the global means for each year presented in the table are an average of the effective 2005] the three parties in the race to the bottom 159 tax rates in all 58 countries weighted by the number of cfcs in each country in 1990. altshuler, grubert, and newlon (2001) (hereafter, agn) used these data to explicitly test whether the location of capital invested abroad by manufacturing affiliates of u.s. mncs became more sensitive to differences in host country effective tax rates between 1984 and 1992. this work provides strong evidence that firms have indeed become more responsive to differences in tax rates. in research using the same tax return data for 1984 through 1992, grubert (2001) looked for changes in the behavior of both taxpayers and governments. among other questions, he asked whether the behavior of governments during this period suggests more tax competition. grubert found that smaller, poorer, and more open countries lowered their tax rates the most between 1984 and 1992. this is consistent with tax competition since one would expect that these countries would be most affected by the increased mobility of capital. here we focus on the period from 1992 to 2000. table 1 shows that the decline in average effective tax rates documented in earlier work has continued. since 1980, the global average effective tax rate has fallen by about 12 percentage points. the data shows a relatively large drop in effective tax rates between 1998 and 2000. it is also interesting to note that the distribution of worldwide tax rates has become tighter in the last decade (the standard deviation has fallen and increased relative to the mean) indicating some convergence in effective tax rates. while we think it is possible that tax competition between countries is responsible for part of the drop in effective tax rates since 1992 (our initial year of analysis for this project), we suspect that the growth of hybrids (and thus company responses) may play an important role in explaining the most recent decreases in effective tax rates. for this reason we look at changes in country effective tax rates between 1992 and 1998 separately from the changes between 1998 and 2000. we start by using simple regression analysis to test for evidence of tax competition in the period between 1992 and 1998. one test is whether country responses to changes in their share of u.s. capital explain changes in effective tax rates. we then look at the period between 1992 and 2000 to see whether the process explaining decreases in country effective tax rates have changed. finally we focus on the last two years of data, 1998 and 2000, and test whether company versus country responses explain differences in the pattern of declines in effective tax rates across countries. the data is subsidiary-level information from the form 5471 aggregated up to the country level (for the same 58 countries used in table 1 and shown in the appendix). to control for heteroskedasticity, we weight by the number of cfcs in each country in 1992. the dependent variable is the change in a country’s average effective tax rate (aetr) measured by subtracting the 1998 160 florida tax review [vol.7:3 rate from the 1992 rate. thus, if the change is positive (negative), effective tax rates have fallen (increased). the main independent variable of interest is the percentage change in u.s. manufacturing affiliate capital, calculated by subtracting the log of real capital held by u.s. manufacturing affiliates in a country in 1984 from the log of real capital held in 1992. this is the change in capital studied in agn so the data was readily available to us and convenient to use. did the locations loosing market share feel pressure to lower their tax rates to compete? in all of the regressions, we control for the country’s initial level of effective tax rate and include a dummy variable that equals one if the country is “small” (has a population of less than 15 million in 1992). note that we use the 1990 rate to control for the “initial” level of each country’s effective tax rate. including the 1992 effective tax rate in the regression could create a spurious correlation between the 1992-1998 change in tax rates and the 1992 rate. furthermore, including a lagged value of the change in capital share ensures that this independent variable is not endogenous. the results presented in table 2a are suggestive of a tax competition story. the first column presents results from what we consider to be a basic test for tax competition. the coefficient on the change in capital share, log(capital in 1992) – log(capital in 1984), is negative and highly significant. countries losing market share relative to their neighbors (those with the most to gain) cut their effective tax rates more between 1992 and 1998. conversely, the higher was a country’s increase in capital between 1984 and 1992, the smaller were their tax cuts. turning to the other independent variables we see that rates fell more for countries with higher initial effective tax rates. the estimated coefficient on the 1990 average effective tax rate variable is positive, large in magnitude, and statistically different from zero at more than a 1% confidence level. this is also consistent with a tax competition story. those countries that had relatively high rates made adjustments to their tax structure that resulted in larger decreases in effective tax rates over the period 1992 to 1998. in a competitive environment, these countries would be the ones that feel the greatest pressure to reduce rates. finally, the coefficient on the dummy for small countries is positive and is also very significant, again suggesting an international motivation for corporate tax reductions. smaller countries, which may face the most elastic supply of capital, lowered effective tax rates relatively more than the average. grubert (2001) found the same result in his analysis of the factors causing the fall in country average effective tax rates between 1984 and 1992. interestingly, as we will see, this result vanishes when we focus on the changes in country effective tax rates between 1998 and 2000. in the second column of table 2a we show the results of a regression that includes a term that interacts the market share variable with the 1990 effective tax rate. this allows us to test, for example, whether countries that had gained market share between 1984 and 1992 and had relatively high effective 2005] the three parties in the race to the bottom 161 tax rates felt less pressure to lower their tax rates. alternatively, the question can be posed as follows: does the increase in capital mobility over the 19841992 period explain the pattern of declines in effective tax rates? the high-tax countries that lost substantial market share would have been the most likely to conclude that capital mobility increased. conversely the low-tax countries that did not gain or even lost would have felt no pressure to lower their tax rates any further. but, the estimated coefficient on the interaction term, shown in column 2, is not significantly different from zero. this suggests to us that the changes in effective tax rates between 1992 and 1998 are more the result of simple tax competition among countries than countries responding to recent increases in capital mobility. the third column shows the result of a more sophisticated test designed to identify the role played by increased capital mobility. we start by using the coefficient estimates from the regression equation in agn to predict the change in capital between 1984 and 1992. we then calculate the difference between the actual change in capital and the predicted change. countries with more elastic supplies of capital will gain (lose) more capital when tax burdens are lowered (increased). to capture this, we interact the difference between the actual and predicted change in capital with the tax terms relevant for the change in capital (the 1984 effective tax rate and the difference in the 1984 and 1992 rates) and test whether the interacted term is a significant explanatory variable. column 3 shows that the interaction term is not statistically different from zero. although we plan to continue work on this topic, our results to date suggest that increased mobility does not explain movements in effective tax rates as well as simple differences in changes in capital shares. we test whether changes in effective tax rates differ across regions in the fourth column of table 2a. only the dummy variable for latin america has an estimated coefficient that is statistically different from zero at conventional levels. interestingly, the coefficient is negative which indicates that latin american countries cut their rates less on average between 1992 and 1998. in an experiment that we do not report, we interact regional dummy variables for two areas of interest, the eec and asia, with the change in capital share variable (log of capital in 1992 – log of capital in 1984). neither coefficient on the regional interaction terms was statistically different from zero which suggests that tax competition was no different on average in these regions. table 2b includes the 2000 data. as mentioned above, we are interested in exploring whether, in recent years, company rather than country behavior explains the pattern of decreases in effective tax rates. accordingly, an important explanatory variable to include in the analysis is the statutory tax rate. the higher is this rate the greater the incentive to strip income out of high-tax countries with related party debt, for example, to lower the effective tax burden on investment. thus, the extent to which company responses cause decreases in effective tax rates will be captured by the coefficient estimate on the statutory rate. if country responses are driving the effective tax rate reductions, we would 162 florida tax review [vol.7:3 not expect statutory rates to be correlated with changes in effective tax rates. countries with high statutory rates and low effective tax rates, for example, would not feel pressure to lower effective tax rates to attract investment. as a result, the initial level of the statutory rate would not be a significant explanatory variable. the first column of table 2b adds the statutory tax rate in 1992 to our regressions and shows that it is not statistically different from zero. these results change markedly when we extend our analysis to the year 2000. changes in capital share no longer explain differences in effective tax rate decreases. and the statutory rate in 1992, while not significant at conventional levels, has much greater explanatory power. this suggests to us that tax changes between 1998 and 2000 may be the result of a different dynamic than that explaining the 1992 to 1998 experience. tax competition seems to explain the changes in rates between 1992 and 1998; company tax-minimizing behavior becomes important when we add the 2000 data. although it is possible that countries are competing by lowering statutory corporate tax rates in order to attract base shifting, it is not clear why the pattern would change when we include the 2000 data. table 3 takes a closer look at the last two years of our data. as explained above, the incentive to use self-help tools such as hybrid entities to lower tax burdens depends on statutory tax rates. earnings stripping, which can be accomplished through the use of hybrids, is beneficial when interest is deducted from an affiliate in a high statutory tax rate country and paid to an affiliate in a low (or no) statutory tax rate country. table 3 begins by testing whether the 1996 average effective tax rate (we use the 1996 rate for the same reasons we used the 1990 rate in the table 2 regressions) or the statutory tax rate better explains differences in changes in average effective tax rates across countries between 1998 and 2000. again the dependent variable is constructed to be positive when tax rates fall: it equals the aetr for 1998 minus the aetr for 2000. the first two columns of table 3 test whether the average effective tax rate in 1996 explains any of the variation in the change in effective tax rates from 1998 to 2000. note that the estimated coefficient on the 1996 rate, while positive, is not statistically different from zero at standard levels. also, the coefficient on the small country dummy is no longer positive and is not statistically different from zero. the evidence for tax competition found in table 2a which examines the period from 1992 to 1998 is no longer evident. in columns 3 and 4 we substitute the statutory rate in 1998 for the aetr in 1996. this exercise provides some suggestive evidence that company rather than country behavior may be responsible for the decrease in effective rates between 1998 and 2000. the estimated coefficient on the statutory rate is positive and significant at the 10% confidence level. however, when we add regional dummies to this regression (in column 4) the magnitude of the coefficient decreases and the standard error increases. 2005] the three parties in the race to the bottom 163 3. the subsidiary level regressions include observations in bermuda and the cayman islands in addition to the 58 listed in the appendix. 4. one possible explanation for the low statutory tax rate coefficient might simply be that cfc effective rates on average fell relative to statutory rates. but, in fact, that is not true in comparing the 1996 and 2000 samples. the sample average effective rate dropped from 23.5% to 21.5% while the sample statutory rate fell proportionately more, from 35.4% to 31.8%. the final column of table 3 shows the results of the test of the tax competition story we explored in tables 2a and 2b. not surprisingly given the results in the last column of table 2b, the change in capital share variable is not significantly different from zero. although only suggestive, our results point to company behavior and not tax competition explaining changes in effective tax rates in the most current data. v. tax planning and changes in firm level effective tax rates the subsidiary level data from form 5471 may be used to shed more light on the question of whether company tax planning behavior made possible by the recent changes in the tax rules explains the latest reductions in effective tax rates. we cannot directly observe the extent to which tax planning has lowered cfc effective tax rates. however, we can determine whether factors explaining the variation in company effective tax rates have changed in recent years. for instance, one would expect statutory tax rates and effective tax rates to be highly correlated. but check-the-box and the opportunity to use hybrid securities to strip income out of high-tax countries may weaken this relationship. the regressions shown in table 4 explore whether determinants of cfc effective tax rates such as statutory rates have changed in a way that is consistent with the use of tax planning techniques. the empirical work uses the3 1996 and 2000 cfc-level form 5471 data matched to parent data from the treasury tax return files. as in our previous work, we include only manufacturing cfcs of u.s. manufacturing parents. the dependent variable in the table 4 regressions is the cfc effective tax rate. independent variables include the country statutory rate and both parent and subsidiary specific information. note that in table 4 we show the results of regressions in which the cfc observations are unweighted and also those weighted by sales to correct for heteroskedasticity. as mentioned above, if companies have increasingly used hybrids, we would expect the significance of the statutory rate in explaining effective tax rates to decrease, since some are presumably in position to take advantage of the new planning structures while others are not due to host country provisions or particular company circumstances. this is born out by the regression results. the coefficient on the statutory rate is smaller and much less statistically significant in the 2000 regressions than in the 1996 regressions. the t-statistics4 in the unweighted (weighted) regression falls from 13.7 (21.1) to 7.7 (10.2). the 164 florida tax review [vol.7:3 5. another piece of evidence consistent with an increase in hybrids is that there are less cfcs in the 2000 sample than in the 1996. there were about 600 fewer manufacturing cfcs among the top 7,500 (in terms of assets or sales) in 2000. some of the highly profitable cfcs in high-tax locations may now be consolidated with another manufacturing cfc using a hybrid, or the surviving consolidated entity may now be classified in some nonmanufacturing industry. another possibility is the change to the system of classification (naics) that may have resulted in some companies formerly in manufacturing ending up in other classifications such as software. as we will see below, the total number of manufacturing cfcs did grow from 1996 to 2000. lower adjusted r-squared in the 2000 regression is consistent with the weaker explanatory power of the statutory rates. note that the constant term in the regressions rose substantially in 2000, suggesting that at the low end effective tax rates were higher for any given statutory rate. these would reflect the cases in which the subsidiary incorporated in a low-tax country is the surviving entity and some of the tax was in fact paid to the high-tax jurisdiction. the lower effective tax rate at high statutory tax rates would reflect the cases in which the consolidated operation is still incorporated in the high-tax location but some of the income has not been subject to tax there. the role of profitability in explaining differences in effective tax rates has also changed. one would expect that the more profitable cfcs would have higher effective rates since they pay the statutory rate on the margin. at the same time, however, the more profitable cfcs have a greater incentive to use hybrids and other planning techniques to strip income from their tax base. our regression results show that in 1996, differences in profitability explained none of the variation in cfc effective tax rates (the coefficient is not statistically different from zero). in 2000, however, the coefficient on cfc earnings and profits (as a percentage of sales) was negative and statistically different from zero at conventional levels. higher profitability in a country is now associated with lower effective tax rates. we also find a difference in the role of parent r&d intensity across the two years. in 1996, parent r&d intensity had a positive and significant effect on cfc effective tax rates. this suggests rent extraction by host countries who believe that, for most intangibles assets like patents, the mnc has to produce locally in order to be in the market. as we explained above, however, checkthe-box made it easier to lower effective tax rates in high-tax countries through cost sharing agreements. our regression results provide some suggestive evidence of this tax planning behavior. the coefficient on parent r&d intensity is smaller in magnitude and significance in 2000 compared to 1996. in the weighted regression results, the coefficient actually becomes negative and highly significant statistically. higher r&d expenditures at the parent level, all else equal, are associated with lower effective tax rates at the cfc-level in 2000.5 2005] the three parties in the race to the bottom 165 vi. evidence on the growth of income shifting at the subsidiary level the observation that reported profitability is much higher in low-tax countries than high-tax countries, suggesting tax induced income shifting, goes back a long way, at least to grubert and mutti (1991). these differences in profitability could be attributable to the shifting of debt, and therefore interest deductions, to high-tax jurisdictions, the manipulation of transfer prices for goods and services, or the failure to pay adequate royalties for intellectual property contributed by the parent company. here we attempt to see whether the new opportunities for tax avoidance made possible by recent regulatory changes, and the possible complaisant attitude of the high-tax host countries wishing to attract investment, contributed to a widening of the profitability difference between highand low-tax countries. the effective tax rate relevant for investment in a location should be reduced to reflect the opportunities created by the investment for shifting income in (for low-tax countries) or out (for high-tax countries). (see grubert (2004) for a discussion of revising effective tax rates to reflect income shifting.) tables 5a and 5b therefore compare income shifting behavior in 1996 and 2000. table 5a includes all manufacturing cfcs with positive profits while table 5b includes only the manufacturing subsidiaries among the 7500 largest. the dependent variable in each of the regressions is the ratio of pre-tax profits to sales. the explanatory variables are two dummies for cfc age, the r&d and advertising intensity of the parent, and the local statutory tax rate. the latter indicates the incentive to shift income in or out because it is the tax paid or saved on a marginal dollar of income. as expected, the r&d and advertising intensity of the parent are significant contributors to cfc profitability. the shifting variable, the statutory tax rate, has the expected negative sign and is highly significant in all the regressions. but what is notable is that the coefficient for 2000 is significantly larger in absolute value than the 1996 coefficient, by about two thirds. there indeed seems to have been a significant widening in the profitability disparities between high-tax and low-tax countries. this evidence of growing profitability disparities has several possible explanations. high-tax host countries may have reacted to the increasing tax sensitivity of investment by easing up on their transfer pricing and thin capitalization rules in order to attract mobile corporations. it could be that some highly profitable subsidiaries in high-tax countries “disappeared” as separate cfcs and became part of a consolidated entity based in a tax haven and are classified as holding companies. (the consolidated entities that survive as hightax corporations in the treasury files explain the negative coefficient for profits in the effective tax rate regressions for 2000 in the previous section. for both structures, the most profitable companies are the ones most likely to avail themselves of the new planning strategies.) some consolidated entities listed in tax havens do continue to be classified in manufacturing and are therefore 166 florida tax review [vol.7:3 6. note that these figures do not include dividends received by hybrid entities in low-tax countries since information on these operations does not appear in the form 5471 file. included as observations in our regressions. in fact, this explains part of the apparent growing amount of income shifting. in some of the regressions, such as the unweighted regressions in table 5b, the increase in the shifting coefficient shrinks by almost one half when cfcs in two “pure” tax havens with no actual manufacturing, bermuda and the cayman islands, are excluded from the regressions. (the next section examines more aggregated data on cfcs incorporated in tax havens and their real investment that must be located elsewhere.) in summary, these subsidiary level data suggest the growing use of aggressive strategies, with the cooperation of host and home countries, to lower tax burdens on direct investment abroad. the next two sections use more aggregate data on income and capital from both the treasury files and the bureau of economic analysis to supplement this picture. vii. evidence on the location of income and real capital further insight on self-help and its impact on the location of income can be obtained from table 6 which presents selected tabulations from the treasury form 5471 files for 1996 and 2000. the first two rows confirm that earnings in seven major low-tax countries grew much more rapidly than total earning and profits of all u.s subsidiaries. the next row shows that a part of this “excess” growth of income in these locations, perhaps a third, is attributable to the growth in dividends. the remainder reflects both increased real activity and6 increased tax planning. as we have noted, tax planning cannot be identified in the treasury data exclusively based on the country of incorporation of the reporting cfc. with a low-tax company being the disregarded entity that disappears from the treasury’s vision, the consolidated income would still be lodged in a cfc incorporated in a high-tax country even though some had been stripped out. (the effective tax rate regressions above, which showed the lower correlation with local statutory rates and the negative influence of profitability, reflected this structure. as explained further below, the bureau of economic analysis (bea) data captures both structures because both locations are given separately, with one owning an interest in the other.) the next two rows provide further evidence of the hybrid structure in which the high-tax company disappears. total tangible capital in all locations grew by 28% from 1996 to 2000. but in five low-tax countries in which holding company income or inter-company equity income is a disproportionate share of income, tangible capital grew by almost 200%. indeed, by 2000 tangible capital in these countries accounted for about 15% of all capital abroad. most of this 2005] the three parties in the race to the bottom 167 growth must reflect the consolidation of the low-tax cfc with the operations of a high-tax affiliate. viii. evidence on tax planning in the bea data sullivan (2004) reports a dramatic increase in u.s. profits reported abroad in low-tax countries between 1999 and 2002. (his analysis received wide coverage in the u.s. press.) according to bea data, the pre-tax profits of foreign subsidiaries grew from $207 billion in 1999 to $255 billion in 2002. this 23% increase in foreign profits was dwarfed by the growth of profits in 18 countries sullivan denotes as tax havens. profits in these countries increased 68% over the same period from $88 billion in 1999 to $149 billion in 2002. sullivan calculates the share of foreign profits as well as effective tax rates by country for both 1999 and 2002. almost one-third (31%) of profits were “located” in luxembourg, ireland, bermuda, and singapore in 2002 (up from 15% in 1999). effective tax rates fell over the sample period from 22% in 1999 to 20% in 2002. for some countries the decrease in effective tax rates was extreme. the effective tax rates for spain, belgium, denmark, luxembourg, portugal and new zealand fell by half or more. ix. the double counting problem sullivan uses data tabulated by country on the income of majorityowned foreign affiliates (mofas) based on annual surveys compiled by the bea. a mofa is a foreign affiliate in which the combined direct and indirect ownership interest of all u.s. parents exceeds 50%. among other items, the parent is asked to provide income and balance sheet information for each mofa. an advantage of this dataset is that, unlike the treasury form 5471 data, these data include information for the “disregarded” hybrid entities. u.s. parents are instructed to include income from equity investments in foreign affiliates in their report of total income for each mofa. if the intercompany payment is a dividend paid out of net income, it will continue to be counted in the paying company’s profits. as a result, these data reflect double counting of inter-company dividends. to see why this would cause a problem in analyzing this data, consider the following example. suppose a u.s. parent fully owns a holding company in country a that has no corporate income tax. suppose further that the holding company in country a fully owns a manufacturing affiliate in country b that generates $1,000 in pre-tax profits. assume that country b has a corporate statutory rate of 40%. for simplicity, suppose that the affiliate in country b remits all $600 of after-tax profits to the holding company in the form of a dividend payment. income earned in the manufacturing affiliate in country b will be reported on the information form the parent files for this indirectly held affiliate. importantly, the income earned in the country b affiliate will also be reported on the information form the 168 florida tax review [vol.7:3 7. see borga and mataloni (2001) for a discussion of the problems created for the bea direct investment data by the rise of holding companies. parent files for the holding company in country a. instead of showing $600 in after-tax total affiliate profits, the bea data shows $1,200. this potential double counting of lower-tier profits presents serious problems in the interpretation of this affiliate income data. continuing with our example using the years 1999 to 2002, assume that the profits of the manufacturing affiliate in country b did not change between 1999 and 2002, but the parent inserted the holding company in our example between itself and country b during this period (in other words, the holding company in country a did not exist in 1999). the bea mofa data would show a 60% increase in worldwide pre-tax profits (from $1000 to $1600) even though there was no change in these profits and no tax savings. further, since country a would be classified as a tax haven country and country b would not, the data would depict a dramatic growth of profits in tax havens (from $0 to $600). note that if the affiliate in country b made a deductible payment to the tax haven affiliate in country a, pre-tax income would increase by the amount of the payment in country a and fall by the same amount in country b, leaving total affiliate income unchanged.7 x. implications of the growth of equity income from foreign affiliates our simple example shows the importance of inter-company equity income in explaining the growth of affiliate profits abroad. the equity in the income of foreign affiliates has increased very rapidly in recent years. table 7 shows information on the growth of equity income from the bea data. from 1997, when check-the-box was implemented, to 2002 this inter-company equity income rose from $40.7 billion to $120.8 billion. indeed, table 7 shows that almost 100% of the growth in income in the seven major low-tax countries (bermuda, the cayman islands, ireland, singapore, the netherlands, luxembourg and switzerland) from 1997 to 2002 can be accounted for by this inter-company equity income. it is difficult to interpret the significance of this inter-company equity income for worldwide tax payments from just the affiliate income data alone. it could just represent inter-company dividends paid up to holding companies. in that case the income paid out by the lower tier company still bears a tax in its host country as before. as we saw in the discussion of hybrids, check-the-box makes it easier to avoid a current tax on inter-company dividends under the cfc rules. on the other hand, these inter-company payments may be deductible in the host country. as noted above, if the inter-company payments are deductible, then any increased income in the receiving country would just be offset by a reduction in net income in the paying country. total affiliate income 2005] the three parties in the race to the bottom 169 would not increase. but if the payments are nondeductible dividends, there would be an equivalent increase in inter-company income and total, double counting distorted, affiliate income. how much of the increase in affiliate income is associated with deductible tax payments and thus lower host country taxes? to estimate this breakdown, it is necessary to know how much total affiliate income would have grown for other reasons, unrelated to intercompany income. this puzzle regarding deductible versus nondeductible payments can be solved by using another bea series, “foreign direct investment income” which is computed for the balance of payments. this income is not double counted and tells us how affiliate net income evolves unrelated to double counting issues. the two series do not have exactly the same coverage because the foreign direct investment (fdi) series includes income earned by affiliates that are not majority owned. however, the overwhelming component of the fdi income is the income of majority owned affiliates. we will assume that the share of non-majority owned income in the total remains constant over the 1997 to 2002 period in our calculations. in 1997, total pre-tax affiliate income (from the mofa data), including double counting, was $188.1 billion and of this, equity income was $41.8 billion. foreign direct investment income (from the fdi data), adjusted for host country corporate tax (from the mofa data), was $157.0 billion. by 2002 this foreign direct investment income had increased to $174.3 billion, or by 11.02%. if total affiliate income and equity income had continued to bear the same relationship to foreign direct investment income as in 1997, total affiliate income would have increased to $208.8 billion and equity income would have increased to $46.4 billion. in fact inter-company equity income increased to $120.8 billion, or $74.4 billion more than projected. furthermore, total affiliate income rose to $255.2 billion, $46.4 billion more than projected if the relationship to foreign direct investment income had remained unchanged. this $46.4 billion of “excess” total affiliate income represents “true” double counting, that is, increased inter-company equity income that is not offset by a reduction in net income in the paying country. accordingly, 46.4/74.4, or 62.3% of the greater than expected increase in equity income represents double counting. our calculation leaves $28 billion of inter-company income that was apparently deductible by the paying company. to estimate the amount of tax saving, we assume an average tax rate of 25% in the paying corporation’s country and no tax in the receiving company’s country, either because it is a tax haven or has a dividend exemption system in which hybrid securities can be used. we also assume that the book income data reported to bea is consistent with the taxable income reported to the respective governments. accordingly we estimate that these arrangements have generated an annual foreign tax saving of approximately $7 billion in 2002, or about 4% of total foreign affiliate income reported in the mofa data. 170 florida tax review [vol.7:3 x. conclusion the various types of evidence used in this paper show the role of the various parties in the decline of tax burdens on multinational companies from 1992 to 2002. in the early part of the period, from 1992 to 1998, the decline in tax burdens seemed primarily driven by the host countries’ desire to compete and defend their market share. from 1998 onwards the tax planning by the companies seems much more significant, facilitated by more permissive u.s. rules introduced in 1997. high-tax host countries had to acquiesce in this income shifting, perhaps because it was a way of favoring more mobile capital. the results illustrate the importance of including both company tax planning and the cooperation of home and host governments in an accurate depiction of any race to the bottom. for example, we estimate that in 2002 u.s. companies paid $7 billion less in host country taxes compared to 1997 by using intercompany payments deductible in the paying country but exempt from tax in the recipient. this amounted to about 4% of total direct investment income, a substantial reduction in such a short period. 2005] the three parties in the race to the bottom 171 references altshuler, rosanne, and harry grubert. 2003, “repatriation taxes, repatriation strategies, and multinational financial policy.” journal of public economics 87 no.1: 73-107. altshuler, rosanne and harry grubert, 2004, “taxpayer responses to competitive tax policies and tax policy responses to competitive taxpayers: recent evidence,” tax notes international, june 28, vol. 34: 1349-1362. altshuler, rosanne, harry grubert, and t. scott newlon, 2001, “has u.s. investment abroad become more sensitive to tax rates ?” in: james r. hines, jr. (editor), international taxation and multinational activity, university of chicago press, 9-32. borga, maria and raymond mataloni, 2001, “direct investment positions for 2000” survey of current business, vol. 81: 16-29. grubert, harry, 2001, “tax planning by companies and tax competition by governments: is there evidence of changes in behavior?” in: james r. hines, jr. (editor), international taxation and multinational activity, university of chicago press: 113-139. grubert, harry, 2004, “the tax burden on cross-border investment: company strategies and country responses.” in: measuring the tax burden on labor and capital, edited by peter birch sorensen. cambridge, massachusetts: mit press (cesifo seminar series): 129-170. grubert, harry and john mutti, 1991, “taxes, tariffs and transfer pricing in multinational corporation decision making.” review of economics and statistics, vol.73: 33: 285-293. sullivan, martin, 2004, “data show dramatic shift of profits to tax havens,” tax notes, september 13,vol. 104: 1190-1200. 172 florida tax review [vol.7:3 table 1 average effective tax rates in manufacturing for 58 countries (weighted by number of cfcs in each country in 1990) ________________________________________________ average effective standard year tax rate deviation 1980 0.33 0.85 1982 0.34 0.98 1984 0.34 1.03 1986 0.32 1.05 1988 0.31 1.09 1990 0.25 0.89 1992 0.25 0.86 1994 0.22 0.72 1996 0.23 0.79 1998 0.24 0.77 2000 0.21 0.67 ________________________________________________ source: authors’ calculations from treasury tax files. 2005] the three parties in the race to the bottom 173 table 2a do changes in capital share explain recent decreases in country average effective tax rates? _______________________________________________________________ independent variables dependent variables aetr for 1992-aetr for 1998 (1) (2) (3) (4) log (capital in 1992) log (capital in 1984) -0.047 -0.047 -0.055*** *** x [aeft for 1990] (0.014) (0.038) (0.014) average effective tax rate for 1990 0.249 0.249 0.334 0.193*** ** *** ** (0.082) (0.118) (0.088) (0.080) dummy for small countries 0.049 0.049 0.052 0.053*** ** *** *** (0.018) (0.018) (0.019) (0.018) log (capital in 1992) log (capital in 1984) x aetr for 1990 .001 (0.119) [predicted actual change in log of capital between 1992 and 1984] x [tax determinants -0.035 of investment] (0.022) [predicted actual change in log of capital between 1992 and 1984] x [tax determinants of investment] 0.053 (0.064) regional dummies latin america -0.049* (0.026) north america 0.020 (0.027) asia 0.025 (0.025) european union -0.032 (0.021) constant -0.027 -0.027 -0.090 0.005*** (0.030) (0.036) (0.027) (0.034) adjusted r 0.27 0.25 0.19 0.392 _____________________________________________________________________ notes: see paper for details on the construction of the variables in the column 3 regressions. the dummy for small countries equals one for countries with populations below 15 million in 1992. all regressions are weighted least squares using the number of cfcs in 1992 as weighing factors. number of observations equals 58. , , denote significance at the 10%, 5%, and 1% levels* ** *** respectively. the mean of the dependent variable is .009. source: treasury tax files. 174 florida tax review [vol.7:3 table 2b do changes in capital share explain recent decreases in country average effective tax rates? 1998 versus 2000 _______________________________________________________________ independent variables dependent variables aetr for 1992 aetr for 1992 aetr for 1998 aetr for 2000 log (capital in 1992) log (capital in 1984) -0.055 -0.024*** (0.015) (0.015) average effective tax rate for 1990 0.205 0.144* (0.121) (0.124) dummy for small countries 0.052 0.032*** * (0.018) (0.019) statutory rate for 1992 -0.016 0.166 (0.117) (0.120) regional dummies latin america -0.049 -0.022* (0.026) (0.027) north america 0.020 0.023 (0.027) (0.028) asia 0.025 0.031 (0.025) (0.026) european union -0.031 -0.013 (0.022) (0.023) constant 0.008 -0.050 (0.040) (0.041) adjusted r 0.37 0.242 _____________________________________________________________________ notes: the dummy for small countries equals one for countries with populations below 15 million in 1992. all regressions are weighted least squares using the number of cfcs in 1992 as weighting factors. number of observations equals 58. , , denote significance a the 10%, 5%,* ** *** and 1% level respectively. the mean of the dependent variable is .009 in column 1 and .035 in column 2. source: treasury tax files. 2005] the three parties in the race to the bottom 175 table 3 analysis of change in country average effective tax rates between 1998 and 2000: country versus company responses? _____________________________________________________________________ independent variables dependent variables aetr for 1998 aetr for 2000 (1) (2) (3) (4) (5) aetr for 1996 0.100 0.102 (0.064) (0.067) statutory rate for 1998 0.102 0.077 0.095* (0.061) (0.066) (0.063) log (capital in 1998)-log (capital -0.005 in 1992) (0.013) dummy for small countries -0.018 -0.017 -0.017 -0.018 -0.016 (0.013) (0.014) (0.013) (0.014) (0.013) regional dummies latin america 0.026 0.022 (0.020) (0.020) north america 0.021 0.005 (0.021) (0.021) asia 0.020 0.019 (0.019) (0.019) european union 0.035 0.031** * (0.016) (0.016) constant 0.009 -0.014 -0.003 -0.013 0.001 (0.018) (0.024) (0.023) (0.028) (0.026) adjusted r 0.09 0.12 0.09 0.11 0.082 _____________________________________________________________________ notes: the dummy for small countries equals one for countries with populations below 15 million in 1992. all regressions are weighted least squares using the number of cfcs in 1992 as weighing factors. number of observations equals 58. , , denote significance at the 10%, 5%,* ** *** and 1% level respectively. the mean of the dependent variable is .026. source: treasury tax files. 176 florida tax review [vol.7:3 table 4 the relationship between effective and statutory tax rates at the cfc-level a comparison of 1996 and 2000 dependent variable = cfc effective tax rate independent variables dependent variables weighted weighted unweighted unweighted by sales by sales 1996 2000 1996 2000 country statutory rate 0.508 0.398 0.717 0.509*** *** *** *** (0.037) (0.052) (0.034) (0.050) cfc age < 5 years -0.066 -0.075 -0.001 -0.050*** *** *** (0.014) (0.014) (0.015) (0.013) -0.014cfc age 5 15 years -0.018 -0.024 -0.019* ** * (0.010) (0.012) (0.010) (0.013) parent advertising/ 0.022 0.218 0.086 0.081* total sales (0.096) (0.120) (0.106) (0.135) parent r&d/ 0.626 0.295 0.981 -0.575** * *** *** total sales (0.271) (0.177) (0.270) (0.172) cfc earnings and -0.043 -0.110 0.024 -0.093*** ** profits/total sales (0.031) (0.034) (0.039) (0.036) constant 0.059 0.107 -0.038 0.100*** *** ** *** (0.016) (0.020) 0.20 0.14 adjusted r 0.10 0.08 0.20 0.142 mean of dependent variable .232 .215 .238 .224 number of observations 1865 1327 1865 1327 notes: , , denote significance at the 10%, 5%, and 1% level respectively. standard* ** *** errors in parentheses. source: treasury tax files. 2005] the three parties in the race to the bottom 177 table 5a comparison of income shifting in 1996 and 2000 dependent variable is pre-tax earnings and profits/cfc sales all manufacturing cfcs with positive income 1996 2000 cfc age < 5 years -.0021 .0296 (.0046) (.0042) cfc age 5-15 years .0085 .0056 (.0033) (.0040) parent r&d/sales .8833 .7230 (.0865) (.0542) parent advertising sales .5207 .8278 (.0359) (.0457) statutory tax rate -.1495 -.2363 (.0109) (.0157) constant term .1225 .1401 (.0046) (.0059) number of observations 6093 6887 mean of dependent variable .0980 .1121 notes: observations are weighted by cfc sales. standard errors are in parenthesis. source: treasury tax files. 178 florida tax review [vol.7:3 table 5b comparison of income shifting in 1996 and 2000 dependent variable is pre-tax earnings and profits/cfc sales manufacturing cfcs with positive income among 7500 largest cfcs 1996 2000 unweighted weighted unweighted weighted age < 5 years .0050 -.0002 .0014 .0326 (.0107) (.0088) (.0112) (.0101) age 5 15 years .0094 .0105 .0142 .0057 (.0073) (.0061) (.0099) (.0098) parent r&d/sales .5807 .9809 .5721 .7921 (.2023) (.1596) (.1409) (.1274) parent advertising sales .2895 .6314 .2405 1.021 (.0782) (.0677) (.1088) (.1105) statutory tax rate -.1710 -.1564 -.2518 -.2600 (.0276) (.0200) (.0407) (.0367) constant term .1713 .1189 .1955 .1402 (.0113) (.0085) (.0450) (.0140) mean of dependent .1305 .0972 .1390 .1131 variable number of observations 1865 1865 1327 1327 notes: weighting is by cfc sales. standard errors are in parenthesis. source: treasury tax files. 2005] the three parties in the race to the bottom 179 table 6 tabulations from the 1996 and 2000 form 5471 files (in billions of dollars) growth between 1996 2000 1996 & 2000 all cfcs 1. total pre-tax earning and profits $160.8 $231.1 44% 2. earnings and profits in seven major low-tax countries (ireland, singapore, bermuda, cayman islands, netherlands, luxembourg and switzerland) 36.5 82.5 126 3. dividends received in the seven major low-tax countries 6.4 19.8 209 4. total tangible capital (net plant & equipment plus inventories) 767.5 982.4 28 5. tangible capital in five major holding company low-tax countries (bermuda, cayman islands, netherlands, luxembourg and switzerland) 51.7 145.9 182 6. earnings and profits of cfcs with parents in finance in the seven major low-tax countries 5.1 5.6 10 top 7500 cfcs 7. earnings and profits 139.8 201.1 44 8. compensation for technical and management services (cost-sharing) 13.2 23.6 79 9. royalties paid to parents 22.4 29.1 30 source: treasury tax files. 180 florida tax review [vol.7:3 table 7 growth of equity income in affiliates (in millions of dollars) __________________________________ __________________________ growth in income from income from income from growth in equity pre-tax equity pre-tax equity pre-tax investments income investments income investments income 1997 1997 2002 2002 19972002 19972002 all countries $41,781 $188,092 $120,782 $255,225 189% 36% selected low-tax countries ireland 1,414 9,359 8,502 26,835 501 187 luxembourg 1,935 2,352 18,995 18,405 882 683 netherlands 9,249 17,612 15,238 20,802 65 18 switzerland 6,326 9,709 11,515 14,105 82 45 bermuda 1,649 5,933 22,142 25,212 1,243 325 cayman islands 1,046 2,678 2,268 2,809 117 5 singapore 578 5,765 2,465 7,533 326 31 total 22,197 53,408 81,125 115,701 265 117 ____________________________________________________________ source: department of commerce, bureau of economic analysis. 2005] the three parties in the race to the bottom 181 appendix country database* argentina australia austria belgium brazil canada chile china colombia costa rica denmark dominican republic ecuador egypt el salvador finland france germany greece guatemala honduras hong kong india indonesia ireland israel italy jamaica japan kenya luxembourg malaysia mexico morocco netherlands new zealand nigeria norway pakistan panama peru philippines portugal singapore south africa south korea spain sri lanka sweden switzerland taiwan thailand turkey united kingdom uruguay venezuela zambia zimbabwe * the subsidiary level regressions include bermuda and the cayman islands. page 1 _hlt109556085 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 page 16 page 17 page 18 page 19 page 20 page 21 page 22 page 23 page 24 page 25 page 26 page 27 page 28 page 29 page 30 page 31 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe tcharity really does begin at home: florida tax review volume 13 2012 number 1 1 the return-reducing ripple effects of the “carried interest” tax proposals by heather m. field* abstract the debate rages on about how to tax private equity fund managers and hedge fund managers who, as part of their compensation, receive rights to share in fund profits (“carried interests”). commentators have paid relatively little attention, however, to the impact that proposals to change the tax treatment of fund managers will have on fund investors, other than to suggest that investors could suffer because managers may try to raise management fees or because overall fund profitability may decline. this article argues that there is a much subtler reason why the carried interest tax proposals that are aimed at fund managers pose economic risks to fund investors. the reason is that a change to the tax treatment of carried interests changes the economic relationship that investors and managers created and consented to in their fund agreement, often after extensive negotiations. specifically, the proposed increase in tax rates on carried interests, when coupled with common provisions found in fund agreements (namely, “clawback” provisions and “tax distribution” provisions), increases the risk that the economic burden of losses will be shifted from the managers to the investors without compensation; incentivizes managers to take more risk when managing fund assets; otherwise erodes the alignment of manager/investor incentives; and delays the return of investors’ capital contributions, thereby imposing a time-value-of-money cost on the investors. * professor of law, university of california, hastings college of the law. i would like to thank gregg polsky and victor fleischer for comments on earlier drafts of this article, and i would like to thank susie morse for her valuable input. i also appreciate the opportunity to present this project at the spring 2012 northern california tax professor roundtable, and i thank all of the event participants, particularly mark gergen, for their helpful feedback. 2 florida tax review [vol.13:1 this article explains the indirect route through which the carried interest tax proposals create these return-reducing ripple effects. this article also provides guidance to investors about how they can protect themselves from harm. more broadly, this article illustrates how changes in law can alter the economic relationships to which private parties consented under carefully negotiated contracts, thereby creating unintended (and potentially adverse) consequences to parties who are not the desired targets of the law change. i. introduction ................................................................................. 2 ii. background ................................................................................... 8 a. brief overview of the structure and taxation of fund manager compensation .............................................................. 8 b. legislative proposals regarding the taxation of carried interests ........................................................................ 10 iii. the circuitous route between increased taxes on fund managers and reduced returns for fund investors .................................................................... 11 a. clawback provisions ................................................................. 12 1. understanding clawbacks ................................................ 13 2. appreciating how clawback problems are exacerbated by increases to the tax on carried interests ................................................................. 23 3. recommendations for fund investors regarding clawbacks ........................................................................... 25 b. tax distribution provisions ...................................................... 32 1. understanding tax distributions ...................................... 32 2. increasing tax distributions in response to increased tax on carried interests ..................................................... 34 3. sensitizing lps to the secondary effects of increasing the gp’s tax distribution ................................................... 35 4. recommendations for fund investors regarding tax distributions ................................................................ 38 iv. conclusion ................................................................................... 39 i. introduction over the past few years, there has been a vigorous debate about how to tax private equity fund managers, venture capital fund managers, and hedge fund managers who, as part of their compensation, receive rights to share in fund profits (“carried interests”).1 recently, mitt romney’s 2012] “carried interest” tax proposals 3 presidential campaign has intensified this debate because part of romney’s immense wealth comes from tax-advantaged carried interests that he received in connection with his work with the private equity firm of bain capital.2 despite the robust academic, legislative, and media discussions about carried interests, relative little attention has been paid to the way in which fund investors3 could be impacted by proposals to change the way fund managers (like romney) are taxed on carried interests.4 some of the 1. see, e.g., noel b. cunningham & mitchell l. engler, the carried interest controversy: let’s not get carried away, 61 tax l. rev. 121 (2008); victor fleischer, two and twenty: taxing partnership profits in private equity funds, 83 n.y.u. l. rev. 1 (2008) [hereinafter fleisher, two and twenty]; philip f. postlewaite, fifteen & thirty-five—class warfare in subchapter k of the internal revenue code: the taxation of human capital upon the receipt of a proprietary interest in a business enterprise, 28 va. tax rev. 817 (2009); david a. weisbach, the taxation of carried interests in private equity, 94 va. l. rev. 715 (2008); karen c. burke, the sound and fury of carried interest reform, 1 colum. j. tax l. 1 (2010) [burke, sound and fury]. 2. see, e.g., heidi przybyla & david j. lynch, carried interest debate in spotlight amid romney tax release (feb 1, 2012), http://www.businessweek. com/news/2012-02-01/carried-interest-debate-in-spotlight-amid-romney-tax-release. html; peter lattman, romney disclosure reignites debate over carried interests (jan. 17, 2012), http://dealbook.nytimes.com/2012/01/17/romney-disclosurereignites-debate-over-carried-interest-tax/; daniel schafer & richard mcgregor, bain chiefs may rue the romney factor (jan. 30, 2012) http://www.ft.com/cms/s/0/ 4b2d88e8-4b60-11e1-b980-00144feabdc0.html#axzz1m7vhuo1a; the daily show with jon stewart at 2:15–6:20 (jan. 24, 2012) http://www.thedailyshow.com/fullepisodes/tue-january-24-2012-elizabeth-warren. 3. references herein to funds and fund investors refer to private equity funds, venture capital funds, hedge funds, and similar investment or real estate funds that are largely unregulated and whose managers are compensated, at least in part, based on a percentage of the fund’s profits. in contrast, this article does not address mutual funds or other funds that are subject to significant regulation by the u.s. government or whose managers’ compensation is based on something other than a percentage of the fund’s profits. 4. this may be because some commentators conclude that fund investors are unlikely to be materially affected by the proposals. see, e.g., alan j. auerbach, u.c. berkeley professor recommends capital gains tax reform, 2007 tax notes today 174–57 (sept. 6, 2007) (concluding that “[i]f half of the tax increase were shifted to investors, this . . . would imply a reduction of at most around 2 basis points in the annual return [for investors] . . . and quite possibly much less.”); orin s. kramer, hedge fund manager dismisses claims that higher taxes on private equity would harm pension funds, 2007 tax notes today 174–46 (sept. 6, 2007). additionally, the limited attention to fund investors may be because investors in funds are generally sophisticated parties who, except for investors that are pensions and charitable foundations, are relatively unsympathetic constituencies. cf. stephen labaton & jenny anderson, pension effect from tax plan is called slight, 4 florida tax review [vol.13:1 commentators that do address the consequences for fund investors suggest that managers may try to pass along part of their increased tax burden by, for example, increasing management fees or increasing the size of the managers’ carried interests.5 other commentators believe that fund investors’ returns are likely to be reduced because of the overall harm these commentators believe will befall the economy and the fund industry if the carried interest proposals pass.6 but the impact on fund investors deserves more careful analysis, particularly because public and private pension funds, foundations, and endowments (and not merely wealthy private individuals) are typically the majority investors in funds.7 this article provides this analysis. this article argues that, while the limited commentary correctly identifies the possibility that proposals to change the tax treatment of carried interests could reduce returns to fund investors, there is a much subtler and more troubling reason for these reduced returns. the reason is that a change to the tax treatment of carried interests changes the economic relationship that investors and managers created and to which they consented in their n.y. times, sept. 7, 2007, at c1 (noting that “critics of the tax proposals have maintained that fund managers would pass on any increase to investors, thus lowering the returns of pension funds that millions of americans rely upon for their retirement.”). 5. see, e.g., leon m. metzger, former hedge fund vice chair testifies on use of offshore hedge funds, 2007 tax notes today 174–55 (sept. 6, 2007) (responding to arguments “that if all carried interests were taxed at ordinary rates, it might lead to fund managers’ increasing their compensation beyond the typical ‘2 and 20’ arrangement, which would reduce the returns of investors like pension plans and endowments”); bruce rosenblum, private equity council chair testifies on carried interest taxation, 2007 tax notes today 174–49 (sept. 6, 2007) (“pe sponsors may look at ways to offset the higher tax burden through changes in economic terms that will adversely impact their lps.”). 6. see, e.g., diana furchtgott-roth, skewing the playing field for investment partnerships, 127 tax notes 1291 (june 14, 2010) (arguing that increased taxes on carried interests may lead to less efficient capital markets, resulting in harm to investors); jack s. levin, kirkland & ellis partner argues against taxation of carried interests as ordinary income, 2007 tax notes today 174–47 (sept. 6, 2007) (arguing that taxing carried interest as ordinary income poses a “substantial risk [that] the flow of entrepreneurial investments will indeed be reduced, with significant harm to our vibrant economy[,]” which in turn could harm pension funds and university endowments that invest in the funds, thereby harming american workers and students). 7. see preqin special report, institutional investor outlook for hedge funds in 2012, fig. 8 (nov. 2011) http://www.preqin.com/docs/reports/ preqin_special_report_hedge_funds_2012.pdf (showing that more than 50 percent of hedge fund investors are foundations, endowments, or pension funds); j. comm. tax’n, present law and analysis relating to tax treatment of partnership carried interests, (jcx-41-007) 37 (july 10, 2007) (same for venture capital funds). 2012] “carried interest” tax proposals 5 fund agreement, often after extensive negotiations.8 an increase of the tax rate applicable to managers’ carried interests alters the way in which investors are impacted by common fund agreement provisions, namely “clawback” provisions9 and “tax distribution” provisions.10 among other consequences, investors face the possibility that the economic burden of a larger amount of fund losses will be shifted from the managers to the investors without compensation; investors suffer an increased likelihood that the managers will take risks that exceed the amount of risk to which the investors intended to consent when originally investing pursuant to the fund agreement; investors sustain other erosions of the alignment of manager/investor economic incentives with respect to the management of fund assets; and investors incur greater time-value-of-money costs arising because the fund may not return their capital contributions as quickly as expected. fundamentally, an increase in the tax rate applicable to carried interests, when coupled with clawback provisions and tax distribution provisions in fund agreements, can result in these economic distortions because managers must pay tax on the allocations of the carry throughout the life of the fund and because those interim carry allocations may not accurately reflect a manager’s ultimate entitlement (based on the aggregate fund earnings over the entire life of the fund). fund investors may be able to protect themselves from these adverse consequences by negotiating with managers about the fund agreement that creates their economic relationship. but the investors must first understand the indirect route through which they could be adversely affected by the carried interest proposals. thus, the goals of this article are to explain how, and in what circumstances, the carried interest tax proposals are likely to 8. extensive negotiations among sophisticated parties generally reflect a joint-tax perspective; that is, the parties will negotiate against the backdrop of the existing tax law in order to maximize their aggregate welfare (minimize their aggregate tax) and share the tax savings among them. see generally chris william sanchirico, the tax advantage to paying private equity fund managers with profit shares: what is it? why is it bad?, 75 u. chi. l. rev. 1071, 1077–79 (2008); burke, sounds and fury, supra note 1, at 2–5, 23–24; ethan yale & gregg d. polsky, reforming the taxation of deferred compensation, 85 n.c. l. rev. 571, 579–80 (2007). 9. as will be explained in more detail in part iii.a.1., under a “clawback” provision, a manager can be obligated to return money to the fund if it turns out that early distributions to the manager from the fund exceeded the amount of the profit to which the manager is ultimately entitled. 10. as will be explained in more detail in part iii.b.1., under a “tax distribution” provision, a fund makes distributions of cash to partners in amounts sufficient to enable the partners to pay the tax due on their allocable share of fund profit. 6 florida tax review [vol.13:1 adversely affect fund investors, and to provide some guidance to investors about how to respond to these consequences. more broadly, this article illustrates how changes in the law can alter the economic relationships to which private parties consented under carefully negotiated contracts, thereby creating unintended (and potentially adverse) consequences to parties who are not the desired targets of the law change. query the extent to which legislators considering changes to the law ought to take into account these types of secondary effects that are created when a change in law ripples through previously established economic relationships. several caveats are warranted before moving to the rest of the article. first, this article takes no position on whether congress should pass legislation to increase the tax rate applicable to carried interests. this is not because i am indifferent. i have an opinion on the issue, but i do not think that the potential indirect impact of the legislation on fund investors adds much, if anything, to that normative debate. on the other hand, the analysis of the potential impact on fund investors is (i hope) quite useful (1) as fund investors contemplate how, if at all, they should change their behavior if the legislation is enacted, (2) as scholars and businesspeople continue to develop their understanding of the agency relationship between managers and investors in the private fund context, and (3) as scholars and legislators consider alternatives for tax reform, taking into account how changes in the law can alter the economic consequences of pre-existing contractuallycreated relationships among private parties. second, this article does not, on its face, distinguish between investors in private equity funds, investors in venture capital funds, and investors in hedge funds.11 clearly, the presence and magnitude of the issues discussed herein will vary depending on factors including the type of fund, the fund’s particular investment strategy, the fund’s method for calculating the carry, and the fund’s timeframe for distributing the carry to the manager. thus, rather than focusing on specific categories of funds, i focus on fund agreement features — particularly clawbacks and tax distributions — that are likely to increase economic risks to investors.12 third, this article assumes that the carried interest tax proposals, if enacted, would increase the tax rate applicable to a substantial amount of the 11. see generally adam h. rosenzweig, not all carried interests are created equal, 29 nw. j. int’l l. & bus. 713, 716–21 (2009) (providing a nice explanation of major differences between private equity funds and hedge funds) [hereinafter rosenzweig, carried interest]; see also andrew w. needham & christian brause, hedge funds, 736 tax mgmt. (bna) iii.a. (2011) [hereinafter needham & brause, hedge funds]. 12. note that these features are generally less common in hedge funds than in private equity funds. needham & brause, hedge funds, supra note 11, at iii.c. 2012] “carried interest” tax proposals 7 general partner’s (gp’s) carry. that is, this article assumes (1) that the manager of the fund (or an affiliate of the manager) is the fund’s gp13 and is a taxable u.s. person(s) or is a flow-through vehicle comprised of or ultimately owned by a taxable u.s. person(s),14 and (2) that the relevant funds earn a substantial amount of income that is characterized as long term capital gain (ltcg), such that a substantial amount of the carry is taxable to the gp at a 15 percent federal income tax rate.15 finally, in order to focus on the impact of the increase in federal income taxes, the examples in this article use only federal (and not state) income tax rates.16 thus, this article assumes a 15 percent rate for ltcg and a 40 percent rate for ordinary income (because 40 percent allows for relatively easy calculations and because top marginal rates may go back up to 39.6 percent). with those caveats out of the way, the remainder of the article will proceed as follows. part ii will provide background about fund manager compensation and the carried interest tax proposals. part iii will discuss the potential problems posed for fund investors by an increase in the tax rate applicable to carried interests, and will focus on two particular features of fund agreements — clawbacks (covered in part iii.a.) and tax distributions (covered in part iii.b.) — that raise these issues. for each feature, i will describe how the fund agreement provision typically works, explain how an increase in the tax rate applicable to carried interests could change how the provision affects fund investors, and provide suggestions for fund investors to consider in response. part iv concludes. 13. in some funds, the manager bifurcates its economic interests between two affiliated entities. see gregg d. polsky, private equity management fee conversions, 122 tax notes 743, 745–49 (feb. 9, 2009). for simplicity, the remainder of this discussion sets this distinction aside. 14. the gp of investment funds are typically llcs or lps in which individuals are the interest-holders. see jack s. levin, structuring venture capital, private equity, and entrepreneurial transactions ¶ 1006.1 (2011) [hereinafter levin, venture capital]; needham & brause, hedge funds, supra note 11, at vi.c. 15. note that this assumption means that this article’s analysis is likely less applicable to hedge funds than to private equity funds because the investment strategies of hedge funds rarely produce long term capital gain. see rosenzweig, carried interests, supra note 11, at 718. 16. note that this disregards possible employment tax consequences of the carried interest proposals. currently, a gp’s carried interest is generally not subject to employment tax, but proposals to change the tax treatment of carried interest contemplate the possibility of subjecting the carry to employment taxes. if this employment tax issue is taken into account, the return-reducing ripple effects described in this article become even more pronounced. 8 florida tax review [vol.13:1 ii. background brief overviews of fund manager compensation and the proposed legislation provide background for the analysis.17 readers familiar with these topics may wish to skip directly to part iii. a. brief overview of the structure and taxation of fund manager compensation private equity funds, venture capital funds, and hedge funds are typically structured as limited partnerships, in which the investors are the limited partners (lps) and the manager is the gp. managers of these funds generally receive two different economic rights in exchange for their services. first, the manager is paid a management fee, commonly equal to 2 percent of assets under management. second, the manager is granted a right to share in the profits of the fund. typically, this “carried interest” or “carry” entitles the manager to 20 percent of the profits earned by the fund. details of the carried interest vary from fund to fund. these details include (1) when the manager is entitled to receive distributions on account of the carried interest (including distributions of the manager’s entire share of profits or distributions of smaller amounts of money that are intended to be sufficient to enable the manager to pay taxes due on the manager’s share of profits (“tax distributions”)),18 and (2) whether and to what extent the manager is obligated to return money to the fund if it turns out that early distributions of carry exceeded the amount of the profit to which the manager was ultimately 17. see generally levin, venture capital, supra note 14, at ch. 10; andrew w. needham, private equity funds, 735-2d tax mgmt. (bna) pts. iii & v–vi (2011) [hereinafter needham, private equity funds]; needham & brause, hedge funds, supra note 11, at pts. iii & v–vi; ronald j. gilson, engineering a venture capital market: lessons from the american experience, 55 stan. l. rev. 1067, 1070–78 & 1088–90 (2003) [hereinafter gilson, venture capital market]; henry ordower, demystifying hedge funds: a design primer, 7 u.c. davis bus. l.j. 324 (2007); stephanie r. breslow, selected excerpts from pli’s private equity funds: formation and operation, 1st ed., chapter 2: terms of private equity funds, 1782 practising law inst. corp. law & practice course handbook 225 (2010) [hereinafter breslow, selected excerpts]. 18. see generally levin, venture capital, supra note 14, at ¶ 1003.5; needham & brause, hedge funds, supra note 11, at iii.b.; breslow, selected excerpts, supra note 17, at §§ 2.7.3, 2.8.1[d][4]; see, e.g., gregory j. nowak, hedge fund agreements line by line: a user’s guide to llc operating contracts 2nd ed., aspatore line-by-line 1, ¶ 7.10 (2009) [hereinafter nowak, hedge fund agreements], (providing sample language); dow jones, private equity partnership terms & conditions 47 (2009) [hereinafter dow jones, partnership]. 2012] “carried interest” tax proposals 9 entitled (a “clawback” obligation).19 the fund agreement provisions regarding the calculation of the gp’s carried interest, including the clawback provision in particular, are among the most heavily negotiated provisions in fund agreements and are among the most important provisions to both gps and lps.20 the management fee and the carried interest are subject to different federal income tax treatments. the management fee is just salary compensation, and thus, it is taxed to the manager at ordinary income rates.21 the taxation of the carried interest is more complicated. generally, the manager is not subject to tax upon the initial receipt of the carried interest.22 rather, the manager is taxed on its allocable share of the fund’s profits, if and as the fund recognizes income.23 the character of that income to the manager generally depends on the character of the income to the fund.24 19. see generally levin, venture capital, supra note 14, at ¶ 1003.1–.4; needham & brause, hedge funds, supra note 11, at iii.b.; needham, private equity funds, supra note 17, at worksheet 3 (providing sample language); breslow, selected excerpts, supra note 17, at § 2.8.1[g]; dow jones, partnership, supra note 18, at 42. there are a number of other details of carried interests that vary from fund to fund, including whether the manager shares in profit from the first dollar or whether the manager shares in profit only after a specific “hurdle rate” of return has been achieved. see generally dow jones, partnership, supra note 18 (providing details about the prevalence of a wide variety of terms in private equity fund agreements). however, i highlight the issues of tax distributions and clawbacks because, as discussed later, these are the features of carried interests that may lead to return-reducing results for fund investors if the tax rate applicable to carried interests is increased. 20. center for private equity and entrepreneurship, tuck school of business at dartmouth, limited partnership agreement survey results – gps 11-12, 38-39 (june 2004) http:/mba.tuck.dartmouth.edu/pecenter/research/pdf/survey_ results_gp.pdf; center for private equity and entrepreneurship, tuck school of business at dartmouth, limited partnership agreement survey results – lps 9–10, 36–37 (june 2004) http://mba.tuck.dartmouth.edu/pecenter/research/pdf/survey_ results_lp.pdf [hereinafter tuck, lp agreement survey – lps]. 21. i.r.c. § 61. this basic description of the tax treatment for management fees assumes that there has been no effort to recharacterize the management fee into an increased carry. 22. a carried interest is merely one version of what the partnership tax law refers to as a “profits interest” — a partnership interest that has a liquidation value of zero as of the time of grant and that is granted in exchange “for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner[.]” rev. proc. 93-27, 1993-2 c.b. 343. profits interests, and hence carried interests, are generally not subject to tax upon grant. id. there are a variety of proposals to change the tax treatment of the carried interest, and these will be addressed in part ii.b. infra. 23. i.r.c. §§ 702(a), 704. 24. i.r.c. § 702(b). 10 florida tax review [vol.13:1 thus, if the fund’s income is entirely ltcg (as is much of the income in private equity funds in particular), then the manager generally pays tax at long term capital gains rates on the income allocable to the manager on account of the carried interest.25 b. legislative proposals regarding the taxation of carried interests many commentators criticize the current tax treatment of carried interests, arguing that the income earned by the managers on account of the carried interest is compensation for services and ought to be taxed at ordinary income rates like other labor income.26 for example, one of the criticisms of mitt romney is that it is unfair that romney was able to pay tax at capital gains rates on income earned as a result of his work at bain capital, while other people pay tax on labor income at higher ordinary income tax rates.27 in response to the critiques of the tax treatment of carried interests, legislators, commentators, and most recently, the president, have put forward proposals that would change the tax treatment of carried interests.28 while some of the details vary from proposal to proposal, the 25. fund managers do not always pay tax at ltcg rates on the income allocable to them on account of their carried interests. if, for example, the fund earns interest, rent, or other ordinary income, then the manager will pay tax on its share of that income at ordinary income rates. however, as mentioned in the introduction, this article assumes that the fund’s income consists largely of ltcg income. to the extent that fund income allocated to the manager would be characterized as ordinary income to the fund (more common in hedge funds), the income would already be ordinary income to the manager, and the carried interest legislation would not change the tax result (except to the extent that the carried interest legislation imposes employment taxes on the carry). see supra note 16. 26. see, e.g., fleischer, two and twenty, supra note 1; mark p. gergen, reforming subchapter k: compensating service partners, 48 tax l. rev. 69 (1992) (proposing that “a compensatory allocation to a partner [such as an allocation on account of a carried interest] be treated [for tax purposes] as salary paid by the partnership”). 27. see, e.g., jack o. nutter, private equity, carried interest and mitt romney (jan. 18, 2012), http://www.marketwatch.com/story/private-equity-carriedinterest-and-mitt-romney-2012-01-18; see also supra note 2. 28. see, e.g., american jobs act of 2011, h.r. 12, 112th cong. § 412 (2011) (reflecting president obama’s proposal to tax 100 percent of carried interest allocations as ordinary income); american jobs and closing tax loopholes act of 2010, h.r. 4213, 111th cong. sess. § 412 (2d. sess. (2010) (provision passed by the house to tax 50–75 percent of carried interest allocations as ordinary income, but excluded from the final legislation); h.r. 2834, 110th cong. (2007) (original proposal, introduced by rep. sander m. levin, to tax all carried interest allocations as ordinary income). 2012] “carried interest” tax proposals 11 proposals typically seek to tax all or part of the return on carried interests as ordinary income rather than capital gain.29 the nuanced differences between these proposals are generally irrelevant for purposes of this article’s analysis, so i will not belabor those details here. it is enough, for purposes of this article, to know that the carried interest proposals generally would cause fund managers to be taxed at ordinary income rates on some or all of their share of fund profits attributable to the carried interests. for funds that earn income that is characterized as ltcg, enactment of any of these proposals would increase the tax rate applicable to income allocated to the gp on account of the gp’s carried interest. iii. the circuitous route between increased taxes on fund managers and reduced returns for fund investors query how an increase in the tax rate applicable to fund managers’ carried interests might affect fund investors. commentators note that carried interest proposals may adversely affect overall fund profits, in which investors share, and that managers may try to pass along to fund investors part of their increased tax costs by, for example, increasing management fees or increasing the carry rate.30 there is a much subtler reason, however, that investors may suffer reduced returns if taxes on fund managers are increased. specifically, a change to the tax treatment of carried interests changes the economic relationships that managers and investors intended to create under their fund agreements. under clawback provisions and tax distribution provisions, both of which are commonly found in fund agreements, an increase in the tax rate applicable to managers’ carried interests can (unless the fund agreements are changed in response to a change in the tax treatment of carried interests)31 increase the risk that the economic burden of losses will be shifted from the managers to the investors without compensation, lead managers to take more 29. see supra note 28. the proposals changed over time to address comments, to incorporate technical modifications, and to reflect attempts at compromise. however, the proposals generally reflect the basic concept of taxing at least some portion of carried interest allocations as ordinary income. 30. see supra notes 5 & 6. 31. the analysis in this article assumes that the carry, clawback, and tax distribution provisions of fund agreements are not changed in response to the change in the tax treatment of carried interests. this assumption enables the article to explain the harms that could befall investors if the taxation of carried interests is changed and investors indeed fail to negotiate for changes to these fund agreements. in response to these potential adverse consequences, this article makes recommendations about how investors might want to change the fund agreements. 12 florida tax review [vol.13:1 risk than they take now, otherwise erode the alignment of manager/investor incentives, and delay the return of investor capital contributions, thereby imposing a time-value-of-money cost on the investors. these consequences may be surprising because they arise indirectly, largely as a result of the way taxes affect the operation of common fund agreement provisions. if, however, fund investors appreciate how they can be adversely affected by legislation that is nominally targeted at fund managers, fund investors can better protect themselves from harm by paying careful attention to, and negotiating about, the clawback provisions and the tax distribution provisions in fund agreements. this section addresses both provisions, and for each provision, explains the provision, the risks to investors that could arise from the provision if taxes on carried interests increase, and the potential investor responses. clawback provisions, which create the more complex and likely more problematic consequences for fund investors, are examined first. then, this section discusses tax distribution provisions, which can also adversely affect investors if tax rates on carried interests increase. a. clawback provisions to the extent that the fund makes any carry distributions to the gp during the life of the fund, fund agreements typically include some type of clawback provision in order to recoup excess distributions of carry to the gp.32 the efficacy and impact of clawback provisions33 can change if tax rates on the gp’s carry increase, and lps should be sensitive to these potential changes particularly given that many lps consider clawbacks to be among the most important economic provisions in the fund agreement.34 this section explains how clawback provisions can help protect lps in general, and how the operation of a clawback provision is affected by taxes on the gp’s carry. then, with this background, this section analyzes how and to what extent an increase in the tax rate applicable to the gp’s carry can exacerbate the possibility of shifting losses from the gp to the lp and the possibility that the gp will be incentivized to take increased risk. 32. see needham, private equity funds, supra note 17, at iii.b.4. (discussing clawbacks) and worksheet 3 (providing language for a sample clawback provision); levin, venture capital, supra note 14, at ¶ 1003.2–.4. 33. admittedly, clawback provisions may not work perfectly now to protect lps from potential over-distributions to gps. this is particularly true if no portion of the gp’s carry is segregated into an escrow from which the clawback obligation can be fulfilled. see dow jones, partnership, supra note 18, at 42–43 (discussing the prevalence of clawback guarantees and escrows). however, the carried interest tax proposals can make clawback provisions less effective; this is true even if the clawback provision is coupled with an escrow. see infra note 67. 34. see tuck, lp agreement survey – lps, supra note 20, at 9–10. 2012] “carried interest” tax proposals 13 finally, this section provides some suggestions to lps who want to limit the amount of additional risk that they assume as a result of the interaction between clawback provisions and an increase in taxes on carried interests. 1. understanding clawbacks a fund risks distributing too much value to the gp if the gp’s carry is calculated based on the fund’s aggregate profits over the life of the entire fund35 and the fund makes cash distributions throughout the life of the fund (i.e., before the amount of the gp’s total carry is finally determined).36 this problem could arise if, for example, early transactions produce profits (seemingly entitling the gp to a large carry), while later transactions produce losses (reducing the size of the total carry to which the gp is ultimately entitled). in order to protect lps’ economic interests in this situation, fund agreements often contain clawback provisions, which require the gp to return part of the previously distributed carry, so that the gp only retains an amount equal to 20 percent of the aggregate profit earned by the fund. the basic concept is relatively straightforward, but a fair bit of background is needed in order to appreciate how increased taxes on carried interests can make a clawback less effective at protecting lps. examples are helpful in providing this background. (a) example #1 — how can lps be harmed in the absence of a clawback? (1) hypothetical & analysis most fund agreements have some sort of clawback,37 but to appreciate the importance of a clawback, imagine a fund agreement that entitles the gp to a 20 percent carry on the fund’s aggregate profits and that 35. the risk of over-distribution of the carry and, thus, the need for a clawback provision are avoided if the carry is calculated on an investment-byinvestment basis without aggregation or is calculated in another way in which carry amounts, once calculated, would not be reduced by subsequent losses. see needham & brause, hedge funds, supra note 11, at iii.c. (noting that hedge fund carries are typically calculated this way, vitiating the need for clawback provisions). of course, calculating the carry on an investment-by-investment basis changes the economics and means that gps will earn carries on deals that succeed, but will not suffer monetary losses with respect to deals that do not succeed. 36. this is quite common particularly in private equity funds. see needham, private equity funds, supra note 17, at iii.b.3 & iii.b.4. 37. see dow jones, partnership, supra note 18, at 42. 14 florida tax review [vol.13:1 lacks a clawback.38 assume that five lps each contribute $200 to the fund,39 and the fund immediately uses that $1000 to invest in two assets: asset a is purchased for $400, and asset b is purchased for $600.40 assume that, during year 2, after asset a has increased in value, the gp causes the fund to sell asset a for $550 cash, generating a profit of $150. twenty percent of this profit ($30) is allocated to gp,41 and the remainder of the profit ($120) is allocated to the lps.42 if the fund makes distributions of all cash available, the fund would distribute the entire $550 of proceeds from the sale of asset a. specifically, if the fund agreement first provides for a return of the lps’ capital contributions with respect to the particular investment and then provides for a distribution of profits, a total of $30 would be distributed to the gp on account of the gp’s carried interest, and the remaining $520 would be distributed to the lps (consisting of $120 of profit earned on asset a and $400 return of capital).43 38. for ease, assume that the gp is entitled to the carry on the first dollar of profit, with no hurdle rate, and that there are no management fees or expenses. 39. assume, for purposes of simplicity of calculations, that the gp does not make a capital contribution. typically, a gp makes some capital contribution (often 0.2 percent of the total capital) both (1) so that, from a business perspective, the gp has “skin in the game,” thereby better aligning the gp’s interests with the lp’s interests, and (2) to provide comfort that the gp will be treated as a true partner for federal income tax purposes. see generally rev. proc. 89-12, 1989-1 c.b. 798 (setting out a 1 percent standard as the minimum contribution to be a partner, declining to 0.2 percent for large partnerships), obsoleted by rev. rul. 2003-99, 2003-2 c.b. 388; breslow, selected excerpts, supra note 17, at § 2.5.3. although rev. proc. 89-12 is obsolete, practitioners still use it to provide an indication about the level of investment the irs may require to establish “partner status.” see, e.g., eric b. sloan & matthew sullivan, deceptive simplicity: continuing and current issues with guaranteed payments, 933 practising law institute: the corporate tax practice series: strategies for acquisitions, dispositions, spin-offs, joint ventures, financings, reorganizations & restructuring 87-1, n.86 (2010). 40. at this point, each of the lps has an outside basis and capital account of $200, and the gp has a zero outside basis and zero capital account. i.r.c. § 722; reg. § 1.704-1(b)(2)(iv)(b)(1). 41. this takes the gp’s outside basis to $30 and the gp’s capital account to $30. i.r.c. § 705(a)(1); reg. § 1.704-1(b)(2)(iv)(b)(3). 42. assuming that the lps are equal partners, the $120 allocated to the lps would be split among the 5 lps, so each would receive an allocation of $22. as a result, each lp would have an outside basis and a capital account of $222. i.r.c. § 705(a)(1); reg. § 1.704-1(b)(2)(iv)(b)(3). 43. see, e.g., levin, venture capital, supra note 14, at ¶ 1003.4 (describing this as a “middle ground” approach to distributions). as a result, each lp ends up with an outside basis and a capital account of $120, and the gp ends up with an outside basis and a capital account of zero. i.r.c. § 733; reg. § 1.7041(b)(2)(iv)(b)(4). the same distributions would be made in the example if the fund 2012] “carried interest” tax proposals 15 if, in year 3, asset b declines in value to $500 and the gp causes the fund to sell it at that price, the fund would experience a $100 loss on that asset. as a result, the net profit earned by the fund during its life would be $50 ($150 gain from asset a minus $100 loss from asset b). thus, the gp should only be entitled to a total carry of $10 (20 percent of the $50 net profit), and the remaining net profit ($40) should belong to the lps. but, the gp already received a distribution of $30 during year 2. because an early transaction produced profits and a later transaction produced losses, the fund distributed too much money to the gp. in the absence of a fund agreement provision to the contrary, the $500 proceeds from the sale of asset b would be distributed to the lps as a return of the lps’ capital contribution. that is, rather than allocating the $100 loss $20 to the gp and $80 to the lps, the entire $100 of loss is allocated to the lps.44 thus, upon a distribution in accordance with capital accounts,45 the lps only receive a total distribution of $500.46 as a result, the agreement first provided for distribution of profits, followed by a return of the lps’ capital contributions with respect to the investment, but this distribution scheme is relatively uncommon. id. at ¶1003.2. if, however, the fund agreement provided that the lps are entitled to a return of their entire capital contributions before the gp receives any distribution (other than tax distributions), this example would operate a little differently. id. at ¶1003.1, .5 (describing this distribution scheme). specifically, a tax distribution of $4.50 (15 percent of $30 profits) would be made to the gp, and the remaining $545.50 would be distributed to the lps. in this situation, the amounts of the distributions are different than in the example from the text, but this scenario still raises the clawback problem described in this section because, as will be noted later, clawback obligations are generally net of taxes. see infra part iii.a.1.c. 44. technically, the allocations would work as follows: typically, losses would be allocated first to reverse prior allocations of profit. see levin, venture capital, supra note 14, at ¶ 1002.2. thus, $80 of the loss (80 percent) would be allocated to the lps, and $20 of the loss (20 percent) would be allocated to the gp (bringing the gp’s net profit allocation down from $30 to the gp’s rightful $10 carry). however, in the absence of a deficit restoration obligation (which gps in investment funds typically do not have except to the extent of any clawback), an allocation of a $20 loss to the gp would create a deficit balance in the gp’s capital account. thus, an allocation of a $20 loss to the gp would lack substantial economic effect, and the allocation would not be respected for federal income tax purposes. i.r.c. § 704(b); regs. §§ 1.704-1(b)(2)(ii)(b), 1.704-1(b)(2)(ii)(d). as a result, the partnership tax regulations require the loss to be reallocated to the partners that would bear the actual economic loss — here, the lps. i.r.c. § 704(b); reg. § 1.7041(b)(3)(iii). this reduces the lps’ capital accounts by $20, thereby reducing the amount of the distribution to which the lps are entitled (assuming liquidating distributions are made in accordance with capital accounts). alternatively, the distortion described in the text could be conceived of as a “capital shift” for federal income tax purposes, which would ultimately have a substantially similar tax result. 45. the allocation of the $100 loss entirely to the lps means that a $20 loss would be allocated to each lp, reducing each lp’s outside basis and capital account 16 florida tax review [vol.13:1 lps would receive a total of $1020 from the fund ($520 in year 2 and $500 in year 3), i.e., a net of only $20 of profit rather than the $40 to which the lps are entitled (80 percent of the $50 net profit). additionally, the gp would keep the $30 carry even though the gp’s rightful 20 percent carry on the fund’s net profits is only $10. (2) the many problems presented by example #1 recall that, in the example, the parties agreed that the gp’s carry is to be calculated on an aggregate basis, meaning that, under the foregoing facts, the gp should only be entitled to a $10 carry. clearly, the intended economic deal is distorted if the gp is allowed to keep $30 when the gp has only “earned” a $10 carry and if the lps only receive $1020 when they are “entitled” to $1040.47 in addition, this arrangement provides an incentive to the gp to strategically time the fund’s exit from various investments.48 specifically, the gp would be incentivized to cause the fund to exit profitable transactions (from which the gp receives a carry) prior to unprofitable transactions (which would reduce the gp’s net carry if the exit from the unprofitable transactions occurred prior to or simultaneously with the exit from profitable transactions).49 further, given the option-like nature of the gp’s carried interest, the economic outcome of example #1 could encourage increased risk-taking by the gp. specifically, as commentators have explained, a carried interest,50 upon grant, is akin to an at-the-money option on a 20 percent interest in the from $120 to $100. see supra note 43 (explaining that each lp’s outside basis and capital account is $120 prior to the loss allocation); i.r.c. § 705(a)(2)(a); reg. § 1.704-1(b)(2)(iv)(b)(7). 46. one fifth of this total distribution, $100 (i.e., the amount equal to each lp’s capital account), would be distributed to each lp. 47. when a few more zeros are added to the end of these numbers (which would be a much better reflection of the magnitude of actual fund investments), the distortions described herein quickly add up to large sums of money. 48. see also gilson, venture capital market, supra note 17, at 1089 (explaining the timing incentive created by a carried interest in the absence of a clawback). 49. this incentive is “particularly acute” if the calculation of the carry, during the life of the fund, does not take account of unrealized losses. needham, private equity funds, supra note 17, at iii.b.3. 50. recall, we are assuming that the gp is entitled to a carry from the first dollar of profit, and that the entitlement to the carry is not subject to a hurdle rate. implicit in this assumption is the assumption that this carry design reflects the parties’ desired economic relationship, so the remainder of the discussion addresses how that desired economic relationship is altered by various factors. 2012] “carried interest” tax proposals 17 fund.51 when the fund earns a profit that would entitle the gp to a carry, the carried interest becomes an in-the-money option on the entire fund.52 however, as soon as any non-forfeitable carry is distributed to the gp, the carried interest reverts back to (or at least become much closer to) being an at-the-money option on just the remaining portion of the fund. this “reset” of the option changes the gp’s risk-taking incentives — before the distribution of any carry, the gp’s incentive is to maximize the value of the entire fund, but after the distribution of a non-forfeitable carry, the gp’s incentive is to maximize the value of the assets remaining in the fund, even if that does not maximize the value of the entire fund (i.e., taking into account the portion of the fund that has been distributed). reputational considerations and capital contributions by the gp may help to constrain the gp from taking excessive risk,53 but the option-like nature of the carried interest affects the gp’s risk-taking incentives. an example helps to illustrate this scenario. recall that the lps in example #1 contributed $1000 and the fund used that $1000 to purchase two assets. at this point, the gp’s carry is akin to an at-the-money option on 20 percent of the lps’ interests in the fund — the carry has zero liquidation value, but it does have upside value if the fund assets increase in value. in year 2, when asset a (which the fund has not yet sold) is worth $550 and when the value of asset b remains at its $600 purchase price, the gp’s carry is in-the-money. that is, the gp’s option now has a liquidation value of $30.54 but because the gp’s economic entitlement still depends on the performance of the entire fund, the gp’s incentive still is to maximize the 51. see victor fleischer, the missing preferred return, 31 iowa j. corp. l. 77, 97–108 (2005) (explaining the option analogy) [hereinafter fleischer, preferred return]; gilson, venture capital markets, supra note 17, at 1089–90. 52. this also occurs when the assets increase in value, such that they could generate a profit, ultimately entitling the gp to a carry. 53. particularly where the gp is a repeat player in a small market, the gp does have reputation at stake, which could inhibit excess risk-taking even if the carry is out-of-the-money. see gilson, venure capital markets, supra note 17, at 1090 (discussing the operation of the “reputation market” as a constraint on risk-taking behavior); fleischer, preferred return, supra note 51, at 101–02. additionally, the larger the gp’s capital contribution, the less the carried interest incentivizes the gp to take excessive risk. see supra note 39. 54. if the value of the assets of the fund has increased by $150, the gp would be entitled to a 20 percent carry on that profit (20% * $150 = $30). alternatively, this could be understood by continuing with the option analogy — if the gp exercises the option, the gp would be entitled to an interest in the fund worth $230 (20 percent of the $1150 aggregate value of the fund assets) in exchange for an exercise price of $200. 18 florida tax review [vol.13:1 value of entire fund, taking into account the amounts already earned.55 assume that the gp has multiple mutually-exclusive ways that it might manage asset b, including an approach that has a 20 percent chance asset b will be worth $2000, and an 80 percent chance that asset b will be worth $0. this approach has a $400 expected value,56 which is less than the asset’s current $600 value. this action would reduce the expected value of the entire fund by $200, holding everything else steady. thus, it is not in the lps’ interest for the gp to take this action. it is also not in the gp’s interest to take this action because the reduction in the expected value of the entire fund would also reduce the total expected value of the gp’s carry (in this example, down to $0).57 that is, with respect to taking this action with asset b, the lp’s and gp’s interests are aligned. in contrast, assume that the fund distributes the proceeds from the sale of asset a in year 2 and that the gp cannot be required to return the $30 it receives in this distribution. the gp’s economic incentive with respect to subsequent fund asset management decisions depends not on the performance of the entire fund in the aggregate, but rather only on the performance of the fund’s remaining asset, asset b (again, assume that asset b is still worth $600). this effectively turns the gp’s carry back into an atthe-money (rather than an in-the-money) option. with this at-the-money option, the gp now does have an incentive to take the riskier approach to managing asset b that is described above.58 this is because, under the 55. to the extent that the gp is risk averse, the in-the-money character of the carry could actually lead the gp to take too little risk with respect to subsequent management decisions. that is, the gp might opt for an approach to asset b that will, with 100 percent certainty, result in $605, rather than an approach to asset b that, while subject to some uncertainty, will have an expected value of $610 (e.g., 50 percent chance of $590, 50 percent chance of $630). however, for simplicity, this discussion will assume (unless otherwise stated) that the gp is a risk-neutral, rational actor or that other factors (e.g., fund agreement limitations on the type of investments the gp may make) constrain any (or most of the) incentive that the gp has to take too little risk. 56. (20% * $2000) + (80% * $0) = $400 57. prior to choosing an action with respect to asset b, the fund assets are worth $1150 ($550 value of asset a plus $600 value of asset b). if the gp opts for the risky approach to managing asset b, the expected value of asset b under this approach is $400. thus, holding everything else steady, the expected value of the total fund assets would be only $950 ($550 value of asset a + $400 expected value of asset b), in which case the gp would not be entitled to any money on account of the carry; the gp’s earlier entitlement to a $30 carry from asset a would be totally eliminated. 58. of course, the gp’s choice of action does depend on what other alternatives are available for managing asset b. here, for purposes of simplicity, i just compare the 20 percent chance of $2000 / 80 percent chance of $0 approach to 2012] “carried interest” tax proposals 19 approach described above (20 percent chance of $2000 value, 80 percent of $0 value), the gp has a 20 percent chance of earning additional carry if the value of asset b increases to $2000. if the risk fails, the gp will keep the $30 carry previously distributed and get nothing more — the same result as if asset b merely maintained its current $600 value. thus, the gp has nothing to lose (setting aside reputational issues)59 by taking a risk with respect to asset management decisions of the fund that the lps would not want to take.60 moreover, this incentive for the gp to take this type of risk (i.e., a long-shot risk that would reduce the fund’s expected value) is increased if the carry becomes akin to an out-of-the-money option, which will happen as soon as the value of asset b declines at all from its original $600 value. and the risk-taking incentive continues to increase as the gp’s carry gets deeper and deeper out-of-the-money (i.e., if and as the value of asset b declines more and more).61 (b) example #2 — how might a clawback help protect the lps? consider again the basic scenario presented by example #1, but now assume that the fund agreement contains a complete clawback provision. a clawback provision corrects the economic distortions encountered in example #1. the clawback requires the gp to return the over-distributed carry (i.e., $20, which is the excess of $30 carry received in year 2 over the the status quo, assuming that the asset could maintain its value in the absence of action. 59. see gilson, venture capital markets, supra note 17, at 1090 (discussing reputational considerations); fleischer, preferred return, supra note 51, at 101–02. 60. in general, an option-holder (such as the gp) and an equity-holder (such as an lp) will have incentives that are somewhat misaligned; generally, an optionholder, even an in-the-money option-holder, will prefer more risk than an equityholder because the option-holder has similar upside potential but less downside exposure. as the option becomes more and more in-the-money (i.e., more equitylike), the option-holder’s risk preference will generally grow closer and closer to the equity-holder’s risk preferences. conversely, the more out-of-the-money an option becomes, the more the option-holder’s risk preferences will diverge from the equityholder’s risk preferences. given this typical option-holder/equity-holder relationship, the point of the example in the text is that a fund agreement that provides for a gp carry without a clawback exacerbates the misalignment of risk-taking preferences. 61. note that a carry that is out-of-the-money may be useful in helping to curtail any incentive the gp may have to take too little risk. this concept is built into fund agreements where the gp is only entitled to a carry after a hurdle rate is surmounted or preferred return is paid. see fleischer, preferred return, supra note 51, at 101–06. 20 florida tax review [vol.13:1 $10 carry to which the gp is rightfully entitled).62 sometimes, the gp’s carry distribution is placed in an escrow to ensure that the funds will be readily available to fulfill any clawback obligation. once the $20 has been “clawed back” by the fund, the $20 can be distributed to the lps. as a result, the gp will have received its rightful 20 percent aggregate carry ($10), and the lps will have received a return of their capital contributions ($1000) and their rightful 80 percent share of the fund’s net profit ($40). thus, the gp and the lps end up with net distributions that reflect the economic deal that the parties originally intended.63 further, with the clawback, the gp has much less incentive to strategically time the fund’s exit from transactions depending on whether they are profitable or unprofitable.64 this is because excess carry distributed 62. technically, the clawback operates as a limited deficit restoration obligation. regs. §§ 1.704-1(b)(2)(ii)(c), -1(b)(2)(ii)(d). thus, when the fund has a $100 loss in year 3, $20 of that loss can be allocated to the gp because even though that would appear to create a deficit in the gp’s capital account, the limited dro would erase that deficit. as a result, the allocation of the $20 of loss to the gp will have substantial economic effect, and the gp ends up bearing the economic burden of that loss. compare this result to the result, explained supra note 44, in the absence of a clawback. again, this transfer of $20 could be conceived of, alternatively, as a capital shift. id. however, i think that the allocation concept better reflects the economic relationship created by the clawback, particularly if and as losses are harvested after gains but before the liquidation of the fund, and particularly if the clawback provision language specifically states that the gp fulfills the clawback by contributing to the fund. see needham, private equity funds, supra note 17, at worksheet 3 (providing sample clawback language that requires the gp to fulfill the clawback by making a contribution to the fund). 63. note that the gp should be entitled to a loss when it fulfills its clawback obligation and/or the fund liquidates. technically, this can be conceived of as either (1) an allocation of $20 loss to the gp, which is supported by the limited dro reflected in the clawback (possibly at liquidation and particularly if interim clawbacks are made during the life of the fund), or (2) a recognition of loss upon the final liquidation of a partnership interest (where the gp contributes the $20, giving the gp a $20 capital account, but where the $20 is actually distributed to the lps). i.r.c. § 704(b) ($20 allocation of loss to the gp); i.r.c. § 731(a)(2) (recognition of loss upon liquidation); see also david j. schwartz, raising a private equity fund— economic provisions: carried interest, clawback and management fees, 1824 practising law inst. corp. law & practice course handbook series 97, 102–04 (2010). if the gp can fully use this loss, the loss will offset the excess taxes previously paid by the gp on the excess carry that was ultimately returned. 64. the gp may have other incentives to time the exit from particular transactions. for example, accelerating the exit from profitable transactions could make the fund look quite profitable, which could be useful to the gp if the gp is trying to raise a second fund during the life of the first fund. also, the gp may still have a slight incentive to accelerate the exit from profitable transactions and delay 2012] “carried interest” tax proposals 21 in connection with early exit from a profitable transaction must be returned, in whole or in part, to the fund if later transactions produce losses. additionally, while the gp’s carried interest is still equivalent to an option, the addition of the clawback means that the value of the previously distributed carry must be taken into account when analyzing the gp’s incentives regarding future management decisions.65 that is, immediately after the distribution of the $30 carry in year 2, the carry’s in-the-money status remains unchanged. thus, in the illustration provided above, the gp’s carry turns into an at-the-money option only after the clawback would consume the entire carry previously distributed to the gp (i.e., until asset b declines in value to $450, completely wiping out the fund’s profit from asset a), and the carry turns into an out-of-the-money option only after the value of asset b declines even further. as a result, the addition of the clawback negates (or at least mitigates) the increased incentive for risk-taking that arises in the absence of a clawback. (c) example #3 — how do taxes on the carry affect the operation of a clawback? clawback provisions are often limited to the amount of the gp’s “after-tax carry.”66 that is, the gp can only be asked to return the amount of the carry previously received, reduced by the taxes paid (or assumed paid) on the gp’s carry.67 this cap can reduce the beneficial effects of a clawback that were described in example #2. consider again example #2, where the gp is entitled to a 20 percent carry (calculated on an aggregate basis), but the carry is subject to a clawback. recall that, in example #2, $30 was allocated and distributed to gp on account of the carry in year 2. assume that, in year 2, the exit from unprofitable transactions because the gp could benefit from the time value of money on the early over-distributions of carry, but this incentive is likely to be relatively small. see also gregg d. polsky, private equity management fee conversion, 122 tax notes 743 (feb. 9, 2009) (discussing how fee waivers can create incentives for gps to time exits from investments). 65. this is because the gp’s ability to retain the $30 carry is contingent on the total performance of the fund. 66. see needham, private equity funds, supra note 17, at iii.b.4; alan j. pomerantz, example of distribution/clawback provisions, 541 practising law inst. real est. law and practice course handbook series 191 (2007) (providing a very nice example of the operation of a clawback that is capped at the after-tax carry). 67. this is generally the case even if the gp’s carry distributions are escrowed. typically, even when there is an escrow of the gp’s carry, a portion of the escrowed funds are distributed out to the gp in an amount sufficient to allow the gp to pay the taxes on the carry. as a result, the carry escrow will often only contain the “after tax” carry. 22 florida tax review [vol.13:1 gp paid (or is assumed to pay) $4.50 of tax on the carry (15 percent tax on $30). if the amount of any clawback is capped at the gp’s after-tax carry,68 the most that could be clawed back from the gp is $25.50 ($30 $4.50). if the clawback obligation is $20 (as it was in example #2), the clawback works to provide the parties with the economics to which they originally agreed. the cap presents no problem. (1) loss-shifting if, however, the fund only earned an aggregate profit of $10 (i.e., the fund sold asset b at $460, producing a loss of $140, wiping out all but $10 of the $150 gain from asset a), the gp would only be entitled to a $2 carry (20 percent of the $10 aggregate profit). thus, a full clawback would require the gp to return $28 (the $30 carry received in year 2 less the $2 carry to which the gp is rightfully entitled). but, if the clawback is capped at the amount of the gp’s after-tax carry ($25.50), the gp is not obligated to return the full $28 of over-distributed carry. thus, the lps can only receive a total distribution from the fund of $1005.50 ($520 distributed in year 2 + $460 proceeds from the sale of asset b + $25.50 clawback from the gp), instead of the $1008 rightfully owed to the lps ($1000 return of capital + 80 percent of the $10 net profit). that is, the “after-tax” cap on the gp’s clawback obligation results in the shifting of the economic burden of losses to the lps.69 the maximum amount of losses that can be shifted from the gp to the lps as a result of the after-tax cap on the clawback is equal to the tax paid (or assumed paid) by the gp on the carry. so, in this example, if the fund had zero aggregate profits and the gp would be entitled to a carry of $0, the gp would return only $25.50 pursuant to the after-tax clawback (rather than the full $30 of carry received), thereby shifting a maximum of $4.50 of economic losses from the gp to the lps. note that, because the maximum amount of economic loss that can be shifted from the gp to the lp is equal to the product of the applicable tax rate and the amount of the carry allocated 68. often, the “after-tax” carry is calculated using an assumed rate of tax. see needham, private equity funds, supra note 17, at iii.b.4. (noting that the clawback provisions often assume that “the general partner bears tax at the marginal rates of a nyc resident and has no unrelated losses to shelter fund income”). 69. see generally howard e. abrams, taxation of carried interests: the reform that did not happen, 40 loy. u. chi. l.j. 197 (2009) (providing a useful explanation as to why an incomplete clawback can hurt lps). cf. burke, sound and fury, supra note 1, at 12–14 (arguing that gps should not be respected as partners in funds where incomplete clawbacks shift to the lps the economic burden of taxes nominally imposed on the gp). 2012] “carried interest” tax proposals 23 to the gp,70 as the early carries increase in size, so too does the potential that the lps will bear more than their share of subsequent losses.71 (2) increasing the gp’s risk-taking incentive again, the gp’s carried interest remains equivalent to an option, but any reduction in the maximum amount of the clawback makes the gp’s carry closer and closer to an out-of-the-money option. that is, in example #3, the gp’s carried interest becomes an out-of-the-money option when the clawback obligation exceeds $25.50 (i.e., once the value of asset b declines by more than $127.50, to below $472.50). if asset b is declining in value from $600, it will be worth $472.50 (i.e., the out-of the-money threshold when the clawback is capped by the after-tax carry) before it is worth $450 (i.e., the out-of-the-money threshold when the clawback can recoup the full amount of the carry). thus, a clawback capped at the gp’s after-tax carry will create an incentive for increased risk-taking before a full (uncapped) clawback will create that incentive.72 2. appreciating how clawback problems are exacerbated by increases to the tax on carried interests the loss-shifting and risk-taking incentive effects of capping the clawback at the gp’s after-tax carry increase dramatically as the tax rate applicable to the gp’s carry increases. specifically as to the loss-shifting problem, the maximum economic loss that could be shifted from the gp to the lps increases in proportion to the increase in the tax rate applicable to the carry. for example, recall the earlier examples where the gp received a distribution of a $30 carry in year 2. if the tax rate applicable to the gp’s carry is 40 percent rather than 15 percent, then capping the clawback at the gp’s after-tax carry ($30 – 40% = $18) could shift $12 (rather than $4.50) of economic loss from the gp to the 70. this assumes that the amount of the carry that gets distributed is at least equal to amount of tax due on the carry that is allocated to the gp. 71. further, as will be explained later, the potential that the lps will bear more than their share of subsequent losses also increases as the tax rate applicable to the carry increases. 72. risk-taking is not inherently problematic. the key, of course, is that parties understand the risks to which they are exposed and that the parties believe that they are adequately compensated for those risks. thus, if lps consent to a contract that creates a particular level of risk-taking incentive for the gps and if a change in the tax law increases that risk-taking incentive, then the lps become exposed to a level of risk to which they did not intend to be exposed. 24 florida tax review [vol.13:1 lps.73 said differently, where the tax rate increases by 267 percent (15%  40%), the maximum potential economic loss that could be shifted from the gp to the lps also increases by 267 percent ($4.50  $12).74 the risk-taking incentive problem is also increasingly problematic as the tax rate applicable to the carry increases. again, consider the example where the gp received a distribution of a $30 carry in year 2, and where the clawback is capped at the gp’s after-tax carry. if the tax rate applicable to the gp’s carry is 40 percent, the gp’s clawback exposure is only $18. as a result, the gp’s carry becomes an out-of-the-money option when the clawback obligation exceeds $18 (i.e., when the value of asset b declines by more than $90, to below $510). recall that, when the carry was taxed at 15 percent, the gp’s carry only became an out-of-the-money option when the value of asset b dropped below $472.50. a comparison of these two scenarios illustrates that, if clawbacks are capped at the gp’s after-tax carry, the carry subject to tax at 40 percent will create a stronger incentive for risktaking than a carry subject to tax at 15 percent. thus, if a clawback obligation is capped by the gp’s after-tax carry, as the tax rate applicable to the gp’s carry increases, the gp becomes increasingly likely to have an incentive for risk-taking that could inure to the detriment of the lps. because gps are often repeat players in the fund business, it is possible that the reputational markets could dampen the gp’s risk-taking incentive.75 if, however, the value of the fund assets decline enough to turn the gp’s carry into an out-of-the-money option, the fund is likely already having trouble (although, the higher the tax rates on the carry, the less trouble the fund needs to be in before the carry turns into an out-of-themoney option). troubled fund performance, by itself, creates adverse reputational consequences. thus, query to what extent the possibility of additional market sanctions is likely to affect the gp’s risk-taking choices. 73. these numbers could be larger if early transactions produced larger profits because of an increase in the tax paid (or assumed paid) on those profits. this increases the amount of the distributed carry that could not be recouped under the clawback, and thus increases the amount of losses that could be shifted to the lps. 74. again, when dealing with dollar numbers that are more realistic (e.g., four or five orders of magnitude larger), the effects described herein could lead to significant economic losses for lps. 75. see gilson, venture capital market, supra note 17, at 1090 (discussing the operation of the “reputation market” as a constraint on risk-taking behavior); fleischer, preferred return, supra note 51, at 101–02. as mentioned earlier, capital contributions made by the gp can also serve as a check on gp risk-taking behavior. see supra note 39. 2012] “carried interest” tax proposals 25 3. recommendations for fund investors regarding clawbacks increased loss-shifting seems likely to be more problematic for lps than increased risk-taking,76 and each concern will be more problematic for some lps and less problematic for others. ultimately, the degree of concern depends on a wide variety of factors including the fund’s distribution scheme (including the timing of the distribution of the carry), the expected timing of the fund’s exits from various investments, the expected volatility of the fund, the lps’ risk preferences, and the strength of the reputational and other contractual constraints on the gp’s behavior. for funds in which the lps are concerned about the potential loss-shifting and/or risk-taking issues that arise from an increase in the tax rate on the gp’s carried interest, the lps can try to mitigate these issues by negotiating about the terms of the carry and the clawback. several potential approaches are available. (a) revise how the carry is calculated one way for lps to respond to the potential consequences of higher taxes on carried interests is to negotiate about how the gp’s carry is calculated during the life of the fund. the objective of this negotiation should be to make the interim carry calculations as reflective of the funds’ true net peformance as possible, thereby reducing the likelihood that the gp receives an over-allocation and over-distribution of carry. for example, assuming that the economic deal between the parties is that the gp’s carry should be 20 percent of the aggregate profits of the fund over the fund’s entire lifetime, the gp’s carry for any particular period could be calculated on a cumulative basis (rather than on a deal-by-deal or year-byyear basis), taking into account at least some prior year losses (if there are any). further, the gp’s carry for any particular period could take into account not only that period’s realized gains and losses, but also any unrealized losses. many funds already take one or both of these approaches.77 both of these alternatives could reduce the gp’s current allocations on account of the carry, thereby reducing the likelihood of an overdistribution of carry that would trigger a clawback. reducing the gp’s current allocations on account of the carry would also reduce the amount of tax paid (or assumed paid) on the carry, thus reducing the impact of any after-tax cap on a clawback obligation. ultimately, the more closely interim 76. this is because the latter is a shift in pre-existing behavioral incentives for risk-taking, on which there are external constraints (like reputation); the behavior may or may not change. in contrast, the adverse consequences of increased lossshifting do not depend on the rationality of economic actors and are not subject to similar external constraints. 77. breslow, selected excerpts, supra note 17, at § 2.8.1 26 florida tax review [vol.13:1 distributions of carry reflect the gp’s aggregate carry entitlement, the less likely a clawback will be needed, and the less impact the after-tax cap on the clawback is likely to have. of course, revising the method for calculating the carry in a way that would reduce the gp’s current allocations and distributions of carry might be highly undesirable to the gp. while these changes should not ultimately change the amount of the aggregate carry to which the gp is entitled, these changes may defer the gp’s receipt of some portion of the carry, thereby subjecting the gp to a non-trivial time-value-of-money cost. (b) change the tax rate used for calculating the “aftertax” carry whether the method for calculating the carry is revised, lps could negotiate with the gp about the tax rate that is used for calculating the “aftertax” carry. typically, fund agreements use either a particular rate that is stated in the agreement (such as 15 percent) or a rate that is determinable for a hypothetical taxpayer under a set of assumptions that are articulated in the fund agreement. where the cap on the clawback is calculated using a stated tax rate, the lps may consider whether they are willing to agree to increase that stated rate to one that is higher than today’s tax rates but lower than the tax rate that the carried interest tax proposals would impose on the gp’s carry. for example, imagine a fund with a clawback that is capped at the gp’s after-tax carry, using a stated tax rate of 15 percent. if the carried interest legislation passes, the gp will likely want the cap on the clawback to be calculated using a stated tax rate of 40 percent.78 instead, the parties could negotiate to use a stated tax rate between 15 percent and 40 percent (say, a compromise rate of 27.5 percent, to split the difference). similarly, where the cap on the clawback is calculated at a tax rate determined based on a variety of assumptions, the lps could negotiate about the assumptions on which the amount of the after-tax carry is calculated. those assumptions include assumptions regarding the rate of tax, regarding the location of the “hypothetical” taxpayer whose tax rate is used for calculating the after tax carry, and/or regarding the availability of losses to offset income from the carry. where the after-tax cap on the clawback is determined based on a variety of assumptions, it is likely that an increase in the tax rate applicable to carried interest will automatically be incorporated into the “after-tax” determination, without any action or agreement by the lps. thus, if the lps want to avoid the loss-shifting and risk-taking 78. where an existing fund agreement uses a “stated rate” for calculating the after-tax cap on the clawback, the gp is likely to approach the lps in an effort to modify the agreement. the bargaining dynamic is likely reversed if the after-tax cap on the clawback is calculated at a rate determined based on a variety of assumptions. 2012] “carried interest” tax proposals 27 consequences described herein, the lps will likely need to approach the gp in an effort to modify an existing agreement. ultimately, if tax rates on carried interests increase, lps may be willing to increase, at least to some degree, the tax rate (stated or assumed) used to determine the cap on the clawback. the lower the tax rate used for purposes of calculating the after-tax carry, the more complete the clawback.79 under a compromise agreement, the lps likely would be agreeing to some increase in potential loss-shifting and likelihood of increased risk-taking, but the lps may be able to limit their exposure to some degree. (c) take the gp’s tax loss into account when calculating the “after-tax” carry another alternative is to include an additional, but typically ignored, factor into the calculation of the cap on the clawback — the value of the tax loss that the gp will have as a result of forfeiting some or all of its previously taxed carry.80 calculations of the after-tax cap on the clawback typically ignore this factor, using the assumption that the gp does not have any capital gains against which the loss could be used.81 this assumption is 79. a more complete clawback is equivalent to an increase in the size of the gp’s limited deficit restoration obligation. see supra note 62. alternatively, rather than arguing about the details of the clawback, the lps could ask the gp to commit to an explicit limited deficit restoration obligation separate and apart from any clawback. where the gp is committed to a limited dro, losses (in an amount up to the limited dro) can be allocated to the gp, even if the allocation to the gp of those losses would otherwise create a deficit in the gp’s capital account. as a result, the limited dro would limit the possibility of loss shifting and would delay the gp’s incentive for increased risk taking. from a partnership tax perspective, the addition of a limited dro would have a very similar economic impact as an increase to the size of the clawback obligation (or elimination/reduction of the after-tax cap on the clawback obligation). a limited dro, however, could present as a different business issue than a clawback primarily because (1) a clawback is a limited dro that is specifically tied to over-distributions of carry, whereas a more general limited dro could be triggered in a wider variety of circumstances, and (2) a limited dro may be located in a different part of the fund agreement than a clawback. i suspect that gps are likely to resist this approach for the same reasons that gps typically resist any dro — they do not want to increase their downside economic exposure, particularly since this could increase the gp’s exposure to claims from the fund’s creditors. nevertheless, this may be an option for lps who are particularly concerned about loss-shifting. 80. see supra note 44 (explaining why a fulfillment of a clawback results in a tax loss for the gp). 81. individuals cannot carry capital losses back to offset previously included capital gains, so use of the capital loss depends on whether the individual 28 florida tax review [vol.13:1 quite likely incorrect in most cases. so, the calculation of the cap on the clawback would better reflect the true economics if the gp’s clawback obligation is not only reduced by the full amount of the assumed tax bill on the carry, but is also increased by the value of the tax loss that arises when the gp pays the clawback. however, the inclusion of this additional factor is “often resisted by general partners because it involves an analysis of personal tax returns” (i.e., to determine the extent to which the gp is able to use the loss).82 nevertheless, if the tax rate on the carry increases (thereby reducing the size of the after-tax clawback, and increasing the loss-shifting and risktaking problems described earlier), lps may feel more strongly about using a more economically accurate formula for calculating the cap on the clawback. in turn, the lps may be able to put more and more pressure on the gp to agree that the clawback amount — the gp’s after-tax carry — should take into account the value of the gp’s tax loss resulting from the clawback. the “personally intrusive”83 nature of the determination of the value of this tax benefit can be mitigated by either (1) using an assumed rate of tax benefit84 (which need not assume full usability of the loss) or (2) by using the gp’s good faith estimate of the value of the tax benefit. moreover, the enactment of the carried interest tax proposals actually increases the likelihood that the loss arising from a clawback payment will largely or fully compensate the gp for excess taxes paid on the carry. given that the carried interest tax proposals would tax (some or all of) the carry at ordinary income rates, the gp’s tax loss upon fulfilling a clawback obligation is arguably characterized as an ordinary loss rather than a capital loss.85 since ordinary losses are not subject to limitations on use to has capital gains from another source during the year of the loss or in subsequent years. i.r.c. § 1211. 82. breslow, selected excerpts, supra note 17, at § 2.8.1[g][4]; see also needham, private equity funds, supra note 17, at iii.b.4. (“fund investors usually accept the possibility of a windfall to the general partner [that arises from ignoring the potential tax benefit to the general partner as a result of the clawback], perhaps in the belief that the general partner will earn positive returns on invested capital.”). 83. breslow, selected excerpts, supra note 17. 84. an assumed rate for calculating the gp’s tax liability on the carry and an assumed rate for calculating the gp’s tax benefit from the clawback can be simplified, on net, to a single assumed rate. for example, assuming a 40 percent tax rate on the carry and a 10 percent tax benefit on the clawback (discounted perhaps to reflect the gp’s ability to use the benefit), could net out to an assumed 30 percent rate of tax for calculating the clawback cap (i.e., the amount of the gp’s net after-tax carry). 85. i.r.c. § 165(c)(1). the availability of an ordinary deduction when the gp fulfills its clawback obligation is suggested by the tax benefit rule. there is some risk that the loss could still be characterized as ltcl even if the income was taxed as ordinary income. this is because repayment of the clawback obligation could be 2012] “carried interest” tax proposals 29 which capital losses are subject, the lps can argue that the calculation of the after-tax carry ought to assume full usability of any losses arising from the clawback obligation. under this assumption, the gp’s argument against taking the value of the tax loss into account is significantly weakened (almost made meritless) because valuation of the loss would no longer require “an analysis of personal tax returns.” in turn, the lps’ argument that the value of the tax loss should be taken into account when determining the gp’s clawback obligation (i.e., the after-tax carry) is significantly strengthened. that is, if the gp’s tax loss is ordinary and fully usable, the gp is quite likely to be able to recover any excess tax paid on the portion of the carry that the gp ultimately had to return. this is particularly true given that the “make whole” rule of section 1341 arguably (but not certainly) applies to the gp’s loss,86 which would considered to be a capital contribution that generates basis in the partnership interest. then, when the gp does not receive that money back in the liquidation of the partnership, the gp may be viewed as recognizing a loss arising from the liquidation of the partnership, which is generally treated as a capital loss. i.r.c. § 731(a)(2) (flush language). 86. i.r.c. § 1341. section 1341 applies if three requirements are met. first, the taxpayer must have included an amount in income for a prior taxable year because it appeared that the taxpayer had a right to the income. id. at § 1341(a)(1). carry distributions are made to gps on the basis that gps are entitled to that money; however, given the contingent clawback obligation, the gp’s entitlement to the carry distribution is arguably “apparent” and not certain. that said, there is some risk that the carry could be conceived of as an unchallengeable right to funds, which is undermined by the subsequent facts that trigger the clawback obligation. the difference between an “apparent right” to funds (that triggers section 1341) and an “unchallengeable right undermined by subsequent facts” (to which section 1341 does not apply) is slight, but it is critical for purposes of determining whether a taxpayer will benefit from the “make whole” provision of section 1341. see boris i. bittker, martin j. mcmahon, jr. & lawrence a. zelenak, federal income taxation of individuals ¶ 4.03[4], n.49 (2d ed. 2011) (citing cases) [hereinafter, bittker, mcmahon & zelenak, taxation]. second, for section 1341 to apply, “a deduction [must be] allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item.” i.r.c. § 1341(a)(2). a clawback obligation is triggered when it is determined that the gp did not, in fact, have an unrestricted right to the previously distributed carry, and the clawback obligation produces a tax loss allowable under section 165. third, the deduction must exceed $3000, and for purposes of this analysis, i assume that this threshold is satisfied. id. at §1341(a)(3). see also generally bittker, mcmahon & zelenak, taxation, supra at ¶ 4.03[4] (discussing the application of section 1341 to situations where taxpayer repays amounts received under claim of right); matthew a. melone, adding insult to injury: the federal income tax consequences of the clawback of executive compensation, 25 akron tax j. 55, 84–95 (2010); rosina 30 florida tax review [vol.13:1 ensure that the gp’s tax liability for the year of the clawback is reduced by at least the tax previously paid on the clawback amount,87 thereby fully reimbursing the gp (setting aside the time value of money) for the excess taxes paid. thus, if the tax loss will effectively refund to the gp all excess taxes paid on the portion of the carry that the gp ultimately had to return (setting aside the time value of money), the lps have a very strong argument that the clawback obligation should be limited only to the pre-tax, and not after-tax, carry.88 (d) restructure the carry as a contingent fee to the extent that the parties want greater certainty that, upon a forfeiture of amounts previously received, the gp will benefit from a reduction in tax liability at least equal to the tax previously paid on the amount forfeited, the parties could restructure the carry into an economic relationship to which section 1341 more clearly applies. for example, rather than structuring the gp’s entitlement to 20 percent of profits as a profits interest in a partnership, the gp’s entitlement to 20 percent of profits could be structured as a “contingent fee” equal to 20 percent of the total profits.89 a contingent fee for services is a classic arrangement to which section 1341 applies.90 a contingent fee could provide economics that are substantially similar to a carried interest, in that both can entitle the recipient to 20 percent of the profits earned by the enterprise. of course, a key difference under the existing tax law is that a contingent fee is taxed as ordinary income,91 whereas the character of income received on account of a carry can be capital gain or ordinary income b. barker and kevin p. o’brien, taxing clawbacks: theory and practice, 129 tax notes 423, 425–435 (oct. 25, 2010). 87. i.r.c. § 1341(a)(4), (5). 88. where the value of a subsequent loss upon payment of a clawback is at least equal to the tax originally paid on the amount clawed-back, a clawback cap that takes into account the value of the tax loss when determining the gp’s after-tax carry is equivalent to a clawback of the entire carry, unreduced by taxes. again, an increase to size of the clawback is tantamount to an increase the gp’s limited deficit restoration obligation, thereby reducing loss-shifting potential and delaying the incentive for increased risk taking. see supra notes 62, 79, and associated text. 89. my thanks to gregg polsky for this idea. 90. see, e.g., rev. rul. 72-78, 1972-1 c.b. 45 (applying section 1341 to a contingent commission arrangement). where the retention of a fee is contingent on the occurrence (or nonoccurrence) of subsequent events, the recipient has an apparent right to the funds, but the right to the funds is clearly challengeable. thus, a contingent fee quite likely satisfies the first prong of section 1341. see supra note 86. 91. i.r.c. § 61. 2012] “carried interest” tax proposals 31 depending on the character of the partnership’s profits.92 this tax difference is quite meaningful today given that long term capital gains are generally taxed at 15 percent, whereas the highest marginal rate applicable to ordinary income is 35 percent.93 if, however, the tax treatment of carried interests changes and income earned on account of a carry is taxed as ordinary income, the tax rate difference between a carry and a contingent fee is largely eliminated.94 in the absence of the tax rate benefit for carried interests, parties may opt to restructure their arrangement to create similar economics while providing greater certainty that the gp would be made whole if the gp is ultimately obligated to return part of the profits previously transferred to the gp. (e) conclusion regarding the lps’ response to the clawback issue ultimately, the lps must determine how much potential loss-shifting they are willing to bear and how willing they are to accept the possibility of increased risk-taking by the gp. this determination is relevant both for investors in newly formed funds and investors in existing funds, although the negotiating dynamics differ. investors in new funds can negotiate about these issues as part of the initial negotiation about the fund agreement provisions. investors in existing funds, however, must negotiate against the backdrop of existing fund agreements,95 the economic impacts of which can be altered by the change in the tax law without any corresponding change in the compensation paid between the parties. either way, if the lps (and their lawyers) appreciate how increases to the tax rate on the gp’s carry can reduce the clawback, and how a reduction in the clawback poses economic risk to the lps, the lps can make informed decisions about whether and to what extent to negotiate for compensation for these risks, to negotiate to change the terms of the clawback to reduce these risks, to negotiate for other contractual protections against these risks, or to take other action. 92. i.r.c. § 702. 93. i.r.c. § 1. 94. there may still be employment tax differences depending on the details of the carried interest tax proposal. see supra note 16. 95. in existing funds where the cap on the clawback is pegged to an assumed tax rate, lps might be approached by gps who wish to renegotiate the cap on the clawback. in other existing funds, the lps might have to initiate the negotiation with the gp because the cap on the clawback might automatically change with any change to the tax rates applicable to carried interests (e.g., if the cap is pegged to the “applicable” tax rate or if the cap is determined in the good faith discretion of the gp). 32 florida tax review [vol.13:1 b. tax distribution provisions an increase in the tax rate applicable to carried interests can change how lps are affected not only by clawback provisions, but also by tax distribution provisions. again, the impact on lps is indirect. and while the issues raised for lps as a result of the tax distribution provisions are likely less troublesome than the issues raised as a result of the clawback provisions, lps should still be sensitive to their potential exposure. this section explains how tax distributions operate and why they are needed. then, with this background, this section discusses the possibility that tax distributions will increase if the tax on carried interests increases, and explains how lps may be indirectly affected as a result. finally, this section provides some guidance to lps who are concerned about how they might be affected by the interaction between the tax distribution provision and the increase in taxes on carried interests. 1. understanding tax distributions under the partnership tax rules, when a partnership earns income, the partnership itself is not taxed.96 rather, the partnership’s income is allocated to the partners in accordance with the partnership agreement, and each partner pays tax on its allocable share of the partnership income.97 this is true whether or not the partnership distributes cash to the partner. thus, when a fund earns income, that income is allocated to the partners in accordance with the fund agreement, and those partners pay tax on that income. if at least a significant portion of that income is concurrently distributed to the partners, the partners can use that cash to pay the tax due. however, where a fund does not make a corresponding distribution of cash from the fund, partners have “phantom income” — the partner may owe current income tax on income that the partner has not yet received.98 some partners have no problem with this result because, for example, they have ample cash flow from other sources, or they are tax-exempt. many partners, however, find this “tax without cash” situation to be quite undesirable. in response, funds often provide for “tax distributions,” particularly to the gp.99 96. i.r.c. § 702. 97. i.r.c. §§ 702, 704. 98. funds vary as to whether they generally distribute income as it is earned, so this “phantom income” issue is more of a problem for partners in some funds and is less of a problem in other funds. in particular, private equity funds (as opposed to hedge funds) commonly distribute proceeds quickly upon realization, reducing the prevalence of phantom income problems in these funds. 99. see needham, private equity funds, supra note 17, at iii.b.5.; levin, venture capital, supra note 14, at ¶ 1003.5. 2012] “carried interest” tax proposals 33 specifically, distributions are made to designated partners in an amount intended to enable a partner to pay tax on the income allocated to that partner. these distributions typically have priority over other distributions in the regular distribution waterfall, and these distributions are typically treated as advances on distributions to which the particular partner would otherwise be entitled.100 again, some of the details of tax distributions vary from fund to fund. for example, (i) tax distributions may be made to all partners or only to the gp,101 (ii) tax distributions may be calculated using an assumed rate of tax or using an approach that is more tailored to the individual tax situations of the particular distributees,102 (iii) tax distributions may be calculated on a year-by-year basis, deal-by-deal basis, or on a cumulative basis,103 and (iv) cash remaining after the tax distributions have been made may be retained and redeployed in the enterprise, or remaining cash may be distributed to the lps to return their capital contributions.104 of course, funds that make current cash distributions in amounts equal to current allocations of income need not provide for tax distributions; partners in these funds receive plenty of cash to pay the tax on the fund income allocated to them. that said, to the extent that the fund regularly makes additional capital calls and the gp (and possibly others) reinvest the amount received in the distribution less the tax due (or assumed due), the fund effectively makes “tax distributions.” further, funds that subject the gp’s carry distribution to an escrow also often make tax distributions out of the escrow to enable the gp to pay taxes on the escrowed funds.105 ultimately, where there are delays between the time a partner is taxed on fund income and the time a partner is to receive that income, a tax distribution helps the partner overcome the cash flow issue and pay the tax due on the partner’s allocable share of fund income. 100. see needham, private equity funds, supra note 17, at iii.b.5. 101. for example, lps who are tax-exempt, foreign, or quite liquid may not need tax distributions. 102. it is much more common to use an assumed rate. see needham, private equity funds, supra note 17, at iii.b.5. 103. see needham, private equity funds, supra note 17, at iii.b.5. (explaining that “[t]he effect of a cumulative approach is that gains in any particular year must exceed the excess of losses over gains in all preceding years before a member is entitled to a tax distribution”). 104. see levin, venture capital, supra note 14, at ¶ 1005 (explaining that it is a business decision as to whether the gp has the power to reinvest proceeds rather than to distribute the proceeds); needham & brause, hedge funds, supra note 11, at i.a. (explaining that hedge funds often have tremendous flexibility to “buy, sell and reinvest proceeds of sale”). 105. see supra note 67. 34 florida tax review [vol.13:1 2. increasing tax distributions in response to increased tax on carried interests in funds that earn significant amounts of ltcg income, the carried interest tax proposals would increase the amount of tax that the gp would owe on the carried interest. in turn, this could affect tax distributions. specifically, gps would want the size of the tax distributions to be increased in order to cover the higher tax bill applicable to the carry. an increase to the amount of the tax distribution may already be built into some fund agreements such that the tax distributions will increase in amount without any additional negotiation or agreement between the parties. this is likely the case where the tax distribution amounts are based on a variety of assumptions.106 for example, consider a fund agreement that defines the tax distribution to be the amount “reasonably required by the [gp] for payment of its federal, state, and local estimated (or other) taxes . . . relating to the [gp’s] distributive share of the income of the [fund].”107 this language is broad enough to allow for the tax distributions to increase if the taxes on the carried interest increase; this can occur without any change to the terms of the fund agreement. for funds that provide tax distributions, but do so at a stated rate (such as 15 percent), gps would likely request an increase in the amount of the tax distribution to help cover the increased tax cost that the gp would have to bear.108 and, for funds that do not provide tax distributions but whose terms result in phantom income, an increase in the tax rate applicable to the carry would increase a gp’s incentive to push for adding tax distributions to the fund agreement. a gp may be able to make a relatively sympathetic case for increasing the tax distribution to the gp if the tax on carried interests increases. in particular, the gp could explain that tax distributions are merely advances on amounts that would eventually be distributed to the gp, so the gp will not end up with any more total money as compared to what the gp would receive if the tax distribution is not increased. and, although an increase in the tax distribution results in an earlier distribution of some funds to the gp, it is the federal government, and not the gp itself, that ultimately 106. recall that a similar approach is often used for purposes of estimating a gp’s “after-tax carry” that may be subject to a clawback. see supra part iii.a.3.b. 107. nowak, hedge fund agreement, supra note 18, at ¶ 7.10(a); see also needham, private equity funds, supra note 17, at worksheet 5 (providing sample tax distribution language that is similarly tied to the relevant prevailing tax rates, rather than to an explicitly stated rate). 108. i have spoken with a handful of fund managers who indicated that this is how they are likely to respond if the carried interest tax legislation passes. of course, this is anecdotal, but it seems like the logical move. i would likely recommend this course of action if i represented a gp. 2012] “carried interest” tax proposals 35 has use of the increased amounts. that is, a gp would argue that the increased tax distribution does not really help the gp (other than to alleviate cash flow problems associated with the gp’s increased tax bill) because the gp cannot use that money in order to make other investments. on its face, this might seem like a reasonably compelling argument for increasing the gp’s tax distribution, but the lps should be careful. 3. sensitizing lps to the secondary effects of increasing the gp’s tax distribution lps should appreciate the subtle ways in which an increase to the tax distribution to the gp could affect the remainder of the economic relationship between the gp and the lps, including the extent to which the alignment of the gp’s and lps’ incentives is altered. (a) eroding the alignment of incentives carried interests, as currently designed, generally are regarded as quite effective at aligning the incentives of the gp with the incentives of the lps.109 this is because the gp’s return is directly proportional to the return that the fund assets produce for the lps. the alignment of incentives largely avoids the potential agency costs that could be created when the fund investors allocate managerial authority over the fund assets to the gp. the alignment of interests is not perfect, and there are some minor agency problems,110 though other features of the carry and the fund help to mitigate those costs, leaving the interests of the gp and the lps largely aligned.111 as discussed in part iii.a., one of the problems created pursuant to the clawback provision is the erosion of the alignment of incentives, particularly with respect to the incentive for risk-taking. tax distribution provisions can also erode the alignment of incentives, though in different respects. specifically, funds that generally limit yearly distributions to tax distributions will have increased liquidity needs if the size of tax distributions to the gp is increased. these increased liquidity needs can cause the gp’s interests in deal harvesting to diverge 109. gilson, venture capital market, supra note 17; fleischer, preferred return, supra note 51; robert c. illig, the promise of hedge fund governance: how incentive compensation can enhance institutional investor monitoring, 60 ala. l. rev. 41 (2008), [hereinafter illig, hedge fund governance]; matthew a. melone, success breeds discontent reforming the taxation of carried interests— forcing a square peg into a round hole, 46 duq. l. rev. 421 (2008). 110. see supra note 60. 111. gilson, venture capital market, supra note 17; illig, hedge fund governance, supra note 109. 36 florida tax review [vol.13:1 from the lps’ interests. this is because, under current law, both the gp and the lps are subject to tax on their fund income at the same rates (ltcg), assuming that the lps are also taxable u.s. persons.112 a large portion of lps are tax-indifferent,113 but when gps and lps are subject to tax at the same rate, the gp and the lps are likely to have similar interests in receiving tax distributions (i.e., both would likely want tax distributions of 15 percent of the allocated income). in contrast, under the carried interest legislation, the gp’s income from the fund is recharacterized as ordinary income, increasing the gp’s tax liability, but the tax rate on the lps’ income from the fund remains unaffected. thus, if taxes are increased on carried interests, a gp’s interest in increasing the tax distribution would be much stronger than the lps’ interests in doing so. as a result, it is likely that it would be primarily the gp, and not the lps, that has an interest in ensuring that the fund has additional cash flow.114 where the gp’s desire for liquidity exceeds the lps’ desire for liquidity, the gp has an incentive to manage the fund’s assets in a way that will ensure cash flow that is sufficient to cover the gp’s larger tax bill, even if such management is not in the best interests of the lps. this pressure may have little, if any, effect in situations where a fund exits a particular investment in exchange for cash, and all of that cash is made available for distribution. however, consider the situation where the fund has a limited amount of cash available for distribution, for example, because a taxable transaction yielded non-cash proceeds115 or because cash proceeds from a transaction are needed to pay fund expenses. in these types of situations, as the size of the gp’s needed tax distribution increases, the gp may become increasingly inclined to cause the fund to exit another investment prematurely in order to ensure that the fund has sufficient cash to cover the 112. this assumes that the lps are also taxable u.s. persons. this may or may not be the case. to the extent that the lps are subject to lower tax rates, the gp’s and lps’ preferences regarding tax distributions are already misaligned. thus, if the tax on the gp’s carry is increased, and the size of the tax distribution to the gp is correspondingly increased, then the alignment between the gp’s and lps’ preferences is made even worse. that is, the gp’s interest and the lps’ interests are misaligned when the gp is subject to tax at 15 percent and the lps are subject to tax at 0 percent. but, the misalignment of interests is even worse when the gp is subject to tax at 40 percent and the lps are subject to tax at 0 percent. 113. see supra note 7. 114. it is possible that, when the gp’s tax distribution is increased, the lps’ tax distributions are also increased proportionately. then, the lps would have some increased interest in increased liquidity. but, even then, the lps’ desire for fund liquidity would be less than the gp’s interest because the gp actually needs the money to satisfy a current liability to the government, whereas the lps do not. 115. see generally needham, private equity funds, supra note 17, at iii.c. (raising this possibility). 2012] “carried interest” tax proposals 37 gp’s tax needs. further, where the fund has limited cash flow, the gp, as its tax bill increases, may be increasingly disinclined to cause the fund to undertake efficient taxable transactions just because they yield non-cash proceeds.116 (b) altering additional aspects of the gp’s/lps’ economic relationship an increase in the size of the tax distribution to the gp can cause other changes to the economic relationship between the gp and the lps. these changes may be slight, but they remain worthy of mention because of how carefully the partners typically negotiate the economic relationship between the gp and the lps. the specific manner of change depends, in part, on the remainder of the fund’s scheme for operating distributions.117 (1) delaying the return of capital to the lps consider a fund agreement that provides for tax distributions to the gp, followed by a distribution of remaining available cash to the lps as a return of the lps’ capital contributions.118 under this distribution scheme, an increase in the size of the tax distribution to the gp will reduce the amount of the current distribution to the lps, thereby delaying the time at which the lps receive a return of their capital contributions. this time value of money issue may or may not be problematic for the lps, depending on the lps’ expectations and needs regarding the rate at which their capital contributions are returned to them and depending on the magnitude of the increase in the amount of tax distributions. (2) foregoing the opportunity for the fund to reinvest the increased amounts distributed as tax distributions consider a different fund agreement that provides for tax distributions to the gp and the lps, with remaining cash available retained by the fund. an increase in the tax distributions to the gp (whether or not accompanied by a proportionate increase to the tax distributions made to the lps) will reduce the total amount of money available with which the fund 116. this incentive actually exists as a result of the mere increase in taxes on the carried interest, whether or not the tax increase is accompanied by an increase in the tax distribution. 117. see generally needham, private equity funds, supra note 17, at iii.b. (describing various distribution schemes); levin, venture capital, supra note 14, at ¶ 1003 (same). 118. see levin, venture capital, supra note 14, at ¶ 1003 (describing this distribution scheme). 38 florida tax review [vol.13:1 can make additional investments. of course, the tax distribution is merely an advance distribution of amounts to which the distributee will be ultimately entitled. however, the earlier this advance is distributed (the larger the tax distribution, the more money advanced earlier), the less time that money is in the fund, and the less time the fund will be able to earn returns by investing that money. again, this may or may not be problematic for the lps, depending in part on the extent to which the fund’s business model depends on retention and redeployment of the fund’s capital over a particular term, and depending on the magnitude of the increase in the tax distributions. 4. recommendations for fund investors regarding tax distributions the existence and magnitude of the foregoing concerns will, of course, vary from fund to fund and lp to lp. lps should evaluate their particular situation to determine the extent to which these concerns are problematic for them. for example — does the fund have significant liquidity constraints? when do the lps expect to receive returns of their invested capital? how important is it to the fund’s business model to retain and redeploy as much cash as possible? the answers to these and other questions should inform both the lps’ assessments about the degree of any problems created by increased tax distributions and the lps’ response thereto. lps may determine that the issues described in part iii.b.3 are not problematic, and do nothing. or, lps may determine that the issues are somewhat problematic but the lps may accept these consequences because the lps believe that the costs of accepting the risks are less than the costs of fighting with the gp about the tax distribution terms. alternatively, lps may determine that the problems created for them by increased tax distributions are sufficiently troublesome to justify their efforts to protect themselves from the potential adverse impact of increased tax distributions. if the lps want to negotiate with the gps in an effort to minimize the consequences described in this part, there are different approaches available. one approach is to negotiate directly about the terms of the tax distributions in an effort to change the assumptions on which the amount of the tax distributions is calculated. those assumptions include assumptions regarding the rate of tax, regarding the location of the “hypothetical” taxpayer whose tax rate is used for calculating the tax distributions, and/or regarding the availability of losses to offset income from the carry. this is similar to the approach described above in part iii.a.3.b as a potential response to the clawback issues. 2012] “carried interest” tax proposals 39 another approach is to negotiate about how the gp’s carry is calculated, thereby negotiating indirectly about the amount of the tax distribution. for example, calculating the carry on a cumulative basis (rather than on a year-by-year basis) or calculating the carry net of unrealized losses could reduce the current allocations of carry,119 thereby reducing the necessary tax distributions, thereby reducing the risks described in this part. this is similar to the approach described above in part iii.a.3.a as a potential response to the clawback issues.120 ultimately, the lps’ response, if any, will depend on the particular facts and circumstances, but hopefully, this discussion enables the lps (and their lawyers) to evaluate the magnitude of any potential concern created by increased tax distributions. iv. conclusion the debate about the taxation of carried interests continues, raising a real possibility of an increase in the taxes paid by fund managers on the value they derive from their carried interests in funds. under the carried interest proposals, fund managers would be the ones who pay higher taxes, but they are not the only ones who could suffer adverse economic consequences. the carried interest legislation puts fund investors at risk too, and not just because managers may try to raise management fees or carry rates or because overall fund profitability may decline. rather, the carried interest legislation puts fund investors at risk of bearing more than their share of economic losses, at risk because managers might take increased risks with the fund assets, and at risk from other changes to the investors’ economic relationships with managers. the risks are raised not directly, but rather indirectly, as a result of common fund agreement provisions, specifically clawback provisions and tax distribution provisions. these may appear to be reasonable, carefully negotiated provisions that are part of industry norms for fund agreements. however, as this article explains, these provisions, when coupled with an increase in the taxes imposed on carried interests, can have return-reducing ripple effects for fund investors. the route through which investors’ economic interests could be affected may be complex, technical, and subtle, but the effect could be significant. and this is merely one example of how a 119. this might change the timing of the allocation and distribution to the gp of the carry, but it should ultimately not change the total amount of the carry to which the gp is entitled. 120. the other approaches described as possibilities in response to the clawback issue (specifically (i) taking into account the gp’s tax loss when calculating the after-tax cap on the carry and (ii) adding a limited dro) are relevant to clawbacks but not to tax distributions. 40 florida tax review [vol.13:1 change in law can create unintended consequences by rippling through private contracts, thereby altering the economic relationships created by those contracts and adversely affecting parties who are not the desired targets of the law change. ultimately, the carried interest legislation may not be explicitly aimed at fund investors, but fund investors ought to be aware of how the legislation could affect them. armed with that knowledge, fund investors can decide whether to accept the potential consequences or whether to protect themselves by negotiating about the details of the fund agreements. either way, fund investors need to know that (and how) they may be vulnerable. ii. background b. legislative proposals regarding the taxation of carried interests iii. the circuitous route between increased taxes on fund managers and reduced returns for fund investors a. clawback provisions 1. understanding clawbacks (a) example #1 — how can lps be harmed in the absence of a clawback? (1) hypothetical & analysis (2) the many problems presented by example #1 (b) example #2 — how might a clawback help protect the lps? (c) example #3 — how do taxes on the carry affect the operation of a clawback? (1) loss-shifting (2) increasing the gp’s risk-taking incentive 2. appreciating how clawback problems are exacerbated by increases to the tax on carried interests (a) revise how the carry is calculated (b) change the tax rate used for calculating the “after-tax” carry (c) take the gp’s tax loss into account when calculating the “after-tax” carry (d) restructure the carry as a contingent fee (e) conclusion regarding the lps’ response to the clawback issue b. tax distribution provisions 1. understanding tax distributions 2. increasing tax distributions in response to increased tax on carried interests 3. sensitizing lps to the secondary effects of increasing the gp’s tax distribution (a) eroding the alignment of incentives (b) altering additional aspects of the gp’s/lps’ economic relationship (1) delaying the return of capital to the lps (2) foregoing the opportunity for the fund to reinvest the increased amounts distributed as tax distributions 4. recommendations for fund investors regarding tax distributions iv. conclusion florida tax review volume 20 2017 number 10 i article redefining a blurry line: a proposal to reform the taxation of pension fund business and investment income jesse boretsky a conceptual framework for capital calvin h. johnson boretsky-johnson_1st 6 pages.pdf 1 8/16/17 12:10 pm florida tax review volume 20 2017 number 10 ii information for subscribers the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. for volume 20, the subscription rate is $125.00 in the united states and $145.00 elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. for volume 20, subscriptions and changes of address should be sent to florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. beginning with volume 21, the florida tax review will be published by the university of florida press on behalf of the graduate tax program of the university of florida levin college of law. for subscription information and queries relating to volume 21 and subsequent volumes, please contact the johns hopkins university press, p.o. box 19966, baltimore, md 21211; phone 1-800-548-1784; jrnlcirc@press.jhu.edu. all correspondence of a business nature, including advertising, should be addressed to the university of florida press, 15 nw 15th st., gainesville, fl 32603; phone 352-392-1351; http://upress.ufl.edu. copyright © 2017 by the university of florida boretsky-johnson_1st 6 pages.pdf 2 8/16/17 12:10 pm florida tax review volume 20 2017 number 10 iii editor-in-chief charlene luke professor of law university of florida associate editors university of florida yariv brauner hugh culverhouse eminent scholar karen burke richard b. stephens eminent scholar dennis a. calfee professor of law patricia e. dilley professor emeritus michael k. friel professor emeritus david hasen professor of law david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law martin j. mcmahon, jr. emeritus james j. freeland eminent scholar lee-ford tritt professor of law samuel c. ullman adjunct professor of law steven j. willis professor of law board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university– bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate student editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell kathleen duggan pfahlert executive assistant jessica e. joseph boretsky-johnson_1st 6 pages.pdf 3 8/16/17 12:10 pm florida tax review volume 20 2017 number 10 iv information for contributors the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law. the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the florida tax review prefers electronic submissions sent via expresso (https://www.bepress.com/products /expresso/); articles may also be e-mailed to ftr@law.ufl.edu as a microsoft word document. if a hard copy submission is necessary, please mail your article to editor-in-chief, florida tax review, university of florida levin college of law, 309 village drive, gainesville, fl 32611. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. all citations should follow the bluebook uniform system of citation (20th ed.); some modifications will, however, be made by our editors to conform to the florida tax review style manual. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the florida tax review. boretsky-johnson_1st 6 pages.pdf 4 8/16/17 12:10 pm florida tax review volume 20 2017 number 10 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations promulgated under the internal revenue code of 1986, as amended, unless otherwise indicated. boretsky-johnson_1st 6 pages.pdf 5 8/16/17 12:10 pm florida tax review volume 20 2017 number 10 vi the 2016 tannenwald writing competition winners sponsored by the theodore tannenwald, jr. foundation for excellence in tax scholarship and the american college of tax counsel first prize $5,000: jesse boretsky, yale law school redefining a blurry line: a proposal to reform the taxation of pension fund business and investment income faculty sponsor: prof. yair listokin second prize (tie, $2,000): sam lapin, temple university beasley school of law finding propaganda: how to stop grassroots lobbying costs from slipping through the cracks of section 162(e) faculty sponsor: prof. alice abreu matthew swift, the university of chicago law school between a rock and a hard place: evaluating the illinois retirement income exemption faculty sponsor: prof. daniel hemel named for the late tax court judge theodore tannenwald, jr., and designed to perpetuate his dedication to legal scholarship of the highest quality, the tannenwald writing competition is open to all full or parttime law school students, undergraduate or graduate. papers on any federal or state tax-related topic may be submitted in accordance with the competition rules (viewable at www.tannenwald.org). boretsky-johnson_1st 6 pages.pdf 6 8/16/17 12:10 pm login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 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amending the amt (and regular tax) linda m bealet i. introduction .......................................... 813 ii. normative principles: coherence and distributive justice ................................... 817 iii. tax cuts, the federal budget, and amt applicability ... 825 a. overall federal tax system progressivity ............... 829 b. federal debt and deficit growth ...................... 838 c. expanding scope of the amt ......................... 842 iv. amt repeal or reform?. .. . . . . .. . . .. . .. . .. . . .. . .. . .. . .. 847 a. downward creep .................................. 848 b. transparency ..................................... 852 c. complexity ....................................... 854 d . consistency ....................................... 858 1. "ability to pay" deductions and exemptions ...... 858 2. state and local taxes ........................ 861 3. medical expenses ............................ 867 e. accidental taxpayers ............................... 869 1. incentive stock options ....................... 869 2. contingent attorney fees ...................... 873 v. proposals for amt reform ............................ 877 a. amend the am t ................................... 877 1. institution of gross income threshold ............ 878 2. treatment of "ability to pay" deductions and exemptions ................................. 879 3. indexation ofamt parameters ................. 882 4. harmonization of medical expense deduction ..... 882 t associate professor, university of illinois college of law. this article is an expansion and further development of ideas first presented at the aba tax section's may 2004 individual amt panel in washington, d.c. i am especially grateful to john colombo, richard kaplan, roberta mann, and gail richmond for their helpful comments and suggestions. i would also like to thank zachary christensen, university of illinois college of law class of 2005, for his helpful research assistance. any errors or omissions, of course, are my own responsibility. 811 812 florida tax review [vol. 6:9 5. retention of excess state taxes preference ........ 883 6. recalculation of gain on incentive stock options... 883 7. addition of new a mt preferences ............... 885 a. untaxed appreciation of charitable contributions ......................... 885 b. preferential capital gain rates .......... 891 b. harmonize the amt and regular tax systems .................. 894 1. indexed phaseouts for exemptions and itemized deductions . 894 2. above-the-line deductions for contingent attorney's fees.. 894 3. additional harmonizing changes ...................... 895 4. 2001-2003 tax cuts sunsets .......................... 896 vi. conclusion ........................................... 896 congress fiddles while middle america burns [l]aws and institutions no matter how efficient and wellarranged must be reformed or abolished if they are unjust.t i. introduction the emperor nero is said to have fiddled away while rome burned, oblivious to the damage he himself had caused. the empire never truly recovered. will this generation's grandchildren look back at the current congress and condemn it for similar frivolity? it may well be claimed that congress has frittered away the next generation's future by passing tax cuts providing excessive benefits to the wealthy while letting the alternative minimum tax fall more and more broadly. this article argues that congress could restore some modicum of tax sanity for ordinary americans by a combination of changes to the regular and alternative minimum tax. the current alternative minimum tax (referred to herein as the amt) is a "back-up" tax system with flatter rate brackets and a broader tax base than the regular income tax.' the base (called "alternative minimum taxable income") is essentially derived from the regular income tax base by making certain "adjustments" and adding back in certain "preference" items that are disallowed for amt purposes.! these adjustments and disallowed tax preferences (both generally referred to herein as "amt preferences") include reduction in the amount of accelerated depreciation that may be taken into account for amt purposes, disallowance of the deduction for interest on certain home equity loans, and required inclusion of otherwise excluded taxexempt interest on certain private activity bonds.' the first $175,000 of income included in the amt base in excess of a specified amt exemption amount is taxed under the amt at a rate of 26%. excess alternative minimum taxable income above that $175,000 bracket is taxed at 28%. capital gains, however, still enjoy preferential rates as under the regular tax." the amt, originally intended for the superrich, developed over time as a kind of secondary boundary fence to ensure that taxpayers cannot overuse various incentive provisions to slip out of the tax system without paying some portion of their economic income to the federal fisc.' several : john rawls, a theory of justice 4 (revised ed., 1971, 1999). 1. the amt is set forth in the internal revenue code (the "code") at §§ 55-59. 2. irc § 55(b)(2) (requiring adjustments and disallowing tax preference items); § 56 (setting out adjustments); § 57 (listing tax preference items). 3. irc §§ 56(a)(1), 56(e), 57(a)(5). 4. irc § 55(b). 5. see infra part iii.c. just what portion should be paid as a minimum has been little discussed. most might be expected to agree that wealthy taxpayers owe more than a de minimis share of their income to the federal government. a reasonable goal, considering the importance of progressivity, see infra part ii, might be to have the 2004] florida tax review features of the budgetary context, the amt and the regular tax system, however, suggest that the amt will increasingly reach into the pool of middleincome taxpayers over the next few years. this is in large part due to the 2001 and 2003 tax cuts, which significantly lowered tax rates, and the lack of indexation of the amt rate brackets and exemption amount. taxpayers with incomes of less than $100,000 may account for as many as 52% of the entire pool of amt taxpayers in 2010, up from about 9% in 2003.6 the increase in taxpayers subject to the amt over time creates a quandary the longer congress waits to limit the scope of the amt, the more it will cost to do so. it has been projected to cost more to repeal the amt in 2013 than it would cost at that time to repeal the regular income tax.7 there is no easy solution to this amt quandary. regular tax repeal is not the appropriate answer, since that would further benefit taxpayers at the very highest income brackets, who now pay regular tax at high marginal rates rather than the amt. 8 the alternative of amt repeal is urged by a number of commentators, supported by what appear to be strong arguments stated in forceful language.' they note the "stealth" nature of the amt, in wealthiest taxpayers pay an effective tax rate that is at least several percentage points higher than the average effective tax rate paid by middle-income taxpayers. the 1978 house ways & means committee suggested that an effective tax rate of 25% on taxable income and preferences was a reasonable target. see 1978 house report, infra note 296, at 201-02. these criteria suggest a minimal target of an effective tax rate for the superrich of at least one quarter of their economic income, assuming that the base adequately reflects economic income. other commentators, however, have arrived at a slightly lower figure. see malamud, infra note 294. 6. leonard e. burman, william g. gale & jeffrey rohaly, the amt: projections and problems, 100 tax notes 105, 105 (july 7,2003). the treasury department predicts that 51.3 million taxpayers will pay increased taxes due to the amt by 2015. department of the treasury office of public affairs, fact sheet: the toll of two taxes: the regular income tax and the amt (mar. 2, 2005), at http://www.treas.gov/press/releases/reports/factsheetthetollofwotaxesupdate.pdf (updating a similar 2004 fact sheet released by the treasury department, at http://www.treas.gov/press/releases/jsl293.htm?, indicating 46.4 million would pay amt in 2014). 7. id. 8. see, e.g., mark a. luscombe, alternative minimum tax our future flat tax?, taxes, nov. 2003, at 3 (explaining that very high income taxpayers pay the regular tax rate rather than the amt, even though the amt base is broader, because the highest marginal rate under the regular tax exceeds the highest amt rate). 9. see, e.g., daniel shaviro, tax simplification and the alternative minimum tax, 91 tax notes 1455, 1455-56 (may 28, 2001) (providing an overview of the strong commentary advocating amt repeal that labels the amt the "biggest headache" and "asininely stupid"); shawn tully, taxpayer, beware!, fortune, june 23, 2003, at 48 (calling the amt a "morally corrupt rip-off'); mary beth franklin, prisoners of the amt, 2003 kiplinger's personal finance 60 (calling the amt "a ticking time bomb"); [vol. 6:9 congress fiddles while middle america burns that many ordinary taxpayers are unaware of its existence or ill-informed about the interplay of various provisions." they critique the apparent lack of consistency with regular income tax policy, because the amt sometimes takes back the benefit of specific provisions targeted by congress to particular statuses, such as the state tax or medical expense deductions." they point out the complexity of multiple computations to determine tax liability and the internal complexity of the amt provisions themselves.2 to catch the attention of ordinary americans and illustrate the reach of the system, various special interest groups highlight the stories of sympathetic "victims" of the elimination of particular preference items.3 those arguments, however, gloss over the negative impact of amt repeal, when combined with the significant tax reductions for wealthier taxpayers under current federal tax law (including the decrease in taxation of capital gains and dividends, as well as the likely permanent reduction or elimination of estate taxes). amt repeal would burden ordinary taxpayers with either future tax increases or benefit reductions, if the tax cuts already enacted are not substantially rolled back and no other changes are made.4 at a time when there is significant and increasing disparity of incomes among taxpayers, amt repeal would remove one of the tools from the tax system toolbox for defeating high-income taxpayers' ability to shelter economic income and reduce their federal tax burdens. even prior to the 2002-2003 tax cuts, analysts noted that the benefit of amt repeal would accrue to higherincome households: "the average tax cut for all households with income above $200,000 [roughly 3% of taxpayers] would rise by $11,000.' ' 6 amt repeal would thus exacerbate the trend that is shifting the overall federal tax burden away from high-income taxpayers. assuming that any attempt to reverse entirely the 2001 and 2003 income and estate tax cuts would meet with insurmountable political shailagh murray, firestorm looms on minimum tax, wall st. j., july 1, 2003, at a4 (calling the amt a "creeping menace"). 10. see david cay johnston, your taxes: a "stealth tax" is creeping up on growing numbers of americans, n.y. times, feb. 17, 2002, at 317. see infra part iv.b for further discussion of the transparency issue. 11. see infra part iv.d for discussion of this issue. 12. see infra part iv.c for discussion of this issue. 13. see infra part iv.e for discussion of this issue. 14. see infra part iii.b for discussion of this issue. 15. see infra part iii.a for discussion of this issue. 16. william g. gale & samara r. potter, an economic evaluation of the economic growth and tax relief reconciliation act of 2001, 55 nat'l tax j. 133, 149 (2002) (citing jerry tempalski, the impact ofthe 2001 tax bill on the individual amt, u.s. treas. memo (2001)). 2004] florida tax review resistance,7 this article argues that there may be a middle road of amt reform. distributive justice principles and a general goal of achieving greater coherence within the overall tax system should guide the reforms: these principles should undergird any assessment of the degree of complexity considered permissible and any balancing of tradeoffs between larger deficits and increases in tax burdens (or lost benefits) for particular groups of taxpayers. generally, distributive justice will be served if amt reforms more successfully target higher-income taxpayers, to ensure that they shoulder at least some reasonable share of the national tax burden based on a fuller measure of their true economic income. coherence will be increased if, whenever possible, any amt and regular tax changes increase transparency, ensure policy consistency between the regular income tax and the amt, and avoid unnecessary complexity in both systems. in particular, both fairness and coherence will be enhanced if amt amendments can completely relieve ordinary taxpayers (intended as a non-technical term to include married taxpayers filing jointly with economic incomes less than $100,000 or single taxpayers with economic incomes less than $50,000) from any amt burden. at the same time, realistic domestic and international revenue needs demand that the price of amt reforms be met through significant concurrent changes to the regular tax system and the disallowance of additional preference items through the amt system. the argument proceeds as follows. part ii briefly explains the normative perspective, founded on distributive justice principles and a demand for coherent structure, that i believe should guide tax policymakers in making the difficult choices among possible tax reforms. part iii discusses in greater detail the effects of recent amendments to the code on progressivity, deficits (and the national debt burden), and the reach of the amt. part iv considers the most common arguments for outright repeal of the amt stemming from the resulting downward creep and concludes that there are strong normative, and practical, reasons to retain the amt despite its flaws. as an alternative to repeal, part v proposes specific provisions to re-target the amt to higher income taxpayers and, acknowledging that this cannot be accomplished solely within the amt, suggests possible harmonizing changes to the regular tax. part vi concludes. 17. see, e.g., meade emory, letters to the editor: estate tax debate simply kicked over 10 years and to a very uncertain time, 91 tax notes 1765 (june 4,2001) (noting that "opponents of the estate tax simply believe that the body politic will not allow a tax increase of the size represented by the estate tax and congress will simply extend the repeal of that tax"). but see martin a. sullivan, unfinished business: the disappearing tax act of 2001, 91 tax notes 1652 (june 4, 2001) (noting that the possibility of the estate tax "spring[ing] back to life at the beginning of 2011, one year after it's repealed, and with a top rate of 55 percent" is "absurd and untenable and will never stand" but suggesting that if there are no surpluses, permanent repeal is unlikely). [v1ol. 6:9 congress fiddles while middle america burns ii. normative principles: coherence and distributive justice tax policymakers have relied on a number of different criteria for selecting among alternative tax systems. some of these criteria appear endogenous to tax and the pragmatic needs for an understandable and administrable tax system, such as a general preference for less complex provisions over more complex provisions. some, such as the concept of structural coherence, relate to the attributes of structures that permit aggregates of items and rules to cohere into an identifiable system or institution. other criteria, such as fairness or efficiency, derive from general philosophical and economic thought about the way legal and social systems operate and the principles that should guide them. this part suggests that two such criteria are critical in thinking about amt reform. relying on dworkin's jurisprudential theory of integrity, i have argued elsewhere that legal systems, such as a tax system, should be construed as a coherent whole, and modifications to the system should be designed and interpreted to conform with that coherent whole.8 structural coherence includes within it some concept of consistency across variations. thus, we generally think that principles of tax law applicable in particular contexts should be consistent with principles of tax law applicable in other contexts, whenever possible. the principle of conservation of basis exemplifies this concept of coherence. basis tracks after-tax investment, and is adjusted upwards when the investment is increased or downwards when the investment is decreased. we would expect the same principle to apply to adjust basis in the context of personal purchases (such as homes) that applies in the context of corporate investments, to taxable exchanges or to nonrecognition transactions. structural coherence does not mean, however, that apparently similar rules must be consistent across all contexts. instead, to the extent there are apparent conflicts between similar rules in different contexts, coherence requires that those conflicts should be susceptible to explanation in terms of overarching themes that justify or provide the rationale for the different contexts themselves. in the context of amt reform, coherence cannot require uniformity between the amt and the regular tax. the essence of the amt is that it is an alternative system that effects changes compared to the results otherwise extant under a system consisting solely of the regular tax. to be an alternative context, there must be (at least some) different rules. thus, while consistency across contexts supports coherence and results in a simpler 18. see book-tax conformity and the corporate tax shelter debate: assessing the proposed section 475 mark-to-market safe harbor, 24 va. tax rev. 301, 363-70 (2004) (discussing the importance of coherence as a structuring principle, drawing from dworkin's constitutional theory of integrity, as expounded in ronald dworkin, freedom's law: the moral reading of the american constitution (oxford univ. press 1996)). 20041 florida tax review overall system, it is not sufficient to argue, without more, that such and such a provision in the amt is inconsistent with a superficially similar provision in the regular tax. the rationale for the amt must be examined, as well as the rationale for the particular type of rule in both systems, to determine what coherence demands. fairness is another evaluative criterion that is almost universally considered important for tax policy. although there is no fixed consensus regarding the core principles that should be applied to evaluate the fairness of a tax system or of particular tax rules, a number of different concepts have been developed and discussed over time. two common concepts rooted in philosophical thought are ability to pay and benefits received, each generally accompanied by a basic humanitarian view that any tax base should exempt at least a bare subsistence amount for the least-well-off in society.'9 at first glance, these concepts appear straightforward, but there is considerable uncertainty as to their scope because of the difficulty in determining commensurability of either ability to pay or benefits received.20 in spite of these uncertainties, most acknowledge that tax systems should raise necessary government revenues from those who are most able to pay them 19. see, e.g., philip d. oliver, tax policy: readings and materials 176, 178 (foundation press, 2d ed. 2004) (quoting charles 0. galvin & boris i. bittker, the income tax: how progressive should it be? (1969), in which bittker points out that ability to pay, benefits received and other principles such as equality of sacrifice and reduction of inequality have long been used as justification for progressivity and that some progressivity is inevitable to account for subsistence exemptions). but see stephen holmes & cass r. sunstein, the cost of rights: why liberty depends on taxes (w.w. norton & co. 1999) (distinguishing between "[t]axes [that] are levied on the community as a whole, regardless of who captures the benefits of the public services funded thereby" and "[flees ... [that] are charged to specific beneficiaries in proportion to the services they personally received"). 20. oliver, supra note 19, at 176-77 (again quoting bittker, who suggests that all four principles reduce to a concept of determining the appropriate level of individual "sacrifice" to fund government, without a satisfactory theory of commensurability). for a discussion of the new school economists' development of the ability-to-pay concept and their response to conservative arguments for the benefits-received concept, see aj ay k. mehrotra, building the modem american fiscal state: progressive-era economists and the intellectual foundations of the u.s. income tax (2004), at http://www 1 .law.ucla.edu/-taxpolicy/documents/2005/papers/mehrotra/akm%20u cla%20tax%2osym.pdf(contrasting libertarian theories that emphasize the individual and support taxation on the basis of benefits received (i.e., property rights protection) with the ability-to-pay concept, based on a theory that taxes are an obligation of citizenship and serve to counterbalance inequalities created by wealth aggregation). for more detailed analysis of the benefits received theory as a theoretical basis for progressive taxation, see the following: galvin & bittker, supra note 19, at 48-55; edwin r.a. seligman, progressive taxation in theory and practice 150-204 (1908); walter j. blum & harry kalven, jr., the uneasy case for progressive taxation, 19 u. chi. l. rev. 417, 451-55 (1952). [vol. 6:9 congress fiddles while middle america burns and in ways that permit those less fortunate to maintain a decent standard of living. some also consider it reasonable to justify tax burdens, at least in part, in terms of the public and private benefits people receive from the government's protection of property rights and individual liberties and provision of a stable and supportive environment for commercial markets, contracting and litigation.2 while these two concepts of ability to pay and benefits received may not provide a sharply delineated normative justification for a particular tax system, they are consonant with a tax regime that raises government revenues disproportionately from those who are able to amass disproportionate levels of wealth and enjoy disproportionate levels of actual and virtual consumption,22 status, and power because of that 21. see, e.g., liam murphy & thomas nagel, the myth of ownership: taxes and justice (oxford univ. press 2002) (arguing that taxation should be viewed as one of the institutions of government without which property and other rights could not exist, and that fair distribution of the tax burden should not be based on mere comparisons of each person's pre-tax income). 22. edward mccaffery has consistently advocated abandonment of the income tax base for a consumption tax on the grounds that the only concern about wealth is its use, not its amassment. see, e.g., edward j. mccaffery, ten facts about fundamental tax reform, 101 tax notes 1463, 1464-65 (dec. 22, 2003) [hereinafter, ten facts] (asserting the superiority of a postpaid consumption tax because it taxes income when spent rather than when it flows into a household, thus advantaging deferred consumption over current consumption); edward j. mccaffery, the fair timing of tax (sept. 2003), u.s.c. l. sch. olin research paper no. 03-21, at http://ssrn.com/abstract---441344 [hereinafter, timing] (similar position); edward j. mccaffery, the uneasy case for wealth transfer taxation, 104 yale l.j. 283 (1994) [hereinafter, uneasy case] (similar position); edward j. mccaffery, the political liberal case against the estate tax, 23 phil. & publ. aff. 281 (1994) [hereinafter, liberal case] (similar position). in contrast, treatment of "virtual consumption" as relevant to the fairness inquiry suggests that a consumption tax that reaches only use fails to fully tax consumption, which should include the added status, power, influence and personal security afforded by the mere possession of wealth. see anne alstott, the uneasy liberal case against income and wealth transfer taxation: a response to professor mccaffery, 51 tax l. rev. 363, 370-71 (1996) [hereinafter, response] (criticizing mccaffery's "[u]ntenable [d]istinction [b]etween [p]ossession and [u]se" because of its disregard of the influence that can be enjoyed without wealth consumption); thomas r. ireland, inheritance justified: a comment, 16 j. l. & econ. 421, 421 (1973) (stating that "the primary functions of wealth accumulation are not in fact leaving wealthy heirs, but rather the status and social power inherent in holding a variety of wealth forms"). a consumption tax that failed to reach this virtual consumption would be flawed, in much the same way that an income tax base that fails to reach imputed income is flawed. furthermore, the fairness concerns that appear to support a consumption tax base, that privileges private savings over consumption, fall short of the demands of liberal egalitarianism. see alstott, supra, at 370-83 (discussing these ideas in depth). 2004] florida tax review wealth.23 these concepts suggest that the tax system should be able to allocate the burdens of support of the government among those most able to pay for, and most likely to benefit from, the enhancement of the physical, fiscal, commercial and social environment provided by that government for the benefit of the polity. commentators also frequently refer to the concepts of horizontal and vertical equity as components of the "ability to pay" tax fairness concept.24 as generally understood, horizontal equity requires that taxpayers with the same ability to pay be taxed alike, while vertical equity requires that people with different abilities to pay be taxed differently. vertical equity supports a progressive tax system that imposes graduated rates ranging from 0% (an exemption from tax) for those at the bottom to relatively high rates applicable at the top of the scale. as with the ability-to-pay concept generally, horizontal and vertical equity both require an answer as to what "counts as" the same ability to pay. is income the appropriate measure, or should we also consider wealth? the decision as to what items to include may predetermine the equity conclusion. the uncertainties, and the related debate over progressivity, go back to the origins of the federal income tax in the 1860s, when congress considered whether to have a flat rate system or a graduated rate structure.25 in spite of periods of stronger opposition, 23. for example, holmes & sunstein note that many uses of tax revenues, including the many services that defend private property, accrue to the benefit of the wealthy. holmes & sunstein, supra note 19, at 14-15, 24-25. marjorie kornhauser provides a more extensive discussion of the argument for progressive rates based on the benefits received theory in marjorie e. kornhauser, the rhetoric of the antiprogressive income tax movement: a typical male reaction, 86 mich. l. rev. 465, 491-97 (1987) (noting that connecting redistribution to progressivity may be misleading, to the extent that higher income taxpayers enjoy disproportionate benefits). 24. the discussion of horizontal and vertical equity in this paragraph ofthe text relies primarily on an exchange between richard musgrave and louis kaplow. see, e.g., richard a. musgrave, in defense of an income concept, 81 harv. l. rev. 44 (1967) (arguing that horizontal and vertical equity are aspects of a single fairness measure); louis kaplow, horizontal equity: measures in search of a principle, 42 nat'l tax j. 139 (1989) (arguing that vertical equity is the appropriate fairness measure because focus on horizontal equity merely preserves the status quo); richard a. musgrave, horizontal equity, once more, 43 nat'l tax j. 113 (1990) (reconsidering his conclusion that horizontal equity is derivative of vertical equity); louis kaplow, a note on horizontal equity, 1 fla. tax rev. 191 (1992) (disputing the independent importance of horizontal equity); richard a. musgrave, horizontal equity: a further note, 1 fla. tax rev. 354 (1993) (restating the case for horizontal equity). 25. see, e.g., joe thomdike, an army of officials: the civil war bureau of internal revenue, 93 tax notes 1739, 1751, 1758-59 (dec. 24, 2001) (describing the discussion in the senate finance committee regarding the rates for the revenue act of 1864, in which republican sen. grimes argued for graduated rates because of rich taxpayers "greater ability to pay" and against consumption taxes because they are [vol. 6:9 congress fiddles while middle america burns congress has consistently treated progressivity as a fundamental aspect of the federal tax system,26 and scholars who take seriously the need to define the normative foundations of tax policy continue to explore this ongoing consensus in favor of progressivity. for example, in a recent article, thomas griffith suggests that a redistributively progressive tax increases people's happiness because of the primary importance of relative, rather than absolute, incomes." under their broadest interpretations, horizontal equity seems to mandate the maintenance of the status quo, while vertical equity seems to require the dismantling of the status quo. this inherent conflict supports location of the determinative principles in a broader, exogenous framework of distributive justice rather than a tax-specific framework of competing fairness concepts.2" in considering the importance of progressivity to amt reform, therefore, i take as fundamental two principles that echo through the foundations of modem theories of law and society: first, that society, through the tax system, should allocate the tax burden according to capacity, without requiring a sacrifice from those fundamentally unable to pay; and second, "broadly regressive" and later repeal of the income tax due to an upper class "anti-tax crusade" aimed at discrediting the progressive tax system). 26. see, e.g., m. susan murnane, selling scientific taxation: the treasury department's campaign for tax reform in the 1920s, 29 law & soc. inquiry 819 (2004) (discussing the use of propaganda by proponents of the mellon proposal for reduced surtaxes on the wealthy in the context of a long-existing consensus favoring progressivity, which created support for some reduction in the steepness of the rate structure, on the basis that wealth creation by high-income beneficiaries of the rate reform would trickle benefits down to those in lower income brackets, but retained a strong concept of progressivity). 27. thomas d. griffith, progressive taxation and happiness, 45 b.c.l. rev. 1363, 1381-88 (2004). see also marjorie e. komhauser, educating ourselves towards a progressive (and happier) tax: a commentary on griffith's progressive taxation and happiness, 45 b.c.l. rev. 1399, 1401-02 (2004) (asserting that "despite apparent widespread criticism of progressivity, most people do not oppose some degree of redistribution by means ofa progressive tax"). another recent article considers empirical evidence for inequality aversion and concludes that individuals' preferences reflect mixed concerns for their own payoffs and for averting inequality for others. see lucy f. ackert, jorge martinez-vazquez & mark rider, tax policy design in the presence of social preferences: some experimental evidence, fed. res. bank ofatlanta working paperno. 2004-33 (dec. 2004), at http://www.frbatlanta.org/filelegacydocs/wp0433.pdf (reporting on student experiments testing preferences for various tax models). 28. the primary competitor to a philosophical concept of distributive justice as the grundsatz of tax policy is economic theory. see, e.g., paul r. mcdaniel & james r. repetti, horizontal and vertical equity: the musgrave/kaplow exchange, 1 fla. tax rev. 607 (1993) (concluding that normative content can derive only from economic or philosophical theories). economic efficiency is neither irrelevant to, nor an improper consideration in, the development of the specifics of a tax regime that is founded on distributive justice principles. 2004] florida tax review that society, by means of the tax system, should move towards a more egalitarian distribution of resources in support of a framework in which all members of society are treated with equal respect. these distributive justice principles derive from the personal liberty reserved to each person as an actor within the social community: the individual deserves respect on his or her own terms from the social community, and that respect requires that the individual have equal access to opportunities to prosper and engage in meaningful relationships within the social community.29 according to john rawls, individuals can cooperate in determining the characteristics of a just society by placing themselves in a position of ignorance about their own attributes.3" christian theology assumes that individuals can make just decisions by applying the "golden rule" to do unto others as they would have done unto themselves. essential to both these philosophical and theological approaches to justice are an understanding of the personal worth of the individual and of the individual's rights to a meaningful and respectful relationship with community members.3 these principles also stem from the nature of a democratic polity that requires a viable national dialogue32 and disdains both dictatorship, the 29. see, e.g., amartya sen, development as freedom (knopf, 1999) (stressing the importance of equal access to opportunity to both economic development and human freedom). 30. john rawls, a theory of justice 118-23 (belknap press rev. ed. 1999). 3 1. see generally philip n. pettit, rawls' political ontology (fall 2004), pol., phil. & econ. (forthcoming), at http://ssm.com/abstract=-600704 (explaining rawls' view of political society as a cooperative venture that is neither a solidarist agency nor an aggregate of singular agents because of the engagement in political debate about the appropriate concept of justice). elizabeth anderson emphasizes the importance of "creat[ing] a community in which people stand in relations of equality to others" in her elaboration of democratic egalitarianism's goal of addressing our needs as humans (rights to shelter, food and other necessities), as participants in a social community (access to education, public accommodations, medical facilities) and as citizens (rights to vote and voice one's opinions), in elizabeth s. anderson, what is the point of equality?, 109 ethics 287, 289, 317-19 (jan. 1999). democratic egalitarianism, as set forth by anderson, does not lead to a requirement ofequal distribution ofresources, but it requires sufficient redistribution to abolish socially created oppression and support a community of reciprocation and consultation. id. at 313 (contrasting a relational theory of equality with a purely distributional theory of equality); id at 320 (noting requirement of "effective access to enough resources to avoid being oppressed by others and to function as an equal in civil society"). it may be, however, that only a roughly equal distribution ofresources can prevent class stratification and co-option ofgovernment for the benefit of the wealthier and hence more powerful classes. 32. see anderson, supra note 31, at 322-24 (discussing the development of an overlapping consensus in democratic societies); bruce a. ackerman, social justice in the liberal state 5 (yale univ. press 1980) (discussing the "comprehensive insistence on dialogue" as a fundamental requirement for determining the nature of a cooperative [vol. 6:9 congress fiddles while middle america burns concentration of power in one person, and oligarchy, the concentration of power in a group of people of certain status." whatever the exact nature of the underlying principle that both facilitates and derives from the dialogue among members of a society, the concept supports a theory of redistribution, supported by progressive mechanisms, to protect that dialogue by preventing undue accumulation of brute power in the hands of a few.34 recent academic commentary has increasingly focused on the negative impact of inequality of asset distribution on both economic growth (which is a societal goal because it offers the possibility of lifting the standard of living of all members of the society) and democratic institutions (which themselves make possible individual liberties within the state infrastructure)." these studies show a society); robert putnam, making democracy work: civic tradition in modem italy (princeton univ. press 1993) (similar insistence on the importance of civic dialogue). 33. see, e.g., reuven s. avi-yonah, risk, rents, and regressivity: why the united states needs both an income tax and a vat, 105 tax notes 1651, 1654-55 (dec. 20, 2004) (presenting arguments for curbing excessive accumulations of power, and discussing michael walzer's view, in spheres of justice: a defense of pluralism and equality (1983), that redistributive taxes are required to curb the harmful effects of concentrations of wealth); reuven s. avi-yonah, book review: why tax the rich? efficiency, equity, and progressive taxation: does atlas shrug? the economics consequences of taxing the rich. edited by joel b. slemrod, ill yale l.j. 1391, 140709 (2002) (noting the concern that accumulations of wealth and power constrains civic republicanism). 34. commentators have long recognized the link between progressivity and redistribution, with varying emphasis on the income base and on taxation of wealth transfers at death. see, e.g., henry c. simons, federal tax reform 12 n.9 (univ. of chi. press 1950) (making the case for "steep progression" in the income tax "to correct excessive economic inequality and to preclude inordinate, enduring differences among families or economic strata in wealth, power, and opportunities"); steven a. bank, the progressive consumption tax revisited, 101 mich. l. rev. 2238 (2003) (emphasizing liberals' focus on the link between progressive taxation and an income base in analyzing progressive consumption tax arguments); alstott, response, supra note 22, at 364 (highlighting the importance of"an estate tax and, under some conditions, a progressive income tax" in "correcting disparities in the distribution of wealth and power that tend to undermine important principles ofjustice"). 35. see, e.g., joel s. hellman & daniel kaufinann, the inequality of influence (dec. 2002), at http://ssm.com/abstract=-386901 (noting that inequality of wealth leads to inequality of influence and subversion of institutions and referencing the literature on inequality) [hereinafter, inequality]. see generally alan b. krueger, inequality, too much of a good thing, 1-75, 11, in james j. heckman & alan b. krueger, inequality in america: what role for human capital policies? (mit press 2003) (noting marked recent trend towards greater inequality in the us compared to other advanced economies and summarizing reasons that inequality harms democratic societies by leading to a "more polarized and static society"); edward l. glaeser, jose a. scheinkman & andrei shleifer, the injustice of inequality (aug. 2002), harv. inst. research working paper no. 1967, at http://ssmcom/abstract=321261 (presenting a model of institutional subversion by the wealthy for their own benefit); abhijit banerjee & andrew newman, 2004] florida tax review "strongly negative impact" of inequality on important institutional attributes such as fairness and impartiality of courts, levels of tax compliance, and bribery.36 further, scholars have explored the government's right to utilize a portion of an individual's purported earnings for societal purposes (with redistributive effect, unless a direct quid pro quo for benefits received) based on the role of society in providing the framework in which the accumulation of those assets is possible.37 in pursuing distributive justice, it is "the overall progressivity of the fiscal system, not that of any single instrument within it, [that] really matters."3 justice is not satisfied by progressive rate structures per se, but rather requires redistributional results that reduce inappropriate concentrations of power by moving towards a more egalitarian equilibrium, taking tax bases and wealth transfer provisions into account. one further aspect of the demands from justice should be noted. for democratic egalitarianism to succeed among a diverse citizenry, there must also be a feedback loop. rule of law, that is, demands transparency, so that citizens can understand, comply with, and support or object to the applicable laws. this demand for transparency is perhaps heightened in respect of tax systems, which must necessarily cover a wide range of economic transactions and situations and hence involve complex sets of rules. transparency therefore requires that diverse and full information about the tax system be readily available including information about the potential applicability of special rules such as the amt. furthermore, because the allocation of the tax burden among taxpayers is such a central aspect of tax justice, full information about the distribution of income, payroll, estate and gift tax burdens among groups of taxpayers must be published by the government in a form widely available and comprehensible to the members risk bearing and the theory of income distribution, in 58 rev. ofecon. studies 211-34 (1991) (discussing effects of inequality of income distribution); klaus deininger & pedro olinto, asset distribution, inequality, and growth (2000), world bank policy research working paper no. 2375, at http://econ.worldbank.org/docs/l 128.pdf (confirming that highly unequal asset distribution has negative impact on growth and on educational intervention). 36. see, e.g., hellman & kaufman, inequality, supra note 35 (reporting the "substantial literature" regarding the ability of the wealthy to use their superior resources to impact economic growth and governmental or political institutions and focusing on the "crony bias" that develops to subvert institutions). 37. see, e.g., murphy & nagel, supra note 21 (developing a theory of taxation based on the role of governmental institutions in furthering individuals' productivity); joel slemrod, the economics of taxing the rich, in does atlas shrug? the economic consequences of taxing the rich, 1, 8-10 (joel slemrod, ed., 2000) (noting the arguments for equality from ability to pay and inequality of political power, as well as the difficulty in ascertaining what inherent right an individual may have in what is earned because of the role of government in making that income possible). 38. shaviro, supra note 9, at 1461. [vol 6:9 congress fiddles while middle america burns of the polity. the people must be able to understand the redistributive effects of government policies (or lack thereof) so that those effects can be taken into consideration in the dialogue among the citizenry regarding fundamental principles. iii. tax cuts, the federal budget, and amt applicability in addition to the normative principles set out in the prior part, other considerations relevant to the potential for amt reform include the current drive towards overall code amendment, the federal budgetary situation, and the interaction of those factors with the amt. recent changes in the tax law reflect an apparently growing trend towards non-taxation of investment earnings and the closing of the tax liability gap between ordinary taxpayers and those at the highest income levels.9 one cause of this trend is the renewed fascination with consumption tax proposals, usually in the guise of a flat, wage-based tax replacing the graduated, wage-and capital-based income tax.' capitalizing on ordinary americans' desire for simplicity, lack of understanding of the ultimate redistributive effects of various provisions,4' 39. internal revenue service, strategic plan 2005-2009, 18 (july 2004), at http://www.irs.gov/pub/irs-utl/strategicplan_05-09.pdf (last visited july 24, 2004) (indicating that about one-third of the approximately $300 billion "tax gap" is due to high-income individuals). 40. a thorough review of consumption tax proposals is well beyond the scope of this article: the various theories have been thoroughly vetted in a range of commentary. see, e.g., robin cooper feldman, consumption taxes and the theory of general and individual taxation, 21 va. tax rev. 293, 296 & nn.l-2 (2002) [hereinafter, consumption taxes] (noting the considerable attention currently being given to flat tax proposals and referencing in the notes several of the key proposals and commentary); avi-yonah, supra note 33, at 1652-53, 1660-61 (providing a brief discussion of various consumption tax proposals, including prepaid and postpaid (cash flow) consumption taxes). the recent interest in consumption taxes stems most directly from books by robert hall and alvin rabushka that familiarized a broader public with the basic concepts. robert e. hall & alvin rabushka, low tax, simple tax, flat tax (1983); robert e. hall & alvin rabushka, the flat tax (2d ed. 1995) (introducing the contemporary flat tax proposal). 41. see baron & mccaffery, infra note 254 (showing that a range of heuristics and biases interferes with people's understanding and support of redistribution, and that people do not generally understand the reduction in progressivity that results from tax expenditures and cuts in government services). this lack of understanding underscores the importance of government dissemination of information about distributional effects highlighted in part ii. perhaps not surprisingly, various consumption tax supporters advocate elimination of distributional tables. see, e.g., joseph j. thomdike, tax analysts exclusive conversations: daniel j. mitchell, 103 tax notes 416,419 (apr. 26, 2004) (advocating elimination of distributional tables from congressional studies of tax changes or reflection only of lifetime consumption and not income, in accord with the heritage foundation's position in support of a flat consumption tax); jason j. fichtner, 20041 florida tax review and frustrations with a federal income tax system that is often characterized as "too complex, too easily evaded by the wealthy, and too likely to distribute the burdens of taxation to the people least able to bear it," '4 proposals for a flat consumption tax have enjoyed varying support for the past thirty years.43 up until recently, however, proposals phrased in terms of eliminating the income tax system as we know it have not fared well with the american public or with congress." a comparison of tax distribution tables: how missing or incomplete information distorts perspectives (joint econ. comm., dec. 2003), at http://www.house.gov/jec/tax/12-19-03.pdf (arguing on behalf of flat tax supporter jim saxton that many tax distribution tables are "incomplete" and "misleading" and may "unduly influence" tax policy makers and attacking in particular distributional tables that reveal non-standard information about tax cuts, such as the impact on economic family units or the impact when imputed income from housing is taken into account). 42. bank, supra note 34, at 2238. 43. see, e.g., hall & babushka, supra note 40 (proposing a flat tax that is a variant of a value-added tax); daniell j. mitchell, heritage foundation, flat tax or sales tax? a win-win choice for america, the heritage foundation backgrounder no. 1134, at 1 (aug. 14, 1997) (advocating replacement of the income tax with either a flat tax or a national retail sales tax because the income tax system "not only penalizes productive behavior, but also violates the fundamental constitutional principle of equal treatment under the law"), at http://www.heritage.org/research/taxes/bgl134.cfn; william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113 (1974) (in the seminal article in the renewed debate over tax bases, arguing that a consumption tax reduces inequities, distortions, and complexities present in the income tax system). steve forbes also ardently advocated a flat tax during the 1996 presidential campaign, with the support of house majority leader dick armey. lawrence zelenak, the selling of the flat tax: the dubious link between rate and base, 2 chap. l. rev. 197, 198 (1999). at the same time, bill archer, chair of ways and means in the house, joined richard lugar in advocating a national retail sales tax generally to replace the current income tax system. americans typically understand the reform proposals as calling for a flat rate structure, although most flat-taxers admit that there will need to be a zero bracket to protect the least fortunate americans from bearing an untenable tax burden. these flat tax proposals have, however, "always concealed the more radical proposal to exempt savings and investment from the tax base." bank, supra note 34, at 2238. under the generally accepted haig-simons definition, income is the sum of savings and consumption. see robert m. haig, the concept of income economic and legal aspects, in the federal income tax 1, 7 (robert m. haig, ed. 1921). a consumption tax that eliminates tax on the return to investment or savings therefore has smaller scope than an income tax. 44. see, e.g., ryan j. donmoyer, in election year gambit, house votes to scrap code, 79 tax notes 1533 (june 22, 1998) (discussing h.r. 3097, the tax code termination act, introduced by rep. largent, which would discard the current income tax system in favor of a flat consumption tax). the house passed the bill, which was referred to the senate finance committee. 144 cong. rec. s6563 (june 18, 1998). the bill never made it to the senate floor. [vol. 6:9 congress fiddles while middle america burns in spite of its past reluctance, congress has recently expanded existing provisions that treat retirement savings favorably and enacted new provisions that have transmuted the federal tax system into a hybrid system with a number of consumption tax features.45 one commentator has termed it an "evolution," rather than revolutionary tax reform 6.4 the 2001 tax legislation (referred to herein by its acronym, egtrra) increased traditional and roth ira contribution limits from $2,000 to $5,000 in 2008 and 401(k) account contributions from $10,000 to $15,000 in 2006 (with indexing to maintain those amounts).7 new provisions permit taxpayers in their prime earnings years (over 50) to make even larger contributions ($1000 more for iras, $5000 more for 401(k)s).48 egtrra also created a new saver's credit, declining from 50% for those with incomes of $30,000 or less to 10% for those with incomes between $32,000 and $50,000.4 1 other provisions that treat savings preferentially include the flexible medical savings plan." these savings provisions are generally of benefit only to those with sufficient income to increase their savings; moreover, the medical savings account requires both a sufficient salary and ability to plan ahead for regular medical expenses. recent administration proposals call for expanding existing provisions to permit personal savings plans with tax-free yields that can be used for any purpose,"' a proposal that, if enacted, would likely lead to renewed calls for an unlimited savings allowance or other version of a 45. see, e.g., mccaffery, ten facts, supra note 22, at 1465 (noting the expansion of savings accounts as part of a move towards a flat, wage-based tax). 46. daniel s. goldberg, the u.s. consumption tax: evolution, not revolution, 57 tax law. 1 (2003). 47. economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, §§ 601(a), 611 (d), 115 stat. 38. 48. id. at §§ 601(a)(2)(b), 631(a). 49. id. at § 618. 50. irc § 223, enacted by the medicare prescription drug, improvement, and modernization act of 2003, pub. l. 108-173, 117 stat. 2066 (dec. 8, 2003), provides for health savings accounts whereby contributions are deductible, earnings are not includible in gross income while held in the account, and distributions used for qualified medical expenses are excluded from income. 51. see press release, office of public affairs, the president's savings proposals: tax-free savings and retirement security opportunities for all americans (feb. 2, 2004), at http://www.treas.gov/press/releases/j s 113 .htm (detailing the savings initiatives included in the administration's fiscal year 2005 budget); h.r. 4078, 108th cong. (2004), as introduced by representative johnson in the house on march 31,2004, and s. 2263, 108th cong. (2004), as introduced in the senate that same day by senator thomas. these additional incentives for savings could cost the treasury as much as $300 billion over the next decade. leonard e. burman, william g. gale, & peter r. orszag, the administration's savings proposals: preliminary analysis, 98 tax notes 1423, 1423 (mar. 3, 2003). 2004] florida tax review consumption tax.52 this agenda to exempt investment has been applauded in particular by those on the extreme right, such as grover norquist, who support wage-based taxation.3 continued piecemeal expansion would inevitably benefit the super-wealthy, whose incomes easily exceed their consumption, most of all.54 the tax cuts themselves have also starkly changed the direction of the code. rates have declined precipitously, 52. enactment of more unrestricted savings plans would likely make possible a return of the 1995 senate proposal for a consumption tax, called the usa tax for its primary emphasis on an unlimited savings allowance. see usa tax act of 1995, s. 722, 104th cong (1995) (providing for a progressive rate of 19-40% on a cash flow consumption base that allows an "unlimited savings allowance" deduction). see also joel slemrod & jon bakija, taxing ourselves: a citizen's guide to the great debate over tax reform 262-71 (mit press, 3d ed. 2004) (discussing rates necessary to raise revenues under various consumption tax proposals; suggesting that a national retail sales tax rate of as much as 40% might be required, and that a rate of about 35% would be necessary for the graduated "x-tax" proposed by david bradford). a new tax reform panel, meeting first in february 2005, has already begun investigation of the possible replacement of the income tax with a consumption tax base. see, e.g., opening statement by senator connie mack, president's advisory panel on federal tax reform (feb. 16, 2005) (emphasizing the comparison of income and consumption tax bases); louis kaplow, income and consumption taxation: central concepts (feb. 16, 2005) (presentation to the reform panel contrasting the two bases); william g. gale, a comparison of income and consumption taxes: a presentation to the president's advisory panel on federal tax reform (feb. 16, 2005). these presentations are available at the panel's website at http://www.taxreformpanel.gov. 53. see grover norquist, step-by-step tax reform, wash. post, june 9, 2003, at a21 (asserting that bush is taking "deliberate steps" towards a "single-rate tax," including abolishing the estate and capital gains taxes, creating accounts that permit unlimited tax-free savings, permitting businesses to deduct all business investment, and abolishing the amt). 54. some assert that a progressive consumption tax avoids these harms. see, e.g., mccaffery, timing, supra note 22 (arguing that a progressive cash-flow consumption tax is fair because it increases the tax burden when capital transactions are used to enhance labor earnings); edward j. mccaffery, fair not flat: how to make the tax system better and simpler (univ. ofchi. press 2002) (similar). others have argued that the only difference between an income and consumption tax is a tax on the purportedly nominal risk-free return of capital. see, e.g., david f. bradford, consumption taxes: some fundamental transition issues, in frontiers of tax reform 13, 129 (michael j. boskin ed. 1996) [hereinafter, fundamental issues] (distinguishing consumption and income taxes based on treatment of risk-free return); daniel shaviro, replacing the income tax with a progressive consumption tax (sept. 2003), nyu l. sch. pub. l. research paperno. 70, at http://ssm.com/abstract--444221 (last visited oct. 21, 2004) (arguing that consumption tax only exempts nominal risk-free return and burdens even unspent wealth). but see avi-yonah, supra note 33, at 1656-58 (arguing that the income tax reaches risky returns and that the risk-free return is higher than posited by proponents of consumption taxation). [vol. 6:9 congress fiddles while middle america burns especially rates on capital gains. egtrra also phased in repeal of the estate tax (though slated as only temporary repeal, unless changed). these changes to the code highlight increasing equity concerns. the increase in the federal deficit and federal debt burdens, combined with the targeting of the tax cuts, result in a substantial intergenerational transfer. the looming applicability of the amt to a majority of taxpayers, rather than to those with substantial financial security, is inextricably linked to the first two results. as noted by two prominent tax analysts, "[n]o permanent tax cut proposal can be sensibly discussed without addressing the alternative minimum tax.,55 the next three sections explore each of these developments in more detail. a. overall federal tax system progressivity america is characterized by increasing income disparity, with more people living in poverty while more ceos earn millions.56 even as the gap between the rich and the poor in the united states expands into a chasm,57 55. william g. gale & peter r. orszag, should the president's tax cuts be made permanent?, 102 tax notes 1277, 1277 (mar. 8, 2004) (noting that the bush administration's 2005 budget does not address the long-term amt problem). see also alan j. auerbach, william g. gale & peter r. orszag, bush administration tax policy: introduction and background, 104 tax notes 1291, 1294 (sept. 13, 2004) (predicting that if the amt is not amended, it will "eventually erase all of the income tax cuts provided in the 2001 and 2003 legislation"). 56. see, e.g., u.s. census bureau, 2003 american community survey, change profile 2001-2002 tbl. 3 (aug. 15, 2003) [hereinafter, 2003 acs change profile], at http://www.census.gov/acs/www/products/profiles/chg/2002/0102/tabular/010/010 00us3.htm (showing that approximately 1.3 million more americans were living in poverty in 2002 than in 2001); david a. hartman, does progressive taxation redistribute income? 3 (feb. 2002), inst. for pol'y innovation policy report no. 162, at http://www.ipi.org (reporting that "since [1971] there has been a steady increase in before and after tax income share of the top 10 percent [of income earners], necessarily matched by declining income share before and after tax of the remaining 90 percent"); james maule, how much is enough? (june 28, 2004), at http://www.mauledagain.blogspot.com (last visited oct. 21, 2004) (noting that the two top-paid ceos in a recent philadelphia inquirer report earned $35.9 and $34.9 million in 2003, with average ceo pay increases at 33% and median earnings at $700,000, while the typical dentist in the philadelphia area earns $132,000 a year). thus, even among professionals, there are substantial gaps between income brackets of the haves and the have-mores. 57. see, e.g., 2003 acs change profile, supra note 56, at tbl. 3 (showing that the percentage of americans living below the poverty line increased from 12.1 in 2001 to 12.4 in 2002 and that the number of families in poverty increased from 6.6 million to nearly 7 million in 2002); angie rodgers & ed lazere, dc fiscal policy institute, income inequality in the district of columbia is wider than in any major u.s. city 1 (july 23, 2004), at http://www.dcfpi.org/7-22-04pov.pdf (reporting that the top 20% of 20041 florida tax review the rich continue to be the primary beneficiaries of both the gradual erosion of the income tax base towards a near-flat wage-based system and the package of 2001-2003 tax cuts." the expanded retirement savings possibilities provide little, if any, benefit to the majority of ordinary wageearners, most of whom cannot afford to contribute the maximum amount permitted by pre-2001 limits;59 instead, the new provisions benefit those who were constrained by the former limits those who "are already the bestprepared for retirement.""0 the 2003 tax cuts contributed even more clearly households in dc have 31 times the average income of the bottom 20%); richard westin, modifying the federal tax framework to stimulate employment without violating gatt principles, 103 tax notes 335, 337 (apr. 19, 2004) (noting that the wealthy are getting wealthier and the top tax rates are declining, citing caroline tolbert, direct democracy and institutional realignment in the american states, 2003, 118 political science quarterly 467 (sept 22, 2003)); bob herbert, oblivious in d.c., n.y. times, june 30, 2003, at a21 (noting that "the wealthiest 400 taxpayers accounted for more than 1 percent of all the income in the united states in 2000, 'more than double their share just eight years earlier"'); alstott, response, supra note 22, at 367 & n.20 (in 1996, citing articles by wolff, bradsher and gramlich indicating that "already-large inequalities in income and wealth in the united states continue to grow"); jon e. hilsenrath & sholnn freeman, affluent advantage: so far, economic recovery tilts to highest-income americans, wall st. j., july 20, 2004, at a 1 (noting increased wage and income disparities accompanying a surge in luxury brand consumer spending by the wealthy). 58. see citizens for tax justice, effects of first three bush tax cuts charted 1 (june 4, 2003), at http://www.ctj.org/pdf/allbushcut.pdf (top 1% will receive an average 15% cut in federal taxes between 2003 and 2010 while bottom 20% will receive an average cut of only 10% and the next three quintiles will receive average cuts of only 12%, 9% and 7%). see also dana milbank & jonathan weisman, middle class tax share set to rise: studies say burden of rich to decline, wash. post, june 4, 2003, at a-i (noting that "[c]onservatives and liberals alike agree that bush's tax policies have shifted more of the tax burden to the middle class"). william gale and peter orszag conclude that making the tax cuts permanent will cause the average tax rate of the top 1% of taxpayers to fall more than that of any other group, with an average tax cut (in dollars) that is 80 times that for middle-income taxpayers. william g. gale & peter r. orszag, bush administration tax policy: distributional effects, 104 tax notes 1559, 1560 (sept. 27, 2004). gale and orszag also conclude that the after-tax income of the poorest 20% of americans will rise only.3% by 2011, while the after-tax income of the richest 1% will increase by 6.4%. id. at 1561 tbl. 1. 59. see len burman & troy kravitz, lower-income households spend largest share of income, 105 tax notes 875, 875 (nov. 8, 2004) (reporting on data from consumer expenditure survey that shows that low-income families exhaust "virtually all" their incomes while high-income (over $200,000) families "spend less than 40 percent"); richard l. kaplan, book review of kevin phillips, wealth and democracy, 101 mich. l. rev. 1987, 1996-99 (2003) (suggesting that increasing retirement savings incentives will increase economic inequality). 60. william g. gale & peter r. orszag, a new round of tax cuts?, 96 tax notes 1397, 1398 (sept. 2, 2002). [vol. 6:9 congress fiddles while middle america burns to the gap between the rich on the one hand and the middle class and poor on the other. [the tax cuts] raise[d] the after-tax income of most people by less than 1 percent not nearly enough to compensate them for the loss of benefits. but people with incomes over $1 million per year will, on average, see their after-tax income rise 4.4 percent.6' a key aspect of the evolving wage-based system is the reduction in the taxation of wealth and investment income." the federal tax system now falls considerably less heavily on those with investment income and gains from stockholdings and other assets. prior to the enactment of the 2003 tax legislation (generally referred to by its acronym, (jgtrra),63 dividends were taxed at ordinary income rates.' the 2003 act reduced the rates applicable to net capital gains in the two capital gains brackets to 5% and 15% (from 10% and 20%, respectively) and also reduced the tax on corporate dividends, even when they are paid out of corporate income that has not been subject to u.s. tax, to the net capital gain rate.65 those rates will further reduce to 0% and 15% in 2008, although they are currently slated to 61. paul krugman, stating the obvious, n.y. times, may 27, 2003, at a25. 62. see, e.g., jan m. rosen, who wins, and who is skipped, in the tax cut, n.y. times, june 8, 2003, at § 3-9 (noting that the 2003 tax cut was "heavily tilted toward higher-income taxpayers because they tend to have the most investments and because they get the biggest rate reductions"). 63. jobs and growth tax relief reconciliation act of 2003, pub. l. no. 10827, 117 stat. 752. 64. these rates, of course, already reflected egtrra's reduction ofpre-2001 rates (from 39.6% for the highest bracket). see economic growth tax relief reconciliation act of 2001, pub. l. no. 107-16, § 101, 115 stat. 38. 65. jobs and growth tax relief reconciliation act of 2003, pub. l. no. 10827, §§ 301-302, 117 stat. 752. see generally joint committee on taxation, summary of conference agreement on h.r. 2, the "jobs and growth tax relief reconciliation act of 2003," (jcx-54-03, may 22, 2003) (overview of tax changes), at http://www.house.gov/jct/x-54-03.pdf; robert willens, jobs and growth tax relief reconciliation act of 2003 gives substantial tax relief for dividends and meaningful tax relief for net capital gains, 103 daily tax report j1 (may 29, 2003) (discussing the highlights of the new law, with particular attention to changes in treatment of capital gains and dividends). since dividend rates are reduced even when out of income that has not been taxed at the corporate level, the benefit is even more substantial. see, e.g., martin a. sullivan, warmed-over, watered-down, bare-bones dividend relief, 99 tax notes 777 (may 12, 2003) (describing the origin of the proposals for a uniform rate on dividends and noting that they violated treasury's own proposition that all income should be taxed at least once). 2004] florida tax review revert to the pre-2003 rates in 2009. the wealthy are the disproportionate beneficiaries of that reduction in rates." the various provisions that move the tax system closer to a consumption tax system, without maintaining significant other taxes on wealth or wealth transfers, also benefit most the highest income taxpayers (those with incomes in the top 1%) and leave the tax burden falling most heavily on wage earners.67 the superrich are also supersavers they have more income than they can spend, even when they consume well beyond the standards of the remaining 99% of the population. as frequently noted by commentators, more than two-thirds of the income of the 400 richest americans is long-term capital gains,68 and the wealthiest 5% receive 60% of all investment income.69 in addition to the statutory shelters for capital gains, 66. this disproportionate benefit was already evident after the 1997 reduction in capital gains rates. see, e.g., joel slemrod, the fortunate 400, 100 tax notes 935, 936 (aug. 18, 2003) (analyzing the irs income statistics for 1992-2000 and concluding that even in that period the average tax rate on the 400 highest income taxpayers declined 7 percentage points, at the same time that it increased for all taxpayers in the aggregate, primarily because of the 1997 reduction in the preferential rate on capital gains and the high proportion of capital gain income enjoyed by the ultra wealthy). 67. see, e.g., department ofthe treasury, blueprints for basic tax reform 159 (jan. 17, 1977) [hereinafter, blueprints] (acknowledging that a flat income tax, even with a zero bracket rate for an exemption amount, would decrease the tax burden on the top brackets while increasing taxes on the majority of the population); feldman, consumption taxes, supra note 40, at 296 (noting that "[c]ommentators generally view consumption taxes as ... regressive [so that] if the united states were to shift from an income tax to a consumption tax, the wealthy would benefit while the poor would suffer greater tax burdens"). the cash flow consumption tax set out in the 1977 tax reform proposals admittedly taxed wages higher than capital, but justified it as a reward for savings balanced by application of tax to recipients of wealth transfers when the wealth was consumed rather than reinvested. blueprints, supra, at 135-37. to address the concern that the cash flow tax placed no restraint on wealth accumulation, the study proposed retention of an estate and gift tax, at rates to achieve the desired equalization of initial wealth. id. at 139. 68. see, e.g., martin a. sullivan, the rich get soaked while the super rich slide, 101 tax notes 581, 583 (nov. 3, 2003) (based on irs's spring 2003 so1 bulletin, noting that two-thirds of the adjusted gross income reported by the top 400 taxpayers from 1992 through 2000 was net capital gain); david cay johnston, the loophole artist, n.y. times, dec. 21, 2003, at § 6-18 (same); see also michael parisi & scott hollenbeck, individual income tax returns 2002, sol bulletin 13 fig. f (fall 2004), at http://www.irs.gov/pub/irs-soi/02indtr.pdf (showing that the 5,000 highestearning taxpayers (those earning $10 million or more) in 2002 had 40.3% of their total agi from long-term capital gains). 69. institute on taxation & economic policy, federal taxation of earnings versus investment income in 2004, app. i (may 2004), at http://www.itepnet.org/earnan.pdf. see also edmund l. andrews, big gap found in [vol. 6:9 congress fiddles while middle america burns dividends and other investment assets, analysts estimate that as much as 24% of investment income is simply not reported on tax returns; in contrast, wages are subject to a withholding tax system that ensures that income (and payroll) taxes are paid by wage earners.7" investment income, of course, is entirely exempt from payroll taxes (e.g., social security, medicare), which average an additional 15.3% of ordinary americans' wage income (including employee and employer amounts). those with considerable wealth, who may receive substantial amounts of low-taxed dividends, may also be able to make significant charitable contributions, reducing their tax bill even further.7' the lopsided result is an average income tax rate on unearned income of merely 9.6% less than half the tax on wage earnings.72 as a consequence, in spite of being in the highest income brackets, the superrich with adjusted gross income over $10 million pay an average overall tax rate of only 25.9% (29.4% for those slightly less rich, with adjusted gross income from $2-10 million).73 in fact, according to martin sullivan's analysis using taxation of wages and investments, n.y. times, may 8, 2004, at c2 (reporting on a citizens for tax justice study that extrapolated from irs data). 70. see robert s. mcintyre, do fat cats pay less?, american prospect 16, may 2004, at 16 (noting that failure of the tax laws to require brokers to report capital gains means that an estimated 25% of capital gains subject to taxation are simply not declared on tax returns: "big-time investors can pretty much make up their own numbers, and many of them do"); johnston, supra note 68 (noting that much of the money involved in tax-avoidance strategies for the wealthy "pass[es] without showing up anywhere in the official income statistics"). 71. see, e.g., the 2004 slate 60 (feb. 28, 2005), at http://www.slate.com/ toolbar.aspx?action=print&id=2112691 (based on statistics compiled by the chronicle of philanthropy, setting forth a chart ofthe 60 largest american charitable contributions of the year, including bill and melinda gates' pledge of $3.4 billion to their foundation and john templeton's payment of $550 million to his foundation); floyd norris, the $32 billion with a bonus in tax breaks, n.y. times, july 22, 2004, at ci (reporting that bill gates will receive a $3 billion dividend from microsoft, which he intends to contribute to his foundation; the dividend will be taxed at the low 15% rate, while the charitable deduction for the gift of the dividend income to the gates foundation will offset his ordinary income, taxed at a 35% rate). 72. robert s. mcintyre, supra note 70. see also andrews, supra note 69 (noting the ctj study's conclusion that the average tax on earnings is 2.5 times the average tax on investment income, after the application of the 2003 tax cuts). 73. internal revenue service, individual returns analysis section, individual returns 2001, tbl.l.1 (col. 19), at http://www.irs.gov/pub/irs-soi/0linllsi.xls. preferential tax provisions reduce the income tax considerably for many taxpayers with income in the latter range. vice president cheney and his wife paid an effective tax rate of only 12.7% on their income, considerably lower than the 29% rate paid by the average in the $1 $2 million group. david cay johnston, a taxation policy to make john stuart mill weep, n.y. times week in review, apr. 18, 2004. see also sullivan, supra note 68, at 581 (reporting information from the irs's spring 2003 statistics of income bulletin showing rapid increase in income growth for the very topmost 400 2004] florida tax review forbes' wealthiest 400 list, the tax rate on economic income for the 400 wealthiest taxpayers in the country was only 9%.74 further, the superrich are the primary beneficiaries of the gradual phase-out of the estate tax.75 the estate tax raised approximately $23.5 billion in 2001, with the superrich paying a substantial portion of overall estate tax revenues." in that year, the federal estate tax affected only about 2% of unrealized appreciation of capital assets of dying taxpayers in any one year." since the bulk of an estate, especially of the superrich, is untaxed appreciation, elimination of the tax on intergenerational transfer means that this gain may never be subject to tax and directly contributes to disparities in wealth, and the power that accompanies wealth, among u.s. taxpayers." william gale, peter orszag, and isaac shapiro recently analyzed the distribution of the 2001-2003 tax cuts, assuming that they are fully in effect, made permanent, but not yet financed by either spending reductions or taxpayers earning at least $87 million, from .5% of all income in 1992 to 1.1% in 2000, while share of all federal income taxes declined from 26.4% to 22.3% and noting that this is a new phenomenon connected to the preferential net capital gains rate, which has been extended through the 2003 tax cuts that are "especially beneficial to the super rich"). 74. sullivan, supra note 68, at 583. 75. because of the use of peculiar sunsetting gimmicks to claim that the tax cuts did not create an intolerable long-term deficit, the estate tax is ostensibly slated for awakening from the dead on the first day of20 11, with the same exemption amounts and rates as existed prior to the onset of its demise in 2002. note that the phrase "without taxation" is actually broader in meaning than some may realize. capital assets are the majority of the assets of the superrich, and the lifetime appreciation of those assets grows without taxation due to the realization system. if no estate tax applies, there is no tax at the most obvious point for realization to occur, the final transfer of those appreciated assets by the owner to another person. 76. internal revenue service, statistics ofincome division, estate tax returns filed in 2001: gross estate by type of property, deductions, taxable estate, estate tax and tax credits, by size of gross estate, tbl. 1 (col. 83-84) (aug. 2003) (showing that in 2001, 52.3% of estate tax revenues came from only 6.8% of estates, those with assets exceeding $5 million, and the wealthiest 469 (or 0.9% of) estates, those with assets exceeding $20 million, paid 20.7% of the total estate tax revenues), http://www.irs.gov/pub/irs-soi/o 1 eso 1 gr.xls. 77. william h. gates sr. & chuck collins, wealth and our commonwealth: why america should tax accumulated fortunes 84 (beacon press, 2002) (noting that under current law, 98% of capital gains growth is exempted at death). 78. see id. at 83 (bulk of estate assets are untaxed appreciation); id. at 84 (noting that "unrealized capital gains make up about 37% of the value of estates worth between $1 million and $10 million and over 56% of estates worth more than $10 million"). [vol. 6:9 congress fiddles while middle america burns offsetting tax increases.79 under these assumptions, although many taxpayers get some tax cut, the benefit is decidedly in favor of higher income taxpayers: tax cuts range from a de minimis 0.1% change in after-tax income (including social security and medicare determinations) for a meager 5.9% of the lowest-income households with less than $10,000 annually to a substantial 7.1% change for more than 98% of the households with more than $1 million annually."0 the lopsided effect of the tax cuts is especially clear when the long-term impact is considered, including the method (tax increases or spending cuts) used to finance this intergenerational transfer."' although the exact method of financing has not yet been determined, the proposed budget for fy 2006 projects substantial cuts to non-defense discretionary programs, which will likely affect ordinary taxpayers most heavily.82 once the financing is included, the 2001 and 2003 "tax cuts" are best seen as net tax cuts for about 20-25 percent of households, financed by net tax increases or benefit reductions for the remaining 75-80 percent of 79. william g. gale, peter r. orszag & isaac shapiro, distribution ofthe 2001 and 2003 tax cuts and their financing, 103 tax notes 1539, 1540-41 & tbl. 2 (june 21, 2004). of course, some of the tax cuts have already been financed at the state and local level by increased property and sales taxes. see, e.g., jonathan weisman & neil irwin, taxes cut, not saved, wash. post, july 25,2004, at f i (noting that "property and sales taxes at the local level have clawed back as much as 27 percent of the federal income tax cuts"). 80. gale, orszag & shapiro, supra note 79, at 1541. earlier studies based on the 2001 tax cuts showed much the same result. see, e.g., citizens for tax justice, yearby-year analysis of the bush tax cuts shows growing tilt to the very rich 1 (june 12, 2002) (stating that by 2010, the richest 1% with average 2010 incomes of $1.5 million would gamer 52% of the 2001 tax cuts (assuming all the changes were made permanent by then)), at http://www.ctj.org/pdf/gwb0602.pdf. 81. the issue of how to fund the massive deficit is beginning to require the attention of the federal reserve bank, with chairman alan greenspan suggesting that the tax cuts for the wealthy could be made permanent by cutting back social security and medicare benefits. see greg ip, greenspan favors entitlement cuts, wall st. j., feb. 26, 2004, at a2. 82. president's fy 2006 budget, overview 4 (feb. 7, 2005), at http://www.whitehouse.gov/omb/budget/fy2006/overview.html (proposing to limit growth in discretionary spending to less than the projected inflation rate and suggesting reduction or elimination of 150 non-defense programs). see also citizens for tax justice, bush budget calls for giant new tax cuts, huge reductions in most federal programs (feb. 7, 2005) (indicating that interest payments will grow to almost one-fifth of on-budget outlays, while cuts to discretionary programs will range from 11% to 56% as shares of the economy by fiscal 2010, with the primary increase projected for discretionary programs slated to pay for the new medicare drug benefit), http://www.ctj.org/pdf/bushbudg.pdf. 20041 florida tax review households . . . [with an] annual net transfer of resources from lowand middle-income households to high-income households [that] would be sizable.3 the gale, orszag and shapiro study projects an annual transfer of 15-35 billion dollars from lower-income households to households with incomes exceeding $1 million." the lowest-income households are the worse off under either financing mode with losses of 2.5% or 21% of their income.85 on the other hand, taxpayers with more than $1 million in income would receive annual net transfers ranging from $60,000 to $135,000.86 "the annual tax cut among households with income above $1,000,000 would equal $144,000 (in 2004 dollars), which exceeds the total income of 94 percent of households."7 a further study confirms those results. assuming that each household pays the same dollar amount to finance the tax cuts ("equal-dollar financing"), the tax cuts worsen the lot of more than 75% of taxpayers, including nearly every household in the bottom two quintiles, while 11% of households in the top quintile would be better off.88 the top quintile would be the only group to experience an average net tax cut, with an average benefit of $4,958, and households in the top 1% would have an average net tax cut of more than $54,000.9 similarly, assuming that each household pays the same percentage of its income to finance the tax cuts ("proportional 83. gale, orszag & shapiro, supra note 79, at 1539. see also budgetary shock and awe, n.y. times, mar. 25, 2003, at a16, (wondering how congress could plan a further "$500 billion in tax cuts for the upper 1 percent of taxpayers" funded by "deep cuts of $475 billion in vital programs for the bottom 99 percent"); dale russakoff, budget woes trickle down: hard-hit state and local governments say bush and congress left them to make cuts, raise taxes, wash. post, july 15, 2003, at al (noting the effect of unfunded mandates for education, health care and homeland security on states facing deficits of approximately $100 billion, resulting in local program cutbacks); bob herbert, tax cut casualties, n.y. times, june 26,2003, ata33 (suggesting that cutbacks in services and tax increases including state college tuition hikes, fare increases, property tax increases, sales tax increases, water fee increases are related to "massive tax cuts for the very wealthy"). 84. gale, orszag & shapiro, supra note 79, at 1539. 85. id. 86. id. at 1540. 87. gale & orszag, supra note 55, at 1278. this average annual tax cut figure does not include the estate tax nor, in comparing the impact on low-income households, the effects of spending cuts that may be used to pay for the tax cuts and which "are likely to hit lower-income families much harder than higher-income households." id. at 1286. 88. gale & orszag, supra note 58, at 1561 tbl. 2. financing is set at a level that would offset the annual revenue loss due to the tax cuts. id. at 1562. 89. id. [vol. 6:9 congress fiddles while middle america burns financing"), a majority of households in every quintile, but only 39% in the top 1%, would be worse off: the average net tax cut for the top 1% would be $22,335.9' these statistics demonstrate a decline in the fair allocation of the tax burden that threatens to undermine the ability of the tax system to serve justice and thus merits attention in any reform that is undertaken of the amt or the regular tax. one thing is clear: the superrich have very high savings rates, while ordinary wage earners whose incomes are fully subject to payroll taxes necessarily spend most or all of their after-tax income. 9' since the wealthy are simply unable to consume a significant portion of their wealth, they benefit the most from the potential elimination of the estate tax and the move towards a consumption tax base.92 put together with the recent rate cuts, these evolving changes in the tax system have a profound potential to increase disparities of resources among american citizens, for this and future generations, with particularly harmful inequalities between the richest and poorest americans that have far-reaching implications for democracy.93 90. id. at 1562 tbl. 3. 91. even ardent consumption tax advocates admit this fact readily. see, e.g., andrews, supra note 43, at 1151 (indicating that since "[m]ost people spend most of their ordinary income for current consumption," "to that extent a consumption-type personal income tax would be no different from the existing tax"). 92. see burman & kravitz, supra note 59, at 875 (noting that, because lowincome families exhaust "virtually all" their incomes while high-income (over $200,000) families "spend less than 40 percent," consumption taxes would have to have very high rates on higher-income families to avoid shifting the tax burden onto lower-income households). 93. various commentators have discussed the disadvantages of concentrated accumulations of wealth, both to economic growth and to our unique american democracy. see, e.g., kevin phillips, wealth and democracy: a political history of the american rich (broadway books 2002) (summarizing the history of wealth accumulation and the influence over the political system attributable to the power and status that accompany great wealth); jeff madrick, the power of the super-rich, n.y. review of books 25, july 18, 2002 (reviewing phillips' book). as madrick notes in his essay, the 1980s saw a rapid increase in wealth disparity, when deregulation and rising stock markets, combined with reagan's tax cut for high-income americans, allowed the gap between rich and poor to grow to "widths unseen since the 1920s and 1930s." id. see also robert s. mcintyre, just taxes, & other options, in less taxing alternatives (citizens for tax justice, mar. 1984) (noting that various economists have concluded that economic success tends to occur in countries with relative equality of income and wealth, whereas countries with concentrated wealth are less likely to have successful economies). 2004] florida tax review b. federal debt and deficit growth the deficit story is a fairly simple one to recite. the bush administration's budget for fy 2002 touted a projected 10-year budget surplus of $5.6 trillion, a result of a "gusher of unexpected revenue" from 1996-2000,94 as the rationale for tax relief that would "[l]et[] taxpayers keep roughly one-fourth of the surplus they produced ($1.6 trillion over 10 years)" while creating a $231 billion surplus in 2002.91 indeed, before the effect of the first round of bush tax cuts, the federal budget for fy 2001 showed a surplus of approximately $128 billion (which includes the social security surplus).96 after the 2001 tax cuts took effect, there was a fy 2002 deficit of $157.8 billion.97 in spite of this deficit, the house budget committee republicans proposed a budget with a further projected deficit for fy 2003 of $221 billion (including the estimated $38.7 billion cost over ten years of the additional tax incentives passed in early march 2002).98 by february 2004, the white house office of management and budget (omb) projected a federal deficit for fy 2003 of $375 billion.99 for fy 2004, the omb announced an expected deficit of $445 billion, 0 and for fy 2005, $331 94. bush administration, a blueprint for new beginnings: a responsible budget for america's priorities 14 (government printing office, washington 2001) [hereinafter, 2001 budget], at http://www.whitehouse.gov/news/usbudget/blueprint/ blueprint.pdf. 95. id. at 7. 96. congressional budget office, the budget and economic outlook: fiscal years 2006-2015, app. f, tbl. 1 (jan. 25, 2005), at www.cbo.gov under the tab "historical budget data" [hereinafter, cbo historical budget data]. see also bush releases agenda for tax relief, highlights & documents, bna tax analysts doc. 2001-3977, at 2028 (feb. 9,2001) (noting, in early february of 2001 before passage of the tax cuts, that the federal budget was "facing an enormous surplus"). 97. cbo historical budget data, supra note 96, at app. f, tbl. 1. 98. see gop proposes $28 billion for tax cuts during next five years, 2002 taxday item c. 1 (cch mar. 14,2002) (summarizing a march 13 hearing of the house budget committee), at http://tax.cch.com/primesrc/bin/highwire.dll (last visited march 14, 2002). for some perspective on the size of the bush tax cuts, see the tax foundation, the bush tax plan: how big is the tax cut? (may 29,2003, updated june 14, 2004) (reporting that the aggregate bush tax cuts are more than triple the reagan 1981 tax cuts in constant 2003 dollars), at http://www.taxfoundation.org/bushtaxplansize.htm (last visited july 16, 2004). 99. office of management and budget, budget of the united states government, fiscal year 2005, at 365 tbl. s-1 (feb. 2, 2004), at http://www.whitehouse.gov/omb/budget/fy2005/pdf/budget/tables.pdf(last visited feb. 8, 2005). 100. office of management and budget, budget of the united states government, fiscal year 2005, mid-session review 1 (july 30, 2004), at http://www.whitehouse.gov/omb/budget/fy2005/05msr.pdf (last visited feb. 8, 2005) [hereinafter fy 2005 mid-session review]. see also william neikirk, u.s. economic [viol. 6:9 congress fiddles while middle america burns billion.' the fy 2006 budget document now projects a fy 2005 deficit of $427 billion."2 those budget figures do not include the costs of making the tax cuts permanent or of reforming the amt. by the spring of 2003, a goldman sachs projection (assuming the 2001 tax cuts were made permanent, a prescription drug benefit was added to medicare, amt reform protected lower-income taxpayers and appropriations grew only modestly) estimated that the deficits over the next ten years would be $4.2 trillion if the social security surplus were included or $6.7 trillion otherwise. 3 the 2003 tax cut added at least an additional $400 billion in costs over ten years."° even the omb attributed 23% of the change in the budget balance from the april 2001 surplus of $237 billion to the july 2003 deficit of $455 billion to the 2001-2003 tax cuts.05 one estimate of the deficit by 2013 attributable just to the 2001 and 2003 tax cuts (assuming that they are made permanent) is $1.133 trillion. 6 some commentators have accused the bush administration growth slows, chi. trib., july 31, 2004, at cl (noting that these new administration figures omit key items, such as the war in iraq and afghanistan, expiring tax provisions, and a continuing defense buildup). 101. fy 2005 mid-session review, supra note 100, at 3 tbl. 1. 102. president's fy 2006 budget, supra note 82, at 3 (projecting a deficit of 3.5% of gdp or $427 billion). 103. see bob kerrey et al., no new tax cuts, n.y. times, apr. 9, 2003, at al 9 (indicating that under these same assumptions, the ratio of publicly held debt to gnp would climb to 50% from the low of 33% in early 2001). 104. see, e.g., john d. mckinnon, caution: tax cuts are bigger than they appear in budget, wall st. j., may 19,2003, at al (noting that the price of a permanent dividend tax cut would be $400 billion over ten years instead of the $124 billion for the temporary measure). the various sunsetting provisions that were included in the 2001 and 2003 tax cuts in order for the legislation to come under the targeted costs make estimates of long-term costs difficult. the mckinnon article reports the estimated price of the dividend tax cut over ten years, assuming that it is made permanent. of course, if corporations pay unusually large dividends during the initial years of the cut because they project that it will not be made permanent, the tax cost of the provision would increase. see, e.g., norris, supra note 71 (discussing the microsoft extraordinary dividend). 105. see office of management and budget, budget of the united states government, fiscal year 2004, mid-session review 3-4 (july 15, 2003), at http://www.whitehouse.gov/omb/budget/fy2004/pdf/04msr.pdf (last visited feb. 8, 2005). 106. see deficit delusions, wash. post, aug. 29, 2003, at a22 (noting that the cumulative deficit through 2013 would be $4.3 trillion under the assumptions given, which is three times the congressional budget office's official projection based on elimination of tax cuts according to the sunset provisions). 2004] florida tax review of "reckless disregard" in pushing such large tax cuts in the face of increased military and other spending."7 similarly, the bush budget for 2002 acknowledged that publicly held u.s. debt had declined from $3.8 trillion to $3.4 trillion between 1998 and 2000.'08 including the federal government's non-publicly held debt (i.e., borrowing from social security for general expenditures), the u.s. debt at the beginning of 2001 was approximately $5.7 trillion.' as of february 8, 2005, the federal debt had reached slightly more than $7.6 trillion."' borrowing to finance tax cuts, the fight against terrorism, and routine government operations is projected to cost $3.60 for each dollar of the tax cuts over the next 6 years."' taxpayers in the $28,000 to $45,000 income range "are especially hard hit by federal borrowing"' as interest rates rise and federal funds for public goods especially important to lower-income households, such as education and health care, dry up. the tax cuts play a significant roll in the growth of federal deficits and debt and will play an even greater role in future decades if they are made permanent. for example, if egttra's repeal of the estate tax (passed through sunset gimmicks that phased in a gradual reduction in rates and completely eliminated the tax only for 2010, reverting to 2000 law for years after 2010) were made permanent, the cost for just the second decade, from 2011 to 2022, is estimated at an astounding $4.1 trillion" 3 just about sufficient to pay off the entire current amount of publicly held federal debt."4 commentaries from liberal and conservative sources alike acknowledge the rapid shift from budget surpluses to years of budget deficits in conjunction with the 2001-2003 tax cuts."5 the joint economic 107. see, e.g., daniel shaviro, reckless disregard: the bush administration's policy of cutting taxes in the face of an enormous fiscal gap (sept. 2003), nyu l. sch. pub. l. research paper no. 71, at http://ssm.com/abstract--444242. 108. 2001 budget, supra note 94, at 29. 109. bureau of the debt, treasury department (online debt statistics), at http://www.publicdebt.treas.gov (last visited for this purpose feb. 8, 2005). 110. id. (showing debt of $7,617,143,521,850.79). of the more than $7.6 trillion in current debt, almost $4.4 trillion is held by the public. id. 111. citizens for tax justice, we're paying dearly for bush's tax cuts 4 (sept. 23, 2003) (using data from congressional budget office, the budget and economic outlook: an update (aug. 2003) to project that from 2002 to 2007 the tax cuts will amount to $1.036 trillion, which will increase the national debt by $3.763 trillion), at http://www.ctj.org/pdf/debt0903.pdf. 112. david cay johnston, studies say tax cuts now will bring bigger bill later, n.y. times, sept. 23, 2003, at c2. 113. see gates & collins, supra note 77, at 104. 114. see supra note 110 and accompanying text. 115. two statements are illustrative: the plan was: a $400 billion federal budget surplus this year and a national debt of $2.1 trillion heading rapidly to zero. that was the [vol. 6:9 congress fiddles while middle america burns committee report optimistically implies that the economy may be able to grow itself out of the debt even with the huge tax cuts."6 other commentators note that rampant inflation could also theoretically solve the debt problem, though at immense social and long-term economic costs."7 the former is at best unlikely, and the latter is troublesome. a glance at recent articles in the national media reveals growing concern that deficits may eventually lead to reductions in savings available for capital investment, less attractiveness of treasury debt to foreigners (who now account for roughly 40% of u.s. debt holders), a currency crisis, and big bills for future generations of taxpayers."' commentators on both sides of the political spectrum generally acknowledge that the deficit and the related federal debt have potentially significant and far-reaching impacts on economic growth, interest rates, consumer purchasing power, net national savings, international monetary policy, and the need to provide safety nets for the least well off, among other issues."" plan back in january 2001 ... [and] [t]hat was the official prediction ofthe nonpartisan congressional budget office. now, we have a new plan.., for a $500 billion deficit. the national debt is $4.4 trillion and headed to more than $6 trillion over the next 10 years. michael kinsley, a bad way to cut the debt, wash. post, july 2, 2004, at a 15. the federal government had budget surpluses in the fiscal years from 1998 to 2001, but it had a deficit in fiscal 2002, and recent estimates suggest deficits will continue for the next several years. kurt schuler, joint economic committee, deficits, taxation, and spending (comm. print, apr. 2003) (from the cover summary), at http://www.house.gov/jec/ tax/deficits.pdf. 116. schuler, supra note 115, at 4-5, 13. 117. kinsley, supra note 115. 118. see, e.g., greg ip, as fear of deficits falls, some see a larger threat, wall st. j., july 12, 2004, at al (noting that the current administration and congress are "more complacent" about deficits, but "a deficit-induced crisis may be far likelier" than when the reagan administration found it had to enact tax increases to minimize the impact oftax-cut induced deficit explosion); steven rattner, what a rate increase can't hide, n.y. times, july 1, 2004, at a21 (discussing interrelated problems of tax cuts, deficits, interest rate increases, consumer loss of buying power); craig karmin, foreigners seem to be souring on u.s. assets, wall st. j., july 26, 2004, at cl (reporting that growth of trade deficits, loss of asian interest in u.s. treasurys, and general loss of foreign interest in u.s. stocks and bonds could lead to climbing interest rates and less purchasing power for the u.s. dollar); alstott, response, supra note 22, at 388 & n.98 (providing references supporting the statement that the decline in net national savings is considered to be largely due to the federal budget deficit); peter a. mckay, inflation can have illusory allure, wall st. j., july 12, 2004, at c3 (indicating hopes that a gradual increase in federal reserve rates will not cause an economic slowdown, though "even small amounts of inflation can cut into stocks' value"). 119. see, e.g., rattner, supra note 118 (noting some of the concerns that back a "national consensus to reduce the budget deficit"). 20041 florida tax review burgeoning deficits pose a particular problem for ordinary taxpayers, who are the primary beneficiaries of spending on federal social programs. commentators have suggested that the bush administration has adopted a "starve the beast" strategy that cuts taxes first and uses the resulting deficit to spur deep spending cuts.2 such a strategy may be effective, because taxpayers are both tax and deficit averse i.e., they prefer lower taxes, but are not willing to use deficits to achieve them; yet, once lower taxes have created a deficit, they will likely support spending cuts rather than higher taxes to remove the deficit.2' whether deficits or spending cuts result, tax cuts come at a significant cost to ordinary taxpayers. c. expanding scope of the amt perhaps the most contentious result of the 2001 and 2003 tax cuts is the impending applicability of the individual amt to many ordinary taxpayers.12 put simply, lowering the regular tax rates while leaving the amt rates as they were prior to the tax cuts (applying on a broader amt base) ensures that the amt will require more taxpayers to pay additional tax compared to their regular tax computation.23 the amt traces its origins to a 1969 treasury study that attributed the ability of some high income taxpayers to pay far less in tax than ordinary taxpayers to four tax provisions: the exclusion for net capital gains (resulting, through a different mechanism, in preferential treatment similar to today's preferential capital gains rate), the deduction for untaxed appreciation on 120. jonathan baron & edward j. mccaffery, starving the beast: the psychology of budget deficits 3 (sept. 2004), usc l. & econ. research paper no. 0424, at http://ssm.com/abstract=-589283. the fiscal year 2006 budget proposals do attempt to cut spending to make up for the gaping deficits. see supra note 82 and accompanying text. 121. id. at 8-9. taxpayers appear to support spending cuts only in the abstract, indicating opposition when asked to identify particular cuts. id. at 14. tax cuts are thus most likely to be supported when they are not matched with specific spending cuts. id. at 14-16. 122. see, e.g., amy feldman, the tax of unitended consequences, money, sept. 2003, at 86 (stating that "much of what the government gave with the regular income tax breaks, it will soon take away with the alternative minimum tax"); tully, supra note 9 (noting that the 2001 tax cut lowered marginal rates and reduced net capital gains taxes, but had "the perverse effect of throwing far more people into the amt"). 123. william g. gale & peter orszag, overdrawn account, the new republic, feb. 4, 2004, at http://www.tnr.com/doc.mhtml?pt=nvvqeonaerwe%2fi49jqb er2%3d%3d (last visited feb. 5, 2005) (indicating that the amt will erase one-third of the tax cuts by 2009, if those cuts are made permanent without amt reform). [vol. 6:9 congress fiddles while middle america burns charitable contributions, tax-exempt interest, and the depletion allowance.2 the 1969 congress enacted an add-on minimum tax,'25 intended to defend against the ability of the superrich to avoid a fair share of the federal tax burden through "extreme concentrations of tax incentives."''26 congress considered it "intolerable" that "taxpayers with substantial incomes have found ways of gaining tax advantages from provisions placed in the code primarily to aid some limited segment of the economy."'27 probably the most important of the regular tax incentives subject to the original minimum tax was the then-existing regular-tax exclusion for 124. dept. of the treasury, tax reform studies and proposals, part 2 (1969), at 132-42 [hereinafter 1969 treasury study]. the treasury proposal would have placed a 50% ceiling on the amount of economic income that a taxpayer could shelter with tax preferences and would have applied graduated tax rates from 7% to 35% to that broader base. id. at 132-33. noting that limitations on the availability of beneficial tax provisions were not new to the tax system, the study emphasized the need for an overall limitation such as the minimum tax to ensure that high-income taxpayers "mak[e] a fair tax contribution to the government in relation to the amount of their true income." id. to protect those at the lower income scale, the study would have permitted a special "alternative standard deduction" of $10,000 for a joint return ($5,000 for individual taxpayers), limiting the tax "to individuals who are deriving substantial benefits from the tax preferences involved." id. at 134. see also nina e. olson, national taxpayer advocate 2003 ann. rep. to cong. 7 (dec. 31, 2003) [hereinafter 2003 nta report] (discussing the treasury study). 125. tax reform act of 1969, pub. l. no. 91-172, § 301(a), 83 stat. 487, 58086 (minimum tax provisions); h.r. conf. rep. no. 91-782 (1969) (describing the minimum tax as enacted and the list of preferences to which it applied), reprinted in 1969-3 c.b. 644, 658-60. 126. glenn e. coven, the alternative minimum tax: proving again that two wrongs do not make a right, 68 cal. l. rev. 1093, 1096 (1980). 127. committee on ways and means report on the tax reform act of 1969, h.r. rep. no. 91-413, at 1(1969), [hereinafter, 1969 ways & means report], reprinted in 1969-3 c.b. 200,200. the house version of the bill would have allocated certain itemized deductions between taxable and tax-exempt income and required a taxpayer to include one-half of the sum of listed preferences (otherwise excludable) in adjusted gross income. id. at 55-60. the goal was to ensure that "individuals with significant amounts of tax-free income [] pay tax on at least one-half of their economic income." id. at 2 (emphasis added). the minimum tax as enacted was a 10% surcharge to the regular income tax that applied (after offset for a then-generous $30,000 exemption amount that applied in addition to an exemption for the regular income tax liability) to specified tax-avoidance techniques, including the one-half of a taxpayer's net long-term capital gains excluded under § 1202 for regular income tax purposes, excess investment interest expense, accelerated depreciation of personal property subject to a net lease, amortization ofpollution control facilities, and depletion in excess ofproperty basis. see s. rep. no. 91-552 (1969), reprinted in 1969-3 c.b. 423. 2004] florida tax review 50% of a taxpayer's capital gains.2' those excluded net capital gains were subject to tax under the minimum tax, along with a few other preferences that were considered central to the ability of some wealthy taxpayers with substantial economic income to pay very little tax under the regular tax system. the minimum tax was expected to reach about one in 500,000 taxpayers, those with incomes of at least $200,000 (more than $1 million in 2004 dollars).29 as explained in the legislative history of the 1986 tax reform act: [t]he minimum tax should serve one overriding objective: to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, and credits. although these provisions may provide incentives for worthy goals, they become counterproductive when taxpayers are allowed to use them to avoid virtually all tax liability. the ability of high-income individuals.., to pay little or no tax undermines respect for the entire tax system. . . . [e]ven aside from public perceptions, . . . it is inherently unfair for high-income individuals . to pay little or no tax due to their ability to utilize various tax preferences.3° in 1978, the minimum tax was supplemented (and eventually replaced) by the amt in its current form a parallel tax with its own base and rate schedules and separate exemption amount.'31 it "require[s] people to 128. coven, supra note 126, at 1097. at the time of the enactment of the minimum tax, capital gains were treated preferentially by excluding 50% of all net capital gains from income. currently, capital gains are generally included in income, but they are treated preferentially by taxing them (and dividends) at a preferential rate that is substantially lower than the rate on ordinary income. 129. see kurt schuler, joint economic committee, the alternative minimum tax for individuals: a growing burden (comm. print, may 2001) [hereinafter, jec amt study], at http://www.house.gov/jec/tax/amt.pdf. see also robert rebelein & jerry tempalski, who pays the individual amt? (office of tax analysis, u.s. dept. of the treasury, ota paper no. 87, june 2000) (citing outgoing treasury secretary barr's statement that no 1967 federal income tax was paid in respect of 155 income tax returns with adjusted gross income of more than $200,000), reprinted in 2000 tnt 13533, 5 (july 13, 2000). 130. s. rep. no. 99-313, at 518-19 (1986), reprinted in 1986-3 c.b. vol. 3. 131. revenue act of 1978, pub. l. no. 95-600, § § 402(a), 421(a), (g), 92 stat. 2763 (1978) (enacting amt provisions for capital gains, but retaining minimum tax provisions for other preferences); h.r. conf. rep. no. 95-1800, at 263-68 (1978), reprinted in 1978-3 c.b. vol. 1 521, 597-602 (describing the relationship between the minimum tax and the new alternative minimum tax). the 1978 amt had four rate brackets (0, 10, 20 and 25%) and an exemption amount of $20,000; it added only two [vol. 6:9 congress fiddles while middle america burns recalculate their taxes under alternative rules that include certain forms of income exempt from regular tax and that do not allow specific exemptions, deductions, and other preferences."'' taxpayers determine their liability under both the regular and amt systems and pay the one that is greater. as a result, the amt can increase total tax liability merely because of the taxpayer's aggregate preferences that reduce the tax base for regular tax purposes. although the amt originally targeted tax-avoidance possibilities of the superrich (e.g., the net capital gain exclusion) and thus affected "less than 1 percent [of taxpayers] in any year before 2000,"'i3 the individual amt is now poised to affect a much broader group of taxpayers. this is in part because the amt exemption amount and rate brackets are not indexed to inflation, but even more because the regular income tax cuts are not matched by similar permanent cuts in the amt. the amt is projected to affect approximately 29 million taxpayers in 2010, up from 3 million in 2004.34 a quirk of the interrelationship between the tax cuts and the amt is that the amt will gradually eliminate the benefit of the tax cuts for middle income taxpayers on the upper end of the scale what one commentator calls the amt "take-backs."'' 5 a 2003 statistical analysis by burman, gale and preference items back into the base excluded capital gains and itemized deductions. see generally craig d. vagt, the alternative minimum tax a new approach for individuals, 45 n.y.u. ann. inst. on fed. tax'n 36-1, 36-1 to 36-11 (1987) (providing a history of the minimum and alternative minimum tax). the amt has been substantially revised several times since, including in the tax reform act of 1986, pub. l. no. 99-514, § 701, 100 stat. 2085 (which changed the treatment of capital gains, among other significant amendments), and the omnibus budget reconciliation act of 1993, pub. l. no. 103-66, § 13203(a), 107 stat. 312 (which imposed the 26% and 28% amt rates, rather than a single amt rate, on amt income above the exemption amount). the idea of the 1978 reform, however, was the same as today's amt: broadening the base through elimination of specified preferences and flattening the rate schedule applicable to that base. 132. congressional budget office, revenue and tax policy brief no. 4, the alternative minimum tax 1 (2004) [hereinafter, the "cbo study"], at http://www.cbo. gov/ftpdocs/53xx/doc5386/04-15-amt.pdf. 133. id. 134. see auerbach et al., supra note 55, at 1294; see also nina e. olson, 2004 national taxpayer advocate ann. rep. to cong. 383 (dec. 31,2004) [hereinafter 2004 nta report] (noting that the treasury department's office of tax analysis projects that by 2010, 34 percent of individual taxpayers who pay income tax (a total of 34.8 million taxpayers) will be subject to the amt). 135. al davis, new household tax cuts are strongly affected by amt and vary over time, 92 tax notes 293 (july 9, 2001). as davis explains, an amt "take-back" occurs when, because of the amt, a taxpayer gets less of an actual tax cut than the cut in the regular income tax. because the amt is a floor on the income tax for a 2004.] florida tax review rohaly at the urban institute suggested that by 2010 the amt would eliminate 70% of the tax cut for taxpayers with gross income between $100,000 and $500,000 and 42% of the tax cut for taxpayers with gross income between $75,000 and $100,000.36 a more recent study suggests that 97% of taxpayers with two children and incomes of $75,000 to $100,000 will be affected by the amt by 2010, and 44 million will be affected by 2014.137 congress has not acted to deal comprehensively with the interaction of the regular tax cuts and the amt. instead, it has passed annual fixes that increase the amt exemption to prevent, for the few years to which the fix is applicable, the vast majority of middle-income taxpayers from having to pay the tax.3' congress' failure to do more is due to the enormous costs of simultaneously making the tax cuts permanent and eliminating the extended reach of the amt into lower tax brackets. the congressional budget office has estimated that full amt repeal would reduce tax revenues by roughly $600 billion over ten years, even assuming that the 2001-2003 tax cut sunsets take effect as planned.33 gale and orszag estimate that indexing the amt under current law would cost $428 billion, while the combined cost of indexing the amt and making the tax cuts permanent would be $1.76 trillion.14' even repeal advocates such as the national taxpayers union admit taxpayer, cutting the regular tax below this floor gives the taxpayer no further benefit. id. at 294. see also robert s. mcintyre, bush's most-favored taxpayers, american prospect, july 1, 2002, at 17 (finding that more than half of the benefit of the 2001 tax cut would go to the richest 1%, if there were no further amt relief after 2004). 136. burman, gale & rohaly, supra note 6, at 105. 137. leonard e. burman, williamg. gale, matthew hall &mohammedadeel saleem, amt relief in the fy 2005 budget: a bandaid for a hemorrhage 1 (feb. 3, 2004), at http://www.urban.org/uploadedpdf/1000601.pdf. 138. see gale & orszag, supra note 55, at 1280 tbl. la (summarizing the egtrra and jgtrra changes, whereby the 2001 act increased the amt exemption amount to $35,750 for singles and $49,000 for married taxpayers, from the preegtrra amounts of $33,750 and $45,000, while jgtrra increased the exemption for 2003 and 2004 to $40,250 and $58,000, respectively); dustin stamper, house clears 'tax cut of the week' a short-term amt fix, 103 tax notes 625 (may 10, 2004) (discussing the 2004 proposal in h.r. 4227 to provide a further one-year repair to the amt exemption limits by indexing the 2004 limits to inflation for 2005, resulting in a $58,950 exemption forjoint returns and $40,900 for individuals, rather than a reversion to the 2002 levels, a change costing $17.8 billion over 10 years). 139. see cbo study, supra note 132, at 7 (citing $600 billion revenue loss over the next ten years to repeal the amt, under current law); sen. sarbanes' statement, 150 cong. rec. s2256 (mar. 8, 2004) (discussing the proposed budget for fy 2005 and noting that the cost to extend the proposed amt fix out 10 years would be $658 billion, versus the one-year cost of $23 billion in the administration's budget). 140. gale & orszag, supra note 55, at 1283. [vol. 6:9 congress fiddles while middle america burns it could cost as much as $800 billion over ten years to repeal the amt and make the 2001-2003 tax cuts permanent.4' these estimates make clear that the cost of repeal would be significant, and that cost will be substantially increased if the 2001-2003 tax cuts are made permanent. full repeal would, of course, have other implications for the overall federal tax system, especially for progressivity'42 congress' approach has therefore been one of piecemeal reform to prevent the worst combined effects of the amt and new tax cuts while "postponing hard choices. "143 iv. amt repeal or reform? proponents of amt repeal have made a variety of arguments, beginning immediately after the 1978 enactment of the current version of the add-on tax and continuing, in increasingly strident form, today.'" an early commentator writing in 1980, for example, acknowledged that curtailing high-income taxpayers' excessive claims for deductions and exclusions was an important way to improve the overall equity of and compliance with the tax system, but argued that the amt was "ill-conceived in every respect" because of its cumbersomeness and inequitable application.45 he particularly complained about the use of the amt mechanism to limit preferences when congress could have achieved the same (or better) results through less cumbersome fine-tuning of the regular tax system.46 today's commentators have similar objections: the most recent report of the national taxpayer 141. see matthew s. bailey, the individual alternative minimum tax: no alternative but repeal (ntu policy paper no. 114, apr. 22, 2004), reprinted in 2004 tnt 79-23, 40 (apr. 23, 2004). 142. see, e.g., shaviro, supra note 9, at 1461 (prior to the enactment of the 2001-2003 tax cuts, noting that full amt repeal "would make the system less progressive than otherwise, notwithstanding that the bullet is not quite aimed at the top"). 143. floyd norris, help grandparents of rich kids now. deal with real problems later., n.y. times, feb. 6, 2004, at c l (noting that the bush administration does not seem "eager to deal with the prospect of the alternative minimum tax... harming many middle-class taxpayers"). 144. see, e.g., bailey, supra note 141, 2, 4, 7 (calling the amt at various points "an alternate universe in the twilight zone," a "seeping wound," and "unfair"). see also supra note 9 (noting the strongly pejorative language typically used to describe the amt). 145. coven, supra note 126, at 1094. coven noted that the tax penalized preferences without regard to the magnitude of income distortion caused and was "regressive relative to income before reduction by preferences." id. at 1096. this was particularly true for the capital gains preference, where the tax only reduced the effective exclusion from 60% to 59.2% for those with half a million of gains, but reduced the exclusion to 56% for those with $200,000 of gains. id. at 1101-02. 146. see, e.g., id. at 1108. 2004] florida tax review advocate considers the amt one of the most serious problems taxpayers face and labels amt repeal a "key legislative recommendation."'47 critics attack the amt on five main grounds: (i) its failure to adequately target the superrich and instead to take back the tax cuts from middleand upper-income taxpayers (the downward creep argument); (ii) its lack of transparency for ordinary taxpayers who are often inadequately informed (if not totally unaware) of the potential applicability of the amt to their situation (the transparency argument); (iii) its lack of consistency with regular income tax policy (the consistency argument); (iv) its addition of a layer of complexity, both in terms of the initial determination of whether the amt may be applicable and the particular mechanisms of amt applicability (the complexity argument), and (v) its apprehension of taxpayers with various kinds of lump sum payments, such as stock options and contingent attorney fee awards (the "accidental taxpayer" argument4 ). the following sections briefly discuss each of these arguments in turn. it should be noted at the outset that these arguments often overlap. the complexity of the amt provisions increases their lack of transparency, while any inconsistency with the regular income tax may play a role in the downward creep of the amt. the primary concern raised by the "accidental taxpayer" situations is one of fairness: revenue leveling devices that are permitted under the regular tax, such as deferral of income on exercise of incentive stock options, may not be permitted under the amt, creating a "gotcha" effect. the other arguments lack of transparency, complexity, lack of consistency evoke broader fairness concerns as well in a voluntary tax system that relies (in part) on self-reported compliance. a. downward creep there are two main types of arguments made about the downward creep of amt liability to lower-bracket taxpayers. critics attack the amt because the downward creep appears inconsistent with the original purpose of the minimum tax. furthermore, those calling for repeal of the amt attack it as unfair because of its effect in rolling back the 2001-2003 tax cuts for those with incomes between $100,000 and $500,000. this section explores those arguments. commentators complain that the amt fails to achieve its original purpose of ensuring that the wealthiest taxpayers pay some federal income tax.' as we have seen, when the original minimum tax legislation was 147. see 2004 nta report, supra note 134, at 2-3. 148. the genesis of this term lies with the aba individual amt task force. 149. see, e.g., 2003 nta report, supra note 124, at iv (indicating that "the amt appears to function... randomly, no longer with any logical basis in sound tax administration or any connection with its original purpose of taxing the very wealthy who escape taxation"); 2004 nta report, supra note 134, at 383 (stating that "[w]hile [vol. 6:9 congress fiddles while middle america burns enacted, congress focused on the ability of 154 individuals with adjusted gross incomes exceeding $200,000 to pay no 1967 income tax at all.5 0 the amt was designed to limit very high income taxpayers' use of a few preferences that could literally wipe out their tax liability in spite of their considerable economic income, resulting in an unfair sharing of the tax burden.' congress made further changes in 1976, again reacting to a study that indicated 244 high-income taxpayers paid no tax in 1974, even with the amt system in place.'52 in spite of the refinements, critics argue that the amt has not added huge numbers of non-taxpaying filers to the tax rolls. one calculation indicates that the amt system adds about 14,000 taxpayers annually to the tax rolls, or one high-income taxpayer for every 1,000 highincome taxpayers already paying some amount of income tax under the regular tax system.'53 the joint economic committee study scoffs at these numbers and suggests that the better way to deal with high-income tax evaders than to catch so few with the amt is to repeal the amt and reduce taxes. 54 the amt is clearly an imperfect method for ensuring that all highincome taxpayers pay some tax. it is not so clear, however, that the ability of the amt to ensnare this number of high-income taxpayers should be scorned. for the years for which the calculations were made, the relative rates of the regular and amt systems were such that the regular income tax liability likely exceeded the amt liability (which was based on a broader base but at generally lower rates), except for those taxpayers with preference items or other adjustments that were significant in the aggregate, such as stock option exercises or itemized deductions that were phased out under the amt. even the national taxpayer advocate acknowledges that "repealing the amt will result in some taxpayers owing nominal or no tax."'55 if the amt only adds i for every 1000 high-income payers, that number is itself not insignificant. this is especially true when one considers that, without an the amt was originally designed to prevent wealthy taxpayers from escaping tax liability through the use of tax avoidance transactions, it now affects large groups of middle-class taxpayers with no tax avoidance motives at all"). 150. see 1969 ways & means report, supra note 127, at 9; 2003 nta report, supra note 124, at 8 & n.11. 151. 1969 ways & means report, supra note 127, at i (noting that "only by sharing the tax burden on a fair basis is it possible to keep the tax burden at a level which is tolerable for all taxpayers"). 152. see jec amt study, supra note 129, at 5. 153. id. at 6-8 (using 1998 return numbers and results of a 2001 gao study to calculate these numbers). 154. id. at 14. 155. 2003 nta report, supra note 124, at 17 (citing the brookings/urban institute study estimating that 2,700 taxpayers with incomes more than $1 million who would not otherwise have paid any tax were caught by the amt in 2003). 2004] florida tax review amt system, considerably larger numbers of high-income taxpayers might engage in aggressive tax-avoidance planning around the very items currently made difficult to use in tax sheltering because of the amt.5' underscoring the complaint regarding failure of purpose is the predicted encroachment of the amt system on upper-middle-income taxpayers. one cause for the broader reach, of course, is congress' change in the treatment of preference items under the amt over the years since the original enactment. the original amt focused on deductions that might be taken by owners of property, a group that we have seen can be expected to be made up predominantly of the wealthy. thus, amt preferences under the 1969 legislation included the portion of net capital gains excluded under the pre-1986 code regular tax and excess depreciation or amortization deductions permitted under the regular tax.'57 the 1976 amendments, however, added a tax preference for itemized deductions, essentially limiting itemized deductions other than medical and casualty losses to no more than 60% of adjusted gross income. further amendments over the years, in 1986, 1993, and 1997, eliminated some of the preferences that could be expected to be used predominantly by the very wealthy (e.g., the ultimately short-lived amt preference for untaxed appreciation on charitable deductions). the amendments, while providing a specific ability-to-pay exemption amount for amt purposes, also resulted in treating as amt preferences a number of items that we think of, at least in part, as ability-to-pay exemptions the standard deduction, miscellaneous itemized deductions, state and local tax deductions, a larger portion of medical expenses, and various credits.'58 the rationale behind these changes appears to be somewhat different from the original goal of targeting disallowed preferences narrowly to the very wealthy. they appear aimed at any taxpayer that might have a large number, in the aggregate, of the kinds of expenses that tend to have a highly personal element. this retains the flavor of the original purpose of the amt to target the wealthy while undoubtedly broadening the group of taxpayers to which it may apply, in order to ensure that no taxpayers are able to lower their tax liabilities to a de minimis level compared to their economic incomes merely because they are able to aggregate a large number of subsidies or incentives (credits), "rough justice" deductions (the standard deduction), and expenses that may carry a highly personal flavor (miscellaneous itemized deductions). in several instances in which taxpayers have claimed that the amt should not apply to a once-in-a-lifetime income jump or undo investment and job 156. johnston, supra note 68 (quoting tax lawyer jonathan blattmachr of milbank, tweed, hadley & mccloy, who commented that "[t]here are lots of things you would not even think about because of the alternative minimum tax .... [b]ut if you repeal it, then there are all sorts of things to start thinking about"). 157. see 2003 nta report, supra note 124, at 7 & n.8 (listing preference items in the 1969 revenue act). 158. irc §56. [vol 6:9 congress fiddles while middle america burns credits offered under the regular tax system, courts have pointed out this somewhat broader purpose of the amt.'59 a further salient feature responsible for the broader reach of the amt is the failure of the amt income brackets, exemption amount and phase-out thresholds to be indexed for inflation, whereas the corresponding regular tax parameters are so indexed.6 ° as a result, each year as inflation causes the regular tax brackets and thresholds to creep upward, the amt brackets and thresholds remain stagnant. accordingly, the amt ensnares more and more taxpayers for whom the applicable marginal regular tax rate is sufficiently lower than the amt tax rate, or the broadened amt base is sufficiently broader than the regular tax base, to cause the amt liability to exceed the regular tax liability. in addition, as discussed in part iii.c, the interaction of tax cuts with the lack of amt indexation results in an inexorable downward creep of applicability of the amt to lower-bracket taxpayers who would otherwise have received a greater benefit from the 2001-2003 tax cuts. those urging amt reform argue that this downward creep is particularly inconsistent with the amt's stated goal of ensuring that the wealthiest americans pay some share of the federal tax burden,' given congress' stated aim of reducing the tax burden for all taxpayers through the 2001-2003 tax cuts. there can be no denying the inconsistency of downward creep with the narrow original minimum tax purpose. it seems apparent, however, that the harm caused by downward creep is more a question of fairness due to decreasing progressivity in the overall tax system than it is a problem of incoherence.62 the amt can be construed as structurally coherent if it is cast as a back-up system that attempts to ensure that those with economic 159. see, e.g., maryhelen bettner v. comm'r, t.c. memo 1991-453 (where a low-income taxpayer received a net long term capital gain from the sale of an apartment building that subjected her to the amt, finding that "[w]hile it is apparent that the congressional purpose in enacting the minimum tax was to assure that the wealthy would pay their fair share of taxes, the statute by no means discriminated between the wealthy and the nonwealthy"); huntsberry v. comm'r, 83 t.c. 742,749 (1984) (noting that the amt was structured quite differently from the original minimum tax, in that it applied graduated rates to "a new concept" of income of which preferences were just one component). 160. 2004 nta report, supra note 134, at 383 (stating that "[t]he amt is ensnaring an ever-growing number of taxpayers because . . . the amt 'exemption amount' is not indexed for inflation" and noting that if the original exemption amount of $30,000 in 1969 had been indexed for inflation, it would today be approximately $153,500 instead of only $45,000 for married taxpayers and $33,750 for most other taxpayers). 161. see, e.g., jec amt study, supra note 129, at 10 (noting that "a tax intended to apply only to high-income taxpayers will eventually become everyone's tax"). 162. see, e.g., gale & potter, supra note 16, at 134, 138-39. 20041 florida tax review income, whether wealthy or merely upper-middle income taxpayers, cannot make undue use of personal expenditures to avoid their fair share of the tax burden. it does, in fact, perform that function in a significant number of cases.63 that slightly different view of the amt casts certain preferences (e.g., deduction for state and local taxes, miscellaneous itemized deductions) as reflecting a substantial element of personal consumption and thus appropriately limited under the alternative system." it suggests there can be too much of a good thing and requires a final weighing of the aggregate use of incentives that may fortuitously accrue to one taxpayer and that would otherwise let that taxpayer avoid taxes on economic income. even applying this perspective, however, it remains bothersome if the combination of the tax cuts (including estate tax repeal) and the operation of the amt results in an overall shift of the federal tax burden away from high-income taxpayers and onto ordinary taxpayers. the answer to this argument is not repeal of the amt, but rather restoration of the overall redistributive potential of the tax system through changes to both the amt and the regular tax, as necessary. this option will be explored in part v, below. b. transparency the argument from purpose can be viewed as one aspect of an argument about the importance of transparency in a self-assessment tax system that relies to a considerable extent on the willingness of taxpayers to report all items of income fairly. prior to 2000, most ordinary taxpayers were probably unaware of the alternative tax system.'65 because of the interaction of the 2001-2003 tax cuts with the amt provisions, however, these ordinary taxpayers may well be surprised to find that they have to do extra 163. for example, although the cheneys paid a rate of tax in 2003 that was significantly below the average rate paid by others in the $1-$2 million income group 19% on reported income (12.7% effective tax rate on total economic income) compared to the 29% average , they paid more than they otherwise would have because of the application of the amt to their income. see johnston, supra note 73. 164. see supra text accompanying note 159 and accompanying text (discussing the huntsberry and bettner cases) and the discussion in part iv.d, infra. 165. see, e.g., statement of david a. lifson, tax division of the american institute of certified public accountants, to the house committee on ways and means, hearings on the revenue provisions in the president's fiscal year 2000 budget (mar. 10, 1999) (noting that "[m]ost sophisticated taxpayers understand that there is an alternative tax system, and that they may sometimes wind up in its clutches; unsophisticated taxpayers, however, may never have even heard of the amt, certainly do not understand it, and do not expect to ever have to worry about it"). only about 40,000 taxpayers with agi less than $50,000 owed any amt in 2001 (and even these taxpayers may have had higher gross incomes because of above-the-line deductions). see 2003 nta report, supra note 124, at 5 n. 3. [vol. 6:9 congress fiddles while middle america burns calculations to be sure that they are not potentially liable for the amt. in the process, they may miss allowable deductions or, if they have a one-time "minimum tax credit" from an earlier payment of amt, they may fail .to use the allowable credit. because of the inconsistency between the amt and regular tax systems and the failure of required interest reporting to make any distinctions among types of interest, some taxpayers may not understand or comply with the different amt treatment of various types of interest.'66 the average additional tax liability for amt taxpayers is $6,000.167 if unaware of the amt, taxpayers may not have set aside sufficient funds to pay the tax and may have failed to make required estimated tax payments. as a result, new amt taxpayers may be more likely to be subject to underpayment penalties.168 this lack of transparency in the tax system is likely to cause considerable resentment, as taxpayers feel that making the extra calculations is an unreasonable burden and, if they indeed have to pay the amt or a related penalty, that they have been cheated out of the additional tax amount required, without fair notice of its potential applicability. while the importance of transparency cannot be denied, it is not clear that the transparency argument is itself a strong reason for outright repeal of the amt, rather than other solutions to the quandary. part of the reason the amt is not transparent is the rhetoric that is used by congress, practitioners, and academics alike to describe it, often in the context of campaigns to support particular reforms that will benefit particular constituent groups.'69 our tax system includes several different tax regimes 166. for example, the amt allows a deduction for interest paid on mortgage loans that are used to purchase a home, but it does not allow a deduction for interest paid on home equity loans that are used for personal consumption. 167. 2004 nta report, supra note 134, at 383 (citing leonard e. burman et al., the individual alternative minimum tax: a data update, tbl. 3 (aug. 30, 2004), reprinted in 2004 tnt 175-15 (sept. 9, 2004)). 168. id. at 384. 169. see, e.g., timothy carlson, letter to sen. grassley (oct. 2, 2003) (on file with author) (arguing without substantiation that iso exercise results in punitive taxes on phantom gains, resulting in "[m]any persons [who] have stopped working because the irs is taking everything they own"). further examples are provided in the materials referenced in note 9, supra. this rhetoric is particularly harmful to democratic deliberations. advocacy groups' demonization of the amt, as though it were an external cancer on the tax system rather than a working part of that system, threatens to overpower reasonable policy debate with colorful but misleading sound bites that distort the facts. for example, matthew bailey of the national taxpayers union accuses "the government" of "punish[ing] the very activities that congress seeks to encourage," as though two different actors enacted the amt and the regular tax. see bailey, supra note 141, at 46 (emphasis added). of course, tax policy debate has long been a focus of political maneuvering and the accompanying use of cultural constructs to depict taxpayer stereotypes. a new group of critical tax scholars is beginning to give this tax rhetoric the attention it deserves. see, e.g., william blatt, why did congress repeal the 2004] florida tax review payroll taxes ostensibly dedicated to social security and medicare, transfer taxes governed by the gift and estate tax regimes, and income taxes governed by the regular and alternative tax regimes. we cannot evaluate overall distributional effects without understanding the combined effects of all of these tax systems, and taxpayers also need to understand how these systems interrelate in order to participate in informed debate about tax policy.'70 if someone claimed not to be sufficiently aware of the regular income tax, we would rightly scoff at them. there is no reason that the approach should not be the same for the amt, and the resources should be spent to ensure that taxpayers become better informed about the overall tax system. congress chose to enact the 2001-2003 tax cuts without at the same time resolving the inconsistency with the amt that the amendments created. the administration was aware of the problem the tax cut would create.171 congress' failure to make the amt fully compatible with the tax cuts suggests an ulterior aim: either the tax cuts were never intended to reach to the population that will be most negatively affected by the downward creep of the amt, or congress counted on ordinary taxpayers' consternation with the encroaching amt to permit it eventually to eliminate the amt in spite of the inevitable deficit. we overlook that history if we imply that the amt is a "stealth tax" that unintentionally takes away the tax cuts. in suggesting appropriate reforms, therefore, responsible tax commentary should look at the amt in conjunction with the 2001-2003 regular tax cuts and consider ways to enhance dissemination of information about the amt. part v attempts to carry out this approach to the amt. c. complexity the amt as it existed prior to the 2001-2003 tax cuts was already a highly complex system, requiring separate computations and careful reading of instructions to ensure that proper adjustments had been made.' the estate tax but not the gift tax?, rutgers-newark critical tax conference (apr. 2004), at 6-8, at http://taxprof.typepad.com/taxprof blog/2004/06/blatt on retent.html (last visited july 1, 2004) (noting the use of cultural constructs in debates about taxation). 170. see, e.g., baron & mccaffery, infra note 254, and accompanying text. 171. see, e.g., shaviro, supra note 9, at 1456 (noting that "[d]espite any such concerns [about the impact of the amt if substantial tax cuts were enacted], president bush has proposed tax cuts largely identical to those he urged during the campaign, without amt relief moreover, his advisers have been issuing strong statements to the effect that congress should not at this stage make costly additions to his short list of proposals"). 172. see, e.g., bailey, supra note 141, at 17 (quoting former irs commissioner rossotti's statement that the amt is "intricate and ambiguous"); shaviro, supra note 9, at 1457-58 (discussing compliance, transactional and rule complexity). [vol 6:9 congress fiddles while middle america burns majority staff of the joint economic committee (jec) prepared a study in 2001 that emphasized the "growing burden" represented by the amt for individuals. noting that a wide array of groups have called for amt repeal, the jec amt study focuses on the imminent explosion of amt applicability and the burden imposed in terms of amt complexity and related high costs of compliance,' and suggests that the problem the amt was designed to attack is not of sufficient importance, and the amt is not sufficiently targeted, to merit retention of the supplemental tax system.'74 the study describes the amt process as follows: calculating the amt is a four-step process. first, taxpayers calculate their regular income tax. second, they determine whether the amt may apply. some taxpayers are automatically subject to the amt because the tax applies to everyone who claims certain kinds of adjustments to income, such as stock options not exercised in the same year they were received. such taxpayers go straight to the third step. other taxpayers may be subject to the amt if their taxable income plus certain other items exceeds $45,000 for married couples filing a joint return (half that for each spouse if they file separately), or $33,750 for a single filer or head of household [the thencurrent amt exemption amounts; these have been temporarily increased through 2005]. those taxpayers complete a 13-line worksheet [12 lines in 2004] provided in the instructions to irs forms 1040 and 1040a, the forms for the regular income tax. if the worksheet indicates that the amt may apply, those taxpayers go on to the third step. third, taxpayers use irs form 6251, which is 50 lines long, to recalculate taxable income using the rules of the amt instead of the rules of the regular income tax. the result of this calculation is called the tentative amt. 173. jec amt study, supra note 129, at 6-10 (noting the groups that have criticized the amt, the lack of amt indexation, and the expectation that the number of affected taxpayers will grow "explosively"); 2004 nta report, supra note 134, at 383-84 (stating that the tax "impos[es] onerous compliance burdens" and reporting that 75 percent of amt taxpayers hire a practitioner to prepare their returns, which is "hardly surprising" given that "taxpayers often must complete a 12-line worksheet, read eight pages of instructions, and complete a 55-line form simply to determine whether they are subject to the amt). 174. jec amt study, supra note 129, at 6-8. 2004] florida tax review finally, taxpayers compare their regular tax before credits with their tentative amt, and pay whichever is greater. 75 a considerable cause of the complexity and compliance cost is the requirement that taxpayers who may well not be subject to the amt must work through at least the short amt worksheet to determine whether they must make the more detailed calculations on form 6251, entailing additional hours of tax return preparation time and hassles.176 repeal would, of course, resolve the issue, but at a high cost in both loss of revenues and potential loss of taxpayers from the tax rolls.77 another solution, that appears to increase the coherence of the amt system, is to institute a bright-line income threshold test for applicability of the amt. such a test would ensure that no ordinary taxpayer under the selected income threshold has to devote any tax preparation time to amt calculations and would at the same time exempt those taxpayers from amt liability, furthering the core purpose of the minimum tax to target the wealthy and taxpayers with excessive preferences. part v develops this suggestion further. even if ordinary taxpayers are exempt from the amt through an income-threshold test, however, the amt itself remains a complex system with a number of required computations for those taxpayers who would still be required to carry out the full amt analysis. various items must be recomputed for amt purposes, including home mortgage interest,7 1 investment interest,'79 depletion deductions,8 ' and depreciation.'8' undoubtedly, these recomputations require time and lead to both frustration and error. for 1997, the jec amt study estimates that the overall cost of compliance with the amt may have been as high as $360 million." 2 the irs estimated that the amt system added 29 million hours to overall 175. id. at 2-4. 176. see instructions to form 1040, line 44, worksheet to see if you should fill in form 6251 line 44 at 35 (2004). 177. see, e.g., supra notes 138-139 and accompanying text. 178. equity lines of credit used for purposes other than home purchases, construction or improvement or that exceed the amount originally financed are not deductible for amt purposes. see, e.g., internal revenue service, 2004 instructions for form 6251, line 4, p. 2 (2004). 179. a taxpayer with investment interest must fill out a new form 4952 to recompute with appropriate amt adjustments. id. at line 8, p. 2. 180. id. at line 9, p. 2. 181. id. at line 17, p. 3. 182. jec amt study, supra note 129, at 8. the jec majority staff argues somewhat speciously that the amt is "not about revenue but about symbolism the resentment of many taxpayers at a few people with high incomes paying no federal income tax.." id. at 13. the study then asserts that the answer to tax avoidance is to simplify the code, which means "reducing tax rates." id. at 14. [vol. 6:9 congress fiddles while middle america burns taxpayer return preparation time in 2000. '83 while these estimates may be high, they do suggest that amt complexity should be addressed, if possible, in structuring any amt reform. the priority of reducing complexity, however, may be limited compared to other reform goals, particularly in the context of choosing between amt repeal or amt (and regular tax) reform. sophisticated taxpayers in the higher income brackets generally can be expected to have complicated finances and to rely on sophisticated tax planning advice. accordingly, the likely application of amt complexity, including recomputations, to this group is less of a tax policy concern. a further aspect of the complexity of the amt is the uncertainty surrounding the relationship between the amt and the regular tax due to the sunsetting provisions used in the 2001-2003 tax acts. congress has so far taken a piecemeal approach. unwilling to let the hammer of the amt fall quite as heavily as it would without any action, congress increased the exemption amounts for 2001 through 2004 in the 2001 tax bill and then increased the exemption again when it enacted the 2003 tax bill.'85 in 2004, congress extended the increased exemption amount to 2005.i"6 clearly, the uncertain future reach of the amt creates complexity and corresponding transparency problems for many taxpayers. any solution that resolves the uncertainty would be an improvement in the tax system. repeal would, of course, eliminate the problem, but is extremely costly. thoughtful steps to re-target the amt, with corresponding changes to the regular tax to increase the harmony of the two systems, would be just as effective in removing the uncertainty and perhaps more realistically possible in the current economic and political climate. part v further explores this alternative. 183. see internal revenue service, annual report from the commissioner of the internal revenue on tax law complexity, at 26 (june 5, 2000). 184. see, e.g., gale & potter, supra note 16, at 162 (noting that the 2001 tax cut made a pre-existing problem more expensive and difficult to resolve and thus added "uncertainty about its evolution"). 185. see economic growth and tax reconciliation relief act of 2001, pub. l. 107-16, §701(a)(l)-(2), 115 stat. 38, 148 (amending irc §55(d) to increase the exemption from $45,000 to $49,000 for married taxpayers (and from $33,750 to $35,750 for others) in 2001-2004); jobs and growth tax reliefreconciliation act of 2003, pub. l. 108-27, § 106(a)(l)-(2), 117 stat. 752, 755 (amending irc §55(d) to increase the exemption amount to $58,000 for married taxpayers and $40,250 for others). congress had first increased the exemption from its original $30,000 level in 1993. omnibus budget reconciliation act of 1993, pub. l. 103-66, §13203(b)(1)-(3), 107 stat. 312 (increasing the joint return exemption to $40,000 and the single taxpayer exemption to $33,750). 186. working families tax relief act of 2004, pub. l. no. 108-311, § 103(a), 118 stat. 1166, 1168. 2004] florida tax review d. consistency one aspect of the amt that adds to complexity and lack of transparency is its inconsistency with the regular tax system in respect of various commonly applicable provisions.i"7 the regular tax system provides numerous incentive provisions (generally termed "tax expenditures") enacted by congress to accomplish economic objectives. congress has also allowed a number of deductions for regular tax purposes even though they are entirely personal expenses or have a highly personal flavor the mortgage interest deduction (including interest on a home equity loan that is taken out to use for personal purposes such as vacations, private plane purchases or furnishings), the miscellaneous itemized deductions (which include deductions for employee expenses that are not reimbursable by the employer), the state and local tax deduction (e.g., property and income taxes (or, temporarily, sales taxes)), and the medical expense deduction (a clearly personal expense the deduction of which has been allowed out of compassion for taxpayers with extraordinary medical expenses).8' the amt effectively disallows some or all of these incentives for any taxpayer for whom the aggregate of these deductions results in a regular tax liability that is less than the amt liability with the items refigured. 1. "ability to pay" deductions and exemptions the amt treats the standard deduction (used by taxpayers who do not itemize their deductions) and the personal exemptions (for taxpayers and their dependents) as disallowed preference items.89 in their place, the amt provides an exemption amount: $58,000 for taxpayers filing jointly in 2005 (but reverting to $45,000 in 2006) and $40,250 for individual taxpayers, including heads of households (but reverting to $33,750 in 2006). 19 this interaction between the regular and amt systems has a number of results that merit consideration. first, the inconsistent treatment of the standard and itemized deductions adds complexity (and perhaps inequities) to the system. the election to take the standard deduction for regular tax purposes cannot be revoked for amt purposes, even though the standard deduction is disallowed for amt purposes. the lack of a standard deduction (coupled with the downward creep of the regular tax due to the 2001-2003 tax cuts) will snare an increasing number of taxpayers over the next ten 187. of course, the amt is necessarily inconsistent with the regular tax, because it is an alternative tax system that affects the tax liability that may result from application of the regular tax system. see the discussion of the role of consistency in establishing coherence in part ii, supra. 188. irc §§ 163(h)(2)(d), 67(b), 164, 213. 189. irc § 56(b)(1)(e) (disallowing deductions under irc §§ 63(c) and 151). 190. irc § 55(d)(1)(a)-(b); see supra note 186 and accompanying text. [vol. 6:9 congress fiddles while middle america burns years.1 ' in contrast, those who itemize deductions for regular tax purposes are entitled to a substantial portion of the benefit of those deductions for amt purposes. consequently, taxpayers who may be subject to the amt essentially must compute their tax liabilities several different ways in order to determine the optimum combination of approaches regular tax with standard deduction, amt without standard deduction; regular tax with itemized deductions, amt with adjusted itemized deductions. the multiplicity of possibilities adds complexity to any potential amt-liable taxpayer. perhaps worse, it is hard to reconcile the approach under the two systems. it is plausible to consider the standard deduction as a rough measure of reasonable deductions for all taxpayers that can be used rather than compute exact itemized deductions.'92 that amount, plus the personal exemptions, should shelter sufficient income for the taxpayer's necessities.'93 that rationale suggests that the same amount should be sheltered under the amt.' 94 instead, the amt has a separate exemption amount (generally larger than the sum of standard deduction and personal exemptions, except of course for those taxpayers with very large families) that replaces both the standard deduction and personal exemptions available under the income tax. yet a taxpayer who itemizes for regular tax purposes can still take most of 191. see supra part iii.c. 192. see, e.g., robert s. mcintyre & michael j. mcintyre, fixing the "marriage penalty" problem, 33 val. u. l. rev. 907,915-17 (1999) (suggesting that the standard deduction is simpler and serves, with the personal and dependent exemptions, to exclude from income tax liability those at the poverty level); joint committee on taxation, estimates of federal tax expenditures for fiscal years 2004-2008, at 3 (dec. 22, 2003) (indicating that the personal exemptions and standard deduction are viewed as defining a zero-rate bracket that is part of normal tax law), at http://www.house.gov/jct/5-8-03.pdf; joshua hall, joint economic committee, tax expenditures: a review and analysis, at 8 (aug. 1999) (indicating that these deductions are not treated by the joint committee on taxation as tax expenditures because they "approximat[e] the level of income below which it would be difficult for an individual or family to obtain minimal amounts of food, clothing, and shelter"), at http://www.house.gov/jec/fiscautax/expend.pdf. 193. see, e.g., 1969 treasury study, supra note 124, at 128 (suggesting that a proposed increase in the standard deduction would "benefit a wide range of taxpayers by bringing that general provision into closer alinement [sic] with today's relative cost and expenditure patterns for deduction items"). 194. these considerations are complicated by the differences in rate structures. a $5,000 standard deduction in the regular tax system can be considered to prevent income taxation on that amount at the individual's highest marginal rate. that rate could be above or below the basic 26% amt rate, depending on the taxpayer's taxable income. if the standard deduction is used in the amt with a gross income exemption threshold, it is more likely that the marginal regular tax rate would exceed the amt rate, leaving the standard deduction worth slightly less in the amt than in the regular tax. the difference is probably not sufficient to merit the complexity of developing two separate measures for the deduction. 2004] florida tax review the itemized deductions for amt purposes, as well as the amt exemption amount, in what appears to be a clear violation of basic equity goals for a tax system. the result in many cases is that a taxpayer should itemize rather than take the simplifying standard deduction. second, the inability to take personal exemptions for amt purposes (coupled with other preference disallowances) may cause very large families to be disadvantaged under the amt in comparison with their tax-favored status under the regular tax system.9 ' that is, the existence of personal exemptions for dependents provides a regular tax subsidy to families while singles or couples with no children bear a disproportionately greater share of the regular tax burden. the amt's elimination of this tax preference, while perhaps reasonable from the perspective of struggling singles or childless couples, does not harmonize with the current emphasis on tax subsidies for families with children. again, the rationale for the treatment of families under the regular tax would appear to support equal exemption under the amt system since it is ultimately a rough justice measurement of the amount of income sufficient to maintain a taxpayer's family above the poverty level. the treatment of dependent exemptions as a preference may be increasingly politically difficult in the face of vociferous complaints from those very large families not in the upper income brackets who find themselves unexpectedly forced to pay the amt because of a combination of disallowance of other preferences and the loss of personal exemptions. clearly, there are arguments that the normatively correct tax policy should not favor very large families or that congress found it politically expedient to appear to favor such large families but through the amt demonstrated that it wanted to limit that favoritism, but those arguments are beyond the scope of this article.'96 once the decision has been made to increase the minimum exemption to cover necessities for large families through the regular tax system by means of personal exemptions and other measures, it appears irrational to take the opposing position for alternative minimum tax purposes. when the decision to support large families through the regular tax system has also been publicly touted by congress as demonstrating a significant commitment of overall federal tax policy to protection of families, 195. this will only affect very large families, since the current amt exemptions easily exceed the sum of the standard deduction and personal exemptions for typical families of two or three children. 196. for instance, providing additional deductions to taxpayers according to the number of children they have provides an incentive to taxpayers to have large families at the expense of all other taxpayers with smaller families, raising equity concerns. furthermore, taxpayers with larger families impose a correspondingly larger burden on public facilities, such as schools, roads, libraries, and hospitals, and potentially may require additional amounts of welfare support, raising concerns about appropriate allocation of resources. [vol. 6:9 congress fiddles while middle america burns it adds to taxpayers' confusion about how the tax system is supposed to affect them if that commitment vanishes without any supporting rationale. something that is considered vitally worthy of support in one system is merely treated as irrelevant in the other. this type of inconsistency of policy undermines the perception of fairness that is important to a self-assessment system. '97 this discussion suggests that the inconsistent treatment of the "ability to pay" deductions generally complicates the tax system, renders it less transparent, and raises basic equity and compliance concerns. the "push/pull" of standard deductions and personal exemptions leaves neither system's apparent priorities satisfied. whatever the policy decision, it appears that it would be appropriate to harmonize the amt with the regular tax system on this issue. part v will consider how this might be done. 2. state and local taxes state and local taxes present another, somewhat similar dilemma, but there may be stronger countervailing arguments to the inconsistency argument. although taxpayers may deduct state and local property and income taxes (or sales taxes in lieu of income taxes, but only in 2004 and 2005) for regular tax purposes,' the deduction is disallowed in full for amt 197. similar arguments can be made about the lack of separate rate brackets and exemption amounts under the amt for taxpayers who qualify for "head of household" status under the regular tax. the status recognizes that single taxpayers with dependent family members have additional income needs to maintain that household compared to singles without those responsibilities. see, e.g., american bar association section of taxation, report to the house of delegates on the alternative minimum tax (may 7,2004) [hereinafter, aba amt report], at http://www.abanet.org/tax/home.html (last visited july 15, 2004). 198. irc §§ 164(a)(1)-(3) (state and local property and income tax deduction), 164(b)(5)(a), (i) (state and local sales taxes deductible in lieu of state and local income taxes; deduction only available in 2004 and 2005), 67(b)(2) (tax deduction not a miscellaneous itemized deduction). sales taxes were made deductible in lieu of state and local income taxes in 2004, but that deduction is set to expire after 2005. american jobs creation act of2004, pub. l. no. 108-357, § 501 (a), 118 stat. 1418, 1520. on february 2, 2005, 59 representatives, most of whom are from texas or florida, introduced h.r. 519, which would make the temporary sales tax deduction permanent. 151 cong. rec. h347 (feb. 2, 2005). the discussion in this section assumes that the temporary sales tax deduction will expire as scheduled at the end of 2005 and thus refers only to property and income taxes as being deductible and treats sales taxes as not deductible for purposes of the hypotheticals. ifthe sales tax deduction provision were made permanent, all taxpayers would be treated equally under the regular tax system regarding their state and local taxes i.e., it would not matter whether a taxpayer's state of residence chose to raise revenues primarily through income or sales taxes. further, because sales tax deductions would be disallowed under the amt, see infra note 199, the likelihood of 2004] florida tax review purposes.'99 critics complain that the treatment of state and local taxes as an amt preference item results in disparate treatment of taxpayers, depending on the happenstance of their state of residence and the attitude of that state towards taxation of its citizens. all else being equal, residents of high-tax states such as new york or california are more likely to pay tax under the amt system than residents of low tax states such as texas or florida."' taxpayers who live in states with low property taxes and no state income taxes usually will enjoy their full income after federal taxes, while taxpayers who live in a state with high property taxes and high state income taxes often will pay tax on the income that is paid to the state due to the amt.2"' this appears, at least at first glance, as an inequity between taxpayers based on pure geographical happenstance, and one that evokes the argument against incoherence that i have suggested should be given weight in the case of the ability-to-pay deductions.0 2 it behooves us to consider, however, whether the result in this case is genuinely unfair or rather a reasonable concomitant of our federal system, under which states are entitled to (and do) raise revenues by different means, and taxpayers who move from one state to another are subject to different tax regimes and receive correspondingly different levels of provision of public goods in return for taxes paid. the state and local tax deduction should be examined from the various perspectives that help inform our concept of distributive justice. one approach is to consider whether the tax payment corresponds roughly to benefits received. if it does, then the taxpayer can be viewed as effectively purchasing consumption of public goods from the government. a number of commentators agree that state and local taxes a taxpayer owing tax under the amt would not be dependent upon whether she lived in an incomeor sales tax-oriented state; rather, it would be determined by whether the taxpayer lived in a lowor high-tax state, regardless of the particular tax regime used by the state. the arguments about the leveling effect of the amt would therefore retain viability even if the sales tax deduction were made permanent. 199. irc § 56(b)(1)(a)(ii). if a taxpayer elects to deduct state and local sales taxes, the deduction is treated the same as a deduction for state and local income taxes, irc § 164(b)(5)(a)(i), and is therefore disallowed in full for amt purposes, irc § 56(b)(1)(a)(ii). 200. see, e.g., feldman, supra note 122 (providing map illustrating high and low tax states that may result in differential applicability of amt); kim rueben & len burman, deductibility of state and local taxes, 106 tax notes 363,363 (jan. 17,2005) (stating that one-fifth of returns that take state and local tax deductions, and 29% of all state and local tax deductions in dollar amount, are in new york and california). 201. see, e.g., rueben & burman, supra note 200, at 363 (stating that the deduction for state and local property and income taxes is the largest preference item under the amt); rebelein & tempalski, supra note 129, at 38-41 (discussing difference in levels of state taxation and effect on amt taxpayers prior to the enactment of the various bush tax cuts). 202. see supra note 196 and accompanying text. [vol. 6:9 congress fiddles while middle america burns should not be deductible if they are "closely related to the public services that individuals receive."2 3 in this view, state and local taxes are not a cost of earning income but rather a component of personal consumption. second, the distributive justice goal of moving towards egalitarian distribution of resources supports, at least in many circumstances, the traditional tax policy of horizontal equity i.e., equal treatment of similarly situated taxpayers. picture two taxpayers, one a resident of washington state and the other a resident of oregon. both own their homes and earn annual salaries of $55,000. assume that the two have identical consumption habits and pay the same amount of property tax on their homes. washington has no income tax, but does utilize state sales taxes. oregon has an income tax, but does not utilize state sales taxes. under our assumption that the temporary sales tax provision is indeed temporary (and therefore disregarding it for purposes of this hypothetical), the washington taxpayer will pay more regular federal income tax than the oregon taxpayer, because the state sales taxes paid are not deductible. the oregon taxpayer will have a lower regular tax bill because of the deductibility of oregon's income taxes. compared with a similarly situated new york state resident who is subject to high income, property, and sales taxes, our two subjects both pay lower state taxes and higher federal taxes, while the new york state resident pays high state taxes but gets a substantial tax benefit that lowers his federal tax bill. these taxpayers who all have similar economic profiles are ultimately treated quite differently under the regular tax system because of the multiplicity of possibilities for state taxation (various combinations of high or low state income taxes with high or low state property taxes with high or low state sales taxes). in other words, disparate treatment of taxpayers from different states is a norm in the regular tax system itself (whether or not state sales taxes are deductible) and hardly argues for duplicating the regular tax system in the amt system in order to achieve greater fairness. 203. see generally louis kaplow, fiscal federalism and the deductibility of state and local taxes under the federal income tax, 82 va. l. rev. 413, 417, 422 (1996) (providing overview of commentary and generally arguing against deductibility of state taxes where there is a correlation between taxes paid and benefits received). kaplow provides a thorough discussion of the various positions on deductibility of state and local taxes for the regular income tax system. there is no consensus. while a number of commentators agree that local taxes relate to benefits received and should not be deductible, others criticize this approach. see, e.g., brookes d. billman, jr. & noel b. cunningham, nonbusiness state and local taxes: the case for deductibility, 28 tax notes 1107 (1985); edward a. zelinsky, the deductibility of state and local taxes: income measurement, tax expenditures and partial, functional deductibility, 6 am. j. tax pol'y 9 (1987). a related theory argues that tax effects are essentially capitalized in prices, so that taxes and the price adjustment perfectly measure benefits received. see, e.g., bruce w. hamilton, capitalization of intrajurisdictional differences in local tax prices, 66 am. econ. rev. 743 (1976) (setting forth the capitalization theory). 2004] florida tax review now assume that our washington and oregon residents each make $250,000 a year and are potentially liable for amt tax. the oregon resident must determine amt liability without taking into consideration the oregon income taxes. inclusion of oregon income taxes as a preference item may well result in the oregon resident's having a tentative amt liability. in this case, the amt disallowance of state income tax deductions levels the playing field between the two residents. the washington resident will pay more regular tax, but the oregon resident will pay an additional amt amount. instead of creating a disparity, the amt treatment of state taxes as a preference item in this case reduces a disparity created in the regular tax system. thus, fairness appears to weigh in at least somewhat on the side of non-deductibility of state taxes for amt purposes. let us carry the examples with hypothetical state residents one step further (again assuming non-deductibility of state sales taxes). assume two residents of a state with an income tax and relatively high real and personal property taxes. the first resident (let's call him worker) has a salaried income, a modest home, and one modest car. he drives a short distance to work at the local donut bakery. the second resident (let's call him wealthy) has most of his income in tax-exempt interest (a portion of which is from qualified private activity bonds) and unrealized appreciation of stock, but he receives as much in dividends as worker receives in salary. wealthy has three different homes a luxurious principal residence in the city inherited from his parents, a vacation home at a ski resort (also inherited), and a vacation home at the beach (purchased by wealthy). there is a luxury sedan at each location and a helicopter for rapid transit between sites. wealthy's use of each of these properties depends to a great extent on the viability of the state government in maintaining order on the roads and airways, ensuring stability of the financial systems, and other aspects. worker pays a relatively modest property tax on house and car let's say $2,000 annually. wealthy pays considerable taxes on his numerous real and personal properties let's say $75,000 annually. both worker and wealthy are able to deduct their property taxes for regular tax purposes. as a result of the numerous state tax deductions and other preferences (e.g., the exclusion for tax-exempt bond interest), wealthy pays little or no regular tax on his economic income, while worker pays a significant regular income tax. neither can deduct their state taxes for amt purposes, and wealthy is therefore required to pay some amt amount." in this case, the amt takes away, at least in part, the 204. see kirk j. stark, fiscal federalism and tax progressivity: should the federal income tax encourage state and local redistribution?, 51 ucla l. rev. 1389, 1414 (2004) (noting that high-income taxpayers receive the most substantial subsidy from deductibility of state taxes under the regular tax system and discussing the resulting "plutocratic bias," as vickrey called it); rueben & burman, supra note 200, at 363 (reporting that "the [state and local income property tax] deduction most benefits the affluent: more than half of the deductions were claimed by the 8 percent of taxpayers [vol 6:9 congress fiddles while middle america burns subsidy to excess property ownership provided in the regular tax system and puts wealthy and worker on a more level footing for federal tax purposes.0 5 this example makes the case even more strongly that state taxes may indeed be correlated with benefits received, so that the expense appears much more a personal consumption item than a mere involuntary cost similar to costs of earning income.6 from a redistributive viewpoint, it appears appropriate that those who consume more (i.e., receive more of the benefits of the stable state environment) should not receive an additional benefit in respect of that consumption against their federal taxes. as for the contribution to complexity of a preference for state taxes, there are mixed arguments. clearly, any difference between the amt and the regular tax system is a complicating factor per se. the question is whether the degree of added complication is merited, given the other benefits. to answer that, it is worth comparing the amt solution to the alternative of limiting the state and local taxes preference more stringently in the regular tax system through the use of income phaseouts, ceilings on deductibility or with incomes exceeding $100,000 in 2002"). rebelein and tempalski report that the state and local tax deduction is generally the largest amt preference for high income amt taxpayers, which they find "not too surprising, because state and local taxes paid generally increase as income goes up." rebelein & tempalski, supra note 129, at 31. they find that "[fror amt taxpayers with agis greater than $200,000, state and local taxes paid are the largest preference for over 75 percent of these taxpayers in all years." id. at 34. 205. this is more clearly shown by adding numbers to the example. suppose that worker has no children, earns a $50,000 salary, and takes the standardized deduction (because he has no itemized deductions other than his property taxes). worker would have taxable income in 2005 of $41,800 ($50,000 $5,000 (std. deduction) $3,200 (personal exemption)) and owe $7,115 in tax. suppose that wealthy has no children, has $100,000 in tax-exempt interest ($40,000 of which is from qualified private activity bonds) and $50,000 in dividends, and elects to itemize because his property taxes exceed the standard deduction. wealthy would have no taxable income and thus owe no regular tax in 2005 because his itemized deductions ($75,000) and personal exemption ($3,200) exceed the amount of dividends ($50,000) he received. wealthy, however, would be subject to the amt because his ami of $90,000 ($50,000 dividends + $40,000 from qualified private activity bonds) exceeds the amt exemption amount of $40,250, resulting in a taxable excess of $49,750. the lesser of(1) taxable excess, (2) adjusted net capital gains, or (3) the maximum amount taxed at the regular tax 10% or 15% rates less ordinary income is taxed at the preferential 5% capital gains rate for amt purposes. see h.r. conf. rep. no. 108-696 (2004), reprinted in 2004 iskcon 1029. accordingly, $29,700 of the $49,750 would be taxed at a 5% rate and the remainder of $20,050 would be taxed at a 15% rate. wealthy would owe amt of $4,492.50. wealthy has three times the economic income of worker, but even with the amt has a tax liability of only about two-thirds that of worker's. this example further illustrates the way the failure of the amt to treat capital gains as a preference limits its ability to balance the tax burdens of worker and wealthy. see infra part v.a.7. 206. see, e.g., kaplow, supra note 203. 2004] florida tax review a percentage of agi test. retaining the amt for this purpose has several pragmatic advantages. first, the amt is a pre-existing condition to any tax legislation: it is generally easier for congress to leave something as it is than to create it anew. except to the extent that lobbyists are able to create concern among ordinary taxpayers about a tax that has not yet struck them, ordinary taxpayers will not demand of their representatives in congress that they act to change the amt, especially not in ways that are intended to benefit primarily the better off. second, if the amt is limited to taxpayers with gross income at a high-enough threshold to ensure that ordinary taxpayers are not brought within its grasp, as recommended here, ordinary taxpayers are in fact advantaged by not having to deal with the complexity that would be added by additional phaseouts and ceilings in the regular tax system. the amt moves the complications to the alternative system that is intended to nab more sophisticated taxpayers for whom the complexity of provisions is of less concern from a tax policy standpoint. third, the amt also simplifies the calculations necessary for those sophisticated taxpayers, who merely aggregate the disallowed preferences and then recalculate a tax rate. this appears to be a simpler process than requiring different ceilings and income phaseouts for different preferences, which would likely be necessary in order to capture the appropriate level of "excess" preference under a phaseout mechanism in the regular tax system. in summary, the amt treatment of state and local taxes is clearly inconsistent with the treatment of state taxes under the regular tax. that is the inherent result of treating any regular tax deduction as an amt preference. the amt treatment also unambiguously leads to disparate amt results for taxpayers depending on their geographic location, since different states in the federal system exercise their powers to tax in different ways. when the treatment of state and local taxes is viewed in the larger context, however, it appears that the amt preference for state taxes acts in some ways as a leveler rather than a gap creator and corresponds to basic notions of fairness in a federal system, in that those who pay higher state taxes are likely to receive correspondingly greater state benefits and the amt acts in this way as a redistributive force. the choice between these policies should therefore be made on the grounds of the ultimate goal expected to be achieved. in part v, i recommend a modest adjustment to the current treatment of state and local taxes for amt purposes, in order to reduce inconsistencies between the two systems while ensuring that wealthy taxpayers cannot use their large property holdings as a free pass on the tax system. the overall result of this adjustment should provide greater structural coherence and closer fidelity to the underlying distributional rationale for the amt. [vol. 6:9 congress fiddles while middle america burns 3. medical expenses the amt includes one adjustment that is viewed as particularly harsh and hard to justify, in that it limits medical deductions."0 7 the itemized deduction for medical expenses is limited under the regular income tax to amounts in excess of 7.5% of agi. under the amt, it is further restricted to amounts in excess of 10% of agi.2 °8 the question that must be addressed is whether the additional limitation under the amt is reasonable, given the purpose of the amt and the nature of the medical expense deduction. one could surmise that congress, in limiting medical expense deductions for regular tax purposes, considered ordinary medical expenses to be quintessentially personal expenditures and did not want the tax subsidy provided by a medical expense deduction to discourage the reasonable purchase of private insurance."9 yet certainly congress was concerned that extraordinary medical expenses could be well outside the range of normal insurance coverage and ordinary taxpayers' ability to pay.2"' that is, the allowance of a regular-tax medical expense deduction acknowledges that some personal expenditures can be so large as to require special consideration under the tax system. the limitation on medical expenses sets a 207. see, e.g., william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309 (1972) (arguing that medical expenses should always be deductible); aba amt report, supra note 197, at 8 (noting that the current amt penalizes taxpayers unable to participate in tax-advantaged health savings plans). 208. compare irc § 213(a) (limiting medical expense deduction to amounts in excess of 7.5% of agi) with irc § 56(b)(1)(b) (limiting the deduction for amt purposes to amounts in excess of 10% of agi). 209. see, e.g., house ways & means committee, report on the revenue act of 1978, h.r. rep. no. 95-1445, at 43 (1978), reprinted in 1978-3 c.b. 181,217 (stating that "[t]he primary rationale" for the medical expense deduction is to cover "extraordinary medical costs those over a floor designed to exclude predictable, recurring expenses"); shaviro, supra note 9, at 1465 (discussing view that the medical expense deduction amounts to quasi-insurance that may be both unnecessary and socially costly); louis chapleau, the income tax as insurance: the casualty loss and medical expense deductions and the exclusion of medical insurance premiums, 79 calif. l. rev. 1485 (1991) (same). 210. see, e.g., house ways & means committee, report on the revenue act of 1978, h.r. rep. no. 95-1445, at 43 (1978), reprinted in 1978-3 c.b. 181, 217 (describing the revision to the deduction for medical expenses and indicating that "[t]he primary rationale for allowing an itemized deduction for medical expenses is that 'extraordinary' medical costs those over a floor designed to exclude predictable, recurring expenses reflect an economic hardship, beyond the individual's control, which reduces the ability to pay federal income tax"). the placement of the line for extraordinary medical expenses has changed over time. at the time of the consolidation of medical expense deductions in 1978, taxpayers were permitted to deduct expenses in excess of 3% of their adjusted gross incomes. id. 2004] florida tax review threshold at a rough-justice line drawn to ensure that deductions are permitted only for genuinely extraordinary medical situations. although any line-drawing in this situation is somewhat arbitrary, medical expenses that exceed 7.5% of agi appear sufficiently substantial to fall within this category. what, then, could be the justification for limiting those expenses even further for amt purposes? once an arbitrary line has been drawn to distinguish "ordinary" medical expenditures from those that are sufficiently substantial to merit some consideration in the tax system, why would it be reasonable to limit those deductions for any reason? one argument for increasing the limitation under the amt is that it takes away from wealthy taxpayers some portion of what otherwise may be a subsidy for "luxury" health care that is beyond the cost of care that an ordinary taxpayer can afford. congress may have noted, for example, that the highest income taxpayers take significantly higher medical expense deductions, when they do itemize for those expenses, than other taxpayers."' under this argument, congress could be considered to have limited wealthy taxpayers with excessive medical expenses from milking the system for deductions not genuinely merited. congress could have considered it inappropriate to subsidize the wealthy taxpayer's ability to select the best of care at the finest facilities with the highest costs, when similar treatment is beyond the reach of ordinary taxpayers. congress could also have considered it likely that the wealthy can arrange to have facilities prescribed for medical purposes that may not be justified if examined too closely."2 under this logic, an increase in the threshold for deductibility might serve as a safeguard to ensure that the government is not merely subsidizing the wealthy taxpayers' ability to enjoy luxury medical care. the problems with this argument are threefold. the increased threshold simply discounts a portion of any medical bill, whether a luxury bill or not. the wealthy may continue to purchase luxury care and continue to utilize the medical deduction to eliminate tax liabilities, if their bills are a substantial enough portion of their incomes. taxpayers with chronic medical 211. see, e.g., ria, latest average itemized deductions and other tax states based on preliminary irs data, 51 fed. tax. weekly alert no. 09 (mar. 3, 2005) [hereinafter, tax stats] (computing average deductions from preliminary irs statistical data that show that taxpayers in the $200,000 and up income category had average medical expense deductions in 2003 of $25,719, while taxpayers in income groups below $100,000 had average medical expense deductions of $5,454 or less). 212. ferris v. comm'r, 582 f.2d 1112 (7th cir. 1978) (denying deductibility as medical expense of much of the costs of constructing luxurious pool room, including gold faucets, as not essentially medical expenses). another argument is that the slightly lower marginal amt rate would support a slightly higher amt deduction to maintain rough equivalence of the exemption. if this were the rationale, however, all deductions permitted under both systems should be similarly adjusted. [vol. 6:9 congress fiddles while middle america burns problems and insufficient insurance may find themselves increasingly caught by the amt as medical expenses continue to escalate faster than other expenses. the increased threshold is thus a very crude instrument for disallowing deductions for luxury medical care. at the same time, the increased threshold operates to penalize with higher tax bills those who have extraordinarily high medical bills not covered by health insurance. it thus appears to strike hardest at those who most need the intended benefit of the deduction. furthermore, many higher-income taxpayers are also the ones able to participate in tax-advantaged health savings plans that entitle them to reimbursement for medical expenses up to the ceiling for set-asides, without certain limitations otherwise applicable to medical expense deductions."3 these three factors suggest that there is not a convincing rationale for inconsistency between the regular tax and amt systems. once congress concluded that medical expenses that exceed a certain percentage of a taxpayer's agi should be deductible for regular tax purposes in order to alleviate this burden, then that amount should be deductible for amt purposes as well. part v incorporates this conclusion in the recommendations for amt reform. e. accidental taxpayers the press has paid considerable attention to two groups of taxpayers who may become subject to the amt because of an unusually large amount of income received within one taxable year. one group is comprised of employees who exercise incentive stock options (isos) to buy stock at a time when the stock has a very high fair market value relative to its purchase price but do not sell the stock until later when the fair market value has declined substantially. the second group is comprised of litigation plaintiffs who seek a damages remedy (e.g., a claim in a non-physical personal injury lawsuit related to employment discrimination or similar violations) and whose award includes an amount payable to their attorneys in respect of contingent attorney fees. these situations involve extraordinary items that in at least some sense may be considered "phantom income," in that the income (stock gain or attorney fee award) is not necessarily accompanied by an increase in liquidity sufficient to pay the amt tax that is due for the taxable year of the fee award or stock option exercise. 1. incentive stock options various commentators (and taxpayers) have raised concerns regarding the amt impact on iso recipients who unwittingly find 213. irc § 125. see also irc §§220, 223 (archer msa and health savings accounts). 2004] florida tax review themselves subject to what appears to be a confiscatory amt liability.214 the amt liability arises from inclusion in amt income of gain from the iso exercise (i.e., the excess of the fair market value of the purchased stock on the date of exercise over the exercise price under the isos).215 ordinarily, an employee must include any bargain purchase in income as ordinary compensation for regular tax purposes, but iso gain is excluded from this requirement.216 a recipient must retain the stock acquired on exercise of an iso for one year after exercise (and must not sell within the two-year period after the option grant) in order for the stock purchase to qualify for iso treatment. otherwise, the option exercise will be taxable under section 83 rather than section 421.27 if a recipient who exercises isos has a high regular income with various amt preferences or if the gain on exercise of the isos is substantial, there is likely to be an amt liability as a result of the iso exercise. in unusual cases, if a recipient who exercises isos does not sell some of the stock received before the end of the taxable year of exercise, he or she may have insufficient liquid assets to pay the amt tax when it 214. see, e.g., francine j. lipman, incentive stock options and the alternative minimum tax: the worst of times, 39 harv. j. on legis. 337, 339-42 (2002) (explaining the treatment ofisos and describing the advocacy group, reform amt, and its efforts to gamer support in congress for revisions to the iso provisions); tim carlson, letter to sen. grassley (oct. 2, 2003) (available on file with the author) (arguing that iso recipients should be relieved of any "excessive tax prepayments based on phantom 'value' of stock," even in those cases where they hold the stock for some time after exercise before a decline in value). 215. see irc § 56(b)(3) (eliminating the section 421 exclusion for amt purposes). 216. compare irc § 61 (a) (requiring inclusion in income ofany compensation received from an employer, unless specifically excluded by another provision) with irc § 421 (a) (excluding gain from the exercise of isos from income for purposes of the regular tax and generally taxing appreciation upon sale of stock at long-term capital gain rates). 217. in other words, a disqualifying early disposition converts the stock options into nonqualified options. irc § 421(b). under § 83, the key question then becomes whether the option had a readily ascertainable value at grant. if so, the value of the option is treated as compensation income at the time of the grant, exercise is not a taxable event, and upon disposition of the stock the recipient has capital gain income or loss (which will be long-term if the stock is held for the long-term holding period after exercise of the option). see regs. § 1.83-7. if not (and there are no restrictions on the stock acquired on exercise), then the bargain part of the share purchase is included as compensation income at exercise, and a later disposition will result in shortor longterm capital gain depending on the holding period. if the stock is restricted, no income will be recognized until the restrictions are removed, unless the holder makes a § 83(b) election. id. [vol. 6:9 congress fiddles while middle america burns becomes due.18 assuming the amt liability is paid, the employee will have a minimum tax credit that can be used, subject to limitations, against the taxpayer's future regular tax liabilities.19 if the taxpayer sells the stock at a loss after the year of exercise, however, the amt capital loss can only be carried forward. such a capital loss will be recouped only if the taxpayer incurs amt liability in future years against which the loss may be offset. for taxpayers who lose their jobs at the same time that stock purchased with isos declines in value (as in the case of employees with stock options who exercised options and then lost gains and jobs with the bursting of the dotcom bubble), there may be limited opportunity in the future to use the capital loss. as other commentators have noted, the case for eliminating amt liability for taxpayers who are subject to the amt because of significant bargain gains in stock purchased under isos is not a sympathetic one, in spite of the stories of taxpayers for whom this provision has yielded harsh results.22° first, recipients, who are predominantly top executives and not rank-and-file employees,221 have actual economic services income from the exercise of isos.222 as in any case when a taxpayer has property with significant appreciation, newly made millionaires are able to benefit by monetizing the gain through borrowing, gaining access to high-status social circles, and otherwise enjoying the fruits of the "excess" fair market value of their stock purchases. they can afford sophisticated tax advisers, and they have, at the time of their stock purchase, the ability to dispose of some of 218. see, e.g., lipman, supra note 214, at 339 (noting that "[i]n many cases, the amt consequences of iso exercises took unsuspecting employees by surprise and caught them without sufficient cash to pay their amt on april 15, 2001"). 219. irc § 53 (providing a credit for the aggregate excess of amt over regular tax for past years against regular taxes in future years when the regular tax exceeds the amt). as a result, the amt operates to accelerate the tax liability associated with the exercise of the option from disposition of the stock to the exercise date of the option. 220. see, e.g., lipman, supra note 214, at 360-61 (describing stories on the reformamt web site at www.reformamt.com); tim carlson, letter to sen. grassley (oct. 2, 2003) (complaining about "devastating effects that the amt is having on many american families who exercised isos in 1999-2002" and proposing large settlements to reduce the "unintended and punitive" amt taxes assessed on those families, as well as legislative reforms to provide "permanent relief' for "taxpayers who have paid unfair and excessive tax rates"); tully, supra note 9 (reciting, among others, the story of bill simmelink, who exercised isos for stock worth $6.5 million on which he paid $1.7 million in taxes, but later found that his wealth had shrunk when his stock's value plunged to $1.8 million). 221. see, e.g., david leonhardt, option math: why so many to so few?, n.y. times, feb. 16, 2003, at 3-1 (reporting that the 250 biggest options-granting companies employ an average of 69,000 people but give options primarily to a few top executives, with only about 1.7% of all private sector workers receiving options). 222. iso recipients would not exercise the options unless there were excess value in the shares. 20041 florida tax review their shares for liquidity purposes and to pay higher tax liabilities.223 furthermore, iso recipients who may be subject to amt liability because of their option exercise are not disadvantaged compared to recipients of nonqualified option grants who are required to treat the entire amount of the bargain gain as compensation income for amt and regular tax purposes. congress appropriately decided to limit the extent of the tax boon to iso recipients, by imposing fairly stringent conditions on iso treatment and by disallowing the iso benefit for amt purposes. recipients have little grounds for demanding that their stock be treated in an even more advantageous manner.224 as shaviro notes, this sort of congressional rationing of preferences may actually "increase efficiency relative to the only politically available alternative, by reducing the overall allocative response to the preference."'225 moreover, the concern that some recipients may be unsophisticated and unaware of the potential tax liabilities associated with the excess value can be addressed relatively simply by requiring companies that award isos to disclose, both at the time of award and upon exercise, the potential application of the amt on exercise.226 finally, repeal of the iso preference item would put iso recipients in an especially privileged position in comparison with ordinary investors whose stock purchases made with after-tax dollars suffer substantial depreciation. those investors have no remedy other than the use of the capital loss against capital gains, if any (and up to $3000 per year of ordinary income): they are not permitted to recoup their original tax payments on the invested dollars because of the loss.227 the problem of iso options is, on closer examination, an example of the inappropriate demonization of the amt. taxpayers who have acquired considerable wealth through iso options and yet avoided much tax liability 223. see lipman, supra note 214, at 369-70 (discussing the various planning strategies that iso recipients can undertake to lessen their tax liabilities); stanley r. finkel & kelly g. besaw, tax-efficient strategies for exercising compensatory stock options, july 2003 practical tax strategies, at http://checkpoint.riag.com (last visited july 8, 2004). 224. see lipman, supra note 214, at 368-70 (making a similar argument for retaining an amt preference for the gain on iso exercise); shaviro, supra note 9, at 1461 (suggesting that congress may be "willing to ration [a given tax preference that has undesirable allocative effects] via inclusion in the amt" even though "unwilling to reduce it directly"). 225. shaviro, supra note 9, at 1461. 226. in an earlier article, i suggested that there were a number of areas in which cooperation between the securities exchange commission (sec) and the irs could be beneficial to the purposes of both organizations. see linda m. beale, putting sec heat on audit firms and corporate tax shelters: reducing tax risk with sunshine, shame and strict liability, 29 j. corp. l. 219, 266 (2004). this is another example where cooperation between the agencies could help further their purposes and yield substantial benefits to ordinary taxpayers. the sec could require general disclosure about the potential applicability of the amt to isos, as part of a public company's reporting obligation. the irs could require similar information reporting to iso recipients upon exercise of an option. 227. see lipman, supra note 214, at 371. [vol 6-9 congress fiddles while middle america burns under the regular tax system are in fact members of the group originally targeted by the amt they have substantial economic wealth but, unlike similarly situated taxpayers receiving nonqualified options, they have been able to take advantage of a tax loophole for isos to avoid paying any tax on that wealth. the more substantial the bargain gain enjoyed by iso recipients, the more appropriate is amt liability. the fact that the wealth may be lost without ever being converted to liquid assets is not unique to these taxpayers and does not merit any unique saving provision. the only problem represented by the amt preference for iso grants lies in the complicated nature of all tax determinations regarding option exercises, whether for amt or regular tax purposes, and the corresponding lack of transparency for onetime grantees who may not be sufficiently aware to avail themselves of sophisticated advisers before amt applicability is determined. to the extent that transparency can be improved by amt and regular tax reforms, this problem can be reduced. amendments to provide further tax advantages to iso recipients do not appear justified. 2. contingent attorney fees in contrast to the case for iso recipients, a more sympathetic amt situation involves successful plaintiffs in lawsuits who owe amt because of a lump sum litigation award.22 the issue arises because, as the supreme court recently held, a successful plaintiffs taxable income includes the entire amount of her award, including the portion that is paid to her attorney as a contingent fee.229 the plaintiff's payment of her attorney's fees is an expense, but generally is considered to be deductible only as a miscellaneous itemized deduction (limited to those deductions in excess of 2% of adjusted gross income).23 under the current amt rules, miscellaneous itemized deductions are treated as a "tainted" preference and therefore not allowed for amt purposes.23' the combination of these rules may cause a plaintiff to 228. see generally gregg d. polsky, a correct analysis of the tax treatment of contingent attorney's fee arrangements: enough with the fruits and trees, 37 ga. l. rev. 57 (2002) [hereinafter polsky, fruits and trees] (describing the amt trap for litigation plaintiffs); gregg d. polsky, the contingent attorney's fee tax trap: ethical, fiduciary duty, and malpractice implications, 23 va. tax rev. 615 (2004) (discussing the "trap" and the various legal issues it engenders); brant j. hellwig & gregg d. polsky, litigation expenses and the alternative minimum tax, 6 fla. tax rev. 899 (2004) (discussing the "trap," the reasons it is frustrating, and implications of the trap for plaintiffs, their lawyers, defendants, and the courts). 229. comm'r v. banks, 125 s. ct. 826 (2005). 230. see id. at 830 (noting that respondents could have treated the contingent attorney fees as miscellaneous itemized deductions subject to the ordinary requirements of irc §§ 67-68). 231. irc § 56(b)(1)(a)(i); see also banks, 125 s. ct. at 830 (noting that treating the contingent attorney fees as a miscellaneous itemized deduction "would have been of no help to respondents" because the amt "does not allow any miscellaneous itemized deductions"). 2004] florida tax review have a large tax payable on the portion of the award paid to the attorney.232 the resulting amt liability may even exceed the recovery allocated to the plaintiff by a substantial amount.33 232. consider a hypothetical developed by roberta mann in the course of the aba task force discussions, involving taxpayer who in 2005 is awarded $450,000 in a false imprisonment suit and pays a 33 1/3% contingent attorney's fee of $150,000. taxpayer has. a full-time job for which he receives a salary of $50,000 in 2005. taxpayer would owe an additional $32,720 on his 2005 tax return because ofthe amt's treatment of the miscellaneous itemized deduction as a "tainted" tax preference, as follows: regular tax determinations: salary $50,000 judgment $450,000 agi $500,000 attorneys fees $150,000 § 67(a) elimination of portion corresponding to 2% agi ($10,000) resulting § 212(1) deduction before phaseout $140,000 § 68 phase out of itemized deductions [reduced by lesser of 80% ($112,000) or 3% of agi over $145,950 (2005 threshold)] $500,000 $145,950 = $354,050 x 3% =($10622) applicable § 212(1) deduction after phaseout $129,378 agi $500,000 itemized deductions ($129,378) taxable income $370,622 regular tax liability $103,780 amt determinations: §55(b)(2) amt income (amti) $500,000 [taxable income as adjusted by §§ 56, 58 and increased by tax preference items in § 57; thus no miscellaneous itemized deduction § 56(b)] § 55(d) exemption amount (joint return before phaseout) $58,000 § 55(d)(3) amti phase out of exemption amount [reduced by 25% of excess of amti over $150,000; $500,000 $150,000 = $350,000 x 25% ($87,500) resulting §55(d) exemption amount 0 §55(b)(1)(a)(ii) taxable excess $500,000 §55(b)(1)(a) tentative tax 26% of taxable excess up to $175,000 $175,000 x 26% $45,500 plus 28% of taxable excess over $175,000 $325,000 x 28% $91,000 total amt (assuming no credits) $136,500 233. see, e.g., alexander v. irs, 72 f.3d 938 (1st cir. 1995) (indicating that the plaintiff/taxpayer was required to pay taxes of $54,000 on a recovery of $5,000 after costs and attorneys' fees); adam liptak, tax bill exceeds award to officer in sex bias [vol. 6:9 congress fiddles while middle america burns litigation of these issues resulted in a split in the circuit courts on the question of whether contingent fees paid out of a taxable damage award or settlement are excludible from gross income or includible in gross income and deductible only as miscellaneous itemized deductions."' both sides sometimes analyzed the strength of the attorney's claims to the fee under the applicable state attorney lien law: courts that found the income excludible generally found that the state lien statute grants the attorney property interests in the claim.235 another argument for exclusion that has appeared in the commentary suggests that attorney's fees should be capitalized as basis in the plaintiff's cause of action and thus reduce the amount realized.236 two recent events a legislative act and a supreme court decision added some much needed clarity to the issue. in october 2004, congress passed the american jobs creation act of 2004 (ajca),237 which permits a successful plaintiff to take an above-the-line deduction for the portion of an award that is attributable to attorney fees if the award is in connection with any action involving either a claim of "unlawful discrimination" (defined as an act that is unlawful under one or more of a number of specifically enumerated laws that provide for employment-related claims) or a claim case, n.y. times, aug. 11, 2002, at 1-18 (reporting that plaintiff-police officer won a $300,000 award and almost $1 million in attorney's fees and costs in a sex discrimination suit, but faced a tax bill that was $99,000 larger than her award); hellwig & polsky, supra note 228, at 900 (stating that the adverse consequences of the amt trap generally are severe). see also laura sager & stephen cohen, how the income tax undermines civil rights law, 73 s. cal. l. rev. 1075, 1078 (2000) (indicating that such a tax liability undoes the intended remedy of the civil rights laws). 234. compare raymond v. united states, 355 f.3d 107 (2d cir. 2004) (including attorney fee awards in income); hukkanen-campbell v. comm'r, 274 f.3d 1312 (10th cir. 2001) (same); kenseth v. comm'r, 259 f.3d 881 (7th cir. 2001) (same); baylin v. united states. 43 f.3d 1451 (fed. cir. 1995) (same) with davis v. comm'r, 210 f.3d 1346 (1 1th cir. 2000) (excluding attorney fee awards from income); cotnam v. comm'r, 263 f.2d 119 (5th cir. 1959) (same). the ninth circuit has gone both ways. compare banaitis v. comm'r, 340 f.3d 1074 (9th cir. 2003), rev'd, 125 s. ct. 826 (2005) with coady v. comm'r., 213 f.3d 1187 (9th cir. 2000). see generally edward a. morse, taxing plaintiffs: a look at tax accounting for attorney's fees and litigation costs, 107 dick. l. rev. 405, 460-73 (2003); robert w. wood, tax treatment of settlements and judgments, 103 tax notes 1134, 1134-35 (may 31,2004) (providing an exhaustive listing of the cases). 235. see generally polsky, fruits and trees, supra note 228, at 74-78 (describing the case law and positions taken by the courts). 236. for the argument and counterarguments, see charles davenport, why tort legal fees are not deductible, 97 tax notes 703 (nov. 4,2002); brant j. hellwig, tax treatment of legal fees: the debate continues, 97 tax notes 1235 (dec. 2, 2002); charles davenport, capitalization of legal fees: professor davenport responds, 97 tax notes 1237 (dec. 2,2002); brant j. hellwig, davenport's capitalization argument fails to convince, 98 tax notes 433 (jan. 20, 2003). 237. pub. l. no. 108-357, 118 stat. 1418. 2004.] florida tax review against the government under the federal false claims act.23 because the amt can arise in other cases (e.g., defamation, intentional infliction of emotional distress, or invasion of privacy),39 the ajca does not completely eliminate the potential for inequity. the irs might also require a plaintiff with multiple claims, only one of which is governed by the new provision, to allocate the attorney fees among the various causes of action.4° in january 2005, the supreme court finally resolved the split in commissioner v. banks, an appeal of cases that held that contingent fees are excludible from gross income.24" ' in a unanimous decision, the court reversed the circuit courts.242 thus, the taxpayers had to include the total amount of their recoveries and could deduct their attorney fees only as miscellaneous itemized deductions (subject to the 2% of agi floor). the court's opinion, however, leaves a number of issues unresolved.243 in particular, the court refused to address the capitalization theory, advocated in an amicus brief by charles davenport,2" because the theory was not considered in the courts below.45 as a result of these changes, the most sympathetic plaintiffs are protected from the loss of their statutory remedy through an above-the-line deduction. plaintiffs in other cases, however, may still find themselves facing a tax bill nearly as large as, and in some cases larger than, their recovery from the litigation. any amt and regular tax reform should resolve this problem. 238. id. § 703(a)-(b), 26 u.s.c. § 62(a)(19), (e) (2004). 239. see robert w. wood, jobs act attorney fee provision: is it enough?, 105 tax notes 961, 961 (nov. 15, 2004) (acknowledging that "employment cases have served as the poster child of inequity" though the problem may arise in other types of cases); hellwig & polsky, supra note 228, at 900 (noting that the amt trap affects many claims, although employment-related claims are the most common). 240. see wood, supra note 239, at 964. 241. 125 s. ct. 826 (2005). the court proceeded with the case, even though it would have come within the ajca change, because the ajca was not retroactively applied to the taxpayers. id. at 831. 242. id. at 829. 243. see generally robert w. wood, supreme court attorney fees decision leaves much unresolved, 106 tax notes 792 (feb. 14, 2005) (analyzing the opinion and the unresolved questions outstanding). 244. see brief of amicus curiae professor charles davenport in support of respondents, comm'r v. banks, 125 s. ct. 826 (2005). capitalization treatment would have the same effect as an above-the-line deduction. 245. banks, 125 s. ct. at 833. [vol. 6:9 congress fiddles while middle america burns v. proposals for amt reform the prior part examined various arguments for repeal of the amt and found them ultimately unconvincing.246 this conclusion does not disregard the flaws of the current amt system, nor does it suggest that an ideal reform of the current tax system would retain an amt. the conclusion is one based on normative values stressing distributive justice and coherence in the context of the current deficit situation, the overall complexity and unfairness added to the tax system by the 2001-2003 tax cuts, and the need to retain whatever tools possible to ensure that higher-income taxpayers actually pay taxes on their economic income to the federal government. given the force of the critiques, what changes can and must be made to address at least the most significant of these flaws? this part proposes a set of amendments to the amt to address the most worrisome flaws, appropriately re-target the amt away from ordinary taxpayers and towards the rich, and make the amt and regular tax more consistent. part v.a sets forth a coordinated program of amt amendments designed to address the valid concerns about the amt while retaining the amt's ability to force higher-income taxpayers to ante up a reasonable share of their income, including incorporation of two additional preference items to better target the amt. part iv.b proposes additional revenue raisers that adjust the regular tax to better harmonize with the amt and, even more importantly, allow the worst of the 2001-2003 tax cuts to lapse into obscurity where necessary to maintain a viable tax regime that does not weigh too heavily on ordinary taxpayers. a. amend the amt this article takes the position that, while flawed, the amt system can play a valuable role in ensuring that higher-income taxpayers cannot elude the tax collector. to serve its purpose, however, the amt system must be revised and made more progressive rather than less so. the revisions proposed here attempt to construct a more coherent system by eliminating complexity for ordinary taxpayers, harmonizing amt and regular tax provisions in respect of determinations regarding basic ability-to-pay amounts, and taking into account the particular situations that give rise to amt liability. 246. see, e.g., shaviro, supra note 9, at 1460 (suggesting that the "actual" rationales underlying the amit are "fundamentally weak" but that there are better arguments related to "distributive and allocational issues" that "might in principle even call for retaining it (albeit perhaps in revised form)"). 2004] florida tax review 1. institution of gross income threshold ordinary taxpayers who do not have substantial economic income should not be subject to the amt, and it should be clear that they are not subject to the amt without their having to work through a worksheet or perform other calculations. the work required of taxpayers who may be (or think they are) on the brink of amt applicability and must deal with amt calculations is a deadweight loss. one simple amendment would eliminate this burdensome task for a large number of ordinary taxpayers establishment of a gross income threshold test that would be indexed for inflation.247 the gross income determination for the test should be based on the "total income" determination for the return, with two adjustments. taxexempt interest on private activity bonds and the bargain value of isos would be added to the return-based gross income to determine gross income for the threshold test.24 if the threshold test were not satisfied, the taxpayer would be automatically exempt from amt liability. at what level should such a gross income threshold test apply to eliminate amt eligibility? it should not be so high that it exempts taxpayers who would pay a significant tax when amt adjustments were taken into account. nor should it be so low that it requires ordinary taxpayers to run the amt calculations. the primary goal of the income threshold test is to provide a convenient and easily determined line for those who on fairness grounds should not have to worry about the amt. various sources provide information about the median or mean earnings per full time worker or per household. the median income per household in the country is approximately $45,000, and the median earnings per person are about $36,000.249 the income threshold for amt applicability should be sufficiently above that level to ensure that the amt cannot reach 247. the test recommended here is similar to, but not the same as, the one recommended by the national taxpayer advocate. see 2003 nta report, supra note 124, at 18. 248. these two are selected because they can be very large in proportion to other income; if they were not included in the income determination, a taxpayer with substantial iso gains could be completely exempted from making the amt determinations. 249. see, e.g., carmen denavas-walt, bernadette d. proctor & robert j. mills, u.s. census bureau, income, poverty, and health insurance coverage in the united states: 2003, current population reports p60-226, at 27, tbl. a-1 and at 4, tbl. 1 (2004), at http://www.census.gov/prod/2004pubs/p60-226.pdf (showing median money income per household of $43,318); u.s. census bureau, current population survey, 2004 annual social and economic supplement, at tbl. pinc-07, at http://pubdb3.census.gov/macro/032004/perinc/toc.htm (showing median earnings for full-time, year-round workers at $35,795 and mean earnings at $46,421); id. at tbl. pinc-08 (showing median earnings per person aged 15 and older at $26,911 and mean earnings at $36,323). [vol. 6:9 congress fiddles while middle america burns into ordinary taxpayer ranks. there are, however, a variety of statistics other than median income that might be used to set the appropriate level. for example, a study before the 2003 tax cuts found that if the 2001 tax cuts were made permanent, 95% of amt taxpayers in 2010 with adjusted gross incomes below $200,000 would face higher marginal rates under the amt than under the regular income tax.25 it would be reasonable to set the threshold so that this number is significantly reduced. the national taxpayer advocate notes that 40% of all amt taxpayers would have been exempt from the amt in 2001 if an adjusted gross income test of $150,000 for married taxpayers and $75,000 for other taxpayers had applied. further, if the original $30,000 exemption amount applicable for the 1970 taxable year were indexed for inflation, the exemption amount would have increased to approximately $146,000 in 2004."' this article has generally taken the approach that the goal should be to protect from amt liability ordinary taxpayers, defined roughly as single taxpayers with $50,000 of income or married taxpayers with $100,000, suggesting that taxpayers with incomes at or below those levels should certainly be exempted from amt liability and from amt calculations. although there is likely not a direct correlation between the threshold and the amt liability, raising the threshold will generally decrease the number of taxpayers with amt liability and increase the cost of amt reform. these various considerations suggest a feasible income threshold might exempt married taxpayers with gross incomes of less than $150,000 (in 2004 dollars) and other taxpayers with incomes of less than $75,000.252 2. treatment of "ability to pay" deductions and exemptions the income threshold test will remove a substantial portion of the problem caused by the amt treatment of ability-to-pay deductions, since the 250. leonard burman, william g. gale, jeffrey rohaly & benjamin h. harris, the individual amt: problems and potential solutions 31 (the urb. inst., tax policy center discussion paper no. 5, 2002), at http://www.brookings.edu/views/papers/ gale/20020918.pdf. see also cbo study, supra note 132, at 3-4 (indicating that 95% of married taxpayers with adjusted gross income between $100,000 and $200,000 would owe amt in 2010, and 90% of taxpayers with income between $100,000 and $500,000, would generally face higher amt rates than regular tax rates). 251. these inflation adjusted numbers were determined using the inflation calculator available on the web at http://www.bls.gov. 252. it is difficult to determine the cost of this change, but the national taxpayer advocates notes that use ofa $150,000 threshold would have eliminated about 40% of taxpayers in 2001 who paid approximately $800 million in amt. 2003 nta report, supra note 124, at 18. lowering the threshold could lower the cost of reform, but the threshold probably should not drop below $100,000 for married taxpayers filing jointly and $50,000 for others (i.e., approximately twice the median earnings for single individuals). 2004] florida tax review group of taxpayers that should most clearly be protected from paying the amt because of a lesser ability to pay will be eliminated from consideration. the arguments for changing the treatment of the standard deduction and personal and dependent exemption because of the inconsistency between the amt and regular tax remain, however, for those who may be just over the threshold income. there are several alternative ways to resolve this problem, at least in theory: (i) increasing the current "one-size-fits-all" exemption amount to a single new amount that can be indexed into the future, (ii) bracketing the exemption amount with different levels for different status taxpayers, or (iii) harmonizing the amt and regular tax by adopting the same personal and dependency exemptions for amt purposes as used for regular tax purposes. the first alternative, increasing the exemption amount, would require a sufficient zero-percent amt bracket for a wide range of typical families (whether made up of a single mom; one child and an elderly parent with higher than usual medical expenses; or a traditional family with one parent earning the family's living, the other a caregiver parent, and two or three young children at home). the exemption amount could again simply be set at the level that it would have been had the $30,000 original exemption amount been indexed for inflation throughout the period since 1970, or about $146,000 for 2004.253 this approach would appear to further the original amt purpose of targeting taxpayers with the highest incomes, but it does so at significant cost and without addressing the inconsistency and added complexity of different exemptions under the regular tax and the amt. the one-size-fits-all solution could still leave large families vulnerable to amt liability, yet may give very small families or single taxpayers inappropriate protection from amt liability. the second alternative, bracketing the exemption amount, would partially resolve the worst problems of a one-size-fits-all exemption amount. it would add considerable complexity, however, and would continue a hardto-justify inconsistency between the amt and regular tax system. accordingly, it appears preferable to harmonize the way the two tax systems provide for a basic standard-of-living exemption amount. this solution should do a number of things. first, the amendment should add a "head of household" status for amt purposes that will duplicate the head of household status for regular tax purposes. second, it should remove the standard deduction and personal exemptions from the amt preference list. for amt purposes, taxpayers would be entitled to the same personal and dependent exemptions (already indexed for inflation) that are permitted for regular income tax purposes. third, it should retain the current regular tax indexed income thresholds for phasing out personal exemptions and apply 253. these inflation adjusted numbers were determined using the inflation calculator available on the web at http://www.bls.gov. [vol. 6:9 congress fiddles while middle america burns the same thresholds to phase-out the exemptions in both systems.54 fourth, taxpayers who elect the standard deduction for regular tax purposes (already indexed for inflation) should be treated automatically as electing the same standard deduction for amt purposes. taxpayers who itemize for regular tax purposes would also itemize for amt purposes, subject to the amt limitations on the specified itemized deductions.255 finally, the income phaseouts for itemized deductions should be retained and should apply for both amt and regular tax purposes.256 this approach reduces complexity and eliminates downward creep, while furthering the tax policy goal of ensuring progressivity by preventing high income taxpayers from avoiding tax altogether. 254. see irc § 15 1(d)(3). the phaseout is currently slated to reduce gradually for taxable years from 2006 to 2009, and to be terminated after 2009. irc § 151 (d)(3)(e)-(f). this proposal would require repeal of that provision. phaseouts are cumbersome, and it may be that neither reinstating the phaseouts nor instituting higher rate brackets applicable to the upper end of the income spectrum is feasible politically. based on the heuristic bias in favor of the status quo, it would appear to be more likely that support could be garnered for reinstating phaseouts. framing of solutions would clearly affect their feasibility. see, e.g., jonathan baron & edward mccaffery, masking redistribution (or its absence) (july 2004), usc l. sch. olin research paper no. 04-5, at http://ssm.com/abstract=528165 (showing that a range of heuristics and biases interferes with people's understanding and support of redistribution and that people generally do not understand the reduction in progressivity that results from tax expenditures and cuts in government services). 255. this means that some taxpayers who itemize for regular tax purposes may find that a significant portion of the itemized deductions is disallowed under the amt. these taxpayers might therefore pay less tax overall if they do not itemize for regular tax purposes, since the standard deduction will be allowed in full for amt purposes. accordingly, itemizing taxpayers for regular tax purposes who may be liable for amt tax will benefit from determining their liability with and without itemizing for regular purposes. this complicates the application vis-i-vis any taxpayer who would otherwise itemize, but that is more appropriate than the current system which forces someone who would otherwise take the standard deduction to do multiple calculations to determine if it would be preferable to itemize solely because of the application of the amt. the latter case defeats the simplifying purpose ofthe standard deduction, whereas the former case appropriately encourages use of the standard deduction and its simplifying assumptions. 256. see irc § 68. the itemized deduction phaseout is currently slated to reduce gradually from 2006 to 2009, and to be terminated after 2009. see irc § 68(f), (g). this proposal would require repeal of those two provisions. the phaseouts raise significant revenue from higher income taxpayers. see, e.g., tax stats, supra note 211 (indicating that "[fjor 2003, 5.2 million higher income taxpayers lost a total of $28 billion of itemized deductions on account of [the section 68] limitation"). 2004] florida tax review 3. indexing amt parameters even those who think that the current amt is serving an important purpose cite the lack of indexation of the amt exemption as one of the most significant problems.257 the proposal here institutes a gross income threshold to eliminate amt liability for ordinary taxpayers, replaces the amt exemption with the already-indexed standard deduction and personal exemptions, and applies the regular tax system's indexed phase-outs to itemized deductions and personal exemptions. thus, the proposal already ensures indexing of all but the gross income threshold for determining potential applicability of the amt and the income brackets. those key additional parameters should be indexed as well. this indexation is particularly important in preventing future downward creep of the amt into ordinary taxpayer brackets and countering the lack of transparency for individual taxpayers who are less sophisticated and less aware of the potential applicability of the amt. the cost of a gross income threshold, substituting the standard deduction and personal exemptions for the single amt exemption, and indexing the threshold, brackets, and exemptions will be significant. some studies (based on indexing the existing amt exemption amount, without an income threshold) have suggested that indexing alone could cost as much as $658 billion over ten years. 8 if reform of the amt is to accomplish its goal, this cost must be offset through other changes that do not simply shift the tax burden (or the spending cuts due to tax reductions) to ordinary taxpayers. if we are serious about structural coherence and consistency between the amt and regular tax systems to the extent possible, the costs should be met by increasing amt collections from higher-income individuals or by increasing regular tax collections from higher-income individuals or some combination of the two. 4. harmonization of medical expense deductions the penalizing approach of further limiting medical expenses for amt purposes is simply too blunt a sword. it would be far better for tax administrators carefully to review provisions for deductibility of medical expenses under the regular tax system in order to restrict further the ability of wealthy taxpayers to deduct items that may be more personal than medically necessary. in any event, if medical expenses are deductible for purposes of 257. see, e.g., luscombe, supra note 8, at 4 ("it is hard to get too excited about an amt problem when the amt has largely achieved its purpose but has a principal defect of not having been adjusted for inflation. we just start adjusting it for inflation, and the problem goes away."). 258. see supra note 139. [v/ol. 6:9 congress fiddles while middle america burns the regular tax system, they should be deductible for the amt system. this is one area where anything other than consistency between the two systems appears senseless. 5. retention of excess state taxes preference based on the arguments establishing a personal consumption element in state and local taxes, it seems reasonable not to permit more than some baseline amount of state and local taxes to be deducted. the baseline amount is not normatively required, but intended to assuage concerns of those on the borderline of amt liability that they are not being unfairly brought within the amt's grasp. this ceiling for the state and local tax deduction could be determined empirically based on national averages for state taxes. in 2001, average per capita state taxes ranged between approximately $300 and $1800.259 this suggests that it would be possible to establish a generous amt deduction ceiling for state and local taxes of around $5000. state taxes in excess of this baseline amount would be treated as a preference item as under the current amt system. 6. recalculation of gain on incentive stock options as noted in part iv, i see little merit in providing for wholesale exclusion of gain from iso exercise under the amt by eliminating iso gain as an add-back amt preference item. although the application of the amt to options primarily creates a difference in when the income is taken into account, removal of the preference would undermine the coherence of the amt's targeting, since many recipients of incentive stock options are highly paid managers and ceos.26 elimination of the amt preference would also disregard the special status given incentive stock options compared to other compensatory plans as well as the monetary and non-monetary benefits accruing to those who acquire large blocks of highly valued stock under option grants. it would thus go against the distributive justice values that underlie the argument for retaining the amt system. in restricted circumstances, however, it may be appropriate to permit partial relief from the current impact of the amt on those who exercise isos. the suggestion here is that this relief be limited to taxpayers whose stock purchased on exercise of isos loses all (or all but a de minimis portion) of its value in excess of the exercise price before the end of the 259. jeanne sahadi, tax-friendly places 2003, cnn/money, apr. 9, 2003, at http://money.cnn.com/2003/04/o8/pf/taxes/q_taxfriendly (last visited july 15, 2004). these figures are based on state reports published by the tax foundation, at http://www.taxfoundation.org. 260. see leonhardt, supra note 221. 2004.] florida tax review filing period for the return for the taxable year of exercise of the isos. this circumstance results unambiguously in considerable phantom gain to which amt applicability may appear punitive. as stated, the proposed relief is not intended to permit all taxpayers to limit their amt tax liability. the provision is not proposed to apply, for example, to a typical employee/taxpayer who exercises isos for a significant gain, retains the stock for several years and sells the stock later for a substantial net capital gain. that gain is appropriately subject to tax under the amt in the return for the taxable year of exercise. nor is it intended to apply to employees who exercise isos for a significant gain and retain the stock for a few years (perhaps in response to tax advice that retention will result in a lower tax burden because of the characterization of the gain as long-term capital gain), only to have it ultimately decline in value below the amount on which they were taxed several years previously under the amt. this is, in fact, a norm of capital investments: they are risky endeavours, and what brings rewards one year may punish the next. taxpayers who accept stock option grants rather than salary and retain the stock rather than selling on exercise in hopes of cashing in on the growth of a start-up firm are essentially making a risky investment with compensation income in the hopes that they will win on both counts avoid ordinary income rates on their compensation and have significant gains from their ownership of the stock. as discussed in part iv, treatment of the option gain as an amt preference is appropriate. the taxpayer enjoys the many non-monetary benefits of the wealth increase for the period that the stock remains high, including the enhanced consumption from borrowing against the stock. accordingly, the amt preference item for stock option gains should be restricted to prevent amt taxation of phantom gain only if two conditions hold: first, a taxpayer exercises isos when the value of the stock in excess of the exercise price represents a significant gain (referred to herein as "exercise gain"); and second, all (or all but a de minimis portion) of the exercise gain is lost because of a decline in stock value before the end of the filing period for the return for the taxable year of exercise. "de minimis" should be defined in this case to mean that the value of the stock on the date for filing of the return (the "return date value") retains less than 5% of the exercise gain reflected in the value of the stock upon exercise of the iso (the "exercise date value"). in that case, the full exercise gain would not be included as an amt preference item in the return for the taxable year of iso exercise; instead, only the portion of the exercise gain reflected in the return date value would be includible. if the stock later increases in value, however, any increase in value up to but not exceeding the exercise date value would be recaptured as amt income inclusions in the year of such increase (whether or not the taxpayer disposes of the stock). the proposed recapture provision is essentially a mark-to-market requirement for stock received on the [vol. 6:9 congress fiddles while middle america burns exercise of an iso that has benefitted from the proposed amt exclusion of any portion of the exercise gain.61 7. addition of new amt preference items to the amt clearly, the substantial modifications proposed to ensure that ordinary taxpayers are not caught in the amt net will be costly. recall that mere indexation of the amt exemption amount, without the other changes proposed here, was estimated at more than $600 billion over a ten-year period.262 the combination of an income threshold test, indexed standard deductions and personal exemptions, elimination of the medical expense preference, allowance of a minimum state tax deduction and minimal provision for relief for taxpayers who suffer immediate loss of value on stock received upon exercise of isos will reduce revenues from the amt. in the current long-term deficit situation, it would be irresponsible to propose such substantial changes without recommending concurrent changes to offset the loss of revenue. this subsection suggests two modifications to the amt that can offset a portion of the cost of the other reforms while re-targeting the amt. a. untaxed appreciation in respect of charitable contributions to offset the cost of these amt reforms protecting middle-income taxpayers from amt liability, congress should disallow the regular tax deduction for untaxed appreciation on charitable contributions for amt purposes by making it an amt preference item. amending the amt in this way would clearly accord with the purpose of the amt to tax high-income individuals without permitting them to take advantage of tax preferences to zero out their income tax liability. high income individuals are by far the major beneficiaries of the charitable contribution deduction. the joint committee on taxation's reports on tax expenditures for the years 2001 through 2004 indicate that, on average, taxpayers with incomes of $200,000 or more (comprising 7.7% of tax returns) garnered approximately $18.3 billion (or 49.2% of the total) in charitable contribution deductions each 261. mark-to-market taxation is required for very few taxpayers under the current code. see irc § 475 (requiring broker-dealers to mark securities to market and permitting traders and commodities dealers to do so). 262. see supra note 258 and accompanying text (referring to statement of sen. sarbanes on congressional budget for the u.s. government for fy 2005, 150 cong. rec. s 2267-68 (mar. 8, 2004), noting that a reasonable projection for the cost of indexing would be $658 billion, which would have to be added to the $1.6 trillion tenyear cost of making the 2001-2003 tax cuts permanent without amt reform). 2004]1 florida tax review year.263 charitable contributions tend to increase as income increases: the wealthiest taxpayers (those with incomes greater than $10 million) give a larger proportion of their assets to charity than any other group." among those wealthy taxpayers who contribute to charity, a few individuals account for most of the contributions.65 the charitable contribution deduction can be quite large for these significant donors, both in one taxable year and cumulatively over a number of taxable years as the donor gives a series of gifts to a charitable organization.266 approximately 50% of the aggregate individual charitable deduction of those with incomes over $200,000 is 263. in 2004, the 3.2 million taxpayers with incomes of $200,000 or more (out of 39.6 million total returns that claimed a charitable contribution deduction) garnered approximately $17.0 billion in charitable contribution deductions (out of $34.4 billion total). joint committee on taxation, estimates of federal tax expenditures for fiscal years 2005-2009, 43 tbl.3 (jan. 12, 2005), at http://www.house.gov/jct/s-l-05.pdf. in 2003, the 3.4 million taxpayers with incomes of $200,000 or more (out of 38.0 million total) garnered approximately $17.5 billion in charitable contribution deductions (out of $36.9 billion total). joint committee on taxation, estimates of federal tax expenditures for fiscal years 2004-2008, 32 tbl.3 (dec. 22, 2003), at http://www.house.gov/jct/s-8-03.pdf. in 2002, the 2.6 million taxpayers with incomes of $200,000 or more (out of 38.0 million total) garnered approximately $20.0 billion in charitable contribution deductions (out of $40.2 billion total). joint committee on taxation, estimates of federal tax expenditures for fiscal years 2003-2007, 30 tbl.3 (dec. 19, 2002), at http://frwebgate.access.gpo.gov/cgibin/getdoc.cgi?dbname=2002joint committee on taxation&docid=f:83132.pdf. in 2001, the 2.4 million taxpayers with incomes of $200,000 or more (out of 35.1 million total) garnered approximately $18.6 billion in charitable contribution deductions (out of $37.2 billion total). joint committee on taxation, estimates of federal tax expenditures for fiscal years 2002-2006, 31 tbl.3 (jan. 17, 2002). http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=2002joint committee on taxation&docid=f:76452.pdf. while these numbers include cash donations as well as property and basis amounts as well as gain, it is likely that wealthy taxpayers comprise an even larger percentage of those taxpayers donating untaxed appreciation. 264. rachel emma silverman, giving by affluent is less generous on basis of assets, wall st. j., apr. 22, 2004, at d2. 265. gerald e. auten, holger sieg, & charles t. clotfelter, charitable giving, income and taxes: an analysis of panel data, mar. 2002 amer. econ. rev. 371, 377. 266. see, e.g., the 2003 slate 50: top donations (noting ted turner's pledge to give $1 billion to the united nations and indicating that he had contributed $128 million in 2003 to various organizations, most of which apparently consisted of gifts of appreciated stock), at http://www.slate.msn.com/toolbar.aspx?action=print&id=2094848 (last visited july 1, 2004); michelle falkenstein, senate widens probe of tax breaks on donated art, artnewsletter highlights (june 22, 2004) (indicating that the art advisory panel in 2003 reviewed 637 items in 122 taxpayer cases considered to be only a small fraction of the total number of donations of art items and recommended adjustments on 51% of those amounting to approximately $69 million), at www.artnews.com (last visited july 1, 2004). [vol 6:9 congress fiddles while middle america burns attributable to untaxed appreciation.267 based on the average total amount contributed by taxpayers with incomes of $200,000 or more between 2001 and 2004, this provision could raise approximately $3 billion annually.268 charitable organizations will likely complain that treating untaxed appreciation as an amt preference would cause drastic reductions in charitable contributions. it is clear that the primary purpose for the deduction is to provide an incentive for charitable giving,269 and the loss of a tax deduction for amt purposes (but not for regular tax purposes) will make charitable giving somewhat less appealing to some taxpayers than it would otherwise be. there are, however, a number of aspects to the charitable deduction that must be considered before concluding that this counterargument weighs sufficiently strongly to argue against the amt preference provision. first, many different tax changes may interact to affect charitable giving, such as tax rate cuts,270 but tax policy decisions are generally polycentric, with various interacting concerns determining the final policy. thus, even though the lower rates for capital gains enacted in 1997 "substantially raised the after-tax cost of giving appreciated property to charities," consideration of the effect of a rate cut on charitable giving did not lead to congressional reluctance to enact rate decreases.27' the change in amt treatment will not be directly correlated with an increased after-tax 267. see, e.g., gerald auten & david joulfaian, dept. of treas. office of tax analysis paper no. 72, 11 & nn. 3-6 (feb. 1996), reprinted in 1996 j. of econ. 55 (indicating that non-cash gifts comprised 30% of the contributions of donors in the data sample, but over half ofthe contributions of taxpayers with at least $200,000 in adjusted gross income). 268. this figure is computed by multiplying the average $18.3 billion by the estimated 50% of such deductions that are attributable to untaxed appreciation, with that product multiplied by the 28% amt tax. 269. see, e.g., 1969 treasury study, supra note 124, at 194 (stating that the deduction is "principally justified as an incentive for charitable giving"). 270. see generally auten & joulfaian, supra note 267 (providing a summary of the literature on the determinants of lifetime charitable giving and demonstrating that gifts do increase as the tax price decreases); david joulfaian & mark rider, errors-invariables and estimated income and price elasticities of charitable giving, 57 nat'l tax j. 25, 27 (2004) (noting that "[t]o varying degrees, studies find that the tax price is an important determinant of giving"). see also auten et al., supra note 265, at 381 (noting that contributions may be 25 to 36% lower due to reduction in top marginal tax rates). 271. richard e. coppage & sidney j. baxendale, capital gain tax cut has charitable donation cost, 1998 taxation for accountants (noting cost of a gift increased 6.4%age points with decrease in capital gain rate from 28% to 20%), at http://checkpoint.riag.com (last visited july 8, 2004). 20041 florida tax review price for charitable contributions, since not all taxpayers who make donations of appreciated property will be subject to the amt.272 in addition, while the charitable deduction is likely a critical incentive to some donors and the amt disallowance will likely be sufficient to reduce some of their gifts, research has long shown that many other factors such as social awareness, altruism, and social pressure figure into the decision to donate.273 those noneconomic influences on charitable giving reduce the impact of the amt disallowance. charitable fundraising techniques also emphasize other values to donors of making contributions, such as name recognition and reputational enhancement, entrde into the exclusive inner circle of the organization, and the general value of altruistic behavior. this consumption element would continue whether or not the contribution results in an amt liability." 4 moreover, as the trend towards greater inequality of income increases, it is likely that the tax benefit will have less significance for at least some at the very top income brackets.275 furthermore, concerns about decreased giving in response to tax changes may be overstated. congress has recently enacted a tentative repeal of the estate tax in spite of the widespread views that the possibility of an estate tax figures largely in wealthy taxpayers' decisions to donate significant portions of their estates to charities. charitable giving statistics suggest that those concerns were misplaced, because giving increased nearly 3% and charitable bequests rose nearly 13%, in spite of the estate tax phaseout.276 it seems reasonable to assume that the amt disallowance of the deduction would have much less impact than estate tax repeal, since only some taxpayers will be subject to the amt, and the tax price is only indirectly increased because of the amt preference. 272. see stephen j. klarquist, amt can reduce (or eliminate) benefits of charitable gifts, 1991 taxation for accountants (discussing the tax cost of donating appreciated property under the pre-1993 amt preference for charitable contribution deductions of untaxed appreciation), at http://checkpoint.riag.com (last visited july 8, 2004). 273. see, e.g., 1969 treasury study, supra note 124, at 198-200 (discussing the american association of fund-raising counsel's recognition of "social awareness, generosity, social pressure, pity, and habit" as motivations for charitable giving). 274. see, e.g., blueprints, supra note 67, at 95 (indicating that "contributors derive satisfaction from giving just as they do from other uses of resources"). 275. see, e.g., auten et al., supra note 265, at 372 (noting that giving patterns differ by income level, so increased inequality in incomes results in greater variance in donations). 276. see, e.g., stephanie strom, charitable giving holds steady, report finds, n.y. times, june 22,2004, at al 2 (reporting charitable contributions of $240.72 billion in 2003, an increase of 0.5% over 2002, including a hearty 10.3% increase in gifts by bequest); rachel emma silverman, charitable giving increased last year, rising nearly 3%, wall st. j., june 21,2004, at b6 (noting that the increase in bequests "comes even as the estate tax is gradually being phased out by 2010, which has spurred widespread concern in the philanthropy industry that charitable gifts and bequests might decline"). [viol. 6:9 congress fiddles while middle america burns there are additional concerns about the charitable deduction itself that support treating it as a tax preference under the amt system. charitable deductions are especially susceptible to fraudulent overstatement due to the difficulty in arriving at accurate valuations and the lack of an adversarial relationship between donor and donee, since gifts are retained by the charitable organization rather than valued in an arm's length sale.277 efforts by congress to tighten valuation requirements may help reduce the fraud, but valuation will continue to be a task that lends itself to subjective adjustments to suit the donor."8 of even more concern, the charitable deduction raises concerns about the fairness of the tax system, in that the wealthiest donors have the ability to choose to a large extent which public good to support through their charitable donations, but ordinary taxpayers with little disposable income support public goods almost exclusively through their tax payments, with little choice as to which types of services or goods are supported. the deduction permits a "hidden public fimance ... under private, and perhaps even individual, control." '279 these factors suggest that the gain in fairness through taxation of untaxed appreciation in respect of charitable contributions will considerably outweigh any harm from marginal reduction in contributions due to the increased tax cost because of the amt preference. this would not be the first time that appreciation on charitable contributions has been considered as a potential preference item. as noted, the original treasury study under president johnson considered untaxed appreciation on charitable donations to be one of the four most significant preferences by which wealthy americans were able to avoid tax on economic income.28 the house report noted that 49 of the 154 high-income 277. for example, millionaire herbert axelrod, under indictment on tax fraud charges for helping a former executive hide $700,000 in a swiss bank account, may have inflated the value of a number of rare stringed instruments in connection with bargain sales to the new jersey symphony orchestra (instruments valued at $50 million and sold for $18 million) and donations to the smithsonian (4 instruments valued by the donor at $50 million). see jeffrey gold, herbert axelrod, millionaire wanted on tax charges arrested in germany, assoc. press, june 16, 2004. 278. see, e.g., falkenstein, supra note 266 (reporting the role of the art advisory panel in monitoring over-valuations for tax purposes as part of the coverage of senate investigations into over-valuations of charitable contributions). congress recently tightened rules for valuations of donated property. american jobs creation act of 2004, pub. l. no. 108-357, §§ 883-884, 118 stat. 1418, 1631-34. specifically, taxpayers are denied a charitable contribution deduction for donations ofproperty (other than cash, publicly traded securities, and certain intangible property) unless they meet the following requirements: (1) for contributions of $500 or more, taxpayers must include a description of contributed properties with their tax returns; (2) for contributions of $5,000 or more, taxpayers must obtain qualified appraisals and include appraisal information with their tax returns; (3) for contributions of $500,000 or more, taxpayers must attach qualified appraisals to their tax returns. id. § 883(a). additionally, for contributions of used motor vehicles valued over $500, taxpayers must provide written donee acknowledgments. id. § 884(a). 279. see blueprints, supra note 67, at 96. 280. see supra note 124 and accompanying text. 2004]1 florida tax review individuals who paid no income tax for the 1966 taxable year benefited from the unlimited charitable contribution deduction.2"' the house version of the 1969 bill reduced the availability of charitable deductions and treated untaxed appreciation as a preference subject to the new minimum tax, along with four other items.282 the senate amendment attempted to balance equity and economic concerns, resulting in reduced availability of the charitable deduction, a broader list of preferences, but not treatment of untaxed appreciation as a preference.283 after numerous attempts to fine-tune the amt, the 1986 overhaul of the tax system generally succeeded in lowering rates across-the-board in exchange for elimination of numerous preferences and tax shelters that had accumulated in the 1954 code. included in the reforms was enactment of a provision to treat the charitable deduction for untaxed appreciation on real, personal and intangible property as a tax preference for amt purposes.284 the legislative history to the 1986 amt changes set forth a general rationale that strongly endorsed the original objective of the amt to enhance progressivity by targeting excessive deductions and exclusions utilized by high-income taxpayers.285 the amt taxation of untaxed appreciation on charitable contributions was regrettably short-lived. as with many of the provisions of the 1986 act which have been limited or eliminated over time, congress ultimately back-tracked to eliminate the preference item, first as a temporary measure and then permanently in 1993.286 its rationale gave short shrift to the purpose of the amt, providing instead a conclusory statement that congress 281. 1969 ways & means report, supra note 127, at 9. 282. see id. at 77-80 (proposing a minimum tax on five preferences: taxexempt interest, excluded net capital gains, untaxed appreciation on charitable contributions, excess depreciation over straight-line, and excess farm losses). 283. s. rep. no. 91-552, at 2-4 (nov. 21, 1969), reprinted in 1969-3 c.b. 423, 424-25 [hereinafter, 1969 finance report]. the senate report claimed that "the principal effect of including gifts of appreciated property in the minimum tax would be to reduce the benefit of the contribution and thus unduly restrict public support of worthwhile educational and other public charitable institutions." id at 116. the list of final preferences is described in the conference report. see h.r. conf. rep. no. 91-782, at 301-02 (1969), reprinted in 1969-3 c.b. 644, 658-59. 284. tax reform act of 1986, pub. l. 99-514 §701(a) (amending the code to add §57(a)(6), which generally disallowed the charitable contribution deduction for untaxed appreciation for amt purposes). see h.r. rep. no. 99-426, at 307 (1985), reprinted in 1993-3 c.b. vol.2 1, 307 [hereinafter 1986 ways & means report] (indicating that certain items should be added as preferences if the amt were "to serve its intended purpose of requiring taxpayers with substantial economic incomes to pay some tax" and including in that list a portion of the untaxed appreciation on charitable contributions). 285. see 1986 ways & means report, supra note 284, at 305-06; s. rep. no. 99-313, at 518-19 (1985), reprinted in 1986-3 c.b. vol. 3 1, 518-19 (quoted extensively supra note 130). 286. omnibus budget reconciliation act of 1993, pub. l. 103-66 § 13171 (a), 107 stat. 312 (amending the code by striking §56(a)(6)). [vol 6:9 congress fiddles while middle america burns believed that elimination of the preference would further encourage charitable giving. 87 restoring the preference and eliminating this windfall deduction for the wealthy would fund a portion of the necessary amt reforms, and it would do so by focusing the tax on those that the amt was originally designed to tax. although there would likely be some marginal reduction in charitable gifts as a consequence, the overall impact might well be small. the importance of targeting the superrich who pay little or no tax because of high charitable deductions should be given priority in our self-assessment system. b. preferential capital gain rates the greatest irony is that the truly rich do not pay the amt .... that may be because their effective tax rate is well above the amt's 26 percent threshold, but not necessarily. last year's tax cut lowered the tax rates on most capital gains and dividends to 15 percent, and taxes paid on investments are not subject to the amt test. that means the country club set... are paying effective federal tax rates that rival those of the man clipping the green for $25,000 a year288 a further complication for the amt is that the tax preferences singled out as tainted may restrain some tax avoidance but fail to target the appropriate taxpayers. wealthy individuals own substantially disproportionate amounts of the nation's assets and have substantially 287. h.r. rep. no. 103-111, at 630 (1993), reprinted in 1993-3 c.b. 167,206 [hereinafter, 1993 house report] (house ways & means explanation of revenue provisions, indicating that "[tihe committee believes that the temporary amt exception for contributions of appreciated property induced additional charitable giving" so that "by permanently extending this rule and expanding it to apply to all appreciated property gifts, taxpayers will be allowed the same charitable contribution deduction for both regular tax and amt purposes. this will provide an additional incentive for taxpayers to make charitable contributions of appreciated property"). this provision did not fit well with the congress' stated overall goal of enhancing progressivity. [t]he budget can't be brought under control by spending cuts alone-not without making deep cuts in benefits that citizens have fairly earned, inflicting hardship on people already suffering, and starving investment programs. a budget balanced by spending cuts alone will not share burdens fairly throughout society. this legislation improves the progressivity of the tax structure and requires those who benefitted from the policies of the 1980's and early 1990's to pay their share of the bill that has come due. id. at 3-4. the 1993 act also provided for a 50% reduction in capital gains tax on small business stock in new irc § 1202. 288. jonathan weisman, falling into alternative minimum trouble, wash. post, mar. 7, 2004, at f9 (quoting chris sintetos, a virginia accountant). 2004] florida tax review disproportionate amounts of the aggregate net capital gains (including most dividend income, under jgtrra).8 9 as the tax shelter debate has shown, large numbers of high-net-worth individuals have engaged in potentially abusive tax shelters that "work" by offsetting income (frequently large capital gains) with bogus losses.29 therefore, these same high-worth individuals are likely to be the ones who have successfully hidden substantial portions of their investment gains from tax administrators and are appropriate targets for the amt. furthermore, the superrich high-worth individuals that are the prime target for the amt may have almost no income other than taxexempt municipal bonds and low-taxed net capital gains. as a result, these high-income individuals may pay a rate of regular tax on their high incomes in excess of $200,000 that is extremely low compared to those who earn average salaries below $100,000.291 yet because the amt does not treat the preferential rate for net capital gains as a "tainted" tax preference, individuals with that type of investment income are less likely to owe tax under the amt. a reasonable source of revenue for amt reforms to protect ordinary taxpayers would therefore be to treat the net capital gains preferential rate (for both gains on exchanges or dispositions of property and qualified dividend income) as a tainted preference.292 that is, for amt purposes, net capital gain income (including that derived from qualified dividends) should be included in the amt base and taxed at the amt rate. in order to protect ordinary taxpayers who are just above the threshold gross income level for exclusion of amt liability and have relatively small financial investments or small gains from sales of investment property, the amt net capital gain provision could apply only to net capital gains in excess of a reasonable threshold amount, such as $3,000.293 ordinary taxpayers are not likely to have capital gains in excess of this amount other than from sales of their homes, and those gains are already generally excluded from taxation. inclusion of excess net capital gains as an amt preference would therefore ensure that high-income taxpayers with substantial investment gains (and 289. see supra notes 57 74 and accompanying text. 290. see, e.g., beale, supra note 226, at 229-39 (discussing various listed transactions). 291. see supra notes 72 74 and accompanying text. 292. leonard burman, william g. gale, jeffrey rohaly & matthew hall, key points on the alternative minimum tax (jan. 21, 2004) (suggesting that treating capital gains as an amt preference would provide revenues to pay for needed amt reforms), at http://www.brookings/edu/views/op-ed/gale/20040121 amt.htm. 293. a similar revenue result could be achieved by eliminating the capital gains preferential rate in the regular tax system, as done for a brief period in connection with the 1986 tax reform act's overhaul of the code, and taxing capital gains and ordinary income under both the regular and amt systems at the same rates. this option of merging the two systems by eliminating regular tax preferences and taxing economic income progressively would be the normatively desirable method of solving the amt quandary, but likely would face substantial practical hurdles that would derail enactment without a sweeping change of view in congress. [vol. 6:9 congress fiddles while middle america burns dividend income) but very little or no wage income would pay a rate of tax greater than 15%.294 this, too, is an old idea whose time has returned. prior to enactment of a revised code in 1986, the regular tax excluded a portion of net long-term capital gains from tax, resulting in a lower effective rate on capital gains than on ordinary income.2 95 before the 1978 amendments, the excluded net capital gains were an item of preference subject to the 15% rate on minimum tax preferences (after reduction of preferences by one-half of the regular tax liability or $10,000).296 this was considered to be one of the most important ways of ensuring that taxpayers with high economic income paid some income tax.297 the 1978 code amendments reduced the taxation of capital gains somewhat by taking capital gains out of the old minimum tax regime (and by increasing the exclusion from 50% to 60% for regular tax purposes), but retained treatment of capital gains as a preference in the base for the new amt system.2 98 the ways and means committee explained that the combined level of taxes on capital gains was quite high under the old minimum tax regime, and it wanted to encourage investment by some lessening of taxation of capital gains.99 the committee nonetheless decided that capital gains should be treated as a preference under the new amt system, based on its belief "that every noncorporate taxpayer with capital gains should pay a minimum amount of taxes with respect to those gains."3°0 capital gains was removed as a preference only when the 1986 reform 294. see supra note 5; richard malamud, 102 tax notes 1427 (mar. 15, 2004) (suggesting that the amt should ensure that the effective tax rate on wealthy taxpayers with predominantly investment income is at least 15%). 295. see former irc § 1202 of the 1954 code (excluding 60% of net long-term capital gains, as enacted by section 402(a) of the tax reform act of 1978, pub. l. no. 95-600). the 1986 tax reforms later removed the preference for capital gains by including capital gains in income and taxing them at the same rate as ordinary income. net capital gains were therefore fully includible in the amt base as well. see, e.g., h.r. rep. no. 99-426, at 196-97 (1986), reprinted in 1986-3 c.b. vol. 2 1, 196-97 (describing the changes to the capital gains provisions). 296. see, e.g., h.r. rep. no. 95-1445, at 118-19 (1978), reprinted in 1978-3 c.b. 187,292-93 [hereinafter, the 1978 house report] (describing the application ofthe minimum tax to net capital gains). 297. matthew s. bailey, supra note 141, at 36 (stating that "[t]he amt was originally designed to capture high-end taxpayers' personal income, particularly emphasizing their capital gains income"). 298. revenue act of 1978, pub. l. no. 95-600, § 421(a), 92 stat. 2763,287174 (1978) (imposing the amt on a base defined to include capital gains under former irc § 57(a)(9)). 299. the ways & means committee noted that the (old) minimum tax could result in a substantial add-on tax even when a taxpayer already paid regular taxes at high rates. 1978 house report, supra note 296, at 118-19. 300. see id. at 119-24 (discussing the act's capital gains provisions). 2004] florida tax review removed the preferential treatment of capital gains for regular income tax purposes.3 'o b. harmonize the regular andamt tax systems the package of changes to the amt proposed here will not be cheap. these costs should be offset by complementary changes in the regular tax system to move the overall system towards greater coherence. 1. treatment of phaseouts for exemptions and itemized deductions a modest regular tax reform that is consistent with the proposals for reform of the amt is the reinstatement of the regular tax phase-outs for exemptions and itemized deductions. for example, section 68 currently provides for a reduction in the total amount of permitted itemized deductions, by the lesser of 3% of the excess of adjusted gross income over $145,950 (for 2005) or 80% of the itemized deductions otherwise allowable.0 egttra added subsections (f) and (g) of section 68 to the code, which gradually eliminate the phaseout for itemized deductions, and subsections (d)(3)(e) and (f) of section 151, which similarly eliminate the phaseout of the personal exemption amount. in 2010, taxpayers will be permitted to take itemized deductions and personal exemptions regardless of income. reinstating these phase-outs would offset some of the cost of amt reforms and at the same time enhance structural coherence and remove complexity caused by the inconsistency between the regular and amt system when one system has a phaseout and the other does not. phaseouts take into account the decreasing utility of each dollar to high-income taxpayers. retaining phaseouts ensures that the benefits of exemptions and deductions accrue to those who have the most need for them and provide further assurance that higher-income taxpayers cannot avoid all taxes on their economic income. 2. institution of a bove-the-line deduction for contingent attorney's fees taxpayers part iv presented the sympathetic case for plaintiffs in lawsuits whose compensation is reduced by the amt treatment of miscellaneous itemized deductions in conjunction with the lump-sum nature of the judgment award. although the ajca eliminates this problem for many cases 301. see supra note 295. it would have been reasonable for congress to restore the amt capital gains preference when the preferential capital gains rate was instated in 1990. omnibus budget reconciliation act of 1990, publ. l. no. 101-508. it is not clear whether failure to do so was simply an oversight or whether it resulted from a deliberate decision to change the historical interaction between preferential treatment of capital gains and the amt system. 302. irc § 68(a). [vol. 6:9 congress fiddles while middle america burns most significantly, those involving employment-related claims by allowing an above-the-line deduction, the banks holding requiring inclusion of fees leaves a problem for other taxpayers. a number of potential solutions might be adopted, the most reasonable of which is to extend the ajca treatment to all types of claims. this solution increases consistency between the regular tax and amt systems. it removes the 2% of agi limitation for both the regular tax and amt systems. it permits retention of the miscellaneous itemized deductions as an amt preference, which seems appropriate because of their flavor of personal expenses and parsimonious allowance even under the regular income tax. 3 finally, it should be relatively inexpensive to implement.3" 3. additional harmonizing changes several of the current amt preferences might be eliminated through harmonization of those items with the regular income tax by eliminating them as an amt preference or by conforming the regular tax to the amt approach. the result would be consistency between the amt and regular tax, and lessened complexity for both systems. items that might be particularly appropriate, though likely difficult to change because of public and political resistance, include the mortgage interest deduction for home equity loans, a limitation on interest deductions on acquisition indebtedness, and accelerated cost recovery deductions that currently require recomputation for amt purposes. the regular income tax deduction for home equity loans runs counter to the stated purpose for mortgage interest deductions of extending home ownership to ordinary americans. it introduces a wealth-based distinction that disadvantages the least well off, in that it permits existing home owners to deduct borrowing costs for personal consumption expenses that are not deductible to non-home owners. eliminating the home equity loan interest deduction in the regular tax would make the amt and regular tax more consistent and simpler. in addition, limitation of the acquisition debt interest deduction to interest payments on mortgages under a reasonable threshold that is more commensurate with home purchases by ordinary taxpayers, and elimination of any interest deduction in respect of mortgages on residences other than the principal residence, would further target the mortgage interest deduction to its original purpose. similarly, the simplified cost recovery deductions could be adopted for both amt and regular income tax systems. accelerated depreciation likely rewards capital investments that would have been undertaken anyway 303. it appears reasonable to disallow miscellaneous itemized deductions entirely for amt purposes, since high-income taxpayers are more likely to have considerable non-reimbursable employee expenses (to the extent their income is wagebased) and other nondeductible expenditures. 304. see hellwig & polsky, supra note 228, at 932 (noting that legislation fixing the amt trap for contingent attorney's fees "would be both simple and cheap") 2004] florida tax review or encourages overheating of investment that may not be matched by productivity gains. reducing the recovery options would simplify both systems. 4. 2001-2003 tax cuts sunsets the best solution to any remaining cost differential because of the amt reforms is to selectively eliminate any further phasing in of the tax cuts at the upper income range. although likely difficult to enact politically at this juncture,3"5 this mode of funding needed amt reforms should not be rejected summarily. if the tax cuts are made permanent without amt reform, a significant percentage of the benefits will be lost anyway to middle-income taxpayers because of the amt system, of which congress was aware when it passed egtrra. one could say, therefore, that congress did not intend to provide tax cuts to middle income taxpayers under egtrra. congress is faced with a hobbsian choice either repeal the amt (and find spending cuts sufficient to account for the loss of revenue, the burden of which will fall primarily on ordinary taxpayers and in many ways undo the benefit of amt repeal for them) or simply decline to extend the regular tax cuts further to the highest income groups. faced with the clear purpose of the amt to enhance rather than reduce progressivity, the latter alternative is preferable and more consistent with a structurally coherent tax system. allowing the top-bracket cuts to sunset as scheduled in 2010 would significantly reduce the number of taxpayers with adjusted gross income between $100,000 and $200,000 who are subject to the amt, leaving their liability to be determined through the more familiar regular tax system. revenues from that approach would fund (through higher regular income taxes, especially on higher income taxpayers) the needed revisions to the amt to ensure that it does not reach too low to penalize ordinary taxpayers who are not its intended targets.0 6 at a minimum, therefore, congress should eliminate the repeal of the estate tax and re-instate higher marginal rates for taxpayers in income brackets of $200,000 or more. the extent to which rate cuts are rolled back should be based on the estimates of revenues needed to finance the necessary amt reforms. vi. conclusion this article considers the amt problem in the context of the 20012003 tax cuts, growth in federal deficits and debt burden, increasing income 305. see, e.g., pay for it, wash. post., july 17, 2004, at a18 (editorial noting that "[t]he sanest way of paying for the tax cuts is the least likely in the current political circumstances-trimming back the existing breaks gratuitously lavished on the wealthiest americans"). 306. see, e.g., paul krugman, health vs. wealth, n.y. times, july 9, 2004, at a19 (indicating that rolling back tax cuts for taxpayers with incomes over $200,000 would free up $631 billion over 10 years). [vol. 6:9 congress fiddles while middle america burns inequality, and a general trend towards a hybrid consumption and income tax base. taking distributive justice and structural coherence as policy guidestars, the article proposes as the solution to the amt quandary the retention of an amt system with specific reforms to better target those higher income taxpayers who benefit from substantial preferences under the regular tax. to protect ordinary taxpayers from any potential amt liability and from having to perform onerous amt calculations, the article proposes a reasonable gross income threshold that would be indexed for inflation. to ease the burden of amt calculations for those who may yet be subject to amt applicability, the article proposes the consistent application of standard deductions and personal exemptions in both the amt and regular tax (all indexed for inflation). in addition, to ensure that high-income taxpayers are appropriately targeted by the amt, the article proposes two new amt preferences: capital gains and untaxed appreciation on charitable contributions. to limit the growth of inequality among american taxpayers, the article argues for related, concurrent changes to the regular tax system, including retention of income phaseouts (and adoption of the phaseouts for both systems), an above-the-line deduction for contingent attorney fees in all types of cases, and retention of the estate tax. finally, policymakers should consider withdrawing the 2001-2003 tax cuts for taxpayers in the highest income brackets to the extent necessary to fund these needed changes and ensure the overall progressivity of the tax system. 2004] microsoft word first 5 pages-new.doc florida tax review volume 9 2009 number 5 555 democracy, sovereignty and tax competition: the role of tax sovereignty in shaping tax cooperation by diane ring∗ i. the sovereignty backdrop ............................................................ 557 ii. tax competition and the locus of sovereignty arguments ...................................................................... 561 a. introduction to the tax competition concept .......................... 561 b. the states in the tax competition debate ................................ 563 c. evolving positions on tax competition ................................... 567 iii. theoretical challenges to tax competition and the underlying vision of sovereignty .................................................. 570 a. normative claims against tax competition: an introduction ........................................................................ 570 b. an efficiency critique of the pro-competition position? ....... 573 c. equity grounds for curbing harmful tax practices ............... 576 1. introduction ................................................................... 576 2. the equity link to sovereignty ...................................... 578 3. developing countries’ race to the bottom – a call for inter nation equity ............................................................. 583 iv. strategic use of sovereignty in the mission to secure cooperation over tax competition ............................................... 591 a. resurgent sovereignty claim .................................................. 591 b. sovereigns and the “right” to use power, leverage and deal making .................................................................... 592 c. seeing beyond the sovereignty ................................................ 594 v. conclusion ......................................................................................... 595 ∗ professor of law, boston college law school. i would like to thank ilan benshalom, yariv brauner, james repetti, and the participants in the university of montreal workshop on “tax competition: how to meet the normative and political challenge,” and the university of florida international tax symposium for their helpful comments. 556 florida tax review [vol. 9:5 democracy, sovereignty and tax competition: the role of tax sovereignty in shaping tax cooperation by diane ring virtually all efforts to confront and curb tax competition effectively require some measure of cooperation among nation-states. regardless of the precise amount and type of competition deemed acceptable, the cooperation question arises. only for those who would advocate a complete acceptance of all forms of “tax competition” would cooperation seem irrelevant, although even for those pro-competition advocates, some joint advocacy on the part of the “competing” nations has formed an important part of their efforts to maintain competitive practices.1 assuming we envision a world in which there is some notable commitment by a number of nations to tackle the problem of “harmful” tax competition, what will their solution look like? the prospect of tax cooperation inevitably raises questions regarding the plausibility of such cooperation, the scope and best context for such cooperation and the normative principles upon which it rests. yet attempting to resolve these broad questions can be daunting. this paper contends that sovereignty shapes both the problem of tax competition and the solution of cooperation. understanding the functional and normative goals underlying nation-states’ claims for tax sovereignty can enable us to assess, predict and influence prospects for tax cooperation. as i have argued elsewhere,2 claims of tax sovereignty are proffered in a variety of situations, by a variety of actors, with a variety of motives, but there are nonetheless several core goals that are at risk when a nation-state makes the decision to surrender some measure of its tax power. an understanding of these goals and principles helps highlight unresolved issues in tax competition conversations, fruitful avenues for cooperation efforts, and the connections among inter-nation equity (which presumes sovereignty), interindividual equity, and competition. 1. many of the tax havens joined together in an effort to resist the oecd harmful tax competition project. see, e.g., free-market activists ask cayman islands to rescind oecd commitment, 22 tax notes int’l 2971 (jun. 11, 2001) (noting a may 2001 presentation at the cayman islands chamber of commerce meeting to encourage the cayman islands to rethink its commitment to comply with the oecd tax competition recommendations). 2. diane ring, what’s at stake in the sovereignty debate?: international tax and the nation-state, 49 virginia j. of int’l l. 155 (2008). 2009] democracy, sovereignty and tax competition 557 this paper does not seek to establish whether and when tax competition is good or bad. that is a distinct question reflecting assessments of government action, the market, externalities, and behavioral predictions. instead, this paper assumes that some subset of countries will contend that certain tax competition is undesirable. from that baseline, the paper considers the question of how sovereignty shapes arguments over the merits of tax competition and how sovereignty influences the design of responses to tax competition. part i provides a basic overview of sovereignty concepts, in particular their relevance to a nation-state desirous of control over tax policy. part ii defines tax competition, identifies the different kinds of states involved, reviews the emergence of the oecd project to limit harmful tax competition, and traces the eu experience with tax competition. part iii explores the normative grounds for challenging tax competition and the role of sovereignty in shaping and limiting these challenges. finally, part iv, working from the practical and theoretical baselines established in part iii, considers how an appreciation of sovereignty claims can facilitate the design of plausible cooperation strategies for states trying to limit tax competition. i. the sovereignty backdrop the consideration of tax competition, and the corresponding prospects for cooperation take place against the backdrop of a world in which sovereign nation-states are the dominant actors in promulgating tax rules and collecting (and using) tax revenues.3 sovereignty bears no single definition, but a reasonable starting point envisions a sovereign state as one which possesses three core elements: “territory, people, and a government.”4 in possessing these elements, a sovereign state should display internal control and supremacy, along with external independence from other states.5 as the 20th century has come to a close, the sovereign state stands as more than a nation with internal control and external independence regarding 3. this paper takes as a premise that the global system we currently see is one in which “sovereign” states play a key role. this premise is not undermined by acknowledging that the definition of a sovereign state faces controversy, nor by the recognition that many non-state actors play a vital role (including international organizations and multinational enterprises). the identification of our global system as one based on sovereign states does not imply a claim that these states are all powerful, exclusive, or monolithic actors. rather it asserts that they continue to have a central organizing and decision making role. moreover, the prospect that the “degree” of sovereignty may be shifting (i.e. that for example, international organizations are gaining more power) is not inconsistent with the paper’s premise. 4. ring, supra note 2 at 160 note 9 (quoting michael ross fowler & julie marie bunck, law, power and the sovereign state 33 (1995). 5. see, e.g., hendrik spruyt, the sovereign state and its competitors 38-39 (1994); fowler & bunck, supra note 4 at 37. 558 florida tax review [vol. 9:5 people, territory and government (i.e. the possessor of a series of rights to exclude and control). the sovereign is also the locus of a duty and an obligation to protect and promote the welfare of its citizens.6 sovereign responsibilities now accompany those sovereign rights. what does “sovereignty” not presume or promise? it does not presume equality of situation. most considerations of sovereignty and a world system based on sovereign states anticipate that states will vary significantly in their resources and power,7 and that the exercise of such power is not inconsistent with the premises of the sovereign state system. in sharp contrast, the “unprovoked” invasion of the territorial sanctity of another state would likely violate the principles and shared expectations of the sovereign state system. of course the existence of the sovereign state system and the ability to define it are not the same as a seal of approval. even if the current world political order takes sovereign states as the primary decision makers (a positive observation),8 is that normatively desirable? the “desirability” of 6. see, e.g., fowler & bunck, supra note 4 at 6, 73; kathryn sikkink, human rights, principled issue–networks, and sovereignty in latin america, 47 int’l org. 411, 413 (1993) (“[u]ntil world war ii, in the widest range of issues, the treatment of subjects remained within the discretion of the state”). 7. “historically, one or the other of the major principles associated with sovereignty has always been under challenge. . . . only a very few states have actually possessed all of the major attributes that are associated with sovereignty – territoriality, autonomy, recognition, and effective control – the united states being the most obvious case. . . . hence, in some sense, almost all of the states of the world have been semi-sovereign.” stephen d. krasner, pervasive not perverse: semisovereigns as the global norm, 30 cornell int’l l.j. 651, 652 (1977). although the reality of widely differing sovereign states is accepted, we find, deeper within the interstices of sovereignty theory, conflict over how states differ. the debate questions whether it is more accurate to see sovereign states as beginning with a uniform package of sovereign state rights and powers, some of which they may lose in the rough and tumble world of power, resources, strategy and luck – or whether some states become sovereigns without the rights and expectations that other states may possess. see, e.g., fowler & bunck, supra note 4 at 29, 42, 63-68; cf. abram chayes & antonia handler chayes, the new sovereignty 27 (1995) (“[s]maller and poorer states are almost entirely dependent on the international economic and political system for nearly everything they need to maintain themselves as functioning societies.”). 8. some observers have argued that sovereignty is dead or dying, although this is an empirical point. ring, supra note 2 at 165 (considering claims that the sovereign state system is in decline). whether the system is dead or dying (which some seriously challenge) tells us nothing about whether this would be good or bad as a normative matter. id. at 165-166 (examining the competing view that interprets recent changes in the role of international organizations as affirming and supporting the sovereign state system). 2009] democracy, sovereignty and tax competition 559 sovereign states raises a series of deeper questions regarding society, justice, human nature, and political science. can we envision the alternative to the sovereign state system (e.g., a single global state, or states based not on territory but on “people” or “religion”9) and what are its weaknesses? although this paper does not aim to resolve the normative question of whether a sovereign state system is good, part iii pursues one strand of this inquiry (theories of cosmopolitan justice) because an assessment of sovereignty’s impact on the tax competition debate requires consideration of how advocates press their claims. at present, it is useful to make one observation and one assertion. the observation is that the sovereign state system is sufficiently healthy and active, as a positive matter, to require that any serious tax competition discussion confront the reality of sovereign states. the assertion, argued by the author elsewhere,10 is that one important “right” of the sovereign state – tax sovereignty – carries meaningful content. states’ anxiety over tax sovereignty can be legitimate (although it can also be a smokescreen for less palatable or reputable goals). the ability to control tax policy enables a state to meet its functional duties (revenue raising and fiscal policy design) and support its two important democratic norms – democratic accountability and democratic legitimacy.11 recognizing this role of tax sovereignty for a democratic sovereign state becomes important as we explore how we might further clarify and expand the duties and obligations between and among sovereign states on the subject of tax competition.12 obviously states do not exercise unimpeded control over tax policy choices – they are influenced and constrained by the political economy within their own domestic system (e.g., pressure from powerful taxpayers) and by the need to account for the implications of their tax rules globally (e.g., will the state’s new tax be deemed a creditable foreign tax by other countries). however, the lack of absolute control does not render a state’s interest in maintaining substantial control an implausible or irrational 9. a world (such as ours) in which international organizations and multinational enterprises influence and shape outcomes is not an alternative to a sovereign state system. it is a version of such a system. 10. ring, supra note 2 at 170, 232. 11. control over tax policy by the states supports goals of democratic accountability and legitimacy because the nation-state (in contrast to certain global structures) provides a closer connection between decision maker and voter, and because the nation-state is more likely to constitute a demos – a certain type of political community considered valuable to true democratic legitimacy in government rule. ring, supra note 2 at 172-77, 213-14; infra part iii.c.2.a. 12. this assertion could be interpreted as a normative claim of the paper. however, even for readers who may challenge the value of these elements of tax sovereignty – as a descriptive matter they form the foundation for states’ interest in tax sovereignty. 560 florida tax review [vol. 9:5 position. furthermore, an expression of interest in retaining more control over tax policy does not translate into a blanket unwillingness to cooperate. beyond establishing a descriptive understanding of sovereignty and an appreciation for the most persuasive normative claims to tax sovereignty, it will also be important to identify the positive role tax sovereignty plays in rhetoric and national decision making. although not wholly independent of the functional and normative roles for tax sovereignty referenced above, the broadly characterized right of a nation to sovereignty over tax matters has proven a potent tool of rhetoric (often without extensive grounding or clarification) in policy debates.13 even national governments are not immune to the magnetism of the rhetoric.14 tax sovereignty, though, is not a “good” in and of itself. rather, it is a tool to achieve important missions of the democratic sovereign state: (1) the continued operation and existence of a functioning government (predicated on revenue and sustainable fiscal policy) and, (2) the accountability and legitimacy underpinning that democratic state. but even though tax sovereignty can be a tool for good, sovereignty ideals do not answer the question, “what should be the response to and the outcome of tax competition?” as explored later in the paper, if an appropriate state goal is not tax sovereignty per se, but rather the functional and normative goals stated above, we may revise our expectations about the need for and required scope of tax sovereignty. moreover, to the extent that the examination of tax competition moves beyond the theoretical and into the practical, strategic realm, a realistic appreciation of the lure of “tax sovereignty” claims becomes an invaluable asset. one important way to consider the question of how to achieve cooperation in tax competition is to consider how knowledge about tax sovereignty might guide us. if we are sensitive to tax sovereignty, what should we highlight or emphasize to encourage cooperative action? what should we avoid? what techniques or cooperative methods of responding to tax competition are most likely to be successful and why? 13. for example, the consideration of a variety of “tax harmonization” possibilities in the european union, including the prospect of a common consolidated corporate tax base has generated innumerable comments from business, government officials and others on the perceived sovereignty implications of such a move. see, e.g., bruno gibert, chairman of the european joint transfer pricing forum, remarks at european competitiveness roundtable, european competitiveness roundtable: competition view with common case, (dec. 1, 2006), in int’l tax rev., available at 2006 wlnr 23404159. see generally, ring, supra note 2 at 209-213. 14. see, e.g., steinbruck accuses ireland of unfair tax practices, 46 tax notes int’l 1197 (jun. 18, 2007) (at meeting of the eu council of economic and finance ministers, ireland repeated its objection to the common consolidated corporate tax base because it would undermine states’ fiscal sovereignty). 2009] democracy, sovereignty and tax competition 561 finally, although this article firmly accepts the reality of an international system premised on sovereign states and operates with a core definition of sovereignty reflecting the modern conception of rights and duties of the state, this vision need not be fixed for time. our conception of the sovereign state developed over the 20th century to incorporate ideas regarding human rights and anti-imperialism.15 it is possible that the fiscal challenges of the 21st century will further refine our vision of appropriate and necessary tax sovereignty for the sovereign state. even if this refinement in the sovereignty concept ultimately takes root, the proscriptions for tax competition cannot significantly anticipate such a shift. the experience of tax competition may be crucial in defining a new “tax sovereignty,” but that experience cannot realistically dictate a view of sovereignty and cooperation dramatically different from the one that currently holds sway in most states. instead, tax competition policy, and any calls for cooperation, must remain part of an interactive relationship among fiscal reality, operational solutions, and prevailing ideas of the sovereignty. tax competition might lead the global community to a new vision of tax sovereignty, but it cannot drag it there. ii. tax competition and the locus of sovereignty arguments a. introduction to the tax competition concept just as an understanding of sovereignty is necessary to assess its impact on the tax competition debate, so too is a precise consideration of what is intended by the term “tax competition.” tax policy discussions are notorious for widely (and wildly) differing uses of terminology,16 and the active debate over tax competition proves no exception. in its broadest conception the phrase captures a country’s use of any feature of its tax system to “enhance” its competitive advantage in the marketplace for capital, 15. see sikkink, supra note 6 at 413; robert h. jackson, quasi-states, dual regimes, and neoclassical theory: international jurisprudence and the third world, 41 int’l org. 519, 526 (1987) (following world war ii, colonialism “became controversial and finally unacceptable in principle.”); fowler & bunck, supra note 4 at 73 (“a century ago sovereignty implied that a state could go to war whenever it pleased. once again, states have renounced such a sovereign prerogative.”). 16. a glaring example from u.s. political discourse on tax reform is the use of the term “flat tax” to mean and convey a wide range of ideas, some of which are not even inherent to the idea of a flat (i.e. single rate) tax system. see e.g., michael graetz, statement on flat tax proposals presented at hearings before the senate finance committee on may 18, 1995, 67 tax notes 1256 (may 29, 1995) (noting that contrary to common misconceptions, flat tax systems do not offer significant simplification of the tax system, do not have a single rate, do not guarantee a low tax burden, and are often actually consumption as opposed to income taxes). 562 florida tax review [vol. 9:5 investment, and/or nominal business presence. the tax features readily susceptible to enlistment in this mission include tax rates, tax base, administrative system,17 transparency, disclosure, information sharing, and special credits, exemptions and deduction. much of the current debate over tax competition emerged in the aftermath of the oecd’s 1998 project on “harmful tax competition.” the competition identified and targeted in that project (and through the oecd’s subsequent efforts and reports) is much narrower than the broad definition of tax competition above. first, the oecd sought to identify and address harmful tax competition, not all tax competition. the oecd expressed a commitment to the view that “there are no particular reasons why any two countries should have the same level and structure of taxation” and that “[c]ountries should remain free to design their own tax systems as long as they abide by internationally accepted standards in doing so.”18 second, at the time of the 1998 project, the oecd was not prepared to consider all realms of tax competition in its effort to ferret out the harmful versions. the report and its recommendations focused on “geographically mobile activities, such as financial and other service activities, including the provision of intangibles.”19 questions of competition for less geographically mobile activities (such as manufacturing, plants, and equipment) and for cross-border interest-bearing instruments were reserved for later work.20 an important thread that runs through the public discourse on tax competition, both in the context of the oecd and elsewhere (such as the european union) is the belief that there is a gap between stated goals and 17. this could include the opportunity for taxpayers to “negotiate” with the state over ultimate tax obligations. 18. oecd 1998 report, harmful tax competition: an emerging global issue at 15. for some readers, the oecd statements in both the 1998 report and the 2000 progress report provided no adequate acknowledgement of the benefits from tax competition, although the 2001 progress report did include an explicit recognition that competition contributed to the desirable base broadening and tax rate reductions of the 1990s. see, e.g., alex easson, harmful tax competition: an evaluation of the oecd initiative, 34 tax notes int’l 1037, 1054 (june 7, 2004). the oecd in recent years has expressly stated that it does not aim to create a system of uniform rates. see, e.g., tni interview: jeffrey owens, tax notes int’l 913, 917 (may 28, 2007) (“the oecd favors competition and that includes tax competition,” and “i believe that in the longer term, having countries compete on the basis of tax rates and the business friendliness of their tax environment (e.g., the consistency and certainty surrounding the application of tax rules) is probably healthier than competing by means of “niche” regimes”). 19. oecd 1998 report, supra note 18 at 8. 20. id. at 8-9. taxation of interest, including interest on bank deposits was reserved at least in part because it was currently under examination as part of a plan to explore the use of withholding taxes and exchange of information techniques. id. at 9-10. 2009] democracy, sovereignty and tax competition 563 ultimate desires. critics of the oecd tax competition project and also of certain efforts at tax harmonization in the eu object not only to the explicit plans and proposals on the table (e.g. the oecd’s 1998 harmful tax competition recommendations) but to what they believe are the unstated and more extreme end goals (e.g., uniform rates).21 both organizations, the oecd and the eu, are limited in their ability to persuade critics that their goals are more modest. just like legislatures, these are entities with many members holding differing views on the underlying questions. the majority may support a particular step (e.g., the 1998 oecd report or the eu common consolidated corporate tax base) but may have very different rationales and very different views on the appropriate extensions of that step. b. the states in the tax competition debate as we consider sovereign state claims for fiscal control, moral claims for global justice, and the possible outcome for tax competition, we must differentiate the various competition scenarios likely to be at issue. in describing the tax competition cases, this section targets three major features – the identity of the state in the debate (oecd member or not – as an initial indicator of likely power, wealth and resources), the type of activity or investment the competing state’s behavior seeks to attract, and the success of that competitive effort. the attention to these factors is not intended to suggest that they are the exclusive points of distinction among competition cases. for example, not all havens are in developing, less regulated environments (see, e.g., the role of switzerland and luxembourg). also, not all havens are only havens – belgium and the netherlands function as headquarters “havens” despite having many other developed business and investment activities. and finally, competition can be fictitious (i.e. competition over fictitious activities),22 can involve real but specialized or limited regimes, or can be comprehensive and broad based. this section 21. see, e.g., eileen o’grady, united kingdom holds its ground in opposing eu tax harmony, 31 tax notes int’l 1121, 1122 (2003) (quoting a british government spokesman in brussels, “the commission talks about moving to majority voting only on issues of tax administration in europe – but that is a slippery slope.”); david cay johnson, former i.r.s. chiefs back tax haven crackdown, n.y. times, jun. 9, 2001, at c1 (following then-treasury secretary paul o’neill’s rejection of the oecd project on the grounds that the u.s. does not support harmonization of tax systems, a “bipartisan group of tax commissioners suggested that mr. o’neill was misinformed about the purpose of the [tax competition] campaign,” and that the “project explicitly rejects harmonizing tax codes,” and that any effort to “unify tax rates would not work,” given the variety of tax systems.). 22. see oxfam tax havens: releasing the hidden billions for poverty eradication at 6-8 (jun. 2000) (at http://www.oxfam.org.uk/resources/policy/debt_ aid/). 564 florida tax review [vol. 9:5 organizes the tax competition discussion by identifying categories of state actors based on their status, behavior, and success because these elements capture the state’s interests, goals and motivations, and provide a strong baseline for evaluating prospects for cooperation. 1. oecd member states eager to limit tax competition: this group of countries forms the backbone of the oecd initiative. they are higher income countries with significant infrastructure and social welfare benefits whose multinational corporations and wealthy individual investors avail themselves of a range of attractive tax opportunities abroad, including but not limited to low tax rates, nondisclosure of information (tax and financial), “taxpayer-friendly” administrations, and special regimes (investment, headquarters, “fictitious” location/activities). some of these competitive tax features may be within the ambit of the oecd harmful tax competition category. 2. oecd member states engaging in competitive behavior: as part of the oecd’s project on harmful tax competition launched in 1998 (from which switzerland and luxembourg were the only member countries to abstain),23 the member states themselves were asked to examine their own domestic tax practices for any regimes that would be deemed harmful under the organization’s guidelines. among member states, 47 preferential tax regimes were labeled as potentially harmful. sensitive to accusations that the oecd did not move as aggressively or quickly against member states, the oecd’s 2004 progress report noted that 18 of these member regimes had been or were being abolished, 14 had been revised to eliminate the potentially harmful features, and 13 of the regimes were deemed not harmful.24 the two remaining regimes (switzerland and luxembourg) were then under discussion and ultimately resolved.25 the fact that the harmful preferential regimes in oecd member countries – and in many of the havens that the oecd identified were addressed does not invite the conclusion that competition was eliminated. after the united states announced a significant 23. both countries abstained from the report and provided written statements outlining their concerns, including those based on the information exchange proposals in the oecd plan. oecd 1998 report, supra note 18 at 73-78. 24. oecd, the oecd’s project on harmful tax practices: the 2004 progress report 7-13 (2004); easson, supra note 18 at 1046. 25. by the time of the 2006 progress report, the switzerland issue had been resolved. oecd, the oecd’s project on harmful tax practices: 2006 update on progress in member countries 4 (2006). soon after the release of the 2006 report, the luxembourg regime at issue (1929 holding companies) was repealed by domestic law. see jean-baptiste brekelmans, luxembourg – year in review, 44 tax notes int’l 1072 (dec. 25, 2006). 2009] democracy, sovereignty and tax competition 565 shift in the scope of its support for the oecd project in may 2001,26 the standard for what constituted cooperation with the project changed to consist of a commitment to improve transparency of the tax system and to exchange information (evidenced by the havens’ willingness to enter into exchange of information agreements).27 although these measures do (if fully executed) curb certain competitive (perhaps more aptly labeled evasion) behaviors, much remains open to competition. as the oecd head of the centre for tax policy and administration acknowledged in 2007: oecd work in eliminating harmful preferential regimes characterized by a lack of transparency, ring-fencing, and with no effective exchange of information – has been very successful. . . . yet, what we see today is a slow proliferation of what i call ‘niche’ regimes that are designed to meet oecd and eu standards, but which nevertheless, give a country a competitive edge. . . . you can see this as a healthy sign that tax competition is thriving, but there is a danger that we will end up with tax systems looking very much like the proverbial swiss cheese: more holes than substance.28 certainly one can anticipate that the same potential for newer, carefully tailored niche regimes exists outside the oecd as well. 3. non-oecd states that feel “forced” to engage in tax competition to secure significant, nonmobile business investment (e.g. manufacturing, production, etc): some developing countries consider tax competition their only option to retain or attract “real” business investment.29 such countries would prefer a system in which they could both collect reasonable tax revenues and maintain investment in their economy. within this group of countries, there are likely instances in which their perception that they must compete (at least in the short term) to attract and keep otherwise fairly mobile business investment is accurate. implicit in agreeing with their need to “compete” is a determination that the benefits of investment encouraged 26. see, infra text accompanying note 36. 27. see, e.g., easson, supra note 18 at 1077; see generally, oecd, the oecd’s project on harmful tax practices: the 2001 progress report (2001). 28. tni interview: jeffrey owens, tax notes int’l 913, 917 (may 28. 2007). 29. see, e.g., yoram margolioth, tax competition, foreign direct investments & growth: using the tax system to promote developing country growth, 23 virginia tax rev. 161 (2003) (exploring the ways in which developing countries might benefit from engaged in tax competition for real, direct investment). 566 florida tax review [vol. 9:5 by competition through taxes more than offset the loss in revenue.30 however, also within this group are likely cases in which the state is in error in assuming that the benefits from competition outweigh forgone revenue, either because the benefits of that investment to the state were low or because business was likely to choose to invest in that state for other reasons. in such cases, the state would be better off not engaging in competition. in making this determination, it is assumed that other countries will continue to engage in tax competition. the only question, given that condition, is whether the state in question truly gains from competition. there is a separate question as to whether all countries would gain from an agreement not to engage in this competition – i.e. whether there is a race to the bottom where all states are losers. the implications of this question for cooperation by sovereign states are taken up in part iii. 4. non-oecd members engaged in tax competition over mobile financial and other activities: these states include both those more likely to be characterized as tax havens (whether under the oecd’s 1998 formal definition, including the absence of substantial activities31 or more colloquially), and those states which would not typically be thought of as havens but which may have a regime competing for such activities. the former might be the most resistant to change, assuming that their dominant commercial existence is perceived to be as a “haven” for business and wealthy individuals from the tax regimes of their residence countries. however, in both cases there is the question of whether the state is accurate in its determination that the competitive behavior is a net positive for the country (lost revenue v. benefits). not only could the calculus be inaccurate, 30. an extensive literature has developed to measure and assess the impact of tax competition on business decisions. not surprisingly the results are complicated and depend on a variety of factors including the nature of the investment, whether it constitutes new investment, and the non-tax factors against which it competes in driving the final business decisions. see, e.g., rosanne altshuler & harry grubert, the three parties in the race to the bottom: host governments, home governments and multinational companies, cesifo working paper series no. 1613 (dec. 2005); mihir a desai, c. fritz foley, & james r. hines, jr., do tax havens divert economic activity? ross school of business paper no. 1024 (apr. 2005); rosanne altshuler, harry grubert & t. scott newton, has u.s. investment abroad become more sensitive to tax rates? nber working paper no. w6383 (jan. 1998); dhammika dharmapala & james r. hines, jr., which countries become tax havens? nber working paper no. 12802 (dec. 2006); harry gruber & john mutti, do taxes influence where u.s. corporations invest? 53 nat’l tax j. (2000). 31. oecd 1998 report, supra note 18 at 23 (listing four key factors in identifying tax havens: no or nominal taxes; lack of effective exchange of information; lack of transparency; and no substantial activities required). 2009] democracy, sovereignty and tax competition 567 it could be measuring costs and benefits for only a segment of society – the competition may benefit some subset of the state, but overall be undesirable. (once again, as with category three above, we assume a world in which continued tax competition by other states is a given). the grouping of states into different categories above is intended to facilitate the consideration of motives and rationales that might ultimately generate some measure of cooperation. to further that effort, a brief review of the evolution of the tax competition debate in the oecd and the eu is outlined in the next section. c. evolving positions on tax competition in the years following the oecd’s 1998 report, an anti-oecd momentum developed, fueled in part by the labors of the u.s.-based center for freedom and prosperity (cfp), which was formed in 2000 with a mission to challenge the oecd’s tax competition project and the united states’ participation in that work.32 the cfp lobbied both congress and the administration, and many of the tax havens. with the congressional black caucus, the cfp characterized the tax competition project as harmful to poor, developing, neighboring countries.33 in other government circles, the cfp contended that the project would ultimately harm the united states both because the united states itself is a successful tax haven and because u.s. taxpayers benefit from the existence and use of (other) tax havens.34 and with the havens, the cfp encouraged their resistance to oecd efforts to secure haven compliance with the recommendations of the tax competition 32. see ring, supra note 2 at 187. 33. ring, supra note 2 at 188 n.136. see also, thomas field, tax competition in europe and america, 29 tax notes int’l 1235, 1242-43 (2003); cordia scott, congressional black caucus says oecd tax moves unfairly blasts developing nations, 22 tax notes int’l 1600, 1600-01 (2001). letter from the cong. black caucus to paul o’neill, u.s. sec’y of the treasury, (mar. 14, 2001) available at http://www.freedomandprosperity.org/cbc/pdf. 34. ring, supra note 2 at 191-93 (describing the cfp campaign). see daniel mitchell, an oecd proposal to eliminate tax competition would mean higher taxes and less privacy, 21 tax notes int’l 1799, 1821 (2000) (“the oecd initiative. . . . is a threat to america’s national interests. . [and] will be bad for u.s. taxpayers”); letter from don nickles, u.s. senator, to paul o’neill, u.s. sec’y of the treasury (feb. 6, 2001) (“our relatively low-tax status has fueled economic growth and enabled our economy to draw investors and savings from many of our high-tax european competitors. those competitors will eventually use the oecd initiative as a weapon to undermine our own sovereignty right to enact pro-growth tax policies.”). 568 florida tax review [vol. 9:5 report.35 the united states, then under a new bush administration (2001), withdrew its prior strong support for the oecd project. the secretary of the treasury announced in may 2001 that the “united states does not support efforts to dictate to any country what its own tax rates or tax systems should be, and will not participate in any initiative to harmonize world tax systems. the united states simply has no interest in stifling the competition that forces governments – like businesses – to create efficiencies.”36 although the united states ultimately continued participating in the oecd tax competition project, the involvement and the scope of the project were both scaled back.37 as the oecd has grappled with how to frame its challenge to tax competition and how to respond to the debates that challenge has generated, the european union has similarly devoted substantial energy to questions of tax competition and tax harmonization within its borders.38 the ultimate question of eu tax harmonization begins with the rules for voting on tax matters. although the eu uses qualified majority voting (qmv) for a growing number of issues, taxation remains subject to unanimous voting rules.39 the unsuccessful eu constitutional treaty would have expanded the number of issues subject to qmv, but nonetheless anticipated retaining unanimous voting for taxation.40 the special place reserved for tax matters in the pantheon of eu voting sends a resounding message of tax sovereignty. even if these voting rules do not reflect the aspirational goals of many in the eu, the rules certainly reflect the clear reality of what is currently plausible – and what is not – in the eu today. against such a backdrop, it is not surprising that the efforts to harmonize the corporate tax base of eu members faced resistance.41 35. ring, supra note 2 at 195. two of the founders of the cfp convinced antigua to allow them to represent the state as “its official delegates to a january oecd summit with other caribbean tax-have countries.” david s. cloud, virginian fights for international tax havens: lobbying finds bush receptive to ideas clinton rejected, wall st. j., jul. 30, 2001, at a20. 36. cordia scott, u.s. secretary says oecd tax haven crackdown is out of line; treasury and oecd hold talks in paris, 2001 wtd 92-1 (may 11, 2001). 37. see, e.g., ring, supra note 2 at 189; easson, supra note 18 at 1059-1063. 38. see, e.g., carlo pinto, tax competition and eu law (2003); easson, supra note 18 at 1047. 39. eu website, http://europa.eu/institutions/inst/council/index_en.htm. see also, sir william nicoll & trevor c. salmon, understanding the european union 25, 555-56 (2001). 40. see eu website, http://europa.eu/scadplus/constitution/majority_en.htm. 41. interpretations of the eu tax competition experience to date have an aspect of the glass half full, glass half empty quality about them. although the history behind the eu’s savings directive could be viewed as suggesting increasing tax unity in the eu, the continued resistance to qmv for direct taxation provides a 2009] democracy, sovereignty and tax competition 569 several fears dominate the harmonization debates, and they reflect the different socio-economic positions of various member states. for example, those eu members who consider their tax systems to be significant, attractive features of their total business climate (e.g., ireland, united kingdom) resisted steps that shift control over tax system design away from the national government and toward the eu because they anticipated that higher tax rates will result.42 even where the issues on the table have concerned only corporate tax base harmonization or voting majorities on administrative tax matters (and not the admittedly sensitive subject of rates), suspicion lingered that a concession of “sovereignty” here would effectively open the floodgates to loss of state control over crucial tax policy.43 according to this story, low tax rates in countries such as the united kingdom and ireland would be the first casualty in this loss of state power. but, perhaps somewhat counterintuitively, the other major set of eu members resisting harmonization efforts in taxation were denmark, sweden, and finland. characterized as “high-tax, high-welfare states,”44 these nordic states placed a high priority on maintaining their social welfare systems and considered efforts at tax harmonization as a threat that would in the future force them to lower their tax rates.45 powerful statement regarding the eu members’ desire to retain the ability to say no to cooperation, even members’ when they may sometimes ultimately say yes. see generally cynthia blum, sharing bank deposit information with other countries: should tax compliance or privacy claims prevail?, 6 fla. tax rev. 579 (2004), (describing the content of the eu savings directive); george guttman, eu taxation of foreign interest is a multiple-choice game: withhold, report, ignore, 28 tax notes int’l 459 (nov. 2. 2002) (same). 42. see, e.g., chuck gnaedinger, eu parliament president discusses tax veto under draft constitution, 30 tax notes int’l 1312, 1312 (2003) (commenting on the impact of lower tax rates in ireland and england). whether these fears are realistic is a separate matter. 43. see, e.g., turlough o’sullivan, eu tax policy is bad news for business, irish times, jun. 8, 2007, finance sec. at 14 (expressing the view that the common corporate tax base project in the eu would result in higher taxes for irish business outside the eu and/or higher tax rates in ireland and contending that “[m]ember states must maintain their sovereignty over tax issues and retain their ability to adopt taxation policies suitable to their needs.”); eileen o’grady, united kingdom holds its ground in opposing eu tax harmony, 31 tax notes int’l 1121, 1122 (2003) (quoting a british government spokesperson in brussels, “tax is the province of the national state. . . . anything to do with tax is about sovereignty, and the treasury must have control over how and what is collected.”); see supra text accompanying note 21. 44. chuck gnaedinger, eu parliament president discusses tax veto under draft constitution, 30 tax notes int’l 1312, 1312 (2003) (quoting european parliament president cox). 45. id. 570 florida tax review [vol. 9:5 these insights from the eu experience with tax competition highlight several points. first, even among developed countries, there can be a strong resistance to steps perceived to constitute a surrender of tax sovereignty and control over tax decision-making.46 second, resistance to tax harmonization ideas in the eu is not restricted to the more “tax competitive” of its members. the position of the nordic members reminds us that support for tax sovereignty need not be a “cover” for tax competition strategies; it can embrace a broader set of concerns about regulating the system of taxation and expenditure in a state. third, the eu story reinforces the reality that no debate takes place in isolation. part of the objection to both qualified majority voting for tax administrative matters and to corporate tax base harmonization derived not from the actual effects of change on those issues, but to the possibility that they would lead directly or indirectly to tax rate changes that were deemed very undesirable. questions of good faith and “inevitable” tax policy creep infiltrate the debate and can be difficult to dismiss, even among states already formally committed to each other to a degree not seen elsewhere in the world. iii. theoretical challenges to tax competition and the underlying vision of sovereignty a. normative claims against tax competition: an introduction how is tax competition justified? the dominant arguments articulated on behalf of tax competition sound in efficiency.47 the strong version of the argument maintains that all tax competition is good because it will lead to an efficient market in government services. but is a market analogy appropriate for taxation? the answer turns on the purposes and the effects of taxation.48 taxation can be characterized as a market in which 46. see, e.g., julie roin, taxation without coordination, 31 j. legal stud. 61 (2002) (considering the reluctance of states to harmonize on tax issues, and discussing the eu work on savings taxation). 47. see, e.g., letter from milton friedman and over 200 other economists urging president bush to reject the oecd’s tax competition project (may 31, 2001) 2001 wtd 107-31 (“tax competition is a liberalizing force in the world economy, something that should be celebrated rather than persecuted. it forces governments to be more fiscally responsible lest they drive economic activity to lowertax environments.”); julie roin, competition and evasion: another perspective on international tax competition, 89 geo. l.j. 543 (2001), m.b. weiss, international tax competition: an efficient or inefficient phenomenon?, 16 akron tax j. 99 (2001); j.d. wilson, theories of tax competition, 52 nat’l tax j. 269 (1999). 48. certainly much of tax policy, especially income taxation, directly affects and influences economic activity. in designing tax rules we must be ever cognizant of their effects. at a minimum, virtually all taxation we see today affects 2009] democracy, sovereignty and tax competition 571 different governments offer different packages of goods and services (e.g., security, roads, educated workforce) in return for a certain price, “taxes.” the market image maintains that the states compete with each other to provide their services and goods at the best price. by eliminating waste and inefficiency in its provision of goods and services, a state can reduce its price and be more “competitive.” to the extent a “market” vision of taxation and government services (with an explicit role for tax competition) can improve efficiency in the provision of government services, certain competitive pressures in taxation can be quite positive.49 however, we must also confront the central ways in which tax regulation is different from other fields of regulation. most government regulation is premised on the view that the government steps in to resolve market failures including externalities and information costs.50 presumably if the market were fully functioning there would be no government involvement. such is not the story of taxation. first, states quite obviously impose taxes to collect revenues that fund government operations including more tangible infrastructure (e.g., roads, utilities) and less direct services (e.g., legislative functions, international negotiations, military, and defense). one could imagine trying to force taxation to remain squarely in the “market” model by arguing for taxation on a benefits only principle: government is treated as just another service provider in the economy, which should charge for its services. in some cases this may be feasible – and we do see certain government charges levied on a “use” basis (e.g., toll roads).51 but more broadly, this exercise is unrealistic. many of the goods are collective goods and/or the amount of behavior. moreover, we regularly use tax policy to affirmatively shape taxpayer behavior, whether social or economic. 49. see, e.g., supra note 47. 50. public choice theory of administrative law starts with the view that regulations are generally justified as a necessary response to market failure. see, e.g., richard a. posner, theories of economic regulation, 5 bell j. econ. & mgmt sci. 335 (1974) (discussing other regulatory theories as also viewing regulation as the government response to the existence of market failures); see also sam peltzman, toward a more general theory of regulation, 19 j. l. & econ. 211, 212 (1976). of course, even if much regulation would be justified by market failure, the reality of the legislative and administrative process may produce an entirely different result. competing theories of regulation and administrative law (including public choice, neopluralism, and public interest) question the degree to which the ideal of regulation as a solution for market failure comports with the actual regulations implemented. see diane m. ring, on the frontier of procedural innovation: advance pricing agreements and the struggle to allocate income for cross border taxation, 21 mich. j. int’l l. 143, 221-24 (2000). 51. although even here, any potential market comparison would be distorted by the fact that most consumer alternatives to the toll road are “free” roads supported by tax dollars. 572 florida tax review [vol. 9:5 each taxpayer’s use or benefit is indeterminate. thus, taxes are not imposed as pure benefit taxes. second, taxation as a theoretical matter has affirmatively adopted a distributive role in society.52 it is not merely practical considerations that prevent the design and pursuit of pure benefits taxation, but also philosophical and moral views on the meaning and legitimacy of government, its roles, and the duties and obligations of citizens:53 [r]egulation in areas such as environment, food safety, and occupational safety differ from regulation in taxation and social security. the former represent acts of government intervention into conduct otherwise undertaken by the market. the government justifies its intervention on the grounds of market failure. in contrast, redistribution regimes such as taxation and social security, do not redress market failure but instead serve a function entirely separate from the market.54 if someone seeks to limit taxation solely to an economic service provider model, then a direct confrontation is required with the practical limitations of pricing government goods and services and with the redistributive political theories underlying the implementation of taxation and social security regimes in a democratic state.55 that said, those who view the tax competition question through a pure market competition lens can legitimately demand an explanation of how the above arguments regarding the special role for tax legislation in our society translate beyond national borders in a sovereign state world. such an advocate of tax competition could contend: (1) yes, the market price for government services may be imprecise, but as countries set their tax systems (and “tax prices”) for the business environment they offer, investor enthusiasm will tell them whether they have set their price too high or too low for the package they offer (leaving the countries the option of changing either); and (2) taxation might have a significant redistributive function (implicit in fairness features) domestically because that comports with our domestic socio-political commitment, but we have no such structure of 52. see, e.g., ring, supra note 50 at 222; steven p. croley, theories of regulation: incorporating the administrative process, 99 colum. l. rev. 1, 4 n.7 (1998). 53. asserting this goal as a principle of our political system does not suggest it is self-executing. as noted elsewhere, the degree, contours, measurement, and context of “redistribution” in the domestic tax system remains contentious. 54. ring, supra note 50 at 223; see also posner, supra note 50; croley, supra note 52 at 4 n.7. 55. see james repetti , democracy and opportunity: a new paradigm in tax equity, 61 vand. l. rev. 1129 (2008). 2009] democracy, sovereignty and tax competition 573 commitment beyond our borders – that is the nature of a sovereign state system. thus, critics of tax competition must answer the challenge of the “pro-competition” position. b. an efficiency critique of the pro-competition position? one obvious option is to accept (at least for purposes of argument) the market model of taxation and demonstrate that this market experiences “failures” which, even under a market model, would support intervention. thus, even if taxation constitutes a market in government services, regulation is justified where the market generates externalities. the oecd 1998 report can be read as urging that view, at least in part: the [oecd] seeks to safeguard and promote an open, multilateral trading system and to encourage adjustments to that system to take into account the changing nature of international trade, including the interface between trade, investment and taxation. . . . [the report’s proposals] will further promote these objectives by reducing the distortionary influence of taxation on the location of mobile financial and service activities, thereby promoting fair competition for real economic activities.56 essentially, proponents of the oecd plan can justify the project on market failure grounds.57 the problem, however, in trying to cast harmful tax competition as market failure requiring government intervention (i.e. regulation) is that the necessary “regulation” would be supranational. if the market experiencing failure is the states’ selling of services and infrastructure for the “price” of taxes, then presumably the design, implementation and enforcement of that regulatory intervention must come from a body above the market players – i.e. a suprastate body.58 but do supranational bodies possess the requisite authority? within the domestic arena the justification (as opposed to “need”) for government intervention itself and for the use of force by a state on its people derives from the nature 56. oecd 1998 report, supra note 18 at 9. 57. the precise nature of that market failure may depend on context. for example, where havens’ rules enable easily hidden financial assets to stay hidden, we might say the market lacks complete information. if a residence country has incomplete information on a taxpayer’s true income and financial situation, it is unable to charge the “accurate” price for the benefits being provided. 58. for comparison, if the market for beef in the united states is experiencing some market failure (perhaps due to information and transaction costs) then remedial intervention would be needed at an enforceable level above the market participants (beef producers). 574 florida tax review [vol. 9:5 and sources of legitimacy in a democratic sovereign state.59 the same rationale fails at the international level. international bodies can be powerful and influential but their ability to use force is constrained by the nature of their legitimacy which differs from that of sovereign states. globally, we may see market failure but we do not see the same political theory supporting supranational imposition of force. yet that is what “regulation” of tax competition on market failure grounds would require. without justification, what is the legitimate role here for the oecd, the eu or other global actor? proponents of the oecd project (or of similar efforts to limit certain tax competition) could challenge this interpretation of the market failure story by contending that their goal is only to curb such “harmful” tax competition and that they do not need or seek a supranational body to enforce it (and thus there will be no use of “force” to justify). the oecd’s harmful tax competition recommendations would be consistent with a world in which no supranational body exists to govern these matters. why? there is no use of force on other actors (including other states), instead merely a redesign of oecd members’ domestic tax and regulatory rules, actions well within the traditional scope of sovereign powers. does acceptance of this oecd story line “answer” the proponents of tax competition? that is if we agree (1) that taxation constitutes a market in government services, (2) that this market experiences failures (externalities from some competition), (3) that the failures justify intervention, (4) that the intervention must be supranational, and (5) that this intervention does not pose legitimacy and use of force concerns precisely because the intervention is not accomplished through force, have we resolved the debate over tax competition? clearly we have not – and the reason why reveals that arguments regarding tax competition are not confined to an efficiency framework but extend beyond to encompass ideas of international political structure and global society. some states resist efforts to change harmful tax practices on the grounds that these practices are valuable from their sovereign perspective (even if potentially inefficient globally). of course the states challenging tax competition consider certain competitive practices to be harmful from their sovereign perspective. thus, there is a clash of sovereign positions, and an appeal to global efficiency provides no clear trump card. why do efficiency arguments fail to resolve the clash here, but not in a domestic market failure? in a domestic market, the players (just like the states in tax competition) may not be concerned with system-wide efficiency and externalities. however, these domestic players are part of a system which has invested the supra-market actor (i.e. the nation-state) with the authority to regulate and use force. where the participants in the market are 59. see, e.g., thomas nagel, the problem of global justice, 33 phil. & pub. aff. 113 (2005). 2009] democracy, sovereignty and tax competition 575 sovereign states, there is no supranational government with legitimate authority to enforce regulation of the market for government services and taxes. thus, efficiency may be a problem but it is not a problem “belonging” to a body with the ability to resolve it. the highest level actors with formal authority (the states) define their interests through their sovereign status. any appeal to change current behavior implicates not only on efficiency but also sovereignty – i.e. the “agreed” terms of global political organization. the positions of both the oecd anti-competition states and the pro-competition states reflect this posturing. the former emphasize the inefficiencies and externalities of the failed market but also identify the infringement upon the tax system of their own sovereign states by the competitive behaviors. conversely advocates for competition identify not only the potential benefits of broad competition by tax systems but also their “inherent” rights as sovereign states to design and utilize their tax systems to best support their state. resolution of this debate can only occur through the processes of international relations whereby sovereigns attempt to persuade others to accede to their views whether through enticements or threats of retaliation, or both.60 if limits on harmful tax competition would generate global efficiency gains, and if the winning states would share those gains with the losing states, a sufficient carrot could exist without a supra-state entity, however, winning states are not obliged to redistribute the gains.61 what do these observations on efficiency analysis of tax competition reveal? recall that the goal of the paper is not to establish whether tax competition is good or bad, or whether it generates certain market failures or not. rather the point is to delineate how the structure of the tax competition problem derives from a sovereign state world and how traditional market regulation analysis of the problem fails for the same reason. tax competition is a problem of sovereign states that cannot be regulated precisely because they are sovereign states. any solution must be a cooperative one grounded in the structure and reality of international relations among sovereign states. to the extent that the much of the analytical discourse on tax competition has focused on assessing the efficiency consequences and merits of the competition and whether it should be regulated, the reality of the question as one more intimately connected to matters of international relations if often obscured. 60. see supra text accompanying notes 7 and 12 (discussing the basic framework of the sovereign state world system and what rights, duties, and behaviors are consistent with that system). 61. if there is the possibility that eliminating “harmful” tax competition might be more efficient globally, but the benefit of that increased efficiency would not be distributed equally across the states, the anticipated implications of traditional efficiency analysis collide with reality. 576 florida tax review [vol. 9:5 c. equity grounds for curbing harmful tax practices 1. introduction other grounds on which tax competition has been challenged further reflect sovereignty’s role in both defining the problem and shaping potential resolutions. what are these other normative grounds? two equity arguments, each mirrored in a classic story of tax competition, provide a central starting point. in the first story, a society has implemented its income tax system (including a tax on income from capital) as part of a societal plan to provide a comprehensive range of benefits to its members (“social welfare”). if that state then faces tax competition (sometimes the “competition” might be more aptly characterized as evasion), the state will be “forced” to either reduce those services and benefits, or alternatively, increase taxes on a less mobile base – typically employment and consumption.62 either option potentially levies an increased burden on a subset of society, sparking equity concerns within that state.63 these equity concerns may dominate the story if the purported benefits of competition fail to materialize (i.e. the competition is “harmful” and does not improve government efficiency). in the second story, a developing country is trying to attract business, perhaps manufacturing, to further its economic growth. the necessary and desired economic growth, however, requires both business activities (including investment and manufacturing) and tax revenues (used for infrastructure). where either prong is inadequate, the country’s growth, measured by the quality of government services64 and by the residents’ standard of living, is in peril. if the developing country believes itself obliged to engage in tax competition (e.g., lower income tax rates on manufacturing profits earned in the jurisdiction), the revenue prong is compromised. it may be possible for the country to exact some additional (i.e. compensating) 62. see, e.g., pedro gomes & francois pouget, corporate tax competition and the decline of public investment, cesifo working paper no. 2384 (sept. 2008) (their model and simulations indicate that the corporate tax rate and public investment are endogenous and that “if the tax rate goes down by 15%, public investment in steady state goes down between 0.2% and 0.4% of gdp;” their empirical analysis indicates “higher values: between 0.6% and 1.1% of gdp.”) 63. these concerns have been extensively explored in the literature. see, e.g., reuven avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 133 harv. l. rev. 1573 passim (2000); oecd, 1998 report, supra note 18. 64. such government services include infrastructure facilitating business operations and social welfare services (e.g., providing access to education and healthcare). 2009] democracy, sovereignty and tax competition 577 revenue from sources not as sensitive to tax competition such as labor or less readily mobile commercial ventures. but for a population of little wealth (an assumed fact given the country’s designation as a developing nation) these prospects are limited. the resulting revenue fails to support much of the necessary internal development. moreover, it is not clear whether the competition for business investment garners the country any net increase in investment. as suggested in part ii’s outline of tax competition actors, a developing country may earnestly believe competition is necessary but may be wrong it its calculus. from this perspective, who is the “winner” among the developing countries competing for global business investment? one assessment is that the multinational enterprises, and potentially their residence countries, benefit. the multinationals gain because the income from business activities located in the competing developing countries bears little or no current tax (and presumably is structured so as to trigger little or no current residence country tax). assuming that most multinationals are not owned by the residents of developing countries, the gain to the corporations translates into gain for its owners who are members of developed countries. in addition to the corporations themselves (and their shareholders), the residence countries might see some gain – at least where the residence country uses a foreign tax credit, not an exemption system, to prevent double taxation of foreign source income.65 if little source country tax is collected, then little credit must offset the residence country’s collection of income tax. this latter point (the revenue advantage to the developed/residence country) should not be overstated. profitable business operations located in developing countries are unlikely to be structured as permanent establishments instead of subsidiaries, and any dividend and interest payments by the foreign subsidiaries to their parent corporations in developed countries are discretionary. 65. the residence country would tax either the current profits of a domestic corporation with a permanent establishment in a low tax developing country or the dividends and interest received by a domestic parent of a foreign subsidiary operating in a low tax country. additionally, strong controlled foreign corporation rules (or similar regimes) might collect current residence country income tax for the parent of a foreign subsidiary. 578 florida tax review [vol. 9:5 2. the equity link to sovereignty a. domestic pursuit of inter-individual equity in both of these stories (a developed country supporting a social welfare system and a developing country seeking economic growth), the equity arguments against tax competition can be understood as making claims based on both inter-individual equity and inter-nation equity, although the full theoretical underpinnings may not be adequately established. for the developed sovereign state seeking to implement its desired vision of a modern social welfare state, tax competition curtails its ability to “appropriately” distribute the revenue burden among its population. to the extent that the major multinationals and wealthy individual investors can rely on “havens”66 with attractive tax and regulatory structures to limit current taxation (through a combination of little or no local tax and a lack of transparency) their tax bills both abroad and at home will be reduced.67 where the competition takes the form of lower rates on actual business activity (for example manufacturing) the loss arises because the business has located elsewhere, moving both jobs and current income from the reach of the parent’s residence jurisdiction.68 when and under what circumstances 66. as reviewed in part ii, the term “tax competition” is often used broadly to cover different situations such as havens relying on a combination of low/no taxes, secrecy, and paper functions, and “real” competition for true economic activity, typified by the competition over manufacturing investment. these cases can be distinguished and can raise unique questions, particularly for the assessment of good and bad competition. 67. the residence jurisdiction will either have no picture or an inaccurate picture of that global taxpayer. 68. although the question of whether foreign investment is always a substitute for domestic investment is contested, the experience of the past two decades has demonstrated a significant exodus of manufacturing, technology and information services operations from some developed countries to developing countries. see, e.g., ashok d. bardhan & cynthia kroll, the new wave of outsourcing, fisher center for real estate and urban economics, u.c. berkeley, paper no. 1103 (2003) (discussing the loss of manufacturing jobs in the united states and comparing it to the prospects for service job loss). certainly these moves are not driven exclusively by taxes; wage costs have been a crucial factor in these decisions. see, e.g., james r. areddy, china’s export machine threatened by rising costs – orders drops, shops idle in sweater city; losing wal-mart, wall st. j. a1 (jun. 30, 2008) (describing the manufacturing threat that china faces from low cost countries such as vietnam). the rise of corporation inversion transactions, where for example a u.s. multinational reorganizes its corporate structure so that the u.s. entities are only subsidiaries and the new parent corporation is a foreign corporation in a desirable jurisdiction, complements the picture of large multinationals placing business activities outside of developed jurisdictions like the 2009] democracy, sovereignty and tax competition 579 these competitive scenarios are definitively “bad” is one question,69 but another is how the complaining state suffers its harm. from the residence country perspective, the argument is that the competition impedes its ability to fully achieve inter-individual equity, a generally accepted principle of domestic tax policy.70 the equity at stake is a domestic one. the violation “committed” by the competing state is not a failure to achieve equity, but rather an interference with the residence state’s efforts to achieve equity in taxation. the competing state has undermined the residence state’s “tax sovereignty,” broadly understood as the ability to effectively implement desired tax policy for its own taxpayers.71 although most nations readily assert and support the concept of tax sovereignty as a crucial power of the sovereign state, there is no clearly established scope or content for this sovereignty.72 definitional ambiguity, however, is not the only problem for tax sovereignty. just as the residence states frame their inter-individual equity objections to tax competition in the language sovereignty, so too have the states engaging in competition. in fact, they have generally been more successful in using sovereignty arguments to further their pro tax competition stance. after the oecd issued its 1998 report, and began pursuing the report’s recommendations, many targeted tax havens resisted. havens and other advocates of competition (or, more united states. moving operations “offshore” provides little advantage if the parent jurisdiction can still reach that activity for income tax purposes. for jurisdictions such as the united states with some real capacity to reach a portion of that income, the “logical” next step for corporate tax planning would be to take the united states out of the loop by transforming the u.s. multinational into a foreign multinational. 69. see infra part iii. 70. even where the contours of this inter-individual equity may be debated (see, for example, the continuing dialogue over horizontal and vertical equity), the expectation that a tax system will implement a system of inter-individual equity is presumed. see, e.g., paul mcdaniel & james r. repetti, horizontal and vertical equity: the musgrave/kaplow exchange, 1 fla. tax rev. 607 (1993); louis kaplow, horizontal equity: measures in search of a principle, 42 nat’l tax j. 139 (1989); richard a. musgrave, horizontal equity, once more, 43 nat’l tax j. 113 (1990). 71. one question that arises is how much these problems are those of the residence state’s own making. if the residence country instituted an entirely different tax regime, for example elimination of deferral, would that be a sufficient solution. the answer depends in part of the nature of the competitive practice (e.g., secrecy cannot be countered by an expansion of the residence country’s current tax base); other competitive pressures (does it matter what other residence countries do); and resolution of the complex challenges of using corporations as proxies for their shareholders. interestingly, the much maligned oecd 1998 recommendations called upon the residence jurisdictions to increase their use of anti-deferral regimes. 72. see, e.g., ring, supra note 2 at 197-201 (examining the content of “tax sovereignty” in modern debates). 580 florida tax review [vol. 9:5 accurately, advocates of minimal taxation) painted the oecd and its member states as aggressively infringing upon the tax sovereignty of these “poor” (literally and figuratively) haven nations.73 the fact that some of this reaction was shaped and prodded by forces in the united states proves interesting on other grounds,74 but does not diminish the reality that the tax havens were able to generate what was perceived by many as a plausible, credible claim that tax sovereignty protected their “competitive” tax behavior.75 ultimately, the tax competition debate could be understood as a battle of competing claims to tax sovereignty. essentially, the havens argue that they have the right to design their own tax and regulatory system in any way they deem beneficial to their state, even if a “side-effect” is reduced taxes collected by residence (generally developed) countries. any steps by the residence countries to try to limit the havens’ effectiveness is an infringement upon the havens’ tax sovereignty. correspondingly, the residence countries (typified by the states supporting the oecd tax competition project) contend that they have the right (as a matter of tax sovereignty) to use their tax and regulatory system (and other rules) to implement a tax system (including one that seeks to limit tax competition) they deem beneficial to their state, even if it limits the attractiveness of havens and competing jurisdictions. although the tax competition problem was not immediately characterized as one of competing claims of tax 73. see, e.g., ring, supra note 2 at 195-197. see also, supra note 35 reviewing the cfp’s role as official delegates on behalf of antigua. 74. see infra part iv.c (discussing the lack of a monolithic position on tax competition within the various countries). 75. for example, twenty six of the thirty eight members of the congressional black caucus signed a letter sent to then secretary of treasury paul o’neill arguing that the oecd project on tax competition: (1) “will undermine the ability of developing nations . . . to strengthen and diversify their economies as well as reduce poverty,” (2) “threatens to undermine the fragile economies of some of our closest neighbors and allies, and (3) “will impose serious economic harm on developing nations.” letter from the cong. black caucus to paul o’neill, u.s. sec’y of the treasury, (mar. 14, 2001) available at http://www. freedomandprosperity.org/publications/publications.shtml. see also, kimberly carlson, when cows have wings: an analysis of the oecd’s tax haven work as it relates to globalization, sovereignty and privacy, 35 j. marshall l. rev. 163, 172 (2002) (“the oecd scheme would encourage the world’s major economies to penalize 41 low-tax countries and territories for maintaining attractively low rates unless they essentially relinquish their fiscal sovereignty.” quoting deroy murdock, attack of the global tax police, national review online, apr. 23, 2001, http://www.nationalreview.com/murdock/murdock042301.shtml). 2009] democracy, sovereignty and tax competition 581 sovereignty, the duality of tax sovereignty in the tax competition realm eventually emerged.76 how can these competing sovereignty claims be resolved? what is the source of the alleged rights to such “tax sovereignty?” at this point the states have moved beyond formal law in their appeal and have drawn upon the general expectations and understandings of the sovereign state world system. ultimately, the sovereignty of any one state is dependent upon the acceptance and recognition of that state by other states in the world. in the modern sense, the system of sovereign states functions precisely because all of the players have a shared commitment to a basic structure and vision of international order and international relations.77 despite the existence of some basic structure, there is not agreement on the exact nature of certain dimensions of sovereignty – such as the tax sovereignty claimed in the tax competition context. neither the literature nor the theory of the sovereign state political system provides an answer. on the most fundamental level, regardless of how egregious some states find the behavior of other states in the realm of tax competition, the conduct does not arise to the level of clear violation of state sovereignty in the way that physical invasion of a state’s territorial borders would. although the analysis and literature currently contemplating these competing claims fails to offer a clear resolution,78 some of the arguments on behalf of the havens foreshadow arguments they may hope will break the deadlock: the actions of the oecd and its member states are “bad” because they constitute the efforts of a powerful state (or group of states) to restrict the options and opportunities of a poor and developing nation. the norm implicated here by the havens is not just respect for sovereignty, because that has proven insufficient, but respect by the powerful 76. see michael littlewood, tax competition: harmful to whom?, 26 mich. j. int’l l. 411, 480 (2004) (“if the tax havens are free to structure their tax systems so as to facilitate the avoidance of other countries’ taxes, it seems to follow that the other countries should be free to structure their tax systems so as to discourage the use of havens.” (e.g. by disallowing deductions to haven entities, levying withholding taxes on payments to haven residents)). 77. the existence of the basic shared understanding that underlies the system does not eliminate disagreements. for example, the status of taiwan remains uncertain. in contrast, where all the relevant parties “agree” then de jure independence can be established – essentially in a moment. for example, the former british colony the ellice islands became independent and sovereign (with british assent) at midnight on september 30, 1978 under the new name tuvalu. alan james, sovereign statehood 23 (1986). thus, tuvalu made the shift to sovereign status at a specified moment in time by virtue of the collective acceptance by the global community of this change. 78. ring, supra note 2 at 179-80, 200-201 (discussing that lack of a clear theoretical solution to the problem of competing claims of tax sovereignty). 582 florida tax review [vol. 9:5 states for the needs of the weaker states. although there may be many reasons that global society would decide that some preference or advantage should be accorded poorer nations, sovereignty per se has not been traditionally understood to require this. as noted in part i,79 an international system based on sovereign states does not anticipate or require equality of power, wealth, or outcome for individual sovereign states. it is not inconsistent with the theory of the sovereign state system for one state to leverage its power and resources to influence the actions of another sovereign and thereby secure an advantage to itself. one critic of the oecd and its tax competition project attempts to distinguish general power plays by nations (permissible) from the specific anti-tax competition activities of the oecd and its members over tax competition (characterized as impermissible): “any sovereignty that is lost by signing worldwide trade agreements . . . is tolerable because it is only forfeited after an opportunity to negotiate. by excluding non-oecd members in the analysis and by recommending coordinated defense measures, the oecd violates the sovereignty of those nations that it unilaterally deems tax havens.”80 according to this vision of sovereignty, the problem is not that the haven nations got a bad deal from the oecd members, but rather that they got this bad deal without having a chance to negotiate for a better one. although this argument implicitly accepts that sovereignty can “legitimately” sustain unequal effects, it still ascribes to sovereigns more “rights” than are traditionally acknowledged. certainly the negotiation of a bad (or perhaps more accurately, uneven) deal is a legitimate act of sovereign states. however, the opportunity to negotiate before another state takes domestic regulatory steps (e.g. tax, banking, foreign aid) is not traditionally understood as an inherent right of a sovereign. moreover, this argument cannot really resolve the impasse created by the competing claims of tax sovereignty because the oecd member states could likely counter that they were not granted a chance to negotiate with the havens before the havens implemented their regimes. this point returns us to one thread of the anti-oecd critique that could tip the balance: the idea that the strength of competing sovereignty claims can differ depending on the wealth and power of the countries involved.81 the idea that the havens’ claim to tax sovereignty in designing their system should be superior to a counterclaim by the oecd members precisely because they are poorer, less powerful nations is essentially an argument for inter-nation equity – the idea that there is some type of fairness calculus on the global state-to-state scale taking account of the difference in situation among states. often inter-nation equity is envisioned loosely as an 79. see supra text accompanying note 7. 80. carlson, supra note 75 at 177-178. 81. see ring, supra note 2 at 179-80, 200-201. 2009] democracy, sovereignty and tax competition 583 analog to inter-individual equity. however, as the literature on that question has recognized, the parallels are not complete.82 the principles and premises of inter-individual equity (generated as a guiding principal of the relationship among members of a political community) cannot be immediately transported to the inter-nation context.83 at present, firm foundations for a generally accepted vision of inter-nation equity have yet to be established although a number of scholars are working actively in this area. until we can generate such a vision, the competing claims of tax sovereignty must be resolved on other grounds. thus, what started out as an objection to haven tax competition because it impeded the residence state’s ability to implement a tax system consistent with domestic inter-individual equity became a conflict over competing claims for tax sovereignty which looks to an as yet unspecified idea of inter-nation equity as a possible resolution.84 yet, inter-nation equity was the basis of the other set of normative equity-based arguments against tax competition: the case of the developing country seeking active business investment. 3. developing countries’ race to the bottom – a call for inter nation equity another dimension to the tax competition problem highlighted above in part ii.a. reflected on the plight of developing countries seeking revenue and investment in their effort to enhance the condition of their economy and social welfare. one way of characterizing the argument on behalf of these havens against competition, is that continued unrestrained competition is a negative race to the bottom where they lose vital revenue, de facto secure no 82. see, e.g., nancy h. kaufman, fairness and the taxation of international income, 29 law & pol’y int’l bus. 145, 153-54, 188-89 (1998); kim brooks, internation equity: the development of an important but underappreciated international tax value (oct. 30, 2008) in tax reform in the 21st century (richard krever, john g. head, eds., kluwer law international) forthcoming (available at ssrn: http://ssrn.com/abstract=1292370); richard a. musgrave & peggy b. musgrave, inter-nation equity, in modern fiscal issues: essays in honor of carl s. shoup, (richard m. bird & john g. head, eds., 1972). 83. see infra text accompanying notes 92-93. see also brooks, supra note 82; ilan benshalom, the new poor at our gates: global justice implications for international trade and tax law (dec. 19, 2008) northwestern public law research paper no. 08-43. available at ssrn: http://ssrn.com/abstract=1319465. 84. although even if we established a clear interest in inter-nation equity, it would still need to be considered against the modern welfare state’s desire to achieve inter-individual equity for a wide group of people. 584 florida tax review [vol. 9:5 real additional business investment,85 and the “advantage” of the competition goes to the multinationals and their home counties.86 these developing countries gain little ground in the fight against poverty and its related ills, and the gap between wealthy and poor states in the global economy widens. according to this critique, such tax competition must be reconsidered in order to promote and support “inter-nation equity.” in this context, the idea of inter-nation equity connotes “more equitable distribution” of the tax pie, but again relies on a concept that has visceral appeal (inter-nation equity) yet unclear foundations.87 tax competition is not the only context in which this type of inter-nation equity argument has been proffered. bilateral double tax treaties face scrutiny as inappropriately favoring capital exporting nations through their allocation of primary and residual taxing rights. developing countries reportedly have made “concessions” in tax treaties without a full awareness of their implications because they believed the provisions were standard and because the provisions were formally reciprocal (enhancing their appearance of mutuality and comparable impact).88 85. as to whether the countries engaging in the “forced” competition do benefit and obtain valuable investment – the question has both a short-term and long-term dimension. short-term – is the state accurate in calculating the loss of revenue and the benefit of business and investment secured by competition? if the state inaccurately concluded competition was needed, the state could improve its fiscal position immediately by ending its competitive features. if the state is “correct” that current competition is crucial to maintaining its place in the business and investment world (but is leading to zero revenue with no significant efficiency gains – i.e. the race to the bottom), then the solution is longer-term and multiparty. 86. for example, the world bank’s statistics paint a picture in which the income gaps have been growing: “trends in global inequality depend on changes in inequality between and within countries. inequality between countries has been characterized by two divergent trends in recent decades. the gap between the richest and the poorest countries has progressively widened (for example, doubling between the top 20 and bottom 20 countries over the past 40 years – figure 2) as a significant number of countries are falling further behind compared not only to industrial countries but to other developing countries. the income distribution between countries has consequently worsened (figure 3). at the same time, there has been an acceleration in growth in many developing countries, including the most populous ones, so that the gap between their average incomes and that of industrial countries has begun to narrow. overall, inter-country inequality weighted by population has decreased as a result (figure 3). china and india account for the bulk of this improvement. while inter-country inequality has improved, inequality within many of the most populous countries, with a large number of poor, has increased modestly.” world bank, poverty in an age of globalization 4 (2000). see also, aviyonah, supra note 63. 87. see, e.g., brooks, supra note 82; benshalom, supra note 83. 88. the reciprocity was more apparent than real because the difference in economic situation of the two states meant that in practice, applications of the 2009] democracy, sovereignty and tax competition 585 a. normative basis for inter-nation equity in both the treaty and tax competition context, the inter-nation equity argument captures the belief that the developing nations currently secure an inadequate and unfair share of the global tax revenue pie. this idea, that international practices disfavoring poorer states might be labeled unfair and warrant re-evaluation to address inter-nation equity, seems plausible. but once again, we are faced with the question – what forms the normative basis for this inter-nation equity? one version of this inter-nation equity claim emerges from the broader inquiry of philosophy and political science into concerns for global justice. globalization has prompted a reconsideration of ideas of distributive justice and its traditional focus (almost exclusively) on the “domestic sphere.”89 among the questions raised are a number that might sound familiar to the tax world, including: “should we recognize a basic right to subsistence or to a basic income?” “how should we distribute or redistribute natural resources or social primary goods?” and “what are the limits of state sovereignty?”90 the answers are unclear because there is no “universal” agreement on obligations (at least above some “basic” human rights minimum) owed to others globally.91 however, the challenge to tax competition sounding in inter-nation equity and global resource allocation relies on some version of moral and political theory in which our obligations extend beyond national borders. a likely candidate for this theoretical support lies in the broad umbrella of cosmopolitan theories of the justice. quite generally, cosmopolitanism is a “moral perspective that emphasizes the unity of humanity as a single moral community of equally valuable individuals . . . . [where] justice requires each person, regardless of citizenship or nationality, to be treated as an equal for the purposes of determining the claims and reciprocal provisions would not offset. see generally, tsilly dagan, the tax treaties myth, 32 n.y.u. j. of int’l l. & politics 939 (2000); allison christians, tax treaties for investment and aid to sub-saharan africa: a case study, 71 brook. l. rev. 639-713 (2005). 89. ronald tinnevelt & gert verschraegen, global justice between cosmopolitan ideals and state sovereignty: an introduction, in between cosmopolitan ideals and state sovereignty, 1, 2 (ronald tinnevelt & gert verschraegen eds., 2006). 90. tinnevelt & verschraegen, supra note 89 at 2; see also charles jones, global distributive justice, in between cosmopolitan ideals and state sovereignty, 13, 13-14 (ronald tinnevelt & gert verschraegen eds., 2006). 91. see, e.g., jones, supra note 90 at 13-24 (discussing the differing approaches taken by peter singer, robert nozick, john rawls, thomas pogge, and thomas nagel) 586 florida tax review [vol. 9:5 duties of distributive justice.”92 as an umbrella concept, cosmopolitanism has a range of variants. the strong version contends that a special concern for an individual is justified only if it is good for humanity as a whole.93 the moderate version acknowledges that although we have duties to all other persons, we might have special duties to a subset (such as fellow members of our nation-state) which are not justified on the grounds of benefiting humanity as a whole.94 cosmopolitanism’s focus on the individual, when directed at international taxation, prompts the question why should a group of individuals have a smaller piece of the revenue pie by virtue of their residence in a historically weak and impoverished state? inter-nation equity demands attention not because nations, per se, have these rights, but because the nation stands as the representative of a large group of individuals. when the nation’s share is not equitable, what we are really saying is that the population’s share is not equitable and is “artificially” based on the division of the world into nation-states. of course this picture of cosmopolitan justice drastically understates the complexities, nuances and disagreements of the multiple theoretical paths. much attention can be and is devoted to examining the implications, variations, limitations, and potential extensions of the rich universe of cosmopolitan thought. however, two important points can be made. i. link between inter-nation equity and inter individual equity first, as noted above, the cosmopolitan ideal and its pursuit of global justice, including distributive justice, has not yet generated a widely accepted vision of the contours of our global commitment to individuals and of the appropriate standard for allocating resources and evaluating distributive justice. when and why does an allocation of resources that would be unacceptable domestically become acceptable globally? in some sense, the inquiry of cosmopolitanism and global justice links inter-individual equity and inter-nation equity by essentially forcing us to answer the questions, “why do inter-individual equity obligations and goals end at the national border?” and “why isn’t inter-nation equity really the same as interindividual equity?” extensively developed answers to these questions are 92. jones, supra note 90 at 14. see generally, thomas pogge, world poverty and human rights (2002). 93. jones, supra note 90 at 15. see also samuel scheffler, boundaries and allegiances: problems of justice and responsibility in liberal thought 111-130 (2001). 94. jones, supra note 90 at 15. see also samuel scheffler, boundaries and allegiances: problems of justice and responsibility in liberal thought 111-130 (2001). 2009] democracy, sovereignty and tax competition 587 grounded in the relationship of government, society, law and the individual.95 our relationship to other members of our own nation-state is different according to these measures, from our relationship to members of other countries. recognizing the interaction between arguments for inter-nation equity and those for inter-individual equity helps identify the sovereigntybased constraints under which they operate and the current limitations on their ability to provide a clear and widely accepted foundation for certain kinds of global justice. inter-individual equity96 issues arise within the nation-state and are consistent with the concepts and expectations in a democratic sovereign state regarding the relationship between the government and the people.97 inter-nation equity, with its demand that equity and distributive justice not be limited by national borders, struggles under cosmopolitanism theory to find its grounding. one “obvious” solution is to characterize inter-nation equity as inter-individual equity (because it is the individuals for whom we are ultimately concerned). however, to fit internation equity into the current framework of inter-individual equity (premised on a legitimate nation-state and community) we can only endorse the “internation version” of inter-individual equity if in fact all of these individuals are members of a single community under one government – a global state.98 that is, if we had a single global state then in theory the arguments that bind us on inter-individual equity grounds to our fellow citizens would now bind us to all humanity. without an accepted and fully developed theory of duty and obligation for “others,” inter-nation equity collapses itself, both theoretically and literally, into inter-individual equity. of course, if that were to happen (the creation of a world state) we would no longer be discussing inter-nation equity. 95. see generally, jones, supra note 90 at 13-22; benshalom, supra note 83; see infra note 96. 96. it is useful to reiterate that although the concept and goals of interindividual equity are more clearly consistent with the system of sovereign states, that does not mean that the application of inter-individual equity principles are without debate. at quick review of the tax literature, see supra note 70 as well as currently political discourse clearly indicates otherwise. 97. see generallyrepetti, supra note 55. 98. some theorists affirmatively maintain that global justice obligations as envisioned by the cosmopolitan theorists are not possible absent a world government because “justice is necessarily connected to sovereignty, it only applies ‘to a form of organization that claims political legitimacy and the right to impose decisions by force and not to a voluntary association or contract among independent parties concerned to advance their common interests.’” tinnevelt & verschraegen, supra note 89 at 3 (quoting thomas nagel, the problem of global justice, 33 phil. & pub. aff. 113, 140 (2005)). 588 florida tax review [vol. 9:5 but could it happen? certainly, as a practical matter, a single global state is unlikely to appear any time soon. moreover, as the author has explored elsewhere, the move to a global state is not just practically implausible, but also theoretically distinct from a world with a multiplicity of sovereigns. a stable, legitimate government with the capacity to enforce sanctions requires a certain connection among the people. according to this view, “democratic legitimacy is possible only within the framework of a demos – that is, a political community expressed in the concept of a nation. beyond the nation-state, there is no strong sense of public interest, and the potential for political regulation is limited.”99 nothing formally limits the demos to the level of the nation-state, but as yet no real demos has emerged beyond that level. even in the european union, with its unique set of commitments among sovereign states, political discourse and commitment remains predominantly national.100 thus, the prospect for grounding internation equity in inter-individual equity is unrealistic and essentially eliminates the distinction between the two. what about inter-nation equity standing alone? why do we have such difficulty establishing the normative framework for this position? as noted, above, there has been extensive work done demonstrating why the justifications and rationales supporting inter-individual equity cannot be directly translated to inter-nation equity. this work focuses in part on the grounding of inter-individual equity in the political theory of the nationstate.101 the political theory supporting the nation state structure (including concepts of justice, power, legitimacy, and the need for a people with a shared political commitment – a demos) would clash with cosmopolitanism’s premise that there should be no distinction among individuals despite their membership in another sovereign state.102 but what if we could imagine a theoretical foundation for internation equity, would that be enough? probably not. the practical barrier that the current sovereign state system poses to the international redistribution required under a cosmopolitan ideal is starkly illustrated by hypotheticals 99. michael zurn, democratic governance beyond the nation-state, in democracy beyond the state 91, 95 (michael th. greven & louis w. pauly eds., 2000). 100. ring, supra note 2 at 176-177; marc plattner, democracy without borders? global challenges to liberal democracy 97 (2008). this assessment may change over time as, and if, the interactions and bonds within the eu continue to develop. but at present, the view that political discourse in the eu is better characterized as national seems accurate. 101. see supra text accompanying note 97-98. 102. could this clash be resolved by positing a single nation-state where all individuals by definition shared that political commitment? in theory this might be possible, but as noted above, supra text accompanying notes 99-100, is highly implausible and likely not even desirable. 2009] democracy, sovereignty and tax competition 589 offered by ilan benshalom.103 cosmopolitan ideals of justice would dictate transfers from wealthy states and their peoples to poor states, without regard to the political identity of the recipient. thus, japan could be asked to redistribute to north korea, and israel to syria, irrespective of the political and military tensions between the states.104 sadly, in a world of substantial political and military conflict, many other compelling examples can be drawn from 20th century history to the present. even if the underlying cosmopolitan theory were morally sound and internally developed, the practical outcome would be a political non-starter at present. ultimately, the sovereign state system requires that claims for internation equity either find a compatible interpretation within the sovereign system or argue persuasively and plausible for its replacement.105 thus, arguments against tax competition based on inter-nation equity face a significant hurdle from the sovereign state system. ii. revisiting the classic sovereign state the second observation we can make with respect to inter-nation equity, sovereignty, and challenges to tax competition is that history shows us the flexibility of the sovereign nation concept. the stereotyped concept of a sovereign state as independent from all external forces and in complete control domestically, has been a fiction,106 and certainly is not theoretically required today. the “compromises” of the 20th century to the ideal image of the sovereign state include acknowledgment of human rights claims and the recognition of the illegitimacy of imperial rule. perhaps we can find room for a moderate variant of cosmopolitan theory which grants a special, and possibly dominant, obligation to fellow citizens but maintains a heightened set of duties to all persons. one question arises: if there are global duties does that imply the need for global institutions (even if not necessarily a world state)? once again, if the currently incomplete cosmopolitan theories could develop a framework for the stable world order that would implement their vision of global justice,107 the sovereign state system might be flexible enough to accommodate it.108 103. benshalom, supra note 83 at 5. 104. id. 105. see generally benshalom, supra note 83 at 2-19. 106. see, e.g., ring, supra note 2 at 161-62. 107. see leif wenar, states, individuals, and equality, in between cosmopolitan ideals and state sovereignty, 25, 33-34 (ronald tinnevelt & gert verschraegen eds., 2006) (encouraging cosmopolitan theorists to provide a more comprehensive theory). 108. simply taking a basic cosmopolitan duty to redistribute to others and funneling that duty through a world organization (instead of a state-to-state transfer, as in the north korea/japan and syria/israel examples) would fail to remedy the 590 florida tax review [vol. 9:5 b. realistic application of inter-nation equity claims but until cosmopolitan theories answer these calls for a more specified vision of the required economic justice and of its stable implementation in the world, where are we? are inter-nation equity challenges to tax competition without support? although the strong moral claim potentially promised by cosmopolitan theory may emerge in the future, there are three ways in which states can press an inter-nation equity claim in the modern sovereign state world. first, policy makers can make appeals on humanitarian grounds that essentially correspond to what the literature refers to as “charity,” in contrast to moral obligations.109 such calls are weaker than a statement of moral obligation, and according to nagel do not constitute true global justice,110 yet they may yield some results, particularly in combination with the two additional points below. to the extent that we believe it is possible to shift and shape norms and behavior without a full scale rethinking of foundational philosophical theory, developing countries might benefit from efforts to promote a charitable norm of this type. second, and likely related to the first, it may be possible to expand upon some of the accepted thinking on human rights to encompass more clearly defined economic rights. some scholars are currently pursuing this line of reasoning,111 considering whether support for human rights can make sense without a corresponding commitment to certain economic baselines for the society. if the latter can be established, or at least argued, then ensuring adequate tax revenue to those developing nations which are the locus of significant human rights concerns (in terms of standard of living and related measures) could constitute a necessary component of a national commitment to human rights globally. third, it may be possible to make arguments against tax competition (influenced by inter-nation equity) that appeal to the core of state sovereignty – the call to national self interest. assuming a competing state inaccurately views its competitive behavior as beneficial, then if that state were convinced its calculation was in error it might change its tax rules and eliminate the competitive component in an act of self interest. however, given the problem. if one country strongly resists direct redistribution to another country given their military/political situation, it is unlikely to view that transfer differently when run through an international body. the transferor state is not in need of an intermediary to save face and avoid a direct transfer it objects (according to the facts of the hypothetical) to such a transfer in any form. 109. see, e.g., thomas nagel, the problem of global justice, 33 phil. & pub. aff. 113, 140 (2005) 110. id. 111. see, e.g., allison christians, fair taxation as a human right, univ. of wisconsin legal studies research paper no. 1066 available at http://ssrn.com/abstract=1272446. 2009] democracy, sovereignty and tax competition 591 difficulty in making these determinations in many cases, and given the pressures on governments to appear active in trying to attract business, this effort at persuasion on the facts is unlikely to be successful. but another push at self interest remains, this time on the developed country side. to the extent one can make plausible arguments that the current distribution of global tax revenues among states is not merely inadequate for developing countries, but also inevitably undesirable for developed countries (perhaps due to decreased political stability in developing countries, or due to a stagnant consumer market in those countries), then challenges to tax competition and the race to the bottom could be re-cast in a manner entirely consistent with the operation of a sovereign state world system. thus, given that cosmopolitan theories of justice have not yet unseated the sovereign state system, either as a theoretical or practical matter, their moral claims for inter-nation equity as its relates to tax competition will have limited force. advocates for developing countries must therefore look to charity arguments, to national self-interest, and to an expanded and clarified conception of human rights (with a detailed economic component) to achieve their desired fiscal changes. iv. strategic use of sovereignty in the mission to secure cooperation over tax competition if a sovereign state system remains the framework against which the battle over tax competition rages, can features of the sovereign state system be co-opted by those aiming to curb harmful tax competition? rather than serving as a reminder of our current absence of a complete, viable theoretical framework of global justice that would demand increased attention to equity, can the sovereign state become part of the solution? this section explores a range of connected strategies that might be available in different circumstances and in different combinations. a. resurgent sovereignty claim the first possibility is a return to tax sovereignty – the very place we left with an impasse. is it possible to characterize a subset of tax competition practices – those that really constitute tax evasion –112 as cases in which it is not “merely” the general tax sovereignty of the state that is at risk but instead the more fundamental obligations of accountability to its people? consider country x, with a number of resident multinational corporations and wealthy individuals who have invested in havens in an effort to hide and avoid 112. even this term is likely to elicit some disagreement over what constitutes permissible facilitation of non-payment of tax in a home jurisdiction and what does not. 592 florida tax review [vol. 9:5 otherwise due country x tax. if country x cannot guarantee to its population that it is acting with reasonably full and complete knowledge in imposing tax burdens and enforcing tax rules,113 (i.e. that its tax bills and enforcement actions adequately reflect the realty of its own taxpayers’ haven investments) and if the people cannot verify those decisions, is a vital component of a legitimate democracy – accountability – missing? to the extent that this line of reasoning can successfully refocus the competing sovereignty claims, it could provide support in a subset of cases. in addition to framing the revitalized sovereignty argument as a question of accountability, it might be useful to return to the core definition of a sovereign state. recall that despite some variation in the definition, the core accepted components of a sovereign state included control over territory and people. the state challenging tax competition should anchor its objections in the very definition of sovereignty purportedly cherished by the competing state. if sovereignty presumes that states exert control over their own people, then tax practices that facilitate the avoidance of domestic country taxes would be an attack on the core sovereignty of that residence country, arguably no different than physically invading its territory (the other feature over which the sovereign state is expected to exhibit control). finally, where examples of tax competition depend significantly on the host jurisdiction’s commitment to secrecy, nondisclosure and little or no information sharing with the residence country, then the tax sovereignty claims of the developed (residence) country) might be better paired with a broader challenge to these competition behaviors based on their ability to facilitate terrorism, money laundering, and other “non-tax” problems. in recent years, the tenor of the debate over issues of secrecy, disclosure and information sharing outside the tax realm has shifted significantly. the tax competition debate though has exhibited less influence from these major events. however, reframing the tax issues as part of, not simply analogous to, the broader financial concerns may prove powerful. b. sovereigns and the “right” to use power, leverage and deal making sovereignty ideals validate one state’s use of its influence and power to exact agreements and concessions from another state. to the extent, for example, that the oecd members sought to use their “power” (including economic advantages) to obtain the consent of havens to the oecd plan to eliminate harmful tax competition, sovereignty is not inherently violated. it 113. recall that in democracies engaged in some measure of redistribution through the tax system, the tax burden varies depending on income levels. if one group of taxpayers can hide their income, then they are not paying their nationally agreed share (and the other will have to pick up the fiscal slack or spending will be reduced). 2009] democracy, sovereignty and tax competition 593 seems that the oecd did initially take a route more aptly characterized as a power move than an invitation to negotiate when it issued the 1998 report. oecd success though would depend on the true power behind the asserted positions. it is unclear what trajectory the 1998 report and its recommendations would have taken in subsequent years had the united states remained fully invested in the project.114 however, without the united states on board, and given the other fractures, sufficient power did not exist as of 2001. at that stage, the strategy of sovereign deal making and negotiation moved to the fore. consideration of this shift draws our attention to the running debate in international relations theory as to whether the neorealists or the neoliberals more accurately describe the nature of inter-state cooperation and regime formation. does power shape the international world, or do the agreements that we see and the regimes that are formed reflect the market nature of interactions and the ever-present desire to produce a more efficient outcome?115 the tax competition controversy does not answer that century old debate, but it provides additional fodder for the theorists. more importantly, however, if a deal on tax competition can make all of the states better off, then cooperation is certainly possible. but as noted earlier, even if certain competitive practices are globally inefficient, simply eliminating those practices may not improve all states’ positions. states achieving an advantage from competition become losers by cooperating unless redistribution (the sharing of the global gain) takes place. although we lack a fully viable theory of global justice that would require redistribution globally, we do not need such an equity theory to justify redistribution undertaken as part of a trade. exactly how this deal would take shape would depend on the machinations of the extensive game theory and modeling that occupies much of the international relations and international regime formation literature.116 three immediate versions can be identified: (1) share the gain – if eliminating certain harmful tax practices generates a net gain for the oecd countries then they can offer to share that gain. this sharing could be done directly, as suggested by steven dean, by paying havens when they 114. see, e.g., hugh ault, reflections on the role of the oecd in the development of international norms (u.s. response to the oecd project may have unexpectedly pushed the process not just in the direction of information exchange, but information exchange beyond the harmful tax competition context) (draft on file with the author). 115. diane m. ring, international tax relations: theory and implications, 60 tax l. rev. 83 (2007). 116. see, e.g., ring, supra note 115 at 104-110 (considering the range of models and factors implicated in the game theory modeling of regime formation theory). 594 florida tax review [vol. 9:5 facilitate the identification of income and taxpayers who are avoiding home country taxation.117 such a plan is not without obstacles including the need to limit negative incentives of states to implement regimes so as to collect the finder’s fee. this sharing could also be done indirectly by modifying certain features of the residence country’s tax system or treaty provisions to expand the source country’s opportunity to engage in “legitimate” revenue collection. (2) bundle strategy – if providing a related tax carrot proves too cumbersome or risky, an agreement on tax competition could be bundled with other issues or benefits not related to taxation (including trade, military, development aid).118 (3) combine deal making with power – the sophisticated understanding of the neoliberal views on cooperation and regime formation in the international arena recognizes that power is not irrelevant, but rather that cooperation develops where there are inefficiencies that can be improved upon through the deal. however, more than one deal may be possible and the ultimate selection among those choices may turn substantially on relative power among the states.119 for example, in a gain sharing solution, although the allocation to the competing states must be sufficient to garner their support (i.e. make them better off than competing), the developed countries might be able to achieve this while still retaining a larger portion of the total tax pie. c. seeing beyond the sovereignty just because the global system operates with sovereign states as dominant players and just because the states set tax policy and collect and use the resulting revenue, it is critical never to lose sight of the fact that sovereignty is about the international relationships among states. in that setting, states act as a monolith and must present a single view and speak with one voice. either the country will or will not sign the treaty; either it will or will not impose withholding taxes. only one official, national position 117. see steven dean, philosopher kings and international tax: a new approach to tax havens, tax flight, and international tax cooperation, 58 hastings l.j. 911 (2007). 118. see, e.g., ring, supra note 115 at 101 (considering the use of bundling and issue linkage in reaching agreement) 119. see, e.g., id. at 100-101(discussing, for example, the battle of the sexes game or other scenarios with multiple potential cooperation points). 2009] democracy, sovereignty and tax competition 595 can operate at a single moment in time (assuming the government has functional control). the state, however, is not a monolith of views. if we open the lid of the nation and look inside we find multiple, competing, and contradictory views on all of the important international issues. the democratic political process within the state sorts through these competing positions and arrives at a single view that it then advocates on behalf of the state. although that process may validate the selection of one view among many, it does not negate the reality that there were many voices and that a different voice may rise to the top at a later date. within tax competition we saw this most dramatically in the evolution of the official u.s. position on the oecd project during the period january 2001may 2001 as the bush administration came into office. in this case the reality that states are not a monolith worked against the oecd harmful tax practices agenda, however, the same observations can be used affirmatively to push for cooperation (perhaps in conjunction with some of the approaches outlined in part iv.b. above). if the oecd members are not monoliths, then neither are the havens. the challenge is determining where a useful and reasonable fissure on the tax competition issue lies. one possibility is a case described in part ii, of a haven that may have miscalculated in deciding that competition was beneficial. if there was a miscalculation, the haven’s administration may resist revisiting the issue and admitting error, but perhaps other segments of the population or business sector could be persuaded that a shift would be in their own and their national interests. another possibility is a country in which the benefits of competition are not widely disbursed and are concentrated at the top. in this case, it could be strategic to identify the ways in which the competition serves a small segment of the population but provides little or no benefit to the majority of the people. for example, a “paper” haven in which the foreign investors have minimal presence and investment in the country does generate business for locals who facilitate that paper existence but may provide little income or investment for the state more broadly. v. conclusion sovereignty permeates the tax competition controversy – both in the characterization of the problem and the crafting of cooperative solutions. it helps explain the limits of efficiency and equity arguments against harmful tax competition. market failure ideas, which generally support intervention and regulation, adapt less readily to an inter-state market which lacks the requisite supra-state above the individual nation-states. similarly, the complex equity arguments are inextricably intertwined with both the practical constraints of a sovereign state system and the theoretical values embodied in the modern democratic sovereign state. certain challenges to 596 florida tax review [vol. 9:5 tax competition (appeals to charity, self-interest, and human rights) remain available despite the absence of a sustainable vision of global economic justice and redistribution with which to critique specific competition practices. moreover, armed with a heightened appreciation for the place of sovereignty in tax competition we can reconsider possible sovereignty based arguments, engage in deal-making, and capitalize on the distinction between sovereign states and monoliths. finally, although a frank and honest conversation about what we value through sovereignty and what we aspire to globally will not provide ready answers to long-standing dilemmas of philosophy and political reality, it will sharpen our focus and attention on the underlying issues of global justice and global governance in a dialogue linking philosophy, law, political science, and economics. tcharity really does begin at home: florida tax review volume 11 2011 number 4 221 the gatt-legality of border adjustments for carbon taxes and the cost of emissions permits: a riddle, wrapped in a mystery, inside an enigma by charles e. mclure, jr. * i. introduction .................................................................................... 223 ii. the gatt and the ascm .............................................................. 233 a. basic rules .............................................................................. 234 b. the article xx exceptions ....................................................... 235 c. primary observations ............................................................. 236 1. why so much uncertainty .......................................... 236 2. the separability of btas for imports and exports .... 238 3. the nature of carbon taxes ...................................... 240 a. carbon taxes are indirect taxes ........................ 240 b. carbon taxes are “taxes occultes” .................. 242 c. carbon taxes are not prior-stage cumulative indirect taxes (psci taxes) ................................ 246 iii. parsing the basic rules ................................................................ 249 a. national treatment and export subsidies ............................... 250 1. are carbon taxes levied on products? ..................... 250 a. taxes on process and production methods ......... 250 b. the superfund tax ............................................... 252 c. the ozone depleting chemicals tax ................... 255 2. are btas based on carbon intensity levied on “like products?” ....................................................... 255 3. best available technology: grasping pyrrhic victory from the jaws of defeat? .............................. 262 *senior fellow, hoover institution, stanford university. much of this analysis was initially presented at a conference on “u.s. energy tax policy” sponsored by the american tax policy institute held in washington, d.c., oct. 1516, 2009. this revision has benefitted from comments by steven powell, but the author is solely responsible for the views expressed here. 222 florida tax review [vol. 11:4 b. a mixed system and most-favored nation treatment ........... 265 c. the shrimp-turtle decision: setting the stage for article xx ................................................................................ 266 iv. btas under gat article xx ....................................................... 268 a. the tests of paragraphs (b) and (g) ....................................... 269 b. satisfying the chapeau ............................................................ 274 1. arbitrary or unjustifiable discrimination between countries where the same conditions prevail .......... 275 2. disguised restriction on international trade ............ 277 3. the importance of design .......................................... 280 c. gatt legality under the basic rules vs. article xx exceptions .............................................................. 282 d. summary appraisal ................................................................. 283 v. bas for emissions permits ........................................................... 283 a. bas for the cost of emissions permits purchased from the issuing government ........................................................... 285 b. bas for the opportunity costs of free allowances ................. 287 c. bas for the cost of permits acquired in the secondary market .................................................................... 290 d. bas for the costs of capture and storage and cdm .............. 291 vi. summary and conclusions..................................................... 291 2011] border adjustments for carbon taxes 223 “russia . . . is a riddle, wrapped in a mystery, inside an enigma.” – winston churchill “the application of btas to energy taxes under the gatt/wto rules is clouded with uncertainty.” – oecd i. introduction with the notable exception of the united states (and, until recently, australia), developed nations and many nations in transition from socialism made commitments under the kyoto protocol to reduce emissions of co2, the most important greenhouse gas thought to be responsible for global warming. by comparison, the protocol excused developing countries from the need to cap emissions. both countries making commitments to reduce emissions and those that have not made commitments, but are considering doing so, are concerned that policies adopted to meet targets for emissions reductions will place their carbon-intensive industries at a competitive disadvantage relative to those in countries not making commitments and induce carbon leakage to those nations which they see as “free riders” in the global effort to reduce greenhouse gas emissions.1 on the other hand, 1. although competitiveness and carbon leakage are related concepts, they are not the same and they have different implications for the gatt-legality of border adjustments. see peter wooders, julia reinaud, and aaron cosbey, options for policy-makers: addressing competitiveness, leakage, and climate change, international institute for sustainable development 5-11 (oct. 2009), http://www.iisd.org/pdf/2009/bali_2_copenhagen_bcas.pdf. in addition, if not all nations adopt policies to reduce emissions (and even if all do adopt such policies, but the price of carbon is not the same in all countries), emissions will not be reduced where it is cheapest to do so. for a more complete discussion and references to the literature, see charles e. mclure, jr., border adjustments for carbon taxes and the cost of emissions permits: economic, administrative, and legal issues, in taxing energy: new insights for policy design 193 (gilbert e. metcalf, ed., cambridge university press). on the economic case for border adjustments for carbon prices, see roland ismer and karsten neuhoff, border tax adjustment: a feasible way to support stringent emission trading, 24 eur. j. l. & econ. 137 (2007). it is important to keep in mind that, contrary to popular perceptions, bas would sensibly apply to only a small fraction of a nation’s trade. wooders, reinaud, & cosbey, supra, at 16-26, survey evidence of the economic impact of carbon prices and bas. they note: [r]esearch has made clear that only a small proportion of economic activity (most studies indicate no more than 1 per cent) is at risk for any significant change in production costs if carbon costs differ between countries. the literature shows that this 224 florida tax review [vol. 11:4 developing countries resist carbon pricing, both because they do not want to hamper economic development and because they believe that primary responsibility for reducing emissions should lie with the developed countries that emitted virtually all the greenhouse gases now in the environment.2 moreover, the statement in the 1992 rio declaration on environment and development that “states have common but differentiated responsibilities” underlies the un framework convention on climate change (unfccc) and thus the kyoto protocol. if committing countries were to employ either a cap and trade system or a carbon tax to “price carbon,” they could use “border adjustments” (bas) to eliminate, or at least reduce, concerns about competitiveness and carbon leakage.3 bas would convert carbon pricing otherwise based on the origin of emissions to carbon pricing based on the destination (or consumption) of includes the cement and lime, aluminum, paper, refining, and iron and steel sectors; other sectors may be important in other countries. for the rest of the economy (generally at least 99 percent), the amount of carbon embedded in products is not significant enough to result in any material increase in production costs. these authors rely especially on estimates in jean-charles hourcade, damien demailly, karsten neuhoff, and misato sato, differentiation and dynamics of eu ets industrial competitiveness impacts, final report, climate strategies (2007), http://www.climatestrategies.org/component/ reports/category/17/37.html. 2. for a useful summary of positions taken by developed and by less developed countries at the 15th conference of parties (cop) held in copenhagen in dec. 2009, see trevor houser, copenhagen, the accord, and the way forward, peterson inst. for int’l econ., policy brief no. pb10-5, mar. 2010. for a more optimistic appraisal of the outcome of the december 2010 cop in cancun, see trevor houser, less can be more: protecting cancun’s fragile victory, peterson inst. for int’l econ., dec. 15, 2010, http://www.piie.com/realtime/?p=1906. for discussions of proposals to deal with issues of competitiveness and carbon leakage in the eu and the u.s., see wooders, reinaud, and cosbey, supra note 1, at 34-40, and harro van asselt and thomas brewer, addressing competitiveness and leakage concerns in climate policy: an analysis of border adjustment measures in the u.s. and the eu, 38 energy policy 42 (2010). 3. bas have also been discussed as a way to facilitate transition from free allowances, a less efficient way to address concerns about carbon leakage and competitiveness effects, to full auctioning of emissions permits; see karsten neuhoff & roland ismer, international cooperation to limit the use of border adjustment, summary of a workshop convened by climate strategies, geneva, sept. 10, 2008, 4, at http://www.eprg.group.cam.ac. uk/wp-content/uploads/2008/11/ba-workshopreport_nov-6-2008.pdf. these authors downplay the incentives bas will provide for countries to reduce emissions. 2011] border adjustments for carbon taxes 225 carbon-intensive products.4 under a cap and trade system such as the european trading system (ets), importers could be required to hold permits (or perhaps be subject to tax on the carbon content of imports). moreover, production for export could be excused from the need to hold emissions permits, and the cost of permits incurred before the export stage could be rebated. “border tax adjustments” (btas, a particular form of ba) under a carbon tax would be similar; tax would be collected on imports, but not on exports, and any tax collected before the export stage would be rebated.5 many in important policy positions in the eu have proposed that bas be instituted,6 and both the waxman-markey bill passed by the u.s. house of 4.the gatt working group on border tax adjustments [hereinafter the working party on btas], in ¶ 4, adopted the following oecd definition of border tax adjustments: any fiscal measures which put into effect, in whole or in part, the destination principle (i.e. which enable exported products to be relieved of some or all of the tax charged in the exporting country in respect of similar domestic products sold to consumers on the home market and which enable imported products sold to consumers to be charged with some or all of the tax charged in the importing country in respect of similar domestic products). the report of the working party is http://www.worldtradelaw.net/reports/ gattpanels/bordertax.pdf. 5. it is assumed here that border adjustments under a cap and trade system would take the form described. it is, however, possible that btas could be utilized, at least on imports, instead. (that is, imports could be subject to a tax intended to equal the cost of emissions permits borne by domestic products.) reinhard quick, “border tax adjustment” in the context of emission trading: climate protection or “naked” protectionism?, 3 global trade & customs j. 163, 164, 166, 172, 174 (2008), argues that the latter approach would violate the basic gatt rules, which do not anticipate such a “mix and match” approach, and would not be eligible for an exception under gatt article xx for the same reason. 6. on april 15, 2010, french president nicolas sarkozy and italian prime minister silvio berlusconi sent a letter to josé manuel barroso, president of the european commission, encouraging imposition of a carbon tax on imports and the discussion of bas for carbon prices in a commission report on emissions trading then expected to be released in june 2010, as mandated by european communities, directive 2009/29/ec of the european parliament and of the council of 23 apr. 2009 amending directive 2003/87/ec so as to improve and extend the greenhouse gas emission allowance trading scheme of the community, official journal of the european union, l 140/63, jun. 5, 2009, prefatory ¶ 25, 66-67, which included the following words: energy-intensive industries which are determined to be exposed to a significant risk of carbon leakage could receive a higher amount 226 florida tax review [vol. 11:4 of free allocation or an effective carbon equalisation system could be introduced with a view to putting installations from the community which are at significant risk of carbon leakage and those from third countries on a comparable footing. such a system could apply requirements to importers that would be no less favourable than those applicable to installations within the community, for example by requiring the surrender of allowances. as early as 2000 the european commission, while noting that “fears that the pursuit of a high level of environmental protection will inevitably lead to a deterioration of the community’s international competitiveness may be exaggerated” and extolling the benefits of “international cooperation on the widest possible scale,” said: in the absence of such coordination, the community could examine the feasibility of making border tax adjustments in a way which would be environmentally and economically sound and consistent with international trading rules. see commission of the european communities, communication from the commission to the council and the european parliament, bringing our needs and responsibilities together-integrating environmental issues with economic policy, com (2000) 576 final, pp. 9-10. the following other examples are cited in timothy e. deal, wto rules and procedures and their implication for the kyoto protocol, u.s. council for int’l bus., jan. 2008, http://www.uscib.org/docs/wto_and_ kyoto_2008.pdf. in november 2006, then french prime minister dominique de villepin indicated that france would urge the eu to study “the principle of a carbon tax on the import of industrial products from countries which refuse to commit themselves to the kyoto protocol after 2012.” later that year, eu enterprise and industry commissioner günter verhheugen, in a letter to josé manuel barroso, president of the eu commission, seconded this idea, suggesting that border tax adjustments could “balance out” competitive benefits enjoyed by non–participants in the kyoto protocol. by comparison, in december 2006 eu trade commissioner peter mandelson dismissed de villepin’s plan as “highly problematic under current wto rules and almost impossible to implement in practice.” even so, in october 2007, sarkozy urged barroso to “examine the option of taxing products from countries that do not respect the kyoto protocol.” that same year john hontelez, secretary general of the european environmental bureau, told bbc news, “border tax adjustments . . . are a justifiable threat to irresponsible governments like those of the us and australia, the only rich countries which refuse to implement kyoto.” john hontelez, “time to tax the carbon dodgers,” bbc news, apr. 5, 2007, http://news.bbc.co.uk/2/hi/ 6524331.stm. more recently germany’s former state secretary for the environment, matthias machnig has described import bas as “eco imperialism” against developing nations; see “bundesregierung: klimazoll wäre öko-imperialismus,” reuters deutschland, jul. 24, 2009, http://de.reuters.com/article/domesticnews/ iddebee56n07x20090724. 2011] border adjustments for carbon taxes 227 representatives on june 26, 2009, and the discussion draft introduced by senators kerry and lieberman on may 12, 2010, stipulate that bas could be applied to imports if by a certain date other countries have not enacted sufficiently stringent restrictions on emissions.7 nations are not free to impose any bas they choose. rather, bas must accord with a nation’s treaty obligations.8 the most relevant of these 7. american clean energy and security act of 2009, h.r. 2454, 111th cong. (2009). border adjustments are generally seen as the “price of passage” of u.s. cap and trade legislation. on the other hand, president barack obama has criticized inclusion of bas in the waxman markey bill, citing the fear of setting off a trade war; see john m. broder, obama opposes trade sanctions in climate bill, n.y. times, jun. 29, 2009. some u.s. and canadian proposals for subnational cap and trade systems or carbon taxes envisage destination-based pricing of carbon. for example, california would require the first in-state seller of electric power to hold emissions permits, thereby achieving destination-based pricing of carbon embedded in imports of power. see michael hanemann, california’s new greenhouse gas laws, 2 rev. envt’l. econ. & pol’y 114, 128 (2008). california might make an exception for power imported from the six states and four canadian provinces that participate in the western climate initiative, in which case origin-based charging for carbon embedded in power generated within those ten jurisdictions would prevail. see cal. air res. bd., climate change scoping plan: a framework for change, dec. 2008, http://www.arb.ca.gov/cc/scopingplan/document/adopted_scoping_plan.pdf. california’s inventory of greenhouse gases includes emissions from out-of-state power plants producing electric power sold in california. see gerry bemis, inventory of california greenhouse gas emissions and sinks: 1990 to 2004, cal. energy comm., staff final report cec-600-2006-013-sf, dec. 2006. in other respects the california system is origin-based. since california does not export electric power, the lack of bas for exports for that sector might seem to not matter. of course, it could matter for other sectors, including especially those relying heavily on electric power, whether generated inside or outside the state. for an excellent discussion of the difficulties of designing and implementing a destination–based cap and trade system, many of which would also be encountered in creating a national system, see james bushnell, the design of california’s cap-and-trade and its impact on electricity markets, 8 climate policy 277 (2008). in canada, provincial imposition of btas is stymied by the constitutional limitation on provincial taxing powers to “direct taxes within the province.” although courts have interpreted this limitation not to prevent provincial use of retail sales taxes (if imposed on the purchaser, but collected by the merchant), it would be difficult to fit provincial btas for carbon taxes through the eye of that needle. on the other hand, it is possible for provincially-owned power companies to collect tariffs on imported electricity, as british columbia power has done. i am grateful to jack mintz for the last point. 8. the sarkozy-berlusconi letter to barroso mentioned supra note 6, notes the need for any measures taken to be consistent with the wto rules. similarly, the prefatory paragraph in the 2009 eu directive quoted supra note 6, continues with these words: 228 florida tax review [vol. 11:4 for present purposes, and the only ones considered here, are the general agreement on tariffs and trade (the gatt) and the agreement on subsidies and countervailing measures (the ascm).9 the world trade organization (wto) oversees compliance with these rules.10 any action taken would need to be in conformity with the principles of the unfccc, in particular the principle of common but differentiated responsibilities and respective capabilities, taking into account the particular situation of least developed countries (ldcs). it would also need to be in conformity with the international obligations of the community, including the obligations under the wto agreement. it appears that the drafters of the waxman-markey bill and other legislation pending in the u.s. were also concerned that the proposed legislation be consistent with the international trade rules. see arjun ponnambalam, u.s. climate change legislation and the use of gatt article xx to justify a ‘competitiveness provision’ in the wake of brazil-tyres, 40 geo. j. int’l l. 261, 279-80 (2008); andrew w. shoyer, comment to jason e. bordoff, international trade law and the economics of climate policy: evaluating the legality and effectiveness of proposals to address competitiveness and leakage concerns, in climate change, trade, and competitiveness: is a collision inevitable? 60 (lael brainard & isaac sorkin eds. 2009). the stated objective of that bill is “[t]o create clean energy jobs, achieve energy independence, reduce global warming pollution and transition to a clean energy economy.” american clean energy and security act of 2009, h.r. 2454, 111th cong. (2009). there are many references to carbon leakage in the bill, which might justify an exception under gatt article xx, but none to loss of u.s. competitiveness, which would not. harro van asselt, thomas brewer & michael mehling, addressing leakage and competitiveness in u.s. climate policy: issues concerning border adjustment measures, climate strategies working paper 52 (2009), note regarding the earlier lieberman-warner bill, “[t]he provisions of art. xx gatt – and subsequent case law – are important in the context of the climate security act, as the wto compatibility of the importer allowance requirement seems to heavily rely on them.” in implicitly targeting non-committing developing countries, drafters of this legislation seem to have been less concerned than the european union about consistency with the unfccc principle that “[s]tates have common but differentiated responsibilities,” which, as discussed in section iv, might preclude bas on trade with these countries. 9. thus the reference in the title of this article to “the gatt-legality” of bas is somewhat incomplete. for a summary of the contents of other international trade agreements that could be relevant but are not considered here, see gary clyde hufbauer, steve charnovitz & jisun kim, global warming and the world trading system 34 (2009). 10. although the gatt dates from 1947, to a large degree it codified practice existing when it was initially negotiated. the gatt and the ascm were both updated, the former in ways that are not relevant for present purposes, in 1994 at the end of the uruguay round of negotiations, which also saw the establishment of 2011] border adjustments for carbon taxes 229 there is little doubt that btas equivalent to taxes on domestic fossil fuels would be allowed for both imported and exported fossil fuels. there is, on the other hand, considerable uncertainty regarding the adjustability of taxes on carbon embedded in the prices of imports and exports.11 the organisation for economic co-operation and development (oecd) has stated that “[t]he application of btas to energy taxes under the gatt/wto rules is clouded with uncertainty.”12 whether the wto would allow border the wto to provide a single institutional framework for interpreting the gatt and related agreements. revisions of the ascm, which built on the 1979 agreement on interpretation and application of gatt articles vi, xvi, and xxiii negotiated during the tokyo round, were more substantial and are of potentially greater significance for present purposes. the wto was a long time aborning. although creation of the international trade organization was originally proposed as part of a post-wwii package that included the international monetary fund and the world bank, institutions that were actually created, the u.s. senate refused to ratify the ito charter. thus from 1947 until the wto was created, no formal institution was charged with implementing the gatt, and a country that did not like the ruling of a gatt panel could ignore it. the establishment of the wto created a dispute settlement mechanism, whose findings were to be binding on member nations. for a brief overview of the institutional framework of the gatt/wto, see geert van calster, international & eu trade law: the environmental challenge 13-17 (2000). 11. regarding these matters, pitschas states: as long as energy is traded as its own product, there is no difficulty in applying the bta rules . . . to energy taxes. however, the application of bta rules to energy taxes is less obvious once energy is used to produce other products. in this case, a tax on energy is also a tax on the production process of these products, but not on the products themselves. it is therefore questionable whether energy taxes are eligible for bta under these circumstances. see christian pitschas, gatt/wto rules for border tax adjustment and the proposed european directive introducing a tax on carbon dioxide emissions and energy, 24 ga. j. int’l & comp. l. 479, 490-91 (1995). as described in section iii, the distinction between taxes on products and taxes on process and production methods is pivotal in determining the gatt-legality of btas. 12. organisation for economic co-operation and development (oecd), the political economy of environmentally related taxes 92 (2006). here is a sample of similar appraisals: “from a wto legality perspective, the issues are less than clear-cut.” gavin goh, the world trade organization, kyoto and energy tax adjustments at the border, 38 j. world trade 395, 395 (2004). 230 florida tax review [vol. 11:4 are border adjustments related to energy taxes permitted under world trade law? a clear-cut answer to this question is not easily found, because many relevant principles and legal terms are not clearly defined in wto law, and the case law through dispute settlement panels and the wto appellate body remains sketchy. frank biermann and rainer brohm, implementing the kyoto protocol without the usa: the strategic role of energy tax adjustments at the border, 4 climate policy 289, 292 (2005) [hereinafter biermann and brohm, strategic role]; frank biermann and rainer brohm, border adjustments on energy taxes: a possible tool for european policymakers in implementing the kyoto protocol? 74 vierteljahrshefte zur wirtschaftsforschung 249, 251 (2005) [hereinafter biermann and brohm, possible tool]. “[t]he disagreement on the adjustability of these taxes still pervades discussions, and little progress has been made. case law has not contributed much to clarify the issue.” javier de cendra, can emissions trading schemes be coupled with border tax adjustments? an analysis vis-à-vis wto law, 15 rev. eur. community & int’l envt’l. l. 131, 139 (2006). “at present, it is difficult to draw firm conclusions from the relevant agreements or wto case law as to whether such [border tax] adjustments are consistent with wto rules.” aaron cosbey and richard tarasofsky, climate change, competitiveness and trade, chatham house report vi (2007), http://www.chathamhouse.org.uk/files/9248_r0607climatechange.pdf. [f]or policies concerning energy or ghg emissions, it is still unclear whether specific taxes on energy are adjustable, and if so, whether adjustments may only be applied to exports and not to imports. . . . . most of the restrictions that multilateral trade agreements pose for market-based climate policies remain speculative at this point. carolyn fischer & alan k. fox, comparing policies to combat emissions leakage: border tax adjustments versus rebates, resources for the future 4, 6, discussion paper 09-02, (2009). “there are a vast number of views expressed by academics, policy-makers, and various stakeholders on how trade is affected by measures to mitigate climate change, and on the extent to which these measures are consistent with wto rules.” world trade organization and the united nations environment programme (wtounep), trade and climate change 142 (2009). 2011] border adjustments for carbon taxes 231 adjustments for the cost of emission permits is even less certain, especially if permits are distributed free of charge or acquired on secondary markets.13 thus the subtitle of this article; like russia, the gatt-legality of border adjustments for carbon prices is truly “a riddle, wrapped in a mystery, inside an enigma.”14 “[w]hether any emissions tax bta could be legal under wto rules is impossible to answer given the present state of the law. . . .” matthew genasci, border tax adjustments and emissions trading: the implications of international trade law for policy design, 2008 carbon & climate l. rev. 33, 36. “[t]he potential adjustability of environmental taxes levied on the producer of a product – for example, a tax on the energy used or the pollution emitted – remains an uncertain and debated issue of trade law.” hufbauer, charnovitz, and kim, supra note 9, at 39. 13. “the legality of border adjustments for energy taxes has long been an unsettled question, and the legal uncertainties only multiply when the concept is extended to an emissions trading scheme.” genasci, supra note 12, at 33. “there may be wto compatibility issues arising from the way such [emissions] permits are allocated.” cosbey and tarasofsky, supra note 12, at vi. see also section v. 14. some authors have, however, been much more conclusive in their appraisals of gatt-legality of bas for carbon taxes or for the cost of emissions permits. roland ismer, mitigating climate change through price instruments: an overview of the legal issues in a world of unequal carbon prices, 2010 eur. y.b. int’l econ. l. 205, 220, opines, “[a] unilateral implementation of border adjustments can be in compliance with world trade law.” by comparison, quick writes, “the suggested trade policy measures to combat climate change can be considered wto incompatible.” quick, supra note 5, at 175. other appraisals are cited infra. many who believe that the wto rules do not necessarily preclude bas for carbon prices emphasize the importance of design; see section iv. that the wto does not want the responsibility of deciding the gattlegality of bas can be discerned from these words of pascal lamy, director-general of the wto: plan a is a world in which clear climate commitments are assigned to all – under common but differentiated responsibilities – and where the wto toolbox is only explored at the implementation stage. plan b is a unilateral, go-it-alone approach to climate change, that mistakenly places the implementation toolbox at centre stage. we must fight for the only real plan that we have, which is plan a. see pascal lamy, director-general, world trade org., keynote address at the carleton university in ottawa, canada: climate first, trade second – gattzilla is 232 florida tax review [vol. 11:4 this article examines the gatt-legality of btas for carbon taxes and bas for the cost of emissions permits.15 at least six primary questions long gone (nov. 2, 2009) (transcript available at http://www.wto.org/english/ news_e/sppl_e/sppl140_e.htm). 15. the literature on the various intertwined aspects of this topic, most of it written within the last decade, is voluminous. in addition to hufbauer, charnovitz & kim, supra note 9, pitschas, supra note 11, goh, supra note 12, de cendra, supra note 12, oecd, supra note 12, quick, supra note 5, van asselt, brewer, and mehling, supra note 8, and van calster, supra note 10, at 416-49, see, for example, paul demaret and raoul stewardson, border tax adjustments under gatt and ec law and general implications for environmental taxes, 28 j. world trade 5 (aug. 1994); j. andrew hoerner & frank muller, carbon taxes for climate protection in a competitive world, in e. staehelin-witt and h. blöchliger, ökologisch orientierte steuerreformen: die fiskalund aussenwirtschaftspolitischen aspekte (1996); j. andrew hoerner, the role of border tax adjustments in environmental taxation: theory and u.s. experience, paper presented at the int’l workshop on market based instruments and int’l trade of the inst. for envt’l. studies, amsterdam, the netherlands (mar. 19, 1998), http://www.rprogress.ort/publications/1998/ bta_1998.pdf; olivier godard, unilateral european post-kyoto climate policy and economic adjustment at eu borders, chaire développement durable, école polytechnique, paris, cahier n° ddx 07-15, oct. 2007; paolo avner, border adjustment: a tool to reconcile climate policy and competitiveness in europe: a legal and economic assessment, chaire développement durable, école polytechnique, paris, cahier n° 2007-07-14, oct. 2007; joost pauwelyn, u.s. federal climate policy and competitiveness concerns: the limits and options of international trade law (nicolas institute for environmental policy solutions, duke university, working paper no. 07-02, apr. 2007) (hereinafter “u.s. federal climate policy”), http://nicholasinstitute.duke.edu/climate/policydesign/u.s.-federal-climatepolicy-and-competitiveness-concerns-the-limits-and-options-of-international-tradelaw [hereinafter pauwelyn, u.s. federal climate policy]; joost pauwelyn, testimony before the subcomm. on trade of the h. comm. on ways and means (mar. 24, 2009) [hereinafter pauwelyn testimony], http://democrats. waysandmeans.house.gov/media/pdf/111/pauw.pdf; reinhard quick border tax adjustment to combat carbon leakage: a myth, 4 global trade & customs j. 353 (2009); katerina holzer, proposals on carbon-related border adjustments: prospects for wto compliance, 4 carbon & climate l. rev. 51 (2010). a recent study coauthored by the secretariat of the wto and the united nations environment programme provides a useful summary of the rules and references to some of the literature, without, however, settling any of the disputes described in what follows; see wto-unep, supra note 12, at 103-10. most of this literature considers only btas for environmental taxes, including in some instances carbon taxes. very little of it considers border adjustments for the cost of emissions allowances under cap and trade systems, much less the implications of free distribution of allowances, or bas for costs incurred for permits bought on the secondary market, capture and storage of carbon, and the clean development mechanism. the exceptions, in addition to de cendra, supra note 12, hufbauer, charnovitz & kim, supra note 9, godard, supra, and avner, supra, include the 2011] border adjustments for carbon taxes 233 (and many subsidiary ones) arise:16 (1) whether the border tax adjustments that convert an origin-based carbon tax to a destination-based tax are consistent with the basic rules governing international trade, (2) if not, whether an exception might be granted under article xx of the gatt, (3) whether the conclusions regarding btas for carbon taxes would be valid for bas for the cost of emissions permits that are purchased from governments, (4) whether free allocation of allowances (the analog of inframarginal exemptions from carbon taxes) would undermine the case for bas, (5) whether bas would be allowed for permits bought on the secondary market, and (6) whether they would be allowed for costs incurred in sequestration of co2 or under the clean development mechanism (cdm). the next section explains the relevant gatt and ascm rules and discusses some preliminary matters. sections iii and iv, which constitute the heart of the article, address the first two of the issues raised above. section v considers the other four, albeit in considerably less detail. section vi summarizes and concludes. sections iii and iv, being concerned with border adjustments for carbon taxes, generally refer to btas, even though more generic references to bas might be appropriate in some cases. ii. the gatt and the ascm it is useful to distinguish between the “basic” international trade rules and the exceptions to those rules allowed under article xx of the gatt. excellent discussion in jason e. bordoff, international trade law and the economics of climate policy: evaluating the legality and effectiveness of proposals to address competitiveness and leakage concerns, in climate change, trade and competitiveness: is a collision inevitable? 35 (lael brainard and isaac sorkin eds. 2009). 16. implementation of bas would also face daunting technical and administrative challenges, as well as strong opposition from noncommitting countries. these issues are not addressed here. see, however, wooders, reinaud & cosbey, supra note 1, mclure, supra note 1, and charles e. mclure, jr., border adjustments for carbon taxes and the cost of co2 emissions permits: politics, economics, administration, and international trade rules, 64 bull. for int’l tax’n 585 (2010). pauwelyn, testimony, supra note 15, stresses the need to strive for administrative feasibility, and julia reinaud, climate policy and carbon leakage – impacts of the european emissions trading scheme on aluminum, int’l energy agency information paper 37 (2008), stresses that “there is an inherent tension between full coverage on the one hand, and administrative feasibility on the other.” 234 florida tax review [vol. 11:4 a. the basic rules the rules that are most relevant for present purposes are those providing “national treatment” of imports and “most-favored nation treatment” of imports and exports and those that define subsidies. national treatment. the first sentence of gatt article iii.2 defines national treatment. it states in part: the products of the territory of any contracting party imported into the territory of any other contracting party shall not be subject, directly or indirectly, to internal taxes or other internal charges of any kind in excess of those applied, directly or indirectly, to like domestic products.17 article ii.2(a) elaborates: nothing in this article shall prevent any contracting party from imposing at any time on the importation of any product . . . a charge equivalent to an internal tax imposed consistently with the provisions of paragraph 2 of article iii in respect of the like domestic product or in respect of an article from which the imported product has been manufactured or produced in whole or in part.18 most-favoured nation treatment. gatt article i.1 requires mostfavoured nation treatment of international trade. it states in part: with respect to customs duties and charges of any kind imposed on or in connection with importation or exportation . . . any advantage, favour, privilege or immunity granted by any contracting party to any product originating in or 17. general agreement on tariffs and trade, oct. 30, 1947, 61 stat. a-11, 55 u.n.t.s. 194, http://www.wto.org/english/docs_e/legal_e/gatt47_ 01_e.htm [hereinafter gatt] (emphasis added). 18. id. at art. ii.2(a) (emphasis added). although most discussion of bas for carbon prices has focused on the elaboration provided by gatt article ii.2(a), article vi.4 on anti-dumping and countervailing duties is also relevant. it states: no product of the territory of any contracting party imported into the territory of any other contracting party shall be subject to antidumping or countervailing duty by reason of the exemption of such product from duties or taxes borne by the like product when destined for consumption in the country of origin or exportation, or by reason of the refund of such duties or taxes. 2011] border adjustments for carbon taxes 235 destined for any other country shall be accorded immediately and unconditionally to the like product originating in or destined for the territories of all other contracting parties.19 subsidies. footnote 1 to article i of the ascm defines the conditions under which export bas will not be considered to be a subsidy: [t]he exemption of an exported product from duties or taxes borne by the like product when destined for domestic consumption, or the remission of such duties or taxes in amounts not in excess of those which have accrued, shall not be deemed to be a subsidy.20 b. the article xx exceptions even if a measure is found to be inconsistent with the basic gatt/ascm rules, it may none the less be allowed under gatt article xx, the most relevant part of which provides: subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade, nothing in this agreement shall be construed to prevent the adoption or enforcement by any contracting party of measures: . . . (b) necessary to protect human, animal or plant life or health; . . . (g) relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption.21 19. agreement on subsidies and countervailing measures, apr. 15, 1994, 1869 u.n.t.s. 14, http://www.wto.org/english/docs_e/legal_e/24-scm_01_e.htm [hereinafter ascm] (emphasis added). 20. id. at art. i, n.1 (emphasis added). this provision repeats the wording in the note to article xvi of the gatt. 21. gatt, supra note 17, at art. xx. 236 florida tax review [vol. 11:4 c. preliminary observations before examining the gatt-legality of bas under the basic rules and the possibility that they would qualify for an article xx exception, it will be useful to make a few preliminary observations. 1. why so much uncertainty? the basic explanations for the uncertainty regarding the gattlegality of bas for carbon pricing can be found in the history of the trade rules that govern the legality of btas. the intent of the rules was to specify that btas are categorically impermissible for direct taxes such as income taxes and social security contributions, but are permitted for certain types of indirect taxes, to delineate the types of indirect taxes for which btas are allowed, and to limit btas to the domestic taxes on like products. these rules were formulated without consideration of their possible interaction with market-based measures intended to mitigate environmental damage, which at that time (mid-1940s) were not being considered seriously, at least not as seriously as now or in the recent past, when some such measures have actually been implemented. demaret and stewardson have written, “the existing rules on border tax adjustments have been developed primarily with the goals of competitiveness and absence of protectionism in mind. . . . they were not developed with environmental taxes in mind.”22 it is thus not surprising that market-based environmental measures, including bas related thereto, do not easily fit into the cubby holes established by the international trade rules, that prospective interpretation of those rules as they apply to such measures may be subject to doubt, that there may be conflicts between those rules and environmental measures, and that imposition of bas for carbon prices could be politically contentious. the disconnect between the international trade rules and bas for the cost of emissions permits is even greater than that between the trade rules and btas for carbon taxes, and not only because the rules governing btas were written explicitly to limit border adjustments for taxes and are not readily applied to bas for the cost of permits.23 substantial quantities of permits may be awarded free-of-charge or acquired in secondary markets, rather than being sold by governments, and the need for permits can perhaps be reduced by sequestration of co2 or offset by the clean development mechanism (cdm). the trade rules do not anticipate inframarginal 22. demaret & stewardson, supra note 15, at 61-62. 23. some suggest that the rules governing application of domestic regulations to trade are more relevant than those governing btas for appraising the legality of bas for the cost of emissions permits. see infra note 164. this article does not consider that possibility. 2011] border adjustments for carbon taxes 237 exemptions from indirect taxes (in this case, carbon taxes), which are analogous to free allocation of permits, much less anything analogous to purchases on the secondary market, sequestration, or cdm. adding at least marginally to uncertainty is the fact that, while wto panels and the appellate body commonly take account of precedent, wto law does not recognize the concept of stare decisis. the wto website says: a dispute relates to a specific matter and takes place between two or more specific members of the (wto). the report of a panel or the appellate body also relates to that specific matter in the dispute between these members. even if adopted, the reports of panels and the appellate body are not binding precedents for other disputes between the same parties on other matters or different parties on the same matter, even though the same questions of wto law might arise. as in other areas of international law, there is no rule of stare decisis in wto dispute settlement according to which previous rulings bind panels and the appellate body in subsequent cases.24 it seems, however, that the severity of the limitation can be overstated. the wto website continues: if the reasoning developed in the previous report in support of the interpretation given to a wto rule is persuasive from the perspective of the panel or the appellate body in the subsequent case, it is very likely that the panel or the appellate body will repeat and follow it. this is also in line with a key objective of the dispute settlement system which is to enhance the security and predictability of the multilateral trading system. in the words of the appellate body, these gatt and wto panel reports—and equally adopted appellate body reports1—“create legitimate expectations among wto members, and, therefore, should be taken into account where they are relevant to any dispute.”25 24. wto, dispute settlement system training module: chapter 7, legal effect of panel and appellate body reports and dsb recommendations and rulings, http://www.wto.org/english/english/tratop_e/dispu_e/disp_settlement_cbt_ e/c7s2p1_e.htm. (last visited feb. 25, 2011). 25. id. the words quoted at the end of this paragraph are from appellate body report, japan taxes on alcoholic beverages, 14, wt/ds8. 10, 11/ab/r, 4 (adopted nov. 1, 1996) [hereinafter japan – alcoholic beverages]. 238 florida tax review [vol. 11:4 2. the separability of btas for imports and exports on the key question of whether the rules for btas on imports and exports should – and would – be considered to constitute a package or be considered separately, views are mixed. economists are accustomed to thinking about btas as forming a symmetrical system that treats imports like domestic products and frees exports of tax. indeed, in 1970 the influential gatt working party on border tax adjustments stated, “it was agreed that gatt provisions on tax adjustment applied the principle of destination identically to imports and exports.”26 moreover, article i of the gatt, which prescribes most favored nation (mfn) treatment, begins: “with respect to customs duties and charges of any kind imposed on or in connection with importation or exportation . . . and with respect to . . . any product originating in or destined for any other country . . . .”27 the two sets of italicized words can perhaps be read to mean that the rules for imports and exports are the same.28 on the other hand, gatt article iii deals only with imports and the ascm only with exports. de cendra states: there are two anchor points for bta in the gatt and wto agreements: gatt, article ii(2)(a) in conjunction with gatt article iii (national treatment on internal taxation and regulation), and gatt article xvi (subsidies) in conjunction with the wto scm agreement. in general, bta on imported products in excess of taxes borne by like domestic products is in violation of the national treatment provisions in article iii of gatt. exemption or rebate or taxes on exported products in excess of internal taxes borne by like products destined for 26. working party on btas, supra note 4, at ¶ 10. avner draws the following inference from this statement: “this is useful as, if the legality of a bta can be proven either on imports or on exports, then it can be extended to the opposite transaction.” avner, supra note 15, at 14. for reason indicated below, the validity of this conclusion is questionable. 27. gatt, supra note 17, at art. i (emphasis added). 28. see also demaret & stewardson, supra note 15, at 31. the rules applied to a given trade flow by different trading partners need not be consistent. of course, gaps and overlaps in taxation of trade flows can occur unless imports and exports are treated consistently by exporting and importing countries. even so, hoerner observes that the gatt secretariat found in 1994 that, under gatt rules, international trade can be subject to the origin principle, the destination principle, double taxation, or no taxation. hoerner, supra note 15, at 6 n.9. double taxation may, however, be relevant in consideration of an article xx exception; see section iv. 2011] border adjustments for carbon taxes 239 domestic consumption are considered as an export subsidy subject to the disciplines of the scm agreement.29 demaret and stewardson write, “gatt contains different provisions, formulated differently, in respect of imports and exports, and no explicit statement as to whether those respective provisions should be implemented in symmetric fashion.”30 thus, hufbauer, charnovitz, and kim write, “symmetry is not required: a government can choose to adjust its product taxes on imports but not exports, or vice versa.”31 by comparison, although acknowledging that “wto/gatt rules treat import and export btas separately,” genasci suggests, “they generally apply the destination principle in a fairly symmetrical fashion.”32 pauwelyn is more uncertain, warning, “whether gatt exceptions apply also to rules under the subsidies agreement remains an open question and has not yet been tested in wto jurisprudence.”33 finally, as discussed in section iv, ambiguity extends beyond the basic rules, to the application of article xx exceptions. much of the discussion of the legality of border adjustments for carbon prices in the literature follows two somewhat independent tracks, one for imports and one for exports – if it considers exports at all.34 moreover, as a practical matter, countries that are considering bas, whether they have already introduced systems for pricing carbon or are considering doing so, have thus far concentrated on protecting domestic producers from imports, to the relative neglect of freeing exports from the cost of embedded carbon prices. moreover, it is quite possible that, for reasons explained in section iv, bas for exports would not pass muster under article xx, even if bas for imports did. 29. de cendra, supra note 12, at 139. gatt article vi.4, dealing with countervailing duties and dumping, is also relevant in the case of imports. supra note 18. 30. demaret & stewardson, supra note 15, at 30. treaties prevailing in the 1930s, or even earlier, made provisions for btas on imports, but not on exports. see robert h. floyd, gatt provisions on border tax adjustments, 7 j. world trade l. 489, 492-93 (1973). 31. hufbauer, charnovitz & kim, supra note 9, at 39. holzer, supra note 15, at 53, observes, “different rules apply to exports and imports.” 32. genasci, supra note 12, at 34. 33. pauwelyn testimony, supra note 15, at 9 n.19. 34. see, for example, biermann & brohm, strategic role, supra note 12; biermann and brohm, possible tool, supra note 12; ismer & neuhoff, supra note 1; wto-unep, supra note 12, at 103-10; ismer, supra note 14, at 220-23, holzer, supra note 15; gary clyde hufbauer & jisun kim, climate policy options and the world trade organization, 3 economics: the open access-open assessment ejournal 2009-29 (2009), http://dx.doi.org/10.5018/economics-ejournal.ja.2009-29. 240 florida tax review [vol. 11:4 the prevailing practice of treating bas for imports and for exports separately is generally followed here. but this begs the important question, encountered at various points below, whether rules established for import bas are applicable to export bas, and vice-versa. 3. the nature of carbon taxes the gatt-legality of btas generally depends on formal distinctions between taxes that economists might argue should be of little relevance, because formally different taxes may have similar economic effects. three questions involving the nature of carbon taxes have sometimes diverted attention from the key issues in the analysis of the gatt-legality of such taxes: whether carbon taxes are direct or indirect taxes, whether they are “taxes occultes,” and whether they are prior-stage cumulative indirect taxes (psci taxes). as explained here, the answers to all three questions are clear. a. carbon taxes are indirect taxes btas are allowed for “indirect” taxes, but not for “direct” taxes.35 the ascm states this explicitly with regard to btas for exports. annex i to the ascm includes the following in its “illustrative list of export subsidies:” e) the full or partial exemption remission, or deferral specifically related to exports, of direct taxes[58] or social welfare charges paid or payable by industrial or commercial enterprises. g) the exemption or remission, in respect of the production and distribution of exported products, of indirect taxes[58] in excess of those levied in respect of the production and distribution of like products when sold for domestic consumption.36 35. for a much more complete discussion, see demaret & stewardson, supra note 15, at 8-16. 36. ascm, supra note 20, at annex i (emphasis added) (internal citations irrelevant for present purposes suppressed) (internal footnote 58, which appears twice, numbered here as in the original). also, as indicated supra note 20, footnote 1 of the ascm picks up the following wording from the note to article xvi of the gatt: [t]he exemption of an exported product from duties or taxes borne by the like product when destined for domestic consumption, or 2011] border adjustments for carbon taxes 241 that is, while export btas for indirect taxes (“exemption or remission of . . . indirect taxes”) are not allowed to the extent they exceed domestic taxes on like products, export btas for direct taxes are per se not allowed.37 footnote 58 of ascm annex i, referenced in both excerpts quoted above, provides these definitions: the term “direct taxes” shall mean taxes on wages, profits, interests, rents, royalties, and all other forms of income, and taxes on the ownership of real property; . . . . the term “indirect taxes” shall mean sales, excise, turnover, value added, franchise, stamp, transfer, inventory and equipment taxes, border taxes and all taxes other than direct taxes and import charges . . . .38 the gatt does not similarly state unequivocally that btas on imports are not allowed for direct taxes.39 rather, this must be inferred from statements regarding the types of taxes for which btas are allowed. gatt article ii.2(a) says that import btas are allowed for: the remission of such duties or taxes in amounts not in excess of those which have accrued, shall not be deemed to be a subsidy. as the discussion that follows will make clear, this statement implicitly refers only to indirect taxes. 37. many commentators opine about the rationale – or lack thereof – for the different treatment of direct and indirect taxes, citing differences in the perceived incidence of the two types of taxes prevailing at the time the gatt was drafted. see demaret and stewardson, supra note 15, at 14-16, and literature cited there. floyd asserts that the rules were based implicitly on the prevalent neoclassical incidence theory that indirect taxes are reflected in prices, but direct taxes are not, which, in turn, was based implicitly on partial equilibrium reasoning, the validity of which was not examined. floyd, supra note 30, at 495. the working party on btas considered these issues, but with inconclusive results. working party on btas, supra note 4, at ¶¶ 8, 21, 22, 25. for present purposes, the rationale for this distinction is irrelevant. besides, as demaret and stewardson argue, “there is no real prospect of the distinction being abandoned.” demaret and stewardson, supra note 15, at 16. 38. ascm, supra note 19, at annex i n.58 (emphasis added). 39. thus pauwelyn observes, “the question remains, however, to what extent these definitions in the agreement on subsidies and countervailing measures on border adjustment for exports can be used also for purposes of interpreting gatt provisions on border adjustment for imports.” pauwelyn, u.s. federal climate policy, supra note 15, at 19 n.47. 242 florida tax review [vol. 11:4 a charge equivalent to an internal tax imposed consistently with the provisions of paragraph 2 of article iii in respect of the like domestic product or in respect of an article from which the imported product has been manufactured or produced in whole or in part.40 article iii.2 states: the products of the territory of any contracting party imported into the territory of any other contracting party shall not be subject, directly or indirectly, to internal taxes or other internal charges of any kind in excess of those applied, directly or indirectly, to like domestic products.41 since direct taxes are not levied on products, the repeated references to taxation of products in these excerpts – and the lack of any reference to direct taxes – implies that, as with exports, btas on imports are per se not allowed for direct taxes.42 in what follows, as in most of the relevant literature, it will be assumed that carbon taxes are indirect taxes, and thus not per se nonadjustable.43 b. carbon taxes are “taxes occultes” some seem to have interpreted the reference in gatt article iii.2 to taxes levied “directly or indirectly” on products as making a distinction between direct and indirect taxes. most significantly, the working party on btas concluded: on the question of eligibility of taxes for tax adjustment under the present rules, the discussion took into account the term “. . . directly or indirectly . . .” (inter alia article iii:2). the working party concluded that there was convergence of views to the effect that taxes directly levied 40. gatt, supra note 17, at art. ii.2(a) (emphasis added). 41. id. at art. iii.2 (emphasis added). 42. wto-unep, supra note 12, at 103 (“generally speaking, two types of internal taxes may be distinguished: taxes on products (called indirect taxes) and taxes on producers (i.e. direct taxes).”). 43. note, however, that pauwelyn asks rhetorically, “[w]ould . . . [a] domestic carbon tax be regarded as an adjustable product tax that can be imposed also on imports of carbon produced abroad? or would the wto classify it [a carbon tax] as a producer (or direct) tax which cannot be adjusted at the border for imports?” pauwelyn, u.s. federal climate policy, supra note 15, at 19. he then opines, “this is a long-standing debate and no definite answer can be given.” id. 2011] border adjustments for carbon taxes 243 on products were eligible for tax adjustment. examples of such taxes comprised specific excise duties, sales taxes and cascade taxes and the tax on value added. . . . furthermore, the working party concluded that there was convergence of views to the effect that certain taxes that were not directly levied on products were not eligible for tax adjustment. examples of such taxes comprised social security charges whether on employers or employees and payroll taxes.44 the wto-unep inserts the words bracketed here in the following excerpt from the working party report: . . . there was convergence of views to the effect that certain taxes that were not directly levied on products [i.e., direct taxes] were not eligible for tax adjustment.45 goh goes even further by inserting still more editorial explanation, again shown here in brackets: . . . there was convergence of views to the effect that certain taxes that were not directly levied on products [but on the producer, i.e., direct taxes] were not eligible for tax adjustment.46 it appears, however, that the working party and the commentators quoted above seriously misinterpret what “directly or indirectly” mean in the context of articles ii.2(a) and iii.2.47 these provisions explicitly deal only with the conditions under which btas are allowed for taxes on products, that is, only with btas for indirect taxes; they do not address whether btas are allowed for taxes not levied on products, i.e., direct taxes.48 if one focuses on the clear meaning of the words in gatt articles ii.2(a) and iii.2, it is apparent that there is a third category of taxes, those that hufbauer, charnovitz, and kim call “taxes in between” – taxes that are not direct taxes, yet are “not directly levied on products” – that is, indirect 44. working party on btas, supra note 4, at ¶ 14 (emphasis added). 45. wto-unep, supra note 12, at n.207. 46. goh, supra note 12, at 402. 47. this is hard to understand, given the working party’s clear recognition of the existence of “taxes occultes,” discussed below. 48. in article iii, “directly” and “indirectly” are adverbs describing how indirect taxes are levied on products; they are not adjectives used to describe taxes, as in “direct taxes” and “indirect taxes.” 244 florida tax review [vol. 11:4 taxes that are borne only indirectly by products.49 this last category can – and should – be subdivided. first, there are indirect taxes applied to products “indirectly,” in that they are levied on physically incorporated inputs, rather than on the product itself. the reference in article ii.2(a) to “an internal tax imposed . . . in respect of an article from which the imported product has been manufactured or produced” seems to say that these are adjustable. second, there are indirect taxes that, although also borne indirectly by products, may not be adjustable, because they are not imposed on an article that is physically incorporated. the second subcategory is what the working party discusses under the rubric of “taxes occultes,” which it defined in the following statement: the working party noted that there was a divergence of views with regard to the eligibility for adjustment of certain categories of tax and that these could be sub-divided into (a) “taxes occultes” which the oecd defined as consumption taxes on capital equipment, auxiliary materials and services used in the transportation and production of other taxable goods. taxes on advertising, energy, machinery and transport were among the more important taxes which might be involved. it appeared that adjustment was not normally made for taxes occultes except in countries having a cascade tax; (b) certain other taxes, such as property taxes, stamp duties and registration duties . . . which are not generally considered eligible for tax adjustment. most countries do not make adjustments for such taxes . . . .50 given the concern that btas might overcompensate for these taxes, in effect creating import tariffs and export subsidies, the working party on btas wrestled with how to treat them. in a statement at the end of paragraph 15 that casts a long shadow on the current debate over the gatt-legality of bas for carbon prices, the working party said 49. hufbauer, charnovitz & kim, supra note 9, at 40. much of the literature follows this approach, at least implicitly; see, for example, hoerner & muller, supra note 15, at 31. 50. working party on btas, supra note 4, at ¶ 15 (emphasis added). 2011] border adjustments for carbon taxes 245 it was generally felt that while this area of taxation was unclear, its importance as indicated by the scarcity of complaints reported in connexion with adjustment of taxes occultes was not such as to justify further examination. of course, the working party could not have anticipated the current interest in the adjustability of carbon taxes (and the cost of emissions permits). there seems to be general agreement that carbon taxes fit best in the category of “taxes occultes.”51 as will become clear in the next section, the treatment of taxes occultes lies at the heart of the current debate over the adjustability of carbon taxes and the cost of emissions permits. a carbon tax levied on fossil fuels combusted to generate electricity (or the cost of emissions permits related to such combustion) is the most important example of such a tax, but hardly the only one. in summary, direct taxes are per se not adjustable, and indirect taxes levied directly on products or on inputs physically incorporated in imports are adjustable. the key question for present purposes is whether article iii:2 contemplates the allowance of btas for taxes on production inputs that are not physically incorporated.52 cosbey and tarasofsky warn that one should not be too certain on an issue where certainty is impossible. in the end, while the gatt allows btas to adjust for direct (sic) taxes in the case of both imports and exports, it is unclear and has never been tested whether such adjustment is permissible for indirect taxes (‘taxes occultes’) on an input 51. hoerner & muller state categorically, “carbon and energy taxes are taxes occultes.” hoerner and muller, supra note 15, at 31. see also, for example, de cendra, supra note 12, at 139-40, and pauwelyn, u.s. federal climate policy, supra note 15, at 19. while some other authors listed in note 15, supra, or cited elsewhere in this article do not make such clear declarations, they generally treat taxes on energy as taxes occultes. by comparison, in harshly condemning the decision of the wto appellate body in the shrimp-turtle case (also known as united states shrimp, discussed in the text infra at note 123), bhagwati and mavroidis quote paragraph 14 of the working party report, but not paragraph 15, and thus do not consider the possibility that energy taxes are taxes occultes; see jagdish bhagwati & petros mavroidis, is action against u.s. exports for failure to sign kyoto protocol wto-legal?, 6 world trade rev. 299, 305 (2007). 52. goh, supra note 12, at 422 (“a critical issue is whether article iii:2 first sentence of gatt 1994 contemplates the use of border tax adjustments on ‘final’ products for taxes on production inputs. notwithstanding the gatt panel’s approach in the superfund case, the question will turn on a proper analysis of the taxes ‘applied, directly or indirectly, to’ the like products to be compared . . . .”). the superfund case is considered infra at note 71. 246 florida tax review [vol. 11:4 that is fully consumed during production. a carbon tax, based on the energy consumed in the production of a product, falls squarely into the latter category.53 the next section addresses this question. c. carbon taxes are not prior-stage cumulative indirect taxes (psci taxes). annex i, paragraph (h) of the ascm provides: [p]rior-stage cumulative indirect taxes may be exempted, remitted or deferred on exported products even when not exempted, remitted or deferred on like products when sold for domestic consumption, if the prior-stage cumulative indirect taxes are levied on inputs that are consumed in the production of the exported product. [footnote suppressed] this item shall be interpreted in accordance with the guidelines on consumption of inputs in the production process contained in annex ii.54 section i of ascm annex ii, “guidelines on consumption of inputs in the production process,” states: indirect tax rebate schemes can allow for exemption, remission or deferral of prior-stage cumulative indirect taxes levied on inputs that are consumed in the production of the exported product . . . .55 footnote 61, attached to the title of annex ii, contains the following definition: inputs consumed in the production process are inputs physically incorporated, energy, fuels and oil used in the production process and catalysts which are consumed in the course of their use to obtain the exported product.56 53. cosbey & tarasofsky, supra note 12, at 20. 54. ascm, supra note 19, at annex i, ¶ (h) (emphasis added). 55. id. at annex ii, § i, ¶ 1 (emphasis added). 56. id. at annex ii, n.61 (emphasis added). 2011] border adjustments for carbon taxes 247 some seem to believe that these provisions would justify btas for at least some carbon taxes.57 it appears, however, that this belief is unjustified – that the provisions cannot reasonably be interpreted to allow btas for carbon taxes.58 section i of annex ii explicitly refers only to priorstage cumulative indirect taxes. carbon taxes would not ordinarily be considered to be “cumulative indirect taxes.” footnote 58 of ascm annex i provides the following definitions: 57. after reviewing ascm annex i and footnote 61 to annex ii, ismer and neuhoff state, “consequently, it appears that tax exemptions and remissions for energy and fuel on exported products would be admissible under wto rules.” ismer & neuhoff, supra note 1, at 144. ismer, supra note 14, at 73 repeats this conclusion. after a similar review, biermann and brohm say, “in other words: if a government exempts a prior-stage cumulative indirect tax on energy, fuels or oil used in the production process only on exported goods and not on goods sold for domestic consumption, then this will not be considered an export subsidy.” see biermann & brohm, strategic role, supra note 12, at 296; biermann and brohm, possible tool, supra note 12, at 253. thus conditioned, this conclusion is presumably valid. but it is also irrelevant, as carbon taxes are not psci taxes. pitschas, after both saying explicitly that energy taxes are not psci taxes and implying that they are, opines that taxes on energy are eligible for adjustment on exports. pitschas, supra note 11, at 493-95. on the other hand, arguing that energy and carbon taxes are not psci taxes, brack et al., conclude that btas would not be allowed for such taxes, since they are imposed on inputs not physically incorporated in products; see duncan brack, michael grubb & craig windram, international trade and climate change policies 87 (2000). they add, however, “[t]his is not a definite conclusion, and it would have to be tested by a dispute panel before one could be certain.” it is not clear where demaret and stewardson stand on this issue. they say: “thus paragraph (h) [of ascm annex i] would not allow countries with cumulative indirect tax systems to adjust for multi-stage taxes on ‘energy, fuels and oils used in the production process’ on the export of the resulting final product.” demaret and stewardson, supra note 15, at 29 (emphasis added). it is difficult to reconcile that statement with either the ascm paragraph cited or their later statement that “only prior-stage taxes levied on inputs physically incorporated in the final product or on fuel, oil, or energy used in production, are eligible for adjustment.” id. at 31-32. their statement that “a country is allowed to remit taxes on exports in respect of prior-stage cumulative indirect taxes” and the subsequent quotation of footnote 61 to ascm annex ii suggests that the inclusion of “not” in the first passage quoted may have been unintentional. id. at 29, n.102. 58. paragraph (g) of annex i mentions only btas for exports. it is not clear whether it would govern the gatt legality of btas for imports, if carbon taxes were found to be psci taxes. thus hufbauer and kim write, “annexes i and ii of the ascm may be read so as to permit the rebate of prior stage energy taxes on exports, but whether that would correspondingly allow imposition of domestic energy taxes on imports remains unclear.” hufbauer and kim, supra note 34, at 6. note, however, that these authors, writing with charnovitz, reject the notion that carbon taxes are psci taxes, see infra note 60. 248 florida tax review [vol. 11:4 “prior-stage” indirect taxes are those levied on goods or services used directly or indirectly in making the product; “cumulative” indirect taxes are multi-staged taxes levied where there is no mechanism for subsequent crediting of the tax if the goods or services subject to tax at one stage of production are used in a succeeding stage of production . . . .59 these definitions are words of art that were developed in a particular historical context to distinguish between the taxes on gross receipts (often called “cascade” or “turnover” taxes) that were once popular and the vats that replaced them.60 they do not describe carbon taxes, and, given the historical context in which they were written, could not have been intended to do so.61 since carbon taxes are not psci taxes, footnote 61 is of no 59. ascm, supra note 19, at annex n.58. 60. oecd, supra note 12, at 99 (“the archetypal psci tax is a cascade tax.”). see also hoerner and muller, supra note 15, at 34-37; brack et al., supra note 57, at 85-87; de cendra, supra note 12, at 139-41; pauwelyn, u.s. federal climate policy, supra note 15, at 20, n.52; genasci, supra note 12, at 36; avner, supra note 15, at 27. footnote 60 to annex i of the ascm states explicitly that the vat is handled by paragraph (g) and not by paragraph (h). hufbauer, charnovitz, and kim seem to suggest that ascm footnote 61 implies that btas might be allowed for energy taxes, as psci taxes, before stating: “of course, by its own terms, item (h) applies only to ‘prior-stage cumulative indirect taxes.’ the carbon taxes being proposed are not designed to be cumulative . . . .” hufbauer, charnovitz & kim, supra note 9, at 44-45. cumulative taxation would occur if carbon taxed at one stage in the production-distribution process were also taxed at a later stage, without relief for the tax levied earlier. see hoerner and muller, supra note 15, at 36. some recent literature to a “carbon-added tax” (cat) suggests clearly that such a design is generally not intended. for references to this literature and an explanation of why the cat does not deserve serious attention – not because carbon taxes should be cumulative, but because the administrative techniques of the value added tax cannot be applied to the cat. see charles e. mclure, jr., the carbon-added tax: an idea whose time should never come, 4 carbon & climate l. rev. 250 (2010). 61. demaret and stewardson refer to an apparently undocumented “gentleman’s agreement” made during the uruguay round negotiations regarding the purpose of ascm footnote 61. demaret & stewardson, supra note 15, at 30. they note that an official of the office of the u.s. trade representative has written regarding the footnote, “the change . . . was never intended to fundamentally expand the rights of countries to apply border adjustments for a broad range of taxes on energy.” it seems to be generally agreed that this argument, even if documented, would carry little weight in a dispute before the wto. see biermann & brohm, “strategic role,” supra note 12, at 297, and hufbauer, charnovitz & kim, supra note 9, at 46. 2011] border adjustments for carbon taxes 249 relevance in determining whether border adjustments would be allowed for carbon taxes.62 unfortunately, deciding that the rules on psci taxes are not relevant for the present discussion does not shed much light on whether taxes on carbon and energy are eligible for border adjustments. de cendra has noted, “the scm agreement does not explicitly prohibit btas for energy taxes in non-cumulative tax systems and, further, it does not provide any guidance on the issue.”63 hufbauer, charnovitz, and kim reach an equally agnostic conclusion: [o]ne could argue that the ascm has clarified that status of energy taxes – as compared to the gatt era, when they were mysterious “taxes occultes” – and that energy taxes can now be rebated upon export. conversely, one could also argue that the possibility for such an export rebate remains uncertain in the ascm or that the ascm actually prohibits energy btas on exports.64 iii. parsing the basic rules the basic international trade rules can usefully be subdivided into (1) those pertaining to national treatment of imports and to export subsidies and (2) that pertaining to the treatment of trade with different countries, the most-favored nation provision. the former prohibit discriminatory treatment of products in bilateral trade, the latter prohibits discriminatory treatment of trade with different countries. 62. de cendra, supra note 12, at 140 (“what becomes clear from the reading of footnote 61 is that its wording does not imply that other taxes occultes are prior stage cumulative indirect taxes.”) (emphasis in original suppressed). given this, the discussion of the implication of the vienna convention on the law of treaties in biermann and brohm, strategic role, supra note 12, at 296-98, seems beside the point. even if btas were to be allowed for carbon taxes, under the annex ii “guidelines,” they would be limited to “taxes levied on inputs that are consumed in the production of the exported product.” presumably, they would not be allowed for taxes on carbon consumed in transportation of either the exported product or inputs thereto, and perhaps they would not be allowed for taxes on carbon consumed in prior stages of production. 63. de cendra, supra note 12, at 140. 64. hufbauer, charnovitz & kim, supra note 9, at 46. 250 florida tax review [vol. 11:4 a. national treatment and export subsidies the concept of “like products” plays a key role in both gatt article iii.2, which defines national treatment, and footnote 1 to article i of the ascm, which defines export subsidies. btas are allowed only for taxes on like products. this raises two closely interrelated questions: whether carbon taxes are levied on products and whether differences in carbon intensity make products unlike, a prerequisite for basing btas on the carbon content of traded products. 1. are carbon taxes levied on products? under gatt article iii.2 and ii.2(a), btas are allowed only for taxes that are levied “directly or indirectly” on products, including those “in respect of an article from which the imported product has been manufactured or produced in whole or in part.” carbon taxes are clearly not levied “directly” on products. the question, then, is whether they are levied either “indirectly” on a product or on “an article” from which the product in question has been produced. before turning to the first issue, it will be useful to dispose of the second. the predominant view seems to be that carbon taxes are not levied “in respect of an article from which the imported product has been manufactured or produced.” many of those who hold this view cite the wording of the equally authentic french version: “une marchandise qui a été incorporée dans l’article importé.”65 of course, carbon that is emitted as co2 is not incorporated in products. a. taxes on process and production methods in the modern debate, carbon taxes are said to be based on “process and production methods” (ppms). the key issue is thus whether btas are allowed for taxes based on ppms. the reference in gatt article iii.2 and 65. see, e.g., biermann & brohm, “strategic role,” supra note 12, at 293; biermann & brohm, “possible tool,” supra note 12, at 252; de cendra, supra note 12, at 138; ismer & neuhoff, supra note 1, at 146 n.2. this wording seems to require that the input be physically incorporated. in that case, as biermann and brohm say, this provision is not likely to be interpreted to include fuel or energy. pauwelyn agrees with this interpretation, although he believes that the word “article” in the english version might be interpreted to include fuel. pauwelyn, u.s. federal climate policy, supra note 15, at 20 n.51. although not relying on the french, pitschas concludes, based on his reading of gatt article ii.2(a), that “since energy taxes are taxes on inputs not physically incorporated into products, they cannot be imposed on imported products.” pitschas, supra note 11, at 493. for a contrary view, see the quotation from hoerner and muller in the text infra at note 70. 2011] border adjustments for carbon taxes 251 footnote 1 to article i of the ascm to taxes on products would seem to imply that taxes based on ppms are not adjustable.66 an oft-quoted statement from a 2004 publication by the wto secretariat, a slightly different version of which appeared on the wto website until recently, seems to confirm this view. it states: under existing gatt rules and jurisprudence, “product” taxes and charges can be adjusted at the border, but “process” taxes and charges by and large cannot. for example, . . . tax on the energy consumed in producing a ton of steel cannot be applied to imported steel. for example, a domestic tax on fuel can be applied perfectly legitimately to imported fuel. but a tax on the energy consumed in producing a ton of steel (a tax on the production process) cannot be applied to imported steel, even if it is charged on domestically produced steel, which could make the imported steel cheaper (and presumably less environmentally friendly).67 by comparison, joost pauwelyn, formerly a legal affairs officer with the appellate body secretariat of the wto, finds it “surprising” that the similar statement appeared on the wto website until december 2006,68 and states that “a carbon tax is an indirect tax applied at least ‘indirectly’ to products” and that border adjustments should therefore be allowed for 66. for a thorough analysis of the gatt-legality of trade measures under both the basic trade rules and gatt article xx, see steve charnovitz, the law of environmental “ppms” in the wto: debunking the myth of illegality, 27 yale j. int’l l. 59 (2002). he concludes that, “article xx will be central to analysis of ppms because . . . many ppms will violate articles i, iii, or xi.” id. at 92. 67. world trade organization, trade and environment at the wto 21 (2004), http://www.wto.org/english/res_e/publications_e/trade_env_e.htm. the slightly different online statement appeared under the rubric of “cte on: how environmental taxes and other requirements fit in.” it was available on the wto website on jul. 13, 2009, http://internet.corpei.ed/carpetas/cicomc/wtocd/ wto%20website/snapshotofwtowebsiteinenglish/english/tratop_e/envir_e/cte0 3_e.htm. since sept. 4, 2009, the author has been unable to access this page. of course, the wto recognizes concerns that this interpretation raises concerns regarding competitiveness. the statement quoted in the text continues: for this reason, there is some concern that the wto rules could affect the competitiveness of domestic producers when they face environmental process taxes and charges. 68. pauwelyn, u.s. federal climate policy, supra note 15, at 19 n.46. 252 florida tax review [vol. 11:4 embedded carbon taxes.69 in support of this conclusion, hoerner and muller contend: it was the intent of the gatt negotiators that process as well as product charges be border adjustable. records of the discussions held in drafting the havana charter for an international trade organization, which served as a basis for the gatt, establishes that all taxes on inputs to a product, whether of physically incorporated raw materials or process inputs or outputs not physically incorporated, were intended to be adjustable. the original draft of article iii:2 referred to taxes or internal charges “applied on or in connection with like products.” this draft was rejected only because of difficulties in translating it into french.70 the decision of the gatt panel in the superfund case, which condoned u.s. legislation imposing btas on imports of a gas deemed to harm the environment, is commonly said to provide reason to believe that btas might be allowed for taxes based on ppms, as is the fact that a u.s. tax on ozone-depleting chemicals was never challenged. b. the superfund tax in 1986 the u.s. imposed the superfund tax on selected domestic chemical feedstocks in order to finance the cleanup of chemical waste.71 the tax did not apply to chemicals produced domestically from the taxed feedstock chemicals. by comparison, chemicals produced from the same feedstocks were taxed upon importation into the u.s.72 the statute provided 69. id. at 20. 70. hoerner & muller, supra note 15, at 27. they quote the u.s. representative at the subsequent london preparatory committee for the havana charter as explaining that the term “indirectly” was intended to allow border adjustments for “a tax, not a tax on a product as such, but on the processing of a product.” 71. panel report, united states taxes on petroleum and certain imported substances, bisd 34s/136 (jun. 5, 1987) [hereinafter u.s. – superfund tax]. paragraphs 2.3 to 2.6 describe the tax. oecd, supra note 12, at 100-02, provides an excellent summary of this case. see also demaret and stewardson, supra note 15, at 24-26; biermann & brohm, strategic role, supra note 12, at 294; goh, supra note 12, at 406. the superfund tax also applied to crude oil and petroleum products, but that is not important for present purposes. 72. the tax was rebated when the chemical feedstocks were exported. the panel did not address the gatt-legality of the btas for exports, which had not been challenged. 2011] border adjustments for carbon taxes 253 that the u.s. government could impose a five percent penalty tax if foreign manufacturers failed to provide information on the amount of feedstock chemicals used in producing imported chemicals. more important for present purposes, it authorized the secretary of the treasury to issue regulations that, in lieu of the penalty tax, would allow foreign exporters to pay a rate of tax equal to that on domestically produced chemicals produced using the primary method of production (pmp) utilized in the united states. the panel addressed three questions: (1) whether the gatt-legality of btas depends on the policy purpose of a tax, (2) whether the tax on imported chemicals intended to compensate for the u.s. tax on domestic feedstocks violated gatt article iii.2 (national treatment), and (3) whether the penalty tax was gatt-legal. the european union argued, in essence, that the destination-based superfund tax was inconsistent with the polluter-pays principle, which it said would have required an origin-based tax. the u.s. countered first that the polluter-pays principle was not part of the gatt, and second, that, in any event, the tax was intended to raise revenue, not to alter behavior, the purpose of environmental taxes levied consistent with the polluter-pays principle. the gatt panel sided with the u.s. in concluding that the tax on imported chemicals was potentially eligible for adjustment, because the policy purpose behind a tax is not relevant for the legality of btas under the gatt.73 having disposed of this argument, the panel found that the tax on imported chemicals did not violate national treatment.74 it is not clear how the panel reached its decision. its analysis is limited to the following: the tax on certain imported substances equals in principle the amount of the tax which would have been imposed under the superfund act on the chemicals used as materials in the manufacture or production of the imported substance if these chemicals had been sold in the united states for use in the manufacture or production of the imported substance. in the words which the drafters of the general agreement used in the above perfume-alcohol example: the tax is imposed on the imported substances because they are produced from chemicals subject to an excise tax in the united states and the tax rate is determined in principle in relation to the amount of these chemicals used and not in relation to the value of the imported substance. the panel therefore concluded that, to the extent that the tax on certain imported substances was equivalent to the tax 73. u.s. – superfund tax, supra note 71, ¶ 5.2.4. 74. id. at ¶ 5.2.8. 254 florida tax review [vol. 11:4 borne by like domestic substances as a result of the tax on certain chemicals the tax met the national treatment requirement of article iii:2, first sentence.75 the panel apparently did not consider whether the feedstocks that were taxed in the u.s. and the chemicals that were imported were “like products,” presumably because the parties had not raised the issue, perhaps because they took it for granted that chemical feedstocks are physically incorporated in the derivatives.76 the panel did not indicate explicitly whether the foreign feedstock chemicals were physically incorporated in the exported chemicals – or whether it thought that the answer mattered. it is thus impossible to know whether or not the panel applied a physical incorporation test or some other.77 on the other hand, its statement that, “this form of border tax adjustment was explicitly foreseen in article ii:2(a), which refers to taxes “‘in respect of an article from which the imported product has been manufactured or produced,’”78 suggests that it did, if only implicitly. this question is, of course, crucial to determining the adjustability of carbon taxes, since co2 is not physically incorporated in products. thus, pitschas opines, “the ruling of the gatt panel in the superfund case is not exactly transferable to energy taxes.”79 even though the regulations allowing foreign producers to pay tax based on the pmp in the u.s. had never been issued, the panel took note of the assurance of the u.s. government that “in all probability the five percent penalty rate would never be applied.”80 of course, foreign manufacturers retained the right to pay a lower amount than calculated under pmp in the u.s. if they could document that they had actually used less feedstocks than under pmp. this is potentially important in the present context, as it suggests that carbon content under pmp in the importing country could be employed to determine btas on imports, with the option of demonstrating lower carbon content. this would, of course, not result in btas based on the actual carbon content of imports, if the actual carbon content of imports exceeds that under pmps in the importing country. 75. id. 76. in its discussion of the tax on petroleum products, the panel noted that the parties to the case had not developed a definition of the term “like products.” it made reference to paragraph 18 of the working party on btas, discussed further infra at note 90, and observed that “the domestic [petroleum] products are thus either identical or, in the case of imported liquid hydrocarbon products, serve substantially identical end-uses.” see id. at ¶ 5.1.1. 77. see also demaret and stewardson, supra note 15, at 26; hoerner & muller, supra note 15, at 39. 78. u.s. – superfund tax, supra note 71, at ¶ 3.2.5. 79. pitschas, supra note 11, at 492. 80. u.s. – superfund tax, supra note 71, at ¶ 5.2.9. 2011] border adjustments for carbon taxes 255 c. the ozone depleting chemicals tax the tax on ozone depleting chemicals (odcs) levied by the u.s. in furtherance of the montreal protocol on substances that deplete the ozone layer would have provided a more definitive test, had it been challenged and considered by the wto.81 significantly for present purposes, btas were levied on imported products produced with odcs (e.g., electronic equipment), as well as directly on imports of the offending chemicals and products containing odcs (e.g., refrigerators).82 that is, the btas applied to chemicals that were not physically incorporated in imports and were thus at least in part process-based. that btas for the odc were never challenged before the wto is sometimes interpreted as suggesting that btas might be allowed for a tax based on ppms.83 but the fact that the odc legislation was not challenged does not reliably reveal whether a challenge would have been successful.84 2. are btas based on carbon intensity levied on “like products?” border tax adjustments for carbon taxes that are intended to level the playing field between domestic products and imports would ideally reflect the carbon-intensity of imports.85 this means, of course, that if an import 81. for a description of the odc tax, see gregory a. orlando, understanding the excise tax on ozone depleting chemicals, 42 the tax executive 359 (1990). hoerner, supra note 15, at 11-12, and brack et al., supra note 57, at 78-79, provide brief summaries of this episode. 82. btas were imposed on imports and allowed for exports. the border adjustment for imports is based on pmp in the u.s., unless the importer can document that the actual amount of odcs employed in production is less. 83. see, e.g., hoerner, supra note 15, at 11-12; biermann & brohm, strategic role, supra note 12, at 294. 84. while sherlock holmes drew conclusions based on the “dog that did not bark” in arthur conan doyle’s “silver blaze,” inferring the results of hypothetical judicial views of laws not challenged is a questionable exercise. 85. implementing this objective could encounter staggering difficulties if extended beyond a few basic products. see mclure, supra note 1, and supra note 16, for illustrations of the problem. the treatment of carbon taxes embedded in the prices of electricity is particularly important. wooders, reinaud, and cosbey provide an excellent description of “drivers of carbon content” for cement, steel, and aluminum, which generally include the process employed (e.g., electric arc vs. blast furnace for producing steel) and its management, energy efficiency, the mix of fuels (e.g., coal, oil, gas, electricity), source of electricity, extent of reliance on recycled products, and the use of blends. wooders, reinaud & cosbey, supra note 1, at 4650. they note that “the ranges of emissions from steel and aluminum production are extremely wide, with the key factor being whether the route is a primary one (starting with the metal ore) or whether scrap material can be used.” id. at 48. on the 256 florida tax review [vol. 11:4 were more energy-intensive than its domestic counterpart, the bta on imports would be greater, as a fraction of the price of the product, than the carbon tax embedded in the price of the domestic product. the question, then, is whether this type of differentiation in the taxation of products, which is necessary to achieve equal taxation of embedded carbon, would be gattlegal? that depends on whether differences in carbon intensity make physically identical products unlike. if not, import btas would be limited to the carbon content of domestic products. bordoff succinctly describes the relevance of this question: the principle behind article iii is straightforward: a member cannot treat imported goods worse than domestic goods. in the case of climate change border adjustments, however, this seemingly straightforward principle proves exceptionally difficult to put into effect because the same goods from a global trade standpoint may be very different from a climate change standpoint if one is much more carbon-intensive than the other.86 the predominant opinion is that products that are physically identical would be found to be “like,” regardless of the amount of carbon embedded in them. gary sampson, former head of the trade and environment division of the wto, states that, “products that have the same physical form are to be considered to be like products by the importing crucial issue of the source of electricity, which may differ from country to country, see the text infra at note 111. 86. bordoff, supra note 15, at 43. see also aaron cosbey, border carbon adjustment, 4, background paper prepared for the trade and climate change seminar, copenhagen (jun. 18-20, 2008), http://www.iisd.org/pdf/2008/cph_trade_ climate_border_carbon.pdf. similarly, pauwelyn says, “the issue is primarily whether, for example, steel from china made with coal . . . is ‘like’ domestically produced u.s. steel using natural gas.” pauwelyn, u.s. federal climate policy, supra note 15, at 28. kejun, cosbey, and murphy write: with respect to discrimination on the basis of embodied carbon, the million-dollar question is how to define “like” goods. is a tonne of inefficiently produced steel “like” a tonne of efficiently produced steel? if so, then tariffs based on embodied carbon may violate the principle of non-discrimination. see jiang kejun, aaron cosbey & deborah murphy, embodied carbon in traded goods, 5, background paper prepared for trade and climate change seminar, copenhagen (jun. 18-20, 2008),http://ictsd.net/downloads/2008/ictsd.net/downloads/ 2008/10/cph_trade_climate_carbon.pdf. 2011] border adjustments for carbon taxes 257 country, irrespective of whether they have been produced abroad in an environmentally friendly manner or not.”87 similarly, goh opines: differences in the amount of energy consumed in the production process– or in the taxes on energy inputs borne by producers – relate to processes and production methods (ppms) that do not normally translate to the physical properties, characteristics or end uses of the final product. it would be difficult to envisage a situation where goods that were otherwise “like” in physical properties, characteristics and end uses ceased to be so because of differences in “embodied” energy or in the amount of taxes applied to energy used in the production process.88 the gatt does not define “like” or indicate what characteristics of products make them “like.”89 that task has, in effect, been left to wto jurisprudence, which has relied heavily on paragraph 18 of the report of the 1970 working party on btas.90 paragraph 18 states: 87. gary p. sampson, wto rules and climate change: the need for policy coherence, in inter-linkages: the kyoto protocol and the international trade and investment regimes 69 (w. bradnee chambers, ed., 2001). 88. goh, supra note 12, at 407. chambers says, “[w]hether the production process . . . entails a ghg-emitting fossil-intensive method such as the burning of coal, or something as clean as wind or solar energy, is irrelevant to a wto decision.” see w. bradnee chambers, international trade law and the kyoto protocol: potential incompatibilities, in inter-linkages: the kyoto protocol and the international trade and investment regimes, supra note 87, at 91. brack et al. agree but, consistent with the theme of this article, urge caution in accepting that view. brack et al., supra note 57, at 89. by comparison, hoerner & muller, supra note 15, at 27-28, reach the opposite conclusion, and hufbauer, charnovitz & kim, supra note 9, at 68, state: “although there is no precise trade law jurisprudence on this point, the language of gatt article ii:2(a) would seem to suggest that a bta equivalent to the domestic tax could be imposed on imports.” 89. in appellate body report, european communities – measures affecting asbestos and asbestos-containing products, at ¶ 99, wt/ds135/ab/r (mar. 12, 2001) [hereinafter ec – asbestos], the appellate body noted that the scope of the term “like” is different in gatt articles iii.2 and iii.4. it is to be construed narrowly in the former, but relatively broadly in the latter. in that case it ruled that under article iii.4 health risks could be considered in determining likeness. see also hufbauer, charnovitz & kim, supra note 9, at 35-36. 90. working party on btas, supra note 4. in japan – alcoholic beverages, supra note 25, at 20, the wto appellate body noted that the working party’s approach has been followed in almost all reports of wto panels subsequent to the working party report. 258 florida tax review [vol. 11:4 with regard to the interpretation of the term “. . . like or similar products . . .,” which occurs some sixteen times throughout the general agreement, it was recalled that considerable discussion had taken place in the past, both in gatt and in other bodies, but that no further improvement of the term had been achieved. the working party concluded that problems arising from the interpretation of the term should be examined on a case-by-case basis. . . . some criteria were suggested for determining, on a case-bycase basis, whether a product is “similar”: the product’s enduses in a given market; consumers’ tastes and habits, which change from country to country; the product’s properties, nature and quality. it was observed, however, that the term “. . . like or similar products . . .” caused some uncertainty and that it would be desirable to improve on it; however, no improved term was arrived at. end-uses, tariff classifications (a criterion the appellate body added in japan – alcoholic beverages91), and the properties, nature, and quality of physically identical products are not likely to depend on the carbon intensity of production, and consumer tastes and habits are likely to be largely irrelevant for the kinds of basic products for which btas are most important – and to which they should be limited.92 moreover, the wto appellate the conclusions of the working party have assumed an authoritative standing approaching that of a commentary on a treaty. indeed, van calster suggests that the findings of the working party “have been elevated into something of a paradigm in international trade law.” van calster, supra note 10, at 116. bhagwati and mavroidis state, “[t]he working party on border tax adjustments is a decision that has been adopted by the gatt contracting parties. as a result, it should, by virtue of art. xvi of the agreement establishing the wto, guide the wto judge.” bhagwati & mavroidis, supra note 51, at 305. but, as de cendra observes, “[t]he findings of the working party have to be put in the context of the group’s mandate. the core of the examination was the parties’ practice with respect to bta. the working party did not state clearly that the report was the ultimate report on bta and its compatibility with gatt.” de cendra, supra note 12, at 139 (drawing on van calster, supra, at 420). indeed, nothing in the report suggests that the working party intended it to be. its far less ambitious charge, noted in paragraph 1 of its report, was to examine the gatt provisions of relevance for btas, practices regarding btas, and the possible effects of btas on international trade; consider any resulting proposals and suggestions; and report its findings to the contracting parties. 91. see japan – alcoholic beverages, supra note 25, at 21. 92. consumers may view final products from a country with a poor reputation for controlling carbon emissions as different from those from countries 2011] border adjustments for carbon taxes 259 group emphasized in ec-asbestos that it is inappropriate to base a conclusion on likeness on an examination of only one or two of the four criteria listed above93 and stated that “a determination of ‘likeness’ . . . is fundamentally, a determination about the nature and extent of a competitive relationship between and among products.”94 the wto-unep states the issue as follows: an important question in relation to the application of the four above-mentioned criteria to climate change measures is whether products may be considered “unlike” because of differences in the way in which they have been produced (referred to as non-product-related processes and production methods (ppms), even though the production method used does not leave a trace in the final product, i.e. even if the physical characteristics of the final product remain identical.95 cosbey explains as follows regarding the possibility that two physically identical products would be found to be unlike, based on consumer tastes and habits: the thin odds of success here are related to two facts: first, as emphasized in ec-asbestos (paragraph 109, inter alia), a full picture of likeness can only emerge as a result of examining all four criteria, and in this case only one of them argues against likeness; second, even were consumer behaviour to be elevated so as to be predominant in this judgement, it would be difficult to argue that consumers with a better reputation. as evidence for the proposition that distinctions not related to the inherent characteristics of a product may be relevant in judging whether products are “like,” hufbauer, charnovitz, and kim offer the example of a wto waiver for trade restrictions on so-called conflict diamonds. hufbauer, charnovitz & kim, supra note 9, at 68 n.3. but consumers are not likely to know the country of origin, and thus the carbon content, of the many inputs that go into making complex imported products such as automobiles. see also goh, supra note 12, at 407-08. 93. ec — asbestos, supra note 89, at ¶ 109. 94. id. at ¶ 99. this interpretation of likeness poses a dilemma for a country thinking of applying border adjustments. pauwelyn observes that if a country “argues that it needs adjustment at the border because of competitiveness concerns, it cannot turn around later under a ‘likeness’ examination and say that high-carbon and low-carbon products do not compete in the first place” (and that adjustments based on the carbon content of import should thus be allowed). pauwelyn, u.s. federal climate policy, supra note 15, at 29. 95. wto-unep, supra note 12, at 107. 260 florida tax review [vol. 11:4 prefer intermediate goods like steel that are efficiently produced, there being no markets or eco-labelling schemes one could point to that would support the claim.96 this analysis suggests that under the basic trade rules border adjustments would likely be limited to the carbon content of production in 96. cosbey, supra note 86, at 4 n.11. the uk, switzerland, japan, australia, and sweden have all instituted carbon labeling, carbon labeling legislation has been introduced in the california assembly, and the waxman-markey climate change bill provides for institution of a voluntary carbon disclosure program following a study by the u.s. environmental protection agency. see generally the discussion of carbon foot printing on the website of the carbon trust, http://www.carbontrust.co.uk/ pages/default.aspx. kejun, cosbey, and murphy note that the california proposal would consider raw material acquisition, transportation to the factory, manufacturing, and transportation to market in its carbon labeling scheme. kejun, cosbey & murphy, supra note 86, at 3. sweden’s national food administration informs consumers about the embedded carbon content of various foods, which depends, inter alia, on whether the food is imported or produced locally, methods and costs of processing, transportation, and storage. see national food administration (sweden), the national food administration’s environmentally effective food choices: proposal notified to the eu, may 15, 2009, http://www.slv.se/upload/dokument/miljo/environmentally_effective_food_ choices_proposal_eu_2009.pdf. it does not, however, distinguish between countries from which food is imported. because most carbon is emitted far upstream in the production-distribution system (e.g., in the generation of electricity used in the aluminum sector), it is hard to think of many good “low-carbon” analogs among consumer goods to “dolphinsafe tuna,” food that has not been genetically modified, “turtle-safe shrimp,” and conflict-free diamonds, all products some consumers may prefer passionately over what they perceive to be less environmentally friendly alternatives. consumers are unlikely to know (or be able to find out) whether aluminum foil has been produced using electricity generated in lowor high-carbon power plants. certainly ecolabelling is not likely to be reliable. as wooders, reinaud, and cosbey observe more generally: giving an exact cost for the carbon footprint of a ghg-intensive process is difficult . . . . the work is based on measuring a set of inputs and outputs—such as electricity consumption in particular countries, transport miles driven by vehicle type, and quantities of steel and concrete used in construction . . . . the emission factors it contains have uncertainty ranges and, depending on the source, differentiate among different technologies and production processes. certain assumptions must be made, for example, about the electricity-generating mix in a particular country. for electricity-intensive processes, the choice made at this point can fundamentally alter the emission factor of the particular product. wooders, reinaud & cosbey, supra note 1, at 51-52 (emphasis added). 2011] border adjustments for carbon taxes 261 the importing country. the wto’s emphasis on competition between imports and domestic products in defining “like products” reinforces this conclusion.97 both the superfund tax and the odc tax mentioned earlier provide precedent for basing import btas on carbon content under the predominant method of production (pmp) in the importing country (or on the actual carbon content of imports, if it is lower). the european commission suggested using a somewhat different methodology to calculate import bas in one option included in an early draft of its proposal to revise the directive on the ets – basing bas for both imports and exports on the average carbon content of products produced within the eu, reduced by the average level of free allowances.98 this raises two questions: first, can bas be based on country averages?99 the actual carbon content of particular imports or exports could, of course, be less than the eu average. the wto panel addressed this issue in united states standards for reformulated and conventional gasoline, finding that imported gasoline subjected to baselines for quality that reflected average u.s. gasoline quality were treated “less favourably” than gasoline produced in the u.s., because u.s. producers could employ entity-level baselines.100 second, can bas applied by individual eu member states be based on 97. see ec — asbestos, supra note 89; supra text accompany note 94. it should be remembered, however, that this case involved a challenge under the broader interpretation of “like products” in article iii.4, not the narrower interpretation under article iii.2. supra note 89. 98. see godard, supra note 15, at 13-14, von asselt & brewer, supra note 2, at 48, and quick, supra note 5, at 167-68. quick quotes at length from the commission’s draft proposal. its so-called fair option includes the following words quoted by quick: “the principle of common but differentiated responsibilities will be reflected by reducing the proportion of allowances to be surrendered in respect of imports from developing countries. . . .” quick, supra note 5, at 168. implementing this reduction would leave import bas applied only to trade with developed countries that do not pledge to reduce emissions. as quick says, “for the time being, it seems that the united states would therefore be the only fair target. . . . [t]the scope of fair seems to be quite limited.” id. 99. it should also be noted that the use of average levels of emissions to calculate import bas, be they the average level in the exporting or in the importing country, rather than actual emissions, means that there will be little incentive to reduce emissions, since bas are independent of actual emissions. this point is made in a somewhat different context by bordoff, supra note 15, at 53. for a contrary view, see godard, supra note 15, at 19. 100. panel report, united states – standards for reformulated and conventional gasoline ¶ 6.16, wt/ds2/r (jan. 29, 1996) [hereinafter panel report – reformulated gasoline]. the panel did suggest, however, that use of an average baseline for imports might be permissible if lack of data precluded use of individual baselines. id. at ¶ 6.28. 262 florida tax review [vol. 11:4 averages for the entire union?101 the eu average could, of course, exceed that for a particular member state. both concerns could be handled by allowing exporters the option of basing import bas on actual carbon content, as under the superfund and odc taxes. as noted earlier, carbon taxes are “taxes occultes.” this raises the question of whether btas based on actual carbon content – or even calculations of carbon content under pmp or best available technology, an option to be considered next – should reflect carbon taxes paid ”indirectly” further up the production-distribution chain, or only those paid directly. this is of paramount importance, because electricity plays a pivotal role in the production of aluminum, one of the most energy-intensive of all products. 3. best available technology: grasping pyrrhic victory from the jaws of defeat? in the interest of assuring that btas are not excessive, and are thus legally fail-safe (and provided, of course, that under international trade rules they are not found to be per se illegal because they are based on ppms), ismer and neuhoff have proposed basing btas for carbon prices on carbon content under “best available technology,” which they define as: for example, the most effective and advanced stage in the development of activities and their methods of operations which indicate the practical suitability for providing in principle the basis for emissions limit values designed to prevent and, where that is not practicable, generally to reduce emissions and the impact on the environment as a whole. . . .102 use of the best availability technology to calculate btas would generally be immune from challenge, as it would assure that discrimination against imports could not occur.103 ismer and neuhoff place great weight on this objective, stating, “the choice should be made in such a way that no-one has reason to suspect the intention of the adjustment is to discriminate against foreign producers.104 the chosen product should therefore be among 101. see quick, supra note 5, at 175. 102. see ismer & neuhoff, supra note 1, at 147. 103. but because of the way bat is defined, it is possible that some techniques being utilized are less carbon-intensive than bat. 104. ismer & neuhoff, supra note 1, at 156. godard favors the use of bat for the same reasons as ismer and neuhoff. godard, supra note 15, at 14. but he undermines the gatt-legality of bas based on bat by suggesting implicitly that the object of concern is competitiveness, not carbon leakage, when he states: 2011] border adjustments for carbon taxes 263 the products with the lowest co2 (equivalent) emission in the class.”105 they acknowledge, however, that this implies that the more divergent the co2 intensity of the production of different products within a class, the lower the proportion of co2 emission allowance costs that can be adjusted for at the border. this is the main driver for subdividing classes with non-homogeneous energy intensity of materials and increasing the number of product classes.106 bas based on bat, or even on pmp in the importing country, would fail to deal adequately with the most egregious cases of carbon emissions related to imports.107 in addition, being independent of the actions nuclear technology to produce electricity is a very low-emitting one . . . . though it covers a significant part of the power generation in the eu (34 percent) or in the united states (20 percent), it is still a minor part when compared with the share of carbon-fired (coal and gas) plants. if this nuclear technology were to be taken as the bat for determining the cbas [climate border adjustments], the latter would be nearly nil, which would miss the predominant weight of emissions of the power generation sector in the ets (75 percent) and considerably underestimate the impact of carbon constraints imposed on power generation in the eu and, with expected passthrough of costs on downstream productions, on costs borne by several ets (steel) and non-ets (aluminium) producers. id. at 15. the real problem is not that basing bas on emissions from nuclear power understates emissions from power generation in the eu, which is relevant only for export bas; it is that it may understate emissions related to imports. even if the pmp in the eu were the basis for import bas, to be gatt-legal it would be necessary to allow importers to demonstrate lower levels of emissions, as under the superfund and odc taxes. although godard would allow importers this option, his emphasis on “bat within the predominant category of technology in use in europe” (emphasis added) suggests a protectionist intent. by comparison, avner avoids this error; he writes, “the bat should be determined by taking into account all technologies used worldwide.” avner, supra note 15, at 54. 105. ismer & neuhoff, supra note 1, at 156. 106. id. at 156-57. 107. for the comparative carbon-intensity of production of steel, chemicals, paper, and cement in various countries, see trevor houser, rob bradley, britt childs, jacob werksman, & robber hellmayr, leveling the carbon playing field: international competition and u.s. climate policy design 46-51 (peterson institute for int’l econ. 2008). note, however, that production in developing countries is not necessarily more carbon-intensive than that in the developed countries that are 264 florida tax review [vol. 11:4 of the producer of the imports, they do not provide any incentive to reduce emissions.108 finally, although ismer and neuhoff describe implementation of btas based on bat as “relatively simple,” wooders, reinaud, and cosbey conclude, “[i]dentifying a best available technology is not always straightforward and . . . the range of ghg emission factors can be very wide.”109 indeed, ismer and neuhoff mention several problematic issues, including the definition of product classes, the treatment of intra-class variations in energy-intensity, which technology should be considered in calculating the carbon content of traded goods under bat, and how to choose the energy source used in making these calculations – an especially troubling issue in the all-important case of electricity, which can be generated using no carbon (wind, solar, geothermal, or hydro), relatively little carbon (gas), intermediates amounts of carbon (oil), or substantial amounts of carbon (coal).110 it is, of course, impossible to know the carbon intensity of power taken from the grid, as neuhoff and ismer, acknowledge: “in a context of an electricity grid, it becomes difficult to ascertain how many allowances had to be surrendered when generating the electricity used for the production of the good.”111 despite their strong advocacy of bat, neuhoff and ismer would considering bas. being more modern, many plants in developing countries emit less co2 per unit of output than their counterparts in advanced countries. thus, in many instances bas based on actual emissions might differ little from those based on bat, especially since it can be expected that imports will come from the most efficient and lowest-cost producers. see neuhoff & ismer, supra note 3, at 4-5. 108. see supra note 99; see also wooders, reinaud, & cosbey, supra note 1, at 52. that export bas would not be related to actual emissions would be an advantage. thus ismer seems to understate the case for basing export bas on bat when he writes, “practicality requirements imply that the adjustment should be fixed at a level that is independent of actual emissions.” ismer, supra note 14, at 223. 109. wooders, reinaud & cosbey, supra note 1, at 52. for a thorough discussion of the difficulties of measuring the carbon content of energy-intensive products, see julia reinaud, issues behind competitiveness and carbon leakage: focus on heavy industry. (int’l energy agency 2008), http://www.iea.org/ textbase/papers/2008/competitiveness_and_carbon_leakage.pdf. 110. ismer & neuhoff, supra note 1, at 154-58. bushnell, supra note 7, examines these issues in the context of a cap-and-trade system for california. 111. neuhoff and ismer, supra note 3, at 8. wooders, reinaud & cosbey ask rhetorically and respond, “is it really possible to define the provenance of electricity? where the plant is tied through a physical connection, the case is relatively simple. even here, the electricity that such a plant generates would find ready customers elsewhere. . . .” wooders, reinaud, & cosbey, supra note 1, at 46 n.36. avner describes the problem of using bat to calculate bas for aluminum, assuming that bas would be allowed for the carbon content of electricity consumed in producing it: 2011] border adjustments for carbon taxes 265 apparently circumvent this problem by basing bas on the marginal cost of electricity, noting, “[i]n most countries all available renewable generation will be used, and some electric power still continues to be produced from fossil fuels. therefore the production of the marginal unit of the commodity will be linked to carbon emissions from fossil fuels. based on this economic logic, border adjustment could be pursued based on the carbon intensity of the fossil generation.”112 they warn, however, that “price increases under such logic probably could not be qualified as a tax under article iii gatt. they would thus have to pass the test of article xx gatt, which would arguably mean that the adjustment could only apply to importers.”113 b. a mixed system and most-favored nation treatment much of the literature on the gatt-legality of bas for carbon prices does not take account of “the elephant in the room” — the fact that, rather than being applied to trade with all nations, bas are likely to be applied only to trade with nations that lack comparable measures for mitigating carbon emissions — primarily nations the kyoto protocol exempted from commitments to reduce emissions.114 no matter how the issues discussed thus far are resolved, the wto would almost certainly find that such a “mixed” system violates article i of the gatt, which prescribes most-favored nation treatment. recent commentators have recognized this implication of applying bas only to trade with some countries. regarding the warner-lieberman bill115 (“the climate security act”), which could eventually require that imports from countries that do not curtail emissions hold permits, hufbauer, charnovitz, and kim write, “the program would clearly be a violation of gatt article 1:1 because of the inherent origin-based discrimination. some wto members would be covered countries and some would not.”116 similarly, van asselt, brewer, and mehling conclude: it should be clear that the heterogeneity of emissions associated with the production of electricity is much larger than with any other border adjustable basic material. therefore bat (let’s say hydroelectricity) would not afford any protection to domestic industries such as aluminium. we thus rule this option out. avner, supra note 15, at 61. 112. neuhoff & ismer, supra note 3, at 8. 113. id. 114. of course, the elephant was not yet in the room when much of this literature was written. it appeared only once it became obvious that not all gatt signatories would limit carbon emissions. 115. s. 2191, 110th cong. (2007). 116. hufbauer, charnovitz, & kim, supra note 9, at 82. 266 florida tax review [vol. 11:4 if border adjustments were applied to ‘like’ products based on their country of origin, favoring products from countries with stringent climate policies and penalizing products from countries with weak or no climate policies, a violation of this principle would appear possible. this appears clearly to be the case in the climate security act, which distinguishes between countries taking ‘comparable action’ and those that do not.117 finally, wiers concludes, “i see basically no escape from infringement of the mfn clause in gatt article i; whether importers need to buy emission rights will depend on whether they are exporting from a country deemed to be applying comparable or otherwise satisfactory emission restrictions.”118 in reaching the same conclusion, quick notes that the prohibition against discrimination in article i is “categorical.”119 a mixed system could only be saved by a successful appeal under the general exceptions provisions of article xx of the gatt. the fact that the kyoto protocol exempted developing countries from commitments to reduce emissions would likely undermine such an appeal, even if it would otherwise be sustained. c. the shrimp-turtle decision: setting the stage for article xx before turning to a detailed examination of article xx, it will be useful to set the stage by reviewing the wto appellate body’s decision in the 1998 shrimp-turtle case, an article xx case that is widely seen as signalling that, under certain circumstances, the wto would allow btas for taxes based on ppms. it reversed a contrary finding in two seemingly similar article xx cases decided only a few years earlier. in the tuna-dolphin cases decided in 1991 and 1994 the gatt panel ruled that an import ban on tuna could not be predicated on the manner in which tuna are caught, as long as the product was not affected, and – more important in the present context – that an article xx exception did not 117. van asselt, brewer, & mehling, supra note 8, at 51; see also infra note 155; holzer, supra note 15, at 59-60. bordoff describes some of the difficulties that would be encountered in trying to determine whether a trading partner had a comparable system for reducing emissions of co2, an important issue that is beyond the scope of this article. bordoff, supra note 15, at 48-49. 118. jochem wiers, multilateral negotiations and unilateral discrimination from a world trade organization legal perspective, in climate and trade policies in a post-2012 world 87-88 (united nations environment programme 2009). 119. quick, supra note 5, at 164. 2011] border adjustments for carbon taxes 267 apply.120 these rulings implied that only the physical characteristics of a product, and not process and production methods, are relevant for judging whether two products are “like.” although these rulings, which frankel describes as “notorious,”121 were never adopted by the gatt council, and thus had no legal weight, they created concern that btas could not be justified by arguing that differences in ppms made products “unlike.”122 by comparison, in the shrimp-turtle case the appellate body found that ppms can matter.123 several asian countries had challenged a u.s. law that restricted imports of shrimp caught in nets that did not have turtleexclusion devices, arguing that trade restrictions could not be based on ppms. the wto appellate body initially ruled against the u.s. because of the way the law was implemented but subsequently approved its efforts to bring implementation into compliance. but more important for present purposes, (1) it found that the exception for measures related to the conservation of natural resources provided by article xx(g) of the gatt, to be discussed further below, applied, rejecting the claim that there was not sufficient nexus between the u.s. and the endangered sea turtles, which migrate to or traverse the territorial waters of the u.s., and (2) it implied that trade restrictions based on ppms would be sustained if implemented in a manner that met the other strictures of article xx.124 the appellate body’s shrimp-turtle decision is widely considered to have been a watershed case. it is commonly interpreted as meaning that 120. panel report, united states – restrictions on imports of tuna, ds21/r 39s/155, (sept. 1991); panel report, united states – restrictions on imports of tuna, ds29/r, (jun. 16, 1994). see also charnovitz, supra note 66, at 8688, 92-94. 121. jeffrey frankel, global environment and trade policy, in post-kyoto international climate policy 493, 514 (joseph e. aldy & robert n. stavins eds., cambridge univ. press 2009). 122. see demaret & stewardson, supra note 15, at 27-29. for a particularly strong condemnation of the tuna-dolphin decisions, see hoerner & muller, supra note 15, at 27-29. for the opposite view, see bhagwati & mavroidis, supra note 51, and references provided there. charnovitz discusses the tuna-dolphin and other cases involving the gatt-legality of trade measures based on ppms. charnovitz, supra note 66, at 86-91. 123. appellate body report, united states – import prohibition of certain shrimp and shrimp products, wt/ds58/ab/r (adopted nov. 6, 1998) [hereinafter shrimp-turtle]. many authors have discussed this case and its importance. see, for example, charnovitz, supra note 66, at 95-98; deal, supra note 6; frankel, supra note 121, at 504-05; peter morici, reconciling trade and the environment in the world trade organization 80-83 (econ. strategy institute, washington 2002). these authors cite other literature on the shrimp-turtle case. 124. shrimp-turtle, supra note 123. for a summary of this dispute, see http://www.wto.org/english/tratop_e/dispu_e/cases_e/ds58_e.htm (lasted visited may 31, 2011). 268 florida tax review [vol. 11:4 environmental provisions that violate articles i and iii of the gatt could pass muster under article xx.125 charnovitz concludes, “no adopted gatt or wto decision has suggested that ppms are outside the scope of article xx.”126 iv. btas under gatt article xx it is possible that under the “basic” rules governing international trade examined thus far, btas would not be allowed for any carbon taxes. furthermore, import btas, if allowed, might be limited to levels calculated under either ppm or bat. in any event, it seems virtually certain that btas applied selectively under a “mixed” system would be found to violate the most-favored nation provision of the gatt. it is possible, however, that btas, including adjustments based on the actual carbon content of traded products and perhaps even a mixed system would nonetheless be allowed under article xx of the gatt.127 as a practical matter, the first two issues are likely to arise only in the context of a challenge under the most-favored 125. see for example, charnovitz, supra note 66, at 95-97; frankel, supra note 121, at 505, and deal, supra note 6, at 7-9, and references provided there. bhagwati & mavroidis interpret the shrimp-turtle decision to mean that, since the united states did not ratify the kyoto protocol, all u.s. exports to signatories of the protocol could be subject to btas, because produced using ppms inconsistent with the protocol. see generally bhagwati & mavroidis, supra note 51. this interpretation of the nature of ppms – that all production in a country that does not sign a particular treaty is produced with a ppm that differs from the ppm employed in signatories – seems far-fetched. as charnovitz has written in a different context, “a law that bans fish imports from a producer owned by a pariah government will be probably be considered a plain embargo rather than a ppm.” charnovitz, supra note 66, at 67. 126. charnovitz, supra note 66, at 100. after reviewing the superfund case, the ocd tax, and the decision in shrimp-turtle, biermann and brohm conclude “although the case law is not unambiguous as to whether national energy taxes could be supported through border adjustments, it seems that taxes on chemicals – possibly also energy – used as materials in the manufacture or production of imported substances can be included in border tax adjustment schemes.” biermann & brohm, strategic role, supra note 12, at 295. 127. among the many other places this issue is discussed are goh, supra note 12, at 413-22; de cendra, supra note 12, at 143-45, ismer & neuhoff, supra note 1, at 149-52; pauwelyn, u.s. federal climate policy, supra note 15, at 33-41; pauwelyn, testimony, supra note 15, at 11-17; bordoff, supra note 15, at 49-54; van asselt, brewer, & mehling, supra note 8, at 52-57; hufbauer, charnovitz & kim, supra note 9, at 49-60, wto-unep, supra note 12, at 107-110; ponnambalam, supra note 8. 2011] border adjustments for carbon taxes 269 nation provision.128 such a challenge is perhaps most likely to be mounted by developing countries against bas introduced by their developed trading partners. but if the u.s. persists in not introducing carbon pricing, the eu might trigger a challenge by applying bas to its trade with the u.s. the wto appellate body has stated that a two-step approach is to be followed in applying article xx. the first step is to determine whether the measure in question satisfies one of the specified exceptions, of which paragraph (b) or (g) are relevant in the present context. the threshold for legality under these exceptions is, of course, lower than that under article iii. if one of these exceptions is satisfied, the second step is to determine whether the measure is also consistent with the introductory paragraph, the so-called “chapeau” of article xx.129 wto case law, as well as a priori reasoning, suggests that it is likely much easier to satisfy paragraph (b) or (g) than to comply with the chapeau, which ponnambalam calls “a formidable gatekeeper.”130 pauwelyn notes that in all cases where the appellate body has denied an article xx exception it was because the chapeau’s test was not met.131 a. the tests of paragraphs (b) and (g) it might seem that satisfaction of the requirement of paragraph (b) of article xx that btas are “necessary to protect human, animal or plant life or health” would require a demonstration that there are no other gattconsistent means of achieving the same objective. however, according to the wto: [t]he interpretation of the necessity requirement of article xx (b) . . . has evolved from a least-trade restrictive approach to a less-trade restrictive one, supplemented with a proportionality test (“a process of weighing and balancing a series of factors”). the appellate body considered that the determination of whether a measure is necessary involves in every case a process of weighing and balancing a series of factors which prominently include the contribution made by the measure to the enforcement of the regulation at issue, the importance of the common interests or values protected by 128. “[t]he debate will in all probability concentrate on article xx because the mfn infringement will need to be justified, whether there is a national treatment violation or not.” wiers, supra note 118, at 88. 129. appellate body report, united states – standards for reformulated and conventional gasoline, 22, wt/ds2/ab/r (adopted may 20, 1996) [hereinafter ab report – reformulated gasoline]. 130. ponnambalam, supra note 8, at 274. 131. pauwelyn, u.s. federal climate policy, supra note 15, at 37. 270 florida tax review [vol. 11:4 the regulation, and the accompanying impact of the measure on imports or exports. [i]n the ec — asbestos case . . ., for the first time, an “environmental” measure passed the necessity test. the appellate body noted that “the more vital or important [the] common interests or values” pursued, the easier it would be to accept as “necessary” measures designed to achieve those ends.132 the predominant view is that btas are more likely to be granted an exception under paragraph (g), which accords conditional approval of measures “relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption.”133 in shrimp-turtle the appellate body acknowledged that conditions placed on access to markets that are 132. see wto, supra note 67, at 52. for optimistic appraisals of the likelihood of success under ¶ (b), see ismer & neuhoff, supra note 1, at 150; van asselt, brewer & mehling supra note 8, at 52-53; quick, supra note 5, at 171-72. the appellate body elaborated on “weighing and balancing” in its decision in brazil – tyres: [i]n order to determine whether a measure is “necessary” within the meaning of article xx(b) of the gatt 1994, a panel must consider the relevant factors, particularly the importance of the interests or values at stake, the extent of the contribution to the achievement of the measure’s objective, and its trade restrictiveness. if this analysis yields a preliminary conclusion that the measure is necessary, this result must be confirmed by comparing the measure with possible alternatives, which may be less trade restrictive while providing an equivalent contribution to the achievement of the objective. this comparison should be carried out in the light of the importance of the interests or values at stake. it is through this process that a panel determines whether a measure is necessary. appellate body report, brazil – measures affecting imports of retreaded tyres, ¶ 178, wt/ds332/ab/r (adopted dec. 17, 2007). for further discussion of the wto appellate body’s evolving interpretation of the term “necessary” in ¶ (b), see quick, supra note 5, at 171-72, and ponnambalam, supra note 8, at 272-74. 133. in any event, the wto appellate body has found that “relating to” is a lower standard to meet than “necessary to.” see ab report – reformulated gasoline, supra note 129, at 16-18. 2011] border adjustments for carbon taxes 271 intended to protect the environment may pass muster under paragraph (g) of article xx.134 in shrimp-turtle the appellate body applied a three-pronged test to determine whether the measure in question satisfied paragraph (g).135 in the present context the first question is whether the atmosphere is an exhaustible natural resource. precedent for an affirmative answer is found in united states – reformulated gasoline, where a wto panel ruled, and the appellate body confirmed, that clean air is a natural resource that can be depleted.136 the appellate body stated in shrimp-turtle that the words “exhaustible natural resources” in paragraph (g) must be read “in light of contemporary concerns of the community of nations about the protection and conservation of the environment.”137 the unfccc and the kyoto protocol, inter alia, would seem to provide adequate predicate for applying this provision in the case of a carbon tax (or a cap and trade system).138 biermann and brohm opine, “[i]t certainly matters for the interpretation of wto law that 95 percent of wto members have ratified the climate convention. . . .”139 moreover, the preamble of the wto agreement itself recognizes “the objective of sustainable development, seeking both to protect and preserve the environment.” second, there must be a “substantial relationship” — a reasonable “means and ends relationship” — between the measure and the conservation of the exhaustible natural resource; the measure cannot be merely 134. shrimp-turtle, supra note 123, ¶ 121. the u.s. had claimed an alternative exception under article xx(b), in case a paragraph (g) exception was denied. the appellate body, having decided that the law in question satisfied paragraph xx(g), did not consider the alternative. id. ¶ 146. see also hufbauer, charnovitz & kim, supra note 9, at 49-50, 55-57. although these authors suggest that it would be “surprising” if programs to mitigate greenhouse gas emissions were not found to fit within paragraph (g) and assume that they would be, they admit that this conclusion is “not free from doubt.” id. at 50-51. 135. shrimp-turtle, supra note 123, ¶¶ 125-45. 136. panel report – reformulated gasoline, supra note 100, ¶ 6.37, confirmed by the appellate body in ab report – reformulated gasoline, supra note 129. the wto appellate body considered whether sea turtles are an exhaustible natural resource in shrimp-turtle, supra note 123, ¶¶ 127-34. 137. shrimp-turtle, supra note 123, ¶ 129. 138. note, however, that article 3.5 of the unfccc contains these words, which are virtually identical to those in the chapeau of article xx: “measures taken to combat climate change, including unilateral ones, should not constitute a means of arbitrary or unjustifiable discrimination or a disguised restriction on international trade.” essentially identical words also appear in principle 12 of the rio declaration on environment and development. the import of these restrictions is discussed below. 139. bierman and brohm, possible tool, supra note 12, at 254. 272 florida tax review [vol. 11:4 “incidentally or inadvertently aimed at” conservation.140 since btas on carbon embedded in imports form an integral part of a policy to reduce co2 emissions, there seems to be little doubt that they would pass this test.141 but bordoff cautions, “it is less clear whether a border adjustment would satisfy the test of being primarily aimed at and substantially related to the goal of reducing ghg emissions when estimates suggest the policy might do little to reduce leakage.”142 finally, the measure must be “evenhanded,” in that it is “made effective in conjunction with restrictions on domestic production or consumption.”143 btas on imports, being imposed in conjunction with a 140. shrimp-turtle, supra note 123, ¶¶ 135-42. the words quoted are from ab report – reformulated gasoline, supra note 129, at 19. the appellate board also noted that the measure in question in that case was “primarily aimed at” conserving a natural resource. ab report – reformulated gasoline, supra note 129, at 18. in shrimp-turtle, the appellate board said that the relationship at issue in the prior case exhibited “a close and genuine relationship of ends and means.” it seems to be generally agreed that there would be no issue of nexus, since co2 emissions occurring in any one country affect all countries. shrimp-turtle, supra note 123, ¶ 136. 141. pauwelyn, u.s. federal climate policy, supra note 15, at 35, and van asselt, brewer, & mehling, supra note 8, at 53, conclude that border measures would pass this test. but, goh notes: [i]t could be argued that a measure that failed to take into account the level of taxes in the country of origin – or other nonfiscal measures taken to address climate change – would not constitute a reasonable “means and ends relationship.” imposing a double environmental penalty on producers in the exporting country could not be said to reasonably contribute to the object of addressing climate change. goh, supra note 12, at 415. as he notes, this issue is also relevant in appraising a measure under the chapeau. 142. bordoff, supra note 15, at 50. see also quick, supra note 5, at 172. quick asserts boldly, “the proposals to apply a ‘border tax’ on imports or to extend the emission trading scheme to imports do not contribute to reducing greenhouse gas emissions. they have no effect on the green house gas emissions of the exporting countries since one must assume that their production will not diminish but trade flows will change due to border measures.” quick, supra note 15, at 354. numerous economic models have found that, by lowering energy prices, bas may actually encourage greater consumption of carbon. see, e.g., ismer & neuhoff, supra note 1, at 150; warwick j. mckibbin & peter j. wilcoxen, the economic and environmental effects of border tax adjustments for climate change policy in climate change, trade and competitiveness: is a collision inevitable? 1-23 (lael brainard & isaac sorkin eds. brookings institution press 2009). 143. shrimp-turtle, supra note 123, ¶¶ 143-45. 2011] border adjustments for carbon taxes 273 domestic carbon tax, would seem to pass this test — provided, of course, that their application is actually evenhanded.144 it would seem much more difficult to gain an exception for btas on exports, which would free domestic producers from the obligation to pay tax on the carbon they emit, as long as it is for the production of exports.145 while, strictly speaking, btas for exports are “made effective in conjunction with restrictions on domestic production or consumption,” their objective and likely effect is not to reduce emissions of co2. it is thus hard to argue that btas for exports are related to the conservation of an exhaustible natural resource; they appear much more clearly aimed at preventing competitive disadvantage.146 there is, of course, no exception for measures deemed necessary to prevent adverse competitive effects on the domestic economy.147 moreover, as hufbauer, charnovitz, and kim note, “[t]he rebate of an energy tax for exports could undermine the environmental justification for applying the bta to imports.”148 ismer and neuhoff suggest that it might be claimed that the treatment of imports and exports should be considered as a package149 – an 144. quick argues that it would not be even-handed to introduce bas in the context of the ets, if 95 percent of permits are provided free of charge. quick, supra note 5, at 173. see also the discussion of free allowances infra at note 177. 145. see ismer & neuhoff, supra note 1, at 150; ismer, supra note 14, at 223; quick, supra note 15, at 357. 146. thus quick has written regarding the possible extension of bas for the cost of emissions permits to exports, “the measure is not taken for environmental but purely for competitiveness reasons.” quick, supra note 5, at 175. 147. see also supra note 142. 148. hufbauer, charnovitz & kim, supra note 9, at 69. holzer states the problem nicely: it is sheer nonsense to rebate the costs of emissions if the whole purpose of an emissions reduction system is to create such costs for selected firms or industries in order to reduce emissions. . . . moreover, it would disarm a country making such rebates of the last argument that carbon restrictions on imports are imposed with the sole purpose of climate protection. inability to apply this argument would result in the failure to invoke gatt article xx. . . . see holzer, supra note 15, at 63. 149. ismer & neuhoff, supra note 1, at 150. it could be argued that, by combating carbon leakage and free riding, export btas would contribute to both the conservation of the global environment and the protection of life and health, but whether the wto would accept it cannot be known. in ab report – reformulated gasoline, the wto appellate body faulted the panel for not considering the baseline establishment rules “as a whole.” ab report – reformulated gasoline, supra note 129, at 19. but the “package” at issue in that case, the treatment of 274 florida tax review [vol. 11:4 argument that might cut against btas for imports, rather than in favor of btas for exports. but, consistent with the view followed here, they note that “the two directions of bta appear to be separable.”150 b. satisfying the chapeau even if btas for carbon taxes could get past the specific hurdles posed by paragraph (b) or paragraph (g), they must also satisfy the chapeau of article xx, in particular, the requirement that they are “not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade. . . .”151 this provision is intended to prevent the abuse of the article xx exceptions and to reflect a balance between substantive rights provided under the basic gatt rules and the right to invoke the exceptions.152 by its own terms, it involves how the measure is applied, not merely the content of statutes or regulations. since it cannot be known in the abstract how a given law will be applied, the focus here is on the other issues inherent in the chapeau. the discrimination at issue in applying the chapeau, being discrimination between “countries where the same conditions prevail,” is different from that at issue in applying articles i and iii, which involves discriminatory treatment of “like products.”153 for purposes of article xx, discrimination could be either against a single trading partner exporting to the country applying btas (as in a violation of national treatment) or discriminatory treatment of different foreign countries (as in a violation of most-favored nation treatment). importers and domestic producers, seems different in kind from the “package” at issue here, bas for exports as well as taxes on domestic products and bas for imports. 150. ismer & neuhoff, supra note 1, at 150. 151. (emphasis added). article 3.5 of the unfccc states that measures taken to combat climate change should satisfy similar standards. 152. shrimp-turtle, supra note 123, ¶ 156. charnovitz distinguishes between two views of the relationship between the basic gatt rules and the exceptions of article xx. one looks at the two types of rules as operating in tandem as coequals in defining violations of the rules. the other — the one adopted by the appellate board — confers “substantive” rights on exporting countries that might be overturned by application of an article xx exception. charnovitz, supra note 66, at 80-82. this distinction is not considered further here. 153. pauwelyn, u.s. federal climate policy, supra note 15, at 37. article i (most-favored-nation) involves discriminatory treatment of “like products” in trade with different trading partners. 2011] border adjustments for carbon taxes 275 1. arbitrary or unjustifiable discrimination between countries where the same conditions prevail the chapeau does not allow exceptions that would sanction “arbitrary or unjustifiable discrimination between countries where the same conditions prevail.” this has several implications. first, btas on trade between advanced countries that have adopted similarly effective originbased measures to reduce emissions of co2 (e.g., u.s. btas on trade with eu members that implement the ets) would almost certainly not satisfy the chapeau.154 this would be true, even if the measures adopted were not the same, as long as they had comparable effects.155 but an advanced country that had adopted such measures (e.g., a member of the eu) could perhaps adopt btas on trade with another advanced country that had not adopted such measures (the u.s.), as long as the discrimination was not “arbitrary or unjustifiable,” even though this would violate both national treatment and most-favored nation treatment.156 154. quoting from the shrimp-turtle decision, pauwelyn says that the requirement under examination “may force the united states to consider whether a foreign country already imposes emission cuts or otherwise addresses climate change. this, in turn, may oblige (or at least enable) the united states to impose lower (or no) import taxes or emission allowance requirements on imports from countries that have their own climate policies in place.” pauwelyn, u.s. federal climate policy, supra note 15, at 38-39. 155. care must be taken in wording and implementing ba provisions. a country cannot condition exemption from bas on its trading partner using “essentially the same” technique to reduce carbon emissions, as that would involve unacceptable coercion; techniques that are “comparable in effectiveness” must also be accepted, in order to provide flexibility. nor is it enough that statutes provide this flexibility; flexibility in implementation is also required. see shrimp-turtle, supra note 123, ¶¶ 161-63. the requirement in the waxman-markey bill that trading partners take “comparable action” thus seems vulnerable to challenge. 156. as godard says “the scope of this limitation depends on the assessment of what ‘same conditions’ are: are countries with no strong climate policies and those having developed such policies and agreed to commit internationally subject to the same conditions?” godard, supra note 15, at 12. on these issues, see pauwelyn, u.s. federal climate policy, supra note 15, at 38-39. godard suggests regarding bas imposed by the eu that, “a more [legally] secure alternative regarding compliance with the general regime of wto would be to apply the cbas [climate border adjustments] to any non-eu country, with the idea that countries having adhered to a mpkca [multilateral post-kyoto climate agreement ]would have a symmetrical opportunity to introduce a similar climate adjustment at their borders, just as countries presently do with consumption or valueadded taxes.” godard, supra note 15, at 12. in essence this would be destinationbased carbon pricing. even if that solution were gatt-legal, it would be impractical for administrative reasons, as explained in mclure, supra note 1 and supra note 16. 276 florida tax review [vol. 11:4 second, the wording of this provision seems to leave a gaping hole—it does not address the status under the chapeau of discriminatory treatment, either favorable or unfavorable, of trade between countries where the same conditions arguably do not prevail. this is crucial, given that most developing countries have taken advantage of the exemption provided by the kyoto protocol, in accord with the unfccc statement that “states have common but differentiated responsibilities.” (to the extent that developing countries adopt measures to limit emissions that are comparable in effect to those adopted by developed countries, this discussion would not apply.) would the chapeau allow a developed country to adopt discriminatory treatment of trade with these countries, as would occur under a mixed system, because the same conditions (state of development) do not prevail? or does it prohibit them from doing so, because difference in state of development is not the type of “condition” contemplated in this provision? or might these words from the chapeau be interpreted to mean that discrimination in favor of these countries might be required? under that interpretation, developed countries would not be allowed to impose btas on trade with developing countries. this conclusion is strengthened by the fact that the both the u.s. and eu member states ratified the unfccc and the later group of nations also ratified the kyoto protocol.157 quick has concluded, “it is difficult to envisage that article xx gatt could be applied in such a way as to sanction trade measures against countries that fully comply with their international climate obligations.”158 as is true of so many of the issues examined here, the answers to these questions are far from clear. evidence that the nation imposing bas has engaged in “serious, across-the-board negotiations with the objective of concluding bilateral or multilateral agreements” is crucial to a finding that a measure does not involve arbitrary or unreasonable discrimination.159 such negotiations need not be successful. the fact that almost 200 countries, including all developed countries, have participated in the sixteen conferences of parties held pursuant to the unfccc shows clearly that this requirement has been met. even so, it would seem hard for countries that ratified the protocol, or even 157. see pauwelyn, u.s. federal climate policy, supra note 15, at 39-40, 40 n.119. 158. quick, supra note 15, at 354. on the other hand, wooders, reinaud, & cosbey write regarding obligations under a successor agreement to the kyoto protocol, “any discrimination in the application of the bca should ‘relate to the pursuit’ of the measure. . . . for example, exceptions for least developed countries on economic development or equity grounds, since they are arguably not relevant to the environmental aims of the measure, might constitute unjustifiable discrimination.” wooders, reinaud & cosbey, supra note 1, at 57 (citing brazil – tyres, supra note 132, ¶ 93). 159. shrimp-turtle, supra note 123, ¶ 166. 2011] border adjustments for carbon taxes 277 the less restrictive unfccc, to justify btas on trade with developing countries, given the recognition in both that “states have common but differentiated responsibilities” and the explicit exemption accorded developing countries in the kyoto protocol.160 2. disguised restriction on international trade there are those who view border adjustments for carbon prices as an unjustified interference with free trade. thus wilson and brown write: despite enthusiasm for carbon tariffs, their legitimacy under international trade rules is questionable. the principle of free trade is that countries should produce goods and services that take advantage of their comparative advantage. imposing a carbon price signal to devalue carbon intensive industries, goods and services is an anathema to that principle because it devalues each country’s comparative advantage.161 such views support a claim that bas constitute a “disguised restriction on international trade” that would render them ineligible for an article xx exception.162 by comparison, others turn this argument on its head, claiming that comparative advantage requires imposition of border adjustments. for example, metcalf and weisbach write: there are good arguments that border tax adjustments . . . are not inconsistent with, and in fact are required by, the principles of free trade. free trade relies on the principle of comparative advantage. . . . a country without a carbon price does not have a true comparative advantage in producing carbon-intensive goods relative to a country with a carbon price; it produces at what looks like a lower cost 160. on the requirement to negotiate, see wiers, supra note 118, at 88-91. quick notes that the unfccc “is less stringent than the kyoto protocol though, since it only encourages developed countries to stabilize green house gas emissions without obliging them to do so.” quick, supra note 15, at 169. of course, the u.s. ratified the former, but not the latter. 161. tim wilson & caitlin brown, institute of public affairs, costly, ineffectual, and protectionist carbon tariffs: why carbon tariffs shouldn’t be adopted to offset the cost of carbon 8, http://sustainabledev.org/wpcontent/uploads/2009/12/carbontariffs.pdf. 162. strangely, wilson & brown, id., do not make such an argument in criticizing btas. 278 florida tax review [vol. 11:4 only because the nominal price of the good does not include the full costs of production.163 it seems reasonable to believe, though impossible to document, that most economists would endorse the latter view. if it were to prevail — and 163. gilbert e. metcalf & david weisbach, the design of a carbon tax, 33 harv. envt’l. l. rev. 499, 504 (2009), nobel laureate joseph stiglitz states this argument as follows: a subsidy means that a firm does not pay the full costs of production. not paying the cost of damage to the environment is a subsidy, just as not paying the full costs of workers would be. . . . american firms are being subsidized—and massively so. there is a simple remedy: other countries should prohibit the importation of american goods produced using energy intensive technologies, or, at the very least, impose a high tax on them, to offset the subsidy that those goods currently are receiving. . . . energy tariffs would simply restore balance—and at the same time provide strong incentives for the united states to do what it should have been doing all along. see joseph e. stiglitz, a new agenda for global warming, economist’s voice, jul. 2006, at 2. stiglitz would actually go further than merely imposing bas on trade with the u.s. he says, “japan, europe, and the other signatories of kyoto should immediately bring a wto case charging unfair subsidization.” id. this suggestion, while perhaps displaying impeccable economic logic, seems a bit farfetched and is inconsistent with wto jurisprudence. referring to the decision of the appellate body in united states – tax treatment for “foreign sales corporations,” wt/ds108/ab/r ¶ 90, (adopted on mar. 20, 2000), mehling, meyer-ohlendorf, & czarnecki state: [t]he key question is whether the failure of a country to price carbon emissions or to internalize the full costs of carbon emission constitutes a subsidy as defined in 1.1 (a)(1) ascm. the wto appellate body has ruled that art. 1.1. ascm requires a comparison between products in one single wto member; the provision does not foresee a comparison between different wto members, for instance between wto members with and without climate change commitments. see michael mehling, nils meyer-ohlendorf & ralph czarnecki, international trade policy in a world of different carbon prices, in competitive distortions and leakage in a world of different carbon prices: trade, competitiveness and employment challenges when meeting the post-2012 climate commitments in the european union 23-29 (european parliament, 2008). 2011] border adjustments for carbon taxes 279 btas were not imposed in a manner that would otherwise create a restriction on trade, an article xx exception might be granted.164 economists are not the only ones who disagree on the case for border adjustments. as noted earlier, divergent views have been expressed by political figures in the eu. french president nicolas sarkozy and president of the italian council silvio berlusconi have been outspoken in their demands for border adjustments, but others have been equally vocal in opposing them.165 although the u.s. house of representatives has passed the waxman-markey bill and democrats have introduced similar legislation in the u.s. senate, opposition by republicans makes its enactment unlikely. of course, spokespersons for developing countries have strongly opposed bas.166 advocates of bas stress the need to be sure that such measures do not violate the international trade rules, and pains have been taken in drafting some proposals for bas to achieve this result. it is necessary to emphasize carbon leakage, which is a question of global emissions that has salience under paragraph (g) of article xx, and not loss of competitiveness, which does not.167 it is not clear how the wto would balance the economic case for bas based on the principles metcalf and weisbach set forth and concerns for carbon leakage expressed in official documents against concerns about 164. avner draws a distinction between bas that are enacted alongside the requirement that domestic producers hold emissions permits, as part of a package, and those that are enacted subsequent to enactment of the domestic measures, arguing that only the latter should be considered protectionist. avner, supra note 15, at 39. this formalistic distinction seems unconvincing. 165. supra note 6. 166. houser, supra note 2. 167. bordoff has noted that there is a sound reason why a nation may introduce import bas based on the carbon intensity of imports (to reduce carbon leakage) and an equally sound reason that they may limit bas to trade with countries that have comparably effective climate policies (lack of concern about carbon leakage to them). bordoff, supra note 15 at 51. but he also warns, that “there is no exception in article xx for preserving the health of u.s. firms, only the environment . . . .” id. at 52. similarly, quick states, “the protection of the industry’s competitiveness is, however, not foreseen among the exception provided for by article xx gatt as it would undermine the economic rationale of the wto . . . .” quick, supra note 15, at 169. pauwelyn observes, “arguments or indications of economic competitiveness concerns or leveling of the economic playing field between, say, u.s. and chinese steel, will not carry much weight in the wto; on the contrary, they would most likely be used in support of a finding that u.s. legislation is protectionist or discriminatory and, therefore, violates the wto treaty.” pauwelyn, testimony, supra note 15, at 14. see also hufbauer, charnovitz & kim, supra note 9, at 49. 280 florida tax review [vol. 11:4 economic disadvantage also mentioned in official documents168 and the cries for protection from unfair competition that fill the popular press. ponnambalam, suggests that if the wto were to focus on the “true purpose” of bas for a u.s. cap and trade system, as it did in brazil – tyres, it would not grant an article xx exception.169 3. the importance of design many have noted the importance of how bas are designed. for example, cosbey has stated, “it is impossible to say in the abstract whether bca [border carbon adjustments] would or would not breach wto obligations, since any such judgment would depend fundamentally on how the scheme was designed.”170 similarly, godard says, “there are strong arguments that cba [carbon border adjustments] would be compatible with wto rules if its design is cautious and takes account of some critical points in relation to basic principles of wto.”171 bordoff has described five ways in which bas might fail to satisfy the chapeau, several of which involve matters of design: (1) by doing little to reduce carbon leakage; (2) by not allowing bas to be based on the actual carbon content of imports; (3) by imposing overly stringent requirements on the means that can be used to reduce emissions; (4) by not taking adequate account of different conditions (namely the state of development); and (5) by failing to undertake serious negotiations.172 wooders, reinaud, and cosbey have proposed detailed “[g]uidance on elaborating and applying border carbon adjustment measures,” so that bas will be “formulated and carried out in a manner that is minimally disruptive to trading partners, equitable in terms of impacts, effective in 168. directive 2009/29/ec incautiously says that the failure of some countries to participate in an international agreement to reduce emissions could both lead to carbon leakage and put energy-intensive sectors at an economic disadvantage. directive 2009/29/ec, supra note 6, at ¶ 24. 169. ponnambalam, supra note 8, at 284-86. he notes that the rationale for u.s. rejection of the kyoto protocol is captured in the byrd-hagel resolution, which the u.s. senate passed by a vote of 95-0. id. at 285. it stated that the united states should not be a signatory to any agreement under the unfccc that is either “environmentally flawed” by failing to impose emissions restrictions on developing countries, or that “would result in serious harm to the economy of the united states.” s. res. 98, 105th cong. (1997). 170. cosbey, supra note 86, at 3. cosbey emphasizes the need for further research into how to make btas gatt-legal. id. at 7. pauwelyn provides guidance on making sure that legislation is gatt-legal. pauwelyn, testimony, supra note 15. see also pauwelyn, u.s. federal climate policy, supra note 15, at 41-44. 171. godard, supra note 15, at 23. 172. bordoff, supra note 15, at 52-54. 2011] border adjustments for carbon taxes 281 achieving the goal of addressing competitiveness impacts and leakage, and in line with the principles of the multilateral system of trade and the multilateral climate change regime.”173 its tenets, which the authors hope might become relevant in dispute settlement before the wto, include: • bas should be a fallback measure, to be employed only if international agreement cannot be reached; • bas should be used only to address leakage, not competitiveness; • rules should be clear and predicable, and there should be mechanisms for international input and appeals; • data requirements should be based on existing conventions, and calculation of sectoral vulnerability should be simple enough to be operational with reasonably available data; • imports should not be subject to bas if they are from a country that is in compliance with its obligations to meet climate change or is making comparable efforts to reduce emissions; • the principle of common but differentiated responsibilities should be observed in the application of bas; • conditions that trigger bas should be transparent and predictable, but decisions to impose bas should not be automatic; • bas should be based on data on physical quantities, not financial records, should reflect the effects of free allowances and related measures, and should not take account of emissions related to consumption or disposal of products; • bas should be calculated for plants; if practicality requires reliance on world or country averages, exporters should have the option of demonstrating lower emissions.174 173. wooders, reinaud & cosbey, supra note 1, at 67. 174. id. at 67-70. 282 florida tax review [vol. 11:4 c. gatt legality under the basic rules vs. article xx exceptions opinion is divided on whether import btas for a carbon tax would have a better chance of passing muster under the basic gatt rules or under the general exceptions of article xx. as suggested in the introduction to this section, three different issues might be involved under the basic rules: whether btas can be based on ppms, whether they can depend on the carbon intensity of traded products, and the legality of a mixed system. regarding the first two issues, pauwelyn proposes that the “first line of defense” of btas would be that they are consistent with the gatt rules regarding “product-related or indirect taxes,” with an appeal under article xx as “a second line of defense.”175 ismer and neuhoff conclude that it is uncertain whether the chapeau of article xx could be satisfied, “in particular with respect to other kyoto regions that pursue a different abatement regime. therefore, it would seem wise to attempt to meet the standards of art. i and iii of gatt.”176 they argue that the use of bat would eliminate a challenge under article iii.177 by comparison, expressing what seems to be the more predominant position, cosbey believes that it would be difficult to construct what is called here a mixed system that would not fail the most-favored nation test of gatt article i and that it would therefore be necessary to rely on the exceptions of article xx.178 those designing a carbon tax and attendant btas thus face a dilemma. van asselt, brewer, and mehling point out the following paradox: interestingly, the more a border adjustment measure differentiates between different countries, the more likely it would violate the mfn-clause, but the more it would be compliant with the chapeau conditions. conversely, applying the border adjustment measure to all countries could avoid a violation of the mfn principle, but would make it unlikely to qualify as an exception. this means, essentially, that countries wanting to design border adjustment measures need to consciously choose a strategy that either rests on avoiding violation of the commitments 175. pauwelyn, u.s. federal climate policy, supra note 15, at 41. 176. ismer & neuhoff, supra note 1, at 152. 177. neuhoff & ismer, supra note 3, at 7. 178. cosbey, supra note 86, at 3-4. 2011] border adjustments for carbon taxes 283 and principles in the gatt or on satisfying the conditions of the general exceptions.179 d. summary appraisal import btas would probably satisfy paragraph (g) of article xx, and perhaps paragraph (b). this is most likely if btas were based on bat or pmp (if it is lower than the actual carbon content of imports) and perhaps not unlikely if they were based on the actual carbon content of imports (if it is higher than that under pmp). the case for export btas is less convincing. a mixed system seems unlikely to satisfy the chapeau, especially as applied to trade with developing countries. it is important to keep in mind bordoff’s warning that, rather than being decided on purely technical grounds of conformity with the basic gatt rules, “the consistency of border adjustments with wto law is in doubt and may come down to whether the wto panel finds the measure to be a genuine effort to protect the environment or a form of stealth protectionism.”180 v. bas for the cost emissions permits most countries that are pricing carbon, or that propose to do so, are using or contemplating cap and trade systems, rather than carbon taxes. it is thus necessary to examine the gatt-legality of bas for the cost of emissions permits under such schemes.181 unfortunately, as noted earlier, legal jurisprudence dealing directly with this issue is virtually non-existent. moreover, it is not even clear whether the wto would consider the cost of allowances to be analogous to a tax or a form of regulation, in which case a different body of wto jurisprudence would apply.182 only the former 179. van asselt, brewe, & mehling, supra note 8, at 55 n.213. 180. bordoff, supra note 15, at 58. 181. recall the working assumption stated supra in note 5 that bas for a cap and trade system would take the form of requiring that importers hold emissions permits, exempting exports from the requirement to hold permits, and refunding the cost of permits incurred before the export stage. quick argues that using border tax adjustments on imports to compensate for the domestic cost of emissions permits has an element of “naked discrimination” and thus might not be allowed under either the basic gatt rules or article xx. see also quick, supra note 5, at 172-73. for a different view, see infra note 183. 182. van asselt, brewer & mehling note that a requirement for importers to hold allowances might be seen as part of an internal regulation that is implemented at the border, and thus governed by article iii.4 of the gatt, or as a measure applying only to imports, in which case it might be found to be either an import tariff prohibited by gatt article ii.1(b) or a quantitative restriction on imports prohibited by gatt article xi.1, rather than being governed by article iii.2, which pertains to 284 florida tax review [vol. 11:4 possibility is considered here.183 given the lack of wto jurisprudence regarding bas for the cost of permits, it is necessary to attempt to infer from taxes. van asselt, brewer & mehling, supra note 8, at 48. they cite robert howse & antonia eliason, domestic and international strategies to address climate change: an overview of the wto legal issues, in international trade regulation and the mitigation of climate change 48-49 (thomas cottier, sadeq bigdeli & olga nartova eds., cambridge univ. press 2009) to the effect that the requirement to hold emissions allowances would be a regulation that would be governed by article iii.4, a conclusion with which wooders, reinaud & cosbey, supra note 1, at 55 agree. bordoff examines the requirement to hold emissions permits for imports under gatt article iii.4, as well as under article iii.2. bordoff, supra note 15, at 43-47. see also quick, supra note 15, at 355-56. this question interacts with the provision of free allowances, to be considered below. de cendra states the issue nicely: in the case of grandfathered allowances, there is no payment to the government and thus the oecd definition [of taxes] mentioned above does not hold. however, it is clear that a stringent allocation will nevertheless increase the production costs of industry. in this case, the eu ets can be compared to any other environmental regulation, which by imposing, for example, standards on emissions, raises the costs for industry. the analysis of the legality of imposing levies at the border to cancel those impacts would have to be done within the remit of article iii(4) of the general agreement on tariffs and trade (gatt). . . . [i]t seems that the case for compatibility would be rendered significantly more difficult. see de cendra, supra note 12, at 138. the definition mentioned is the oecd definition of taxes that is considered in the text infra at note 187. there are, of course, many regulations that raise costs of domestic production for which there are no bas. see infra note 183. in any event, the requirement might pass muster under the general exceptions of gatt article xx. 183. in proceeding it is useful to keep in mind the intriguing — and troubling — possibility raised by quick: traditionally, command and control environmental legislation has been adopted by many countries without a discussion of border adjustment notwithstanding their costs for domestic businesses. suppose the eu would have prescribed in its legislation a mandatory greenhouse gas reduction obligation for covered installations without a cap and trade system. would such a measure have triggered the border adjustment discussion? if one were to consider that an environmental legislation applying a market-based instrument (e.g., emission trading) was different from a ‘normal’ command and control environmental legislation as far as the application of border tax adjustment is 2011] border adjustments for carbon taxes 285 the jurisprudence on btas discussed above how the wto would decide a case involving bas for emissions permits. doing so is complicated by the fact that important aspects of cap and trade systems, including free allowances and acquisition of permits on the secondary market, have no tax analogs. a. bas for the cost of emissions permits purchased from the issuing government it might seem that, as a matter of economic logic, the gatt-legality of bas for the cost of emissions permits purchased from the issuing government should be governed by the same reasoning as the gatt-legality of btas for carbon taxes.184 but the cost of permits is not a tax, in the usual sense of that word. as ismer and neuhoff note regarding their conclusion that btas for exports would be gatt-legal, “it does not automatically follow . . . that any costs of allowances should be deductible as well.”185 gatt articles i and iii.2, respectively, refer to “customs duties and charges of any kind” and “internal taxes or other internal charges of any kind.” the first question is whether the cost of permits acquired directly from a government could be construed to be a tax or a charge for purposes of these provisions.186 to answer this question, it is customary to refer to the following oecd definition of taxes: “compulsory, unrequited payments to general government.”187 while the cost of permits is compulsory – or at least as compulsory as any tax that can be avoided by refraining from the taxed concerned, wto members could turn their domestic legislation dealing with environmental media . . . into market-based instruments and then apply border tax adjustments. . . . . from a trade policy point of view, border tax adjustment for market-based environmental instruments would have to be qualified as a slippery slope into protectionism. can the application of article iii gatt really depend on whether a state has chosen to apply a market-based instrument instead of a command and control measure? quick, supra note 15, at 356-57. 184. godard, supra note 15, at 28, states, “from an economic viewpoint, as a matter of principles, there is no reason to discriminate between a carbon tax and emissions trading when discussing options for border adjustment.” 185. ismer & neuhoff, supra note 1, at 144. “rebatable” seems more apt than “deductible.” 186. see also neuhoff & ismer, supra note 3, at 9. 187. organisation for economic co-operation and development, chairman of the negotiating group on the multilateral agreement on investment, note on the definition of taxes, daffe/mai/eg2(96)3 (apr. 19, 1996), http://www1.oecd.org/daf/mai/pdf/eg2/eg2963e.pdf. 286 florida tax review [vol. 11:4 activity – whether it is also unrequited is a matter of interpretation.188 while a firm buying permits may seem to get nothing in return, in fact it gets the privilege of discharging co2 into the environment. under the former interpretation, the cost of permits would be a tax for which bas might be allowed;189 under the latter, it would be a fee, for which adjustments are not allowed.190 if bas for the cost of permits were found to be governed by the rules for btas for carbon taxes, all the uncertainties described above would exist, namely whether the cost of permits constitute a tax on a product and, if so, whether differences in carbon intensity make products unlike. in addition, an issue that is reminiscent of the debate over the adjustability of taxes occultes is extremely important. is adjustment allowed if it is a supplier to an exporter or to a domestic firm that competes with imports (rather than the exporter or the import-competing firm) that buys permits? this issue is especially important if the supplier in question is a generator of electric power and even more important if the purchaser of power produces non-ferrous metals (most notably aluminum) or uses electric arc furnaces to produce ferrous metals. de cendra opines that no bas would be available for the cost of emission permits embedded in the price of electricity, because the entity seeking the ba would not have made a payment to the government.191 genasci elaborates in the context of a carbon tax, “[e]ven if such costs could be measured precisely, it is hard to make a convincing case that they could be adjustable through a bta mechanism, given that the increased price of electricity is neither a tax nor a charge levied by the government.”192 be this 188. see bordoff, supra note 15, at 46-47; de cendra, supra note 12, at 135, ismer & neuhoff, supra note 1, at 144, pauwelyn, u.s. federal climate policy, supra note 15, at 21 n.55; avner, supra note 15, at 16. quick, supra note 5, at 166, citing the oxford english dictionary definition of a charge, “a price asked” or “a financial liability or commitment,” concludes that the options available to buy permits or sell those not needed to offset emissions makes it difficult to consider the auctioning of permits “an internal charge on products.” 189. for this view, see ismer & neuhoff, supra note 1, at 144, and pauwelyn, u.s. federal climate policy, supra note 15, at 21. 190. godard argues that if the cost of emissions permits is deemed to be similar to a tax, bas should be allowed for them (including the cost of permits bought on the secondary market) under the basic gatt rules, but if not, they could only be justified by an article xx exception. godard, supra note 15, at 29. 191. de cendra, supra note 12, at 136-37. 192. genasci, supra note 12, at 38. he continues: moreover, were indirect costs determined to be eligible for adjustment in theory, the need to accurately measure those costs would pose technical and legal challenges. recent research suggests that measuring wholesale electricity price increases as a result of emissions costs on electricity producers is extremely 2011] border adjustments for carbon taxes 287 as it may, the eu included the following words in the 2009 modification of the directive establishing the ets: “for those specific sectors or subsectors where it can be duly substantiated that the risk of carbon leakage cannot be prevented otherwise, where electricity constitutes a high proportion of production costs and is produced efficiently, the action taken may take into account the electricity consumption in the production process . . . .”193 the ascm contains no wording that leads one to believe that border adjustments for any types of payments beyond taxes, as that term is usually understood, are contemplated or would be allowed. if the cost of acquiring emissions permits from a government could not be likened to a tax, the wto might see the rebate of such costs as a prohibited export subsidy.194 b. bas for the opportunity costs of free allowances in order to combat unfair competition from firms located in countries that do not price carbon and carbon leakage to those countries, emissions permits may be granted free of charge. there may be demands for bas for the value of free allowances, even though the combination of free allowances and bas would constitute “double dipping.”195 an economic case can, however, be made for this seemingly anomalous combination. the reasoning is simple: the grant of free allowances is tantamount to a cash subsidy, since the allowances can be sold. the use of allowances to offset emissions has an opportunity cost – what they would fetch in a sale – that will be reflected in the price of domestic products. unless bas are allowed for the value of free allowances, unfair competition and carbon leakage can occur.196 difficult, and the precise extent to which the observed price changes are translated into increased electricity costs would also be hard to determine. any uncertainty in measuring cost passthrough could have legal implications, since overestimating passthrough might result in excess adjustments to exporters. id. the research he mentions is reinaud’s, discussed infra at note 193. 193. directive 2009/29/ec, supra note 6, ¶ 24. for extensive discussions of the treatment of electricity, see julia reinaud, international energy agency, co2 allowance and electricity price interaction: impact on industry’s electricity purchasing strategies, (2007), http://www.iea.org/papers/2007/jr_price_interaction. pdf, and avner, supra note 15, at 60-70. 194. see hufbauer, charnovitz, & kim, supra note 9, at 69-70. 195. writing in the analogous context of exemptions from environmental taxes, hoerner & muller, say that, “exemptions and btas are incompatible approaches to dealing with competitiveness issues.” hoerner & muller, supra note 15, at 45. 196. see frankel, supra note 121, at 513; pauwelyn, u.s. federal climate policy, supra note 15, at 22; bordoff, supra note 15, at 45, 56 cong. budget office, 288 florida tax review [vol. 11:4 again, electric power provides the poster child for this proposition. even though 95 percent of permits were distributed free of charge during the first two phases of the etc, most generators of electricity were reflecting the value of permits in charges or were expected to do so.197 if no relief is allowed for these higher prices, domestic producers could be placed at a competitive disadvantage and carbon leakage could occur. non-ferrous metals and ferrous metals produced in electric arc furnaces would be most at risk. even if the cost of permits purchased from a government would be treated as a border adjustable tax, it seems unlikely that border adjustments would be allowed for the full value of permits that are distributed free of charge.198 since there is no payment, the oecd definition of taxes would not tradeoffs in allocating allowances for co2 emissions (2007). frankel writes in the context of the ets: [g]iving a firm free permits is the same as giving them a cash subsidy. according to simple microeconomic theory, however, these subsidies would do nothing to address leakage. because carbon intensive production is cheaper in non-participating countries, the european firms would simply sell the permits they receive and pocket the money, while carbon-intensive production would still move from europe to non-participants. frankel, supra note 121, at 513. 197. it has been reported that 70 percent of responding electric power generators were reflecting these costs in prices and that 87 percent expected to do so. see european comm’n directorate gen. for env’t et al., eu ets review: report on international competitiveness, 12 (dec. 2006), http://ww1.mckinsey.com/ clientservice/sustainability/pdf/report_on_international_competitiveness.pdf. in simulating the effects of the ets, it is assumed that companies include the opportunity cost of emissions permits in their prices, if possible, given their competitive situation. id. at 12. see also reinaud, supra note 193. 198. free distribution of permits also raises another question: whether this is a subsidy that is actionable under the ascm. holzer writes, “export rebates under free initial allocation of allowances might constitute compensation of costs ‘in excess of those which have accrued’ and, pursuant to gatt ad article xvi, might qualify a subsidy.” see holzer, supra note 15, at 63; see also hufbauer & kim, supra note 34, at 6-7. hufbauer, charnovitz and kim warn, “the question of whether the free allocation of emissions allowances is a subsidy does not have an obvious answer, and there has been no wto jurisprudence on this point.” hufbauer, charnovitz & kim, supra note 9, at 61. output-based rebates for energy-intensive industries have been proposed as an alternative way to offset the cost of purchasing emissions permits that is more likely to withstand legal scrutiny. writing of outputbased rebates, fischer & fox note, “an open question is whether such rebates or allocations would raise scm issues.” fischer & fox, supra note 12, at 6. these topics are well beyond the scope of this article. but see pauwelyn, testimony, supra note 15. 2011] border adjustments for carbon taxes 289 be satisfied. moreover, gatt article iii.2 states that imports cannot be subject to internal taxes or other internal charges in excess of those applied to like domestic products. similarly, footnote 1 to article 1.1 of the ascm states: [t]he exemption of an exported product from duties or taxes borne by the like product when destined for domestic consumption, or the remission of such duties or taxes in amounts not in excess of those which have accrued, shall not be deemed to be a subsidy. the free distribution of allowances means, of course, that domestic producers are not subject to a charge for which bas are being sought.199 this would be comparable to allowing btas for an excise tax from which a domestic producer is exempt. de cendra concludes that auctioning of permits would seem to be a prerequisite for the legality of border adjustments.200 it may thus be legally necessary, as well as politically desirable, to allow border adjustments only for a fraction of the cost of permits equal to the percentage of permits that are sold.201 alternatively, bas could be allowed 199. quick says that it is difficult to argue that the current ets system, in which 95 percent of permits are allocated free of charge, constitutes a charge on products. quick, supra note 5, at 164. holzer asks, “would there be anything that these companies could be compensated for?” holzer, supra note 15, at 63. quick also notes that one could argue that, for the same reason, the current ets system does not satisfy the requirement of paragraph (g) of article xx that measures must be applied “in conjunction with restrictions on domestic production or consumption.” quick, supra note 5, at 172-73. for the latter proposition quick cites the following words from the decision of the appellate body in ab report – reformulated gasoline: [i]f no restrictions on domestically-produced like products are imposed at all, and all limitations are placed upon imported products alone, the measure cannot be accepted as primarily or even substantially designed for implementing conservationist goals. the measure would simply be naked discrimination for protecting locally-produced goods. (emphasis in original) ab report – reformulated gasoline, supra note 129, at 22. he adds, however, that the european cap and trade system does have the effect of restricting domestic production, since domestic producers have a variety of choices of how to comply with the ets rules. id. 200. de cendra, supra note 12, at 145. 201. neuhoff writes, “[b]order adjustments can only be applied to the extent that installations pay for their allowances. border adjustment is not possible to the extent installations receive free allowances. . . .” karsten neuhoff, the political 290 florida tax review [vol. 11:4 for the average cost of allowances. import bas, limited in this way, would presumably be implemented on a sector-by-sector basis. but what if, in a given sector, existing domestic emitters receive free allowances, but new entrants must purchase them, or some emitters (e.g., small emitters) are excluded from the need to hold permits? genasci opines that basing bas on the cost of permits borne by those not receiving free permits would violate national treatment, which “would hold that the imported good should face the lowest level of charges faced by any domestic like product.”202 it would seem necessary to calculate export bas on a firm-specific basis, since sector-specific bas could result in subsidies for the exports of particular firms.203 making the requisite calculations accurately for particular traded products would be virtually impossible. c. bas for the cost of permits acquired in the secondary market under a cap and trade system, permits may be acquired on the secondary market. whether bas should be allowed for the cost of permits acquired in this way raises issues that do not arise in the context of btas for carbon taxes. consider first acquisition on the secondary market of permits originally purchased from a government. assuming for argument’s sake that the cost of such permits is adjustable, whether or not the cost of permits acquired on the secondary market is adjustable may depend on how one interprets the oecd definition of a tax as “compulsory, unrequited payments to general government.” although the holding of permits is arguably compulsory and perhaps unrequited, payment is not made directly to a government.204 the adjustability of the cost of acquiring on the secondary market permits that were originally granted without charge increases uncertainty, as do falling prices of permits. genasci concludes that allowing full bas when economy of a world with different carbon prices, in competitive distortions and leakage in a world of different carbon prices: trade, competitiveness and employment challenges when meeting the post-2012 climate commitments in the european union 9, 19 (european parliament 2008). cosbey observes that nondiscrimination requires that “if domestic producers in certain sectors are given free allocations of emission permits, for example, then their foreign counterparts must also get such treatment.” cosbey, supra note 86, at 3; see also ismer & neuhoff, supra note 1, at 144. 202. see genasci, supra note 12, at 41. 203. id. at 39. 204. avner offers a novel analysis, suggesting that the requirement to hold permits, which have an opportunity cost, and submit them constitutes a tax, even if the permits are bought on secondary markets. he warns, however, that this interpretation “does not have authority with respect to gatt legal texts.” avner, supra note 15, at 18. 2011] border adjustments for carbon taxes 291 the government has not received an equal amount “would appear to constitute a rather obvious violation of gatt article xvi.4, which prohibits rebates in excess of taxes that have been paid.”205 regarding falling permit prices, he reasons that bas “would need to be set at the lower of (a) the price paid by the exporter and (b) the payment actually received by the government. such a system would be quite complex where there is a secondary market in emissions allowances in which prices fluctuate.”206 d. bas for the costs of capture and storage of cdm capture and storage of co2 may offer a means of avoiding the need to hold emissions permits. moreover, the clean development mechanism, (cdm) under which credit is allowed for reducing carbon emissions in developing countries, has been touted as a way of meeting kyoto targets for emissions abatement. this raises the question of whether border adjustments would be allowed for the cost of utilizing these techniques to avoid or meet requirements to surrender emissions permits. a negative answer seems likely, since the costs of capture and storage and cdm payments clearly do not meet the definition of a tax or other charge.207 vi. summary and conclusions although the gatt-legality of border adjustments for a carbon tax or the cost of emissions permits is ultimately uncertain, it is possible to draw the following conclusions — some of them more tentative than others — regarding this “riddle, wrapped in a mystery, inside an enigma.” (1) it is possible that the wto would treat the cost of purchased emissions permits like a tax. in that case the conclusions regarding btas for carbon taxes would apply to border adjustments for these costs. if the cost of emissions permits is not considered a tax, no adjustments would be allowed under the gatt provisions dealing with taxes.208 (2) there is little reason to believe that conclusions regarding the gatt-legality of border adjustments for imports and for exports would be identical; more likely, adjustments for the two flows of trade would be 205. genasci, supra note 12, at 39-40. although written in the context of freely allocated permits that are bought on the open market, this conclusion seems equally apt in the case of free permits surrendered by entities who bought them from a government. 206. id. at 40. 207. they might better be considered costs of satisfying regulatory requirements and thus subject to gatt article iii.4. 208. as noted above, whether bas for the cost of emissions permits would be allowed under article iii.4 is not considered here. supra note 183. 292 florida tax review [vol. 11:4 considered separately, perhaps under different standards. this is especially true of an appeal for an article xx exception. (3) it seems fairly certain that carbon taxes would not be considered to be direct taxes. if not they are not per se non-adjustable. it seems even less likely that the cost of emissions permits would be treated as a direct tax. (4) it is likely that carbon taxes — and a fortiori the cost of emissions permits — would not be considered to be “prior stage cumulative indirect taxes” (psci taxes). but expert opinion on this is not unanimous. if carbon taxes are psci taxes, they are probably adjustable. if they are not, then the discussion of the adjustability of psci taxes is beside the point. (5) since co2 is not physically incorporated in traded products, carbon taxes are best seen as taxes occultes. if the cost of emissions permits is a tax, it is also occulte. unfortunately, the 1970 working party on border tax adjustments decided that the question of btas for taxes occultes, while unclear, was not important enough to justify further examination.209 this lack of guidance helps explain why there is so much uncertainty concerning the gatt-legality of btas for carbon taxes, and thus bas for the cost of emissions permits. (6) much of the debate over the gatt-legality of btas for carbon taxes (aside from viewpoints that assume that such taxes are psci taxes) has revolved around (a) whether carbon taxes, being based on ppms, are levied on products, and if so, (b) whether products that differ in carbon intensity are “like” — a necessary condition for adjustability based on actual carbon content. the outcome of this debate is relevant for judging the gattlegality of border adjustments for the cost of emissions permits, if such costs are seen as taxes. (7) some observers believe that carbon taxes would be adjustable, but others — and pronouncements in wto publications — suggest that this belief is incorrect, because taxes based on ppms are not levied on products. (8) the wto decision in the superfund case — and the fact that the u.s. tax on ozone depleting chemicals (odcs) has never been challenged — has been interpreted to mean that border adjustments for a carbon tax or the cost of emissions permits, both of which involve charging for an input that is not incorporated into the traded product, might pass scrutiny. (9) it appears that differences in ppms do not make physically identical products unlike. in that case, bas could not be based on the carbon content of traded goods. (10) experience with the superfund and odc taxes suggests that it would be acceptable to base border adjustments for imports on the predominant method of production in the importing country, providing there is an option to demonstrate that the imports are produced using less carbonintensive methods. 209. working party on btas, supra note 4 at ¶ 15. 2011] border adjustments for carbon taxes 293 (11) basing border adjustments for imports on best available technology (bat) would assure that imports are not taxed more heavily than domestic products and would thus likely be gatt-legal. but, like pmp, use of bat would imply that imports would often not be subject to charges high enough to reflect their actual carbon content. moreover, there would be no incentive to reduce emissions. (12) border adjustments under a mixed system — applied only to trade with countries that do not have comparably effective programs to curb emissions — would clearly violate the most favored nation provision of the gatt. (13) even if border adjustments, including especially those under a mixed system, failed to pass muster under the basic rules of the gatt and ascm, they might be found acceptable under the article xx exception for measures necessary to protect health or, more likely, for those relating to the conservation of exhaustible natural resources. (14) the decision in the shrimp-turtle case supports the view that bas based on ppms may be granted an exception under gatt article xx. (15) for a successful appeal under the chapeau of article xx, it is crucial that the measures in question not be applied in such a manner as to constitute either arbitrary or unjustifiable discrimination between countries where the same conditions prevail or a disguised restriction on international trade. import bas probably would not be allowed if the trading partner is an advanced country that has in place a rigorous scheme to reduce emissions and they might not be allowed if it is a developing country. (16) if border adjustments are to be gatt-legal under either the basic international trade rules or one of the article xx exceptions, they must be designed carefully and administered fairly. (17) policymakers may need to consider carefully whether to try to satisfy the basic trade rules (e.g., by eschewing the mixed system) or one of the article xx exceptions (by adopting such a system), since one approach may doom the other. (18) border adjustments are most likely to be allowed for the cost of emissions permits that are purchased from a government, rather than being distributed without charge or bought on the secondary market. (19) if some permits are distributed without charge, it would probably be necessary to limit border adjustments to the fraction of the permits that are auctioned. (20) it seems unlikely that the wto would allow border adjustments for the cost of permits bought on the secondary market, of capture and storage, or of cdm. (21) since upstream producers are likely to set prices to reflect the opportunity cost of emissions permits and the costs of capture and storage and cdm, as well as the costs of permits bought from governments or on the secondary market, failure to allow border adjustments for the value of freely 294 florida tax review [vol. 11:4 allocated permits or for all such costs would leave downstream producers at a competitive disadvantage and encourage carbon leakage. (22) virtually all of the above conclusions must be considered tentative, in the absence of guidance from the wto. c. gatt legality under the basic rules vs. article xx exceptions opinion is divided on whether import btas for a carbon tax would have a better chance of passing muster under the basic gatt rules or under the general exceptions of article xx. as suggested in the introduction to this section, three different issues... regarding the first two issues, pauwelyn proposes that the “first line of defense” of btas would be that they are consistent with the gatt rules regarding “product-related or indirect taxes,” with an appeal under article xx as “a second line of defen... those designing a carbon tax and attendant btas thus face a dilemma. van asselt, brewer, and mehling point out the following paradox: florida tax review volume 4 1999 number 3 benefits and burdens of subchapter s in a check-the-box world jerald david august" l introduction ................................ 289 ii. s corporation versus partnership comparison after the ctb regulations ..................... 294 a. state law differences ...................... 295 b. eligibility limitations ...................... 296 1. number of equity participants ........... 296 2. eligible equity participants ............. 297 3. limitations on use of debt and equity ..... 298 4. use of multi-tiered structures or affiliates 299 5. qualified subchapter s subsidiaries (qsubs) .......................... 300 a. deemed liquidation ............ 301 b. conversion of consolidated group into qsub group ......... 302 c. termination of qsub election: deemed section 351 transfer ...... 303 6. tax rate comparison ................. 304 7. certainty of tax status ................ 305 8. formation issues .................... 305 9. services provided in exchange for equity interests ..................... 308 10. entity level taxation ................. 309 11. use of cash method of accounting ....... 310 12. effects of entity level debt on outside basis and loss limitation rules ......... 311 a. rules for s corporations ......... 311 b. rules for llcs ................ 312 13. distributions not in redemption of stock or llc interest ..................... 313 a. from s corporations ........... 313 b. from llcs .................. 314 * august & kultmas, p.a., west palm beach, florida. florida tax review 14. redemptions of stock and interests ....... 316 a. s corporations ................ 316 b. redemption of llc interests ...... 317 15. sales or exchanges of equity interests ..... 317 a. s corporations ................ 317 b. limited liability companies ....... 318 m. where art thou subchapter s? .................. 319 iv. evolution of subchapter s: why congress should further aid s corporations ............. 322 v. why not repeal subchapter s? .................. 331 a. conversions to subchapter s or subchapter k: the practical barriers ...................... 331 b. further reforms to subchapter s .............. 333 1. reform i: allow nonresident aliens to be shareholders of an s corporation .... 333 2. reform 11. allow an s corporation to issue plain vanilla preferred stock ....... 334 3. reform 111: further expansion of straight debt ....................... 334 4. reform iv: repeal termination rule for excess passive investment income ........ 335 5. reform v: repeal section 752 for partnerships ....................... 335 vi. moving towards a single regime of taxing private business enterprises .................... 336 [vol 4.3 benefits and burdens of subchapter s i. introduction the treasury's issuance of the check-the-box regulations (ctb) in late 1996' has intensified debate about whether there should be a single federal income tax regime for all private business firms (pbfs), including passthrough entities, whose equity interests are not publicly traded.2 this revived concern for parity in tax treatment among the various forms of passthrough entities arose because the ctb regulations generally allow a business entity with two or more owners to be taxed as a partnership for federal income tax purposes, regardless of its organizational structure and corporate-like characteristics under state law.3 before the ctb regulations, unincorporated entities were required to maintain at least two noncorporate characteristics in order to avoid the double tax regime of subchapter c.' 1. 61 fed. reg. 66,588 (1996), revising regs. §§ 301.7701-1, -2, -3. the effective date of the regulations was january 1, 1997. see also notice 95-14, 1995-1 c.b. 297. see regs. §§ 301.7701-1(f), 301.7701-2(e), 301.7701-3(0(1). for extended discussions of the regulations, see mary a. mcnulty, entity classification: final check-the-box regulations issued, 9 j. s corp. tax'n 60 (1997); roger f. pillow et al., simplified entity classification under the final check-the-box regulations, 86 j. tax'n 197 (1997); george k. yin, the taxation of private business enterprises: some policy questions stimulated by the "checkthe-box" regulations, 51 smu l. rev. 125 (1997). 2. a partial list of tax regimes for business entities includes c corporations, s corporations, partnerships (and all entities eligible to file as partnerships), real estate investment trusts (reits), regulated investment companies (rics), fixed investment trusts, financial asset securitization investment trusts (fasits), and real estate mortgage investment conduits (remics). for discussion of the future of more exotic tax entities. see willard b. taylor, beyond check-the-box-neglected issues, 75 taxes 671 (1997). 3. alternatively, a business entity may elect to be taxed as an association. this election is reminiscent of the former § 1361, which was enacted in 1958 to allow partnerships to elect to be taxed as corporations but was repealed in 1966, largely for lack of use. see small business tax revision act of 1958, pub. l. no. 85-866, § 63, 72 stat. 1606; pub. l no. 89-389, § 4(b)(1), 80 stat 111 (1966). 4. under the former regulations, an unincorporated entity (other than a trust) was classified as an association, taxable as an association, if it exhibited three of the four corporate characteristics of (1) free transferability of interest, (2) continuity of life, (3) centralized management, and (4) limited liability. a trust was an association if it possessed two corporate characteristics: (1) beneficiaries acting as "associates" and (2) an objective to carry on business and divide the gains therefrom. see regs. § 301.7701-2(a)(2) (1954) (before amendment in 1996); estate of harry m. bedell, sr., trust v. commissioner, 86 t.c. 1207, 1216-17 (1986), acq., 1987-2 c.b. 1. under the ctb regulations, a trust is an "arrangement" whose purpose is to vest in trustees responsibility for the protection and conservation of the trust's assets for its beneficiaries. see regs. § 301.7701-4(a). a "business trust," which otherwise may fall into the association abyss, may elect to be treated as a "business entity" under ctb regulations, allowing it to elect partnership status. see regs. § 301.7701-4(b). 19991 florida tax review revenue ruling 88-76,' which permitted limited liability companies (llcs) to achieve partnership tax status under the former regulations, inspired state legislatures to jump on the llc bandwagon by adopting llc statutes and amending existing llc statutes to conform to liberalized federal income and transfer tax interpretations. all states now have limited liability company laws,6 and many have added the limited liability partnership (llp), which is a hybrid form of organizational structure, between the llc and the limited partnership (lp),7 intended primarily for professional service organizations. the primary benefit of the llp is that it insulates partner-members in professional service organizations from vicarious liability for malpractice errors and omissions. taxpayer efforts to clothe their entities with various corporate attributes without incurring association status for federal (and state) income tax purposes generated varying differences of opinion among practitioners, the service, and the courts on whether particular unincorporated entities had crossed over the line.' especially troublesome for the service was that organizations having the corporate characteristic of limited liability could achieve partnership tax status. although it later conceded the point, the treasury once proposed a bright line rule that unincorporated entities with limited liability under state law should be taxed as associations.9 the former 5. 1988-2 c.b. 360. 6. see, e.g., del. code ann. tit. 6, §§ 18-101 to -1107 (1997); fla. stat. ch. 608.401 511 (1998); tex. rev. civ. stat. ann. art. 1528n (west 1998); see also unif. lim. lia. co. act, 6a u.l.a. 429-508 (1995). 7. see, e.g., del. code ann. tit. 6, § 17-214 (1997); fla. stat. ch. 620.78 (1998); tex. rev. civ. stat. ann. art. 6132b (west 1998). 8. see larson v. commissioner, 66 t.c. 159 (1976); zuckman v. united states, 524 f.2d 729 (ct. cl. 1975); rev. proc. 95-10, 1995-1 c.b. 501; rev. proc. 94-46, 1994-2 c.b. 688; rev. proc. 92-88, 1992-2 c.b. 496; rev. proc. 89-12, 1989-1 c.b. 798. before the development of the professional corporation, when more generous provisions could be made under qualified retirement plans for owner-employees of corporations than for self-employed persons (including partners), unincorporated entities engaged professional practices found it beneficial to be classified as associations for federal tax purposes. see united states v. kintner, 216 f.2d 418 (9th cir. 1954) (state law partnership imbued with sufficient corporate characteristics to adopt corporate qualified retirement plan). for a thorough analytical and historical overview of this area, see mckee, nelson & whitmire, federal taxation of partnerships and partners 3-1 (1997). 9. in 1980, the treasury proposed a regulation (prop. regs. § 301.7701-2(a)(2)) that would have treated an organization as an association if (1) the organization was not formed under a statute corresponding to the uniform limited partnership act and (2) no member of the organization was personally liable for the entity's obligations. see classification of limited liability companies, 45 fed. reg. 75,709 (1980) (proposed nov. 17, 1980). llcs and foreign entities having limited liability would have been trapped by the proposed regulations. see id. the proposal was withdrawn in 1983. see classification of limited liability companies, 48 fed. reg. 14,389 (1983) (withdrawn april 4, 1983). a formal concession of the issue was [vol 4:3 benefits and burdens of subchapter s regulations generally recognized partnership status for entities organized under state laws conforming to the uniform partnership act and the uniform limited partnership act. 0 still, the economic stakes were quite high for investors in business and investment partnerships where the owners' underlying assumption of conduit treatment for federal income tax purposes might later be challenged by the service. substantial investments in joint ventures generally were not made without receiving a boilerplate-like legal opinion that the venture would "more likely than not" be taxed as a partnership for federal income tax purposes. for those who desired not to get to close to the edge of where partnership status ended and association status began without receiving a prior favorable ruling, the service issued several safe-harbor ruling guidelines." the ctb regulations have relegated the former regulations to historical significance, except for disputes for prior years.' 2 under the regulations, unincorporated entities, with the exception of certain ("per se") foreign entities required to be taxed as associations under subchapter c,'3 may have all four corporate characteristics and still be taxed as partnerships. an llc may therefore achieve partnership classification for federal tax purposes, even if it possesses limited liability, centralized management, free transferability of interest, and continuity of life.' 4 additional organizational and tax benefits flow from the regulation's introduction of the "tax nothing," which is the default status of an unincorpomade in rev. rul. 88-76, 1988-2 c.b. 360, which held that a wyoming llc could be a partnership for federal tax purposes, even if no member was personally liable for debts of the entity. 10. see regs. § 301.7701-3(b)(1) (prior to amendment by t.d. 8697, 61 fed. reg. 66,584 (1996)). 11. see, e.g., rev. proc. 92-35, 1992-1 c.b. 790, amplified by rev. proc. 94-46, 1994-2 c.b. 688; rev. proc. 89-12, 1989-1 c.b. 798, supplemented by rev. proc. 92-33. 1992-1 c.b. 782, modified by rev. proc. 95-10, 1995-1 c.b. 501, and amplified by rev. proc. 91-13, 1991-1 c.b. 477 (checklist questionnaire); rev. proc. 86-12, 1986-1 c.b. 534. 12. the ctb regulations concede to taxpayers most lingering uncertainties over the pre-1997 classification of business entities. unless a pre-1997 entity is a per se corporation under the ctb regulations, the classification that it claimed is "respected" for all periods before 1997 if (1) the entity had a reasonable basis (per § 6662) for the claim, (2) the entity and its members consistently maintained the claimed status for all periods, and (3) neither the entity nor any of its members received written notification before may 9. 1996, that the classification of the entity was under examination by the service. see regs. § 301.77013(f)(2). for pre-ctb foreign entities, see regs. § 301.7701-2(d). 13. the regulations designate one type of entity in each country, considered equivalent to a corporation under the corporate laws of the u.s. states, as a per se corporation. regs. § 301.7701-2(b)(8). notice 98-35, 1998-27 i.r.b. 35 and notice 98-11, 1998-6 i.r.b. 18, dealing with the tax status of foreign hybrid entities. 14. states using federal piggyback type models for income taxation will probably go along with the liberalized ctb regulations. 19991 florida tax review rated entity having only one owner. for tax purposes, such an entity is treated as a sole proprietorship if the owner is an individual or a division or branch if the owner is an entity. the entity exists for state law purposes but not for federal income tax purposes unless the owner elects association status.1 5 the advent of the ctb regulations, including the metaphysically wonderful tax nothing, has opened a new world of passthrough entities and multiple-tiered structures. proponents of the ctb regulations contend that the federal tax law should permit various forms of entities under state law to be taxed under the same passthrough system by removing emphasis on formalisms inherent in the organizational and governance rules under state law. in contrast with unincorporated entities, an incorporated pbf has the choice of being taxed in the double-tax world of subchapter c or as a passthrough entity under subchapter s. the s election is allowed only if various eligibility rules are met at both the entity and investor levels. thus, the ctb regulations only indirectly benefit incorporated pbfs by permitting them to be members of llcs or limited partnerships and to have whollyowned llc tax nothings. the underlying premise of the ctb regulations is that state law differences in entity structure and governance should not be controlling for federal tax purposes. however, given the substantial differences between subchapter k, the passthrough regime for unincorporated entities, and subchapter s, the passthrough regime for incorporated entities, this premise is not fully realized. although the possibility of a single passthrough regime for all pbfs, whether incorporated or unincorporated, has obvious appeal, this vision would not be without its own problems. consider the definitional problems that would plague business lawyers and estate planners without substantial tax backgrounds in working with incorporated pbfs taxed as partnerships. under such a unified passthrough regime, preferred stock would be nothing more than a preferred partnership interest. for state law purposes, however, the corporation must have adequate surplus to make payments on the preferred stock. for tax purposes, the preferred stock might even receive a special allocation of income. would the corporate and banking lawyers understand this new science? or is it more likely to be a hapless exercise into schizophrenia? other follies seem destined to happen. a state law merger between two corporations, now partnerships for federal tax purposes, could be a taxable event, at least with respect to some partners. 6 how are the entities to be treated for estate tax purposes, as corporations or as partnerships?17 15. see regs. §§ 301.7701-2(a), 301.7701-3(a). 16. see regs. § 1.708-1(b)(2). 17. for example, § 303, which does not apply to partnerships, would not apply to a corporation taxed as a partnership. guidance is presently needed on the treatment of mergers [vol. 4:3 benefits and burdens of subchapter s how would the principal and income act of a particular jurisdiction apply to distributions from tax nothings or from corporations that are partnerships and vice-versa. consider the estate planner's task and checklist of questions that she must ask in order to prudently plan for the demise of a wealthy client for whom she has prepared trust and will documents for years. since the last set of will and trusts were executed several years ago, the llc became the entity of choice, the ctb regulations were promulgated, and congress has adopted the treasury's recent proposals to treat a c to s or s to k conversion as a taxable liquidation. if one could eavesdrop on their estate planning conversation, which will occur sometime in the not too distant future, it might go like this. lawyer: mr. jones, tell me about your corporation. client: well, i have a great business. i have had it for many years, and i am proud of my success. i know that business as well as anyone in the country. but, i am not sure if i can tell you, lawyer, whether it is a corporation. lawyer: well, mr. jones, why is it that you don't know whether you have a corporation? you've had the same business for over 40 years? client: well, the tax people tell me that i am no longer a corporation but instead i am a partnership with my fellow shareholders who are partners. lawyer. you mean abbott, costello, and the young guy, crystal? client: yeah. lawyer: well, mr. jones, is your paycheck drawn on a corporation? client: yeah. lawyer. do you file an annual corporation report with the state and hold directors and shareholders meetings? client: yeah. lawyer: do you still have that shareholders agreement we executed with abbot, costello, and crystal years ago? client: yeah, but you don't understand. it is not a corporation. it's a partnership or an llc thing is what the tax guys are saying. lawyer. you mean your corporation was liquidated and is now a partnership or an llc? are you then a member or a manager of the llc, or both? involving single-member tax nothings owned by corporations. see prop. regs. § 301.77013(g); tech. adv. mem. 98-22-0021 (oct. 23, 1997). 1999] florida tax review client: you didn't listen to me, lawyer. it's a corporation!! it's not a partnership or an llc. only for tax purposes is it a partnership. lawyer: i find this difficult to understand, you own stock, you get paid from a corporation, you have a shareholders' agreement, you have run the same business in your corporation for over 40 years, you haven't liquidated the corporation, but you are taxed as a partnership. does that mean you have a capital account in your stock? i mean, if your capital account is negative, that might be a liability under state law. client: ignore state law dammit, that is what my tax advisers tell me. state law doesn't mean a thing. lawyer: let's go through this one more time, do you own stock in a corporation, or an interest in a partnership, mr. jones? client: i'm leaving. as reflected by this not too far fetched dialogue, a single world for taxing all pbfs as partnerships will erase long-standing accepted norms of corporate taxation. in its wake underlying state law will now dissolve and only the tax expert, sitting in a laboratory of magic and metaphysics will understand what is going on. stock is not really stock, but instead is as a partnership interest; a partnership interest is not really a partnership interest but is to be treated as stock; a real entity for state law purposes is really a "nothing"; a corporation is really a partnership. ii. s corporation versus partnership comparison after the ctb regulations the past few years have witnessed the growth of the llc as a preferred method for organizing and operating pbfs. although lps enjoy the same tax advantages as llcs, the llc permits members to be active in the organization's day-to-day affairs without risk of becoming liable as general partners. the llc's state-law characteristics closely resemble those of the s corporation, but it is generally taxed as a partnership. a comparison of s corporations and llcs is set forth below, although most of the tax comparisons are the same for limited partnerships and limited liability partnerships. what this comparison reveals is that the combination of corporate state-law characteristics with conduit tax rules and the flexibility of subchapter k makes the llc the super-passthrough entity.1 18. publicly traded partnerships are treated as corporations unless their income is predominately from passive sources. see irc § 7704(a) & (c). a partnership falls within the scope of § 7704 if its interests are traded on an established securities market or are readily [vol. 4:3 benefits and burdens of subchapter s a. state law differences a corporation, c or s, is organized under a state statute pursuant to its corporate charter, which usually identifies the corporation's purpose, organizers or incorporators, place of residence, initial board of directors, and classes of stock. by-laws are adopted by the board of directors. shareholders may enter into agreements concerning, for example, the voting of shares, participation on the board of directors, restrictions on the transferability of shares, super-majority voting requirements on some matters, and buy-sell arrangements in the event of death or other defined event. a corporation's owners are generally not liable for its debts, and the corporation has centralized management through its board of directors and exists perpetually until it is dissolved by vote of its shareholders. a wealth of jurisprudence and statutory authority delineates the duties and responsibilities of a corporation's officers, directors, and majority shareholders towards other shareholders. since the corporation is recognized in all jurisdictions, its limited liability feature is universally accepted, subject to limited "piercing the corporate veil" theory for alter ego scenarios. an llc is also a creature of state law and borrows from both the centralized management model of the corporation and the aggregate or agency model of the partnership. although the states' llc laws vary from each other, especially on default provisions, the legislative trend is to permit freedom of contract among llc members on fundamental management and ownership issues. as a result, the llc, through a comprehensive member agreement, can blend the amounts of fiduciary responsibility, management, and voting rules desired by the owners.' 9 as the new entity kid on the block, however, there is not yet a body of jurisprudence that can be drawn upon to guide llc members as to their rights and duties. accordingly, the members' agreement and the rules governing the interpretation and enforcement of contracts has paramount importance. because the llc allows the same type of ownership and management structure available to shareholders in a close corporation and limited liability for entity obligations, state law should be considered a neutral factor in comparing multiple member llcs to s corporations. the efficacy of a single member llc for conducting business operations in multiple jurisdictions is tradeable on a secondary market or the equivalent of a secondary market. see irc § 7704(b); regs. §§ 1.7704-1(a)(1), (b). some passive publicly-traded partnerships still qualify for passthrough treatment. see irc § 7704(c). 19. see unif. lin. lia. co. act § 103, 6a u.l.a. 434-35 (1995) (allowing members to internally regulate such matters using an operating agreement). 19991 florida tax review still open to debate. although recognized in all but seven jurisdictions," the single member llc may afford its owner less protection from unlimited liability than an s corporation, which generally ensures limited liability.2 b. eligibility limitations 1. number of equity participants.-there is no limitation on the number of investors who can participate in a partnership or in an llc taxable as a partnership, although a public market for interests in the entity will cause it to be a publicly traded partnership, taxable under §7704 as an association. under ctb, a single member llc is usually ignored as a separate entity for federal tax purposes unless an election is made to have the entity taxed as a corporation.22 presently, all but seven states permit single member llcs.23 a single member llc, organized in one of the states authorizing singlemember llcs, that does business in states not allowing single member llcs must grapple with critical state law conflicts of law questions as to whether the other states will recognize the limited liability of the foreign llc's single member. subchapter s has always restricted the number of shareholders.2 4 starting off by limiting s corporations to not more than 10 shareholders, congress gradually increased the maximum number to the present 75.' spouses and their estates are considered to be one shareholder, regardless of which spouse owns the stock and even if they are both shareholders,26 but 20. bruce p. ely & christopher r. grissom, the llc/llp scorecard, 81 tax notes 1005 (nov. 23, 1998) (california, district of columbia, idaho, massachusetts, montana, pennsylvania and tennessee either do not recognize or do not clearly recognize single member llcs). 21. however, the separate identity and formalities of the corporation must be observed by the sole shareholder to avoid a nominee or "pierce the corporate veil" attack. see also james d. cox & brian w. woods, piercing the veil in limited liability companies, 4 j. lim. lia. co. 24 (1997). 22. see regs. § 301.7701-3(b)(1); gen. couns. mem. 39,395 (aug. 5, 1985) (fourpart test under prior regulations applied to single member entity); francis j. wirth & kenneth l. harris, tax classification of the one-member limited liability company, 59 tax notes 1829 (june 28, 1993). 23. see ely & grissom, supra note 20, at 1005. 24. until recently, use of multiple s corporations to engage in a single business as partners, in order to circumvent the shareholder number limitation, jeopardized each s corporation's election. rev. rul. 77-220, 1977-1 c.b. 263, revoked by rev. rul. 94-43, 1994-2 c.b. 198. see also rev. rul. 78-390, 1978-2 c.b. 220 (more than maximum number of shareholders receiving distributions during year as a result of a stock transfer did not result in termination). 25. see irc § 1361(b)(1)(a) (ceiling is 75 shareholders for taxable years beginning after 1986). 26. irc § 1361(c)(1). [vol 4:3 benefits and burdens of subchapter s there is no other rule for attributing stock among family members or entities." the increases in the shareholder ceiling were intended to facilitate multi-generational ownership of s corporations, an important factor in estate planning for shareholders. however, the number limitation has never been problematic for most s corporations because the overwhelming majority of them have five or fewer shareholders. 2 2. eligible equity participants.-although any individual or entity, whether domestic or foreign, including a trust, estate, corporation, llc, llp, or partnership, may be a member of an llc, s corporations continue to be subject to rigid shareholder eligibility limitations. for example, nonresident aliens are not permitted to own s stock, even though tax compliance concerns could be greatly reduced by a withholding regime like the one presently in place for partnerships with foreign partners.2" similarly, a corporation may not own stock in an s corporation," although a qualified subchapter s subsidiary (qsub) rule, discussed more fully below, is an important exception to this prohibition. partnerships, including llcs and lllps, are also impermissible shareholders of an s corporation.3' the same holds true for trusts that are not grantor trusts, qualified subchapter s trusts (qsss), or electing small business trusts (esbt). given the long-standing advantages for entities taxed as partnerships and the ctb regulations' scrapping of state law characteristics as determinative of entity tax status, the continued limits on s corporations are hard to justify. an eligibility question generated by the ctb provisions is whether a single member llc can be an s shareholder. since its tax status is that of a "tax nothing," stock held by such an llc should be considered owned by the llc's owner, much in the same way as a grantor trust is ignored and the beneficial owner is treated as shareholder with respect to stock held by a nominee." the service has also ruled that a corporation's s election did not terminate when its stock was held by a nonresident alien as custodian for a 27. see rev. rul. 59-187, 1959-1 c.b. 224. 28. see susan c. nelson, s corporations: the record of growth after tax reform, 5 j. s corp. tax'n 138 (1993). 29. see irc § 1446. 30. see irc § 1361(b)(1)(b). 31. see kates v. commissioner, 27 t.c. memo (cch) 1423, t.c. memo (p-h) 68,264 (1968). but see guzowski v. commissioner, 26 t.c. memo (cch) 666, t.c. memo (p-i-) 67,145 (1967) (s stock owned by partners, not partnership, because partnership found to have dissolved). 32. see pahl v. commissioner, 82 a.f.t.r. 2d 98-5418 (9th cir. 1998); ozier v. commissioner, 36 t.c. memo (cch) 236, t.c. memo (p-h) 77,053 (1977), aff d, 600 f.2d 594 (6th cir. 1979). see also priv. lr. rul. 90-10-042 (dec. 11, 1989); priv. ltr. rul. 89-34020 (may 24, 1989) (momentary ownership of s stock by partnership ignored). 1999] florida tax review u.s. citizen under a uniform gift to minor's act.3 thus, if the owner of the llc "tax nothing" is an eligible shareholder, stock owned by the llc should be considered held by an eligible shareholder, notwithstanding the llc's separate identity under state law.' 3. limitations on use of debt and equity.-the most serious disadvantage faced by s corporations and their shareholders, relative to unincorporated businesses taxed under subchapter k, is a rule precluding an s corporation from having more than one class of stock. 5 thus, an s corporation cannot provide a liquidation or distribution preference to any shareholder. even buy-sell agreements and similar arrangements must be sanitized to avoid a prohibited second class of stock. a buy-sell agreement, agreement to restrict the transferability of stock, or cross purchase and redemption agreement creates a prohibited second class of stock if a principal purpose of the agreement is to circumvent the one class requirement and the agreement establishes a redemption or purchase price that, at the time the agreement is made, is significantly below or in excess of the stock's fair market value. 6 an s corporation can only issue or enter into the following types of securities or arrangements without placing its s status at indeterminable risk: (1) issue "straight debt";37 (2) issue nonvoting (in addition to voting) common stock;" (3) enter into equity-type arrangements not resulting in the issuance of stock, including options (other than "in the money" options), phantom stock, and stock appreciation rights; 39 or (4) enter into a joint venture or other business arrangement with persons otherwise desirous of owing stock in the s corporation directly. 33. see rev. rul. 71-287, 1971-2 c.b. 317. 34. see regs. § 1.1362-6(b)(3)(i); hook v. commissioner, 58 t.c. 267 (1972); kean v. commissioner, 51 t.c. 337 (1968), aff'd 469 f.2d 1183 (9th cir. 1972). 35. see irc § 1361(b)(1)(d); regs. § 1.1361-1(1). 36. see regs. § 1.1361-1(l)(2)(iii). generally, agreements to redeem or purchase stock upon the death, divorce, disability or termination of employment are disregarded under the one-class-of-stock analysis. see regs. § 1.1361-1(l)(2)(iii)(b). 37. straight debt is a written and unconditional obligation to pay a sum certain in money with interest rate and payment dates not contingent on the borrower's profits, discretion, or other factors and with no right to convert, directly or indirectly, into stock. see irc § 1361(c)(5). the holder of the debt must be an eligible shareholder except that after 1996, a entity or person actively and regularly engaged in the business of lending money may hold straight debt under the safe harbor. see irc § 1361(c)(5)(b)(iii). 38. see irc § 1361(c)(4). 39. see regs. § 1.1361-1(b)(4) (permissible incentive compensation arrangements); priv. ltr. rul. 94-06-017 (nov. 15, 1993) (stock appreciation rights did not violate the oneclass-of-stock requirement); priv. ltr. rul. 90-40-035 (july 6, 1990) (phantom stock plan did not result in second class of stock). as to restricted stock under § 83, see regs. § 1.13611(b)(3). [col 4:3 benefits and burdens of subchapter s use of a tax partnership, which may now have all four of the corporate characteristics identified in the former regulations, facilitates the issuance of various types of equity interests, accommodating the interests of the parties without sacrificing passthrough status.o llcs and partnerships may, without jeopardizing their tax status as passthrough entities, issue multiple classes of equity interests, create distribution and liquidation preferences and priorities, make special allocations of tax items within boundaries permitted by section 704, and issue equity-flavored debt, which may include a debt-to-equity conversion privilege. 4. use of multi-tiered structures or affiliates.-except as barred by state regulations of various professions, a partnership, llc, or llp can itself be a partner or member of another partnership, llc, or llp. multi-tiered structures of unincorporated passthrough entities are quite common and facilitate combinations of business and investment pools and assets. even within a single set or group of owners, use of subsidiary llcs, including single member llcs, may achieve a desired segregation of business assets and creditors. it may also provide state tax or licensing benefits. until 1996, s corporations were greatly disadvantaged in this respect because former section 1361(b)(2)(a) prohibited an s corporation from being a member of an "affiliated group," which, under section 1504, generally required that the corporation own at least 80%, by vote and value, of the stock of another corporation.4 this prohibition could be avoided by intentionally flunking one of the two 80% tests in testing for affiliation. since no attribution rule applies for this purpose, the s corporation's shareholders could hold the remaining stock of the subsidiary, thereby achieving a de facto affiliation. in its plain vanilla form, issuance of 21% of the stock of an affiliate to one or more shareholders of the s corporation would preserve the parent corporation's s status. if the cost to the shareholders of buying more than 20% of the subsidiary's stock was too steep, much of the s corporation's investment could be represented by nonvoting stock, and the shareholders could acquire, at a much reduced cost, voting stock sufficient to flunk the 80% test. s corporations were permitted to "affiliate" with another corporation in order to engage in a tax-free reorganization or division, but only 40. but see regs. § 1.1361-1(0) (generally prohibiting a corporation with more than one class of stock from qualifying as an s corporation). 41. limited statutory relief was provided for an "inactive" subsidiary. irc § 1361(c)(6) (before amendment in 1996). before 1983, an s corporation could control an "excluded" corporation under § 1504(b), but this exception was repealed in 1982, subject to grandfathering relief, in the subchapter s revision act of 1982, pub. l no. 97-354, § 6(c)(1), 69 stat. 1697 (codified at irc § 1361(c)(1) (1982)), reprinted in internal revenue acts, text and legislative history, at 273, 301 (1982). 1999] florida tax review momentarily.42 the service extended this exception to acquisitions of the stock of a target corporation followed by a liquidation within 30 days,43 but the tax court cast doubt on whether there was the necessary statutory foundation for a 30-day grace period." after the 1996 repeal of section 1361(b)(2)(a), an s corporation may own any percentage of the stock of a c corporation. a c subsidiary may also file a consolidated return with its c corporation affiliates, although the s corporation parent may not join in this filing. dividends to the parent s corporation are ineligible for a dividends received deduction, and other intercompany transactions are further excluded from application of the consolidated return rules.45 5. qualified subchapter s subsidiaries (qsubs).-a far greater benefit introduced in 1996 is that an s corporation may now own all of the outstanding stock of a subsidiary and achieve passthrough treatment at the subsidiary level if the parent s corporation elects to treat the subsidiary as a division.46 this rule, which is effective for taxable years beginning after 1996, is the most important amendment to subchapter s contained in that year's legislation. a qualified subchapter s subsidiary (qsub) is a domestic corporation, otherwise eligible to make an s election, (1) all of the issued and outstanding stock of which is owned by an s corporation and (2) which the s corporation elects to treat as a qsub.47 in temporary guidance, the service announced that qsub elections, which must be made subsidiary by subsidiary, are to be made on form 966 with special notation.4' the blue book explanation allows for tiers of qsubs. 49 once a break in the qsub 42. see rev. rul. 72-320, 1972-1 c.b. 270 (reorganization momentary affiliation disregarded); gen. couns. mem. 39,768 (dec. 1, 1988). 43. see rev. rul. 73-496, 1973-2 c.b. 312. 44. see haley brothers construction corp. v. commissioner, 87 t.c. 498 (1986); see also jerald d. august, acquisitions involving s corporations, in new york university-proceedings of the fifty-second institute on federal taxation § 3-1 (1994); samuel p. starr, s corporations: operations, 371 tax mgmt. (bna) 105-127. 45. the inapplicability of the intercompany (deferred or matching) transaction rules requires that attention be given to intercompany sales or transfers between an s corporation and a c corporation in which the s corporation owns 50% or more of its stock. see irc §§ 267(a)(1); 267(a)(2); 267(b)(3); 267(0; 1239; 453(e). 46. see irc § 1361(b)(3). 47. see irc § 1361(b)(3)(b). a qsub may not be a financial institution described in § 585, insurance company subject to subchapter l, possessions corporation, disc, or former disc. see irc § 1361(b)(2). 48. see notice 97-4, 1997-1 c.b. 351. 49. staff of joint comm. on tax'n, 104th cong., 2d sess., general explanation of tax legislation enacted by the 104th congress 120 nn.120-21 (comm. print 1996). [vol 4:3 benefits and burdens of subchapter s chain occurs by the interposition of a c corporation, the qsub election may not be made with respect to any lower-tier subsidiary, but lower-tier corporations may join in a consolidated tax return.-' in a manner resembling the effect of a single member llc, a qsub is treated as a division of the s corporation, and its separate existence is ignored during the qsub period. the qsub therefore does not maintain a separate accumulated adjustments account or collect earnings and profits. instead, the computation of taxable income or loss, accumulated adjustments account, built-in gains subject to entity level tax, passive investment income, characterization of distributions, and other tax accounting is determined on an aggregate basis by the parent s corporation. a. deemed liquidation.-if the subsidiary existed before the first year for which the qsub election is made, the election is treated as a liquidation of a wholly owned subsidiary into its electing s corporation parent.5 generally, under sections 337 and 332, no gain or loss is recognized by the liquidating subsidiary or the parent. under sections 381 and 334(b), the s corporation parent inherits the qsub's tax attributes and the adjusted basis of its assets. if the subsidiary was a c corporation, the deemed liquidation causes the parent s corporation to become subject to the built-in gains tax under section 1374 with respect to the qsub's assets. if, as a c corporation, the qsub used the lifo method of inventory accounting, the special four-year recapture rule of section 1363(d) comes into play. postqsub election problems may also arise from inheriting the c earnings and profits, which may affect the s corporation's post-qsub distributions to its shareholders.52 if there is a significant amount of passive investment income, the carryover of earnings and profits may also result in an entity level tax under section 1375 and eventually pose a termination risk under section 1362(d)(3). aside from the tax attribute issues generated by a deemed liquidation, the most immediate drawback to the qsub election may be a disappearing basis problem for a purchased subsidiary. assume an s corporation purchases all of the stock of a target c corporation for $2,000x and does not make a section 338 election; the target's basis for its assets is $500x. by purchasing all of the target's stock and making the qsub election (or, alternatively, by immediately liquidating the target into the purchaser), $1,500x of basis-the excess of the $2,000x paid by the parent for the subsidiary stock over the target's basis for its assets-disappears because, under section 334(b), the 50. see irc § 856(i). for an analogy, see priv. ltr. rul. 95-27-020 (apr. 6, 1995) (reit lower tier subsidiaries). 51. see staff of joint common tax'n, supra note 49, at 120 n.121. 52. see irc § 1368(c) (distributions by s corporations with earnings and profits). 1999] florida tax review parent succeeds to the subsidiary's basis for its assets. gain equal to the lost basis may be recognized by the s corporation as built-in gain under section 1374 if the qsub sells its assets within 10 years. finally, the service has been heard to be rattling its saber that it will apply the bausch & lomb doctrine to a contribution of more than 20% of the stock of a subsidiary to an s corporation in order to make a the subsidiary eligible for a qsub election.53 this fear was confirmed by proposed regulations issued this year.' b. conversion of consolidated group into qsub group.-if there is 100% ownership of each member of a consolidated group, and the shareholders of the parent c corporation are permissible shareholders, the qsub rules make it possible to convert the entire group to a subchapter s regime. as previously mentioned, such a conversion would result in the application of the built-in gains tax and lifo recapture and other c to s conversion issues. before 1996, the group could have been converted from c to s only by merging or liquidating all of the subsidiaries into the parent, which may have caused an undesirable shift in risk to the parent since all subsidiary debt would effectively be assumed. with the new qsub rule, the conversion to subchapter s can be accomplished without changing the group's structure, thereby maintaining desired asset and liability segregation. a consolidated group has a tax history, including intercompany transactions that have been deferred or nonaccelerated, and, in appropriate instances, a group must track the parent company's obligation of a subsidiary's losses in excess of the parent's investment in the subsidiary ("excess loss account" or ela). a question arising in converting a consolidated group to a qsub regime is the effects of the conversion on intercompany accounts and elas. as to deferred or nonaccelerated intercompany gain, since the benefits of consolidated reporting are revoked in favor of a single tax system under subchapter s, the service may feel that it is appropriate to require a complete catch-up, triggering deferred gain on intercompany transactions upon a qsub conversion. on the other hand, the long-standing policy is that a c to s conversion is not a realization event. since there is a carryover of adjusted basis to the s corporation parent, there is arguably no need to impose tax.55 53. bausch & lomb optical co. v. commissioner, 267 f.2d 75 (2d cir.), cert. denied, 361 u.s. 835 (1959). 54. see prop. regs. §§ 1.1361-2 to -5; jerald d. august et al., a planning guide to the proposed regulations on qualified subchapter s subsidiaries, 10 j. s corp. tax'n 171 (1999); jerald d. august & jeffrey l. rubinger, proposed regulations dealing with qualified s corporation subsidiaries issued by the service, 10 j. s corp. tax'n 109 (1998). 55. under regulations in effect for taxable years commencing prior to july 12, 1995, deferred intercompany gain generally was not recognized in a § 332 liquidation. see regs. [vol 4:3 benefits and burdens of subchapter s the issue with ela recapture is perhaps easier to resolve favorably than the intercompany transaction issue since the consolidated return regulations do not impose ela recapture on a section 332 liquidation.' however, confirmation of this result is needed because an argument may be made that given the qsub election, the affiliated group will not be in existence at the time of the deemed liquidation that would trigger ela recapture. perhaps using a preemptive strategy of effectuating a state law merger of the subsidiary into a single member llc avoids the issue even during this wait-for-guidance period. if the qsub or chain of qsubs generating the ela is insolvent, a section 332 triggers recapture.' c. termination of qsub election: deemed section 351 transfer.-qsub status may be terminated by revocation or by a transfer of a single share of subsidiary stock to a shareholder or third party. following the termination, the qsub is treated as a new corporation that acquires all of its assets and assumes all of its liabilities from the s corporation parent in exchange for its stock in a deemed section 351 transaction.' the former qsub is prohibited from re-electing s status or qsub status for 5 years unless the service grants permission.5 9 section 351 treatment may seem innocent, especially since the statute provides that the deemed transfer occurs "immediately before such [qsub] cessation." since a section 351 exchange is generally nontaxable where there is a single shareholder who transfers all of the assets in exchange for all of the issuing corporation's stock, only section 357(c), which applies if the transferred liabilities exceed the basis of the transferred assets, should pose a trap for the unwary. however, the service may take the position that the 80% control test is violated if more than 20% of the qsub's stock is transferred out, either by a distribution of subsidiary stock to shareholders or sale to third party.' this would cause all of the former qsub's asset value in § 1.1502-13(a)(1)(ii) (withdrawn by t.d. 8597, 60 fed. reg. 36,671 (1995)). the result is otherwise under the new (accelerated and matching) intercompany rules. see regs. § 1.150213(ft(5)(i). 56. see regs. § 1.1502-19(a), (b). 57. see regs. § 1.1502-19; textron, inc. v. united states, 561 f.2d 1023 (1st cir. 1977). compare norman scott, inc. v. commissioner, 48 t.c. 598 (1967); rev. rul. 68-602, 1968-2 c.b. 135. 58. irc § 1361(b)(3)(c). 59. see irc § 1361(b)(3)(d); see generally august et al., supra note 54. 60. compare american bantam car. co. v. commissioner, 11 t.c. 397 (1948), aff'd per curiam, 177 f.2d 513 (3d cir. 1949) with intermountain lumber co. v. commissioner, 65 t.c. 1025 (1976) (binding obligation to sell 50% of stock to underwriter broke 80% control requirement under § 351). see also bausch & lomb, supra note 53. recently issued proposed regulations confirm the service's hard line position. see august & rubinger, supra note 54. 1999] florida tax review excess of adjusted basis to be fully taxable to the transferor s corporation which gain would passthrough to its shareholders. depreciable capital gain property deemed transferred to the former qsub would generate ordinary income. 6. tax rate comparison.-the present maximum marginal income tax rate of 39.6% on an llc member who is an individual is the same as that for an s shareholder. in contrast, the maximum rate of federal income tax on a c corporation is 34% (35% for personal service corporations and corporations with taxable income exceeding $10,000,000). s shareholders, however, enjoy a slight advantage in the employment tax area. the combination of fica and hospital insurance taxes for employees, including s employee/shareholders, is 15.3% on the first $61,200 on wages, but the hospital insurance tax of 2.9 percent also applies to compensation in excess of this dollar ceiling.6 by setting a reasonable salary, in this context one that is not unreasonably too low, an s shareholder can avoid these employment taxes on the shareholder's share of the corporation's income after salaries. under section 1402(a), an individual partner's net earnings from selfemployment, which is also taxed at a rate of 15.3%, includes the partner's entire distributive share of partnership income unless the individual is a limited partner.62 it is not possible to restrict the amount subject to selfemployment taxes to amounts designated as wages. a limited partner's distributive share of income (or loss) is exempt from self-employment tax, but a guaranteed payment to a limited partner for services is within the selfemployment tax base. under recently revised proposed regulations,63 an individual investor in a passthrough entity, including an llc, will be considered a limited partner for self-employment tax purposes unless the individual (1) is 61. cf. irc §§ 3101(a), (b); 3111(a), (b). but see rev. rul. 59-221, 1959-1 c.b. 225 (shareholders in s corporations not subject to self-employment tax on share of undistributed income). 62. exceptions are also provided for rental income, interest and dividends, and capital gains and losses. irc §§ 1402(a)(1), (2), (3). 63. reg-209824-96, 62 fed. reg. 1,702 (jan. 13, 1997), which superseded regulations proposed in 1995. 1995-1 c.b. 853. the revised regulations are effective for the first taxable year of the member or partner beginning after they are published as final regulations. see id. under the earlier proposed regulations, an individual member of an llc was treated as a limited partner for self-employment tax purposes if the member (1) did not have authority to make management decisions and (2) would have been a limited partner under the state in which the llc was organized had the llc instead been formed as a limited partnership. see also priv. ltr. ruls. 95-25-058 (june 23, 1995), 94-45-024 (nov. 10, 1994), 94-23-018 (june 10, 1994). [vol 4:3 benefits and burdens of subchapter s personally liable for entity debts by reason of being a partner or member,(2) has authority to contract on behalf of the entity under state law or the governing instrument, or (3) participates for more than 500 hours during the taxable year in the entity's trade or business.6' the exclusion for limited partners could not apply to certain "service" members or partners.6 the proposed regulations acknowledge, somewhat favorably, that an individual may bifurcate his or her distributive share of llc (or partnership) income between an "active" and "passive" class for self-employment tax purposes.6 7. certainty of tax status.-despite recent efforts to reform subchapter s, its tax status as a passthrough entity must still be perfected by affirmative act of its shareholders and then carefully monitored and maintained throughout its existence. once lost, an s corporation cannot reelect s status for five years unless the termination was inadvertent or the service permits an early re-election. for most re-elections, a substantial cost is incurred in the form of the built-in gains tax under section 1374 for ten years after the re-election. this corporate-level tax generally applies to realizations during the 10-year period of gains accrued before the re-election, including gains accrued during s years. although it applies whether an early re-election is allowed or the five-year sentence is imposed, accrued gains tend to be larger if the intervening c period is longer. in contrast, after ctb, a domestic unincorporated business entity with two or more owners is a partnership for federal tax purposes unless it elects to be an association, 7 and a single member llc is disregarded for tax purposes unless it elects association treatment.' the tax status of an llc as a passthrough entity is thus simple to establish and maintain. again, the advantage goes to the llc. 8. formation issues.-section 351 provides tax free treatment for transfers of property to a corporation if the transferors control the corporation 64. prop. regs. § 1.1402(a)-2(h)(2). the reference to personal liability would put the day-to-day participation or control in partnership affairs test of state partnership law into the equation. see rev. unif. limited partnership act, § 303 (1976). a partner or member participating in the partnership's business for more than 500 hours during the year would be limited partners if other persons holding "substantial continuing interest[s]" in the same class of partnership interests do not participate for as many as 500 hours. prop. regs. § 1.1402(a)2(h)(4). 65. the excluded persons are "service partners" of an entity "substantially all the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting." prop. regs. § 1.1402(a)-2(h)(5). 66. see prop. regs. § 1.1402(a)-2(h)(3). 67. see regs. §§ 301.7701-2(c)(1), 301.7701-3(b)(1)(i). 68. see regs. §§ 301.7701-2(c)(2), 301.7701-3(b)(1)cii). 19991 florida tax review immediately thereafter.69 section 368(c) defines control for this purpose as ownership of at least 80% of the stock, by vote and value. if appreciated property is transferred to a controlled corporation in exchange for stock and other consideration (e.g., cash or debt instruments of the corporation), gain or loss is recognized to the extent of the fair market value of the other consideration (boot). also, if the adjusted basis of the transferred property is less than the debt assumed or taken subject to by the corporation, the excess is taxable gain. 0 the transferring shareholder recaptures depreciation on the transferred assets only to the extent that gain is recognized on the transfer of the depreciated assets.7 the transferee corporation generally receives the contributed assets with a carryover basis and inherits the transferor's holding period for the property.72 the shareholder's basis for the stock received is the adjusted basis of the property transferred, less the value of boot received and liabilities assumed, plus any gain recognized.7' in contrast, under section 721, no gain or loss is recognized on a transfer of property to a partnership in exchange for a partnership interest, regardless of the transferor's proportionate interest in the partnership. if a contributing partner receives consideration in addition to the partnership interest, this consideration is treated as distributed by the partnership to the partner. generally, a partner recognizes gain on a distribution only to the extent that the cash distributed exceeds the adjusted basis of the partner's partnership interest, which initially equals the adjusted basis of the contributed property.74 the partnership's assumption of a partner's liability or taking of contributed property subject to a liability is treated as a cash distribution to the partner equal to the amount by which this liability exceeds the partner's share of the partnership's liabilities, including the liability assumed or taken subject to.75 a partner who contributes property encumbered by debt exceeding the property's basis thus may, but is not certain to, recognize gain on the contribution. gain may be recognized, for example, where an llc member's contribution for her llc interest consists of real property that has been depreciated while the member held it at a rate faster than the member paid down principal on a mortgage on the property. 69. contributions of property by a shareholder to a corporation not in exchange for stock also are generally tax-free. see irc § 118. 70. see irc § 357(c). but see lessinger v. commissioner, 872 f.2d 519 (2d cir. 1989); irc § 357(b) (tax avoidance purpose rule). transfers to investment corporations and partnerships are usually taxable. see irc § 721(b); regs. § 1.351-1(c)(5). 71. see irc §§ 1245(b)(3), 1250(d)(3). 72. see irc §§ 362(a), 1223(2). 73. see irc § 358(a). 74. see irc §§ 722, 731(a)(1). 75. see irc § 752; regs. § 1.752-3. [vol 4:3 benefits and burdens of subclapter s despite the seeming competitive advantage of section 721 over section 351, there are several potential advantages to s corporations with respect to contributions of property. first, the character of property held by a corporation is usually determined by reference to the corporation's purpose in acquiring and holding the property. thus, if a shareholder contributes inventory or dealer property to an s corporation, the dealer or inventory taint 76does not automatically remain. assume a real estate developer, who has held a tract of land for development while it has substantially appreciated, contributes it to an s corporation that she organizes with other investors, and the corporation constructs an apartment or office building on the property. gain on a subsequent sale of the property may be section 1231 gain, even though it would have been ordinary income if the developer had constructed the building. a second subchapter s benefit from the same scenario is that the developer's pre-contribution built-in gain is not allocable to him. instead, the gain, like all other items of the corporation's income, is allocated among the shareholders in proportion to their stock ownership in the year of sale.' contributions of capital assets may bring opposite results. assume an investor contributes loss property held for investment to an s corporation. the investor would have had capital loss on a sale of the property before the contribution. if the s corporation develops the property for sale to customers, loss on its sale of the property will be ordinary. as with the gain, the investor's precontribution built-in loss will, when realized by the corporation, be allocated among all shareholders in proportion to their daily stock ownership during the year of the sale. such changes in character and shifts in gain or loss are less likely to occur when property is transferred to a partnership. in contrast to the s corporation approach, which looks to the entity's purpose in holding an asset contributed by a shareholder, section 724 often fixes asset characterization, providing that contributed property that was an unrealized receivable, inventory, or capital loss property in the contributing partner's hands retains this character in the hands of the partnership for five years after the contribution. appreciated capital gain property, however, is not subject to section 724 and can be immediately recharacterized as a noncapital asset by virtue of partnership activities. also, under section 704(c), precontribution built-in gain or loss must be allocated back to the contributing partner when it is realized by the partnership. the partner may be required to recognize precontribution gain 76. this is not to suggest that the service would not raise a challenge if it perceived an abuse. see bouno v. commissioner, 74 t.c. 187 (1980), acq. 1981-1 c.b. 1; see also irc § 341(e). 77. see irc § 1366(a). 19991 florida tax review before the partnership realizes it if the partner receives a large distribution from the partnership within five years after the contribution.78 the partner must also recognize precontribution gain or loss if the contributed property is distributed to another partner within seven years after the contribution.79 moreover, if a contribution of property is followed shortly (e.g., within 2 years) by a distribution to the contributing partner, the contribution may be recharacterized as a sale.8" subchapter s has no analogues, except that a corporation recognizes gain under section 311(b) on any distribution of appreciated property. since a single member llc is disregarded for federal tax purposes unless it elects to be taxed as an association, gains and losses realized by the entity are taxed to the owner in precisely the way in which they would have been taxed if the entity had not been organized. 9. services provided in exchange for equity lnterests.-if a member of an llc receives a capital interest in exchange for services, the transfer falls outside of section 721, and the value of the interest is a guaranteed payment, includable in the recipient's gross income.8' a capital interest for services may also have tax consequences for the other members.82 efforts are frequently made, sometimes successfully, to achieve tax-free treatment under section 721 by claiming that the service provider contributed "property."83 if a services member receives only an interest in future profits, the service's position is that receipt of the interest is not taxable unless there is a certain and predictable stream of income from llc assets or the recipient member disposes of the profits interest within two years."4 s stock received for services is taxable to the recipient if the stock is either nonforfeitable or transferable. a corresponding deduction is allowed to 78. on such a distribution, the contributing partner must recognize as gain the lesser of (1) the excess of the distributed property's fair market value over the adjusted basis of the partner's partnership interest or (2) the previously unrealized precontribution gain. see irc § 737(a). 79. see irc § 704(c)(1)(b). 80. see irc § 707(a)(2)(b); regs. § 1.707-3(c). see also regs. § 1.731-1(c)(3); otey v. commissioner, 70 t.c. 312 (1978), affd per curiam, 634 f.2d 1046 (6th cir. 1980). 81. see irc §§ 83(a), 707(c); regs. § 1.721-1(b)(2). 82. regs. §§ 1.721-1(b)(1); 1.83-6(b). 83. united states v. stafford, 727 f.2d 1043 (11th cir. 1984); united states v. frazell, 335 f.2d 487 (5th cir. 1964); ungar v. commissioner, 22 t.c.m. (cch) 766 t.c. memo (p-h) 63,159 (1963); cf. rev. rul. 78-357, 1978-2 c.b.227. 84. see rev. proc. 93-27, 1993-2 c.b. 343; cf. campbell v. commissioner, 943 f.2d 815 (8th cir. 1991 ), rev'g 59 t.c.m. (cch) 236 t.c. memo (p-h) 90,162 (1990). but cf. diamond v. commissioner, 56 t.c. 530 (1971), aff'd, 492 f.2d 286 (7th cir. 1974). [vol 4:3 benefits and burdens of subchapter s the corporation or imputed transferor.' as with the llc service provider receiving an interest in the entity for services, individuals receiving stock for services attempt to find service-flavored "property" in order to support a nontaxable exchange under section 351. the transfer of stock to a service recipient often is a critical factor in planning for tax-free incorporations since, if the stock is considered received for services and the service provider receives more than 20% of the stock, all transferors fail the 80% control requirement of section 351, which must be satisfied by transferors of "property."86 10. entity level taxation.-partnerships, including llcs taxable as partnerships, are not subject to federal income tax. single member llcs are ignored for federal income tax purposes unless the owner opts for association treatment most states, with the exception of texas and pennsylvania, do not tax llcs although some states impose limited franchise or capital taxes.' tax items are determined as if the llc were an individual and are allocated between separately and nonseparately stated items in accordance with section 702. most tax elections must be made by the llc, and income and deductions are characterized at the entity level.' the llc's taxable year generally must conform to that of a majority in interest of its members."° its taxable year will close on a termination or sale of 50% or more of its equity within one year, and it will also terminate with respect to a member who sells, exchanges, or liquidates his or her entire interest." s corporations generally are not subject to corporate income taxes, including the corporate alternative minimum tax, personal holding tax, and accumulated earnings tax. however, c corporations that convert to s status are subject to some entity level taxes. section 1374 taxes such corporation on net built-in gains recognized within ten years after the conversion, and section 1375 imposes tax on excess passive income if the corporation has undistributed c year earnings and profits. taxes imposed under either provision are at the maximum corporate rate of 35%, but the taxes reduce the corporate income taxable to the shareholders. for purposes of the built-in gains tax only, prior c year carryovers are permitted to reduce the base of the 85. see irc § 83(h), regs. § 1.83-6. see irc § 1032 (corporation recognizes no gain on receipt of property for its stock). 86. see regs. §§ 1.351-1(a)(1), (2). 87. see ely & grissom, supra note 20, at 1005. 88. see irc § 703(b). 89. see united states v. basye, 410 u.s. 441 (1973). but see irc § 724; casel v. commissioner, 79 t.c. 424 (1982); regs. § 1.267(b)-1(b). 90. see irc § 706(b). but see irc § 444 (election of different taxable year). 91. see irc § 706(c). 1999] florida tax review tax. in addition, a corporation using the lifo method of inventory accounting when it converts to s status must recapture the lifo-fifo spread over the succeeding four years.' since conversion of a c corporation to an llc taxed as a partnership is treated as a corporate liquidation, causing both the corporation and its shareholders to recognize gain or loss with respect to all assets and stock, the entity level taxes on s corporations that were formerly c corporations cannot be counted as a relative disadvantage of the s regime. an s corporation's taxable income is determined as if the corporation were an individual, and income and deductions are characterized with reference to the corporation's activities and purposes. most tax elections are made at the corporate level.93 the corporation's taxable year generally must be a calendar year or one that is the same as its principal shareholders' taxable year.94 its taxable year may, at the election of the corporation and its shareholders, be closed in the event of a shareholder's complete termination or where a certain percentage of its stock is sold over a certain period.9 11. use of cash method of accounting.-a literal interpretation of sections 446(c) and 448(a), and the definition of "tax shelter" in section 461(i)(3), could support the position that llcs are not permitted to use the cash method of accounting.9 6 the service has, however, issued several favorable rulings permitting an llc to use the cash method if (1) the llc did not expect to generate losses, (2) the llc members practiced in the profession in which the llc is engaged, (3) the llc was not formed for a tax avoidance purpose, (4) the interests in the llc were not syndicated, and (5) the equity partners manage the llc.97 an s corporation may adopt the cash method unless it is a "tax shelter" under section 461(i)(3)."s as for all taxpayers, if inventories are used the accrual method of accounting must be adopted unless the service permits otherwise.99 92. see irc § 1363(d). 93. see irc § 1363(c). 94. see irc § 1378; see also rev. proc. 87-32, 1987-2 c.b. 396. 95. irc § 1377(a)(2); see generally regs. § 1.1362-2. 96. for explanations of the terms "syndicate" and "tax shelter" (as specially defined within the § 461(i)(3) definition of the same term), see irc §§ 1256(e)(3)(b), 6662(d)(2)(c)(iii). 97. see priv. ltr. rul. 94-07-030 (apr. 15, 1994); priv. ltr. rul. 94-15-005 (feb. 18, 1994); priv. ltr. rul. 93-21-047 (may 28, 1993) (conversion of law partnership to llc). 98. see also irc § 1256(e)(3) (regarding syndicates). 99. see regs. § 1.446-1(e)(1) (permitting taxpayers to adopt any "permissible" accounting method for each trade or business). [vol 4:3 benefits and burdens of subchapter s 12. effects of entity level debt on outside basis and loss limitation rules.-both llc members and s shareholders may deduct their shares of entity losses only to the extent of the adjusted bases of their interests in the entity. for llcs, but not for s corporations, loss deductions are facilitated by the inclusion of the llc's debt in the members' bases for their interests. a. rules for s corporations.-an s shareholder may deduct corporate losses only to the extent of the sum of the shareholder's stock basis and the adjusted basis of any corporate debt held by the shareholder 1 ° the basis of stock received from the corporation in a section 351 exchange includes only the money paid and the adjusted basis of any property exchanged for the stock. the shareholder may not add to stock basis any indirect contribution, such as a proportionate amount of corporate indebtedness, even if its repayment has been personally guaranteed by the shareholder. the shareholder obtains basis only by making an "actual economic outlay."10' this limitation often prevents s shareholders from deducting their shares of corporate losses and deductions, although excess losses may be carried forward indefinitely. "' an s shareholder is also subject to the at-risk limitations of section 465, which restrict deductions for losses from property to the amount the taxpayer has at risk in the investment. an s shareholder is not at-risk for corporate debt, even personally guaranteed corporate debt.0 3 symmetrically with the s corporation basis rules, however, the proposed regulations under section 465 permit a shareholder to increase the at-risk amount by funds loaned to the corporation.'o 100. see irc § 1366(d). 101. underwood v. commissioner, 535 f.2d 309 (5th cir. 1976); raynor v. commissioner, 50 t.c. 762 (1968). but see selfe v. united states, 778 f.2d 769 (11 th cir. 1985) (shareholder entitled to a determination of who was the real debtor). the tax court does not follow selfe, except under its administrative golsen rule for cases appealable to the eleventh circuit. see estate of leavitt v. commissioner, 90 t.c. 206 (1988). aftd, 875 f.2d 420 (4th cir. 1989). in one instance, a novation of a corporate debt provided shareholder level basis. gilday v. commissioner, 43 t.c. memo (cch) 1295, t.c. memo (p-h) 82,242 (1982); cf. underwood v. commissioner, supra. 102. see irc § 1366(d)(2). 103. see prop. regs. §§ 1.465-24(a)(3). ia65-6(d). but cf. melvin v. commissioner, 88 t.c. 63 (1987); abramson v. commissioner, 86 t.c. 360 (1986). it remains uncertain how a shareholder establishes the initial at-risk amount after the corporation converts from c to s status. in the absence of guidance, it should be assumed that stock (and debt) basis outstanding as of such date is the gross amount, which then must be allocated among the corporation's at-risk activities. 104. see prop. regs. § 1.465-10(c). 19991 florida tax review moreover, the passive activity loss rules of section 469 apply after the foregoing two loss limitations are hurdled. 5 an s shareholder is separately allocated items of income, deduction, loss, and credit, and these are segregated among items of portfolio income (and directly allocable expense) and the corporation's section 469 activities."° each shareholder then determines to what extent he or she materially (or significantly) participated in each section 469 activity. b. rules for llcs.-a well-recognized advantage of the partnership for federal income tax purposes is the ability to include a proportionate share of entity level debt in a partner's outside basis. this enhances a partner's ability to deduct partnership losses currently and facilitates tax-free distributions. this advantage applies to members of llcs taxed as partnerships. a threshold issue in determining the partner/member's share of entity debt is whether the debt should be characterized as recourse or nonrecourse, based on an "economic risk of loss" analysis." generally, all of an llc's debt is nonrecourse if no member is liable for repayment. as nonrecourse debt, it is usually allocated among the members in proportion to their profit ratios. °8 however, a debt may "recourse" with respect to a particular member, to whom the debt must then be allocated, if, for example, the member or a person related to the member guarantees the debt or the debt is loan to the llc from the member or related person." the at-risk rules also apply to llc members. since the debt is typically without recourse to the members, they usually cannot include it in their at-risk amounts unless they have personally liable for repayment or have pledged property as security for the debt."' thus, an llc member who personally guarantees a debt of the entity is considered "at-risk," whereas an s shareholder counterpart may not be."' also, llc members should be able to include their shares of nonrecourse debt secured by real estate if the 105. see temp. regs. § 1.469-2(d)(5); jerald d. august, basis traps under subchapter s: competing in the basis triathlon, in new york university-proceedings of the forty-eighth institute on federal taxation § 7-1 (1990); jerald d. august, how do the passive activity loss rules apply to s and c corporations? 5 j. partnership tax'n 218 (1988). 106. see generally regs. § 1.469-4. 107. see regs. §§ 1.752-1(a)(2), -2(c), -2(d). 108. see regs. § 1.752-3. 109. other instances for finding recourse debt in an llc may exist where the debt falls within the interest guarantee or property pledge rules in regs. §§ 1.752-2(e) and -2(h). 110. see irc §§ 465(b)(1), (2). 111. see melvin, 88 t.c. at 63. but see prop. regs. § 1.465-6(d). [vol. 4.3 benefits and burdens of subchapter s debt meets the definition of qualified nonrecourse financing in section 465(b)(6)." 2 this exception is not applicable to s shareholders." 3 the application of the passive activity loss rules to llcs is uncertain. section 469(h)(2) precludes a limited partner from satisfying the material participation test, except where the regulations lift this bar. under the regulations, a limited partner is active as to the partnership's activities if he or she satisfies either (1) the 500 hour material participation test,"4 (2) the five out of prior ten year test,"5 or (3) the three-year rule applicable to service activities." 6 if an llc member could be considered a general partner, which is presently uncertain, the material participation test could also be satisfied by one of four additional tests."' a manager-member of an llc should be treated as a general partner, as should possibly members of a member managed llc. however, in the absence of further guidance, it should be assumed that members who are not also managers are limited partners for purposes of section 469.18 13. distributions not in redemption of stock or llc interest a. from s corporations.-distributions received by a shareholder from an s corporation with no earnings and profits are not taxable to the extent of the shareholder's stock basis, which is first adjusted for current year's income (but not deductions or loss)." 9 a distribution in excess of basis is treated as gain on a sale of property. if the corporation has accumulated earnings and profits from prior c years, distributions are excluded from gross income until the corporation has exhausted its accumulated adjustments account (aaa), which is essentially the sum of its taxable income for the most recent uninterrupted period of s years."2 under a 1996 amendment, a distribution may be from prior years' 112. to qualify, the debt must be nonrecourse to the entity as well as the members. 113. see irc § 465(b)(6)(d). final regulations under the qualified nonrecourse financing exception were recently issued. see t.d. 8777, 63 fed. reg. 41,420 (1998). 114. see temp. regs. § 1.469-5(a)(1). 115. see temp. regs. § 1.469-5(a)(5). 116. see temp. regs. § 1.469-5(a)(6). 117. see temp. regs. §§ 1.469-5(a)(2), (4). 118. if an llc member is considered a limited partner, the member is also prevented from qualifying under the "active participation" exception for certain rental real estate activity under § 469(i). see also irc § 4 69(c)(7); prop. regs. § 1.469-9(f)(1). perhaps, the use of a general partnership to directly engage in the activity, which is owned by individuals whose interests as general partners are held in single member llcs, may avoid limited partner status. 119. see irc §§ 1368(b), (d). 120. see irc §§ 1368(c)(1), (e). 19991 florida tax review aaa, even if there is a net negative adjustment to the account for the year of distribution.'2 ' distributions from aaa are subtracted from stock basis,'2 and are gain to the extent they exceed the shareholder's stock basis. distributions in excess of aaa are taxed as dividends to the extent of c earnings and profits."z distributions in excess of both aaa and c earnings and profits are gain on sales of property. if the corporation distributes appreciated property, it recognizes gain as though it had sold the property to the distributees at fair market value, and this gain is allocated among the shareholders as part of the corporation's taxable income for the year. 24 if the distribution is of property held by the corporation when it converted from c to s status and occurs within 10 years after the conversion, any built-in gain as of the date of conversion is subject to corporate tax under section 1374. a corporation generally recognizes no loss on distributing property to shareholders,"z and this rule presumably trumps section 1374 to disallow recognition of built-in loss.'26 in all cases, the shareholder-distributee takes a fair market value basis for the property. 27 distributions in liquidation are taxable to the corporation in accordance with section 336, which, in the case of a former c corporation, may result in corporate tax under section 1374 for preconversion appreciation in the distributed assets. since losses are generally permitted to be recognized in a liquidation, built-in losses should be treated as recognized for purposes of section 1374. capital gain or loss results at the shareholder level, after first making the corresponding passthrough adjustments for current year's income or loss, including income or loss from the liquidating distributions. b. from llcs.-the tax treatment of distributions to llc members under subchapter k is generally more favorable than the results under subchapter s, especially with respect to distributions of appreciated property. unless the llc makes a disproportionate distribution of section 751 property (unrealized receivables and substantially appreciated inventory), it recognizes no gain or loss on distributing property to its members. 28 a disproportionate distribution occurs if the distributee's interest in section 751 property increases or decreases as a result of the distribution. in the event of 121. see irc § 1368(e)(1)(c) (applicable for taxable years beginning after 1996). 122. see irc § 1367(a)(2)(a). 123. see irc § 1368(c)(2). 124. see irc §§ 311(b), 1371(a). 125. see irc § 311(a). 126. see irc § 1374(d)(4) (defining "recognized built-in loss"). 127. see irc § 301(d). 128. see irc § 731(b). [vol 4:3 benefits and burdens of subchapter s such a distribution, section 751 property equal in value to the amount of the increase is deemed sold between the member and the llc. this stands in marked contrast to the results under subchapter s, where any distribution of appreciated property is taxable. generally, no gain or loss is recognized by a distributee llc member unless distributions of money or money equivalents exceed the basis of the member's interest. '9 marketable securities are treated as money to the extent of their fair market value. 130 the distributee succeeds to the llc's adjusted basis for the property, except that this basis cannot exceed the basis of the member's interest immediately before the distribution.' 3' although the character of distributed property in the distributee's hands normally depends on the distributee's use or purpose in holding the property, gain or loss on the distributee's sale or exchange of distributed unrealized receivables or inventory is ordinary, regardless of the distributee's use or purpose.' 32 most of the foregoing rules, and a few others, apply to distributions in liquidation of the llc or of the member's interest. llc memberdistributees generally recognize no gain or loss on liquidation. however, cash distributions in excess of the basis of the member's interest are taxable, and relief from indebtedness (net of debts assumed or taken subject to) and certain marketable securities are treated as cash for this purpose. if a member receives only money in liquidation of his or her interest, loss is recognized to the extent the distribution is less than the basis of the member's interest. 33 if the liquidation distribution is disproportionate as to section 751 property, gain or loss is recognized."s distributed unrealized receivables and inventory bear an ordinary-income taint under section 735(a). 129. see irc § 731(a)(1); regs. § 1.731-1(a)(l)(ii) (treating advances and draws as distributions on the last day of the relevant taxable year). money includes any reduction in the partner-distributee's share of partnership liabilities. irc § 752(b). an llc member who has contributed appreciated property to the llc may, however, recognize gain as a result of two types of distributions. under § 737, the contributing partner recognizes gain on receiving a distribution within seven years after the contribution and while the llc continues to hold the contributed property if the value of distributed property other than money exceeds the basis of the member's interest. under § 704(c)(1)(b), the contributing partner may recognize gain if the contributed property is distributed to another member within seven years after the contribution. 130. see irc § 731(c) (applicable to distributions made after december 8, 1994, subject to various transitional rules). this rule is subject to a few exceptions, including distributions of originally contributed securities and distributions from "investment partnerships." irc § 731(c)(3). 131. see irc § 732(a)(2). 132. see irc §§ 735(a). 133. see irc § 731(a)(2). 134. see yourman v. united states, 277 f. supp. 818 (s.d. cal. 1967); rev. rul. 77-412, 1977-2 c.b. 223. 1999] florida tax review liquidation analysis is required where there is a constructive termination under section 708, which may result in a bunching of income for more than a 12-month period with respect to llc members. 14. redemptions of stock and interests a. s corporations.-distributions in redemption of s stock are either nonexchange events, subject to the rules for ordinary distributions, or exchange events. a redemption is considered a sale or exchange of the redeemed stock if the shareholder's interest is meaningfully reduced (section 302(b)(1)), the redemption meets the substantially-disproportionate test of section 302(b)(2), the shareholder's interest in the corporation is terminated (section 302(b)(3)), or the redemption is made to pay death taxes (section 303). in determining gain or loss on a redemption qualifying for exchange treatment, stock basis is adjusted for corporate income and loss for the year of redemption, which may be closed on the redemption date by election of the corporation and its shareholders. 3 5 gain or loss is generally capital, and installment sale reporting may be available. if a redemption does not qualify for exchange treatment, the distribution is treated under section 1368. if the corporation does not have accumulated earnings and profits for years before the s election, the distribution is nontaxable to the extent of the shareholder's basis, and any amount by which the distribution exceeds basis is usually long-term capital gain. if the corporation has undistributed c year earnings and profits, the distribution is first a nontaxable distribution of the aaa (generally consisting of s period taxable income), second a dividend to the extent of the c earnings and profits, and third gain on a sale of the stock. 36 if the redeemed shareholder has a high stock basis, nonexchange treatment is frequently advantageous because it facilitates recovery of stock basis and, where a large aaa is available, a dollar-for-dollar allocation to the account. a redemption generally has no direct tax impact on the corporation unless the distribution is made with appreciated property, in which event gain is recognized under section 311 (b). unlike the ability of a tax partnership to make a section 754 election, no adjustment is made to the basis of either the corporate assets or the stock of the nonredeeming shareholders. if the redemption qualifies as an exchange, earnings and profits are proportionately reduced. if it is not an exchange, the charge to earnings and profits is the amount of any dividend. 135. see irc § 1377(a)(2). 136. see irc § 1368(c)(2). [vol. 4:3 benefits and burdens of subchapter s b. redemption of llc interests.-complete liquidation of an llc member's interest may be accomplished by one distribution or a series of distributions, even in a two member context.'" the departing member generally recognizes no gain or loss, except to the extent that money distributed or deemed distributed exceeds basis. 8 if the llc's business is performing services (that is, if capital is not a material income producing factor), payments for the member's interest in the llc's unrealized receivables or goodwill qualify for special treatment under section 736(a).39 these payments are taxed as ordinary income to the recipient and the entitypayor's income is correspondingly reduced. other distributions in liquidation of a member's interest are governed by the rules for distributions described above. if the other distributions are a series of payments, the redeemed member offsets the distributions against basis, and money distributions are gain only after basis has been fully recovered.' loss is usually recognized, if at all, only when the final distribution is received, but ratable reporting may be elected to accelerate the loss. 15. sales or exchanges of equity interests a. s corporations.-an s shareholder's sale of part or all of his or her stock usually results in long-term capital gain or loss.' 4' however, unlike the situation of a partner, the amount realized in the sale does not include any portion of the s corporation's debt. the shareholder's stock basis is adjusted for income, loss, and distributions through the date of sale. if the sale is of all of the shareholder's stock, an election may be made to close the corporation's tax year as to the shareholder if the necessary consents are given by the corporation and its shareholders and the termination election is filed with the corporation's return. 42 if the election is not made, 137. see regs. §§ 1.736-1(a)(6), 1.761-1(d). if a series of distributions is made to a departing member of a two-member llc, the departing member continues to be recognized as a member for tax purposes until the liquidation is completed. 138. see irc § 731(a)(2); see also supra text accompanying notes 133-134. 139. section 736(a) payments, which are treated as either a distributive share of llc income or as a guaranteed payment, are not subject to the disproportionate distribution rules of § 751(b). 140. regs. § 1.736-1(a)(1). ratable basis reporting may be elected. regs. § 1.7361(b)(6). 141. but see irc § 341(a). under the passive loss rules of § 469, gain or loss from a sale of s stock is allocated among the corporation's various activities as if it had sold all of its assets. portfolio assets of the s corporation are treated as a single activity. if the shareholder's interest is completely terminated in a taxable event, all prior suspended passive activity losses , as well as any loss on the disposition, is freed from the constraints of § 469. 142. see irc § 1377(a)(2). also, if a shareholder disposes of 20% or more of the corporation's stock during a 30-day period, the corporation may elect to close the books as of the date of disposition for allocation purposes. regs. § 1.1368-1(g)(2). see also irc 19991 florida tax review the normal daily allocation of tax items applies, and the selling shareholder is allocated a pro rata share of income or loss for the entire year, based on the number of days such person owned stock. s corporations may engage in tax-free reorganizations pursuant to section 368. generally, s shareholders recognize no gain or loss on stock exchanges pursuant to a plan of reorganization.'43 this is perhaps the most striking difference between s corporations and llcs taxed as partnerships, which cannot be parties to a reorganization. b. limited liability companies.-gain or loss on a sale of an interest in an llc is usually capital gain or loss under section 741, but if the llc has unrealized receivables or inventory, a portion of the amount realized in the sale is allocated to the member's share of these assets, and this is treated by section 751 as received on a sale of property that is not a capital asset. the amount realized on the sale includes the cash and the value of other property received and the selling member's share of llc liabilities.144 the basis of the interest sold is adjusted for the member's distributive share of the llc's profit or loss for the year of sale.4 5 if the member's sale is of his or her entire interest, the llc's year closes on the date of sale. 46 installment sale reporting is not available to the extent of the selling member's share of llc assets that are not eligible for installment sale reporting. 47 for example, installment reporting is unavailable for the portion of the amount realized that is attributable to recapture amounts under section 1245 or section 1250. the purchaser of an llc interest has an initial basis for the interest equal to the sum of cost and an allocable share of llc liabilities. following a sale of an interest or a transfer at death, an llc, unlike an s corporation, may, under section 743(a), adjust the inside basis of its assets to reflect the outside basis of the new holder of the interest. 48 these adjustments provide substantial estate planning benefits for family businesses operated as llcs. § 1362(e)(6) (automatic termination of books where sale of 50% or more of stock occurs in s termination year). 143. see irc § 354(a)(1). 144. see irc § 752(d). 145. see regs. § 1.705-1(a)(1). 146. see irc § 706(c)(2)(a). if the member sells less than the entire interest, the varying interest rule of § 706(c)(2)(b) applies. 147. see irc § 453(i). 148. the adjustment may be made only if the partnership makes an election under § 754, which has future consequences for the llc and its members that should be considered before the election is made. [vol 4.3 benefits and burdens of subchapter s an llc, unlike an s corporation, may not be a party to a tax-free reorganization. 49 however, some partnership conversions are not taxable.' 0 m. where art thou subchapter s? the preceding comparison reveals several advantages of subchapter k over subchapter s, and some that s has over k, but the overall advantage lies with subchapter k, especially after the states' widespread adoption of llc legislation and the treasury's issuance of the ctb regulations. the question that must be asked, especially by one who has lived within the hybrid world of subchapter s for many years, both as a tax practitioner and commentator, is: why hasn't congress placed subchapter s on a level playing field with its passthrough siblings?'5 ' several reasons for this inequity are plausible. the continuing restrictions on subchapter s may reflect an anxious preoccupation by the treasury over the exodus from subchapter c to subchapter s that occurred in response to the 1986 repeal of the general utilities doctrine.5 2 the exodus from c to s directly impacted the balanced budget debate since any reform or liberalization of subchapter s, regardless of its merit, would be scored by the joint committee on taxation as losing revenue.' given that the treasury has arguably given the house away with the ctb regulations, it is paradoxical that statutory liberalizations of subchapter s are tightly restricted by budget considerations. this discrimination against s corporations was most noticeable during the process which led to congress' enactment of 17 "reforms" to subchapter s in 1996.'149. see irc § 1031(a)(2)(d) (nonrecognition rule of § 1031 does not apply to exchange of partnership interest). 150. see rev. rul. 84-52, 1984-1 c.b. 157. 151. see generally james s. eustice, subchapter s corporations and partnerships: a search for the passthrough paradigm (some preliminary proposals), 39 tax l rev. 345 (1984). 152. the decision in general utils. & operating co. v. helvering, 296 u.s. 200 (1935), is usually considered the genesis of the nile that a corporation recognized no gain or loss on distributions of property to its shareholders, including distributions in liquidation. the doctrine, after having been eroded by successive amendments to § 311(b), was repealed in 1986 by a further revision of § 311(b) and the enactment of the present § 336. see irc §§ 337(d) (authorizing legislative regulations to prevent circumvention of §§ 336, 1374): 1374 (built-in gains tax applicable to former c corporations for ten years after they elect s status). 153. the word "scored" refers to the revenue estimate made by staff economists with the joint committee on taxation. 154. the 1996 amendments were enacted by the small business jobs protection act of 1996, pub. l. no. 104-188, §§ 1301-1317(b), 110 stat. 1755, 1777-87 (1996). the subchapter s amendments originated in a bill introduced by senators danforth and pryor, s corporation reform act of 1993, s. 1690, 103d cong. for an extended discussion of the 19991 florida tax review one of the reforms most desired by tax professionals is a rule allowing an s corporation to issue plain vanilla preferred stock. the purpose of this reform was overwhelmingly benign. the one class of stock rule, which has been part of the subchapter s landscape since its enactment in 1958, restricts an s corporation from issuing more than one class of equity, with differences in voting rights being ignored. under the one class limitation, an individual advancing funds to a family s corporation may receive a distribution priority reflecting investment risk only if the contribution is booked as debt. intrafamily debt, even if subordinated, may limit the corporation's ability to raise additional capital in the form of either debt or equity. even if an intrafamily cash infusion is intended to be debt, it could be considered a disqualifying second class of stock if the obligation's terms and conditions, or its repayment, do not fall within the safe harbor for straight debt. 155 the one class of stock rule also unfairly restricts an s corporation's access to venture capital and more sophisticated forms of financing. commercial lenders, in addition to fixed payments of interest, frequently insist on receiving equity-like payments (kickers) as consideration for the risk they assume. often, a commercial lender will extend financing only if it receives a right to convert its debt into equity. no similar tax penalty applies to hybrid or equity-flavored debt of an entity taxable as a partnership. legislation permitting s corporations to issue preferred stock is long overdue. the justification sometimes offered for the one class rule-that it avoids income shifting and complex allocations of income and loss-has long been out of touch with business reality. the only rationale for the rule must be that an amendment allowing preferred stock would be scored as a revenue loser. "'56 a bill introduced by senators pryor and danforth in 1993, which contained several of the reforms enacted in 1996, would have allowed an s amendments, see generally jasper l. cummings & samuel p. starr, the impact of the new s corporation revisions, 85 j. tax'n 197 (oct. 1996). 155. section 1361(c)(5) defines straight debt as a (1) written instrument containing (2) an unconditional promised to pay on demand on date certain (3) in money, provided that (4) the interest rate and payment dates are not contingent on profits, the borrower's discretion, or similar factors, (5) the debt is not convertible, directly or indirectly, into stock of the debtor, and (6) the creditor is individual who is eligible to own s stock. a 1996 amendment relaxes the latter requirement by permitting a person who is actively and regularly engaged in the business of lending money to hold straight debt. see irc § 1361(c)(5)(iii) (enacted by p.l. 104-188, § 1304, 110. stat. 1755 (1996)). 156. corporations holding preferred stock of other corporations have long been allowed the deduction for dividends received for dividends on these investments. irc § 243; regs. § 1.1502-26. but see irc § 1059 (basis reduction for nontaxed portions of certain extraordinary dividends). [vol 4:3 benefits and burdens of subchapter s corporation to issue preferred stock that (1) is nonvoting, (2) is limited and preferred as to dividends, so as not participate in the corporation's growth, and (3) has redemption and liquidation rights not exceeding the issue price of the stock, plus a modest redemption or liquidation premium.'" under the bill, only persons eligible to hold s common stock could be preferred shareholders [or, ownership of qualifying preferred stock was not restricted to persons eligible to hold s common stock.] however, the preferred stock proposal was dropped from the legislation passed in 1996, a victim of negative scoring. juxtaposed against the one class of stock straightjacket, an unincorporated entity taxed as a partnership can issue multiple classes of equity interests, regardless of the holder's identity, without losing conduit tax stats.58 for example, a generous grandmother could receive a preferred interest in capital for her advance to an llc organized by her granddaughter, with the granddaughter holding the common or residual interest. 59 the venture capital lender can easily receive a hybrid interest or kicker in lending funds to a partnership, and debt instruments issued by partnerships may be convertible. one reform that survived the scoring process is a rule permitting s stock to be owned by a tax-exempt organization described in section 401(a) (qualified pension, profit sharing, and bonus plans) or section 501(c)(3) (charities)." ° however, a tax-exempt organization's allocable share of s income, and gain on its sale of s stock, is automatically classified as unrelated business taxable income (ubti) unless the organization is an employee stock ownership plan (esop).16 1 partnerships have always been allowed to have tax-exempt organizations as partners, and the ubti rule for them is less restrictive. a tax-exempt partner's distributive share of an item of partnership income is ubti only if it is income of a trade or business regularly carried on by the partnership that is unrelated to the organization's exempt purpose."l 2 a tax-exempt partner's share of partnership dividends, 157. see s corporation reform act of 1993, supra note 154. 158. special withholding rules apply to the distributive shares of foreign partners. see irc § 1446. 159. this structure may, however, raise estate and gift tax concerns, especially if distributions are not made regularly on the preferred interest. see irc §§ 2701(a), (d)(imputed transfer tax on cumulative unpaid distributions); see also jerald d. august, special transfer tax valuation rules for interests in family owned enterprises: the micro-surgery of chapter 14, in new york university-proceedings of the fifty-fourth institute on federal taxation § 31 (1996). 160. see irc § 1361(c)(6) (effective for taxable years beginning after 1997). 161. see irc § 512(e). the exception for esops was added in 1997, but it is effective as though it were included in the 1996 legislation. 162. see irc § 512(c). 1999] florida tax review interest, royalties, and capital gains thus is usually not ubti. in finally allowing s shareholders to make gifts of s stock to charity, why did congress make the rule for owners of s corporations more restrictive than that for partners? again, the assumed culprit must be the scoring process, which result comes at the expense of fairness. the slow pace of subchapter s reform stands in contrast with the process by which the ctb regulations dramatically altered partnership taxation. ironically, ctb, whose precursor was a series of rulings mapping the way for llcs to be characterized as partnerships, 63 came by administrative fiat and did not receive formal congressional approval. the logic behind the service's and treasury's largesse was presumably that since partnerships and llcs had already evaded subchapter c, generous allowance of partnership status to newly-organized entities would not directly reduce federal revenues. the contradictory treatment of s corporations and partnerships may be blamed upon the process by which the treasury is authorized to issue regulations under existing law for unincorporated pbfs, while the consensus building and deficit conscious processes of congress must apply to subchapter s reform. iv. evolution of subchapter s: why congress should further aid s corporations in enacting subchapter s in 1958, congress' conception of the profile of s investors was very restrictive." the first generation of s investors suffered from various organizational and operational handicaps. s corporations could not have more than 10 shareholders, could only issue one class of stock, and could not issue hybrid debt or debt to an ineligible shareholder without assuming substantial tax risk. since trusts were not permitted shareholders, s shareholders were severely restricted in achieving customary estate planning objectives, especially in planning for multi-generational ownership of s stock. congress apparently intended that more sophisticated incorporated businesses, possessing more complex organizational and capital structures and requiring more sophisticated estate planning, should be subject to the double tax regime of subchapter c, which, until 1986, reflected a strong tax bias in favor of liquidation strategies to avoid double taxation. in contrast, subchapter s was designed to be utilized only by small businesses, such as the corner grocery store, pharmacy, or closely-held accounting or law firm. the intent was to allow smaller businesses to incorporate but be taxed like partnerships, allowing passthrough of start-up 163. see supra text accompanying note 5. 164. s. rep. no. 1983, 85th cong., 2d sess. 87-89,216-26 (1958), reprinted in 1954 u.s.c.c.a.n. 4791, 4876-78, 5005-14 and 1958-3 c.b. 922, 1008-10, 1137-47. [vol 4:3 benefits and burdens of subchapter s losses and only one level of taxation once the business became profitable. the single class of stock limitation promoted administrative efficiency by avoiding complex allocation and assignment of income issues. given the initial landscape of subchapter s, it is surprising that congress did not impose an economic size limitation, based, for example, on gross assets or receipts.'" early rumblings of a size limitation on s corporations, at least for c corporations converting to s status, may now be heard.'" congress' first major changes, the subchapter s revision act of 1982, occurred after subchapter s had been on the books for 24 years. 67 they liberalized the eligibility rules, authorized nonvoting common stock, and introduced a safe harbor for straight debt. the rule permitting nonvoting common was long overdue because it presented no tax shifting or special allocation opportunities. the straight debt sale harbor allowed s corporations with less favorable debt-equity ratios to avoid a termination for having a second class of stock."es also, congress eliminated the sinister rule terminating s status retroactively to the beginning of the year in which a termination event occurred, substituting rules under which a termination takes effect not earlier than the date of the terminating event. 165. see, e.g., irc §§ 55(e)(1) (corporation with average annual gross receipts for preceding three years not exceeding $7.5 million exempt from corporate alternative minimum tax), 448(c) (average annual gross receipts ceiling for using cash method of accounting), 474(c) (permitting certain small businesses, based on gross receipts test used in § 448(c), to use simplified dollar value method of lifo accounting), 1202(d)(1) (special capital gains exclusion restricted to c corporations with gross assets not exceeding $50 million), 1244(c)(3) (limitation on ordinary loss treatment with respect to stock in small business corporation based on shareholder contributions), 2033a (federal estate taxation exclusion for family-owned business interests limited by dollar value). 166. president clinton, in his package of budget proposals issued on february 10, 1997, recommended that a c to s conversion be treated as a deemed liquidation if the corporation had a value exceeding $5 million at the time of the conversion. the proposal, which the administration later dropped, would have repealed the built-in gains tax for corporations subject to this rule. see jerald d. august, the proposed blockade of c to s conversions: the application of gunboat diplomacy to corporate taxation, 9 j. s corp. tax'n 107 (1997). 167. see subchapter s revision act of 1982, pub. l no. 97-354, § 1361, 96 star. 1669 (1982). many of the 1982 changes were recommended in staff of the joint committee on taxation: recommendations for simplification of tax rules relating to subchapter s corporations, 96th cong., 2d sess. (comm. print 1978). earlier, in 1969, the treasury proposed subchapter s reform. u.s. treasury dep't, technical explanation of treasury reform proposals: hearings before the house comm. on ways and means, 91st cong., 1st sess. 5228 (1969). the tax reform act of 1976 made minor fixes to subchapter s, most notably the rules permitting grantor trusts, voting trusts, and some testamentary trusts to be shareholders. 168. straight debt may, however, be equity for other purposes. see irc § 385. 1999] florida tax review the 1982 reforms substantially streamlined the distribution rules, replacing a byzantine set of distribution tiers, first separated into money versus property categories, in determining whether a distribution was a return of basis, a distribution in excess of basis, or a dividend from earnings and profits from c or even s years. 69 finally, losses in excess of a shareholder's stock and debt basis are not vaporized forever as under prior law, but may now be carried forward indefinitely, although they are not transferable and, until 1996, could not be used against gain from a sale of stock. the next wave of subchapter s legislation occurred in 1986. before 1986, a former c corporation was subject to a corporate tax on its capital gains in excess of $25,000 for the three years following a conversion to s status.' the tax was designed to prevent one-shot s elections in order to bail out large appreciated assets at a single round of capital gains tax. the bite of former section 1374 was not as strong as its bark.' the 1986 legislation repealed the general utilities doctrine, substituting rules requiring corporations to recognize gain on distributions of appreciated property to shareholders.'72 in order to prevent c to s conversions from being a means of avoiding general utilities repeal, a more imposing backstop than former section 1374 was needed. as revised in 1986, section 1374 imposes corporate tax on the built-in appreciation in corporate assets at the time of a c to s conversion if these assets are sold or otherwise 169. the 1982 revisions made it impossible for a corporation to have earnings and profits for an s year, and in 1996, congress allowed s corporations to eliminate earnings and profits accumulated in pre-1983 s years. see small business jobs protection act § 1311. 170. see irc § 1374 (before amendment in 1986). 171. the most common technique for circumventing former § 1374 was an installment sale providing for minimal, if any, principal payments during the three years following the conversion. a balloon payment in year four would not be subject to the corporate tax. this strategy was specifically stripped of its effectiveness shortly after enactment of the 1986 legislation. see announcement 86-128, 1986-51 i.r.b. 22. see jerald david august, the 'big' tax under section 1374: blocking the erosion of corporate level taxation in a post-general utilities world, parts i and ii, corporate tax and business planning review (march & april, 1996). 172. former § 337 permitted a corporation to avoid corporate gain on sales of capital and § 1231 assets, as well as bulk sales of inventory to a single buyer. in order to avoid corporate recognition, the corporation had to adopt a plan of liquidation and complete the sale and liquidation within one year. section 337 did not apply to recapture amounts or nonqualifying sales of inventory. shareholder nonrecognition was possible under § 333, under which a shareholder's gain on liquidation was limited to a ratable share of corporate earnings and profits, which was taxed as ordinary income. the § 333 liquidation required some fancy dancing since all distributions in liquidation had to be made within one calendar month. sections 333 and 337 could not be used in tandem. see george k. yin, taxing corporate liquidations (and related matters) after the tax reform act of 1986, 42 tax. l. rev. 573 (1987). [vol 4:3 benefits and burdens of subchapter s disposed of during the subsequent ten years.' section 1374, as amended in 1986, is designed to tax appreciation accrued before the effective date of the conversion." although trapping accrued c gains for ten years may seem to be an appropriate policy, the revision of section 1374 added complexity and cost (e.g., need for appraisals, difficult burden of proof issues on whether gain accrued before or after conversion), and it has the added detriment of forced double taxation. built-in gains are taxed at the maximum corporate rate and are then passed through to the shareholders for inclusion on their individual returns. the tax is allocated among the shareholders, who may deduct their shares as a loss.7 in contrast, if the corporation had remained a c corporation, shareholder-level tax would be imposed only if and when the corporation distributed the net proceeds of the asset sale as dividends. since the amount taxable under §1374 may not exceed the corporation's entire taxable income for the year,7 6 the tax may be reduced or avoided by planning deductible expenditures for the year of sale, but if net built-in gain year exceeds taxable income for the year, the excess is carried forward as built-in gain for the following year.'" the service further closed the door on installment sale transactions designed to circumvent the corporate tax, including installment sales entered into before the conversion. 78 the revised section 1374 has been criticized by practitioners and commentators as imposing too severe a price for converting from c to s. most troublesome is the ten-year window of continued corporate tax on pre173. other roadblocks to c to s conversion strategies are the tax on excess passive investment income under § 1375 and corresponding termination rule under § 1362(d)(3)(a), and the lifo recapture rule of § 1363(d), although no recapture of business credits arises by virtue of the election. see irc § 1371(d)(1). other consequences of a conversion are loss of fringe benefit exclusions for more than 2% shareholders, a proscription against qualified retirement plans making loans to participant-shareholders, loss limitation rules at the shareholder level, the inability to use carryovers from c years except in computing the built-in gains tax, and application of the at-risk and passive activity loss rules at the shareholder level. moreover, the corporation must account for its aaa. 174. some corporations that converted to s status after 1986 but before 1988 were granted transitional relief based on the value of the corporation on august 1. 1986, generally resulting in full or partial use of former § 1374. see regs. § 1.1374-ia; rev. rul. 86-141, 1986-2 c.b. 151, modified by notice 88-134, 1988-2 c.b. 559; priv. ltr. rul 92-18-019 (jan. 23, 1992). 175. see irc § 1366(0(2). the character of the loss is determined by allocating net gain proportionately among the recognized built-in gains. see id. 176. see irc § 1374(d)(2). 177. irc § 1374(d)(2)(b) (applicable to corporations that filed s elections after march 30, 1988). 178. see regs. § 1.13744(h)(1); notice 90-27, 1990-1 c.b. 336; see also irc § 337(d); regs. § 1.1374-9 (anti-stuffing rules). 19991 florida tax review conversion appreciation. on the other hand, the features of the section 1374 tax may reflect the treasury's concern about the number of c to s conversions resulting from the 1986 changes and the expected revenue drain from the exodus out of subchapter c.179 after 1986, the service and the treasury wanted dam the flood of c to s conversions even further, perhaps because the number of c to s conversions that would occur as a result of the 1986 legislation had been underestimated. the tool selected was regulations under the one class of stock rule. the case law under this rule had been generally favorable to s corporations and their shareholders.' the first set of proposed regulations under a revised one class of stock rule, issued in october, 1991,18! may fairly be described as draconian and strayed well beyond the legislative history of the purpose of the one class of stock limitation.8 2 for example, all debt not qualifying for the straight debt safe harbor was automatically recharacterized as a second class of stock.'83 a nonconforming distribution rule would have raised the specter of a second class of stock whenever any economic benefit flowed from the corporation to shareholders disproportionately with stock ownership." under this rule, actual and constructive distributions, compensation, fringe benefits, and numerous other types of payments would have had to have been analyzed closely. this nonconforming distribution rule had all the characteristics of an interrorum provision. its policy objectives were greatly exceeded by the applicable sanction of a termination. in-the-money options were also targeted for second class of stock treatment. the regulations were to be given retroactive application. in addition to the other defects evident in the proposed regulations, this last feature caught the attention of senator david pryor, former chairman of the senate oversight subcommittee of the senate finance committee, who labeled this provision a "dirty trick" on small and family owned business.8 5 179. see generally, nelson, supra note 28. 180. see portage plastics co. v. united states, 486 f.2d 632 (7th cir. 1973); amory cotton oil co. v. united states, 468 f.2d 1046 (5th cir. 1972); stinnett v. commissioner, 54 t.c. 221 (1970); gamman v. commissioner, 46 t.c. 1 (1966). 181. see one class of stock requirement, 55 fed. reg. 40,870 (1990), reprinted in ps-4-83, 1990-2 c.b. 864. 182. see jerald d. august, editor's comment: the subchapter s termination act? 3 j. s corp. tax'n 53 (1991). 183. see one class of stock requirement, 55 fed. reg. at 40,873 (former prop. regs. § 1.1361-1(l)(3)(ii)), reprinted in ps-4-73, 1991-2 c.b. 1092. 184. see id. (former prop. regs. § 1.1361-1(o)(2)(ii)). 185. see 137 cong. rec. s1852-02 (daily ed. feb. 7, 1991) (statement of senator pryor). in response to sharp criticism voiced from the professional community, as well as from senators pryor and bumpers, the service later announced that the proposed regulations would [vol 4:3 benefits and burdens of subchapter s retreating from the criticism and controversy generated by its initial proposals, the service issued new proposed regulations, completely replacing the first set.1 6 the final regulations, issued in may 1992, were much softer and gentler and generally were well received by the professional community.' the one class of stock regulation project, which was a public relations debacle for the service and the treasury, fostered a belief among tax professionals and the business community that subchapter s was in need of assistance. statutory revisions to subchapter s were proposed in 1993 by senators pryor and danforth,s which included the following: 1. increase the maximum number of shareholders to 75; 2. provide family attribution for shareholder counting; 3. permit exempt organizations to be s shareholders; 4. allow nonresident alien shareholders, and extend the partnership withholding rules of section 1446 to foreign s shareholders;189 5. allow discretionary trusts to own s stock; 6. permit s corporations to issue simple preferred stock; 7. permit financial institutions to hold safe harbor debt, and permit some convertible debt to be safe harbor debt; only apply prospectively. a proposed legislative override was introduced. tax simplification bill of 1991, h.r. 2777, s. 1394, 102d cong., § 401 (1991). a few of the articles on the proposed regulations include richard d. blau & bruce n. lemons, s corps. may face retroactive terminations under prop. regs. on single class of stock. 74 j. tax'n 24 (1991); jack s. levin & philip a. stoffregen, new "s" second-class of stock proposed regulation-a gigantic trap, 50 tax notes 641 (feb. 11, 1991); richard m. lipton, the proposed one class of stock regulations: a first class problem, 49 tax notes 695 (nov. 5, 1990). this author suggested that the proposed regulations, if finalized, would effectively cause the death of subchapter s. see august, supra note 182. 186. see one class of stock requirement, 56 fed. reg. 38.392 (1991), reprinted in ps-4-73, 1991-2 c.b. 1092. 187. see t.d. 8419, 1992-2 c.b. 217; robert cassanos, subchapter s: living with the new one class of stock regulations and other limitations on stock ownership, in new york university-proceedings of the fiftieth institute on federal taxation § 5-1 (1992); scott n. carlson, one class graduates: final regulations define one-class-of-stock requirement, 4 j. s corp. tax'n 241 (1993). 188. see s corporation reform act of 1993, supra note 154. 189. this recommendation was made to conform to treaty nondiscrimination requirements. see, e.g., convention between the government of the united states of america and the united kingdom of great britain and northern ireland for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, dec. 31, 1975, art. 24, 5, 31 u.s.t. 5668, 5687. 1999] florida tax review 8. extend inadvertent termination relief to inadvertent defective elections; 9. repeal the entity-level audit rules for s corporations; 10. repeal the rule making the presence of excess passive investment income for three years a termination event; 11. allow s corporations to have subsidiaries, including a wholly owned subsidiaries; 12. conform the basis adjustments for losses and distributions to the partnership rules of section 705; 13. broaden the application of subchapter c to s corporations; 1 90 14. eliminate pre-1983 earnings and profits from s years; 15. apply the c corporation rules for fringe benefit purposes; 9 and 16. permit ordinary losses to the extent of a shareholder's "ordinary income basis" for distributions in complete liquidation. after these proposals wound their way through congressional processes for several years, congress, in 1996, enacted several subchapter s reforms, which were significantly watered down from those of pryor-danforth bill. 192 190. in gen. couns. mem. 39,768 (dec. 1, 1988), the service acknowledged that § 1371(a)(2)-which until its repeal in 1996 required that an s corporation, as shareholder of another corporation, "be treated as an individual"-did not prevent an s corporation from being a party to a tax-free reorganization or division. however, in priv. ltr. rul. 88-18-049 (feb. 10, 1988), the service ruled that an s corporation could not make a qualified purchase of a target corporation's stock under § 338 or liquidate a controlled subsidiary under §§ 337 and 332. the service later changed its position, allowing a qualified stock purchase by an s corporation if the controlled subsidiary was immediately liquidated. tech. adv. mem. 92-45004 (july 28, 1992). see generally jerald d. august, taxable stock acquisitions by s corporations: technical advice memorandum 9245004 permits use of sections 332 and 338, 5 j. s corp. tax'n 203 (1994); seth m. zachary & philip r. weingold, stock acquisitions and liquidations by s corporations: availability of benefits afforded by sections 332 and 338, 20 j. corp. tax'n 211 (1993). see also jerald d. august, integration of subchapter c with subchapter s after the subchapter s revision act, 37 fla. l. rev. 491 (1985). 191. this proposal would have repealed § 1372, which requires s corporation's shareholders who are more than 2% shareholders to be treated as partners in a partnership for employee fringe benefit purposes. for the consequences of such treatment, see irc § 162(l)(5). 192. pub. l. no. 104-188, 110 stat. 1755 (1996). see jerald david august, s corporations: new law liberalizes s corporation provisions, 14 j. partnership tax'n 50 (1997); steven r. looney, miscellaneous s corporation changes made by the small business job protection act of 1996, 8 j. corp. tax'n 346 (1997); joel h. sharp, jr. & hewitt b. shaw, jr., subchapter s reform: the small business job protection act of 1996, 24 j. corp. tax'n 3 (1997). [vol. 4:3 benefits and burdens of subchapter s the most beneficial of the reforms is new section 1361(b)(3), which allows an s corporation to elect to treat a wholly-owned subsidiary as a division or branch for federal tax purposes. 193 a "qualified subchapter s subsidiary" (qsub) is thus included in the s corporation's conduit system, even though it is a separate legal entity under state law. an s corporation can also hold an uninterrupted chain of qsubs.' the qsub thus resembles the tax nothing construct of the ctb regulations for conduit entities with only one owner. a related provision of the 1996 legislation repealed the rule that formerly barred an s corporation from owning 80% or more of the voting and value of an issued stock of a c corporation. 95 the qsub rule allows a segregation of assets and liabilities among various lines of business and reduces the administrative complexities and inefficiencies of multiple brother-sister s affiliates. since an s corporation can now own any percentage of stock of a c corporation, or immediately elect qsub status where it acquires all of the stock of a target, it will no longer be required to immediately liquidate an acquired corporation to preserve s status. the second most notable change among the 1996 revisions is the provision for electing small business trusts (esbts).'96 added to the list of trusts that may own s stock, the esbt fulfills the wishes of many estate planners to allow accumulation or discretionary (nongrantor) trusts to be s shareholders. until 1996, a trust could own s stock only if it was a grantor 193. the requirements of a qsub are that it must be (1) a domestic corporation (2) that is not an "ineligible corporation" (a financial institution using the reserve method of accounting for bad debts, an insurance company taxed under subchapter l, a § 936 corporation, or a disc or former disc), (3) 100% of the stock of which is owned by the s corporation parent, and (4) which the s corporation elects to treat as a qsub. see prop. regs. §§ 1.1361-2 to -5; notice 97-4, 1997-1 c.b. 351 (qsub election filed on form 966). the qsub has its roots in reit provisions allowing qualified reit subsidiaries. see irc § 856(i). see generally, jerald d. august et al., a planning guide to the proposed regulations on qualified subchapter s subsidiaries, supra note 54; jerald d. august, the new world of controlled subsidiaries under subehapter s, 9 j. s corp. tax'n 3 (1997); bryan p. collins et al., qualified subchapter s subsidiaries: a tax planning guide to the new law, 9 j. s corp. tax'n 219 (1998). 194. see staff of joint comm. on tax'n, 104th cong., 2d sess., general explanation of tax legislation enacted in the 104th congress 120 (comm. print 1996). although the general explanation is not official legislative history, it indicates congressional intent as to a particular provision. arguably, the statutory language adequately supports this conclusion without assistance from legislative history. 195. this provision was § 1361(b)(2) (before amendment by p.l 104-188, § 1308(a), 110 stat. 1755, 1782 (1996)). 196. see irc § 1361(c)(2)(a)(v). in order to qualify as an esbt (1) all beneficiaries of the trust must be individuals eligible to own s stock, estates, or charitable organizations, (2) no interest in the trust may have been acquired by "purchase,"and (3) an election must be made by the trustee as prescribed in the regulations. see irc § 1361(e)(1). 1999] florida tax review trust, held the stock for only a short period after the death of the grantor, or was a "qualified subchapter s trust" (generally, a simple trust with only one beneficiary, who elects to be taxed on all of the trust's income). 7 the peculiar feature of the esbt rules is the treatment of the portion of the trust consisting of s stock as a separate taxpayer with respect to its allocable share of subchapter s income. 9 ' an esbt is taxed on its s income at the maximum rate of tax on individuals, subject to the special rates for net capital gain. trust distributions from s income are nontaxable to the beneficiaries and nondeductible by the trust. the normal rules of subchapter j, including carryovers and excess deductions in the trust's final taxable year,'99 apply to the trust's other income and deduction. the treasury presumably endorsed the esbt model because tax could be charged and collected from a single source-the trust. if subchapter j had applied to the accumulation trust and shareholder, the trust could have allocated the incidence of tax between the trust and the beneficiary in order to minimizing tax.2'0 by taxing the esbt's share of s income at the highest individual rate, the rules eliminate all bracket shifting opportunities. the design and effect of esbts bear a striking resemblance to the "comprehensive business income tax" (cbi proposed by the treasury in its corporate integration study of 1992.0! the cbit regime, which would apply to all businesses regardless of size or form of organizational, would impose an entity level tax on its taxable income, computed without deductions for interest expense and whether the income was distributed or not, and distributions and interest payments would be exempt from tax to the owners and creditors. a major goal of the cbit is to remove the bias in favor of debt over equity under current law under subchapter c. 197. see irc § 1361(c)(2)(a). for the definition of qualified subchapter s trust, see § 1361(d). 198. see irc § 641(d). each potential current beneficiary of the trust is counted as one shareholder for purposes of the 75-shareholder ceiling; if there are no potential current beneficiaries, the trust is treated as the shareholder. see jerald d. august, recent regulations clarify use of qssts in estate planning, 23 es. plan. 102 (1996). 199. see irc § 642(h). 200. see irc §§ 661-663 (distribution deductions for accumulation trusts); §§ 665668 (excess accumulation distributions). see generally m. carr ferguson et al., federal income taxation of estates, trusts, and beneficiaries (2d ed. 1997). 201. dep't of the treasury, report on integration of the individual and corporate tax systems: taxing business income once (1992). see also alvin c. warren, jr., reporter's study of corporate integration, integration of the individual and corporate income taxes, 1993 a.l.i. income tax project (1993). for analysis of the treasury and ali studies, see michael l. schler, taxing corporate income once (or hopefully not at all): a practitioner's comparison of the treasury and ali integration models, 47 tax l. rev. 509 (1992); george k. yin, corporate tax integration and the search for the pragmatic ideal, 47 tax l. rev. 431 (1992). [vol, 4:3 benefits and burdens of subchapter s v. why not repeal subchapter s? after 40 years of subchapter s, especially after the ctb regulations and the wide use of llcs and llps, the obvious question is whether we really need it? while many traps for the unwary were removed in 1982 and 1996, subchapter s continues to be plagued by eligibility and operational impediments. these restrictions make the llc and its partnership siblings better passthrough vehicles for business and investment activities. since state law no longer determines an unincorporated entity's tax status, why not simplify the taxation of all passthrough entities into one regime? indeed, the conduit rules of subchapter k offer far greater structural and transactional flexibility, with the exception of an inability to engage in tax-free reorganizations, and also offer more income deferral techniques than subchapter s. moreover, in not providing subchapter s corporations with the same organizational flexibility as partnerships-by, for example, prohibiting nonresident alien shareholders and preferred stock-congress has restricted s corporations and their shareholders in their access to capital. although these defects may sometimes be avoided by using a joint venture including one or more s corporations, this structure results in greater transactional and compliance costs and rewards the more sophisticated business owners over the less sophisticated. ideally, subchapter k should be the paradigm passthrough model for all private business firms. in a world without subchapter s, business entities might be grouped into two categories, entities with ownership interests readily tradeable on established securities markets and all other business entities.' publicly traded enterprises would always be taxed as c corporation, as under current law, while all nonpublicly traded business enterprises would be taxed as partnerships under subchapter k. although this simplification of the taxation of business entities has broad conceptual appeal, it could be considered seriously only if very liberal transitional rules were enacted to reduce the tax cost of converting from c to k or s to k status. a. conversions to subchapter s or subchapter k: the practical barriers the tax cost of converting a c corporation to a partnership is often very high because the conversion is treated as a corporate liquidation, causing the corporation to be taxed on unrealized gains in its assets and the 202. see rev. rul. 77-220, 1977-1 c.b. 263, revoked by rev. rul. 94-43, 1994-2 c.b. 198; see regs. § 1.701-2(d) ex. 2. 203. this was the baseline proposal in a draft of an ali study on passthrough entities. see george k. yin & david j. shakow, memorandum no. 3, taxation of private business enterprises, 1997 a.l.i. fed. income tax project (1997). 19991 florida tax review shareholders to be taxed on the gains on their shareholdings." the combined effective federal rate may be as high as 48% (corporate tax of 35%, plus shareholder capital gains tax of 20% of 65%). including state taxes, the tax cost of a liquidation can exceed 60%. because of this lock-in problem, unincorporated business enterprises that have always been subject to subchapter k enjoy a competitive advantage over incorporated firms. the older the corporation, the greater the possibility that it has a successful track record, producing substantial appreciation in intangibles, including goodwill and going concern value, or assets such as improved real estate. this lockedin aspect of operating a veteran business in corporate solution hits hardest and most inequitably on owners of closely held corporations. the only viable escape route is to convert to subchapter s. but as mentioned, this path is often littered with formidable obstacles, including recapture of the spread between lifo and fifo inventory, the ten-year application of section 1374, or the tax on excess passive investment income. eligibility restrictions must also be satisfied, perhaps requiring preconversion redemption of an ineligible shareholder or repayment of hybrid debt. the cost associated with a c to s conversion is frequently too high. sophisticated planning techniques have been offered to move around these handicaps. for example, a corporation, c or s, faced with double taxation but hoping to benefit from subchapter k, can contribute one or more lines of its business to an llc or lp whose remaining equity interests are held by shareholders.2 5 the corporation receives back a preferred interest with a reasonable redemption privilege, while the shareholder-partners receive common interests and are allocated the growth.2" 6 the partnership contribution transfer is generally nontaxable,2" although section 704(c) precludes shifting precontribution gains and losses away from the contributing partner. overall, the plan should not be vulnerable under the partnership antiabuse rules.20 another method for mitigating the second round of taxation is to find a deductible source for making cash payments to shareholders, such as 204. irc §§ 331(a), 336(a). section 336(d) sets forth exceptions to loss recognition, including anti-stuffing rules. 205. frequently such transactions are partially motivated by estate planning concerns, such as making gifts of the limited partnership or llc member interests to trusts for the benefit of children or grandchildren. there is also the sweetener of a § 754 election to step-up the value of any retained partnership interests included in the estate of a deceased partner (and shareholder). donative transfers of partnership interests must also be placed under the lens of the family partnership rules of § 704(e). 206. for controlled family entities, the chapter 14 quartet of valuation rules for transfer tax purposes must be consulted. 207. see irc § 721(a). but see irc §§ 707(c), 731, 751(b). 208. see regs. § 1.701-2. [vol. 4.3 benefits and burdens of subchapter s bonuses, deferred compensation, or the leasing of real or personal property.2' a third option is to sell the corporation's assets to an llc or lp comprised of the shareholders. the transaction may be structured as an installment sale in order to defer the corporate tax, but the parties' expectations are often frustrated by various statutory tools available to the service.10 a more daring and risky approach is to form a new entity as an llc or lp and shift future business opportunities to it while phasing down the corporation's business operations. the latter technique is burdened by a risk that the steps will be collapsed and treated as a deemed distribution of intangibles to the shareholders."' notwithstanding the possible methods for limiting the impact of double taxation prospectively, one may ponder why subchapter s has not been given equal treatment with partnerships. moreover, if all pbfs are to be taxed under subchapter k, a c to k or s to k conversion should be allowed at a reasonable cost. such cost should not be a full round of double taxation, which may approach or exceed 50% of the value of its equity. b. further reforms to subchapter s until we adopt a single system of taxation for private business enterprises, which, as suggested above, should carry with it liberal transitional relief for owners of c and s corporations, the disadvantages that s corporations face versus their partnership counterparts should be alleviated. five reforms are suggested below that would produce a more equitable system of passthrough taxation for owners of incorporated and unincorporated pbfs. 1. reform i: allow nonresident aliens to be shareholders of an s corporation.--given our global economy and existing structure of permitting nonresidents to be partners in partnerships, subject to applicable withholding 209. in order to be deductible, such payments must be ordinary and necessary and reasonable in amount. see irc § 162(a); see also irc §§ 263, 263a. 210. see irc § 56(c) (corporate alternative minimum tax on increase in adjusted earnings and profits); § 168(f)(5) (antichuming rule for depreciation); § 197(f)(9) (antichurning rule for intangibles amortization); § 304(a)(1) (purchase of stock by related corporation taxable as a dividend); § 312(n)(5) (installment sale gain included in earnings and profits for year of sale); 368(a)(1)(f) (mere change in identity, form, or place of organization of one corporation is a reorganization); § 446(b) (service's power to require adjustments to clearly reflect income); § 453(e) (acceleration of installment obligation on second disposition of purchased property by related person-buyer); § 453(g) (denial of installment sale treatment of depreciable property by related persons unless tax avoidance is not one of the principal purposes of the transaction); § 482 (reallocation of items between commonly controlled trades or businesses); § 1239(a) (recharacterization of gain from any depreciable asset as ordinary). 211. see gregory v. helvering, 293 u.s. 465 (1935). 19991 florida tax review under section 1446, it is long overdue that nonresident aliens should be entitled to own stock interests in an s corporation.21 2. reform ii: allow an s corporation to issue plain vanilla preferred stock.-to reduce a major advantage of partnerships over s corporations, an s corporation should be permitted to issued preferred stock closely resembling debt without terminating its s status.2" 3 this preferred stock should be required to be (1) nonvoting, (2) limited and preferred as to dividends, (3) not participating in corporate growth to any significant extent, and (4) entitled to redemption and liquidation rights not in excess of the issue price plus a reasonable redemption or liquidation premium. the preferred shareholders would not be treated as shareholders and could be persons otherwise ineligible to own the s stock. unless made in redemption, distributions on the preferred stock would be treated as interest income of the holder and deductible to the corporation when paid. this last feature would remove potential allocation and timing problems. 3. reform mi. further expansion of straight debt.-since 1996, straight debt, as defined under section 1361(d), can be held by any individual (other than a nonresident alien), an estate or trust that is permitted to be an s shareholder, or a person actively and regularly engaged in the business of lending money. based on reform i, which would permit nonresident aliens to be s shareholders, the straight debt safe harbor should also opened to nonresident aliens. also, convertible debt cannot presently qualify as safe harbor debt. this impedes an s corporation's ability to obtain venture capital and other forms of financing available to other passthrough entities." 4 the proscription on the convertibility of straight debt should be lifted in instances where the convertible feature is held by a person that is actively and regularly engaged in the business of lending money and is issued in connection with a commercially reasonable loan to the corporation. 212. for a discussion of the existing limitations, see supra text accompanying notes 29-34. 213. see supra text accompanying notes 155-156. 214. convertible debt may be a prohibited second class of stock if (1) the instrument is equity under general principles of federal tax law and a principal purpose of issuing the instrument is to circumvent the rights to distribution or liquidation proceeds conferred by the outstanding stock or to circumvent the limitation on eligible shareholders, or (2) the convertible debt contains rights equivalent to an in the money call option. regs. §§ 1.1361-1(/(4)(iv). however, a call option is not a second class of stock if it is issued to a person that is actively and regularly engaged in the business of lending and issued in connection with a commercially reasonable loan to the corporation. regs. § 1.13611 (!)(4)(iii)(b). [vol 4:3 benefits and burdens of subchapter s 4. reform iv: repeal termination rule for excess passive investment income.-section 1362(d)(3) terminates an s corporation's election if it has c earnings and profits and receives excess passive investment income for three consecutive s years. the tax on passive investment income under section 1375 is a sufficient sanction for passive corporations seeking to convert from c to s status. the termination rule should be repealed. 5. reform v: repeal section 752 for partnerships.-an s shareholder has basis only to the extent that he or she has made an "actual economic outlay."2 ' under section 1366(d), an s shareholder's pro rata share of corporate losses is deductible only to the extent of the shareholder's basis in stock and debt. in contrast, partners are able to include their shares of partnership indebtedness in the bases of their partnership interests. normally, partners share partnership liabilities according to their economic exposure to the liabilities, but if no partner is personally liable for the repayment of a partnership obligation, the liability is shared by all partners, including limited partners or llc members, in proportion to their profit shares."16 other than historical precedent, which is rooted in the aggregate theory of partnership taxation, there is no persuasive justification for permitting partners to increase basis for entity level debt. any rationale that might be offered becomes tenuous as applied to nonrecourse debt. in most instances, owners of a closely-held business enterprise must personally guaranty financing to the business. such guarantees do not increase basis of s shareholders, but the guaranteed debt is included in partner basis. partner basis benefit also facilitates tax-free distribution of cash flow to the partners. a partner's ability to receive tax-free distributions of funds from refinancings and to deduct depreciation on debt-financed property is unavailable to s shareholders. partners should not be allowed to increase basis for nonrecourse debt. were congress to repeal the partnership debt rules, consideration could also be given to repealing the at risk and passive activity loss limitations of sections 465 and 469.217 215. raynor v. commissioner, 50 t.c. 762 (1968). but see selfe v. united states, 778 f.2d 769 (11th cir. 1985). 216. see regs. § 1.752-1. 217. it was always difficult for this author to understand why an investor was not permitted under § 469 to deduct losses to the extent of cash invested, simply because the investor did not actively participate in the venture. the repeal of § 752 might persuade congress that it overshot the mark in enacting § 469. 19991 florida tax review vi. moving towards a single regime of taxing private business enterprises professor yin, in his excellent article published in this issue, endorses the concept that all pbfs, regardless of organizational form and state law characteristics, should be taxed as partnerships under a two track elective system.18 under his proposals, the present complex partnership provisions would continue to apply to most pbfs, but some (spbfs) would be eligible to elect a second, simplified system, which would be available only if all of the entity's owners were eligible to own stock under present s rules. under the spbf system, allocations of income and deduction would generally be in proportion to the owners' percentage interests. preferred interests, which would have varying priorities as to repayment and claims on assets, would be permitted under a cash method system of income to the payee and income reduction to the payor. the present liability rules under section 752 would apply. contributions to an spbf would be handled similarly to the treatment under section 351, except that there would be no control requirement. section 704(c) would not apply to spbfs, removing much complexity. spbf owners would recognize gain on nonliquidating distributions to the extent that the value of the distribution (including cash) exceeds the basis of the distributee's ownership interest, but no loss would be recognized. a liquidating distribution would be treated as a sale or exchange of the ownership interest. the entity would recognize gain on distributing appreciated property unless the distribution effected a "mere change in form," as such phrase would be defined, subject to an election out. entity recognition of gain on distributions in kind would render unnecessary numerous antishifting rules of subchapter k. the collapsible asset rules of section 751 and section 341 would not apply to spbfs. section 754 is also outside of the spbf system. the idea of taxing all pbfs under a single tax system has strong appeal. it recognizes that present law imposes unfair burdens and detriments on corporations and their shareholders. the earnings of a c corporation are potentially subject to double taxation, and a c corporation pbf is thus faced with trying to avoid a second round of taxation. the subchapter s restrictions and c to s conversion problems strongly advantage the partnership over s status. so, should all pbf's be taxed as partnerships? professor yin answers this question in the affirmative, but he proposes a two track system-keeping subchapter k in place for pbfs while allowing some pbfs to elect a simplified version of subchapter k. 218. see generally yin, supra note 1. [vol 4.3 benefits and burdens of subchapter s this author believes that all pbfs should be taxed under a single system. a two-system partnership world retains the complexity of present law, needlessly interjects elective rules, and would produce a new set of imponderables. particularly troublesome would be electing-in and electing-out strategies and outcomes for pbfs that are advantaged by moving back and forth from the more complex default system. the two system proposal does recognize, however, that the present law governing the taxation of partnerships is strongly favored by many sectors of our business and investment communities. the ability to make special allocations and have debt, even nonrecourse debt, reflected in outside basis are significant factors in the use of partnerships. however, the complexity of the partnership rules, especially in tracking and adjusting capital accounts, detracts from its usefulness as the passthrough paradigm for all pbfs. in many instances, highly sophisticated tax professionals disagree on the proper treatment under present law of special allocations, gain chargebacks, negative capital accounts, and the application of section 704(c), producing much uncertainty and potential for abuse. many provisions of subchapter k are frequently overlooked or ignored. decisions on proper tax reporting are often made subjectively, based on an accountant's sense of fairness or equity. subchapter k, despite its flexibility, is too complicated, and it should be streamlined as far as it can be without significantly compromising the basic goal of taxing entity income to its beneficial owner. these simplifications should include, for example, disallowing special allocations, removing nonrecourse debt from outside basis, and taxing nonliquidating distributions of appreciated property. this author's preference is to select the entity, not the individual investor, as the proper taxpayer for pbfs. although an entity tax does not directly fall on the beneficial owner of the income, it is imposed on the person that realizes the profits. the treasury's cbit model, with the basis add-on drip, is a good alternative. it is administratively manageable because compliance and audit issues would be resolved at the entity level. how does subchapter s fit within the pbf debate? those who do not favor the cbit proposal can agree that subchapter s taxes the right person-the shareholder. subchapter s is less flexible than subchapter k, but it is much simpler and straightforward. it does not permit special allocations. it does not suffer from byzantine rules for maintaining capital accounts. it properly differentiates between owner debt and entity debt. unlike a partnership, an s corporation can be a party to a tax-free reorganization. if subchapter s were to apply to unincorporated pbfs, the reorganization rules could be extended to encompass them. a super subchapter s, which removes many of the present restrictions on owner eligibility and permits the issuance of simple preferred stock, could satisfy the objectives of entity parity, 1999] 338 florida tax review ivol 4:3 fairness, and simplification and be a far superior means of conduit taxation than present law. florida tax review volume 5 2002 number 6 the good, the bad, and the ugly in post-drye tax lien analysis steve r. johnson* 1. introducton ...................................... 417 ii. tax lien analysis after drye ....................... 419 a. facts of drye ................................. 419 b. teaching ofdrye .............................. 420 1. roles of state and federal law in defining property .............................. 420 2. criteria or elements of property ........... 421 3. law governing post-lien attachment issues .. 424 it. change or clarification? ......................... 425 a. second and third aspects ....................... 425 b. first aspect .................................. 426 1. pre-drye history ....................... 427 2. evaluation ............................. 430 3. tenacity of the old, wrong understanding ... 431 iv. the good ......................................... 433 a. federal law versus state law in defining property .. 433 b. contents of federal definition of property .......... 435 c. post-lien attachment consequences ............... 437 v. thebad ........................................... 439 a. background .................................. 440 1. tenancy by the entireties generally ........ 440 2. application to federal tax lien ............ 442 b. green ....................................... 443 c. craft ........................................ 445 1. facts and opinions ...................... 445 2. evaluation ............................. 449 a. embracing nature of section 6321 ... 449 b. irrelevance of state characterizations 451 vi. the ugly .......................................... 452 a. verbally imprecise cases ....................... 452 1. stage two issue ........................ 456 2. stage three issue ....................... 457 b. analytically wrong cases ....................... 457 1. land sale contracts ..................... 457 * professor oflaw, william s. boyd school oflaw, university ofnevada, las vegas. ba., st. francis college; j.d., new york university. 416 florida tax review [vol. 5:6 2. nominee liens ......................... 460 a. error as to stages one and three .... 461 b. error as to stage two ............. 462 vii. conclusion ....................................... 464 the good, the bad, and the ugly i. introduct[on the general federal tax lien1 attaches to "all property and rights to property, whether real or personal" which belong to the delinquent taxpayer.in most cases in which the irs takes enforced collection action based on its lien, there is little doubt that the property the irs is pursuing constitutes "property [or] rights to property." the easiest cases, of course, are those in which the tax delinquent is the fee simple owner of realty or personalty. the irs typically goes after such assets first because the tax lien obviously attaches to them and they are relatively easy to convert into cash to pay the liability. if such assets are unavailable or have been exhausted, the irs may pursue items involving less than fee simple ownership. as it does so, the question may arise whether the items constitute property or property rights. the supreme court has repeatedly stressed that the language of section 6321 "is broad and reveals on its face that congress meant to reach every interest in property a taxpayer might have. 3 despite this expansive construction, controversies as to the reach of the general lien are perennial. whether a given interest constitutes "property [or] rights to property" for section 6321 purposes has been litigated in hundreds of cases. the most challenging of these controversies involve one or more of three situations. first, the taxpayer's interest may not yet have ripened (and may never ripen) into full possession or control of the underlying property. a continuum exists from mere hope, to expectancy, to contingent interest, to present possessory interest. second, the taxpayer's interest may be shared with others. it may be undivided not individual, joint not single, or fractional. third, restrictions may exist, under the instrument governing the property or under state law, on the taxpayer's ability to use or dispose of the property or on the ability of the taxpayer's creditors to reach the property or the taxpayer's interest in it. the more the taxpayer's interest diverges from fee simple ownership, because of one or more of these situations, the more likely is an argument that the tax lien does not attach to the interest because it is not "property [or] rights to property." 1. the general lien authorized by irc § 6321 is by far the most important tax lien. special federal tax liens also exist as to estate taxes, see irc §§ 6324(a), 6324a and 6324b, gift taxes, see irc § 6324(b), and taxes on distilled spirits, see irc § 5004. 2. irc § 6321. this lien arises upon assessment of the tax by the irs (followed by notice and demand for payment, and failure to pay) and relates back to the date of assessment. see irc §§ 6201(a), 6203 and 6303(a). see also united states v. tempelman, 111 f. supp. 2d 85, 90 (d.n.hl 2000). 3. united states v. national bank of commerce, 472 u.s. 713,719-20 (1985); see also glass city bank v. united states, 326 u.s. 265, 267 (1945) ("stronger language could hardly have been selected to reveal a purpose to assure the collection of taxes."). 20021 judicial decisions in such cases sometimes have been inconsistent or simply wrong.4 in december 1999, however, the supreme court decided drye v. united states.5 the court's unanimous opinion should infuse tax lien litigation with greater clarity and precision. this article explores whether this promise is being realized. although drye was decided only fairly recently, several dozen lower court cases have applied it. have they done so well? part ii of this article describes diye and contemporary tax lien analysis in light of it. part ii assesses whether drye changed the law or just clarified what had been the law but often was misunderstood. although ammunition exists to fight for either interpretation, i conclude that the latter is the case. part iii is not purely historical. it demonstrates that loose language in several pre-drye decisions by the court created confusion, indeed error, for decades thereafter. that fact places courts and counsel now under a burden to state drye precisely, to avert new rounds of confusion and error. parts iv, v, and vi examine post-drye decisions, assessing whether they have met this burden and displayed fidelity to the supreme court's teaching.6 these parts describe, respectively, the good, the bad, and the ugly. 4. the specific issue resolved by the drye case discussed herein is an example. before the supreme court's resolution of the issue, two circuits-the fifth and the ninth-held that state law disclaimers can defeat attachment of the federal tax lien to inherited property, while two others-the second and the eighth-held that they cannot. compare leggett v. united states, 120 f.3d 592 (5th cir. 1997), and mapes v. united states, 15 f.3d 138 (9th cir. 1994), with united states v. comparato, 22 f.3d 455 (2d cir. 1994), and drye family 1995 trust v. united states, 152 f.3d 892 (8th cir. 1998), affd sub nom, drye v. united states, 528 u.s. 49 (1999). a number of other courts also had weighed in on the issue, again disagreeing. compare united states v. davidson, 55 f. supp. 2d 1152 (d. colo. 1999), and united states v. mccrackin, 189 f. supp. 632 (s. d. ohio 1960) (both holding against the irs on this issue), with tinari v. united states. 96-2 u.s. tax cas. 50,460,78 a.f.t.r. 2d (ria) 638 (e.d. pa. 1996), and in re spruance, 95 tnt 111-24 (pa. ct. common pleas 1994), ajfd without published opinion, 660 a.2d 661 (pa. super. ct. 1995) (both holding for the irs). 5. 528 u.s. 49 (1999). 6. the cases considered in parts iv, v, and vi are tax lien cases only. drye also has been invoked in a variety of civil and criminal non-tax contexts. whether such "extra-territorial" applications are appropriate is an interesting and important question, which would profit from deeper exploration by courts and commentators. among the non-tax areas in which drye has been cited are: (1) mail fraud, see cleveland v. united states, 121 u.s. 12 (2000); (2) criminal restitution, see united states v. allen, 247 f.3d 741 (8th cir. 2001); and (3) bankruptcy, compare in re kloubec, 247 b.r. 246 (bankr. n.d. iowa 2000) to in re nistler, 259 b.r. 723 (bankr. d. or. 2001) (disagreeing as to whether trye affects disclaimers made shortly before bankruptcy filing). the bankruptcy disclaimer issue is likely to remain controversial for some time. the district court affirmed kioubec on other grounds, stating that it did not need to resolve the applicability of drye to bankruptcy disclaimers but also calling the bankruptcy court's analysis "apt[ ]." in re kloubec, 2001 wl 1222197, at *3 (n.d. iowa 2001). other courts, though, seem unconvinced. see, e.g., cassel v. kolb, 2001 wl 1181025, at *5 (n.d. cal. 2001) (seeming to disagree with kloubec although not mentioning that case by name). for discussion of the bankruptcy cases, see in re florida tax review [vol. 5:6 the good, the bad, and the ugly that is, good: cases which recognize the importance of drye and apply it properly; bad: cases which misapply drye and reach results inconsistent with drye's teaching; ugly: cases which understand or describe drye imprecisely but, by the grace of providence or because of strong facts, nonetheless reach the correct result. the conclusion that will emerge from this examination is that, despite mostly encouraging results, greater care will be required in future cases, both in the statement of doctrine and in its application, if the full promise of drye is to be realized. in addition to providing a critical examination of the cases, this article will comment on matters remaining unsettled after drye, suggesting desirable directions for future elaboration of tax lien doctrine. ii. tax lien analysis after drye a. facts ofdrye narrowly put, the issue in drye was whether the federal tax lien attaches to disclaimed inheritances. rohn f. drye, jr. had unpaid federal tax assessments of approximately $325,000. the irs had filed liens against him. it had little prospect of being paid, though, because mr. drye was insolvent. thereafter, drye's mother died intestate, leaving an estate worth over $230,000. he was her sole heir and the administrator of her estate. six months later, drye disclaimed any interest in his mother's estate. the disclaimer was effective under state (arkansas) law. two days after that, drye resigned as administrator to be succeeded by his daughter. the effect of the disclaimer was to cause drye's mother's estate to pass to drye's daughter. in short order, the daughter established the drye family 1995 trust. she used the proceeds of the estate to fund the trust. the daughter and her parents (including mr. drye) were the beneficiaries of the trust. mr. drye's attorney was the trustee. he had discretion to make distributions to the beneficiaries for their health, maintenance, and support. the trust was a spendthrift trust, its assets shielded under state law from creditors of the trust's beneficiaries. the irs filed a notice of tax lien against the trust, asserting that the trust was drye's nominee. the irs also served a notice of levy on accounts held in the trust's name by an investment bank. in-response, the trust filed a wrongful levy suit under section 7426(a) in federal district court. the irs popkin & stem, 223 f.3d 764,769 n.12 (8th cir. 2000) (noting the disagreement but expressing no position); steve r. johnson, the irs as super creditor, 92 tax notes 655, 659-60 (2001); william p. lapiana, recent non-tax developments, estate planning in depth, se90 ali-aba 117,121-22 (2000);davidb. young, preferences andfraudulenttransfers,23rdannual current developments in bankruptcy and reorganizations, 819 pli/comm 881, 906-09 (2001). 2002] florida tax reviev counterclaimed against the trust, its trustees, and its beneficiaries. the irs sought to reduce to judgement its assessments against drye, to confirm its right to levy on the trust assets in order to satisfy the assessments, to foreclose on the liens, and to sell the trust property. as is the rule in most states,7 arkansas law provides that an effective disclaimer "relates back for all purposes to the date of death of the decedent,"8 creating the legal fiction that the disclaimant predeceased the decedent. thus, drye maintained that, as a result of his disclaimer, he never had a property interest in his mother's estate. as a result, there was nothing to which the tax liens against him could attach. in response, the irs contended that its liens attached to drye' s interest in the estate as of the date of his mother's death and that drye's subsequent disclaimer could not remove them. the irs relied on the primacy of substance over legal fictions in tax matters9 and the settled principle that, once the tax lien attaches, it remains on the property until released by the irs, satisfied by payment, or extinguished by expiration of the collection statute of limitations.' 0 both parties moved for summary judgement. the district court held for the irs, and the eighth circuit affirmed. the supreme court granted certiorari to resolve conflict among the circuits.1' the court, in an opinion authored by justice ginsburg, held unanimously for the irs. b. teaching of drye three aspects of thye are of principal significance: its clarification of the roles of state law and federal law in defining property and property rights, its discussion of the criteria or elements of property, and its confirmation of the body of law governing post-lien attachment issues. 1. roles ofstate andfederal law in defining property.-the court saw the case principally as an opportunity to clarify the role of state law in federal tax lien analysis. '2 it was right to do so. too often, pre-drye pronouncements by the supreme court were loosely worded, sending conflicting signals. 3 7. see, e.g., unif. probate code § 2-801(c) (amended 1993). 8. ark. code ann. § 28-2-108(a)(3) (michie 1997). 9. see, e.g., united states v. irvine, 511 u.s. 224, 239-40 (1994) (observing that the tax law is not "struck blind by a disclaimer"). see also cases cited in infra note 287. 10. irc § 6322. 11. see supra note 4 and accompanying text. 12. the first sentence of drye identified what the court perceived to be the heart of the case: "this case concerns the respective provinces of state and federal law in determining what is property for purpose of federal tax lien legislation." 528 u.s. at 52. 13. see infra part iii. [vol 5:6 the good, the bad, and the ugly is it state law or federal law that defines whether a given interest rises to the level of being "property [or] rights to property"? that question was answered decisively by drye. the supreme court instructed: "the internal revenue code's prescriptions are most sensibly read to look to state law for delineation of the taxpayer's rights or interests, but to leave to federal law the determination whether those rights or interests constitute 'property' or 'rights to property' within the meaning of § 6321."' 4 thus, now it is clear that there are two separate analytical stages in determining whether the federal tax lien attaches to a particular interest." the first stage is: what powers or privileges does the delinquent taxpayer have as to the underlying property? can the taxpayer receive, use, or benefit from the property, or prevent others from doing so? if so, in whatways? one answers the questions at this stage by consulting state law. the second stage is: do those powers or privileges rise to the level of "property" or "rights to property" for purposes of section 6321? this characterization is purely a question of federal law, and any characterization of the powers or privileges as "property" or "not property" under state law is entirely irrelevant to the characterization.' 6 2. criteria or elements ofproperty.-as we have seen, whether the interest in question is or is not "property [or] rights to property" is now firmly established as a federal law question. yet, neither the code nor the regulations define these terms. thus, the criteria for the second stage determination, the characterization of the interest, emerge from the case law. drye did not propound a general or comprehensive definition of section 6321 property and property rights. nonetheless, in three respects, the case contains worthwhile discussion of the point. first, the court quoted approvingly earlier cases holding that the reach of section 6321 should be construed expansively. 7 14. 528 u.s. at 52. 15. after it is determined that the lien does attach to the interest, analysis of the collection controversy shifts to a third stage: what actions the irs can take against the property and what the taxpayer and others can do against those actions. see subpart 1i.b.3. 16. one commentator has argued that this aspect of drye traduces the principle of federalism. note, drye v. united states: limiting the traditional state right to define property, 69 u.lk.c. l. rev. 909 (2001). this is incorrect. congress used the word "property" in § 6321 as part of a federal statute to govern federal revenue collection. it is not corrosive of federalism for one sovereign to define a word in a particular way for purposes entirely internal to its operations, or for that sovereign to define the word in a way different from how other sovereigns define it for their own, separate purposes. the federal definition of property under § 6321 in no way interferes with how states define property for their own non-federal-tax purposes. see steve r. johnson, after drye: the likely attachment of the federal tax lien to tenancy-by-the entireties interests, 75 ind. l.j. 1163, 1186-87 (2000). it is worth noting that the drye decision was unanimous. none of the justices on a court highly protective of federalism suggested that drye contravened that principle or was a retreat from its recent protection. 17. 528 u.s. at 56; see cases cited in supra note 3. 2002] florida tax reviev second, the court addressed the "property" status of mr. drye's interest in his mother's estate. in concluding that his interest did constitute a section 6321 property right, the court emphasized the element of control. "arkansas law primarily gave drye a right of considerable value-the right either to inherit or to channel the inheritance to a close family member (the next lineal descendant)," who would take as a result of drye's disclaimer. 8 if drye did nothing, i.e., did not disclaim, his mother's estate would come to him. he could deflect that only by taking the affirmative act of filing a disclaimer. even then, the result of his affirmative act would be the passage of the estate to his daughter. whether by taking the affirmative act or by refraining from it, "the heir inevitably exercises dominion over the property."' 9 this "power to channel" the underlying property, this "control rein" over it "warrants the conclusion that drye held 'property' or a 'righ[t] to property' subject to the government's liens. 20 third, without committing itself to them, the court reprised criteria of "property" advanced in prior cases. the court rehearsed the following definitions or criteria: -"'every species of right or interest protected by law and having an exchangeable value,'' -a right to gain possession of an item, even if such possession does not amount to ownership, 22 -items available to the taxpayer," 'within [her] reach to enjoy,' ,23 -"any beneficial interest, as opposed to 'bare legal title,' in the [asset] at issue, ' -"a valuable, transferable, legally protected right to the property at issue,"2 5 -"rights or interests that have pecuniary value and are transferable, 26 and -more than a mere expectancy, even if valuable and transferable.27 18. 528 u.s. at 60. 19. id. at 61. 20. id. (alteration in original). 21. id. at 56 (quoting jewett v. commissioner, 455 u.s. 305,309 (1982) (quoting 1932 legislative history)). 22. see id. at 58; see also united states v. national bank of commerce, 472 u.s. 713, 723-27 (1985) (holding that the right to withdraw money from a joint bank account is a § 6321 property right even though it was not established that it was the taxpayer (as opposed to his codepositors) who owned the money in the account). 23. 528 u.s. at 59 (quoting bess v. united states, 357 u.s. 51, 56 (1958)). 24. id. at 59 n.6 (quoting aquilino v. united states, 363 u.s. 509, 515-16 (1960)). 25. id. at 60 (citing drye family 1995 trust v. united states, 152 f.3d 892, 895 (8th cir. 1998)). 26. id. (quoting drye family 1995 trust, 152 f.3d at 895). 27. see id. at 60 n.7 (commenting on drye family 1995 trust). [-vol. 5:6 the good, the bad, and the ugly it should be emphasized, however, that the court embraced none of these formulations absolutely. none is intended as a litmus test or a hard-andfast rule. for example, several of the formulations include the transferability of the asset or interest. yet the court cautioned: "[w]e do not mean to suggest that transferability is essential to the existence of 'property' or 'rights to property' under [§ 6321]."'2s other inclusions in the formulations also may require refinement. for instance, it may be too confining to say that expectancies can never be property for section 6321 purposes. a non-tax case 9 decided less than two months after drye is suggestive. rubylien badouh executed a will in 1990 bequeathing her home to her daughter, elaine. in 1992, elaine's brother edward obtained a $150,000 judgement against her. in 1994, elaine executed a promissory note in favor of her attorney for legal services he rendered to her in an unrelated matter. elaine secured that note by a deed of trust pledging her expectancy in her mother's home. the attorney filed the deed of trust in the county records. in 1996, rubylien died, and her will was filed for probate. edward applied for a turnover order to satisfy his judgement against elaine's interest in rubylien's estate, whereupon elaine filed a disclaimer of her interest in the estate. the attorney (who still hadn't been paid by elaine) intervened in the probate proceedings to assert his lien claims against elaine's interest in the estate. the texas supreme court held the disclaimer invalid since, by pledging the expectancy as security for the deed of trust, elaine had exercised dominion and control over her expectancyin the house prior to making the disclaimer.3" when an expectancy is treated as having the significance and substance that it was accorded by the actors in this texas case, it probably should be seen as rising to the level of being a property right,3 particularly since, as we have seen, both drye and prior supreme court cases have emphasized the extremely broad reach of section 6321.32 28. id. at 60 n.7. 29. badouh v. hale, 22 s.w.3d 392 (tex. 2000). 30. id. at 395-98. 31. see fouts v. united states, 197 f. supp. 2d 815, 817 (w.d. mich. 2000) (finding that a taxpayer had "a present interest in property, although it is an expectant interest" and holding, based on drye, that the interest was subject to the federal tax lien). 32. see text accompanying supra notes 3 & 17. of course, the irs would have no greater interest than the possessor of the expectancy had. see, e.g., united states v. durham lumber co., 363 u.s. 522, 525-26 (1958); boris i. bittker & martin j. mcmahon, jr., federal income taxation of individuals 44.5[4][a] (2d ed. 2001) ("the tax collectornot only steps into the taxpayer's shoes but must go barefoot if the shoes wear out"). thus, for instance, hadelaine been a tax debtor against whom tax liens had been filed and had rubylien, before her death, disinherited elaine, the tax lien would have died with the expectancy. an interesting question is whether more testators will disinherittax-delinquent devisees and legatees, since drye removes the disclaimer technique. see edward kessel & steven r. klammer, supreme court finds disclaimer ineffective to avoid federal tax lien, 92 j. tax'n 118, 121 (2000) ("unfortunately, most estate planners probably have not inquired into the 20021 these and other matters will have to be handled in future cases, their resolution to be informed by the particular facts of those cases. thus, we may take the stage two remarks of the drye court as starting points, but it would be a mistake to rush to judgement as to the eventual contours of a federal definition of property and property rights. 3. law governing post-lien attachment issues.-attachment of the federal tax lien is by no means the end of the collection road. the lien "is not self-executing. affirmative action by the irs is required to enforce collection of the unpaid taxes. 3 3 which body of law will govern post-lien attachment matters? although the relationship of federal law and state law at earlier stages was, before drye, either controversial or confused,3 4 the relationship between these bodies of law after lien attachment has long been clear. the supreme court repeatedly held that "the consequences that attach [after it has been ascertained that a given item of property is amenable to the tax lien] is a matter left to federal law., 35 unsurprisingly, drye confirmed that rule. 6 concretely, what does it mean that post-lien attachment consequences are controlled by federal, not state, law? consider these examples: -the ways in which the irs may proceed against the property burdened by the tax lien are controlled by federal law.37 -the safeguards or protections available to taxpayers and third parties against the irs's "formidable arsenal of collection tools"'3 are set out by federal law. -state exemptions or immunities for debtors do not limit the federal tax lien.4" -state renunciation and disclaimer rules do not affect the federal tax lien.41 delinquent tax status of their clients' beneficiaries, and now must do so."). 33. united states v. national bank of commerce, 472 u.s. 713, 720 (1985). 34. see infra part iii. 35. united states v. rodgers, 461 u.s. 677, 683 (1983); see also united states v. national bank of commerce, 472 u.s. 713,722-23 (1985); aquilino v. united states, 363 u.s. 509, 513-14 (1960); united states v. bess, 357 u.s. 51, 56-57 (1958). 36. see 528 u.s. at 52 (quoting bess). 37. e.g., national bank of commerce, 472 u.s. at 720. 38. rodgers, 461 u.s. at 683. 39. e.g., fried v. new york life ins. co., 241 f.2d 504, 506 (2d cir. 1957), cert. denied, 354 u.s. 922 (1957). 40. e.g., united states v. wagner, 235 f. supp. 854,855 (s.d.n.y. 1964); treas. reg. § 301.6334-1(c). 41. e.g., united states v. mitchell, 403 u.s. 190, 205 (1971). florida tax reviewv [vol. 5:6 the good, the bad, and the ugly . -state rules do not govern the relative priorities of the federal tax lien and any other liens competing with it as to the same property.42 -state filing requirements do not control federal tax liens. 43 -state law does not govern how property seized by the irs may be sold.' mi. change or clarification? diye is a case of fundamental significance. in my estimation, it is the most important tax lien decision ever handed down." even those taking a more restrained view surely would agree that dye is the most important case in the area since the early to mid 1980s.46 but, is drye significant because it announces new law or because it clarifies old, but sometimes misunderstood, law? as to what i have called the second and third aspects-the contents of the federal definition of property and procedures applicable after lien attachment-the answer clearly is the clarification function. as to the first aspect-the relation between federal and state law in defining property-there is room for debate. again, though, i believe the correct answer is clarification, not change. a. second and third aspects drye focused mainly on whether the tax lien attached to the property at issue, not on post-attachment consequences. it did reaffirm that such later 42. e.g., united states v. acri, 348 u.s. 211,213 (1955); united states v. city ofnew britain, 347 u.s. 81, 86 (1954); united states v. security trust & savings bank, 340 u.s. 47, 50-51 (1950). 43. e.g., united states v. union central life ins. co., 368 u.s. 291,293-95 (1961). 44. e.g., springer v. united states, 102 u.s. 586, 594 (1881). 45. drye may also have significance outside tax lien law. in an excellent recent article, professor thomas merrill sought "to make sense of the landscape of" the concept of property under the due process and takings clauses in light of recent decisions. thomas w. merrill, the landscape of constitutional property, 86 va. l. rev. 885, 890 (2000). in addition to three constitutional cases, merrill considers dye at length. combined with the non-tax cases looking to dye, see supranote 6, the article maybetoken extension ofdrye's beneficial influence beyond the tax law. parenthetically, i note that, like me, merrill thinks highly of dtye. he remarks: drye comes as a breadth of fresh air after the three previous [constitutional] decisions. it articulates a clear conception ofthe relationship between federal and state law in determining the existence of property, it sets forth a reasonably clear federal criterion for the identification of property, and it applies this criterion to the facts in a way that seems persuasive. if only constitutional law were that simple. id. at 916. 46. when the supreme court decided united states v. rodgers, 461 u.s. 677 (1983), and united states v. national bank of commerce, 472 u.s. 713 (1985). 2002] consequences are governed by federal law, not state law. however, that principle had been widely understood for generations.47 the third aspect of drye, thus, did not change or add to the law. as to the second aspect of its teaching, drye confirmed that "property and rights to property" has avery broad meaning for section 6321 purposes, but we knew that already.48 no change. drye also listed indicia of property suggested in prior cases.49 it did so only illustratively, though, and elevated none of them to authoritative, exclusive, and comprehensive definitional status. no change. drye also stated, with specific reference to transferability, that the non-existence of any of various listed indicia need not be fatal, in the context of particular cases, to classification of an interest as a section 6321 property right."0 but again, that had been generally understood.5 no change. finally, drye discussed at length the aspect of control: the taxpayer's control over the items on which the irs seeks to impress its liens. some have read drye to stand for the position that control is the most important element in the federal definition of property, but, as discussed later, i believe that reading is wrong.12 thus, again, no change. b. first aspect it is a closer question whether the first aspect of drye's teaching-the relationship between state law and federal law in defining section 6321 property-is a change or clarification in the law. forthrightly, the court conceded in diye that its prior decisions had "not been phrased so meticulously as to preclude" the argument that state law, not federal law, defines property for section 6321 purposes.5 3 sad, but true, as the following history shows. 47. see supra note 35. 48. see supra note 3 and accompanying text. 49. see supra notes 18-27 and accompanying text. 50. see supra note 28 and accompanying text. 51. for example, interests in spendthrift trusts which are transferable only in the sense that they can be renounced or disclaimed, have long been held to be amenable to the federal tax lien. e.g., in re orr, 180 f.3d 656, 661-63 (5th cir. 1999); bank one ohio trust co. v. united states, 80 f.3d 173, 176 (6th cir. 1996); leuschner v. first w. bank & trust co., 261 f.2d 705, 708 (9th cir. 1958); united states v. dallas nat'l bank, 152 f.2d 582 (5th cir. 1945), further opinion, 164 f.2d 489 (5th cir. 1947), further opinion, 167 f.2d 468 (5th cir. 1948); first of america trust co. v. united states, 1993 u.s. dist. lexis 4694; 93-2 u.s. tax cas. (cch) pso, 507; 72 a.f.t.r. 2d (ria) 5296 (citing cases); in re rosenberg's will, 199 n.e. 206 (n.y. app. 1935), cert. denied sub nom. rosenberg v. united states, 298 u.s. 669 (1936). 52. see infra subpart vi.b.2. 53. 528 u.s. at 57. florida tax reviov [vol 5:6 the good, the bad, and the ugly 1. pre-drye history.-the supreme court has discussed in many cases the role of state law in federal tax analysis.54 early, the primacy of federal over state law in federal tax collection seemed a settled proposition. in 1893, the supreme court stated that "remedies for [the collection of federal taxes] has always been conceded to be independent of the legislative action of the states."55 the reasons for this are rooted in both the federal government's constitutional powers and the policy of uniform application of the tax laws. as the court said in a 1932 case: here we are concerned only with the meaning and application of a statute enacted by congress, in the exercise of its plenary power under the constitution, to tax income. the exertion of that power is not subject to state control. it is the will of congress which controls [and its legislation] is to be interpreted so as to give a uniform application to a nation-wide scheme of taxation.... state law may control only when the federal taxing act, by express language or necessary implication, makes its own operation dependent upon state law. 56 nearly half a century later, though, the 1940 decision morgan v. commissioner57 confused matters. first it declared: state law creates legal interests and rights. the federal revenue acts designate what interests or rights, so created, shall be taxed.... if it is found in a given case that an interest or right created by local lawwas the object to be taxed, the federal law must prevail no matter what name is given to the interest or right by state law.58 this first statement is fully consistent with the 1893 case and with drye's later teaching. shortly thereafter, however, the morgan court said: "in the application of a federal revenue act, state law controls in determining the nature of the legal interest which the taxpayer had in the property or income to be reached by the statute."59 54. some of the cases involved pre-assessment determination of liability while others concerned post-assessment collection. the court has freely commingled the two types of cases in its various discussions, as it did in drye, see 528 u.s. at 56-61. 55. united states v. snyder, 149 u.s. 210,214 (1893). 56. burnet v. harmel, 287 u.s. 103, 110 (1932). 57. 309 u.s. 78 (1940). 58. id. at 80-81. 59. id. at 82. 2002] how to read this second passage: state law determines the "nature" of the interest? does "nature" include classification of the interest as property or not property for section 6321 purposes? such a reading would be possible on the bare term itself. however, that reading would, comparing the two passages, make morgan inconsistent with itself. it also would place morgan in tension with the 1893 decision. thus, a less embracing construction of the second passage is more plausible. that is, "nature" should be limited to the content of the interest-what the taxpayer could do as to the property or prevent others from doing-and should not also include the classification or definition of the interest as section 6321 property or not. this more modest interpretation received further support in the next several years. in 1941, the court reiterated the policy of uniform nationwide application of the tax laws and the consequently limited role of state law.6" in 1942, the court stated: "once rights are obtained by local law, whatever they may be called, these rights are subject to federal definition of taxability."'" then, in 1945, the court stated that whether "future earning capacity" constituted property or a property right was "not to be determined by resorting to the local law of pennsylvania., 62 but some decisions in the late 1950's and early 1960's muddied the waters. in united states v. bess, the court phrased the analysis thusly: "[o]nce it has been determined that state law creates sufficient interests in the [taxpayer] to satisfy the requirements of [what is now section 6321]," recourse to state law ends.63 this presents a similar ambiguity to the "nature" language of morgan. the bete noire of this chronicle is the 1960 decisionaquilino v. united states.6' there, the court stated: the threshold question... is whether and to what extent the taxpayer had "property" or "rights to property" to which the federal tax lien could attach. in answering that question, both federal and state courts must look to state law .... the application of state law in ascertaining the taxpayer's property rights and of federal law in reconciling the claims of competing lienors is based upon logic and sound legal principles. this approach strikes a proper balance between the legitimate and traditional interest which the state has in creating and defining the property interest of its citizens and 60. united states v. pelzer, 312 u.s. 399, 402 (1941). 61. helvering v. stuart, 317 u.s. 154, 162 (1942). 62. glass city bank v. united states, 326 u.s. 265,268 (1945). 63. united states v. bess, 357 u.s. 51, 56-57 (1958). 64. 363 u.s. 509 (1960). the holding of aquilino is that § 6321 property includes beneficial interests, not bare legal title. id. at 515-16. 1 am not troubled by that holding, only by aquilino's phrasing of the relationship between federal and state law. florida tax review [vol. 5:6 the good, the bad, and the ugly the necessity for a uniform administration of the federal revenue statutes.65 this is the formulation most nearly at odds with drye's explication of tax lien doctrine.66 yet even it can be argued to be reconcilable. to say that state law must be looked to in making the property status determination is not to say that state law is the only thing to be considered. tunnel vision is not required. drye too requires that state law be looked to, but only up to a certain point and not exclusively. aquilino is not terminally incompatible with that approach. moreover, this reconciliation gains force from the fact that the supreme court, just one year after aquilino and seemingly not thinking it at odds with aquilino, quoted with approval the language of the 1893 decision.67 there the matter lay for a decade. then, in 1971, the court repeated that "state law creates legal interests but the federal statute determines when and how they shall be taxed," and it called these principles "long established in the law of taxation. 68 in 1985, the court again stated the rule in a manner consonant with the later teaching of drye. in national bank of commerce, the court stated: "the question whether a state-law right constitutes 'property' or 'rights to property' is a matter of federal law., 69 finally, in the irvine case in 1994, the court referred to "the general and longstanding rule in federal tax cases that although state law creates legal interests and rights in property, 65. id. at 512-14. aquilino had a companion case, united states v. durham lumber co., 363 u.s. 522 (1960), which spoke in similar terms, including the "nature" language. the supreme court noted that the court of appeals below "stated that the nature and extent of the [taxpayer's] property rights, to which the tax lien attached, must be ascertained under state law." id. at 524. the supreme court affirmed. id. at 526 ("the court of appeals was correct in asserting that the government's tax lien attached to the taxpayers' property interests in the fund as defined by north carolina law.") andn.4 ("hat constitutes the taxpayer's propertyin the first place is a question of state law"). durham lumber is cited far less frequently than aquilino. 66. for an argument that aquilino and drye are inconsistent, see note, supra notel6, at 912-17. 67. see united states v. union central life ins. co., 368 u.s. 291,293-94 (1961). on the other hand, two more years later, the court remarked: "our recent cases... [hold] that state law controls the determination of what is included within... 'property or right to property."' meyer v. united states, 375 u.s. 233,322 (1963). also, shortlybeforeaquilino was decided, the court, in another little cited tax collection case, had expressed concern about "the severe dislocation to local property relationships which would result from our disregarding state procedures." united states v. brosnan, 363 u.s. 237,242 (1960). inbrosnan, though, the court strangely failed to employ the customary several stages of analysis that the main cases discussed herein used. 68. united states v. mitchell, 403 u.s. 190, 197 (1971) (citing cases previously described) (internal quotation marks omitted); cf. butnerv. united states, 440 u.s. 48,55 (1979) (stating that, for bankruptcy purposes, "property interests are created and defined by state law. unless some federal interest requires a different result.... ). 69. united states v. national bank of commerce, 472 u.s. 713, 727 (1985) (citing united states v. bess, 357 u.s. at 56-57). 20021 florida tax review federal law determines whether and to what extent those interests will be taxed."7 and that was the high court's last treatment of the issue until drye. 2. evaluation.-with this background, we return to the question whether drye changed or merely clarified the law when it held that state law is confined to stage one and federal law governs stage two of contemporary tax lien analysis. at least three views have been put forward as to when this relationship between federal and state law became the rule. (1) one view is that this has been the true rule throughout. this view sees cases like morgan, bess, andaquilino as being doctrinally consistent with the other pre-diye cases described above, just less cautiously phrased. if this view is correct, then drye only clarifies.71 i have previously expressed my support of this view,72 and i remain of that conviction. a number of other commentators have shared this view,73 as have a number of courts.74 (2) at least sometimes, the department of justice trial or appellate sections appear to have argued that state-law definition of section 6321 property rights had once been the rule, but that national bank of commerce changed the rule.75 (3) in one recent case, the trial or appellate sections appear to have 70. united states v. irvine, 511 u.s. 224, 238 (1994) (citing cases discussed previously). 71. this does not diminish the importance of drye. the imprecise formulations in previous decisions by the court made such clarification most desirable. 72. see johnson, supra note 16, at 1174-77. 73. see, e.g., william d. elliott, tax liens and levies involving partners: will a partnership's assets be attached?, 4 j. partnership tax'n 320, 324 (1998) (pre-drye piece summarizing cases in manner consistent with eventual drye holding); robert e. madden & lisa ilr. hayes, uncle sam no longer struck blind by heir's disclaimer to defeat tax liens, estate planning, may 2000, at 168, 169 (calling drye "consistent[ ] with past rulings on similar issues"); merrill, supra note 45, at 889 (stating that drye "at least seems to have some continuity with the conventional method [used by the court to define property for non-tax, constitutional purposes] and with prior decisions in the tax area"); note, "property subject to the federal tax lien," 77 harv. l. rev. 1485, 1486-91 (1964) (pre-drye piece summarizing cases in manner consistent with eventual drye holding). 74. this is the necessary inference from the many pre-drye decisions taking the view that the property classification determination is a matter of federal law. see, e.g., in re orr, 180 f.3d 656,660 (5th cir. 1999); randall v. h. nakashima & co., ltd., 542 f.2d 270,273 (5th cir. 1976); united states v. citizens & southern nat'l bank, 538 f.2d 1101, 1105 (5th cir. 1976); fidelity & deposit co. v. new york housing auth., 241 f.2d 142, 144-45 (2d cir. 1957). 75. see magavern v. united states, 550 f.2d 797, 800 (2d cir. 1977) (pre-national bank of conmmerce case in which the court stated that the government conceded that"in asserting its federal tax lien, the government must look to state law for a determination of what legal rights and interests, if any, comprise 'property and rights to property' to be attached"); id. (citing aquilino v. united states, 363 u.s. 509 (1960); united states v. durham lumber co. 363 u.s. 522 (1960); united states v. bess, 357 u.s. 51 (1958)); united states v. davidson, 55 f. supp. 2d 1152, 1154 (d. colo. 1999). [vol. 5:6 the good, the bad, and the ugly advanced as an alternative argument the idea that state-law definition of section 6321 property rights had once been the rule, but that drye had changed the rule.76 this position apparently was taken to avoid a "law of the case" issue unique to that case.77 the case for the first of these views rests on the textual analysis set forth above, both within particular decisions and in reconciliation of the several decisions. that case is fortified by drye itselfwere drye announcing a new rule, one would have expected the court to have said so in its opinion, particularly if state determination of property status had been a rule of long standing (sixty years going back to morgan or forty years going back to aquilino). no such acknowledgment appears in the court's unanimous opinion, and none of the nine justices wrote separately to explain that drye changed the law. even more significant is what the drye court affirmatively said about the prior cases. in two paragraphs and a footnote, the court discussed morgan, aquilino, and national bank of commerce, and it found them "[i]n line with" and "compatibl[e]" with drye's own teaching as to the "division of competence" between federal and state law.7" specifically, the court read aquilino as "reaffirm[ing] that federal law determines whether the taxpayer's interests are sufficient to constitute 'property' or 'rights to property' subject to the government's lien,"79 and it quoted with approval a commentator's conclusion that "aquilino supports the view that the court has chosen to apply a federal test of classification" of property interests.8" thus, the evidence internal to drye-both what it did not say and what it did say-suggests two things: first, that the court did not see drye as changing the law and, second, that the court saw the pre-drye law as mandating federal, not state, classification of property at stage two of tax collection analysis. 3. tenacity of the old, wrong understanding.-as stated above, i believe that drye clarifies, not changes, tax lien law because that view best accounts for language in pertinent supreme court cases before drye, and is the only alternative to concluding that the court changed its mind on the issue not once but several times over generations, without acknowledging even once that it had done so. still, not everyone has read the historical record in the same fashion. some remarks in that direction are appropriate, if only to underline the 76. see craft v. united states, 233 f.3d 358,366 (6th cir. 2000) ("at oral argument, the irs added that drye stands for the 'new' legal rule that a federal tax lien attaches to a taxpayer's right to inherit property."). id. 77. see infra notes 198 & 201 and accompanying text. 78. see drye, 528 u.s. at 58-59 & n.6. 79. id. at 59 n.6 (citingaquilino, 363 u.s. at 513-14). 80. id. (quoting note, property subject to the federal tax lien, 77 harv. l. rev. 1485, 1491 (1964)). 2002] florida tax review importance of clear statement of the correct rule now. even national bank of commerce in 198581 did not convince some courts that federal law, not state law, controls the section 6321 property characterization. for example, in united states v. davidson,82 a federal district court, although not recounting the full history given above, discussed at length the relationship among bess, aquilino, and national bank of commerce, noting that the court had "struggled" with the issue.8 3 the davidson court concluded that (1) the law pre-national bank of commerce was that state, not federal, law controlled the classification question' and (2) national bank of commerce supported, not displaced, that rule." even in the 1990's, a number of federal circuit court,8 6 district court,87 and bankruptcy court88 cases applied state law to section 6321 property classification. as late as several months before drye was handed down, a lower court pronounced it "well-settled" that "the definition of underlying property interests is left to state law.... thus, the court looks to state law to determine the character of any property right [the taxpayer] may have had. . .. "' presumably, it was on the basis of such cases that one commentator stated that drye "reversed the long held belief that state law defines property."9 although the above is founded, i believe, on misunderstanding, enough has been said to show that, in some soils, the roots of error were sunk deeply. since human beings tend to resist change, those roots may prove hard to extract. this fact is indexed by the bad and ugly cases described in parts v and vi. recognition of this tenacity imposes a considerable burden of precision on courts and commentators. to state the instruction of drye haphazardly or to apply it in an analytically sloppy fashion risks sliding back into the error often committed before drye, the error as to the proper roles of federal law and state law that drye sought to correct. 81. see supra note 69 and accompanying text. 82. 55 f. supp. 2d 1152 (d. colo. 1999). 83. id. at 1154. 84. id. 85. id. at 1154-55. 86. e.g., leggett v. united states, 120 f.3d 592, 597 (5th cir. 1997); mapes v. united states, 15 f.3d 138, 140 (9th cir. 1994). 87. e.g., foust v. foust, 1998 u.s. dist. lexis 1806, at *14 (s.d. ind. july 9, 1997); united states v. dusterberg, 1997 wl 327395, at *2 (s.d. ohio march 12, 1997); united states v. klimek, 952 f. supp. 1100, 1114-15 (e.d. pa. 1997); talbot v. united states, 850 f. supp. 969, 972 (d. wyo. 1994). 88. e.g., in re pletz, 225 b.r 206, 208 (bankr. d. or. 1997), affd on other grounds, 234 b.r. 800 (d. or. 1998), aff'd, 221 f.3d 1114 (9th cir. 2000). 89. miller v. conte, 72 f. supp. 2d 952, 958 n.6 (n.d. ind. 1999). 90. note, cases, statutes, and recent developments: property law, 33 urb. law. 221, 221 (2001). [vol 5:6 the good, the bad, and the ugly iv. the good below, i consider cases properly applying drye, discussing them under the three aspects of drye's teaching described in part ii.' a. federal law versus state law in defining property in united states v. stolle, a california district court summarized post-drye lien analysis thusly: "having determined whether a taxpayer could have a right to the property under state law, the court then applies federal law to determine whether such a right constitutes property or a right to property under § 6321.291 here is how the court appliedthat standard. the case involved whether the general tax lien against one spouse attaches to communityproperty held by a revocable trust on behalf of the taxpayer and the other spouse. at stage one, the court noted that the trust instrument gave the spouses a right to withdraw all of the underlying property (four parcels of real estate) from the trust, the absolute right to dissolve the trust at any time, and the right to dispossess any other beneficial interest in the trust. thus, the court had "little difficulty" concluding that the spouses owned the four parcels.92 the irs was permitted to reach all of the parcels to satisfy the lien against the taxpayer since, under california law, community property is available to satisfy a debt from either spouse, even if the other spouse is not responsible for the debt.9' a first circuit case, unitedstates v. murray, 94 involved both stage one and stage two ofpost-drye tax lien analysis. the issue was whether the irs's lien against michael murray attached to a house in massachusetts. the house was purchased in 1976 by michael and his then-wife judith. in 1980, they deeded it to themselves and judith's stepbrother as trustees of the m & j murray family trust. the trust was to be managed bymajorityvote of the three trustees. in september 1988, as part of a separation agreement, michael agreed to convey his interest in the property to judith, but he did not carry out this promise. in november 1988, the irs made an assessment against michael. in march 1989, when the divorce became final, the three trustees deeded the property to judith. in march 1997, the irs filed an action in federal district court. it asserted that its lien reached one-half of the value of the property. the district court held for the irs, and the first circuit affirmed. opposing the irs, judith had stressed that, under the terms of the trust, michael's interest in the property was subject to being terminated by the other trustees (judith and her stepbrother) acting together. this gave rise to two 91. united states v. stolle, 2000 wl 1202087, at *5 (c.d. cal. feb. 14, 2000). 92. id. 93. id. at *6. 94. 217 f.3d 59 (1st cir. 2000). 2002] arguments. first, under the first circuit's decision in markham,95 a prior case, she argued that a power in a person other than the taxpayer to cut off the taxpayer's interest in the trust corpus "means that such an interest is not 'vested' under massachusetts law and is therefore not 'property' to which a federal lien may attach."96 second, judith maintained that the possibility of termination by the two other trustees rendered michael's interest "so contingent, uncertain or speculative that it did not constitute 'property' or 'rights to property' under [section 6321]." 9" the circuit court rejected judith's first argument on the basis ofdrye's teaching as to the relationship of federal and state law. under drye, the court observed, [t]he "bundle of rights" that michael had vis-a-vis the trust income and corpus, including the juliette roadhouse, depends on massachusetts law; but regardless of what label massachusetts law may attach to that bundle, federal law determines whether this interest rises to the level of"property" or "rights to property" for purposes of the federal tax lien statute.98 the circuit court questioned judith's reading of the earlier markham case.99 but, even had she read it right, markham was displaced by drye in the respect relevant to the case. markham's holding on this point depended on its assumption that the federal tax lien issue turned on whether "under massachusetts law ... a right in a trust has vested ...... what drye now makes clear is that labels like "vesting" and "nonvesting" under massachusetts law are not determinative, and that federal law determines whether an interest that exists under state law is sufficiently substantial that it should be treated as "property" or "rights to property" for purposes of the federal tax lien statute.100 95. markham v. fay, 74 f.3d 1347 (1st cir. 1996). 96. murray, 217 f.3d at 64. 97. id. at 63. 98. id. 99. see id. at 63-64. 100. id. at 64. florida tax review [vol 5:6 the good, the bad, and the ugly in rejecting judith's second argument, the circuit court entertained drye's illustrative remarks about what characterizes property or property rights under the federal definition. the court remarked: "perhaps the situations are too numerous and varied to permit a single comprehensive definition, and such elements-transferability, pecuniary value, control, enj oyment-shouldbe treated as among the relevant considerations in a highly fact-specific inquiry."'' the "possibility of termination" urged by judith would be one factor considered in the inquiry, but it was insufficient to remove michael's interest from the category of property or property rights. in this, the court was particularly influenced by national bank of commerce.0 2 under that decision, the general tax lien attached to one co-depositor's right to withdraw money from ajoint bank account, even though the other depositors (who did not owe tax) had the same withdrawal rights and it was not known which of the persons on the account was the owner of the money in it. the taxpayer's interest in national bank of commerce was "equally subject to divestiture at the control of a third party, namely, [by withdrawal of all the money by one of the other depositors]" as michael's interest was by act of the other two trustees.10 3 the possibility of divestiture, then, cannot remove an interest from property status under section 6321. b. contents of federal definition of property in re herraras'° addressed mainly the second stage of tax collection analysis: when a power or interest rises to the status of a section 6321 property right. the taxpayer was an attorney who owed taxes. after filing a chapter 7 bankruptcy petition, he surrendered to the bankruptcy trustee the assets of his law practice, including his work-in-progress as of the bankruptcy filing date. thereafter, he repurchased those assets from the trustee. the irs filed a proof of claim to enforce its liens against the proceeds in the trustee's hands. the trustee objected to the application of the liens to the portion of the proceeds attributable to the work-in-progress. the bankruptcy court sustained the objection, holding that the taxpayer did not have an unqualified right to receive fees from the work-in-progress at the time the petition was filed." 5 101. id. at 63. 102. united states v. national bank of commerce, 472 u.s. 713, 724-26 (1985). 103. murray, 217 f.3d at 65. 104. 257 b.r. 1 (bankr. c.d. cal. 2000). 105. that was the crucial measuring point. although the tax lien usually applies to after-acquiredproperty, e.g., glass citybankv. united states, 326 u.s. 265 (1945), several cases have heldthat it does not attach to property acquired after the taxpayer files a bankruptcypetition, e.g., in re connor, 27 f.3d 365, 366 (9th cir. 1994); in re braund, 423 f.2d 718, 719 (9th cir. 1970). 2002] florida tax review the irs appealed to the district court. that court quoted dlye for the broad reach of section 6321 property, 1 1 6 then explored the work-in-progress. two principal points emerge from the court's treatment of the issue. first, the court invoked one of the illustrative descriptions of section 6321 property mentioned by drye: interests protected by law and having exchangeable value.07 the attorney-taxpayer's rights were "protected by law in that they are enforceable upon the happening of the condition and are treated as valuable assets in such contexts as that of marital property division; and it is clear that they had an exchangeable value because herreras purchased them from the trustee.'108 second, the court acknowledged the caution in drye that "[i]n recognizing that state-law rights that have pecuniary value and are transferable fall within § 6321, we do not mean to suggest that .... an expectancy that has pecuniary value and is transferrable under state law would fall within § 6321 prior to the time it ripens into a present estate."'19 the herraras court noted, though, that the attorney-taxpayer's work-in-progress was a present estate before the bankruptcy petition was filed, not a mere expectancy. the court was right. as it observed, "interests of uncertain status have often been held to be 'property' for purposes of a § 6321 tax lien.""' for example, the tax lien presently attaches to contract rights even though the right to payment thereunder will mature in the future or depends upon subsequent performance."' and it attaches to claims and choses in action even before suit is brought or concluded." 2 the herraras court rightly noted: "[e]ven if all were contingent fee cases, herraras had a right to be paid contingent on a future event, and this is sufficient.""' 3 in re jeffrey"4 also involved a stage two issue, specifically the extent to which the irs's claims against the taxpayer-debtor had secured status. the bankruptcy code provides that a claim "secured by a lien on property in which the [bankruptcy] estate has an interest.. . is a secured claim to the extent of the 106. id. at 5 (quoting drye, 528 u.s. at 56). 107. see drye, 528 u.s. at 56 ("when congress so broadly uses the term 'property,' we recognize... that the legislature aims to reach every species of right or interest protected by law.... "). 108. herraras, 257 b.k. at 6. 109. drye, 528 u.s. at 60 n.7. 110. herraras, 257 b.r. at 5. 111. see, e.g., plymouth saving bank v. united states, 187 f.3d 203 (lst cir. 1999); atlanticnat'l bank v. united states, 536 f.2d 1354 (ct. cl. 1976); in renevadaenvtl. landfill, 81 b.r. 55 (bankr. d. nev. 1987). 112. see, e.g., united states v. hubbell, 323 f.2d 197 (5th cir. 1963); in re weninger, 119 b.r. 238 (bankr. d. colo. 1990). 113. herraras, 257 b.r. at 6. 114. 261 b.,. 396 (batkr. w.d. pa. 2001). [vol 5:6 the good, the bad, and the ugly value of [the] creditor's interest in the estate's interest in such property." '115 since the irs had made assessments against the debtor, had made notice and demand for payment, and had not received payment, the irs had a lien against the taxpayer, which attached to all his property and property rights under section 6321. the issue in jeffery was whether the tax lien attached to an unliquidated medical malpractice claim of the debtor's, which was valued at $10,000. this claim was an asset of the bankruptcy estate since, like the internal revenue code,'16 the bankruptcy code has "an extremely broad definition of property" which includes "interests in causes of action.""' 7 the debtor sought to deny the irs secured status as to the malpractice claim, arguing in part that the claim "is not property under applicable pennsylvania law and, therefore, the irs cannot attach a tax lien."' 8 the court rejected this argument, holding that the tax lien attached to the cause of action and any proceeds thereof. it relied in part on drye, citing it for the proposition that "although state law governs the nature of the interest which a taxpayer has in property, whether the right or interest created under state law constitutes 'property' or a 'right to property' subject to a § 6321 tax lien is a matter of federal law."119 in this regard, the court applied drye correctly. moreover, its holding is consistent with case law concluding that the federal tax lien attaches to unliquidated tort 120 or contract 121 claims22 c. post-lien attachment consequences the final stage of contemporary tax lien analysis involves what the irs may do by way of enforced collection once the lien is established to attach to the property in question. drye confirmed that this stage is governed by federal 115. 11 u.s.c. § 506(a). apart from exemptions not here applicable, the debtor's property becomes property ofthe bankruptcy estate upon the filing ofthe bankruptcypetition. 11 u.s.c. § 541(a). 116. see supra note 3 and accompanying text. 117. jeffrey, 261 b.r. at 401. 118. id. at 400. 119. id. at 401. 120. e.g., hubbell v. united states, 323 f.2d 197 (5th cir. 1963); simon v. playboy elsinoreassocs., 91-1 u.s. tax cas. 50,231 (e.d. pa. 1991); inre walton's estate, 247n.y.s. 2d 21 (n.y. app. div. 1964). 121. e.g., united states v. walker, 92-1 u.s. tax cas. 50,065 (w.d. ky. 1991); bensinger v. davidson, 147 f. supp. 240,245 (s.d. cal. 1956). 122. the luster of jeffiey is dulled in one respect. before the discussion described above, in a boilerplate paragraph, the court cited the long troublesome aquilino case for the proposition that the extent to which "a taxpayer has 'property' or 'rights to property' to which a tax lien can attach is determined by state law." 261 b.r. at 398 (ciingaquilino, 363 u.s. at 51213). 2oo02] florida tax review[ law. a recent case at this level is the sixth circuit's decision in blachy v. butcher.12' this was a multi-party case involving numerous layers.y14 the butchers owned land in michigan as tenants by the entireties. however, they falsely represented that the land was owned by corporations they controlled. from 1981 to 1985, the corporations sold pieces of the land and condominiums developed on them to a number of unrelated buyers. in 1988, the irs made assessments against the butchers for unpaid income taxes for the 1986 tax year and the irs filed notices of tax lien against the butchers' property, including the land. in 1991, the butchers asserted ownership of the land, stating correctly that the corporations had not owned it, and therefore the 1981 through 1985 sales were void. litigation proceeded in several courts. in 1998, a federal district court in michigan imposed a constructive trust on the property. on account of their fraudulent representations, the court ruled that the butchers held the property in constructive trust for the buyers. the court also ruled that the constructive trust related back to before 1981, and therefore the 1988 federal tax lien was subordinate to the buyers' interests in the property and so was ineffective against them. on appeal, the sixth circuit affirmed the imposition of the constructive trust but, relying on drye and other cases, held that the tax lien was superior to the constructive trust. the circuit court was right, and the district court was wrong. this can be understood through the following steps: (1) the federal tax lien attached to the land at issue in blachy. the irs made assessment against the butchers, and the butchers failed to pay after notice and demand. that means a federal tax lien arose. 125 that lien attached to all the butchers' "property and rights to property, 126 thus to their land. (2) the claim competing with the federal tax lien was the constructive trust imposed by the district court in favor of the buyers. the priority of competing claims is a post-lien attachment issue, a stage three issue. as we have seen, stage three is entirely a function of federal law; state law is inapposite at stage three.127 123. 221 f.3d 896 (6th cir. 2000), cert. denied, 121 s. ct. 1653 (2001). 124. the first paragraph of the opinion is a cry-from-the-judicial-heart: "even a diabolical bar examiner would be reluctant to impose this case's complex mixture of subject matter jurisdiction, fraud, real estate, marital property, bankruptcy, tax liens, contributory negligence, equitable remedies, and civil procedure uponhapless law school graduates. because reality often marches in where creators of hypotheticals fear to tread, however, we are the 'hapless' appellate court judges obliged to struggle with this twisted tale of true-life conflict." id. at 900 (emphasis in original). 125. irc §§ 6321 & 6322. 126. irc § 6321. 127. see, e.g., united states v. dishman indep. oil, inc., 46 f.3d 523, 526 (6th cir. 1995) ("it is undisputed that when a federal [tax] lien is involved, the relative priority between competing liens is a question of federal law."). [vol 5:6 the good, the bad, and the ugly (3) under federal law, the basic rule 12 1 for determining the priority of the tax lien relative to competing liens and interests is "that the first in time is the first in right. 129 the tax lien against the butchers arose in 1988, when the assessment was made.13 that date must be compared to the date the constructive trust became choate. (4) a constructive trust is a remedy. thus, it does not arise until a judicial decision imposing the trust is obtained.131 the constructive trust against the butchers arose in 1998 when it was imposed by the district court. since this is after the 1988 tax lien date, the tax lien would have priority over the constructive trust under the general priority rule. (5) the constructive trust would have priority over the lien if it related back before the 1988 assessment date. under the applicable state law, it would. however, state law does not control stage three, and federal law (which does control) has no comparable "relation back" rule for constructive trusts.132 here's how the blachy court put it: even if michigan law allows the doctrine of "relation back" to give the beneficiary of a constructive trust priority over private intervening interests, this would not be determinative as to the irs. federal law... makes no provision for the subordination of a tax lien through the use of the "relation back" doctrine. 133 the court cited drye in support. the michigan "relation back" rule as to constructive trusts should be no more effective against the federal tax lien than was the arkansas "relation back" rule for disclaimed inheritances.3 v. tme bad but there are weeds as well as flowers in the post-drye garden. the most redolent involve an old issue: the extent to which the federal tax lien attaches to tenancy by the entireties interests when only one spouse owes the taxes in question. after providing background on the issue, i will examine two post-drye cases in the area-one bad, the other excusable. 128. congress has created special rules as to priorities of the tax lien against certain classes of competing lienholders, see irc § 6322, but those special rules didnot come into play in blachy. 129. e.g., united statesv. mcdermott, 507 u.s. 447,449 (1993); united states v. city of new britain, 347 u.s. 81, 85 (1954). 130. irc § 6322. 131. e.g., in re omegas group, inc., 16 f.3d 1443, 1451 (6th cir. 1994). 132. e.g, united states v. security trust & savings bank, 340 u.s. 47, 50 (1950). 133. blachy, 221 f.3d at 905 (citations omitted). 134. see blachy, 221 f.3d at 905. 2002] a. background 1. tenancy by the entireties generally.-tenancy by the entireties is a form ofjoint ownership available only between wife and husband. it originated in england in the middle ages to serve several objectives: feudal military organization,' male supremacy,136 and scriptural literalism." 7 as those objectives lost luster, england138 and some u.s. jurisdictions'39 abolished entireties tenancies. the device has been assailed by numerous judges and commentators who have called it, among other things, "repugnant to modem views of the status of married women,"'40 supported by "no reason,'' based on an "absurd theory,"'142 and "quite incomprehensible."' 43 be that as it may, under our constitutional arrangement, the states have the undoubted authority to prescribe the forms of property legally recognized for their citizens. by legislation or court decision, many states have chosen to retain tenancies by the entireties in some form.1' although generalizations are hazardous in this area, the following are among the frequently noted attributes of entireties regimes: -in most states, personal property as well as real property can be owned by the entireties. 45 -as originally conceived, and sometimes still described, the entireties form was based on the idea that neither the husband nor the wife owned the underlying property, that instead it was owned by a fictive, metaphysical entity: the marital union.146 rather than saying that neither spouse has any personal interest, however, it is more common for modem courts to speak of each spouse 135. see, e.g., femanderv. duffly, the effect of the state equal rights amendment on tenancy by the entirety, 64 mass. l. rev. 205,206 (1979). 136. see, e.g., oval a. phipps, tenancy by entireties, 25 temp. l.q. 24, 24 (1951). 137. see, e.g, united states v. gurley, 415 f.2d 144, 149 (5th cir. 1969) (the entireties form developed from the genesis pronouncement that husband and wife "shall be of one flesh"). 138. see law of property act, 1925, 15 & 16 geo. 5, c. 20, § 37 (eng.). 139. see richard r. powell, 4 a powell on real property $ 620[3] (patrick j. rohan rev. ed. 1993). 140. cornelius j. moynihan, introduction to the law of real property 219 (2d ed. 1988). 141. kerner v. mcdonald, 84 n.w. 92 (neb. 1900). 142. phipps, supra note 136, at 26. 143. king v. greene, 153 a.2d 49, 60 (n.j. 1959) (weintraub, c.j., dissenting). 144. see, e.g., swada v. endo, 561 p.2d 1291 (haw. 1977) (discussing tenancies bythe entireties in various jurisdictions); richard r. powell, 7 powell on real property 52-11 to 52-12 (shelby d. green rev. ed. 1998). 145. see roger a. cunningham, william b. stoebuck & dale a. whitman, the law of property 208 (2d ed. 1993). 146. see, e.g., 2 wiliam blackstone, commentaries on the law of england 182 (5th ed. 1773). florida tax reviewv [vol. 5:6 the good, the bad, and the ugly "own[ing] and control[ling] the whole" property,147 each spouse owning "an undivided half interest in the whole,' ' 148 or, in the most sophisticated rendition, the entireties estate not being the separate property of either spouse but the interest each spouse has in that estate being that spouse's "separate property. 149 -each spouse is often said to possess two principal interests in the entireties property: (1) a present right to use it 5 ° and (2) a survivorship right, i. e, automatic succession of the survivor spouse to fee simple ownership of the property upon the death of the other spouse.1'5 -the entireties tenancy can end in any of several ways: (1) a spouse can convey his interest in the entireties estate to the other spouse, making her the fee simple owner of the property.'52 (2) the spouses can terminate the entireties estate by agreement, dividing the property between them in any way they choose.'53 (3) as noted above, the death of one spouse vests the survivor with fee simple ownership of the property. (4) if the spouses divorce, the tenancy by the entireties is converted into a tenancy in common by operation of law, each of the ex-spouses becoming half owner of the property. 54 (5) although there is a split of authority, 55 some courts treat the filing of a bankruptcy petition by only one of the spouses as, in effect, a severance of the entireties estate. 56 the filing spouse's interest in theproperty becomes an asset of the bankruptcy estate; the whole of the formerly entireties property may be sold; the sale proceeds are divided between the bankruptcy estate and the nonfiling spouse; and the proceeds allocable to the bankruptcy estate may be used to pay any of the filing spouse's debts-separate debts of hers as well as joint debts of hers and her spouse' s. 1 57 147. quick v. leatherman, 96 so. 2d 136, 138 (fla. 1957). 148. lapp v. united states, 316 f. supp. 386,389 (s.d. fla. 1970); see also wife (l.r) v. husband (n.g.), 406 a.2d 34,35 (del. 1979). 149. newman v. equitable life assurance soc'y, 160 so. 745, 747 (fla. 1935). 150. e.g., yarde v. yarde, 71 n.e.2d 625, 625 (ind. app. 1947). 151. e.g., united states v. 2525 leroy lane, 910 f.2d 343, 350-51 (6th cir. 1990), cert. denied, 499 u.s. 947 (1991). 152. e.g., craft v. united states, 140 f.3d 638, 645 (ryan, j., concurring). 153.e.g., runco v. ostroski, 65 a.2d399,400 (pa. 1949); cf. in redaughtry, 221 b.r. 889, 892 (bankr. m.d. fla. 1997) (consent to sale in bankruptcy context). 154. e.g., sebold v. sebold, 444 f.2d 864, 871 (d.c. cir. 1971); smith v. smith, 107 s.e.2d 530, 534 (n.c. 1959); mich. comp. laws ann. § 552.102 (west 1988). 155. see, e.g., in redaughtry, 221 b.r. 889, 890-91 (bankr. m.d. fla. 1977); paul c. wilson, "fresh start" or "head start": missouri courts rethink the role of tenancies by the entireties in bankruptcy, 56 mo. l. rev. 817 (1991). 156. see young, supra note 6, at 911-13. 157. in re vanderheide, 164f.3d 1183,1184-86 (8th cir. 1999); in reblair, 151 b.r. 849 (bankr. s.d. ohio 1992), aft'd, 33 f.3d 54 (6th cir. 1994). 2002] florida tax review -it is universally acknowledged thatjoint creditors of the spouses can go against entireties property to enforce payment.158 the jurisdictions recognizing the entireties form of ownership are divided, however, as to the collection rights of separate creditors of only one of the spouses. (1) in some jurisdictions, separate creditors can proceed against the present life interest of the debtor spouse but subject to the survivorship interest of the other spouse. 159 (2) in otherjurisdictions, separate creditors may reach only the debtor spouse's survivorship interest. 16 (3) in yet other jurisdictions, entireties property is wholly beyond the reach of separate creditors.'61 2. application to federal tax lien.-as seen above, the laws of the various states limit the ability of ordinary creditors to proceed against entireties property to satisfy separate debts. do these laws similarly limit the ability of the irs? the courts have said "yes." the foundational cases of this line'62 were decided during the period when language in morgan, bess, and aquilino led some to think that state law governs section 6321 property classification. 63 since that time, the supreme court has made it clear that tax collection by the irs "does not arise out of [the irs's] privileges as an ordinary creditor" and "is not the act of an ordinary creditor, but the exercise of a sovereign prerogative" grounded in the constitution.' nonetheless, the weed sprouted from the early cases has proved hardy, and later decisions have continued to hold that the amenability of entireties interests and entireties property to the federal tax lien depends upon the terms of state law. 165 hereafter, this view is called the "entireties bar to collection" or the "entireties bar." 158. see, e.g., whittaker v. kavanagh, 100 f. supp. 918, 920 (e.d., mich. 1951). 159. e.g., in re persky, 893 f.2d 15, 19-20 (2d cir. 1989) (new york law). 160. e.g., in re arango, 992 f.2d 611, 613 (6th cir. 1993) (tennessee law). 161. e.g., in re garner, 952 f.2d 232, 234-35 (8th cir. 1992) (missouri law); in re carroll, 237 b.r. 872, 874 (bankr. d. md. 1999). hereafter, jurisdictions of this third group are called "full bar jurisdictions." 162. e.g., united states v. american nat'l bank, 255 f.2d 504 (5th cir. 1958), cert. denied as to another issue, 358 u.s. 835 (1959); raffaele v. granger, 196 f.2d 620 (3d cir. 1952); united states v. hutcherson, 188 f.2d326 (8th cir. 1951); pettengill v. united states, 205 f. supp. 10 (d. vt. 1962); united states v. nathanson, 60 f. supp. 193 (e.d. mich. 1945). 163. see supra subpart hi.a. 164. united states v. rodgers, 461 u.s. 677, 697 (1983); see also united states v. national bank of commerce, 472 u.s. 713, 727 (1985); randall v. h. nakashima & co., 542 f.2d 270, 274 n.8 (5th cir. 1976) (criticizing a position which would "compare the [irs] to a class of creditors to which it is superior"); johnson, supra note 6, at 655-57. 165. e.g., irs v. gaster, 42 f.3d 787, 791 (3d cir. 1994); united states v. waltman, 98-1 u.s. tax cas. (cch) $ 50,487, 81 a.f.t.r. 2d (ria) 1054 (s.d. ind. 1998); theo. h. davies & co. v. long & melone escrow, 876 f. supp. 230 (d. haw. 1995). [vol 5:6 the good, the bad, and the ugly despite such judicial endorsement, the entireties barhas been criticized on a number of doctrinal and policy grounds.166 these need not be rehashed here in detail. instead our present focus is on entireties cases decided after drye. are they faithful to the supreme court's teaching in that case? it is to such cases and to that question that we now turn. b. green several states in the third circuit are full bar jurisdictions, including pennsylvania.167 at an early date-during the period of confusion between morgan andnationalbankofcommercee6 -the third circuit accepted that the federal tax lien is limited by pennsylvania entireties law, that is, that the lien does not attach to entireties property when only one spouse owes the taxes in question. 169 it was against that backgroundthat the third circuit considered united states v. green. 7 the facts were nicely framed by the opinion's introductory paragraph: this case stems from howard green's efforts to stay one step ahead of his creditors, including the [irs]. during several years of financial struggle, bankruptcy filings, flight from federal prosecution and ultimately jail time, green underestimated his federal tax liabilities . . . . the irs eventually caught up with green and in 1992 attempted to foreclose against all of his property, including property in huntington valley, pennsylvania. greenrespondedthat he had conveyed the huntington valley property to his wife... thus insulating it from foreclosure.'7 ' the underpayments were of income taxes for 1979, 1980, and 1981. these underpayments were assessed in 1991 .172 the transfer of the huntington 166. e.g., william d. elliott, federal tax collections, liens & levies 9-92 (2d ed. 1995); johnson, supranote 16, at 1171-80; stever. johnson, fog,fairness, andthefederal fisc: tenancy-by-the-entireties interests and the federal tax lien, 60 mo. l. rev. 839 (1995); comment, federal tax liens and state homestead exemptions: the aftermath of united states v. rodgers, 34 buff. l. rev. 297, 323 (1985). 167. see stauffer v. stauffer, 465 pa. 558, 576, 351 a.2d 236 (1976). 168. see supra notes 57-70 and accompanying text. 169. see, e.g., raffaele v. granger, 196 f.2d 620 (3d cir. 1952). 170. 201 f.3d 251 (3d cir. 2000). 171. id. at 252. 172. id. at 253. green filed income tax returns for these years. normally, the irs must assess deficiencies within three years after the filing of the return. irc § 6501(a). however, green's returns were false or fraudulent, creating an unlimited period for assessment. irc § 6501(c)(2). 20021 florida tax review[ valley property (a residence) occurred in 1981, when howard conveyed it from himself individually to his wife and himself as tenants by the entireties. the essence of the scheme was that howard had filed returns in his individual status; none of the returns for the years at issue were joint with his wife. thus, the assessments were against howard only, not against both of the spouses.'7 3 nonetheless, the government claimed that it should be able to proceed against the property, asserting that its transfer was a fraudulent conveyance which the court should set aside. the trial court agreed; green appealed; the third circuit affirmed. the portion of the third circuit's opinion of direct concern here is as follows: "courts look to state law to determine what rights a taxpayer has in the property the government seeks to reach. see drye v. united states .... under pennsylvania law, property owned by tenants by the entirety is not subject to the debts of either spouse."'1 74 this suggests that, in the eyes of the green court, state law restrictions on creditors' remedies are incorporated into federal tax lien analysis under drye. but of course they are not. under drye, one would look to pennsylvania law to ascertain what powers as to the underlying property each entireties tenant (each spouse) has. that is stage one, and that is where recourse to pennsylvania law would end. federal law would control stages two and three, i.e., whether the powers rise to the level of section 6321 property rights and what the irs could or could not do against the underlying property owned by the entireties estate. the green court misapplied drye. however, this lapse is mitigated by the circumstances. green was decided only about five weeks after drye was handed down. perhaps insufficient time was available to fully assess the impact of drye on the old bar cases. moreover, the case did not compel such assessment in order to hold for the right party. it long has been recognized that property fraudulently conveyed into entireties status is not protected by the entireties bar.1 75 since that exception applied in green, the case did not necessitate a searching reexamination of the bar cases in light of the then quite new drye. for these reasons green is more an ugly case than a bad one. the circumstances of the case made it unnecessary to engage in the scrutiny that 173. even the bar cases acknowledge that the federal tax lien attaches to entireties property if the irs has a joint assessment against the spouses. e.g., tony thornton auction service, inc. v. united states, 791 f.2d 635,637-38 (8th cir. 1986) (missouri law); united states v. eglinton, 90-1 u.s. tax cas. (ccii) 50,322 at 84,127, 71a a.f.t.r. 2d (ria) 93-3689 at 93-3692 (e.d. pa. 1990) (pennsylvania law). 174. 201 f.3d at 253. this is the only reference to drye in the green opinion. 175. e.g., craft v. united states, 140 f.3d 638, 644 (6th cir. 1998); philips v. commissioner, 61 t.c. memo (ccm) 1883, 1885 (1991), t.c. memo (ria) 91,056, 91-273, aff'divithout opinion, 978 f.2d 719 (11th cir. 1992); alonso v. commissioner, 78 t.c. 577,581 (1982). [vol 5:6 the good, the bad, and the ugly could have caused the third circuit to properly overthrow the bar in light of drye or to improperly reaffirm it despite drye. c. craft 1. facts and opinions.-a case that did squarely reconsider the entireties bar in light of drye-and, unfortunately, reaffirmed it-is the sixth circuit's 2000 decision craft v. united states.176 wheels within wheels. craft is a saga within the larger sagas of sixth circuit and national entireties bar litigation. in 1972, sandra and don craft, spouses, purchased real property in michigan (the berwyck property) as tenants by the entireties. don failed to file federal income tax returns for 1979 through 1986; in 1988, the irs made an assessment against him exceeding $480,000. don did not pay; indeed, he was insolvent from april 1980 through august 1989. in late august 1989, don and sandra transferred the property to sandra by a quitclaim deed, in exchange for one dollar.177 in 1992, sandra sold the berwyck property to a third party for almost $120,000. the irs asserted that it was entitled to half of the sale proceeds because its lien attached to don's interest in the property. it also claimed that don had fraudulently conveyed his interest in the property to sandra. the district court178 noted the sixth circuit's 1971 cole v. cardoza decision, which concluded that, under michigan law, entireties tenants hold property under a single title and that a tax lien against only one spouse does not attach to the property.17 9 however, the district court saw that case as having been eroded by subsequent statutory 80 and case law181 developments. that 176. 233 f.3d 358 (6th cir. 2000), cert. granted 150 led. 2d 804 (u.s. 2001). 177. this transfer was "most likely intend[ed] to defeat the irs lien." craft v. united states, 140 f.3d 638, 645 (1998) (ryan, j., concurring). 178. craftv. united states, 94-2, u.s. tax cas. (cch) 50,493, 74a.f.t.r. 2d(ria) 94-6362 (w.d. mich. 1995). 179. 441 f.2d 1337 (6th cir. 1971). 180. 1975 michigan legislation to equalize women's rights in entireties property provided that "husband and wife shall be equally entitled to rents, products, income, or profits, and to the control and management of real or personal property held by them as tenants by the entirety." m.c.l.a. § 557. 71, mich. stat. ann. § 26.210 (1)(1975), quoted by 94-2 u.s. tax cas. (cch) 50,493 at 85,817, 74 a.f.t.r. 2d (ria) 94-6362 at 94-6363. 181. for sixth circuit decisions permitting seizure of entireties property under the drug forfeiture laws, see united states v. certain real propertylocated at2525 leroylane, 910 f.2d 343 (6th cir. 1990), cert. denied sub nom. marks v. united states, 499 u.s. 947 (1991),fi rther decision, 972 f.2d 136 (6th cir. 1992), as well as the district court's previous fischre decision. infischre, the united states had obtained ajudgement against one michigan spouseindividually. the court held that the government'sjudgement lien attached to the debtor spouse's individual survivorship interest in property he owned with his spouse as tenants by the entireties. fischre v. united states, 852 f. supp. 628, 630 (w.d. mich. 1994). 2002] court held that the august 1989 conveyance terminated the entireties estate. "at that point, each spouse took an equal half interest in the estate and the government's lien attached to mr. craft's interest."' 82 on appeal, a panel of the sixth circuit reversed, in a decision commonly called craft l183 the court acknowledged that "the government's tax liens attach to every interest in property a taxpayer might have, regardless of whether that interest is less than full ownership or is only one among several claims of ownership"'1' and that "a federal tax lien can attach to a future or contingent interest in property.' ' 85 nonetheless, the court cited bess, aquilino, and morgan'86 and concluded that more recent cases "do not support the proposition that federal law can be used to trump a state's definition of a property interest.' 187 the court found that, under michigan law, "it is well established that one spouse does not possess a separate interest in an entireties property. [as a result,] a federal tax lien against one spouse cannot attach to property held by that spouse as an entireties estate.' 88 however, there remained the factual issue-unaddressed by the district court-as to whether the transfer of the berwyck property was a fraudulent conveyance. "if the conveyance was fraudulent and therefore set aside, the irs could be entitled to half the [sale] proceeds.' 89 the sixth circuit remanded for consideration of this issue. worth noting is judge ryan's opinion in craftl he concurred with the desirability of remanding to further develop factual issues, but he disagreed with his two panel colleagues as to the current viability of the entireties bar to collection. in his view, "binding cases decided since 1971 clearly state a different doctrine" from that of cole v. cardoza 9 ° judge ryan agreed that tax liens attach only to a taxpayer's "exclusive rights in property."' 9 ' don craft's present possessory interest in the berwyck property was not an exclusive right, but his "future interests-the right to share in future proceeds [in the event of sale of the property] and right of survivorship [if sandra predeceased don]" were exclusive rights. 9" thus, the federal tax lien could attach to those future interests if the transfer of the property to sandra was set aside as fraudulent. 182. craft, 94-2 u.s. tax cas. (cch) 50,493 at 85,818, 74 a.f.t.r. 2d (ria) 946362 at 94-6364. 183. craft v. united states, 140 f.3d 638 (6th cir. 1998). 184. id. at 641 (citing united states v. safeco ins. co. of america, 870 f.2d 338, 341 (6th cir. 1989)). 185. 140 f.3d at 644 (citing safeco, 870 f.2d at 341). 186. id. 187. id. at 643. 188. id. 189. id. at 644. 190. id. at 645 (relying on national bank of commerce, irvine, and other cases). 191. id. at 646. 192. id. florida tax review [vol. 5:6 the good, the bad, and the ugly on remand, the district court held that the transfer of the berwyck property to sandra by quitclaim deed "did not, by itself, constitute a fraudulent conveyance."'' this was based on the conclusion that, before the transfer, the property would have been unreachable by don's creditors, so its transfer to sandra could not have prejudiced them. 94 however, the court found that don, while insolvent, had used nearly $7000 of his funds to enhance the berwyck property. that conveyance was fraudulent, and the irs was entitled to recover to that extent.195 both parties appealed. the government also petitioned for en banc review by the sixth circuit, which was denied. in a decision known as craft ii, a panel of the circuit196 affirmed the district court's decision on remand." 7 the court observed: "at this juncture, this case is not really about federal tax liens. nor is it about state law property rights." '198 the court held that the government was precluded from relitigating the bar issue because of the "law of the case" doctrine199 and the "law of the circuit" doctrine."' however, these doctrines are not absolute. both can be avoided if a supreme court decision subsequent to the first panel decision is contrary to it.2 ' drye, the government argued, was such a subsequent decision. thus, the sixth circuitwas compelledto examinedrye. inits discussion, the circuit court did relent at times on its earlier, uncompromising assertion of the entireties bar. specifically: -"[w]e acknowledge that there are colorable arguments on both sides of the question whether a federal tax lien... attaches to a tenancy by the entirety. , -2 193. craft v. united states, 65 f. supp. 2d 651, 658 (w.d. mich. 1999). 194. id. at 657 (michigan cases "have consistently held that creditors have no right to complain of a debtor's disposition ofexempt propertybecause such property conldnot be reached to satisfy debts had it remained in the debtor's hands."). 195. id. at 659. 196. one of the three judges on this panel also was part of the craft ipanel. 197. craft v. united states, 233 f.3d 358 (6th cir. 2000). 198. id. at 363. 199. id. at 363-69. under that doctrine, a court should not reopen issues decided at an earlier phase in the same litigation. e.g., agostini v. felton, 521 u.s. 203,236 (1997). 200. craft, 233 f.3d at 369. under that doctrine, one panel of the circuit should not overturn the decision of another panel; only an enbanc decision may accomplish that result. e.g., pollard v. e.i dupont de nemours co., 213 f.3d 933, 945 (6th cir. 2000) rev'd, 532 u.s. 843 (2001). 201. see, e.g., hanover ins. co. v. american eng'g co., 105 f.3d 306, 312 (6th cir. 1997) (lawofthe case); smith v. united states postal service, 766 f.2d 205,207 (6th cir. 1985) (law of the circuit). 202. craft, 233 f.2dat365 (recognizingjudgeryan's concurrencein craftland judge gilman's concurrence in craft 11). the panel took away much of that concession, though, by adding: "there are colorable arguments in virtually every case we hear." id. 20021 florida tax review -"we further recognize that this court has held that federal law supersedes state property law in other circumstances. 2 3 -the panel also agreed that, under diye and prior cases, "a court must look to federal law to determine whether something constitutes 'property' or 'rights to property' for purposes of section 6321 .,204 -the panel also repudiated some of the more aggressive "state law controls" language of craft i, admitting: "we note that, upon careful review, some of the language we used in craft iwas not 'phrased so meticulously' as we would have liked., 20 5 nonetheless, the craft i1panel reaffirmed its support of the entireties bar. "upon careful review, we find that craft !is essentially consistent with the drye court's reasoning., 2 1 6 why so? the craft i court first looked to michigan law and found that: 1) michigan law holds that an individual spouse possesses no separate interest in entireties property... and 2) michigan law holds that an individual spouse possesses no future interest in entireties property. . . . [b]ecause state law delineated no individual interest or right held by don, there was nothing for federal tax law to deem to be "property" or "rights to property" for purpose of i.r.c. § 6321.207 like the craft i panel, the craft ii panel contained a member who believes the old entireties bar is no longer viable in light of drye. judge gilmore concurred in the craft ii result because of the "law of the case" and "law of the circuit" doctrine. but on the underlying substantive issue, he was quite clear. he believed that "the legal landscape has changed considerably 203. id. the court cited two cases in this regard: bank one ohio trust co., n.a. v. united states, 80 f.3d 173, 176 (6th cir. 1996) (tax lien attaches to spendthrift trust interest despite state law restraint on alienation), andin re grosslight, 757 f.2d 773,775 (6th cir. 1985) (entireties property is part of bankruptcy estate). 204. id. at 366-67 (citing drye, irvine, and national bank of commerce). 205. id. at 367 n.13 (mirroring the admission in drye, 528 u.s. at 57). 206. id. at 366; see also id. at 367. 207. id. at 367. the panel also invokedthe supreme court's rodgers decision, saying: "[cases which have found that a federal tax lien does not attach to a tenancy by the entirety 'because neither spouse possessed an independent interest in the property... do no more than illustrate the proposition that, in the tax enforcement context, federal law governs the consequences that attach to property interests, but state law governs whether any property interests exist in the first place."' id. at 368 (rodgers, 461 u.s. at 702-03 n.3 1) (citing early bar cases). however, craft irs statement of rodgers is incomplete. the same footnote 31 in rodgers contains the following language not quoted by the craft iipanel: "thus, ifthe tenancy by the entirety cases are correct... ." the emphasis on "if' was the court's. thus, the rodgers court clearly stopped short of endorsing the old bar cases, indeed cast doubt on them. [vol. 5:6 the good, the bad, and the ugly since" cole v. cardoza 20 and that "craft ireached the wrong result, and the irs ought to have had the right to attach don craft's valuable interest in the tenancy by the entirety. 20 9 2. evaluation.-craft 11is wrong as to the substantive issue: whether the federal tax lien can attach to entireties property and interests even when only one spouse owes taxes.210 as described above, craft hi's conclusion that the entireties bar is consistent with drye turns on its finding that, under michigan law, neither spouse has a separate or individual interest in entireties property. there are two problems with this: (1) section 6321 says the tax lien attaches to "all" property rights, not just separate or individual property rights and (2) under dye, the stage one analysis looks to the powers created by state law, not to how state law characterizes those powers. a. embracing nature of section 6321.-this point should be dear to the heart of a statutory literalist. the language of section 6321 is that the federal tax lien attaches to "all" the taxpayer's property and property rights, not that it attaches only to taxpayer's "separate" property and property rights. the statutory language embraces all undivided property rights as surely as it does all separate property rights. bare legal title is excluded from section 6321 because of the fundamental rule that federal taxation turns on substance, not form.211 apart from that, the statute should be taken at its face-"all" means "all. ' 212 reading an exception into the statute for undivided property rights runs contrary to drye's reaffirmation of the expansive reach of section 6321.213 significantly, it has often been held that the tax lien attaches to undivided rights, not just to separate rights. thus, undivided homestead 208. id. at 376. 209. id. at 377. 210. whether craft ii is right as to law of the case or law of the circuit is a matter beyondthe scope ofthis article. those matters will depend in part on one's view offiietherdrye changed the law or merely clarified the law. see supra part i1. 211. see infra note 264 and accompanying text. 212. see, e.g., in re voelker, 42 f.3d 1050, 1051 (7th cir. 1994) ("the language of [§ 6321] shows that the federal tax lien attaches to all of a debtor's property, without exception."). 213. see 528 u.s. at 56. in a non-entireties case, a michigan district court noted this aspect ofdrye, then added: "the fact that a taxpayer's right to property may be restricted will not prevent attachment of a federal tax lien. a tax lien can also attach to future and contingent interests in property .... therefore, if the taxpayer has any interest at all in the property, a tax lien may attach to that interest." fouts v. united states, 107 f. supp. 2d 815, 817 (w.d. mich. 2000) (emphasis added). 20021 interests, 214 community property interests, 15 and trust interests216 all have been held amenable to the federal tax lien even when only one of the interest holders owed taxes. we saw in the various craft opinions disagreement over whether michigan entireties tenants have only undivided interests. but it doesn't matter. even if the craft ii majority was right that such tenants have only undivided interests, the cases underline the clear statutory language: section 6321 is not confined to only separate or individual property rights. it may be that the sixth circuit's focus on separate rights related to the aspect of transferability, i.e., a cotenant with only an undivided interest lacks the ability to unilaterally convey the property. transferability is among factors identified by drye as being relevant to the stage two classification. -17 however, entireties interests are unilaterally transferable, albeit to only one person (by quitclaim to the other spouse), and they are transferable to anyone with the consent of the other spouse. more importantly, drye suggested that transferability may not be essential to "property" status under section 6321 .21 8 this suggestion is consistent with prior case law, including that of the sixth circuit itself. for example, in the bank one case 219 the irs sought to attach its lien to the taxpayer's interest in a spendthrift trust. the interest was neither alienable nor encumberable under state law. indeed-in contrast to michigan law which recognizes (at least) an undivided interest in an entireties spouse-state law in bank one declared that a spendthrift trust beneficiary "does not have any interest in the trust. '22° nonetheless, the court upheld the attachment of the lien, declaring: when congress says, as it has done in § 6321, that an unpaid tax "shall" constitute a lien upon "all" of a delinquent taxpayer's property or rights to property, it follows that the tax is a lien both on property that is alienable under state law and on property that is not.21 214. e.g., united states v. rodgers, 461 u.s. 677, 684-85 (1983); broday v. united states, 455 f.2d 1097, 1100 (5th cir. 1972). 215. e.g., united states v. overman, 424 f.2d 1142, 1146-47 (9th cir. 1970). 216. e.g., dallas nat'l bank v. united states, 167 f.2d 468, 469 (5th cir. 1948) (holmes, j., specially concurring). 217. see 528 u.s. at 56-60. 218. id. at 60 n.7; cf. robert b. chapman, coverture and cooperation; the firm, the market, and the substantive consolidation of married debtors, 17 bankr. dev. j. 105, 127 (2000) ("rights which are not ordinarily exchanged or exchangeable are included in the [bankruptcyl estate."). 219. bank one ohio trust co, n.a. v. united states, 80 f.3d 173 (6th cir. 1996). 220. domo v. mccarthy, 612 n.e.2d 706, 709 (ohio 1993). 221. bank one ohio trust co., 80 f.3d at 176. florida tax reviewv [vol 5:6 the good, the bad, and the ugly b. irrelevance of state characterizations.-craft h1 took reliance on state law too far. under diye, state law is properly used to ascertain what powers or controls the taxpayer has as to the underlying property. but it should not also be used to characterize the interest. characterization is a matter for stage two, which is governed exclusively by federal law.' in other words, craft 11 should not have taken as determinative michigan's characterization of don craft's entireties rights as separate or not. instead, it should have focused on what don could have done with the berwyck property, and what he could have prevented others from doing with it. judges ryan and gilman provided this focus in their concurrences.2' first, don craft had the right to enter and enjoy the property to the exclusion of all others, except for sandra craft.... if the crafts had decided to rent or sell the property, don craft would have received half of the proceeds .... he further possessed a contingent future interest, because he would have taken the entire estate in fee simple if sandra had predeceased him.... finally, if the crafts had divorced, they would have become tenants in common, and don craft would have had the right to bring an action for partition and sale. 4 those powers having been established under state law under stage one of tax collection analysis, the matter moves to stage two to ascertain whether the powers rise to the level of property rights. the case is strong that they do. i will not argue the matter at length here, for four points should suffice: (1) the taxpayer has an absolute right to occupy and use the entireties property. not even the other spouse can oust him from possession. the supreme court stated in a landmark gift tax case: "we have little difficulty accepting the theory that the use of valuable property ... is itself a legally protectible property interest." 25 (2) the taxpayer can exclude all the world save one (her spouse) from the entireties property. this power to exclude has been recognized as an attribute of property by tax cases. 2 6 moreover, in a major case (decided the 222. judge gilman's concurrence captured the distinction: "[t]he craft i majority committed a subtle but critical error in accepting at face value michigan's description of the property interests held by a tenant by the entirety, rather than looking past that description to the actual substance of those interests under michigan law." 233 f.3 d at 377 (emphases in original). 223. in fact, their descriptions of the powers of entireties spouses may be underinclusive. see johnson, supra note 166, at 860-61, for enumeration of such powers. 224. craft , 233 f.3dat377 (gilman, j., concurring); see also crafti, 140 f.3dat 645 (ryan, j., concurring). don craft's contingent interest also might have been activated had either he or sandra filed a bankruptcy petition. see supra text accompanying notes 155-57. 225. dickman v. commissioner, 465 u.s. 330, 336 (1984). 226. e.g., kimura v. battley, 969 f.2d 806, 810 (9th cir. 1992). 20021 same year as drye) defining property for constitutional purposes, the supreme court stated that the right to exclude others is "one of the most essential sticks in the bundle of rights that are commonly characterized as property. 227 (3) the taxpayer's contingent rights-the right to all the property should the other spouse die first, the right to half the property in the event of divorce, and perhaps the right to half the property in the event of bankruptcy-are substantial. even craft i acknowledged that "a federal tax lien can attach to a future or contingent interest in property.5228 (4) at the end of the day, after drinking the brew of legal doctrine and legal fictions, a sobering draught of common sense and common practice is perhaps beneficial. what sort of reaction would one get if he told an entireties husband or wife, "you know, that's not your house (or car or bank account or stock or vacation home), and it's not your spouse's. neither of you have any ownership interest in it." one who said that would be viewed as unstable or detached from reality. people think of entireties property as theirs; they use it as such; and they respond with law suits or worse if they think people are trying to deprive them of it.29 the vision of tax lien law put forth in drye accords with practical reason. that put forth in craft i does not. vi. the ugly cases in this class are of two types. first, some decisions leave the reader with the impression that the court may have understood drye but was less than desirably exacting in the terms used to describe it. second, more seriously, other decisions, while they ultimately hold for the right party (distinguishing them from a "bad" case), apply the wrong analysis, not just the wrong words, suggesting that the meaning of drye was not understood by the court authoring the decision. a. verbally imprecise cases decisions of this type are less problematic than those of the second type, of course. indeed, one accustomed to the pitfalls of written expression and sympathetic to the press of business under which our courts labor is at first inclinedto let decisions of this type pass without critical remark. unfortunately, 227. college savings bank v. florida prepaid postsecondary educ. expense bd., 527 u.s. 666, 673 (1999). thus, a leading commentator has said: "the hallmark of a protected property interest is the right to exclude others." merrill, supra note 45, at 910. 228. 140 f.3d at 644. 229. see, e.g., myers v. united states, 145 f.3d 1332 (table disposition), 1998 wl 246370, at *4 (6th cir. 1998) (non-tax case in which aggrieved entireties spouse argues that she has "significant property rights in the residential estate, including her interest as a tenant by the entirety"). florida tax review, [vol 5:6 the good, the bad, and the ugly that indulgence would be misplaced. we have seen the confusion and error created by loose language in some pre-drye decisions." today's verbal lapse can metastasize into tomorrow's erroneous holding. for this reason, turning the spotlight on unfortunate formulations in early post-drye cases is an act neither of mean-spiritedness nor idle pedantry. as a first example, consider knight v. commissioner, 1 an en banc decision of the tax court. cases in that court typically involve pre-assessment determination of correct liability, not post-assessment application of the federal tax lien,232 so drye-related matters would be expected to arise there only indirectly. thus it was in knight. knight was another of the spate of cases in which taxpayers attempted to minimize transfer tax liability by creating family trusts and limited partnerships. among other contentions, the irs argued that the family limited partnership lacked economic substance, so should be disregarded for gift tax purposes. the majority opinion began its analysis of this issue by stating: "state law determines the nature of property rights, and federal law determines the appropriate tax treatment of those rights."' 3 the majority cited three pre-drye cases for this proposition: national bank of commerce, rodgers, and aquilino.2 34 language in support of this formulation can be found in those cases, but the formulation remains ambiguous. readers of knight, including future attorneys and judges, might read "the nature of property rights" to include the definitional question of whether the interest at issue rises to the level of being property or rights to property. they would then conclude-erroneouslyfrom knight's formulation that state law controls the definitional question. to avert such possible misunderstanding, it would have been preferable for the knight majority to have quoted or paraphrased drye rather than the pre-drye cases. indeed, since drye is the clearest and the most recent controlling case, the failure of the knight majority to even cite it is striking. also regrettable is judge foley's concurring opinion in knight. he wrote: "a fundamental premise of transfer taxation is that state law defines and federal tax law then determines the tax treatment of property rights and interest. see drye v. united states, 528 u.s. 49 (1999); morgan v. commissioner, 309 u.s. 78 (1940)."'' 5 to say that "state law defines... 230. see supra part i. 231. 115 t.c. 506 (2000). 232. although its jurisdiction has grown in recent decades, the tax court's core responsibility remains deficiency actions. see irc §§ 6213(a), 7442. 233. 115 t.c. at 513. 234. id. (citing united states v. national bank of commerce, 472 u.s. 713, 722 (1985); united states v. rodgers, 461 u.s. 677,683 (1983); aquilino v. united states. 363 u.s. 509, 513 (1960)). 235. 115 t.c. at 522 (foley, j., concurring in result, joined by wells, c.j.). 20021 florida tax review property rights and interests" presents an even greater risk of misunderstanding than does the majority's formulation. another case of this type is in re strate.23 6 an adversary proceeding was brought in a bankruptcy case for determination of the rights of various parties, including ray and april wishman, in a forty-acre tract of real property. the irs claimed an interest, based on its tax liens against ray and april. the strate court correctly observed that the lien attached only to ray and april's property.237 it then quoted as "instructive" the following passage drawn from a 1977 circuit court case: "it is long-established, and conceded by both parties to this case, that in asserting its federal tax lien, the government must look to state law for a determination of what legal rights and interests, if any, comprise 'property and rights to property' to be attached., 3 the magavern court's conclusion was based principally on the supreme court's aquilino decision, which was quoted at length.239 strate's invocation of the 1977 circuit court case and, indirectly, of the 1960 supreme court case disserves clear understanding of contemporary tax lien doctrine. whatever might have been thought "long-established" and conceded by the parties in 1977,240 now after drye it is emphatically not the case that state law determines "what legal rights and interests, if any, comprise 'property and rights to property' to be attached." indeed, the strate court itself knew that. it immediately followed the above by quoting drye for the proposition that one looks to state law to see "what rights the taxpayer has in the property the government seeks to reach" but then "to federal law to determine whether the taxpayer's state-delineated rights qualify as 'property' or 'rights to property' within the compass of the federal tax lien legislation. 241 it is extraordinary that the strate court, knowing what the supreme court held in drye in 1999, should continue to quote earlier cases inconsistent with drye, or at least so ambiguously or imprecisely phrased as to suggest, contrary for drye, that the stage two inquiry is controlled by state law. what can explain cases like knight and strate? more than we like to admit, the greater things in life often turn on the lesser-habit, for example-and i suspect that habit looms large here. attorneys who handled tax lien cases in the past continue to cite the old cases. if they handled many of them, they may have boilerplate citations to those cases in their word processors; if they 236. 259 b.r. 711 (bankr. d. mont. 2001). 237. id. at 720. 238. id. at 720 (quoting magavern v. united states, 550 f.2d 797, 800 (2d cir. 1977), cert. denied, 434 u.s. 826 (1977)). 239. strate, 259 b.r. at 720 (quoting magavern, 550 f.2d at 800, quoting aquilino v. united states, 363 u.s. 509, 512-13 (1960)). 240. i disagree that this was true even in 1977. see supra part mh. 241. strate, 259 b.r. at 721 (quoting drye, 528 u.s. at 58). [vol 5:6 the good, the bad, and the ugly handled only a few, at least they likely retain file copies of their old briefs citing the old cases. as an exercise of habit or convenience, the attorney continues to plug that old material into new briefs, even after drye. judges and their clerks similarly borrow from their word processor boilerplate or their previous opinions, or borrow from the parties' briefs in the current cases, which themselves contain the old citations. in short, habit. once a case, especially a supreme court case, is put into common citational circulation in briefs and opinions, it often displays a pertinacity outliving its doctrinal relevance. so it likely is with the pre-diye cases.242 while one must concede, as a practical matter, the power of habit, lawyers and judges should escape its tyranny. the clarity of the law would be well served if bar and bench in future cases, recognizing the importance of drye, get into a newhabit: citing onlydrye as to general principles, eschewing citation of prior cases.24 a muddling of a different sort occurred in united states v. jepsen. jepsen has been a saga, involving (so far) four district court and one circuit court decisions. for our purposes, three of the five decisions are relevant: the district court's may 2000 opinion denying motions for cross-judgement,2" the district court's june 2000 opinion holding for the government aftertrial,24 and the eighth circuit's opinion affirming that holding.246 the case involved the following facts. in 1989, the taxpayer (jack) executed a deed conveying a vacation house and two acres of land to his two children. in return, the children executed in jack's favor a promissory note for $95,000, payment of which was secured by a mortgage on the property. in 1994, the irs made a $214,000 assessment against jack, the bulk of which remained unpaid. in 1995, jack executed a release of the mortgage. jack received no payments on the note from his children and no consideration for the 242. for example, i earlier criticized the otherwise good jeffrey decision for resurrectingaquilino. see supra note 122. a subsequent case extended the error by citing jeffiey citing aquilino and also craft citingaquilino and morgan. see in reready, 2001 wl 1191157, at *4 (m.d. fla. 2001). 243. in particular, one may hope to see far less of aquilino, the prior case whose statement of general tax lien principles contrasts most starkly with drye's. the suggestion that one "must look to state law" to determine "whether and to what extent the taxpayerhad 'property' or 'rights to property' to which the tax lien could attach,"aquilino, 363 u.s. at 512-13, should be banished from future briefs and decisions. 244. 131 f. supp. 2d 1076 (w.d. ark. 2000). 245. 105 f. supp. 2d 1031 (w.d. ark. 2000). 246.268 f.3d 582 (8th cir. 2001). the othertwo district court opinions granted partial summaryjudgement to the government allowing it to reduce to judgement its assessment against the taxpayer, 2000 wl 637341 (w.d. ark. 2000), and denied the taxpayer's motion to stay the irs's sale of the property involved, 2000 wl 1367888 (w.d. ark. 2000). 20021 release of the mortgage. the united states brought suit seeking to reduce to judgement its assessment against jack, to foreclose on its tax lien against him, and to set aside as a fraudulent conveyance the release of the mortgage. among the many issues in the case, two are relevant here. one is a stage two issue as to whether the interest jack possessed was a section 6321 property right. the other is a stage three issue as to the irs's collection options in light of the release. the courts correctly resolved the issues although the district court muddled the first of them. 1. stage two issue.-the first relevant aspect of jepsen was whether jack's right to sue on the note constituted property subject to the lien. the district court held that it was.the court correctly described drye' s teaching that state law identifies what powers or interests the taxpayer has, but that federal law determines whether those powers or interests constitute property or property rights under section 6321.248 then, the court concluded that jack's right to sue on the mortgage was a section 6321 property right. why? first, citing a state case, the court found that "illinois [the state of residence] attaches property rights to choses in action."249 second, quoting one federal case and citing another, the court found that "[i]t has been held that so long as the state law interest is an economic asset in the sense that it has pecuniary worth and is transferrable, then it is subject to the federal tax lien. '" 250 it was unnecessary, indeed irrelevant, for the court to cite the state case or to discuss the property or non-property status of choses in action under state law. once state law established that jack had a chose in action (stage one), it then became a matter exclusively of federal law whether that chose in action constituted a section 6321 property right (stage two). the status of choses in action as property for illinois purposes would neither add to, nor detract from, the case for their classification as section 6321 property rights. plainly, jepsen is explicable by the "make weight" instinct, the tendency of judges (and, one must admit, commentators) to "throw in something more" to bolster a conclusion already reached on the basis of, or solidly grounded in, some other genuinely dispositive factor. this is far from a sin. still, the invocation of a state characterization in jepsen might lead an uncareful reader to think-contrary to drye-that state law is pertinent to the stage two characterization. 247. 131 f. supp. 2d 1076 (w.d. ark. 2000). the circuit court did not discuss this conclusion since, on appeal, the taxpayer pursued other arguments, not challenging this conclusion directly. 248. see id. at 1081-82. the circuit court also noted this teaching. see 268 f.3d at 585. 249. id. at 1085 (citing kaiser-ducett corp. v. chicago-joliet livestock mktg. ctr., inc., 407 n.e.2d 1149 (1980)). 250. 131 f. supp. 2d at 1085 (quoting united states v. stonehill, 83 f.3d 1156, 1159 (9th cir. 1996), and citing united states v. goldberg, 362 f.2d 575, 577 (3d cir. 1966)). florida tax review [vol 5:6 the good, the bad, and the ugly 2. stage three issue.-the district court found it unnecessary to determine whether the release was a fraudulent conveyance. it took this view because "once a tax lien has attached the taxpayer cannot avoid or defeat liability by disclaiming or renouncing interest in the property or transferring, conveying, or releasing the interest." '51 this is a stage three issue: post-lien attachment consequences, including irs's collection options and taxpayer defenses thereto. the district court resolved it correctly, on the basis of dryez52 and other cases.253 on appeal, jack tried to reframe the irs options/taxpayer defenses issue as a matter of defining his property interest. he argued that, as a result of the release, the only right the irs acquired, stepping into his shoes as the tax debtor, was a right to reinstate the released mortgage. the eighth circuit rejected this attempt. it noted that "the survival of a federal tax lien is a question of federal law [and it found] no authority for the proposition that a taxpayer may defeat an existing [tax] lien by releasing a mortgage."2 54 indeed, it cited its decision in dye for authority contrary to jack's proposition. -55 b. analytically wrong cases cases examinedhere are distinct from the cases discussed immediately above because they reflect actual misunderstanding of drye, not merely loose expression of an accurate understanding. they also are distinct from the bad cases examined in part v because, despite their analytical errors, they held for the right party. we consider two groups of cases, dealing with land sale contracts and nominee liens. 1. land sale contracts.-two recent cases-orme2 6 and ready257-involved attachment of the federal tax lien to purchasers' interests under land sales contracts. the contracts were governed by montana and florida law, respectively. in orme, the ormes had transferred real property to the burgesses pursuant to a land sale contract. during the term of the contact, the irs made 251. 105 f. supp. 2d at 1037. 252. drye was cited for the preopsition that the "tax lien could not be defeated by disclaiming interest in an estate." id. (citing drye, 120 s. ct. at 482-83). 253. see also united states v. rodgers, 461 u.s. 677, 691 n.16 (1983); united states v. goldberg, 362 f.2d 575, 577 (3rd cir. 1966). 254. 268 f.3d at 587. 255. id. (quotingdryefamily 1995 trustv. united states, 152 f.3d 892,899 (8th cir. 1998) ("congress did not intend that taxpayers have the prerogative to relinquish rights in property in favor of avoiding tax liability."), aff'd, 528 u.s. 49 (1999)). 256. orme v. united states, 2001 wl 1242297 (9th cir., oct. 18, 2001). 257. in re ready, 2001 wl 1191157 (m.d. fla., sept. 7, 2001). 2002] an assessment and filed a tax lien against the burgesses. thereafter, the burgesses forfeited the contract and title to the property returned to the ormes. the ormes then brought suit to quiet title to the property. the government argued that the forfeiture was a nonjudicial sale of the property58 subject to a notice requirement and that, since notice had not been given to the irs, the tax lien against the burgesses' property remained on the land after it reverted to the ormes.259 reversing the district court, the ninth circuit agreed with the government. in ready, the readys owned a home on luce road and the livelys owned a home on laurel lane, both located in lakeland, florida. in july 1984, they entered into an agreement to execute warranty deeds, each couple transferring their home to the other couple. they agreed that these deeds would be held in escrow and not be recorded until both parties qualified to assume the respective mortgages on the properties. the warranty deeds were executed, and in august, 1984, the readys obtained possession of the laurel lane property. they lived there for the next sixteen years as their home. -60 they paid the mortgage payments, property taxes, and insurance premiums on the property during that time, and they deducted the mortgage interest payments on their tax returns. in december, 1999, the livelys signed a quitclaim deed transferring the laurel lane property to the readys, and that deed was recorded in march, 2000. in 1992, the irs made an assessment and filed a notice of tax lien against the readys with respect to the 1990 income taxes. in 1995, it made an additional assessment and filed a notice of an additional lien against the readys with respect to 1991 income taxes. in june, 1999 (that is, six months before the quitclaim deed conveying the laurel lane property to them), the readys filed a chapter 7 bankruptcy petition. they received a discharge, including discharge as to their 1990 and 1991 income tax liabilities. however, the bankruptcy court's finaljudgement provided that any properly filed tax liens "shall remain in full force and effect as to any property, and any rights to property, belonging to the [readys] as of the filing of [their] bankruptcy petition."26' after the irs 258. see irc § 7425(c)(4) ("for purposes of subsection (b), a sale of property includes anyforfeiture of a land sales contract."); h.r. conf. rep. no. 99-841, at 11-818 (1986), reprinted at 1986 u.s. code cong. & ad. news 4075, 4906. 259. under irc § 7425(b), a nonjudicial sale of property to which the federal tax lien attaches is effected "subject to and without disturbing" that lien as long as notice of the lien has been properly filed and the irs is not given notice of the sale in a prescribed fashion. both conditions were present in ornie. 260. the readys never did qualify to assume the mortgage, and the warranty deed in their favor was never recorded. 2001 wl 1191157, at *2. however, the livelys allowed the readys to make the payments on the mortgage. id. at *3. 261. id.; see, e.g., dewsnup v. timm, 502 u.s. 410 (1992) (a pre-existing lien on property remains enforceable against that property even after the personal liability of the property's owner has been discharged in bankruptcy). florida tax reviewv [vol 5:6 the good, the bad, and the ugly refused to release the laurel lane property from its tax liens, the readys asserted that the irs violated the final bankruptcy judgement. holding that the tax liens properly attached to the laurel lane property, the bankruptcy court rejected the readys' assertion. orme and ready turned on a common question of law. neither the readys nor the burgesses were the legal owners of the properties at issue.262 did they nonetheless possess sufficient rights to property, as purchasers under their land sale contracts, that the section 6321 lien could attach to their rights? both courts said "yes" on similar, but flawed, reasoning. both courts identified drye as among the controlling cases,6 ' and the ready court noted the broad reach of the section 6321 lien under drye. 64 however, they both took state law further than drye permits. the orme court stated: "montana law makes clear that the purchaser under a land sales contract holds an equitable interest in real property, although legal title remains in the seller."26 similarly, the ready court found: "under florida law, a contract for the purchase and sale of real property creates an equitable interest in the purchaser, and the purchasers become the beneficial owners of the property."266 the quoted material reveals the error. whether something is or is not an "equitable interest" is a matter of characterization, and both courts adverted to state law to make that characterization. that improperly conflates stages one and two of drye. state law should be used only to identify what powers the taxpayer has as to the property. the subsequent characterization of those powers should be reserved for federal law. the slip here was one of analysis, though not of result. the same result, decision for the government, as was reached by the orme and ready courts, also would be reached on a properly reconstructed analysis. applying stage one of drye, the courts in those cases would have asked what powers or strings montana or florida law conferred on purchasers under land sales contracts. the main such power or string is the ability to live on, occupy, or use the properties, as the taxpayers did in both cases. secondary powers exist as well. as the ready court noted: "the beneficial interest acquired by a purchaser, for example, would be subject to sale on execution, could be made the subject of a trust, would pass to the purchaser's heirs upon his death, and would entitle the purchaser to recover damages for any trespass to the property." '267 262. the burgesses never obtained record ownership. the readys obtained record ownership six months after the relevant, measuring moment; the june, 1999, filing of their bankruptcy petition. see 2001 wl 1191157, at *4. 263. orme, 2001 wl 1242297, at *2 n.4; ready, 2001 xvl 1191157, at *4-5. 264. 2001 wl 1191157, at *4. 265. 2001 wl 1242297, at *2 n.4 (citing a montana case). 266. 2001 wl 1191157, at *5 (citing florida cases). 267. id. (citing a florida case). 20021 florida tax review there-at the recitation of powers possessed-is where recourse to florida and montana law should have ceased, where stage one of drye ceased. thereafter, at stage two, it would be necessary to characterize those powers, to declare whether those powers, taken together, rise to the level of section 6321 property rights under federal, not state, law. there is little doubt that they would under the illustrative criteria of property rights set out by drye.26 8 2. nominee liens.-our focus here is on a 2001 district court case, nantucket village development co. v. alex.269 jordan alex was a shareholder, director, and officer of five companies, including car lot, inc. and nantucket village development company. there were unpaid income tax assessments against car lot exceeding $1,600,000 and against jordan exceeding $50,000. the irs believed that these taxpayers were using others, both individuals and related entities, to hold property for them in order to defeat collection of the assessments. as particularly relevant to this case, the irs believed that nantucket was holding property (the summit property) as a nominee of car lot. the irs filed a nominee lien against the summit property on this basis.20 nantucket brought an action to quiet title to the summit property. along with its answer, the government filed counterclaims against nantucket and cross-claims against other defendants, a total of eighteen counts. several parties moved for partial summary judgement, asserting that ohio law does not recognize a nominee cause of action. the court identified the primary issue as whether car lothad an interest in the summit property "sufficient to constitute property or a right to property. ' '271 analyzing the matter, the court proceeded through the following steps: (1) the court noted (correctly) that the courts "have interpreted the statutory language of section 6321 broadly and held that it reveals congress's intent 'to reach every interest in property that a taxpayer might have.' 272 (2) summarizing drye and other cases, the court defined stage one and stage two of the analysis thusly: [t]his court's initial task is to understand and define the bundle of rights and privileges that ohio law has created under 268. see subpart ii.b.2 supra. pre-drye case law also reached the conclusion that the federal tax lien attaches to interests acquired under purchase contracts. e.g., united states v. big ialue supermarkets, inc. 898 f.2d 493 (6th cir. 1990); crough v. scheets, 1994 wl 409628, at *2 (d. kan. 1994); cardinal v. united states, 817 f. supp. 647, 652 (e.d. mich. 1993). 269. 2001-1 u.s. tax cas. (cch) 50,202, 87 a.f.t.r 2d (ria) 743 (n.d. ohio 2001). 270. for description of nominee liens and related collection devices, see elliott, supra note 166, 9.10. 271. 2001 wl 169316 at *4. 272.2001 wl 169316 at *4 (quotingunited statesv. nationalbank ofcommerce, 472 u.s. 713,720 (1985)). [vol 5:6 the good, the bad, and the ugly the nominee lien doctrine for the "true" owner of the properties allegedly held by the nominees .... the second step is to determine, as a matter of federal law, whether the interest created by ohio law is property or a right to property to which the federal income tax liens can attach.273 (3) the court found that "[tihere is a split among the district courts of ohio regarding whether ohio law recognizes the nominee doctrine."'74 after several pages of dissection of prior cases, the court concluded that ohio law does not recognize the nominee doctrine2 5 but that ohio does recognize the alter ego doctrine under which "the concept of equitable ownership is, essentially, a recognition of the nominee doctrine by another name.' 276 (4) the court found that the government's counter and cross claims asserted sufficient facts which, if proved at trial, would establish that jordan alex and car lot are alter egos of each other, and that the related individuals and entities had been used to hold property of theirs, including that nantucket held the summit property for car lot, and that car lot was the equitable owner of the summit property.277 thus, the court denied the motion for partial summary judgement and allowed the government to proceed with its claims. the court reached the correct conclusion, but it misapplied drye. the errors in nantucket village involved all three stages of the three-stage analysis governing federal tax collection controversies. a. error as to stages one and three.-the first and principal error made by nantucket village involves the court's conclusion that it was compelled to ascertain "the bundle of rights and privileges that ohio law has created under the nominee doctrine for the 'true' owner of the properties allegedly held by the nominees."27 the court confused stages one and three of the analysis. the nominee lien doctrine is a stage three collection option or remedy available to the irs.279 thus, it is a function of federal law. 273.2001 wl 169316 at *5 (omitting internal citations). 274. id. 275. id. at *7. 276. id. at *8; see also id. at *9 ("[i]t is clear that ohio law recognizes the concept of equitable ownership, despite the fact that the term 'nominee doctrine' is not used."). 277. id. at *11-12. 278. 2001 wl 169316 at *5 (omitting internal citations). 279. see stophel v. united states, 81-2 u.s. tax cas. (cch) 9,669, 88,257 (e.d. tenn. 1981). the tax lien alreadyhas arisen as to the taxpayer, and it already applies to all of the taxpayer's property and property rights. the nominee lien and alter ego lien techniques merely counter the taxpayer's tactic of lodging her property in the hands of others, nominally different from her, but related to her or under her control. in this regard, these techniques are similar to transferee liability assessments under § 6901 and fraudulent conveyance suits. 200-71 as the nantucket village court recognized,28° the nominee lien remedy is amply recognized under federal law."' application of that remedy depends upon the taxpayer being the true or beneficial owner of the property which is held by another. it had been well pled, and was accepted for summary judgement purposes, that car lot was the true or beneficial owner of the summit property. once that was established or accepted, stage one-and therefore recourse to state law-should have ended. it was wrong to go further and ask what remedies state law accorded to the true or beneficial owner, or to creditors of that owner.2 2 remedies is a stage three matter controlled by federal law, not state law.283 b. error as to stage two.-the other error committed by the nantucket village court involved stage two of contemporary tax collection analysis. although not central to its analysis, the court discussed what constitutes "property" for section 6321 purposes. in the course thereof, it cited ahye for the following proposition: "in determining whether a taxpayer's statelaw rights constitute 'property' or the 'right to property,' the important consideration is the breadth of control the taxpayer can exercise over the property. ' '2 1 some commentators also have read drye as making "control" the key factor in the federal definition of property.8 5 i believe this conclusion is incorrect. it wrongly elevates the particular to the universal. control was the key consideration on the facts at issue in drye, 280. see 2001 wl 169316 at * 7-8. 281. see, e.g., united states v. letscher, 83 f. supp. 2d367,375 (s.d.n.y. 1999); hill v. united states, 844 f. supp. 263, 270 (w.d.n.c. 1993); stophel v. united states, 81-2 u.s. tax cas. (cch) 9,669,88,257 (e.d. tenn. 1981); see also baldassari v. united states, 144 cal. rptr. 741,742-43 (cal. ct. app. 1978) (state case finding that nominee liens are well recognized under federal law). 282. see, e.g., united states v. tempelman, 111 f. supp. 2d 85,93 n.18 (d.n.h. 2000) (since it was established that the taxpayers were the owners of the property at issue, the court "need not engage in a state law analysis of their rights in the property"). 283. my criticism here is not just doctrinal. in its microscopic dissection of state law cases as to equitable ownership, the nantucket village court risked forgetting the purpose and flexibility that characterize equity. better is the awareness that informed a circuit court nominee lien opinion: "we must avoid an over-rigid 'preoccupation with questions of structure' ... and 'apply the preexisting and overarching principle that liability is imposed to reach an equitable result."' libutti v. united states, 107 f.3d 110, 119 (2d cir. 1997) (quoting william wrigley jr. co. v. waters, 890 f.2d 594,601 (2d cir. 1989) and brunswick corp. v. waxman, 599 f.2d 34, 36 (2d cir. 1979)). 284. see 2001 wl 169316 at * 5. 285. see, e.g., madden & hayes, supra note 73, at 170 ("the supreme court held that in determining whether a taxpayer's state-law rights constitute 'property' or 'rights to property,' the important consideration is the breadth of control the taxpayer could exercise over the property"). florida tax review [vol. 5:6 the good, the bad, and the ugly but that does not mean that it need always be. other cases with other facts may well hinge on other considerations.286 consider some examples. it is fundamental that, in general, substance controls over form in federal taxation.287 reflecting this, it long has been held that the tax lien attaches to beneficial interests in property, not mere legal title to it.288 yet, legal title holders may exercise a great deal of control over the property. for instance, depending on the terms of a trust, the trustee may have substantial discretion as to which of the various beneficiaries will receive distributions of corpus and/or income, how much those distributions will be, and (almost as important) when the beneficiaries will get those amounts. similarly, depending on the terms of the power, the holder of a special power of appointment may have vast control indeed: the ability to confer the underlying property perhaps on anyone in the world, except only herself, her estate, her creditors, and creditors of her estate.289 assume that the trustee or holder of the appointment power in our examples owe federal taxes. any tax liens against them would not, under current law, attach to the trust property or the property subject to the power of appointment,29 ' despite the very great control they exercise over the property. it is clear that the drye court did not intend to change that outcome.2 1 thus, it is too broad to say, as nantucket village did and some commentators have, that drye made control the critical criterion at stage two of tax collection analysis.292 286. see, e.g., united states v. murray, 217 f.3d 59,63 (1st cir. 2000) (suggestingthat control and other particular factors need not be decisive under drye but only be "among the relevant considerations in a highly fact-specific inquiry"). 287. e.g., commissioner v. sunnen, 333 u.s. 591, 604-05 (1948); gregory v. helvering, 293 u.s. 465, 470 (1935); corliss v. bowers, 281 u.s. 376, 378 (1930); speca v. commissioner, 630 f.2d 554, 557 (7th cir. 1980); kohn v. commissioner, 197 f.2d. 480, 482 (2d cir. 1952). 288. see, e.g., aquilino v. united states, 363 u.s. 509, 515-16 (1960) (remanding for determination whether the taxpayer had a beneficial interest, as opposed to bare legal title, in the property at issue); united states v. johnson, 200 f. supp. 589,592 (d. ariz. 1961) (taxpayerheld bare legal title to property as security for repayment of a loan; held: tax lien does not attach). 289. see irc §§ 2041(b)(1) & 2514(c) (defining powers of appointment). 290. e.g.,walwyn v. united states, 51 f. supp. 2d 320 (e.d.n.y. 1999) (trust); chamberlain v. conley, 64-2 u.s. tax cas. (ccii) 9663 (d. conn. 1964), 14 a.f.t.r. 2d (ria) 5588 (trust); cf. 11 u.s.c. § 541(b)(1) (a power which the debtor can exercise only for the benefit of others is not included in the property of the bankruptcy estate). 291. in its recounting ofprior stage two decisions, the court cited with apparent favor the rule that a beneficial interest, not mere legal title, is required for attachment of the tax lien. see 528 u.s. at 59 n.6. 292. what distinguished the disclaimer situation in drye from the bare legal title situation is the possibility of personal benefit. mr. drye had control over his mother's estate and could personally benefit from how he chose to exercise that control. the trustee and the holder of the special power of appointment cannot benefit from how they exercise their control; only others can benefit. 2oo02] florida tax review vii. conclusion diye is a landmark case in federal tax collection analysis. it offers the opportunity to undo confusion of generations-long duration and provides a foundation on which to build future doctrine. the fulfillment of this promise depends on keeping drye's teaching in clear focus, unobstructed by the discarded undergrowth of previous error or imprecise statement. on balance, at this early time in the drye era, one may feel encouraged by the treatment of dye by the lower courts. most decisions reflect correct understanding of diye and satisfactory expression of that understanding. of the cases that are less than fully satisfying, more suggest a want of sufficient care than actual error. the power of history and habit most plausibly explains both the bad cases and many of the ugly ones. the antidote is rigor: unstinting recollection of what drye teaches, and uncompromising excision of thinking incompatible with it. at this point in the evolution of tax lien law, the two most pressing items on the agenda are (1) establishing that stage one of the analysis involves only what powers state law creates, not what characterizations it attaches to them-to uproot the error of craft ii-and (2) clarifying that control may be situationally important, but it is not universally predominant-to move past an imprecision of nantucket village. [vol. 5:6 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe * paul g. kauper professor, university of michigan law school. the author wishes to thank professors andrea monroe and yale kamisar for their helpful suggestions that were incorporated into this piece. 411 florida tax review volume 7 2006 number 6 is the report of lazarus’s death premature? a reply to cameron and postlewaite by douglas a. kahn* i. introduction . .................................................................................... 413 ii. was there an implied or effective repeal of irc section 707(c) in 1984? . .................................................................. 415 a. post-1984 regulations apply irc section 707(c) . .................. 415 b. disfavor of implied repeal of statutes . ................................... 416 1. no conflict in language or purpose of two statutes . .... 416 2. purported repeal by legislative history is unwarranted . ............................................................... 417 3. proposal of standards for determining partner capacity contained in the legislative history. ............... 417 (a) absence of risk factor . .................................. 418 (b) role of absence of risk factor . ...................... 418 4. rejection by treasury of standards contained in the legislative history – an invitation declined. ................................................ 419 iii. should irc section 707(c) be repealed? . ................................ 423 iv. reply to the criticisms of the 2004 article . ........................ 424 a. the adoption of irc section 707(a)(2) has no bearing on the issues discussed in the 2004 article . ......................... 425 b. no expressed legislative intent regarding guaranteed payments in kind . .................................................................... 425 c. congressional goal of nonrecognition for transactions between a partnership and partners . ..................................... 426 d. eclectic application of entity and aggregate treatments of a partnership . ..................................................................... 427 e. slight presumption favoring aggregate treatment . .............. 428 412 florida tax review vol.7:6 f. examination of policies cameron and postlewaite rely upon for contention that partnership recognizes gain or loss . ........................................................................... 429 1. deduction for disposition of unrealized appreciation . .............................................................. 429 (a) partnership-partner and employer-employee transactions are not equivalent . ................... 435 (b) comparison of guaranteed payments to ordinary section 731 distributions . .............. 436 (c) similar consequence of partnership’s deduction and allocation of partnership income . .......................................................... 437 2. potential for abuse . .................................................... 439 g. administrative burden generated by requiring gain recognition . ........................................................................... 444 v. conclusions . ..................................................................................... 450 2006] is the report of lazarus’s death premature? 413 1. douglas a. kahn and faith cuenin, guaranteed payments made in kind by a partnership, 6 fla. tax rev. 405 (2004) [hereinafter 2004 article]. 2. david l. cameron and philip f. postlewaite, the lazarus effect: a commentary on in-kind guaranteed payments, 7 fla. tax rev. 339 (2006) [hereinafter lazarus effect]. 3. id. at 351 and 391. i. introduction over a year ago, ms. faith cuenin and i wrote an article in this review (which i hereafter refer to as the “2004 article”) about the tax treatment of guaranteed payments under section 707(c) that are made in kind. we concluded1 that a partnership does not recognize gain or loss on the making of a guaranteed payment with appreciated or depreciated property. we also concluded that the partner’s basis in the property received will equal its fair market value at the time of payment, and that the payment does not affect the partner’s outside basis in his partnership interest except to the extent of the partner’s share of any deduction that the partnership obtained by making the payment. professors cameron and postlewaite strongly disagree with one of the conclusions we reached in our article (i.e., our conclusion that the partnership does not recognize gain or loss) and with all of our reasoning. they are publishing in this issue of the florida tax review (in what i will refer to as their “lazarus effect” article) their analysis for rejecting our treatment of the topic. while i find their2 arguments well reasoned and documented, for reasons that i will explain in this response, i continue to hold to the conclusions that ms. cuenin and i reached in the 2004 article. i will not reiterate in this response all of the analysis that is set forth in the 2004 article, and i hope that an interested reader will turn to that piece. i will, however, respond to many of the points that are made in cameron and postlewaite’s lazarus effect article. the lazarus effect article can be divided into two principal parts. one is the contention that section 707(c) was impliedly or effectively repealed by the adoption of section 707(a)(2) as part of the tax reform act of 1984. the3 second is a contention that, even if section 707(c) is still viable, the conclusion concerning the partnership’s nonrecognition of income that ms. cuenin and i reached in the 2004 article, and our reasons for reaching that conclusion, are wrong. i will address both contentions. while there is no discussion in the 2004 article concerning the issue of the continuing vitality of section 707(c), the 2004 article is predicated on the assumption that section 707(c) is still operative. there would be no point in examining the question of the proper treatment of making guaranteed payments in kind if there were no such thing as a guaranteed payment. the assumption that section 707(c) is viable and that it applies to the circumstances described 414 florida tax review vol.7:6 4. e.g., william s. mckee, william f. nelson & robert l. whitmire, federal taxation of partnerships and partners ¶ 13.03 (3d ed. 1997) [hereinafter mckee]; stephen a. lind, stephen schwarz, daniel j. lathrope & joshua d. rosenberg, fundamentals of partnership taxation 233-42 (7th ed. 2005) [hereinafter lind] laura e. cunningham and noel b. cunningham, the logic of subchapter k 127-29 (3d ed. 2006) [hereinafter cunningham]. 5. cameron and postlewaite expressly acknowledge that a number of post-1984 commentators and regulations treat § 707(c) as a viable provision. lazarus effect, supra note 2, at n. 38. 6. lazarus effect, supra note 2, at 341-42, where the authors state: [w]e uncovered a recently published article in this journal by douglas kahn and faith cuenin regarding the treatment of in-kind guaranteed payments. because of the article’s provocative and thorough analysis, we feared that kahn and cuenin’s efforts might be viewed as breathing new life into § 707(c), not dissimilar from the return of lazarus from the dead. 7. philip f. postlewaite and david l. cameron, twisting slowly in the wind: guaranteed payments after the tax reform act of 1984, 40 tax law 649, 696 (1987) [hereinafter twisting slowly]. 8. id. at 711. 9. lazarus effect, supra note 2, at 340. in the 2004 article is shared by a number of other commentators and, as we4 shall note below, by treasury as well. 5 cameron and postlewaite expressed concern that the 2004 article would breathe life into a previously moribund statutory provision by ascribing significant consequences to the application of the statute – i.e., the “lazarus effect.” they authored an article some 18 years earlier contending that the6 legislative history to the adoption of section 707(a)(2) as part of the tax reform act of 1984 establishes that the standard for determining the capacity in which a partner performs services for a partnership was altered by that act in such a manner as to make section 707(c) “self-contradictory and, thus, obsolete.” in7 that article, the authors also contended that other statutory changes adopted in 1984 minimized the difference in consequence between applying section 707(a) and section 707(c) to a transaction. given the asserted obsolescence of section 707(c) and the asserted insignificance of its operation from that of section 707(a), cameron and postlewaite urged congress to expressly repeal section 707(c) to avoid any confusion its retention in the code might engender. while,8 in their current lazarus effect article, the authors acknowledge that they may have been “somewhat premature” in authoring a eulogy for section 707(c) 18 years ago, they flatly state that “[a]s a result of the enactment of section9 707(a)(2), congress effectively repealed section 707(c)” and that, in our 2004 article, cuenin and i “erroneously assumed that section 707(c) remains alive 2006] is the report of lazarus’s death premature? 415 10. lazarus effect, supra note 2, at 391-92. in addition to other statements to that effect, the lazarus effect article also states that “[i]n 1984, congress dealt the final blow to what little remained of the vitality and independence of § 707(c) through its enactment of § 707(a)(2)” and “[e]ffectively, § 707(c) had been repealed and all that remained was statutory surplusage prone to produce confusion and complexity.” id. at 348, 351. 11. see supra note 4. 12. prop. regs. § 1.721-1(b)(4)(i). 13. preamble, proposed regulations – partnership equity for services, 70 fed. reg. 29675 (may 24, 2005), item 2 [hereinafter preamble]. and well.” since the conclusions reached in the 2004 article give added10 significance to the characterization of a transfer of property to a partner as a guaranteed payment, cameron and postlewaite feared that if those conclusions were accepted, it might adversely effect the prospects for the adoption of their proposal for an explicit legislative repeal of section 707(c). independently of that concern, they disagree with the analysis and one of the conclusions of the 2004 article. ii. was there an implied or effective repeal of section 707(c) in 1984? a. post-1984 regulations apply irc section 707(c) as cameron and postlewaite note, many tax commentators continue to discuss section 707(c) and treat it as a viable provision. moreover, in11 regulations promulgated after the 1984 amendments, treasury has demonstrated its belief that section 707(c) is an operative provision. for example, regulations section 1.721-1(b)(2), which was last amended in 1996, characterizes a partnership’s transfer of a partnership interest in exchange for services as a “guaranteed payment for services under section 707(c).” treasury repeated that statement in a proposed amendment of that regulation that was promulgated in 2005. in a preamble to the 2005 proposed amendments of regulations dealing12 with a transfer of a partnership interest for services, treasury expressly examined the question of whether a transfer of a partnership interest for services should be treated as a guaranteed payment under section 707(c), and concluded that section 707(c) does apply to such transfers. while cameron and13 postlewaite note the 2005 proposed version of the section 721 regulation in footnote 129 of the lazarus effect article, they fail to explain why the proposed regulation refers to section 707(c) guaranteed payments and why treasury concluded that the transfer constitutes a guaranteed payment if they are correct in asserting that the 1984 amendment rendered section 707(c) obsolete. moreover, several other final regulations that were promulgated or amended 416 florida tax review vol.7:6 14. e.g., regs. § 1.707-4(a)(1)(i) (1992). additionally, the proposed amendments to regs. § 1.707-1(c), promulgated in 2005, left intact the references in that regulation to guaranteed payments. prop. regs. § 1.707-1(c) 15. posadas v. national city bank, 296 u.s. 497, 503 (1936). 16. j.e.m. ag supply v. pioneer hi-bred intern., 534 u.s. 124, 122 s.ct. 593, 604 (2001). see also, morton v. mancari, 417 u.s. 535, 550 (1974). years after the 1984 amendments discuss guaranteed payments and refer to section 707(c).14 b. disfavor of implied repeal of statutes. 1. no conflict in language or purpose of two statutes – there is nothing in the language of section 707(a)(2) itself that conflicts with or makes obsolete the previously established construction of section 707(c). reading section 707(a)(2) alone, there would be no reason to assert that it has effectively or impliedly repealed section 707(c). there is no possibility that the drafters of section 707(a)(2) were unaware of section 707(c), and so it is virtually certain that congress did not intend that the 1984 addition to the code of section 707(a)(2) replace section 707(c), since it did not delete the latter section from the code and left it intact. if congress had wished to repeal section 707(c), it surely would have included the repeal in the 1984 act. thus, if cameron and postlewaite are correct in their assertion that congress effectively repealed section 707(c) in 1984, it did so unintentionally. as a matter of statutory construction, implied legislative repeals of statutes are disfavored. the supreme court stated that view as follows: the cardinal rule is that repeals by implication are not favored. where there are two acts upon the same subject, effect should be given to both if possible. there are two well-settled categories of repeals by implication – (1) where provisions in the two acts are in irreconcilable conflict, the later act to the extent of the conflict constitutes an implied repeal of the earlier one; and (2) if the later act covers the whole subject of the earlier one and is clearly intended as a substitute, it will operate similarly as a repeal of the earlier act. but, in either case, the intention of the legislature to repeal must be clear and manifest . . . .15 in a more recent case, the supreme court stated, “the only permissible justification for a repeal by implication is when the earlier and later statutes are irreconcilable.”16 2006] is the report of lazarus’s death premature? 417 17. lazarus effect, supra note 2, at 348-50; twisting slowly, supra note 7, at 677-81. 18. see twisting slowly, supra note 7, at 677-81. 19. as noted below, treasury has not yet adopted those six proposed factors and has impliedly rejected their application to § 707(c). 2. purported repeal by legislative history is unwarranted – the asserted repeal or obsolescence of section 707(c) is especially questionable because it does not rest on the adoption of a statute whose language or purpose is in any way inconsistent with section 707(c). the purported repeal is based on a more tenuous ground. it rests on language in the legislative history to the adoption of a 1984 amendment that proposed standards for the application of such amendment (i.e., section 707(a)(2)) that conflict with the established standard for determining partner capacity for purposes of section 707(c). it would be17 quite a stretch to find that a statute had been made obsolete or effectively repealed, not by the subsequent adoption of a conflicting statute, but by a conflict with the legislative history of a subsequent statute, the provisions of which are fully consistent with the statute that is claimed to have been repealed. in any event, let us consider the legislative history to the adoption of section 707(a)(2) and the question of whether it has affected the operation of section 707(c). 3. proposal of standards for determining partner capacity contained in the legislative history – section 707(a)(2) is aimed at preventing a partnership from successfully disguising a payment to a partner for the purchase of property or for services as an allocation of partnership income. section 707(a)(2) applies to certain transactions between a partnership and a partner who is “acting other than in his capacity as a member of the partnership.” section 707(c) applies to payments to a partner for services or for the use of property in the latter’s capacity as a partner to the extent that the payments are determined without regard to the income of the partnership. in construing section 707(c), the standard that the service and the courts have applied to determine whether the services that a partner provided were performed in his capacity as a partner turned on the nature of the services in relation to the activity of the partnership. the claim that section 707(c) was effectively repealed rests on the18 contention that since the legislative history to the 1984 amendment that added section 707(a)(2) proposed that, in applying that provision, treasury adopt a standard that utilizes six factors to determine partner capacity, and since that proposed standard differs from the standard for determining partner capacity for purposes of section 707(c) that the service and the courts have previously applied, the proposed new standard should also be applied to section 707(c) in substitution of the previously employed standard. cameron and postlewaite19 contend that an application of the new proposed standard to section 707(c) 418 florida tax review vol.7:6 20. s. rep. no. 169, 98th cong., 2d sess., at 227-28 (1984). joint committee staff’s “general explanation of the revenue provisions of the deficit reduction act of 1984,” h.r. 4870, 98th cong. at 227-229 (1984) [hereinafter blue book]. 21. s. rep. no. 169, supra note 20, at 227; blue book, supra note 20, at 227. 22. s. rep. no. 169, supra note 20, at 228-29. would prevent that provision from applying to virtually any payment by a partnership. (a)absence of the risk factor the proposed new standard is comprised of six factors listed in the senate finance committee’s report to the 1984 act and in the blue book to that act. the senate report and the blue book state that “[t]he first, and20 generally the most important factor is whether the payment is subject to an appreciable risk as to amount”[emphasis added]. the word “generally” gives21 some indication that entrepreneurial risk is not always the most important of the six proposed factors. cameron and postlewaite, however, treat the absence of risk as conclusively establishing non-partner capacity. since most payments that were previously characterized as guaranteed payments are of fixed value, the contention of cameron and postlewaite is that, after the 1984 amendment, virtually no payment to a partner can qualify as a guaranteed payment under the risk standard. i will examine below the question of whether the proposed new standard has been adopted, but first let us consider whether entrepreneurial risk is a necessary and sufficient factor under the new proposed standard. (b) role of absence of the risk factor entrepreneurial risk is merely one of six factors. even acknowledging that generally it is the most important of the six factors, it does not necessarily follow that that factor alone is sufficient to determine partnership capacity. the senate finance committee’s report provides an example (example (1)) of the application of its multi-factor standard. in that example, an architect for a22 building constructed by a partnership purchased a partnership interest and also received an allocation of $20,000 of the partnership’s gross income for each of the first two years of partnership operations after the building was leased. the architect’s normal fee for his services was $40,000. in determining that the partnership’s allocation of a specified amount of two years’ gross income was a fee under section 707(a) rather than a partnership allocation, the senate report concluded that four of the six listed factors were satisfied. the absence of risk factor was one of those four. the listing and discussion of the other three factors suggest that the absence of risk alone was not sufficient to resolve the issue, and the support of other factors was needed to determine the capacity in which the money was received. the example goes on to state that if meaningful risk as to 2006] is the report of lazarus’s death premature? 419 23. id. at 229. cameron and postlewaite point out that the senate finance committee’s report also stated that the payments that were characterized as § 707(c) guaranteed payments in rev. rul. 81-300 would, under the committee’s view, be treated as § 707(a) payments. s. rep. no. 169, supra note 20, at 230. rev. rul. 81-300 dealt with a provision compensating general partners for their ongoing managerial services by granting them 5% of gross rentals from a shopping center that the partnership owned. the ruling indicates that the provision for a percentage of gross rentals did not provide a fixed amount of money since the service deemed it necessary to rule that guaranteed payments are not limited to fixed amounts. the service focused on the fact that the payments were reasonable for the services performed and that the method of payment was one that would have been used to compensate an unrelated party for those services. it would seem that a partner who has a right to a percentage of gross income does bear an entrepreneurial risk unless the amount can be determined with some certainty. it is difficult to see why the arrangement in rev. rul. 81-300 did not fall outside of the senate finance committee’s standards for § 707(a) transactions. in discussing the risk standard, the senate finance committee stated, “continuing arrangements in which purported allocations and distributions (under a formula or otherwise) are fixed in amount or reasonably determinable under all the facts and circumstances and which arise in connection with services also shield the purported partner from entrepreneurial risk.” the facts stated in rev. rul. 81-300 do not indicate that the payments of the percentage of gross rents fit the requirements of the above statement. the committee’s reference to that ruling is therefore hard to reconcile with the risk standard as the committee explained it. the committee did state that short-lived gross income allocations are suspect, but the facts of the ruling indicate that the gross income provision therein was not a temporary or short-lived one. whether the partnership would have sufficient gross income to pay the architect was present, “the special allocation might (even though a gross income allocation), depending on all the facts and circumstances, properly be treated as a distributive share and partnership distribution.” the senate finance23 committee’s discussion of that example suggests that, under the proposed new standard, the presence of significant risk is nearly sufficient to establish partner capacity, but the absence of significant risk is not sufficient by itself to establish non-partner capacity, even though it is an important factor. 4. rejection by treasury of standards contained in the legislative history – an invitation declined. the contention of cameron and postlewaite that section 707(c) does not apply to a payment of a specified amount of property where there is no significant risk as to whether the partnership can make the payment is belied by regulations adopted years after the 1984 amendment. regulations section 1.707-4(a)(4), example (1), which was adopted in 1992, treats a cash payment of a specified amount (plus compounded interest) as a guaranteed payment under section 707(c). regulations section 1.721-1(b)(2) and proposed regulations section 1.721-1(b)(4)(i) (promulgated 420 florida tax review vol.7:6 24. a partnership interest can be either a “partnership capital interest” or a “partnership profits interest.” a “partnership capital interest” is a partnership interest that includes an interest in the assets of the partnership, as contrasted to a “partnership profits interest” which represents an interest only in the partnership’s income. see rev. proc. 93-27, 1993-2 c.b. 343. the transfer of a partnership capital interest as payment for services will be treated as ordinary income to the transferee in an amount equal to the value of the partnership interest. prop. regs. § 1.721-1(b)(4)(i) that is cited above treats that payment as a guaranteed payment. there has been some controversy as to whether the transfer of a partnership profits interest for services causes income to be recognized by the transferee. after some mixed results in litigation, the service appeared to have resolved that issue by conceding in a revenue procedure that the receipt of a partnership profits interest for services generally does not cause the transferee to recognize income, but there are a few exceptions to that general rule. rev. proc. 93-27, 1993-2 c.b. 343, and rev. proc. 2001-43, 2001-2 c.b. 191 (both of which rulings will be obsoleted by irs notice 2005-43, 2005-24 i.r.b. 1221 when a proposed regulation under irc § 83 is finalized). the 2005 proposed regulation, which states that the transfer of a partnership interest as payment for services constitutes a guaranteed payment, refers to a “partnership interest” without specifying whether it has to be a capital interest. prop. regs. § 1.721-1(b)(4)(i). one pair of commentators has concluded that the proposed regulation applies to both capital and profits partnership interests and will therefore obsolete those revenue procedures if finalized. cunningham, supra note 4, at 134. perhaps, the proposed regulation will be restricted to the compensatory transfer of partnership interests that are otherwise taxable to the transferee. in any event, even if the cunninghams are correct, they also note that, under the method commonly used to value a partnership interest (the so-called “liquidation method”), a partnership profits interest will have a zero value and so will not cause the transferee to recognize any income. id. at 135. for a description of the liquidation method, see § 2.01 of rev. proc. 93-27, 1993-2 c.b. 343 and irs notice 2005-43, supra. 25. lazarus effect, supra note 2, at n. 39. in 2005) treat the transfer of a partnership interest in exchange for services to24 the partnership as a guaranteed payment under section 707(c). the value of a partnership capital interest can be ascertained and is no different in that respect from the payment of any other property in kind. the value of a partnership interest is subject to subsequent market changes and risk, but that is true of any property in kind that is paid to a partner. the risk to which the legislative history to the 1984 act refers is the risk as to the amount of property the partner will receive. proposed regulations section 1.721-1(b)(2) also provides that a partnership does not recognize gain or loss upon transferring a partnership interest in payment for services, and i will discuss that provision later in this article. cameron and postlewaite acknowledge that, to date, the regulations have not adopted the risk standard in applying section 707(c). indeed, as25 discussed below, treasury adopted an entirely different standard in regulations section 1.707-4(a), which was promulgated some eight years after the 1984 congressional adoption of section 707(a)(2). there is no suggestion that regulations section 1.707-4(a) is invalid. it is far from certain that the risk 2006] is the report of lazarus’s death premature? 421 26. regs. § 1.707-4(a)(1)(i). standard will ever be adopted, much less that it will be made determinative. there is no basis for concluding that section 707(c) is a nullity; to the contrary, the application of the 1984 amendment by treasury demonstrates that section 707(c) continues to have vitality. the legislative history to the 1984 amendment in not the equivalent of the adoption of a statute. the suggestion that treasury adopt the six factors described in the senate finance committee’s report is no more than an invitation to treasury to adopt those standards. regulations that were subsequently adopted by treasury show that the invitation was declined and that treasury adhered to a quite different standard. regulations section 1.707-4(a), which deals with disguised sales of property by a partner to a partnership (i.e., with section 707(a)(2)), expressly states that a “guaranteed payment” to a partner for capital is not treated as part of a sale of property. the regulation further states, “[t]he term guaranteed payment for capital means any payment to a partner by a partnership that is determined without regard to partnership income and is for the use of that partner’s capital” [emphasis in original], and the regulation refers specifically to section 707(c). significantly, the regulation makes no mention of26 entrepreneurial risk, or of any of the other five factors that are listed in the legislative history, in determining whether a payment constitutes a guaranteed payment. any doubt as to whether treasury rejected the invitation contained in the legislative history to adopt a risk standard is laid to rest by the two examples in that regulation that illustrate how guaranteed payments are to be determined. let us examine example (1) of regulations section 1.707-4(a)(4). in that example, a, a partner, transfers property with a fair market value of $100,000 to partnership ab. at that time, “the partnership agreement is amended to provide that a is to receive a guaranteed payment for the use of [his] capital of 10% (compounded annually) of the fair market value of the transferred property in each of the three years following the transfer.” partnership net income and loss and cash flow will be allocated and distributed equally between a and b. if the payment qualified as a guaranteed payment under section 707(c), the deduction the partnership obtained thereby would be allocated equally between the two partners (that is, in the same manner as other partnership items are allocated). the amount payable to a for the use of his capital for the three-year period was found to be reasonable. the regulation concludes that the payments to a over the three year period are guaranteed payments for the use of capital. it is noteworthy that there is no mention in example 1 of any facts suggesting that there was a significant risk as to whether the partnership would be able to make the payments when they are due. to the contrary, the facts suggest that there was no significant risk of nonpayment and that the certainty of payment did not prevent them from being characterized as guaranteed payments. this regulation demonstrates that treasury has not 422 florida tax review vol.7:6 27.while example (2) of that regs. § 1.704-4(a)(4) found that payments of a specified amount from a newly formed two-person partnership were not guaranteed payments, in reaching that conclusion, the regulation did not rely on (or refer to) the absence of risk factor or to any of the other five factors listed in the legislative history to the 1984 act. under the terms of the partnership agreement, the payments in question were borne entirely by the partner who was not the distributee (i.e., the non-distributee partner). treasury determined that the substance of the transaction was identical to a prepartnership sale by the distributee partner of a portion of his property to the nondistributee partner, followed by a contribution of the properties by both parties to the newly formed partnership. the specified payments to the distributee partner were deemed to have been made by the non-distributee partner utilizing the partnership as a conduit to make the payments. see regs. § 1.707-4(a)(4), ex. (2)(iv). 28. lazarus effect, supra note 2, at n. 39. 29. id. accepted the invitation to adopt risk and the other five factors for purposes of applying section 707(c). 27 in their lazarus effect article, cameron and postlewaite concede that, in regulations section 1.707-4, treasury did not utilize the standards for determining capacity that were suggested in the legislative history to the 1984 act. surprisingly, they treat that evidence of this decision not to accept the28 invitation to adopt the new criteria for determining partner capacity as “virtually meaningless” because the payments made in the regulatory examples were made in cash. because the regulation did not have to deal with the added complexity29 of a payment made in kind, they conclude that the regulation is of no consequence in determining whether the adoption of section 707(a)(2) has changed the standards for determining partnership capacity. surely, that cannot be so. the test of partnership capacity is the same for payments made in kind as it is for payments made in cash. cameron and postlewaite’s contention that section 707(c) was rendered a nullity by the 1984 amendment is not limited to payments made in kind. indeed, when they wrote their twisting slowly article 18 years ago, which is when they first articulated their contention that section 707(c) was impliedly repealed, they did not even consider payments made in kind. the fact that treasury declined to adopt the criteria enunciated in the 1984 legislative history and set forth an example in which a provision for a payment with no significant risk factor was characterized by treasury as a guaranteed payment is of great significance; it demonstrates that not only has treasury declined the invitation to change its criteria for determining partner capacity, it has effectively repudiated the absence of risk factor by characterizing as a guaranteed payment a payment in which there was no risk factor. moreover, the question of how partner capacity should be determined for purposes of applying section 707(c) to a payment is not made more or less complex when the payments are in kind or in cash. the question of how to treat a guaranteed payment that was made in kind raises complex considerations, but the 2006] is the report of lazarus’s death premature? 423 30. for example, the payments could be subjected to withholding and employment taxes, and favorable tax provisions for fringe benefits might be deemed to apply. see e.g., armstrong v. phinney, 394 f.2d 661 (5th cir. 1968) (applying the § 119 exclusion for employees to meals and lodging provided to a partner where § 707(a) was held to apply). employment taxes, withholding provisions, and employee benefit complexity of the determination of partner capacity is not affected by the type of the payment. iii. should irc section 707(c) be repealed? if a partner provides ongoing services to a partnership in his capacity as a partner, the benefit that the partner provides to the partnership needs to be reflected in some manner, such as granting the partner an additional share of profits or capital, by paying the partner a specified amount, or some combination of these options. if the parties choose to have the partnership pay the partner a specified amount, that amount could be characterized either the same as a payment to an unrelated third party for services rendered, or as a division of partnership profits or capital to reflect the contribution made by the partner. by adopting section 707(c), congress chose a middle ground between those two options – treating the payment as if it were made to a third party for some purposes, but not for others. cameron and postlewaite urge the repeal of section 707(c) so that such payments would be treated under section 707(a) as having been made to a third party. while, for reasons noted in the paragraph below, i prefer the retention of the current separate treatment, reasonable people can differ on that issue. congress has given special treatment in subchapter k to a partner’s receipt of property from a partnership. that treatment is part of a complex scheme that congress adopted as to how partners and a partnership are to be treated for federal income tax purposes. if a partner receives a payment from the partnership for services performed in a non-partner capacity, there is merit to treating that payment the same as a payment made for services provided by a non-partner. there is no reason to give any special treatment to such a payment just because the recipient also happens to be a partner when the payment had nothing to do with his partner capacity. however, when a partner performs services for the partnership in his partner capacity, the manner in which the partnership chooses to reflect that contribution should not alter the fact that the partnership is dealing with him as a partner. there are good reasons to treat such payments differently from ones made to a non-partner (or to those made to a partner in a non-partner capacity). one consideration against repealing section 707(c) is that the application of section 707(a) to guaranteed payments could make other tax provisions outside of subchapter k applicable to those payments. moreover,30 424 florida tax review vol.7:6 provisions do not apply to guaranteed payments under § 707(c). mckee, supra note 4, at ¶ 13.03[6][b], [c]. 31. preamble, supra note 13, at item 2. in the 2005 preamble to a number of proposed amendments to regulations dealing with the transfer of partnership equity for services, treasury stated: in drafting these regulations, the treasury department and the irs considered alternative approaches for resolving the timing inconsistency between section 83 and section 707(c). one alternative approach considered was to provide that the transfer of property in connection with services is not treated as a guaranteed payment within the meaning of section 707(c). this approach was not adopted in the proposed regulations due to, among other things, concern that such a characterization of these transfers could have unintended consequences on the application of provisions of the code outside of subchapter k that refer to guaranteed payments.31 in addition, if ms. cuenin and i are correct in our view that the principle of deferring gain for partnership to partner transactions, together with additional considerations, are of sufficient importance to warrant granting nonrecognition of gain for guaranteed payments made in kind, then that view is another strong point in favor of retaining section 707(c) in the code. as noted later in this article, reasonable people can come to different conclusions on the question of whether a partnership recognizes gain in that circumstance; i do not know whether the position that ms. cuenin and i took ultimately will prevail. while i believe that section 707(c) should not be repealed, i am content to urge no more in this article than that it has not yet occurred. iv. reply to the criticisms of the 2004 article cameron and postlewaite make several points in support of their contention that the 2004 article was wrong in its analysis and in the conclusion that the partnership does not recognize gain on making a guaranteed payment with appreciated property. i will address their points concerning nonliquidating guaranteed payments made in kind. because of time limitations, i will not comment on the points they made concerning the discussion in the 2004 article of liquidating distributions. i do not intend my failure to discuss liquidating distributions to be deemed a concession of error on that issue. i think that the discussion below of nonliquidating payments is sufficient to show the difference between my analysis of this subject and that of cameron and postlewaite, and the time frame for writing this reply led me to focus on what i believe to be their principal topic. 2006] is the report of lazarus’s death premature? 425 32. see supra notes 25-29, and the accompanying text. 33. lazarus effect, supra note 2, at 358. a. the adoption of irc section 707(a)(2) has no bearing on issues discussed in the 2004 article. on page 345 of the lazarus effect article, cameron and postlewaite state: although we acknowledge that, in the absence of section 707(a)(2), our conclusions are not entirely free from doubt, we believe that the better interpretation of section 707(c) requires that a partnership recognize gain or loss on the transfer of property in satisfaction of a guaranteed payment. after bringing the changes wrought by section 707(a)(2) into the analysis, any lingering doubt in this regard vanishes. the changes “wrought by section 707(a)(2)” to which cameron and postlewaite refer is the change in the standard for determining partner capacity that they contend was effected by the adoption of section 707(a)(2). in the preceding part ii of this response, i set forth my reasons for concluding that neither section 707(a)(2), nor its legislative history, changed the standard for determining partner capacity. regulations adopted after the 1984 addition of section 707(a)(2) have treated section 707(c) as viable and have not applied the proposed new standards for determining partnership capacity that the legislative history to the 1984 act invited treasury to adopt. unless and until treasury32 adopts the new standards proposed in the 1984 legislative history and applies those standards to the application of section 707(c), the 1984 adoption of section 707(a)(2) is of no consequence to the issue at hand (namely, whether a partnership recognizes gain on making a guaranteed payment with appreciated property). the deletion of the section 707(a)(2) point from cameron and postlewaite’s argument that the partnership recognizes gain weakens their case, as they themselves acknowledge in the two sentences quoted above. however, independently of their section 707(a)(2) contention, cameron and postlewaite have made significant points in criticism of the analysis employed in the 2004 article, and i will address those points. before doing so, there are several general propositions on which the 2004 article relies that need to be put in focus. b. no expressed legislative intent regarding guaranteed payments in kind as acknowledged in both the 2004 article and the lazarus effect article, it is virtually certain that congress did not contemplate the possibility33 that guaranteed payments might be made in kind when it adopted section 426 florida tax review vol.7:6 34. preamble, supra note 13, at item 6. the determination of treasury that a partnership does not recognize gain on transferring a compensatory partnership interest is discussed in part iv.f.1 of this article. 707(c). so, there is no explicit legislative intent to guide us in deciding whether a partnership can recognize gain or loss in that circumstance. instead, it is necessary to look to the basic structure of subchapter k and the tax principles that are represented both there and in other parts of the code. the resolution of the question of gain recognition depends upon a determination of what treatment best accommodates those tax principles and best conforms to the statutory language of section 707(c). i do not believe that there is any disagreement between cameron and postlewaite and myself on that framing of the issue; our disagreement centers on the weight to be accorded to competing tax values that are implicated in that decision. c. congressional goal of nonrecognition for transactions between partnership and partners. a premise on which the 2004 article rests is that, in subchapter k, congress showed that it was willing to go to great lengths to prevent the recognition of gain on transactions between a partnership and a partner when it was reasonable to do so, and instead to defer the recognition of gain. it was ms. cuenin’s and my contention that the principle of deferring gain on such transactions plus the desirability of avoiding complexity must be weighed against contrary considerations in determining whether a partnership should recognize gain on making a guaranteed payment. i will examine later the opposing considerations and the weight to be accorded them. for now, i merely wish to establish that the principle of deferral is a highly valued goal of subchapter k. treasury itself made reference to the importance of that goal (at least as to one aspect of subchapter k) in its preamble to the 2005 promulgation of amendments to regulations dealing with the transfer of a partnership interest for services. in that preamble, treasury stated: [t]he treasury department and the irs believe that partnerships should not be required to recognize gain on the transfer of a compensatory partnership interest. such a rule is more consistent with the policies underlying section 721 – to defer recognition of gain or loss when persons join together to conduct a business . . . .34 i do not believe that cameron and postlewaite disagree with the statement that deferral of recognition is an important goal of subchapter k. their thesis focuses on competing tax principles which they believe outweigh the goal of nonrecognition. i will discuss that later. 2006] is the report of lazarus’s death premature? 427 35. see mckee, supra note 4, at ¶ 1.02; lind, supra note 4, at 3-4. 36. mckee, supra note 4, at ¶ 1.02[3]. 37. see e.g., irc § 751. d. eclectic application of entity and aggregate treatments of a partnership. a partnership could be viewed as an entity that is separate from its partners in the same manner that a corporation is regarded as an entity that is separate from its shareholders. that is sometimes referred to as the “entity approach.” alternatively, a partnership could be regarded as a convenient fiction representing an aggregate of interests of each of its partners. that is sometimes referred to as the “aggregate” or “conduit” approach. the question of whether to treat a partnership as an entity or as an aggregate of interests could be resolved by treating it entirely as one or the other. when congress adopted subchapter k in 1954, it chose to treat a partnership as an entity for some purposes and as an aggregate of interests for other purposes. congress35 declined to adopt a single approach to the treatment of partnerships, and instead adopted an eclectic approach. one prominent treatise described this blending of entity and aggregate concepts in the following language: the drafters of subchapter k combined the entity and aggregate concepts in developing a comprehensive scheme for the taxation of partnerships. the aggregate concept predominates in connection with the taxation of partnership income to partners and the general nonrecognition provisions for contributions to and distributions from partnerships. even in these matters, however, the drafters incorporated certain entity notions. . . . the entity approach, on the other hand, predominates in the treatment of transfers of partnership interests as transfers of interests in a separate entity rather than in the assets of the partnership. aggregate notions come into play in this area as well, however . . . [emphasis added].36 this eclectic application of entity and aggregate approaches is a pragmatic solution to the treatment of partnerships, in that aggregate treatment operates better in some circumstances and entity treatment better in others. congress chose to treat each situation individually rather that to commit exclusively to one approach or the other. the eclectic treatment is not limited to having the entity approach apply to some sections of the code and the aggregate to others. a single section of subchapter k can have both entity and aggregate approaches apply to different applications of that provision. this37 eclectic approach to a single section of the code is evident in section 707(c) itself. section 707(c) directs an entity approach for guaranteed payments for purposes of the three code provisions listed in that section. for purposes of 428 florida tax review vol.7:6 38. regs. § 1.707-1(c). 39. regs. § 1.704-1(b)(2)(iv)(b). 40. 2004 article, supra note 1, at 416-18. 41. regs. § 1.707-1(c). 42. 2004 article, supra note 1, at 418-19. other tax provisions, one might expect guaranteed payments to be given aggregate treatment – i.e., treated the same as partnership distributions to a partner. in fact, however, the regulations to that section list three additional code provisions to which entity treatment is accorded, and another regulation38 applies entity treatment in determining the effect of a guaranteed payment on the distributee partner’s capital account.39 in the 2004 article, ms. cuenin and i acknowledged that the language making the entity approach applicable to section 707(c) only for purposes of three code sections has not controlled the construction of that provision.40 instead, as noted above, treasury has expanded the circumstances in which a guaranteed payment will be treated as one made to an unrelated third party (i.e., an entity treatment). we concluded that the same pragmatic eclectic approach should be applied to section 707(c) that congress applied to subchapter k. it is for that reason that, in reaching our conclusions, we were able to accept that a guaranteed payment in kind should be treated as a partnership distribution for some purposes and as a payment to a third party for other purposes. that treatment is consistent with the eclectic statutory scheme and with the very language of section 707(c). the determination of how a guaranteed payment should be treated therefore often will turn on a weighing of tax policy considerations, which was the approach taken in the 2004 article. e. slight presumption favoring aggregate treatment. given the statement in section 707(c) that a guaranteed payment is to be treated as having been made to a third party only for purposes of three code provisions, and given the statement in the treasury regulation, after listing three other exceptions to aggregate treatment, that “[f]or the purposes of other provisions of the internal revenue laws, guaranteed payments are regarded as a partner’s distributive share of ordinary income,” ms. cuenin and i concluded41 that the aggregate approach should be applied to the application of section 707(c) for purposes other than those expressly designated for entity treatment, unless there are strong reasons to apply the entity approach. in other words,42 our point is that if there are competing tax policies, some pointing towards entity treatment and some towards aggregate treatment, the choice should be made for aggregate treatment unless the policies favoring entity treatment clearly outweigh those favoring aggregate treatment. if the competing polices are in equilibrium, or nearly so, then the tie goes to the aggregate approach. i do not think that it is essential to the adoption of the 2004 article’s conclusions 2006] is the report of lazarus’s death premature? 429 43. lazarus effect, supra note 2 at 364-68. 44. 7 fla. tax rev., pg. 377, where the authors state, “deductions are typically not allowed on the transfer of appreciated property unless the taxpayer has previously taken the value supporting the deduction into income.” 45. irc § 170(b)(1)(c), (d). 46. lazarus effect, supra note 2, at n. 129. that one accept the contention that there is a slight presumption in favor of aggregate treatment since i believe that the policies for nonrecognition of gain outweigh the competing considerations. i will examine those factors later. as discussed later, the amount of weight to be accorded to competing tax policies will vary among individuals depending upon their priorities; it is not surprising that even specialists in the tax field arrive at different conclusions. f. examination of policies cameron and postlewaite rely upon for contention that partnership recognizes gain or loss. let me now turn to cameron and postlewaite’s criticisms of the conclusion in the 2004 article that a partnership does not recognize gain or loss on making a distribution of property in kind. the thrust of those criticisms is that when tax policies favoring recognition of income are matched with those that favor nonrecognition, the balance lies with recognition. the polices favoring nonrecognition that are stated in the 2004 article are: (1) the general policy of subchapter k to defer recognition of income for transactions between a partnership and a partner when it is reasonable to do so, and (2) the complexity engendered by requiring recognition of income in certain circumstances. cameron and postlewaite question the extent of the complexity to which the 2004 article refers and question the significance of that issue. i43 will address those questions later. first, let us look at the policies favoring recognition upon which the lazarus effect article relies. 1. deduction for disposition of unrealized appreciation – one principle on which the lazarus effect article relies is that a taxpayer should not be allowed a deduction for a transfer of unrealized appreciation unless the taxpayer is required to recognize the gain that the appreciation represents. that44 proposition is generally correct, but there are exceptions when competing policies warrant it. a contribution of appreciated property to a qualified charity can be deducted, subject to limitations, even thought the contributor is not required to recognize gain for the appreciation that created the deduction.45 more significantly, as cameron and postlewaite note, proposed46 regulations section 1.721-1(b)(2) provides that a partnership that transfers a partnership interest in exchange for services does not recognize income therefrom, even when the partnership can deduct the value of the partnership interest as a business expense. 430 florida tax review vol.7:6 47. 62 t.c. 720 (1974). 48. mckee, supra note, 4 at & 5.08[2][b]. 49. preamble, supra, note 13 at item 6. interestingly, the preamble states that while the proposed regulation=s provision for nonrecognition applies to the compensatory transfer of an interest in an existing partnership, it does not apply to the receipt of a partnership interest in a newly formed partnership. in the latter case, the exchange of property for services is deemed to occur between the parties before the partnership comes into existence, and so the nonrecognition principles of subchapter k do not apply to that situation. id. so, the mcdougal case is still good law for newly formed partnerships. in mcdougal v. commissioner, mr. mcdougal and mr. mcclanahan47 formed a partnership in which mr. mcdougal contributed a race horse and mr. mcclanahan contributed services. the court treated the transaction as a sale of an interest in the horse from mr. mcdougal to mr. mcclanahan before the partnership was formed, followed by a contribution of the horse to the newly created partnership by both mr. mcdougal and mr. mcclanahan. as a result, mr. mcdougal had income for the appreciation of the fraction of the horse that was deemed to have been sold to mr. mcclanahan. a number of commentators concluded that the same approach as that used in mcdougal should be applied to an existing partnership=s transfer of a partnership interest to a person in exchange for services. under that approach,48 the partnership would be treated as having sold a fraction of each of its assets and recognized gain or loss on each constructive sale. proposed regulations section 1.721-1(b)(2) rejects that approach and provides that a partnership does not recognize gain or loss in that situation even though the partnership can deduct the value of the payment. the preamble that treasury wrote for that regulation states: generally, when appreciated property is used to pay an obligation, gain on the property is recognized. . . . however, the treasury department and the irs believe that partnerships should not be required to recognize gain on the transfer of a compensatory partnership interest. such a rule is more consistent with the policies underlying section 721– to defer recognition of gain or loss when persons join together to conduct a business – than would be a rule requiring the partnership to recognize gain on the transfer of these types of interests. 49 the preamble makes clear that treasury and the irs deem the nonrecognition policy of subchapter k to be more important than the policy of forcing recognition of unrealized appreciation that creates a deduction. one might question whether the policy for deferral of gain for partnership distributions is of the same magnitude as the policy for nonrecognition on 2006] is the report of lazarus’s death premature? 431 50. supra note 36 and the accompanying text. 51. martin j. mcmahon jr. “recognition of gain by a partnership issuing an equity interest for services: the proposed regulations get it wrong,” 109 tax notes 1161, 1161 (nov. 28, 2005), [hereinafter cited as “mcmahon article”]. partnership formation, but there seems little reason to treat the former as being of less consequence. in this regard, note the statement, quoted above, of the mckee, nelson and whitmire treatise that the aggregate concept predominates the general nonrecognition provisions for contributions to and distributions from partnerships.50 in a recent article by professor martin j. mcmahon jr., he contends51 that treasury and the irs erred in providing in proposed regulations section 1.721-2(b) that a partnership does not recognize gain on making a compensatory transfer of a partnership interest even though the partnership is allowed to deduct (or capitalize) the value of the partnership interest. mcmahon argues that the combination of allowing nonrecognition for a portion of the appreciation of the partnership’s assets and also allowing a deduction for the full value of the partnership interest provides the other partners with a double tax benefit that results in what is sometimes referred to as “tax arbitrage.” he predicts that aggressive tax planners will exploit that benefit. mcmahon proposes that either the partnership should be required to recognize gain for a portion of the appreciation of its assets or the amount of deduction allowable to the partnership should be limited to a pro rata portion of the partnership’s inside basis in its assets. it would seem that the latter proposal could be adopted only by congressional action. even if mcmahon’s contention were correct, and i do not think that it is, it would serve to emphasize how strongly the treasury adheres to the policy of deferring recognition of gain or loss on transactions between a partnership and its partners to the extent that it is reasonable to do so. even facing the possibility that its nonrecognition policy could lead to abuses, treasury and the irs chose not to require recognition of gain or loss. they balanced the competing considerations and deemed the policy for nonrecognition the weightier. similarly, in balancing the opposing considerations for determining the treatment of a guaranteed payment that is made in kind, it is likely that treasury would assign greater weight to the nonrecognition policy. professor mcmahon’s analysis is similar to some of those advanced by cameron and postlewaite in the lazarus effect article. it should come as no surprise then that i disagree with professor mcmahon’s conclusions and with much of his analysis. to discuss all of the points made by mcmahon in his article would expand this piece far beyond the scope that i intended. so, i will discuss only two of the points that professor mcmahon has made. before taking up those two points, i wish to note that i am not alone in concluding that proposed regulations section 1.721-1(b)(2) appropriately provided that the partnership does not recognize gain. in a recently published 432 florida tax review vol.7:6 52. cunningham, supra note 4, at 136. 53. mcmahon article supra note 51, at 1167. 54. preamble, supra note 13, at item 6; see also accompanying text to supra note 49. text on partnership taxation, professors noel cunningham and laura cunningham expressly approved of the nonrecognition treatment that was adopted in the proposed regulations. they stated: although some may argue that . . . [nonrecognition] is difficult to justify technically, we believe that the rule is justified from an administrative point of view and is consonant with the underlying policies of section 721.52 their view, like mine, is contrary to the position that professor mcmahon adopted. let us now turn to the two points of professor mcmahon that i wish to discuss. in his recent article, professor mcmahon states: in light of the legislative history and statutory structure, section 721 simply cannot be read to provide nonrecognition to a partnership that admits a service-provider partner with a capital account that is transferred in exchange for services. under the current statutes, the transaction must be a recognition event.53 but, the inapplicability of section 721 is besides the point. in the preamble to the proposed regulation, treasury did not claim that section 721 applies to the transaction. what treasury said was that it was adopting a position that conforms to “the policies underlying section 721.” treasury54 sought to conform to those polices its construction of the application of the guaranteed payment provision to a compensatory transfer of a partnership interest. i suggest that the underlying nonrecognition policy of section 721 to which treasury referred is merely one aspect of a broader policy to defer gain or loss on transactions between a partnership and its partners. another point that mcmahon makes relates to what is sometimes called “tax arbitrage.” he notes that by granting a full deduction to the partnership and not requiring it to recognize gain, the amount of the other partners’ investment that had previously been taxed is reduced by the amount of the deduction. that reduction causes a rise in the other partners= subsequent after-tax rate of return on their remaining previously taxed investment. as mcmahon uses the term, “previously taxed investment” apparently refers to the basis of the partnership=s assets, provided that cash is included in the figure. more accurately, the term should refer to the outside basis that the other partners have in their partnership interests. mcmahon maintains that the resulting increase in the non-distributee 2006] is the report of lazarus’s death premature? 433 partners’ after-tax rate of return amounts to tax arbitrage and should be prevented. let us examine whether the result reached in the proposed regulations is inappropriate. consider the following examples that are drawn from illustrations that mcmahon provided in his article. example (1) – p partnership has two equal partners, a and b. p’s assets consist of cash in the amount of $120, and a widget (a capital asset) with a value of $120 and a basis of zero. the aggregate value of p’s assets therefore is $240, and p’s aggregate basis in its assets is $120. p earns a before-tax return of 10% on its assets, and so p has income of $24 per year. c performs services for p in exchange for which p transfers to c a 25% capital interest in the partnership. the value of the partnership interest that c received is $60. p is allowed a $60 deduction for transferring the partnership interest to c, all of which is allocated to a and b. under the proposed regulations, p does not recognize any gain. as a result of the transaction, a and b will have a 75% interest in p’s assets instead of the 100% interest they previously had. p retains all of its assets and continues to earn $24 per year, of which $18 is allocated to a and b. instead of calculating the after-tax rate of return of a and b for their share of p’s subsequent income, i will concede that the rate of their after-tax return on their previously taxed investment (i.e., on their outside basis in their partnership interests) will be increased as a result of these transactions even though the partnership continues to produce the same amount of annual income. but, does that constitute an abuse that needs to be prevented? contrast example (1) with the following two examples. example (2) – the same facts as those stated in example (1) except that instead of giving c a partnership interest, p pays c $60 cash for his services. p takes a $60 deduction for making that payment, all of which is allocated to a and b. immediately after that payment, d, an unrelated party, pays $60 cash to p to purchase a 25% partnership interest. p does not recognize income because of the payment to c, nor does it recognize income because of d’s payment to p. when all the smoke is cleared, p has $120 of cash and has a widget with a value of $120 and a basis of zero. p’s annual income will be $24, of which a and b’s share is $18. the end result is that p (and a and b) are in the identical economic and tax position that they occupied at the close of example (1) except that d has been substituted for c as the new 25% partner. since the economic and tax positions of a, b and p are identical in both examples, and since the tax treatment described for the parties in example (2) is incontrovertible, there is no reason to regard the treatment accorded to the parties in example (1) as abusive or even inappropriate. before d made his contribution to p in example (2), the partnership had $60 in cash and the $120 widget, all of which were allocable to a and b. after d joined the partnership, it had $120 in cash, and the widget; and a and b’s allocable share of those properties was $90 of cash and $90 of the widget. as a result of d’s addition to the partnership, the value of a and b’s share of the partnership’s cash increased by $30, and the value of their share of the widget 434 florida tax review vol.7:6 decreased by $30. in effect, the addition of d resulted in a and b’s selling 1/4 of their interest in the widget for $30 of cash. but subchapter k prevents p (and therefore a and b) from recognizing gain in this circumstance. this policy of providing nonrecognition, even though there was an effective sale of a portion of the widget for a gain, is the policy on which treasury and the irs relied when they extended nonrecognition to the facts of example (1). the consequence of allowing p a deduction for its cash payment to c and not requiring p to recognize income on the admission of d to the partnership provides a and b with the same after-tax rate of return on their previously deducted investment (i.e., on their outside basis in their partnership interests) that they achieved in example (1). example (3) – the same facts as those stated in example (2) except that after receiving his payment of $60 cash for his services, c pays $60 to p to purchase a 25% partnership interest. if the formal facts are respected, p will have a $60 deduction, and p will not recognize gain on receiving c’s $60 contribution. yet, the economic circumstances of example (3) are identical to those of example (1). there is no reason that the tax treatment of the parties should differ. of course, the step transaction doctrine could be applied to the facts of example (3) to ignore the payment of cash to c and the repayment from c to p. if so, the transaction in example (3) would be recharacterized to describe it as a payment of a 25% partnership interest in p to c for his services. but, why should the step transaction be applied here? the formal facts of example (3) track the substance of the transaction. if an employer transfers property in kind to an employee as compensation for services, the transaction is treated for tax purposes as if the employer had paid the employee cash equal to the value of the distributed property, followed by the employee’s purchase of that property from the employer with the cash that the employee constructively received. true, the taxation of the transaction as if those events had occurred does not necessarily mean that they should be regarded as actually having occurred. but, the reconstruction of the transaction to a cash-out and cash-in structure is helpful to see the true nature of the transaction. similarly, in the case of a compensatory payment of a partnership interest, the cash-out, cash-in scenario is useful to grasp the nature of the transaction. when example (3) is compared to the facts of example (2), it becomes difficult to see a reason to punish the partnership in example (3) just because c is the investor instead of d. the economic positions of a and b in example (3) are identical to their positions in example (2), and it is a and b who would bear any tax imposed on p for the recognition of gain if the proposed regulation were rejected. 2006] is the report of lazarus’s death premature? 435 55. lazarus effect, supra note 2, at 356-58. 56. id. at 375. 57. see also irc § 732(d). 58. the partnership interest of the partner is taken into account for purposes of characterizing any gain recognized on the transaction and for determining whether a recognized loss can be deducted. irc § 707(b). (a) partnership-partner and employer-employee transactions are not equivalent. cameron and postlewaite equate a guaranteed payment in kind to a partner with an employer’s payment of compensation to an employee in kind and urge that the two should be treated the same, i.e., the employer would recognize gain on making payment with appreciated property, and so cameron and postlewaite contend that the partnership should also have to recognize gain. but, there is a significant difference between a payment to an employee55 and a payment from a partnership to a partner in the latter’s capacity as a partner. the income and deductions of a partnership are not taxed to the firm as an entity. instead, they pass through to the partners. in that important aspect, as well as with many others, subchapter k treats the partnership as an aggregate of interests rather than as an entity. this aggregate treatment of the partnership as a conduit of tax items to the partners is a foundational element of subchapter k. if a partnership were required to recognize gain on making guaranteed payments in kind, that gain would be allocated among the partners. 56 the aggregate of interests approach means that each partner can be viewed as owning an interest in a fraction of each asset that the partnership holds. while, for some purposes, subchapter k treats a partnership as an entity, it recognizes in numerous provisions that realistically the partners have a kind of equitable interest in the partnership=s assets. for example, section 751 is predicated on that assumption, and so is the election provided by section 754.57 a portion of the guaranteed payment to a partner therefore can be seen as a transfer of property which, while held in the name of the partnership, in one meaningful sense is beneficially owned by the distributee partner. one might question whether such a transfer, essentially from the distributee to himself, should trigger any income recognition, but it especially should not trigger recognition of the appreciation in the portion of the property that essentially already belonged to the distributee. concededly, the same point as that made above could be applied to payments that are made in kind to a partner for his services in a non-partner capacity to which section 707(a) applies. yet, gain or loss is recognized in such transactions. why should section 707(c) payments to a partner be treated differently? the congressional scheme for section 707(a) is to ignore, for almost all purposes, the partnership role of the partner since he is not acting58 in that capacity. in other words, the partner in a section 707(a) transaction has two hats, a partner hat and a non-partner hat, and congress chose in section 436 florida tax review vol.7:6 59. id. section 707(a)’s treatment of a partnership as a separate entity puts the transaction in the same light as a similar transaction between a corporation and its shareholder in which gain on an appreciated asset will be recognized. 60. gain or loss is not recognized on ordinary distributions to partners under irc § 731. to distinguish ordinary distributions from guaranteed payments, i refer to the former as “ordinary § 731 distributions.” 707(a) to ignore the partner hat. by ignoring his partnership role, congress59 also ignores the fact that the distributee has an interest in a percentage of the distributed property. section 707(a) represents an unqualified adoption of the entity approach; and since the partner is not acting in his partner capacity, that approach is justified. in contrast, congress chose an eclectic approach to section 707(c) transactions and applies an entity approach only in certain circumstances. since the partner is acting in his partner capacity, there is good reason to treat that transaction, for many purposes, as one between a partner and a partnership rather than as one between two strangers. as noted below, there is little substantive difference between allocating a share of partnership profits to a service partner in recognition of the ongoing services he provides or, instead, providing for a fixed amount to be payable to that partner. in both cases, the distribution satisfies a kind of obligation, i.e., the distributee is owed either a share of the partnership’s profits or a specified amount. if the distribution is made in kind with appreciated property, regardless of whether the distribution is a guaranteed payment or a distribution of partnership profits, the partnership is satisfying an obligation with appreciated property. yet, under section 731(b), a distribution of property in kind to a service partner that represents a distribution of his share of partnership profits does not cause the partnership to recognize gain. just because a service partner is provided a specified amount, instead of a share of income, and just because section 707(c) then applies, there seems little reason to deny the partnership the nonrecognition of gain or loss that applies to a similar in kind distribution of profits. (b) comparison of guaranteed payments to ordinary section 731 distributions. to the extent that the property that a distributee partner received was beneficially owned by the non-distributee partners, one could see a justification for requiring a recognition of gain. but the transfer of property as a guaranteed payment is much the same in this respect as an ordinary section 731 distribution of partnership property. when a partnership makes an ordinary60 section 731 distribution of property in kind to one partner, the distributee acquires the portion of that property that represented the beneficial interests of the non-distributee partners. yet, except for the special circumstances addressed by section 751(b), the partnership (and therefore the non-distributee partners) 2006] is the report of lazarus’s death premature? 437 61. irc § 731(b). 62. see the 2004 article, supra note 1, at 408-410 (discussing the history of irc § 707(c)). 63. section 707(c)’s treatment of some guaranteed payments as capital expenditures reflects the entity approach utilized by that section for some purposes. section 707(c) expressly provides entity treatment to guaranteed payments for the application of three code sections, of which, the capital expenditure provision is one. in the case of a capital expenditure, there is no immediate offsetting deduction to the distributee’s recognition of income. instead, the deduction is deferred. if the capital expenditure can be amortized, the deduction will be taken ratably over a period of years. does not recognize gain even though the property has unrealized appreciation.61 the preclusion of gain recognition for operating distributions is one element of the congressional scheme to defer gain recognition for transactions between partnerships and partners. to what extent does a guaranteed payment differ in its nature from an ordinary section 731 distribution of property to a partner? the fact that a guaranteed payment is given because of the receipt of the partner’s services is not a substantive difference since ordinary section 731 distributions of partnership profits can be made to service partners because of the receipt of their services. the difference between a guaranteed payment and an ordinary section 731 distribution of profits is that the right to a guaranteed payment does not depend upon there being partnership income (regardless of whether there is a genuine risk that it will be paid). putting aside for the moment the other considerations that cameron and postlewaite have raised, which are discussed below, it seems likely that if congress were presented with this issue, it would give the same nonrecognition treatment to guaranteed payments in kind that it chose for ordinary section 731 distributions. (c) similar consequences of partnership’s deduction and allocation of partnership income what about the fact that the distributee partner of a guaranteed payment recognizes ordinary income for receiving the property and the partnership often obtains a deduction? prior to 1954, such transfers were treated as distributions of partnership income to the extent that the partnership had income. the62 consequence of that treatment, at least to the extent that the partnership had income, was to shift the recognition of the non-distributee partners’ portion of that income from them to the distributee partner. in effect, an amount of the partnership’s income that otherwise would have been allocated to the nondistributee partners was instead allocated to the distributee partner. because of the complexity that arose when the partnership did not have income, congress chose, in section 707(c), to treat the distributee partner as receiving ordinary income and allowing the partnership an offsetting deduction (unless it was a capital expenditure). if the partnership did not have sufficient income to make63 438 florida tax review vol.7:6 if it cannot be amortized, the basis created by the expenditure is taken into account when the asset is disposed of. irc § 1001(a). 64. irc § 702. the guaranteed payment and made it anyway, the payment is more like compensation to the service partner than a return of his capital, and section 707(c) adopted an entity approach to accommodate that situation. the entity approach that section 707(c) applies for purposes of causing the distributee to recognize ordinary income and usually allowing the partnership to deduct the amount is blended with conduit treatment because the partnership’s deduction passes through to the partners. the economic effect64 of the section 707(c) provision, when the partnership has sufficient ordinary income and the payment is deductible, is to shift the portion of the partnership’s ordinary income that would have been taxed to the non-distributee partners from them to the distributee partner. the effect is the same as can be accomplished by allocating to the distributee partner some of the partnership’s ordinary income that otherwise would have been allocated to the non-distributee partners. the identity of consequences of those circumstances suggest that if property in kind is used by the partnership to make either a distribution of profits (that is, a distribution made in accordance with the partnership agreement’s allocation of an amount of ordinary income to that partner) or a guaranteed payment, the rules for recognition or nonrecognition of gain or loss for the distributed property should be the same for either transaction. to illustrate how the section 707(c) scheme operates in the situation when there is ample ordinary income and the guaranteed payment is deductible, consider the following example. example – a, b and c are equal partners of the p partnership. in year one, before taking any guaranteed payment into account, p had taxable income of $90,000, all of which is ordinary income. if no guaranteed payments were payable, each of the three partners would report $30,000 of ordinary income from p. but, p is required to pay a $30,000 as a guaranteed payment under section 707(c), and p made that payment. the payment is deductible. after taking a deduction for that payment, p had taxable income of $60,000. each of the partners reports $20,000 of ordinary income from p. in addition, a has $30,000 of income as a guaranteed payment, and so a has a total of $50,000 income from p – $20,000 as his distributable share of the partnership=s taxable income and $30,000 as a guaranteed payment. of the $30,000 guaranteed payment income that a recognized, $10,000 would have been taxed to him in any event if no partnership distribution had been made. the remaining $20,000 of guaranteed payment income represents the $20,000 of ordinary income that b and c would have recognized if the guaranteed payment had not been made. the net effect then is to shift the $20,000 of ordinary income that otherwise would have been taxed to the non-distributee partners (b and c) to the distributee partner (a). 2006] is the report of lazarus’s death premature? 439 65. even if the partnership in the example above also had capital gain income, the result of an allocation of partnership profits will be the same if the partnership agreement makes a § 704 allocation of $30,000 of its ordinary income to a. 66. lazarus effect, supra note 2, at 368-69. the economic consequence that attended the example above is the same as would attend a section 704 special allocation and distribution of $30,000 of ordinary income to a instead of a guaranteed payment of that amount. in that case, the partnership would have $90,000 of ordinary income with no deduction. the special allocation and distribution to a would have caused $30,000 of the partnership’s ordinary income to be allocated to a under sections 702 and 704. the remaining $60,000 of partnership income would be allocated equally among the three partners. the net effect is that the three partners will have the same economic consequence whether the payment to a represents a guaranteed payment or an allocation of partnership profits.65 however, if a guaranteed payment is not deductible because it is a capital expenditure, or if the partnership’s ordinary income is less than the amount of the payment, the consequences of making the payment as a distribution of profits will be significantly different from the consequences of making a guaranteed payment. that difference in consequence does not mean that recognition of gain treatment for the two types of transactions should also be different, but it does not provide a ground for treating the two the same. the similarity of consequence in the situation described in the example above provides an additional ground for granting the same nonrecognition treatment to both types of transactions; the dissimilarity of consequences in the latter situations does not detract from that consideration, albeit it does not add weight to it. 2. potential for abuse a major point of the lazarus effect article is that the conclusions reached in the 2004 article open up an opportunity for taxpayers to manipulate the making of a guaranteed payment in such manner as to abuse the tax system by deferring income from the disposition of an appreciated asset and by shifting the characterization of income from ordinary to capital gain. the potential for66 abuse arises, not because of the nonrecognition of income alone, but because of the combination of that nonrecognition with the 2004 article’s conclusion that the distributee’s basis in the distributed asset will equal its fair market value. when ms. cuenin and i began writing the 2004 article, i anticipated that we would conclude that the distributee would take a carryover basis in the distributed asset (i.e., take over the partnership’s basis) because of our view that no gain or loss would be recognized by the partnership and because we had adopted the aggregate approach in resolving the nonrecognition issue. upon further reflection, we realized that the built-in gain of an appreciated asset will continue to be reflected in the partners’ outside basis in their partnership 440 florida tax review vol.7:6 67. 2004 article, supra note 1, at 425-26, 433. 68. id. 69. on the recognition side, there is the principle of not allowing a deduction for a disposition of unrealized appreciation. that principle, and its significance to the issue at hand, is discussed in part iv (f)(1) of this article. on the nonrecognition side, there is the point that requiring recognition of income will unduly complicate the administration of § 707(c) in certain circumstances. that point is discussed below in part iv (g) of this article. 70. in regard to that issue, cameron and postlewaite identified an error in the 2004 article. lazarus effect, supra note 2, at 371. in that article, i stated that congress had accepted the transfer of potential ordinary income to capital gain in the operation of §§ 108 and 1017. 2004 article, supra note 1, at 427. they correctly point out that § 1017(d) prevents that change from occurring. i inserted that statement in the article and so i am the one responsible for the error. ms. cuenin’s only error was to defer to my insertion in the article. interests, and so there would be double taxation of that gain if the distributee partner took a carryover basis in the property and if no adjustment was made to the partners= outside basis in their partnership interests. it was for that reason that we determined that the amount of built-in gain does not escape taxation if the distributee receives a fair market value basis and that the fair market value treatment prevents double taxation of the built-in gain. obviously, other methods of dealing with the double taxation issue are possible, but the one we chose does not require a legislative solution and seems to solve the problem adequately. ms. cuenin and i recognized that the approach we adopted raised opportunities for abuse, and we expressly noted that in the 2004 article. we stated in that article that while the same amount of income will be recognized, the timing of recognition will be different and that the transaction could be manipulated to change the characterization of the income. we noted that the67 change of timing of recognition and the potential for changing characterization weighed against our conclusions, but we regarded them as minor costs that are outweighed by the considerations that favor nonrecognition. 68 in their lazarus effect article, cameron and postlewaite have done a thorough and commendable job of illustrating how our proposed treatment alters the timing of recognition and how it can be manipulated to alter characterization. while these points were noted in the 2004 article, the lazarus effect article demonstrates with clarity just how this can take place. ultimately, the determination of whether gain should be recognized rests on a weighing of the potential for abuse on one side and the objective of nonrecognition for partnership to partner transactions on the other. there is an additional consideration on each side of that issue, but those two are the69 principal considerations. in the 2004 article, we concluded that the potential for abuse consideration is of less significance than the nonrecognition principle, and cameron and postlewaite have properly taken us to task for not fleshing out our reasons for that conclusion.70 2006] is the report of lazarus’s death premature? 441 71. e.g., irc § 1245(b)(3). 72. regs. § 1.1245-4(c)(4), ex. (3). the gain was recognized to the extent that the liability of which the partner was relieved exceeded his outside basis in his partnership interest. see irc § 731(a)(1). 73. id. the regulation has been criticized because the gain recognized by the partner literally was on his partnership interest rather than on the contributed property, and the recapture rules do not apply to gain on a partnership interest. however, the regulation arrives at a proper result by recognizing that the gain that is created by the transaction is attributable to the previous depreciation deductions taken on the contributed property and to the contribution of that property to the partnership. the regulation was promulgated before changes were made to the regulations under § 752 dealing with the allocation of partnership liabilities among the partners. under the current rules, the constructive distribution to the contributing partner resulting from his relief of a nonrecourse liability would not be large enough to trigger gain as to the possibility that taxpayers will manipulate the making of guaranteed payments so as to shift what would have been ordinary income on the disposition of a distributed asset to the capital gain that is recognized on the disposition of a partnership interest, that seems unlikely to occur with any frequency. the shifting of potential gain from an ordinary income asset to a capital asset can be accomplished under the system advocated in the 2004 article by the partnership’s using an ordinary income asset to make the guaranteed payment. the principal ordinary income assets of a business are inventory and accounts receivable. inventory can be sold more readily by the business entity than by the owners, and so inventory typically will be sold and the proceeds distributed to partners rather than distributing the inventory directly to them. similarly, accounts receivable typically will be collected by the business entity and the proceeds distributed to the partners. one type of ordinary income property that could conveniently be used to make a guaranteed payment is property in which there is a potential recapture of depreciation (e.g., property for which some or all of the gain on disposition would be ordinary income under section 1245). however, there is a significant possibility that one of the recapture provisions (such as section 1245) would override the nonrecognition principle and require the partnership to recognize gain. while section 731 nonrecognition takes priority over recapture of depreciation provisions, the71 nonrecognition proposed in the 2004 article is not based on an application of section 731 itself, but rather on the principles which are reflected in section 731. in a regulation, treasury has applied section 1245 recapture rules to a constructive receipt of cash from a partnership because of nonrecourse liabilities encumbering property contributed to the partnership to the extent that the partner recognized gain therefrom under section 731(a)(1). that regulation72 shows that treasury will protect the recapture of income by applying the recapture provision broadly to cover transactions that are not literally within its scope.73 442 florida tax review vol.7:6 recognition. regs. § 1.752-3(a)(2). but, the regulation is still significant in demonstrating that the recapture rules will be applied broadly. 74. e.g., irc §§ 358, 722, 1031(d). of course, it is possible that if the views of the 2004 article are adopted, it might induce partnerships to make guaranteed payments with ordinary income assets, and the abuse would then become significant. if that occurs, then congress could address the problem and cure it. the potential for shifting ordinary income to capital gain was the object of the adoption of section 751 to prevent that from occurring in the circumstances to which that provision applies. while section 751 has been criticized and thought to be unnecessary, it shows that congress chose to address the problem by singling out the ordinary income issue rather than to change subchapter k’s basic treatment of sales of partnership interests and partnership distributions. similarly, if it turns out that there are significant instances in which partnerships actually do abuse the 2004 article’s approach, rather than to abandon the nonrecognition principle entirely, congress could adopt a more limited and targeted prevention of that abuse. apart from the ordinary income issue, there also is a timing question of whether it is an abuse to permit the parties to shift the potential gain on the distributed property to the partners’ partnership interests. the distributee could then sell the distributed property for no gain, and the potential gain from the distributed property will be deferred until it is recognized on the disposition of the partnership interests of all the partners. the timing certainly will be different, and that is acknowledged in the 2004 article. the gain may be recognized before the distributee disposes of the distributed asset if the partnership liquidates before then or if the partners sell their interests before then. concededly, the liquidation of the partnership or the disposition of the partnership interests could occur later. but, just how does that transfer of appreciation from one asset to another differ from the transfer of appreciation that commonly occurs in other nonrecognition provisions? there are a number of circumstances in which the code allows the gain from one asset to be deferred by transferring the potential gain to a different asset. many nonrecognition provisions operate in that manner. what makes the74 nonrecognition in this instance different is that the distributee continues to possess the distributed property and can dispose of it without gain. however, the non-distributee partners, whose potential gain in the asset also was not recognized, do not posses the distributed property, and so their position is no different in principle from beneficiaries of other nonrecognition provisions whose appreciation in one asset is transferred to another asset. the deferral to which cameron and postlewaite object, therefore, seems to apply only to the deferral of the distributee’s share of the appreciation and not to the deferral of the share of the appreciation attributable to the non-distributee partners. the deferral of the distributee’s income applies only to his percentage share of the pre-distribution appreciation of the distributed property. to obtain that deferral of only a fraction of the built-in gain of the property, the distributee 2006] is the report of lazarus’s death premature? 443 75. irc §§ 705(a)(2), 732(a)(1), 733. 76. id. has to endure recognizing ordinary income in the amount of the full value of the distributed property, or more accurately, in the amount of the full value that exceeds his share of the partnership’s deduction. it would seem that the cost of this transaction to the distributee will deter the making of guaranteed payments primarily for the purpose of obtaining a deferral, but if a guaranteed payment is otherwise to be made, it might encourage the partnership to make it in kind in certain circumstances. there is some evidence that congress rates the nonrecognition principle for transactions between a partnership and a partner higher than the potential for deferral. when a partnership makes ordinary section 731 distributions to its partners, it can distribute property with a large amount of appreciation to one partner (the second partner) and property with little or no appreciation to another partner (the first partner). in so doing, the partnership can shift one partner’s (the first partner) share of the appreciation of a partnership asset to another partner (the second partner) so that the first partner will not recognize his share of that appreciation until he disposes of his partnership interest. the cost of that deferral may be borne by the second partner when he disposes of the appreciated asset, but the second partner may be in a lower tax bracket or have carryover losses to offset against the gain. this consequence is permissible so long as the transaction does not cause a shift of a partner’s share of the built-in gain of the partnership’s ordinary income assets to capital gain assets. the manner in which a partner’s share of the appreciation of a partnership asset can be transferred to another partner is illustrated by the following example. ex. a and b are equal partners of the p partnership. p’s assets consist of $130,000 in cash, land 1 having a basis of $20,000 and a fair market value of $50,000, and land 2 having a basis of $50,000 and a value of $50,000. a’s outside basis in his partnership interest is $100,000, and b’s outside basis in his partnership interest also is $100,000. since the value of each of their partnership interests is $115,000, each had a potential gain of $15,000 if he disposes of his partnership interest. this reflects each partner’s one-half share of the $30,000 appreciation of land 1. as operating distributions, p distributes land 1 to a and land 2 to b. a’s basis in land 1 will be $20,000, and a’s outside basis in his partnership interest will be reduced to $80,000. since the value of a’s partnership interest75 will be reduced to $65,000 because of the partnership=s distributions, a has a built-in loss of ($15,000) in his partnership interest and a built-in gain of $30,000 on land 1. b has a $50,000 basis in land 2, and b’s outside basis in his partnership interest is $50,000. so, b has no built-in gain on land 2, and he76 has a $15,000 built-in gain on his partnership interest. the parties have successfully shifted b’s one-half share of the partnership’s $30,000 built-in gain to a, and b has thereby deferred his recognition of that gain until he disposes of his partnership interest. this transaction is significantly different from the 444 florida tax review vol.7:6 deferral to which cameron and postlewaite object because b’s deferral is obtained by transferring b=s $15,000 share of the built-in gain on land 1 to a who can offset it only by disposing of his partnership interest and recognizing the ($15,000) loss thereby. but, insofar as b is concerned, the potential for abuse is similar to the one about which cameron and postlewaite complain, and yet it has not moved congress to change its nonrecongition rules on partnership distributions to prevent it from occurring. because of the significant differences with the guaranteed payment situation, the above example does not prove that congress would choose nonrecognition over deferral in the case of guaranteed payments in kind. but, it is evidence that, in general, the deferral of the potential gain from a partner’s share of a partnership’s appreciated asset until the partner disposes of his partnership interest is of lesser concern to congress than the nonrecognition principle. the ultimate question is whether the principle of nonrecognition should be sacrificed because of a possibility that it will lead to abuses or whether congress should wait to see if those abuses arise and, if so, deal with them then in an appropriate fashion. the weight to be accorded to the possibility that abusive tactics might be employed depends, in part, on how likely and how extensively one believes that practice will occur. in balancing the competing considerations against each other, different people will evaluate them differently and will attribute different amounts of weight to them. i cannot say that cameron and postlewaite are wrong in balancing these competing considerations differently than i do. on the other hand, i prefer the balance that ms. cuenin and i have reached. time will tell which of these choices is more attractive to the profession. if the competing policies are deemed to be of approximately the same weight, then i suggest that the slight presumption for aggregate treatment that is proposed in part iv (e) of this article tip the decision in favor of nonrecognition. for purposes of my own evaluation, i do not need that presumption because i find the policies for nonrecongition to weigh more heavily on the scales. g. administrative burden generated by requiring gain recognition. as noted above, the most important considerations weighing for and against requiring the partnership to recognize gain are the potential for abuse on one side and the policy favoring nonrecognition for partnership-partner transactions on the other side. those two competing considerations are discussed earlier in this article. there are two other considerations, albeit of lesser significance, that weigh in on opposite sides of the recognition issue. on the side of recognition, cameron and postlewaite rely on the basic tax principle that a deduction should not be allowed for a disposition of unrealized appreciation. that principle, and the weight to be accorded it, is discussed in part iv (f)(1) of this article. on the side of nonrecognition, cuenin and i 2006] is the report of lazarus’s death premature? 445 77. 2004 article, supra note 1, at 423-24. 78. regs. § 1.707-1(c), ex. (2). 79. of course, if the partner’s share of partnership income is not less than the minimum guaranty, then all of the distribution is an ordinary § 731 distribution and none of it is a guaranteed payment. 80. irc § 731(a)(1). contend in the 2004 article that requiring recognition would, in certain circumstances, complicate the administration of the applicable tax provisions, and the avoidance of that complexity is a factor favoring nonrecognition. our77 contention is that the complexity that can be caused by gain recognition is a factor to be considered, but we do not claim that it is dispositive. the complexity described in the 2004 article arises when the guaranteed payment occurs in the form of a guaranty by the partnership that a partner’s share of partnership profits will not be less than a stated minimum figure. in such a case, a portion of the distribution to that partner can be a guaranteed payment and a portion can be an ordinary section 731 distribution. the regulations deal with a partner who is entitled to a percentage of partnership income “as determined before taking into account guaranteed payments,” but not less than a minimum amount. the regulations provide that an amount of the distribution to that partner that equals the partner’s share of the partnership income is treated as an ordinary section 731 distribution. only the excess that the partner received over the amount of the ordinary section 731 distribution is treated as a guaranteed payment. so, a distribution to a partner78 in that circumstance is divided into two parts, one part is an ordinary section79 731 distribution, and one part is a guaranteed payment. the determination of the portion of the distribution that is a guaranteed payment depends upon the size of the partnership’s income. this problem arises only when the minimum guaranty is greater than the distributee partner’s share of partnership income. if the distribution to the partner in the circumstance described above is made with appreciated property, and if gain recognition is required for guaranteed payments made in kind, the partnership will recognize gain on the portion of the property that constitutes a guaranteed payment, but will not recognize gain on the portion of the property that is treated as an ordinary section 731 distribution. to calculate the gain on the guaranteed payment, the80 partnership’s basis in the distributed property must be apportioned between the two parts of the distribution. unless the partnership agreement excludes from the calculation of the partner’s share of partnership income gain or loss that is recognized by making a guaranteed payment in kind, the gain recognized by the partnership on the guaranteed payment portion of the distribution will increase the partnership’s income, thereby increasing the dollar amount of the distributee partner’s share of partnership income and accordingly increasing the percentage of the distributed property that constitutes an ordinary section 731 distribution. similarly, that distribution reduces the portion of the distributed property that constitutes a guaranteed payment. once the guaranteed payment is reduced, the 446 florida tax review vol.7:6 81. lazarus effect, supra note 2, at 364-365. 82. regs. § 1.707-1(c), ex. (2). amount of gain recognized therefrom must be recalculated using a smaller amount of guaranteed payment and a smaller amount of basis. that will result in a smaller amount of gain than was originally calculated. consequently, the amount of the partnership’s gain must be recalculated using the smaller amount of gain from the guaranteed payment. the resulting reduction in the partnership’s gain will reduce the portion of the distributed property that constitutes an ordinary section 731 distribution and will increase the amount of the guaranteed payment. this recalculation will continue until the two mutually dependent figures (i.e., the amount of the guaranteed payment and the amount of the partnership’s income) are finally settled. the recalculations are made even more complicated by the fact that the portion of the basis of the distributed property that is allocated to the guaranteed payment portion of the distribution will have to be recalculated each time that the amount of the guaranteed payment is changed. cameron and postlewaite describe the circumstance of a partner’s receiving a right to a percentage of partnership profits subject to a minimum figure as unusual. in their words, they said: to document the potential complexity resulting from a requirement that the partnership recognize gain or loss, they [kahn and cuenin] resort to an atypical type of payment, one in which the payment is, in part, a guaranteed payment and, in part, a distribution of partnership property, . . . one should not be surprised that an added layer of difficulty is encountered in such an atypical setting.81 cameron and postlewaite do not explain why they think that this situation is unusual. treasury considered the occurrence of sufficient magnitude to warrant the promulgation of a regulation that describes how the tax law treats it. while i have no empirical data, the situation seems likely to82 occur frequently. for example, if a small law firm offers to make an associate a partner, the firm may provide a minimum guaranty to assure the associate that his income will not be reduced if he accepts the partnership’s offer. shortly after joining the faculty at michigan, i received an offer from a law firm of a partnership position with a percentage interest in the partnership’s income and a minimum guaranty. the offer did not strike me as unusual. after reading the lazarus effect article, i asked a senior partner of a large national law firm whether he had ever encountered an arrangement of this type. he informed me 2006] is the report of lazarus’s death premature? 447 83. id. 84. lazarus effect, supra note 2, at n. 91. 85. id. that his firm had made that arrangement with newly appointed partners during several years when law earnings were depressed. perhaps it is not the arrangement that cameron and postlewaite find unusual. perhaps, they mean that it would be unusual for a partner’s share of partnership income to be less than his minimum guaranty. again, treasury thought that this situation occurs frequently enough to justify promulgating a regulation describing how such payments are taxed. also, it seems reasonable83 that this occurrence will not be a rarity. the purpose of providing the partner with a guaranty likely is because there is reason for doubt that partnership profits will be adequate to produce the minimum amount. one might expect there to be a fair number of occurrences in which that fear is realized. cameron and postlewaite contend that the complexity of which the 2004 article complains is “overstated, and, in any event, can easily be avoided.” as to the overstatement, they wrote in a footnote,84 their [kahn and cuenin] concern that any gain or loss resulting from the distribution of partnership property in satisfaction of the guaranteed payment will require the recomputation of the amount of the guaranteed payment is overstated because in many, if not most, instances the partnership will not distribute property in satisfaction of a guaranteed payment until the taxable year following that in which the services are actually rendered. this is because the partnership’s income, and thus the amount of the guaranteed payment, cannot be determined until after the end of the taxable year.85 it is not necessary for the partnership to know the amount of its taxable income to make guaranteed payments to its partner in the year in which the payments are earned. the partner is guaranteed a minimum figure. the partnership can make distributions to the partner up to the amount of that minimum in complete confidence that the entire amount is owed to the partner. the partnership and the partner will not know how much of a distribution that was made to the partner is a guaranteed payment and how much is a section 731 distribution until the amount of the partnership’s income is determined in the following year, but that does not interfere with making the distribution before that determination is made. partners cannot wait until the end of the year to receive their distributions. they need to pay their living expenses and other items currently. the problem can be solved by paying a partner a “draw” or advance on the share of income it is anticipated he will earn. the “draw” is treated as an 448 florida tax review vol.7:6 86. see regs. § 1.731-1(a)(1)(ii). 87. 2004 article, supra note 1, at 423-424. 88. lazarus effect, supra note 2, at n. 91. interest-free loan which is then converted to a distribution at the end of the partnership=s taxable year. regardless of whether that deferral to the end of the86 year will apply to the portion of a withdrawal that constitutes a guaranteed payment, the gain from making that payment with appreciated property will be recognized in the taxable year of the partnership in which the payment is made. in the 2004 article, ms. cuenin and i acknowledged that guaranteed payments, other than liquidating distributions, are typically made in cash. guaranteed payments in kind are unusual. the 2004 article seeks to resolve some difficult issues that will arise when a guaranteed payment is made in kind, but it was never our expectation that such payments would become a common occurrence. in the 2004 article, cuenin and i expressly note that the problem of recalculation will not arise if the partnership’s income is to be computed without taking into account gains or losses recognized from making guaranteed payments. so, the partnership can avoid the recalculation problem by87 including an express provision in the partnership agreement to exclude from the calculation of the guaranteed partner’s share of partnership income any gain or loss recognized from making a guaranteed payment in kind. if adopted, the provision should indicate whether such gains or losses are to be excluded only if they are recognized on a guaranteed payment to the distributee of that payment, so that gains or losses on guaranteed payments made to other partners are to be included. while the inclusion of a provision of this nature will resolve the recalculation problem, it is not likely to be included in a partnership agreement unless the parties are aware of the problem and are informed as to how it can be resolved. unfortunately, not all parties are well informed. one of the facts of the example in the regulation that deals with the tax treatment of minimum guarantees is that the partner’s share of partnership income is to be determined “before taking into account any guaranteed payments.” obviously, that provision prevents the taking into account of any deduction that the partnership may receive for making the guaranteed payment. can that same language be construed to prevent taking into account the gain or loss that the partnership recognized from making a guaranteed payment in kind? in footnote 61 of the 2004 article, cuenin and i noted the possibility that that language could be so construed and thereby eliminate the recalculation problem. cameron and postlewaite give reasons why that language should be so construed and question why cuenin and i did not give reasons why that construction would be improper. cuenin and i did not argue against that88 construction because we do not believe that it is improper. on the other hand, we do not know whether that construction will be adopted. a contrary construction also is not improper. the question of how that language will be 2006] is the report of lazarus’s death premature? 449 89. 2004 article, supra note 1, at 424. 90. lazarus effect, supra note 2, at n. 91. construed is unresolved. until it is resolved, requiring gain recognition by the partnership would raise the possibility of causing the recalculation problem. if the recalculation problem does occur, as noted in the 2004 article,89 the two mutually dependent figures can be determined by using an algebraic formula. the fact that they can be determined does not mean that the necessity to resort to a mathematical solution does not impose complexity and burden the administration of the provision. cameron and postlewaite have included in their article several algebraic formulas that solve this problem and a related one. i am impressed by their mathematical acumen. while there are other90 examples of mutual dependency in the tax law, and they have not prevented the administration of those provisions, one might still prefer a statutory construction that does not present that problem. apart from the recalculation issue, there is another consequence of gain recognition that adds to the complexity it can create. the gain recognized by the partnership is determined by comparing its basis in the guaranteed payment portion of the distributed property with the amount of the guaranteed payment. that gain is then allocated among the partners under the conduit approach applied to partnership tax items. the partnership’s basis in its assets is sometimes referred to as ‘inside basis.’ if the partnership has made an election under section 754, the partnership may effectively have a different inside basis for each partner. the section 754 election invokes section 743, which requires that the inside basis attributable to a partner must be adjusted in certain circumstances. in effect, the inside basis that is attributable to each partner’s share of a partnership asset must be determined separately. so, in that situation, the partnership will have to calculate the gain for each of its partners by using the specific inside basis that applies to that partner’s share of the property. if there are a number of partners, that could be a burdensome requirement. in addition, if recalculation of the partnership’s gain is required, then the amount of basis for each partner that is allocated to the part sale of the distributed asset will also have to be recalculated to conform to the changes in the portion of the property that is deemed to have been sold, and that would magnify the complexity of calculation. that separate set of calculations would not be necessary if the partnership does not recognize gain on making the distribution. although the distributee takes the same basis that the partnership had in the portion of the distributed property that constitutes the ordinary section 731 distribution, his basis will be equal to the partnership’s inside basis in that portion of the property without adjustment for the special inside basis that other partners might have under the section 754 election. any adjustment for a special inside basis of the distributee partner will have to be taken into account, but the 450 florida tax review vol.7:6 91. id at 368. adjustments for the other partners can be ignored. the calculations will be much less onerous if the partnership does not recognize a gain on the transaction. cameron and postlewaite shrug off this additional computational burden as being “simply one of a number of additional burdens that result from a partnership’s decision to make a section 754 election.” it is true that the91 section 754 election creates comparable burdens in other situations, and that the computational problem in the instant situation would not arise were it not for the operation of the section 754 election. but, section 754 is part of the landscape. if gain is required to be recognized, it will cause a computational burden that would not occur if nonrecognition is adopted. the fact that the burden is a product of another code provision is irrelevant to the determination of whether it might be preferable to avoid that burden by adopting nonrecognition. moreover, if recalculation of gain is required, the determination of each partner’s share of inside basis to be allocated to the portion of the distributed asset that is deemed to have been sold will be much more complex than occurs with the ordinary operation of section 754. v. conclusions the case for treating section 707(c) as having been impliedly repealed by the 1984 adoption of section 707(a)(2) is very weak. it rests on the assertion that the criteria that the senate finance committee’s report to the 1984 act adopted for determining partner capacity would vitiate the application of section 707(c) to any payment if the absence of risk factor of those criteria were applied to section 707(c). there is reason to doubt that the absence of risk factor alone is determinative of non-partner capacity under the senate finance committee’s standard. more importantly, the criteria that the senate finance committee suggested have not been adopted by treasury and have impliedly been rejected in one of the examples provided in a regulation adopted some years after 1984. given the well established doctrine that implied repeals of statutes are disfavored and occur only when two statutes are totally inconsistent, there is little to be said for the suggestion that section 707(c) no longer exists. the question of whether a partnership recognizes gain or loss on making a guaranteed payment in kind is a closer issue. there is much to be said on both sides of that question. for the reasons discussed in the body of this article, i favor nonrecognition. however, i cannot say that cameon and postlewaite are wrong in arguing for recognition and that my view is correct. there are competing policies that favor each side of that issue, and the difference between us rests on how we weigh those competing policies. in their lazarus effect article, cameron and postlewaite generously concede that, absent their contention that section 707(c) was impliedly repealed by the 1984 adoption of section 707(a)(2), their “conclusions are not entirely free from 2006] is the report of lazarus’s death premature? 451 92. id at 345. 93. richard a. posner, forward: a political court, 119 harvard l. rev. 32, 4041 (2005). doubt.” i will concede with equal candor that my conclusion that gain should92 not be recognized also is not free from doubt. nevertheless, they are convinced that theirs is the better conclusion, and i am convinced that mine is better. reasonable people can take either side. individual evaluations and priorities determine how one balances close questions. judge posner, writing about the correctness of the supreme court’s constitutional decisions, expressed a similar thought. judge posner wrote, a federal appellate judge has convinced me that it is rarely possible to say with a straight face of a supreme court constitutional decision that it was decided correctly or incorrectly. . . . one may be able to give reasons for liking or disliking the decision . . . and people who agree with the reasons will be inclined to say that the decision is correct or incorrect. . . . the problem . . . is that there are certain to be equally articulate “reasonable” people who disagree and can offer plausible reasons for their disagreement. . . .93 when ms. cuenin and i decided to write the 2004 article, we were hoping to generate interest in exploring a question that seemed to have been given little thought by the commentators. if that were true, it certainly is no longer. professors cameron and postlewaite have done an exemplary job of exploring the issues. while i disagree with their conclusions, i am pleased that the issues have been given such careful and thoughtful attention. tcharity really does begin at home: florida tax review volume 10 2011 number 10 841 tax lawyers, tax defiance, and the ethics of casual conversation michael hatfield* i. casual conversations professionals endure ....................... 841 ii. tax defying rhetoric ................................................................... 844 iii. why not just walk away? .......................................................... 851 iv. tax lawyers as public educators ............................................ 857 v. murder and taxes: concluding examples .............................. 865 i. casual conversations professionals endure each profession entails a risk for a different kind of casual conversation its members must endure. medical doctors probably endure casual conversations about pains and rashes, second guesses of primary care physicians, and disorganized thoughts about health care reform, prescription drugs, vitamin c, and chelation. pastors, priests, and rabbis probably endure unbridled enthusiasm for ecumenical dialogue and experience. lawyers listen to horror stories of divorce and custody battles, disorganized thoughts on tort reform, and, of course, lawyer jokes, most of which are not new, few of which are funny, and none of which are clever. specialists within each profession suffer with specific conversations. the psychiatrist and the dermatologist risk different conversations, as do the tax lawyer and the criminal defense lawyer. the conversational risks of tax lawyers are fairly predictable. first are those conversations premised on confusing us with accountants, usually beginning with an inquiry as to our annual april 15th-related workload.1 second are political conversations, usually about tax rates—especially those on capital gains, corporations, and * professor of law, texas tech university school of law. j.d. 1996, new york university school of law. for thoughtful comments and suggestions, i would like to thank danshera cords, susan fortney, michelle kwon, rich lavoie, dave rifkin, mark tushnet, and larry zelenak. all errors and omissions are mine. 1. this lamentable lumping of tax lawyers and accountants in the public mind may be beyond remedy, despite erik jensen’s 1991 work in which he identified this enduring problem, rightly distinguishing tax lawyers as the ones who are “bright, engaging, and athletic” and “combine animal magnetism with erudition” from accountants who have “thick spectacles, green eyeshades, cluttered minds, and unlimited capacities for boredom.” erik m. jensen, aside, the heroic nature of tax lawyers, 140 u. pa. l. rev. 367, 367 (1991). 842 florida tax review [vol. 10:10 estates. some while back, the conversation was likely to begin with the wonders of the so-called flat tax, and no doubt the flat tax proposals will circle back again in our casual conversations. (recently a medical doctor engaged me on the wonders of the flat tax, and given his conversation ensued during a medical procedure, i found myself more enamored with the proposal than ever before.) perhaps the most common political tax topic at the moment is the income tax burden borne at the top and the income tax ease enjoyed on the bottom. the third common casual conversation topic for tax lawyers has to do with tax gimmicks and, especially, rumors of tax gimmicks. with this kind of conversation, tax lawyers are fairly skilled in conversational evasiveness, worrying about unintentionally forming an attorney-client relationship. our fears related to this kind of conversant are not merely avoiding ethical issues or providing undeserved free legal advice but more so avoiding inviting him or her into a professional relationship. clients interested in the latest tax gimmicks must be avoided, and those willing to chat-up strangers about tax advice are especially to be avoided. casual conversations with tax lawyers seem to be changing, however. one change has been the form of conversation, or more often, at least, the form of a solicitation to conversation. these days it is not only at the barbeque, picnic, or party where one risks an unwanted conversation but simply while checking one’s e-mail. there, one may be invited into discussions that one would not want to enter, much less document via e-mail, with most clients and friends, much less the acquaintance with whom one swapped electronic addresses—or the acquaintance who found your address through an internet search or firm web site. but there has been another change recently in such conversations, and it has to do with both tone and subject matter. otherwise seemingly reasonable and pleasant individuals are increasingly repeating the inanities of anti-tax conspiracy theorists. these are not opinions that are merely critical of current tax policies, as those opinions have long occurred in casual conversations with tax lawyers (and may make for perfectly good conversation). no, these are statements that deny the government the right to tax, defy the authority of the tax system as it is, or otherwise seek to destroy the taxation system of the federal government. the new tone and subject matter is that of defiance, denial, and destruction.2 the conversant may be located at any spot on the continuum from curiosity to militancy. not all are true believers. this is the good news; but that they are open to becoming so is the sobering news. below, in part ii, i devote several pages to describing what is alarming about these conversations, trying carefully to distinguish between these conversations and those that are runof-the-mill political conversations. the latter may be aimed at reforming 2. to sample the potential tone and subject matter, i recommend watching aaron russo’s america: from freedom to fascism (2006), available at http://freedomtofascism.com, as an introduction. 2011] tax lawyers, tax defiance, and the ethics of casual conversation 843 government, while the former more likely imply revolution. just as there is a material difference between libertarianism and anarchy, there is a material difference between alleging the tax system to be inefficient but remediable, and alleging it to be irremediably illegitimate. this essay is to help tax lawyers decide how to handle casual conversations centered on denying, defying, or destroying the tax system. one option is to walk away, ending the conversation and silencing the dialogue. the next option is to engage. i want to persuade tax lawyers that they should usually engage in the conversation. i try to do this in part iii. there are two kinds of legal ethics essays, and one must choose which kind to write, and it is useful to the reader to know upfront which kind the author chose to write. one kind begins with the ethics rules of a state, or the american bar association, or, for tax lawyers, perhaps circular 230 and provisions of the internal revenue code, such as section 6694, as the selfevident premises, and then proceeds deductively and categorically to opine for all. this essay is not of that kind. rather it is a collection of my thoughts, helpfully organized, i hope, offered as suggestions to help tax lawyers handle an awkward situation that, with increasing regularity, it seems, must be handled—whether it is by walking or talking. i hope to put the problem into the greater context of tax ethics and legal ethics and policy and legal problems in order to generate greater light on handling the situation. i want to encourage tax lawyers who feel they ought to engage in conversation with the tax protestors and anti-tax conspiracy theorists and those of similar moods and minds to do so—and to do so aware of the greater context.3 and for those tax lawyers who are inclined to walk away, i want to give enough reason to them to pause and reflect on the rippling consequences that even one wildly misinformed person can have. i also want to share some thoughts about how tax lawyers ought to prepare for these conversations so as to be ready when they arise, and i turn to this in part iv. finally, in part v, i describe some public responses along these lines, commending the tax lawyers who responded and offering their seizing of a teachable moment as an example for the rest of us. 3. i am not the first to suggest that tax lawyers have law-related ethical duties in casual conversations, though it is not a well-known suggestion. this suggestion was made almost a half-century ago by merle h. miller, a prominent tax attorney in indianapolis, indiana. mr. miller cautioned against tax lawyers “aiding and abetting taxpayers in their suspicion, distrust and even animosity toward those who are writing and enforcing our tax laws.” merle h. miller, morality in tax planning, 10 n.y.u. ann. inst. on fed. tax’n 1067, 1081 (1952). mr. miller wrote that tax lawyers ought to be held to a high degree of accuracy in their comments about the tax system because “[t]he people who hear him, think that he speaks with authority and therefore give more weight to his pronouncements than they would to the ordinary citizen.” id. 844 florida tax review [vol. 10:10 having written that it is good for an essayist to alert the reader upfront to the type of arguments to be presented, it also seems helpful to disclose what the reader may otherwise guess to be a hidden agenda. i will make my greater agenda clear up front, so that the reader will not be burdened with guesses, and so i will not be burdened with slipping it in here and there rather than offering it up in full. in general, i favor a robust professionalism, that is, one that takes seriously that professions are granted a monopoly on their business in exchange for the promise that the profession will benefit the public good—and not merely the professionals’ business. in contrast, there is what i consider to be a weak professionalism, that is, one that seeks to drive the hardest bargain with the public that the profession can with respect to the exchange for the business monopoly. a weak professionalism considers the ideal professional responsibility duties to consist of the minimum constraints necessary to satisfy the public’s demands. a robust professionalism emphasizes that the professional has no right to engage in the business, but only a privilege conditioned on an overriding and greater duty to the public good (in the case of lawyers, the legal system). both lawyers with a weak professional sense and lawyers with a robust professional sense may behave ethically. lawyers with a weak professional sense are likely to understand the self-interest in avoiding bar discipline and malpractice suits and otherwise being known as a diligent, competent, and personable professional. but lawyers with a robust professional sense tend to identify ethical considerations as the essence of their profession—not merely as the best practices required for avoiding discipline and suit. this essay is of absolutely no use for avoiding discipline or suit. however, i hope it is still of interest, premised upon lawyers having professional duties outside the confines of the business of law. ii. tax defying rhetoric taxation is a political topic, apt to pop up or be dropped into a casual conversation much as discussions of wars, education, health care, and environmental regulation. there are many legitimate and important disagreements about tax policy, just as there are legitimate and important disagreements about wars, education, health care, and environmental regulation. there is a range of reasonable disagreement, even if some of the positions seem more reasonable to me than the positions of those with whom i disagree most strongly. there ought to be ample space in our conversations for disagreement. indeed, it is in that space we are most likely to have the most useful conversations. thus, it is essential that i distinguish between ordinary political positions on taxation and tax defying rhetoric. 2011] tax lawyers, tax defiance, and the ethics of casual conversation 845 the term “tax defier” today is used much as the term “tax protester” was once used.4 it refers not to those who advocate a lower tax burden or a different allocation of the tax burden, but rather those who advocate frivolous legal arguments against the validity of the tax system (especially that it is unconstitutional), or refuse to file tax returns or take other actions that defy the administration of the tax system, or deny its legitimacy, or seek to undermine or destroy it.5 the term may have different meanings for different purposes, and, perhaps, in some marginal situations, one may ponder the line between tax defying rhetoric and legitimate tax politics. but, on the whole, differentiating the two is both possible and practical. before focusing on tax defiance, i want to make a point about american income taxation that seems is not often enough the focus of casual conversation. it is commonly understood that our federal income tax system is one of voluntary self-assessment, which simply refers to the requirement that each of us assess his or her own tax liability each year, submitting a check to the irs on or before april 15. what may be less well understood is that americans do so with a remarkable reliability: well over 80% of american taxpayers voluntarily pay the (right amount of) taxes owed.6 this is one of the highest voluntary compliance rates in the world.7 and it applies 4. see nathan j. hochman, tax defiers and the tax gap: stopping “frivolous squared” before it spreads, 20 stan. l. & pol’y rev. 69, 69 & n.6 (2009). 5. id. at 69-70. 6. u.s. dep’t of the treasury, office of tax policy, a comprehensive strategy for reducing the tax gap 5 (2006), available at http://www.ustreas. gov/press/releases/reports/otptaxgapstrategy%20final.pdf [hereinafter tax gap]. 7. dave rifkin, a primer on the “tax gap” and methodologies for reducing it, 27 quinnipiac l. rev. 375, 381 (2009) (citing u.s. dep’t of the treasury, treasury inspector gen. for tax admin., additional actions are needed to effectively address the tax gap (2008), available at http://www.ustreas.gov/tigta/auditreports/2008reports/200830094fr.pdf); see also danshera cords, tax protestors and penalties: ensuring perceived fairness and mitigating systemic costs, 2005 byu l. rev. 1515, 1516-17 (2005) (citing national taxpayer advocate’s report to congress: fiscal year 2006 objectives 6 (2005); steve johnson, the 1998 act and the resources link between tax compliance and tax simplification, 51 u. kan. l. rev. 1013, 1015 (2003); leandra lederman, the interplay between norms and enforcement in tax compliance, 64 ohio st. l.j. 1453, 1459 (2003); leandra lederman, tax compliance and the reformed irs, 51 u. kan. l. rev. 971, 973 (2003); james andreoni, brian erard & johnathan feinstein, tax compliance, 36 j. econ. lit. 818, 819 (1998); phil brand, irs’s worker classification program–an inside look at new ways to resolve the problems, 85 j. tax’n 17, 19 (1996)). of course, in a system that increasingly relies on third-party withholding and reporting, it bears noting that more and more taxpayers have more and more limited opportunities to choose not to comply. http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0297604253&fn=_top&sv=split&referenceposition=1015&pbc=1198a094&tc=-1&ordoc=0307888733&findtype=y&db=1527&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0297604253&fn=_top&sv=split&referenceposition=1015&pbc=1198a094&tc=-1&ordoc=0307888733&findtype=y&db=1527&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0296873382&fn=_top&sv=split&referenceposition=1459&pbc=1198a094&tc=-1&ordoc=0307888733&findtype=y&db=1216&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0296873382&fn=_top&sv=split&referenceposition=1459&pbc=1198a094&tc=-1&ordoc=0307888733&findtype=y&db=1216&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0297604252&fn=_top&sv=split&referenceposition=973&pbc=1198a094&tc=-1&ordoc=0307888733&findtype=y&db=1527&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0297604252&fn=_top&sv=split&referenceposition=973&pbc=1198a094&tc=-1&ordoc=0307888733&findtype=y&db=1527&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0106980204&fn=_top&sv=split&referenceposition=19&pbc=1198a094&tc=-1&ordoc=0307888733&findtype=y&db=100326&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0106980204&fn=_top&sv=split&referenceposition=19&pbc=1198a094&tc=-1&ordoc=0307888733&findtype=y&db=100326&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 846 florida tax review [vol. 10:10 to “over 138 million taxpayers filing over 235 million returns annually.”8 empirically, this high degree of compliance is inexplicable merely in terms of a deterrence model, which would be “a function of the risk of detection and the penalty applied to discovered noncompliance.”9 in other words, the high degree of compliance cannot be explained merely in terms of fear among taxpayers of being caught and punished. after all, only about 12% of individual tax returns are audited.10 were we to consider the very low risk of audit and that the penalty for understatement of tax liability is usually only 20%, “the deterrence model wildly over-predicts the level of noncompliant behavior” we should expect.11 in other words, americans have a relatively good “tax morale.”12 the majority of americans consider it a matter of integrity to pay their taxes.13 unlike their counterparts in some other countries, americans trust their government to provide valued services funded with the tax revenue, and, generally, trust that their fellow “citizens are not shirking their [tax paying] duties.”14 this makes the trust mutual: the government trusts citizens to calculate correctly their own tax liabilities, and the citizens trust the government. this mutual trust “may be important in symbolizing that the powers of the government are indeed (in the words of the declaration of independence) derived ‘from the consent of the governed.’”15 no doubt, most american taxpayers, like most taxpayers anywhere, would prefer a lower to a higher personal tax burden, but in the final analysis, americans tend to trust the system. the essential aspect of the problematic anti-tax system rhetoric is that it denies the trustworthiness of the american tax system. it is squarely at odds with the tax morale of americans who pay their taxes and trust the 8. hochman, supra note 4, at 70 (citing internal revenue service data book 4 (2007), available at http://www.irs.gov/pub/irs-soi/07databkrevised.pdf); see also cords, supra note 7, at 1516-17. 9. richard lavoie, flying above the law and below the radar: instilling a taxpaying ethos in those playing by their own rules, 29 pace l. rev. 637, 640 (2009). 10. internal revenue service, fiscal year 2007 irs enforcement and service statistics 3, available at http://www.irs.gov/pub/newsroom/irs_enforcement_ and_service_tables_fy_2007.pdf. 11. lavoie, supra note 9, at 641. 12. id. at 642. 13. cords concludes it is a matter of patriotism and integrity. cords, supra note 7, at 1516-17. rich lavoie has recently considered the influence of patriotism in his tea parties and taxes: what’s patriotism got to do with it? (aug. 2, 2010) (u of akron legal studies research paper no. 10-09), available at http://ssrn.com/abstract=1653527. 14. lavoie, supra note 9 at 646, 650-55 (discussing trust in government), 655-60 (discussing trust in fellow taxpayers); see also hochman, supra note 4, at 70. 15. lawrence zelenak, justice holmes, ralph kramden, and the civic virtues of a tax return filing requirement, 61 tax l. rev. 53, 64 (2007). 2011] tax lawyers, tax defiance, and the ethics of casual conversation 847 system.16 (it also reveals that those who claim the system is untrustworthy do not know what an untrustworthy system looks like: pakistan, for example.17) the threat the rhetoric has is in its ability to erode the sense of trustworthiness, and, thereby, the compliance rate. thus, whatever other difficulties there are in dividing legitimate criticisms of the tax system from illegitimate system-bashing, the latter, inevitably, alleges that the tax system as such is inherently untrustworthy. abstractly, it may seem difficult to distinguish legitimate from illegitimate criticisms of the tax system, especially insofar as the system itself benefits from critique and the political involvement of citizens who have fundamental disagreements about tax policy. yet, therein lies much of what distinguishes the two. those who make fair, even if marginal or unpopular, criticisms of the tax system presume a general legitimacy to it, even if there are any number of specific internal revenue code sections, or treasury regulations sections, or case law holdings, or economic, legal, or policy concepts that they argue ought be changed. radical critics may have radical agendas, but still work within the tax system rather than seeking to destroy it. they may lobby congress or the irs, argue before courts, or otherwise “channel their protest to the details of the taxes themselves.”18 even if their criticism amounts to claiming it would be better to kill the system as we know it in order to resurrect an improved system, there is a presumption that the political process related to taxation is legitimate. thus to refer to tax defying rhetoric is not to refer to criticisms that happen to be marginal or unpopular, but rather those that allege an irremediable illegitimacy to the tax system. distinguishing between legitimate and illegitimate tax law arguments is not an academic undertaking. courts “have had to strike a balance between welcoming honest taxpayers with legitimate tax claims . . . and spurning tax defiers with rejected, meritless claims.”19 the fifth circuit put it: “[w]e are sensitive to the need for the courts to remain open to all who seek in good faith to invoke the protection of law. . . . however, we are not obliged to suffer in silence . . . unsupported assertions, irrelevant platitudes, and legalistic gibberish.”20 given that the courts recognize a difference between legitimate and illegitimate tax system criticism, i am confident that 16. lavoie, supra note 9, at 646, 650-55 (discussing trust in government), 655-60 (discussing trust in fellow taxpayers); hochman, supra note 4, at 70. 17. see pakistian’s elite pay few taxes, widening gap, n.y. times, july 19, 2010, at a1, available at http://www.nytimes.com/2010/07/19/world/asia/ 19taxes.html. 18. hochman, supra note 4, at 69. 19. id. at 77-78. 20. crain v. commissioner, 737 f.2d 1417, 1418 (5th cir. 1984); see hochman, supra note 4, at 78. 848 florida tax review [vol. 10:10 the latter can be identified in a manner that allows the former its due space for operation. by “tax defying rhetoric,” i do not narrowly mean the defier arguments identified in the courts, but more broadly mean any claims of denying the trustworthiness of the tax system. by the “tax system” i mean not only the internal revenue code, treasury regulations, irs publications, and irs administration, but also those individuals involved in drafting legislation and regulations, implementing the tax law, and adjudicating tax law disputes, and the democratic processes of affecting the legislation, regulation, court cases, and administration of the tax system. i mean not only the law and procedures as we have them, but also the mechanisms we have for changing them. rather than beginning with an exact definition, i will offer some illustrations of what i mean. for example, tax defying rhetoric includes any claims that violence to protest the tax system is justifiable.21 in early 2010, when an irs building in austin, texas was destroyed by a tax protesting pilot, he left a suicide note that ranted about the tax system, concluding that violence was not only a justifiable means but also the only means of response.22 the suicide notes of anti-tax terrorists are an example of the antitax system rhetoric. relatively speaking, however, it seems unlikely that there are many anti-tax system activists who will be motivated to violence, or even willing to publicly endorse the violent activities of others.23 though not physically 21. while few anti-tax activists may engage in violence, their rhetoric is likely sufficient to cause “lone-wolf violence” such as the attack on the irs building in austin. benedict carey, when does political anger turn to violence, n.y. times, mar. 28, 2010, at wk1, available at http://www.nytimes.com/2010/03/28/ weekinreview/28carey.html?scp=1&sq=%22mad+as+hell%22&st=nyt. 22. michael brick, man crashes plane into texas irs office, n.y. times, feb. 19, 2010, at a14, available at http://www.nytimes.com/2010/02/19/us/19 crash.html; murder-suicide letter from pilot joe stack (feb. 18, 2010), available at http://graphics8.nytimes.com/packages/pdf/us/20100218-stack-suicide-letter.pdf. [hereinafter murder-suicide letter]; see also tax lawyer’s blog, deconstructing a tax wacko, http://blog.pappastax.com/index.php/2010/02/23/deconstructing-a-taxwacko (feb. 23, 2010) (tax lawyer and blogger peter pappas took the time and energy to deconstruct the detailed rant against the irs left by the pilot beginning with the observation that the ill of “no taxation without representation” was cured with the right to vote – not the end of taxation.) [hereinafter wacko]. 23. considering how few people with radical political ideologies actually turn violent, professor kathleen blee, a sociologist at the university of pittsburgh, said that “‘[i]n the white power groups i study, people can have all kind of crazy racist ideas, spend their evenings reading hitler online, all of it, . . . but many of them never do anything at all about it.’” carey, supra note 21. researchers have identified two factors that increase the chances of actual violence among political extremists: a morally shocking event and a specific target connected to it. id. 2011] tax lawyers, tax defiance, and the ethics of casual conversation 849 violent, these activists may make any number of illegitimate criticisms of the tax system. the irs has cataloged the most common frivolous tax arguments: the filing of a tax return is not necessary; the payment of taxes is not necessary; federal reserve notes are not income; the united states consists only of the district of columbia, federal territories, and federal enclaves; only employees of the federal government must pay taxes; and, of course, the various arguments that the tax system is unconstitutional— whether the argument is based on the first amendment (religious opposition to taxation), the fifth amendment (taxes are an unjust takings or filing a return is self-incrimination), the thirteenth amendment (taxation is slavery), or the sixteenth amendment (the amendment was not properly ratified or does not authorize a direct non-apportioned income tax).24 similar to tax defying rhetoric undermining the validity of the tax laws is rhetoric that frivolously criticizes the irs or some other part of the tax administration system. this may be a universal description of irs employees as corrupt, inept, or vindictive. or it may be a mis-description of the irs as the source of the tax law rather than the enforcer of it.25 or it may be one of a number of other frivolous claims attacking the authority of the irs employees or standard tax collection procedures, such as claiming that due process notices or federal tax liens are invalid if not signed by the treasury secretary.26 or it may be a claim that the u.s. tax court does not have the authority to decide legal issues,27 or that any court holding session in a room with a gold-fringed u.s. flag is not a legitimate court.28 24. internal revenue service, the truth about frivolous tax arguments (2010), available at http://www.irs.gov/taxpros/article/0,,id=159853,00.html (last visited oct. 20, 2010) [hereinafter irs, frivolous tax arguments]; notice 2010-33, 2010-17 i.r.b. 609 (list of frivolous positions that can result in imposition of civil penalties or prosecution for criminal tax fraud). 25. interestingly, members of congress, which is the author of the internal revenue code, may attempt to shift attention from congress to the irs, such as by using the phrase “the irs code.” presumably, very few of these elected representatives believe the tax system to be irremediably illegitimate (insofar as they are the very ones with the authority), yet their willingness to use this phrase may indicate how susceptible we are becoming to passing along such inaccuracies – and doing so in emotionally and politically-charged ways. for example, the web site of j. randy forbes (r-virginia, 4th) criticizes the complexity of “the irs code” (by citing its word count). see congressman j. randy forbes fourth district virginia, http://forbes.house.gov/issues/issue/?issueid=3339 (last visited oct. 22, 2010). while many of us would like to see the internal revenue code simplified by the act of congress, there is no code passed by the irs. 26. irs, frivolous tax arguments, supra note 24. 27. id. as an article i court, the u.s. tax court does have a very limited jurisdiction, even as with respect to tax matters. it only hears cases involving deficiencies asserted by the irs. if a taxpayer pays the deficiency alleged by the irs, then the taxpayer can seek a refund in the federal district court or the united http://forbes.house.gov/issues/issue/?issueid=3339 850 florida tax review [vol. 10:10 tax defying rhetoric is any rhetoric that explicitly discourages or otherwise would tend to reduce compliance. explicitly, it may assert a frivolous claim that the tax laws are invalid. or it may asset a frivolous claim that the tax laws are unenforceable. or it may assert that the tax laws are so unjust that non-compliance is a moral right or a political good. it may explicitly misinform about the potential tax penalties for non-compliance, or it may simply fail to include the potential penalties in whatever argument it forwards the conclusion of which is to encourage non-compliance. the penalties for failing to file a tax return, or under-reporting income include not only significant fines, but prison terms.29 these are consequences directly borne by some anti-tax activists, and consequences we all should prefer would have been avoided by lawful compliance. at least one former tax protester maintains an internet presence warning others of the foolishness of tax protesting, offering his sad personal experience as evidence.30 tax defying rhetoric may also encourage non-compliance in other ways. for example, by encouraging the idea that only chumps pay taxes.31 by undermining taxpayers’ confidence in other taxpayers, anti-tax system rhetoric undermines the tax system itself. anti-tax system rhetoric may also encourage non-compliance by characterizing a failure to comply as something not worthy of shame or guilt. another mark of tax defying rhetoric is that it entails no appropriate solution to the alleged grievance. it is not aimed at affecting the relevant legal institutions in order to implement reform. rather, it may deny the states court of federal claims. the u.s. tax court cannot hear claims, “other than when a refund is determined to be due a taxpayer in the course of an action on an asserted deficiency.” joshua d. rosenberg & dominic l. daher, the law of federal income taxation § 1.05[3] (2008). given that there are substantial restrictions on the u.s. tax court’s jurisdiction, it is always legitimate to query which issues are within it. the illegitimate claim, of course, is simply that the court lacks authority to hear any issue. 28. kevin d. hill, popular delusions & the law in the age of the internet: a review of damian thompson’s counterknowledge, 35 ohio n.u. l. rev. 801, 811-12 (2009). 29. irc §§ 7201 (willful attempt to evade or defeat tax punishable by imprisonment of not more than 5 years), 7202 (willful failure to collect or pay over tax punishable by imprisonment of not more than 5 years), 7203 (willful failure to file return, supply information, or pay tax in some circumstances punishable by imprisonment of not more than 5 years), 7206 (fraud and false statements punishable by imprisonment of not more than 3 years). 30. tax fool: the truth about income tax, http://taxfool.net (last visited july 12, 2010). 31. professor larry zelenak has studied sitcoms produced from 1940 to 2006 focusing on how tax compliance is portrayed in the popular culture and documenting the transformation of tax-paying as a civic virtue to tax evasion as generally acceptable. see zelenak, civic virtues, supra note 15, at 62-64. 2011] tax lawyers, tax defiance, and the ethics of casual conversation 851 necessity of appealing to legal institutions or the usefulness of doing so. anti-tax system rhetoric offers no legally legitimate proposals to solve the problems it claims. tax defying rhetoric denies the trustworthiness of the american tax system and also denies the possibility of improving its trustworthiness. its essential claim is that compliance is inevitably and inherently unwarranted. iii. why not just walk away? having laid out my terms, i now turn to the question, why not just walk away? suppose yourself to be standing at a reception, exchanging small talk pleasantries with a new acquaintance when, upon hearing that you are a tax lawyer, he remarks on his recently being told by a close friend—perhaps a conspiracy theorist buff, perhaps a history professor at the local college, perhaps even a lawyer—that the sixteenth amendment was never properly ratified. why not just slip away without protest? surely this is covered by the rule to avoid religion and politics in small talk. and not knowing where on the conspiracy theory continuum he is (merely curious? militantly confrontational?), why not avoid the risk of significant annoyance and perhaps even explosive argumentation by declaring your sudden hunger and heading for the tabled hors d'oeuvres? he is not a client to whom you are compelled to speak. and there is no hope for a fee in return for investing your time and energy. now i shall lay out what i think are good reasons not to walk away, despite the perhaps strong impulse to do so. first, have some sympathy for the fellow. he may be sincerely unclear on the legal obligation to pay income taxes. after all, the argument goes, if the sixteenth amendment were not properly ratified, then no one properly owes incomes taxes. it may be the fellow is not at all convinced this is true, but having heard it from someone he considers reliable—who perhaps electronically forwarded a rather detailed-looking memorandum—he sincerely seeks clarification. he may not be a conspiracy theory nut—yet. you may be able to save him from that dangerous condition with relative ease. tax protestor arguments do not raise hard tax issues involving subchapter k basis computations, consolidated returns, or carried interests. the issues raised are covered in the introductory lectures of law school income tax classes. (the practical problem may be remembering what was read and said those many years ago.) but why would i describe his condition as potentially “dangerous,” if you do not save him with rudimentary information? for one, he may become a criminal if he becomes convinced of the conspiracy to conceal the sixteenth amendment’s true status.32 if he decides not to file a return or decides that he needs not pay the tax owed under the code, he may be 32. see infra text at notes 67-68. 852 florida tax review [vol. 10:10 subject to conviction for willfully evading his legal obligations.33 he may be fined and imprisoned. it seems there is a general duty of all citizens, or at least an interest of all citizens, to discourage crimes. if one’s neighbor or sister-in-law discuses her intention to shoplift next weekend or to write a hot check, surely there is some basic civic duty to try to correct her path. even though the small talk acquaintance at the reception is not the lawyer’s client, it seems the lawyer has the same kind of general civic duty to try and correct his path as the lawyer would have if chatting with someone about her plans to shoplift or steal by hot check. it may be that only a tax lawyer appreciates that it is a felony to evade rather than avoid taxation, and so it may be that only a tax lawyer is able to correct the potential tax criminal. this small talk acquaintance may not be a client, but we ought to acknowledge an interest in his situation, either a general civic interest or a personal interest, given the social connection reflected in sharing the reception. he may be the father or brother-in-law of a close friend, after all. or, to tweak the example, perhaps he is an uncle at a family reunion or a former classmate at a school reunion. so, why not just walk away? you may be able to prevent a crime. by engaging in the conversation you are also enlisting in the fight to close the tax gap. the “tax gap” is “the difference between the amount of tax that taxpayers should pay under the tax law and the amount they actually pay on time.”34 and the tax gap is significant. the most recent study estimates it is $345 billion.35 congress, the irs, and the department of justice are all fighting to close the tax gap, and special attention is on tax defiers.36 but the 33. see infra text at notes 67-68. on the issue of willfulness, a mistaken belief may be a defense, so long as it is in good faith, even if it is not objectively reasonable. however, the more unreasonable the belief is, the less likely it is the taxpayer will be found to have held in good faith. and, importantly in this context, a mistaken belief about the constitutionality of the income tax is not a defense to failing to comply with its demands. see cheek v. united states, 498 u.s. 192 (1991), on further proceedings, united states v. cheek, 3 f.3d 1057 (7th cir. 1993), cert. denied, 510 u.s. 1112 (1994); united states v. bonneau, 970 f.2d 929 (1st cir. 1992); united states v. lindsay, 184 f3d 1138 (10th cir. 1999), cert. denied, 528 u.s. 981 (1999). see generally boris i. bittker, martin j. mcmahon, jr. & lawrence a. zelenak, federal income taxation of individuals ¶ 50.08[2] (3d ed. 2002) willful attempts to evade tax. 34. tax gap, supra note 6. the tax gap has become a congressional focus, especially as “congress views it as an easier way to raise revenue and lower the deficit, as compared to raising taxes.” rifkin, supra note 7, at 386. 35. tax gap, supra note 6. 36. congress has pushed the irs to focus on the tax gap, which has substantially increased its enforcement workers and enforcement budget in response. rifkin, supra note 7, at 385-87. the irs commissioner has made reducing the tax gap on of his major objectives. id. at 387. additionally, the u.s. department of justice has specifically focused on aggressively pursuing “tax defiers,” (i.e., those who make frivolous anti-tax 2011] tax lawyers, tax defiance, and the ethics of casual conversation 853 tax gap is not merely “official” business. it is the business of every compliant taxpayer. those who bear the burden of the tax gap are those who pay what they owe on time. the cost of the tax gap to each compliant taxpayer is $2,000 per year—that is, if the tax gap were eliminated, “each compliant taxpayer . . . could receive a check for approximately $2,000 from the government.”37 and it is not merely the honest taxpayer’s business to the extent of $2,000. it is a consequential matter of principle. now, what do honest, law-abiding taxpayers expect in return [for paying their taxes] from the government? they expect that, if they are honoring their legal obligation to truthfully and accurately file their returns and pay their taxes, their neighbors on their right and their neighbors on their left are going to do so as well. and if they don’t, they expect the government to enforce tax laws equally on everyone. one of the greatest challenges to tax compliance is the perception, today and in the past, that everyone may not be paying their fair share of taxes.38 no one alleges that the tax gap is wholly allocable to tax defiers either underreporting their income or failing to file. the threat tax defiers pose to the tax system is in their rhetorical attacks on the legitimacy of the system itself.39 their failure to comply likely leads in turn to other taxpayers failing to comply.40 as one commentator explained, if honest taxpayers were to become convinced that either (i) the income tax system violated the articles or amendments of the constitution, or did not statutorily require them to file a tax return or pay the tax due and owing; or (ii) there was a class of taxpayers making these arguments with impunity, then the voluntary compliance component necessary for the nation’s tax system to properly operate would be jeopardized arguments) by creating the national tax defier initiative. id. at 405. this is intended to “reinvigorate the tax division’s commitment to investigate, pursue, and, where appropriate, prosecute those who take concrete action to defy and deny the fundamental validity of tax laws.” id. 37. id. at 383 (citing joann m. weiner, truth and taxes, 119 tax notes 249, 250 (2008)). 38. nathan j. hochman, transcript available of doj press conference on tax defier initiative, 2008 tax notes today 70-57 (2008). 39. hochman, supra note 4, at 79. 40. rifkin, supra note 7, at 376. the risk that tax “outlaws” undermine others’ respect for the tax system, thereby threatening the system has long been noted. it was noted at least as early as 1952. see, e.g., e. barrett prettyman, a judge answers some questions, questions prepared and propounded by robert n. miller and given by e. barrett prettyman, 10 nyu inst. on fed. tax’n 1053, 1062-64 (1952). 854 florida tax review [vol. 10:10 and the tax gap would be in danger of growing significantly.41 in other words, the anti-tax system rhetoric of the tax defiers has the potential to undermine the trust in the fairness of the tax system that supports the very high compliance rate of the american tax system.42 without that compliance rate, the tax system itself is jeopardized. and so here is another reason not to walk away: closing the tax gap. it is not that the small talk acquaintance’s potential financial contribution to the tax gap is likely to be significant. but his willingness to pass along a tax defying attitude may be. this attitude may be contagious in those with information deficiencies, and it may be infecting ever greater numbers of our citizens, especially through electronic transmissions.43 if more and more honest taxpayers come to believe that there are no ill consequences, then the system may be weakened further. even the smallest instances of resistance may prove increasingly important in minimizing the threat. unfortunately, the threat is not merely to the revenue. another reason not to walk away from the conversion is that tax defiance may lead to violence. even the most ardent tax defier may not become violent, just as the most ardent racist may fail to strike physically.44 yet, innocent people are 41. hochman, supra note 4, at 79-80. 42. id. at 83. 43. it is interesting to note the correlation between the increase in communication transmissions and the increase in tax protestor returns. for example, tax protestor returns increased more than eight-fold between 1980 and 2001. cords, supra note 7, at 1517-18 (regarding tax protestor returns). like other outlandish conspiracy theories and immortal urban legends, the explosion of internet use has facilitated the spread of anti-tax system rhetoric. hochman, supra note 4, at 81-82; hill, supra note 28, at 802-06, 809. much like the poodle-in-the-microwave story, or the “stella awards” for outrageous tort suits (which never occurred), anti-tax system rhetoric spread by mass e-mail lists and blogs “informs” the public. id. at 802-06, 812. the speed of such communication, and the ease with which it is broadcast, likely means that the threat of anti-tax system rhetoric increases in the future. urban legends and other misinformation may have once travelled from the water cooler to the family dinner table to the bowling alley to the water cooler, but, today, it travels at the speed of light, filling the in-boxes and browser search results of otherwise honest taxpayers who lack the education to recognize it for what it is: wrong. two tangential aspects of anti-tax system rhetoric bear mentioning. first, some anti-tax system activists make money from peddling the conspiracy. id. at 801. second, an anti-irs sentiment in the country may serve to benefit high income tax payers. david m. schizer, enlisting the tax bar, 59 tax l. rev. 331, 341 (2007). it bears remembering that this rhetoric services the financial interests of some, even while undermining the financial interests of others. 44. considering how few people with radical political ideologies actually turn violent, professor kathleen blee, a sociologist at the university of pittsburgh, 2011] tax lawyers, tax defiance, and the ethics of casual conversation 855 killed by tax protestors, just as innocent people are killed by racists.45 more than 900 threats against irs employees are investigated each year.46 the southern poverty law center has cataloged some of the more dramatic threats.47 in reno, nevada, an irs building was targeted by a tax protester who placed a drum of ammonium nitrate and fuel oil in its parking lot.48 in colorado springs, colorado, an irs building was torched.49 in austin, texas, a decorated vietnam veteran was murdered when a tax protesting terrorist struck an irs building.50 tax defiance is a delusion that may be cured, and a delusion that may kill if not cured. the small talk opportunity may be a chance to treat the delusion, and perhaps the best chance there will be. of course, it may be too late: the acquaintance may be suffering a full-blown delusion. true believers of any sort are rarely persuaded, and there may be no use in engaging a true believer, and it may even be that a true believer walks away from an encounter emboldened for having confronted a member of the pro-tax conspiracy. common sense suggests that militantly confrontational tax defiers need not be entertained. but there is a much greater chance that one encounters the merely curious rather than the said that “‘[i]n the white power groups i study, people can have all kind of crazy racist ideas, spend their evenings reading hitler online, all of it . . . but many of them never do anything at all about it.’” carey, supra note 21. researchers have identified two factors that increase the chances of actual violence among political extremists: a morally shocking event and a specific target connected to it. id. 45. while professor blee, emphasizes how few individuals with “crazy racist ideas” ever “do anything,” supra note 44, the southern poverty law center maintains reports on those with “crazy racist ideas” who do engage in actual violence. see southern poverty law center, intelligence files, http://www.splcenter.org/get-informed/intelligence-files (last visited sept. 9, 2010). 46. andrea ball, hatred toward irs nothing new, the dallas morning news, mar. 3, 2010, http://www.dallasnews.com/sharedcontent/dws/news/ texassouthwest/stories/dn-irsworkers_03tex.art.state.edition1.4bdd764.html. 47. posting of heidi beirich to southern poverty law center hatewatch blog, irs long a target of antigovernment extremists, http://www.splcenter.org/ blog/2010/02/18/irs-long-a-target-of-antigovernment-extremists (feb. 18, 2010). 48. id. 49. id. 50. associated press, hundreds salute irs worker killed in plane crash, dallas morning news (feb. 26, 2010), http://www.dallasnews.com/sharedcontent/ apstories/stories/d9e44qe00.html; jeremy schwartz & melissa b. taboada, family, friends gather at home of missing man, austin american-statesman (feb. 19, 2010), http://www.statesman.com/news/local/family-friends-gather-at-home-ofmissing-man-257976.html; orangeburg native killed as plane hits irs building, times & democrat (s.c.) (feb. 21, 2010), http://thetandd.com/articles/ 2010/02/21/news/doc4b80bf4c5d00a962267536.txt [hereinafter orangeburg]; see supra note 22 and accompanying text. 856 florida tax review [vol. 10:10 militantly confrontational. the merely curious are those who have heard rumors on the golf course, the sunday school class, or online that the tax system is unconstitutional, for example, and, while open to being persuaded of a vast conspiracy, they have not been. walking away when they raise what strikes them as an important set of reasonable questions may be taken by them as evidence that they are on to something. choosing to respond in the casual conversation may itself be enough to satisfy the tax defying curiosity in the small talk acquaintance. responding reveals a personal identification with the tax system, and the personal conclusion that it is legally legitimate. the small talk acquaintance’s questions about the system’s legitimacy become questions about your integrity. sharing a social connection increases the chance that your professional involvement with the tax system is interpreted as evidence of its legitimacy. but even more so is that as a tax lawyer, you are professionally devoted to reducing tax liabilities. as someone undeniably sympathetic with lowered tax liabilities, the defense of the tax system’s legitimacy is even likely more persuasive. simply by responding rather than walking away, a great deal is communicated. identifying with the fundamental integrity of the system may have significant personal consequences as well. it strengthens professional identity, and deepens the personal sense of professional duty. it is a reminder of what it means to be a professional, what it means to have professional duties. it is reminder of our interest in the system as tax lawyers specifically. but it also reminds us of the duties all lawyers have as public servants, as officers of the legal system that is attacked by tax defiers. it is an instance of robust professionalism, acting professionally while acting outside of our business context. it is a practical reminder that our professional identity is not as consultants or information specialists but as lawyers.51 51. professor tanina rostain has argued that over the past thirty years, cpas intentionally moved their primary professional orientation from that of tax return preparers and auditors to that of tax reduction consultants. tanina rostain, sheltering lawyers: the organized tax bar and the tax shelter industry, 23 yale j. on reg. 77, 89 (2006). professor rostain explored this development in connection with the rise of abusive tax shelters in the 1990s, contrasting how cpas and tax lawyers appeared to perceive their professional duties. in addition to the 2006 article in the yale journal on regulation, professor rostain continues to work analyzing the role of tax professionals in the tax shelter industry. her work is expected to be published as a book by mit press in 2011. see her biography at http://www.law.georgetown.edu/faculty/facinfo/tab_faculty.cfm?status=faculty&id =2597 (last visited oct. 26, 2010). professor rostain concluded that the organized tax bar was unwilling to reduce their professional identity as a lawyer to that of a “mere consultant or legal information specialist[].” id. at 120. professor rostain considers this a stark counter-example to securities lawyers who are increasingly and willingly “refashioning themselves as ‘consultants’ or ‘information specialists.’ id. 2011] tax lawyers, tax defiance, and the ethics of casual conversation 857 iv. tax lawyers as public educators what does it mean to identify as a lawyer rather than merely a consultant? it means not merely being in the business of earning fees from clients, but being a member of a profession in which we serve clients in particular but the system in general. we are members of a learned profession, obligated to cultivate and use knowledge beyond its use for clients.52 a lawyer’s professional responsibilities are difficult to summarize because, as a professional, a lawyer’s role is multifaceted and cannot be reduced to one or two principles. in describing the lawyer’s responsibilities, the preamble to the model rules references the multifaceted nature of the profession: “a lawyer, as a member of the legal profession, is a representative of clients, an officer of the legal system and a public citizen having special responsibility for the quality of justice.”53 acknowledging the many facets of the legal profession has several important consequences described in the model rules. lawyers should “demonstrate respect for the legal system and for those who serve it;”54 “further the public’s understanding of and confidence in the rule at 82 (citing robert eli rosen, “we’re all consultants now:” how change in client organizational strategies influences change in the organization of corporate legal services, 44 ariz. l. rev. 637 ((2002)). professor simon is concerned with this same phenomenon, which he characterizes as involving “the most fundamental claim of modern professionalism—that professionals can simultaneously serve their client’s interest and the public’s interest.” william h. simon, after confidentiality: rethinking the professional responsibilities of the business lawyer, 75 fordham l. rev. 1453, 1454 (2006). professor simon writes that his interest is in how securities lawyers’ and tax lawyers’ “general understanding of their obligations to law and the public interest and how that understanding shapes their conception of their role.” id. at 1456. thus, tax lawyers have been contrasted with cpas, on the one hand, and with securities lawyers, on the other, insofar as the organized tax bar has insisted on viewing tax lawyers as gatekeepers with a duty to the system—and not as mere consultants with duties only to clients. 52. “as a member of a learned profession, a lawyer should cultivate knowledge of the law beyond its use for clients, employ that knowledge in reform of the law and work to strengthen legal education. in addition, a lawyer should further the public’s understanding of and confidence in the rule of law and the justice system because legal institutions in a constitutional democracy depend upon popular participation and support to maintain their authority.” model rules of prof’l conduct pmbl. ¶ 6 (2004). 53. id. at ¶ 1. the preamble to the model rules provides the “general orientation” to the professional considerations that should inform a lawyer. id. at scope ¶ 21. 54. “a lawyer should demonstrate respect for the legal system and for those who serve it, including judges, other lawyers and public officials.” id. at pmbl. ¶ 5. 858 florida tax review [vol. 10:10 of law and the justice system;”55 and be “competent, prompt and diligent” with respect to all their “professional functions.”56 these duties transcend the many duties a lawyer has when representing a client, and instead reflect a lawyer’s more general professional duties. all of these duties help describe how lawyers and their relationship to the legal system “play a vital role in the preservation of society.”57 inasmuch as “[t]axes are what we pay for civilized society,”58 the tax lawyer’s role in preserving the tax system is his role in preserving civilized society.59 some have located the tax lawyer’s duty to the tax system within a citizen’s sense of gratitude: each american should be grateful “for the freedom and security the u.s. government provides” and “if we feel grateful, we [as tax lawyers] should want to preserve the government’s lifeline, the tax system.”60 the tax lawyer’s duty to the tax system may be conceptualized as 55. id. at ¶ 6. 56. “in all professional functions, a lawyer should be competent, prompt and diligent.” id. at ¶ 4. 57. “lawyers play a vital role in the preservation of society. the fulfillment of this role requires an understanding by lawyers of their relationship to our legal system.” id. at ¶ 13. 58. compania general de tabacos de filipinas vs. collector of internal revenue, 275 u.s. 87, 100 (1927) (holmes j., dissenting). 59. nathan j. hochman considers tax defiers in the context of our civilized society: the irony of the tax defiers’ situation is that the very system that they reject pays for their ability to live in and reject that system. while tax defiers refuse to pay their fair share of taxes, they have no problem accepting their fair share of the benefits paid for by that tax system, including the courts they litigate in, the roads they drive on, the police and fire departments they call during emergencies, the military that defends them, the sanitation trucks they rely on to pick up their garbage, and the regulators they count on to ensure the safety of the food they eat, the water they drink, and the air they breathe. hochman, supra note 4, at 70. the obligation to fund civilized society has been emphasized in patriotic terms, such as when, after september 11, 2001, corporations that expatriated themselves for tax purposes were characterized as antipatriotic, refusing to fund the military in a time of threat. anthony c. infanti, eyes wide shut: surveying erosion in the professionalism of the tax bar, 22 va. tax rev. 589, 595 (2003). 60. schizer, supra note 43, at 370. tax lawyer merle miller, almost a half century before, wrote that the tax lawyer owes a great duty to the country that has educated him, and made possible his present success. he must do his best to maintain in his fellow citizens a proper respect for the methods we have set up under a democratic system for the collection of each citizen’s share. . . . he must inculcate in each citizen a respect for the 2011] tax lawyers, tax defiance, and the ethics of casual conversation 859 a duty to all “who ascribe value to a well-functioning tax system,” that is a duty to the public’s “abiding interest in protecting the government’s ability to fund itself and in ensuring that each taxpayer pays her fair share of governmental costs as allocated by democratic processes.”61 the tax system needs the help of tax lawyers as public educators. the tax bar should enlist itself into the public service to combat the anti-tax system rhetoric that threatens the public interest.62 this is a call to fulfill the duty of lawyers as “public citizen[s] having special responsibility for the quality of justice.”63 professor mark tushnet has made a general call for lawyers to serve as public educators to improve constitutional knowledge.64 lawyers, after all, have more knowledge on these matters than “ordinary” people do.65 but, unlike constitutional law which flavors our daily political discussions, or criminal law that reflects much, even if not most, of our moral intuitions, tax law is neither commonly discussed nor commonly an object of reliable intuition. the public “remains blissfully ignorant” of most of the tax law.66 so how would a lawyer prepare to become an “educator” for the chance conversation about tax defiance? there is no way to anticipate accurately what the small talk acquaintance may have heard, read, or experienced. there is no script to rehearse; no lecture to deliver. the tax lawyer, however, can read and think about the tax system generally, and her personal, professional, and political relationship to it. system, and a proper respect for the part which honesty plays in that system. merle miller, morality in tax planning, 10 n.y.u. ann. inst. on fed. tax’n 1067, 1083 (1952). 61. linda galler, the tax lawyer’s duty to the system, 16 va. tax rev. 681, 693-94 (1997) (reviewing bernard wolfman et al., ethical problems in federal tax practice (1995) (quoting, in part, ann southworth, note, redefining the attorney’s role in abusive tax shelters, 37 stan. l. rev. 889, 912 (1985)). 62. this draws on dean david m. schizer’s proposal to enlist the tax bar to combat aggressive tax planning. as dean schizer argues, the resources of the government to defend the tax system are too meager to be sufficient. schizer, supra note 43, at 331-33. 63. model rules of prof’l conduct pmbl. ¶ 1 (2004) (preamble sets forth duties in a general way). 64. mark tushnet, citizen as lawyer, lawyer as citizen, 50 wm. & mary l. rev. 1379 (2009). 65. id. at 1385. 66. schizer, supra note 43, at 343. there may be multiple reasons for the public ignorance of tax law. contemporary empirical studies into educating the public on tax policy concepts suggest that some tax policy concepts may be “too difficult for most of the public to grasp.” lawrence zelenak, the conscientious legislator and public opinion on taxes, 40 loy. u. chi. l.j. 369, 375 (2009). all the more reason for the tax bar to enlist itself as educators. http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0108646939&fn=_top&sv=split&referenceposition=687&pbc=2259b44b&tc=-1&ordoc=0350764203&findtype=y&db=1508&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 http://web2.westlaw.com/find/default.wl?tf=-1&rs=wlw10.06&referencepositiontype=s&serialnum=0108646939&fn=_top&sv=split&referenceposition=687&pbc=2259b44b&tc=-1&ordoc=0350764203&findtype=y&db=1508&vr=2.0&rp=%2ffind%2fdefault.wl&mt=208 860 florida tax review [vol. 10:10 as a first step towards that end, the tax lawyer should remind herself of the issues in distinguishing between tax avoidance and tax evasion. this is not a subject most responsible advisors must often consider, but discussing the penalties for the latter may be useful in the conversation. there are both civil and criminal penalties, potential fines and prison time. civilly: section 6702 imposes a penalty for filing a frivolous return; section 6662 imposes various accuracy-related penalties; and section 6663 imposes a civil penalty for fraud. criminally: section 7201, which imposes up to a $100,000 fine and five years imprisonment for willfully attempting to evade or defeat taxation and section 7203, which imposes up to a $25,000 fine and one year jail term for willfully failing to file a return, supply information, or pay tax. the courts have their own authority for sanctioning frivolous anti-tax arguments.67 it may be eye-opening for the acquaintances to learn about the standards for tax advice, and the penalties applicable to lawyers who provide unreasonable advice as to return positions, as well as the organized tax bar’s concern with upholding standards for tax advice.68 considering the same topic but from a personal perspective, the tax lawyer should ponder and come to some clarity as to how she personally relates to the tax system as a professional. does she understand the “duty to the system” tax lawyers are usually said to have, and how does she consider that duty personally and in her daily practice?69 if taxes are the price of 67. see, e.g., irc § 6673; fed. r. civ. p. 11. 68. irc § 6694; reg. § 301.7701-15; dep’t of treasury circular no. 230, 31 c.f.r. §§ 10.2(a)(4), 10.21, 10.22, 10.33, 10.37 (2007); rostain, supra note 51, at 83. 69. tax lawyers are said to have a “duty to the system.” bernard wolfman et al., standards of tax practice § 101.2 (5th ed., 1999). professor deborah schenk has written that the self-assessment nature of the tax system means that the tax system cannot permit the “absolute adversarial” relationship that lawyers might have in other situations. deborah h. schenk, book review: tax ethics, 95 harv. l. rev. 1995, 2005 (1982). the idea that “[t]ax ethics . . . must be approached from a special perspective” as a consequence of self-assessment nature of our tax system seems the most common argument for tax lawyers’ duty to the system. id. at 2005; see also infanti, supra note 59, at 606. dean david m. schizer has described other unique aspects of tax administration that may justify a duty to the system. “first, government tax lawyers are not backstopped by private attorneys general as they are, for instance, in the securities field by the plaintiff’s bar. second, tax rules generally are written narrowly and precisely. . . [and as] a result, the tax authorities are more likely to face conduct that violates the spirit, but not the letter. . . . third, the tax regime—for capital, especially—may be more malleable than other regimes. . . . [for example,] a tax lawyer can easily shift certain types of income from one jurisdiction to another without changing anything substantive. . . .” schizer, supra note 43, at 338. however, some have criticized this conception of the tax lawyer. see, e.g., david j. moraine, loyalty divided: duties to clients and duties to 2011] tax lawyers, tax defiance, and the ethics of casual conversation 861 civilization, how does her working to ensure her clients pay no more than they must provide civic benefit? she should have developed significant clarity on these fundamentals of a professional identity as a tax lawyer. how she fits within the tax system is likely to become an issue when she tries to make the case for the system’s legitimacy. she is lending her personal standing to the system in this conversation by identifying as a professional part of the system. thus, she should have reflected on what it means to be a professional part of the system. of course, she need not over-identify with the system. she should be prepared to admit the problems with the system that she sees. the problems may be political, such as her preferences for changes in the tax base or tax rates. or the problems may be administrative, such as the frustration in dealing with incompetent irs agents or inefficient irs procedures. to express her professional obligation and commitment to the legitimacy of the tax system does not imply she considers the system to be perfect—or even in good shape. sometimes tax lawyers are so focused on the technical aspects of the issues that recur in their daily practice that they do not step back and consider the tax system as a whole.70 of course, any highly specialized field likely tempts its members into technical myopia. but in order to effectively engage in a casual conversation about the system’s legitimacy, the tax lawyer needs to put the system as a whole into perspective, considering her professional relationship to the system, her personal opinions on its problems, and her political preferences for fixing those problems. her small talk acquaintance may have personally experienced some of these problems. for example, she may have experienced a sense of powerlessness during an audit, as well as reasonably concluding that the irs agents involved were ill-prepared or ill-motivated, or both. she may deserve considerable sympathy for what he personally experienced in the tax system. but he also may need help putting his personal experience into a greater perspective, provided by the tax lawyer describing the burdens on the system abstractly but on the irs agents particularly. there are, after all, well over two hundred million returns filed each year, and need for systematic integrity.71 but there is also the pressure on the professionals at the irs, pressure that comes with holding a position essential to protecting the system’s integrity but also widely despised, as well as involving material others—the civil liability of tax attorneys made possible by the acceptance of a duty to the system, 63 tax law. 169, 190 (2009). 70. “as tax practitioners, we generally focus on the trees, particular branches, or even leaves. we rarely stand back and look at the forest. most lawyers are specialists, and tax lawyers are more specialized than most.” robert w. wood, what good is a tax opinion anyway? 2010 tax notes 1071, 1071 (sept. 6, 2010). 71. hochman, supra note 4, at 70 (citing irs, statistics of income data book 4 (2007), available at http://www.irs.gov/pub/irs-soi/07databkrevised.pdf), see also cords, supra note 7, at 1516-17. 862 florida tax review [vol. 10:10 personal risk.72 these professionals work under the burden of representing all the taxpayers when determining the honesty and accuracy of any given taxpayer; the taxpayer under review cannot be cut slack without considering all of the taxpayers who are not being cut slack. and, yes, of course, there are bad irs revenue agents. but that is also true of employees in banks, insurance companies, utilities, universities, and hospitals. bad service, bad attitudes, and bad people are real problems—inside and outside the irs. these are human problems; not tax problems. although the tax lawyer’s small talk acquaintance may have had a negative personal experience with the irs (it is quite unlikely any of us would consider any personal audit as “positive,” of course), the more difficult issue may be his being convinced by any number of tax protestor arguments. most practicing tax lawyers have probably never considered the issues these arguments raise, and, upon being briefed on the arguments, may themselves come to wonder. all tax lawyers should take time to read the irs’s the truth about frivolous tax arguments.73 there are also law review articles on these arguments.74 some tax protestor arguments are constitutional. for example, one common argument is that requiring tax returns violates the fifth amendment’s right against self-incrimination, or that tax collection violates the fifth amendment’s guarantee of due process.75 another argument is that income taxation is a form of slavery outlawed by the thirteenth amendment.76 several arguments are made that 72. andrea ball, hatred toward irs nothing new, dallas morning news, mar. 2, 2010, http://www.dallasnews.com/sharedcontent/dws/news/texassouthwest/ stories/dn-irsworkers_03tex.art.state. edition1.4bdd764.html. 73. irs, frivolous tax arguments, supra note 24. 74. see, e.g., christopher s. jackson, the inane gospel of tax protest: resist rendering unto caesar—whatever his demands, 32 gonz. l. rev. 291 (1997); cords, supra note 7. unfortunately, sources of good information are far fewer than sources of misinformation. online searches for information are especially likely to result in substantial misinformation. there is, at least, one reliable source of information online: for example, george washington university school of law professor jonathan r. siegel maintains http://docs.law.gwu.edu/facweb/jsiegel/ personal/taxes/f2f.htm (last visited july 12, 2010) [hereinafter, siegel]. it is a very useful site, and stands out among search results as an anti-tax protestor site. 75. see jackson, supra note 74, at 307-08. as to the first argument, filing a tax return is not in and of itself an incriminating act, so requiring it is not requiring a self-incrimination. as to the second, “because the government cannot operate without revenue, it must collect taxes. moreover, because the means of collecting taxes must be efficient, the courts have repeatedly allowed summary tax collection proceedings where they were followed by an opportunity for judicial review.” cords, supra note 7, 1539. 76. see jackson, supra note 74, at 310. those who make this argument equate taxation with slavery. of course, at the time the 13th amendment was adopted, americans did not believe they were amending the constitution in order to 2011] tax lawyers, tax defiance, and the ethics of casual conversation 863 the sixteenth amendment was not properly ratified.77 one variation is that ohio was not a state until 1953, thus president taft (who hailed from ohio) had no authority to convene congress when the amendment was ratified.78 other arguments focus on clerical mistakes, typographical irregularities, or states failing to follow internal procedures.79 many of the arguments are not constitutional, however. some rely on technical readings of the internal revenue code, such as arguing that provisions on foreign-source income exempts wages earned by u.s. citizens.80 there is also the argument that the taxpayer is not a “u.s. citizen,” but rather a citizen of a particular state.81 there is an argument that no one is obligated to pay income tax except by contract.82 another argument (occasionally made with biblical citations) is that federal reserve notes are not real money insofar as the gold standard has been abandoned.83 familiarizing oneself with the tax protestor arguments forbid taxation—it was to forbid slavery. at that time, americans were very familiar with real slavery. siegel, http://docs.law.gwu.edu/facweb/jsiegel/personal/ taxes/incometax.htm (last visited aug. 30, 2010). 77. see jackson, supra note 74, at 301-07. 78. id. at 305. “this contention improperly uses public law 204, which congress passed in 1953 to settle a dispute as to the precise date in 1803 that ohio became a state. this argument is clearly erroneous because the 1953 resolution did nothing more than confirm that ohio became a state in 1803.” cords, supra note 7, at 1515. 79. see jackson, supra note 74, at 302-05. these superficial defects were known at the time, and were addressed at the time. the conclusion, then and now, was that the irregularities were irrelevant as a substantive matter. see, e.g., united states v. benson, 941 f.2d 598 (7th cir. 1991); united states v. foster, 789 f.2d 457 (7th cir. 1986); cook v. spillman, 806 f.2d 948 (9th cir. 1986); united states v. house, 617 f.supp. 237, 238-39 (w.d. mich. 1985). see generally siegel, http://docs.law.gwu.edu/facweb/jsiegel/personal/taxes/16th.htm (last visited, aug. 30, 2010). 80. see cords, supra note 7, at 1542. those who are neither citizens nor residents of the united states are only subjected to income tax to the extent their income is earned in the united states. this argument confuses complex provisions intended to distinguish between domestic and foreign income for those who owe u.s. income tax to the extent of u.s.-source income. siegel, http://docs.law.gwu.edu/facweb/jsiegel/personal/taxes/861.htm (last visited aug. 30, 2010). 81. see jackson, supra note 74, at 310-11. of course, one is a citizen of both one’s state and the united states. this is made clear in the 14th amendment, among other places. siegel, http://docs.law.gwu.edu/facweb/jsiegel/personal/ personal/taxes/sovereign.htm (last visited aug. 30, 2010). 82. see jackson, supra note 74, at 320-21. the internal revenue code imposes the obligation, not a contract. see irc §§ 1, 61, 63, 6012, 6051, 6072. siegel, http://docs.law.gwu.edu/facweb/jsiegel/personal/taxes/justnolaw.htm (last visited, aug. 30, 2010). 83. see jackson, supra note 74, at 316-17. 864 florida tax review [vol. 10:10 is educational (and entertaining) but also exasperating: some of the arguments invoke a good number of obscure historical details, while others are so fundamentally misguided that the real problem is the fundamental ignorance of the person making the argument, not the details of the allegations or inferences. a casual conversation with someone sincerely convinced by these arguments could be very challenging for the casually prepared, but the arguments are so numerous, and subject to so many variations, that moderate familiarity with the generalities of the arguments, coupled with a tax lawyer’s specific expertise in tax and general training as a lawyer, should go towards making the convinced less so. while the tax lawyer could exhaust herself studying tax protestor arguments, and while some study is probably helpful, the essential goal of the conversation is to increase the small talk acquaintance’s trust in the tax system. and, as i mentioned above, by “tax system,” i do not mean merely the laws and administrative procedures that are in place, but the mechanisms for changing those laws and procedures. the conversational objective is to re-direct distrust of the system into legitimate work to improve the system. this involves emphasizing that it is congress that writes the laws, so writing one’s congressional representatives may be in order. and also that there are opportunities to comment on regulations and procedures adopted by the irs, and that public participation and involvement is solicited and welcomed. it may be useful to be prepared to explain the history of the income tax specifically, how it replaced tariffs and is theoretically intended to be a tax on the ability to pay tax, as well as explaining commonly suggested changes in the tax base, such as to a consumption tax and what that would mean. an even greater familiarity with the history of taxation may be rhetorically useful, even if it is no more than to point out that taxes are older than money itself, and that the rally to end taxation without representation was a call for representative government—not the end of taxation.84 ultimately, it is also a matter of civic duty. those who refuse to comply with the tax system are criminals threatening the fabric of our system—and cost each honest american who pays what she owes when she owes it.85 ultimately, there must be an appeal to the gratefulness americans should have for our standard of living and our mode of government, and an urging to use the latter to try to improve the former, but not to undermine both through tax defiance. on one hand, the conversational goal is to convince the other person not to engage in defying the tax system, and not to spread misinformation about the tax system. on the other hand, the goal is to improve the tax system. increasing the public’s understanding and confidence in the tax system is also likely to improve the law itself, which is a general duty 84. see wacko, supra note 222. 85. id. 2011] tax lawyers, tax defiance, and the ethics of casual conversation 865 lawyers are to undertake.86 citizens who understand the law are presumably better equipped to work for improvement in the law, and those citizens who trust that the system will respond to their work for improvement in the law are presumably more likely to undertake such work. channeling citizens out of anti-tax system activism and into tax system reform efforts is also likely to increase the confidence that citizens have in the law.87 participating in the process to change laws tends to increase compliance with laws—even for those whose reform proposals “lose.” 88 thus, not only would a better tax system likely result from increased public education and participation, but better compliance with the tax system would likely result—merely from the informed understanding and participation. and this is a very good reason not to walk away from conversations about tax defiance. v. murder and taxes: concluding examples on february 26, 2010, vernon hunter was mourned at the st. james missionary baptist church in austin, texas.89 a 68 year-old father of six, described by friends “as an exceptionally kind man who was the glue in both his neighborhood and at work,” a “spiritual man” and a patriot, vernon hunter had grown up in orangeburg, south carolina, joining the united states army after graduating from high school in 1959.90 he served twenty years in the army, including two tours of duty in vietnam.91 he was killed when a suicidal pilot flew his plane into an irs office building in austin.92 the pilot, who according to his father-in-law, intended “to damage the irs,” left a six page murder-suicide note that identified the irs and the internal revenue code as the primary sources of his rage.93 vernon hunter was an irs employee. after retiring from the army, he had worked for the irs for twenty-seven years.94 he was buried with full military honors.95 the pilot who killed vernon hunter was hailed as a “hero” by some americans: “the web was studded with praise for [the pilot] almost immediately after his plane slammed into the austin office complex 86. id. 87. lavoie, supra note 9, at 652-53. 88. id. 89. associate press, supra note 50. 90. see id. 91. orangeburg, supra note 50. 92. id. 93. see sources cited supra note 222. 94. orangeburg, supra note 50. 95. obituary for vernon hunter, austin american-statesman (feb. 25, 2010), http://www.legacy.com/obituaries/statesman/obituary.aspx?n=vernon-hunter &pid=140008570. 866 florida tax review [vol. 10:10 thursday morning.”96 abc news reported that the federal bureau of investigation requested that an internet service provider remove the pilot’s “angry rant against the irs and the government” from a web site on which it had been posted the morning of the attack—after it had received around 20,000,000 hits.97 the president of the service provider said that “within minutes of taking the note down,” thousands of e-mails were received demanding it be reposted—some with the threats of additional violence.98 most of the e-mail praised the pilot.99 there was even a facebook page for his admirers, one of whom posted “he sacrificed his life to inspire the quest for truth.”100 it seems appropriate to commend two tax lawyers who used the attack that killed vernon hunter and the tax defiance alleged to justify it, as an opportunity to explicitly address anti-tax system rhetoric, and who did so in public and useful ways. robert wood took the opportunity to write a forbes article educating the public about frivolous tax arguments.101 he explained the accuracy-related, civil fraud and other penalties that taxpayers should know about, and he explained the “top 10” tax arguments taxpayers should avoid—if they wish to avoid the risks of making frivolous tax arguments.102 tax lawyer peter pappas took the time and energy to deconstruct the detailed rant against the irs left by the pilot, beginning with the observation that the ill of “no taxation without representation” was cured with the right to vote—not the end of taxation.103 mr. pappas also explained that the complexity of the tax code is not evidence of totalitarianism, as well as addressing convoluted arguments claiming the american tax system is a nightmare, churches should not be tax exempt, and that accountants are part of a conspiracy that should be stopped.104 mr. pappas wrote: “i am no fan of big government and inefficient bureaucracy, but i loath to the core antigovernment maniacs who would do harm to federal employees. they are terrorists of the worst kind—even worse than the islamofascist true believers 96. lee ferran, joe stack hailed as hero in american ‘patriot’ resurgence, abc news (feb. 19, 2010), http://abcnews.go.com/thelaw/patriotmovement-calling-joe-stack-hero/story?id=9889443. 97. id. 98. id. 99. id. 100. id. 101. robert w. wood, ten tax protester claims to avoid, forbes.com, feb. 19, 2010, http://www.forbes.com/2010/02/19/irs-tax-protestor-stack-snipespersonal-finance-robert-wood_3.html. see also wood & porter, a professional corporation, http://www.woodporter.com/ (last visited july 12, 2010). 102. wood, surpa note 101. 103. wacko, supra note 222. 104. id. 2011] tax lawyers, tax defiance, and the ethics of casual conversation 867 formerly hunkered down in the caves of damadola.”105 in addition to his workload advising clients on how to comply with the tax system, mr. pappas took upon himself the burden of using his special knowledge to limit the negative effects that this anti-tax system rant otherwise may have had. hopefully, variations on mr. wood’s and mr. pappa’s public responses were articulated privately by tax lawyers across the country who also took the opportunity as a “teachable moment” for their family members, friends, and colleagues. may mr. wood’s and mr. pappas’s public responses encourage each of us to engage in private conversations when those teachable moments arise–even if our first impulse it to walk away. 105. characteristics of extreme anti-irs wackos, tax lawyer’s blog (mar. 14, 2010), http://blog.pappastax.com/index.php/category/absurdprotester-arguments. 868 florida tax review [vol. 10:10 i. casual conversations professionals endure 841 ii. tax defying rhetoric 844 iii. why not just walk away? 851 iv. tax lawyers as public educators 857 v. murder and taxes: concluding examples 865 i. casual conversations professionals endure ii. tax defying rhetoric iii. why not just walk away? iv. tax lawyers as public educators v. murder and taxes: concluding examples newvirtual tax library 8-6-08 935 florida tax review volume 8 2008 number 9 the virtual tax l ibrary : a comparison of five electronic tax research platforms by katherine pratt jennifer kowal daniel martin abstract. ................................................................................................. 937 introduction . ......................................................................................... 939 i. background and methodology . ................................................ 940 a. the development of new and improved electronic tax research databases......................................................................... 940 b. our project and methodology.................................................. 941 ii. comparison of content ................................................................ 943 a. primary sources available on the five electronic tax research platforms......................................................................... 943 b. secondary sources available on the five electronic tax research platforms. ........................................................................944 1. the tax specific electronic platforms.......................... 945 a. bna............................................................... 945 b. cch............................................................... 946 c. ria checkpoint............................................. 947 2. the comprehensive legal research electronic platforms........................................................................... 948 a. lexisnexis...................................................... 948 b. westlaw......................................................... 948 c. free tax information available on the internet........................949 1. federal government sites........................................... 949 2. tax scholarship sites.................................................. 951 3. think tank and tax policy organization sites.............. 951 4. tax oriented blogs...................................................... 952 iii. comparison of functionality . ...................................................952 a. similarities among functional features offered by the five electronic tax research platforms...................................... 953 b. specific functional features offered by each of the five electronic tax research platforms............................................ 954 936 florida tax review [vol. 8:9 1. bna............................................................................ 954 2. cch…………………………………………………. 955 3. ria.............................................................................. 955 4. lexisnexis...................................................................955 5. westlaw...................................................................... 956 iv. comparison of tax hypothetical research results.......... 957 c. bna research results............................................................. 959 d. cch research results.............................................................. 964 e. ria checkpoint research results............................................. 965 f. lexis research results.............................................................. 973 g. westlaw research results......................................................... 981 v. designing an effective electronic tax research system . 987 conclusion .............................................................................................. 990 appendix a: comparison of primary source content. appendix b: comparison of functionality features. 2008 the virtural tax library 937 the virtual tax l ibrary : a comparison of five electronic tax research platforms 1 by katherine pratt2 jennifer kowal3 daniel martin4 abstract improved lexisnexis and westlaw tax research platforms and new electronic tax research platforms offered by bna (bna tax management library), cch (cch tax research network), and ria (ria checkpoint) constitute a virtual tax library that offers tax researchers much of the content and functionality of a physical tax library, as well as some useful functionality features (e.g., direct linking of primary and secondary sources) a physical tax library cannot provide. the new virtual tax library offers tax researchers numerous benefits, including the convenience of a portable library, more reliable and current research results, and increased research efficiency. many tax researchers have not adapted their tax research techniques to effectively utilize the virtual tax library, however, because they are unfamiliar with the new and improved electronic tax research platforms. to reduce tax researchers’ costs of evaluating and comparing the five electronic platforms, this article provides detailed comparisons of the content and functionality features offered by the platforms. this article also explains how to access various types of primary and secondary tax sources on the platforms and provides detailed “search pathways” that will enable tax researchers to navigate around the electronic platforms. 1. © 2007. the authors thank david burch (head of library computing services at loyola law school, los angeles) for his contributions to the comparative research project that led to this article. the authors also thank: rosalie sanderson and russell switzer for comments on an earlier draft of this article; loyola students dorit shaybani-rad and margaret taslakhyan and loyola librarians laura cadra, joshua phillips, lisa schultz, and katie thompson for research assistance; marsha battee, bridget klink, and amy nakano for administrative support; dan weiss for technical support; and john baldwin, sharon fountain, melissa hagar, valerie henderson, kristin husmoe, robert horsting, betsy klampert, adam ryan, and david schulbaum for product information about the electronic tax research platforms. 2. professor of law, loyola law school los angeles; katherine.pratt@lls.edu; jd, ucla (1984), ll.m. (taxation), nyu (1989); ll.m. (corporate law), nyu (1990). 3. associate clinical professor and director, tax ll.m. program, loyola law school los angeles; jennifer.kowal@lls.edu; jd, ucla (1996). 4. director, law library and professor of law, loyola law school los angeles; daniel.martin@lls.edu; jd, university of texas (1989), m.l.s. indiana university (1976). 938 florida tax review [vol. 8:9 part i of this article provides background information regarding the development of the new electronic tax research platforms and explains our project and methodology. part ii compares the primary and secondary source content offered on the five electronic platforms and compares various types of free tax information that are available on the internet. part iii compares the various functionality features offered on the five electronic platforms. part iv illustrates the differences in search results obtained by using the various electronic platforms to research a topical tax research question. part v discusses the factors that are relevant when designing an electronic tax research system and makes recommendations about combining the electronic tax research platforms to create a workable virtual tax library. a chart in appendix a provides a side-by-side comparison of the primary source content available on the five electronic tax research platforms. the chart includes search pathways and date restrictions for each type of content. a chart in appendix b provides a side-by-side comparison of the functionality features offered by each platform. the chart includes quick reference guides for initiating various types of searches, as well as user support information for each platform. (note to readers who are unfamiliar with ssrn: you can download the full-text article free from ssrn. first, you must register on ssrn, which is quick, easy, and free. go to http://www.ssrn.com/; the registration link is in the upper left part of the screen. after you register, return to this abstract. scroll down to the very bottom of the page on which this abstract appears and click on the “download the document from” link to one of the ssrn sites. this will allow you to download the full-text document at no charge.) 2008 the virtural tax library 939 introduction technological advances are rapidly transforming the world in which we live and work, including the world of tax research. the first generation of lexisnexis and westlaw electronic tax research platforms has been supplanted by a much more sophisticated second generation of electronic tax research platforms, including improved lexisnexis and westlaw tax research platforms and new electronic tax research platforms offered by the bureau of national affairs (bna), commerce clearing house (cch) and ria (formerly research institute of america).5 the new electronic tax research platforms constitute a virtual tax library that offers tax researchers much of the content and functionality of a physical tax library, as well as some functionality a physical tax library cannot provide. the content available in the new virtual tax library (including primary sources, authoritative treatises, bna portfolios, and periodicals) is more comprehensive and more current than the content in the physical tax libraries of many private firms.6 also, the improved functionality of the electronic tax research platforms allows a researcher to browse the electronic content in the virtual tax library in the same way one would browse a physical copy of a book, as an alternative to performing keyword searches. the electronic tax research platforms also offer a search functionality advantage that a physical tax library cannot provide, by directly linking various related primary and secondary sources, including authoritative treatises, on specific tax topics. using the new virtual tax library to do tax research can benefit tax researchers in several ways. first, effective use of the new electronic tax research tools can increase the efficiency of tax research and reduce the cost of performing tax research. second, the new electronic tax research tools can help tax researchers ensure that their information is complete and current, which is critical given the daunting complexity of the tax law and speed with which the tax law changes. third, the new electronic platforms offer tax researchers the convenience of performing tax research in any location with internet access. many tax professionals have not adapted their tax research techniques to effectively utilize the new virtual tax library. one impediment to adoption of the new electronic platforms is the dearth of objective 5. jasper l. cummings, jr., legal research in federal taxation, 109 tax notes 335, 338-340 (oct. 17, 2005). 6. jack cummings observes that the new electronic tax research platforms currently are more like bookstores than public libraries, because the electronic tax research platforms offer the most popular tax research sources, but do not provide everything one might require to do tax research. id at 337. a comprehensive library collection includes many seemingly obscure tax sources that are sometimes essential for answering a tax research question. for a comprehensive list of print tax sources a law school library collection may include, see katherine pratt, federal tax sources recommended for law school libraries, 87 l. libr. j. 387 (1995). 940 florida tax review [vol. 8:9 comparative information about each of the five major electronic tax research products: (1) lexisnexis; (2) westlaw; (3) ria checkpoint; (4) cch tax research network (cch); and (5) bna tax management library (bna). this article provides a comparison of the content and functionality of these five electronic tax research products, to reduce the search costs of evaluating and comparing the various platforms. in addition, this article makes recommendations about combining the electronic tax research platforms to create a workable virtual tax library. part i of this article provides background information regarding the development of the new electronic tax research platforms and explains our project and methodology. part ii compares the primary and secondary source content offered on the five electronic platforms and describes various types of free tax information that are available on the internet. part iii compares the various functionality features offered on the five electronic platforms. part iv illustrates the differences in search results obtained by using the different electronic platforms to research a topical tax research question. part v discusses the factors that are relevant when designing an electronic tax research system and offers advice about how to combine the various platforms. i. background and methodology a. the development of new and improved electronic tax research databases the development of new and improved electronic tax research databases has transformed the processes for conducting tax research.7 in the “old days” of tax research, a tax researcher physically visited the law library to search in the large numbers of books on the shelves. generally, the tax researcher initiated searches by consulting code section indexes or topical indexes, or by consulting secondary sources and working backwards to primary sources. a tax researcher conducting a thorough search had to read many different primary and secondary sources in many different books. 8 7. for an introduction to federal tax research, see gail richmond, federal tax research (7th ed. 2007), gail richmond, federal tax research, in fundamentals of legal research (roy m. mersky & donald dunn eds., 8th ed. 2002), cummings, supra note 5, and two georgetown university law library tax research guides: (1) georgetown law library, federal tax research guide, at http://www.ll.georgetown.edu/guides/federal_tax.cfm; and (2) georgetown law library, federal tax research reference chart, at http://www.ll.georgetown.edu/guides/fedtax_chart.cfm. 8. the types of tax sources in which a tax researcher typically would search have not changed. the key primary and secondary sources include: the unabridged internal revenue code and treasury regulations; looseleaf services such as cch standard federal income tax reporter and ria (formerly prentice hall) u.s. tax reporter; case reporters; internal revenue bulletins; cumulative bulletins; private letter rulings; legislative histories; treatises and other authoritative secondary 2008 the virtural tax library 941 the keyword search functionality of the lexisnexis and westlaw databases limited the effectiveness of those databases as an initial search tool, because the researcher had to know specific relevant keywords to effectively research a tax topic using the databases.9 in addition, many of the most commonly used authoritative secondary sources were not included in the databases, which also limited the effectiveness of the databases as an initial search tool. in this environment, lexisnexis and westlaw were used primarily to double check and update “book” research. it was generally considered a mistake to begin a tax research project by searching on lexisnexis or westlaw, unless the tax researcher already knew a great deal about the specific research issue and could frame a precise keyword search inquiry. the new generation of electronic tax research platforms, by contrast, can be used to initiate tax research in a manner that is remarkably similar to the traditional “book” research techniques. tax researchers can now perform the traditional “book” research processes electronically, because the electronic tax research platform publishers have designed their products to provide tax researchers much of what books can offer, and more. the new electronic tax research functionality features include table of contents browsing, index browsing, and citation searches, often using templates. these features make it much easier to use electronic tax research platforms to gain an overview of an unfamiliar topic than was possible with more limited keyword searches. in some respects (e.g., cost, convenience, and currency of information), the virtual tax library can sometimes be superior to a physical library. as jack cummings has noted, however, the electronic tax research platforms currently include only the most popular types of tax research materials.10 thorough tax researchers still will need to do some of their research in physical books in physical libraries, but more and more tax research can be done electronically in an efficient, cost effective manner. b. our project and methodology our project began when we read jack cummings’ october 2005 tax notes article, in which he described some of the features of the new and improved electronic tax research platforms.11 we resolved to learn more sources, including bna portfolios, practicing law institute (pli) publications, and journal articles; and tax citators. 9. in some cases, even knowing the relevant keywords was not sufficient, because various tax terms of art (e.g., “property” and “control”) can have different meanings in different parts of the code. novice tax researchers often are unaware of this basic fact of tax research. 10. cummings supra, note 5, at 337. 11. id. 942 florida tax review [vol. 8:9 about the new electronic tax research platforms,12 in part to update the tax research training we offer our tax llm students at loyola law school los angeles. in addition, the tax executives institute requested that loyola law professors prepare a half day program for tei on new electronic tax research techniques.13 we began our project by setting up training sessions with representatives of the five major electronic tax research platforms: lexisnexis; westlaw; ria checkpoint; cch; and bna.14 we asked the representatives to explain and demonstrate the content and functionality of their electronic tax research platforms in detail. we also asked the representatives to identify the key relative strengths of their products. after we completed our training sessions, we experimented with the various tax research platforms and compiled comparative information about the content and functionality of the various platforms. in addition, we “reverse engineered” a tricky tax research problem to discover how each of the tax research platforms performed in a more natural research setting. we also wanted to explore the extent to which the functional linkage available on the electronic tax research platforms could alert a tax researcher to an important current development that would change the answer to the research question posed. the research problem we designed was framed as a section 83 stock option issue,15 although the answer to the research question depended critically on section 409a,16 a relatively new code section with which many income tax practitioners may be unfamiliar. following individual experimentation with the products, we met as a group to discuss our experiences and conclusions about the comparative strengths and weaknesses of the various platforms. finally, we developed recommendations for combining the electronic tax research tools to achieve effective tax research results.17 12. our project focused on electronic tax research techniques for performing u.s. federal income tax research. we did not compare the electronic platforms with respect to other specialized types of tax research, such as state tax research or international tax research. 13. we presented this tei program on the loyola law school los angeles campus in 2006. david burch joined us for all of the training sessions and assisted with additional research for the comparative project. 14. although we all are experienced lexisnexis and westlaw tax researchers, we wanted to offer all five publishers an equal opportunity to demonstrate their electronic tax research products. 15. see irc § 83. in this article, references to sections are to the internal revenue code and references to regulation sections are to treasury regulation sections. 16. see irc § 409a. 17. we conducted most of the research for this project in the spring of 2006. recently, bna launched a new platform called the tax and accounting center and lexisnexis launched a new tax specific product called tax center, we corresponded with both bna and lexisnexis to learn more about these revised platforms. there is 2008 the virtural tax library 943 ii. comparison of content the primary source content offered by the five electronic tax research platforms varies slightly from platform to platform, but the secondary source content varies quite significantly from platform to platform. a. primary sources available on the five electronic tax research platforms the five electronic tax research platforms generally offer the key primary sources essential for performing tax research, although the date limitations for each type of primary source vary by platform. (the content chart in appendix a shows the date limitations for various types of primary sources in the databases of the five platforms.) each platform offers the complete internal revenue code and treasury regulations, revenue rulings and revenue procedures, notices and announcements, private letter rulings, and opinions in tax cases. they also offer other miscellaneous administrative pronouncements. there are material differences among the platforms with respect to legislative histories, however. lexisnexis and westlaw are the only platforms to offer comprehensive tax legislative histories.18 the legislative histories available on the ria checkpoint, cch, and bna platforms are much more limited. bna offers legislative history only for the most recent tax legislation and scattered references to legislative histories in its tax management portfolios. ria and cch have selective legislative histories, but these legislative histories usually “are not citable”19 because they lack some of the information that would be required for a citation. a great deal of overlap between the new and old platforms, but we think that certain features offered on these platforms would be useful to tax researchers. in our view, the most useful new features on the revised bna platform are: (1) new direct links to news and commentary from the bna portfolios; and (2) enhanced display options, including both split screen and full screen views. the new lexisnexis tax center platform offers certain advantages as compared to the more comprehensive lexisnexis platform. tax center isolates primary and secondary tax sources in a smaller tax focused database and allows researchers to search all tax center sources (including cch, tax analysts, matthew bender, and kleinrock sources) at the same time. 18. westlaw’s legislative histories go back as far as 1948, and lexisnexis’ legislative histories go back as far as 1954. 19. cummings, supra note 5, at 341 (ria and cch legislative histories “are not citable” because “they do not state the number of the report, much less its official citation and page number”). as we researched the hypothetical discussed in part iv of this article, we discovered that journal articles in the ria checkpoint database similarly are not “citable” because the database does not provide all of the information required for a proper citation. see infra note 67. 944 florida tax review [vol. 8:9 all but one of the platforms provide an easy, streamlined “citator” for checking the subsequent history of many primary tax sources. westlaw and lexisnexis provide the keycite and shepard’s citation systems, respectively. both are comprehensive citators with useful features, such as keycite’s “depth of treatment” stars. ria checkpoint and cch each provide their own tax citators, but these citators do not cite to as many sources as the keycite and shepard’s citation systems. bna has no citator and requires a new search of the database (using the source to be cite checked as a search term) to check subsequent history. for example, if one wanted to determine whether rev. rul. 60-3120 had been superceded or rendered obsolete, it would be necessary to run a search using “rev. rul. 6031” as the search term. it is often helpful to supplement the citators with additional database searches, to catch subtle changes in the law. for example, although a citator search of rev. rul. 60-31 indicates that the revenue ruling has not been superceded or rendered obsolete, the enactment of section 409a could potentially change the outcome of some of the compensation deferral mechanisms discussed in rev. rul. 60-31. b. secondary sources available on the five electronic tax research platforms there are significant differences in the secondary sources available on the various electronic tax research platforms. secondary sources include treatises, portfolios, and journal articles written by tax experts from academia and the practicing tax bar. the most commonly used authoritative secondary sources are tax treatises and tax practice journals published by warren, gorham & lamont21 and other publishers,22 bna tax management portfolios, bna daily tax report, tax analysts’ tax notes weekly magazine, tax analysts’ tax notes today, practicing law institute (pli) publications, proceedings of the major tax institutes (e.g., nyu and usc), and law review articles. secondary sources also include much less authoritative content prepared by the editorial staff of various legal publishers, such as cch and ria. in recent years, there has been a consolidation of legal publishers, with numerous tax publishers being acquired by larger publishers. currently: (1) reed elsevier owns (a) lexisnexis and (b) matthew bender; (2) thomson owns (a) westlaw, (b) ria checkpoint, (c) warren, gorham & lamont, and (d) ppc (practitioners publishing company); and 20. rev. rul. 60-31, 1960-1 c.b. 174. 21. see, e.g., boris i. bittker & james s. eustice, federal income taxation of corporations & shareholders (7th ed. 2000 & supp. 2007). 22. see, e.g., martin d. ginsburg & jack s. levin, mergers, acquisitions & buyouts: a transactional analysis of the governing tax, legal, and accounting considerations (2007). 2008 the virtural tax library 945 (3) wolters kluwer owns (a) cch, (b) aspen, (c) panel, (d) kleinrock, and (e) loislaw. the consolidation of the publishers has had an impact on the content available on the various electronic tax research platforms. for example, the highly authoritative warren, gorham & lamont treatises and journals are available exclusively on the ria checkpoint and westlaw platforms, due to the thomson publishing affiliation. despite the recent consolidation of tax publishers, some tax publishers, such as bna and tax analysts, have remained independent. some of these independent publishers have contracted to make their print content available on specific electronic research platforms. for example, tax analysts content is available exclusively on the lexisnexis platform. bna, on the other hand, allows electronic subscribers to add its tax management portfolios to any of the other electronic tax research platforms. all five platforms offer specific sources (as well as functional features) that researchers can use to update their research results.23 the current developments sources often include both editorial content and convenient links to underlying primary sources. the electronic platforms can be divided into two groupings: (1) the tax specific electronic platforms, including bna, cch, and ria checkpoint; and (2) the comprehensive legal research electronic platforms, including lexisnexis and westlaw. a comparison of the secondary source content on each of the five platforms follows. 1. the tax specific electronic platforms a. bna the bna electronic platform offers two types of extremely helpful secondary sources. first, the bna database includes the detailed and comprehensive bna tax management portfolios.24 the bna database does not include other commonly used types of authoritative treatises or journals. second, the bna database includes the daily tax report, bna’s daily tax newsletter. 23. bna offers the bna daily tax report and a weekly report; cch offers federal tax day; ria checkpoint offers a “newsstand” with daily updates, federal taxes weekly alert, and ria tax watch; lexisnexis offers tax analysts tax notes today and tax notes weekly magazine; and westlaw offers the bna daily tax report (by separate subscription) and ria’s federal taxes weekly alert. 24. the bna tax management portfolios are divided into three series: (1) the u.s. income series; (2) the foreign income series; and (3) the estates, gifts, and trusts series. all references in this article to the bna portfolios are to the u.s. income series. 946 florida tax review [vol. 8:9 in our opinion, the lack of additional authoritative secondary sources makes it difficult to use bna as a stand-alone tax research platform. however, we do regard the bna portfolios as an essential secondary tax research source. we would like to have access to the bna portfolios electronically, but can live without electronic access to the portfolios, as long as we have access to the hard copies of the bna portfolios in our school’s law library collection. we also think that access to either the bna daily tax report or tax analysts’ tax notes today is an essential tax research tool. (we have a slight preference for tax notes today, but either of the two daily newsletters is fine.25) bna content can be added to any of the other electronic research platforms. b. cch the cch electronic tax research platform offers the combined primary and secondary source content found in its popular print looseleaf service, the standard federal income tax reporter. this series is a compilation of irc sections and treasury regulations, some legislative history, and explanations and annotations prepared by cch editorial staff. cch’s offerings of authoritative secondary sources are somewhat limited. although cch is affiliated with aspen publishers, not all aspen treatises are available in the cch database. for example, the cch database does not include the henderson & goldring treatise, tax planning for troubled corporations.26 the most useful secondary sources currently available on the cch electronic platform are taxes magazine and the following aspen and panel treatises: (1) ginsburg & levin, mergers, acquisitions & buyouts;27 (2) garlock, federal income taxation of debt instruments;28 (3) ferguson, freeland & ascher, federal income taxation of estates, trusts & beneficiaries;29 and (4) isenbergh, international taxation: u.s. taxation of foreign persons and foreign income.30 in our opinion, cch’s federal tax research database does not include a large enough 25. as paul weiss librarian russell switzer noted, in comments he submitted to us, tax researchers often search in tax notes today to access primary sources that are otherwise difficult to access. 26. gordon d. henderson & stuart j. goldring, tax planning for troubled corporations: bankruptcy and non-bankruptcy restructurings (2006). 27. supra, note 22. access to this treatise is only available by separate subscription to a special “mergers & acquisitions” database. 28. david c. garlock, federal income taxation of debt instruments (5th ed. 2005 & supp. 2007). 29. m. carr ferguson, james j. freeland, & mark l. ascher, federal income taxation of estates, trusts, & beneficiaries (3rd ed. 1998 & supp. 2007). 30. joseph isenbergh, international taxation: u.s. taxation of foreign persons and foreign income (3rd ed. 2002). 2008 the virtural tax library 947 collection of authoritative secondary sources to use cch as a stand-alone electronic platform for performing federal income tax research.31 c. ria checkpoint ria checkpoint offers a looseleaf series that is similar to cch’s. the ria looseleaf series, the u.s. tax reporter, is a compilation of the code and regulations, some legislative history, and brief explanations and annotations prepared by ria editorial staff. ria checkpoint also offers a second looseleaf set, the federal tax coordinator, with detailed explanations prepared by ria editorial staff. this series does not include primary source material, but includes citations to primary sources. ria checkpoint also offers the bna daily tax report as its daily tax newsletter.32 the authoritative secondary sources offered by ria include the entire warren, gorham & lamont library (which includes over 60 tax treatises and over a dozen tax journals). compared to bna, both cch and ria checkpoint offer more comprehensive tax research platforms with extensive looseleaf sets and various secondary sources. why then, does there seem to be greater “buzz” in the practicing tax community about ria checkpoint than about cch?33 we think the buzz is attributable to the fact that ria checkpoint offers superior content in the area of authoritative secondary sources. as jack cummings has noted, secondary materials prepared by a publishing company’s editorial staff are not comparable to secondary materials prepared by expert authors, such as jim eustice, “whose words you can take to the bank.”34 cummings observes that authoritative expert authors: (1) can be counted on to analyze a particular rule correctly; and (2) are unlikely to omit important caveats or related material.35 the authoritative secondary sources in the cch database (including taxes magazine and the treatises listed above) are much more limited in number and scope than the authoritative secondary sources in the ria checkpoint database, which includes the 31. this article does not compare the electronic research platforms as tools for performing tax research in other specialized areas, such as state and local tax practitioners have told us that cch is their preferred platform for state and local tax research, in part due to the comprehensive state and local tax source content (including annotations) offered by cch. 32. access to the daily tax report is not included as part of the standard ria checkpoint package, but is available to ria checkpoint subscribers for an additional fee. 33. in an informal survey of tax practitioners affiliated with loyola’s tax llm program, many told us that their firms had recently subscribed to ria checkpoint, to supplement the firms’ lexisnexis and westlaw subscriptions. 34. cummings, supra note 5, at 340. 35. id. 948 florida tax review [vol. 8:9 complete warren, gorham & lamont library of treatises and journals.36 in our opinion, ria has a distinct competitive advantage over cch with respect to authoritative secondary source content. 2. the comprehensive legal research electronic platforms westlaw and lexisnexis offer much more comprehensive content. in addition to tax specific content, both platforms offer general law reviews (subject to varying date limitations) and extensive primary and secondary source coverage of subject areas related to tax. a. lexisnexis the lexisnexis database typically includes the tax specific content offered on the cch electronic platform.37 lexisnexis also provides the tax analysts library,38 which includes tax notes today, tax notes weekly magazine, and other useful content, such as petitions filed in the u.s. tax court. in addition, lexisnexis offers various other useful tax specific secondary source content, including: (1) selected pli publications; (2) some wiley publications; and (3) most matthew bender publications, including materials from major tax institutes such as the usc and nyu tax institutes. lexisnexis also offers a compilation feature, called “listen to the experts,” which includes articles from tax institute proceedings, aba tax section meeting presentations and papers, and various tax analysts publications. b. westlaw the westlaw database includes the tax specific content offered on the ria checkpoint platform.39 westlaw also offers various other useful tax specific secondary source content including: (1) an extensive library of pli publications, including materials from pli programs; (2) a comprehensive collection of trial documents and briefs; (3) selected congressional research 36. we note, however, that ria checkpoint does not currently provide enough information to properly cite the helpful journal articles in its database. see infra note 67. 37. the sources available on the lexisnexis platform vary, depending on the subscriber’s subscription package. lexisnexis subscribers can tailor their subscriptions to suit their research needs, by subscribing to specific sources from menus of available sources. this menu of available sources includes cch materials, for which the subscriber would be charged. in the analysis of lexisnexis content in this article, we assumed that a researcher would have access to the content in a typical law school library lexisnexis subscription package, including cch sources. 38. the tax analysts library is included in all lexisnexis subscription packages. 39. as with lexisnexis content, the specific content available to westlaw subscribers varies depending on subscription packages. 2008 the virtural tax library 949 service (crs) documents; and (4) government accounting office (gao) documents. c. free tax information available on the internet various tax sources are available at no charge on the internet, but the limited free content available on the internet is no substitute for the comprehensive primary and secondary source content on the five electronic platforms. in addition, the content that is available on free tax oriented websites often is out of date and generally is difficult to search, due to the limited functionality features of most of the free websites.40 although a tax researcher cannot use internet searches exclusively to perform tax research, a researcher often can find useful supplemental information with internet searches. tax researchers can access relevant tax content on: (1) federal government websites; (2) tax scholarship websites: (3) websites maintained by think tanks and tax policy organizations; and (4) tax oriented blogs. searching these websites can be particularly helpful if the research topic is a tax policy topic or current developments topic. this section provides some links to specific websites. 1. federal government sites41 http://www.irs.gov/ (irs forms and publications and miscellaneous other sources)42 40. some university websites have seemingly helpful links to tax content, but the linked tax content often is out of date. see, e.g., http://www.law.cornell.edu/wex/index.php/income_tax (legal information institute of cornell university law school, last visited jan. 22, 2008) and http://www.lib.umich.edu/govdocs/fedtax.html (university of michigan library, federal government resources, taxation, last visited jan. 22, 2008). more general internet tax searches typically yield mostly irrelevant and out of date information, although a “google” “advanced search” using a specific search phrase occasionally yields useful content. some commercial tax related websites include compilations of links to various other tax websites, but the linked tax information is spotty and often out of date. see, e.g., http://www.taxsites.com (last visited jan. 22, 2008) and http://www.virtualchase.com/topics/tax_law.shtml (last visited jan. 22, 2008). some sites provide no search functions at all and those that do permit a keyword search do not permit sophisticated terms and connectors searches or natural language searches. 41. the government site list does not include a public site for the congressional research service (crs), which is part of the library of congress, because crs reports are provided directly to congress, not to the public. members of congress who have access to crs reports can make the reports public, however. a nonprofit civil liberties group called the center for democracy and technology collects crs reports that have been made public by members of congress and posts the crs reports on a public site, http://www.opencrs.com/about.php (last visited jan. 22, 2008). selected crs reports also are available on the westlaw and cch platforms. 950 florida tax review [vol. 8:9 http://www.gpoaccess.gov/cfr/retrieve.html (cfrs) http://www.whitehouse.gov/omb/ (office of management and budget) http://www.ustreas.gov/ (department of the treasury) http://www.ustreas.gov/offices/tax-policy/ (department of the treasury office of tax policy) http://www.ustreas.gov/offices/tax-policy/miscdocs.shtml (miscellaneous tax policy documents, including blue books) http://www.ustreas.gov/offices/tax-policy/testimony/(congressional testimony) http://www.house.gov/jct/ (joint committee on taxation) http://waysandmeans.house.gov/ (house ways and means committee) http://finance.senate.gov/ (senate finance committee) http://www.gao.gov (government accountability office) http://www.gao.gov/special.pubs/longterm/ (government accountability office site for our nation’s fiscal outlook: the federal government’s long-term budget imbalance, with links to various publications and projects) http://www.ustaxcourt.gov/ (tax court) http://www.ustaxcourt.gov/ustcinop/asp/historicoptions.asp (tax court opinions43) 42. the i.r.s. website also provides links to the text of the internal revenue code, but the links are, surprisingly, to out of date versions of the code. starting at the main page of the i.r.s. website, http://www.irs.gov/, a tax researcher can access the irc with the following search pathways: > click on top line “tax professionals” link > click on left side “code, regs & guidance” link > click on “internal revenue code” link. this takes the researcher to http://www.irs.gov/taxpros/article/0,,id=98137,00.html. caveats on the main irc page indicate: (1) the linked irc materials are current through 2003; and (2) “[t]he irc materials retrieved via the above functions are provided as a public service by the legal information institute of cornell university law school], not the irs.” 43. the tax court internet database includes regular and memorandum opinions published from 09/25/95 and summary opinions published from 01/01/01. the database is searchable by case name, but not by keyword, which limits the usefulness of the database as a primary tax research tool. 2008 the virtural tax library 951 http://www.ustaxcourt.gov/court_schedules/ (tax court docket) 2. tax scholarship sites44 many experienced tax researchers are unaware of the new tax scholarship websites, which can be used to access current tax scholarship. both websites listed below require the user to register at no charge. after registering, the user can search the databases, using keyword or author searches, to find works in progress and published papers. http://www.ssrn.com/ (social science research network)45 www.bepress.com (berkeley electronic press, also know as bepress)46 3. think tank and tax policy organization sites47 http://www.cbpp.org/ (center on budget and policy priorities) http://www.urbaninstitute.org/ (urban institute) http://www.brookings.edu/ (brookings institution) http://www.brookings.edu/es/taxpolicycenter.htm (tax policy center) 44. in addition to these two free websites, other websites that require paid subscriptions offer tax scholarship content. these websites include: (1) http://www.nber.org/ (national bureau of economic research); and (2) http://heinonline.org/front/front-index (“law journal library” database in hein online includes pdfs of law review articles published in 1,200 journals). 45. a tax researcher can locate ssrn abstracts by clicking on the “e-library” link, filling in the search template, and clicking on “search.” to access the full-text article, the researcher scrolls down to the bottom of the page on which the abstract appears and clicks on one of the ssrn download links. the full-text of most ssrn documents is available at no charge. ssrn charges a fee for certain types of documents, such as nber articles. if the tax researcher is affiliated with an institution that has a subscription to nber, the researcher can go to the nber website and download the full-text article at no additional charge. 46. from the bepress webpage, a researcher can locate abstracts by clicking on the “go to journals” button, clicking on the “research now” link, choosing “advanced search,” filling in the search template, and clicking on “search.” the full-text document may be downloaded from the article abstract. 47. numerous other tax policy organizations are listed on the left side of the taxprof blog’s main page. the tax experts at tax policy organizations do a very good job of compiling information on tax policy issues. tax researchers should be aware, however, that the documents produced by these organizations typically are a mix of objective and persuasive writing and are frequently intended to advance the ideological agenda of the organization. 952 florida tax review [vol. 8:9 http://www.aei.org/ (american enterprise institute) http://www.cato.org/ (cato institute) http://www.ctj.org/blog/ (citizens for tax justice) http://www.taxfoundation.org/blog/ (tax foundation) http://www.taxhistory.org/thp/thpwebsite.nsf/web/thphome?opendocument (tax history project, sponsored by tax analysts) 4. tax oriented blogs48 http://taxprof.typepad.com/ (taxprof blog49 maintained by professor paul caron, university of cincinnati college of law) http://mauledagain.blogspot.com/ (mauledagain blog maintained by professor jim maule of villanova university school of law) http://ataxingmatter.blogs.com/tax/ (taxingmatter blog maintained by professor linda beale of wayne state university law school) http://danshaviro.blogspot.com/ (start making sense blog maintained by professor dan shaviro of new york university school of law) http://www.rothcpa.com/taxupdates.php (roth cpa blog maintained by roth & company, p.c.) in addition to these specific sites, tax researchers should be aware of the helpful online tax research guides maintained by the georgetown university law library.50 iii. comparison of functionality the amount of content available on an electronic platform is related to the functionality of the platform. the enormous amount of content in the westlaw and lexisnexis databases, most of which is not tax specific, can 48. we have listed just a few of the many tax oriented bogs. the listed blogs are those with which we are most familiar from our own tax research. tax researchers who would like to look at other tax blogs can follow numerous blog links provided on the blogs listed in the text. 49. the taxprof blog is widely recognized in the academic tax community as the leading tax oriented blog. the main page of the taxprof blog includes many useful links to other tax blogs, tax policy organization websites, and government websites. 50. see supra, note 7. 2008 the virtural tax library 953 make it more difficult to navigate around the databases and find all of the relevant tax sources. effective research in these large databases sometimes requires knowing exactly where to look for relevant sources. for example, a tax researcher would not find a relevant tax court petition on the lexisnexis database unless the researcher knew to go to the tax analysts library, click on the tax court petitions link, and run the search there. ria checkpoint and cch offer many of the tax specific primary and secondary sources that are useful for tax research, but do not offer the same breadth of content as westlaw and lexisnexis, particularly with respect to general legal sources. the more limited content in these databases makes it easier to navigate around the databases and find relevant sources, however. the most extreme example of the inverse relationship between breadth of content and functionality is the bna platform; the fact that the variety of bna’s authoritative secondary source content is so limited makes it easy to know where to search, since it most often will be in the tax management portfolios. a. similarities among functional features offered by the five electronic tax research platforms there are similarities among some of the functionality features of the electronic tax research platforms. the publishers have designed the electronic platforms to mimic hard copy “book” research as much as possible. all five platforms offer some version of a “tab” format, for quickly locating various types of content in the databases. 51 all five also display table of contents for primary and secondary sources, generally showing content by chapter, subchapters and pages. in addition, all five allow a researcher to browse pages as in a hard copy book. all five electronic platforms offer multiple modes to search for specific information in the databases: (1) keyword searches. as one would expect, all five platforms offer traditional keyword searching using boolean terms and connectors. lexisnexis and westlaw also offer natural language searching capability. (2) citation searches. all five platforms also offer searching by citation, often using templates. (3) table of contents searches. in keeping with the goal of mimicking print research as much as possible, all of the platforms offer table of contents searching for treatises, the irc and treasury regulations. all five platforms display tables of contents and allow a 51. cch and lexisnexis offer the most tabs and westlaw and ria the fewest. 954 florida tax review [vol. 8:9 researcher to “drill down” to the next level of contents (and eventually to text) by clicking on specific subheadings in the displayed table of contents. (4) index searches. ria, cch, and bna all permit searching of topical indices. lexisnexis and westlaw do not offer tax specific topical indices to search, due to the large amount of content in their databases. lexisnexis offers no index searching and westlaw offers index searching only of statutes and regulations. in addition, all five electronic platforms: (1) offer easy steps to review, print, export and save data; (2) permit a researcher to print text with references attached and save data and searches on the publisher’s server; and (3) provide e-mail updates from saved searches to allow a researcher to automatically update search results. all five electronic platforms also offer user support. most offer technical support by phone, e-mail, and live chat. all generally offer “help” and “faq” online, as well as training, online tutorials, and user guides. as might be expected, while all sales and technical support staff are generally helpful and knowledgeable, some are better than others.52 b. specific functionality features offered by each of the five electronic tax research platforms each of the five electronic tax research platforms offers specific functionality features, described below. 1. bna the bna platform offers internal linking, as the other platforms offer. although the bna platform offers fewer unique functionality features than some of the other platforms, two particularly helpful functionality features are: (1) new direct linking of the news and commentary content from the tax management portfolio content; and (2) recently enhanced display options, including both split screen and full screen views. users who like to use the bna platform generally like it because of its portfolio content, not because of its unique functionality features. when 52. as we conducted our research for this article, over a period of about a year and a half, we found that the expertise of the electronic publishers’ sales representatives varied considerably. (we typically worked with the electronic publishers’ law school sales representatives, rather than their private practice sales representatives.) during that period, there was no turnover of loyola’s lexisnexis and westlaw representatives, both of whom have years of experience. there was turnover of the representatives of the other platforms, however, which meant that we sometimes found ourselves working with novice representatives who were not very knowledgeable about the platforms. we found that the expertise and effectiveness of technical support staff also varies significantly. 2008 the virtural tax library 955 the bna content is added to the other platforms, researchers can search the bna content using the more varied functionality features of the host platform. 2. cch the cch tax research network functionality features include “smart relate” links to other types of documents (including regulations, cch annotations, cch explanations, and committee reports) on the same topic and “related topics” links to other documents on related topics. the “topic navigator” allows a researcher to search a browsable, expandable topic index and locate all sources addressing a specific topic. the “cch@hand” feature also enables users to have one-click access to cch online materials from any ms office application (word, excel, or outlook). 3. ria checkpoint the functionality features of the ria checkpoint platform make it a “user-friendly” platform that is relatively easy to navigate, even for novice researchers. ria checkpoint’s “top line” links provide immediate access from a document to relevant sections in ria “explanations,” the ria federal tax coordinator, the irc, committee reports, and warren, gorham & lamont treatises. “deep cite links” or “side line links” enable the user to drill down deeper into the topic, for example, from discussion of a section to discussion of a subsection. these links display other sources within ria checkpoint that discuss the subsection specifically. ria also has a split screen feature that permits users to see the current document in the right side of the frame and contents (system navigation), document links, or current document outlines on the left side of the frame. it also offers an “in-place supplementation” feature, which allows users to update a document without having to perform a separate search. 4. lexisnexis lexisnexis is not designed specifically for tax researchers, but offers some functionality features that tax researchers often find helpful. the “atleast” feature in terms-and-connectors searching permits the user to specify that the relevant word appear in the document at least a minimum number of times (to focus on sources with more in-depth discussion of a topic). for instance “atleast 15(casualty loss)” would result in hits with the phrase “casualty loss” occurring 15 times or more. the lexisnexis “search advisor” helps users construct searches using a topical, menu-driven sequence of questions. lexisnexis also offers searchable headnotes (with issue summaries) for all case databases. 956 florida tax review [vol. 8:9 5. westlaw westlaw also is a general electronic legal research platform, not a tax specific platform, but offers some functionality features that tax researchers find helpful. one well known feature is the topic and key number system that westlaw uses to classify all american law. the westlaw topic number for tax is 371, and the westlaw key numbers for tax range from 2000 to 3714.53 tax researchers can use the topic and key number system (and headnotes, along with west digest information) to search the westlaw database for cases in particular subject areas of federal income tax. westlaw also offers several other useful functionality features that are designed to help users quickly identify the most relevant related authority. these features include flags and a “star” system that ranks the relevance of citing authorities. the keycite system, which is used to update research, is the westlaw analogue of the shepard’s citation system offered by lexisnexis. the keycite system includes graphics to illustrate the history of a case. the following slide shows westlaw’s visual case history of murphy v. irs54 53. information on this the westlaw topic and key number system is contained in the westlaw digests and in various editions of west’s analysis of american law. 54. 493 f.3d 170 (d.c. cir. 2007). 2008 the virtural tax library 957 westlaw also offers a specific functionality feature, regulations plus, which is particularly helpful to tax researchers. the regulations plus feature provides direct links from temporary and final treasury regulations (but not proposed regulations) to related primary and secondary sources. various functionality features are compared in a chart in appendix b iv. comparison of tax hypothetical research results we drafted a research hypothetical to explore the content and functionality differences between the various electronic tax research platforms. we found that important sources or issues that are easily found when using one platform may not surface as easily or clearly when using other platforms, even when performing similar searches. the facts of the research hypothetical are as follows: rmail, a private company founded five years ago by private and institutional investors, created and developed a system for sending registered e-mails that would provide proof of mailing and receipt. rmail has gone through several stages of financing from both portfolio and strategic investors. during the last two years, rmail has developed a 958 florida tax review [vol. 8:9 growing market for its product, including contracts with several well-known large business organizations around the world. alex kanan is the founder and ceo of rmail. he owns approximately 20% of the outstanding stock. after reading a december 2005 article about the google founders and their $1 salaries, kanan decided to forgo his 2007 salary and instead work for additional stock options. on january 1, 2007, kanan received options to purchase 10,000 additional shares of common stock at $20/share. the options will vest ratably over the next two years on january 1, 2008 and january 1, 2009, provided that kanan remains ceo of rmail. the $20/share exercise price is based on the value of the company used in the last round of financing, which occurred in july 2006. rmail has had informal discussions with several potential acquirers over the last two years, but so far none have moved forward. rmail would like to take the company public sometime in 2008, depending on market conditions. kanan and rmail have requested advice on the income tax consequences of the issuance of kanan's options. the first irc section that typically springs to mind with respect to nonqualified stock options is section 83. most experienced tax researchers would probably begin their research process with section 83. novice tax researchers, on the other hand, may not know to look at section 83 and might begin by researching the tax treatment of “stock options” generally. these differing starting points can be important, depending on the platform being used. the rest of this part summarizes the results of researching our hypothetical, using the five electronic tax research platforms. for each platform, we have indicated many of the search pathways we followed to do our research and have included screen shots of some of the research results.55 55. we have created more than 70 screen shots of our research results using the various electronic platforms. in this part, we have included only the most interesting screen shots. readers who would like to see more of the screen shots can follow the pathways indicated in the text, or send us an e-mail request for our entire collection of screenshots. 2008 the virtural tax library 959 a. bna research results the topical organization of bna’s tax management portfolios makes it easy to research even when little, perhaps not even the relevant code section, is known about a tax issue. we began our search by browsing in the table of contents for the bna tax management portfolios. looking under the heading “compensation planning,” we saw two portfolios that might be relevant: (1) portfolio 383, nonstatutory stock options;56 and (2) portfolio 384, restricted property – section 83.57 we selected portfolio 383 and clicked on its title to browse the table of contents of the portfolio. section ii of the portfolio addresses “income taxation of nonstatutory stock options.” section iii of the portfolio addresses “option-related transactions.” by scrolling down the table of contents, we found subsection c, “section 409a and the american jobs creation act of 2004,” which includes a discussion of the application of section 409a to nonstatutory stock options. we clicked on the linked subheading in the table of contents to view the relevant sections of the portfolio. this part of the portfolio provides a detailed discussion of the 56. john l. utz, nonstatutory stock options, 383-3rd tax mgmt. (bna). 57. john l. utz, restricted property: section 83, 384-3rd tax mgmt. (bna). 960 florida tax review [vol. 8:9 section 409a rules and their applicability to nonqualified stock options. we clicked on links in the text of the portfolio to view section 409a and the final section 409a regulations (including the preamble to the regulations).58 summary of search pathways: home > federal/foreign library > u.s. income portfolios59 > “compensation planning” topical heading > portfolio 383-3rd: nonstatutory stock options (toc view) > click on toc subheading iii.c. “option-related transactions; section 409a and the american jobs creation act of 2004” > click on section 409a and regulations links in the text. 58. the first two and fourth screen shots below show the results of our search on the bna tax management library platform. the third screen shot below looks different because it is a screen shot from the recently revised bna platform, which is called the bna tax and accounting center. although we did not update all of the screen shots from our original research, to reflect the look of recent revisions to the lexisnexis and bna platforms, we included this screen shot from the revised bna platform because it illustrates a useful new feature of the platform, the direct link (in the upper right corner of the screen shot) to news and commentary from the bna portfolios. 59. table of contents browsing. 2008 the virtural tax library 961 we also searched in the table of contents of portfolio 384, “restricted property -section 83.” section iii of the portfolio explains the operation of section 83. scrolling down in section v, “interrelationship of 962 florida tax review [vol. 8:9 section 83 with other provisions,” leads to subsection d “nonqualified deferred compensation plans under section 409a.” this subsection contains a brief discussion of section 409a, as applied to nonqualified options, with a link to a detailed discussion of section 409a in portfolio 385, deferred compensation arrangements.60 searching by index also offers a way to find the relevant portfolios without knowing which code section applies. we found “nonstatutory stock options” in the keyword index for the portfolios. this heading led us to a list of subtopics, including subheadings on: (1) options with a readily ascertainable fmv at grant; and (2) options without a readily ascertainable fmv at grant. these subheadings linked to subsections of portfolio 383 and portfolio 384 in which application of section 83 to options was explained, but did not link to the subsections of those two portfolios in which the section 409a issue was raised with respect to options. summary of search pathways: home > federal/foreign library > federal/foreign indexes > u.s. income portfolios keyword index > click on the letter “n” > click on “nonstatutory stock options (nsos)” > scroll down to index subheadings under “readily ascertainable fmv” > click on links to portfolio 383 and portfolio 384. searching in the bna daily tax report is also a good way to look for current developments related to a research topic. searching all issues of the bna daily tax report for “83 and options” yields many results, some of which are not relevant. however, about one page down from the top of the results are two hits for “irs final rules (t.d. 9321) on 409a nonqualified deferred compensation plans.” searching for “409a and options” yields many potentially useful articles as well. 60. a. thomas brisendine, e. thomas veal, & elizabeth drigotas, deferred compensation arrangements, 385-4th tax mgmt. (bna). 2008 the virtural tax library 963 summary of search pathways: daily tax report > search all issues > keyword search of “83 and options” yields 1000 hits > scroll down to hits from 4/11/2007, to view final regulations under section 409a. summary of alternate search pathways: daily tax report > search all issues > keyword search of “409a and options” yields 275 hits. a citation search could provide another route to the relevant portfolios. from the home page, a researcher could click on “go to,” which brings up a citation template with boxes in which to enter various types of citations. entering “83” in the irc box and clicking on “go” would take the researcher to the text of section 83. links to the portfolios are embedded in the text of section 83. a researcher could also access the portfolios with a citation search of regulations section 1.83-7. the bna platform offers many different ways to access the relevant portfolios. which of the alternative routes is best depends on how much is known about the research problem and the researcher’s preferences. our first and second searches clearly identified the section 409a issue. the portfolios on section 83 and on nonqualified stock options both discussed section 409a, which would alert a researcher to the issue, even if he did not know to look for it. the portfolios and the bna daily tax report provided quite 964 florida tax review [vol. 8:9 useful content, but we did not find most of the other secondary source content on the bna platform to be particularly helpful. b. cch research results we started our research by browsing the table of contents of the standard federal income tax reporter, which led us to section 83, regulations section 1.83-7, and a “cch explanation” of the section 83 treatment of nonqualified options. summary of search pathways: federal tax > cch explanations and analysis > standard federal income tax reporter (toc view 61) > income – secs. 61-90 > property exchanged for services – sec. 83 > final-reg 2007fed ¶6388, § 1.83-7., taxation of nonqualified stock options > click on link to “cch explanations” > click on link to “related topics.” regulations section 1.83-7 provides the general rule that section 83 does not apply to the grant of a nonqualified stock option if the option does not have a readily ascertainable fair market value. section 83 instead applies on the subsequent exercise of the option. a click on the “cch explanations” link yields explanatory text consistent with this understanding, and a click on the “related topics” link takes us to some broadly related topics. importantly, the cch editorial material does not alert the researcher to the potential interaction of section 83 and new section 409a. next, we formulated a keyword search (using the search term “83 and options”) and searched again in the standard federal income tax reporter. this search produced 41 “hits,” the first of which was a “cch explanation” with a cross-reference to proposed regulations section 1.409a-1(b). we clicked on the first hit, to view the cch explanation, and clicked on a top line link to view the final section 409a regulations. (in other words, the internal links to proposed regulations sections, including section 1.409a-1(b), actually linked to the final regulations.) summary of search pathways: federal tax > cch explanations and analysis > standard federal income tax reporter > keyword search of “83 and options” yields 41 hits > click on first hit, cch explanation ¶ 18,960.042 > click on top line link to “regulations.” 61. table of contents view. 2008 the virtural tax library 965 the irc and regulations indicate that section 409a accelerates inclusion of income for non-qualified deferred compensation and imposes interest and a 20% penalty unless the taxpayer meets rather burdensome election requirements, the timing of which is somewhat unclear.62 the regulations also provide that a nonqualified stock option is generally outside of the scope of section 409a if it is not “in-the-money” at the time of the grant.63 under this rule, the tax treatment of the issuance of kanan’s stock options depends on the fair market value of the underlying rmail stock at the time the options were granted. the regulations provide rules for valuing the stock of a non-public company.64 this search revealed that section 409a is clearly relevant, for purposes of providing tax advice regarding the issuance of the rmail options. we followed this search with a keyword search, using the search term “options and 409a,” in a cch content grouping called “current features and journals.”65 this search yields 92 hits, several of which provide further discussion of how section 409a applies to nonqualified stock options. a search of the excellent ginsburg & levin treatise, mergers, acquisitions & buyouts, yielded one very useful and extended discussion of section 409a and how it applies to various compensation agreements.66 the results of these searches demonstrate that different searches produce different results. there is no warning of the section 409a issue in the standard federal income tax reporter explanation of section 83. however, a keyword search for “83 and option” produced a section 409a discussion as the first hit. the third and fourth searches also were productive. the series of searches revealed important related primary sources, as well as relevant discussions and explanations. c. ria checkpoint research results an easy way to begin researching on ria checkpoint is to go straight to the text of the relevant code section. we began our search by clicking on the “research” tab and selecting “federal” as the search practice area. we clicked on “code & regs” (under the heading “find by citation” 62. irc § 409a(1), reg. § 1.409a-2. 63. reg. § 1.409a-1(b)(5). 64. id. 65. this cch grouping includes the following income tax sources: (1) federal tax day; (2) tax shelter alert; (3) cch federal tax weekly; (4) taxes, the tax magazine; (5) corporate business taxation monthly; and (6) advance release documents. 66. see ginsburg & levin, supra note 22, at § 1505.6.2. at the time we performed our research, this treatise was included in the standard cch federal tax research package. this treatise is now available on the cch platform only if the user purchases a separate subscription to a specialized mergers and acquisitions database. 966 florida tax review [vol. 8:9 on the left hand toolbar), to bring up a citation search template. we typed “83” in the “current code” box and clicked on “search.” from the text of the code section, a researcher can click on the top line buttons to link directly to: (1) explanations and annotations in the us. tax reporter; (2) the federal tax coordinator; (3) regulations; (4) legislative history; and (5) warren, gorham & lamont treatises. clicking on the top line “expl” link produces links along the left side of the split screen to specific relevant paragraphs in the u.s. tax reporter. (in each paragraph number, the numbers to the left of the “4”67 indicate the code section to which the paragraph relates.) midway down the left side list of links is a link from section 83 to ¶409a4, “inclusion in gross income of deferred compensation under nonqualified deferred compensation plans.” knowing only that section 83 applies to the issuance of nonstatutory stock options, a researcher thus would immediately see that section 409a may apply as well. clicking on the left side link to exp ¶409a4 allows the researcher to view that paragraph, which provides an overview of section 409a, explains 67. in the ria checkpoint system, there are left side links to other content, designated by paragraph numbers. these paragraph numbers include a series of numerals with a period in the middle of the paragraph number. the numeral just to the left of the period designates the type of linked content: (1) a “1” designates an irc link; (2) a “2” designates a committee report link; (3) a “3” designates a treasury regulation link,(4) a “4” designates a u.s. tax reporter explanations link; and (5) a “5” designates a u.s. tax reporter annotations link. 2008 the virtural tax library 967 how it applies to nonqualified deferred compensation plans, and cross references section 83. from this screen, the researcher can click on the “regs” top line buttons to link directly to the section 409a final regulations. from this screen, the researcher can click on the “wg&l treatises” top line button to link directly to relevant explanations in warren, gorham & lamont treatises. in this case, clicking on the “wg&l treatises” button takes us to a description of section 409a in the bittker, mcmahon & zelenak 968 florida tax review [vol. 8:9 treatise, federal income taxation of individuals.68 the explanation in the treatise clearly indicates that section 409a may apply to the issuance of stock options. summary of search pathways: click on “research” tab > select “federal” as the search practice area > click on “code & regs” under the heading “find by citation” > type “83” in the citation search template “code” box > click on “search” > from the split screen view of the text of § 83, click on the left side link to expl ¶409a4 > from the view of expl ¶409a4, click on “regulations” top line button > from the view of the section 409a regulations, click on the “wg&l treatises” button. rather than beginning the search with the text of the code section, the researcher could begin the research with a keyword search. we also performed a keyword search, in the u.s. tax reporter and federal tax coordinator, using the search term “83 and options,” with the results illustrated in the following screen shot. 68. boris i. bittker, martin j. mcmahon & lawrence zelenak, federal income taxation of individuals (3rd ed. 2002. & supp. 2007). 2008 the virtural tax library 969 clicking on the “analysis/federal tax coordinator” link produced a list of 251 hits. one of listed hits is ¶h3200.29, “when nonstatutory stock options (nsos) defer compensation under the nonqualified deferred compensation plan failure rules.” this paragraph addresses nonqualified deferred compensation, citing section 409a, again highlighting the applicability of section 409a to stock options. 970 florida tax review [vol. 8:9 summary of search pathways: click on “research” tab > select “federal” as the search practice area > enter keyword term “83 and options,” check boxes next to federal tax coordinator and us tax reporter, and click on “search” > click on “analysis/federal tax coordinator” link > click on ¶h3200.29, “when nonstatutory stock options (nsos) defer compensation under the nonqualified deferred compensation plan failure rules.” we followed this search with a keyword search, using the keyword term “409a and options,” in a content group called “news and current awareness,” which includes warren, gorham & lamont journals, federal taxes weekly alert newsletter, cummings corporate tax insights, and ria tax watch. this search produced 99 hits, several of which included relevant discussion of section 409a in the context of nonqualified stock options. for example, clicking on the “journal of taxation” link took us to seven hits in the journal of taxation,69 which included detailed discussion of section 409a. 69. unfortunately ria checkpoint’s journal articles currently are not “citable,” as they provide only the issue date, but not the issue number or page number. 2008 the virtural tax library 971 summary of search pathways: click on “research” tab > select “federal” as the search practice area > enter keyword term “409a and options,” check box next to “new/current awareness” content group, and click on “search” > click on the “journal of taxation” link to view seven hits in the journal of taxation. bna daily tax report is also available on ria checkpoint and is accessed from the “newsstand” tab. results of keyword searches are listed in 972 florida tax review [vol. 8:9 order of relevance, rather than by date. a keyword search of “409a and options” yielded the following results: summary of search pathways: click on “newsstand” tab > select “search daily tax report” from split screen links on left > enter keyword term “409a and options,” and click on “search” > click on “bna daily tax report and tax core” to view 64 hits. ria checkpoint, like bna and cch, offers tax researchers several different ways to find relevant primary and secondary sources. the ria top line links and split screen with left side links to paragraphs in the u.s. tax reporter provide very convenient linking of relevant primary and secondary sources, including authoritative secondary sources in the warren, gorham & lamont library. left side links to explanations of section 409a appeared next to the text of section 83, connecting sections 83 and 409a, although the section 409a issue was somewhat buried among numerous left side links. the excellent warren, gorham & lamont sources enhanced the coverage of the section 409a issue. 2008 the virtural tax library 973 d. lexisnexis research results we started with the text of section 83. on the assumption that most practitioners know how to perform basic tax searches on the lexisnexis platform, we have simply summarized the search pathways we used to view the full text of section 83. summary of search pathways: legal > area of law – by topic > taxation > select uscs title 26 internal revenue code annotated (under the “find federal statutes & regulations” heading) > enter 83 in search term box, select toc only, click on search > click on link to section 83. we also wanted to view the section 83 regulations, but found that lexisnexis does not provide direct links to those regulations from the full text view of section 83.70 we ran the following new search to view the section 83 regulations. 70. the “get a document” tab sometimes can be used as a shortcut to quickly access a specific document. we tried to use get a document to quickly access the § 83 regulations, but were stymied by the rigid formatting requirements for such searches. without knowing the magic format in which to frame a search for reg. § 1.83, we could not perform the search. we tried clicking on the link that suggests get a document citation formats, but did not see “treasury regulations” listed under the “t” heading or “regulations” under the “r” heading. we subsequently learned 974 florida tax review [vol. 8:9 summary of search pathways: legal > area of law – by topic > taxation > click on “final and temporary regulations” (under the “find federal statutes & regulations” heading) > enter 1.83 in search term box, select toc only, click on search > click on links to the eight section 83 regulations > click on “§ 1.83-7 taxation of nonqualified stock options.” after reading the regulations, we returned to the full text of section 83. several links appear on the right side of the screen, under the heading “practitioner’s toolbox.” clicking on the “interpretive notes and decisions” link brings up some brief explanatory notes about the general operation of section 83, along with some irrelevant case annotations. clicking on “related statutes & rules” activates links to nine irc sections, one of which is section 409a. clicking on the section 409a link yields a full-text view of section 409a, which cross-references section 83. dropping into the middle of section 409a, which is a detailed and technical “employee benefits” section, makes it difficult for a tax generalist to completely understand the relationship between section 83 and section 409a. at this point, however, a tax researcher would know to do more research on section 409a. we searched for the section 409a regulations, using a search like the search we used for the section 83 regulations. regulations section 1.409a-1 provides that section 409a is not applicable to out-of-the-money options if section 83 applies to the grant or exercise of the option and other requirements are met.71 the negative inference to be drawn from this language is that section 409a can apply to options that are in-the-money at the time of the grant. at this point, we thought it might be helpful to consult treatises for discussion of the application of section 409a to stock options. we searched in the “analysis, law reviews and journals” file in the “taxation” materials. we clicked on the link to tax planning for corporations and shareholders and entered a keyword search, using the search term “409a w/30 options.” this search produced one hit, a discussion of section 409a in the context of deferred compensation for executives, but this discussion did not address the applicability of section 409a to the issuance of stock options.72 that the correct citation format to locate treasury regulations from get a document is “26 c.f.r. ____”, or in our example “26 c.f.r. 1.83-7.” 71. reg. § 1.409a-1(b). 72. zolman cavitch & matthew p. cavitch, tax planning for corporations and shareholders § 5.05 (2006). 2008 the virtural tax library 975 summary of search pathways: legal > area of law – by topic > taxation > search analysis, law reviews & journals > click on tax planning for corporations and shareholders > click on “+” to the left of the heading “chapter 5 methods of compensating the executive > click on “§ 5.05 how deferred compensation agreements can be used to maximum advantage” we decided to browse through a list of other treatises on the lexisnexis database. on the first page of the “analysis, law reviews and journals” file, we clicked on the “by subtopic” link to see a list of treatise topics. from this topic list, we clicked on “investments and securities.” from a list of treatises on this subtopic, we clicked on the title of a particular treatise, taxation of securities transactions, and read the table of contents of the treatise, which included a chapter on “stock options.” we clicked on the “+” sign to the left of this chapter heading, to expand the table of contents. from this expanded table of contents, we clicked on “§ 9.06 nonstatutory stock options.”73 the discussion of section 409a in this treatise included citations to other related sources, with links in the text and footnotes. we followed one 73. martin l. fried, taxation of securities transactions § 9.06 (2006). 976 florida tax review [vol. 8:9 of these links to notice 2006-4.74 “shepardizing” this notice led us to eight other “treatises” in the lexisnexis database, including several relevant chapters from the proceedings of the annual nyu and usc tax institutes. we clicked on the links for the related sources and found that several of them provided detailed discussion of section 409a, directly addressed the applicability of section 409a to nonstatutory stock options, and raised some new section 409a issues to consider.75 our next search was for the legislative history of section 409a. one simple route to the legislative history was through links in the text of the treatises.76 when we did our original research, we clicked on a link, in the text, to the section 409a proposed regulations.77 from the proposed 74. notice 2006-4, 2006-1 c.b. 307 (providing interim guidance on application of § 409a to stock options, prior to issuance of final § 409a regulations). for a more direct route to notices, use the search pathways like those described for proposed regulations infra at note 77. 75. see, e.g., federal income taxation of nonqualified deferred compensation plans after the american jobs creation act of 2004, notice 2005-1, the first proposed regulations and other tidbits, in n.y.u. annual inst. on fed. tax’n 64(s)-3 (2006); and equity compensation issues -demons and dilemmas, in n.y.u. annual inst. on fed. tax’n 64-28 (2006). 76. as an alternate route to the legislative history, one can easily access the legislative history of § 409a by searching for the full text of § 409a and clicking on the “history” link that appears under the “practitioner’s toolbox” heading on the right side of the screen: summary of search pathways: legal > area of law – by topic > taxation > select uscs title 26 internal revenue code annotated (under the “find federal statutes & regulations” heading) > enter 409a in search term box, select toc only, click on search > click on link to § 409a > click on link to history. 77. 70 fed. reg. 57930 (proposed oct. 4, 2005). (when we did our original research, the final 409a regulations had not yet been issued.) alternative searches could be used to access the proposed regulations. on the lexisnexis database, a researcher has to use different types of searches to locate (1) proposed regulations and (2) final and temporary regulations. summary of search pathways to access final and temporary regulations: legal > area of law – by topic > taxation > click on “final and temporary regulations” (under the “find federal statutes & regulations” heading) > enter the number of the regulation in search term box, select toc only, click on search > click on links to the regulations. 2008 the virtural tax library 977 regulations, we clicked on a link to the text of public law 108-357 (the american jobs creation act of 2004),78 and from that text we clicked on links to the related legislative history, in particular, to the conference report.79 this series of searches produced numerous helpful primary sources and authoritative secondary sources. summary of search pathways: legal > area of law – by topic > taxation > search analysis, law reviews & journals > by subtopic > investments and securities > taxation of securities transactions > click on “+” sign to the left of heading for “chapter 9 stock options” to expand the toc > click on “§ 9.06 nonstatutory stock options” > from footnote 1.2, click on link to notice 2006-4 > click on the “i” to the left of the notice heading to begin shepard’s search > click on link to citations of the notices in treatises > from the list of eight additional “treatises” citing notice 2006-4, click on each link to view the related “treatise” text > from the “treatise” footnotes, click on link to “70 fr 57930” for section 409a proposed regulations > from text of 70 fr 57930, click on link to the statute enacting section 409a, “public law 108357” > click on “108 cis legis. hist. p.l. 357” link for legislative history > scroll down to conference report citation > click on link to “cis no. 04-h783-13” for text of the conference report, h. rep. 108-755. when researching current developments, we also like to run searches in tax notes weekly magazine and tax notes today. we ran keyword searches in each publication, using the search term “409a w/30 options.” the searches produced 92 hits in tax notes weekly and 283 hits in tax notes today. some of these hits led us to useful information about the application of section 409a to the issuance of stock options. several of the hits also led us to discussion of pending legislation that could change the summary of search pathways to access proposed regulations: legal > area of law – by topic > taxation > find federal administrative materials > federal tax cases, irs decs., regulations, legislation and irs manual > enter keyword search “1.409a-1 and proposed.” this line of research produces seven hits, including: (1) several notices (e.g., notice 2006-4); (2) 72 fr 19234 (final § 409a regulations issued on april 17, 2007); (3) 70 fr 75090 (dec. 19, 2005 correction to earlier notice of proposed rulemaking); and (4) 70 fr 57930 (oct. 4, 2005 notice of proposed rulemaking and notice of public hearing). 78. american jobs creation act of 2004, pub. l. no. 108-357, 118 stat. 1418 (2004). 79. h.r. rep. no. 108-755 (2004) (conf. rep.). 978 florida tax review [vol. 8:9 consequences of the issuance of rmail stock options.80 of course, sorting through several hundred hits takes both time and patience. summary of search pathways: legal > area of law by topic > taxation > search analysis, law reviews & journals > federal > tax analysts > tax analysts tax notes weekly > terms and connectors keyword search of “409a w/30 options” summary of search pathways: legal > area of law by topic > taxation > search analysis, law reviews & journals > federal > tax analysts > tax analysts tax notes today > “continue with your search” > terms and connectors keyword search of “409a w/30 options” we also searched for relevant law review articles in the “tax law review articles, combined” file in the lexisnexis database. our keyword search, using the search term “409a w/30 options,” produced nine hits, several of which were potentially relevant.81 80. see, e.g., thomas jaworski, tax deductions from executive stock options concern lawmakers at senate hearing, 2007 tax notes today 109-1 (2007). 81. see, e.g., richard ehrhart, section 409a – treasury “newspeak” lost in the “briar patch,” 38 j. marshall l. rev. 743 (2005) (arguing that congress did not intend change in the treatment of stock options when it enacted § 409a). 2008 the virtural tax library 979 as jack cummings has noted, finding a well written law review article on a specific tax research topic can be extremely helpful.82 on the other hand, law review articles can quickly become dated, due to the long lead time for publication. when researching a developing topic, such as section 409a, a tax researcher sometimes finds that law review articles are less helpful than more current articles in practice oriented publications or recent working papers posted on the social science research network.83 summary of search pathways: legal > area of law – by topic > taxation > search analysis, law reviews & journals > law reviews & journals > tax law review articles, combined > enter keyword search “409a w/30 options.” 82. cummings, supra note 5, at 343 (noting that a relevant article written by an authoritative expert is “a thing of beauty” for a tax researcher). 83. of the nine articles located in the law review file, none were written after the issuance of the final § 409a regulations in april, 2007. a search in the ssrn “elibrary” for “409a and options” does not yield any articles written after the issuance of the final § 409a regulations, but does yield a february 2007 working paper in which the authors criticize the proposed § 409a regulations. daniel i. halperin & ethan yale, deferred compensation revisited (georgetown univ. law ctr., business, economics and regulatory policy working paper series, research paper no. 969074, 2007), available at http://ssrn.com/abstract=969058. 980 florida tax review [vol. 8:9 our search results demonstrate that lexisnexis is an extremely comprehensive platform, containing sources that the individual “tax specific” platforms do not offer. the large amount of content on the lexisnexis database can sometimes make it more difficult to find relevant sources, however. lexisnexis does link related sources, but in a way that requires more research steps than are required to do comparable research on the tax specific platforms, especially ria checkpoint. e. westlaw research results the "tax" tab provides a convenient starting point for tax research using westlaw. as you can see from the screen shot below, the tax tab main page includes links to many different types of primary and secondary sources, including many of the most useful tax research sources in the ria checkpoint database. we began by searching for the text of section 83. when we clicked on the “internal revenue code” link (under the "federal tax primary sources" heading), a search template appeared. we entered “83” in the “irc section” box and clicked on “search westlaw.” on the next screen, the full text of section 83 appears on the right, and various links to related primary and secondary sources appear on the left. 2008 the virtural tax library 981 at this point, a researcher might be tempted to start clicking on the various links to related sources, but that approach would be inefficient at this stage of the research because it would produce a large amount of irrelevant section 83 material.84 a better approach is to proceed to the relevant section 83 regulations, to narrow the scope of the related linked sources. the link in the bottom left corner for "administrative code" conveniently links directly to the section 83 regulations.85 we clicked on that link to view the regulations. summary of search pathways: tax > federal tax primary sources > internal revenue code > enter “83”in “irc section” box and click “search westlaw” > click on section 83 link > click on “administrative code” near bottom of links on left side > click on hit #13, for section 1.83-7. 84. a possible exception is the link to “cross references” under the heading “statutes.” clicking on this link would produce 17 hits, the third of which is § 409a. the cross reference to § 83 in § 409a would alert the researcher to the possible connection between the two sections. 85. as an alternate, less direct route to the regulations, a tax researcher could: click on “regulations – final, temporary & proposed” (under the “federal tax primary sources” heading on the tax tab main page); enter the relevant regulation number (in this case, “1.83”) in the “regulation section” search template box; and click on the links for the regulation sections that seem relevant. in this case, we would click on the link for reg. § 1.83-7. 982 florida tax review [vol. 8:9 the full text of the regulations appears on the right. the "regulations plus" feature86 on the left provides direct links to various types of related primary and secondary sources, including: case annotations; agency decisions; administrative pronouncements; irc cross references; law review articles; and treatises, forms and pli publications. these links provide an efficient, “user friendly” way to find related authority. clicking on “treatises and forms” under “analysis” yields many potentially useful treatise references. 86. this feature is available for final and temporary regulations, but not for proposed regulations. 2008 the virtural tax library 983 summary of search pathways: tax > federal tax primary sources > internal revenue code > enter “83”in “irc section” box and click “search westlaw” > click on section 83 link > click on “administrative code” near bottom of links on left side > click on hit #13, for section 1.83-7 > click on “treatises and forms” link under “analysis” heading near bottom of left side links. in addition, a researcher can link to a “regulations plus” topical index, from regulations section 1.83-7, by clicking on the ““regulations plus index” link (under the “full text document” heading in the upper left part of the screen). unfortunately the topical index references are too broad to be useful, as the index is for all c.f.r. sections, rather than just for the specific regulations section under view. for example, the entry in the index for “options” showed the following results. 984 florida tax review [vol. 8:9 summary of search pathways: tax > federal tax primary sources > internal revenue code > enter “83”in “irc section” box and click “search westlaw” > click on section 83 link > click on “administrative code” near bottom of links on left side > click on hit #13, for section 1.83-7 > click on “regulations plus index” link (under “full-text document” heading) > type “options” into search box > click on link for “options. we also searched for authoritative secondary sources in the warren, gorham & lamont library. on the tax tab main page, we clicked on the “wg&l tax treatises” link (under the “treatises and handbooks” heading). we entered a “terms and connectors” keyword search, with the search term “83 /s [within sentence with] options,” and selected the “wg&l tax treatises combined” database. this search produced 60 hits, the sixth of which was “¶ 60.2 nonqualified deferred compensation arrangements” in the bittker & lokken series, federal taxation of income, estates and gifts.87 87. boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts § 60.2 (rev. 3rd ed. 2005 & supp. 2007). 2008 the virtural tax library 985 the discussion of stock options in this paragraph highlights the section 409a issue. 986 florida tax review [vol. 8:9 a new search in the warren, gorham & lamont combined treatises database, using the search term “409a and options,” produced hits for numerous relevant sources. summary of search pathways: tax > treatises and handbooks > wg&l tax treatises > check box for “wg&l tax treatises combined” > search “83 /s options” > click on hit #6. summary of search pathways: tax > treatises and handbooks > wg&l tax treatises > check box for “wg&l tax treatises combined” > search “409a and options”. we also ran a similar search in the warren, gorham & lamont journals database. from the tax tab main page, we clicked on the “more” link under the “journals & newsletters” heading. we checked the box for “wg&l journals combined” under the “wg&l” heading and again did a keyword search of “409a and options.” this search also produced hits for relevant articles. 2008 the virtural tax library 987 summary of search pathways: tax > journals and newsletters > click “more” > check box for “wg&l journals combined” > search “409a and options”. westlaw offers a great deal of high quality tax related content, including some content not available otherwise, as well as many functionality features designed to make it easier to find relevant sources. due to the large size and breadth of the westlaw database, however, a tax researcher sometimes has to sift through unhelpful sources to find the “gems.” if a researcher knows little about a tax research topic, it can be difficult to use westlaw to gain a broad overview of the topic, although the content in the warren, gorham & lamont treatises often can provide such an overview. the next part summarizes the results of using the five electronic tax research platforms to research the rmail stock option hypothetical and makes recommendations about combining the platforms to create an effective tax research system. v. designing an effective electronic tax research system if presented with the rmail stock option hypothetical discussed in part iv, many tax researchers would think they already know the tax consequences of the issuance of the options. they would assume that the tax consequences are determined under section 83 and regulations sections 1.83-3 and 1.83.7 and would think the answer turns on whether the options 988 florida tax review [vol. 8:9 did or did not have a readily ascertainable fair market value. they might reread section 83 and the regulations (just to double check their conclusion) and think they had finished their research. as the research results demonstrate, however, that approach would produce the wrong answer to the hypothetical research question. the goal in tax research is to find the relevant primary sources that provide the answer to the research question. as the research hypothetical demonstrates, however, sometimes the most efficient way to find all of the relevant primary sources is to consult authoritative secondary sources early in the research process. this is especially true where the researcher (even an experienced researcher) may be unaware of an issue raised by the fact pattern. to adequately research the rmail stock option hypothetical, a researcher would need to consider various primary sources in addition to section 83 and regulations sections 1.83-3 and 1.83.7, including: section 409a; the section 409a final regulations (including the preamble to the regulations); various administrative pronouncements,88 and the legislative history of section 409a. secondary materials offered on the five electronic research platforms would have helped a researcher spot and analyze the section 409a issue lurking in the rmail hypothetical. as we saw in part iv, the helpful secondary sources included: several bna portfolios; the bna daily tax report; the ginsburg and levin treatise; the proceedings of the nyu tax institute, ria’s u.s. tax reporter explanations; various warren, gorham & lamont treatises and journals; tax notes weekly magazine; and tax notes today.89 none of the five electronic tax research platforms offers all of these useful secondary sources. we had the luxury of having access to all five platforms when we researched the hypothetical, but few private firms would purchase electronic subscriptions to all five platforms and a researcher certainly could find the correct answer to the hypothetical without having access to all of the platforms. which electronic tax research platform or platforms would we recommend to a firm or library? the answer depends on various factors, including the content and functionality features discussed in parts ii and iii and illustrated in part iv. other relevant factors include: the specific types of tax topics that will be researched; the personal preferences of the firm or 88. see, e.g., notice 2005-1, 2005-1 c.b. 274; notice 2006-4, 2006-1 c.b. 307. 89. the law review articles we found were a bit dated (due to the long lead time for publication of law review articles), but provided some background information about § 409a. see, e.g., ehrhart, supra note 82 (arguing that proposed rulemaking under notice 2005-1 exceeds the treasury’s authority under § 409a). 2008 the virtural tax library 989 library’s decision-makers; availability and accessibility of alternative print tax sources; and availability and expertise of technical support staff.90 in addition, cost is often one of the key factors. the publishers do not have unitary fixed prices for the electronic tax research platforms. instead, the subscription price depends on various factors, primarily the number of users and the choice of content.91 in many cases, discounts are available for users already subscribing to the publisher’s print materials. we recommend combining the platforms to increase the variety of content and functionality features available to the researcher.92 in our opinion, the best tax research systems are designed to encourage redundancy (and thereby reduce the probability of missing a critical aspect of a tax research project). the optimal combination of electronic tax research platforms will vary for each firm or library. for many firms, the best approach will be to combine one of the comprehensive platforms, lexisnexis or westlaw, with one or more of the tax specific platforms.93 recall that the westlaw database includes the ria checkpoint content, and the lexisnexis database often includes the cch content.94 combining (1) westlaw and cch or (2) lexisnexis (with cch content) and ria checkpoint increases the variety of content available to researchers. we like the combination of lexisnexis (with cch content) and ria checkpoint because it gives researchers access to a wide variety of publisher-specific source content, including: comprehensive legislative histories, law review articles, warren, gorham & lamont treatises and journals; tax analysts content; and the ria and cch looseleaf series. we offer our loyola law school los angeles tax llm students access to the lexisnexis (with cch content), westlaw, and ria checkpoint 90. as we note in part iic, supra, some tax content is available on-line at no charge but: (1) often is out of date; (2) is difficult to search (due to the absence of functionality features such as terms and connectors searching or table of contents searching) and (3) typically does not include authoritative secondary sources. as we researched the rmail hypothetical, we searched various websites offering free tax content, but the search results were not particularly helpful. our experience was consistent with the old bromide: “you get what you pay for.” this conclusion is partly a function of the fact that the rmail hypothetical is a doctrinal tax research problem. if we had been researching a tax policy issue, the free content available on government websites and the websites of tax policy organizations probably would have been much more helpful. 91. the publishers bundle specific types of content together into content groupings and offer subscribers various packages of the content groupings. 92. see also cummings, supra note 5, at 338 (recommending that researchers combine the platforms). 93. bna content also can be integrated into the content on the other platforms. 94. see supra, text accompanying notes 37 and 39. 990 florida tax review [vol. 8:9 electronic platforms and require our tax llm students to complete advanced tax research training on the lexisnexis and ria checkpoint platforms. in our opinion, the combined lexisnexis and ria checkpoint electronic databases offer our students much of the content they might require to research a tax question in practice, and ria checkpoint offers the benefit of streamlined functionality.95 in addition, we offer print copies of cch materials and bna portfolios in our law library and encourage our students to use them.96 we also encourage our students to search for new working papers and articles in the ssrn e-library. conclusion the lexisnexis, westlaw, ria checkpoint, cch, and bna electronic tax research platforms constitute a new virtual tax library that provides tax researchers with much of the content and functionality of physical libraries, as well as some functionality features not provided by physical libraries. the new virtual tax library offers tax researchers numerous benefits, including the convenience of a portable library, more reliable and current research results, increased research efficiency, and reduced research costs. tax researchers should update their tax research techniques to realize the benefits of the new virtual tax library. the comparisons in this article of the content and functionality features offered by the various electronic platforms can help researchers decide which platforms should be part of their updated tax research system. the optimal combination of electronic tax research platforms will depend on various factors, but we generally recommend subscribing either to (1) a combination of lexisnexis (with cch content) and ria checkpoint or (2) a combination of westlaw and cch. we prefer the former combination, which combines the comprehensive content available on the lexisnexis platform (including legislative histories, law review articles, and tax analysts materials) with 95. in our opinion, westlaw offers more efficient tax research functionality than lexisnexis (with the caveat that the new lexisnexis “tax center” platform may offer more streamlined functionality for tax research). we definitely wanted to train our students on ria checkpoint, however, due to the exceptional functionality features offered on ria checkpoint, and thought that ria checkpoint is better paired with lexisnexis to offer our students a greater variety of tax content (including tax analysts materials). 96. we assign our tax llm students a mandatory “open universe” tax research and writing assignment. part of the grade for their work depends on the sources they find in their research. if we had given our students the rmail research hypothetical, we would have expected them to find all of the sources we found, not just the sources available in the electronic databases. 2008 the virtural tax library 991 the user-friendly functionality features and authoritative warren, gorham & lamont materials that are available on the ria checkpoint platform. 97 97. cost permitting, we also recommend subscribing to bna and adding the bna content (including the excellent tax management portfolios) to the ria checkpoint platform. florida tax review volume 6 2004 number 6 family limited partnerships: discounts, options, and disappearing value karen c. burke* grayson m.p. mccouch** i. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 650 ii. disappearing value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 650 iii. partnership discounts and options. . . . . . . . . . . . . . . . . . 655 a. formation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655 b. transfer of interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 656 c. purchase from partnership. . . . . . . . . . . . . . . . . . . . . . . 659 iv. preserving value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 665 v. conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670 addendum. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672 * warren distinguished professor, university of san diego school of law. ** professor, university of san diego school of law. the authors acknowledge generous research support from the university of san diego school of law. 649 650 florida tax review [vol.6:6 i. introduction family partnerships have been become increasingly popular as a means of avoiding estate and gift taxes. as other estate freezing techniques have been closed off by statutory anti-abuse rules, estate planners have increasingly resorted to partnerships as a vehicle for transferring assets within a family at deeply discounted values. discounts ranging from one third to over one half of the value of the underlying assets are routinely claimed, and often allowed, based on lack of marketability and lack of control, even where these disabilities have no lasting or ascertainable economic effect. nevertheless, the use of family partnerships to suppress value for transfer tax purposes rests on shaky conceptual premises that deserve closer scrutiny.1 ii. disappearing value reduced to its essential components, the family partnership transaction operates as a sort of sleight-of-hand trick in two steps. in the first step, the transferor contributes assets to a partnership in exchange for a limited partnership interest. in the second step, the transferor transfers the partnership interest, during life or at death, to another family member. if the technique is successful, the initial exchange does not give rise to a taxable gift because no value is actually shifted at that time. in effect, the partnership interest is deemed to represent full consideration for the contributed assets. the shift in value occurs in the subsequent transfer, and at that time the amount included in the transferor’s gift or estate tax base is equal to the fair market value of the transferred interest, reflecting a substantial discount from the value of the assets in the partnership’s hands. the difference between the “inside” value of the contributed assets and the “outside” value of the partnership interest – the entity discount – escapes transfer tax altogether, even though the assets remain intact in partnership solution and available for tax-free distribution to the transferee upon liquidation. the use of family partnerships can be illustrated by a simple example involving a and her two children b and c. a contributes investment assets 1. for a valuable recent discussion of family partnerships and transfer tax avoidance, see laura e. cunningham, remember the alamo: the irs needs ammunition in its fight against the flp, 86 tax notes 1461 (mar. 13, 2000), and sources cited therein. see also leo l. schmolka, flps and grats: what to do?, 86 tax notes 1473 (mar. 13, 2000); brant j. hellwig, revisiting byrum , 23 va. tax rev. 275 (2003). 2004] family limited partnerships 651 worth $99 to a newly formed partnership in exchange for a 99% limited partnership interest; x, a corporation owned equally by b and c, contributes $1 in exchange for a 1% general partnership interest. the partners’ capital accounts are initially equal to the value of their respective contributions, and all items of income, gain, and loss are allocated in proportion to the partners’ respective percentage interests. a files a gift tax return showing no taxable gifts. subsequently, by gift or by will, a transfers her 99% limited partnership interest to b and c. this subsequent transfer is valued for gift or estate tax purposes at $66, reflecting a one-third discount from liquidation value (i.e., the amount that a would be entitled to receive on a hypothetical liquidation of the partnership) due to lack of marketability and lack of control. eventually, the partnership liquidates and distributes $1 to x and $49.50 of investment assets each to b and c. the net result, if a’s reporting of the transaction is accepted, is that a has transferred assets worth $99 for a reported value of only $66; the difference of $33, representing a one-third valuation discount, simply disappears from the transfer tax base. the above example raises two interrelated issues: whether a makes a gift upon formation of the partnership, and, if not, whether a one-third discount is allowable in valuing the transfer of the partnership interest in the subsequent transfer. on the first question, the courts appear to accept the notion that no gift occurs upon formation of a partnership as long as each partner’s contribution is properly reflected in his or her capital account and does not enhance the value of any other partner’s interest in the partnership. these requirements are2 usually met without difficulty, even though the partnership interest that a receives is worth less than the assets she contributed. there is no immediate capital shift from a to another partner, nor is the value of any other partner’s interest enhanced by a’s contribution. instead, the formation of the partnership is treated as if it resulted in a loss or destruction of value, since the aggregate value of the partners’ interests in the partnership is less than the total value of the contributed assets. nevertheless, the contributed assets remain intact in the hands of the partnership, which could sell the assets at any time and distribute the proceeds to the partners in liquidation. arguably, since there is no actual loss or destruction of value, a should be treated as making a gift of the difference in value between the assets she contributed and the partnership interest she 2. see estate of strangi v. commissioner, 115 t.c. 478, 489-90 (2000), aff’d in part and rev’d in part on other grounds, 293 f.3d 279 (5th cir. 2002); estate of jones v. commissioner, 116 t.c. 121, 127-28 (2001); see also church v. united states, 2000-1 u.s. tax cas. (cch) ¶ 60,369, 85 a.f.t.r. 2d (p-h) 2000-804 (w.d. tex. 2000), aff’d mem ., 268 f.3d 1063 (5th cir. 2001). 652 florida tax review [vol.6:6 received in exchange. she has relinquished dominion and control of property3 in exchange for property of lesser value; for gift tax purposes, it does not matter that the transfer does not immediately enrich an ascertainable donee, nor that the transferred assets may eventually return to a or be included in her gross estate at death.4 there are two possible arguments that could be advanced against a completed gift on formation of the partnership, but neither of them ultimately offers a much comfort. first, a might argue that she retained sufficient control over the beneficial enjoyment of the contributed assets to prevent a completed transfer from taking place. this degree of retained control, however, would merely defer the taxable transfer until her retained control terminated during life or at death and would not result in any transfer tax reduction.5 alternatively, a might argue that her partnership interest is equal in value to the contributed assets and thus represents full consideration received in exchange for the contributed assets. this argument, however, implies that a’s partnership interest would continue to be worth her proportionate share of the value of the partnership assets at the time of the subsequent transfer. in that case, the6 transaction would fail to achieve the intended result of making value disappear from a’s transfer tax base, and there would be no point in creating the family partnership. by ignoring the difference in value between the contributed assets and the partnership interest received in exchange, the courts allow a to set the stage for substantial transfer tax avoidance. having escaped gift tax liability on the initial exchange, a is free to claim a substantial valuation discount on a subsequent transfer of her partnership interest during life or at death. as long as the existence of the partnership is respected for gift and estate tax purposes, the difference between the inside value of the assets contributed by a and the 3. for an elaboration of this argument, see schmolka, supra note 1, at 1487 (“the loss in value is not the subject of the transfer. the property contributed to the partnership is the subject of the transfer; the extent of the transfer is measured by the inadequacy of the consideration (the partnership interest) received in exchange.”). 4. the transaction is analogous to a transfer in trust. if the trust is irrevocable and the settlor relinquishes dominion and control while retaining a reversionary interest, there is clearly a taxable gift. see smith v. shaughnessy, 318 u.s. 176 (1943). the amount of gift tax payable on such a transfer should be allowed as a credit or offset against any subsequent estate tax liability. see irc §§ 2001(b)(2), 2012. 5. see irc § 2038 (estate tax); reg. § 25.2511-2(f) (gift tax). cf. estate of strangi v. commissioner, 115 t.c. 478, 490 (relying in part on a finding that “we do not believe that decedent gave up control over the assets” to support conclusion that the formation of the partnership did not result in a taxable gift). 6. see discussion infra part iv (pursuing this argument further). 2004] family limited partnerships 653 outside value of the partnership interest that she receives in return will disappear from her transfer tax base.7 the discounts for lack of control and lack of marketability reflect the notion that a would not be able to sell her partnership interest to a hypothetical arm’s-length purchaser for a price approaching her proportionate share of the partnership’s net asset value. this disparity of value prompts a question about the nature and purpose of the partnership: why would an investor exchange assets worth $99 for a limited partnership interest worth $66, with no right to control the partnership and no right to compel a distribution of her share of partnership assets? the short answer is that no rational person dealing at arm’s length would ever make such an investment. in fact, the notion of fair market value, premised on a voluntary arm’s-length exchange, is profoundly unrealistic in this context. a’s partnership interest is specifically designed to be given away during life or at death, and it seems incongruous to postulate an arm’s-length sale of such an interest. nevertheless, the courts appear to have accepted the8 notion that a family partnership can generate substantial valuation discounts for gift and estate tax purposes even if it has no business purpose. to obtain the largest available discount, however, a taxpayer must take care to ensure that the transaction is structured as a gift of a partnership interest rather than an indirect gift of the contributed assets. in the case of a disproportionate capital contribution to a corporation, the contributing shareholder is generally treated as making an indirect gift to the other shareholders “to the extent of their proportionate interests in the corporation.”9 courts have traditionally valued the gift simply by subtracting the donor’s retained proportionate interest from the value of the contributed assets. in the10 7. if a retains possession or enjoyment of the contributed property or a right to control beneficial enjoyment of the property for life, the existence of the partnership may in effect be disregarded for estate tax purposes under § 2036. see infra notes 79-80 and accompanying text. 8. see wallace v. united states, 566 f. supp. 904, 918-21 (d. mass. 1981) (noting the difficulty of constructing terms of a hypothetical sale of “property interests that would never be fashioned for transfer in an arms-length transaction”). in some cases, a token 1% limited partnership interest is given to an unrelated party, often a charity, in order to create the appearance of an arm’s-length transfer. the charity, however, does not retain the interest. instead, the interest is likely to be redeemed by the partnership, possibly at a bargain price. see, e.g., mccord v. commissioner, 120 t.c. 358 (2003). 9. regs. § 25.2511-1(h)(1). 10. see kincaid v. united states, 682 f.2d 1220 (5th cir. 1982), involving a contribution of assets to a newly formed family corporation. the court characterized the gift as an enhancement of the value of the donees’ stock, equal to the difference between the value of the contributed assets and the taxpayer’s interest based on her proportionate stock ownership; the court did not consider or allow any valuation discounts. see id. at 654 florida tax review [vol.6:6 case of a partnership, however, the capital account rules of section 704(b) require that the value of the contributed assets be credited to the contributing partner’s capital account. if the contribution results in the enhancement of11 another partner’s capital account – in violation of the capital account rules – the contributing partner is likely to be treated as making an indirect gift of the contributed assets, generating a smaller discount than a gift of a partnership interest.12 to illustrate several alternative ways of valuing the contributing partner’s gift, suppose d contributes land worth $100 to a family partnership of which d is a 40% general partner and her two children are each 30% general partners. instead of crediting the full value of the land to d’s capital account, d receives a capital account of $40 and each of the children receives a capital account of $30. the available discount is 15% for a gift of an undivided fractional interest in the land, or 30% for a gift of a partnership interest. depending on how the transfer is characterized, d’s gift might be valued in any of five possible ways: (a) $42, the sum of the discounted partnership interests13 received by the children; (b) $51, the sum of the fractional interests in land14 received by the children; (c) $60, the value of the land less d’s proportional15 retained interest (or the sum of the children’s proportional interests in the land); (d) $66, the value of the land less d’s discounted fractional interest in16 the land; or (e) $72, the value of the land less d’s discounted partnership17 1224, 1226. see also heringer v. commissioner, 235 f.2d 149 (9th cir. 1956) (contribution of land to family corporation of which donors were 40% owners, treated as gift of 60% of value of contributed land). 11. see regs. § 1.704-1(b)(2)(iv)(d)(1). 12. see shepherd v. commissioner, 115 t.c. 376 (2000), aff’d, 283 f.3d 1258 (11th cir. 2002). in shepherd, the tax court treated a contribution of land to a newly formed partnership as an indirect gift of undivided fractional interests in the land. the court allowed a combined 15% discount to reflect lack of operational control, risk of disagreement about disposition, and possibility of future partition. see 115 t.c. at 38890, 400-02. this was less than half the 33.5% stipulated discount for lack of control and lack of marketability that would have applied to gifts of limited partnership interests. 13. the example in text is adapted from richard covey’s hypothetical based on the shepherd case. see the shepherd, knight and strangi cases – family partnerships survive irs attack but more to come, practical drafting 6295, 6297 (u.s. trust co., 2001). 14. 2 × ($30 × (1 ! 30%)). this is apparently the approach favored by judge foley. see shepherd, 115 t.c. at 416-17 (foley, j., dissenting); shepherd, 283 f.3d at 1266-68 (ryskamp, j., dissenting). 15. 2 × ($30 × (1 ! 15%)). this is the approach of the majority in both shepherd decisions. see shepherd, 115 t.c. at 400-02; shepherd, 283 f.3d at 1260-64. 16. $100 × (1 ! 40%). this is apparently the approach favored by judge ruwe. see shepherd, 115 t.c. at 409-14 (ruwe, j., concurring in part and dissenting in part). 17. $100 ! ($40 × (1 ! 15%)). this is a variant of the approach apparently favored by judge beghe. see shepherd, 115 t.c. at 414-16 (beghe, j., concurring in part and dissenting in part). 2004] family limited partnerships 655 interest. although the distinction may seem highly formalistic, an indirect gift18 of assets at the time of the contribution is apparently taxed more heavily than a gift of partnership interests following a contribution. iii. partnership discounts and options for the family partnership to produce the intended results, it is important that each partner’s contributions be reflected in his or her capital account. scrupulous maintenance of capital accounts is necessary to document the absence of a capital shift from one partner to another upon formation of the partnership for gift tax purposes. capital accounts also establish a link between the individual partners and their respective shares of partnership assets for income tax purposes. capital accounts reflect an aggregate view of the partners as owning shares of partnership assets, which underlies many of the income tax provisions of subchapter k. in effect, capital accounts serve both to measure the value of the partnership assets to which a partner is entitled on liquidation and to preserve the partner’s share of built-in gain or loss attributable to particular assets. a partner may acquire a discounted partnership interest from an existing partner in a transfer (by gift or by sale) or from the partnership in exchange for a capital contribution. if the acquiring partner’s interest is worth less than a ratable share of the partnership assets that he would receive in a hypothetical liquidation of the partnership, the issuance of the partnership interest gives rise to a capital shift from the existing partners to the acquiring partner. in turn, this capital shift may trigger a deemed gift of a fractional interest in a corresponding portion of the partnership assets. if the bargain issuance of a partnership interest would give rise to a deemed gift, a similar result may be appropriate in the case of a capital contribution followed by a transfer of a discounted partnership interest. a. formation the family partnership transaction assumes that the total outside value of the partners’ partnership interests is less than the total inside value of the partnership’s assets. if all of the partners’ interests have the same proportionate discount and partnership items are shared ratably, it would be possible to equate the partners’ initial capital accounts with aggregate outside value without distorting the partners’ economic arrangement. consider again the example in which a contributes investment assets worth $99 to a newly formed partnership 18. $100 ! ($40 × (1 ! 30%)). this is apparently the approach favored by judge beghe. see shepherd, 115 t.c. at 414-16 (beghe, j., concurring in part and dissenting in part). 656 florida tax review [vol.6:6 for a 99% limited partnership interest and x, a corporation owned equally by b and c, contributes $1 in exchange for a 1% general partnership interest. if the value of each partner’s capital contribution is understated by one third, the formation of the partnership should not give rise to a capital shift among the partners. even though a’s capital account is initially credited with a19 contribution of $66 (the discounted value of her partnership interest), a has a right to 99% of the “excess” inside value not yet reflected on the partnership’s books. thus, upon an eventual sale of the partnership’s assets for their full fair market value, a’s initial capital account would be increased by $33 to reflect her 99% share of the excess inside value attributable to her own contribution as well as the contributions of b and c, remedying the initial understatement.20 if a subsequently transfers a portion of her partnership interest for its discounted value, however, a will relinquish her ability to recoup her full share of the excess inside value. b. transfer of interest if a transfers one half of her discounted partnership interest (worth $33) to d as a gift, the capital account rules treat d as stepping into a’s shoes with respect to the transferred interest. because a transfer of a partnership21 interest merely substitutes one partner for another partner, no revaluation of the partnership’s assets or the partners’ capital accounts is required or permitted.22 if capital accounts are initially stated at the undiscounted value of the partners’ contributions, d would receive a capital account of $49.50 (one half of a’s capital account of $99). the offsetting reduction in a’s capital account ($49.50) represents the outside value of the transferred interests ($33) plus a corresponding share of excess inside value ($16.50). thus, a has permanently relinquished her claim on $16.50 of inside value which has been shifted to d. even though d is treated as acquiring a discounted partnership interest, the capital account rules continue to link the partners with particular partnership assets. thus, the transferee is tagged with a proportionate share of any built-in gain (or loss) inherent in assets contributed by the transferor.23 19. such an understatement could arise, for example, as a result of a mistaken valuation of the underlying assets at the time of contribution. cf. regs. § 1.7041(b)(2)(iv)(d)(1). 20. the capital shift from a to b and c would be $.33 (1% × a × $99); there would, however, be an offsetting capital shift of $.33 (99% × a × $1) from b and c to a. 21. see regs. § 1.704-1(b)(2)(iv)(l) (transferor’s capital account attributable to the transferred interest carries over to the transferee). 22. see regs. § 1.704-1(b)(2)(iv)(f) (permitted revaluation events). 23. see regs. §§ 1.704-3(a), 1.704-4(d)(2). 2004] family limited partnerships 657 assume instead that d (an unrelated party) purchases one half of a’s partnership interest for its discounted value of $33 when a’s entire partnership interest has a basis of $99 (the same as the basis and value of the assets contributed by a). for capital account purposes, d again takes over one half of a’s capital account ($49.50), reflecting a shift of $16.50 of excess inside value to d. upon the transfer of one half of her interest to d, a recognizes a tax loss24 of $16.50 ($49.50 allocable share of outside basis less $33 amount realized).25 a’s recognized loss does not reflect any shrinkage in the fair market value of the partnership’s assets, since inside value has remained constant; instead, the recognized loss arises solely because a has relinquished her claim to the excess inside value shifted to d.26 if a section 754 election is in effect, the basis adjustment rules of section 743 identify the transferee with an undiscounted share of partnership assets. even though the transaction involves a transfer of a partnership27 interest, the transferee is essentially treated as acquiring a proportionate share of the partnership’s assets at a bargain price. because d would be treated as28 acquiring $49.50 worth of partnership assets for a bargain price of $33, d would be required to “write down” his share of inside basis in the partnership’s assets to reflect the $16.50 potential gain inherent in his partnership interest.29 24. see regs. § 1.704-1(b)(2)(iv)(l). 25. a’s basis must be allocated between the retained and transferred interests based on their respective fair market values; the seller’s amount realized also includes her allocable share of liabilities attributable to the transferred interest. see irc § 752(d). 26. if the partnership had any § 751 assets, the seller would recognize ordinary income (or loss) equal to her allocable share of the partnership’s total income or loss on a hypothetical sale of its § 751 assets. see regs. § 1.751-1(a)(2). the hypothetical sale approach under the § 751 regulations is based on the assumption that the transferee has a proportionate share of the inside value of the partnership’s ordinary income assets. 27. technically, the § 743 adjustment is personal to the transferee and does not affect the partnership’s common basis in its assets. see regs. § 1.743-1(j)(1); see also regs. § 1.704-1(b)(2)(iv)(m)(2) (§ 743 adjustment not reflected in the transferee’s capital account or on the partnership’s books). 28. the § 743 adjustment is equal to the difference between the transferee’s outside basis and the transferee’s share of the common basis of partnership assets. see regs. § 1.743-1(b). the transferee’s share of the common basis of partnership assets (i.e., the transferee’s share of previously taxed capital plus liabilities) is determined by reference to a “hypothetical transaction” in which the partnership sells all of its assets in a fully taxable transaction. see regs. § 1.743-1(d)(1) and (2). 29. the § 743 adjustment is allocated between and among different classes of partnership assets (i.e., capital assets and ordinary assets) based on the amount of tax gain (or loss) that would be allocated to the transferee on a hypothetical sale of partnership assets for their fair market value. see regs. § 1.755-1(a)(1) and (b); see also regs. § 1.755-1(a)(2) (residual method of determining fair market value). 658 florida tax review [vol.6:6 thus, the basis adjustment rules create inside gain to match the transferee’s outside gain in the case of a bargain purchase of a partnership interest.30 no such basis adjustments occur if a partnership interest is acquired by gift because the donor’s basis in the transferred interest carries over in the donee’s hands. thus, there is generally no disparity between the partnership’s31 inside basis and the partners’ aggregate outside basis to remedy. any32 economic loss to the donor as a result of the capital shift is simply disregarded, an appropriate result because the “lost” value reappears in the donee’s capital account. the carryover basis rule for gifts of partnership interests merely serves to mask the capital shift between a and d. by contrast, a sale of a discounted interest between unrelated parties results in an economic loss to the transferor and a matching potential economic gain to the transferee. assuming a section 754 election is in effect, d’s potential gain inside the partnership is equal to a’s recognized loss on the transfer. if a partner purchases a partnership interest from another partner at a discount, presumably a similar discount should be allowed if a new partner contributes cash to the partnership for an equivalent interest. for example, assume that a recontributes the $33 cash paid by d for one half of a’s limited partnership interest; in exchange for a’s contribution, the partners agree to treat a as acquiring an additional 33% limited partnership interest. because a has contributed an amount equal to d’s purchase price for a similar interest, it might appear that a should also be entitled to a $49.50 capital account. this result is not permitted, however, because the total inside value allocable to the combined limited partnership interests is only $132 (a’s original contribution of $99 worth of investment assets plus $33 cash). a pro rata division of inside value among the limited partners based on their percentage interests would result in the following capital accounts: $88 for a (b × $132) and $44 for d (a × $132). in effect, a would recapture a portion of the value shifted to d,33 30. any shortfall in the § 743 adjustment is allocated first to capital assets and then to ordinary income assets if the basis of capital assets is insufficient to absorb the required adjustments. see regs. § 1.755-1(b)(2). 31. see irc § 1015(a) (donee takes donor’s basis in transferred property, subject to fair market value limit for loss purposes). 32. a discrepancy may arise, however, if the donor incurs a gift tax liability on a gift of a partnership interest with a value exceeding the donor’s outside basis. see irc § 1015(d) (basis adjustment for gift tax attributable to net appreciation in gift). 33. the result is the same if the general partner’s $1 contribution is taken into account. following a’s additional $33 contribution, the combined percentage interest of the limited partners, based on their capital contributions, is 99.25% ($132/$133), while the percentage interest of the general partner is 0.75% ($1/$133). a pro rata division of the total inside value of $133 among all the partners yields the following capital accounts: $88 for a ($133 × (b × 99.25%)), $44 for d ($133 × (a × 99.25%)), and $1 for x ($133 × 0.75%). 2004] family limited partnerships 659 reducing the total capital shift to d from $16.50 to $11 ($44 capital account less $33 purchase price).34 since such treatment would dilute d’s discount, however, d may35 insist that his capital account should remain $49.50 to reflect the agreed upon discount at the time of purchase. in this event, a’s remaining limited partnership interest would correspond to a capital account credit of $82.50 ($49.50 retained capital account increased by $33 contribution). of course, it36 makes no economic sense for a to agree to a capital account credit of only $33 in exchange for her contribution, in view of the one-third discount reflected in d’s purchase of one half of a’s former interest. more importantly, treating partners as acquiring interests at a discount may threaten to undermine the function of the elaborate capital account rules linking each partner’s interest in the partnership with a share of partnership assets upon liquidation. the threat37 to the integrity of the capital account rules is heightened to the extent that such discounts occur between related parties who lack adverse economic interests. the claimed discounts may be economically meaningless because no actual market exists for sales of comparable discounted interests and the shifted value merely reappears in a related party’s capital account. c. purchase from partnership as exemplified by the family partnership transaction, the allowance of discounts in connection with gifts of partnership interests has become quite routine. until recently, there was considerable uncertainty concerning the 34. the shortfall in inside value ($16.50) is borne two thirds by a ($11) and one third by d ($5.50). see infra note 36. 35. d’s discount would be diluted from one third ($16.50/$49.50) to one fourth ($11/$44). 36. a’s capital account ($82.50) represents the undiscounted value of a’s initial contribution ($99) less the capital shifted to d ($16.50). the partners’ capital accounts are no longer proportionate to their percentage interests in the partnership, however, since the shortfall in inside value is borne entirely by a. if d’s capital account is $49.50, the implied value of the total limited partnership interests is $148.50 ($49.50 × 3), producing a $16.50 shortfall in inside value ($148.50 less $132). 37. see mark p. gergen, the end of the revolution in partnership tax?, 56 smu l. rev. 343, 356 (2003) (“at best, the response to discounts and options will erode the system’s conceptual elegance and require more complex rules. . . . the proliferation of ways or justifications for making payoffs from a partnership that differ from capital accounts makes it difficult to trust how partners value assets, which is the linchpin of the system of capital accounts analysis.”); see also id. at 359 (“there also will be vexing technical issues in translating an interest in a partnership into an interest in assets.”). cf. lawrence lokken, as the world of partnership taxation turns, 56 smu l. rev. 365, 373-376 (2003) (suggesting that the existing system is capable of handling this phenomenon). 660 florida tax review [vol.6:6 capital account treatment of a bargain issuance of a partnership interest.38 nevertheless, a bargain issuance of a partnership interest may be structured in a manner that is economically equivalent to a transfer of a discounted interest. recently issued proposed regulations provide guidance on how to account for a capital shift resulting from the exercise of a noncompensatory option to acquire a partnership interest.39 assume again that a contributes investment assets worth $99 to a newly formed partnership for a 99% limited partnership interest and x, a corporation owned equally by b and c, contributes $1 in exchange for a 1% general partnership interest. subsequently, the partners agree to admit d as a 33% limited partner in exchange for a capital contribution of $33, $11 less than d’s one-third share ($44) of the total partnership capital attributable to the combined limited partnership interests immediately after d’s admission ($132). the partners agree to the discounted price based on the conclusion that a purchaser would demand a 25% discount for such a limited partnership interest. in connection with d’s admission, a’s capital account is reduced from $99 to $88 to reflect the $11 capital shift to d. if the capital shift occurred upon formation of the partnership, a would apparently be treated as having transferred a fractional interest in the underlying assets to d as a gift.40 nevertheless, if d acquires the identical interest in partnership capital upon transfer of a discounted partnership interest, no gift is deemed to occur. yet the two transactions are economically indistinguishable and both should be analyzed in terms of the underlying capital shift. under the proposed regulations, the exercise of an option to acquire a partnership interest is treated as a capital shift from the historic partners to the 38. see notice 2000-29, 2000-1 c.b. 1241 (inviting public comments concerning the tax treatment of options to acquire a partnership interest and similar instruments). upon exercise of an option to acquire a partnership interest, the § 721 regulations might be construed as requiring recognition of gain as a result of the capital shift from the historic partners to the option holder. see regs. § 1.721-1(b)(1) (denying § 721 treatment to the extent that a partner gives up his right to be repaid all or a portion of his capital contribution in favor of another partner “as compensation for services (or in satisfaction of an obligation)”). in the case of noncompensatory options, commentators offered various rationales for nonrecognition treatment of both the historic partners and the option holder. see generally simon friedman, partnership securities, 1 fla. tax rev. 521 (1993); sherwin kamin, partnership options–a modified aggregate theory, 91 tax notes 975 (may 7, 2001); new york state bar ass’n tax section, taxation of partnership options and convertible securities, 94 tax notes 1179 (mar. 4, 2002) [hereinafter nysba report]. 39. the regulations do not address the treatment of options and similar instruments issued in connection with the performance of services. see reg-103580-02, noncompensatory partnership options, 2003-9 i.r.b. 543, 543 [hereinafter preamble]. 40. see supra notes 9-12 and accompanying text. 2004] family limited partnerships 661 option holder who acquires a bargain partnership interest. typically, the41 option holder pays a premium for the option and is entitled to receive a partnership interest upon payment of the exercise price to the partnership. the option privilege has value because it represents the opportunity to benefit from any appreciation in the value of the property subject to the option, without risking any capital. thus, the fair market value of an option includes not only42 any value inherent in the option at the time of grant (i.e., the difference between the current value of the property subject to the option and the exercise price) but also the value of the option privilege for the remaining period until exercise.43 the option holder will normally exercise the option only if he would be entitled to receive an interest in partnership capital in excess of the amount of the option premium and exercise price. upon exercise, the option holder is in the same position as a partner who acquires a bargain interest from the partnership which reflects market discount. in both situations, the acquiror obtains a partnership interest in exchange for a capital contribution that is less than a ratable share of the fair market value of partnership assets to which the contributor would be entitled upon an immediate liquidation of the partnership. the market discount is analogous to the fair market value of the44 option, i.e., the difference between the option holder’s capital account based on liquidation value and the exercise price (plus any option premium). in the above example, the partnership could agree to issue d an immediately exercisable option to acquire a 33% limited partnership interest for an aggregate option price and exercise price of $33. (for this purpose, ignore any additional option premium that d should be willing to pay for the privilege of deferring exercise.) suppose d immediately exercises the option, entitling him to a capital account of $44. if d is treated as acquiring an option to purchase a 33% partnership interest for which a market discount of 25% would be allowed, there is apparently no disguised gift to d. under the proposed regulations, however, d is treated as receiving a capital shift of $11 from the 41. the shift may consist of previously booked capital as well as a share of unrealized appreciation which has not yet been reflected on the partnership’s books. although the § 721 regulations refer to a partner’s right to be repaid his “contribution,” it is commonly understood that a partner’s share of capital also includes his share of unrealized appreciation in partnership assets. see william s. mckee et al., federal taxation of partnerships and partners ¶ 5.02[1] at 5-5 (3d ed. 1997). 42. see regs. § 1.83-7(b)(3). 43. see id. 44. if the exercise price of a noncompensatory option exceeds the capital account received on exercise, the proposed regulations warn that the transaction will be treated according to its “true nature.” prop. regs. § 1.721-2(a). in this situation, the option holder would be paying more for the interest than its liquidation value, suggesting the possibility of a disguised transfer to the historic partners. 662 florida tax review [vol.6:6 historic partners. although the proposed regulations provide that exercise of45 an option is treated as a nonrecognition event with respect to the option holder and the historic partners, the resulting capital shift should arguably give rise46 to an indirect gift of a disproportionate share of partnership assets from the historic partners to d.47 the exercise of an option entitles the option holder to acquire a partnership interest at a bargain price. nevertheless, the proposed regulations look through the partnership and treat the option holder as acquiring a share of partnership assets based on the liquidation value of his capital account immediately after exercise. the partnership’s assets are revalued immediately after exercise, and the option holder’s capital account is initially credited with the amount of his contribution, i.e., the option premium and the exercise price.48 next, the option holder’s capital account is credited with unrealized appreciation in the partnership’s assets (not yet reflected in the partners’ book capital accounts) to substitute for the built-in gain inherent in the option itself.49 if the option holder is entitled to additional capital in excess of the built-in gain in the partnership’s assets, capital is reallocated from the historic partners’ capital accounts to the option holder’s capital account. in this situation, the50 45. since the fair market value of the contributed property was reflected in the partners’ book capital accounts at the time of contribution, the $11 capital shift consists entirely of previously booked capital; if the partnership’s assets had appreciated after contribution, the capital shift would include a share of unrealized appreciation. 46. see preamble, supra note 39, at 543-44. while concluding that § 721 applies to exercise of a noncompensatory option, the proposed regulations fail to state “the specific theory or principles” overriding the contrary implication in regs. § 1.7211(b). elliott manning, proposed non-compensatory partnership options regulations, 16 j. tax’n fin. institutions 16, 22 (may/june 2003). 47. see regs. § 1.704-1(b)(1)(iv) (warning that a capital shift may be treated as a disguised gift). 48. see prop. regs. § 1.704-1(b)(2)(iv)(s)(1). under the conventional approach of the § 704(b) regulations, the partners’ capital accounts would be booked up immediately before admission of a new partner. see regs. §§ 1.704-1(b)(2)(iv)(f), 1.704-1(b)(5) exs. 14 and 18. a post-exercise bookup allows pre-exercise unrealized appreciation to be allocated on a priority basis to the option holder to the extent necessary to implement the parties’ economic arrangement. 49. see prop. regs. § 1.704-1(b)(2)(iv)(s)(2). the built-in gain inherent in the option privilege cannot be allocated to the option holder directly under § 704(c) principles because the option privilege terminates upon exercise. see preamble, supra note 39. nonrecognition treatment on exercise merely results in deferral, since the option holder will eventually recognize built-in gain attributable to the underlying assets under § 704(c) principles. 50. see prop. regs. § 1.704-1(b)(2)(iv)(s)(3). 2004] family limited partnerships 663 partnership is required to make corrective allocations to reflect the “capital account reallocation.”51 the required adjustments under the proposed regulations resemble section 743 basis adjustments in connection with a bargain purchase of a partnership interest. the common assumption underlying these different adjustments is that the bargain element inherent in the partnership interest can be translated into a bargain acquisition of partnership assets. from the historic partners’ perspective, it might seem unrealistic to distinguish between a shift to the option holder of pre-admission unrealized appreciation (to the extent not previously booked in the partners’ capital accounts) and a shift of previously booked capital. in economic terms, both types of shifts represent a loss of value to the historic partners. to the extent that the previously unbooked52 appreciation will eventually be taxed entirely to the option holder, however, the historic partners are not entitled to any tax loss to match their economic loss.53 the proposed regulations reject the notion of taxing the historic partners on the unrealized appreciation transferred to the option holder as part of the bargain purchase. as one commentator noted, treating the shift in unrealized54 appreciation as a taxable event would mean that the historic partners “would be taxed not on an accession to wealth, the value they received, but on a deaccession to wealth, value they had forever foregone.”55 from the option holder’s perspective, receipt of a partnership interest upon exercise of the option is a tax-free event, based on section 721 and general open-transaction principles applicable to options. in acquiring the option, the56 option holder has bargained for the right to acquire a capital account in excess 51. see prop. regs. § 1.704-1(b)(2)(iv)(s)(4). a corrective allocation is an allocation for tax purposes of gross income or other items that differs from the partnership’s allocation of the corresponding book items. see prop. regs. § 1.7041(b)(4)(x). if the partnership has significant gross income, corrective allocations may trigger immediate income to the option holder, reducing the historic partners’ share of income and eliminating any deferral to the option holder. 52. alternatively, the option holder could be viewed as having been entitled to a share of appreciation from the outset. see gergen, supra note 37, at 357 n.49 (“in truth, the original partners give up and get nothing on exercise for the option holder always had a claim on asset appreciation.”). 53. thus, corrective allocations are necessary only with respect to capital account reallocations which represent shifts in value that have already been taken into account for book purposes. 54. although the regulations do not specifically state that the historic partners are entitled to nonrecognition treatment upon a capital shift, the examples confirm such treatment. see, e.g., prop. regs. § 1.704-1(b)(5) ex. 21. 55. simon friedman, a better tax treatment of compensatory options, 90 tax notes 1107, 1107 (feb. 19, 2001). 56. see preamble, supra note 39, at 544. see also rev. rul. 78-182, 1978-1 c.b. 265 (from the option holder’s perspective, purchase of an option is merely an investment in the option). 664 florida tax review [vol.6:6 of the amount of his contributions. thus, the option holder has simply made a bargain purchase of a partnership interest or, equivalently, a share of partnership assets. generally, an option to acquire a partnership interest is likely to be “out of the money” at the time of grant, since the holder is speculating on future appreciation in the property subject to the option. by contrast, a hypothetical option to acquire a discounted partnership interest, as in the above example, is likely to be “in the money” at the time of grant if the property subject to the option is viewed as a share of the underlying partnership assets. from this perspective, the option privilege represents the ability of the option holder to unlock excess inside value upon a sale of the partnership’s assets or a liquidation of the partnership. although the economic value of such57 an option may be difficult to measure, it is clearly greater than zero. nor is there any reason to believe that the value of the option is accurately reflected in the discounted value assigned to the minority partnership interest when the shifted value merely reappears in a related transferee’s capital account. the proposed regulations suggest the alternative possibility of measuring the value of the option privilege based on a liquidation approach. for example, the proposed regulations require the pre-exercise “fair market value” of an option to be determined in connection with a revaluation of partnership assets upon admission of a new partner. if the revaluation failed to take the58 fair market value of the option into account, the historic partners’ capital accounts would generally be overstated because the option holder may ultimately be entitled to a portion of the partnership’s assets. in this situation, the fair market value of an option is deemed to be equal to the value of the assets to which the option holder would be entitled on exercise of the option followed by an immediate liquidation of the partnership, less the exercise price. by identifying the fair market value of the option with the share of59 underlying partnership assets to which the option holder would be entitled, the proposed regulations apparently assume away the problem of a discount for a minority interest. of course, such a liquidation approach is arguably60 57. see lokken, supra note 37, at 375 (alternative view that “all partnership interests are minority interests, none is more valuable than any other and the excess of inside value over outside value does not truly exist for any partner until it is unlocked by sale of the [partnership’s assets] and distribution of the proceeds to the partners”). 58. see prop. regs. § 1.704-1(b)(2)(iv)(h)(2). 59. although the proposed regulations do not specifically prescribe the method of determining an option’s fair market value, the examples consistently adopt a liquidation approach. see, e.g., prop. regs. § 1.704-1(b)(5) ex. 22. 60. see paul carman & sheldon i. banoff, proposed regulations on noncompensatory partnership options: no gain, some pain, 98 j. tax’n 197, 221-22 (apr. 2003) (noting problems that arise if discounts are taken into account in determining the actual fair market value of an option). 2004] family limited partnerships 665 unrealistic if the option is viewed as entitling the option holder only to a discounted partnership interest, not a proportionate share of partnership assets.61 in other situations involving transfers of hard-to-value interests, however, the service has also used a liquidation approach to measure the fair market value of the transferred interest. for example, the service has ruled that the taxable value of a partnership interest received in exchange for services should be determined based on the liquidation value of the interest. in effect,62 the liquidation approach disregards certain factors (e.g., rights to manage the partnership and restrictions on transferability) that theoretically should be taken into account in valuing such an interest. one advantage of the liquidation63 approach is its relative ease of administration, since it requires valuing only the partnership’s underlying assets. thus, application of subchapter k rules in64 other areas may furnish indirect support for a liquidation approach in determining the amount of a capital shift for gift and estate tax purposes. iv. preserving value to the extent that the problem of disappearing value flows from inconsistent valuation assumptions in the separate steps of the transaction, it may be appropriate to impose a consistent framework for valuing the partnership interest in both steps. a consistent valuation rule could be formulated in any of several ways. one approach, based on the capital account rules of subchapter k, would deem the transferor’s partnership interest to have a value equal to the assets that would be distributed to the transferor in a hypothetical liquidation of the partnership. under this capital account approach, there would still be no taxable gift in the initial exchange because the transferor would receive a partnership interest equal to the value of the contributed assets (as reflected in his or her capital account, assuming compliance with the capital account rules of section 704(b)). in the subsequent transfer the partnership interest would again be valued as a proportionate share of the inside value of the partnership assets. as a result, no entity discount would be allowed in the 61. because the liquidation approach requires that a portion of the partnership’s assets be effectively “set aside” for anticipated future allocation to the option holder, the references to the fair market value of an option may not be intended literally. 62. see rev. proc. 93-27, 1993-2 c.b. 343; see also rev. proc. 2001-43, 20012 c.b. 191. 63. see nysba report, supra note 38, at 1201-02 (noting that the liquidation approach would create a disparity between the treatment of corporate stock options under § 83 and compensatory partnership options under subchapter k, but recommending such an approach to achieve “internal consistency within subchapter k”). 64. see id. at 1202 (liquidation approach “does not require analyzing myriad other factors (many of which are quite subjective) relevant to determining the true fair market value of a partnership interest”). 666 florida tax review [vol.6:6 subsequent transfer, and the transferor would make a taxable gift of the full amount that he or she would be entitled to receive in a hypothetical liquidation. the capital account approach would undoubtedly prove controversial. in 1995 the treasury department attempted to extend the anti-abuse rules of subchapter k to curb transfer tax avoidance techniques. although the rules65 could be interpreted narrowly to disallow entity discounts only for family partnerships involving non-business, non-income-producing assets (e.g., a vacation home), the rules were promulgated without the usual opportunity for66 public comment and were hastily withdrawn following an outcry from members of the tax and estate planning bars. by limiting the scope of the anti-abuse67 rules to income tax avoidance and failing to address valuation discounts in the transfer tax context, the treasury department has created a vacuum of guidance which has in turn encouraged the development and marketing of aggressive techniques involving family partnerships.68 the proliferation of entity discounts also prompted the clinton administration to propose curbing valuation discounts by requiring that interests in certain entities be valued based on a proportional share of the net value of the entity’s non-business assets. this proposal reflected the notion that it is69 appropriate to allow entity discounts based on the traditional fair market value standard in a bona fide business setting but that a stricter standard is needed in a non-business setting. similarly, the present discussion focuses primarily on70 65. see t.d. 8588, 60 fed. reg. 23, 29 (jan. 3, 1995), promulgating regs. § 1.701-2(d) exs. 5 and 6. 66. the anti-abuse rules originally included an example involving a vacation home held in a family partnership. in that example, the partnership lacked any substantial business purpose. because the subsequent transfer of discounted partnership interests would produce a substantial reduction in aggregate federal tax liability, the service asserted the right to recast the transaction in a manner consistent with the intent of subchapter k. see id. ex. 6. in contrast, another example involving actively-managed, income-producing property passed muster under the anti-abuse rules. see id. ex. 5. in a subsequent revision of the anti-abuse rules, however, both examples were deleted. see infra note 67 and accompanying text. 67. see t.d. 8592, 60 fed. reg. 18741 (apr. 13, 1995) (revised final regulations, omitting exs. 5 and 6). 68. for example, the family partnership documents in strangi were based on forms provided by the fortress financial group, inc., which “trains and educates professionals on the use of family limited partnerships” as a tax and estate planning tool. see estate of strangi v. commissioner, 115 t.c. 478, 480, aff’d in part and rev’d in part on other grounds, 293 f.3d 279 (5th cir. 2002). 69. see staff of the joint comm. on tax’n, description of revenue provisions contained in the president’s fiscal year 2000 budget proposal 291 (jcs 1-99, feb. 22, 1999). 70. see cunningham, supra note 1, at 1469 (noting the definitional problem of carving out an exception for family partnerships engaged in an “active business”). 2004] family limited partnerships 667 family partnerships that have no substantial business purpose. family71 partnerships offer special opportunities for transfer tax avoidance because they can ordinarily be formed and liquidated without any toll charge in the form of an income tax on contributions or distributions of appreciated assets.72 moreover, the capital account analysis pursued here is particularly well suited to deal with family partnerships. to the extent this analysis helps to resolve the problem of disappearing value in the core case of family partnerships, it may serve as a starting point to address related but distinct problems involving other forms of ownership such as closely held corporations, joint tenancies, and73 74 trusts.75 71. the existence of a substantial business purpose may present a factual controversy. see, e.g., estate of strangi, 115 t.c. at 484-87 (expressing skepticism concerning purported business purpose but nevertheless concluding that “the partnership had sufficient substance to be recognized for tax purposes”). similar questions arise in determining whether an arrangement falls within the statutory safe harbor for a “bona fide business arrangement” under § 2703. see irc § 2703(b). 72. see irc §§ 721, 731. careful planning may be necessary, however, to avoid recognizing gain on certain contributions or distributions of appreciated assets. see irc §§ 704(c)(1)(b) (distribution of contributed built-in gain property within seven years), 721(b) (contribution to investment partnership), 731(c) (distribution of marketable securities), 737 (distribution to contributing partner within seven years). see thomas i. hausman, mixing bowls and marketable securities in a family limited partnership, 101 tax notes 373 (oct. 20, 2003); mark p. gergen, potential tax traps in liquidating a family limited partnership, 101 tax notes 1431 (dec. 22, 2003). 73. distributions of appreciated assets from a partnership ordinarily do not constitute a taxable event. see supra note 72 and accompanying text. in contrast, distributions of appreciated assets from a corporation give rise to an income tax at the entity level. see irc §§ 311(b) and 336(a). in some cases, a built-in capital gain tax liability may give rise to a discount in valuing a transfer of shares. see estate of eisenberg v. commissioner, 155 f.3d 50 (2d cir. 1998); estate of dunn v. commissioner, 301 f.3d 339 (5th cir. 2002). individual shareholders may also face a substantial toll charge as a result of a corporate distribution, notwithstanding the current preferred rates for qualifying dividends. see irc § 1(h)(11)(a). 74. as a practical matter, joint ownership is less attractive than a family partnership for two reasons. first, the creation of a joint tenancy often results in either a gift tax (if one party furnishes all of the consideration) or an income tax (if there is an exchange of interests in appreciated assets). second, a joint tenancy with fragmented ownership and control may lead to difficulties in reaching decisions concerning management or liquidation of the underlying property. the “fractional interest” discount allowed in valuing a transfer of an undivided joint ownership interest is typically smaller than the entity discount allowed for a limited partnership interest in a family partnership. see supra note 12 and accompanying text. indeed, the tax court has denied any fractional interest discount in valuing a joint tenancy interest in real property for estate tax purposes under irc § 2040(a). see estate of young v. commissioner, 110 t.c. 297 (1998). 75. from a functional perspective, perhaps the closest analog to a family partnership is an express private trust. denying an entity discount in valuing partnership interests would be fully consistent with the actuarial valuation methods traditionally employed in valuing trust interests. see irc § 7520. 668 florida tax review [vol.6:6 if the capital account approach is rejected, an obvious alternative would be to require consistent valuation of the partnership interest reflecting the discount claimed by the taxpayer. this entity discount approach would result in a taxable gift at the formation of the partnership, to the extent that the value of the assets contributed to the partnership exceeds the discounted value of the partnership interest received in exchange. it should not matter that the excess76 inside value is now locked in the transferor’s capital account, since the transferor has deliberately taken advantage of the partnership form to claim an entity discount. the main difference between the two approaches is one of77 timing: under the entity discount approach a taxable gift occurs at the formation of the partnership, while under the capital account approach the taxable event is deferred until the transferor disposes of the partnership interest during life or at death. under either approach, however, the transferor’s proportional share78 of the inside value of the partnership assets would be included in his or her transfer tax base. a somewhat different approach to the problem of disappearing value is found in section 2036, which requires that property transferred during life be drawn back into the gross estate at death if the decedent retained possession or enjoyment of the property or a right to control beneficial enjoyment of the property for life. section 2036 has recently been invoked to reach assets held79 in a family partnership where the decedent retained substantially unimpeded access to the partnership assets until death. the effect of section 2036, where80 76. see supra note 3 and accompanying text. 77. see schmolka, supra note 1, at 1486 (“it makes no difference where the [excess inside value] goes, or, indeed, whether it goes anywhere”). with this analysis, compare the analysis in estate of bosca v. commissioner, 76 t.c. memo (cch) 62, t.c. memo (ria) 98,251 (1998), holding that a 50% shareholder who exchanged voting shares for nonvoting shares in a corporate recapitalization made separate gifts to the other two 25% shareholders equal to the value of the relinquished voting rights in two 25% blocks of stock. 78. if the value of the partnership assets is expected to appreciate substantially, a rational taxpayer might prefer to incur a gift tax immediately on formation of the partnership, in order to avoid incurring a later tax at a higher marginal rate. experience suggests, however, that taxpayers often prefer to defer paying transfer tax even if this results in a higher overall tax burden. 79. see irc § 2036(a)(1) (retained “possession or enjoyment of, or the right to the income from, the property”), (a)(2) (retained right “to designate the persons who shall possess or enjoy the property or the income therefrom”). under § 2036(b), retention of the right to vote shares of stock in a controlled corporation is treated as retention of the enjoyment of transferred property for purposes of § 2036(a)(1). by its terms, however, § 2036(b) applies only to stock in a controlled corporation, not to interests in a family partnership. see irc § 2036(b). 80. see estate of schauerhamer v. commissioner, 73 t.c. memo (cch) 2855, t.c. memo (ria) 97,242 (1997); estate of reichardt v. commissioner, 114 t.c. 144 (2000); estate of harper v. commissioner, 83 t.c. memo (cch) 1641, t.c. memo (ria) 2002-121 (2002); estate of thompson v. commissioner, 84 t.c. memo (cch) 2004] family limited partnerships 669 it applies, is to disregard the existence of the partnership and to negate any entity discount previously allowed with respect to a lifetime gift of the partnership assets. in this sense, section 2036 may be viewed as an antidote to the lenient gift tax treatment of family partnerships. the reach of section 2036, however, is limited. if the transferor is careful to observe the formalities of partnership formation and operation during life, and is willing to relinquish management and control to other family members, the family partnership remains viable as a technique for making value disappear for gift and estate tax purposes. this is so even if after the transferor’s death the other partners81 promptly liquidate the partnership in order to unlock the undiscounted value of the partnership assets. in theory the “back-end” approach of section 2036 could be expanded to address family partnerships more comprehensively. a more flexible “front-82 end” approach, however, would focus on gift tax valuation and would assign a tentative value of zero to a partnership interest received in exchange for a contribution to a family limited partnership. this approach, which draws on the present law treatment of hard-to-value partial interest transfers and resembles the zero-value rule of section 2701, has the advantage of fitting in rather easily with traditional gift tax principles. under the proposed approach, a83 contributing partner would be free to overcome the zero-value rule by showing that his or her partnership interest had a positive fair market value. to provide maximum flexibility, the partner could even be allowed to elect a special value for the partnership interest anywhere in the range from zero to the value of the contributed assets. any difference between the value of the contributed assets and the special value of the retained partnership interest would be treated as a transfer for gift tax purposes. moreover, the partner would be required to report any subsequent transfer of the retained partnership interest, during life or at 374, t.c. memo (ria) 2002-246 (2002); estate of strangi v. commissioner, 85 t.c. memo (cch) 1331, t.c. memo (ria) 2003-145 (2003). for critical commentary on the strangi decision, see mitchell m. gans & jonathan g. blattmachr, strangi: a critical analysis and planning suggestions, 100 tax notes 1153 (sept. 1, 2003); louis a. mezzullo, is strangi a strange result or a blueprint for future irs successes against flps?, 99 j. tax’n 45 (july 2003). 81. see, e.g., estate of stone v. commissioner, 86 t.c. memo (cch) 551, t.c. memo (ria) 2003-309 (2003). 82. under former § 2036(c), enacted in 1987 and amended in 1988, if a person held a substantial interest in an enterprise and transferred property having a disproportionately large share of the potential appreciation in the interest while retaining an interest in the income of, or rights in, the enterprise, the transferred property would be drawn back into the gross estate under § 2036(a)(1). this provision drew fierce criticism from the tax bar and organized interest groups, and was eventually repealed in 1990 concurrently with the enactment of §§ 2701 through 2704. 83. see robinette v. helvering, 318 u.s. 184 (1943); regs. § 25.2511-1(e). cf. irc § 2701(a)(3)(a) (zero-value rule). 670 florida tax review [vol.6:6 death, using a consistent valuation assumption. the valuation adjustment in84 the subsequent transfer would ensure that any portion of the value of the contributed assets that escaped gift tax in the initial transfer would ultimately be included in the partner’s gift or estate tax base, and would also avoid double taxation of any portion previously included at the time of the initial transfer, by analogy to principles of existing law.85 to illustrate the proposed front-end approach, assume that parent contributes $99 to a newly formed partnership in exchange for a 99% limited partnership interest; child contributes $1 in exchange for a 1% general partnership interest. parent would be treated as making a gift of $99 unless she either proved that her limited partnership interest had a positive fair market value or elected to assign a special value (between zero and $99) to her interest. if the zero-value rule applied, parent would be treated as making a gift of $99, but on a subsequent transfer her interest would be deemed to be worthless, consistent with the valuation assumption in the initial transfer. alternatively, if parent claimed a one-third discount (for lack of control and marketability) and established a fair market value of $66, on a subsequent transfer the value of her interest would be deemed to be equal to two-thirds of its liquidation value (i.e., the value of the partnership assets that would be distributed to her in a hypothetical liquidation of her interest). if she elected a special value of $99, there would be no gift upon formation of the partnership, and on a subsequent transfer the full liquidation value of her interest would be subject to gift or estate tax. v. conclusion the basic family partnership transaction involves nothing more complicated than a parent’s initial contribution of assets in exchange for a partnership interest, followed by a subsequent transfer of the partnership interest to a child. under existing law, the transaction can be structured to avoid any taxable gift on the formation of the partnership and to generate substantial valuation discounts on the subsequent transfer of the partnership interest. as a result, the difference between the inside value of the contributed assets and the outside value of the partnership interest escapes gift and estate tax in the parent’s hands, even though the assets remain intact and available for distribution to the child upon liquidation of the partnership. 84. the concept of an election to claim or forego favorable tax treatment in an initial transfer coupled with consistent treatment in a subsequent transfer has counterparts in existing law. cf. irc § 2701(c)(3)(c) (election into or out of special valuation rules), 2701(e)(6) (valuation adjustment on subsequent transfer). cf. also irc §§ 2044, 2056(b)(7), 2519, 2523(f), relating to qualified terminable interest property. 85. cf. rev. rul. 84-25, 1984-1 c.b. 191. 2004] family limited partnerships 671 there is nothing inherently abusive in allowing valuation discounts for lack of marketability and lack of control in connection with the subsequent transfer of the partnership interest. instead, the problem of disappearing value reflects a discrepancy between the tax treatment of the initial exchange and the subsequent transfer. the courts hold that no taxable gift occurs on formation of the partnership, if capital accounts are properly maintained and no capital is shifted from one partner to another. although the capital account rules developed in the income tax context do not necessarily control the valuation of partnership interests for transfer tax purposes, they help to expose the problem of disappearing value. in effect, the courts treat the formation of the partnership as an ordinary business transaction in which each partner is deemed to receive adequate and full consideration for his or her contribution. typically,86 however, the formation of a family partnership is not an ordinary business transaction but rather an initial step in a donative transfer between related parties. when a parent contributes assets to the partnership in exchange for a partnership interest of lesser value, the difference in value is not destroyed but merely suspended in partnership solution. so far, the courts have failed to provide a coherent explanation for exempting the unequal exchange from the reach of the gift tax. one possible reason for treating the parent leniently is that it is not clear at the time of the initial exchange that the assets contributed by the parent will actually emerge intact in the child’s hands. it is possible, though unlikely, that a disagreement may erupt within the family or that the parent may sell his or her partnership interest to an unrelated party for its fair market value. but this sort of uncertainty about future events does not generally prevent an unequal exchange occurring outside the ordinary course of business from being treated as a taxable gift. another possible concern is that a child who ultimately expects to benefit from a gift of the parent’s partnership interest, should not incur a gift tax on his or her contribution to the partnership. the simplest way to avoid this problem is to allow the child to elect to ignore the entity discount upon formation of the partnership while requiring that the child abide by a consistent valuation assumption on any subsequent transfer of his or her partnership interest. under the flexible front-end approach described above, each partner would be free to elect the most convenient and advantageous assumption for valuing his or her partnership interest upon formation of the family partnership, but would be required to apply a consistent assumption in a subsequent transfer. each partner could make the election independently of the others, but the end result would be to capture the value that disappears from 86. under the gift tax regulations, a “transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm’s length, and free from any donative intent)” is exempt from gift tax because such a transfer is “considered as made for an adequate and full consideration in money or money’s worth.” regs. § 25.2512-8. 672 florida tax review [vol.6:6 the transfer tax base under existing law as a result of inconsistent valuation assumptions. ** addendum ** note to readers: following the completion of this article in the spring of 2004, the federal appellate courts issued decisions in kimbell v. united states, 371 f.3d 257 (5th cir. 2004), and turner v. commissioner, 382 f.3d 367 (3d cir. 2004). although these two decisions clearly represent contrasting approaches to the estate tax treatment of family limited partnerships under section 2036(a), they do not significantly affect the analysis or the conclusions set forth in the article. preserving value tcharity really does begin at home: florida tax review volume 7 2005 special issue recent developments in federal income taxation: the year 2004 ira b. shepard * martin j. mcmahon, jr.** i. accounting. ................................................................................. 51 a. accounting methods........................................................... 51 b. inventories. ......................................................................... 53 c. installment method............................................................. 53 d. year of receipt or deduction. ............................................ 53 ii. business income and deductions. ........................................... 55 a. income. ............................................................................... 55 b. deductible expenses versus capitalization........................ 57 c. reasonable compensation. ................................................ 60 d. miscellaneous expenses. .................................................... 61 e. depreciation and amortization. ......................................... 62 f. credits. ............................................................................... 64 g. natural resources deductions & credits. ......................... 64 h. loss transactions, bad debts and nols........................... 65 i. at-risk and passive activity losses. .................................. 66 iii. investment gain. ........................................................................ 66 a. capital gain and loss. ...................................................... 66 b. section 1031. ...................................................................... 68 c. section 1041. ...................................................................... 70 d. section 1042. ...................................................................... 72 iv. compensation issues. ................................................................ 73 a. fringe benefits. .................................................................. 73 b. qualified deferred compensation plans. .......................... 74 c. nonqualified deferred compensation, section 83, and stock options. .................................................................... 77 d. individual retirement accounts. ........................................ 78 v. personal income and deductions. ......................................... 79 a. rates................................................................................... 79 * professor of law, university of houston law center. ** clarence j. teselle professor of law, university of florida fredric g.levin college of law. 47 48 florida tax review [vol.7:si b. miscellaneous income. ....................................................... 80 c. profit-seeking individual deductions. ............................... 80 d. hobby losses and section 280a home office and vacation homes. ................................................................ 84 e. deductions and credits for personal expenses. ................ 84 f. education. .......................................................................... 85 vi. corporations. ............................................................................. 85 a. entity and formation. ........................................................ 85 b. distributions and redemptions. ......................................... 85 c. liquidations. ...................................................................... 87 d. s corporations. .................................................................. 87 e. affiliated corporations. ..................................................... 90 f. reorganizations. ................................................................ 92 g. corporate decisions. ......................................................... 93 h. personal holding companies and accumulated earnings tax. ..................................................................... 93 i. miscellaneous corporate issues. ....................................... 94 vii. partnerships. .............................................................................. 95 a. formation and taxable years............................................ 95 b. allocations of distributive share partnership debt, and outside basis............................................................... 95 c. distributions and transactions between the partnership and partners. .................................................. 96 d. sales of partnership interests, liquidations and merges......................................................................... 96 e. inside basis adjustments. ................................................... 98 f. partnership audit rules. .................................................... 98 g. miscellaneous..................................................................... 98 viii. tax shelters. .............................................................................. 98 a. tax shelter cases. .............................................................. 98 b. identified “tax avoidance transactions”. ......................... 104 c. disclosure and settlement. ............................................... 108 d. tax shelter penalties, etc.. ............................................... 114 e. individual tax shelters. ................................................... 117 f. tax shelter discovery. ..................................................... 117 ix. exempt organizations and charitable giving. ............... 121 a. exempt organizations . .................................................... 121 b. charitable giving. ........................................................... 122 x. tax procedure. ......................................................................... 123 a. interest, penalties and prosecutions. ............................... 123 b. discovery: summonses and foia.................................... 123 c. litigation costs. ............................................................... 124 d. statutory notice................................................................ 125 e. statute of limitations. ...................................................... 125 2005] recent developments in federal income taxation 49 f. liens and collections. ...................................................... 126 g. innocent spouse. .............................................................. 130 h. miscellaneous................................................................... 131 xi. witholding and excise taxes. .............................................. 139 a. employment taxes. .......................................................... 139 b. self-employment. .............................................................. 139 c. excise taxes. .................................................................... 139 xii. tax legislation........................................................................ 140 a. enacted. ........................................................................... 140 50 florida tax review [vol.7:si recent developments in federal income taxation: the year 2004 by ira b. shepard martin j. mcmahon, jr. this current developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the year 2004. most treasury regulations, however, are so complex that they cannot be discussed in detail; only the basic topic and fundamental principles are highlighted. amendments to the internal revenue code generally are not discussed unless they are significant or have led to administrative rulings and regulations that are covered by the outline. the outline focuses primarily on topics of broad general interest: income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, but generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. 2005] recent developments in federal income taxation 51 i. accounting a. accounting methods 1. really kind taxpayer-favorable § 481 adjustments. rev. proc. 2002-19, 2002-13 i.r.b. 696 (1/1/02). this revenue procedure modifies rev. proc. 97-27, 1997-1 c.b. 680, and rev. proc. 2002-9, 2002-3 i.r.b. 327 (1/22/02). it revises the revised rules for obtaining the irs’s consent to changes in accounting methods. the most significant changes to rev. proc. 97-27 and rev. proc. 2002-9 are: (1) allowing a taxpayer to change its method of accounting prospectively, without audit protection, when the method to be changed is an issue pending for a taxable year under examination or an issue under consideration by either an appeals office or a federal court; and (2) taking negative, i.e., taxpayer-favorable, § 481(a) adjustments into account entirely in the year of change. this revenue procedure was amplified and clarified by rev. proc. 2002-54, 2002-35 i.r.b. 432 (8/14/02). a. and just a little more for taxpayers in the name of simplicity. reg-142605-02, administration simplification of section 481(a) adjustment periods in various regulations, 68 f.r. 25310 (5/12/03). proposed amendments to regulations under §§ 263a and 448 to allow taxpayers changing a method of accounting to take any § 481(a) adjustments over the same number of taxable years that is provided in the general guidance provided under rev. proc. 92-27, 1997-1 c.b. 680 (as modified and amplified by rev. proc. 2002-19, 2002-13 i.r.b. 696, and modified by rev. proc. 2002-54, 2002-35 i.r.b. 432) for accounting method changes [four years for positive adjustments and one year for negative adjustments]. (1) made final. t.d. 9131, administration simplification of section 481(a) adjustment periods in various regulations, 69 f.r. 33571 (6/15/04). effective on and after 6/16/04. b. new regulations provide that a change in depreciation will generally constitute a change in accounting method. t.d. 9105, changes in computing depreciation, 69 f.r. 5 (1/2/04); reg126459-03, 69 f.r. 42 (1/2/04). these final, temporary and proposed regulations provide that changes in depreciation or amortization are generally changes in accounting method under reg. § 1.446-1(e). additionally, these regulations (1) amend reg. § 1.167(e)-1 to provide that certain changes in depreciation method for property for which depreciation is determined only under § 167 are not changes in accounting method, and (2) amend reg. § 1.1016-3 to provide that § 1016(a)(2) does not permanently affect a 52 florida tax review [vol.7:si taxpayer’s lifetime income for purposes of determining whether a change in depreciation or amortization is a change in method of accounting. ! the useful life exception to the general rule that a change in depreciation method is a change in accounting applies only to property for which depreciation is determined under § 167. however, a change to or from a useful life (or recovery period or amortization period) that is specifically assigned by the code, the regulations, or other guidance published in the internal revenue bulletin is a change in method of accounting. ! other exceptions include (1) a change in computing depreciation allowances made in the year in which the use of property changes in the hands of the same taxpayer, (2) the making of a late depreciation election or the revocation of a timely valid depreciation election, and (3) a change in the placed-in-service date of an asset. (1) automatic consent procedure to make a change in method of accounting for depreciable or amortizable property after its disposition. rev. proc. 2004-11, 2004-3 i.r.b. 311 (12/30/03). this revenue procedure provides an automatic consent procedure that allows a taxpayer to make a change in method of accounting under § 446(e) for depreciable or amortizable property disposed of in the year of change. this revenue procedure modifies rev. proc. 2002-9 (as modified by rev. proc. 2002-54, rev. proc. 2002-19, rev. proc. 2002-33, and as modified and clarified by announcement 2002-17), and other revenue procedures to conform with temp. reg. § 1.446-1t(e)(2)(ii)(d), and waives the application of the two-year rule set forth in rev. rul. 90-38, 1990-1 c.b. 57, and holds that one year is sufficient to establish even an erroneous method of accounting. ! accounting method changes with respect to depreciation may be made so long as the year of sale of the property is open. 2. credit card issuers may recognize annual fee income ratably over the year under the ratable inclusion method, whether or not the fee is refundable on a pro rata basis should the cardholder close the account during the year. rev. proc. 2004-32, 2004-22 i.r.b. 988 (6/1/04). credit card issuers described in rev. rul. 2004-52, i.e., those on the accrual method that charge cardholders a credit card annual fee under agreements that allow each cardholder to use a credit card to access a revolving line of credit to make purchases of goods and services (and, if so authorized, to obtain cash advances), are permitted to use the ratable inclusion method for credit card annual fees. under this method a credit card is recognized in income ratably over the period covered by the fee. 2005] recent developments in federal income taxation 53 a. if not on the ratable inclusion method, credit card issuers must include annual fees in income when they are due and payable. rev. rul. 2004-52, 2004-22 i.r.b. 973 (6/1/04). this revenue procedure holds that (1) credit card annual fees are not interest for federal income tax purposes, and (2) credit card fees are includible in gross income when they become due and payable under the terms of the credit card agreements. notwithstanding the holding of this ruling, rev. proc. 2004-32 allows issuers to account for annual fee income using the ratable inclusion method for credit card annual fees, and that revenue procedure also provides automatic consent for a taxpayer to change its method of accounting for annual fee income. b. inventories there were no significant developments regarding this topic during 2004. c. installment method there were no significant developments regarding this topic during 2004. d. year of receipt or deduction 1. section 461(f) deductions for transfers related to contested liabilities. t.d. 9095, transfers to provide for satisfaction of contested liabilities, 68 f.r. 65634 (11/21/03); reg-136890-02, 68 f.r. 65645 (11/21/03). the treasury has promulgated temporary regulations and published identical proposed regulations clarifying issues under § 461(f) and coordinating § 461(f) and § 461(h) [the economic performance requirement]. temp. reg. § 1.461-2t(c)(1) and prop. reg. § 1.461-2(c)(1) provide that the transfer to a trust of the transferor’s debt instrument or stock, or the stock or indebtedness of a related person or corporation, does not give rise to a deduction under § 461(f) with respect to a contested liability. temp. reg. § 1.461-2t(e) and prop. reg. § 1.461-2(e) provide that a payment to a trust to provide for satisfaction of a contested claim with respect to which the economic performance rules of § 461(h) require payment to the claimant – e.g., tort and workers compensation claims, rebates, prizes and jackpots, warranty claims, etc. – will not result in a deduction under § 461(f) so long as the economic performance rules are not satisfied. a. fudging around with § 461(f), especially when combined with economic performance requirements, makes for a “listed transaction.” notice 2003-77, 2003-49 i.r.b. 1182 (11/19/03), clarified 54 florida tax review [vol.7:si (12/1/03). certain contested liability trusts used improperly to attempt to accelerate deductions under § 461(f) are identified as “listed transactions.” these transactions include those involving: (1) retention of powers over the trust assets by the taxpayer; (2) transfers of promissory notes to a trust under circumstances indicating the underlying liability is not genuine; (3 and 4) transfers to trusts for contested tort, workers compensation and similar, liabilities for which economic performance requires payment to the claimant, except where the trust is the person to which the liability is owed or payment to the trust discharges the taxpayer’s liability to the claimant; and (5) transfers of stock of the taxpayer, or indebtedness or stock issued by a party related to the taxpayer, that are made on or after 11/19/03 to a trust purported to be established under § 461(f). b. retroactive change in accounting method by filing amended returns is the exclusive procedure for getting out of this box. rev. proc. 2004-31, 2004-22 i.r.b. 986 (5/6/04). this revenue procedure sets forth exclusive procedures for obtaining consent to change accounting methods for transfers related to contested liabilities described in notice 2003-77, which requires that taxpayer amend its return for the year in which the (accelerated) deduction was taken (or the earliest open year if that year is closed) and include the entire § 481(a) adjustment in income in that year. ! while under rev. rul. 90-38, 1990-1 c.b. 57, a taxpayer must use an erroneous method for two or more consecutive years to adopt a method of accounting, this procedure requires taxpayers whose transactions were listed to change accounting method. 2. “hello, i’m from the irs, and i’m here to help you.” – and this time it really is true. rev. proc. 71-21 deferral of prepaid income rules loosened. notice 2002-79, 2002-50 i.r.b. 964 (12/16/02). this notice is a proposed revenue procedure to modify and supersede rev. proc. 71-21, 1971-2 c.b. 549. the proposed revenue procedure would expand the availability of deferred reporting of advance receipts that are not accrued for financial accounting. first, certain income from other than services would be eligible: (1) sales of goods not covered by reg. § 1.4515(b)(1)(ii); (2) rents for the use of property in connection with the provision of services, e.g., hotel rooms, recreational facilities, cable converter boxes; (3) royalties for intellectual property; (4) warranties of services or items in the three preceding categories; (5) subscriptions not subject to §455; and (6) memberships not subject to § 456. second, payments would be eligible even if performance might extend beyond the next succeeding year, although deferral could not extend beyond the next succeeding year. the revenue procedure will not apply to rents generally, insurance premiums, or payments with respect to financial instruments. 2005] recent developments in federal income taxation 55 a. finalizes (with modifications) the proposed procedure first announced in notice 2002-79. payments for use of intellectual property are added to the list of payments that may be deferred. rev. proc. 2004-34, 2004-22 i.r.b. 991, modifying and superseding rev. proc. 71-21, 1971-2 c.b. 549. this revenue procedure permits deferral of income by accrual basis taxpayers, but not beyond the next succeeding tax year. ! qualifying advance payments include services; goods other than those utilizing §1.451-5; use of intellectual property, i.e., copyrights, patents, trademarks, service marks, trade names, and similar items; occupancy or use of property if ancillary to the provision of services; sale, lease, or license of computer software; guaranty or warranty contracts ancillary to the above items; subscriptions; memberships in an organization; and combinations of the above qualifying items. ! non-qualifying advance payments include rents; insurance premiums; payments with respect to financial instruments (but see rev. proc. 2004-32 allowing deferral for credit card annual fees); payments with respect to certain service warranty contracts; payments subject to withholding; and payments in property for § 83 services. b. no deferral for advance rental receipts. reg151043-02, rents and royalties, 67 f.r. 77450 (12/18/02). the treasury department has published a proposed amendment to reg. § 1.61-8(b) that expressly require current inclusion of advance rent receipts, regardless of the period covered or the taxpayers method of accounting, except as otherwise provided in § 467 or in other published guidance. (1) made final, t.d. 9135, rents and royalties, 69 f.r. 41192 (7/7/04). ii. business income and deductions a. income 1. congress might have changed one of the holdings of gitlitz, but the treasury put another one in the regulations. t.d. 9080,1 reduction of tax attributes due to discharge of indebtedness, 68 f.r. 42590 (7/21/03). the treasury has promulgated temp. reg. §§ 1.108-7t and 1.1017-1t(b)(4), dealing with reduction in tax attributes under §§ 108(b) 1. gitlitz v. commissioner, 531 u.s. 206 (2001). see, job creation and worker assistance act of 2002, which reverses the result of gitlitz by providing that excluded cancellation of indebtedness income of s corporations does not result in a § 1366 adjustment to the basis of stock owned by the shareholders. 56 florida tax review [vol.7:si and 1017 when cod income is excluded from income under § 108(a)(1)(a)c). examples (and the preamble) indicate that the tax liability for the year of discharge first must be determined without any reduction in attributes in order to identify the amounts, if any, of the tax attributes that will be reduced. “this ordering rule affords the taxpayer the use of certain of its tax attributes described in section 108(b)(2), including any losses carried forward to the taxable year of discharge, for purposes of determining its tax for the taxable year of discharge, before subjecting those attributes to reduction.” basis reductions under § 1017 occur at the beginning of the taxable year following the year in which the discharge occurred. if a § 381 transaction ends in a taxable year in which the distributing or transferor corporation excluded cod income under § 108(a), the basis of the property acquired by the acquiring corporation reflects the reduction under § 1017. a. temporary regulations are made final. t.d. 9127, reduction of tax attributes due to discharge of indebtedness, 69 f.r. 26038 (5/11/04). in order that the attribute reduction result in a deferral, rather than a permanent elimination, of income, the final regulations provide that the basis of stock or securities of a corporation received by the taxpayer in a § 381(a) transaction is not available for reduction under § 108(b)(2). final and temporary regulations are effective 5/10/04. 2. this deduction should prove so effective that it will be extended to all business income. section 102 of the american jobs creation act of 2004 adds new § 199 to provide a nine percent deduction for u.s. manufacturing income, i.e., “income attributable to domestic production activities.” the deduction may not exceed 50 percent of the w-2 wages of the employer for the taxable year. the deduction will be phased in over six years, beginning with 2005. ! the provision was meant to replace the export subsidy that was found illegal by the world trade organization, i.e., the deduction of extraterritorial income (eti), which will be eliminated in 2007 after being phased out in 2005 [80 percent deduction] and 2006 [60 percent deduction]. a. if the statute appears to have a short shelf-life, the guidance under it should be even more ephemeral. notice 2005-14, 2005-7 i.r.b. 498 (2/14/05). lengthy guidance on the new manufacturing deduction. 2005] recent developments in federal income taxation 57 b. deductible expenses versus capitalization indopco aftermath: “. . . deductions are exceptions to the norm of capitalization . . . .” indopco, inc. v. commissioner, 503 u.s. 79, 84 (1992) (blackmun, j.) 1. kudos from taxpayers; pans from professors. treasury abandons the future benefits test of indopco – long live the separate and distinct asset test. or, do the final regulations go beyond the separate and distinct asset test and interpret indopco in a more efficient way? t.d. 9107, guidance regarding deduction and capitalization of expenditures, 69 f.r. 436 (1/5/04), making final proposed regulations, reg-125638-01, 67 f.r. 77701 (12/19/02). the treasury department promulgated reg. § 1.263(a)-4 and § 1.263(a)-5, which deal comprehensively with the capitalization of expenditures that relate to intangible assets and “future benefits.” these regulations are commonly referred to as the indopco regulations, because they are intended to provide bright-line rules to make the standards based approach to capitalization articulated by the supreme court in indopco more administrable. however, the regulations more aptly might be called the antiindopco regulations, because they reverse the principle, if not the specific holding of indopco.2 2. how to change accounting methods for the 2003 year to comply with the final regulations. rev. proc. 2004-23, 2004-16 i.r.b. 785. this revenue procedure provides an exclusive administrative procedure for taxpayers to obtain automatic consent to change to a method of accounting pursuant to reg. §§ 1.263(a)-4, 1.263(a)-5, and 1.167(a)-3(b), the final capitalization of intangible regulations for the 2003 tax year. a. changing accounting methods for years after 2003 to comply with the final regulations. rev. proc. 2005-9, 2005-2 i.r.b. 303 (1/10/05). this procedure is similar to, but not identical with, rev. proc. 2004-23. b. rev. proc. 2005-17, 2005-13 i.r.b. 797 (3/28/05). this revenue procedure modifies rev. proc. 2005-9 to provide guidance for a taxpayer’s second year ending on or after 12/31/03 [for a calendar year taxpayer, the 2005 year]. this makes the 5-year prior change scope limitation inapplicable to that year. 2. these final regulations are discussed more fully in shepard & mcmahon, “recent developments in federal income taxation: the year 2003,” 6 fla. tax rev. 445, 457-60 (2004) (hereafter, “s&m”). 58 florida tax review [vol.7:si 3. notice 2004-18, 2004-11 i.r.b. 605 (3/15/04). comments are sought on the treatment of transaction costs that are to be capitalized under § 263(a) with respect to issues including (1) whether the costs should be treated as giving rise to a new asset or allocated to existing assets, (2) consistent treatment for costs relating to similar taxable and tax-free transactions, and (3) consistent treatment of all capitalized costs that facilitate a transaction regardless of the type of cost. 4. would you like to fly on a jet without its engines? fedex corp. v. united states, 91 a.f.t.r.2d 2003-1940 (w.d. tenn. 4/7/03). the district court denied the taxpayer’s motion for summary judgment that expenditures for its off-wing engine maintenance program were deductible repairs under reg. § 1.162-4. the court found that there was a genuine issue of fact regarding whether the appropriate unit of property for measuring whether the expenditures added value or materially prolonged life was (1) the entire aircraft, as argued by fedex, or (2) the jet engines and auxiliary power units, as argued by the government. the court concluded that there is no ‘entire vehicle’ rule of law requiring that repairs be measured against the entire vehicle rather than against components. a. you don’t have to, at least in memphis. fedex corp. v. united states, 2003-2 u.s.t.c. ¶ 50,697 (w.d. tenn. 8/27/03). taxpayer was permitted to deduct the costs of engine shop visits for jet aircraft engine inspection, heavy maintenance and repair because the relevant unit of property was held to be the entire aircraft, not the engine. b. affirmed by the sixth circuit in an unpublished opinion, which holds that engines are part of a jet plane even when they are “off wing.” 2005 tnt 40-19, 2005 u.s. app. lexis 2834 (2/16/05). the $70 million in taxes and accrued interest determined by the irs having capitalized the costs incurred for “off-wing maintenance” of its jet aircraft engines and auxiliary power units in 1993 and 1994 were improperly collected because fedex was entitled to deduct “such maintenance costs” as incidental repairs that did not appreciably prolong the life of the aircraft. 5. just when you thought you were safe from capitalization under § 263(a), § 263a rears its ugly head. rev. rul. 2004-18, 2004-8 i.r.b. 509 (2/23/04). costs incurred to clean up land that a taxpayer contaminated with hazardous waste by the operation of its manufacturing plant must be capitalized under § 263a and included in inventory costs. rev. rul. 98-25 and rev. rul. 94-38 are clarified by providing that the otherwise deductible amounts at issue are subject to capitalization to inventory under § 263a. 2005] recent developments in federal income taxation 59 ! not applicable to years ending on or before 2/6/04. ! presumably the costs would be currently deductible if they were covered by § 198. a. rev. rul. 2004-17, 2004-8 i.r.b. 516 (2/23/04). costs paid or incurred in the taxable year to remediate environmental contamination that occurred in prior taxable years do not qualify for treatment under § 1341. b. section 308 of the working families act of 2004 extends the deduction of environmental remediation costs under § 198 for two years through 12/31/05. 6. irs identifies issues to be addressed in forthcoming proposed regulations on tangible property costs. notice 2004-6, 2004-3 i.r.b. 308 (1/20/04). these issues include [using the numbering from the notice]: (1) what general principles of capitalization should be applied? (2) what is the appropriate “unit of property?” (3) what is the starting point for determining whether property value is increased or useful life is prolonged? (11) should the regulations provide “repair allowance” type rules? (12) should the regulations provide a de minimis rule? (13) when should the “plan of rehabilitation” doctrine be applied? (15) are there circumstances where tax treatment should follow financial or regulatory accounting treatment? 7. no indopco here; no § 162(k) either. chief industries v. commissioner, t.c. memo. 2004-45 (3/2/04). the taxpayer paid its former president/shareholder over $3 million to settle various law suits that arose from his removal as president. contemporaneously, pursuant to the settlement, the taxpayer corporation redeemed the president/shareholder’s stock for over $40 million. judge laro held that the $3 million settlement was an ordinary and necessary expense deductible under § 162, rather than a capital expenditure under indopco, because the origin of the claim was the board of director’s decision to remove the president. section 162(k) did not bar the deduction because the payment to settle the claims relating to the removal of the president/shareholder were not associated with or related to the redemption. 8. a solomon-like decision on capitalization. putnam-greene financial corp. v. united states, 308 f.supp.2d 1374, 93 a.f.t.r.2d 20041049, 2004-1 u.s.t.c. ¶ 50,178 (m.d. ga. 2/6/04). the taxpayer, a bank holding company, incurred legal fees to defend against suits by minority shareholders in a subsidiary. legal fees relating to disputes over recapitalization attempts and buy-out prices were held to be capital expenditures, but legal fees seeking damages for general mismanagement of the subsidiary and for failure to 60 florida tax review [vol.7:si pay dividends were held to be deductible as ordinary and necessary business expenses. c. reasonable compensation 1. tax court distinguishes exacto spring in case appealable to seventh circuit. menard, inc. v. commissioner, t.c. memo. 2004-207 (9/16/04), reconsideration denied, t.c. memo. 2005-3 (1/6/05). in this decision, appealable to the seventh circuit and presumably governed by the “hypothetical independent investor” test of exacto spring corp. v. commissioner, 196 f.3d 833 (7th cir. 1999), judge marvel nevertheless used compensation for ceos of comparable publicly-traded corporations to disallow deduction of $13 million of the $20 million of compensation paid to the john r. menard, the ceo and owner of 89 percent of taxpayer’s stock. ! judge marvel relied on language in reg. § 1.162-7(b)(3) – not discussed in exacto spring – which provides, “in any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. it is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” a. on reconsideration, t.c. memo. 2005-3 (1/6/05). in denying taxpayer’s motion for reconsideration, judge marvel reiterated – as an alternative ground for her decision – that taxpayer did not intend that its payment to mr. menard of “5 percent of pretax profits” was “purely for services” in light of (1) its never having paid a dividend, (2) the existence of a reimbursement agreement should any portion of the compensation be found excessive, and (3) the failure of the board of directors to make any effort to evaluate whether the bonus would make mr. menard’s total compensation excessive. 2. taxpayers who receive w-2 forms that do not correctly reflect income will be penalized for filing returns that reflect the w-2 amounts. williams v. commissioner, 120 fed. appx. 289 (10th cir. 1/26/05). taxpayer was employed as a staff radiation therapist for a medical corporation owned by two physicians who were married to one another. taxpayer and her husband became close friends with the physicians. the corporation expanded and opened cancer treatment centers in multiple geographical locations, and taxpayer supervised all of the corporation’s radiation therapists. for the years 1993, 1994 and 1995, taxpayer received payments of $25,000, $35,000 and $35,000 respectively that were not included on her w-2 forms. taxpayer left her employment in 1996, following the firing of her sister. in early 1997, taxpayer was furnished with corrected w-2 forms that included the payments. 2005] recent developments in federal income taxation 61 the court held that the payments were not “gifts” because § 102(c) precludes such treatment, and the imposition of the § 6662 negligence penalty was upheld. d. miscellaneous expenses 1. the irs never seems able to catch up with the movements in the price of gasoline, and more tinkering is in store for 2005. rev. proc. 2004-64, 2004-49 i.r.b. 898 (12/6/04), superseding rev. proc. 2003-76, 200343 i.r.b. 924. the optional standard mileage rate for business use of automobiles will increase on 1/1/05 from 37.5 cents per mile to 40.5 cents per mile; the mileage rate for medical and moving will increase from 14 cents per mile to 15 cents per mile; and the mileage rate for giving services to a charitable organization will remain at 14 cents per mile. ! query whether increasing the deduction for driving to the doctor so it is now greater than the deduction for driving to the charitable board meeting – in 2003, the deduction for medical mileage was less than charitable mileage – is because many more taxpayers deduct charitable miles than medical miles? 2. a taxpayer who seeks the safe harbor of a revenue procedure can’t complain about the anchorage. boyd v. commissioner, 122 t.c. 305 (4/27/04). the taxpayer’s s corporation trucking company (continental) paid its drivers’ for services on a cents per mile basis, and in lieu of paying other expenses, continental paid drivers a “per diem” of 9 cents per mile. continental deducted 80 percent of the payments, but the commissioner allowed only fifty percent of the per diem under § 274(n), treating the full amount as meal reimbursement. in order for the deduction to be allowed the per diem had to meet the deemed substantiation requirements of rev. proc. 94-77, 1994-2 c.b. 825; rev. proc. 96-28, 1996-1 c.b. 686, and rev. proc. 96-64, 1996-2 c.b. 427 the taxpayer claimed that under § 6.05 of the revenue procedures [the fourth sentence of which applies if the per diem was less that the federal m&ie rate] it could treat 40 percent of the per diem as lodging and 50 percent as meal reimbursement, thus allowing an 80 percent deduction. the tax court (judge vasquez) held that the per diem was treated under § 4.04(2) of the revenue procedures as being solely for meals and incidentals because it was computed on the same basis as compensation [cents per mile]. thus, under § 274(n), only 50 percent of the per diem was deductible. the provisions in the revenue procedures treating the per diem as being solely for meals and incidentals because it was computed on the same basis as compensation were not in conflict with § 274(n), and the revenue procedure was not otherwise invalid. finally, since as in beech trucking co., inc. v. commissioner, 118 t.c. 428 (2002), the taxpayer was relying on the revenue procedures for deemed substantiation, in the absence of any evidence of actual substantiation, it would not be heard to challenge the conditions in the revenue procedure. 62 florida tax review [vol.7:si 3. this performance did not impress the tax court. fleischli v. commissioner, 123 t.c. 59 (7/14/04). judge colvin held that the $16,000 agi limitation in § 62(b)(1)(c) for qualified performers to take above-the-line deductions is based on total agi from all sources, not merely on agi from performing business. the taxpayer earned more than $16,000 as a part-time lawyer, and earned $13,435 and incurred $17,878 of expenses as a part-time actor. the statutory limitation is constitutional. 4. “it’s a bird, it’s a plane . . .” what is a credit default swap? notice 2004-52, 2004-32 i.r.b. 168 (8/9/04). the irs has requested information on credit default swaps in connection with requests for further guidance. possible analogues include contingent options, financial guarantees, standby letters of credit and insurance contracts. suggestions also include sui generis classification. 5. section 307 of the working families act of 2004 extends the above-the-line $250 deduction for k-12 teachers’ supplies through 12/31/05. as before, no deductions for books or cucumbers by pe and health education teachers. 6. section 201 of the american jobs creation act of 2004 amends § 179 to extend the $100,000 amount for expensing for small businesses through years beginning before 2008. ! the amount is indexed for inflation, and for 2004 the maximum deduction is $102,000 and the phase-out begins at $410,000 of § 179 property placed in service. for 2005, the indexed amounts are $105,000 and $420,000, respectively. see rev. proc. 2004-71, 2004-50 i.r.b. 970. 7. section 907 of the american jobs creation act of 2004 amends § 274(c) to limit the deduction for personal use by corporate officers of corporate aircraft or other corporate facilities to the amount the officer included as compensation. this reverses the holding to the contrary in sutherland lumber-southwest, inc. v. commissioner, 114 t.c. 197, aff’d, 255 f.3d 495 (8th cir. 2001). the amendment is applicable to expenses incurred after the date of enactment (10/22/04). e. depreciation & amortization 1. regulations on 50 percent bonus depreciation. t.d. 9091, special depreciation allowance, 68 f.r. 52986 (9/8/03); reg-157164-02, special depreciation allowance, 68 f.r. 53008 (9/8/03). the treasury has promulgated temporary regulations [temp. reg. § 1.167(a)-14t (dealing with qualified intangible property); temp. reg. § 1.168(k)-1t (dealing with tangible 2005] recent developments in federal income taxation 63 property)] and published identical proposed regulations [prop. reg. § 1.167(a)14; prop. reg. § 1.168(k)-1t] dealing with first year bonus depreciation under § 168(k). 2. changes in use change macrs depreciation. reg-13849902, changes in use under section 168(i)(5), 68 f.r. 43047 (7/21/03). the treasury has published comprehensive proposed regulations to provide rules for determining macrs depreciation under § 168 when the taxpayer changes the use of the property. changes in use include: (1) a conversion of personal use property to a business or income-producing use, (2) conversion from business or income-producing to personal use, or (3) a change in use that results in a different recovery period, depreciation method, or both. the regulations will be effective when finalized. any reasonable method will be acceptable for changes after 12/31/86 and before final regulations are published. however, current reg. § 1.167(g)-1 limits the depreciable basis of property converted from personal to business use to its fair market value at the time of the conversion. a. revised proposed regulations made temporary. t.d. 9115; reg-106590-00; reg-138499-02, changes in use under section 168(i)(5), 69 f.r. 9529 & 9560 (3/1/04). the treasury has published final, temporary and proposed regulations that render obsolete notice 2000-4, 2000-1 c.b. 313, and withdraw prop. reg. §§ 1.168(a)-1 and 1.168(b)-1 (that were contained in the july 2003 proposed regulations). b. and made final. t.d. 9132, changes in use under section 168(i)(5), 69 f.r. 33840 (6/17/04). effective 6/17/04. 3. for depreciation of property received in a § 1031 exchange or § 1033 replacement, see iii.b., below. 4. treasury makes life a little happier for suv salesmen. t.d. 9133, depreciation of vans and light trucks, 69 f.r. 35513 (6/25/04), making final t.d. 9069, 68 f.r. 40129 (7/7/03). final and temporary regulations applicable to property placed in service on or after 7/7/03. provides that a truck or van is not subject to the § 280f(a) limits if it is a qualified nonpersonal use vehicle as defined in reg. § 1.274-5t(k). effective 7/7/03. a. but not for salesmen of expensive suvs. section 910 of the american jobs creation act of 2004 amends § 179 to reduce the suv deduction to $25,000 for suvs placed in service after 10/22/04. 5. king kong might have been able to move them, so they’re not inherently permanent. pdv america, inc. v. commissioner, t.c. memo. 2004-118 (5/12/04). judge marvel held that petroleum storage tanks, holding as 64 florida tax review [vol.7:si much as 151,000 barrels and weighing as much as 1 million pounds [some of in fact had been in place 60 years] are not inherently permanent structures, because they sometimes are moved, with only minimal damage, for purposes of environmental remediation or repairs. accordingly, the tanks were in asset class 57.0, distributive trades and services, of rev. proc. 97-56, 1987-2 c.b. 686, and treated as 5-year property, rather than asset class 57.1, distributive trades and services – billboard, service station buildings and petroleum marketing land improvements. [pursuant to § 1245(a)(3)(e), storage facilities used in the distribution of petroleum products are § 1245 property.] 6. section 211 of the american jobs creation act of 2004 amends § 168 to provide for a 15-year recovery period for depreciation of qualified leasehold improvements and qualified restaurant property placed in service between 10/23/04 and 12/31/05. generally, the improvements and property must be in buildings that are at least three years old. 7. fifteen-year amortization for pre-opening and organizational expenses, except for deductibility of the first $5,000. section 902 of the american jobs creation act of 2004 amends §§ 195, 248 and 709 to provide for a deduction of the first $5,000 of costs in each category in the year that amortization would have begun. amounts not deductible are to be amortized over 15 years. the deduction is phased out dollar-for-dollar as the amount in each category exceeds $50,000. f. credits 1. new final research credit regulations retain the requirement that experimentation “must be an evaluative process . . . capable of evaluating more than one alternative.” they validate the old joke: “‘how’s your wife?’ ‘compared with whom?’” t.d. 9104, credit for increasing research activities, 69 f.r. 22 (1/2/04). final regulations generally retain the provisions of december 2001 proposed regulations. the rules for internal-use software are not included in these regulations, but are the subject of an advanced notice of proposed rulemaking.3 a. section 301 of the working families act of 2004 extends the research credit for 18 months until 12/31/05. g. natural resources deductions & credits 1. tax court holding reversed by the eighth circuit: 7-year recovery period for gathering pipelines. clajon gas. co. lp v. 3. these regulations are discussed more fully at s&m, supra note 2, at 471-74. 2005] recent developments in federal income taxation 65 commissioner, 354 f.3d 786, 93 a.f.t.r.2d 2004-396, 2004-1 u.s.t.c. ¶50,123 (8th cir. 1/12/04). the eighth circuit followed the tenth circuit’s duke energy decision and the sixth circuit’s saganaw bay pipeline decisions, and permits gathering pipelines to be depreciated over 7 years.4 h. loss transactions, bad debts and nols 1. graves v. commissioner, t.c. memo. 2004-140 (6/15/04). judge gerber held that a § 166 business bad debt deduction arising from employee’s loan to employer to help preserve salary income was an employee business deduction that was a miscellaneous itemized deduction subject to the 2 percent of agi floor of § 67. 2. maximizing the availability of post-bankruptcy nols. benton v. commissioner, 122 t.c. 353 (5/12/04). the taxpayer filed a chapter 11 bankruptcy petition in 1995 and the plan, which included a continuing liquidating trust, was confirmed in 1997. judge gerber held for the taxpayer in allowing the taxpayer to apply his pre-bankruptcy nols, as well as the bankruptcy estate’s nols, to which he succeeded under § 1398(i) to 1995, 1996, and 1997. for purposes of § 1398(i), the chapter 11 bankruptcy terminated when the plan was confirmed and the debtor’s discharge was granted [1997], not on the later date on which a final order was entered. section 1398(g) barring a carryback to pre-petition years does not bar a carryback to the year the bankruptcy petition was filed or years the bankruptcy was pending. the taxpayer could apply the nols – subject to the period limits in § 172 based on the source years of the loses – to the year the bankruptcy was commenced and the year the bankruptcy was pending, as well as using nols in the year the proceeding terminated. 3. south carolina has a sharply defined public policy against gambling – except, of course state sponsored gambling. hackworth v. commissioner, t.c. memo. 2004-173 (7/22/04). the taxpayer operated an illegal gambling operation in south carolina. after the local sheriff’s office seized cash proceeds of the gambling operation, which were forfeited under state law, the taxpayer claimed a § 165 loss deduction. the commissioner disallowed the loss on public policy grounds, and judge cohen upheld the commissioner’s position because allowing the deduction would frustrate a sharply defined policy of the state of south carolina. [the opinion fails to note that the state of south carolina sponsors a state lottery. perhaps the sharply defined public policy that was violated was a restraint on competition.] 4. the background to this case is set forth more fully at s&m, supra note 2, at 474-75. 66 florida tax review [vol.7:si i. at-risk and passive activity losses 1. sooner or later, all amounts borrowed from your partner will not increase amount at-risk. reg-209377-89, at-risk limitations; interest other than that of a creditor, 68 f.r. 40583 (7/8/03). section 465(b)(3) provides that amounts borrowed for use in an activity do not increase the borrower’s amount at risk in an activity listed in § 465(c)(1) [(1) motionpicture films or videotapes; (2) farming; (3) leasing § 1245 property; (4) oil and gas resources and geothermal deposits] if the lender has an interest other than that of a creditor in the activity or if the lender is related to a person (other than the borrower) who has a disqualifying interest in the activity. section 465(c)(3)(d) provides that § 465(b)(3) applies to activities to which § 465 is extended by § 453(c)(3)(a) – all other business and profit seeking activities – only to the extent provided in regulations; alexander v. commissioner, 95 t.c. 467 (1990), aff’d by order sub nom. stell v. commissioner, 999 f.2d 544 (9th cir. 1993), held that until regulations were issued, §465(b)(3) does not apply to activities other than those described in § 465(c)(1). revisions to prop. reg. § 1.465-8 and 1.465-20 would apply § 465(b)(3) to the activities described in § 465(c)(3)(a). the regulation will be effective when finalized. a. proposed regulations are made final. t.d. 9124, atrisk limitations; interest other than that of a creditor, 69 f.r. 24078 (5/3/04). the regulation applies to amounts borrowed after 5/3/04. there are exceptions for amounts borrowed from a related person that are “qualified nonrecourse financing,” and for amounts borrowed from a related person that would have been “qualified nonrecourse financing” had the borrowing been nonrecourse. iii. investment gain a. capital gain and loss 1. “the purpose of narrowly construing the term capital asset under the substitute for ordinary income doctrine is to ‘protect the revenue against artful devices’ that undermine the revenue code’s standard treatment of ordinary income and capital gains. [p.g. lake, 356 u.s. [260 (1958)]. that is precisely what maginnis has attempted here.” united states v. maginnis, 356 f.3d 1179, 93 a.f.t.r.2d 2004-660, 2004-1 u.s.t.c. ¶ 50,149 (9th cir. 1/30/04), aff’g 2002-1 u.s.t.c. ¶ 50,494 (d. ore. 5/28/02). the taxpayer won $9 million in the oregon lottery, payable over 20 years in $450,000 installments. after receiving 5 installments, he sold his remaining 15 installments for $3,950,0000. after reporting the sales proceeds as ordinary income, he sought a refund based on the claim that the sales proceeds were capital gain. the court (judge fisher) held that the right to payments was not a 2005] recent developments in federal income taxation 67 “capital asset” for purposes of § 1221, because (1) the taxpayer did not make any underlying capital investment and (2) there was no accretion in value over time. judge fisher rejected the argument that cost of the lottery ticket was an “investment,” on the grounds that the underlying transaction was a gambling transaction for tax purposes. he concluded that “maginnis’ sale of his lottery right is almost indistinguishable from the paradigmatic situation in which the substitute for ordinary income doctrine removes a right to future income from the definition of a capital asset, which occurs when a taxpayer assigns his right to future income from employment to a third party for a lump sum.” ! the court also rejected the taxpayer’s argument that arkansas best corp. v. commissioner, 485 u.s. 212 (1988), mandates that § 1221 be read broadly, because the court in arkansas best expressly held that its decision did not affect the way in which the substitute for ordinary income doctrine modifies the term capital asset. ! finally, the court also rejected the taxpayer’s argument that because he sold his entire right to the lottery payments [a “vertical slice”], instead of merely a carved-out income stream [a “horizontal slice”], the income was capital gain. “[a] transaction in which a taxpayer sells his entire interest in an underlying asset without retaining any property right does not automatically prevent application of the substitute for ordinary income doctrine.” 2. judge goeke says mcallister is no longer good law. clopton v. commissioner, t.c. memo. 2004-95 (4/6/04). the taxpayer sold 20 of 22 remaining payments to which he was entitled as a winner of texas lottery. judge goeke held that the sales proceeds were ordinary income, not capital gains, following davis v. commissioner, 119 t.c. 1 (2002) and united states v. maginnis, 356 f.3d 1179 (9th cir. 2004). he declined to follow mcallister v. commissioner, 157 f.2d 235 (2d cir. 1946), not on the grounds that it was distinguishable because in that case the taxpayer had sold all of her rights to future payments, but on the grounds that mcallister was stripped of precedential value by the subsequent supreme court decision in commissioner v. p.g. lake, inc., 356 u.s. 260 (1958) (holding that a present money substitute for future ordinary income is not a capital gain). 3. the stock is still in the box. rev. rul. 2004-15, 2004-8 i.r.b. 515 (2/23/04). when a taxpayer who has sold stock short satisfies the obligation to the broker from the taxpayer borrowed the stock with stock borrowed from another broker, the transfer of the borrowed stock does not close the short sale under reg. § 1.1233-1(a). because replacing the obligation to one broker with an obligation to another does not close the short sale, the transfer does not cause the § 1259 transition rule for short sales before the close of the 30-day period beginning on august 5, 1997 to cease to apply to either the short sale or stock in the box. 68 florida tax review [vol.7:si 4. the negative side of estate tax valuation discounts. janis v. commissioner, t.c. memo. 2004-117 (5/12/04). the taxpayers inherited an art galley that held in inventory a large number of paintings by famous artists [e.g., jean arp, piet modrian, grandma moses]. in prior administrative proceedings, the estate had succeeded in applying a blockage discount in valuing the items for estate tax purposes. in this income tax case involving determination of the cost of goods sold, judge cohen upheld applying a “blockage” discount to determine the § 1014 basis of the inventory. in addition to applying the blockage discount on the merits of the fair market value issue, judge cohen found that the taxpayers were bound by the duty of consistency because as executors of the estate they had agreed to the amount of the blockage discount in determining the estate tax value. 5. coleman v. commissioner, t.c. memo. 2004-126 (5/25/04). judge gerber held that payments under an unexpired covenant not to compete that are payable and received after the decedent’s death are ird under § 691(a) and ineligible for a § 1014 step-up in basis. the receipts remain ordinary income to the heirs. b. section 1031 1. depreciation for macrs property acquired in a § 1031 exchange of macrs property, or acquired in replacement of involuntarily converted macrs property to which § 1033 applies. notice 2000-4, 2000-3 i.r.b. 313. to the extent the taxpayer’s basis in the acquired macrs property does not exceed the taxpayer’s adjusted basis in the exchanged or involuntarily converted macrs property, the acquired property is depreciated over the remaining recovery period of, and using the same depreciation method and convention as that of, the exchanged or involuntarily converted property. any additional basis in the acquired property is treated as newly purchased macrs property. [this is the same method as provided for acrs property in prop. reg. §1.168-5(f) (1984).] effective for acquired macrs property placed in service on or after january 3, 2000, in a like-kind exchange of macrs property under § 1031 or as a result of an involuntary conversion of macrs property under § 1033. for property acquired before january 3, 2000, taxpayers who treated the entire basis as new macrs property may continue to do so, or may change accounting methods to conform. a. temporary regulations. t.d. 9115, reg-106590-00 and reg-138499-02, depreciation of macrs property that is acquired in a like-kind exchange or as a result of an involuntary conversion, 69 f.r. 9529 (3/1/04). the treasury has published final, temporary and proposed regulations that render obsolete notice 2000-4, 2000-1 c.b. 313, and withdraw prop. reg. §§ 1.168(a)-1 and 1.168(b)-1 (that were contained in the july 2003 proposed 2005] recent developments in federal income taxation 69 regulations). under these temporary and proposed regulations, generally the exchanged basis is depreciated over the remaining recovery period of, and using the depreciation method of, the relinquished macrs property if the useful life of the replacement property is the same or shorter than the relinquished property. if the replacement property has a longer useful life, depreciation is computed as if the replacement property had originally been placed in service when the relinquished property was placed in service by the acquiring taxpayer. any excess basis is treated as property placed in service in the year the acquiring taxpayer places it in service. there are specific rules for deferred exchanges and reverse exchanges, as well as for automobiles. 2. no “parking” of your own property. rev. proc. 2004-51, 2004-33 i.r.b. 294 (8/16/04), modifying rev. proc. 2000-37, 2000-2 i.r.b. 308. provides that the safe harbor provision of rev. proc. 2000-37 does not apply to reverse like-kind “parking” arrangements if the taxpayer owns the property intended to qualify as replacement property within the 180-day period ending on the date of transfer of qualified indicia of ownership of the property to an exchange accommodation titleholder. 3. no gain exclusion if taxpayer exchanges investment property for a rent house he later moves into and sells two years later – until five years have elapsed from the date of the exchange. section 839 of the american jobs creation act of 2004 adds new § 121(d)(10) to make the § 121 exclusion of gain on the sale of a principal residence inapplicable to any property acquired in a § 1031 exchange within five years of the sale. 4. exclusion of gain under §§ 121 and 1031 when a single property is both a personal residence and a business or investment property. rev. proc. 2005-14, 2005-7 i.r.b. 528 (2/14/05) (as corrected). provides guidance on how a homeowner can exclude gain on the sale or exchange of a home under § 121 and also defer gain from a like-kind exchange on the same property under § 1031. this guidance also clarifies that the property can be used consecutively or concurrently as a home and a business, i.e., use as rental property or an office in the home, respectively. detailed examples are included. 5. nonrecognition denied – caught by a targeted anti-abuse rule. rev. rul. 2002-83, 2002-49 i.r.b. 927 (12/9/02). individual a owned highly appreciated real property held for investment (property 1) and individual b, related to individual a within the meaning in § 267(b), owned real property (property 2), which was not appreciated. in a multiparty like-kind exchange a and b each transferred their properties to a qualified intermediary. c, an unrelated purchaser of property 1, transferred cash to the qualified intermediary, who transferred property 2 to a, property 1 to c, and the cash to b. the irs 70 florida tax review [vol.7:si ruled that pursuant to § 1031(f), a taxpayer – a – who transfers relinquished property to a qualified intermediary in exchange for replacement property formerly owned by a related party is not entitled to nonrecognition treatment under § 1031(a) if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property. based on the legislative history [h.r. rep. no. 101-247 at 1340 (1989)], the irs reasoned that the purpose of §1031(f) is to deny nonrecognition treatment for transactions in which related parties make like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. accordingly, the irs applied § 1031(f)(4) because the multi-party exchange was “part of a transaction (or a series of transactions) structured to avoid the purposes of § 1031(f)(1).” a. reality overtakes rev. rul. 2002-83. teruya brothers, ltd. v. commissioner, 124 t.c. 45 (2/9/05). taxpayer transferred properties to a qualified intermediary, who sold them to unrelated third parties and used the proceeds to purchase like-kind replacement property from a related party. judge thornton held that the transactions were economically equivalent to direct exchanges between the taxpayer and related party, followed by the related party’s sale of the properties to unrelated third parties, and that they were structured to avoid the purposes of § 1031(f). he further held that taxpayer failed to prove that avoidance was not one of the principal purposes of the transactions under the § 1031(f)(4) exception because [even though more gain was recognized by the related party on some of the properties, the only tax consequences of the gain recognition were reduction of the related party’s net operating loss – as opposed to current taxation for taxpayer]. c. section 1041 1. a sensible ruling that favors § 1041 over the assignment of income theory on the transfer of vested stock options and vested nonqualified deferred compensation incident to divorce. rev. rul. 2002-22, 2002-19 i.r.b. 849 (5/13/02). this ruling held that: (1) a taxpayer who transfers interests in nonstatutory stock options and nonqualified deferred compensation to the taxpayer’s former spouse incident to divorce is not required to include an amount in gross income upon the transfer, and (2) the former spouse, and not the taxpayer, is required to include an amount in gross income when the former spouse exercises the stock options or when the deferred compensation is paid or made available to the former spouse. ! the ruling stated, similarly, applying the assignment of income doctrine in divorce cases to tax the transferor spouse when the transferee 2005] recent developments in federal income taxation 71 spouse ultimately receives income from the property transferred in the divorce would frustrate the purpose of § 1041 with respect to divorcing spouses. that tax treatment would impose substantial burdens on marital property settlements involving such property and thwart the purpose of allowing divorcing spouses to sever their ownership interests in property with as little tax intrusion as possible. further, there is no indication that congress intended § 1041 to alter the principle established in the pre-1041 cases such as meisner [v. united states, 133 f.3d 654 (8th cir. 1998)] that the application of the assignment of income doctrine generally is inappropriate in the context of divorce. ! the ruling also cited hempt bros., inc. v. united states, 490 f.2d 1172 (3d cir. 1974), by way of analogizing § 1041 to § 351. this ruling does not apply to transfers of property between spouses other than in connection with divorce. this ruling also does not apply to transfers of nonstatutory stock options, unfunded deferred compensation rights, or other future income rights to the extent such options or rights are unvested at the time of transfer or to the extent that the transferor’s rights to such income are subject to substantial contingencies at the time of the transfer. see kochansky v. commissioner, 92 f.3d 957 (9th cir. 1996). [emphasis added] ! this ruling clarified that rev. rul. 87-112, 1987-2 c.b. 207, which held that § 1041 did not apply to accrued interest on transferred u.s. savings bonds that were subsequently cashed in, was based on § 454 rather than on assignment of income principles. ! query whether the non-employee spouse will be required to follow this ruling? perhaps, the divorce decree or separation agreement should address this issue. however, the irs would be required to follow this ruling regardless of what position the non-employee spouse takes. a. notice 2002-31, 2002-19 i.r.b. 908. proposes that fica/futa taxes on exercise of stock options and distribution of deferred compensation be imposed as if the income was that of the employee spouse. b. rev. rul. 2002-22 and notice 2002-31 are clarified. rev. rul. 2004-60, 2004-24 i.r.b. 1051 (6/14/04). the options and deferred compensation remain subject to employment taxes as if the employee spouse had retained them but the employee portion of the fica taxes is deducted from the payment to the nonemployee spouse. income recognized by the 72 florida tax review [vol.7:si nonemployee spouse with respect to the exercise of the nonstatutory stock options is subject to § 3402 withholding at the flat rate of 25 percent and is also to be deducted from the payments to the nonemployee spouse. 2. division of military retirement pay in a divorce is taxed the same as a qdro. pfister v. commissioner, 359 f.3d 352, 93 a.f.t.r.2d5 2004-1113, 2004-1 u.s.t.c. ¶ 50,176 (4th cir. 2/27/04). the taxpayer was awarded one-half of her former husband’s military retirement pay pursuant to a divorce decree, as permitted by the uniformed service’s former spouses’ protection act. she claimed the receipts were excludable under § 1041. the court of appeals (judge gregory) affirmed the tax court’s holding that the receipts were gross income to the recipient former spouse; § 1041 did not apply to receipt of the payments [although it would apply to the initial division of property rights in the pension]. d. section 1042 1. cpas have to get that § 1042 nonrecognition election right before the due date of the return. estate of john w. clause v. commissioner, 122 t.c. 115 (2/9/04). the taxpayer [before he died] sold all of his shares of a corporation he controlled to the corporation’s esop and purchased qualified replacement property [under § 1042(c)(4)] with most of the proceeds from the sale within a year of the sale. he did not report the transaction on his original return, but after an audit was commenced, he filed an amended return indicating that certain proceeds from the sale had been reinvested in qualified replacement property, but which did not contain the written statement required by § 1042(b)(3), which is a requirement to obtain nonrecognition. he subsequently filed a second amended return that to which was attached a statement that he elected nonrecognition under § 1042. section 1042(c) provides that the election must be made on a return filed by the due date [with extensions]. temp. reg. § 1.1042-1t imposes a number of detailed procedural rules for form and content of the statement required under § 1042(c), none of with which the taxpayer complied. judge haines held that temp. reg. § 1.1042-1t was a valid legislative regulation and that the taxpayer was not entitled to nonrecognition because he failed properly to comply with the procedural requirements of § 1042 and temp. reg. § 1.1042-1t. neither the “substantial compliance” doctrine nor the fact that the taxpayer relied on his cpa to file his return saved the day for the taxpayer. 5. under § 402(e)(1) a former spouse who receives a distribution pursuant to a “qualified domestic relations order” (qdro), as defined in § 414(p), is treated as an alternative beneficiary of the plan who is taxable on distributions from the qualified plan under §§ 402(a) and 72. 2005] recent developments in federal income taxation 73 iv. compensation issues a. fringe benefits 1. guidance on health savings accounts. notice 2004-2, 20042 i.r.b. 269 (12/23/03). the irs has issued guidance in q&a form on health savings accounts under new § 223 (added by § 1201 of the medicare prescription drug improvement, and modernization act of 2003). this guidance provides basic information about hsas. this new provision offers health spending accounts without the “use it or lose it” requirement of health fsas. a. notice 2004-23, 2004-15 i.r.b. 725 (4/12/04). the notice provides a safe harbor for preventive care benefits allowed to be provided by a high deductible health plan (“hdhp”) without satisfying the § 223(c)(2) minimum deductible. preventive care under the safe harbor includes “annual physicals” (including tests and diagnostic procedures), routine prenatal and well-child care, child and adult immunizations, tobacco cessation programs, obesity weight-loss programs and a long list of “screening services” (for cancer; heart and vascular diseases; infectious diseases; mental health conditions and substance abuse; metabolic, nutritional and endocrine conditions; musculoskeletal disorders; obstetric and gynecologic conditions; pediatric conditions; and vision and hearing disorders); however it does not generally include any service or benefit intended to treat an existing illness, injury or condition. ! this notice also provides that the definition of “preventive care” is a question of federal tax law, and not a question of state law. therefore a service required by state law to be provided on a first-dollar basis is not necessarily a “preventive service,” and a plan that complies with state law may well be disqualified from being an hdhp. (1) notice 2004-43, 2004-27 i.r.b. 10 (7/6/04). this notice provides transition relief for plans that include state-mandated firstdollar coverage. these plans would not be disqualified for that reason alone for months before 1/1/06, provided that the state law was in effect on 1/1/04. (2) notice 2004-50, 2004-33 i.r.b. 196 (8/16/04). this notice provides that any treatment that is incidental or ancillary to a preventive care service or screening described in notice 2004-23 also falls within the safe harbor for preventive care. b. notice 2004-25, 2004-15 i.r.b. 727 (4/12/04). this notice provides general transition relief for 2004 from the requirement that qualified medical expenses may be paid or reimbursed by an has only if they 74 florida tax review [vol.7:si were incurred after the has had been established for eligible individuals who establish an hsa before 4/16/05. c. the inability to get general prescription drug coverage is the sticking point for many potential users of hsas. rev. rul. 2004-38, 2004-15 i.r.b. 717 (4/12/04). an individual who had prescription drug coverage that was not subject to the annual deductible of the hdhp is not eligible to make contributions to (or have his employer make contributions to) an hsa. (1) rev. proc. 2004-22, 2004-15 i.r.b. 727 (4/12/04). this revenue procedure provides transition relief for the months before 2006 for an individual who is covered by both an hdhp and a separate plan or rider that provides drug benefits on a co-pay basis or in some other manner before the minimum annual deductible of the hdhp is met. d. rev. rul. 2004-45, 2004-22 i.r.b. 971 (6/1/04). this ruling provides guidance on the interactions of the hsa rules with the rules concerning health flexible spending arrangements (“health fsa”) (under prop. reg. § 1.125-1, q&a 7) and health reimbursement arrangements (“hra”) (under notice 2002-45, 2002-2 c.b. 93). an individual can be eligible for making hsa contributions while being covered by a limited-purpose health fsa or hra, a suspended hra, a post-deductible health fsa or hra, or a retirement hra. e. notice 2005-8, 2005-4 i.r.b. 368 (1/24/05). this notice provides guidance regarding a partnership’s contributions to a partner’s hsa and an s corporation’s contributions to a 2-percent shareholderemployee’s hsa. generally, the contributions are included in the income of the partner or shareholder-employee and are deductible by him or her as hsa contributions. b. qualified deferred compensation plans 1. the employer can pay administrative expenses allocable to current employees, while stiffing former employees. rev. rul. 2004-10, 2004-7 i.r.b. 484 (1/19/04). a qualified deferred compensation plan does not fail to satisfy the requirements of § 411(a)(11) merely because it charges reasonable plan administrative expanses to the accounts of former employees and their beneficiaries on a pro rata basis, but does not charge the accounts of current employees. 2. plan qualification after sale of a subsidiary. rev. rul. 200411, 2004-7 i.r.b. 480 (1/19/04). tax consequences of the sale of a subsidiary on its defined benefit pension plan and its employee profit-sharing plan with 2005] recent developments in federal income taxation 75 respect to the nondiscrimination requirements of § 401(a)(4) and the minimum coverage requirements of § 410(b). 3. if you roll it over, you can take it out whenever you want to. rev. rul. 2004-12, 2004-7 i.r.b. 478 (1/29/04). if an eligible retirement plan separately accounts for amounts attributable to rollover contributions, distributions of amounts attributable to these rollover contributions are generally permissible at any time pursuant to the individual’s request (with spousal consent, if applicable). 4. if a plan is sweetened beyond a coda with safe harbor matching, dolly parton may well smother it in her warm embrace. rev. rul. 2004-13, 2004-7 i.r.b. 485 (1/29/04). a profit-sharing plan containing a cash or deferred arrangement with safe harbor matching contributions meets the requirements of § 416(g)(4)(h) and is not subject to the top-heavy rules. however, (1) adding employer-provided discretionary nonelective contributions, (2) allocation of forfeitures to participants’ accounts, or (3) deferring matching contributions for newly hired nonhighly compensated employees who make elective contributions will result in the plan becoming subject to the top-heavy rules. 5. the pension funding equity act of 2004, establishes a temporary replacement for the benchmark 30-year treasury bond interest rate for use in determining funding liabilities of pension plans. a. notice 2004-34, 2004-18 i.r.b. 848 (4/12/04). this notice provides interim guidance on the determination of the weighted average interest rate under § 412(b)(5)(b)(ii)(iii) and erisa § 302(b)(5)(b)(ii)(iii). 6. they’re taking all the fun out of calculating minimum required distributions from plans and iras. reg-130477-00 and reg130481-00, required distributions from retirement plans, 66 f.r. 3928 (1/17/01). proposed regulations under § 401(a)(9), etc., substantially simplify the calculation of minimum required distributions from qualified plans, iras, and other related retirement savings vehicles. the changes in the proposed regulations are based on the concept of a uniform lifetime distribution period. the regulations provide a single table that any recipient can use to calculate his or her yearly mrd amount by plugging in his or her age and the prior year-end balance of his or her retirement account or ira. the table eliminates the need to elect recalculation of life expectancy, determine a designated beneficiary by the required beginning date, or satisfy a separate incidental death benefit rule. the proposed regulations will result in reducing mrds for the vast majority of employees and ira holders. although mrds will be calculated without regard to the beneficiary’s age, the regulations will continue to permit a longer payout 76 florida tax review [vol.7:si period if the beneficiary is a spouse more than 10 years younger than the employee. payments after the death of the employee or participant may be made over the life expectancy of the beneficiary designated by the close of the year following the participant’s death. a. regulations are final, with temporary regulations also. t.d. 8987, required distributions from retirement plans, 67 f.r. 18988 (4/17/02). the final regulations retain the simplifications to the minimum distribution rules for separate accounts provided in the 2001 proposed regulations, including the calculation of the mrd during the individual’s lifetime using a uniform table (which is changed in the final regulations to reflect updated mortality calculations). the final regulations change the date for determining the designated beneficiary to september 30 of the year following the year of the employee’s death (to permit sufficient time to calculate the mrd before the end of the year). the temporary regulations provide a number of changes to the annuity rules in the proposed regulations, which merely reflected the 1987 proposed regulations. effective for 2003 and following calendar years; for determining minimum distributions for the 2002 year, taxpayers may rely on the final regulations, the 2001 proposed regulations, or the 1987 proposed regulations. b. final regulations make modifications, but retain the basic rules contained in the april 2002 temporary regulations. t.d. 9130, required distributions from retirement plans, 69 f.r. 33288 (6/15/04). these regulations are effective 6/15/04, and apply for purposes of determining required minimum distributions for calendar years beginning on or after 1/1/03. 7. think twice before you sign blank documents. armstrong v. united states, 366 f.3d 622, 93 a.f.t.r.2d 2004-2098, 2004-1 u.s.t.c. ¶ 50,238 (8th cir. 5/3/04). the taxpayer borrowed money from a bank to pay his children’s college expenses. he intended to pledge a life insurance policy, but was in a hurry and signed blank loan documents, intending to deliver the life insurance contract later. while he was out of town, his employee delivered qualified retirement plan annuity contracts to the bank, which completed the documents based on the retirement annuity contracts. the court (judge heaney) held that the collateral assignment of the qualified retirement plan annuity contracts was valid and thus constituted a distribution to the taxpayer under § 72(p)(1). 8. cumulative list of changes in plan qualification requirements. notice 2004-84, 2004-52 i.r.b. (12/14/04). this notice contains the 2004 cumulative list of changes in plan qualification requirements, which reflects changes to plan qualification requirements and remedial amendment periods. 2005] recent developments in federal income taxation 77 9. comprehensive final regulations on matching contributions and employee contributions to 401(k) plans update the final regulations issued in 1991. t.d. 9169, retirement plans; cash or deferred arrangements under section 401(k) and matching contributions or employee contributions under section 401(m) regulations, 69 f.r. 78144 (12/29/04). these are comprehensive final regulations that provide guidance on the requirements (including the nondiscrimination requirements) for cash or deferred arrangements under § 401(k) and for matching contributions and employee contributions under § 401(m). a. “mr. gotbucks, meet senator roth.” reg-15235404, designated roth contributions to cash or deferred arrangements under section 401(k), 70 f.r. 10062-02 (3/2/05). proposed regulations relating to an election under § 402a that will be available beginning in 2006 for employees to designate contributions to a 401(k) plan made under a qualified cash-or-deferred arrangement as roth contributions. these contributions will be currently includible in gross income but qualified distributions will be excludable from gross income. c. nonqualified deferred compensation, section 83, and stock options 1. the irs says that the modification of a recourse note given by an employee upon the exercise of a stock option would result in compensation income, not discharge of indebtedness income. rev. rul. 2004-37, 2004-11 i.r.b. 583 (2/26/04). when an employee exercises a nonstatutory stock option by using a recourse note with interest not less than the afr on the date the note is issued, compensation income is measured by the difference between the value of the stock and the stated principal amount of the note. if, in a later year, the principal amount of the note is reduced, the amount of the reduction is treated as additional compensation income under § 83, not as cancellation of indebtedness income under § 108, which could purportedly be excluded from gross income under § 108(e)(5) and treated as a reduction in purchase price. the rules of reg. § 1.1001-3 are applied in determining whether a significant modification occurred. ! note denny v. commissioner, 33 b.t.a. 738 (1935), which held that a loan that ripened into a bonus in a later year constituted income in that year. after so holding, judge arundell further stated: “the case here is much like that where one receives as compensation property encumbered by a mortgage to the full value of the property. in that situation there would be no income in the year of the receipt. upon cancellation of the mortgage by the transferor in a subsequent year there would be income to the recipient, and the result would be the same whether the cancellation be regarded as the forgiving of indebtedness or as property then freed for the first time from restriction on use.” 78 florida tax review [vol.7:si 2. section 885 of the american jobs creation act of 2004 adds new § 409a which significantly modifies the taxation of nonqualified deferred compensation plans for amounts deferred after 2004 (a) by requiring that deferred compensation may not be distributed earlier than separation from service, disability, death, a specified time (or pursuant to a fixed schedule), on change of control (to be defined in regulations) or “the occurrence of an unforeseeable emergency;” (b) by requiring that the first deferral election be made before the beginning of the year in which the services are performed (or, if contingent compensation, at least six months before the end of the year in which the services are performed), and (c) by prohibiting acceleration of benefits except as permitted by regulations. changes in the time and form of distribution, so-called “second [deferral] elections” will have to be made at least twelve months before the payment was to have been made, and must postpone the payment for at least five years from the date it otherwise would have been made. additionally, offshore rabbi trusts are not permitted. ! violations of these rules would make immediately taxable all amounts not subject to a substantial risk of forfeiture, plus interest at one percentage point above the underpayment rate plus additional tax of 20 percent of the amount improperly deferred. ! even more restrictive special rules apply to officers, directors and ten-percent shareholders of publicly-held corporations and to persons holding the same positions in non-publicly held corporations. ! these new rules do not apply to nonqualified stock options, incentive stock options and employee stock purchase plans, but apparently do apply to stock appreciation rights. ! benefits earned through the end of 2004 are grandfathered if the plan complied with prior law and it was not materially modified after 10/3/04. a. section 409a guidance provides transition rules and excludes stock appreciation rights from the purview of that section. notice 2005-1, 2005-02 i.r.b. 274 (12/20/24). this notice provides in q&a form the first part of what is intended to be a series of guidance with respect to the application of § 409a. significant is the exclusion of stock appreciation rights from coverage by § 409a where the sar can only be satisfied with stock provided that the exercise price is not less than the market price on the day the sar was granted and the underlying stock is traded on an established securities market. in addition, general transition rules and reporting requirements are provided in the notice. d. individual retirement accounts there were no significant developments regarding this topic during 2004. 2005] recent developments in federal income taxation 79 v. personal income and deductions a. rates 1. section 101 of the working families tax relief act of 2004 extends the reductions in the child tax credit, marriage penalty relief [standard deduction and the top of the 15-percent bracket], and the 10 percent rate bracket. a. section 102 continues for one more year the relief from amt of personal tax credits. b. section 103 extends the increase in amt exemption amount for one year through 2005. 2. dividends received are to be taxed at capital gains rates. the jobs and growth tax relief reconciliation act of 2003 added § 1(h)(11), which provides that dividends received by taxpayers other than corporations generally will be taxed at the same rate as long-term capital gains, i.e., 15 percent for taxpayers otherwise taxable at a rate greater than 15 percent; and five percent for taxpayers otherwise at 10 or 15 percent (with a special zero percent rate for 10and 15-percent bracket taxpayers in 2008). this rate applies to dividends received from domestic and qualified foreign corporations for purposes of both the regular tax and the alternative minimum tax. a dividend is treated as investment income for purposes of determining the amount of deductible investment interest under § 163(d) only if the taxpayer elects to treat the dividend as not eligible for the reduced rates. the provision is effective for taxable years beginning after 12/31/02, and beginning before 1/1/09. ! if a shareholder does not hold a share of stock for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date (as measured under section 246(c)), dividends received on the stock are not eligible for the reduced rates. also, the reduced rates are not available for dividends to the extent that the taxpayer is obligated to make related payments with respect to positions in substantially similar or related property. note that the 60-day holding period cannot be satisfied by stock that is acquired one day before the ex-dividend date. this anomaly is to be retroactively corrected in the tax technical corrections bill (h.r. 3654), which was introduced by ways & means committee chair thomas and ranking minority member rangel. 2003 tnt 236-1. a. let’s pretend it has been already corrected for the spring 2004 filing season. ir-2004-22 (2/19/04). the irs announced it agreed to make the provisions of § 2 of the tax technical corrections act of 2003, related to dividends, available to taxpayers in advance of its passage. these include an increase of the 120-day period to 121 days, as well as 80 florida tax review [vol.7:si permitting passthrough entities that received dividends in fiscal years beginning in 2002 to treat as qualifying dividends those qualifying dividends received in 2003. b. it is finally corrected in october. section 402(a)(2) of the working families tax relief act of 2004 does, indeed, correct that glitch. b. miscellaneous income 1. home-made alimony. dato-nodurft v. commissioner, t.c. memo. 2004-119 (5/17/04). payments under a written support agreement qualified as alimony even though the husband and wife, who were living apart, were not legally separated and the agreement was not enforceable under state law. 2. prejudgment interest in a personal injury lawsuit is not excluded from income. chamberlain v. united states, 401 f.3d 335, 95 a.f.t.r.2d 2005-1069, 2005-1 u.s.t.c. ¶ 50,194 (5th cir. 2/18/05). prejudgment interest recovered in a personal injury lawsuit is not excluded from income under § 104(a)(2) because it was compensation for the lost time value of money and is not received “on account of” the personal injury. ! may prejudgment interest be excluded if there is a settlement? more specifically, post-judgment interest exclusion is permitted by the exclusion of the entire amount of any future payment received pursuant to a structured settlement. does this create a difference between a recovery by way of settlement and a recovery by way of judgment? c. profit-seeking individual deductions 1. the alternative minimum tax (“amt”) trap for attorneys’ fees on large recoveries will continue to be an issue despite legislation and a supreme court decision. a. cases decided by a majority of courts in recent years sprang the amt trap. attorney’s fees incurred by an individual in a nonbusiness profit-seeking transaction are [§ 212] miscellaneous itemized deductions [§ 67] and may not be deducted for amt purposes. to avoid this result, taxpayers in a number of cases in recent years have argued the portion of a taxable damage award retained by the taxpayer-plaintiff’s attorney as a contingent fee is excluded from the taxpayer-plaintiff’s income and treated as income earned directly by the attorney. generally, the tax court and most circuits hold that attorney’s fee awards paid directly to a plaintiff’s attorney [or the portion of a damage award that is the attorney’s contingent fee that is so 2005] recent developments in federal income taxation 81 paid] are nevertheless includable in the litigant’s gross income, and that the taxpayer then may claim a deduction, subject to any applicable limitations, including disallowance of the deduction for amt purposes if it is a § 212 deduction. bagley v. commissioner, 105 t.c. 396 (1995), aff’d 121 f.3d 393 (8th cir. 1997). accord baylin v. united states, 43 f.3d 1451 (fed. cir. 1995), aff’g 30 fed. cl. 248 (1993); alexander v. irs, 72 f.3d 938, 96-1 u.s.t.c. ¶ 50,011 (1st cir. 1995), aff’g t.c. memo. 1995-51 (1/31/95); coady v. commissioner, 213 f.3d 1187, 2000-1 u.s.t.c. ¶ 50,528 (9th cir. 2000), aff’g t.c. memo. 1998-291 (8/6/98); benci-woodward v. commissioner, 219 f.3d 941, 2000-2 u.s.t.c. ¶ 50,595 (9th cir. 2000), aff’g t.c. memo. 1998-395 (11/9/98), cert. denied, 531 u.s. 1112 (2001); kenseth v. commissioner, 259 f.3d 881, 88 a.f.t.r.2d 2001-5378, 2001-2 u.s.t.c. ¶ 50,570 (7th cir. 8/7/01), aff’g 114 t.c. 399 (5/24/00) (reviewed, 8-5); young v. commissioner, 240 f.3d 369, 87 a.f.t.r.2d 2001-889, 2001-1 u.s.t.c. ¶ 50,244 (4th cir. 2/16/01), aff’g, 113 t.c. 152 (8/20/99); hukkanen-campbell v. commissioner, 274 f.3d 1312, 88 a.f.t.r.2d 2001-7983, 2002-1 u.s.t.c. ¶ 50,351 (10th cir. 12/19/01), aff’g t.c. memo. 2000-180 (6/12/01), cert. denied, 535 u.s. 1056 (5/13/02); raymond v. united states, 355 f.3d 107, 93 a.f.t.r.2d 2004-416, 2004-1 u.s.t.c. ¶ 50,124 (2d cir. 1/13/04). b. but the eleventh circuit relied on state (attorneys’ lien) law and held that attorney’s fees were not included in the client’s recovery. davis v. commissioner, 210 f.3d 1346, 2000-1 u.s.t.c. ¶ 50,431 (4/27/00) (per curiam), aff’g t.c. memo. 1998-248 (7/7/98). willa mae davis recovered $151,000 of compensatory damages and $6 million of punitive damages against two companies that made loans to homeowners in alabama. her share of the recovery after legal fees and expenses was $3,039,191. in davis, which was appealable to the eleventh circuit, the tax court followed cotnam under the golsen rule because under bonner v. city of prichard, alabama, 661 f.2d 1206 (11th cir. 1981), fifth circuit decisions rendered before the eleventh circuit was created are binding precedent in the eleventh circuit. ! in cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959) (2-1), wisdom, j. dissenting), the fifth circuit held that attorney’s fees paid directly to a plaintiff’s attorney are not includable by the litigant. the majority reasoned that under the alabama attorney’s lien law, the ownership of the portion of the award representing attorney’s fees vested in the attorney ab initio. ! this view was followed by the sixth and ninth circuits in estate of clarks v. united states, 202 f.3d 854, 85 a.f.t.r.2d 2000-405, 2000-1 u.s.t.c. ¶ 50,158 (6th cir. 1/13/00) (michigan law), and banaitis v. commissioner, 340 f.3d 1074 (9th cir. 8/27/03), rev’g t.c. memo. 2002-5 (1/8/02) (oregon law), rev’d sub nom commissioner v. banks, 125 s. ct. 826, 2005-1 u.s.t.c. ¶ 50,155 (u.s. 1/24/05). 82 florida tax review [vol.7:si (1) banaitis v. commissioner, 340 f.3d 1074 (9th cir. 8/27/03), rev’g t.c. memo. 2002-5. in a case involving attorney’s fees subject to oregon attorney’s fee lien law, the ninth circuit (judge thomas) held the portion of a taxable damage award (for wrongful discharge from employment) retained by the attorney as a contingent fee was not includable in the taxpayer-plaintiff’s gross income. judge thomas found that the nature of the attorney’s fee lien was determinative. examining relevant state law, he concluded that under oregon law, the attorney’s claim to the fee was even stronger than under alabama law. therefore he applied the fifth circuit’s decision in cotnam v. commissioner, 263 f.2d 119 (5th cir.1959), holding that contingent attorney’s fees paid directly to an attorney were not includable in the client’s gross income because alabama attorney’s fee lien law vested title in the attorney ab initio. judge thomas declined to apply the ninth circuit’s precedents in benci-woodward v. commissioner, 219 f.3d 941, 943 (9th cir.2000), cert. denied, 531 u.s. 1112 (2001), and coady v. commissioner, 213 f.3d 1187 (9th cir.2000), on the grounds that oregon attorney’s fee lien law was significantly different than that of california and alaska, which were relevant in those cases. ! in his opinion, judge thomas described the fifth circuit as having “reached a similar conclusion about the operation of texas law” in srivastava v. commissioner, 220 f.3d 353 (5th cir. 2000), and the eleventh circuit as “extending cotnam’s alabama-lawbased holding into the law of the entire eleventh circuit” in foster v. united states, 249 f.3d 1275, 1278 (11th cir. 2001), notwithstanding that in srivastava the fifth circuit actually reached its conclusion wholly apart from the niceties of texas attorney’s lien law and in foster the eleventh circuit was dealing with a case that arose in alabama, for which there was no doubt that cotnam was the controlling precedent. [the eleventh circuit has not yet decided an attorney’s fees amt trap case arising in florida or georgia.]. c. the fifth and sixth circuits held that attorney’s fees were not included in the client’s recovery under a national standard regardless of the particulars of state attorneys’ lien law. srivastava v. commissioner, 220 f.3d 353, 2000-2 u.s.t.c. ¶ 50,597 (5th cir. 2000) (2-1), rev’g t.c. memo 1998-362 (10/6/98), overruled by commissioner v. banks, 125 s. ct. 826 (1/24/05). a majority of the court held that cotnam applied to attorneys’ fees under texas law because there is no difference in the “economic reality facing the taxpayer-plaintiff” between alabama and texas attorney’s liens and any distinction between them does not affect the analysis required by the anticipatory assignment of income doctrine. a dissent by judge dennis distinguished cotnam on the ground that alabama law gives the holders of attorney’s liens greater power than does texas law. (1) and the sixth circuit followed the national standard in banks. banks v. commissioner, 345 f.3d 373, 92 a.f.t.r.2d 2005] recent developments in federal income taxation 83 2003-6298 (6th cir. 9/30/03), rev’d and remanded by commissioner v. banks, 125 s. ct. 826 (1/24/05). the sixth circuit followed the fifth circuit’s decision in srivastava v. commissioner, 220 f.3d 353 (5th cir. 2000), and reaffirmed that the sixth circuit’s holding in estate of clarks v. commissioner, 202 f.3d 854 (6th cir. 2000), the decision was based on a broader principle than the ground that state attorney’s fee lien law determines whether the taxpayerplaintiff can exclude attorney’s fees. the taxpayer, who lived in michigan when he filed his tax court petition, but who had previously been employed in california and had settled a wrongful termination suit brought in california for taxable tort damages under california law, was allowed to exclude the contingent attorney’s fees, even though they were governed by california law and the ninth circuit would have reached a contrary conclusion under benciwoodward v. commissioner, 219 f.3d 941 (9th cir. 2000). d. the supreme court reverses banks and banaitis and decides the amt trap issue in favor of the government, following the majority of courts that have faced this issue. commissioner v. banks, 125 s. ct. 826, 2005-1 u.s.t.c. ¶ 50,155 (u.s. 1/24/05) (8-0) (consolidated with banaitis). justice kennedy’s unanimous opinion held that a contingent fee agreement should be viewed as an anticipatory assignment of income to the attorney by the client. he relied on the assignment of income doctrine cases, e.g., lucas v. earl, 281 u.s. 111 (1930) and helvering v. horst, 311 u.s. 112 (1940), and found this doctrine to be relevant in arm’s length transactions as well as family transactions, stating, “we hold that, as a general rule, when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.” the court ruled that the attorney-client relationship was governed by agency law, and not by partnership law (although, later in the opinion, it refused to rule on the partnership argument because it was raised too late). ! the court did not rule on whether attorney’s fees awarded pursuant to claims brought under federal statutes that authorize fee awards to prevailing plaintiffs, noting that banks settled his discrimination case and the fee paid to his attorney was based upon the contingent fee agreement, and was not awarded by a court. e. congress grants relief for civil rights plaintiffs, but not for all clients of plaintiffs’ lawyers. amt trap to be closed, but only prospectively and not with respect to taxable recoveries not listed in new § 62(e). section 703 of the american jobs creation act of 2004 adds new paragraph (19) to § 62(a) which permits above-the-line deductibility of contingent attorneys’ fees in lawsuits for unlawful discrimination (which is defined in § 62(e) to include 18 separate categories of civil rights-type lawsuits, but not simple defamation, consumer fraud and punitive damages). the 84 florida tax review [vol.7:si provision applies to judgments and settlements occurring after the date of enactment. ! left open are attorney’s fees relating to recoveries for consumer fraud, defamation and possibly employment contract disputes. as well as punitive damages and taxable interest in personal injury cases. d. hobby losses and section 280a home office and vacation homes 1. section 183 sent the claimed loss deduction to davy jones’s locker. magassy v. commissioner, t.c. memo. 2004-4 (1/5/04). judge swift applied § 183 to disallowing a claimed § 1231 loss on the sale of a yacht. e. deductions and credits for personal expenses 1. deduct some of those retirement community costs as medical expenses, but not the swimming pool. does this result in whipsaw for the irs? baker v. commissioner, 122 t.c. 143 (2/19/04). if a taxpayer pays a monthly life-care fee to a retirement home, the portion of the fee that the taxpayer proves is for medical care is deductible as a medical expense. this case addressed the question of the proper method for allocating fees paid to a long-term care facility between deductible medical expenses and nondeductible personal living expenses. relying on rev. rul. 67-185, 1967-1 c.b. 70, rev. rul. 75-302, 1975-2 c.b. 86, and rev. rul. 76-481, 1976-2 c.b. 82, judge goeke approved the taxpayer’s use of the “percentage method,” and declined to require the taxpayer to use the more complex “actuarial method” advocated by the commissioner. the percentage method assumes that the medical care portion of entrance fees and monthly service fees is the same portion or percentage as the [continuing care retirement community’s] medical expenses to total costs because the sum of the fees over the resident’s lifetime is expected to cover the costs of care for residents in a ccrc. based on several revenue rulings, the court held that there is “no requirement . . . that taxpayers engage in an actuarial analysis to factor in life expectancy and health care level expectancy on the basis of the residency population of a ccrc to determine estimated lifetime medical care costs and total costs.” the burden of proof on the issue had been shifted to the commissioner under § 7491 because the taxpayer had presented credible evidence to support the amount claimed as a deduction and had met all of the other statutory requirements. 2. the amt kicks new yorkers again. ostrow v. commissioner, 122 t.c. 378 (5/21/04). judge colvin held that the § 56(b)(1) disallowance for amt purposes of taxes deductible under § 164 extends to taxes on a cooperative housing corporation that are deductible by the shareholder-tenant under § 216. 2005] recent developments in federal income taxation 85 3. we now have a uniform definition of “child;” can we now get a uniform definition of “married?” sections 201-208 of the working families tax relief act of 2004 provides a uniform definition of “child” for head of household, dependent care credit, child tax credit, earned income tax credit, and dependent exemption purposes. forms 8332 would not be required by the non-custodial parent when the shifting to that parent of the dependency deduction is provided for in the divorce decree or separation agreement. f. education there were no significant developments regarding this topic during 2004. vi. corporations a. entity and formation 1. rev. rul. 2004-59, 2004-24 i.r.b. 1050 (5/25/04). a partnership that converts to a corporation under a state law formless conversion statute will be deemed to contribute all its assets and liabilities to the corporation in exchange for stock in such corporation, and immediately thereafter, the partnership liquidates distributing the stock of the corporation to its partners. this is the same method provided by reg. § 301.7701-3(g)(1)(i) when a partnership elects to be classified as an association. ! rev. rul. 84-111, 1984-2 c.b. 88, which permits selection among the three methods of incorporating a partnership, provided that the steps described are actually undertaken. rev. rul. 84-111 superseded and revoked rev. rul. 70-598, 1970-2 c.b. 168, which had held that partnership incorporations would be treated for tax purposes as if the partnership transferred assets to the corporation in exchange for stock. 2. section 836(a) of the american jobs creation act of 2004 amends adds new § 362(e) to provide limitation on the importation, or transfer in § 351 transactions, of built-in losses to corporations. the aggregate basis of the property so received will be limited to its fair market value immediately after the transaction. b. distributions and redemptions 1. the tax court is bearish on merrill lynch. merrill lynch & co., inc. v. commissioner, 120 t.c. 12 (1/15/03). in 1986 and 1987 merrill lynch structured several transactions to sell certain assets of first-tier and second-tier subsidiaries not only eliminate any tax on the gains, but to create losses. to take advantage of the interaction of the consolidate return regulations 86 florida tax review [vol.7:si and § 304 [before the promulgation of reg. § 1.1502-80(b), rendering § 304 inoperative in consolidated returns], merrill lynch caused the subsidiaries holding the assets to drop the assets to be retained into new lower level subsidiaries [in § 351 transactions], following which the new subsidiaries were sold cross chain to other merrill lynch subsidiaries. the sales proceeds were then distributed to its parent by the subsidiary to be sold, and that subsidiary was then sold. the plan was that the cross-chain sale would be recharacterized as a dividend under § 304, which would result in a basis increase under reg. §§ 1.1502-32 and -33 [as then in effect] in the stock of the subsidiaries to be sold. the irs did not contest that § 304 applied, but responded that the “distributions” coupled with the sales of the subsidiaries outside the group were part of a firm and fixed plan by the subsidiaries that were sold outside the group to dispose of the stock of the lower tier subsidiaries that had been sold cross chain. therefore, even after applying § 304 the distributions were treated as amounts received in a redemption under § 302(b)(3) [applying zenz v. quinlivan, 213 f.2d 913 (6th cir. 1954)]. the tax court (judge marvel) held that under the principles of niedermeyer v. commissioner, 62 t.c. 280 (1974), a firm and fixed plan existed with respect to every such sale and held for the irs. the record establishes that on the dates of the cross-chain sales, petitioner had agreed upon, and had begun to implement, a firm and fixed plan to completely terminate the target corporations’ ownership interests in the issuing corporations (the subsidiaries whose stock was sold cross-chain). the plan was carefully structured to achieve very favorable tax basis adjustments resulting from the interplay of section 304 and the consolidated return regulations, and the steps of the plan were described in detail in written summaries prepared for meetings of merrill parent’s board of directors. as described in those written summaries, the cross-chain sales of the issuing corporations’ stock and the sales of the target corporations were part of the same seamless web of corporate activity intended by petitioner to culminate in the sale of the target corporations outside the consolidated group. a. as is the second circuit, which affirmed the tax court. 386 f.3d 464, 94 a.f.t.r.2d 2004-6119, 2005-1 u.s.t.c. ¶ 50,243 (2d cir. 9/28/04). the second circuit affirms the tax court conclusions but remands for consideration of a new issue advanced for the first time on appeal. this issue was that, by reason of the § 318 attribution rules, the cross-chain sales did not terminate the interest of merrill lynch within the meaning of § 302(b)(3). 2005] recent developments in federal income taxation 87 2. pushing the envelope on complete termination. hurst v. commissioner, 124 t.c. 16 (2/3/05). the taxpayer pushed the envelope on a classic § 302(b)(3) complete redemption by a closely held corporation controlled by his children, and succeeds even though he retained a security interest in the redeemed shares, he continued to own the corporation’s headquarters building, and (especially) his wife continued to be an employee of the corporation under a 10-year employment contract (under which she and her husband continued to receive medical insurance). it was significant that taxpayer’s wife never owned stock in the corporation. c. liquidations there were no significant developments regarding this topic during 2004. d. s corporations 1. s corporation stock rolled over from an esop to an ira does not disqualify the s election if the stock is repurchased on the same day. rev. proc. 2004-14, 2004-7 i.r.b. 489 (2/17/04). the rollover distribution of s corporation stock by an esop to a participant’s ira will not affect the corporation’s s election if the stock is immediately repurchased from the ira by the s corporation or the esop. 2. daisy-chain loans don’t represent an economic outlay. oren v. commissioner, 357 f.3d 854, 93 a.f.t.r.2d 2004-858, 2004-1 u.s.t.c. ¶ 50,165 (8th cir. 2/12/04), aff’g t.c. memo. 2002-172 (7/19/02). the taxpayer was the controlling shareholder of three s corporations, one of which (dart) passed-through substantial income, and the others of which (highway leasing and highway sales) passed-through losses in excess of the taxpayers basis [due to depreciation on leveraged depreciable equipment]. the taxpayer sought to utilize the losses by creating basis in highway leasing and highway sales through a series of circular loan transactions: the taxpayer borrowed money from dart, which he lent to highway leasing and highway sales on terms identical to the terms of the loans from dart to the taxpayer, following which highway leasing and highway sales lent the funds to dart. in the tax court, judge ruwe held that the loans had no economic substance and that oren had not made any “economic outlay.” thus, except to the extent of $200,000 lent from his own personal assets, oren did not acquire basis in the promissory notes from highway leasing and highway sales against which the losses could be deducted. furthermore, the circular loan arrangement was a “loss limiting arrangement” under § 465(b)(1) because there was no “any realistic possibility of loss” by oren because the facts did not indicate that the circular chain of payment could be broken. judge ruwe rejected the possibility that the chain of 88 florida tax review [vol.7:si payment might be broken by a tort judgment against one of the corporations in excess of its large insurance coverage. ! the court of appeals affirmed. oren’s loans to highway leasing and highway sales had no economic substance and, thus, were not real economic outlays, even though all of the formalities necessary to create legal obligations were followed. no external parties were involved and the transactions were not at arm’s length. oren was in the same position after the transactions as before. the transactions resembled offsetting book entries or loan guarantees more than substantive investments. furthermore, oren was not at-risk under § 465. the possibility that he would suffer at loss was remote because he was protected by the circular nature of the loan transactions. “the ‘theoretical possibility that the taxpayer will suffer economic loss is insufficient to avoid the applicability of [§ 465].’” 3. reg-131486-03, adjustment to net unrealized built-in gain, 69 f.r. 35544 (6/25/04). proposed regulations under § 1374 provide guidance for an adjustments to net unrealized built-in gain in certain cases in which an s corporation acquires assets from a c corporation in an acquisition to which § 1374(d)(8) applies. treasury rejected an approach that would provide for a single determination of nubig for all of the assets of an s corporation in favor of an approach that adjusts the nubig of the pool of assets that included the stock of the liquidated or acquired c corporation to reflect the extent to which the built-in gain or loss inherent in the c corporation stock is eliminated. 4. it just keeps gett’n tougher and tougher to be an s corporation shareholder when bankruptcy is in the air. williams v. commissioner, 123 t.c. 144 (7/22/04). the taxpayer owned all of the stock of two calendar year s corporations that incurred losses for the year. he filed a personal bankruptcy petition at the beginning of december and reported a pro rata share of the losses on his personal return. the commissioner disallowed the passed through losses on the grounds that § 1377 [allocating losses on a per share per day basis] did not apply and that § 1398 allocated all of the losses to the bankruptcy estate. judge kroupa upheld that commissioner’s position, reasoning that “[u]nder § 1398(f)(1) a transfer of an asset from the debtor to the bankruptcy estate when the debtor files for bankruptcy is not a disposition triggering tax consequences, and the estate is treated as the debtor would be treated with respect to that asset.” thus the bankruptcy estate was treated as if it had owned all of the shares of the s corporations for the entire year and was entitled to all of the passed-through losses. [the tax court reached the same conclusion with respect to a bankrupt partner in a partnership passing through losses in gully v. commissioner, t.c. memo. 2000-190.] furthermore, any passed-though losses to which the bankruptcy estate succeeded, or losses that were passed through to the bankruptcy estate, and which were not used to offset income realized by the bankruptcy estate, pursuant to § 108(b)(2) were reduced 2005] recent developments in federal income taxation 89 by the amount of cod income that was not recognized under § 108(a) before being passed on to the taxpayer pursuant to § 1398(i) upon termination of the bankruptcy proceeding. a. compare the situation where it is the s corporation that goes into bankruptcy. mourad v. commissioner, 121 t.c. 1 (7/2/03), aff’d, 387 f.3d 27, 94 a.f.t.r.2d 2004-6440, 2004-2 u.s.t.c. ¶ 50,419 (1st cir. 10/20/04) as amended, (1st cir. 11/20/04). when an individual’s wholly-owned s corporation filed for a bankruptcy chapter 11 plan of reorganization [and an independent trustee was appointed by the bankruptcy court] the individual remained liable for the tax on any income or gain recognized by the s corporation. 5. rev. rul. 2004-85, 2004-33 i.r.b. 189 (7/16/04). if an s corporation that owns a qsub engages in an “f” reorganization, the qsub election does not terminate. but if the qsub stock is sold or transferred in a reorganization that does not qualify as an “f” reorganization, then the election terminates. an entity classification election described in reg. §301.7701-3(b) does not terminate solely because the owner transfers all of the membership interest in the eligible entity to another person. 6. members of one (greatly extended) family are treated as one shareholder. section 231 of the american jobs creation act of 2004 amends § 1361 to treat members of a family as one shareholder at the election of any family member. shareholders with a common ancestor going back six generations are members of the same family. ! this means that a shareholder and his fifth cousin are members of the same family. this would have the effect of making the entire population of arkansas members of the same family. research on this issue should most easily be done in the mormon church archives located in salt lake city. ! query whether this provision could be used to capitalize an s corporation with subscriptions from thousands of shareholders, the stock of which would be readily marketable to members of the 100 families. a. the maximum number of shareholders is increased from 75 to 100. section 232 of the american jobs creation act of 2004 amends § 1361 to increase the number of eligible shareholders from 75 to 100. 7. section 233 of the american jobs creation act of 2004 amends § 1361 to permit iras to be shareholders of bank s corporations. 90 florida tax review [vol.7:si a. section 237 of the american jobs creation act of 2004 amends § 1362 to exclude investment securities income from the passive income test for bank s corporations. 8. this change is not really needed because members of the same family are counted as a single shareholder, § 234 of the american jobs creation act of 2004 amends § 1361 to disregard unexercised powers of appointment in determining potential current beneficiaries of an esbt. 9. section 235 of the american jobs creation act of 2004 amends § 1366 to permit transfers of suspended losses between spouses incident to divorce. 10. section 236 of the american jobs creation act of 2004 amends § 1361 to permit use of passive activity loss and at-risk amounts by qsst beneficiaries. 11. section 238 of the american jobs creation act of 2004 amends § 1362 to provide relief from inadvertently invalid q-sub elections and terminations. a. information returns to be required for q-subs. section 239 of the american jobs creation act of 2004 amends § 1361 to provide for q-sub treatment with respect to information returns. 12. section 240 of the american jobs creation act of 2004 amends § 4975 to provide that the repayment by s corporations of loans for qualifying employer securities will not be treated as violating employment plan rules nor will they be prohibited transactions. e. affiliated corporations 1. schizophrenic temporary regulations for consolidated group discharge of indebtedness income and reduction of attributes. t.d. 9089, guidance under section 1502; application of section 108 to members of a consolidated group, 68 f.r. 52487-03 (9/4/03). the treasury has promulgated temporary regulations under § 1502, amending temp. reg. § 1.1502-19t(b) and (h), temp. reg. § 1.1502-21t(b), and temp. reg. § 1.1502-32t and adding temp. reg. § 1.1502-28t, governing the application of § 108 when a member of a consolidated group realizes discharge of indebtedness income. the regulations provide that the amount of discharge of indebtedness income excluded from gross income in the case in which the debtor-corporation is insolvent is determined based on the assets and liabilities of only the member with discharge of indebtedness income. however, applying 2005] recent developments in federal income taxation 91 an interpretation of dominion industries, inc. v. united states, 532 u.s. 822 (2001), the regulations provide that the group’s consolidated attributes in their entirety are subject to reduction under §108(b), but the attributes attributable to the debtor member are the first attributes reduced. the regulations also adopt a look-through rule that applies if the debtor member’s attribute that is reduced is the basis of stock of another group member. in this case, corresponding adjustments are made to the attributes attributable to the lower-tier member. identical proposed regulations have been published. 68 f.r. 52542-01 (9/4/03). a. temporary regulations are amended. t.d. 9098, guidance under section 1502; application of section 108 to members of a consolidated group, 68 f.r. 69024-01 (12/11/03). temp. reg. § 1.150228t(a)(4) provides that when a member of a consolidated group realizes cod income excluded under § 108(a), after the reduction of the tax attributes attributable to the debtor member under § 108(b), tax attributes attributable to other members other than the debtor member (other than asset basis) that arose in a separate return year or that arose (or are treated as arising) in a separate return limitation year to the extent that no srly limitation applies to the use of such attributes by the group are subject to reduction. generally effective 8/29/03. b. temporary and proposed regulations address issues related to § 1245, the § 1.1502-13 matching rules and excess loss accounts. t.d. 9117, guidance under section 1502; application of section 108 to members of a consolidated group, 69 f.r. 12069-01 (3/15/04); reg167265, guidance under section 1502; application of section 108 to members of a consolidated group; computation of taxable income when section 108 applies to a member of a consolidated group, 69 f.r. 12091-01 (3/15/04). the temporary and proposed regulations provide rules to preclude inclusion in consolidated taxable income amounts reflecting previously excluded cod income more than once, albeit as ordinary income where attributable to § 1245 property. they also provide that if the basis of an intercompany obligation held by a creditor member is reduced in respect of excluded cod income, reg. § 1.1502-13(c)(6)(i) will not apply to exclude income of the creditor member attributable to the basis reduction. the proposed regulations include rules for the computation of that portion of an excess loss account that must be taken into income, as well as its timing. 2. consolidated return regulations may prescribe results for corporations filing consolidated returns different from the results for corporations filing separate returns. but if the rite aid holding is not changed, what does this provision mean? section 844(a) of the american jobs creation act of 2004 amends § 1502 by providing that the consolidated return regulations may contain “rules that are different from the provisions of 92 florida tax review [vol.7:si chapter 1 that would apply if such corporations filed separate returns.” section 844(b) of the american jobs creation act of 2004 provides that “[n]otwithstanding the amendment made by subsection (a), the internal revenue code of 1986 shall be construed by treating treasury regulation § 1.1502-20(c)(1)(iii) (as in effect on january 1, 2001) as being inapplicable to the factual situation in rite aid corporation and subsidiary corporations v. united states, 255 f.3d 1357 (fed. cir. 2001).” 3. the definition of “controlled group” is expanded. section 900 of the american jobs creation act of 2004 amends § 1563 to expand the definition of controlled group of corporations for purposes of multiple use of the lower tax rates on the first $75,000 of taxable income. the requirement that 80 percent of the stock be owned by 5 or fewer shareholders has been eliminated. 4. loss limitation rules are provided in temporary and proposed regulations. t.d. 9118, loss limitation rules, 69 f.r. 12799-01 (3/18/04); reg-153172-03, loss limitation rules, 69 f.r. 12811-01 (3/18/04). temporary regulation amendments relate to the deductibility of losses under the temporary regulations under § 337(d) and the anti-duplication temporary consolidated returns regulations relating to the claiming of a worthless stock deduction with respect to a subsidiary’s stock. the proposed regulations crossreference the temporary regulations. a. basis disconformity method will be permitted. notice 2004-58, 2004-39 i.r.b. 520 (8/25/04). the irs will permit taxpayers to use the basis disconformity method or other methods, e.g., tracing, for determining the amount of stock loss or basis that is not attributable to the recognition of built-in gain on the disposition of an asset; such stock loss will be allowed. such amount of stock loss will not be disallowed and such amount of subsidiary stock basis will not be reduced. b. regulations are now final. t.d. 9187, loss limitation rules, 70 f.r. 10319-01 (3/3/05). these final regulations under §§ 337(d) and 1502 follow the rules described in notice 2004-58. f. reorganizations 1. notice 2004-44, 2004-28 i.r.b. 32 (6/22/04). this notice requests comments on rev. proc. 81-70, 1981-2 c.b. 729, which sets forth guidelines on estimating the basis of stock acquired by an acquiring corporation in a b reorganization. the request is prompted by concern that changes in the marketplace since 1981, i.e., changes in the way stock is held today, may prevent access to the information necessary to determine shareholders’ bases in such stock. 2005] recent developments in federal income taxation 93 2. rev. rul. 2004-78, 2004-31 i.r.b. 108 (7/13/04). target merges into an acquiring corporation in an a reorganization, and in the merger target shareholders exchange their stock for common stock in the acquiring corporation and holders of target securities exchange their target debt for debt of the acquiring corporation. the debt instruments had two years remaining on their term, and were identical except for the interest rate. held, the debt is a security, which may be exchanged tax-free under § 354. ! query how reg. § 1.1001-3 applies to what would be a “significant modification” were this exchange of debt within a single corporation? 3. rev. rul. 2004-83, 2004-32 i.r.b. 157 (7/16/04). if, pursuant to an integrated plan, a parent corporation sells the stock of a wholly owned subsidiary for cash to another wholly owned subsidiary and the acquired subsidiary is completely liquidated into the acquiring subsidiary, the transaction is treated as a “d” reorganization. if the corporations are members of a consolidated group, § 304 cannot apply to the stock sale nor can § 338 apply because there is no stock purchase within the meaning of § 338(h)(3)(a); if they are not members of a consolidated group, the transaction would be treated as a § 332 liquidation if the steps are not integrated and as a “d” reorganization if they are. g. corporate divisions 1. business purpose may be satisfied even if the personal planning purposes of a shareholder are also satisfied if the shareholder purpose is so coextensive with the corporate business purpose as to preclude any distinction between them. rev. rul. 2004-23, 2004-11 i.r.b. 585 (2/13/04). a distribution by a publicly traded corporation that is expected to cause the aggregate value of the stock of distributing and controlled corporations to exceed the pre-distribution value of the distributing corporations satisfies the corporate business purpose requirement of § 355 when the increased value is expected to serve a corporate business purpose of either or both corporations, even if it benefits the shareholders of distributing corporations. h. personal holding companies and accumulated earnings tax there were no significant developments regarding this topic during 2004. 94 florida tax review [vol.7:si i. miscellaneous corporate issues 1. contingent liabilities assumed in an asset acquisition must be capitalized. illinois tool works inc. v. commissioner, 355 f.3d 997, 93 a.f.t.r.2d 2004-548, 2004-1 u.s.t.c. ¶ 50,130 (7th cir. 1/21/04), aff’g 117 t.c.39 (7/31/01). the taxpayer acquired the assets of another corporation [for approximately $126 million] in a taxable transaction in which the taxpayer assumed the target’s liabilities, including a contingent liability for a patent infringement claim, [lemelson v. champion spark plug co., 975 f.2d 869 (1992)], for which it established a reserve of $350,000. subsequently, the taxpayer, as the target’s successor was held liable for damages, interest, and court costs [totalling over $17 million], which it paid. the court upheld the commissioner’s treatment requiring capitalization of the payments as a cost of acquiring the assets rather than a deductible expense, even though the parties had not adjusted the purchase price to reflect the contingent liability. the liability was known, was considered in setting the price, and was expressly assumed. that the taxpayer considered it highly unlikely that it would be called upon to pay was not relevant.6 2. sale of shares by a taxpayer to his brother in a closely held corporation claiming a net operating loss deduction resulted in a § 382 change of control that triggered the limitation on nol carryovers. garber industries holding co. v. commissioner, 124 t.c. 1 (1/25/05). in a 1986 “d” reorganization, one of the garber brothers (charles) had his interest in the corporation decreased from 68 percent to 19 percent and the other brother (kenneth) had his interest increased from 26 percent to 65 percent. in 1988, charles sold all of his remaining shares to kenneth, with the result that the kenneth’s interest in the corporation increased from 19 percent to 84 percent. the parents of charles and kenneth were both deceased, and when living never had any ownership interest in the corporation. ! the court refused to follow taxpayers’ argument that siblings are treated as one individual under the nol aggregation rule, which provides that an individual and all members of his family described in § 318(a)(1), i.e., spouses, children, grandchildren and parents, are treated as one individual. ! judge halpern also refused to follow the commissioner’s argument that the family aggregation rule does not apply because none of the parents and grandparents of the garber brothers were alive at the beginning of the 3-year testing period immediately preceding the 1998 transaction. ! instead, he concluded that a third interpretation was correct, i.e., that the aggregation rule is to apply solely from 6. this case is discussed more fully at s&m, supra note 2, at 519-20. 2005] recent developments in federal income taxation 95 the perspective of individuals who are shareholders of the loss corporation, and that the brothers were unrelated under this perspective. vii. partnerships a. formation and taxable years there were no significant developments regarding this topic in 2004. b. allocations of distributive share, partnership debt, and outside basis 1. these related corporations were not related for purposes of this case. ipo ii v. commissioner, 122 t.c. 295 (4/23/04). forsyth was a partner with his wholly owned s corporation (indeck overseas) in a partnership that borrowed money to purchase an airplane. the loan was guaranteed by forsyth, but not by indeck overseas. in addition, the loan was guaranteed by indeck energy, an s corporation 70 percent of the stock of which was owned by forsyth, and 30 percent of which was owned by his daughter; the loan was also guaranteed by indeck power, a c corporation that was 63 percent owned by forsyth. for purposes of allocating partnership indebtedness under § 752, and accordingly losses under § 704(b), the partners claimed that the loan was fully recourse to both forsyth and indeck overseas. they argued that indeck overseas was at-risk for the partnership debt because by virtue of forsyth’s common ownership of both corporations, it was related to indeck energy, which had guaranteed the debt. under reg. §§ 1.752-1(a)(1) and 1.752-2(c)(2) a liability is recourse if a partner or a related party bears the risk of loss. however, an exception to this related party provision in reg. § 1.752-4(b)(2)(iii) provides that persons owning directly or indirectly interests in the same partnership are not treated as related. judge haines held that the relationship between the indeck energy, the guarantor, and indeck overseas was negated by reg. § 1.752-4(b)(2)(iii) because the relationship was traced through forsyth, who was a partner in the partnership. 2. reg-128767-04, treatment of disregarded entities under section 752, 69 f.r. 49832 (8/12/04). proposed regulations provide that in determining the extent to which a partner bears the economic risk of loss for a partnership liability, payment obligations of a disregarded entity are taken into account only to the extent of the net value of the disregarded entity, except where the owner of the disregarded entity is otherwise required to make a payment with respect to the obligation of the disregarded entity. 96 florida tax review [vol.7:si c. distributions and transactions between the partnership and partners 1. permitting a partnership book-up when a partnership interest is granted for services and you can’t make the regs work if you don’t do it. reg-139796-02, section 704(b) and capital account revaluations, 68 f.r. 39498 (7/2/03). proposed amendments to the § 704(b) regulations would expressly allow partnerships to increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property on the partnership’s books in connection with the grant of an interest in the partnership (other than a de minimis interest) in consideration of services to the partnership by an existing partner acting in a partner capacity or by a new partner acting in a partner capacity or in anticipation of being a partner. the regulation will be effective when finalized. a. proposed regulations are made final without change. t.d. 9126, section 704(b) and capital account revaluations, 69 f.r. 25615 (5/6/04). effective 5/6/04. 2. section 833 of the american jobs creation act of 2004 amends §§ 704(c), 734 and 743. ! under § 704(c)(1)(c), a built-in loss on property contributed to a partnership will be taken into account only by the contributing partner and not by other partners. note that this is the transaction involved in the long-term capital holdings case. ! section 734(b) basis adjustments will be mandatory with respect to built-in losses or adjustments that exceed $250,000 at the partnership level. section 743(b) basis adjustments will be mandatory for basis adjustments that exceed $250,000 at the partnership level. such adjustments under §§ 734 and 743 had been heretofore optional, and need not have been made in the absence of a § 754 election. an elective exception is provided for investment partnerships, but the election requires outside basis adjustments to be made. 3. section 834(a) of the american jobs creation act of 2004 amends § 755 to provide that in making reductions to the basis of property under § 734(b), no allocation is to be made to the basis of stock of a corporation that is a partner in the partnership. d. sales of partnership interests, liquidations and mergers 1. effect of partnership mergers on gain recognition under §§ 704(c)(1)(b) and 737(b). rev. rul. 2004-43, 2004-18 i.r.b. 842 (4/12/04). this ruling deals with the application of §§ 704(c)(1)(b) and 737(b) in partnership mergers. the ruling holds that § 704(c)(1)(b) applies to newly 2005] recent developments in federal income taxation 97 created § 704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership in an assets-over partnership merger, but does not apply to newly created reverse § 704(c) gain or loss resulting from a revaluation of property in the continuing partnership. similarly, for purposes of § 737(b), net precontribution gain includes newly created § 704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership in an assets-over partnership merger, but does not include newly created reverse § 704(c) gain or loss resulting from a revaluation of property in the continuing partnership. thus, a distribution of property previously held by the disappearing partnership will trigger gain recognition if the distribution occurs within seven years after the merger. a. rev. rul. 2004-43 is revoked, and forthcoming regulations will be effective for distributions after 1/19/05. rev. rul. 200510, 2005 i.r.b. (1/19/05), revoking rev. rul. 2004-43, 2004-18 i.r.b. 842. the irs has deferred to commentators whose view is that rev. rul. 2004-43 is inconsistent with the current regulations under §§ 704(c)(1)(b) and 737, and therefore should not be applied retroactively. the irs and treasury will amend the regulations to provide the same result as rev. rul. 2004-43. 2. continuing suit over the termination of a partnership means the partnership hasn’t terminated. harbor cove marina partners partnership v. commissioner, 123 t.c. 64 (7/15/04). harbor cove marina partners partnership filed a tax return indicating that its affairs had been terminated in 1998, and all of the partners but one (collins) reported consistently. following a tefra audit in which the irs issued a notice of final partnership administrative adjustment indicating that the “final” return was correct and that the irs would make no changes, and the tax matters partner’s [understandable] failure to petition the tax court for review under § 6226(a), collins, a notice partner petitioned under § 6226(b) to readjust partnership items relating to the fpaa. judge laro held that the partnership did not terminate under § 708(b)(1)(a) when (1) its managing general partner purportedly wound up the affairs of the partnership’s business operation using procedures apparently contrary to those stated in the partnership agreement, (2) another partner filed a lawsuit to compel the use of the procedures stated in the agreement, and (3) a resolution of that lawsuit could reasonably lead to the partnership’s reporting in a subsequent year of significant income, credit, gain, loss, or deduction. 3. “partnership interest for debt” is to be treated in the same way as “stock for debt.” section 896 of the american jobs creation act of 2004 amends § 108(e)(8) to require recognition of cancellation of indebtedness income realized on the satisfaction of debt with a partnership interest. 98 florida tax review [vol.7:si e. inside basis adjustments 1. rev. rul. 2004-49, 2004-21 i.r.b. 939 (5/24/04). when a partnership revalues a § 197 intangible pursuant to reg. § 1.704-1(b)(2)(iv)(f), the partnership may allocate amortization with respect to the intangible so as to take into account the built-in gain or loss from the revaluation provided that the intangible is amortizable in the hands of the partnership. in that event, the partnership may make remedial, but not traditional or curative allocations of amortization. f. partnership audit rules 1. rev. rul 2004-88, 2004-32 i.r.b. 165 (8/9/04). a partnership that has a disregarded entity as a partner cannot qualify for the “small partnership” exclusion from the §§ 6221-6234 unified partnership and audit provisions because the disregarded entity is a pass-thru partner under § 6231(a)(9). the disregarded entity may, however, be designated the tax matters partner. g. miscellaneous there were no significant developments regarding this topic during 2004. viii. tax shelters a. tax shelter cases 1. significant government victory in tax shelter case! taxpayers’ in-house tax counsel should have taken nancy reagan’s advice when don turlington pitched him a tax planning idea. long-term capital holdings v. united states, 330 f. supp. 2d 122, 2004-2 u.s.t.c. ¶ 50,351 (d. conn. 8/27/04). judge janet bond arterton poured out taxpayers by holding that the tax shelter transaction [under which preferred stock with an inflated basis was contributed to a partnership in a carryover basis transaction] lacked economic substance (or, in the alternative, that the step transaction doctrine required that it be recast into a direct sale of preferred stocks to taxpayers with the result that the basis was equal to the amount they paid) and by upholding the imposition of (in the alternative) both the 40-percent gross valuation misstatement and the 20-percent substantial understatement penalties. after that introductory statement, the remainder of the 198-page opinion was all downhill for taxpayers and their lawyers. ! the inflated basis was the result of several cross-border lease-stripping transactions which left a foreign entity holding 2005] recent developments in federal income taxation 99 several million dollars worth of preferred stocks at a basis $385 million greater than value. the lease-stripping transactions were supported by “should” tax opinions issued by shearman & sterling when they were entered into. ! taxpayers’ in-house tax counsel became interested in the possible utilization of the losses when approached by don turlington, who suggested that the foreign entity contribute the preferred stock to one of taxpayers’ related partnerships, after which the foreign entity would have its partnership interest redeemed. king & spalding agreed to furnish a “should” tax opinion that taxpayers could utilize the foreign entity’s losses, but did not actually provide the opinion until almost a year after the partnership filed the return that took the losses. ! holdings included: (1) the burden of proof did not shift to the government under § 7491 because taxpayers failed to provide a powerpoint presentation and accompanying handout for a presentation of myron scholes to the other eleven of taxpayers’ principals and taxpayers’ net worth was not unambiguously shown to be under $7 million; (2) the transaction lacked economic substance because the reasonably expected return on it could not have resulted in a profit (with the court calling into question the credibility of the former king & spalding lawyer who was the primary drafter of the opinion); (3) the “end result” variety of the step transaction doctrine – the most liberal of the three varieties – was applied to conclude that taxpayers acquired the preferred stocks by purchase at a fair market value basis; (4) the gross valuation misstatement resulted from the claimed adjusted basis of the preferred stocks being more than 400 percent of the adjusted basis that was found by the court to equal fair market value; (5) the substantial understatement penalty was applied based upon taxpayers’ failure to show any authority that held a transaction devoid of economic substance could produce deductible losses; (6) the § 6664(c) “reasonable cause . . . and . . . good faith” exception did not apply because taxpayers failed to prove that the king & spalding oral advice provided to it before 4/15/98 [the day it filed the relevant partnership return] satisfied the “reasonable cause” defense because of the vagueness and lack of credibility of testimony as to the content of the oral advice; and (7) the 1/27/99 written king & spalding opinion did not provide reasonable cause because its facts were unsubstantiated and its legal analysis unsatisfactory in that it failed to discuss second circuit cases. judge arterton summarized the opinion as follows: finally, no other evidence such as companion memoranda discussing the application of the second circuit’s decisions in goldstein, gilman, grove, blake, and grove, or the tenth circuit’s decision in associated to the actual facts of the [foreign entity] transaction was offered to show research for king & spalding’s legal analysis and opinions. such background research does not involve obscure or inaccessible caselaw references, is basic to a sound legal product, especially 100 florida tax review [vol.7:si for “should” level opinion and a premium of $400,000. with hourly billing totals exceeding $100,000 there could not have been research time constraints. in essence, the testimony and evidence offered by long term regarding the advice received from king & spalding amounted to general superficial pronouncements asking the court to “trust us; we looked into all pertinent facts; we were involved; we researched all applicable authorities; we made no unreasonable assumptions; long term gave all information.” the court’s role as factfinder is more searching and with specifics, analysis, and explanations in such short supply, the king & spalding effort is insufficient to carry long term’s burden to demonstrate that the legal advice satisfies the threshold requirements of reasonable good faith reliance on advice of counsel.” j u d g e a r t e r t o n ’ s o f f i c i a l b i o g r a p h i c a l i n f o r m a t i o n a t http://air.fjc.gov/servlet/tgetinfo?jid=66 is set forth in the footnote. she has an7 av rating in martindale-hubbell. ! myron scholes and robert merton, who shared the 1997 nobel prize in economics were two of taxpayers’ twelve principals. taxpayers were the component parts of one of the highest-flying hedge funds until it had to be rescued from collapse by 14 banks [acting at the instigation of the federal reserve] providing $3.65 billion to take the hedge fund over. ! query about where the substantial authority penalty fits when you have told all to a tax professional and he tells you that you have substantial authority – but the court finds that the underlying facts are different from the facts that both you and the tax professional believe to be true? ! is there a duty on a client to read and understand a tax opinion beyond checking that the facts upon which the opinion is based are correct?” 7. arterton, janet bond. born 1944 in philadelphia, pa. federal judicial service: u. s. district court, district of connecticut. nominated by william j. clinton on january 23, 1995, to a seat vacated by jose a. cabranes; confirmed by the senate on march 24, 1995, and received commission on march 24, 1995. education: mount holyoke college, b.a., 1966; northeastern university school of law, j.d., 1977. professional career: law clerk, hon. herbert stern, u.s. district court of new jersey, 1977-1978; private practice, new haven, connecticut, 1978-1995. race or ethnicity: white. gender: female. 2005] recent developments in federal income taxation 101 2. after long-term capital holdings, the irs takes a few victory laps. a. penalties may no longer be bargained away in appeals. chief counsel notice cc-2004-036 (9/22/04). the notice includes a memorandum from the chief of appeals stating, “effective immediately we will no longer trade penalty issues in appeals. penalties can and should still be settled, but the settlement should be based on the merits and the hazards surrounding each penalty issue standing alone.” b. irs takes a tougher stand on tax shelters. ir-2004128 (10/20/04). the irs announced that it was sending letters to taxpayers involved in three listed transactions, (1) losses and deductions from lease strips, (2) inflated-basis assets derived from lease strips, and (3) intermediary transactions, that it would tighten its settlement guidelines to require concession of 100 percent of the claimed losses or deductions, reduced only by the amount of transaction costs up to 10 percent of the claimed losses or deductions. additionally, taxpayer would have to concede 50 percent of the accuracyrelated penalty at issue. 3. significant taxpayer victory when its summary judgment motion was granted; the contingent liability transaction was upheld despite its being a listed transaction under notice 2001-17. black & decker corp. v. united states, 340 f. supp. 2d 621 (d. md. 10/20/04, revised, 10/22/04). judge quarles held that the transaction could not be disregarded as a sham because it had economic implications for the parties to the transaction as well as to the beneficiaries of taxpayer’s health plans. ! under the fourth circuit test in rice’s toyota world v. commissioner, 752 f.2d 89 (1985), a transaction will be treated as a sham only if “the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of profit exists.” taxpayer conceded for purposes of its motion “that tax avoidance was its sole motivation.” the court held that “[a] corporation and its transactions are objectively reasonable, despite any tax-avoidance motive, so long as the corporation engages in bona fide economically-based business transactions.” ! note how judge quarles shifted the second prong of the test from “reasonable possibility of profit” to “bona fide business transaction.” ! the transaction was a listed tax shelter under notice 2001-17, 2001-9 i.r.b. 730. a. government’s summary judgment motion had been denied earlier on a pro-taxpayer rationale. black & decker corp. v. 102 florida tax review [vol.7:si united states, 2004-2 u.s.t.c. ¶ 50,539 (d. md. 8/3/04). as the facts were stated in the opinion, in 1998, b & d sold three of its businesses. as a result of these sales, b & d generated significant capital gains. id. that same year, b & d created black & decker healthcare management inc. (“bdhmi”). b & d transferred approximately $ 561 million dollars to bdhmi along with $ 560 million dollars in contingent employee healthcare claims in exchange for newly issued stock in bdhmi. b & d sold its stock in bdhmi to an independent third-party for $ 1 million dollars. because b & d believed that its basis in the bdhmi stock was $ 561 million dollars, the value of the property it had transferred to bdhmi, b & d claimed approximately $ 560 million dollars in capital loss on the sale, which it reported on its 1998 federal tax return. b & d applied a portion of the capital loss to offset its capital gains from selling the three businesses, and carried back and carried forward the remaining capital loss to offset gains in prior and future tax years. (citations omitted) ! the court went on to analyze and conclude that §§ 357(c)(3) and 358(d) applied so the basis of the subsidiary’s stock is not reduced by the amount of the contingent employee healthcare claims. it rejected the irs contention that the claims had to be deductible by the transferee [the subsidiary], and held that (based upon the 1978 legislative history to § 357(c)(3)) the only requirement is that the claims must be deductible by taxpayer [the transferor corporation]. ! section 358(h), added in 2000 and amended in 2002, would preclude this result for assumptions of liability after its 10/18/99 effective date. 4. a second taxpayer victory in a listed contingent liability transaction. coltec industries, inc. w. united states, 62 fed. cl. 716 (fed. cl. 10/29/04). taxpayer transferred its asbestos liabilities to an asbestos case management entity [“garrison”], which was an existing shell subsidiary that had no assets, together with a related party note for $375 million and some other miscellaneous assets. it sold about 6.67 percent of the garrison stock to two banks for a total of $500,000 and reported a multimillion dollar loss that saved it over $82 million in taxes. judge susan g. braden found that this transaction satisfied all the requirements of existing law. ! judge braden rejected the concept of a court applying the economic substance doctrine to tax cases on the ground that 2005] recent developments in federal income taxation 103 under our time-tested system of separation of powers, it is congress, not the court, that should determine how the federal tax laws should be used to promote economic welfare. . . . . accordingly, the court has determined that where a taxpayer has satisfied all statutory requirements established by congress, as coltec did in this case, the use of the “economic substance” doctrine to trump “mere compliance with the code” would violate the separation of powers. 5. the third taxpayer victory in 13 days, in a self-liquidating partnership note transaction in which the lion’s share of income was allocated to a tax-indifferent party. so far, this lease stripping transaction works for a burned-out tax shelter. tifd iii-e, inc. v. united states, 342 f. supp. 2d 94 (d. conn. 11/1/04). the court found that the creation of castle harbour, a nevada llc, by general electric capital corp. subsidiaries was not designed solely to avoid taxes, but to spread the risk of their investment in fullydepreciated commercial airplanes used in their leasing operations. gecc subsidiaries put the following assets into castle harbor: $530 million worth of fully-depreciated aircraft subject to a $258 million non-recourse debt, $22 million of rents receivable, $296 million of cash, and all the stock of another gecc subsidiary that had a value of $0. two tax-indifferent dutch banks invested $117.5 million in castle harbour under the llc agreement, the taxindifferent partner was allocated 98 percent of the book income and 98 percent of the tax income. ! the book income was net of depreciation and the tax income did not take depreciation into account [because the airplanes were fully depreciated]. depreciation deductions for book purposes were on the order of 60 percent of the rental income for any given year. ! scheduled distributions in excess of book income would have resulted in the liquidation of the investment of the dutch banks in eight years, with the dutch banks receiving a return of approximately nine percent, with some “economically substantial” upside and some downside risk. castle harbour was terminated after five years because of a threatened change in u.s. tax law, but during that period about $310 million of income was shifted to the dutch banks for a tax saving to the gecc subsidiaries of about $62 million. ! query whether § 704(b) was properly applied to this transaction? ! this appears to be a lease-stripping transaction in which the income from the lease was assigned to foreign entities while the benefits of ownership were left with a domestic entity. 104 florida tax review [vol.7:si 6. despite its two losses on contingent liability tax shelters, the irs is hanging tough. did taxpayer have something else in its closet, or has it become a believer? ir-2004-151 (12/16/04). the irs announced that hercules incorporated settled a contingent liability transaction case pending in the tax court by conceding 100 percent of the capital loss and the 20-percent accuracy-related penalty [and waiving taxpayer privacy and disclosure rules] in order to avoid the 40-percent gross valuation understatement penalty. the irs8 chief counsel has stated that the two recent taxpayer victories in black & decker and coltec would be reversed on appeal, and that the irs would pay no attention to them. b. identified “tax avoidance transactions.” 1. shortly after notice 2003-76, here’s another one! notice 2003-77, 2003-2 c.b. 1182 (11/19/03), clarified (12/1/03). certain contested liability trusts used improperly to attempt to accelerate deductions under § 461(f) are identified as “listed transactions.” see i.d., above, for contested liability trusts used for an attempted acceleration of deductions under § 461(f). 2. and, yet one more! notice 2003-81, 2003-2 c.b. 1223 (12/4/03). this transaction involves the purchase by the taxpayer of offsetting options on foreign currency (which are § 1256 contracts) (the “purchased options”) and the receipt of premiums by the taxpayer for writing offsetting options on a different foreign currency that has a very high positive correlation with the first currency, but which is not traded through regulated futures contracts (which are not § 1256 contracts) (the “written options”). the taxpayer assigns to a charity both (1) the purchased option that has a loss (which is marked to market when it is assigned to the charity and recognized by the taxpayer) and (2) the offsetting written option that has a gain (which is limited to the premium received for the option, and which the taxpayer does not recognize). 3. abusive roth ira transactions are listed transactions. notice 2004-8, 2004-4 i.r.b. 333 (12/31/03). a taxpayer who owns a preexisting business sells property from the business, such as accounts receivable, for less than fair market value to a corporation owned by taxpayer’s roth ira. the notice applies to any arrangement between the roth ira and the taxpayer 8. compare dixon v. commissioner, 316 f.3d 1044, 2003-1 u.s.t.c. ¶50,194 (9th cir. 1/17/03), remanding t.c. memo. 2000-116 and t.c. memo. 1999-101 (tax court was directed to enter judgment in favor of taxpayers on terms equivalent to the secret settlement agreements entered into with the taxpayers who cooperated with the government). see also, robert frost, “provide, provide” (1936) (“better to go down dignified / with boughten friendship at your side / than none at all. / provide, provide!”). 2005] recent developments in federal income taxation 105 that has the effect of transferring value to the corporation owned by the roth ira that is comparable to a contribution to the roth ira that exceeds the statutory limits on such contributions contained in § 408a. 4. s corporation stock owned by esops that fail to provide benefits to rank-and-file employees. rev. rul. 2004-4, 2004-6 i.r.b. 414 (1/23/04). ownership structures of s corporations that are designed to allow taxpayers to take advantage of the tax-exempt status of the s corporation that results from the ownership of its outstanding stock by the esop result in the esop not providing benefits to rank-and-file employees will result in the s corporation income being taxed to the person who earned it. transactions that are the same or substantially similar to the following transaction are identified as “listed transactions.” these are transactions in which (i) at least 50 percent of the outstanding shares of an s corporation are employer securities held by an esop, (ii) the profits of the s corporation generated by the business activities of a specific individual are accumulated and held for the benefit of that individual in a qsub or similar entity, (iii) these profits are not paid to the individual as compensation within 2-1/2 months after the end of the year in which earned, and (iv) the individual has rights to acquire shares of stock of the qsub or similar entity representing 50 percent or more of the fair market value of the stock of such qsub or similar entity. 5. silo transactions. interestingly enough, sale-in, lease-out (silo) deals [under which a tax-exempt or foreign entity sells property to the taxpayer and leases it back, with the lessee depositing collateral in defeasance of its obligation] were not made “listed transactions,” although president bush’s budget proposal seeks a legislative remedy for this widespread perceived abuse. 2004 tnt 19-3. a. silo transactions were closed retroactive to 3/12/04. section 848 of the american jobs creation act of 2004 adds new § 470 to disallow losses on leases of property for tax-exempt use that were entered into after 3/12/04. the disallowed losses would be carried over to the following year much as disallowed passive activity losses are carried over. there is a safe harbor provision contained in § 470(d). b. silos are now listed transactions even though the door was closed after 3/12/04. notice 2005-13, 2005-9 i.r.b. 630 (2/20/05). this notice distinguishes the silo transaction from the one in frank lyon co. v. united states, 435 u.s. 561 (1978). c. relief for partnerships and pass-thru entities who looked like they fed from “silos” in 2004 but really didn’t. notice 2005-29, 2005-13 i.r.b. 796 (3/10/05). the service will not apply § 470 to partnerships 106 florida tax review [vol.7:si and pass-thru entities described in § 168(h)(6)(e) for taxable years that begin before 1/1/05 in order to disallow losses associated with property that is treated as tax-exempt use property solely as a result of the application of § 168(h)(6) (describing property owned by a partnership that has both tax-exempt and nontax-exempt partners). 6. removes from the list a transaction in which expected economic profit is insubstantial in comparison to the value of the expected foreign tax credits. notice 2004-19, 2004-11 i.r.b. 606. the irs has removed from the list of listed transactions those described in notice 98-5, 1998-1 c.b. 334, which are transactions in which the expected economic profit is insubstantial in comparison to the value of the expected foreign tax credits. 7. porc transactions also removed from the list so it’s no longer considered piggy to be “porc-y.” notice 2004-65, 2004-41 i.r.b. 599 (9/24/04), modifying notice 2002-70, 2002-2 c.b. 765, and notice 200376, 2003-49 i.r.b. 1181. this notice removes the producer owned reinsurance company transaction from the list of “identified tax avoidance transactions.” the rationales for the removal are: (1) that examination of this type of transaction showed fewer abusive transactions than anticipated; and (2) the amendment of § 501(c)(15) [to limit the gross income of organizations exempt under that section to $600,000] by section 206 of the pension funding equity act, p.l 108-21, as described in notice 2004-64, 5004-41 i.r.b. (9/24/04). 8. updated list of listed transactions minus the above two. notice 2004-67, 2004-41 i.r.b. 600 (9/24/04), supplementing and superseding notice 2003-76, as modified by notice 2004-19 and notice 2004-65. updated list of listed transactions. notice 2003-76, 2003-49 i.r.b. (11/7/03), supplementing and superseding notice 2001-51, 2001-34 i.r.b. 190 (8/3/01). the irs has identified 24 listed transactions for purposes of reg. §§ 1.60114(b)(2) and 301.6111-2(b)(2). as restated and updated, the list includes: (1) rev. rul. 90-105, 1990-2 c.b. 69, transactions (deductions for contributions to certain pension plans attributable to future year’s compensation); (2) notice 9534, 1995-1 c.b. 309, certain trust arrangements (purported multiple employer welfare benefit funds); (3) transactions substantially similar to those at issue in asa investerings partnership v. commissioner, 201 f3d 505 (d.c. cir. 2000) and acm partnership v. commissioner, 157 f.3d 231 (3d cir. 1998) (contingent installment sales transactions in order to accelerate and allocate income to a tax-indifferent partner); (4) prop. reg. § 1.643(a)-8 transactions involving distributions from charitable remainder trusts; (5) notice 99-59, 19992 c.b. 761, transactions involving the distribution of encumbered property in which taxpayers claim tax losses for capital outlays that they have in fact recovered (the pwc so-called boss tax shelter); (6) reg. § 1.7701(1)-3 fastpay arrangements; (7) rev. rul. 2000-12, 2000-11 i.r.b. 744 certain 2005] recent developments in federal income taxation 107 transactions involving the acquisition of two debt instruments the values of which are expected to change significantly at about the same time in opposite directions; (8) notice 2000-44, 2000-36 i.r.b. 255 transactions generating losses resulting from artificially inflating the basis of partnership interests (the kpmg so-called blips tax shelter); (9) notice 2000-60, 2000-49 i.r.b. 568,9 transactions involving the purchase of a parent corporation’s stock by a subsidiary, a subsequent transfer of the purchased parent stock from the subsidiary to the parent’s employees, and the eventual liquidation or sale of the subsidiary; (10) notice 2000-61, 2000-49 i.r.b. 569, transactions purporting to apply § 935 to guamanian trusts; (11) notice 2001-16, 2001-9 i.r.b. 730, intermediary sales transactions; (12) notice 2001-17, 2001-9 i.r.b. 730, contingent liability § 351 transfer transactions; (13) notice 2001-45, 2001-33 i.r.b. 129 (certain redemptions of stock in transactions not subject to u.s. tax in which the basis of the redeemed stock purports to shift to a u.s. taxpayer); (14) notice 2002-21, 2002-1 c.b. 730, transactions involving the use of a loan assumption agreement to inflate basis in assets acquired from another party in order to claim losses; (15) notice 2002-35, 2002-1 c.b. 992, transactions involving the use of a notional principal contract to claim current deductions for periodic payments made by a taxpayer while disregarding the accrual of a right to receive offsetting future payments; (16) notice 2002-50, 2002c.b. 98 (transactions involving the use of a straddle, a tiered partnership structure, a transitory partner and the absence of a § 754 election to claim a permanent noneconomic loss), and similar transactions identified in notice 2002-65, 2002-2 c.b. 690, and notice 2003-54, 2003-33 i.r.b. 363; (17) rev. rul. 2002-69, 2002-2 c.b. 760, modifying and superseding rev. rul. 99-14, 1999-1 c.b. 835, lease-in/lease-out [lilo] transactions); (18) rev. rul. 2003-6, 2003-3 i.r.b. 286, arrangements involving the transfer of esops that hold stock in an s corporation for the purpose of claiming eligibility for the delayed effective date of § 409(p); (19) notice 2003-22, 2003-18 i.r.b. 851, arrangements involving foreign leasing companies used to evade or avoid federal income and employment taxes; (20) notice 2003-24, 2003-18 i.r.b. 853, arrangements that purportedly qualify as collectively bargained welfare benefit funds excepted from the account limits of §§ 419 and 419a; (21) notice 2003-47, 2003-30 i.r.b. 132, transactions involving compensatory stock options and related persons to avoid or evade federal income and employment taxes; (22) notice 2003-55, 2003-34 i.r.b. 395, modifying and superseding notice 95-53, 1995-2 c.b. 334, transactions in which one participant claims to realize rental income and another participant claims the deductions related to that income (often referred to as “lease strips”); (23) notice 2003-77, 2003-49 i.r.b. 1182, transactions that use contested liability trusts improperly to accelerate deductions under § 461(f); (24) notice 2003-81, 2003-51 i.r.b. 1223, transactions in which a taxpayer claims a loss upon the assignment of a section 9. see 2003 tnt 112-12. 108 florida tax review [vol.7:si 1256 contract to a charity but fails to report the recognition of gain when the taxpayer’s obligation under an offsetting non-section 1256 contract terminates; (25) notice 2004-8, 2004-4 i.r.b. 333, transactions designed to avoid the limitations on contributions to roth iras; (26) rev. rul. 2004-4, 2004-6 i.r.b. 414, transactions that involve segregating the profits of an esop-owned s corporation in a qsst so that rank-and-file employees do not benefit from participation in the esop; (27) transactions similar to those described in rev. rul. 2004-20, 2004-10 i.r.b. 546, situation 2, involving arrangements in which an employer deducts contributions to a qualified plan for life insurance premiums that provide death benefits in excess of the participant’s death benefit; (28) notice 2004-20, 2004-11 i.r.b. 608, transactions in which a domestic corporation purports to acquire stock in a foreign target corporation in a preplanned transaction that generates gain under a 338 election that is not taxable for u.s. purposes; (29) notice 2004-30, 2004-17 i.r.b. 828, transactions in which s corporation shareholders attempt to transfer the incidence of taxation by purportedly donating s corporation nonvoting stock to an exempt organization while retaining the economic benefits associated with that stock; and (30) notice 2004-31, 2004-17 i.r.b. 830, transactions in which corporations claim inappropriate deductions for payments made through a partnership. c. disclosure and settlement 1. proposed revisions to circular 230 related to tax shelters require disclosures in tax shelter opinions of relationship between practitioner and promoter, etc. reg-122379-02, regulations governing practice before the internal revenue service, 68 f.r. 75186 (12/30/03). new proposed amendments differ from the 1/12/01 proposed amendments in several ways: (1) § 10.33 prescribes best practices for all tax advisors; (2) § 10.35 combines and modifies the standards applicable to “marketed” and “more likely than not” tax shelter opinions from former §§ 10.33 and 10.35; (3) § 10.36 contains the revised procedures for ensuring compliance with §§ 10.33 and 10.35; and (4) new § 10.37 contains provisions relating to advisory committees to the office of professional responsibility. ! under § 10.33 “best practices” include: (1) communicating clearly with the client regarding the terms of the engagement and the form and scope of the advice or assistance to be rendered; (2) establishing the relevant facts, including evaluating the reasonableness of any assumptions or representations; (3) relating applicable law, including potentially applicable judicial doctrines, to the relevant facts; (4) arriving at a conclusion supported by the law and the facts; (5) advising the client regarding the import of the conclusions reached; and (6) acting fairly and with integrity in practice before the irs. 2005] recent developments in federal income taxation 109 ! tax shelter opinions covered by § 10.35 are more-likely-than-not and marketed tax shelter opinions; they, however, do not include preliminary advice provided pursuant to an engagement in which the practitioner is expected subsequently to provide an opinion that satisfies § 10.35. the definition of “tax shelter,” tracking the one found in § 6662 which was contained in the 2001 proposed regulations, remains the same. the requirements for tax shelter opinions include: (1) identifying and considering all relevant facts and not relying on any unreasonable factual assumptions or representations; (2) relating the applicable law to the relevant facts in a reasonable manner; (3) considering all material federal tax issues and reaching a conclusion supported by the facts and the law with respect to each issue; and (4) providing an overall conclusion as to the federal tax treatment of each tax shelter item, and the reasons for that conclusion and providing an overall conclusion as to the federal tax treatment of each tax shelter item and the reasons for that conclusion. ! under § 10.35(d), a practitioner must disclose any compensation arrangement he may have with any person (other than the client for whom the opinion is prepared) with respect to the tax shelter discussed in the opinion, as well as any other referral arrangement relating thereto. the practitioner must also disclose that a marketed opinion may not be sufficient for a taxpayer to use for the purpose of avoiding penalties under § 6662(d), and must also state that taxpayers should seek advice from their own tax advisors. a limited scope opinion must also disclose that additional issues may exist and that the opinion cannot be used for penalty-avoidance purposes. ! under § 10.36 procedures to ensure compliance are required to be followed by tax advisors with responsibility for overseeing a firm’s practice before the irs. these include ensuring that the firm has adequate procedures in effect for purposes of complying with § 10.35. ! under § 10.37 the director of the office of professional responsibility is authorized to establish advisory committees to review and make recommendations regarding professional standards or best practices for tax advisors. they may also, more particularly, advise the director whether a practitioner may have violated §§ 10.35 or 10.36. a. extended statutory authority granted to treasury with respect to circular 230. section 822 of the american jobs creation act of 2004 amends 31 u.s.c. § 330(b) to permit the imposition of censures and monetary penalties for circular 230 violations. it also clarifies treasury’s authority to impose standards applicable to written tax shelter opinions. b. tax shelter revisions to circular 230 are made final. to paraphrase president clinton, oral opinions are not real opinions. t.d. 9165, regulations governing practice before the internal review service, 69 f.r. 75839 (12/20/04). 110 florida tax review [vol.7:si ! as to final § 10.33, the preamble states: the final regulations adopt the best practices set forth in the proposed regulations with modifications. these best practices are aspirational. a practitioner who fails to comply with best practices will not be subject to discipline under these regulations. similarly, the provision relating to steps to ensure that a firm’s procedures are consistent with best practices, now set forth in § 10.33(b), is aspirational. although best practices are solely aspirational, tax professionals are expected to observe these practices to preserve public confidence in the tax system. ! as to final § 10.35, the preamble states: under the final regulations, the definition of a covered opinion [i.e., one subject to § 10.35] includes written advice (including electronic communications) that concerns one or more federal tax issue(s) arising from: (1) a listed transaction; (2) any plan or arrangement, the principal purpose of which is the avoidance or evasion of any tax; or (3) any plan or arrangement, a significant purpose of which is the avoidance or evasion of tax if the written advice (a) is a reliance opinion, (b) is a marketed opinion, (c) is subject to conditions of confidentiality, or (d) is subject to contractual protection. a reliance opinion is written advice that concludes at a confidence level of at least more likely than not that one or more significant federal tax issues would be resolved in the taxpayer’s favor. written advice will not be treated as a reliance opinion if the practitioner prominently discloses in the written advice that it was not written to be used and cannot be used for the purpose of avoiding penalties. similarly, written advice generally will not be treated as a marketed opinion if it does not concern a listed transaction or a plan or arrangement having the principal purpose of avoidance or evasion of tax and the written advice contains this disclosure. the treasury department and the irs intend to amend 26 cfr 1.6664-4 to clarify that a taxpayer may not rely upon written advice that contains this disclosure to establish the reasonable cause and good faith defense to the accuracy-related penalties. written advice regarding a plan or arrangement having a significant purpose of tax avoidance or evasion is excluded 2005] recent developments in federal income taxation 111 from the definition of a covered opinion if the written advice concerns the qualification of a qualified plan or is included in documents required to be filed with the securities and exchange commission. the final regulations also adopt an exclusion for preliminary advice if the practitioner is reasonably expected to provide subsequent advice that satisfies the requirements of the regulations. written advice that is not a covered opinion for purposes of § 10.35 is subject to the standards set forth in new § 10.37. ! as to final § 10.36, “procedures to ensure compliance,” the preamble was silent. ! as to final § 10.37, the preamble states: the final regulations also set forth requirements for written advice that is not a covered opinion. under § 10.37 a practitioner must not give written advice if the practitioner: (1) bases the written advice on unreasonable factual or legal assumptions; (2) unreasonably relies upon representations, statements, findings or agreements of the taxpayer or any other person; (3) fails to consider all relevant facts; or (4) takes into account the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be settled. section 10.37, unlike § 10.35, does not require that the practitioner describe in the written advice the relevant facts (including assumptions and representations), the application of the law to those facts, or the practitioner’s conclusion with respect to the law and the facts. the scope of the engagement and the type and specificity of the advice sought by the client, in addition to all other facts and circumstances, will be considered in determining whether a practitioner has failed to comply with the requirements of § 10.37. ! as to final § 10.38 [§ 10.37 in the proposed regulations], the preamble states: newly designated § 10.38, formerly § 10.37 in the proposed regulations, is adopted as proposed with the following modifications. section 10.38 is modified to clarify that an advisory committee may not make recommendations about actual practitioner cases, or have access to information pertaining to actual cases. the section also is modified to clarify that the director of the office of professional 112 florida tax review [vol.7:si responsibility should ensure that membership of these committees is balanced among those individuals who practice as attorneys, accountants and enrolled agents. ! the provisions contained in the final regulations will generally become applicable on 6/21/05. 2. warm-up the photocopier for those tax accrual workpapers. announcement 2002-63, 2002-27 i.r.b. 72 (7/8/02). in auditing returns filed after 7/1/02 that claim any tax benefits from a “listed transaction,” see notice 2001-51, 2001-34 i.r.b. 190, the irs may request tax accrual workpapers. listed transactions will be determined “at the time of the request.” neither the attorney client privilege nor the § 7525 tax practitioner privilege protects the confidentiality of the workpapers. a. specific procedures regarding requests for tax accrual workpapers. chief counsel notice cc-2003-012 (4/9/03). procedures to be used regarding requests for tax accrual and other financial audit workpapers. b. the definition of “tax accrual workpapers” is clarified. chief counsel notice cc-2004-010 (1/22/04), supplementing cc2003-012. the general definition is as follows: tax accrual workpapers are those audit workpapers, whether prepared by the taxpayer or by an independent accountant, relating to the tax reserve for current, deferred and potential or contingent tax liabilities, however classified or reported on audited financial statements, and to footnotes disclosing those tax liabilities on audit financial statements. they reflect an estimate of a company’s tax liabilities and may also be referred to as the tax pool analysis, tax liability contingency analysis, tax cushion analysis, or tax contingency reserve analysis. ! documents created prior to or outside of the consideration of whether reserves should be created are not within the definition tax accrual workpapers nor are workpapers reconciling book and tax income, but they both “likely fall within the scope of the general idrs issued at the beginning of an examination and should be produced . . . even though no request for the tax accrual workpapers has been made.” 3. making it harder for taxpayers to “fess up” in order to avoid penalties. notice 2004-38, 2004-21 i.r.b. 949 (4/30/04). treasury will issue temporary and proposed regulations that will modify the definition of 2005] recent developments in federal income taxation 113 “qualified amended return” in reg. § 1.6664-2(c)(3) to provide that the period for filing is terminated when the irs contacts a promoter, organizer or material advisor concerning a listed transaction for which the taxpayer has claimed a tax benefit or when the taxpayer is contacted for examination concerning the activity. this will deprive a taxpayer who knows he is in the service’s sights of the right to file a qualified amended return to avoid penalties. ! previously, the right to file such a return ended at the earliest of a taxpayer receiving a notice of deficiency or the promoter receiving a § 6700 notice. ! the irs is also contending that the filing of a qualified amended return retroactively revokes the interest holiday under § 6404(g)(2)(c) that begins 18 months after the filing of the original return because the interest holiday does not apply to tax shown on a return. 4. son-of-boss settlem ent term s are announced. announcement 2004-46, 2004-21 i.r.b. 964 (5/5/04). the irs announced a settlement initiative for taxpayers to resolve “son-of-boss” transactions described in notice 2000-44, 2000 c.b. 255, and substantially similar transactions. taxpayers will be required to concede all claimed tax benefits and attributes, including basis adjustments with a sliding scale of penalties [none, if disclosed under announcement 2003-2; 10 percent if this was the taxpayer’s only listed transaction; and 20 percent otherwise]. net out-of-pocket costs and fees will be allowed as a long term capital loss (or half of these as an ordinary deduction) in the year these items were paid or accrued. the settlement initiative was open through 6/21/04. 5. irs settlement terms for executive stock option shelters. announcement 2005-19, 2005-11 i.r.b. 744 (2/22/05). the offer, which extends until 5/23/05. is for payment of tax on the full amount of compensation received, plus interest and a 10 percent penalty (which is half of the 20 percent penalty). the parties must pay employment taxes, but they will be allowed to deduct their out-of-pocket transaction costs; the corporations will be permitted a deduction for the compensation expense when reported by the executive. employment taxes are also due. the irs has identified 42 corporations, close to 200 executives and more than $700 million of unreported income involved in the scheme, and will ask that the matter be referred to the audit committee of the board of directors for appropriate review. this transaction was listed in notice 2003-47, 2003-30 i.r.b. 132, ! in ir-2005-17 (2/22/05). the transaction is described as follows: the transaction first involves the transfer of stock options by the executive to a related entity, such as a family limited partnership, under terms of an agreement to defer payment to 114 florida tax review [vol.7:si the executive. next, the partnership exercises the options and sells the stock in the marketplace. the executive then takes the position that tax is not owed until the date of the deferred payment, typically 15 to 30 years later, although the executive has access to the partnership assets undiminished by taxes. tax laws require executives to include in income and pay tax on the difference between the amount they pay for the stock and its value when the option is exercised. corporations are entitled to a deduction for the compensation when the options are exercised. d. tax shelter penalties, etc. 1. a non-reviewable penalty for failure to disclose a reportable transaction that applies even if the courts uphold taxpayer’s position. section 811 of the american jobs creation act of 2004 adds new § 6707a which provides a new penalty for any taxpayer who fails to include on his tax return any required information on a reportable transaction “of a type which the secretary determines as having a potential for tax avoidance or evasion.” the penalty would apply regardless of whether there is an understatement of tax and would apply in addition to any accuracy related penalty. the penalty would be $10,000 for a natural person and $50,000 for other taxpayers; for a listed transaction the penalty would increase to $100,000 for a natural person and $200,000 for other taxpayers. ! the commissioner could rescind any portion of the penalty if it did not involve a listed transaction and rescinding would promote compliance and effective tax administration. a decision not to rescind may not be reviewed in any judicial proceeding. a. doesn’t the commissioner trust his own appeals officers? notice 2005-11, 2005-7 i.r.b. (1/19/05). this notice provides guidance on § 6707a, including a statement that the commissioner’s determination whether to rescind a § 6707a penalty “is not reviewable by the irs appeals division or any court.” 2. modified accuracy-related penalty for reportable transactions. section 812 of the american jobs creation act of 2004 adds new § 6662a which provides a modified accuracy related penalty on understatements with respect to reportable transactions. it replaces the § 6662 accuracy related penalty for tax shelters and the amount is 20 percent, – but is 30 percent if the transaction is not properly disclosed. taxpayers can not rely on an opinion of a tax advisor to establish reasonable cause under new § 6664(d) [applicable to reportable transaction understatements] for any opinion: 2005] recent developments in federal income taxation 115 (a) provided by a “disqualified tax advisor” or (b) which is a “disqualified opinion.” a. notice 2005-12, 2005-7 i.r.b. (1/19/05). this notice provides further guidance, including a statement that the new § 6664(d) defense is not available for the 30 percent penalty. it also provides guidance on when a material tax advisor participates in a transaction: consistent with the legislative history, a tax advisor, including a material advisor, will not be treated as participating in the organization, management, promotion or sale of a transaction if the tax advisor’s only involvement is rendering an opinion regarding the tax consequences of the transaction. in the course of preparing a tax opinion, a tax advisor is permitted to suggest modifications to the transaction, but the tax advisor may not suggest material modifications to the transaction that assist the taxpayer in obtaining the anticipated tax benefits. merely performing support services or ministerial functions such as typing, photocopying, or printing will not be considered participation in the organization, management, promotion or sale of a transaction. 3. section 813 of the american jobs creation act of 2004 amends § 7525(b) to make the current exception to the federally authorized tax practitioner privilege for “corporate tax shelters” applicable to all tax shelters. 4. the audit lottery that can never be won and taxpayer can never get repose! the statute of limitations never expires on listed transactions that are not disclosed. section 814 of the american jobs creation act of 2004 adds new § 6501(c)(10) to extend the statute of limitations for listed transactions which a taxpayer fails to disclose until one year after the transaction is disclosed by the taxpayer or by a material advisor’s satisfying the list maintenance requirement in connection with a request from treasury. 5. material advisors are subject to increased disclosure. section 815 of the american jobs creation act of 2004 amends §§ 6111 and 6112 to require increased disclosure on an information return for each reportable transaction by any material advisor [in lieu of tax shelter registration]. “material advisor” is defined more broadly to encompass any person who “provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction” and derives fees in excess of $50,000 for tax shelters for natural persons ($250,000 for tax shelters for other taxpayers). 116 florida tax review [vol.7:si a. section 816 of the american jobs creation act of 2004 amends §§ 6707 and 6708 to increase the penalty for failure to file a return under § 6111 to $50,000 – for listed transactions, the greater of $200,000 or 50 percent of the gross income derived by the person required to file the return [75 percent if the failure was intentional]. b. section 817 of the american jobs creation act of 2004 amends § 6708 to provide a penalty of $10,000 per day on any material advisor for failure to make available to the irs within 20 business days any investor list required to be maintained under the provisions of § 6112. c. section 818 of the american jobs creation act of 2004 amends § 6707 to increase the penalty on tax shelter promoters to 50 percent of the gross income to be derived from the activity on which the penalty is imposed. d. section 820 of the american jobs creation act of 2004 amends § 7408 to allow injunctions (a) against material advisors for violating reporting requirements and (b) for violating any of the circular 230 rules. e. interim guidance for material advisors. notice 2004-80, 2004-50 i.r.b. 963 (11/16/04). this notice provides interim guidance for the disclosure requirements for material advisors under § 6111 by defining the terms “reportable transaction” and “material advisor,” and specifying the applicable forms and filing dates. the form is form 8264, as modified by instructions in the notice. (1) several revenue procedures were issued on 10/16/04 to give “angels’ lists” of transactions that need not be reported. they are rev. proc. 2004-65 [transactions with contractual protection], rev. proc. 2005-66 [loss transactions], rev. proc. 2005-67 [transactions with book-tax differences], and rev. proc. 2005-68 [transactions with brief asset holding periods]. (2) notice 2005-17, 2005-8 i.r.b. 606 (1/28/05). this notice provides an extension for compliance with the reporting provisions to 3/1/05. (3) notice 2005-22, 2005-12 i.r.b. 456 (2/24/05). this notice provides additional guidance, and a further extension for compliance with the reporting provisions to 4/30/05. 6. section 819 of the american jobs creation act of 2004 amends § 6662(d) to provide that a corporation’s understatement of tax in 2005] recent developments in federal income taxation 117 excess of $10 million is subject to the substantial understatement penalty even if it does not exceed 10 percent of the correct tax. 7. a penalty for non-willful failure, and increased penalties for willful failure, to answer the two questions about foreign bank accounts. section 821 of the american jobs creation act of 2004 amends 31 u.s.c. § 5321(a)(5) to provide a penalty of up to $10,000 for non-willful failure to report interests in foreign financial accounts. the penalties for willful violations are increased to the greater of $100,000 or 50 percent of the amount of the transaction or 50 percent of the balance in the account at the time of the violation. 8. no interest deductions for underpayments related to reportable transactions that are not disclosed. section 838 of the american jobs creation act of 2004 adds new § 163(m) [former § 163(m) is redesignated as § 163(n)] to deny interest deductions for any underpayments attributable to nondisclosed reportable transactions. e. individual tax shelters 1. united states v. gleason, 94 a.f.t.r.2d 2004-6344, 2004-2 u.s.t.c. ¶ 50,116 (m.d. tenn. 8/28/04). tax shelter promoter permanently enjoined under § 7408 from selling the so-called “tax toolbox” which would permit the deduction of personal expenses by falsely characterizing them as business expenses. f. tax shelter discovery 1. april was a pretty cruel month for tax shelter investors. john doe 1 v. kpmg llp, 93 a.f.t.r.2d 2004-1808, 2004-1 u.s.t.c. ¶ 50,270 (n.d. tex. 4/2/04). investors in a kpmg-recommended “son-ofboss” tax shelter were not entitled to require kmpg to keep their identities10 confidential under the § 7525 tax advisor privilege because the confidentiality agreements they entered into with kpmg merely required that kpmg claim the privilege, and, since privilege does not apply to their identities and motives for participating in the tax shelter, kpmg does not breach its fiduciary duty by releasing the information. judge barefoot sanders held that (1) identifying the investors does not identify the particular “underlying communication” that would be revealed by revealing investors’ participation in the tax shelter, and (2) investors did not have a reasonable expectation that their identities or participation in the tax shelter would be protected because § 7525 does not protect “information transmitted for the purposed of preparing a tax return.” 10. notice 2000-44, 2000-36 i.r.b. 255. 118 florida tax review [vol.7:si also, §§ 6111 and 6112, requiring registration and list maintenance, prevent investors from having any reasonable expectation of confidentiality. ! judge sanders went on to hold that because the investors included losses on their year 2000 tax returns, they could not have believed that their participation in the tax shelter transactions was confidential in that “[i]f [investors’] tax returns were audited, [they] would be required to explain how the losses resulted.” 2. sidley austin brown & wood clients can intervene to protect their identities. united states v. sidley austin brown & wood llp, 93 a.f.t.r.2d 2004-1849 (n.d. ill. 4/15/04). judge kennelly granted a motion of 46 former anonymous sidley austin brown & wood clients to intervene in the summons enforcement action seeking their identities with respect to whether the summonses are unenforceable as unduly ambiguous. the does include “chamberlain does” and “fulbright does.” the court noted that “[t]he issue of whether sab&w organized or sold tax shelters within the meaning of section 6112 is a complicated question.” 3. the clients lose, but they may appeal. united states v. sidley austin brown & wood llp, 93 a.f.t.r.2d 2004-2031 (n.d. ill. 4/28/04). judge kennelly granted the government’s motion to enforce the john doe summons that seeks to obtain the names of the former clients who had been granted permission to intervene in a limited fashion. the court held that the mere fact that the law firm assembled the 46 names does not show the summons to be unambiguous because “it may just show sab&w’s desire to cooperate [in hopes of pacifying the irs].” however, the burden on the government is to “show only that the summons seeks information with ‘potential relevance.’” the court answered by stating that “just because an issue is complicated does not necessarily mean that the governing regulations are ambiguous or impermissibly require sab&w to draw legal conclusions,” and that “any marginal uncertainty that the summons leaves with sab&w does not defeat its enforceability.” ! on 4/29/04, judge kennelly stayed his order of the preceding day pending appeal to the seventh circuit. 4. are you practicing law or practicing tax when you write that opinion letter? united states v. kpmg llp, 237 f. supp. 2d 35, 91 a.f.t.r.2d 2003-317, 2003-1 u.s.t.c ¶ 50,174 (d. d.c. 12/20/02). the irs served administrative summonses on kpmg in connection with investigating kpmg’s promotion and participation in tax shelters and sought judicial enforcement when it determined that kpmg had not complied. kpmg withheld documents that would have been responsive to the summonses on grounds that the documents were privileged, and kpmg provided the irs with a privilege log of the withheld documents. citing united states v. lawless, 709 2005] recent developments in federal income taxation 119 f.2d 485 (7th cir. 1983), for the principle that the attorney-client privilege does not extend to communications between a taxpayer and his attorney simply for the purpose of preparing a tax return, the court held that the § 7525 privilege does not extend to communications between a taxpayer and tax practitioner simply for the purpose of preparing a tax return. the court then went on to hold that kpmg’s tax opinion letters to its clients were not privileged because they were prepared in connection with the preparation of tax returns. furthermore, memoranda of kpmg’s employees’ discussions with clients’ lawyers were not privileged because the communications were in connection with tax return preparation. somewhat contradictorily, however, the court held that opinion letters prepared by law firms in connection with preparation of tax returns were privileged if the taxpayer, rather than the accounting firm, retained the lawyer. ! the court also held that § 7525 did not protect accountant work product. with respect to attorney work product, the court articulated the following standard: “the burden of showing that the materials prepared were in anticipation of litigation is on the party asserting the privilege,” and “[t]his burden entails a showing that the documents were prepared for the purpose of assisting an attorney in preparing for litigation, and not for some other reason.” after an in camera review and comparison of a random sample of thirty allegedly privileged documents and the corresponding entries in the privilege log prepared in response to the summons, the court found that only four of the privilege log entries were completely supportable; accordingly it referred the matter to a special master to conduct an examination of the withheld documents, evaluate the asserted privileges, and submit a report and recommendation. a. a subsequent kpmg magistrate’s opinion. united states v. kpmg llp, 92 a.f.t.r.2d 2003-6498, 2003-2 u.s.t.c.¶ 50,691 (d. d.c. 10/10/03). kpmg’s documents were reviewed by a special master, who found some of them protected by attorney-client privilege and some by § 7525. b. the district court rules for the government in a long omnibus memorandum. united states v. kpmg llp, 316 f. supp. 2d 30 (d. d.c. 5/4/04). judge hogan adopted the rationale of bdo seidman, wachovia and kmpg (n.d. texas) to hold that the identity of kpmg clients who participated in potentially abusive tax shelters must be disclosed to the irs. he stated, having reviewed the brown & wood “opinion letters” through the lens of the newly discovered evidence, the court finds these opinion letters to be boiler-plate templates that are almost, if not completely, identical except for date, investor name, investor advisor, and dates and amounts of investment 120 florida tax review [vol.7:si transactions. there is little indication that these are independent opinion letters that reflect any sort of legal analysis, reasoned or otherwise. in fact, when examined as a group, the letters appear to be nothing more than an orchestrated extension of kpmg’s marketing machine. regarding any documents that involve opinion letters from the brown & wood law firm, however, the court declines at this time to broadly and definitively state that all of them are not privileged. at this point, it is only fair to shift the burden to kpmg to show that any or all of the brown & wood “opinion letters” are privileged by either the attorney-client privilege or the attorney work product privilege. ! he said the following regarding privilege: putting aside for the moment that participation in potentially abusive tax shelters is information ordinarily subject to full disclosure under the federal tax law, in order to be privileged the discussion of legal or tax advice must be based upon information communicated in confidence from the client to the lawyer or tax practitioner. see united states v. kpmg, 237 f. supp. 2d 35, 39-40 (d. d.c. 2002) (setting forth d.c. circuit’s concise summary of the attorney-client privilege as found in in re sealed case, 237 u.s. app. d.c. 312, 737 f.2d 94, 98-99 (d.c. cir. 1984)). kpmg did not support with evidence, and the special master did not discuss, that any of these 141 documents discussing legal or tax advice is based upon or contains information communicated in confidence to the lawyers or tax practitioner by a client or a prospective client for the purpose of seeking legal or tax advice. accordingly, these documents are not privileged and must be released to the irs. ! judge hogan concluded that “kpmg is misrepresenting its unprivileged tax shelter marketing activities as privileged communications. the court has lost confidence in kpmg’s privilege log since it has been shown to be inaccurate, incomplete, and even misleading regarding a very large percentage of the documents.” footnote 10 reads, “the court hesitates to consider the judicial resources that have been wasted as a result of these improper claims of privilege.” 5. on the other hand, a district court in illinois holds that outside and in-house counsel memorandums are protected by the attorney client privilege, and other documents protected by the work product doctrine. united states v. bdo seidman, llp, 94 a.f.t.r.2d 2004-5066, 2004-2 u.s.t.c. ¶ 50,288 (n.d. ill. 6/28/04). judge holderman rules that bdo seidman is entitled to claim privilege on 110 documents (other than six 2005] recent developments in federal income taxation 121 documents ordered to be produced in redacted form) prepared by the three outside law firms and in-house counsel because (1) the outside firms were not “co-promoters” of tax shelters because the government failed to submit proof other than the allegations in a civil complaint denney v. jenkens & gilchrist, 340 f. supp. 2d 338 (s.d. n.y. 4/30/04) (ruling on defendants’ motions to compel arbitration), and communications with in-house counsel are protected to the same extent as communications with outside law firms; (2) the work product doctrine covers six documents created in anticipation of litigation; and (3) the crime-fraud exception does not apply “particularly in light of the uncertain and complex nature of the internal revenue code and the regulations thereunder.” 6. jenkens & gilchrist joins the parade of losing tax firms. united states v. jenkens & gilchrest p.c., 93 a.f.t.r.2d 2004-2074, 2004-1 u.s.t.c. ¶ 50,154 (n.d. ill. 4/20/04). senior judge moran denied the law firm’s motion to dismiss and quash a government motion to compel disclosure of the identities of hundreds of clients who engaged in tax shelter strategies based upon judge kennelly’s sidley austin opinion and judge sanders’ kmpg opinion. a. united states v. jenkens & gilchrest p.c., 93 a.f.t.r.2d 2004-2288, 2004-1 u.s.t.c. ¶ 50,244 (n.d. ill. 5/13/04). senior judge moran provided a schedule for the production of identities and documents. clients wishing to assert privilege claims have 21 days to do so, but are warned about sanctions for frivolous claims. ! jenkens & gilchrist turned over the list of names on 5/17/04. 2004 tnt 97-1. ix. exempt organizations and charitable giving a. exempt organizations 1. joint ventures between an exempt organization and a forprofit organization. rev. rul. 2004-51, 2004-22 i.r.b. 974 (5/7/04). to expand its teacher training seminars, a university enters into ownership of an llc with a for-profit company to conduct interactive video training programs. each of the partners has a 50 percent ownership interest and equal representation on the governing board of the llc. the ruling holds that an ancillary activity – the university’s participation in the llc is an insubstantial part of its activities – conducted by a partnership with a for-profit organization is attributable to the exempt organization. in the facts given, the trade or business was substantially related to the charity’s exempt purposes. 122 florida tax review [vol.7:si b. charitable giving 1. addis v. commissioner, 374 f.3d 881, 94 a.f.t.r.2d 20045134, 2004-2 u.s.t.c. ¶ 50,291 (9th cir. 7/8/04). judge noonan held that the substantiation rule of § 170(f)(8) bars deduction of contribution of amounts donated in 1997 and 1998 to the national heritage foundation to pay premiums on charitable split-dollar life insurance. the nhf gave taxpayers receipts that stated they received no consideration. under the arrangement, the nhf was to pay $36,000 per year for twelve years (90 percent of the $40,000 annual premium) in return for 56 percent of the initial death benefit; the addis trust was to pay $4,000 per year in return for 44 percent of the initial death benefit plus projected increases in the death benefit. of course, the reason nhf entered into this arrangement is the taxpayers contributed $36,000 per year to it. ! in 1999, § 170(f)(10) was added to the code to disallow deductions for funds transferred to charities that are used to pay premiums on life insurance with respect to the transferor, and levies a 100 percent excise tax on the premium payments to boot. 2. section 882 of the american jobs creation act of 2004 amends §§ 170(e)(1) and 6050l to restrict the amount of deductions from the contribution of intellectual property to the basis of the contributed property. this amount may be increased to the extent that “qualified donee income” over the following years exceeds the basis. 3. section 883 of the american jobs creation act of 2004 amends § 170(f) by adding new paragraph 11 that codifies reporting requirements for contributions of property valued at more than $5,000 and includes contributors that are c corporations in these reporting requirements. 4. does new § 170(f)(12) close the door to inflated deductions for motor vehicle contributions? or, is the door left open wide enough to drive a truck [or other vehicle] through it? section 884 of the american jobs creation act of 2004 amends § 170(f) by adding new paragraph 12 that requires written acknowledgment of contributions of motor vehicles, boats and airplanes that includes the amount of the gross proceeds from any arm’s length sale and a statement that the deduction may not exceed such amount. new § 6720 provides for penalties for furnishing fraudulent acknowledgements. the only exceptions to the reporting of gross sale proceeds is where the charity makes “material improvements” to the vehicle or where the charity puts the vehicle to “substantial use” in its own endeavors. 2005] recent developments in federal income taxation 123 x. tax procedure a. interest, penalties and prosecutions 1. bell v. united states, 355 f.3d 387, 93 a.f.t.r.2d 2004-369, 2004-1 u.s.t.c. ¶ 50,118 (6th cir. 1/7/04). corporate funds are not considered “encumbered” and therefore unavailable to pay over withholding and payroll taxes merely because a contractual obligation to a creditor limits the ability of the employer freely to use its assets. 2. welcome to debtor’s prison, but you do have to try to get there. united states v. schoppert, 362 f.3d 451, 93 a.f.t.r.2d 2004-1590 (8th cir. 4/1/04). a willful attempt to evade payment of the tax shown on the taxpayer’s return was held to constitute criminal tax fraud under § 7201. 3. more tax court jurisdiction over interest calculations despite §§ 6512(b)(2) and 6402. estate of smith v. commissioner, 123 t.c. no. 15 (7/13/04). after the tax court had determined the amount by which the taxpayer had “overpaid” estate tax, in making the refund the commissioner offset asserted assessed but unpaid underpayment interest. the majority, in a reviewed opinion by judge ruwe, held that for purposes of determining an overpayment of tax pursuant to § 6512(b), the proper tax includes underpayment interest and that the amount of an overpayment is the amount by which payments exceed the tax, including any underpayment interest. as a matter of law, the tax court’s prior decision that the estate overpaid its estate tax by $238,847.24 took into account underpayment interest as part of the calculation in arriving at the amount of an overpayment. accordingly, the tax court had jurisdiction over the taxpayer’s motion to enforce its order that the irs refund $238,847.24. section 6512(b)(2) does not apply to bar tax court jurisdiction over interest determinations where a final decision in the same case precludes the existence of the interest liabilities to which the commissioner attempts to apply the overpayment. there were a number of overlapping concurrences and five dissents. the dissents were based on the proposition that the majority’s holding exceeded the tax court’s statutory jurisdiction because the tax court’s prior order had merely approved rule 155 computations that, as is customary, did not include underpayment interest owed. b. discovery: summonses and foia 1. hi-ho, hi-ho, it’s off to redact we go. united we stand america, inc. v. irs, 359 f.3d 595, 93 a.f.t.r.2d 2004-1236, 2004-1 u.s.t.c. ¶ 50,190 (d.c. cir. 3/5/04). united we stand america sought to obtain under foia a report by the irs to the joint committee on taxation, prepared pursuant to the committee’s request, dealing with an investigation by the joint 124 florida tax review [vol.7:si committee of “whether the irs’s selection of tax-exempt organizations . . . for audit has been politically motivated. . . .” the court of appeals (judge tatel: one dissent) held that the report was not subject to the foia exception for congressional documents in toto and was partially discoverable under foia. however, the exception for congressional documents applied to the joint committee’s request and any portions of the irs report that “would effectively disclose the request.” the case was remanded for a determination of whether the report could be redacted sufficiently to protect the confidentiality of the joint committee’s request. 2. a “serious” violation of procedural rules by the irs didn’t invalidate the summons. robert v. united states, 364 f.3d 988, 93 a.f.t.r.2d 2004-2770, 2004-1 u.s.t.c. ¶ 50,233 (8th cir. 4/29/04). the court of appeals (judge melloy) upheld the enforcement of irs summonses even though the issuance followed improper ex parte communications between the irs appeals office assigned to the case and audit personnel regarding the substance of the taxpayer’s appeal. the court reasoned that under the standards of united states v. powell, 379 u.s. 48 (1964), as long as the summons is issued for a legitimate purpose and the irs acts in good faith, the summons will be enforced even though the irs has failed properly to follow required internal procedures where congress has not specifically provided a remedy. c. litigation costs 1. the irs has not taken a position until it issues a 90-day letter or appeals has made a decision. florida country clubs, inc. v. commissioner, 122 t.c. 73 (2/3/04). even though § 7430(c)(2) provides that reasonable administrative cost include costs incurred after the irs sends a 30day letter, attorney’s fees are not available with respect to a case in which the irs has issued a 30-day letter but which has been settled without either an deficiency notice or appeals decision having been issued. although the definition of “reasonable administrative costs” includes costs incurred from the date of the 30-day letter, the government still has not “taken a position” for purposes of § 7430(c)(7) until a deficiency notice or appeals decision has been issued, and thus the taxpayer cannot be a “prevailing party” as defined in § 7430(c)(4). 2. the commissioner concedes the substantive issue and that a § 7430 award is proper, but the taxpayer still loses because of the fee structure. grigoraci v. commissioner, 122 t.c. 272 (3/25/04). the taxpayer prevailed in an earlier case involving the same issue [employment taxes] for an earlier year. on the basis of that decision, the commissioner conceded the substantive issue in the instant case and that the taxpayer was entitled to recover costs. however, judge thornton denied the taxpayer’s claim for amounts in 2005] recent developments in federal income taxation 125 excess of the filing fee on two grounds: (1) the taxpayer’s obligation to pay any fees that had been billed to him was contingent on receiving a fee award, and § 7430 does not authorize an award of contingent fees); and (2) the fees related to the first tax court case involving the taxpayer, § 7430 does not authorize awarding fees that relate to an earlier case involving the taxpayer, even if the earlier case involved the same issue for a different year. ! query whether an attorney’s fee award under § 7430 constitutes income to the taxpayer. d. statutory notice 1. “clear and concise” notification of a change of address. hunter v. commissioner, t.c. memo. 2004-81 (3/23/04). judge holmes held that it is not necessary to file a form 8822 to give the irs “clear and concise” notification of the taxpayer’s new address. the taxpayer filed a form 2848, power of attorney, showing his new address as the address to which all originals were to be sent with a copy to his attorney. that was “clear and concise” notification to irs of taxpayer’s new address. “[t]he irs is chargeable with knowing the information that it has readily available when it sends notices to taxpayers.” e. statute of limitations 1. the statute of limitations when taxpayers litigate identity privilege issues in lawsuits against their tax advisers. john doe 1 v. kpmg llp, 93 a.f.t.r.2d 2004-1808, 2004-1 u.s.t.c.¶ 50,270 (n.d. tex. 4/2/04). judge barefoot sanders denied the government’s motion to require the john doe taxpayers to sign consents to extend the statute of limitations, but found instead that the statute was suspended. ! query why the court did not dismiss taxpayers’ lawsuit unless they filed consents to extend the statute of limitations. a. reversed on appeal by the fifth circuit; equitable tolling is inapplicable as an exception to the statute of limitations. john doe 1 v. united states, 398 f.3d 686, 95 a.f.t.r.2d 2005-742, 2005-1 u.s.t.c. ¶ 50,161 (5th cir. 1/26/05). judge jones held that equitable tolling is unavailable to extend the § 6501 statute of limitations. she further held that the general jurisdiction granted by § 7402(a) to district courts to issue appropriate orders to enforce the internal revenue laws does not “authorize[] a court to inject an equitable tolling provision into a detailed, highly specific provision (section 6501).” b. united states v. kpmg llp, 316 f. supp. 2d 30, 93 a.f.t.r.2d 20042106, 2004-1 u.s.t.c. ¶ 50,281 (d. d.c. 5/4/04). judge 126 florida tax review [vol.7:si hogan adopted the rationale of kmpg (n.d. texas), and finds that the statute of limitations was similarly suspended during the pendency of the action. 2. another tax procedure song from the supremes. united states v. galletti, 124 s. ct. 1548, 93 a.f.t.r.2d 2004-1425, 2004-1 u.s.t.c. ¶ 50,204 (3/23/04). a unanimous supreme court, in an opinion by justice thomas, held that a valid statute of limitation on judicially colleting the tax against the general partners assessment of an employment tax deficiency against a partnership extends the 10-year individually, even though there had been no individual assessments against the partners within three years. 3. no refund of paid but unassessed taxes. williams-russell & johnson, inc. v. united states, 371 f.3d 1350, 93 a.f.t.r.2d 2004-2543, 20041 u.s.t.c. ¶ 50,266 (11th cir. 6/7/04). the court of appeals, judge edenfield, held that the statue of limitation on refunds [on employment taxes in this case] under § 6511 runs from the later of payment or the due date of return even if irs fails to make a timely assessment of taxes. a payment due, owing, and made is not an “overpayment” under § 6401(a) merely because the irs failed to formally assess the tax after it was paid. 4. why did the irs contest this one? the statutory language is clear. zarky v. commissioner, 123 t.c. 132 (7/20/04). the taxpayer failed to file a return, received a deficiency notice, and filed a tax court petition within three years after the return due date. the tax court determined that the taxpayer had overpaid his taxes by the amount that had been withheld [$270]. normally, under § 6511(b)(2) and § 6512(b) where a refund claim has not been field within three years of filing a return, the refund is limited to amounts paid within two years prior to filing the claim. the second paragraph of flush language of § 6512(b)(2), added in 1997 provides a special limitation if a taxpayer who fails to file a return receives a deficiency notice and files a tax court petition within three years after the due date of the return; in this case the taxpayer may obtain a refund of an overpayment for the year of the asserted deficiency if the overpayment was made within three years prior to the date of the deficiency notice. in this case, judge laro applied the special rules to order refund of overpaid withholding taxes for the year of the asserted deficiency because the withholding was deemed paid on april 15, which was within three years prior to the date of the deficiency notice. f. liens and collections 1. montgomery v. commissioner, 122 t.c. 1 (1/22/04). because no deficiency notice is issued when the irs attempts to collect unpaid taxes shown as due on the return filed by the taxpayer, at a § 6330 collection due process hearing the taxpayer may challenge the existence or amount of the tax 2005] recent developments in federal income taxation 127 liability reported on the original tax return. the taxpayer did not have any other opportunity to “contest” the liability. 2. you don’t actually have to receive the notice that appeals has not granted relief in a due process hearing for the clock to start ticking on the time to appeal to the tax court. weber ii v. commissioner, 122 t.c. 258 (3/22/04). section 6330(a)(2) requires an irs written notice to the taxpayer of its intent to levy on any of the taxpayer’s property be delivered in person, left at the taxpayer’s home or usual place of business, or sent by certified or registered mail to his last known address at least thirty days before the date of the levy. although the statute does not specify the manner in which the appeals office must inform the taxpayer of its determination following a due process hearing, the tax court has held that notice sent by certified or registered mail to the taxpayer’s last known address – the method specifically authorized for sending deficiency notices in § 6212(a) and (b) – suffices. [the court also observed that notice might be sufficient if it is given in person or left at the taxpayer’s dwelling or usual place of business, analogizing to § 6330(a)(2), but did not decide that question.] accordingly, because the irs proved such mailing, even though the notice was returned by the postal service as “unclaimed” taxpayer’s petition to the tax court was untimely. the subsequent mailing a “courtesy copy” of the notice did not revive the period for appeal. 3. urbano v. commissioner, 122 t.c. 384 (6/10/04). although, the tax court’s jurisdiction to review §§ 6320/6330 due process hearing decisions is limited to cases involving taxes over which it has deficiency jurisdiction, judge laro held that the tax court has jurisdiction to redetermine interest in reviewing due process hearings, even though it generally lacks jurisdiction to redetermine interest [other than to review decisions regarding abatement of interest under § 6404(h)]. 4. iannone v. commissioner, 122 t.c. 287 (4/19/04). in a review of an appeals decision in a §§ 6320/6330 due process hearing, judge nims held that a tax lien against a bankrupt taxpayer’s § 401(k) retirement account, which, under new jersey law, was exempt from creditor’s claims in bankruptcy, survived the bankruptcy. accordingly, the irs could levy against the § 401(k) account. [in the tax court the irs tried to argue that the § 401(k) account was not exempt, but judge nims held that the appeals officer’s agreement in the determination letter to assume that the account was an exempt asset foreclosed any subsequent argument in the tax court that it was not exempt.] 5. tax court review of collection due process hearings is not perfunctory. fowler v. commissioner, t.c. memo. 2004-163 (7/13/04). in reviewing the irs’s rejection of the taxpayer’s offer in compromise in a collection due process hearing, judge gerber held that the rejection was an 128 florida tax review [vol.7:si abuse of discretion because in considering whether the taxpayer could make installment payments the appeals officer relied solely on national average statistics to determine living expenses rather than taking taxpayer’s actual expenses into account. 6. tax court makes it easier to find abuse of discretion in collection due process hearings. robinette v. commissioner, 123 t.c. 85 (7/20/04). in 1995, the taxpayer had entered into an offer in compromise (based on doubts as to collectibility) relating to years prior to 1992, which required that he file timely returns for 1995 through 1999. the returns for 1995 through 1997 were timely filed, but the 1998 return was never received. the taxpayer and his accountant claimed that on the day the 1998 return was due, his accountant prepared it, the taxpayer signed it, and the accountant mailed it using a private postage meter [uh-oh]. the irs declared the compromise in default. after a due process hearing in which the taxpayer claimed good faith compliance and offered alternative proof of mailing, including a copy of the 1998 return, the appeals officer issued a notice of determination to proceed with collection, because the appeals officer would accept only a certified or registered mail receipt as proof of mailing. even though the tax court’s review of collection due process hearings is for abuse of discretion, in a reviewed opinion by judge vasquez (in which 5 judges joined), the tax court held that it may consider evidence presented at trial that was not in the administrative record (but not new issues). the court held that the administrative procedures act review provisions do not apply to § 6330(d) proceedings, and admitted taxpayer’s testimony that he signed and delivered returns to his accountant for mailing, the accountant’s testimony regarding the procedures used to mail the return, and other evidence not in the administrative record indicating that the return was mailed. although the testimony was admitted, it did not prove timely mailing because the accountant used a private meter and the return was not received, until several years later when the copy was delivered to appeals. nevertheless, the court held that the taxpayer did not materially breach the offer in compromise and that the appeals officer abused his discretion in declaring the compromise in default. there were an indescribable number of overlapping concurrences by an additional nine judges, in some of which the five “majority” judges joined, and one of which concurring opinions was supported by more judges than supported the “majority” opinion; there were three dissents. a. chief counsel’s response. chief counsel notice cc2004-031 (9/1/04). deborah butler provides guidance to chief counsel attorneys as to how to handle collection due process cases in light of robinette. the recommended course of action when such evidence is presented to the court is to ask for a remand of the case to appeals for a supplemental determination. 2005] recent developments in federal income taxation 129 7. tithes are allowed for people in the pulpit, but not for those in the pews. unless it is a requirement of ministerial employment, tithes to the church are disallowed in an offer in compromise computation of ability to pay. pixley v. commissioner, 123 t.c. 269 (9/15/04). ordained baptist minister was not entitled to claim tithes to the church as expenses on an offer in compromise in appeals where he was not currently employed as a minister and such tithes were therefore not required as “a condition of employment.” 8. a trap for the unwary deprives tax court of jurisdiction with respect to a petition for lien or levy action. prevo v. commissioner, 123 t.c. 326 (12/14/04). the tax court held it lacked jurisdiction with respect to a petition for lien or levy action filed by taxpayer after she filed a voluntary bankruptcy petition because the tax court petition for lien or levy action was filed in violation of the 11 u.s.c. § 362 automatic stay. judge gerber stated, unfortunately here, where the petition in bankruptcy was voluntary, petitioner has fallen victim to a trap for the unwary. as the notice of determination was issued to petitioner on february 23, 2004, petitioner normally would have had 30 days – until march 24, 2004 – to file a timely petition for lien or levy action with the court. however, upon the filing of the bankruptcy petition on march 1, 2004, the automatic stay was invoked, and petitioner was barred from commencing a proceeding in this court. n4 further, the automatic stay remained in effect until march 31, 2004 – 7 days after the 30day statutory filing period under sections 6320(c) and 6330(d) expired. thus, but for the provisions of section 11 u.s.c. section 362(a)(8) and the lack of a tolling provision analogous to section 6213(f), this court would have jurisdiction over this case. n5 n4 had petitioner first filed a petition with this court and then filed a bankruptcy petition, the proceeding before this court would have been active and then stayed, thereby preserving petitioner’s ability to contest respondent’s determination. n5 see, however, sec. 6330(d), which provides in part: “if a court determines that the appeal was to an incorrect court, a person shall have 30 days after the court determination to file such appeal with the correct court.” we do not decide herein whether our determination in this opinion that we lacked jurisdiction over the petition filed during the pendency of petitioner’s bankruptcy case means that we are or are not the 130 florida tax review [vol.7:si “incorrect” court for purposes of the above-quoted flush language. if we were the “incorrect” court, petitioner would have 30 days from the date decision is entered in this case to refile in the “correct” court. that issue, however, is not currently before the court and was not briefed by the parties. a. but the trap does not exist where the irs issued its notices after the taxpayer filed a bankruptcy petition. smith v. commissioner, 124 t.c. 36 (2/8/05). judge gerber distinguished the prevo case, and held the tax court lacked jurisdiction because the irs notices were void because they violated the automatic stay under bankruptcy law. g. innocent spouse 1. ewing v. commissioner, 122 t.c. 32 (1/28/04). in a reviewed opinion by judge, the tax court held that even though the standard for reviewing the commissioner’s failure to grant equitable relief under § 6015(f) is abuse of discretion, the tax court’s review is not necessarily limited to the facts that were in the administrative record. judges halpern, holmes, chiechi, and foley dissented. 2. did a procedural detail slip through the statutory cracks? maier v. commissioner, 119 t.c. 267 (11/20/02). when one spouse requests innocent spouse relief from the irs, § 6015(h)(2) assures the other spouse a right to participate in the process [although it does not guarantee a personal appearance]. if a requesting spouse seeks tax court review of a denial of innocent spouse relief in a proceeding to which the other spouse is not already a party, § 6015(e)(4) provides the nonrequesting spouse the right to intervene. but if the irs administratively grants the requesting spouse innocent spouse relief, according to the tax court [judge panuthos], the nonrequesting spouse has no independent right to petition the tax court to review the administrative grant of relief to the requesting spouse. a. yes, answers the second circuit. affirmed, maier v. commissioner, 360 f.3d 361, 93 a.f.t.r.2d 2004-1139, 2004-1 u.s.t.c. ¶ 50,179 (2d cir. 2/26/04). judge walker affirms by reason of lack of tax court jurisdiction over petitions for review from non-electing spouses after innocent spouse relief has been administratively granted, and cites ira shepard & martin mcmahon, recent developments in federal income taxation: the year 2002, 6 fla. tax rev. 81, 177 (2003), in support of his conclusion that a legislative remedy would be needed in order for judicial relief to be granted in such situations. 2005] recent developments in federal income taxation 131 3. accepted offer in compromise bars subsequent innocent spouse relief. dutton v. commissioner, 122 t.c. 133 (2/11/04). the taxpayer’s offer in compromise (based on doubt as to collectibility) was accepted by the irs. the taxpayer mistakenly thought that because an irs agent informed him that § 6015(c) apportioned liability would be considered, he would obtain a refund of amounts paid under the compromise. judge goeke held that once a taxpayer has entered into a valid compromise of his tax liability pursuant to § 7122, he cannot thereafter seek innocent spouse relief under § 6015 with respect to the liability. 4. tax liens against possibly innocent spouses are ok. beery v. commissioner, 122 t.c. 184 (3/1/04). after election has been made, § 6015(e)(1)(b)(i) generally bars the irs from levying or collecting the tax until the later of the expiration of the ninety-day period for petitioning the tax court or, if a petition has been filed, the date the tax court order becomes final. however, judge panuthos held that § 6015(e)(1)(b)(i) does not bar the irs from filing a lien after an innocent spouse election has been filed and during the pendency of a petition for innocent spouse relief. 5. well, the former spouses weren’t totally antagonistic. he supported her innocent spouse claim. van arsdalen v. commissioner, 123 t.c. 135 (7/22/04). the taxpayer filed a stand-alone tax court petition seeking review of the commissioner’s denial of innocent spouse relief under § 6015(f). the irs issued her former husband a notice of filing petition and right to intervene that stated that his right to intervene was limited to intervening solely for the purpose of challenging the taxpayer’s right to innocent spouse relief. her former husband intervened to support her claim. judge panuthos held that neither § 6015 nor tax court rule 325 precludes a nonelecting spouse from intervening for the purpose of supporting the electing spouse’s claim for relief. h. miscellaneous 1. burton kanter in trouble again. investment research associates, ltd. v. commissioner, t.c. memo. 1999-407 (12/15/99). in a 600page opinion burton kanter was held liable for the §6653 fraud penalty by reason of his being “the architect who planned and executed the elaborate scheme with respect to the kickback income payments . . . . in our view, what we have here, purely and simply, is a concerted effort by an experienced tax lawyer [kanter] and two corporate executives [claude ballard and robert lisle] to defeat and evade the payments of taxes and to cover up their illegal acts so that the corporations [employing the two corporate executives] and the federal government would be unable to discover them.” 132 florida tax review [vol.7:si a. so far, he is unable to wriggle out, the way he did 25 years ago when he was acquitted by a jury. the taxpayers subsequently11 moved to have access to the special trial judge’s “reports, draft opinions, or similar documents” prepared under tax court rule 183(b). they based their motion on conversations with two unnamed tax court judges that the original12 draft opinion from the special trial judge was changed by judge dawson before he adopted it. they were turned down because the tax court held that the documents were related to its internal deliberative processes. see, tax court order denying motion, 2001 tnt 23-31 (4/26/00) and (on reconsideration) 2001 tnt 23-30 (8/30/00). taxpayers sought mandamus from the fifth, seventh and eleventh circuits, but were unsuccessful. b. and the tax court’s procedures are vindicated and taxpayer ballard loses on appeal on the fraud issue in the eleventh circuit. ballard v. commissioner, 321 f.3d 1037, 91 a.f.t.r.2d 2003-928, 2003-1 u.s.t.c. ¶ 50,246 (11th cir. 2/13/03), aff’g t.c. memo. 1999-407. the eleventh circuit affirmed the tax court decision and rejected the taxpayers’ argument that changes allegedly made by the tax court special trial judge were improper. judge fay stated: even assuming dick’s [taxpayers’ lawyer’s] affidavit to be true and affording petitioners-appellants all reasonable inferences, the process utilized in this case does not give rise to due process concern. while the procedures used in the tax court may be unique to that court, there is nothing unusual about judges conferring with one another about cases assigned to them. these conferences are an essential part of the judicial process when, by statute, more than one judge is charged with the responsibility of deciding the case. and, as a result of such conferences, judges sometimes change their original position or thoughts. whether special trial judge couvillion prepared drafts of his report or subsequently changed his opinion entirely is without import insofar as our analysis of the alleged due process violation pertaining to the application of [tax court] rule 183 is concerned. despite the invitation, this court will simply not interfere with another court’s deliberative process. 11. his partner (and son-in-law) was convicted and imprisoned. see united states v. baskes, 649 f.2d 471 (7th cir. 1980), cert. denied, 450 u.s. 1000 (1981). 12. kanter’s attorney revealed the names of the two judges when asked at oral argument to the seventh circuit as tax court judge julian jacobs and chief special trial judge peter j. panuthos. see the text at footnote 1 of judge cudahy’s dissent in the seventh circuit kanter estate opinion, below. 2005] recent developments in federal income taxation 133 the record reveals, and we accept as true, that the underlying report adopted by the tax court is special trial judge couvillion’s. petitioners-appellants have not demonstrated that the order of august 30, 2000 is inaccurate or suspect in any manner. therefore, we conclude that the application of rule 183 in this case did not violate petitioners-appellants’ due process rights. accordingly, we deny the request for relief and save for another day the more troubling question of what would have occurred had special trial judge couvillion not indicated that the report adopted by the tax court accurately reflected his findings and opinion. (1) cert. granted. a writ of certiorari was granted on 4/26/04, 72 u.s.l.w. 3672, 124 s. ct. 2066, and the case was consolidated with estate of kanter. see e.g., below. c. and the tax court’s procedures are vindicated and taxpayer kanter’s estate loses on appeal on the fraud issue in the13 eleventh circuit estate of kanter v. commissioner, 337 f.3d 833, 92 a.f.t.r.2d 2003-5459, 2003-02 u.s.t.c. ¶ 50,605 (7th cir. 7/24/03) (per curiam) (2-1), aff’g in part and rev’g in part t.c. memo. 1999-407. the court finds the nondisclosure of the special trial judge’s original report to be proper, following the eleventh circuit’s ballard opinion. it affirms the findings on deficiencies, fraud and penalties, but reverses on the issue of the deductibility of kanter’s expenses for his involvement in the aborted sale of a purported john trumball painting of george washington because “kanter has shown a distinct proclivity to seek income and profit through activities similar to the failed sale of the painting.” (1) the supremes will sing over kanter’s grave. a writ of certiorari was granted on 4/26/04, 72 u.s.l.w. 3672, 124 s. ct. 2066, and the case was consolidated with ballard. see e.g., below. d. and the tax court’s procedures are vindicated but taxpayer lisle’s estate wins on appeal on the fraud issue in the fifth circuit. estate of lisle v. commissioner, 341 f.3d 364, 92 a.f.t.r.2d 20035566, 2003-02 u.s.t.c. ¶ 50,606 (5th cir. 7/30/03), aff’g in part and rev’g in part t.c. memo. 1999-407. the fifth circuit (judge higginbotham) followed the eleventh and seventh circuits on the nondisclosure of the special trial judge’s original report by the tax court. it affirms the findings of deficiencies, except for the deficiency in a closed year because the government’s proof of lisle’s fraud did not rise to the level of “clear and convincing evidence.” 13. burton kanter died on october 31, 2001. 134 florida tax review [vol.7:si e. justice ginsburg to tax court judges: “you article i judges don’t understand your own rules, so let me tell you what you meant when you adopted them in 1983.” ballard v. commissioner, 125 s. ct. 1270, 95 a.f.t.r.2d 2005-1302, 2005-1 u.s.t.c. ¶ 50,211 (3/7/05) (72), reversing and remanding 337 f.3d 833 (7th cir. 7/24/03) and 321 f.3d 1037 (11th cir. 2/13/03). justice ginsburg held that the tax court may not exclude from the record on appeal and may not conceal from the taxpayers the original draft reports of special trial judges under tax court rule 183(b). justice ginsburg so held because no statute authorizes the concealment and the rule’s “current text” does not warrant it. her reading of tax court rule 183 is that it does not authorize the tax court to treat the special trial judge’s rule 183(b) report as a draft subject to collaborative revision. she held that it is particularly important that the process be transparent in fraud cases such as this one. ! chief justice rehnquist’s dissenting opinion, joined in by justice thomas, states that the “tax court’s compliance with its own rules is a matter on which we should defer to the interpretation of that court.” he concludes that “seminole rock deference” [bowles v. seminole rock & sand co., 325 u.s. 410 (1945)] should extend to an article i court’s interpretation of its own rules as well as to an executive agency’s interpretation of its rules. he further notes that the issue of compliance with rule 183 was not presented to the supreme court, and that under supreme court rule 14.1(a) the “court does not consider claims not included within a petitioner’s questions presented.” he notes, “only by failing to abide by our own rules can the court hold that the tax court failed to follow its rules.” 2. sometimes the tax court has jurisdiction to redetermine interest due on overpayments for years not covered by the deficiency notice. sunoco, inc. v. commissioner, 122 t.c. 88 (2/4/04). once the tax court’s jurisdiction has been properly invoked, it has jurisdiction under § 6512(b) to determine that there was an overpayment. this jurisdiction extends to overpayments of interest as well. estate of baumgardner v. commissioner, 85 t.c. 445 (1985). judge whalen held that both underpayment and overpayment interest are calculated with respect to the cumulative balance of the taxpayer’s account with the irs, the tax court’s jurisdiction also extends to determination that irs had not properly credited taxpayer with overpayment interest attributable to other years. 3. factor nols into your qualified settlement offer up front or forfeit the right to raise the issue. johnson v. commissioner, 122 t.c. 124 (2/11/04). the taxpayer made a qualified settlement offer under § 7430(g) that was accepted by the irs. subsequently the taxpayer attempted to reduce the amount through claimed net operating loss carrybacks that were not in dispute at the time the offer was made. judge nims held that under temp. reg. § 301.7430-7t, the irs’s acceptance of the qualified offer “fully resolved the 2005] recent developments in federal income taxation 135 issue” of the taxpayer’s liabilities for the years in question, and he was “not now allowed to add additional terms to the agreement by applying nols from other years to reduce the agreed-upon amounts,” where the offer did not expressly provide that the offered amount was subject to adjustment for net operating loss carrybacks. he noted that the final regulations provide that whether the qualified offer can be reduced by nols depends on contract principles, but that those regulations did not apply because the taxpayer’s offer was made before that date. 4. eighth circuit to tax court: “who will you believe, us or your own lying eyes and ears?” just how detailed a finding on the burden of proof issue does the eighth circuit want the tax court to make? griffin v. commissioner, 315 f.3d 1017, 91 a.f.t.r.2d 2003-486, 2003-1 u.s.t.c. ¶ 50,186 (8th cir. 1/14/03), rev’g t.c. memo. 2002-6 (1/8/02), on remand, t.c. memo. 2004-64 (3/11/04). reversing the tax court, the eighth circuit, in a per curiam opinion, held that the taxpayer had introduced credible evidence that payments of real estate taxes on property owned by an s corporation in which he was a shareholder were made in his capacity as a proprietor of a business, not in his capacity as a shareholder. (if the payments had been made in his capacity as a proprietor they could have been deductible.) the court accepted the commissioner’s definition of “credible evidence:” “the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted (without regard to the judicial presumption of irs correctness),” and found this standard satisfied by the testimony of the taxpayer and his accountant. the commissioner had cross examined the taxpayer’s witnesses, but had not introduced any evidence. the case was remanded to the tax court for further proceedings to determine if the commissioner met the burden of proof, even though the tax court opinion, in a footnote, stated that its decision would have been the same if the commissioner had borne the burden of proof. perhaps tipping its hand that it wanted the taxpayer to win, the court of appeals admonished the tax court that “[i]f the same conclusion is reached by the tax court without a new hearing, an explanation is warranted as to how the existing record justifies the conclusion that the commissioner has met his burden of proof.” ! according to the tax court, the taxpayers did “not contend that the real property taxes in question were imposed upon them, that they owned the real property against which the taxes were assessed, or that they owned any equitable or beneficial interest in the real property that might entitle them to a deduction under section 164. . . . the only evidence regarding the nature of [taxpayers’] business activities consists of [one taxpayer’s] summary and uncorroborated testimony. he testified, with little elaboration, that he has been a building contractor and land developer for about 30 years, during which time he has developed about one project a year. on cross-examination, he 136 florida tax review [vol.7:si testified that his construction and real-estate development businesses are not separate businesses, but are ‘all tied together. they’re all – any business i have is – if i – if they are – oftentimes i incorporate, because of the liability aspect. they are subchapter s if they are.’ . . . [t]here is no credible evidence that the tax payments were made with respect to such activities. to the contrary, [taxpayer’s] accountant testified that the tax payments were reported on schedule e because they were attributable to [his] s corporations. . . . [taxpayers] failed to introduce credible evidence to establish that [taxpayer’s] failure to make the tax payments would have caused direct and proximate adverse consequences to any businesses conducted in [taxpayers’] individual capacities. [one taxpayer] testified that he made the tax payments ‘in order to preserve my integrity and my standing with the bank, and my good name, my goodwill.’ there is no evidence to indicate, however, to what extent [the taxpayer’s] failure to make the tax payments would have resulted in any damage to his reputation or creditworthiness. [taxpayers] have introduced no credible evidence to show that petitioner made the tax payments to protect the reputation of any business operation conducted in [their] individual capacities. on the basis of [taxpayer’s] testimony, we are unable to conclude that the tax payments would have represented ordinary expenses to advance any business carried on in [taxpayers’] individual capacities, as opposed to capital outlays to establish or purchase goodwill or business standing. . . .” a. tax court responds, “if you tell us to believe taxpayer’s rooster-and-gentleman-cow story, we will be forced to.” section 7491 has real teeth, and the burden of proof is shifted. on remand, t.c. memo. 2004-64 (3/11/04). neither party accepted the tax court’s offer to introduce further evidence, but both parties submitted briefs on the issue of the burden of proof. judge thornton found himself bound by the eighth circuit’s holding that taxpayer had produced sufficient “credible evidence” to shift the burden of proof to the government, even though he found to the contrary in his initial decision. moreover, he felt himself bound to change his earlier conclusion that, had the burden of proof been shifted to the government, it had satisfied that burden. footnote 7 states in our original opinion, we noted: “even if the burden of proof were placed on respondent, we would decide the issue [as to the deductibility of the tax payments] in his favor based on the preponderance of the evidence.” t.c. memo. 2002-6 n. 4. this statement reflected this court’s conclusion that mr. griffin’s testimony was not only insufficient to support petitioners’ claim to ordinary and necessary business deductions but indeed undermined their claim, insofar as mr. griffin’s testimony convinced us that his relevant business activities were conducted entirely through s corporations. in light of the court 2005] recent developments in federal income taxation 137 of appeals’ conclusion that mr. griffin’s testimony was sufficient to support the claimed deductions, the preponderance of the evidence, thus evaluated, is no longer in respondent’s favor. ! query whether the caveat in footnote 6 is sufficient to prevent game-playing taxpayers from taking advantage of § 7491? . . . we do not construe the opinion of the court of appeals as standing for the proposition that, in assessing the credibility of evidence for purposes of deciding the placement of the burden of proof pursuant to sec. 7491(a)(1), the trial court is required to accept at face value self-serving testimony which it finds unworthy of belief. see, e.g., day v. commissioner, 975 f.2d 534, 538 (8th cir. 1992) (stating that “the tax court is not required to give credence to the self-serving testimony of interested parties.”), affg. in part, revg. in part and remanding t.c. memo. 1991-140. as stated in the relevant legislative history of sec. 7491: “the introduction of evidence will not meet this standard [of credible evidence] if the court is not convinced that it is worthy of belief.” h. conf. rept. 105-599, at 241(1998), 1998-3 c.b. 747, 995; cf. kincade v. mikles, 144 f.2d 784, 787 (8th cir. 1944) (“as to the contention that the evidence is unworthy of belief, it need only be said that it was the function of the trial court to pass upon the credibility of the witnesses and the weight to be given their testimony.”) 5. an example of post-divorce cooperation between former spouses. threat to ex-husband that she would write the irs and get them to audit his returns results in irs employee losing her job for committing a “deadly sin.” james v. tablerion, 363 f.3d 1352, 93 a.f.t.r.2d 1814 (fed. cir. 4/13/04). the federal circuit (judge clevinger) reversed an arbitrator’s decision ordering restatement of a revenue agent in tempe after she was dismissed by the commissioner pursuant to the provisions of § 1203 of the irs reform and restructuring act of 1998 for “threatening to audit a taxpayer for the purpose of extracting personal gain or benefit.” mrs. tablerion told her exhusband that if he did not sign forms 8332 relinquishing his claim for a tax exemption for one of their two children (after she had signed such forms with respect to their other child), saying “if you don’t . . . i will write the irs and, and, uh inform them to audit your returns.” her ex-husband eventually (but not immediately) reported the statement to the treasury inspector general for tax administration (tigta). ! the court determined that under the criteria of metz v. department of treasury, 780 f.2d 1001 (fed. cir. 1986), witness testimony was to be weighed for “(1) the listener’s reactions; (2) the listener’s 138 florida tax review [vol.7:si apprehension of harm; (3) the speaker’s intent; (4) any conditional nature of the statements; and (5) the attendant circumstances.” while the arbitrator found in favor of the irs employee, the court found that § 1203 applied to off-duty conduct so a threat to audit made by an irs employee violates the statute and is conclusively presumed to be made “in the performance of the employee’s official duties.” the court found that, under the legislative history, if the threat is made for personal gain, “threats to audit made by irs employees must be discouraged by the penalty of removal.” 6. the roaster got roasted, but just once. siddiqui v. united states, 359 f.3d 1200, 93 a.f.t.r.2d 2004-1305, 2004-1 u.s.t.c. ¶ 50,193 (9th cir. 3/9/04). an irs special agent made a negligent disclosure of a criminal investigation of the taxpayer at a retirement dinner that included numerous guests, many of whom were not irs cid personnel. in the absence of proof of any actual damages, the taxpayer was awarded the $1,000 minimum damages award under § 7431. the court of appeals (judge alarcon) held that the $1,000 minimum is based on each separate event of unauthorized disclosure, not how many people heard the unauthorized disclosure. furthermore, punitive damages were denied because the statutory language precludes an award of punitive damages in absence of actual damages. 7. to the irs, he was never a window. payne v. united states, 2004-2 u.s.t.c. ¶ 50, (5th cir. 9/8/04) (unpublished per curiam opinion), aff’g 290 f. supp. 2d 742 (s.d. tex. 2003). affirms district court denial of damages for alleged unlawful disclosure of confidential tax return information during an irs criminal investigation because the disclosures resulted from the irs agent’s good faith, but erroneous, interpretation of the internal revenue code. 8. proposed regulations reject the mailbox rule and hold that – absent actual delivery – only registered or certified mail will suffice as proof. reg-138176-02, timely mailing treated as timely filing, 69 f.r. 56377 (9/21/04). proposed regulations under § 7502 would provide that a registered or certified mail receipt is the only prima facie evidence of delivery of documents that have a filing deadline prescribed by the internal revenue laws – other than direct proof of actual delivery. 9. section 842 of the american jobs creation act of 2004 adds new § 6603 to codify the existing treatment of deposits made to suspend the running of interest on potential underpayments. these deposits had been governed by rev. proc. 84-58, 1984-2 c.b. 501. 10. section 881 of the american jobs creation act of 2004 adds new §§ 6306 and 7433a to permit “qualified tax collection contracts” to be 2005] recent developments in federal income taxation 139 entered into with persons who are not irs employees, and to provide damages for certain unauthorized collection actions by such persons. 11. you have a choice of forum for review of the commissioner’s refusal to abate interest. beall v. united states, 336 f. 3d 419, 92 a.f.t.r.2d 2003-5001, 2003-2 u.s.t.c. ¶ 50,551 (5th cir. 6/27/03). the fifth circuit (judge garwood) held that a district court has jurisdiction in a refund suit to review for abuse of discretion the commissioner’s refusal to abate interest. judge garwood reasoned that the grant of jurisdiction to the tax court in § 6404(h) was not exclusive. a. but not in the court of federal claims, which holds that beall is not the “be all and end all” on this issue. hinck v. united states, 64 fed cl. 71, 95 a.f.t.r.2d 2005-873, 2004-1 u.s.t.c. ¶ 50,270 (fed. cl. 2/3/05). judge allegra held that the 1996 amendments to § 6404 gave the tax court jurisdiction to review the failure to abate interest under the “abuse of discretion” standard.” before 1996 the federal courts did not have jurisdiction to review abatement decisions, and the 1996 amendments to § 6404 did not do so. the court of federal claims disagrees with, and refuses to follow, the beall case. xi. withholding and excise taxes a. employment taxes 1. section 251 of the american jobs creation act of 2004 amends various code sections to provide that employment taxes (including withholding) are not required with respect to the spread on the exercise of incentive stock options and employee stock purchase plan stock options. this spread is includable for amt purposes, but not for regular income tax purposes. ! there has been for the past several years a freeze in effect on the collection of employment taxes on the exercise of qualified options. b. self-employment there were no significant developments regarding this topic during 2004. c. excise taxes 1. clear statutory language cannot be changed by an interpretive regulation. horton homes, inc. v. united states, 357 f.3d 1209, 93 a.f.t.r.2d 2004-463, 2004-1 u.s.t.c. ¶ 70,215 (11th cir. 1/20/04). horton 140 florida tax review [vol.7:si purchased vehicles, known as “toters,” to transport manufactured homes. the irs asserted the 12-percent excise tax levied in § 4051 because it contended that the toters were “[t]ractors of the kind chiefly used . . . in combination with a trailer or semitrailer.” the statute had not changed since 1938, but in 1983, temporary regulations that expanded the definition of “tractor” to include “a highway vehicle primarily designed to tow a vehicle, such as a trailer or semitrailer,” and further provided that a vehicle “equipped with air brakes and/or towing package will be presumed to be primarily designed as a tractor.” the court held that the regulation could not change the clear statutory language, and decided for horton. a. rev. rul. 2004-80, 2004-32 i.r.b. 164 (7/28/04). a chassis cab with a gross vehicle weight rating of 23,000 and a gross combination weight rating of 43,000 pounds [when it is towing a 20,000 pound trailer], with hydraulic disc brakes with a four-wheel automatic braking system, a 300 horsepower engine, and a six-speed automatic transmission as well as a removable ball gooseneck hitch, a fifth wheel hitch, and a heavy duty trailer receiver hitch [all of which maximize towing capacity at the expense of carrying capacity]. held that pursuant to the 1983 temporary regulations referred to in horton homes, the vehicle is a tractor for purposes of § 4051. 2. tam 200425048 (2/17/04). this tam concludes that monthly management fees and variable rate fees paid to an aircraft management company by aircraft owners participating in a joint ownership program are subject to the § 4261 excise tax on amount paid for taxable transportation. this arrangement is comparable to payments under a “wet lease” that are subject to tax as payments for air transportation, as opposed to payments under a “dry lease” that are treated as rental payments. xii. tax legislation a. enacted 1. the pension funding equity act of 2004, p.l. 108-218, h.r. 3108, was signed by president bush on 4/10/04. 2. the working families tax relief act of 2004 (“working families act of 2004”) p.l. 108-311, h.r. 1308, was signed into law by president bush on 10/4/04. 3. fire your lobbyist if you didn’t get relief in this act. the american jobs creation act of 2004 (“american jobs creation act of 2004”) h.r. 4520, was signed by president bush on 10/22/04. the year 2004 the record establishes that on the dates of the cross-chain sales, petitioner had agreed upon, and had begun to implement, a firm and fixed plan to completely terminate the target corporations’ ownership interests in the issuing corporations (the subsidiaries whose stock was sold cross-chain). the plan was carefully structured to achieve very favorable tax basis adjustments resulting from the interplay of section 304 and the consolidated return regulations, and the steps of the plan were described in detail in written summaries prepared for meetings of merrill parent’s board of directors. as described in those written summaries, the cross-chain sales of the issuing corporations’ stock and the sales of the target corporations were part of the same seamless web of corporate activity intended by petitioner to culminate in the sale of the target corporations outside the consolidated group. in essence, the testimony and evidence offered by long term regarding the advice received from king & spalding amounted to general superficial pronouncements asking the court to “trust us; we looked into all pertinent facts; we were involved; we researched all applicable authorities; we made no unreasonable assumptions; long term gave all information.” the court’s role as factfinder is more searching and with specifics, analysis, and explanations in such short supply, the king & spalding effort is insufficient to carry long term’s burden to demonstrate that the legal advice satisfies the threshold requirements of reasonable good faith reliance on advice of counsel.” in 1998, b & d sold three of its businesses. as a result of these sales, b & d generated significant capital gains. id. that same year, b & d created black & decker healthcare management inc. (“bdhmi”). b & d transferred approximately $ 561 million dollars to bdhmi along with $ 560 million dollars in contingent employee healthcare claims in exchange for newly issued stock in bdhmi. b & d sold its stock in bdhmi to an independent third-party for $ 1 million dollars. because b & d believed that its basis in the bdhmi stock was $ 561 million dollars, the value of the property it had transferred to bdhmi, b & d claimed approximately $ 560 million dollars in capital loss on the sale, which it reported on its 1998 federal tax return. b & d applied a portion of the capital loss to offset its capital gains from selling the three businesses, and carried back and carried forward the remaining capital loss to offset gains in prior and future tax years. (citations omitted) under our time-tested system of separation of powers, it is congress, not the court, that should determine how the federal tax laws should be used to promote economic welfare. . . . . accordingly, the court has determined that where a taxpayer has satisfied all statutory requirements established by congress, as coltec did in this case, the use of the “economic substance” doctrine to trump “mere compliance with the code” would violate the separation of powers. written advice will not be treated as a reliance opinion if the practitioner prominently discloses in the written advice that it was not written to be used and cannot be used for the purpose of avoiding penalties. similarly, written advice generally will not be treated as a marketed opinion if it does not concern a listed transaction or a plan or arrangement having the principal purpose of avoidance or evasion of tax and the written advice contains this disclosure. the treasury department and the irs intend to amend 26 cfr 1.6664-4 to clarify that a taxpayer may not rely upon written advice that contains this disclosure to establish the reasonable cause and good faith defense to the accuracy-related penalties. written advice that is not a covered opinion for purposes of § 10.35 is subject to the standards set forth in new § 10.37. the final regulations also set forth requirements for written advice that is not a covered opinion. under § 10.37 a practitioner must not give written advice if the practitioner: (1) bases the written advice on unreasonable factual or legal assumptions; (2) unreasonably relies upon representations, statements, findings or agreements of the taxpayer or any other person; (3) fails to consider all relevant facts; or (4) takes into account the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be settled. section 10.37, unlike § 10.35, does not require that the practitioner describe in the written advice the relevant facts (including assumptions and representations), the application of the law to those facts, or the practitioner’s conclusion with respect to the law and the facts. the scope of the engagement and the type and specificity of the advice sought by the client, in addition to all other facts and circumstances, will be considered in determi newly designated § 10.38, formerly § 10.37 in the proposed regulations, is adopted as proposed with the following modifications. section 10.38 is modified to clarify that an advisory committee may not make recommendations about actual practitioner cases, or have access to information pertaining to actual cases. the section also is modified to clarify that the director of the office of professional responsibility should ensure that membership of these committees is balanced among those individuals who practice as attorneys, accountants and enrolled agents. tax accrual workpapers are those audit workpapers, whether prepared by the taxpayer or by an independent accountant, relating to the tax reserve for current, deferred and potential or contingent tax liabilities, however classified or reported on audited financial statements, and to footnotes disclosing those tax liabilities on audit financial statements. they reflect an estimate of a company’s tax liabilities and may also be referred to as the tax pool analysis, tax liability contingency analysis, tax cushion analysis, or tax contingency reserve analysis. the transaction first involves the transfer of stock options by the executive to a related entity, such as a family limited partnership, under terms of an agreement to defer payment to the executive. next, the partnership exercises the options and sells the stock in the marketplace. the executive then takes the position that tax is not owed until the date of the deferred payment, typically 15 to 30 years later, although the executive has access to the partnership assets undiminished by taxes. tax laws require executives to include in income and pay tax on the difference between the amount they pay for the stock and its value when the option is exercised. corporations are entitled to a deduction for the compensation when the options are exercised. consistent with the legislative history, a tax advisor, including a material advisor, will not be treated as participating in the organization, management, promotion or sale of a transaction if the tax advisor’s only involvement is rendering an opinion regarding the tax consequences of the transaction. in the course of preparing a tax opinion, a tax advisor is permitted to suggest modifications to the transaction, but the tax advisor may not suggest material modifications to the transaction that assist the taxpayer in obtaining the anticipated tax benefits. merely performing support services or ministerial functions such as typing, photocopying, or printing will not be considered participation in the organization, management, promotion or sale of a transaction. unfortunately here, where the petition in bankruptcy was voluntary, petitioner has fallen victim to a trap for the unwary. as the notice of determination was issued to petitioner on february 23, 2004, petitioner normally would have had 30 days – until march 24, 2004 – to file a timely petition for lien or levy action with the court. however, upon the filing of the bankruptcy petition on march 1, 2004, the automatic stay was invoked, and petitioner was barred from commencing a proceeding in this court. n4 further, the automatic stay remained in effect until march 31, 2004 – 7 days after the 30day statutory filing period under sections 6320(c) and 6330(d) expired. thus, but for the provisions of section 11 u.s.c. section 362(a)(8) and the lack of a tolling provision analogous to section 6213(f), this court would have jurisdiction over this case. n5 . . . we do not construe the opinion of the court of appeals as standing for the proposition that, in assessing the credibility of evidence for purposes of deciding the placement of the burden of proof pursuant to sec. 7491(a)(1), the trial court is required to accept at face value self-serving testimony which it finds unworthy of belief. see, e.g., day v. commissioner, 975 f.2d 534, 538 (8th cir. 1992) (stating that “the tax court is not required to give credence to the self-serving testimony of interested parties.”), affg. in part, revg. in part and remanding t.c. memo. 1991-140. as stated in the relevant legislative history of sec. 7491: “the introduction of evidence will not meet this standard [of credible evidence] if the court is not convinced that it is worthy of belief.” h. conf. rept. 105-599, at 241(1998), 1998-3 c.b. 747, 995; cf. kincade v. mikles, 144 f.2d 784, 787 (8th cir. 1944) (“as to the contention that the evidence is unworthy of belief, it need only be said that it was the function of the login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review tax consequences of assigning life insurance-time for another look douglas a. kahn* and lawrence w. waggoner" i. introduction ................................ 382 hi. the economic components of life insurance ....... 384 m. the general framework for taxing life insurance ................................... 388 a. inconme taxation of life insurance ............. 388 1. exclusion of proceeds from gross income .. 388 2. appreciation in reserve ............... 389 b. gift taxation of life insurance ................ 390 c. estate taxation of life insurance .............. 392 1. in general ........................ 392 2. transfers within three years of death ..... 393 iv. assignment more than three years before death ...................................... 395 a. payment of premiums by the insured ............ 396 b. premium payments as a constructive transfer of a portion of a policy ........................ 396 v. assignment in substance within three years of death ...................................... 398 a. the proper boundary of the constructive transfer principle ......................... 400 b. the ill-advised abrogation of the constructive transfer principle ......................... 402 vi. outright assignment within three years of death ...................................... 405 viii. conclusion .................................. 416 volume 4 number 5 * paul g. kauper professor of law, university of michigan. ** lewis m. simes professor of law, university of michigan. copyright © 1999 by douglas a. kahn and lawrence w. waggoner. florida tax review i. introduction the taxpayer relief act of 1997 furnishes the courts and the internal revenue service an opportunity to close certain loopholes in the federal tax consequences of assigning life insurance. about twenty years ago, we published an article arguing that the tax consequences of assigning life insurance affords taxpayers unwarranted opportunities for tax avoidance.' since then, developments in the case law and internal revenue service rulings have broadened the loopholes. in this update of our article, we show how the new tax law supports our original position. the most litigated estate tax issue concerning life insurance' is whether the proceeds are includible in the insured's gross estate. this question is usually governed by section 2042 of the internal revenue code of 1986 (code), the estate tax provision specifically dealing with life insurance. to be included under section 2042, the insured must "possess at his death any of the incidents of ownership [in the policy], exercisable either alone or in conjunction with any other person," or the proceeds must be "receivable by the [insured's] executor.",3 usually at minimal gift tax cost, an insured can avoid section 2042 by giving the policy to the beneficiary or placing it in an irrevocable trust.4 i. douglas a. kahn & lawrence w. waggoner, federal taxation of the assignment of life insurance, 1977 duke l.j. 941. 2. under the terminology used in connection with life insurance, the insurer is the company that issues the policy, the insured is the person whose life is insured by the policy, the beneficiary is the person to whom the proceeds of the insurance are payable, and the policyholder is the owner of the policy. as owner, the policyholder possesses the economic rights in and power over the policy, including the right to surrender the policy for cash, borrow against the policy, and name the beneficiary. the policyholder need not be the insured. 3. irc § 2042. some of the previously unresolved questions concerning the interpretation of § 2042 have apparently been settled. compare estate of skifter v. commissioner, 468 f.2d 699 (2d cir. 1972) (broad fiduciary powers conveyed to, and not retained by, an insured did not constitute an "incident of ownership"), and estate of connelly v. united states, 551 f.2d 545 (3d cir. 1977) (power to elect settlement option, and thus to affect proceeds' payment schedule, the exercise of which required consent of employer and insurer, did not constitute an "incident of ownership" under irc § 2042), with terriberry v. united states, 517 f.2d 286 (5th cir. 1975) (power, as a trustee, to elect a settlement option constituted an "incident of ownership" even though insured's wife could terminate his power at will), and rose v. united states, 511 f.2d 259 (5th cir. 1975) (power, as a trustee, to alter time and manner of enjoyment of policy held in trust constituted an "incident of ownership"). skifter is the most significant case in that list. although the commissioner initially rejected the skifter decision in rev. rul. 76-261, 1976-2 c.b. 276, the commissioner later revoked that ruling and adopted the skifter position. see rev. rul. 84-179, 1984-2 c.b. 195. 4. for gift tax purposes, a life insurance policy is valued on the date of the gift without regard to the insured's actual life expectancy or medical condition. see infra text accompanying notes 26-28. [vol 4:5 tax consequences of assigning life insurance if the insured dies within three years after making the gift, however, and if the policy was not terminated, the full value of the proceeds may be included under another section of the code, section 2035. as amended by the taxpayer relief act of 1997, section 2035 provides that if the decedent, within three years of death, transferred an interest in or relinquished a power over property, the value of which would otherwise have been included in the decedent's gross estate under certain specified sections including section 2042, then "the value of the gross estate shall include the value of any property (or interest therein) which would have been so included" had the transfer or relinquishment not taken place.' under the case law that predated the 1997 act, it was well established that a gift of life insurance within three years of death caused the full value of the proceeds to be included in the insured's gross estate if no post-assignment premiums became due.6 if, however, the insured outlived the period covered by the last pre-assignment premium, post-assignment premiums had to be paid in order to keep the policy in force. if the insured paid the post-assignments premiums, the case law predating the 1997 act included the full value of the proceeds in the insured's gross estate. if the assignee paid the post-assignment premiums, the pre-1997 act case law reduced the amount includible. the leading case on the latter issue is estate of silverman v. commissioner,8 a case decided by the tax court in 1973. the tax court struck a ratio of premiums paid by the insured and by the assignee to the 5. irc § 2035(a), as amended by the taxpayer relief act of 1997, p.l 105-34 § 1310. section 2035 does not apply if an insurance policy is transferred pursuant to a bona fide sale for adequate and full consideration in money or money's worth. see irc § 2035(d). 6. see, e.g., berman v. united states, 487 f.2d 70 (5th cir. 1973); bel v. united states, 452 f.2d 683 (5th cir. 1971); rev. rul. 71-497 (situation 2), 1971-2 c.b. 329. see also regs. § 20.2042-1(a)(2). 7. see, e.g., estate of compton v. commissioner, 532 f.2d 1086 (6th cir. 1976); vanderlip v. commissioner, 155 f.2d 152 (2d cir. 1946). see also estate of silverman v. commissioner, 521 f.2d 574, 576 (2d cir. 1975). in compton, the premiums on a group-term life insurance policy, which became due after the insured had assigned the policy, were presumably paid by the insured's employer. if so, the insured would be deemed to be the transferor of the premiums. see estate of porter v. commissioner, 442 f.2d 915, 919-20 (1st cir. 1971); rev. rul. 76-490, 1976-2 c.b. 300. 8. 61 t.c. 338 (1973), aff'd on the limited grounds raised on appeal, 521 f.2d 574 (2d cir. 1975). when silverman arose, one of the requirements for including the proceeds of an assigned life insurance policy in the insured's gross estate was that the assignment have been made in contemplation of the insured's death as well as having been made within three years of that death. in silverman, the tax court found that the insurance policy, which had been assigned to the insured's son six months prior to the insured's death, had been assigned by the insured in "contemplation of his death." the "contemplation of death" requisite was eliminated when the code was amended in 1976. 19991 florida tax review total premiums paid on the policy. 9 the court, then, applied that ratio to the proceeds of the policy to determine the amount includible in the insured's gross estate. in silverman, the insured had paid 88.71% of the premiums and the assignee had paid 11.29% of the premiums. the tax court held, therefore, that 88.71% of the proceeds of the policy were includible in the insured's gross estate and 11.29% were excludible. our position is that the silverman analysis gives taxpayers a windfall and provides life insurance an unfair advantage over other investment vehicles. we argue that silverman was inconsistent with the law existing when the case was decided and, more importantly, is inconsistent with section 2035 as reformulated by the 1997 act. to set the stage for our argument, we begin with brief discussions of the operation of life insurance, the different types of life insurance, and the economic elements that comprise life insurance. we next survey the relevant provisions of the tax laws, as they now exist, that apply to life insurance policies and proceeds. finally, we examine several different types of circumstances in which an insured has assigned life insurance to a third party and consider whether the current tax treatment of such assignments "has it right," in light of the amendments to section 2035 made by the 1981 act and especially the 1997 act. special emphasis will be given to the silverman-type situation in which the insured assigns a policy within three years of death and the assignee pays the postassignment premiums. ii. the economic components of life insurance life insurance covers the risk that the insured will die while the policy is in force. once purchased, a policy remains in force as long as the premiums are paid. unless a policy is a single-premium policy, premiums become due at specified intervals.10 if the insured dies while the policy is in force, the life insurance company pays a specified amount of money to the beneficiaries of the policy. the cost of the risk coverage (the pure insurance cost of the policy) is determined roughly in the manner indicated by the following example. 9. although the tax court spoke of the ratio of premiums paid by the insured and by the assignee to the total premiums paid on the policy, it seems clear that the tax court meant to refer to the ratio of premiums paid by the insured before or after the assignment and the premiums paid by the assignee (or someone else) after the assignment. the difference between the two formulations made no difference in the silverman case itself, because the insured paid all of the premiums that became due before the assignment and the assignee paid all of the premiums that became due after the assignment. 10. because there is no legal obligation to pay the premiums on a life insurance policy, the policy can be terminated at any time. [vol 4:5 tax consequences of assigning life insurance suppose that a person of x age and in good health wishes to acquire $1,000 of life insurance for a one-year period. the insurance company's actuarial tables indicate that 1% of persons of x age will die during that year. thus, a premium charge of approximately 1% ($10) will cover the risk of death for that year. but the company will pass on management and selling expenses, and will charge a somewhat higher premium. if the insurer is a profit-making stock company, the premium may also include an allowance for the company's profit. if the insurer is a mutual company," the company will charge a larger premium than it reasonably expects to need and at the end of each year will return the excess amount over its actual needs to the policyholders as a so-called "dividend."' 2 policies that pay such "dividends" are called "participating insurance." while participating insurance is commonly offered by mutual companies, it is also offered by some stock companies. pure insurance coverage for a stated term is called "term insurance." in the case of the insured of x age, the annual premium of a $1,000 one-year term policy was $10 plus. if the insured should wish to continue that coverage for an additional year, the premium cost will be higher, since the percentage of persons x + 1 years of age who are projected to die during the year is greater than the percentage of persons only x years of age. thus, each year the premium cost of the term insurance will increase. term insurance typically is issued for a specific term such as five years, with an automatic renewal for an additional five years at the end of each term." the premium cost of the insurance, however, will increase as the insured ages. if the insured attains an advanced age, the premiums will become quite costly. if the insured wishes to have insurance for more than one year but seeks to avoid this steady increase in the annual premium, the insured can purchase life insurance for a term consisting of a substantial number of years and pay the same amount of premium each year for a decreasing amount of insurance. the annual premium payments will remain constant, but every few years the amount of insurance coverage will be reduced. this variation of term insurance is called "declining term life insurance." a second type of life insurance is ordinary life, frequently called "straight life" or "whole life." ordinary life insurance combines the purchase of pure risk coverage with an investment. part of the premium is charged to the pure insurance coverage of the policy (including the company's expenses) and part of the premium is treated as an investment by the policyholder with the insurer. the investment portion is referred to as the policyholder's 11. a mutual company has no stockholders and passes its earnings on to its policyholders and to certain beneficiaries of matured policies. 12. see infra notes 21-22. 13. because the policyholder can terminate a policy at any time. the policyholder need not accept the renewal. 1999] florida tax review "reserve," or "terminal reserve," or "equity reserve" in the policy. the reserve is an equity interest that typically appreciates in value each year at a fixed rate established in the insurance contract. 14 in the first few years of an ordinary life policy, the policyholder obtains little or no reserve in the policy because most of the early premiums are used to pay the company's expenses, including selling commissions. after this initial period, the reserve increases each year, both because of appreciation in the established reserve and because of the policyholder's payment of additional premiums. since the amount payable at death is typically a fixed dollar figure (or a minimum amount), the amount of insurance risk coverage purchased by the policyholder is the difference between the amount payable at death and the policyholder's reserve. since the reserve, representing the policyholder's equity, increases each year, the policyholder actually purchases less insurance each year, resulting in premiums that remain at a constant level. in effect, the policyholder has combined an investment program providing a secure (but often relatively low) rate of return with declining term life insurance coverage. a policyholder has the right to borrow against the reserve or to surrender the policy for its cash surrender value. because of administrative costs, the cash surrender value is slightly less than the policyholder's reserve. the cash surrender value of a nonvariable ordinary life insurance policy can typically be determined from tables included in the policy. after approximately five years from the date a policy is taken out, the cash surrender value will usually be only slightly less than the policyholder's reserve and can be used as an approximation of the reserve for planning purposes. upon request, the insurer will provide the policyholder with a statement of the current value of the reserve. in the case of variable life insurance, the insurer's statement will be the only means of obtaining a valuation. on the death of the insured, the proceeds of the policy are payable according to the method of settlement elected by the owner of the policy or by the beneficiary. the various methods available for settling the proceeds of a matured life insurance policy are referred to as "settlement options." these settlement options, typically elected by the beneficiary after the insured's death, permit an election either to have the insurance proceeds paid in one 14. a variation of ordinary life is "variable life insurance." it is similar to ordinary life insurance, except that it may not guarantee a specified return. the policyholder's reserve and the death benefit may vary from year to year according to the relative success or failure of the insurer's investment program. a guaranteed minimum death benefit is, however, typically provided. [vol 4:5 tax consequences of assigning life insurance lump sum or to have the insurance company retain the proceeds and pay them out under one of a variety of plans.' 5 three economic components of life insurance emerge from the above description of life insurance: (1) the term insurance coverage component (coverage against the risk of the insured's death within the period covered by the last premium paid); (2) the right of continuation component (the right to continue having insurance coverage at a fixed price, regardless of the insured's health, beyond the period covered by the last premium); and (3) the 15. some of the most common options are: (a) interest only or deposit option-interest is paid currently to the beneficiary, who is empowered to change to some other settlement option (including a lump sum payment). some policies require the beneficiary to make a change of election within some stated period of time after the insured's death, but most policies permit the change of election to be made at any time. the purpose of the deposit option is to provide interest on proceeds left with the insurer while the beneficiary decides which settlement to elect. (b) fixed period option-the proceeds are paid out in installments of no less than a specified amount over a fixed period of time. if the policy earns more than a minimum guaranteed interest for any installment period, the amount of installment payment made to the beneficiary for that period will be increased accordingly. (c) fixed amount option-the proceeds are payable in a specified minimum number of installments of a fixed amount. if the policy earns more than the guaranteed minimum income, the number of payments is increased but the amount of each installment payment remains constant. (d) straight life annuity-a periodic payment of a fixed dollar amount to be made during the life of the beneficiary. recently, some life insurance companies have offered a variation of the straight life annuity called the "variable life annuity," under which the periodic payments will vary in amount according to the success of the company's investments. (e) self and survivor annuity-an annuity of a specified amount paid periodically for the life of the primary beneficiary and on his or her death, survived by a named secondary beneficiary, an annuity of a specified amount (which may be smaller than the primary beneficiary's annuity) will be paid to the secondary beneficiary for life. (f) joint and survivor annuit)---an annuity for the joint lives of two beneficiaries and for the life of the survivor. (the term "joint and survivor annuity" is sometimes used to describe a self and survivor annuity option.) (g) annuity with a refimd or guaranteed payment-a refund feature of an annuity provides that if less than a specified amount has been paid to the beneficiary or beneficiaries at the time of the death of the last annuitant, the difference is payable in one lump sum to some named person or persons. another variation of this is an annuity option with a guaranteed payment feature which provides that payments aill be made for no less than a specified period of time, regardless of when the beneficiaries die. although settlement options are not as flexible a vehicle as a trust, they are not entirely inflexible. for example, a fixed period option may provide for installment payments for part of the option period larger than other payments, although the size of the payments typically must be fixed at the time that the election is made. 19991 florida tax review equity or terminal reserve component. of course, not all life insurance policies contain all three components. term insurance, for example, provides no equity for the policyholder. nevertheless, it is important to keep these components in mind for they will be crucial to our analysis of the proper tax treatment that should be accorded to assignments of life insurance policies. to set the stage for this analysis, part ii describes the general framework of the current system of taxing life insurance. m. the general framework for taxing life insurance a. income taxation of life insurance 1. exclusion of proceeds from gross income.-in general, section 101 of the internal revenue code excludes life insurance proceeds from the beneficiary's gross income.1 6 the exclusion is straightforward when the proceeds are payable in one lump sum. the exclusion becomes somewhat complicated when the pay-out is governed by one of the settlement options providing for the retention of the proceeds by the insurer. interest paid to a beneficiary on proceeds held by the insurer is included in the beneficiary's gross income.17 in the case of installment payments,'" the interest portion of the payment is included in the beneficiary's gross income, but the portion of the installment payment that is characterized as principal is excluded. 9 typically, the "principal" portion of an installment payment is a percentage of the face amount of the insurance. the same proportion of each installment payment is excluded at least until the aggregate of the excluded amounts exceeds the face amount of 16. one important exception to the exclusion is the "transferee for value" rule. if the person owning a life insurance policy on the death of the insured had acquired it for valuable consideration from someone other than the insurer, the amount of proceeds excluded from gross income is limited to the consideration, premiums, and certain other amounts paid by such person. see irc § 101(a)(2). for policies issued after june 8, 1997, the reference to "other amounts" includes interest paid or accrued by the transferee on a debt incurred with respect to the insurance if such interest is not deductible because of irc § 264(a)(4). this rule does not apply to a person who initially purchased the policy from the insurer, nor to a transferee of a policy who received it without consideration, provided that the transferor was not a transferee for value (or a transferee of a transferee for value). see regs. §§ 1.101l(b)(3)(iii), 1.101-1(b)(5) ex. (4). even if a transferee acquired the policy for valuable consideration, the transferee for value rule is not applicable if the transferee was the insured, a partner of the insured, a partnership in which the insured is a partner or a corporation in which the insured is a shareholder or officer. see irc § 101(a)(2)(b). 17. see irc § 101(c). 18. typically, such payments are made under an annuity, fixed amount, or fixed period option. see supra note 15. special rules apply to certain life insurance policies that were issued before 1985 (or before 1983 in certain cases). see irc § 101(f). 19. see irc § 101(d)(1). [vol 4:5 tax consequences of assigning life insurance the policy, which occurs when a beneficiary of an annuity option outlives his or her life expectancy.2 2. appreciation in reserve.-a policyholder's reserve or equity interest in an ordinary life insurance policy appreciates each year. although the appreciation constitutes "earnings" from the policyholder's investment to the extent that the appreciation is not due to the payment of additional premiums, those "earnings" are not taxed to the policyholder.21 the rationale is that the income has not been "realized," or even "constructively received," 20. if the transferee for value rule applies, however, the principal portion is not excluded from gross income. see supra note 16. it is currently unclear whether the principal portion continues to be excluded for payments received in excess of the face amount of the policy. before the adoption of the tax reform act of 1986, the principal portion continued to be excluded, even though the face amount of the policy had already been received by the beneficiary. the regulations still so provide. see regs. § 1.101-4(c). before 1986, the same rule of exclusion applied to annuity payments taxable under § 72. however, in the tax reform act of 1986. congress amended § 72 to limit the exclusion to the investment in the annuity contract. see irc § 72(b)(2). while no explicit amendment was made to § 101, the question remains whether the amendment to § 72 implicitly amended § 101 as well. 21. if a policyholder owns a participating life insurance policy, the so-called "dividend" paid by the insurer to the policyholder each year is in fact a return of part of the premiums previously paid by the policyholder, and so such "dividends" are not included in the policyholder's gross income. see i j. mertens, the law of federal income taxation § 7.08 (rev. ed. 1974) (citing regs. § 1.72-11(b) (1960)); cf. rev. rul. 64-258, 1964-2 c.b. 134, obsoleted by rev. rul. 82-148, 1982-2 c.b. 401 (holding that such payments do not constitute an inurement of net earnings to the policyholders so that a tax exempt organization's distribution to its members of the "dividends" it received on policies insuring the life of its members did not disqualify the organization of its tax exempt status under irc § 501(c)( 10)). even "dividends" remitted on paid-up policies-policies for which no further premium payments are due-are excluded from gross income because such dividends are in essence a reduction of premiums paid in prior years. see i j. mertens, supra, § 7.08, at 18 n.35. if, however, the policyholder does not withdraw the dividends from the insurance company, but instead leaves them on deposit with the insurer to earn interest, the interest credited to the accumulated dividends is included in the policyholder's gross income; such interest is no different from interest credited to a savings account deposit. id. if a policyholder sells an insurance policy to a third party, the policyholder will recognize a gain on the sale only if the amount realized thereon exceeds the policyholder's basis in the policy. since all of the premiums previously paid by the policyholder (less "dividends" received) are included in the policyholder's basis, the amount realized often will not exceed the seller's basis. the reason that the amount realized on a surrender of the policy often will be less than the policyholder's basis is that the policyholder is permitted to include in basis the portion of the premiums that was attributable to the purchase of the insurance coverage for a specified period. the policyholder's basis is not limited to the portion of the premium that constituted the policyholder's addition to the reserve. under a special provision in irc § 101(g), sales by an insured who is chronically or terminally ill of any part of a death benefit to a "viatical settlement provider" will not be taxed. 19991 florida tax review in the tax sense.22 moreover, even though the face amount of the proceeds payable to the beneficiary upon the death of the insured includes this appreciation in the policyholder's equity, such proceeds are typically excluded from the gross income of the beneficiary by section 101.23 b. gift taxation of life insurance there is no statutory gift tax provision expressly dealing with the transfer of a life insurance policy or the payment of its premiums. such transfers are dealt with under the general gift tax provisions applicable to all types of transfers. 4 the regulations do provide that if the insured irrevocably assigns an insurance policy to another, "[t]he insured has made a gift of the value of the policy" to the extent that the assignment exceeds the value of any consideration received by the insured.25 the gift tax value of a life insurance policy is its replacement cost-the amount necessary to purchase a comparable policy from a company regularly engaged in selling insurance.26 although the value of a policy can be influenced by unusual provisions in the policy itself,27 the value is not affected by any external facts such as the health of the insured at the time of the gift. if the insured's health were taken into account, it would be necessary to determine the health of the insured in the case of every assignment and to estimate the effect of the insured's health on the valuation question by resorting to medical evidence and actuarial expertise. such inquiries would impose a great administrative burden on both the government and on taxpayers. presumably believing the burden to be too costly, the service has not taken the insured's health into account in valuing policies for gift tax purposes.' in some cases, such as the case of a policy that has been in effect for some time and upon which further premiums must be paid, the value of an insurance policy may not be readily ascertainable. in such cases, if the insurance is an ordinary life, nonvariable policy, the value of the gift is obtained by combining the amount of the terminal reserve of the policy at the date of the gift and the proportionate part of the last premium paid before the 22. see cohen v. commissioner, 39 t.c. 1055, 1062-64 (1963). 23. it should be recalled, however, that irc § 101(a)(2)-the "transferee for value" provision discussed supra note 16-is an exception to this rule. 24. see irc §§ 2511-2512. 25. regs. § 25.2511-1(h)(8). although the regulation only refers to a gift by the insured, a gift tax will be imposed on any donor of a life insurance policy, unless a section of the code expressly provides otherwise. 26. see regs. § 25.2512-6(a). 27. see id. see also rev. rul. 77-181, 1977-1 c.b. 272. 28. nor has the service taken the insured's health into account for estate tax purposes when a decedent dies owning a policy on the life of another. [vol 4:5 tax consequences of assigning life insurance date of the gift covering the period extending beyond that date.z9 if the insurance is a variable policy, the value can be obtained from the insurer. if the donor continues to pay premiums after assigning the policy, each premium payment is an additional gift.3" all or a portion of a gift of a life insurance policy may be excluded from gift tax. section 2503(b) provides that a donor is entitled to an annual exclusion (currently in the amount of $10,000) for gifts, other than gifts of "future interests,"'" given to each donee. an outright gift of an insurance policy (as contrasted to a gift in trust) is treated as a gift of a present interest, even though the proceeds will not be collected until a future date.32 the 29. the regulations give the following example: example (4). a gift is made four months after the last premium due date of an ordinary life insurance policy issued nine years and four months prior to the gift thereof by the insured, who was 35 years of age at date of issue. the gross annual premium is s2,811. the computation follows: terminal reserve at end of tenth year s14,601.00 terminal reserve at end of ninth year 12.965.00 increase s 1,636.00 one-third of such increase (the gift having been made four months following the last preceding premium due date), is s 545.33 terminal reserve at end of ninth year 12,965.00 interpolated terminal reserve at date of gift 13,510.33 two-thirds of gross premium ($2,811) 1.874.00 value of the gift s15,384.33 regs. § 25.2512-6(a) ex. 4. 30. see regs. § 25.2511-1(h)(8). 31. the term "future interest" has its own definition under the gift tax provisions and does not have the same meaning as it does under general property law. any gift under which the donee's possession, use or enjoyment is postponed is a gift of a future interest. see regs. § 25.2503-3(a). note that beginning in 1999, the $10,000 exclusion figure will be increased annually to reflect inflation. irc § 2503(b)(2). if the donor is married and the donor's spouse consents to split the donor's gifts between them under irc § 2513, the s10,000 available annual exclusion for the donor's gifts to a third party (someone other than the donor's spouse) may be doubled to $20,000. if a gift is made to the donor's spouse, only $10,000 can be excluded, but the balance of the gift may qualify for a marital deduction. 32. in rev. rul. 55-408, 1955-1 c.b. 113, the commissioner repudiated a suggestion made by the tax court in nashville trust co. v. commissioner, 2 t.c. memo (cch) 99 (1943), that a gift of a policy before it had built up any cash surrender value was a gift of a future interest. see also regs. § 25.2503-3(a). it should be noted, however, that if the gift is subject to a limitation which restricts the donee's right to reassign the policy, obtain its cash surrender value or borrow against its terminal reserve, then the donated property constitutes a future interest, and no annual exclusion can be claimed. see ryerson v. united states, 312 u.s. 405, 408-09 (1941); skouras v. commissioner, 188 f.2d 831 (2d cir. 1951); smyth v. commissioner, 2 t.c. memo (cch) 4 (1943). 19991 florida tax review annual exclusion can also apply to premium payments subsequently made by the donor.33 if a life insurance policy is assigned to a trustee, however, the gift of the policy and any subsequent premiums paid by the donor likely will not qualify for the annual exclusion.' a gift of a life insurance policy or the payment of premiums on a policy owned by another may also be exempt from gift taxation if the gift qualifies for the gift tax charitable or marital deduction.35 c. estate taxation of life insurance 1. in general.-upon the insured's death, the proceeds paid to the beneficiaries are composed of two elements: the policyholder's equity interest in the policy and a death benefit payment (an amount representing the proceeds of the risk coverage element of the policy).36 if the proceeds are payable to the insured's executor, section 2042(1) requires the proceeds to be included in the insured's gross estate, even if the policy was owned by another at the insured's death. application of this provision, while not free of ambiguity, has not been especially troublesome. in general, the reference to the insured's "executor" means payable to or on behalf of the insured's estate.37 if the proceeds are payable to someone other than the insured's executor, section 2042(2) requires the proceeds to be included in the insured's gross estate if the insured possessed, at death, any "incidents of ownership" in the policy. although the code makes no attempt to define "incidents of ownership," the regulations provide that the term is not limited to actual dominion over the policy, but also includes a lesser economic interest or benefit, such as the right to surrender or cancel the policy, change the named beneficiary, or pledge the policy for a loan.38 33. see rev. rul. 76-490, 1976-2 c.b. 300; rev. rul. 55-408, 1955-1 c.b. 113. 34. see kahn & waggoner, supra note 1, at 954. but see rev. rul. 76-490, 1976-2 c.b. 300. 35. see irc §§ 2522, 2523. 36. see, e.g., united states v. bess, 357 u.s. 51, 59 (1958); old kent bank and trust co. v. united states, 430 f.2d 392, 395-96 (6th cir. 1970). this view of insurance conforms with the actuarial justification for the size of premiums charged for a policy, which is that the premiums are sufficient only to purchase risk coverage for the difference between the face amount of the policy and the policyholder's equity. see supra text accompanying notes 10-11. 37. see regs. § 20.2042-1(b). 38. see regs. § 20.2042-1(c)(2). the term also includes "a reversionary interest in the policy or its proceeds, whether arising by the express terms of the policy or other instrument or by operation of law, but only if the value of the reversionary interest ... exceeded 5 percent of the value of the policy." regs. § 20.2042-1(c)(3). [val 4:5 tax consequences of assigning life insurance 2. transfers within three years of death.-section 2035 operates in conjunction with section 2042 to impose an estate tax on life insurance proceeds when an insured assigns a policy to another within three years of death. before 1976, the estate and the gift tax statutes operated independently. 39 each tax had its own structure, tax rates, exemptions, and other rules. testamentary transfers were taxed separately from and more heavily than inter vivos gifts. the major reform implemented by the tax reform act of 1976 was the integration of estate and gift taxation. the 1976 act adopted a single transfer tax base, subjected that base to a comprehensive rate schedule, and reduced the tax produced by that schedule by a "unified credit."' 4 under section 2035 as it existed before the 1976 act, all gifts made within three years of death (and in contemplation of death) were included in the donor's gross estate at their death-time value.4 although the 1976 act continued section 2035's application to all gifts within three years of death, a byproduct of integrating the estate and gift taxes was to remove much of the purpose for subjecting all such gifts to the estate tax, especially since the 1976 act also introduced a gross-up rule under which any gift tax paid on a gift within three years of death was brought into the donor's gross estate.4" under the integrated system, the only tax saving that would be produced by a gift of property that otherwise would have been included in the donor's gross estate under section 2033 would be to exempt the post-gift appreciation on the property from transfer taxation. the integration of estate and gift taxes did not, however, eliminate all potential for using death bed transfers to reduce transfer taxes. a potential for abuse continued to exist for a gift of an item whose retention would have 39. see douglas a. kahn et al., federal taxation of gifts, trusts and estates 1-8, 387-91 (3d ed. 1997). 40. see id. 41. more precisely, such gifts were included at their estate tax value. ordinarily, the decedent's gross estate is valued at its death-time value, but it might be valued at a date up to six months after the decedent's death if the executor elects the alternate valuation method under irc § 2032. in this article, we refer to the death-time value because the estate tax value of a life insurance policy equals the value of its proceeds, which is its death-time value even if the alternate valuation method is elected. 42. more precisely, this provision requires inclusion of the gift tax paid by the decedent (or by the decedent's estate) on any gift made by the decedent or by the decedent's spouse within three years of the decedent's death. see irc § 2035(b). this provision was originally set forth in § 2035(c) prior to the amendment made by the taxpayer relief act of 1997. the purpose of adding this provision was to eliminate the incentive for making deathbed taxable gifts in order to exclude the resulting gift tax payments from the donor's transfer tax base. see h.r. rep. no. 1380, 94th cong., 2d sess. 14 (1976). 19991 florida tax review caused a much larger amount than would result from ordinary post-gift appreciation to be included in the donor's gross estate than the item's current value, most notably a gift of a life insurance policy. the 1976 act could therefore have limited the scope of section 2035 by making it applicable only to transfers having the potential for abuse. but it did not. instead, the 1976 act expanded the scope of section 2035. before 1976, section 2035 required the inclusion in a decedent's gross estate of the value of all property, including life insurance, given away by the decedent within three years of death, but only if the transfer was made in contemplation of death. the 1976 act eliminated the contemplation of death requirement. as revised in 1976, section 2035 required the inclusion of all gifts made within three years of death, regardless of motive. the economic recovery tax act of 1981 made section 2035 no longer applicable to all gifts within three years of death.43 the 1981 act confined section 2035 to what we call "tainted gifts"-gifts of an interest in or power over property that would have been included in the decedent's gross estate under sections 2036 through 2038 or section 2042 had the transfer not taken place.' the 1981 act also retained the provision pertaining to the 43. see irc § 2035(a). this narrowing of the scope of § 2035 was originally set forth in § 2035(d)(1) prior to the amendment made by the taxpayer relief act of 1997. for an article urging congress to return § 2035 to the form it took under the 1976 act, under which all gifts within three years of death were included in the donor's gross estate, see jeffrey g. sherman, hairsplitting under irc section 2035(d): the cause and the cure, 16 va. tax rev. 111 (1996). 44. see irc § 2035(a)(2). this provision was originally set forth in § 2035(d)(2) prior to the amendment made by the taxpayer relief act of 1997. in general terms, irc § 2036 includes in the gross estate transfers with a retained life estate, § 2037 includes transfers with a retained reversionary interest, and § 2038 includes transfers with a power to alter, amend, revoke, or terminate. the inclusion of § 2038 in § 2035's list of tainted gifts was probably unnecessary, since § 2038 itself already provided that a relinquishment of the power to alter, amend, revoke, or terminate within three years of death causes the full value of the property to be included in the decedent's gross estate. see irc § 2038(a)(1). congress should reconsider its decision to classify a gift of a retained life estate or a relinquishment of a power to revoke within 3 years of death as a tainted gift to which § 2035 applies. under irc § 2702, added to the code in 1990, a transfer to a family member with a retained life estate subjects the full value of the property to gift taxation, not the value of the remainder interest. the original transfer, whether within or more than 3 years before death, is in effect treated as an outright gift with no strings attached. under regs. § 25.2511-2, a relinquishment of a power to revoke, whether within or more than three years before death, subjects the full value of the property to gift taxation. because the question of whether congress should amend § 2035 to remove these types of gifts from the tainted gift category is beyond the scope of this article, we do not discuss the question further. for a more complete discussion of this question, see sherman, supra note 43, at 148-51. [vol 4:5 tax consequences of assigning life insurance inclusion of the gift tax on all gifts within three years of death. 5 congress restyled and reorganized section 2035 in the taxpayer relief act of 1997. although congress largely retained the substance of the 1981 revisions, it shifted the wording in a subtle but significant way. as reformulated in 1997, section 2035 straightforwardly includes the amount that would have been included had the tainted gift not been made.' the preceding version was less clear regarding how the amount to be included was to be calculated.47 in sum, although section 2035 has undergone significant change over the years, the need for section 2035 to prevent evasion of section 2042 has remained constant. iv. assignment more than three years before death if, more than three years before death, an insured assigns to another all incidents of ownership in a life insurance policy (whether the assignment is made outright or in trust), the proceeds of the policy will not be included in the insured's gross estate, provided that the insured does not retain or subsequently acquire (directly or indirectly) any incident of ownership in the policy. section 2035 does not apply since, on its terms, that provision only covers transfers made within three years of death. the assignment is, of course, subject to the gift tax, except to the extent that the assignment qualifies for the gift tax annual exclusion or the marital or charitable 45. see supra note 42. 46. as revised in 1997, irc § 2035 provides that "if (1) the decedent made a transfer (by trust or otherwise) of an interest in any property, or relinquished a power with respect to any property, during the 3-year period ending on the date of the decedent's death. and (2) the value of such property (or an interest therein) would have been included in the decedent's gross estate under section 2036, 2037, 2038, or 2042 if such transferred interest or relinquished power had been retained by the decedent on the date of his death, [thenl the value of the gross estate shall include the value of any property (or interest therein) which would have been so included." (emphasis added.) the taxpayer relief act of 1997 is applicable to estates of decedents dying after august 5, 1997. in this article, we sometimes refer to the law existing before the effective date of the 1997 act as "pre-1998" law, though the 1997 act does apply to part of 1997. 47. the language of the preceding version was generally read to include an amount calculated by determining the death-time value of the donated property. as revised in 1981, § 2035 provided in effect that if the decedent transferred "an interest in property which is included in the value of the gross estate under section 2036, 2037, 2038, or 2042 or would have been included under any of such sections if such interest had been retained by the decedent," then "the value of the gross estate shall include the value of all [such] property to the extent of any interest therein of which the decedent has at any time made a transfer, by trust or otherwise, during the 3-year period ending on the date of the decedent's death." (emphasis added.) 19991 florida tax review deduction. except to the extent excludible or deductible, the value of the gift is also included in the insured's estate tax base as an "adjusted taxable gift." 48 a. payment of premiums by the insured if, after assigning a policy to another more than three years before death, the insured continues to pay the premiums, those payments are subject to the gift tax, except to the extent that they are excluded by the annual exclusion or deductible under the marital or charitable deduction. any such premium payments that are not excludible or deductible are also included in the insured's estate tax base as "adjusted taxable gifts."49 the question of the amount includable under section 2035 because of premium payments made by the insured within three years of death, once a controversial issue, has been settled for some years now. the nature of this controversy and its ultimate resolution bear on the question of the merits of the silverman approach, which is the focus of this article. we now turn to that issue. b. premium payments as a constructive transfer of a portion of a policy in 1967, in revenue ruling 67-463,5o the commissioner ruled that the insured's gross estate included that proportion of the insurance proceeds equal to the ratio that the amount of premiums paid by the insured within three years of death bore to the aggregate amount of premiums paid on the policy. the theory was that an insured's payment of a premium on a life insurance policy owned by another-in this case, the person to whom the insured had previously transferred the policy-constituted a transfer to the policyholder of a proportionate interest in the underlying policy.5 revenue ruling 67-463 relied on the 1929 decision of the supreme court in chase national bank v. united states.51 in chase, the insured had 48. see irc § 2001(b). if the assignment was made to someone other than the insured's spouse, and the insured and his or her spouse elected to split the gift under irc § 2513, then only the insured's one-half share (less the annual exclusion, if any) is included in the insured's adjusted taxable gifts. the other half (less any annual exclusion allowed to the nondonor spouse) will be included in the estate tax base of the nondonor spouse on that spouse's death. 49. if split gift treatment under irc § 2513 was elected for such payments (see supra note 48), the portion of the payments attributable to the insured's spouse is excluded from the insured's adjusted taxable gifts. see irc § 2001(b). 50. 1967-2 c.b. 327 (revoked by rev. rul. 71-497, 1971-2 c.b. 329). 51. id. the position adopted by the commissioner in 1967 applied only to premium payments made in contemplation of death. as noted in the text, the 1976 act eliminated the contemplation of death requirement. 52. 278 u.s. 327 (1929). [vol 4:5 tax consequences of assigning life insurance purchased life insurance in which he named his wife as beneficiary and retained incidents of ownership until his death. the insured, who died within two years of purchasing the insurance, had paid all premiums due on the policies. the insured's estate challenged the constitutionality of the statute (the antecedent of section 2042(2)) that subjected the insurance proceeds to estate taxation. the estate contended that the tax was one on property itself, and therefore an unconstitutional unapportioned direct tax, rather than a tax on a "transfer" of property. this was so, the estate argued, because the insured had never transferred the proceeds to the beneficiary. rather, the beneficiary had acquired the proceeds directly from the insurer.53 in upholding the validity of the tax, the supreme court held that in substance the insurance proceeds had been transferred by the insured to the beneficiary, since his instruction to the insurer to pay the proceeds to his wife constituted a procurement of the proceeds by him for delivery to his wife. the court determined that a person who purchases property from another to be delivered to a third party is to be treated as having transferred that property to the third party, and indicated that this principle would apply in interpreting the word "transfer" in the code as well as in deciding the constitutionality of a particular provision.' the courts, however, uniformly rejected the commissioner's attempt to apply the chase holding to premiums paid within three years of death on a policy that the insured had irrevocably transferred to another more than three years before death.55 the courts did not repudiate the supreme court's construction of the word "transfer," but held it inapplicable to the payment of premiums on a policy owned by another. the clearest statement of the rationale for rejecting the commissioner's position' was given by the fifth circuit in first national bank v. united states:57 53. id. at 334. 54. id. at 337-38. 55. see first nat'l bank v. united states, 423 f.2d 1286, 1288 (5th cit. 1970); gorman v. united states, 288 f. supp. 225, 228-31 (e.d. mich. 1968); estate of coleman, 52 t.c. 921, 923-24 (1969). see also estate of chapin, 29 t.c. memo (cch) 11, 15-16 (1970); lowndes & stephens, identification of property subject to the federal estate tax, 65 mich. l. rev. 105, 124-25 (1966); note, section 2035 as a basis for including life insurance proceeds in the gross estate of an insured who paid premiums on a policy owned by another person, 67 mich. l. rev. 812 (1969). 56. even if the commissioner had prevailed in arguing that there was a constructive transfer of a portion of the insurance proceeds, the portion includible should not have been figured on the basis of the commissioner's formula. the commissioner's formula undoubtedly was derived from the old payment of premiums test that congress eliminated from irc § 2042 in 1954. the failings of the premium payment test are discussed in kahn & waggoner, supra note 1, at 970-75. 57. 423 f.2d 1286 (5th cir. 1970). 19991 florida tax review the actual essence of the government's position is that it wishes to place a decedent who pays the premiums on a policy owned by another on the same footing with one who physically transfers the policy itself. it is said that the ... [policyholders] received insurance benefits and not cash and that the payment of each and every premium helped to produce the proceeds. the answer to this, however .... [is] that the rights maintained belonged to the owners, not to the decedent, and were thus neither transferred nor transferrable by the decedent.58 after losing every litigated case on this issue, the commissioner reconsidered his original position and issued revenue ruling 71-497, which revoked the 1967 ruling and conceded that only the dollar amount of premiums paid by the insured within three years of death would be included in the insured's gross estate. 59 this latter portion of revenue ruling 71-497 was made obsolete by the 1981 amendments of section 2035. 60 for decedents dying after 1981, premium payments made by an insured within three years of death are subject to the gift tax but are no longer includible in the insured's gross estate, though any gift tax paid on such premium payments is includible.1 v. assignment in substance within three years of death revenue ruling 71-49762 dealt with another issue-the purchase of an insurance policy for another within three years of death. under the facts considered in this portion of the ruling, the insured, nine months before he died from accidental causes, purchased a one-year term accidental death policy insuring his life. the insured's children were designated as the owners as well as beneficiaries of the policy. although the insured never actually possessed an incident of ownership in the policy, the commissioner ruled that under section 2035, the entire proceeds were includable in the insured's gross 58. 423 f.2d at 1288, accord bintliff v. united states, 462 f.2d 403, 406 (5th cir. 1972). 59. 1971-2 c.b. 329, revoking rev. rul. 67-463, 1967-2 c.b. 327. in rev. rul. 71-497, the premiums were paid on both an ordinary life insurance policy and on a term life insurance policy. 60. none of the exceptions discussed supra in the text accompanying notes 43 through 45 apply. 61. see irc § 2035(b). also, any premium payments that constituted a gift will be included in the donor's adjusted taxable gifts to the extent not covered by the annual exclusion or the marital or charitable deduction. see irc § 2001(b). 62. 1971-2 c.b. 330. [vol 4:5 tax consequences of assigning life insurance estate. the commissioner's theory was that the insured had transferred ownership of the policy to his children and had not merely paid a premium on a policy that they owned. the commissioner again relied on the chase national bank case, and this time, until section 2035 was amended in 1981, the commissioner's position was sustained by the courts, initially in a decision of the fifth circuit, bel v. united states.6 in bel, the insured had used community funds each year to purchase a one-year term accidental death policy in the name of his three children. 4 the insured died within ten months of acquiring the last policy.' referring to the chase national bank opinion and relying on section 2035 rather than section 2042, the fifth circuit treated the insured as having assigned the policy itself to his children within three years of death and accordingly included half of the proceeds (the insured's community share) in his gross estate.66 while explicitly recognizing that the insured never possessed any incident of ownership, the court concluded: [s]ection 2042 and the incidents-of-ownership test are totally irrelevant to a proper application of section 2035. we think our focus should be on the control beam of the word "transfer." the decedent, and the decedent alone, beamed the accidental death policy at his children, for by paying the premium he designated ownership of the policy and created in his children all of the contractual rights to the insurance benefits. these were acts of transfer. the policy was not procured and ownership designated and designed by some goblin or hovering spirit. without [the decedent's] conception, guidance, and payment, the proceeds of the policy in the context of this case would not have been the children's. his actions were not ethereally, spiritually, or occultly actuated. rather, they constituted worldly acts which by any other name come out as a "transfer." had the decedent, within three years of death, procured the policy in his own name and immediately thereafter assigned all ownership rights to his children, there is no question but that the policy proceeds would have been included in his estate. in our opinion the decedent's mode of execution is functionally indistinguishable. therefore, we hold that the action of the decedent constituted a "transfer" of the 63. 452 f.2d 683 (5th cir. 1971). 64. see id. at 686. 65. see id. 66. see id. at 691-92. 19991 florida tax review accidental death policy within the meaning of section 2035, and that the district court erred in failing to include [the decedent's] community share of the proceed value of the policy in his gross estate.67 the position adopted in bel is sometimes referred to as the "constructive transfer principle" or as the "beamed transfer principle." as a consequence of the 1981 amendment to section 2035, the courts subsequently repudiated the constructive transfer principle. the commissioner also accepted that it is no longer valid. 68 although we later discuss (and decry) the rejection of the constructive transfer principle to original purchases of policies in the name of another, we first defend the inapplicability of that principle to payments of insurance premiums on policies owned by another. a. the proper boundary of the constructive transfer principle as previously noted in part iv, even before the repudiation of the constructive transfer principle, the courts had rejected its application to payments of insurance premiums on policies owned by another, but accepted its application to original purchases of policies in the name of another. in each case, the donor purchased something of his or her choosing from the insurance company for the donee. from this standpoint, both cases are quite different from a situation clearly outside the proper boundary of the constructive transfer principle, for example, where the donor gives cash to a donee to do with it as the donee sees fit. it should be equally clear that, prior to its repudiation, the constructive transfer principle was fully warranted in the case of an original purchase of a policy for a donee. indeed, it would be difficult to think of a case that would fall more clearly within the proper boundary of that principle.69 why then, while the constructive transfer principle was still valid, did the situation where an insured paid premiums within three years of death on a policy owned by another not also fall within the proper boundary of that 67. id. at 691-92. 68. see infra text accompanying notes 77-78. 69. prior to 1981, other situations were held to fall within the constructive transfer principle. for example, when a decedent "had" his wife apply for term insurance on the decedent's life and subsequently paid the policy premiums, the decedent was deemed to have transferred the policy to his wife. see first nat'l bank v. united states, 488 f.2d 575 (9th cir. 1973). similarly, when a decedent created an irrevocable trust, directed the trustee to acquire $100,000 of insurance on the decedent's life out of cash transferred to the trust, and died within six months thereafter, the decedent was deemed to have transferred the $100,000 policy to the trustee. see detroit bank & trust co. v. united states, 467 f.2d 964 (6th cir. 1972). see also estate of kurihara v. commissioner, 82 t.c. 51 (1984) (reviewed by the court). [vol 4:5 tax consequences of assigning life insurance principle? simply put, the reason is that the item of property that the donor acquired for the donee when purchasing an insurance policy for the donee, a situation where the constructive transfer principle previously applied, is an item of property that the donor could have acquired and then given to the donee. but when an insured pays the premiums on a policy already owned by the donee, the donor's premium payment does not purchase items of property that the donor could have acquired and then transferred to the donee. only the donee, the policyholder, owns the right to keep the policy in force, and thus is the only person in whose name the term insurance coverage7" can be continued and who can benefit from the increase in the equity reserve in the policy resulting from the premium payment made by the donor. in the words of the fifth circuit in first national bank, these property interests were not "transferable by the decedent. ' 71 holding that the insured's payment of premiums on a policy owned by another is outside the boundary of the constructive transfer principle conforms to the policy underlying section 2035. that section was aimed at capturing in a decedent's gross estate property that would have been included had the decedent not made a transfer shortly before death. if the insured possessed no incidents of ownership in a policy within three years of death, the proceeds would not be included in the decedent's gross estate regardless of whether the premiums were paid or not.' the gift of the premium payments therefore do not remove an item (the proceeds) from the decedent's gross estate since the item would not be part of the decedent's gross estate in any event. since the premium payments do remove the dollar amount of those payments from the decedent's gross estate, the pre-1982 version of section 2035 captured all or part of those premium payments in the decedent's gross estate. as a result of the 1981 amendment of section 2035, the premium payments are no longer captured by that provision. the integration of estate and gift taxes made it irrelevant that the dollar amount of the premium payments themselves were removed from the decedent's holdings during life rather than transferred at death. the 1997 amendment of section 2035 makes it even more obvious that the insured's payment of premiums does not cause an inclusion of the 70. in this article, the phrase "insurance coverage" refers to the difference between the proceeds payable on the death of the insured and the policyholder's equity reserve in the policy. 71. see first nat'l bank v. united states, 423 f.2d 1286. 1288 (5th cir. 1970). 72. however, if the proceeds were payable to the decedent's executor (i.e.. payable on behalf of decedent's estate), the proceeds would be included in decedent's gross estate under irc § 2042(1). in this article, we have not discussed that provision because it has no relevance to the issues at hand. 1999] florida tax review insurance proceeds. the current version of section 2035 applies to a transfer of life insurance within three years of death only when the insurance proceeds would have been included in the decedent's gross estate under section 2042 if the transfer had not taken place. manifestly, if the insured possessed no incidents of ownership within three years of death, section 2042 would not operate regardless of whether the insured paid premiums during that period. in sum, the now defunct constructive transfer principle was properly limited, at least insofar as section 2035 is concerned, to purchases in the name of the donee of property interests that the donor could have acquired. b. the ill-advised abrogation of the constructive transfer principle changes made by congress to section 2035 in 1981 led three united states courts of appeals, one of which affirmed a unanimous decision by eighteen tax court judges, to abrogate the constructive transfer principle (as it had been applied in bel). in estate of perry v. commissioner,3 the decedent, within three years of death, applied for two insurance policies by signing application forms as the person to be insured. the decedent's three sons signed the applications as the proposed policy owners. the decedent paid the only premium that fell due on one of the policies by a check drawn on his personal checking account. the decedent paid all of the premiums on the other policy, consisting of an initial premium paid by check drawn on his personal checking account and subsequent monthly premiums by preauthorized withdrawals from his personal checking account. in estate of headrick v. commissioner,74 the decedent, a tax attorney, within three years of death, drafted an irrevocable trust agreement that authorized, but did not require, the trustee to invest in life insurance policies on his life and to hold such policies as trust principal. the decedent selected a bank to act as trustee of the irrevocable trust. the bank president testified that based on a discussion with the decedent he believed that the decedent intended the trust to function as an "insurance trust for his family," although the decedent did not condition the establishment of the trust on the bank's commitment to acquire life insurance with the funds contributed to the corpus. after the trust was established, the bank, as trustee, completed an application for an insurance policy on the decedent's life. the application stated that the policy owner and the beneficiary would be the bank as trustee of the decedent's trust. the decedent signed the application as the insured. 73. 927 f.2d 209, 210-11 (5th cir. 1991). 74. 918 f.2d 1263, 1264 (6th cir. 1990), affg 93 t.c. 171 (1989) (unanimous, reviewed opinion). [vol 4:5 tax consequences of assigning life insurance the bank paid the premiums on the policy from funds that the decedent contributed to the trust. in estate of leder v. connissioner,75 the decedent, within three years of death, signed an insurance application form as the insured and his wife signed the application as the owner. the premiums were paid by preauthorized withdrawals from the account of the decedent's wholly owned corporation. the corporation treated the premium payments as loans to the decedent. the courts in all three cases reasoned that the 1981 amendment of section 2035 makes that section apply to life insurance proceeds only when section 2042(2) would have applied if the insured had retained an incident of ownership in the policy instead of transferring it. the courts concluded that section 2035 does not apply unless the insured once possessed an incident of ownership and transferred that incident within three years of death. if the original ownership of the policy was placed in someone other than the insured, the courts held that the fact that the insured had initiated the purchase of the policy and directly or indirectly paid the premiums is not enough to trigger the post-1981 version of section 2035.76 in light of the unanimity of these decisions, the commissioner conceded the issue in an action on decision.' in that aod, the commissioner asserted disagreement with the results in these cases, but decided not to litigate the issue any further. in several subsequent rulings, the commissioner acknowledged that the constructive transfer principle is no longer valid.78 complete abrogation of the constructive transfer principle was illadvised. the constructive transfer principle, which is merely an application of the widely-utilized substance-over-form doctrine, and is analogous to the indirect transfer doctrine recognized in the gift tax regulations, 9 should 75. 893 f.2d 237, 238 (10th cir. 1989), aff g 89 t.c. 235 (1987). 76. see perry, 927 f.2d at 211-13; headrick, 918 f.2d at 1265-68: leder, 893 f.2d at 240-42. 77. see a.o.d. 1991-012 (jan. 18, 1991) ("although we continue to believe that substance should prevail over form and that such indirect transfers should be included in a decedent's gross estate, in light of the three adverse appellate opinions .... we will no longer litigate this issue."). 78. see tech. adv. mem. 93-23-002 (feb. 24, 1993); tech. adv. mem. 91-41-007 (jun. 19, 1991). 79. see regs. § 25.2511-1(a). the regulation provides: "the gift tax applies to a transfer by way of gift whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible." id. (emphasis added.) regs. § 25.2511-1(c)(1) explains: "the gift tax also applies to gifts indirectly made. thus, any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed, constitutes a gift subject to tax." id. (emphasis added.) 1999] florida tax review continue to apply to cases in which, in substance, the insured acquired the policy and then assigned it, even though nominally the assignee initially acquired the policy. the insured's payment of premiums should not be a decisive element. rather, the insured's premium payments should be just one datum of evidence suggesting that the insured was the actual acquirer of the policy. other factors, such as whether the insured initiated the acquisition of the policy, should also be taken into account. this more restricted view of the constructive transfer principle had been adopted by the tax court before the doctrine was abrogated entirely.8" by elevating the formal facts over the substance of what took place, the courts have opened a loophole in the system. it should not matter that the donee nominally acquired the newly issued policy from the insurer if the substance of the arrangement is that the insured instigated the acquisition and is the true purchaser behind the scenes. it also should not matter whether the insured was in good health when acquiring the policy because the initial purchase of a policy in the name of another is a hedge against increased estate tax liability if the insured dies prematurely, which should only be allowed to succeed if the insured outlives the initial purchase by more than three years.8 ' the abrogation of the constructive transfer principle allows 80. see, e.g., estate of clay v. commissioner, 86 t.c. 1266, 1272-73 (1986); cf. schnack v. commissioner, 848 f.2d 933, 939-40 (9th cir. 1988) (following clay). 81. for a contrary argument, see harrison s. lauer, estate taxation of life insurance transfers: the impact of the tax reform act of 1976 still ignored twelve years later, 41 tax law. 683, 696, 730 (1988). lauer's argument is that an insured must be in good health in order to acquire a policy and, consequently, only about half of the insureds who acquire a policy will die prematurely, the other half outliving their life expectancy. see id. at 716. thus, he argues, this is not the type of situation to which § 2035 is properly addressed. he assumes that the only reason that the assignment of an existing policy within three years of death is brought back into the insured's gross estate under § 2035 is because at the time of assignment the insured's health might have deteriorated, even if assignment occurred one day after purchasing the policy, so that at death the insurance element of the policy will have appreciated substantially beyond its gift tax value at the time of assignment. see id. at 720-21. lauer's argument rests on several false assumptions. first, it is not always true that an insured must take a physical examination and be found to be in good health in order to acquire a life insurance policy. employer-paid group term life insurance is usually provided to new employees without a physical. secondly, there will be a time gap between taking a physical examination and the actual purchase of the policy, so that the insured's health might have deteriorated before purchasing the policy. finally, and most importantly, application of § 2035 does not depend on a finding that the insured was in poor health at the time of assignment. section 2035 is not based exclusively on a policy of preventing tax benefits from accruing to transfers made in anticipation of imminent death. even the original "contemplation of death" rule referred to death motives for making the transfer, such as a potential reduction of estate tax liability, rather than to an anticipation of imminent death. a transfer of a policy by a healthy individual is a hedge against the possibility of premature death. the purpose of having another person own the policy is a further hedge designed to reduce the insured's estate [vol 4:5 tax consequences of assigning life insurance anyone contemplating the purchase and gift of a life insurance policy to structure the form, but not the substance, of the transaction to eliminate the risk of incurring estate tax on the full proceeds if death occurs within three years. nothing in the legislative history suggests that congress intended to open up such a loophole when it amended section 2035 in 1981. the issue likely is moot now, but the commissioner might wish to reconsider the decision to concede the position taken by the tax court and the three courts of appeal.8 2 vi. outright assignment within three years of death we now turn to a gift of a life insurance policy within three years of death by an insured who, before making the assignment, unquestionably owned incidents of ownership in the policy. under section 2035 as reformulated by the taxpayer relief act of 1997, the amount included in the decedent's gross estate is the amount that would have been included under section 2042 had the gift not been made.8 3 oe sometimes call this the what-would-have-been-included method of calculating the amount includible.) because section 2042 requires the full value of the proceeds to be included in the insured's gross estate if the insured possessed at death any of the incidents of ownership in the policy, the starting point is that a gift by the insured within three years of death of any incident of ownership requires inclusion of the full value of the proceeds under section 2035. in 1981, congress confined section 2035 to tainted gifts.84 (a "tainted gift" is a gift within three years of death of an interest in or power over property that would have been included tunder sections 2036 through 2038 or section 2042 had the gift not been made.) before 1981, most of the litigation and rulings under section 2035 concerned nontainted gifts-gifts of property that would have been included in the donor's gross estate under section 2033 had the gift not been made. the practice under the case law and rulings, supported by the language of the statute,' was to revalue the donated property as of the date of death and include that amount in the tax liability in the case of premature death, which should be allowed to succeed only if the insured lives for more than three years. 82. see also sherman, supra note 43, at 131-37. 83. see irc § 2035(b); see also supra note 46. any gift tax paid on the gift is also included. see irc § 2035(b). 84. see supra text accompanying notes 43-44. 85. irc § 2035 then provided that the decedent's gross estate includes "the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer... in contemplation of his death." 19991 florida tax review donor's gross estate.86 (we sometimes call this the death-time-value-of-thegift method of calculating the amount includible.) we argue that even before the 1997 act expressly adopted the whatwould-have-been-included method, the use of that method for gifts of a life insurance policy would have avoided many difficulties and would have led to a more sound result.87 we want to emphasize that using that method is not essential for a gift of a life insurance policy.8 the old death-time-valueof-the-gift method, properly applied, would reach the correct result in the case of a gift of a life insurance policy within three years of death. the advantage of the new what-would-have-been-included method is that the correct result is much easier to recognize. in fact, even under the death-timevalue-of-the-gift method, the courts and the service did reach the correct 86. this practice sometimes proved troublesome. see, e.g., commissioner v. estate of gidwitz, 196 f.2d 813 (7th cir. 1952) (income generated by property transferred within three years of death not includible in donor's gross estate); rev. rul. 80-336, 80-2 c.b. 271 (death-time value of gift of stock within three years of death includes the value of post-gift stock dividends paid before death); rev. rul. 72-282, 72-1 c.b. 306 (value of gift included in donor's gross estate at its death-time value even though the donee had sold the donated property before the donor's death). 87. even before congress confined § 2035 to tainted gifts, the courts had at least indirectly recognized that the proper amount includible in the case of one type of tainted gift, a gift of a retained life estate within three years of death, was the amount that would have been included had the gift not been made-the full value of the property, not the death-time value of the then-expired life estate. see, e.g., united states v. allen, 293 f.2d 916, 917-18 (10th cir. 1961) (although the decedent sold her retained life income interest within three years of death for more than its value, the court held that the consideration received was not adequate for estate tax purposes because it was less than would have been included in her gross estate if the "sale" had not taken place); estate of d'ambrosio v. commissioner, 101 f.3d 309, 312 (3d cir. 1996) (citing allen with approval). also, well before congress confined § 2035 to tainted gifts, congress itself had expressly recognized that the proper amount includible in the case of another type of tainted gift, a relinquishment of a retained power to revoke within three years of death, is the amount that would have been included had the gift not been made-the full value of the property, not the death-time value of the then-expired power to revoke. section 2038 of the code has long expressly so provided. see irc § 2038(a)(1) (applicable to transfers after june 22, 1936); irc § 2038(a)(2) (applicable to transfers on or before june 22, 1936). the tax reform act of 1976 substituted "during the 3-year period ending on the date of the decedent's death" for "in contemplation of ... death." see tax reform act of 1976, pub. l. no. 94-455, § 2001(c)(1)(k), 90 stat. 1520, 1852-53 (1976). these express provisions in irc § 2038 made the reference in § 2035 to § 2038 duplicative and unnecessary. 88. in contrast, use of the what-would-have-been-included method is essential for a gift of a retained life estate or relinquishment of a retained power to revoke because the death time value of the gift-the retained life estate or power to revoke-would be zero. see supra note 87. note, however, the need for congress to reassess its decision to classify a gift of a retained life estate or a relinquishment of a power to revoke within three years of death as a tainted gift to which § 2035 applies. see supra note 44. [vol 4:5 tax consequences of assigning life insurance result in cases in which no post-assignment premiums became due. the pre1998 case law and rulings held that the full value of the proceeds was includible,89 which is the same amount that would be includible under the new what-would-have-been-included standard. it was principally when the assignee paid some or all of the postassignment premiums that the case law faltered and reached an incorrect result. as noted earlier,9 the leading case on the issue is estate of silverman v. cormnissioner,91 a case decided by the tax court in 1973, before section 2035 was confined to tainted gifts,9and long before the 1997 reformulation expressly adopted the what-would-have-been-included standard. in silvennan, the insured, within six months of death, assigned a $10,000 life insurance policy to his son. before the assignment, the insured had paid the monthly premiums as they became due, but after the assignment, the insured's son paid the premiums. in total, $3,261.20 in premiums were paid on the policy. of these, the insured paid $2,893 and the son paid $368.20. the tax court attempted to determine the death-time value of the insured's gift by using the ratio of premiums paid by the insured to the total premiums paid on the policy. because the insured paid 88.71% of the premiums, the insured, in the tax court's view, only transferred 88.71% of the policy within three years of death. in consequence, the tax court held that only 88.71% of the proceeds should be included in the insured's gross estate: [because] the petitioner [the assignee of the policy] paid all the insurance premiums after the assignment ... [,] we feel that the petitioner contributed to the value of the policy, and it would be inappropriate to include in the gross estate that portion of the value which petitioner contributed. 89. see supra text accompanying note 6. 90. see supra note 8. 91. 61 t.c. 338 (1973), affd on the limited grounds raised on appeal, 521 f.2d 574 (2d cir. 1975). when silverman arose, one of the requirements for including the proceeds of an assigned life insurance policy in the insured's gross estate was that the assignment have been made in contemplation of death as well as having been made within three years of death. in silverman, the tax court found that the insurance policy, which had been assigned to the insured's son six months before the insured's death, had been assigned in contemplation of death. congress eliminated the "contemplation of death" requirement when it amended the code in 1976. 92. as explained earlier, a "tainted" gift is a gift within three years of death of an interest in or power over property that would have been included in the decedent's gross estate under §§ 2036 through 2038 or § 2042 had the transfer not taken place. see supra text accompanying note 44. 19991 florida tax review throughout its existence, including the time of transfer, the policy had a face value of $10,000. at the time of the decedent's death, however, a certain number of premiums were required to keep the face value intact. it is apparent, therefore, that at the time the decedent transferred the policy, only a portion of the premiums necessary to maintain the face value payment on death had in fact been paid. the petitioner's continued premium payments were thus a vital part of the consideration necessary to secure full payment on the insurance policy on decedent's death. to hold otherwise would tax the estate on an asset greater than that which the decedent transferred. .. . we are further bolstered in our decision by sec. § 20.2035-1(e), estate tax regs., which states: "however, if the transferee has made improvements or additions to the property, any resulting enhancement in the value of the property is not considered in ascertaining the value of the gross estate." we therefore hold that the decedent's estate must include that portion of the face value of the life insurance policy which the decedent's premium payments bore to all premium payments.93 the taxpayer appealed to the second circuit, contending that only the cash surrender value of the policy at the time of assignment ($1,120) or the amount of premiums paid by the insured within three years of death ($1,525) should have been included.94 in response, the commissioner merely urged the court to affirm the tax court's decision, but did not argue that the tax court's analysis was more favorable to the taxpayer than warranted. in dismissing the taxpayer's contention, the second circuit "freely admit[ted] some uneasiness"95 about the tax court's use of the ratio of premium payments to calculate the amount includible. the circuit court noted that another possible approach would have been to include the full dollar value of the proceeds, reduced only by the dollar amount of the post-assignment premiums paid by the son.96 since the commissioner had not challenged the tax court's analysis, however, the second circuit affirmed without developing the analytical argument for the position it seemed to favor.97 93. 61 t.c. at 342-43. (emphasis added.) we noted earlier that the tax court meant to refer to the ratio of premiums paid by the insured before or after the assignment and the premiums paid by the assignee (or someone else) after the assignment. see supra note 9. 94. 521 f.2d 574 (2d cir. 1975). 95. id. at 577. 96. see id. at 577-78. 97. see id. at 578. [vol 4:5 tax consequences of assigning life insurance unfortunately, the commissioner acquiesced in silverman and applied the tax court's analysis in subsequent rulings and internal memoranda. 91 as a result, the issue has not been litigated since.99 although silvennan applied the old death-time-value-of-the-gift standard, not the new what-would-have-been-included standard, the tax court's view that each premium payment purchases a fractional share of the policy" cannot be completely dismissed as irrelevant. the tax court used the ratio of premiums paid by the insured to the total premiums paid on the policy to hold that the insured had only transferred 88.71% of the policy. the tax court bolstered its position by suggesting that the assignee's premium payments were in the nature of expenditures for improvements or additions to the property transferred. if the tax court's analysis were correct, then only 88.71% of the policy ought to be included even under the new what-wouldhave-been-included standard.' 0' the fallacy of silvennan, however, is the idea that the decedent only transferred a fractional interest in the policy. at the time of the transfer, which is when the property transferred should be determined, the decedent was the sole owner of the policy. the decedent was not a part owner. there was no co-owner. the decedent owned and transferred the entire policy."c 98. the commissioner acquiesced in the tax court's decision, see 1978-1 c.b. 2, and applied the silverman analysis in a.o.d. 1978-113 (1978); a.o.d. 1978-114 (1978); gen. couns. mem. 38,110 (sept. 25, 1979); tech. adv. mem. 79-07-011 (oct. 27, 1978): priv. ltr. rul. 87-24-014 (mar. 11, 1987). 99. in estate of friedberg v. commissioner, 63 t.c. memo (cch) 3080 (1992), the service unsuccessfully sought to distinguish sil'ennan, not to overturn it. the insured had transferred his life insurance policy to his daughter within three years of death. the daughter paid the post-assignment premiums and was the beneficiary of the policy. because the daughter served as the executor of the insured's estate, the service argued that the full value of the proceeds was included under § 2042(l). the tax court held that the proceeds were payable to the insured's daughter in her individual capacity, not in her capacity as the insured's executor. therefore, the tax court applied the silerman proration approach to determine the amount includible in the insured's gross estate under § 2035. 100. "to hold otherwise," the tax court said, "would tax the estate on an asset greater than that which the decedent transferred." 61 t.c. at 343. 101. if a decedent-insured only owns a fractional interest in a policy at death, only that fractional interest of the proceeds is includible under irc § 2042. see regs. § 20.20421(c)(5), -1(c)(6). 102. the tax court's position in silernan is reminiscent of the premium payment test that was once employed by the estate tax laws as part of the antecedents to § 2042(2). under the premium payment test, which congress repudiated in 1954. the estate of a deceased insured was required to include in the gross estate a percentage of the life insurance proceeds equal to the percentage of premiums that were paid by the insured. this test was properly eliminated by congress when it adopted the 1954 code. see kahn & waggoner, supra note 1, at 970-75. 19991 florida tax review as noted above, the tax court attempted to bolster its position by suggesting that the assignee's premium payments were in the nature of expenditures for improvements or additions to the property transferred. were this a correct characterization, the death-time value of the improvement or addition would not be included in the decedent's gross estate because the decedent did not transfer the improvement or addition. after all, if the sole owner of a parcel of vacant land gave the land to a grantee who built a building on it, the death-time value of the gift would ignore the value of the building. in actuality, however, only a small part of the assignee's premium payments can properly be characterized as expenditures for improvements or additions to the transferred policy. the other part of the payments are more in the nature of maintenance expenses. to develop this point, we return to the economic components of a life insurance policy. an insurance policy has three components: the equity or terminal reserve component, the term insurance coverage component, and the right of continuation component. 3 to determine the death-time value of the gift accurately when the assignee pays the post-assignment premiums, the tax court should have identified and examined these components separately, since they are what the decedent's assignment transferred. the equity reserve component. if the policy had an equity reserve component at the time of the transfer, the decedent clearly transferred it. the equity reserve may increase between the time of the transfer and the time of death. the increase is partly attributable to the appreciation of the equity reserve that the decedent transferred. that portion of the proceeds attributable to the transferred equity reserve component and the appreciation thereon is clearly includible in the transferor's gross estate. a portion of the post-assignment premiums paid by the assignee is added to the equity reserve component. that portion, including the appreciation thereon, is in the nature of an improvement or addition to the property by the assignee, and should be excluded under section 2035.'l4 103. see supra text accompanying notes 15-16. 104. it is arguable that when congress amended § 2035 in 1981, it should have excluded the entire equity reserve component of a life insurance policy transferred within three years of death. the 1981 amendments restricted § 2035 to items of property in which the value of the gift is likely to be much less than the amount that would have been included in the transferor's gross estate if the transfer had not taken place. with respect to a transferred life insurance policy, the component that dramatically increases in value is the term insurance coverage component, not the equity reserve component. because the equity reserve component does not dramatically increase in value at the insured's death, it is more like the types of property to which § 2035 no longer applies-property such as land or stocks and bonds. it would better suit tax policy then for congress to have expressly excluded all of the equity reserve element of a life insurance policy from the insured's gross estate-i.e., the equity [vol 4:5 tax consequences of assigning life insurance that portion of the equity reserve was not transferred by the decedent and, since the insured did not pay those premiums, would not have been included in the insured's gross estate had the transfer not occurred. the tenn insurance coverage and the right of continuation components.105 an assignment of a life insurance policy also constitutes a gift of the term insurance coverage component. the value of the term insurance component at the time of death is the full value of the proceeds of the policy, less any equity reserve. in one respect, however, it could be argued that the term insurance coverage component that the insured transferred has expired by the time of death and was replaced by the term insurance coverage bought by the assignee's last premium payment. the question is, should the assignee's last premium payment be treated as a de novo purchase of term insurance coverage or should all of the assignee's premium payments combined be treated merely as a maintenance expense of the term insurance coverage that the insured transferred? the only reason that the assignee had the right to maintain the insurance coverage in force is reserve at the time of the gift, the incremental additions thereto, the equity reserve added by the assignee's premium payments, and the incremental additions thereto. as drafted, however, § 2035 clearly includes the equity reserve component in the transferor's gross estate. perhaps congress considered the several components of life insurance to be so blended into the proceeds payable at death as to make it inappropriate or administratively inconvenient to separate the proceeds into its several component elements. in fact, however, the amount of the equity reserve can be determined easily and presents no administrative or other difficulties. more likely, congress simply did not think about the idea of separating the elements that make up the proceeds payable at death. it would be worthwhile for congress to consider amending § 2035 to exclude that portion of insurance proceeds attributable to the equity reserve component. 105. at the time of assigmnent, the value of these components is at least equal to the portion of the premium previously paid by the insured that is attributable to the remainder of the period for which that premium was paid. thus, if the insured paid a premium of s 1,200 on march 1 for term insurance coverage for one year, and the insured assigned the policy to his wife three months later (on june 1), he would have made a gift having a value of at least $900 (three-fourths of $1,200). if the insured is in good health, this allocation of the premium will accurately reflect the value of both components. the amount of each premium will equal the value of the risk coverage involved; the premium will have been set according to an actuarial determination of the risk assumed by the insurer, including the granting to the policyholder of an option to continue that insurance coverage in future years at a cost designed for healthy persons. stating it differently, if the assignee has an insurable interest in the insured, the assignee could purchase the same amount of insurance coverage, including a right of continuation component, at the same price. however, if the insured is in poor health at the time of the assignment, the premium payable for the term insurance coverage will be less than the actual value of such insurance coverage; consequently, the value of the insurance granted to the assignee (both the coverage for the remainder of the period and the option to continue the coverage at a bargain price) will exceed the premium allocation described above. 1999] florida tax review because the assignment of the policy carried with it the right of continuation component.1'6 rather than treating each premium payment as the purchase of an independent asset (risk coverage for a stated term), it is more accurate to characterize such payments as a maintenance expense of the term insurance coverage component. the insurance coverage element of a policy should therefore be treated as a continuum and not as a collection of a number of individual contractual arrangements-one for each term of a premium payment.107 treating insurance coverage as a continuum or single asset is not only a realistic view of the asset itself, it is necessary in order to accommodate the legislative purpose of section 2035 and to avoid great administrative burdens. if the assignee's last premium payment were treated as an independent purchase of risk coverage for the stated term, it might then be necessary to exclude the entire risk coverage element of the proceeds (that is, the difference between the amount of the proceeds and the reserve), since that value would then be deemed to have been added by the assignee. excluding this amount would frustrate the purpose of section 2035, which is to prevent the use of lifetime transfers in anticipation of imminent death as a means of minimizing transfer tax costs. particularly when the insured was in poor health when assigning the policy, this method would overstate the amount added to the policy's value by the assignee. there is a way of preventing that frustration and overstatement, but doing so would necessitate valuing the risk coverage element of the policy at the time of 106. if the assignee had an insurable interest in the insured, the assignee could have bought a new policy on the insured, but not the existing policy that the insured transferred. if the insured was in poor health at the time of the assignment, the cost of a new policy would be much higher than the premiums on the existing policy. in fact, the insured's health might be so poor that he or she was then uninsurable. 107. in two earlier and now obsolete revenue rulings, the service recognized that life insurance coverage is properly characterized as a continuum. under pre-1982 law, when an insured assigned a straight life or a term policy more than three years before death but paid premiums within three years of death, the service only included the amount of premiums paid by the insured within three years of death. see rev. rul. 71-497, 1971-2 c.b. 329; text accompanying supra note 56. this position treats a premium paid on term or straight life insurance as merely maintaining continuous insurance coverage, not as a de novo purchase of new insurance coverage. see also rev. rul. 82-13, 1982-1 c.b. 132, where the service ruled that § 2035 did not apply to a case in which the insured, more than 3 years before death, assigned a group term, employer-paid policy to another. although the insurance was for a term, it was subject to an automatic right of renewal by payment of the premiums for the next term. after the assignment, the employer continued to pay the premiums, which were therefore deemed to have been paid by the insured. some of the premiums were paid within 3 years of the insured's death. since the policy was renewable, the service treated the premium payments as a continuation of a single policy, not as a de novo purchase of a new policy. [vol 4:5 tax consequences of assigning life insurance assignment and then deducting that value from the risk coverage element at death to determine the amount of the proceeds that actually are attributable to the assignee's premium payment. this method would provide a more accurate reflection of the assig-nee's addition to the value of the policy. valuing the risk coverage element at the time of assignment is objectionable, however, because it would require making an appraisal of the health of the insured at the time of assignment and making an actuarial and medical evaluation of the insured's life expectancy at that time. the difficulties in making that determination and the burden of exploring those issues led the government to value unmatured insurance policies for gift tax purposes without regard to the actual health of the insured." s the same difficulties point to rejecting the idea of valuing the risk coverage element of the policy at the time of assignment and then deducting that value from the risk coverage element at death to determine the amount of the proceeds that actually are attributable to the assignee's premium payment. indeed, the factual problems raised by requiring such a valuation are reminiscent of the problems that arose in determining whether a transfer was made in contemplation of death. congress replaced the "contemplation of death" test in 1976 with an automatic rule of inclusion just so that it could eliminate both the administrative burden of making inquiries of this type and the frequent factual errors made in resolving such issues. while it is true that the contemplation of death rule involved questions of subjective intent that would not be raised in examining the insured's state of health, it would still be necessary to look into the past and determine some aspect of an individual's personal state possibly without having any access to information from the individual. even if the health evaluation method were correct in theory, it would operate equitably only when the past health of the insured could be accurately determined. the great likelihood that substantial errors would be made in resolving such factual issues renders this approach undesirable. while treating the assignee's payments as maintenance of the right of continuation component is somewhat draconic, it has the advantage of being doctrinally supportable, not only for the reasons discussed above, but also because such treatment is consistent with the usual perceptions of the insured and assignee. as previously noted, the portion of the assignee's premium payments that are added to the equity reserve should be deducted from the amount of death proceeds that otherwise would be included in the insured's gross estate. viewing the assignee's contribution as a maintenance cost, the question is whether the proceeds should also be reduced by the rest of the assignee's post-assignment premium payments. since the insured's gross estate would 108. see rev. rul. 77-181, 1977-1 c.b. 272; supra text accompanying notes 27-28. 1999/ florida tax review have been reduced by such payments if the insured had retained the policy and made the premium payments (that is, the cash used to pay the insurance cost would no longer be part of the insured's assets), the assignee's payment should be treated as a contribution to the extent that the payment is allocated to the cost of purchasing insurance coverage (which cost includes the insurer's expenses that are passed on to its policyholders). therefore, the amount of the portion of each premium payment that is not applied to the policy's reserve should also be deducted from the proceeds that are includible in the insured's gross estate.' °9 consequently, the proper method of calculating the amount includible under the old death-time-value-of-the-gift method was to include the full value of the proceeds less the dollar amount of the post-assignment premiums paid by the assignee, not by using the ratio of premiums paid by the insured to the total premiums paid on the policy, as the tax court did in silverman. the second circuit, it turns out, had it right."' the new what-would-have-been-included standard makes it unnecessary to identify and separately revalue the components of the policy that the insured transferred. the starting point is that a gift by the insured within three years of death of any incident of ownership requires inclusion of the full value of the proceeds. the question under this standard is whether there should be any reduction in the amount includible because of the assignee's premium payments, and if so how that reduction should be calculated. we believe that that amount should be reduced by the dollar amount of the post-assignment premiums paid by the assignee. as noted above, if the insured had in fact retained the policy, the insured would have paid the premiums in order to maintain the policy. because those premium payments would have reduced the amount includible in the insured's gross estate under section 2033, the assignee's premium payments should be deducted from the full value of the proceeds in order to determine the amount ultimately includible under section 2035 in its current form. we make this argument purely as a matter of tax policy. section 2035 makes no provision for such a reduction. it requires inclusion of the amount that would have been 109. cf. estate of peters v. commissioner, 386 f.2d 404 (4th cir. 1967) (the value of a surviving joint tenant's capital improvements were deducted from the value of jointly owned property that was included in the decedent's gross estate under § 2040). the joint tenants were the decedent and her son. 110. recall that the second circuit expressed uneasiness about the tax court's use of the ratio of premium payments to calculate the amount includible, and noted that another possible approach would be to include the full dollar value of the proceeds, reduced only by the dollar amount of the post-assignment premiums paid by the son. see supra text accompanying note 95. [vol 4:5 tax consequences of assigning life insurance included under section 2042 had the gift not been made, not the amount that would have been included overall. our position is that it is consistent with tax policy to graft this reduction onto section 2035, either by administrative or judicial construction. the final question is, what if the insured, not the assignee, paid the post-assignment premiums? under the case law and rulings that predated the 1997 act, the full value of the proceeds was included without any reduction for the amount of the post-assignment premiums."' one could argue that in substance the insured's post-assignment premium payments should be attributed to the assignee." 2 the rationale would be that the assignee, as owner of the policy, is the only one entitled to pay the premiums on the policy.' consequently, if without objection from the assignee the insured pays the post-assignment premiums directly, the transaction could be treated as a gift from the insured to the assignee of the cash amount of the premiums, coupled with a constructive payment of the premiums by the assignee. 114 assuming that post-assignment premiums paid by the insured are properly treated as constructively made by the assignee, the question still remains whether the amount of the constructive payments should reduce the amount of the proceeds that are included in the insured's gross estate under the what-would-have-been-included standard of the 1997 act. our argument for such a reduction when the assignee actually pays the post-assignment premiums rests on the theory that the insured would have paid the premiums if the policy had not been assigned, thus removing the amount of those payments from the insured's gross estate. it is another matter, however, to grant such a reduction when the assignee pays the premiums from funds obtained from the insured. whether there should be such a reduction turns on the extent to which the assignee's payments constitute an act that is independent from the insured's gifts to the assignee. when the insured pays the premiums directly, the gifts to the assignee are in effect conditioned on being used to pay the premiums, making the gifts so connected to the premium payments that the rationale for reducing the includible insurance proceeds by the amount of the 111. see cases and rulings cited supra note 7. 112. see lauer, supra note 81, at 725-27. 113. see id. at 686, 726. 114. in other contexts, the tax law has so treated the payment of another's debt. see, e.g., rev. rul. 57-481, 1957-2 c.b. 48, in which the service ruled that a third party's payment (as a gift or loan to the taxpayer) of interest owed by the taxpayer on a loan is a payment by the taxpayer, making it deductible by the taxpayer under the provisions then existing that allowed an income tax deduction for interest payments. this line of authority is analogous to the insured's payment of premiums on a policy owned by the assignee, despite the fact that the assignee has no legal obligation to pay those premiums. 19991 florida tax review assignee's premium payments is negated. in that case, the payments do not reflect amounts that substitute for what otherwise would have been payments that reduce the insured's gross estate. since the premium payments were derived from the insured, the gifts already reduced the insured's gross estate. no additional reduction by deducting the payments from the insurance proceeds is justified. viii. conclusion we end where we began. the taxpayer relief act of 1997 furnishes the courts and the internal revenue service an opportunity to rectify the erroneous conclusion reached by the tax court in silverman, which affords taxpayers unwarranted opportunities for tax avoidance. the silverman analysis gives taxpayers a windfall and provides life insurance an unfair advantage over other investment vehicles. silverman misapplied the death-time-value-of-the-gift standard and, more importantly, is inconsistent with the what-would-have-been-included standard expressly adopted by section 2035 as reformulated by the 1997 act. if the insured dies within three years after making the gift, the full value of the proceeds less the dollar amount of the premiums paid by the assignee should be included under section 2035 as reformulated by the taxpayer relief act of 1997. [val 4:5 florida tax review volume 6 2003 number 2 back to the future interest: the origin and questionable legal basis of the use of crummey withdrawal powers to obtain the federal gift tax annual exclusion bradley e.s. fogel although the future of the estate tax is uncertain, the federal gift tax and the federal gift tax annual exclusion survived recent congressional action. in fact, recent changes to the internal revenue code may increase the use of the annual exclusion in the short term. the federal gift tax annual exclusion allows donors to give $11,000 per year to an unlimited number of donees free of gift tax. the exclusion is unavailable for gifts of “future interests,” including most gifts in trust. in order to make a gift in trust that fully qualifies for the annual exclusion, donees are frequently given temporary powers – called “crummey powers” – to withdraw the gift to the trust. crummey powers are based on unjustifiable analogies to the federal income tax. in fact, crummey powers are inconsistent with the language of the internal revenue code, the treasury department’s regulations and united states supreme court precedent concerning the annual exclusion. moreover, crummey powers defeat the legislative intent behind the annual exclusion. the law has become muddled in this area due to missteps by the irs. despite the potential for abuse, the irs has never contested the fundamental validity of crummey powers. instead, the irs accepted the basic premise behind crummey powers and litigated side issues. the irs’s agreement on the basic premises, however, precluded its success on the side issues. the treasury department or congress may effect an abrogation of crummey powers. in the current political climate, however, they are unlikely to do so. unless they do, the irs will likely be forced to continue to accept the sham it sanctioned when it acquiesced in crummey v. commissioner. 1. assistant professor, saint louis university school of law; l.l.m . new york university; j.d. columbia university school of law; b.a. new york university. the author wishes to thank professor nancy h. kaufman, professor henry ordower and professor douglas williams for their assistance with, and comments to, this article. courtney e. harashe (saint louis university school of law, class of 2004) and geoffrey t. dobran (saint louis university school of law, class of 2003) provided invaluable assistance. the author also wishes to thank bella l.f. sanevich, esq., of nisa investment advisors, llc, for her enormous help and extraordinary efforts. she reviewed more drafts of this article than any human could ever have been expected to. 189 florida tax review volume 6 2003 number 2 back to the future interest: the origin and questionable legal basis of the use of crummey withdrawal powers to obtain the federal gift tax annual exclusion bradley e.s. fogel1 i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191 ii. background , purpose & operation of the annual exclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 iii. the origin and use o f crummey powers . . . . . . . . . . . . . 202 a. crummey v. commissioner and its precedents . . . . . . . 202 b. the modern crummey power . . . . . . . . . . . . . . . . . . . . 210 c. crummey powers after the economic growth and tax relief reconciliation act of 2001 (“egtrra”) . . 214 iv. a second look at withdrawal powers . . . . . . . . . . . . . 218 a. sham transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 b. crummey powers and the statutory requirements for the annual exclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . 222 1. section 2503 and the treasury department regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224 2. the inapposite income tax analogies . . . . . . . . . . . . 227 3. powers to vest property in oneself in other transfer tax contexts . . . . . . . . . . . . . . . . . . . . . . . . 229 190 florida tax review [vol.6:2 4. the legislative history of the annual exclusion . . . 230 5. the viability of crummey v. commissioner . . . . . . . 232 v. the futur e of crummey pow ers possibilities for reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233 a. possibilities for congressional action . . . . . . . . . . . . . 233 b. administrative abrogation of crummey . . . . . . . . . . . . 236 1. action by the irs . . . . . . . . . . . . . . . . . . . . . . . . . . . 237 2. action by the treasury department . . . . . . . . . . . . . . 241 vi. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244 2003] back to the fu ture interest 191 2. the economic growth tax relief refunding act of 2001 (“egtrra”) repealed the federal estate tax for decedents dying after dec. 31, 2009. irc § 2210(a). egtrra itself is, however, repealed after dec. 31, 2010. economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, § 901 115 stat. 38, (2001). thus, the estate tax is repealed only for decedents dying during calendar year 2010. the one-year repeal of the federal estate tax has earned egtrra the appellation “the throw momma from the train act” based on the assumption that heirs might wish to hasten the departure of a loved one in order to avoid the federal estate tax. paul krugman, reckonings; bad heir day, n.y. times, may 30, 2001, at a23. many commentators feel that congress will likely act sometime before 2010 to prevent the one-year repeal of the federal estate tax. see, e.g., charles p. rettig, the life & death of estate taxes, 24 nov. l.a. law. 32, 38 (nov. 2001); david j. wilfert & martha j . leighton, matching the estate planning tool to the investment plan, 314 pli/est 529, 535 (2002). although making estate tax repeal permanent has been proposed, that proposal is, at the moment, dead. see, e.g., h.r. 2143 , 107th cong. (2001); see also warren rojas, permanent estate tax repeal dealt blow in senate, 2002 t ax notes 114-1 (june 13, 2002). 3. egtrra did not repeal the federal gift tax. cch, 2001 tax legislation: law, explanation and analysis economic growth and tax relief reconciliation act of 2001, ¶ 305 (2001); see also infra note 31. 4. see infra notes 134-51 and accompanying text. cf. irc § 2511(c). 5. jeffrey g. sherman, ‘tis a gift to be simple: the need for a new definition of future interest for gift tax purposes, 55 u. cin. l. rev. 585, 585 (1987) (“the most troublesome and most frequently litigated issue in gift tax law is undoubtedly the availability of the ‘annual exclusion’ authorized by section 2503(b).”). 6. crummey v. commissioner, 397 f.2d 82 (9th cir. 1968); rev. rul. 73-405, 1973-2 c.b. 321. i. introduction regardless of the future of the federal estate tax,2 it seems that the gift tax will remain a feature of federal tax law.3 moreover, recent changes to the federal estate and gift taxes have left unchanged4 what has been described as the most litigated aspect of the federal gift tax:5 the annual exclusion. one issue – the use of crummey withdrawal powers to obtain the federal gift tax annual exclusion – was surrendered by the internal revenue service (“irs” or “service”) over thirty years ago.6 however, crummey powers are, in fact, not supported by the internal revenue code (“code”), treasury department regulations, united states supreme court precedent or the legislative intent behind the annual exclusion. as argued herein, crummey powers have no place in the federal gift tax. 192 florida tax review [vol.6:2 7. h.r. rep. no . 72-708 (1932); s. rep. no. 72-665 (1932). 8. irc 2503(b). the annual exclusion increased to $11,000 per year, from $10,000 per year, as of calendar year 2002. compare rev. proc. 2001-59, 2001-52 i.r.b. 623. 9. walter d. schwidetzky, estate planning: hyperlexis and the annual exclusion rule, 32 suffolk u. l. rev. 211, 211 (describing the annual exclusion as “[o]ne of the true bonanzas in the internal revenue code”). in stifel stifles kieckhefer, the author commented that taxpayers’ “preoccupation” with the federal gift tax annual exclusion was “excessive.” dwight rogers, 7 tax l. rev. 500 (1952). this somewhat unusual statement indicates either a failure to appreciate the power of multiplication or an argument that regardless of how many annual exclusions are obtained by the donor the amount is insignificant. 10. irc § 2503(b). 11. this example is loosely based on the facts of tech. adv. mem. 91-41-008 (oct. 11, 1991). in that ruling, the donor made annual exclusion gifts, in trust, to each of her three children and thirty two grandchildren through the use of crummey withdrawal powers. the irs denied the exclusions for the grandchildren since they had only contingent remainder interests in the trust. id . the irs’s reason for denying the annual exclusions is not supported by law and has been rebuffed by the courts. see infra note 21. regardless, the grandmother could clearly have obtained all thirty five annual exclusions had she merely made the gifts outright, rather than in trust. regs. § 25.25033(b). 12. thirty-five descendants x $11,000 exclusion equals a $385,000 transfer. 13. for calendar year 2002, the maximum federal estate and gift tax rate is 50%. irc § 2001(c)(1). thus, a $385 ,000 tax-free transfer potentially saves up to $192,500 in federal estate and gift tax. the federal transfer tax system consists of three distinct, but interrelated, federal taxes -the gift tax, the estate tax and the generation-skipping transfer tax. irc §§ 2001, 2501, 2601 . although the estate and gift taxes were largely integrated in 1976, the integration was incomplete and they remain conceptually distinct. richard b. stephens, et. al, federal estate & gift taxation, § 1.02[1] (7th ed. 1996). 14. regs. § 25.2503-3(b); irc § 2503(b). the annual exclusion was enacted to exclude routine gifts (such as holiday and birthday gifts) from gift taxation.7 it exempts gifts under $11,000 per year from a donor to each donee.8 the relatively modest dollar amount of the annual exclusion belies its importance.9 the exclusion is per year, per donor and, most notably, per donee.10 thus, a munificent donor could, for example, give $11,000 to every resident of the city of new york without incurring any gift tax liability. in a more mundane case, the matriarch of a family could give $11,000 annually to each of her thirty-five descendants.11 thus, she could give away almost $400,00012 annually free of federal transfer tax.13 the annual exclusion is available only for gifts of “present interests.”14 this requirement makes the annual exclusion unavailable for most gifts in 2003] back to the fu ture interest 193 15. regs. § 25.2503-3. cf. irc § 2503(c). if trust income is paid to the beneficiary, then the income interest is a present interest and may be offset by the annual exclusion. regs. § 25.2503-3(b); commissioner v. lowden, 131 f.2d 127, 128 (7th cir. 1942). the remainder of the gift (the value in excess of the income interest) will be a future interest and no exclusion will be allowed to offset that portion. regs. § 25.2503-3(a); fisher v. commissioner, 132 f.2d 383, 386 (9th cir. 1942); sensenbrenner v. commissioner, 134 f.2d 883, 885 (7th cir. 1943). 16. crummey v. commissioner, 397 f.2d 82 (9th cir. 1968). as discussed below, crummey addressed withdrawal powers held by minors. id. at 83. the service never contested the use of withdrawal powers held by adults. see infra notes 61-74 and accompanying text. despite this distinction, the term “crummey power” is generally used to refer to powers held by adults or minors. 17. crummey, 397 f.2d 82, action on dec., 1966-144 , 1972 wl 32868 (jan. 14, 1972); rev. rul. 73-405, 1973-2 c.b. 321. 18. see, e.g., estate of kohlsaat v. commissioner, 73 t.c. memo (cch) 2732 (1997); holland v. commissioner, 73 t.c. memo (cch) 3236 (1997); estate of cristofani v. commissioner, 97 t .c. 74 (1991). 19. john l. peschel, major recent tax developments in estate planning, 33 u. s. cal. tax inst. ch. 14, ¶ 1401 (1981) (“[t]he crummey power, in theory, has a strong legal basis but, in practice, emits an equally strong odor of sham.”); willard h. pedrick, crummey is really crummy, 20 ariz. st. l.j . 943, 948 (“[t]he [crummey] withdrawal right is transparently a flim flam.”); benjamin n. henszey, crummey power revisited, taxes, feb. 1981, at 76, 77 (“[t]he irs is aware that the [crummey] power is a sham in most cases”); dept. of the treasury, general explanations of the administration’s revenue proposals, 98 tax notes 22-6, ¶¶ 461-63 (feb . 3, 1998) (“the crummey power is essentially a legal fiction”); joseph m. dodge, a deemed realization approach is superior to carryover basis (and avoids most of the problems of the estate and gift tax), 54 tax l. rev. 421, 490 n.324 (2001). although crummey withdrawal powers give the power-holder insubstantial rights, the argument that they should be disregarded under the sham transaction doctrine rests on tenuous footing. see infra notes 156-80 and accompanying text. trust.15 donors, however, frequently wish to make gifts in trust for a variety of tax and non-tax reasons. crummey powers, named after a seminal ninth circuit case, have evolved in order to allow donors to side-step the present interest requirement and make gifts in trust that fully qualify for the federal gift tax annual exclusion.16 a crummey power is a temporary power, which is generally given to the beneficiaries of the trust, to withdraw an aliquot portion of a gift made to the trust. although the irs acquiesced in crummey v. commissioner,17 it has repeatedly tried to limit the use of crummey powers. the irs has had little success in this regard.18 the service’s zeal to limit the use of crummey powers is easily understood. it cannot be seriously argued that crummey powers are anything other than a ruse.19 moreover, from their humble beginning in crummey v. commissioner, crummey powers have evolved into a cornucopia of transfer tax 194 florida tax review [vol.6:2 20. life insurance trusts are a powerful and ubiquitous estate planning technique. bruce felton, life insurance trusts can help your heirs, n.y. times, apr. 7, 1996, § 3, at 7. the life insurance is owned by the trustee of the trust. the trust assures that the insured has no “incidents of ownership” in the policy and that the policy proceeds will not be paid to the insured’s estate. thus, the policy proceeds will not be included in the insured’s gross estate for federal estate tax purposes. irc § 2042; bradley e.s. fogel, life insurance and life insurance trusts: basics and beyond, probate & property, jan./feb. 2002, at 8, 8. typically, the premiums on life insurance held by the trust are paid by periodic gifts by the insured to the trust. fogel, supra, at 10; georgiana j. slade, personal life insurance trusts, 807 tax mgmt., (bna) at a-6 – a-7. based on crummey withdrawal powers held by the beneficiaries, gifts to the trust are considered gifts of present interests that may be offset by the federal gift tax annual exclusion. priv. ltr. rul. 81-180-51 (feb. 9, 1981); priv. ltr. rul. 78-260-50 (mar. 29, 1978); fogel, supra, at 10-11. if the annual exclusion was not available, the gifts made to the trust in order to pay the life insurance premiums would be taxable. regs. § 25.2503-3; slade, supra, at a-7. 21. traditionally, crummey withdrawal powers were given only to beneficiaries with relatively substantial interests in the trust. taxpayers have, however, realized that the number of exclusions allowed can be multiplied, almost without limit, by giving individuals with little or no interest in the trust withdrawal powers. kent mason, an analysis of crummey and the annual exclusion, 65 marq. l. rev. 573, 593 (1982). thus, the donor may obtain as many exclusions as she can find people who can be trusted not to exercise the withdrawal power. id. at 593-94. withdrawal powers held by individuals with little or no interest in the trust are frequently called “naked crummey powers.” malcolm a. moore, crummey trusts, 26 philip e. heckerling inst. on est. plan. ¶ 203 .1 (1992). the irs has challenged naked crummey powers in the courts. see, e.g., estate of cristofani, 97 t.c. 74; kohlsaat, 73 t.c. memo 2732. since the power-holder’s withdrawal power, rather than any other interest in the trust that the power-holder may have, is the source of the annual exclusion, the irs’s arguments opposing the use of naked crummey powers are largely specious. see, generally, bradley e.s. fogel, the emperor does not need clothes – the expanding use of “naked” crummey withdrawal powers to obtain federal gift tax annual exclusions, 73 tul. l. rev. 555 (1998). accordingly, the irs has been unsuccessful in litigating this issue. 22. carlyn s. mccaffrey, drafting and planning to minimize the generationskipping transfer tax, se09 ali-aba 129, 174 (1999); jonathan g. blattmacher & georgiana j. slade, life insurance trusts: how to avoid estate and g st taxes, estate planning, 259, 263-64 (1995); see also infra text accompanying note 127. avoidance. life insurance trusts,20 naked crummey powers21 and cascading crummey powers,22 among others, are all based on the point of law yielded by the irs when it acquiesced in crummey. 2003] back to the fu ture interest 195 23. see infra notes 156-80 and accompanying text. depending on the type of proceeding and the court, the irs may be represented either by attorneys in the service’s office of the associate chief counsel (litigation) or the justice department. michael i. saltzman, irs practice and procedure ¶ 1.02[3][e] at 1-14. similarly, the litigant may be either the united states or the commissioner of internal revenue. no distinction is made herein between the irs and the attorneys representing the irs, regardless of whether the attorneys actually work for the service. 24. see, generally, brief for respondent commissioner, crummey v. commissioner, 397 f.2d 82 (9th cir. 1968) (no. 21607). 25. crummey v. commissioner, 25 t.c. memo (cch) 772 t.c. memo (ria) 66144 (1966), rev’d in part, crummey, 397 f.2d 82 (9th cir. 1968). 26. crummey, 397 f.2d at 83. 27. see, e.g., k ieckhefer v. commissioner, 189 f.2d 118 , 119-20 (7 th cir. 1951); gilmore v. commissioner, 213 f.2d 520, 522 (6th cir. 1954); stifel v. commissioner, 197 f.2d 107, 110 (2nd cir. 1952); perkins v. commissioner, 27 t.c. 601, 603-04 (1956); see also jonathan e. gopman, crummey, the saga continues, 25 tax mgmt. estates, gifts & trusts journal, 194 (bna) 200 (july/aug. 2000) (“crummey involved an innovative planning technique because it was the first case where a beneficiary’s demand power was limited to a specific period. unlike the previous cases, the demand power was noncumulative, i.e., it lapsed on an annual basis.”). 28. joint committee on t axation, description of possible options to increase revenues prepared for the committee on ways and means, 17-87, at 269 (comm. print 1987); see also infra note 98. despite significant tax avoidance, the fundamental issue underlying crummey powers has never been contested by the irs.23 specifically, the irs has never contested that a lapsing withdrawal power is a present interest for purposes of the annual exclusion. indeed, the issue in crummey related solely to withdrawal powers held by minor beneficiaries.24 the irs agreed with the taxpayer that exclusions based on withdrawal powers held by adults were justified.25 further, although the withdrawal powers in crummey lapsed,26 and the earlier cases all involved non-lapsing powers,27 the irs never argued that this distinction made a difference. lapsing crummey powers are, however, significantly more abusive than non-lapsing crummey powers. indeed, in 1987 the joint committee on taxation (“joint committee”) sought to limit the tax avoidance inherent in crummey powers by requiring that a gift subject to a crummey power would be a present interest only if the power never lapsed.28 the joint committee’s proposal met with no success in congress. the irs lost the crummey battle before it began. hindsight makes abundantly clear that the real abuse in crummey powers has nothing to do with the majority of the power-holder. the abuse is endemic to all crummey powers. as discussed herein, in crummey and the earlier cases, the irs should have argued that a withdrawal power does not create a present interest, regardless of the majority of the power-holder. 196 florida tax review [vol.6:2 29. cf. irc § 2511(c); see also infra notes 134-51 and accompanying text. 30. see infra notes 150-51 and accompanying text. part two of this article addresses the basic workings of the annual exclusion. part three discusses the operation of crummey powers and notes that the economic growth tax relief reconciliation act of 2001 (“egtrra”) made few changes to the basic operation of crummey powers.29 indeed, egtrra may increase the use of crummey powers in the short term.30 part four argues that crummey was wrongly decided. a withdrawal power does not create a present interest for purposes of the federal gift tax annual exclusion. part five discusses the possibilities for reform. clearly, the abrogation of crummey could be accomplished by congress. the power of the irs and the treasury department to administratively overrule crummey is also considered. part six concludes that, due in large part to the irs’s missteps, the law concerning the use of crummey withdrawal powers has gone awry. although the use of crummey powers is unsupportable, the irs’s acceptance of crummey for the past thirty years may force the irs to lie in the bed that it made for itself (and the fisc) when it acquiesced in crummey. 2003] back to the fu ture interest 197 31. revenue act of 1932, ch. 209, §§ 501-532 , 47 stat. 169 245-59 (1932); stephens, supra, note 13, at ¶ 1.03[1]. an earlier gift tax statute was enacted in 1924 and then repealed in 1926. stephens, supra note 13, at ¶ 1.03[1]. the 1924 gift tax was repealed due to its complexity and ease of avoidance. regis w. campfield, et al., taxation of estates, gifts & trusts, ¶ 2001 (22d ed.). the purpose of both the 1924 gift tax and the current gift tax was to act as a backstop to the federal estate tax. sherman, supra note 5, at 589; campfield, supra, at ¶ 2001; see also w . leslie peat & stephanie j . willbanks, federal estate and gift taxation § 1.01, at 2, (2d . 1995); stephens, supra note 13, at ¶ 1.03[1] (“the gift tax is a junior partner of the estate tax.”); sanford v. commissioner, 308 u.s. 39, 44 (1939) (“an important, if not the main purpose, of the gift tax was to prevent or compensate for avoidance of death taxes by taxing the gifts of property inter vivos which, but for the gifts, would be subject in its original or converted form to the tax laid upon transfers at death.”). considering that the federal gift tax was enacted predominately as a back-stop to the federal estate tax, it is curious that egt rra repealed (albeit for one year) the federal estate tax but not the gift tax. irc § 2210(a). earlier proposals considered by congress repealed both the estate tax and the gift tax. see, e.g., h.r. 8, 107th cong. (2001); h.r. 130, 107th cong., (2001). however, commentators noted that repeal of the gift tax would permit substantial income tax avoidance by facilitating gifts of income producing property to lower tax bracket individuals. see, e.g., jonathan g. blattmachr & mitchell m. gans, wealth transfer tax repeal: some thoughts on policy and planning, trusts & estates, feb. 2001, at 49, 58; william m. vandenburgh & philip j. harmelink, the uncertainty of death and taxes, journal of accountancy, oct. 2001, at 95, 97. therefore, congress retained the federal gift tax in order to use it as a backstop to the federal income tax. john s. seich & jason l. seifert, estate planning in a time of unpredictability, ohio cpa journal, jan. 1, 2002, at 30; campfield, supra, at ¶ 1033. further, retaining the federal gift tax reduced the estimate of the cost of egtrra by, at least theoretically, ameliorating the possible income tax loss. 32. revenue act of 1932, ch. 209, § 504, 47 stat. 169, 247 (1932); boris i. bittker, the $10,000 annual per-donee gift tax exclusion, 44 ohio st. l.j. 447, 447 (1983). the 1924 gift tax contained an annual $50,000 per donor exclusion. revenue act of 1924, ch. 234, § 321, 43 stat. 253, 314 (repealed 1926). 33. economic recovery tax act of 1981. pub. l. no. 97-34, § 441(a), 95 stat. 172, 319 (1981). the annual exclusion was $5,000 between 1932 and 1938. revenue act of 1932 ch. 209, § 504, 47 stat. 169, 247 (1932). beginning in 1939, it was reduced to $4,000. irc § 1003(6)(2) (1939). it was reduced, once again, in 1942 to $3,000. revenue act of 1942, ch. 619 § 454 , 56 stat. 798, 953 (1942); h.r. rep. no. 77-2333, ii. background, purposes & operation of the annual exclusion since the enactment of the current federal gift tax in 1932,31 the structure of the annual exclusion has remained unchanged.32 although the amount of the annual exclusion has varied, the exclusion has always been a specific sum per donee per year.33 198 florida tax review [vol.6:2 at 37 (1942) (no ting that the $4,000 annual exclusion allowed donors “to distribute property of large aggregate value over a period of years, free not only of gift tax but of estate tax as well”); h. r. rep. no. 75-1860, at 61 (1938) (“in view of the frequency with which donors are induced by the exemption to build up estates of considerable size for the members of their families, the present amount of the exemption is regarded as unreasonably large.”). the annual exclusion remained $3,000 until 1982. in 1982, the exclusion was increased to $10,000 per year. bittker, supra note 32, at 447; pub. l. no. 97-34, § 441(a), 95 stat. 172, 319 (1981). the taxpayer relief act of 1997 indexed the annual exclusion for inflation, beginning after calendar year 1998 . irc § 2503(b)(2); pub . l. no . 105-34, § 501(c) 111 stat. 845 (1997). for calendar year 2002, the exclusion is $11,000 per year. rev. proc. 2001-59, 2001-52 i.r.b. 623. although the exclusion is, in nominal terms, larger than it has ever been, it has been more substantial. for example, the $5,000 annual exclusion enacted in 1932 is equivalent to $65,789 in 2002 dollars. <<http://www.cjr.org/resources/inflater.asp>>; revenue act of 1932 , ch. 209 § 504, 47 stat. 247 (1932). 34. h.r. rep. no. 772-708, at 29 (1932) (“[the annual exclusion] on the one hand, is to obviate the necessity of keeping an account of and reporting numerous small gifts, and, on the other, to fix the amount sufficiently large to cover in most cases wedding and christmas gifts and occasion gifts of relatively small amounts.”); see also s. rep. no. 72-665, at 41 (1932). arguably, the annual exclusion far exceeds the “relatively small amounts” discussed by the house and senate. see pedrick, supra note 19, at 951. 35. h.r. rep. no. 77-2333 (1942) (“under existing law, the first $4,000 in value of gifts to any person during the year is not counted in the total of net gifts subject to tax. . . while administrative difficulties prevent the abolition of the exclusion, your committee recommend [sic] that it be reduced to $3,000.”). the exclusion was reduced to $3,000 in 1942 revenue act of 1942 ch. 619, § 454 , 56 stat. 798 953 (1942). 36. kent d. schenkel, will a crummey beneficial interest qualify for an annual gift tax exclusion 1997, tax adviser, 378; scott h. malin, crummey withdrawal rights: watch your step, probate & property, mar./apr. 1996, at 52. the annual exclusion was intended as a rule of administrative convenience. it was meant to exempt gifts of “relatively small amounts” from taxation and the concomitant record-keeping requirements.34 indeed, in 1942 the house of representatives noted that only “administrative difficulties” prevented complete elimination of the annual exclusion.35 despite the original purpose of the annual exclusion, it has grown into a significant estate planning tool.36 indeed, donors frequently make use of the 2003] back to the fu ture interest 199 37. crummey powers are not the only means for making annual exclusion gifts in trust. for example, gifts to a minor in a trust that meets the requirements of section 2503(c) of the code may be fully offset by the annual exclusion. irc § 2503(c). such trusts are, however, substantially less flexible than trusts using crummey powers. 38. robert b. smith, should we give away the annual exclusion? 1 fla. tax. rev. 361 , 383 (1993); boris j. bittker, et. al., federal estate and g ift taxation 161 (7th ed. 1996); david c. johnson, the 1997 federal estate, gift and trust tax changes, 22 s. ill. u. l.j . 27, 37 (1997); peter c. m axfield, troublesome trust powers under section 2503(b), 47 t axes, at 457, 484 (1969). the routine occasion gifts made by the donor are disregarded with impunity due to some combination of the difficulty the irs would have in tracking small gifts and the average layperson’s understanding that such gifts are beyond the scope of the federal gift tax. smith, supra, at 394-95; see also johnson, supra, at 37 n.29. 39. irc § 2503(b)(1). “in the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of such gifts to such person shall not, for purposes of [the gift tax] be included in the total amount of gifts made during such year.” (emphasis added). id. 40. regs. § 25.2503-3(a). 41. h. r. rep. no. 72-708, (1932) (“the exemption does not apply with respect to a gift to any donee to whom is given a ‘future interest’. the term ‘future interests in property’ refers to any interest or estate, whether vested or contingent, limited to commence in possession or enjoyment at a future date.”). 42. commissioner v. disston, 325 u.s. 442, 446 (1945). 43. fondren v. commissioner, 324 u.s. 18, 20 (1945) (“under these decisions it is not enough to bring the exclusion into force that the donee has vested rights. in addition he must have the right presently to use, possess or enjoy the property.”). full annual exclusion, often through the use of crummey powers,37 without considering the occasion gifts made by the donor to the donee.38 the code expressly provides that the annual exclusion is not available for gifts of “future interests.”39 the code does not, however, define the term. the treasury department regulations provide a definition: “‘future interest’ is a legal term, and includes reversions, remainders, and other interests or estates, whether a vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time.”40 the regulation is similar to the definition of “future interest” in the congressional committee reports41 and has been approved by the united states supreme court.42 based on this definition, the annual exclusion is available only if the donee receives immediate enjoyment of property.43 even a short 200 florida tax review [vol.6:2 44. id. at 26; hessenbruch v. commissioner, 178 f.2d 785, 787 (3d cir. 1950). 45. 324 u .s. 18 (1945). 46. id . with respect to gifts in trust, the united states supreme court decided early in the history of the annual exclusion that the crucial inquiry was whether the beneficiary(ies) of the trust, received a present interest in the gifted property. helvering v. hutchings, 312 u.s. 393, 396-67 (1941); ryerson v. united states, 312 u.s. 405, 408 (1941). in contrast, earlier cases held that the key inquiry was whether the trustee received a present interest, regardless of the beneficiary’s interest in the trust. commissioner v. krebs, 90 f.2d 880, 881 (3d cir. 1937) (noting that the trustees received a present interest). 47. fondren, 324 u.s. at 22-24. “in view of the apparently conflicting terms of [the trust agreement] for use of the corpus, the scope of the trustee’s discretion is by no means clear. . . whether the disposition is in [the trustee’s] judgment entirely, as the first clause indicates, or under the second is only with reference to how much of the fund may be needed, the trustee cannot act in any case to apply corpus or income for the support, maintenance and education of the beneficiary until necessity arises.” id. 48. id. at 23 . in fact, the trust agreement noted that distribution to the beneficiaries during minority were unlikely. id. 49. id. at 20. “it is not enough to bring the exclusion into force that the donee has vested rights. . . [t]hese terms are not words of art, like “fee” in the law of seizin, . . .”). 50. in a “discretionary trust” the trustee may, but is not required to, make distribution of income or principal to the beneficiary. restatement (second) of trusts § 155; black’s law dictionary 1515 (7th ed. 1999). 51. fondren, 324 u .s. at 24 . delay in a beneficiary’s enjoyment is sufficient to render the gift a future interest.44 fondren v. commissioner, decided by the united states supreme court in 1945, is illustrative of the metes and bounds of the future interest exception.45 in fondren, the court addressed several trusts created by the taxpayer for the benefit of her minor grandchildren.46 the trustee had the power to use trust principal or income for the beneficiary, if a necessity arose.47 the court noted that the beneficiaries’ parents were sufficiently wealthy so that such a need seemed unlikely.48 the court held that a beneficiary has a future interest unless he has a “substantial present economic benefit” in the gift.49 since the trust at issue was a discretionary trust,50 the court held that the beneficiary’s right was not “absolute and immediate;” thus, the exclusions were denied.51 a few months 2003] back to the fu ture interest 201 52. commissioner v. disston, 325 u.s. 442 , 449 (1945); see also prejean v. commissioner, 345 f.2d 995, 996 (5th cir. 1966). cf. morgan v. commissioner, 42 t.c. 1080, 1089 (1964). 53. fondren, 324 u.s. at 21 (“if the income of a trust is required to be distributed periodically, as annually, but the distribution of the corpus is deferred, the gift of the income is one of a present interest, that of the corpus is one in futuro.”); see also regs. § 25.2503-3(b). the term present interest, although not used in the internal revenue code, is used extensively in the treasury department regulations. see, e.g., regs. § 25.25033(b). a present interest is, rather obviously, an interest that is not a future interest. id. 54. regs. § 25.2503-3(b). only the beneficiary’s income interest would be a present interest. thus, only that portion is offset by the annual exclusion. 55. see, e.g., hessenbruch v. commissioner, 178 f.2d 785, 787(3d cir. 1950); see also united states v. pelzer, 312 u.s. 399 , 403-04 (1941). 56. charles v. hassett, 43 f. supp. 432 , 434 (d. mass. 1942) (noting that a “layman” would be surprised to learn what constitutes a future interest as compared to what constitutes a present interest for purposes of the annual exclusion). 57. regs. § 25.2503-3 . 58. for example, a well planned gift in trust can yield an income tax savings. see generally irc §§ 551, 552, 661, 662. in addition, assets held in a spendthrift trust are not generally subject to claims by beneficiaries’ creditors. erwin n. griswold, spendthrift trusts § 1 (2d ed. 1947); restatement (third) of trusts § 58 (tentative draft no. 2, 1999). 59. for example, by making the gift in trust, the donor can designate a trustee to manage the property for the benefit of the minor. further, donors are frequently concerned that the gift would be squandered if the donee received unfettered access to it at a young age. through a trust, the donor can delay a minor donee’s unfettered access to the gift. congress was concerned that it was unclear how annual exclusion gifts could be made to minors. thus, in 1954, it enacted section 2503(c) of the internal revenue after fondren, the united states supreme court reaffirmed its holding that, as a general rule, no annual exclusion would be allowed for gifts to a discretionary trust.52 the fondren court noted, in dicta, that if the beneficiary was entitled to periodic payment of trust income, then the gift of the income would be a present interest.53 the gift of the corpus, however, would be a future interest. thus, for example, a gift in trust that required trust income be regularly paid to the beneficiary would be partially a gift of a present interest, regardless of when (or if) trust principal was to be paid.54 in contrast, a gift to a discretionary trust is entirely a future interest, even if trust principal was required to be paid to the beneficiary shortly after the gift.55 in this regard, the future/present interest distinction is somewhat counter-intuitive.56 thus, a typical gift in trust is at least partially a future interest.57 donors, however, frequently prefer to make gifts in trust (as opposed to outright) for a variety of tax and non-tax reasons.58 this is especially true if the beneficiary is a minor.59 therefore, donors sought a method of making gifts in 202 florida tax review [vol.6:2 code to permit gifts to certain discretionary trusts for the benefit of minors to qualify for the federal gift tax annual exclusion. irc § 2503(c) (1954); s. rep. no. 83-1622, at 127, 83rd cong., 2d sess. at 4760 (1954); see also estate of levine v. commissioner, 526 f.2d 717 , 719 (2nd cir. 1975). such trusts are frequently called “2503(c) trusts.” one of the requirements for a trust to qualify as a 2503(c) trust, is that trust assets must be distributed to the beneficiary upon her attaining age twenty-one. irc § 2503(c)(3). although there are some methods available to ameliorate the risk that the young beneficiary will squander the assets, the risk remains significant and, in many donors’ opinion, unacceptable. see, e.g., rev. rul. 74-43, 1974-1 c.b. 285. thus, many donors are not satisfied with 2503(c) trusts as a means to make annual exclusion gifts to minors. 60. 397 f.2d 82 (9th cir. 1968). 61. an earlier case, strekalovsky v. delaney, involved a trust containing a demand clause created for the benefit of a minor. 78 f. supp. 556 (d. mass. 1948). although the court allowed the annual exclusions claimed by the taxpayer, it did not base its decision on the demand clause. id. at 558. instead, the court held that, since the trust agreement provided that the trustee had d iscretion to make distributions to the child “as if” the trustee were a guardian, the minor beneficiary received a present interest. id. at 557; see also united states v. baker, 236 f.2d 317, 320 (4th cir. 1956); kieckhefer v. commissioner, 15 t.c. 111 (1950), rev’d, 189 f.2d 118 (1951) (noting that strekalovsky was not on point due to the provisions of the trust). 62. 189 f .2d 118 (7th cir. 1951). 63. id. at 119. 64. id . 65. id.; see also fondren v. commissioner, 324 u.s. 19, 21; commissioner v. disston, 325 u.s. 442, 448-49 (1945). trust that fully qualified for the annual exclusion. one such method – the use of withdrawal powers to create a present interest – led to the ninth circuit’s decision in crummey v. commissioner60 in 1968. iii. the origin s and use o f crummey powers a. crummey v. commissioner and its precedents the first reported case to address the availability of the federal gift tax annual exclusion based on a withdrawal power61 was kieckhefer v. commissioner.62 it was decided by the seventh circuit in 1951. in kieckhefer, the donor created a trust for the benefit of his minor grandchild.63 the trust was a discretionary trust; that is, the trustee had discretion to use income or principal for the beneficiary “as may be necessary for [his] education, comfort and support. . .”64 thus, gifts to the trust would not, in and of themselves, qualify for the federal gift tax annual exclusion.65 however, the trust agreement also gave the beneficiary, or his “legally appointed guardian,” the right to 2003] back to the fu ture interest 203 66. kieckhefer, 189 f.2d at 120. 67. brief for respondent commissioner at 10, kieckhefer, (no. 10301). (“[i]t should be noted that [the demand] provision was inserted merely in an attempt to convert an obvious ‘future interest’ . . . into a seeming ‘present interest.’ if the money had been given directly to the donee-child, then a guardian would have been required, with the concomitant incidental expenses and nuisance requirements. the taxpayer wished to avoid this. hence, the trust involved here was established.”). it is unclear why the irs made this point in it’s brief. the service may have been trying to argue that the donor did not intend to create a present interest and, thus no exclusion should be allowed. the donor’s intent is, however, largely irre levant. fondren, 324 u.s. at 28. moreover, the difficulty in making an annual exclusion gift to a minor, alluded to by the irs, was a central reason that the seventh circuit decided to allow the claimed exclusions. brief for respondent commissioner at 10, kieckhefer (no. 10301); kieckhefer, 189 f.2d at 121. in 1954, congress enacted section 2503(c), which facilitates making annual exclusion gifts to minors in trust. see supra notes 37, 59 . the trust in keichkhefer would have qualified as a “2503(c) trust,” had that section been enacted at that time. kieckhefer, 189 f.2d at 119; irc § 2503(c). 68. brief for respondent commissioner at 6, 10, kieckhefer , (no. 10301); kieckhefer, 189 f.2d at 119; fondren, 324 u.s. at 21; disston, 325 u.s. at 448-49; see also kieckhefer, 15 t.c. 111, 114 (1950), rev’d, 189 f.2d 119 (“but for . . .[the demand clause] this case could be resolved for the [irs] without further discussion under the authority of fondren v. commissioner.”). 69. kieckhefer, 189 f.2d at 121. 70. id. at 120-21. the tax court denied the exclusions sought by the taxpayer based on its conclusion that the minor beneficiary could not make an effective demand. kieckhefer, 15 t.c. at 116, rev’d, 189 f.2d 118. the tax court no ted that even if the minor’s parents sought the appointment of a guardian for the purposes of exercising the demand power, it is unclear whether a court would appoint a guardian for that purpose. id. in contrast, in its brief the taxpayer argued that the beneficiary could make an effective terminate the trust and demand distribution of the trust assets.66 the taxpayer claimed that this demand right made gifts to the trust present interests. indeed, the sole purpose behind the demand power was to obtain the federal gift tax annual exclusion for gifts made to the trust.67 the irs’s argument in kieckhefer was quite straightforward. the service reasoned that, as a minor, the beneficiary could not make an effective demand. moreover, although the trust agreement expressly allowed a “legally appointed guardian” to make a demand on behalf of the beneficiary, no such guardian had been appointed. therefore, the service reasoned, the demand clause was meaningless. absent the demand clause, the trust in kieckhefer was a routine discretionary trust, gifts to which are future interests.68 the court held that the gifts were present interests that qualified for the federal gift tax annual exclusion.69 the court agreed with the irs that the minor beneficiary could not exercise the demand power.70 unlike the irs, however, 204 florida tax review [vol.6:2 demand. brief for petitioner taxpayer at 5, kieckhefer, (no. 10301) “the court may not rewrite the trust agreement by holding a minor beneficiary is incapable of making an effective demand for the trust estate, where the trust agreement expressly grants the beneficiary that right.” 71. kieckhefer, 189 f.2d at 121. “the commissioner’s reasoning reduces to a myth his concession that ‘gifts to minor beneficiaries are placed on an equality with gifts to adults’. . . [n]o illustration is given as to how a gift of a ‘present interest’ could be made to minor of tender years.” 72. id. at 122 [t]he fallaciousness of the commissioner’s contention is the failure to distinguish between restrictions and contingencies imposed by the donor (in this case the trust instrument), and such restrictions and contingencies as are due to disabilities always incident to and associated with minors and other incompetents. as to the former, it is authoritatively settled that a gift upon which the donor imposes such conditions are restrictions is a future interest. in the latter, such restrictions as exist are imposed by law due to the fact that the beneficiary is incapable of acting on his own. in our view, and we so hold, such restrictions could not transform what otherwise would be a gift of present interest to one of future interest. id. 73. brief for petitioner taxpayer at 4-6, 8-13, kieckhefer, (no. 10301). 74. see generally brief for respondent commissioner, kieckhefer, (no. 10301). the irs did attempt to distinguish the case relied on by the taxpayer for this point. id. at 13 (citing strekalovsky v. delaney, 78 f.supp 556 (d. mass 1948)). see also brief for petitioner taxpayer at 4, 6, kieckhefer, 189 f.2d 118 (no. 10301). the service’s argument was, however, largely based on its main point that the demand power in kieckhefer was an “empty sham” due to the minority of the beneficiary. brief for respondent commissioner at 13, kieckhefer, (no. 10301). 75. brief for petitioner taxpayer at 4, kieckhefer, (no. 10301). the court did not find this fact dispositive. the seventh circuit reasoned that the service’s position was untenable because it made it nearly impossible to make an annual exclusion gift to a minor.71 thus, the court concluded (without citation) that restrictions and contingencies caused by the disability of the beneficiary (in this case, minority) are disregarded in determining whether a gift is a present interest.72 this conclusion brought the court to a new issue: whether a demand power held by an adult created a present interest. this issue was discussed at length by the taxpayer in its brief.73 it was not, however, addressed by the irs.74 the taxpayer argued that, disregarding the issue of minority, the beneficiary’s demand power was the “equivalent” of outright ownership.75 the taxpayer 2003] back to the fu ture interest 205 76. id. at 4-5, 7-11. in these cases the courts concluded that the income earned by the trust would be taxed to the beneficiary that held the withdrawal power. see infra notes 211-12 and accompanying text. 77. kieckhefer, 118 f.2d at 121 (“suppose in the instant situation that the beneficiary had been an adult rather than a minor. such adult, of course, could immediately have made a demand upon the trustee and have received the trust property. we suppose that such a gift unquestionably would be one of a ‘present interest.’”); see also stifel v. commissioner, 197 f.2d 107, 110 (2d cir. 1952). as discussed infra, the kieckhefer court’s statement regarding a withdrawal power held by an adult is incorrect. see infra notes 181-210 and accompanying text. further, the court’s juxtaposition of the terms “suppose” and “unquestionably” seems to be an oxymoron. see, webster’s third new international dictionary 2298, 2507 (3d ed. 1971), compare definition of “suppose” as “to accept tentatively as true or real” or “to assume as true for the sake of argument,” with definition of “unquestionable” as “acknowledged as beyond question or doubt” or “indisputable.” 78. see supra note 72 and accompanying text. 79. kieckhefer, 189 f.2d at 122. 80. gilmore v. commissioner, 213 f.2d 520, 522 (6th cir. 1954). in gilmore, the taxpayer created seven trusts – one for the benefit of each of his minor grandchildren. id. at 520. t he trust agreements were largely identical. id. each trust contained a provision that gave the beneficiary the power to terminate the trust and demand distribution of the trust assets. id. the sixth circuit largely adopted the reasoning of kieckhefer and allowed the claimed annual exclusions. id. at 522-23 (citing, kieckhefer, 189 f.2d 118). although the tax court in gilmore denied the annual exclusions claimed by the taxpayer, its decision was partially based on its conclusion that the agreement did not give the beneficiaries withdrawal powers. gilmore v. commissioner, 20 t.c. 579, 583-84 (1953), rev’d, 213 f.2d 520. the sixth circuit disagreed and held that the trust agreement gave the beneficiaries enforceable withdrawal powers. 213 f.2d at 523. relied on cases regarding the income taxation of trusts with demand provisions.76 the kieckhefer court did not mention the taxpayer’s argument or cite the suggested cases. instead, the court “suppos[ed]” that the gift would “unquestionably” be a present interest, if the beneficiary were an adult.77 thus, the court concluded that a withdrawal power held by an adult created a present interest. further, as previously noted, the court also held that the legal disability of a minor would, for purposes of determining the availability of the annual exclusion, be ignored.78 thus, the kieckhefer court allowed the annual exclusions claimed by the taxpayer.79 three years after kieckhefer, the sixth circuit adopted the kieckhefer court’s holding in a similar case.80 moreover, in a case that did not directly involve withdrawal powers, the fourth circuit also adopted the reasoning of the 206 florida tax review [vol.6:2 81. baker v. commissioner, 236 f.2d 317 (4th cir. 1956). the taxpayer in baker created a trust in which the trustee was directed to use trust assets for the benefit of the minor beneficiary “as if” the trustee were the beneficiary’s guardian. id. at 319. the baker court allowed the annual exclusions since the beneficiary received rights that were essentially equivalent to the rights the beneficiary would receive if the gift was actually made to a guardian. id. at 320. the baker court specifically endorsed kieckhefer. id. at 320 (citing, kieckhefer, 189 f.2d 118). 82. 197 f.2d 107 (2d cir. 1952). 83. id. at 110 (citing, kieckhefer, 189 f.2d 118) (noting that kieckhefer “under-estimates the traditional judicial knack of line drawing.”). 84. both stifel and kieckhefer involved gifts to a trust that contained a provision granting the minor beneficiary’s guardian the power to terminate the trust and demand the trust assets. the trust in kieckhefer provided that the demand power could be exercised by the beneficiary or “the legally appointed guardian for his estate.” 118 f.2d at 120. in stifel, the demand power could be exercised by the beneficiary’s general guardian, if any, or by any special guardian appointed for such purpose by a court. 197 f.2d at 109. 85. stifel, 197 f.2d at 110 (noting that if the court “irrevocably lock[ed] itself inside the ‘four corners’ of the [trust agreement] a donor could make gifts which on paper were 100% present but in practice were 100% future.”). 86. id. at 110. 87. id. 88. id. 89. 397 f.2d 82 (9th cir. 1968). 90. id. at 83. 91. id. at 82. the gifts were made in 1962 and 1963. crummey, 397 f.2d at 8283. one of the beneficiaries, janet sheldon crummey, attained age twenty-one during 1963. crummey, 25 t.c. memo (cch) 772, t.c. memo (ria) 66144 (1966), rev’d, crummey, 397 f.2d 82. the irs originally denied the annual exclusions claimed based on janet sheldon crummey’s withdrawal powers. id. in the tax court, however, the service conceded that the taxpayers were entitled to an exclusion based on janet seventh circuit in kieckhefer.81 in contrast, in stifel v. commissioner82 the second circuit rejected kieckhefer.83 the facts of stifel are quite similar to the facts of kieckhefer.84 in stifel, however, the court held that it was necessary to consider the surrounding circumstances in determining whether the gift was a present interest.85 the court noted that the minors could not by themselves make an effective demand and that no guardian had been appointed.86 thus, the stifel court concluded that gifts to the trust were future interests and the annual exclusions were denied.87 in dicta, however, the court noted that the claimed exclusions would have been allowed if the beneficiaries were adults.88 against this backdrop, the ninth circuit decided crummey.89 the taxpayer in crummey created four different trusts -one for the benefit of each of her children. each trust contained a demand provision that allowed the beneficiary, or the beneficiary’s guardian, to withdraw any gift made to the trust.90 two of the four beneficiaries were adults and two were minors.91 the 2003] back to the fu ture interest 207 sheldon crummey’s withdrawal power for 1963 since she attained age twenty-one during that year. id.; see also brief for respondent commissioner at 26-29, crummey (no. 21607). with respect to 1962, the irs attempted to deny the exclusion since janet sheldon crummey, although over age eighteen, was still a minor under age twenty-one. brief for respondent commissioner at 26-29, crummey (no. 21607). 92. crummey, 25 t.c. memo (cch) at 772, t.c. mem o (ria) rev’d, crummey, 397 f .2d 82 (“no question is raised as to the right of the adult beneficiary, john knowles crummey, to make an effective demand . . . his right was secure and he therefore received a ‘present interest.’”). 93. crummey, 25 t.c. memo (cch) at 772, t.c. memo (ria) at rev’d, 397 f.2d 82. 94. brief for respondent commissioner, crummey (no. 21607); gopman, supra note 27, at 200. 95. the withdrawal powers in crummey lapsed at the end of the calendar year in which the gift to the trust was made. crummey, 397 f.2d at 83-84. since some of the gifts were made to the trust in late december, the beneficiaries had a short time to exercise the withdrawal power. id. at 83; see also kieckhefer v. commissioner, 189 f.2d at 120; gilmore, 213 f.2d 520, 520-21 (6th cir. 1954); stifel v. commissioner, 197 f.2d 107, 109 (2d cir. 1952); perkins v. commissioner, 27 t.c. 601, 602 (1956). 96. see, e.g., united states v. baker, 236 f.2d 317, 321 (4th cir. 1956) (noting that the gifts made by the taxpayers were “equivalent to outright gifts”); see also infra note 189. 97. fondren v. commissioner, 324 u.s. 18, 24 (1945) (holding that a donee received a present interest only if her right was “absolute and immediate”). 98. if the withdrawal power does not lapse, then the property that could have been withdrawn will be included in the power-holder’s gross estate upon his death. irc § 2041. further, non-lapsing crummey powers cannot be efficiently given to individuals who do not have significant interests in the trusts. thus, without lapsing crummey powers it would be impossible to obtain multiple annual exclusions through the use of “naked” crummey powers. see supra note 21. in addition, non-lapsing withdrawal powers reduce donor’s ability to control assets subsequent to the gift; thus, they are less attractive to many donors. see infra note 116. service allowed the exclusions derived from the withdrawal powers held by the adult beneficiaries.92 the irs and the tax court denied the annual exclusions allocable to the withdrawal powers held by the minor beneficiaries.93 although not noted by the crummey court or the irs in its brief, crummey involved an innovative estate planning technique that was not presented in the earlier cases.94 specifically, the withdrawal powers in crummey lapsed.95 it seems that the power-holder’s interest is closest to outright ownership, and thus more likely a present interest,96 if the withdrawal power does not lapse. moreover, a non-lapsing withdrawal power is a more “absolute” right than a lapsing power; thus, the argument that it is a present interest is stronger.97 from an estate planning point of view, however, a lapsing withdrawal power is significantly more useful than a non-lapsing power.98 208 florida tax review [vol.6:2 non-lapsing withdrawal powers are so limited that some legislative proposals to eliminate the use of crummey powers have addressed only lapsing withdrawal powers. see supra note 28. 99. crummey, 397 f.2d at 85; brief for respondent commissioner at 10-12, crummey (no. 21607). 100. stifel held the court must consider the “surrounding circumstances” in determining whether a gift is a present interest. 197 f.2d 107, 110 (2d cir. 1952); see supra notes 82-88 and accompanying text. stifel did not explicitly state that the relevant consideration was whether it was likely that the withdrawal power would be exercised. however, the crummey court summarized stifel as holding that it created a likelihood test. crummey, 397 f .2d at 85. as we read the stifel case, it says that the court should look at the trust instrument, the law as to minors, and the financial and other circumstances of the parties. from this examination it is up to the court to determine whether it is likely that the minor beneficiary is to receive any present enjoyment of property. id. 101. crummey, 397 f.2d at 86-88. 102. id. at 86. curiously, in an action on decision released a few years after crummey, the service incorrectly stated that crummey adopted the holding of kieckhefer. crummey, 397 f.2d, action on dec., 1966-144, 1992 wl 32868 (jan. 14, 1972). in fact, crummey expressly rejected kieckhefer, although it reached the same conclusion. crummey, 397 f.2d at 86. 103. crummey, 397 f.2d at 86-88 (citing perkins v. commissioner, 27 t.c. 601 , 606 (1956). in perkins, the minor beneficiaries of a trust (or their guardians) had the power to withdraw funds from the trust at any time – the withdrawal powers did not lapse. 27 t.c. at 606. the perkins court allowed the annual exclusions since the power was legally enforceable. id. at 604-05. the irs proposed that the court determine whether the minors’ interest in the trust was a present interest based on whether it was “likely” that the minor would exercise the withdrawal power.99 the likelihood test urged by the irs was based on the second circuit’s decision in stifel.100 crummey expressly rejected the likelihood test.101 the crummey court also declined to adopt the seventh circuit’s reasoning in kieckhefer.102 instead, crummey adopted the reasoning of perkins v. commissioner, which was decided by the tax court in 1956.103 based on perkins, crummey held that a valid and enforceable demand power is a present interest, regardless of the likelihood that the power-holder would exercise the 2003] back to the fu ture interest 209 104. crummey, 397 f.2d at 88 (noting that was “unlikely that any demand ever would have been made” but allowing the annual exclusions); perkins, 27 t.c. at 606 (allowing the annual exclusions even though it was “unlikely” that the withdrawal powers would be exercised). of course, both perkins and kieckhefer allowed the exclusions claimed by the taxpayer. kieckhefer, 189 f.2d at 121; perkins, 27 t.c. at 605. thus, it is unclear whether the distinction between the two cases made by the crummey court has any practical relevance. however, the perkins and kieckhefer courts employed different analyses to reach their conclusions. these differences could be significant in other contexts. 105. crummey, 397 f.2d at 87 (“[a]s a technical matter, we think a minor could make the demand. . . . all exclusions should be allowed under the perkins test . . . under perkins, all that is necessary is to find that the demand could not be [legally] resisted.”). 106. crummey, 397 f.2d 82, action on dec., 1966-144, 1972 w l 32868 (jan. 14, 1972). shortly after crummey was decided, the chief counsel’s office recommended that the irs not file a petition for writ of certiorari due to the service’s other losses on the issue. crummey, 397 f.2d 82, action on dec., 1968 w l 16563 (aug. 19, 1968). in fact, the service did not seek certiorari in any of kieckhefer, gilmore, baker or crummey. 107. crummey, 397 f.2d 82, action on dec., 1966-144, 1972 w l 32868 (jan. 14, 1972) (“[f]our circuits have adopted a position contrary to that of [the irs]. . . [f]urther litigation of this issue is unwarranted.”). the four circuits referred to are the fourth, sixth, seventh and ninth. id.; united states v. baker, 236 f.2d 317 (4th. cir. 1956); gilmore v. commissioner, 213 f.2d 520 (6th cir. 1954); kieckhefer v. commissioner, 189 f.2d 118 (7th cir. 1951); crummey v. commissioner, 397 f.2d 82 (9th cir. 1968). 108. rev. rul. 73-405, 1973-2 c.b. 321. since all taxpayers may rely on revenue rulings, issuance of the ruling established that crummey powers may be safely used. regs. § 601.601(e). cf. dixon v. united states, 381 u.s. 68, 72-3 (1965). although the revenue ruling only d iscusses withdrawal powers held by minor beneficiaries, the irs has never disallowed annual exclusions based on withdrawal powers held by adults. see supra notes 61-74 and accompanying text. power.104 based on this analysis, the crummey court allowed all of the annual exclusions claimed by the taxpayer.105 in 1972, approximately four years after crummey, the irs’s chief counsel recommended that the service acquiesce in crummey.106 the chief counsel noted that four circuits had adopted a position contrary to the irs’s position in crummey.107 in 1973, the irs issued a revenue ruling embracing the holding of crummey.108 by giving a green light to the use of crummey powers, the irs 210 florida tax review [vol.6:2 109. of course, this statement assumes that all crummey powers are abusive. as discussed in more detail below, this assumption is not unintentional. see infra notes 19, 155-80 and accompanying text. 110. although it is not necessary that beneficiaries have equal withdrawal powers, crummey power provisions are frequently drafted so that the beneficiaries’ powers are equal. 111. crummey, 397 f.2d 82, 88 (9th cir. 19968); estate of holland v. commissioner, 73 t.c. memo (cch) 3236, 3237-9 (1997). thus, for example, under § 2503(b), if five individuals hold withdrawal powers, the donor may transfer $55,000 to the trust free of federal gift tax. if the donor is married and the spouse consents to split the gift, then the donor could transfer twice as much ($110,000) to the trust. see irc § 2513. 112. richard s. rothberg, crummey powers enhance the usefulness of trusts for minors and life insurance trusts, is estate planning 322, 323-24, (1988); slade, supra note 20, at a-9. the service’s rulings make clear its belief that a crummey power must remain outstanding for at least thirty days, although no ruling directly addresses this issue. mason, supra note 21, at 579-80; malcolm moore, tax consequences and uses of crummey withdrawal powers: an update, philip e. heckerling 22 miami inst. on est. plan. ¶ 1101.1, at 11-9 (1988); rothberg, supra note 112, at 323; see, e.g., priv. ltr. rul. 92-23-013, priv. ltr. rul. 90-30-005 (apr. 19, 1990); priv. ltr. rul. 91-31-008 (ruling that a 20 day period too severely restricted the power-holders rights). cf. priv. ltr. rul. 81-11-123 (dec. 19, 1980) (exclusion allowed even though power lapsed 10 days after gift); priv. ltr. rul. 79-22-107 (3 days). this requirement seems intuitively reasonable. although it is possible to quibble regarding the minimum number of days, it seems beyond cavil that the beneficiary must have a meaningful opportunity to exercise her legally enforceable withdrawal power. crummey, 397 f.2d at 88; estate of holland, 73 t.c. memo (cch) at 3237-10. a withdrawal power that remains outstanding for a short period of time, even if legally enforceable, does not provide the beneficiary with such a meaningful opportunity. encouraged creative attorneys to develop techniques that are more abusive109 than the withdrawal powers addressed in crummey v. commissioner. b. the modern crummey power from their innocuous beginnings in crummey v. commissioner, crummey powers have evolved into an incredibly powerful estate planning technique. their use, however, is subject to several technical requirements that the irs has imposed through public and private rulings. although these technical requirements increase the administrative burden of using crummey powers, they do little to reduce their benefit or use. in practice, crummey powers operate simply. after the donor makes a gift to the trust, each of the relevant power-holders is given a right to withdraw an aliquot110 portion of the gift. to the extent the gift is subject to legally enforceable withdrawal powers, the donor may take advantage of the annual exclusion.111 shortly (frequently thirty days) after the gift is made to the trust, the withdrawal powers lapse.112 2003] back to the fu ture interest 211 although no court has directly addressed the amount of time a crummey power must remain outstanding, courts have allowed annual exclusions based on crummey powers that lapsed after less than thirty days. see, e.g. , estate of cristofani v. commissioner, 97 t.c. 74, 78 (1991). indeed, in crummey the beneficiaries had only a few days to exercise their withdrawal powers. see crummey, 397 f.2d at 83. 113. when unconstrained by tax considerations, donors frequently make gifts (including testamentary gifts) to be held in trust until the beneficiary attains age thirtyfive or forty. jerome a. manning, et. al., manning on estate planning, at 4-8 (practicing law institute, 5th ed. 1998). 114. if trust assets are ever paid to the donor’s grandchildren (or other “skip persons”) then the transfer may be subject to the federal generation skipping transfer tax. see irc §§ 2611, 2612, 2613. although annual exclusion gifts are generally exempt from the generation-skipping transfer tax, special rules apply if the annual exclusion is obtained through the use of crummey powers. see irc § 2642(c); see also infra notes 256-57 and accompanying text. 115. the term “dead hand” is used to refer to individuals’ desire to contro l their assets, and thereby the beneficiaries, after death. see michael w. mcconnell, textualism and the dead hand of the past, 66 geo. wash. l. rev. 1127, 1127 (1998); webster’s third new international dictionary 579 (3d ed. 1971) (defining “dead hand” as “the influence, especially when felt to be oppressive, of the dead on the living”). 116. francis m. nevins, jr., testamentary conditions: the principle of uncertainty and religion, 18 st. louis u. l.j. 563, 563 (1974). 117. crummey, 397 f.2d at 87-88; see also john l. peschel, major recent tax developments in estate planning, u.s.c. law center t ax inst. ¶ 1400 , 1401.2 (“prudent practitioners have been troubled by the . . . casual approach to the notice and time factors in crummey”). more recently, in holland the court suggested that whether the power-holder was aware of their withdrawal right is irrelevant. estate of holland, 73 t.c. memo (cch) 3237-10. 118. rev. rul. 81-7, 1981-1 c.b. 474. 119. see, e.g., burke a. christensen, obtaining the annual exclusion for gifts, trusts & estates, may 1998, at 72; beverly j. greenley, the deductible interest expense of the not-so-crummey “crummey trust”, the tax adviser, august 1983, at 459, 460. once the crummey powers lapse, the gifts remain in the trust and are administered according to the trust terms. thus, for example, the trust could continue until the beneficiary reaches what the donor feels is a suitable age113 or even for the beneficiary’s entire life.114 the donor could also arrange the trust to encourage or discourage certain behavior by the beneficiaries. the power to exercise such “dead hand”115 control is frequently quite attractive to donors.116 although the crummey court specifically noted that the beneficiaries were unaware of their withdrawal rights,117 the irs has ruled that the beneficiaries must know of their right.118 as a practical matter, most attorneys recommend sending power-holders notice, called “crummey notices,” of the withdrawal power.119 crummey notices are generally drafted in language that 212 florida tax review [vol.6:2 the irs has privately ruled that, in the case of a minor power-holder, the crummey notice should be sent to an individual who has the right to exercise the withdrawal power on behalf of the minor beneficiary. priv. lt. rul. 81-43-045 (july 29, 1981). if the trustee of the trust is also a power-holder, the service does not require that the trustee send a crummey notice to herself. tech. adv. mem. 95-32-001 apr. 12, 1995). this is consistent with the idea that a beneficiary must have actual notice of her withdrawal power, rather than necessarily receive a crummey notice. estate of holland, 73 t.c. memo at 3237-10. 120. see, e.g., edward f. koren, estate and personal financial planning, 1 est. pers. fin. plan § 8.22 (2002); joint exhibits 21-u, 21-v, estate of kohlsaat v. commissioner, 73 t.c. memo (cch) 2732 (1997). delivery of crummey no tices is similarly excessively formal. for example, in kohlsaat, one of the trustees, peter kohlsaat, mailed a crummey notice to his wife of forty years at the marital home. joint exhibit 21-u, estate of kohlsaat, 73 t.c. memo (cch) at 2732 (no. 22465-94); trial transcript at 88, 101-02, estate of kohlsaat, 73 t.c. memo (cch) at 2732. peter kohlsaat also sent a crummey notice to himself. joint exhibit 22-v, estate of kohlsaat, 73 t.c. memo (cch) at 2732. 121. suppose, for example, that a daughter receives a crummey notice from the trustee of a trust created by her mother. due to the highly formal language and delivery of the notice, the daughter will likely realize that the notice (and the right) is merely a technicality. rothberg, supra note 112 , at 322-23; see also smith, supra note 38, at 390. if the donor wanted the beneficiary to receive the assets outright, she would not have gone through the effort of creating the trust, making the gift to the trust, etc. instead, the donor would simply have given the assets directly to the beneficiary. regs. § 25.2503-3(b). presumably, the power-holder will realize this. moreover, if the powerholder asked the donor (o r another party) about the right, the true nature of the withdrawal power would likely be revealed. see, e.g., trial transcript at 35-6, estate of kohlsaat, 73 t.c. memo (cch) at 2732 (noting the trial judge’s skepticism regarding testimony that no conversations between the donor and the power-holders regarding the withdrawal powers took place). even if the parties informally agreed to allow the powers to lapse, it is possible that the exclusions would be allowed. estate of holland, 73 t.c. memo (cch) at 3237-10. cf. fogel, supra note 21, at 613. is sufficiently stilted as to make it apparent that the notice was written by the attorney.120 thus, crummey notices not only notify the power-holder of the existence of the power, they also effectively, albeit silently, communicate that the power is not meant to be exercised.121 even if the power-holder were inclined to exercise the power, he would be unlikely to risk angering the donor 2003] back to the fu ture interest 213 122. smith, supra note 38, at 390; peschel, supra note 19, at ¶ 1401.2; see also jane ann schiltz, life without crummey, sd85 ali-aba 1541, 1551 (1999) (suggesting that trusts include provisions allowing the grantor to exclude beneficiaries who have previously exercised the withdrawal power from future transfers); karpf v. karpf, 481 n.w.2d 891, 894-95 (neb. 1992). 123. david westfall, lapsed powers of withdrawal and the income tax, 39 tax l. rev. 63, 65 (1983); sherman, supra note 5, at 656. 124. irc § 2514(e). since the power-holder can, by exercising the crummey power, appoint the property to himself, he has a general power of appointment, for federal gift tax purposes. irc § 2514. 125. if the power-holder has the right to control trust assets after the lapse of the crummey power, then the lapse will not be a completed gift since the power-holder still has “dominion and control” over the assets. see regs. § 25.2511-2(a); priv. ltr. rul. 85-17-052 (jan. 29, 1985); priv. ltr. rul. 82-29-097. thus, for example, if the power-holder has a power of appointment (even a non-general power of appointment) over the trust assets, then the lapse of the crummey power will not be a completed gift and no adverse gift tax ramifications to the power-holder ensue. 126. if the power-holder is the sole beneficiary, then lapse of a crummey power is not a gift for want of a donee. priv. ltr. rul. 81-42-061 (july 21, 1981). 127. the lapse of a general power of appointment, such as a crummey power, is deemed to be a transfer of property only to the extent that the amount of the lapsed power exceeds the greater of: (i) $5,000 or (ii) five percent of the value of the trust principal from which the power could have been satisfied . irc § 2514(e); regs. § 25.2514-3(c)(4). thus, the lapse of a withdrawal power that does not exceed the “five and five” amount will not be taxed as a gift by the power-holder. irc § 2514(e). indeed, it is a common practice to limit crummey powers accordingly. rothberg, supra note 112, at 324-25; slade, supra note 20, at a-14 – a15. a withdrawal power so limited is frequently called a “five and five” power. rothberg, supra note 112, at 324. if the withdrawal power is limited to the five and five amount, the donor will receive a similarly limited exclusion. since the annual exclusion is currently, $11,000 per year, limiting the power (and thus the exclusion allowed) to the five and five amount potentially wastes a portion of the allowable exclusion. rev. proc. 2001-59, 2001-52 i.r.b. 623. in order to obtain a greater annual exclusion for the donor, a technique called a “hanging crummey power” may be employed. a hanging crummey power by choosing to exercise the withdrawal power.122 indeed, crummey powers are very rarely exercised.123 the lapse of a crummey power is largely irrelevant to the donor from a transfer tax viewpoint. the donor may take advantage of the annual exclusion regardless of whether the power is exercised. the lapse of a crummey power is, however, a potentially significant transfer tax event for the power-holder. when the power lapses, the power-holder is deemed to have made a transfer of the assets he could have withdrawn.124 thus, the power-holder has potentially125 made a taxable gift to the other beneficiaries of the trust, if any.126 there are a variety of techniques to eliminate the adverse gift tax consequences to the power-holder.127 these techniques are, for the most part, quite effective. 214 florida tax review [vol.6:2 allows the power-holder(s) to withdraw the full amount covered by the annual exclusion ($11,000). louis s. harrison, lapse of crummey power need not result in taxable gift if hanging power is used, 17 estate planning 140, 141-43, (1990). the power will only lapse to the extent such lapse is covered by the five and five amount – the remaining portion that could have been withdrawn “hangs” until the next year. id. eventually the five and five amount will, as the trust size increases or when gifts are no longer made to the trust, catch up with the annual exclusion. ano ther possibility is the use of naked crummey powers. specifically, numerous beneficiaries with little or no interest in the trust may be given crummey withdrawal powers. see supra note 21. in this manner, the donor may obtain an almost limitless number of exclusions, although each will be limited to the five and five amount. irc § 2514(e). one particularly novel technique, called a “cascading crummey power” attempts to create a secondary crummey power that will allow the power-holder to take advantage of the annual exclusion in order to offset the gift caused by the lapse of his withdrawal power. see mccaffrey, supra note 22, at 174; blattmacher & slade, supra note 22, at 263-64. thus, through the use of seriatim crummey powers, no individual power-holder ever makes a taxable gift. the legislative purpose of the five and five exclusion was to allow a donor to give the income beneficiary of a trust an additional right to receive funds from the trust. s. rep. no. 82-382, at 7 (1951). thus, the use of the five and five exclusion in the context of crummey powers seems inconsistent with the congressional intent behind the exclusion. 128. egtrra, supra note 2, 107 stat. at 38. 129. cch, 2001 tax legislation: law, explanation and analysis economic growth and tax relief reconciliation act of 2001, at 3 (2001). 130. richard s. rothberg, impact of new federal tax law?, n.y. l. j., sept. 10, 2001, at 11, 11. 131. see egtrra supra note 2, 107 stat. at 38. egtrra’s sunset provision has a somewhat ignominious origin. at the time egtrra was passed, both the house and the senate were narrowly under republican control and the republican george w. bush was in the w hite house. kathy kristof, sunset breaks can flame out, cast lasting glow, chi. trib., july 8, 2001, at p. 3. in order to avoid a filibuster in the senate, egt rra was passed as part of the budget reconciliation process. alexander bolton, senate rule may sunset tax cut, the hill, may 16, 2001 . under the senate rules for the reconciliation process, a bill may be passed as a part of reconciliation only if it has no revenue effect on fiscal years after the c. crummey powers after the economic growth and tax relief reconciliation act of 2001 (“egtrra”) the economic growth and tax relief reconciliation act of 2001 was enacted in june 2001.128 egtrra is a grab-bag of tax provisions,129 many of which were based on campaign promises made during the 2000 presidential election.130 one of the major provisions of egtrra was temporary estate tax repeal, effective only for decedents dying during 2010.131 2003] back to the fu ture interest 215 reconciliation period. 2 u.s.c.a. § 644 (2002). otherwise, the bill is subject to a “point of order” objection that may be overcome only by sixty or more votes. id. in order to avoid such an objection, the sunset provision was included in egtrra. 132 . see supra note 31. 133. cch, supra note 3, at ¶ 305; see also blattmachr & gans, supra note 31, at 54. 134. irc § 2511(c); see also supra text accompanying note 133. 135. section 2511(c) of the internal revenue code is effective only for gifts made after dec. 31, 2009. see egtrra supra note 2, § 511(e), (f)(3), 115 stat. at 71. it is repealed, along with the rest of egtrra, after dec. 31, 2010. see egtrra supra note 2, § 901(a)(2), 115 stat. at 150. 136. see egtrra supra note 2, § 511(e), 115 stat. at 71 ; see also infra note 137 . trusts treated as owned by the grantor for income tax purposes, are frequently called “grantor trusts.” blacks law dictionary 1516 (7th ed 1999). depending on the terms of the trust, a trust using crummey powers may (or may not) be a grantor trust. irc § 678(b); priv. ltr. rul. 91-41-027 (july 11, 1991). in fact, the power-holder may be treated as the owner of the trust property for income tax purposes. irc § 678(a). except for the one year section 2511(c) is effective, whether the trust is a grantor trust has no effect on the availability of the annual exclusion. 137. in contrast, as originally enacted in egtrra, section 2511(c) provided: (c) treatment of certain transfers in trust. -notwithstanding any other provision of this section and except as provided in regulations, a transfer in trust shall be treated as a taxable gift under section 2503, unless the trust is treated as wholly owned by the donor or the donor’s spouse under subpart e of part i of subchapter j of chapter 1.” egtrra supra note 2, § 511(e), (f)(3), 115 stat. at 71 (emphasis added). although the federal gift tax was originally intended as a back-stop to the federal estate tax,132 repeal of the estate tax was not coupled with repeal of the gift tax. the gift tax was retained to allow it to act as a back-stop to the federal income tax.133 egtrra changed the annual exclusion to reflect the new role of the gift tax as a back-stop to the income tax.134 this change, reflected in section 2511(c) of the code, is effective only for gifts made during 2010.135 as enacted in egtrra, section 2511(c) provided that a transfer in trust “shall be treated as a taxable gift under section 2503, unless” the trust is treated as owned by the donor for income tax purposes (commonly called a “grantor trust”).136 in march 2002, the job creation and worker assistance act of 2002 amended section 2511(c). as amended, section 2511(c) provides that a transfer in trust is treated as a gift (as opposed to a taxable gift) “unless” the trust is a grantor trust.137 the change from the term “taxable gift” to “gift” is significant. 216 florida tax review [vol.6:2 after the march 2002 amendments section 2511(c) provides: (c) treatment of certain transfers in trust. -notwithstanding any other provision of this section and except as provided in regulations, a transfer in trust shall be treated as a transfer of property by gift, unless the trust is treated as wholly owned by the donor or the donor’s spouse under subpart e of part i of subchapter j of chapter 1.” (emphasis added). irc § 2511(c); pub. l. no. 107-147, § 411(g)(1), (x), 116 stat. 21 (mar. 9, 2002). 138. irc §§ 2503(a), (b). 139. id. 140. e.l. piesse & j. gilchrist smith, the elements of drafting, 22 (stevens & sons pub. 1950) in symbolic terms, a unless b is equivalent to if not b then a. 141. see supra notes 2, 135. 142 . but see infra note 145 and accompanying text. 143. returning to symbolic logic, irc § 2511(c) may be reduced to if not b then a. see supra text accompanying note 140. the converse of this statement (if b then not a) is, however, not necessarily true. piesse & smith, supra note 140, at 19. 144. see supra note 133. specifically, if a transfer is a “taxable gift,” then the annual exclusion is not available.138 in contrast, if a transfer is a “gift,” then the annual exclusion may be used to offset the transfer.139 as a mater of semantics, section 2511(c) is equivalent to a statement that if the trust is not a grantor trust, then transfers to the trust will be treated as gifts.140 thus, during 2010,141 transfers to non-grantor trusts are treated as gifts and may be eligible for the annual exclusion. presumably, the annual exclusion may be obtained through the use of a crummey power. thus, even after estate tax repeal, crummey powers remain viable.142 the implications of section 2511(c) are less clear if the trust is a grantor trust. as mentioned, section 2511(c) provides that a transfer to a non-grantor trust is treated as a gift. it does not, however, directly address treatment of transfers to grantor trusts.143 thus, section 2511(c) arguably has no effect on the taxation of transfers to grantor trusts. in that case, crummey powers would remain a viable means of making annual exclusion gifts in grantor trusts. on the other hand, interpreting section 2511(c) to imply that transfers to a grantor trust are not gifts is consistent with the revised purpose of the gift tax. as mentioned, after estate tax repeal, the purpose of the gift tax is to act as a back-stop to the federal income tax.144 as long as income earned on the gift is taxable to the grantor (i.e., is held in a grantor trust), no income tax avoidance is possible. thus, there is little reason to impose a gift tax on such transfers. if transfers to grantor trusts are not gifts, then they are not subject to the gift tax, regardless of whether they are present interests. thus, crummey powers would be superfluous. 2003] back to the fu ture interest 217 145. on the other hand, annual exclusion transfers to a non-grantor trust may produce an income tax savings. income earned on property held by a non-grantor trust would be taxable to the trust or the beneficiary, depending on the trust terms. irc §§ 651, 652, 661, 662. whether an income tax savings would result depends on the marginal income tax rates of the donor, the trust and the beneficiaries. since trust income tax rates are more sharply progressive than individual income tax rates, taxing the income to the trust is unlikely to produce a benefit. see generally irc § 1. in contrast, if the income is taxed to the beneficiary, then it is more likely that an income tax savings may be realized. in a nutshell, trust income will be taxed to the beneficiary if trust income is distributed to the beneficiary or if the trust is treated as owned by the beneficiary for income tax purposes. irc §§ 652, 662, 678(a). a more detailed description of the income taxation of trusts is not appropriate here. 146. irc § 2011. there is a credit against the federal estate tax for any estate or inheritance tax paid to a state. this “state death tax credit” is limited based on the value of the taxable estate. id. all states, even traditional tax havens such as florida, impose an estate tax at least equal to the state death tax credit. see, e.g., fla. stat. § 198.02; tex. tax code ann. §§ 211.051(a), 211.055; mo. rev. stat. § 145 .011; n.y. tax law § 952; see also fla. const. art. vii, § 5(a). generally, the state estate tax is directly tied to the cred it allowable under federal law. thus, repeal of the federal estate tax (and, obviously, the state death tax credit) costs states substantial revenue. see infra note 147. further, the state death tax credit is repealed for decedents dying after dec. 31, 2004. irc § 2011(f). between dec. 31, 2004 and the estate tax repeal, the state death tax credit is replaced with a deduction for state death taxes paid. irc § 2058; egtrra supra note 2 , § 511(e) stat. at 71. repeal of the state death credit eliminates state estate taxes in states that d irectly tie the state estate tax to the allowable federal credit. campfield, supra note 31, at ¶ 1097. in effect, the federal government keeps the revenue that would have been paid to the state. mark a. luscombe, decoupling and complexity, taxes, july 1, 2002 at 3. thus, changing the credit to a deduction reduced the cost to the federal government of estate tax repeal. roby b. sawyers & brian t . whitlock, estates, trusts & gifts: post-egtrra analysis & planning, the tax adviser, dec. 1, 2001, at 822. 147. internal revenue service, estate tax returns filed in 1996: gross estate by type of property, deductions, t axable estate, estate tax, and tax credits, by size of gross estate, col. 80, available at <<http://www.irs.gov/businesses/display/ 0,,i1%3d2%26genericid%3d16853,00.html>> (noting that a total of almost $4 billion in state death tax credits were claimed on federal estate tax returns filed in 1996); see also luscombe, supra note 146. although crummey powers remain effective after estate tax repeal, their use may be more limited. many donors make lifetime gifts, frequently through crummey powers, to decrease the estate tax that would be due if they retained the property until death. thus, estate tax repeal may leave crummey powers technically effective, but less useful.145 in the unlikely event that estate tax repeal were made permanent, crummey powers may become an important state estate tax planning technique. under the current federal estate tax, the states share in the tax revenue.146 repeal of the federal estate tax thus causes significant revenue loss to the states.147 some states have already revised their estate tax statutes to assure that 218 florida tax review [vol.6:2 148. see, e.g., r.i. gen laws § 44-22-1.1 (2001); 2002 r.i. pub. laws ch. 65, art. 16, § 2; 2001 r.i. pub. laws ch. 77, art. 7, § 3; 2002 md. laws ch. 440, § 7-309 (codified as md. code ann. tax-gen. § 7-309; see also luscombe, supra note 146 (noting that several states have already taken action in order to retain their estate tax, even if the federal tax is repealed); crossfire: why do some states want to revive the death tax? (cnn broadcast, mar. 25, 2002). the new york estate tax imposed on new york residents is equal to the federal credit in effect on july 22, 1998. n.y. tax law §§ 951, 952 . although the date has been changed periodically, it seems that this provision will allow the new york estate tax to survive repeal of the federal estate tax. see, e.g., 1999 n.y. laws ch. 407, pt. a, § 1; see also rothberg, supra note 130, at 11. 149. this seems particularly likely considering the current interrelation between the federal estate tax and the state estate tax. see supra note 146; but see also luscombe, supra note 146 (noting that some states are considering imposing a new estate tax that is not tied to the federal tax). 150. individuals may forego estate planning based on the incorrect assumption that the estate tax has been permanently repealed. see supra note 2. in the alternative, they may assume that estate tax repeal will be made permanent, which seems unlikely at this time. rojas, supra note 2, at 114-1; see also david cay johnston, lawyers and accountants expect w indfall from estate tax repeal, new york times, june 14, 2001, at c1 (discussing the uncertainty and confusion caused by egt rra). 151. john g. steinkamp, common sense and the gift tax annual exclusion, 72 neb. l. rev. 106, 170 (1993). 152 . see supra note 19 and accompanying text. the state estate tax survives federal estate tax repeal.148 if states enact a transfer tax system that is similar to the current federal transfer tax,149 crummey powers may survive federal estate tax repeal as a state estate planning technique. in the short term, egtrra may increase use of crummey powers. individuals may delay estate planning on the assumption that they will survive the estate tax.150 if death becomes imminent, the individual may attempt to reduce the estate tax burden through last-minute estate planning techniques. annual exclusion gifts (including gifts subject to crummey powers) may be made up to the moment of death.151 thus, the increase in last minute estate planning may yield a corresponding increase in the use of the annual exclusion and crummey powers. iv. a second look at withdrawal powers the obvious attack on crummey powers seems to be a sham transaction (or substance over form) analysis.152 this analysis has a great deal of merit. as more fully developed below, however, it is not clear that a crummey power must be disregarded as a sham. instead, crummey powers fail to meet the basic statutory requirements for the annual exclusion. specifically, crummey powers operate based on the 2003] back to the fu ture interest 219 153. henszey, supra note 19, at 76; moore, supra note 112 , at ¶ 1100; richard w. harris & steven w . jacobson, maximizing the effectiveness of the annual gift exclusion, 70 taxes 204 , 204, (1992). 154. rev. rul. 73-405; see also owen g. fiore & john f. ramsbacher, irs takes a tougher position on crummey trusts in new tam, 23 est. plan. 413, 413 (1996) (noting that “the irs long has been evaluating what it perceived as the taxpayer abuse represented by” the expansive use of crummey powers); jeffrey g. sherman, supra note 5, at 656 (“[a]lthough the irs is justified in its opposition to crummey . . . there is no logical basis, . . . as the irs has finally, albeit reluctantly, conceded.”). 155. admittedly, from a practical point of view, crummey powers are clearly viable. the irs has acquiesced in crummey, and has approved of their use in numerous rulings. see, e.g., rev. rul. 73-405; rev. rul. 83-108, priv. ltr. rul. 78-26-050 (m ar. 29, 1078); priv. lt. rul. 80-04-172 (nov. 5, 1979); see also regs. §§ 601.601(d)-(e). thus, absent a seismic shift in policy it seems that even careful practitioners may assist clients in employing crummey powers. see also infra notes 265-307 and accompanying text. 156. both the sham transaction and substance over form doctrines are usually stated to be derived from gregory v. helvering, 293 u.s. 465 (1935). compare, karen nelson moore, the sham t ransaction doctrine: an outmoded and u nnecessary approach to combating tax avoidance, 41 fla. l. rev. 659, 660 (1989) with joseph isenbergh, musings on form and substance in taxation, 49 u. chi. l. rev. 859, 866-67 (1982). see also moore, supra note 156, at 660 (noting that the sham transaction is largely subsumed under other anti-tax-avoidance judicial doctrine). 157. jay a. soled , use of judicial doctrines in resolving transfer tax controversies, 42 b.c. l. rev. 587, 588 (2001). assumption that a power to withdraw trust assets is a present interest. as discussed below, this assumption is unwarranted. thus, crummey powers, although well established in the field of estate planning153 and reluctantly accepted by the irs,154 are unsupportable as a means of obtaining the federal gift tax annual exclusion.155 a. sham transaction the sham transaction doctrine (and the related substance over form doctrine),156 serve to prevent taxpayers from avoiding taxation through subterfuge. the doctrine is not, however, without controversy.157 on the one hand, it allows taxation based on the actual transaction, rather than the labels 220 florida tax review [vol.6:2 158. commissioner v. court holding, 324 u.s. 331, 334 (1945) (“to permit the true nature of the transaction to be disguised by mere formalisms, which exist solely to alter tax liab ilities, would seriously impair the effective administration of the tax policies of congress.”); waterman s.s. corp. v. commissioner, 430 f.2d 1185, 1193 (5th cir. 1970), overruled on other grounds, utley v. commissioner, 906 f.2d 1033 (5th cir. 1990). stewart v. commissioner, 714 f.2d 977 , 987 (9th cir. 1983) (noting that the sham transaction doctrine distinguishes allowable tax avoidance from prohibited tax evasion). 159. isenbergh, supra note 156, at 879. 160. gregory, 293 u.s. at 467. 161. id. 162. see, e.g., united parcel service v. commissioner, 254 f.2d 1014, 1018 (“this economic substance doctrine, also called the sham transaction doctrine, provides that a transaction ceases to merit tax respect when it has no ‘economic effect other than the creation of tax benefits.’”). 163. rice’s toyota world, inc. v. commissioner, 752 f.2d 89, 91 (4th cir. 1985). in rice’s toyota world, the court noted that sham transaction analysis required a two-prong inquiry. a transaction will be disregarded as a sham if, first, the taxpayer was motivated only by the tax benefits and, second, objectively, no reasonable possibility of profit exists. id. at 91-2. 164. soled, supra note 157, at 599-601; see also isenbergh, supra note 156, at 865-6 (noting that tax motivated choices are “precisely what they purport to be and therefore cannot be swept aside as shams”). in fact, based on the difficulty of applying the sham transaction doctrine in the gift tax context, taxpayers have argued that the doctrine is inapplicable. courts have, however, uniformly held that the sham transaction doctrine is applicable in the gift tax context. griffin v. united states, 42 f. supp. 2d. 700, 704 (w.d. tex. 1998); schultz v. united states, 493 f.2d 1225 (4th cir. 1974). 165. see supra note 19. used by the parties.158 on the other, the doctrine permits overreaching as courts and the irs stray from the code.159 even if the requirements of the code are met, a transaction will be disregarded as a sham unless the taxpayer actually did the “thing which the statute intended.”160 for example, a transaction that met the statutory requirements for a corporate reorganization, but accomplished its sole purpose of transferring property from the corporation to a shareholder, was taxed instead as a corporate dividend.161 many cases applying sham transaction analysis look for the profit motive in the transaction.162 transactions that do not have a business purpose, other than tax avoidance, are disregarded.163 thus, it is difficult to apply sham transaction analysis in the gift tax context since even the most bona fide gift lacks a profit motive.164 nevertheless, crummey powers seem vulnerable to an argument that they should be disregarded as shams.165 clearly, crummey powers are used solely to garner the tax benefits of the annual exclusion. no case has considered 2003] back to the fu ture interest 221 166. griffin, 42 f. supp. 2d. at 701. no gift tax was owed on that transfer due to the gift tax marital deduction. id.; irc § 2523. 167. the wife was under no obligation to actually make the gift to the trust. griffin, 42 f. supp. 2d. at 706. indeed, the husband “worried and feared” that his wife would decide to keep the 45% of the corporation he had given her. id. 168. id. treating the transaction as two gifts of minority interests would allow the taxpayers to obtain gift tax valuation minority discounts. id. at 703; estate of bright v. united states, 658 f.2d 999 (5th cir. 1981); rev. rul. 93-12. 169. griffin, 42 f. supp. 2d. at 703. 170. id. at 706. 171. id. 172. indeed, the griffin taxpayers relied on crummey. id. at 704, n. 3. the griffin court, however, dismissed the taxpayer’s reliance on crummey. id. it noted that crummey was distinguishable on its facts. further, the issue in crummey was whether the gift was a present interest, in contrast, the issue in griffin was whether the transaction should be disregarded as a sham. id. at 704, n. 3. but see infra notes 172-76. 173 . of course, the power-holder may be a beneficiary of the trust. 174. estate of holland, 73 t.c. memo (cch) 3236-5 (1997) 3236; griffin, 42 f. supp. 2d. at 706. in fact, in crummey the court noted that it was unlikely that the powers, even though enforceable, would be exercised. 397 f.2d at 87. the sham transaction doctrine as it relates to crummey powers. in arguably analogous cases, however, courts have applied the sham transaction doctrine. for example, in griffin v. united states, a husband gifted 45% of his wholly owned corporation to his wife.166 shortly thereafter, both husband and wife each gave 45% of the company to a trust for the benefit of their newborn son.167 the taxpayers treated the transaction as two distinct gifts of minority interests in the corporation.168 in contrast, the irs sought to treat the transaction as a single gift of 90% of the corporation, which would greatly increase the aggregate value of the gift.169 the court stated that the entire arrangement was a scheme to gift 90% of the corporation, while still obtaining minority valuation discounts.170 since the exclusive motivation behind the gift to the wife was tax-avoidance, that portion of the transaction was disregarded as a sham.171 thus, the transaction was treated as a single gift of 90% of the corporation. the facts of griffin are arguably analogous to a typical crummey power situation.172 griffin involved a gift by the husband to the trust using the wife as a conduit, solely for tax purposes. similarly, in the case of a typical crummey power, the donor makes a gift to a trust using the power-holder173 as a conduit, solely for tax purposes. in both cases, the conduit (wife or powerholder) has the power to retain the property (or exercise the crummey power), but there is no real expectation that she will do so.174 222 florida tax review [vol.6:2 175. griffin, 42 f. supp. 2d. at 702, n.3. in the crummey power context, the issue is whether the power-holder has been given a present interest. crummey, 397 f.2d at 83-4. in griffin, the issue is whether severing the gift into two portions was a sham that should be disregarded. griffin, 42 f. supp. 2d. at 703. 176. griffin, 42 f. supp. 2d. at 706. similarly, in heyen v. united states 945 f.2d 359 (10th cir. 1991), the tenth circuit disregarded as a sham a taxpayer’s use of twenty-seven unrelated straw men to obtain twenty-seven additional annual exclusions for gifts to the taxpayer’s family. see also cidulka v. commissioner, 71 t.c. memo (cch) 2555 (1996). 177. griffin, 42 f. supp. 2d. at 706. cf. id. at 704, n.3 (noting that crummey was not on point). 178. indeed, as mentioned, the power-holder has a general power of appointment, for federal gift tax purposes. irc § 2514. thus, subject to exceptions, the lapse of the power will, for gift tax purposes, be treated as a gift by the power-holder to the other beneficiaries of the trust. see supra notes 124-27 and accompanying text. 179. in holland, the tax court held that an annual exclusion would be allowed even if the donor and power-holder had a gentlemen’s agreement, that the power would be allowed to lapse. see estate of holland 73 t.c. memo (cch) at 3237-10. the author has argued that holland was incorrectly decided. fogel, supra note 21, at 613-616. 180. soled, supra note 157, at 599-604; see supra notes 162-64 and accompanying text. 181. kieckhefer, 189 f.2d at 121. although the situations are clearly distinguishable,175 griffin held, under facts arguably analogous to a crummey power situation, that the taxmotivated transaction should be disregarded as a sham.176 in some circumstances, use of crummey powers may be distinguished from griffin by the extent to which the subsequent gift by the conduit (powerholder or wife) is correlated with the original gift by the donor. if the gift to the conduit is part of the donor’s “explicit . . . plan”177 to transfer assets to the trust, griffin would support disregarding the power as a sham. in contrast, if the power-holder’s actions are independent from the donor, then the lapse of the crummey power may be fairly viewed as an independent gift.178 in this case, the power should not be disregarded as a sham.179 analysis of whether crummey powers should be disregarded as shams encounter the difficulty of applying the sham transaction doctrine in the gift tax context.180 in a context where options with similar results are taxed differently, at what point must a taxpayer’s choice of one course of action over another be disregarded as a sham? it is unclear on which side of that gray line crummey powers fall. b. crummey powers and the statutory requirements for the annual exclusion crummey powers rely on the unwarranted assumption that a withdrawal power is a present interest.181 in fact, no court has ever passed on the validity 2003] back to the fu ture interest 223 182. see id. in stifel, the court noted that the exclusions would be allowed if the powerholders were adults. 197 f.2d at 110. since stifel involved only powers held by minors, however, this statement is dicta . id. at 110. stifel denied the exclusions claimed by the taxpayer. id. at 110-11. 183 . see supra notes 61-62 and accompanying text. 184. brief for petitioner taxpayer at 4,8, kieckhefer, 189 f.2d 118 (no. 10301). in its brief, the taxpayer in the section labeled “propositions of law relied on” and, again, in its “argument” section stated the issue as follows: the right of the beneficiary of the trust to require payment to him at any time of the corpus of a trust gives him unfettered command equivalent to ownership and makes the beneficiary taxable on the income under [irc § 61]; the same right gives the beneficiary a present interest for gift tax purposes. id. 185 . see infra notes 211-19 and accompanying text. 186. brief for respondent commissioner at 6, kieckhefer, 189 f.2d 118 (no. 10301) (“the provision of the trust instrument permitting the infant-donee or a legally appointed guardian to make a demand for the trust property does not change this gift into a present interest. from a practical standpoint, the beneficiary, being of tender years, could not make an effective demand. . . ”). 187. kieckhefer, 189 f.2d at 121-22. of this fundamental assumption.182 further, the irs has never litigated this issue. as mentioned, the first case to directly address the use of withdrawal powers to obtain the annual exclusion was kieckhefer.183 in kieckhefer, the taxpayer argued that the beneficiary’s power to demand payment of the trust assets gave him “unfettered command equivalent to ownership” of the trust assets.184 as detailed below, although the taxpayer’s argument may have some intuitive appeal, it is specious.185 in contrast, the service framed the issue as solely dependent on the minor beneficiary’s ability to exercise the demand power.186 this strategy proved fatal to the service’s case. the kieckhefer court felt that it was unfair to create distinctions based solely on the incapacity of the minor beneficiary.187 the court was thus left with the issue ignored by the service: whether a withdrawal power creates a present interest regardless of the power-holder’s incapacity. the court, without citation, “suppose[d]” that a withdrawal power 224 florida tax review [vol.6:2 188. see id. (“suppose in the instant situation that the beneficiary had been an adult rather than a minor. such adult, of course, could immediately have made a demand upon the trustee and have received the trust property. we suppose that such a gift unquestionably would be one of a present interest.”); see also stifel v. commissioner, 197 f.2d 107, 109-10 (2d cir. 1952). 189. irc § 2503(b). of course, section 2503 does not require that the beneficiary receive outright ownership of the property. instead, in order to obtain the annual exclusion the donor must give the beneficiary a present interest in the property. id.; regs. § 25 .2503-3(b). since the most obvious present interest is outright ownership, however, there is a great deal of overlap between the two concepts. baker, 236 f.2d at 321 (discussing the annual exclusion in terms of outright ownership); brief for petitioner taxpayer at 4,8, kieckhefer, 189 f.2d 118 (no. 10301) (same); see also maxfield, supra note 38, at 484 (suggesting that only outright gifts should be classified as present interests); dept. of the treasury, supra note 19, ¶¶ 461-3 (1998) (proposing limiting the annual exclusion only to outright gifts). 190. regs. § 25.2503-3(b). the term “future interest” is used only one other time in the code. section 170(a)(3) provides that no charitable deduction is allowed for a gift of a “future interest in tangible personal property” unless all interests held by the taxpayer and persons related to the taxpayer have expired. irc § 170(a)(3). based on this language, the tax court has held that a taxpayer was entitled to a deduction for a gift of a 10% undivided interest in artworks to a museum. winokur v. commissioner, 90 t.c. 733, 740 (1988). although the museum did not take possession of the artworks, the court held that possession by the museum was not required. id. at 740. the court noted that the museum had the right to obtain possession of the artworks for the fractional part of the year and declined to do so without any input from the taxpayer. id. unlike in the crummey power context, however, the museum’s power to posses the artworks did not lapse. id.; see also priv. ltr. rul. 92-180-67 (jan. 31, 1992). moreover, the museum ultimately took possession of the artworks. winokaur, 90 t.c. at 735. it is difficult to draw conclusions regarding the annual exclusion from section 170(a)(3) due to the drastically different contexts. held by an adult creates a present interest.188 thus, the claimed exclusions were allowed. in fact, the conclusion “supposed” by kieckhefer is incorrect. a demand power is not the equivalent of outright ownership and, more importantly, is not a present interest.189 1. section 2503 and the treasury department regulations – a withdrawal power may be distinguished from a present interest on a number of different levels. the regulations define a present interest as “an unrestricted right to the immediate use, possession, or enjoyment of property.”190 based on this definition, the mere fact that a power-holder must exercise the power to 2003] back to the fu ture interest 225 191. generally, a power-holder exercises a crummey power by delivering written notice to the trustee. see, e.g., priv. lt. rul. 80-03-152 (oct. 29, 1979) (noting that power-holders exercise the power by delivering written notice to the trustees). 192. fondren, 324 u.s. at 26. 193. perhaps the granting of a withdrawal power can be viewed as similar to the donor giving the donee a check. certainly, the donee will confront some administrative burden and delay in converting the check to cash. it seems absurd, however, to argue that the check is a future interest. tech. adv. mem. 97-08-004 (oct. 31, 1996) (allowing exclusions for gifts made by an attorney-in-fact via check). of course, a check, unlike a withdrawal power, is generally negotiable. 194. regs. § 25.2053-3(b); fondren, 324 u.s. at 21; fisher v. commissioner, 132 f.2d 383, 386 (9th cir. 1942). 195. for administrative convenience, the income may be distributed to the donee at reasonable intervals, while still qualifying as a present interest. fisher v. commissioner, 45 b.t.a. 958, 963 (1941), aff’d, 132 f.2d 383; commissioner v. lowden, 131 f.2d 127, 128 (7th cir. 1942); regs. § 25.2503-3(b). 196. regs. § 25.2503-3(b). 197. estate of newhouse v. commissioner, 94 t.c. 193, 217 (1990); penn v. commissioner, 219 f.2d 18, 20 (9th cir. 1955). generally, fair market value for tax purposes is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” regs. § 20.2031-1(b). obtain the property191 may be sufficient to defeat the immediacy required by the regulation. although the administrative delay is arguably sufficient to render the gift a future interest, there are shortcomings to this line of reasoning. first, the delay is presumably slight. even in light of the united states supreme court’s admonition that the length of the delay is irrelevant,192 it seems that the brief purely administrative delay may be disregarded.193 further, in determining the availability of the annual exclusion, administrative delays are sometimes disregarded. for example, a gift of an income interest in property is a present interest.194 it is unlikely, however, that even the first income payment is made immediately.195 therefore, in some cases an administrative delay between the beneficiary and her enjoyment of the property does not render the gift a future interest. a better analysis focuses on the interest actually given to the powerholder. the amount of the annual exclusion is limited to the value of the present interest given to the donee.196 in the case of a withdrawal power, the donee receives a power to claim the property rather than the property itself. thus, the allowable exclusion should be limited to the value of the withdrawal right. this valuation issue, like all others, is an issue of fact.197 it is the taxpayer’s burden 226 florida tax review [vol.6:2 198. disston, 325 u.s. at 449. 199. eisenberg v. commissioner, 155 f.3d 50 , 53 (2nd cir. 1998); glen v. commissioner, 79 t.c. 208, 211 (1982). 200. non-lapsing withdrawal powers, such as those addressed in the precrummey cases, may be more credibly valued at a value equal to the underlying property. see supra note 27 and accompanying text. moreover, in the case of non-lapsing withdrawal powers, the kieckhefer court’s rationale for allowing the exclusion seems more credible. specifically, kieckhefer viewed the power solely as a means of facilitating gifts to minors. kieckhefer, 189 f.2d at 121-2. 201. considering the rarity of exercised withdrawal powers, the assumption that the power will be exercised seems absurd. see supra text accompanying notes 12123. consideration of such likelihood – the “likelihood of exercise” test – has been eschewed by some courts. crummey, 397 f.2d at 85-6; estate of holland, 73 t.c. memo (cch) 3236, 3237-10 (1997). 202. commissioner v. brandegee, 123 f.2d 58, 61 (1st cir. 1941) (denying the annual exclusion because even if the gift may be called a present interest, such an interest is inherently incapable of valuation); brody v. commissioner, 19 t.c. 126, 132 (1952) (based on the specific facts of the case, holding that “the gifts of income are ‘present interests’ which can not be valued,” thus, no exclusions were allowed). 203. ryerson v. united states, 312 u.s. 405, 409 (1941) (holding that “those who might become entitled to [the gifted property] were ascertainable only upon the happening of one or more uncertain future events” and, thus, the interests gifted were future interests). to demonstrate the claimed value.198 typically, the taxpayer will be unable to carry this burden; thus, no exclusions will be allowed. presumably, in the crummey power context, the taxpayer will argue that the value of the withdrawal right is equal to the value of the property. if this were the case, the entire gift could potentially be offset by the annual exclusion. the taxpayer’s supposed argument is, however, untenable. the value of the withdrawal power must be determined at the time of the gift, i.e., when the property is transferred to the trust.199 at that time its value is highly speculative. if the power-holder exercises the withdrawal power, the value of the right should be approximately equal to the value of the property that could be withdrawn. if the power is allowed to lapse,200 however, it is valueless. by assuming that the value of a power to withdraw is equal to the amount that can be withdrawn, courts (and the irs) value all withdrawal rights, even lapsing rights, as if it were certain that the power will be exercised. since this assumption is unjustifiable, valuation of a withdrawal power is speculative.201 in similar circumstances, no exclusion is allowed if the value of the present interest cannot be determined.202 indeed, the united states supreme court has noted that the annual exclusion is unwarranted if the amount that the beneficiary receives is speculative.203 this case is no different. 2003] back to the fu ture interest 227 204. 197 f.2d 107 (2nd cir. 1952). 205. crummey, 397 f.2d at 85-86. 206. id.; stifel, 197 f.2d at 110. 207. the difference seems much more significant in the case of a lapsing power as compared to a non-lapsing withdrawal power. see supra note 200. 208 . see infra notes 220-29 and accompanying text. 209 . see infra notes 218-19 and accompanying text. 210 . see infra notes 220-37 and accompanying text. the analysis described in the preceding few paragraphs may be reminiscent of the “likelihood” of exercise test described in stifel v. commissioner204 and explicitly rejected in crummey.205 the likelihood of payments test requires consideration of whether it is likely that the beneficiary would exercise the power.206 in contrast, the analysis described herein eschews consideration of such likelihood. instead, it is concluded that the taxpayer’s burden of demonstrating the value of the withdrawal power cannot be met due to the inherent uncertainty surrounding the exercise of the withdrawal right. indeed, the assumption that the value of the withdrawal right is equal to the value of the underlying property is an example of the “likelihood” of exercise test because it assumes that the power-holder will exercise the power. it is therefore submitted that the plain meaning of section 2503, the treasury department regulations and united states supreme court precedents concerning the annual exclusion, demonstrate that a gift of a withdrawal power is a future interest. thus, crummey was wrongly decided. admittedly, it is possible, although tenuous, to argue otherwise. arguably, a withdrawal right may be the functional equivalent of outright ownership of the property. this disregards that the donee receives a power to vest property in himself as opposed to the actual property – a small,207 but significant difference. a difference that has, in fact, been dispositive in other transfer tax contexts.208 if crummey powers can be justified at all, such justification requires an expansive reading of section 2503. provisions of the code granting exclusions, however, must be narrowly construed.209 thus, disregarding the difference between a gift of a withdrawal power and a gift of the underlying property is inappropriate. moreover, as detailed below, there are numerous other reasons to dismiss the tenuous argument that a withdrawal power is a present interest.210 2. the inapposite income tax analogies – as mentioned, in kieckhefer the taxpayer argued that a withdrawal power creates a present interest regardless of whether the beneficiary is a minor. its argument was based on the 228 florida tax review [vol.6:2 211. brief for petitioner taxpayer at 4,6, kieckhefer, 189 f.2d 118 (no. 10301). the taxpayers did cite one gift tax case – strekalovsky v. delaney. brief for petitioner taxpayer at 9, kieckhefer, 189 f.2d 118, citing, strekalovsky v. delaney, 78 f.supp. 556 (mass. 1948). as mentioned, however, strekalovsky, is not on point. see supra note 60. 212. the income tax conclusion is not necessarily correct under current income tax law. see supra note 136. 213. see, e.g., jergens v. commissioner, 136 f.2d 497, 498 (5th cir. 1943) (“the taxpayer was given control so absolute as to be consonant with full ownership. the trust instrument gave [the taxpayer] unlimited power to withdraw [trust assets]”); mallinckrodt v. nunan, 146 f.2d 1 ,3-4 (8th cir. 1945); richardson v. commissioner, 121 f.2d 1, 2 (2nd cir. 1941). 214. see, e.g., jergens, 136 f.2d at 498 (citing 26 irc § 22(a) (1936)). irc § 22(a) is the predecessor to irc § 61 of the internal revenue code of 1986, as amended (the current version). internal revenue act of 1954, 68a stat. 931 (appendix). 215. compare irc § 61 with irc § 2503(b). 216. mallinckrodt, 146 f.2d at 4; russell v. commissioner, 45 b.t.a. 397, 401(1941) (noting that the property and income “are, in substance, [the taxpayer’s]”). see, e.g., jergens, 136 f.2d at 498 (describing the issue, alternatively as whether the taxpayer had “full ownership” or “actual dominion” over the income). 217. fondren v. commissioner, 324 u.s. at 18 (1945) (noting that vesting is not the issue); commissioner v. glos, 123 f.2d 548, 550 (2d. cir. 1941). 218. commissioner v. glenshaw glass, 348 u.s. 426, 429 (1955); helvering v. clifford, 309 u.s. 331, 334 (1940); see also u.s. const. amend xvi; boris i. bittker, a “comprehensive tax base” as a goal of income tax reform, 80 harv. l. rev. 925, 925 (1967) (“it is no exaggeration to say that a ‘comprehensive tax base’. . . has come to be the major organizing concept in most serious discussions of our federal income tax structure.”). cf. nancy h. kaufman, fairness and the taxation of international income, 29 law & pol’y in int’l bus. 145, 203 (“[w]e should stop asserting . . . that fairness in the international tax system necessitates the adoption of a worldwide tax base. . .”). income tax consequences concerning withdrawal powers.211 specifically, at that time, a holder of a demand power was taxed on the income earned by the property.212 thus, the taxpayer argued, the power-holder should be treated as having received outright ownership for gift tax purposes. certainly, dicta in some of the cases cited by the kieckhefer taxpayers support their conclusion.213 these cases, however, all involve the federal income tax and the code section defining gross income.214 applying these cases in the annual exclusion context requires drawing an analogy between drastically different sections of the code.215 moreover, the issue in the income tax cases was whether the taxpayer had dominion over the income and whether she owned the income.216 such dominion or ownership is, however, irrelevant in determining whether a gift is a present interest.217 in defining “gross income” in the code, congress exercised the “full measure of [its] taxing power.”218 in contrast, federal estate and gift tax provisions have never been given such broad construction. moreover, the 2003] back to the fu ture interest 229 219. stinson estate v. united states, 214 f.3d 846, 848 (7th cir. 2000) (“internal revenue code provisions dealing with deductions, exemptions, and exclusions are matters of legislative grace. the [annual] exclusion must be narrowly construed. . . (citations omitted)); see also indopco inc. v. commissioner, 503 u.s. 79, 84 (1992) (concerning the federal income tax deduction for business expenses); wisely v. united states, 893 f.2d 660, 666 (4th cir. 1990). 220. of course, the issue is whether the power creates a present interest. irc § 2503(b). however, some cases discuss the issue in terms of outright ownership. see supra note 189. cf. supra notes 216-17 and accompanying text. 221. in some cases, a power to vest property in oneself is treated similarly to outright ownership of the underlying property. see, e.g., heidrich v. commissioner, 55 t.c. 746, 752 (1971); rev. rul. 74-43 1974-1 c.b. 284. the power to vest property in oneself is not, however, so treated in all (or even most) cases. 222. 255 u.s. 257 (1921). 223. field stated that the decedent has a “general power of appointment” over trust property, although it was not then defined in the code or regulations. id. it was later defined by the treasury department as a power to appoint to “any person or persons.” regs. no. 80, art. 24 (1926) under current law, a decedent has a general power of appointment if he has the power to appoint property to himself, his estate, his creditors or the creditors of his estate. irc § 2041. 224. field, 255 u.s. at 259. at the time the trust was created, the code did not include an estate tax provision that specifically dealt with powers of appointment. field, 255 u.s. at 264-65; walter e. barton & carroll w. browning, federal income and estate laws 490-91 (8th ed. 1938). the treasury department had promulgated a regulation that specifically stated that “property passing under a general power of appointment” must be included in the decedent’s gross estate. field, 255 u.s. at 261 (citing regs no. 37, art. xi (1917)). the court held that the regulation was invalid. id. 225. id.; field, 255 u.s. at 261 (citing, irc § 202 (1916)). section 202 of the internal revenue code of 1916 has evolved into § 2033 of the internal revenue code of 1986, as amended. barton & browning, supra note 224, at 482-83; walter e. barton, annual exclusion is a matter of “legislative grace” that is required to be narrowly construed.219 thus, analogy between the broadly construed income tax provision and the narrowly construed annual exclusion is inappropriate. 3. powers to vest property in oneself in other transfer tax contexts – crummey powers rely on the claim that a power to withdraw property is essentially equivalent to outright ownership of the property.220 equating a power to vest property in oneself with outright ownership of the property has, however, been rejected in some federal transfer tax contexts.221 for example, in united states v. field,222 the united states supreme court addressed whether property subject to a general power of appointment223 exercised by the decedent was included in her gross estate for federal estate tax purposes.224 the code provides (both when field was decided and currently) that a decedent’s gross estate includes all property “to the extent of the interest therein of the decedent at the time of his death.”225 after considering this 230 florida tax review [vol.6:2 federal income estate and gift tax laws, 9565-7 (9th ed. 1944); internal revenue code of 1954, 68a stat. 936 (table 1). the language of the section that was re levant to field remains the same. see irc § 2033 (“the value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.”). 226. field, 255 u.s. at 265. 227. 316 u.s. 56 (1942). the safe deposit court noted that field left little doubt that unexercised powers, like exercised powers, would not be included in the gross estate. id. at 59-60. the safe deposit court did, however, also address an amendment to the internal revenue code that specifically included in the gross estate “property passing under a general power of appointment exercised by the decedent.” id. at 62 (citing, irc§ 302(f) (1919)). this provision had been enacted, but was not effective, when the court decided field. field, 255 u.s. at 264-65. the safe deposit court held that the language of the amendment to the code addressed only exercised powers and, as mentioned, the power in safe deposit was not exercised by the decedent. safe deposit 316 u.s. at 60-61. 228. a testamentary power of appointment is exercisable by an individual after their death in their will. black’s law dictionary 1190-91 (7th ed. 1999). 229. regs. § 25.2503-3(b); see also irc § 2503(b). provision, the united states supreme court held that the property subject to mrs. field’s exercised power of appointment was not included in her gross estate.226 similarly, in helvering v. safe deposit & trust company of baltimore (“safe deposit”), the united states supreme court held that property subject to an unexercised power of appointment was not included in a decedent’s gross estate.227 clearly, analogy between crummey powers and field and safe deposit is imperfect. field and safe deposit both involved testamentary powers of appointment.228 in contrast, crummey powers are exercisable during the powerholder’s lifetime. moreover, the issue in field and safe deposit was whether the property subject to the power would be included in the decedent’s gross estate. in contrast, the issue in crummey is whether a withdrawal power creates a present interest in property.229 at bottom, however, both safe deposit and field held that a power to vest property in oneself (or one’s estate) would not be treated as the equivalent of ownership of the property. in that respect field and safe deposit militate against annual exclusions based on crummey withdrawal powers. 4. the legislative history of the annual exclusion – as mentioned, the history of the annual exclusion illustrates that it was intended to “obviate the necessity of keeping an account of and reporting numerous small gifts,” such 2003] back to the fu ture interest 231 230. h. r. rep. no. 72-708 (1932); s. rep. no. 72-665 (1932) (“[the annual exclusion] on one hand, is to obviate the necessity of keeping an account of and reporting numerous small gifts, and, on the other, to fix the amount sufficiently large to cover in most cases wedding and christmas gifts and occasional gifts of relatively small amounts .”); see also s. rep. no.72665, (1932) (containing language that is nearly identical to the h ouse report); supra notes 34-35 and accompanying text. 231. h. r. rep . no.72708 (1932). 232. bittker, supra note 32, at 451; sherman, supra note 5, at 589-90. although not a legal necessity, as a practical matter the creation of a trust generally requires the services of an attorney. unif. trust code §§ 401, 402. it is possible to gift a future interest without a trust. for example, a gratuitous transfer to a corporation is a future interest gift to the shareholders. chanin v. united states, 393 f.2d 972, 976 (ct. cl. 1968); see also n ote, federal gift tax exclusions: gifts to corporations, 6 duke b.j. 150 (1957). 233. h. r. rep. no. 72-708, (1932) (“the exemption does not apply with respect to a gift to any donee to whom is given a ‘future interest.’ the exemption being availab le only in so far as the donees are ascertainable, the denial of the exemption in the case of ‘future interests’ is dictated by the apprehended difficulty, in many instances, of determining the number of eventual donees and the value of their respective gifts.”). the senate report contains identical language. see s. rep. no. 72-665, (1932). 234. see supra note 21; see also dep’t of the treasury, supra note 19, ¶ 463 (noting that crummey powers “undermine” the present interest requirement). 235. h. r. rep . no. 72-708, (1932); s. rep. no. 72-665, (1932). 236. see supra note 38. as holiday and occasion gifts.230 this history supports denial of exclusions based solely on withdrawal powers. the exclusion was intended as a rule of administrative convenience.231 instead, withdrawal powers make the annual exclusion a significant estate planning tool. unlike the simple gifting of a holiday or occasion gift, the creation of a crummey trust generally requires the services of an attorney.232 a gift made using a crummey power is more accurately viewed as part of the transmission of an estate through an attorney-created estate plan rather than the occasion gifts envisioned by congress. moreover, the present interest requirement was enacted due to the “apprehended difficulty . . . in determining the number of eventual donees and the values of their respective gifts” when future interests are gifted.233 annual exclusions claimed based on crummey powers potentially exploit this difficulty. the holder of a crummey power may not have any interest in the trust other than the withdrawal power.234 even if the power-holder has an interest in the trust, it may not be apparent at the time the gift is made how much, if any, property will eventually be distributed to her. this is exactly the situation the present interest requirement was intended to avoid.235 moreover, many taxpayers make full annual exclusion gifts using crummey powers without deducting the routine occasion gifts.236 thus, 232 florida tax review [vol.6:2 237. see, e.g., united states v. pelzer, 312 u.s. 399, 403-04 (1941) (citing, h. r. rep. no. 72-708, (1932); denying the annual exclusions claimed by the taxpayer because “[t]he gift . . . involved the difficulties in determining the ‘number of eventual donees and the value of their respective gifts’ which it was the purpose of the statute to avoid”). s. rep. no. 72-665, (1932) 238 . see supra notes 181-206 and accompanying text. 239 . see supra notes 206-08 and accompanying text. 240 . see supra notes 220-29 and accompanying text. 241. see, e.g., crummey v. commissioner, 25 t.c. memo (cch) 772 t.c. memo (ria) 6144 (1966) rev’d, 397 f.2d 82 (9th cir. 1968); gilmore v. commissioner, 20 t.c. 579 (1953), rev’d, 213 f.2d 520 (6th cir. 1954); kieckhefer v. commissioner, 15 t.c. 111 (1950), rev’d, 189 f .2d 118 (7th cir. 1951). cf. perkins v. commissioner, 27 t.c. 601, 606 (1956). 242. heidrich v. commissioner, 55 t.c. 746, 750 n. 8 (1971). heidrich was decided after the ninth circuit decided crummey, but before the irs issued rev. rul. 73-405, in which it accepted the result in crummey. 243. see rev. rul. 73-405, 1973-2 c.b. 321. crummey has changed the annual exclusion from a rule of administrative convenience into an exemption that is routinely used over and above the occasion or holiday gifts. in short, the legislative intent behind the annual exclusion is inconsistent with crummey powers. courts have shown a willingness to consider the legislative intent behind the annual exclusion in deciding cases in other contexts.237 there seems to be no reason to make an exception for crummey. 5. the viability of crummey v. commissioner – the plain language of section 2503, as well as the united states supreme court precedent interpreting it, do not support the use of crummey withdrawal powers.238 in essence, crummey confused the donee’s receipt of property with the donee’s receipt of a power to vest property in himself.239 it is possible to ignore this difference, as crummey and its precedents did. as detailed above, there are, however, compelling reasons not to do so. further, this difference is dispositive in other transfer tax contexts.240 the courts’ erroneous decisions allowing crummey powers may be partially attributed to the irs’s failure to litigate the fundamental validity of crummey withdrawal powers. even after crummey, the issue the service litigated (withdrawal powers held by minors) seemed far from settled. the tax court had repeatedly ruled in favor of the irs.241 moreover, a few years after crummey, the tax court noted that annual exclusions claimed based on withdrawal powers held by minors “stand on less than secure ground.”242 nevertheless, crummey caused the irs to finally surrender the issue.243 2003] back to the fu ture interest 233 244. see supra note 19. 245. schwidetzky, supra note 9, at 218 (noting that “it was predictable that taxpayers would run with the ball”). 246. crummey was decided in 1968. 247. rev. rul. 73-405, 1973-2 c.b. 321; see also rev. rul. 85-88, 1985-2 c.b. 202; rev. rul. 81-7, 1981-1 c.b. 474. 248. see supra notes 190-237 and accompanying text; see also pedrick, supra note 19, at 946. schwidetzky, supra note 9, at 218; 249 . see infra notes 250-264 and accompanying text. 250. for example, professor robert smith has proposed severely limiting the annual exclusion and increasing the scope of the exemption under § 2503(e). smith, supra note 38, at 428; harry l. gutman, reforming federal wealth transfer taxes after erta, 69 va. l. rev. 1183, 1244-50 (1983). under § 2503(e), gifts to pay for the donee’s educational or medical expenses are exempt from the gift tax. irc § 2503(e). the section is, however, relatively narrow. for example, if the donor pays a student’s room and board, that payment would not be exempt from gift taxation under § 2503(e). irc § 2503(e)(2)(a). when the irs acquiesced in crummey, it failed to foresee the many (arguably nefarious) uses taxpayers would make of crummey powers. the service should have realized that taxpayers would make the most of the “sham”244 that it sanctioned.245 crummey has been the law for more than thirty years.246 in that time, fueled by the service’s acceptance of the decision,247 crummey powers have become ubiquitous. it may be too late for the irs or the treasury department to rectify the mistakes made. v. the futur e of crummey pow ers – possibilities for reform although crummey was wrongly decided, and the irs’s acquiescence was short-sighted,248 it is unclear what can be done about the muddled state of the law concerning the annual exclusion. it seems that the best course of action is for congress to amend section 2503 of the code.249 although the treasury department or the irs may try to rectify crummey, administrative action is rife with uncertainties. a. possibilities for congressional action if congress were to act, it would be faced with numerous choices. certainly, there are various well-considered proposals for fundamental change in the annual exclusion.250 such proposals have significant advantages. in 234 florida tax review [vol.6:2 251. charles v. hassett, 43 f . supp. 432, 434 (d. m ass. 1942) (no ting that a “layman” would be surprised to learn what constitutes a future interest as compared to what constitutes a present interest for purposes of the annual exclusion). 252. revenue act of 1932, ch. 209 § 504, 47 stat. 245, 247 (1932). 253. there are, of course, exceptions. for example, a recent case concluded that a gift of an interest in a limited liability company was not a present interest gift because the interest was subject to restrictions on transfer. hackl v. commissioner, 118 t.c. 14, 41 (2002); see also stinton v. united states, 214 f.3d 846 (7th cir. 2000); heringer v. commissioner, 235 f.2d 149 (9th cir. 1956); chanin v. unites states, 393 f.2d 972 , 976 (ct. cl. 1968) (concluding that a gift to a corporation is a future interest gift to the shareholders). 254. see smith, supra note 38, at 401, supra notes 34-35 and accompanying text. certainly a smaller, but similarly structured, exclusion might serve the same purposes. pedrick, supra note 19, at 951 . further, the lesser exclusion would offer less potential for tax avoidance. 255. joint committee on taxation, description of possible o ptions to increase revenues prepared for the committee on ways and means, 17-87 at 269 (comm. print 1987); see also supra note 28 and accompanying text. 256. irc § 2642(c) which provides that the inclusion ratio of an annual exclusion gift is zero. id. since the generation-skipping transfer tax is imposed at a flat rate of the maximum estate tax rate multiplied by the inclusion ratio, a transfer with a zero inclusion ratio is exempt from the tax. irc §§ 2602, 2641(a). an annual exclusion gift will not, however, get the automatic zero inclusion ratio if it is a “transfer to a trust for the benefit of an individual unless (a) during the life of such individual, no portion of the corpus or income of the trust may be distributed to (or for the benefit of) any person other than such individual, and (b) if the trust does not terminate before the individual dies, the assets of such trust will be includable in the gross estate of such individual.” irc § 2642(c). addition to eliminating crummey, fundamental changes may eliminate some of the odd distinctions made under current law.251 more limited changes are, however, also possible and have advantages. the annual exclusion has been in place in its current form since the enactment of the gift tax in 1932.252 this has, for the most part, lead to a settled understanding regarding the exclusion.253 further, it seems that whatever change is made would create new uncertainties. moreover, there are advantages to a substantial per donee annual exclusion. other than the crummey issue, the annual exclusion arguably serves the purposes for which it was enacted.254 there is precedent supporting a limited change to the annual exclusion. such a limited amendment to the annual exclusion has been proposed.255 moreover, a limited exception aimed at crummey powers has been enacted in other transfer tax contexts. for example, the generation-skipping transfer tax provisions dealing with annual exclusion gifts provide a limited exception that applies only to annual exclusions claimed for gifts in trust.256 as an oversimplification, in order for an annual exclusion gift to be exempt from the 2003] back to the fu ture interest 235 257. id. 258. irc § 2511(c); egtrra, supra note 2, § 511(e), 115 stat. at 71; supra notes 134-44 and accompanying text. 259. irc § 2642(c). 260. janet kidd stewart, there’s still time for year-end tax cheer, chi. trib., dec. 17, 2000, at 3c. 261. martin a. sullivan, estate tax compromise or repeal: the rich versus the super rich, 88 tax notes 298, 299 (july 17, 2000); william m. vandenurgh & philip j. harmelink, a bipartisan compromise on the estate tax, 90 tax notes 683, 684-85 (jan. 29, 2001) (noting that politicians in favor of estate tax repeal are unlikely to compromise); see also r ichard neal, congress should simplify the income tax laws, the hill, apr. 10, 2002, at 52. 262. see schwidetzky, supra note 9, at 232; supra note 20. 263 . see infra notes 265-307 and accompanying text. 264. it seems likely that making changes prospective would adequately address most taxpayers’ reliance concerns. some taxpayers will, however, have existing trusts with crummey power provisions that were created with the expectation that the taxpayer would be able to make annual exclusion gifts to the trust for the indefinite future. congress could, of course, consider whether to grandfather these existing trusts. generation-skipping transfer tax, the beneficiary must be the sole beneficiary of the trust.257 this greatly limits the use of crummey powers to avoid the generation-skipping transfer tax. similarly, egtrra enacted a provision that dealt exclusively with gifts in trust.258 it seems possible that a similar legislative change aimed at exclusions obtained to offset a “transfer to a trust”259 could eliminate the abuses caused by crummey. clearly, crummey can be statutorily overruled by congress. the current administration’s animosity toward transfer taxes,260 as well as transfer tax simplification,261 seems to make legislative abrogation of crummey unlikely. this is especially true considering that, as a political reality, the insurance lobby is likely to oppose such a change since crummey powers are integral to life insurance trusts.262 although legislative change seems unlikely, it is clear that congress is the best suited to eliminate the use of crummey powers. first, congressional action, unlike administrative action, would clearly be valid.263 moreover, congress seems best able to address the reliance concerns that would be raised by such a change.264 lastly, congress has the power to consider all of the possible reforms that could be made to the annual exclusion. in contrast, administrative agencies can, at most, add an anti-crummey gloss to the language of section 2503. 236 florida tax review [vol.6:2 265. the internal revenue service is a bureau in the treasury department. irc §§ 7802, 7803(a); michael i. saltzman, supra note 23, ¶ 1.02. the commissioner of internal revenue reports to the secretary of the treasury department, which is a cabinet level position. irc § 7803(a)(2); 31 u.s.c.a. § 301 (2000); saltzman, supra , ¶ 1.02. the internal revenue service is responsible for enforcing the federal tax law and collecting the proper amount owed. irc § 7803(a)(2); saltzman, supra, ¶¶ 1.01, 1.02. 266. although the treasury department has never issued such a regulation, some regulations deal with situations that arise due to the prevalence of crummey withdrawal powers. for example, the treasury department regulations address the identity of the transferor (for federal generation-skipping transfer tax purposes) of a trust created by the lapse of withdrawal powers. regs. § 26.2652-1(a)(5), ex. 5; see also regs. § 26.2612-1(f); regs. § 25.2503-2(e), ex. (1) and (2) (addressing the effect of an increase in the annual exclusion on withdrawal powers); regs. § 26.2612-1(f). but see gopman, supra note 27, at 201 (stating that crummey powers have been “condoned” by the regulations). regulations are promulgated by the treasury department. although interpretive regulations are not, under the administrative procedures act, required to undergo the notice-and-comment process, the treasury department promulgates a ll permanent regulations by giving the public notice of, and opportunity to comment on, the regulations. 5 u .s.c.a. § 553(b)(a) (2000); saltzman, supra note 23, ¶ 3.02[3]. these regulations are generally entitled to broad deference by the courts. atl. mut. ins. co. v. commissioner, 523 u.s. 382, 389 (1998); see also chevron u.s.a., inc. v. natural resources defense council, inc., 467 u.s. 837, 865-66 (1984). in contrast, rulings issued by the irs are, generally, given little deference by the courts. abc rentals of san antonio, inc., v. commissioner, 142 f.3d 1200, 1205 (10th cir. 1998), (citing am. stores co. v. am. stores ret. plan, 928 f.2d 986 (10th cir. 1991)(“irs revenue rulings are not binding on this court”)). 267. see, e.g., rev. rul. 85-55, 1985-1 c.b. 323; rev. rul. 81-7, 1981-1 c.b. 474; rev. rul. 73-405, 1973-2 c.b. 321; priv. ltr. rul. 2001-23-034 (mar. 8, 2001); priv. ltr. rul. 2000-11-055 (dec. 15, 1999); priv. ltr. rul. 78-26-050. 268. see supra note 154. 269. pedrick, supra note 19, at 950. b. administrative abrogation of crummey the treasury department265 has not promulgated a regulation endorsing the use of crummey powers.266 the internal revenue service has, however, issued numerous rulings tacitly and explicitly approving crummey powers.267 the service’s reluctant268 complicity in the use of crummey powers has arguably made crummey as much a part of section 2503 as if it were actually written into the statute.269 thus, it is unclear whether either the treasury department or the irs have the power to administratively overrule crummey. 2003] back to the fu ture interest 237 270. rev. rul. 85-55, 1985-1 c.b. 323; see also regs. § 601.601(e) (noting that taxpayers may rely on revenue rulings unless revoked or superceded by statute, regulations or court decisions). but see dixon v. united states, 381 u.s. 68, 73 (1965) (noting that the irs’s “acquiescence in an erroneous decision, published as a ruling, cannot in and of itself bar the united states from collecting a tax otherwise lawfully due”); vons companies v. united states, 51 fed. cl. 1 , 6 (2001). rev. rul. 81-7 1981-1 c. b. 474; rev. rul. 73-405, 1973-2 c.b. 321. although the irs has also issued several private rulings that approve of crummey, private rulings are not precedent. irc § 6110(k)(3); regs. § 1.6661-3(b)(2); see also vons companies, 51 fed. cl. at 12 (“private letter rulings . . . may not be used to support, in any fashion, an argument that one interpretation of the code is more authoritative than another.”). thus, the service will not need to revoke those rulings to reflect its new position. 271. baker, 236 f .2d 317; crummey, 397 f.2d 82; gilmore, 213 f.2d 520; kieckhefer, 189 f.2d 118; see a lso supra notes 61-107 and accompanying text. the tax court, in contrast, had repeatedly resolved the issue in favor of the irs. see supra note 242. in fact, even after crummey was decided, the tax court expressed its agreement with the service’s position. heidrich v. commissioner, 55 t.c. 746, 750, n.8 (1971). although the tax court has subsequently decided a few cases that involve crummey powers, none of these cases involve the fundamental efficacy of crummey withdrawal powers. see, e.g., estate of cristofani v. commissioner, 97 t.c. 74 (1991); estate of kohlsaat v. commissioner, 73 t.c. memo (cch) 2732 (1997). 272. stifel v. commissioner, 197 f.2d 107 (2d cir. 1952). 273. id. at 109-10. 274. maislin indus. v. primary steel, inc., 497 u.s. 116, 131 (1990). 275. see, e.g., jacobs eng’g group, inc. v. united states, 97-1 u .s. tax cas. (cch) ¶ 50, 340, 79 a.f.t.r.2d (ria) 97-1673, (c.d. cal. 1997). cf. pension benefit guar. corp. v. r. a. gray & company. oregon-w ashington carpenters-employers pension trust fund, 467 u.s. 717, 729 (1984) (“[o]ur cases are clear that legislation readjusting rights and burdens is not unlawful solely because it upsets otherwise settled expectations.”). 1. action by the irs – the service could, theoretically, revoke the public rulings endorsing crummey270 and issue a new ruling pronouncing its epiphany. taxpayers’ reluctance to accept the irs’s new stance would likely lead to litigation. the irs’s chance of success might depend on the circuit. when the service acquiesced in crummey, the fourth, fifth, sixth and ninth circuits (the “crummey circuits”) had resolved the crummey issue against the irs.271 in contrast, the second circuit had decided the issue in the service’s favor.272 the second circuit noted, however, that the exclusions would have been allowed, if the power-holder were an adult.273 in the crummey circuits, the courts would be confronted with an issue they resolved decades earlier. the courts’ earlier decisions would, under the doctrine of stare decisis, militate against the irs’s position.274 moreover, crummey powers have become a ubiquitous estate planning tool and courts may be reluctant to disturb taxpayers’ settled expectations.275 238 florida tax review [vol.6:2 276. tax reform act of 1976, pub. l. 94-455, 90 stat. 1520, 1846-97 (1976) (title xx). 277. the united states supreme court has noted that treasury department regulations that have survived congressional reenactment of the underlying statute get a greater degree of deference than other regulations. nat’l muffler dealers ass’n v. united states, 440 u.s. 472, 561 (1979). a similar analysis would militate against abandoning an irs interpretation that has survived congressional reenactment of the underlying statute, in this case section 2503. maislin indus., 497 u.s. at 135 (“congress must be presumed to have been fully cognizant of this interpretation of the statutory scheme, . . . congress did no t see fit to change it when congress carefully reexamined this area of the law . . .”). cf. dixon v. united states, 381 u.s. 68, 72 (1965) (noting that the commissioner may retroactively correct its mistakes of law); john f. coverdale, court review of tax regulations and revenue rulings in the chevron era, 64 geo. wash. l. rev. 35 , 77-79 (1995) (noting that the assumption that congress fully understood all statutes it reenacts is unwarranted). 278 . see supra note 28 and accompanying text. 279. united states v. craft, 535 u.s. 274, 122 s. ct. 1414, 1425 (2002) (“[c]ongressional inaction lacks persuasive significance . . .”) (citation omitted). 280. wash. energy co. v. united states, 94 f.3d 1557, 1561 (fed. cir. 1996) (“[a]s the courts of appeals have long recognized, the need for uniformity of decision applies with special force in tax matters.”). desire for uniform application of the tax laws across the nation would be a powerful reason for these courts to adopt the reasoning of crummey. id. cf. stifel v. commissioner, 197 f.2d 107 (2d cir. 1952). 281. see stifel, 197 f.2d 107 . but see supra note 88 and accompanying text. 282. see supra notes 181-210 and accompanying text. the author refuses to consider the possibility that the courts may not be convinced by the analysis contained herein. further, despite numerous revisions to the code, including major changes to the federal estate and gift taxes in 1976,276 congress never amended section 2503 to eliminate crummey powers.277 indeed, proposals to legislatively abrogate crummey have failed.278 although it is dangerous to draw conclusions from congressional inaction,279 it may be interpreted as tacit acceptance of crummey. the analysis would be only slightly different in a circuit that had never addressed the crummey issue. in this case, stare decisis would, obviously, not be an issue. circuit courts’ tendency to use precedent from other circuits would, however, partially take its place.280 in the second circuit, in contrast, stare decisis would militate against crummey powers.281 of course, if a split in the circuits were to develop (or even if it did not), it is possible that the united states supreme court would grant certiorari. in that instance, stare decisis would be irrelevant since the united states supreme court has never addressed the crummey issue. there are reasons that the courts might refuse to follow the reasoning of the crummey circuits. primarily, they may realize that crummey was wrongly decided.282 even in the crummey circuits, stare decisis is not an 2003] back to the fu ture interest 239 283. harris v. united states, 122 s. ct. 2406, 2414 (2002) (“stare decisis is not an ‘inexorable command,’ but the doctrine is ‘of fundamental importance to the rule of law.’ even in constitutional cases, in which stare decisis concerns are less pronounced, we will not overrule a precedent absent a ‘special justification.’”) (citations omitted). since the doctrine of stare decisis applies with greater force to cases involving statutory construction, the crummey circuits may be even less likely to overrule their earlier cases. see patterson v. mclean credit union, 491 u.s. 164, 172-73 (1989)(“considerations of stare decisis have special force in the area of statutory interpretation, for here, unlike in the context of constitutional interpretation, the legislative power is implicated, and congress remains free to alter what we have done.”). it has been suggested that stare decisis considerations should be modified to include “demonstrable error” as an independent reason for overruling precedent. see, e.g., caleb nelson, stare decisis and demonstrably erroneous precedents, 87 va. l. rev. 1 (2001). if this reasoning is accepted, then the crummey circuits may have yet another justification for overturning their earlier decisions. 284. in planned parenthood v. casey, the united states supreme court enumerated some of its considerations in deciding whether to overrule precedent. the court noted that we may ask whether the rule has proven to be intolerable simply in defying practical workability; whether the rule is subject to a kind of reliance that would lend a special hardship to the consequences of overruling and add inequity to the cost of repudiation; whether related principles of law have so far developed as to have left the old rule no more than a remnant of abandoned doctrine; or whether facts have so changed, or come to be seen so differently, as to have robbed the old rule of significant application or justification. planned parenthood v. casey, 505 u.s. 833, at 854-5 (1992). 285. revenue rulings are issued by the irs as “official interpretations” of the internal revenue code. regs. § 601.201(a)(6). they are generally reviewed by the treasury department. saltzman, supra note 23, ¶ 3.03[2][a]; regs. § 601.601(d)(2). revenue rulings are not subject to notice and comment rule making, however, the irs considers them binding. regs. §§ 601.601(d)-(e), 601.201(a); see also coverdale, supra note 277, at 79. cf. dixon v. commissioner, 381 u.s. 68, 72-73 (1965). excuse to retain bad law if there is a “special justification” for overruling the earlier decision.283 the experience of the last few decades demonstrates the numerous abuses of crummey. this may be a sufficient “special justification” to warrant a court’s departure from its earlier decision.284 as mentioned, the irs would presumably issue a revenue ruling285 stating its new position that a withdrawal power does not create a present interest. courts have, however, varied regarding the amount of deference, if 240 florida tax review [vol.6:2 286. mitchell m. gans, deference and the end of tax practice, 36 real prop. prob. & t r. j. 731, 775-76 (2002). some courts have held that rulings are nothing more than the opinion of the irs – one of the litigants. thus, rulings are entitled to no deference. see, e.g.,; estate of kosow, 45 f.3d 1524, 1529 n. 4 (11th cir.1995) (“an irs ruling is not the product of notice and comment procedures, but is merely an opinion of an irs attorney.”) (citing stubbs, overbeck & assoc., inc. v. united states, 445 f.2d 1142 , 1146-47 (5th cir. 1971)); costantino v. t rw inc., 13 f.3d 969, 981 (6th cir.1994) (“unlike the regulations, irs rulings do not have the force of law and are merely persuasive authority.”) in contrast, some courts have given irs rulings some deference. these courts have noted that, due to the service’s expertise in administering the internal revenue code, its pronouncements should be respected. see, e.g., foil v. comm issioner, 920 f.2d 1196, 1201 (5th cir.1990) (revenue rulings are “to be given weight as expressing the studied view of the agency whose duty it is to carry out the statute.”); brook, inc. v. commissioner, 799 f.2d 833, 836 n. 4 (2d cir.1986) (“[w]e give some weight to the commissioner’s reading of the section, as expressed in [a revenue ruling] . . ., because it expresses the studied view of the agency whose duty it is to carry out the statute.” (citation omitted)). 287. 323 u.s. 134 (1944). but see united states v. mead corp., 533 u.s. 218, 241 (scalia, j., dissenting) (arguing that chevron overruled skidmore). skidmore provides a level of deference to the agency that is substantially less than the amount afforded the agency under chevron. richard j. p ierce, jr., administrative law treatise §§ 3.5, 3.6 (4th ed. 2002). in christensen v. harris county, the united states supreme court held that a statutory construction contained in an opinion letter issued by the department of labor was not entitled to deference under chevron. 529 u.s. 576, 587 (2000). instead, the court held that “[i]nterpretations [such as those in opinion letters] . . . agency manuals, and enforcement guidelines, all of which lack the force of law” are entitled only to the lesser level of deference provided by skidmore. id. (citing skidmore v. swift and co., 323 u.s. 134, 140 (1944)). cf. mead, 533 u.s. at 254 (scalia, j., dissenting) (stating that this portion of christensen is dicta). similarly, in mead the united states supreme court reached the same conclusion regarding a tariff classification ruling by the united states customs service. 533 u.s. 218, id. at 221 (citing, skidmore, 323 u.s. 134); see also richard j. pierce, jr., supra, §§ 3.5, 3.6. it seems that christensen and mead require that revenue rulings be given the modest amount of skidmore deference. cf. johnson city med. ctr. v. united states, 999 f.2d 973 , 977 (6th cir. 1993) (“[t ]his court accords deference to revenue ruling . . . under the standard set forth in chevron.”). indeed, the service agrees that revenue rulings do not have the force of law. rev. proc. 89-14 1989-1 c.b. 814. (“revenue rulings . . . do not have the force and effect of treasury department regulations”); coverdale, supra note 277, at 79 . any, afforded irs rulings.286 recent united states supreme court cases seem to indicate that the requisite degree of deference is described in skidmore v. swift & co. decided by the court in 1944.287 2003] back to the fu ture interest 241 288. skidmore, 323 u.s. at 140. skidmore seems to afford a low level of deference. samuel issacharoff, behavioral decision theory in the court of public law, 87 cornell l. rev. 671, 677 (2002). if the court is “persuaded” that the agency’s interpretation is correct, then it seems that no amount of deference is needed for the court to adopt its analysis. 289. skidmore, 323 u.s. at 140. 290. patterson v. credit union, 491 u.s. 164 , 172-3 (1989). in contrast, in the second circuit stare decisis would support the irs. stifel v. commissioner, 197 f.2d 107 (2d cir. 1952). but see supra note 88 and accompanying text. stare decisis would not be an issue in the remaining circuits. 291. pedrick, supra note 19, at 950. 292. irc § 7805(a). 293. chevron u.s.a. v. national resources defense council, inc., 467 u.s. 837, 865 (1984); see also atlantic mutual insurance co. v. commissioner, 523 u.s. 382, 387 (1988) (applying chevron deference to a treasury department regulation); tate & lyle, inc. v. commissioner, 87 f.3d 99, 104-105 (3d cir. 1996); regs. § 601.601(a)(2). cf. united dominion indus., inc. v. united states, 532 u.s. 822 (2001) (refusing to give treasury department regulations an expansive reading based, in part, on the fact that the regulations pre-dated revision to the relevant statute). pierce, supra note 287, § 3.5. in skidmore, the united states supreme court held that deference given to an agency interpretation would be based on its “power to persuade.”288 the united states supreme court noted that whether the agency had been consistent in its earlier pronouncements is relevant to whether its interpretation is persuasive.289 the irs’s hypothetical new ruling would be inconsistent with its long acceptance of crummey. thus, under skidmore, it would probably receive little, if any, deference. it seems unlikely that the irs could eliminate the use of crummey powers. in the crummey circuits, stare decisis would support the continued viability of crummey.290 further, although the irs would likely issue an anticrummey ruling, it would be entitled to negligible deference by the courts. moreover, congressional inaction and taxpayers’ settled expectations regarding the viability of crummey would likely undermine the irs’s efforts.291 2. action by the treasury department – the treasury department could attempt to end the use of crummey powers by promulgating a regulation.292 most of the analysis concerning action by the irs is the same in the case of action by the treasury department. the crucial difference is the degree of deference afforded to actions by each. specifically, treasury department regulations are generally afforded chevron deference as described in chevron v. national resources defenses council.293 in chevron, the united states supreme court held that the courts must defer to an agency’s interpretation of the statute the agency administers if: (1) the statute is silent or ambiguous on the “precise issue” addressed by the 242 florida tax review [vol.6:2 294. 467 u.s. at 843. the agency’s “permissible construction” will prevail even if the court would have chosen a different interpretation of the statute. id. at 843, n. 11. 295. irc § 2503(b). 296. chevron, 467 u.s. at 843 ; see also supra note 294 and accompanying text. 297. chevron, 467 u.s. at 843. 298. richard j. pierce, jr., reconciling chevron and stare decisis, 85 geo. l.j. 2225, 2225-26 (1997). 299. lechmere v. nlrb, 502 u .s. 527, 536-37 (1992); pierce, supra note 287, § 3.6. 300. pierce, supra note 298, at 2253. 301. pierce, supra note 287, § 3.6. for example, the second circuit held that an administrative regulation that was inconsistent with an earlier decision by the same court would be upheld unless the regulation “exceeded the secretary’s authority [or is] arbitrary and capricious.” schisler v. sullivan, 3 f.3d 563, 568 (2d cir. 1993) (citation omitted). similarly, in aguirre v. ins, the second circuit addressed the i.n.s.’s interpretation of a statute that was inconsistent with second circuit precedent. 79 f.3d 315 (2d cir. 1996). the earlier decision, however, noted that the court’s analysis was based on the plain meaning of the statute. jenkins v. ins, 32 f.3d 11, 14 (2d cir. 1994); see also pierce, supra note 287, § 3.6. the aguirre court held that the agency cannot compel the court to abandon its earlier decision, however, the court may, in light of the agency’s interpretation, make “an independent decision whether . . . a revised reading of the statute” was required. aguirre 79 f.3d at 317. in the interest of uniform application of the immigration laws, the court adopted the agency’s interpretation. id.; pierce, supra note 287, § 3.6. similarly, in chemical waste management, inc. v. e.p.a., the d.c. court of appeals upheld a regulation even though the regulation was inconsistent with both prior agency interpretations of the statute and decisions by that court. 873 f.2d 1477, 1481 (d.c. cir. 1989). agency, and (2) the agency’s interpretation is “based on a permissible construction of the statute.”294 if the treasury department were writing on a clean slate, an interpretation of the term future interest295 that precludes the use of crummey powers would clearly be a “permissible construction.”296 thus, the hypothetical treasury department regulation would be upheld.297 the treasury department is not, however, writing on a clear slate. in the crummey circuits, the hypothetical treasury department regulation would cause a conflict between two conflicting policies: chevron deference and stare decisis.298 the united states supreme court has held that stare decisis for its decisions trumps agency regulations.299 the supreme court has not, however, addressed this issue with respect to decisions of the lower courts.300 generally, lower courts have deferred to the agency’s interpretation and overruled their earlier decision.301 it seems likely that a treasury department regulation in abrogation of crummey would be upheld, assuming the court decided that the treasury 2003] back to the fu ture interest 243 302. chevron, 467 u.s. at 843. since an interpretation of irc § 2503 does not permit crummey powers is not only “permissible” but is, in fact, correct, the hypothetical regulation should meet the requirements of chevron. see id.; see supra notes 181-210 and accompanying text. 303. see supra note 275. action by the treasury department to make such a sweeping change in the law is not, however, unprecedented. for example, in 1997, the treasury department promulgated the “check the box” regulations that supplanted the widely criticized kitner regulations. treas. reg. §§ 301.7701-2 – 301.7701-4. the kitner regulations provided a formal set of rules to determine whether an entity is taxed as a partnership or a corporation. tres. reg. §§ 301 .7701-2 (1996 ); irs notice 95-14 (april 3, 1995). although the validity of the check the box regulations has been questioned, the regulations are relatively pro-taxpayer and they have not been challenged. see, e.g., william s. mckee & m ark a. kuller, issues relating to choice of entity, entity characterization and partnership anti-abuse rules, 464 pli/tax 9, 19-20 (2000). 304. chevron, at 865-66. chevron anticipated that agency attitudes may change over time because an agency, unlike the courts, is politically accountable. id. in this regard, the political reality is that the current administration’s attitude toward transfer taxes makes treasury department action unlikely. see supra notes 260-62 and accompanying text. 305. smiley v. citibank (south dakota), n.a., 517 u.s. 735, 742 (1996). 306. irc § 7805(b); bowen v. georgetown univ. hosp., 488 u.s. 204, 208-09 (1988). it seems possible that reliance concerns may be adequately addressed by a prospective regulation. irc § 7805(a); see supra note 264. department’s interpretation of the statute was permissible.302 in the crummey circuits, stare decisis would complicate the issue. it seems, however, that chevron deference may trump stare decisis. on the other hand, courts may be reluctant to disturb taxpayers’ settled expectations regarding crummey powers.303 this is especially true considering the extensive use of crummey powers in estate planning. further, it is possible that a court would conclude that the irs’s long acquiescence in crummey, and the treasury department’s silence, has rendered the hypothetical treasury department regulation an impermissible construction of the statute. part of the rationale for chevron deference, however, is to allow the agency to reflect changing political environments.304 thus, even though an agency’s interpretation of a statute may change, the new interpretation may receive chevron deference.305 therefore, a treasury department regulation that adequately addresses taxpayers’ reliance concerns306 may receive chevron deference and end the abuse inherent in crummey powers. crummey powers are, however, ubiquitous. thus, the treasury department would likely be reticent to disturb such a well-settled understanding of the federal gift tax annual exclusion, even though it likely has the power to do so. moreover, given the current administration’s animosity towards transfer 244 florida tax review [vol.6:2 307 . see supra notes 260-62 and accompanying text. 308 . see supra note 219 and accompanying text. 309 . see supra notes 211-19 and accompanying text. 310 . see supra notes 230-37 and accompanying text. 311. see supra notes 61-79, 181-89 and accompanying text. once the service acquiesced in crummey it may have precluded litigating the basic validity of withdrawal powers. see supra notes 270-91 and accompanying text. thus, by the time of the later cases it was relegated to only litigating ancillary issues. see, e.g., estate of kohlsaat v. commissioner, 73 t.c. memo (cch) 2732 (1997). 312. crummey v. commissioner, 397 f.2d 82, 83-84 (9th cir. 1968). 313. gopman, supra note 27, at 200. as mentioned, the potential for abuse in a lapsing crummey power is substantially greater than the opportunities for taxavoidance provided by a non-lapsing power. see supra note 98 and accompanying text. 314. stifel v. commissioner, 197 f.2d 107 (2d cir. 1952). taxes and transfer tax simplification,307 treasury department action seems unlikely for now. vi. conclusion crummey and the related withdrawal power cases were incorrectly decided. they fail to distinguish between a gift of property and a gift of a power to vest property in oneself. the difference is significant, especially considering the mandated narrow construction of the annual exclusion.308 the arguments in favor of allowing federal gift tax annual exclusions based on withdrawal powers are weak and rely largely on inapposite analogies to the federal income tax.309 moreover, crummey powers are wholly inconsistent with the legislative intent behind the annual exclusion.310 the blame for the sad state of law concerning crummey powers must be laid at the feet of the internal revenue service. it never litigated the use of withdrawal powers to create a present interest and obtain the federal gift tax annual exclusion. instead, the service accepted the basic premise of withdrawal powers and litigated ancillary issues.311 indeed, crummey itself involved solely an ancillary issue: whether the power-holder must be an adult.312 once the service accepted the basic tenets behind withdrawal powers, however, it assured its loss on the ancillary issues. the service compounded its litigation error by acquiescing in crummey. in acquiescing, the service ignored that crummey – unlike the earlier cases – involved a lapsing withdrawal power.313 moreover, the service turned its back on its victory in the second circuit314 and its repeated success 2003] back to the fu ture interest 245 315. see supra note 242 and accompanying text. even after crummey, the tax court expressed, albeit in dicta, its continued reticence to accept crummey powers. heidrich v. commissioner, 55 t.c. 746 , 753, n. 8 (1971). 316 . see supra note 244 and accompanying text. 317. mason, supra note 21, at 593. this is accomplished by giving crummey powers to numerous individuals with little or no interest in the trust. see supra note 21. 318. commissioner’s brief at 19, estate of cristofani v. commissioner, 97 t.c. 74 (1991) (no. 28538-89). 319 . see supra notes 250-64 and accompanying text. 320 . see supra notes 150-51 and accompanying text. 321. see, e.g., l. henry gissel, jr., has crummey turned lousy? not yet according to kohlsaat!, sc13 ali-aba 265, 265 (1997); gregory m. mccoskey, why relying on cristofani to draft trust withdrawal powers is a “crummey” idea, fla. b. j., july/aug. 1997 at 67. pedrick, supra note 19, at 943 (“crummey is really crummy!”). in the tax court.315 indeed, the service surrendered the issue seemingly without realizing the potential for abuse inherent in the ruse it had sanctioned.316 a provision initially intended to exclude informal gifts has evolved into a highly structured estate planning tool. allowing annual exclusion gifts through the use of crummey powers may seem a minor side-step of congressional intent. this fails, however, to account for the varied uses of crummey powers. for example, skillful use of crummey powers allow taxpayers to multiply the number of exclusions almost without limit.317 indeed, crummey powers have the potential to undermine the entire transfer tax system.318 abrogation of the use of crummey powers is necessary. it seems that a considered congressional response in this area would be the best course of action.319 admittedly, however, congressional action to eliminate crummey is currently unlikely. a treasury department regulation that sought to eliminate crummey powers would likely be given effect, despite inconsistent court precedent. however, treasury department action in this area is also currently unlikely. it seems that the service may be stuck with crummey powers. although the service can revoke its earlier rulings and begin litigating the withdrawal powers issue anew, its chances for success in this regard are slim. thus, absent action by congress or the treasury department, the irs will be forced to lie in the bed it made for itself decades ago. regardless of the future of the federal estate tax, the federal gift tax and the annual exclusion seem likely to remain a part of the federal transfer tax system for the foreseeable future. indeed, recent changes to the estate tax may, in the short term, increase the use of the annual exclusion and crummey powers.320 perhaps such use will eventually convince congress or the treasury department to act. until they do, the homonym that has amused many familiar with crummey powers321 will continue to be both amusing and, sadly, accurate. page 1 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 page 16 page 17 page 18 page 19 page 20 page 21 page 22 page 23 page 24 page 25 page 26 page 27 page 28 page 29 page 30 page 31 page 32 page 33 page 34 page 35 page 36 page 37 page 38 page 39 page 40 page 41 page 42 page 43 page 44 page 45 page 46 page 47 page 48 page 49 page 50 page 51 page 52 page 53 page 54 page 55 page 56 page 57 page 58 page 59 page 60 page 61 page 62 just to be ornery, i'll take issue with alan on this, and point out that these dicta can o * stearns weaver miller weissler alhadeff & sitterson professor of law, florida state university college of law. 369 florida tax review volume 8 2007 number 4 murphy and the sixteenth amendment in relation to the taxation of non-excludable personal injury awards by joseph m. dodge* i. framing constitutional tax issues . . . . . . . . . . . . . . . . . . . . . . 371 a. constitutional provisions relating to the taxing power of congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371 b. is the indirect tax issue relevant to murphy? . . . . . . . . . . . . 373 ii. interpreting the sixteenth amendment . . . . . . . . . . . . . . . . . 380 a. textualism rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380 b. interpreting ambiguous text . . . . . . . . . . . . . . . . . . . . . . . . . 385 c. interpretative theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386 iii. does “income” under the sixteenth amendment include emotional harm damages? . . . . . . . . . . . . . . . . 392 a. the no-gain theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392 1. “incomes” under the sixteenth amendment means “gross receipts” . . . . . . . . . . . . . . . . . . . . . . . 392 2. the meaning of “capital” under the income tax . . . . 408 3. there is no recoverable basis in personal injury recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420 b. the “in lieu of” theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424 1. there really is no “in lieu of” doctrine . . . . . . . . . . . 425 2. the murphy version of the doctrine would destroy the income tax . . . . . . . . . . . . . . . . . . . . . . . . 427 iv. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427 370 florida tax review [vol.8:4 1. 460 f.3d 79 (aug. 22, 2006). 2. see murphy v. irs leaves tax community reeling, at http://www. taxanalysts.com/www/website.nsf/web/spotlightonmurphy?opendocument&simple=1 (providing link to 5 pieces that appeared in tax notes within three weeks of the murphy decision). 3. on october 5, 2006, the government filed a petition for rehearing en banc. the petition can be found at: http://taxprof.typepad.com/taxprof_blog/files/murphy_en_ banc_petition.pdf. 4. see 2006 u.s. app. lexis 32293 (d.c. cir. dec. 22, 2006). 5. see 460 f.3d at 92. on a point of procedure, the u.s. court of appeals for the district of columbia held that the internal revenue service (the irs) was not a proper party (and not subject to injunction), but that it could entertain a refund suit against the united states. see id. at 83. murphy and the sixteenth amendment in relation to the taxation of non-excludable personal injury awards a recent panel decision of the u. s. court of appeals for the district of columbia, murphy v. internal revenue service, shocked the tax community1 2 by holding that internal revenue code section 104(a)(2) was unconstitutional by failing to exclude from gross income revenue (damages for emotional distress and injury to professional reputation) that is not “income” under the sixteenth amendment to the u.s. constitution. a petition for rehearing en banc was filed, but, in a highly unusual3 move, the d.c. circuit panel that decided the case, on its own motion, vacated its judgment and set the case for re-argument.4 before 1996, section 104(a)(2) had excluded from gross income compensatory damages on account of personal injuries, including non-physical personal injuries of the type suffered by plaintiff murphy. in 1996, congress narrowed the exclusion so that it only applied to damages on account of physical personal injuries, thereby removing the exclusion for non-physical injuries. the panel stated its constitutional holding as follows: insofar as § 104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional.5 part i contains a brief description of the federal constitutional provisions concerning taxation and how they are related to each other. part ii discusses the issue of how to interpret the sixteenth amendment. part iii considers the on-the-merits exclusionary theories offered by the murphy panel. 2007 murphy and the sixteenth amendment 371 6. see arts. of confederation, art. viii (mar. 1, 1781), at: http://www.yale.edu/lawweb/avalon/artconf.htm#art8. 7. see the federalist no. 15, at 89-90 (alexander hamilton), at: http://www.foundingfathers.info/federalistpapers/fedindex.htm (stating that the states treated requisitions as mere recommendations); calvin h. johnson, the apportionment of direct taxes: the foul-up at the core of the constitution, 7 wm. & mary bill of rights j. 1, 131-33 (1998) (hereinafter “foul-up”) (difficulty of honest appraisals). 8. see cohens v. virginia, 6 wheat. (19 u.s.) 264, 388 (1821) (marshall, c.j.): “the requisitions of congress, under the confederation, were as constitutionally obligatory as the laws enacted by the present congress. that they were habitually disregarded, is a fact of universal notoriety. with the knowledge of this fact, and under its full pressure, a convention was assembled to change the system.” 9. see hylton v. united states, 3 u.s. (3 dall.) 171, 173, 176, 181 (1796). 10. see fernandez v. wiener, 326 u.s. 340 (1945); united states v. ptasynski, 462 u.s. 74 (1983). i. framing constitutional tax issues section a describes the constitutional provisions relating to the taxing power of congress (with which most readers will be familiar) and section b deals with the issue of whether the murphy panel properly ignored the “indirect tax” issue. a. constitutional provisions relating to the taxing power of congress under the articles of confederation, the federal government had only the power to impose requisitions on the states in proportion to the value of land and improvements thereon. however, the states typically refused to pay over6 their assigned quotas, and the federal government possessed no other taxing7 power. the constitutional convention of 1787 was called in part to overcome this problem. under article i, § 8, clause 1, of the constitution, congress is8 granted authority to “lay and collect taxes, duties, imposts, and excises,” but “all duties, imposts and excises shall be uniform throughout the united states.” the uniformity requirement has been construed by judicial decisions to apply to “taxes” (other than direct taxes) as well as to duties, imposts, and excises,9 but it is deemed to prevent only patent or intentional discrimination based on geography.10 the “direct tax” concept appears in article i, § 2, dealing with representation in the house of representatives. clause 3 thereof requires both direct taxes and representatives to be apportioned among the states in accordance with population, in which slaves were counted as three-fifths of a person. somewhat redundantly, article i, § 9, clause 4, states that no “capitation or other direct tax shall be laid except in proportion to the census.” there is no definition of “direct tax” in the constitution, and none was offered 372 florida tax review [vol.8:4 11. on aug. 20, 1787, rufus king asked for the meaning of “direct tax,” but no reply was given. see madison’s notes of aug. 20, 1787, at: http://www.teachingamericanhistory.com/convention/debates/0820.html. 12. see hylton v. united states 3 u.s. (3 dall.) 171 (1796), upholding an unapportioned annual tax on the value of carriages, where it was stated that a direct tax is a tax (like a head tax or requisition on the states) that was capable of apportionment among the states in proportion to population, but it was also stated in dictum that a tax on real estate (including slaves) would also be a direct tax. the federal government initially subsisted on customs duties and excises, but on three occasions imposed a tax on real estate that was apportioned among the states in accordance with population. see act of july 14, 1798, 1 stat. 597, vh. 75, 5th cong., 2d sess.; acts of july 22 and aug. 2, 1813, 3 stat. 22, 53, chs. 22 & 37, 13th cong., 1st sess.; act of aug. 5, 1961, 12 sta. 292, ch. 45, 37th cong., 1st sess. the civil war income tax was upheld as an indirect tax in springer v. united states, 102 u.s. 586 (1881). 13. 157 u.s. 429 (1895) (holding tax on rents to be unconstitutional as an unapportioned direct tax), on rehearing, 158 u.s. 601 (holding tax on income from personal property to be equally unconstitutional). 14. see knowlton v. moore, 178 u.s. 41 (1899) (federal inheritance tax of 1898 is an excise); flint v. stone tracy co., 220 u.s. 107 (1911) (1909 tax on privilege of doing business as corporation, measured by annual net income, is an excise). 15. see brushaber v. union pacific railroad co., 240 u.s. 1 (1916). in the constitutional convention. thus, the matter has been left to judicial11 construction, culminating in the 1895 case of pollock v. farmers’ loan &12 trust co., invalidating the unapportioned 1894 income tax on the ground that13 a tax on the income from any property (real or personal) was a tax on the property itself, and therefore “direct.” pollock created an uproar, and in subsequent years various federal taxes were upheld as indirect taxes, not subject to the apportionment requirement.14 the political impetus that gave rise to the 1894 income tax not only survived pollock but gained support. the sixteenth amendment, proposed by congress in 1909 and ratified in 1913, states: the congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration. congress enacted a personal (individual) income tax in 1913, which has continued (with numerous additions and changes) to the present. the supreme court upheld the tax in 1916, stating that the purpose of the 16th amendment15 2007 murphy and the sixteenth amendment 373 17. pollock is now a dead letter with respect to its holding that a tax on income from property is a direct tax. see stanton v. baltic mining co., 240 u.s. 103, 112-13 (1915) (general repudiation of pollock rationale); new york v. graves, 300 u.s. 308, 314 (1937) (new york could tax a new york resident on rents from new jersey property, although new york could not impose a property tax on new jersey real estate); south carolina v. baker, 485 u.s. 505 (1988) (overruling that portion of pollock that held that a tax on state bond interest was a tax on the state itself in violation of the 10th amendment). however, the portion of pollock that held that a tax on personal (as well as real) property is a direct tax was implicitly followed in eisner v. macomber, 252 u.s. 189 (1920). 18. see penn mutual ins. co. v. comm’r, 277 f.2d 16, 19-20 (3d cir.1960). 19. see, e.g., edward dibartolo corp. v. florida gulf coast building construction trade council, 485 u.s. 568 (1988); rust v. sullivan, 500 u.s. 173 (1991). 20. see conference report no. ???, 104th cong., 2d sess. 141-44 (with caption: “include in income damage recoveries for non-physical injuries”). however, the text under the caption makes no mention of inclusion. was to remove the apportionment requirement from federal income taxes, rather than to redefine the contours of “direct tax.”17 to summarize, congress lacks the power to impose a tax only if the tax is not on “income” and it is an unapportioned direct tax. thus, an18 unapportioned federal tax is valid if it is either an income tax or an indirect tax. b. is the indirect tax issue relevant to murphy? given that a federal tax provision, to be unconstitutional, must flunk both the “income” (16th amendment) test and the (unapportioned) direct tax test, it would appear to be the case that any enactment that flunks the 16th amendment must also be tested under the direct tax test. however, it is first necessary to ascertain how, if at all, the constitution is relevant in murphy, as it is axiomatic that a court should not reach the constitutionality of a federal statute if such can be avoided and the case can be resolved on other grounds, such as statutory interpretation. the murphy panel violated this axiom,19 because it could have avoided the invalidation of any statutory provision. section 104(a)(2), the provision held by the murphy panel to be unconstitutional as applied to the facts of that case, merely excludes specified recoveries from gross income. the panel seemed to believe that the failure of the exclusion to apply to the facts automatically resulted in inclusion. indeed, congress probably assumed that removal of the exclusion resulted in automatic gross income inclusion. however, congress creates law through legislation,20 not by way of assumptions, understandings of existing law, and statements in 374 florida tax review [vol.8:4 21. examples of erroneous congressional assumptions are found in irc §§ 195(c)(1)(b) (assumption as to what is an “expense”) and 274(b) (assumption as to what is “gift”). 22. holding that an exclusion doesn’t go far enough smacks of judicial legislation. it might be said that the murphy panel decision goes beyond merely striking of the word “physical” from the statutory exclusion provided by irc § 104(a)(2), because it also states (460 f.3d at 91, 92) that damages (from non-physical injuries) relating to lost wages or earnings would be taxed. thus, the panel effectively amended the statute to read that the exclusion applied to damages for “non-physical personal injuries (except for damages related to lost wages or earnings) and physical personal injuries.” 23. this dictum is discussed in the text accompanying notes 25-32. committee reports. such matters might be considered by courts or the21 treasury (in promulgating regulations) in interpreting statutory text or filling a gap in the statutory scheme. however, the assumption that a non-excluded item is automatically included is neither an interpretation of the text of section 104(a)(2), nor does it fill any gap, because any such gap as may exist is already filled by section 61(a), which specifies what is included in gross income. section 61 states that “except as otherwise provided in this subtitle [by way of statutory exclusion], gross income means all income from whatever source derived, including (but not limited to) the following items: [there follows a list of enumerated items, such as compensation for services, gains from property transactions, interest, dividends, and so on].” note that the lead-in clause to section 61(a) itself picks up where the statutory exclusions leave off. thus, it was error to hold that section 104(a)(2) was unconstitutional, because the nonapplicability of that exclusionary rule must lead to consideration of the issue of whether the recoveries in question were gross income under section 61(a). if section 61 did not purport to include the item in question, then there could be no unconstitutional tax. since none of the enumerated items in22 section 61(a) refer explicitly or implicitly to recoveries of damages, the controlling language with respect to the murphy facts is “all income from whatever source derived,” which is commonly referred to as the “catch-all clause.” at this point the relevance of the constitution to murphy comes into focus: “income” in the catch-all clause is the same as “income” in the 16th amendment. this position derives support from the fact that the catch-all clause language (“all income from whatever source derived”) tracks the 16th amendment language (“incomes, from whatever source derived”). further support is lent by an oft-repeated supreme court dictum to the effect that section 61 represents the “full measure of the taxing power [of congress].”23 thus, the relevant exercise is that of defining a statutory term with reference to the 16th amendment, and not of holding that section 61 (as applied) is unconstitutional, much less that section 104(a)(2) is constitutionally defective. 2007 murphy and the sixteenth amendment 375 22. several supreme court cases holding irc § 104(a)(2) to be inapplicable resulted in inclusion, but in all of these cases inclusion (the issue posed in murphy) was simply assumed (and conceded by the taxpayer). see united states v. burke, 504 u.s. 229, 233 (1992); comm’r v. schleier, 515 u.s. 323 (1995); comm’r v. o’gilvie, 519 u.s. 79 (1996). 23. see martin v. hunter’s lessee, 1 wheat. (14 u.s.) 304, 326-27 (1816) (story, j.): [w]here a power is expressly given [by the constitution] in general terms, it is not to be restrained to particular cases. ... the instrument was not intended to provide merely for the exigencies of a few years, but was to endure through a long lapse of ages... . it could not be foreseen what new changes and modifications of power might be indispensable to effectuate the general objects of the charter; and restrictions and specifications, which, at the present, might seem salutary, might, in the end, prove the overthrow of the system itself. hence its powers are expressed in general terms, leaving to the legislature, from time to time, to adopt its own means to effectuate legitimate objects, and to mold and model the exercise of its powers, as its own wisdom, and the public interests, should require. whether the murphy panel correctly held that emotional distress damages were not income under the catch-all clause as viewed through the lens of the 16th amendment is a different issue, taken up later in part iii. the question considered here is whether the murphy panel, after having held (erroneously, in my view) that such damages were not “income,” should have gone on to consider the power of congress to lay indirect taxes without apportionment. on this point, the murphy panel correctly (if perhaps without reflection) declined to consider the indirect tax issue. no provision exists that specifically states that non-excludible damages are taxed (by being included in gross income). therefore, the sole locus of the inclusion of emotional distress damages must be in the catch-all clause of section 61, which states that the22 item is includible (only) if it is “income.” if it is not “income,” it is not taxed under the statute. the fact that other inclusion provisions might derive their power (in whole or in part) from the power to impose indirect taxes is beside the point with regard to the murphy facts. it seems unlikely that “income” under the catch-all clause could have a broader meaning than “incomes” under the 16th amendment. a contrary supposition would run into several problems. first, it would violate a general canon of constitutional interpretation that a power granted by the constitution should encompass particular statutory exercises of such power. second, if23 “income” in the catch-all clause of section 61 were construed to include anything that congress could tax as an indirect tax, then it would no longer mean “income,” but something broader and perhaps indeterminate. third, such a construction would amount to treating congress as having legislated what it didn’t actually legislate, thereby violating separation-of-powers theory. 376 florida tax review [vol.8:4 24. see helvering v. clifford, 309 u.s. 331, 334 (1940). 25. if congress has the power to tax compensation for services, it is hard to conceive of a theory under which all of the existing exclusions for employee fringe benefits are constitutionally mandated. cf. comm’r v. kowalski, 434 u.s. 77, 82-83 (1977) (narrowly construed the irc § 119 exclusion, resulting in inclusion). congress has to act by actual legislation. it cannot enact an open-ended rule whose content is dictated by possible future (valid) legislation. the indirect-tax power would come into play under two scenarios. the first scenario (not presented in murphy) is where the statute specifically taxes an item (by including it in income), but such an item is not “income” under the 16th amendment. the second scenario is where (contrary to the analysis in the preceding paragraph) the catch-all clause meaning of “income” is broader than the meaning of “incomes” under the 16th amendment. but no court (including the murphy panel decision) has, to my knowledge, taken such a view, and so it must be viewed as being only a remote theoretical possibility. the murphy panel decision implicitly adopted a narrow construction of catch-all “income” because it adopted a restrictive view of 16th amendment incomes. it is worth pausing over the import of the dictum about congress having “fully exercised its taxing power.” the full original statement of the dictum was: “the broad sweep of this language [the predecessor of irc section 61(a)] indicates the purpose of congress to use the full measure of its taxing power within those definable categories.” [emphasis added.] in other words, the24 dictum does not apply to the code as a whole, but only to particular provisions therein. the position that congress has fully exercised its taxing power in the code as a whole is untenable, unless one makes the implausible assumption that each and every statutory income exclusion is mandated by the constitution,25 but in that case the statutory exclusions would be pointless. it is axiomatic that a reading of statutory and constitutional text that renders the same futile or redundant is to be avoided. in the context of particular code provisions, the dictum has always been deployed as a maxim of statutory interpretation, rather than as a statement of constitutional principles. none of the cases in which the dictum appears seriously entertained a constitutional challenge to the provision requiring inclusion. instead, the effect of the maxim was always to construe various clauses of section 61 (including the catch-all clause) as having a broad 2007 murphy and the sixteenth amendment 377 26. the clifford statement, note 24, was followed by a cite to helvering v. midland mutual life insurance co., 300 u.s. 216, 223 (1937), which found “interest” income to exist for tax purposes in a situation where interest was neither received in cash nor accrued on the taxpayer’s books. in a similar vein, “dividends” would include any kind of economic benefit transferred by a corporation to a shareholder on account of stock ownership, whether in cash or in kind, and whether or not treated as a “dividend” on the corporation’s books. the “full use of the taxing power” phrase was cited notably in comm’r v. glenshaw glass co., 348 u.s. 426 (1955), which held that punitive damages in a commercial setting were “income” under the catch-all “income” clause. 27. 245 u.s. 151 (1917). 28. it is possible that gould may have simply been wrongly decided within the framework of 1917 jurisprudence. however, gould is still considered “good law” for the rule that “support” payments are excluded unless specifically included. 29. see mahana v. united states, 88 f. supp. 285 (ct.cl.1950), cert. denied 339 u.s. 978; fairbanks v. comm’r, 191 f.2d 680 (9th cir.1951), cert. denied, 343 u.s. 915 (taxation of alimony is statutory matter); neeman v. comm’r, 26 t.c. 864 (1956), aff’d per curiam , 255 f2d 841 (2d cir.1958) (gould was statutory-construction case). 30. there is a fourth possible theory, namely, that congress has the power to expand the meaning of “income” under the 16th amendment. erik m. jensen, the taxing power, the sixteenth amendment, and the meaning of “incomes,” 33 ariz. st. l.j. 1057, 1091-1107 (2001), accuses certain commentators of endorsing this “delegation” theory. i do not. the notion that congress can expand the concept of income under the 16th amendment can only be true if the constitution has delegated such a power to congress, which is a proposition that cannot be gleaned from any constitutional text, and one that undermines the very idea of a constitution. reach, and a broad construction of statutory provisions implies a broad26 construction of the federal taxing power. the evolution of the tax treatment of alimony offers a useful case history of the interplay of the taxing statute and the federal taxing power from the earliest days of the income tax. the 1917 supreme court decision in gould v. gould held that cash support received by a wife from her husband under a27 decree of separate maintenance was not income. although gould purported to rest on the predecessor of section 61 rather than the constitution, gould would have implicated the 16th amendment if the dictum (which first appeared 20 years after gould was decided) were taken at face value. however, in 194228 congress enacted the predecessor of section 71, which treats cash alimony (as defined therein) as gross income to the recipient. if gould were implicitly a decision resting on the 16th amendment, and if the 16th amendment were “the only game in town,” then section 71 would necessarily be unconstitutional. but section 71 has been long been held to be valid, and such validity can be based29 only on three plausible theories. one is that gould correctly held that alimony30 is not “income” under the 16th amendment, but that section 71 is valid as being 378 florida tax review [vol.8:4 31. the irc § 71 tax on alimony is not a tax on property (or the income from property), which is the only kind of tax (other than a head tax or requisition) that current doctrine clearly assumes to be a direct tax. see note 12. conversely, a tax on a transfer is considered to be an indirect tax. see marjorie kornhauser, the constitutional meaning of income and the income taxation of gifts, 25 conn. l. rev. 1 (1992) (hereinafter “gifts”). 32. see note 53 and accompanying text. 33. see 460 u.s. at 88-90. 34. in mahana, note 29, the court upheld the validity of irc § 71 under the 16th amendment, stating that gould only purported to be a case of statutory interpretation, and that the “full exercise of its taxing power” maxim appearing in later cases should not be deployed to treat gould (retroactively) as having had constitutional import. see also, hawkins v. comm’r, 6 b.t.a. 1023, 1025 (1927) (stating that certain personal injury damages were non-income under the catch-all clause, but that congress could reverse this result). 35. for what it is worth, the relevant title of the u.s. code is called the “internal revenue code,” not the “income tax code.” subtitle a thereof is called “income taxes,” but it includes provisions (relating to the corporate income tax) that were upheld (prior to ratification of the 16th amendment) as an indirect tax. see note 13. other titles contain excises and other indirect taxes. an indirect tax provision not subject to the apportionment requirement. (this31 possibility is not relevant to murphy, because there is no “damages” analogue to section 71.) the second is that gould (despite purporting to be a statutoryconstruction case) was a narrow construction of “incomes” under the 16th amendment that was subsequently (if perhaps implicitly) overruled by the supreme court in later decisions. (this possibility undermines the murphy32 panel’s view that early interpretations of the 16th amendment are definitive.)33 the third is that gould was indeed (as it claimed) a statutory-construction case that adopted a narrow view of catch-all income as of 1913 but did not adopt a narrow construction of “incomes” in the 16th amendment. (under this view,34 later cases could – and did – adopt a broader view of statutory construction, as evidenced by the emergence of the “full exercise of the taxing power” dictum in the late 1930s, without running afoul of the 16th amendment, in the case of catch-all income, or the direct tax problem, in other cases.) the effect of treating something (such as certain alimony) as gross income by statute is that it is included in the tax base that is subject to tax. a way of stating the problem is whether congress has the power to tax something (such as alimony) as “income” that the supreme court has held not to be “income” (within the 16th amendment). but the power of congress is not thwarted by its means of expression. there is nothing in the constitution requiring statutory law to be organized and labeled in a certain way, and the35 2007 murphy and the sixteenth amendment 379 36. see stanton v. baltic mining co., 240 u.s. 103 (1915) (provisions within an income tax that arguably do not tax income can be valid as indirect tax provisions); penn mutual ins. co. v. comm’r, 277 f.2d 16, 19-20 (3d cir.1960) (same). 37. the case that is most hostile to the taxing power, the pollock case, note 12, supports this conclusion. there, the wage portion of the tax was held to be valid as an indirect tax, despite being contained within an “income tax.” in agreement with this analysis are, e.g., kornhauser, note 31 (gifts); douglas a. kahn, the constitutionality of taxing compensatory damages for mental distress when there was no accompanying physical injury, 4 fla. tax rev. 128, 130 (1999); bruce a. ackerman, taxation and the constitution, 99 colum. l. rev. 1, 16-18 (1999); lawrence zelenak, radical tax reform, the constitution, and the conscientious legislator, 99 colum. l. rev. 833, 843-44 (1999); calvin h. johnson, fixing the constitutional absurdity of the apportionment of direct tax, 21 const. comm. 295, ??? (2004) (hereinafter “apportionment”). jensen, note 30, appears to be the only outlier, characterizing this position (at 1086) as “anything goes,” which is false, since (1) the item must be explicitly taxed by congress, and (2) any tax on non-income must still pass the indirecttax test. 38. the well-known case of eisner v. macomber, 252 u.s. 189 (1920), involved a specific statutory provision that treated stock dividends as gross income. the supreme court held that pro rata stock dividends were not “income” under the 16th amendment, but it also held (at 217-18) that the resulting tax on (a portion of the value) of the shares of stock was an unapportioned direct tax. 39. another example is presented by the statutory exclusion for “qualified scholarships” under irc § 117. if the exclusion is found not to apply, it is not certain that it is includible in income, because no code provision so states. thus, the inclusion issue, if not otherwise settled under some specific code provision (such as the “compensation for services” clause that is irc § 61(a)(1)), must be dealt with under the catch-all clause of § 61(a) (and the 16th amendment), and here certain scholarships might be viewed as entailing non-income commercial price discounts. see palmer v. comm’r, 302 u.s. 63 (1937); pellar v. comm’r, 25 t.c. 299 (1955) (acq,); rev. rul. 91-36, 1991-2 c.b. 17 (all holding that the excess of the value, or highest market price, over the actual price charged is non-income where the transaction is arms-length in commerce). as to the taxation of scholarships generally, see joseph m. dodge, scholarships under the income tax, 45 the tax lawyer 697 (1993). scope of congressional power cannot be constrained by mere labels. if36 congress has the power to tax cash alimony received on the ground that the tax is not a direct tax, then the exercise of that power must be valid despite the fact that the item is taxed under the rubric of “income.”37 to summarize, a specific income-inclusion provision, whether found as an enumerated section 61(a) item or elsewhere in the code, is constitutionally valid if it passes either the 16th amendment “income” test or the “indirect tax” test. however, if an item is potentially taxable only under the catch-all clause38 of section 61(a), then it must pass the “incomes” test, and it cannot be bootstrapped into validity as being potentially the subject of a hypothetical (but non-existent) provision that would be valid as an unapportioned indirect tax.39 380 florida tax review [vol.8:4 41. burk-waggoner oil ass’n v. hopkins, 269 u.s. 110, 114 (1925), is cited by the murphy panel (460 f.3d at 87) for the proposition that congress cannot make something income that is not income, but that is different from the false proposition that congress cannot tax something that is not income. in any case, the holding in burkwaggoner (that an unincorporated joint stock company could be taxed as a corporation by congress) lends no support whatsoever to the murphy panel decision. 42. 252 u.s. 189 (1920). 44. id. at 206-07. this frame of analysis avoids the “delegation problem,” because it rejects the proposition that congress can expand the concept of “income” without regard to the 16th amendment.41 in the emotional damages situation considered in murphy, there is no specific-inclusion provision. therefore, the outcome hinges solely on the applicability of the catch-all clause of section 61 as viewed through the sixteenth amendment. the issue of what is a “direct tax,” although interesting and important, is not relevant to murphy. ii. interpreting the sixteenth amendment although the murphy panel got one thing right (perhaps by accident) by not considering the indirect tax issue, it got the rest of it wrong in holding that the damages were not income under the catch-all clause of section 61 as interpreted by reference to the 16th amendment. in discussing the 16th amendment, it is necessary to discuss not only its substantive content (considered in part iii) but the “procedure” of its interpretation. the usual starting point for interpretation is the text itself. only if the text is ambiguous should one refer to external sources, namely, (1) context and (2) original intent. the murphy panel made no attempt at textual analysis, and made no finding that “incomes” was ambiguous as applied to emotional distress damages. instead, the panel moved directly (and without discussion) to a particular version of the original-intent approach, which privileged early non-judicial interpretations of the 16th amendment and allowed the panel to disregard later authority inconsistent with its views. a. textualism rules the murphy panel erred in ignoring the settled law pertaining to the interpretation of the 16th amendment, which overwhelmingly has adopted textualism as its guiding principle. in the 1920 case of eisner v. macomber, considering (inter alia)42 whether a pro-rata stock dividend was income within the meaning of the 16th amendment, the majority opinion stated:44 2007 murphy and the sixteenth amendment 381 45. the macomber definition first appeared in stratton’s independence v. howbert, 231 u.s. 399, 415 (1913), a case arising under the 1909 corporation tax act. there it was offered without citation, and had no bearing on the holding, which was that the income from a mining operation was not required to be computed in a way that never showed a profit or loss. the court noted (id. at 417) that the term “income” in the 1909 act need not be construed the same as under the 16th amendment. the court also stated that theories of income didn’t matter under an excise tax, which the 1909 tax was held to be. see note 13. the next appearance of the definition was in doyle v. mitchell bros. co., 247 u.s. 179, 185 (1918), where the “gain” notion was culled out to advance the notion that gross income under the 1909 corporation tax act was net of “return of capital.” 46. “income” is still defined in one dictionary as it might have been in the early 20th century. see merriam-webster dictionary (online version as of sept. 25, 2006), at http://www.m-w.com/cgi-bin/dictionary, as follows: “1: a coming in ...; 2: a gain or recurrent benefit usually measured in money that derives from capital or labor; also: the amount of such gain received in a period of time <has an income of $30,000 a year.>” a more contemporary definition is found in webster’s dictionary (online version as of sept. 25, 2006), at http://www.websters-online-dictionary.org/definition/income, as follows: “1. the financial gain (earned or unearned) accruing over a given period of time.” the dictionary definitions circa 1920, as reported in kornhauser, note 31 (gifts), at 9 (n. 30), laid more emphasis on the idea of “regular or recurring,” but at the same time referred to the income of persons (from all sources), not to particular items of income. the fundamental relation of “capital” to “income” has been much discussed by economists. ... for the present purpose we require only a clear definition of the term “income,” as used in common speech. after examining dictionaries in common use ..., we have little to add to the succinct definition adopted in two cases decided under the corporation tax act of 1909 ... “income may be defined as the gain derived from capital, from labor, or from both combined,” provided it be understood to include profit gained through a sale conversion of capital assets. ... that the pedigree of the particular macomber definition of income is suspect need not be of concern here. what is significant is the macomber45 definition is found in dictionaries circa 1920, as well as at least one of those in current use. there is not a whiff of originalism in macomber, but rather a clear46 commitment to textualism. the murphy panel ignored macomber on the issue of interpretive stance, even though macomber was the most influential case in constitutional tax jurisprudence for the next 25 years. instead, it picked language out of the 382 florida tax review [vol.8:4 47. 255 u.s. 509, 519 (1921). 48. the cases were macomber, already noted, and mitchell bros. co., which arose under a 1909 excise tax. 49. the supreme court brief for the taxpayer in merchants’ loan & trust is summarized at: http://ww.lexis.com/research/retrieve/frames?_m=aa97e06c76aacdbae 2eed82569ddbc79&csvc=le&cform=bycitation&_fmtstr=full&docnum=1&_start doc=1&wchp=dglbvtb-zskaa&_md5=e5488b2ba312919186c999fdba917e65. 50. such was the view of prominent commentators both during the gestation of the 16th amendment and at the time of the merchants’ loan & trust decision. see e. r. a. seligman, the income tax 675-704 (1911); carl c. plehn, the concept of income, as recurrent, consumable receipts, 14 am. econ. rev. 1, 5 (1924). 51. the significance of merchants’ loan & trust in this respect (and others) is discussed in marjorie e. kornhauser, the origins of capital gains taxation: what’s law got to do with it?, 39 sw. l. j. 869 (1985) (hereinafter “origins”). 52. this view was maintained in trust law until quite recently. see revised uniform principal and income act , § 3 (1962), 7b un. laws ann. 145 (1985). 1921 case of merchants’ loan & trust co. v. smietanka, where the court,47 after setting out the passage from macomber just cited, added: in determining the definition of the word “income” thus arrived at, this court has consistently refused to enter into the refinements of lexicographers or economists and has approved, in the definitions quoted, what it believed to be the commonly understood meaning of the term which must have been in the minds of the people when they adopted the 16th amendment to the constitution. this sentence was followed by citations to cases that made no reference whatever to any “original understanding” of the 16th amendment. in addition,48 merchants’ loan & trust was decided in 1921, only eight years after 1913, and there is no statement of any “contemporary” 1921 definition of income that was offered in opposition to the 1913 understanding. thus, merchant’s loan & trust cannot be said to “hold” that an original-understanding approach is to be followed. in fact, the substantive holding of merchants’ loan & trust, that casual capital gains of an individual investor are income, rejected an originalunderstanding approach. taxpayer’s main argument was that the 1913 concept of “incomes” implied “regular and recurring,” which would have excluded casual gains and windfalls. this argument indeed had a firm (if not49 uncontested) basis in 1909-1913 sources. but that argument was rejected. a50 51 second possible “original understanding” argument was that (in accordance with early 20th century trust law), investment capital gains were simply not income at all, but were upwards adjustments to “capital.” again this argument was52 rejected. merchants’ loan & trust rejected two originalist arguments and followed the macomber textualist approach. 2007 murphy and the sixteenth amendment 383 53. 252 u.s. at 219-20. 54. the majority in merchants’ loan & trust stated (255 u.s. at 520-21): it is elaborately argued ... that the word “income” as used in the 16th amendment and in the income tax act ... does not include the gain from capital realized by a single isolated sale of property but that only the profits realized from sales by one engaged in buying and selling as a business ... constitute income which may be taxed. it is sufficient to say of this contention, that no such distinction was recognized [heretofore]. the interesting and ingenious argument ... that this distinction is so fundamental and obvious that it must be assumed to be a part of the “general understanding” of the meaning of the word “income” fails to convince us that a construction should be adopted which would, in a large measure, defeat the purpose of the amendment. [emphasis added.] 55. 348 u.s. 426 (1955). 56. glenshaw glass v. comm’r, 18 t.c. 860 (1952), non-acq., 1953-1 c.b. 7, and william goldman theaters v. comm’r, 19 t.c. 637 (1953), non-acq., 1953-1 c.b. 8, both cases aff’d, 211 f.2d 928 (3d cir. 1954) (en banc). in fact, the contemporaneous-understanding language in merchants’ loan & trust appears to have been added to unhinge the 16th amendment from any limiting definition of income, since it is a clear and intended reference to justice holmes’ brief dissent in macomber, which stated:53 i think that the word “incomes” in the 16th amendment should be read in “a sense most obvious to the common understanding at the time of its adoption.” [citations to indiana and florida cases omitted.] for it was for public adoption that it was proposed. ... the known purpose of this amendment was to get rid of nice questions as to what might be direct taxes, and i cannot doubt that most people not lawyers would suppose when they voted for it that they put a question like the present to rest. i am of opinion that the amendment justifies the tax [on pro rata stock dividends]. holmes is here taking a functionalist approach to the 16th amendment that by-passes text altogether. it is this approach that is adopted in merchants’ loan & trust, where the majority opinion has no patience with the taxpayer’s attempt to advance a “nuanced” concept of the “common understanding” of income that limits its reach.54 the macomber definition held sway until the 1955 case of comm’r v. glenshaw glass, involving punitive damages in commercial litigation. the55 lower courts “found” that these damages were not derived from capital and/or labor, and therefore were non-income under the catch-all clause of the predecessor of section 61. neither the briefs nor the lower court decisions56 384 florida tax review [vol.8:4 57. 348 u.s. at 430-31. 58. 348 u.s. at 432-33. 59. see helvering v. independent life ins. co., 292 u.s. 371, 379 (1934) (imputed income is not “income” in the tax sense); united states v. gotcher, 401 f.2d 118 (5th cir.1958) (consumption-type benefits received are not income under catch-all clause). 60. 348 u.s. at 431. played up the constitutional dimension of the case, but that was necessarily implied, because the supreme court cited the “full exercise of its taxing power” dictum. the supreme court reversed, stating that the macomber definition may have been useful in earlier days in order to distinguish capital from income, but did not constitute a comprehensive definition of income. the court noted that57 “source” was irrelevant under both the catch-all clause and the 16th amendment. crucially, the supreme court stated that it was following a “plain meaning” approach.58 glenshaw glass effectively further confirmed the rejection of originalism in favor of textualism. glenshaw glass has not been overruled or questioned on this point since. the murphy panel’s originalist approach ignores glenshaw glass (not to mention macomber), and misinterprets merchants’ bank & trust, which actually supports a textual and/or functional approach. is the term “incomes” ambiguous as applied to damages for emotional harm? disregarding possibly-relevant judicial gloss, the term “incomes” does possess a literal meaning, namely, “coming in.” this literal meaning has to be applied to a statute imposing a tax. since the tax in question is payable in cash, income must refer to cash (and what might might be converted to cash) coming in to the taxpayer, namely, material wealth (as opposed to, say, “utility”). in short, the plain meaning concept of “income” is a taxpayer’s increase in material (i.e., objective) wealth. no supreme court case has held that “incomes” is to be measured by utility or the absence thereof. utility is a59 concern of policy makers in deciding what to tax and what not to tax, but it does not define “incomes” in the catch-all clause of section 61 or the 16th amendment. the most recent authoritative judicial gloss on “income” is found in glenshaw glass, where the court said: “here we have an accession to wealth, clearly realized, and over which the taxpayers have complete dominion.” the60 “accession to wealth” phrase is a pretty close to the literal meaning of “income” (increase in material wealth), with perhaps a hint that the increase occurs at a definite point in time (“realization”) and is attributable to a particular taxpayer (“dominion and control”). b. interpreting ambiguous text 2007 murphy and the sixteenth amendment 385 61. among the problems of original intent as applied to lawmaking are: (1) the problem of multiple authors and coalition building, (2) the fact that statements of lawmaker intent may be strategically motivated (and therefore unreliable), (3) the fact that reliance on lawmaker intent violates separation-of-powers theory by conferring both legislative and interpretive powers on the lawmakers, and (4) the possibility that ambiguity was deliberately crafted to pass the buck on to courts and administrative agencies. if the textual meaning of a term is clear in the proposed application, no further inquiry is made. in order to go beyond the text to consult extrinsic sources, an ambiguity must be found. the murphy panel did not “find” an ambiguity in the text or its application, but rather created it by citing a particular theory of “income” that had a following in the first decade or so of the income tax that limited the plain meaning thereof (increase in material wealth). this move is wholly illegitimate. it allows a court to “find” an ambiguity in text (where none exists on its face) by discovering a theory or the view of a losing faction as evidence of an ambiguity and then adopting the same theory or (losing) view to resolve the ambiguity. but not so fast! assuming arguendo that the meaning of “incomes” is unclear as applied to personal injury damages, the first fall-back interpretive mode is context (including function), which can be objectively determined, rather than original intent. certain context features have already been alluded61 to. thus, context is provided for simply by the fact that the 16th amendment relates to taxation (implying the determination of taxpaying capacity), which as an inquiry into changes in objective wealth. a second context scenario already alluded to is that the creation of the modern income tax (involving both the proposal and ratification of the 16th amendment and the enactment of revenue acts that contained an income tax) was concerned with the “big issue,” which was enabling the federal government to tax income from property. a third context point derives from the fact that personal injury (and especially emotional distress) damages of individuals are an issue unique to tax. trusts and business entities do not obtain such damages, and there are no trust and business accounting precedents. the return-of-capital concept derived from business and trust accounting has no relevance, because in those contexts the concept has the function of determining the liquidation rights of stakeholders or rights of holders of successive temporal interests, as the case may be, whereas in tax the issue is simply one of objective taxpaying capacity. the fact that congress enacted a statutory exclusion for personal injury damages in 1918 is contextual evidence for the proposition that it was thought that such damages clearly were, or might be held to be, income under both the 386 florida tax review [vol.8:4 62. the 1918 house report stated that it was “doubtful” that personal injury damages were gross income.” see h.r. rep. no. 65-767, 9-10 (1918). but doubt cuts both ways, and even the murphy panel declined to cite this statement in support of the claim that such taxation was unconstitutional. see 460 f.3d at 90. 63. see sidney ratner, american taxation: its history as a social force in democracy 326-36 (1942). 64. see 460 f.3d at 90-91. 65. see note 80. 16th amendment and the catch-all clause of the predecessor of section 61.62 otherwise the enactment would serve no purpose. if text and context do not supply the answer, the last resort is lawmaker intent. however, the fact that the personal-injury damages issue is unique to tax also suggests that there was no “original intent” in the 1909-1913 period on this issue. indeed, the murphy panel cites no direct evidence of framer intent on this issue, and indeed it appears not to exist. the absence of any tax provision dealing with such damages in the 1913 revenue act is explained by (1) the hypothesis that the narrow issue of the taxation of damage recoveries was simply not on the radar screen in 1913 or (2) the supplementary hypothesis that it might have been on the radar screen but that its resolution was deliberately deferred due to lack of agreement. the murphy panel goes to great lengths to63 show that emotional damages were recognized by tort law in many states, but64 citations to numerous libel and slander cases prove nothing about the overall level of personal injury litigation or the amount of recoveries. if these were low, then it can be surmised that it could not have been viewed as a significant tax issue. supporting the “insignificance” hypothesis is the fact that the income tax was aimed at the few who were very wealthy. thus, the 1913 income tax was imposed at a rate of only one percent on a very small percentage of the population (the highest in terms of taxable income). it was only the united states entry into world war i, occurring in 1917, that caused expansion of the population subject to the income tax, and that expansion would have significantly expanded the visibility of tax issues that otherwise would have been barely noticed. if recoveries for nonphysical personal injuries were significant enough by 1913 to be viewed as a tax issue, then the failure of congress to address it suggests that the issue was consciously put off to the future. supporting this “disagreement” hypothesis is the fact that in 1913 disputes existed over several quite fundamental issues pertaining to the concept of income that possessed “priority” over (and which might determine the resolution of) the taxation-ofdamages issue.65 2007 murphy and the sixteenth amendment 387 66. a brief discussion of the pros and cons of using legislative history (the official repository of lawmaker intent) in construing statutes is found in abner j. mikva & eric lane, an introduction to statutory interpretation and the legislative process, 2741, 50-54 (1997). in general, the use of committee reports in interpreting federal tax statutes has long been accepted practice. 67. see 460 f.3d at 90 (“and to discern the original understanding of a provision of the constitution, we must examine any contemporaneous implementing legislation.”) in theory, the original-audience version of originalism avoids some of the problems of looking to the subjective intent(s) of the enactors, which in the case of a constitutional amendment includes the ratifiers as well as the proposing congress. see, e.g., antonin scalia, originalism: the lesser evil, 57 u. cin. l. rev. 849, 862-64 (1989). 68. the murphy panel, 460 f.3d at 90, also cites macomber, 252 u.s. at 202, where it was stated the district court properly treated the construction of the 1913 revenue act as inseparable from the interpretation of the 16th amendment. but here the reference was not to construction by congress or the treasury, but to construction by the courts. moreover this statement is no longer good law, because the supreme court’s construction of the 1913 act in gould, note 27, was validly overridden by the later (1942) enactment of irc § 71, see text accompanying note 29. 69. 272 u.s. 52, 175 (1926) (“this court has repeatedly laid down the principle that a contemporaneous legislative exposition of the constitution ... acquiesced in for a long-term of years, fixes the construction to be given its provisions.”). c. interpretative theory the murphy panel ignored text, context, and original intent in the conventional sense of “lawmaker intent.” instead it relied on an interpretative66 theory that might be stated as follows: what controls is the text as it was likely to be understood by the audience at the time of its initial application, and the best evidence of that understanding is found in near-contemporaneous implementing legislation (specifically, the 1918 enactment of the predecessor of section 104(a)(2)). this approach fails both as a matter of positive law and67 as theory. it has already been pointed out that the positive law of the interpretation of the 16th amendment is plain-meaning textualist, with the “audience” being posited to be that in existence at the time of the application (which in murphy would be the early 21st century). the principal case cited by the murphy panel68 for the proposition that early implementing legislation fixes the meaning of a constitutional provision, myers v. united states, is a non-tax case that deals69 with the much different problem of who has the power to fire “presidential appointees” (executive-branch employees whose appointment requires senate confirmation), an issue about which the 1787 constitution was silent. in 1876, congress enacted a statute providing that certain presidential appointments could be removed by the president only with the consent of the senate. myers held this statute to be unconstitutional on the ground that the power to remove 388 florida tax review [vol.8:4 70. the attempt by the congress to restrict presidential powers had its origin in the strong disapproval of the republican congress regarding the post-civil-war actions of president andrew johnson. 71. all but one of the cases cited by myers (as well as myers itself) for the stated proposition involved separation-of-powers and/or federalism issues. see stuart v. laird, 1 cranch (5 u.s.) 299, 309 (1803) (jurisdiction of inferior federal courts); martin v. hunter’s lessee, 1 wheat. (14 u.s.) 304, 351-52 (1816) (power of supreme court to hear appeals from state courts under the judiciary act of 1789); cohens v. virginia, 6 wheat. (19 u.s.) 264, 420-21 (1821) (marshall, c.j.) (same); cooley v. board of wardens, 12 how. (53 u.s.) 299, 320 (1852) (dormant commerce clause issue); ames v. kansas, 111 u.s. 449 (1884) (power of congress to allow certain actions brought in state courts, involving federal questions, to be removed to federal circuit courts); in re the laura, 114 u.s. 411 (1885) (issue was whether explicit exclusive presidential power to grant pardons barred the secretary of the treasury to remit fines and penalties); wisconsin v. pelican ins. co., 127 u.s. 265 (1887) (holding that original supreme court jurisdiction did not lie in a case where the state was effectively enforcing its own penal laws); mcpherson v. blacker, 146 u.s. 1 (1892) (upholding the power of the states, expressly granted by art. ii, § 1, cl. 2, to decide how presidential electors were to be chosen); knowlton v. moore, 178 u.s. 41, 56-57 (1900) (power of congress to levy inheritance tax was not barred by state power to control inheritance rights); ex parte grossman, 267 u.s. 87 (upholding right to president to grant pardon for criminal contempt). the only exception is burrow-giles lithographic co. v. sarony, 111 u.s. 53, 57) (1884) (power of congress to confer copyright protection on photographs), and that case involved an expansion of a granted power. 72. president taft, who in 1909 supported the proposal of the 16th amendment, became chief justice, and wrote the majority opinion in myers. executive officers was inherently an executive function that could be exercised by the president alone. the court cited separation-of-powers theory, a vote in the house on a 1789 bill in which it was agreed that the power of removal was lodged only in the president, and subsequent government culture up to 1866.70 it is hard to see any parallel between myers and murphy. myers had to do with a dispute between two branches of government on which the constitution was silent, so that the practice filled a gap in the constitutional scheme, whereas murphy involves the meaning of a specific term used in the constitutional text. the 1789 statute cited in myers followed the 1787 constitutional convention by one year, occurred in the same year as ratification, involved the same illustrious personalities (the framers) in the stages of constitutional deliberation, ratification, and statutory enactment, and was backed by legislative history that addressed the constitutional issue; in addition, the practice continued for several decades, and it is reasonable that “practice” should be given weight in cases involving relations between different branches or levels of government. the 1918 statute cited in murphy followed71 the proposal of the 16th amendment (1909) by nine years, a different party was in control of the white house and congress, the existing legislative history72 2007 murphy and the sixteenth amendment 389 73. see note 60. 74. the administrative decisions are cited and discussed in the text following note 181. 75. see note 23. 76. the first supreme court case, gould, note 27, that had an opportunity to construe the catch-all clause of the predecessor of section 61 treated it as having no independent significance whatsoever, but instead treated the catch-all clause as referring to things “like” the then-enumerated items (income from wages, investments, and business). this restrictive approach was overturned by comm’r v. glenshaw glass, 348 u.s. 426 (1955). gould also adopted the maxim that revenue acts are to be construed against the sovereign. that was rejected in the 1938 case of white v. united states, 305 takes no definite stand on the constitutional issue in question, and no sensitive73 issues of inter-governmental relations are involved. finally, myers and all of the cases cited by it involved situations where the federal government (or a branch thereof) asserted a power that was acquiesced in, whereas murphy cited a nearcontemporaneous enactment as limiting a power. this last point is fatal to the interpretive approach of the murphy panel. early statutory (and administrative) decisions to exclude personal injury74 damages from income (and that do not cite the constitution) cannot be viewed as “interpretations” of the constitution. the scope of a constitutional power conferred upon the federal government by the constitution cannot be reduced by the way the power is exercised. congress has the discretion not to assert its constitutional authority to the fullest, and statutory exclusions from income are unnecessary if such exclusions are already inherent in the constitution itself. similarly, administrative agencies have discretion not to enforce the law to the maximum extent. indiscriminately treating early congressional and administrative applications as binding (or even persuasive) interpretations of constitutional text verges on being a violation of separation of powers norms by positing a kind of “delegation” by the constitutional framers to the congress and administrative agencies to define the content of the constitution. such a delegation would invert the hierarchy: administrative interpretation is supposed to be subordinate to statutory utterance, and the latter in turn is supposed to be subordinate to the constitution. in addition, the view that early statutes and administrative interpretations are an authoritative-for-all time limiting interpretation of the constitution is plainly dysfunctional from the point of view of republican political theory, because tentative solutions to new problems should be subject to revision as understandings of the problems increase. this point is basic to established constitutional jurisprudence.75 the branch of government that is charged with interpreting the constitution is the judiciary. courts have no inherent obligation to construe federal taxing statutes in the broadest possible manner. this was certainly the early attitude of the courts, although it later shifted. since the ultimate76 390 florida tax review [vol.8:4 u.s. 281, 292 (1938), and replaced by the maxims that (1) gross income provisions are to be broadly construed, see note 26, and (2) exclusion and deduction provisions are to be narrowly construed, see, e.g., chickasaw nation v. united states, 534 u.s. 84 (2001) (exclusions generally); comm’r v. schleier, 515 u.s. 323 (1995) (the irc § 104(a)(2) exclusion specifically). 77. in 1921, the notions that income excluded gains and nonrecurring items were both rejected. see notes 47-50 and accompanying text. in 1940, the notion that “realization” was a constitutional prerequisite for income was cast off. see helvering v. bruun, 309 u.s. 461 (1940); helvering v. horst, 311 u.s. 112 (1940). see also cottage savings ass’n v. comm’r, 499 u.s. 554, 559 (1991). 78. see jack m. balkin, “abortion and original meaning” (aug. 28, 2006). yale law school, public law working paper no. 119, available at ssrn: http://ssrn.com/abstract=925558. balkin argues that “original intent” (in a constitutional context) might refer to: (1) the subjective intent of the enactors, (2) the way the enactors would have expected the text to be applied to issues of their time, or (3) the way the enactors would have expected agents (judges) to apply the text in changing future circumstances. the first of these refers to lawgiver’s intent, and the other two implicitly refer to “audience” insofar as the interpreters (judges) are part of the “audience community”). 79. the question is, “why should i in 2007 be bound by a constitution and laws enacted in prior years without my (deemed) participation?” the “to prevent anarchy” response doesn’t explain why any law is better than any other law. allowing prior laws to be applied and interpreted with reference to contemporary problems, attitudes, values, linguistic usages, and so on, creates a bridge between the past and the present. 80. thus, “original expected application” is inconsistent with the very idea of a constitution. see balkin, note 76. authority on constitutional matters is the constitutional text, constitutional interpretation allows not only for case-by-case “evolution” but outright overruling of prior decisions. in fact, judicial interpretation of the sixteenth amendment (and the catch-all clause of section 61 of the code) has expanded on several occasions.77 as a matter of pure interpretative theory, the better view (in my opinion) is that constitutional and statutory text should be deemed to be addressed to the audience that exists at the time of any particular application (as opposed to the audience in existence at the time of enactment). otherwise, the78 notion that law is a command that binds future actors (until repealed or amended) lacks sufficient justification.79 this point is especially forceful in the case of the u. s. constitution, which is extremely difficult to amend.80 but even if one takes a more originalist view of interpretative theory, the citing of early statutes and administrative applications proves little in the case of such an abstract term as “incomes,” which encompasses almost an infinite number of potential applications. the particular application (to exclude certain damages) is just one way in which the statutory and constitutional text 2007 murphy and the sixteenth amendment 391 81. proponents of ratification of the 16th amendment would have been motivated to underplay its significance in order to persuade moderates that the amendment was not radical. 82. models of “income” were offered by various disciplines and tax commentators: (1) financial accounting, (2) trust accounting, (3) macro-economics (the share-of-national-income concept), (4) the “accretion” (schanz-haigsimons) model, (5) the cash-flow consumption (vickrey) model, and (6) eclectic concepts (such as advanced by e.r.a. seligman). see richard goode, the economics definition of income, in joseph pechman (ed.), comprehensive income taxation 1-30 (1977); kornhauser, note 49 (origins). 83. specific issues of tax theory that bear on the exclusion for personal injury damages included (but were not limited to): (1) the meaning of “capital” (as opposed to “income”), (2) the role and content of the realization principle, (3) whether irregular items could be income, and (4) whether receipts not generated by labor or capital could be income. 84. thus, the early exclusion of personal injury damages was consistent with the contemporaneous notion that income had to be the product of capital or labor. see notes 41 and 43. under this definition of income, the receipt of a “transfer” (such as personal injury damages) is not income. this theory held sway until it was expressly jettisoned by the case of comm’r v. glenshaw glass, 348 u.s. 426 (1955) (holding that punitive damages in commercial litigation were within the catch-all clause even if not, as the lower courts had found, derived from capital or labor). could have been interpreted at the time, but it is not a “necessary” conclusion from the text itself. this particular application could have been motivated by such post-enactment instrumental considerations as politics, the outcome of a debate, a misunderstanding of tax principles, administrative convenience, or reliance on lawgiver statements of intended meaning that may have been strategically motivated.81 even if the early interpretations are deemed to be principled, the move from the text (“incomes”) to the applications (exclusion of personal injury damages) requires a theory, and it turns out that from 1909 on there were many theories of “income” competing for dominance. the early rationale offered for82 the exclusion for personal injury damages is consistent with some theories but not others. the theory, which effects a bridge from the text to the application,83 is not itself the text (and certainly not any common understanding thereof). theories, concocted by intellectual elites (often after the fact), are contestable, and the theories advanced for excluding personal injury damages around 1918 (and thereafter) have been discredited and superseded, as will be explained in84 part iii immediately following. 392 florida tax review [vol.8:4 85. this point is elaborated upon in joseph m. dodge, the story of glenshaw glass: towards a modern concept of gross income, chapter 1 of tax stories (paul caron ed.) (2002), pp. ???. 86. see note 82. 87. this concept was reaffirmed in united states v. burke, 504 u.s. 229, 233 (1992). in the most recent supreme court case involving income issues, glenshaw glass was cited for the proposition that gross income under the catch-all phrase reaches “all economic gains unless otherwise exempted.” see comm’r v. banks, 543 u.s. 426, 433 (2005). 88. it is commonplace for various business and investment expenses to be disallowed. see irc §§ 67, 68, 183, 264, 265, 266, 267, 269, 271, 274, 275, 280a, 280e, 280g. iii. does “income” under the sixteenth amendment include emotional harm damages? the plain-meaning approach to what is “income” under the 16th amendment effectively liberated the income tax concept of income from (1) concepts borrowed from other disciplines and (2) theories advanced by particular commentators. according to the most recent supreme court85 pronouncement on the subject of catch-all income (and, hence, the 16th amendment), glenshaw glass, the core idea of income is “accession to86 wealth.” glenshaw glass itself involved punitive damages received in a87 commercial context. against this principle, the murphy panel offered two theories for exclusion: (1) a “no gain” theory, and (2) an “in lieu of nonincome” theory. the discussion below will explain the bankruptcy of both theories both as a matter of principle and as applied to personal injury damages. a. the no-gain theory the no-gain theory as applied in murphy requires that the following propositions all be correct: (1) the catch-all concept of gross income is net of “recovery of capital,” (2) the term “capital” extends meaningfully beyond the technical concept of income tax “basis,” and (3) the taxpayer has basis that is lost or used up in the transaction giving rise to the damages award. all of these propositions are false. 1. “incomes” under the sixteenth amendment means “gross receipts” it is clear by long usage that “incomes” under the 16th amendment does not mean “net income,” in the sense of being net of all costs of producing income. at the other extreme, “incomes” could mean “gross receipts,” with88 offsets never being required. the common wisdom is that “incomes” under the 16 amendment means “gross income,” and that gross income usually means 2007 murphy and the sixteenth amendment 393 89. the paradigm scenario is the sale of shares of stock purchased for $7,000, in which the sales proceeds are $10,000. the issue is whether the constitution requires a “basis offset” (representing a “recovery of capital”) of $7,000 against the gross proceeds of $10,000. 90. see irc §§ 1011, 1012. 91. see pacific insurance co. v. soule, 74 u.s. 433 (1869); veazie bank v. fenno, 75 u.s. 533 (1969); nicol v. ames, 173 u.s. 509 (1898); spreckels sugar refining co. v. mcclain, 192 u.s. 397 (1904); flint v. stone tracy co., 220 u.s. 107 (1911). 92. in gould v. gould, note 27, the court appeared to frame the issue as whether the alimony payment was taxable to the payor or the payee. but since the court lacked the power to create a deduction for the payor, the only available option was to hold that the receipt was non-income to the wife. gross receipts, but in the case of a disposition of an asset it means “gross receipts less recovery of capital.” the concept of “capital” certainly includes89 “basis,” which in its most elemental meaning denotes the cost of an asset. i90 argue here, perhaps controversially, that the term “incomes” refers only to gross receipts, so that subtractions are never constitutionally required by the 16th amendment. there is very little law or discussion of this issue because of the fact that a tax on gross receipts would be valid as an indirect tax, independently of the 16th amendment. the issue only matters in a case, like murphy, where91 the item is taxed (if at all) only under the catch-all clause as considered together with the 16th amendment, and there the dispute may be resolved on some other ground. (a) limitations on judicial power the deep norm of separation of powers argues against allowing the courts to decide what costs must be subtracted in arriving at “incomes” under the 16th amendment. since it is settled that such term does not mean “net income,” the courts are left with the options of (a) requiring the subtraction of no costs or (b) requiring the subtraction of some costs. but costs are costs, and saying that the subtraction of some costs (but not others) is necessary to arrive at “gross income” amounts to the waving of a magic wand to create new terminology based on thin air rather than substance. the constitutional text offers no basis for distinguishing some costs of producing income from others. it is best left up to congress to decide what costs of producing income should be subtracted as a matter of policy. if certain subtractions were considered mandatory in arriving at “incomes,” then courts, which lack the power to require subtractions, are placed in the quandary of either having to usurp92 congressional power (by creating subtractions) or else holding unconstitutional a tax seemingly within the letter and spirit of the 16th amendment that does not provide for the “required” subtractions. 394 florida tax review [vol.8:4 93. see brushaber v. union pacific railroad co., 240 u.s. 1, 13-19 (1916) (stating that the 16th amendment did not redefine “direct tax” but only removed the apportionment requirement with respect to taxes on income.) brushaber made no reference to the netting issue in upholding the denial of interest deductions to certain taxpayers. 94. see note 12. 95. see 157 u.s. at 579. 96. see brushaber v. union pacific railroad co., 240 u.s. 1, 12, 17-19, 24 (1916); stanton v. baltic mining co., 240 u.s. 103, 112-14 (1916). (b) the function of the sixteenth amendment a structural (or purposive) interpretation of the 16th amendment supports the view that “income” effectively means gross receipts. the 16th amendment was designed solely to overturn the result of the pre-16th-93 amendment pollock case, which held that a tax on gross rents was invalid as94 an unapportioned direct tax. pollock based its holding on the bare proposition that a tax on the issue of land (gross rents) is essentially a tax on the land itself (taking it as given that a tax on land is a direct tax). but pollock also acquiesced in the proposition that a tax on wages or gross income from professions would be valid as an indirect tax. the 16th amendment removed the apportionment95 requirement with respect to taxes on the gross yield from property. that the income tax act that was invalidated by pollock provided for deductions and offsets to arrive at net income was irrelevant to pollock. it follows, then, that the 16th amendment can have nothing to do with recovery of capital, however conceived. the more sweeping proposition that the constitution, by way of the 16th amendment, commands capital (basis) recovery is an argument that the 16th amendment actually added a restriction on the federal taxing power that did not exist prior to 1913. prior to the 16th amendment, the federal government had the power to lay and collect taxes on anything or anyone, the only meaningful restriction being that direct taxes had to satisfy the apportionment requirement. the distinction between direct and indirect taxes had nothing to do with subtractions from gross receipts. in fact, a tax on gross receipts from asset sales is a common form of excise (indirect) tax. there is nothing in the history of the 16th amendment that suggests a trade-off or compromise in which the apportionment requirement was removed for a certain kind of (what was then taken to be a) direct tax (an income tax) in return for a concession in the form of the imposition of a new “subtraction” limitation on what could be taxed without apportionment (as an indirect tax). the supreme court has explicitly stated that constitutional provisions relating to the taxing power will not be treated as conflicting with each other, and that the 16th amendment is not to be viewed as a limitation on the general taxing power.96 2007 murphy and the sixteenth amendment 395 97. see comm’r v. sullivan, 356 u.s. 27, 28 (1958) (also stating, at 29, that congress could disallow all deductions of a business); burnet v. thompson oil & gas co., 283 u.s. 301 (1931); stanton v. baltic mining co., 240 u.s. 103, 112-14 (1916). 98. see irc §§ 165, 167, 168, 179, and 612. 99. see doyle v. mitchell bros. co., 247 u.s. 179, 188 (1918) (“it may be observed that it is a mere question of methods, not affecting the result, whether the amount necessary to be withdrawn in order to preserve capital intact should be deducted from gross receipts in the process of ascertaining gross income, or should be deducted from gross income in the form of a depreciation account in the process of determining net income.”). 100. congress can also manipulate basis recovery rules by deciding what costs to match against what income. initially, any alleged basis-recovery mandate only extends to the preclusion of double taxation of the same dollars. thus, if a taxpayer purchases an asset for $13,000 and sells it for $10,000, only the first $10,000 of basis offset against the sales proceeds could be constitutionally mandated, with the $3,000 loss deduction being subject to possible disallowance. but suppose the asset is a machine and the $13,000 cost is to be taken as depreciation deductions against gross manufacturing income. in that case, there would be no claim that depreciation deductions of $13,000 would be constitutionally mandated up to the amount of such income. alternatively, congress might decide that the $13,000 cost of the machine should be added to the basis of an asset constructed by the machine, see irc § 263a(a), if congress has the power to tax gross receipts in any event under its power to lay indirect taxes without apportionment, then any subtraction requirement under the 16th amendment is wholly pointless. in the abstract, it is conceivable that constitutional or statutory text might explicitly state a pointless rule, but surely a pointless rule should not be imported into such a text where no such rule is clearly stated. (c) the incoherency of a netting mandate the view that “incomes” under the 16th amendment is net of capital recovery is incoherent and unworkable in comparison to the view that subtractions are a matter of legislative discretion. the income tax has long separated, for the most part, gross income and deduction (subtraction) issues, and “deductions” are conceded to be a matter of legislative grace. there is no97 principled distinction between “deductions” for costs of producing income and (capital recovery) “offsets.” even (cost) basis in an asset can be recovered either by way of “offset” against the “amount realized” (gross proceeds of sale or other disposition) or by way of (depreciation or loss) “deduction.” it is98 congress that decides when basis is to be recovered by offset and when it is recovered by way of deduction. if congress can require that capital recovery99 be taken as a “deduction,” and if congress also can enact rules that permanently disallow such deductions, then capital recovery cannot be a constitutional mandate.100 396 florida tax review [vol.8:4 and that would defer capital recovery beyond the time the machine is exhausted or disposed of. 101. see irc § 1016(a). 102. see virginia hotel corp. v. helvering, 319 u.s. 523 (1943). the court held that basis was to be reduced by depreciation claimed in a year even though the depreciation deduction failed to reduce taxable income. this result was later changed by congress. see irc § 1016(a)(2). 103. see burnet v. sanford & brooks co., 282 u.s. 359, 364-66 (1931) (congress can impose annual accounting system even though resulting in effective disallowance of costs of producing income); burnet v. thompson oil & gas co., 283 u.s. 301, 307 (1931) (disallowed depletion could not be taken as depletion in later years). 104. see irc § 61(a)(2) & (3). 105. see note 113 and accompanying text. 106. the category of “gross income from business” is dependent upon methods of inventory accounting allowed by irc §§ 471 & 472; the category of “gains from dealings in property” is dependent upon irc §§ 453 and 1001; those of “annuities” and “pensions” are dependent upon irc § 72; that of “dividends” is dependent upon irc §§ 301(c) and 316; that of “interest” is partly dependent upon irc §§ 461, 483, 12721278, and 7872. it can be argued that depreciation is a mere acceleration of capital recovery that is not itself constitutionally mandated. if such acceleration did not occur, the basis would remain with the asset to be recovered on sale or disposition. however, the supreme court has held that congress can enact101 a depreciation system that results in the permanent loss of basis. although the102 majority opinion in the case so holding did not discuss possible constitutional issues, such issues were implicit, because such a loss of basis would violate the alleged constitutional mandate that capital (basis) recovery (sooner or later) is mandatory. thus, congress has control over accounting issues and can require that income be accounted for on an annual basis, and let the chips fall where they may.103 there are, of course, statutory gross income provisions that do allow for built-in basis recovery, the most notable being the enumerated categories of “gross income from business” and “gains from dealings in property.”104 however, the fact of their statutory existence does not prove that they are mandated by the 16th amendment. two possible alternative explanations exist. first, netting at the gross income stage may result from the recognition of sound policy. second, netting may serve the cause of administrative convenience.105 in any event, even these netting provisions are “dependent” on other code provisions that prescribe the method (timing) of basis recovery. indeed, the106 entire domain of methods of basis recovery is controlled by statutory provision. 2007 murphy and the sixteenth amendment 397 107. see irc §§ 163(a), 164(a), 173, 174, 175, 179, 180, 213, 217, 219; regs. §§ 1.162-6, -20. 108. see, e.g., regs. §§ 1.212-1(k), 1.263(a)-2, -4, -5; rev. rul. 77-354, 19772 c.b. 63; rev. rul. 83-105, 1983-2 c.b. 51; rev. rul. 2001-4, 2001-1 c.b. 295. as further evidence of the imprecise line between capital expenditures and expenses, consider the case of loss carryovers, derived from the excess of deductions over gross income, which are often allowed to expire. see irc §§ 172, 280a(c), 465, and 467. many loss carryovers result from the taking of deductions that are subsequently judged to be premature, suggesting that they were “really” capital expenditures. 109. see note 95. there are very few provisions disallowing capitalization (and, hence, basis). see irc §§ 195(c)(2), 263a(a)(2); regs. §§ 1.61-3(a) & 1.471(3)(d); rev. rul. 77-244, 1977-2 c.b. 58. 110. a classic exposition is found in nicholas kaldor, an expenditure tax (3d ed. 1955). 111. jensen, note 30, argues that a consumption tax is unconstitutional as an unapportioned direct tax that is not an “income tax,” on the ground that an income tax is a tax on investment income, whereas a consumption tax effectively exempts investment income. for what it is worth, i disagree on the points (1) that a consumption tax is a direct tax (the holding of pollock, note 12, being that a tax on investment income was a direct tax) and (2) that a consumption tax really exempts investment income. in any event, jensen appears to be the only commentator taking this position. capital-recovery offsets in the case of asset dispositions are equal to basis. basis in turn derives from capital expenditures. however, there are numerous statutory provisions that treat capital expenditures as “expenses,”107 as well as rules and regulations dealing with the imprecise boundary between capital expenditures and expenses. and it is a given that expenses can be108 disallowed under various code provisions. if basis recovery were109 constitutionally mandated, and if basis derives from capital expenditures, then provisions treating capital expenditures as expenses, in combination with provisions disallowing deductions for any such deemed expenses, must violate the constitution. indeed, congress could enact statutory rules that accelerate all capital recovery to the date of expenditure (that is, rendering them as “expenses”). in that event, there would be no basis in anything at all, and there would be no such thing as “capital recovery,” as that term is understood in tax culture. a tax in which there is no capital recovery (positive or negative) is called by different names, such as “expenditure tax,” “consumed income tax,” and “cash-flow consumption tax.” could such a tax be unconstitutional110 because it fails to require capitalization (so as to create basis that can be “recovered”)? and what is one to make of the fact that the so-called income111 398 florida tax review [vol.8:4 112. any provision of the current income tax that allows “expensing” of a capital expenditure or that exempts investment income can be called a consumption tax feature. examples abound. see note 105. 113. it might be said that a (consumption tax) that is alleged (falsely, in my view) to exempt investment income is not an “income tax” that can be supported by the 16th amendment. whatever the dubious merits of this argument, it would not rule out validation as an indirect tax. 114. see the discussion of the sanford & brooks co. case in the text accompanying note 130. see also stanton v. baltic mining co., 240 u.s. 103 (1916) (congress is not required by the constitution to provide for an adequate depreciation or depletion allowance); von baumbach v. sargent land co., 242 u.s. 503, 524 (1917) (congress did not intend the “depreciation” allowance to include depletion of minerals in place). 115. see generally joseph m. dodge, the logic of tax pg. 20-21 (1989). 116. in this case, the “loss” under irc § 1001(a) is disallowed under irc § 165(c), but gross proceeds are non-taxable by reason of the basis offset. 117. see irc §§ 183(b), 280a(c)(5). however, the deductions may be of little value on account of the fact that such deductions are “miscellaneous itemized deductions” under irc § 67 that are subject to a significant “floor,” as well as being wholly disallowed for purposes of the alternative minimum tax. in addition, tax already has numerous consumption tax features? would there be a112 “tipping point” at which the entire tax would be unconstitutional?113 the only conceivable textual basis for mandating capital recovery would derive from a question-begging assumption that “incomes” is something distinct from “capital.” it didn’t help the early evolution of tax doctrine that thinking about “capital” was confused (a matter discussed shortly). the relevant notion of capital under an income tax is “costs of income production.” the distinction between basis offsets and business and investment “expenses” is, therefore, not fundamental with respect to the concept of income in the tax sense, because both are equally costs of producing income. conceptually, the only difference is that basis is a carryover from a prior-year’s expenditure, whereas an expense is a current expenditure. it is unimaginable that a mere timing rule has constitutional significance, and in fact the supreme court has held that congress has the power to decide tax accounting issues as it sees fit.114 capital recovery (in the tax sense) reflects a core policy to avoid double taxation of the same dollars to the same taxpayer. without capital recovery,115 business and investment would be systematically disfavored by the tax system relative to wage-earning and consumption. this is a classic policy justification. but tax policy issues are also best left to congress to decide (and to balance against non-tax policies). this particular policy cuts across the distinction between basis offsets and expenses. thus, just as basis is an offset against the proceeds of sale (but only to the extent of such proceeds) even in the case of personal-use assets, so expense deductions with respect to personal (hobby)116 activities are allowed to the extent of the gross income from such activity. if117 2007 murphy and the sixteenth amendment 399 deductions in excess of gross income (disallowed in the current year) are not carried over to future years. 118. see higgins v. comm’r, 312 u.s. 212 (1941) (holding that costs of managing investments could not be claimed as deductions of carrying a business). 119. see note 95. 120. these and other cases referring to “gain” are discussed below, mainly in note 153. 121. see irc § 1001(a) (defining “gain” on sale or disposition as the excess of amount realized over basis). 122. even the decision to account for property dispositions on an asset-by-asset basis is arbitrary. assets (within a class having the same relevant tax attributes) could simply be aggregated into a mass asset account in which aggregate gross receipts are compared to aggregate basis. see irc §§ 165(d) (gambling gains and losses), 471 (inventories). 123. the deductions that are listed in irc § 62 (to be taken in arriving at “adjusted gross income”) are effectively netted against gross income for tax reporting purposes, because they are allowed in full. schedules c, d, and e of the current form 1040 provide for netting of certain § 62 deduction items against gross receipts in the “gross income” section of the form 1040 individual income tax return, even though such items are “deductions” under the code. basis and expenses of income production are equally “capital,” then all expenses of income production must be deducted. yet the supreme court has rejected attempts to require such deductions where not authorized by congress, and118 has rejected constitutional attacks on the disallowance of business deductions.119 the only doctrinal answer that makes sense is that recovery of capital is not constitutionally mandated at all. (d) income as gain? the murphy panel cited numerous statements in supreme court cases to the effect that “income” is “gain” in an effort to establish the self-evidence120 (or a priori necessity) of the proposition that “incomes” in the 16th amendment must be net of capital recovery (as is the case with gain in the statutory sense).121 essentially the notion of gain depends on accounting conventions. even in the paradigm gain scenario (sale of an asset), it is logically possible that “amount realized” could be a gross income item and an amount equal to basis could be a separate “loss” deduction by reason of a complete disposition of the property. it is simply more convenient to do the netting at the gross income stage, and accordingly the tax return published by the irs would undoubtedly122 allow netting in arriving at “gross income” regardless of the statutory organization. but surely a constitutional principle does not emerge from what123 looks like a pragmatic choice as to how to organize netting rules in a statute. 400 florida tax review [vol.8:4 124. 271 u.s. 170 (1926). 125. see old colony r. co. v. comm’r, 284 u.s. 552, 556 (1932) (“interest” construed to mean stated interest and not stated interest net of amortized bond premium); vukasovitch v. comm’r, 790 f.2d 1409 (9th cir. 1986) (stating that kerbaugh-empire is a dead letter); estate of newman v. comm’r, 934 f.2d 426, 431-32 (2d cir.1991) (kerbaugh-empire is “discredited”); rev. rul. 92-99, 1992-2 c.b. 35 (same). kerbaugh-empire was wrong on the facts, because the loss, having been already deducted, was counted twice. with respect to the currency transaction, kerbaughempire was superseded by united states v. kirby lumber co., 284 u.s. 1 (1931). in helvering v. american chicle co., 291 u.s. 426 (1934), the court followed kirby lumber in a case involving purchase-money debt. the sanford & brooks case, note 101, effectively interred kerbaugh-empire, because a combined-transaction approach is inconsistent with an annual accounting approach. 126. see gershkowitz v. comm’r, 88 t.c. 984 (1987); rev. rul. 91-31, 1991-1 c.b. 19 (both holding that a reduction in non-recourse acquisition debt is debt-discharge income, with no effect on basis); rev. rul. 90-16, 1990-1 c.b. 12 (separating debtdischarge income from amount realized upon transfer of appreciated property to creditor in lieu of foreclosure). see generally, deborah a. geier, tufts and the evolution of debt-discharge theory, 1 fla. tax rev. 115 (1992); theodore p. seto, the function of the discharge of indebtedness doctrine: complete accounting in the federal income tax system, 51 tax law rev. 199 (1997) (discussing the separation of debt accounting from asset accounting in the case of debt-financed investments). that the word “gain” does not necessarily require any offset is evidenced by numerous examples where gross receipts standing alone constitute gains: compensation for services, prizes and awards, punitive damages, found treasure trove, and (possibly) compensatory damages (not involving property losses). basis recovery is simply not relevant to these situations, because the taxpayer acquired something without reference to any kind of prior investment. the concept of “gain” posits the question, “relative to what?” “gain” only means that material wealth has increased relative to some baseline. there are different ways of conceptualizing the baseline, and none are a priori correct. this point is reflected in tax doctrine. the early case of bowers v. kerbaugh empire co. involved an investment financed with borrowed foreign currency.124 there the supreme court held that the gain from the debt transaction could be offset by the loss on the related investment transaction. however, this relatedtransaction-netting approach is now considered to be passé, and it is settled that the components of even integrally-related transactions are to be accounted for separately. the most closely-connected common transactions are asset-125 purchase installment obligations, and even here the borrowing aspect is treated separately from the asset aspect. this same bifurcation approach can be126 readily applied to the forms of income that currently entail built-in basis recovery: they can all be conceptualized as involving separate, but linked, accessions to wealth and losses. thus, a sale of an asset represents both an increase in cash wealth (in the full amount of the gross proceeds) and a decrease 2007 murphy and the sixteenth amendment 401 127. the loss (measured by basis, see irc § 165(b)), is realized because the taxpayer “loses” (disposes of) the property that possessed basis. of course, in the case of personal-use assets, the excess of basis over amount realized would be disallowed as a personal-use loss representing consumption. see irc § 165(c). 128. in financial accounting, the sale transaction (at a gain) would be accounted for by (1) a debit to cash account, (2) a credit to the asset account equal to its book value (the accounting analogue to basis) and (3) a credit to income account in the amount of the excess of (1) over (2). 129. 481 u.s. 368 (1987). 130. four justices signed the plurality opinion. one justice concurred on the ground of deference to the eligibility regulations. four judges dissented on the ground that the tax-law exclusion for personal injury recoveries indicates that congress wouldhave adopted the same rule in the afdc context. 481 u.s. at 384, 389. significantly, no judge treated the tax issue as having a constitutional dimension. 131. see 481 u.s. at 374-77. in property wealth (measured by the entire basis). business accounting127 operates in exactly this fashion.128 the precise point advanced here was made by the supreme court in the 1987 case of luckhard v. reed, a case arising under the afdc program. the129 state eligibility requirement in question treated personal injury damages as “income,” resulting in disqualification of the applicant. the applicant argued that “income” for welfare eligibility purposes should exclude personal injury damages on the basis of a similar exclusion in the income tax. the supreme court rejected this contention, the plurality opinion stating:130 131 respondents’ principal contention is that virginia’s revised regulations are inconsistent with the meaning of “income: ... used in the afdc statute. to support this argument they first advance the broader proposition that it does violence to common usage to interpret “income” to include personal injury awards. this argument begins from the premise that since personal injury awards are purely compensatory, they do not result in any gain to their recipients. and since both general and legal sources define “income” as involving gain, see, e. g., webster’s third new international dictionary 1143 (1976) (“a gain or recurrent benefit that is usu. measured in money ...”); eisner v. macomber, ... [other citations omitted], respondents conclude that personal injury awards cannot fairly be characterized as income. but the premise that personal injury awards cannot involve gain is obviously false, since they often are intended in significant part to compensate for the loss of gain, e. g., lost wages... . n2 [note 2: moreover, as we discuss below, ... other typical components of personal injury awards, 402 florida tax review [vol.8:4 132. 282 u.s. 359 (1931). 133. see § 1001(a). including compensation for pain and suffering, can reasonably be treated as gain under the afdc statute.] more importantly, however, ... general and legal sources also commonly define “income” to mean “any money that comes in,” without regard to any related expenses incurred and without any requirement that the transactions producing the money result in a net gain. see, e. g., 5 oxford english dictionary 162 (1933) (“that which comes in ... (considered in reference to its amount, and commonly expressed in money); ... receipts ...”); 42 c. j. s., income, p. 529 (1944) (“generally or ordinarily the term means all that comes in; ... something which is paid over and delivered to the recipient; ... without reference to the outgoing expenditures ...” (footnotes omitted)); heckler v. turner, 470 u.s. 184 (1985) (“income” under the afdc statute means gross income, without reference to expenses reasonably attributable to its earning)... . thus, contrary to respondents’ assertion, virginia’s revised regulations are consistent with a perfectly natural use of “income.” so, of course income entails “gain” in some sense, but there are various accounting methods that can be used in calculating income and gain, and it seems far-fetched to suppose that the 16th amendment mandates one particular accounting approach in preference to others. as noted earlier, the supreme court has held that accounting for profits and gains is within the realm of congress’s discretion. particularly relevant is burnet v. sanford & brooks co., where the court held that losses (i.e., the excess of expenses over132 revenue) from early years were not required by the constitution to be treated as “capital” that had to be offset against the profits of later years. but if early-year costs ended up generating revenue in later years, then such costs really were capital expenditures. the court’s refusal to treat them as capital expenditures necessarily acknowledges the power of congress to decide what are capital expenditures and expenses on a year-to-year basis. if congress can decide what is “capital,” then there can be no constitutional mandate relating to capital recovery. in light of the foregoing, the move of equating “income” with “gain,” with the implication that “gain” must be taken in its current statutory meaning as being the excess of amount realized over basis, is deceptive (intentionally133 or not). effectively, it is an argument that current statutory law defines the 16th amendment concept of “income.” alternatively, it is tautological, as a particular definition of “gain” is trotted out that has the desired conclusion 2007 murphy and the sixteenth amendment 403 134. 231 u.s. 399 (1913). 135. see note 13. 136. see 231 u.s. at 414 (“ ... we are little aided by a discussion of theoretical distinctions between capital and income”). 137. the taxpayer’s position was that gross proceeds from mining, less expenses, less the value of ore in place extracted, equals zero. 138. 231 u.s. at 422-23. 139. in the later case of von baumbach v. sargent land co., 242 u.s. 503, 524 (1917), the court held that the removal of ore did not constitute depreciation as intended by congress. (congress subsequently enacted a depletion allowance.) 140. corporation excise tax, act of august 5, 1909, c. 6, § 38, 36 stat. 11. embedded within it. but the equation of income with gain ultimately backfires, because the authority to decide on accounting methods resides with congress. (e) authority re-examined the following will show that the supreme court authority that supposedly establishes the proposition that recovery of capital is constitutionally mandated does no such thing. the first relevant case is stratton’s independence v. howbert,134 decided (in october, 1913) under the 1909 corporation tax act, an act that preceded ratification of the 16th amendment and whose validity was based on its being an indirect tax. the act purported to tax only net income, and135 specifically allowed deductions for expenses and depreciation, but not for depletion. the actual holding of stratton’s independence is that, in computing net income from mining, the value of the ore in place was not required to be subtracted as a depreciation deduction. the court made it clear that it was dealing with an excise tax, not an income tax as such. thus, the distinction between capital and income was not of particular import. the court simply136 rejected the theory advanced by the taxpayer that would have effectively exempted mining operations from tax, and refused to speculate on the issue137 of whether some kind of cost depletion could have been taken under the “depreciation” provision of the act (although a later case answered this138 question in the negative) . the court made it clear that the 16th amendment139 was not applicable and, therefore, not under consideration. the most oft-cited case for the proposition that income is net of capital recovery is doyle v. mitchell bros. co., 247 u.s. 179 (1918), which again construed the 1909 corporation income tax act. although that act purported140 to tax “net income,” it only provided for the deduction of business “expenses” from gross income. the taxpayer had purchased timber property in 1903, which had substantially appreciated as of december 31, 1908, the day before the act came into effect. the then treasury regulations allowed the cost of inventory (costs of goods sold) to be netted against gross receipts from the sale of 404 florida tax review [vol.8:4 141. 235 f. 686 (6th cir.1916). the opinion in this case contains a long discussion of the difficulties of accounting for inventory goods, as opposed to what were then called “capital assets.” 142. “if the gross receipts upon such a conversion are to be treated as gross income, what authority have we for deducting either the cost or the previous market value of the assets converted in order to arrive at net income? the deductions specifically authorized are only such as expenses ..., ... losses, [and] depreciation. ... there is no express provision that even allows a merchant to deduct the cost of the goods that he sells.” 247 u.s. at 184. 143. see 247 u.s. at 184-85: yet it is plain, we think, that by the true intent and meaning of the act the entire proceeds of a mere conversion of capital assets were not to be treated as income. whatever difficulty there may be about a precise and scientific definition of “income,” it imports, as used here, something entirely distinct from principal or capital ...; conveying rather the idea of gain or increase. ... understanding the term in this natural and obvious sense, it cannot be said that a conversion of capital assets invariably produces income. if sold at less than cost, it produces ... loss. nevertheless, in many if not in most cases there results a gain that properly may be accounted as a part of the “gross income” ...; and by applying to this the authorized deductions we arrive at “net income.” in order to determine whether there has been gain or loss, and the amount of the gain, if any, we must withdraw from the gross proceeds an amount sufficient to restore the capital value that existed at the commencement of the period under consideration. [emphasis added.] inventory, but in the case of other assets (including timber) the subtraction was (in effect) the greater of the cost or the value at the end of 1908. the commissioner allowed a subtraction only for the 1903 cost, apparently on the ground that the timber sold was inventory. in a somewhat impenetrable opinion, the 6th circuit applied the rule for non-inventory assets. the solicitor141 general argued in the supreme court that “net income” under the act equaled gross income (meaning gross receipts) less “expenses” construed to include the cost of the timber. the supreme court held that the intent of congress was to exclude pre-enactment appreciation from net income, but the problem was that the statute did not appear to provide for such a result. the court’s (ingenious)142 solution involved the following moves: (1) that “income” under the act does not mean gross receipts but implies “gain,” (2) that gain is net of return of capital, and (3) that “capital” includes (or is) pre-enactment value. in short, the desired result of excluding pre-enactment appreciation from tax was obtained by defining “gross income” to mean “gross receipts less capital recovery,” with “capital” defined to include (or to mean) pre-enactment appreciation.143 there are problems with all of these moves. since the government already conceded that cost could be subtracted as an “expense” deduction in 2007 murphy and the sixteenth amendment 405 144. the reasoning in mitchell bros. on the effective-date issue requires acceptance of gray v. darlington, 82 u.s. (16 wall.) 63 (1872), involving the civil war income tax, which had held that the gain accruing over a four-year period could not all be allocable to the year of sale on the theory that unrealized appreciation up the year of sale itself was “capital.” see lynch v. turrish, 247 u.s. 221, 229, 230 (1918) (relying on gray v. darlington in case similar to mitchell bros. but arising under the 1913 income tax). in hays v. gauley mountain coal co., 247 u.s. 189, 191 (1918), gray v. darlington was held to be no bar to taxing the entire post-1908 gain resulting from a stock sale in 1911 under the 1909 corporation tax act, the court noting that the holding of the earlier case was under the different language of the civil war income tax. the entire group of 1918 cases cited in this note and in notes 143, 146, 148, and 150, has only to do with effective dates, and none of them hold that gross income is net of basis recovery. in fact, stratton’s independence v. howbert, note 132, appears to have rejected any requirement of basis recovery, and nothing in mitchell bros. questions this aspect of stratton’s independence. 145. see merchants’ loan & trust co. v. smietanka, note 45 (gain accrued over several years subject to tax in year of sale). stratton’s independence, note 132, had already rejected the contention that gain was net of the value just prior to the disposition. 146. 38 stat. 166, 167 (1913), stating: (a)(1) that there shall be levied, assessed, collected and paid annually upon the entire net income arising or accruing from all sources in the preceding calendar year to every citizen of the united states, and to every person residing in the united states, a tax of one per centum per annum upon such income, except as hereinafter provided; (b) that, subject only to such exemptions and deductions as are hereinafter allowed, the net income of a taxable person shall include gains, profits, and income derived from salaries, wages, or compensation for personal service, also from interest, rent, dividends, securities, or the transaction of any lawful business carried on for gain or profit, or gains or profits and income derived from any source whatever. among the deductions allowed for the purpose of the normal tax is the amount received as dividends upon the stock or from the net earnings of any corporation, which is taxable upon its net income as hereinafter provided. [emphasis added.] arriving at “net income,” the implication (if any) that the subtraction of basis occurs at the “gross income” stage is simply obiter dictum, and lies in contradiction to stratton’s independence, which rejected the notion that basis recovery was required even in arriving at net income. the only true “holding” of mitchell bros. is that pre-1909 appreciation is exempt from tax, a result that might have been achieved by less devious means. the idea that any appreciation could be “capital” was problematic even at the time, and (being derived from144 trust accounting) was soon cast off altogether in arriving at the modern view that capital refers to some notion of cost, not value. of course, nothing in the145 mitchell bros. opinion rests on the 16h amendment. a trio of other cases decided in the same term as mitchell bros. can be similarly characterized as effective date cases. all of them were decided under the 1913 income tax statute, which also purported to tax only net income, and146 406 florida tax review [vol.8:4 147. id. at subsection (d). 148. 247 u.s. 221 (1918). 149. the court relied on gray v. darlington, note 142, for the notion of allocating gain realized in one year over the period in which it accrued. 150. 247 u.s. 339 (1918). 151. congress changed its mind in 1916 in what is now irc § 316(a)(1). 152. 247 u.s. 330 (1918). 153. curiously, the murphy panel decision cites southern pacific co. v. lowe for the proposition that “return of capital is not income under ... 16th amendment.” but southern pacific co. neither holds nor states any such thing. it states (247 u.s. at 335) that the 1909 act and the 1913 act, both of which refer to “net income,” are to be construed in a like manner. 154. bowers v. kerbaugh-empire co., 271 u.s. 170, 177 (1926). which stated that gains were to be taken into account in arriving at net (not gross) income, while expressly providing that only net income that accrued after february 28, 1913, was to be taxed. in lynch v. turrish, the transaction147 148 was a corporate liquidation, and it was held that none of the gain accrued after that date, the liquidation proceeds being less than the then value of the stock.149 but in lynch v. hornby the court held that (1) dividends paid after the150 effective date of the 1913 act out of profits accumulated before such date were intended to be taxed, and (2) congress was not prohibited by the constitution151 from doing so. the third case, southern pacific co. v. lowe, was held to be152 distinguishable: since the dividend there was paid by a controlled corporation (out of earnings accumulated before march 1, 1913), such earnings were viewed as having accrued to the controlling corporation itself before that date, resulting in non-taxation thereof. these cases all involve application of a clear statutory provision relating to the effective date of the tax, none of them really involve “return of capital,” and none involve a construction of the 16th amendment.153 mitchell bros. has been often cited by the supreme court for the proposition that income includes gain, and there is one ipse dixit to the effect that “income” under the 16th amendment is the same as income under the corporation tax act of 1909 (as re-written by mitchell bros.). perhaps this154 confusion derived from the fact that the 1909 corporation tax act appeared in the same year as the proposal by congress of the 16th amendment. however, the act used the term “net income” and the proposed amendment used “incomes” without any modifier. in any event, none of the supreme court cases citing mitchell bros. actually held that the 16th amendment requires capital 2007 murphy and the sixteenth amendment 407 155. apart from companion cases to mitchell bros. co. and cases already discussed (macomber, note 41; merchants’ loan & trust, note 45; bowers v. kerbaugh-empire co., note 122; luckhard v. reed, note 127; burnet v. sanford & brooks co., note 130), the supreme court has cited mitchell bros. co. in the following cases: la belle iron works v. united states, 256 u.s. 377, 390 (1921)(appreciation is not recoverable “invested capital”); lucas v. alexander, 279 u.s. 573, 577 (1929) (computation of feb. 28, 1913 value of life insurance policy); bromley v. mccaughn, 280 u.s. 124, 130 (1929) (upholding gift tax as an excise); burnet v. thompson oil & gas co., 283 u.s. 301, 307 n. 9 (1931) (disallowed depletion of earlier years could not be taken as depletion in later years); burnet v. logan, 283 u.s. 404, 413 (basis in contingent-payment sale to be recovered according to the then-current method of taxing annuities); old colony r. co. v. comm’r, 284 u.s. 552, 556 (1932) (“interest” construed to mean stated interest and not stated interest net of amortized bond premium); maclaughlin v. alliance ins. co., 286 u.s. 244, 252 (1932) (congress intended, and had power, to tax insurance company gains accruing after 1913 but prior to a 1928 amendment removing the exemption for life insurance company capital gains); helvering v. independent life ins. co., 392 u.s. 371, 379 (1934) (upholding disallowance of deductions relating to company owned-and-used building unless rental value was included in gross income); snyder v. comm’r, 295 u.s. 134, 140 (1935) (stock trader could use inventory-like accounting approach); united states v. safety car heating & lighting co., 297 u.s. 88, 97 (1936) (damages from patent infringement claim that was fixed after 1913 was entirely taxable, even though damages related back in part to before 1913); helvering v. midland mutual life ins. co., 300 u.s. 316, 32223 (1937) (broadly construing category of “interest” income in opposition to taxpayer’s accounting treatment); foster v. united states, 303 u.s. 118, 122 (1938) (issue was whether dividends were out of pre-1913 earnings and profits); comm’r v. glenshaw glass, 348 u.s. 426, 430 (1955) (mitchell bros. as source of macomber definition of income); united states v. catto, 384 u.s. 102, 109 (1966) (upholding regulation requiring capitalization of costs of raising livestock); o’gilvie v. united states, 519 u.s. 79, 84 (1996) (narrating history of exclusion for personal injuries). 156. see note 123 (discussing discreditation of the kerbaugh-empire case, note 122). 157. see luckhard v. reed, note 127; sanford & brooks co., note 130; thompson oil & gas co., note 153; independent life ins. co., note 153. 158. see sullenger v. comm’r, 11 t.c. 1076 (1948) (reviewed), non-acq. 1949-1 c.b. 6, non-acq. withdrawn 1952-2 c.b. 3, nonacq. reinstated 1976-2 c.b. 4 (congress barred by 16th amendment from disallowing cost of goods sold); hochman v. comm'r, t.c. memo. 1986-24 (stating in dictum that congress cannot disallow cost of goods sold, but holding that gambling losses were not costs of goods sold). cf. irc § 280e (disallowing expenses of carrying on the business of illegally dealing with controlled substances but not disallowing cost of goods sold). compare max sobel wholesale liquors v. comm’r, 69 t.c. 477 (1977), acq. 1982-2 c.b. 2 (issue avoided recovery. the one case that clearly so stated has been discredited. and155 156 several of the cases undermine such a proposition.157 a 1948 tax court decision, not acquiesced in by the commissioner, did hold that congress could not constitutionally disallow basis. this case has158 408 florida tax review [vol.8:4 by holding that payments were not disallowed by the code), aff’d 630 f.2d 670 (9th cir.1980) (congress intended to disallow only “deductions;” treasury regulations purporting to extend disallowance rule to cost of goods sold were invalid as inconsistent with the statute; no constitutional issue decided). 159. see penn mutual ins. co. v. comm’r, 277 f.2d 16, 19-20 (3d cir.1960); cases cited at note 89. the opinion in the sullenger case (in the previous note) simply (and improperly) ignored the indirect tax issue. 160. see note 107 for explicit disallowance provisions. implicit basis disallowance occurs when: (1) a depreciated value asset is held at death (see irc § 1014(a)), (2) loss carryovers expire (see note 106), (3) basis is reduced on account of losses and depreciation that produce no tax benefit (see note 100), and (4) there is no realization event that gives rise to a deduction or offset. an example of the latter situation is presented by the case of frank v. comm’r, 20 t.c. 511(1953) (individual’s costs of searching for business or investment). 161. the oft-quoted passage from doyle v. mitchell bros. co., 247 u.s. 179, 185, is: in order to determine whether there has been gain or loss, and the amount of the gain, if any, we must withdraw from the gross proceeds an amount sufficient to restore the capital value that existed at the commencement of the period under consideration. [emphasis added.] 162. for another version that reaches essentially the same conclusion as reached here, see deborah a. geier, murphy and the evolution of basis, 113 tax notes 576 (nov. 6, 2006). lain dormant because of the now-recognized power of congress to impose a gross receipts tax under its indirect-taxation authority. it is worth noting that159 congress disallows basis in a few instances under the current code.160 in conclusion, the proposition that “incomes” under the 16th amendment (and the catch-all gross income clause of section 61) requires basis recovery or other “netting” is not supported by text, purpose, reason, or authority. if there is no netting requirement, then a cash recovery for emotional damages, being an accession to wealth in itself, must be gross income under section 61 as construed in light of the 16th amendment. 2. the meaning of “capital” under the income tax assuming (contrary to the conclusion reached above) that the 16th amendment defines “incomes” to be net of capital recovery, it next has to be determined what is meant by “capital, the receipt of which is non-income. the circa-1913 notion of “capital” was taken to mean something like “starting point.” however, it took a relatively short time for “capital” to be equated161 with income tax basis. this story is told below, with its ramifications for murphy explained.162 2007 murphy and the sixteenth amendment 409 163. cases dealing with the concept of income were virtually non-existent under the civil war income tax. gray v. darlington, note 142, is an exception, but that case clearly is obsolete as far as the modern income tax is concerned. 164. see eisner v. macomber, 252 u.s. 189, 207 (1920) (pro-rata stock dividend is a portion of capital); lucas v. earl, 281 u.s. 111 (1930) (income is attributed to the owner of the source). 165. capital could also be contributed (without a quid pro quo) by shareholders and non-shareholders. capital was the “base” from which income (earnings and profits) flowed. borrowed money was neither capital nor income; creditors possessed liquidation priority over equity-holders. a legal consequence of “capital” was it that was not available for “dividends” (to equity-holders), to the potential detriment of creditors. capital could be created “internally” by an accounting adjustment (usually accompanied by a “stock dividend”) that subtracted from accumulated profits. 166. 268 u.s. 628 (1925). 167. see note 162. 168. see 268 u.s. at 633 (“the subsidy payments taxed were not made for services rendered or to be rendered. they were not profits or gains from the use or operation of the railroad ... .”). (a) the endowment theory of capital and its collapse there was little detailed understanding as to what “income” meant in the purely tax sense in 1913, and so it was natural that reference would be163 made to existing lore in other disciplines in which “income” had prominence, namely, business accounting, trust accounting, and economics. in these disciplines, “income” was conceived of as being distinct from “capital,” and the distinction was often captured by such metaphors as “the flow that proceeds from the source” and “the fruit that falls from the tree.”164 business and trust accounting (circa 1913) both pertained exclusively to legal entities (trusts, estates, corporations, etc.), and so it was necessary to articulate the distinction between the entity itself and its stakeholders. the concept that was the fulcrum of this articulation was that of “endowment.” thus, in the case of business accounting, endowment (capital) mostly (but not exclusively) took the form of the proceeds of initial-issue stock sales (or contributions of cash or property by partners in a partnership). however, the “capital” concept extended further to encompass additions to the entity’s earnings base from sources other than retained earnings and profits. this165 concept of “capital” was followed by the supreme court in an early (1925) decision, edwards v. cuba r.r. co., holding that a non-shareholder166 contribution to capital dedicated to long-term investment was non-income. the decision in cuba r.r. was clearly influenced by the 1920 macomber definition of income as being gain “proceeding from” capital or labor, because the167 contribution went into the earnings base, and was not itself the fruit of operating the business.168 410 florida tax review [vol.8:4 169. see detroit edison co. v. comm’r, 319 u.s. 98 (1943). a zero basis results in eventual taxation of the item in question. 170. see note 82. 171. see irc §§ 118 (exclusion for contribution to capital of corporation), 305(a) (exclusion for pro-rata stock dividend), 721 (exclusion for contributions to tax partnership), and 1032 (exclusion for proceeds of sale by corporation of its own stock). 172. see note 50. 173. see irc §§ 101(a) (exclusion for life insurance proceeds received by reason of death) and 102(a) (exclusion for other gratuitous receipts). 174. 278 u.s. 470 (1929). 175. for example, if x buys property for $10,000 that is gifted to b when the property is worth $100,000, and b sells the property for $100,000, b is taxed on gain of $90,000. if the gift is to be “permanently” exempt from donee tax, the donee would have to have a basis equal to its value as of the date of gift. (such is the rule for property acquired by bequest and inheritance under irc § 1014.) 176. the court relied on united states v. phellis, 257 u.s. 156 (1921) (holding that a shareholder could be taxed on the entire dividend even though the dividend represented earnings and profits of the corporation accrued before the shareholder acquired the stock), and irwin v. gavit, 268 u.s. 161 (holding that the exclusion for bequests did not exempt a bequest of a right to trust income). but cuba r.r. was soon shorn of all effect by the supreme court in a case holding that a corporation obtained no basis from a non-shareholder contribution of capital, and was later implicitly overruled by glenshaw169 glass, holding that an accession to wealth (regardless of source or use) is170 gross income (unless specifically excluded). in the case of entity taxation, the concept of endowment capital has been comprehensively implemented by detailed statutory provision.171 in the case of trusts (and estates), the equivalent of “capital” is “principal,” which originally consists of the gratuitous transfers that fund the entity, but was also deemed to have included net appreciation in property, whether realized or unrealized. this “endowment” concept appears to lie172 behind the long-standing statutory exclusions for gratuitous receipts of not only trusts and estates but also of individuals. however, the 1929 case of taft v.173 bowers rejects the notion that the “original endowment” notion is built into174 the 16th amendment. that case dealt with the constitutionality of the predecessor of section 1015, providing that the donee of an in-kind gift takes the same income tax basis as the donor, exposing the donee to being taxed on a portion of the gift. the donee in taft argued that the entire value of the gift175 was permanently-excludible “capital” under the 16th amendment, because the value of the property received was endowment to the donee. the supreme court upheld the statutory provision, holding that the only non-taxable “capital” was the cost of the property to the donor. since the carry-over basis rule176 upheld in taft effectively overrides the section 102 gift exclusion, it must be the case that the exclusion for gratuitous receipts itself is not mandated by the 16th 2007 murphy and the sixteenth amendment 411 177. treating gratuitous receipts as gross income would be valid as an indirect tax as well. see notes 13 and 89; kornhauser, note 31 (gifts). 178. see, e.g., stratton’s independence v. howbert, note 132; hays v. gauley mountain coal co., 247 u.s. 189 (1918); merchants’ loan & trust co. v. smietanka, note 45; la belle iron works v. united states, 256 u.s. 377 (1921). 179. see text accompanying note 138. 180. see irc §§ 316(a)(1) (exclusion of corporate distributions out of profits accumulated prior to march 1, 1913), 1053 (basis of property acquired before march 1, 1913). 181. see, e.g., nichols v. coolidge, 274 u.s. 531 (1927); helvering v. helmholz, 296 u.s. 93 (1935) (both cases holding that the estate tax could not constitutionally be applied to pre-enactment gratuitous transfers). amendment. that being the case, “capital” (to the extent that it has any177 constitutional status under the 16th amendment) can no longer, in the realm of the income tax, be equated with “taxpayer endowment.” numerous early cases rejected the thesis that realized gains from property are non-income on the trust-accounting theory that the gains represented a conversion into cash of an increase in “capital.” critically, these178 cases establish the proposition that gain (or loss) is to be measured with reference to the basis, not the value, of the thing given up. the mitchell bros. case, holding that “income” under the 1909 corporation tax act did not179 include pre-enactment appreciation, was one of statutory construction and not the meaning of the 16th amendment. the issue dealt with in mitchell bros. is dealt with under the current income tax by explicit statutory rule. if congress180 were to attempt to reach pre-1913 income, issues (of unfair retroactivity) might be raised under the due process clause, but that issue is distinct from the 16th181 amendment. in sum, there is no longer any support for the proposition that “capital” is equated with “starting point,” “original endowment,” or “earnings base.” it is worth re-emphasizing that the issue here is one of the interpretation of the 16th amendment. statutory provisions embodying business and trust accounting concepts of capital do not define the content of the 16th amendment. instead “capital” under the income tax is now understood to be synonymous with “basis,” which is a technical tax concept roughly meaning “dollars in the investment previously subject to tax.” it follows that personal injury damages broadly viewed (as well as the narrower category of emotional distress damages) cannot be said to be non-income (under the 16th amendment and the catch-all income clause) on any theory (except possibly that of income tax basis). 412 florida tax review [vol.8:4 182. see hawkins v. comm’r, 6 b.t.a. 1023, 1025 (1927) (declining to base the exclusion on the macomber definition of income, but stating that personal injury damages are excludible in the absence of a statute including them). the opinion doesn’t state whether such a statute would be valid under the 16th amendment or under the power to lay indirect taxes (or both). 183. 31 op. atty gen. 304 (1918). 184. the irs then applied the reasoning of the attorney general opinion to personal injury recoveries obtained by way of suit or settlement. see t.d. 2747, 20 treas. dec. int. rev. 457 (1918). 185. see downey v. comm‘r, 97 t.c. 150, 158 (1991) (reviewed) (criticizing the atty gen. opinion as advancing “too generous a view” of the return-of-capital concept, but holding irc § 104(a)(2) to be applicable), on reconsideration, 100 t.c. 634 (1993) (reviewed), rev’d, 33 f.3d 836 (7th cir. 1994) (holding adea damages to be fully includible), cert. denied, 515 u.s. 1141 (1995). (b) the lack of any constitutional doctrine barring the taxation of damage recoveries the murphy panel decision cites early rulings, some cases, and the enactment of the predecessor of section 104 for the proposition that “income” does not encompass personal injury awards under a recovery (or replacement) of capital theory. however, the early authorities are all based on obsolete notions of capital, and the more recent ones merely note the theory without endorsing it. none of the authorities rely on the 16th amendment, and the only judicial decision that actually held personal injury damages to be excluded (apart from section 104) stated that congress has the power to tax such damages.182 the predecessor of section 104(a)(2) first appeared in the revenue act of 1918. the earliest interpretation of prior law was in a 1918 opinion by the u. s. attorney general addressed to the treasury secretary, which held that183 accident insurance policy proceeds were non-income under the 1916 revenue act. that the attorney general was then giving advice to the treasury184 secretary on a matter of basic income tax doctrine shows the inchoate status of the concept of income immediately following ratification of the 16th amendment and the lack of any acknowledged expertise on the subject. the attorney general opinion clearly embraces the now-irrelevant endowment185 theory of capital: the proceeds of life insurance policies are expressly exempted from the act ... “the value of property acquired by gift, bequests, devise, or descent” is treated in the same way, and yet the “income” from such property is included. this seems to imply that the property itself is capital. 2007 murphy and the sixteenth amendment 413 186. 31 op. atty gen. 304, at p. 9: without affirming that the human body is in a technical sense the “capital” invested in an accident policy, in a broad, natural sense the proceeds of the policy do but substitute, so far as they go, capital which is the source of future periodical income. they merely take the place of capital in human ability which was destroyed by the accident. they are therefore “capital” as distinguished from “income” receipts. the idea that compensatory damages replace human capital is sometimes referred to as the “make whole” theory. 187. 31 op. atty. gen. 304, at p. 6: as to fire, marine, and casualty insurance, [the revenue act] impliedly prohibits the deduction of losses when compensated for by such insurance. upon this point the ... 6th circuit in doyle v. mitchell brothers co. (235 fed. 686, 688), in illustrating the principles subsequently declared to be sound by the supreme court in the same case, said: “if an illustration were needed to show that money received from selling capital assets cannot be ‘income,’ it would be found in the statutory treatment of insurance money... . fire insurance money is clearly a substitute for the assets burned; but we find that in case of a fire loss uninsured the loss may be deducted from income, while if it is insured, and if the insurance money is ‘income,’ the loss may not be deducted, and the insurance money must be added – an absurdity which can be avoided only by saying that such insurance money is not income at all. the proceeds of the sale of a building or other permanent assets are as clearly a substitute therefor as is the insurance money paid to indemnify for a building burned.” ...[ i]f the proceeds of accident insurance are held to be “income,” they are in a category different from the proceeds of any other kind of insurance. this passage demonstrates utter confusion. fire insurance proceeds are excluded only to the extent of the basis of the property, not its value. see regs. §§ 1.1651(c), 1.1033(a)-1(c) (fire, marine and casualty insurance); raytheon production co. v. comm’r, 144 f.2d 110 (1st cir. 1944), cert. denied, 323 u.s. 779 (1944) (damages for appropriation of property). the supreme court affirmance did not comment on this passage, which is contrary to the holding of the cases cited at note 136. 188. h.r. rep. no. 65-767, 65th cong., 2d sess., pp. 9-10 (1918). as applied to accident insurance, the “property” implicated in this passage is human capital, which is the source of compensation income.186 the opinion then embraces another wholly incorrect theory of income, namely, that there is no gain if the value of the property disposed of (as opposed to its basis) equals the recovery amount.187 in 1918, congress enacted the predecessor of section 104(a), which excludes personal injury recoveries from gross income. the house report stated (without elaboration) that it was “doubtful” under current law whether such recoveries were income. the issue was indeed doubtful, because no case188 414 florida tax review [vol.8:4 189. the murphy panel opinion, 460 f.3d at 87, cites dotson v. united states, 87 f.3d 682, 685 (5th cir. 1996) for the statement: “congress first enacted the personal injury compensation exclusion ... when such payments were considered the return of human capital, and thus not constitutionally taxable ‘income’ under the 16th amendment.” this statement was offered merely as background, and no authority is cited to support the reference to the constitution. the dotson case itself dealt strictly with the application of irc § 104(a)(2), and did not consider the return-of-capital theory. 190. 519 u.s. 79 (1996). 191. see id. at 89-90. up to that point had considered the issue, and the government had announced that it wouldn’t pursue the matter. contrary to the view expressed by the murphy panel opinion, an expression of doubt on the “law” is not the same as a conclusion that taxing personal injury damages would be unconstitutional.189 moreover, the opinion of congress on what the law was prior to a statutory enactment does not really count. this precise issue was raised in the 1996 case of o’gilvie v. united states, involving the exclusion of punitive damages190 received in personal injury litigation. the taxpayer noted that congress in 1989 added a sentence to section104(a) stating that punitive damages would henceforth not be excluded, the inference being that congress thought that such damages were excludable under prior law. in holding that the pre-1989 punitive damages were nevertheless includible, contrary to any such implication, the majority opinion stated:191 why, petitioners ask, would congress have enacted this amendment removing punitive damages (in nonphysical injury cases) unless congress believed that, in the amendment’s absence, punitive damages did fall within the provision’s coverage? the short answer to this question is that congress might simply have thought that the then-current law about the provision's treatment of punitive damages ... was unclear, that it wanted to clarify the matter in respect to nonphysical injuries, but it wanted to leave the law where it found it in respect to physical injuries. the fact that the law was indeed uncertain at the time supports this view. [citations omitted.] ... we add that, in any event, the view of a later congress cannot control the interpretation of an earlier enacted statute. [citations omitted.] [emphasis added.] separation-of-powers theory supports this view: congress legislates, and the courts interpret the law. 2007 murphy and the sixteenth amendment 415 192. 1-1 c.b. 92. 193. actually, sex, companionship, domestic services, children, and even wives are all available in the market. 194. see united states v. garber, 607 f.2d 92 (5th cir.1979) (en banc) (sale of one’s own rare blood plasma); starrels v. comm’r, 304 f.2d 574 (9th cir.1962) (future loss of privacy); roosevelt v. comm’r, 43 t.c. 77 (1964) (rights in family member’s privacy and reputation). these cases cannot turn on the voluntariness of the transaction, as involuntariness is not a ground for exclusion (absent a specific code provision). see note 215. 195. see rev. rul. 54-418, 1958-2 c.b. 18 (libel and slander of personal reputation); rev. rul. 74-77, 1974-1 c.b. 33 (stating also that sol. op. 132 was thereby “superseded”). 196. see note 82. in 1922, the internal revenue service issued solicitor’s opinion 132,192 which held that damages for (1) alienation of affection, (2) libel and slander, and (3) surrendering custody of a minor child were excludible. apparently, the irs thought that the 1918 statute did not cover these items. sol. op. 132 advanced a “new” theory on account of the fact that wives and children, as things, are not unequivocally “assets” in the financial sense (due to the inherent support obligations), so that application of the conventional (equal-value) nogain theory would be unconvincing. that new theory was that there is no gain in these situations because: (1) personal rights are not transferable in the market, (2) cash recoveries and personal rights are incommensurable, and (3) to hold these recoveries to be includible would be to treat the alienated wife and surrendered child as chattels. however, none of these “reasons” relate to tax doctrine. moreover, the fact that the law provides damages in these situations answers both the “non-market” and “incommensurability” points. the logic193 of this version of the no-gain theory would treat sales of personal rights as nonincome, but the authority is overwhelmingly to the contrary. finally, taxing194 the damages (in full) would not treat the alienated wife and surrendered child as chattels, because there would be no basis offset and the income would not be capital gain. in any event, the irs later came around to the view that compensatory damages in these categories were excluded by statute under section 104(a)(2) under a broad construction of “personal injury,” and solicitor’s opinion 132 has been effectively withdrawn. 195 the murphy panel opinion cited both the glenshaw glass and o’gilvie decisions as having endorsed the proposition that the 16th amendment bars congress from taxing personal injury recoveries. neither case does anything of the kind. in glenshaw glass, the issue was whether punitive damages in a196 commercial context were excludible on the theory that punitive damages are not the product of capital or labor. in holding such damages to be gross income under the catch-all clause, the supreme court noted in a footnote that the returnof-capital theory underlying the exclusion for compensatory damages for 416 florida tax review [vol.8:4 197. 348 u.s. at 423 n. 8. curiously, the murphy panel quotes (460 f.3d at 86) the beginning of the footnote as follows: “the long history of ... holding personal injury recoveries nontaxable [etc.].” the omission (indicated by three dots) is of the three words “of departmental rulings.” this omission alters the import of the footnote. as quoted by the murphy panel opinion, the implication is that glenshaw glass is noting a series of court decisions. the actual glenshaw glass footnote only acknowledges a series of departmental rulings, which do not have the status of “law.” 198. 519 u.s. 79 (1996). 199. in o’gilvie the majority opinion states (519 u.s. at 86): we concede that the original provision’s language does go beyond what one might expect a purely tax-policy-related “human capital” rationale to justify. that is because the language excludes from taxation ... those damages that substitute, say, for lost wages, which would have been taxed had the victim earned them. to that extent, the provision can make the compensated taxpayer better off from a tax perspective than had the personal injury not taken place. 200. see note 127. 201. three of the four justices on the plurality opinion were among the most “conservative” on the court at that time: justice scalia, who authored the opinion, chief justice rehnquist, justice white, and justice stevens. 202. 481 u.s. at 374-78. 203. see 481 u.s. at 383-84 (concurring opinion of justice blackmun). 204. the dissent was authored by justice powell and was joined by justices brennan, marshall, and o’connor, none of whom are on the current court. personal injuries could not possibly apply to punitive damages, which are not compensatory at all. the holding of glenshaw glass, that accessions to197 wealth are income, implies that all compensatory damages in excess of statutory basis recovery are income. the glenshaw glass opinion itself neither states nor implies any limitations on the taxing power of congress. in the o’gilvie case, the supreme court held that punitive damages198 in a personal injury context were not excluded under the pre-1989 version of section 104(a)(2). again the supreme court majority cited the no-gain rationale of section 104(a)(2) for the purpose of showing its inapplicability to punitive damages arising from the same cause of action as compensatory damages. the discussion of the rationale is strictly in terms of theory and policy, and not in199 terms of congressional taxing power. in luckhard v. reed, a welfare-eligibility case that was noted earlier,200 the income tax exclusion for personal-injury compensatory damages was discussed. in that case, four justices signed the plurality opinion that stated201 the view that the word “income” could encompass personal injury awards.202 the swing vote relied on deference to the federal administrative agency. the203 dissent argued that section 104(a)(2) of the internal revenue code manifests204 congress’s considered judgment that personal injury awards should be excluded 2007 murphy and the sixteenth amendment 417 205. 481 u.s. at 387-88. 206. 481 u.s. at 389-90. 207. united states v. burke, 504 u.s. 229 (1992); comm’r v. schleier, 515 u.s. 323 (1995). 208. see 460 f.3d at 85. 209. the murphy panel, 460 f.3d at 85, invokes the concept of human capital as advanced by the nobel-prize-winning economist gary becker. however, the murphy panel makes no attempt to connect emotional distress damages to the concept of “capital.” as a policy matter because it was “not reasonable” to treat an entire personal205 injury award as gain. of course, congress has the power to legislate, whether206 reasonably or unreasonably. none of these opinions raised any issue regarding the federal taxing power, and eight of the nine justices couched their discussion in terms of the judgment of congress. in two modern-era supreme court cases, the actual outcome was the taxation of compensatory damages for personal injury on account of a narrow construction of section 104(a)(2). it is true that no constitutional issue in these207 cases was raised by the taxpayer or by any judge or justice involved in the proceedings at any level, but surely that fact is itself not without significance. (c) the attempted move to a “replacement of capital” theory the murphy panel actually relies on a “restoration” (replacement) of capital theory. the replacement-of-capital (make-whole) theory is advanced208 as a way of getting around conventional tax analysis by way of substituting the term “replacement of capital” for the very similar term “recovery of capital.” the latter term has the specific meaning of subtracting basis upon the disposition of an asset. in contrast, the term “replacement of capital” attempts to avoid tax analysis (basis and loss thereof) by positing a truth that is supposedly self-evidently true on its face: where all or a portion of one’s capital is (wrongfully) destroyed or removed, then it would seem that any recovery (computed with reference to lost future earnings) that replaces that capacity should be untaxed, because otherwise the taxpayer would be diminished relative to her prior state. however, “replacement of capital” is not a recognized tax term. instead, it is a description of a fact situation that is meant to invoke, in the manner of a metaphor, the notion of “no gain.” unfortunately, a cash damages award does not even fit the proffered replacement-of-capital description, because the receipt of damages for emotional distress does not represent any loss of “capital” as that term is being advanced in this context, namely, as the “tree” that produces income. certain personal injury recoveries are for loss of “human capital” in the economic sense, meaning an individual’s uniquely209 personal capacity to earn wages. whether the capacity to have a “normal” 418 florida tax review [vol.8:4 210. congress can override this separateness by conditioning the tax treatment of the disposition to the reinvestment of the cash. it has done so in the case of involuntary conversions of property (see irc § 1033), but not (under irc § 104) in the case of involuntary dispositions of human capital. 211. see irc § 1001(c); cottage savings ass’n v. comm’r, 499 u.s. 554 (1991) (replacement of mortgage investments with virtually identical mortgage investments is a taxable event). 212. the gain is deferred by treating the basis of the original investment as being (with appropriate adjustment) the basis of the replacement investment. see, e.g., irc §§ 358, 722, 1031(b), 1033(b). emotional life is a component of human capital is highly debatable: observation of the human scene suggest little correlation between earnings and emotional well-being. moreover, emotional well-being produces its own “psychic income,” but psychic income is not income in the tax sense, and it follows that emotional well-being is not “capital” in the tax sense. even if the capacity to feel positive and negative emotion were viewed as “capital” in the tax sense, such capital is not “lost” as a result of the events giving rise to the damages recovery. suffering does not manifest any lack (or loss) of capacity. on the contrary, the suffering demonstrates that the capacity is fully intact. finally, even if capacity to enjoy life were demonstrably lost, such a capacity is an aspect of a person’s natural “endowment.” but endowment (natural or otherwise) is not considered to be “capital” in the income tax sense. furthermore, the receipt of a cash damages award is not a “replacement” of capital. replacement can occur only if the cash award is invested. the disposition of an asset and its replacement are separate transactions for tax purposes. there is no general doctrine that the210 replacement of one investment by another (whether voluntarily or involuntarily) results in a permanent exemption from tax. whether any ”replacement transaction” is structured as an exchange of properties or as a sale followed by a reinvestment, the disposition of the original investment is a taxable event unless the code expressly states otherwise. even if there is a gain that the211 code expressly treats as not being recognized (currently taxed), there is no permanent exemption of gain.212 if there never was a general replacement-of-capital doctrine (apart from basis recovery), how can one exist uniquely in the case of personal injury recoveries, and, if so, how can it be located in the 16th amendment? the embarrassing truth is that there has never been a “replacement” requirement under section 104 or any of the non-statutory authority for excluding personal injury damages. shorn of any relevance to facts or even broad (non-tax) notions of capital, the replacement-of-capital theory appears to be nothing more than a new cover draped over the “no (economic) gain” theory. but (to sound like a broken record) gain in tax is measured with reference to basis, not comparative values. 2007 murphy and the sixteenth amendment 419 213. thus, excluding damages recoveries from tax (while allowing damages paid by business to be deductible) has the net effect of lowering the cost of wrongdoing. 214. if there were such a right, then comparative negligence regimes could well be unconstitutional. 215. several of the ideas set out here and below are presented in a different form in joseph dodge, et al., federal income tax: doctrine, structure & policy: text, cases, problems 270-72 (3d ed. 2004). 216. various damage-computation and tax scenarios are explored in joseph m. dodge, taxes and torts, 77 cornell l. rev. 601 (1992). if the damages are figured on a before-tax basis (future wages unreduced by tax), then taxing the damages is the correct way to make the victim whole. even on its own terms, the notion that an income tax exclusion for personal injury damages is necessary to maintain the victim’s pre-injury condition is false. a problem relevant to murphy is that a recovery for emotional harm, even if reinvested, does not make the victim “whole” (does not restore any lost capacity). it is merely compensation for having undergone an unpleasant experience, just as wages are compensation for the loss of the psychic benefits of not working. a broader problem for personal injury recoveries generally is that a norm of making tort victims whole is nowhere expressed in the federal constitution, much less the 16th amendment. the notion of making victims whole is a “policy,” but there are competing policies in tort law, namely, the deterrence of wrongdoing and the internalization of social costs, and these policies might conflict with each other and with the policy of making victims whole. the constitution shows no preference for213 one tort-law policy over others. even if there were a federal constitutional right of individual tort victims to be made whole, an income tax exemption is not a necessary means214 of securing it. such a claim may lie against the government itself, not the wrongdoer. assuming the claim resides against the wrongdoer, the correct end result of making the victim whole is not obtainable by tax law alone but by the proper synergy of tax law and tort law. it is up to tort law to determine215 whether lost earning capacity is to be figured before-tax or after-tax, and whether to use a before-tax or after-tax discount rate. depending on the damages formula used, it is possible that including damages for lost earning capacity in income is the only way to make the victim whole.216 there is the further issue of whether structured settlements (annuity-type recoveries) should be treated as having a taxable interest component. personal-injury recoveries result from “involuntary” occurrences, but the “replacement of capital” theory of exclusion makes no reference to involuntariness. in tax law, involuntariness is often seen as posing a hardship issue that is accommodated (if at all) by a statutory deferral rule rather than by 420 florida tax review [vol.8:4 217. see, e.g., irc §§ 1033 (involuntary conversion gains) and 1038 (gains on property foreclosure). 218. see irc § 1001(b) (basis subtracted from amount realized upon sale or disposition). 219. see united states v. burke, 504 u.s. 229, 233 (1992) (in narrowly construing irc § 104(a)(2), stating that, “congress intended ... to exert the full measure of its taxing power, and to bring within the definition of income ‘any accession to wealth.’” an accession to wealth entails a “before and after” measurement of “wealth,” which refers to material wealth (cash and property), not well-being, utility, and other intangibles. 220. see irc §§ 1011-1023 (defining basis). for the function of basis, see note 113 and accompanying text. 221. in economics jargon, “opportunity cost” means foregone utility: the true cost of something is what you give up to get it. this includes ... the economic benefits (utility) that you did without because you bought (or did) that particular something... . for example, the opportunity cost of choosing to train as a lawyer is not merely the tuition fees, price of books, and so on, but also the fact that you are no longer able to spend your time holding down a salaried job or developing your skills as a footballer... . economics is primarily about the efficient use of scarce resources, and the notion of total exclusion. there is nothing inherently illegitimate in congress217 fashioning tax rules to alleviate hardship. such an accommodation would be within the policy-making competence of congress, and is not mandated by the 16th amendment. 3. there is no recoverable basis in personal injury recoveries the inescapable conclusion is that a receipt of cash is income unless a basis offset is available. in order to obtain a basis offset, it is necessary both (1) that the item in question possess a basis and (2) that the item be “disposed of” so as to entitle the taxpayer to offset the basis against the cash receipt. there218 is no basis in personal attributes generally, and in the murphy case there was no “disposition” of any personal attribute. (a) personal attributes have no basis the idea of “gain” under the income tax is defined purely in monetary terms, and not in terms of overall well-being. in technical jargon, gain is net219 receipts (amount realized) minus net cost (adjusted basis), both being measured in money or money’s worth received or spent, as the case may be. thus, “cost” means net monetary outlay, not “effort,” “pain,” “prior status,” or220 “opportunity cost. 221 2007 murphy and the sixteenth amendment 421 opportunity cost plays a crucial part in ensuring that resources are indeed being used efficiently. see http://www.economist.com/research/economics/alphabetic.cfm?term=oecd. 222. see united states v. garber, 607 f.2d 92 (5th cir.1979 (en banc) (zero basis in one’s own rare blood plasma). 223. see 460 f.3d at 88. 224.it might be argued on behalf of the murphy panel decision that uncompensated losses (and depreciation) of human capital are not deductible on the theory that they are “personal” losses. see welch v. helvering, 290 u.s. 111 (1933) (suggesting that human capital is “personal”); sharon v. comm’r, 66 t.c. 515 (1976), aff’f 591 f.2d 1273 (9th cir. 1978) (per curiam), cert. denied, 442 u.s. 941 (1979) (education costs not amortizable); regs. § 1.162-5 (cost of acquiring human capital by way of education never results in deductions or offsets). in contrast, basis is recoverable upon the disposition of a personal-use asset for cash, but not to exceed the amount of the cash, and the same principle could apply to personal injury recoveries. neither the murphy panel decision nor any other commentator (of whom i am aware) has made this argument. in any event, it does not survive the critiques stated in the text following this note. 225. see irc § 165(b); regs. § 1.165-1(c). 226. see the discussion of partial losses in dodge et al., note 213, at 711-12. it is settled that a person’s physical being (and the components thereof) possess no basis for tax purposes. assuming that human capital has both222 physical and non-physical components, neither component possesses basis. there are no depreciation or loss deductions on account of the wasting or loss of human capital. the murphy panel opinion attempts to avoid the no basis difficulty by suggesting that the reason human capital basis does not generate deductions is simply because it is too difficult to account for it; in contrast, in a personal223 injury recovery the basis can be deemed to be equal to the amount of the recovery. but damages simply represent a determination of value, and the loss of value attendant upon a non-compensated loss of human capital is capable of determination in the same manner as in any case where there is compensation.224 in addition, it cannot simply be assumed that the basis of the lost human-capital component equals its value. first, it must be established that such basis exists in the first place (and that it exceeds the amount of the loss). second, the225 amount of basis that can be taken as an offset is the taxpayer’s basis in the particular component of human capital that is lost; if such basis cannot be identified (which is certain to be the case), the taxpayer’s basis in the lost component is the same percentage of her total basis in her entire human capital as the total amount of the loss bears to the total pre-loss value of the human capital.226 the problem isn’t simply one of accounting difficulties. human capital simply does not possess basis as a matter of law. basis represents a taxpayer’s 422 florida tax review [vol.8:4 227. basis can derive from “income” expressly exempt from tax. in such a case, basis “preserves” the express exclusion. 228. such “wealth” (if it be so conceived) is not transferable, nor can it be liquidated. 229. see note 167. the basis rules for gifts and bequests (irc §§ 1014 and 1015) do not apply, as these only apply to “property” that can be transferred (gratuitously). human capital is not transferable. see bateman v. comm’r, 686 f.2d 217 (4th cir. 1982). 230. see regs. § 1.162-5(b). 231. this appears to be the theory underlying the basis disallowance rules referred to in note 107. 232. not only can the costs be recorded and tallied, but also the basis can be amortized as an intangible over the taxpayer’s actuarially-determined professional life expectancy. cf. sharon v. comm’r, note 222 (allowing amortization of the cost of obtaining a license to practice law). 233. see generally, joseph m. dodge, taxing human capital acquisition costs or why costs of higher education should not be deducted or amortized, 54 ohio st. l. j. 927 (1993). 234. see 460 f.3d at 87-88. cost expressed in dollars that have previously been taxable to that taxpayer.227 the principal component of human capital is a person’s body and its attendant capabilities. other components result from the acquisition of learning, culture, social skills, and the like. however, none of these items is considered “income” (an accession to wealth) upon acquisition. in addition, any costs incurred by228 third parties (parents, relatives, friends, government) in providing a person with human capital do not transfer to the taxpayer, the supreme court having held that third-party contributions to the capital of a corporation have a zero basis to the corporation. finally, most costs incurred by the taxpayer with her own229 funds that result in the acquisition of human capital (living costs) are treated as expenses, not capital expenditures. about the only item that might create basis (in theory, at least) would be self-paid education that qualifies one for a new trade or business. however, it appears that such costs do not create basis as230 a matter of positive law, on the theory that inherently personal costs (that cannot be deducted as expenses) cannot be deducted indirectly through capitalization and depreciation or basis offset. in any event, most people incur no human-231 capital capital expenditures, and none were alleged to have been incurred in murphy. note, however, that such a discrete category of cost is capable of accurate accounting. in sum, human capital is similar to self-created goodwill232 in having a zero basis (or close to it) as a matter of law.233 it is not clear that the murphy panel really relied on a restoration-ofhuman-capital theory. not only does a recovery for emotional harm fail to demonstrate any loss of human capital in fact, but also it is not clear that as a matter of purely tax policy (as distinct from tort policy) an exclusion is appropriate where human capital is lost and replaced by cash. a recovery for234 2007 murphy and the sixteenth amendment 423 235. although some human capital may be viewed as having been acquired with after-tax (nondeductible) dollars of the taxpayer, most of it is acquired tax-free from third parties and the environment. 236. wages are taxed. cash that is invested (treated as a capital expenditure) is not deductible in theory and in a good deal of practice, see irc § 263, and therefore retains its after-tax status. 237. cf. irc § 1033 (no gain on involuntary conversion of property if entire proceeds are rolled-over into similar-use property). 238. 313 u.s. 28 (1941). lost earning capacity can be viewed as a conversion from human capital, which is “before tax,” to either wages or investment capital, both of which are235 supposed to be after-tax. a recovery for lost human capital can be invested236 in an annuity that would replace the lost wage stream. taxing the recovery would simply place the annuitant on an equal tax footing with other investors. excluding the award would have the effect of preserving the taxpayer’s status as a (deemed) wage-earner, rather than investor (despite being an investor in fact). surely it is in the discretion of congress to make this choice or to perhaps to select some other approach, such as conditioning the exclusion on an actual annuity investment. 237 even if the taxpayer in murphy had a basis in her human capital, she could not have a basis in her capacity for emotional well-being (even if such a basis could be calculated). at least in the realm of speculation, costs of acquiring human capital might be capitalized, because human capital is the capacity to generate future wage income, and capital expenditures are present costs of obtaining future includible income. however, emotional capacity or normalcy is not an asset capable of producing income in the tax sense, present or future. emotional states (positive and negative) do not measure changes in material wealth, and “highs” and “lows” are neither income nor loss items. (b) there was no disposition of anything in murphy even if one were deemed to have an income tax basis in one’s capacity to enjoy a normal emotional life, the suffering of emotional distress cannot be equated with the loss (“disposition”) of any asset. cash-for-pain is a simple trade-off, resulting in economic (or tax) gain, just as is the trading of services for wages. suffering (like wage-earning) does not manifest any lack (or loss) of capacity. as noted earlier, the suffering demonstrates that the capacity remains in place. without a loss of a portion of an asset, there can be no basis offset against a cash receipt. a case directly on point in this respect is the 1941 decision of the supreme court in hort v. comm’r, where the taxpayer-lessor238 received a payment from the lessee for the termination of a lease that was unfavorable to the lessee. the taxpayer argued that the lease termination 424 florida tax review [vol.8:4 239. see, e.g., irc §§ 165(c), 167(a), and 262 (disallowing personal expenses, losses, and depreciation), and 264 and 265 (disallowing costs of producing tax-exempt income). payment was compensation to the lessor for the loss of the premium value of the lease. it is true that the taxpayer was compensated for losing the lease, but the tax issue was whether any of the lessor’s basis in the underlying real estate could be “allocated to” the premium lease and used as an offset against the termination payment. the court held that such payment was not subject to any basis offset whatsoever, because there was no final disposition of any identifiable portion of the underlying real estate investment, given that the premises could be re-leased upon the lessee’s departure. in other words, a loss (decline) in rental value does not necessarily reflect a realized loss of incomeproducing capacity. similarly, there was no permanent or final disposition in murphy of anything that (even if it had a basis) could support a basis recovery. emotional states are temporary. the capacity to experience emotional states, both high and low, persisted. ___________________________ to sum up, the murphy panel is wrong on all three of the elements needed to establish the existence and applicability of the no-gain theory. there is no netting requirement in the 16th amendment concept of “incomes.” “capital” means only “basis” (or, more broadly, the monetary “cost” of producing income). there is no basis in human capital, much less in emotional distress damages, and (even if there were) there can be no basis offset without a realized (permanent) loss of an asset (or a portion thereof). in the tax sense, personal injury recoveries (other than recoveries of non-deductible costs) are pure monetary gain, and therefore “income.” b. the “in lieu of” theory the entire notion of “capital” in the history of the income tax (as well as in business and trust accounting) is as something that produces monetary income. emotional well-being does not produce monetary income. its presence might contribute to it, but so might its absence. and non-monetary (psychic) benefits (and detriments) do not count under the income tax. if psychic benefits are non-income, then any costs of producing the same cannot be allowed as deduction or offset, explicitly or implicitly. in short, the human capital notion239 cannot provide a theory for excluding damages for emotional harm. another theory is needed, and the theory offered by the murphy panel is the “in lieu of” theory. as applied in the murphy panel opinion, this theory operates to exclude emotional-harm damages on the ground that the recovery is a substitute for (in 2007 murphy and the sixteenth amendment 425 240. 305 u.s. 188, 196 (1938): there is no question that petitioner obtained that portion [of a decedent’s estate], upon the value of which he is sought to be taxed, because of his standing as an heir and of his claim in that capacity. it does not seem to be questioned that if the contest had been fought to a finish and petitioner had succeeded, the property which he would have received would have been exempt under the [predecessor of section 102]... . we think that the distinction sought to be made between acquisition through such a judgment and acquisition by a compromise agreement in lieu of such a judgment is too formal to be sound, as it disregards the substance of the statutory exemption. 241. 144 f.2d 110 (1st cir.1944), cert. denied, 323 u.s. 779 (1944). 242. see id. at 113. lieu of) a non-taxed (non-income) benefit, namely, emotional well-being. this section demonstrates that there is no doctrinal support for the version of the inlieu-of theory advanced in murphy, and that the theory, if accepted, would cause the income tax to collapse. 1. there really is no “in lieu of” doctrine the murphy panel decision’s application of the so-called “in lieu of test” is radical in that no other case has applied this notion to find that that an item is non-income. the “in lieu of” phrase is found in the supreme court 1938 decision in lyeth v. hoey, but that case only construed the statutory exclusion for240 gratuitous receipts, holding that an heir’s receipt of an estate in settlement of a will contest was as much an “inheritance” as if obtained by way of a routine intestacy scenario or a court judgment. the most frequently cited authority for the so-called in-lieu-of doctrine is the first circuit’s 1944 decision in raytheon production co. v. comm’r,241 in which the taxpayer received a settlement in a civil anti-trust suit. the court stated: “the test is not whether the action was in tort or contract but the question to be asked is “in lieu of what were the damages received?” the242 court then asked whether the recovery was of lost profits (fully taxable) or of the value of an asset (goodwill) that was wrongfully appropriated by the defendant. the court decided that the damages were for appropriated goodwill, but that the taxpayer failed to show any basis therein. 426 florida tax review [vol.8:4 243. see francisco v. united states, 267 f.3d 303, 319 (3d cir. 2001) (part of settlement of tort action treated as taxable interest); tribune publishing co. v. united states, 836 f.2d 1176 (9th cir.1988) (settlement of securities fraud suit treated as a taxable boot-dividend received in a tax-free reorganization); gilbertz v. united states, 808 f.2d 1374 (10th cir.1987) (characterizing payments received by ranch-owner from oil and pipeline companies, treating some as the equivalent of rent and others as warranting capital recovery). 244. see 460 f.3d at 88. 245. see note 196. 246. the majority opinion in o’gilvie states (519 u.s. at 86-87): we concede that the original provision’s language does go beyond what one might expect a purely tax-policy-related “human capital” rationale to justify. that is because the language excludes from taxation not only those damages that aim to substitute for a victim’s physical or personal well-being – personal assets that the government does not tax and would not have taxed had the victim not lost them. it also excludes from taxation those damages that substitute, say, for lost wages, which would have been taxed had the victim earned them. ... finally, we have asked why congress might have wanted the exclusion to have covered these punitive damages, and we have found no very good answer. those damages are not a substitute for any normally untaxed personal (or financial) quality, good, or “asset.” ... other cases cited by the murphy panel opinion are of like import. in243 all of them there was a settlement (or its equivalent), and the issue was categorization of the settlement proceeds under the tax code. given that all of the cases invoking the in-lieu-of concept involve litigation settlements, its adoption by the murphy panel decision is both odd and inappropriate, because in murphy there was no settlement, but rather an award specifying that the damages were for “emotional distress or mental anguish” and for “injury to professional reputation.” thus, the nature of the recovery is manifest on its face. moreover, the relevant statutory category is also clear: the cash award is a recovery on account of a non-physical injury. instead of using the in-lieu-of idea to characterize the facts in relation to one or more relevant legal rules, the murphy panel treats the concept as a “theory” that cash received in lieu of non-income (emotional well-being) is itself non-income. no case is cited as so holding, and none (to my knowledge) exists. the theory is implausible on its face, because it treats a cash accession to wealth as if it were an immaterial psychic benefit. the murphy panel suggests, nevertheless, that the o’gilvie case endorses such a theory as a244 245 principle of 16th amendment jurisprudence. however, o’gilvie does no such thing, but merely cites the notion as a possible reason for congress’s decision to exclude certain compensatory damages from gross income.246 2007 murphy and the sixteenth amendment 427 the dissenting opinion (justice scalia, joined by justices o’connor and thomas) was based on a textual approach. in passing, it debunks (519 u.s. at 97-99) the replacement-of-capital rationale of the early administrative rulings. 247. see, e.g., gregory v. helvering, 293 u.s. 465 (1935), aff’g, 69 f.2d 809, 810 (2d cir.1934) (opinion by l. hand) (issue was dividend vs. capital gain); knetch v. united states, 364 u.s. 361 (1960) (no interest deduction allowed where there is no real indebtedness). it is worth noting that the in-lieu-of idea, which emerged in the late 1930s and early 1940s, cannot possibly be said to have been part of the 1913 understanding of the 16th amendment, assuming arguendo that such understanding is relevant to the interpretation thereof. 2. the murphy version of the doctrine would destroy the income tax the function of the in-lieu-of idea is simply to ascertaining the “substance” of a settlement in relation to statutory categories under the tax law. thus, in lyeth v. hoey the settlement was an “inheritance,” excluded by247 statute, and in raytheon production it was “payment for a stolen asset” (rather than profits). really, the “in lieu of” notion is misnamed: it really should be called the “what is it?” doctrine. a doctrine that is designed to accurately describe facts is perverted if it is used to misdescribe facts. such a perversion occurs where, as in murphy, it is deployed to treat a receipt of cash as if it were really a (non-income) psychic benefit. the “substance” of the transaction in murphy was precisely the conversion of emotional well-being into cash. the cash award cannot be viewed as not being a cash award! the tax code would be wholly undermined if transactions involving material wealth could be converted by a magic wand into non-material ephemera. such a “transubstantiation doctrine” would have the potential to operate virtually without constraint so as to change income into non-income. are wages in lieu of the untaxed psychic benefits of not working? are interest, dividends, rents, property royalties, and even capital gains “in lieu of” pride of possession and feelings of security derived from possessing cash and property?” are punitive damages a substitute for moral indignation and a desire to wreak revenge? these are truly silly and irrelevant questions in the context of an income tax. iv. conclusion the murphy panel decision should not only be reversed, but it should be condemned in the strongest terms. contrary to this decision, cash damages for personal injury (that are not excluded under code section 104) are included under the catch-all clause of section 61 and the 16th amendment. in addition, 428 florida tax review [vol.8:4 248. see the text accompanying notes 17-21. 249. for example, the opinion (460 f.3d) cites the quote “the power to tax is the power to destroy” (mcculloch v. maryland, 4 wheat. (17 u.s.) 316, 431 (1819)), as if the supreme court has adopted a narrow construction of the taxing power. however, it has done just the opposite. in knowlton v. moore, 178 u.s. 1, 60 (1899), the court stated that this concern only comes into play where “there is no power to tax a particular subject,” and went on to hold that a federal inheritance tax was valid as an indirect tax. in this connection, see also note 23. some other examples of non-relevant generalizations are noted in note 40, the text accompanying notes 67-69, and note 187. 250. the discussion of the replacement-of-capital theory in murphy is pointless, because the taxpayer neither lost nor replaced anything considered to be “capital.” 251. examples of the mis-citation of cases are noted at note 24 and in the text accompanying notes 45-52 and 194-197. 252. examples are noted in the text accompanying notes 41-58 and 180-193. it is certain that congress has the power to tax such damages under its power to levy indirect taxes without apportionment. the murphy panel was correct in not reaching the indirect tax issue, although it should have mentioned this issue and explained why it was not relevant. however, the case was wrongly decided on every other point. the 16th amendment is construed according to its text (not by early misunderstandings. on the merits, the 16th amendment does not require netting. “capital” means basis. a taxpayer has no basis in a personal injury recovery, and (even if a taxpayer were to have such basis) it cannot be recovered against an award of emotional distress damages. there is no support for the theory that an accession to wealth can be treated as if it were a mere non-taxable psychic benefit, and adoption of any such theory would cause the collapse of the income tax. the “craft” of the murphy panel decision is abysmal. the holding is inaccurately and confusingly stated. the opinion is a disorganized pastiche248 of quotes and generalizations culled from various sources without regard to249 the facts of murphy, the facts, context, or holdings (of cases), the current250 251 status of authorities or theories, or any real analysis of relevant legal252 materials. the panel opinion is truly radical in showing no real respect for constitutional text, the body of judicial authority as it has evolved up to the present, or even the nature of the judicial function. it is one thing to invoke outdated and obsolete theories in class discussion or e-mail colloquies for their instructional or entertainment value. it is another to actually adopt them at in a judicial opinion at the next-to-highest level. in contrast to congress or the executive, who are free to recycle old ideas, courts do not decide issues in a vacuum. decisions close doors, although they may open others. “anything goes” is the wrong motto. florida tax review volume 2 1995 number 7 scoping out the uncertain simplification (complication?) effects of vats, bats and consumed income taxes j. clifton fleming, jr.* i. introduction ................................ 392 ii. what if congress enacts a vat? . . . . . . . . . . . . . . . . 393 a. is a single-rate vat simpler than the income tax? . 393 b. is a vat inherently simple or inherently complex? 395 c. can a vat be made even more complex? ....... 398 d. does it matter how the vat revenues are used? . 399 1. a vat replacing the individual and corporate income taxes ............... 399 2. a vat used to pay for deficit reduction, income tax cuts, or spending programs ... 402 3. a vat financing corporate integration .... 402 4. dropping taxpayers out of the system ..... 405 e. the danforth-boren proposal: using a vat to eliminate the corporate income tax and pay for other good stuff .......................... 405 1. complexities preserved and expanded by danforth-boren ..................... 408 2. new complexities created by danforthboren ............................ 409 3. transition from the corporate income tax to the bat ........................ 411 * j. clifton fleming, jr. is associate dean and professor of law, j. reuben clark law school, brigham young university. the author acknowledges research assistance by amy williams and helpful comments from deborah a. geier, calvin h. johnson, christian e. kimball, janet a. spragens, and george k. yin. this is not to suggest, however, that they completely agree with this article or that they have any responsibility for its inevitable errors. the indispensable secretarial work of florence beal, who suffered through an interminable series of drafts, is also thankfully acknowledged. copyright © 1995 by j. clifton fleming, jr. scoping out the uncertain simplification effects 4. does danforth-boren simplify the tax system ? ........................... 412 1h. what if congress enacts a consumed income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413 a. addition to or replacement for the accretion income tax? .................................. 413 b. simplifications resulting from substituting a consumed income tax for all accretion tares ..... 414 c. nunn-domnenici proposal: carrying danforth-boren the rest of the way ......................... 416 1. simplifying features of nunn-domenici .... 418 2. why two consumption tares? .......... 419 3. complexities in calculating gross receipts . 421 4. fringe benefits ..................... 421 5. savings and dissavings ............... 422 6. business versus personal under nunndomenici ......................... 422 7. long-lived consumer assets ............ 423 8. personal residences .................. 425 9. other long-lived consumer assets ....... 426 10. gifts and inheritances ................ 428 11. income splitting ..................... 432 12. charitable contributions and tax-erempt organizations ...................... 434 13. accommodating lowand middle-income taxpayers ......................... 437 14. qualified retirement plans ............. 438 15. state and local government bonds ....... 439 16. transition problem .................. 439 17. nunn-domenici vat ................. 440 d. the devil is in the details ................... 441 iv. conclusion .................................. 44 1 1995] florida tax review i. introduction of the many things we do not know about a national, broad-based consumption tax, this article addresses only one of the important uncertainties: the impact of a consumption tax on the overall intricacy of the federal revenue system. more specifically, this article examines some important issues regarding the effects on tax system complexity of the three principal candidates for a national consumption tax-the european-style, credit method value added tax (vat), the subtraction method vat, and the consumed income tax.' under a credit method vat, a business subtracts the vat paid on its purchases (including capital expenditures) from the vat it collects on sales and either remits to the government the tax collected in excess of tax paid or receives from the government a refund of tax paid in excess of tax collected.2 this system effectively taxes each business on the value that it adds to goods and services. under a subtraction method vat, a business deducts business purchases, including capital outlays, from sales and pays tax on the difference. a subtraction method vat, sometimes called a business activities tax (bat), differs from a single-rate credit method vat only in computation procedure, and the two taxes produce the same revenue if imposed at the same rate.3 businesses are usually required to settle vat accounts with the government more often than annually. in simplified terms, a consumed income tax is assessed annually on individuals by applying progressive rates to a tax base composed of gross 1. a national retail sales tax is another possibility. however, the vat is generally considered a superior method of taxing consumer sales because (1) its multistage collection process is more effective at extracting revenue from tax evaders than the single-stage collection mechanism of a retail sales tax, (2) the states of the united states have found it quite difficult to eliminate nonconsumption sales to other businesses from the retail sales tax base, and (3) european vats have been more successful at bringing services into the tax base. see generally 3 u.s. treas. dep't, tax reform for fairness, simplicity, and economic growth 13-16, 31-32, 47 (1984); david f. bradford, untangling the income tax 72-73 (1986); sijbren cnossen, the value added tax: questions and answers, 42 tax notes 209, 210-11 (jan. 9, 1989). perhaps for these reasons, there is little current interest in a national retail sales tax, and this article does not deal with the simplification/complication issues raised by such a tax. 2. see generally 3 treas. dep't, supra note 1; bradford, supra note 1, at 59-72; ward m. hussey & donald c. lubick, basic world tax code and commentary 217-27 (prelim. ed. 1992); aba sec. of tax'n, report of the special subcommittee of the committee on general income tax problems on the value-added tax, 24 tax law. 419 (1971). 3. see 3 treas. dep't, supra note 1, at 7-11; oliver oldman & alan schenk, the business activities tax: have senators danforth and boren created a better value added tax? 65 tax notes 1547, 1551-52 (dec. 19, 1994). see also general accounting office, implications of replacing the corporate income tax with a consumption tax 2-3 (1993). [vol 2:7 scoping out the uncertain simplification effects income increased by borrowings and withdrawals from savings and reduced by debt payments, additions to savings, and business expenses.4 i do not contend that complexity considerations should take precedence over all other tax policy criteria. even if enactment of a vat or consumed income tax would lead to a more complex system, other tax and economic policies, including revenue needs, might make that the wisest course. complexity considerations are, nevertheless, of considerable importance in formulating tax changes, and a consumption tax should not be enacted without carefully considering its effects on systemic complexity. unfortunately, the determination of these effects is itself a complex and uncertain exercise requiring an analysis of numerous scenarios. il. what f congress enacts a vat? vat proponents often say that a vat is the essence of simplicity,5 and the suggestion is sometimes made that adoption of a vat would reduce complexity in the federal tax system. 6 however, the characterization of a vat as simple may be misleading, and whether a vat would reduce overall complexity depends on how vat revenues are used. a. is a single-rate vat simpler than the income tar? a single rate vat effectively imposes tax equal to a flat percentage of the value added at each stage of the production and distribution of goods and services, with the sum of these incremental taxes usually being viewed as borne by consumers in comparison with the federal income tax, the vat gets high marks for simplicity. because businesses are allowed to expense the costs of capital goods and inventory in making value added computations, 4. see 1 u.s. treas. dep't, tax reform for fairness, simplicity, and economic growth 191-93 (1984); u.s. treas. dep't, blueprints for basic tax reform 113-44 (1977) [hereinafter blueprints]. 5. see, e.g., cnossen, supra note i, at 211. 6. see u.s. treas. dep't, restructuring the u.s. tax system for the 21st century: an option for fundamental reform, 92 tnt 247-15 (dec. 11, 1992) (lexis, fedtax library, tnt file); m. carr ferguson, it's time to step up to the plate for a bat, 72 taxes 639 (1994). 7. jonathan r. kesselman, assessing a direct consumption tax to replace the gst, 42 can. tax j. 709, 724-25 (1994); oldman & schenk, supra note 3. at 1548. see also 3 treas. dep't, supra note 1, at 29, 43. for a different view of the incidence issue, see cliff massa iii & david g. raboy, the canadian value-added tax: does anybody care? 45 tax notes 481, 485-88 (oct. 23, 1989). 8. under a credit method vat, a business subtracts, from the vat that it collects on its sales, the vat paid on all of its business purchases, including purchases of productive 19951 florida tax review the capitalization and capital cost recovery rules that contribute so importantly to the complexity of the income tax are absent from a vat. since nothing is capitalized, a vat has no depreciation or inventory rules, and basis need not be recorded, tracked, or adjusted. gain or loss, in the sense of the difference between amount realized and basis, never has to be calculated when assets are sold.9 also, under a vat, compensation payments to a firm's employees are neither deducted in computing the firm's value added nor treated as taxable sales made by the employees to the firm.'0 thus, a vat allows both employers and employees to ignore cash compensation payments and deferred cash compensation issues." yet another way in which a vat is less complex than the income tax is that a vat has no separate entity regimes. because the tax applies to sales transactions regardless of the seller's form of organization, but does not apply to income distributions, a vat has no need for provisions dealing specially with corporations, partnerships, or trusts. 2 for these and other reasons, replacement of the income tax with a vat would be an enormously simplifying development in the federal revenue system. unfortunately, for reasons described below, this is also a politically improbable development.' 3 in the most likely scenarios, a federal vat would be an addition to the revenue system that would coexist with the income tax.14 to understand the effect of such a vat on the overall intricacy of the tax system, it is necessary to consider the extent to which a vat possesses inherent complexities and the extent to which those complexities might be increased by the political process. assets and goods and services absorbed into inventory. this credit effectively removes all capital expenditures and inventory costs from the vat base. see 3 treas. dep't, supra note 1, at 7-9. see also bradford, supra note 1, at 61-64. 9. see 3 treas. dep't, supra note 1, at 7; bradford, supra note 1, at 61-64. 10. 3 treas. dep't, supra note 1, at 5; bradford, supra note i, at 61, 88; aba sec. of tax'n, supra note 2, at 422-23; hussey & lubick, supra note 2, at 105, 109; kesselman, supra note 7, at 709, 718; oldman & schenk, supra note 3, at 1550, 155 n.55. see also s. 2160, 103d cong., 2d sess. § 10013 (1994), reprinted in 140 cong. rec. s6524-30 (daily ed. june 7, 1994). 11. under a rigorously principled vat, an employer's furnishing of goods or services to an employee as compensation is a taxable sale if the employee's purchase of these items would be a taxable sale. 3 treas. dep't, supra note 1, at 80-81. 12. see generally general accounting office, value added tax: administrative costs vary with complexity and number of businesses 29 (1993) [hereinafter vat administrative costs]; general accounting office, choosing among consumption taxes 1314 (1986). 13. see infra text accompanying notes 42-54. 14. see infra text accompanying notes 55-119. [vol 2:7 scoping out the uncertain simplification effects b. is a vat inherently simple or inherently complex? a vat inherently entails significant complexity. millions of businesses must make periodic returns and remittances, perhaps as often as monthly.' 5 these payments and returns must be processed, and the returns must be audited. without audits, taxpayers would cheat by diverting amounts owed to the government,' 6 by overstating vat payments to vendors and understating vat collections from customers, 7 by misclassifying goods and services if the vat has multiple rates,' 8 and by claiming that domestic sales are zero-rated export sales.' 9 the resulting administrative complexities are hardly trivial. the internal revenue service estimated in 1984 that a vat would involve up to 20 million taxpayers, would necessitate hiring 20,000 additional irs employees, and would, when fully phased in, require $700 million of annual irs administration costs.20 the general accounting office estimated in 1993 that a u.s. vat would have 9 million to 24 million taxpayers, depending on the size of an assumed small business exclusion,2' and that administration costs could be as high as $1.83 billion annually, plus up to an additional $700 million if there were exemptions and multiple rates.states 15. see, e.g., hussey & lubick, supra note 2, at 224. 16. vat administrative costs, supra note 12, at 43. 17. id. at 46. see also kesselman, supra note 7, at 774-75. 18. vats are often imposed at a lower or zero rate on food and medical supplies. see infra note 24. this creates an incentive for sellers to misclassify items in order to take advantage of the more favorable rate. see generally william h. morris, a "national debate" on vat: the gibbons proposal, 60 tax notes 1259, 1264-65 (aug. 30, 1993); james w. wetzler, the value added tax: the relevance of states' sales tax experience. 52 tax notes 719, 720 (aug. 5, 1991). 19. the vat rate for export sales is typically zero. 3 treas. dep't. supra note 1, at 11-13, 45-46. see also morris, supra note 18, at 1268. this gives sellers an incentive to characterize domestic sales as export transactions because a successful misclassification causes the sale to be tax-free even though the seller gets a credit for vat paid on inputs used to produce the sold item and thus obtains a vat refund. see vat administrative costs, supra note 12, at 46. 20. 3 treas. dep't, supra note 1, at 111, 122. in making these estimates, it was assumed that the vat would coexist with the income tax. id. at i 11. 21. vat administrative costs, supra note 12, at 3-4, 6, 102. for small business exclusions, see infra text accompanying notes 32-34. 22. vat administrative costs, supra note 12, at 3. the 1984 treasury department and 1993 general accounting office estimates have been implicitly criticized by sijbren cnossen as overly pessimistic. sijbren cnossen, administrative and compliance costs of the vat: a review of the evidence, 63 tax notes 1609, 1610 (june 20, 1994). cnossen gives as his own estimates an annual u.s. vat administrative cost of si billion in 1995 and an annual aggregate taxpayer compliance cost of $5 billion in 1995. id. however, these amounts seem sufficiently large to imply significant complexity. furthermore, cnossen's estimates are 19951 florida tax review with retail sales taxes and european countries with vats have been unable to resist pressures for exemptions and multiple rates,23 and we should therefore expect to find such features, and their resulting costs, in a u.s. national vat. 24 these estimates imply large numbers of taxpayers and overly optimistic in that they assume adoption of a single-rate vat. id. as noted below, this seems unlikely. 23. see 3 treas. dep't, supra note 1, at 44; vat administrative costs, supra note 12, at 71, 78; comparative tax systems: europe, canada, and japan 48, 112-13, 177-78, 232, 278, 315, 334 (joseph a. pechman ed., 1987); jack m. mintz et al., canada's gst: sales tax harmonization is the key to simplification, 8 tax notes int'l 661, 668-69 (mar. 7, 1994); wetzler, supra note 18, at 720. 24. sheldon s. cohen, the classic pipe dream: a perfect u.s. vat, letter to the editor, 64 tax notes 275-76 (july 11, 1994); peter jakubowicz, will vat-man cometh to u.s.? small business groups hope not, 59 tax notes 731 (may 10, 1993). however, japan was able to enact a single-rate vat. see alan schenk, japanese consumption tax: the japanese brand vat, 42 tax notes 1625 (mar. 27, 1989). a broad-based, flat-rate vat is usually considered inherently regressive because consumption expenditures, which are the tax base of a vat, tend to absorb larger portions of the incomes of low-income individuals than of middleand high-income individuals. staff of joint comm. on tax'n, methodology and issues in measuring changes in the distribution of tax burdens 54-59 (comm. print 1993); 3 treas. dep't, supra note 1, at 19-20, 43, 87; bradford, supra note 1, at 320-21, 324; cnossen, supra note i, at 212; kesselman, supra note 7, at 758-60. this fact creates substantial pressure to decrease the vat's regressivity by creating lower or zero vat rates for "necessities" such as food, clothing and medical care. 3 treas. dep't, supra note 1, at 43, 90, 93. the resulting multiple rates, and the difficult classification issues that they produce, materially complicate vat compliance and administration. see morris, supra note 18, at 1264-65; wetzler, supra note 18. the preferred method for dealing with the vat's regressivity is to maintain a flat rate but provide a refundable, phased out income tax credit for low-income taxpayers that effectively rebates all or part of the vat to them. 3 treas. dep't, supra note 1, at 44, 98-100. although this approach keeps complexity out of the vat, it adds complexity to the income tax and contributes to the overall complexity of the tax system, particularly if taxpayers whose incomes are so small that they would ordinarily not be required to file tax returns must now do so in order to get the vat refund credit. see bradford, supra note 1, at 321. the concern for low-income individuals that has resulted in the earned income tax credit would surely result in either zero rates for necessities in a u.s. vat or a vat credit in the income tax. our canadian cousins have interwoven the preceding themes to create the worst of both worlds in terms of complexity. they have provided both zero vat rates on necessities and a refundable income tax credit to ameliorate regressivity. robert couzin et al., business operations in canada-taxation, 955 tax mgmt. (bna) a-i to a-2(l) (1991). yet another approach to mitigating the vat's inherent regressivity is to increase government transfer payments to offset the vat burden of low-income people. 3 treas. dep't, supra note 1, at 43, 89-90. if transfer payments are increased without enlarging the beneficiary group and without creating new benefit programs, this approach does not increase complexity. however, if the beneficiary group is enlarged or new benefit programs are established, overall governmental complexity will increase. [vol 2:7 scoping out the uncertain simplification effects administrators spending significant amounts of time in complying with and enforcing any vat that is likely to be enacted by congress.2 further complexities result from sourcing rules needed to distinguish zero-rated exports from taxable domestic sales.' additional rules are required to (1) deal with the treatment of transactions between members of affiliated corporate groups and between other related parties,27 (2) exclude transactions deemed inappropriate for vat taxation (as under code sections 332, 351, and 368),28 (3) provide for post-sale price adjustments and uncollectible debts arising from sales on credit,29 (4) allow vat refunds where the taxes on sales for a period are less than the vat paid on purchases for the period,' and (5) deal with financial services." european vats typically contain small business exemptions based on turnover or gross receipts,32 as does the japanese vat.33 if a small business exemption were included in a u.s. vat, businesses claiming the exemption would have to be examined for compliance with the qualification requirements, and the exemption would probably be accompanied by complex 25. see jakubowicz, supra note 24; 3 treas. dcp't, supra note 1, at 112-21. the experience with canada's goods and services tax, a credit method vat, confu'ms these implications. see richard m. bird, the cost and complexity of canada's vat: the gst in an international perspective, 8 tax notes int'l 37 (jan. 3, 1994); kesselman, supra note 7. at 713, 765-70. 26. see s. 2160, supra note 10, §§ 10011, 10012, 10024. 10031 (1994); john c. danforth & david l. boren, the comprehensive tax restructuring and simplification act of 1994: technical overview 16-17, 94 tnt 103-26 (may 27, 1994) (lexis, fedtax library. tnt file) [hereinafter technical overview]; cliff massa iii, the "business activities tax'----a primer, 64 tax notes 1219, 1222, 1227 (aug. 29, 1994). see also charles e. mclure, jr., substituting consumption-based direct taxation for income taxes as the international norm. 45 nat'l tax j. 145, 148-49 (1992). 27. see s. 2160, supra note 10, §§ 10014(f), 10063. rules of this type provide for establishing vat sales prices for goods and services transferred to employees as compensation or to buyers not dealing at arm's length with the seller. they also deal with conversions of business property to consumption uses and with transfers among commonly owned businesses. technical overview, supra note 26, at 34. 28. see s. 2160, supra note 10, § 10016; oldman & schenk. supra note 3, at 155859. 29. see id. § 10023. 30. see id. § 10041. for fiscal 1992-93, revenue canada collected gross vat revenues of $30.5 billion and refunded $10.7 billion to firms whose vat payments on purchases exceeded vat due on sales. kesselman, supra note 7, at 768. 31. see s. 2160, supra note 10, § 10034; technical overview, supra note 26, at 2129; aba sec. of tax'n, comm. on value added tax, analysis of tax treatment of financial services under a consumption-style vat, 44 tax law. 181 (1990). 32. vat administrative costs, supra note 12, at 61; william j. tumier, accommodating to the small business problem under a vat, 47 tax law 963, 970 (1994). 33. schenk, supra note 24, at 1628-29. 1995] florida tax review aggregation rules to prevent larger businesses from being subdivided into smaller units that fall below the qualification ceiling. 4 i do not contend that the vat is as complex as the income tax. a credit method vat, even if encumbered by the intricacies described above, is a good deal simpler than the federal income tax. nevertheless, when evaluating any vat proposal, the vat's inherent complexities must not be lightly dismissed.35 c. can a vat be made even more complex? in many ways, the political process of developing a vat law can add significantly to the complexity that is inherent in the multistage collection process, exemptions, and multiple rates of a european-style vat. an example is the treatment of plant and equipment costs. under a credit method system, vat paid on the purchase of plant and equipment for use in producing goods and services is immediately credited against vat collected on sales.36 in other words, vat paid on long-lived business assets is not amortized over asset lives; all investments in plant and equipment are treated as current costs. because no distinction is drawn between various classes of business assets employed to produce goods, a credit method vat does not have the effect of steering investments toward particular assets. this is, however, radically at variance with american tax culture. the history of the federal income tax is replete with attempts to manage the flow of investment capital by means of credits and other preferences that are not required to measure economic income but are, instead, designed to direct investment capital into assets that are favored for various policy reasons. 37 34. see, e.g., irc § 447(d)(1). 35. for examples of vat statutes, see s. 2160, supra note 10, §§ 10001-10065 (1994); hussey & lubick, supra note 2, at 101-18. 36. 3 treas. dep't, supra note 1, at 7-9; aba sec. of tax'n, supra note 2, at 422. 37. see generally c. eugene steuerle, the tax decade 27, 45-48, 77-79, 189, 191 (1992); jack teuber, tax expenditure trends: growth is the word, 62 tax notes 943 (feb. 21, 1994). the real aggregate revenue loss from tax expenditures grew between 1974 and 1993 at an average annual rate of approximately 4%, while average annual real growth in gross domestic product over the same period was only about 2.5%. general accounting office, tax expenditures deserve more scrutiny 35 (1994). some recent examples of this pattern are the 1993 increases in expensing for equipment investments in enterprise zones, § 1397a, and accelerated depreciation for investments in indian reservation property. irc § 168j). see h.r. rep. no. 111, 103d cong., 1st sess. 791, 794-99 (1993), reprinted in 1993 u.s.c.c.a.n. 378, 1021, 1024-29. tax expenditures will be further enhanced if congress accedes to the often made argument that the investment tax credit (repealed in 1986) should be restored because equipment investment has a very high net social return. see j. bradford delong & lawrence h. summers, equipment investment and economic growth: how strong is the nexus? 2-1992 [vol. 2:7 scoping out the uncertain simplification effects the congress that included these investment incentives in the income tax will be the architect of any u.s. vat, and the staff, executive branch officers, and lobbyists assisting congress in the development of a vat will be drawn from the same ranks that have counseled in the formulation of income tax preferences. it is not unreasonable to anticipate that the income tax habits of tax law writers will carry over to a vat and that instead of merely allowing the expensing of the costs of all business assets, a u.s. vat will include additional credits with respect to preferred assets. these credits will have to be hedged with complex rules to ensure that they apply only to favored types of property acquired from unrelated persons after the effective date of the vat.38 there may be recapture of the credits when assets are disposed of or diverted to disfavored uses. any investment incentives included in a national vat will add to the vat's inherent complexity. in short, there is a more-than-trivial danger that in a u.s. vat, the inherent complexities of a typical vat, including the multistage collection process, exemptions, and multiple rates, will be augmented by substantial additional complexities deriving from attempts to direct the flow of investment capital toward the achievement of various policy goals. we cannot, however, evaluate the extent of this additional complexity until we see the details of proposed legislation. d. does it matter how the vat revenues are used? a vat's complexity or simplification consequences cannot be determined by examining the vat in isolation. we first have to learn whether this tax will be a revenue-raising addition to the current structure or will be coupled with simplifying changes in that structure. in short, we need to know how the vat yield will be used. 1. a vat replacing the individual and corporate income tares.-a vat functions without capitalization rules, capital cost recovery provisions, entity taxation systems, and many other complexities that bedevil the income brookings papers on economic activity 157, 159, 197. indeed, the 1993 clinton administration proposal for a temporary revival of the investment tax credit was based on a judgment that macroeconomic policy considerations required a strong incentive for increased investment in equipment. see u.s. treas. dep't, summary of the administration's revenue proposals 5-8 (1993). 38. if adopted, these credits might take the form of new or expanded income tax allowances providing the same results for the revenue system as if they were included in the vat. nevertheless, they will have been prompted by the vat and must be considered vatcreated complexity. 19951 florida tax review tax.39 thus, a vat that funds a repeal of the individual and corporate income taxes would substantially simplify our tax system,4" even if it is encumbered with intricate provisions meant to direct investment flows into favored assets and activities." unfortunately, substitution of a vat for the federal income taxes appears to be politically unlikely, principally because the vat is generally considered to be both inherently regressive42 and regressive in comparison with the income tax." the vat has also been criticized as an unfairly large levy on the poorest individuals.44 these consequences (large and disproportionate burdens on low-income persons) would be exacerbated if vat revenues are used to fund repeal of the individual and corporate income taxes. this is because, to raise enough money to replace all income tax revenues, a vat would have to be imposed at a rate that is very high in comparison with the sales taxes familiar to most americans.45 contrast this state of affairs with congress' 1993 decision to increase markedly the progressivity of the income tax rate structure, which, in 1986, had become relatively flat.' the 1986 flirtation with a nonprogressive system might be viewed as a brief episode succeeded by a return to our historic preference for progression. 47 furthermore, the expansion in 1993 of 39. see 3 treas. dep't, supra note 1, at 7-11; bradford, supra note 1, at 60-64. 40. see bradford, supra note 1, at 312-14. 41. see supra text accompanying notes 36-38. 42. see staff of joint comm. on tax'n, supra note 24, at 54-59; 3 treas. dep't, supra note 1, at 19-20, 43, 87; cnossen, supra note 1, at 212; kesselman, supra note 7, at 75860. for tentative contrary views, see massa & raboy, supra note 7, at 486; morris, supra note 18, at 1264. 43. see staff of joint comm. on tax'n, supra note 24, at 58. 44. see 3 treas. dep't, supra note 1, at 43. 45. the treasury's 1984 vat study implied that each percentage point of vat tax rate, applied to two alternative politically feasible tax bases, would raise $24 billion or $17.1 billion for 1988. 3 treasury dep't, supra note 1, at 85-86. since individual and corporate income tax receipts for 1988 were $516.2 billion, steuele, supra note 37, at 212-13, the treasury study suggests that a vat rate of either 21.5% or 30.2% would have been required in 1988 to replace income tax revenue. see also james m. bickley, how much revenue could a u.s. vat yield? 60 tax notes 1273 (aug. 30 1993); joel b. slemrod, the simplification potential of alternatives to the income tax, 66 tax notes 1331, 1335 (feb. 27, 1995). vat rates in this range would be higher than commonly applicable sales tax rates. see perry d. quick & thomas neubig, tax burden comparison: u.s. vs. the rest of the g-7, 65 tax notes 1409, 1417 (dec. 12, 1994). 46. h.r. rep. no. 111, 103d cong., ist sess. 633-36 (1993), reprinted in 1993 u.s.c.c.a.n. 378, 864-67. 47. see marvin a. chirelstein, federal income taxation: a law student's guide to the leading cases and concepts 3-6 (7th ed. 1994). the danforth-boren proposal, discussed below in part ii.e, would preserve the progressive income tax, and the nunn-domenici proposal (part iii.c) includes a progressive consumed income tax. although the legislative [vol 2:7 scoping out tie uncertain simplification effects the earned income tax credit suggests a continuing consensus that the tax system should at least have the appearance of accommodating the lowincome.4 thus, replacement of the individual and corporate income taxes with a vat that imposes relatively large burdens on the poor and is generally viewed as regressive would conflict with major political trends.49 moreover, the preferred technique for dealing with the vat's regressivity and its impact on the poor is to give low-income taxpayers a vat credit against the individual income tax.o without an income tax, the credit remedy is unavailable. the two other major techniques for ameliorating the vat's disproportionate and absolute impacts on the poor-increased transfer payments and zero-rating or exempting food, medical care, and other necessities-are usually considered inadequate because there are no practical tools for keeping high income purchasers from sharing the benefits of this approach." furthermore, increased transfer payments are problematic in the current political and economic climate. 2 thus, it appears inevitable that any proposal to replace the corporate and individual income taxes with a vat will fall to objections based on the vat's regressivity and its large absolute impact on low-income individuals. indeed, there does not appear to be any country that has effected such a proposals contained in the house republicans' "contract with america" have distributional effects that favor upper income groups, they do not alter the rate tables enacted in 1993. see h.r. 1215, 104th cong., 1st sess. (1995). see also milton friedman. why a flat tax is not politically feasible, wall st. j., mar. 30, 1995. at a16. 48. see h.r. rep. no. 111, supra note 46, at 608-10, reprinted in 1993 u.s.c.c.a.n. at 839-41. 49. see staff of joint comm. on tax'n, supra note 24, at 58 (finding that a broad based consumption tax is substantially more regressive than the present income tax). see also general accounting office, supra note 3, at 17-20 (concluding that replacement of the corporate income tax with a consumption tax would likely reduce progressivity). 50. 3 treas. dep't, supra note 1, at 44, 98-100. 51. vat administrative costs, supra note 12, at 75-76; general accounting office, value-added tax issues for u.s. tax policymakers 29-31 (1989); morris, supra note 18, at 1265-66. see also kesselman, supra note 7, at 759-60. indeed, zero rating or exempting consumer purchases of clothing might increase a vat's regressivity. see david f. bradford, what are consumption taxes and who pays them? 39 tax notes 383, 389-90 (apr. 18, 1988). 52. david f. bradford has proposed mitigating the vat's regressivity and impact on the poor by rebating part or all of the federal payroll taxes. bradford, supra note 1. at 32021. however, this approach does not address the problems of low-income taxpayers who are outside the federal payroll tax system and flies in the face of increasing public resistance to more or larger transfer payments. 19951 florida tax review change in its tax structure.53 consequently, i do not consider substitution of the vat for the income taxes to be a realistic possibility.' 2. a vat used to pay for deficit reduction, income tax cuts, or spending programs.-as indicated above, a vat under which all productive assets are uniformly treated is moderately complicated, and a vat that provides disparate treatment for various classes of productive assets could be very complex. thus, a vat grafted onto the existing tax structure to generate funds for deficit reduction, income tax cuts, national health insurance, or other spending programs would be a complicating addition to the federal tax system, under any assumptions, and a substantially complicating addition in a worst-case scenario. 3. a vat financing corporate integration.-if vat revenues are used to make up revenue losses incurred in achieving the long-sought goal of integrating the corporate and individual income taxes, will the result be a simpler system?56 53. lee a. sheppard, will america ever adopt a consumption tax? 61 tax notes 1040, 1041 (nov. 29, 1993). see also slemrod, supra note 45, at 1335. 54. see also id. at 1335-38. however, the simplification/complication consequences of using the vat to pay for reduced income tax rates are discussed below in the text at note 56, the effects of using the vat to pay for larger personal exemptions and standard deductions are covered in the text at notes 69-71, and the consequences of using the vat to pay for repeal of the corporate income tax are examined in the text at notes 56-68, 72-119. 55. morris, supra note 18, at 1262. 56. in 1992, the treasury issued a report advocating two alternative approaches to corporate tax integration-a dividend exclusion and a comprehensive business income tax (cbit) under which both interest payments and dividends are nondeductible by corporate payors but are excluded from the incomes of investor-payees. u.s. treas. dep't, integration of the individual and corporate tax systems: taxing business income once viii (1992) [hereinafter treasury integration study]. the dividend exclusion was estimated to have an annual cost, when fully phased in, of $13.1 billion in lost revenue (at 1991 income levels). id. at 151. by contrast, the cbit, imposed at 31%, was projected to increase annual tax revenues by $3.2 billion if capital gains on sales of business interests were not taxed or $41.5 billion if present treatment of capital gains is preserved. id. at 151. these projections assumed that the cbit would be imposed on the incomes, calculated without an interest deduction, of all sole proprietorships, partnerships, and s corporations with annual gross receipts of $100,000 or more. moreover, the cbit would apply regardless of the identity of the shareholders and debtholders and would therefore effectively reach business income paid out as dividends or interest to foreign investors, charities, and retirement plans. id. at 40-42; samuel c. thompson, jr., reform of the taxation of mergers, acquisitions, and lbos 221-23 (1993). in addition, the $41.5 billion projection assumes that congress retains the capital gains tax for all sales of business interests, even if the gains derive from retained earnings that have already been subjected to the 31% cbit. treasury integration study, supra, at 151. taxation of such gains is inconsistent with integration. id. at 81, 83. because congressional adoption of these crucial [vol. 2:7 scoping out the uncertain simplification effects a useful way to begin searching for an answer is to note that although the taxation of partnership income is integrated with the individual income tax, partnerships are treated as entities that can engage in realization events with other partnerships and with their own partners. for example, if partnership a acquires the assets of partnership b, b generally recognizes the gains and losses inherent in its assets,' but these gains and losses are not recognized if the acquisition consideration consists of equity interests in a."8 also, when a partnership distributes money or other property to its partners, neither the partnership nor the partners recognize gain or loss, as a general rule, but recognition is required in some instances. "9 (few students of partnership taxation would urge it as a model for simplification.) similarly, administratively feasible integration models typically treat corporations as entities distinct from each other and their shareholders,' and employ realization and recognition concepts with respect to transactions between corporations and shareholders and between two or more corporations.6 thus, an integration regime must deal with such issues as when stock dividends should trigger the consequences of a cash distribution and when they should be ignored. statutory provisions distinguishing between taxable and nontaxable stock dividends thus will probably persist in an integrated system.62 an integration model must also specify the circumstances under which the acquisition of a corporation's stock or assets by another corporation will, and will not, produce recognized gain or loss. corporate reorganization provisions thus will probably remain with us.63 an integration scheme must deal with transfers of net operating losses and other corporate tax attributes, demanding that sections 381 and 382 also endure.64 predicates is highly doubtful, a revenue-gaining integration scheme should not be viewed as a realistic possibility. it seems likely that corporate integration will require a funding source to offset lost revenue. 57. irc § 1001. 58. irc § 721. 59. irc §§ 707(a)(2)(b), 731. 751(b). 60. see treasury integration study, supra note 56, at 23, 40-41, 55; alvin c. warren, jr., reporter's study of corporate tax integration 13-20 (1993) [hereinafter ali reporter's study]. 61. see treasury integration study, supra note 56, at 17, 23,40, 55; all reporter's study, supra note 60, at 101, 143-50. 62. see irc §305; treasury integration study, supra note 56, at 17, 21, 40; au reporter's study, supra note 60, at 143; michael l. schler, taxing corporate income once (or hopefully not at all): a practitioner's comparison of the treasury and au integration models, 47 tax l. rev. 509, 538-41 (1992). 63. treasury integration study, supra note 56. at 23, 55; au reporter's study, supra note 60, at 99; thompson, supra note 56, at 233-35. 64. the partnership integration model, which would pass corporate-level losses and other tax attributes through to shareholders, is generally considered not feasible for 1995] florida tax review finally, integration models typically treat ordinary corporate distributions differently from disproportionate stock redemptions.6 5 accordingly, the statutory provisions and case law governing when redemptions qualify as stock sales will persist in an integrated system.66 in addition to these continuing subchapter c complexities, the various integration models have their own peculiar, and dauntingly extensive, intricacies. 67 furthermore, virtually all complexities of the individual income tax persist in an integrated system. s in sum, the combination of a vat, an integration regime, and the individual income tax would likely not be meaningfully simpler than the corporations with large numbers of shareholders. thus, the partnership approach will probably be confined to a universe very much like that of the present s corporation. see treasury integration study, supra note 56, at 27; all reporter's study, supra note 60, at 47-49. feasible integration systems for larger corporations will require keeping track of important tax attributes at the corporate level and also require rules governing the transfer of those attributes. see treasury integration study, supra, at 17, 23-24, 40, 55; all reporter's study, supra, at 99-100. 65. see treasury integration study, supra note 56, at 83-86; all reporter's study, supra note 60, at 143-46; schler, supra note 62, at 541-43. 66. see treasury integration study, supra note 56, at 222 n.23; all reporter's study, supra note 60, at 143-46; george k. yin, corporate tax integration and the search for the pragmatic ideal, 47 tax l. rev. 431, 451-56, 467-68 (1992). this also seems to require preservation of § 304. in addition, if dividend distributions are treated differently from share sales and disproportionate stock redemptions and if § 305 is retained in some form (see supra text accompanying note 62), § 306 will likely have to be kept. see treasury integration study, supra note 56, at 196 n.37. the enduring popularity of § 1014 suggests that in an integrated world, corporate shares will continue to get a stepped-up basis at death. thus, § 303 will probably continue as a device for estates to make tax-free withdrawals from closely-held corporations. 67. the treasury integration study advocates a dividend exclusion model that retains the § 11 tax and the corporate alternative minimum tax, continues corporate earnings and profits accounts, and requires corporations to keep a new "excludable distributions account." treasury integration study, supra note 56, at 17, 19, 24. alternatively, the treasury study advocates a comprehensive business income tax that preserves the § ii tax, but without a deduction for interest payments, id. at 40, and requires corporations to maintain an "excludable distributions account," id., and perhaps an earnings and profits account. id. at 207 n.21. the ali reporter's study (1) continues the § 11 and corporate alternative minimum taxes as parts of an advance withholding system, ali reporter's study, supra note 60, at 9394, (2) creates new dividend and interest withholding taxes, id. at 92-93, 112-13, (3) requires corporations to maintain a "taxes paid account" (but abolishes the earnings and profits account), id. at 93, (4) requires corporations to report to dividend and interest recipients the amounts of associated dividend and interest withholding taxes, id. at 102, 112-13, and (5) imposes new taxes on dividends and interest received from u.s. corporations by tax-exempt and foreign investors and new taxes on the gains of such investors from sales of stock and debt of u.s. corporations. id. at 163-64, 190-91. 68. see treasury integration study, supra note 56, at 17, 39-40; all reporter's study, supra note 60, at 13-20, 143. [vol 2:7 scoping out the uncertain simplification effects current regime. it is probably impossible, however, to get clarity on these points without examining the details of a fully articulated vat-integration proposal. 4. dropping taxpayers out of the system.-would the tax system be simplified by the enactment of a vat to finance expanded personal exemptions or standard deductions that would have the effect of sharply reducing the number of itemizers and of dropping large numbers of taxpayers from the federal income tax system? for example, the treasury's december 1992 comprehensive reform proposal included a single-rate subtraction method vat, called a business transfer tax, which would have, among other things, financed an expanded standard deduction ($33,800 for marrieds filing jointly).69 this change would have reduced itemizers by 94% and removed 52% of individual taxpayers with positive tax liabilities from the federal income tax rolls. vat revenues spent in this way clearly achieve impressive simplification for large numbers of taxpayers. however, if a refundable income tax credit is used to mitigate the vat's regressivity,70 many of those whose positive income tax liabilities are eliminated must still file returns to get the credit refund or must file appropriate forms to get advance refunds through the withholding system.7 , e. the danforth-boren proposal: using a vat to eliminate the corporate income tax and pay for other good stuff vat revenues need not be ear marked for a single purpose. indeed, by mixing the vat revenue uses discussed above and varying the emphasis given to particular items in the mix, one can imagine a wide variety of ways to spend a vat's yield, with an equally wide variety of complexity implications. a proposal by senators john c. danforth and david l. boren, 69. treas. dep't, supra note 6. the proposed business transfer tax would also have financed corporate integration through a dividend exclusion. 70. see supra note 24. 71. general accounting office, supra note 51, at 33; bradford. supra note 1, at 321. data with respect to the earned income tax credit (eitc) suggest that the number of taxpayers required to file income tax returns solely to claim a refundable vat credit would be significant. for example, treasury's december 1992 proposal contemplated a 36% increase in the number of returns filed to obtain eitc refunds. it is estimated that 84% of the eitc claimed on 1994 income tax returns will be received as refunds. house comm. on ways and means, overview of entitlement programs, w.m.c.p. 27. 103d cong., 2d sess. 702 (1994). 19951 florida tax review the comprehensive tax restructuring and simplification act of 1994,72 illustrates the point. it would: 1. impose a subtraction method vat,73 called a business activities tax (bat), at a flat-rate of 14.5% on all businesses, both corporate and noncorporate.74 2. repeal the corporate income tax, including the corporate alternative minimum tax, the section 531 tax on accumulated earnings, and the section 541 personal holding company tax,75 making the bat the only entity-level tax on c corporation business income. (the individual income tax would be preserved, and would apply to the incomes of pass-through entities unless they elect c corporation treatment.) 3. permit s corporations and unincorporated businesses to elect c corporation treatment so that the bat would usually be the only business-level tax applicable to their incomes.76 4. defer income taxation of the incomes of c corporations and c-electing unincorporated businesses and s corporations until earnings are distributed to individuals.77 72. s. 2160, supra note 10. see massa, supra note 26, at 1219; oldman & schenk, supra note 3. for the economic and distributional effects of a bill similar to the danforthboren proposal, see general accounting office, supra note 3, at 3-4. for preliminary analysis of the danforth-boren proposal's economic consequences, see john copeland, thumbs down on the bat, letter to the editor, 65 tax notes 249 (oct. 10, 1994); alan d. viard, who would really get bitten by the bat? letter to the editor, 65 tax notes 784 (nov. 7, 1994); john copeland, further analysis of the bat, letter to the editor, 66 tax notes 617 (jan. 23, 1995). 73. see massa, supra note 26, at 1220, 1224; oldman & schenk, supra note 3, at 1548, 1552, 1565; viard, supra note 72. under a subtraction method vat, a business subtracts business purchases, including capital costs, from its sales receipts and pays tax on the difference. a flat-rate, subtraction method vat produces the same revenue as a flat-rate, credit method vat at the same rate. see 3 treas. dep't, supra note 1, at 7-11. see also general accounting office, supra note 3, at 2-3. 74. s. 2160, supra note 10, §§ 10001, 10051(7). 75. id. § 1400(a); technical overview, supra note 26, at i n. 1., and simplification act of 1994, at i n.1. however, the § 881 withholding tax and the § 884 branch profits tax would be preserved. s. 2160, supra note 10, § 1400(c). 76. s. 2160, supra note 10, § 1402(a)(1). 77. id. §§ 1401(a), 1402(a)(2), (c)(2). for purposes of subjecting earnings distributions to the individual income tax, each equity owner of a partnership or sole proprietorship would be treated as a shareholder in proportion to his or her equity interest. id. § 1402(a)(2). interest from both incorporated and unincorporated businesses would be taxed to the creditors as income under existing rules. this means that interest from c corporations, electing s corporations, and electing unincorporated businesses would generally be taxed on an accrual basis, whereas distributions to equity holders would presumably be taxed when distributed. id. [vol. 2:7 scoping out the uncertain simplification effects 5. impose a new tax on c corporation passive income,7' which would also apply to s corporations, partnerships, and sole proprietorships that elect c corporation treatment. 9 6. reduce the old age, survivors, and disability insurance (oasdi) portion of the federal payroll taxes by half for both employers and employees.'a 7. substantially increase the standard deduction for lowand middle-income taxpayers.8 ' 8. mitigate the bat's regressivity by a refundable income tax credit, receivable in advance, for part of the bat borne by lowand middle-income taxpayers.' the danforth-boren proposal would have two important simplification consequences. first, it would eliminate capitalization and capital cost recovery provisions from business taxation because the bat, like other vats, permits business assets to be expensed. 3 second, the enlargement of the standard §§ 1401(a), 1402(a)(1). interest expense would generally be nondeductible under the bat. id. § 10015(a)(2)(a); technical overview, supra, at 13, 24-27. thus, corporate receipts paid out as interest and earnings distributions would be net of the bat. see technical overview, supra, at first unnumbered page; massa, supra note 26, at 1225. 78. s. 2160, supra note 10, §§ 1400(b), 1402(a)(1); technical overview, supra note 26, at 2, 5-6. receipts of dividends and interest would not typically be subject to the bat. s. 2160, supra, §§ 10012, 10014; technical overview, supra note 75, at 11-13, 19, 25. the tax on c corporation passive income, which applies unless the income is distributed, is designed to interdict taxpayers who would otherwise accumulate business earnings in passive investments instead of distributing the earnings, thus deferring the individual income tax. the tax would apparently not reach passive investments that produce only unrealized appreciation. see s. 2160, supra, §§ 1400(b)(1)(a), (3)(b). dividends and interest received by businesses in providing financial intermediation services would be subject to the bat but not to the passive investment tax. technical overview, supra, at 3 n.6. the proposal intentionally does not resolve the issue of how to apply these rules to businesses that are primarily engaged in selling goods but also receive substantial amounts of interest on deferred payment sales. id. at 19-20. 79. s. 2160, supra note 10, § 1402(a)(1). 80. technical overview, supra note 26, at 9. 81. for married persons filing 1994 joint returns, the standard deduction would increase from $6,350 to $15,000. id. 82. id. at 9-10. this approach avoids the complexities that arise when exemptions or multiple rates are adopted to ameliorate regressivity. see supra text accompanying notes 2224. however, the credit mechanism creates its own complexities. see infra text accompanying notes 85, 102-03. 83. technical overview, supra note 26, at 7 n.12, 13-14, 18. capitalization and capital cost recovery rules would continue to apply to s corporations and unincorporated businesses not electing c corporation treatment. see technical overview, supra note 26, at 8. 19951 florida tax review deduction would reduce the number of itemizers and drop many lowand middle-income taxpayers out of the income tax system,84 except for those required to file returns or advance refund eligibility certificates in order to get a bat credit refund through the income tax system.85 1. complexities preserved and expanded by danforth-boren.-the danforth-boren proposal preserves and expands some important complexities. although it reduces the oasdi taxes, it otherwise leaves that taxing regime intact. the proposal also continues the individual income tax. for purposes of determining whether distributions of business earnings are subject to the individual income tax, the proposal would continue the rules on stock dividends and extend them to distributions by electing unincorporated businesses.8 6 to determine the individual income tax consequences of corporate distributions, the proposal would preserve the corporate tax rules on (1) distributions in excess of earnings and profits,87 (2) distributions in full or partial liquidation of a corporation,88 and (3) distributions in complete redemption of a shareholder's stock. 9 the proposal would also make these rules applicable to distributions by electing s corporations and electing unincorporated businesses. 9 in addition, the proposal would apparently preserve the anti-general utilities rules of sections 311(b), 336, and 337 for purposes of measuring the gross receipts of corporate and electing noncorporate businesses under the bat,9' and the rules on corpo84. see supra text accompanying notes 69-71. 85. see technical overview, supra note 26, at 9-10 and supra note 71. 86. irc § 305; s. 2160, supra note 10, §§ 1402(a), (c)(2); technical overview, supra note 26. at 8. this may require preservation of § 306. 87. irc § 301(c)(2), (3); technical overview, supra note 26, at 6-8. these rules would apply only if the corporation maintains adequate records of earnings and profits. 88. irc § 331-346; technical overview, supra note 26, at 6-8. 89. irc § 302(b)(3); technical overview, supra note 26, at 6-8. the retention of § 302(b)(3) would seem to require preservation of §§ 302(c)(2), 318, and 304. section 303 would also probably persist in a danforth-boren world. see supra note 66. 90. s. 2160, supra note 10, §§ 1402(a), (c)(2); technical overview, supra note 26, at i. the proposed statute provides that "all distributions made by a corporation to a shareholder with respect to its stock shall be treated as ordinary income," except distributions in excess of earnings and profits, in full or partial liquidation, and in complete redemption of a shareholder's stock. s. 2160, supra, § 1401. however, the technical overview states that "the bill is not intended to change present law as to whether or when distributions are taxable. thus, for example, proportionate stock distributions would continue to be excluded from gross income .... technical overview, supra note 75, at 8. this suggests that §§ 354, 355, and 356 would be preserved under the proposal. if this supposition is correct, §§ 354, 355, and 356 would also be extended to electing unincorporated businesses. s. 2160, supra, § 1402(a)(2). 91. see s. 2160, supra note 10, § 1402(a)(1), (c)(2); technical overview, supra note 26, at 8, 11-13. [vol 2:7 scoping out the uncertain simplification effects rate formations and reorganizations would apply to identify transactions of corporate and electing noncorporate businesses to be ignored for bat purposes.92 in addition to the continuation and expansion of these complex corporate tax rules, the bat portion of the proposal would utilize much of the income tax law regarding accounting periods and methods, as well as a rule requiring the "clear reflection" of gross sales and business purchases. 93 the bat would also require imputed interest rules.' 2. new complexities created by danforth-boren.-regrettably, the danforth-boren proposal also imposes new complexity. for example, if a sole proprietorship, partnership, or s corporation does not elect c corporation treatment, its income is currently taxable to the owners of the business, whether distributed or not, even though the business is subject to the bat." if the election is made, the bat would continue to apply, but the individual income tax would only attach to funds distributed from the business to individual owners.96 presumably, the election would usually be made, but it would give small business owners one more item of red tape to worry about.97 the proposal would also impose a complicated new penalty tax on undistributed passive income of c corporations and electing s corporations and noncorporate businesses.98 although this tax would fill the role of the present taxes on inappropriate corporate accumulations, it would use a new computational approach based on irs determinations of reasonable accumula92. s. 2160, supra note 10, §§ 1402(a)(1), (c)(2). 10016(b); technical overview. supra note 26, at 13. 93. technical overview, supra note 26, at 18-19, 33. 94. id. at 19-20. also, under a bat, employees must be distinguished from independent contractors because payments to the former are not deductible under the bat while payments to the latter are. see massa, supra note 26, at 1225. 95. technical overview, supra note 26, at 1. 96. under the proposal, no income tax would be imposed on c corporation earnings until the earnings are distributed to shareholders. thus, c corporations would become a device for deferring income tax, and this would make them preferable to pass-through business entities (s corporations, partnerships, and sole proprietorships) because the owners of passthrough entities are subjected to income taxation of business earnings on a current, nondeferred basis. the election for s corporations and unincorporated businesses to be treated as c corporations is provided to remove what would otherwise be a systemic bias in favor of doing business through c corporations. 97. since the election would usually be advantageous, complexity could be reduced by applying the c corporation regime to any s corporation, sole proprietorship, or partnership that does not elect otherwise, thus ensuring that the commonly preferred outcome is also the default outcome. 98. technical overview, supra note 26, at 5-6. 19951 florida tax review tions of working capital for various industries, and it would apply to organizations that elect c corporation treatment." the proposal's substantial increase in the standard deduction would be accomplished by an additional standard deduction that would be phased out starting at $45,000 of adjusted gross income for joint returns and lesser amounts for other filing categories.'00 since this phaseout calculation would apply at income levels far below the levels at which the present phaseout of the personal exemption begins, it would introduce millions of additional taxpayers to the complexities of phaseout rules.'' the bat credit that would be added to the individual income tax would be phased out based on a new concept called modified adjusted gross income. 2 the phaseout would begin at $15,000 of modified adjusted gross income for 1994 joint returns and lesser amounts for other filing categories. this additional phaseout computation would burden millions more taxpayers. 1 03 the new bat would have most of the complexities described above that are inherent in vats." furthermore, since the bat would be the only entity-level tax for corporations and unincorporated businesses, it would usually be the only available device for affecting business behavior through the tax system. this would virtually ensure that the bat would be adorned with most, or all, of the following complex tax incentive provisions presently found in the income tax: 05 a. qualified electric vehicle credit. 10 6 b. alcohol fuels credit. 07 c. research credit.'08 99. id. at 3. 100. id. at 9. 101. for 1994 joint returns, the personal exemption phaseout begins at $167,700. rev. proc. 93-49, 1993-2 c.b. 581, § 3.07. 102. technical overview, supra note 26, at 10. 103. see supra note 101 and accompanying text. 104. the bat, which would be a flat-rate tax, would avoid the complexities of a multiple-rate vat. however, the complexities of the multistage collection process would be present, as would most of the complexities referred to in the text at notes 26-34. 105. see supra text accompanying notes 37-38. although the bat is viewed as borne by consumers, the tax incentives described below would, to the extent they effectively reduce the bat rate, allow some goods and services to be sold at lower prices and thus induce producers of goods and providers of services to pursue these tax incentives. see, e.g., 3 treas. dep't, supra note 1, at 10. 106. irc § 30. 107. irc § 40. 108. irc § 41. [vol 2:7 scoping out the uncertain simplification etfcts d. low-income housing credit." e. enhanced oil recovery credit."' f. disabled access credit."' g. renewable electricity production credit." 2 h. empowerment zone employment credit."' i. indian employment credit." 4 j. targeted jobs credit."t5 similarly, we should not be surprised if the bat were to include credits accomplishing results analogous to the present provisions allowing limited expensing of business equipment," 6 increased expensing for enterprise zone investments," 7 and accelerated depreciation for investments in indian reservation property."' finally, if investment tax credit proponents are ultimately successful in their persistent advocacy," ' we might find an investment tax credit added to the bat. 3. transition from the corporate income tax to the bat.-if the bat replaces the corporate income tax as the taxing regime for businesses conducted in corporate form, corporations will, when the substitution is made, have billions of dollars of undepreciated asset costs and undeducted inventory costs. these costs would be unusable in a danforth-boren world because the bat requires such outlays to be expensed when they are incurred, which for these costs was before the bat's effective date. corporations can be expected to object strenuously. (unincorporated businesses may also object but because they have the option, unattractive to be sure, to remain under the income tax, their objection may carry less force.) a simple response is to allow corporations no deduction or credit under the bat for unrecovered pre-bat costs. after all, the deduction allowed under the bat for plant, equipment, and inventory costs is a means of recovering the bat included in the prices paid for these items. the prices of items purchased before the bat's enactment do not include bat, and 109. irc § 42. 110. irc § 43. see also frank m. burke. jr., recent study recommends incentives for marginal oil and gas properties, 64 tax notes 947 (aug. 15. 1994). 111. irc § 44. 112. irc § 45. 113. irc § 1396. 114. irc § 45a. 115. irc § 51. 116. irc § 179. 117. irc § 1397a. 118. irc § 1680). 119. see supra note 37. 19951 florida tax review arguably, no deduction for their cost is appropriate under the bat, even if the items are used or sold after the bat takes effect. for example, if widgets cost $100 each before the bat is enacted, their price can be expected to rise to $117 after the enactment of a bat at 14.5% ($117, less 14.5% thereof, is $100). assume business a buys widgets for $100 each before the bat comes into effect and sells them to customers after enactment, and business b buys widgets after enactment for $117 and also sells them to customers after enactment. if b is allowed a bat deduction for its inventory costs, but a is not, the after-bat cost of each widget to both businesses is $100. nevertheless, businesses can be expected to insist on obtaining at least some tax benefit for their unrecovered pre-bat costs. 2 ' a second simple approach is to give corporations an immediate bat deduction for all unrecovered plant, equipment, and inventory costs. this approach might be justified by a judgment that the effect on prices of the repealed corporate income tax is not materially different from that of the new bat. it would, however, entail a large revenue loss for the initial bat period. consequently, this solution seems unlikely to be adopted. the remaining approach is to permit unrecovered pre-bat costs to be deducted over a post-bat transition period. this could be accomplished by requiring corporations to follow the present income tax rules under the bat with respect to unrecovered pre-bat costs of plant, equipment, and inventory. alternatively, an arbitrary period could be selected over which the pre-bat basis and inventory costs would be spread and claimed as bat deductions. either solution would be a complicating element because it would require pre-bat assets to be accounted for separately. the danforth-boren proposal seems to adopt the simple approach of allowing no recovery for unrecovered pre-bat costs. taxpayer objections, however, will surely be raised in congress, and if the proposal is enacted, the preceding analysis indicates that it will likely contain a recovery provision that will erode simplicity gains. 4. does danforth-boren simplify the tax system?-the proposal contains several simplifying features-elimination of capitalization and capital cost recovery rules for corporations, repeal of corporate-level income taxes, and decreases in the numbers of both itemizers and taxpayers by virtue of the enlarged standard deduction. however, other features increase complexitythe assured and probable bat intricacies, the phaseouts of the standard deduction enlargement and the bat credit under the income tax, the election for s corporations and unincorporated businesses to be treated as c corpora120. see ernest s. christian & george j. schutzer, unlimited savings allowance (usa) tax system, 66 tax notes 1485, 1534 (mar. 10, 1995). [vol 2:7 scoping out the uncertain simplification effects tions, the preservation of various corporate tax rules and their extension to electing unincorporated businesses, and the complex new tax on excess passive income. it is difficult to say whether the simplifications or the complexities predominate. however, if the proposal yields net simplification, it is likely not of the magnitude that taxpayers seem to hope for or that is typically implied in the political rhetoric that accompanies simplification proposals. more importantly, this review of the danforth-boren proposal reaffirms that responsible assertions about whether and to what extent a vat should be adopted as a simplification measure cannot be made until the provisions of the vat and uses of vat revenues are both known and analyzed in detail. 1m. what if congress enacts a consumed income tax? another consumption tax regime that has recently attracted attention is an annual tax on consumed income, also known as a cash flow tax or consumption-based income tax. would the adoption of such a tax be a simplifying measure? a. addition to or replacenent for the accretion income tar? professor william d. andrews has cogently argued that a consumed income tax and an accretion tax should be utilized concurrently,' with only high-income taxpayers being burdened by both levies and lowand middle-income taxpayers being subjected to only the accretion tax.1 -2 121. our income tax might more accurately be called a hybrid accretionconsumption tax because of its many consumption tax features. see, e.g., edward j. mccaffery, tax policy under a hybrid income-consumption tax. 70 tex. l rev. 1145, 1149-1155 (1992). however, for simplicity reasons, this article refers to the current tax as an accretion income tax. 122. william d. andrews, a supplemental personal expenditure tax, in what should be taxed: income or expenditure? 127, 133-34 (joseph a. pechman ed., 1980). according to professor andrews, a consumed income tax that applied concurrently with the income tax, but covered only high-income individuals (who would also remain subject to the accretion income tax), could accomplish the following useful things: 1. pay for a reduction in the top accretion income tax rates, thus easing the distortions occasioned by those rates but without causing a major loss of progressivity. id. at 136-37. 2. serve as a better minimum tax. id. at 13941. 3. provide tax relief for savers. id. at 141. 4. allow a trial run of a consumed income tax and ease the transition to full substitution of such a tax for the accretion income tax. id. at 14142. 19951 florida tax review however, the andrews proposal seems politically unfeasible. a vat might conceivably be adopted in addition to the individual income tax because a vat is collected from consumers on daily transactions, independently of the payment of income taxes and the filing of annual income tax returns. individuals never file vat returns unless they operate businesses. by contrast, a consumed income tax would involve annual filings by consumers, presumably at the same time as the accretion income tax returns. the concurrent application of the two taxes would be much more visible and attention-grabbing than the concurrent application of a vat and an income tax. it seems unlikely that voters and members of congress could be persuaded to require a significant number of individuals to annually compute liabilities under both an accretion income tax and a separate, highly visible consumed income tax. also, most of the support for a consumed income tax rests on a belief that it is inherently superior to an accretion income tax and should therefore replace the present income tax.' 23 thus, enactment of a consumed income tax would most likely be coupled with repeal of the accretion tax.'24 for these reasons, the consumed income tax probably does not present the unresolved issue of how will the revenue be used, which is critical to the complexity implications of a vat. 125 rather, it appears likely that revenues generated by a consumed income tax would substitute for the yield of the accretion income tax and that to determine whether a consumed income tax would simplify the federal revenue raising system, the tax should be evaluated as a replacement for the present individual and corporate income taxes. b. simplifications resulting from substituting a consumed income tax for all accretion taxes a consumed income tax can be conveniently thought of as a levy on individuals assessed annually on the following base: (1) the sum of all receipts, including borrowings, withdrawals from savings, and in-kind receipts, (2) reduced by income-earning outlays, amounts added to savings, the impact of the andrews proposal on systemic complexity is clear; its adoption would significantly increase the intricacy of the federal revenue system. 123. see, e.g., center for strategic and int'l studies, the strengthening of america commission first report 82-86, 96-100 (1992) [hereinafter nunn-domenici report); david f. bradford, the case for a personal consumption tax, in what should be taxed: income or expenditure? 75 (joseph a. pechman ed., 1980). 124. this is the approach proposed by both treasury, blueprints, supra note 4 at 113, and by the nunn-domenici plan. nunn-domenici report, supra note 123, at 96. 125. see supra part ii.d. 414 [vol 2:7 scoping out the uncertain simnplification effects and payments of principal and interest on debt. 26 this base is designed to ensure that the tax reaches only amounts spent on consumption (whether borrowed or drawn from current earnings or savings) and not to amounts added to savings or spent to produce income. 27 thus, a consumed income tax effectively allows a taxpayer to remove any cash receipt, including borrowed funds, from the tax base simply by purchasing or adding to an investment, thereby obtaining a savings deduction that offsets the cash receipt. the conventional wisdom is that replacement of the accretion income tax with a tax on consumed income would be a simplifying move' 28 because: 1. capital cost recovery provisions would no longer be needed since all investments are expensed under a consumed income tax. 129 2. because all investments are expensed, the distinction between current expenses and capital expenditures would be irrelevant, 30 and section 263a and indopco 3' issues would disappear. 3. basis (and the indexing thereof) would be irrelevant because the expensing of investments dispenses with depreciation and the computation of gain and loss on asset dispositions and, with these features eliminated, the basis rules have no role. 132 4. there would be no need for entity-level taxes because an entity's retention of earnings adds to the investment of its 126. see i treas. dep't, supra note 4, at 191-93; bradford, supra note 1. at 84-85. 93-97; aba sec. of tax'n, committee on simplification, complexity and the personal consumption tax, 35 tax law. 415, 417 (1982) [hereinafter simplification committee report]. 127. bradford, supra note 1, at 82, 87-89. 128. see, e.g., nunn-domenici report, supra note 123, at 85-86, 97-100. 129. blueprints, supra note 4, at 119. 130. simplification committee report, supra note 126, at 419. 131. indopco, inc. v. commissioner, 503 u.s. 79 (1992) (addressing issue of whether expenditure may be deducted or must be capitalized). 132. blueprints, supra note 4, at 134; simplification committee report, supra note 126, at 419. for example, if a sells blackacre for s100 but reinvests the sales proceeds in corporate stock, no tax would be paid on the sales proceeds. conversely, if a spends the sales proceeds on consumption, the entire $100 would be taxed. the amount a paid for blackacre would not, in either case, affect the tax result. although disappearance of the basis concept would eliminate any need to index basis, progressive rate brackets would have to be indexed under a consumed income tax in order to avoid "bracket creep." simplification committee report. supra. at 419 n. 12. 19951 florida tax review owners and this addition, like the original investment, should not be taxed until withdrawn and consumed. 33 5. the realization doctrine would disappear because the taxing event under a consumed income tax is consumption, not realization."3 with the disappearance of realization, the nonrecognition rules, which modify that concept, can go as well. moreover, there would no longer be any need to distinguish between capital gains and ordinary income. these simplifying aspects of a consumed income tax are impressive by any standard. does such a tax, however, entail sufficient new complexity, or preserve so much old complexity, that the simplifications are substantially neutralized, or even outweighed, by the complexity? this question was extensively addressed in a 1982 report by the committee on simplification of the aba section of taxation 135 and a 1979 article by professor michael j. graetz. 36 in general, they concluded that a tax adhering strictly to the principles of a consumed income levy would probably be significantly simpler than the accretion income tax. however, they warned that a consumed income tax was vulnerable both to errors in selecting design options and to intricate deviations from principle that would substantially erode the simplification advantages and, in a worst case scenario, could make it even more complex than the present income tax. in other words, these studies adopted the view taken in this article regarding the vat: the impact of a consumed income tax on systemic complexity cannot be judged until the details are known. this article does not comprehensively restate the analysis of the graetz piece and the simplification committee report, and the reader is referred to the full versions of those items. instead, this article examines the recent consumed income tax proposal of senators sam nunn and pete domenici as a case study of the simplification effects of a consumed income tax. c. nunn-domenici proposal: carrying danforth-boren the rest of the way unlike the danforth-boren plan, the nunn-domenici proposal does not (as this article is being written) exist in statutory language with a detailed technical explanation. the published specifics of the nunn-domenici plan are 133. simplification committee report, supra note 126, at 419-20; blueprints, supra note 4, at 133-34. 134. see simplification committee report, supra note 126, at 419. 135. id. 136. michael j. graetz, implementing a progressive consumption tax, 92 harv. l. rev. 1575, (1979). [vol 2:7 scoping out the uncertain sinplification effects principally contained in two documents-a 1992 report by the center for strategic and international studies,' 37 which gives only a brief description, and a recent law review article by senator domenici, s which provides considerably more information but also leaves many details unspecified. thus the following analysis of the nunn-domenici proposal is necessarily tentative and qualified. the proposal would: 1. replace the accretion income tax, including the corporate income tax, with an annually-assessed consumed income levy at progressive rates that would reach only consumption expenditures by individuals.'39 2. impose a flat-rate (approximately 10%), subtraction method value added tax,"4 called a cash-flow tax, on all businesses engaged in selling goods or services.'' this tax (the nunndomenici vat) would be the only levy on business activity. 3. allow employers a credit against the nunn-domenici vat for the employer portions of the oasdi and hospital insurance payroll taxes, 4"2 and allow employees two credits against the consumed income tax-an earned income tax credit and a phased-out, refundable credit for part of the employee portions of the federal payroll taxes.'4 3 137. nunn-domenici report, supra note 123. 138. pete v. domenici, the unamerican spirit of the federal income tax. 31 harv. j. on legis. 273 (1994) [hereinafter unamerican spirit]. for a more fully articulated consumed income tax proposal, see christian & schutzer, supra note 120. 139. id. at 288, 304-05; nunn-domenici report, supra note 123, at 98-99. repeal of the accretion income tax would eliminate all of its complex international elements. unamerican spirit, supra note 138, at 288, 316 n.127. 140. senators nunn and domenici disclaim any intention to include a vat in their proposal. unamerican spirit, supra note 138, at 313. see also nunn-domenici report. supra note 123, at 96-97. however, their disclaimer should be understood as rejecting only a european-style credit method vat. see supra text accompanying note 2. their cash-flow tax would be a flat-rate levy on the domestic sales minus the business outlays, including capital expenditures, of every business. unamerican spirit, supra, at 307-09, 317-18. this is a classic description of a subtraction method vat. general accounting office, supra note 51. at 11; 3 treas. dep't, supra note 1, at 7-11; oldman & schenk, supra note 3, at 1547. see also general accounting office, supra note 3, at 2-3. consequently, this article refers to the cashflow tax as the nunn-domenici vat. 141. unamerican spirit, supra note 138, at 307-08. dividends and interest received by a business would not generally be included in its sales receipts. id. at 310-11. 142. id. at 313. it is not clear whether this credit would be refundable. 143. id. at 296. 199.51 florida tax review 4. replace the present standard deduction and personal and dependent exemptions with a family living allowance deduction under the consumed income tax.'44 a quick comparison of the nunn-domenici proposals major features with those of the danforth-boren plan shows that the two schemes are structurally alike in that would both repeal the corporate income tax and impose a subtraction method vat on all sales of goods and services by both incorporated and unincorporated businesses. 14' their principal point of difference is that danforth and boren would retain the individual accretion income tax, 146 but nunn and domenici would wholly replace it with a consumed income tax. thus, while the danforth-boren plan represents a major shift toward consumption taxation, nunn-domenici is a proposal for complete replacement of accretion income taxation with consumption taxation. 1. simplifying features of nunn-domenici.-the nunn-domenici proposal would fully capture the impressive simplification gains, described above, that flow from replacing an accretion income tax with a consumed income levy. it is also anticipated that the proposal would enlarge the number of lowand middle-income taxpayers who are relieved of having to file tax returns because the proposal's family allowance would be much more generous for these taxpayers than the sum of the standard deduction and the personal and dependent exemptions under present law.'47 unfortunately, this number would not be as large as might first appear because many people with no consumed income tax liability would, nevertheless, have to file returns to get the refundable payroll tax and earned income tax credits. 48 there is an important point on which nunn-domenici is simpler than both current law and danforth-boren. the danforth-boren proposal generally eliminates the accretion income tax for businesses but retains it for individuals; business income is subjected to accretion taxation when it is distributed to individuals. 49 consequently, danforth-boren preserves, and extends to electing unincorporated businesses, some of the most complex of the corporate tax rules for characterizing and taxing distributions to business 144. id. at 295. 145. see supra text accompanying notes 73-74, 139-41. 146. see supra text accompanying notes 75-77. 147. for 1994, a family ofjoint-filing parents and two dependent children is entitled to a $6,350 standard deduction and four exemptions of $2,450 each. rev. proc. 93-49, 1993-2 c.b. 581, §§ 3.03, 3.07. the total of these items is $16,150. the nunn-domenici consumed income tax would provide this family with a family living allowance of $25,160. unamerican spirit, supra note 138, at 295. 148. unamerican spirit, supra note 138, at 296. 149. see supra text accompanying notes 75-77. [vol 2:7 scoping out the uncertain simplification effects owners. 50 furthermore, to discourage deferral of the individual accretion tax through excessive accumulation of income within businesses, danforthboren imposes a complex penalty tax on undistributed passive income of businesses. 151 because nunn-domenici completely eliminates accretion taxation, it avoids the necessity for these complicating features. an additional simplifying aspect of nunn-domenici is that its basic elements are mandatory. this avoids the complications arising from the danforth-boren rule allowing pass-through entities to elect out of the accretion income tax.' 52 the payroll tax system would remain intact under the nunn-domenici proposal, although employers would be allowed a credit against the vat for their portions of the oasdi and hospital insurance payroll taxes' and employees would be allowed a credit against the consumed income tax for part of the employee portions of the federal payroll taxes." thus, the taxpayer compliance and irs enforcement burdens of the payroll taxes would not be reduced. the danforth-boren proposal, however, also continues these taxes. 1 55 2. why two consumption taxes?-nunn-domenici employs two broad-based consumption taxes-the nunn-domenici vat56 and the progressive consumed income tax. the bases of these two levies are probably quite similar, 58 raising the question of why nunn and domenici did not make the plan even simpler by using only one consumption tax. there are, however, reasonable grounds for employing both a consumed income tax and a vat. first, the decision to convert the federal revenue system to a consumption tax regime means that all savings, including retained corporate earnings and distributed corporate earnings that are saved by the distributees, are removed from the tax collector's reach. 59 thus, if nunn and domenici employed only a consumed income tax, the rates would probably have to be 150. see supra text accompanying notes 86-92. 151. see supra text accompanying notes 98-99. 152. see supra text accompanying notes 95-97. 153. unamerican spirit, supra note 138, at 313. 154. id. at 296. 155. see supra text accompanying notes 85-86. 156. see supra text accompanying notes 140-41. 157. see supra text accompanying note 139. 158. see bradford, supra note 1, at 87-89; kesselman, supra note 7, at 730-31. see also congressional budget office, revising the individual income tax 114 (1983); simplification committee report, supra note 126, at 416-17; unamerican spirit. supra note 138, at 289, 307-08. 159. unamerican spirit, supra note 138, at 289-90. 307-08. 19951 florida tax review higher than current accretion income tax rates in order to avoid revenue losses. 6 also, withholding and estimated tax systems are difficult to fashion under a consumed income tax because individuals pay tax only on what they consume and many would find it difficult to estimate their taxable consumption and nontaxable savings closely enough to avoid underwithholding and insufficient estimated tax payments.' 61 the combined problem of higher rates, underwithholding, and underpayment of estimated tax is considerably mitigated if a broad-based vat is used in tandem with a broadbased consumed income tax. the vat effectively functions as a surrogate withholding system by collecting tax from consumers throughout the year, 162 and the vat revenues permit the consumed income tax rates to be lower than would otherwise be possible. second, if nunn and domenici relied solely on a vat, the tax rate would substantially exceed the sales tax rates familiar to most americans. 63 furthermore, since a vat, standing alone, seems to be inherently and irreparably regressive," sole reliance on a vat would probably result in the federal revenue system being perceived as both burdensome and regressive. by employing an annually-assessed, progressive, consumed income tax in addition to a vat, nunn and domenici can have both a lower vat rate and progressivity through the consumed income tax. 65 a workable progressive rate structure is impossible in a vat because the vat is applied to separate purchases and not to a taxpayer's total consumption. 66 these reasons provide a practical basis for the decision of nunn and domenici to employ two consumption taxes instead of one, even though a single-tax regime would be simpler. moreover, the lower rates facilitated by the two-tax approach may reduce the incentive to engage in tax planning and tax evasion and may thus reduce compliance and enforcement burdens for taxpayers and the irs.'67 factoring in this point may narrow the complexity 160. 1 treas. dep't, supra note 4, at 194; congressional budget office, supra note 158, at 117; simplification committee report, supra note 126, at 420. see also graetz, supra note 136, at 1580-81. nunn-domenici is intended to be revenue neutral. unamerican spirit, supra note 138, at 288. 161. see 1 treas. dep't, supra note 4, at 202-03; graetz, supra note 136, at 159596. 162. see unamerican spirit, supra note 138, at 288. 163. see supra note 45. see also unamerican spirit, supra note 138, at 287-88. 164. see supra text accompanying notes 42-52. 165. with respect to progressive rates under the nunn-domenici consumed income tax, see unamerican spirit, supra note 138, at 304-05. the nunn-domenici plan is said to be no less progressive than the current income tax. id. at 288. 166. see i treas. dep't, supra note 4, at 191; graetz, supra note 136, at 1578-79. 167. see generally 3 treas. dep't, supra note 1, at 26; simplification committee report, supra note 126, at 420; graetz, supra note 136, at 1584-85. [vol 2:7 scoping out the uncertain simplification effects difference between the two-tax approach and a system that relies exclusively on either a vat or a consumed income tax. 3. complexities in calculating gross receipts.-although the nunndomenici consumption taxes are markedly simpler than the accretion income tax, their system is significantly complex and has the potential for becoming even more intricate as it passes through the political process. for example, calculation of the consumed income tax begins by summing up gross income in much the same way that it is computed under the accretion income tax. 68 the record keeping, reporting, and enforcement burdens required by this approach seem to be approximately the same as under the current tax regime. 4. fringe benefits.-although the nunn-domenici consumed income tax is described by its authors as a levy that "would rely on cash receipts and outlays"'169 and is "based on cash-flow principles,"'70 its authors surely do not intend to excuse taxpayers from reporting compensation received in the form of consumer goods and services. thus, fringe benefit and related valuation issues raised by noncash compensation under the accretion income tax are likely to be substantially replicated in the nunn-domenici regime.172 likewise, that system might require an analog to section 7872 in order to deal with interest-free loans made by employers to employees." 168. unamerican spirit, supra note 138, at 289. business income is not included in the consumed income tax base until it is received by individuals as interest, earnings distributions, compensation for services, or loans. see id. at 289-90. 294. 310-12. 169. nunn-domenici report, supra note 123. at 99. 170. unamerican spirit, supra note 138, at 289. see also nunn-domenici report, supra note 123, at 99. 171. see irc §132; regs. §1.61-21. 172. see 1 treas. dep't, supra note 4, at 191, 193; bradford, supra note 1. at 84; christian & schutzer, supra note 120, at 1509-10; graetz, supra note 136, at 1586-88. 173. the premise underlying § 7872 is that an interest-free loan from employer to employee is properly characterized as an interest-bearing loan coupled with an interest payment from employee to employer and an equal compensation payment from employer to employee. see staff of joint comm. on tax'n, 98th cong., 2d sess., general explanation of the revenue provisions of the deficit reduction act of 1984, 528-29 (comm. print 1984). if this characterization applies under the nunn-domenici system, the imputed compensation payment would presumably be included in the employee's gross receipts under the consumed income tax, see unamerican spirit, supra note 138, at 289, but the employee would apparently not be allowed an offsetting interest deduction if the loan were a home equity loan. see id. at 293-94. there might also be no offsetting interest deduction if the borrowed funds were used to purchase a long-lived consumer asset other than a principal residence. see infra text accompanying notes 189-94. 19951 florida tax review 5. savings and dissavings.-two distinctive features of a consumed income levy are that no tax is imposed on receipts that are saved but dissavings are taxed.'7 4 under the nunn-domenici consumed income tax, savings are removed from the tax base by allowing individuals "a 'net new savings deduction' for net additions to savings accounts, investments in stocks, bonds, mutual funds, life insurance, and other savings assets."'' 75 although nunn and domenici give no details on their plan's handling of dissavings, the flip side of the net savings deduction is presumably a net dissavings inclusion for years in which a taxpayer's withdrawals from savings exceed additions. 76 the record keeping and enforcement burdens of tracking components of the net savings deduction and the net dissavings inclusion seem to be about the same as the burdens of accounting for those items under the accretion income tax.'77 6. business versus personal under nunn-domenici.-under a consumed income tax, individuals are allowed to deduct expenses of business and investment activities, as under sections 162 and 212 of present law, because these expenses, while not additions to savings, are not consumption either. "'78 although the nunn-domenici documents do not address the point,'79 a fully-developed nunn-domenici consumed income tax will likely follow the classic pattern. this means that much of the present law distinguishing personal (consumption) outlays from business expenses will have to be preserved in the consumed income tax. 8° for example, the consumed income tax regime will have to deal with the issues of when entertainment expenses,181 travel expenses, 82 education expenses,'83 job-hunting expenses,184 and moving expenses85 are sufficiently distinguishable from 174. 1 treas. dep't, supra note 4, at 192; bradford, supra note 1, at 82; supra text accompanying notes 126-27. 175. unamerican spirit, supra note 138, at 290. 176. see bradford, supra note 1, at 82-84; christian & schutzer, supra note 120, at 1505; nunn-domenici report, supra note 123, at 99. 177. see graetz, supra note 136, at 1585, 1595. 178. see id. at 1588-91; william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1151 (1974). see also 1 treas. dep't, supra note 4, at 191; bradford, supra note 1, at 82. 179. see supra notes 137-38. 180. see graetz, supra note 136, at 1588-91. 181. see irc § 274(a), (d), (e). 182. see irc §§ 162(a)(2), 274(c), (h). 183. see regs. § 1.162-5. 184. see rev. rul. 75-120, 1975-1 c.b. 55. 185. see irc § 217. [val 2:7 scoping out the uncertain simplification effects consumption outlays to be deductible.' 6 similarly, under the consumed income tax it will have to be determined when items furnished to, and consumed by, an employee for the convenience of the employer, such as sleeping quarters on the employer's business premises, are so unlike ordinary consumption that they should be excluded from the tax base.'" under the accretion income tax, all of these issues have provided profitable employment for lawyers and accountants and burdens for taxpayers and the irs, and they would seem to be equally alive in a consumed income tax world.' 7. long-lived consuner assets.-the proper treatment under a consumed income tax of consumer durables and owner-occupied housing (long-lived consumer assets) is an enduring conundrum with two solutions, one of which is theoretically correct but impractical and the other of which is regarded as an acceptable alternative in a world requiring practical results. the theoretically correct solution is to treat a long-lived consumer asset like any other income-producing property, allowing a deduction for its cost but taxing the income flow (the consumption benefits) from the asset. this approach relieves the purchaser from paying tax when the asset is acquired, but it requires an annual inclusion in the tax base of an imputed flow of consumption benefits from the asset. since the imputed amount is immediately consumed through personal use of the asset, there would be no savings deduction to offset its inclusion in gross income. if the asset were ultimately sold, the proceeds would be included in gross income for the year of the sale.189 unfortunately, this approach collides with the long-standing expectation that imputed income from the use of consumer assets will not be taxed, particularly when the asset is the sacrosanct family residence. taxpayer opposition would likely be heightened by the lack of any associated cash-flow from which tax on imputed consumption benefits could be paid and by the fact that valuation of those benefits would be burdensome and complex if done accurately and often inaccurate if done by reference to statistical averages or returns on financial investments.'90 the theoretically correct approach seems to have no chance of adoption. 186. see generally 1 treas. dep't, supra note 4, at 191: graetz. supra note 136, at 1588-91. 187. see irc § 119; christian & schutzer, supra note 120, at 1510. 188. see graetz, supra note 136, at 1585-86. 189. bradford, supra note 1, at 85; andrews, supra note 178. at 1155-58, graetz, supra note 136, at 1599, 1614, 1620. 190. see generally i treas. dep't, supra note 4. at 201; bradford, supra note 1, at 85; andrews, supra note 178, at 1155-56; graetz, supra note 136, at 1614, 1621. 19951 florida tax review the alternative is essentially the flip side of theoretical correctness-allow no deduction for the cost of a long-lived consumer asset but exclude from gross income both the flow of consumption benefits from the asset and the proceeds of its eventual sale. thus, if the acquisition of a car or residence is financed from current earnings, no purchase deduction would shelter those receipts from immediate taxation. if the purchase is financed from savings, the consumer would have a large, taxable withdrawal from savings, but no offsetting purchase deduction. 19' if the purchase is financed with a loan, the loan proceeds would be included in taxable receipts without any offsetting deduction. 92 under each of these scenarios, the asset's purchase price would be fully taxed in the acquisition year, but there would be no further income inclusions as the asset was used and ultimately sold.' 93 191. supra text accompanying notes 126-27; bradford, supra note 1, at 85-86. the problem of the taxpayer being pushed into a higher rate bracket by a large savings withdrawal could be alleviated with an averaging provision. id. at 86. both this problem and the related problem of the taxpayer having to pay a large tax, irrespective of the marginal rate, could be mitigated by a provision for a special account into which a taxpayer could make nondeductible deposits while saving for a long-lived consumer asset and from which nontaxable withdrawals could be made when the purchase occurs. id. alternatively, the large tax might be allowed to be paid in interest-bearing installments over several years. see 1 treas. dep't, supra note 4, at 202. all of these solutions, however, would erode the simplification gains of a consumed income tax. 192. this consumer would be helped by the averaging and installment payment provisions referred to in note 191. an alternative method for dealing with the higher rate bracket and large tax liability problems of taxpayers who finance purchases of long-lived consumer assets by borrowing is to permit them to exclude the loan proceeds from gross receipts in exchange for forgoing the deductions for principal and interest payments that are usually allowed to borrowers under a consumed income tax. 1 treas. dep't, supra note 4, at 192, 202; bradford, supra note 1, at 86; graetz, supra note 136, at 1618-19, 1621. if this alternative were employed, taxpayers would be required to handle loans in two different ways: (1) exclusion of loan proceeds from income and no deduction for loan payments where the loan finances the purchase of a long-lived consumer asset and (2) in all other cases, inclusion of loan proceeds and deduction of principal and interest payments. to the extent that a loan handled under the first alternative was forgiven, the forgiven amount would have to be treated as income. simplification committee report, supra note 126, at 423. this might lead congress to retain the exceptions to debt discharge income presently found in §§ 108(a)(1)(a) (bankruptcy discharge), 108(a)(1)(b) (discharge when insolvent), and 108(e)(5) (purchase money debt reduction). all of this would complicate the consumed income tax for both taxpayers and irs. see generally graetz, supra note 136, at 1618-20. 193. blueprints, supra note 4, at 122; bradford, supra note 1, at 85; simplification committee report, supra note 126, at 419-20; andrews, supra note 178, at 1155-56; graetz, supra note 136, at 1614-18. however, matters become complicated if an asset accounted for under this approach is sold for more than its original cost (a common outcome for residences). arguably, the theoretically correct result is to include any unexpected market gain in the seller's consumption [vol 2:7 scoping out the uncertain simplification effects by contrast, under the present accretion regime, there is no tax, at time of purchase, on funds used to acquire long-lived consumer assets unless the funds come from current income. this alternative treatment of long-lived consumer assets is based on the familiar insight that expensing an asset and taxing the returns from it (the method described above for achieving a theoretically correct result) is the economic equivalent of allowing no deduction for the cost of an asset (thus taxing the purchase price) and exempting all returns from the asset." nevertheless, taxpayers can be expected to oppose this alternative because it would give them a large tax liability on top of a large purchase price. taxpayer objections would be particularly sharp with respect to the acquisition of a personal residence which taxpayers have been conditioned to think of as a tax-preferred asset. 8. personal residences.-nunn and domenici, having seemingly weighed these considerations, adopt an approach for personal residences that gets the economics partly wrong but undoubtably gets the politics right. under this approach, the acquisition of a personal residence is treated like the purchase of an investment asset; the purchase price is fully deductible.'95 purchase money borrowing would apparently be included in the tax base, but deductions would be allowed for payments of principal and interest.' because the purchase price deduction would effectively offset purchase money loan proceeds as well as current earnings or savings withdrawals used to finance the purchase, there would be no consumption tax liability associated with the acquisition of a residence. to this point, the nunn-domenici treatment of owner-occupied housing follows the theoretically correct approach outlined above. however, the next step deviates fundamentally from theoretical correctness-the flow tax base. stated differently, the taxpayer should arguably be taxed on the portion of the sales price representing an unexpected windfall that was not taxed on a present-value basis when the house was purchased. graetz, supra, at 1617-18, 1621. see also andrews, supra, at 1158. implementation of this refinement would be so complicated as to seriously erode the simplification gains of a consumed income tax. at a minimum, taxpayers would be required to keep track of their basis in long-lived consumer assets, forgoing one of the virtues of a consumed income tax. 194. blueprints, supra note 4, at 123-24; andrews, supra note 178. at 1126, 115556; alvin c. warren, jr., accelerated capital recovery, debt, and tax arbitrage, 38 tax law. 549, 550-52 (1985). for an argument that this insight is wrong in most real-world situations, see graetz, supra note 136, at 1598-1609. blueprints, supra note 4, at 128-29 also raises questions about its validity. 195. unamerican spirit, supra note 138. at 294. 196. id. however, the interest deduction would be subject to an unspecified cap, and residential real property taxes would not be deductible. 19951 florida tax review of consumption benefits from the residence would be ignored; no attempt would be made to value and tax this imputed income. 97 this solution gets high marks for simplicity, but it puts investments in personal residences in a privileged position. 98 nunn and domenici frankly recognize this economic flaw in their plan and seemingly confess that they are bowing to political realities.1 99 9. other long-lived consumer assets.-the nunn-domenici proposal apparently has a different approach to long-lived consumer assets other than housing. it does not seem to permit purchase price deductions for such assets and appears to exempt the related flow of consumption benefits. 200 in other words, the alternative approach described above seems to be adopted for long-lived consumer assets other than residences. the proposal apparently includes an averaging provision for taxpayers pushed into higher tax brackets by large purchases of this type, but the details of the averaging provision have not yet been published.20' although this approach to long-lived consumer assets may be theoretically correct,2 °2 the averaging provision adds complexity. inclusion of the averaging provision is virtually compelled, however, by a contradiction between two of the principal justifications for the consumed income tax. the first of these justifications is that the consumed income tax, unlike the vat, can utilize graduated rates and serve as a means for effectuating progression.203 indeed, it has been asserted that "[t]he decision to adopt a progres197. id. 198. see 1 treas. dep't, supra note 4, at 201-02. see also graetz, supra note 136, at 1622-23. 199. unamerican spirit, supra note 138, at 294. 200. id. at 292. by treating personal residences more favorably than other long-lived consumer assets, the proposal raises the issue of whether a yacht or motor home in which the owner lives most of the year is a personal residence or a nonresidential consumer durable. presumably, answering this question will not be unduly complicated. however, if the answer is that any property, real or personal, that serves as the taxpayer's principal residence qualifies under the residence rule, the nunn-domenici system would have to deal with whether a newlyacquired yacht or motor home was, in fact, purchased as a principal residence or as a lessfavored recreational asset. see temp. regs. §§1.163-10(p)(3)(ii), 1.1034-1(c)(3)(i) (drawing this distinction under current law). this would be a complicating addition to the nunndomenici system. 201. unamerican spirit, supra note 138, at 292. 202. but see graetz, supra note 136, at 1598-1609, 1614-15 (implicitly arguing that this approach is not theoretically correct but concluding that it is an acceptable practical solution). 203. 1 treas. dep't, supra note 4, at 191; congressional budget office, supra note 158, at 114; nunn-domenici report, supra note 123, at 97-100. see also unamerican spirit, supra note 138, at 304. [vol 2:7 scoping out the uncertain simplification eff'cts sive rate structure is thus the principal basis for choosing an expenditure [consumed income] tax over other taxes levied on a consumption base."' the second of the conflicting justifications is that the consumed income tax achieves neutrality between consumers and savers, thereby overcoming a major distortion of the accretion income tax.2-'y the contradiction is illustrated by individual a, who earns $100 and enjoys an annual return on investments of 10%. in a no-tax world, her choice is between $100 of consumption today and $1 10 of consumption next year. under a 50% flat-rate consumption tax, a could consume $50 today or save for one year and consume $55. the tax has cut her consumption in half, but it has left her able to consume 10% more if she defers consumption for one year. the relative tradeoff between present and future consumption has not been disturbed.2" 6 however, if the tax is imposed at progressive rates-say, 50% on the first $100 and 80% on consumed income in excess of $100, a's tax under the savings alternative is $58 ($50 on the first $100 and $8 on the investment earnings), and the amount remaining for consumption is only $52 ($110 less $58), which is only 4% more than the $50 she could have consumed without saving. progressive rates thus have the effect of altering the relative tradeoff between present and future consumption in a way that disfavors saving. for this reason, the nunn-domenici authors are virtually forced to provide a complicating averaging rule for taxpayers pushed into a higher tax brackets when they purchase expensive long-lived consumer assets from savings withdrawals. having come this far, nunn and domenici are forced to make the averaging provision available to all purchasers of long-lived consumer assets because it would be quite complicated to differentiate between taxpayers financing purchases of these assets from savings and those using other financing approaches. 20 7 another interesting consequence of the nunn-domenici treatment of long-lived consumer assets other than housing is that purchasers of valuable items of tangible personal property producing no cash-flow would prefer that 204. graetz, supra note 136, at 1579. 205. nunn-domenici report, supra note 123, at 98-99; blueprints, supra note 4. at 40. 206. congressional budget office, supra note 158, at 116. by contrast, under a 50% flat-rate income tax, a would have only $50 to save after tax, would have an investment return of $5, pay $2.50 in tax on that amount, and have only $52.50 to consume after one year. thus. the income tax would allow the saver to consume only 5% more than the consumer who immediately spent the $50 of after-tax income and saved nothing. 207. for example, if averaging applied only to acquisitions out of savings and a taxpayer with $100 of savings and $100 of current earnings purchases a long-lived consumer asset for $100, it would have to be determined whether the asset was purchased from the savings or the earnings. 19951 florida tax review these items be treated as investments, rather than long-lived consumer assets. this is because consumer-asset classification means that the purchase price for the item is immediately included in the tax base, 08 whereas investment asset classification means that the purchase price is deducted from the tax base and the absence of cash flow ensures that there is no taxation while the taxpayer uses the asset even though the taxpayer is receiving current consumption benefits through that use." 9 thus, taxpayers who purchase expensive art objects and jewelry can be expected to argue that these items are investments, even though the art is displayed in a personal residence and the jewelry is occasionally worn by the owner or members of the owner's family.210 under nunn-domenici, taxpayers and the irs would bear the costs of making the factual distinctions required to properly classify property of this type. if the proposal attempts to avoid this issue by denying a deduction for investments in art objects and jewelry, taxpayers will presumably make such investments through business entities. the proposal would then either have to acquiesce in this strategy or adopt complicating rules that look through business ownership interests to the underlying assets. 10. gifts and inheritances.-the nunn-domenici treatment of gifts and bequests is based on three premises: (1) the making of a gift or bequest is not taxable consumption by the transferor;21' (2) gifts and inheritances should be taxed only once under a consumed income tax;2 2 and (3) the appropriate imposition of the tax is on the donee when the gift or inheritance is consumed.21 3 thus, the proposal "treats inheritance [or a gift] as income to the recipient and taxes it to the extent that it is consumed rather than saved. if the entire inheritance [or gift] is saved, inheritance [or inter vivos giving] is not a taxable event for either the donor or the beneficiary. 214 208. see i treas. dep't, supra note 4, at 201-02; supra text accompanying notes 191-92, 200-01. 209. see supra text accompanying note 191-93. under the nunn-domenici proposal, income is not imputed from any asset. thus, property that is treated as an investment but produces no cash-flow generates no tax liability when it is acquired or while it is held. the proceeds of a sale of such an asset are included in gross income but can be offset by a savings deduction if reinvested. 210. see generally 1 treas. dep't, supra note 4, at 201-02. 211. unamerican spirit, supra note 138, at 302. 212. id. at 303-04. accord: simplification committee report, supra note 126, at 427; andrews, supra note 178, at 1163-64; graetz, supra note 136, at 1626-27. 213. unamerican spirit, supra note 138, at 302. however, the wealth transfer taxes would be retained. 214. id. at 302. this outcome is arguably correct under consumed income tax principles. see blueprints, supra note 4, at 12, 15; simplification committee report, supra note 126, at 427; andrews, supra note 178, at 1162-63; graetz, supra note 136, at 1624-25. but see 1 treas. dep't, supra note 4, at 193; bradford, supra note 1, at 89. [vol 2:7 scoping out the uncertain simplification effects this system is relatively simple for donees, but it has significant complexity on the donor's side. the following examples illustrate this point: example 1: individual a makes a $100 gift out of current receipts (e.g., salary or dividends) to individual b. since the receipts are part of a's consumption tax base in the year of the gift, a is presumably allowed a $100 deduction for the gift.2 5 without the deduction, a would be taxed on the $100, violating the policy of not taxing the donor. example 2: instead of making a cash gift, a uses the $100 of current receipts to buy corporate stock, which she immediately gives to b. a receives a $100 savings deduction for the stock purchase.3 6 if she also gets a $100 gift deduction, she will have leveraged her $100 transfer into $200 of deductions, deflecting tax from both the $100 investment outlay-a correct result under a consumed income tax-and an additional $100 that a could consume tax free. example 3: a makes a gift to b of stock that was acquired years earlier out of current receipts for $100 but is worth $200 at the time of the gift. if a gets a $200 gift deduction in addition to the $100 savings deduction allowed when she bought the stock, she will have deducted her investment cost twice, once when she bought the stock and again as a component of her $200 gift deduction. furthermore, the gift deduction will have included $100 of untaxed appreciation.217 for a $100 cost, she will get $300 of deductions that will, in addition to deflecting tax from her $100 investment outlay, shelter $200 of otherwise taxable consumption expenditures. the tax shelter outcomes in examples 2 and 3 are indefensible, but the published details of the nunn-domenici plan do not explain how they will be prevented. a possible solution is to require a to treat the stock gifts as deemed withdrawals from savings that are added to the tax base for the year of the gift. in example 2, this approach produces the following computational steps for a: (1) a $100 inclusion of the cash receipts; (2) a $100 deduction for the stock purchase; (3) a $100 inclusion for the deemed savings 215. see simplification committee report, supra note 126, at 427; andrews, supra note 178, at 1163; graetz, supra note 136, at 1624. 216. see supra text accompanying note 126 and 175. b also excludes the stock from her income. see supra text accompanying note 214. 217. because the gift is not a consumption event, unamerican spirit, supra note 138, at 302, the $100 of appreciation is apparently not included as consumption in a's tax base. 19951 florida tax review withdrawal; and (4) a $100 gift deduction. in example 3, the steps are: (1) a $100 inclusion of the cash receipts; (2) a $100 deduction for the stock purchase; (3) a $200 inclusion for the deemed withdrawal from savings; and (4) a $200 deduction for the gift. in both cases, items (3) and (4) cancel each other so that a is limited to one $100 deduction and only the $100 of cash receipts is sheltered from taxation. this system reaches the right results in examples 2 and 3,21 but it is hardly simple. a must go through four steps, and the irs has to make sure that a gets them right. an alternative is to deny the gift deduction for gifts of business or investment property, thereby eliminating the need to treat gifts of such property as constructive withdrawals from savings. z 9 in examples 2 and 3, this system would restrict a to the $100 deduction for the stock purchase, and her deduction would not exceed the amount originally included in her tax base. this is a far simpler solution, but it is moderately complex because it requires donors to handle cash gifts differently from gifts of business and investment property. however, this is not the end of the complexity arising from the nunn-domenici treatment of gifts. recall that purchases of long-lived consumer assets, other than residences, would apparently be treated as taxable consumption expenditures. 220 thus, amounts spent on cars, boats, jewelry, and art objects acquired as consumer items would be taxed when these items are purchased. assume a gives a personal-use car to b. if b is also taxed on the receipt of the car and is allowed no offsetting deduction (as is appropriate if b holds the car for personal use),22 ' there is a violation of the nunndomenici principle that gifts and inheritances should be taxed only once.2 there are three ways out of this problem. first, the transferee could be taxed notwithstanding the earlier tax on the transferor. this is a very simple solution because it treats all transferees the same and requires no inquiry into whether the transferred asset was previously taxed. however, this 218. simplification committee report, supra note 126, at 427; graetz, supra note 136, at 1624-25. 219. see simplification committee report, supra note 126, at 427; andrews, supra note 178, at 1162-63; graetz, supra note 136, at 1625. 220. see supra text accompanying notes 200-10. 221. since nunn and domenici would not impute income to owner-users of longlived consumer assets and since such assets, other than housing, are apparently treated as consumed when acquired, see supra text accompanying notes 200-10, a donee would seemingly be required to include the full value of nonresidential consumer assets in income when received. a donee who holds the property for business or investment use would presumably be allowed an offsetting deduction. 222. see supra text accompanying note 214. more precisely, there would be double taxation to the extent that the value of the property at the time of the gift does not exceed its original purchase price. [vol 2:7 scoping out the uncertain simplification effects solution also conflicts with the nunn-domenici principle that gifts and inheritances should be taxed only once and only when devoted to consumption by the transferee. a second solution would be to absolve the transferee from tax if the transferor was previously taxed. -3 for example, if an art object or jewelry was acquired for investment, the purchase price should have been treated as a deductible savings outlay, eliminating any tax at the time of purchase, and if so, the item would be included in the tax base of a donee or heir. in contrast, if the item was acquired for personal use, its cost should have been treated as a taxable consumption expenditure, and if so, a donee or heir would not be taxed on receipt of the item. however, there can be no guarantee that the purchase was correctly reported. furthermore, a transferee of an art object or jewelry would not be able to tell by examining the property whether tax was paid by the transferor. thus, if transferees are to be excused from tax with respect to consumer assets that were earlier taxed to the transferors, transferors and their estates must be required to maintain and disclose records allowing the transferees to determine whether consumer durables passing by gift or bequest were previously taxed. a third solution would be to tax the transferee if the property is put to personal use, but give the transferor (or the transferor's estate) a refund of any tax paid by the transferor.24 this approach entails approximately the same record-keeping burden as the second solution, except that the transferor's records would also need to show how much tax was paid. from a simplification standpoint, none of these solutions is particularly attractive, but one of them has to be chosen. nunn and domenici have hinted at the third.' this is a perfectly reasonable resolution, --2 but the record keeping that it requires must be scored as a complicating feature of the consumed income tax. furthermore, consider the situation of an individual who purchased a $100,000 boat for personal use and transfers it by gift or inheritance after it has declined in value to $50,000 because of wear and tear, not market changes. because the transferor consumed one half of the boat's value before the transfer, it is inappropriate to give the transferor, or the transferor's estate, a refund of the consumed income tax paid on the entire $100,000 price of the boat and collect a tax from the donee on only the remaining $50,000 of value. since the donee can consume only $50,000 in using the boat, it is equally inappropriate to give a full refund of the earlier tax and charge the 223. unamerican spirit, supra note 138, at 303 n.86: graetz, supra note 136. at 1626-27. 224. see simplification committee report, supra note 126. at 427. 225. unamerican spirit, supra note 138, at 303 n.86. 226. see simplification committee report, supra note 126, at 427. 19951 florida tax review donee with tax on the original $100,000 price. the nunn-domenici principle of taxing the person who engages in consumption would be properly implemented by giving the transferor or her estate a refund for only half of the earlier tax payment and collecting tax from the donee on the boat's remaining value of $50,000. however, the record keeping, computations, and valuations required by this solution detract further from simplification gains.227 11. income splitting.-as noted above, the nunn-domenici proposal apparently allows a donor to deduct cash gifts from current receipts (e.g., salary or dividends) and includes the gifts in the donees' gross receipts for purposes of the consumed income tax.22 this permits high-bracket donors to shift the tax burden on current salary, interest, and dividend income to low-bracket donees,2 a result that is anathema under the income tax.230 if this income-splitting superhighway is considered unacceptable, cash gifts to family members might be removed from the general pattern by taxing them as nondeductible consumption expenditures of the donor. this approach would, however, create several disagreeable problems. first, in order to avoid double taxation, a donee would have to separate a cash gift from other cash receipts and exclude it from the consumed income tax base.23' the irs would then have to police the exclusion to make certain that the amount really was a gfit from a related donee. second, if intra-family cash transfers were treated as nondeductible consumption by the donor and as excludable from the donee's income, a decision would have to be made and administered regarding the definition of 227. in the example, the decline in value is from wear and tear, not market decline. if value is lost as a result of market decline, the solution of refunding the entire tax paid by the transferor, while collecting tax from the transferee only on the remaining value, is less obviously wrong. arguably, if the value declines from $100,000 to $50,000 before any consumption occurs, the transferor was overtaxed on the $100,000, and the appropriate tax is on the $50,000 of consumption that the transferee can enjoy. however, it is not feasible to determine whether a loss in value resulted from market decline or wear and tear. in the example, for instance, the $50,000 loss in value might be partly from wear and tear and partly from market decline. the solution suggested in the text should therefore apply to any decline in value in property that was treated as a consumption item when purchased by the transferor, regardless of the cause of this decline. 228. see supra text accompanying notes 211-14. 229. see simplification committee report, supra note 126, at 427; graetz, supra note 136, at 1625. nunn and domenici apparently would not require the family to report income as a unit. see unamerican spirit, supra note 138, at 288, 304-06. 230. see helvering v. horst, 311 u.s. 112 (1940); lucas v. earl, 281 u.s. 111 (1930). see also chirelstein, supra note 47, at 200-01. 231. see simplification committee report, supra note 126, at 427; unamerican spirit, supra note 138, at 303. taxing gifts only once seems to be a major goal of nunn and domenici. id. at 287, 303-04. [vol 2:7 scoping out the uncertain simplification effects family. specifically, when would a relative be considered sufficiently distant to permit a donor to make deductible cash gifts to that individual? 2 this could involve many of the complexities of current law on the dependency exemptions. third, denying the deduction for cash gifts to family members might simply cause donors to make loans to relatives, requiring the irs to police the bona fides of nominal loan transactions. finally, denial of the deduction would distort individual behavior by encouraging potential donors to consume more than they otherwise would or to accumulate property and pass it to relatives at death. an alternative means of blocking income splitting by intra-family cash gifts would be to allow donors to deduct the gifts but tax the donees at the donor's marginal tax rate when the donees consume the gifts. this would involve many of the complexities of the present kiddie tax (section l(g)), with the added twist that tracing would be required to determine the source of funds spent by donees on consumption. from a simplification standpoint, these are not happy consequences. arguably, income splitting is not a problem under a consumed income tax because the tax should be imposed on the consumer, based on the amount the consumer consumes. if high-income individuals choose to shift consumption to family members taxed at lower marginal rates, the resulting revenue losses are inherent in the nature of the tax. however, without restraint on income shifting, parents would effectively have the ability to shift to their children the tax burden on support provided by the parents, and working spouses could shift to nonworking spouses the tax burden on support furnished by the working spouses. what is bad about this is that it would not happen automatically, only through tax planning. parents who simply put food on the table and clothes in the children's closets would be taxed on funds spent on the children's support, while parents who made cash gifts to the children, which the children used for their needs, would shift the tax burden to the children. if cash gifts are deductible by donors, the only way to stop this tax planning would be to wade into the problems, described above, of prohibiting tax deductible cash gifts to family members or to permit such gifts only to the extent that they exceed support. the latter approach would embroil taxpayers and the irs in controversies over support levels-a most disagreeable prospect from a simplification standpoint-unless an arbitrary support level is specified by statute. regrettably, there is yet another income splitting problem here. if the consumed income tax permits donors to make untaxed gifts of income232. the nunn-domenici treatment of gifts apparently covers transfers to nonfamily members. see unamerican spirit, supra note 138. at 302-04. 19951 florida tax review producing property to donees, the tax burden on future income from the property would be shifted to the donees. this was judged unacceptable under the present income tax for donees who had not reached age 14. the result was section 1(g), the so-called kiddie tax, which generally taxes the property income at the marginal tax rate of the child's parent. a similar approach might be used under the consumed income tax; income from property might be taxed at the parent's rate when consumed by the child. to implement this approach, however, it would be necessary to trace the child's consumption expenditures to their sources-not a pretty thought if one is concerned about simplification. it is now clear why nunn and domenici have not (as this article is being written) published a proposal dealing with the income splitting problems resulting from the treatment of gifts. the problems are truly daunting, and none of the solutions is attractive. it is evident, however, that unless nunn and domenici are prepared to tolerate income splitting to a degree far in excess of what can be accomplished under current law, they will be drawn inexorably into complicating solutions. 12. charitable contributions and tax-exempt organizations.-the broad public support for charitable giving incentives is accommodated in the nunn-domenici plan by a tax credit for charitable contributions, in lieu of the deduction of present law.233 although details have not been provided, the credit could be quite complex, particularly if it is amended as it works its way through the political process. for example, if the credit percentage is less than a donor's marginal tax rate, the donor would be better off making cash gifts to noncharitable donees and claiming the gift deduction, instead of giving the cash to a charity and taking the less generous credit.2" presumably, this state of affairs would encourage donors to give directly to a multiplicity of needy individuals, rather than making a smaller number of larger gifts to charitable organizations. the irs would then have to audit many more deduction claims, and taxpayers would have to substantiate more gifts-an obvious increase in complexity for everyone. if the credit were set between the highest and lowest tax rates, it would encourage high-bracket donors to make 233. unamerican spirit, supra note 138, at 297-98. a recent example of strong political support for the charitable contribution deduction is the 1993 repeal of § 57(a)(6), under which the deduction for charitable gifts of property was reduced for purposes of the alternative minimum tax by the amount of any long-term capital gain that would have been recognized on a sale of the property for its fair market value. see also gene steuerle, charitable donations of grants: expanding the hatch bill, 64 tax notes 1101 (aug. 22, 1994). 234. for the gift deduction, see supra text accompanying notes 211-14. [vol 2:7 scoping out the uncertain simplification effects deductible cash gifts to low-bracket family members, who would contribute the cash to charity and use the resulting credit to eliminate tax on receipts exceeding the amount given to charity. these problems could be avoided by providing a deduction, instead of a credit, for charitable contributions. this would put charitable and noncharitable gifts on an equal footing, but it would also allow high-bracket taxpayers a larger tax benefit from charitable transfers than low-bracket taxpayers. these problems could also be finessed by allowing noncharitable gifts to be deducted only if made to family members. this would deprive donors of the opportunity to make tax deductible gifts directly to unrelated needy individuals, but it would require a definition of family that might involve difficult distinctions. for example, would a former son-in-law or daughter-inlaw qualify as a member of the donor's family? would it make any difference if the former in-law had custody of the donor's grandchildren? also, this solution would not address the use of low-bracket family members as conduits for charitable gifts. clearly, the simplest way through this thicket is to set the charitable contribution credit at a percentage equal to the highest marginal tax rate, thereby ensuring that the deduction for cash gifts to noncharitable donees would never be more attractive than the charitable contribution credit. senators nunn and domenici propose this solution. " however, the revenue loss from allowing low-bracket taxpayers to use ross perot's marginal rate in calculating the tax savings from their charitable gifts might make this approach too costly. if so, the drafters will be driven back to the complexities described above. furthermore, the proposed solution does not avoid a frustrating issue posed by gifts of property other than money, which is illustrated by the following examples: example 4: individual a wishes to make a $100 charitable donation. if she gives cash, she will receive a consumed income tax credit equal to a percentage of $100. but suppose she uses $100 out of her next paycheck to buy corporate stock that she immediately gives to charity. would a be entitled to both a savings deduction for the purchase of the stock and a charitable contribution credit for the gift of the stock? if a is taxed at the top marginal rate and the credit percentage equals that rate, the credit is the economic equivalent of a $100 deduction, and if a savings deduction and a charitable 235. unamerican spirit, supra note 138, at 297-98. 19951 florida tax review contribution credit are both allowed, a single $100 outlay would effectively create $200 of deductions. although tax incentives encouraging charitable giving have broad public and congressional support, allowing a to double her tax benefits in this manner seems to be more than is required to stimulate donor generosity.23 6 furthermore, many would surely balk at the appearance created by allowing a charitable contribution credit for a's $100 cost after it has generated a $100 savings deduction. thus, the credit will probably be crafted so that it does not apply to a's $100 stock gift.237 example 5: a's charitable gift instead consists of stock purchased years ago for $100 that is worth $200 at the time of the gift. the long-standing policy of encouraging charitable gifts of appreciated property will probably lead nunn and domenici to make their credit available with respect to the $100 of appreciation in example 5.238 but what about the portion of the stock value that represents a's $100 cost? does the analysis of example 4 establish that the credit should not apply to the cost portion of a's stock gift in example 5 or does the fact that the stock investment is old and cold at the time of the gift argue for awarding the credit with respect to the stock's entire value as an incentive to make the gift? the answer to these questions is unclear.2 39 however, if the credit 236. for a possible contrary argument, see graetz, supra note 136, at 1632-33. 237. see generally id. at 1632. 238. gifts are not taxable events to donors under the nunn-domenici proposal. see supra text accompanying notes 211-14. consequently, a would not be taxed on the appreciation when she gives the stock to charity, and, with respect to the untaxed appreciation, her credit would provide approximately the same charitable giving incentive that she would get from the present charitable deduction. see graetz, supra note 136, at 1632. 239. under present law, a's charitable deduction includes her $100 cost, but because the cost consists of after-tax dollars, a could have sold the stock and consumed the $100 without further tax. under the consumed income tax, by contrast, because a would have been allowed a $100 deduction for her stock purchase, this cost would consist of pre-tax dollars that she could not consume without paying tax but could give to a charity free of any tax. thus, if there is any structural bias in the nunn-domenici plan between charitable giving and consumption of the cost of an existing investment, the bias favors charitable donations over consumption. consequently, denying a charitable contribution credit for a donation of the $100 of untaxed original investment in the stock may not make her incentive to give that $100 to a charity materially less than her incentive to give after-tax dollars under the income tax. however, under nunn-domenici, a has the option of continuing to hold the stock and saving the returns thereon so that those returns compound at a pretax rate. this option is not available under an accretion tax and continuing to hold the shares may be so comparatively attractive under nunn-domenici that it will be necessary to give a the contribution credit with respect [vol 2:7 scoping out the uncertain simplification effects is denied with respect to a charitable donor's original cost, taxpayers will effectively be required to maintain records of the costs of all investments, even though the consumed income tax is supposed to dispense with the cost basis concept. on the other hand, if a is allowed the credit with respect to the cost of old and cold stock (example 5) but not the cost of newly acquired stock (example 4), the drafters will have the difficult problem of drawing the dividing line between examples 4 and 5. if the distinction is made by an intent test (a bought the stock in example 4 for the purpose of giving it to a charity but bought the stock in example 5 as an investment), taxpayers and the irs will have to deal with an uncertain, fact sensitive issue. if, alternatively, the drafters use an arbitrary holding-period rule to distinguish examples 4 and 5, a will have to maintain holding period records for her various blocks of investment shares, and there will surely be rules that allow a to tack the holding period of old shares onto new shares if she can trace the old to the new. in short, regardless of how this issue is resolved, the result will be complex. in addition, most of the percentage-limitation paraphernalia of present section 170(b) will probably be retained under the charitable contribution credit, and the credit will surely be reserved for gifts to organizations satisfying criteria which ensure that contributions to them will further approved charitable purposes. these rules will probably require the persistence of provisions like the private foundation rules. furthermore, nunn and domenici have stated that charities will be exempt from the nunn-domenici vat,2' suggesting a strong likelihood that section 501-type criteria will also be used to determine eligibility for the vat exemption. nunn and domenici have also stated that under their approach for tax-exempt organizations, unrelated business income tax issues will continue to be a source of complexity. 24' thus, their plan does not seem to threaten the continued employment of lawyers and accountants who specialize in exempt organizations issues. 13. accotiwdating lowand middle-income taxpayers.-the nunndominici proposal includes a family living allowance, varying with family size, that would combine and enlarge the standard deduction and the personal and dependent exemptions of present law.242 this allowance would apparently not be subject to a phaseout. its adoption would be a simplifying to her $100 cost as a donation incentive. 240. unamerican spirit, supra note 138, at 311. 241. id. 242. unamerican spirit, supra note 138, at 295. 19951 florida tax review measure if it eliminates the personal and dependent exemption phaseout of current law.243 the nunn-domenici plan also includes both an equivalent of the present earned income tax credit and a new refundable credit for part of the federal payroll taxes paid by employees.2' although the documents describing the proposal do not mention a phaseout for the earned income tax credit, a phaseout would probably be employed since the credit is intended to "accomplish the same objectives as the current eitc., '245 nunn and domenici have stated that the payroll tax credit would contain a phaseout beginning at $25,001 of income.246 the phaseout of the earned income tax credit will probably not increase complexity over present law, but it erodes the simplification gains of a consumed income tax, as does the payroll tax credit phaseout. moreover, the complexity would increase substantially if the two phaseout mechanisms employ separate formulas, requiring two different phaseout computations. in addition, many taxpayers dropped out of the consumed income tax system by the family living allowance will find that they have to file returns to get refunds of the earned income and payroll tax credits. for these taxpayers, the credits detract from the simplification brought about by the family living allowance. to assist working parents, congress is likely to include a child-care credit, with a phaseout, in any consumed income tax it might enact.247 there might also be a phased-out second earner credit to facilitate participation of married women in the work force, regardless of whether child-care is involved.248 these would be additional complicating features. 14. qualified retirement plans.-under the nunn-domenici consumed income tax, employees would continue to defer paying tax on 243. see irc § 151(d)(3). however, since the allowance would depend on family size, a definition of the family unit would be needed. furthermore, the family living allowance would likely mimic the present standard deduction by differing in amount for joint filers, marrieds filing separately, surviving spouses, heads of household, and unmarried individuals, see § 63(b)(2), and perhaps for the elderly and the blind, see § 63(f). the rules required to distinguish between these categories will preserve the corresponding complexities of current law. 244. unamerican spirit, supra note 138, at 296. 245. id. 246. id. 247. see, e.g., irc § 21. 248. see edward j. mccaffery, taxation and the family: a fresh look at behavioral gender biases in the code, 40 ucla l. rev. 983, 996, 1004-05, 1040 (1993). but see deborah a. geier, restoration of the two-earner couple deduction: why? 65 tax notes 497 (oct. 24, 1994). [vol. 2:7 scoping out the uncertain simplification effects employer contributions to retirement plans until withdrawals occur.2 9 if this feature of the plan is ultimately coupled with an employer credit or deduction under the nunn-domenici vat for employer contributions to retirement plans,"0 complex nondiscrimination rules would also probably be included to prevent creditable or deductible employer contributions from being unduly skewed in favor of highly-compensated employees.2'the trusts that hold and invest employer contributions surely would also be subjected to prohibited transaction rules and other regulations. 15. state and local government bonds.-since all investment expenditures are deductible under the consumed income tax, bonds issued by state and local governments should lose their preferred status. nunn and domenici have stated, however, that this status will be preserved by allowing "the interest earned from tax-exempt bonds to be spent without being taxed."252 presumably, this would be accomplished simply by having the taxpayer exclude the interest from the tax base. however, the present complications relating to municipal bonds in sections 103 and 141-147 would surely be preserved. 16. transition problei.-a consumed income tax does not use the basis concept. when an asset is sold and the sales proceeds are spent on consumption, 100% of those proceeds are subjected to the consumed income tax, regardless of how much the taxpayer paid for the asset,5' under an accretion income tax, basis consists of after-tax dollars.' consequently, if an asset is purchased under the present accretion tax and, after adoption of a consumed income tax, the asset is sold and the proceeds consumed, the consumed income taxation of the proceeds amounts to a second income tax on the portion representing the taxpayer's cost for the asset. 249. unamerican spirit, supra note 138, at 298. employees paid in cash, who invest both the cash and the resulting investment earnings, would have offsetting savings deductions that would spare them from taxation until they withdraw from savings for consumption spending. employer contributions to retirement plans create the economic equivalent of employee investments of cash compensation, and nunn and domenici would give them equivalent tax treatment. 250. the persistent concern over the adequacy of social security funding might lead congress to encourage private retirement savings by including in the nunn-domenici vat a deduction or credit for employer contributions to qualified retirement plans. 251. see irc §§ 401,410, 411, 416. 252. unamerican spirit, supra note 138, at 298. 253. see supra text accompanying note 132. 254. see irc § 1012; simplification committee report. supra note 126, at 439. 19951 florida tax review this double taxation is probably politically unacceptable and will have to be avoided or at least mitigated .1 5 the nunn-domenici proposal would deal with this problem by selecting a period of years over which taxpayers could spread and deduct part or all of their investments acquired before the effective date of the consumed income tax. 6 the consequent revenue loss would be offset by a two percentage point increase in the consumed income tax rates during the deduction years. 7 it is not clear whether the deduction would apply to asset basis or asset value and whether real estate would be included. 8 in addition, the time period and the percentage that could be spread and deducted have apparently not yet been selected. regardless of what this transition provision looks like when fully developed, it will be a complicating element. furthermore, many taxpayers will have purchased assets at prices reflecting the fact that the assets were entitled to more favorable depreciation treatment than other assets under the accretion tax. these taxpayers can be expected to insist that the preferred status of their assets be preserved under the transition provision. if they are successful, this provision could be very complex indeed. 17. nunn-domenici vat.-recall the vat employed by the nunndomenici plan as a device to lower consumed income tax rates and ease the difficulty of implementing withholding and estimated tax systems under the tax.259 this vat will possess all of the intricacy that is inherent in singlerate vats.2 6 ' furthermore, many in congress may see the nunn-domenici vat as an important instrument for managing the economy through manipulation of corporate behavior, particularly because the vat would be the only entity-level tax on corporate income.26' thus, we should expect that the nunn-domenici vat would emerge from the political process with many of the complicated investment incentive provisions that were projected for inclusion in the danforth-boren bat.262 the nunn-domenici vat would likely be a significantly intricate tax regime. 255. see generally 1 treas. dep't, supra note 4, at 210-11; blueprints, supra note 4, at 181; simplification committee report, supra note 126, at 439-41; graetz, supra note 136, at 1653-58, 1660. 256. unamerican spirit, supra note 138, at 301-02. 257. id. at 301. 258. id. at 300-02. 259. see supra text accompanying notes 156-67. 260. see supra text accompanying notes 15-22, 26-35. 261. see simplification committee report, supra note 126, at 433-34. 262. see supra text accompanying notes 104-19. indeed, the authors of the nunndomenici vat contemplate provisions conferring tax-favored status on health care fringe benefits. unamerican spirit, supra note 138, at 312. [vol. 2:7 scoping out the uncertain simplification effects d. the devil is in the details in short, the devil is in the details. although the replacement of accretion income taxation with either a consumed income tax, or with a vat/consumed income tax combination as proposed by senators nunn and domenici, would seem to yield a tax system that is less intricate than the present accretion regime, we cannot know the precise extent of the resulting simplification until we learn a great many details that may not be revealed until the political process is well-advanced. however, we can say that although the consumption tax system that comes forth will probably be significantly simpler than the present income tax law, it will be a complex structure that provides a comfortable living for many lawyers and accountants. iv. conclusion the goal of simplifying the tax system does not occupy a paramount position that allows it to trump all other tax policy objectives. thus, there may be good reasons for enacting a federal consumption tax, regardless of its impact on tax system complexity. 3 however, if adoption of a consumption tax is determined to be substantially dependent on the extent to which the change alleviates complexity, it is important to recognize that a meaningful answer to this question cannot be provided by an inquiry directed solely to the theoretical characteristics of a pure vat or consumed income tax. as the preceding discussion has indicated, the precise impact of a vat or consumed income tax on the intricacy of the federal tax system cannot be evaluated until we know how vat revenues will be used and the details of the vat or the consumed income tax that ultimately emerges from the political process. the preceding discussion has also shown that while these unknowns can be answered in ways that dramatically reduce systemic complexity, they are quite likely to be resolved in a manner that leaves us with a highly complex tax regime. thus, so long as we lack firm answers to these critical inquiries, neither a vat nor a consumed income tax should be promoted at the national level as a measure guaranteed to accomplish major simplification. nevertheless, an analysis of the most likely answers to these uncertainties suggests that: 263. see 3 treas. dep't, supra note 1, at 17--3; bradford, supra note 123; nunndomenici report, supra note 123, at 20; andrews, supra note 178: ferguson, supra note 6; morris, supra note 18, at 1261; laurence j. kotlikoff, the case for the value-added tax. 39 tax notes 239 (apr. 11, 1988). 19951 florida tax review 1. substitution of a vat for the current individual and corporate income taxes would be a major simplifying development, but this is an unlikely outcome.2 2. a deficit control vat that is simply added to present law would significantly complicate the system. 65 3. a vat that pays for corporate integration and nothing else would not significantly simplify the system.266 4. a vat that pays for enlarged personal exemptions and standard deductions, and thus reduces the numbers of taxpayers and itemizers, would be a moderately simplifying development. 267 5. the danforth-boren proposal, which uses a vat to substitute for the corporate income tax but draws unincorporated businesses into the business tax system and preserves the individual income tax, may be a simplifying move but the resulting simplification is hardly dramatic.268 6. substitution of a consumed income tax for all forms of accretion income taxation would make the tax system much simpler, but would still leave us with a significantly complex revenue-raising regime.269 7. the nunn-domenici plan, which replaces all forms of accretion income taxation with a combination of a vat and a consumed income tax, appears simpler than both the current system and the danforth-boren proposal. nevertheless, nunn-domenici is a significantly intricate system in its own right, and it is more complex than plans to replace accretion income taxation solely with a vat or solely with a consumed income tax.270 a persistent theme of this article has been that the political process is quite likely to deliver a much more complicated consumption tax package than initially seems possible when one reads textbook descriptions of the vat and the consumed income tax. consumption tax advocates will probably 264. see supra text accompanying notes 39-54. 265. see supra text accompanying note 55. 266. see supra text accompanying notes 56-68. 267. see supra text accompanying notes 69-71. 268. see supra part ii.e. 269. see supra part ii.b. "a consumption-type tax is indeed more complicated than a simple tax on ordinary income alone that omits capital gains." andrews, supra note 178, at 1149 n.81. 270. see supra part iii.c. [vol 2:7 scoping out the uncertain simplification etfects view this as unduly pessimistic, and they may be correct. however, it is useful to recall that in 1913, when america stood optimistically poised to adopt a new tax system, the house ways and means committee said: in view of the many valuable governmental purposes to be subserved, those citizens required to do so can well afford to devote a brief time during some one day in each year to the making out of a personal return of income for purposes of taxation. this is done without complaint under the operation of all the general property tax laws of the states. all good citizens, it is therefore believed, will willingly and cheerfully support and sustain this, the fairest and cheapest of all taxes, in order to secure to the largest extent equality of tax burdens, an adjustable system of revenue, and in all respects a modernized fiscal system.' 7 ' these confident predictions of compliance burdens that would involve no more than a brief period of time on a single day and of warm public support for the income tax now seem laughable. the 1913 income tax proponents, being merely human, could not begin to foresee the complexities that would emerge over time from a system that appeared so promising at the outset. likewise, unimagined and extensive complications may be lurking in the vat and the consumed income tax, particularly in the latter, that will make this article's complexity speculations seem naively understated. as our experience with the income tax shows, u.s. tax systems have a way of coming to reflect thoroughly the intricacy of our society and its economy. 271. h.r. rep. no. 5, 63d cong., 1st sess (1913), reprinted in 1939-1 c.b. (part 2) 1,3. 19951 florida tax review volume 2 1994 number 5 zero basis hoax or contingent debt and failure of proof?. sorting out the issues in the lessinger case jasper l. cumnmings, jr. the author practices law in raleigh, north carolina with womble carlyle sandridge & rice, pllc. he argues that commentary on the second circuit's 1989 lessinger decision involving section 357(c) has not clearly identified the tax logic issues that are at stake in the case. he agrees that the controlling shareholder's obligation is not section 351 "property" and should not be accorded basis in the shareholder's hands. instead, the obligation should be treated as a purchase money obligation that affords basis in the shareholder's stock unless it is properly viewed as contingent. in any event, proper structuring of section 351 exchanges of property subject to debt in excess of the property's basis for stock in order to reflect an actual retention of liability on that debt by the shareholder should prevent shareholder gain recognition under section 357(c). florida tax review i. introduction ............................... 285 ii. is the lessinger result desirable as a matter of policy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288 iii. what has zero basis to do with lessinger? . . . . . . 293 a. zero basis has nothing to do with the correct answer in lessinger ......................... 293 b. zero basis is correct, if the obligation is section 351 property ............................ 294 iv. how can the lessinger result be justified? . . . . . . . . 296 a. overview ............................... 296 b. the cash analogy ......................... 297 c. the proper justification ..................... 299 1. overview .......................... 299 2. transferor, who is personally liable on the debt, transfers property to the corporation subject to the debt, but is not released from personal liability; the corporation does not assume the debt ..................... 299 a. section 1001 ................. 302 b. section 453 .................. 304 c. section 752(c) ................ 306 d. section 1031(d) ............... 307 3. transferor is personally liable and remains personally liable; the corporation assumes the debt .......................... 307 4. transferor is not personally liable but the transferred property is subject to a debt .... 308 5. transferor notes .................... 310 v. an obligation given with a section 351 exchange can be characterized as a purchase money obligation to make a contingent contribution to capital ..................................... 311 a . overview ............................... 311 b. treatment of obligations issued for stock outside section 351 ............................. 312 c. issues peculiar to section 351 controlling shareholders; treating transferor's obligation as contingent d ebt ............................... 315 1. overview .......................... 315 2. section 351 transferor ................ 315 3. partner transferor ................... 321 vi. legislative or administrative solutions? . . . . . . . . 323 vii. conclusion .................................. 325 [vol 2:5 zero basis hoar i. introduction in lessinger v. commissioner,' the court of appeals for the second circuit held that the impact of section 357(c)-which requires that any excess of the debt assumed or taken subject to by the corporation in a section 351 exchange must be recognized as gain by the transferor/shareholder-can be avoided if the shareholder, as part of the exchange, promises to pay to the corporation an amount equal to the excess. continuing commentary on the decision indicates that disagreement and confusion persist about the tax consequences of a shareholder's issuance of an obligation to a controlled corporation.2 the commentary reflects two disturbing views about the problem in lessinger. one view questions the proposition that a maker has no basis (or a zero basis) in his or her own obligation.' the other view is that the lessinger result can best be justified by a analyzing the obligation as if it were cash.4 while these views add insight on some issues, they fail to identify fully or resolve properly the range of basic issues raised by lessinger, including (1) whether lessinger reaches a desirable result, (2) what having basis in one's own obligation has to do with that result, (3) what role a transferor's obligation should generally play in section 351 exchanges, (4) how courts can better justify the lessinger result when appropriate, and (5) what legislative solution or administrative guidance may be desirable. lessinger involved a transfer of "property," as that term is used in section 351(a),5 by a controlling shareholder,6 sol lessinger, to his pre1. 872 f.2d 519 (2d cir. 1989). rev'g 85 t.c. 824 (1985). 2. for recent commentary, see kenneth p. brewer. the zero basis hoax, 63 tax notes 457 (apr. 25, 1994) [hereinafter brewer]; kenneth p. brewer. revenge of the zero basis hoax, 64 tax notes 1615 (sept. 19, 1994) [hereinafter brewer ill; kenneth p. brewer, hoax busters, 65 tax notes 778 (nov. 7. 1994); j. clifton fleming, a second look at the zero basis hoax, 64 tax notes 811 (aug. 8. 1994); ronald g. bauer. zero basis opponent puts in his two cents, letter to the editor, 65 tax notes 129 (oct. 3. 1994): george k. yin. was lessinger decided correctly? more on zero basis. letter to the editor, 65 tax notes 131 (oct. 3, 1994). other articles on the subject not cited elsewhere in this article include michael m. megaard & susan l. megaard, can shareholder's note avoid gain on transfer of excess liabilities? 71 j. tax'n 244 (1989); lee a. sheppard, reading section 357(c) out of the code, 47 tax notes 1556 (jun. 25, 1990); colleen m. martin, note, lessinger and section 357(c): why a personal guarantee should result in owen taxes?. 10 va. tax. rev. 215 (1990); louis s. nunes, comment, taking section 357(c) out of the scheme of things: has the second circuit stranded this section of the internal revenue code?, 65 tul. l. rev. 663 (19911. 3. see brewer, supra note 2; but see brewer 1i, supra note 2 (clarifying that giving basis to the obligation is only his second-best approach). 4. see fleming, supra note 2. 5. section 351 does not define "property," but § 351(d) excludes certain items, including services, which resemble a maker's obligation in that services are created by the 1994] florida tax review existing wholly owned corporation in exchange for stock (actually a deemed issuance of additional stock), coupled with the corporation's assumption of debts of the shareholder in an amount exceeding the property's basis. the court found the nonrecognition rule of section 351 applicable to the transfer. under the basis rules for section 351 exchanges, sol's basis for the transferred property became the corporation's basis for the property, and his basis for the stock deemed received in the transaction equaled the property's basis, reduced by the debts assumed by the corporation.7 the tax basis rules effectively preserve and double any gain or loss that goes unrecognized in the section 351 exchange. sol's basis in the transferred property was less than the amount of his debt assumed by the corporation. section 357(c) alters the nonrecognition rule of section 351(a) by requiring the transferor/shareholder to recognize gain equal to any amount by which debt that the corporation assumes or takes subject to in a section 351 exchange exceeds the adjusted basis of the transferred property. sol tried to avoid the application of section 357(c) by issuing his own obligation to the corporation. he did this by entering in the corporation's books an account receivable from himself for the amount of the excess debt. the entry was purportedly part of the section 351 transaction, but it was not made until five months after the debt assumption. in similar cases, the service and the courts have ruled that a transferor like sol must recognize gain under section 357(c), notwithstanding the transferor's promise to pay to the corporation an amount equal to the excess debt.8 the tax court in lessinger dispatched sol's arguments summarily on the basis of its earlier decisions, observing that either (1) his obligation should be ignored as artificial and not a true asset of the corporation or (2) the obligation was "property" transferred to the corporation under section 351 but had a zero basis and therefore did not reduce the imbalance of debt assumed in excess of basis in property transferred.9 the second circuit reversed. it did not say that sol had a basis for his obligation. it did not deny that the corporation assumed sol's debt. services-performer, usually without incurring cost. see raich v. commissioner, 46 t.c. 604, 610 (1966) (holding that a cash method taxpayer has no basis in his services or accounts receivable therefor), overruled on other grounds by focht v. commissioner, 68 t.c. 223 (1977). 6. a transferor has control for purposes of § 351 if, immediately after the transfer, the transferor (alone or together with others making contemporaneous transfers of property in exchange for stock) owns stock of the corporation carrying 80% of the voting power and also owns 80% of each class of nonvoting stock. irc §§ 351(a), 368(c). 7. irc §§ 358(a), (d); 362(a). 8. smith v. commissioner, 84 t.c. 889 (1985), aff'd, 805 f.2d 1073 (d.c. cir. 1986); christopher v. commissioner, 48 t.c. memo (cch) 663, t.c. memo (p-h) 84,394 (1984); alderman v. commissioner, 55 t.c. 662 (1971); rev. rul. 68-629, 1968-2 c.b. 154. 9. lessinger v. commissioner, 85 t.c. 824 (1985), rev'd, 872 f.2d 519 (1989). ivol. 2:5 zero basis hoar rather, the court employed a more novel theory: by assuming debts in exchange for sol's obligation, the corporation incurred a cost and thereby acquired a basis (apparently under section 1012) in the obligation equal to its face amount. finding that to be the basis referred to in section 357(c), the court concluded that the corporation did not assume debt in excess of its basis for the transferred property. as virtually all commentators have pointed out," the second circuit's analysis is surely incorrect. the section 357(c) debt-over-basis comparison refers to sol's basis for the property, not to a cost basis obtained by the corporation. the corporation could obtain a cost basis for the obligation under section 1012 only if the obligation's transfer were excluded from the section 351 exchange; under section 362(a), the corporation takes a carryover of the shareholder's basis, not a cost basis, for property received in a section 351 exchange. presumably, the obligation could be outside the section 351 exchange only if it is not "property" to which that section applies. but, if the obligation is excluded from the section 351 exchange, it is also excluded from the section 357(c) debt-over-basis computation because that computation includes only the basis of property transferred in the section 351 exchange." thus, even if one believes that the nonrecognition result in lessinger is desirable on policy grounds, it requires a better justification than the second circuit provided. as discussed below, the view that sol had basis in his own obligation is not a better justification. the result in lessinger may be reasonable. in substance, the corporation did not assume the excess debts if sol's obligation is recognized as bona fide and if it is netted against his debt nominally assumed by the corporation. however, the result probably is not permitted under the statute because the corporation did assume sol's debts, and netting is not justified because sol did not prove that he intended to remain liable for the excess debts. in the absence of such proof, sol's obligation should be disregarded for purposes of section 357(c); it is not "property," with or without basis, and it does not reduce the amount of debts assumed or to which transferred property is subject. on different and stronger facts, shareholders whose actions better reflect an intent to remain liable on their debts should be able to escape section 357(c) gain recognition, without relying on either the second circuit's dubious approach or the equally dubious theory that an obligation has basis in the obligor's hands. the sounder justification for a taxpayer victory in such cases would be proof that there has been no debt assumption and no transfer 10. see, e.g., john a. bogdanski. closely held corporations: shareholder debt, corporate debt: lessons from leavitt and lessinger, 16 j. corp. tax'n 348, 352 (1990) (labeling the second circuit's reasoning -preposterous"). 11. irc § 357(c)(1). 19941 florida tax review subject to debt because the shareholders are found to have a continuing obligation to pay their debts. the broader issue of how a transferor's obligation should generally be treated under section 351 (regardless of whether section 357(c) applies) is particularly confused. the service and the tax court indicate (but without a bold display of confidence) that the obligation is section 351 "property., ' 12 that is an erroneous analysis, which only accidentally happens to produce some results that are defensible under the following analysis (such as no immediate basis in stock on account of the transferor's obligation). characterizing the obligation as property diverts attention from a preferable characterization: a purchase money obligation. the principal implication of the latter characterization is that it provides a section 1012 cost basis for the stock acquired in exchange for it unless it is considered contingent. if it is contingent, the obligation represents an open transaction for which treatment as section 351 "property" may be a serviceable proxy, so long as we understand that proxy's limitations. while the justification for treating the obligation as contingent is not clear cut, this treatment is far more satisfying than the zero-basis-property approach. ii. is the lessinger result desirable as a matter of policy? does the lessinger result frustrate the purposes of section 357(c)?"3 it does not if one treats the transferor's obligation as undoing the debt assumption and if one ignores the administrative difficulties of determining whether related party transactions are bona fide. the abuses at which section 12. cf. gemini twin fund iii v. commissioner, 62 t.c. memo (cch) 104, t.c. memo (p-h) $ 91,315 (1991) (assuming that a partner's contribution was "property" and calling it "only a contractual obligation"). 13. the fleming and brewer articles, supra note 2, reflect a general lack of sympathy for the goals of § 357(c). this is even clearer in professor fleming's earlier article, the highly avoidable section 357(c): a case study in traps for the unwary and some positive thoughts about negative basis, 16 j. of corp. l. 1 (1990). while § 357(c) may be a trap for the unwary, that is hardly grounds to repeal it; as brewer noted, much of the code can be similarly characterized. fleming argues that if § 357(c) is aimed at loan recapture it operates improperly because it does not require recognition of the entire loan amount but only the part that exceeds basis. he does not understand why the transferor's basis should protect him from taxation on a loan that the corporation will repay. however, when property is sold subject to a mortgage, gain is realized only to the extent the sum of the mortgage and any other consideration received by the seller exceeds the property's basis. in other words, in the case of a sale, as under § 357(c), the original exclusion of the loan proceeds from income is reversed only to the extent the mortgage is not covered by basis. in any event, i will not go further here in defending § 357(c) except to illustrate in the text the classic abuses that it is or should be intended to curb. [vol 2:5 zero basis hoar 357(c) aims probably do not exist if the parties intend that the transferor will pay the debt that the corporation nominally assumes or takes property subject to. the second circuit and many of the commentators apparently agree. although the reasons for its enactment are unclear, 4 section 357(c) can be viewed as aimed at two abuses.' 5 those abuses are illustrated below, together with an analysis of how the addition of the transferor's obligation can ameliorate the abuses. pre-transfer borrowing abuse: transferor t borrows and pockets $75. shortly thereafter, t transfers property worth $100, basis of $50, to newly formed x corp. in exchange for all of the x stock and x's assumption of the $75 debt, from which t is released. these transactions reach the same economic results as if t had incorporated the property unencumbered and the $75 had been borrowed by x and distributed to t. in the latter case, if x has no earnings and profits for its first taxable year, $50 of the distribution would be characterized by section 301(c)(2) as a return of basis, and $25 would be gain to t under section 301(c)(3). under section 357(c), t gets the same result in the original illustration." in the distribution alternative, if t also issues a note to x promising to pay $25, it appears that $25 of the corporation's payment to t is a loan, and the corporation has distributed only $50, reducing ts stock basis to zero. 1 7 if ts note is worth $25, the stock should be worth $50, and the $50 of gain that t avoided 14. the early legislative history is not illuminating. s. rep. no. 1622, 83d cong., 2d sess. 270 (1954), reprinted in 1954 u.s.c.c.a.n. 4621, 4908. 15. see s. rep. no. 1263, 95th cong.. 2d sess. 183-84 (1978). reprinted in 1978 u.s.c.c.a.n. 6761, 6946 (confirming the dual aim of § 357(c)): wiebusch v. commissioner, 59 t.c. 777, 781 (stating that § 357(c) is intended to recapture depreciation or tax-free cash), aff'd, 487 f.2d 515 (8th cir. 1973). 16. section 357(b) could apply instead if the debt assumption were found to have no bona fide business purpose. when § 357(b) applies, the transferor is deemed to receive money equal to the debt assumed. in the example. § 357(b) would cause t to recognize gain of $50 (lesser of the realized gain of s50 or the boot deemed received of s75). it might seem that § 357(c) is inappropriately less harsh on the transferor. the difference in treatment can be explained by (1) the lack of business purpose causing the exchange to be subject to § 357(b), (2) the aim of § 357(b) to reverse § 357(a) and thus to treat the entire debt assumption as cash, and (3) the view that § 357(c) is partly aimed at avoiding negative basis plus recognition of the minimum amount of gain required by the rationale of commissioner v. tufts, 461 u.s. 300 (1983). see boris i. bittker & james s. eustice, federal income taxation of corporations and shareholders i 3.0614][al n. 138 (6th ed. 1994). furthermore, § 357(c) can require gain recognition where § 357(b) could not: when there is no gain realized on the property disposition but the debt assumed still exceeds the basis of property transferred. 17. cf. regs. § 1.301-1(j) (providing partial distribution treatment for sale to shareholder at less than fair market value). 19941 florida tax review recognizing on the incorporation is deferred but not escaped. the lessinger decision reaches that result. in effect, t remains liable on $25 of his original $75 debt and, arguably, only $50 should be considered assumed by the corporation. pre-transfer depreciation abuse: t buys depreciable property for $100, paying $25 in cash and issuing a purchase money note for $75. after taking $50 of depreciation, t transfers the property to newly formed x corp. in exchange for all of the x stock, and x assumes t's debt of $75, from which t is released. t's depreciation was determined from a basis of $100 on the presumption that t would eventually pay $100 for the property. the transfer contradicts the presumption by shifting the debt to x, and the amount by which the depreciation of $50 exceeds t's actual investment of $25 should be recaptured as income to t.18 section 357(c) accomplishes this recapture, and t takes the stock with a zero basis. if, in addition to the property, t gives to x a note by which t promises to pay $25, t should arguably not recognize $25 of gain because x will pay only $50 of t's debt. in effect, t remains liable on $25 of his original $75 note, and ts presumed investment ($25 already paid and $25 to be paid on the note) does not exceed the depreciation allowed. these examples show that congress either was, or reasonably could have been, concerned with t effectively receiving cash from the corporation without the recognition that normally attends distributions or with t enjoying deductions without ever paying for them in cash or by gain recognition. t's eventual recognition of this gain could have been arranged by providing a negative basis of $25 for the stock received, but congress chose not to permit that deferral, probably for either fiscal or administrative reasons. 9 as shown above, the targeted abuses can disappear if t remains liable for part of the debt. t has merely obtained a continued deferral of his gain, at the price of his continued promise to pay. similarly, the second circuit evidently did not believe that sol had benefitted economically by the corporation's debt assumption; instead of being relieved of debt, sol remained liable, albeit to a different creditor. 18. see crane v. commissioner, 331 u.s. 1 (1947) (holding that debt to which a buyer took subject was included in the seller's amount realized because the debt was included in the seller's basis in determining depreciation for prior years). 19. see generally george cooper, negative basis, 75 harv. l. rev. 1352, 1358-60 (1962) (discussing the legislative history of § 357(c)). [vol 2:5 zero basis hoar if sol's obligation was bona fide, the second circuit surely was right in principle because sol was simply taking advantage of the rule that the proceeds of borrowing are not income.the borrowing was either sol's original borrowing of cash or his original purchase money forbearance. that the creditor changed (or sol became also liable to his corporation) should not change the substance of his borrowing. some commentators have defended the government's contrary view as based on a reasonable concern about the bona fides of obligations such as sol's.2 however, the concern seems inapt because these obligations are simply a subset of shareholder-to-corporation liabilities generally. every controlling shareholder of every corporation in america can borrow most of the corporate cash on any day of the year by the simple expedient of giving a note (and usually by just creating a book receivable, as sol did). such loans are occasionally reclassified as distributions, but the government audits for them, and the cases are replete with both government and taxpayer victories. 2 the government has not attacked the abuses by taxing all shareholder loans as distributions. -3 there is a troubling difference between a loan to a shareholder and a substitution of the controlled corporation for an outside creditor. in the reported cases under section 357(c), it does not appear that the obligation given by the transferor had any business purpose,-' aside from a desire to tidy up the corporate balance sheet. the normal shareholder loan is at least designed to get the cash. compounding this aura of tax avoidance (by deferral) is the fact that the issuance of the transferor's obligation seems suspiciously inconsistent with other parts of the transaction, thus possibly supporting a particular 20. see rev. rul. 72-2, 1972-1 c.b. 19. 20. see generally commissioner v. glenshaw glass co., 348 u.s. 426, 431 (1955) (defining income as an accession to wealth). see also commissioner v. tufts, 461 u.s. 300, 307 (1983) (discussing whether loan proceeds are gross income); brewer ii, supra note 2. at 1619 (dismissing the tufts discussion of loan proceeds as dictum); deborah a. geier, tufts and the evolution of debt-discharge theory, 1 fla. tax rev. 115, 124-25 (1992) (noting that the treatment of the nonrecourse loan as a "true loan" that was not recognized as income upon receipt is the foundation of the tufts opinion). 21. see, e.g., elliott manning, the issuer's paper property or what? zero basis and other income tax mysteries, 39 tax l. rev. 159, 193-97 (1984). 22. see bittker & eustice, supra note 16. at 1 8.05161. 23. see babette b. barton, economic fables/tax-related foibles: on the "'cost" of promissory notes, guarantees, contingent liabilities and nonrecourse loans. 45 tax. l. rev. 471, 481 (1990). 24. cf. rev. rul. 55-36, 1955-1 c.b. 340 (imposing a business purpose requirement on § 351 exchanges). however, possible business purposes might include avoiding bifurcating liability for debts that should be assumed by the corporation upon incorporation of a going business. see part iv.c.5 below. 1994] florida tax review concern about whether the obligation will be paid. for example, sol caused his corporation to affirmatively assume his debts. why would he have done that if the parties intended that he retain the liability? why shift sol's liability to the corporation, refocusing the outside creditor on the corporation? an obvious answer is that sol wanted the corporation to pay the debts in the future without causing a constructive distribution to sol.25 if the transferor is obligated to and does reimburse the corporation not later than when the corporation pays the creditor, perhaps there is no economic benefit to the transferor, but the terms of the transferors' obligations in the reported cases have not closely mirrored the outside debt. for example, the book entry in lessinger did not specify a time at which sol was required to pay the corporation. the suspicion is that an uncircumscribed extension of liability for sol has been arranged. for another suspicious example, the transferor might not cause the corporation to assume debt, but the corporation might take the transferred property subject to debt, which the transferor attempts to offset by issuing a note. as discussed in part iv.c below, even the tax court should rule for the transferor if the transaction is structured as a wrapped mortgage, wherein the transferor remains contractually obligated to pay the outside lender and does so. aside from the paperwork, why would the transferor not use the wraparound debt format if his intent is to pay the debt? the cases have not involved a transferor properly documenting and paying a wrapped mortgage; rather, transferors have shifted creditors, exchanging an arms length lender for a related lender that can be expected to be kinder and gentler. these concerns loom larger if the lessinger result is justified by a theory that accords basis to an obligation in the obligor's hands. as illustrated in part iii below, that theory is contrary to normal tax logic. the focus of section 357(c) is to snare debt assumed or taken subject to in amounts exceeding the basis of the transferred property. the proper balancing of these concerns with the true economics of the cases should therefore cause taxpayers to try more accurately to distinguish debts that are assumed or taken subject to from debts with respect to which transferor retains liability. there are ways, not so heavily freighted with a tax avoidance aura, by which shareholders such as sol can avoid section 357(c) recognition, albeit by turning square corners in proving that their debts have not been assumed or taken subject to. thus, the result reached by the second circuit in lessinger accords with good tax policy if one believes the transfer of sol's obligation proved 25. see bittker & eustice, supra note 16, at t 3.06[2]. instead, the tax detriment to sol (future income recognition) was accomplished by the stock basis reduction that attended the initial debt assumption. see irc § 358(d)(1). [vol. 2:5 zero basis hoax the corporation did not assume his debts. but the corporation did assume sol's debts, and the tax court properly expressed serious doubts about the bona fides of the account receivable from sol. thus, the lessinger case does not involve a zero basis hoax so much as a failure of proof. ill. what has zero basis to do with lessinger? a. zero basis has nothing to do with the correct answer in lessinger zero basis should play no role in the analysis under section 357(c) of a transferor's obligation. the lessinger result, if justifiable, should flow from the fundamental rule that sol can borrow without realization because he is obligated to repay the debt, not because sol had a basis in his own obligation. it is true that the section 357(c) gain would disappear if sol's obligation were treated as property for purposes of section 351 and if it were accorded basis equal to its face amount. as discussed in section b below, according basis to sol's obligation in sol's hands is tax-illogical. there is, however, a kernel of truth at the core of the anti-zero basis argument: the issuance of an obligation in exchange for property normally produces basis in the property equal to the amount of the obligation. 6 perhaps, that result should obtain even when the obligation is given at the same time as a section 351 exchange, as discussed in part v below. but this approach would not prevent section 357(c) gain recognition. assume t issues a $50 note to a wholly owned corporation, and simultaneously transfers to the corporation land worth $100, subject to debt of $50 and having a basis of $25; t receives in exchange 100 shares of the corporation's stock. if one half of the stock is deemed received for the land and the other half for the note, t might have a cost basis of $50 for the latter shares. if so, the exchange of the note for these shares cannot be governed by sections 351 and 358, which do not provide a cost basis in stock, but must be governed by section 1012. thus, under this approach, the obligation is not section 351 "property," and the exchange of the note for stock is not part of the section 351 exchange, which consists of the exchange of the land, subject to the debt, for the other 50 shares. in the section 351 exchange, the debt assumed ($50) exceeds the basis of the transferred property ($25) by s25, which section 357(c) requires that transferor recognize as gain. 26. see, e.g., brewer, supra note 2. at 460. however. the basis acquired for purchase money debt may not equal the debt's face amount if the debt carries original issue discount. 19941 florida tax review b. zero basis is correct if the obligation is section 351 property because the section 357(c) problem is not solved by treating the transferor's obligation as given in a purchase transaction yielding a cost basis in stock under section 1012, as illustrated in section a above, some have agreed with the tentative position of the service and the tax court that the obligation should be viewed as "property" for section 351 purposes.27 they disagree with the position that the obligation has a zero basis and argue that the obligation has its own positive cost basis to the obligor. the argument goes that (1) the obligor incurs a cost in obligating himself to pay,28 (2) this cost is reflected in the basis acquired in property bought for debt, and (3) the obligation must therefore have basis to the obligor (as evidenced by the lack of section 1001 gain recognition by the obligor on issuing an obligation). each step of this proof is faulty.29 the view that the obligation is property in the obligor's hands, the sale or other disposition of which produces section 1001 gain or loss, has been rebuffed in a definitive 1984 article by professor manning." instead, as shown in part v below, the normal role of the issuance of an obligation is not as a property disposition but as evidence of section 1012 cost. in the section 357(c) context, manning proposes viewing the obligation as an open purchase transaction that will provide stock basis to the transferor when it is paid in cash.3 this approach seems correct and is further explained by viewing the obligation as contingent, as discussed in part v.c below. even if the obligation were property in the obligor's hands, the obligor does not acquire the obligation in exchange for promising to pay it. therefore, it cannot be said that the obligor has a section 1012 cost basis in 27. see alderman v. commissioner, 55 t.c. 662 (1971) (refraining from calling the note property, but grounding the result in its zero basis); rev. rul. 68-629, 1968-2 c.b. 154 (same). see also gemini twin fund iii v. commissioner, 62 t.c. memo (cch) 104, 107, t.c. memo (p-h) 91,315 (1991) (assuming for purposes of petitioner's argument that note contributed to partnership was property, but stating that it was "only a contractual obligation to the partnership"), aff'd, 8 f.3d 26 (9th cir. 1993). 28. see barton, supra note 23, at 479 (arguing that the maker's economic cost in executing a note makes zero basis therein "fallacious"). however, as explained below, barton's reliance on economic cost and cash equivalence fails to explain why sol's obligation should be treated as property with basis to sol. 29. see brewer ii, supra note 2, at 1619 (clarifying his view that assigning basis to the transferor's obligation is only a second-best solution). 30. manning, supra note 21, at 195. but see irc § 31 l(b)(l)(a) ("if a corporation distributes property (other than an obligation of such corporation) .... "). 31. manning, supra note 21, at 193-95. cf. rev. rul. 80-235, 1980-2 c.b. 229 (indicating that basis in partnership interest increases as partner pays his note); jeremiah luxemburger & mark s. lange, an "open transaction" analysis of promissory note transactions among partners, their partnerships, and third persons, 8 va. tax rev. 1 (1988). [vol 2:5 zero basis hoar the obligation.3 2 furthermore, the fact that the issuance of an obligation creates basis in the property received in exchange does not mean that the obligation had basis. rather, it means that the tax law assumes the obligation will be paid and thus allows advance (often depreciable) basis for the promise of future payment,3 3 despite the normal inability of a cash method taxpayer to obtain a deduction by issuing an obligation. the only theoretically possible way for the obligation to have basis to the obligor would be for its issuance to be a taxable exchange of property for property, which it is not.furthermore, it is not necessary to give the obligor basis for the obligation in order to prevent the obligor from recognizing gain under section 1001 on the obligation's issuance.3 5 even if the obligation is treated as property exchanged for other property, there is no accession to the obligor's wealth, and thus no income, because the value received is offset by the obligation to pay.36 thus, the fundamental absence of income precludes the applicability of the gain computation rule of section 1001, which does not itself define income realization events.37 32. a general principle of unadjusted basis can be stated as follows: an owner's unadjusted basis in property should equal its value when received, or the value of the property exchanged for it, which amount was or will be included in the gross income of the owner or an alter ego of the owner. see jasper l. cummings. jr., the silent policies of conservation and cloning of tax basis and their corporate applications. 48 tax l. rev. 113, 119-20 (1992). 33. see commissioner v. tufts, 461 u.s. 300. 307-08 (1983) ("because of the obligation to repay, the taxpayer is entitled to include the amount of the loan in computing his basis in the property. ); mayerson v. commissioner, 47 t.c. 340. 352 (1966) ("'he effect of such a policy is to give the taxpayer an advance credit for the amount of the mortgage. this appears to be reasonable since it can be assumed that a capital investment in the amount of the mortgage will eventually occur despite the absence of personal liability."). acq., 1969-2 c.b. xxiv. cf. estate of franklin v. commissioner, 544 f.2d 1045 (9th cir. 1976) (holding that purchase money debt cannot be included in basis if it is not economically reasonable for the purchaser to pay the debt); estate of isaacson v. commissioner, 860 f.2d 55 (2d cir. 1988) (following franklin and denying all depreciation deductions): pleasant summit land corp. v. commissioner, 863 f.2d 263 (3d cir. 1988) (including excessive nonrecourse debt in basis up to value of property), cert. denied sub nom. commissioner v. prussin, 493 u.s. 901 (1989). 34. for example, if t exchanges land with a zero basis and a slo0 value for a car worth $100, t recognizes the $i00 of gain built into the land. arguably, at the moment of the transfer, the land takes a basis of $100 to t, deriving from the s100 gain recognition. in contrast, a taxpayer does not realize gain in issuing an obligation, and therefore cannot claim that giving the obligation invests it with basis, even for an instant. 35. but see brewer, supra note 2. at 459. 36. see commissioner v. glenshaw glass co.. 348 u.s. 426 t1955) (defining income as accession to wealth); rev. rul. 72-2. 1972-1 c.b. 19 (holding that taxpayer realized no income on borrowing money). 37. see t.d. 7741, 1981-1 c.b. 430, 431 (describing the § 1001 regulations, and declining to define "disposition" as being beyond the scope of § 1001). 19941 florida tax review most importantly, as i have argued elsewhere, 38 basis (here in one's obligation) cannot be created without a related income realization, immediate or deferred, either by the taxpayer or an alter ego. basis in property acquired in exchange for a purchase money obligation does not contradict this principle because the cash needed to pay the obligation cannot be acquired without recognition of income, when the cash is received or at some earlier or later time, either by the taxpayer or an alter ego.39 arguably, if the transferor in a section 351 exchange issues an obligation offsetting debt assumed by the corporation in excess of the transferred property's basis, the transferor should not recognize section 357(c) gain, by virtue of the same sort of advance credit for anticipated future payment that a property purchaser gets in the form of basis credit. that argument has force if the transferor's obligation amounts to a debt retention that conforms with the code's particularized requirement in section 357(c), which asks: has the corporation assumed or taken property subject to the transferor's debts? if it has, it appears that congress has chosen (as discussed in part v) to bifurcate the transferor's obligation from the section 351/357 property exchange and debt assumption in order to close that transaction for section 357(c) gain recognition purposes at the time of the transfer. iv. how can the lessinger result be justified? a. overview on the facts of lessinger, the code seems to require gain recognition in a situation where the second circuit evidently believed that no income had been realized. section 357(c) refers to an exchange-the section 351 exchange-that the court found to have occurred. the section further refers to the property transferred in that exchange, its basis to the transferor, and the liabilities of the transferor that are assumed or taken subject to by the corporation. this statutory language seems to make no provision for an obligation issued by the transferor unless the obligation is property transferred in the exchange or the obligation reduces the liabilities assumed or to which transferred property is subject. we already have seen that treating the obligation as property transferred in the section 351 exchange is illogical and does not eliminate the section 357(c) gain because the transferor/obligor cannot have a basis for the obligation. for section 357(c) purposes, the obligation should either be 38. see cummings, supra note 32, at 119-20. 39. if the property is transferred in discharge of the obligation, the amount of the obligation is included in determining gain or loss on the transfer. see regs. § 1.1001-2(c) ex. 7; commissioner v. tufts, 461 u.s. 300 (1983). [vol 2:5 zero basis hoar viewed as a bona fide obligation of the transferor to retain debt nominally assumed or taken subject to by the corporation or viewed as extraneous to the section 351 exchange (because it is not property). if it is viewed as a bona fide debt retention by the transferor, it can reduce the liabilities assumed or taken subject to, which can reduce the section 357(c) gain and reduce the stock basis reduction that otherwise would occur under section 358(d). however, the alternative cash analogy justification for giving effect to a transferor's obligation is not satisfactory. b. the cash analogy it has been argued that "a buyer who acquires property with seller financing is effectively treated as if she had borrowed the financed amount from the seller and then paid it to the seller in cash." " ' recharacterizing the lessinger transaction in this way-as though sol had borrowed cash from the corporation equal to the amount of his obligation and had included this cash among the property transferred to the corporation-would avoid section 357(c) by increasing the basis end of the debt-in-excess-of-basis computation by the amount of cash so deemed transferred. however, this analogy does not provide a reasoned basis for the result in lessinger.41' the issuance of a note for property is treated for some computational and illustrative purposes like borrowing cash from the seller and paying the cash back.42 for example, in its often-cited decision in mayerson v. commissioner,u the tax court stated that a purchaser giving purchase money debt should get the same basis in the acquired property as one who borrowed from a third party in order to pay cash for property. the policy at work in mayerson, however, is that debt gives basis because the law assumes it will be paid;' the cash analogy is a mere illustration. furthermore, as applied in lessinger, the cash analogy runs counter to the fundamental (if sometimes conflicting) principles of integrating step transactions,45 seeking substance over form,46 holding taxpayers to their 40. fleming, supra note 2, at 812. 41. see generally cummings. supra note 32. at 143-52 (discussing and rejecting the cash analogy as used to explain certain deductions allowed to corporations on issuing their own stock). see also brewer ii, supra note 2, at 1617 (agreeing that the cash analogy does not provide a sound basis for the lessinger result). 42. see, e.g., commissioner v. tufts. 461 u.s. 300, 312 (1983) (using an "'as if cash" analogy to support a decision made on other grounds): united states v. hendler, 303 u.s. 564, 566 (1938) ("its gain was as real and substantial as if the money had been paid it and then paid over by it to its creditors.") 43. 47 t.c. 340, 349 (1966). acq., 1969-2 c.b. xxiv. 44. mayerson, 47 t.c. at 349, 352. 45. see bittker & eustice, supra note 16. at i 1.051211d1. 19941 florida tax review chosen forms, 4 7 rejecting transitory steps (particularly in borrowing transactions),4" and rejecting conduct not undertaken for a business purpose.49 in fact, there was no cash; the corporation may not have had cash that it could have loaned, and sol may not have been able to borrow from another partyi 0 the substance in lessinger is the form: sol promised to pay the corporation in the future." a variation of the cash analogy is the argument that the transferor should get the same result from issuing a note to the corporation as from borrowing the cash from a third person and contributing it to the corporation.52 this formulation shows that the heart of the cash analogy argument as applied to lessinger is that a note should be treated the same as cash." however, the two cases are not equivalent because in one the corporation has the cash and in the other it does not. there is, however, a possible equiva46. id. at 1.05[21[b]. 47. see united states v. morris & essex r.r., 135 f.2d 711, 713 (2d cir.), cert. denied, 320 u.s. 754 (1943). 48. for example, if a debtor purports to pay interest by borrowing an amount equal to the interest from the creditor and immediately paying this amount to the creditor as interest, the interest is not considered paid (and therefore is not deductible if the debtor uses the cash method of accounting) because the borrowing and payment change the form of the interest obligation without changing its substance. see rubnitz v. commissioner, 67 t.c. 621, 629 (1977). 49. see 1 boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts 4.3.5 (2d ed. 1990). 50. cf. commissioner v. national alfalfa dehydrating & milling co., 417 u.s. 134, 148 (1974) (refusing to treat a corporation's issuance of $50 bonds for its stock (worth $33) as if the corporation had sold the $50 bonds for $33 cash and used the cash to buy the stock, saying that this recharacterization "would require rejection of the established tax principle that a transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred"). 51. a classic case in which the supreme court rejected the cash analogy is helvering v. price, 309 u.s. 409 (1940). a cash method taxpayer, who had made good on a guarantee by giving his note, deducted the note amount as a loss. the fourth circuit sustained the deduction, reasoning that giving the note was equivalent to borrowing and using the borrowed funds to pay cash and stating that transactions having identical business results should not have divergent tax treatment. price v. commissioner, 106 f.2d 336 (4th cir. 1939), rev'd, 309 u.s. 409 (1940). the supreme court disagreed, properly so because such divergence does exist. "deductions are regularly allowed for business expenses paid with borrowed funds, provided the funds are not borrowed from the person to whom payment is made .... 4 bittker & lokken, supra note 49, at t 105.3.4, p. 105-60. see also don e. williams co. v. commissioner, 429 u.s. 569 (1977) (holding that giving a note to a qualified plan was not payment). 52. see fleming, supra note 2. 53. fleming, supra note 13, at 14 (describing the difference as "economically insignificant"). [vol 2:5 zero basis hoar lence: that in both cases the corporation has not assumed sol's debt, as discussed below. c. the proper justification 1. overview.-the correct analysis of lessinger is that the transferor's obligation is not property for purposes of section 351 and that the obligation (or, more importantly, some more convincing contractual arrangement) is relevant to the section 357(c) computation only if it reduces the transferor's liabilities assumed or taken subject to " if one piece of paper says the transferred property is subject to a $100 liability of sol lessinger and another piece of paper says that sol will pay that $100 liability, there is in substance no debt assumption or taking of property subject to debt if sol's obligation is bona fide. the important question is how to identify the cases to which this approach should apply. the most common fact patterns are described below. 2. transferor, who is personally liable on the debt, transfers property to the corporation subject to the debt, but is not released from personal liability; the corporation does not assume the debt.-at least one case, owen v. commissioner,55 holds that section 357(c) requires gain recognition on these facts because the corporation received property subject to debt. the court rejected the transferor's argument that section 357(c) only applies when the transferor realizes an economic benefit from the transfer.56 while the transferor remained liable to the outside creditors, he made no promise to the corporation to pay the debt. whether a transfer is subject to debt should not be determined so mechanically. the determination should depend on whether, in light of all of the interrelated legal obligations, the parties intend to condition the corporation's ownership on its payment of the debt as it falls due. the corporation's assumption of or taking subject to the debt is evidence that the parties intended the corporation to pay the debt, and a court should require convincing evidence to justify the contrary conclusion that they intended the transferor to pay. in owen, the court states that it is not relevant whether the transferor realizes economic benefit from the corporation's assumption of or taking subject to the transferor's debt. this idea apparently derives from rosen v. 54. this possibility is mentioned in passing, but not pursued. in brewer. supra note 2, at 459. it was first discussed in detail in bittker & eustice, supra note 16, at u1 3.06121, [4][b]. 55. 881 f.2d 832 (9th cir. 1989), cert. denied, 493 u.s. 1070 (1990). 56. id. at 835. 19941 florida tax review commissioner," which involved an assumed recourse debt to which the transferred property was not subject. while the transferor intended that the corporation pay the debt from the proceeds of a stock offering, the offering never occurred, and the transferor ultimately paid the debt. the tax court stated: "section 357(c) may even result in the realization of a gain for tax purposes where none in fact exists. however, the petitioner did not contend, and the court is loath to find, that the result exceeds the constitutional powers to tax vested in the congress. 58 in a footnote, the court stated that in enacting section 357(c), "the congress intended to deal with the case where the transferor takes the deduction for depreciation on account of assets purchased with borrowed funds and the transferee repays the loan. its effect is analogous to other recapture provisions in the code."59 in rosen, the corporation assumed the debts, and the intention was that the corporation pay the debts. therefore, the discussion of whether the transferor realized economic gain at the time of the section 351 exchange is dictum. furthermore, the legislative history cited in the footnote does not support the gratuitous statement that a transfer without gain can be taxed,' and the footnote itself states that the "transferee repays the loan," which surely results in economic gain. thus, rosen does not stand for the proposition that section 357(c) applies without regard to whether the transferor enjoys economic benefit. at most, it refers to the rule (not there applicable) that under crane and tufts, a transferor's amount realized includes even nonrecourse purchase money debt to which property is actually subject upon disposition, regardless of economic benefit to the transferor.6 similarly, the other cases cited by owen do not support disregard of economic benefit. in smith v. commissioner,6" the court stated that section 357(c) applies whether or not the transferor is released from personal liability. the taxpayer in smith transferred property subject to nonrecourse debt but agreed with the corporation that, as between them, he would be liable for the debt. despite the undertaking, the corporation made some of the payments on the nonrecourse debt. the court discounted the transferor's undertaking and 57. 62 t.c. 11 (1974), aff'd, 515 f.2d 507 (3d cir. 1975). 58. id. at 19. 59. id. at 19 n.3 (cites to 1954 code leg. history omitted). 60. s. rep. no. 1622, 83d cong., 2d sess. 270 (1954), reprinted in 1954 u.s.c.c.a.n. 4621, 4908; h. rep. no. 1337, 83d cong., 2d sess. a129 (1954). reprinted in 1954 u.s.c.c.a.n. 4017, 4266. 61. commissioner v. tufts, 461 u.s. 300 (1983); crane v. commissioner, 331 u.s. 1 (1947). phantom gain can seem to result because the seller receives neither cash nor discharge of personal liability on debt. 62. 84 t.c. 889, 909 (1985), aff'd, 805 f.2d 1073 (d.c. cir. 1986). [vol 2:5 zero basis hoar relied instead on a literal reading of "subject to," quoting a property law text for the proposition that "[glenerally, a transfer subject to a mortgage is an agreement that, as between the transferee and the transferor, the debt is to be satisfied out of the land. 63 the opinion implies that the court thought that the parties intended that the corporation pay the debt, despite the transferor's undertaking to pay, and that the transferor merely indemnified the corporation.64 the smith opinion cites rosen, discussed above, and alderman v. commissioner.65 what the aldernan and smith cases have in common is the transferor's promise to the corporation that the transferor will pay the debt and subsequent behavior contradicting that promise.' the court found that the transferor in alderman gave her obligation to the corporation simply for the purpose of balancing the corporate balance sheet, and that during the succeeding eight years, the corporation paid all of the debt from its own funds and the transferor failed to pay her note.67 beaver v. commissioner also evidences the tax court's skepticism of a transferor's claim to have retained liability on debts assumed or taken subject to by the corporation.68 the case involved a recourse debt that was secured by transferred property and presumptively assumed by the corporation. the court found no evidence to support the taxpayer's contention that the debt was not assumed by the corporation. these cases should not be read to hold that it is irrelevant whether the transferred property is in substance subjected to the transferor's debts. they should instead be taken as determinations that these transferors did not prove that they intended to stand for their debts. in the absence of proof by the taxpayer bearing the burden of proof, the courts have let stand the presumption that the owner of property subject to debt will pay the debt. what different facts should produce a different result? even if transferred property is nominally subject to debt, the transferor can prevent the transfer from being considered made subject to the debt by making contractual arrangements with the outside creditor, as well as with the corporation, to pay the debt.69 in other contexts in which tax results depend on whether 63. 84 t.c. at 909. see also crane v. commissioner, 331 u.s. 1, 14 (1947) (referring to "the reality that an owner of property, mortgaged at a figure less than that at which the property will sell, must and will treat the conditions of the mortgage exactly as if they were his personal obligations"). 64. 84 t.c. at 899, 907. 65. 55 t.c. 662 (1971). aldenna is cited in smith at 84 t.c. 909. 66. see smith, 84 t.c. at 909, n. 20 (suggesting that the outside creditor might have had a claim against the transferor, but not deciding that issue). 67. aldennaz, 55 t.c. at 665. 68. 41 t.c. memo (cch) 52, 54, t.c. memo (p-h) 1 80,429 (1980). 69. see generally bittker & eustice, supra note 16. at 'i 3.061411b]. 19941 florida tax review property is transferred subject to debt, authorities support the view that the phrase "subject to" is not to be interpreted literally to encompass every debt that nominally encumbers transferred property.7 ° parallel with that authority, a court can and should find that property transferred in a section 351 transaction is not subject to debt if all of the following conditions are met: (1) the transferor is personally liable to the outside creditor on the debts to which the transferred property is subject and does not cause the corporation to assume the debts; (2) the transferor negates any assumption that would occur presumptively under state law; and (3) the transferor affirmatively contracts with the corporation to pay directly to the creditor the debts to which the transferred property is subject and to exonerate the property from the burden of the debts, and the transferor performs that contract. a. section 1001.-most importantly, the presumption of debt relief should be overcome if the circumstances prevent the debt from being included in the transferor's amount realized for purposes of section 1001. this is so because section 357(c) was intended to apply only to those debts referred to in section 357(a),71 which provides that in an otherwise qualify70. analogous issues arise under several provisions in addition to those discussed in the text. section 1041(a) provides that exchanges between spouses are nontaxable and the basis of the property exchanged carries over to the spouse. section 1041(e), added in 1986, provides that § 1041(a) does not apply when property subject to debt in excess of its basis is transferred to a trust; rather, the transferor recognizes the excess as income. the legislative history gives no clue to the intent behind § 1041(e). h. rep. no. 426, 99th cong. 1st sess. 977 (1985). however, a companion amendment to § 453b(g) provides that the rule allowing installment obligations to be transferred from spouse to spouse without triggering gain recognition does not apply to a transfer to a trust. these two rules seem to reflect a view that the trust is not the spouse and simply seek to impose the normal recognition and application of § 1001. thus, § 1041(e) does not prove that "subject to" debt must inevitably be realized by the property transferor. under § 956, u.s. shareholders of a controlled foreign corporation are taxed on any increase in the amount of the cfc's undistributed earnings that is invested in u.s. property. the amount invested in property is its basis, reduced by liabilities to which it is subject. apparently, the idea is that there has been no repatriation of the cfc's earnings to the extent of the liabilities against the property. however, the regulations provide that the reduction is not allowed if the property is an obligation of a related person and the debt encumbering it is with recourse to the cfc. temp. regs. § 1.956-1(e)(5). see also irc § 312(c) (requiring that the reduction of corporate earnings and profits upon a distribution of property be offset by the amount of debt to which the property is subject); § 336(b) (presuming that the fair market value of property distributed in corporate liquidation is not less than the amount of any liability to which the property is subject). 71. focht v. commissioner, 68 t.c. 223, 233 (1977). see generally douglas a. kahn & dale a. oesterle, a definition of "liabilities" in internal revenue code section 357 and 358(d), 77 mich. l. rev. 461 (1975). in enacting § 357(c)(3), providing that items deductible on payment are not liabilities for purposes of § 357(c), congress stated that it did [vol 2:5 zero basis hoar ing section 351 transaction, the transferee's assumption of a transferor's debts, or the taking of property subject to such debts, is generally not treated as a receipt of money or other property (boot) by the transferor. if a debt is not included in the amount realized under section 1001, it could not be subject to section 357(a) and hence should not be subject to section 357(c). the regulations provide that the amount realized on a disposition of property includes any debt of the transferor that is "discharged" in the transaction.72 moreover, "[t]he sale or other disposition of property that secures a recourse liability discharges the transferor from the liability if another person agrees to pay the liability (whether or not the transferor is in fact released from liability). '73 this sentence implies that if the other person does not agree to pay the liability, the debt is not included in the transferor's amount realized. there appears to be no authority to the contrary. indeed, in the usual case, including the debt to which the property is subject as an amount realized would improperly double up the transferor's income. assume a sells land worth $100, subject to a $60 recourse debt, to b for $100 cash; b does not agree to pay the debt. if the debt were treated as discharged for purposes of section 1001, a would realize $160. clearly, a should be treated as realizing only $100.74 the application of this rule to a section 351 exchange is inherently more difficult because of the control relationship between transferor and transferee. assume transferor t transfers land worth $100, subject to a $60 recourse debt, to newly organized x corp. in exchange for x stock; the corporation does not agree to pay the debt. whether the stock is worth $100 depends on who is intended to pay the debt. this factual question cannot be answered from the objective facts of the case because the corporation does not pay a defined amount for the land. this difficulty of knowing whether debt to which the property is subject enters into the transferor's amount realized probably is the implicit reason why the tax court and the service not thereby limit the meaning of "liabilities" under § 357(a). s. rep. no. 1263, 95th cong., 2d sess. 183, 185 (1978), reprinted in 1978 u.s.c.c.a.n. 6946. 6948. this statement is not inconsistent the view that "liabilities" should generally mean the same thing under § 357(a) and (c), but it probably reflects an intent to retain the greatest possible breadth for the nonrecognition rule of § 357(a). 72. regs. § 1.1001-2(a). 73. regs. § 1.1001-2(a)(4)(ii). 74. see regs. § 15a.453-1(b)(3)tii) (avoiding double counting in the wraparound mortgage case by giving the seller a basis in the wraparound mortgage that reflects the deemed assumed wrapped debt); stonecrest corp. v. commissioner, 24 t.c. 659, 667-68 (1955) (applying § 453 to a wraparound mortgage and observing that the circumstance of controlling importance is whether the wrapped mortgage was considered in determining the purchase price), nonacq., 1956-2 c.b. 11. 19941 florida tax review in effect have adopted a presumption against the transferor in cases like lessinger. b. section 453.-the next most important analogy is the treatment of wraparound mortgages in installment sales. a wraparound mortgage is a mortgage given by a buyer in exchange for property that is already subject to a mortgage. the seller agrees to pay the pre-existing wrapped debt, so that the buyer is not called on to pay twice. for example, property worth $1,000, subject to a mortgage of $400, might be sold for $200 down and the buyer's wraparound note for $800, with the parties agreeing that the seller will pay the wrapped mortgage as it comes due. the installment sales regulations, like section 357(c), use the phrase "subject to." the gain reportable by an installment seller on receipt of an installment payment is the amount of the payment, multiplied by the "gross profit ratio," which is the ratio of the "gross profit" to the "total contract price."75 the "gross profit" is the excess of the "selling price" over the seller's adjusted basis for the property.76 the "selling price" includes any mortgage on the property, "whether assumed or taken subject to by the buyer.'"77 the "total contract price" (the denominator of the gross profit ratio) is the selling price, reduced by most indebtedness "assumed or taken subject to by the buyer," except that the reduction for indebtedness cannot exceed the seller's adjusted basis for the property.78 in applying these rules, the tax court has stated that the customary meaning of the phrase "subject to" excludes debt to which property is nominally subject but that the transferor agrees to pay.79 the court rejected an inflexible definition: while in a sense every sale of mortgaged property is subject to a mortgage since the property remains liable to have the mortgage debt satisfied from it, we think the expression was used in the regulation in its customary meaning, to define the [actual as contrasted with the nominal] obligations of the 75. regs. § 15a.453-1(b)(2)(i). 76. regs. § 15a.453-1(b)(2)(v). 77. regs. § 15a.453-1(b)(2)(ii). 78. regs. § 15a.453-1(b)(2)(iii), (iv). 79. stonecrest, 24 t.c. at 667 ("the expression means that the buyer has no personal obligation to pay the mortgage debt; that, as between seller and buyer, the seller has no obligation to pay the debt; and that the debt is to be satisfied from the property."). [vol 2:5 zero basis hoar parties to a sale of property with respect to the mortgage debt. 80 the tax court followed the supreme court's directive that the customary meanings of words used in the code usually govern.8 the same customary meaning of "subject to" should also apply under section 357(c). in professional equities, inc. v. commissioner,' a decision in which the service subsequently acquiesced, the tax court held that wrapped debt should not be treated as assumed or taken subject to for purposes of determining the total contract price if the following conditions exist: the seller must contract with the buyer to remain liable on the wrapped debt, the buyer must rely solely on that promise for protection from the wrapped debt and must agree to pay the full purchase price to the seller, and the buyer must not serve as an agent for payment of the outside debt."' the court found "no justification for reducing the sales price by the amount of any underlying mortgage in determining the 'contract price' in the denominator, since the buyer neither 'assumed' the underlying mortgage nor took 'subject' to it-the only circumstances set forth in the regulations for any such extraordinary reduction."' further, "[t]he seller in a wraparound sale receives neither 80. id. at 668. see voight v. commissioner, 68 t.c. 99, 111 n.6 (1977) (observing that a statement in the conveyance that the property is "subject to" debt is not dispositive for tax purposes). 81. stonecrest, 24 t.c. at 666 (citing crane v. commissioner. 331 u.s. 1, 6 (1947j). 82. 89 t.c. 165 (1987) (holding regs. § 15a.453-1i(b)(3)(ii) invalid as inconsistent with § 453), acq., 1988-2 c.b. 1. in professional equities, the court stated that where the seller's wrapped debt exceeds the property's basis, it might be reasonable to treat the excess as payment in the year of sale. 89 t.c. at 178 n. 17. this statement has no application to the lessinger scenario, but rather refers to the typical wraparound mortgage case where the buyer is giving debt that replicates the wrapped debt but is not being treated as payment in the year for installment sale purposes. 83. see republic petroleum corp. v. united states, 613 f.2d 518 (5th cir. 1980) (holding that buyer's payments on the wrapped debt were evidence of intent to assume); goodman v. commissioner, 74 t.c. 684, 713-14 (1980) (holding that the buyer took the property subject to the wrapped mortgage because it was obligated to make payments on the purported wraparound mortgage to a bank that applied part of the payment to the wrapped mortgage), affd without published opinion, 673 f.2d 1332 (7th cir. 1981). voight v. commissioner, 68 t.c. 99, 113 (1977) (holding that the purchaser assumed a wrapped mortgage where it was intended to pay the wrapped debt directly to the outside creditor), afrd, 614 f.2d 94 (5th cir. 1980). 84. professional equities, 89 t.c. at 171. the opinion in stonecrest contains extensive discussion of why the property should not be considered sold subject to the wrapped debt. 19941 florida tax review 'current payment nor the practical benefit of current payment of the underlying debt.' "85 the tax court, in dictum in a footnote of a memorandum opinion, has rejected the analogy between section 357(c) and wraparound mortgages under section 453 on the ground that the latter merely deals with timing and not the amount of income.86 this argument is unpersuasive. in both contexts, the question involves the meaning of the phrase "subject to," and the normal meaning should apply in both cases.87 furthermore, a crucial element of the wraparound mortgage treatment is that the seller/transferor's amount realized does not include both the wraparound mortgage and the wrapped mortgage.88 c. section 752(c).-another analogous provision, section 752(c), provides that in determining whether a partner's liabilities have increased or decreased, a liability to which property is subject shall be considered as a liability of the owner of the property. an increase in a partner's share of partnership liabilities is treated as a contribution to the partnership by the partner, and a decrease in liability share is treated as a distribution by the partnership to the partner.8 9 where a partner transfers property to a partnership subject to debt but (as among the partnership and the partners) remains ultimately responsible for paying the debt, the partnership is deemed to make a distribution to the partner in the amount of the debt, and the partner is deemed to make an equal contribution, with the result that there is no net contribution or distribution.9" where a partnership transfers property subject to debt to a person who is not a partner but retains liability for the debt, there is no authority on whether the transaction should have the effect of reducing partnership liability and causing 85. professional equities, 89 t.c. at 179 (quoting hunt v. commissioner, 80 t.c. 1126, 1142-43 (1983)). see also regs. § 1.1274-5(c) (providing that for purposes of the old rules a wraparound mortgage is not treated as an assumption). 86. owen v. commissioner, 53 t.c. memo (cch) 1480, 1484 n.19, t.c. memo (p-h) 87,375 (1987). 87. in united pac. corp. v. commissioner, 39 t.c. 721,728 (1963), the court states: respondent argues that "the purchaser can realistically be regarded as having assumed the mortgage on the property at the time of the sale for federal tax purposes regardless of recitals in the agreements." in the absence of any compelling reasons, we cannot accept this invitation to "realism" which involves a distortion of the agreement of the parties, and which also ignores the established distinctions in real property law in this area which were pointed out in the stonecrest case. 88. see hunt v. commissioner, 80 t.c. 1126, 1144 (1983) (stating that even the commissioner presumably would not require multiple recognition of the same gain). 89. irc § 752(a), (b); regs. § 1.752-1(b), (c). 90. regs. § 1.752-1(g). [vol 2:5 zero basis hoar a deemed distribution to partners. however, the leading commentators have stated that no reduction should occur if, under section 453, the property would not be treated as transferred subject to the debt.' d. section 1031(d).-a final code analogy involves section 1031, under which a taxpayer can exchange property for property of like kind without recognition of gain or loss and with a carryover of the basis of the exchanged property to the acquired property. under section 1031(d), "where as part of the consideration" in a like kind exchange the other party acquires the taxpayer's property subject to debt, the debt amount is treated as money received (boot), and the taxpayer recognizes gain equal to the lesser of the boot or the gain inherent in the exchanged property. 2 the service has ruled, however, that a taxpayer can avoid having the debt amount treated as boot by issuing a note to the other party to the exchange for the amount of the debt to which the transferred property is subject.9 in so ruling, the service necessarily determined that the note offset the debt, eliminating it from the "subject to" category, and that the other party did not in substance assume the burden of the debt. 3. transferor is personally liable and remains personally liable; the corporation assumes the debt.-these appear to have been the facts in alderman, lessinger, and rosen.9 also, because of a presumption under the laws of some states that such assumption automatically occurs on the incorporation of a proprietorship or partnership, several other reported cases involve the same facts.95 normally, the most reasonable conclusion is that the parties intended the most recent undertaking (by the corporation) to be controlling as between them, particularly if the creditors were informed of the assumption. 91. william s. mckee, et al., federal taxation of partnerships and partners 7.01[2] (2d ed. 1990). 92. if the property received in the exchange is also subject to a mortgage, the mortgages are usually netted, and the taxpayer is treated as receiving or giving boot equal to the net decrease or net increase in mortgage liability resulting from the exchange. regs. § 1.1031(d)-l(c). 93. rev. rul. 79-44, 1979-1 c.b. 265. 94. alderman v. commissioner, 55 t.c. 662 (1971); lessinger v. commissioner, 85 t.c. 824, 837 n.8 (1985), rev'd, 872 f.2d 519 (2d cir. 1989); rosen v. commissioner. 62 t.c. 11 (1974), affd, 515 f.2d 507 (3d cir. 1975). 95. christopher v. commissioner, 48 t.c. memo (cch) 663, t.c. memo (p-h) 84,394 (1984) (oklahoma law presumes that the successor of an unincorporated entity assumes the entity's debt); beaver v. commissioner, 41 t.c. memo (cch) 52.54. t.c. memo (p-h) 80,429 (1980) (ohio law presumes that liabilities follow incorporated assets). 19941 florida tax review sol lessinger attempted to reverse the corporate assumption by creating a book receivable. the tax court found for the government on two grounds: that sol's obligation had a zero basis-the ground that has received the most notoriety-but also that the receivable from sol was too artificial to warrant recognition for tax purposes. the court found that under state law, the corporation's assumption of sol's debts occurred five months before the entry of a simple "loan-receivable-sl" on the corporate books. sol did not execute a note or pay any interest. according to the court, the entry did not create a "bona fide asset of the corporation. 96 on facts as dubious as those in lessinger, courts have found that purported borrowings by shareholders from their corporations were dividends.97 similarly, lessinger at the tax court level should be viewed as a failure of proof that sol retained the liability. the facts were somewhat better for the taxpayer in alderman because the transferor gave a written note. 98 however, although the corporation paid the creditors, the transferor failed to service the note for at least eight years after the exchange, providing ample basis for the tax court's refusal to give effect to the note.99 perhaps, a court would find for the taxpayer on facts involving a tightly documented arrangement whereby the corporation formally assumes the debt for some valid business reason but the transferor contracts with the corporation to actually pay the debt as it becomes due and does so, as discussed in part iv.c.5 below. the cumbersomeness of such a scheme belies its wisdom as well as its bona fides. the corporation should not assume the debt if the parties intend that transferor will pay it. 4. transferor is not personally liable but the transferred property is subject to a debt.-section 357(c) appears to apply to this case also because the normal presumption is that the corporation will pay the debt to which the property is subject.'0° however, the transferor could probably avoid section 96. lessinger, 85 t.c. at 837 n.8. 97. see generally bittker & eustice, supra note 16, at 8.05[6]. 98. alderman, 55 t.c. at 662-63. 99. alderman is the fountainhead of the tax court's view that a transferor's obligation should be treated like zero basis property under § 357(c). its authority is somewhat undermined by the fact that it relied on the tax court's earlier decision in raich for the proposition that § 357(c) should be literally interpreted. id. at 665 (quoting raich v. commissioner, 46 t.c. 604, 608 (1966)). the tax court subsequently reversed raich in focht, adopting a nonliteral interpretation excluding from the scope of "liabilities" the payables of a cash method transferor. focht v. commissioner, 68 t.c. 223, 229 (1977), acq., 1980-2 c.b. 1. 100. smith v. commissioner, 84 t.c. 889 (1985), aff'd, 805 f.2d 1073 (d.c. cir. 1986). see also crane v. commissioner, 331 u.s. 1, 14 (1947) (stating that the owner of property mortgaged at less than its value will treat the liability as his own). [vol 2:5 zero basis hoar 357(c) by contracting with the corporation to pay the creditor, as in the wraparound mortgage case under section 453. the case that came closest to addressing this issue was smith.""j d the tax court took a simplistic approach to the "subject to" question, citing only the general presumption that the parties must have agreed that the nonrecourse debt was to be satisfied out of the security. it expressed doubt about the bona fides of the transferor's undertaking to pay the debt by analogizing it to the "pre-incorporation paper transaction" of the aldernam case.v2 the court did not consider the possibility of treating the debt as a wrapped mortgage, but wraparound mortgage treatment as under section 453 was probably precluded by the facts. the court viewed the transferor's undertaking more as an indemnity than a reservation of primary liability on the debt, and the corporation actually made some of the payments on the debt. thus, smith does not preclude a different result on better facts that properly support application of the wraparound mortgage approach. while the wraparound mortgage approach can apply to nonrecourse debt under section 453 without the seller undertaking personal liability to the outside creditor, 0 3 transferors in section 357(c) transactions might consider taking that additional step to stifle possible doubts about the bona fides of the retention of liability. in section 453 cases, those doubts are diminished by the existence of the wraparound mortgage itself because the amount of that mortgage usually supplies ample proof that the buyer did not also intend to pay the wrapped debt.'o° in section 357(c) transactions, the consideration received by the transferor is stock, not a wraparound mortgage. the same preclusive evidence might exist if the stock of the corporation has an ascertainable value apart from the debt assumption. however, where the transferee is a closely held corporation, the value of its stock is likely to depend on whether the parties intend that the corporation pay the debt, and not vice versa. therefore, a formal assumption of the debt by the transferor to the creditor should serve the same evidentiary purpose.'"furthermore, a transferor undertaking personal liability to the outside creditor has a much 101. smith, 84 t.c. at 889. 102. id. at 909. 103. see united pac. corp. v. commissioner, 39 t.c. 721 (1963). 104. see stonecrest corp., v. commissioner, 24 t.c. 659, 667 (19551 ("it has been stated that in determining whether or not a transfer is subject to a mortgage, 'a circumstance which is usually of controlling importance in this regard is whether the mortgage was considered in adjusting the purchase price" '), nonacq.. 1956-2 c.b. 10. 105. support for this approach is found in the regulations governing partnership capital accounts, which permit a partner's capital account to be increased by the partner's assumption of a partnership debt only if the partner assumes a direct personal obligation to the outside creditor, the creditor knows it, and, as between the partner and the partnership, the partner is ultimately liable. regs. § 1.704-1(b)(2)(iv)(c). 19941 florida tax review stronger technical argument because that moves the debt from the nonrecourse to the recourse category vis a vis the creditor,0 6 and the discussion above concerning recourse debt should apply. ' °7 that transferors know how to take such contractual precautions (albeit too late) is evidenced by the owen'08 and smith'0 9 cases, where the shareholders attempted after the fact to create (and backdate) personal liability to the outside creditors and obtain release of security interests. even sol lessinger's obligation was ultimately conveyed to the outside creditor. these transferors' problems lay not in zero basis but in their failure to prove their intent to pay. 5. transferor notes.-in the foregoing discussion, the principal technique advocated for avoiding the impact of section 357(c) is transferor retention of direct liability on debts relating to the transferred property. it is possible, in theory, for direct liability to be retained by the transferor using the corporation as the transferor's paying agent. perhaps this approach should be permitted when there is a business purpose for using it. for example, in many cases, the assumed debts are those of a business being incorporated in the section 351 transaction, and the transferor wants to retain liability for only the amount by which the debts exceed the basis of the transferred assets. for the transferor to retain direct liability for only such a specific amount might be very inconvenient for the transferor and the corporation if it requires, for example, that each party pay portions of particular debts. it might also be confusing to creditors who deal with the business both before and after the incorporation. an appropriate solution to 106. see bressi v. commissioner, 62 t.c. memo (cch) 1668, 1672, t.c. memo (p-h) 91,651 (1991) (defining "nonrecourse" to mean that the lienor may look only to the property and cannot look to the debtor). 107. regulations § 1.1001-2(a)(4)(i) states that the sale of property subject to nonrecourse debt discharges the transferor from the liability, which is therefore included in the amount realized on the sale. this regulation should be read no more literally than § 15a.4531 (b)(3)(ii). the regulation examples make clear that it applies the "subject to" concept. regs. § 1.1001-2(c) exs. 2, 4, 6. if recourse debt encumbering property can be eliminated from the "subject to" category by failing to have the buyer to assume it, nonrecourse debt should have the same treatment. tufts stands for the proposition that recourse and nonrecourse debt should receive the same treatment under § 1001 (although recourse debt discharge can be bifurcated between discharge of indebtedness and sale proceeds, while nonrecourse debt cannot). tufts v. commissioner, 461 u.s. 300, 311-12, reh'g denied, 463 u.s. 1215 (1983). see marvin a. chirelstein, federal income taxation: a law student's guide to the leading cases and concepts 270 (6th ed. 1991) ("in effect, borrowing with personal liability and borrowing without personal liability are to be treated alike for" purposes of § 1001). 108. owen v. commissioner, 881 f.2d 832 (9th cir. 1989), cert. denied, 493 u.s. 1070 (1990). 109. smith, 84 t.c. at 889. [vol 2:5 zero basis hoar these business problems may be for the transferor to make a personal promise to pay the corporation an amount equal to the excess debt and to have the corporation make all payments to the outside creditors. should the transferor be treated as retaining liability for the desired amount if, at the time of the incorporation, the transferor issues a note to the corporation for the amount, the note requires payments roughly parallel to the corporation's obligations under the assumed debts, and the transferor is punctilious in meeting obligations under the note? it seems harsher to deny effect to this arrangement than was the tax court's action in lessinger. nevertheless, it is a borderline, facts dependent case that tests the bounds of the techniques advocated above. v. an obligation given with a section 351 exchange can be characterized as a purchase money obligation to make a contingent contribution to capital a. overview having shown how the section 357(c) problem can be resolved without according basis to the section 351 transferor's obligation, we turn to the broader issue of the basis effects of that obligation, outside the narrow scope of section 357(c). to do so, we must focus on the difference between acquisitions of property by purchase and acquisitions in nonrecognition, substituted basis exchanges. a purchase transaction is one in which property is acquired in a way that obtains for the purchaser a "cost" basis for the property under section 1012. n1 a purchase can be accomplished by the acquiror paying cash, giving a purchase money obligation, exchanging property for property in a taxable transaction, or recognizing the value of the acquired property as income.' for example, property received as compensation for services takes a basis equal to the gross income recognized on the property's receipt (often called a tax cost basis). 12 conversely, in a nonrecognition, substituted basis exchange, the basis in the acquired property is either the exchanged basis of property transferred by the taxpayer or the transferred basis of the other party to the exchange for the property received.'13 we have seen above that an obligation issued by the transferor in a section 351 exchange transaction should not be considered property given in 110. see irc § 338(h)(3) (defining purchase in this manner for purposes of the § 338 election); § 1033(a)(2)(a)(ii) (defining purchase in this manner for purposes of § 1033). 111. see generally cummings, supra note 32. at 118-22. 112. regs. § 1.83-4(b)(1). 113. see irc § 7701(a)(42) (defining "substituted basis property"). 19941 florida tax review that exchange. the alternative is to treat the obligation as a purchase money obligation. indeed, obligations issued for stock outside section 351 are treated as purchase money obligations, as discussed below in part v.b. when the obligation is given with a section 351 exchange, it also can and probably should be treated as given in a type of purchase in which the usual basis acquired by a purchase money obligation is deferred until payment because the obligation is viewed as contingent. the commentators' dislike of zero basis for the transferor's obligation stems principally from the absence of purchase treatment of the transaction. without purchase treatment, phantom gain is built into stock acquired for an obligation in a section 351 exchange, and phantom gain is also built into the obligation in the corporation's hands." 4 assume t receives 100 shares of x corp. stock in exchange for t's $100 note. if the obligation is section 351 "property" with a zero basis and a value of $100, t has a zero basis for the stock and will recognize $100 of gain on selling it for $100. x holds t's obligation with a zero basis and will recognize $100 of gain on factoring it for $100. while this double phantom gain could be eliminated by according basis to the obligation in the obligor's hands equal to the face amount, more fundamentally, this potential gain flows from the failure to treat the issuance of the obligation as a purchase. the reasons for that failure have not been made clear, and therein lies the root of most of the confusion about the lessinger case. b. treatment of obligations issued for stock outside section 351 a transferor who is not a controlling person under section 351 takes a cost basis for stock purchased in exchange for the transferor's obligation, and the corporation's basis for the obligation equals the value of the stock given. 1 5 should these purchase rules also apply when the obligation is 114. thus, brewer focused on problems "outside the section 357(c) context." brewer, supra note 2, at 459. 115. there is little direct authority on non-351 obligation-for-stock exchanges, under general tax principles on purchase money debt, the shareholder should take a cost basis equal to the amount of the note because there is no reason to treat newly issued stock differently from any other type of property. see parker v. delaney, 186 f.2d 455, 458 (1 st cir. 1950), cert. denied, 341 u.s. 926 (1951); mayerson v. commissioner, 47 t.c. 340, 351-52 (1966). the loss limitations, discussed infra part v.c.2, necessarily imply that the stock has basis and that this basis could be deducted as a loss but for the limitations. indirect authority appears in g.c.m. 33937 (sept. 30, 1968), stating that an obligation to make future payments can affect the basis of stock acquired in recognition transactions. general tax principles may be less helpful in determining the corporation's basis for the shareholder's obligation because the issuance of the stock is a nonrecognition transaction [vol 2:5 zero basis hoar given by a section 351 transferor? when appreciated property is transferred in exchange for stock in a section 351 transaction, the property's basis, not its fair market value, becomes the corporation's basis for the property and the shareholder's basis for the stock received in exchange. 16 basis is not stepped up to include gain realized in the exchange because that gain goes unrecognized under the good graces of section 351; the section 351 nonrecognition rule justifies not treating the section 351 exchange as a purchase. however, the nonrecognition rule of section 351 is not the source of the nonrecognition enjoyed by an obligor who issues a note for value. rather, the obligor depends on the more general rule that no gain or loss is realized upon issuance of an obligation. l i7 consequently, there appears to be no reason inherent in the gain-orloss deferral/carryover basis system of sections 351, 358, and 362 for denying a cost basis to a section 351 controlling transferor for stock received in exchange for the transferor's note. furthermore, there are special rules that apply to purchases of stock by exchange of obligation that prevent certain abuses. after reviewing these loss limitation rules, we return in part v.c below to section 351 and show that it can be viewed as precluding the normal purchase treatment of a transferor's obligation, but for another reason. there are other rules that deny the use of a cost basis for stock acquired in exchange for an obligation, but they seem to have little pertinence to the lessinger context. first, when a cash method taxpayer issues a note in a purchase of stock outside section 351, the taxpayer is not allowed to deduct a worthless stock loss on account of basis acquired with that obligation until for the corporation. irc § 1032. the limited authority on the issue indicates that a corporation's basis for property received in exchange for stock equals the stock's fair market value unless the stock is issued in a transaction (such as a § 351 exchange) for which special basis rules are provided. 11t corp. v. united states, 963 f.2d 561 (2d cir. 1992): fx sys. corp. v. commissioner, 79 t.c. 957, 963 (1982): rev. rul. 56-100. 1956-1 c.b. 624. article 833 of regulation 62 under the revenue act of 1921 allowed notes given for stock to be considered as tangible property of the corporation for purposes of computing "invested capital" under the excess profits tax; because increasing "invested capital" also increased a deduction based thereon, many shareholders treated their notes as invested capital. see, e.g., ehret magnesia mfg. co. v. lederer, 273 f. 689 (e.d. pa. 1921). the paucity of authority on the consequences of purchasing stock for notes may stem from the fact that in many states, corporations were historically barred from issuing stock for notes, a limitation that has eased in recent years. see graves, inc. v. commissioner, 202 f.2d 286 (5th cir. 1953) (concerning a mississippi statute that precluded the issuance of stock for debt); model business corp. act ann. § 6.21 (1984); 4 william m. fletcher. fletcher cyclopedia of the law of private corporations § 1599 (penn. ed. rev. vol. 1985). 116. irc §§ 358(a), 362(a). 117. brewer, supra note 2, at 460. 19941 florida tax review it is paid." 8 however, where the stockholder uses the accrual method, worthless stock deductions have been allowed before the shareholder paid the purchase debt to the corporation.1 9 second, the service and the courts have rejected efforts by shareholders of s corporations to obtain additional basis in their stock by contributing their obligations to the corporations or buying more stock for their purchase money obligations. 2 ' the primary reason for this rejection has been that congress requires an "investment" in the s corporation in order to support a loss deduction, and no investment is made by virtue of a shareholder's obligation, even the obligation of an accrual method shareholder. it appears that both the stock loss cases and the s corporation loss cases ultimately derive from application to cash method taxpayers of the principle that a loss cannot be deducted until it is sustained.' where no net loss on stock is involved, however, as where basis simply reduces a larger amount realized, this principle apparently has not inhibited the utilization of basis acquired with a purchase money obligation. furthermore, when stock 118. rev. rul. 74-80, 1974-1 c.b. 117. this rule reflects the principle of helvering v. price, 309 u.s. 409, 413 (1940), that a cash method taxpayer's issuance of a note is not payment sufficient to support a deduction (upon a guarantee, in that case); rather, the deduction is delayed until the note is paid. courts have applied this principle to deny cash method shareholders any deduction for worthless stock bought from other shareholders for debt, until the debt is paid. see tams v. united states, 33 f. supp. 764, 770 (s.d. w.va 1940); miniger v. denman, 15 a.f.t.r. (p-h) 593 (n.d. ohio 1930); boyer v. commissioner, 14 t.c. memo (cch) 350, t.c. memo (p-h) 55,105 (1955); larkin v. commissioner, 46 b.t.a. 213 (1942); estate of spruance v. commissioner, 43 b.t.a. 221, 229 (1941), acq., 1941-1 c.b. 10, rev'd on other grounds sub nom. mcknight v. commissioner, 127 f.2d 572 (5th cir. 1942). 119. n. sobel, inc. v. commissioner, 40 b.t.a. 1263 (1939); g.c.m. 33937 (sept. 30, 1968) (agreeing with sobel). 120. perry v. commissioner, 54 t.c. 1293 (1970), aff'd, 27 a.f.t.r.2d (p-h) 1464 (8th cir. 1971) (denying additional basis even if the shareholder is on the accrual method, due to the peculiar requirements of § 1374); rev. rul. 81-187, 1981-2 c.b. 167 (referring to the shareholder's zero basis). cf. wilson v. commissioner, 62 t.c. memo (cch) 1122, t.c. memo (p-h) 91,554 (1991) (ruling that a shareholder acquired no stock basis when another s corporation owned by him distributed to him the note of the s corporation whose losses the shareholder wanted to deduct; the note represented no additional investment); griffith v. commissioner, 56 t.c. memo (cch) 220, t.c. memo (p-h) 88,445 (1988) (disregarding journal entries substituting the shareholder as creditor of the s corporation; the entries lacked economic substance); rev. rul. 80-236, 1980-2 c.b. 240 (collapsing the steps of a convoluted loan transaction when the shareholder made no economic advance to the s corporation and so got no basis increase). for related efforts to obtain basis by guaranteeing corporate debt, see generally james s. eustice & joel d. kuntz, federal income taxation of s corporations 9.05[2][i] (3d ed. 1993). 121. see perry, 54 t.c. at 1297. see also irc § 165(a); regs. § 1.165-1(b), (d)(l) ("economically genuine realizations of loss"). [vol 2:5 zero basis hoar bought with a purchase money obligation is sold at a loss but is not worthless (obviously necessitating the seller to remain liable for the obligation and the obligation not to encumber the stock), the regulations themselves provide that a loss is sustained.y thus, it appears that the treatment of worthless stock losses is nearly "unique."' 2' these rules relating to worthless stock losses and s corporation stock basis prevent abuses normally perceived to accompany purchase treatment of the acquisition of stock for an obligation outside section 351. are there other issues that are peculiar to a section 351 setting? c. issues peculiar to section 351 controlling shareholders; treating transferor's obligation as contingent debt 1. overview.-the service has decided that a shareholder should not be able to obtain basis by issuing an obligation to a corporation that the shareholder controls for section 351 purposes.'24 it has extended this rule to a partner's issuance of an obligation to a partnership, -' although such an obligation can indirectly provide basis, as discussed below. the service justifies these results on the ground that the obligation is property with a zero basis. the tax court has agreed. 26 we already have seen that the zero basis property rationale is illogical. nevertheless, it well may stand because it has a literal appeal and its dangers can be planned around, as discussed in part iv above. the intriguing question is what valid source, if any, can be found for the view that the obligations should not supply basis? at least in the section 351 case, it must be that an obligation given to a controlled entity should not generate basis until paid (at which time basis arises under the rules for capital contributions) because the obligation is contingent on a future choice whether and when to pay the obligation. the reality of this contingency has not been examined. 2. section 351 transferor.-the service early recognized the difficult issues attending the treatment of shareholder obligations issued in 122. regs. § 1.1001-1(a). cf. page v. rhode island hosp. trust co., 88 f.2d 192 (1st cir. 1937) (rejecting government's argument that sale of stock is sufficient to identify time of loss where substance of transaction was not purchase and sale of stock but rather was a liability of the taxpayer to his broker.) 123. g.c.m. 38003 (july 10, 1979). 124. see rev. rul. 68-629, 1968-2 c.b. 154 (implying this result by effectively treating the transferor's obligation as § 351 property with a zero basis). 125. rev. rul. 80-235, 1980-2 c.b. 229. 126. for the rule in partnership cases, see bussing v. commissioner. 88 t.c. 449. 463-64, supplemental opinion, 89 t.c. 1050 (1987): oden v. commissioner. 41 t.c. memo (cch) 1285, t.c. memo. (p-h) 81,184 (1981), affd, 679 f.2d 885 (4th cir. 1982). 19941 florida tax review connection with section 351 transactions. therefore, it perhaps wisely chose to address those issues as vaguely as possible in revenue ruling 68-629,27 the starting point for the service's and tax court's current views on basis for obligations transferred to corporations and partnerships. that ruling was guided by general counsel memorandum 33937. 128 the g.c.m. is fascinating in the concerns it reveals and the mental gymnastics it employs to reach the result that the transferor's obligation does not reduce the section 357(c) gain recognition. the g.c.m. expressed concern about characterizing the transferor's obligation as a contract calling for future contributions to capital and about identifying the amount of stock basis acquired by transferor for his obligation. the g.c.m. implied that the obligation could be a current contribution to capital, but the authors of the g.c.m. apparently feared that characterization of the obligation as a current or future contribution to capital might somehow preclude calling the obligation "property" (with a zero basis) that was transferred as part of the section 351 transaction. nevertheless, neither the g.c.m. nor revenue ruling 68-629 calls the obligation "property." rather, the g.c.m.'s conclusion springs from the assertion that the transferor could not obtain immediate stock basis for the obligation because it was given in a nonrecognition transaction. the g.c.m. acknowledged that a transferor can obtain stock basis by issuing an obligation in a recognition transaction (see section b above) or by a contribution to capital of an item in which the transferor has basis (such as the cash payment of the obligation), but asserted that crane129 did not apply to provide basis for an obligation given in a nonrecognition transaction. the necessary implication of this assertion is that it is impossible to separate a controlling shareholder's obligation from a related section 351 exchange. assuming that impossibility, the service must have felt compelled to deal with the obligation within the rules for section 351 exchanges, and the only pigeonhole available was to treat the obligation as property with a zero basis. in effect, that is what revenue ruling 68-629 did in stating, "since the taxpayer incurred no cost in making the note, its basis to him was zero. therefore, the transfer of the note to the corporation did not increase the basis of the assets transferred."' 130 in other contexts, contemporaneous purchase and nonrecognition transactions are given separate significance for basis purposes. for example, the regulations under section 1031 provide that the basis of property acquired 127. 1968-2 c.b. 154. 128. g.c.m. 33937 (sept. 30, 1968). 129. crane v. commissioner, 331 u.s. 1 (1947) (confirming that basis is obtained by a purchase money obligation). 130. 1968-2 c.b. 154, 155. [vol 2:5 zero basis hoar in a like kind exchange is increased by any consideration given in addition to the like kind property transferred in the exchange."' this surely means that if an obligation is given as boot in a section 1031 exchange, the obligor's basis in the property received is increased by the amount of the obligation. the fact that a like kind exchange is occurring at the same time cannot prevent the acquisition of crane basis. under the regulations, a taxpayer who pays cash boot in a like kind exchange takes a basis for the property received equal to the sum of the money and the basis of the exchanged property, and crane teaches that for the purpose of determining basis, the issuance of a note is equivalent to a payment of money. thus, contrary to the implicit reasoning of the g.c.m., it cannot be the nonrecognition feature of the section 351 exchange that precludes purchase treatment for the obligation; basis can only be precluded by the relatedness of the parties to the obligation (usually absent from the like kind exchange). what has the relationship between obligor and obligee to do with acquiring purchase money basis? normally, a purchase money obligation fails to produce basis in the property acquired only if the obligation is contingent. 32 likewise, this is the only logical ground on which the normal credit for purchase money obligations can be denied in cases under section 351. the relationship between the obligor and obligee evidently calls into question the unqualified duty of the obligor to pay. however, the government and the tax court not only have failed to articulate this ground, they also have failed to justify it. only by recognizing this ground and confronting the issue of its propriety can one assess the basis consequences that have been provided under the zero basis rubric. obviously, the degree of contingency in section 351 cases varies widely as the facts shift from a 100% shareholder's obligation to the obligation of a 10% shareholder who happens to contribute the obligation as part of a section 351 exchange along with a controlling group of shareholders.' 33 in view of the difficult factual issues presented, it is perhaps reasonable to presume that all section 351 transferors can give only contingent obligations to their corporations. 131. regs. § 1.1031(d)-l(a) (referring confusingly to § 1016 rather than § 1012). revenue ruling 79-44, 1979-1 c.b. 265, which deals with the receipt of a note in a § 1031 exchange, does not discuss the obligor's basis. 132. see, e.g., albany car wheel co. v. commissioner. 40 t.c. 831 (1963). aff'd per curiam, 333 f.2d 653 (2d cir. 1964). the contingent debt issue has been developed in cases involving nonrecourse debt in an amount that exceeds the value of the security. e.g.. estate of franklin v. commissioner, 544 f.2d 1045 (9th cir. 1976). the concept is also applied in the partnership area. regs. § 1.752-2(b)(4). 133. section 351 applies if property is transferred "'by one or more persons" in exchange for stock and these persons "are in control" of the corporation immediately thereafter. see bittker & eustice, supra note 16, at 1 3.08. 19941 florida tax review that presumption may be further justified by a fear that the transferor has not added value to the corporation equal to the crane basis that would result from treating the obligation's issuance as a purchase. assume t transfers property to newly organized x corp. in exchange for all x stock and the corporation's assumption of liabilities of t in an amount exceeding the basis of the transferred property by $25; in an effort to avoid gain recognition under section 357(c), t simultaneously issues a $25 note to the corporation. if the note is worth $25, it increases the value of the stock by $25, and the gain built into the transferred property is preserved in the relationship between the zero basis for the stock and the stock value. however, if the note is worth only $15, transferor's built-in gain on the property transferred is not preserved. others have argued that such an obligation necessarily has full value because in corporate extremis the corporation's creditors could enforce the obligation."' this argument is analogous to the rule that a partner's obligation to his partnership can produce basis in his partnership interest where there is partnership debt to outside creditors who could force the partner to pay if all partnership assets become worthless, as discussed in part v.c.3 below. while there is also the possibility of the shareholder being ultimately forced to pay, it is more likely that the obligation will languish in the corporation for years. should a section 351 transferor's obligation be considered bona fide because the service can treat it as a distribution if it is not properly serviced? a corporation's loan to a shareholder is treated as a constructive distribution (dividend) to the borrower only if, when the loan is made, there is no genuine expectation of repayment (as may be evidenced by the fact that it is not serviced and collected in a reasonable commercial manner by the corporation) 13 or if the obligation is forgiven in a later year.136 the issue of whether a shareholder loan is made with a genuine expectation of repayment is no different than whether a section 351 transferor's obligation is contingent (except for the fact that in the section 357(c) cases the purpose for the obligation was tax avoidance or deferral). therefore, we return again to the question: why should a controlling shareholder's obligation be viewed more skeptically in the context of a section 351 exchange than where the shareholder simply borrows money from the corporation? logically it should not, though perhaps the following explanation provides a contrary view. 134. see sheppard, supra note 2, at 1556. 135. see, e.g., alterman foods, inc. v. united states, 505 f.2d 873 (5th cir. 1974); tollefsen v. commissioner, 52 t.c. 671, 678 (1969); ackerman v. commissioner, 18 t.c. memo (cch) 715, t.c. memo (p-h) t 59,164 (1959); roschuni v. commissioner, 29 t.c. 1193 (1958); baird v. commissioner, 25 t.c. 387 (1955). 136. see bartel v. commissioner, 54 t.c. 25 (1970). [vol 2:5 zero basis hoar according basis to property purchased with an obligation is a triumph of substance over form. for example, a cash method buyer has paid nothing in the form required by the cash method of accounting, but, in substance, the buyer has paid by obligating himself to pay. it is a familiar concept that only unrelated parties are permitted, on occasion, to reject the form and rely on the substance of their transactions.' in the section 351 setting the parties are, by definition, related. therefore, perhaps they should not be allowed to reject the form of their transactions and must be treated as if no payment is made by transfer of the obligation. this limitation on basis acquisition is not applied to other related party acquisitions (save the partnership case, discussed below) because normally the seller recognizes gain that offsets the basis acquired by the buyer. 3 however, in the case of a corporate stock issuance, section 1032 prevents the corporation's recognition of gain or loss upon issuance of its own stock. furthermore, as a practical matter of administration, the section 351 exchange provides an occasion when shareholder notes can and perhaps should be examined carefully because both parties are receiving generally taxbeneficial treatment. thus, while it is fairly clear that the section 351 transferor's obligation should be treated as an obligation given in a section 1012 purchase transaction in connection with the section 351 exchange, perhaps these various factors justify treating the obligation as contingent. if so, it is proper to use prof. manning's approach of treating the transferor's obligation as an open transaction wherein the transferor obtains stock basis when the obligation is paid. 139 this approach seems reasonable because it is consistent with the principle that a loss should be deductible only when sustained, with the service's implied view that later payment of the obligation produces basis,"t4 with the apparent treatment of contingent purchase money obligations,14 and with the delayed basis apparently allowed for partner obligations to partnerships.1 42 137. see, e.g., bartels v. birmingham, 332 u.s. 126 (1947) (treating a party denominated by the contract as employee as an independent contractor): helvering v. f. & r. lazarus & co., 308 u.s. 252 (1939) (treating sale-leaseback as a mortgage). 138. the recognition of a loss upon a sale to a related party can be limited. irc § 267; higgins v. smith, 308 u.s. 473 (1940). 139. manning, supra note 21, at 195. 140. g.c.m. 33937 (sept. 30, 1968). 141. see albany car wheel co. v. commissioner, 40 t.c. 831, 841 (1963). afrd per curiam, 333 f.2d 653 (2d cir. 1964) (stating, in dicta, that payments on contingent obligations may be taken into account when accrued). 142. see bussing v. commissioner, 88 t.c. 449, 463-64 (1987) rev. rul. 80-235. 1980-2 c.b. 229. 19941 florida tax review in view of the fact that the treatment of later payment of contingent obligations has not been fully worked out, 143 it is not surprising that the service has guided the matter into the relatively safe (but ill-fitting) harbor of zero basis property under section 351. it might be said that the fit is "close enough for government work"'" if it is made clear that later payment of the obligation produces stock basis and that the corporation is protected from unsuspected gain on the obligation. as to the treatment of the corporation holding the transferor's obligation, contrary to the fears of the second circuit in lessinger, 45 the phantom gain concerns should be manageable. if the obligation is viewed as a contingent promise to make a capital contribution, sections 118 and 1032 should protect the corporation from recognizing income on collecting the obligation. while the corporation might recognize gain in the unlikely event that it sells the obligation, 46 the service may provide relief, as it has in the cases of parent stock received by a subsidiary in a triangular reorganization and used by the subsidiary in compensating employees. 47 though it might be too complicated to effectuate, the proper view is that at the time of factoring, the previously contingent capital contribution has been made certain due to the substitution of the independent creditor. the partnership capital account regulations adopt this approach to account for contributed obligations.' as a result, not only should the shareholder then acquire basis in that amount, but the corporation should then obtain basis in the obligation in that amount, and should recognize gain or loss only to the extent the amount realized differs from the amount of the note. 49 this 143. see 2 bittker & lokken, supra note 49, at$ 41.2.2; alfred o. youngwood, the tax treatment of contingent liabilities in taxable asset acquisitions, 44 tax law. 765 (1991). the scant authority in the corporate area includes whiting v. commissioner, 47 t.c. memo (cch) 1334, t.c. memo (p-h) 84,142 (1984) (holding that a reduction in the amount of shareholders' unpaid subscription did not produced discharge of indebtedness income). 144. associated industries of missouri v. lohman, 114 s. ct. 1815, 1820 (1994) (citing a dissenting state court judge's characterization of the majority's reasoning). 145. lessinger v. commissioner, 872 f.2d 519, 525 (2d cir. 1989). 146. this eventuality is not entirely speculative, as evidenced by rev. rul. 74-80, 1974-1 c.b. 117, involving such factoring. 147. rev. rul. 57-278, 1957-1 c.b. 124 (involving a triangular c reorganization in which the parent contributed its stock to a subsidiary which transferred the stock to the target for its property; if the stock had been treated as property other than the subsidiary's stock under the normal rules, the subsidiary would have recognized gain upon its exchange for value); rev. rul. 80-76, 1980-1 c.b. 15 (involving a parent that directly owned at least 80% of the vote and value of the subsidiary's stock and stating that no gain is recognized upon transfer of the parent's stock "[blecause section 83 applies"). 148. regs. § 1.704-1(b)(2)(iv)(d)(2). 149. cf. prop. regs. § 1.453-1(f)(3)(ii) (basis step-up to corporation delayed until transferor reports boot gain under § 453). see generally cummings, supra note 32, for the view [vol 2:5 zero basis hoar approximates the result that would follow if the corporation simply were given basis in the obligation upon its receipt equal to the value of the stock issued, which presumably would equal the value of the obligation. however, that approach is not consistent with the tax logic of the corporate entity; the corporation should derive basis in property acquired from a shareholder (controlling or not) only to the extent the shareholder also obtains basis in the corporation's stock. 5' however, if the transferor's obligation is in such form as to reduce the amount of debt assumed or taken subject to for purposes of section 357(c), as discussed in part iv, the obligation cannot also be treated as a contingent purchase money obligation. rather, it simply reduces the reduction of stock basis that otherwise would be caused by section 358(d). the note should not be an independently transferable asset of the corporation, any more than is the installment seller's duty to pay the wrapped mortgage. therefore, its basis to the corporation should be irrelevant. 3. partner transferor.-the foregoing has proposed that the section 351 transferor's obligation should perform one of two functions: (1) reduce the amount of debt assumed or taken subject to by the corporation or (2) serve as a shareholder's contingent obligation to make a capital contribution. how do these functions match up with analogous situations in the partnership area, where the basis rules are defined in more detail? they match up surprisingly well, so long as the fundamental differences between corporations and partnerships are observed. the service and the tax court have imported into the partnership area the zero basis property approach applied to section 351 transactions, holding that a partner's issuance of an obligation to a partnership does not directly produce basis in the partner's partnership interest.'" this, however, is not the end of the basis story. the obligation can indirectly increase the basis of the partner's interest through the rule of section 752(a), which treats a partner's assumption of partnership recourse debt as a contribution of money by the partner. under section 722, the basis of the partner's interest is increased by a contribution of money. if the partnership is indebted to outside creditors (or owns property that the corporation clones the shareholders' basis: thus when the shareholder obtains basis. the corporation should do likewise. see also luxemburger & lange, supra note 31, at 10-11 (recommending the same results for a partnership's factoring of a contributed obligation). 150. the "basis cloning" policy is fully developed in cummings. supra note 32, at 126-41. 151. see, e.g., rev. rul. 80-235, 1980-2 c.b. 229; bussing v. commissioner, 88 t.c. 449, supplemental opinion, 89 t.c. 1050 (1987); oden v. commissioner, 41 t.c. memo (cch) 1285, t.c. memo (p-h) 81,184 (1981). aff'd, 679 f. 2d 885 (4th cir. 1982). 19941 florida tax review that is subject to debt), the partner's obligation may increase the basis of the partner's partnership interest basis through sections 752(a) and 722. assume one of several general partners issues a note to the partnership, and the partnership borrows money from an outside creditor secured in part by a pledge of the partner's note. to the extent of the amount of the note, the partner shoulders the "economic risk of loss" with respect to that outside debt because the partner may be required to pay the note in order to repay the loan. the partner is therefore treated as contributing money to the partnership in that amount.152 in contrast, a partner's issuance of a note to the partnership does not increase the partner's economic risk of loss if no legal arrangement, such as a pledge to an outside creditor, makes the partner ultimately liable to pay the note without right of contribution from other partners.153 the example of a partner note pledged to secure a partnership debt might appear to be similar to the facts of the lessinger case, and the basis result might appear to support the second circuit's result. in the partnership example, the partner's obligation to pay the pledged note is not considered so contingent as to prevent the acquisition of basis, despite the many and very real contingencies that may protect the partner from having to come out of pocket. for example, the partnership might pay its debt from other funds and not demand payment of the partner's note. does the partnership example therefore prove that the approach suggested above for section 351 cases is wrong? it does not. because the partnership is viewed as an aggregation of its partners for many tax purposes, the partner's obligation should be viewed as no more contingent than is, for example, a property purchaser's obligation to pay purchase money debt. that the debt may be repaid from future income from the property, rather than from other funds of the purchaser, is not relevant to the basis arising from the purchase money obligation.'54 similar152. see regs. § 1.752-2; william s. mckee, et al., federal taxation of partnerships and partners 8.03[6] ex. 10 (2d ed. 1990); see also regs. § 1.752-1(g) ex. (where partner remains liable on recourse debt to which contributed property is subject, and partnership does not assume the debt, the debt has no impact on the partner's basis in his partnership interest because the subject-to-debt is offset by the partner's debt assumption). 153. see regs. § 1.752-2(h)(2), (4). 154. cf. pritchett v. commissioner, 85 t.c. 580 (1985) reviewed, rev'd in part and remanded in part, 827 f.2d 644 (9th cir. 1987) (the tax court called a limited partner's obligation to make an additional capital contribution "contingent" for purposes of determining the partner's amount "at risk" because the use of partnership income to pay partnership debt might preclude a capital call). the tax court has retreated from its position in pritchett. see bennion v. commissioner, 88 t.c. 684 (1987); melvin v. commissioner, 88 t.c. 63 (1987); gefen v. commissioner, 87 t.c. 1471 (1986). commentators have noted that no partner could be at risk with respect to partnership recourse liability if the pritchett decision's reasoning is correct. mckee, et al., supra note 153, at 10.06[2][b]. nvot. 2:5 zero basis hoar ly, in the partnership example, that partnership debt may be paid from partnership income, rather than by enforcing the contributing partner's note, does not preclude the issuance of the note from creating basis. a corporation, in contrast, is not an aggregate of its shareholders for tax purposes. corporate debt is not the debt of shareholders, much to the relief of shareholders. furthermore, there is no mechanism by which a shareholder's obligation to the corporation could produce a fluctuating basis in the stock as can occur under the partnership basis rules of section 752, which can result in continuous adjustment of outside basis as inside partnership debt fluctuates. the insulation of shareholders from liability on corporate debt is modified by a special contractual arrangement whereby a shareholder retains liability on debt that otherwise would have become corporate debt. these arrangements that future sol lessingers might make were discussed in part iv above. absent such an arrangement, the section 351 transferor is in the same posture as the partner who issues a note to a partnership that owes no outside debt with respect to which the partner has the economic risk of loss. in both cases, the obligation should be viewed as contingent if it is not to give rise to basis. in one sense, this contingency is more easily presumed in the controlling shareholder case than in the partnership case because, under section 721, a control relationship is not a condition of nonrecognition for a transfer of property by a partner in exchange for a partnership interest. on the other hand, a partner can obtain basis in his partnership interest by indirect liability for partnership debt to outsiders who can be expected to enforce their rights as arms length creditors; where such creditors and such liability are absent, why should the partnership be expected to enforce a partner's contribution of his obligation? in such case, the partner's obligation also may properly be presumed to be contingent. vi. legislative or administrative solutions? a legislative solution for the lessinger problem could be pursued, but it does not seem nearly as necessary as was the enactment of section 357(c)(3). before its enactment in 1978, in many incorporations of cash method businesses, the transferors of zero basis accounts receivables were surprised to find themselves taxed under section 357(c) because their corporations had assumed liabilities in excess of the basis of the property transferred. courts devised various remedies for this "trap for the unwary," 19941 florida tax review but a legislative solution was desirable, given the volume of cases in which the trap could be sprung and the uncertainty of the judicial remedies.'55 the lessinger problem seems both less common and less of a trap than the problem of incorporating zero basis receivables. the problem arises only where the transferor has enjoyed a benefit of the type section 357(c) is intended to recapture-a prior borrowing against the transferred property in an amount exceeding the property's basis or depreciation exceeding the taxpayer's investment in the property. as to being trapped, the transferors in the lessinger and alderman cases gave their obligations to the corporations after they became aware of the potential of gain recognition under section 357(c). in the case of recourse debtors transferring property subject to that debt, any concern about their being trapped is attributable to section 357(c) itself, and not to the lessinger problem. some transferors may be unwary, as when they are liable on recourse debt and do not cause the corporation to affirmatively assume the debt, but the corporation is deemed to do so under state corporate law. it is likely in most such cases that absent some other facts to the contrary, there was an intent to have the corporations pay the debts, and so the presumption is justified. proponents of a legislative solution would likely seek a netting of the transferor's obligation against debt assumed or taken subject to by the corporation. such a result is questionable because it either must ignore concerns about bona fides and permit all such obligations to offset debt assumed or must define the quality of the obligation needed to be bona fide. so far, both congress and the treasury have been reluctant to define bona fide debt, and this seems an inappropriate place to force that issue. a partial administrative solution seems more appropriate. the service could begin by clarifying or augmenting revenue ruling 68-629 to shift the focus away from zero basis in the transferor's obligation. instead, guidance should address the issue of when debt has been assumed or taken subject to. it could provide that for purposes of section 357(c) (and section 358(d)), there is no assumption of liabilities unless, under state law, the outside creditors could hold the corporation liable. more importantly, it should provide that where debt is not assumed but transferred property is encumbered, the property is considered not subject to debt under the same circumstances that wrapped debt is not considered taken subject to for purposes of section 453, in light of the service's acquiescence in professional equities.'56 while a wrapped mortgage may be either recourse or nonrecourse for purposes of section 453, it seems that for purposes of section 357(c) the 155. see s. rep. no. 1263, 95th cong., 2d sess. 183-85 (1978), reprinted in 1978 u.s.c.c.a.n. 6761, 6946-48. 156. professional equities, inc. v. commissioner, 89 t.c. 165 (1987), acq., 1988-2 c.b. 1. [vol. 2:5 zero basis hoar transferor might also be required to have personal liability on the debt to the outside creditor. the reason for this added strictness is the lack of objective evidence, in the form of cash and wraparound note given by the corporation, that the corporation has paid full value for the transferred property without also intending to pay the debt. as to the deeper basis questions attending a section 351 transferor's obligations, if transferors are not to obtain basis therefor until paid (and even the second circuit in lessinger did not indicate otherwise), the code ideally should declare that rule. legislative history should base the rule on a legislative presumption of contingency of a purchase money debt. the corporation should be accorded a basis in the obligation equal to its face amount upon factoring. lacking legislation (as congress surely has weightier concerns, both in the code and outside), the treasury should be able to reach the same results by regulations. vii. conclusion zero basis is not a hoax, it is the truth. an obligation is not property in the maker's hands, and the maker has no basis for it. a maker obtains basis by issuing an obligation, but does not have basis in the obligation. in any event, the solution to the section 357(c) problem of transferors like sol lessinger lies not in supplying a jury-rigged basis to the obligation, but rather in supplying facts that better prove an intention that the transferor retained liability on his debts. the solution to the dual built-in gain problem spawned by the spurious zero basis property approach is to cast it aside and to recognize the section 351 transferor's obligation for what it must be: a purchase money obligation that is presumed to be contingent. 19941 microsoft word 1st 5 pages-farah western.doc florida tax review volume 9 2009 number 8 703 mandatory arbitration of international tax disputes: a solution in search of a problem by ehab farah∗ abstract................................................................................................... 705 i. introduction ............................................................................. 707 a. arbitration of international tax disputes – general background .............................................................................. 707 b. do we really need arbitration? ............................................. 709 c. defining the goals of arbitration in the international tax arena ................................................................................. 711 ii. the oecd proposal for mandatory and binding arbitration ................................................................................ 713 a. the oecd proposal: overview ........................................ 713 b. what is the mutual agreement procedure (map)? .......... 715 c. what is the case when no map was set in motion? ....... 715 d. is there a duty to negotiate? various positions .............. 716 1. the oecd view ......................................................... 717 2. the us view ............................................................... 719 3. the canadian view ..................................................... 723 4. the german view ....................................................... 724 5. the israeli view .......................................................... 726 6. the japanese view ..................................................... 727 7. the australian view .................................................... 728 8. the spanish view ........................................................ 728 ∗ i am an associate at the new york office of paul, weiss, rifkind, wharton & garrison llp. this article is based on my s.j.d. thesis. i thank the members of my s.j.d. committee professors reuven s. avi-yonah, michael j. mcintyre and edward a. parson for their insightful comments, guidance and support. thanks to professors douglas a. khan and william w. park for their suggestions at the early stages of this work. i also wish to thank dr. nicola sartori, dr. fadi shaheen and the participants of the s.j.d. colloquium (2007/2008) at the university of michigan law school for their comments. special thanks to my wife sahar, and to my children george and sama for affording me their unconditioned support. all views and errors are my own. 704 florida tax review [vol. 9:8 9. the french view ......................................................... 730 10. the belgian view ........................................................ 730 e. summary of possibilities and preferred interpretation .... 731 f. justifications: map functions positively ......................... 731 g. structural deficiencies of the proposal ............................ 734 1. the two step approach and the blocking method ..... 734 2. mapping the arbitration ............................................. 736 h. arbitrage and arbitration ................................................. 739 1. is tax arbitrage a concern? ...................................... 739 2. the relevance to the mandatory arbitration provision ..................................................................... 740 iii.the u.s. and mandatory and binding arbitration ................ 742 a. introduction ....................................................................... 742 b. historical background ...................................................... 743 c. has the u.s. tax treaty policy changed? ........................ 745 iv. conclusion…………...………………………………….………….748 a. addressing the concerns ................................................... 748 b. more effective structure ................................................... 750 2009] mandatory arbitration of international tax disputes 705 abstract improving the resolution of international tax disputes has witnessed recent developments. the organization of economic development and cooperation (“oecd”) amended its model convention and commentary to include mandatory and binding arbitration of tax disputes between two treaty countries that have been unsuccessful in resolving the disputes through negotiations between their tax authorities. the united states has amended its income tax treaties with belgium, canada, germany and france to include mandatory and binding arbitration of unresolved tax disputes. these amendments are undoubtedly an important step toward improving the resolution of international tax disputes. nevertheless, the article argues that these amendments fail to achieve this goal. by their terms, the amendments enable countries to avoid the arbitration. there is a risk these amendments will damage previously existing resolution methods that have generally been successful. the arbitration, as currently proposed, can be used by taxpayers to achieve abusive and undesirable tax results. the article argues that these amendments will not serve the two primary goals income tax treaties aim at achieving which are preventing double taxation as well as double nontaxation (i.e., escaping taxation). in part one of the article i present a brief overview of major contributions to the literature in this field. i set forth an evaluation methodology that focuses on two questions: first, does a mandatory arbitration provision fit in the overall network of tax treaties? second, can the mandatory and binding arbitration provision actually resolve disputes? i argue that when we are able to answer positively to both questions, a recommendation to adopt such a provision will follow. in part two i focus on the oecd proposal for mandatory and binding arbitration aimed at improving the resolution of international tax disputes. i conclude that under the current proposed structure, a negative answer to the above evaluation questions is more likely to be given than a positive one. i address certain policy issues related to the proposal, structural deficiencies embodied in it as well as possible negative consequences it may have. i conclude that the proposal should be reexamined. in part three i examine the mandatory and binding arbitration provisions that were adopted recently in a few income tax treaties to which the united states is partner. i conclude that the united states expresses a position aimed at limiting the application of mandatory and binding arbitration. part four is a summary of the work. i explain that i generally do not oppose the adoption of mandatory and binding arbitration. nevertheless, i offer some considerations regarding the circumstances accompanying the application of the proposed provisions as well as their structure. i suggest that the proposals should be reexamined because they lack features that are 706 florida tax review [vol. 9:8 major and crucial for successful mandatory and binding arbitration and because of the risk that they will negatively affect pre-existing dispute resolution mechanisms. 2009] mandatory arbitration of international tax disputes 707 i. introduction a. arbitration of international tax disputes – general background the issue at stake is the following: an income tax treaty (“itt”), exists between two countries. if a taxpayer has connections to both countries, and if both tax administrations exert their authority to tax, the taxpayer will be subject to double taxation. this result is arguably undesirable and the itt is aimed at preventing it. “income tax treaties have two primary operational goals to reduce the risk of double taxation to taxpayers engaged in crossborder transactions and to mitigate the risks of under-taxation of taxpayers by promoting cooperation and exchange of information among responsible members of the international family of nations.”1 perhaps a clear example of the above scenario is the boulez case.2 the issue in the case was whether certain payments received by pierre boulez constituted royalties or compensation for personal services. had the payments been characterized as royalties, they would have been exempt from u.s. tax. had they been compensation for personal services, they would have been subject to u.s. tax. under the u.s.-german itt valid at that time the only dispute resolution mechanism available was the mutual agreement procedure (“map”). the map article in the itts is usually similar in its wording to article 25 of the oecd model convention (mc).3 in the map, 1. brian j. arnold & michael j. mcintyre, international tax primer, second edition, at 6. see also at 105: the objective of tax treaties, broadly stated, is to facilitate crossborder trade and investment by eliminating tax impediments to these cross-border flows. this broad objective is supplemented by several more specific, operational objectives. the most important operational objective of bilateral tax treaties is the elimination of double taxation. see also stef van weeghel, the improper use of tax treaties, series on international taxation no. 19, (kluwer law), (1998) at 33 addressing the two above mentioned objectives as major objectives and adding to them, as a third and major objective, the non-discrimination clause. 2. boulez v. comm’r, 83 t.c. 584 (1984). 3. because of its relevance to the discussion i will cite the wording of article 25 of the oecd model conventions which reads as follows: (1)where a person considers that the actions of one or both of the contracting states result or will result for him in taxation not in accordance with the provisions of this convention, he may, irrespective of the remedies provided by the domestic law of those states, present his case to the competent authority of the contracting state of which he is a resident or, if his case comes under ¶ 1 of article 24, to that of the contracting state of which he is a national. the case must be presented within three years from the first notification of the action resulting in taxation not in accordance with the provisions of the convention. (2) the competent authority shall endeavour, 708 florida tax review [vol. 9:8 a taxpayer introduces its case to the relevant competent authority and if that competent authority cannot resolve the matter independently, the case will usually be negotiated between the competent authorities of the involved states in an attempt to settle the dispute. this is what happened in the boulez case. the dispute was referred to the competent authorities for resolution in an attempt to prevent double taxation of boulez’s income. the competent authorities of germany and the u.s. were unable to reach an agreement regarding the characterization of the payments. germany took the position that the payments were royalties and therefore taxable exclusively by germany. the u.s. took the position that the income generated from the performance of personal services in the u.s. and therefore taxable there. boulez was taxed on the same income twice. this was the result, even though one of the primary purposes of the itt was to prevent it. the map article lacks the power to compel the competent authorities to resolve the dispute and grant relief to the taxpayer. the article entails a quasi duty4 to endeavour to resolve the dispute in order to prevent taxation not in accordance with the itt. nevertheless, there is no obligation to actually settle the dispute. therefore, there is no guarantee that one of the primary goals of the itts (preventing double taxation) will be met. because of disputes similar to this, which remain unresolved after the map, the search for a solution accelerated. mandatory arbitration has been introduced in this context. more common disputes are transfer pricing disputes.5 in these disputes, a taxpayer with cross-border activity will try to allocate income and deductions in a tax favorable manner. the concerned tax administrations if the objection appears to it to be justified and if it is not itself able to arrive at a satisfactory solution, to resolve the case by mutual agreement with the competent authority of the other contracting state, with a view to the avoidance of taxation which is not in accordance with the convention. any agreement reached shall be implemented notwithstanding any time limits in the domestic law of the contracting states. (3) the competent authorities of the contracting states shall endeavour to resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of the convention. they may also consult together for the elimination of double taxation in cases not provided for in the convention. (4) the competent authorities of the contracting states may communicate with each other directly, including through a joint commission consisting of themselves or their representatives, for the purpose of reaching an agreement in the sense of the preceding paragraphs. 4. see part two of the paper for discussion regarding the scope of this duty and the controversies as to its existence. 5. see report to the congress on earning stripping, transfer pricing and u.s. income tax treaties, available at http://www.ustreas.gov/offices/taxpolicy/library/ajca2007.pdf noting that a substantial portion of the inventory of the u.s. competent authority consists of cases that involve transfer pricing agreements. 2009] mandatory arbitration of international tax disputes 709 may disagree with the taxpayer’s allocation and levy tax based on an adjusted allocation. this in turn may cause potential double taxation. if the taxpayer regards the taxation not in accordance with the itt, it can seek relief either at the domestic level or by utilizing the map. b. do we really need arbitration? the need for a mandatory and binding dispute resolution mechanism seems evident. it is clear, however, that implementing such an option will be accompanied with tradeoffs the major of which is accepting the binding authority of an arbitral panel and surrendering tax sovereignty. this dilemma has long occupied proponents and opponents of mandatory and binding arbitration and due to this concern, mandatory and binding arbitration has not been considered a feasible option. one of the relevant and basic works in this field was that of lindencrona and mattsson in 1981.6 the authors present an overview of the work of international professional organizations up to that date and examine the manner in which international arbitration functions in other fields. if to be extremely brief, they acknowledged that under the then-existing itts, avoiding double taxation was not guaranteed and therefore recommended adopting a mechanism that would ensure a solution in all cases.7 despite the logic upon which this recommendation lies, it was not praised by the vast majority of countries who in fact have not adopted arbitration clauses in their itts to this day. the oecd committee on fiscal affairs (1984) released a report noting: the committee does not, for the time being, recommend the adoption of a compulsory arbitration procedure to supersede or supplement the mutual agreement procedure. in this view the need for such compulsory arbitration has not been demonstrated by evidence available and the adoption of such a procedure would represent an unacceptable surrender of fiscal sovereignty. 8 6. gustaf lindencrona & nils mattsson, arbitration in taxation (1981). 7. id. at 17. the authors state that: “if two states have decided to conclude an agreement on the avoidance of double taxation, they have thereby accepted to refrain from their right of taxation in certain situations. it is only logical that the states find solutions that ensure that disputes on the contents of the agreement can be solved in all situations.” 8. oecd, transfer pricing and multinational enterprises: three taxation issues, (1984). see also karl koch, mutual agreement-procedure and practice, lxvia cahiers de droit fiscal international 109, general report to the ifa congress (1981), at 125: “although there has long been a call for the creation of arbitration 710 florida tax review [vol. 9:8 despite this concern, many scholars and non-governmental organizations have suggested mandatory arbitration as a means to address international tax disputes.9 i agree that an effectively functioning mandatory and binding arbitration provision that meets the goals of the itt network would constitute an appropriate solution. whether the current proposals fall within this framework or not is discussed below. the question addressed in this sub-chapter could be approached in a different manner. defenders of mandatory arbitration point to the prevention of double taxation as the primary justification for adopting it. they argue that improving taxpayer protection in international tax matters will facilitate cross-border transactions and flow of capital and investment. potentially subjecting taxpayers to double taxation, they continue, will affect their investment choices leading to a distortion that ultimately causes inefficiencies. the mandatory and binding arbitration is therefore offered by them to combat this defect. this analysis is logical assuming the unresolved cases are double taxation cases. yet this assumption is not free from doubts.10 because of the secrecy of map in general, and the lack of detail as to why some disputes remain unresolved and what the nature of the disputes were in particular, the process of evaluating whether or not the mandatory arbitration provision is necessary is more complicated. to illustrate this point assume that all unresolved map cases are double non-taxation cases, i.e. had the taxpayer’s position been adopted, the income would have been under-taxed or even subjected to no tax at all. further assume that one of the competent authorities was unwilling to settle the dispute through map in order to prevent the no-tax result. in this case, the “preventing double taxation” argument in favor of mandatory and binding arbitration is lost because the taxpayer has not been subjected to double taxation. this distinction will be relevant to the analysis and the evaluation of the proposals. in the same manner that preventing double procedure or an international court for tax matters, the opposition is probably too strong.” for further discussion on fiscal sovereignty see generally ramon j. jeffery, the impact of state sovereignty on global trade and international taxation, series of international taxation no. 23, (kluwer law), (1999). see also william w. park & david r. tillinghast, income tax treaty arbitration (sdu fiscal), (2004). see also tax notes international’s interview with carol danahoo, former u.s. irs competent authority, available at lexis (2004 wtd 12-5) (jan. 19, 2004). see also kevin bell, germany-u.s. tax treaty arbitration process addresses sovereignty issue, 43 tax notes int’l 214 (jul. 17, 2006). 9. see william w. park, income tax treaty arbitration, tax mgmt. int’l j, 31(5), 219 and the references thereafter. see also park & tillinghast, supra note 8. 10. see michael mcintyre, comments on the oecd proposal for secret and mandatory arbitration of international tax disputes, 7 fla. tax rev. 622. 2009] mandatory arbitration of international tax disputes 711 taxation can benefit the public, preventing double non-taxation has a similar positive effect. double non-taxation causes economic distortions as well. if the unresolved cases are double non-taxation cases, this may question the need for a mandatory and binding arbitration provision. c. defining the goals of arbitration in the international tax arena: in 1927 the league of nations took the following position:11 from the very outset, the committee realized the necessity of dealing with questions of tax evasion and double taxation in co-ordination with each other. it is highly desirable that states should come to an agreement with a view to ensuring that a taxpayer shall not be taxed on the same income by a number of different countries, and it seems equally desirable that such international cooperation, should prevent certain incomes form escaping taxation altogether. the most elementary and undisputed principles of fiscal justice, therefore, required that the experts should devise a scheme whereby all incomes would be taxed once, and once only. this principal is referred to in the literature as the “single tax principal” and apparently, it enjoys the support of many countries, academics and organizations.12 this is the oecd’s position as well.13 this principal is a 11. see league of nations, double taxation and tax evasion – report presented by the committee of technical experts on double taxation and tax evasion, league of nations doc. g. 216 m. 85. ιι (geneva, april 1927). see also cole, venuti, gordon and croker, income: income tax treaties – administrative and competent authority aspects, 940 t.m., at a-1: “the most important functions (of tax treaties) are (i) to avoid double taxation of income … (iii) to assist in the prevention of tax avoidance and tax evasion.” 12. see generally reuven avi-yonah, international tax as international law, law & economics working paper series, 7-13 (2004). see also reuven aviyonah, international tax as international law-an analysis of the international tax regime, cambridge tax law series, (2007) at 8: income from cross-border transactions should be subject to tax once (i.e., neither more nor less than once). the single tax principle thus incorporates the traditional goal of avoiding double taxation, which was the main motive for setting up the international tax regime in the 1920s and 1930s. taxing crossborder income once also means, however, that it should not be under-taxed or (at the extreme) be subject to no tax at all. 712 florida tax review [vol. 9:8 manifestation of the two identified primary goals of the itts: preventing double taxation as well as double non-taxation. i believe that the mandatory and binding arbitration provisions, as an inherent part of the treaties, should participate in fulfilling these primary goals.14 in order for this to be possible, the provision should meet a two-part evaluation test. first, it should fit within the overall itt network which basically means that the provision should facilitate achieving these primary goals. second, the provision should be able to function in a manner that resolves disputes. the first part of this test addresses a legal concern and the second part is a technical one. the success of a mandatory and binding arbitration provision is dependent on meeting both parts of this test. see also joint committee on taxation, testimony of the staff of the joint committee on taxation before the senate committee on foreign relations hearing on the proposed tax treaty with belgium and the proposed tax protocols with denmark, finland, and germany (jcx-51-07), (jul. 17, 2007), thomas a. barthold, acting chief of staff of the joint committee on taxation, stated that: “the principal purposes of the treaty and protocols are to reduce or eliminate double taxation of income earned by residents of either country from sources within the other country and to prevent avoidance or evasion of the taxes of the two countries.” 13. see oecd, commentary on the articles of the 2005 oecd model income and capital tax convention (jul. 15 2005), commentary on article 1, ¶ 7 titled: “improper use of the convention” states that: 7. the principal purpose of double taxation conventions is to promote, by eliminating international double taxation, exchanges of goods and services, and the movement of capital and persons. it is also a purpose of tax conventions to prevent tax avoidance and evasion. 7.1 taxpayers may be tempted to abuse the tax laws of a state by exploiting the differences between various countries’ laws. such attempts may be countered by provisions or jurisprudential rules that are part of the domestic law of the state concerned. such a state is then unlikely to agree to provisions of bilateral double taxation conventions that would have the effect of allowing abusive transactions that would otherwise be prevented by the provisions and rules of this kind contained in its domestic law. 14. many other goals of the itts have been identified but i chose to focus on these two as they are the primary goals. for an exhaustive discussion see zvi d. altman, dispute resolution under tax treaties, volume 11, doctoral series, (ibfd, 2005). see generally michael lang and mario züger, settlement of disputes in tax treaty law (eucotax, 2003), mario züger, arbitration under tax treaties, volume 5, doctoral series, (ibfd, 2001). see also henry j. brown and arthur l. marriot q.c., adr principles and practice, 2nd edition, (sweet & maxwell) (1999). 2009] mandatory arbitration of international tax disputes 713 ii.the oecd proposal for mandatory and binding arbitration a. the oecd proposal: overview a few years ago the oecd launched a project aimed at improving the resolution of international tax disputes the outcome of which has been included in a final report that was released in 2/2007. the project was focused on enhancing the map under article 25 of the oecd mc while simultaneously including a mechanism that will ensure a final, definite and binding resolution of disputes.15 there was a previous version to this report and the basic change, according to the oecd, between the draft from 2/200616 and the final report mainly reflects the decision not to require a waiver of domestic remedies as a condition for initiating the arbitration process.17 in this part of the article i wish to evaluate the structure of the proposed provision. i argue that the proposed structure has a “built-in” flaw which, in certain circumstances, can defeat the idea of having mandatory and binding arbitration as a final resort for the resolution of disputes. in addition i argue that the proposal (as currently structured) can negatively damage the map which it was originally aimed at improving. a few recent commentaries address the oecd proposal and offer some suggestions for its improvement.18 i generally agree with these suggestions. yet i will tackle the proposal from a structural point of view. the oecd proposal adds paragraph 5 to the existing article 25 of the oecd mc: 15. see oecd official website at http://www.oecd.org/dataoecd/17/59/ 38055311.pdf for the full report “improving the resolution of tax treaty disputes,” report adopted by the committee on fiscal affairs on 30 jan. 2007, feb. 2007 (hereinafter “the oecd report”). 16. see oecd official website at http://www.oecd.org/dataoecd/5/20/ 36054823.pdf for the full version: “proposals for improving mechanisms for the resolution of tax treaty disputes,” public discussion draft, (feb. 2006), (hereinafter “the 2006 oecd report”). 17. see the oecd report, supra note 15 ¶ 15. 18. see mcintyre, supra note 10. see also marcus desax and marc veit, arbitration of tax treaty disputes: the oecd proposal, arb. int’l 23:3 (2007), 405. see also james morgan, new developments in the resolution of international tax disputes, 43 tax notes int’l 77 (jul. 3, 2006). 714 florida tax review [vol. 9:8 5. where, a) under paragraph 1, a person has presented a case to the competent authority of a contracting state on the basis that the actions of one or both of the contracting states have resulted for that person in taxation not in accordance with the provisions of this convention, and b) the competent authorities are unable to reach an agreement to resolve that case pursuant to paragraph 2 within two years from the presentation of the case to the competent authority of the other contracting state, any unresolved issues arising from the case shall be submitted to arbitration if the person so requests. these unresolved issues shall not, however, be submitted to arbitration if a decision on these issues has already been rendered by a court or administrative tribunal of either state. unless a person directly affected by the case does not accept the mutual agreement that implements the arbitration decision, that decision shall be binding on both contracting states and shall be implemented notwithstanding any time limits in the domestic laws of these states. the competent authorities of the contracting states shall by mutual agreement settle the mode of application of this paragraph.19 to trigger the mandatory and binding arbitration under the proposal, the competent authorities of both countries must first negotiate the dispute through map. if they are unable to settle the dispute within two years, the mandatory and binding arbitration can be triggered upon taxpayer’s request. in other words, the arbitration is an extension of the map and not an independent procedure.20 19. see the oecd report, supra note 15, at 5. 20. see the oecd report, supra note 15, the proposed commentary on the new paragraph provides that: the paragraph is, therefore, an extension of the mutual agreement procedure that serves to enhance the effectiveness of that procedure by ensuring that where the competent authorities cannot reach an agreement on one or more issues that prevent the resolution of a case, a resolution of the case will still be possible by submitting those issues to arbitration. thus, under the paragraph, the resolution of the case continues to be reached through the mutual agreement procedure, whilst the resolution of a particular issue which is preventing agreement in the case is handled through an arbitration process. this distinguishes the process established in ¶ 5 from other forms of commercial or 2009] mandatory arbitration of international tax disputes 715 b. what is the mutual agreement procedure (map)? in order to better understand the proposal, especially because of the manner in which it was structured, a few words addressing the scope and nature of the map are necessary. the map is a mechanism utilized in cases where a dispute regarding the application or interpretation of a itt arises between two contracting states usually upon taxpayer’s request. the intention is to enable the contracting states to reach a settlement which would help improve the fiscal relationship between the competent authorities and provide better taxpayer protection. the map is part of a diplomatic process manifested in the bilateral negotiations between two governments that maintain their status as the decision makers. they decide to what extent to release fiscal sovereignty, which cases are suitable to be negotiated and whether or not to settle. the basic feature of map, and the most widely criticized, is that the parties are under no obligation to resolve a dispute. c. what is the case when no map was set in motion? an inevitable question is whether the wording of the proposed paragraph 5(b) “the competent authority are unable to reach an agreement to resolve that case pursuant to paragraph 2 within two years from the presentation of the case to the competent authority of the other contracting state” includes a situation where the competent authorities do not commence negotiations at all. in other words, if the two year period elapses yet no map negotiations commence, will the mandatory and binding arbitration be triggered? based on the wording of the proposed paragraph the answer should be no. i take this position for the following reasons: first, the arbitration is clearly structured as an extension of the map. the intention is for the arbitration to be triggered only after both competent authorities were unable to settle through the map. paragraph 12 of the oecd report21 states that: recourse to these techniques, however, must be an integral part of the mutual agreement procedure and should not constitute an alternative route to solving tax treaty disputes between states, which would risk undermining the effectiveness of the mutual agreement procedure.22 government-private party arbitration where the jurisdiction of the arbitral panel extends to resolving the whole case. (emphasis in original). 21. see the oecd report, supra note 15. 22. id., ¶ 46. 716 florida tax review [vol. 9:8 second, from the proposed paragraph 46 to the commentary23 it is clear that there is a distinction between the “case” and the “issue.” this paragraph addresses a hypothetical situation where the competent authorities are unable, during the negotiations, to resolve one or more issues and are therefore unable to resolve the case in whole. in such circumstances, the proposed paragraph would cause the unresolved issues to be resolved through the mandatory and binding arbitration, leaving the resolution of the case to be achieved through map.24 here too the assumption is that the negotiations have already commenced. third, paragraph 50 of the proposed commentary clarifies that its application is conditioned upon the availability of map:25 where the mutual agreement procedure is not available, for example because of the existence of serious violations involving significant penalties, it is clear that paragraph 5 is not applicable. fourth, mandatory and binding arbitration is triggered under the proposal when the parties were unable to settle pursuant to paragraph 2. paragraph 2 (of article 25) deals with the map negotiations. the referral to paragraph 2 in this case emphasizes that exhausting the map negotiations is a condition to triggering the arbitration. d. is there a duty to negotiate? various positions because of the manner in which the proposal was structured, the question whether or not a duty to initiate map exists directly affects the operation of the provision. as clarified above, commencing the map is a condition to triggering the arbitration. if the competent authorities are under no duty to participate in map negotiations, this could create a tool that could be utilized to prevent triggering the arbitration. by denying a request to commence map negotiations, the competent authority will never be subject to mandatory and binding arbitration.26 23. id., ¶ 16. 24. id., ¶ 46 of the commentary in ¶ 16. 25. id., ¶ 16. 26. see § g(1) below for a deeper discussion on this point. 2009] mandatory arbitration of international tax disputes 717 1. the oecd view the oecd takes the view that the competent authorities are under a duty to initiate map upon request from the taxpayer.27 in my mind this position is problematic, let alone contrary to the language of article 25. article 25(2) implies that the so called “duty to negotiate” is not unconditioned. the article poses two conditions once met, will presumably establish a duty, or better say a quasi duty, to “endeavour” to resolve the case by mutual agreement. the first condition is: “if the objection appears to it to be justified.” the second condition is: “if it is not itself able to arrive at a satisfactory solution, to resolve the case by mutual agreement with the competent authority.” if a competent authority considers a taxpayer’s objection not justified, the first condition is not met and the “duty” to negotiate is therefore not established. the oecd commentary is inconsistent. paragraph 20 of the commentary28 provides that: the provisions of paragraph 1 give the taxpayer concerned the right to apply to the competent authority of the state of which he is a resident ... that competent authority is under an obligation to consider whether the objection is justified and, if it appears to be justified, take action on it in one of the two forms provided for in paragraph 2. paragraph 23 of the commentary states: an application by a taxpayer to set the mutual agreement procedure in motion should not be rejected without good reason.29 the commentary is not clear on this issue. what constitutes “a good reason” to deny a map request? paragraph 22 addresses a situation where the taxpayer approaches the resident competent authority and “if it appears to that competent authority that the taxation complained of is due wholly or in 27. see oecd, commentary on the articles of the 2005 oecd model income and capital tax convention (jul. 15, 2005), commentary on article 25, ¶ 26, stating that: “paragraph 2 no doubt entails a duty to negotiate; but as far as reaching mutual agreement through the procedure is concerned, the competent authorities are under a duty merely to use their best endeavours and not to achieve a result.” 28. see oecd, commentary on the articles of the 2005 oecd model income and capital tax convention (jul. 15, 2005), commentary on article 25, ¶ 20. (emphasis added). 29. id., ¶ 23. (emphasis added). 718 florida tax review [vol. 9:8 part to a measure taken in the other state, it will be incumbent on it, indeed it will be its duty – as clearly appears by the terms of paragraph 2 – to set in motion the mutual agreement procedure proper.”30 to set in motion the map, at this stage, means that the “resident” competent authority approaches the “source” competent authority with the potential taxation not in accordance with the itt. the “resident” competent authority is under a duty – established in paragraph 22 of the commentary – to do so. the “source” competent authority, in return, is also obliged to set the map in motion. this is established by paragraph 26. yet the duty imposed upon the “resident” competent authority (initially approached by the taxpayer) is subject to the taxpayer’s objection being justified. paragraph 23 of the commentary makes this clear. the same could be argued regarding the “source” competent authority. it too must consider taxpayer’s objection justified. nevertheless, paragraph 26 emphasizes that paragraph 2 no doubt entails a duty to negotiate. this confusion does not contribute to the discussion. it seems difficult, therefore, to reconcile between these different approaches.31 one commentator, richard hammer, believes that: paragraph 1 (of article 25) provides the taxpayer with the right to seek ca intervention, whether or not the taxpayer has yet exhausted all his legal remedies in his home country. paragraph 2 then refers it to the judgment of the relevant ca to decide whether or not the case is of sufficient merit for pursuance by the ca. if the complaint is justified, the ca to which the appeal was directed (generally the ca of the country of residence or citizenship of the complainant) is obliged to trigger off the mutual agreement procedure mechanism, which of course involves government to government negotiations.32 30. id., ¶ 22. 31. an additional issue that should be pointed out is that the commentary is not as emphatic, regarding the interpretive and legislative map under ¶ 3, as under ¶¶ 1 and 2 of article 25. see ¶ 32 of the commentary stating that the first sentence of the ¶ 3 of article 25 invites and authorizes the competent authorities to resolve, if possible, difficulties of interpretation or application by means of mutual agreement. in one case the oecd sees a “duty” and in the other only an “invitation.” 32. richard hammer, introduction to competent authority, in new york university, international institute on tax and business planning, (1977), at 171. (emphasis added). 2009] mandatory arbitration of international tax disputes 719 according to this view, which strikes me as reasonable, it is up to the competent authority to judge whether or not the case is of sufficient merit.33 pierre kerlan, former director of international tax affairs in france, went beyond and questioned whether article 25(2) could oblige the competent authority to initiate map, even assuming that taxpayer’s objection is justified.34 jon bischel notes that: yet, to be truly effective, some alterations are essential to existing competent authority structures. for instance, the present procedure is voluntary since a competent authority to which a claim is presented may refuse to consider the request if it determines it meritless.35 2. the u.s. view the u.s. tax authorities are required to notify the taxpayer whether or not the case is suitable for consideration under map.36 the flip-side of this requirement is that some cases are not suitable for map. previously, it was possible for a taxpayer to request review of the decision not to initiate map.37 this review option was decreased by rev. proc. 79-3238 and 33. see also id., at 177, he states: “from the u.s. taxpayer’s point of view, there are several weaknesses in the ca procedure. first of all, the irs has the sole right to decide if a case is meritorious and if it should go to ca. the taxpayer has no right to appeal an adverse determination on this question.” (emphasis added). 34. pierre kerlan, international disputes with respect to tax conventions – the french view, in new york university, international institute on tax and business planning (1977), supra note 32, at 232. 35. jon e. bischel, tax allocations concerning inter-company pricing transactions in foreign operations: a reappraisal, 13 va. j. int’l l. 490 at 514. see also adrian a. kragen, avoidance of international double taxation arising from § 482 reallocations, 60 cal. l rev. 1493 at 1514 arguing in favor of this argument. 36. see matthew t. adams, the procedure for invoking competent authority assistance under united states income tax treaties, in new york university, international institute on tax and business planning, (1977), supra note 32 at 188. 37. rev. proc. 77-16; 1977-1 c.b. 573, § 6.03. the rev. proc. provides that: “the decision of the review panel as to whether competent authority assistance should be provided is not further reviewable within the service. (however, the taxpayer may pursue all rights to judicial review of the review panel’s decision under the laws of the united states.).” 38. rev. proc. 79-32; 1979-1 c.b. 599, § 3.02 amended § 6.03 of rev. proc. 77-16 by making the decision of the review panel designated by the internal revenue commissioner final and omitting the part granting right for judicial review of the reviewing panel’s decision under u.s. laws. it could be argued though that the 720 florida tax review [vol. 9:8 abolished completely by rev. proc. 91-23.39 these modifications indicate the u.s. position as to taxpayers’ rights (and competent authority’s obligation) to initiate map. the omission of the right to request review of the competent authority’s decision was coupled with an increase in the number of circumstances in which the competent authority could deny map assistance. rev. proc. 77-16 enumerated three such circumstances while rev. proc. 2006-54 enumerates eight.40 for example, the competent authority can classify a case as unsuitable for map consideration or assistance if the taxpayer is willing to accept a settlement under conditions that are unreasonable or prejudicial to the interests of the u.s. government.41 authority to deny map assistance is also granted where the competent authority believes that the transaction giving rise to the request for competent authority assistance is more properly within the jurisdiction of irs appeals or is designated by the irs for litigation.42 other commentators acknowledge that article 25 does not entail a duty upon the competent authorities to commence the negotiations while taking the position that this should be revised.43 in presenting some of the judicial review is still available despite the fact that the sentence granting this review was omitted. 39. rev. proc. 91-23; 1991-1 c.b. 534, § 1 pointed out that: “rev. proc. 8229, 1982-1 cb. 481, and rev. proc. 77-16, 1977-1 c.b. 573, as amplified by rev. proc. 79-32, 1979-1 c.b. 599, are superseded by this revenue procedure.” in § 11.04 the rev. proc. 91-23 read: “review of denial of request for assistance. the u.s. competent authority’s denial of a taxpayer’s request for assistance or dismissal of a matter previously accepted for consideration pursuant to this revenue procedure is final and not subject to administrative or judicial review.” rev. proc. 2006-54; 2006 i.r.b 1035, which is valid to date, states, in § 12.04 that: “the u.s. competent authority’s denial of a taxpayer’s request for assistance or dismissal of a matter previously accepted for consideration pursuant to this revenue procedure is final and not subject to administrative review.” 40. see § 12.02 of rev. proc. 2006-54, supra note 39. 41. see § 12.02 (2) of rev. proc. 2006-54, supra note 39. 42. see § 12.02 (8) of rev. proc. 2006-54, supra note 39. see also paul c. rooney and nelson suit, competent authority, 49 tax law 675, at 681: “moreover, the competent authority procedure, by stating that assistance may be denied if the case has been “designated for litigation” by the service, shows the manner in which the service would appear to retain discretion to litigate a case rather than allow it to proceed through the competent authority process.” 43. see john f. avery jones et al., the legal nature of the mutual agreement procedure under the oecd model convention-i, [1979] brit. tax rev. 333 at 337, citing pierre kerlen, supra note 34, arguing that the question whether competent authorities are under an obligation to refer the matter to the other competent authority, or merely under a recommendation to do so, is disputed by some states. 2009] mandatory arbitration of international tax disputes 721 technical and practical problems associated with map negotiations, sanford goldberg deals with the procedural aspects of the map and he also acknowledges these limitations.44 john f. avery jones and others proposed procedural improvements to the map acknowledging that: at present the taxpayer’s only right is to present his case to the competent authority of the state of which he is resident (or in some cases of which he is a national). after that, the matter is outside his control in a way which does not happen in litigation. he cannot force his competent authority to take the matter up with the other competent authority, and, even if it does so, the taxpayer does not know how strongly it will press his case.45 arvid skarr has expressed a similar opinion.46 referring to article 25(2) of the oecd mc, he notes that the taxpayer’s rights depend upon the discretionary assessment of the competent authority of his state of residence.47 the general report presented to the international fiscal association (ifa) congress in 198148 addressed this issue as well. in reviewing the several reasons for refusal to grant competent authority assistance, the report makes clear that: the taxpayer has no legal right to require implementation of mutual agreement procedure (except in belgium), but solely 44. stanford h. goldberg, how and does the competent authority work? 39 tax executive, 1985-87, 3. he points out that a request for map may be denied for substantive or procedural reasons. 45. see john f. avery jones et al., the legal nature of the mutual agreement procedure under the oecd model convention-ii, [1980] brit. tax rev. 13, at 19. (emphasis added). 46. arvid aage skaar, the legal nature of mutual agreements under tax treaties, 5 tax notes int’l 1441 (1992). see also zvi d. altman, supra note 14 at 272. he enumerates the disadvantages of the map and notes that: “another very important disadvantage of the map concerns the unlimited discretion given to the competent authority in deciding which cases to accept and which to reject.” 47. id., at 1447. in elaborating the question whether or not a taxpayer’s claim is justified, he points out that: “unfortunately, the authorities of different countries have different policies concerning what makes it “justified” to initiate mutual agreement procedure. from the taxpayer’s point of view, the most frightening aspect of this procedure is that the competent authorities may refuse to institute the mutual agreement procedure simply because they disagree with the taxpayer.” 48. see koch, supra note 8. 722 florida tax review [vol. 9:8 a right to require that the competent authority should decide, within the scope of its due discretion, whether mutual agreement procedure should be started.49 it is also noteworthy that the u.s. commentary does not contain a paragraph similar to paragraph 26 of article 25 of the oecd mc, which states that a duty to negotiate exists, and this is in-line with the united states’ position. considering the above commentary and the changes in the revenue procedures throughout the past thirty years it seems conceivable to argue that from the united states’ perspective, competent authority assistance is granted at the discretion of the tax authority and there is no duty to grant it. this position was upheld by the district court in yamaha motor corp. v. united states.50 yamaha sought a declaratory judgment that the service wrongfully refused its request for map assistance under the itt and to compel the service to consider this request.51 the irs filed a motion to dismiss and the court granted the motion holding that it lacked jurisdiction to review the determination.52 in denying yamaha’s plea the court noted: first, it is entirely possible that the government could prevail in its attempt to prevent plaintiffs from immediate access to negotiations via the treaty. for example, the government could decide that the plaintiffs’ double tax claim has no merit, and could deny the request.53 in filler v. comm’r,54 a similar decision, denying the court’s jurisdiction to initiate competent authority proceedings, was granted.55 the court characterizes the map as an international administrative procedure between the competent authorities of the contracting states rather than a procedure. these decisions have not escaped the criticism of some 49. id., at 109. 50. 779 f. supp 610 (d.d.c. 1991). 51. id. at 611. 52. id. 53. id., at 613. (emphasis added). 54. 74 t.c. 406 (1980). 55. id. at 407-408: (“we hold that article 25, which establishes a certain procedural device for dealing with rights agreed upon in the convention, does not afford petitioner a remedy which can be asserted in this court.”) see also american law institute, international aspects of united states income taxation ii, proposals on united states income tax treaties, 1991 a.l.i. fed. income tax project 99 (may 13). “in the united states, a claim for relief under article 25, ¶ 1 may not be asserted in court, but may only be made to the competent authority.” (citing filler, 74 t.c. at 408). 2009] mandatory arbitration of international tax disputes 723 commentators.56 nevertheless, they are valid and support the policy of the u.s. tax authorities as reflected in rev. proc. 2006-54. 3. the canadian view the canada revenue agency (cra) has issued information circular 71-17r5 guidance on competent authority assistance under canada’s tax conventions which is valid to date.57 paragraph 12 of the information circular provides: where a request is made to the canadian competent authority under the map article of a tax convention, the canadian competent authority will first, if the request appears to be justified and can be accepted by the canadian competent authority from a policy standpoint, attempt to resolve the matter unilaterally. section 24 of the information circular, dealing with the acceptability of requests, enumerates 4 circumstances in which the canadian competent authority will accept a request for assistance, the last of which is that the issue is not one that the canadian and/or the foreign competent authority have decided, as a matter of policy, not to consider. this indicates that cra has discretion to deny certain map requests. 56. see rooney & suit, supra note 42, at 696-700 (arguing that the yamaha decision was wrongful and that there should exist a judicial review mechanism that would ensure taxpayer rights to initiate map proceedings and provide judicial review for the service’s decision whether or not to commence map negotiations). see also sanford h. goldberg & seth b. goldstein, u.s. district court lacks jurisdiction to compel irs to consider request for competent authority assistance, 40 can. tax j., 1009, 1015 (1992), (arguing that the u.s. position violates many treaties and that the yamaha decision is very disturbing). see also stanford h. goldberg and peter a. glicklich, treaty-based nondiscrimination: now you see it now you don’t, 1 fla. tax rev. 51, 57 (1992) (“nor is it clear that a u.s. taxpayer can compel the internal revenue service to participate in negotiations under the competent authority procedure.”) 57. information circular 71-17r5 is available at http://www.craarc.gc.ca/e/pub/tp/ic71-17r5/ic71-17r5-e.pdf. this circular replaced information circular 71-17r4 dated may 12, 1995. section 25 of information circular 71-17r5 provides: “the cra will notify the taxpayer in writing whether the canadian competent authority has accepted or declined the request for competent authority assistance normally within thirty days of receiving a complete request. the taxpayer will be provided with the reasons for the decision where a request is declined.” 724 florida tax review [vol. 9:8 in a 1998 article, claude lemlin and regina deanehan acknowledge that such authority for denial of map assistance, on both the canadian and u.s. sides exists. they refer to information circular 71-17r4 and rev. proc. 96-13, 1996-1 c.b. 616 which were valid at time.58 this view was also presented by the national reporter of canada in the 1981 international fiscal association congress on mutual agreement – procedure and practice.59 4. the german view klaus vogel points out that the competent authority must first of all determine whether the taxpayer’s assertion that he has been taxed contrary to the treaty is justified. the authority is duty bound by article 25 to make that determination.60 in other words, the obligation upon the competent authority is to determine whether the objection is justified, rather than to proceed to the negotiations. it is clear, however, that this is a two-step process in which the competent authority considers whether the taxpayer’s objection is justified and whether the taxation complained of is – wholly or partly – 58. see claude lemelin and regina deanhan, the competent authority process: a canadian and us comparative analysis, 46 can. tax j, 657 (1998) at 664-665. see also catherine brown, the u.s.-canada tax treaty: its impact on the cross border transfer of technology, 9 transnat’l law. 79 at 117: relief from double taxation can be sought through the mutual agreement procedure. to access this procedure, taxpayers must request competent authority assistance from their government. approval can be denied, and has been in the united states in at least one recent instance. the canadian government will also refuse to act for a number of reasons, including whether the issue is one the competent authorities of each jurisdiction may not agree to accept, or where the foreign government refuses to deal with the case. 59. see koch, supra note 8, at 122. the article presents the various positions that were taken regarding the suggestion to improve the mutual agreement procedure by, inter alia, giving taxpayers a legal right to require initiation of mutual agreement procedure or in the event of refusal to appeal to the domestic courts. the article goes on to note: the national reporters for austria, canada, japan and norway do not regard improvements as necessary, expressing substantial doubts in this respect. in the view of the national reporter for canada, such measures would strike at the very root of the consensual nature of mutual agreement procedure, and could also result in appeals to the courts beyond those provided by the domestic legislation. 60. see klaus vogel, double taxation conventions, 3rd edition (1998), at 1366. 2009] mandatory arbitration of international tax disputes 725 attributable to actions of the other contracting state. if so, it will endeavour to set a mutual agreement in the narrower sense in motion.61 the question is whether the taxpayer has the right to demand that the competent authority properly use its discretionary powers when deciding to set a map in motion. vogel indicates that: according to bfh [abbreviation for bundesfinanzhof, (the supreme tax court of the federal republic of germany), rulings, the competent authority has on the other hand the power of discretion to decide whether or not to allow the objection and consequently to set the mutual agreement procedure in motion even when the taxation complained of has been proved to be contrary to the convention.62 either way, it is clear that the competent authority of germany has no duty to initiate map negotiations. furthermore, under the german federal fiscal court rulings, map initiation authority is entirely committed to the discretion of the competent authority, even in cases where it has been proven that the subject taxation is not in accordance with the itt. jacob friedhelm and others agree with the view that taxpayers have no right to require the german tax authorities to pursue map.63 peter dehnen and silke bacht also present a similar position.64 61. id., at 1367 (citations omitted). 62. id., at 1367. (emphasis in original). 63. jacob friedhelm, et. al, hand book on the 1989 double taxation convention between the federal republic of germany and the united states of america, international bureau of fiscal documentation, at 15, on article 25, citing also § 3.3.1 of bstbl 1997 ι (administrative principles published by the federal ministry of finance in germany). 64. peter h. dehnen and silke bacht, compatibility of the recent oecd proposals with germany’s tax dispute resolution mechanism, bull. for int’l fiscal documentation 463 (nov. 2006), at 466, under the discussion about the itt between germany and sweden stating that: “... none of the tax treaties obliges the contracting states to start map. and, while german national law gives taxpayers the right to appeal against the tax administration’s refusal to start a map, the higher courts are only allowed to ascertain whether the tax administration’s decision was within its discretionary authority.” see also: may a taxpayer force the use of a mutual agreement procedure, 23 european taxation 195, dealing with the same case, at 198 (arguing that the tax authorities to whom the request is made may also base their decisions on reasons of suitability or convenience). see also peter h. dehnen, germany updates mutual agreement procedure, 44 tax notes int’ 10 (oct. 2, 2006). 726 florida tax review [vol. 9:8 5. the israeli view the unit for international taxation in israel issued map guidelines in executive instruction 23/2001 that deal with the mutual agreement procedures.65 section 5.1 states that the competent authority will consider the application for map assistance and whether or not it could be justified. if the competent authority considers the assistance request not justified, it will notify the taxpayer of its decision in writing. this position was upheld in a district court decision in israel.66 jeteck technologies ltd., a company resident in israel, carried on a business in software production and development. jeteck had an agreement with a japanese company whereby it would sell to the japanese company the right to use its computer software in return for royalties. the japanese company withheld tax from the payments it made to the jeteck. jeteck claimed a tax credit in israel for the taxes withheld in japan. the israeli tax authorities denied the claim, arguing that jeteck did not prove which part of the payments constituted royalties and which part constituted business income. consequently, the tax authorities considered the whole amount of the payments as business profits subject to tax only in israel under the itt (since jeteck did not have a permanent establishment in japan). the payments that jeteck received were therefore taxed twice, once in japan and again in israel. jeteck contested the assessment of the israel tax authority and requested it initiate map negotiations. the israel tax authority denied the request claiming that map could be initiated only after the israeli court had determined the character of the payments. the district court held in favor of jeteck and obliged the tax authority to consider the merits of the taxpayer’s request for map assistance, and whether it was justified, before hearing the appeal that jeteck had filed to the israeli court.67 this case constitutes a good example for the question at stake. a careful reading of the court’s reasoning makes clear that the court did not regard the initiation of map as an obligation. however, the opinion does espouse the view that the taxpayer has the right to demand that the competent authority to properly use its discretionary powers when deciding whether or not to set a map in motion. nevertheless, the court acknowledges that when the tax authority deals with an international matter, it will sometimes be required to appraise, in view of the contracting state’s practices, the map’s chance of being successful, the involved expenditures and how the procedure could influence the relations between the two authorities involved.68 in 65. executive instruction income tax no. 23/2001 dated dec. 16, 2001. 66. see income tax appeal 1255/02 jeteck technologies ltd. v. assessing officer kfar saba (tel-aviv district court, apr. 7, 2005). 67. id., at 11. 68. id., at 8. 2009] mandatory arbitration of international tax disputes 727 jeteck, the israeli competent authority did not revoke the necessity of commencing the map, it only took the position that the map should be postponed to a later stage. the court disagreed with this position. the court emphasized that it is granting an order to consider the merits of the taxpayers’ request and not an order to initiate map. the court further clarified that the order is granted because the israeli competent authority did not contest the need to commence the negotiations and sought only to postpone them to a later stage.69 6. the japanese view the national tax authorities of japan have also published guidelines for the map known as “commissioner’s directive on mutual agreement procedures.”70 section 13 (1) of the directive provides: where the office of mutual agreement procedures has received an application for mutual consultations and attachments as described in 6(2) and the request is considered to have merit for mutual consultations, the office of mutual agreement procedures shall, except in the cases given below, propose to commence mutual consultations to the competent authority of the treaty partner nation. the situation in japan is similar and the competent authority must determine that the application has merit for consultations in order to agree to initiate the negotiations.71 this has also been japan’s historical view, as 69. id., at 11. this decision was cited again, in a later decision rendered by the same tel-aviv district court: income tax appeal 1192/04 kloteen yigaal & sara v. assessing officer kfar saba (tel-aviv district court, opinion rendered on may 17, 2006). in this case, the court upheld the tax authority’s position not to initiate map, which was based on the fact that the taxpayer did not cooperate. the court rules that it will seldom interfere with the authority’s decision, especially in a case such as this one, where the competent authority notified the taxpayer that lacking some information and documentation it had requested, it was unable to take a fundamental position as to whether or not to initiate map and therefore denied the request. 70. “the commissioner’s directive on mutual agreement procedures” is available at http://www.nta.go.jp/foreign_language/00.pdf. 71. according to § 13(2) of the directive, the office of mutual agreement procedures shall notify the applicant when it does not propose mutual consultations to the competent authority of the treaty partner nation. this also indicates that such authority to deny competent authority assistance exists. 728 florida tax review [vol. 9:8 expressed by the national reporter of japan in the international fiscal association congress.72 7. the australian view the australian tax authorities also condition the initiation of map upon a finding that taxpayer’s request is justifiable. the taxpayer does not have a right to cause the map to be set in motion and in certain circumstances the competent authority will characterize a case as unsuitable for map. this was the position of the australian national reporter at the international fiscal congress.73 this is also the official position in taxation ruling 2006/12, which was issued by the australian taxation office and remains valid to date.74 8. the spanish view the competent authority of spain is the general directorate of taxes.75 as is the case in other countries, the competent authority receives a request for map assistance from the taxpayer and determines whether it is justified and whether or not to approach the other competent authority.76 nonetheless, the tax administration is never compelled to start the mutual agreement procedure. therefore, it may at its election refuse to ask the foreign administration to reach an agreement following the procedure and is no longer compelled to find a solution with respect to the double taxation matter, since it only has an obligation to use all the necessary means at its disposal to achieve a good result, and not an obligation to achieve a good result. the taxpayer has no means to force the competent authority to start the mutual agreement procedure… however, [t]he taxpayer is 72. see koch, supra note 8, at 327 73. see koch, supra note 8, at 190-191. (enumerating the circumstances under which the competent authority will usually refuse to initiate the map negotiations.) 74. taxation ruling 2000/16 is available at http://law.ato.gov.au. section 4.4 states that stage one of the consideration process is divided into three elements, the second of which is “consideration by the competent authority whether the case presented is justified.” 75. see fernando serrano antόn, settlements of disputes in spanish tax treaty law, in settlement of disputes in tax treaty law, supra note 14 at 427. 76. id. 2009] mandatory arbitration of international tax disputes 729 allowed to challenge this refusal before courts or administrative bodies since there is a deed to challenge.77 this position was upheld by the high courts of spain. the spanish tax courts’ approach was examined by jose calderόn.78 he addresses two different rulings, from the supreme court of spain and another high court (audiencia nacional), that he believes to have opened the door to the judicial review of spanish competent authority decisions.79 in calderón’s view, these rulings are positive because they acknowledge that the competent authority’s administrative decision is subject to judicial review, something that was not that clear before these rulings. nevertheless, calderón acknowledges that the spanish courts should take into account not only the taxpayers’ legitimate interests “but also the ‘tax policy’ reasons underlying in the decision of the competent authority denying the setting in motion of the mutual agreement procedure….”80 in the above mentioned rulings, both the spanish supreme court and the audiencia nacional upheld the competent authority’s decision not to initiate map. the audiencia nacional ruled that the tax conflict was an internal issue that does not concern either the interpretation or the application of the itt. the supreme court found that the tax conflict between the taxpayers and the tax administration did not have international relevance; that is, the controversy did not involve either the interpretation or the application of the provisions of the spain-austria itt.81 77. id. at 431-32 (emphasis added.) 78. see jose m. calderόn, the taxpayer’s right to set the ‘mutual agreement procedure’ in motion: the spanish tax court’s approach, 29 intertax 362 (2001). 79. id., at 364: it can be said that as a consequence of these rulings taxpayers’ rights deriving from the tax treaties are strengthened; any taxpayer who considers that the actions of the spanish tax administration constitute taxation which is not in accordance with a tax treaty can file an application to set in motion the mutual agreement procedure. the spanish competent authority cannot deny such claim without having a legitimate reason; the fact that the decision of the competent authority can be subjected to judicial review can exert an important influence in order to limit the discretion of the competent authority when deciding whether or not a ‘legitimate reason’ is met. 80. id., at 364 (citation omitted). 81. id., at 363-64. the tax conflicts involved in each of the cases concerned the taxation applicable to a typical interest stripping transaction in which the taxpayers bought . . . [austrian bonds] and sold them just after collecting the interest derived from the securities; according to the spain-austria tax treaty the interest 730 florida tax review [vol. 9:8 these examples clarify that a taxpayer does not have a right to cause the initiation of competent authority negotiations, and that in certain cases the request for map assistance will be denied. 9. the french view in summarizing the french tax authority’s position on this issue, which follows the above mentioned trend, hugues perdriel-vaissiёre states, the practice is to invoke the competent authority procedure where all the required conditions are met. nonetheless, the tax administration remains entirely free to refuse to ask the foreign administration to reach an agreement following the procedure…. aside from this example (referring to the itt with italy which imposes an obligation to settle) the taxpayer has no means of forcing the competent authority to start a map.82 10. the belgian view in belgium, the taxpayer’s “right” to demand the initiation of map seems to be better secured. the fiscal administration has no discretionary power to veto map. the taxpayer’s right is safeguarded since the request for map assistance is presented to the regional director of taxes against whose decision the taxpayer can appeal before the courts in accordance with domestic law.83 was exempt from tax in both countries; the taxpayers also considered that the capital loss which resulted from the sales of the austrian bonds had to be taken into account in computing their taxable income; however, the tax administration denied the capital loss, considering it a sham. 82. hugues perdriel-vaissiёre, settlement of disputes in french tax treaty law, in settlement of disputes in tax treaty law, supra note 14, at 193, 200-01. (emphasis added). perdriel-vaissiëre goes on to note that the council of state (counseil d’etat) and the administrative courts of appeal have always had this point of view and the sources thereof. 83. see koch, supra note 8, at 223. see also klaus vogel supra note 60, at 1367: (“belgian law, moreover, affords the taxpayer a legal claim to have a mutual agreement procedure set in motion.”) (emphasis in original, citation omitted). see also luc meeus, settlements of disputes in belgian tax treaty law, in settlement of disputes in tax treaty law, supra note 14, at 87: (“if it appears to the competent authority of the state where the complaint was filed that the taxation complained if is due, wholly or in part, to a measure taken in the other state, it will be incumbent on it to set in motion the mutual agreement procedure proper.”) belgium’s position is 2009] mandatory arbitration of international tax disputes 731 e. summary of the possibilities and preferred interpretation: it is beyond the scope of this paper to examine every state (editor: no need to capitalize, correct?) and its internal procedural rulings or customary laws regarding the duty to initiate map.84 the general trend, however, seems clear: the decision whether or not to initiate map is for the competent authority to make. f. justifications: map functions positively as clarified above, map is voluntary. when taking this into consideration, in addition to the informality accompanied with the negotiations, the fact that it is a government-to-government negotiation process, its secrecy and the fact that it is not binding on the taxpayer, all these strengthen the view that map should be commenced when competent authorities believe it is justified. the spirit of map is that it is fully consensual and voluntary and in my mind, imposing a duty to negotiate contradicts with this spirit85 based, apparently, on its more general principle of giving higher priority to a (tax) treaty than domestic (tax) legislation. this principle is based on the belgian supreme court decision from 1971 (cour de cassation/hof van cassatie), 27 may 1971, pas., 1971, i, 886 (case of fromagerie franco-suisse “le ski”), securing individual rights granted under treaties and ensuring that these rights are superior to domestic laws. 84. note that denmark, the netherlands and finland maintain a similar position. see generally in michael lang and mario züger, supra note 14, the following: karin skov nilaysen, settlement of disputes in danish tax treaty law, at p. 143 arguing that it is not possible to force the competent authority of denmark to initiate maps, yet if it decides to refuse a request, it will have to give reasons for the refusal. eric velthuizen, settlement of disputes in dutch tax treaty law, at p. 158 arguing that: “the specific case mutual agreement procedure provisions do not grant many rights to the taxpayer. it is clear that a taxpayer has the right to present his case to the authorities. but, it is not clear whether the taxpayer can go to a dutch court and request that a mutual agreement procedure is initiated. the most likely view is that in the netherlands, the taxpayer is not entitled to call for proceedings; the initiation of the mutual agreement procedure is at the discretion of the authorities.” marjaana helminen, settlement of disputes in finnish tax treaty law, at p. 188 clarifying that the taxpayer may not force the authority to invoke the mutual agreement procedure or to grant a tax exemption. entering into negotiations and granting an exemption is totally up to the case-by-case consideration of the authorities. an appeal is not possible against the decision. 85. see rooney & suit supra note 42 at p.700 noting: courts, however, may be especially hesitant to interfere in competent authority negotiations because of the perceived executive nature of the government-to-government negotiation 732 florida tax review [vol. 9:8 interestingly, and despite the near consensus that there is no duty to grant map assistance, map has generally been successful. this is because states favor map, where they do not relinquish their taxing powers, over mandatory and binding arbitration. this is why competent authorities are generally receptive to taxpayers’ requests to grant map assistance.86 in the u.s. refusal to grant map assistance is also rare.87 during a joint conference of the canadian and u.s. branches of the international fiscal association in toronto on may 18, 2007 discussing a fifth protocol to the canada-u.s. income tax treaty, frank ng said that: “in general the success rate of competent authority cases handled by the irs is good, with only about 5% of cases failing to produce tax relief. that tends to suggest the process is working in terms of results.”88 process and perhaps out of deference to the service’s administration of the tax treaties. judicial review may also be more difficult when only one party to the negotiation is subject to u.s. jurisdiction, but should not be impossible for that reason alone. it is a more serious objection that foreign governments may decline to negotiate if their positions and approaches would become public in u.s. court proceedings. it may be, therefore, that aspects of the u.s. competent authority process leading up to sovereign-tosovereign negotiations are the more promising candidates for invoking the courts. (citation omitted) 86. cf. james r. mogle, competent authority procedure, 23 geo. wash. j. int’l l. & econ. 725 (1990) (arguing that while treaties generally do not require competent authority assistance requests to be granted, they are typically granted absent unusual circumstances); perdriel-vaissiëre supra note 82 (indicating that in france the practice is to invoke map); nilausen, supra note 84, at 144 (claiming that the competent authority of denmark is quite open to initiating a map, and resenting a few cases where, despite the fact that the tax authority was unwilling to give up its own taxing rights, the tax authority tried to convince the other country to give up its right to tax or provide other relief on the base of equity). 87. cole, venuti, gordon & croker, supra note 11, at a-34. 88. lisa m. nadal, u.s. canadian officials discuss upcoming protocol, joint initiatives, 2007 tax notes today 99-7 (may 21, 2007). see also kathleen m. matthews, w.s. canadian, and mexican competent authorities discuss dispute resolution, 97 tax notes today 96-4 (may 16, 1997) (interviewing deborah nolan, then irs deputy assistant commissioner (international), who said that “[n]inety-five percent of the competent authority cases in the united states are resolved with either 100% or partial relief. . . .” 2009] mandatory arbitration of international tax disputes 733 the canadian side reports success of the map as well. over 80% of canadian map cases involve the united states, and more than 50% of u.s. cases involve canada.89 cra reported that: of the 303 map cases that were resolved in fiscal year 20082009, 83 cases were categorized as negotiable, which means that bilateral negotiations with another tax administration were required to resolve an issue. of the 83 cases negotiated with other tax administrations, 89% of taxpayers who sought assistance obtained full relief from double taxation and 11% did not obtain relief.90 in a 2006 public discussion draft dealing with proposals for improving the resolution of international tax disputes, the oecd characterized the cases where the competent authority were unable to reach an agreement as rare.91 this is compatible with the data cited above.92 89. greg noble and robert turner, competent authority update, report of the proceedings of the fifty-seventh tax conference, canadian tax foundation, p. 29:13. 90. see canada revenue agency, mutual agreement procedure program report (apr. 1, 2008 – mar. 31, 2009) at http://www.craarc.gc.ca/tx/nnrsdnts/cmp/mp_rprt_2008-2009-eng.pdf. 91. see the 2006 oecd report, supra note 16. the proposed commentary in this report stated that: “this paragraph provides that, in the rare cases where the competent authorities are unable to reach an agreement under ¶ 2, the unresolved issues will, at the request of the person who presented the case, be solved through an arbitration process” (emphasis added). note that this characterization has been omitted from the oecd report, the final report adopted by the committee on fiscal affairs on 30 jan. 2007, feb. 2007, supra note 15. nevertheless, it is very reasonable to argue that this omission does not indicate a change in the oecd characterization which occurred within the one year period between feb. 2006 and feb. 2007. if in fact rare cases remained unresolved through map according to the 2006 report, one could presumably rely on this data as being accurate in 2007 as well, especially when this position is evident in the literature. it could well be that this characterization was omitted from the final report due to comments of michael mcintyre who argued that if in fact only rare cases remain unresolved then it is worth double checking whether adopting the arbitration provision outweighs the other costs associated with such a step. see mcintyre, supra note 10. 92. other commentators disagree with the general notion in the literature regarding the rate of success of map cases. for a thorough discussion see generally altman, supra note 14. see also cole, venuti, gordon & croker, supra note 11 at a36: “statistics show that most double taxation cases brought before the u.s. competent authority are resolved with full relief from double taxation or through withdrawal of the adjustment. however, there are cases where only partial relief or no relief was obtained.” 734 florida tax review [vol. 9:8 g. structural deficiencies of the proposal 1. the two-step approach and the blocking method the link between map and arbitration and the fact that arbitration operates only as an extension to the map weaken the proposal. assume that a taxpayer requests competent authority assistance claiming taxation not in accordance with the treaty. assume further that the competent authority is not interested (say for policy reasons) that the issue at stake be resolved through mandatory and binding arbitration. the competent authority, therefore, takes the position that the request for map assistance is unjustified and declines to initiate map. as clarified above, this is possible. in this scenario the mandatory and binding arbitration provision will malfunction. this is because under the current proposal, the arbitration will be triggered only after the competent authorities exhaust the map negotiations. because in this example there was no map, the arbitration is not triggered. this mechanism will be referred to hereinafter as the blocking method. the competent authority utilized this mechanism to block the mandatory arbitration, hence the name. 93 the issue of the obligatory feature of the map was addressed in the work of william w. park and david r. tillinghast in 2004, sponsored by the international fiscal association.94 the ifa-sponsored draft treaty avoids the 93. see gerrit groen, arbritration in bilateral tax treaties, 30 intertax 3, 14 (2002), noting: “as a consequence, if a contracting state is unwilling to enter into a mutual agreement procedure, the mutual agreement procedures have not been fully exhausted, and the dispute can therefore not be submitted to arbitration. furthermore, the standard arbitration clause does not give a general consent to submit an unsettled dispute to arbitration before the two-year period has elapsed even if it is evident that within this period the dispute will not be resolved through negotiations.” 94. park & tillinghast, supra note 8. park and tillinghast note: the tax treaty arbitration has a close connection with the mutual agreement procedure. arbitration would be initiated only after a mutual agreement procedure. therefore, binding and mandatory arbitration would actually require also that the initiation of a mutual agreement procedure would be obligatory. for example, the dutch representative (mr. gerrit groen) has pointed out that mandatory tax treaty arbitration should require that the competent authorities would be obliged to initiate a mutual agreement procedure at the request of the taxpayer. it could be considered whether the mutual agreement procedure should be rewritten to this effect. alternatively, as the representative from singapore (mrs. christina ng) has suggested, the arbitration article could 2009] mandatory arbitration of international tax disputes 735 problem by taking, as a trigger mechanism, presentation of the claim to only one of the competent authorities.95 the oecd proposal was influenced by this work in many respects but not regarding the triggering event. structuring the arbitration as an extension of the map article has been referred to as the two-step-approach.96 it is not at all clear to me, however, that this is the preferred method. the major problem, as shown above, is the availability of the blocking method. the fact that competent authorities are generally receptive to requests for map assistance should not, and cannot, justify the existence of the blocking method, let alone the fact that this is likely to change, as i argue below. the oecd has emphasized in its reports that the proposal’s major goal is to increase the effectiveness of the map.97 a risk exists that the proposal will have an opposite effect. the idea of arbitration, in various forms, has been debated for quite a while, yet the majority of states have not embraced it. it is no secret that states are reluctant to give up their taxing powers. this is especially true in cross-border transactions of multinational corporations where millions of dollars of potential revenue is at stake. expressly state that arbitration would be initiated also in a situation where the taxpayer was unable to avail itself or was denied the mutual agreement procedure notwithstanding the presentation of its case to the mutual agreement procedure. id. at 74. 95. id. 94. it should be noted that there is no reference here to ¶ 2 of article 25 dealing with the negotiations themselves as in the oecd proposal. william park expressed a similar view in a tax council policy institute symposium in washington in feb. 2002, see kevin a. bell, dunahoo favors exploring arbitration to resolve competent authority disputes, 2002 tax notes today 31-10 (feb. 14, 2002). 96. see luc hinnekens, the search for an effective structure of international tax arbitration within and without the european community, in michael lang, multilateral tax treaties, series on international taxation 18 (1998) 539. 97. see the oecd report supra note 15, ¶ 13 noting: “these additional techniques (referring to the mandatory arbitration) can make the map itself more effective even in cases where resort to the techniques is not necessary. the very existence of these techniques can encourage greater use of the map since both governments and taxpayers will know at the outset that the time and effort put into the map will be likely to produce a satisfactory result. further, governments will have an incentive to ensure that the map is conducted efficiently in order to avoid the necessity of subsequent supplemental procedures. in addition, the introduction of supplementary dispute resolution techniques will reduce the likelihood of costly, time-consuming and possibly conflicting domestic judicial proceedings.” 736 florida tax review [vol. 9:8 so why then would states take a different position now and embrace the arbitration? is it because of the availability of the blocking method that states are less concerned? if tax authorities are still reluctant to adopt mandatory and binding arbitration, the proposal will undoubtedly have a boomerang effect. denying requests for map assistance (as an inherent part of utilizing the blocking method) will become more attractive. the direct result is blocking the mandatory and binding arbitration. the indirect result is that fewer cases will be referred to map (in order not to subject them to mandatory and binding arbitration, in the event they remain unresolved). eventually, instead of enhancing the map and ensuring a “fully effective map process that has the confidence of taxpayers”,98 the outcome could well be weakening it. 2. mapping the arbitration the proposed structure suffers from an additional structural flaw. the differences in the nature of a map and mandatory and binding arbitration are sufficient to make the marriage between the two problematic. the current proposal is to add a new paragraph to the existing map article. by “mapping the arbitration,” if i may use this phrase, the proposal mixes two separate proceedings that have significantly different features. map is consensual and voluntary whereas mandatory arbitration is compulsory. map is a government-to-government diplomatic procedure while mandatory arbitration is referring a dispute to a third and unrelated party for a binding resolution. states should be allowed to control whether or not to grant competent authority assistance while they should not be granted this privilege in mandatory arbitration.99 in a map the parties are free to settle on grounds that best suits them. this is the advantage of the map. and the fact that the taxpayer is not bound by the agreement supports this feature. in mandatory arbitration, on the other hand, it is presumed that general and internationally accepted principals should guide the arbitration panel in reaching its decision and should be the controlling source of law during the arbitration.100 international arbitration plays a significant role in producing international trans-border rule of law that will constitute a source of law to be 98. oecd, “improving the process for resolving international tax disputes” 2, (july 27, 2004), available at http://wwwoec.org/dataoecd/44/6/33629447.pdf suggesting a different view when the dispute involves tax arbitrage. 99. see part h of this chapter suggesting a different view when the dispute involves tax arbitrage. 100. see generally international fiscal association, ifa resolution of tax treaty conflicts by arbitration, (1994). 2009] mandatory arbitration of international tax disputes 737 referred to in future disputes.101 some kind of transparency and publicity is therefore necessary in mandatory arbitration. in map, confidentiality is an accepted feature.102 map has limitations and restrictions that emerge from domestic and internal legal systems of the contracting states. the map is different in each jurisdiction while mandatory and binding arbitration requires a more unified feature to ensure its success. more importantly, the parties to the arbitration relinquish control over the proceedings,103 unlike the case in the map where the parties are constantly in control of how the proceedings develop, when and if to settle or when to abandon the negotiations. in other words, there is an inherent distinction between the two proceedings and by “mapping the arbitration,” we defeat the purpose of the mandatory arbitration. the mechanism under the proposal is neither mandatory nor is it arbitration. it lacks the compulsory feature because of the existence of the blocking method and the classification as arbitration is inaccurate because the proposed provision lacks basic features that are present in arbitration. 101. see thomas e. carbonneau, the law and practice of arbitration, 429 (2d ed. 2007) arguing for this point in the international commercial arbitration context. 102. see mcintyre, supra note 10 at 636: “defenders of secrecy are likely to argue that secrecy is a normal feature of an arbitration procedure. it is certainly true that most domestic arbitration proceedings are secret. the analogy to domestic arbitrations, however, is inappropriate. domestic arbitrations are typically between private parties, the costs of the arbitration are privately financed, and the issues being resolved are private disputes. in sharp contrast, the oecd is proposing an international body that would be charged with the responsibility of deciding the amount of tax due to sovereign states. that dispute is a public dispute, the costs of resolving it are charged to the public, and the parties to that dispute (the governments) are public bodies accountable to their citizens.” (citation omitted). 103. see carbonneau., supra note 101, at 1 defining arbitration: “arbitration is a private and informal procedure for the adjudication of disputes. it is an extrajudicial process. it functions as an alternative to conventional litigation. it yields binding determinations through less expensive, more efficient, expert and fair proceedings. although it can engender settlements, arbitration is not intended to operate as a means for achieving dispute resolution directly through party agreement. arbitration is neither negotiation nor mediation. the parties confer upon the arbitrator’s full legal authority.” 738 florida tax review [vol. 9:8 a final remark on this issue is noteworthy. paragraph 46 of the oecd commentary on article 25, addressing a situation where map was unsuccessful, originally stated:104 it is difficult to avoid this situation without going outside the framework of the mutual agreement. this approach was not adopted, however, in the current proposal. in the revised commentary, paragraph 46 is replaced with a new paragraph 46 stating that: the arbitration process provided for by the paragraph is not an alternative or additional recourse….the paragraph is, therefore, an extension of the mutual agreement procedure....105 the language of the pre-revised commentary seems to suggest a similar logic that map and arbitration are two separate frameworks and the mixture of the two is bound to result in confusion and complexity in developing the arbitration and this could undermine the mandatory and binding arbitration. i think the following comparison could serve as a good example to further illustrate this argument. assume that a taxpayer files a tax return with the tax authority who in turn disagrees with certain issues, for example allocation of deductions or income. the taxpayer has the option of litigation but, in most cases, it also has available an “internal” appeals process, where the taxpayer attempts to settle the issue with the tax authority before turning to judicial remedies.106 this internal appeals process enjoys characteristics similar to the map: it is voluntary, the parties can decide whether to utilize it or to skip directly to litigation; it is a bilateral negotiation process between the two parties and binding only on the taxpayer and the tax authority, and it has no precedential value. the negotiations are secret, as is any settlement reached. the parties do not relinquish control over the process, the outcome or the determination whether or not to settle. this is the case in map as well. 104. see oecd commentary on article 25, supra note 27, at ¶ 46. (emphasis added.) 105. see oecd report, supra note 15, at ¶ 46. (citation omitted). 106. in the u.s. the tax decision reached by the examiner may be appealed to a local appeals office, which is separate and independent of the irs office that conducted the examination. if the parties agree, a closing agreement will be signed and the resolution is final. see internal revenue service, appeals process, at: http://www.irs.gov/govt/fslg/article/0,,id=158488,00.html. see also irc § 7121. 2009] mandatory arbitration of international tax disputes 739 nevertheless, if the taxpayer is unable to settle the case with the tax authority through the appeals process (or if it decides not to utilize this option), the case will proceed to litigation, at which point the parties are no longer decision makers. this is now an external proceeding rather than an internal one. the mandatory arbitration resembles the external proceeding while map resembles the internal one. these are two separate proceedings. h. arbitrage and arbitration in taxation international tax arbitrage has been defined as a lofty term that refers to taking advantage of differences among country tax systems, usually differences in addressing a common tax question.107 i will approach the discussion in this part of the article in the following manner: first, i will briefly raise the question whether international tax arbitrage is a concern; then, concluding that such a concern exists and under the assumption that oppressing tax avoidance is a goal of the itt network, i will check how the mandatory arbitration provision addresses this issue and how it fits this framework. 1. is tax arbitrage a concern? some commentators argue that the arbitrage is not (and should not) be a concern and so long as a transaction does not rise to the level of a tax shelter or tax evasion, taxpayers should be allowed to benefit from the tax results as permitted by each tax jurisdiction’s laws.108 nevertheless, other players in the international tax arena side with the opposing view including the league of nations and the oecd.109 the u.s. has embraced this view as well.110 107. see h. david rosenbloom, the david r. tillinghast lecture: international tax arbitrage and the international tax system, 53 tax l. rev. 137, 142. see also daniel n. shaviro, more revenues, less distortion? responding to cross-border tax arbitrage, 1 n.y.u. j. l & bus. 113, 116: “taking advantage of inconsistencies between different countries’ tax rules to achieve a more favorable result than that which would have resulted from investing in a single jurisdiction.” 108. see rosenbloom, supra note 107. 109. see generally supra notes 11-13. 110. see irs news release ls-1068 (dec. 8, 2000) “challenges for tax policy in a global economy,” treasury acting assistant secretary for tax policy jonathan talisman remarks to the irs/gw annual institute on current issues in international taxation, washington, dc, available at http://www.ustreas.gov/press/releases/ls1068.htm (arguing that tax arbitrage is problematic and distorts economic behavior). 740 florida tax review [vol. 9:8 2. the relevance to the mandatory arbitration provision one might wonder what relevance the above issue has to the discussion of mandatory and binding arbitration. michael mcintyre has pointed out this relevance.111 mcintyre argues that mandatory and binding arbitration could facilitate double non-taxation because taxpayers can utilize the arbitration to achieve no-tax results. the assumption behind this argument is that the arbitration panel will resolve the disputes based, first and foremost, on the wording of the itts.112 therefore, in the same manner that taxpayers utilize the itts to achieve double non-taxation they will be able to utilize the mandatory and binding arbitration to enforce double non-taxation. surprisingly (or not) the oecd did not address this issue. the proposal addresses only double taxation cases. the oecd did not condition triggering the mandatory arbitration upon actual double taxation. this is the case in the eu convention for the arbitration of transfer pricing disputes.113 had this approach been adopted, this would have eased the concern of tax arbitrage. 111. see mcintyre, supra note 10. 112. see sample mutual agreement on arbitration (“applicable legal principles,”) attached annex to the oecd report, § 14, supra note 15: the arbitrators shall decide the issues submitted to arbitration in accordance with the applicable provisions of the treaty and, subject to these provisions, of those of the domestic laws of the contracting states. issues of treaty interpretation will be decided by the arbitrators in light of the principles of interpretation incorporated in articles 31 to 34 of the vienna convention on the law of treaties, having regard to the commentaries of the oecd model tax convention as periodically amended, as explained in ¶¶ 28 to 36.1 of the introduction to the oecd model tax convention. issues related to the application of the arm’s length principle should similarly be decided having regard to the oecd transfer pricing guidelines for multinational enterprises and tax administrations. the arbitrators will also consider any other sources which the competent authorities may expressly identify in the terms of reference. 113. see convention on the elimination of double taxation in connection with the adjustments of profits of associated enterprises, article 14 (addressing the scope of the convention and clarifying that its application is in double taxation cases), available at www.vilp.de/enpdf/e271.pdf. see also id. at article 6 and 7 making clear that the map and arbitration procedures are triggered where double taxation has not been removed. 2009] mandatory arbitration of international tax disputes 741 i will borrow an example from lee burns114 to illustrate this issue. burns addresses an arbitrage known as the “double dipping” transaction, where the transactions are structured in a way that a single expenditure is deducted twice. the key to the tax benefit under such transactions is that the expenditure is deducted against two separate amounts of income in two countries with neither country taxing both amounts.115 the example presented by burns is that of a cross-border finance lease that involves the lessor (financier) in one country and the lessee in another country. the aim of a cross-border leasing transaction is to structure the transaction so that the tax treatment of the lease is different in the two countries it is treated as a lease for tax purposes in the financier’s country of residence and as a purchase on credit in the lessee’s country of residence. this means that both the financier and the lessee can claim deductions in relation to the ownership of the asset (particularly, depreciation deductions). these deductions are applied against the income of the lessor (financier) and against the income of the lessee. while both countries are allowing a deduction for the same costs, each country is taxing only one amount of income. so a single outlay is being deducted against two separate amounts of income by two different taxpayers in two different countries.116 if one of the countries disallows the deduction under tax avoidance principles and the dispute is eventually referred to an arbitration panel for resolution, it appears that the arbitration panel would have no other option but to accept and enforce the structure of the transaction resulting in double non-taxation.117 114. lee burns, cross-border tax arbitrage, 2001 tax conference, adb institute (sep. 5-11, 2001), available at: http://www.adb.org/documents/events/2001/tax_conference/tax_arbitrage.pdf. 115. id. at 2. 116. id. at 6. 117. for further illustration see mcintyre, supra note 10 at 627: double non-taxation cases are themselves common and are often the goal of sophisticated tax planning. as an example, assume that country a exempts capital gains and country b does not. country b, however, has a tax treaty with country a that exempts some but not all capital gains earned in country b by a resident of country a. the taxpayer, a resident of country a, earns a capital gain of $100 million in country b, which it claims is exempt from tax in country b under the tax treaty. the tax officials of country b disagree and have a reasonable basis for that disagreement. the taxpayer asks the competent authorities of country a to intervene on its behalf, claiming that taxation by country b is ‘not in accordance with’ the treaty. if the matter were to go to arbitration and the taxpayer were to win, the result would be international double nontaxation. 742 florida tax review [vol. 9:8 the oecd proposal does not contribute to achieving the two primary goals of the itt network. in fact, it can be utilized to defeat them. the result is that a negative answer will be given to the two evaluation questions presented in part one of the article thereby facilitating the conclusion that the proposal, in its current structure, should be reexamined. iii. the united states and mandatory and binding arbitration a. introduction the situation in the u.s. regarding mandatory and binding arbitration of international tax disputes does not differ from that in other countries. the u.s. has agreed to include, in some itts, ad hoc arbitration provisions, where the contracting states can refer a dispute to arbitration if and when both countries agree to do so. this is usually referred to as “voluntary” arbitration.118 in this case, the contracting states are under no obligation to refer the dispute to arbitration and the authority to do so is entirely committed to their discretion. for example, this is the situation in the itt between the u.s. and mexico and the previous itt between the u.s. and germany before the recent change, as will be addressed below.119 however, despite its existence in some itts, voluntary arbitration has not been utilized. i have personally contacted the competent authorities of both germany and mexico inquiring how many disputes between each of these countries and the u.s. have been referred to arbitration under the voluntary arbitration provisions. both respectful representatives replied that not any disputes have been referred to voluntary arbitration. when the then new voluntary arbitration provision in the germanu.s. itt was first introduced, it was regarded a major and even unusual step because this was the first time an arbitration provision was presented.120 this was the notion despite it being voluntary arbitration.121 nonetheless, as mentioned, this provision was never tested. it was broadly worded granting both contracting states discretion as to how, when and if to submit a dispute to arbitration. the question i wish to address in this part of the article is whether or not there has been a change in the u.s. tax treaty policy regarding the inclusion of mandatory and binding arbitration provisions in its itt network. 118. for an exhaustive discussion regarding the distinction between predispute and post-dispute provisions see park & tillinghast, supra note 8. 119. see infra note 137. 120. see andre p. fogarasi, et al., use of international arbitration to resolve double taxation cases, 18 tax mgmt. int’l j. 319 (aug. 11, 1989). 121. id. at 320, citing joseph h. guttentag and ann e. misback, resolving tax treaty issues: a novel solution, bull. for int’l fiscal documentation (1986). 2009] mandatory arbitration of international tax disputes 743 do the recent ratifications of the protocols to the itts with germany, belgium, canada and france, in which mandatory and binding arbitration provisions have been introduced, indicate a policy change? and if yes, to what extent is the u.s. willing to implement this policy, what method of arbitration will be favored, is the referral to arbitration in fact guaranteed and how will the proposed provisions operate? b. historical background it is not a secret that the unites states, as other countries, has opposed the inclusion of mandatory arbitration in its itt network. this was the position of the national reporters of the united states presented in the 1981 conference of the international fiscal association.122 the previous voluntary arbitration provision in the itt with germany was advanced by the german government and therefore some scholars have doubted this indicated a policy decision from a u.s. perspective.123 during the discussions for the inclusion of a voluntary arbitration provision in the canada-u.s. itt, it was clarified in the 122. see koch, supra note 8, at 279: it is understood that the irs does not favor arbitration, as it believes that the mutual agreement article will work better if it continues to represent the us. since there are many factors involved in the resolution of mutual agreement cases, arbitration would prevent the consideration of all these factors and the development of the bilateral rapport that has been so important in the resolution of cases until now. see also oecd, transfer pricing and multinational enterprises: three taxation issues, supra note 8, for the oecd position at that time. see also forgarasi, supra note 120, at 321: “we understand that the irs and treasury representatives to the oecd were reluctant to accept the principles of arbitration to resolve double taxation cases, feeling that such a procedure would, in effect, be ceding the u.s. government’s right to determine and assess its taxes.” 123. see mark k. beams, obtaining relief through competent authority procedures and treaty exchange of tax information – the us approach, 46 bull. for int’l fiscal documentation, 119 (1992) at 121, addressing the then recently ratified treaty with germany with the earlier version of the voluntary arbitration provision, because the german government advanced this concept, it is not clear the extent to which it represents the current treaty policy of the united states, and it is therefore unclear whether this provision will appear in future u.s. treaties; indeed some more recent treaties have appeared that contain no arbitration provision. for a different opinion, see forgarasi, supra note 119 at 321: “the acceptance of the arbitration provision in the proposed u.s.-german income tax treaty indicates a change in view, at least by the treasury department negotiators.” 744 florida tax review [vol. 9:8 explanation of the proposed protocol to the itt, prepared by the joint committee on taxation, that the application of this provision was limited.124 this approach was the united states’ position with other treaty partners where voluntary arbitration provisions were adopted.125 hesitancy toward mandatory arbitration continued to persist. in an annual meeting of the federal bar association tax section in march 1996, devoted to the competent authority process, irs assistant commissioner for international tax matters, mr. john lyons, noted that arbitration procedures are interesting concepts, but he cautioned against putting too much hope in the arbitration process. he concluded, based on u.s. experience, that even agreeing to the architecture for arbitration takes an exceedingly long and difficult period of time.126 this was also the notion at the aba tax section meeting that took place on may 10, 1997.127 the u.s. maintained this 124. see staff of joint comm. on taxation, explanation of proposed protocol to the income tax treaty between the united states and canada 44 (joint comm. print (1995), available at: http://www.house.gov/jct/pubs_byyear_1995.html: even within the bounds of the competent authorities’ decision making power, there likely would be issues that one or the other competent authority would not agree to put in the hands of arbitrators. consistent with these principles, the technical explanation expects that the arbitration procedures will ensure that the competent authorities generally would not accede to arbitration with respect to matters concerning the tax policy or domestic tax law of either treaty country. 125. see robert green, antilegalistic approaches to resolving disputes between governments: a comparison of the international tax and trade regimes, 23 yale j. int’l l. 79, 101 (1998) and references thereafter. he states that: arbitration under these u.s. treaties will be voluntary, occurring only when both governments and the affected taxpayer agree to submit the case and to be bound by the award. the united states, germany, mexico, and the netherlands have further stipulated that they generally will not agree to arbitrate matters concerning “tax policy or “domestic tax law.” the u.s. legislative history of the treaties with canada, france, and kazakhstan also suggests that arbitration under these tax treaties likely will be confined to fact-specific disputes. 126. see susan lyons, competent authority process discussed at fba meeting, tax notes today (mar. 11, 1996), available at lexis (96 tnt 49-5). 127. see kathleen matthews, u.s., canadian, and mexican competent authorities discuss dispute resolution, tax notes today (may 19, 1997), available at lexis (97 tnt 96-4): “the competent authorities of canada, mexico, and the united states said may 10 that they do not see increasing the availability of arbitration as an important incentive to resolve disagreements.” representing the u.s. was irs deputy assistant commissioner (international) deborah nolan, who made clear that the united states does not intend or desire to invoke arbitration as long as the competent authority process continues to enjoy its 90% success rate. she 2009] mandatory arbitration of international tax disputes 745 consistency in its position during the uruguay round of negotiations over expanding the general agreement on tariffs and trade (“gatt”). against the position of all the other members, the u.s. maintained its resistance to the national treatment obligation of the gatt to apply to income tax measures until very limited language was adopted.128 c. has the u.s. tax treaty policy changed? in the last 10 years or so, it seems as if the positions of irs officials have deviated from consistent reluctance to “willing to consider” mandatory and binding arbitration. this, at least, is the impression from some of the interviews with irs officials throughout this period.129 in his testimony before the senate committee on foreign relations on pending income tax agreements, john harrington, treasury international tax counsel stated: over the past few years, we have carefully considered and studied mandatory arbitration procedures. in particular, we examined the experience of countries that adopted mandatory binding arbitration provisions with respect to tax matters. many of them report that the prospect of impending mandatory arbitration creates a significant incentive to compromise before commencement of the process. based on our review of the u.s. experience with arbitration in other areas of the law, the success of other countries with arbitration in the tax area, and the overwhelming support of the business community, we concluded that mandatory binding arbitration as the final step in the competent denied any knowledge of the united states engaging in discussions on its possible inclusion in the ec arbitration directive. see also jacqueline manasterli, multinational government officials address secret comparables at irsgw international tax institute, worldwide tax daily (dec. 11, 1998), available at lexis (98 tni 238-1). 128. for an exhaustive discussion regarding the development of the negotiations and the u.s. position see green, supra note 125. 129. see tax notes international’s interview with carol danahoo, former u.s. irs competent authority, (jan. 19. 2004), available at lexis (2004 wtd 125). danahoo argues for the inclusion of mandatory and binding arbitration to the u.s. treaty policy and believes that such a provision is in need. she argues for mandatory and binding “baseball” arbitration where the taxpayer is heard and the outcome of the arbitration is not published. see also kevin bell, germany-u.s. tax treaty arbitration process addresses sovereignty issue, 43 tax notes int’l 214 (july 17, 2006). 746 florida tax review [vol. 9:8 authority process can be an effective and appropriate tool to facilitate mutual agreement under u.s. tax treaties.130 he also mentioned that: “moreover, a country’s fundamental tax policy choices are reflected not only in its tax legislation but also in its tax treaty positions.”131 nevertheless, i believe it would be dubious to claim that the united states’ tax treaty policy has changed. first of all, why wasn’t such a provision included in the revised u.s. mc released november 2006? one explanation offered by benedetta kissel, treasury deputy international tax counsel was: “we don’t want to get ahead of senate.”132 i am skeptical as to how convincing this argument is and to me it still seems that the u.s. is hesitant when it comes to adopting mandatory and binding arbitration. second, when comparing the scope of the map article in the u.s. mc and the proposed arbitration provisions, an attempt to narrow the application of mandatory and binding arbitration is evident. the map article is broad in coverage and is intended to apply to a wide variety of disputes. the u.s. has taken steps towards expanding the application and utilization of map.133 the map article in the u.s. mc is even broader in its language than that of the oecd mc. for example, a taxpayer can present its case to any of the competent authorities and is not limited to the resident competent authority, as is the case in the oecd mc. the structure of the arbitration provisions in the u.s. follows the two-step-approach as well.134 not all disputes eligible for discussion and resolution under map, however, fall within the scope of the mandatory and binding arbitration. the itts between the u.s. and belgium, germany, canada and france grant the competent authorities discretion to agree that certain cases are not suitable for arbitration.135 in the itts between the u.s. and both germany and 130. see john harrington, treasury international tax counsel recommends committee approval of four pending income tax agreements, tax notes today (jul. 18, 2007), available at lexis (2007 tnt 138-60). 131. id. 132. see robert goulder, u.s. tax officials talk up treaty arbitration, worldwide tax daily (dec, 15, 2006), available at lexis (2006 wtd 241-1). 133. see generally christine halphen and ronald bordeaux, international issue resolution through the competent authority process, 9 tax notes int’l 433 (aug. 8, 1994). see also supra note 14 and accompanying text. the fact that very few requests for map assistance have been denied can indicate the trend to utilize this mechanism at maximum. 134. note that here the provision refers the case to arbitration unlike the oecd proposal that refers only the unresolved issues to the arbitration. 135. see for example the convention between the government of the united states of america and the government of the kingdom of belgium for the 2009] mandatory arbitration of international tax disputes 747 canada, yet additional limitations were added. in the itt with germany, disputes regarding the dividends and interest articles were excluded from the scope of the mandatory and binding arbitration.136 in the itt with canada, in addition to the dividend and interest articles, certain disputes under the royalties article were also carved out of the scope of mandatory and binding arbitration.137 avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, (nov. 27, 2006), available at lexis (2006 wtd 229-7). 136. see protocol amending the convention between the united states of america and the federal republic of germany for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital and to certain other taxes, (jun. 1, 2006), available at lexis (2006 wtd 107-9). the protocol amends ¶ 22. the new ¶ 22 states: in respect of any case where the competent authorities have endeavored but are unable to reach an agreement under article 25 regarding the application of one or more of the following articles of the convention: 4 (residence) (but only insofar as it relates to the residence of a natural person), 5 (permanent establishment), 7 (business profits), 9 (associated enterprises), 12 (royalties), binding arbitration shall be used to determine such application, unless the competent authorities agree that the particular case is not suitable for determination by arbitration. in addition, the competent authorities may, on an ad hoc basis, agree that binding arbitration shall be used in respect of any other matter to which article 25 applies. 137. the full version of the protocol is available at lexis (2007 tnt 18582). in the letters exchanged between the two governments, it is clarified that the mandatory arbitration will deal only with specified issues: in respect of any case where the competent authorities have endeavored but are unable to reach a complete agreement under article xxvi (mutual agreement procedure) of the convention regarding the application of one or more of the following articles of the convention: iv (residence) (but only insofar as it relates to the residence of a natural person), v (permanent establishment), vii (business profits), ix (related persons), and xii (royalties) (but only (i) insofar as article xii might apply in transactions involving related persons to whom article ix might apply, or (ii) to an allocation of amounts between royalties that are taxable under ¶ 2 thereof and royalties that are exempt under ¶ 3 thereof), binding arbitration shall be used to determine such application, unless the competent authorities agree that the particular case is not suitable for determination by arbitration. in addition, the competent authorities may, on an ad hoc basis, agree that binding arbitration shall be used in respect of any other matter to which article xxvi applies. if an arbitration proceeding (the 748 florida tax review [vol. 9:8 last, a common feature to the u.s. arbitration provisions is the use of the so called “baseball” arbitration where the arbitral panel can chose only one of the two proposed resolutions submitted by the contracting states.138 officially referred to as “final-offer” arbitration, this is an arbitration in which each party submits a “final offer” to the arbitrator, who may choose only one.139 this type of arbitration does not suit disputes regarding the existence of a permanent establishment, for example, or the definition of terms such as “investment bank,” “royalties” or “services.”140 for the reasons mentioned above, i believe the u.s. expresses a policy position aimed at limiting the application of mandatory and binding arbitration.141 iv. conclusion a. addressing the concerns i have attempted to present the structural deficiencies that exist in the current proposals for mandatory and binding arbitration. addressing these deficiencies is not the only amendment that could improve the proposals. “proceeding”) under paragraph 6 of article xxvi commences, the following rules and procedures shall apply…. 138. the relevant provision in the u.s. – belgian itt for example states that: “the arbitration board will deliver a determination in writing to the contracting states within six months of the appointment of its chair. the board will adopt as its determination one of the proposed resolutions submitted by the contracting states.” protocol belgium/usa 27/11/2006, convention between the government of the kingdom of belgium and the government of the united states of america for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income; available at www.treas.gov/press/releases/reports/initialed %20protocol%20%2011.20.06%20%20final%20for%20printing.doc. 139. black’s law dictionary 41, (8th ed. 2004). 140. see park, supra note 9, noting that: “however, for other issues the more traditional process might be appropriate.” for example, arbitrators might be asked to determine what is a royalty (as opposed to personal services), interest (as opposed to rent in a finance lease), or to decide where the taxpayer has a “center of vital interest: or a permanent establishment. in international tax arbitration in which taxpayers are given a role it is uncertain how the baseball format would work.” 141. i will note that between the time this article was originally written and its publication, the u.s. senate ratified a new protocol to the itt with france which, among other things, added the mandatory arbitration provision discussed above. during the hearing before the senate foreign relations committee, manal corwin, international tax counsel to treasury, testified that mandatory arbitration would not be included in the u.s. mc and will be considered only on a case-by-case basis. see kristen a. parillo, no plans to include mandatory arbitration in u.s. model treaty, treasury official says, worldwide tax daily (nov. 12, 2009), 2009 wtd 216-1. 2009] mandatory arbitration of international tax disputes 749 scholars have raised additional concerns regarding issues such as the selection of the arbitration panel, implementation of the arbitration decision and conflicts with domestic laws, time limitations, precedential value of the decisions, taxpayer participation in the proceedings, the binding aspect of the decision to the states and to the taxpayer, appointing the arbitrators, review of the arbitration decision, the costs and expenses of the proceeding, legal status of the treaty and commentary and, the language of the arbitration.142 i have chosen to focus on the structural problem which in my mind is the first step in the adoption of such proposals. the mechanics of the arbitration are not less important than the structure of the provision itself, yet the structure is the foundation. adopting a provision which lacks structural consistency with the anticipation of future fixings is similar to building on weak foundations. this is why i believe that no arbitration is better than bad arbitration. if it were up to me, i would adopt mandatory and binding arbitration only when we are certain that it will function positively and not in a situation, as is currently, where reasonable risks of wrongful application (or non-application) are present. a major flaw is the availability of the blocking method which defeats the basic concept of mandatory arbitration. because of the blocking method, the mandatory and binding arbitration will lose its efficiency and effectiveness. the provision will not function in a manner compatible with the goals of the itt network. on one hand, it does not secure the prevention of double taxation and on the other hand, it could be abusively utilized to achieve a no-tax result. the concern of the itts historically was to prevent double taxation. this concern played a leading role in the evolution of the itt network. yet nowadays more attention is given to preventing double non-taxation and confronting sophisticated and aggressive tax planning strategies. this change clouds the necessity for mandatory and binding arbitration. accepting the status quo and postponing the adoption of mandatory and binding arbitration might not a bad option.143 the characterization of the oecd that the 142. see generally park & tillinghast, supra note 8. see also park supra note 9. see also mcintyre, supra note 10. see also altman supra note 14. see also züger supra note 14. see also desax & veit, supra note 18. see also morgan supra note 18. see also ault, improving the resolution of international tax disputes, 7 fla. tax rev. 137 (2005) and infra note 146. see also groen, supra note 93. 143. see groen, supra note 93, at 27, expressing a skeptical view as to the adoption of mandatory arbitration claiming: mandatory arbitration at the request of the taxpayer should not be introduced, due to the obscurity of tax treaties on many issues such as e-commerce and hybrid entities. in cases like these it may be difficult for a board to decide a case on the basis of the treaty and principles of international law, thereby increasing the likelihood of decisions based primarily on considerations of equity which 750 florida tax review [vol. 9:8 unrelieved cases of double taxation are “rare”144 buttresses this conclusion. the overall result does not seem that dramatic. the itts have been developing for years and changes in one tax jurisdiction have affected others. the consensus regarding taxpayers’ protection against double taxation is strong and this explains why only a small portion of double taxation cases remain unresolved. the question is whether it is plausible to anticipate that the same course of development will occur with the campaign against double nontaxation. is it reasonable to predict that contracting states will acknowledge the necessity of accepting harmonized and uniformed principles such as the single tax and the matching principles? will countries accept the argument that aligning their tax systems as much as possible will have an overall benefit? trends in this direction are evolving constantly and the oecd’s focus on this issue is the best evidence. the ultimate goal should be to arrive to a mandatory and binding arbitration provision uniformed in terms of the triggering event, with taxpayer participation, binding to all parties and with clear guidelines regarding the initiation of the arbitration, how to conduct it and which controlling principles to follow. while i appreciate that this may be too much to ask for, the question remains whether to adopt the current proposals or to reexamine them before doing so. i have advocated against introducing mandatory and binding arbitration as proposed. the current proposals do not meet the basic goals of the itt network, fail the two evaluation tests set forth in part one of the article and are neither efficient nor effective. they could be abused both by competent authorities and by taxpayers.145 b. a more effective structure? as an alternative, i believe the mandatory and binding arbitration should be introduced as an independent stand-alone provision. the nature and core of map are its consensual and voluntary features. these do not exist in arbitration when it is mandatory and binding. this resembles the should be avoided. only with respect to specific factual disputes, such as transfer pricing disputes, could mandatory arbitration at this point in time be considered. moreover, further research should be done on the implementation of arbitration awards in the national legal order of the states involved and guidelines should be drafted concerning the annulment of the award by municipal courts in order to avoid incongruent implementation of the award. 144. see supra note 91. 145. in addition, note that the difference in the provisions adopted by the u.s. (with baseball arbitration) and mandatory arbitration under the oecd proposal (which will presumably be followed by the majority of the oecd member states) will cause additional confusion. 2009] mandatory arbitration of international tax disputes 751 dispute resolution mechanisms under bilateral investment treaties and free trade agreements. this is the case in the eu transfer pricing convention as well.146 the arbitration should be triggered in the case of a dispute, as the default mechanism for the resolution of the dispute, at the request of the taxpayer, unless both competent authorities express their willingness to commence map negotiations, in which case the arbitration will be postponed. if the parties are able to settle the case, we can applaud the result. if within the two year period they do not settle, the dispute will be transferred to mandatory and binding arbitration for final resolution. when one or both competent authorities deny a map request, the arbitration will be triggered with no need to wait for the two year period to elapse. in addition, the arbitration should be conditioned on actual double taxation from which the taxpayer is seeking relief. i realize that not only double taxation could be a violation of itts.147 nevertheless, this condition will mitigate the concern that taxpayers can achieve no-tax results. taxpayer participation seems necessary, as a party potentially affected by the arbitration decision. this would require the taxpayer to waive its domestic remedies and accept the outcome, as was the situation in the original draft of the oecd. in addition, some sort of transparency would contribute to strengthening and implementing the arbitration. by making these modifications it will be possible to achieve the following: first, this will eliminate the availability of the blocking method. denying map assistance in order to prevent triggering arbitration is not available under this structure. second, the effectiveness and efficiency of map will be enhanced. this structure will motivate the competent authorities to go to length in their efforts to settle. when being subject to mandatory and binding arbitration is a definite alternative, competent 146. see desax & veit, supra note 18, at 413: a person familiar with international commercial or investment arbitration may regret that oecd has shied away from setting up an independent system of arbitration. however, it must be recognized that the process leading to the proposal to supplement the mutual agreement procedure by arbitration had been a tedious one whereby lots of obstacles had to be removed. several national tax authorities were afraid that by setting up an independent system of arbitration, they would give up a substantial part of their legal prerogatives to tax, which could raise delicate constitutional issues. see also hugh ault, arbitration in international tax matters: some structural issues, series of international taxation no. 27, (kluwer law), (2001) at 63: “more useful, perhaps, would be to provide a separate article in the model convention which would actually set forth a coherent arbitration scheme.” 147. see mario züger, icc proposes arbitration in international tax matters, 2004 european taxation 221, 224. 752 florida tax review [vol. 9:8 authorities will find it more “attractive” to negotiate with the perception of settling. we could then expect more cases to be referred to map than under the current proposals. this is bound to improve the effectiveness of the map and to motivate the competent authorities to efficiently take advantage of it. third, this structure will presumably goad tax administrations to augment the authority delegated to their competent authorities. the goal would be to enable the competent authorities to freely negotiate with broader authority to settle. fourth, by conditioning the arbitration on the existence of double taxation we mitigate the concern that taxpayers seeking under-taxation results can rely on the arbitration provision to execute this strategy.148 the oecd and many commentators have argued that the mere existence of mandatory and binding arbitration will make the map more effective.149 this argument has been presented by proponents of mandatory and binding arbitration in only so many occasions. yet this is not applicable to the current proposals. by utilizing the blocking method the competent authorities can block triggering the mandatory and binding arbitration. the mandatory and binding arbitration is not an incentive to utilize map, under 148. at this point the reader may wonder how to reconcile between the voluntary nature of map and this alternative that in effect turns map into an inevitable alternative. two comments are offered: first, this is only an alternative. maintaining the status quo for the time being doesn’t carry harsh results and is as good a solution. second, only double taxation cases are at stake. in this case, if the competent authorities do not want to negotiate, they are free to do so, but taxpayer is provided with full protection from being taxed twice. if they decide not to negotiate and no double taxation is at stake, this is a bearable result as well. 149. see oecd report supra note 15. see also park & tillinghast, supra note 8 at 20: “perhaps the most significant effect of treaty arbitration provisions will lie in the incentive to the competent authorities to arrive at prompt and satisfactory agreements. certainly, the number of cases which would actually go to arbitration would be a small fraction of those which entered the competent authority process.” see also desax & veit, supra note 18, at 429: “possibly, the mere existence of the supplemental arbitration procedure will cause the competent authorities to reach agreement, and to reach agreement before the two-year waiting period to institute arbitration proceedings expires.” see also yitzhak hadari, resolution of international transfer-pricing disputes, 46 can. tax j. 29, 57 (1998): it is contended that the mere fact that rules of compulsory arbitration are added to tax treaties would strongly encourage the competent authorities of the countries involved to resolve the dispute before the invocation of this avenue of this last resort. thus, an arbitration mechanism would serve a useful purpose even if it were not invoked in practice. see also thomas rixen, a politico-economic perspective on international double taxation avoidance, 49 tax notes int’l 599 (2008). 2009] mandatory arbitration of international tax disputes 753 the current proposals, but rather a disincentive. on the other hand, when the mandatory and binding arbitration clause is an independent stand-alone provision, triggered as discussed above, the only way to “block” the arbitration is by settling the dispute. in this latter case, the mandatory and binding arbitration functions as an incentive to utilize map. i recommend reexamining the proposals before their adoption augments. the holy bible, proverbs (chapter xv, v. 17): “better is a dinner of herbs where love is, than a stalled ox and hatred therewith” tcharity really does begin at home: florida tax review volume 13 2012 number 2 41 the u.s. and chile tax treaty and its impact on foreign direct investment by hugo hurtado* abstract the tax treaty signed between chile and the united states will reduce withholding rates applicable to interest, royalties, and capital gains and will exempt certain income derived from pension funds, services, and business profits not attributable to permanent establishments. this article concludes that the exemption and reduction of withholding taxes may have a positive impact on chilean foreign direct investment (“fdi”) in the united states since chilean investors and pension funds will benefit from this exemption or reduction and from the fact that a broader type of investment income (interest, capital gains, and services) will be available for tax credits under the chilean income tax law. however, it is not altogether clear whether the loss of revenues from the reduction of taxes applied to income accrued by u.s. residents in chile will be rewarded with greater fdi from the united states in chile. this conclusion is mainly based on the fact that unless the u.s. investor has an excess tax credit position, such reduction will be offset by the higher u.s. corporate income tax on the income. furthermore, the loss of revenues can be especially relevant for chile as a result of applying the most favored nation clause included in several tax treaties signed with other organisation for economic co-operation and development (“oecd”) members. *professor of law, universidad diego portales and pontificia universidad católica de chile. ll.b. universidad católica de chile; s.j.d. in taxation and ll.m. in international taxation, university of florida levin college of law. i would like to thank yariv brauner for his helpful feedback and emily dawson and guillermo vial for their assistance. all mistakes are mine. 42 florida tax review [vol.13:2 i. introduction ............................................................................... 43 ii. taxation of business and investment income in chile and the united states ............................................................... 46 1. taxation of business profits ............................................... 46 2. taxation of dividends ......................................................... 48 3. taxation of interest ............................................................. 50 4. taxation of royalties .......................................................... 53 5. taxation of capital gains ................................................... 55 6. current withholding tax on fdi ....................................... 58 iii. the chile-u.s. tax treaty ....................................................... 59 1. historic background ........................................................... 59 2. treaty negotiations ............................................................. 61 3. taxation of business profits in the treaty ......................... 64 3.1 permanent establishment ............................................ 64 3.2 income attributable to a permanent establishment ..... 67 4. taxation of dividends in the treaty .................................... 69 5. taxation of interest in the treaty ........................................ 73 6. taxation of royalties in the treaty ..................................... 76 7. capital gains in the chile-u.s. tax treaty ....................... 80 7.1 capital gains on traditional assets ............................. 80 7.2 capital gain on non-traditional assets ..................... 82 7.2.1 the equity swap: a practical approach ................... 83 8. practical effect of the treaty on fdi ................................ 85 iv. the tax credit system ............................................................. 86 1. the tax credit system ....................................................... 86 2. interaction between the tax credit system and fdi ......... 87 3. effect on fdi of the tax credit system in connection with the tax benefits of the treaty .................................... 90 v. the limitation on benefits clause ...................................... 92 1. residents qualified to receive the benefits of the treaty . 93 2. effect of the limitation on benefits clause on fdi ........... 97 vi. conclusion ................................................................................... 98 2012] u.s. and chile tax treaty 43 i. introduction foreign direct investment (“fdi”) from both the united states in chile and from chile in the united states has consistently grown in both amount and diversity during the last decade.1 in fact, the united states is the most important source of fdi in chile, and the united states is the second greatest recipient of chilean fdi after brazil.2 fdi is usually encouraged because it is considered to have a positive effect on the gross domestic product (“gdp”) of the recipient country3 based on the general argument that greater investment generates a higher gdp.4 a country’s gdp has three main components: consumption, investment, and government spending.5 the result of the interaction between the three components and its direct effect on the gdp is not altogether clear; however, at least some macroeconomists believe that a greater investment rate generates a higher gdp.6 borensztein, de gregorio, and lee proposed that fdi has a positive effect on the gdp of the recipient country if that country has qualified human capital.7 the basic premise behind this positive effect is that if one of the components of gdp (investment materialized by foreign investors) increases, gdp will rise as a natural effect of this growth. however, there is 1. u.s. investment in chile for 2009 was usd$ 2,252 billion, whereas chilean investment in the united states amounted to usd$ 1,333 billion in the same period. see amcham chile, cifras comerciales entre chile y estados unidos [commercial figures between chile and the united states], el mercurio (chile), mar. 21, 2011 at se 4, http://www.amchamchile.cl/sites/default/files/ amcham%20el%mercurio.pdf. 2. francisco gaete & miguel ángel urbina, chilean direct investment 2006-2009, stud. in econ. stat. no. 84, mar. 2011, at 12, http://www.bcentral.cl/estudios/estudios-economicos-estadisticos/pdf/see84.pdf (last visited mar. 24, 2012). 3. see eduardo borensztein et al., how does foreign direct investment affect economic growth?, 45 j. int’l econ. 115, 115 (1998). 4. see generally felipe larraín, inversión productiva [productive investment], el mercurio (chile), sept. 17, 2009, at b13, http://www.mer.cl/ modulos/generacion/mobileasp/detailnew.asp?idnoticia=c17858220090917&strn amepage=merstce013bb1709.htm&codcuerpo=710&codrev=&inumpag=13& strfecha=2009-09-17&ipage=1&tipopantalla= (analyzing the relationship between fdi and gdp using world bank data). 5. olivier blanchard, macroeconomics 46–47 (pearson prentice hall, 4th ed. 2006). 6. see generally felipe larraín, supra note 4, at b13. 7. borensztein et al., supra note 3, at 115. 44 florida tax review [vol.13:2 not unanimous agreement on the subject mainly because of the considerable number of variables involved that are hard to isolate.8 in consequence, some countries are tempted to lower their taxes unilaterally or bilaterally — through tax treaties — in order to attract fdi with the hope of raising gdp and increasing revenue collected through income taxes. on the other hand, fdi exposes the investor to different economic and legal systems since the tax system of the resident country together with the tax system of the country that receives the investment must be analyzed in conjunction to determine the investor’s final profit.9 many countries try to grant relief from uncoordinated tax systems that often create double taxation for residents conducting business abroad through the use of unilateral relief. however, since the first implementation of unilateral tax relief by the united states in 1918, most countries have understood that tools granted by domestic laws are not sufficient to deal with the different rules related to sources of income, allocation of expenses, exchange of information, dispute resolution, and other issues that arise in international trade.10 since these goals cannot be fully achieved by unilateral measures, countries negotiate tax treaties with other countries to pursue these objectives.11 the main purposes of tax treaties include avoiding double taxation and preventing tax avoidance and evasion.12 with that in mind, the governments of chile and the united states signed the unites states of america and chile tax convention (“the treaty”) in january 2010. the treaty is based on the 2006 u.s. model (also including clauses from the 8. see anil kumar, does foreign direct investment help emerging economies, fed. reserve bank of dallas econ. letter (jan. 2007) http://www.dallasfed.org/assets/documents/research/eclett/2007/el0701.pdf but see henrik hansen & john rand, on the causal links between fdi and growth in developing countries, 29 world econ. 21 (jan. 2006) (pointing out that countries must reach a certain level of development in education or infrastructure before they are able to attract fdi; hence, fdi seems to have a limited effect on the gdp of less developed countries). 9. tsilly dagan, national interests in the international tax game, 18 va. tax rev. 363, 366 (1998-1999). 10. organisation for economic co-operation and development, comm. on fiscal affairs, model tax convention on income and on capital (2005) [hereinafter 2005 oecd model]. for an historic background on unilateral tax relief, see also michael j. graetz and michael m. o’hear, the original intent of u.s. international taxation, 46 duke l.j. 1021 (1997). 11. id. 12. staff of j. comm. on taxation, background and issues relating to the taxation of foreign investments in the united states (comm. print 1990). 2012] u.s. and chile tax treaty 45 2001 u.n. model and the 2008 oecd model tax convention)13 and is the second treaty that the united states has ever signed with a south american country.14 this article will explore the main consequences on fdi of the treaty between the united states and chile and will be divided into four sections. for this purpose, the article will analyze the major tax provisions applicable to investment income in chile and the united states that are currently in force (without a treaty), reviewing the main changes to the domestic tax treatment of fdi provided by the treaty. the article will then examine the effect of the limitation of benefits clause and the tax credit system on fdi and will present conclusions, arguing that when the treaty is in force, the treaty’s reduction of withholding rates might have an effect on chilean investments in the united states given chile’s low corporate tax rate,15 but the rate reduction granted by the chilean government will have an uncertain impact on united states fdi in chile since the u.s. has a worldwide system that will offset these decreased tax rates. however, the treaty is expected to reduce chile’s fiscal revenues because of the reduction in withholding rates and the consequential reduction in tax rates in other treaties under the most favored nation clause included in other tax treaties signed with other oecd members such as spain, canada, korea, denmark, france, ireland, mexico, united kingdom, new zealand, sweden, and switzerland. 13. the oecd model tax convention is the main framework to negotiate tax treaties among developed countries and is based on a reciprocal level of investment flows among residents of both countries. however, the u.n. model tax convention is used when a developing country negotiates a tax treaty with either a developing country or a developed country and is based on different levels of investment among countries. the main difference between both models is that the u.n. model grants greater tax authority to the source country, thus reducing the impact on the fiscal losses derived from the signature of a tax treaty. 14. the other tax treaty signed was between the united states and venezuela. see convention between the government of the united states of america and the government of venezuela for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital, u.s-venez., jan. 25, 1999, t.i.a.s. 13020, http://www.irs/gov/pub/irstrty/venezu.pdf. 15. in accordance with law no. 20.455 — enacted partially to finance chile’s reconstruction efforts after the 2010 earthquake — first category tax is currently set at 20 percent for 2011; 18.5 percent for 2012 and 17 percent for 2013 and beyond. law no. 20.455, july 31, 2010, diario oficial [d.o.] (chile). 46 florida tax review [vol.13:2 ii. taxation of business and investment income in chile and the united states this section will review introductory aspects of the united states and chilean tax systems regarding investment income such as business profits, dividends, interest, royalties, and capital gains. in order to provide a practical approach to the matter, this section will analyze the current taxation of a corporation incorporated in the united states that obtains these types of profits in chile and vice versa to compare it with the taxation after the treaty is in force in the next section. 1. taxation of business profits business profits obtained by a u.s. corporation (“usco”) in chile that are considered chilean source are generally taxable with the additional tax (“impuesto adicional”) at a flat rate of 35 percent under sections 58 and 60 of decree law number 824 of 1974 (“chilean income tax law” or “citl”). income will be considered chilean source if it arises from assets that are located in the country or from activities performed therein.16 if usco acts directly in the country, the additional tax must be withheld by the resident payor of the income.17 if usco has any kind of permanent establishment (“pe”), such as branches, offices, agents, or representatives, in chile, a 35 percent additional tax will be assessed on the permanent establishment on a net basis on any income distributed to the united states18 the concept of pe is not defined in the citl, but the chilean internal revenue service (“sii”) recognizes that this concept must be broadly interpreted.19 it basically includes any extension of usco’s activity in chile, through an office or a fixed place that is entitled to represent usco and perform formal activities such as entering into agreements as per usco’s instructions.20 therefore, a small threshold of activity is sufficient to consider that usco is acting through a pe in chile.21 16. ley sobre impuesto a law renta [hereinafter “l.i.r.”], law no. 824, dec. 28, 1974, diario oficial [d.o.] (chile). 17. l.i.r. art. 74. 18. servicio de impuestos internos [s.i.i.], oficio no. 1259, apr. 29, 2005 (chile), http://www.sii.cl/pagina/jurisprudencia/adminis/2005/otras/ja935.htm. 19. s.i.i., oficio no. 2205, june 5, 2000 (chile), http://www.sii.cl/ pagina/jurisprudencia/adminis/ 2000/renta/junio13.htm. 20. id. 21. s.i.i., oficio no. 2530, july 13, 1994 (chile), http:www.sii.cl/pagina/ jurisprudencia/adminis/1994/ renta/jul2.htm. 2012] u.s. and chile tax treaty 47 the taxation of profits obtained by usco in chile combines corporate and withholding taxes. first, once the profit is accrued, a 20 percent corporate tax called first category tax (“impuesto de primera categoría”) is assessed on the business’s annual taxable income determined on an accrual basis.22 if usco acts in chile through a subsidiary, the additional tax is levied only when business profits are distributed to usco. in consequence, if the subsidiary does not remit profits to the parent, the additional tax can be deferred. the total effective rate payable on profits remitted abroad to a nonresident partner or shareholder, as the case may be, is normally 35 percent because the 20 percent corporate tax is generally credited against the amount due at the second level of taxation.23 on the other hand, in order to determine the taxation of business profits of a chilean corporation (“chileco”) obtained in the united states, two key elements must be analyzed: whether chileco is engaged in a u.s. trade or business and whether its income is effectively connected to a u.s. source trade or business.24 under section 882 of the internal revenue code (“irc”), if chileco is engaged in a u.s. trade or business, it is taxable on its net effectively connected income at normal corporate rates (generally 35 percent);25 otherwise, such income will be taxable at a flat 30 percent on a gross basis.26 the determination of whether chileco is engaged in a u.s. trade or business is done on a case-by-case basis and is analogous to the concept of “permanent establishment,” whereas the concept of “effectively connected” is analogous to the “attributable” notion under article 7 of the oecd model.27 generally speaking, there are four28 categories of effectively connected income for chilean corporations currently engaged in the conduct of a trade or business in the united states.29 the first and second categories encompass investment income such as capital gains, fixed or determinable annual or periodical income, and certain other income that is treated similarly. as a consequence, investment income will be considered effectively connected if it satisfies tests (the asset use test and the business 22. l.i.r. art. 15. 23. l.i.r. art. 63. 24. see paul r. mcdaniel et al., introduction to united states international taxation 72 (aspen publisher 5th ed. 2005). 25. i.r.c. § 882. 26. i.r.c. § 881. 27. mcdaniel et al., supra note 24, at 54. 28. there are actually five categories, but due to the similarities among capital gains and fixed or determinable, annual or periodical income, they are treated together for practical purposes. 29. i.r.c. § 864(c). 48 florida tax review [vol.13:2 activity test) designed to determine whether they have sufficient economic nexus to the u.s. trade or business.30 fixed or determinable, annual or periodical income includes interest, dividends, rents, royalties, salaries and wages (in the case of individuals), premiums, annuities, and other forms of compensation.31 third, capital gains derived from the disposal of u.s. real property investment are treated as if chileco were engaged in a trade or business in the united states, and that gain is effectively connected to such trade or business.32 lastly, all other income not expressly included in the aforesaid categories is treated as effectively connected with the conduct of a trade or business in the united states under a limited force of attraction principle.33 2. taxation of dividends dividends distributed from a chilean corporation to usco are subject to the additional tax at a flat rate of 35 percent under article 58(2) of the citl. the tax is withheld by the chilean corporation when the dividend is distributed.34 the same treatment is generally granted to distributions from partnerships to non-resident partners.35 the integrated chilean system ensures that the dividend paid to the non-resident shareholder will not be subject to an effective income tax rate higher than 35 percent. this is also the reason claimed by chile for including the so called “chile clause” in all of its tax treaties in order to not reduce the withholding tax on dividends since the 35 percent overall tax is considered sufficiently fair.36 30. jessica l. katz, et al., u.s. income taxation of foreign corporations, 908-2nd tax mgmt. (bna). 31. robert meldman & michael schadewald, a practical guide to u.s. taxation of international transactions 373–386 (kluwer law international 3rd ed. 2000). 32. i.r.c. § 897. 33. i.r.c. § 864(c)(3). 34. l.i.r. art. 74, no. 4. 35. l.i.r. art. 60. 36. for example, article 10 of the chile-u.s. tax treaty provides: “this paragraph shall not affect the taxation of the company’s profits out of which the dividends are paid.” in the case of chile, this taxation includes the application of the additional tax. convention between the government of the republic of chile and the government of the united states of america for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital [hereinafter chile-u.s. tax treaty], chile-u.s., art. 10, feb. 4, 2010, http://www.treasury.gov/resource-center/tax-policy/treaties/documents/chiletreaty 2010.pdf; see also sandra benedetto & astrid schudeck, el convenio para evitar la 2012] u.s. and chile tax treaty 49 on the other hand, article 58 no. 1 of the citl subjects permanent establishments and agencies to the same 35 percent tax on distributions to non-resident owners. under article 21 of the citl, loans granted by a partnership to its non-resident partners are taxable as distribution of profits if the sii considers that such loan is a disguised distribution of profits.37 in the case of a corporation, if the same conditions are met, a flat tax of 35 percent is applied to that distribution.38 in contrast, as a general rule, a 30 percent tax is applied on dividends paid by a u.s. corporation to chileco under section 881 of the i.r.c.39 nevertheless, if the income from which the dividend arises is at least 80 percent from non-u.s. source, an exemption is granted to the non-resident recipient of the dividend if certain conditions are met.40 the term “dividends” is broadly defined under the i.r.c. and regulations to include distributions by corporations from current retained earnings and profits and substitute payments that are derived from the ownership of stocks.41 under section 884 of the i.r.c., a branch profit tax of 30 percent is applied to foreign corporations on a dividend equivalent amount for the taxable year, granting a similar tax treatment to distributions of profits from branches as that applied to subsidiaries.42 although the term “dividend equivalent amount” aims to be analogous to a tax on dividends, it has a different basis. indeed, section 884 (b) and (c) of the i.r.c., defines this term as chileco’s effectively connected earnings and profits for the taxable year adjusted by differences on the u.s. net equity (u.s. assets minus u.s. liabilities) of the foreign corporation as of the close of the preceding taxable year and the u.s. net equity of the foreign corporation as of the close of the taxable year.43 doble imposición: tratamiento aplicable a los dividendos [the chile-u.s. tax treaty: taxation of dividends], 1 serie de estudios técnicos amcham 9, 12 (2010) (chile). 37. l.i.r. art. 21, ¶ 1. 38. id. 39. i.r.c. § 881(a). 40. the income must arise from the active conduct of business in a foreign country for the three-year period ending with the close of the taxable year of the individual or corporation preceding the payment. see i.r.c. §§ 871(i)(2), 881(d). 41. see generally boris i. bittker & lawrence lokken, fundamentals of international taxation ¶ 67.2.3, at 67–20 (warren, gorham & lamont ed. 2005–2006). 42. i.r.c. § 881(b). 43. i.r.c. § 881(c). 50 florida tax review [vol.13:2 3. taxation of interest under article 59 of the citl, interest on loans made by usco to a resident company or individual is currently taxed at 35 percent. interest is considered to be sourced in chile if the debtor is domiciled in chile.44 this rate is reduced to 4 percent on interest arising from certain types of credits or debt instruments.45 a total exemption from additional tax is granted to interest obtained by foreign bank or financial institution lenders that grant a loan to a chilean financial institution that in turn loans the principal abroad.46 thin capitalization rules were enacted in 200147 to restrict the application of the 4 percent tax rate when loans are granted between related parties, especially in connection with back-to-back arrangements. parties are deemed to be related if: (a) the lender is domiciled or incorporated in a jurisdiction considered to be a tax haven; (b) the lender directly or indirectly owns or holds 10 percent or more of the borrower’s capital or profits; (c) the lender and the borrower48 are owned by a common shareholder that directly or indirectly owns or holds 10 percent or more of the capital or profits of both; and (d) the financing has been granted with a direct or indirect guarantee from a third party in cash or valuables, up to the amount effectively guaranteed in this manner.49 this rule provides that an additional 31 percent is levied on a portion of the interest paid if the total amount of the related borrowing is in excess of an objective debt to equity ratio of 3:1.50 44. l.i.r. art. 10. 45. in accordance with article 59 of l.i.r., the following transactions benefit from the 4 percent tax rate: (i) credit extended abroad by foreign or international banks or financial entities, insurance companies or foreign pension funds registered in accordance with article 106 of l.i.r.; (ii) interest paid from publicly traded debt instruments in accordance with article 104; (iii) balances (unpaid portions) on the price of imported goods; (iv) interest payments arising from bonds or debentures issued by the chilean government and the chilean central bank; (v) interest paid on deposits made in foreign or local currency accounts made with chilean institutions duly authorized by the chilean central bank; and (vi) interest on latin american banking acceptances made by members of the latin american integration association (aladi). l.i.r. art. 59. 46. l.i.r. art. 59, ¶ 4, no. 1(b). 47. law no. 19.738 (2001) (chile). 48. in accordance with article 59, number 1, paragraph 7(e) of the l.i.r., thin capitalization rules do not apply in cases where the debtor is engaged in financing activities and is recognized as a financing institution by the ministry of finance. l.i.r. art. 59, no. 1, ¶ 7(e). 49. l.i.r. art. 59, ¶ 4, no. 1, ¶ 3(c). 50. s.i.i., circular no. 24, mar. 14, 2002 (chile), http://www.sii.cl/ documentos/circulares/2002/circu24.htm. 2012] u.s. and chile tax treaty 51 it is important to point out that the difference (31 percent) between the tax rate effectively paid (35 percent) and the reduced tax applicable (4 percent) will be borne by the payor related company and, therefore, it could be accepted as an expense to decrease its taxable income under article 31 of the citl.51 current thin capitalization rules included in the citl encourage investment through debt instead of equity because, from the economic perspective of foreign investors, both the interest52 and the 31 percent tax difference are deductible expenses, thereby decreasing the chilean subsidiary’s taxable income.53 from the standpoint of tax policy, this tax treatment was enacted in 2001 as a response to the need to attract fdi to a developing country.54 nevertheless, with chile’s current economic situation and the expectation that the country can become a developed country by 2018,55 it is unclear whether such policy is optimal for chile in the near future because it deflects revenue to the country in which the non-resident company is established, consequentially reducing chilean revenue that could be targeted to other objectives.56 51. l.i.r. art. 59, no. 1, ¶ 3(e). 52. articles 37 and 38 of the l.i.r. provide rules that require an arm’s length price on the interest charged between related parties, but it does not provide rules related to debt that partakes of business risk. l.i.r. arts. 37–38. 53. a stamp tax with a rate of up to 0.6 percent of the total amount borrowed may be assessed on this loan, and transfer pricing rules under article 38 of the l.i.r. may apply to decrease the amount of interest paid to the non-resident. therefore, all factors must be considered to make a final decision as to the most convenient form of investment. l.i.r. art. 38. 54. law no. 19.738, supra note 47. 55. the finance minister, felipe larraín, estimates that chile will become a developed country in 2018 if gdp grows at an annual rate of 6 percent. if this occurs, the country will achieve a gdp per capita of usd$ 22,000, similar to that of portugal. it is important to bear in mind that the term “developed country” is not altogether clear, and major global institutions (e.g., the world bank, oecd, and u.n.) do not agree on a specific definition. see, chile pretende llegar en 2018 al nivel de riqueza del mundo desarrollado (chile in 2018 aims to reach the level of wealth of the developed world), this is chile (may 28, 2010), http://www.thisischile.cl/article.aspx?id=4176&sec=288&eje=&t=chile-pretendellegar-en-2018-al-nivel-deriqueza-del-mundo-desarrollado&idioma; felipe larrain, chile pretende llegar en 2018 al nivel de riqueza del mundo desarrollado, http://www.thisischile.cl/articles.aspx?id=4176&sec=288&eje=&t=chile-pretendellegar-en-2018-al-nivel-deriqueza-del-mundo-desarrollado&idioma (last visited nov. 1, 2010). 56. this legislation was intended to reduce the cost of financing internationally, since most lenders simply added the tax withheld in the payor’s country to the interest rate applicable to the loan using a gross-up clause. the 52 florida tax review [vol.13:2 from a u.s. perspective, interest from a u.s. source paid to chileco is subject to a 30 percent withholding tax under section 871 of the i.r.c.57 similar to chile, interest is generally sourced according to the residence of the payor; hence any interest paid by a u.s. corporation to a corporate nonresident of the united states is considered u.s. source interest by the federal government.58 however, the i.r.c. includes an important exception.59 if chileco makes deposits with a foreign branch of a u.s. corporation or a u.s. partnership, if such branch is engaged in the commercial banking business, interest arising from such deposits will be tax exempt in the united states.60 on the other hand, the i.r.c. provides specific exemptions for certain types of interest. interest paid from a portfolio investment to chileco is exempt from the 30 percent withholding tax.61 for these purposes, portfolio interest is any u.s. source interest other than interest effectively connected with the conduct of a u.s. trade or business paid or accrued on debt obligations issued after july 8, 1984.62 the i.r.c. also provides an exemption for interest on bank deposits and similar arrangements held by an insurance company under an agreement to pay interest.63 with respect to thin capitalization rules, section 385 of the i.r.c. allows regulations classifying obligations as debt in part and equity in part.64 however, no regulations under this provision have yet been proposed; hence, main issues on this topic are solved based on case law and revenue rulings taking into consideration that a high debt to equity ratio suggests that purported debt is equity because a holder of the corporation’s debt is not protected by the equity cushion typically enjoyed by a debt holder and thus bears risks more like those of a shareholder 65 deflection of revenues is derived from the fact that this interest is likely to be subject to tax in the country where the lender is domiciled. 57. i.r.c. § 871(a)(1)(a). 58. richard l. doernberg, international taxation 29 (thomson west 6th ed. 2004). 59. i.r.c. § 861(a)(1)(b). 60. the education, jobs, and medicaid assistance act, pub. l. no. 111226, enacted on august 10, 2010 repealed another benefit associated with interest paid by a u.s. corporation that obtains at least 80 percent of its gross income from non-u.s. trade or business, in which case none of the interest paid to a non-resident was subject to taxes in the united states see also doernberg, supra note 58, at 30. 61. i.r.c. §§ 871(h)–1444(c)(9). 62. see meldman & schadewald, supra note 31. 63. i.r.c. §§ 871(i)–881(i)(3)(c). 64. i.r.c. § 385. see paul r. mcdaniel et al., federal income taxation of corporations 147-156 (foundation press 2d ed. 2001). 65. id. 2012] u.s. and chile tax treaty 53 4. taxation of royalties payments derived from the use in chile of trademarks and other analogous rights owned by usco related to industrial and intellectual property are deemed to be sourced in chile.66 in accordance with article 59 of the citl, income from these royalties is subject to a 30 percent withholding tax at source.67 however, the rates of the applicable additional tax may vary depending on the nature of the intangible asset that generates the income.68 the 30 percent rate is reduced to 15 percent when royalties are paid for the use or the right to use software or other intellectual property in connection with a computer or a processor. however, if payments are made to a related party, the tax rate is increased to 20 percent.69 deductions for royalty payments to usco are generally fully deductible if they are deemed necessary to produce income for the recipient of the intellectual property.70 however, the citl provides that the deductions will be limited to up to 4 percent of the payor’s gross income when payments are made to a non-resident unless the non-resident is not related to the payor of the royalty or — if related — unless the income derived from the royalty payments is subject to an income tax rate equal to or greater than 30 percent.71 consequently, given the current corporate tax rate in the united states, royalty payments to usco should not be subject to the aforesaid limitation on deductions. from a u.s. perspective, royalties arising from property or interests located in the united states owned by chileco are deemed u.s. source taxable at a 30 percent withholding rate under section 861.72 since the location of the intangible property can be an arguable issue, the i.r.c. determines that the use or privilege of using patents, copyrights, secret processes and formulae, goodwill, trademarks, trade brands, franchises, and 66. l.i.r. art. 10, ¶ 2. 67. l.i.r. arts. 59, 74, 79. 68. the rates included in (i) above can be raised up to 80 percent if the president of chile considers that the intangible asset is unproductive or not necessary for the country’s economic progress. additionally, the l.i.r. applies a 20 percent tax rate on the total amount paid to non-resident producers and/or distributors for material shown in theaters or on television and a 15 percent tax rate on copyrights paid to non-residents. 69. one party is deemed to be related to another if the recipient of the payments owns 10 percent or more of the equity or the right to profits of the payer of the royalties or if both recipient and payor are under a common partner that directly or indirectly owns 10 percent or more of the equity or right to profits of each company. l.i.r. art. 59, ¶ 4, no. 1. 70. l.i.r. art. 31, no. 1. 71. l.i.r. art. 31, no. 12. 72. i.r.c. § 861(a)(4). 54 florida tax review [vol.13:2 the like within the united states is equivalent to the intangible property being located within the united states.73 payments considered to be contingent on the productivity of the intangible asset are treated as royalties rather than capital gains.74 the allocation of expenses must respect the arm’s length standard under section 482 and its regulations on transfer pricing; however, this topic is highly litigated in courts due to the disparity in criteria between the i.r.s. and taxpayers.75 for instance, a conflict over transfer pricing between the i.r.s. and the multinational pharmaceutical giant glaxosmithkline resulted in a usd$ 3.7 billion settlement, putting an end to the largest tax conflict in u.s. history.76 the main conflict regarding transfer pricing arises from the particularity of the intellectual property.77given the innovative or unique nature of intangibles, which is their essence, comparables generally do not 73. joseph isenbergh, foundations of u.s. international taxation, 900-2nd tax mgmt. (bna) ch. i, sec. h. 74. id. 75. for example, in eli lilly co. v. commissioner, 856 f.2d 855 (7th cir. 1988), a u.s. parent company constituted a subsidiary in puerto rico to which it transferred patents and know-how. this subsidiary in turn manufactured a medication and sold the product to its parent company.75 the i.r.s. decided that the price charged for the assets transferred by the parent company was insufficient, and, thus, the parent company’s profits should be increased. the united states tax court decided to use the residual profit split method, allocating the revenue from manufacturing and renting the facilities in puerto rico to its subsidiary and the expenses related to marketing the product in the united states to the parent company. it then allocated the residual profit between the parent company and subsidiary in a 45/55 proportion. the problem with the decision adopted by the court was that no basis was provided for this proportion of the parent’s transfer of patents and manufacturing know-how to its subsidiary in exchange for stock in the subsidiary. in a similar case, hospital corp. v. commissioner, 81 t.c. 520 (t.c. 1983), the united states tax court ruled that the combined profits from the u.s. parent company and its subsidiary in the cayman islands should be distributed 75 percent for the former and 25 percent for the latter. these parameters were not based on objective criteria, but rather a subjective estimate by the court, which calculated that the contribution of personnel, know-how, experience, and contract negotiation assistance was worth three-fourths of the business’s profits. see also the united states tax court’s decision in bausch & lomb inc. v. commissioner, 92 t.c. 525 (t.c. 1989), in which the court decided to divide the business’s profits from the production of contact lenses in equal parts without providing grounds for the criteria used for this division. 76. irs accepts settlement offer in largest transfer pricing dispute ir2006-142 (sept. 11, 2006), http:www.irs.gov.newsroom/article/0,,id= 162359,00.html. 77. yariv brauner, value in the eye of the beholder: the valuation of intangibles for transfer pricing purposes, 28 va. tax rev. 79 (2008). 2012] u.s. and chile tax treaty 55 exist and, when they do exist, there is no reliable information for determining their price.78 considering that research and development (“r&d”) might considerably reduce u.s. source income and not affect foreign source income — and related tax credits — the united states has a mixed system of legal and geographical deductions together with a formulary apportionment based on sales or gross income in order to allocate r&d expenses among parent and subsidiaries related to the production and exploitation of the intangible.79 for instance, if chileco must incur r&d expenses to meet legal requirements imposed by a food, drug, safety or compliance institution, or any similar entity, such expenses are exclusively allocated to the country that imposes such requirements.80 the remaining expenses are allocated as follows: 50 percent to the location where most of the expenses were incurred and the remaining 50 percent under a formula based on the ratio of u.s. sales to worldwide sales.81 alternatively, the regulations permit 25 percent of r&d to be allocated to the place where the expenses were materialized, and the remainder can be apportioned based on the ratio of u.s. gross income to worldwide income.82 however, this is applicable only to the extent that the result of the apportionment is at least 50 percent of the result under the sales method.83 5. taxation of capital gains in accordance with the citl, the general rule is that gains realized by usco on chilean capital assets are subject to the first category tax with a 20 percent tax rate and the additional tax with a 35 percent tax rate.84 as mentioned above, the former can be credited against the latter. a capital gain is deemed realized in chile if the capital asset is located in the country.85 as a result, if usco sells shares in corporations and interests in partnerships established under the laws of chile at a gain, such income will be taxable in chile.86 if usco has held its stock for more than one year, the capital gain realized on the sale of those shares is subject to the 78. id. 79. i.r.c. § 864(f). 80. see doernberg, supra note 58, at 66. 81. reg. § 1.861-17(c). 82. reg. § 1.861-17(b); mcdaniel et al., supra note 24, at 50. 83. see doernberg, supra note 58, at 67. 84. l.i.r. art. 20, nos. 2–5; art. 60. 85. l.i.r. art. 10. 86. l.i.r. art. 10, ¶ 1. 56 florida tax review [vol.13:2 first category tax as a sole tax.87 however, if usco is engaged in selling shares on a habitual basis, or if it sells the stock to a related party,88 the additional tax is applied in addition to the first category tax.89 the citl also taxes gains from the sale of shares or interest in a foreign entity made by usco to an individual or entity established under the laws of chile. this gain is sourced in chile if the acquisition permits direct or indirect participation in the equity or profits of a corporation or partnership established under chilean law.90 furthermore, the citl provides several exemptions for capital gains. for instance, gains from american depositary receipts (adrs)91 and cuotas (or units) of chilean investment funds are exempted of taxes if at least 90 percent of the underlying assets are invested outside of chile.92 in addition, capital gains realized on sales of stocks, debt instruments, investment fund units, and mutual fund units that are publicly traded by a non-resident institutional investor, such as a foreign investment fund, mutual fund or pension fund, are also exempted.93 in order to access this benefit, the nonresident institutional foreign investor must meet a series of additional registration and reporting requirements.94 however, the most important exemption for capital gains is granted to both residents and non-residents with respect to gains on the sale of issued 87. a similar tax treatment is granted to alienation of mining rights when they do not form part of the asset registry of a company that has full accounting in chile and is taxable under the first category tax, intellectual property when it is sold by its inventor or author, alienation of rights in a mining company, and alienation of bonds or debentures. l.i.r. art. 17, no. 8. 88. in accordance with paragraph 4 of article 17 of the l.i.r., a transaction is deemed to be made with a “related person” if it is made by a partner or shareholder of a company and the company in which he or she has an interest. the s.i.i. has ruled that this interest is of an economic nature and does not include a family relationship. s.i.i., oficio no. 3150, nov. 12, 1996 (chile), http://home.sii.cl/sacn/oficios/ja0328.pdf. 89. l.i.r. art. 17, no. 8(a); art. 10. 90. however, this source rule will not apply if this transaction does not result in the acquisition of more than 10 percent of the equity or profits of the “target” chilean entity. if the chilean acquirer and the acquired company are under a common shareholder — direct or indirect — participation in the equity or profits of the acquired company must also not exceed 10 percent to avoid application of this provision. l.i.r. art. 10, ¶ 2. 91. l.i.r. art. 11, ¶ 3. 92. id. 93. l.i.r. art. 106. 94. see l.i.r. art. 106, §§ 1, 2, 3, 4, 5, 6 and 7 for a detailed list of the requirements. 2012] u.s. and chile tax treaty 57 shares of publicly traded corporations, investment funds, and mutual funds that are actively traded and sold on the chilean stock market.95 finally, a capital gain on immovable property is not taxable for usco if the real estate or rights in real estate held with others do not form part of the asset registry of a company that has full accounting in chile and is taxable under the first category tax.96 however, the taxation on capital gains will be triggered if either of the following conditions are met: (a) the sale is made to a related person or (b) usco is engaged on a habitual97 or regular basis in real estate transactions.98 conversely, in accordance with section 865 of the i.r.c., income from the sale of personal property by chileco is sourced at its residence; therefore, as a general principle, a sale of personal property made by a chilean resident will be exempt of taxes in the united states.99 nevertheless, this general rule has several exceptions. for instance, gain arising from the sale of inventory, which is sourced at the place where the sale occurred.100 nevertheless, if the capital gain arises from the sale of property attributable to an office or fixed place of business located abroad, it is treated as foreign source if the foreign country imposes at least a 10 percent tax on income from such sale.101 in accordance with the i.r.c., if chileco sells depreciable property at a gain, it is sourced in the united states if the depreciation deduction was 95. to apply this tax exemption, the following requirements must be met: (i) the sold shares or units must be of a publicly-held corporation with a “stock exchange presence.” for this purpose, “stock exchange presence” means that the total daily transactions of these securities exceeded approximately usd$ 9,000 for at least 45 business days within the last 180 business days; (ii) the sale must take place on a chilean stock exchange approved by the chilean securities and exchange commission (“svs”) or in a public offer to buy shares under the procedure regulated by the securities law; and (iii) the shares must have been acquired on a stock exchange, in an initial public offering when a company incorporated or increased its capital, in an exchange of convertible bonds, or in a redemption of the underlying assets of an exchange traded fund. l.i.r. art. 107. 96. l.i.r. art. 17, no. 8(b). 97. see oficio no. 1693 of 2002 for elements used by the s.i.i. to determine whether the seller is habitual. s.i.i., oficio no. 1693, may 29, 2002 (chile), http://www.sii.cl/pagina/jurisprudencia/adminis/2002/renta/ja294.htm. 98. pursuant to article 18 of the l.i.r., if usco sells the property within one year of acquisition of the property or four years from the date of acquisition if the property has been subdivided, the taxpayer will be considered habitual whether or not he is engaged in the real estate trade or business. l.i.r. art. 18. 99. i.r.c. §§ 865(a)–(b). 100. see mcdaniel et al., supra note 24, at 41; see also reg. § 1.861-7(a) (providing that a sale of personal property is consummated at the time when and the place where the rights, title, and interest of the seller in the property are transferred to the buyer). 101. see doernberg, supra note 58, at 47; see also i.r.c. § 865(e). 58 florida tax review [vol.13:2 used against income sourced in the united states102 payments on the sale of intangible property owned by chileco that are contingent on the productivity, use, or disposition of the intangible are sourced and taxable as royalties rather than capital gain.103 gain realized by chileco from the disposition of a united states real property interest (“usrpi”) is sourced in the united states.104 a usrpi is defined in very broad terms including an interest in real property located in the united states or the virgin islands; shares in u.s. corporations that own a sufficient u.s. real property interest to satisfy an asset ratio test (more than 50 percent) on certain testing dates; and equivalent interest in a foreign corporation that directly or indirectly (through other entities) owns real property situated in the united states.105 finally, if — instead of chileco — the capital gain is accrued directly by a chilean individual that is not a resident of the united states,106 such gain can still be exempted of taxes if he does not meet the presence test described in the i.r.c.107 under this test, if a non-resident alien is physically present in the united states for at least 183 days during a taxable year, he is subject to a 30 percent tax on the excess of u.s. source gains over capital losses allocable to u.s. sources.108 6. current withholding tax on fdi the following table illustrates the current withholding tax on usd$ 100 in profits — after corporate tax — for both chileco and usco of a classic investment structure in a wholly-owned manufacturing subsidiary in each country from which 40 percent of the profits are remitted as dividends; 30 percent as interest from a regular loan; 20 percent as royalties derived from the use of software; and 10 percent as payments for services provided by the parent in the subsidiary’s country.109 102. i.r.c. § 865(c)(1)(a)–(b). 103. i.r.c. § 865(d)(1)(a)–(b). 104. i.r.c. § 861(a)(5). 105. i.r.c. § 897(c). 106. in contrast, see i.r.c. § 861(5)(f), ruling that a gain realized by a u.s. resident on a foreign corporation is sourced in the united states if more than 50 percent of the gross income is not derived from active trade or business outside of the united states for the last three years preceding the year in which the sale took place. 107. i.r.c. § 871(a)(2). 108. see bittker & lokken, supra note 41, ¶ 67.2.10, at 67–42. 109. the percentages used to illustrate the applicable tax burden are based on the author’s experience with general international investment structures in each country. 2012] u.s. and chile tax treaty 59 chileco’s investment in the u.s. usco’s investment in chile type of payment amount in u.s. dollars tax rate tax type of payment amount in u.s. dollars tax rate tax dividends 40 30% 12 dividends 40 15%110 6 royalties 30 30% 9 royalties 30 30% 9 interest 20 30% 6 interest 20 35% 7 services 10 30% 3 services 10 20% 2 total 100 30 total 100 24 as the table illustrates, the current withholding tax on investment income is a fixed rate in the united states, but it varies in chile depending on the type of income that creates opportunities for advanced tax planning techniques.111 the following section will review the impact of the treaty on current withholding tax to analyze its potential effect on reciprocal fdi. iii. the chile-u.s. tax treaty the objective of limiting double taxation is generally accomplished in treaties by each country agreeing to limit, in certain specified situations, its right to tax income earned from its territory by residents of the other country.112 for the most part, the various rate reductions and exemptions by the source country provided in the treaties are premised on the assumption that the country of residence will tax the income in any event at levels comparable to those imposed by the source country on its residents.113 1. historic background the first tax treaty signed by chile was the convention between chile and argentina for the avoidance of double taxation signed in 1976 110. this rate is calculated as the difference between the additional tax of 35 percent and the current first category tax of 20 percent. 111. this effect is even greater if the structure includes a back-to-back scheme that reduces the withholding tax on interest to 4 percent. as mentioned in section ii.3, this type of structure is accepted by the l.i.r. if it meets the objective 3:1 debt/equity ratio. 112. dagan, supra note 9, at 364. 113. however, this objective is not always achieved because the resident country is not obligated to tax income that was tax exempt in the source country. michael lang, general report on double non-taxation, 89a cahiers de droit fiscal int’l (2004) (austria) (explaining that this consequence is an example of a treaty causing double non-taxation for the taxpayer). 60 florida tax review [vol.13:2 and in force since 1986.114 this treaty follows the exemption method as a system to avoid double taxation and uses as a reference a model from the andes pact (pacto andino),115 although, it also has several sourcing rules of its own.116 since the signing of this convention, all treaties signed by chile have mainly been based on the oecd model tax convention on income and capital (oecd model).117 this model was created in 1963 and, together with its commentaries, has been updated several times, the last of which occurred in 2010.118 on the other hand, while a member of the oecd, the united states opted to promulgate its own model in 1981, which was modified in 1996 and 2006, including its technical explanations.119 this model is substantially similar to the oecd model. however, it contains several differences that affect the taxation of business and investment income, including differences in withholding rates, the power of taxation of the united states with respect to its citizens without regard to their residence (“saving clause”), and provisions related to the limitation of benefits.120 114. see convenio entre la república de argentina y la república de chile para evitar la doble tributación en materia de impuestos sobre la renta, ganancia o beneficio y sobre el capital y el patrimonio [agreement for the avoidance of double taxation between argentina & chile], arg.-chile, nov. 13, 1976, http://www.sii.cl/pagina/ jurisprudencia/convenios/chileargen.htm 115. comm’n of the cartagena agreement [cca] decision 40 (1971) reprinted in ordenamiento juridico de acuerdo cartagena, decisiones 1– 90, 110–30 (junta del acuerdo de cartagena, 1982), http://www.comunidadandina. org/ingles/normativa/d040e.htm (approval of the agreement among member countries to avoid double taxation and of the standard agreement for executing agreements on double taxation between member countries and other states outside the subregion). 116. rivas norberto, doble tributación internacional [double international taxation] (2002) (chile). 117. see oecd, supra note 10. 118. the 2010 update included changes to the attribution of profits for permanent establishments, tax benefits for collective investment vehicles, and other minor issues related to telecommunication services and employment income. see oecd, the oecd approves the 2008 update to the model tax convention, http://www.oecd.org/document/32/0,3746,en_2649_33747_45689952_1_1_1_1,00. html (last visited june 29, 2011). 119. u.s. treasury united states model technical explanations accompanying the united states model income tax convention of november 15, 2006 [hereinafter u.s. 2006 model technical explanations], in martin b. title & reuven s. avi-yonah, the integrated 2006 united states model income tax treaty 255-350 (vandeplas publishing ed. 2008). 120. see martin b. title & reuven s. avi-yonah, the integrated 2006 united states model income tax treaty 1–199 (vandeplas publishing ed. 2008). 2012] u.s. and chile tax treaty 61 u.s. tax treaty policy has not made south america a priority. in fact, of the sixty-seven tax treaties that the united states currently has in force with countries throughout the world, the venezuelan and mexican treaties are the only agreements currently in force with latin american countries.121 the reasons for the limited u.s. tax treaty network in latin america are not altogether clear but, in this author’s opinion, it is likely based on two facts: (i) the strong exchange of information requirements imposed by the united states as a basic condition to start tax treaty negotiations is considered inappropriate interference with secrecy laws and, as a result, with the sovereignty of most latin american countries; and (ii) the relatively small investment by latin american countries in the united states together with relevant political differences between this country and several other countries in the region do not create an appropriate incentive to the united states to move forward with the process of tax treaty negotiation. 2. treaty negotiations the negotiations process for the treaty, which is still pending approval from both congresses, lasted over ten years.122 the main reason for such lengthy negotiations is that the united states required a stricter policy regarding the exchange of information and considered chile’s secrecy laws in appropriate for achieving the desired level of interaction between tax authorities.123 at the same time, the oecd declared that a series of adjustments needed to be made to the chilean tax system, especially in regards to bank secrecy limits on tax matters and policies on the exchange of information by tax authorities. in response, the chilean congress passed law no. 20,406, amending article 62 and adding new article 62 bis to the tax code.124 this law permitted the sii to request information on certain banking transactions, including any data subject to bank secrecy, as required to verify the veracity, completeness or omission of tax returns. this power is also conferred in 121. u.s. income tax treaties – a to z, http://www.irsgov/businesses/ international/article/0,,id=96739,00.html (last visited aug. 22, 2011). the first tax treaties entered by the united states were with france and sweden in 1939. with respect to other latin american countries, the united states terminated a tax treaty with honduras in 1966 and is prompted to start a tax treaty negotiation with brazil. see press release of senator lugar, http://lugar.senate.gov/news/record.cfm?id= 332042&& (last visited oct. 24, 2011). 122. the first round of meetings began in december 1999 and finished in december 2009. see josé madariaga, convenio para evitar la doble imposición entre chile y estados unidos. aspectos generales [the chile-u.s. tax treaty: general issues], 2 revista de estudios tributarios 183, 185 (2010). 123. id. 124. law no. 20.406 (2009) (chile). 62 florida tax review [vol.13:2 cases where such information is requested of the sii by administrative authorities from other countries with which chile has signed international conventions — either specific agreements on this issue or general income tax treaties — that allow such requests.125 once law no. 20,406 was published, as part of chile’s accession effort to the oecd, treaty negotiations moved forward rather quickly since the main barrier to enactment was eliminated. despite the existence of a model to negotiate tax treaties, it is important to point out that countries are usually willing to modify their tax policies to grant concessions to a country treaty partner when such concessions are not deemed to have a large impact on revenues.126 from a tax policy perspective, when chile negotiates a tax treaty with both developed and developing countries, some elements of the united nations model double taxation convention between developed and developing countries of 2001 (“u.n. model”) are also included in the final treaty version, which basically increases the authority of the developing country to tax certain income arising in the source country.127 these modifications attempt to strike a balance between the losses of revenues of the contracting states as a result of signing a tax treaty.128 for instance — and considering that determination of the dynamic effect of taxes on investment is highly complex — since chilean fdi in the united states is less than u.s. fdi in chile,129 the cost to chile of allowing exemptions or reducing tax rates on business and investment income might 125. see código tributario [c.t.] [tax code] arts. 62 and 62bis (chile). 126. for example, in the case of the u.s.-mexico tax treaty, the rental of most commercial, scientific, or industrial equipment that does not constitute immovable property is included in the definition of a royalty. hence, the right to tax that income is shifted to the country in which the tangible property is located, which will generally be the developing country (mexico). see convention between the government of the united states of america and the government of the unites mexican states for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, u.s.-mex., art. 12(3), sep. 18, 1992 [hereinafter u.s.-mex. tax treaty]; see also trea. dep’t, technical explanations of this treaty, ¶ 13 (1992). 127. u.n. dep’t of int’l & soc. affairs, united nations model double taxation convention between developed and developing countries 382, u.n. doc. st/esa/pad/ser.e/21, u.n. sales no. e.01.xvi.2 (2001). 128. bart kosters, the united nations model tax convention and its recent developments, asia-pac. tax bull., jan.–feb. 2004, at 4, http://unpan1.un. org/intradoc/groups/public/documents/unpan/ unpan014878.pdf. 129. see el mercurio, supra note 1. 2012] u.s. and chile tax treaty 63 be higher than the reciprocal benefits granted by the united states to chilean business or investments.130 as explained below, the impact on chilean revenues derives from the direct reduction of withholding taxes and from the fact that such reduction has an even greater impact since it has a collateral effect on other treaties — especially those signed with other oecd members — due to the application of the most favored nation clause.131 under this clause — included in most treaties signed with oecd countries — chile is obligated to grant other oecd members the same reduced withholding rates on dividends, interests, and royalties as those granted to the united states. as a consequence, the tax expenditures related to the treaty must not be measured only considering the direct effect on taxation of u.s. investment, but they have to also consider the effect of the reduction of the withholding tax on income obtained by other oecd members in chile. this is a relevant and complex topic for chile considering its recent oecd membership because it presents the challenge of a country that has aspirations of becoming a developed country but has not yet reached that level. as explained below, this intermediate position has forced chile to present several reservations in most tax provisions on investment income and arbitration clauses included in the oecd model, showing that chile is still preserving the source-country position over the residency-country position as of 2010. as described in section 7.1 below, the most important concession made by the united states to chile was most likely the granting of tax authority to the source country in the event of certain capital gains.132 it is important to bear in mind that this concession has only been granted by the united states in very limited cases (e.g., article 13 of the u.s.-india tax treaty). this issue is extremely relevant for chile because, due to the low corporate tax in chile (20 percent), many times profits are not distributed to the non-resident shareholder to defer the additional tax. as a consequence, if the capital gain is exempted of tax as in most tax treaties signed by the united states, the deferral can become a permanent saving for the foreign investor. from a chilean perspective, the reduction of withholding tax on interest (from 15 percent to 10 percent) and certain royalties (up to 2 percent) 130. for more on the subject, see hugo a. hurtado, is latin american taxation policy appropriate for promoting foreign direct investment in the region?, 31 nw. j. int’l l. & bus. 313 (2011). 131. the most favored nation clause is included in thirteen tax treaties signed by chile and its main purpose is to grant similar reduced rates on dividends, interest, and royalties included in new tax treaties to countries that have previously signed tax treaties with chile. 132. interview with liselott kana, head of international taxation, s.i.i., in santiago, chile (oct. 5, 2011). 64 florida tax review [vol.13:2 seems to be the most relevant concession upon comparison with other treaties. as explained above, this apparently minor reduction of the withholding tax on interests and royalties represents an important concession by chile to the united states, not only for its relevance to the treaty but also for the effect on other treaties signed by chile with other oecd members under the most favored nation clause. the following sections will review the main provisions applicable to investment income in order to determine the treaty’s potential impact on both fdi and fiscal revenues. 3. taxation of business profits in the treaty business profits are defined in paragraph 9 article 7 as income from any trade or business.133 article 7 of the treaty establishes two requirements in order to enable the host country to tax the business profit income of a resident from a contracting state doing business in the source country: (i) the enterprise of the resident state must carry on business in the source country through a permanent establishment; and (ii) the income must be attributable to that permanent establishment.134 3.1 permanent establishment a pe is defined in article 5 of the treaty as a fixed place of business through which the business of an enterprise is wholly or partly carried on. the term pe includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources.135 the treaty follows the u.n. model rather than the oecd and the u.s. model with respect to the length of time required for a building site or construction or installation project to constitute a permanent establishment, fixing such time at six months rather than twelve months.136 furthermore, the treaty reduces to three months the time required for a natural resource installation to create a pe.137 additionally, and in accordance with the reservations expressed by chile in the oecd commentaries to the model tax convention (the “commentaries”), the treaty sets forth that the performance of services constitutes a pe if they are rendered for a period or periods exceeding, in the aggregate, 183 days in any twelve month period 133. chile-u.s. tax treaty, supra note 36, art. 7, ¶ 9. 134. chile-u.s. tax treaty, supra note 36, art. 7. 135. chile-u.s. tax treaty, supra note 36, art. 5, ¶ 2. 136. see u.n. dep’t of int’l & soc. affairs, supra note 127, art 5, ¶ 3(a), at 10. 137. chile-u.s. tax treaty, supra note 36, art. 5, ¶ 3. 2012] u.s. and chile tax treaty 65 and such services are performed in and provided by individuals present in the source country.138 paragraph 4 of article 5 moves forward on the term pe, excluding “ancillary” activities such as storage, display, maintenance of a stock of goods for processing purposes, and maintenance of a fixed place of business for auxiliary activities.139 however, the treaty does not contain a provision such as that included in both the 2006 u.s. model and the 2010 oecd model in which the maintenance of a fixed place of business solely for any combination of the aforesaid activities does not constitute a pe provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.140 the concept of electronic commerce brings new challenges to the definition of permanent establishment since the location of a website or computer equipment can constitute a pe with all of the consequences stemming from this qualification.141 the u.s. technical explanations make no comment on this issue, but the commentaries have addressed this point by basically determining that the website hosting arrangement and an internet service provider usually will not be a pe.142 the issue of whether computer equipment at a given location constitutes a permanent establishment (under the concept of a fixed place of business) will depend on whether the functions performed using that equipment exceed the preparatory or auxiliary threshold, something that can only be decided with a case-by-case analysis.143 the treaty provides that certain activities are deemed to create a pe, regardless of whether the non-resident maintains a fixed place of business in the host country.144 specifically, a person (other than an independent agent) acting in the source country as an agent (“agency permanent establishment”) of an enterprise of the residency country who has the authority to conclude contracts that are binding on the enterprise will create a pe in the source 138. id. in this respect, in the commentaries, chile expressly reserved the right to deem an enterprise to have a permanent establishment in certain circumstances where services are provided. see oecd centre for tax policy and administration [oecd tpa], the 2010 oecd model tax convention (2010), cmt. 48 on art. 5, http://www.oecd-ilibrary.org/taxation/model-taxconvention-on-income-and-on-capital-condensed-version-2010_mtc_cond-2010-en. 139. chile-u.s. tax treaty, supra note 36, art. 5, ¶ 4. 140. see title & avi-yonah, supra note 121, at 47. 141. oecd comm. on fiscal affairs, clarification on the application of the permanent establishment definition in e-commerce: changes to the commentary on article 5 (2000), http://www.oecd.org/ dataoecd/46/32/1923380.pdf. 142. id. 143. oecd tpa, supra note 138, cmt. 42.8 on art. 5 144. chile-u.s. tax treaty, supra note 36, art. 5, ¶ 5. 66 florida tax review [vol.13:2 country unless the activities are limited to those mentioned in paragraph 4 (“ancillary activities”).145 in this respect, the commentaries on article 5 provide that the mere fact that a person has attended negotiations with a client on behalf of the enterprise will not be sufficient in itself to conclude that that person has the ability to exercise authority to conclude contracts in the name of that enterprise.146 however, the sii has expressly addressed this issue in chile, ruling that if the agent carries out most of the negotiations of the agreement, fixing terms and resolving issues in connection with it, but he does not formally sign the agreement, such agent will be considered to have the authority to conclude contracts.147 on the other hand, a foreign corporation shall not be deemed to have a permanent establishment if it conducts business in the country through an independent agent, broker, or general commission agent, and that agent or broker acts in the ordinary course of its business.148 finally, a company will not be deemed to have a permanent establishment in chile or the united states merely because it has a subsidiary in chile or the united states149 thus, ownership or control between two companies is not a factor to determine the existence of a pe.150 however, the commentaries rule that if the subsidiary has any place or premises at the disposal of the parent company which constitutes a fixed place through which the parent conducts its business, it will constitute a pe for the parent company.151 the same conclusion is reached if the subsidiary has, and habitually exercises in that state, authority to conclude contracts in the name of the parent unless these activities are those considered of auxiliary or preparatory character or unless the subsidiary acts within its ordinary course of business as an independent agent.152 145. id. 146. oecd tpa, supra note 138, cmt. 33 on art. 5. 147. s.i.i., oficio no. 2176, april 26, 2009 (chile), http://www.sii.cl/ pagina/jurisprudencia/adminis/ 2009/otras/ja2176.htm. 148. chile-u.s. tax treaty, supra note 36, art. 5, ¶ 6. 149. chile-u.s. tax treaty, supra note 36, art. 5, ¶ 7. 150. u.s. 2006 model technical explanations, supra note 120, art. 5, ¶ 7. 151. oecd tpa, supra note 138, cmt. 40 on art. 5. 152. in the case of a company that is a member of a multinational group, the determination of the existence of a pe must be made separately for each member of the group. oecd tpa, supra note 144, cmt. 41 on art. 5. 2012] u.s. and chile tax treaty 67 3.2 income attributable to a permanent establishment under article 7 of the treaty, if a resident of a country carries out business in the source country through a permanent establishment, the source country will impose a tax at the regular rates153 on the business profits, but only on those profits that are attributable to the permanent establishment.154 the tax is applied on a net basis allowing deductions of expenses necessary for the business of the pe, including reasonable allocation of executive and general administrative expenses, research and development expenses, and interest, among others.155 in order to determine the profits allocable to the pe, the same accounting method must be used each year.156 the amount of profits attributable to the pe is a matter of much debate due to the complexity of applying this theoretical principle to a practical business reality.157 the treaty defines profits attributable to the permanent establishment as those it might be expected to make if it were a distinct and independent enterprise at arm’s length158 dealing with third parties and the enterprise of which it is a permanent establishment.159 in this respect, it is important to bear in mind that a new article 7 was added to the oecd model on july 22, 2010, based on the conclusions derived from the 2010 oecd report on the attribution of profits to permanent establishments.160 this report takes into consideration functions performed, assets used, and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise in order to determine the profit allocable to the enterprise and the pe. the new addition is based on the fictional notion that the permanent establishment is a separate enterprise independent from the rest of the enterprise.161 consequently, since the pe’s result is independent from that of 153. special rules are applicable to premiums and policies of reinsurance and insurance businesses, but limited to 2 percent and 4 percent respectively. see chile-u.s. tax treaty, supra note 36, art. 7, ¶ 8. 154. chile-u.s. tax treaty, supra note 36, art. 7, ¶ 1. 155. chile-u.s. tax treaty, supra note 36, art. 7, ¶ 3. 156. chile-u.s. tax treaty, supra note 36, art. 7, ¶ 5. 157. see oecd tpa, report on the attribution of profits to permanent establishments (2006), http://www.oecd.org/dataoecd/55/14/ 37861293.pdf. 158. u.s. 2006 model technical explanations, supra note 120, art. 7, ¶ 3. 159. chile-u.s. tax treaty, supra note 36, art. 7, ¶ 2. 160. see oecd tpa, 2010 report on the attribution of profits to permanent establishments (2010), http://www.oecd.org/dataoecd/23/41/ 45689524.pdf. 161. oecd tpa, supra note 138, cmt. 16 on art. 7. 68 florida tax review [vol.13:2 the enterprise, it may derive a profit (or loss) even if the enterprise of which it is a part has a loss (or a gain) based on a two-step analysis.162 the first step involves a functional and factual analysis in order to determine the attribution of profits to the pe based on the following factors: the rights and obligations derived from the enterprise’s transactions with unrelated companies; the identification of people functions and attribution of assets; the identification of people functions and risks involved; the identification of other functions of the pe; the nature of dealings between the pe and the enterprise; and the attribution of capital considering assets and risks.163 the second step applies the oecd transfer pricing guidelines (“the guidelines”) to transactions between the pe and its enterprise using the method established in the guidelines to reach the arm’s length price, giving special consideration to the functions performed and risks and assets attributed by the pe.164 however, the most relevant and practical effect of the new article 7 stems from its third paragraph, which rules that if the contracting state adjusts the profits attributable to the pe — as a result of dealings using the separate entity assumption — and tax profits that are taxed at the enterprise level are located in the other state, the latter must adjust the tax charged on such profits in order to eliminate double taxation.165 this amendment is an important advance in tax treaties since it obligates states to apply adjustments to avoid double taxation unlike the former article 7, which contained no such provision. nevertheless, it is important to bear in mind that chile presented reservations on these amendments.166 specifically, chile did not endorse changes to the article 7; hence the attribution of profits to a permanent establishment under chilean tax policy is still acceptable on the basis of an apportionment of the total profits of the enterprise to its various parts.167 the u.s. federal court of appeals has provided that the treaty provision on pe deductions shall be interpreted to have primacy over the u.s. domestic rules related to allocation of expenses (i.e., royalties and interest),168 which generally adopt a formulary approach and do not treat the 162. oecd tpa, supra note 138, cmt. 17 on art. 7. 163. oecd tpa, supra note 138, cmt. 21 on art. 7. 164. oecd tpa, supra note 138, cmt. 22 on art. 22. 165. oecd, supra note 10, art. 7, ¶ 7. 166. oecd tpa, supra note 138, cmt. 96 on art. 7. 167. id. 168. see national westminster bank, plc v. u.s., 512 f.3d 1347 (fed. cir. 2008), motion for rehearing and motion for rehearing en banc denied, no. 20075028 (fed. cir. apr. 21, 2008), for a recent decision confirming the supremacy of the u.k.-u.s. tax treaty’s separate entity approach of a foreign bank (u.k.) and a 2012] u.s. and chile tax treaty 69 pe as a separate and distinct entity.169 the court’s decision ruled that the denial of the deduction of expenses, such as royalties, interest, and other expenses related to ancillary services performed for another unit of the enterprise, charged to a permanent establishment by another unit of the enterprise, violates the treaty provision on this matter.170 the concept of “attributable” profits also includes payments deferred until the pe has ceased to exist.171 this provision grants the host state tax authority on income attributable to the permanent establishment even if the payments are deferred until such permanent establishment or fixed base has ceased to exist.172 an example of income attributable to a pe that ceases to exist is the sale of its inventory of assets after its liquidation under an installment method that bears interest. the interest generated in subsequent years will also be considered effectively connected and therefore taxed in the host country. this provision is similar, but not identical, to that included under section 864(c)(6) of the i.r.c., but without the limitation of years included in section 864(c)(7). these provisions consider the sale of a pe made within ten years after the cessation of use of property held in the united states as made immediately before such cessation. paragraph 4 of article 4, in conjunction with article 5(4)(d), provides that business profits are not attributed to a permanent establishment by reason of mere purchases of goods.173 this provision aims to overrule section 864(c)(3) of the irc, which includes the limited force of attraction rule by which all income accrued by a foreign company is treated as effectively connected with the conduct of a trade or business within the united states. finally, paragraph 7 of article 7 states that if profits include items of income dealt with separately in other articles, the specific provisions included thereby will prevail over this article. 4. taxation of dividends in the treaty the treaty grants unlimited tax authority to the country of which the recipient of the dividend is a resident. however, limited tax authority is also granted to the source country (the country of which the distributing company branch under the u.s. domestic rules. see also william w. chip, interpreting tax treaties after natwest, 37 tax mgm’t int’l j. 1, 2 (2008). 169. in national westminster bank v. u.s., 44 fed. cl. 129 (fed. cl. 1999) the court held that the u.s. branch of a u.k. bank was a separate entity under the u.s.-u.k. treaty. 170. see westminster bank, 512 f.3d. at 1347. 171. chile-u.s. tax treaty, supra note 36, art. 7, ¶ 7. 172. id. 173. chile-u.s. tax treaty, supra note 36, art. 7, ¶ 4; art. 5, ¶ 4(d). 70 florida tax review [vol.13:2 is a resident).174 in this case, the withholding tax shall not exceed 5 percent of the gross amount of the dividends if the non-resident shareholder owns at least 10 percent175 of the capital company and 15 percent of the gross amounts of the dividend for all other cases.176 as mentioned above — and in line with the reservations presented by chile to the oecd — these reductions on tax rates are not applicable to chile as long as the first category tax is creditable against the additional tax.177 paragraph 14 of the treaty protocol provides different rules for dividends arising from the ownership of stocks in a regulated investment company (ric) or in a real estate investment trust (reit) incorporated in the united states178 in the first case, this provision is aimed at denying the reduced tax rate of 5 percent to dividends in connection with u.s. stocks in rics applying the regular rate of 15 percent regardless of the ownership percentage.179 this provision seeks to avoid a tax benefit being obtained through the incorporation of a holding company. indeed, in the absence of this provision, if a chilean resident owns the portfolio of stocks directly, the dividends will be taxed at 15 percent, but if the stocks are owned by a ric wholly owned by a chilean resident, he will be entitled to the 5 percent reduced tax rate.180 the second part of this provision is related to a u.s. tax policy in which it usually reserves the right to tax all income derived from real estate located in the united states.181 in accordance with the protocol, the reduced tax rate of 15 percent (instead of the domestic 30 percent rate) is only granted if: (i) the beneficial owner of the dividends is an individual holding an interest of 10 percent or less; (ii) the dividends are paid with respect to publicly traded stocks and are beneficially owned by a person who holds no more than 5 percent in any class of reits; or (iii) the dividends are paid by a diversified reit and are beneficially owned by a person holding a 10 percent or smaller interest in the reit.182 174. chile-u.s. tax treaty, supra note 36, art. 10, ¶ 1. 175. the u.s. model requires direct ownership of at least 10 percent of the voting stock of the company paying dividends, whereas the oecd model requires ownership of at least 25 percent of the company’s capital to be eligible for the reduced tax rate of 5 percent. 176. chile-u.s. tax treaty, supra note 36, art. 10, ¶ 2(a)–(b). 177. see infra section ii.2, oecd tpa, supra note 138, cmt. 74 on art. 10. 178. chile-u.s. tax treaty, supra note 36, protocol, ¶ 14. 179. id. 180. u.s. 2006 model technical explanations, supra note 119, art. 10, ¶ 4. however, neither the treaty nor its technical explanations specify if constructive or indirect ownership applies to determine the “real” participation in the company. 181. i.r.c. § 897. 182. requirements on (i) and (ii) are new additions of the 2006 u.s. model not included in the 1996 u.s. model. see staff of j. comm. on taxation, 2012] u.s. and chile tax treaty 71 the term “dividends” is defined broadly and includes “income from shares or other rights not being debt-claims, participating in profits,” and any other form of distribution that is defined as a dividend under the laws of the distributing company.183 for example, in accordance with article 21 of the citl, a loan from a chilean subsidiary to its parent incorporated in the united states may be considered a dividend for purposes of applying this article.184 on the other hand, the sale or redemption of shares or upon a transfer of shares in reorganization, such as the sale of a foreign subsidiary’s stock to a u.s. sister company, is a deemed dividend up to the accumulated earnings and profits of the subsidiary and the sister company.185 nevertheless, it is unclear whether the term “dividends” applies to payments based on the profits of a company but paid in accordance with a lending stock arrangement under the term “substitute dividends.” the relevance of this matter is that if article 10 is not applicable, the residual provision established under article 7 of the treaty will apply. in consequence, substitute dividends will be considered business profits and only taxable by the country of residency of the beneficial owner of the income (the united states in this case). regarding this matter, the commentaries point out that the term “profits” “has a broad meaning including all income derived from carrying on an enterprise.”186 in consequence, any income derived from the regular trade or business of financial or investment companies should be considered business profits and thus exempt from withholding taxes in chile. authors like marjaana helminen agree on this concept, stating: “the recipient of substitute dividend payments is not, strictly speaking, a shareholder and the substitute payments do not derive from corporate rights, but, instead, are based on a lending contract.”187 an exemption from the source country is provided for dividends paid to certain pension funds.188 in this case, no tax is imposed on the dividends by the distributing company as long as they are not derived from commercial comparison of the u.s. model income tax convention of september 20, 1996 with the u.s. model income tax convention of november 15, 2006 11 (comm. print, 2007). 183. chile-u.s. tax treaty, supra note 36, art. 10, ¶ 4. 184. chile-u.s. tax treaty, supra note 36, art. 10, ¶ 5; see also oecd tpa, supra note 138, cmt. 25 on art. 10, ¶ 3. 185. u.s. 2006 model technical explanations, supra note 119, art. 10, ¶ 5. 186. oecd comm. on fiscal affairs, model tax convention on income and on capital: condensed version (8th ed. 2010), cmt. 71 on art. 7 (emphasis added). 187. marjaana helminen, the dividend concept in international tax law: dividend payments between corporate entities 176 (1999). 188. chile-u.s. tax treaty, supra note 36, art. 10, ¶ 3; u.s. 2006 model technical explanations, supra note 119, art.10, ¶ 3. 72 florida tax review [vol.13:2 activities performed directly or from a company controlled by the qualified governmental entity.189 however, dividends will be taxable under article 7 as a part of the business profits of a pe — therefore fully taxable at source — if they are paid with respect to holdings forming part of the assets of the permanent establishment or the dividends are attributable to that pe.190 paragraph 6 of article 7 provides that if a distributing company that is located in a contracting state (i.e., chile) obtains income in the other contracting state (i.e. the united states), the latter cannot tax the distributions made by the company in chile unless these distributions are paid to residents of the united states or to a permanent establishment of the chilean company in the united states that holds stock of the distributing company. in addition, the i.r.s. cannot tax the undistributed profits of the chilean company even if those profits consist of income obtained in the united states. to understand this provision, it is important to bear in mind that the united states formerly imposed a “secondary withholding tax” on dividends or other distributions paid by a non-resident foreign corporation to nonresidents, if most of the income came from the united states.191 indeed, the i.r.c. provided authority to the united states to tax dividends paid by a nonresident corporation if 25 percent or more of its gross income that was effectively connected with trade or business in the united states192 paragraph 6 of article 7 does not preclude the right of the united states to tax undistributed profits under controlled foreign corporation provisions193 aimed at avoiding tax deferral by establishing subsidiaries in low tax countries without truly conducting a trade or business there.194 finally, it is important to bear in mind that the treaty does not incorporate an additional clause regularly included in most chilean tax treaties to limit the benefit of this article to stocks acquired with a legitimate business reason.195 this paragraph provides that the benefit of this article 189. id. 190. chile-u.s. tax treaty, supra note 36, art. 10, ¶ 5; see also oecd tpa, supra note 138, cmt. 31 on art. 10. 191. this secondary tax was repealed for payments made after december 31, 2004 in the american jobs creation act of 2004. see also u.s. 2006 model technical explanations, supra note 119, art. 10, ¶ 7. 192. i.r.c. §§ 861(a)(2)(b), 871(a)(1)(a), 881(a)(1). 193. see also u.s. 2006 model technical explanations, supra note 119, art. 10, ¶ 7. 194. see i.r.c. § 951. 195. this clause is also included with respect to interest, capital gains, royalties, and other income. see, for instance, article 10(6) of the chile-u.k. tax treaty: “the provisions of this article shall not apply if it was the main purpose or one of the main purposes of any person concerned with the creation or assignment of the shares or other rights in respect of which the dividend is paid to take advantage of this article by means of that creation or assignment.” convention between the 2012] u.s. and chile tax treaty 73 shall not apply if the main purpose or one of the main purposes of any person is to take advantage of this article by creating or assigning the shares or other rights in respect of which the dividend is paid.196 this provision was omitted mainly because of the extensive scope of article 24 (limitation on benefits) that covers this situation to a greater extent.197 5. taxation of interest in the treaty under article 11 of the treaty, full tax jurisdiction is granted to the country in which the recipient of the interest is a resident, and limited tax jurisdiction is granted to the country in which the payer of the interest is domiciled.198 the latter country can impose a withholding tax on such interest that shall not exceed 10 percent of the gross amount of the interest. however, this tax rate is raised to 15 percent during the first five years the treaty is in force.199 from a practical standpoint, the burden of this tax is usually transferred to the borrower, which translates into a higher interest rate for the transaction, a result that can be undesirable, especially for residents of developing countries (e.g., chile) seeking funds to finance projects. 200 the term “beneficial owner” is not defined in the treaty; hence, it must be defined in accordance with the domestic law of the source country. for this purpose, the source country is that in which the resident to whom the contracting state of residency attributes the payment for tax purposes.201 article 11(2)(a) provides that the tax rate on interest derived from the following activities shall not exceed 4 percent (instead of the regular 10 percent): (a) loans granted by banks, insurance companies, and companies that derive their gross income from the active and regular conduct of lending money; (b) a sale or credit paid by the purchaser of machinery and equipment to a beneficial owner that is the seller of the machinery and equipment; and (c) interest arising from enterprises that derive more than 50 percent of their liabilities from issuing bonds in the financial market and government of the united kingdom of great britain and northern ireland and the government of the republic of chile for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and on capital gains, u.k.-chile, july 12, 2003, art. 10, ¶ 6, http://www.sii.cl/pagina/jurisprudencia/ convenios/chile_reinounido_english.pdf. 196. this clause follows the advice of the commentary on article 10, ¶¶ 2 and 32. oecd comm. on fiscal affairs, supra note 186, cmts. 2 & 32 on art. 10. 197. see infra section v. 198. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 1. 199. chile-u.s. tax treaty, supra note 36, art. 11, ¶¶ 2, 3. 200. oecd comm. on fiscal affairs, supra note 186, cmt. 7.1 on art. 11. 201. u.s. 2006 model technical explanations, supra note 119, art. 11, ¶ 1. 74 florida tax review [vol.13:2 taking deposits at interest as long as more than 50 percent of their assets are based on non-debt claims with unrelated persons as defined in article 9 of the treaty.202 this article has a major difference with the 2006 u.s. model since article 11 of the model grants the exclusive right of taxing interest only to the state of which the beneficial owner of the interest is a resident, and therefore no withholding tax is applied by the source country.203 these changes to the tax rates are within the flexibility granted under the u.n. model and the oecd commentaries on this article.204 the reduced tax rates are established only for the beneficial owner of the interest, which —as with the corresponding provision with respect to dividends — must be interpreted broadly while still taking into consideration that the treaty is designed to avoid double taxation and tax avoidance.205 for example, if a third party that is a resident from a country without a tax treaty with chile establishes a corporation in a country with a tax treaty to access the 10 percent tax rate instead the 35 percent tax rate, this corporation will be the recipient of the interest, but the real beneficial owner is the resident of the third party country; thus, the reduced rate shall be denied by chile.206 on the other hand, the treaty includes an express provision for backto-back loans granting a 10 percent tax rate to interest arising from this type of transaction.207 in the case of chile, this provision will conflict with the sii position on the matter expressed in revenue ruling 3939 of 2004 (“r.r. 3939”).208 in this ruling, the sii decreed that the rate reduction from 35 percent to 15 percent in accordance with article 11 of the chile-canada tax treaty is not applicable on interest paid to a canadian beneficial owner because of thin capitalization rules.209 this conclusion was based on a formality established in the citl under which the interest paid by the payor on a back-to-back arrangement is deductible from its gross income; hence, the sii claimed that this “special” tax burdened the payor (chilean resident) and not the recipient (canadian 202. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 2(a)(v). 203. see title & avi-yonah, supra note 120, at 93. 204. oecd tpa, supra note 138, cmt. 7.2 on art. 11. it is interesting to note that all those considered “not as much” developed countries of the oecd such as chile, hungary, mexico, portugal, the slovak republic and turkey presented reservations of their positions on the rate provided in paragraph 2. oecd tpa, supra note 138, cmt. 38 on art. 11. 205. oecd tpa, supra note 138, cmt. 9 on art. 11. 206. in this case, the provisions of article 24 (limitation on benefits) will also be applicable. chile-u.s. tax treaty, supra note 36, art. 24. 207. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 4. 208. s.i.i., oficio no. 3939, aug. 19, 2004 (chile), http://www.sii.cl/ pagina/jurisprudencia/adminis/2004/otras/ja813.htm. 209. id. 2012] u.s. and chile tax treaty 75 resident) and thus was not eligible for the benefits of the chile-canada tax treaty.210 however, r.r. 3939 shall not be applicable in cases of interest payments to a u.s. resident, since the treaty has supremacy over domestic law and certainly over an administrative ruling; therefore, in this case the 10 percent rate shall be applicable. another consideration to bear in mind is that in accordance with article 11(3) of the treaty, for a period of five years from the date on which the provisions of paragraph 2 take effect, the 15 percent rate “shall apply in place of the rate provided in subparagraph b) of paragraph 2.”211 since the back-to-back provisions are enacted in a separate paragraph (paragraph 3 of article 11), there is no certainty that the rate increase from 10 to 15 percent is applicable to this type of transaction because they are not included in subparagraph b) of paragraph 2. the term “interest” is used to comprise “income from debt-claims of every kind” including mortgages and all other income that is subjected to the same taxation treatment as income from money lent under the laws of the country where the payor is a resident.212 the term does not include disguised dividends, which shall be treated as described under article 10 of the treaty.213 this last point is relevant because interest is subject to different rates (4 percent, 10 percent, and 15 percent) under domestic and treaty provisions, and these rates differ from those applicable to dividends (5 percent or 15 percent in the united states and 35 percent in chile). furthermore, it is important to bear in mind that interest is tax deductible, whereas dividends are not deductible from the taxpayer’s gross income. article 7 — instead of article 11 — applies if the beneficial owner of the interest has a pe in the source country, but only if the interest income is attributable to this pe.214 therefore, in this case the treaty grants full tax authority to the source country.215 as mentioned above, interest is sourced in the country in which the payor is a resident (e.g., chile); however if the loan has an obvious link with a pe in a contracting state (e.g., the united states) and the interest is borne by that pe, the source rule is modified, and the place where the pe is located determines the source (e.g., the united states).216 the treaty also provides a special rule for interest derived from a debt-claim between related parties in which one related party charges excessive interest to the other related party to access the reduced tax rates of 210. id. 211. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 3. 212. chile-u.s. tax treaty, supra note 36, art. 11, ¶¶ 5, 7. 213. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 5. 214. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 6. 215. oecd comm. on fiscal affairs, supra note 186, cmt. 27 on art. 11. 216. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 7. 76 florida tax review [vol.13:2 this article.217 only the part of the interest that is based on arm’s length price can access the reduced tax rate in this article, whereas the remaining portion will receive the general tax treatment of each country but respecting the other provisions of the treaty.218 for instance, if the excessive part is considered a dividend, the tax law of each country will apply, but with the limit on the applicable tax rates under article 10 of the treaty.219 article 11(9) of the treaty grants the tax rate of 15 percent applicable to dividends to contingent interest connected to receipts, sales, income, profits, dividends, partnership distributions, or other cash flows and changes in the value of the property of the debtor or a related person.220 however, if the interest is paid as a consequence of a securitization plan of real estate mortgages or other assets,221 and the interest is greater than the return of a similar debt instrument, full tax authority is granted to the source country without the 15 percent limitation.222 finally, paragraph 10 of article 11 includes a special provision for interest (i) allocable to profits attributable to a pe under the provisions of the treaty or (ii) subject to tax under the provisions on real estate income or capital gains.223 in these cases, if there is excess interest allocable to such profits or income that exceeds the interest effectively paid, it will be deemed to arise in the source country and be taxable with the 10 percent tax rate (or 15 percent for the first five years that the treaty is in force).224 6. taxation of royalties in the treaty unlike the u.s. and oecd models, which grant an exclusive right of taxation to the country of residency of the beneficial owner of the royalty, the treaty also permits taxation by the source country.225 however, in this 217. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 8. 218. id. 219. u.s. 2006 model technical explanations, supra note 119, art. 11, ¶ 5. 220. chile-u.s. tax treaty, supra note 36, art.11, ¶ 9(a). see also u.s. 2006 model technical explanations, supra note 119, art. 11, ¶ 2. 221. this provision has no parallel rule in the oecd model or its commentaries. 222. in this case, there is no special provision to grant a different tax treatment for interest not paid in excess of the return on comparable debt instruments and interest that exceeds such return. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 9(b). 223. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 10. 224. id. 225. chile-u.s. tax treaty, supra note 36, art. 12, ¶ 2. this is consistent with the reservation presented by chile to the commentaries in which it reserves the 2012] u.s. and chile tax treaty 77 case there is a maximum withholding tax rate limit of 2 percent in the case of payments of any kind received as a consideration for the use of, or the right to use, industrial, commercial, or scientific equipment and 10 percent for other types of royalties.226 it is important to bear in mind that payment for the use of equipment generally falls under article 7 of the oecd and u.s. models, thus it is not taxable at source.227 however, this clause is usually included by developing countries following the 2001 u.n. model, since it is likely that most payments of this type will be received by u.s. residents, and therefore the source country will get a “fair cut” on these payments.228 the term “royalties” includes any “consideration for the use of, or the right to use, any copyright of literary, artistic [or scientific work]” including films, any patent, trademark, design or model, plan, secret formula or process, or “information concerning industrial, commercial or scientific experience.”229 another important distinction is between a know-how contract and a contract for the provision of services. the former must be understood only as sharing of private and specific knowledge but it does not obligate the licensor to play a part in the application of the formula transferred to the licensee, whereas the latter includes work completed by the other party and, therefore, is taxable under article 7.230 in this respect, the protocol of the treaty includes a direct reference to the commentary to article 12 of the oecd model for an analysis of taxation applicable to computer software.231 for instance, the commentary on this article points out that transfers of software will not always be considered use of intellectual property.232 indeed, if the software is completely transferred, this is not considered payment for use of intellectual right to tax royalties at their source. see also oecd tpa, supra note 138, cmt. 36 on art. 12. 226. chile-u.s. tax treaty, supra note 36, art. 12, ¶¶ 2, 3. 227. for a more extensive analysis on this matter, see u.n. dep’t of int’l & soc. affairs, supra note 127, at 127. 228. see also article 12 of the u.s.-mexico treaty for a more generous 10 percent concession from the united states to mexico. u.s.-mex. tax treaty, supra note 126, art. 12. 229. chile-u.s. tax treaty, supra note 36, art. 12, ¶ 3(b). see also oecd tpa, supra note 138, cmt. 40 on art. 12, in which chile reserves the right to add the words “for the use of, or the right to use, industrial, commercial or scientific equipment” to paragraph 2 of the oecd model. 230. oecd tpa, supra note 138, cmts. 11.3–4 on art. 12, provides several criteria that must be used to distinguish between a contract for provision of services and a know-how contract. 231. see chile-u.s. tax treaty, supra note 36, protocol, ¶ 15. 232. oecd tpa, supra note 138, cmt. 11.5 on art. 12. 78 florida tax review [vol.13:2 property but rather payment for the full property of the assets. in this case, article 7 (business income) or article 13 (capital gain) will apply.233 however, it is important to consider that gain derived from the sale of intellectual property is treated as a royalty if it is recognized on receipt of a payment “contingent on the productivity, use, or disposition of the property.”234 this provision is consistent with u.s. regulations that mandate that contingent payments for the u.s. owner of the intellectual property must be calculated with due regard to the appropriate charge determined in accordance with section 482 and the regulations thereunder.235 as mentioned above, the term “beneficial owner”236 is not defined in the treaty; however, the oecd commentaries on article 10 on dividends are also applicable in this case and make clear that this term must be interpreted “in its context and in light of the object and purposes of the convention, including avoiding double taxation and preventing fiscal evasion and avoidance.”237 notwithstanding the limited right of taxation granted to the source country (i.e., chile), if the beneficial owner of the royalty conducts business in the other contracting state (i.e., the united states) through a permanent establishment and the right of property with respect to which the royalties if paid are effectively connected with this pe, the provisions of article 7 will apply, and therefore such royalties will be taxed under the general tax rates of the united states.238 as with interest, the treaty provides that if prices charged in royalties between parties with a special relationship239 are not based on an 233. oecd tpa, supra note 138, cmt. 8.2 on art. 12. 234. chile-u.s. tax treaty, supra note 36, art. 12, ¶ 3(b). 235. i.r.c. § 482 provides that “[i]n the case of any transfer (or license) of intangible property . . ., the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” see also reg. § 1.367(d)-1t(c)(1). 236. this is a topic of much controversy. for instance, in the canadian prevost car inc. case, two e.u. members established a subsidiary in a third e.u. member to invest in a non-e.u. member (a swedish company and a british company established a subsidiary in the netherlands that later invested in canada). the court examined the meaning of “beneficial owner” under the canada-netherlands tax treaty. the tax court of canada ruled that if the beneficial owner of a dividend is the person who assumes and enjoys all of the attributes of ownership of that dividend, including control of the dividend received, tax benefits can be granted to the holding company in the netherlands. prévost car inc. v. canada, [2008] 2008 carswellnat 1114, 2008 tcc 231 (can.). 237. oecd comm. on fiscal affairs, supra note 186, cmt. 12 on art. 10, is also applicable to interest and dividends. 238. chile-u.s. tax treaty, supra note 36, art. 12, ¶ 4. 239. according to the oecd comm. on fiscal affairs, supra note 186, cmt. 24 on art. 12, the term “special relationship” includes relationships based on 2012] u.s. and chile tax treaty 79 arm’s length price, the excess can be taxable under the laws of the contracting states with due regard to other articles of the treaty.240 a current controversy related to this topic is cost sharing agreements (“csas”). these agreements consist of a contract signed by two or more parties to participate in the costs and risks related to the development, production, and procurement of assets, services, or rights, intended to determine each party’s share of the assets, services, or rights arising from that agreement.241 csas have the benefit that once the objective for which the agreement was signed is achieved, each of the participants is considered to own his share, and, therefore, no royalty payment or other amount must be paid to use that share. this can encourage the creation of intellectual property in different countries and the use of new technologies since csas are usually used to develop intellectual property among multinational enterprises.242 nevertheless, the conflict arises due to the use (or abuse) of csas to shift profits to related companies incorporated in countries with lower tax burdens.243 this might be an issue in the chile-u.s. tax treaty due to the disparity of the current corporate tax rates (35 percent for the united states and 20 percent for chile).244 for instance, in xilinx v. commissioner, the u.s. court of appeals (ninth circuit) established that in case of conflict between the application of transfer pricing rules and the contents of the tax treaty, the former takes precedence over the latter regarding citizens of each country.245 in particular, the u.s. court of appeals held that related companies established in the united states and ireland (that has a corporate tax rate of 12.5 percent) in a cost sharing agreement to develop intangibles must share all costs related to the joint venture even if unrelated companies would not do so, therefore denying the fiction of fully independent parties. this is based on the fourth paragraph of the first article of the ireland-u.s. tax treaty, which “blood or marriage and, in general, any community of interests as distinct from the legal relationship giving rise to the payment of the royalty.” 240. chile-u.s. tax treaty, supra note 36, art. 12, ¶ 6. 241. oecd, transfer pricing guidelines for multinational enterprises and tax administrations, ¶ 8.3 (2010). 242. id. ¶ 8.6. 243. yariv brauner, cost sharing and the acrobatics of arm’s length taxation, 38 intertax 554 (2010). 244. this problem can acquire greater relevance when chile’s corporate tax rate returns to the former 17 percent in 2013 in accordance with law no. 20.455 (2010). 245. xilinx v. commissioner, 567 f.3d 482, 494 (9th cir. 2009). 80 florida tax review [vol.13:2 establishes that each country may tax its citizens as if the treaty had never taken force.246 7. capital gains in the chile-u.s. tax treaty this section will review the main tax provisions in connection with capital gains on both traditional assets and non-traditional assets (i.e. financial instruments). 7.1 capital gains on traditional assets the treaty provides, as a general rule, that both the country of which the alienator is a resident and the source country can tax the capital gain.247 the term “capital gain” is not defined in the treaty, so its scope must be framed within the laws of the country for the purposes of the taxes to which the convention applies.248 for instance, liquidation or a reduction of the paid-in capital of a u.s. corporation in which the shareholder sells its shares to the issuing company may be treated as a dividend under article 10 of the treaty rather than capital gain under article 13.249 in this case, the provisions of article 10 will prevail over this article and, therefore, the tax treatment granted for dividends shall be applied.250 in accordance with article 13 and following the same principle as the oecd model, the treaty gives the right to tax income to the country in which the real property is situated. however, the treaty includes an explicit definition of the term “real property,” applying the concept of u.s. real property interest as defined in section 897 of the i.r.c. and the regulations thereunder.251 the definition contained in this article creates an important difference with the oecd model. under the terms of this article of the treaty, there is not a 50 percent ownership threshold requirement as in the 246. convention between the government of the united states of america and the government of ireland for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, u.s.ir., july 28, 1997, art 1, ¶ 4. this provision is based on a principle known as the “savings clause,” by which the united states never waives its tax authority over its citizens regardless of how much time they have resided abroad. 247. chile-u.s. tax treaty, supra note 36, art. 13, ¶ 1. see also oecd tpa, supra note 138, cmt. 39 on art. 13 for an explicit reservation that chile presented to the commentaries on article 13 enabling capital gains to be taxed at source. 248. chile-u.s. tax treaty, supra note 36, art. 3, ¶ 2. 249. oecd tpa, supra note 138, cmt. 31 on art. 13. 250. id. 251. see chile-u.s. tax treaty, supra note 36, art. 13, ¶ 2. 2012] u.s. and chile tax treaty 81 oecd model to trigger the full tax at source, and, therefore, any sale of shares that meets the asset-ratio rest for being u.s. property will be taxable in the united states.252 the gain derived from immovable property situated in chile or from a sale of shares in which at least 50 percent of the value is derived from immovable property, may be taxable in chile.253 in this respect, it is important to bear in mind that the gain can be exempt from taxes if the seller of the real estate property has held the chilean real estate property for at least one year, the seller does not sell real estate property on a customary basis, and such sale is not made to a related party.254 in the case of a resident of a contracting state that has a pe in the other country and alienates movable property that forms part of the business property of the pe, the source country can tax the capital gain derived from the alienation of both the assets of the pe and the pe as a whole.255 this paragraph corresponds to the provision under article 7 related to business profits.256 similar treatment will be granted in the united states for a chilean partner of a u.s. partnership, but in this case the united states has the authority to apply tax on the partner’s distributive share of income under section 864(c)(6) of the i.r.c.257 the right to tax gains from the alienation of ships and aircrafts operated on international routes, boats engaged in waterway transport, or movable property related to the operation of those ships, aircrafts, and boats is granted only to the country of residency of the alienator.258 this provision is similar to that used by the oecd, but it has an important difference since the oecd uses the concept of “place of effective management” instead of “place of residency.”259 article 13(5) sets forth a general limit of 16 percent for capital gains arising from the alienation of other rights or interests on the capital of companies incorporated in the other country.260 however, this general rule has three main exceptions: (i) capital gains derived by a pension fund are 252. u.s. 2006 model technical explanations, supra note 119, art. 13, ¶ 2. 253. chile-u.s. tax treaty, supra note 36, art. 13, ¶ 2(c). 254. l.i.r. art. 17, no. 8(b). 255. chile-u.s. tax treaty, supra note 36, art. 13, ¶ 3. 256. oecd tpa, supra note 138, cmt. 24 on art. 13. 257. u.s. 2006 model technical explanations, supra note 119, art. 13, ¶ 3. 258. chile-u.s. tax treaty, supra note 36, art. 13, ¶ 4. 259. oecd comm. on fiscal affairs, supra note 186, cmt. 28 on art. 13. 260. as mentioned above, this limit is only relevant for chilean tax purposes since the united states generally exempts capital gains if certain conditions are met. chile-u.s. tax treaty, supra note 36, art. 13, ¶ 5. see also section ii.5 82 florida tax review [vol.13:2 only taxable at the state of residency;261 (ii) capital gains derived from shares or rights in the capital of a company that is resident in the other state are taxable at source if the alienator has owned, at any time during the twelvemonth period preceding the alienation, 50 percent or more of the shares or 20 percent or more of the rights of a company;262 and (iii) capital gains derived from the sale of shares that meet the conditions set forth in articles 106 and 107 of the citl for publicly traded securities disposed on a recognized stock exchange are not taxable in chile.263 finally, a step-up basis is granted to an individual who ceases to be a resident of a country (e.g., the united states) and is taxed with “an exit or departure tax” on the fair market value of the property.264 in such case, the former resident may elect to be treated in the other country (e.g., chile) as if he alienated and reacquired such property. however, this benefit is only granted to property located in the former country (e.g., the united states) and does not apply to property located in the other country (e.g., chile).265 7.2 capital gains on non-traditional assets the use of financial instruments such as forwards, options, and equity swaps for both hedging and speculative investment presents important challenges for the application of article 7 (business profits), article 10 (dividends), article 11 (interest), article 13 (capital gains), and article 21 (other income) under the treaty because such instruments present a variety of components that make it difficult to determine their tax treatment a priori.266 the basic rule on financial instruments is that if they derive from the conduct of a trade or business they are considered business profits and taxable under article 7 of the treaty.267 if they are not connected to a trade 261. chile-u.s. tax treaty, supra note 36, art. 13, ¶ 6(a). 262. however, the protocol rules that the tax imposed by chile under the provisions of paragraph 7 of article 13 shall not exceed 35 percent. chile-u.s. tax treaty, supra note 36, art. 13, ¶ 7(a)–(b). 263. this rule would also apply for the united states if a tax were imposed on capital gains in the future. chile-u.s. tax treaty, supra note 36, art. 13, ¶ 6(b)– (c). see also section ii.5. 264. this provision is currently applied only to u.s. residents, since chile does not include a similar provision in the l.i.r. see i.r.c. § 877a(h)(2), enacted by heroes earnings assistance and relief tax act of 2008, pub. l. no. 110-245, § 301(a), 122 stat. 1624 (2008). 265. chile-u.s. tax treaty, supra note 36, art. 13, ¶ 9. 266. see generally reg. § 1.861-3(a)(6) for the concept of substitute dividends in securities lending transaction. 267. the authority for advance rulings (aar) of india, in the case of royal bank of canada (a.a.r no. 816 of 2009), held that the profits/losses on 2012] u.s. and chile tax treaty 83 or business, to the extent that such income is not otherwise taxable under another article (e.g. article 10 or article 11), they can be taxable under article 13.268 however, this income can also be included under other income in accordance with article 21 of the treaty.269 the difference is not minor, since under the treaty income characterized as “business profits” is not taxable at source; income deemed capital gain is not taxable at source unless it represents interest rights or interest in the capital of a company; and income considered “other income” is fully taxable at source. indeed, unlike the 2006 u.s. model and the oecd model, following the u.n. model and the reservations presented by chile to the commentaries, article 21 of the treaty grants full tax authority to both the residence and the source country on income not specifically dealt with in another article of the treaty.270 the two most relevant issues connected to the taxation of derivatives relate to the characterization of the income and the point in time when the income is taken into account for tax purposes.271 on the first topic, “some [states] would treat the income from a derivative contract as a capital gain, whilst others would treat it as ordinary income.”272 regarding the second issue, some countries would take into account the income from a derivative contract on an accrual basis (i.e., over the lifetime of the instrument) and others on a realization basis (i.e., when it is actually paid).273 due to the complexity and ongoing development of the financial market, there are many varieties of financial instruments. the next section describes the tax treatment under the treaty of one of the most commonly used instruments: the equity swap. 7.2.1 the equity swap: a practical approach under the equity swap, the short party pays the long party over the life of the swap, amounts equal to the excess, if any, of the dividends paid on a specified number of shares of the futures and options contracts (derivative transactions) carried out by a canadian entity would be considered “business income.” 268. see u.s. 2006 model technical explanations, supra note 119, art. 13, ¶ 6. 269. see u.s. 2006 model technical explanations, supra note 119, art. 21. 270. chile-u.s. tax treaty, supra note 36, art. 21, ¶¶ 1–3. see also oecd tpa, supra note 138, cmt. on 13 art. 21. 271. chris finnerty et al, fundamentals of international tax planning 164–170 (raffaele russo ed. 2007). 272. id. at 165. 273. id. 84 florida tax review [vol.13:2 common stock of a specified corporation . . . that have a specified value on the date the swap is entered into (the “notional amount” of the swap) over the interest that would accrue at a specified interest rate on the notional amount of the swap; plus . . . at maturity of the swap, amounts equal to . . . any increase in the market value of the specified shares over the life of the swap.274 likewise, the long party pays the short party an amount equal to any excess of interest accruing at the specified interest rate on the notional amount of the swap over the dividends paid on the specified shares, plus . . . at maturity of the swap, an amount equal to any increase in the market value of the specified shares over the life of the swap.275 this type of income shall be reviewed on a case-by-case basis; however, in the case of the equity swap explained above, if such instrument is entered into as part of the regular course of business, the income arising from this contract will be included in article 7.276 however, if the equity swap contract is entered into as a result of a specific transaction, the income arising from this agreement is taxable under the general income tax law of the country where it arises under article 21 of the treaty.277 in the united states, the treasury regulations provide certain guidelines to address the taxation of international financial instruments using the concept of “notional principal contract.”278 for this purpose, “[a] notional principal contract is a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.”279 the income arising from this type of transaction is sourced by reference to the residence of the taxpayer on whose books the asset, liability, or item of income or expense is properly reflected.280 if the income is sourced in the u.s., the taxpayer may elect to treat the income arising from 274. david hariton, equity derivatives, inbound capital and outbound withholding tax, 60 tax. law. 313, 321 (2007). 275. id. 276. see, for instance, oecd tpa, supra note 138, cmt. 21.1 on art. 11, for express mention that the concept of interest is not applicable to non-traditional financial instruments such as interest swaps. 277. chile-u.s. tax treaty, supra note 36, art. 21, ¶ 3. 278. reg. § 1.863-7(a)(1). 279. id. 280. reg. § 1.863-7(b)(1). 2012] u.s. and chile tax treaty 85 notional contracts as ordinary income/loss in which case it will be treated as interest, or he may elect to treat it as capital gain/loss.281 in chile, the use of derivative instruments has been subject to specific sii revenue rulings but is not addressed in a systematic regulation with a more general scope.282 under these terms, the sii has determined that if funds are remitted abroad to meet the conditions of a derivative for hedging purposes, no withholding tax is applied.283 however, if such remittance has a speculative purpose, the transaction will be taxable in chile with a 35 percent withholding rate.284 since determining the hedging or speculative purpose of the derivative is a very subjective issue from a practical standpoint, the chilean congress just passed a bill to modify the law, introducing a special tax regime for derivative instruments.285 under this law, derivatives will be sourced where the recipient of the income is domiciled; hence, since the treaty grants tax authority to both the source and the residence country, income accrued on these types of contracts by u.s. residents dealing with chilean counterparties will be only be taxable in the united states.286 8. practical effect of the treaty on fdi considering the same facts used in section ii.6 to determine the current withholding tax of usco and chileco when doing business in chile and the united states, respectively, the following table illustrates the withholding tax, after the treaty is in force, on usd$ 100 in profits — after corporate tax — for both chileco and usco of a classic investment structure in a wholly-owned manufacturing subsidiary in each country from which 40 percent of the profits are remitted as dividends; 30 percent as interest from a regular loan; 20 percent as royalties derived from the use of software; and 10 percent as payments from services provided by the parent in the subsidiary’s country.287 281. i.r.c. § 881(a)(1)(b). 282. s.i.i., oficio no. 727, apr. 1, 2011 (chile), http://www.sii.cl/ pagina/jurisprudencia/adminis/2011 /renta/ja727.htm. 283. s.i.i., oficio no. 4.279, dec. 21, 1988 (chile), http://home.sii.cl/ sacn/oficios/ja1622.pdf. 284. s.i.i., oficio no. 4.619, oct. 6, 2004 (chile), http://www.sii.cl/ pagina/jurisprudencia/adminis/ 2004/renta/ja821.htm. 285. law no. 20544, oct. 22, 2011 (chile), http://www.leychile.cl/ navegar?idnorma=1031504. 286. id. at art. 3. 287. services are not deemed to create a permanent establishment for the purposes of this calculation. 86 florida tax review [vol.13:2 chileco’s investment in the u.s. usco’s investment in chile type of payment amount in u.s. dollars tax rate tax type of payment amoun t in u.s. dollars tax rate ta x dividend s 40 5% 2 dividend s 40 15% 288 6 royalties 30 10% 3 royalties 30 10% 3 interest 20 15% 289 6 interest 20 15% 3 services 10 0% 0 services 10 0% 0 total 100 11 total 100 12 as the table illustrates, the withholding tax on payments or distributions to usco and chileco is drastically reduced in both cases. for instance, the overall withholding tax on profits paid to a chilean resident is reduced from 30 percent to 11 percent whereas withholding tax on payments made to u.s. residents decreases from 24 percent to 12 percent. the following section will analyze whether the reduction in these tax rates can have a positive impact on fdi. iv. the tax credit system this section will review two main clauses included in the treaty that can create an impact on fdi by residents of the united states and chile in their respective country. this part will analyze the main considerations regarding the effect of the tax credit system on the reduced tax rates under the treaty and its effect on fdi. 1. the tax credit system both chile and the united states tax their residents — and, in the case of the united states, also its citizens — on a worldwide basis. in order to relieve the effects of double taxation on income earned abroad, the u.s. and chile grant a tax credit for taxes paid by their residents on foreign source income.290 288. this rate is calculated as the difference between the additional tax of 35 percent and the current first category tax of 20 percent. as a result of applying the chile clause, there is no reduction in this rate. 289. the 15 percent tax rate is used instead of the 10 percent rate because, in accordance with article 11, the latter rate is only applicable once the treaty has been in force for five years. chile-u.s. tax treaty, supra note 36, art. 11, ¶ 3. 290. l.i.r. arts. 41a–c; i.r.c. § 901 (2010). 2012] u.s. and chile tax treaty 87 under the tax credit system, chile and the united states apply taxes on foreign source income and if there is a difference between the tax paid in the source country and the tax payable in the residency country, the taxpayer must pay the difference.291 this policy is consistent with a goal of capital export neutrality, as the tax laws of the residency country will not cause foreign investment to bear a higher income tax burden than domestic investment.292 if the tax paid abroad is greater than the tax payable in the residency country, no refund is granted.293 2. interaction between the tax credit system and fdi in the case of chile, the tax credit is granted with different limits based on the type of foreign source income and whether the income arises in a country with which chile has a tax treaty in force.294 a 30 percent tax limit is imposed on dividends and profit distributions and a 20 percent limit is imposed on taxes on profits obtained by agencies and permanent establishments, royalties, technical services, and other similar services creditable regardless of the country from which they derive.295 taxes on other types of income obtained in countries that do not have a tax treaty in force with chile are not creditable in chile and can only be used as a deductible expense.296 if a country has a tax treaty in force with chile, the income tax on all types of income (e.g., interest, capital gains, pensions, personal services, director’s fees, etc.) included in that treaty are creditable in chile.297 this is an important benefit directly derived from tax treaties signed by chile that broadens the scope of alternatives for which tax credits are granted. an additional benefit related to income accrued in a treaty country is the citl’s provision in case of capital gain for corporate tax paid by the foreign company of which shares or rights are being sold (underlying tax) to be used as a tax credit to offset chilean taxes on that income.298 291. i.r.c. § 904; l.i.r. art. 41a (a). 292. see bna tax management, supra note 30. 293. under the u.s. tax credit system this statement is always accurate. in chile’s case, an unusual exemption to this general rule is applicable under article 41.c.3. this article provides a tax credit for tax imposed on dependent services provided abroad, and if such tax is greater than the taxes applicable in chile, a tax refund might be granted to the taxpayer. see s.i.i., circular no. 25, apr. 25, 2008 (chile), http://www3.sii.cl/normainternet/#pantallabuscador2. 294. l.i.r. art. 41c. 295. l.i.r. art. 41a (a), (b), (c). 296. l.i.r. art. 12. 297. see l.i.r. art. 41c; chile-u.s. tax treaty, supra note 36, art. 23, ¶ 2. 298. l.i.r. art. 41c, no. 2. javascript:top.docjs.prev_hit(20) javascript:top.docjs.next_hit(20) javascript:top.docjs.prev_hit(21) javascript:top.docjs.next_hit(21) 88 florida tax review [vol.13:2 in the case of the united states, the tax is limited to the same percentage of the tax that would be applicable to such income (e.g., 35 percent in the case of corporations with taxable income over usd$ 18.3 million).299 unlike the chilean system, which only permits a tax credit on a separated income basis,300 the united states’ overall method allows the taxpayer to average the high and low rate countries and thus currently utilize the excess credits301 from the higher rate countries.302 as explained below, the excess tax credit position places u.s. multinational companies in a position similar to that of a company from an exempt country because they will basically only be subject to the foreign tax on that income.303 whether the residency country has a tax credit system or an exemption system can be a determining factor in fdi. for instance, james hines concluded that low tax rates are more likely to influence a location decision by an investor resident in an exemption regime than one in a tax credit regime.304 the following example will illustrate this conclusion for usco. as mentioned above, usco is a manufacturing company established in the united states, where a tax credit is granted for taxes paid in foreign countries of up to 35 percent. assume that usco purchases 40 percent of the rights of chileco — a limited liability company established in chile — and usco sells its rights in this company making a profit of usd$ 100. in accordance with article 13 of the treaty, the gain will be taxable at a 16 percent rate instead of the regular 35 percent additional tax. in consequence, usco will pay $16 in chile and $19 later when profits are received in the united states (because the residency country will apply taxes on the worldwide income) for a total tax burden of $35. now, assume the same facts mentioned above but with the united states using the exemption method. usco will pay $16 in chile and $0 in the united states for a total tax burden of $16, which provides a net savings of $19. this basic example explains why the tax factor is more relevant for exemption countries than for tax credit countries when fdi is located in a low income tax country. 299. i.r.c. § 904(a). 300. s.i.i., circular no. 25, apr. 25, 2008 (chile), § iii.1.a. 301. under i.r.c. § 904(d)(1), a two-basket system is used in the united states to distinguish between tax credit connected to passive category income and to general category income. 302. see mcdaniel et al., supra note 24, at 97. 303. i.r.c. §§ 901–908. 304. james r. hines, jr., tax policy and the activities of multinational corporations 1–43 (nat’l bureau of econ. research, working paper series no. 5589, 1996), http://www.nber.org/papers/w5589.pdf?new_window=1. 2012] u.s. and chile tax treaty 89 other studies on fdi conclude that taxes are not relevant when an investor is deciding whether to invest domestically or abroad.305 this conclusion is based on two main factors: (i) capital that has been allocated abroad may be perfectly mobile between alternative foreign locations, but there is not perfect mobility between foreign and domestic locations; and (ii) the factors — different to tax — may be more relevant to determine the allocation of the corporation’s activities between domestic investment and fdi.306 in the oecd’s opinion, the tax factor becomes relevant to attract fdi only after the following determinants are met by the fdi recipient country: strong political and macroeconomic fundamentals, sizeable markets, a stable and transparent policy framework towards fdi, strong human and material resources, good infrastructure facilities, and a distortion-free economic and business environment.307 however, once an investor decides to invest abroad rather than domestically, taxes in potential host countries can influence the choice of location.308 for example, rosanne altshuler analyzed the effective tax rates of sixty countries where u.s. investments are located and concluded that taxes exert a strong influence on location decisions and that foreign investments of manufacturing firms are sensitive to differences in hostcountry tax rates.309 in a related study on taxation in the european union, griffith and devereux concluded that both the harmonization of the statutory tax rate and the treatment of dividends have an important effect on the location of fdi by multinational companies with high levels of profitability.310 305. michael p. devereux & harold freeman, the impact of tax on foreign direct investment: empirical evidence and the implications for tax integration schemes, 2 int’l tax & pub. fin. 85 (1995). 306. id. 307. oecd, global forum on international investment, new horizons and policy challenges for foreign direct investment in the 21st century: foreign direct investment in developing countries: determinants and impact (2001), http://www.oecd.org/datatoecd/53/20/ 2407305.pdf [hereinafter oecd global forum]. this report is mainly based on previous research performed by rolf langhammer, mario levis, friedich schneider, and bruno frey. 308. see rosanne altshuler et al., has u.s. government investment abroad become more sensitive to tax rates?, in international taxation and multinational activity 9–38 (james r. hines jr. ed., 2001) 309. id. 310. michael p. devereux & rachel griffith, evaluating tax policy for location decisions, 10 int’l tax & pub. fin. 107, 121 (2003), reprinted in international taxation 123 (james r. hines jr. ed., 2007). 90 florida tax review [vol.13:2 a newer study has determined that responsiveness to tax policies has been increasingly important in recent years.311 this stems from the fact that vertical fdi, which is mainly driven by the relative cost of production, is becoming more important.312 multinationals use the new globalization opportunity for minimizing tax burden by relocating mobile capital to countries with more friendly fiscal conditions.313 a more recent article by neumayer presented data on tax treaties signed with the united states, concluding that “[d]eveloping countries that sign tax treaties with the united states benefit from higher fdi originating from u.s. investors.”314 he estimates that the increase in fdi related to a tax treaty could be as much as 20 percent to 22 percent. nevertheless, such benefit will only occur in middle-income countries, not in low-income countries. 315 finally, a recent article by taro ohno concluded that tax treaties entered into by japan in the last twenty years had a significant, long-term, positive effect on japanese fdi in the treaty country; however tax treaties revised during the same period showed no relevant effect on fdi.316 ohno estimated that “newly concluded tax treaties have a negative effect on investment in the short term, but as time passes, they increase their positive effects and in the long term, they will have a statistically significant effect.”317 on the other hand, the revision of old tax treaties executed by japan, aimed to reduce both double taxation and tax avoidance, did not produce any statistically significant improvements on fdi during the same period of time.318 based on the data analyzed here and the fact that the direct relationship between fdi and gdp has not been easily substantiated because 311. dimitri g. demekas et al., foreign direct investment in southeastern europe: how (and how much) can policies help? 24–25 (int’l monetary fund [i.m.f.], working paper no. 5, 2005), http://www.imf.org/external/pubs/ft/wp/ 2005/wp05110.pdf. 312. in this article, vertical fdi is considered a counterpart of horizontal fdi, which is characterized as market-seeking fdi rather than cost-saving fdi. 313. roberta de santis et al., taxes and location of foreign direct investments: an empirical analysis for the european union countries 2, 25–26 (istituto di studi e analisi economica, working paper no. 24, 2001), http://www.isae.it/working_papers/desantis_mercuri_vicarelli24.pdf. 314. eric neumayer, do double taxation treaties increase foreign direct investment to developing countries?, 43 j. developing stud. 1515 (2007). 315. id. 316. taro ohno, empirical analysis of international tax treaties and foreign direct investment, 6 pub. pol’y rev. 287, 287 (2010). 317. id. at 304. 318. see id. at 305. 2012] u.s. and chile tax treaty 91 of the considerable number of variables involved, the following section examines the impact of the treaty benefits on bilateral fdi. 3. effect on fdi of the tax credit system in connection with the tax benefits of the treaty in the specific case of the treaty, a reduction in the chilean withholding tax at source on interest, royalties, and capital gains derived from the sale of rights and shares in chilean companies will have a very limited impact on u.s. fdi319 in chile based on the fact that the united states’ worldwide tax system will offset such reduction with the higher corporate tax rate of 35 percent currently imposed on that income.320 under this scenario, the decrease in chilean withholding tax will likely only produce a shift in tax collection from the chilean treasury to the u.s. treasury but will not provide a relevant benefit to u.s. investors doing business in chile. for instance, the reduction of tax rates on capital gains by usco — connected to long term investments — in the case explained above will translate into a shift of profits from the chilean treasury to the u.s. treasury of usd$ 19 ($35 from the applicable tax rate before the treaty is in force minus $16 from the applicable tax rate after the treaty is in force) but the foreign investor will not receive a net benefit from this reduction. the impact of the treaty on chilean fiscal revenues may be even greater considering the effect on other tax treaties derived from the application of the most favored nation clause. the 2 percent tax rate for certain types of royalties and, most importantly, the 10 percent tax rate on interests will force chile to reduce its tax rates on thirteen treaties with other oecd countries that include the most favored nation clause.321 to the best of this author’s knowledge, the effect of the loss of revenue versus the potential increase in fiscal revenues from a potential increase in fdi has not been analyzed by chilean authorities to determine the exact dimension of this tax expenditure. on the other hand, the treaty would likely have a positive effect on chilean fdi in the united states since the tax credit will be available to new types of income such as services, interest, and certain capital gains. furthermore, the reduction in u.s. withholding rates on interest, royalties, and especially dividends, together with the elimination of the tax on services, will not be completely offset by the chilean corporate rate of 20 percent; thus, such reduction can increase the net return of the chilean investor on 319. chile does not reduce its withholding tax on dividends. see chile.-u.s. tax treaty, supra note 36, protocol, ¶ 12 320. this statement can vary if the u.s. foreign investor has an excess credit position. 321. madariaga, supra note 122, at 222. 92 florida tax review [vol.13:2 u.s. income.322 for example, before the treaty, the total tax burden applied to usd$ 100 in profits paid by a wholly-owned subsidiary to its chilean resident parent as a dividend was usd$ 54.5; once the treaty is in force, that amount will be reduced to usd$ 38.25, of which up to usd$ 30 will be creditable in chile.323 another issue to consider when determining the treaty’s impact on fdi is the limitation on benefits (“lob”) clause. in this context, the next section of this article will study the implications and scope of article 24, which contains the limitations on benefits clause included in the treaty, to analyze its effect on fdi. v. the limitation on benefits clause a lob clause can be found in most conventions for the avoidance of double taxation entered into by the united states and in all u.s. treaties signed after 1981.324 this clause is based on the fact that the united states considers a tax treaty a vehicle for granting tax benefits to only the two contracting states and not to third jurisdictions, thus preventing the “whole world” from benefitting from a treaty signed with a given country.325 as its name indicates, the lob clause seeks to limit the use of benefits from a tax convention by third-country residents that employ a technique known as “treaty shopping” to establish legal vehicles in countries with which the united states has signed tax conventions in order to benefit from the treaty between the u.s. and the other contracting state.326 provisions aiming to stop tax treaty shopping deal only with the question of access to a tax treaty to a “deemed” resident of the other country, but they do not deal with issues related to the abuse of a tax treaty and recharacterization of income.327 in order to determine whether a person may or may not be entitled to the benefits of the convention, article 24 includes a series of tests designed to objectively determine whether benefits should be granted.328 in effect, if 322. since the tax rates of 20 percent and 18.5 percent are only applicable for 2011 and 2012, respectively, this article assumes for all purposes that the effective corporate rate is 17 percent. 323. the calculations are as follows: before treaty: 100*0.35 + 65*0.30=54.5. after treaty: 100*0.35 + 65*0.05=38.25. 324. see bittker & lokken, supra note 41, ¶ 67.3.3, at 67–72. 325. see mcdaniel et al., supra note 24, at 182–184. 326. the comments on article 1 of the oecd model for avoiding double taxation include a proposed clause that is similar, although less specific, to the convention. 327. david ward et al., how domestic anti-avoidance rules affect double taxation conventions, 19c ifa congress seminar series (1994). 328. u.s. 2006 model technical explanations, supra note 119, art. 22. 2012] u.s. and chile tax treaty 93 the taxpayer complies with any of the tests indicated in the clause, it will be considered to have a real business objective in the country of residence, or a connection of such relevance with that country that the taxpayer will be given access to the treaty benefits.329 from a practical point of view, the lob clause aims to prevent treaty shopping by assuming that a company established in the contracting state that is owned substantially by residents of that contracting state and does not make relevant tax-deductible payments to third countries was probably not established by residents of other countries to improperly take advantage of the benefits of the treaty.330 also, if the company does not meet these conditions but does actively conduct trade or business in the other contracting state, it can secure the treaty benefits for certain income derived from this trade or business. additionally, if a company does not satisfy any of the above requirements, it can ask the competent authority of the other country to grant the benefits of the treaty.331 it is important to point out that the lob rules are not exclusive of internal law provisions that seek to limit abuse of domestic law in order to obtain tax benefits.332 in effect, internal law can be used to identify the beneficial owner of income and the lob clause can be applied to determine whether that beneficial owner can or cannot receive the treaty benefits for that income.333 1. residents qualified to receive the benefits of the treaty a resident of a contracting state will be considered qualified to receive the benefits of the convention if the resident is:334 a) an individual resident of one of the contracting states; b) the signing country or any political subdivision, local authority, agency, or body of that country; c) a pension fund, as long as more than 50 percent of its beneficiaries, members, or participants are persons that are residents of the other country; d) a non-profit entity established for religious, charity, educational, or other similar purposes; 329. id. 330. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 2(g). 331. chile-u.s. tax treaty, supra note 36, art. 24, ¶¶ 3(a), 4. 332. u.s. 2006 model technical explanations, supra note 119, art. 22, ¶ 1. 333. id. 334. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 2. 94 florida tax review [vol.13:2 e) a company whose shares are regularly traded on one or more stock exchanges or a company that is a subsidiary of a company whose shares are regularly traded on a stock market.335 however in both cases, the latter company must also meet either one of the following additional requirements: (i) the main class of shares is traded on one or more exchanges in its country of residence; or (ii) the company’s primary place of management and control is in the company’s country of residence.336 the benefits of the treaty will also be granted to a company if at least 50 percent of its shares are held by five or fewer companies whose shares are traded on recognized stock exchanges.337 should indirect ownership exist, each owner must be a resident of chile or the united states.338 f) a person that functions as a “headquarters company” for a multinational corporate group. for these purposes, “headquarters company” is defined as an entity that meets the following copulative conditions: (i) carries out overall supervision and administration — discretionally or independently — of a group of companies in the country where it resides; (ii) the corporate group to which it belongs is engaged in active business in at least five countries, generating in the aggregate 10 percent or more of the group’s gross income but with no one country generating more than 50 percent of the group’s gross income; (iii) does not obtain more than 25 percent of its gross income from the other contracting state; (iv) is subject to the general tax rules established for companies engaged in the active trade or business; and (v) the income it generates in the other state either is obtained in connection with, or is incidental to, the 335. article 24 of chile-u.s. tax treaty also limits evasion of these rules through the creation of “disproportionate shares,” or shares that entitle shareholders to the right to a disproportionately higher participation through dividends, redemption payments, or other types of payments. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 2(c). 336. pursuant to article 24 of the treaty, the primary place of management and control is located in the country where the executive officers and senior management employees exercise more day-to-day responsibility for the strategic, financial, and operational policy decision making for the company than in any other country and where the staff of such persons conduct more of the day-to-day activities necessary for preparing and making those decisions than in any other country. chileu.s. tax treaty, supra note 36, art. 24, ¶ 2(c)(i). 337. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 2 (c)(ii). 338. id. 2012] u.s. and chile tax treaty 95 group’s active business.339 despite the rigid nature of this provision, it is somewhat flexible since the treaty establishes that if the above percentages are not met, average income from the four preceding years can be used to calculate these percentages.340 this means that the benefits of the treaty cannot be denied as a result of very poor or very successful earnings in a specific year. g) a legal entity that meets the “ownership/base erosion” test.341 this test seeks to limit companies being established in contracting states with the sole purpose of receiving the benefits of the treaty. in practice, a person is considered qualified to receive the benefits of the treaty if 50 percent or more of each class of shares or interests is owned directly or indirectly for at least half of the tax year by a person that is a beneficiary of the convention under the terms indicated above342 and, also, less than 50 percent of the gross income of that person is paid to non-beneficiaries of the treaty via tax-deductible payments.343 examples of tax-deductible payments include interest, royalties, and services, except for arm’s length payments for services or goods during the normal course of business. h) a person that does not qualify for the benefits of the treaty based on the rules above may still be entitled to the treaty benefits for a specific item of income derived from the country from which the income is paid (source country) related to the active conduct of a trade or business in the other state (country of residence).344 for this benefit to apply, the income should be derived from business other than making or managing investments, unless in the case of banking, insurance, or securities activities carried on by a bank, insurance company, or registered securities dealer (in which 339. in conformity with article 24, paragraph 2(d)(ii) of the treaty, this group of companies can include, but not consist primarily of, a financial group. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 2 (d)(i). 340. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 2(d). 341. bittker & lokken, supra note 41, ¶ 67.3.3, at 67–75. 342. in the case of indirect ownership, each owner shall be considered a resident of that contracting state. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 2(g)(i). 343. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 2(g)(ii). 344. for these purposes, article 24, paragraph 3(c) sets forth that “activities conducted by persons connected to a person shall be deemed to be conducted by such person.” the concept of connected persons includes interests equal to or greater than 50 percent of the beneficial interest of one company in another, or “if, based on all the relevant facts and circumstances, one person has control of the other or both are under the control of the same person or persons.” chile-u.s. tax treaty, supra note 36, art. 24, ¶ 3(c). 96 florida tax review [vol.13:2 case such activities are accepted). furthermore, active development of a trade or business in the country of residence should be “substantial” with respect to the source country activity.345 to determine whether an activity or business is substantial, all the facts and circumstances related to that activity or business shall be analyzed.346 i) a person who does not meet any of the conditions in paragraphs a) to g) for qualifying as a beneficiary of the treaty and does not satisfy the requirements of paragraph h) for a given item of income to be entitled to receive the benefits of the convention can be a beneficiary if the competent authority of the other contracting state decides to grant it these benefits.347 for these purposes, the authority shall consider whether one of the main purposes for acquiring or maintaining such person or of its business operations is to obtain benefits under this treaty.348 a taxpayer is also entitled to present his case to the relevant competent authority for an advance determination based on the facts.349 lastly, paragraph 5 of article 24 of the treaty sets forth that income obtained in the source country that is attributable to a permanent establishment in a third country shall not be entitled to receive the benefits of this convention.350 this holds true as long as the tax paid for that income in the country of residence of the pe’s parent company plus the tax paid in the third country is less than 60 percent of the tax that would have been paid in the country of residence if the income had been obtained in that country.351 dividends, interest, and royalties in this particular situation shall be taxed in the source country, but the rate shall not exceed 15 percent of the gross amount paid. any other income shall be subject to general taxation rules under domestic law.352 this latter rule should be carefully studied in the case of dividends since this provision could conflict with paragraph 12 of the treaty’s protocol, which establishes that paragraphs 2, 3, 7, and 8 of article 10 do not limit the application of the additional tax (withholding tax) to the extent that, in accordance with chilean domestic law, first category tax is fully 345. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 3(b). 346. special attention should be given to the relative size of the economies of the contracting states. u.s. 2006 model technical explanations, supra note 119, art. 22, ¶ 3. 347. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 4. 348. id. 349. u.s. 2006 model technical explanations, supra note 119, art. 22, ¶ 4. 350. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 5. 351. id. 352. id. 2012] u.s. and chile tax treaty 97 deductible when calculating additional tax payable. the problem arises since paragraph 5 of article 24 is not expressly included in paragraph 12 of the protocol; hence, chile shall be obligated to decrease its additional tax from 35 percent to 15 percent in this case. this unintended situation will be unique in chilean tax treaty policy since chile has never agreed to decrease its tax authority on dividends because, as mentioned above, it considers that an overall tax burden of 35 percent is fair enough for foreign investors. notwithstanding, the restrictions set forth in paragraph 5 do not apply if the payments are for royalties received as compensation for the use of intangible property produced or developed by the pe or for any other income derived in connection with, or incidental to, the active development of a trade or business by the pe in the third country.353 2. effect of the limitation on benefits clause on fdi the lob clause makes significant progress in international tax law for the avoidance of abuse from treaty shopping, imposing a series of restrictions on companies that are established in a given country in order to obtain the benefits of a convention entered into with the united states. however, a measure aimed at reducing tax avoidance can have a negative effect on fdi. for instance, ohno analyzes several factors of tax treaties that can unfavorably impact fdi and the lob clause is among the first in the list.354 this result is, in the opinion of this author, due to four reasons: (i) it denies the benefit to companies owned by foreign individuals for reasons other than purely economic grounds such, as political stability and tax savings;355 (ii) the strict screening of persons eligible for the benefits of the treaty beforehand, under the exchange of information clause, may be regarded as a potential unwanted audit of the companies and its owners;356 (iii) the complexity of applying this clause requires reviewing and adapting diverse legal structures and business units used by multinationals established in chile to conduct business in both latin america and the united states since, although their principal objective for establishing companies in chile might not be 353. notwithstanding this exception, article 24, paragraph 5(b), sets forth that the business of investing, managing, or simply possessing investments on behalf of the company shall be subject to general taxation rules under the domestic law of the source country. chile-u.s. tax treaty, supra note 36, art. 24, ¶ 5(b). 354. ohno, supra note 316, at 294. 355. for instance, in recent years venezuelan and argentinean companies have formed companies in chile to avoid the political instability of those countries. 356. see chile-u.s. tax treaty, supra note 36, art. 27. 98 florida tax review [vol.13:2 tax-related, they could be denied the benefits of the convention because of limitations imposed by this clause; and (iv) the lob can produce an undesired effect related to derivative benefits.357 indeed, the treaty does not include a provision that extends the benefits under the treaty to companies owned by foreign persons that are residents of another treaty country unlike other treaties signed by the united states, such as those with canada, denmark, ireland, the netherlands, switzerland, and finland.358 this will mainly affect multinational companies from european countries that have a treaty in force with both chile and the united states, since the benefits of both treaties might be denied if they conduct their investment in the united states through chile. even if the benefits of the treaty are granted by the u.s. competent authority, there is no certainty as to what tax rate will be applied by the united states if the withholding tax between chile and the united states is different than that agreed upon in the tax treaty between the united states and the third country. an additional perspective connected to the lob clause is the denial of treaty benefits under the concept of a “platform company” to a company established in chile that uses the special regime established by article 41d of the citl. this kind of structure is mostly used by investors domiciled in other latin american countries (e.g., argentina, venezuela, and bolivia) that seek asset protection in chile given the uncertainties in their domestic legal and economic frameworks. under a platform company regime, if the entity meets several conditions and invests abroad, it does not pay taxes in chile with respect to foreign source income. however, the treaty benefits would likely be denied under the lob requirements.359 notwithstanding the aforesaid, the application of the lob clause might also create collateral benefits for chile because it will likely encourage foreign investors to pursue a greater level of investment and establishment (i.e., more expenditure on labor force and acquisition of facilities) in chile in order to be eligible for treaty benefits. however, if ohno is right, it is unlikely that benefits derived from this potential increase on fdi can offset the reduction on fdi derived from the lob clause. vi. conclusion 357. for more detailed analysis on this matter, see ruth mason, when derivative benefits provisions don’t apply, 112 tax notes 367 (2006). 358. richard l. reinhold, what is tax treaty abuse? (is treaty shopping an outdated concept?), 53 tax law. 663, 690 (2000). 359. see l.i.r. art. 41d. 2012] u.s. and chile tax treaty 99 the treaty will reduce withholding rates at source on interest, royalties, and capital gains and will exempt income derived from services and business profits not attributable to a permanent establishment. in the case of chilean investment in the united states, an increase in chilean fdi can be expected since the reduction in withholding tax by the united states will not be fully offset by chilean taxes on such payments. furthermore, it can be argued that the existence of the treaty has a positive effect on investors’ attitudes and willingness to invest and, hence, may positively affect fdi. since there are no tax treaties in the region — other than the u.s.-mexico and u.s.-venezuela tax treaties — the treaty may also attract investment that goes through chile for tax savings purposes but that also meets the requirements under the lob clause. in contrast, it is unclear whether the decreased withholding tax will increase u.s. fdi in chile, because such decrease will likely be offset by the u.s. tax credit system. consequently, the treaty’s most direct effect is not a reduction in the tax burden of the u.s. investor but rather a shift in tax revenues from the chilean treasury to the u.s. treasury. the treaty’s effect on chilean revenues and the country’s welfare can be even greater if the impact of the most favored nation clause included in tax treaties signed with oecd members is taken into account. even if fdi increases as a result of the treaty, there is no empirical evidence that such an increase — and its potential favorable effect on the first category tax — will create a net benefit for chile that compensates the loss of revenues arising from the treaty. florida tax review i volume 13 2012 number 7 florida tax review article partnership special allocations revisited david hasen university of florida college of law florida tax review volume 13 2012 number 7 article partnership special allocations revisited david hasen 349 florida tax review volume 13 2012 number 7 the florida tax review is a publication of the graduate tax program of the university of florida college of law. each volume consists of ten issues published by tax analysts. the subscription rate, payable in advance, is $125.00 per volume in the united states and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: customer service dept., tax analysts, 400 s. maple ave, suite 400, falls church, va 22048. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify tax analysts of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at 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the university of florida college of law and tax analysts do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 13 2012 number 7 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 13 2012 number 7 349 partnership special allocations revisited by david hasen abstract special allocations of items of partnership income, gain, loss, and deduction have long created difficulties for the tax law. the paper argues that most such allocations should not be respected for tax purposes because they inappropriately separate the character of partnership items from the partners that are economically entitled to them. the paper suggests that special allocations instead ought to be viewed as transactions in partnership interests between or among the partners themselves. a number of consequences follow. the paper also argues that treasury‘s rules for establishing the partners‘ interests in the partnership when an allocation fails the test for substantiality likely are inconsistent with section 704(b) of the internal revenue code. i. introduction ............................................................................. 350 ii. overview .................................................................................... 358 iii. substantial economic effect .............................................. 360 a. economic effect ................................................................ 360 b. substantiality .................................................................... 363 iv. special allocation economics ........................................... 366 a. depreciation and gain chargeback example .................. 366 b. taxable and tax-exempt securities example ................... 377 v. possible approaches to special allocations ................. 382 a. partnership within a partnership ..................................... 383 1. simple disproportionate allocation ........................... 383 2. disproportionate allocation coupled with special allocation....................................................... 384 b. permissible character assignments ................................. 387 vi. conclusion ................................................................................. 394 ________________________ *associate professor, santa clara university law school. thanks to gregory broome, terence cuff, heather field, mark gergen, martin mcmahon, george wolf, participants at the northern california tax roundtable, and the editors of the florida tax review. i remain solely responsible for any errors. 350 florida tax review [vol. 13:7 i. introduction subchapter k 1 of chapter 1 of the internal revenue code governs the tax treatment of partnerships. very generally, it establishes a ―pass-through‖ regime: partnerships themselves are not subject to income tax but rather function largely as accounting entities that allocate the partnership‘s items of income, gain, loss, and deduction among the partners, who are subject to tax on the items so allocated. 2 the allocation rules are complex, burdensome, and prone to abuse. 3 perhaps nowhere are the unattractive features of subchapter k more clearly on display than in the area of so-called special allocations — allocations of specific items of partnership income, gain, loss, and deduction (―igld‖) that do not generally track one or more partners‘ overall interest in the partnership. 4 under section 704(b) and treasury regulations interpreting that provision, special allocations will be respected for tax purposes if they either satisfy a detailed test for ―substantial economic effect‖ or are deemed to be in accordance with the partners‘ interests in the partnership. 5 one of the difficulties with the special allocation rules is that they are quite complex. another is that, despite their complexity, they are manifestly inadequate to the task: they permit assignments of partnership items that, in other contexts, including in subchapter k itself, both congress and the courts have found inconsistent with basic principles of income taxation and have disallowed. 6 unfortunately, it is not readily apparent how treasury‘s rules on special allocations could be made more effective within the existing framework of subchapter k. in enacting the current version of section 704(b), in 1976, congress seems to have had in mind that income assignments among partners should be permissible as long as they are not, or are not unduly, tax-motivated. 7 since that time, both the opportunities for 1. i.r.c. §§ 701–777. 2. i.r.c. §§ 701, 702. 3. see, e.g., george k. yin, the future taxation of private business firms, 4 fla. tax rev. 141 (1999) [hereinafter yin, future taxation] (one among many commentators noting these features of subchapter k). 4. i.r.c. § 704(b); reg. § 1.704-1. 5. reg. § 1.704-1. 6. see, e.g., i.r.c. §§ 724 (character of ordinary income items contributed to partnership is retained), 751 (ratable allocation of ordinary and capital items of partnership income and loss on disposition or redemption of a partnership interest). 7. s.rep. no. 94-938, pt. 1, at 100 (1976), reprinted in 1976 u.s.c.c.a.n. 3438, 3536 (―the committee amendment provides generally that an allocation of overall income or loss (described under section 702(a)(9) [now section 702(a)(8)]), or of any item of income, gain, loss, deduction, or credit (described under section 702(a)(1)-(8) [now section 702(a)(1)-(7)]), shall be controlled by the partnership 2012] special allocations revisited 351 abuse that section 704(b) makes available and the inadequacies of the treasury regulations to police abuse have become more apparent. 8 in consequence, many commentators have suggested various types of simplifying reform, 9 most of which involve far-reaching changes to subchapter k or even beyond. george yin, for example, has suggested a fundamental revamping of the business tax rules that would put all business entities onto one of two tracks, depending upon the entities‘ sophistication, the type of owners involved, and other factors. 10 mark gergen has suggested somewhat less sweepingly that special allocations be disallowed; the recommendation is part of a larger package of proposed reforms gergen has suggested to subchapter k. 11 this article joins the chorus of those who have argued that special allocations generally should be disallowed. as i develop below, an appropriate analysis of a special allocation is to consider it as a transfer of a partnership interest between or among two or more partners. as a general matter, such transactions would not be sales or exchanges but, instead, would be taxable as ordinary income to the recipient of the interest and would create an ordinary deduction to the transferor. there is not much reason why two economically identical arrangements, differing only in that one is structured as a partnership using special allocations, ought to generate different tax results. accordingly, i indicate how one would derive the transactions in partnership interests that are economically equivalent to partnership special allocations in a variety of cases in order to show how most special allocations should be treated under the tax law. further, because special allocations are tantamount to transfers of partnership interests, ancillary rules of subchapter k as well as other tax principles may come into agreement if the partner receiving the allocation can demonstrate that it has ‗substantial economic effect,‘ i.e., whether the allocation may actually affect the dollar amount of the partners‘ shares of the total partnership income or loss independently of tax consequences.‖). 8. see, e.g., mark p. gergen, reforming subchapter k: special allocations, 46 tax l. rev. 1, 9, passim (1990) [hereinafter gergen, special allocations]; yin, future taxation, supra note 3, at 154–55. 9. see, e.g., mark p. gergen, the end of the revolution in partnership tax?, 56 smu l. rev. 343 (2003); mark p. gergen, reforming subchapter k: compensating service partners, 48 tax l. rev. 69 (1992) [hereinafter gergen, compensating service partners]; gergen, special allocations, supra note 8. see also gregg d. polsky, deterring tax-driven partnership allocations, 64 tax law. 97 (2011) [hereinafter polsky, tax-driven allocations]; yin, future taxation, supra note 3. 10. yin, future taxation, supra note 3. 11. together, gergen, compensating service partners, supra note 9, and gergen, special allocations, supra note 8, constitute a proposal to revamp subchapter k. 352 florida tax review [vol. 13:7 play in evaluating their tax consequences. principal among these is the election under section 754 to take account of discrepancies between the basis and the fair market value of partnership property when an interest in the partnership is transferred. a further consequence would be the recognition of gain or loss by the transferor to the extent the fair market value of the interest transferred differed from its adjusted basis in the transferor‘s hands. i also argue, however, that an exception to a general rule of not respecting special allocations ought to be available where there is a sufficient non-tax-avoidance motive to support the allocation. i also propose that the regulations under section 704(b) be modified to permit greater variation in the initial allocations of partners‘ interests in particular items of partnership property and therefore of particular items of partnership igld. apart from these qualifications, special allocations generally should be disregarded, which is to say that accounting for the outcomes of special allocations generally should take place outside of the partnership itself. perhaps counterintuitively, i believe that the recommendations offered here would result in a less burdensome set of partnership tax rules overall, even though the recommendations would add complexity to partnerships choosing to avail themselves of the special rules on allocations within the partnership. if, as i suspect, the appetite for special allocations is driven in large measure by the search for unwarranted tax benefits, then the adoption of complex rules that curb or eliminate the tax advantages of special allocations is likely to have a simplifying and compliance burden-reducing effect, even if the special allocation provisions themselves become more difficult to apply. as i develop below, the principal benefit that respecting partnership special allocations affords is to enable the partners to engage in untoward tax avoidance by means of character assignment. 12 a character assignment separates the owner of a type of igld from the asset or arrangement that produces it. for example, a special allocation may shift capital income or loss from a partner who, based upon ownership, economically earns or bears it to another partner who, for tax reasons, derives greater benefit from capital income or loss than does the partner from whom it is allocated. 13 as a general matter, assignments of either amounts or kinds of igld are not permitted under the tax law. 14 outside of the partnership area, congress and 12. see, for example, regulations section 1.704-1(b)(5) for common examples of special tax items. 13. i am aware of at least one special allocation under which items of partnership capital gain are allocated to a partner having a profits interest. document on file with author. 14. see lucas v. earl, 281 u.s. 111 (1930) (disallowance of income assignments). various rules limit character assignment. see, e.g., sections 702 (passthrough taxation of partnership items), 724 (preservation of character of income contributed to a partnership), 751 (requiring ratable allocation of ordinary and capital income and loss on disposition or redemption of a partnership interest). 2012] special allocations revisited 353 the courts have agreed that items of igld should be taxed to the person who economically owns them, not to someone else. 15 permitting special allocations seems to fly in the face of this general tax principle since, by definition, the special allocation creates a divergence between a partner‘s quantum of ownership of partnership property and the extent to which the partner enjoys or bears a particular item of igld in respect of partnership property. one might respond that congress has overridden the principle in the special allocation area in favor of a weaker rule that permits income assignments when they are a consequence of, but not the motivating force behind, an otherwise business-driven allocation. but congress‘s concern to avoid such assignments in other areas of subchapter k, together with the emerging consensus among tax scholars that most special assignments are tax-motivated, suggest it is time to reconsider that decision. 16 assignment generally comes in two flavors, but most special allocation problems concern just one: the inappropriate assignment of character, or type of income, from one partner to another. the other principal form of assignment, of amount, is less common. in a typical character assignment, each partner assigns one type of partnership item in exchange for another that is of greater value to the transferor than what was surrendered, the increased value coming in the form of tax benefits. by contrast, in an ―amount‖ assignment, an item is simply shifted from one person to another but not in a reciprocal arrangement, again with attendant tax benefits. 17 assignments of amount tend to arise in settings in which a 15. examples of this policy in the code include the rules in subchapter k cited in note fourteen as well as numerous provisions outside of subchapter k. see rules cited supra note 14; see, e.g., i.r.c. §§ 1(g) (investment income of minor children taxed to parents on theory that parents are owners of the investments), 132(a)(2) (fringe benefits provided to dependents of employees are taxed to the employees), 382 (limiting availability to an acquiring corporation of an acquired corporation‘s net operating losses). the policy of disallowing income assignments was forcefully articulated in earl, 281 u.s. at 113 (no anticipatory assignment of income from husband to wife where the wife was in a lower tax bracket). see also commissioner v. culbertson, 337 u.s. 733, 739–40 (1949) (―to hold that ‗individuals carrying on business in partnership‘ include persons who contribute nothing during the tax period would violate the first principle of income taxation: that income must be taxed to him who earns it.‖). 16. see, e.g., gergen, compensating service partners, supra note 9; gergen, special allocations, supra note 8; calvin h. johnson, partnership allocations from nickel-on-the-dollar substance, 134 tax notes 873 (feb. 13, 2012); polsky, tax-driven allocations, supra note 9; yin, future taxation, supra note 3. 17. boris i. bittker & lawrence lokken, federal taxation of income, estates & gifts ¶ 75.2 (2007) [hereinafter bittker & lokken, federal taxation]. typical situations include assignments from one family member to another or from a donor of one kind or another to a donee. by contrast, because 354 florida tax review [vol. 13:7 special relationship between the assignor and assignee makes the assignment desirable, such as between family members. by contrast, character assignments generally create net after-tax value to both of the parties involved. character assignments may be desirable to the partners because the character of income, unlike its amount, may have variable tax effect but not non-tax economic effect. as examples, on a pre-tax basis, tax-exempt interest is no different from taxable interest, and capital income is not different from ordinary income. a taxpayer is indifferent on a pre-tax basis between a dollar of one and a dollar of the other. however, on an after-tax basis, different partners, because of their particular tax situations, may place different values on the different types of income. a partner in a high tax bracket will gladly exchange one dollar of taxable interest for 75 cents of tax-exempt interest, while a tax-indifferent partner will be more than happy to accept the 25-cent fee for the tax break; if, however, the asset (or the relevant fractional interest in it) that gives rise to the tax-exempt interest is not also transferred, then the benefits and burdens associated with the right to the interest, which evidently were intended to be borne by the person enjoying the tax exemption, remain with someone else. transactions such as these, where it is possible to separate the tax character of an item of igld from the economic arrangement that gives rise to the character, by definition generate undesired results, and they represent the central problem that special allocations pose for the tax law. another way of characterizing the point is to observe that special allocations are generally inconsistent with the aggregate theory of partnership taxation, though it is important to recognize that the aggregate theory is more limiting on partnership economics than is the idea that character assignments should not be permitted. (the theory is more limiting than would be denial of character assignments in the sense that it would require the partners to treat themselves as having ratable ownership even of partnership assets within individual tax classes, despite the fact that no tax consequences would flow from failing to respect varied ownership within individual classes.) under the aggregate theory, the partners are considered to own a ratable share of each of the partnership‘s assets for tax purposes. 18 partners typically deal with each other at arm‘s length, they generally demand something of equal value in exchange for something surrendered, as may arise in a character assignment. the problem of income assignment does arise prominently in one partnership setting — the case of family partnerships, in which older generations of partners may attempt to pass partnership interests to their offspring on a taxfavored basis. see i.r.c. § 704(e)(1). 18. a leading treatise offers the following characteristic description of the aggregate understanding of the partnership: ―subchapter k represents a blending of two views as to the nature of partnerships. the first view is that a partnership is simply an aggregation of individuals, each of whom should be treated as the owner of a direct undivided interest in partnership assets and operations. this is sometimes 2012] special allocations revisited 355 by contrast, under the competing ―entity‖ theory, the partnership is viewed as separate from its partners, so that the partner is not considered to own a ratable share of each partnership asset but instead an interest in the entity, which interest is defined by the terms of the partnership agreement. 19 subchapter k embodies a mix of entity and aggregate conceptions, but in general it favors the aggregate conception for purposes of determining the economic rights and obligations of the partners; 20 the entity theory generally applies for purposes of administrative convenience. 21 special allocations are inconsistent with the aggregate theory because the theory embodies the idea that each partner‘s ownership of each item of partnership property is proportional to the partner‘s overall interest in the partnership, while the special allocation by definition departs from ratable ownership. returning to the example of taxable and tax-exempt interest, a partnership in which the two partners each contribute $50 in exchange for equal partnership interests may purchase equal quantities of taxable and tax-exempt debt obligations. if the interest earned by these obligations is not allocated equally to the two partners, then under the aggregate theory, each receives an assignment of one type of interest income in exchange for parting with some of the other. the foregoing considerations suggest that a resolution of the problem of special allocations would focus on methods by which to establish the associated non-equity-based transactions that would result in the allocations of income provided under the partnership agreement. in general, the most direct method to achieve the result is to view the partner receiving a net amount in excess of its ratable share as receiving a partnership interest from the other partner or partners. such a constructive transaction arrives at the appropriate tax outcome, albeit at the cost of some complexity, without disturbing the aggregate analysis of the partners‘ interests in the partnership (pip). under this approach, each partner treats itself as earning the ratable share of each type of income, based upon relative partnership interests, referred to as the ‗aggregate‘ or ‗conduit‘ view of partnerships.‖ william s. mckee et al., federal taxation of partnerships and partners ¶ 1.02 (2007) [hereinafter mckee et al., partnerships and partners]. 19. ―the second view is that a partnership is a separate entity, with a tax existence apart from the partners. under this view, a partner has no direct interest in partnership assets or operations, but only an interest in the partnership entity separate and apart from its assets and operations.‖ id. 20. see, e.g., i.r.c. §§ 702 (pass-through of partnership items to partner), 724 (preserving character of certain contributed property), 732 (allocation of basis among capital and non-capital assets), 751 (requiring ratable allocation of ordinary and capital income on dispositions and redemptions of partnership interests). 21. see, e.g., i.r.c. §§ 703(b) (elections affecting computation of taxable income to be made by the partnership), 706 (partnership has one taxable year), 754 (partnership election to recompute partnership‘s basis in its property on certain dispositions or redemptions of partnership interests). 356 florida tax review [vol. 13:7 through the partnership, and then as either transferring to or receiving from the other partner or partners a partnership interest equal in value to the net amount the partner loses or gains, respectively, by reason of the special allocation. applied to the example in the preceding paragraph, each partner‘s initial inclusion will be taxable to the extent it is of non-tax-exempt interest, 22 while the transfer should generate a deduction under section 162 to the payor and an ordinary inclusion to the payee regardless of the character of the income item to the partnership. 23 the net effect would be that the recipient of a disproportionately large amount of tax-exempt interest will not avoid tax, while the recipient of a disproportionately large amount of taxable interest will continue to have a reduced quantity of taxable income. 24 going forward, the partners will no longer have equal partnership interests. there is, however, a feature of partnership operations that makes the straightforward application of a principle of ratable allocation somewhat more nuanced than might appear. it is that there is, and really can be, no entry in the partners‘ capital accounts that reflects anticipated labor income of the partnership. 25 human capital, in short, cannot be reflected on the partnership‘s books. as a consequence, where a partner‘s compensation is based on partnership profits, one cannot determine pip simply by reading off the partners‘ capital account balances except in the limited cases in which the income of the partnership does not depend upon any partner‘s labor, or where a partner is leaving the partnership, in which case the relevant labor income has accrued and should be reflected on the books, either as part of partnership goodwill or as embodied in identifiable partnership property. 26 22. i.r.c. §§ 61(a)(4) (interest generally includible), 103(a) (interest on certain municipal bonds excluded from gross income), 702(a) (partner includes allocable share of partnership items of igld). 23. economically the exchange is closely similar to a notional principal contract, as developed below, which generally are treated as producing ordinary income and ordinary loss to the parties. see reg. § 1.446-3; infra note 71 and accompanying text. 24. if, for example, each partner ratably earns $50 of each type of income and the special allocation provides for a full assignment of taxable income to the non-taxable partner and of tax-exempt income to the taxable partner, then each partner has $50 of taxable interest through the partnership, $50 of tax-exempt interest through the partnership, a $50 deduction on transfer to the other partner, and a $50 inclusion on the receipt. 25. brad borden makes a similar point in arguing that the test for allocations ought to be ―deal-centric‖ rather than capital-account-centric. bradley t. borden, partnership tax allocations and the internalization of tax-item transaction, 59 s.c. l. rev. 297, 344–45 (2008). 26. in many cases, partners are compensated in part on a basis other than with reference to partnership profits, in which case the payments are characterized under section 707(c) to that extent. under that provision, payments generally are includible by the partner and deductible or capitalizable by the partnership (including 2012] special allocations revisited 357 the arrangement in a typical ―brains and money‖ partnership that anticipates all income to be derived from the sale of partnership services illustrates the difficulty. often the agreement will provide that one partner contributes all the capital while the other contributes services, with the partners agreeing to some division of partnership profits. 27 the laboring partner‘s initial capital account balance may or may not reflect a percentage of total partnership capital equal to the percentage of profits to which the partner is entitled, and, even if it does equal that percentage, fluctuations in the capital accounts over time may not correspond to the agreement on the division of partnership income. consequently, it makes sense to construe the laboring partner‘s pip as determined at least in part by the partner‘s share of partnership income as provided under the partnership agreement and not by the partners‘ capital account balances, assuming the partners deal with each other at arm‘s length. thus, in determining pip for purposes of analyzing special allocations, one must recognize that a partner‘s entitlement to partnership income that differs from the relative capital account balances may be appropriate to the extent partnership income depends upon services provided by the partners. the import of this observation has not so much to do with the analysis of ratable ownership under the aggregate theory as it does in recognizing that an agreement to divide partnership profits in a ratio different from the partners‘ capital account balances does not always constitute a ―special allocation.‖ the analysis offered here suggests congress should amend section 704(b) to eliminate special allocations to the extent they are inconsistent with pip broadly understood. the principal goals are to remove the opportunities for abuse that arise under the special allocation rules and to make those rules consistent with congress‘s evident concern, expressed in other provisions of subchapter k, that taxpayers not use the partnership form to shift the timing or character of income among partners for tax reasons. a secondary suggestion, and in effect an alternative one, is that congress and treasury move toward greater consistency across subchapter k. if congress were to decide not to pursue the types of reform detailed here or by other commentators, one might wonder whether the rules on unwarranted character shifts in other code provisions ought to survive. although a repeal of these rules also would require congressional action, repeal would appear to be appropriate given the manifest inconsistency between incomeand charactershifting opportunities permitted to survive under section 704(b) and those shut down under such provisions as sections 707, 737, and 751. the recipient partner qua payor), depending upon the nature of the services for which the payment is made. see reg. § 1.707-1(c). 27. see curtis j. berger, w(h)ither partnership taxation?, 47 tax l. rev. 105, 108–09, 131–33 (1991) (discussing propriety of allocations in ―money and brains‖ partnerships not in accordance with capital contributions). 358 florida tax review [vol. 13:7 the discussion proceeds as follows. part ii offers a general overview of the operation of the special allocation provisions under the section 704(b) regulations. part iii provides an abbreviated overview of the rules on substantial economic effect (see). part iv identifies problems with some exemplary special allocations. part v suggests two possible approaches to addressing the problem of special allocations, either or both of which congress could adopt. ii. overview to give effect to the pass-through regime of partnership income taxation, the code provides in most cases that the partnership is treated as an aggregate of its partners. in essence, aggregate treatment means that the income tax effect of the partnership‘s activity is accounted for wholly at the partner level. 28 if, for example, the partnership realizes net losses on sales of capital assets, whether the losses operate as an offset (to the extent permitted) to ordinary income or instead reduce capital gain is determined at the partner level. similarly, if the partnership sells at a gain property used in its trade or business, then whether the sale generates a recapture of loss under section 1231 will be determined at the partner level, not the partnership level, even though the character of the item as a section 1231 loss is determined at the partnership level. while it is true that some provisions of subchapter k treat partnerships as entities, for the most part these provisions reflect the need for administrability 29 rather than a desire to treat the partnership in economic terms as separate from the partners. as an example, the already dauntingly complex rules on allocations of various partnership items would become substantially more complex if each partner had his or her own partnership tax year. as another example, similar complexity would arise if each partner could make the election under section 179 to expense certain depreciable business property. for these and other purposes, the partnership is treated as an entity. the mandate of aggregate taxation is substantially complicated by the extraordinary flexibility the code affords to partners in the arrangement of their economic deal. 30 if the code required all items of partnership income 28. i.r.c. § 703. 29. examples of entity treatment include sections 703(b) (most partnership elections), 706 (determination of partnership tax year), and 754 (election to adjust ―inside‖ basis of partnership assets on disposition or redemption of partnership interest). 30. see mckee et al., partnerships and partners, supra note 18, at ¶ 1.03 (―one of the principal legislative objectives of subchapter k was to afford partners ‗flexibility‘ in allocating the tax burden of partnership transactions among themselves.‖). 2012] special allocations revisited 359 to be allocated ratably to the partners based upon their overall interest in the partnership, the computation of the various items of partnership igld would be relatively straightforward (relatively, that is, by comparison with the rules that actually apply). twenty-percent partners would receive 20 percent of the depreciation, ordinary income, capital gain, and so on of the partnership. fifty-percent partners would receive 50 percent of these items. in general, the allocation of partnership items would be an exercise in determining the overall percentage interest each partner has in the partnership and the assignment of that portion of each partnership item to the partner. the code, however, permits the partners to allocate items of igld more or less however they wish, as long as the allocation either has see, or if it lacks see, is in accordance with pip (or is so deemed in the case of items that by their nature cannot have see). 31 the animating idea appears to be that the types of business arrangements partners may find economically desirable are indefinitely varied, and tax rules that required one or another set of tax allocations would inefficiently impair the flexibility necessary to allow partners to craft their non-tax-motivated economic arrangements. consequently, the code and its accompanying body of regulatory provisions generally permit non-ratable allocations of specific partnership items, subject, however, to the principle that inappropriately tax-motivated allocations will not be respected. 32 the regime, in short, is limiting, not prescriptive. when it comes to the tax effect of allocations, no insistence on any particular arrangement is made. instead, arrangements will be respected that do not run afoul of rules designed to ensure that substantiality is satisfied. it is worth contrasting subchapter k‘s treatment of special allocations with other provisions in subchapter k that are designed to address inappropriate shifting of partnership items among the partners. these include principally section 751, which generally requires partners to account for items of ordinary income and loss and capital gain and loss properly allocable to them on disposition of a partnership interest (whether by sale or redemption); section 724, which provides for a carryover of character on property contributed to the partnership; and sections 731, 732, 733 and 735, which generally operate to ensure that unrealized items of partnership ordinary and capital income and loss carry over to a partner who receives a distribution of partnership property. unlike these provisions, which set out detailed rules that govern the allocation of ordinary and capital items of the partnership, section 704(b) permits the partners wide latitude, subject to the 31. i.r.c. § 704(b). such items include allocations of non-recourse deductions and so-called ―section 704(c) gain or loss,‖ which by their nature cannot correspond to an economic burden borne by the partner to whom they are assigned. 32. reg. § 1.704-1(b)(2)(iii). 360 florida tax review [vol. 13:7 principle that allocations deemed to reflect excessive tax motivation will not be respected. iii. substantial economic effect the regime for policing the allocation of partnership items among the partners is set out in section 704(b). it provides that a partner‘s distributive share of items of partnership igld generally is determined by the partner‘s interest in the partnership unless the partnership agreement provides for a different allocation of distributive shares and that allocation has see. at least until recently, as a practical matter the test meant that sophisticated partnerships generally sought to satisfy the see rules, since these provide a fair amount of both flexibility and certainty that a particular allocation will be respected for tax purposes. 33 by contrast, the concept of the partners‘ interest in the partnership is inherently more nebulous, though the regulations provide some guidance. 34 in order for an allocation to have see, it must both have ―economic effect‖ and be ―substantial.‖ 35 the rules on economic effect are detailed but largely mechanical. they are designed to ensure that allocations of partnership tax items correspond to the partners‘ actual business deal. the rules on substantiality, by contrast, focus on the extent to which the economic benefit of allocations is traceable to tax reduction rather than to pre-tax economics; they are less certain because they rely on such indefinite ideas as substantiality and the existence of a ―strong likelihood‖ that an allocation will have primarily tax effect. 36 a. economic effect the test for economic effect actually comprises three alternative tests: the basic test, the ―alternate test,‖ and the test for ―economic effect 33. of late, many partnerships have opted to eschew the capital accounts method mandated by the see safe harbor in favor of ―target allocations‖ that do not rely on capital accounts but instead seek to satisfy the pip standard. see william g. cavanagh, targeted allocations hit the spot, 129 tax notes 89, 102–06 (oct. 4, 2010). 34. reg. § 1.704-1(b)(3), (5) ex. 25. 35. reg. § 1.704-1(b)(2)(iii). 36. reg. § 1.704-1(b)(2)(iii)(a). the formulation in question technically requires that there must not be a strong likelihood that no partner‘s economic consequences will not be substantially diminished. polsky reformulates the language as follows: ―whether there exists a ‗reasonable possibility‘ that any partner‘s economic consequences might be ‗substantially diminished.‘‖ polsky, tax-driven allocations, supra note 9, at 102. 2012] special allocations revisited 361 equivalence.‖ 37 since the issues i discuss in part iv arise under each of the tests, for simplicity the discussion treats the basic test as exemplary. under that test, an allocation has economic effect if three requirements are met: (1) the partnership agreement must provide that capital accounts are maintained in accordance with the rules set out in regulations section 1.704-1(b)(2)(iv); (2) liquidating distributions must be made in accordance with positive capital account balances; and (3) each partner must have an unlimited deficit restoration obligation (a ―dro‖), meaning that on liquidation the partner must pay into the partnership the amount, if any, of the partner‘s negative capital account balance. 38 the core of the basic test is the requirement that capital accounts be maintained in accordance with regulations section 1.704-1(b)(2)(iv), which generally requires that capital accounts be increased by contributions of money or property and income or gain allocable to the partner, and reduced by distributions of money or property and items of loss or expense allocable to the partner. the idea is to ensure that capital accounts reflect the economic stakes of the partners. consider the following simple example: example 1— on day 1 of year 1, a and b each contribute $200 to the newly-formed ab general partnership in exchange for interests in ab. the partnership agreement provides that their interests in items of partnership igld are equal, except that the partnership agreement assigns to a all items of depreciation with respect to real property owned by ab. a also is allocated, or charged back, all gain realized on the disposition of real property by ab up to previously taken depreciation thereon. any remaining gain and all loss are shared equally by a and b. 39 the partnership agreement provides that capital accounts will be maintained in accordance with the section 704(b) regulations, liquidating distributions will be made in accordance with positive capital account balances, and each partner has an unlimited dro. the preceding arrangement, including the special allocation of real property depreciation and the chargeback to a, satisfies the basic test for economic effect. in particular, by incorporating reference to the 704(b) 37. reg. § 1.704-1(b)(2)(ii)(b) (basic test), (ii)(d) (alternate test), (ii)(i) (equivalence test). 38. reg. § 1.704-1(b)(2)(ii). 39. yin uses a closely similar example. yin, future taxation, supra note 3, at 161. 362 florida tax review [vol. 13:7 regulations and the rules on liquidation, the agreement satisfies the basic test, as long as the partnership actually complies with it in practice. further development of the example illustrates the operation of the basic capital accounting rules as applied to the special allocation. suppose that ab borrows $800 on a recourse basis and purchases factory for $1,000, with no principal due on the loan until the earlier of the sale of factory or five years from the date of borrowing, at which time the full principal amount becomes due. a‘s and b‘s initial capital accounts are $200 each. their ―outside bases‖ are $600 each, reflecting basis credit for the borrowing. 40 if depreciation is $50 per year 41 and all items of igld other than depreciation net to zero each year, then after one year, a receives a $50 depreciation deduction, and a‘s capital account and outside basis each drop by $50, to $150 and $550, respectively, while b‘s capital account and outside basis remain unchanged. 42 ab‘s ―inside basis‖ in factory likewise falls by $50, to $950. the allocation has economic effect because it is reflected in the actual dollar amounts to which the partners would be entitled on liquidation. in particular, if the partnership sold the property at its book value ($950) and the partnership liquidated, the loan would be repaid, a would receive $150, and b would receive $200. suppose this basic state of affairs continues until the end of year 3, at which time ab sells factory for $900. immediately prior to the sale, a‘s capital account is $50, reflecting three years of depreciation at $50 per year, 40. i.r.c. §§ 722 (basis includes amount of money contributed to the partnership), 752(a) (partner‘s assumption of a partnership liability is treated as the partner‘s contribution of money to the partnership). 41. as is customary in discussion of allocations involving depreciation, simplifying assumptions for the depreciation rules are made, including that neither the mid-year nor mid-month convention applies and useful lives often are assumed to be round numbers of years. 42. the accounting results and balance sheets set out in this paper follow the general rules for partnership tax accounting, in particular that the partnership‘s initial book accounts initially reflect the fair market value of partnership property and are adjusted downward by depreciation, upward by expenditures on partnership property, and adjusted up or down on disposition of partnership property. the partnership‘s adjusted basis in its property generally reflects the partnership‘s cost or the partner‘s basis in the case of contributed property, as adjusted by depreciation, expenditures, and other items. the partners‘ capital accounts reflect the same principles. the partners‘ bases in their partnership interests on formation of the partnership generally equal the bases of property contributed plus the fair market value of services, if any, they contribute to the partnership. see reg. § 1.7041(b)(2)(iv)(b). the accounting identity applicable to partnership balance sheets is that the partners‘ net equity plus partnership liabilities equals the book value of partnership property. see laura e. cunningham & noel b. cunningham, the logic of subchapter k, ch. 4 (4th ed. 2011) for an explication of partnership capital accounting. 2012] special allocations revisited 363 and b‘s is $200. the adjusted basis of factory immediately prior to the sale is $850, reflecting an additional two years of depreciation at $50 per year, so $50 of capital gain is recognized on the sale. 43 pursuant to the special allocation of gain on factory, the entire $50 of gain is allocated to a, increasing a‘s capital account to $100. the special allocation continues to have economic effect. on sale of factory, the loan is repaid, leaving $300 in partnership assets (equal to the $200 initially contributed plus the $100 excess of amount realized on sale of factory over the loan amount). if ab were to liquidate, a would be entitled to $100 in a liquidating distribution and b would be entitled to $200, consistent with their capital account balances. finally, suppose the same facts as above, except that the sale price of factory is $700, meaning that ab realizes a $150 loss on the sale. the $150 loss is allocated equally to a and b, reducing a‘s capital account to negative $25 and b‘s to $125. the partnership has $900 of cash following the sale, $800 of which is used to repay the loan. if ab were to liquidate, a would be required under the dro to contribute $25 to ab, and b would be entitled to a $125 distribution. again, the economic effect regulations are satisfied. b. substantiality the substantiality portion of the see test asks whether the economic advantage of an allocation otherwise having economic effect derives principally from tax benefits or reflects the transfer of a real (that is, non-tax) economic benefit and the assumption (by some partner) of a corresponding burden. as contrasted with the test for economic effect, the test for substantiality focuses on the inherently less definite concept of undue tax reduction. though somewhat involved, the test generally involves two parts. first, the allocation must pass an initial test of substantiality, which provides that an allocation is (provisionally) substantial if it ―will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences‖ (the ―pre-tax test‖). 44 second, and notwithstanding its satisfaction of the pre-tax test, if: (1) the after-tax consequences (in present value terms) to at least one partner of the allocation are enhanced when compared with the consequences that would arise in the absence of the allocation, and (2) there is a strong likelihood that the aftertax consequences of no partner will, in present value terms, be substantially diminished as a result of the allocation, then the allocation will be held to lack substantiality (the ―insubstantiality test‖). 45 (in addition, there are further sub-tests of insubstantiality for so-called shifting and transitory 43. see i.r.c. § 1231. 44. reg. § 1.704-1(b)(2)(iii)(a) (first sentence). 45. id. (second sentence). 364 florida tax review [vol. 13:7 allocations. 46 ) because such terms as ―substantial‖ and ―strong likelihood‖ are imprecise and to some extent context-dependent, in many cases it is not possible to know with certainty whether an allocation lacks substantiality. 47 the special allocation in example 1 unambiguously qualifies as substantial in light of the presumption in the special allocation regulations that value equals book basis. 48 specifically, it satisfies the pre-tax test because, without regard to tax consequences, it reduces the dollar value a will receive from the partnership on liquidation, since a‘s capital account is adjusted downward dollar-for-dollar by depreciation. under the valueequals-book presumption, amounts subtracted from a‘s capital account because of depreciation are not expected to be restored on later disposition of factory. in addition, the allocation does not satisfy the insubstantiality test because it reduces the after-tax value of a‘s interest in the partnership by the after-tax cost of an annual $25 reduction in a‘s capital account and increases b‘s capital account by the same amount (subject to differences in their marginal rates). it therefore is not ―insubstantial.‖ other special allocations, however, are more problematic. as contrasted with the allocation in example 1, for most of them the decisive factor in determining see will be the second prong of the insubstantiality test, since nearly any allocation that plausibly passes muster will satisfy the pre-tax test but also will improve the after-tax consequences to at least one partner. 49 in those circumstances, the question becomes whether anyone bears a sufficient risk of a large enough after-tax cost from the improvement of a partner‘s after-tax position. if so, then the allocation may well be substantial; if not, it is likely not substantial. gregg polsky provides an illustrative example, 50 modified from the special allocation regulations. 51 in polsky‘s example, h and l form an equal partnership that is expected to generate between $450 and $550 of taxable income and of tax-exempt income each year. h is subject to a marginal tax rate of 50 percent, while l‘s rate is 15 percent. the partners allocate 84 percent of the tax-exempt income to h and all other income to l (in each case, whatever those income amounts happen to be). other partnership items are allocated equally. polsky notes that this is a relatively easy case in which to conclude the allocation lacks substantiality. as compared with an equal allocation of the two types of income, the worst case for h ($450 tax-exempt income and $550 taxable income) yields h $378 of after-tax income (= 0.84*$450) under the special allocation as compared to $362.50 of after-tax 46. reg. § 1.704-1(b)(2)(iii)(c), (d) 47. see, e.g., polsky, tax-driven allocations, supra note 9, at 103–04. 48. reg. § 1.704-1(b)(2)(iii)(c) (flush language). 49. polsky, tax-driven allocations, supra note 9, at 101 & n.24. 50. id. at 101. 51. reg. § 1.704-1(b)(5) ex. 5. 2012] special allocations revisited 365 income (= 0.5*$450 + 0.5*$550*0.5) under an equal division. therefore the first prong of the insubstantiality test is satisfied. the second prong also is satisfied, because in the worst case for l ($450 taxable income and $550 taxexempt income), under the special allocation, l receives $470.50 (= $450*0.85 + 0.16*$550), while under an equal allocation, l would receive $466.25 (= 0.5*$450*0.85 + 0.5*$550). the example is useful because it illustrates both the problem that treasury faces in dealing with special allocations and the factors on which the partners need to focus in order to increase the probability that a taxmotivated special allocation nonetheless will be respected under the special allocation regulations. as polsky notes, the effect of the allocation in his example is a sale of l‘s low tax rate to h. the reason the allocation fails, however, is not simply that such a sale occurs, but that there is no scenario under which a net tax savings is sufficiently offset by an after-tax loss for either partner to conclude that the risk of such a loss is ―substantial.‖ 52 in other words, the allocation results in a net transfer from treasury to each partner under all scenarios. where the prospect of an overall loss for any partner is absent, the capacity for arm‘s-length negotiations to control the abuse of tax benefits is removed, and it is safe to conclude that the parties will cooperate to reap a payment from treasury that would be unavailable to them if they were acting individually. 53 the analysis indicates that the principal question for the partners is how far they need to go in ensuring that at least one of them risks being enough worse off on an after-tax basis under some possible outcomes in order for what amounts to a sale of tax attributes on an expected value basis to be respected. note, however, that this inquiry is not what congress intended by the statutory requirement of ―substantial economic effect.‖ congress‘s object was not to authorize tax-motivated allocations as long as they incorporated a substantial enough risk of an after-tax loss in some cases, but to authorize non-tax-motivated allocations even if, in some cases, they also would carry an expected tax benefit. as the legislative history to the current version of section 704(b) states: ―[the amendment seeks] to prevent the use of special allocations for tax avoidance purposes, while allowing their use for bona fide business purposes.‖ 54 an approach that focuses on the substantial enough possibility of a meaningful after-tax loss is a poor way to operationalize congressional intent. under the approach, the economic value of a tax-motivated allocation is measured on an ex ante basis (discounted by 52. polsky, tax-driven allocations, supra note 9, at 102. 53. compare section 1060, which relies on the adverse tax positions of the parties to a purchase and sale transaction to ensure proper allocation of the purchase price among the items sold. 54. s.rep. no. 94-938, pt. 1, at 100 (1976), reprinted in 1976 u.s.c.c.a.n. 3438, 3536. 366 florida tax review [vol. 13:7 the risk premium associated with uncertain outcomes in particular cases), while the test for insubstantiality is applied ex post. 55 that is, the inquiry into whether there exists the requisite likelihood that a partner will be worse off focuses on the chances in any given situation of an unfavorable after-tax outcome, not on the expected tax value of the special allocation in the long run. therefore, as long as it is reasonable to conclude that tax-motivated allocations having a positive expected value are sufficiently likely to cause a sufficiently adverse result to a partner in any given case, one can expect them to arise. these considerations suggest that special allocations generally ought to be much more tightly controlled, if they are to be permitted at all. as long as special allocations can be accounted for outside of the partnership itself — so that opportunities for character assignment generally remain unavailable — there does not appear to be much basis to tolerate them as partnershiplevel arrangements for purposes of the tax law. if the allocations have a substantial non-tax business purpose, then they will proceed anyway, but with the same tax consequences that would apply if the persons involved were not partners. if, however, the allocations would not proceed in the absence of tax rules that authorize them, then in most cases, it would seem there is no reason for the tax law to respect them. iv. special allocation economics this part examines more closely the economic consequences of special allocations on the assumption that pure aggregate accounting applies at the partnership level. the assumption of pure aggregate accounting implies that special allocations must be analyzed, for tax purposes, as nonequity-based transactions either between or among the partners, or between one or more partners and the partnership itself. stated otherwise, this part demonstrates how to account in tax terms for special allocations that depart from the pure aggregate theory of the partnership, assuming that partnership tax accounting proceeds on a pure aggregate theory. a. depreciation and gain chargeback example 56 on day 1 of year 1, a and b each contribute $200 to the newly-formed ab general partnership in exchange for interests in ab. the partnership agreement provides that their interests in items of partnership igld are equal, except that the partnership agreement assigns to a all items of 55. polsky discusses this difficulty. polsky, tax-driven allocations, supra note 9, at 107. 56. this example is identical to example 1, supra in part iii.a. 2012] special allocations revisited 367 depreciation with respect to real property owned by ab. a also is allocated, or charged back, all gain realized on the disposition of real property by ab up to previously taken depreciation thereon. any remaining gain and all loss are shared equally by a and b. the partnership agreement provides that capital accounts will be maintained in accordance with the section 704(b) regulations, liquidating distributions will be made in accordance with positive capital account balances and each partner has an unlimited dro. in year 1, ab borrows $800 on a recourse basis and purchases factory for $1,000. interest only is due until the earlier of five years or the date on which ab disposes of factory, at which time all outstanding interest and principal are due. table 1 sets out ab‘s opening balance sheet. table 1: opening ab balance sheet partnership assets partnership liabilities: $800 capital accounts asset a/b book partner a/b book cash $200 $200 a $600 $200 factory 1,000 1,000 b 600 200 total $1,200 $1,200 total $1,200 $400 under a pure aggregate theory of the partnership, each partner is considered to own a ratable share of the partnership‘s assets measured by the partner‘s capital account balance. because the special allocation of depreciation has a disproportionate effect on the partners‘ capital account balances, it is not consistent with the aggregate theory. therefore, under an aggregate theory, the effect of the allocation must be analyzed either as the result of transactions between or among the partners — that is, outside the partnership — or, possibly, as some other, non-equity-based arrangement between the partnership and either or both partners. it cannot be analyzed as an equity arrangement at the partnership level. further, any effort to accommodate the special allocation under the basic capital account model will result in a series of constantly shifting capital account balances and, consequently, of ever-changing deemed payment arrangements between the partners or between the partnership and one or more partners. consider first the effect just of allocating the depreciation solely to a. in economic terms, prior to any disposition of the property, a annually experiences a $50 loss unmatched by b, even though a and b each have contributed one-half of the capital to ab. if, as we must suppose, a and b 368 florida tax review [vol. 13:7 deal with each other at arm‘s length, one ought to conclude that a is agreeing to a reduced overall interest in the partnership as a way to compensate b. under a pure aggregate theory, there are two ways to understand the nature of this compensation, though in the end, they appear to come out the same. the first is to consider the compensation as an annual ownership shift in ab from a to b of a proportion of ab equal to what b otherwise would have suffered in depreciation, divided by total partnership equity, a ratio that increases over time as depreciation takes place, due to the declining book value of factory. the second is as a guaranteed payment. the capital shift analysis under the aggregate theory runs as follows. a and b each begin with equal depreciation allocations since their capital accounts are equal. after one year, each of their capital accounts drops by $25 as a result of depreciation 57 and each has a $25 tax deduction, 58 causing concomitant outside basis reductions 59 (and a $50 inside basis reduction to factory 60 ). separately, as a way to provide b with an interest commensurate with what the parties believe will be b‘s overall contribution to the success of ab, a would be deemed to transfer to b a $25 equity interest in ab. this transfer is not an exchange because a receives nothing directly in return. rather, a‘s return on the overall arrangement is reflected in a‘s resulting equity interest, which was calculated upon formation of the partnership to be worth what a ends up with after the transfer. consequently the transfer should represent ordinary income to b 61 and, assuming a enjoys the benefits of b‘s efforts annually, an ordinary deduction to a under standard tax principles. 62 at the end of year 1, the $25 deemed transfer represents one-seventh of a‘s interest in ab (equal to the ratio of $25 to a‘s total equity interest of $175), and a‘s basis in that one-seventh interest would be $82.14. 63 in the transfer, b would assume one-seventh of a‘s share of the liability, or $57.14, for a net deduction to a of $25 and an outside basis for a of $492.86. b‘s outside basis increases to $657.14. however, since the economic deal provides that the partners remain equally liable on the loan even though a‘s equity interest is reduced relative to b‘s, for basis purposes there would follow a deemed contribution of $57.14 by a to the partnership and a 57. reg. § 1.704-1(b)(2)(iv)(b). 58. i.r.c. § 168. 59. i.r.c. § 702. 60. i.r.c. § 1016(a). 61. compare i.r.c. §§ 61(a), 64 with i.r.c. § 1221. 62. i.r.c. § 162(a). if, however, a enjoys the benefits over time, a would have to capitalize the payment under section 263 and deduct it over the useful life of the benefit provided, assuming that period could be determined. see i.r.c. § 167. 63. a‘s basis includes a‘s share of the loan. i.r.c. § 752(a). 2012] special allocations revisited 369 deemed distribution of the same from the partnership to b. 64 the resulting balance sheet is depicted in table 2. this table is identical to the table that results simply from allocating depreciation to a under the capital accounting rules. table 2: ab balance sheet at end of year 1 partnership assets partnership liabilities: $800 capital accounts asset a/b book partner a/b book cash $200 $200 a $550 $150 factory 950 950 b 600 200 total $1,150 $1,150 total $1,150 $350 in subsequent years, the depreciation and deemed transfer amounts differ because of the different ownership ratios. the net effect is an annual transfer of equity from a to b such that a $50 increase in the disparity between the partners‘ equity arises each year. for example, during year 2, b owns 4/7 ($200) and a 3/7 ($150) of partnership equity respectively. b, therefore, gets $28.57 in depreciation and a $21.43 leaving their capital account balances at $171.43 and $128.57, respectively. a then transfers a $28.57 equity interest to b. in year 3, the ratio of equity ownership between a and b is 1:2 ($100:$200), meaning that b has a $33.33 depreciation deduction, a‘s is $16.67, and a transfers $33.33 in partnership capital to b, leaving a with a $50 capital interest, or one-fifth of total partnership equity and b with the remaining $200. the second way of viewing the special allocation is as an agreement for ab to make an annual guaranteed payment to b (for as long as the partnership holds factory) followed by a deemed contribution of the payment back to ab (since no distribution of the payment actually occurs). such a payment is governed by section 707(c), which generally applies to amounts paid to a partner that do not depend on partnership profits, while the deemed contribution back is described in section 721(a). the theory supporting this characterization would be that b receives the ―payment‖ from the partnership without regard to partnership income. 65 consequently, it is not an equity payment but a non-equity-based form of compensation. as 64. section 752 generally treats an assumption of a liability as the payment of cash and the off-loading of one as the receipt of cash. see i.r.c. § 752(a), (b). 65. i.r.c. § 707(c) provides: ―to the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses).‖ 370 florida tax review [vol. 13:7 contrasted with a partner‘s distributive share, guaranteed payments are always ordinary income to the partner and either deductible or capitalizable by the partnership depending upon the nature of the benefit provided to the partnership as determined under sections 162 and 263. 66 the overall effect is identical to the results under the capital shift: each partner takes a $25 depreciation deduction. the deemed payment to b generates a $50 deduction under section 162(a), which is shared equally by a and b. with the depreciation deduction, each partner‘s capital account drops by $50, and each enjoys a $50 deduction. separately, b has a $50 ordinary inclusion from the guaranteed payment, and the deemed contribution of the payment back to ab increases b‘s outside basis and capital account by $50 returning both to where they were at the beginning of year 1. in subsequent years, the same cycle occurs, but the size of the payments increases in order to ensure that an additional $50 disparity in capital account balances between a and b occurs. 67 although the guaranteed payment characterization and capital shift analysis come out the same on the facts of the example, the capital shift analysis is more general. not every special allocation can be recharacterized as a guaranteed payment, because a special allocation may be equity-based. for example, a special allocation could accord a disproportionate percentage of net capital gain of the partnership to a partner. because the size of such a special allocation is determined by an item of partnership income, the guaranteed payment analysis is inapt. accordingly, the rest of the discussion compares results under current law to those under the more general capital shift analysis. as indicated, the balance sheet in table 2 is identical to the balance sheet ab will have under the special allocation regulations after one year simply by assigning the depreciation on factory to a. 68 the agreement of the 66. reg. § 1.707-1(c). 67. at the beginning of year 2, a‘s capital account is $150 and b‘s is $200, meaning a owns three-sevenths of ab and b owns four-sevenths. based on their relative ownership interests, the $50 depreciation deduction will be allocated $21.43 to a and $28.57 to b. the amount of the guaranteed payment must be such that, when three-sevenths of it (the portion to which a is entitled as a deduction) is added to $21.43, the total is $50. that figure is $66.67, which b includes in gross income and of which b deducts four-sevenths, or $38.10, in b‘s capacity as a partner. the net effect of the $66.67 inclusion and $38.10 deduction is $28.57 of income to b, which b is deemed to contribute to ab, exactly offsetting b‘s depreciation deduction, again leaving b with a $200 capital account balance and a with a $100 capital account balance. for year 3, the guaranteed payment would be $100. 68. the identity of results follows in part from the simplifying assumptions that there is no built-in gain or loss in the partnership and there is no section 754 election in effect. if either of these assumptions were false, the analyses would not come out the same. see infra. text at note 79. 2012] special allocations revisited 371 two follows from the fact that while the capital shift alters the partners‘ relative ownership interests from a 1:1 to a 4:3 ratio (after that year), the actual partnership interests in fact are 4:3, not 1:1, as long as factory is presumed to have a fair market value equal to its book value, and there is no other net income or loss to the partnership. in other words, even though the partnership agreement nominally provides for an equal partnership (apart from depreciation), where there are no partnership items that would be divided on an equal basis, the partners‘ interests in the partnership are in fact governed by the ratio of their capital accounts, here 4:3, and the aggregate treatment of the partners remains in effect. it is, however, critically important to bear in mind that the identity of the results under the existing regulations and the capital shift analysis depends upon the value-equals-basis presumption of the special allocation regulations. 69 the presumption, which is based on administrative convenience, is generally inaccurate especially in the case of tangible personal property, which typically is subject to a variety of non-economic, taxpayer-favorable assumptions designed to promote business investment. 70 if, as is often the case, partnership property subject to depreciation has a greater fair market value than book value, then the economics of the allocation are not properly reflected on the partnership‘s books. in any event, the effects of the inaccuracy surface once factory is disposed of at any price other than book value, because the sharing ratio for items of capital income or loss differs from the ratio of the partners‘ capital account balances. assuming the partnership‘s sole source of income is capital, it is not possible to account for these items under the aggregate theory unless one postulates some further set of transactions between the partners. consider as an example the sale of factory at the end of year 3 for $900 assuming, again, no other items of partnership income or loss other than depreciation. table 3 sets out the balance sheet immediately prior to the sale. 69. reg. § 1.704-1(b)(2)(iii)(c) (flush language). for a discussion of the policies underlying these rules, see bittker & lokken, federal taxation, supra n.17, at ¶ 1.1 and authorities cited therein. 70. reg. § 1.701-2(a)(3); see also bittker & lokken, federal taxation, supra n.17, at ¶ 86.4, text at nn.35–37. see generally i.r.c. § 168 (which provides for double-declining balance depreciation, short asset lives, and a presumption of zero-salvage value for many items of tangible business property). 372 florida tax review [vol. 13:7 table 3: ab balance sheet at end of year 3, pre-sale partnership assets partnership liabilities: $800 capital accounts asset a/b book partner a/b book cash $200 $200 a $450 $50 factory 850 850 b 600 200 total $1,050 $1,050 total $1,050 $250 based on the capital shift analysis, a‘s partnership interest now stands at $50 while b‘s stands at $200. under a ratable ownership theory of the partnership, any gains or losses realized by the partnership should be shared in a 1:4 ratio between a and b. therefore, when factory is sold at $900 for a $50 gain, the balance sheet should appear as in table 4. table 4: ab balance sheet immediately post-sale, capital shift economics partnership assets partnership liabilities: $800 capital accounts asset a/b book partner a/b book cash $1,100 $100 a $460 $60 b $640 $240 total $1,100 $1,100 total $1,100 $300 in total, a would have experienced a net loss of $140 while b would have experienced a gain of $40 for an overall partnership loss of $100 (equal to the difference between the purchase and sale prices of factory). the $100 corresponds to the netting of $150 in depreciation against $50 of gain on disposition of factory. by contrast, if there had been no special allocation of depreciation to a, the same overall result would have been reached, but each partner would have experienced a net loss of $50 in the form of $75 of ordinary deductions and $25 of capital gain. thus, the overall effect, assuming, contrary to the actual partnership agreement, that the consequences of the capital shift are followed through on sale, is an income shift of the appropriate character given that the form of the income shift is a transfer of a partnership capital interest. a would have an overall loss reflecting a‘s experience of economic losses on factory while b would have an overall gain reflecting b‘s enjoyment of gain without loss. of course, the actual effect of the special allocation in the example is very different from what appears in table 4. under the terms of the special allocation, all of the $50 of gain is allocated to a as set out in table 5. 2012] special allocations revisited 373 table 5: ab balance sheet immediately post-sale, special allocation economics partnership assets partnership liabilities: $800 capital accounts asset a/b book partner a/b book cash $1,100 $100 a $500 $100 b $600 $200 total $1,100 $1,100 total $1,100 $300 the disposition of factory at a price that differs from its book value highlights the crux of the economic question that the special allocation of depreciation raises. how should the allocation of gain (or loss) on the sale of factory — a section 1231 (capital) asset — in a manner different from the partners‘ relative capital interests be understood? the issue is that a enjoys gain and suffers loss in respect of a 20 percent property interest that differs from 20 percent. in order to answer this question, it becomes necessary to focus on the consequences under the partnership agreement of payouts (sales of factory) under all possible alternatives. there are three: (1) if factory is sold at book value, no deemed transfer arises; (2) if it is sold above book value but not at a price in excess of all gain chargeback, all gain goes to a, representing a transfer of 80 percent of the total gain from b to a; and (3) if it is sold below book value or above the gain chargeback amount, then all loss or all gain in respect of such excess, as the case may be, is divided equally between a and b, representing a shift of 30 percent of such loss or gain from b to a. this set of payouts is similar to a form of stratified ownership of factory much as one finds in a standard option transaction or even a notional principal contract or bullet swap. 71 the main difference is that all of the latter arrangements generally involve the complete separation, over some interval of possible prices, of opportunity for gain and risk of loss as measured by a reference asset. for example, if x sells y a call option on one share of brand x corp. stock having a $100 strike price, y acquires all opportunity for gain 71. in a standard option transaction, one party purchases from a counterparty the right, but not the obligation, to purchase or sell an asset at a particular price on one or more dates. john c. hull, options, futures, and other derivatives, 179–84 (7th ed. 2009). in a standard notional principal contract, one party promises to make regular payments to a counterparty based upon the value of some reference index applied to a notional principal amount, while the counterparty promises to make regular payments to the first party based upon some other reference index as applied to the same notional principal amount. at each payment date, the parties net the amounts, with a payment going only to the party whose position‘s value exceeds that of the other party. see reg. § 1.446-3. 374 florida tax review [vol. 13:7 on the share above $100 without bearing any risk of loss for prices below $100. similarly, in a bullet swap, the parties to the arrangement agree to net the value of one position (or group of positions) against that of another. 72 the overall effect is to assign all gain in respect of the difference in values between the positions to one party. under the special allocation, by contrast, the partners agree that over all intervals other than gain in respect of previous depreciation, both of them will bear risk of loss and opportunity for gain — just not in proportion to their ownership interests in factory. this difference does not appear significant in terms of understanding the nature of the partners‘ agreement as akin to a risk-based property division much like that in an option or a swap. in theory, one could attempt to capture the tax aspects of this arrangement on either an ex ante or an ex post basis. that is, one could assess the net expected value transfer (which undoubtedly runs from b to a given a‘s right to all gain chargeback) at some time prior to the cash-out of the special allocation and assess tax then or instead tax the transfer when the payout — which can go either way — occurs. a variety of considerations suggest that taxation on an ex post basis is strongly preferable. ex ante taxation seems nearly impossible as a practical matter for at least four reasons. first, unless the partnership‘s property is publicly traded, it will be exceedingly difficult to value the net transfer (if any) from one partner to one or more other partners resulting from the special allocation. second, even if the partnership property is publicly traded, the division itself is non-standard, complicating valuation further: there are unlikely to be comparable transactions in the market to which the partners can refer in valuing the special allocation. third, it is not entirely clear when taxation would occur if it occurs before the property is sold. would it happen when the special allocation became part of the partnership agreement? annually? fourth, the net value of the transfer varies depending upon the disparities in the partners‘ capital accounts, and these shift over time along with the value of the underlying property. accordingly, even ex ante taxation could not occur less often than annually if there were any doubts about the partners‘ relative capital account balances from year to year. in addition to these practical considerations, taxation at the creation of the special allocation would seem to be inconsistent with the code‘s general policy of deferring taxation in connection with the realization of gain or loss on the formation of partnerships or the adjustment of relative ownership in the partnership among the partners. 73 this policy is embodied in numerous provisions, including those covering formation, 74 shifts of 72. see, e.g., prop. reg. § 1.1234a-1(c)(2) (defining bullet swaps). 73. for deferral on formation, see i.r.c. § 721. for deferral (where possible) on adjustment of ownership positions, see i.r.c. § 732. 74. i.r.c. § 721. 2012] special allocations revisited 375 ownership interests, and liquidation. 75 and finally, and perhaps of greatest importance, the value-equals-book rule of the see regulations 76 is likely to distort materially the pricing of a special allocation on an ex ante basis. as noted previously, the rule is grounded in administrability and bears little relation to reality especially in the case of property subject to accelerated depreciation. 77 if partnership property is assumed to have an artificially low fair market value for future years, then efforts to price the value of a capital shift that takes the form of an option or option-like position on depreciable property (or a portion of it) having a strike price equal to book value are likely to understate, perhaps quite substantially, the value of the position. these considerations would seem to point decisively to taxation on termination of the position, at which time the difficulties described above are absent, and no policy of continuing deferral would seem to be in play. a possibly countervailing consideration is that taxation on realization may create tax electivity or arbitrage opportunities if similar arrangements can be established in settings outside the partnership context in which a different set of timing or character rules applies. nonetheless, given the uniqueness of most positions resulting from partnership special allocations, it appears that electivity and arbitrage worries should be minimal. accordingly, as the partnership realizes income or loss, a net transfer in partnership interest goes from one party to the other based upon the extent to which a partner is enjoying an extra gain or absorbing an extra loss relative to the partner‘s capital account. in the example, if the property is sold at a loss, there is a net payment from a to b equal to 30 percent of the loss, since by capital ownership b suffers 80 percent of the loss but by the partnership aggregate theory it is just 50 percent. conversely, if the property is sold at a gain, the net payment runs from b to a. to the extent the payment is made in respect of gain chargeback, it represents 80 percent of the gain; to the extent, if any, the payment is made in respect of gain in excess of gain chargeback, it will be for 30 percent of such gain. critically, all of these payments would appear to be ordinary in character since they do not represent income or loss from the sale or exchange of a capital asset but, instead, reflect an agreement between the partners to compensate themselves with partnership interests in a manner different from the way that the return on partnership capital would redound to them. the idea that the character of the payment is not determined by the character of the gain or loss giving rise to it is grounded in the judgment that assignments of character, like income assignments, are not generally permitted under the income tax. 75. i.r.c. § 731. 76. reg. § 1.704-1(b)(2)(iii)(c) (flush language). 77. generally, this property being personal tangible property. see i.r.c. § 168. 376 florida tax review [vol. 13:7 note that these calculations would be made more complicated if there were built-in gain or loss in the transferring partner‘s partnership interest or if a section 754 election were in effect, assuming that special allocations were comprehensively treated as transactions in partnership interests. as an example of the former, suppose that a ends up making a payment of $15 of a‘s partnership interest to b and that that payment reflected one-quarter of the value of a‘s pre-transfer interest in the partnership. suppose further (and contrary to the facts here) that a‘s basis in the partnership interest were $40. then a‘s allocable basis in the portion transferred would be $10, and a would recognize $5 of gain on the transfer. 78 the burdens that a section 754 election imposes on the parties are greater. section 754 permits a partnership to elect to adjust the basis of the partnership‘s assets when there is a transfer of a partnership interest or a partnership interest is redeemed. the purpose of the election is to enable the partnership‘s tax attributes to reflect more accurately the tax profiles of the partners. as an example, if the equal xyz partnership has $200 of assets and the assets have a $300 fair market value, x‘s sale to r of x‘s one-third interest would be for $100. on purchase, r has in effect paid for r‘s share of the built-in gain in the ryz assets, even though the gain has not yet been taxed to the partners. however, if ryz were to sell its assets for $300, r would be taxed on r‘s ratable share of the gain, in effect causing r to be double-taxed. r would eventually recoup the extra tax in the form of a loss when r sold the partnership interest or was redeemed, but the timing difference could be significant. the section 754 election eliminates these consequences by requiring the partnership to adjust its basis on disposition or redemption of a partnership interest, pursuant to section 743 or section 734, respectively. very generally, the partnership will adjust its basis in its assets with respect to the portion thereof that is attributable to the new partner. 79 in treating a special allocation as the disposition of a partnership interest for all purposes of subchapter k, any partnership for which a section 754 election is in effect would be required to adjust the basis in its assets to reflect the purchaser‘s fair market value basis therein. 78. the requirement of gain or loss recognition to the transferor reflects the principle that the transferor realizes a benefit (detriment) to the extent the fair market value of the property transferred exceeds (falls short of) the transferor‘s basis. see reg. § 1.83-6(b) (applying the principle in the compensation setting). 79. see i.r.c. §§ 734(b) (adjustment to partnership‘s basis on redemption of partnership interest), 743(b) (adjustment to partnership‘s inside basis on disposition of partnership interest), & 755 (mechanism for allocating the basis adjustment among the partnership‘s assets). 2012] special allocations revisited 377 moreover, the adjustment in many cases would be required on both sides. in example 1, the effect of the special allocation is a simple transfer from a to b. in other settings, however, the transfer may in effect be the net of two transfers, each of which ought to trigger a section 743(b) adjustment. b. taxable and tax-exempt securities example polsky‘s example, discussed in part iii, is a variation on example 5 from regulations section 1.704-1(b)(5), which reads in pertinent part as follows: individuals i and j are the only partners of an investment partnership. the partnership owns corporate stocks, corporate debt instruments, and tax-exempt debt instruments. over the next several years, i expects to be in the 50 percent marginal tax bracket, and j expects to be in the 15 percent marginal tax bracket. there is a strong likelihood that in each of the next several years the partnership will realize between $450 and $550 of taxexempt interest and between $450 and $550 of a combination of taxable interest and dividends from its investments. i and j made equal capital contributions to the partnership, and they have agreed to share equally in gains and losses from the sale of the partnership's investment securities. i and j agree, however, that rather than share interest and dividends of the partnership equally, they will allocate the partnership's tax-exempt interest 80 percent to i and 20 percent to j and will distribute cash derived from interest received on the tax-exempt bonds in the same percentages. in addition, they agree to allocate 100 percent of the partnership‘s taxable interest and dividends to j and to distribute cash derived from interest and dividends received on the corporate stocks and debt instruments 100 percent to j. 80 as previously discussed, under the special allocations regulations, the substantiality question in practice turns on how great a risk of loss a partner must assume in order for there to be a sufficient likelihood that the 80. reg. § 1.704-1(b)(5) ex. (5)(i). the example assumes that dividends are taxed at ordinary rates rather than at the rate for net capital gains, as has been the case for non-corporate shareholders since 2003. see i.r.c. § 1(h)(3). as of this writing, dividends generally are taxed at preferential rates but it is uncertain whether they will continue to be so taxed. 378 florida tax review [vol. 13:7 after-tax prospects of the partner will be substantially diminished as compared to the results without the special allocation under outcomes that are reasonably likely to occur. in the example, treasury concludes that the arrangement fails the substantiality test because there is no situation in which the low-tax partner is worse off than under a ratable allocation while in the worst-case scenario for the high-tax partner ($450 tax-exempt income and $550 taxable income), that latter partner is only $2.50 worse off on an aftertax basis than the partner would be under a ratable allocation, an amount that is not ―substantial.‖ 81 having concluded the allocation lacks substantiality, treasury analyzes it under pip. 82 in treasury‘s view, the pip analysis does not result in a disregard of the allocation but instead in a disregard of its tax effect: the allocation is treated as valid in the sense that it determines the partners‘ capital account balances but invalid to the extent it purports to allocate taxable and tax-exempt income as a means to achieve the balances. accordingly, since there is $450 of tax-exempt income and the high-income partner‘s capital account is to be credited with 80 percent of that amount and none of the taxable income, that partner is allocated $360 of partnership income. the low-income partner is allocated the balance of partnership income, or $640. 83 because the special allocation lacks see, treasury views each partner as receiving a proportion of each type of partnership income equal to that partner‘s proportion of overall partnership income — presumably this is what is meant by pip, in treasury‘s view. therefore, the high-taxed partner receives 36 percent of both partnership taxable income, or $198, and partnership tax-exempt interest, or $162, for $360 total and $99 of tax due (equal to 50 percent of $198). the low-taxed partner receives 64 percent of these items, or $352 and $288, respectively, for $640 total and $53 of tax due (equal to 15 percent of $352). treasury‘s pip analysis has an apparent plausibility. it supposes that the partners intended to have the allocation for non-tax reasons and therefore that the allocation ought to be respected as a determination about how to allocate the (non-tax) attributes of partnership igld, including amounts thereof. having reached that conclusion, the tax consequences would seem to follow from the usual principle of ratability, given that the stipulated tax consequences lack substantiality. if the allocation provides that a given partner ends up with x percent of partnership income, and if the allocation is taken at face value for non-tax purposes but not for tax purposes, then it would seem to follow that the partner‘s share of each of the various components of partnership income ought to be x percent as well. 81. reg. § 1.704-1(b)(5) ex. (5)(ii). 82. i.r.c. § 704(b); reg. § 1.704-1(b)(1). 83. reg. § 1.704-1(b)(5) ex. 5(ii). 2012] special allocations revisited 379 the logic, however, is faulty. to conclude that the special allocation lacks see is in essence to determine that it is improperly tax-motivated. in other words, it is to conclude that the partners were not serious about their economic deal as specified in the allocation apart from its tax consequences or, stated in the converse, that the only basis upon which it did reflect their economic deal was with taxes factored in. having concluded the tax consequences are not to be respected because the allocation was taxmotivated, it seems incorrect to continue to credit the allocation as reflecting the partners‘ deal on a pre-tax basis for purposes of the pip analysis. respecting the allocation for non-tax purposes is, in a sense, to contradict the regulations‘ initial determination that the allocation is tax-motivated. what drives the purported allocation is the link between the amounts of various items of igld and their type. if that were not the case, then the substantiality analysis should have been based upon a comparison with the outcome used in the pip determination, since, by hypothesis, that is used as the tax-neutral baseline for the purpose of determining the tax consequences when the allocation fails substantiality. consequently, although the regulations allocate the types of partnership income in accordance with each partner‘s putative entitlement to overall partnership income, the entitlement itself remains unexplained. the facts of example 5 state that the partners formed the partnership with equal capital contributions and that the partnership has no source of income other than from distributions on and sales and exchanges of securities. 84 on that basis, each partner would seem to own 50 percent of partnership capital and accordingly ought to be entitled to one-half of the partnership‘s income, at least on an ex ante basis. while the equal ownership ratio does not imply that the partners would bargain only for equal ratios of each item of partnership igld if tax considerations were not in play, for partners dealing with each other at arm‘s length, one would suppose that a departure from strict ratability for various types of igld would reflect an exchange of roughly equal expected values. treasury‘s pip analysis does not proceed on this basis. once one takes tax benefits out of the picture, as the regulations‘ pip analysis does, the high-tax partner is treated as exchanging a right to one-half of partnership investment income for a right to 40 percent of that income (on an expected value basis). that choice is unmotivated. if the underlying rationale of the see/pip analysis is that partnership allocations that fail to track pre-tax economics with sufficient fidelity will be readjusted to be in accordance with pip, the pip inquiry ought to focus on pre-tax economics, not the economics of an allocation that, on a pre-tax basis, does not conform to the partners‘ actual interests in partnership capital. instead, treasury‘s pip analysis functions as a kind of punishment designed to ensure that partners 84. reg. § 1.704-1(b)(5) ex. 5(i). 380 florida tax review [vol. 13:7 adopt allocations that satisfy the see test. but, as others have noted, 85 that test is inherently ambiguous. consequently, under treasury‘s approach, allocations that lack see are apt to be reallocated in a manner that does not conform to pip — arguably in conflict with the statute. at least one commentator has suggested that a reason for the regulations‘ approach to pip may be that a non-punitive pip outcome — that is, one that simply disregarded the special allocation for all purposes — would substantially vitiate the force of the existing statutory scheme. 86 because the statute provides that pip is the fallback for an allocation that lacks see, a formula for pip that simply disregarded a special allocation that lacked substantiality might not dissuade the partners from special allocations that had little likelihood of success, as the penalty would be the arrangement that would have been in effect if no special allocation had been attempted. the effect would be to provide taxpayers with a free option, or two bites at the apple. 87 the point, while valid, should not be lent too much weight. in many cases an allocation that lacks substantiality would have had substantiality if more after-tax risk had been built in, and overly aggressive taxpayers will have forgone the more modest benefits they could have had by attempting more reasonable allocations. further, a position that is too aggressive will in fact be subject to penalties. 88 and, finally, it is not up to treasury to compensate for defects in the statutory scheme if doing so violates the scheme. treasury‘s substantiality/pip analysis may be usefully compared with the alternative of simply disregarding the assignment effects of the allocation, which is to say not disregarding the assignment in toto, as the substantiality analysis does, but viewing the ultimate capital account balances as the result of supplementing the aggregate theory of partnership taxation with transfers of partnership interests necessary to reach those balances. such an approach is much more consistent with the theory of pip as set out in the regulations since the regulations take the position that the allocation is valid even though the means to get there are not (since the allocation lacks substantiality). accordingly, the baseline is the set of transactions that, on a pre-tax basis, get to the allocation, which is to say the aggregate theory supplemented by non-partnership-level transactions. the analysis is straightforward as applied to example 5. under the same facts as in example 5 ($550 of taxable income and $450 of tax-exempt income, no other net income or loss to the partnership), each partner is treated as receiving allocations from the partnership of $275 of taxable 85. polsky, tax-driven allocations, supra n.9; yin, future taxation, supra n.3. 86. polsky, tax-driven allocations, supra n.9, at 115–16. 87. id. 88. i.r.c. § 6662. 2012] special allocations revisited 381 income and $225 of tax-exempt income. since the net effect of the special allocation is the transfer of $140 in value from h to l (equal to $275, or onehalf of the taxable income, less $135, or 30 percent of the tax-exempt income), h ends up with a partnership interest $360 greater in value than at the beginning of year 1, and l with a partnership interest $640 greater in value. 89 after these transactions, the high-tax partner‘s taxable income is $135 (equal to the $275 inclusion of partnership taxable income less the net $140 payment to the low-tax partner), and the high-tax partner‘s tax liability is $68 on $360 of total (taxable plus tax-exempt) income. the low-tax partner‘s taxable income is $415 (equal to the $275 inclusion of partnership taxable income plus the $140 net payment from the high-tax partner), and the low-tax partner‘s tax liability is $62 on $640 of total (taxable plus taxexempt) income. the partners‘ combined tax liability is $130 on $550 of taxable income and $1,000 of total income, or 23.6 percent and 13 percent respectively. by contrast, if the special allocation had been respected, the high-tax partner‘s return would have been $360 of tax-exempt income, and the low tax-partner‘s would have been $550 of taxable income and $90 of tax-exempt income, resulting in total combined tax paid of $82.50 on $550 of combined taxable income, or 15 percent on the combined taxable income and 8.3 percent on combined total income. it is important to note that, as contrasted with the depreciation/gain chargeback example, in more complicated settings, the preceding analysis would need some refinement. the exchange here cannot be viewed simply as the transfer of a $140 partnership interest from h to l. from the 50-50 baseline, h gives up $275, equal to the amount of taxable income owned by h on a ratable basis, and receives $135, equal to sixty percent of l‘s ratable share of tax-exempt income. these two transfers are equivalent to a single net transfer of a $140 partnership interest only if there is no unrealized gain or loss in both partners‘ partnership interests and a section 754 election is not in effect. if the first of these requirements is not met, then each partner must reckon the consequences of the disposition of a partnership interest for an amount different from its basis; 90 if the second is not met, the partnership‘s bases in its assets will need to be adjusted to reflect both transfers. 91 because the facts assume no variation between inside and outside basis (following the accounting for each partner‘s ratable share under section 702) and that no section 754 election is in effect, these issues may be disregarded. table 6a sets out the partners‘ tax liabilities and rates (as a percentage of shares of total partnership income) under the aggregate 89. the valuations assume no change to the values of the underlying assets of the partnership. 90. see i.r.c. § 61. 91. see i.r.c. § 743(b). 382 florida tax review [vol. 13:7 analysis as well as under the alternative assumptions that the see is valid and that treasury‘s pip analysis applies. table 6a: tax liabilities and rates 92 on total partnership income under alternative theories: $450 tax-exempt interest and $550 taxable income 93 partner sa respected amount/rate pip amount/rate aggregate theory amount/rate high-tax $0 0% $99 27.5% $68 18.9% low-tax 83 12.9 53 8.3 62 9.7 total $83 8.3% $152 15.2% $130 13% table 6b sets out the partners‘ after-tax receipts under these alternatives. table 6b: total after-tax 94 amounts under alternative theories: $450 tax-exempt interest and $550 taxable income partner sa respected pip aggregate theory high-tax $360 $261 $292 low-tax 557 587 578 total $917 $848 $870 v. possible approaches to special allocations it is not immediately clear why partnership special allocations ought to be tolerated when the aggregate theory supplemented by non-partnershiplevel transactions would seem to achieve the desirable result of accounting for pre-tax economics without sacrificing tax accuracy. here i suggest two possible reforms, consistent with this general observation. the first is that greater flexibility in accounting for varying ownership arrangements within the partnership would go some way toward alleviating concerns about different ownership ratios for different types of partnership property. second, i suggest that a limited place for special allocations may remain where it is clear that tax avoidance is not the principal motivation and, critically, material tax reduction does not arise. from this perspective, partnerships 92. rates are expressed as the percentage of all partnership income, both taxable and non-taxable, allocated to the partner that is paid in tax. 93. figures are rounded to the nearest dollar and the nearest one-tenth percent. 94. under each theory, the pre-tax amounts are $360 for the high-tax partner and $640 for the low-tax partner. 2012] special allocations revisited 383 could be viewed as the mechanism by which (among other things) character assignments are permitted when there is a legitimate business-purpose-driven reason for them. subpart a argues that the best approach to dealing with special allocations is not to abrogate the aggregate theory but instead to make it more nuanced through what might be termed a partnership within a partnership (―pwp‖), or mini-partnership, approach. subpart b discusses the limited situations in which genuine character assignments ought to be tolerated — those cases in which policy considerations favor character assignments through special allocations. a. partnership within a partnership in many situations, for non-tax reasons the partners may wish to have a sharing arrangement with respect to some items of partnership property that differs from the larger sharing arrangement reflected in their capital accounts. indeed, this is just what a special allocation is. as long as the partners carry through the consequences of the altered sharing consistently, there should be no problem of improper assignment. consider that, instead of a special allocation, the partners in many cases could have established a separate partnership that owned just the assets for which a different sharing arrangement was desired and effectuated through a special allocation. if allocations in that separate partnership tracked the capital account balances or, more generally, the pip in that partnership, there would be no special allocation. accordingly, the provision of special rules that permit varying ownership ratios of specific items of partnership property in a single partnership ought to not pose a problem as long as the ownership ratios are respected all the way down. 1. simple disproportionate allocation the simplest kind of special allocation that can be accommodated under the pwp approach is one that assigns all aspects of the ownership of an item of partnership property to the partners in a ratio that differs from the overall ownership ratio. where the ownership is carved out of existing partnership property, there would be a taxable transfer at the formation of the special allocation, and thereafter the treatment of all items in respect of the carved-out item would be treated as though part of its own partnership. the consequences of transactions or events with respect to the special allocation could, in principle, simply pour over into the larger partnership, but only as long as earnings in respect of partnership capital are allocated in accordance with the ratio of capital account balances. example 2 illustrates these features. 384 florida tax review [vol. 13:7 example 2 — on day 1 of year 1, e and f each contribute $100x to the ef partnership in exchange for 50-percent interests therein. the ef partnership agreement satisfies the requirements of the section 704(b) regulations for economic effect. the partnership agreement further provides that all items of partnership igld will be shared equally, except that e and f will share items of partnership igld in respect of partnership depreciable property 70-30, respectively. on the same day that ef is formed, the partnership purchases warehouse for $150x. since e and f share all items in respect of warehouse 70-30, the purchase of warehouse effectuates a $30x capital transfer from f to e. like the transfer of a portion of factory from a to b in the depreciation/gain chargeback example, this transfer must be understood as a payment to e, not as the sale or exchange of a capital asset. accordingly, the transfer is deductible to f and includible as ordinary income to e. subsequent to the purchase, e and f establish separate partnership capital subaccounts for their respective interests in warehouse by deducting appropriate balances from their principal accounts. items of igld in respect of warehouse are allocated in the 70-30 ratio. suppose warehouse is depreciable over fifteen years on a straightline basis at $10x per year. in each year, e takes $7x of depreciation and f takes $3x, adjusting the warehouse accounts accordingly. in theory, the partners could maintain completely separate capital accounts consistently for warehouse as though it were a separate partnership, or they could cause the results of the warehouse account to pour over into the general capital accounts, provided that sharing ratios in the larger partnership were adjusted to reflect the adjusted ratio of capital account balances. (note, however, that the sharing ratio would apply solely with respect to items of capital income, not with respect to items of labor income. 95 ) 2. disproportionate allocation coupled with special allocation it is also possible to combine disproportionate allocations with special allocations that are recharacterized as ratable allocations together with transactions between the partners (or, in some cases, between the partnership and the partners but not on the basis of partnership equity). the purpose of such an arrangement would be to minimize the extent to which an allocation that varies from the basic allocation of the partnership agreement produces untoward tax consequences. in general, a special allocation creates assignment problems because it allocates part but not all aspects of 95. see supra introduction. 2012] special allocations revisited 385 ownership of a partnership item to the partners in a ratio that differs from the general sharing ratio. accordingly, one can view a special allocation as a departure from ratability with respect to a feature of ownership. once one can choose the underlying sharing ratio against which the departure is measured, it is possible to minimize the adverse tax consequences of the special allocation by choosing the disproportionate allocation from which the least tax distortion arises under the special allocation. the taxable and tax-exempt securities example discussed previously illustrates how such rules might operate. in that example (as set out in the treasury regulations), the high-tax partner, whom i refer to as h, is allocated 80 percent of partnership tax-exempt income, and the low-tax partner, whom i refer to as l, is allocated the remaining partnership income. the partners share in all other items of partnership igld equally. 96 the facts state that the partnership is expected to realize between $450 and $550 of each type of interest income annually. the consequences of the special allocation under the pure aggregate theory are set out in part iv. under the disproportionate approach presently under consideration, the adverse consequences of the special allocation could be mitigated to some extent. consider that all income of the partnership derives either from distributions on the securities or from dispositions of the securities (which also can generate loss). rather than begin with equal ownership of the securities (so that non-ratable allocations of distributions trigger deemed transactions under the aggregate theory but gains and losses on dispositions, at least initially, do not), one might begin with ownership ratios that reflect, or more nearly reflect, the sharing agreement on distributions. if h is to receive 80 percent of the distributions, then h might be deemed to own 80 percent of the tax-exempt obligations and a reduced (or perhaps even zero) interest in the taxable obligations. distributions on the securities then would be allocated with little or no recharacterization, but gains and losses on dispositions of the securities would be re-allocated, in effect reversing the consequences under the existing rules and applying the aggregate theory to the special allocation. to see how such an arrangement might play out, it is worth developing the example in somewhat more detail. in general, the return on tax-exempt debt is discounted to reflect the tax benefit, meaning that the fair market values of the two sets of securities cannot be approximately the same given that the expected distributions are expected to be approximately the same. the tax-exempt securities must have a higher face amount since they generate less interest per dollar invested, but the total interest paid (on a pretax basis) is roughly equal for the two types of instrument. the size of the discount on tax-exempt debt tends toward (though generally does not 96. reg. § 1.704-1(b)(5) ex. (5)(i). in the example, h and l are i and j respectively. 386 florida tax review [vol. 13:7 reach 97 ) an interest rate such that the after-tax yield on taxable debt subject to the highest marginal rate approximates the yield on tax-exempt debt. 98 if the maximum individual tax rate is 35 percent, it is reasonable to assume that the rate on tax-exempt debt reflects a 30 percent discount from the rate on taxable debt. suppose that the pre-tax rate of return on taxable debt is 10 percent and therefore that the rate on tax-exempt debt is seven percent. if total distributions are expected to be $500 for each type of security, the partnership‘s basket of taxable securities would be worth approximately $5,000 while the basket of tax-exempt securities would be worth approximately $7,142. 99 table 7 sets forth the capital accounts of the partnership on these assumptions. again to keep things simple, the example supposes that the partnership purchases the securities using cash contributed by the partners. table 7: hl initial balance sheet–capital accounting rules partnership assets partnership liabilities: $0 capital accounts asset a/b book partner a/b book taxable securities $5,000 $5,000 h $6,071 $6,071 tax-exempt securities 7,142 7,142 l 6,071 6,071 total $12,142 $12,142 total $12,142 $12,142 under the terms of the example, the partners contribute equal amounts of cash in exchange for their partnership interests. the partnership then purchases the securities and allocates partnership items according to the partnership agreement. as discussed above, the consequences of doing so if the aggregate theory applies include deemed taxable transactions between the partners. 97. for an analysis of the reasons why the rate on tax-exempt debt fails to capitalize fully the tax benefit it offers, see calvin h. johnson, a thermometer for the federal tax system: the overall health of the tax system as measured by the implicit tax, 56 smu l. rev. 13 (2003). 98. for example, according to edwardjones.com, as of aug. 31, 2012, rates on aaa-rated municipal bonds topped out at 3.14 percent while those on investment-grade corporate debt topped out at 4.10 percent. edward jones, https://www.edwardjones.com/en_us/market/rates/current_rates/index.html (last visited sept. 1, 2012). 99. that is, $500 is 10 percent of $5,000 and 7 percent of $7,142. 2012] special allocations revisited 387 another possibility, however, is that the partners employ some kind of disproportionate allocation to minimize the adverse tax consequences of the allocation. for example, the partnership could immediately allocate 80 percent of the tax-exempt securities to h and adjust ownership in the taxable securities appropriately. the value of 80 percent of the tax-exempt securities is $5,714. since the partners contribute equal amounts, or $6,071 under the assumptions used here, it would seem likely that h would continue to own $357 worth of the additional partnership securities. the partnership‘s capital accounts would include separate entries for tax-exempt securities, allocated 80-20 to h and l, and for taxable securities, allocated entirely to l, in both cases but for $357 of securities that could be composed of any combination of taxable and tax-exempt securities and would be allocated to h. to the extent partnership income derived from distributions on the securities, there would be only minimal further transactions deemed to occur between the partners (specifically, distributions on the portion of taxable securities that l owns). by contrast, gains or losses realized on dispositions of the securities would be allocated between the partners roughly equally triggering deemed transfers between the partners under the aggregate theory because of the disproportionate ownership. in the case of the disposition of a tax-exempt security, approximately 30 percent of the gain or loss realized would be deemed shifted from h to l while in the case of the disposition of taxable securities, slightly less than 50 percent of the gain or loss would run in the opposite direction. whether this arrangement proved superior to the default arrangement (equal ownership interests) would depend upon the partners‘ expectations about the sources of partnership income and loss. b. permissible character assignments the assignment of character is not intrinsically problematic; rather, it is the tax-motivated assignment of character that by its nature creates difficulties. in the case of most character assignments, the purpose of the special allocation is to reduce after-tax income without reducing concomitantly the aggregate pre-tax economic return of all the partners. the result is achieved by the partners‘ cooperation with each other in a way that effectively produces a payment from the treasury to the partnership, which payment is divided among the partners. example 5 from the special allocation regulations illustrates how this would work if the example satisfied the see rules. (and, presumably, it would be possible to build enough additional after-tax risk into the partners‘ sharing arrangement for those rules to be satisfied even though the expected after-tax value of the allocation to all partners would exceed the expected after-tax value of ratable allocations of partnership income.) in that situation, the special allocation will generally increase the returns of both partners relative to the returns they would receive absent the allocation, even though the economic activity of the 388 florida tax review [vol. 13:7 partnership — holding taxable and tax-exempt securities — and its pre-tax income are the same. in other situations, however, it may be appropriate to permit character assignments. 100 where untoward tax motivation is absent, the question becomes whether the interest in providing flexibility to the partners in their economic arrangement outweighs the policy reasons that favor differentiating among types of income for tax purposes. one such frequently recurring situation involves so-called tax-exempt bond partnerships (a ―tebp‖). tebps are investment vehicles used primarily by money market funds to obtain short-term-rate, variable returns on tax-exempt obligations in a highly liquid form. 101 the demand for tebps exists because issuers of taxexempt bonds generally prefer to issue bonds having a longer fixed-rate term, while a number of investors seek shorter-term variable yields as well as reduced risk to the capital invested. 102 consequently, the market does not supply short-term tax-exempt debt obligations directly in quantities that match demand or with sufficient liquidity to enable investors to avoid risk of loss. tebps fill this lacuna by creating synthetic short-term tax-exempt bonds that generally can be put back to the partnership at or close to purchase price. 103 in a typical tebp, a sponsor creates the tebp as a statelaw trust that is treated as a partnership for federal tax purposes. 104 the trust purchases tax-exempt debt obligations having a variety of maturity dates and issues two types of certificates in exchange for contributions: variable and residual. holders of the variable certificates (the primary investors) are entitled to a variable rate of return on their capital contributions; the returns are funded by payments on the underlying tax-exempt obligations held by the trust. holders of the residual certificates are entitled to any remaining trust income. the returns on the variable certificates generally track short-term interest rates. the variable holders‘ instrument is a synthetic short-term variable-rate bond. the rate on the synthetic bond is always less than the blended rate achieved by the tebp. the money market fund generally has a 100. other commentators who generally oppose special allocations have recognized that in limited circumstances special allocations may be appropriate. see, e.g., darryll k. jones, towards equity and efficiency in partnership allocations, 25 va. tax rev. 1047, 1099 (2006) (arguing that in the rare case in which the partners can demonstrate a sufficient non-tax motivation, a special allocation may be permissible). 101. see generally stanley i. langbein, federal income taxation of banks & financial institutions, ¶ 3.07[10][b] (discussion of tebps). 102. see notice 2008-80, 2008-2 c.b. 820. 103. id. 104. see reg. § 301.7701-4. 2012] special allocations revisited 389 right to put its certificates to the partnership on short notice, such as seven days, at a price that is at or close to fair market value. 105 the principal tax issue for tebps concerns the qualification of the returns for tax-exempt status when they are paid to holders of interests in the money market fund. money market funds are generally formed as regulated investment companies — mutual funds — which are corporations subject to pass-through treatment on their earnings as long as a number of detailed requirements are met. 106 among the requirements that must be satisfied if tax-exempt returns earned by the money market fund are to be passed through to its holders as tax-exempt are that at least 50 percent of the money market fund‘s assets by value consist of tax-exempt obligations and the fund distributes at least 90 percent of its net excludable interest income to its holders. 107 because the tax year of the money market fund may differ from that of the tebp, it is possible that these rules will not be satisfied for every tax period during which the money market fund holds its certificates. the irs has addressed this issue in a number of revenue procedures. 108 there is, however, a subsidiary issue that tebps pose in the context of an analysis of whether assignments of character should be permitted. (the issue does not arise if one assumes, as the irs must, that the see rules are valid.) in order for all amounts distributed in respect of the residual certificates to qualify as tax-exempt, an assignment of tax-exempt income among the tebp‘s partners must be permissible. otherwise, allocations of income from distributions on the underlying bonds that differ from the ratable distributions would be treated as taxable transfers from the variable to the residual interest holders, not as distributions of tax-exempt interest income. under the theory proposed here, the transfers would be of partnership interests themselves. it is not readily apparent whether the failure to account for the allocations of taxable and tax-exempt income as transfers of partnership interests is abusive. the economic substance of the partners‘ arrangement is that the variable holders take a reduced rate of return and surrender most of the opportunity for gain in exchange for liquidity and the elimination of most risk of loss. if the parties engaged in these transactions outside of a partnership, the net effect would likely be a liquidity purchase by the mutual funds (since transfer of the opportunity for gain and risk of loss likely offset). the question is how to characterize a payment for liquidity for income tax 105. see notice 2008-80, 2008-2 c.b. 820 (describing the features of tebps). 106. see i.r.c. §§ 851–855 (subchapter m of chapter 1 of the code covering regulated investment companies.) 107. i.r.c. § 852(a). 108. rev. proc. 2003-84, 2002-2 c.b. 1159, rev. proc. 2002-68, 2002-2 c.b. 753, rev. proc. 2002-16, 2002-1 c.b. 572. 390 florida tax review [vol. 13:7 purposes. for the funds, it is either an ordinary business expense 109 or a capital outlay. 110 although the mutual funds are not taxable 111 and no deduction would be available to the mutual funds for the expenses of producing tax-exempt income anyway, 112 the characterization matters because it affects whether the funds are able to pass through tax-exempt income to their shareholders. section 852 permits a regulated investment company such as a money market fund to pass tax-exempt income to its holders as tax-exempt only if certain requirements are met. in particular, the fund must distribute at least 90 percent of its tax-exempt income, net of deductions disallowed under section 265 (and section 171(a)(2)), to its holders during the taxable year. 113 because the provision does not permit an offset for capitalized expenditures, a liquidity payment that qualified as a capital outlay would not reduce the amount of tax-exempt income the fund would have to distribute to its holders in order for the tax-exempt character to pass through to them. however, if the liquidity payment qualified as a business expense, then, although it would be disallowed under section 265, it would count as an offset to the amount needed to be distributed. as a general matter, business outlays are deductible, subject to certain limitations. 114 the principal limitation relevant for this discussion is that the payment be ―ordinary‖ rather than capital in nature. 115 a capital payment is generally understood as a payment for the purchases of an item, tangible or not, having material value beyond the taxable year of purchase, 116 whereas ―ordinary‖ generally means providing a short-term benefit 117 and typically is deductible as long as ―necessary,‖ or fitting. 118 payments for liquidity, as long as made for the current year tax year, certainly are ―necessary‖ and likely qualify as ordinary when they are not made in connection with the acquisition of the asset with respect to which the liquidity is provided. the irs has held in field service advice that liquidity payments, to the extent not in excess of the actual market cost of liquidity, 109. see i.r.c. § 162. 110. see i.r.c. § 263. 111. i.r.c. §§ 561, 852(b)(2). 112. i.r.c. § 265(a)(1). 113. i.r.c. § 852(a)(1)(b). 114. i.r.c. § 162(a). 115. see i.r.c. § 263. 116. indopco v. commissioner, 503 u.s. 79, 87–88 (1992). 117. deputy v. dupont, 308 u.s. 488, 495 (1940). 118. welch v. helvering, 290 u.s. 111, 113 (1933) (―necessary‖ means ―‗appropriate and helpful.‘‖). 2012] special allocations revisited 391 are deductible. 119 further, liquidity payments are closely similar to guarantee fees, which also generally are deductible. 120 the issue in the tebp context is clouded by the fact that the agreement to take a reduced return in exchange for liquidity arguably represents a cost of the partnership interest and therefore could be viewed as requiring capitalization under the general rule that acquisition costs of capital assets must be capitalized. 121 under this view, the amounts paid for the liquidity would not be deductible under section 162 (assuming the disallowance under section 265 did not apply) but would be added to the mutual fund‘s basis in the tebp interest. in favor of the view that the liquidity payments represent a cost of the partnership interest are that the liquidity is not separately purchased and is not an optional payment; on the other side, the fact that the liquidity payment is ongoing rather than up front in nature points in favor of characterization as ordinary. 122 it is my understanding that it was the uncertainty in the characterization of the liquidity payment as ―ordinary‖ versus capital that gave rise to the decision to structure the money market funds‘ investments in pools of tax-exempt obligations as a partnership. 123 as indicated above, in the partnership setting the issue disappears because the liquidity payment is made through a partnership special allocation, and the allocation clearly has see. the special allocation mimics a deduction for liquidity through the mechanism of an exclusion from gross income of the amounts that would be paid for liquidity. for present purposes, however, where the appropriateness of special allocations themselves is the focus of the inquiry, the question is whether the motive of characterizing a liquidity payment as in effect deductible (by simply directing it to the other partners) rather than potentially capitalizable is improper and so should not be permitted. the question is somewhat closer than in the usual special allocation setting, which i have argued generally involves an inappropriately taxmotivated assignment of character. from the perspective of the money market funds, the issue is whether it becomes possible to create, with sufficient certainty, a variable-return tax-exempt obligation when the market does not supply those obligations directly. the question is one of tax risk. if the liquidity payment would properly be deductible, then the use of the 119. f.s.a. 1992-927. 120. irs rev. rul. 70-544, 1970-2 c.b. 6, modified by rev. rul. 74-169, 1974-1 c.b. 147 and clarified by rev. rul. 84-10, 1984-1 c.b. 155. 121. see reg. § 1.263(a)-(4) (requiring capitalization of costs to acquire intangible assets such as corporate stock). 122. see generally bittker & lokken, federal taxation, supra n.17, at ¶ 105a.1 (discussing factors relevant to the capitalization-versus-deduction question). 123. e-mail from george g. wolf to author (aug. 13, 2012, 4:29:46 pdt) (on file with the author). 392 florida tax review [vol. 13:7 partnership structure with a special allocation is unnecessary; the same result could be had outside of the partnership structure. if, however, the liquidity payment ought to be capitalized, then it is not possible for money market funds to invest in variable-rate, synthetic tax-exempt debt and to pass the tax exemption on to their holders. it, thus, becomes necessary to evaluate the tax significance of the distinction between a capitalizable payment and a deductible one in the context of the tax rules for money market funds. as discussed previously, the main reason for requiring capitalization of certain business outlays under an income tax is to ensure that income is properly timed. if a payment produces a material on-going benefit to the taxpayer, it would be inappropriate to permit a deduction for the full amount of the payment in the period it is made, because the taxpayer has not ―lost,‖ or at any rate has not converted into goods or services, the full value of the payment in that period. rather, the taxpayer has purchased an asset that has value even at the close of the period of purchase. the significance of the issue, however, is diminished in the case of money market funds, which as regulated investment companies are largely tax-exempt because of the deduction to which they are entitled for dividends paid. 124 the tax question becomes whether there should be a taxable inclusion for the money market fund‘s holders if the purchase of liquidity protection for tax-exempt income is properly characterized as a capitalizable cost rather than as an ordinary and necessary business expense that is nonetheless not deductible by reason of section 265. if there is, then the availability of the partnership form as a way around capitalization permits tax reduction that arguably is untoward; if there is not, then, at least on the funds‘ side, there does not seem to be much reason to preclude use of the partnership form as a way to get around the technical difficulty that a liquidity payment would not qualify as a reduction of income for purposes of the 90 percent distribution requirement (assuming, that is, that the payment would have to be capitalized). 125 the principal basis for concluding that untoward tax reduction does not occur is that the payments are not deductible in any case, because of the anti-arbitrage rule of section 265(a), which generally denies deductions for costs incurred in order to generate taxexempt income. in addition, the technical rule that capitalizable costs do not count for purposes of calculating the 90 percent rule of section 852(a)(1) does not appear to have a deep theoretical foundation. even if an outlay for liquidity protection would properly be capitalized rather than deducted, it does not appear that effectively permitting a deduction (by the mechanism of an exclusion through the partnership form) for the protection that is purchased provides a tax benefit. the outlay, recall, is made on an on-going basis in the 124. i.r.c. § 561. 125. i.r.c. § 852(a)(1)(b). 2012] special allocations revisited 393 form of a reduced rate of return on the tebp‘s securities. the effect of permitting an immediate deduction (or exclusion) of amounts actually paid (constructively received and paid over) is not, then, to accelerate the deduction for a capital item because only the portion of the outlay attributable to the current year is actually made in the current year, and only that portion is effectively deducted under the partnership arrangement (by means of the exclusion). 126 in short, if the only tax concern were the treatment of money market fund shareholders, the use of the partnership form to get around the technical difficulties that section 852(a)(1)(b) creates does not appear problematic. there remains, however, the treatment of the holders of residual interests in the tebp. outside of the partnership setting, a liquidity payment would be taxable to the recipient as ordinary income. under the partnership special allocation, the liquidity payment takes the form of tax-exempt interest redirected from the variable holders to the residual holders (assuming they are the liquidity providers; in some cases they are not 127 ). consequently, there is a net reduction in total tax revenue. however, the fact that a revenue loss arises should not be determinative, by itself, of whether the special allocation ought to be permitted. in light of these considerations, it would appear that the tax policy issue for tebps is whether the failure of the market to supply an investment vehicle for which legitimate demand exists is a sufficient basis to permit the residual holders, through the mechanism of a special allocation, to avoid tax on what is effectively compensation income. the issue is not what the right answer to the question is, or even if there is a right answer in the abstract, but whether it would be reasonable for the irs or treasury to conclude that the tax revenue loss is worth it. unlike the typical special allocation for which the impetus is tax avoidance, the special allocation in the tebp case is not motivated by untoward tax avoidance. (the motivation is tax-based in that it is to ensure the preservation of a tax exclusion, but the exclusion itself is provided under the code.) however one comes down on the answer to the underlying question, the factors to be weighed in making the determination differ from those in the usual special allocation in that valid considerations exist on both sides. in other words, congress or treasury could reasonably believe that fixing market imperfections justifies providing an otherwise untoward tax benefit to the residual holders. 126. even accrual method taxpayers would be unable to deduct the portion of a liquidity payment attributable to future years because neither the amount nor the fact that the obligation is fixed. see reg. § 1.461-1(a)(2)(i). in addition, economic performance occurs only as liquidity protection is provided. see i.r.c. § 461(h)(2)(a). 127. notice 2008-80, 2008-2 c.b. 820. 394 florida tax review [vol. 13:7 vi. conclusion partnership special allocations present a problem under the tax law. in the abstract, it may seem reasonable to permit partners, when motivated by a non-tax business purpose, to use special allocations to assign types and perhaps even amounts of partnership igld among themselves in ways that vary from their ratably determined economic rights to these items. this abstract idea seems to have motivated the 1976 amendments to section 704(b), which permit assignments that have ―substantial economic effect.‖ 128 in practice, however, the rules that govern special allocations are too lenient. they permit many assignments that are clearly tax-motivated and that on an ex ante basis have positive value because of taxes. the rules have a further problem in that, in cases in which they classify a special allocation as lacking see, they provide a determination of pip that seems at odds with the concept of pip itself. it is not clear how anything other than a substantial narrowing or elimination of the availability of special allocations within the framework of partnership accounting can address these difficulties. an elimination of special allocations would require accounting for the results of special allocations outside of the partnership, much as has been explored here in the framework of aggregate accounting. a narrowing of the special allocation provisions as suggested in part v would entail largely the same accounting, with, however, the possibility for limited exceptions to aggregate accounting where non-tax business concerns motivate the allocation and tax considerations are adjudged insignificant enough in relation to those concerns to warrant the special allocation. an alternative to the approach of narrowing or eliminating special allocations would be to move in the opposite direction, in which case the effort should extend beyond section 704 to other aspects of subchapter k. one might conclude that the abuses that the see rules permit are simply too costly to police or too small to worry about, since they generally involve character and not amounts. while i am not of the view that this is the appropriate course, reasonable minds can disagree. 129 if congress were to make the judgment that the character-motivated shifts under the see rules are not abusive, it would seem congress ought to make the same judgment about character shifts across the board. in particular, it would seem that congress should apply similar reasoning to other provisions of subchapter k, many of which seek to prevent the same type of abuse that the see rules in their current form permit. of particular note in this context would be section 751, which mandates a complicated and quite burdensome test and set of 128. i.r.c. § 704(b). 129. see, e.g., mckee et al., partnerships and partners, supra n.18, at ¶ 21.01[2] (arguing that concerns over character shifts are overstated). 2012] special allocations revisited 395 constructive transactions in order to determine whether liquidations or dispositions of partnership interests are disproportionately tilted toward capital or ordinary items and, if they are, to recharacterize the transaction in a manner that prevents character shifts. repeal or significant narrowing of the scope of section 751 would seem to reduce compliance costs, administrative burdens and costly tax planning. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review florida tax review volume 13 2012 number 4 157 the illusory promise of economic nexus by adam b. thimmesch* abstract the economic nexus standard has gained significant support during the last decade as the proper standard for determining the scope of states’ taxing powers under the dormant commerce clause. unfortunately, however, despite the widespread acceptance of that standard in the abstract, there is no uniform understanding of what economic nexus actually means. state courts that have adopted that standard have generally failed to explain its parameters, and those few courts that have actually addressed the scope of economic nexus have adopted artificially high standards that severely restrict its reach. actions by state legislatures and revenue authorities have been much the same. uncertainty reigns, yet those disparate approaches to the same constitutional standard have yet to receive scholarly attention. this article seeks to fill that void by analyzing state actions in this area and by evaluating how states’ different formulations for economic nexus will likely develop over time. such an analysis shows that states’ economic nexus formulations have little theoretical or jurisprudential grounding and will necessarily change and deteriorate over time. as a result, states’ actions in this area will be non-uniform and will maintain the significant uncertainty that currently exists. federal attention to economic nexus is thus warranted to prevent state actions from undermining the goals of the dormant commerce clause. this article analyzes several potential federal responses and concludes that congress should intervene and adopt a federal factor nexus standard based on the multistate tax commission’s model formulation. i. introduction ............................................................................. 158 ii. the history of economic nexus .......................................... 161 * assistant professor of law, university of nebraska college of law. i want to thank steve bradford, brian lepard, bill lyons, and richard moberly for their review and comments on prior drafts. all errors and omissions are my own. 158 florida tax review [vol. 13:4 a. conceptual and jurisprudential introduction to economic nexus ................................................................ 166 b. economic nexus as adopted by state courts ................... 173 c. state economic nexus legislation .................................... 181 iii. evaluating state economic nexus formulations ........ 187 a. the future of qualitative economic nexus ...................... 188 b. the future of quantitative factor nexus ........................ 198 iv. what should be done with economic nexus? ................ 204 a. potential approaches for economic nexus ...................... 205 b. the appropriate approach for economic nexus ............. 207 v. conclusion ................................................................................. 216 “our new constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes!”1 i. introduction ben franklin’s observation about the inevitability of death and taxes is likely known by most. we understand that individuals can attempt to cheat both for short periods of time, but few have illusions of winning the battle altogether. upon venturing into the corporate world, however, the rules change. perpetual existence is likely a birthright for a firm.2 further, while federal taxation tends to follow any domestic profits, a corporation’s obligations regarding state taxation are much less certain. contrary to mr. franklin’s declaration, firms may find that they can generate significant income on which they are not forced to suffer the burden of state taxation. such firms’ benefactor on this front is the dormant commerce clause and its limitations on state taxing power. under the dormant commerce clause, a state can only tax a business that has a “substantial nexus” within it.3 if a business’s presence in a state falls short of that standard, the state simply lacks the jurisdiction to compel the business to pay its tax. but what is a substantial nexus? how is it generated? when evaluating state sales and use taxes, the supreme court has repeatedly held that the substantial nexus requirement can only be met where 1. benjamin franklin. letter from benjamin franklin to jean baptiste le roy (nov. 13, 1789), in memoirs of benjamin franklin 619 (1834). 2. see, e.g., del. code. ann. tit. 8, § 102(b)(5) (2012) (providing a default rule of perpetual existence for corporations formed under delaware law). 3. complete auto transit, inc. v. brady, 430 u.s. 274, 279 (1977). 2012] economic nexus 159 a taxpayer has a physical presence in the taxing state.4 the court has remained silent, however, as to whether this physical presence rule is limited only to those taxes or whether it applies to state business activity taxes, such as corporate income taxes, as well.5 in the absence of guidance from the court, commentators have widely lauded an economic nexus standard6 as the appropriate standard for business activity tax purposes.7 that standard allows states to tax businesses that do not have a physical presence within their boundaries as long as those businesses have sufficient economic contacts with the state. for example, imagine a software company that has all of its employees, offices, and physical assets located in california. due to aggressive marketing on the internet, the business has secured several lucrative contracts with companies in new jersey. under an economic nexus standard, new jersey could tax that business based on its economic connection to the state regardless of its distant physical footprint. such taxation would not be permissible under a physical presence rule. academic support of the economic nexus standard has focused almost exclusively on its permissibility under the dormant commerce 4. quill corp. v. north dakota, 504 u.s. 298, 311–13 (1992); nat’l bellas hess, inc. v. dep’t of rev. of ill., 386 u.s 753 (1967), overruled by quill corp. v. north dakota, 504 u.s. 298 (1992). 5. “business activity taxes” refer to taxes that are not transaction based, like sales taxes, but rather are measured by net income, profits, or receipts. they include income taxes, franchise taxes, gross receipts taxes, and business and occupation taxes, among others. the discussion in this article applies equally to all types of business activity taxes. 6. the use of the term “standard” here does not necessarily imply a subjective standard rather than a rule (although that issue is discussed later herein). the term “standard” in this context merely refers to which economic nexus “test” should govern, whether expressed as a rule or as a standard. for a summary of the conceptual difference between rules and standards and for a good sample of the literature in this area, see scott dodson, the complexity of jurisdictional clarity, 97 va. l. rev. 1, 15–20 (2011). 7. see, e.g., christina r. edson, quill’s constitutional jurisprudence and tax nexus standards in an age of electronic commerce, 49 tax law. 893, 942–47 (1995) [hereinafter edson, quill’s constitutional jurisprudence]; michael t. fatale, geoffrey sidesteps quill: constitutional nexus, intangible property and the state taxation of income, 23 hofstra l. rev. 407, 447–52 (1995); michael t. fatale, state tax jurisdiction and the mythical “physical presence” constitutional standard, 54 tax law. 105 (2000); craig j. langstraat & emily s. lemmon, economic nexus: legislative presumption or legitimate proposition?, 14 akron tax j. 1 (1999); john d. snethen & andrew a. swain, paying their fair share: the hidden lessons of complete auto and quill, 46 st. tax notes 749 (december 11, 2007); john a. swain, state income tax jurisdiction: a jurisprudential and policy perspective, 45 wm. & mary l. rev. 319, 373–93 (2003) [hereinafter swain, a jurisprudential and policy perspective]. 160 florida tax review [vol. 13:4 clause. only limited attention has been given to defining what economic nexus actually means. this limited attention has resulted in a range of proposals — from a heightened qualitative formulation that requires significant economic exploitation,8 to a formulation that requires only minimal levels of economic contact,9 to a federal quantitative standard.10 what is missing from the literature, however, is a significant discussion about how individual states have defined economic nexus and whether those state definitions are suitable or sustainable.11 this article fills that gap by providing a comprehensive review of states’ actions regarding economic nexus and by evaluating how their different formulations will likely evolve over time. such a discussion will show that state authority regarding economic nexus largely follows the academic literature. that is, state courts evaluating economic nexus have focused nearly all of their energies on justifying their support of that standard. they have given almost no attention to determining what economic nexus means.12 further, even where states have adopted particular formulations, they have not acted uniformly. states’ formulations have taken both qualitative and quantitative forms, and within those forms, significant variations already exist. this article shows that those variations will continue and that states’ current economic nexus formulations will ultimately suffer from significant erosion. in light of these problems, a federal economic nexus standard is warranted. without federal action, the great variety and instability of state formulations will create impermissible burdens on interstate commerce, regardless of the impact of any one formulation. although such intervention would certainly weaken state taxing autonomy and could be challenged on 8. edson, quill’s constitutional jurisprudence, supra note 7. 9. swain, a jurisprudential and policy perspective, supra note 7. 10. charles e. mclure, jr., implementing state corporate income taxes in the digital age, 53 nat’l tax j. 1287, 1295–97 (2000) [hereinafter mclure, implementing]. 11. but see julie roman lackner, note, the evolution and future of substantial nexus in state taxation of corporate income, 48 b.c. l. rev. 1387 (2007) (providing a limited overview of the variety of state judicial economic nexus formulations at the time). this note provides a good positive analysis of the various judicial formulations that had been announced through 2007, but further work is obviously required. this article thus discusses the additional judicial standards that have been adopted since that time, reviews the states’ legislative approaches to economic nexus, analyzes how those judicial and legislative approaches will develop over time, and provides a normative assessment of economic nexus. 12. further, the few economic nexus formulations that states have adopted have yet to be reviewed by the supreme court, which has maintained indifference towards this issue for nearly twenty years. see infra part ii.b.1 (listing a series of economic nexus cases in which the supreme court has denied certiorari). 2012] economic nexus 161 federalism grounds, it would infringe on state authority in a way that is limited to the federal interests underlying the commerce clause. federal regulation in this area would intervene at a jurisdictional level and would leave states free to adopt varying substantive taxing structures to serve their local interests. this article offers and evaluates four potential approaches for a federal economic nexus standard and concludes that the best option — considering both tax and constitutional policy — is for congress to adopt a quantitative standard based on the multistate tax commission’s model formulation. that approach would provide bright-line guidance, comport with normative tax principles, and provide adequate constitutional protection for interstate commerce. to form the groundwork for that proposal, part ii of this article provides a history of the economic nexus standard, from supreme court authority to state judicial and legislative actions. part iii then evaluates how states’ current economic nexus formulations will likely evolve without federal intervention. part iv analyzes four potential federal approaches to the economic nexus standard and determines that congress should adopt a federal factor nexus standard. part v briefly concludes. ii. the history of economic nexus the “nexus” concept in state taxation has a long and detailed history. however, the modern era of nexus can be traced to the united states supreme court’s 1977 enunciation of a four-part test for evaluating state taxes under the dormant commerce clause in complete auto transit, inc. v. brady.13 for a tax to be upheld under that test, it must: (1) be “applied to an activity with a substantial nexus with the taxing state;”14 (2) be “fairly apportioned;” (3) “not discriminate against interstate commerce;” and (4) be “fairly related” to the benefits afforded to the taxpayer by the state.15 in turn, the concept of economic nexus has developed under the first prong of complete auto, which explicitly sets forth a “substantial nexus” requirement. interestingly, the only real guidance that the court has provided regarding the substantial nexus requirement has involved use tax collection 13. 430 u.s. 274, 279 (1977). 14. less than one month after complete auto, the court clarified that this substantial nexus requirement necessitates only a nexus between the taxing state and the taxpayer (or tax collector in the case of a use tax collected by an out-of-state merchant), not the particular activity being taxed. nat’l geographic soc’y v. cal. bd. of equalization, 430 u.s. 551, 560 (1977). 15. complete auto, 430 u.s. at 279, 287. of course, the complete auto court did not create this four-factor test out of whole cloth but simply joined the elements together from the court’s long history of commerce clause analysis. see id. at 279. 162 florida tax review [vol. 13:4 obligations rather than direct impositions of tax. a use tax is complementary to a state’s sales tax. whereas sales taxes are generally imposed on retail transactions that occur within a state, use taxes are imposed on the use or consumption of taxable property within a state.16 such taxes are designed to compensate states for the tax revenues that are lost when taxpayers make purchases without paying sales tax.17 this occurs, for example, when a person buys an item online — or in a neighboring state — without paying sales tax.18 absent a use tax on that person’s use of the goods in his or her home state, the person would avoid paying any sales or use tax on that purchase merely by making the purchase online (or across the border). the principal problem for states with use taxes has been collecting them. it is not practical — or politically expedient — for states to take enforcement actions against individual consumers for small sums.19 states have thus responded by imposing use tax collection obligations on certain out-of-state vendors (e.g., catalog or internet businesses). those vendors naturally resist those obligations, often arguing that those requirements violate the due process and commerce clauses. the court upheld one state’s collection obligations against those challenges less than one month after complete auto.20 in that case, the national geographic society argued that the due process and commerce clauses barred california from requiring it to collect a use tax on sales to california customers because its mail-order business did not have any physical connection to the state.21 the court rejected that challenge because one of the society’s other business lines —within the same legal entity — did have a physical presence in california.22 the court did not evaluate the case under complete auto’s substantial nexus prong, but it did hold that the 16. see jerome r. hellerstein & walter hellerstein, state taxation ¶ 12.01 (3d ed. 1998 & supp. 2010) [hereinafter hellerstein, state taxation]. 17. id. ¶ 16.01[2]. 18. residents of iowa, for example, can travel to minnesota to purchase clothing, which is exempt from minnesota sales tax. minn. stat. § 297a.67, subd. 8 (2012). 19. states have attempted to encourage voluntary compliance with their use taxes by putting use-tax remittance lines on their income tax returns. see nina manzi, use tax collection on income tax returns, 36 st. tax notes 25 (july 2, 2012) (evidencing that twenty-five states currently provide for use-tax reporting on their states’ individual income tax returns). voluntary compliance in those states appears to be low. id. at 26 (showing that the percentage of income tax returns that actually report use tax due ranges from 0.2 percent to 9.8 percent). 20. nat’l geographic soc’y v. cal. bd. of equalization, 430 u.s. 551, 560 (1977). 21. id. 22. id. at 562. 2012] economic nexus 163 society’s “continuous presence in california . . . provides a sufficient nexus to justify the state’s imposition”23 of use taxes. that physical presence analysis was consistent with the court’s pre-complete auto decision in national bellas hess, inc. v. department of revenue of illinois, which explicitly recognized a physical presence rule under both the due process and commerce clauses.24 national bellas hess also involved a use-tax collection obligation imposed on a remote vendor. in that case, however, the vendor did not have a physical presence in the taxing state. the court found that factor to be determinative in upholding the vendor’s challenge, noting the “sharp distinction . . . between mail order sellers with retail outlets, solicitors, or property within a state, and those who do no more than communicate with customers in the state by mail or common carrier as part of a general interstate business.”25 fifteen years after complete auto the court was presented with another of these cases in quill corporation v. north dakota.26 the state of north dakota’s unilateral determination that national bellas hess was no longer valid law and its adoption of a statute that imposed a use-tax collection obligation on out-of-state vendors that merely advertised in the state precipitated this case.27 quill challenged the tax-collection obligation as a violation of both the due process and commerce clauses. the quill court made two very important determinations with respect to the substantial nexus prong of complete auto. first, the court recognized that its due process jurisprudence since national bellas hess had abandoned a bright-line physical presence rule in favor of a minimum contacts standard.28 the court thus determined to extend that lower threshold to its due process clause analyses of state tax statutes.29 the quill court’s second important determination was to retain its more exacting physical presence standard for purposes of the commerce clause.30 23. id. 24. nat’l bellas hess, inc. v. dep’t of rev. of ill., 386 u.s 753, 758 (1967). 25. id. 26. 504 u.s. 298 (1992). quill’s physical presence in the state was limited to a few floppy diskettes over which it retained title. id. at 315 n.8. 27. id. at 302–04. 28. id. at 307 (citing int’l shoe co. v. washington, 326 u.s. 310, 316 (1945)). the court recognized that the due process inquiry was satisfied if the outof-state actor “purposefully avail[ed] itself of the benefits of an economic market in the forum state” regardless of the actor’s physical presence there. id. 29. id. at 308. 30. the court noted that it might not have adopted this test had it been asked to do so for the first time in that case but that its determination was not inconsistent with complete auto. id. at 311. further, the court acknowledged that it 164 florida tax review [vol. 13:4 the combination of those two decisions operated to create a “gap” between the protections afforded to taxpayers under these two constitutional provisions. the court justified this disconnect by discussing the difference in their purposes: despite the similarity in phrasing, the nexus requirements of the due process and commerce clauses are not identical. the two standards are animated by different constitutional concerns and policies. due process centrally concerns the fundamental fairness of governmental activity. thus, at the most general level, the due process nexus analysis requires that we ask whether an individual’s connections with a state are substantial enough to legitimate the state's exercise of power over him. we have, therefore, often identified “notice” or “fair warning” as the analytic touchstone of due process nexus analysis. in contrast, the commerce clause and its nexus requirement are informed not so much by concerns about fairness for the individual defendant as by structural concerns about the effects of state regulation on the national economy. under the articles of confederation, state taxes and duties hindered and suppressed interstate commerce; the framers intended the commerce clause as a cure for these structural ills. it is in this light that we have interpreted the negative implication of the commerce clause. accordingly, we have ruled that that clause prohibits discrimination against interstate commerce . . . and bars state regulations that unduly burden interstate commerce . . . . the complete auto analysis reflects these concerns about the national economy. the second and third parts of that analysis, which require fair apportionment and nondiscrimination, prohibit taxes that pass an unfair share of had applied the physical presence test after complete auto (in nat’l geographic). id. the court then proceeded to defend the physical presence test on several grounds, including stare decisis. for a complete discussion of quill and its reasoning for upholding the physical presence test, see swain, a jurisprudential and policy perspective, supra note 7, at 328–29. for a discussion supporting quill’s ongoing validity as a positive matter, see adam b. thimmesch, the fading bright line of physical presence: did kfc corporation v. iowa department of revenue give states the secret recipe for repudiating quill?, 100 ky. l.j. 339 (2012) [hereinafter thimmesch, the fading bright line]. 2012] economic nexus 165 the tax burden onto interstate commerce. the first and fourth prongs, which require a substantial nexus and a relationship between the tax and state-provided services, limit the reach of state taxing authority so as to ensure that state taxation does not unduly burden interstate commerce. thus, the “substantial nexus” requirement is not, like due process’ “minimum contacts” requirement, a proxy for notice, but rather a means for limiting state burdens on interstate commerce. accordingly, contrary to the state’s suggestion, a corporation may have the “minimum contacts” with a taxing state as required by the due process clause, and yet lack the “substantial nexus” with that state as required by the commerce clause. 31 this discussion is of paramount importance when analyzing nexus cases under the “substantial nexus” requirement of complete auto. the court made it very clear that the due process and commerce clauses protect different interests and that a taxpayer’s actions in a state could constitutionally satisfy the former without satisfying the latter. quill represents the court’s last guidance regarding the jurisdictional limitations reflected in the substantial nexus prong of complete auto. however, despite the court’s affirmation of the physical presence rule, there has been considerable conflict regarding whether this rule applies to taxes other than sales and use taxes. that debate has been aided principally by the tone and language of quill, which indicates a less-than-enthusiastic adherence to the rule.32 indeed, the quill court explicitly stated that it had not, “in [its] review of other types of taxes, articulated the same physical presence requirement” and that it may not have adopted such a test if it were being offered as a matter of first impression.33 consequently, taxpayers and state revenue authorities have debated whether — for purposes of taxes other than sales and use taxes — a taxpayer must have a physical presence in a state or whether an “economic” presence suffices.34 this article does not attempt to address the underlying question of whether quill compels a physical presence test for all state taxes or whether it should be limited to state sales and use taxes.35 rather, this article focuses 31. quill, 504 u.s. at 312–13 (citations omitted). 32. see hellerstein, state taxation, supra note 16, ¶ 6.02[2] (labeling the quill court’s affirmation of the physical presence test “almost apologetic”). 33. quill, 504 u.s. at 314. 34. a discussion of state-court determinations on this issue is discussed in part ii.b.1. 35. a great amount of attention has already been given to this debate. see supra note 7 and accompanying text. 166 florida tax review [vol. 13:4 on the proper formulation for economic nexus once it is accepted as an appropriate standard under the dormant commerce clause. part ii.a begins this discussion by providing background on the economic nexus concept and its place in the court’s nexus jurisprudence. part ii.b and ii.c then provide an overview of the various state judicial and legislative adoptions of economic nexus. a. a conceptual and jurisprudential introduction to economic nexus before discussing how states have defined what economic nexus means, it is important to understand the conceptual structure under which nexus issues arise. nexus, of course, refers to a person’s connection with a state and that state’s concomitant power to impose a tax — or tax-collection obligation — on that person. walter hellerstein has identified nexus as being comprised of two elements: (1) substantive jurisdiction and (2) enforcement jurisdiction.36 the former refers to a state’s substantive connection with an item of income, while the latter refers to the state’s power over the taxpayer.37 substantive jurisdiction itself is considered to have two bases: residence and source.38 residence-based jurisdiction allows a state to tax the income of persons who reside within the taxing state.39 in contrast, sourcebased jurisdiction gives a state jurisdiction over income that is attributable to sources within the taxing state without regard to the residence of the recipient.40 substantive jurisdiction thus gives states power over the income of nonresidents who economically exploit state markets. of course, this expanded reach over the income of non-residents raises questions regarding a state’s ability to actually collect the tax it imposes on that income. that concern is encompassed by the concept of enforcement jurisdiction. as indicated above, the boundaries of a state’s enforcement jurisdiction dictate the extent to which that state can collect tax on income over which it has substantive jurisdiction. under current law, states’ enforcement and substantive jurisdictions are not coterminous. rather, states’ enforcement jurisdiction has been limited by both judicial41 and 36. walter hellerstein, jurisdiction to tax income and consumption in the new economy: a theoretical and comparative perspective, 38 ga. l. rev. 1, 3–4 (2003) [hereinafter hellerstein, jurisdiction to tax income]. 37. id. 38. id. at 4; hellerstein, state taxation, supra note 16, ¶ 6.03. 39. see, e.g., shaffer v. carter, 252 u.s. 37, 57 (1920). 40. hellerstein, jurisdiction to tax income, supra note 36, at 6–8. 41. the quill physical presence test discussed above is an example of a judicial limitation on enforcement action. although a state may have substantive jurisdiction over the income derived from a sale made to an in-state resident, the 2012] economic nexus 167 legislative42 action. thus, due to tax-specific jurisdictional rules, a state can have jurisdiction over a taxpayer’s income without actually having the ability to require the taxpayer to remit the tax.43 with this framework in mind, complete auto reveals itself as addressing both enforcement and substantive jurisdiction. first, the requirement of nexus with the taxpayer under complete auto’s substantial nexus prong evidences a concern for the state’s connection to that person (i.e., its ability to enforce an assessment of tax — its enforcement jurisdiction). second, the requirement that income be fairly apportioned under complete auto’s second prong speaks to a particular state’s right to tax only the income that is fairly attributable to it. this test reflects a concern that states have an underlying substantive right to the income being taxed — in other words, substantive jurisdiction.44 current debate regarding the efficacy and scope of economic nexus occurs within the purview of an enforcement jurisdiction analysis or whether a state has sufficient authority over the person to require its payment of tax state does not have enforcement jurisdiction over the remote vendor if that vendor does not have a physical presence in the state. 42. see, e.g., 15 u.s.c. §§ 381–84 (2012) (restricting state enforcement power over taxpayers with only limited physical presence in a state) [hereinafter p.l. 86-272]. p.l. 86-272 was enacted by congress after the court’s decision in northwestern states portland cement co. v. minnesota. in that case, the court upheld the imposition of state income taxes on companies whose only presences in the taxing states were in-state salespersons who solicited orders for fulfillment from outside the states in which they solicited orders. nw. states portland cement, 358 u.s. 450, 454–56, 465 (1959). congress reacted swiftly to the decision and adopted p.l. 86-272 within the year. pub. l. no. 86-272, 73 stat. 555 (1959); see hellerstein, state taxation, supra note 16, ¶ 6.16. p.l. 86-272 limits states’ enforcement jurisdiction over remote vendors that sell tangible personal property and that only have limited activities within their boundaries, including solicitation activities. 15 u.s.c. § 381(a). it is important to note at the outset of this article that the discussion of economic nexus here is limited to taxpayers that are not protected by p.l. 86-272. regardless of the proliferation and scope of economic nexus among the states, p.l. 86-272 limits its impact to those who do not fall within its protections. for a full discussion of the scope and impact of p.l. 86-272, see hellerstein, state taxation, supra note 16, ¶¶ 6.16–6.18. 43. this disconnect can be remedied if the state has enforcement jurisdiction over a third party who controls the out-of-state person’s funds. for example, a state can impose a withholding requirement on in-state persons who make payments to out-of-state businesses that do not have a nexus with the state. see infra notes 65–74 and accompanying text. 44. bradley w. joondeph, rethinking the role of the dormant commerce clause in state tax jurisdiction, 24 va. tax rev. 109, 118–20 (2004); swain, a jurisprudential and policy perspective, supra note 7, at 328–29. 168 florida tax review [vol. 13:4 (i.e., the substantial-nexus prong of complete auto).45 in this light, it is safe to say that the supreme court has never explicitly recognized economic nexus as a legitimate basis for the imposition of a state business activity tax under the dormant commerce clause.46 this lack of direct guidance, however, has not prevented states from arguing that the supreme court has recognized the validity of economic nexus for purposes of enforcement jurisdiction analyses.47 two cases generally form the basis for such arguments: new york ex rel. whitney v. graves48 and international harvester co. v. wisconsin department of taxation.49 whitney involved a due process challenge to the imposition of new york state income tax on gains received by an out-of-state taxpayer from the sale of a fractional membership on the new york stock exchange.50 whitney’s membership on the exchange gave him rights to trade on the exchange and access to certain other benefits, including an insurance fund and access to reduced commissions for transactions undertaken on his behalf.51 whitney challenged the imposition of new york income tax on his gains from the sale of his fractional membership as a violation of the due process clause, arguing that the membership did not have a business situs in new york.52 the supreme court evaluated the rights to which whitney’s membership entitled him and determined that the very nature of the asset was that it was “localized” at the exchange.53 the court noted that wherever the 45. this is not to say that the concept of economic nexus does not apply to substantive jurisdiction. to the contrary, economic nexus is the heart of substantive jurisdiction. that inquiry focuses solely on the source of income without regard for presence of the income earner. economic nexus for purposes of substantive jurisdiction is thus on sound footing, so to speak. the discussion in this article therefore discusses economic nexus in the context of enforcement jurisdiction and complete auto’s substantial nexus requirement. 46. see swain, a jurisprudential and policy perspective, supra note 7, at 328–29 (stating that “the supreme court has not directly answered the question of whether mere economic presence is a sufficient ground for a state to assert its income tax jurisdiction”). state courts have pointed to many supreme court decisions to justify the adoption of economic nexus. however, for reasons discussed below, those decisions are less than definitive with respect to the scope of states’ enforcement jurisdiction. 47. see, e.g., kfc corp. v. iowa dep’t of rev., 792 n.w.2d 308, 314 (iowa 2010); kmart prop., inc. v. tax’n and rev. dep’t of n.m., 131 p.3d 27, 36 (n.m. ct. app. 2001); geoffrey, inc. v. s.c. tax comm’n, 437 s.e.2d 13, 23 (s.c. 1993). 48. 299 u.s. 366 (1937). 49. 322 u.s. 435 (1944). 50. whitney, 299 u.s. at 367. 51. id. at 370–71. 52. id. 53. id. at 372–73. 2012] economic nexus 169 owner of a membership right resides, “he must go to the exchange to exercise his privilege to trade upon its floor.”54 in turn, the court held that “the dominant attribute of relator’s membership in the new york stock exchange so links it to the situs of the exchange as to localize it at that place and hence bring it within the taxing power of new york.”55 whitney arguably provides support for an economic nexus standard under the commerce clause.56 first, the court upheld the new york income tax based solely on its analysis of the business situs of whitney’s intangible asset. that analysis rings of an economic nexus — rather than a physical presence — analysis. further, although whitney involved a due process challenge, the court’s due process standard for purposes of state taxation had not yet been lowered pursuant to quill.57 whitney may therefore signal how the court would analyze an economic nexus dispute today. despite the foregoing, whitney falls short of being dispositive on the economic nexus inquiry for many reasons. first, the decision’s singular focus on the presence of an asset in the state suggests that the court may have been focused on a quasi in rem jurisdiction theory,58 which the court later rejected.59 second, the court’s focus on a business situs analysis may indicate that, even if economic nexus is accepted, it is bound by businesssitus analyses.60 third, whitney’s membership in the new york stock exchange could be likened to an interest in a pass-through entity, which can generate a physical presence for its owners where the entity operates.61 fourth, despite the recognition above — that then-current due process analysis was similar to present-day commerce clause analysis — the decision was a due process decision. applying whitney for commerce 54. id. 55. whitney, 299 u.s. at 372–73. 56. for a discussion of those arguments, see swain, a jurisprudential and policy perspective, supra note 7, at 347–49. 57. see supra notes 26–29 and accompanying text; see also swain, a jurisprudential and policy perspective, supra note 7, at 347–49 (discussing how whitney could be instructive on this point). 58. quasi in rem jurisdiction refers to a state’s jurisdiction over a person’s property that is located in the state. see black’s law dictionary 689 (7th ed. 2000). 59. shaffer v. heitner, 433 u.s. 186, 207–12 (1977); swain, a jurisprudential and policy perspective, supra note 7, at 347–48. 60. swain, a jurisprudential and policy perspective, supra note 7, at 348. 61. id.; see also borden chems. & plastics, l.p. v. zehnder, 726 n.e.2d 73, 81 (ill. app. ct. 2000) (“certainly, the physical presence in the taxing state of the partnership that generates the income suffices as a physical presence of the nonresident partner in the state.”). 170 florida tax review [vol. 13:4 clause purposes can be problematic to the extent that the due process and commerce clauses are focused on different concerns.62 finally, whitney could have been decided on physical presence grounds. the court has repeatedly recognized that the physical presence of a taxpayer’s agents can be attributed to the taxpayer so long as the activities of the agents are “significantly associated with the taxpayer’s ability to establish and maintain a market” in the taxing state.63 in whitney, the court explicitly noted that the taxpayer’s right to trade on the market could only be exercised by a member physically present at the exchange.64 as a result, if whitney himself were not physically present in new york, to exercise his right would have required the use of an agent acting on his behalf in the state. thus, whitney appears to be as easily reconcilable with a physical presence standard — with attribution principles — as with an economic nexus standard. international harvester provides similarly mixed signals. that case involved a challenge to the imposition of a wisconsin tax on dividends paid from a corporation doing business in the state.65 two shareholder-recipients who had no personal connection to wisconsin challenged the imposition of the tax as a violation of the due process clause.66 the tax was collected by the state through a withholding obligation imposed on the corporation making the distribution.67 the appellants challenged the imposition of the tax on their dividend distributions as a violation of the due process clause because they had no 62. see supra note 31 and accompanying text. 63. tyler pipe indus., inc. v. wash. dep’t of revenue, 483 u.s. 232, 249– 50 (1987) (quoting tyler pipe indus., inc. v. wash. dep’t of revenue, 715 p.2d 123, 126 (wash. 1986)); see also scripto, inc. v. carson, 362 u.s. 207, 211–13 (1960). for a full discussion of these “agency nexus” cases, see mark cowan, tax planning versus business strategy: the rise and fall of entity isolation in sales and use taxes, 44 idaho l. rev. 63, 93–109 (2007); andrew haile, affiliate nexus in ecommerce, 33 cardozo l. rev. 1803, 1811–13 (2012); john swain, cybertaxation and the commerce clause: entity isolation or affiliate nexus, 75 s. cal. l. rev. 419, 433–35 (2002); thimmesch, the fading bright line, supra note 30, at 345–48. 64. new york ex rel. whitney v. graves, 299 u.s. 366, 373 (1937) (“wherever the owner may reside he must go to the exchange to exercise his privilege to trade upon its floor. if he prefers to have his customers’ orders executed through other members, still they must execute these orders on the exchange under its rules.”). 65. int’l harvester co. v. wis. dep’t of tax’n, 322 u.s. 435, 437–38 (1944). the wisconsin tax at issue applied to the portion of a corporation’s dividend distribution that was attributable to the corporation’s income earned in wisconsin. id. at 438. 66. id. 67. id. at 437. despite this mechanism for collecting the tax, the incidence of the tax was on the shareholders. id. 2012] economic nexus 171 connection with wisconsin, nor were the dividends declared or paid from within the state.68 the court rejected that challenge,69 noting that “[p]ersonal presence within the state of the stockholder-taxpayers is not essential to the constitutional levy of a tax taken out of so much of the corporation’s wisconsin earnings as is distributed to them.”70 the court went on to note that “[a] state may tax such part of the income of a non-resident as is fairly attributable either to property located in the state or to events or transactions which, occurring there, are subject to state regulation.”71 the international harvester court’s analysis may seem to lend credence to an economic nexus concept. the court certainly was unimpressed by the taxpayers’ lack of physical connections to the taxing state. however, several factors weigh against viewing this opinion as direct support for economic nexus under complete auto’s first prong. first, the opinion seems to focus on substantive jurisdictional grounds rather than on enforcement jurisdictional grounds.72 this is highlighted principally where the court recognizes that “[s]o long as the earnings actually arise [in wisconsin] . . . the conditions of state power to tax are satisfied . . . even though some practically effective device be necessary in order to enable the state to collect its tax.”73 the latter portion of this statement speaks directly to enforcement jurisdiction, a concern that was alleviated by the state’s use of a taxpayer with a physical presence in the state — the dividend issuer — to collect the tax.74 the court may have also inappropriately attributed the source of the corporation’s income (and its activities) directly to the shareholders — as in the case of a flow-through entity.75 that analysis would be inappropriate because it would ignore the separate legal existence of the corporation. if 68. id. at 439–40. 69. id. at 445 (“we conclude that appellants’ stockholders can have no constitutional objection to the withholding by wisconsin of a tax measured by their dividends distributed from wisconsin earnings.”). 70. id. at 441. the court also noted that “the fact that the stockholdertaxpayers never enter wisconsin and are not represented in the wisconsin legislature cannot deprive it of its jurisdiction to tax.” id. at 443. 71. id. at 441–42. 72. for a similar critique, see swain, a jurisprudential and policy perspective, supra note 7, at 350 (stating that “the opinion does not unequivocally state that wisconsin has jurisdiction over the stockholders and not merely jurisdiction over their income”). 73. int’l harvester, 322 u.s. at 443–44. 74. see hellerstein, state taxation, supra note 16, ¶ 6.04 n.66 (recognizing the questions regarding enforcement jurisdiction presented by the int’l harvester decision). 75. swain, a jurisprudential and policy perspective, supra note 7, at 350– 51. 172 florida tax review [vol. 13:4 accepted, however, such an analysis would be consistent with a physical presence standard (i.e., the shareholders would have been physically present through attribution). finally, one can limit the relevancy of international harvester to the economic nexus debate by limiting that case to its due process roots. (recall that the taxpayers in the case challenged the wisconsin tax solely on that ground.) in fact, the court nearly compels this limitation with its clear statement that its due process jurisprudence did not prohibit “unfair or burdensome taxes, merely because they are unfair or burdensome.”76 this statement is in direct conflict with the quill court’s declaration of the purpose for the commerce clause’s enforcement jurisdiction bar. as noted above, the quill court characterized the substantial nexus prong of complete auto as “limit[ing] the reach of state taxing authority so as to ensure that state taxation does not unduly burden interstate commerce.”77 the international harvester court’s express rejection of that concern undercuts an extension of that case to the substantial nexus inquiry under the commerce clause. beyond whitney and international harvester, quill itself perhaps can be viewed as supporting an economic nexus standard for purposes of state business activity taxation. the court’s opinion in quill explicitly (and repeatedly) noted that it had not adopted a physical presence rule for the purpose of evaluating impositions of taxes other than sales and use taxes.78 the court thus could be viewed as implying that an economic nexus standard suffices for those purposes. the problem with relying on this analysis, of course, is that the court did not say that the standard was proper. it only implied that it was. as this discussion evidences, the court’s nexus jurisprudence may provide some indirect support for an economic nexus standard for enforcement jurisdiction purposes, but that support falls short of being definitive on several grounds. as a result, it has fallen upon state courts and state legislatures to determine the extent to which an economic nexus satisfies complete auto’s substantial nexus prong. 76. int’l harvester, 322 u.s. at 444. 77. quill corp. v. north dakota, 504 u.s. 296, 313 (1992) (emphasis added). 78. id. at 314 (“although we have not, in our review of other types of taxes, articulated the same physical presence requirement that bellas hess established for sales and use taxes, that silence does not imply repudiation of the bellas hess rule.”); id. at 317 (“in sum, although in our cases subsequent to bellas hess and concerning other types of taxes we have not adopted a similar bright-line, physical presence requirement, our reasoning in those cases does not compel that we now reject the rule that bellas hess established in the area of sales and use taxes.”). 2012] economic nexus 173 b. economic nexus as adopted by state courts 1. state judicial acceptance of the economic nexus standard the supreme court’s lack of direction regarding economic nexus has not prevented states from adopting that standard when analyzing the imposition of state income taxes. indeed, less than a year after the quill decision, the south carolina supreme court accepted the validity of the economic nexus standard for income taxes in geoffrey, inc. v. south carolina tax commission.79 the taxpayer in this case was an out-of-state company (geoffrey) whose only connection to the state was that it licensed intellectual property to a related entity (toys-r-us) operating in the state.80 the state asserted that geoffrey was subject to the state’s tax because it earned income from the use of its intellectual property in the state under its licensing agreements with toys-r-us. geoffrey challenged the imposition of the tax as a violation of both the due process and commerce clauses. the south carolina supreme court found that neither clause was violated by the state’s imposition of tax on geoffrey. with respect to the due process clause, the court found that “geoffrey purposefully directed its activities towards south carolina,” that it had the required minimum connection with the state, and that “south carolina ha[d] conferred benefits upon geoffrey to which the challenged tax [was] rationally related.”81 turning to geoffrey’s commerce clause challenge, the court stated: “[i]t is well settled that the taxpayer need not have a tangible, physical presence in a state for income to be taxable there.”82 the court dismissed geoffrey’s argument that quill’s physical presence standard applied by use of a mere footnote, stating that the quill decision itself had “noted that the physical presence requirement had not been extended to other types of taxes [beyond sales and use taxes].”83 geoffrey petitioned the supreme court to review the case, but the court denied the request.84 geoffrey stands as the starting point for state assertions that an economic nexus standard for income taxes is permissible after quill. 79. 437 s.e.2d 13 (s.c. 1993). 80. id. at 16–17. 81. id. at 19–22. 82. id. at 23. the geoffrey court’s sole supporting citation from the supreme court was a reference to int’l harvester. id. as discussed earlier, the south carolina court’s reference is unsatisfactory for many reasons. see supra notes 65–77 and accompanying text. 83. geoffrey, 437 s.e.2d at 23 n.4. 84. geoffrey, inc. v. s.c. dep’t of rev. & tax’n, 510 u.s. 992 (1993). the geoffrey court’s limited commerce clause analysis and subsequent determination are subject to critique on several grounds. see, e.g., hellerstein, state taxation, supra note 16, ¶ 6.11[2]. 174 florida tax review [vol. 13:4 initially, however, other states were not overwhelmingly convinced that geoffrey was correct; in the next decade, many cases were decided on each side of the issue. courts in illinois,85 new mexico,86 north carolina,87 ohio,88 and washington89 agreed with the south carolina court and held that quill did not foreclose an economic nexus standard outside of sales and use tax cases. in contrast, cases in tennessee,90 texas,91 and new jersey92 held that quill prohibited the use of an economic nexus standard for state income taxes. state courts began to approve economic nexus standards with increasing regularity and unity beginning in 2005. in june 2005, a west virginia circuit court determined that mbna bank, an out-of-state credit card company, had a sufficient nexus with the state based merely upon its solicitation of, and business with, west virginia customers.93 the west virginia supreme court affirmed this decision in 2006, and the u.s. supreme court declined to review the case in 2007.94 the west virginia experience played out almost simultaneously in new jersey. in 2005, the appellate division of the new jersey superior court held that an out-of-state intangible holding company had a nexus with new jersey for income tax purposes simply based upon its receipt of royalty income from its related-party licensor in the state.95 the supreme court of 85. borden chems. & plastics v. zehnder, 726 n.e.2d 73 (ill. app. ct. 2000). 86. kmart props., inc. v. tax’n & rev. dep’t of n.m., 131 p.3d 27 (n.m. ct. app. 2001), cert. granted, 40 p.3d 1008 (n.m. 2002), cert. dismissed, aff’d in part, rev’d in part sub nom. kmart corp. v. tax’n & rev. dep’t of n.m., 131 p.3d 22 (n.m. 2005). 87. a & f trademark, inc. v. tolson, 605 s.e.2d 187 (n.c. ct. app. 2004). 88. couchot v. state lottery comm’n, 659 n.e.2d 1225 (ohio 1996), cert. denied, 519 u.s. 810 (1996). the couchot court expressed support for an economic nexus standard, but the taxpayer in that case had a physical presence in the taxing state. id. the income at issue was lottery winnings from a ticket that the taxpayer purchased and redeemed while physically present in ohio. id. at 1230–31. 89. gen. motors corp. v. city of seattle, 25 p.3d 1022 (wash. ct. app. 2001), cert. denied, 535 u.s. 1056 (2002). 90. j.c. penney nat’l bank v. johnson, 19 s.w.3d 831 (tenn. ct. app. 1999). 91. rylander v. bandag licensing corp., 18 s.w.3d 296 (tex. app. 2000). 92. lanco, inc. v. dir., div. of tax’n, 21 n.j. tax 200 (n.j. tax ct. 2003), cert. denied, 551 u.s. 1131 (2007). 93. tax commissioner of w. va. v. mbna am. bank, n.a., no. 04-aa157, (w. va. cir. ct. june 27, 2005), aff’d, 640 s.e.2d 226 (w. va. 2006). 94. tax commisioner of w. va. v. mbna am. bank, n.a., 640 s.e.2d 226, 236 (w. va. 2006), cert. denied, 551 u.s. 1141 (2007). 95. lanco, inc. v. dir., div. of tax’n, 879 a.2d 1234, 1242 (n.j. super. ct. app. div. 2005). 2012] economic nexus 175 new jersey affirmed that decision in 2006, and the u.s. supreme court declined to review the case in 2007.96 in 2005, the oklahoma court of civil appeals also held that no physical presence was required under the commerce clause for the state to impose its income tax on an out-of-state intangible-holding company.97 the new mexico supreme court followed that decision just six days later with its rejection of the extension of the physical presence rule in kmart corporation v. taxation & revenue department of new mexico, another case involving an intangible-holding company structure.98 these developments that began in 2005 have set the stage for an overwhelming state rejection of a physical presence test for purposes of state income taxes. in addition to the above-referenced decisions, cases and administrative rulings in arizona,99 florida,100 indiana,101 iowa,102 louisiana,103 massachusetts,104 missouri,105 ohio,106 and washington107 have 96. lanco, inc. v. dir., div. of taxation, 908 a.2d 176 (n.j. 2006), cert. denied, 551 u.s. 1131 (2007). the new jersey supreme court reiterated its economic nexus holding in praxair tech., inc. v. dir., div. of tax’n, 988 a.2d 92 (2009). 97. geoffrey, inc. v. okla. tax comm’n, 132 p.3d 632 (okla. civ. app. 2005) (geoffrey okla.). 98. kmart corp. v. tax’n & rev. dep’t of n.m., 131 p.3d 22, 23 (n.m. 2005). for a discussion of the unique procedural history of the kmart corp. case, see walter hellerstein, green light, red light, or blue light: new mexico supreme court sends mixed signals with kmart decision, 39 st. tax notes 141 (jan. 16, 2006). 99. decision of hearing officer, no. 200700083-c, ariz. dep’t of rev., mar. 28, 2008, http://www.azdor.gov/linkclick.aspx?fileticket=9zy8i7xzvne% d&tabid=105&mid=474. 100. fla. technical assistance advisement 07c1-007 (oct. 17, 2007), https://taxlaw.state.fl.us/wordfiles/cit%20taa%2007c1-007.doc. 101. mbna am. bank, n.a. v. ind. dep’t of state rev., 895 n.e.2d 140 (ind. t.c. 2008) (mbna ind.). 102. kfc corp. v. iowa dep’t of rev., 792 n.w.2d 308 (iowa 2010). 103. bridges v. geoffrey, inc., 984 so. 2d 115 (la. ct. app. 2008) (geoffrey la.). 104. geoffrey, inc. v. commissioner of rev., 899 n.e.2d 87 (mass. 2009), cert. denied, 129 s. ct. 2853 (2009) (geoffrey mass.); capital one bank v. commissioner of rev., 899 n.e.2d 76 (2009), cert. denied, 129 s.ct. 2827 (mass. 2009). 105. acme royalty, co. v. dir. of rev., case no. 99-2839 ri, 2002 wl 200921 (mo. admin. hearing comm’n jan. 3, 2002), rev’d on other grounds, 96 s.w.3d 72 (mo. 2002); gore enter. holdings, inc. v. dir. of rev., case no. 99-2856 ri, 2002 wl 200918 (mo. admin. hearing comm’n jan. 3, 2002), rev’d on other grounds, 96 s.w.3d 72 (mo. 2002). 106. couchot v. state lottery comm’n, 659 n.e.2d 1225 (ohio 1996). 107. lamtec corp. v. dep’t of rev., 246 p.3d 788 (wash. 2011). 176 florida tax review [vol. 13:4 all rejected the application of the physical presence test to taxes other than sales and use taxes. state revenue authorities also indicate broad acceptance of an economic nexus standard.108 in contrast, only a few state courts have held that a physical presence is required for taxes other than sales and use taxes.109 the great weight of the authority has thus rejected the application of quill outside of those taxes. as discussed below, however, states have varied greatly in their explanation of the standard that applies in the absence of a physical presence rule. 2. state judicial economic nexus formulations although state courts have readily accepted the validity of economic nexus, they have given very little attention, if any, to what economic nexus actually means.110 their decisions have focused almost exclusively on justifying the adoption of that standard and the rejection of the physical presence standard of quill.111 many of those courts have simply found that an economic nexus existed based on the particular facts presented without explaining what standard they applied. for example, in cases involving intangible-holding-company structures,112 many courts have stated only that deriving income from licensing intangible property for use in the state is sufficient to establish an economic nexus with the state.113 those cases do 108. see generally bna 2012 state tax department survey results, http://www.riacheckpoint.com (state & local tax library). 109. see, e.g., innova diagnostics, inc. v. strayhorn, 166 s.w.3d 394 (tex. app. 2005); in re wascana energy mktg. inc., dta no. 817866, 2002 wl 1726832 (n.y. div. tax app. july 18, 2002); rylander v. bandag licensing corp., 18 s.w.3d 296 (tex. app. 2000); j.c. penney nat’l bank v. johnson, 19 s.w.3d 831 (tenn. ct. app. 1999), cert. denied, 531 u.s. 927 (2000). 110. this article will take the opposite approach. while one can debate whether state-court adoptions of an economic nexus concept are on firm footing, this article is aimed at evaluating the meaning of economic nexus. for writings evaluating the former issue, see supra note 7. 111. see, e.g., mbna am. bank, n.a. v. ind. dep’t of state rev., 895 n.e.2d 140 (ind. t.c. 2008); kfc corp. v. iowa dep’t of rev., 792 n.w.2d 308, 324–28 (iowa 2010); capital one bank v. commissioner of rev., 899 n.e.2d 76, 83–86 (mass. 2009); lanco, inc. v. dir., div. of tax’n, 908 a.2d 176, 176–77 (n.j. 2006); a & f trademark, inc. v. tolson, 605 s.e.2d 187, 193–95 (n.c. ct. app. 2004); geoffrey, inc. v. okla. tax comm’n, 132 p.3d 632, 635–38 (okla. civ. app. 2005); tax commissioner of w. va. v. mbna am. bank, n.a., 640 s.e.2d 226, 230–34 (w. va. 2006). 112. for a description of the intangible holding company structure, see sheldon laskin, trademark royalties, nexus, and taxing that which enriches, 22 akron tax j. 1, 5–7 (2007) [hereinafter laskin, trademark royalties]. 113. see geoffrey, inc. v. commissioner of rev., 899 n.e.2d 87, 92 (mass. 2009) (“[s]ubstantial nexus can be established where a taxpayer domiciled in one 2012] economic nexus 177 not discuss whether the first dollar of such income created that economic nexus or whether some higher amount of income was required. one line of cases does, however, provide an actual formulation for economic nexus — a substantial economic presence standard. this standard was first adopted by the west virginia supreme court in tax commissioner of west virginia v. mbna america bank, n.a., a case addressing the taxation of mbna america bank, a delaware corporation in the principal business of issuing and servicing visa and mastercard credit cards.114 mbna solicited customers in west virginia through mail and telephone solicitations.115 during the two tax years at issue, those efforts resulted in gross receipts attributable to west virginia customers of approximately $8.4 million and $10 million.116 the west virginia tax commissioner asserted that mbna was subject to the state’s corporate income tax because it regularly engaged in business in west virginia.117 mbna challenged that assertion, arguing that the commerce clause barred the state’s imposition of tax because mbna did not have a physical presence in the state.118 the mbna w. va. court carefully evaluated national bellas hess and quill and determined that their physical presence requirement applied only to state sales and use taxes.119 the court concluded that “[r]ather than a physical presence standard . . . a significant economic presence test is a better indicator of whether substantial nexus exists for commerce clause purposes.”120 the court cited to a 1995 article as “suggesting” this test and providing its bounds: state carries on business in another state through the licensing of its intangible property that generates income from the taxpayer.”); kmart props., inc. v. n.m. tax’n & rev. dep’t, 131 p.3d 27, 36 (n.m. ct. app. 2001) (“[t]he use of kpi’s marks within new mexico’s economic market, for the purpose of generating substantial income for kpi establishes a sufficient nexus”); a & f trademark, 605 s.e.2d at 195 (“rather, we hold that under facts such as there where a wholly-owned subsidiary licenses trademarks to a related retail company operating stores located within north carolina, there exists a substantial nexus with the state sufficient to satisfy the commerce clause.”); geoffrey, inc. v. s.c. tax comm’n, 437 s.e.2d 13, 18 (s.c. 1993) (“we hold that by licensing intangibles for use in this state and deriving income from their use here, geoffrey has a ‘substantial nexus’ within south carolina.”); see also kfc, 792 n.w.2d at 328 (“we hold that, by licensing franchises within iowa, kfc has received the benefit of an orderly society within the state and, as a result, is subject to the payment of income taxes that otherwise meet the requirements of the dormant commerce clause.”). 114. mbna w. va., 640 s.e.2d at 227. 115. id. 116. id. at 227–28. 117. id. at 228. 118. id. 119. mbna w. va., 640 s.e.2d at 232. 120. id. at 234. 178 florida tax review [vol. 13:4 according to this commentator, a substantial economic presence standard incorporates due process purposeful direction towards a state while examining the degree to which a company has exploited a local market. further, a substantial economic presence analysis involves an examination of both the quality and quantity of the company’s economic presence. finally, under this test, purposeful direction towards a state is analyzed as it is for due process clause purposes and the commerce clause analysis requires the additional examination of the frequency, quantity and systematic nature of a taxpayer’s economic contacts with a state.121 the court in turn found this test “persuasive” and determined to apply it to the case at hand.122 the taxpayer raised two principled objections to the adoption of an economic nexus standard. it first argued that the court should apply a more onerous nexus standard for purposes of direct taxes (i.e., income taxes) than for purposes of indirect taxes (i.e., sales and use taxes). mbna argued that direct taxes create a greater burden on interstate commerce because they require not only administrative efforts, but they also take money directly from the corporate coffers.123 second, it argued that the adoption of a substantial nexus requirement, which does not require a physical presence, would be tantamount to adopting a due process minimum contacts standard.124 the court quickly disposed of mbna’s concerns. with respect to mbna’s “burden” argument, the court relied on the national bellas hess and quill courts’ focus on the “substantial compliance burdens attached to the collection of sales and use taxes.”125 the court then simply decided to “reject mbna’s claim that the imposition of direct taxes is a greater burden that the duty of collecting taxes.”126 this reasoning is unsatisfying. the court made no attempt to compare the burdens of sales and use tax compliance with those of state income tax compliance. perhaps the burdens of the former are more onerous 121. id. (citations omitted). 122. id. 123. id. at 234. of course, one can debate how different those are. the burden of administrative efforts can be boiled down to the costs that they impose as well. 124. mbna w. va., 640 s.e.2d at 235. 125. id. 126. id. 2012] economic nexus 179 than the latter, but the court did not undertake that analysis. instead, the court relied on the fact that the national bellas hess and quill courts focused on sales and use taxes — an unsurprising focus given the issue presented in those cases. the court’s reliance on that analysis also failed to take into account the additional burdens of actually funding those taxes. sales and use taxes are collected from a customer, whereas income taxes must be paid from the corporation’s funds. as noted above, compliance burdens are not a unique exaction. they are simply the cause for additional capital outlays. the funding of a tax thus imposes the same type of burden on taxpayers as do pure compliance costs, and that burden must be taken into account. the court addressed mbna’s concerns about the convergence of the commerce and due process inquiries with similar brevity. the court simply disagreed with mbna’s assertion and explained that the commerce clause requires “that an entity’s contacts with the taxing state be more frequent and systematic in nature” and that a taxpayer’s “exploitation of the market must be greater in degree than under the due process standard so that its economic presence can be characterized as significant or substantial.”127the court thus expressed that “although a substantial economic presence standard is by nature more elastic than the bright-line physical presence test, . . . when properly applied, a greater nexus is required under the substantial economic presence standard than under the minimum contacts analysis.”128 after a relatively brief explanation of its new economic nexus standard, the mbna w. va. court gave an equally brief application of that test. the court looked to both mbna’s activities directed at west virginia and its economic returns from those efforts. with respect to the former, the court noted that mbna had “continuously and systematically engaged in direct mail and telephone solicitation and promotion in west virginia.”129 with respect to the latter, the court focused on mbna’s derivation of revenue from west virginia customers in amounts ranging from eight to ten million dollars during the two years at issue. the court labeled those amounts “significant gross receipts.”130 in sum, the court held that mbna’s “systematic and continuous business activity in this state produced significant gross receipts attributable to its west virginia customers which indicate[d] a significant and economic presence sufficient to meet the substantial nexus prong of complete auto.”131 127. id. 128. id. 129. mbna w. va., 640 s.e.2d at 235. 130. id. at 236. 131. id. 180 florida tax review [vol. 13:4 the mbna w. va. analysis has been utilized, to one degree or another, by a variety of courts since 2006.132 in bridges v. geoffrey, inc., for example, the court of appeals of louisiana discussed the mbna w. va. case and its significant economic presence test in the context of analyzing whether quill applied to the state’s income tax.133 after determining that quill did not so apply, the court made its economic nexus determination by focusing on the taxpayer’s licensing agreements with “eight to eleven stores in louisiana” and its receipt of “significant royalty income from the use of its trademarks in th[e] state.”134 in 2009, the supreme judicial court of massachusetts gave a similar analysis in its decision in capital one bank v. commissioner of revenue.135 in the course of its examination of whether the physical presence rule applied to the state tax at issue, the court discussed the mbna w. va. court’s analysis and found it to be “persuasive.”136 the court’s limited economic nexus analysis then focused on capital one’s lending activities in the state, its solicitation and conduct of “significant” business with “hundreds of thousands of massachusetts residents,” and its receipt of “millions of dollars in income” from the state.137 the court also expressly addressed the relationship between its economic nexus standard and the due process standard, stating that “[w]hile the concept of ‘substantial nexus’ is more elastic than ‘physical presence,’ it plainly means a greater presence, both qualitatively and quantitatively, than the minimum connection between a state and a taxpayer that would satisfy a due process inquiry. simply put, the test is ‘substantial’ nexus, not ‘minimal’ nexus.”138 132. although none of those courts have explicitly adopted the mbna w. va. test, they have issued opinions that apply the same analysis. 133. bridges v. geoffrey, inc., 984 so. 2d 115, 126–27 (la. ct. app. 2008). 134. id. at 126–28. 135. 899 n.e.2d 76 (mass. 2009). 136. id. at 86. 137. id. the court also noted that the taxpayer had made use of the state’s attorney general’s office and court system. id. at 86–87. the mbna ind. court also looked to this factor in a footnote in its analysis. mbna am. bank, n.a. v. ind. dep’t of state rev., 895 n.e.2d 140, 144 n.4 (ind. t.c. 2008) (“mbna admits that during the years at issue, it had pending in indiana’s court system debt collection actions also exceeding a ‘de minimis’ number.”). 138. capital one bank, 899 n.e.2d at 86; see also kmart props., inc. v. n.m. tax’n & rev. dep’t, 131 p.3d 27, 36 (“although quill did establish that ‘substantial nexus’ under complete auto transit has more than the minimum contacts required of due process . . . we need not quantify that difference here.”). these courts’ limited discussions provide a uniform interpretation of economic nexus as a standard that is more exacting than the supreme court’s due process requirements. they fail, however, to provide any precise guidance on the quantum of difference between the two. 2012] economic nexus 181 other courts have provided similar analyses without specifically mentioning the mbna w. va. test. those courts have focused on the taxpayers’ systematic and continuous solicitation in the taxing states and their receipt of significant revenue from customers in those states without explicitly setting forth any “test.”139 those cases can be interpreted consistently with the substantial economic presence test but still provide no explicit guidance on what standard for economic nexus actually applies. the import of this discussion is that most state courts adopting the economic nexus standard have failed to provide any formulation for how that test is to be applied. additionally, those courts that have provided some formulation have adopted heightened qualitative standards that require “substantial” economic presences in their state. those standards purposefully require a market exploitation that is more significant than that required under the due process clause, but they provide little additional guidance on their boundaries. c. state economic nexus legislation state legislatures have been mindful of economic nexus, and many have enacted (or retained) legislation that imposes a business activity tax on out-of-state parties based simply on their economic contacts with the taxing state.140 that economic nexus legislation has taken both qualitative and quantitative forms. 1. qualitative economic nexus standards states legislatures have adopted a variety of qualitative economic nexus standards. those standards reflect two distinct interpretations of economic nexus. the first follows the mbna w. va. model and recognizes economic nexus as a heightened jurisdictional bar on state taxation. the second simply applies a pure substantive jurisdiction analysis, which looks only to a taxpayer’s derivation of revenue from sources within a state. new hampshire has adopted the former approach and imposes its business profits tax on every organization “carrying on any business activity 139. see, e.g., mbna ind., 895 n.e.2d at 144 (looking at the regular solicitation of business from indiana customers and the receipt of “significant gross receipts” from indiana customers); geoffrey, inc. v. commissioner of rev., 899 n.e.2d 87, 93 (mass. 2009) (focusing on the taxpayer’s extensive contacts with customers in the state and the annual royalty income that it received therefrom). 140. undoubtedly, not all of the statutes discussed below were passed with conscious thought towards the current economic nexus debate. however, as discussed herein, many of the recent statutory enactments directly incorporate standards from this debate. 182 florida tax review [vol. 13:4 within the state.”141 the term “business activity” is defined to mean “a substantial economic presence evidenced by a purposeful direction of business toward the state examined in light of the frequency, quantity, and systematic nature of a business organization’s economic contacts with the state.”142 this statute thus directly incorporates the mbna w. va. standard for economic nexus.143 the state of connecticut has adopted a similar approach. connecticut general statutes section 12–216a provides: any company that derives income from sources within this state and that has a substantial economic presence within this state, evidenced by a purposeful direction of business toward this state, examined in light of the frequency, quantity and systematic nature of a company’s economic contacts with this state, without regard to physical presence, and to the extent permitted by the constitution of the united states, shall be liable for the tax imposed under this chapter.144 this statute, like that adopted by new hampshire, adopts the heightened mbna w. va. standard for economic nexus.145 141. n.h. rev. stat. ann. §§ 77-a:1(i), 77-a:2 (2012). 142. id. § 77-a:1(xii). see also or. admin. r. 150-317.010(2) (2012) (proving that substantial nexus exists with the state “where a taxpayer regularly takes advantage of oregon’s economy to produce income for the taxpayer and may be established through the significant economic presence of a taxpayer in the state.”). 143. despite this qualitative standard, new hampshire does not require corporations to file income tax returns in the state unless their “gross business income” exceeds $50,000. n.h. rev. stat. ann. § 77-a:6(i). this return-filing threshold gives the look of a quantitative test, but it is implemented through an administrative provision rather than a nexus provision. the threshold is also significantly lower than other states’ quantitative nexus thresholds, which are discussed below. 144. see 2011 conn. pub. acts 100, § 55 (june spec. sess.). prior to this legislation, connecticut law imposed the state’s corporate income tax on companies that either derived income from the state or that had a substantial economic nexus in the state. id. under that statute, the substantial economic nexus portion of the statute was seemingly subsumed by the source prong of the state’s disjunctive statute. the apparent heightened mbna w. va. standard of the second prong was rendered irrelevant by less exacting, source-based first prong. 145. the connecticut department of revenue services supplemented the state’s qualitative economic nexus provision with an information publication indicating that a corporation will not be deemed to have an economic nexus with the state if its activities have resulted in less than $500,000 of connecticut sales during the tax year. state of connecticut department of revenue services, informational publication 2010(29.1) (dec. 28, 2010), q&a on economic nexus 2012] economic nexus 183 other state statutes rely on source principles without requiring an mbna w. va. level of contacts with their state. kentucky, for example, has defined “doing business” in the state to include “[d]eriving income from or attributable to sources within this state” and “[d]irecting activities at kentucky customers for the purpose of selling them goods or services.”146 this formulation contains both source principles (deriving income from sources in the state) and activity principles (directing activities at in-state customers). this is similar to the approach adopted in minnesota. minnesota statutes section 290.015, subdivision 1(b) provides that a business is subject to the state’s income tax “if the trade or business obtains or regularly solicits business from within this state, without regard to physical presence in this state.” this formulation contains the same two elements, imposing tax on those who (1) obtain business from the state (a source concept) or (2) regularly solicit business from the state (an activity concept). many state statutes adopt the same approach,147 while some rely solely on source concepts.148 regardless of the approach, however, these states’ standards accept that the simple derivation of revenue from a state is sufficient for the imposition of the states’ business activity taxes without an inquiry into the level of that revenue or the level of the economic contacts that created those returns.149 the foregoing qualitative economic nexus formulations provide three principal lessons. first, even among states that have adopted such standards, there is significant variation in how they are structured. second, only formulations like those adopted in connecticut and new hampshire (http://www.ct.gov/drs/lib/drs/publications/pubsip/2010/ip2010-29.1.pdf) [herein after connecticut, q&a]. although this standard appears to set up a purely quantitative standard, the publication notes that taxpayers not meeting this threshold can still be assessed tax under other nexus standards. id. 146. ky. rev. stat. ann. § 141.010(25)(f)-(g) (west 2012). of course, this statute respects p.l. 86-272, providing that “[n]othing in this subsection shall be interpreted in a manner that goes beyond the limitations imposed and protections provided by the united states constitution or pub. l. no. 86-272.” id. § 141.010(25). 147. see, e.g., ala. code § 40-18-2(a)(3) (2012); ariz. rev. stat. ann. § 43-102(a)(5) (2012); ga. code ann. § 48-7-31(a) (2012); iowa code § 422.33(1) (2012); kan. stat. ann. § 79-32, 110(c) (2012); n.j. admin. code § 18:7-1.6(a)(2) (2012); n.m. stat. ann. § 7-2a-3(a) (2012); s.c. code ann. § 12-6-530 (2012). 148. see, e.g., ind. code § 6-3-2-2(a)(5) (2012); la. rev. stat. ann. § 47:31(3) (2012); me. rev. stat. tit. 36 § 5102(6), (10) (2012); or. admin. r. § 150-318.020(2)(1) (2012); utah code ann. § 59-7-201(1) (west 2012); va. code ann. § 58.1-400 (2012). 149. a lack of case law analyzing the boundaries of these standards suggests that states have not yet attempted to exercise their taxing powers to the full extent allowed by their statutes. 184 florida tax review [vol. 13:4 attempt to provide meaningful guidance on what actions constitute an economic nexus. third, many of those formulations allow the imposition of tax based simply on source principles. 2. quantitative tests for economic nexus many states have eschewed qualitative economic nexus standards in favor of purely quantitative rules. those rules are generally based upon a 2002 model statute promulgated by the multistate tax commission.150 under that model legislation, a taxpayer has a sufficient nexus with a state if it has more than (1) $50,000 of property; (2) $50,000 of payroll; (3) $500,000 of sales; or (4) 25% of its total property, payroll, or sales in the state.151 the model statute also provides for inflation adjustments to those threshold amounts152 and provides model sourcing rules for determining the property, payroll, and sales factors.153 legislatures and revenue authorities in california,154 colorado,155 michigan,156 ohio,157 oklahoma,158 and washington159 have adopted this factor nexus concept in some form.160 the california factor nexus standard follows the mtc model formulation’s threshold amounts.161 like the mtc model, those amounts are 150. multistate tax commission, factor presence nexus standard for business activity taxes (oct. 17, 2002), http://www.mtc.gov/uploadedfiles/ multistate_tax_commission/uniformity/uniformity_projects/a_-_z/factorpresence nexusstandardbusinessacttaxes.pdf [hereinafter mtc, factor]. the mtc’s factor nexus standard is based on a proposal by economist charles mclure, jr. see mclure, implementing, supra note 10, at 1295–97. 151. mtc, factor, supra note 150, § b(1). 152. id. § b(2) (providing that the state tax administrator shall adjust those threshold amounts if the consumer price index has changed by 5 percent or more since the last adjustment”). 153. id. § c. 154. cal. rev. & tax. code § 23101(b) (west 2012). 155. 1 colo. code regs. § 201-2:39-22-301.1 (2012). 156. mich. comp. laws ann. § 206.621 (west 2012). 157. ohio rev. code. ann. § 5751.01(i) (west 2012). 158. okla. stat. tit. 68, § 1218(h)(3)–(6) (2012). 159. wash. rev. code § 82.04.067(6) (2012). 160. a number of other states have adopted quantitative nexus standards specifically for financial institutions. see hellerstein, state taxation, supra note 16, at ¶ 6.29. those statutes raise the same constitutional questions as do the broader factor nexus standards discussed herein. however, due to the limited scope of those statutes on one particular industry, they are not specifically discussed herein. note, however, that attention will need to be paid to this issue if and when congress evaluates a national nexus standard. 161. cal. rev. & tax. code § 23101(b). 2012] economic nexus 185 also to be adjusted for inflation.162 a taxpayer’s sales, property, and payroll, however, are determined under california’s general rules for apportionment rather than under specific formulas for purposes of factor nexus.163 california also deviates from the mtc model in a significant way. the california franchise tax board has recently indicated that the state’s quantitative nexus standard is not necessarily a bright-line rule for nexus in the state. rather, the board has indicated that it can find that a taxpayer has nexus with the state if that taxpayer meets the state’s factor nexus thresholds or if it “actively engages in any transaction for the purpose of financial or pecuniary gain or profit in california.”164 the ability to “opt out” of the factor nexus standard makes that standard nearly meaningless in determining the lower boundary of the state’s reach under economic nexus. the michigan corporate income tax also utilizes a factor nexus standard based on the mtc model. under this tax, a taxpayer has a substantial nexus with the state if it has a physical presence in the state for more than one day or if it actively solicits in the state and has michigan gross receipts of at least $350,000.165 the michigan statute does not include inflation adjustments or a unique provision for determining a taxpayer’s michigan gross receipts. presumably, then, the state’s general apportionment rule will apply to the factor nexus determination.166 ohio adopted the mtc’s factor nexus standard for purposes of its commercial activity tax in 2005.167 the statute differs from the mtc model by providing neither an inflation-adjustment provision nor specialized apportionment rules for purposes of the factor nexus standard. ohio law also provides an alternative rule under which a person has a substantial nexus with the state if the person “[o]therwise has nexus with the state to an extent that the person can be required to remit the tax [ ] under . . . the constitution 162. id. §§ 23101(c); 17041(h). 163. id. §§ 23101(b)(2)–(4); 25120(c), (e)–(f); 25129–25131; 25133. 164. state of california franchise tax board, general information on new rules for doing business in california, www.ftb.ca.gov/businesses/new_ rules_for_doing_business_in_california.shtml (last visited june 14, 2012) [hereinafter california, general information]. 165. mich. comp. laws ann. § 206.621 (west 2012). this standard was previously incorporated into the michigan business tax. that tax was repealed in favor of the corporate income tax on may 25, 2011. 2011 mich. pub. acts 38. for a discussion of this bill and its effect, see cara griffith, a primer on the new michigan corporate income tax, 60 st. tax notes 819 (june 13, 2011). 166. the michigan provision is less closely related to the mtc model than other states’ formulations because it includes only a sales factor and a de minimis physical presence factor. however, for purposes of this article, it is discussed with those other standards because it relies on a quantitative formulation. 167. ohio rev. code. ann. § 5751.01(i) (west 2012). 186 florida tax review [vol. 13:4 of the united states.”168 oklahoma followed that model (including reserving the state’s right to impose its tax if the taxpayer otherwise has nexus sufficient under the u.s. constitution)169 with its enactment of a business activity tax in 2010.170 the effect of the ohio and oklahoma opt-out provisions is the same as the effect of the opt-out policy adopted by the california franchise tax board. finally, washington has adopted a bifurcated approach for purposes of its business and occupations tax.171 the state applies a factor nexus concept to out-of-state entities with respect to their service and royalty income. however, taxpayers with income from retailing, wholesaling, or other classifications are still subject to a physical presence standard.172 for taxpayers engaged in activities subject to the factor nexus standard, washington has adopted the mtc levels for the property and payroll factors, but it reduced the sales threshold to $250,000 — one-half of the mtc model’s amount.173 those factors are adjusted for inflation consistent with the mtc’s model statute,174 but they are determined under the state’s general apportionment rules.175 in addition to these state legislative factor nexus standards, two states have adopted factor nexus by administrative action. first, the colorado department of revenue adopted a factor nexus standard by regulation in april of 2010.176 the colorado regulation follows the mtc model formulation’s threshold amounts and adopts the mtc’s factor calculation provisions, but it does not provide for inflation adjustments.177 connecticut revenue authorities similarly adopted factor nexus at the agency level, supplementing the state’s statutory qualitative economic nexus standard via publication. under that agency guidance, a corporation has an economic 168. id. § 5751.01(h)(4). 169. okla. stat. tit. 68, § 1218(h)(7) (2012). 170. id. § 1218(h)(3)–(6). 171. the washington business and occupations tax is a tax on the “value of products, gross proceeds of sales, or gross income of [a] business.” wash. rev. code § 82.04.220(1) (2012). 172. id. § 82.04.067(6). 173. id. § 82.04.067(1). 174. id. § 82.04.067(5). 175. id. § 82.04.067(4). 176. 33 colo. reg. 8 (april 2010), http://www.sos.state.co.us/ccr/ registerhome.do?pyear=2010. 177. 1 colo. code regs. § 201-2:39-22-301.1(2)(c) (2012). taxpayers subject to the department’s special apportionment methods calculate their nexus factors consistent with those regulations as they were defined for tax periods prior to january 1, 2009. id. § 201-2:39-22-301.1(2)(c)(iv). 2012] economic nexus 187 nexus with connecticut if its activities have resulted in at least $500,000 of connecticut sales during the tax year.178 these divergent legislative and regulatory actions show that states are keen to adopt quantitative economic nexus standards based upon the mtc model, but states are not limiting their reach to that set forth by the mtc. states have adopted widely divergent sales thresholds, many fail to provide for inflation adjustments, and some retain the right to tax businesses that do not meet their factor thresholds. iii. evaluating state economic nexus formulations the discussion above shows that significant variation exists among states’ economic nexus standards, whether in qualitative or quantitative form. the most obvious variation is among states that have insisted on “heightened” economic nexus formulations and those that have either failed to address the scope of their formulations or those that simply rely on source principles.179 evaluating the validity of source based economic nexus is straightforward180 — its validity depends on whether the commerce clause requires something more than the simple derivation of revenue from a state.181 heightened economic nexus formulations present a much different inquiry. such formulations purport to require heightened levels of connection to a state and, in doing so, attempt to avoid the more difficult constitutional question presented by economic nexus once it is accepted that physical presence is not required. those heightened formulations thus serve to lessen the need for the court to evaluate that issue and purport to provide a meaningful method for evaluating economic nexus disputes moving forward. but are those formulations likely to remain as restrictive as they are today? do they rest on foundations that will stand firm in the face of continued evaluation and pressure for more state revenue? if the answers to these questions are “no,” then states’ current heightened economic nexus formulations provide only a snapshot of what economic nexus currently 178. connecticut, q&a, supra note 145. 179. the term “heightened” in this sense refers to those economic nexus standards that require some level of economic connection to a state that is significantly higher than the minimum connections required by the due process clause or the simple derivation of revenue from a state. 180. to call the evaluation “straightforward” is not to call it “easy.” it is straightforward because it directly presents the fundamental constitutional question, not because that question is easily answered. 181. the initial step in determining the validity of those standards is thus determining whether quill compels the conclusion that the commerce clause provides a higher jurisdictional bar on business activity taxes than does the due process clause. see infra part iii.a.1. 188 florida tax review [vol. 13:4 means rather than formulations on which taxpayers can rely. significantly, they would also lack meaning in the search for a rational economic nexus standard going forward. this section thus analyzes whether and how those formulations will develop over time. a. the future of qualitative economic nexus the discussion above evidences that states’ qualitative economic nexus formulations have taken many forms, from the mbna w. va. substantial economic presence test to unarticulated standards providing no explicit bounds. it also shows that the courts that have evaluated the scope of their states’ economic nexus formulations have indicated that those formulations provide heightened jurisdictional bars that are more onerous than that provided by the due process clause. those heightened standards require taxpayers to have “significant” or “substantial” economic connections with a state.182 constitutionally adequate economic nexus under those standards can thus only be found where a taxpayer has undertaken frequent, meaningful, and systematic efforts to exploit the market of the taxing state.183 evaluation of those standards shows three fundamental weaknesses that call into question the sustainability of their heightened formulations. first, the u.s. supreme court’s commerce clause jurisprudence does not compel elevation of those commerce clause standards over the due process clause. second, established precedent shows that the concept of substantiality has very little meaning for purposes of state tax nexus analyses. third, those standards unnaturally elevate physical contacts over economic contacts. 1. the gratuitous elevation of the commerce clause over the due process clause as discussed above, state courts adopting heightened economic nexus standards have done so based on a belief that the commerce clause must restrict state power more than the due process clause restricts state power.184 each of those courts has expressed support for this belief by 182. tax commissioner of w. va. v. mbna am. bank, n.a., 640 s.e.2d 226, 235 (w. va. 2006). 183. id. at 234–35. 184. id. at 235 (“exploitation of the market [under the commerce clause] must be greater in degree than under the due process standard”); capital one bank v. commissioner of rev., 899 n.e.2d 76, 86 (mass. 2009) (stating that the concept of substantial nexus “plainly means a greater presence, both qualitatively and quantitatively, than the minimum connection between a state and a taxpayer that 2012] economic nexus 189 referencing quill and its discussion regarding the purposes and requirements of the commerce and due process clauses.185 the steadfastness of those heightened economic nexus standards thus depends on whether quill actually commands that result. it does not. prior to quill, the court had held that both the commerce and due process clauses required that a remote vendor have a physical presence in a state before the state could require the business to collect its sales or use taxes.186 the quill court, however, recognized that its general due process jurisprudence had evolved to reject the physical presence rule in favor of a minimum-contacts standard.187 the court thus agreed to “lower” its due process bar for purposes of analyzing state taxes. at the same time, the court determined to maintain its physical presence rule under the commerce clause (at least for purposes of state sales and use taxes).188 that simultaneous lowering of the due process bar and maintenance of a heightened commerce clause bar can be interpreted to mean that the commerce clause requires a “higher” jurisdictional bar than does the due process clause, and states have certainly felt limited by that construction. such a conclusion holds true, however, only as long as the commerce clause still imposes a physical presence requirement. indeed, the comparison to be made in quill is not between the commerce and due process clauses, but between the physical presence standard and the minimum contacts standard. if the commerce clause test is no longer one of physical presence (as is the case if one accepts an economic nexus standard), then that comparison is no longer relevant.189 would satisfy a due process inquiry”); kmart props., inc. v. n.m. tax’n & rev. dep’t , 131 p.3d 27, 36 (n.m. 2001) (“although quill did establish that ‘substantial nexus’ under complete auto transit has more than the minimum contacts required of due process . . . we need not quantify that difference here.”). 185. mbna w. va., 640 s.e.2d at 235 (responding to the taxpayer’s argument that an economic nexus test was “in fact [] applying a due process minimum contacts standard in violation of quill”); capital one, 899 n.e.2d at 86 (citing back to the court’s discussion of quill’s commerce clause discussion in a prior footnote); kmart props., 131 p.3d at 36 (noting that quill established that the commerce clause imposes a higher burden than the due process clause). 186. nat’l bellas hess, inc. v. dep’t of rev. of ill., 386 u.s. 753, 758 (1967). 187. quill corp. v. north dakota, 504 u.s. 298, 307 (1992). 188. id. at 311. 189. for the mathematically inclined, assume that “pp” stands for the physical presence standard, that “mc” stands for the minimum-contacts standard, that “dp” stands for the due process clause standard, and that “cc” stands for the commerce clause standard. under quill, it can be said that cc=pp and that dp=mc. it can also be said that pp>mc. it necessarily follows that cc>dp (i.e., that the commerce clause imposes a higher burden than the due process clause). however, if a state accepts the validity of economic nexus, it necessarily believes 190 florida tax review [vol. 13:4 quite simply, quill’s concomitant lowering of its due process standard and its adherence to a physical presence rule under the commerce clause does not mandate that the commerce clause always be more restrictive than the due process clause. it only does so as long as the commerce clause requires a physical presence standard. for states rejecting a physical presence rule, then, quill provides a different lesson. its only guidance is found in its discussion of the purposes for the jurisdictional requirements under the due process and commerce clauses. the quill court very clearly explained that the constitutional protections provided under those clauses are based on different concerns and policies.190 the court also explained that “a corporation may have the ‘minimum contacts’ with a taxing state as required by the due process clause, and yet lack the ‘substantial nexus’ with the state as required by the commerce clause.”191 this statement reflects that the commerce clause can impose a higher jurisdictional bar on states’ powers. however, it does not necessarily require that it do so. it also does not establish any required quantum of difference between the two or foreclose the possibility that a taxpayer could have a substantial nexus under the commerce clause without having the minimum contacts necessary for due process nexus.192 the only true lesson that one can take from quill is that the requirements under those constitutional provisions are truly “different.”193 a commerce clause inquiry must focus on the structural impacts of the state tax at issue, and a due process inquiry must focus on fairness to the individual taxpayer. this does not necessarily compel a heightened economic nexus standard, and courts’ reliance on quill to justify such standards is thus unwarranted. states’ heightened economic nexus formulations thus have great latent structural that cc ≠ pp. as a consequence, it does not follow that cc must necessarily be greater than dp. 190. quill, 504 u.s. at 312 (“despite the similarity in phrasing, the nexus requirements of the due process and commerce clauses are not identical. the two standards are animated by different constitutional concerns and policies.”). 191. id. at 313. 192. assume, for example, a customer from state a travels to state b and makes a significant purchase from b corp. b corp operates only in state b, limits its advertising to mailed advertisements within state b, and sends no personnel outside of the state. if state a sources b corp’s income from the customer to state a (because state a was the ultimate destination of the goods), b corp could be subject to state a’s income tax under an economic nexus standard. however, it is very likely that b corp would lack the minimum contacts necessary to be subject to state a’s tax under the due process clause. 193. see swain, a jurisprudential and policy perspective, supra note 7, at 372. 2012] economic nexus 191 weakness. if those standards are challenged as unduly restrictive, it is unlikely that quill will compel their preservation.194 2. the insignificance of substantiality just as the prior analysis shows a jurisprudential weakness in the foundation of states’ heightened economic nexus standards, current case law under the physical presence test shows a weakness in the principles used to frame those standards. those standards have relied on formulations that require “substantial” or “significant” economic presences. courts adopting those standards thus presume that those adjectives provide meaningful limitations on state power. current nexus jurisprudence proves that to be untrue. as previously discussed, the very basic standard under which commerce clause nexus disputes are evaluated is the complete auto standard, which requires that a taxpayer have a “substantial” nexus in a state.195 consequently, courts evaluating nexus disputes in sales tax cases have extensively evaluated the concept of substantiality. those courts have been forced to determine how much of a physical presence is required to meet complete auto’s substantial nexus test.196 the courts’ decisions in those cases establish that the “substantial” qualifier is substantial only in name. the most direct guidance from the court on this question came in its decision in national geographic society v. california board of equalization.197 as discussed above,198 this case involved the question of 194. of course, quill continues to compel a physical presence rule for sales and use taxes until the court or congress provides otherwise. 195. complete auto transit, inc. v. brady, 430 u.s. 274, 279 (1977). 196. see hellerstein, state taxation, supra note 16, ¶ 19.02[4]. this continued debate has led some to question whether the quill court’s bright-line test achieved its goal of reducing litigation. laskin, trademark royalties, supra note 112, at 11 n.46. that critique, however, focuses on the area of continued debate rather than recognizing the certainty that quill did provide. quill did provide certainty and eliminate litigation for taxpayers with only an economic nexus in a state (for purposes of sales and use taxes). to ignore that benefit is akin to ignoring the number of fatalities that seat belts have prevented by focusing on the remaining number of traffic deaths. as the michigan court of appeals aptly stated, “the ‘bright-line’ rule of quill does not cut as cleanly on both sides. it definitively answers the question who cannot be taxed . . . but leaves somewhat open the question who may be taxed.” magnetek controls, inc. v. rev. div., dep’t of treasury, 562 n.w.2d 219, 222 n.5 (mich. ct. app. 1997). 197. nat’l geographic soc’y v. cal. bd. of equalization, 430 u.s. 551 (1977). as noted previously, the court issued that decision only three weeks after complete auto. 192 florida tax review [vol. 13:4 whether the national geographic society could be required to collect california sales and use tax where its only physical presence in california was its maintenance of two offices in the state.199 the california supreme court upheld the imposition of that obligation on national geographic, adopting a “slightest presence” test.200 the supreme court rejected california’s slightest presence test, but did not opine as to the proper level of contacts required. rather, the court simply noted that national geographic’s actions in the state201 established “much more substantial presence than the expression ‘slightest presence’ connotes”202 and held that “the society’s continuous presence in california in offices that solicit advertising for its magazine provides a sufficient nexus to justify” the state’s imposition of tax.203 the national geographic court thus provided only minimal guidance on the magnitude of physical presence required under complete auto. in the absence of further guidance from the court, a number of states have interpreted its rejection of the slightest presence test to mean that a taxpayer’s physical presence in a state must be only somewhat greater than a slightest presence.204 the seminal case in this regard is in re orvis company inc. v. new york.205 the orvis court first determined that the substantial 198. see supra notes 20–23 and accompanying text. 199. nat’l geographic, 430 u.s. at 552–54. 200. id. at 555–56. the california court noted that “the slightest presence within such taxing state . . . will permit the state constitutionally to impose on the seller the duty of collecting the use tax from such mail order purchasers and the liability for failure to do so.” nat’l geographic soc’y v. state bd. of equalization, 547 p.2d 458, 462 (cal. 1976). 201. national geographic’s physical presence in california consisted of the “maintenance of two offices in the state and solicitation by employees assigned to those offices of advertising copy in the range of $1 million annually.” nat’l geographic, 430 u.s. at 556. 202. id. interestingly, the court supported its conclusion in part by pointing to its earlier decision in standard pressed steel co. v. wash. department of revenue, 419 u.s. 560 (1975), in which it upheld the imposition of a direct tax on a taxpayer that had only a single employee in the taxing state. nat’l geographic, 430 u.s. at 557. the court found it “significant” that it had labeled the taxpayer’s nexus argument in that case “frivolous.” id. 203. nat’l geographic, 430 u.s. at 562. 204. orvis co. v. tax appeals tribunal of n.y. (in re orvis co.), 654 n.e.2d 954 (n.y. 1995); magnetek controls, inc. v. rev. div., dep’t of treasury, 562 n.w.2d 219, 224 (mich. ct. app. 1997); wash. rev. code § 82.04.067(6) (2012). 205. 654 n.e.2d 954. orvis involved two cases that were consolidated on appeal from the new york appellate division. in the first — in re orvis co. — the taxpayer’s physical presence in the state was limited to visits to as many as nineteen customers on average of four times a year. id. at 962. in the other — in re vt. 2012] economic nexus 193 nexus requirement of complete auto did not require a taxpayer to have a substantial physical presence in the taxing state.206 instead, the court stated that the taxpayer’s presence need only “be demonstrably more than a ‘slightest presence.’”207 the court then determined that the taxpayers’ visits to nineteen customers four times per year and forty-one in-state visits over a three-year period, respectively, satisfied that standard.208the orvis court’s distillation of national geographic down to a standard that requires only more than a slightest presence has been adopted by a number of other states.209 the quantum of physical presence required to establish a substantial nexus under current law is thus fairly minimal — and certainly falls short of anything systematic or continual. this discussion is not intended to intimate that states find a substantial nexus in each case where a taxpayer has any repeated or sustained physical presence in a state.210 however, it does show that states do not feel informational processing, inc. — the taxpayer had visited customers’ locations in the state forty-one times during the three-year audit period. id. 206. id. at 959 (“quill simply cannot be read as equating a substantial physical presence of the vendor in the taxing state with the substantial nexus prong of the complete auto test . . . .”). 207. id. at 960–61. 208. id. at 961–62. cf. in re petition of nada servs. corp., no. 810592, 1996 wl 54197, *15 (n.y. div. tax app. feb. 1, 1996) (holding that the slightest presence test was not met where the taxpayer’s connection with the state consisted of twenty trips into new york and an unspecified number of trips in the state by independent contractors over the three-year audit period). 209. see, e.g., wash. rev. code § 82.04.067(6) (2012) (“a person is deemed to have a substantial nexus with this state if the person has a physical presence in this state, which need only be demonstrably more than a slightest presence”); brown’s furniture, inc. v. wagner, 665 n.e.2d 795, 803 (ill. 1996) (holding that the taxpayer had “established more than a slight physical presence within the [s]tate”); magnetek controls, 562 n.w.2d at 224 (“tax obligations may be imposed, consistent with the commerce clause, on taxpayers with ‘demonstrably more than a ‘slightest presence’’ in a state’); comptroller of maryland, nexus information for sales and use tax, http://business.marylandtaxes.com/taxinfo/sales anduse/nexus.asp (last visited oct. 5, 2012) (“all that is required is for the out-ofstate vendor to demonstrate more than a ‘slightest presence’ in the taxing state.”); state of tennessee office of the attorney general, opinion 09-101, (may 28, 2009), http://www.tn.gov/attorneygeneral/op/2009/op/op101.pdf (“by contrast, the commerce clause’s ‘substantial nexus’ prong requires something more than the ‘slightest presence’ in the taxing jurisdiction.”). 210. for example, the kansas supreme court has held that the imposition of the state’s use tax against an out-of-state vendor was not permissible based upon the vendor’s eleven visits into the state over a forty-eight-month audit period. in re appeal of intercard, inc., 14 p.3d 1111, 1113, 1122–23 (kan. 2000). the florida supreme court came to the same conclusion where the taxpayer was present in the state only three days a year. dep’t of rev. of fla. v. share int’l, inc., 676 so. 2d 194 florida tax review [vol. 13:4 bound to require an extensive exploitation of a state simply because the relevant standard incorporates the adjective “substantial.” rather, once a physical presence of more than a slightest amount is established, a taxpayer is generally found to be subject to the state’s taxing authority. the concept of substantiality simply has very little meaning under current nexus jurisprudence.211 the totality of this authority calls into question the intractability of the substantial economic presence test. just as relatively minimal levels of physical presence in a state appear to satisfy the substantial nexus requirement, it seems likely that increasingly lower levels of economic presence could satisfy the substantial economic presence test.212 this conclusion is certainly supported by looking at the very authority that states and commentators cite as support for an economic nexus standard. recall that in international harvester, the taxpayers simply invested in a corporation that engaged in business in the taxing state. the court’s decision to uphold the tax in that case rested solely on the fact that the taxpayers derived income from wisconsin, not on any showing of a heightened 1362 (fla. 1996), cert. denied, 519 u.s. 1056 (1997); cf. lamtec corp. v. dep’t of rev., 246 p.3d 788, 790, 795 (wash. 2011) (upholding the imposition of tax based on fifty to seventy in-state visits over the course of seven years); ariz. dep’t of rev. v. care computer sys., inc., 4 p.3d 469, 471–72, 474–75 (ariz. 2000) (upholding the state’s imposition of tax on an out-of-state vendor whose sales personnel visited the state seven times and whose training personnel visited the state for eighty days during the seven year audit period); mich. comp. laws ann. § 206.621 (west 2012) (imposing the state’s income tax on corporations that are physically present in the state for more than one day). for a detailed discussion of these cases and others, see hellerstein, state taxation, supra note 16, ¶ 19.02[4]. 211. to be fair, the mbna w. va. economic nexus formulation does purport to require frequent or systematic economic contacts with a state. one could thus claim that substantial economic nexus is not subject to the same erosion as the physical presence standard. the answer to this claim is two-fold. first, not all heightened qualitative economic nexus standards contain these further qualifiers. second, the terms “frequent” and “systematic” are not unlike the term “substantial” in that they do not have independent meaning. they must be measured against something. in that way, they are subject to the same pressures as the “substantial” qualifier of complete auto’s substantial nexus test. 212. see supra notes 65–74 and accompanying text. of course, this discussion assumes that one can quantify and attribute economic contacts in the same way that one can quantify and attribute a taxpayer’s physical contacts. this type of inquiry may not be appropriate when discussing nexus in the context of electronic commerce. see walter hellerstein, state and local taxation of electronic commerce: reflections on the emerging issues, 52 u. miami l. rev. 691, 694–95, 701–702 (1998) (arguing that attempting to assign economic contacts to a particular jurisdiction “makes little sense in cyberspace” and presents questions “not worth answering”). 2012] economic nexus 195 economic nexus. thus, if that case is relevant to an enforcement jurisdiction analysis, it significantly undercuts the significance of substantiality as a requirement for economic nexus.213 3. the arbitrary elevation of physical presence over economic presence heightened economic nexus standards purport to require taxpayers to have much more meaningful economic contacts with a state than the physical contacts that are required to establish a substantial nexus under orvis. those standards therefore necessarily ascribe more constitutional significance to physical contacts than to economic contacts,214 and their legitimacy — from a theoretical perspective — rests on whether that elevation of physical contacts is warranted. answering that question is a short task. elevating physical contacts in that way would cut at the core of the rationale for an economic nexus standard as a matter of first import. the economic nexus standard is based in large part on states’ recognitions of the great technological and social changes that have made economic exploitation the equal sister of physical exploitation in the modern economy. the emergence of the internet, for example, has largely obviated the need for businesses in many industries to have physical storefronts. in addition, other businesses have developed solely in the digital realm — cloud computing or online-dating services for instance. it is now possible for a business to exploit a remote market more comprehensively with electronic methods than it can with a local physical presence. for example, would anyone argue that a shoe manufacturer in north carolina could exploit the california market more fully as a transient vendor on a street corner in berkeley than by setting up an internet storefront and sending repeated e-mail solicitations to california customers? certainly not. a heightened standard for economic exploitation simply does not comport with this economic reality. 213. the preceding analysis of the insignificance of substantiality has been intended to show that states’ limitations of economic nexus can effectively change without requiring changes to their current formulations — that is, that current formulations do not necessarily require a heightened economic nexus standard. it is a separate issue, however, to consider whether those standards will change. will states push those standards ever lower? will they seek to expand their power in that way? this issue is discussed below. 214. michigan compiled laws § 206.621(1) clearly demonstrates this in the context of a heightened quantitative standard. that statute imposes tax on businesses that have gross receipts of $350,000 or more sourced to michigan or that have a physical presence in the state for a period of only more than one day. the significance of one day of physical presence over hundreds of thousands of dollars of gross receipts is remarkable. 196 florida tax review [vol. 13:4 a different standard for economic and physical presence would simply ignore the vast diversity of economic “experiences” that can occur in the modern economy. a physical presence can range from an unintended frolic across state lines in a company vehicle to the operation of multiple physical storefronts. similarly, an economic presence can range from an undirected electronic communication to a significant portfolio of long-term licensing agreements with multiple businesses in a state. the constitutional protection afforded to taxpayers under the commerce clause cannot rest on a distinction as meaningless as whether they physically or economically exploit their markets. rather, the quantity and quality of contacts must govern. of course, this equivalization of physical and economic presences conflicts with the court’s personal jurisdiction jurisprudence, which does elevate physical presences over other presences to a certain extent.215 under that jurisprudence, a taxpayer that does not have a physical presence in a state needs to otherwise have “minimum contacts” with that state to be subject to its jurisdiction. the court thus holds out physical presences as different, more meaningful, than other presences in that context. why then can we limit the import of physical presences for purposes of a commerce clause analysis? why can we be comfortable equating physical and economic contacts in that realm? the answer is twofold. first, different purposes underlie the court’s due process and commerce clause standards.216 due process is concerned with fairness and notice whereas the commerce clause is concerned about economic factors — here, the impact of a state’s nexus standard on interstate commerce.217 thus, although physical presences are given some weight for purposes of personal jurisdiction, that factor alone is not sufficient to conclude that they should have the same relevancy under the commerce clause. the importance of physical presences for that purpose depends on the extent to which they impact the burdens of state taxation. only if they lessen those burdens (as they lessen our concerns about fairness and notice for personal jurisdiction inquiries) should they have weight in the relevant commerce clause standard. a quick analysis shows that physical presences do not lessen taxcompliance burdens such that they should be given weight for commerce clause purposes. fundamentally, if an out-of-state business’s costs of 215. int’l shoe co. v. washington, 326 u.s. 310, 316 (1945) (“due process requires only that in order to subject a defendant to a judgment in personam, if he be not present within the territory of the forum, he have certain minimum contacts with it such that the maintenance of the suit does not offend ‘traditional notions of fair play and substantial justice’”). 216. see supra note 31 and accompanying text. 217. see supra note 31 and accompanying text. 2012] economic nexus 197 compliance with a state’s income tax laws are $x, how would those costs be less than $x if the business decided to have an employee attend a conference in the state or to retain title to inventory in the state? the business’s burdens of compliance would be unrelated to those minimal physical connections. rather, the burdens of the state’s tax system would be related to the rate of the state’s tax, the clarity and complexity of its reporting rules, the corporate structure of the taxpayer, and the taxpayer’s economic returns from the state. the taxpayer’s physical presence in the state would play no role in those costs. 218 for these reasons, physical presences should have a lesser role (if any) for purposes of the commerce clause than they do for purposes of analyzing personal jurisdiction. of course, to say that physical presences should play a lesser role for commerce clause purposes than for purposes of analyzing personal jurisdiction leaves them with little worth. the court’s personal jurisdiction standard already reflects little reverence for physical presences. the standard against which physical presences are measured is only one of “minimum” contacts. thus, physical presences are only afforded more weight than economic contacts that are something less than minimum. that is not saying much. if we start with that limited elevation of physical presences and discount it further by the relative lack of importance of physical presences for commerce clause purposes, it is easy to justify putting physical presences and economic presences on the same plane, as suggested above.219 once that occurs, orvis and its kin have considerable meaning when evaluating states’ promises of heightened economic nexus. just as a taxpayer’s limited, but repeated physical presence in a state creates substantial nexus under the physical presence standard, so too will limited, but repeated economic exploitations likely create a substantial nexus under an economic nexus standard. there is simply no theoretical (or, as discussed above, jurisprudential) basis under which economic exploitation should be held to a meaningfully higher standard than physical exploitation.220 218. it could be argued that a physical presence would actually increase those costs rather than decrease them. that would occur because the business’s physical presence could generate an in-state property or payroll factor, which could increase the taxpayer’s return-preparation difficulty and level of tax owed. of course, these impacts suggest that out-of-state businesses may be more burdened if it has a minimal physical presence than if it has none. 219. one could go even further and argue that perhaps physical presence alone is insufficient under the commerce clause, but that goes beyond the bounds of this article. 220. of course, it is much more difficult to accidentally find oneself physically present in a jurisdiction than economically present. however, a critique based on that rationale would speak more towards fairness concerns than it does to the difference between the quality of economic and physical contacts. that fairness concern would properly be analyzed under the due process clause. 198 florida tax review [vol. 13:4 4. summary the analysis above shows that states’ heightened qualitative economic nexus formulations are not compelled by the court’s commerce clause jurisprudence, that the actual language of those formulations provides only limited practical limitations on states’ applications of those formulations, and that there is no theoretical basis for those formulations’ elevation of physical presence over economic presence. what, then, will actually happen to those standards? will they necessarily weaken over time? of course, none of us can know the future. nonetheless, a few factors indicate that states’ expansion of their power is most likely. first, states have an obvious interest in expanding their taxing power to the greatest extent possible. broad economic nexus standards would give states the flexibility to deal with new situations (or, perhaps more directly to the point, abusive tax structures) as they arise even if, as a matter of policy, states do not fully exercise their self-defined power. second, and more fundamentally, states have little real reason to deny themselves that power. as shown above, there is little jurisprudential or theoretical basis for a restrictive economic nexus standard. the only reason for state restraint would be to avoid unintentionally inviting the supreme court to the party. however, given the supreme court’s general lack of interest in reviewing nexus disputes (and given states’ confidence in their power under the dormant commerce clause), assuming restraint on this basis is suspect. to the contrary, states may wish to push the boundaries precisely to get the supreme court to look at the issue — and to support economic nexus directly. the one potential obstacle to an expanded economic nexus standard, then, would appear to be state courts. will state courts reject attempts by state legislatures and revenue authorities to expand economic nexus? even if they felt so inclined, the analysis offered above suggests that state courts will have limited bases on which to require heightened economic nexus standards. unless a physical presence rule is required, there is little jurisprudential basis for limiting economic nexus in that way. it is thus difficult to imagine that states’ qualitative economic nexus formulations will not deteriorate over time. b. the future of quantitative factor nexus in lieu of the qualitative standards discussed above, a number of state legislatures and revenue departments have adopted quantitative factor nexus rules consistent with the mtc model formulation.221 those rules 221. see supra part ii.c.2. 2012] economic nexus 199 provide much needed certainty for taxpayers doing nexus analyses,222 and they provide significant administrative benefits.223 unfortunately, however, state factor nexus formulations are inherently arbitrary and hence exceptionally malleable. three forms of flexibility224 prevent those standards from being suitable forms for economic nexus going forward: (1) magnitude flexibility; (2) definitional flexibility; and (3) application flexibility. 1. magnitude flexibility factor nexus operates by exempting from tax those businesses that do not exceed prescribed minimal levels of property, payroll, or sales in a state. the determination of the magnitude of those levels is thus of the utmost importance to both businesses and state revenue authorities. unfortunately, however, the levels at which those thresholds are set is ultimately arbitrary. nexus under the commerce clause has never been recognized as a purely quantitative inquiry. thus, a state need only set its threshold amounts high enough to effectively eliminate any unreasonable risk that taxpayers will exceed them without having expended constitutionally significant efforts to exploit its market.225 there is nothing that requires states to act uniformly. indeed, significant variation already exists among the states that have adopted factor nexus standards. as noted above, the mtc model sets the sales factor threshold at $500,000.226 many states have also adopted that threshold, but not all states have been uniform. michigan has adopted a sales threshold that is $350,000 222. but see supra notes 165 and 170 and accompanying text (discussing two states’ provisions allowing them to opt out of their factor nexus provisions). 223. the standard also loosens the physical presence standard by allowing certain levels of property and payroll in the state without requiring the taxpayer to pay tax in that state. 224. although flexibility is sometimes viewed as a valuable trait, it is not favorable in this context. flexibility undermines the value of a factor nexus standard as providing certain, uniform, bright-line guidance. 225. in proposing a factor nexus standard, professor mclure was very deliberate in noting that his standard would require “significant amounts” of activity in the taxing state. mclure, implementing, supra note 10, at 1295–96 (“the repetition of the words ‘significant amounts’ in the previous paragraph is intended to prevent a finding of nexus where the economic activities of the corporation that could create nexus are de minimis.”). there is not universal agreement that all states’ factor nexus thresholds are currently set high enough. see steven roll, states take contrasting approaches to implementing economic nexus standards, state tax blog http://www.bna.com/blogs_post.aspx?id=2147484887&blogid=97 (last visited may 18, 2012) (noting that fred nicely, tax counsel for the committee on state taxation had expressed that washington’s $250,000 threshold was impermissibly low). 226. see mtc, factor, supra note 150. 200 florida tax review [vol. 13:4 — only 70 percent of the mtc model.227 the sales threshold in washington is even lower, at one-half of the mtc model — $250,000.228 this disparate practice is the result of using dollar values as a proxy for a real constitutional standard. until a constitutional boundary is established, states will likely continue to adopt lower standards.229 further, states that have already adopted threshold amounts will be free to lower them. magnitude flexibility will almost certainly lead to magnitude erosion over time. another less apparent way for factor thresholds to differ or erode over time is through the use or nonuse of inflation adjustments. the mtc model requires annual review and potential inflation adjustment of the factors,230 and california and washington have adopted that rule. other states have not been uniform. as shown above, colorado, connecticut, michigan, ohio, and oklahoma do not require inflation adjustments.231 a necessary consequence of this lack of uniformity is that states’ thresholds can vary from one another over time even if they were enacted at the same level. 2. definitional flexibility definitional flexibility refers to the fact that the determination of a taxpayer’s factors is purely a matter of legislative (or perhaps administrative) discretion.232 this manifests itself more clearly with respect to a taxpayer’s sales factor than its property or payroll factors because attributing property or payroll to a state is generally self-evident. the sourcing of sales is much 227. mich. comp. laws. ann. § 206.621 (west 2012). 228. wash. rev. code § 82.04.067 (2012). 229. this again assumes that states will utilize the current uncertainty regarding the bounds of economic nexus to lower their standards over time. it appears most reasonable to assume that states will seek to expand their taxing power as far as possible. of course, this begs the question of why states have not already done so. the answer is two-fold. first, states have wisely chosen to litigate economic nexus disputes that involve taxpayers with very significant income from their states (and hence large potential tax liabilities). this has allowed state courts to adopt standards to meet those limited facts. second, economic nexus is still in its relative infancy. states have been focused on obtaining widespread acceptance of that standard in the abstract. states thus have been justifiably cautious with their economic nexus standards to date. as the concept is more readily accepted, it seems safe to assume that the aforementioned expansion will begin. 230. mtc, factor, supra note 150, § b(2). 231. see supra notes 166–179 and accompanying text. 232. see charles e. mclure, jr. & walter hellerstein, congressional intervention in state taxation: a normative analysis of three proposals, 31 st. tax notes 721, 733 (mar. 1, 2004) [hereinafter mclure & hellerstein, congressional intervention] (noting that the “choice of apportionment formulas . . . and the definition of each of the factors are, to some extent, arbitrary”). 2012] economic nexus 201 more problematic. the revenue from a single sale of a service, for example, can be attributed to several states. assume that a lawyer in new york receives a call from an illinois client that has a legal question related to a patent used in its manufacturing process in its georgia facility. the lawyer undertakes her legal research in her new york office and calls the client in illinois with her advice. the client immediately calls the facility manager in georgia to implement the advice and eagerly awaits the lawyer’s bill. the income that the lawyer receives from the client could be fairly sourced to at least three states: the state where the work was performed (new york), the state where the client received the advice and the bill for the lawyer’s services (illinois), or the state where the advice was ultimately used (georgia). the sourcing of those receipts will depend on how the state legislatures or revenue authorities determine to define their sales factors.233 as a result, unless states adopt the same methods for calculating taxpayers’ factors, wide variations can exist regarding how those factors are calculated from state to state. this concern is not merely academic. as shown above in part ii.c.2, the mtc has issued model attribution rules, but states adopting a factor nexus standard have not uniformly adopted them. sales factors can also be manipulated due to concerns other than properly sourcing income. for example, significant attention has been paid to the potential for “nowhere” income that results from the apportionment of sales to states in which a business is not subject to tax —either due to jurisdictional reasons or because the state does not impose a corporate income tax.234 states have responded to this concern by adopting throwout and throwback rules to further the goal that all of a taxpayer’s income be subject to tax somewhere. apportionment formulae thus represent not only a method for properly attributing income to its source state, but also a method 233. for recent discussions of the sourcing of services income, see cara griffith, using market-based sourcing for service receipts: the difficulties, 56 st. tax notes 387 (may 3, 2010); giles sutton, jaime yesnowitz, chuck jones & terry f. conley, the nuances of market-based sourcing of service revenue: not all markets look the same, 21 j. multistate tax’n & incentives 2, 6 (may 2011); john a. swain & walter hellerstein, the market state approach to the attribution of receipts from services, 59 st. tax notes 331 (jan. 31, 2011). of course, the same issue can arise with respect to the sale of goods. sales of goods can be attributed to the state where the items are sold, shipped, or put to use. 234. hellerstein, state taxation, supra note 16, ¶ 9.18[1][b]; institute on taxation and economic policy, ‘nowhere income” and the throwback rule (aug. 2011), www.itepnet.org/pdf/pb39throw.pdf; michal mazerov, closing three common corporate income tax loopholes could raise additional revenue for many states, (may 23, 2003), http://www.union1.org/oip/pdf%20files/ economics/three%20loopholes.pdf. 202 florida tax review [vol. 13:4 for ensuring that all of a taxpayer’s income is subject to tax by at least one state. under a throwback rule for example, a taxpayer’s sales are added back to their sales factor numerator235 in a state if (1) the taxpayer is not subject to tax in the state to which the sale would otherwise be sourced and (2) the item sold originates from the taxing state.236 the effect of a throwback rule is that the taxpayer’s sales are attributed to the state from which the goods were shipped, rather than the state in which the taxpayer’s customer consumes the goods. the rule thus ensures that “mismatches” between states’ overall substantive jurisdiction and their enforcement jurisdiction do not arise.237 it does not, however, reflect an increase in the origination state’s enforcement jurisdiction. throwback rules thus take on an uneasy tone when pulled into the enforcement jurisdiction inquiry. the purpose of factor nexus is not to ensure that a taxpayer’s income is subject to tax somewhere, but rather to determine when a taxpayer’s connection to a particular state is sufficient to meet the demands of the commerce clause. a throwback rule is thus unsuited to an economic nexus analysis. throwing back sales for purposes of a factor nexus inquiry would improperly source sales to a state based not upon a taxpayer’s actions with respect to that state, but with respect to another state’s jurisdiction to tax. that focus is inappropriate when attempting to determine the scope of a state’s enforcement jurisdiction. 235. a taxpayer’s sales factor numerator represents its sales that are attributable (under the states’ particular rules) to the taxing state. state corporate income taxes make use of apportionment formulae to properly allocate income among the states in which a taxpayer does business. historically, states have used three factors (the property factor, the payroll factor, and the sales factor) to develop an overall apportionment formula that is applied to the taxpayer’s apportionable income. see hellerstein, state taxation, supra note 16, ¶ 8.05–8.06. 236. for a detailed discussion of throwback rules, see hellerstein, state taxation, supra note 16, ¶ 9.18[1][b]. the throwback rule is a component of the uniform division of income for tax purposes act (“uditpa”), a model income tax act drafted by the national conference of commissioners on uniform state laws. unif. div. of income for tax purposes act (1957). the udipta throwback rule provides that “[s]ales of tangible personal property are in this state if . . . the property is shipped from an office, store, warehouse, factory, or other place of storage in this state and (1) the purchaser is the united states government or (2) the taxpayer is not taxable in the state of the purchaser.” id. § 16(b). a taxpayer is deemed to be taxable in the state of the purchaser if the taxpayer is either “subject to a net income tax, a franchise tax measured by net income, a franchise tax for the privilege of doing business, or a corporate stock tax” in that state or “that state has jurisdiction to subject the taxpayer to a net income tax regardless of whether, in fact, the state does or does not.” id. § 3. 237. see william j. pierce, the uniform division of income for state tax purposes, 35 taxes 747, 747–51 (1957). 2012] economic nexus 203 a throwback rule is only one example of how a taxpayer’s factors can be manipulated238 to reflect aspects of its business operations other than its connection with a particular state.239 because the factors are ultimately subject to state legislative control, factor definitions can be shaped and changed in myriad ways.240 that definitional flexibility calls into question the ability of state quantitative economic nexus standards to provide uniform or consistent guidance to taxpayers regarding their multi-state taxcompliance obligations. 3. application flexibility the final weakness of current factor nexus standards is that nothing prevents states from adopting opt-out provisions like those enacted by the ohio and oklahoma legislatures and by the california franchise tax board. as discussed above, the ohio factor nexus provision provides an alternative rule under which a person has a substantial nexus with the state if the person “[o]therwise has nexus with the state to an extent that the person can be required to remit the tax [ ] under the constitution of the united states.”241 oklahoma law similarly allows the state to impose its tax on a business that “[o]therwise has nexus with this state to an extent that the person can be required to remit the tax imposed under this act under the constitution of the united states.”242 the california franchise tax board has also indicated that it can assert nexus over a taxpayer if that taxpayer actively engages in 238. “manipulated” is not used in a pejorative sense. rather, it merely refers to the fact that states can change (or customize) their factors to take into account elements perhaps not previously contemplated or that cause the standard factor formulation to produce results that were not desired or anticipated. 239. although the mtc formulation for calculating a taxpayer’s sales for purposes of its factor nexus standard does not include a throwback rule, as show above in part ii.c.2, states have often relied upon their general apportionment provisions rather than the mtc’s formulation. most states’ general apportionment provisions contain throwback rules. see hellerstein, state taxation, supra note 16, at ¶ 9.18[1][b][i]. 240. the mtc’s model regulations to the uditpa include both a provision allowing the use of alternative apportionment formulas “where the apportionment an allocation provisions contained in article iv produce incongruous results” and special rules that modify the normal apportionment rules in specific situations. see multistate tax comm’n, allocation and apportionment regulations §§ iv.18(a)-(c) (2010), http://www.mtc.gov/uploadedfiles/multistate_tax_commission/uniformity/ uniformity_projects/a_-_z/allocaitonandapportionmentreg.pdf. states have followed suit by adopting special apportionment rules. see, e.g., cal. rev. & tax code § 25137 (west 2012); ga. comp. r. & regs. § 560-7-7-.03(5)(e) (2012); ill. admin. code tit. 86, § 100.3380(c) (2012). 241. ohio rev. code. ann. § 5751.01(h)(4) (west 2012). 242. okla. stat. tit. 68 § 1218(h)(7) (2012). 204 florida tax review [vol. 13:4 business transactions for profit in the state, regardless of whether those activities meet the state’s factor nexus thresholds.243 these economic nexus “safety valves” undercut any potential for state-adopted factor nexus to provide uniformity or certainty. a taxpayer that does not meet a state’s prescribed thresholds must still consider whether the state could argue that it has nexus under some non-defined, qualitative nexus standard. application flexibility thus completely undermines the administrative and commercial benefits of factor nexus and is perhaps the most damning type of flexibility for state-adopted factor nexus. if factor nexus is to be accepted as an administrative proxy for economic nexus, states (just as taxpayers) should be bound to their choice. 4. summary the sum of this discussion evidences that factor nexus (in its current form) does not provide any assurance of a consistent, uniform economic nexus standard. that approach to economic nexus certainly provides administrative benefits and may capture a good portion of taxpayers with an economic nexus in a taxing state. however, state factor nexus standards simply do not provide any guidance on the constitutional question — when does an economic nexus rise to the level of a substantial nexus? at best, those standards provide bright-line rules that create some level of certainty for states and taxpayers — at least with respect to a single state.244 at worst, factor nexus represents a flexible system under which states can change and lower their nexus thresholds at will, requiring taxpayers to undertake a burdensome review of state standards each year even though their business activity is unchanged. iv. what should be done with economic nexus? the analysis above demonstrates that states’ current economic nexus formulations are non-uniform, that those formulations lack concrete foundations, and that there is no direct supreme court authority requiring adherence to their forms. taxpayers can thus fairly expect that current economic nexus formulations will change as states evaluate new applications of the economic nexus construct. consequently, without a conscious effort to develop a unified approach to economic nexus, an unacceptable lack of uniformity and an unacceptable lack of certainty will result. that lack of uniformity and lack of certainty will create a state tax environment that is 243. see california, general information, supra note 164. 244. of course, that certainly is maintained only as long as states do not change any of the variables that go into the calculation of a taxpayer’s factors or retain the flexibility to assert nexus under other standards as well. 2012] economic nexus 205 inconsistent with the purpose of the court’s dormant commerce clause jurisprudence — to create structural protections against undue burdens on interstate commerce. something must be done. it is no longer sufficient to discuss the efficacy of economic nexus. the dialog must evolve to more comprehensively discuss what economic nexus should mean. a. potential approaches for economic nexus in developing the ideal approach to economic nexus, two aspects must be evaluated: (1) what principles should guide the development of that approach and (2) who should develop or impose that approach. the answer to the first dictates the answer to the second. as a principal matter, the economic nexus “question” is one implicating the core concerns of the dormant commerce clause — ensuring that state regulation (and specifically here state taxation) — does not unduly burden interstate commerce. to those ends, two guiding principles should govern: uniformity245 and certainty.246 to the extent that states’ rules are uniform, multistate taxpayers bear little marginal burdens when entering a new market (other than payment of the tax imposed), and interstate commerce is encouraged.247 in contrast, a 245. see, e.g., hellerstein, jurisdiction to tax income, supra note 36, at 67 (discussing a desire for a clarified, uniform standard for enforcement jurisdiction); w. bartley hildreth, matthew n. murray & david l. sjoquist, interstate tax uniformity and the multistate tax commission, 58 nat’l tax j. 575, 581 (2005) (“certainly uniformity of state corporate income taxes would be preferred to nonuniformity.”); charles e. mclure, jr., the difficulty of getting serious about state corporate tax reform, 67 wash. & lee l. rev. 327, 328 (2010) [hereinafter mclure, the difficulty] (stating that “an ideal system of state corporate income taxes would exhibit uniformity in . . . standards for jurisdiction to tax”); mclure & hellerstein, congressional intervention, supra note 232 (general extolling the benefits of uniformity). 246. there has been some discussion in recent tax scholarship regarding the potential benefits of uncertainty within the tax laws. see, e.g., sarah b. lawsky, probably? understanding tax law’s uncertainty, 157 u. pa. l. rev. 1017 (2009). cf. leigh osofsky, the case against strategic tax law uncertainty, 64 tax l. rev. 489 (2011). that discussion generally focuses on the potential benefits/detriments of uncertainty with respect to substantive tax provisions. the constitutional and jurisdictional dimensions of the issues discussed herein present a drastically different question. 247. for an article supporting the notion that the court’s commerce clause concerns about nexus stem from the marginal costs of tax compliance, see generally david gamage & devin j. heckman, a better way forward for state taxation of ecommerce, 92 b.u. l. rev. 483 (2012). 206 florida tax review [vol. 13:4 lack of uniformity causes increased burdens on interstate commerce through increased tax compliance costs.248 certainty also significantly reduces the marginal burdens of compliance. certainty for these purposes means that a state’s nexus rule is available, easy to apply, and static. where a state’s rule does not meet those criteria, compliance costs are increased and interstate commerce is discouraged. with these two principles in mind, it becomes clear that a federal “solution” for economic nexus is needed. parts ii.b–c, above, evidence the lack of uniformity among the states with respect to their economic nexus formulations. wide variations already exist among current state standards, whether in qualitative or quantitative form. indeed, even the states that have adopted the mtc’s model factor nexus standard have failed to adopt it uniformly. further, there is little reason to expect widespread uniform action among states in the future.249 it is thus clear that state-adopted economic nexus is highly unlikely to satisfy the goal of uniformity. 248. sanjey gupta & lillian f. mills, does disconformity in state corporate income tax systems affect compliance cost burdens, 56 nat’l tax j. 355, 357, 369–70 (2003); see also pricewaterhousecoopers, total tax contribution: how much do large u.s. companies pay in taxes? (2009), at 5, http://www.pwc.com/us/en/national-economic-statistics/assets/total_tax_contribu tion.pdf (noting that state and local tax compliance costs are more than double the study participants’ federal tax compliance costs per dollar of taxes paid — suggesting that the lack of uniformity increases compliance costs). two factors may mitigate the results of these studies. first, significant technological advances have certainly reduced compliance costs since the data used in the gupta study. second, the compliance costs in those studies undoubtedly include planning costs that firms “voluntarily” incur to lower their effective state tax rates. we can debate whether those costs should be charged to the states or to taxpayers. while those are voluntary costs in one sense, firms may be required to engage in those activities from a competitive standpoint. as much as a firm’s tax personnel may dislike artificial state-tax-minimization strategies, the capital markets are not forgiving of lost opportunities to increase earnings per share. 249. see charles e. mclure, jr., understanding the nuttiness of state tax policy: when states have both too much sovereignty and not enough, 58 nat’l tax j. 565, 570–72 (2005) [hereinafter mclure, understanding the nuttiness] (discussing the lack of uniform state action on tax matters); state taxation: the impact of congressional legislation on state and local government revenues: hearing before the subcomm. on commercial and admin. law of the comm. on the judiciary, 111th cong. 25 (2010) (statement of rep. johnson, jr., member, house comm. on the judiciary) (“[t]here has never been an instance where all states have enacted a uniform tax law. they have gone as far — group states — agreeing to model uniform tax laws; but a minority of those states have enacted the various model laws.”) the streamlined sales and use tax agreement, for example, has developed for over a decade, yet only 24 states have adopted its basic structure. the 2012] economic nexus 207 state economic nexus formulations also fail to provide any certainty. first, there is significant uncertainty in states whose courts have simply approved the concept of economic nexus without defining what it means. further, in the states in which standards have been announced, the preceding analysis suggests that those standards will change and erode over time. state-adopted economic nexus thus provides little certainty to taxpayers. the combination of these factors compels the conclusion that purposeful, proactive action by the supreme court or congress250 is warranted. the question, then, is what the ideal federal approach to economic nexus would be. there are four main options. first, the court or congress could adopt simple source-based economic nexus and effectively remove the substantial nexus prong of complete auto (at least for purposes of business activity taxation). second, the court or congress could adopt a physical presence rule and reject economic nexus altogether. third, the court or congress could adopt a heightened economic standard based on the mbna w. va. standard. finally, congress could adopt a federal factor nexus standard.251 b. the appropriate approach for economic nexus determining the best formulation for economic nexus requires that both tax and constitutional policy considerations be taken into account. this streamlined sales tax governing board, about us, http://www.streamlined salestax.org/index.php?page=about-us (last visited oct. 4, 2012). 250. to be sure, there may be concerns about congress inserting itself in such a material way into state affairs. however, two factors mitigate those concerns. first, the intervention would be purely jurisdictional. a federal formulation would not change states’ substantive tax rules. rather, it would operate just as the dormant commerce clause currently operates — as a pure jurisdictional threshold. second, congress has on many occasions promulgated jurisdictional rules for state taxation. (perhaps most notably, its enactment of p.l. 86-272. see supra note 42.) states are even currently turning to congress to expand their jurisdiction to impose use-tax collection requirements on remote vendors. see, e.g., main street fairness act, h.r. 2701, 112th cong. § 4(a)(1) (2011); the marketplace equity act of 2011, h.r. 3179, 112th cong. (2012). congress also clearly has the constitutional authority to enact an economic nexus standard. paul j. hartman & charles a. trost, federal limitations on state and local taxation 585–95 (thompson west 2d ed. 2003); hellerstein, state taxation, supra note 16, ¶ 4.23. 251. these options necessarily exclude the option of the court adopting a factor nexus standard. the court simply is not a good body to develop a quantitative test. see john a. swain, state sales and use tax jurisdiction: an economic nexus standard for the twenty-first century, 38 ga. l. rev. 343, 364 (2003) (stating that the court “is not well-equipped to make quantitative distinctions”); hellerstein, state taxation, supra note 16, ¶ 8.09[4][c] (stating that “[l]egislatures are far better equipped than courts to establish quantitative standards”). 208 florida tax review [vol. 13:4 is not only a tax issue, but a commerce clause (and hence commercial) issue as well. the determination of the ideal approach for economic nexus should thus be guided by the formulation that can best serve both masters. an evaluation of each proposal follows with that framework in mind. 1. source-based economic nexus the first option discussed above was for the supreme court or congress to adopt source-based economic nexus. that option would serve the goal of aligning states’ enforcement and substantive jurisdiction and would perhaps best serve good tax policy.252 however, the absence of a de minimis rule in a pure source-based standard likely makes that approach the least palatable option from a constitutional perspective. recall that the court’s dormant commerce clause jurisprudence is driven by concerns about the effects of state taxation on interstate commerce. subjecting businesses to a state’s tax regime based on the generation of minimal amounts of revenue from within that state would severely implicate that concern. for example, no business could operate on the internet without opening itself to taxation in any (or every) state.253 this failure counsels heavily against the adoption of pure source-based economic nexus.254 2. a physical presence standard the second option would be for the court or congress to reject economic nexus and to adopt a physical presence rule. from a constitutional perspective, this option has merit. a bright-line physical presence rule would provide clear guidance to taxpayers engaged in interstate commerce and 252. see hellerstein, jurisdiction to tax income, supra note 36, at 47–49 (discussing two possible “solutions” to the misalignment of states’ substantive and enforcement jurisdiction); swain, a jurisprudential and policy perspective, supra note 7, at 374–393 (discussing these issues and noting that the “next step” in this area “would be a rule providing that if there is nexus with the income (i.e., if the income is apportionable to the state), then there is nexus with the taxpayer.”). “good tax policy” in this instance means that states have the power to tax all income over which they have substantive jurisdiction. that construct ensures that all income is subject to tax somewhere and that taxation does not depend on the type of commerce or corporate structure that generated that income. 253. of course, due process considerations might counsel otherwise. 254. in advocating for source-based nexus, john swain has noted that exceptions would be needed in two situations: (1) where taxation would violate the due process clause and (2) where a taxpayer’s income attributable to the state is de minimis. swain, a jurisprudential and policy perspective, supra note 7, at 390–91. the recognition of a need for a de minimis rule highlights the constitutional concerns raised by pure source-based nexus. 2012] economic nexus 209 reduce litigation regarding the scope of state power. businesses would not only save money by reducing their tax and return-preparation costs, but they would also save money by not having to research and evaluate as many as fifty different state standards.255 a physical presence would thus provide the same benefits that the quill court noted with its enunciation of that rule for state sales and use taxes.256 of course, where the physical presence rule shines for constitutional purposes, it is remarkably dull from a tax-policy perspective. again, good tax policy would ensure that states have the power to collect tax on all of the income over which they have substantive jurisdiction.257 good tax policy does not allow for “nowhere income” (which results from a disconnect between substantive and enforcement jurisdictions) or a preference between types of economic actors (whether operating in tangible or digital form). reliance on a physical presence rule would violate those ideals by preventing states from taxing income over which they had substantive jurisdiction and by ensuring that taxpayers that exploited a market through electronic or other non-physical means would have an advantage over those who did so physically. that standard would continue to exalt form over substance and place greater strains on state resources without a compelling policy justification. consequently, although that standard might serve the goals of the commerce clause admirably, its failure to comport with good tax policy counsels against its adoption.258 255. assuming, of course, that all fifty states determined to implement a business activity tax. 256. see quill corp. v. north dakota, 504 u.s. 298, 315–16 (1992) (noting that the artificiality of bright-line tests is “more than offset by the benefits of a clear rule,” including “firmly establish[ing] the boundaries of state authority . . . and reduc[ing] litigation”). 257. see supra note 252. 258. see mclure, understanding the nuttiness, supra note 249, at 569–70 (discussing how p.l. 86-272 is an example of congress poorly legislating state tax policy); mclure & hellerstein, congressional intervention, supra note 232, at 734– 35 (noting the “opportunities for tax planning” and the revenue loss created by p.l. 86-272); swain, a jurisprudential and policy perspective, supra note 7, at 393 (“but good tax policy demands more. congress should repeal p.l. 86-272. its safe harbors have no place in a modern economy.”). cf. marjorie gell, broken silence: congressional inaction, judicial reaction, and the need for a federally mandated physical presence standard for state business activity taxes, 6 pitt. tax. rev. 99, 119–29 (2009) (discussing economic, constitutional, administrative, and systematic concerns with an economic nexus standard and proposing a federal physical presence rule). 210 florida tax review [vol. 13:4 3. a qualitative economic nexus standard the third option would be for the court or congress to adopt a qualitative economic nexus formulation in the form of the mbna w. va. test. from a tax-policy perspective, that option would be favorable because it would finally establish the validity of economic nexus. as discussed above, however, such a standard would improperly elevate physical contacts over economic contacts.259 it would thus artificially limit economic nexus and would be internally inconsistent. from a constitutional standpoint, a heightened, qualitative economic nexus standard would serve the goals of the commerce clause by protecting taxpayers from taxation in remote states unless they had significant economic presences in those states. businesses considering expanding their marketing or distribution could thus do so without fear that their taxcompliance costs will outweigh their economic returns from that expansion. despite those benefits, however, the soft, qualitative language of such a standard would invite continued controversy between taxpayers and taxing authorities and would not be easy to administer.260 those debates would ultimately generate the same litigation that is occurring today, and the court would be solicited repeatedly to review that standard. given the court’s general lack of interest in reviewing cases under the physical presence standard,261 it is reasonable to assume that it would have a similar lack of interest in reviewing cases under a federal, qualitative economic nexus standard. the adoption of such a standard would thus lead, again, to significant debate and uncertainty unless congress intervened to provide guidance. in sum, a federal, qualitative standard for economic nexus would only marginally represent good tax policy, would fall short of providing adequate guidance for taxpayers, and would unnecessarily burden interstate commerce. that approach is consequently not ideal under either of the relevant benchmarks. 259. see supra part iii.a.3. 260. charles mclure recognized this point in initially proposing a factor nexus standard. mclure, implementing, supra note 10, at 1296 (“it would not be satisfactory merely to specify in general terms that ‘significant amounts’ of in-state payroll, property, or sales would be required for nexus; that leaves too much uncertainty and too much room for litigation.”). it is also worth recognizing that disputes under a federal qualitative standard would naturally result in different state interpretations of the uniform federal standard. a lack of uniformity would again commence. 261. see supra part ii.b.1 (listing a long line of cases in which the supreme court has denied certiorari over state tax jurisdiction cases). 2012] economic nexus 211 4. factor nexus legislation the final option listed above would be for congress to exercise its authority under the commerce clause and to adopt federal factor nexus legislation.262 this option would be desirable from a constitutional perspective for two reasons. first, it would pay due accord to the goals of the commerce clause by providing a de facto de minimis rule through its minimum nexus thresholds. consequently, businesses could expand their marketing efforts into new states without worrying that their marginal costs of tax compliance will exceed their monetary benefits from exploiting those markets.263 additionally, from a constitutional policy perspective, the adoption of a federal “rule” rather than a “standard” would be appropriate in this area. while there has been vigorous debate regarding the benefits of rules versus standards,264 the concerns of the commerce clause counsel towards a clear, bright-line rule. as the quill court noted, a bright-line rule “firmly establishes the boundaries of legitimate state authority . . . and reduces litigation.”265 the court lauded such a rule because its law in the area of state taxation has been “something of a ‘quagmire’ and the ‘application of constitutional principles to specific state statutes leaves much room for controversy and confusion and little in the way of precise guidelines to the states in the exercise of their indispensable power of taxation.”266 bright-line rules also “encourage[] settled expectations and, in doing so, foster[] investment by businesses and individuals” — core concerns underlying the dormant commerce clause.267 federal factor nexus (appropriately structured) would provide all of those benefits.268 262. a proper starting point for such legislation would be the mtc model discussed above. see supra part iii.c.1. a concomitant repeal of p.l. 86-272 would be ideal. that artificial limitation on states’ jurisdiction to tax would be inconsistent with the recognition of a federal economic nexus standard. 263. this assumes, of course, that the thresholds are set appropriately. 264. see, e.g., pierre schlag, rules and standards, 33 ucla l. rev. 379 (1985) (discussing the perceived benefits and detriments of rules and standards); seana valentine shiffrin, inducing moral deliberation: on the occasional virtues of fog, 123 harv. l. rev. 1214 (2010) (discussing the potential benefits of standards over rules); cass r. sunstein, problems with rules, 83 calif. l. rev. 953 (1995) (discussing potential weaknesses with rules). 265. quill corp. v. north dakota, 504 u.s. 298, 315 (1992). 266. id. at 315–16. 267. id. at 316. 268. implicit in this discussion is that a federal factor nexus standard would provide standard definitions for determining taxpayers’ factors. that mandatory uniformity would alleviate the undue burdens created by a system that requires taxpayers to determine their tax obligations by applying a multiplicity of different 212 florida tax review [vol. 13:4 a federal factor nexus standard would also further good tax policy by relying on source principles rather than on artificial distinctions between economic and physical presences. the factor nexus thresholds could be set sufficiently low to avoid the conceptual problems that heightened economic nexus standards present.269 most importantly, federal factor nexus would eliminate nexus variability among states.270 as discussed above, even among states that have adopted factor nexus standards, those standards are not uniform. they also have three weaknesses that effectively foreclose their potential for obtaining that uniformity: states’ flexibility with respect to the magnitude of those thresholds, the uncertainty and flexibility with respect to how sales are actually sourced, and states’ adoptions of opt-out provisions to those standards.271 a federal factor nexus standard would solve each of those problems while serving the same policy goals. the federal solution would eliminate magnitude variability because the magnitude of the factor threshold amounts would be set by congress, and could only be changed through deliberation and debate at a national level. further, that legislation would eliminate definitional flexibility by providing uniform apportionment rules (for purposes of the nexus determination). nexus rules. states would still be free, however, to apply their own apportionment formulae. there is no inherent need to unify a taxpayer’s factors for purposes of nexus determinations and for purposes of apportioning their income. this is different than the proposals of the willis committee and of charles mclure. they each note the inherent inconsistency in using one rule for nexus purposes and another for apportionment purposes. h.r. rep. no. 88-1480, pt. 1, at 485–87 (1964); mclure, implementing, supra note 10, at 1297. while there is truth to their concerns, i believe that the need for a uniform nexus standard counsels towards as light of a touch as necessary. by adopting a broad economic nexus standard and allowing states to adopt their own apportionment formulae, states retain more flexibility and can reduce incidences of nowhere income to the greatest extent possible. 269. as previously discussed, heightened economic nexus standards have artificially limited scopes so as to avoid the appearance of overbreadth. 270. john swain has also recently offered factor nexus as the preferred standard for addressing economic nexus. john a. swain, misalignment of substantive and enforcement jurisdiction in a mobile economy: causes and strategies for realignment, 63 nat’l tax. j. 925, 941 (2010) [hereinafter swain, causes & strategies] (advocating for factor nexus standards as the ideal approach to factor nexus); see also quinn t. ryan, note, beyond batsa: getting serious about state corporate tax reform, 67 wash. & lee l. rev. 275, 307–20 (2010) (proposing a federal adoption of factor nexus and uniform apportionment rules). the major difference between professor swain’s approach and that considered herein is that this article advocates for a federal factor nexus standard. as described in the text, a federal standard would provide the uniformity and certainty that state factor nexus standards do not provide. 271. see supra part iii.b. 2012] economic nexus 213 finally, federal factor nexus would eliminate application flexibility by precluding states from adopting opt-out rules. the federal standard would be mandatory and exclusive. of course, this discussion assumes that a federal factor nexus standard would provide uniform thresholds for all states. this may seem problematic at first blush because it seems to ignore the very real differences between states’ markets — $250,000 of sales into wyoming is very different than $250,000 of sales into new york. this issue, like others, deserves to be considered in further scholarship. however, uniform standards for all states would be sensible. interstate commerce is burdened if the costs of compliance overwhelm a taxpayer’s returns from a state, regardless of the size of the market. thus, the magnitude of the federal factors should be set at the point at which a taxpayer’s returns from a state can be reasonably expected to overcome its costs of compliance with the state’s income tax laws. a focus on market sizes is irrelevant to that question. if “indexing” the threshold amounts were desirable, the more compelling basis would be the level of complexity of that state’s income tax (or perhaps its level of divergence from a standard system like the uditpa). of course, if a federal factor nexus standard were considered, congress would resolve these issues with adequate input and guidance from the relevant constituencies. in sum, federal factor nexus presents the option for economic nexus that would best serve both good tax and constitutional policy goals.272 it would recognize the legitimacy of economic nexus without artificially limiting its scope and would provide a clear, uniform rule with built in de minimis protection.273 without more then, this article could conclude. 272. once the idea of a federal factor nexus standard is accepted as worthy, a number of secondary issues would need to be considered. do the property and payroll factors maintain relevance? should certain industries have different formulations? these issues are beyond the scope of this article, but they deserve to be explored in further scholarship. 273. as noted at the outset, this proposal would also be consistent (in large part) with the recommendations of other prominent state tax scholars. see, e.g., mclure, implementing, supra note 10, at 1295–97; swain, a jurisprudential and policy perspective, supra note 7, at 390–93; swain, causes & strategies, supra note 270, at 941. see also tax section, n.y. state bar ass’n, nexus requirements for imposition of business activity taxes (jan. 25, 2008), http://www.nysba.org/ am/template.cfm?section=tax_section_reports_2008&template=/cm/cont entdisplay.cfm&contentid=13360 (proposing a federal economic nexus standard that contains de minis thresholds). of course, the proposal offered herein is different than prior proposals for two reasons. first, as previously noted, john swain has advocated for factor nexus at the state level rather than at a federal level. second, charles mclure and others have proposed wider-reaching federal intervention that would include federal apportionment rules, for example. the proposal herein is thus more and less restrictive than prior proposals. 214 florida tax review [vol. 13:4 congress could implement this proposal and clear the muddy waters. of course, the world is not that simple, and several obstacles stand in the way of a federal factor nexus standard.274 the principal obstacle to the adoption of a federal factor nexus standard is that such a standard would not be ideal for either of the two constituencies that it would most directly impact — states and the business community. states would naturally prefer to retain their current (essentially unfettered) power, and business would prefer a physical presence rule.275 outside of a few interested academics, then, congress is unlikely to find much support for extending its hand in this way. not since the adoption of p.l. 86-272 in 1959 has congress passed such expansive state tax legislation, and it is unlikely to do so without a request from at least one of the major interested parties. as an additional complication, state tax nexus is as much of a political issue as it is a tax-policy issue. for those who believe that a physical presence rule currently governs, a federal factor nexus rule would be branded a tax increase (and a tax increase that did not inure to the benefit of congress).276 on the other hand, to states that believe that a federal factor nexus standard would limit their power, such a bill could be construed as another unfunded mandate stretching state resources. each of these constructs is less than palatable for congress. the only realistic possibility that federal factor nexus has for enactment appears to be for the business community and states to adopt a unified front and to approach congress to intervene. that unity would have to be fostered through serious discussion regarding the current state of the law and the potential benefits that a federal standard would provide. states would have to give up sovereign control of their standards in favor of a clear directive from congress to taxpayers. that directive (in the form of factor nexus) would allow states to retain a significant level of power and would prevent states from having to litigate threshold economic nexus disputes in perpetuity. on the other side of the debate, taxpayers would have to abandon hope of a physical presence rule in favor of uniformity and a satisfactory de minimis rule. this will perhaps become more palatable as more states adopt broad economic nexus standards. 274. see mclure, the difficulty, supra note 245, at 338 (explaining why federal action on apportionment and nexus issues is unlikely). 275. currently, congress has before it a bill that would extend the protections of p.l. 86-272 to all vendors, whether of tangible personal property, intangible personal property, or services. business activity tax simplification act of 2011, h.r. 1439, 112th cong. (2011). that bill would provide business with the broad-reaching physical presence standard that it has sought for years. 276. expanded state tax power would actually reduce federal revenues due to the federal income tax deduction for state income taxes paid or incurred. see i.r.c. § 164(a)(3). 2012] economic nexus 215 the other potential room for agreement between states and the business community would be as part of a “package deal” on nexus for purposes of state sales and use taxes. as noted above, quill currently imposes a physical presence rule for purposes of sales and use taxes. the losses to states from that rule have been estimated to be over ten billion dollars annually.277 to the extent that the physical presence rule for purposes of state sales and use taxes protects a smaller subset of vendors than those that suffer from uncertainty or continued debate regarding economic nexus for purposes of business activity taxes, it may be possible to form an alliance of interests among business and states. if business feels that economic nexus is here to stay, and that states’ standards will be either unduly broad or uncertain, it may be willing to support a repudiation of quill in exchange for federal factor nexus. states will be less inclined to make that deal, of course, if they feel that quill is not on firm footing. however, given the current lack of interest by the court and the lack of agreement in congress in dealing with these nexus issues, a reversal of quill does not seem imminent.278 on the other hand, the revenue losses from the physical presence rule are current and very real. states accordingly may be willing to give some ground on economic nexus to see quill abandoned once and for all. finally, congress could force compromise by refusing to adopt a bill addressing sales tax nexus unless that legislation included rules for business activity taxes as well. that approach would surely frustrate states, but might be the quickest way for congress to resolve these issues. congress should consider whether it wants to use the current momentum on sales tax nexus to encourage resolution of both issues in one fell swoop. none of this is to say that compromise is likely in the short term. however, it will never happen if the dialogue regarding economic nexus does not evolve. for too long, the discussion has centered on the threshold issue of whether economic nexus is permissible. that focus has resulted in a multiplicity of varied standards that fail to provide the certainty or uniformity required by the dormant commerce clause. it is time for states, the business 277. see donald bruce, william f. fox & leann luna, state and local sales tax revenue losses from e-commerce, 52 st. tax notes 537, 540 (may 18, 2009) (projecting losses of $11.4 billion in 2011). 278. there has been recent optimism regarding the likelihood of a congressional reversal of quill as the house judiciary committee evaluates a new proposal — marketplace equity act of 2011. h.r. 3179, 112th cong. (2011). laura saunders, online sales tax is coming!, wall st. j., july 21, 2012, at b9. however, it is unclear whether that legislation will gain traction in the near future. john buhl, u.s. house panel undecided on remote sales tax legislation, 65 st. notes 299, 299–301 (july 30, 2012). this bill may fare the same as previous bills attempting to achieve similar ends. of course, to the extent that this bill is either passed (or gains significant support), business’s ability to use quill as a bargaining chip for a federal factor nexus standard would be eliminated. 216 florida tax review [vol. 13:4 community, the tax bar, and tax scholars to turn their attentions to developing a satisfactory federal factor nexus standard. v. conclusion economic nexus is a doctrine that has no precise formulation. state courts adopting that standard have either ignored its boundaries or have adopted heightened standards that have questionable bases and that are subject to significant erosion. state legislatures have adopted more satisfactory approaches, but those standards will also be subject to erosion and will create undue compliance burdens on multi-state enterprises. ultimately, then, the idea that “economic nexus” currently means something is illusory, and the supreme court or congress will be required to intervene. a federal factor nexus standard is the most appropriate method for addressing economic nexus in a way that pays proper attention to both tax and constitutional policy considerations. at the very least, the discourse in this area should evolve to discussing how that standard should be formulated and how to achieve that goal. the current approach of simply adopting ad hoc economic nexus formulations cannot continue. a. potential approaches for economic nexus 205 a. potential approaches for economic nexus florida tax review volume 3 1997 number 9 creating complex monsters: joint operating agreements and the logical invalidity of treasury regulation 1.502-1(b) darr.ll k. jones" for mckeizzie i. introduction ................................ 564 ii. conceptualizing joint operating agreements ..... 572 1ii. the bane of complexity ........................ 590 iv. the unfair competition rationale .............. 600 v. conclusion .................................. 613 * general counsel, columbia college chicago, chicago, illinois. j.d. 1986, university of florida college of law; ll.m. (taxation) 1994. university of florida college of law. his tax practice focuses on tax exempt organizations. 563 florida tax review i. introduction a familiar mathematical axiom holds that the shortest distance between two points is a straight line.' indeed, in most any human endeavor simplicity should be encouraged and complexity discouraged. modem armies, for example, adhere to acronyms' intended to remind leaders and followers alike to strive for simplicity in an effort to conserve energy and avoid misunderstandings. it can be stated intuitively that complexity inevitably excludes understanding in a certain portion of the intended audience. those who engineer complexity understand it best, but understanding decreases as one moves farther from the source until the thing engineered is not understood at all.3 more importantly, complexity causes unnecessary expense, it results in a diversion of resources, and, by the weight of its own process, obscures the original goal to the ultimate extent that the goal is deemed unworthy of achievement.4 1. arthur f. coxford & zalman p. usiskin, geometry: a transformation approach 403 (1971). 2. for example "kiss" means "keep it simple, stupid." it is a "catchphrase used by the military to remind commanders that complex military plans seldom work in wartime conditions, and that it's best to keep tactics and strategies as simple as possible." s.f. tomajczyk, dictionary of the modem united states military 336 (1996). 3. the idea that drafters intentionally make tax laws and regulations complex is cynical, but one which has been expressed from time to time: [t]here is a perverse incentive for the draftsmen of treasury regulations to write the regulations as long and complex as possible. the draftsmen know that they will probably soon be entering private practice, where they can make a lucrative living pontificating on their own regulations. it has become common for draftsmen to leave treasury shortly after the regulations are issued, in many cases, no doubt, lured by the potential to make a buck off their own regulations. several prior draftsmen now give speaking tours around the country. others have profited by writing books. thus, there is a tremendous economic incentive for the draftsmen to write regulations that are as obscure, complex, and arcane as possible. schuyler m. moore, a proposal to reduce the complexity of tax regulations, 37 tax notes 1167 (1987). 4. the problem of complexity in tax law is an old one and is explored in great detail in various articles. see generally james s. eustice, tax complexity and the tax practitioner, 45 tax l. rev. 7 (1989); farley p. katz, the infernal revenue code, 50 tax law. 617 (1997); sheldon d. pollock, tax complexity, reform, and the illusions of tax simplification, 2 geo. mason. indep. l. rev. 319 (1994); sidney i. roberts et al., a report on complexity and the income tax, 27 tax l. rev. 325 (1972); adrian j. sawyer, why are taxes so complex and who benefits? 73 tax notes 1337 (1996); stanley s. surrey, complexity and the internal revenue code: the problem of the management of tax detail, 34 law & contemp. probs. 673 (1969); michelle j. white, why are taxes so complex and who benefits? 47 tax notes 341 (1990). [vol 3:9 creating complex monsters the internal revenue code has never been hailed as an example of the mathematical axiom concerning the shortest distance between the status quo and a desirable result. in fairness though, complexity in the code is often in response to other factors, including complexity in financial transactions.' the latter complexity is not necessarily without purpose. it is often employed, for example, to provide assurances between trading partners who do not trust one another or, as is the wont of lawyers, in an exercise in overkill designed to anticipate every possible contingency. complexity is also sometimes used in an effort to shield, hide, or recharacterize the nature of income generated by a particular transaction. thus, in its own complexity, the code is often necessarily designed to root out the true character of a given transaction.6 sometimes the code is designed to allow a narrow way to achieve a desirable goal and simultaneously avoid undesirable side effects. 7 all of this, in simple terms, is only to say that whenever a particular provision or regulatory requirement is characterized by, fosters, encourages, or condones complexity, there ought to be an apparent and sound justification. this conclusion, that complexity ought to be purposeful and not gratuitous, is demonstrated by the emergence of joint operating agreements. also known as "virtual mergers,"8 joint operating agreements are the internal revenue service ("service")-approved mechanisms9 by which unrelated tax 5. one commentator, however, argues that tax complexity is not only a result of complexity in business transactions but also a cause of such complexity. pollock. supra note 4, at 338 ("the rise in complexity of the tax laws cannot be attributed solely to an increasingly complex economy and business world. rather, the tax laws themselves contributed to the complexity in the business world.") resolving the debate is like trying to determine whether the chicken preceded the egg. 6. the passive activity limitation rules are favorite examples of complex anti-abuse provisions. irc § 469. but other provisions rival the passive activity rules for complexity. see, e.g., irc §§ 1272-1275, 7872 (pertaining to imputed interest), 1311. see generally h. stewart dunn, improved development of complex tax legislation, 10 am. j. tax pol'y 307. 313-20 (1992). 7. irc § 501(h), for example, provides tax exempt organizations with an objective measure of how much propaganda and legislative activity in which they may engage without jeopardizing their tax exempt status under irc § 501(c)(3) (which prohibits tax exempt organizations from making such activities a "substantial" part of their operations). the process of applying irc § 501(h) is painfully complex and involved, but is probably justified because it allows exempt organizations to safely engage in a certain level of propaganda and legislative advocacy with the assurance that they will not lose their tax exemptions. 8. michael w. peregrine & robert l. capizzi, new developments in tax planning for joint operating company arrangements, 14 exempt org. tax rev. 101 (1996); roderick darling & marvin friedlander, internal revenue service. virtual mergers-hospital joint operating agreement affiliations, in 1996 exempt organizations continuing professional education technical instruction program textbook 131, 132 (1996). 9. the service has not issued regulations or any other guidance upon which taxpayers may rely regarding joint operating agreements. instead, it has expressed its approval 19971 florida tax review exempt organizations may pool resources to obtain goods and services necessary to the accomplishment of their common goal without diverting the charitable fund to waste, profit-taking by other individuals or entities, or taxation by the government. virtual mergers are so-called because they involve detailed contractual undertakings, not amounting to legal merger under state law,' 0 but creating sufficient governance, management, and financial connections between several entities such that the previously unrelated parties are treated as a single entity for purposes of regulations section 1.502-1(b)." as a result the several entities are allowed to consolidate the performance of their activities by use of a newly created exempt of joint operating agreements through a series of private letter rulings. see priv. ltr. rul. 9722-042 (mar. 3, 1997); priv. ltr. rul. 97-21-031 (feb. 26, 1997); priv. ltr. rul. 97-16-021 (jan. 17, 1997); priv. ltr. rul. 97-14-011 (dec. 24, 1996); priv. ltr. rul. 96-51-047 (sept. 24, 1996); priv. ltr. rul. 96-23-011 (feb. 29, 1996); priv. ltr. rul. 96-09-011 (nov. 22, 1995). the legal standards applied in each of the rulings are essentially identical. private letter rulings may not be used or cited as precedent unless the secretary of treasury determines otherwise. irc § 61100)(3). 10. darling & friedlander, supra note 8, at 132. ("because a joint operating agreement affiliation is not a true merger, it has come to be called a "'virtual merger.' "), 11. regs. § 1.502-1(b) provides: if a subsidiary organization of a tax-exempt organization would itself be exempt on the ground that its activities are an integral part of the exempt activities of the parent organization, its exemption will not be lost because, as a matter of accounting between two organizations, the subsidiary derives a profit from its dealings with its parent organization, for example, a subsidiary organization which is operated for the sole purpose of furnishing electric power used by its parent organization, a tax exempt educational organization, in carrying on its educational activities. however, the subsidiary organization is not exempt from tax if it is operated for the primary purpose of carrying on a trade or business which would be an unrelated trade or business (that is, unrelated to exempt activities) if regularly carried on by the parent organization. for example, if a subsidiary organization is operated primarily for the purpose of furnishing electric power to consumers other than its parent organization (and the parent's tax exempt subsidiary organizations), it is not exempt since such business would be an unrelated trade or business if regularly carried on by the parent organization. similarly, if the organization is owned by several unrelated exempt organizations, and is operated for the purpose of furnishing electric power to each of them, it is not exempt since such business would be an unrelated trade or business if regularly carried on by any one of the tax-exempt organizations. for purposes of this paragraph, organizations are related only if they consist of: (1) a parent organization and one or more of its subsidiary organizations; or (2) subsidiary organizations having a common parent organization. an exempt organization is not related to another exempt organization merely because they both engage in the same type of exempt activities. [vol 3:9 creating complex monsters entity without engaging in unrelated business activity or otherwise jeopardizing their separate tax exempt statuses. using the mathematical analogy to illustrate, point a is the status quo at which the unrelated parties have a common need which must be met if they are to achieve a commonly-held goal. for example, five tax exempt hospitals in a given locale, although unrelated, might share a common need for a specialized medical diagnosis procedure. point b is the later point at which the exempt organizations are able to obtain necessary goods and services at cost and without wasting charitable funds or diverting them to personal profit or taxation. to remain with the above example, the five hospitals might each establish a captive subsidiary to provide the diagnostic procedure at cost, or they might each establish an in-house facility. each exempt hospital would then be able to obtain the necessary service without the diversion of the charitable fisc to personal profit or taxation.' 2 still, neither option would constitute the shortest distance as it relates to all the hospitals because the five-fold duplication creates waste and a combined capacity which outweighs overall demand. the shortest, i.e., least complex, distance from point a to point b would be to allow the exempt organizations to share access to a single facility which would provide all five organizations with diagnostic services at cost and on a consolidated basis, thereby achieving a certain self-contained economy based on charity rather than profit and ultimately working to the advantage of common charitable beneficiaries. however, this option would not get the hospitals entirely to point b because the resulting "consolidated" entity would be taxable under present law. 3 neither could any one hospital provide the diagnostic service to the four other hospitals on a consolidated basis without engaging in an unrelated business activity.14 to gain tax exempt status, avoid the imposition of the unrelated business income tax, and remain in compliance with regulations section 1.502-1(b), the exempt organizations must actually merge or engage in a complex transaction resulting in a virtual merger. the tax free consolidation of services is thereby finally achieved but the process is much more expensive and complex than if the unrelated parent organizations were permitted to create a single mutually-owned subsidiary or designate one of their five to provide the service for the entire group. 12. regulations section 1.502-1(b) would shield the hospitals from taxation in either case. 13. "if the organization is owned by several unrelated exempt organizations and is operated for the purpose of furnishing electric power to each of them. it is not exempt since such business would be an unrelated trade or business if regularly carried on by any one of the exempt organizations." reg. § 1.502-1(b). 14. id. 19971 florida tax review since the goal, consolidation, is manifestly desirable and complexity is to be avoided when possible, it is appropriate to ask what purpose is served by regulations section 1.502-1(b)'s insistence upon virtual mergers as a means to achieve the goal rather than opting for the easier approach of allowing unrelated exempt organizations to create a single exempt subsidiary or allowing one exempt entity to serve similarly situated entities. why should the exempt organizations be required to "reinvent the wheel?" after all, regulations section 1.502-1(b) presently allows the five unrelated exempt organizations, for example, to establish five separate exempt subsidiaries without taxation so long as each of the five subsidiaries provides goods or services solely to its single parent. what purpose is served, then, by taxing five unrelated exempt organizations who establish one mutual subsidiary but not taxing those organizations when they collectively establish five separate subsidiaries? how does the imposition of the joint operating agreement requirement make the former option less objectionable than it is already deemed to be? the primary focus of regulations section 1.502-1(b) is preventing exempt organizations from engaging in unfair competition. 5 thus, to prevent the competitive disadvantages to taxable entities resulting from exempt organizations engaging in business activity, regulations section 1.502-1(b) requires that exempt organizations undertake an arduous process which results in a merger as a legal fiction-a virtual merger. 6 the joint operating agreement is thought to bring otherwise unrelated exempt organizations within the literal meaning of regulations section 1.502-1 (b) and thereby achieves the purpose of preventing unfair competition. 7 yet from the standpoint of taxable entities, the purported beneficiaries of the requirement, the end result is identical regardless of the process by which consolidation is achieved. by whatever process, mutual subsidiary or joint operating agreement, there results a new entity which provides goods and services that might otherwise be provided by existing taxable entities, albeit at greater expense to the exempt recipient entities. the only apparent difference is that the joint operating agreement requirement is more expensive and time 15. see geisinger health plan v. commissioner, 30 f.3d 494, 500 (3d cir. 1994); geisinger health plan v. commissioner, 100 t.c. 394, 401 (1993); associated hospital services, inc. v. commissioner, 74 t.c. 213, 223-24 (1980); hospital bureau of standards and supplies v. united states 158 f. supp. 560, 563-64 (ct. cl. 1958). the regulation was originally enacted on august 4, 1952, as regs. § 29.101-3(b), i 11. 16. darling & friedlander, supra note 8, at 134. ("if the hospitals establish a "super" parent to implement the joint operating agreement, and the facts and circumstances establish that the equivalent of a parent-subsidiary relationship exists, then the "super" parent will be considered to be an integral part of the subsidiaries. thus, essential services it provides to the subsidiaries will not constitute unrelated trade or business.") 17. id. [vol 3:9 creating compler monsters consuming. hence, the complexity of virtual mergers and the disadvantages attendant to them-primarily diversion of resources, but also the discouragement of innovation and/or centralization of charitable services-do not appear justified by any good policy reason, unless the complexity is intended to serve as negative reinforcement of tax exempt subsidiaries. this article questions the validity of regulations section 1.502-1(b) and its resulting insistence upon virtual mergers. it argues that the regulation is invalid as having no basis in section 502, the statute under which it was codified. this article argues, instead, that the regulation is a logically incorrect amalgamation of two distinct judicial tax doctrines by which tax exemption may be or could have been gained vicariously: (1) the integral part doctrine which allows one organization to achieve tax exemption on the basis of another organization's charitable activities, 8 and (2) the now-discarded destination of income doctrine under which tax exemption could be had on 18. the integral part doctrine did not originate with regs. § 1.502-1(b). instead it arose from the ninth circuit's decision in squire v. student books, 191 f.2d 1018 (9th cir. 1951). in that case, a tax exempt educational institution owned all the stock of a bookstore which sold textbooks and supplies to the college's students and faculty. the court held that the bookstore was entitled to tax exemption because its activities stood in a "close and intimate relationship to the functioning of the college itself." id. at 1020. recently, the third circuit court of appeals mistakenly traced the "genesis" of the integral part doctrine to regs. § 1.502-1(b). geisinger health plan v. commissioner, 30 f.3d 494, 499 (3d cir. 1944). as noted earlier, though, the regulation was first enacted in 1952, a year after the decision in squires. see supra note 15. more importantly, though, the third circuit in geisinger confused the vicarious nature of the integral part doctrine. the doctrine, as demonstrated in squires and even regs. § 1.502-1(b), grants exempt status to an organization which provides admittedly commercial goods and services exclusively to a tax exempt parent. tax exemption is granted to the first organization because it is viewed as the second organization's alter ego, not because the first organization is otherwise engaged in a charitable activity. in geisinger, though, the court stated that the organization's relationship to a tax exempt organization must "somehow enhance[] the subsidiary's own exempt character to the point that, when the boost provided by the parent is added to the contribution made by the subsidiary itself, the subsidiary would be entitled to § 501(c)(3) status." 30 f.3d 494, 501 (emphasis added). the integral part doctrine applies when the organization has no independent exempt character but is seeking to qualify vicariously through assistance to another organization's exempt activities. the "boost" characterization used in geisinger would have resulted in the denial of tax exempt status to the bookstore in squires because the bookstore had no exempt character separate from the college whose students and faculty it served. in a more recent case, the tax court did not adopt the geisinger "boost" rationale but indicated that the squires integral part doctrine could apply to mutual organizations such as those prohibited by regs. § 1.502-1(b): the cases applying this doctrine have held that where an organization (1) bears a "close and intimate relationship" to the operation of one or more tax-exempt organizations and (2) provides a "necessary and indispensable" service solely to those tax-exempt organizations, it will take on the exempt status of those organizations. university med. resident serv. v. commissioner, 71 t.c.m. (cch) 3130 (1996). 1997] florida tax review the sole basis that all the earnings of a corporation, however realized, were distributed to an organization directly providing charitable goods and services.' 9 an analysis of the two doctrines shows they are oriented toward distinct aspects of the unfair competition problem and do not simply address the same problem in different ways. although the two doctrines may be legally and theoretically sound as separate doctrines, they are legally and theoretically unsound as a single merged doctrine resulting in the requirement of virtual mergers. this article also argues that the abdication of judicial power with respect to regulations section 1.502-1(b), particularly by the united states tax court,2" contributes to unnecessary complexity. the tax court has essentially admitted that the regulation has no statutory or even logical support.2' in the end, though, the tax court sustained the regulation based upon a questionable application of principles of judicial deference to administrative rulemaking. had it overturned the regulation, the tax court would have eliminated the needless complexity which presently unnecessarily attaches to exempt organizations' efforts to economize through consolidation. rather, the tax court assumed that the complexity of the issue demanded that it take an unduly deferential approach to the regulation and thereby perpetuated the complexity of virtual mergers.22 finally, this article concludes that even were the regulation a valid interpretation of law, it is nevertheless incorrect as a matter of tax policy because it fosters complexity without a corresponding policy benefit. the regulation is grounded on the rejection of the self-contained charitable economic model; that is, a separate economic system comprised of direct providers of charitable goods and services which own and are served by a secondary market within the same economy. within this self-contained economic model, the secondary market is comprised of tax exempt entities indistinguishable from ordinary commercial businesses except for their limitation of customers to their charitable parent entities, all of whom share a common charitable goal. thus, the economy is based upon charitable need, rather than profit, as the production incentive and the system's currency remains exclusively within the exempt economy, neither taxed nor subject to profit-taking. regulations section 1.502-1(b) unalterably deems this selfcontained economy as one which results in unfair competition, apparently on the basis of the same considerations which underlie the rejection of the 19. roche's beach, inc. v. commissioner, 96 f.2d 776, 778-79 (2nd cir. 1938); c.f. mueller co. v. commissioner, 190 f.2d 120, 121-22 (3d cir. 1950). 20. associated hospital services, inc. v. commissioner, 74 t.c. 213,226-31 (1980). 21. id. at 227. 22. the tax court termed the history behind the enactment and application of regs. § 1.502-1(b) a "perplexing saga." id. at 222. [vol 3:9 creating comple.r monsters destination of income doctrine. the drafters presume that without the regulation, the resulting self-contained economy would have a negative effect on the taxable economy in the same manner as organizations claiming exemption under the destination of income doctrine. this article argues that the premise of regulations section 1.502-1(b) is incorrect and that the complexity engendered by the regulation, in the form of joint operating agreements, is therefore unnecessary. the solution suggested by this article is the repeal of regulations section 1.502-1(b) and a reliance, instead, upon sections 501(c)(3) 23 and 51124 of the code, as the exclusive tools by which to prevent unfair competition. this simple solution, properly applied, would allow tax exempt organizations to get from point a to point b, without the 23. section 501(c)(3) might have been enacted as four separate provisions since it contains (1) the identification of those organizations entitled to exempt status, (2) a prohibition against the use of tax exempt revenues for private gain, (3) a partial prohibition against activities involving propaganda or attempts to influence legislation, and (4) a total prohibition against participation in campaign activities. as it is. irc § 501(c)(3) provides exemption for: corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment). or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office. the provision thus covers all of the basic issues relating to operation of a tax exempt organization. there are, of course, 27 other subdivisions of § 501tc)(3) which grant tax exemption on other grounds. but approximately 630,000 of the 1.5 million exempt organizations in the united states are classified as 501(c)(3) organizations. i.r.s. fact sheet 97-7 (feb. 1997). approximately 300,000 exempt organizations are churches and 140,000 organizations are 501(c)(4) organizations. id. unless otherwise specified, this article focuses on 501(c)(3) organizations. 24. the unrelated business income tax, unlike the rules regarding basic qualification, is set out in incremental statutes. section 511 imposes a tax on "unrelated business taxable income." section 512 defines unrelated business taxable income as income from an "unrelated trade or business." section 513(a) defines unrelated trade or business: the term "unrelated trade or business" means, in the case of any organization subject to the tax imposed by section 511. any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501 .... 1997] florida tax review complexity of, and without sacrificing the policy interests thought to be protected by, joint operating agreements. ii. conceptualizing joint operating agreements the basic concept underlying joint operating agreements-virtual mergers-is consolidation. in its most prevalent present use, a joint operating agreement results in two or more tax exempt hospitals associating in an effort to eliminate duplicative services and thereby reduce operating expenses, gain negotiating power with third party payers or service providers, and reduce overall costs to patients.' the result of the joint operating agreement is the creation of a consolidation entity,26 normally a partnership or a corporation, which governs and coordinates the activities of the participating hospitals. the consolidation entity might itself perform administrative services for all participants to the joint operating agreement or it might designate one of the participants as the central provider of particular administrative services for all other participants. from a tax standpoint, the primary concern for the participating hospitals is that the consolidation entity not be subject to corporate tax if the entity is organized as a corporation, or that the participating hospitals not be subject to the unrelated business income tax if the 25. see steven r. hollis, strategic and economic factors in the hospital conversion process, 16 health affairs 131, 132 (1997) (affiliations generally motivated by desire to obtain "negotiating clout" with health maintenance organizations, and to achieve "economies of scale"). joint operating agreements have not previously been the subject of analysis from a policy perspective. the "nuts and bolts" of joint operating agreements, however, have been discussed in recent literature. see rochelle korman & william f. gaske, joint ventures between tax-exempt and commercial health care providers, 74 tax notes 1575 (1997) (providing an excellent overview of the nonprofit/for-profit hospital structures emerging in the last 20 years). the following articles provide insights into the more practical aspects of joint operating agreements but do not address the integral part doctrine's validity or necessity: leslie j. gold, irs issues favorable ruling on company coordinating multiple hospital alliance, daily tax rep., dec. 6, 1996, at g-l; gerald m. griffith & brad m. tomtishen, irs adopts facts and circumstances approach for joas-part one, 14 exempt org. tax rev. 403 (1996); gerald m. griffith & brad m. tomtishen, exempt hospital affiliations: bond and ubit issues-part two, 13 exempt org. tax rev. 215 (1996); gerald m. griffith & brad m. tomtishen, exempt hospital affiliations: bond and ubit issues, 11 exempt org. tax rev. 709 (1995); peregrine & capizzi, supra note 8, at 101; michael w. peregrine et al., new guidance on tax treatment of joint operating agreements, 13 exempt org. tax rev. 439 (1996). 26. the resulting entity is more often called a "joint operating company" or a "super" parent. this article uses the term "consolidation entity" because it identifies the organization's functions in the same manner that the term "feeder organization" readily identifies organizations which function only to "feed" profits to an organization exempt under irc § 501(c)(3). [val 3:9 creating complex monsters consolidation entity is a partnership. 27 additionally, the hospital participants seek to avoid engaging in unrelated business activity or otherwise jeopardizing their separate tax exempt statuses by virtue of their sharing administrative burdens, such as billing or payroll activities. once approved by the service, the joint operating agreement will result in an exempt organization, the consolidation entity, which is owned by, takes its power and authority from, governs, and operates for the exclusive benefit of its tax exempt owners. although joint operating agreements are particular to the nonprofit health care industry, the concept of a tax exempt consolidation entity, i.e., an organization having as its claim to tax exemption the centralized provision of services to other tax exempt organizations, is neither foreign nor unprecedented to tax law. the service has previously approved tax exempt status for organizations which do not directly provide a charitable service, but which provide seemingly commercial services exclusively to organizations which themselves provide charitable services. for example, in revenue ruling 38512' the service approved tax exempt status for an organization that operated a cemetery exclusively for the benefit of its member churches. in revenue ruling 69-572,29 the service approved tax exempt status for an organization that constructed, owned and operated a building which provided rental space exclusively for other tax exempt entities. ' a likewise, congress has granted tax exempt status to certain organizations-apparently selected 27. irc § 512(c)(1) imposes the unrelated business tax on the partners when the unrelated activity is conducted via a partnership. 28. 1938-2 c.b. 166. 29. 1969-2 c.b. 119. other rulings granting tax exempt status to an organization which provides services exclusively to tax exempt entities include rev. rul. 71-529, 1971-2 c.b. 234 (organization that provides management services for unrelated colleges' and universities' endowment funds held exempt under irc § 501(c)(3)), and rev. rul. 74-614, 1974-2 c.b. 164 (organization providing computer services to several unrelated colleges and universities held exempt under irc § 501(c)(3)). 30. revenue ruling 69-572, 1969-2 c.b. 119, is most significant because of its explicit recognition that a charitable purpose is manifested through the consolidation of the efforts of other exempt organizations: because of the close connection between [the applicant organization] and the charitable functions of the tenant-organizations, the rental of the organization's facilities at rates substantially below their fair rental value, and the operation by the organization with the intention of realizing an amount sufficient only to meet annual operating costs, the organization is dedicated to carrying out the charitable endeavors of the community chest and its member agencies. the ruling did not discuss the potential for unfair competition. 19971 florida tax review without identifiable rhyme or reason-which provide otherwise commercial services solely to tax exempt organizations.3' section 501(m) of the code is especially noteworthy in that it specifically rejects the consolidation concept as it might apply to a company that sells "commercial-type insurance" solely to tax exempt organizations." again, there is no apparent rhyme or reason to the rejection of the concept when applied to the insurance industry, but section 501(m) certainly suggests a recognition of the basic concept.33 hence, the idea that the definition of "charity" might include the provision of cost or below cost goods and services to unrelated tax exempt organizations which themselves directly assist a class of beneficiaries is not at all new to tax jurisprudence. the service's grant of tax exempt status to consolidation entities resulting from joint operating agreements implies a further recognition of the underlying concept, but only after a good deal more refinement or perhaps regression, depending upon one's viewpoint. unlike joint operating agreements, in which structural form is of paramount importance, the service granted tax exempt status in older rulings to entities serving similar or even dissimilar tax exempt entities without regard to the structure between the service entity and the tax exempt entities being served.' 4 when the concept is recognized in various code provisions, there is also little attention paid to the structure of the relationships between the consolidation entity and the tax exempt organizations being served or between the tax exempt organizations themselves.35 under the present incarnation of the consolidation concept, by way of joint operating agreements, the relationship between the consolidation entity and the tax exempt participants, and the relationship between the tax exempt participants themselves is absolutely dispositive. ultimately, approval of tax exempt status for the consolidation entity and avoidance of tax liability by the individual participants depends upon a 31. see irc § 501(c)(12) (mutual ditch, irrigation or cooperative telephone companies); irc § 501(c)(13) (mutual cemetery companies); irc § 501(c)(25) (mutual real estate management company); irc § 501(e) (hospital service organizations); irc § 501(f) (cooperative mutual fund managers); irc § 501(n) (charitable risk pools). 32. florida hosp. trust fund v. commissioner, 103 t.c. 140 (1994), aff'd, 71 f.3d 808 (11 th cir. 1996) (affirmed without reaching the § 501(m) issue). 33. in addition, irc § 501(n) creates an exception to irc § 501(m), which might itself be viewed as an exception to irc § 501(c)(3) and therefore an implicit recognition that mutual organizations might achieve tax exempt status under irc § 501(c)(3). irc § 501(n) grants tax exempt status to a limited class of captive and mutual insurance companies. i have previously discussed captive and mutual insurance companies as they relate to irc § 501 (c)(3) and regs. § 1.502-1(b). darryll k. jones, the lingering demise of tax exempt mutual and captive insurance companies, 69 fla. b.j. 88 (1995). 34. see supra note 29. 35. see supra note 30. [vol 3:9 creating complew monsters high degree of governance, managerial and financial integration between and amongst the consolidation entity and the service recipients; an actual merger is not required but a mutual association or joint venture such as is found in previous revenue rulings or in various code provisions is insufficient. instead, the essential goal of a joint operating agreement, if it is to be approved by the service, is the appearance of a single parent controlling one or more subsidiaries. approval not only results in tax exempt status for the consolidation entity, but also allows any one of the subsidiaries to engage in otherwise normal business activity for the benefit of co-participants without engaging in an unrelated activity or otherwise jeopardizing their existing tax exempt status. so long as the activity is one which any one of the participating could perform for itself without incurring unrelated business income tax, and there is a sufficient degree of governance, management and financial integration, the consolidation entity will be granted tax exempt status and none of the participating entities will be considered to be engaging in an unrelated activity. through private correspondence 6 and internal agency training material,37 the service has listed several factors which it deems important to the establishment of sufficient governance, management, and financial integration. the factors are prefaced by an introductory comment which clarifies that the joint operating agreement must result in the appearance and substance of a shifting of functions and income from one department to another within a single entity, even though the agreement involves several unrelated entities.38 the comment further emphasizes that no single fact or pattern of facts is required, but the totality of the facts and circumstances must demonstrate a centralized source of control over the several entities such 36. internal revenue service letter to applicants for hospital joint operating agreements setting out factors for exemption, reprinted in daily tax rep.. july 24, 1996, at l-2 [hereinafter, joa applicant letter]. 37. darling & friedlander, supra note 8. at 135-36. 38. the service is looking for explicit manifestations of control under all the facts and circumstances of a joint operating agreement (joa) between otherwise unrelated hospitals or hospital systems such that dealings between the hospitals (and the parts of the hospital system that are completely financially integrated) under the agreement are merely [al matter of accounting between related organizations rather than rising to a level of unrelated trade or business activity contemplated by section 513 of the code .... this is a flexible control analysis that does not rely on structural control or any one factor (although some factors are more significant than others) but, rather, a preponderance of all the facts and circumstances that demonstrate that significant control over management and financial decisions have been ceded by participating entities to a mutual governing body under a joint operating agreement joa applicant letter, supra note 36. 19971 florida tax review that the several ostensibly unrelated entities function as a single multidepartmental unit.39 the factors which the service believes demonstrate the required control include whether the joint operating agreement delegates "significant management responsibility" to the consolidation entity. 40 for this factor to demonstrate the desired control, the consolidation entity must have concrete authority not only over long range plans, but also over "day-to-day" management decisions. a second factor considers the ease with which a joint operating agreement may be dissolved or a participant may withdraw from the joint operating agreement." the easier it is to dissolve or withdraw from 39. id. the service further instructs its field agents that: the ... facts and circumstances provide the basis for more flexible control analysis that does not rely strictly on the degree of structural control or any one factor. although some factors are more significant than others, the analysis looks to a preponderance of all the facts and circumstances that demonstrates significant control over management and financial decisions which have been ceded by participating entities to a governing body under a joint operating agreement or a "super" parent organization. there may be other facts and circumstances that have not been listed and they too will be considered if raised by organizations. darling & friedlander, supra note 8, at 134-35. 40. elements of specific management authority include: (1) authority to establish budgets. this significant aspect includes responsibility to establish overall budgets, as well as authority to approve major expenditures, debt, contracts, managed care agreements, and capital expenditures. this aspect also considers whether the joa governing body regularly meets to establish long term and short term budgets and to implement its decisions. (2) authority by the joa governing body to monitor and audit each participating entity's compliance with its directives. this is a significant aspect. (3) authority to direct services. this significant aspect considers whether the joa governing body can direct that health care services be undertaken or not be undertaken by the participating entities. for example, whether the governing body of the joa can direct a participating hospital to refrain from being a provider of pediatric services. (4) authority to enter agreements that bind participating entities, particularly agreements with managed care providers. (5) authority to hire and fire personnel. (6) authority to grant hospital staff privileges. (7) authority to set or approve fees and prices. (8) authority to buy assets for and sell assets of participating entities. (9) authority to re-allocate income among the participating entities to balance income and expenses to assure financial integration and to achieve mutual objectives. id. at 135. 41. factors that establish a permanent arrangement include whether there are significant penalties or other hindrances to terminating the agreement, and whether [vol 3:9 creating complex monsters a joint operating agreement, the less logical it is to view the arrangement as a merger-in-fact. the third factor is actually a subset of the second factor and focuses on whether the joint operating agreement establishes informal dispute mechanisms.42 the existence of informal dispute resolution procedures, particularly binding arbitration, makes it more difficult for a participant to withdraw from the joint operating agreement and thereby provides a level of permanence coming closer to that found in an actual merger. the fourth factor listed by the service is whether any particular participant possesses or may exercise routine veto power over decisions made by the consolidation entity.43 if so, then authority really hasn't been ceded to the consolidation entity since any one party might thwart the consolidation entity's authority. under the facts and circumstances approach, only a preponderance of these factors need be present to demonstrate an integrated governance, managerial, and financial structure. the reservation of too much veto power, however, is logically most significant since the exercise of that power could negate the existence of all other factors. there are mechanisms such as direct negotiations and binding arbitration in place to resolve disputes among the parties. the degree to which the joa is permanent also effects the determination whether the joa establishes the equivalent of a parentsubsidiary relationship. id. at 136. 42. this factor is indeed listed as part of the second factor in the training material. see id. but it is listed as a third factor in correspondence to applicants. joa applicant letter, supra note 36. 43. a veto power is not the same as a power to initiate an action. if the authority ceded to the joa governing body is merely the power to veto actions taken by participating hospitals, then the facts and circumstances necessary to establish the equivalent of a parent-subsidiary relationship would not be present. similarly, if actions of the joa governing body are subject to veto by the participating hospitals, this too would negate a finding that the hospitals function as subordinates of the joa. if participating hospitals retain some authority, this is not necessarily determinative of whether the equivalent of a parent-subsidiary relationship has been established. for example, authority over ethical or moral issues based on religious principles may be reserved by the participating entities. if all of the other surrounding facts and circumstances showed that sufficient authority had otherwise been ceded to the joa governing body, this type of reservation would not preclude a finding that the equivalent of parent-subsidiary relationship had been established. darling & friedlander, supra note 8, at 136 (headings omitted). two practitioners suggest that instead of allowing a party to veto action with respect to a very significant matter, the service prefers that the agreement not allow the action in the first place except in accordance with a supermajority voting provision. kenneth l tracy & elizabeth b. lewis, latest joa ruling confirms internal revenue service flexibility on parent-subsidiary relationship issue, 16 exempt org. tax rev. 449. 455 (1997). 19971 florida tax review in the original series of private letter rulings approving the implementation of joint operating agreements, 44 the service discussed the governance and managerial factors which supported its approval of the arrangements. the results in all four rulings was the creation of tax exempt consolidation entities and a determination in each ruling that an exempt participant would not derive unrelated business income from the provision of goods and services to another participant. although the results were identical in each ruling, the service discussed the governance and managerial factors in much greater detail in the second and third rulings. in private letter ruling 9623011, the second ruling, corporation a owned 100% of corporation b, hospital a-i, hospital a-2, and other unspecified "health care facilities." corporation b owned 100% of hospital b. collectively, the several entities were referred to as group a. a second group, referred to as group c, contained corporation d which owned 100% of corporation c. corporation c owned 100% of hospital c-i, hospital c-2 and also unspecified "health care facilities." figure i (page 579) graphically illustrates the corporate structures of the two groups prior to entering into the joint operating agreement. 44. priv. ltr. rul. 97-14-011 (dec. 24, 1996); priv. ltr. rul. 96-51-047 (sept. 24, 1996); priv. ltr. rul. 96-23-011 (feb. 29, 1996); priv. ltr. rul. 96-09-011 (nov. 22, 1995). since the first four rulings were issued, the service has approved joint operating agreements with almost verbatim boilerplate language. see supra note 9 and the subsequent private letter rulings cited therein. [vol 3:9 19971 creating comzplex monsters 579 -cou 0 c--clc florida tax review according to the facts provided in the ruling, both groups operated within the same geographical area. thus, several relevant assumptions concerning the operating environment might be safely accepted. first, there existed substantial duplication of services within the geographical area. many of the health services available from hospitals within group a were also available from hospitals in group c. second, the competition between the two groups in the same geographical area increased the labor costs associated with staff physicians, nurses, technicians, administrators and staff. third, the collective capacities of the two groups was greater than overall demand for health care. fourth, the added effect of available health care from for-profit hospitals served to aggravate the earlier stated factors and all four factors resulted in increased costs to patients. the ruling does not explicitly acknowledge these assumptions but states that the parties proposed the joint operating agreement to unify and enhance health care services, and eliminate duplicate services in order to achieve cost efficiencies and improve health care access. 45 45. in the most recently approved joint operating agreement, the hospitals confirmed the adverse consequences by an independent study which identified areas of potential savings. tracy & lewis, supra note 43, at 449. the macroeconomic factors which make the listed assumptions more acute than they would otherwise be generally revolve around the federal government's efforts to impose cost controls on escalating health care costs. cost control is the essence of "managed care" and is generally achieved through greater scrutiny of the need for certain health care services and shorter hospital stays. the "tools" of managed care include "preadmission certification" of need for services, controlling the length of hospital stays and close supervision and management of acute or long term care. see paul b. ginsburg & jeremy d. pickreign, tracking health care costs, 15 health affairs 140, 148 (1996); see also james j. mcgovern, restructured nonprofit hospitals, 16 tax notes 405 (1987). as operating costs increased, government support decreased. james j. mcgovern, the irs compliance program for nonprofit hospitals, 16 exempt org. tax rev. 201 (1997). the result was an effort to maintain viability by controlling costs through consolidation efforts, including actual mergers and acquisitions, and increased competition for patient revenue. since health care costs remain relatively static in the new "managed care" environment, volume and efficiency has become more important. thus hospitals, both forand not-for-profit, have also been forced to compete for physician and staff support. see gary j. young et al., does the sale of nonprofit hospitals threaten health care for the poor, 16 health affairs 137 (1997); mcgovern, the irs compliance program for nonprofit hospitals, supra. two commentators have cataloged the macroeconomic factors given in requests for irs approval of joint ventures between exempt hospitals and nonexempt hospitals. these factors include (1) price competition resulting from a shift in government policies regarding reimbursements for medical care, (2) impact of managed care on cost of health care delivery to employers and other third party payers, (3) increased working capital needs, (4) providing new health care or maintaining present health care to a community, (5) increased efficiency and reduced financial risk, and (6) expanding opportunities to specialized cases in order to further medical education. korman & gaske, supra note 25, at 1575. [vol 3:9 creating complex monsters the adverse consequences resulting from the status quo might have been mitigated within each group and without affecting each participant's separate tax exempt status by resort to the integral part doctrine. under that doctrine, a subsidiary which provides otherwise commercial type services, such as billing, laundry, or food service, to a parent organization may achieve or maintain tax exempt status and will not be considered as engaging in an unrelated activity, provided the commercial type services are activities in which the parent itself could have engaged without carrying on an unrelated business activity.46 the basic rationale is that if the parent could conduct the activity without adverse tax consequences, it should not suffer these consequences simply because nontax considerations lead the parent to conduct the activity through a subsidiary.47 the performance of services by the subsidiary is viewed merely as the shifting of income and activity from one department within an entity to another.48 to ignore this reality, by denying tax exempt status, would unnecessarily interfere with the sound business practice which presumably led to the establishment of the subsidiary.49 the service's integral part doctrine has a number of distinctions relating to the relationship of the service provider and recipient of the services; some of these distinctions are rejected by or absent from judicial opinions.5" in addition to the provision of services to a parent, a subsidiary may provide services to other exempt entities but only if they have the same parent corporation as the service-providing subsidiary. the rationale stated earlier is not violated by allowing sister organizations to consolidate since each are performing services ultimately for the benefit of a single parent which could have performed the service itself. a subsidiary corporation, though, cannot perform services for an organization with whom the subsidiary does not share a common parent even if the service-recipient organization 46. regs. § 1.502-1(b). 47. id. whether the parent could have engaged in the activity itself is a determination made under irc § 513. see supra note 24. if the subsidiary's activity is substantially related to the parent's accomplishment of the parent's exempt goals, regs. § 1.502-1(b) will allow the subsidiary to be granted tax exempt status. 48. rev. rul. 38-51, 1938-2 c.b. 166 ("pv]hat a corporation. exempt under [irc § 501(c)(3)].. ., may do directly without forfeiting its right to exemption, it may do through a corporation organized for that purpose, and... a corporation so organized and operated is entitled to exemption."). 49. regs. § 1.502-1(b) ("[e]xemption will not be lost because, as a matter of accounting between the two organizations, the subsidiary derives a profit from its dealing with its parent."). 50. this portion of the article focuses on regs. § 1.502-1(b) to demonstrate how the joint operating agreement requirement is derived from this regulation. in part iv, the article discusses the judicial rejection (but not overruling) of some of regs. § 1.502-1(b)'s distinctions and therefore the invalidity of the joint operating agreement requirement. 1991 florida tax review performs a similar charitable service as the service-provider or the serviceprovider's parent organization.5 nor may the subsidiary corporation perform services for multiple parent organizations even though the multiple parents share similar charitable goals. 2 the one point on which regulations section 1.502-1(b) is consistent with the judicial articulation of the integral part doctrine is in the regulation's recognition that a formal parent-subsidiary corporate structure is not absolutely necessary. instead, both the serviceproviding and service-recipient organizations must only be in a "close and intimate" relationship with a common parent-type organization, i.e., an organization exercising some degree of control over, but not necessarily having a formal ownership relationship with all the other organizations involved.53 the distinctions made by the regulation, together with its acceptance of less than a formal parent-subsidiary relationship collectively result in the necessity and applicability, respectively, of joint operating agreements. thus, within group a of private letter ruling 9623011, hospital a-1 may provide administrative and medical support services to any other participant within the group. in this manner, group a and likewise group c could achieve some degree of consolidation and mitigate the adverse consequences discussed above, and no doubt did so. but neither hospital ai nor hospital c-i, for example, could provide services to one another or to any other hospital within the opposite group without engaging in an unrelated business activity. hence, duplication of services, increased labor costs, capacity in excess of need and the resulting increased costs to patients is only partially mitigated through separate application of the integral part doctrine to the two groups as illustrated in figure 1 (page 579). to fully alleviate the adverse consequences using the integral part doctrine, the two groups would have to submit to the control of a common parent or parent-like organization. then, the sharing of resources and services would fit within the analogy of merely shifting income and functions between several departments of a single entity. the resulting agreement therefore created a third corporation, corporation e, which possessed governance and managerial authority over all participating hospitals. figure 2 (page 583) illustrates the corporate structure after the joint operating agreement. 51. regs. § 1.502-1(b)(2) ("an exempt organization is not related to another exempt organization merely because they both engage in the same type of exempt activities."). 52. id. 53. the regulation does not state this rule explicitly but it has been so interpreted by the service. see rev. rul. 81-19, 1981-1 c.b. 353; rev. rul. 76-336, 1976-2 c.b. 143. [vol. 3:9 1997] crealing complex monsters 583 c-)) 0 c-w7 0 0 0~0 0 c, ~c =a c3. ci, 0 florida tax review the authority ceded to corporation e, the consolidation entity, included the right to review and approve strategic plans, manage network participants and establish overall operating procedures. ownership and liabilities of each participant, however, remained unchanged. corporation e also lacked any real authority over the financial integration of the parties. instead, the net revenues were distributed to the participants according to a formula which required the two groups to make annual payments to each other.54 the amount of the payments were based upon the value of assets and excess revenue potential contributed by each party, with more weight assigned to the value of assets contributed. the actual ratios and assigned weights given to them, however, would not be subject to change as a result of any participant's future performance. the implication is that the weights and ratios could be changed for noncompetitive reasons. thus, although financial authority was lacking, financial integration was still achieved. no participant would have a competitive motivation vis-a-vis another participant to make capital contributions or increase its patient base. instead, the success of any one participant would be tied to the success of all other participants. the joint 54. network participants effectively accomplish financial integration through annual payments between group a and group c. the amount of payment will be based upon a weighted average of two ratios each determinable as of a financial statement date described in the [joint operating agreement]. one ratio is based upon the fair market value of the assets of group a and the assets of group c, plus or minus (as appropriate) certain specified assets or liabilities. the other ratio is based on the average excess of revenues over expenditures for the four most recently completed fiscal years of group a and group c prior to the execution of the [joint operating agreement]. the amount of weight given to each ratio will vary over a term of years with a declining weight given to the income ratio and an increasing weight given to the asset ratio. priv. ltr. rul. 96-23-011 (february 29, 1996). 55. once the [joint operating agreement] is effective, neither the ratios nor the weighted averages will be adjusted because of the future performance of any network participant. thus, there will be no financial incentive for any network participant to encourage the use of services at, or to make capital additions to, any particular facility and a network participant performing a service pursuant to the [joint operating agreement] will not receive any separate profit or benefit for rendering the service. similarly, corporate and administrative services performed by any network participant will financially benefit any particular network participant only insofar as all network participants benefit from efficient performances of these services. id. it is difficult to visualize the actual methodology used to achieve financial integration. see supra note 54. but it is easier to conclude from the above quote and an understanding of regs. § 1.502-1(b) that financial integration means that the parties must achieve the same cooperative, noncompetitive relationship as that which would result from an actual merger. [vol. 3:9 creating complex monsters operating agreement thus resulted in the structure of a parent organization, corporation e, having most of the attributes of ownership over, without actually owning, all the other participants. under the integral part theory discussed above, then, any one of the participants could provide services to any other participant without engaging in an unrelated activity or otherwise jeopardizing the service-providing participant's tax exempt status. one hospital could provide billing services for the others, another could provide food service, another legal and yet another could provide payroll and labor management services. the consolidation entity could provide any of these services for any participant. this consolidation within and between both groups more fully alleviates the adverse consequences resulting from the duplication of services existing prior to the joint operating agreement and ultimately benefits the commonly shared charitable beneficiaries.' one significant difference between the parent-subsidiary model of prior rulings and the typical joint operating agreement is that authority and control are ceded from the parents to the "subsidiary." what might appear to be a subordinate entity is, in actuality, a superior entity which exercises governance, managerial and financial control over the creating entities. traditionally, the integral part theory is applicable to a subordinate entity which engages in some activity which its exempt parent organization could itself perform without adverse consequences." in joint operating agreements, the integral part doctrine is applied in reverse order. as far as the integral part doctrine is relevant, the parent gains its exemption through the activity 56. a recent study demonstrates that 1990 administrative expenses accounted for approximately 25% of overall hospital spending in the united states, more than twice the percentage spent by canadian hospitals. steffie woolhandler & david u. himmelstein. costs of care and administration at for-profit and other hospitals in the united states, 336 the new eng. j. med. 769 (1997). the united states amount increased to 26% by 1994. curiously, 1994 administrative costs accounted for 34% of spending by for-profit hospitals but only 24.5% of spending for not-for-profit hospitals. id. at 770. the study included the following activities in the definition of "administrative": administrative and general as defined by medicare regulations, nursing administration, central services and supplies, medical records and library, employee-benefits department (salary costs only), administrative and general home health, skilled-nursing facility utilization review. id. at 771. the study included the following activities as "mixed administrative and clinical": capital-related costs-building and fixtures, capital-related costs-movable equipment, employee benefits (except benefits-department salaries), maintenance and repairs, operation of plant, and debt-service. id. with hospital administrative costs comprising one-quarter of nonprofit hospital spending, there is certainly incentive and need for consolidation. 57. see mcgovern, supra note 45, at 405, 411. ("this structure suggests that the basis for the integral part theory of exemption is the control vested in the tax-exempt parent over the activities of its subsidiary. the relationships of organizations within the reorganized hospital system, however, are the inverse of that suggested by the regulations. it is the parent organization seeking to derive its exemption from subsidiary organizations.") 19971 florida tax review of its subordinate organization. if the "close and intimate relationship" exists, however, granting tax exempt status to the parent does not violate the substantive notion that income and functions are merely shifted from one department to another within a single entity. 8 logically, that notion is more important than the hierarchy between the parties. private letter ruling 9651047 contains the service's most comprehensive discussion of the factors leading to approval of a joint operating agreement.59 the facts of that ruling, prior to the implementation of the joint operating agreement, demonstrated a greater degree of duplication of services and a corresponding increased severity of adverse consequences than in other rulings. unlike the prior rulings, none of the five hospitals involved in private letter ruling 9651047 belonged to a health care network prior to the joint operating agreement.6 0 instead, each participant was a stand-alone hospital and each provided similar services all within the cincinnati, ohio area. 6' thus, the integral part doctrine was unavailable to allow even the partial consolidation of services. the service's approval of the resulting joint operating agreement in the private letter ruling 9651047 indicates that the facts and circumstances approach allows for more than one method to achieve the level of integration necessary to the application of the integral part doctrine. particularly, the parties demonstrated a much greater degree of centralized government management, and financial integration than in other rulings.62 to a much 58. see regs. § 1.502-1(b). 59. priv. ltr. rul. 96-51-047 (sept. 24, 1996). 60. the ruling does not identify the hospitals involved in the agreement. thanks, however, are owed to ms. kathleen bruvold, associate general counsel for the university of cincinnati, for providing the author with a copy of the agreement. amended and restated joint operating agreement among the christ hospital and university of cincinnati and the st. luke hospitals, inc. and jewish health system, inc. and the health alliance of greater cincinnati (jan. 1, 1996) (on file with the florida tax review) [hereinafter greater cincinnati joint operating agreement.] certain provisions of the agreement are reproduced verbatim in the footnotes which follow. 61. the hospital participants are: the christ hospital, a 501(c)(3) organization having its principle offices in cincinnati, ohio, the university of cincinnati hospital, a state agency having its principle offices in cincinnati, ohio, the college of medicine of the university of cincinnati, also a state agency having its principle offices in cincinnati, ohio, st. luke's hospital, a 501(c)(3) organization having its principle offices in ft. thomas, kentucky, and jewish health systems, inc., a 501(c)(3) organization having its principle offices in cincinnati, ohio. greater cincinnati joint operating agreement, supra note 60, at 73. 62. priv. ltr. rul. 96-51-047 (sept. 24, 1996). article iii of the greater cincinnati joint operating agreement, supra note 60, at 14-15, provides: 3.3. role of the joint operating company board. the joc board, subject to certain powers reserved to the participating entities, shall have responsibil[vol 3:9 creating complex monsters greater extent than other rulings, the overall facts support the conclusion that the five formally separate hospitals achieved an "all for one, one for all" relationship such that competitive motivations between the participants would be preempted by cooperative motivation. the result, as in prior and subsequent rulings, was the unification of services and conservation of funds to the benefit of shared charitable beneficiaries.63 ity for the overall management and supervision of the joc and its activities, including but not limited to the operation of the alliance, in furtherance of the purposes set forth in the articles of incorporation. including but not limited to the power to: 3.3(a). establish appropriate policies and strategic direction to enable the alliance to function as an integrated health care delivery system providing a full range of health care services without regard to race, creed, color, national origin or economic status; 3.3(b). facilitate cooperative and collaborative efforts by and among the participating entities with respect to the provision of health care services, including but not limited to efforts to enhance existing health care delivery facilities and systems and establish efficient and economical systems of health care delivery operating on an integrated basis and providing a continuum of care; 3.3(c). reduce the cost of the delivery of health care services and otherwise effect efficiencies and economies of scale in the delivery of health care services by the participating entities; 3.3(d). enhance the health status of the community by developing and offering new and/or expanded health care services, including but not limited to wellness programs, preventative health initiatives and services, and community and patient need and satisfaction assessments: 3.3(e). govern the alliance and provide health care services in a non-discriminatory manner for the benefit of all persons in the community, including the indigent and those persons whose care is paid for in whole or in part through government sponsored programs such as medicare or medicaid; 3.3(f). develop, promote, operate and/or support educational and scientific research activities and programs through the alliance in furtherance of the general health of the communities served by the alliance: 3.3(g). review and approve financial and strategic plans and operating and capital budgets for the alliance to be developed and implemented by joc management, including issuance of all debt: 3.3(h). enter into contracts on behalf of the participating entities with respect to the organization and operation of the alliance; 3.3(i). hire, evaluate and compensate the joc ceo and participate in the selection of the other senior management of the alliance: and 3.3(j). do all other things necessary and appropriate to carry out the duties and responsibilities of the joc in governing, managing and operating the alliance and achieving its strategic goals consistent with the terms and conditions of this agreement. 63. priv. ltr. rul. 96-51-047 (sept. 24. 1996). article i1 of the greater cincinnati joint operating agreement, supra note 60, at 12, states: 19971 florida tax review the consolidation entity created in private letter ruling 9651047 has virtually all the power and authority over the five participants that a single governing board would have over its own single institution. for example, the consolidation entity has the authority to enter into contracts on behalf of the entire system or any one of the participants. it also has authority to formulate strategic and financial plans, direct which hospital would perform which service, reassign assets from one hospital to another, coordinate the practices of the hospitals' staff physicians, and establish budgets for the hospitals.64 additionally, the consolidation entity's chief executive officer serves as the chief executive officer for each of the five participating hospitals.65 unlike the prior and subsequent rulings, however, this ruling did not involve a formalistic method of annualized payments between the participants. instead, the consolidation entity has the authority to retain all net revenues and direct them to any facility within the system as the system's needs dictate.' thus the consolidation entity has financial governance authority greater than that in other rulings. the service reviewed the facts in great detail and concluded that the consolidation entity qualified for tax exempt status and that any party to the joint operating agreement could transfer assets, resources and personnel to any other party without jeopardizing its tax exempt status or engaging in 2.2. strategic goals. the alliance will accomplish its mission by achieving the following strategic goals: 2.2(a). to enhance the ability of the participating entities to respond to health care needs of the communities served by the participating entities by creating an integrated health care delivery system serving ohio, kentucky and indiana, developing a primary care network, and developing the necessary infrastructure and information systems to more effectively manage the delivery of health care to enrolled populations. 2.2(b). to reduce the costs of health care providers participating in the alliance, and the ultimate cost of health care to the communities served by the alliance. 2.2(c). to improve the quality of educational programs offered by the participating entities through continual support of the teaching and research activities of the participating entities, focusing resources and expanding primary care training venues and modalities, and as otherwise provided herein. 2.2(d). to enhance the general health status of the communities by developing the capabilities to manage enrollee health care costs through risk-sharing arrangements including capitation; offering new methods of health care delivery including wellness, preventative health initiatives and patient satisfaction measures; and maintaining a commitment to provide care (subject to the availability of resources) on a nondiscriminatory basis to the indigent and those whose health care is paid for, in whole or in part, by any governmental program, including medicare and medicaid. 64. priv. ltr. rul. 96-51-047 (sept. 24, 1996). 65. id. 66. id. [not. 3:9 creating complex monsters an unrelated business activity.67 the parties were therefore able to achieve complete consolidation. the resulting merger in private letter ruling 9651047 was more actual than virtual, since the consolidation entity exercised almost all the attributes of ownership over assets, legal title to which remained with the participants. that fact leaves one to wonder about the degree of integration that the service's facts and circumstances test actually requires. a synthesis of the rulings certainly suggests that at a minimum the parties must achieve a codependent/cooperative rather than competitive/duplicative relationship. but if the degree of integration in the third ruling is now the standard or even a safe harbor, there is little difference between a virtual and actual merger, the latter of which the parties presumably disdained for sound nontax operating reasons. hence, the joint operating agreement requirement, at least as demonstrated by the third ruling, results in the law's coming full circle from a point at which an actual parent-subsidiary relationship need not exist to the requirement that such a relationship be proven even while the parties disdain and deny its existence. the overall conceptualization of joint operating agreements begs the question not whether the virtual merger requirement is sensibly imposed from a tax policy standpoint, but whether actual or virtual mergers are sensible alternatives to the simple creation of a mutually-owned captive subsidiary or mutual cooperation between exempt organizations. certainly, approval ofjoint operating agreements represents the service's grant of relief to entities who need to consolidate but who do not wish to effect an actual merger. but joint operating agreements, vis-a-vis mutual subsidiaries, are as burdensome and complex as actual mergers and hence provide little or no relief for those exempt organizations who, for sound operating reasons, do not wish to actually merge but still need to eliminate duplication of services. the need, moreover, is caused by the service's prohibition of mutual subsidiaries under regulations section 1.502-1(b)'s articulation of the integral part theory, not from an apparently logical limitation of choices to mergers on the one hand, and debilitating and wasteful duplication of services on the other. none of the rulings or internal training material, though, address the necessity for the complexity engendered by joint operating agreements. in fact, the emergence of joint operating agreements is notable for the lack of any real policy discussion beyond the way these agreements work. such a discussion is necessary and should first acknowledge the problem of complexity in tax law and how joint operating agreements contribute to that complexity, and then examine the policy reasons, if any, which justify the complexity particular to joint operating agreements. 67. id. 19971 florida tax reviewv mi. the bane of complexity there is no great revelation in the recognition that the tax code, along with its interpretive byproducts, is massive, complex, and massively complex.68 in fact, any statement concerning the tax code's complexity necessarily falls in the category of understatement since no single scholar can accurately measure the infinitesimal nature of the code's complexity. nevertheless, several scholars have identified particular aspects of the complexity with both elegance and analytical acuity. 69 although the problem is stated differently and only by way of anecdotal examples, commentators and indeed the courts70 generally accept the notion that tax law is simply too complex. the manifestation of complexity, oddly enough, can be summarized in a few easily understood statements. first, complexity is manifested in the inability of taxpayers and tax collectors to arrive at a "reasonably certain conclusion [concerning a transaction] despite diligent and expert research.' this first type of complexity might generally be stated as an inability to know the law. the most immediate cause of this form of complexity, although certainly not the only cause, is the shear length of the code.72 even a straight line between two points can be confusing if one cannot know where to start or when to stop. if nothing else, the code's volume creates anxiety 68. defining "complex" is itself a complex exercise. the american heritage college dictionary seems to have the tax code in mind when defining "complex." it uses a list of synonyms in the following discussion: these adjectives mean having parts so interconnected as to make the whole perplexing. complex implies a combination of many associated parts .... complicated stresses elaborate relationship of parts .... intricate refers to a pattern of intertwining parts that is difficult to follow or analyze .... involved stresses confusion arising from the commingling of parts and the consequent difficulty of separating them .... tangled strongly suggests the random twisting of many parts .... knotty stresses intellectual complexity leading to difficulty of solution or comprehension. the american heritage college dictionary 285 (3d ed. 1993). 69. see eustice, supra note 4; pollock, supra note 4; roberts et al., supra note 4; sawyer, supra note 4; surrey, supra note 4; white, supra note 4. 70. the courts have, on occasion, noted or decried the complexity even in the provisions relating to tax exempt organizations. see bob jones university v. united states, 461 u.s. 574, 596-99 (1983); windsor foundation v. u.s. 77-2 ustc (cch) t 9,709 (e.d. vir. 1977) ("on the basis of the congressional enactment, 26 u.s.c. § 501, et seq., the internal revenue service has drafted fantastically intricate and detailed regulations in an attempt to thwart the fantastically intricate and detailed efforts of taxpayers to obtain private benefits from foundations while avoiding the imposition of taxes."). for a compilation of judicial statements concerning the code's complexity see, katz, supra note 4. 71. roberts et al., supra note 4, at 327. 72. one commentator notes that the code and regulations consisted of a single volume of approximately 400 pages in 1913, but, by 1994, the code and regulations took up eight volumes and consisted of more than 36,000 pages. pollock, supra note 4, at 320 n.3. [vol. 3:9 creating complex monsters which in real terms translates into delay and expense as practitioners are forced to consider and then apply or discard, as the case may be, the many different cross-referenced provisions which may be relevant to a transaction. second, complexity is manifested in the inability to achieve a reasonably certain conclusion except after an inordinate expenditure of time and money." this type of complexity can be summarized as an inability to afford the law. being unable to afford knowledge of the law is too often the case with provisions which are intended to narrow the path to a desirable result, i.e., anti-abuse provisions. 74 third, a conclusion might be knowable with or without much time or effort, but implementation may require an inordinate amount of time and money, or an inordinate change in operating practices. in other words, the tax rule might be easily found and stated, but its substance requires involved or detailed changes in operating practice, which would otherwise not be undertaken. this type of complexity is best described as "transactional complexity" because the tax rule is easy enough to determine but difficult to implement." each of the three types of complexity, but the third most of all, violate the accepted notion that tax rules should be neutral and "not distort the economy or the efforts" of those subject to the rules.76 thus, in all respects and however crude it may sound, complexity is defined by reference to time and money. too much time and too much money must be diverted to tax compliance and away from the purpose of the taxpayer's principle endeavors. congress is foremost amongst the list of usual suspects responsible for tax complexity.77 it is faulted for several reasons, including the apparently opposite assertions that statutes are written much too ambiguously78 and with too much detail and specificity.79 this criticism might be reconciled by 73. roberts et al., supra note 4, at 327. 74. see, e.g., irc §§ 469, 1272-1275, 7872. 75. charles e. mclure, jr., the budget process and tax simplification/complication, 45 tax l. rev. 25, 46 (1989) ("for one thing, factoring tax considerations into business decisions can be expected to complicate decision making, creating transactional complexity."). 76. eustice, supra note 4, at 10. 77. id. at 13. 78. pollock, supra note 4, at 339 (discussing vague and overly-broad language). 79. eustice, supra note 4, at 10 ("but surely the charitable deduction section, a provision commonly used by taxpayers with widely varying levels of expertise in statutory analysis, is not worthy of a 13-page provision in the code, but there it is."): see also dunn, supra note 6, at 321. dunn states: [a] full and detailed legislative solution is not only enormously complicating, but it allows taxpayers to develop schemes and plans to avoid the legislative purpose when that purpose is set forth in precise and detailed statutory language. this, in turn, as noted above, leads to further legislative responses .... because such legislation is necessarily complicated and detailed, it is normally very difficult for taxpayers, their advisors 19971 florida tax review the notion that it ought to be possible to draft a statute in broad general terms and still adequately identify the consequences of a particular transaction, or favored/disfavored transactions, without including the degree of specificity which gives the code its impenetrability.8" the use of overly specific language merely expresses a lack of confidence in the judiciary's role in interpreting tax provisions. it co-opts the judiciary's role by stating a rule and determining a result in a fact situation far too specific to be reasonably injected into a statute. 1 courts too often accede to this subordination by stating that the code's complexity necessitates the judiciary's acceptance of a passive role.82 this accession by the courts only reinforces the result. the code becomes increasingly specific, i.e., complex, as the judiciary become more and more reluctant to interpret or analyze these tax provisions ostensibly because of their complexity. and tax administrators to understand and implement such legislation. such complex tax legislation presents taxpayers, tax professionals, and tax administrators with enormous compliance problems and not infrequently leads to a general disregard and disrespect for such legislation. id. 80. the danger to this observation and the catch-22 for drafters, at least with respect to regulations, is that if a regulation is drafted too generally, it may be struck down as unconstitutionally vague. see big mama rag, inc. v. united states, 631 f.2d 1030 (d.c. cir. 1980) (finding the definition of "educational" in regs. § 1.501(c)(3)-1(d)(3) unconstitutionally vague.) but irc § 61 is a good example of legislative drafting that is general, yet with the assistance of the judiciary, has a generally understood and agreed upon meaning. professor eustice argues that drafting statutes and regulations in general terms does not solve the complexity problem but merely shifts the problem to another branch-from the legislative and executive to the judiciary. eustice, supra note 4, at 10-11. but one of the problems of statutory detail is that it discourages the simplification of tax laws through the application of trial and error that is most appropriate to the executive and judicial branches. courts seem most reluctant to offer the benefit of interpretation under a sharply focused set of facts when the statute is long and cumbersome, trusting instead that the detail is in the statute and the executive branch knows the detail best. 81. see generally michael livingston, congress, the courts, and the code: legislative history and the interpretation of tax statutes, 69 tex. l. rev. 819 (1991); karla w. simon, constitutional implications of the tax legislative process, 10 am. j. tax pol'y 235 (1992) [hereinafter simon, constitutional implications]; karla w. simon, congress and taxes: a separation of powers analysis, 45 u. miami l. rev. 1005 (1991) [hereinafter simon, congress and taxes]. 82. see bob jones university v. united states, 461 u.s. 574, 596 (1983). but see simon, supra note 80, at 244 ("the rules developed by the treasury and the service will tend not to reflect the wishes of special interest groups. as a result, courts by and large may defer to treasury and internal revenue service rules and regulations without fear that the process of their adoption has been tainted ... "). [val. 3:9 creating complex monsters another criticism not as often mentioned as a source of complexity is congress' excessive reliance on nonstatutory legislative material."z by using committee reports and other nonstatutory material to express substantive tax law, congress contributes to both the inability to know and the ability to afford the law in procedural and substantive ways. from a procedural standpoint, the use of nonstatutory legislative material contributes to the diffusion of authority which makes tax practice so time consuming, unscientific and expensive relative to other areas of law. in addition to statutes, regulations, revenue rulings and judicial opinions, practitioners must also find and decipher various committee reports, post-enactment explanations and any number of other bits and pieces from the legislative process.' substantively, nonstatutory legislative material contributes to tax complexity because it raises serious questions of authority. since it is enacted, if at all, entirely outside of the constitutional process,ss committee reports and the like are of dubious value. yet, however dubious and obscure it may be, a piece of legislative history regarding a particular transaction can be ignored only at the taxpayer's peril.8 6 83. see livingston, supra note 81, at 847 ("[tlhe use of legislative history results in an unnecessary expenditure of time and money, and lawyers (and perhaps some judges) lack the ability to interpret and apply such history correctly."). 84. for a good discussion of the difficulties of finding and then interpreting the mass of tax legislative history created by congress and the interpretive statements issued by the service, see sheldon i. banoff, dealing with the "authorities": determining valid legal authority in advising clients, rendering opinions, preparing tax returns and avoiding penalties, 66 taxes 1072, 1075-1133 (1988). 85. see simon, constitutional implications, supra note 81. at 256. professor simon states: by elevating legislative history to the level of a statute and giving the materials as much deference as is given to the words of a statute, congress would be writing laws without going through the normal political process. and it would be stealing power from the executive by telling it how to write rules and from the judiciary by telling it how it must interpret them. this is something the courts should not readily permit.... id. 86. a simple case demonstrates the proposition. in porten v. commissioner. 65 t.c.m. (cch) 1994 (1993), a student sought relief from the realization of income from the discharge of a student loan under irc § 108(f)(1). irc § 108(f)(1) provides relief from realization if the discharge is made conditional upon the student's agreement to work "for a certain period of time in certain professions for any of a broad class of employers." the postenactment legislative history known as the "bluebook" amongst tax practitioners, limits the "certain professionals" to medicine, nursing, and teaching, although the limitation is not stated in the statute or regulations. staff of the joint comm. on taxation, 98th cong., general explanation of the revenue provisions of the deficit reduction act of 1994, at 1200 (joint comm. print 1985). the court, though, adopted the post-enactment legislative history and relied upon it to deny relief to the student. porten. 65 t.c.m. (cch) at 1996. 19971 florida tax review the treasury department, too, is faulted for its role in creating unnecessary complexity. unlike congress, treasury's role can be summarizedby reference to a fiscal stinginess, which is entirely appropriate, but which is too often manifested by an overly cautious and sometimes obsessive approach to substantive questions of tax law.87 final regulations, for example, are routinely enacted years after they are initially proposed, apparently as a result of a fear of expressing a binding (upon the service) interpretation lest the interpretation leave room for abuse.8 treasury's obsessive characteristics are most demonstrated, frankly, by an inability or unwillingness to take "no" for an answer when to do so would be both reasonable and provide needed certainty to an issue. this is particularly true with respect to judicial decisions with which the treasury disagrees and, despite well reasoned opinions, continues to litigate.89 that the treasury might continue to litigate a point encourages a disrespect for the judiciary's role in tax jurisprudence and increases the transactional burdens, i.e., the complexity, of a related transaction since the taxpayer must factor in the risk of future litigation. one final example of treasury's stinginess concerns the length of time the service takes to issue technical advice and private rulings to taxpayers, who, being unable to safely conclude a transaction due to already existing complexity, must invariably seek prior approval from the service. this latter result, the necessity to obtain prior irs approval, might appropriately be called the "reverse tax lottery." the tax lottery is said to occur when, because tax laws are so complex and the stakes in a particular transaction are relatively low, 87. eustice, supra note 4, at 14 ("[t]he treasury has been excessively concerned with the fisc-some have even called this fiscal paranoia-the fact that they might lose a dollar of revenue if they ever gave in on something."); roberts et al., supra note 4, at 36 ("[t]he treasury has sometimes been obsessed with the fear of possible tax abuse by some and consequently has pushed for provisions which lean too far in the direction of specificity and complexity."). 88. for example, the service proposed regulations to interpret irc § 117 on june 9, 1988. prop. regs. § 1.117-6. almost ten years later, the regulations have still not been enacted in final form. likewise, the service initially proposed regulations to interpret irc § 125 on may 7, 1984. prop. regs. § 1.125-1. those regulations have also not been enacted in final form. on the other hand, temporary regulations interpreting irc § 170(f)(8) were issued on may 27, 1994. 59 fed. reg. 27458 (may 27, 1994). final regulations regarding irc § 170(f)(8) were issued on december 16, 1996. 61 fed. reg. 65,946 (dec. 16, 1996). 89. even after a string of defeats and partial victories with respect to the definition of "royalty" for purposes of irc § 512(b)(2), including a well-reasoned opinion by the ninth circuit court of appeals, the service continues to challenge the definition as it might apply to proceeds from "affinity" credit cards. see sierra club, inc. v. commissioner, 86 f.3d. 1526 (9th cir. 1996); disabled am. veterans v. commissioner, 94 t.c. 60 (1990), rev'd, 942 f.2d 309 (6th cir. 1991); disabled am. veterans v. commissioner, 650 f.2d 1178 (ct. cl. 1981); oregon state univ. alumni ass'n v. commissioner, 71 t.c.m. (cch) 1935 (1996); see also mississippi state univ. v. commissioner, t.c. memo. 1997-397. [vol 3:9 creating complex monsters a taxpayer takes a position that is probably unjustified but unlikely to be challenged by the service.90 the reverse tax lottery is the opposite; the inability to come to a "reasonably certain conclusion" coupled with the relatively high value of the transaction requires that the taxpayer always seek the service's prior review and approval. the result of the reverse tax lottery is an increase in time and money necessarily diverted from the principle endeavor. complexity, of course, is an elusive and relative concept. rules and regulations applicable to any endeavor necessarily increase the number of discrete tasks which must be achieved to accomplish the endeavor. in the tax exempt arena, for example, there is a basic endeavor, providing charitable goods and services, which is accomplished through a basic subsidy, tax exemption. to that basic subsidy, though, is attached certain other rules and regulations generally involving prohibitions against the use of tax exemption for unfair competition, 9' private profit92 or political purposes.9" thus the basic endeavor is complicated by the necessity to accomplish the tasks dictated by the added rules and regulations. these added rules and regulations, being directed to real possibilities of human nature, have never been seriously questioned and indeed are viewed as necessary and worth the added complexity-worth the diversion of time and money from the provision of charitable goods and services. that is, the benefits of the rules and regulations outweigh the diversion of time and money from the basic endeavor because without the rules and regulations there is the real possibility that even more time and money might be diverted from the subsidized goal by those who would engage in profit taking or political advocacy. thus, the question in any case is not merely whether a particular tax rule or regulation increases complexity. invariably rules and regulations do so. the question is whether the benefits of the rule or regulation outweigh the diversion of time and money from the basic endeavor. with regard to joint operating agreements, the inquiry involves an identification of the benefits obtained by adherence to the complexities 90. roberts et al., supra note 4, at 330. roberts states: the "appallingly complicated" tax law, the inadequacy of audits by the service, the manpower of the service devoted to complexity. the impracticality of training revenue agents to achieve expertness in the morass of the existing tax law and the flexibility available to the taxpayer in legitimately resolving to his own advantage the numerous doubtful issues resulting from those complexities, all serve to turn the income tax return of the affluent taxpayer into a lottery.... id. 91. irc §§ 502, 511. 92. irc § 501(c)(3). 93. id. 1997.1 florida tax review engendered. and because the complexity is indeed a relative concept, it is also relevant to compare the joint operating agreement model to other forms of achieving the consolidation goal which ultimately benefit the more effective delivery of charitable goods and services ("the basic endeavor"). the result of this inquiry will answer the question whether joint operating agreements are unnecessarily complex impositions on tax exempt organizations. the basic endeavor of joint operating agreements is the consolidation of services, reduction in overhead costs and the resulting delivery of greater portions of the charitable fisc to charitable beneficiaries. joint operating agreements accomplish this goal by eliminating the practical requirement that several different nonprofit hospitals within a general area and having the same or substantially similar goals each offer identical services. consolidation is achieved because different tasks are undertaken by one hospital for the benefit and use of the others, rather than several hospitals each undertaking the same tasks for their own benefits. to achieve this consolidation without adverse tax consequences, a joint operating agreement requires completion of several incremental tasks.94 foremost, the several hospitals must negotiate and agree upon basic philosophical goals and embody these goals in an overall constitutional document.95 since the essential aspect of a joint operating agreement is the formation of and acquiescence of power to a consolidation entity, the several participants must somehow coordinate their individual philosophies into a single articulation which, in turn, will be assumed by the consolidation entity.96 although several hospitals may appear functionally identical to one another, religious, historical, educational, public and private affiliations and commitments make the coordination process both sensitive and time 94. see generally hollis, supra note 25, at 131-33. 95. one hospital consultant lists twelve different areas which hospital boards must coordinate with those with whom it enters into a joint venture. hollis, supra note 25, at 134. each hospital participant should be able to demonstrate or agree upon the following: commitment to a central mission, sharing of governance, commitment to serve a certain region, continuation of services deemed important to a particular participant, evidence of regional exclusivity, ability to effect physician integration, ability to attract patients, ability and willingness to undertake risky managed care contracts, employee development, financial strength, commitment to sufficient capitalization, and demonstrated ability to achieve economies of scale. id. 96. the strategic rationale that leads a hospital to seek an affiliation may be clear; the process, however, is never easy. the boards of community hospitals typically are emotionally attached to "their" hospital, fiercely loyal to its employees, and very concerned about their community. in addition, boards often are highly protective of their independence and reluctant to share control. see, hollis, supra note 25, at 132. [vol 3:9 creating complex monsters consuming,97 necessarily involving discussions and negotiations as to basic points and then the more difficult task of actually articulating those basic points in a manner politically acceptable to the participants, their individual governing bodies and their constituents." once agreement on a basic philosophy is reached and sufficiently recorded, the participants must then begin the process of completing the discrete tasks necessary to the accomplishment of the joint operating agreement. initially, the parties must agree upon how their individual interests and concerns will be represented in the consolidation entity's governance structure. the natural tendency to retain autonomy must give way to the consolidation entity's authority over the previously independent participants. the parties must negotiate the extent of the authority ceded to the consolidation entity, keeping in mind that too little authority will preclude the application of the integral part doctrine, but too much authority will result in a sacrifice of identity. the resulting agreement as to the cessation of power is merely one part of the joint operating agreement's foundation. a necessary next step in the process involves the creation of trust between the parties, particularly concerning each participant's ability to perform its role in the joint operating agreement and avoid harming another participant's financial status. trust is not inherent in the basic endeavor. it is created by each hospital's governing members, in meeting their respective fiduciary duties, obtaining and reviewing the normally confidential papers, documents and performance histories pertaining to other participants with the help of various auditors, consultants, and attorneys skilled in such matters.' after having done so, and perhaps having innumerable questions and 97. in priv. ltr. rul. 96-51-047 (sept. 24. 1996). the parties were required to coordinate the philosophies of a state university and medical school with three other hospitals operating in conformance with three different religious faiths. greater cincinnati joint operating agreement, supra note 60. certain hospitals in that ruling reserved the power to veto changes effecting their abilities to provide certain services with which the hospitals were traditionally associated. id. in the most recently approved joint operating agreement, one participant was owned and operated by a religious order which abided by certain policies limiting the alienation of church property. tracy and lewis, supra note 43, at 455. the parties were also required to make certain promises to the state regarding the continuation of certain types of health care. id. 98. the joint operating agreement in priv. ltr. rul. 96-23-011 eventually dissolved due to the participant's inability to agree upon a single leadership, operating, and managing philosophy. david burda, joint operating agreement gets irs nod, modern healthcare, june 17, 1996, at 6. the greater cincinnati joint operating agreement became the subject of litigation involving the cincinnati city council, the legal aid society of cincinnati and a coalition of taxpayers all seeking to block the university of cincinnati hospital's conversion from a public teaching hospital to a private nonprofit medical center. gold, supra note 25, at g-1. 99. see hollis, supra note 25, at 138. 19971 florida tax review concerns answered through meetings and exchanges of correspondence, the governing authorities may satisfy themselves that involvement in the virtual merger will not adversely jeopardize their basic missions. the similarity of the joint operating agreement to actual mergers, as well as its involvement of entities which are essentially public trusts and, in some cases, financed by tax exempt bond issues, necessarily requires that the participants make statutory or regulatory notifications to state and federal organizations having enforcement authority over certain issues. in the private letter ruling 9651047, for example, the parties felt it necessary to notify the united states department of justice concerning antitrust issues,' and request rulings from the service regarding change of use in facilities financed by tax exempt bonds, in addition to application for recognition of the consolidation entity as a tax exempt organization.' these required notices and requests for rulings and approval involving incremental governmental review necessarily increase the time and money which must be dedicated to the endeavor. the final major group of tasks which go into the building of the joint operating agreement concerns financial integration. the parties must determine the formula by which risks and costs will be shared. participants will likely bring to the agreement assets and earning potentials of varying values. these contributions must be reconciled with the need to achieve a unitary, noncompetitive structure necessary to the application of the integral part doctrine. a hospital with lower contribution values must nevertheless be granted a degree of representation in the overall governance such that individual autonomy and identity is maintained to whatever extent is allowable within a virtual merger. additionally, each hospital may bring with it financial obligations and accrued liabilities which must be integrated into the whole structure. this may involve the other participant's assumption of liabilities through guarantees and other third party undertakings. these financial integration tasks, as with prior tasks, involved significant expenditures of time and money. the incremental tasks discussed above are also complimented by the undertaking of prospective obligations. the parties must make various 100. greater cincinnati joint operating agreement, supra note 60, at 3. the parties to priv. ltr. rul. 96-23-011 also submitted the proposed agreement to the department of justice for antitrust review. burda, supra note 98, at 6. see generally 15 u.s.c. §§ 1, 2 (1988). the antitrust implications of joint operating agreements are beyond the scope of this article but are explored in gloria j. bazzoli et al., federal antitrust merger enforcement standards: a good fit for the hospital industry? 20 j. health pol. pol'y & l. 137 (1995). 101. conditions under which the irs will issue a favorable change of use ruling are generally explained in rev. proc. 93-17, 1993-1 c.b. 507 and rev. proc. 97-13, 1997-6 i.r.b. 13. [vol 3:9 creating compler monsters warranties and accept mutual prohibitions all designed to ensure that the investment into the unitary structure is maintained for a period of time sufficient to make the joint operating agreement worth the effort and expense incurred by each participant and also to achieve the level of permanence sufficient to achieve a virtual merger. the entire endeavor is completed by various enforcement and supervision mechanisms which allow each party to monitor the performance and viability of the other participants. from a more global perspective, the joint operating agreement mechanism, at least in the manner in which it is presently implemented, increases the complexity surrounding the tax code. the joint operating agreement contributes to the diffusion of authority because it allows exempt entities to do that which is otherwise prohibited by statute, regulations and case law"°2 but only after accessing the minds and opinions of those in the service charged with enforcing applicable tax law. this is particularly true with respect to joint operating agreements because the entire mechanism is implemented via private, nonprecedential letter rulings having no general applicability. 3 indeed, implementation of the joint operating agreement as a condition of necessary consolidation takes undue drafting specificity to new heights. it essentially involves administrative adjudication one case at a time, as each joint operating agreement must be submitted to the service for review and approval. this final result, too, is essentially a pushing aside of the judiciary's role since law is applied to fact in the piecemeal fashion most appropriate to the judicial process. the building of the joint operating agreement, then, involves transactional complexity. while, the integral part doctrine is relatively simply determined, it is very difficult to implement, at least with respect to separate tax exempt entities who might otherwise consolidate their efforts through the 102. for example, irc § 501(e) unquestionably denies tax exempt status to an organization which provides laundry services to unrelated exempt hospitals. hscs-laundry v. u.s., 450 u.s. 1, 7 (1981). but a group of unrelated hospitals can use a joint operating agreement to create a tax exempt mutually owned laundry facility. in a recent tax court memorandum decision, judge foley made the astonishing distinction that irc § 501(e) prevents an organization from gaining tax exempt status by virtue of their provision of services to "two or more hospitals." but if the organization serves two hospitals and a nonhospital tax exempt organization, irc § 501(e) is rendered inapplicable. university med. resident servs. v. commissioner, 71 t.c.m. (cch) 3130, 3131-33 (1996) ("to qualify as a hospital cooperative under section 501(e), the organization must provide services 'solely for two or more hospitals.' petitioners serve schools in addition to hospitals. thus. they are not hospital cooperatives, and section 501(e) does not preclude petitioners from qualifying under section 501(c)(3)."). if upheld, the interpretation would render irc § 501(e) a nullity since hospital service organizations would only have to add a single nonhospital to get around the prohibition of irc § 501(e). 103. irc § 61100)(3) states that such rulings may not be relied upon as precedent. 19971 florida tax review use of mutually-owned subsidiaries or by providing commonly needed administrative services to one another; that is, the separate entities might consolidate their efforts without joint operating agreements were it not for the restrictions of regulations section 1.502-1(b). but for the adverse tax consequences created by regulations section 1.502-1(b), the parties might very well eliminate the wasteful duplication by creating a mutually-owned subsidiary using the customary parent-subsidiary model. alternatively, or additionally, the parties might enter into relatively simple joint service contracts whereby one hospital undertakes to provide needed administrative support services for the others. from a policy standpoint, then, the inquiry should identify and analyze the tax rules which prevent the hospitals from resorting to the more simple alternatives and instead undertaking the difficulties of creating joint operating agreements. iv. the unfair competition rationale exactly what is meant by the term "unfair competition" is a useful inquiry since that is the primary concern of regulations section 1.502-1(b) and its resulting joint operating agreement requirement. in its most relevant sense, unfair competition is the harm to the taxable business community which results when a tax exempt entity engages in a noncharitable activity." 4 although the term "charitable activity" is often defined by traditional 104. "unfair competition" is more often defined by reference to harm to individual taxable businesses or their investors, as if the harm were actually provable. see john m. strefeler & leslie t. miller, exempt organizations: a study of their nature and the applicability of the unrelated business income tax, 12 akron tax j. 223, 230-31 (1996); henry b. hansmann, unfair competition and the unrelated business income tax, 75 va. l. rev. 605 (1989) [hereinafter hansmann, unfair competition]; susan rose-ackerman, unfair competition and corporate income taxation, 34 stan. l. rev. 1017 (1982). but the cases in which unfair competition is found are notable for the lack of proof with regard to a particular taxable entity. note the hypothetical nature of justice marshall's discussion of unfair competition in american bar endowment v. united states: if abe's members may deduct part of their premium payments as a charitable contribution, the effective cost of abe's insurance will be lower than the cost of competing policies that do not offer tax benefits. similarly, if abe may escape taxes on its earnings, it need not be as profitable as its commercial counterparts in order to receive the same return on its investment. should a commercial company attempt to displace abe as the group policyholder, therefore, it would be at a decided disadvantage. the claims court failed to find any taxable entities that compete with abe, and therefore found no danger of unfair competition. it is likely, however, that many of abe's members belong to other organizations that offer group insurance policies. employers, trade associations, and financial services companies frequently offer group insurance policies. [vol. 3:9 creating complex monsters notions of kindness and altruism,' in practice it is just as often identified by reference to gaps in market availability. the provision of goods and services which the market does not adequately provide is considered a "charitable" activity regardless of its dissimilarity to traditional or "inherently" charitable activities such as the provision of food and shelter.t" filling presumably those entities are taxed on their profits, and their policyholders may not deduct any part of the premiums paid. such entities may therefore find it difficult to compete for the business of any abe members who are otherwise eligible to participate in these group insurance programs. 477 u.s. 105, 114-15 (1986); see also living faith v. commissioner. 950 f.2d 365, 373 (7th cir. 1991) ("it is significant that living faith is in direct competition with other restaurants.); presbyterian and reformed publ'g co. v. commissioner, 743 f.2d 148, 152 (3d cir. 1984) ("the principal issue we must address is at what point the successful operation of a ax exempt organization should be deemed to have transformed that organization into a commercial enterprise and thereby to have forfeited its tax exemption."); carolinas farm & power equip. dealers ass'n v. united states, 699 f.2d 167, 169 (4th cir. 1983) ("one [court] has held that the proper inquiry is whether the activity might be unfairly competitive with taxpaying enterprises .... while... another concludes that . . . the proper inquiry is whether the activity is conducted in a competitive and commercial manner.") (citations omitted): united states v. community servs., inc. 189 f.2d 421, 425 (4th cir. 1951) ("manifestly, a corporation engaged in commercial activities, if exempt from federal taxes, would have a tremendous economic advantage over competitors in the same field. such a corporation could effectively eliminate competitors, actual and potential, since it could undersell corporations, whose earnings are subject to diminution by federal taxation."): hope school v. united states, 612 f.2d 298, 304 (7th cir. 1980) (evidence must prove a "possibility" of an unfair competitive advantage over taxpaying greeting card business). hence, individual taxable entities are rarely, if ever, actually identified as proven victims of unfair competition. instead victims are hypothetically assumed as a proxy for the taxable economy. that is, potential harm is as equally important as actual harm. see also bruce r. hopkins. the law of tax exempt organizations 863 (6th ed. 1993) ("[ilt is theoretically possible for an activity of a tax-exempt organization to be wholly uncompetitive with a taxpaying organization activity and nonetheless be treated as an unrelated trade or business."). 105. for the traditional and historical discussion of the concept of "charity," see hopkins, supra note 104, at 70-84. 106. this definition of "charitable activity" is not one which i have found explicitly stated in the literature or judicial opinions, but one which is implied in cases finding that an organization is either primarily engaged in a business activity or engaged in an unrelated business activity. see, e.g., supra note 104. implicit in both findings is the conclusion that taxable organizations stand willing and able to engage in the activity alleged to be "charitable" by the organization claiming exempt status. economically put, then, a "charitable" activity is one that does not prevent or supplant the normal market operation. at least one other commentator, professor henry hansmann, seems to indulge a similar "market failure" based definition. hansmann, unfair competition, supra note 104; henry b. hansmann, the rationale for exempting nonprofit reorganizations from corporate income taxation, 91 yale .j. 54 (1981) [hereinafter hansmann, rationale]. although he states the issue with more sophistication, he still seems to postulate that nonprofits are necessary and justifiable when consumers cannot reasonably obtain goods and services from the taxable economy: 19971 florida tax review a market gap is, rather, "functionally" charitable and therefore entitled to the indirect subsidy represented by exemption from tax.1°7 but since the taxable economy is the preferred method by which goods and services should be provided,'08 the government subsidy is unnecessary and counterproductive to the extent the taxable economy is willing and able to fill the need. thus, when the market recognizes and responds to the need, it naturally demands and is, under economic theory, entitled to the greatest share of the customer base. the label, unfair competition, is therefore more likely applied to tax exempt organizations which operate in a market economy supplying similar contract failure arises when, owing to the nature of the service itself or to the circumstances under which it is consumed, the purchasers of the service-whether we style them donors or consumers-are likely to have difficulty in (1) comparing the quality of performance offered by competing providers before a purchase is made, or (2) determining, after a purchase is made, whether the service was actually performed as promised. as a result of such conditions, ordinary market competition may be insufficient to police the performance of for-profit firms, thus leaving them free to charge excessive prices for inferior service. in such circumstances consumers often turn to nonprofit providers, which, owing to the nondistribution constraint, [i.e., the prohibition against private inurement] have less opportunity and incentive to exploit consumers than do for-profit firms, and thus serve as fiduciaries of a sort for their consumers. in short, under circumstances of substantial contract failure, nonprofit firms may serve consumers more efficiently than for-profit firms. perhaps, then, tax exemption can be justified as a means of encouraging the development of nonprofit firms in those industries in which, owing to the existence of contract failure, they are likely to have this efficiency advantage. hansmann, rationale, supra, at 69, 71. if this means that tax exemption is necessary and justified when the market forces leave large number of "patron" needs unfulfilled-because prices are too high for most patrons, for example-then i agree with the conclusion, although i do not necessarily agree with the steps leading to the conclusion. at other times, professor hansmann appears to state the conclusion explicitly. see hansmann, unfair competition, supra note 104, at 617 ("the rationale for granting tax exemption to nonprofits that perform these functions, such as aiding the poor or performing scientific research, is presumably that the services involved would be underprovided in the absence of a subsidy."); see also hopkins, supra note 104, at 829 ("a tax-exempt organization is engaged in a nonexempt activity when that activity is engaged in in a manner that is considered 'commercial.' an act is a commercial one if it has a direct counterpart in the world of for-profit organizations."). 107. see supra note 106. tax exemption is granted in other cases when the market fails to provide what is considered a necessary or desirable service. for example, irc § 108(t) exempts from taxation income from the discharge of a student loan in exchange for the performance of services in industries or areas with labor shortages. see irc § 108(t); see also supra note 86. 108. hopkins, supra note 104, at 830. [vol. 3:9 creating compler monsters goods and services via taxable entities. °9 correspondingly, when the market is either unwilling or unable to provide a good or service, an exempt organization is less likely to be considered to be engaging in unfair competition. thus, when tax exemption subsidizes an entity that prevents or supplants the normal operation of the taxable economy, the tax exemption is viewed as encouraging "unfair competition." hence, the more efficient the taxable economy is functioning, the easier it is that a tax exempt entity violates the unfair competition prohibition. the apparent anomaly is that the tax exempt organization's survival is dependent upon a market structure which does not satisfy all needs. as the market gets better, the justification for tax exemption erodes. the goal, though, from a policy standpoint, is to subsidize the satisfaction of the need, not the operation of a particular entity. tax exemption is not a job program. ideally, then, the managers of a tax exempt entity would be satisfied that the need is met and voluntarily relinquish tax exempt status or, still motivated to do good rather than collect profits, the managers may go on to another charitable endeavor-that is, identify and satisfy some other need not being met by the market economy. some charitable endeavors, primarily the provision of food and shelter for the poor, education and health care are viewed as so inherent to human existence that the taxable market can never satisfy the needs involved."' 0 as implied above, these needs are most often thought of with respect to the term "charity." in contrast to exempt organizations which provide functionally charitable activities, exempt organizations which provide inherently charitable activities are much less likely to be viewed as engaging in unfair competition precisely because that market is not subject to monopolization by taxable entities. thus, unfair competition has a different meaning or, perhaps no meaning at all, when applied to exempt organizations engaging in inherently charitable activities. implicit in the phrase, "unfair competition," and regardless of whether one is discussing inherently or functionally charitable activities, is the recognition that there is some level of competition which is fair, otherwise the prohibition would simply limit "competition.""' indeed, for exempt 109. id. 110. hansmann, too, acknowledges that his "contract failure" theory, see supra note 106, does not provide a rationale for nonprofit health care organizations generally operating in a market environment which meets consumer demand. hansmann, rationale, supra note 106, at 70. 111. indeed, the service recognizes that the primary impetus of joint operating agreements is the necessity for nonprofit hospitals to compete in the health care market. darling & friedlander, supra note 8, at 132 ("virtual mergers are intended to unify operations to achieve cost efficiencies necessary to compete successfully in a managed care environment."). 19971 florida tax review organizations which collect and depend in part on user fees, competition is essential to the accomplishment of the subsidized goal. for example, to subsidize nonpaying customers or high cost areas, provide a cooperative discount to all customers, and/or fund research,"' exempt hospitals must provide a level of service which equals or exceeds the quality of service available at for-profit hospitals. in the absence of doing so, the exempt hospital will not attract a sufficient amount of paying customers to supplement its grants and private donations. at least some of the paying customers might otherwise patronize nonexempt hospitals. thus, however charitable the hospital may be, it could not achieve its subsidized goal were it required to maintain a completely hands off attitude with respect to abled customers. certainly, then, the term "unfair competition" is not synonymous with "competition," but refers to that point at which harm to the taxable economy is foreseeable. one of the two primary vehicles for preventing unfair competition is the requirement that to achieve tax exempt status, an organization must be "exclusively" engaged in a charitable activity under section 501(c)(3). the second is that an otherwise qualified tax exempt organization may be subject to tax on a portion of its revenues under section 511 if those revenues were obtained through an unrelated activity. both concepts revolve in sort of a circular manner around the idea of "substantiality." that is, an organization may qualify in the first instance as long as any noncharitable activity may be deemed "insubstantial.""' 3 but the insubstantial activity, if engaged in with sufficient regularity, will be subject to taxation unless the insubstantial activity is "substantially" related to the exercise or performance of the organization's subsidized goal." 4 with respect to the one saving provision, 112. user fees collected by exempt organizations are often used to "cross-subsidize" other users unable to pay the fees or other high cost functions which do not necessarily account for revenue (e.g., research). hansmann, the role of nonprofit enterprise, 89 yale l.j. 835, 877-78 (1980). 113. better bus. bureau of wash. v. united states, 326 u.s. 279, 283 (1945) ("[t]he presence of a single non-[exempt] purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly [exempt] purposes."); regs. § 1.501(c)(3)-1(c) ("an organization will be regarded as "operated exclusively" for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3). an organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose."). 114. irc §§ 511-513. regs. § 1.513-1(d)(2) states: type of relationship required. trade or business is "related" to exempt purposes, in the relevant sense, only where the conduct of the business activities has causal relationship to the achievement of exempt purposes (other than through the production of income); and it is "substantially related," for purposes of section 513, only if the causal relationship is a [vol 3:9 creating complem monsters it should be noted that when a noncharitable activity is essential to the success of the charitable activity, the organization can more efficiently utilize the tax subsidy if it may itself engage in the necessary but noncharitable activity. thus, the foregone tax in that instance encourages the efficiency of self-help and is apparently based upon the conclusion that the market opportunity lost to the taxable economy does not result in unfair competition. the only "customer" lost to the taxable economy is the tax exempt organization which performs the noncharitable activity in-house. the loss of that single customer, moreover, is outweighed by the benefits ultimately directed to charitable beneficiaries in greater amounts than if the tax exempt organization could not economize. collectively, these two tools, section 501(c)(3) and section 511, address the need to establish a basic formula for identifying charitable institutions on the one hand, and permissible activities for those institutions on the other. the vagueness necessarily inherent in the term "substantial" in both provisions is rather to be commended given the market based variability of the term "charitable." in those difficult cases where the market variability does not clearly determine whether an activity is charitable or noncharitable, the judicial system is properly available to make the determination on a caseby-case basis. another provision aimed at preventing unfair competition is section 502.25 commendable, too, for its simplicity, that provision provides that an organization does not qualify as tax exempt merely because its profits are used exclusively to support a charitable endeavor. the provision thus eliminated the "destination of income" rationale as a means of achieving tax exemption. the operation of that rational is demonstrated by such cases as roche's beach v. commissioner' 6 and the more infamous successor, c.f. mueller v. commissioner."7 the entities in both cases achieved tax exempt status because they were "feeder organizations;" the entities "fed" all of their profits to entities which were tax exempt under section 501(c)(3) because substantial one. thus, for the conduct of trade or business from which a particular amount of gross income is derived to be substantially related to purposes for which exemption is granted, the production or distribution of the goods or the performance of the service from which the gross income is derived must contribute importantly to the accomplishment of those purposes. 115. irc § 502 provides: an organization operated for the primary purpose of carrying on a trade or business for profit shall not be exempt from taxation under section 501 on the ground that all of its profits are payable to one or more organizations exempt from taxation under section 501. 116. 96 f.2d 776 (2d cir. 1938). 117. 190 f.2d 120 (3d cir. 1951). 1997] florida tax review they engaged in the direct provision of charitable services. in roche's beach, the profits were obtained through the normal operation of a beach resort"8 and, in c.f. mueller, the profits were obtained through the normal operation of a pasta manufacturing corporation." 9 thus, comparing the activities to the market-based theory discussed above easily demonstrates the nature of unfair competition. in both cases, neither entity provided an inherently charitable service such as food or shelter for the poor, or education. nor is there any indication that pasta or beach umbrellas, for example, were in short supply in the taxable economy because of a lack of consumer demand or provider willingness or ability. the tax subsidy-tax exemption-was therefore superfluous and rightly revoked by section 502. the service's promulgation of its version of the integral part doctrine in regulations section 1.502-1(b) as an interpretive byproduct of section 502 thus suggests a conclusion that the unfair competition potential of companies which provide goods and services only to exempt organizations is substantially similar to the unfair competition created by feeder organizations. recall that under the service's integral part doctrine, 1) a company is not entitled to tax exemption merely because it provides necessary goods and services to unrelated exempt organizations, 2) an exempt organization engages in an unrelated business activity if it provides necessary goods and services to unrelated exempt organizations, and 3) an organization can achieve exempt status and will not engage in unrelated activity if it limits its provisions of goods and services to its single controlling entity and its sister entities. 121 the first determination is based upon the conclusion that acting as a cost or below cost provider of goods and services exclusively to unrelated tax exempt organizations is not an "exclusively" charitable activity, even though the recipients need the goods and services and could provide the goods and services in-house or through a wholly owned subsidiary without jeopardizing their exempt status. the second and third determinations are based upon the conclusions that a tax exempt organization's provision of cost or below cost goods and services to other exempt organizations is not substantially related to the accomplishment of the service provider's charitable goals and is therefore an unrelated business activity. collectively, the service's integral part doctrine treats consolidation entities as though they created unfair competition to the same extent as feeder organizations. treating consolidation entities and feeder organizations as though they created the same effect, however, is supported neither by statute nor judicial opinion. initially, section 502 is not logically consistent with 118. 96 f.2d at 777. 119. 190 f.2d at 120. 120. see supra note 18 (referring to the integral part doctrine). [val 3:9 creating complex monsters regulations section 1.502-1(b). section 502 was enacted to address organizations characterized by two identifying factors. first, the organization provides goods and services to any willing and able purchaser, and only to willing and able purchasers.12' if nothing else, the desire to sell to any willing and able to pay customer most characterizes encroachment upon the taxable economy. second, the excess revenues realized by the organization are used exclusively to fund admittedly charitable organizations.' -" the service's integral part doctrine deals with consolidation entities that provide goods and services solely to exempt organizations, not to any willing and able to pay customer. that limitation, too, eliminates the second factor which would make consolidation entities functionally identical to feeder organizations. by limiting itself to tax exempt entities, the consolidation entity cannot expect or desire to fund the admittedly charitable endeavors of the other organizations, except to the extent the consolidation entity allows the exempt organizations to save funds they have raised from other sources. thus, section 502 of the code and regulations section 1.502-1(b) are not logically related. the apparent inconsistency between the statute and regulation is the reason why the regulation has been so forcefully criticized by courts which have explicitly addressed the regulation. in united hospital services v united states,"2 for example, the court was so baffled by the inconsistency that it incredulously asked: what does [irc § 502] have to do with two or more [exempt] organizations setting up a not-for-profit corporation, wholly controlled by them and not serving the public, in order to effect the economies in their own charitable operations?' 24 an even more effective indictment is contained in associated hospital services, inc. v. conunissionerl' where the tax court stated: unlike the abuse situations like mueller, which sections 502 and 511 were clearly meant to foreclose, we are here dealing with a closed circle. the "profit" does not derive from outside sources and flow to the exempt organizations, as in the mueller line of cases. nor does it flow from vendors to 121. see united states v. community sets.. 189 f.2d 421, 424 (4th cir. 1951) ("taxpayer was, in effect, organized and operated for two purposes: (1) to engage in commercial business, for profit, and (2) to turn over the profits realized from its commercial activities to charitable organizations."), cert. denied, 342 u.s. 932 (1952). reh'g denied, 343 u.s. 911 (1952). 122. id. 123. 384 f. supp. 776 (s.d. ind. 1974). 124. id. at 782. 125. 74 t.c. 213 (1980). 19971 florida tax review potentially nonexempt destinations, as in b.s. w. group inc. v. commissioner... and federation pharmacy service, inc. v. commissioner. we would therefore question whether the profit, if any, derived by petitioner was any different from the profit between an exempt parent and its wholly-owned subsidiary ... 126 associated hospital services, inc., is worth reviewing in detail because it provides a useful case study of the issues raised by regulations section 1.502-1(b) and the joint operating agreement requirement. in that case, four 501(c)(3) hospitals and two county-owned hospitals created associated hospital service, inc. ("associated"). 2 7 associated's sole purpose was to provide bacteria free laundry service exclusively to the six hospitals. although taxable entities provided normal laundry services in the locale in which the hospitals operated, they did not provide the specialized laundry services needed by the hospitals. 2 nevertheless, the service denied associated hospital's application for tax exempt status because, in its view, associated was a feeder organization described in section 502 and also failed to meet the qualification provisions of section 501(e). 129 section 501(e) is one of the congressional provisions mentioned earlier which recognize the consolidation concept as a basis of tax exemption.13 ° the provision grants tax exempt status to organizations which provide statutorily identified services exclusively to hospitals. laundry service, however, is not one of the identified categories.' the service therefore concluded that associated did not qualify under section 501(e). at the time of associated's application for tax exempt status, every other court to have considered the issue, all of which were district courts, had concluded that section 501(e)'s specific delineation of services did not preclude organizations which provided nondelineated services from qualifying for tax exempt status. 132 the tax court, however, had not previously addressed the issue and did not do so in this case either. 126. id. at 229 (citations omitted). 127. id. at 214. 128. id. at 215. 129. id. at 213. 130. see supra note 31. 131. the listed services are "data processing, purchasing (including purchasing of insurance on a group basis), warehousing, billing and collection, food, clinical, industrial engineering, laboratory, printing, communications, record center, and personnel (including selection, testing, training, and education of personnel) services." irc § 501(e)(1)(a). 132. 74 t.c. 213, 222-23. [vol. 3:9 creating complex monsters since associated provided laundry services to unrelated exempt organizations, the service also concluded that it could not gain exempt status in any event because regulations section 1.5021 (b) prevented tax exemption for consolidation entities. the tax court gave considerable attention to this conclusion. its discussion not only reflected unfavorably on the methods by which the service promulgated the regulation but also demonstrated the logical invalidity of the regulation. if the court had the magic of foresight and known that the service would later allow that which associated sought, via joint operating agreements and without any change to statutes or regulations underlying the service's arguments in the case before it, the tax court might have overturned the service's conclusions as simply creating unnecessary complexity. instead, even despite the unfavorable analysis, the court sustained the regulation essentially on the ground that the regulation had not been changed in the thirty years since it had been enacted.'" the tax court began its discussion by tracing the purpose of section 502's enactment in 1950 and the history of regulations section 1.502-i (b)'s enactment in 1952. it noted that the regulation purported to further the legislative purpose of preventing the unfair competition which motivated the enactment of sections 502 and 51 l. following the statutory enactment, the service issued the regulation and revenue ruling 54-305135 in both of which it concluded that consolidation entities such as associated created unfair competition. the court noted, however, that revenue ruling 54-305 "made no effort to analyze the commercial aspects of the subject corporation's activities, notwithstanding the foregoing legislative rationale for the adoption of the feeder organization provisions.' 3 6 instead, according to the court, the service "simply assumed" that a consolidation entity creates unfair competition. the court referred to a 1958 court of claims decision'3 rejecting the conclusions stated in regulations section 1.502-1(b) and noted that the service "rather obliquely" attempted to solidify the rejected regulation by "quietly" amending it.138 according to the court, the service clarified that 133. id. at 230. 134. id. at 216-18. 135. rev. rul. 1954-2 c.b. 127. in that ruling, the service concluded that a purchasing organization which served only exempt hospitals was engaged in a noncharitable trade or business and therefore was not entitled to tax exemption. 136. id. at 218. 137. hospital bureau of standards & supplies, inc. v. united states, 158 f. supp. 560 (ct. cl. 1958). 138. the commissioner declined to go along with the result in hospital bureau of standards & supplies, inc., and rather obliquely attempted to solidify his position by amending section 1.502-1(b) to limit the concept of related organizations to a formal parent-subsidiary relationship. the 1997] florida tax review organizations are not sufficiently related simply because they engage in the same activity. 39 the amendments contradicted the conclusions made by the court of claims and, if upheld, would mean that consolidation entities do not achieve tax exempt status under the integral part doctrine unless there exists some formal relationship between the parties served by the consolidation entity. significantly, though, the court found the focus on the relationship between the consolidation entity and the service recipients as "totally beside the point."1 40 that conclusion was the court's way of saying that the relationship has no relevancy to the question of whether a particular activity results in unfair competition. the court stated as much when it observed: in terms of effect on competition, the case where a subsidiary provides integrally related services to only one entity, its exempt parent, may, depending on the facts and circumstances, stand in contrast to the jointly owned service organization situation. in the former situation, it might be argued that the entity could not, standing alone, preempt the market because it only serves one parent, while in the latter situation, it could. on the other hand, there may be little to distinguish, in terms of frustrating commercial competition, between one giant hospital doing its own laundry and four small ones using a jointly owned cooperative.'41 although it did not reject the regulation, the court's opinion persuasively articulated the inherent inconsistencies between section 502 and regulations section 1.502-1(b). it also clearly suggested the logical invalidity of the regulation. the invalidity demonstrated by comparing the statute and regulation and by judicial opinions, though, is for the most part merely technical. certainly, the regulation is misplaced to the extent it purports to interpret or expand upon the problem addressed by section 502. in associated hospital service, the damning opinion is largely a result of the court's comparison of the regulation with section 502, the statute under which the regulation was enacted. but the regulation could be divided into its constituent parts and those parts would logically fall under either section 501 or section 511. the amendment stated that "an exempt organization is not related to another exempt organization merely because they both engage in the same type of exempt activities." 74 t.c. 213, 219 (citations omitted); regs. § 1.502-1(b)(2) (last sentence). 139. 74 t.c. at 219. 140. id. 141. id. at 227. [vol 3:9 creating compler monsters determination that tax exemption should not be granted to a consolidation entity is essentially stating a conclusion that such activity is not exclusively charitable; that instead it is a nonexempt activity. as such, that portion of regulations section 1.502-1(b) containing that determination would more properly be promulgated under section 501, setting aside for the moment the determination's substantive merit. the second and third determinations which state that a tax exempt organization engages in unrelated activity if it provides goods and services to an unrelated exempt organization, but does not do so if the other exempt organization is a parent or sister organization, are essentially drawing distinctions between activities that are and are not substantially related to the achievement of the parent's charitable goal. thus, the last two parts would more properly be promulgated under section 511. the apparent misplacement of regulations section 1.502-1 (b) may prove its technical invalidity but it does not address its substantive merit. it is, as shown above, possible to identify the overriding concern of the unfair competition prohibitions, i.e., the maintenance of the taxable market's ability to provide goods and services.'42 it is altogether a different matter to identify those facts which, in every case, will support the conclusion that the activities of a particular tax exempt organization impedes the market's ability to function effectively. 143 therefore it is impossible to state categorically that the consolidation efforts prohibited by the integral part doctrine do not constitute unfair competition. the one thing that can be determined, however, is that joint operating agreements allow the identical degree of consolidation otherwise prohibited by the regulations section 1.502-1(b). where the regulation prohibits unrelated exempt organizations from sharing the costs of goods and services, the service's joint operating agreement allows such sharing. where the regulation denies tax exempt status to a consolidation entity, the service's joint operating agreement requirement grants exemption. likewise, where specific statutory law denies tax exempt status to an entity which provides laundry service to unrelated hospitals, for example, the joint operating agreement allows such activity. it is difficult to see how the result in one instance can be characterized as unfair competition while the identical result in another is fair competition. the identical result in either case, where one method is prohibited and the other allowed, leads inexorably to the conclusion that consolidation such as that prohibited in the absence of joint operating agreements does not really constitute unfair competition. with the joint operating agreement mechanism, it is the achievement of centralized control 142. see supra notes 104-110 and accompanying text. 143. "while an economically sophisticated definition of unfairness is possible, its application involves subtle empirical issues--so subtle that they may be beyond the administrative capacities of the irs." rose-ackerman, supra note 104. at 1022. 19971 florida tax review between otherwise unrelated exempt organizations that apparently is thought to alleviate the market harm which characterizes the concept of unfair competition. the lack of centralized control is the apparent basis of regulations section 1.502-1(b)'s consolidation prohibitions. this suggests, without explanation, that the process of consolidation embodied in joint operating agreements somehow alleviates the unfair competition resulting in the absence of joint operating agreements. but the unfair competition is concerned with the resulting harm to the taxable economy, not the process by which the harm occurs. with joint operating agreements, the result relative to the policy interest in maintaining the viability of, or at least maintaining governmental neutrality with respect to, the taxable economy, is identical to the result which would occur without regulations section 1.502-1 (b). to the extent taxable entities would be denied certain market opportunities in the absence of the regulation, the resulting denial is identical using the joint operating agreement mechanism. certainly, unchecked consolidation between tax exempt entities might very well constitute unfair competition in the same manner that monopolies are thought to affect the taxable economy,'" but that case has not been made and indeed is weakened by the approval of joint operating agreements which allow an identical, and in most cases increased consolidating result as that which would be available in the absence of regulations section 1.5021(b)145. the only difference is the process by which that result is obtained. as the tax court in associated hospital services noted, focusing on the process is "totally beside the point."'' 46 this conclusion is supported by prior rulings and statutory provisions which grant tax exempt status to consolidation entities without regard to the relationship between the consolidation entity and the service-recipient organizations.'47 thus, had the tax court in associated hospital services been presented with the knowledge that the decried consolidation was available under a more complicated process, it very well might have been more confident in its speculation that consolidation does not ipso facto constitute unfair competition and rejected the regulation. as noted earlier, creating a joint operating agreement is a complicated and burdensome process. the transactional complexity of joint operating agreements. by discouraging consolidation, ultimately decreases the extent to 144. see supra note 100. 145. the imposition of the joint operating agreement requirement essentially makes mergers, real or otherwise, a necessary step to achieve consolidation and will therefore encourage market clout being concentrated in larger organizations than would result if unrelated exempt hospitals were allowed to share burdens or utilize mutual organizations. 146. 74 t.c. at 219. 147. see supra notes 28-29 and accompanying text. [not. 3:9 creating complex monsters which charitable funds are used to achieve the charitable goal and, to that extent, reduces the effectiveness of the tax subsidy"48 since process is irrelevant to the unfair competition, the transactional complexity of joint operating agreements serves no purpose except a counterproductive one. that is, exempt organizations which would consolidate in any event, using multiple in-house facilities or single, multiple-parent subsidiaries, are forced to divert even more of the charitable fisc away from charitable beneficiaries and instead to tax compliance activities. hence, the subsidy of tax exemption would be more effective if regulations section 1.502-1(b) were repealed. v. conclusion when exempt organizations share the costs of necessary administrative services by providing at or below costs goods and services to one another, they effectuate what is essentially a self-contained economy. charitable funds come to the economy through grants, donations, user fees, and government tax exemption. ideally, these funds should leave the selfcontained economy only by way of charitable beneficiaries and then in the greatest amounts possible. when entities within the self-contained economy must duplicate the efforts of one another, the goal of providing the greatest amount of funds to charitable beneficiaries is thwarted and all contributing sources to the charitable fisc are used inefficiently. the charitable fisc is wasted. taxation of the effort to share administrative costs discourages efficiency and renders counterproductive the tax subsidy represented by tax exemption. it is incorrect to simply assume, as regulations section 1.502-1(b) does, that efficiencies between unrelated entities necessarily results in "unfair" competition and therefore should be discouraged by the imposition of taxation. indeed, consolidation might be viewed as denying a market opportunity to taxable entities that would otherwise be called upon to provide the goods and services necessary to the charitable goal. but it is not a given that taxable entities are entitled or would be called upon to provide these goods and services. regulations section 1.502-1 (b), being logically related to 148. the prospect of merging with a neighbor can excite a board that is focused on reducing costs and investing the community's charitable resources as rationally as possible, without duplication of services. yet. boards can be frustrated in their attempt to merge by a regulatory structure that ascribes private, corporate (profit-maximizing) motives to them. although many such mergers are announced, far fewer actually close, and an even smaller number proceed to achieve the kind of rationalization that spurred the merger in the first place. hollis, supra note 25, at 135. 19971 florida tax review the substantiality concepts of sections 501 and 511, admits that even when an exempt organization may not resort to another unrelated tax exempt organization for goods and services, the exempt organization can provide the services on an in-house basis or through a wholly-owned subsidiary. thus, the foregone market ostensibly thought to be protected by the integral part doctrine is not one which would necessarily be satisfied by taxable entities or one that even exists since exempt organizations are not at all more likely to chose a higher costing taxable entity to provide the goods and services over an in-house facility or a wholly-owned subsidiary. the prohibition of consolidation between unrelated exempt entities contained in regulations section 1.502-1(b) incorrectly assumes that tax exempt entities will indeed become customers of taxable entities. the repeal of regulations section 1.502-1(b) would therefore eliminate the complexity of joint operating agreements and leave sections 501 and 511 as the basic tools with which to prevent unfair competition. providing tax exemption to consolidation entities through the joint operating agreement mechanism already suggests that consolidation entities would pass muster under those provisions since centralized control is the only element added by joint operating agreements and that element has no logical relationship to the prevention of unfair competition. insistence upon that added element mistakenly assumes that the market harm of "unfair" competition is a function of process-building a joint operating agreement-rather than a function of result. since it is the result that determines "unfair" competition and since the permitted consolidating result is the same whether joint operating agreements are required or not, regulations section 1.502-1(b) and its resulting joint operating agreement requirement serves only to create unnecessary complexity and should therefore be discarded. [vol. 3:9 tcharity really does begin at home: florida tax review volume 12 2012 number 5 183 recent developments in federal income taxation: the year 2011 martin j. mcmahon, jr. * ira b. shepard ** daniel l. simmons *** * stephen c. o‘connell professor of law, university of florida fredric g. levin college of law. ** professor emeritus, university of houston law center. *** professor of law emeritus, university of california davis school of law. this recent developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the most recent twelve months — and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted – unless one of us decides to go nuts and spend several pages writing one up. this is the reason that the outline is getting to be as long as it is. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide dan and marty the opportunity to mock our elected representatives; again, sometimes at least one of us goes nuts and writes up the most trivial of legislative changes. the outline focuses primarily on topics of broad general interest (to the three of us, at least) – income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. any mistakes in this outline are marty’s responsibility; any political bias or offensive language is ira’s; and any useful information is dan’s. 184 florida tax review [vol. 12:5 i. accounting ................................................................................ 185 a. accounting methods ................................................................... 185 b. inventories .................................................................................. 188 c. installment method ..................................................................... 188 d. year of inclusion or deduction ................................................... 188 ii. business income and deductions ......................................... 191 b. deductible expenses versus capitalization ................................ 197 c. reasonable compensation .......................................................... 208 d. miscellaneous deductions .......................................................... 209 e. depreciation & amortization ..................................................... 220 f. credits ......................................................................................... 227 g. natural resources deductions & credits ................................... 229 h. loss transactions, bad debts, and nols .................................. 229 i. at-risk and passive activity losses ............................................ 233 iii. investment gain and income ................................................. 240 a. gains and losses ........................................................................ 240 b. interest, dividends, and other current income ......................... 253 c. profit-seeking individual deductions ......................................... 254 d. section 121 .................................................................................. 255 e. section 1031 ................................................................................ 255 f. section 1033 ................................................................................ 255 g. section 1035 ................................................................................ 255 h. miscellaneous ............................................................................. 256 iv. compensation issues ................................................................ 256 a. fringe benefits ............................................................................ 256 b. qualified deferred compensation plans .................................... 256 c. nonqualified deferred compensation, section 83, and stock options ........................................................................................ 257 d. individual retirement accounts .................................................. 258 v. personal income and deductions ........................................ 258 a. rates ........................................................................................... 258 b. miscellaneous income ................................................................. 258 c. hobby losses and § 280a home office and vacation homes ... 261 d. deductions and credits for personal expenses .......................... 262 e. divorce tax issues ...................................................................... 264 f. education .................................................................................... 265 g. alternative minimum tax ........................................................... 265 vi. corporations ............................................................................ 265 a. entity and formation .................................................................. 265 b. distributions and redemptions ................................................... 266 c. liquidations ................................................................................ 266 d. s corporations ............................................................................ 266 e. mergers, acquisitions and reorganizations ............................... 268 f. corporate divisions .................................................................... 278 2012] recent developments in federal income taxation 185 g. affiliated corporations and consolidated returns .................... 279 h. miscellaneous corporate issues ................................................. 280 vii. partnerships .............................................................................. 280 a. formation and taxable years .................................................... 280 b. allocations of distributive share, partnership debt, and outside basis ............................................................................................ 289 c. distributions and transactions between the partnership and partners ...................................................................................... 297 d. sales of partnership interests, liquidations and mergers ......... 297 e. inside basis adjustments ............................................................ 297 f. partnership audit rules .............................................................. 298 g. miscellaneous ............................................................................. 305 viii. tax shelters ......................................................................... 305 a. tax shelter cases and rulings ................................................... 305 b. identified ―tax avoidance transactions‖ ..................................... 310 c. disclosure and settlement .......................................................... 320 d. tax shelter penalties, etc. ........................................................... 321 ix. exempt organizations and charitable giving ............... 326 a. exempt organizations ................................................................. 326 b. charitable giving ....................................................................... 328 x. tax procedure .......................................................................... 335 a. interest, penalties and prosecutions........................................... 335 b. discovery: summonses and foia .............................................. 347 c. litigation costs ........................................................................... 349 d. statutory notice of deficiency .................................................... 349 e. statute of limitations .................................................................. 350 f. liens and collections.................................................................. 367 g. innocent spouse .......................................................................... 371 h. miscellaneous ............................................................................. 379 xi. withholding and excise taxes ............................................ 388 a. employment taxes ...................................................................... 388 b. self-employment taxes ............................................................... 395 c. excise taxes ................................................................................ 395 xii. tax legislation ........................................................................ 397 a. enacted ....................................................................................... 397 b. pending ....................................................................................... 399 i. accounting a. accounting methods 1. new and improved automatic consent procedures for changes of accounting methods. rev. proc. 2011-14, 2011-4 i.r.b. 330 186 florida tax review [vol. 12:5 (1/11/11). this revenue procedure provides automatic consent procedures for a wide variety of accounting method changes. rev. proc. 97-27 clarified and modified; rev. procs. 2001-10, 2002-28, 2004-34, and 2006-56 modified; rev. procs. 2008-52 and 2009-39 superseded in part. a. rev. proc. 2011-14 has since been modified by rev. proc. 2011-27, 2011-18 i.r.b. 740 (4/4/11), rev. proc. 2011-28, 2011-18 i.r.b. 743 (4/4/11), and rev. proc. 2011-43, 2011-37 i.r.b. 326 (8/ 19/11). 2. judge haines writes a treatise on defective claims to automatic consent to change an accounting method. capital one financial corp. v. commissioner, 130 t.c. 147 (5/22/08). following the enactment in 1997 of § 1272(a)(6)(c)(ii), which provides that credit card late-fee receipts create or increase original issue discount rather than constituting an income item when they accrued under the all events test, the taxpayer claimed to have received the irs‘s consent to change its accounting method, pursuant to an automatic consent procedure, by filing form 3115 with its 1998 tax return. however, the taxpayer did not change its accounting method for 1998 and 1999. in the tax court, the taxpayer sought to retroactively change its method for 1998 and 1999. judge haines held that § 446(e) prohibited the taxpayer from retroactively changing its treatment of income from credit card late-fees for years 1998 and 1999 from the currentinclusion method to the method under § 1272(a)(6)(c)(iii) that requires latefee receipts to create or increase original issue discount, even though the oid method was mandatory under the statute, because the taxpayer did not file a form 3115 to notify the irs of the change of accounting method with its 1997 return. because the form 3115 was not timely filed and did not specifically mention ―late fees,‖ automatic consent had not been granted. judge haines stated: [a] taxpayer forced to change its method of accounting under section 448 must still file a form 3115 with its return for the year of change. [reg. § 1.448-1(h)(2)] if the form 3115 is not filed timely, a taxpayer forced off the cash method must comply with the requirements of [reg. § 1.446-1(e)(3)] in order to secure the consent of the commissioner. reg. § 1.448-1(h)(4). pursuant to [reg. § 1.446-1(e)(3)], a taxpayer requesting to change its method of accounting is required to file a form 3115 during the year in which it intends to make the change. a. the taxpayer won the substantive issue, but foot-faulted on seeking a change in method of accounting, so most of 2012] recent developments in federal income taxation 187 the deficiency is upheld. but in future years, it’s ―ooh la la‖ for the taxpayer! capital one financial corp. v. commissioner, 133 t.c. 136 (9/21/09). this case involved two issues and over $280 million – $175 million for one year alone – (apart from penalties). the first issue was the time that third-party credit card issuers are required to recognize credit card income known as interchange. interchange is the difference between the amount charged on a credit card and the lesser amount remitted to the merchant by the issuing bank. interchange resembles interest in that it is expressed as a percentage of the amount lent, usually with an additional nominal fee, although it is not time-sensitive and does not vary as interest rates fluctuate. the government argued that interchange income was credit card fee income that was recognized under the all events test at the time the interchange accrued – when the cardholder‘s credit card purchase was settled through either the visa or mastercard system – while the taxpayer argued that the interchange income was original issue discount (oid) that was properly recognized under § 1272(a)(6)(c)(iii), which was added to the code in 1997, over the anticipated life of the pool of credit card loans to which the interchange related. the tax court (judge haines) agreed with the taxpayer and held that the interchange income was oid. interchange is not a fee for any service other than the lending of money. however, because the taxpayer failed to follow proper procedures to change its accounting methods, the oid method was not available for credit card receivables creating or increasing oid in 1998 or 1999. with certain modifications, the method used by the taxpayer to compute the oid income (using a model developed by kpmg) was reasonable.  a second issue was whether the taxpayer could currently deduct the estimated cost of future redemptions of ―miles‖ it issued to cardholders that could be redeemed for airline tickets, the cost of which would be paid by the taxpayer. the court held that under § 461(h) and reg. § 1.461-4, those expenses could not be deducted currently, but instead were deductible only to the extent that the amounts were fixed and known under the all events test and for which economic performance had occurred. b. and judge wilkinson of the fourth circuit likes judge haines’s approach to change of accounting method rules, but avoids writing a treatise. capital one financial corp. v. commissioner, 659 f.3d 316 (4th cir. 10/21/11). the fourth circuit, in an opinion by judge wilkinson, affirmed both tax court decisions. addressing the oid change of accounting method issue first, the court of appeals rejected the taxpayer‘s argument that because it was changing from an improper method of accounting to a proper method of accounting, it was not required to obtain the irs‘s consent to the change of accounting method. it also rejected the taxpayer‘s argument that an uncodified provision of the 1997 legislation changing the oid rules, which provided that requests to 188 florida tax review [vol. 12:5 change to the new oid method would be subject to automatic consent, obviated the need to obtain consent. the court reasoned that an uncodified provision cannot override § 446(e), which ―requires that taxpayers receive consent before a change in accounting method ‗except as otherwise expressly provided in this chapter.‘‖ finally, the court rejected the taxpayer‘s arguments that (1) automatic consent changes do not require the filing of a form 3115, and (2) a form 3115 filed with the tax return suffices.  turning to the issue of whether the taxpayer could currently deduct the estimated cost of future redemptions of ―miles‖ it issued to cardholders, the court of appeals affirmed on the grounds that the expenses did not meet the all events test: ―when a single mile is awarded for each dollar charged on the card, it remains unknown when the cardholder will earn the 18,000 miles necessary to qualify for an airline ticket. it also remains uncertain when, if ever, the cardholders will redeem their outstanding accumulated miles. therefore, the amount and timing of capital one‘s liabilities with respect to airline tickets for milesone cardholders are not fixed until customers redeem their miles.‖ the court rejected the taxpayer‘s argument that reg. § 1.451-4, allowing a current deduction for coupons issued in connection with was applicable, holding that credit card lending is not a ―sale‖ of goods. b. inventories there were no significant developments regarding this topic during 2011. c. installment method there were no significant developments regarding this topic during 2011. d. year of inclusion or deduction 1. the long arm of § 267(a)(2). bosamia v. commissioner, t.c. memo. 2010-218 (10/7/10). section 267(a)(2) applies to the determination of the cost of goods sold when an accrual method taxpayer purchases from a related cash method taxpayer property that will be included in the purchaser‘s inventory. thus, because the costs were not paid within two and one-half months after the close of the purchaser‘s taxable year, the amounts could not be included in cogs. furthermore, because the adjustment was a change of accounting method, § 481 applied to eliminate from the cogs amounts previously included in costs of goods sold with respect to amounts that remained unpaid in the current year for goods purchased in years beyond the statute of limitations. 2012] recent developments in federal income taxation 189 a. affirmed by the fifth circuit. bosamia v. commissioner, 661 f.3d 250 (5th cir. 10/24/11). in this case presenting a question of first impression, the fifth circuit (judge garza) held that when the irs requires a taxpayer to postpone a deduction from gross income under § 267(a)(2), that disallowance constitutes a change in a taxpayer‘s method of accounting under § 481. an accrual method s corporation purchased music as inventory from a related cash method s corporation during the years 19982002, and treated the $877,581 amounts accrued as costs of goods sold when its liability became fixed. however, the purchasing s corporation failed to pay for the music purchases made during those years, which had been closed by the statute of limitations before the irs audit of the 2004 year. indeed, the purchasing corporation has not yet to date made those payments, and the selling s corporation has not included those amounts in income. in its audit of the purchasing s corporation for the year 2004, the irs disallowed $23,351 of erroneously accrued liabilities for music purchased during that year, but not paid for during that year or in the first 2½ months of 2005. the issue was whether the irs could include the amounts accrued during the closed years 1998-2002 in income under § 481 as resulting from a change of accounting method. an amendment made to § 267(a)(2) in 1984 changed the result of failure to make timely payment from a complete denial of the deduction to a postponement of the deduction until the year of actual payment.  the court held that the 2004 irs audit change in the purchasing s corporation‘s treatment of a ―material item,‖ i.e., its cost of goods sold, constituted a change in its method of accounting pursuant to reg. § 1.446-1(e)(2)(ii)(a). it further held that, even though § 267(a)(2) could preclude any deduction if the payment were never made, that would be the result had the payments been properly accounted for on the cash basis in the years 1998-2002. the court was also unimpressed with the absence of precedent because the irs‘s ―reasonable‖ position in its interpretation of the code and regulations would have been sustained even had it represented a change of position by the irs. 2. the irs retreats on group liabilities! how far will it go? rev. rul. 2011–29, 2011-49 i.r.b. 824 (11/9/11). this revenue ruling holds that an accrual method employer can establish the ―fact of the liability‖ under § 461 for bonuses payable to a group of employees even though the employer does not know the identity of any particular bonus recipient and the amount payable to that recipient until after the end of the taxable year. rev. rul. 76–345, 1976-2 c.b. 134, in which the irs announced that it would not follow washington post co. v. united states, 405 f.2d 1279 (ct. cl. 1969), was revoked. a change in a taxpayer‘s treatment of bonuses to conform to this revenue ruling is a change of 190 florida tax review [vol. 12:5 accounting method that must be made in accordance with §§ 446 and 481, the regulations thereunder, and the applicable administrative procedures. see section 19.01(2) of the appendix of rev. proc. 2011-14, 2011-4 i.r.b. 330.  the logic of this revenue ruling should extend beyond bonuses to other types of ―group‖ liabilities where the group and the aggregate amount owed, but not necessarily the exact identity and payment to each recipient, can be identified. 3. simplifying oid! is that oxymoronic? notice 2011–99, 2011-50 i.r.b. 847 (11/28/11). this notice provides a proposed revenue procedure that will allow taxpayers to use a simplified proportional method of accounting for oid on pools of credit card receivables under § 1272(a)(6). the proportional method allocates to an accrual period an amount of unaccrued oid that is proportional to the amount of pool principal that is paid by cardholders during the period. 4. is the irs reining in the recurring item exception to the ―economic performance‖ rules? rev. rul. 2012–1, 2012-2 i.r.b. 255 (12/13/11). this ruling clarifies the treatment for accrual method taxpayers of liabilities under the recurring item exception to the economic performance requirement under § 461(h)(3) by addressing the application of the ―not material‖ and ―better matching‖ requirements of the recurring item exception to a lease and a related property service contract having one-year terms beginning on july 1 that runs over two taxable calendar years, with the entire amount being prepaid, where the taxpayer reasonably expects that it will enter into similar leases and service contracts on a recurring basis in the future. to apply the recurring item exception, the taxpayer must show either that (1) the liability is immaterial or (2) accruing the full liability in the year incurred results in better matching of expenses to related income. because the taxpayer accrued the liabilities over more than one taxable year for financial statement purposes, the liabilities were material, so the first alternative was not met. because the taxpayer used the leased property to generate income over the period of lease, accrual of the full amount of the liabilities in a year before economic performance did not result in better matching. thus, the taxpayer cannot use the recurring item exception. the ruling distinguishes contracts for the provision of services from insurance and warranty contracts and applies the recurring item exception differently. a change in a taxpayer‘s method of accounting to conform to the revenue ruling is an accounting method change to which §§ 446 and 481 apply. rev. proc. 2011-14, 2011-4 i.r.b. 330, is modified and amplified to provide automatic consent. 2012] recent developments in federal income taxation 191 5. ―one potato, two potato, three potato, four ….‖ to have spudded or not to have spudded, that is the question. caltex oil venture v. commissioner, 138 t.c. no. 2 (1/12/12). the taxpayer, which was on the accrual method, entered into a turnkey contract under which it paid $5,172,666 by cash and note in december 1999 for the drilling of two oil and gas wells. some site preparation required under the contract occurred in 1999, but drilling was not commenced within ninety days after the end of 1999. the taxpayer deducted the full amount as intangible drilling and development costs (idc) under § 263(c) in 1999 and the irs disallowed the deduction on the ground that the economic performance requirement of § 461(h) was not satisfied. the tax court (judge gustafson) held that for purposes of the special rules in § 461(i)(2)(a), which provide ninety days leeway after the close of the year for economic performance to occur with respect to drilling oil and gas wells, ―drilling of the well commences‖ when there is ―actual penetration‖ of the ground surface in the act of drilling for purposes of spudding a well. mere site preparation is insufficient. he emphasized that the title of the provision refers to ―spudding,‖ which webster‘s third new international dictionary 2212 (2002) defines as ―to begin to drill (an oil well) by alternately raising and releasing a spudding bit with the drilling rig.‖ thus, the taxpayer did not qualify under the special rule. furthermore, the 3-1/2-month rule of reg. § 1.461-4(d)(6)(ii), which allows a taxpayer to treat a liability as having been economically performed at the time of payment if that taxpayer ―reasonably expect[ed] the ... [provider of services] to provide the services ... within 3 ½ months after the date of payment,‖ did not apply ―because, in the case of an undifferentiated, non-severable contract, the 3-1/2-month rule contemplates that all of the services called for must be provided within 3-1/2 months of payment.‖ moreover, even if the 3-1/2-month rule applied to treat some of the services due under the contract as having been economically performed in 1999, the deductions allowed under the 3-1/2-month rule were limited to payments of cash or cash equivalents and did not include payments made by notes. finally, judge gustafson held that a trial was warranted on how much of the idc was actually incurred in 1999 and could be deducted under the general economic performance rule of § 461(h). ii. business income and deductions 1. this claim of a tax-free contribution to capital goes down in flames. at&t, inc. v. united states, 629 f.3d 505 (5th cir. 1/3/11), aff’g 104 a.f.t.r.2d 2009-6036 (w.d. tex. 7/16/09). the court of appeals (judge dennis) affirmed a district court decision holding that payments from the federal government for universal telephone access were includible in income and were not excluded under § 118 as contributions to capital. the payments were part of state and federally mandated programs 192 florida tax review [vol. 12:5 funded by fees collected from telecommunications carriers based on revenues. under those programs, payments are made to carriers with high cost obligations to provide universal access to telephone services. the district court followed the decision in united states v. coastal utilities, inc., 514 f.3d 1184 (11th cir. 2008). the court traced the history of the exclusion for contributions to the capital of a corporation, ending with the five characteristics of a nonshareholder contribution to capital set forth in united states v. chicago, burlington & quincy railroad co., 412 u.s. 401 (1973). [1] it certainly must become a permanent part of the transferee‘s working capital structure. [2] it may not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee. [3] it must be bargained for. [4] the asset transferred foreseeably must result in benefit to the transferee in an amount commensurate with its value. and [5] the asset ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect.  from the supreme court jurisprudence, the court derived ―three principles.‖ (1) whether a payment to a corporation by a nonshareholder is income or a capital contribution is controlled by the intention or motive of the transferor. (2) when the transferor is a governmental entity, its intent may be manifested by the laws or regulations that authorize and effectuate its payment to the corporation. (3) also, a court can determine that a transfer was not a capital contribution if it does not possess each of the first four, and ordinarily the fifth, characteristics of capital contributions that the supreme court distilled from its jurisprudence in cb&q.  applying these principles to the facts of the case, the court concluded that, ―either by construing the controlling statutes and regulations or by applying the cb&q five-factor test, the governmental entities in making universal service payments to at&t did not intend to make capital contributions to at&t; and thus, that the payments were income to at&t.‖ under the statutes authorizing the payments, the administrative implementation in regulations, the payments ―were not intended to be capital contributions to at&t, but to be supplements to at&t‘s gross income to enable it to provide universal service programs while meeting competition ... .‖ the payments ―were compensation to at&t for the specific and quantifiable services it performed for high-cost and lower-income users as well as for developing and maintaining universal service ... .‖ furthermore, the 2012] recent developments in federal income taxation 193 payments did not become ―a permanent part of at&t‘s working capital structure, as is demanded by the first cb&q requirement.‖ a. and the beat goes on. sprint nextel corporation v. united states, 779 f. supp. 2d 1184 (d. kan. 3/4/11). payments from the fcc high cost program to make available communications services in high cost areas were not excluded nonshareholder contributions to capital. 2. a give on § 118 for corporations, but the irs carefully limits it to corporations. rev. proc. 2011-30, 2011-21 i.r.b. 802 (4/14/11). the irs will not challenge a corporate taxpayer‘s treatment of an award from the department of energy under various programs for clean coal energy and carbon recapture, ccpi round 3, iccs, or futuregen 2.0, as a nonshareholder contribution to the capital of the corporation under § 118(a) of the code if the corporate taxpayer properly reduces the basis of its property under § 362(c)(2) and the regulations. 3. transparent insolvency for disregarded entities. reg–154159–09, guidance under section 108(a) concerning the exclusion of section 61(a)(12) discharge of indebtedness income of a grantor trust or a disregarded entity, 76 f.r. 20593 (4/13/11). prop. reg. § 1.108-9 would provide that, for purposes of applying § 108(a)(1)(a) and (b), the bankruptcy and insolvency exclusions, to discharge of indebtedness income of a grantor trust or a disregarded entity, the term taxpayer, as used in § 108(a)(1) and (d)(1) through (3), refers to the owner(s) of the grantor trust or disregarded entity. 4. mr. wood’s stealing from his employer for the benefit of woodie’s market, inc. is income to wood. wood v. commissioner, t.c. memo. 2011-190 (8/10/11). mr. wood embezzled funds from the overhead door company where he was general manager and used the money for personal expenses and operating money for woodie‘s market, inc., owned and operated by wood and his wife. the court (judge goeke) rejected the taxpayer‘s assertion that because checks were written on the overhead door company account to woodie‘s market the income was taxable to the market rather than taxpayer personally. the court concluded that because the taxpayer had control over the funds and determined their use, the embezzled money was includable in the taxpayer‘s gross income. the court pointed out that the taxpayer confused how the money was spent with how the money was acquired. the court also rejected the taxpayer‘s argument that the embezzled funds were a contribution to capital of the market. using stolen funds as a contribution to capital did not relieve the taxpayers of their liability to report the income. 194 florida tax review [vol. 12:5 5. negotiated allocations characterizing damages received pursuant to a settlement have to be based on fact to be respected. healthpoint, ltd v. commissioner, t.c. memo. 2011-241 (10/3/11). in two different cases healthpoint sued ethex for false advertising, unfair competition, and trademark dilution under the lanham act and unfair competition, misappropriation, business disparagement under state law, and theft of trade secrets, in connection with ethex‘s marketing of a generic drug substitute for one of healthpoint‘s trademarked drugs. in one case (ethex i) the jury awarded healthpoint (1) actual damages of $5,000,000, (2) disgorgement of ethex‘s profits from false advertising and unfair competition of $1,640,000, (3) punitive damages of $3,174,515, and (4) lanham act enhanced damages of $6,349,030. the other case (ethex ii) was not tried. pending appeals, healthpoint and ethex settled both cases — ethex i for $12 million and ethex ii for $4.5 million. subsequently, ethex and healthpoint signed the settlement agreement resolving both cases. after intense negotiations, the damages were allocated under the settlement agreement as follows: (1) ethex i: (a) damage to goodwill and reputation, $10,450,000; (b) lost profits/disgorgement of profits, $1,350,000; (2) ethex ii: (a) damage to goodwill and reputation, $4,050,000, (b) lost profits/disgorgement of profits, $450,000. healthpoint reported $14.5 million in long-term capital gain and $1.8 million in ordinary income. on audit, the irs determined that all proceeds of the settlement were ordinary income to healthpoint (and applied a § 6662(a) penalty), but in the tax court, the irs conceded that the lanham act enhanced damages of $6,349,030 awarded by the jury for loss of goodwill were taxable as long-term capital gain. the taxpayer argued that the allocation of damages in the settlement agreement should be respected, but the tax court (judge cohen) held otherwise because the allocation of damages in the settlement agreement was not negotiated on the basis of adverse interests. the court held that ―in the light of the circumstances of the settlement and the verdict in ethex i, the allocations made by the jury should be applied to the settlement of ethex i for tax purposes.‖ with respect to ethex ii, in which the issues were very similar, the court found that the taxpayer had not met its burden to show that the allocations according to the settlement agreement in ethex ii should be respected. accordingly, the amounts paid to settle ethex ii were allocated in the same proportions and classifications as those in ethex i, on the basis of the jury verdict. the court also upheld accuracy related penalties under § 6662 because, while healthpoint relied on the advice of tax counsel to oversee the settlement agreement, there was no proof that tax counsel offered an opinion on the propriety of the allocations in the settlement agreement or that tax counsel participated in the negotiation of the allocation. 6. offshore employee leasing arrangement produces constructive income and fraud penalties. browning v. commissioner, t.c. 2012] recent developments in federal income taxation 195 memo. 2011-261 (11/3/11). the taxpayer was the principal shareholder and ceo of a vermont-based manufacturing corporation. the taxpayer leased his services to an irish corporation, which in turn subleased the taxpayer‘s services to a u.s. employee leasing company, which then leased the services to the taxpayer‘s manufacturing company. for tax years 1995-2000 the manufacturing company paid the equivalent of the taxpayer‘s salary to the u.s. leasing company. the u.s. leasing company paid a portion of the payment to the taxpayer as wages, which the taxpayer reported. after deducting an amount for employment taxes, the u.s. leasing company remitted the remainder of the payment to the irish corporation, which deposited the payment in a deferred compensation account for the taxpayer. the retirement account was opened in a bahamas bank by a subsidiary of the irish corporation. from 1998 the taxpayer obtained a credit card from a bahamas bank that was supported by an account in the bank that was funded from the retirement account. the credit card was used by the taxpayer for personal expenses. the court (judge halpern) found that the taxpayer exercised unrestricted access to the bahamas retirement account by means of the credit card and easily concluded that the evidence convincingly supported the irs assertion that the taxpayer was in constructive receipt of income directed through the employee leasing arrangement. for the years after 1998, the court concluded that the taxpayer fraudulently intended to evade tax based on the taxpayer‘s use of the credit cards and concealment of the existence of the bahamas bank accounts by answering ―no‖ to the return question asking whether the taxpayer had signature authority over a foreign financial account. because of the fraud, the statute of limitations remained open for years after 1998. however, the court did not extend its fraud finding to years 1995-1997 because the bahamas account was not created before 1998. the court also imposed fraud penalties under § 6663 for the years 1998-2000. 7. a theory that is becoming more attractive to a couple of us is rejected. the one of us who is over 72 is old enough to know better. west v. commissioner, t.c. memo. 2011-272 (11/16/11). the court (judge paris) found that the taxpayer failed to meet the burden of proof required to overcome the irs assertion of a deficiency on the basis of the taxpayer‘s belief that he did not have to report gross income because he was over the age of 72. 8. the dentist’s income is taxable to the dentist, just like his lawyer’s income is taxable the lawyer. walker v. commissioner, t.c. memo. 2012-5 (1/9/12). the taxpayer dentist practiced through an llc, owned 1 percent by the taxpayer and 99 percent by a partnership that included the dentist‘s children. the arrangement was patterned on entities created by scott and darren cole to avoid income and employment on their 196 florida tax review [vol. 12:5 law practice and rejected in cole v. commissioner, 637 f.2d 767 (7th cir. 2011). the tax court (judge cohen) held that the arrangement represented an anticipatory assignment of income that was taxable to the taxpayer. the only distinction between the taxpayer and the taxpayers in cole was the practice of dentistry versus law, a distinction that did not make a difference. 9. assignment of income principles are alive and well, sort of. owen v. commissioner, t.c. memo. 2012-21 (1/19/12). the taxpayers, john and laura owen incorporated a personal services company, j&l owen, inc., in which they were the sole shareholders. in 1997, john owen and two others formed two companies, family first insurance services companies (ffis) and ffeap, which sold insurance related and financial products. john was both an officer/employee and an independent contractor salesman. laura was employed by ffis as an executive. in 2002, john sold his 50 percent interest in the two companies for $7.5 million, $3.8 million of which was paid in the form of a cashier‘s check. the taxpayer reported $1.9 million on the sale of ffis as capital gain and attempted to roll over $1.9 million of gain on the sale of ffeap into a jewelry business under § 1045 (rollover of an investment of one small business corporation into another small business corporation). in each of january and december 2003 the purchaser paid an additional $1.5 million into the own family trust. the taxpayers‘ accountant mistakenly omitted the second payment from the taxpayers‘ 2003 return. an employment agreement retained john as president of ffis and vice-president of ffeap. various compensation and incentive payments pursuant to the agreement and amendments signed by john in his role as president of ffis were made to j&l owen, inc. in 2002 j&l owen, inc. reported $910,454 of wages to john and $225,000 to laura on forms w-2, which wages were deducted by the corporation. the tax court (judge wherry) held that payments to john for his sales activity in his capacity as an independent contractor for the insurance companies were under the control of j&l owen, inc., and were thus income of the corporation. the court indicated that, as an independent contractor, an individual has control over earned income, which includes the right to choose to do business as a corporation. after a factual inquiry into the nature of other payments, the court held that payments to john for consulting and sales promotion activities were made in his capacity as an officer of the insurance companies and therefore not subject to assignment to the personal service corporation. the court rejected the taxpayers‘ assertion that they over-reported their income for 2002 in the amount reported as compensation from the personal services corporation, stating that the taxpayers failed to meet their burden of showing that they did not receive the amounts reported on w-2s from the personal services corporation. (the irs also conceded that amounts includable in the taxpayers‘ income for 2002 under assignment of income principles had been included in the w-2s from the personal services 2012] recent developments in federal income taxation 197 corporation.) the court also noted that while a taxpayer may conduct business in whatever form the taxpayer chooses, the taxpayer must also accept the result.  with respect to the capital gain the taxpayer attempted to roll over under § 1045, the court held that the jewelry business into which the taxpayer invested proceeds from the sale of ffeap was not an active trade or business and thus not a qualified small business for § 1045 purposes.  the court imposed § 6662 accuracy related penalties, holding that the taxpayer did not reasonably rely on the tax advice of the accounting firm that structured the various transactions. b. deductible expenses versus capitalization 1. those fancy pyrex® and oneida® branded kitchen products are made by robinson knife manufacturing, which is required to capitalize license fees. robinson knife manufacturing co. v. commissioner, t.c. memo. 2009-9 (1/14/09). the taxpayer designs and produces kitchen tools for sale to large retail chains. to enhance its marketing, the taxpayer paid license fees to corning for use of the pyrex trademark and oneida for use of the oneida trademark on kitchen tools designed and produced by the taxpayer. the taxpayer‘s production of kitchen tools bearing the licensed trademarks was subject to review and quality control by corning or oneida. the irs asserted that the taxpayer‘s licensing fees were subject to capitalization into inventory under § 263a under reg. § 1.263a-1(e)(3)(ii)(u), which expressly includes licensing and franchise fees as indirect costs that must be allocated to produced property. agreeing with the irs, the court (judge marvel) rejected the taxpayer‘s argument that the licensing fees, incurred to enhance the marketability of its produced products, were deductible as marketing, selling, or advertising costs excluded from the capitalization requirements by reg. § 1.263a-1(e)(3)(iii)(a). the court noted that the design approval and quality control elements of the licensing agreements benefited the taxpayer in the development and production of kitchen tools marketed with the licensed trademarks. the court rejected the taxpayer‘s argument that rev. rul. 2000-4, 2000-1 c.b. 331, which allowed a current deduction for costs incurred in obtaining iso 9000 certification as an assurance of quality processes in providing goods and services, was applicable to the quality control element of the license agreements. the court noted that although the trademarks permitted the taxpayer to produce kitchen tools that were more marketable than the taxpayer‘s other products, the royalties directly benefited and/or were incurred by reason of the taxpayer‘s production activities. the court also upheld the irs‘s application of the simplified production method of reg. § 1.263a-2(b) to allocate the license fees between cost of goods sold and 198 florida tax review [vol. 12:5 ending inventory as consistent with the taxpayer‘s use of the simplified production method for allocating other indirect costs. a. but the second circuit disagrees. robinson knife manufacturing co. v. commissioner, 600 f.3d 121 (2d cir. 3/16/10). like the tax court, the court of appeals rejected robinson‘s arguments that the royalty payments were deductible as marketing, selling, advertising or distribution costs under reg. § 1.263-1(e)(3)(iii)(a), or that the royalty payments were deductible as not having been incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced under reg. § 1.263a-1(e)(3)(ii)(u). the court of appeals concluded, however, that ―royalty payments which are (1) calculated as a percentage of sales revenue from certain inventory, and (2) incurred only upon sale of such inventory, are not required to be capitalized under the § 263a regulations.‖ the court held that the royalties were neither incurred in, nor directly benefited, the performance of production activities under reg. § 1.263a-1(e)(3)(i). unlike license agreements, the court concluded that robinson could have manufactured the products, and did, without paying the royalty costs. the royalties were not, therefore, incurred by reason of the production process. the court also concluded that since the royalties were incurred for kitchen tools that have been sold, ―it is necessarily true that the royalty costs and the income from sale of the inventory items are incurred simultaneously.‖ the court noted further that had robinson‘s licensing agreements provided for non-sales based royalties, then capitalization would have been required. b. proposed regulations make you wonder why the irs ever litigated robinson knife. reg-149335-08, sales-based royalties and vendor allowances, 75 f.r. 78940 (12/17/10). the irs has proposed regulations under § 263a that generally provide the taxpayerfavorable result reached by the second circuit in robinson knife. the proposed regulations provide that sales-based royalties must be capitalized, but also provide that sales-based royalties required to be capitalized are allocable only to property that a taxpayer has sold, rather to closing inventory. the preamble asserts that the second circuit in robinson knife misconstrued the nature of costs required to be capitalized and that the costs of securing rights to use intellectual property directly benefits, or are incurred by reason of, production processes requiring that the costs be capitalized even if payable only on the basis of the number or units sold or as a percentage of revenue. nonetheless, the proposed regulations are consistent with the holding of robinson knife where they provide that sales based royalties are related only to units that are sold during the taxable year. thus, https://checkpoint.riag.com/getdoc?docid=t0advaftr:12983.1&pinpnt= 2012] recent developments in federal income taxation 199 prop. reg. § 1.263a-3(d)(3)(i)(c)(3) would provide that sales based costs would not be included in ending inventory under § 471.  however, in light of the generous treatment of sales-based royalties, the proposed § 263a regulations, along with proposed amendments to reg. § 1.471-3(e), require that sales-based vendor allowances [which are rebates or discounts from a vendor as a result of selling the vendor‘s merchandise] must be taken into account as an adjustment to the cost of merchandise sold, effectively requiring that such allowances be included in gross income immediately, and should not be taken into account in ending inventory.  the formulas allocating additional indirect costs to ending inventory under the simplified production and resale methods would be modified to remove capitalized sales based royalties and vendor allowances allocable to property that has been sold. c. but the irs still disagrees with the second circuit. aod 2011-01, 2011-9 i.r.b. 526 (2/9/11), corrected by ann. 2011-32, 2011-22 i.r.b. 836 (5/31/11). the irs disagrees with the second circuit analysis stating that the court ―confused the timing with the purpose of the payments.‖ the irs opines that robinson incurred the royalty expenses first to produce then to sell the trade-marked items, adding that in order to sell the items it first had to produce them. 2. starting-up is cheaper. the small business jobs act of 2010 increases the amount of deductible § 195 start-up expenses for investigating or creating an active trade or business from $5,000 to $10,000 for expenses incurred in a year beginning in 2010. the phase out amount is also increased from $50,000 to $60,000. a. start-up and organization expenses final regulations are adopted. t.d. 9542, elections regarding start-up expenditures, corporation organizational expenditures, and partnership organizational expenses, 76 f.r. 50887 (8/17/11). sections 195 (start-up expenditures in an active trade or business), 248 (corporate organization expenditures), and 709 (partnership organization expenditures), each provide for an election to deduct such expenditures in the year business begins to the extent of the lesser of the amount of the expenditures or $5,000 reduced by the amount that the expenditures exceed $50,000. under the election, the remaining expenses are amortizable over 180 months beginning with the month that business commences. the finalized regulations, reg. §§ 1.195-1, 1.248-1, and 1.709-1, following temporary and proposed regulations, provide that a taxpayer is deemed to make the election to amortize start-up or organization expenses for the year in which the active business, corporate business, or partnership business to which the expenditure relates begins. 200 florida tax review [vol. 12:5 the regulations provide that a taxpayer may choose to forego the election by affirmatively electing to capitalize the expenditures on a timely filed return for the year in which the business begins. the final regulations are effective on the date of filing in the federal register, but may be applied by taxpayers to expenditures incurred after 10/22/04, provided the period for assessing a deficiency for the year the election is deemed made is still open. 3. subsidizing oscar hopefuls. the compromise tax relief act of 2010, § 744, extends the election under code § 181 to expense up to $15 million of qualified film and television production costs incurred in low-income or distressed communities through 2011. a. final regulations come out just in time for the expiration date of the statute. t.d. 9551, deduction for qualified film and television production costs, 76 f.r. 60721 (9/30/11). section 181 provides for an election to deduct qualified film or television production costs incurred in productions commenced prior to 1/1/12, as an expense not chargeable to capital account in an amount up to $15 million for each production, or $20 million for production expenses incurred in certain low income or distressed county areas. a production qualifies for the election if at least 75 percent of the total compensation for the production is for services performed in the united states by actors, directors, producers, and production personnel. final regulations §§ 1.181-1 through -6, replacing temporary and proposed regulations, clarify the owner of production costs, the definition of aggregate production costs for purposes of the election and limitations, and provisions applicable to participations and residuals. b. temporary and proposed regulations update the rules. reg-146297-09, deduction for qualified film and television production costs reg. §§ 1.181-0, 1.181-1, 76 f.r. 64879 (10/19/11). the temporary and proposed regulations clarify that the $15 million (or $20 million) limitation under amendments to § 181 applies to limit the aggregate deduction for production costs paid or incurred by all owners of a qualified film or television production for each qualified production, rather than limit the aggregate production costs. 4. avoided interest attributable to associated property taken out of service requires capitalization under chevrontested regulations that barely survive. dominion resources, inc. v. united states, 97 fed. cl. 239 (2/25/11). the taxpayer, an electric utility, removed boilers from service to replace burners. reg. § 1.263a-11(e)(1)(ii)(b) requires that the capitalized cost of improvements under § 263a include both direct expenditures and the capitalized cost of interest (under the avoided cost rules) attributable to the basis of property temporarily removed from https://checkpoint.riag.com/getdoc?docid=iaftrinc:123421.1&pinpnt= 2012] recent developments in federal income taxation 201 service in order to complete the improvements. the court (judge lettow) rejected the taxpayer‘s arguments that (1) the associated property rule of reg. § 1.263a-11(e)(1(ii)(b) is invalid as inconsistent with § 263a, and (2) it was adopted in contravention of the requirements of the administrative procedure act. under the test of chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), the taxpayer argued that the regulation was inconsistent with § 263a(f)(2)(a)(ii), which provides that for purposes of determining production period interest ―with respect to any property . . . interest on any . . . indebtedness [not directly attributable to production expenditures] shall be assigned to such property to the extent that the taxpayer‘s interest costs could have been reduced if production expenditures . . . had not been incurred.‖ the taxpayer asserted that ―property‖ for this purpose under the statutory language can include only the improvement itself, which is separately depreciable, and cannot, therefore be expanded to include associated property as provided in the regulation. the taxpayer also argued that the production costs were incurred with respect to the replacement burners, and not with respect to the boilers themselves. while the court was not completely happy with the irs argument that the property can be separated for depreciation purposes while considered as a unit for purposes of the interest allocation, the court concluded that the statute was sufficiently ambiguous under the first prong of the chevron test, that the regulation could be tested under the second prong of chevron, which asks whether the regulation is a permissible construction of the statute. here the court indicated that, ―it is stretching the statute quite far to say that the associated-property rule ‗is a reasonable interpretation‘ of the enacted text [of section 263a].‖ the court added that the irs‘s rationales ―are not very satisfying.‖ the court then concluded, however, that ―it is not this court‘s province to be making such policy choices. in this very close case, the court cannot say that treasury overstepped the latitude granted by the statute to adopt regulations prescribing the calculation of interest to be capitalized in connection with an improvement to existing property used by the taxpayer to produce income‖ and held that the regulation therefore survived the taxpayer‘s challenge. with respect to the taxpayer‘s challenge under the administrative procedure act, the court again found that ―it is a stretch to conclude that treasury ‗cogently explain[ed] why it has exercised its discretion in a given manner,‘‖ but added that ―[t]he ‗path‘ that treasury was taking in the rulemaking proceedings can be ‗discerned,‘ albeit somewhat murkily‖ and upheld the regulation. finally, the court rejected retroactive application of a de minimis rule of reg. § 1.263a-11(e)(2) to the taxpayer, and denied the irs counterclaim for capitalization of additional interest.  no pretzel in existence has as many twists and bends as does this opinion. for background, see mayo foundation for medical education and research v. united states, 131 s. ct. 704 (1/11/11), at xi.a., below. 202 florida tax review [vol. 12:5 5. amounts paid that are contingent on successfully closing a transaction could be 70 percent deductible and 30 percent capitalizable. rev. proc. 2011-29, 2011-18 i.r.b. 746 (4/8/11). reg. § 1.263(a)-5 requires a taxpayer to capitalize any amount paid to facilitate a business acquisition, which includes any amount paid to investigate or pursue the acquisition. an amount contingent on successfully closing a transaction is presumed to facilitate the transaction. the revenue procedure indicates that the irs will not challenge the allocation of success based fees if the taxpayer treats 70 percent of the fee as an amount that does not facilitate the transaction, capitalizes the remaining 30 percent of the fee as an amount that does facilitate the transaction, and attaches a statement to the return for the year indicating that the taxpayer is electing the safe harbor.  the irs seems to be giving up a lot in order to avoid these types of controversies. 6. housing construction on unimproved lots is production. gardner v. commissioner, t.c. memo. 2011-137 (6/20/11). the taxpayer was a self-employed contractor who built single and multiple family housing on unimproved land that he purchased. the tax court (judge halpern) held that the taxpayer was required to capitalize engineering costs and taxes incurred in connection with a 34 acre parcel that the taxpayer prepared for subdivision then sold. the court concluded that the parcel was held for production, and § 263a requires capitalization of pre-production costs with respect to property held for construction or improvement. see § 263a(g)(1) and reg. § 1.263a-2(a)(3)(ii). however, because no physical production had occurred during the year, the rule of § 263a(f), requiring capitalization of production period interest, did not apply to require capitalization of interest, so the interest was deductible. the court also held that the sale of three subdivided/duplex lots resulted in short-term capital gain. the court found that, although the taxpayer regularly purchased undeveloped land for development and sale, the taxpayer held some properties with the intent of developing the property and holding it for rent rather than for sale to customers. 7. temporary and proposed regulations provide extensive rules for the acquisition, production, or improvement of tangible personal property. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11), and reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81128 (12/27/11). the treasury department has promulgated temporary regulations, generally effective for tax years beginning on or after 1/1/12, addressing capitalization requirements for expenditures to acquire and improve tangible property. the temporary regulations adopt provisions of https://checkpoint.riag.com/getdoc?docid=itcm:35730.1&pinpnt= 2012] recent developments in federal income taxation 203 regulations proposed in 2008 (reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 73 f.r. 12838 (3/7/08)), which were in turn based on a 2006 proposal that was substantially modified by the 2008 proposed regulations (reg-16874503, guidance regarding deduction and capitalization of expenditures related to tangible property, 71 f.r. 48590 (8/21/06)). the temporary regulations provide detailed capitalization rules and several bright-line standards under §§ 162(a) and 263(a) regarding the acquisition, improvement or repair of tangible real and personal property. the temporary regulations also revise rules under § 168 regarding disposition and maintenance of general asset accounts for macrs property. in general, the regulations adopt the provisions of the 2008 proposed regulations, but with multiple modifications. temp. reg. § 1.263(a)-2t provides rules for amounts paid for the acquisition or production of tangible property, and § 1.263(a)-3t provides rules for amounts paid for the improvement of tangible property. however, these new proposed regulations provide many additional rules. the temporary regulations define material and supplies to treat as deductible (1) the cost of any property with a useful life that does not exceed one year and (2) any item that cost not more than $100. they add a book-conformity de minimis rule, a safe-harbor for routine maintenance, and an optional simplified method for regulated taxpayers. the temporary regulations contain provisions defining a unit of property as a key concept and address capitalization of expenditures that improve or restore a unit of property. the regulations do not provide for a detailed repair allowance rule, but do provide for future i.r.b. guidance regarding industry-specific repair allowance methods.  acquisition and production costs. temp. reg. § 1.263(a)-2 provides that a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property (as determined under temp. reg. § 1.263(a)-3t(d)(2)), including leasehold improvement property, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. amounts paid to create intangible interests in land are treated as capital expenditures. amounts paid for work performed on a unit of property prior to the date the property is placed in service must also be capitalized. temp. reg. § 1.263(a)-2t(d)(1). transaction costs to facilitate the acquisition of property are expressly required to be capitalized, temp. reg. § 1.263(a)-2t(f), but facilitative expenditures do not include employee compensation or overhead unless the taxpayer elects to capitalize such expenditures. expenditures to defend or protect title must be capitalized. temp. reg. § 1.263(a)-2t(e).  selling expenses. temp. reg. § 1.263(a)-1t(d) provides for the capitalization of selling expenses as an offset against sales proceeds (except in the case of dealers). 204 florida tax review [vol. 12:5  materials and supplies. as under the prior rules, temp. reg. § 1.162-3t allows a deduction for incidental material and supplies in the year an expenditure is made. materials and supplies are incidental when they are carried on hand and for which no record of consumption is maintained or when not carried in inventory. a deduction for non-incidental materials and supplies is allowed in the year the property is consumed. materials and supplies include tangible property that is (1) a component acquired to repair or improve a unit of tangible property that is not acquired as part of a unit of property, (2) fuel, lubricants, water and similar items that are reasonably expected to be consumed within 12 months, and (3) tangible property that is a unit of property with (a) an economic useful life to the taxpayer of not more than 12-months, or (b) that costs not more than $100 (an embedded de minimis rule). temp. reg. § 1.162-3t(c). taxpayers may elect to capitalize the cost of each item of material or supply. items used in the production of other property remain subject to the uniform capitalization rules of § 263a. temp. reg. § 1.263a-1t(b). on sale or disposition, materials and supplies are not treated as capital assets. temp. reg. § 1.162-3t(g).  rotable spare parts. rotable spare parts are components treated as materials and supplies that are installed in a unit of property, are removable from the unit of property, and are generally repaired and improved for installation in a unit of property or stored for later use. the cost of rotable spare parts is deductible in the year of the disposition of the part. temp. reg. § 1.162-3t(a)(3). temp. reg. § 1.162-3t(e) provides an elective optional method of accounting for the treatment of rotable and temporary spare parts under which (1) the taxpayer deducts the amount paid for the part in the year the part is first installed on a unit of property, (2) in each year the part is removed from a unit of property the taxpayer includes the fair market value of the part in gross income, (3) includes in the basis of the part the value taken into income plus amounts paid to remove the part, (4) includes in the basis of the part any amounts expended to maintain the part, (5) then deducts the basis and any cost incurred to reinstall the part in a unit of property, and finally (6) deducts the basis of the part on final disposition.  financial accounting de minimis rules. temp. reg. § 1.263(a)-2(g) allows a taxpayer to deduct expenditures to acquire or produce property (other than property produced for resale) if the taxpayer expenses the cost on a certified audited financial statement (including audited financial statements prepared by an independent cpa and used for nontax purposes and certain financial statements filed with regulatory agencies) pursuant to a written accounting procedure adopted by the taxpayer that treats as expenses amounts paid for property costing less than a specified dollar amount, as long as the amounts deducted under the de minims rule do not exceed the lesser of 0.1 percent of the taxpayer‘s gross receipts or 2 percent of the taxpayer‘s total depreciation and amortization expense reflected in its financial statement. (the temporary regulations remove a provision in the 2008 2012] recent developments in federal income taxation 205 proposed regulations that the aggregate amount deducted do not materially distort the taxpayer‘s income for purposes of § 446.) property subject to the de minimis rule cannot be treated on sale or other disposition as a capital or § 1231 asset. a taxpayer may elect to apply the de minimis rule of temp. reg. § 1.263(a)-2t(g) to material and supplies, including rotable spare parts, which are then not treated as materials or supplies under temp. reg. § 1.162-3t. temp. reg. § 1.162-3t(f).  unit of property. temp. reg. § 1.263(a)-3t(e). the unit of property concept is central to the proposed regulations‘ requirement that improvements to a unit of property must be capitalized.  temp. reg. § 1.263(a)-3t(e)(2) provides that a building and its structural components (as defined in reg. § 1.48-1(e)(2)) are treated as a unit of property. 1 however, the improvement rules must be separately applied to components of a building including heating, ventilation and air conditioning systems, plumbing systems, electrical systems, elevators and escalators, fire protection and security systems, gas distributions systems, and other systems identified in published guidance. condominium units and cooperative units are each treated for the owner as a unit of property. similarly, a leasehold interest in a portion of a building is treated as a unit of property.  temp. reg. § 1.263(a)-3t(e)(2) defines a unit of property for property other than buildings as including all the components that are functionally interdependent. components of property are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component. however, a component that is recorded on the taxpayer‘s books as having a different economic useful life or which is in a different class of property for macrs depreciation would be treated as separate unit of property. thus, for example, all of the component parts of a railroad locomotive constitute a single unit of property, as does a truck trailer and its tires (unless the taxpayer the taxpayer‘s financial statements treat them as separate property). a special rule applies to ―plant property,‖ which is a functionally integrated collection of equipment and machinery used to perform an industrial process; each component (or group of 1. under reg. § 1.48-1(e)(2), structural components of a building include such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefor such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building. 206 florida tax review [vol. 12:5 components) that performs a discrete and major function or operation within the functionally interdependent machinery or equipment constitutes a separate unit of property. determinations of a unit of property with respect to network assets are based on the taxpayer‘s facts and circumstances unless otherwise provided in published guidance. network assets include property such as railroad tracks, oil, gas, water and sewage pipelines, power transmission lines, and cable and telephone lines that are owned or leased by taxpayers in those industries.  capitalization of improvements. expenditures to improve a unit of property must be capitalized. temp. reg. § 1.263(a)-3t(d). amounts expended for repairs and maintenance of tangible property are deductible if they are not required to be capitalized under temp. reg. § 1.263(a)-3t. temp. reg. § 1.162-4t. expenditures that improve tangible property and that are required to be capitalized include expenditures that: (1) result in a ―betterment‖ to a unit of property (replacing the term ―material increase in value‖ used in the original proposal); (2) restore a unit of property; or (3) adapt the unit of property to a new or different use. temp. reg. § 1.263(a)-3t(f) provides special rules requiring a lessee to capitalize expenditures for improvements to a unit of leased property. a lessor is required to capitalize the cost of improvements to leased property paid directly or through a construction allowance to the lessee. (the preamble to the regulations states that the recovery period for an improvement or addition to the ―underlying property‖ begins on the placedin-service date of the improvement or addition. see § 168(i)(6); temp. reg. § 1.168(i)-8t(c)(4)(ii)(e).)  betterment. temp. reg. § 1.263(a)3t(h). an expenditure results in a betterment of a unit of property if it (1) ameliorates a material condition or defect that existed prior to acquisition of the property or arose during production of the property, (2) results in a material addition to a unit of property, or (3) results in a material increase in capacity. determination of whether an expenditure results in a betterment is factual and requires a comparison of the condition of the property immediately prior to the circumstance necessitating the expenditure (or the condition of property the last time the taxpayer corrected for normal wear and tear) with the condition of the property after the expenditure. an expenditure that results in a betterment of a component of a building is treated as a betterment to the unit of property consisting of the building and its structural components.  restoration. temp. reg. § 1.263(a)3t(i). an expenditure is capitalized as a restoration if it (1) replaces a component for which the taxpayer has deducted a loss, (2) replaces a component the adjusted basis of which has been accounted for in realizing gain 2012] recent developments in federal income taxation 207 or loss on a sale or exchange of the component, (3) repairs damage for which the taxpayer has deducted a casualty loss under § 165, (4) returns the property to its ordinary operating condition after the property as fallen into a state of disrepair and is no longer functional, (5) results in rebuilding the property to a like-new condition at the end of its class life under the § 168(g) alternative depreciation system, or (6) is for the replacement of a major component or structural part of the unit of property. whether there is a replacement of a major component or structural part is determined under the facts and circumstances and includes replacement of a major component or structural part that comprises a large portion of the physical structure of the unit of property or that performs a discrete and critical function in the operation of the nit of property. (the 50 percent of replacement cost test of the proposed regulations was eliminated.) again, the restoration of a component of a building is treated as a restoration of the unit of property consisting of the building and its structural components.  new use. temp. reg. § 1.263(a)3t(j). a unit of property is treated as adapted to a new or different use if the adaptation is not consistent with the taxpayer‘s ―intended ordinary use of the unit of property at the time originally placed in service by the taxpayer.‖ an expenditure to adapt a component of a building to a new use must be capitalized as an expenditure to adapt the unit of property consisting of the building and its structural components to a new use.  rehabilitation doctrine is no more. temp. reg. § 1.263(a)-3t(f)(3) eliminates the judicially created rehabilitation doctrine by providing that, ―[i]ndirect costs that do not directly benefit or are not incurred by reason of an improvement are not required to be capitalized under section 263(a), regardless of whether they are made at the same time as an improvement.‖ but the regulations provide that if otherwise deductible repairs benefit or are incurred by reason of an improvement, the cost of the repairs must be capitalized under § 263a.  routine maintenance safe harbor. temp. reg. § 1.263(a)-3t(g) provides a safe harbor from the capitalization requirement for ―the recurring activities that a taxpayer expects to perform as a result of the taxpayer‘s use of the unit of property to keep the unit of property in its ordinarily efficient operating condition.‖ the safe harbor applies to activities that the taxpayer reasonably expects to perform more than once during the class life of the property, as determined under the macrs alternative depreciation schedule of § 168(g). routine maintenance includes maintenance with respect to and the use of rotable spare parts. routine maintenance excludes activities that follow a basis recovery event similar to the items that are described as restorations. 208 florida tax review [vol. 12:5  repairs. temp. reg. § 1.162-4t allows as a deductible repair expense any costs that are not required to be capitalized under temp. reg. § 1.263(a)-3t.  repair allowance. the regulations do not provide for a repair allowance, but temp. reg. § 1.263(a)-3t(l) permits taxpayers to use a repair allowance method that is authorized by published guidance in the federal register or the internal revenue bulletin, suggesting that such rules will be forthcoming.  examples. the regulations are full of examples that seem to cover most of the litigated cases and rulings addressing capitalization versus repair. the examples are necessary to understand the substantive provisions, which, although intended to provide clarity, are not so clearly applied. c. reasonable compensation 1. every time a reasonable compensation case is appealable to the seventh circuit, it seems that whoever the judge is, after doing the exacto spring bit to satisfy judge posner, he or she adds something like, ―and in any event it wasn’t deductible because it wasn’t intended to be compensation.‖ mulcahy, pauritsch, salvador & co. v. commissioner, t.c. memo. 2011-74 (3/31/11). the taxpayer, an accounting and consulting firm operating as a c corporation, made payments to three related entities owned by the three named principals of the corporation that essentially resulted in zeroing out the taxpayer‘s income for the year. the related entities performed no services for the taxpayer, and at trial the taxpayer claimed that the payments were deductible as compensation to the named principals, who did perform services for the taxpayer. the court (judge morrison) held that even if the payments were viewed as compensation to the named principals, the payments were not deductible. applying the ―hypothetical independent investor‖ test of exacto spring corp. v. commissioner, 196 f.3d 833 (7th cir. 1999), because the case was appealable to the seventh circuit, judge morrison found that the rate of return on the firm‘s equity was ―too low to create a presumption that the amounts claimed as ‗consulting fees‘ were reasonable compensation for the [principals‘] services.‖ because the taxpayer presented no other relevant evidence that the payments were reasonable in amount, the deduction was disallowed. judge morrison added that besides being reasonable in amount, to be deductible the payment must be intended to be compensation, and the payments in question were not intended to be compensation. [the firm] intended for the payments to the related entities to distribute profits, not to compensate for services. ... salvador chose the amount to pay each year so that the payments distributed all (or nearly all) accumulated profit 2012] recent developments in federal income taxation 209 for the year. he did this for tax planning purposes. each [principal‘s] percentage of the payments to the related entities was tied to hours worked, but the firm‘s intent in making the payments was to eliminate all taxable income. the firm did not intend to compensate for services.  accuracy related penalties were upheld, with judge morrison taking special note of the fact that the taxpayer was an accounting firm. 2. non-limit limitations on excessive compensation to corporate officers. reg-137125-08, certain employee remuneration in excess of $1,000,000 under internal revenue code section 162(m), 76 f.r. 37034 (6/24/11). section 162(m) limits deduction for compensation to top corporate officers of publicly traded corporations to $1 million with an exception to performance based compensation attributable to stock options and stock appreciation rights. proposed regulations § 1.162-27(e)(2)(iv) would require that performance based compensation plans designate the maximum number of shares with respect to which options or rights may be granted to an individual employee during a specified period. the preamble to the proposed regulations indicates that the irs rejects assertions that specifying a limit is not necessary because such plans require shareholder approval as contrary to its interpretation of legislative history as requiring an objective formula for determining the maximum amount of compensation an employee could receive if the employee‘s performance goal is met. d. miscellaneous deductions 1. standard mileage rate rules published in a revenue procedure while the amounts will be disclosed in a separate notice. rev. proc. 2010-51, 2010-51 i.r.b. 883 (12/3/10). the irs indicated that beginning in 2011 it will publish mileage rates in a separate annual notice. the revenue procedure indicated that a taxpayer may use the business standard mileage rate to substantiate expenses for business use of an automobile in lieu of fixed and variable costs. parking fees and tolls are deductible as separate items. the basis of an automobile used for business is reduced by a per-mile amount published in the annual notice. separate rates are provided both for charitable use of an automobile and medical and moving use of an automobile. the revenue procedure also provides details for treating as substantiated a fixed and variable rate allowance for expenses incurred by an employee in driving an automobile owned or leased by the employee in performing services for the employer. a. standard mileage rates announced. notice 2010-88, 2010-51 i.r.b. 882 (12/3/10). standard mileage rates for 210 florida tax review [vol. 12:5 2011 are: (1) 51 cents per mile for business miles driven [up from 50 cents]; (2) 19 cents per mile driven for medical or moving purposes [up from 16.5 cents]; and (3) 14 cents per mile driven in service of charitable organizations [unchanged because the rate is statutory, § 170(i)]. b. mileage rates are back up for second half of 2011. ann. 2011-40, 2011-29 i.r.b. 56 (6/23/11). the irs has announced that the standard optional mileage rates for computing the deductible costs of operating an automobile for business will increase from 7/1/11 through 12/31/11 to 55.5 cents per mile. the standard rate for purposes of medical and moving expenses is 23.5 cents per mile. the statutory rate for charitable deductions purposes is 14 cents per mile. c. and remain almost the same for (part of?) 2012. notice 2012-1, 2012-2 i.r.b. 260 (12/9/11). the standard mileage rate for rolling the tires after 1/1/12 remains at 55.5 cents (23 cents representing depreciation). the mileage rate for charitable service is 14 cents, and for medical care or moving expenses the rate is slightly down to 23 cents. the maximum standard automobile cost for computing the allowance under a fixed and variable rate (favr) plan is $28,000 for automobiles and $29,300 for trucks and vans. 2. have you documented that your own cell phone is used for business rather than personal purposes? tash v. commissioner, t.c. memo. 2008-120 (4/29/08). among the many deductions claimed by a lawyer that judge haines disallowed was the deduction claimed for his cellular telephone, because ―[t]he record did not indicate whether petitioner used his cellular telephone for business and/or personal calls.‖ inasmuch as cell phones are listed property, reg. § 1.2745(c) and (f) require substantiation for the deduction. a. how do you steer the car? it might or might not be ok to drive while talking on your cell phone, but it is imperative to take notes in your log book while chatting on the phone. alami v. commissioner, t.c. memo. 2009-42 (2/23/09). judge vasquez denied the taxpayer‘s claimed business deductions for cellular telephone service because the taxpayer failed to establish the amount of time he used his cell phone for business and personal purposes. a cellular phone is ―listed property‖ that is subject to the strict substantiation requirements of § 274(d) pursuant to § 280f(d)(4)(a)(v), and a taxpayer must establish the amount of business use and the amount of total use for the property to substantiate the amount of expenses for listed property. an alternative ground for denying the deduction was that the taxpayer‘s employer did not require that he have a cell phone. 2012] recent developments in federal income taxation 211  query whether there are employer reporting obligations with respect to cell phones furnished to employees who fail to keep records? b. but, simplified methods for reporting cell phone use are under consideration. notice 2009-46, 2009-23 i.r.b. 1068 (6/8/09). irs is considering methods to simplify treatment of employerprovided cell phones, including a (1) ‖minimal personal use method‖ (if the employee accounts to the employer that he has a personal cell phone for use during business hours); and (2) a safe harbor method under which an employer would treat 75 percent of each employee‘s use of the cell phone as business usage.  in a letter to representative skelton, info 2009-0141 (7/8/09), the irs advised that it is seeking clarifying legislation from congress. 2009 tnt 216-62. c. and the prez says to congress ―delist‖ cell phones. president obama‘s fiscal year 2011 budget calls for congress to amend § 280f to remove cellular telephones from the category of listed property, thereby ―effectively removing the requirement of strict substantiation and the limitation on depreciation deductions.‖ department of the treasury, general explanations of the administration‘s fiscal year 2011 revenue proposals 26 (february 2010). the substantiation requirements are ―burdensome for employers‖; it is difficult to document the cost of cell phone calls, and ―the cost of accounting for personal use often exceeds the amount of any resulting income.‖ the proposal specifically contemplates that ―a cell phone (or other similar telecommunications equipment) provided primarily for business purposes would be excluded from gross income.‖ d. finally, there is no longer a need to keep a log book on the front seat of your car. section 2043 of the small business jobs act of 2010 removed ―cellular telephones and similar telecommunications equipment‖ from the definition of ―listed property‖ contained in § 280f(d)(4) for taxable years beginning after 12/31/09. this, in turn, eliminates the § 274(d) substantiation requirement for business cell phone use. e. ♬♪―hanging on the [cellular] telephone.‖♪♬ notice 2011-72, 2011-38 i.r.b. 407. (9/15/11). after 12/31/09, a cellular telephone provided to an employee for a substantial noncompensatory purpose is a working condition fringe benefit. the employer‘s need to contact the employee at all times for work-related emergencies, the employer‘s requirement that the employee be available to 212 florida tax review [vol. 12:5 speak with clients at times when the employee is away from the office, and the employee‘s need to speak with clients located in other time zones at times outside of the employee‘s normal work day are possible substantial noncompensatory business reasons. a cell phone provided to promote the morale or good will of an employee, to attract a prospective employee or as a means of furnishing additional compensation to an employee is not provided primarily for noncompensatory business purposes. if the provision of the phone qualifies as a working condition fringe benefit, the value of any personal use of an employer-provided cell phone can be excluded from income as a de minimis fringe benefit. 3. the cost of figuring out what kind of work you’re going to do isn’t deductible. forrest v. commissioner, t.c. memo. 2011-4 (1/4/11). the court (judge wherry) held that expenses incurred in a ―fledgling effort‖ solo law practice by a lawyer who reported no income from her law practice, but which were incurred to make contacts and network in an effort to ―figure out what kind of work ... [the taxpayer] was going to do,‖ were nondeductible start-up expenses under § 195. 4. appropriately-named television news anchor was denied a deduction for her wardrobe, etc. hamper v. commissioner, t.c. summary opinion 2011-17 (2/24/11). the court (special trial judge dean) denied a television news anchor‘s deduction of clothing costs and upkeep because the clothing in question was suitable for everyday wear and held that taxpayer‘s claimed business deductions were personal expenses. accuracyrelated penalties were upheld. 5. let the judicial interpretation of § 199 begin! gibson & associates, inc. v. commissioner, 136 t.c. 195 (2/24/11). section 199 allows a corporate taxpayer to deduct a percentage (equal to 3 percent for the year in question) of its ―qualified production activities income.‖ the starting point for the computation is ―domestic production gross receipts.‖ section 199(c)(4)(a)(ii) provides that domestic production gross receipts include a taxpayer‘s gross receipts from the construction of real property performed in the united states if the taxpayer is engaged in the active conduct of a construction business and the gross receipts are derived in the ordinary course of that business, but § 199 does not define the phrase ―construction of real property.‖ the taxpayer is an engineering and heavy construction company that primarily erects or rehabilitates streets, bridges, airport runways, and other related real property. its rehabilitation services relate mainly to real property that is substantially dilapidated or damaged from a casualty. the taxpayer also repairs and maintains real property. the taxpayer treated all of its receipts as ―domestic production gross receipts‖ eligible for the § 199 deduction, but the irs disallowed the deduction on the 2012] recent developments in federal income taxation 213 ground that none of its receipts qualified. the tax court (judge paris) held that the receipts derived from the erection or substantial renovation of real property (that operated and performed a discrete function in and of itself) were domestic production gross receipts to the extent that the taxpayer‘s activities with respect to each property (1) materially increased the value of the real property, (2) substantially prolonged the useful life of the real property, and/or (3) adapted the real property to a different or new use. many of the taxpayer‘s activities met this test. however, the gross receipts from the taxpayer‘s real property repair business that were unrelated to its primary business and which did not materially increase the value of the real property, substantially prolong its useful life, and/or adapt the real property to a different or new use did not qualify. the case was highly factual. 6. hard rock cafes are unified but not substantiated. morton v. united states, 98 fed. cl. 596 (4/27/11). the taxpayer is one of the co-founders of the hard rock café chain, which is operated through a series of s corporations in which the taxpayer was the sole or majority investor. in addition the taxpayer owned the real property underlying hard rock cafes, which was leased to the s corporations. the taxpayer travelled in a gulfstream iii aircraft, which he exchanged for a gulfstream iv through a qualified intermediary. the aircraft was used both for business and personal travel. while the pilot logs for the aircraft recorded the date, time of the trips, destinations, and the number of passengers, the logs did not record the identity of passengers or the purpose of the trips. the court accepted the taxpayer‘s argument that the taxpayer‘s unified business enterprise permitted deductions for the aircraft use that furthered the business purpose of the taxpayer‘s various entities other than the entity to which the aircraft was registered. deputy v. du pont, 308 u.s. 488 (1940), and moline properties, inc. v. commissioner, 319 u.s. 436 (1943), held that the taxpayer and his corporations must be treated as separate entities for determining business expenses under § 162. the court concluded that, ―undisputed facts support the conclusion that plaintiff‘s entities were intertwined and formed a unified business enterprise that operated for profitmaking purposes.‖ however, the court deferred ruling on the summary judgment motion on the deductibility of the expenses and depreciation pending indicating that its ruling would be dependent upon substantiation of business use of the aircraft.  the court also held that a mistaken disbursement of cash to the taxpayer‘s corporation on the exchange of the gulfstream iii rather than to the qualified intermediary, when the money was immediately returned to the intermediary should not defeat like-kind exchange treatment under § 1031 because the error was quickly rectified. https://checkpoint.riag.com/getdoc?docid=iadc22bcf6934c857ca8aa4da9ba66fc8&pinpnt= 214 florida tax review [vol. 12:5  however, the court also deferred ruling on the § 1031 exchange pending a determination of the business use of the aircraft. 7. folks never give up trying to claim they are away from home when the job is really permanent. scroggins v. commissioner, t.c. memo 2011-103 (5/18/11). the court (judge wherry) held that the taxpayer who maintained a residence in georgia but worked in california, was not entitled to away from home deductions for california expenses. the taxpayer was employed exclusively in california, and he knew that he would be away from georgia for a very long time. the taxpayer‘s employment as a medical technician was highly specialized as a type of work not available in georgia. finally, the taxpayer had no business reason for maintaining a home in georgia. 8. day trading is a losing proposition, but it’s not a trade or business. kay v. commissioner, t.c. memo 2011-159 (7/6/11). as the sole owner of a ball bearing manufacturing operation the taxpayer reported wages of $36,400, $43,600, and $52,000 in tax years 2000, 2001, and 2002. the taxpayer‘s s corporation reported net income of $657,683, $385,270, and $278,213 in those years. the taxpayer also claimed losses of $2,052,637, $399,740 and $278,297 from sales of stocks in his day trading activities. in the years 2000, 2001, and 2002, the taxpayer executed 313, 172 and 84 trades respectively. the taxpayer rarely purchased and sold stocks on the same day. during the years at issue, the taxpayer conducted trading activity on 29 percent, 7 percent, and 8 percent of the available trading days. the tax court (judge cohen) held that, although the taxpayer‘s trading was substantial, the taxpayer‘s activities were not sufficiently frequent to be treated as a trade or business. the court noted that the taxpayer‘s s corporation was his primary source of income and rejected the taxpayer‘s claim that he spent the majority of his time in his trading activities. thus the taxpayer‘s losses were capital losses, the deductions of which were limited to $3,000 per year. the court also sustained penalties under § 6662. 9. deductible legal fees incurred in defending internet shoe sales. ramig v. commissioner, t.c. memo. 2011-147 (6/27/11). the taxpayer incurred legal expenses successfully defending an investor suit against a failed internet shoe store in which the taxpayer was the ceo and an investor. the tax court (judge morrison) agreed with the taxpayer‘s assertion that because he was sued personally, the legal claims originated out of the taxpayer‘s services for the company as an employee and allowed deductions under § 162. the court disallowed claimed bad debt deductions for advances that the taxpayer made to the company when it was unable to obtain external financing, holding that the advances were equity. 2012] recent developments in federal income taxation 215 10. the girlfriend’s house is not a primary place of business. bogue v. commissioner, tc memo. 2011-164 (7/11/11). the taxpayer shared a home with his fiancée from which he travelled to various construction job worksites. the taxpayer stored tools at the residence, made business related phone calls, and used a computer to search for materials, but did not establish an exclusively used home office. the tax court (judge wells) denied deductions for travel between the residence and the worksites holding that under the judicial exception for travel expenses between a home and worksites requires that the residence constitute a principal place of business at which the taxpayer maintains a home office that meets the requirement of § 280a(c)(1) that the home office be used regularly and exclusively as the taxpayer‘s principal place of business. the court also denied deductions for travel from the taxpayer‘s residence in cherry hill, new jersey to worksites in the philadelphia area as travel to temporary distant worksites. 11. what’s a freeway flyer adjunct professor who teaches online courses? why an employee, of course. schramm v. commissioner, t.c. memo. 2011-212 (8/30/11). the taxpayer was an adjunct professor at nova southern university (nsu) who taught online economics courses under separate contracts entered into for each course. nsu provided the syllabus for each course and specified the material that was to be covered. nsu filed forms w-2 for the taxpayer treating him as an employee. the court (judge ruwe) agreed with the irs that the taxpayer was an employee and denied deductions for business expenses reported by the taxpayer on schedule c as an independent contractor. the court found an employment relationship under multiple factors, noting that even though the taxpayer‘s position as an adjunct professor allows an independent approach in teaching his classes, nsu had authority to exercise control in a manner that rendered the taxpayer an employee, the taxpayer‘s own investment in tools or facilities was insubstantial, the remuneration received by the taxpayer was not subject to fluctuation as independent profit or loss, the taxpayer did not demonstrate that he would be entitled to breach of contract damages if the relationship were terminated, the taxpayer was engaged in nsu‘s regular business, the taxpayer maintained a continuing relationship with nsu over a period of years, and nsu considered the relationship to be an employer-employee relationship. the court indicated that the fact that nsu did not provide employment benefits, indicating an independent contractor status, carried little weight in the overall analysis. 12. farm spouse’s medical reimbursement plan may be deductible if she is a common law employee. shellito v. commissioner, 437 fed. appx. 665 (10th cir. 8/24/11). the taxpayer conducted a farming operation in all of which he claimed a sole proprietary interest. the 216 florida tax review [vol. 12:5 taxpayer‘s wife worked on the farm since 1982 assisting in planting and harvesting, operation of tractors, caring for livestock, repairing fences and equipment, handling books and records, and other tasks. the taxpayer claimed that he made all of the business and operating decisions without input or consent from his wife, whose work he directed. he did not regard his wife as a business partner and listed her occupation on their joint return as housewife. in 2001 the taxpayer adopted a medical reimbursement plan for employees and entered into an employment agreement with his wife that indicated that she was a hired farm hand to do farm work as the taxpayer directed. the tax court, t.c. memo. 2010-41, sustained the irs disallowance of the taxpayer‘s deductions on the couple‘s joint return for expenses of the medical reimbursement plan holding that the taxpayer‘s wife was not an employee because she was not compensated concluding that the wife was an equal owner of all funds paid into her individual account from the couple‘s joint checking account, that payment of her medical expenses was simply an assumption of her husband‘s liability under kansas state law, and that the form of the transaction did not in substance give rise to a true employment relationship. in reversing the tax court, the tenth circuit reviewed numerous tax court memorandum and summary opinions to point out that the irs position on a spouse as employee has been inconsistent. the court also referred to rev. rul. 71-588, 1971-2 c.b. 91, which provides that, ―amounts reimbursed under an accident and health plan covering all bona fide employees, including the owner‘s wife, and their families are not includable in the employee‘s gross income and are deductible by the owner as business expenses.‖ the court rejected the irs argument that the medical reimbursement should be disregarded because they convert a legal obligation to support into a deductible expense as not supported by any case law. the court also rejected the tax court‘s conclusion that the payments were not deductible because they were made from the couple‘s joint checking account noting that such a requirement would only add a another structural layer to the holding of rev. rul. 71-588 providing for spousal employment. the court also noted that there was no proof that the funds in the joint checking account were equally owned by the spouses. the appellate court also rejected the tax court‘s ―substance over form‖ holding by indicating that the tax court was incorrect in concluding that the taxpayer‘s wife worked for no compensation. ultimately, the appellate court remanded the case for findings on the issue of whether the wife was an employee under the common law agency doctrine. 13. it’s how you spend the loan proceeds, not what you pledge to secure the loan that determines deductibility of interest. sherrer v. commissioner, t.c. memo. 2011-198 (8/15/11). under temp. reg. § 1.163-8t(c), the actual use of loan proceeds is generally determinative of the classification of the interest paid on the loan. except in 2012] recent developments in federal income taxation 217 the case of qualified residence interest subject to § 163(h)(3), the absence or presence of a security interest is not relevant. applying this rule, the tax court (judge carluzzo) held that interest paid by the taxpayer on loans secured by business property was not deductible as interest on trade or business indebtedness, because taxpayer failed to show that proceeds of the loans were used for business purposes. the interest on the loans was treated as nondeductible personal interest. 14. home may be a tax home. lyseng v. commissioner, t.c. memo. 2011-226 (9/21/11). the taxpayer was a contract laborer performing maintenance work on nuclear plants and other utilities. the taxpayer worked temporarily at job sites that required travel away from the taxpayer‘s residence in northern minnesota where he lived with his father and fiancé. petitioner‘s jobs lasted less than one year, and most lasted only a few months. petitioner sought work through his union located in his city of residence. the tax court (judge swift) indicated that ―the taxpayer‘s home may be the tax home if, (1) the taxpayer incurs duplicate living expenses while traveling and maintaining the home; (2) the taxpayer has personal and historical connections to the home; and (3) the taxpayer has a business justification for maintaining the home,‖ citing hantzis v. commissioner, 638 f.2d 248, 255 (1st cir. 1981). the court concluded that because the taxpayer‘s jobs were temporary he had no principal place of work, the taxpayer incurred duplicated expenses, and his home historically had been around the city of his residence. thus, the court ruled that the taxpayer was entitled to claim deductions for his travel away from his place of residence. the court allowed some and denied some of the taxpayer‘s claimed deductions based on an evaluation of the substantiation provided by the taxpayer in accord with the strict requirements of § 274(d). 15. researching tax dodges doesn’t qualify for the r&d credit. the heritage organization, llc v. commissioner, t.c. memo. 2011-246 (10/19/11). heritage was an llc owned by four members consisting of holdings, inc. and three limited partnerships. heritage was operated by gary kornman, the sole owner of holdings, which in turn was a five percent member of heritage, and william ralph canada. heritage was engaged in producing and managing life insurance for high net worth individuals and became involved in tax and estate planning for clients. heritage maintained a subsidiary responsible for identifying and researching potential clients and referring them to kornman and canada who worked to complete life insurance transactions. heritage‘s research subsidiary also conducted legal and tax research regarding corporate and trust structures to minimize taxes, including son of boss transactions. kornman controlled eleven dormant corporations, each of which was transferred to a trust created by kornman and canada. heritage lent $1 million to each corporation which https://checkpoint.riag.com/getdoc?docid=icf43462906336ec28f93ae94ab3c4bc4&pinpnt= https://checkpoint.riag.com/getdoc?docid=icf43462906336ec28f93ae94ab3c4bc4&pinpnt= 218 florida tax review [vol. 12:5 was used by the corporation to engage in a short sale of u.s. treasury notes through individual brokerage accounts that were in turn transferred to a trading partnership. in january 2000 each corporation closed its short sales at a loss and transferred funds back to heritage in partial payment of the loans, leaving an outstanding balance of $275,000 in each corporation. in december 2000, the heritage secretary, who also was an officer in each corporation, sent checks to herself from each corporation in the amount of $550,000. the checks were ultimately rejected and payment was effected through a wire transfer in january 2001. while checks sent by a cash method taxpayer are generally deductible in the year the checks are distributed, the court (judge paris) ruled that since the checks were ultimately settled by the subsequent wire transfer in 2001, the expenditures were attributable to heritage‘s 2001 tax year. in addition, the court rejected the taxpayer‘s claim that the $6,050,000 represented by the payments to the eleven corporations was deductible as a § 174 research and experimental expense based on the taxpayer‘s assertion that the expenses were incurred to ―develop‖ a set of shelf corporations with embedded losses. the court indicated that the expenditure was not for research in the experimental or laboratory sense and was not incurred to eliminate uncertainty concerning the development of a product. the court also rejected the taxpayer‘s argument that the expenditure was deductible under § 162 as an ordinary and necessary business expense. the court concluded that the payoff to the eleven corporations was to meet the losses incurred by the corporations on their short sales and that heritage had not shown that it was obligated to repay the corporations for losses from investment activity. the court further indicated that under the tefra rules the disallowed deduction was a partnership item thereby increasing the distributive share of each partner‘s partnership income. finally, the court sustained negligence penalties under § 6662. 16. apparently the tax court is unaware that under no child left behind teachers’ pay is determined with reference to their students’ performance. farias v. commissioner, t.c. memo. 2011-248 (10/24/11). the taxpayer was an elementary school teacher whose classes included health, nutrition, and fitness. the school provided teachers with basic classroom supplies, and purchases of anything beyond basic supplies were left to the teacher‘s discretion. teachers were not reimbursed for any items purchased for the classroom. the taxpayer claimed deductions for the cost of ―candy and sugar‖ provided to students as incentives, although her documentation was not perfect. she also testified that she purchased a u.s. savings bond that was presented to a student in recognition of community service provided to the school. judge cohen upheld the disallowance of all of the claimed expenses. ―there is no evidence that the school required the purchase of the candy or the savings bond for petitioner‘s students. these 2012] recent developments in federal income taxation 219 expenses were not necessary to petitioner‘s job; and no matter how well intentioned, gifts to students are not deductible as business expenses.‖ 17. unsubstantiated expenses are not allowed as deductions, but the business had to have some expenses even after walking away. bell v. commissioner, t.c. memo. 2011-296 (12/22/11). in a return for his 1996 tax year, filed ten years late, the pro se taxpayer claimed expenses from his landscaping business. the irs assessed a deficiency for understated income and disallowed the expenses. the taxpayer asserted that he lost all of his records because, ―it has been all destroyed due to the [criminal] case that i was dealing with in ‗96. i had a choice of walking away or doing jail time, and i chose to walk away.‖ the court (judge wherry), following the rule of cohan v. commissioner, 39 f.2d 540, 543-544 (2d cir. 1930), indicated that ―it is inconceivable that he did not pay some expenses operating the landscaping business. we believe petitioner had to have paid expenses such as for the rental of machinery, for repairs and maintenance of his equipment, and incidental expenses such as gas for lawnmowers and related equipment.‖ the court thus allowed $3,283 of the approximately $36,000 claimed by the taxpayer. the court also rejected the taxpayer‘s assertion the wage income shown on his 1996 return, prepared by beverly a. arrington, was fabricated by her, and imposed penalties under § 6651(a)(1) for failure to file a timely return and § 6662(a) accuracy-related penalties. 18. a partner’s unreimbursed reimbursable expenses incurred on behalf of the partnership are not deductible on his own return. mclauchlan v. commissioner, t.c. memo. 2011-289 (12/19/11). the taxpayer was a partner in a law firm and he paid various expenses, such as advertising, home office, automobile, travel, meals, entertainment, cell phone, professional organizations, continuing legal education, state bar membership, supplies, interest, banking fees and legal support services in connection with his law practice. the partnership reimbursed him for over $60,000 of the expenses in each year in question, but he claimed more than $100,000 of additional expense on schedule c in each year. the tax court (judge kroupa) articulated the principal issue as whether a partner can deduct unreimbursed expenses incurred in furtherance of the partnership‘s business. she then articulated the relevant legal principle as prohibiting a partner from deducting on his own return expenses of the partnership, even if the expenses were incurred by the partner in furtherance of partnership business, unless there is an agreement among partners, or a routine practice equal to an agreement, that requires a partner to use his or her own funds to pay a partnership expense, citing cropland chem. corp. v. commissioner, 75 t.c. 288, 295 (1980), aff’d without published opinion, 665 f.2d 1050 (7th cir. 1981). in the instant case, the partnership agreement required petitioner to pay ―indirect partnership expenses‖ that were 220 florida tax review [vol. 12:5 unreimbursable, but there was no routine practice that required petitioner to pay any other partnership expenses. thus, expenses at issue were deductible only if they were unreimbursable indirect partnership expenses that were actually incurred. turning to the facts, judge kroupa found that all of the claimed expenses were either reimbursable under the partnership agreement or not properly substantiated. accordingly, all of the claimed deductions were disallowed and § 6662 accuracy related penalties were upheld. 19. the empire strikes back against the ―millennium plan.‖ goyak v. commissioner, t.c. memo. 2012-13 (1/11/12). the individual husband and wife taxpayers‘ wholly owned corporation, goyak & associates, contributed $1.4 million to a purported § 419a(f)(6) employee welfare benefit plan, known as the ―millennium plan,‖ of which the taxpayer husband was the sole beneficiary with respect to goyak & associates, and goyak & associates claimed a § 162 deduction. the tax court (judge goeke) held that the amount was a constructive dividend to mr. goyak, rather than a deductible ordinary and necessary business expense. the covered employee, i.e., mr. goyak, in the plan was able to (1) freely void his participation in the plan and have the life insurance policy maintained by the plan distributed to him, or (2) receive life benefits at a time of his choosing by ―timing‖ a severance event. a 20 percent § 6662 accuracy-related penalty was upheld. 20. reimbursement insurance is really a deposit. f.w. services, inc. v. commissioner, 109 a.f.t.r. 2d 2012-676 (5th. cir. 1/25/12). the taxpayer, a temporary personnel agency, purchased insurance policies to cover workers compensation and employer‘s liability. the policies required the taxpayer to reimburse the insurer up to $500,000 for each claim. to provide evidence of financial responsibility to the insurer, the taxpayer entered into a second ―insurance‖ contract to cover the reimbursement obligation. the second contract provided for an estimated premium of $3.9 million. the actual premium would be determined at the end of the policy year and provided for an increase or decrease in the amount owed depending upon experience. the taxpayer claimed a § 162 deduction for the full premium. upholding the tax court, the circuit court agreed with the irs position that the premium paid was a non-deductible deposit on the taxpayer‘s potential reimbursement liability under the first policy. the court added that funds set aside for future reimbursement did not constitute insurance as there was no shift in the risk of loss. e. depreciation & amortization 1. section 179 limits are extended again – is this becoming permanent like research credits? the compromise tax relief 2012] recent developments in federal income taxation 221 act of 2010, § 402, provides for code § 179 first year expensing for tax years beginning in 2012 in an amount not to exceed $125,000 with a phaseout amount beginning at $500,000. for tax years beginning after 2012 the maximum deduction drops to $25,000 with the phase-out beginning at $200,000 (at least until the business community makes sufficient campaign contributions to extend the higher numbers into later years). a. the sunny side of inflation. rev. proc. 2011-52, 2011-45 i.r.b. 701, § 3.20 (11/7/11). as adjusted for inflation as provided in § 179(b)(6), the 2012 ceiling for expensing machinery and equipment and certain other § 1231 property) is $139,000, and the phase-out threshold is $560,000. b. section 179 is applied to computer software for another year. the compromise tax relief act of 2010, § 402, extends eligibility as qualified code § 179 property to off-the-shelf computer software placed in service before 2013. 2. that light-weight crossover suv might get caught by § 280f, but that ridiculously expensive heavyweight suv is fully deductible under § 168(k). rev. proc. 2011-21, 2011-12 i.r.b. 560 (3/18/11), amplifying and modifying rev. proc. 2010-18, 1010-9 i.r.b. 427. for automobiles placed in service in 2011 that qualify as § 168(k) property, the § 280f ceilings on depreciation deductions are $11,060 for the first year, $4,900 for the second year, $2,950 for the third year, and $1,775 for each succeeding year. for light trucks or vans placed in service in 2011 that qualify as § 168(k) property, the limits are $11,260 for the first year, $5,200 for the second year, $3,150 for the third year, and $1,875 for each succeeding year. for automobiles placed in service in 2011 that do not qualify as § 168(k) property, the limits are $3,060 for the first year, $4,900 for the second year, $2,950 for the third year, and $1,775 for each succeeding year. for light trucks or vans placed in service in 2011 that do not qualify as § 168(k) property, the limits are $3,260 for the first year, $5,200 for the second year, $3,150 for the third year, and $1,875 for each succeeding year. a. the irs identifies property eligible for 100 percent depreciation, including the unintended consequences for business autos. rev. proc. 2011-26, 2011-16 i.r.b. 664 (3/29/11). 2010 tax acts extended the placed in service date for property to be eligible for the § 168(k)(1) 50 percent first year depreciation allowance to property placed in service before 2013 (2014 in the case of certain property described in § 168(k)(2)(b) and (c)) and adopted § 168(k)(5) to allow a 100 percent depreciation deduction for qualified property acquired after 9/8/10 and 222 florida tax review [vol. 12:5 before 1/1/12, and placed in service before 1/1/12. the revenue procedure sets out several rules for the application of these provisions.  reg. § 1.168(k)-1(b)(4)(iii)(c)(1) and (2) provide that if the larger part of self-constructed property commences before the applicable dates for the 50 percent depreciation deduction, components selfconstructed after the effective date are also ineligible for the accelerated deduction. if the construction of the larger part of self-constructed property begins before 9/9/10, but the qualified property otherwise qualifies for the 50 percent depreciation deduction, self-constructed components after 9/9/10, that are qualified property may be subject to an election to claim 100 percent depreciation deductions with respect to the component.  section 168(k)(2)(d)(iii) provides an election not to claim first year depreciation with respect to a ―class of property‖ placed in service during the taxable year. reg. § 1.168(k)-1(e)(2)(i) applies the election to each class of property described in § 168(e). the revenue procedure allows an election to claim 50 percent first year depreciation rather than 100 percent depreciation for a class of property.  the passenger automobile anomaly. the additional first year depreciation allowance is limited to $8,000 for passenger automobiles and light trucks subject to the § 280f limitations ($3,060, $4,900, $2,950 in years one through three respectively, and $1,775 in years four through six). thus the first year depreciation allowance in year one is $11,060 ($3,060 plus $8,000). this allowance is treated as the 100 percent depreciation deduction. under § 280f(a)(1)(b)(i), unrecovered passenger automobile basis is treated as a deductible expense (up to $1,775) in each year after the sixth year. unless the taxpayer elects to forego 100 percent depreciation recovery with respect to a passenger automobile, the taxpayer would be treated as claiming 100 percent depreciation in year one, with no further deductions allowable in years two through six. the revenue procedure provides a safe harbor method of accounting that the taxpayer is deemed to apply by deducting depreciation of the passenger automobile for the first taxable year succeeding the placed in service year. in effect, the revenue procedure continues to treat passenger automobile and light truck depreciation as if the first year deduction were 50 percent depreciation. 3. antenna support structures and leased digital equipment have longer lives than the taxpayer would like. broz v. commissioner, 137 t.c. 25 (7/7/11). the tax court (judge kroupa) held that cellular antennas, equipment shelters, and related land improvements were depreciable over 15 years in asset class 48.14 (telephone distribution plant), rather than over seven years in asset class 48.32 (high frequency radio and microwave systems). the court also agreed with the irs that cell phone site equipment including base station radio and switching equipment is classified as ten year property under asset class 48.12 (telephone central 2012] recent developments in federal income taxation 223 office equipment) rather than as five year property under asset class 48.121 (computer-based telephone central office switching equipment). the court concluded that the primary difference between asset classes 48.12 and 48.121 is that the latter category includes equipment that functions as a computer. the digital cellular equipment within the base station functioned as a radio rather than as a computer. 4. ouch! fifteen year recovery period for a oneyear lived asset. covenant not to compete from a minority s corporation shareholder is a § 197 intangible. recovery group, inc. v. commissioner, t.c. memo. 2010-76 (4/15/10). the taxpayer s corporation paid a retiring 23 percent shareholder/employee $400,000 for a one-year covenant not to compete. the taxpayer asserted that the acquisition of a 23 percent interest was not ―entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof‖ as provided in § 197(d)(1)(e), and claimed a full year‘s deduction for the amount paid. the court (judge gustafson) upon a careful analysis of the statutory phrase concluded that the covenant was part of an acquisition of an interest in a trade or business, that the interest was ―substantial,‖ and that in any event the term ―thereof‖ in the statutory language does not modify ―an interest,‖ which, therefore, need not be substantial. a. and the first circuit says ―eat your peas‖ to the taxpayer. recovery group, inc. v. commissioner, 652 f.3d 122 (1st cir. 7/26/11). in an opinion by judge torruella, the court of appeals for the first circuit affirmed the tax court decision holding that a covenant not to compete entered into in connection with the redemption of a portion of the stock of a corporation that is engaged in a trade or business is considered a § 197 intangible as defined in § 197(d)(1)(e), regardless of whether the portion of stock acquired constitutes at least a ―substantial portion‖ of such corporation‘s total stock. the court expressly rejected the taxpayer‘s argument that ―the term section ‗197 intangible‘ means ... any covenant not to compete ... entered into in connection with an acquisition ... of [(1)] [the entire] interest in a trade or business or [(2)] [a] substantial portion [of an interest in a trade or business],‖ based on the legislative history of the statutory provision. the court reasoned that the purpose of § 197 was to reduce controversies regarding the allocation of purchase price between goodwill and covenant not to compete, and that since goodwill reasonably could be conveyed only if a substantial portion of the assets of a business were transferred, in the context of asset acquisitions, ―congress made [§ 197(d)(1)(e)] applicable only where the covenant not to compete was entered into in connection with the acquisition of at least a substantial portion of assets constituting a trade or business.‖ the court then explained 224 florida tax review [vol. 12:5 how entering into a covenant not to compete in connection with a stock sale and purchase differed in the context of stock acquisitions, however, the uncertainty — and consequently the possibility for much litigation between taxpayers and the irs — caused by the inherent difficulty in valuing goodwill and going concern is generally present even where the purchased stock does not constitute a substantial portion of the corporation‘s total stock. this is due to the fact that goodwill and going concern generally constitute an essential component of the value of each share of corporate stock, as each share of stock reflects a proportionate allotment of the value of the corporation‘s goodwill and going concern. ... if [§ 197(d)(1)(e)] had not applied to a covenant not to compete entered into in connection with the acquisition of a corporation‘s stock, a buyer of such stock would have had a very significant incentive to allocate to the cost of the covenant what was in fact stock purchase price, because the ostensible cost of the covenant would presumably be amortized and deducted over its usually short useful life, while amounts allocated to the stock‘s purchase price would not be deductible and would simply form part of the buyer‘s basis in the stock, presumably to be recovered only after the buyer subsequently disposed of such stock and a capital gain/loss was computed on such disposition.  according to the court, this analysis explains why ―congress chose different tax treatments for (1) covenants executed in connection with the acquisition of at least a substantial portion of assets constituting a trade or business, as opposed to (2) covenants executed in connection with the acquisition of less than a substantial portion of assets constituting a trade or business.‖ 5. no chickening out of the allocation agreement in an applicable asset acquisition – even after a cost segregation study. peco foods, inc. v. commissioner, t.c. memo. 2012-18 (1/17/12). the taxpayer entered into an agreement with the sellers of two poultry processing plants that allocated a large portion of the purchase price to processing plants on which the taxpayer claimed depreciation deductions as nonresidential real property with a macrs life of 39 years. subsequently, after a cost segregation study, the taxpayer attempted to change its method of accounting to separate out components of the plants as equipment and machinery and claim accelerated depreciation on the basis of shorter macrs recovery periods. the tax court (judge laro) held that under commissioner v. danielson, 378 f.2d 771, 775 (3d cir. 1967) and § 1060 unless the taxpayer 2012] recent developments in federal income taxation 225 could show fraud, undue influence, duress, etc. the taxpayer was bound by the purchase price allocation agreement. the court rejected the taxpayer‘s argument that nothing in § 1060 precluded the taxpayer from segregating components of assets broadly described as a production plant into components consisting of the real property and related equipment and machinery. the court also refused to accept the taxpayer‘s assertion that the agreements with the sellers should be disregarded because the use of the terms ―processing plant building‖ and ―real property improvements‖ were ambiguous. finally the court agreed with the irs that the irs did not abuse its discretion in prohibiting the taxpayer from adopting depreciation schedules that were inconsistent with the terms of the purchase agreements. 6. new accounting and disposition rules for macrs property. t.d. 9564, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81060 (12/27/11), and reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 76 f.r. 81128 (12/27/11). the capitalization and repair regulations (discussed above) provide significant new rules for the maintenance of multiple asset accounts and disposition of property from macrs single and multiple asset accounts.  accounting for macrs property. consistent with prior rules under reg. § 1.167-7, temp. reg. § 1.168(i)-7t allows taxpayers to account for macrs property in a single asset account or by combining multiple assets in a multiple asset account. assets in a multiple asset account must have been placed in service in the same taxable year, have the same recovery period and convention. assets that are subject to different recovery rules or special limitations, such as automobiles, assets subject to additional first year recovery, or property used partly for personal purposes, may not be combined with assets subject to different recovery provisions. assets with the same recovery periods and conventions may be combined in a multiple asset account even if the assets have different uses. in addition, the taxpayer is permitted to use as many single and multiple asset accounts as the taxpayer may choose.  dispositions. temp. reg. § 1.168(i)8t(d) defines a disposition of macrs property as occurring when the asset is transferred or permanently withdrawn from use in the taxpayer‘s trade or business or from the production of income. thus, a disposition includes the sale, exchange, retirement, abandonment, or destruction of an asset. significantly, the definition of disposition is expanded in the temporary regulation to include the retirement of a structural component of a building.  gain or loss. gain or loss on the sale, exchange or conversion of an asset is determined under applicable tax principles. loss on abandonment is determined from the ―adjusted depreciable basis‖ of the asset (basis adjusted for depreciation). temp. reg. § 1.168(i)226 florida tax review [vol. 12:5 8t(d). recognized loss on other dispositions is the excess of the adjusted depreciable basis of the asset over fair market value. identification of the asset disposed of from a multiple asset account, and its basis, is generally determined from the taxpayer‘s records. temp. reg. § 1.168(i)-8t(e) & (f). the temporary regulations provide rules for identifying assets if the taxpayer‘s records do not do so; a first-in first-out method, a modified fifo method, a mortality dispersion table method, or any other method designated by the irs. the asset cannot be larger than a unit of property. in case of a disposition of a structural component of a building, the structural component is the asset disposed of. an improvement placed in service after the asset is treated as a separate asset provided that it is not larger than the unit of property. temp. reg. § 1.168(i)8t(c)(4)(ii)(e). disposition of an asset in a single asset account terminates depreciation for the asset as of the time of the disposition. disposition of an asset in a multiple asset account removes the asset from the account as of the beginning of the year of disposition, requires separate depreciation for the asset in the year of disposition, and reduction of the depreciation reserve of the multiple asset account by the unadjusted basis of the disposed asset as of the first day of the taxable year of the disposition. temp. reg. § 1.168(i)-8t(g).  general asset accounts. consistent with prior reg. § 1.168(i)-1, the temporary regulations provide for an election to group assets into one or more general asset accounts. temp. reg. § 1.168(i)1t(c)(2) provides for grouping assets in a general asset account as long as the assets have been placed in service in the same taxable year and have the same recovery period and convention. assets that are subject to different recovery rules or special limitations, such as automobiles, assets subject to first year recovery, or property used partly for personal purposes, may not be combined with assets subject to different recovery provisions. the temporary regulations do not include the requirement of prior regulations that general asset accounts include only assets in the same asset class. assets eligible for additional first year depreciation deductions must be grouped with assets eligible for the same first year depreciation deductions and may not be grouped with assets not eligible for additional first year depreciation. temp. reg. § 1.168(i)1t(c)(2)(ii)(d) & (e). the temporary regulations expand existing rules for dispositions of assets from a general asset account to encompass as a disposition the retirement of a structural component of a building. as under existing rules, the temporary regulations treat the basis of any asset disposed of from a general asset account as zero, and any amount realized results in ordinary gain. the taxpayer continues to deprecate assets in the general asset account as if no disposition occurred. temp. reg. § 1.168(i)-1t(e)(2). however, consistent with existing regulations, the temporary regulations allow a taxpayer to elect to terminate general asset account treatment on disposition of an asset in a qualifying disposition, in which case gain or loss is recognized under the rules of temp. reg. § 1.168(i)-8t. the list of qualifying disposition is expanded generally to include any disposition. temp. reg. § 1.168(i)-1t(e)(3). 2012] recent developments in federal income taxation 227 in addition, general asset accounts are terminated in certain nonrecognition dispositions and on termination of a partnership under § 708(b)(1)(b). gain or loss may also be recognized on disposition of all of the assets, or the last asset, in a general asset account. temp. reg. § 1.168(i)-1t(e)(3)(ii). f. credits 1. simplified research credit elections regulations are final. t.d. 9528, alternative simplified credit under section 41(c)(5), 76 f.r. 33994 (6/10/11). section 41(c)(5) provides a ―simplified‖ research credit of 14 percent of so much of qualified research expenditure as exceeds 50 percent of the average qualified research expenditures for the three preceding taxable year, or, if the taxpayer has no qualified research expenditures in prior years, the simplified credit is 6 percent of qualified research expenditures for the year. (the regular credit under § 41(a)(1) is 20 percent of qualified expenditures over a base.) temporary regulations are finalized as reg. § 1.41-9 to require an election for the alternative simplified credit to be made with the return filed for the year to which the election applies. the election may not be made on an amended return, nor will the irs grant an extension of time to file the election. while the election may not be revoked absent the consent of the irs, consent is deemed to have been requested and granted if the taxpayer files a form 6765 calculating the credit under regular methods and attaches the revocation to a timely filed (including extensions) original return for the year to which the revocation applies. the final regulations allow taxpayers to prorate short tax years by the number of days in the year. a. can the incomprehensively complicated be ―simplified‖? t.d. 9539, election of reduced research credit under section 280c(c)(3), 76 f.r. 44800 (8/27/11). these regulations, reg. § 1.280c-4, ―simplify‖ how taxpayers make the election to claim the ―reduced research credit‖ under § 280c(c)(3). 2. new markets credit is revised to help markets other than real estate. reg-101826-11, new markets tax credit non-real estate investments, 76 f.r. 32882 (6/7/11). section 45d allows a new markets tax credit for an equity investment at original issue in a community development entity (cde), an entity that invests in qualified low income community projects. in order to encourage investments in projects other than real estate development proposed regulations would reduce the requirement that returns on investments by a cde be re-invested in community development projects during a seven year credit period. the proposed regulation would allow a cde to reinvest capital from non-real estate businesses in unrelated certified community development financial 228 florida tax review [vol. 12:5 institutions that are cdes under § 45d(c)(2)(b) at various points during the seven-year credit period. the proposed regulations would allow an increasingly aggregate amount to be invested in certified community development financial institutions in the latter part of the seven year period. a. final regulations define an entity serving targeted populations for the new markets tax credit. t.d. 9560, targeted populations under section 45d(e), 76 fed. reg. 75774 (12/5/11). section 45d provides a 5 percent credit each year for three years, then 6 percent for subsequent three years for equity investment in a qualified community development entity. a qualified entity is a domestic corporation or partnership with a primary mission to serve or provide investment capital for low-income communities or persons that maintains accountability to the community with representation on its governing board and which certified by treasury as being a qualified community development entity. qualified investment includes investment in a qualified active low-income community business, a business for which at least 50 percent of total gross income is derived from the active conduct of a qualified low income community business (including rental real estate) and a substantial portion of its property and services are within a low-income community. sections 1400m and 1400n include the maximum amount of investment qualified for the credit is an amount allocated to the community development entity from a pool that is limited to $3.5 billion for 2011, with nothing specified thereafter. § 45(f)(2). following the proposed regulations and guidance contained in notice 2006-60, 2006-2 c.b. 82, the final regulations, § 1.45d-1, provide that an entity will not qualify as an active low-income community business unless at least 50 percent of the entity‘s total gross income for any taxable year is derived from sales, rentals, services, or other transactions with individuals who are low income persons, at least 40 percent of the entity‘s employees are low-income persons, or at least 50 percent of the entity is owned by individuals who are low income persons. the regulations provide that an entity may determine the status of an individual as low income using any reasonable method including u.s. census bureau measures, hud rules or income from form 1040. also, income derived from transactions with low income persons includes both payments made directly by low-income persons plus money and the fair market value of contributions of property or services provided to the entity primarily for the benefit of low income persons (provided that the contributor not receive a direct benefit). an entity whose sole business is rental real property will be treated as satisfying the 50 percent gross income requirement if the entity is treated as being located in a low-income community. 2012] recent developments in federal income taxation 229 g. natural resources deductions & credits 1. actually passing gas is required for the alternative fuels credit. collins v. commissioner, t.c. memo. 2011-37 (2/9/11). on the recommendation of his return preparer, mr. tax of america, the taxpayer invested in gas recovery partners to claim a credit under § 29 (now § 45k) for alternative fuel produced from landfills in puerto rico and ohio. the court (judge paris) denied the credit because neither petitioners nor the person they dealt with or the partnership they paid had an interest in a fuel-producing source and no fuel was produced. accordingly, the court found it unnecessary to explore the complexities of the credit provision. the court also denied the taxpayer‘s claimed expense deductions under §§ 162 and 212 finding that the taxpayer had not engaged in the activity primarily for profit. the court denied a § 165 theft loss deduction for payments made to the partnership finding that there was no evidence that the taxpayer discovered the losses during the years at issue. h. loss transactions, bad debts, and nols 1. he lost at the track, but showed in the tax court. mayo v. commissioner, 136 t.c. 81 (1/25/11), acq. aod 2011-006 (12/21/11), 2012-3 i.r.b. (unnumbered) (1/17/12). in a reviewed opinion, the tax court (judge gale) applied § 165(d) to limit the allowable gambling losses of a taxpayer who the irs conceded was in the ―trade or business of gambling on horse races.‖ the court rejected the taxpayer‘s argument that under the reasoning of the supreme court in commissioner v. groetzinger, 480 u.s. 23 (1987), which held that § 162 expenses of a professional gambler were deductible in computing agi (rather than as itemized deductions), the § 165(d) limitation on the deduction of wagering losses to wagering income should not apply to a professional gambler. in this respect, the court reaffirmed its holding in offutt v. commissioner, 16 t.c. 1214 (1951), which reached the same result under the 1939 code predecessor to § 165(d). the taxpayer‘s $11,297 net wagering loss was disallowed. however, with respect to the taxpayer‘s trade or business expenses, the court overruled its opinion in offutt, which had treated such expenses as additional disallowed losses, and held that the taxpayer‘s trade or business incurred in connection with his gambling activities (which did not include the amounts actually wagered). accordingly, the taxpayer was allowed to deduct under § 162(a) the $10,968 of business expenses incurred in carrying on his gambling business. 2. character of income versus character of deductions for venture capital fund managers: capital gain income and ordinary deductions, or ―heads the taxpayer wins, tails the government 230 florida tax review [vol. 12:5 loses.‖ dagres v. commissioner, 136 t.c. 263 (3/28/11). the tax court (judge gustafson) held that a $5 million loan from a venture capital fund manager to a business associate who provided leads on companies in which the venture capital funds (organized as limited partnerships) might invest was proximately related to the taxpayer‘s trade or business of managing venture capital funds (which was conducted as the managing member of llcs that were the general partners of the funds, with actual management conducted through an s corporation owned by the partners (llc members) of the general partner). although the venture capital funds‘ sole activity was investing, the taxpayer‘s activities in managing the funds on behalf of the investors (even though he had a hefty carry — raking-in over $40 million for the year in issue), rose to the level of a trade or business. judge gustafson reasoned that ―[t]he general partner l.l.c.s were thus different from an investor (whose nonbusiness activity involves buying and selling securities for his own account) and were more like a broker (whose business is to buy and sell securities as inventory for commissions).‖ he rejected the irs‘s argument that the fact that the general partner managing llcs were one percent partners rendered their activity investment rather than a trade or business. significantly, the court observed as follows: it may be anomalous that, with the irs‘s concurrence, a venture capitalist may treat its receipt of ―carry‖ as a nontaxable event, see rev. proc. 93-27, sec. 4.01, 1993-2 c.b. 343, 344, and may then report its eventual income as capital gain, see rev. proc. 2001-43, sec. 4.01, 2001-2 c.b. 191, 192; 23 but that treatment is not challenged here. accordingly, even though this profit interest is compensation for personal services, it is deemed to remain passthrough income with the same character in the hands of the recipient (the general partner l.l.c.) as in the hands of the partnership (the venture fund l.p.) — i.e., primarily capital gains from investment. see secs. 701, 702; 26 c.f.r. secs. 1.701-1, 1.702-1, income tax regs. we do not agree with the irs that the character of this income proves that the general partner l.l.c.s were investors and were not in a trade or business... .  because the managing llcs were in the trade or business of managing investments, that trade or business was imputed to the taxpayer in his capacity as a member manager of the llcs. see rev. rul. 98-15, 1998-1 c.b. 718. because the taxpayer‘s income from his management activities was more than twenty times his return from the capital investment, he satisfied the test set forth in united states v. generes, 405 u.s. 93 (1972). thus, the taxpayer was allowed a business bad debt deduction under § 166(a) for the amount of the loan ($3,635,218) that was unpaid and uncollectible. 2012] recent developments in federal income taxation 231  the court failed to consider the potential application of § 1271, which would have resulted in the taxpayer‘s loss being a capital loss. section 1271(a), which has applied to debts issued by individuals since 1997, in relevant part provides as follows: ―amounts received by the holder on retirement of any debt instrument shall be considered as amounts received in exchange therefor.‖ because the debt was retired at less than its principal amount, rather than being wholly worthless, as long as the debt owed to dagres was a capital asset, which it should have been, § 1271 would mandate capital loss treatment. mcclain v. commissioner, 311 u.s. 527 (1941), held where a creditor received less than all of the principal of a debt obligation upon the retirement of the debt by the obligor, the predecessor of § 1271 applied to provide capital loss treatment, rather than a bad debt deduction being allowed under the predecessor of § 166, even though if the creditor had received nothing, he would have had a bad debt deduction. interestingly, however, mcclain has not been cited in any cases or revenue rulings in over thirty years. (the mcclain principle has not been applied to taxpayers engaged in the trade or business of making loans by virtue of § 1221(a)(4), see burbank liquidating corp. v. commissioner, 39 t.c. 999 (1963), acq. sub. nom. united associates inc., 1965-1 c.b. 5, modified on other grounds, 335 f.2d 125 (9th cir. 1964), but that is another story.)  in addition, the dagres opinion does not discuss rev. rul. 2008-39, 2008-2 c.b. 252, which in determining whether investment advisory expenses incurred with respect to an investor upper tier partnership that invested in lower tier partnerships that were traders were deductible under § 212 or under § 162, applied an ―on behalf of standard,‖ to determine that the upper tier management fees were § 212 expenses, because they were not incurred ―on behalf of‖ the lower tier partnership, for which management fees were § 162 expenses. 3. a bad investment in an abusive shelter is a theft loss, but the taxpayer has to prove no possibility of recovery. vincentini v. commissioner, t.c. memo 2008-271 (12/8/08), aff’d, 429 fed. appx. 560 (6th cir. 7/12/11). the taxpayer in 1999 invested in an international tax fraud scheme on the basis of listening to audio tapes produced by keith anderson, founder of anderson ark and attending an anderson ark conference in costa rica. in a petition challenging the irs assessment of a deficiency for 1999 denying losses claimed from the taxpayer‘s anderson ark investment, the taxpayer claimed a theft and casualty loss from the investments in 2001 or 2002 that could be carried back to taxpayer‘s 1999 taxable year. in 2002 the anderson ark promoters were convicted of money laundering and/or conspiracy to commit money laundering by the district court for the eastern district of california (united states v. anderson, 391 f.3d 970, 974 (9th cir. 2004)). in 2004 the same defendants were convicted in the washington district court on charges of conspiracy to commit wire and mail fraud and to 232 florida tax review [vol. 12:5 defraud the united states. the judgment of the washington district court ordered the anderson ark defendants to provide restitution to anderson ark investors, including the taxpayer. the tax court (judge marvel) held that since the government in the anderson ark criminal cases took the position that the taxpayer was a victim of fraud and was entitled to restitution, judicial estoppel prevented the government from asserting in the tax court that the taxpayer did not suffer a theft loss. however, the court also held that the taxpayer failed to establish that it was reasonably certain at the end of 2001 that the taxpayer would not recover his loss from anderson ark. thus, the casualty loss deduction was denied. in addition, the taxpayer was assessed penalties under § 6662 with respect to losses claimed from the anderson ark investment. the court rejected the taxpayer‘s assertion of reasonable reliance on the advice of a tax professional noting that, reliance on the advice of an accountant who was referred to the taxpayer by the promoter was not reasonable reliance. a. affirmed on appeal. vincentini v. commissioner, 429 fed. appx. 560 (6th cir. 7/12/11). the court of appeals found that in examining the evidence the tax court could properly conclude that vincentini did not meet his burden of proving that at the end of 2002 there was no possibility of recovery. the court was not persuaded by vincentini‘s assertion that the tax court overlooked the facts that in 2002 the anderson ark defendants were convicted in california and facing lengthy imprisonment, and that they were represented by appointed council, as providing proof that there was no reasonable possibility of recovery. the court also affirmed the § 6662 penalties noting that vincentini put his faith in a ―biased professional, affiliated with the organization promoting the investments‖ and that he ―either errantly omitted important investigatory steps or chose to ignore the telltale signs of an investment that was too good to be true.‖ 4. a nol not used is a nol absorbed. hall v. united states, 99 fed. cl. 617 (8/9/11). section 172(b) provides that net operating losses shall be carried back to each of the two taxable years preceding the taxable year of the loss, then forward to each of the next twenty taxable years following the year of the loss. for taxable years beginning before 8/6/97, the carryover was back three years and forward fifteen years. section 172(b)(2) mandates that the entire amount of the loss be carried back to the appropriate years. section 172(b)(3) allows an election to waive the carryback in a timely filed return for the year in which a loss was incurred. in a refund action based on amended returns, the taxpayer attempted to offset 2003 income with losses going back to 1988. in granting summary judgment to the government, the court stressed that the carryback provision is mandatory unless waived in a timely filed return. thus, portions 2012] recent developments in federal income taxation 233 of the taxpayer‘s nols were consumed in prior carryback years when the taxpayer had operating income. the court also rejected the taxpayer‘s argument that the mandatory provisions of § 172 were discriminatory against a group of smaller and less wealthy entities and individuals. 5. irs expands its rescue of bernie madoff’s ponzi scheme victims to include death. rev. proc. 2011-58, 2011-50 i.r.b. 849 (11/28/11). in rev. proc. 2009-20, 2009-1 c.b. 749, the irs provided a safe harbor under which qualified investors are allowed to treat a lost investment in a ponzi scheme as a theft loss deduction. among the condition in the safe harbor is a requirement that the perpetrator of the scheme be charged with criminal theft. inconveniently, the irs notes that the lead figure in some of these cases has avoided indictment by dying. thus, the requirement of rev. proc. 2009-20 is amended to provide for indictment, information, or state complaint charging theft that has not been withdrawn for reasons other than the death of the lead figure. i. at-risk and passive activity losses 1. after winning cases on the failure of attempted aggregation elections, the irs makes relief available to real estate professionals who fail to make timely aggregation elections. rev. proc. 2011-34, 2011-24 i.r.b. 875 (5/27/11). real estate professionals may make elections under reg. § 1.469-9(g) to treat all interests in rental real estate as a single rental real estate activity for making the determination as to whether those professionals materially participate in that activity; if there is material participation, losses from that activity are not treated as passive activity losses. this election is normally made by filing a statement with the taxpayer‘s original income tax return for the taxable year. under this revenue procedure, relief for late elections is available provided that (i) the taxpayer failed to file the election with an original tax return in the year the election was to take effect as required by reg. § 1.469-9(g), (ii) the taxpayer has filed all returns for years subsequent to the year for which an election is made consistent with having made a timely election to aggregate properties, (iii) the taxpayer had timely filed each return affected by the election if it had been made (or filed within six months of the due date excluding extensions), and (iv) the taxpayer had reasonable cause for its failure to file under reg. § 1.469-9(g). application for relief is to be made in a statement as required by reg. § 1.469-9(g)(3) attached to an amended return for the most recent tax year. the statement requires a declaration under penalty of perjury by a person with personal knowledge that ―the election contains all the relevant facts relating to the election, and such facts are true, correct, and complete.‖ the application for relief is not treated as a request for a private letter ruling, and thus does not require a user fee. 234 florida tax review [vol. 12:5 2. ill bank president is not a real estate professional. harnett v. commissioner, t.c. memo. 2011-191 (8/11/11). the taxpayer founded a savings and loan association to provide financing to customers of his real estate development company. in 2003 the taxpayer suffered a heart attack and other health problems. he resigned as ceo of the bank in 2005, but continued to work as a consultant to the bank and served as chairman of the board. after 2003 the taxpayer had stopped renting his real estate properties and had begun trying to sell them. the real estate was managed partly by the taxpayer‘s son, his wife, and his former bank secretary. the court (judge thornton) found that the taxpayer‘s unsubstantiated testimony did not meet the burden of proof required to establish that the taxpayer had performed more than 750 hours of service during the tax years at issue and thus failed to qualify as a real estate professional for purposes of § 469(c)(7). the taxpayer‘s real estate losses were, therefore, passive activity losses not deductible against active income sources. the court found that the taxpayer‘s statement that he spent most of his time on real estate activities and only ten hours a month at the bank strained credibility since ―for most of this period he was both chairman of the board and ceo of the bank, with wide-ranging responsibilities and six-figure compensation‖ and added that the court saw no reason to think that managing the taxpayer‘s dormant real estate holdings required him to spend anywhere near 750 hours each year. 3. this taxpayer piloted ships over the bar of the passive activity loss limitations. miller v. commissioner, t.c. memo. 2011-219 (9/18/11). taxpayer was a san francisco bay bar pilot, which means that he piloted commercial ships in and out of san francisco bay over the shallow bar that blocks entrance to the bay as a partner in the san francisco bay bar pilots association. in addition taxpayer served as the contractor on the construction of rental real estate which he and his wife also managed. the taxpayer convinced the court (judge kroupa) that he spent more time in real estate activities [―in which he materially participate[d]‖] than he did in piloting ships, and that he met the 750 hour requirement [by ―performing services … in real property trades or businesses in which [he] materially participate[d]‖] under § 469(c)(7) to qualify as a real estate professional entitled to claim real estate losses without limitation to passive activity income under § 469. however, the taxpayer failed to elect under § 469(c)(7)(a) to treat all of his real estate activities as a single activity. the court found that the taxpayer was a material participant in only two of his six real estate properties having participated more than 100 hours in each activity, which was more than any other participant. the taxpayer failed to establish that he met the 100 hour requirement or that his participation was more than other participants in four properties. the court rejected the irs imposition of § 6662 accuracy related penalties. 2012] recent developments in federal income taxation 235 4. borrowed funds contributed to s corporation cellular company were neither at-risk nor did they create basis for loss deductions. broz v. commissioner, 137 t.c. 46 (9/1/11). in a structure typical for the industry, the taxpayer was the shareholder of two s corporations, rfb and alpine, that held fcc licenses to operate cellular networks in rural areas. rfb held licenses directly and was the original business. alpine was formed to expand the business and held the licenses through a number of single-owner llcs. alpine and the llcs were formed at the insistence of creditors to isolate the liabilities of the thinly capitalized expansion. rfb owned and operated all of the equipment. alpine and its llcs owned only licenses, and rfb allocated some its income to alpine for use of the licenses. rfb obtained financing to construct cellular equipment and for working capital, and re-lent some of the loan proceeds to alpine. alpine and the taxpayer documented the loans from rfb to alpine as shareholder loans. the taxpayer pledged rfb stock for the loans, but did not guarantee the loans, which were also secured by corporate assets.  first, for purposes of determining the taxpayer‘s basis in alpine, for purposes of applying the § 1366(d) limitation on passed-through losses, the court (judge kroupa) held that (1) the taxpayer had not established that he had borrowed money from the bank that he personally re-lent to alpine because rfb did not advance the funds to alpine on the taxpayer‘s behalf, i.e., the loan ran directly from rfb to alpine; and (2) the taxpayer had not made any ―economic outlay.‖ thus, the loans were not included in the shareholder‘s basis to support loss deductions.  second, for purposes of determining the taxpayer‘s at-risk amount with respect to alpine, in what was described as an issue of first impression, the court held that the rfb stock pledged for the loans represented pledged property used in the business not eligible to be treated as an amount at-risk by virtue of § 465(b)(2)(a). since alpine was formed to expand rfb‘s cellular networks, the pledged rfb stock was related to alpine‘s business. thus, because the shareholder did not guarantee the loans to alpine, the shareholder was not economically or actually at-risk with respect to his involvement with alpine.  third, the court held that alpine could not deduct interest, expenses, and depreciation during the years at issue because it was not yet engaged in an active trade or business utilizing the licenses it held. the court rejected the taxpayer‘s argument that operation of cellular networks by rfb could be attributed to alpine. acquisition of licenses and related equipment was not sufficient to establish alpine as engaged in the active conduct of a trade or business. alpine failed to attach the required statement to the return for the taxable year to claim § 195 amortization of startup expenses [which it could not have deducted even if it had attached the form because it had not yet commenced business operations]. 236 florida tax review [vol. 12:5  fourth, in another issue that the court described as one of first impression, the court concluded that deductions under § 197 for amortization of the costs of fcc licenses were not available in years in which the taxpayers was not yet engaged in a trade or business. the court concluded that the language of § 197 that provides the deduction ―in connection with the conduct of a trade or business‖ requires that the intangibles ―must be used in connection with a business that is being conducted.‖ 5. a song and a dance doesn’t make the law practice a professional real estate business, but renting your building to the law practice is active. langille v. commissioner, t.c. memo. 2010-49 (3/18/10). the taxpayer deanna langille, formerly known as deanna birdsong, worked long hours in her law practice and devoted somewhat less of her time to her rental real estate activities. unfortunately for the taxpayer she resigned from her law practice in lieu of disciplinary proceedings implemented for misappropriation of funds from her firm‘s client trust accounts. to make matters worse, after an unsuccessful negotiation for the sale of her law practice, the potential buyer reported to the irs that the taxpayer maintained two sets of books for the practice, which resulted in a criminal investigation and a guilty plea to one count of a tax fraud indictment. in the civil tax matter the tax court (judge gustafson) found that the taxpayer willfully failed to report income from her law practice and residential real estate rental activities (from which she had no profit). the taxpayer was unable to establish the number of hours she worked on her residential real estate activities and thus was unable to establish herself as a real estate professional under the 50 percent of all personal services requirement of § 469(c)(7)(b)(i) or that she satisfied the 750 hour requirement of § 469(c)(7)(b)(ii). in addition, the court held that income from the taxpayer‘s rental of office space to her law practice in which she was a material participant was not passive activity income under reg. § 1.469-2(f)(6). a. the eleventh circuit sings the same tune but without making a recording. langille v. commissioner, 447 fed. appx. 130 (11th cir. 11/22/11). in an unpublished per curiam opinion, the court affirmed the tax court in spite of the court‘s statement that it construes briefs of pro se litigants liberally. 6. limited liability doesn’t necessarily mean limited partner. reg-109369-10, passive activity losses and credits limited, 76 f.r. 72875 (11/28/11). the treasury has published proposed amendments to reg. § 1.469-5, dealing with the definition of an ―interest in a limited partnership as a limited partner‖ for purposes of determining whether a taxpayer materially participates in an activity under § 469. prop. reg. 2012] recent developments in federal income taxation 237 § 1.469-5(e) would eliminate the current reliance (in temp. reg. § 1.4695t(e)(3)) on limited liability for determining whether an interest is an interest in a limited partnership as a limited partner under § 469(h)(2) and replace it with an approach that relies on the individual partner‘s right to participate in the management of the entity. specifically, prop. reg. § 1.4695(e)(3) would provide that ―an interest in an entity shall be treated as an interest in a limited partnership as a limited partner if ... [t]he holder of such interest does not have rights to manage the entity at all times during the entity‘s taxable year under the law of the jurisdiction in which the entity is organized and under the governing agreement.‖ a right to manage includes authority to bind the entity. furthermore, an individual who holds a limited partnership interest would not be treated as holding a limited partnership interest if the individual also holds an interest in the partnership that is not a limited partnership interest as defined in prop. reg. § 1.469-5(e)(3). the regulations will be effective upon promulgation of final regulations a. but you really don’t have to wait to claim the benefit of this concession. limited liability partnership and limited liability company membership interests are not presumptively limited partnership interests under the passive activity loss rules. garnett v. commissioner, 132 t.c. 368 (6/30/09). the taxpayers held a number of direct and indirect interests in limited liability partnerships and llcs that were engaged in agribusiness. section 469(h)(2) provides that a limited partnership interest will not be treated as an interest with respect to which a taxpayer is a material participant, except as provided in regulations. temp. reg. § 1.469-5t(e)(2) provides that a limited partner materially participates in a partnership activity only if (1) the taxpayer devotes more than 500 hours to the activity in the year, (2) the taxpayer materially participates in the activity for five of the preceding ten taxable years, or (3) the activity is a personal service activity in which the taxpayer materially participated for any three preceding years. temp. reg. § 1.469-5t(e)(2)(1), (5), (6). temp. reg. § 1.469-5t(e)(3) defines a limited partnership interest as an interest designated as a limited partner interest in a partnership agreement or an interest for which the partner has limited liability. temp. reg. § 1.4695t(e)(3)(ii) has an exception from the material participation rule for an interest of a limited partner who also holds a general partnership interest. the court (judge thornton) concluded that in the case of an interest in a limited liability partnership or a limited liability company, both of which the court described as different from a limited partnership, the interests are not to be treated as limited partnership interests under § 469(h)(2). holders of such interests are not barred by state law from materially participating in the affairs of the entity and thus hold their interests as general partners within the meaning of the temporary regulations. thus, whether or not the taxpayer is a material participant requires a full factual inquiry and an llc member can 238 florida tax review [vol. 12:5 satisfy the material participation requirement under any of the seven tests in temp. reg. § 1.469-5t(a). b. the court of federal claims agrees. thompson v. united states, 87 fed. cl. 728 (7/20/09). the court (judge block) granted summary judgment treating the taxpayer member/manager of an llc as a material participant. the taxpayer‘s degree of participation was stipulated and the only question was whether § 469(h)(2) precluded treating the taxpayer as a material participant in a texas llc. the court noted that § 469(h)(2) treats limited partners differently because of an assumption that limited partners do not materially participate in their limited partnerships. in an llc, on the other hand, all members have limited liability but members may participate in management. the court noted that temp. reg. § 1.4695t(e)(3) treats a partnership interest as a limited partner interest if the holder has limited liability ―under the law of the state in which the partnership is organized.‖ the court held that the quoted language applies only to an entity that is a partnership under state law, which does not include an llc, which, although treated as a partnership for tax purposes, is a different type of entity under state law. the taxpayer was both a member and manager of the llc. unlike a limited partner, a member manager does not lose limited liability by participation in the management of the llc. the court also recognized that shareholders of an s corporation have limited liability as shareholders, but participate in management, and are not subject to being automatically treated as passive participants. the taxpayer, therefore, was able to demonstrate his material participation in the activity by using all seven of the temp. reg. § 1.469-5t(a) tests. c. ditto. newell v. commissioner, t.c. memo. 2010-23 (2/16/10). relying on garnett v. commissioner, supra, judge marvel held that the interest of a managing member of a california llc was not a limited partnership interest for purposes of reg. § 1.4695t(c)(1). taxpayer‘s losses were not passive activity losses because the irs conceded that the taxpayer met the ―significant participation‖ test of temp. reg. § 1469-5t(a)(4). d. the irs acquiesces. aod 2010-02, 201014 i.r.b. 515 (4/5/10). the irs acquiesces in the result in thompson. 7. ya gotta keep records of hours worked. vandegrift v. commissioner, t.c. memo. 2012-14 (1/12/12). the taxpayer, who was employed as a salesman, invested in nine rental properties. six of the properties were rented. the taxpayer acquired three properties for rental after renovations were completed, but sold the properties before they were rented. the tax court (judge goeke) held that the taxpayer failed to 2012] recent developments in federal income taxation 239 establish that he was a real estate professional under § 469(c)(7), because the taxpayer was unable to provide contemporaneous verification of the time he devoted to the real estate activity. the court also held that the taxpayer‘s rental real estate activity was a passive trade or business that included all nine properties. thus, the taxpayer was permitted to offset losses from the rental properties against the capital gain recognized on the sale of three properties. the court rejected the irs‘s argument that since the three properties that produced short-term capital gain were never rented the gain could not be offset by the losses. 8. yeah, it’s true — ya really do gotta keep records of hours worked. iverson v. commissioner, t.c. memo. 2012-19 (1/18/12). the tax court (judge swift) held that the taxpayer failed to prove he had satisfied the 500 hour participation test of reg. § 1.469-5t(a)(1) in the operation of a rocky mountain cattle ranch that was principally run by a resident manager. evidence of eleven trips (along with his children) to the ranch (which had a 20,000 square foot lodge) in a private plane funded by the taxpayer‘s successful medical supplies business and telephone conversations with the ranch manager did not convince the court that the taxpayer was a material participant. in addition, the court concluded that much of the taxpayer‘s activities were in the capacity of an investor, which do not qualify as participation under reg. § 1.469-5t(f)(2(ii)(a) and (b). the court did not sustain accuracy related penalties on the ground that the taxpayer reasonably relied on his accountant to prepare the returns. 9. self-rent to the taxpayer’s business was not passive income. samarasinghe v. commissioner, t.c. memo. 2012-23 (1/19/12). applying reg. § 1.469-2(f)(6), the tax court (judge marvel) held that income from the taxpayer‘s rental of a building owned by the taxpayer, which was used in the taxpayer‘s medical practice was not passive activity income that could be offset with the taxpayer‘s losses from passive activities. the court also held that, under new jersey state law, the original lease for the medical building entered into in 1980 was not subject to the transitional rule of reg. § 1.469-2(f)(6), which is not applicable to binding contracts entered into before 1988. the court determined that the original lease had been ignored by the parties and not followed in the 2004 through 2009 time period at issue in the case. the court refused to impose § 6662 penalties because it found that the taxpayers reasonably relied on their tax advisor with respect to the treatment of the lease payments. 240 florida tax review [vol. 12:5 iii. investment gain and income a. gains and losses 1. the irs begins to gear up on basis reporting. reg-101896-09, basis reporting by securities brokers and basis determination for stock, 74 f.r. 67010 (12/17/09). these proposed regulations relate to reporting sales of securities by brokers (prop. reg. § 1.6045-1) and determining the basis of securities (prop. reg. § 1.1012-1). the proposed regulations reflect changes in the law made by the energy improvement and extension act of 2008 that require brokers when reporting the sale of securities to the irs to include the customer‘s adjusted basis in the sold securities and to classify any gain or loss as long-term or short-term. the proposed regulations under § 1012 alter how taxpayers compute basis when averaging the basis of shares acquired at different prices and expand the ability of taxpayers to compute basis by averaging with respect to ric shares and shares specifically held in a dividend reinvestment plan. brokers must furnish information statements to customers by february 15th. the proposed regulations provide for the implementation of new reporting requirements imposed upon persons that transfer custody of stock and upon issuers of stock regarding organizational actions that affect the basis of the issued stock. it also contains proposed regulations reflecting changes in the law that alter how brokers report short sales of securities. a. final regulations on basis reporting and basis determination. t.d. 9504, basis reporting by securities brokers and basis determination for stock, 2010-47 i.r.b. 670 (11/22/10). these regulations adopt, with only minor changes, the regulations proposed in december 2009. they permit the use of the average basis method by regulated investment companies and dividend reinvestment plans. brokers must use either the specific identification method or the fifo method for securities sold from any particular account.  to minimize the possibility of identification foot-faults, the creation of different accounts to hold securities acquired at different times is recommended.  the final regulations also permit election of the fido method if the securities in any account consist predominantly of dogs. b. interim guidance. notice 2011-56, 201129 i.r.b. 54 (6/22/11). this notice provides interim guidance under § 1012 on issues relating to the basis of stock pending the anticipated publication of superseding regulations. these regulations will provide that a taxpayer may revoke the broker‘s average cost method for ric or drp stock by notifying 2012] recent developments in federal income taxation 241 the broker to change to the cost basis method before the earlier of one year or the first disposition of stock. different methods may be used on an accountby-account basis. 2. when does a debt instrument that has in effect become a proprietary interest because the debtor is insolvent remain a debt instrument? reg–106750–10, modifications of debt instruments, 75 f.r. 31736 (6/4/10). the treasury department has proposed amendments to reg. § 1.1001-3, which deals with when a modification of a debt instrument results in an exchange for purposes of § 1001 (gain or loss realization by creditor) and § 61(a)(12) (realization of cod income by debtor). under reg. § 1.1001-3(e)(5), a modification of a debt instrument that results in an instrument or property right that is not debt for tax purposes is a significant modification. an analysis of all of the factors relevant to a debt determination of the modified instrument at the time of an alteration or modification is required. however, prop. reg. § 1.1001-3(f)(7) would clarify that any deterioration in the financial condition of the issuer between the date the debt instrument was issued and the date it was altered or modified, insofar as it relates to the issuer‘s ability to repay the debt instrument, will not be taken into account in determining whether the instrument has been converted to another type of interest unless there is a substitution of a new obligor or the addition or deletion of a co-obligor. thus, any decrease in the fair market value of a debt instrument (whether or not publicly traded) is not taken into account to the extent that the decrease in fair market value is attributable to the deterioration in the financial condition of the issuer, rather than to a modification of the terms of the instrument, but only for purposes of determining the nature of the instrument. according to the preamble, ―[c]onsistent with this rule in the proposed regulations, if a debt instrument is significantly modified and the issue price of the modified debt instrument is determined under reg. § 1.1273-2(b) or (c) (relating to a fair market value issue price for publicly traded debt), then any increased yield on the modified debt instrument attributable to this issue price generally is not taken into account to determine whether the modified debt instrument is debt or some other property right for federal income tax purposes. however, any portion of the increased yield that is not attributable to deterioration in the financial condition of the issuer, such as a change in market interest rates, is taken into account.‖  the provisions of prop. reg. § 1.1001-3(f)(7) will be effective upon finalization, but taxpayers may rely on paragraph (f)(7) of this section for alterations of the terms of a debt instrument occurring before that date. see prop. reg. § 1.1001-3(h)(2). a. finalized with only very minor clarifications. t.d. 9513, modifications of debt instruments, 76 fed. reg. 242 florida tax review [vol. 12:5 1603 (1/7/11). the proposed amendments to reg. § 1001-3 have been finalized with only a clarifying change. the final regulations add language to the general rule of reg. § 1.1001-3(b) that makes it clear that the rules of reg. § 1.1001-3(f)(7) apply to determine whether the modified instrument received in an exchange will be classified as debt for federal income tax purposes. according to the preamble, ―unless there is a substitution of a new obligor or the addition or deletion of a co-obligor, all relevant factors (for example, creditor rights or subordination) other than any deterioration in the financial condition of the issuer are taken into account in determining whether a modified instrument is properly classified as debt for federal income tax purposes.‖ 3. the return of tax-free basis step-up (or down) at death — with a very interesting twist for george steinbrenner and others who followed the same tax planning technique. the compromise tax act, § 301(a), reinstated the § 1014 fair-market-value-at-death basis rule for taxable years after 2010. for estates of decedents dying in 2010, act § 301(c) provides a special rule that allows the executor to elect between (1) applying the rules enacted in 2001, i.e., no estate tax for 2010 coupled with the § 1022 carryover basis rules, or (2) paying an estate tax (applying the rates and exemptions provided in act § 302 for years after 2009) and applying the § 1014 fair-market-value-at-death basis rules. a. here is how to elect to not pay the estate tax for someone who died in 2010. nice of them to tell a bit less than three months before the form is due. notice 2011-66, 2011-35 i.r.b. 184 (8/5/11). this notice provides guidance regarding the time and manner in which the executor of the estate of a decedent who died in 2010 elects to have the estate tax not apply and to have the carryover basis rules in § 1022 apply to property transferred as a result of the decedent‘s death. it also addresses some issues arising in the application of § 1022. to elect out of the estate tax and into § 1022 carryover basis, the executor must file a form 8939, allocation of increase in basis for property acquired from a decedent, on or before 11/15/11. (if no executor has been appointed, any person in actual or constructive possession of property acquired from the decedent may file a form 8939 for the property he or she actually or constructively possesses.) prior filings purporting to make the § 1022 election must be replaced with a timely filed form 8939. the election is irrevocable except as provided in the notice. the allocation of any basis increase under § 1022 must be made on the form 8939. an allocation of the spousal basis increase may be made on an amended form 8939 filed after 11/15/11 under certain limited conditions. executors may apply for § 9100 relief to (1) revoke an election, (2) seek additional time to allocate a basis increase, or (3) seek additional time to file form 8939. the notice cautions, 2012] recent developments in federal income taxation 243 however, that: ―taxpayers should be aware, however, that, in this context, the amount of time that has elapsed since the decedent‘s death may constitute a lack of reasonableness and good faith and/or prejudice to the interests of the government (for example, the use of hindsight to achieve a more favorable tax result and/or the lack of records available to establish what property was or was not owned by the decedent at death), which would prevent the grant of the requested relief.‖ b. and here are the rules for figuring out that nasty carryover basis if you opt out of the estate tax. this rev. proc. is long enough and complicated enough to have been a set of regulations, but they probably couldn’t have gotten regulations out before the due date of the form on which you tell them the amount of the carryover basis. rev. proc. 2011-41, 2011-35 i.r.b. 188 (8/5/11). this very long and detailed revenue procedure – detailed enough to be worthy of regulations if the issue were permanent – provides safe harbor guidance regarding the determination of the basis of property under § 1022. it is generally incapable of being concisely summarized, except to say that it describes the types of property and types transfers of property to which § 1022 does and does not apply. it also describes the types of property for which no allocation of an otherwise permitted basis increase is allowed, and the methods for allocating allowable basis increase among permitted property. no basis increase may be allocated in a manner that increases the basis to increases in value occurring after the decedent‘s death. the decedent‘s depreciation deductions for § 1245 property are taken into account by the transferee in computing § 1245 recapture. the revenue procedure reiterates that under § 1040, the satisfaction of a pecuniary bequest with property having a fair market value in excess of basis results in gain recognition, noting that this rule does not apply to satisfaction of a pecuniary bequest with an item of ird. the revenue procedure is effective 8/29/11. 4. the key to the philosopher’s stone, which transmutes ordinary income into capital gain. t.d. 9514, time and manner for electing capital asset treatment for certain self-created musical works, 76 f.r. 6553 (2/7/11). the treasury has finalized reg. § 1.1221-3, which deals with the election to treat gain or loss from the sale or exchange of taxpayer-created musical compositions or copyrights in musical works as gain or loss from the sale or exchange of a capital asset. it also covers taxpayers whose basis is determined by reference to the basis of such property in the hands of the taxpayer whose personal efforts created the property.  this levels the playing field between creators of musical works and creators of patented inventions. 244 florida tax review [vol. 12:5 5. what does ―traded on an established securities market‖ mean in the internet era? reg-131947-10, property traded on an established market, 76 f.r. 1101 (1/7/11). under the oid rules, if a debt instrument is issued for stock or other debt instruments (or other property) that is traded on an established securities market (often referred to as ―publicly traded‖), the issue price of the debt instrument is the fair market value of the stock or other property. similarly, if a debt instrument issued for property, such as another debt instrument, is traded on an established securities market, the issue price of the debt instrument is the fair market value of the debt instrument. see reg. § 1.1273-2(c). among other issues, a debt-for-debt exchange (including a significant modification of existing debt) in the context of a work-out may result in a reduced issue price for the new debt, which generally would produce (1) cod income for the issuer (i.e., debtor), (2) a loss to a holder (i.e., creditor) whose basis is greater than the issue price of the new debt, and (3) oid that must be accounted for by both the issuer and the holder of the new debt. the treasury has published proposed regulations that are intended to simplify and clarify the determination of when property is traded on an established market. prop. reg. § 1.1273-2(f)(1) would identify four ways for property to be traded on an established market: (1) the property is publicly traded on an exchange (as defined), which is relatively unusual for debt instruments other than corporate bonds; (2) a sales price for the property is reasonably available – ―it appears in a medium that is made available to persons that regularly purchase or sell debt instruments, or persons that broker purchases or sales of debt instruments‖ (―a sale that is reported electronically at any time in the 31-day time period, such as in the trade reporting and compliance engine (―trace‖) database maintained by the financial industry regulatory authority, would cause the instrument to be publicly traded, as would other pricing services and trading platforms that report prices of executed sales on a general basis or to subscribers‖); (3) if a firm price quote to buy or sell the property is available; or (4) a price quote (other than a firm quote) that meets certain standards set forth in the regulations is provided by a dealer, a broker, or a pricing service (an indicative quote). in all four cases, the time for determining whether the property is publicly traded is the 31-day period ending fifteen days after the issue date of the debt instrument. the regulations will apply to debt instruments that have an issue date on or after the promulgation of final regulations. 6. this case is a poster child for the argument that § 1221 ought to list what are capital assets rather than listing what are not capital assets. 2 tempel v. commissioner, 136 t.c. 341 (4/5/11). on 2. see martin j. mcmahon, jr., reinstating a capital gains preference and tax expenditure analysis, 48 tax notes 1437 (september 10, 1990). 2012] recent developments in federal income taxation 245 december 17, 2004, the taxpayers donated a qualified conservation easement to a qualified organization and qualified for $260,000 of conservation easement income tax credits, which were transferrable, from the state of colorado. they incurred $11,574.74 of expenses in connection with the donation that primarily consisted of various professional fees. under complex colorado statutory provisions (which are not fully explained in the opinion) only $50,000 of the credits was currently refundable to the taxpayers, and then only in a year in which colorado had a budget surplus; the excess could be carried over for twenty years. however, colorado law permitted the sale of excess credits to third parties, who could use them to offset their tax liabilities. in december of 2004, the taxpayers sold $40,500 of their state tax credits to an unrelated third party for net proceeds of $30,375. later in december of 2004, they sold an additional $69,500 of their credits to another unrelated third party for net proceeds of $52,125. they reported $77,603 of short-term capital gains from the sale of their state tax credits, reflecting total sales proceeds of $82,500 and a basis of $4,897 in those credits. they computed their basis in the state tax credits by allocating the $11,574.74 of expenses they incurred to make the donation to the portion of the credits they sold (i.e., $110,000 of credits sold / $260,000 of total credits x $11,574.74 = $4,897). the irs took the position that the sales resulted in ordinary income and that the credits had no basis. the tax court (judge wherry) rejected the irs argument that the credits were not capital assets, but agreed with the irs that the credits had a zero basis. thus the taxpayers recognized an $82,500 short-term capital gain.  the irs relied on the ―substitute for ordinary income‖ doctrine, which excludes a wide variety of property rights from capital asset status. judge wherry rejected the irs‘s argument that the credits were analogous to contract rights to receive ordinary income, which under tax court precedent, e.g., gladden v. commissioner, 112 t.c. 209 (1999), rev’d on a different issue, 262 f.3d 851 (9th cir. 2001), are not capital assets. judge wherry likewise rejected the application of the more general ―substitute for ordinary income‖ doctrine. the irs‘s position was that the sales proceeds were a substitute for the up-to-$50,000 tax refund that a colorado taxpayer could receive in a year the state had a budget surplus. judge wherry noted that there had been no opportunity for a refund from the state either during 2004 (the year the taxpayers sold their credits) or in 2006 through 2010, and that there was no evidence and the irs did not assert that the taxpayers had sold credits they otherwise could have used to receive a refund. thus, he concluded that the sales proceeds were not a substitute for a tax refund.  he also rejected the irs‘s argument that a taxpayer who sells a credit, rather than claiming the credit against his own tax liability has the ―economic equivalent of ordinary income‖ because as a result the taxpayer‘s itemized deduction for state income taxes is greater than it 246 florida tax review [vol. 12:5 would have been had the taxpayer retained and used the credits. ultimately, he reasoned as follows: it is also apparent that the transferred state tax credits never represented a right to receive income from the state. instead, they merely represented the right to reduce a taxpayer‘s state tax liability. it is without question that a government‘s decision to tax one taxpayer at a lower rate than another taxpayer is not income to the taxpayer who pays lower taxes. a lesser tax detriment to a taxpayer is not an accession to wealth and therefore does not give rise to income. it follows that the taxpayer who is able to claim a deduction or credit has no more income by virtue of having that right than the taxpayer who is unable to make such a claim. had petitioners used all of their credits to offset their state tax liability, rather than selling them, it appears that respondent would agree there would have been no income to petitioners. using a tax credit to offset a tax liability is not an accession to wealth. petitioners never possessed a right to income from the receipt of the credits. they did not sell a right either to earned income or to earn income. consequently, the sale proceeds are not a substitute for rights to ordinary income.  in a pyrrhic victory for the irs on the basis issue, judge wherry held that taxpayers‘ expenses to create the easement were not the purchase price of the state tax credits under § 1012, but if anything, they were deductible under § 212(3) (which was a question not before the court). furthermore, allocating basis to the credits would be inconsistent with the basis allocation rules in § 170(e)(2) and reg. § 1.170a14(b)(3)(iii)), which allocate the donor‘s entire basis in the property between the conservation easement and the retained interest according to the ratio that the fair market value of the easement bears to the total pre-easement fair market value of the property.  judge wherry rejected the taxpayers‘ claim, raised in a cross motion for summary judgment, that the holding period of the credits was the same as the holding period of the property the easement burdened. the taxpayers had no property rights in the credits until the donation of the easement was complete and the credits had been granted by the state.  the taxpayer in this case recognized capital gain treatment with respect to an asset that had never appreciated over the time they held it. that is not the type of situation that should receive preferential treatment. in commissioner v. gillette motor transport, inc., 364 u.s. 130, 134 (1960), the supreme court said: 2012] recent developments in federal income taxation 247 this court has long held that the term ―capital asset‖ is to be construed narrowly in accordance with the purpose of congress to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation and the entire gain in one year.  the court cited gillette motor transport, inc. and quoted part of the above passage, but gave it no real weight. a. just because a case is wrongly decided doesn’t mean it’s not binding precedent. mcneil v. commissioner, t.c. memo 2011-109 (5/23/11). in a case involving facts substantially the same as the facts in tempel v. commissioner, 136 t.c. 341 (4/5/11), the tax court (judge cohen) followed tempel and allowed the taxpayer‘s claimed shortterm capital gain treatment for the proceeds from the sale of state tax credits. 7. judge goeke protects the lays from irs overreach following the enron bankruptcy. estate of lay v. commissioner, t.c. memo. 2011-208 (8/19/11). in the summer of 2001, when kenneth lay was asked by the board of directors to re-take the position of ceo of enron (which he had resigned in february 2001) upon the unexpected resignation of his successor, jeffrey skilling, the enron board‘s compensation committee decided that the best way to compensate him and ensure his remaining at enron was for enron to purchase two single premium annuities owned by mr. lay and his wife for their $10 million cost. the purchase would both provide liquidity to the lays and provide a retention device to enron because the annuities could be earned back by the lays if mr. lay remained as ceo for 4.25 years. the lays provided the original annuity contracts and transfer documents to enron on 9/21/01, but instead of providing the original documents to the insurance company, as required by the annuity contracts, enron faxed them. enron did not include the $10 million on the original form w-2 it sent to mr. lay, but in 2004, after an employment tax audit, sent mr. lay an amended form w-2 for 2001 that included the $10 million as compensation. judge goeke held, ―[w]e do not find this after-the-fact event relevant to the case before us.‖  the irs took the position that the lays did not sell the annuity contracts and that the $10 million was an employee cash bonus includable in income for the 2001 year. judge goeke found that the lays completed their requirements to transfer the annuities and that the risks and rewards of the annuity contracts were transferred to enron on 9/21/01.  the irs also took the position that the purchase price of the annuities was in excess of the $4.691 million the lays 248 florida tax review [vol. 12:5 would have received from the insurance company if they liquidated but less than the $11.2 million that compensation consultant towers perrin valued the annuities. judge goeke held that, based on commissioner v. brown, 380 u.s. 563 (1965), the purchase price was within a reasonable range and held that a sale had taken place.  judge goeke also held that no compensation income was realized by virtue of the contractual provision under which lay could earn back the annuity contracts if he worked for enron for 4.25 years. the annuity contracts were not transferred or set aside and insulated from creditor‘s claims; lay had no right to them and they were subject to forfeiture. the contracts were not constructively received and would not be so received until lay had completed 4.25 years of service (or upon an earlier termination that triggered a transfer to him under the terms of the agreement). 8. pizza is the eighth deadly sin, and the ninth is stealing the sausage process, even if the damages are taxable. freda v. commissioner, t.c. memo. 2009-191 (8/25/09). the taxpayer was the shareholder of c&f packing co., an s corporation that supplied pizza hut with pre-cooked sausage prepared with the taxpayer‘s patented process. c&f also entered into license and royalty agreements to provide its trade secrets to other pizza hut suppliers. after discovering that pizza hut disclosed the process to an unlicensed supplier (ibp) who also sold pre-cooked sausage to pizza hut, c&f recovered damages from pizza hut for misappropriation of trade secrets. the tax court (judge chiechi) held that the damages were received as compensation for lost profits, and thus were taxable as ordinary income. the court applied the principle that ―the tax treatment of the amount at issue ‗depends upon the nature of the claim and the actual basis of recovery,‘‖ quoting sager glove co. v. commissioner, 36 t.c. 1173, 1180 (1961), aff’d, 311 f.2d 210 (7th cir. 1962). the court rejected the taxpayer‘s argument that the damages were for injury to or destruction of the trade secret, a capital asset. a. affirmed. freda v. commissioner, 656 f.3d 570 (7th cir. 8/26/11). the court of appeals (judge tinder) first noted that ―trade secret misappropriation, aside from signaling that a capital asset may be in some way implicated, does not tell us very much about the actual nature of c&f‘s original claim, which can take many forms.‖ it then went on to hold that the tax court‘s finding that ―pizza hut paid the amount at issue to [the taxpayer] for ‗lost profits, lost opportunities, operating losses and expenditures,‘‖ which tracks the language of the relief requested in the complaint and ―ha[d] some support in the trial testimony,‖ was not clearly erroneous. in the civil suit, the taxpayer-plaintiff ―sought profits and other types of monetary recovery that may properly be taxed as ordinary income 2012] recent developments in federal income taxation 249 from the get-go rather than focusing on the damage to or destruction of its capital asset.‖ the factual allegations incorporated into c&f‘s misappropriation claim highlight vast reductions to c&f‘s margins, ... c&f‘s financial losses, ..., the disproportionate impact pizza hut‘s conduct had on c&f‘s total sales, ... and c&f‘s inability to ―exploit‖ its c&f process ... . the shareholders did not offer the tax court evidence which undercut the commissioner‘s reasonable conclusion that the damages c&f alleged were the main attraction rather than mere placeholders; their sole attempt to do so was (properly) rejected on hearsay grounds. they likewise failed to make any effort to explain why they voluntarily treated some of the money they received for a virtually identical claim (trade secret misappropriation against ibp) as ordinary income if all such claims necessarily net capital gains [sic]. based on the record before it, the tax court did not err in upholding the commissioner‘s presumptively correct determination that the settlement was not ―in lieu of‖ a replacement of capital.  finally, the court noted that ―the settlement agreement gives no indication that pizza hut believed it was compensating c&f for the sale or even the use of its trade secrets. ... without at least some hallmarks of a sale, c&f‘s transfer to pizza hut of its trade secrets should not be considered one for tax purposes.‖  judge manion dissented and would have reversed, on the ground that the tax court was ―wrong because it misread the complaint.‖ judge manion read the complaint, which after describing the elements of its trade secret misappropriation claim against pizza hut, c&f alleged that ―[a]s a result, c&f has been damaged, and has suffered, among other things, lost profits, lost opportunities, operating losses and expenditures,‖ as including the lost opportunity to negotiate a transfer of the secret process to another pizza giant after pizza hut cut c&f off. he concluded that the tax court improperly over-emphasized the phrase ―lost profits.‖ according to judge manion‘s analysis, the nature of the claim that c&f was bringing against pizza hut was that pizza hut had wrongfully acquired and then disclosed a trade secret to c&f‘s competitor, ibp, and that this damaged c&f‘s property interest in the trade secret; the phrase ―lost profits‖ was part of a non-exclusive list describing ways c&f had been injured by pizza hut‘s trade secret misappropriation. but this phrase ―lost profits‖ did not negate the fact that c&f‘s trade secret had been severely damaged and that c&f was also seeking compensation for this damage. 9. getting rip off by bernie ebbers wasn’t a theft loss. schroerlucke v. united states, 100 fed. cl. 584 (9/21/11). in an opinion 250 florida tax review [vol. 12:5 that was far longer than necessary to employ a well-established principle to resolve the case, the court held that the loss of value of stock, purchased pursuant to employee stock options, in worldcom (from $79.4375/share to $0.91/share) caused by bernie ebbers/worldcom‘s fraudulent accounting practices was not a theft loss. there was no theft under relevant state law, which is prerequisite to § 165 theft loss. 10. ♪♫―lipstick on your collar told a tale on you.‖♫♪ anschutz co. v. commissioner, 135 t.c. 78 (7/22/10). an s corporation, through a q-sub (tac) entered into transactions with donaldson, lufkin & jenrette securities (dlj) involving appreciated stock that it owned. the agreements were memorialized by a master stock purchase agreement (mspa) that included ―prepaid variable forward contracts‖ (pvfcs) and share-lending agreements (slas) with respect to the shares subject to the pvfcs. the pvfcs required dlj to make an upfront payment to tac in exchange for a promise by tac to deliver a variable number of shares to dlj in ten years. the amount of the payment was 75 percent of the fair market value of the shares subject to the pvfcs. if the stock subject to the pvfcs appreciated over the term of the contract, tac was entitled to retain 50 percent of the appreciation, and the remainder accrued to dlj. tac pledged the shares of stock at issue in the pvfcs as collateral for the upfront payment and to guarantee tac‘s performance under the pvfc. the pledged shares were delivered to a trustee. before each stock transaction dlj executed short sales of that stock in the open market. after tac lent shares to dlj pursuant to the slas, dlj used the shares to close out the short sales. tac received upfront payments under the pvfcs totaling $350,968,652 and $23,398,050 in prepaid lending fees under the slas.  the taxpayer claimed that tac executed two separate transactions – pvfcs and slas – and neither constituted a current sale for tax purposes, relying, in part, on § 1058. the tax court (judge goeke) agreed with the irs that the shares subject to the pvfcs and lent pursuant to the slas were sold for income tax purposes. the transaction consisted of two integrated legs, one of which called for share lending, but the two legs were clearly related and interdependent. analyzing the mspa as a whole, in exchange for valuable consideration tac transferred to dlj the benefits and burdens of ownership, including (1) legal title to the shares; (2) all risk of loss; (3) a major portion of the opportunity for gain; (4) the right to vote the stock; and (5) possession of the stock. although the slas provided that tac could terminate share loans and recall the shares, in reality any share recalls were really tac borrowing shares from dlj. because dlj closed out its original short sales with the lent shares, the shares later transferred to tac were in substance dlj borrowing shares from third parties and delivering them to tac. gain was recognized with respect to the upfront cash payments received in the transactions. the taxpayer‘s reliance on § 1058 was rejected 2012] recent developments in federal income taxation 251 because the taxpayer‘s argument relied on the premise that the pvfcs were separate from the slas. the mspa violated the requirement of § 1058(b)(3) that the agreement not limit the lender‘s risk of loss or opportunity for gain, because the agreements eliminated tac‘s risk of loss with regard to the lent shares.  on the bright side ☺, judge goeke rejected the irs‘s alternative argument that the transactions were also either a constructive short sale by tac under § 1259(c)(1)(a) or a constructive forward contract sale under § 1259(c)(1)(c). tac did not enter into any short sale because dlj was acting as a principal and not as an agent in making the short sales. the transactions were not constructive forward contract sales because they were not forward contracts as defined in § 1259(d)(1) in that they did not provide for delivery of a substantially fixed amount of property for a substantially fixed price.  the transaction in anschutz co. occurred before the issuance of rev. rul. 2003-7, 2003-1 c.b. 363, in january 2003. that ruling offered a roadmap to avoidance of gain recognition although a collar around unrealized appreciation was achieved. a. ―not only did dlj effectively obtain and dispose of the actual shares pledged by tac, tac received significant value for those shares and simultaneously lost nearly all of the incidents of ownership of those shares.‖ anschutz co. v. commissioner, 664 f.3d 313 (10th cir. 12/27/11). in affirming the tax court‘s decision, the court of appeals applied the principles from grodt & mckay realty, inc. v. commissioner, 77 t.c. 1221, 1237 (1981) – ―the term ‗sale‘ is given its ordinary meaning and is generally defined as a transfer of property for money or a promise to pay money‖ – and relied on factors listed in h.j. heinz co. and subsidiaries v. united states, 76 fed. cl. 570, 581 (2007): ―(1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity was acquired in the property; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damages to the property; and (8) which party receives the profits from the operation and sale of the property.‖ the court continued that with respect to stock transactions in particular, the following factors are also considered relevant to this determination: ―(i) whether the purchaser bears the risk of loss and opportunity for gain; (ii) which party receives the right to any current income from the property; (iii) whether legal title has passed; and (iv) whether an equity interest was acquired in the property.‖ looking at the transactional documents, the court of appeals concluded that the transaction ―effectively afforded dlj all incidents of ownership in the pledged and borrowed shares, 252 florida tax review [vol. 12:5 including the right to transfer them.‖ given the specifics of the underlying agreements, the court did not assign much weight to the fact the parties treated the transactions as executory contracts for the sale of shares to dlj, rather than current sales of the shares. as for the third factor, dlj obtained an equity interest in the shares because it had the right to do as it saw fit with them. tac received (a) upfront cash equal to 75 percent of the pledged stock‘s then-existing market value, (b) a 5 percent prepaid tranche fee, (c) the potential of benefitting to a limited degree if the pledged stock increased in value over the life of the transactions, and (d) the complete elimination of any risk of loss. the fourth, fifth, and seventh factors were easily satisfied on the facts. (the sixth factor was not relevant.) looking at the eighth factor, the court noted that ―tac had significantly less ... price reward from the ... shares [at issue] by executing [the transactions] than it would have [had] by simply holding onto the shares and selling them after ten years.‖ in addition, the court noted that tac effectively transferred the voting rights, had only limited rights to received dividends or dividend equivalent payments, and ―dlj the right to possess, and ultimately dispose of, the shares.‖  the court rejected the taxpayer‘s argument that the taxpayer‘s transaction was ―substantially identical‖ to the one in revenue ruling 2003-7, 2003-1 c.b. 363, and that, consequently, ―the transactions at issue should not be treated as current sales of tac‘s shares to dlj.‖ unlike revenue ruling 2003-7, which involved only a variable prepaid forward contract, the transaction in the instant case also included a master stock purchase agreement and share lending agreement. the result was that that ―dlj obtained possession, and most of the incidents of ownership, of tac‘s pledged shares. tac, in turn, obtained cash payments and an elimination of any risk of loss in the pledged stock‘s value at the end of the term of the transactions.‖  finally, the court rejected the taxpayer‘s argument that the transaction was protected by the so-called ―safe harbor‖ § 1058. to qualify as a loan of securities under § 1058, the loan agreement must (1) provide for the return to the lender of identical securities, (2) require payments to the lender equal to all interest, dividends, and other distributions on the securities during the period of the loan, and (3) not reduce the risk of loss or opportunity for gain of the transferor of the securities in the securities transferred. section 1058 did not apply because the transactions did not satisfy the requirements of § 1058(b)(2) and (3): the transactions at issue did not ensure that tac would receive amounts equivalent to all interest, dividends, and other distributions to which tac was otherwise entitled on the pledged stock, and the transactions effectively reduced tac‘s risk of loss and opportunity for gain on the pledged shares. b. no ring-around-the-collar here: this collar just plain clean works. rev. rul. 2003-7, 2003-1 c.b. 363 2012] recent developments in federal income taxation 253 (11/16/03). the irs ruled that a shareholder has neither sold stock currently nor caused a constructive sale of stock under § 1259 where he (1) receives a fixed amount of cash, (2) simultaneously enters into an agreement to deliver on a future date a number of shares of common stock that varies significantly depending on the value of the shares on the delivery date [but which does provide a ―collar‖ on the number of shares of stock to be delivered, in effect providing a ―collar‖ on the ultimate sale price], (3) pledges the maximum number of shares for which delivery could be required, (4) has the unrestricted right to deliver the pledged shares or to substitute cash or other shares on the delivery date, and (5) is not economically compelled to deliver the pledged shares.  there was not a sale of the pledged shares because the shareholder was not required to relinquish the pledged shares but had an unrestricted right to reacquire them by delivering cash or other shares. there was not a constructive sale under § 1259(c)(1)(c) because due to the variation in the number of shares that might be delivered, the agreement was not a contract to deliver a substantially fixed amount of property for purposes of § 1259(d)(1). b. interest, dividends, and other current income 1. quasi-substitutes for dividends ain’t qualified dividends – pay up at ordinary rates. rodriguez v. commissioner, 137 t.c. no. 14 (12/7/11). the tax court agreed with the irs‘s conclusion in notice 2004-70, 2004-2 c.b. 724, that amounts of a controlled foreign corporation‘s income that are includable by the shareholders as ordinary income under §§ 951(a)(1)(b) and 956, because the cfc‘s earnings and profits were invested in u.s. property, were not qualified dividend income subject to the § 1(h)(11) preferential tax rate. because there was no distribution, and neither the code nor the regulations provides a special rule treating a § 951 inclusion as a dividend for purposes of §1 (h)(11), there was no dividend. ―[t]o say that section 951 treats a cfc‘s investments in u.s. property ‗much like‘ a constructive dividend is a far cry from saying that such amounts actually constitute dividends. in fact, the statutory structure and operating rules in the code, particularly as they have evolved over time, strongly suggest that these amounts do not constitute dividends under the code.‖ there are important distinctions between dividends and § 951 inclusions: (1) while dividend distributions reduce the earnings and profits of the distributing corporation, § 951 inclusions do not; and (2) while a dividend does not result in an increase to the shareholder‘s stock basis, a § 951 inclusion does. 254 florida tax review [vol. 12:5 c. profit-seeking individual deductions 1. the irs still can’t figure out knight. notice 201032, 2010-1 c.b. 594 (4/1/10). this notice provides that pending further guidance, taxpayers are not required to determine the portion of a ―bundled fiduciary fee‖ that is subject to the § 67 two-percent of agi floor on miscellaneous itemized deductions for any taxable year beginning before 1/1/10. taxpayers may deduct the full amount of the bundled fiduciary fee; payments by the fiduciary to third parties for expenses subject to the twopercent floor must be treated separately. it modifies and supersedes notice 2008-116, 2008-1 c.b. 593, which provided similar relief for years beginning before 1/1/09. a. and we don’t have to until final regulations are published. notice 2011-37, 2011-20 i.r.b. 785 (4/13/11). this notice extends the interim guidance provided in notice 2010-32, 2010-1 c.b. 594 (4/1/10), to taxable years that begin before the date final regulations under temp. reg. § 1.67-4 are published. b. proposed regulations are published. reg128224-06, section 67 limitations on estates or trusts, 76 f.r. 55322 (9/7/11). these proposed regulations would add reg. § 1.67-4, to define whether some costs incurred by an estate or non-grantor trust would have been ―commonly or customarily … incurred by a hypothetical individual owning the same property ….‖ fees for investment advice would be covered by the 2-percent floor but incremental costs of investment advice incurred because the advice is rendered to a trust or estate are not subject to the floor. bundled fees may be allocated by ―[a]ny reasonable method ….‖ 2. the taxpayer fought an almost spot-on example in the regulations and, unsurprisingly, lost on summary judgment. ellington v. commissioner, t.c. memo. 2011-193 (8/11/11). the taxpayers borrowed over $1.5 million from merrill lynch to purchase a residence. the loan was secured by the residence and nearly 9,000 shares of intel stock worth approximately $650,000. the taxpayer‘s subsequently refinanced the merrill lynch loan with another lender, and the refinanced loan was secured only by the residence. the taxpayers deducted a portion of the interest on the merrill lynch loan as investment interest (because of the statutory ceiling on the amount of the home mortgage for which interest is deductible). the taxpayers argued that a portion of the interest accrued on the merrill lynch loan was allocable to the intel stock because the loan was partly secured by the intel stock. the tax court (judge kroupa) rejected the argument, applying the tracing rules in temp. reg. §1.163-8t(c)(1) to conclude that the entire loan was attributable to the purchase of the residence. under the 2012] recent developments in federal income taxation 255 regulations, debt and interest are allocated to expenditures according to the use of the debt proceeds, and merrill lynch had disbursed all of the loan proceeds directly to the sellers from whom the taxpayers had purchased the residence. judge kroupa cited reg. § 1.163-8t(c)(1), example, which provides that a taxpayer who finances the purchase of a personal-use automobile with a loan secured by corporate stock held for investment incurs personal interest expense, not investment interest expense. d. section 121 there were no significant developments regarding this topic during 2011. e. section 1031 there were no significant developments regarding this topic during 2011. f. section 1033 there were no significant developments regarding this topic during 2011. g. section 1035 1. instructions for qualifying for a tax-free annuity swap. rev. proc. 2011-38, 2011-30 i.r.b. 66 (6/28/11). the direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract (regardless of whether the two annuity contracts are issued by the same or different companies) is a tax-free exchange under § 1035 if no amount, other than an amount received as an annuity for a period of ten or more years or during one or more lives, is withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 180 months beginning on the date on which amounts are treated as received as premiums or other consideration paid for the contract received in the exchange (the date of the transfer). a transfer that is not treated as a taxfree exchange under § 1035 will be examined under general tax principles to determine if it will be treated as a distribution, taxable under § 72(e), followed by a payment for the second contract, or as boot in an otherwise tax-free exchange. this revenue procedure is effective for transfers completed after 10/23/11. rev. proc. 2008-24, 2008-1 c.b. 684, which is modified and superseded, controls transfers before 10/24/11. 256 florida tax review [vol. 12:5 h. miscellaneous there were no significant developments regarding this topic during 2011. iv. compensation issues a. fringe benefits 1. did the tax court really mean to deny a deduction for a taxable fringe benefit? dkd enterprises, inc. v. commissioner, t.c. memo. 2011-29 (1/31/11). the tax court (judge chiechi) upheld the irs‘s denial of the corporation‘s deduction of the cost of medical insurance premiums for a policy covering its employee/sole shareholder because the corporation ―failed to carry its burden of establishing that it had in effect during any of the years at issue a sickness, hospitalization, medical expense, or similar benefit plan for employees.‖ for that same reason, the individual shareholder /employee was not entitled to exclude the amount of the premiums under either § 105 or § 106.  notably, the court did not expressly recharacterize the premium payment as a constructive dividend. 2. the irs modifies guidance on reporting of employer-provided healthcare coverage despite the fact that the amounts reported have no relevance whatsoever to anyone’s taxes. notice 2012-9; 2012-4 i.r.b. 315 (1/3/12), superseding notice 2011-28, 2011-16 i.r.b. 656. the irs has issued interim guidance on informational reporting to employees of the cost of their group health insurance coverage under § 6051(a)(14). the notice includes the following statement: ―this reporting to employees is for their information only. the reporting is intended to inform them of the cost of their health care coverage, and does not cause excludable employer-provided health care coverage to become taxable. nothing in § 6051(a)(14), this notice, or the additional guidance that is contemplated under § 6051(a)(14), causes or will cause otherwise excludable employer-provided health care coverage to become taxable.‖ b. qualified deferred compensation plans there were no significant developments regarding this topic during 2011. 2012] recent developments in federal income taxation 257 c. nonqualified deferred compensation, section 83, and stock options 1. what’s the fmv of a life insurance policy? schwab v. commissioner, 136 t.c. 120 (2/7/11). the tax court (judge holmes) held that ―the amount actually distributed‖ and therefore includable in gross income under §§ 402(b) and 72 where a variable universal life insurance policy was received as a distribution upon termination of a § 419 nonqualified employee-benefit plan was not the ―stated value‖ determined by the insurance company. rather the amount distributed was the fair market value of the contract, including paid up insurance, but reflecting surrender charges and other limiting conditions imposed on the beneficiary by the insurance contract. section 6662 penalties did not apply because the understatement of income, i.e., the amount distributed, was less than $5,000, and taxpayers were not careless, reckless, or in intentional disregard of rules or regulations. 2. getting paid in volatile stock that you cannot sell for a while due to lapsing restrictions is a tax unhealthy behavior. gudmundsson v. united states, 634 f.3d 212 (2d cir. 2/11/11). in 1999, the taxpayer received 73,105 unregistered shares of stock in his employer pursuant to an incentive compensation plan. the stock was worth approximately $1.3 million. the stock was not subject to forfeiture, but the taxpayer‘s ability to transfer the stock was subject to three lapse restrictions. first, pursuant to sec rule 144, the stock could not be sold on a public exchange until july 1, 2000, although it could be sold privately or pledged. second, pursuant to contract with the employer, prior to july 1, 2000, the stock could be sold only to certain ―permitted transferees,‖ a group which included family members and relatives. third, the sale of the stock was limited by the employer‘s insider trading policy, which required compliance with certain waiting periods and consent procedures prior to trading the stock. by the time the stock was freely marketable on july 1, 2000, its value had fallen dramatically. the court of appeals held that the $1.3 million value of the stock in 1999 was properly includable in that year under § 83, because it was not subject to a substantial risk of forfeiture. none of the limitations on trading the stock could result in its forfeiture. because all of the restrictions were lapse restrictions, none were taken into account in valuing the stock. 3. at least one kind of forfeiture must have ―an objectively reasonable chance of success,‖ even if most do not. strom v. united states, 641 f.3d 1051 (9th cir. 4/6/11). section 83(c)(3) specifically provides that property will be treated as subject to a substantial risk of forfeiture as long as the sale of the property at a profit ―could‖ subject the 258 florida tax review [vol. 12:5 individual to suit under § 16(b) of the securities exchange act. the ninth circuit held that § 83(c)(3) applies to defer inclusion only if the taxpayer shows that a § 16(b) suit premised on a sale of the property ―would have had an objectively reasonable chance of success.‖ after extensive analysis of the treatment of stock options under the exchange act, as applied to the facts, the court of appeals reversed the district court‘s judgment for the taxpayer and held that § 83(c)(3) did not apply to defer inclusion. however, it remanded the case to the district court for a determination of whether deferral was allowed under reg. § 1.83-3(k), which provides that ―property is subject to substantial risk of forfeiture and is not transferable so long as the property is subject to a restriction on transfer to comply with the ‗pooling-ofinterests accounting‘ rules set forth in accounting series release numbered 130 and ... 135.‖ the record was not fully developed regarding the existence and terms of any such restrictions. d. individual retirement accounts there were no significant developments regarding this topic during 2011. v. personal income and deductions a. rates there were no significant developments regarding this topic during 2011. b. miscellaneous income 1. a blackwater mercenary cannot exclude combat zone pay. holmes v. commissioner, t.c. memo. 2011-26 (1/31/11). the tax court (judge goeke) held that income received by a private contractor performing military duties in iraq during the iraq war was not excludable under § 112. section 112 applies only to members of the u.s. armed services and not to civilian employees of military contractors. 2. the irs uses taxpayer’s net losses at the casino to prove unreported gross income from other sources. pan v. commissioner, t.c. memo. 2011-40 (2/14/11). judge vasquez upheld the irs‘s reconstruction of unreported gross income determined in part based on currency transactions reports filed by foxwoods gambling casino. the nongambling gross income was determined to be at least equal to the taxpayer‘s net cash expenditures (chip purchases minus the sum of chip redemptions and complementary expenses) at the casino. 2012] recent developments in federal income taxation 259 3. no sympathy for veterans here. robinson v. commissioner, t.c. memo. 2011-59 (3/10/11). the tax court (judge wells) held that a pension received from the united states to a retired u.s. postal service worker, whose retirement was due to delayed effect of injuries received while serving in the military in vietnam, was not excludable under § 104(a)(4). the cause of the disability was irrelevant when determining eligibility for the pension. thus the disability payments the taxpayer received were not paid as compensation for personal injuries or sickness incurred in military service, which is a requirement for § 104(a)(4). 4. qui tam relator’s award is a taxable ―reward.‖ campbell v. commissioner, 658 f.3d 1255 (11th cir. 9/28/11), aff’g 134 t.c. 20 (1/21/10). the taxpayer recovered a gross award of $8.75 million as a relator in a qui tam action on behalf of the united states government against a military contractor and paid $3.5 million of attorney‘s fees, which amount was retained by the taxpayer‘s attorney to whom the $8.75 million had been remitted; the taxpayer received only $5.25 million from his attorney. the eleventh circuit affirmed the tax court‘s decision (judge wells) holding that the entire gross award of $8.75 million was includable in gross income, and the $3.5 million of attorney‘s fees was deductible as a miscellaneous itemized deduction. the court of appeals reasoned that the $8.75 million was in the nature of a ―reward.‖ the court of appeals also upheld the § 6662(b) substantial understatement penalty; even though the taxpayer filed a form 8275, there was neither reasonable cause nor substantial authority supporting the omission from gross income.  ―qui tam‖ is an abbreviation of the latin phrase ―qui tam pro domino rege quam pro se ipso in hac parte sequitor,‖ which means ―who pursues this action on our lord the king‘s behalf as well as his own.‖  the tax year involved in this case (2003) pre-dates the effective date of 2004 amendments to § 62(a), which now permits attorney‘s fees in a false claims act case to be an above-the-line deduction. 5. compensation to victims of human trafficking is tax-free. the irs would have been pilloried if it had ruled the other way. notice 2012-12, 2012-6 i.r.b. 365 (1/19/12). mandatory restitution payments awarded under 18 u.s.c. § 1593, which criminalizes (1) holding a person to a condition of peonage; (2) kidnapping or carrying away a person to sell the person into involuntary servitude or to be held as a slave, (3) providing or obtaining a person's services or labor by actual or threatened use of certain means including force, physical restraint, serious harm, and abuse of legal process, and (4) sex trafficking of children or by force, fraud, or coercion, are excluded from gross income. 260 florida tax review [vol. 12:5 6. the treasury department uses regulations to reverse a principle established in a supreme court decision that the government won. do mayo doubters think that the treasury exceeds its powers when it issues regulations giving away government victories in the supreme court? t.d. 9573, damages received on account of personal physical injuries or physical sickness, 77 f.r. 3106 (1/23/12). the treasury department has finalized proposed amendments (reg-127270-06, damages received on account of personal physical injuries or physical sickness, 74 f.r. 47152 (9/15/09)) to reg. § 1.104-1(c) under § 104(a)(2) to reflect amendments to § 104 and certain judicial decisions. the amended regulations provide that the § 104(a)(2) exclusion applies to personal physical injuries or physical sickness. emotional distress is not considered to be a physical injury or physical sickness. however, the regulations provide that damages for emotional distress attributable to a physical injury or physical sickness are excludable under § 104(a)(2). the regulations do not address loss of consortium or emotional distress from witnessing physical injury to another person. under the amended regulations, the term ―damages‖ means an amount received (other than workers‘ compensation) through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution. notably, the amended regulations eliminate the requirement in the prior regulations that to be excludable under § 104(a)(2) the damages must have been ―based upon tort or tort type rights.‖ thus, damages for physical injuries may qualify for exclusion under § 104(a)(2) even though the injury giving rise to the damages is not defined as a tort under state or common law. the reason for the change was the treasury department's concern that the supreme court‘s interpretation of the tort type rights test in united states v. burke, 504 u.s. 229 (1992), limiting the § 104(a)(2) exclusion to damages for personal injuries for which the full range of tort-type remedies is available, could preclude an exclusion under § 104(a)(2) for redress of physical personal injuries under a ―no-fault‖ statute that does not provide traditional tort-type remedies.  taxpayers may apply the amended regulations to amounts paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after 9/13/95 and received after 8/20/96. 7. it pays really big tax benefits to run your own church and give yourself two parsonage allowances. driscoll v. commissioner, 135 t.c. 557 (12/14/10) (reviewed, 7-6). the taxpayer (phillip driscoll) received a parsonage allowance from mighty horn ministries, inc., later known as phil driscoll ministries, inc., as the ministries, that was applied to the acquisition and maintenance of not only a principal residence but also a second home — a vacation residence. the irs 2012] recent developments in federal income taxation 261 disallowed a § 107 exclusion for the portion of the parsonage allowance received with respect to the second home — for four years amounts totaled over $400,000 — on the grounds that § 107(a) refers to ―a home‖ and that the legislative history limited the§ 107 exclusion to only one home. the tax court majority, in an opinion by judge chiechi (in which four judges joined), with four concurrences, rejected the irs‘s argument, stating ―[w]e find nothing in section 107, its legislative history, or the regulations under section 107, which, as respondent points out, all use the phrase ―a home,‖ that allows, let alone requires, respondent, or us, to rewrite that phrase in section 107.‖ the opinion pointed to § 7701(p)(1) [(m)(1) for the years at issue)], which refers to the definition in 1 u.s.c. § 1 that provides that in interpreting the united states code, the singular includes the plural, unless the context indicates otherwise.  judge gustafson, joined by five other judges, dissented, on the grounds that exclusions should be interpreted narrowly, and ―[t]he chance that congress in 1954 thought it was permitting the exclusion of multiple parsonage allowances seems remote.‖ a. reversed and remanded. a home means only one home. commissioner v. driscoll, 109 a.f.t.r.2d 2012-832 (11th cir. 2/8/12). in a per curiam opinion, the eleventh circuit held that the rental allowance taxpayers received for their second house was not excluded from income under § 107(2) because the proposition that singular terms also include their plural terms, contained in the dictionary act, 1 u.s.c. 1, does not apply if ―‗the context indicates otherwise‘‖ and the use of ―home‖ in § 107(2) ―has decidedly singular connotations.‖ c. hobby losses and § 280a home office and vacation homes 1. they did everything right except make money. blackwell v. commissioner, t.c. memo. 2011-188 (8/8/11). the taxpayer husband worked full time as a senior officer of a number of motorcycle, snowmobile, atv, and personal watercraft manufacturing companies. the wife taxpayer was involved in the couple‘s horse breeding and training activity. during the relevant years in which the couple conducted the horse activity, his salary income ranged from approximately $371,000 to over $1,200,000. the wife typically spent 15-20 hours a week on the horse activity and the husband typically spent two to five hours a week on the horse activity. over the years they acquired and sold over twenty horses. over a seven year period the activity lost over $500,000. judge swift held that they conducted the horse activity for a profit motive and that § 183 did not apply to limit their deductions. before starting the activity, they took over seven years learning about horse breeding and management before 262 florida tax review [vol. 12:5 attempting to start the operation. they were not ―absentee, aloof, or recreational horse owners.‖ the wife ―managed and worked diligently and daily on the horse activity, doing essentially all of the horse maintenance herself.‖ the taxpayers ―consulted expert horsemen, hired expert horse trainers to assist in training the horses, advertised, showed the horses, and paid significant stud fees to have their mares bred with stallions which they regarded as having good bloodlines.‖ they made adjustments to their business plan, maintained reasonably good books and records for the activity, and, after seven years of losses, terminated the activity. ―the time, effort, and financial resources [the taxpayers] personally put into and invested in their ... horse activity are not indicative of a hobby; rather, they are indicative of a for-profit activity.‖ d. deductions and credits for personal expenses 1. singing ♬ ―i’m a yankee doodle dandy‖♪ supports some of the claimed deductions for which no records were available. zilberberg v. commissioner, t.c. memo. 2011-005 (1/5/11). judge wherry applied the cohan rule [cohan v. commissioner, 39 f.2d 540 (2d cir. 1930)] with respect to deductible personal expenses. the taxpayer was allowing $3,000 of a claimed $5,000 § 217 moving expense deduction, even though he had inadequate records, because he established that he had moved for employment purposes and that he had incurred some expenses. he was also allowed $15,500 of a claimed $36,250 § 165(c)(3) casualty loss deduction with respect to his residence, where his records were destroyed in the hurricane that gave rise to the casualty. 2. this ruling is expressly for lactating mothers. announcement 2011-14, 2011-9 i.r.b. 532 (2/10/11). this announcement held that breast pumps and supplies that assist lactation are medical care under § 213(d) because ―they are for the purpose of affecting a structure of the body of the lactating woman.‖ the announcement did not refer at all to the health of the baby. a. making what was recently held to be a deductible medical expense into a mandatory freebee. a new mandate under obamacare makes all this stuff mandatory for group plans, as well as miraculously free for the insureds. t.d. 9541, group health plans and health insurance issuers relating to coverage of preventive services under the patient protection and affordable care act, 76 f.r. 46621 (8/3/11). temp. reg. § 54.9815-2713t(a)(1)(iv) requires coverage by all group plans of contraceptive, breast-feeding and many other services for women without co-pays and without deductibles. reg-120391-10, group health plans and health insurance issuers relating to coverage of 2012] recent developments in federal income taxation 263 preventive services under the patient protection and affordable care act, 76 f.r. 46677 (8/3/11), promulgates identical proposed regulations. the effective date is 8/1/12. 3. is this a casualty loss in limbo? alphonso v. commissioner, 136 t.c. 247 (3/16/11). the taxpayer owned stock in a n.y. cooperative housing corporation from which she rented an apartment as her personal residence. when a retaining wall on the grounds of the apartment complex collapsed, the corporation levied an assessment for the cost of repairs, and the taxpayer paid $26,390, with respect to which she claimed a casualty loss deduction of $23,188 (reflecting computational limitations in § 163(h)). the irs disallowed the deduction, and the tax court (judge chiechi) upheld the disallowance. judge chiechi reasoned that under the relevant state law and controlling legal instruments, the taxpayer had no property interest in the retaining wall, which was part of the common grounds – nothing in the lease, the corporation charter and by-laws, or any other governing documents indicated that the taxpayer possessed a leasehold interest, an easement, or any other property interest in the common grounds. finally, judge chiechi rejected the taxpayer‘s argument that § 216, which allows cooperative apartment owners to deduct their shares of the real estate taxes and mortgage interest paid by the cooperative corporation, should be extended by judicial interpretation to casualty losses. although judge chiechi rejected the irs‘s argument that the absence of a reference to casualty losses in § 216 conclusively determined that it did not apply to casualty losses, after examining the legislative history she concluded that congress intended § 216 to apply only to interest and real estate taxes. 4. a pang of tax pain. pang v. commissioner, t.c. memo. 2011-55 (3/9/11). the tax court (judge gustafson) upheld the disallowance by the irs of the taxpayer‘s claim of a § 165(c)(3) casualty loss deduction for damages paid to the plaintiff in a wrongful death suit against the taxpayer, citing whitney v. commissioner, 13 t.c. 897 (1949). to be a casualty loss the taxpayer‘s own property must be damaged or stolen, which did not occur in this case. 5. the irs tries to defy national middle-income income housing policy and be too stingy with the first time homebuyer credit and, as a result, gets slapped down by the tax court. woods v. commissioner, 137 t.c. 159 (10/27/11). the taxpayer entered into a contract for deed to purchase a house in 2008, took possession of the house in 2008, and claimed the § 36 first-time homebuyer credit for 2008. the house required renovations before being ready for occupancy, and the intended to use the credit proceeds to pay for the necessary renovations. he received a refund for the credit in 2009 and began renovations. the irs subsequently 264 florida tax review [vol. 12:5 denied the credit on the grounds that the taxpayer was not entitled to the credit because (1) the taxpayer took possession of the house under a contract for deed and therefore had not ―purchased‖ the house, and (2) even if the ―purchase‖ requirement was satisfied the house was not the taxpayer‘s ―principal residence‖ in 2008 for purposes of § 36. the tax court (judge haines) held for the taxpayer (who represented himself pro se). first, under state (texas) property law, the contract for deed conferred equitable title to the house on the taxpayer, and therefore he had ―purchased‖ the house. second § 36 requires a prospective analysis, asking whether a taxpayer will occupy a house as a principal residence. because the taxpayer established that he intended to occupy the house as his principal residence as soon as the necessary renovations were complete, he was entitled to the first-time homebuyer tax credit for 2008. 6. only in the irc can ―first-time‖ mean not within the past three years, but these taxpayers still weren’t ―property virgins.‖ foster v. commissioner, 138 t.c. no. 4 (1/30/12). the taxpayers bought a home on july 28, 2009 and claimed the temporary, then-in-effect § 36 firsttime homebuyer credit. they had listed their previously-owned house for sale in february 2006 and spent ―considerable time‖ at one of their parents‘ house; the taxpayers sold their old house on june 6, 2007 and rented an apartment that month. the tax court (judge foley held that the taxpayers did not qualify for the credit. under § 36(c)(1), a ―first-time homebuyer‖ is any individual who has not owned a principal residence for three years prior to the date of purchase of a new principal residence. thus, the taxpayer‘s could have qualified if they had not owned a principal residence after july 27, 2006, and before july 28, 2009 (i.e., the period three years prior to the purchase of their new house). although the taxpayers owned the old house until june 6, 2007, they argued that they ceased using it as their principal residence in february 2006. judge foley found that the taxpayers‘ original home remained their principal residence through at least july, 2006 – a date within the three years preceding the purchase of the new home – because until it is was sold the original home was fully furnished, and taxpayers maintained utility services, frequently stayed overnight, hosted family holiday gatherings, kept personal belongings, accessed the internet, and received bills and correspondence at that home, as well as listing it as the address for renewing a driver‘s license and filing federal income tax returns. e. divorce tax issues 1. he was on the hook for the mortgage even if she died, so paying the mortgage wasn’t alimony. moore v. commissioner, t.c. memo. 2011-200 (8/16/11). judge vasquez held that the payment by the husband of the mortgage debt on the martial home pursuant to the 2012] recent developments in federal income taxation 265 divorce instrument was not deductible as alimony. because neither the divorce instrument nor state law provided that the husband‘s obligation to pay the debt would be terminated by the wife‘s death, the condition in § 71(b)(1)(d) had not been met. f. education there were no significant developments regarding this topic during 2011. g. alternative minimum tax there were no significant developments regarding this topic during 2011. vi. corporations a. entity and formation 1. did the tax court hint that moline properties might trump the economic substance doctrine, or did it merely conclude that a corporation that passes muster under moline properties has ―economic substance?‖ weekend warrior trailers, inc. v. commissioner, t.c. memo. 2011-105 (5/19/11). the sole shareholder of the taxpayer corporation, which manufactured travel trailers, established a sibling corporation (leading edge) to provide design and management services, to be performed by the taxpayer‘s shareholder as an employee of leading edge (while he also continued to serve as a managerial employee of the taxpayer), for the taxpayer‘s manufacturing operations. leading edge elected to be an s corporation. the taxpayer also transferred its employees to leading edge, which then leased the employees to the taxpayer. the shareholder then sold almost all of the stock of leading edge to an esop, of which he was the sole beneficiary. the taxpayer made substantial payments (millions of dollars) to leading edge for management services. when § 409(p) was amended to eliminate the tax benefits of the structure, in june 2004 leading edge repurchased its shares from the esop. the irs disallowed the taxpayer‘s management fee deductions for 2002 through 2004 on the grounds that (1) leading edge ―‗should be disregarded for federal income tax purposes as leading edge design, inc. lacked both economic substance and economic purpose and was formed for the primary purpose of obtaining tax benefits‘, and (2) ‗transactions entered into between leading edge design, inc. and weekend warrior trailers, inc. should be disregarded for federal income tax‘ purposes because they lacked economic substance and economic purpose and were entered into for the primary purpose of obtaining tax 266 florida tax review [vol. 12:5 benefits.‖ at trial the irs also argued that the sale of the leading edge stock to the esop had no business purpose. applying the moline properties doctrine (moline properties v. commissioner, 319 u.s. 436 (1943)), judge marvel held for the taxpayer, stating as follows: even if a corporation was not formed for a valid business purpose, it nevertheless must be respected for tax purposes if it actually engaged in business activity. see moline props., inc. v. commissioner, 319 u.s. at 438-439; bass v. commissioner, [50 t.c. 595, 602 (1968)]. the prongs of the test under moline props. are alternative prongs. see moline props., inc. v. commissioner, supra at 438-439; bass v. commissioner, supra at 602; see also rogers v. commissioner, t.c. memo. 1975-289 (―moline establishes a two-pronged test, the first part of which is business purpose, and the second, business activity. *** business purpose or business activity are alternative requirements.‖). accordingly, the issue turns on whether leading edge engaged in business activity. whether a corporation is carrying on sufficient business activity to require its recognition as a separate entity is a question of fact. bass v. commissioner, supra at 602 (status of a corporation respected when testimony established that ―the corporation was managed as a viable concern, and not as simply a lifeless facade.‖)  judge marvel then concluded that, on the record, leading edge was not a ―lifeless facade.‖ nevertheless, the taxpayer‘s scheme failed because judge marvel went on to hold that the evidence did not prove that the management fees paid by weekend warrior to leading edge were necessary or reasonable.  b. distributions and redemptions there were no significant developments regarding this topic during 2011. c. liquidations there were no significant developments regarding this topic during 2011. d. s corporations 1. despite wildly disproportionate distributions, with no evidence of corrective distributions, the corporation was still an 2012] recent developments in federal income taxation 267 s corporation. miller v. commissioner, t.c. memo., 2011-189 (8/9/11). the taxpayer reported that he had gifted 95 percent of the stock of his s corporation, having a basis of $823,450, to his son in 2002, leaving the taxpayer with a basis of only $43,339 in his remaining stock. for 2003 the corporation‘s original tax return allocated 5 percent of its $366,162 of income ($18,308) to the taxpayer and 95 percent to the son. in 2003 the corporation distributed $619,551 to the taxpayer and $385,692 to the taxpayer‘s son. after audit, the irs determined that the taxpayer had received distributions of $548,664 that exceeded his basis in the stock. the parties stipulated that the corporation was an s corporation, despite the disproportionate distributions. judge cohen rejected the taxpayer‘s argument that because of the disproportionate distributions, the events should be recharacterized to treat the effective date of the transfer of stock from the taxpayer to his son as occurring after the disproportionate distributions. accordingly, the deficiency was upheld. 2. poison pill warrants issued in an s corporation tax shelter scheme turn truly poisonous to s corporation status. santa clara valley housing group, inc. v. united states, 108 a.f.t.r.2d 20116361 (n.d. cal. 9/21/11). the stock of santa clara valley housing group, inc. (scvhg) originally was held by a husband and wife and their children. to implement a kpmg tax shelter product known as the s corporation charitable contribution strategy (sc2), scvhg recapitalized itself so as to have 100 shares of voting stock and 900 shares of nonvoting stock. scvhg also issued to each shareholder a warrant to purchase ten shares of nonvoting stock for each share of voting stock (which was tax-free under § 305(a)). the warrants were issued solely to protect the original shareholders‘ interest in scvhg while they engaged in the sc2 strategy. (the warrants protected against the possibility that the donee charity would refuse to sell its stock back to the original shareholders after the agreed-upon length of time, because if the warrants were exercised, the warrants would dilute the stock held by the charity to such an extent that the original shareholders would end up owning approximately 90 percent of the outstanding shares.) thereafter, the shareholders transferred all of the nonvoting stock to stock to the city of los angeles safety members pension plan (clasmpp), a tax-exempt entity as a ―donation,‖ with the understanding that clasmpp would sell the shares back after a certain period of time. while clasmpp held the stock, scvhg reported over $114 million of income, of which more than $100 million was passed through to clasmpp, but clasmpp received distributions of only $202,500, representing .02 percent of the income allocated to clasmpp. after four years, clasmpp sold the 900 shares of stock back to the original shareholders for $1,645,002, and the warrants were cancelled. the irs concluded that the transaction was an abusive tax shelter. the irs concluded that under reg. § 1.1361-1(l)(4)(ii) the warrants constituted a second class of 268 florida tax review [vol. 12:5 stock in scvhg and scvhg‘s status as an s corporation was terminated and issued a deficiency notice based upon treating scvhg as a c corporation. the district court agreed with the irs. the warrants ―constitute equity,‖ and were intended to prevent clasmpp ―from enjoying the rights of distribution or liquidation that ordinarily would come with ownership of the majority of a successful company‘s shares.‖ thus the warrants were a second class stock and scvhg‘s s corporation status was terminated. however, the warrants were not a second class of stock under reg. § 1.13611(l)(4)(iii), which provides that options are a second class if, under the facts and circumstances, (1) the option is substantially certain to be exercised and (2) has an exercise price substantially below the fair market value of the underlying stock on the date the option is issued. in this case it was never intended that the options be exercised; they were a ―poison pill.‖ a. reconsidered. santa clara valley housing group, inc. v. united states, 109 a.f.t.r.2d 2012-554 (n.d. cal. 1/18/12). on reconsideration of its summary judgment, the court determined that there is a triable issue of fact whether the warrants are protected from being treated as a second class of stock under the safe harbor of reg. § 1.13611(f)(4)(iii)(c), which provides that a call option will not be treated as a second class of stock if the strike price is at least 90 percent of the fair market value of the underlying stock on the date the option is issued, transferred to an ineligible shareholder, or materially modified. the regulation also directs that a good faith determination of value will be respected unless it can be shown that the valuation was substantially in error and the determination was not made with reasonable diligence. the court indicated that there is conflicting evidence regarding the value of the stock at the time the warrants were issued. e. mergers, acquisitions and reorganizations 1. this case decided under old case law might come out differently if decided under new regulations. ralphs grocery co. v. commissioner, t.c. memo. 2011-25 (1/27/11). this case involved the validity of a joint § 338(h)(10) election with respect to the transfer of the stock of a subsidiary in the course of a chapter 11 bankruptcy proceedings of its parent corporations, in which the stock of the subsidiary was eventually distributed to parent corporation‘s creditors. the question was whether the transfer was a sale and purchase, as argued by the taxpayer, or a tax-free reorganization, as argued by the irs. the tax court (judge chiechi) held that the § 338(h)(10) election was valid, because the acquisition of stock was a purchase as defined in § 338(h)(3) and a qualified stock purchase under § 338(d)(3), and rejecting the irs‘s claim that it was a reorganization. the irs‘s argument was based on the fact that the consideration received by the 2012] recent developments in federal income taxation 269 transferor corporations was stock of the transferee corporation, and that although the stock received was transferred to creditors, under helvering v. alabama asphaltic limestone co., 315 u.s. 179 (1942), the creditors were equity holders of the parent corporations for continuity-of-interest purposes. judge chiechi found the continuity of interest requirement not to have been satisfied, distinguishing alabama asphaltic. judge chiechi found that alabama asphaltic and its progeny differed from the instant case because in those cases the creditors had instituted involuntary bankruptcy proceedings or took other ―proactive‖ steps to ―take ‗effective command‘‖ over the corporation‘s assets. in this case, however, the chapter 11 proceeding was voluntary, and ―none of the ... creditors took any proactive steps to enforce or protect their respective rights to payment ... of their respective debts.‖ thus, the acquisition of ralphs‘ stock was a purchase as defined in § 338(h)(3) and a qualified stock purchase under § 338(d)(3), and consequently the § 338(h)(10) election was valid.  note that if this transaction had occurred in a later year in which reg. § 1.368-1(e)(6) would have controlled (on and after 12/12/08), the determination of whether the continuity of interest requirement for a reorganization was satisfied, and the result might have differed. to treat the creditors as holders of a proprietary interest for continuity of interest purposes, reg. § 1.368-1(e)(6) does not require that the creditors have instituted involuntary bankruptcy proceedings or have taken other ―proactive‖ steps to ―take ‗effective command‘‖ over the corporation‘s assets. reg. § 1.368-1(e)(6) simply provides that ―[a] claim of the most senior class of creditors receiving a proprietary interest in the issuing corporation and a claim of any equal class of creditors will be treated as a proprietary interest ... .‖ none of us has had the patience to wade through the pages and pages of fact findings in the case to try to figure out what the result actually might have been had the current regulations applied. 2. the ninth circuit finds basis in rights created from the collapse of the savings and loan industry in the 1970s: the hell with § 362(b). washington mutual inc. v. united states, 636 f.3d 1207 (9th cir. 3/3/11). the taxpayer, as the successor corporation to home savings of america, filed a refund action claiming amortization deductions for certain rights, and loss deductions for abandonment of branching rights, created in a § 368(a)(1)(g) reorganization by the federal savings and loan insurance corporation (fslic) in which home savings acquired three failed savings and loan associations in a transaction structured. the district court granted summary judgment to the irs, concluding that home savings had no basis in the rights. the ninth circuit reversed and remanded, disagreeing with the district court‘s conclusion regarding basis. as part of the acquisition of the three failed thrifts in a supervisory merger transaction structured as a type g reorganization, fslic entered into an ―assistance agreement‖ with home 270 florida tax review [vol. 12:5 savings that included, among other things, approval for home savings to establish branches in florida and missouri as if home savings maintained its home office in those states, and approval of the purchase method of accounting under which home savings was permitted to apply a percentage of acquired intangible assets in its deposit base and for amortization of the remainder over forty years. the ninth circuit accepted the taxpayer‘s argument and concluded that the excess of liabilities of the acquired thrifts over the value of assets represented a cost that was consideration for the rights represented in the assistance agreement in the integrated transaction, and concluded that allowing the taxpayer a cost basis was not inconsistent with characterizing the transaction as a § 368(a)(1)(g) reorganization, notwithstanding the transferred basis rule of § 362(b). the court rejected the irs‘s assertion that ―recognizing home savings a cost basis in the rights based on the assumption of fslic‘s liabilities requires characterizing some of the acquired thrifts‘ liabilities as fslic‘s liabilities, because home savings did not pay fslic or the bank board separate consideration for the rights.‖ the district court concurred with the irs position holding that the excess liabilities of the acquired thrifts were the same as fslic‘s insurance liabilities which remained liabilities of fslic. the ninth circuit reasoned that home savings received a generous incentive package, the cost of which was the excess of the failing thrifts liabilities over the value of their assets. a concurring opinion argued that the acquired rights had a fair market value basis as acquired directly from fslic in exchange for taking over the liabilities of the failed thrifts. the ninth circuit remanded the case to the district court to determine the proper amortization amounts for the intangibles and the amount of abandonment loss for the branch rights. 3. the irs tells corporations how to determine transferred basis when they don’t know who the transferors were. rev. proc. 2011-35, 2011-25 i.r.b. 890 (6/1/11), amplified and modified by rev. proc. 2011-42, 2011-37 i.r.b. 318 (8/19/11). the irs has published revised procedures that update, revise, and replace the survey methodology of rev. proc. 81-70, 1981-2 c.b. 729, for corporations to determine the basis of the stock of a target corporation acquired in a tax free reorganization in which the acquirer takes a transferred basis, i.e., in § 368(a)(1)(b) reorganizations and § 368(a)(2)(e) reorganizations that could have qualified as a § 368(a)(1)(b) reorganization (if the acquirer elects a transferred basis). these new procedures in part reflect the fact that shares are often held by nominees under confidentiality agreements not to disclose true ownership. the revenue procedure provides safe harbors to determine the basis of shares acquired from various categories of transferring shareholders, including reporting shareholders, registered non-reporting shareholders, and nominees. the revenue procedure describes methodologies for determining the basis of acquired shares. the acquiring corporation may follow procedures for 2012] recent developments in federal income taxation 271 surveying all surrendering target shareholders, use a statistical sampling when a full survey is not feasible, or use one of two statistical sampling techniques when specified criteria are met. an acquiring corporation may use a different methodology as agreed between the irs and the acquiring corporation. however, if the acquiring corporation has actual knowledge of a surrendering shareholder‘s basis in acquired stock, that basis must be used for the acquired shares. a. tracking the basis of nonexistent stock ain’t easy. t.d. 9558, corporate reorganizations; allocation of basis in ―all cash d‖ reorganizations, 76 fr 71878 (11/21/11). temp. reg. § 1.358-2t deals with stock basis in all cash type d reorganizations under reg. § 1.368-2(l). if an actual shareholder of the acquiring corporation is deemed to receive a nominal share of stock of the issuing corporation described in reg. § 1.368-2(l), that shareholder must, after allocating and adjusting the basis of the nominal share in accordance with the rules of reg. § 1.358-1, and after adjusting the basis in the nominal share for any transfers described in reg. § 1.358-1, designate the share of stock of the acquiring corporation to which the basis, if any, of the nominal share will attach. under these rules, the ability to designate the share of stock of the acquiring corporation to which the basis of the surrendered stock or securities of the target will attach applies only to a shareholder that actually owns shares in the issuing corporation. thus, for example, if in an all cash d reorganization, y corporation, a first tier subsidiary of p corporation, acquires the assets of t corporation, a second tier subsidiary of p corporation, owned by x corporation, a first tier subsidiary of p corporation, x corporation cannot designate any share of y corporation stock to which the basis, if any, of the nominal share of y corporation stock will attach; and p corporation cannot designate a share of y corporation stock to which basis will attach because p corporation‘s basis in the nominal share of y corporation stock (deemed to have been distributed to it by x corporation) is zero (its fair market value). 4. this district court decision, if followed, makes it much much more difficult ever to have personal goodwill as an employee-shareholder. howard v. united states, 106 a.f.t.r.2d 20105533 (e.d. wash. 7/30/10). the taxpayer was a dentist who practiced through a solely owned (before taking into account community property law) professional corporation until the practice was sold to a third party. he had an employment agreement with the corporation with a noncompetition clause that survived for three years after the termination of his stock ownership. the purchase and sale agreement allocated $47,100 to the corporation‘s assets, $549,900 for the taxpayer-shareholder‘s personal goodwill, and $16,000 in consideration of his covenant not to compete with the purchaser. the corporation did not ―dissolve‖ until the end of the year following the sale. 272 florida tax review [vol. 12:5 the taxpayer reported $320,358 as long-term capital gain income resulting from the sale of goodwill (the opinion does not explain how the remainder of the sales price was reported), but the irs recharacterized the goodwill as a corporate asset and treated the amount received by the taxpayer from the sale to the third party as a dividend from the taxpayer‘s professional service corporation. because the sale occurred in 2002, when dividends were taxed at higher rate than capital gains, a deficiency resulted. the government‘s position was based on three main reasons: (1) the goodwill was a corporate asset, because the taxpayer was a corporate employee with a covenant not to compete for three years after he no longer owned any stock; (2) the corporation earned the income, and correspondingly earned the goodwill; and (3) attributing the goodwill to the taxpayer-shareholder did not comport with the economic reality of his relationship with the corporation. after reviewing the principles of norwalk v. commissioner, t.c. memo. 1998279, and martin ice cream co. v. commissioner, 110 t.c. 189 (1998), the court held that because the taxpayer was the corporation‘s employee with a covenant not to compete with it, any goodwill generated during that time period was the corporation‘s goodwill. the court also rested its holding that the goodwill was a corporate asset on its conclusions that the income associated with the practice was earned by the corporation and the covenant not to compete, which extended for three years after the taxpayer no longer owned stock in the corporation, rendered any personal goodwill ―likely [of] little value.‖  see solomon v. commissioner, t.c. memo. 2008-102, for an extended discussion of the issues underlying an attempted sale of individual goodwill. a. affirmed – ―dr. howard has offered no compelling reason why he should be let out of the corporate structure he chose for his dental practice.‖ 448 fed. appx. 752 (9th cir. 8/29/11). the ninth circuit affirmed the district court in an opinion that contains an elegantly concise summary of the current state of the law. goodwill ―is the sum total of those imponderable qualities which attract the custom of a business, — what brings patronage to the business.‖ grace brothers v. comm’r, 173 f.2d 170, 175-76 (9th cir. 1949). for purposes of federal income taxation, the goodwill of a professional practice may attach to both the professional as well as the practice. see, e.g., schilbach v. comm’r, 62 t.c.m. (cch) 1201 (1991). where the success of the venture depends entirely upon the personal relationships of the practitioner, the practice does not generally accumulate goodwill. see martin ice cream co. v. comm’r, 110 t.c. 189 at 207–08 (1998). the professional may, however, transfer his or her 2012] recent developments in federal income taxation 273 goodwill to the practice by entering into an employment contract or covenant not to compete with the business. see, e.g., norwalk v. comm’r, 76 t.c.m. (cch) 208, *7 (1998) (finding that there is no corporate goodwill where ―the business of a corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation‖) (emphasis added); martin ice cream co., 110 t.c. at 207-08 (finding that ―personal relationships ... are not corporate assets when the employee has no employment contract [or covenant not to compete] with the corporation‖) (emphasis added); macdonald v. comm’r, 3 t.c. 720, 727 (1944) (finding ―no authority which holds that an individual‘s personal ability is part of the assets of a corporation ... where ... the corporation does not have a right by contract or otherwise to the future services of that individual‖) (emphasis added). in determining whether goodwill has been transferred to a professional practice, we are especially mindful that ―each case depends upon particular facts. and in arriving at a particular conclusion ... we ... take into consideration all the circumstances ... [of] the case and draw from them such legitimate inferences as the occasion warrants.‖ grace brothers v. comm’r, 173 f.2d 170, 176 (9th cir. 1949).  looking at the facts as found by the district court, the ninth circuit concluded that ―while the relationships that dr. howard developed with his patients may be accurately described as personal, the economic value of those relationships did not belong to him, because he had conveyed control of them to the howard corporation.‖ furthermore, the court rejected the taxpayer‘s argument that the purchase and sale agreement impliedly terminated both the employment contract and the non-competition agreement, thereby transferring the accumulated goodwill of the practice back to dr. howard, added that even if it accepted that argument, ―such a release would constitute a dividend payment, the value of which would be equivalent to the price paid for the goodwill of the dental practice.‖ 5. ―[a]doption of these exceptions [to § 382(g)] is appropriate because these transactions do not introduce new capital into the loss corporation and because direct or indirect ownership of the loss corporation becomes less concentrated, thus diminishing the opportunity for loss trafficking.‖ reg–149625–10, application of the segregation rules to small shareholders, 76 f.r. 72362 (11/23/11). the treasury department has published proposed amendments to reg. § 1.382-3 274 florida tax review [vol. 12:5 that would reduce the complexity of applying § 382 in tracking transactions involving small amounts of stock of a loss corporation. reg. § 1.382-3 currently provides that all shareholders who do not individually own five percent of a loss corporation are grouped together and treated as a single ―public group‖ five-percent shareholder. however, current temp. reg. § 1.382-2t segregates into two or more public groups any public group of less than five percent stockholders that can be separately identified as having acquired their stock in a particular transaction. the proposed regulations would provide that the segregation rule does not apply to transfers of a loss corporation‘s stock to non-five-percent shareholders by fivepercent shareholders, or entities that directly or indirectly own at least five percent of a loss corporation whose owners (excluding those who are five percent shareholders of a loss corporation) own, in the aggregate, five percent or more of a loss corporation. the proposed regulations also would provide that the segregation rules do not apply to transfers of ownership interests in fivepercent entities to shareholders who are not themselves five-percent shareholders. the proposed regulations also provide a special exception under which a loss corporation may annually redeem ten percent of the value of its stock, or 10 percent of the shares of a particular class of stock, without triggering the segregation rules and the creation of new 5 percent groups. under the proposed regulations, transactions that under the current rules result in the creation of a new public group, and thus a possible owner shift, simply will be folded into the existing public groups, thereby reducing the chance of an ownership change. 6. corporate shareholders knew what midcoast’s midco deal was all about. transferee liability imposed. feldman v. commissioner, t.c. memo. 2011-297 (12/27/11). the tax court (judge swift) upheld transferee liability against the shareholders of a corporation who sold the stock of the corporation engaged in a purported stock sale to a midco (the infamous midcoast) to avoid recognition of gain from earlier sale of the corporation‘s assets. the transaction was structured as a stock redemption for cash after the asset sale, with the remainder of the stock being sold in the same taxable year of the corporation to a midco that purported to shelter the gains with losses from purported distressed debt tax shelter transactions. the purported stock sale ―lack[ed] both business purpose and economic substance‖ and was disregarded for federal income tax purposes. ―the substance of the transaction was a liquidation [of the corporation] and a fee payment to midcoast for its role in facilitating the sham.‖ the court specifically noted that the taxpayers took no actions to ensure that the corporate income tax liability triggered by the asset sale would be paid, and that it remained unpaid. 2012] recent developments in federal income taxation 275 a. a different tax court judge sees a somewhat differently structured midcoast deal as immune from transferee liability. frank sawyer trust of may 1992 v. commissioner, t.c. memo. 2011-290 (12/ 27/11). the tax court (judge goeke) refused to uphold transferee liability against the shareholders of a corporation who sold the stock of the corporation engaged to a midco (fortrend, which was brought into the deal by the infamous midcoast to provide financing) after an asset sale. he found that the shareholders knew little about the mechanics of the transaction and exercised due diligence. the trust representatives believed fortrend‘s attorneys to be from prestigious and reputable law firms. they assumed that fortrend must have had some method of offsetting the taxable gains within the corporations. they performed due diligence with respect to fortrend to ensure that fortrend was not a scam operation and that fortrend had the financial capacity to purchase the stock. the trust representatives believed fortrend assumed the risk of overpaying for the taxi corporations if they did not have a legal way for offsetting or reducing the tax liabilities.  judge goeke applied state fraudulent conveyance law to determine whether the transactions should be collapsed and concluded that they should not, because the irs, which has the burden of proof in transferee liability cases, did not prove that ―the purported transferee had either actual or constructive knowledge of the entire scheme.‖ because in this case the transaction was structured in such a manner that the corporation never made any payments to the shareholders, there was no actual or constructive fraudulent transfer to the shareholders. finally, turning to federal tax law, judge goeke held that ―substance over form and its related doctrines [were] not applicable,‖ because the transaction was an arm‘s length stock sale between the shareholders and a purchaser in which the parties agreed that the purchaser would be responsible for reporting and paying the corporation‘s income taxes. ―there was no preconceived plan to avoid taxation ... .‖ judge goeke distinguished feldman v. commissioner, t.c. memo. 2011-297 (12/27/11), supra, because in that case ―[i]t was ‗absolutely clear‘ that the taxpayer was aware the stock purchaser had no intention of ever paying the tax liabilities [and] the taxpayer did not conduct thorough due diligence of the stock purchaser ... .‖ 7. when to measure the value of consideration to determine whether continuity of interest exists: it is the business day before the day on which the binding contract is entered into. continuity of interest regulations revised, finally! t.d. 9565, corporate reorganizations; guidance on the measurement of continuity of interest, 76 f.r. 78540 (12/19/11). the treasury department finalized, with only minor 276 florida tax review [vol. 12:5 changes, prop. reg. § 1.368-1(e)(2), reg-146247-06, corporate reorganizations; guidance on the measurement of continuity of interest, 72 f.r. 13058 (3/20/07), which were identical to temp. reg. § 1.368-1(e)(2), which had expired on 3/19/10. reg. § 1.368-1(e)(2)(i) provides that for purposes of determining whether shareholders received a sufficient proprietary interest in the acquiring corporation, the value of consideration received in a reorganization is determined as of the last business day before the contract is binding, if the contract provides for fixed consideration. under reg. § 1.368-1(e)(2)(iii)(a), a contract provides for fixed consideration if it specifies the number of shares of the acquiring corporation, the amount of money, and the other property (identified by value or by description) that is to be exchanged for the stock of the target corporation. with an orwellian flourish, reg. § 1.368-1(e)(2)(iii)(c)(1) states that ―a contract that provides for contingent consideration will be treated as providing for fixed consideration if it would satisfy the requirements of paragraph (e)(2)(iii)(a) of this section without the contingent adjustment provision.‖ reg. § 1.3681(e)(2)(iii)(c)(2) adds that contingent consideration will not be fixed consideration if the adjustments prevent the target shareholders from being subject to the economic benefits and burdens of ownership of the acquiring corporation stock as of the last business day before a binding contract. thus, adjustments that reflect changes in the value of the stock or assets of the acquiring corporation at a later date will prevent the contract from being treated as providing for fixed consideration. the preamble to the temporary regulations, t.d. 9316, 72 f.r. 12974 (2007), suggested that the contingent consideration provision allows adjustments to the consideration that do not decrease the ratio of the value of the shares of the acquiring corporation to the value of money or other property delivered to the target shareholders relative to the ratio of the value of the target stock to the value of the money or other property that would be delivered to the target shareholders if none of the contingent consideration were delivered.  under temp reg. § 1.3681(e)(2)(iii)(b), if the target corporation‘s shareholders may elect to receive either stock or money, the contract provides for fixed consideration if the determination of the number of shares of issuing corporation stock to be provided to the target corporation shareholder is based on the value of the issuing corporation stock on the last business day before the first date there is a binding contract. the preamble to the temporary regulations indicates that the irs and treasury department believe that if shareholders have an election to receive stock of the acquiring corporation at an exchange rate based on the value of the acquiring corporation stock on the date of a binding contract, the target shareholders are at risk for the economic benefits and burdens of ownership of the acquiring corporation stock as of the contract date. thus, the preamble concludes that it is appropriate to value the stock of the acquiring corporation as of the signing date for purposes of testing continuity of interest. 2012] recent developments in federal income taxation 277 reg. § 1.368-1(e)(2)(v), ex. (9) provides an example of the application of the shareholder election.  reg. § 1.368-1(e)(2)(ii)(a) provides that a binding contract is an instrument enforceable under applicable law. however, the presence of a condition outside of the control of the parties, such as a requirement for regulatory approval, will not prevent an instrument from being treated as a binding contract. reg. § 1.368-1(e)(2)(ii)(c) provides rules pursuant to which a tender offer can be considered to be a binding contract, even though it is not enforceable against the offerees, if certain conditions are met. the regulations also provide for modifications of a binding contract. if the contract is modified to change the amount or type of consideration that the target shareholders would receive, the date of the modification becomes a new signing date for purposes of testing for continuity of interest. reg. § 1.3681(e)(2)(ii)(b)(1). however, if in a transaction that provides for adequate continuity of interest, the contract is modified to increase the amount of stock of the acquiring corporation to be delivered to the target shareholders, or to decrease the amount of cash or value of other property, then the modification will not be treated as a modification of the binding contract. reg. § 1.3681(e)(2)(ii)(b)(2). similarly, in a transaction that does not qualify as a reorganization for failure to meet the continuity of interest requirement, a modification that reduces the number of shares of stock to be received by the target shareholders, or increases the amount of money or value of property, will not be treated as a modification of the binding contract so that the consideration will continue to be valued as of the signing date. reg. § 1.368-1(e)(2)(ii)(b)(3). reg. § 1.368-1(e)(2)(iii)(d) provides that stock that is escrowed to secure customary pre-closing covenants and representations and warranties is not treated as contingent consideration, which would render the safe harbor unavailable. however, escrowed consideration that is forfeited, is not taken into account in determining whether the continuity of interest requirement has been met. reg. § 1.368-1(e)(2)(iv), ex. 2.  notice 2010-25, 2010-1 c.b. 527 (3/17/10), provided that, until the issuance of new regulations, taxpayers could choose (subject to strict consistency rules) to apply the proposed regulations after the expiration of the temporary regulations. the ability of taxpayers to elect to apply the rules of the proposed regulations, as provided in the notice, is incorporated into reg. § 1.368-1(e)(9)(ii). a. still work left to be done. isn’t that always true? reg-124627-11, corporate reorganizations; guidance on the measurement of continuity of interest, 76 f.r. 78591 (12/19/11). the treasury department has published prop. reg. § 1.368-1(e)(2)(vi), under which application of the signing date principles for determining whether continuity of interest is satisfied would be expanded. the proposed regulations would also permit the use of an average value for issuing 278 florida tax review [vol. 12:5 corporation stock, in lieu of the value of issuing corporation stock on the closing date, in certain circumstances. an average value could ―be used if it is based on issuing corporation stock values occurring after the signing date and before the closing date, and the binding contract utilizes the average price, so computed, in determining the number of shares of each class of stock of the issuing corporation, the amount of money, and the other property to be exchanged for all the proprietary interests in the target corporation, or to be exchanged for each proprietary interest in the target corporation.‖ this rule applies signing date rule ―principles,‖ because ―the target shareholders become subject to the fortunes of the issuer‘s stock across the range of dates being averaged.‖  the proposed regulations would apply to transactions occurring on or after they are finalized, unless the transaction was completed pursuant to a binding agreement that was in effect immediately before the date such final regulations are published and all times afterwards. f. corporate divisions 1. ―hot stock‖ cools off in a dsag. t.d. 9548, guidance regarding the treatment of stock of a controlled corporation under section 355(a)(3)(b), 76 f.r. 65110 (10/20/11). the treasury has promulgated amendments to reg. § 1.355-2(g) and (i) to replace temporary regulations promulgated in t.d. 9435, guidance regarding the treatment of stock of a controlled corporation under section 355(a)(3)(b), 73 f.r. 75946 (12/25/08), and proposed in reg-150670-07, guidance regarding the treatment of stock of a controlled corporation under section 355(a)(3)(b), 73 f.r. 75979 (12/15/08). the final regulations adopt the substantive rules of the temporary regulations without change. reg. § 1.355-2(g), deals with the ―hot stock‖ rule of § 355(a)(3)(b) to conform to the 2006 amendments of § 355(b)(3), creating the ―sag‖ rules, which treat a corporation‘s sag [separate affiliated group] as a single corporation for purposes of determining whether the active trade or business requirements of § 355 have been met. section 355(a)(3)(b) provides that stock of a controlled corporation that has been acquired by the distributing corporation in a taxable transaction within the five year period preceding distribution to stockholders otherwise qualifying under § 355 will be treated as boot taxable to the stockholders. generally speaking, the temporary regulations provide that the hot stock of § 355(a)(3)(b) rule does not apply to any acquisition of stock of controlled where controlled is a dsag [separate affiliated group of the distributing corporation] member at any time after the acquisition (but prior to the distribution of controlled). transfers of controlled stock owned by dsag members immediately before and immediately after the transfer are disregarded and are not treated as acquisitions for purposes of the hot 2012] recent developments in federal income taxation 279 stock rule. (prop. reg. § 1.3553(b)(1)(ii) would apply a similar rule for purposes of the active trade or business requirement.) the temporary regulations also incorporate the exception of former reg. § 1.355-2(g), which provides that the hot stock rule does not apply to acquisitions of controlled stock by distributing from a member of the affiliated group (as defined in reg. § 1.355-3(b)(4)(iv)) of which distributing was a member. the final regulations generally apply to distributions occurring after 10/20/11. (the temporary regulations generally apply to distributions occurring after 12/15/08, but there are a number of transition rules. taxpayers also may elect to apply the regulations to distributions made after 5/17/06.) g. affiliated corporations and consolidated returns 1. we can always use some new consolidated return regs — they’re still too easy to understand. t.d. 9515, guidance under section 1502; amendment of matching rule for certain gains on member stock, 76 f.r. 11956 (3/4/11). the treasury has promulgated final amendments to reg. § 1.1502-13 that provide for the redetermination of intercompany gain as excluded from gross income in certain transactions involving stock transfers between members of a consolidated group. under the regulations, intercompany gain with respect to member stock may be permanently excluded from gross income following certain stock basis elimination transactions, for example, tax-free spin-offs and § 332 liquidations. the rule in the regulations applies only if: (1) the group has not and will not derive any federal income tax benefit from the intercompany transaction; and (2) the excluded gain will not be treated as tax-exempt income for purposes of the investment adjustment regulations. the excluded gain is not treated as tax exempt income for purposes of § 1.1502-32 and does not increase earnings and profits.  the treasury also has revised temp. reg. § 1.1502-13t (as promulgated in 2009) to take into account the abovedescribed amendments to the final regulations and repromulgated it in the revised form without substantive change. generally speaking, these regulations provide that an intergroup liquidationreincorporation that also could be treated (under step-transaction, substance over form, or recast) as a tax-free reorganization (asset transfer for stock followed by liquidation) will be treated as a reorganization. 2. section 382 alone is complicated; the consolidated return rules alone are complicated. when the time comes to apply § 382 to consolidated returns, only rocket scientists need apply. reg–133002–10, redetermination of the consolidated net unrealized built-in gain and loss, 76 f.r. 65634 (10/24/11). the treasury and irs 280 florida tax review [vol. 12:5 have published proposed amendments to reg. § 1.1502-91(g), which provides rules for determining whether an acquired loss group has a net unrealized built-in gain (nubig) or a net unrealized built-in loss (nubil) for purposes of applying § 382 in the consolidated return context. under the current regulations, reg. § 1.1502–91(g)(1) provides that the determination of whether a loss group has a consolidated nubig or nubil is based on the aggregate amount of the separately determined nubigs and nubils of each member included in the loss group. under this rule, unrealized gain or loss with respect to the stock of a member of the loss group (an included subsidiary) is disregarded in determining the separately determined nubig or nubil. the proposed amendments would modify the current regulations to take into account the unduplicated gain or loss on stock of included subsidiaries, but only to the extent that such gain or loss is taken into account by the group during the recognition period. this will generally be the case only if, within the recognition period, such stock is sold to a nonmember or becomes worthless, or a member takes an intercompany item into account with respect to such stock. h. miscellaneous corporate issues there were no significant developments regarding this topic during 2011. vii. partnerships a. formation and taxable years 1. creation of two wholly owned corporations as llc members didn’t avoid disregarded entity status. robucci v. commissioner, t.c. memo. 2011-19 (1/24/11). the taxpayer converted his psychiatric practice from a sole proprietorship into an llc. the members of the llc consisted of the taxpayer and two corporations, both of which were wholly owned by the taxpayer. the taxpayer owned 95 percent of the llc interests, 85 percent as a limited partner based on the value of transferred intangibles and 10 percent as a general partner based on the taxpayer‘s provision of medical services. one of the corporations, westsphere, entered into an expense reimbursement plan with the llc under which the corporation agreed to provide health insurance for llc employees and reimburse them for expenses of diagnostic medical procedures at specified medical facilities. the second corporation was to provide financial management services to the llc. the taxpayer had little understanding of the purpose of the corporations that were created on the advice of his cpa. the taxpayer‘s medicare and medicaid billings (a small portion of his practice) were done as an individual practitioner. the corporations did not 2012] recent developments in federal income taxation 281 independently undertake business activities. the court (judge halpern) held that neither corporation was formed with a purpose equivalent to business activity under the test of moline properties, inc. v. commissioner, 319 u.s. 436 (1943), nor did either corporation undertake business activity. the court disregarded both entities. as a consequence, the taxpayer‘s llc was a single member entity disregarded for federal tax purposes. net income of the llc, including amounts paid to the corporations, was taxable to the taxpayer. the court also upheld accuracy related penalties under § 6662(a), holding that the taxpayer‘s reliance on the advice of his cpa to produce employment tax savings that were too good to be true was not reasonable. the court indicated that the taxpayer failed to exercise ordinary business care by failing to question an arrangement that purported to minimize his taxes ―while effecting virtually no change in the conduct of his medical practice.‖ 2. asset management joint venture is not a partnership, so take that ordinary income. rigas v united states, 107 a.f.t.r.2d 2011-2046 (s.d. tex. 5/2/11). hydrocarbon capital, llc, which held a number of oil and gas industry financial assets, entered into a loan management and servicing agreement (specifically stating the arrangement was not a partnership) with odyssey energy capital i, lp, formed by five individual limited partners with an llc general partner. the management agreement provided for a performance fee representing 20 percent of profits after provisions for disposition of income realized on the asset portfolio designed to recoup hydrocarbon‘s expenses, the capital value of the portfolio and a 10 percent preferred return. in a claim for refund, the taxpayer, one of odyssey‘s limited partners, claimed pass-through capital gain treatment on gains from disposition of the managed assets. the district court (judge ellison) agreed with the irs determination that the income to the odyssey partners was ordinary income as a service fee rather than pass-through partnership income from a joint venture with hydrocarbon. the court indicated that notwithstanding the unambiguous text of the management agreement eschewing partnership status, it may still look to the conduct of the parties to determine whether the arrangement was a partnership. the court indicated that the odyssey partners contributed both capital and services to the relationship with hydrocarbon, and the arrangement provided for a profit sharing and some risk of loss for the odyssey partners, which supported treating the arrangement as a partnership. odyssey maintained significant management responsibility for the hydrocarbon assets, but it did not have authority to withdraw funds from hydrocarbon bank accounts, it could not increase hydrocarbon‘s capital commitment to a particular asset, it could not enter into binding agreements in hydrocarbon‘s name, and it could not dispose of an asset without hydrocarbon‘s written approval. odyssey did not share control over bank accounts that corresponded to companies in the asset portfolio, nor could it disburse funds from the accounts, and thus lacked https://checkpoint.riag.com/getdoc?docid=ia293511dd5d24e6de4b2cb625f083713&pinpnt= https://checkpoint.riag.com/getdoc?docid=ia293511dd5d24e6de4b2cb625f083713&pinpnt= 282 florida tax review [vol. 12:5 control over the assets and income of the venture. finally, the court pointed to the fact that neither hydrocarbon nor odyssey filed tax returns treating the arrangement as a partnership. thus, the court found that the irs established by a preponderance of the evidence that a partnership did not exist.  the court also held that it had jurisdiction to consider the taxpayer‘s refund claim under tefra as a partner item based on its holding that the taxpayers‘ amended returns qualified as a partner administrative adjustment request as being in substantial compliance with the requirements of reg. § 301.6227(d)-1, notwithstanding the absence of a timely filed form 8802 as required by the regulations. 3. foreign tax credit shelter fails to deliver because the investment was a loan rather than a partnership. pritired 1, llc v. united states, 108 a.f.t.r.2d 2011-6605 (d. iowa 9/30/11). the district court granted summary judgment to the irs on a partnership refund claim for deficiencies imposed on denial of $21 million of foreign tax credits. pritired, the taxpayer llc, was formed as a partnership by principal life insurance company (a subsidiary of principal financial group) and citibank. pritired invested $300 million in a french equivalent of an llc along with two french banks. pritired received $9 million of class b shares of the french llc plus $291 million of ―perpetual certificates‖ structured to provide a libor based return. the interest payments were offset with libor based swaps that the court described as equivalent to providing an interest rate less french taxes. the court found that the only return available to pritired was the value of foreign tax credits. the french banks contributed $930 million to the french llc in exchange for $455 million of class a stock and $455 million of one percent convertible notes. the $1.2 billion was invested in low return securities. the foreign tax credits on the $1.2 billion investment returns were allocated by the french llc to pritired. the french banks treated the transaction as a debt. pritired asserted that through the swap mechanism its investment in the class b shares and the perpetual certificates constituted an equity investment in the french llc that was a partnership. the court described the transaction as follows: through this transaction, the french banks were able to borrow three hundred million dollars at below market rates. the american companies received a very high return on an almost risk free investment. only one thing could make such a transaction so favorable to everyone involved. united states taxpayers made it work.  the court applied traditional debt/equity concepts to conclude that the transaction represented a loan to the french banks rather than an equity investment. based on the attributes of debt specified in notice 94-47, 1994-1 c.b. 357, the court ultimately found that the class b shares and the perpetual certificates had more debt-like attributes than 2012] recent developments in federal income taxation 283 equity-like attributes. the court then concluded that ―as a practical matter‖ the transaction was structured to be a loan rather than an equity investment treated as partnership, citing tifd iii-e, inc. v. united states (castle harbour), 459 f.3d 220, 236 (2d cir. 2006). the court also concluded that the transaction lacked economic substance. although the transaction was designed to appear as a partnership equity investment, it was primarily structured to generate foreign tax credits. the court applied the anti-abuse rule of reg. § 1.701-2 to disregard the partnership and disallow the foreign tax credits claimed by the u.s. taxpayers for french taxes purportedly paid by the french llc. given these holdings, the court found it unnecessary to address the irs‘s additional argument that allocation of the french taxes to the pritired lacked substantial economic effect under reg. § 1.704-2(b)(2). 4. the castle harbour saga. will it ever end? the second circuit twice reverses a taxpayer victory in a self-liquidating partnership note transaction, in which the lion’s share of income was allocated to a tax-indifferent party, on the ground that the taxindifferent dutch banks were not really equity partners. tifd iii-e, inc. v. united states, 342 f. supp. 2d 94 (d. conn. 11/1/04), rev’d, 459 f.3d 220 (2d cir. 8/3/06), on remand, 660 f. supp. 2d 367, as amended, 2009 u.s. dist. lexis 98884 (d. conn. 10/23/09), rev’d, 666 f.3d 836 (2d cir. 1/24/12). a. castle harbour i: district court holds for the taxpayer. the court found that the creation of castle harbour, a nevada llc, by general electric capital corp. subsidiaries was not designed solely to avoid taxes, but to spread the risk of their investment in fully-depreciated commercial airplanes used in their leasing operations. gecc subsidiaries put the following assets into castle harbour: $530 million worth of fullydepreciated aircraft subject to a $258 million non-recourse debt; $22 million of rents receivable; $296 million of cash; and all the stock of another gecc subsidiary that had a value of $0. two tax-indifferent dutch banks invested $117.5 million in castle harbour. under the llc agreement, the taxindifferent partner was allocated 98 percent of the book income and 98 percent of the tax income.  the book income was net of depreciation and the tax income did not take depreciation into account (because the airplanes were fully depreciated for tax purposes). depreciation deductions for book purposes were on the order of 60 percent of the rental income for any given year.  scheduled distributions in excess of book income would have resulted in the liquidation of the investment of the dutch banks in eight years, with the dutch banks receiving a return of approximately nine percent, with some ―economically substantial‖ upside and 284 florida tax review [vol. 12:5 some downside risk. castle harbour was terminated after five years because of a threatened change in u.s. tax law, but during that period about $310 million of income was shifted to the dutch banks for a tax saving to the gecc subsidiaries of about $62 million.  query whether § 704(b) was properly applied to this transaction?  this appears to be a lease-stripping transaction in which the income from the lease was assigned to foreign entities while the benefits of ownership were left with a domestic entity.  the court (judge underhill) held that satisfaction of the mechanical rules of the regulations under § 704(b) transcended both an intent to avoid tax and the avoidance of significant tax through agreed upon partnership allocations. in this partnership, 2 percent of both operating and taxable income was allocated to gecc, a united states partner, and 98 percent of both book and taxable income was allocated to partners who were dutch banks. the dutch banks were foreign partners who were not liable for united states taxes and thus were indifferent to the u.s. tax consequences of their participation in the partnership. because the partnership had very large book depreciation deductions and no tax depreciation, most of the partnership‘s taxable operating income, which was substantially in excess of book taxable income, was allocated to the tax-indifferent foreign partners, even though a large portion of the cash receipts reflected in that income was devoted to repaying the principal of loans secured by property that gecc had contributed to the partnership. the overall partnership transaction saved gecc approximately $62 million in income taxes, and the court found that ―it appears likely that one of gecc‘s principal motivations in entering into this transaction – though certainly not its only motivation – was to avoid that substantial tax burden.‖ the court understood the effects of the allocations and concluded that ―by allocating 98% of the income from fully tax-depreciated aircraft to the dutch banks, gecc avoided an enormous tax burden, while shifting very little book income. put another way, by allocating income less depreciation to taxneutral parties, gecc was able to ―re-depreciate‖ the assets for tax purposes. the tax-neutrals absorbed the tax consequences of all the income allocated to them, but actually received only the income in excess of book depreciation.‖ nevertheless, the court upheld the allocations. ―the tax benefits of the … transaction were the result of the allocation of large amounts of book income to a tax-neutral entity, offset by a large depreciation expense, with a corresponding allocation of a large amount of taxable income, but no corresponding allocation of depreciation deductions. this resulted in an enormous tax savings, but the simple allocation of a large percentage of income violates no rule. the government does not – and cannot – dispute that partners may allocate their partnership‘s income as they choose. neither does the government dispute that the taxable income allocated to the dutch banks could not be offset by the allocation of non-existent depreciation deductions to the banks. and … the bare 2012] recent developments in federal income taxation 285 allocation of a large interest in income does not violate the overall tax effect rule.‖  judge underhill concluded: the government is understandably concerned that the castle harbour transaction deprived the public fisc of some $ 62 million in tax revenue. moreover, it appears likely that one of gecc‘s principal motivations in entering into this transaction though certainly not its only motivation was to avoid that substantial tax burden. nevertheless, the castle harbour transaction was an economically real transaction, undertaken, at least in part, for a non-tax business purpose; the transaction resulted in the creation of a true partnership with all participants holding valid partnership interests; and the income was allocated among the partners in accordance with the internal revenue code and treasury regulations. in short, the transaction, though it sheltered a great deal of income from taxes, was legally permissible. under such circumstances, the i.r.s. should address its concerns to those who write the tax laws. b. castle harbour ii: second circuit reverses. 459 f.3d 220 (2d cir. 8/3/06). the second circuit, in an opinion by judge leval, held that the dutch banks were not partners because their risks and rewards were closer to those of creditors than partners. he used the facts-and-circumstances test of commissioner v. culbertson, 337 u.s. 733 (1949), to determine whether the banks‘ interest was more in the nature of debt or equity and found that their interest was overwhelmingly in the nature of a secured lender‘s interest, ―which would neither be harmed by poor performance of the partnership nor significantly enhanced by extraordinary profits.‖  in acm (colgate), judge laro wrote a 100+ page analysis to find that there was no economic substance to the arrangement. the next contingent payment installment sale case in the tax court was asa investerings (allied signal), in which judge foley wrote a much shorter opinion finding that the dutch bank was not a partner; the d.c. circuit affirmed on judge foley‘s holding that the dutch bank was not a partner. the irs began to pick up this lack-of-partnership argument and began to use it on examinations. later, the tax court (judge nims) used the economic substance argument in saba (brunswick], which the dc circuit remanded based on asa investerings to give taxpayer the opportunity to argue that there was a valid partnership, which it could not do, as judge nims found on remand. even later, the d.c. circuit reversed the district court‘s boca (wyeth, or american home products) case based upon this lack-of-partnership argument – 286 florida tax review [vol. 12:5 even though cravath planned boca carefully so that if the dutch bank was knocked out, there would still be a partnership – based upon its asa investerings and saba findings on appeal that there was no partnership. now the second circuit has adopted the lack-of-partnership argument. c. castle harbour iii. judge underhill still likes ge. on remand in castle harbour, the district court found a valid partnership to have existed under § 704(e) because the heading does not alter the clear language of a statute. a valid family partnership is found in the absence of a family. additionally, in his contingent penalty findings, judge underhill stated that his 2004 taxpayer-favorable decision ipso facto means that the taxpayer‘s reporting position was based upon substantial authority. 660 f. supp. 2d 367 (d. conn. 10/7/09), as amended, 2009 u.s. dist. lexis 98884 (d. conn. 10/23/09). in a carefully-written 3 opinion, judge underhill held that, while the second circuit opinion decided that the partnership did not meet the culbertson totality-of-the-circumstances test (―whether . . . the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise‖), it did not address the § 704(e)(1) issue. he held that the dutch banks did satisfy the requirements of that paragraph, which reads: (e) family partnerships. (1) recognition of interest created by purchase or gift. – a person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person.  in so holding, he relied upon wellsettled law that the title of a statute cannot limit the plain meaning of the text, and that the title is of use only when it sheds light on some ambiguous word or phrase. see also i.r.c. § 7806(b).  it is worth noting that although evans v. commissioner, 447 f.2d 547 (7th cir. 1971), aff’g 54 t.c. 40 (1970), which judge underhill relied upon extensively to reach his conclusion, held that the application of § 704(e)(1) was not limited to the context of family partnerships, evans involved the question who, between two different persons —the original partner or an assignee of the original partner‘s economic interest—was the partner who should be taxed on a distributive share of the partnership‘s income. although in the family context § 704(e) frequently has been applied to determine whether a partnership exists in the first place, judge underhill‘s 3. we do not all share the opinion that the opinion is ―carefully-written,‖ but ira thinks so. ira‘s college classmate [judge] pierre leval characterized the district court‘s analysis as ―thorough and thoughtful.‖ 2012] recent developments in federal income taxation 287 decision in castle harbour iii is the very first case ever to discover that § 704(e)(1) applies to determine whether an arrangement between two (or more) otherwise unrelated business entities or unrelated individuals constituted a partnership.  it has sometimes been adduced that the fact that a court of applicable jurisdiction subsequently upholds the tax treatment of a transaction should be a strong argument for the proposition that such tax treatment was based upon substantial authority. with respect to the applicability of penalties should he be reversed on appeal, judge underhill stated: to a large extent, my holding in castle harbour i in favor of the taxpayer demonstrates the substantial authority for the partnership‘s tax treatment of the dutch banks, as does my discussion above of the dutch banks‘ interest in castle harbour under section 704(e)(1). in addition, the government‘s arguments against the substantial authority defense are unavailing.  judge underhill also sought to place the application of the penalty provisions in a temporal context when he stated: the government argues that culbertson and second circuit cases like slifka and dyer that interpreted culbertson cannot provide substantial authority for the partnership‘s tax position because the second circuit held in castle harbour ii that the dutch banks were not partners under culbertson. the government, however, has not pointed to any second circuit case or other authority, prior to 1997 and 1998 when the castle harbour partners took the tax positions at issue, where the parties‘ good faith intention or valid business purpose in forming a partnership was not sufficient to support a conclusion of partnership status for tax purposes.  in the context of the previous two bullet points, it is worth noting that judge underhill‘s observations in the immediately preceding bullet point appears to be consistent with reg. § 1.66624(d)(2)(iv)(c), which provides that whether a position was supported by substantial authority must be determined with reference to authorities in existence at the time. but, judge underhill‘s observations in the second preceding bullet point appear to be inconsistent with both treas. reg. § 1.66624(d)(2)(iv)(c), and observations in the immediately preceding bullet. however, we are not all in agreement with what judge underhill intended the observations in the second preceding bullet point to mean. d. castle harbour iv: the second circuit smacks down the district court again in an opinion that leaves you wondering why it ever remanded the case in the first place. 666 f.3d 836 288 florida tax review [vol. 12:5 (2d cir. 1/24/12). in another opinion by judge leval, the second circuit again reversed judge underhill and held that the enactment of § 704(e)(1), which recognizes as a partner one who owns a ―capital interest in a partnership,‖ did not ―change[] the law so that a holding of debt (or of an interest overwhelmingly in the nature of debt) could qualify as a partnership interest.‖ notwithstanding that they tend to favor the government‘s position, the governing statute and regulation leave some ambiguity as to whether the holder of partnership debt (or an interest overwhelmingly in the nature of debt) shall be recognized as a partner. therefore, we may consult the legislative history to see whether it sheds light on their interpretation. … the reports of the house and the senate accompanying the passage of § 704(e) make clear that the provision did not intend to broaden the character of interests in partnerships that qualify for treatment as a partnership interest to include partnership debt. the purpose of the statute was to address an altogether different question. the concern of § 704(e)(1) was whether it matters, for the determination of whether a person is a partner for tax purposes, that the person‘s purported partnership interest arose through an intrafamily transfer. the section was passed to reject court opinions that refused to recognize for tax purposes transfers of partnership interests because the transfers were effectuated by intrafamilial gift, as opposed to arm‘s length purchase. its focus is not on the nature of the investment in a partnership, but rather on who should be recognized for tax purposes as the owner of the interest.  the second circuit went on to describe that district court as having found that the banks incurred ―real risk‖ that might require them to restore a negative capital accounts, and thus having concluded ―that the banks‘ interest was therefore an ‗interest in the assets of the partnership‘ distributable to them upon liquidation.‖ the second circuit then described the district court‘s finding that the banks‘ interest qualified as a capital interest as having been ―premised entirely on the significance it accorded to the possibility that the banks would be required to bear 1% of partnership losses exceeding $7 million, or 100% of partnership losses exceeding $541 million.‖ but the second circuit disagreed, holding that there was a mere appearance of risk, rather than any real risk, which did not justify treating the banks‘ interest as a capital, or equity, interest, noting that it had reached the same conclusion in its earlier opinion. the second circuit then suggested that ―[t]he district court was perhaps reading § 704(e)(1) to mean that the addition to a debt interest of any possibility that the holder‘s ultimate 2012] recent developments in federal income taxation 289 entitlement will vary, based on the debtor‘s performance, from pure reimbursement plus a previously fixed rate of return will qualify that interest as a partnership interest, no matter how economically insignificant the potential deviation and how improbable its occurrence.‖ the second circuit ―disagree[d] with any such reading of the statute. no such interpretation is compelled by the plain language of § 704(e)(1). and the fact that the statute was intended to serve an altogether different purpose is confirmed by the legislative reports.‖ the second circuit continued: in explaining our conclusion that the banks‘ interest was not a genuine equity interest, we repeatedly emphasized that, as a practical matter, the structure of the partnership agreement confined the banks‘ return to the applicable rate regardless of the performance of castle harbour. … the banks‘ interest was therefore necessarily not a ―capital interest … . because the banks‘ interest was for all practical purposes a fixed obligation, requiring reimbursement of their investment at a set rate of return in all but the most unlikely of scenarios, their interest rather represented a liability of the partnership. … accordingly, for the same reasons that the evidence compels the conclusion that the banks‘ interest was not bona fide equity participation, it also compels the conclusion that their interest was not a capital interest within the meaning of § 704(e)(1)  turning to the § 6662 penalty issue, the second circuit again trashed judge underhill‘s opinion and reversed, reinstating the penalties, stating that judge underhill had ―mistakenly concluded that several of our decisions supported treatment of the banks as partners in castle harbour.‖ b. allocations of distributive share, partnership debt, and outside basis 1. tax law firm misses on its own special allocation. renkemeyer, campbell & weaver, llp v. commissioner, 136 t.c. 137 (2/9/11). the taxpayer law firm practiced tax law in a kansas limited liability partnership. the partnership consisted of the three lawyers in the firm plus a subchapter s corporation wholly owned by an esop whose beneficiaries were the three attorney partners. for the partnership‘s 2004 tax year the partnership allocated 87.557 percent of the law firm‘s net business income to the s corporation partner. k-1s filed for the 2004 year showed each attorney partner with a 30 percent profit and loss interest and a 10 percent profit and loss interest for the s corporation. capital interests were reported as 33.3 percent for each attorney partner. the taxpayer could not produce a written 290 florida tax review [vol. 12:5 partnership agreement for the 2004 tax year. the firm amended its partnership agreement in 2005 to eliminate the s corporation partner and allocate partnership income among the three attorneys under a formula that reflected income from the individual clients of each attorney, which was accepted by the irs. the court (judge jacobs) held that the taxpayer failed to meet its burden to establish the allocation of income in the face of the missing partnership agreement for 2004. the court did not accept the taxpayer‘s assertion that the amended 2005 agreement provided evidence of the 2004 provisions. as a consequence, the court determined the partners‘ share of 2004 partnership income taking into account the facts and circumstances to identify the partners‘ distributive shares. the court affirmed the irs reallocation of income in accord with the partners‘ capital and profits interests absent the special allocation. see another issue in this case at xi.a., below. 2. section 47 historic rehabilitation credits were allowed to an llc (taxed as a partnership) in which pitney bowes was a 99.9 percent member despite an irs challenge under the anti-abuse provisions of reg. § 1.701-2, but it was too late to keep the miss america pageant in atlantic city. historic boardwalk hall, llc v. commissioner, 136 t.c. 1 (1/3/11). the tax court (judge goeke) held that the ownership interest on the historic east hall of the atlantic city boardwalk hall under a 35-year lease belonging to the new jersey sports and exposition authority could be transferred to historic boardwalk hall, llc, in which pitney bowes (through a subsidiary and an llc) was the 99.9 percent member (and the njsea was the 0.1 percent member). along with ownership went the § 47 federal tax credit of 20 percent of the qualified rehabilitation expenditures incurred in transforming the run-down east hall from a flatfloor convention space to a ―special events facility‖ that could host concerts, sporting events and other civic events. pitney bowes became the 99.9 percent member of historic boardwalk hall, llc, following an offering memorandum sent to nineteen large corporations, which described the transaction as a ―sale‖ of tax credits (although that description was not repeated in any of the subsequent documents relating to the transaction). njsea lent about $57 million to historic boardwalk hall and pitney bowes made capital contributions of more than $18 million to that llc, as well as an investor loan of about $1.2 million. in that offering memorandum, losses were projected over the first decade of operation of east hall. the irs argued that the bulk of the pitney bowes contributions were paid out to njsea as a ―development fee‖ and that the entire transaction was a sham because njsea was going to develop east hall regardless of whether pitney bowes made its capital contributions and loan.  judge goeke held that one of the purposes of § 47 was ―to encourage taxpayers to participate in what would 2012] recent developments in federal income taxation 291 otherwise be an unprofitable activity,‖ and the rehabilitation of east hall was a success, leading to the conclusion that historic boardwalk had objective economic substance. he also held that pitney bowes and njsea, ―in good faith and acting with a business purpose, intended to join together in the present conduct of a business enterprise‖ and that while the offering memorandum used the term ―sale,‖ ―it was used in the context of describing an investment transaction.‖ finally, judge goeke used reg. § 1.701-2(d), example (6), involving two high-bracket taxpayers who joined with a corporation to form a partnership to own and operate a building that qualifies for § 42 low-income housing credits, to conclude that reg. § 1.701-2 did not apply to the historic boardwalk transaction because that regulation ―clearly contemplate[s] a situation in which a partnership is used to transfer valuable tax attributes from an entity that cannot use them . . . to [a taxpayer] who can . . . .‖  query whether ―economic substance‖ requirements are applicable when the tax benefits take the form of tax credits enacted to encourage specific types of investments? 3. state rehabilitation tax credits for sale, or not. virginia historic tax credit fund 2001 lp v. commissioner, t.c. memo. 2009-295 (12/21/09). the virginia historic rehabilitation credit program contains an allocation provision that allows a developer partnership to allocate state rehabilitation tax credits to partners in proportion to their ownership interests in the partnership or as the partners mutually agree. the taxpayer partnership was a state tax credit partner in partnerships developing historic rehabilitation projects in virginia. the taxpayer limited partnership, as a state tax credit partner, held a small percentage ownership interest in virginia rehabilitation projects but was allocated most of the rehabilitation tax credits that the developer partnership could otherwise not use. the taxpayer partnership also purchased state tax credits under a one-time transfer provision. the taxpayer in turn received capital contributions from 282 investor limited partners (either directly or through a lower-tier llc or lp). the pooled capital was invested in various developer rehabilitation partnerships. the virginia state rehabilitation credits were allocated to the investor partners. in general each investor was allocated $1 of state tax credit for each $0.74 invested. the investors were ―bought out after the partnerships accomplished their purpose.‖  the court (judge kroupa) rejected the irs‘s alternative assertions that the partnership derived income from the sale of state tax credits to the investors who were not partners, or if the investors were to be recognized as partners in the tax credit partnerships, the transactions constituted disguised sales of the state tax credits under § 707(a)(2)(b). the court was impressed by several elements of the transactions in determining that the investors created a community of interest in profits and losses by joining together for a business purpose: the parties agreed to form a partnership, they 292 florida tax review [vol. 12:5 acted as partners, the parties pooled resources in that the investors‘ contributed capital and the general partners contributed capital and services, and that the partners had a business purpose in terms of deriving a net economic benefit from state income tax savings (which was not a federal tax savings). the court further held that the substance of the transactions was the formation of a partnership rather than the sale and purchase of the state tax credits in part because the transaction was compelled by the form of investment specified by the virginia program that encouraged the use of partnerships as a vehicle for attracting capital into historic rehabilitation. rather than treating the investors as purchasers of state tax credits, the court concluded that the investors‘ funds were pooled to facilitate investments in developer partnerships and that the investors remained as participants in the partnerships until the developer partnerships completed rehabilitation projects.  the court also found that the investors bore a risk that the developer partnerships would fail to generate rehabilitation credits. the court rejected the irs‘s § 707(a)(2)(b) argument for similar reasons. the court concluded that the substance of the transactions reflects valid contributions and allocations rather than sales based upon the court‘s findings that the investors made capital contributions in furtherance of the partnership‘s purpose to invest in developer partnerships engaged in historic rehabilitation and to receive state tax credits, the partnerships were able to participate because of the investors‘ pooled capital, the state tax credits were allocated to the investors consistent with the allocation provisions of the virginia program, and that the investors were subject to the entrepreneurial risks of the partnerships operations. see reg. § 1.707-3(b)(1). finally, the court held that since the partnership did not have unreported income from the sale of state tax credits, the three year statute of limitation barred assessment and was not subject to extension to six years under § 6229(c)(2) because of an omission of 25 percent of gross income.  one of the taxpayer‘s lawyers is a former student of professor mcmahon in the university of florida college of law graduate tax program. [paid advertisement.] a. the fourth circuit reversed virginia historic and found that there was, indeed, a sale — albeit one that was disguised. virginia historic tax credit fund 2001 lp v. commissioner, 639 f.3d 129 (4th cir. 3/29/11). on appeal, the fourth circuit (judge duncan) reversed the tax court opinion and found that the alleged capital contributions were disguised sales under § 707(a)(2)(b) and reg. § 1.707-3 and should have been reported by the funds as income. the court did not decide whether ―bona fide‖ partnerships existed, but held that the irs properly recharacterized the transactions as sales based upon § 707, which ―prevents the use of the partnership provisions to render nontaxable what would in substance have been a taxable exchange if it had not been ‗run 2012] recent developments in federal income taxation 293 through‘ the partnership.‖ as it was strengthened in 1984, § 707(a) provides that ―[i]f a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall . . . be considered as occurring between the partnership and one who is not a partner.‖ under § 707(a)(2)(b), non-partnership-capacity transactions include the situation where: (i) there is a direct or indirect transfer of money or other property by a partner to a partnership, (ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (iii) the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property.  there is a cross-reference in reg. § 1.707(b)-6(a) to reg. § 1.707-3, which requires an evaluation of all the facts and circumstances to determine whether the transfer of money or other consideration would not have been made but for the transfer of property; and in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations. transfers made within two years of one another are presumed to be sales. reg. § 1.707-3(b)(2) lists ten factors to be considered, five of which were relevant to this case. they are: (i) that the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer; (ii) that the transferor has a legally enforceable right to the subsequent transfer; (iii) that the partner‘s right to receive the transfer of money or other consideration is secured in any manner, taking into account the period during which it is secured; *** (ix) that the transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner‘s general and continuing interest in partnership profits; and (x) that the partner has no obligation to return or repay the money or other consideration to the partnership, or has such an obligation but it is likely to become due at such a distant point in the future that the present value of that obligation is small in relation to the amount of money or other consideration transferred by the partnership to the partner.  the court further held that the tax credits in question were property, looking to the substance of state law and not to labels given by, or conclusions drawn from these labels. 294 florida tax review [vol. 12:5  it further held that any entrepreneurial risks to the investors were ―both speculative and circumscribed,‖ continuing ―that the only risk here was that faced by any advance purchaser who pays for an item with a promise of later delivery.‖ this conclusion was based upon the investors being promised a fixed rate of return, they did not expect any allocations of partnership income, gains or losses, and they were promised refunds if the tax credits were not delivered. 4. dad follows the son of boss into the tax shelter abyss. superior trading, llc v. commissioner, 137 t.c. 70 (9/1/11). this case involved a so-called distressed asset/debt (dad) tax shelter structure created by john rogers, tax lawyer and purported international finance expert. the court (judge wherry) described the structure by noting that, ―true to the poet‘s sentiment that ‗the child is father of the man,‘ the dad deal seems to be considerably more attenuated in its scope, and far less brazen in its reach, than the son-of-boss transaction.‖ at the top of rogers‘ pyramid, warwick trading, llc acquired uncollectable receivables from a bankrupt brazilian retailer under a contribution arrangement. warwick claimed a transferred basis in the receivables equal to their face value under § 723. the receivables were then contributed through multiple tiers of trading companies, interests in which were sold to individual investors. not long after the contribution transaction, the interest of the brazilian retailer in warwick was redeemed, but no § 754 election to adjust basis under § 743(b) was made. ultimately the individual investors claimed loss deductions though their interests in the trading company partnerships as the receivables were liquidated at their depreciated value through an accommodating party. these transactions occurred before the october 2004 revisions to §§ 704(c), 734 and 743 (requiring allocations of built-in loss only to the contributing party, limiting basis to fmv at the time of contribution, and requiring mandatory basis adjustments on distributions involving substantial basis reductions). the court found multiple grounds on which to undo these transactions.  first, the court held that the original contribution of the receivables was not a partnership transaction under § 721 with § 723 transferred basis, but was instead a sale. the court concluded that the brazilian retailer was never a partner in a partnership with a joint-profit motive, and thus the transfer of the receivables in the initial transaction was not a § 721 contribution to a partnership.  the brazilian retailer‘s receipt of money within two years of the transfer of the receivables supported recharacterization of the transaction as a sale under § 707(a)(2)(b). https://checkpoint.riag.com/getdoc?docid=iadvtcr:322.1&pinpnt= 2012] recent developments in federal income taxation 295  from the brazilian retailer‘s financial statements the court found that the receivables had a zero basis at the time of the contribution in any event.  and if that was not enough, the court collapsed the transaction under the step-transaction doctrine into a single transaction that consisted of a sale of the receivables for the amount of cash payments eventually made to the brazilian retailer on redemption of its interest. thus, warwick‘s basis in the receivables was no higher than the cash payment, which the taxpayer failed to substantiate resulting in a zero basis.  interestingly, the court concluded that it was not necessary to address the broad judicial economic substance doctrine that other courts had used to disallow the tax benefits of the son-of-boss cases. the court said that, ―because of a dad deal‘s comparatively modest grab and highly stylized garb, we can safely address its sought-after tax characterization without resorting to sweeping economic substance arguments‖ and added that, ―we need only look at the substance lurking behind the posited form, and where appropriate, step together artificially separated transactions, to get to the proper tax characterization.‖  all of that was followed by an accuracy related penalty under § 6662. 5. partnership debt for equity swaps. holy asymmetry! the partners have cod income but the creditor doesn’t have a loss deduction. reg-164370-05, section 108(e)(8) application to partnerships, 73 f.r. 64903 (10/31/08). as amended by the american jobs creation act of 2004, § 108(e)(8) provides that for purposes of determining cod income of a partnership, if a debtor partnership transfers a capital or profits interest to a creditor in satisfaction of either recourse or nonrecourse partnership debt the partnership is treated as having satisfied the debt with an amount of money equal to the fair market value of the interest. any cod income recognized under § 108(e)(8) passes through to the partners immediately before the discharge. prop. reg. § 1.108-8 would provide that for purposes of § 108(e)(8), the fair market value of a partnership interest received by the creditor is the liquidation value of that debt-for-equity interest, if: (1) the debtor partnership maintains capital accounts in accordance with reg. § 1.704-1(b)(2)(iv), (2) the creditor, the debtor partnership, and its partners treat the fair market value of the debt as equaling the liquidation value of the partnership interest for purposes of determining the tax consequences of the debt-for-equity exchange, (3) the debt-for-equity exchange is an arm‘s-length transaction, and (4) subsequent to the exchange, neither the partnership redeems, nor any person related to the partnership purchases, the creditor‘s partnership interest as part of a plan that has as a principal purpose the avoidance of cod income by the partnership. if these 296 florida tax review [vol. 12:5 conditions are not satisfied, all of the facts and circumstances are considered in determining the fair market value of the debt-for-equity interest for purposes of applying § 108(e)(8). prop. reg. § 1.721-1(d) would provide nonrecognition of loss in a debt-for-partnership interest exchange in which the liquidation value of the partnership interest is less than the outstanding principal balance of the debt. the creditor‘s basis in the partnership is determined under § 722. however, the proposed regulations provide that § 721 does not apply to the transfer of a partnership interest to a creditor in satisfaction of a partnership‘s indebtedness for unpaid rent, royalties, or interest on indebtedness (including accrued original issue discount). in addition, the proposed regulations do not supersede the gain recognition rules of § 453b regarding dispositions of installment obligations. the proposed regulations will be effective when final regulations are published in the federal register. a. finalized, with some modifications, but learn to live with the asymmetry. t.d. 9557, application of section 108(e)(8) to indebtedness satisfied by a partnership interest, 76 f.r. 71255 (11/17/11). the final regulations generally are the same as the proposed regulations, with certain modifications. (1) first, reg. § 1.108-8(b)(2)(i)(b) requires as a condition to the liquidation value safe harbor that a partnership apply a consistent valuation methodology to all equity issued in any debt-for-equity exchange that is part of the same overall transaction. this prevents selective exploitation of the discrepancy between liquidation value and fair market value. (2) second, reg. § 1.108-8(b)(2)(i)(c) clarifies that the arm‘s length transaction requirement for the liquidation value safe harbor is available to a transaction involving related parties as long as the debt-for-equity exchange has terms that are comparable to terms that would be agreed to by unrelated parties negotiating with adverse interests. (3) third, for the anti-abuse provision [condition (4) in the proposed regulations, supra] ―related‖ party is defined by cross-references to §§ 267(b) and 707(b); reg. § 1.108-8(b)(2)(i)(d). (4) fourth, the liquidation value of an interest in an upper-tier partnership is determined by taking into account the liquidation value of any lower-tier partnership interest; reg. § 1.108-8(b)(2)(ii). (5) fifth, reg. § 1.108-8(b)(1) provides that if the fair market value of the debt-for-equity interest does not equal the fair market value of the indebtedness exchanged, then general tax law principles shall apply to account for the difference. the preamble notes that, if appropriate, § 707(a)(2)(a) can be applied. (6) sixth, reg. § 1.721-1(d)(2) provides that § 721 does not apply to a debt-for-equity exchange to the extent the partnership interest is exchanged for the partnership‘s indebtedness for unpaid rent, royalties, or interest on the 2012] recent developments in federal income taxation 297 partnership‘s indebtedness (including accrued oid) that accrued on or after the beginning of the creditor‘s holding period for the indebtedness. (7) seventh, the final regulations provide that cod income arising from a discharge of a partnership or partner nonrecourse indebtedness is treated as a first-tier item for minimum gain chargeback purposes under regs. §§ 1.704-2(f)(6), 1.704-2(j)(2)(i)(a) and 1.704-2(j)(2)(ii)(a); reg. § 1.704-2(f)(6). c. distributions and transactions between the partnership and partners 1. de minimis partners become substantial under proposed regulations. reg-109564-10, partner‘s distributive share, 76 f.r. 66012 (10/25/11). the economic effect of a partnership allocation is not substantial under reg. § 1.704-1(b)(2)(iii)(a) if, at the time the allocation (or allocations) becomes part of the partnership agreement: (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement. reg. § 1.704-1(b)(2)(iii)(e) provides that the tax attributes of a de minimis partner (a partner who owns less than 10 percent of partnership capital or profits) need not be taken into account in applying the substantiality tests. the proposed regulation would remove the de minimis partner rule ―in order to prevent unintended tax consequences.‖ the preamble to the proposed regulation indicates that the de minimis partner rule was ―not intended to allow partnerships to entirely avoid the application of the substantiality regulations if the partnership is owned by partners each of whom owns less than 10 percent of the capital or profits, and who are allocated less than 10 percent of each partnership item of income, gain, loss, deduction, and credit.‖ the regulations will be effective when finalized. d. sales of partnership interests, liquidations and mergers there were no significant developments regarding this topic during 2011. e. inside basis adjustments there were no significant developments regarding this topic during 2011. 298 florida tax review [vol. 12:5 f. partnership audit rules 1. partner’s outside basis in a tax-shelter partnership is a partner item. napoliello v. commissioner, t.c. memo. 2009-104 (5/18/09). the taxpayer invested in a son-of-boss transaction involving digital foreign currency items. the irs issued an fpaa to the taxpayer as a notice partner. in the uncontested partnership proceeding it was determined that the partnership was a sham that lacked economic substance, that transactions entered into by the partnership should be treated as transacted directly by the partners, and that purported losses claimed on disposition of distributed property with an enhanced basis should be disallowed. the irs assessed a deficiency against the taxpayer based on the partnership items. the tax court previously had held in petaluma fx partners, llc v. commissioner, 131 t.c. 84 (2008), that the determination of whether a partnership was a sham that will be disregarded for federal tax purposes is a partnership item. in the instant case, the court (judge kroupa) agreed with the irs that the partner‘s basis in distributed securities from the sham partnership is an affected item subject to determination in the partnership proceeding, and not subject to re-determination in the partnerlevel deficiency proceeding. because the amount of any loss with respect to the partner‘s disposition of securities distributed from the partnership required a factual determination at the partner level, the court held that it had jurisdiction in the partner deficiency proceeding to proceed under normal deficiency procedures. the court thus proceeded to determine that the taxpayer‘s claimed loss on the sale of the distributed securities was disallowed, that the taxpayer‘s basis in the securities was their direct cost rather than an exchange basis from the partnership interest, and that the taxpayer was not allowed to deduct transaction costs attributable to the investment. the tax court also held that the fpaa gave the taxpayer fair notice of the irs claims. a. part of the tax court’s holding in petaluma fx partners retains its vitality, but not the part the tax court relied upon in napoliello. petaluma fx partners, llc v. commissioner, 591 f.3d 649 (d.c. cir. 1/12/10). the tax court in this son-of-boss tax shelter case determined that it had jurisdiction in a tefra partnership proceeding to determine that the partnership lacked economic substance and was a sham. since the partnership was disregarded, the tax court concluded that it had jurisdiction to determine that the partners‘ outside basis in the partnership was zero. the tax court reasoned that a partner could not have a basis in a partnership interest that did not exist. (131 t.c. 84 (2008)) the court of appeals agreed that the tax court had jurisdiction in the partnership proceeding to determine that the partnership was a sham. temp. reg. § 301.6223-1t(a) expressly provides that ―[a]ny final partnership https://checkpoint.riag.com/getdoc?docid=t0advaftr:12675.1&pinpnt= 2012] recent developments in federal income taxation 299 administrative adjustment or judicial determination ... may include a determination that the entity is not a partnership for such taxable year.‖ the court of appeals held that the regulation was explicitly authorized by § 6233. a partnership item is defined in § 6231(a)(3) as an item required to be taken into account in determining the partnership‘s income under subtitle a of the code that is identified in regulations as an item more appropriately taken into account at the partnership level. the court indicated that, ―logically, it makes perfect sense to determine whether a partnership is a sham at the partnership level. a partnership cannot be a sham with respect to one partner, but valid with respect to another.‖ however, the appeals court concluded that the partners‘ bases were affected items, not partnership items, and that the tax court did not have jurisdiction to determine the partners‘ bases in the partnership proceeding. the court rejected the irs argument that the tax court had jurisdiction in the partnership proceeding to determine the partners‘ outside basis as an affected item whose elements are mainly determined from partnership items. the court held that resolution of the affected item requires a separate determination at the partner level even though the affected item could easily be determined in the partnership proceeding. finally, the court of appeals held that accuracy related penalties under § 6662(a) could not be determined without a determination of the partners‘ outside basis in a partner level proceeding and vacated and remanded the tax court‘s determination of penalty issues. b. on remand, the tax court disavowed jurisdiction over penalties in the partnership-level proceeding. petaluma fx partners, llc v. commissioner, 135 t. c. 581 (12/15/10). the court (judge goeke) held that in light of the court of appeals holding that determination of adjustments attributable to the partner‘s outside basis is an affected item properly addressed in individual partner level proceedings, any § 6662 penalties must also be determined at the partner-level proceeding and that the tax court had no jurisdiction to assess the penalties. the court rejected the irs argument that the penalties proceeded from the partner-level determination that the partnership was a sham, thereby providing jurisdiction for the tax court to determine the negligence penalty. the tax court held that if a penalty ―does not relate directly to a numerical adjustment to a partnership item, it is beyond our jurisdiction. in this case there are no such adjustments to which a penalty can apply.‖ judge halpern dissented, asserting that the tax court could reconsider the penalty on grounds other than the partners‘ outside bases under the court‘s initial findings that the partnership was a sham and did not provide the basis increase claimed by the partners. a dissent by judge marvel (joined by three others) argued that the tax court has jurisdiction to determine the imposition of a penalty for negligence related to adjustment of a partnership item in the partnership level 300 florida tax review [vol. 12:5 proceeding, but the amount of the individual penalty depends upon a computation at the partner level. c. partner’s outside basis in a tax-shelter partnership is a partner item. napoliello v. commissioner, 655 f.3d 1060 (9th cir. 8/23/11). the taxpayer invested in a son-of-boss transaction involving digital foreign currency items. the irs issued an fpaa to the taxpayer as a notice partner. in the uncontested partnership proceeding it was determined that the partnership was a sham that lacked economic substance, that transactions entered into by the partnership should be treated as transacted directly by the partners, and that purported losses claimed on disposition of distributed property with an enhanced basis should be disallowed. the irs assessed a deficiency against the taxpayer based on the partnership items. upholding the tax court, the ninth circuit joined the d.c and eighth circuits, petaluma fx partners, llc v. commissioner, 591 f.3d 649 (d.c. cir. 2010); rjt invs. x v. commissioner, 491 f.3d 732 (8th cir. 2007), holding that the determination of whether a partnership was a sham that will be disregarded for federal tax purposes is a partnership item. the ninth circuit also agreed with the tax court that the partner‘s basis in distributed securities from the sham partnership is an affected item subject to determination in the partnership proceeding, and not subject to redetermination in the partner-level deficiency proceeding. because the amount of any loss with respect to the partner‘s disposition of securities distributed from the partnership required a factual determination at the partner level, the court held that the tax court had jurisdiction in the partner deficiency proceeding to proceed under normal deficiency procedures. thus, the tax court could determine that the taxpayer‘s claimed loss on the sale of the distributed securities was disallowed, that the taxpayer‘s basis in the securities was their direct cost rather than an exchange basis from the partnership interest, and that the taxpayer was not allowed to deduct transaction costs attributable to the investment. 2. the tax court finds jurisdiction to address § 6662 penalties in this son-of-boss tefra partnership proceeding. taxpayer’s reasonable cause defense was rejected because advisors were promoters and the opinion was sloppy. 106 ltd. v. commissioner, 136 t.c. 67 (1/10/11). the taxpayer‘s tax matters partner responded to ann. 2004-46, 2004-1 c.b. 964, and filed an amended return removing losses attributable to a son-of-boss transaction promoted by joe garza. the irs issued an fpaa to the partnership that adjusted partnership items and asserted penalties. in prior proceedings the tax court issued orders granting summary judgment to the irs on the substantive partnership issues and the presence of a gross valuation misstatement. in this proceeding the court (judge holmes) held that the tax court had jurisdiction to determine https://checkpoint.riag.com/getdoc?docid=t0tcr:3727.1&pinpnt= https://checkpoint.riag.com/getdoc?docid=t0tcr:3727.1&pinpnt= 2012] recent developments in federal income taxation 301 whether the partnership had a reasonable cause defense based on reliance on opinion of counsel, but that the reliance itself was not reasonable. the court concluded that the decision in petaluma fx partners v. commissioner, 591 f.3d 649 (d.c. cir. 2010) holding the tax court did not have jurisdiction in a partnership proceeding to determine the partners‘ outside basis or whether penalties were applicable to the outside basis issues did not bar jurisdiction to adjudicate a reasonable cause defense where outside basis is not at issue. following am. boat co., llc v. united states, 583 f.3d 471, 480 (7th cir. 2009), and similar authorities, the court held that it had jurisdiction in a partnership proceeding to consider entity level defenses to the accuracyrelated penalty. nonetheless, the court rejected the reasonable cause defense finding that the partnership could not in good faith rely on advisors who were promoters of the transaction. in addition, the court found that the tax-matters partner entered into a ―tax strategy‖ with the intent to ―lose money,‖ which combined with the sloppy opinion and the tax-matters partner‘s unusual experience demonstrated a lack of good faith reliance. 3. son of jade trading finds that penalties based on a partner’s basis are a partner item. jade trading, llc v. united states, 98 fed. cl. 453 (4/29/11). in affirming the court of federal claims‘ determination that the taxpayers‘ son of boss transaction lacked economic substance the court of appeals for the federal circuit remanded the case for a determination as to whether penalties could be imposed without relying on individual partners‘ outside basis, which is not a partnership item. jade trading, llc v. united states, 598 f.3d 1372, 1381 (fed. cir. 2010). section 6226(f) confers jurisdiction in a partnership proceeding to determine penalties that relate to an adjustment of a partnership item. partnership item is defined in § 6231(a)(3) as an item required to be taken into account under any provision of subtitle a to the extent that regulations provide that the item is more appropriately determined at the partnership level. in the son of boss transactions, various options contracts are structured to permit a distribution of property (usually foreign currency) with an artificially high basis determined from the outside basis of a liquidated partnership interest. tax deficiencies resulted from denying losses claimed using the partners‘ outside basis transferred to distributed assets. relying on petaluma fx partners, llc v. commissioner, 591 f.3d 649 (d.c. cir. 2010), the court pointed out that, even though the partnership proceeding determined that the partnership was a sham, which is a partnership item, the resulting effect on the partner‘s outside basis remains a partner item not within the jurisdiction of the partnership proceeding. the court rejected the irs argument that the determination that the partnership was a sham and that the option spread transaction lacked economic substance was converted into a finding that something other than the partners‘ outside bases justified penalties as the partnership level. the court also rejected the irs attempt to recharacterize https://checkpoint.riag.com/getdoc?docid=i49bf468d1a30cfa9ff07abc51c4c5b0c&pinpnt= 302 florida tax review [vol. 12:5 the litigation as denying deductions on the partnership‘s misstatement of a partnership item based on the partner‘s contributions of options rather than as basing adjustments on the partners‘ bases. 4. if you pay without a statutory notice, you can’t get a refund. bush v. united states, 599 f.3d 1352 (fed. cir. 3/31/10). during the pendency of a partnership level proceeding, the taxpayers entered into closing agreements with the irs with respect to their § 465 at-risk amounts in the partnership. the closing agreements did not waive the right to a deficiency notice. subsequently, the irs issued notices of adjustment, without issuing any deficiency notices, based on the application of the agreed upon at-risk amount in the closing agreements. the taxpayers paid the assessed taxes and sought a refund. a deficiency notice is not required if a tax liability issue has been resolved in a partnership-level proceeding. in that case any additional tax due is assessed as a computational adjustment, § 6230(a)(1), which § 6231(a)(6) defines for this purpose as the ―change in the tax liability of a partner which properly reflects the treatment under this subchapter of a partnership item.‖ but a deficiency notice is required if the additional tax asserted by the irs to be due does not involve such a ―computational adjustment.‖ thus, a deficiency notice is required if the deficiency is attributable to ―affected items which require partner level determinations.‖ i.r.c. § 6230(a)(2)(a)(i). the court (judge dyk) held for the government, concluding that on the facts of the case, the irs‘s failure to issue a deficiency notice was harmless error. after first concluding that § 6213(a) ―does not broadly provide for a refund of amounts paid by the taxpayer after assessment or provide for a refund where the taxpayer voluntarily pays the assessment before collection proceedings are initiated,‖ the court continued as follows: the irs did not issue a demand for payment (which is a predicate to collection, see i.r.c. § 6303) or initiate collection proceedings. the taxpayers do not ... seek repayment of funds improperly collected. rather, the taxpayers paid the assessments and then sued for a refund, alleging that they are entitled to a refund simply because the irs failed to issue the requisite notice, without regard to whether the tax was in fact owed, and without any showing that the taxpayers were prejudiced by litigating the tax issue in the refund proceedings rather than in the tax court. nothing in the language of the statute confers such a refund right on the taxpayer, and the failure in the statute to provide for a refund under such circumstances strongly suggests that no such automatic refund was intended.  finally, the court explained that despite the taxpayers not having received a deficiency notice, had they not 2012] recent developments in federal income taxation 303 voluntarily paid the tax, they could have had their day in tax court simply by not paying and seeking collection due process relief under § 6330 when the irs subsequently took actions to collect the assessed taxes. a. and the full court upholds the irs, but for different reasons. bush v. united states, 655 f.3d. 1323 (fed. cir. 8/24/11). after vacating its prior decision and rehearing the case en banc, the federal circuit again ruled for the government. the court held that under § 6231(a)(6) a computational adjustment may be made for any changes in a partner‘s tax liability that arise from the partnership proceeding regardless of whether the tefra proceeding makes changes to the treatment of partnership items from the partnership returns. thus, the fact that the partnership proceeding was settled with a closing agreement permits subsequent computational adjustments to the partners without requiring a notice of deficiency. the court also held that because of the settlement, redetermining the partners‘ at-risk amounts did not require partner level factual determinations that would treat the adjustments as affected items requiring a partner-level notice of deficiency. 5. son-of-boss sham partnership determination, partner’s basis, and liability for penalties are not affected items over which the tax court has jurisdiction in a partner proceeding. thompson v. commissioner, 137 t.c. no. 17 (12/27/11) (reviewed). the taxpayer invested in a son-of-boss transaction through a partnership. in a final partnership proceeding affirmed by the eighth circuit, the court determined that the partnership was a sham, that there was no basis in a partnership interest, and that the partnership was subject to a 40 percent accuracy penalty. rjt invs. x, llc v. commissioner, 491 f.3d 732 (8th cir. 2007). the irs thereafter issued an affected item notice of deficiency to the taxpayer for the deficiency attributable to the partnership action and to collect the penalty. on the following day, the irs directly assessed the deficiency and the penalty amount as a computational item based on the partnership proceeding, not requiring a notice of deficiency. the taxpayer filed a petition with the tax court to set aside the deficiency. the irs responded that the notice of deficiency was invalid and that the tax court lacked jurisdiction in the case on the ground that no valid statutory notice of deficiency had been sent to the taxpayers. the tax court (judge wherry) held for the irs with two dissents. the court held that assessing the deficiency based on the final partnership proceeding did not require any partner level determinations and thus was not subject to deficiency procedures. the court rejected the taxpayer‘s argument that under petaluma fx partners, llc v. commissioner, 591 f.3d 649 (d.c. cir. 2010), aff’g. in part, rev’g in part, and remanding in part 131 t.c. 84 (2008), an accuracy related penalty does not relate to adjustment of a partnership item and can be 304 florida tax review [vol. 12:5 assessed only in a partner proceeding. the court held that the accuracy related penalty can be directly assessed and is not subject to deficiency procedures, notwithstanding the need for partner-level determinations. the court also held that the fact that the irs‘s direct assessment contained errors that required correction resulting in a reduction of the deficiency did not make the assessment a determination that required a notice of deficiency under § 6212(a). the majority determined that all of the four items in the notice of deficiency followed directly from the treatment of the partnership as having no profit motive and were thus computational. judge goeke dissented on the question of subject matter jurisdiction asserting that, even though the taxpayer and the irs resolved the factual issues presented in the notice of deficiency, the determination of partner level losses requires a partner-level determination subject to a notice of deficiency. judge holmes argued that the multiple adjustments asserted in the notice of deficiency involved partner-level determinations that went beyond the adjustments that directly resulted from the partnership level proceeding, including the taxpayer‘s claimed loss on liquidation of the partnership, which judge holmes concluded was an item one-step removed from the partnership level determination. judge holmes‘ dissent expressed a concern that the rejection of jurisdiction will require a case-by-case assessment of whether a computational adjustment will involve a partner level determination. 6. who settled with whom and when? mathia v. commissioner, 109 a.f.t.r.2d 2012-375 (10th cir. 1/5/12). the taxpayer‘s deceased husband was a partner in a swanton coal partnership that the irs challenged with an fpaa. in 1991 the law firm representing the tax matters partner entered into a settlement agreement in principle, but which required further negotiation with the irs to determine the settlement amount. in 1995 the irs sent a stipulation of settlement agreement to the partnership that was signed by the partnership but not by the irs. an identical agreement was signed by both parties in 2001 and entered as a final judgment by the tax court. within the one year allowed from the date of final judgment under § 6225(a), the irs issued a deficiency assessment against the taxpayer, who asserted that the earlier settlements represented a settlement with individual partners that reclassified the claimed partnership losses as nonpartnership items under § 6231(b)(1)(c), which then required an assessment within one year of the settlement. the court held that even if the 1991 agreement in principle and the subsequent settlement were binding agreements, the agreements dealt only with partnership items and not settlement agreements with individual partners. thus, the taxpayer was not dismissed from the partnership level proceeding and the assessment within one year of the final tax court judgment was timely. 2012] recent developments in federal income taxation 305 g. miscellaneous there were no significant developments regarding this topic during 2011. viii. tax shelters a. tax shelter cases and rulings 1. another corporate tax shelter investor with a ―never say die‖ attitude toward litigating hopeless cases. god bless their willingness to pay attorney’s fees for cases that can’t be won. wells fargo & co. v. united states, 641 f.3d 1319 (fed. cir. 4/15/11). wells fargo was denied the tax benefits it sought from another package of fairly generic silo transactions with tax-exempt entities involving transportation and technology equipment. the court of claims had ―found that the claimed tax deductions are for depreciation on property wells fargo never expected to own or operate, interest on debt that existed only on a balance sheet, and write-offs for the costs of transactions that amounted to nothing more than tax deduction arbitrage.‖ accordingly, the federal circuit affirmed the court of federal claims‘ determination that transactions did not pass muster under the substance over form doctrine. judge bryson‘s opinion noted: the only flow of funds between the parties to the transaction was the initial lump sum given to the tax-exempt entity as compensation for its participation in the transaction. from the tax-exempt entity‘s point of view, the transaction effectively ended as soon as it began. the benefits to wells fargo continued to flow throughout the term of the sublease, however, in the form of deferred tax payments. the thirdparty lender and its affiliate were also compensated for their participation, as were the creators and promoters of the transactions. these transactions were win-win situations for all of the parties involved because free money—in the form of previously unavailable tax benefits utilized by wells fargo—was divided among all parties. the money was not entirely ―free,‖ of course, because it was in effect transferred to wells fargo from the public fisc. 2. a twenty first securities tax shelter bites the dust. samueli v. commissioner, 132 t.c. 37 (2009). the taxpayer entered into a tax shelter transaction planned by twenty first securities (of compaq fame), a simplified (☺) explanation of which is as follows. in october 2001, the taxpayer purchased fixed-income securities (freddie mac principal strips) from a broker (refco) on a margin loan (refco was entitled to hold 306 florida tax review [vol. 12:5 the securities as collateral for the margin loan) and then ―lent‖ the securities to refco. the standard form agreement allowed the taxpayer to terminate the transaction and receive identical securities from refco by giving notices on any business day, but an addendum overrode that provision and provided that the ―loan‖ of the securities would terminate on january 15, 2003, or at the taxpayer‘s election on july 1 or december 2, 2002. the taxpayer purchased the securities for $1.64 billion, but immediately ―lent‖ the securities to refco and received cash ―collateral‖ of $1.64 billion, which he used to repay the margin loan. the loan contracts provided that the taxpayer was entitled to receive all interest, dividends, and other distributions attributable to the securities, but that the taxpayer was obligated to pay refco a variable rate fee for use of the $1.64 billion cash collateral. in december 2002, the taxpayer paid refco $7.8 million of ―interest‖ on the $1.64 billion cash collateral, which was re-lent to the taxpayer (secured by the securities, which had increased in value). the transaction terminated on january 15, 2003 and refco was obligated to pay the taxpayer $1.69 billion to purchase the securities in lieu of transferring them to the taxpayer. the taxpayer was simultaneously obligated to pay refco $1.68 billion, which reflected repayment of the $1.64 billion cash collateral, plus accrued but unpaid variable rate fees, but the amounts were offset and refco paid the taxpayer $13.6 million. the taxpayer reported a $50 million long term capital gain and deducted $33 million of interest (cash collateral fees). judge kroupa held that the purported loan transaction did not satisfy the requirements of § 1058. to qualify as a loan of securities under § 1058, the loan agreement must (1) provide for the return to the lender of identical securities; (2) require payments to the lender equal to all interest, dividends, and other distributions on the securities during the period of the loan, and (3) not reduce the risk of loss or opportunity for gain of the transferor of the securities in the securities transferred. if any of these conditions is not satisfied, the purported loan will be treated as a realization event. because the taxpayer could demand return of the securities only on three specified dates, and not at any time during the term of the loan, he could not sell the securities to realize a gain at any and all times that the possibility for a profitable sale arose. thus, the taxpayer‘s opportunity for gain with respect to the transferred securities transferred was reduced. judge kroupa rejected the taxpayer‘s argument that because the taxpayer had not surrendered all opportunity to realize a gain with respect to the securities that the third condition prerequisite to qualifying for loan treatment under § 1058 had been satisfied. the statutory test for disqualification does not require complete elimination of the benefits of ownership, but merely a reduction. as a result, the ―loan‖ of the securities in 2001 was treated as a sale on which no gain was realized (because the basis and amount realized were identical), and the ―repayment‖ of the securities to the taxpayer in 2003 was treated as a repurchase followed by a resale to refco on which a $13.5 million short term capital gain was realized. 2012] recent developments in federal income taxation 307 furthermore, the taxpayer was not entitled to deduct the cash collateral fees paid as interest in connection with the purported securities lending arrangement because no debt existed. the cash transferred in 2001 represented the proceeds of the first sale and not collateral for a securities loan. thus, no ―cash collateral‖ was outstanding during the relevant years on which the claimed collateral fees could accrue. a. on appeal, every argument in the taxpayer’s kitchen sink goes down the drain. samueli v. commissioner, 658 f.3d 992 (9th cir. 9/15/11). in an opinion by judge tashima, the ninth circuit affirmed the tax court. the first sentence was worded in an manner that left no suspense: ―this case requires us to decide whether a purported securities loan with a fixed term of at least 250 days and possibly as long as 450 days, entered into not for the purpose of providing the borrower with access to the lent securities, but instead for the purpose of avoiding taxable income for the lender, qualifies for nonrecognition treatment as a securities loan pursuant to § 1058 ... .‖ the core reasoning of the court of appeals was the same as the tax court‘s. the plain language of §1058(b)(3), with the gloss provided by elementary economic analysis, supports the tax court‘s conclusion on this point. taxpayers relinquished all control over the securities to refco for all but two days in a term of approximately 450 days. during this period, taxpayers could not have taken advantage of a short-lived spike in the market value of the securities, because they had no right to call the securities back from refco and sell them at that increased price until several months later. common sense compels the conclusion that this reduced the opportunity for gain that a normal owner of the securities would have enjoyed.  the court rejected the taxpayer‘s argument, which it labeled as ―superficially appealing‖ that ―their inability to secure the return of the securities on demand did not affect their ability to recognize gain because the securities were ‗zero-coupon bonds whose value [did] not widely fluctuate with windfall profits at some momentary period,‘‖ because ―when one owns $1.6 billion of a particular security, even a small fluctuation in value can produce a significant opportunity, in absolute terms, for profit.‖ furthermore, ―refco‘s option to purchase the securities at the liborbased prices still affected taxpayers‘ ability to realize the market price of the securities on the dates when they had the option of getting them back from refco.‖  the court noted, however, that its conclusion that the transaction at issue reduced the taxpayers‘ opportunity for gain ―does not necessarily imply a conclusion that a securities loan must be 308 florida tax review [vol. 12:5 terminable upon demand to satisfy the requirements of § 1058(b)(3),‖ but declined to address the issue further, noting that additional guidance from the irs and treasury should deal with the issue.  the court also rejected the taxpayer‘s argument that § 1058 is merely a safe harbor and even if the transaction did not qualify under § 1058, it nevertheless was a loan under general tax principles. although the taxpayer‘s purchase of the securities funded by a margin loan had a non-tax business purpose, ―[t]he sole motivation for adding the purported securities loan to the transaction was tax avoidance. ... unlike a typical securities lending arrangement, this transaction was designed around minimizing taxpayers‘ tax bill rather than around refco‘s need to have the securities available to deliver to its customers.‖  the court also rejected the taxpayer‘s argument that § 1058 was irrelevant and the transaction was in substance the ―liquidation‖ of a contract right to receive the securities from refco, which would result in long term capital gain because the contract right was held for more than one year. 3. low value, high substitute basis tax shelter falls on the absence of a partnership and a lack of economic substance. rovakat, llc. v. commissioner, t.c. memo. 2011-25 (9/20/11). this is a tefra partnership proceeding against a cookie-cutter tax shelter arrangement created by lance o. valdez who did business as a tax attorney and financial advisor. in this particular case, the taxpayer, rovakat, was an llc taxed as a partnership formed by international capital partners lp (icp), a cayman islands partnership controlled by valdez, and international strategic partners (isp), a delaware llc, which was owned 99.6 percent by mr. hovnanian who acted as the tax matters partner for rovakat, and the remaining interest was owned by icp and another valdez-controlled entity. in a series of transactions through partners in icp, rovakat acquired as a contribution from icp 50,000 swiss francs with a fair market value of $34,185 in which icp then rovakat claimed a basis of $5.8 million. one month later, mr. hovnanian purchased 90 percent of icp‘s interest in rovakat for $30,776. the next day rovakat sold the francs for $30,776, and claimed a loss of $5,769,532. the court (judge laro) ruled for the irs disallowing the losses after a trial that involved seven lay and three expert witnesses, 700 stipulated facts and over 600 exhibits, finding that—  icp, one of the rovakat partners was not itself a partnership so that icp‘s acquisition of the francs provided it with a cost basis rather than a high transferred basis. thus, in turn, rovakat‘s basis in the francs was only the cost basis of icp. the court found that the icp partners did not intend to join together to carry on a trade or business, but only to acquire tax basis in ―what was otherwise a worthless shell entity.‖ 2012] recent developments in federal income taxation 309  the transaction lacked economic substance under what the court described as the integrated two-part analysis of the economic substance doctrine, holding on consideration of multiple factors that the various transactions had no practical economic effect apart from tax savings, and that the taxpayer did not participate in the transaction for a valid non-tax business purpose.  the court also held that rovakat omitted $650,000 of gross income attributable to fees for consulting that were not offset by claimed deductions, and that this income was self-employment income subject to self-employment tax.  to make victory complete, the court upheld § 6662 penalties indicating that the partnership‘s reliance on tax opinions from de castro, west, chodorow, glickfield & nass, inc. and sidley, austin, brown, and wood llp, was not reasonable reliance. as to the former, the court indicated that mr. hovnanian had no personal contact with the attorneys who wrote the opinion, and that the opinion contained material misstatements of fact. the sidley austin opinion was obtained by valdez and icp and made no reference to hovnanian or rovakat. 4. another lilo tax shelter bites the dust. can anyone really be surprised? altria group v. united states, 658 f.3d 276 (2d cir. 9/27/11). altria claimed $24,337,623 in depreciation, interest, and transaction cost deductions relating to nine leveraged lilo transactions with tax-indifferent entities. ―in each transaction, altria leased a strategic asset from a tax-indifferent entity; immediately leased back the asset for a shorter sublease term; and provided the tax-indifferent entity a multimillion dollar ‗accommodation fee‘ for entering the transaction and a fully-funded purchase option to terminate altria‘s residual interest at the end of the sublease term.‖ the district court, in a jury trial, held that altria was not entitled to the claimed tax deductions. ―applying the substance over form doctrine, the jury rejected altria‘s contention that it retained a genuine ownership or leasehold interest in the assets and therefore was entitled to the tax deductions.‖ altria appealed on the grounds that the court‘s jury instructions were incorrect as a matter of law, and that the court erred by not entering judgment for it as a matter of law. the court of appeals affirmed, for all the usual reasons in lilo transactions. 5. culbertson — oh yeah!, but canal — no thanks! southgate master fund llc v. united states, 659 f.3d 466 (5th cir. 9/30/11). the fifth circuit affirmed a district court decision upholding the disallowance of artificial loss deductions generated by a complex multi-party chinese non-performing loan (npl) investment transaction. the taxpayer invested approximately $19.4 million in a transaction, structured through the purchase of a partnership interest in a partnership that held the npls, which 310 florida tax review [vol. 12:5 purported to produce tax losses of approximately $210 million. [note: under current § 704(c)(1)(b), the transaction would have failed on a technical analysis.] to pass the losses through without running afoul of the § 704(d) limitation, the taxpayer purported to contributed securities with a basis of over $180 million to the partnership. although the acquisition of the npls had economic substance under the fifth circuit precedent in klamath strategic inv. fund v. united states, 568 f.3d 537 (5th cir. 2009), southgate was a ―sham‖ partnership under a culberson analysis (commissioner v. culbertson, 337 u.s. 733 (1949)). the parties did not join together with a business purpose to share profits. applying a ―substance over form‖ analysis, the court concluded that the acquisition of the portfolio of npls was a direct acquisition by the purported partners. nevertheless, the court of appeals affirmed the district court‘s holding that no § 6662 accuracy related penalties should be imposed. there was no error in the district court‘s finding that the taxpayer reasonably relied on ―more likely than not‖ opinions from his tax advisors, who had structured the deal. 6. given the government’s winning percentage in tax shelter cases, is continued litigation of tax shelter cases really just self-help welfare for tax controversy attorneys? wfc holdings corp. v. united states, 108 a.f.t.r.2d 2011-6531 (d. minn. 9/30/11). a tax shelter so complicated that we cannot understand from the opinion how it purported to work bit the dust because it was ―devoid of economic substance.‖ we think it was based on a variation of the kind of structure involved in coltec industries v. united states, 454 f.3d 1340 (fed. cir. 2006), cert. denied, 549 u.s. 1261 (2007). 7. yet another investor in a kpmg opis tax shelter gets devoured by the economic substance doctrine. blum v. commissioner, t.c. memo. 2012-16 (1/17/12).the taxpayer‘s bogus $45 million loss claimed from a kpmg opis tax shelter was disallowed. the taxpayers did not contest that their loss was ―fictional.‖ section 6662 accuracy-related penalties for gross valuation misstatements and negligence were upheld. b. identified ―tax avoidance transactions‖ 1. now let me get this straight. i followed the code and regs meticulously, claimed my loss deduction, but it was disallowed because i really had no possibility of actually making money on the deal and all i was looking for was a nice tax loss, and even though i’ve got this letter from my lawyer saying the deduction is 100 percent legal, i’m still looking at a 40 percent penalty on the deficiency. but my neighbor who deducted the cost of his kid’s college education as a business 2012] recent developments in federal income taxation 311 expense, which every kindergartner knows you can’t do, doesn’t have to pay any penalty because he’s dumb and his dumb, but probably honest, cpa said it was ok. say what!? well, we don’t have to ―know it when we see it‖ because congress has defined it for us. the 2010 health care reconciliation act added new code § 7701(o), codifying the economic substance doctrine, which has been applied by the courts for several decades as a judicial interpretive doctrine to disallow tax benefits otherwise available under a literal reading of the code and regulations.  background — codification of the economic substance doctrine has been on the legislative agenda many times since early in the first decade of this century, or for the past ten years (for those of us still hung up on y2k). the move for codification was motivated in part by the insistence of not a few tax practitioners that the economic substance doctrine simply was not actually a legitimate element of the tax doctrine, notwithstanding its application by the courts in many cases over several decades. this argument was based on the assertion that the supreme court had never actually applied the economic substance doctrine to deny a taxpayer any tax benefits, ignoring the supreme court‘s decision in knetsch v. united states, 364 u.s. 361 (1960), and instead focusing on the supreme court‘s subsequent decisions in cottage savings ass’n v. commissioner, 499 u.s. 554 (1991), and frank lyon co. v. united states, 435 u.s. 561 (1978), in which a transaction that on the facts showed the total lack of ―economic substance‖ was upheld. congressional concern was intensified by the decision of the court of federal claims in coltec industries, inc. v. united states, 62 fed. cl. 716 (2004), vacated and remanded, 454 f.3d 1340 (fed. cir. 2006), cert. denied, 127 s. ct. 1261 (2007), which questioned the continuing viability of the doctrine, stating that ―the use of the ‗economic substance‘ doctrine to trump ‗mere compliance with the code‘ would violate the separation of powers.‖ see staff of the joint committee on taxation, technical explanation of the revenue provisions of the ―reconciliation act of 2010,‖ as amended, in combination with the ―patient protection and affordable care act,‖ 144 (jcx-18-10 3/21/10). however, in that case the trial court found that the particular transaction at issue in the case did not lack economic substance, and thus the trial court did not actually rule on its validity, and on appeal, the court of appeals for the federal circuit vacated the court of federal claims decision and, reiterating the validity of the economic substance doctrine and, in the opinion of some, expanding it greatly, held that transaction in question lacked economic substance. although the economic substance doctrine has been articulated in a number of different manners by different courts over the years, its purpose is aptly described by the court of appeals for the federal circuit in coltec industries v. united states, supra. the economic substance doctrine represents a judicial effort to enforce the statutory purpose of the tax code. from its inception, the economic substance doctrine has been used to 312 florida tax review [vol. 12:5 prevent taxpayers from subverting the legislative purpose of the tax code by engaging in transactions that are fictitious or lack economic reality simply to reap a tax benefit. in this regard, the economic substance doctrine is not unlike other canons of construction that are employed in circumstances where the literal terms of a statute can undermine the ultimate purpose of the statute.  the modern articulation of the doctrine traces its roots back to frank lyon co. v. united states, 435 u.s. 561 (1978), where the court upheld the taxpayer‘s treatment of an early version of a silo, stating as follows: [w]here, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax avoidance features that have meaningless labels attached, the government should honor the allocation of rights and duties effectuated by the parties.  this passage – which sets forth a statement as to what was sufficient for economic substance, but which was subsequently interpreted to be a statement as to what was necessary for economic substance 4 – has led courts to two different formulations of the economic substance doctrine. one, the so-called ―conjunctive test‖ requires that a transaction have both (1) economic substance and (2) a non-tax business purpose in order to be respected for tax purposes. see, e.g., klamath strategic investment fund v. united states, 568 f.3d 537 (5th cir. 2009); pasternak v. commissioner, 990 f.2d 893, 898 (6th cir. 1993); james v. commissioner, 899 f.2d 905 (10th cir. 1990); new phoenix sunrise corp. v. commissioner, 132 t.c. 161 (2009); coltec, supra. under the other formulation, the so called ―disjunctive test,‖ represented principally by ies industries v. united states, 253 f.3d 350, 358 (8th cir. 2001), and rice’s toyota world, inc. v. commissioner, 752 f.2d 89 (4th cir. 1985), a transaction would be respected for tax purposes if it had either (1) economic substance and (2) a non-tax business purpose. yet a third articulation appeared in acm partnership v. commissioner, 157 f.3d 231 (3d cir. 1998), cert. denied, 526 u.s. 1017 (1999), where the court concluded that ―these distinct aspects of the economic sham inquiry do not constitute discrete prongs of a ‗rigid two-step analysis,‘ but rather represent related factors both of which inform the analysis of whether the 4. ira believes that the interpretation contains an error in logic which takes a statement from the frank lyon case as to what is ―sufficient‖ for economic substance and construes it as a statement as to what is ―necessary‖ for economic substance. marty and dan do not so believe, or think that the alleged error is irrelevant. 2012] recent developments in federal income taxation 313 transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes.‖ the courts also have differed with respect to the nature of the non-tax economic benefit a taxpayer is required to establish to demonstrate that a transaction has economic substance. some courts required a potential economic profit. see, e.g., knetsch v. united states, 364 u.s. 361 (1960); goldstein v. commissioner, 364 f.2d 734 (2d cir. 1966), cert. denied, 385 u.s. 1005 (1967). other courts have applied the economic substance doctrine to disallow tax benefits where – even though the taxpayer was exposed to risk and the transaction had a profit potential – compared to the tax benefits, the economic risks and profit potential were insignificant. sheldon v. commissioner, 94 t.c. 738 (1990); goldstein, supra. yet other courts have asked whether a stated business benefit – for example, cost reduction, as opposed to profit-seeking – of a particular transaction was actually obtained through the transaction in question. see coltec industries, inc. v. united states, 454 f.3d 1340 (fed. cir. 2006), cert. denied, 127 s. ct. 1261 (2007). finally, notwithstanding that several courts have rejected the bootstrap argument that an improved financial accounting result — derived from tax benefits increasing after-tax profitability — served the valid business purpose requirement, see, e.g., american electric power, inc. v. united states, 136 f. supp. 2d 762, aff’d, 326 f.3d.737 (6th cir. 2003); wells fargo & company v. united states, 91 fed. cl. 35 (2010), taxpayers continued to press such claims.  the codified economic substance doctrine — the codification of the economic substance doctrine in new § 7701(o) clarifies and standardizes some applications of the economic substance doctrine when it is applied, but does not establish any rules for determining when the doctrine should be applied. according to the legislative history, ―the provision [i.r.c. § 7701(o)(5)(c)] does not change present law standards in determining when to utilize an economic substance analysis.‖ see staff of the joint committee on taxation, technical explanation of the revenue provisions of the ―reconciliation act of 2010,‖ as amended, in combination with the ―patient protection and affordable care act,‖ 152 (jcx-18-10 3/21/10). thus, ―the fact that a transaction meets the requirements for specific treatment under any provision of the code is not determinative of whether a transaction or series of transactions of which it is a part has economic substance.‖ id., at 153. codification of the economic substance doctrine was not intended to alter or supplant any other judicial interpretive doctrines, such as the business purpose, substance over form, and step transaction doctrines, any similar rule in the code, regulations, or guidance thereunder; § 7701(o) is intended merely (merely?) to supplement all the other rules. id., at 155.  conjunctive analysis of objective and subjective prongs — one of the most important aspects of new § 7701(o) is that it requires a conjunctive analysis under which a transaction has economic substance only if (1) the transaction changes the taxpayer‘s economic position 314 florida tax review [vol. 12:5 in a meaningful way apart from federal income tax effects and (2) the taxpayer has a substantial business purpose, apart from federal income tax effects, for entering into such transaction. (the second prong of most versions of the codified economic substance doctrine introduced in earlier congresses added ―and the transaction is a reasonable means of accomplishing such purpose.‖ see, e.g., h.r. 2345, 110th cong, 1st sess. (2007); h.r. 2, 108th cong., 1st sess. (2003). it is not clear what difference in application was intended by adoption of the different final statutory language.) this conjunctive test resolves the split between the circuits (and between the tax court and certain circuits) by rejecting the view of those courts that find the economic substance doctrine to have been satisfied if there is either (1) a change in taxpayer‘s economic position or (2) a nontax business purpose, see, e.g., rice’s toyota world v. commissioner, 752 f.2d 89 (4th cir. 1985); ies industries, inc. v. united states, 253 f.3d 350, 353 (8th cir. 2001). section 7701(o)(5)(d) allows the economic substance doctrine to be applied to a single transaction or to a series of transactions. the staff of the joint committee report indicates that the provision ―does not alter the court‘s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the doctrine,‖ and gives as an example the courts‘ ability ―to bifurcate a transaction in which independent activities with non-tax objectives are combined with an unrelated item having only tax-avoidance objectives in order to disallow those tax-motivated benefits.‖  claim of profit potential — section 7701(o)(2) does not require that the taxpayer establish profit potential in order to prove that a transaction results in a meaningful change in the taxpayer‘s economic position or that the taxpayer has a substantial non-federal-income-tax purpose. nor does it specify a threshold required return if the taxpayer relies on the profit potential to try to establish economic substance. (in this respect the enacted version differs from earlier proposals that would have required the reasonably expected pre-tax profit from the transaction to exceed a risk-free rate of return. see, e.g., h.r. 2345, 110th cong, 1st sess. (2007); h.r. 2, 108th cong., 1st sess. (2003).) but if the taxpayer does rely on a profit potential claim, then the profit potential requires a present value analysis: the potential for profit of a transaction shall be taken into account in determining whether the requirements of [the § 7701(o) test for economic substance] are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.  thus the analysis of profit potential by the court of federal claims in consolidated edison co. of new york v. united states, 90 fed. cl. 228 (2009), which appears not to have thoroughly taken into account present value analysis, would not stand muster under the 2012] recent developments in federal income taxation 315 new provision. in all events, transaction costs must be taken into account in determining pre-tax profits, and the statute authorizes regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases. any state or local income tax effect that is related to a federal income tax effect is treated in the same manner as a federal income tax effect. thus, state tax savings that piggy-back on federal income tax savings cannot provide either a profit potential or a business purpose. similarly, a financial accounting benefit cannot satisfy the business purpose requirement if the financial accounting benefit originates in a reduction of federal income tax.  don’t worry, be happy! [?] — section 7701(o)(5)(b) specifically provides that the statutory modifications and clarifications apply to an individual only with respect to ―transactions entered into in connection with a trade or business or an activity engaged in for the production of income.‖ (we wonder what else anybody would have thought they might apply to?) the home mortgage interest deduction? charitable contributions of appreciated property? how about a son of boss transaction where there is no possibility for profit?) more importantly, according to staff of the joint committee on taxation, technical explanation of the revenue provisions of the ―reconciliation act of 2010,‖ as amended, in combination with the ―patient protection and affordable care act,‖ 152-153 (jcx-18-10 3/21/10), ―[t]he provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.‖ the list of transactions and decisions intended to be immunized for the application of the economic substance doctrine includes: (1) the choice between capitalizing a business enterprise with debt or equity; (2) a u.s. person‘s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter c; and (4) the choice to utilize a related-party entity in a transaction, provided that the arm‘s length standard of section 482 and other applicable concepts are satisfied.  leasing transactions will continue to be scrutinized based on all of the facts and circumstances.  jettisoned along the way — many earlier versions of the codification of economic substance doctrine, some of which were adopted by the house, also provided special rules for applying what was essentially a per se lack of economic substance in transactions with tax indifferent parties that involved financing, and artificial income and basis shifting. see, e.g., h.r. 2345, 110th cong, 1st sess. (2007); h.r. 2, 108th cong., 1st sess. (2003). these rules did not make it into the enacted version. 316 florida tax review [vol. 12:5 special statutory rules for determining the profitability of leasing transactions also did not find their way into the final statutory enactment.  penalties, oh what penalties! — new §§ 6662(b)(6), in conjunction with new § 6664(c)(2), imposes a strict liability 20 percent penalty for an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance, within the meaning of new § 7701(o), ―or failing to meet the requirements of any similar rule of law.‖ (does that extend to substance versus form in a silo? how about business purpose in a purported tax-free reorganization?) the penalty is increased to 40 percent if the taxpayer does not adequately disclose the relevant facts on the original return or an amended return filed before the taxpayer has been contacted for audit — an amended return filed after the initial contact cannot cure original sin. i.r.c. § 6664(i). because the § 6664(c) ―reasonable cause‖ exception is unavailable, outside (or in-house) analysis and opinions of counsel or other tax advisors will not insulate a taxpayer from the penalty if a transaction is found to lack economic substance. likewise, new § 6664(d)(2) precludes a reasonable cause defense to imposition of the § 6662a reportable transaction understatement penalty for a transaction that lacks economic substance. (section 6662a(e)(2) has been amended to provide that the § 6662a penalty with respect to a reportable transaction understatement does not apply to a transaction that lacks economic substance if a 40 percent penalty is imposed under § 6662(i)). a similar no-fault penalty regime applies to excessive erroneous refund claims that are denied on the ground that the transaction on which the refund claim was based lacked economic substance. § 6676(c). however, under the ―every dark cloud has a silver lining‖ maxim, the §§ 6662(b)(6) and 6664(c)(2) penalty regime does not apply to any portion of an underpayment on which the § 6663 fraud penalty is imposed.  effective date — section 7701(o) and the revised penalty rules applies to transactions entered into after the date of enactment and to underpayments, understatements, and refunds and credits attributable to transactions entered into after 3/30/10. a. better than a sharp stick in the eye, but not much better. the irs is catching conjunctivitis, weighing in on the conjunctive test. notice 2010-62, 2010-2 c.b. 411 (9/13/10). the irs indicates that it will rely on relevant case law in applying the two-pronged conjunctive test for economic substance. thus, both in determining whether a transactions meets both of the requirements of the conjunctive test, the irs will apply cases under the common law economic substance doctrine to determine whether tax benefits are allowable because a transaction satisfies the economic substance prong of the economic substance doctrine and to determine whether a transaction has a sufficient nontax purpose to satisfy the requirement that the tax benefits of a transaction are not allowable because 2012] recent developments in federal income taxation 317 the taxpayer lacks a business purpose. the irs adds that it will challenge taxpayers who seek to rely on case law that a transaction will be treated as having economic substance merely because it satisfies either of the tests. the irs also indicates that it anticipates that the law of economic substance will continue to evolve and that it ―does not intend to issue general administrative guidance regarding the types of transactions to which the economic substance doctrine either applies or does not apply.‖  the notice also indicates that, except for reportable transactions, disclosure for purposes of the additional penalty of § 6621(i) will be adequate if the taxpayer adequately discloses on a timely filed original return, or a qualified amended return the relevant facts affecting the tax treatment of the transaction. a disclosure that would be deemed adequate under § 6662(d)(2)(b) will be treated as adequate for purposes of § 6662(i). the disclosure should be made on a form 8275 or 8275-r. b. in the absence of helpful irs guidance, lb&i steps up with something to lean on for the meanwhile. taxpayers must be notified at the outset of the process. lb&i-4-0711-015. guidance for examiners and managers on the codified economic substance doctrine and related penalties (7/15/11). the large business and international division of the irs has issued guidance regarding the process that an examiner must follow in determining whether to seek approval of the director of field operations (dfo) to apply the § 7701(o) economic substance doctrine. ―an examiner should notify a taxpayer that the examiner is considering whether to apply the economic substance doctrine to a particular transaction as soon as possible, but not later than when the examiner begins the analysis in the steps described below.‖ there are three steps in the analysis.  three step analysis: (1) first, an examiner should evaluate whether the circumstances in the case are those under which application of the economic substance doctrine to a transaction is likely not appropriate. (2) second, an examiner should evaluate whether the circumstances in the case are those under which application of the doctrine to the transaction may be appropriate. (3) third, if an examiner determines that the application of the doctrine may be appropriate, the examiner must make a series of inquiries before seeking approval to apply the doctrine.  facts and circumstances indicating that the economic substance doctrine should not be applied: (1) the transaction is not promoted/developed/administered by tax department or outside advisors; (2) the transaction is not highly structured; (3) the transaction contains no unnecessary steps; 318 florida tax review [vol. 12:5 (4) the transaction that generates targeted tax incentives is, in form and substance, consistent with congressional intent in providing the incentives; (5) the transaction is at arm‘s length with unrelated third parties; (6) the transaction creates a meaningful economic change on a present value basis (pre-tax); (7) the taxpayer‘s potential for gain or loss is not artificially limited; (8) the transaction does not accelerate a loss or duplicate a deduction; (9) the transaction does not generate a deduction that is not matched by an equivalent economic loss or expense (including artificial creation or increase in basis of an asset); (10) the taxpayer does not hold offsetting positions that largely reduce or eliminate the economic risk of the transaction; (11) the transaction does not involve a tax-indifferent counter-party that recognizes substantial income; (12) the transaction does not result in the separation of income recognition from a related deduction either between different taxpayers or between the same taxpayer in different tax years; (13) the transaction has credible business purpose apart from federal tax benefits; (14) the transaction has meaningful potential for profit apart from tax benefits; (15) the transaction has significant risk of loss; (16) tax benefit is not artificially generated by the transaction; (17) the transaction is not pre-packaged; (18) the transaction is not outside the taxpayer‘s ordinary business operations.  facts and circumstances indicating that the economic substance doctrine should be applied: (1) the transaction is promoted/developed/administered by tax department or outside advisors; (2) the transaction is highly structured; (3) the transaction includes unnecessary steps; (4) the transaction is not at arm‘s length with unrelated third parties; (5) the transaction creates no meaningful economic change on a present value basis (pre-tax) (6) the taxpayer‘s potential for gain or loss is artificially limited; (7) the transaction accelerates a loss or duplicates a deduction; (8) the transaction generates a deduction that is not matched by an equivalent economic loss or expense (including artificial creation or increase in basis of an asset); (9) the taxpayer holds offsetting positions that largely reduce or eliminate the economic risk of the transaction; 2012] recent developments in federal income taxation 319 (10) the transaction involves a tax-indifferent counter-party that recognizes substantial income; (11) the transaction results in separation of income recognition from a related deduction either between different taxpayers or between the same taxpayer in different tax years; (12) the transaction has no credible business purpose apart from federal tax benefits; (13) the transaction has no meaningful potential for profit apart from tax benefits; (14) the transaction has no significant risk of loss; (15) tax benefit is artificially generated by the transaction; (16) the transaction is pre-packaged; (17) the transaction is outside the taxpayer‘s ordinary business operations.  the seven required subsequent inquiries: (1) is the transaction a statutory or regulatory election? if so, then the application of the doctrine should not be pursued without specific approval of the examiner‘s manager in consultation with local counsel. (2) is the transaction subject to a detailed statutory or regulatory scheme? if so, and the transaction complies with this scheme, then the application of the doctrine should not be pursued without specific approval of the examiner‘s manager in consultation with local counsel. (3) does precedent exist (judicial or administrative) that either rejects the application of the economic substance doctrine to the type of transaction or a substantially similar transaction or upholds the transaction and makes no reference to the doctrine when considering the transaction? if so, then the application of the doctrine should not be pursued without specific approval of the examiner‘s manager in consultation with local counsel. (4) does the transaction involve tax credits (e.g., low income housing credit, alternative energy credits) that are designed by congress to encourage certain transactions that would not be undertaken but for the credits? if so, then the application of the doctrine should not be pursued without specific approval of the examiner‘s manager in consultation with local counsel. (5) does another judicial doctrine (e.g., substance over form or step transaction) more appropriately address the noncompliance that is being examined? if so, those doctrines should be applied and not the economic substance doctrine. to determine whether another judicial doctrine is more appropriate to challenge a transaction, an examiner should seek the advice of the examiner‘s manager in consultation with local counsel. 320 florida tax review [vol. 12:5 (6) does recharacterizing a transaction (e.g., recharacterizing debt as equity, recharacterizing someone as an agent of another, recharacterizing a partnership interest as another kind of interest, or recharacterizing a collection of financial products as another kind of interest) more appropriately address the noncompliance that is being examined? if so, recharacterization should be applied and not the economic substance doctrine. to determine whether recharacterization is more appropriate to challenge a transaction, an examiner should seek the advice of the examiner‘s manager in consultation with local counsel. (7) in considering all the arguments available to challenge a claimed tax result, is the application of the doctrine among the strongest arguments available? if not, then the application of the doctrine should not be pursued without specific approval of the examiner‘s manager in consultation with local counsel.  approval process. if an examiner completes the inquiries described above and concludes that it is appropriate to seek approval for the application of the economic substance doctrine, the examiner, in consultation with his or her manager and territory manager, should describe the analysis in writing for the appropriate director of field operations, whose approval is required.  penalties limitation. until further guidance is issued, the penalties provided in §§ 6662(b)(6) and (i) and 6676 are limited to the application of the economic substance doctrine and may not be imposed due to the application of any other ―similar rule of law‖ or judicial doctrine (e.g., step transaction doctrine, substance over form or sham transaction).  really!? the final sentence of the directive reads as follows: ―this lb&i directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.‖ c. ―i’m not sure how important it is to have formal guidance — this is what’s supposed to be issued. it sets forth the procedures that exam, counsel, [and] managers need to follow . . . who’s the formal guidance supposed to benefit?‖ mark silverman, 2011 tnt 137-1. deborah butler states that taxpayers may not rely on this guidance. c. disclosure and settlement there were no significant developments regarding this topic during 2011. 2012] recent developments in federal income taxation 321 d. tax shelter penalties, etc. 1. if it’s ―too good to be true,‖ it ain’t true. gustashaw v. commissioner, t.c. memo. 2011-195 (8/11/11). in an opinion by judge halpern, the tax court upheld accuracy related penalties of over $1,000,000 against an investor in a cards tax shelter, with respect to which the investor had an opinion from brown & wood. judge halpern concluded as follows: a reasonable and ordinarily prudent person would have considered as ―too good to be true‖ a carryover deduction generated from a previously claimed $9,938,324 tax loss when he did not suffer an associated economic loss and invested only $800,000 in the transaction. as such, he would have conducted a thorough investigation before claiming the deduction on his tax return. ... [the taxpayer] did not attempt to understand the mechanics of the cards transaction, executed the transaction documents without reading them and without an attorney‘s review, and, although aware of the transaction‘s untested tax ramifications, declined to seek a ruling from the irs. further, he did not question the claimed carryover loss amount even though he knew that he did not suffer an associated economic loss.  furthermore, judge halpern held that the taxpayer‘s reliance of the brown & wood opinion was ―unreasonable‖ because he should have known that brown & wood had an inherent conflict of interest; the promoter of cards both referred brown & wood to the taxpayer and supplied him with a model tax opinion letter describing a cards transaction that was not unique to the taxpayer‘s situation. the was no evidence that the taxpayer had an engagement letter with brown & wood, spoke to any attorney at the law firm, or directly compensated brown & wood for a tax opinion letter. the taxpayer ―could not have reasonably believed that brown & wood was an independent adviser.‖ 2. tax professionals compensated at hourly rates were ―independent advisers,‖ but § 6662 penalties were nevertheless imposed because the son of boss transaction was ―too good to be true.‖ candyce martin 1999 irrevocable trust v. united states, 108 a.f.t.r.2d 2011-6693 (n.d. cal. 10/8/11). trusts for the san francisco chronicle heirs and the heirs themselves entered into digital option son-of-boss transactions to shield more than $300 million of capital gain from taxation arising from the sale of their stock in chronicle publishing company in 2000. judge hamilton held that the transactions failed for federal income tax purposes because (1) the obligations on the short options constituted liabilities for 322 florida tax review [vol. 12:5 purposes of § 752; (2) the transactions lacked economic substance; and (3) the transactions were not entered into for profit so losses were nondeductible under § 165.  the trustee of the trusts [peter folger] and the leading martin family member [francis martin] engaged san francisco tax lawyer richard sideman – a harvard law school graduate, with a masters in tax from nyu, who had previously advised the family on gift tax and trust reformation issues – to advise the trusts and heirs as to the tax and non-tax consequences of their chronicle publishing stock sale. sideman did a great deal of investigation by getting advice from large accounting firms, investment banks, economists, and r.j. ruble, which resulted in proposed transactions and proposed opinion letters undergoing numerous changes. finally, the transactions proposed by jp morgan and implemented by pwc, with r.j. ruble opinion letters were decided upon; sideman ―greenlight[ed],‖ i.e., approved, the transactions. in upholding § 6662 penalties and denying taxpayers‘ ―reasonable cause and good faith defense,‖ judge hamilton stated: [m]ere reliance on the advice of a professional tax advisor ―does not necessarily demonstrate reasonable cause and good faith.‖ id. a taxpayer‘s claim of reliance upon professional advice as support for this defense is to be evaluated under an objective standard. … while the record is clear that mr. folger and the martin family relied heavily on mr. sideman, the record is not clear as to the extent that they relied directly on the advice of dr. rubinstein and mr. ruble, if at all. it was mr. sideman who appears to have relied on the advice of dr. rubinstein and mr. ruble in advising mr. folger and the martin family. … [a]ny reliance on dr. rubinstein‘s advice would not be reasonable because his conclusions were not based on all pertinent facts and circumstances as required for reasonable cause. … mr. sideman testified that he saw his role as that of overseeing the transaction ―in a broad way [and] hiring or engaging at my recommendation the most qualified people that i knew who could provide the actual expertise about the transaction and about its financial implications.‖ … mr. sideman characterized himself as a tax controversy lawyer, unfamiliar with economic judgments involving financial matters to advise the martin family directly on the issue whether the tax proposal by arthur andersen, and the subsequent proposal by pwc, would have an economic reality or economic benefit. mr. sideman testified that he relied on the advice of pwc, dr. rubinstein and mr. ruble 2012] recent developments in federal income taxation 323 to examine the business purpose of the proposed transaction. … while the evidence at trial establishes that mr. folger and the martin family relied on mr. sideman‘s advice, the trial evidence lacks clarity as to exactly what advice mr. sideman gave them, other than approving or ―greenlighting‖ the transaction based on the advice he received from the other professionals. the weaknesses noted above in the ruble and rubinstein opinions, as well as other aspects of the transaction, should have put at least mr. sideman, if not the taxpayers, on notice that the transaction was a questionable tax avoidance scheme lacking economic substance. however, the question before the court is not whether mr. sideman‘s reliance on professional advice was reasonable, but whether mr. folger and the martin family‘s reliance on mr. sideman‘s and the other professionals‘ advice was reasonable. as previously noted, it is not clear to what extent the taxpayers themselves relied on any advice other than mr. sideman‘s. nor was it established that mr. sideman ever specifically advised them that the transaction was bona fide or legal. all the evidence clearly establishes is that mr. sideman approved the transaction.  judge hamilton rejected government contentions that the taxpayers could not rely on pwc and sideman because they had an inherent conflict of interest, stating that advisers compensated at an hourly rate were not conflicted.  however, the court found that taxpayers did not rely reasonably on sideman‘s advice, concluding: the government has not provided a clear argument or any authority for whether mr. sideman‘s unreasonable reliance on the professionals he hired should be imputed to the taxpayers. this was a highly sophisticated transaction, one for which a taxpayer would reasonably be expected to hire a tax lawyer. the court is not prepared to find that having retained a tax lawyer who ―greenlights‖ a complicated transaction as having a business purpose, a taxpayer necessarily acts unreasonably by relying on that advice. see united states v. boyle, 469 u.s. 241, 250-51, 105 s. ct. 687, 83 l. ed. 2d 622 (1985) (when an accountant or attorney advises a taxpayer on a matter of tax law, it is reasonable for the taxpayer to rely on that advice, ―even when such advice turned out to have been mistaken‖). even assuming, however, that the taxpayers acted reasonably in relying on their tax lawyer‘s advice to proceed with the 324 florida tax review [vol. 12:5 transaction, to be entitled to the reasonable cause and good faith defense, the taxpayers must also prove that they acted in good faith. good faith is not synonymous with objective reasonableness. even if the concept of business purpose was too complicated for the taxpayers to assess and apprehend, the court finds that mr. folger and the martin family have not demonstrated good faith under the circumstances and in light of the underlying purposes of entering into the transaction. first, mr. folger and the martin family should have known that the transaction resulting in a $315.7 million tax basis for a $0.9 million offsetting options transaction was ―too good to be true.‖ stobie creek, 608 f.3d at 1383. furthermore, they knew that the purpose of the transaction was to boost the basis to generate a large capital loss to offset the capital gains from the cpc sale. finally, they proceeded with the transaction even after the issuance of notice 2000-44, entitled ―tax avoidance using artificially high basis,‖ which alerted them that the basis created by the options transaction would likely be disallowed. although they were advised by mr. sideman that the transaction had a legitimate business purpose, mr. folger and the martin family entered into this transaction with the knowledge that it would generate an artificially high capital loss. given the level of education and business experience shared by mr. folger and the martin family, they should have known that the absence of a tax liability on a sizeable capital gain did not reflect the economic reality of the transaction. the underpayment of tax was not, therefore, the result of ―an honest misunderstanding of fact or law.‖ treas. reg. § 1.6664-4(b)(1). because mr. folger, with the consent of the martin family, did not act in good faith, the court finds that the accuracy-related penalty was appropriately applied here. 3. conceding that a 2001 transaction lacked economic substance avoided the § 6662(h) 40-percent gross valuation misstatement penalty, but this particular ploy won’t work as well for years to which the § 6662(b)(6) strict liability penalty applies. bergman v. commissioner, 137 t.c. 136 (10/11/11). the taxpayers, the husband taxpayer being a partner in kpmg, participated in two sos (short option strategy) transactions promoted by kpmg that was the same as or substantially similar to a tax avoidance transaction described in notice 200044, 2000-2 c.b. 255. the irs served kpmg with a summons concerning transactions described in notice 2000-44, seeking among other things, a list 2012] recent developments in federal income taxation 325 of clients that had engaged in such transactions. kpmg provided a list that included the taxpayer‘s 2000 transaction but not the 2001 transaction. after filing original returns claiming the deductions from the sos transactions, subsequent to the irs issuing the summons to kpmg, the taxpayers filed amended returns that eliminated the losses. the irs argued that the summons terminated the period for the taxpayers to file a qualified amended return under reg. § 1.6664-2(c)(3), and the taxpayers conceded they were liable for a 20-percent accuracy-related penalty under § 6662(a) if they failed to file a qualified amended return, but that their amended returns were a qualified amended returns. in addition, the irs also asserted that the taxpayers were liable for a 40-percent gross valuation misstatement under § 6662(h) if the amended returns were not qualified amended returns. this required the court (judge kroupa) to decide whether the irs must impose a promoter penalty under § 6700 (relating to abusive tax shelters) to terminate the time to file a qualified amended return under reg. § 1.6664-2(c)(3)(ii). the taxpayers argued that the irs failed to establish that kpmg was liable for a promoter penalty under § 6700 and therefore the time to file a qualified amended return never terminated. with regard to the first issue, judge kroupa held that the period to file a qualified amended return terminated before the taxpayers filed the amended return. the taxpayers ―could reasonably conclude that [the irs] would discover their 2000 transaction once kpmg was served the notice 2000-44 summons. accordingly, disclosure after the notice 2000-44 summons was served on kpmg would not have been voluntary.‖ the amended return petitioners filed was not a qar since it was filed after respondent issued kpmg the notice 2000-44 summons. as a result, for penalty purposes, the additional tax stated on the amended return was not includable in the amount of tax shown on the original return, and the taxpayers had an underpayment of tax for 2001 equal to the additional tax reported on the amended return. but with regard to the second issue, she held that the taxpayers‘ underpayment was not attributable to a gross valuation misstatement and they thus were not liable for the gross valuation penalty. mccrary v. commissioner, 92 t.c. 827 (1989), held that where the irs asserts a ground unrelated to value or basis of property for totally disallowing a deduction or credit and a taxpayer concedes the deduction or credit on that ground, any underpayment resulting from the concession is not attributable to a gross valuation misstatement; that holding was extended in rogers v. commissioner, t.c. memo. 1990-619, to situations where the taxpayer does not state the specific ground for the concession as long as the irs has asserted some ground other than value or basis for totally disallowing the relevant deduction or credit. in this case the taxpayers conceded that the transactions lacked economic substance, and thus had conceded ―‗on grounds other than regarding the value or basis of the property‘‖ that they were not entitled to deduct any portion of the losses at issue.‖ 326 florida tax review [vol. 12:5 ix. exempt organizations and charitable giving a. exempt organizations 1. an agency’s interpretation of its regulation is controlling unless the interpretation is ―plainly erroneous or inconsistent with the regulation.‖ polm family foundation v. united states, 644 f.3d 406 (d.c. cir. 5/6/11). the issue in this declaratory judgment case was whether the polm family foundation was a private foundation under § 509 or a § 509(a)(3)(a) supporting organization, treated as a public charity, the irs having conceded that it was a § 501(c)(3) organization. among the requirements to qualify under § 509(a)(3)(ii) is that the organization demonstrate that it is ―organized, and at all times thereafter is operated, exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified [publicly supported] organizations.‖ the foundation‘s articles of incorporation designated as supported organizations ―the class of organizations ... which support, promote and/ or perform public health and/or christian objectives, including but not limited to christian evangelism, edification and stewardship.‖ reg. § 1.509(a)-4(d)(2)(i)(b) does not require a specific listing of the name each publicly supported organization, but reg. § 1.509(a)-4(d)(3) indicates that the articles of incorporation must require that it be operated to support or benefit one or more beneficiary organizations which are designated by class or purpose. the irs argued that the exception to specific designation applies only if the class of beneficiary organizations is ―readily identifiable,‖ and the court accepted the irs‘s argument that the class of beneficiary organizations was not ―readily identifiable,‖ citing example (1) in reg. § 1.509(a)-4(d)(2)(iii) (―institutions of higher learning in the state of y‖) and rev. rul. 81-43, 1981-1 c.b. 350 (―[tax-exempt public charities] located in the [city of] z area‖). the court found that ―unlike the examples contained in the regulation and the revenue ruling, [the foundation‘s] designation does not make its beneficiary organizations readily identifiable. there is no geographic limit. there is no limit by type of publicly supported organization (such as churches or seminaries). in light of the broad purposes mentioned in foundation‘s articles of incorporation, we agree with the government that it would be difficult, if not impossible, to determine whether the foundation will receive oversight from a readily identifiable class of publicly supported organizations.‖  very significantly, in its analysis, the court stated as follows: an agency‘s interpretation of its regulation is controlling unless the interpretation is ―plainly erroneous or inconsistent with the regulation.‖ auer v. robbins , 519 u.s. 452, 461 2012] recent developments in federal income taxation 327 (1997). this is so even if the interpretation appears for the first time in a legal brief. chase bank usa, n.a. v. mccoy, 131 s. ct. 871, 880–81 (2011); bigelow v. dep’t of def., 217 f.3d 875, 878 (d.c. cir. 2000). ―because the interpretation the [irs] presents in its brief is consistent with the regulatory text,‖ chase bank, 131 s. ct at 880, we have no basis for rejecting it in favor of some other version. 2. your client put it off for three years, so why not put it off until year-end 2012: organizations which lost their tax-exempt status may seek reinstatement until 12/31/12. ir-2011-63 (6/8/11). this information release provides guidance to help reinstate currently-existing organizations among the 275,000 which lost their tax-exempt status for failure to file required annual reports for three consecutive years. notice 2011-43, 2011-25 i.r.b. 882; notice 2011-44, 2011-25 i.r.b. 883; and rev. proc. 2011-36, 2011-25 i.r.b. 915, provide full details. 3. even the tax court is anti-union. national education association v. commissioner, 137 t.c. 123 (9/28/11). national education association (nea) is a tax-exempt labor organization described in § 501(c)(5). it published two magazines at an expense of about $7 million that it distributed to dues-paying members and to a few non-member paying subscribers. nea‘s literature stated that members received the magazines as a benefit of membership and stated an amount of dues that paid for the magazines. members who declined the magazines did not pay a smaller amount of dues. nea made most but not all of the content of the magazines available for free over the internet to the general public. nea published paid advertising in the magazines from which it earned annual net income of approximately $1 million. nea reported negligible circulation income, resulting in a substantial claimed loss on its circulation activity; nea used that loss to fully offset its taxable advertising profit. thus, nea reported that it owed no unrelated business income tax (ubit). the irs allocated a portion of nea‘s membership dues to circulation income, which resulted in nea having circulation income substantially in excess of the advertising income, resulting in the advertising income being ubit. reg. § 1.512(a)1(f)(3)(iii) provides that ―[w]here the right to receive an exempt organization periodical is associated with membership or similar status in such organization for which dues, fees or other charges are received (hereinafter referred to as ‗membership receipts‘), circulation income includes the portion of such membership receipts allocable to the periodical (hereinafter referred to as ‗allocable membership receipts‘).‖ the nea argued that its members did not have ‗the right to receive‘ the magazines because it was under no obligation to continue publishing and because its members as well as the general public could access the magazines for free on the internet. on these 328 florida tax review [vol. 12:5 grounds, the nea argued that it thus had virtually no circulation income, but had substantial excess readership costs that it could deduct from its advertising income, reducing that income to zero. the irs argued that nea members had the right to receive the magazines because a portion of the nea's members' dues was paid for magazines. as a result, the nea had substantial circulation income that more than covered the cost of producing the magazines; thus it had no excess readership costs, and accordingly had unrelated business taxable income from its paid advertising. the tax court (judge gustafson) upheld the deficiency, finding that the nea members, in fact, had a right to receive the publications. under its bylaws it could not ―halt publication of the magazines at its whim,‖ its contracts with advertisers limited its right to halt publication, as did relevant postal regulations. furthermore, the enrollment forms used by state affiliates, through which all nea members joined, separately listed the portion of the dues allocable to the publication subscriptions and promised delivery of the publications. finally, the court concluded that the alternative free availability of a publication to members did not nullify their right to receive the publication resulting from payment of dues.  as a preliminary matter the court rejected the irs‘s argument that ―the principle that an agency's interpretation of its own regulation is controlling unless it is ‗plainly erroneous or inconsistent with the regulation‘‖ applied in this case. the court concluded that ―[d]eference here to the agency's interpretation is difficult, second, because the irs is unable to show that the agency has in fact stated a position on the interpretation of ‗right to receive.‘‖ b. charitable giving 1. a ―gotcha‖ for the irs! the tax court just says ―no‖ to deductions for contributions of conservation easements on mortgaged properties. kaufman v. commissioner, 134 t.c. 182 (4/26/10). the tax court (judge halpern) held that as a matter of law no charitable contribution deduction is allowable for the conveyance of an otherwise qualifying conveyance of a facade conservation easement if the property is subject to a mortgage and the mortgagee has a prior claim to condemnation and insurance proceeds. because the mortgage has priority over the easement, the easement is not protected in perpetuity – which is required by § 170(h)(5)(a). the deduction cannot be salvaged by proof that the taxpayer likely would satisfy the debt secured by the mortgage. a. plea for a mulligan is rejected! kaufman v. commissioner, 136 t.c. 294 (4/4/11). on the taxpayers‘ motion for reconsideration, the tax court (judge halpern) in a lengthy and thorough opinion reaffirmed its earlier decision that the conservation easement failed 2012] recent developments in federal income taxation 329 the perpetuity requirement in reg. § 1.170a-14(g)(6), because under the loan documents, the bank that held the mortgage on the property expressly retained a ―‗prior claim‘ to all insurance proceeds as a result of any casualty, hazard, or accident occurring to or about the property and all proceeds of condemnation,‖ and agreement also provided that ―the bank was entitled to those proceeds ‗in preference‘ to [the donee organization] until the mortgage was satisfied and discharged.‖ the court also disallowed a deduction in 2003, but allowed the deduction in 2004, for a cash contribution to the donee of the conservation easement in 2003 because the amount of the cash payment was subject to refund if the appraised value of the easement was zero, and the appraisal was not determined until 2004. the court also rejected the irs‘s argument that the taxpayers received a quid pro quo for the cash contribution in the form of the donee organization accepting and processing their application, providing them with a form preservation restriction agreement, undertaking to obtain approvals from the necessary government authorities, securing the lender agreement from the bank, giving the taxpayers basic tax advice, and providing them with a list of approved appraisers. the facts in evidence did not demonstrate a quid pro quo, because, among other things, many of the tasks had been undertaken by the organization before the check was received.  finally, the court declined to uphold the § 6662 accuracy related penalties asserted by the irs for the taxpayer‘s overstatement of the amount of the contribution for the conservation easement, but sustained the negligence penalty for the 2003 deduction for the cash payment. because the issue of whether any deduction was allowed for the easement, regardless of its value, was a matter of law decided in the case as a matter of first impression, the taxpayers were not negligent, had reasonable cause, and acted in good faith. b. another facade conservation easement deduction on mortgaged property bites the dust, with an alternative ground of uselessness. 1982 east, llc v. commissioner, t.c. memo. 2011-84 (4/12/11). kaufman was followed to deny the claimed charitable contribution deduction for a facade conservation easement burdening mortgaged property where the lender had a ‗―prior claim‘‖ to all condemnation and insurance proceeds ―‗in preference‘ to [the donee] ‗until‘ that mortgage was satisfied and discharged. ... [a]t any point before the mortgage was repaid, the possibility existed for [the lender] first republic bank to deprive [the donee] of value that should have otherwise been dedicated to the conservation purpose.‖  alternatively, the deduction was disallowed because the building with respect to which the easement was granted was in the new york city metropolitan museum historic district, and 330 florida tax review [vol. 12:5 local law protected the building against alteration and the easement provided no additional protection. 2. a possibly faulty conservation easement deduction saved by local preservation laws. simmons v. commissioner, t.c. memo. 2009-208 (9/15/09). judge wherry held that facade conservation easements validly supported a charitable contribution deduction, even though they allowed the easement holder to consent to changes to the properties, because any rehabilitative work or new construction on the facades was required to comply with the requirements of all applicable federal, state, and local government laws and regulations. reg. § 1.170a-14(d)(5) allows a donation to satisfy the conservation purpose‘s test even if future development is allowed, as long as that future development is subject to local, state, and federal laws and regulations. that the properties were already subject to local preservation laws did not prevent any charitable contribution deductions, because even though the easements were duplicative in some respects, the easements subjected the taxpayer to a higher level of enforcement than that provided by local law. a. affirmed. 646 f.3d 6 (d.c. cir. 6/21/11). the court of appeals (judge ginsburg) agreed with the tax court that even though the deeds did not spell out precisely what would happen upon the dissolution of the donee, district of columbia law provides the easements would be transferred to another organization that engaged in ―activities substantially similar to those of‖ the grantee. the court reasoned that the clauses permitting changes or abandonment upon the donee‘s consent had ―no discrete effect upon the perpetuity of the easements‖ because ―[a]ny donee might fail to enforce a conservation easement, with or without a clause stating it may consent to a change or abandon its rights, and a tax-exempt organization would do so at its peril.‖ the deduction could not be disallowed based upon the remote possibility the donee would abandon the easements. finally, the court rejected the government‘s argument that the deduction should be disallowed because the taxpayer did not obtain qualified appraisals meeting the requirements of reg. § 1.170a-13(c)(3)(ii); the tax court did not clearly err in concluding that the appraisals sufficiently identified the method and basis for the valuations. 3. conditionally revocable conservation easements are no-good. carpenter v. commissioner, t.c. memo. 2012-1 (1/3/12). conservation easements that could be extinguished by the mutual consent of the donor taxpayer and the donee organization failed as a matter of law to comply with the enforceability in perpetuity requirements under reg. § 1.170a-14(g). the easements were not protected in perpetuity and thus were not qualified conservation contributions under § 170(h)(1). 2012] recent developments in federal income taxation 331 4. ―too good to be true‖ turns out not to be true at all. gundanna v. commissioner, 136 t.c. 151 (2/14/11). in 1998, the taxpayer transferred over $250,000 of appreciated stock to the xélan foundation, a § 501(c) (3) organization that was not a private foundation. the stock was held ―as ‗a donor advised fund‘ or ‗family public charity‘ (foundation account), by means of which a donor‘s donations would be segregated for investment and future distribution as the donor might recommend.‖ the taxpayer claimed a charitable contribution deduction; he did not include in income any gain from the sales of the stocks that had been transferred to the foundation and which foundation had sold in 1998, or any dividends or interest generated by the assets in petitioner‘s foundation account. pursuant to the taxpayer‘s requests, the foundation made distributions from his foundation account of several thousand dollars to the shiva vishnu temple in each of the years 1999 through 2002. in addition, in 2001 and 2002, at the taxpayer‘s request, $70,299 was distributed from his foundation account to the university of pennsylvania in connection with the foundation‘s student loan program, as a loan to the taxpayer‘s son to cover the cost of his tuition, room, and board. in 2003, approximately $19,500 was distributed to the taxpayer to pay his legal fees in connection with an audit that proposed disallowance of the charitable contribution deduction claimed for 1998. during the course of the audit, the taxpayer repaid the principal of his son‘s student loans, but the foundation waived accrued interest. the tax court (judge gale) upheld the irs‘s disallowance of the charitable contribution deduction on the ground that the taxpayer retained dominion and control over the property transferred to the foundation and held in his foundation account. this conclusion was based ―principally on the basis of the use of funds in petitioner‘s foundation account for student loans to his son.‖ the taxpayer‘s ―understanding, at the time he transferred the stocks to his foundation account in 1998, that the account‘s assets could be used to make student loans to his children, and the foundation‘s perfunctory acquiescence in making such loans in subsequent years, provide substantial support for the conclusion that petitioner neither intended, nor in fact did, cede dominion and control over the property transferred to the foundation in 1998.‖ judge gale also found ―that the promotion of another foundation account feature – petitioner‘s ability to arrange for distributions of account funds to compensate himself or family members for performance of ‗good works‘ – also support[ed] the conclusion that petitioner maintained control of the assets in his foundation account.‖ alternatively, judge gale held that the substantiation requirements of § 170(f)(8)(a) had not been satisfied because, despite the foundation providing the taxpayer with a contemporaneous written acknowledgment stating that no goods or services had been provided, under reg. § 1.170a-13(f)(6) goods or services that the taxpayer expects to receive in the future must be taken into account, and when the taxpayer transferred the stock to the foundation he expected to receive goods or 332 florida tax review [vol. 12:5 services in the form of student loans to his children. in addition to upholding disallowance of the charitable contribution deduction, judge gale held that because the taxpayer retained dominion and control over the funds, he was taxable on the capital gains and other income earned by the fund. finally, and not surprisingly, § 6662 accuracy related penalties for negligence and substantial underpayment were upheld. [p]etitioners were negligent because petitioner failed to make a reasonable attempt to ascertain the correctness of a deduction which would seem to a reasonable or prudent person to be ―too good to be true‖ under the circumstances. a reasonable or prudent person would have perceived as ―too good to be true‖ a deduction for a supposed charitable contribution where the amounts deducted could be used to fund student loans for his own children.  judge gale rejected the taxpayer‘s argument that because the foundation was listed in publication 78, he had substantial authority for the deduction. 5. another claimed conservation easement sinks in quicksand. boltar, l.l.c. v. commissioner, 136 t.c. 326 (4/5/11). in a conservation easement charitable contribution deduction case, the tax court (judge cohen), sustained the irs‘s motion to exclude the taxpayer‘s expert‘s valuation report because the taxpayer‘s expert failed to apply the correct standards required by reg. § 1.170a-14(h)(3)(i). he did not determine the value of the donated easement by the ―before and after‖ valuation method, did not value contiguous parcels owned by the taxpayer and encumbered by conservation easements, and assumed development potential (for a 174 unit condominium) that actually was not feasible on the property. as a result, the deduction was disallowed and the deficiency upheld. 6. the boilerplate can kill ya! schrimsher v. commissioner, t.c. memo. 2011-71 (3/28/11). the taxpayers granted a facade easement with respect to property in huntsville, alabama, commonly known as the ―times building,‖ to the alabama historical commission. they claimed a charitable contribution deduction, listing on the form 8283 the appraised fair market value of the facade easement as $705,000. the ―appraisal summary‖ on the form 8283 omitted various items of required information, and it was not signed or dated by the donor, the appraiser, or any representative of the donee; a written appraisal of the facade easement was not attached. the agreement facade easement stated: [f]or and in consideration of the sum of ten dollars, plus other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the grantor [taxpayer] does hereby irrevocably grant, bargain, 2012] recent developments in federal income taxation 333 sell, and convey unto the grantee [the commission], its successors and assigns, a preservation and conservation easement to have and hold in perpetuity ... .  the agreement also provided as follows: ―this agreement sets forth the entire agreement of the parties with respect to the easement and supercedes all prior discussions, negotiations, understanding, or agreements relating to the easement, all of which are merged herein.‖ the tax court (judge thornton) granted summary judgment upholding the disallowance of the deduction because there was no other written acknowledgment of the gift, the agreement failed the requirements of § 170(f)(8)(b)(iii) because it did not include a description and good faith estimate of the ―other good and valuable consideration.‖ 7. a touch of cohan [?], with a cap, for the cat woman’s unreimbursed charitable volunteer expenses. van dusen v. commissioner, 136 t.c. 515 (6/2/11). the taxpayer claimed charitable contribution deductions for out-of-pocket expenses incurred in caring for ―foster cats‖ as a volunteer on behalf of fix our ferals, a § 501(c)(3) organization. the tax court (judge morrison) applied the ―substantial compliance doctrine‖ to allow a deduction for expenses incurred by a volunteer providing services to a charitable organization, even though the taxpayer‘s records did not strictly meet the specific requirements of reg. § 170a-13(a)(1). the taxpayer‘s documents were ―legitimate substitutes for canceled checks,‖ because they contained all of the information that would have been on a canceled check — the name of the payee, the date of the payment, and the amount of the payment. although the regulation requiring substantiation records to reflect the name of the donee was not written with unreimbursed volunteer expenses in mind, because the amounts expended exceeded $250 and the taxpayer failed to satisfy requirements of § 170(f)(8)(a) and reg. § 1.170a-13(f)(1) for substantiation in the form of a contemporaneous written acknowledgment from the charitable organization, the deductible amount for each separate expenditure was limited to $250.  query whether prudent planning in the future should be: ―if it flies or floats, don‘t own – rent; if it barks or meows, don‘t adopt – foster.‖ 8. how can the tax court deny a charitable donation deduction to a taxpayer named ―didonato‖? didonato v. commissioner, t.c. memo. 2011-153 (6/29/11). the tax court (judge laro) denied a 2004 charitable contribution deduction on grounds of lack of substantiation under § 170(f)(8). the alleged donation was memorialized by a 2004 contract between taxpayer and the charitable recipient but the formal transfer did not occur until 2006, when the donation was acknowledged. the 2006 acknowledgment was too late to substantiate a 2004 deduction because 334 florida tax review [vol. 12:5 it was received by taxpayer after his 2004 federal income tax return was filed. 9. both their house and their claimed charitable contribution deduction went up in smoke. rolfs v. commissioner, 135 t.c. 471 (11/4/10). the taxpayers donated a home, but not the underlying land, to the local volunteer fire department to be burned down in a training exercise. the fire department could not use the house for any purpose other than destruction by fire in training exercises. the taxpayers claimed a charitable contribution deduction of $76,000 based on a ―before and after‖ valuation, comparing the value of the parcel with the building intact and the value of the parcel after demolition of the building; they complied with all record keeping and substantiation requirements. the tax court (judge gale) upheld the irs‘s denial of the deduction. first, based on expert testimony, he found that the taxpayers received a quid-pro-quo in the amount of $10,000, which was the value of the demolition services provided to them by the donee fire department. second, he found that the building, with ownership severed from the land and burdened by the condition that it be removed, i.e., in this case demolished, had no value. the lack of value was established by the expert testimony of home movers, who testified that considering the costs of removal to another site, the modest nature of the home, and the value of nearby land, no one would purchase the home for more than a nominal amount, between $100 and $1,000, sufficient to render the contract enforceable. applying the principles of hernandez v. commissioner, 490 u.s. 680 (1989), and united states v. american bar foundation, 477 u.s. 105 (1986), judge gale held that because the consideration received by the taxpayers exceeded the value of the transferred property, there was no charitable contribution. he rejected application of the ―before and after‖ valuation method, because that method did not take into account the restrictions that would have affected the marketability of the structure severed from the land. a. while the tax court opinion is very fact specific, the court of appeals affirmance looks to establish a broader principle. rolfs v. commissioner, 668 f.3d 888 (7th cir. 2/8/12). in an opinion by judge hamilton, the seventh circuit affirmed the tax court‘s decision. the seventh circuit concluded that ―proper consideration of the economic effect of the condition that the house be destroyed reduces the fair market value of the gift so much that no net value is ever likely to be available for a deduction, and certainly not here.‖ the appellate court reasoned that ―the fair market valuation of donated property must take into account conditions on the donation that affect the market value of the donated property,‖ and that the tax court properly rejected the before-andafter method for valuing a donation of property conditioned on the 2012] recent developments in federal income taxation 335 destruction of the property. the valuation must take into account any reduction in fair market value that results from the condition. moving and salvage, under which the house had no actual value, were analogous situations reasonably approximated the actual facts. the before-and-after valuation method proffered by the taxpayer was not appropriate, because the facts were not analogous to conservation easements, where that method typically is used; in this case the donation destroyed the residential value rather than transferring it. x. tax procedure a. interest, penalties and prosecutions 1. the instructions for the new fbar are fubar. ir-2009-58 and announcement 2009-51, 2009-1 c.b. 1105 (6/5/09). the irs announced that for the reports of foreign bank and financial accounts (fbars) due on 6/30/09, filers of form td f 90-22.1 (rev. 10-2008) need not comply with the new instruction relating to the definition of a united states person, i.e.: united states person. the term ―united states person‖ means a citizen or resident of the united states, or a person in and doing business in the united states. see 31 c.f.r. 103.11(z) for a complete definition of ‗person.‘ the united states includes the states, territories and possessions of the united states. see the definition of united states at 31 c.f.r. 103.11(nn) for a complete definition of united states. a foreign subsidiary of a united states person is not required to file this report, although its united states parent corporation may be required to do so. a branch of a foreign entity that is doing business in the united states is required to file this report even if not separately incorporated under u.s. law.  instead, for this year, taxpayers and others can rely on the definition of a united states person included in the instruction to the prior form (7-2000): united states person. the term ―united states person‖ means: (1) a citizen or resident of the united states; (2) a domestic partnership; (3) a domestic corporation; or (4) a domestic estate or trust. a. notice 2009-62, 2009-2 c.b. 260 (8/7/09). by this notice, the irs extended the filing deadline until 6/30/10 to report foreign financial accounts on form td f 90-22.1 for persons with signature authority over (but no financial interest in) a foreign financial account and 336 florida tax review [vol. 12:5 persons with signature authority over, or financial interests in, a foreign commingled fund. b. still clear as mud: new definitions and instructions. rin 1506-ab08, financial crimes enforcement network; amendment to the bank secrecy act regulations – reports of foreign financial accounts, 75 f.r. 8844 (2/26/10). this proposed rule would include a definition of ―united states person‖ and definitions of ―bank account,‖ ―securities account,‖ and ―other financial account,‖ as well as of ―foreign country.‖ it also includes draft instructions to form td f 90-22.1 (fbar). (1) notice 2010-23, 2010-1 c.b. 441 (2/26/10). provided administrative relief to certain person who may be required to file and fbar for the 2009 and earlier calendar years by extending the filing deadline until 6/30/11 for persons with signature authority, but no financial interest in, a foreign financial account for which an fbar would have otherwise been due on 6/30/10. it also provides relief with respect to mutual funds. (2) announcement 2010-16, 20101c.b. 450 (2/26/10). the irs suspended, for persons who are not u.s. citizens, u.s. residents, or domestic entities, the requirement to file an fbar for the 2009 and earlier calendar years. c. second (or, is it the third?) special voluntary disclosure initiative available through 8/31/11. ir-2011-14 (2/8/11). the 2011 offshore voluntary disclosure initiative is similar to the 2009 offshore voluntary disclosure program with a 25-percent penalty and an 8-year look-back requirement (both slightly-increased from 2009). there are lower penalties in some limited situations (5 percent), and where offshore accounts do not surpass $75,000 (12.5 percent). all original and amended tax returns must be filed and payment of all taxes, interest and penalties must be made by the 8/31/11 deadline.  subsequent q&as offer the possibility of a 90-day extension to complete the voluntary disclosure where total compliance had not been made by the deadline despite good faith attempts. see q&a 25.1. d. additional relief for persons with signature authority. notice 2011-54, 2011-29 i.r.b. 53_ (6/16/11). provides additional relief to persons whose requirement to file form td-f 90-22.1, report of foreign bank and financial accounts (fbar), for calendar year 2009 or earlier calendar years was based solely upon signature authority. their deadline is now 11/1/11. the deadline for reporting 2012] recent developments in federal income taxation 337 signature authority over, or a financial interest in, foreign financial accounts for the 2010 calendar year remains 6/30/11.  reporting problems occur for former employees, as well as with respect to foreign accounts that give signature authority to ―all officers.‖ e. complying with fatca may cause tax return preparers to become confused. ir-2011-117, dec. 14, 2011. an information return on form 8938 must be filed by individuals with more than the threshold amount for foreign financial assets. it will serve as a check on foreign financial institutions providing form 1099 with respect to income from such assets. f. ♪♫ ―this is a song that doesn’t end / it goes on and on, my friend ….‖ ♫♪ third (or fourth) voluntary disclosure program is announced. ir-2012-5 (1/9/12). the irs has announced the reopening of the offshore voluntary disclosure program (ovdp) following the closure of the 2011 and 2009 programs. there is no set deadline within which to apply, but the program could be changed or terminated at any time. the penalty structure for the program will be similar to the 2011 program except the highest penalty will be 27.5 percent instead of 25 percent. details will be available on the irs website in february 2012. 2. since the same penalty statute applies, the principle of this estate tax penalty case should also apply to late payment of income taxes. baccei v. united states, 632 f.3d 1140 (9th cir. 2/16/11). in united states v. boyle, 469 u.s. 241 (1985), which involved a § 6651(a)(1) penalty for failure to timely file an failure to an estate tax return, the supreme court held that reliance on an accountant, lawyer, or other agent to file the return is not ―reasonable cause‖ for late filing. in another estate tax case, the ninth circuit (judge burgess) extended this principle to the § 6651(b) penalty to timely pay a tax, holding that the taxpayer‘s reliance on an accountant, lawyer, or other tax advisor to seek an extension of time to pay the estate tax was not ―reasonable cause‖ for the late payment. 3. the tax court won’t waste time or paper on frivolous arguments! or will it? wnuck v. commissioner, 136 t.c. 498 (5/31/11). the irs determined a deficiency based on the taxpayer‘s unreported wages. at the trial the taxpayer admitted, ―i exchanged my skilled labor and knowledge for pay.‖ in a bench opinion the tax court sustained the deficiency, ruling that the taxpayer‘s arguments were frivolous, imposed a $1,000 § 6673(a) penalty, and warned the taxpayer that if he repeated his frivolous positions he faced the risk of a larger penalty. on the 338 florida tax review [vol. 12:5 taxpayer‘s motion for reconsideration on the grounds that the court had not adequately addressed his arguments, judge gustafson wrote a magisterial full opinion, denying the motion for reconsideration and holding that the taxpayer was not entitled to a court opinion addressing his frivolous arguments. while the opinion did not directly answer the substance of the frivolous arguments, it did show why the arguments were frivolous. it also increased the penalty to $5,000, and warned taxpayer that further frivolous arguments would subject him to a penalty of up to $25,000.  judge gustafson stated at the outset: if one is genuinely seeking the truth, if he focuses on what is relevant, and if he confines himself to good sense and logic, then the number of serious arguments he can make on a given point is limited. however, if one is already committed to a position regardless of its truth, if he is willing to say anything, if he is willing to ignore relevance, good sense, and logic, and if he is simply looking for subjects and predicates to put together into sentences in ostensible support of a given point, then the number of frivolous arguments that he can make on that point is effectively limitless. when each frivolous argument is answered, there is always another, as long as there are words to be uttered. such arguments are without number. consequently, a court that decides cases brought by persons willing to make frivolous arguments – such as ―tax protesters‖ or ―tax defiers‖ [fn. 2] – would by definition never be finished with the task of answering those frivolous arguments.  that notable footnote [fn. 2] explained as follows: persons who make frivolous anti-tax arguments have sometimes been called ―tax protesters‖. section 3707 of the internal revenue service restructuring and reform act of 1998, pub. l. 105-206, 112 stat. 778, provided that ―the officers and employees of the internal revenue service *** shall not designate taxpayers as illegal tax protesters‖, because congress was ―concerned that taxpayers may be stigmatized‖, s. rept. 105-174, at 105 (1998), 1998-3 c.b. 537, 641. this prohibition applies only to irs employees and not to the courts; and we use here the alternative term ―tax defier‖ for a reason having nothing to do with any supposed stigma attached to being a ―zero returns‖ or who otherwise try to shirk their civic responsibility, evade their fair share of the tax burden, waste tax enforcement resources, and clog the courts with pointless lawsuits are simply scoff-laws. they enjoy the benefits of american 2012] recent developments in federal income taxation 339 security and stability while refusing to shoulder their portion of the burden. they are not protesters but are defiers. 4. mistakes that were the result of ―confusion, inattention to detail, or pure laziness‖ of a tax advisor who was the vice president of taxes were not attributable to ―reasonable cause,‖ but when the same tax advisor acted as an independent consultant between stints as a corporate employee and made those same mistakes, the taxpayers’ reliance was in good faith. huh! seven w. enterprises, inc. v. commissioner, 136 t.c. 539 (6/7/11). the irs asserted § 6662 accuracy related penalties for 2000 through 2003 with respect to the underpayment of the personal holding company tax. for certain years during that period, william mues, a cpa, prepared the 2000 and 2001 tax returns for one of the taxpayer corporations and the 2001 return for another of the taxpayer corporations as an independent consultant. in 2002, the taxpayer corporations‘ group hired mues as vice president of taxes, and in that capacity he prepared and signed, on behalf of one of the taxpayer corporations its 2001, 2002, and 2003 tax returns and the 2002, 2003, and 2004 tax returns of another of the taxpayer corporations. the taxpayers contended that they had reasonable cause for their underpayments and acted in good faith and that they reasonably relied on mues‘s advice in 2000 when he served as a consultant and in 2001 through 2004 when he served as vice president of taxes. the tax court (judge foley) held that even though mues had been an employee of the taxpayer corporations from 1990 until january 2001 and during that time period executed various tax documents on behalf of the taxpayer corporations, at the time he signed the tax returns as an independent consultant, he was acting as an independent consult and not as an employee. because he was an ―experienced and knowledgeable tax professional, with all of the relevant information necessary to prepare the return‖ the taxpayer relied in good faith on mues to accurately and correctly prepare the 2000 return, even though he made several mistakes in applying the personal holding company tax rules. however, with respect to the 2001 through 2004 returns, the taxpayer corporations did not satisfy the good faith reliance test. for those years, mues was a corporate employee acting on behalf of the corporations, not an independent advisor. because he was not a person ―other than the taxpayer‖ the ―good faith reliance‖ defense to the penalties was not available. furthermore, the taxpayers did not have ―reasonable cause‖ for the understatements. ―it is unclear whether [taxpayers‘] myriad of mistakes was the result of confusion, inattention to detail, or pure laziness, but we are convinced that petitioners and mues failed to exercise the requisite due care. ... [the taxpayers‘] repeated audit adjustments relating to multiple irs audits coupled with mues‘ experience, expertise, and education further bolster [the] conclusion that [the taxpayers] 340 florida tax review [vol. 12:5 failed to exercise ordinary business care and prudence as to the disputed items.‖ 5. yes, it’s my return but can’t i rely on my cpa’s transcription and arithmetic skills? held: reliance on a return preparer who omits a $3.4 million gain on a transaction in which the taxpayer personally participated and for which he received a form-1099 was not good faith reasonable reliance. woodsum v. commissioner, 136 t.c. 585 (6/13/11). in 2006 the taxpayers realized a $3.4 million gain on ―swap‖ transaction in which one of the taxpayers, who was a managing director of a private equity investment firm, was personally involved. the taxpayers received a form 1099-misc, miscellaneous income, that reported the payment. the taxpayers retained a firm with a lawyer and a certified public accountant to prepare their 2006 income tax return and gave the firm all the over 160 information returns they had received from third-party payors, including the form 1099–misc reporting the $3.4 million gain. the taxpayers‘ 115-page return that the firm prepared reported $29.2 million of agi, but omitted the $3.4 million from the swap transaction. the taxpayers briefly reviewed the return on the due date but did not compare or match the items of income reported on the form 1040 and its schedules with the information returns that the third-party payors had provided before they signed and filed the return. when the irs asserted a deficiency for the $3.4 million gain and § 6662 substantial understatement penalty, the taxpayers conceded the deficiency with respect to the gain but contested the penalty on the grounds of ―reasonable cause‖ and good faith reliance on their tax return preparer. the tax court (judge gustafson) upheld the penalty. even though he ―assumed‖ that the taxpayers were unaware of the omission when they signed and filed the return, they ―failed to make sure that all their income items were reported on the return that [the return prepared] had prepared. the court reasoned that ―to constitute ‗advice‘ within the definition of [reg. § 1.6662-4(c)(2)] the communication must reflect the adviser‘s ‗analysis or conclusion.‘‖ the taxpayer must show that he relied on the advisor‘s ―judgment.‖ the taxpayers did not rely on the preparer‘s judgment, because ―[n]o ‗special training‘ was required for mr. woodsum to know that the law required him to include on that return an item of income that he had received and that deutsche bank had reported on form 1099.‖ furthermore, even though reg. § 1.6664-4(b)(1) provides that ―[a]n isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith,‖ assuming that the omission was an innocent oversight by the return preparer, the taxpayers‘ review of the return was not reasonable under the circumstances. although a taxpayer is not required to duplicate the work of his return preparer, and an omission of an income item in a return prepared by a third party is not necessarily fatal to a finding of reasonable cause and good faith on the taxpayer‘s part if the taxpayer conducts a review 2012] recent developments in federal income taxation 341 of his third-party prepared return with the intent of ensuring that all income items are included, that effort must be reasonable under the circumstances. in this case, the taxpayers failed to demonstrate that they made a reasonable effort to review the return. the taxpayer had personally ordered the transaction that gave rise to the income and had received a form 1099–misc reporting that income. the amount should have appeared on schedule d as a distinct item, but it was omitted. the taxpayers‘ ―‗review‘ of the defective return was of an unknown duration and that it consisted of the preparer turning the pages of the return and discussing various items.‖ the $3.4 million understatement ―was substantial not only in absolute terms but also in relative terms (i.e., it equaled about 10 percent of petitioners‘ adjusted gross income). a review undertaken to ‗make sure all income items are included‘ ... or even a review undertaken only to make sure that the major income items had been included—should, absent a reasonable explanation to the contrary, have revealed an omission so straightforward and substantial.‖ finally, the court concluded as follows: mr. woodsum terminated the swap ahead of its set termination date because his watchful eye noted that it was not performing satisfactorily as an investment. that is, when his own receiving of income was in question, mr. woodsum was evidently alert and careful. but when he was signing his tax return and reporting his tax liability, his routine was so casual that a half-million-dollar understatement of that liability could slip between the cracks. we cannot hold that this understatement was attributable to reasonable cause and good faith.  if this cpa cannot copy and cannot add, he is nevertheless not subject to preparer penalties because this was an isolated mistake. the one of us who uses a cpa to prepare his tax returns is outraged that a taxpayer who employs a cpa to prepare his income tax return cannot rely on the cpa‘s transcription and arithmetic skills. 6. canal opinion redux? paschall v. commissioner, 137 t.c. 8 (7/5/11). through a series of convoluted preplanned transactions designed by grant thornton that the tax court found to lack economic substance, the taxpayer in essence moved approximately $1.3 million from a traditional ira to a roth ira, without paying any taxes. the irs asserted that he had made excess contributions to a roth ira. the taxpayer had filed timely forms 1040 for the years in issue, but failed to file forms 5329 reporting the excess contributions for the years in issue. more than three years after the due date for the forms 1040 for the years in issue, the irs proposed § 4973 excise tax assessments. the taxpayer asserted that the statute of limitations had run, but the tax court (judge wherry) held that the filing of the forms 1040 did not start the statute of limitations running for 342 florida tax review [vol. 12:5 purposes of the § 4973 excise tax in the absence of accompanying forms 5329. section 6651(a)(1) failure to file a required return penalties were sustained. the taxpayer did not demonstrate reasonable cause and ―good faith‖ to mitigate the penalties. the taxpayer paid his advisors a flat fee of $120,000, which was payable only if the transaction was completed, and relied solely on the advice of the advisors promoting the transaction; the tax advisors were not independent. furthermore, ―paschall should have realized that the deal was too good to be true.‖ mr. paschall had doubts, repeatedly asking whether the roth restructure was legal. despite these doubts, he never asked for an opinion letter or sought the advice of an independent adviser, including mr. jaeger, who was preparing his tax returns at the time he met mr. stover. this was even after he received a letter warning him that there might be problems with the roth restructure and that his name was being turned over to the irs. a. different taxpayer, same scam, same tax advisors, same result, this time citing and quoting canal. swanson v. commissioner, t.c. memo. 2011-156 (7/5/11). this case involved a transaction substantially similar to paschall, supra, if not essentially identical. the taxpayer conceded the substantive excise tax penalty issue and contested only the penalty issue, which he lost. the court (judge wherry) rejected the taxpayer‘s claim reasonable cause defense to the § 6662 penalties. the taxpayer claimed reliance on his tax advisors, who participated in structuring the transaction. in rejecting the taxpayer‘s argument, judge wherry quoted from canal corp. v. commissioner, 135 t.c. 199, 218 (2010): ―courts have repeatedly held that it is unreasonable for a taxpayer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest.‖ judge wherry found that ―at a minimum‖ the tax advisors on whom the taxpayer relied ―had a conflict of interest and were not independent‖ because they ―set up the various entities and coordinated the deal ‗from start to finish‘.‖ they ―were paid ‗a flat fee for implementing *** [the roth restructure] and wouldn‘t have been compensated at all if *** [mr. swanson] decided not to go through with it.‘ therefore [the taxpayers] cannot argue that their reliance on [the tax advisors] establishes reasonable cause and good faith.‖ 7. ―same taxpayer‖ really does mean the same taxpayer. energy east corp v. united states, 645 f.3d 1358 (6/20/11). section 6621(d) deals with overlapping periods of underpayment and overpayment by the ―same taxpayer‖ by imposing a net interest rate of zero on the equivalent underpayment and overpayment for the period of the overlap. energy east corporation filed a refund claim, seeking to offset the 2012] recent developments in federal income taxation 343 amount it underpaid in 1999 with amounts two of its subsidiaries overpaid from 1995–97, even though consolidation did not occur until 2000 and 2002. the court of appeals for the federal circuit (judge gajarsa) held that § 6621(d) did not apply in this situation. the parent and the subsidiaries were not the same taxpayer in the pre-consolidation years that the underpayments and overpayments were made. the court rejected the taxpayer‘s argument that § 6621(d) merely requires the taxpayers to be the same only as of the time the netting claim was filed. the court rejected the taxpayer‘s alternative argument that § 6621(d) allows interest netting when two or more corporations file consolidated returns for years during which interest accrues. a. but a particular corporation is the ―same taxpayer‖ after it joins a consolidated group as it was before it joined the consolidated group, even though energy east is law of the circuit. magma power co. v. united states, 101 fed. cl. 562 (10/28/11). prior to 2/24/95, magma power was not part of a consolidated group. in 2000 magma power was assessed a deficiency for 1993, which it paid in 2002 and 2003. in 2004 and 2005, the irs determined that the consolidated group of which magma power was a member overpaid its taxes for the years 19951998 and paid a refund. a portion of the refund for those years was attributable to an original overstatement of magma power‘s contribution to consolidated taxable income. the court of federal claims (judge baskir) held that for purposes of applying the interest netting rule of § 6621(d), magma power was the ―same taxpayer‖ with respect to its underpayment for 1993, before it joined a consolidated group and with respect to the consolidated group‘s overpayments for the period of 1995 through 1998. the court rejected the government‘s argument that the ―plain meaning‖ of § 6621(d) ―contemplates a complete identity between the entities reflected on the tax returns in question, regardless of which specific taxpayers are responsible for underpayments and overpayments,‖ reasoning – correctly in our opinion – that the group is not a ―taxpayer‖ under the code. the court distinguished energy east corp v. united states, 645 f.3d 1358 (fed. cir. 6/20/11), supra, because the overpayments and underpayments in that case related to different corporations and were with respect to pre-consolidation years. 8. does he go to ―club fed‖ or do ―hard time‖? united states v. cooper, 645 f.3d 1104 (10th cir. 8/15/11). the tenth circuit upheld the criminal conviction for wire fraud under 18 u.s.c. § 1343 and mail fraud under 18 u.s.c. § 1341 of an individual who was the founder, president, and ceo of renaissance, the tax people, inc., a corporation that marketed and sold tax materials — the ―tax relief system‖ — and a bundle of services — platinum tax advantage — aimed at home based businesses. the package included a scheme to enable anyone associated with 344 florida tax review [vol. 12:5 renaissance to avoid paying taxes on their w-2 income through the use of the ―w-4 exemption increase estimator‖ and fraudulently claimed deductions, including the cost of vacations, ―‗wages‘/allowance paid to children,‖ commuting miles, and ―unreasonable percentage use of the home for business purposes.‖  somehow the jury had acquitted him of aiding and abetting in the preparation of fraudulent returns under § 7602(2). 9. enjoy being enjoined. united states v. stover, 650 f.3d 1099 (8th cir. 8/16/11). the eighth circuit upheld a permanent injunction under § 7408 against an accountant barring him from promoting his ―parallel c,‖ ―esop/s,‖ or ―roth/s‖ fraudulent tax evasion schemes. 10. the irs must speak quickly or lose interest. t.d. 9545, interest and penalty suspension provisions under section 6404(g) of the internal revenue code, 76 f.r. 52259 (8/22/11). the treasury department has promulgated reg. § 301-6404-4, providing specific rules dealing with the suspension of interest, penalties, additions to tax, or additional amounts under § 6404(g), which suspends the accrual of interest for the period beginning one year (or eighteen months, if applicable) after the due date (or filing, if applicable) of the return if the return is timely filed and the irs has not sent the taxpayer a notice of additional liability (e.g., a math error notice of deficiency), including an explanation of the basis for the liability, within one year following the later of (1) the due date of the return (without regard to extension) or (2) the date on which the taxpayer filed the return. (interest resumes running twenty-one days after the irs sends a notice to the taxpayer.) among other things, the regulations provide (1) that a notice may be provided in person, to the taxpayer‘s representative, or by mail (if notice is sent to taxpayer‘s last known address under principles of § 6212(b); certified or registered mail is not required; (2) if a taxpayer files an amended return showing an increase in tax liability, the date on which the return was filed will be the filing date; if an amended return shows a decrease in tax liability, interest will not be suspended if the irs proposes to adjust the items on the amended return. 11. if you’re the guy who doesn’t remit the wage withholding taxes to the irs, you can’t claim a credit for taxes withheld, and you might be hit with a fraud penalty to boot. may v. commissioner, 137 t.c. 147 (10/24/11). the taxpayer was the ceo and president, as well as a shareholder of his employer. the employer corporation withheld taxes from paychecks, but did not remit the taxes to the government. the taxpayer nevertheless claimed credit of the withheld taxes on his own return. following the taxpayer‘s conviction for criminal tax fraud, the irs asserted a deficiency, and the taxpayer filed a tax court petition. the tax court (judge 2012] recent developments in federal income taxation 345 goeke) held, first, that the tax court has jurisdiction over fraud penalties in a case involving a deficiency based on overstated withholding credits, citing rice v. commissioner, t.c. memo. 1999-65. the tax court had jurisdiction over the case as involving a ―deficiency‖ because an ―underpayment‖ includes a taxpayer‘s overstated credits for withholding under feller v. commissioner, 135 t.c. 497 (2010). the court rejected the taxpayer‘s argument that under reg. § 1.31-1 which provides that ―[i]f the tax has actually been withheld at the source, credit or refund shall be made to the recipient of the income even though such tax has not been paid over to the government by the employer.‖ instead, following united states v. blanchard, 618 f.3d 562 (6th cir. 2010), it concluded that ―the proper test to determine whether actual withholding at the source occurred should consider whether the funds functionally left the control of a taxpayer. such a test should not be strictly constrained by the multiple identities one person may have when acting in both a personal and a corporate capacity.‖ on the facts, ―[b]ecause mr. may was responsible for the nonremittance and fully controlled the corporate finances,‖ the court concluded that ―that the funds never left mr. may‘s functional control and were therefore not ‗actually withheld at the source‘ from his wages.‖ furthermore, the irs carried its burden of proof on the fraud issue and the 75-percent fraud penalty was justified with respect to the underpayments resulting from overstated withholding credits. 12. the treasury explains the penalty for failing to rat yourself out regarding reportable transactions. t.d. 9550, section 6707a and the failure to include on any return or statement any information required to be disclosed under section 6011 with respect to a reportable transaction, 76 f.r. 55256 (9/7/11). reg. § 301.6707a-1 provides that a taxpayer may incur a separate penalty under § 6707a with respect to each reportable transaction that the taxpayer was required, but failed, to disclose within the time and in the form and manner required under reg. § 1.6011-4(d) and (e) or as stated in other published guidance. a taxpayer who is required to disclose a reportable transaction on a form 8886 (or successor form) filed with a return, amended return, or application for tentative refund and who also is required to disclose the transaction on a form 8886 (or successor form) with the office of tax shelter analysis (otsa), is subject to only a single § 6707a penalty for failure to make either one or both of those disclosures. the regulations define ―reportable transaction‖ and ―listed transaction‖ by reference to the regulations under § 6011. 13. a careful reading of this criminal tax fraud case should put the fear of god, or at least of the cid and doj, in the hearts of many tax shelter investors. united states v. rozin, 664 f.3d 1052 (6th 346 florida tax review [vol. 12:5 cir. 1/6/12). the sixth circuit, in an opinion by judge rogers, upheld the defendant‘s conviction for criminal tax fraud. the defendant had claimed business and individual tax deductions for the cost of so-called ―loss of income‖ (loi) insurance policies, although the insurance aspect of the policies was questionable, and the policies allegedly permitted the defendant to reclaim or maintain control of the amount paid as premiums. the loi policies insured against loss of income due to certain circumstances, including corporate downsizing, changes in technology, or employee layoffs arising within one year from the date the policy was issued, but did not cover death; disability; voluntary termination; self-inflicted injuries; proven criminal acts; negligent or willful misconduct; substance abuse; dishonesty or fraud; insubordination, incompetence, or inefficiency; conflict of interest; or breach of employment contract. in conjunction with the loi insurance policy, the defendant also purchased from the same ―return of premium‖ (rop) riders. if no claim was filed on the loi policy, under the rider the loi premium would be invested for the policy owner and would be distributed to the owner after ten years or at age sixty-five. according to the promotional materials, the loi premium payments (but not the rider) were deductible. in convicting the defendant of tax evasion and conspiracy to defraud the irs, the district court noted: (1) the lack of a ―true business purpose for purchasing the various loi policies,‖ (2) the ―dubious nature‖ of the policies, including the high premium to coverage ratio, as well as the practice of backdating, (3) rozin‘s access to and control over the funds, (4) rozin‘s descriptions of the policies to [friends to whom he recommended the scheme] as ―tax-savings product[s],‖ and (5) the differences between the policies rozin bought and those that were advertised in [the insurance broker‘s] promotional materials. the district court held that ―rozin did not have a good faith reliance defense because he withheld relevant information and had reason to suspect the motives of the individuals on whom he supposedly relied.‖ in upholding the conviction, the court of appeals made the following points: (1) ―though peddled as ‗insurance,‘ ... the covered risks – corporate downsizing, employee layoffs, and technological obsolescence – were unlikely to happen to rozin because he was an owner of a carpet company. many of the most obvious causes of loss of income, such as death, disability, voluntary termination, and breach of contract, were not covered, and rozin, inc. was not under any immediate threat of bankruptcy. in addition, unlike other legitimate insurance policies, rozin maintained control of the funds; when pitching the loi policies to potential buyers, rozin described them as ―a way to lower your taxes‖ while also receiving ―a large percentage of that money back.‖ 2012] recent developments in federal income taxation 347 (2) ―[b]ackdating the loi policies showed willfulness, because there was no reason for such backdating other than to claim the improper tax deductions.‖ (3) ―when selling the loi policies to friends, rozin stated outright that about eighty-five percent of the money would ‗come back and be held in a trust‘ that the individual would ‗have control over.‘ evidence that rozin knew that he would have access to most of his money, while reaping the benefits of a large tax deduction, would permit a rational trier of fact to find that he willfully utilized the loi policies in order to evade taxes.‖ (4) ―because rozin either did not provide full information to those he supposedly relied upon, or he had reason to believe that the advice provided by these individuals was incorrect, the district court correctly held that rozin could not mount a credible good faith reliance defense.‖ (5) ―because rozin either did not provide full information to those he supposedly relied upon, or he had reason to believe that the advice provided by these individuals was incorrect, the district court correctly held that rozin could not mount a credible good faith reliance defense.‖ (6) ―because [the cpa who prepared the tax returns] was not aware of the full facts regarding the loi policies, rozin cannot claim that he relied on [his] advice in good faith.‖ (7) ― ... rozin did not rely on cohen, let alone rely on cohen in good faith. ... cohen also told rozin that if the irs did ‗challenge the deduction,‘ the worst thing that rozin would have to do would be to pay the taxes owed plus interest. noting the possibility that the irs could challenge the deduction should have raised a red flag for rozin, giving him reason to suspect that the information cohen provided him was incorrect. in addition ... cohen's motivations were at least suspect because he received commissions from the sale of the loi policies.  if those ―factors‖ don‘t describe a lot of tax shelter investors to a ―t,‖ we don‘t know what does! b. discovery: summonses and foia 1. appraiser’s work papers are not protected by privilege when the appraisal is part of the tax return. united states v. richey, 632 f.3d 559 (9th cir. 1/21/11). the court of appeals held that the work papers of an appraiser hired by the taxpayer‘s lawyer to provide a valuation for a conservation easement contributed to charity were not protected by attorney-client privilege. the appraisal was required by reg. § 1.170a-13(c)(1) and was attached to the taxpayer‘s tax return. ―[a]ny communication related to the preparation and drafting of the appraisal for submission to the irs was not made for the purpose of providing legal advice, but, instead, for the purpose of determining the value of the easement.‖ similarly, the file was not protected by the work product 348 florida tax review [vol. 12:5 doctrine, because the materials were not prepared ―in anticipation of litigation.‖ unless an appraisal had been attached to the return, the taxpayers would not have been entitled to any deduction at all. ―had the irs never sought to examine the taxpayers‘ 2003 and 2004 federal income tax returns, the taxpayers would still have been required to attach the appraisal to their 2002 federal income tax return. nor is there evidence in the record that richey would have prepared the appraisal work file differently in the absence of prospective litigation.‖  query whether fin 48 workpapers would be protected by work product privilege when a schedule 1120-utp prepared using those workpapers is part of a tax return? note also the possibility of disclosure to the irs by a whistleblower. 2. you can’t use the third party summons notice requirement as a heads-up to clean out the bank account. viewtech, inc. v. united states, 653 f.3d 1102 (9th cir. 8/10/11). section 7609(c)(1)(d)(i) excepts from the third-party summons notice requirement any summons issued in aid of collection of an assessment of tax against the person with respect to whose liability the summons is issued. in construing the application of this provision in ip v. united states, 205 f.3d 1168 (9th cir. 2000), the ninth circuit reasoned that ―giving taxpayers notice in certain circumstances would seriously impede the irs‘s ability to collect taxes,‖ as would giving notice to fiduciaries or transferees of the taxpayer. it therefore concluded that the clause (i) exception should be given a limited reading to avoid vitiating the legislative purpose. in the instant case the court applied the § 7609(c)(1)(d)(i) to a summons issued to a bank with respect to a corporation in which the taxpayer owned 100 percent of the stock in one year and 97 percent of the stock in another year, and of which he was an officer. ―this close legal relationship is sufficient to give [the taxpayer] the requisite interest in the viewtech bank account such that viewtech is disqualified from receiving notice under the clause (i) exception.‖ because the corporation was not entitled to notice, it had no standing to seek to quash the summons. 3. you can’t hide your foreign bank account records behind the fifth amendment. m.h. v. united states, 648 f.3d 1067 (9th cir. 8/19/11). m.h. was the target of a grand jury investigation seeking to determine whether he used secret swiss bank accounts to evade paying federal taxes. the district court granted a motion to compel his compliance with a grand jury subpoena duces tecum demanding that he produce certain records related to his foreign bank accounts. the district court declined to condition its order compelling production upon a grant of limited immunity and, pursuant to the recalcitrant witness statute, 28 u.s.c. § 1826, held him in contempt for refusing to comply. the ninth circuit 2012] recent developments in federal income taxation 349 upheld the district court order. the court of appeals held that ―[b]ecause the records sought through the subpoena fall under the required records doctrine, the fifth amendment privilege against self-incrimination is inapplicable, and m.h. may not invoke it to resist compliance with the subpoena‘s command.‖ the records were required to be kept pursuant to the predecessor of 31 c.f.r. § 1010.420. c. litigation costs 1. here’s a case of nonliteral interpretation of the code that was taxpayer favorable. we didn’t know that courts can waive sovereign immunity without a clear statutory rule. reynoso v. united states, 108 a.f.t.r.2d 2011-5654 (n.d. cal. 8/8/11). in this refund case the taxpayer recovered over 80 percent of the refund sought, and the court awarded attorney‘s fees under § 7430 because the government‘s position was not substantially justified. the court also awarded attorney‘s fees with respect to the taxpayer‘s administrative refund claim, rejecting the government‘s argument that because § 7430(c)(7) defines the term ―position of the united states‖ with respect to administrative proceedings as the position taken ―as of the earlier of: (i) the date of the receipt by the taxpayer of the notice of decision of the office of appeals, or (ii) the date of the notice of deficiency,‖ and in the refund claim the taxpayer never received a notice of decision from the irs office of appeals or a notice of deficiency, the government has not taken a ―position‖ with respect to taxpayer‘s case at the administrative level. without dealing with any technical interpretation of the statutory language, the court simply concluded that the irs had taken an administrative position: the irs‘s failure to respond to plaintiff‘s repeated requests for his refund and for the return of the unapplied portion of the cash bond was tantamount to a denial of those requests. the government cannot insulate itself from paying attorney‘s fees by simply ignoring a refund request instead of issuing a formal denial. the court thus rejects the government‘s contention that it did not take a ―position‖ prior to litigation in this case. plaintiff is therefore entitled to costs and fees incurred at the administrative level. d. statutory notice of deficiency 1. did the malefactor escape on a technicality or did the irs chase the wrong guy as the malefactor? shockley v. commissioner, t.c. memo. 2011-96 (5/2/11). the irs sought to impose transferee liability (for corporate income taxes) on shockley (an officer/shareholder who sold corporate stock in a midco transaction) and 350 florida tax review [vol. 12:5 shockley filed a tax court petition seeking dismissal of the proceeding for lack of jurisdiction because the statute of limitations had run. the tax court (judge cohen) ruled in favor of shockley. at the time the irs sent to the transferor corporation (and shockley) the deficiency notice with respect to the asserted corporate tax liability, the irs knew that it had not been sent to the transferor‘s last known address. in response to that deficiency notice shockley, who was a former corporate officer of the transferor, had filed petition seeking dismissal of the proceeding for lack of jurisdiction because of the absence of proper notice. because the tax court previously had held that the deficiency notice with respect to which the petition was filed was invalid, in the instant case it held that the period of limitations was not suspended. thus, the notice determining that shockley was subject to transferee liability was invalid because it was beyond the period of limitations. because the statute of limitations was not suspended by the earlier invalid notice and the petition in response to that notice, the period of limitations on transferee liability under § 6901(c) – one year after the expiration of the period of limitation for assessment against the transferor – had expired. e. statute of limitations 1. the courts hold that overstating basis is not the same as understating gross income, but the treasury department ultimately plays its trump card by promulgating regulations. section 6501(e)(1) extends the normal three-year period of limitations to six years if the taxpayer omits from gross income an amount in excess of 25 percent of the gross income stated in the return. section 6229(c)(2) provides a similar extension of the statute of limitations under § 6229(a) for assessments arising out of tefra partnership proceedings. a critical question is whether the six year statute of limitations applies if the taxpayer overstates basis and as a consequence understates gross income. a. the tax court says overstating basis is not the same as understating gross income. bakersfield energy partners, lp v. commissioner, 128 t.c. 207 (6/14/07). the taxpayer overstated basis, resulting in an understatement of § 1231 gain. looking to supreme court precedent under the statutory predecessor of § 6501(e) in the 1939 code (colony, inc. v. commissioner, 357 u.s. 28 (1958)), from which the six-year statute of limitations in § 6229(c)(2) is derived and to which it is analogous, the tax court concluded that this understated gain was not an omission of ―gross income‖ that would invoke the six-year statute of limitations under § 6229(c)(2) applicable to partnership audits. 2012] recent developments in federal income taxation 351 b. the ninth circuit likes the way the tax court thinks: bakersfield energy partners is affirmed. bakersfield energy partners, lp v. commissioner, 568 f.3d 767 (9th cir. 6/17/09). the ninth circuit affirmed the tax court on the grounds that the language at issue in the instant case was the same as the statutory language interpreted in colony. the court noted, however, that ―[t]he irs‘s interpretation of § 6501(e)(1)(a) is reasonable.‖ c. and a judge of the court of federal claims agrees. grapevine imports, ltd v. united states, 77 fed. cl. 505 (7/17/07), rev’d, 636 f.3d 1368 (fed. cir. 3/11/11). in a tefra partnership tax shelter case, the court of federal claims (judge allegra) held that the § 6501(e) six-year statute of limitations does not apply to basis overstatements, citing colony, inc. v. commissioner, 357 u.s. 28 (1958). section 6501(e), rather than § 6229(c)(2) as in bakersfield energy partners, lp, applied because in earlier proceedings in the instant case (71 fed. cl. 324 (2006)), the court had held that § 6229 did not create an independent statute of limitations, but instead only provides a minimum period for assessment for partnership items that could extend the § 6501 statute of limitations, and because the fpaa was sent within this six-year statute of limitations under § 6229(d) the statute of limitations with respect to the partners was suspended. d. but a district court in florida disagrees. brandon ridge partners v. united states, 100 a.f.t.r.2d 2007-5347 (m.d. fla. 7/30/07). the court refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) six-year statute of limitations does apply to basis overstatements. the court reasoned that as a result of subsequent amendments to the relevant code sections, the application of colony, inc. v. commissioner, 357 u.s. 28 (1958) is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or services. [―in the case of a trade or business, the term ―gross income‖ means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.‖] the court reasoned that to conclude otherwise would render § 6501(e)(1)(a)(i) superfluous. because the transaction at issue was the partnership‘s sale of stock, which was not a business sale of goods or services, the gross receipts test did not apply. on the facts, the partners and partnership returns (and statements attached thereto), taken together ―failed to adequately apprise the irs of the true amount of gain on the sale of the ... stock.‖ thus, the partnership did not show that the extended limitations period was inapplicable. 352 florida tax review [vol. 12:5 e. and a different judge of the court of federal claims agrees with the district court in florida and disagrees with the prior court of federal claims opinion by a different judge in grapevine imports. salman ranch ltd. v. united states, 79 fed. cl. 189 (11/9/07). the court (judge miller) refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) six-year statute of limitations does apply to basis overstatements. judge miller reasoned that an understatement of ―gain‖ is an omission of gross income, and that omission can result from a basis overstatement as well as from an understatement of the amount realized. like the brandon ridge partners court, judge miller concluded that the application of colony, inc. v. commissioner, 357 u.s. 28 (1958), is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or services. (―in the case of a trade or business, the term ‗gross income‘ means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.‖) because the transaction at issue was the partnership‘s sale of a ranch, which was not a business sale of goods or services, the gross receipts test did not apply. on the facts, the partners‘ and partnership returns failed to adequately apprise the irs of the amount of gain in a variant of the son-of-boss tax shelter. accordingly, the partnership did not show that the extended limitations period was inapplicable. the amended order certified an interlocutory appeal and stayed the case pending further court order, because of the split of opinion between salman ranch, on the one hand, and bakersfield energy partners and brandon ridge partners, on the other hand. f. and the pro-government opinion by judge miller is slapped down by the federal circuit. salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09). following colony, inc. v. commissioner, 357 u.s. 28 (1958), the federal circuit (judge schall, 2-1) held that ―omits from gross income an amount properly includable therein‖ in § 6501(e)(1)(a) does not include an overstatement of basis. accordingly, the six-year statute of limitations on assessment did not apply – the normal three-year period of limitations applied. judge newman dissented. g. but a second district court sees it the government’s way. home concrete & supply, llc v. united states, 599 f. supp. 2d 678 (e.d. n.c. 10/21/08), rev’d, 634 f.3d 249, cert. granted, 132 s. ct. 71 (9/27/11). the court held that §6501(e) extends the statute of limitations for deficiencies attributable to basis overstatements that result in omitted gross income exceeding 25 percent of the gross income reported on the return. the court refused to follow the tax court‘s decisions in 2012] recent developments in federal income taxation 353 bakersfield energy partners and grapevine imports, because it concluded that those cases were erroneously decided. h. a hiccup from judge goeke in the tax court: overstated basis in an abusive tax shelter is a substantial omission from gross income that extends the statute of limitations. highwood partners v. commissioner, 133 t.c. 1 (8/13/09). the taxpayers invested through partnerships in foreign currency digital options contracts designed to increase partnership basis and generate losses marketed by jenkens & gilchrist (son of boss and miscellaneous other names). after expiration of the three-year statute of limitations, the irs issued an fpaa to the partnership based on the six-year statute of §6501(e)(1) applicable if there was a greater than 25 percent omission of gross income on each partner‘s or the partnership‘s return. the court (judge goeke) held that the digital options contracts produced § 988 exchange gain on foreign currency transactions, which, under the regulations, are required to be separately stated. the long and short positions of the options contracts were treated as separate transactions. thus, failure to report the gain on the short position, not offset by losses on the accompanying stock sale, represented an omission of gross income. the court also rejected the taxpayer‘s argument that because the irs asserted that the options transactions should be disregarded in full, there can be no omission of gross income from the disregarded short position. finally, the court refused to apply the adequate disclosure safe harbor of § 6501(e)(1)(a)(ii) because the taxpayer‘s netting of the gain and loss from the long and short positions was intended to mislead and hide the existence of the gain and did not apprise the irs of the existence of the gain. i. but judge haines follows the tax court orthodoxy. beard v. commissioner, t.c. memo. 2009-184 (8/11/09), rev’d, 633 f.3d 616 (7th cir. 1/26/11). in a basis offset deal involving contributions of long and short positions in treasury notes contributed to s corporations, the court (judge haines) granted summary judgment to the taxpayer holding that the basis overstatement attributable to the short sale was not an a substantial omission of gross income. because the transaction involved treasury notes, there were no § 988 issues involved. this holding is consistent with bakersfield energy partners v. commissioner, 568 f.3d 767 (9th cir. 6/17/09), and salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09). j. and the irs loses again in the tax court. intermountain insurance service of vail v. commissioner, t.c. memo. 2009-195 (9/1/09). the court (judge wherry), again following bakersfield energy partners lp v. commissioner, 128 t.c. 207 (2007), granted summary judgment to the taxpayer holding that a basis overstatement is not a 354 florida tax review [vol. 12:5 substantial omission from gross income that triggers the six-year extended statute of limitations under § 6229. k. finally, the irs gets the upper hand with temporary regulations. t.d. 9466, definition of omission from gross income, 74 f.r. 49321 (9/24/09). temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)-1t both provide that for purposes of determining whether there is a substantial omission of gross income, gross income as it relates to a trade or business includes the total amount received from the sale of goods or services, without reduction for the cost of goods sold, gross income otherwise has the same meaning as under § 61(a). the regulations add that, ―[i]n the case of amounts received or accrued that relate to the disposition of property, and except as provided in paragraph (a)(1)(ii) of this section, gross income means the excess of the amount realized from the disposition of the property over the unrecovered cost or other basis of the property. consequently, except as provided in paragraph (a)(1)(ii) of this section, an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of section 6229(c)(2).‖ l. but the irs still suffers from a hangover in cases on which the extended statute had run before the effective date of the regulations. utam, ltd v. commissioner, t.c. memo. 2009-253 (11/9/09), rev’d, 645 f.3d 415 (d.c. cir. 6/21/11). judge kroupa followed bakersfield energy partners to hold that the statute of limitations is not extended to six years pursuant to § 6229(c)(2) or § 6501(e)(1)(a) as a result of a basis overstatement that causes gross income to be understated by more than 25 percent.  although the date of the decision was after the effective date of temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)1t, the result was dictated by prior law effective when the fpaa was issued in 1999. m. judge wherry shoves it up the commissioner all the way to his ―colon(-y)‖ in a reviewed tax court decision that holds the temporary regulations invalid. intermountain insurance service of vail v. commissioner, 134 t.c. 211 (5/6/10) (reviewed, 7-0-6), supplementing t.c. memo. 2009-195 (9/1/09) (granting summary judgment to the taxpayer, holding that a basis overstatement is not a substantial omission from gross income that triggers the six year extended statute of limitations under § 6229), rev’d, 650 f.3d 691 (d.c. cir. 6/21/11). on the irs‘s motions to reconsider and vacate in light of temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)-1t, the tax court (judge wherry) held that the supreme court‘s opinion in colony, inc. v. commissioner, 357 2012] recent developments in federal income taxation 355 u.s. 28 (1958), ―‗unambiguously forecloses the [irs] interpretation‘ … and displaces [the] temporary regulations.‖ the first ground was that the temporary regulations were specifically limited their application to ―taxable years with respect to which the applicable period for assessing tax did not expire before september 24, 2009,‖ and in this case that period was not open as of that date. the second ground was that the supreme court had held in colony that the statute was unambiguous in light of its legislative history and foreclosed temporary regulations to the contrary.  judges halpern and holmes concurred in the result. they stated that they were not persuaded by either of the majority‘s analyses, but that the temporary regulations should be invalidated on procedural grounds for failure to comply with the administrative procedure act‘s notice-and-comment requirement. n. ―tax court, we’ll see ya at high noon in front of the courts of appeals,‖ says the irs. t.d. 9511, definition of omission from gross income, 75 f.r. 78897 (12/17/10). the irs and treasury have finalized amendments to regs. §§ 301.6229(c)(2)-1 and 301.6501(e)-1, replacing temp. reg. §§ 301.6229(c)(2)-1t and 301.6501(e)1t, t.d. 9466, definition of omission from gross income, 74 f.r. 49321 (9/24/09). the final regulations are identical to the temporary regulations in providing that for purposes of determining whether there is a substantial omission of gross income, gross income as it relates to a trade or business includes the total amount received from the sale of goods or services, without reduction for the cost of goods sold, gross income otherwise has the same meaning as under § 61(a).  the irs and treasury declared in the preamble that they believed that the tax court‘s decision in intermountain insurance service of vail v. commissioner, 134 t.c. 211 (5/6/10), invalidating the temporary regulations, was erroneous: the treasury department and the internal revenue service disagree with intermountain. the supreme court stated in colony that the statutory phrase ‗‗omits from gross income‘‘ is ambiguous, meaning that it is susceptible to more than one reasonable interpretation. the interpretation adopted by the supreme court in colony represented that court‘s interpretation of the phrase but not the only permissible interpretation of it. under the authority of nat’l cable & telecomms. ass’n v. brand x internet servs., 545 u.s. 967, 982–83 (2005), the treasury department and the internal revenue service are permitted to adopt another reasonable interpretation of ‗‗omits from gross income,‘‘ particularly as it is used in a new statutory setting. 356 florida tax review [vol. 12:5  according to the preamble, the final regulations have been clarified to emphasize that they only apply to open tax years and do not reopen closed tax years. however, the preamble states: the tax court‘s majority in intermountain erroneously interpreted the applicability provisions of the temporary and proposed regulations, which provided that the regulations applied to taxable years with respect to which ‗the applicable period for assessing tax did not expire before september 24, 2009.‖ the internal revenue service will continue to adhere to the position that ―the applicable period‖ of limitations is not the ―general‖ three-year limitations period. ... consistent with that position, the final regulations apply to taxable years with respect to which the six-year period for assessing tax under section 6229(c)(2) or 6501(e)(1) was open on or after september 24, 2009.  the supreme court‘s decision in mayo foundation for medical education and research v. united states, 131 s. ct. 704 (1/11/11), holding that treasury regulations are entitled to deference under chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), will play a major role in who wins this shoot-out. o. and government wins in the seventh circuit, without any help from the temporary regulations. beard v. commissioner, 633 f.3d 616 (7th cir. 1/26/11), rev’g t.c. memo 2009-184 (8/11/09). the seventh circuit, in an opinion by judge evans, reversed the tax court‘s decision that an overstatement of basis results in an omission of gross income that triggers the six year statute of limitations under § 6501(e)(1)(a). in a ―very carefully reasoned opinion,‖ (but see the burks case, below) the court concluded that the supreme court‘s decision in colony, inc. v. commissioner, 357 u.s. 28 (1958) was not controlling. the seventh circuit reasoned that colony was both factually different – colony involved an overstatement of the basis of lots held by a real estate developer for sale to customers in the ordinary course of business, while the instant case involved an overstatement of basis in a partnership interest in a son-ofboss tax shelter transaction – and legally different because of changes between the 1939 code § 275(c), which was interpreted in colony and 1954 code § 6501(e). the court held that ―colony‘s holding is inherently qualified by the facts of the case before the court, facts which differ from our case, where the beards‘ omission was not in the course of trade or business. from the perspective of statutory interpretation, the court focused on the impact of the addition of § 6501(e)(1)(b)(ii) in the 1954 code, which provides that ―in determining the amount omitted from gross income, there shall not be taken into account any amount which is omitted from gross income stated in the return if such amount is disclosed in the return, or in a statement attached to 2012] recent developments in federal income taxation 357 the return, in a manner adequate to apprise the secretary of the nature and amount of such item.‖ quoting phinney v. chambers, 392 f.2d 680 (5th cir. 1968), the court stated ―[w]e conclude that the enactment of subsection (ii) of section 6501(e)(1)[(b)] makes it apparent that the six year statute is intended to apply where there is either a complete omission of an item of income of the requisite amount or misstating of the nature of an item of income which places the ―commissioner ... at a special disadvantage in detecting errors.‖ (emphasis supplied). even though it distinguished colony and concluded that it was ―left without precedential authority,‖ the court nevertheless concluded that because the language of § 6501(e)(1)(a) at issue in the case was identical to the language of § 275(c) interpreted in colony, it was required to interpret § 6501(e)(1)(a) in light of colony. however, it also reasoned that it must ―bear in mind‖ that congress did add subsections (i) and (ii) to § 6501(e)(1)(b) and that ―the section as a whole should be read as a gestalt.‖ in analyzing colony, the court noted that the supreme court had found § 275(c) to be ambiguous, but was more persuaded by the taxpayer‘s argument that focused on the word ―omits.‖ the seventh circuit noted that what colony ―does not address in depth is ‗gross income‘‖ which is defined generally in section 61 of the code as ―all income from whatever source derived,‖ but which is not defined in § 6501(e) except for the special definition in § 6501(e)(1)(b)(i) that applies to trade or business income. the court then went on to hold: using these definitions and applying standard rules of statutory construction to give equal weight to each term and avoid rendering parts of the language superfluous, we find that a plain reading of section 6501(e)(1)(a) would include an inflation of basis as an omission of gross income in nontrade or business situations. ... it seems to us that an improper inflation of basis is definitively a ―leav[ing] out‖ from ―any income from whatever source derived‖ of a quantitative ―amount‖ properly includible. there is an amount-the difference between the inflated and actual basiswhich has been left unmentioned on the face of the tax return as a candidate for inclusion in gross income.  the court was reinforced in its conclusion by the existence of § 6501(e)(1)(b)(i), reasoning that ―[i]f the omissions from gross income contemplated section 6501(e)(1)(a) were only specific items such as receipts and accruals, then the special definition in subsection (i) would be, if not superfluous, certainly diminished. the addition of this subsection suggests that the definition of gross income for the purposes of section 6501(e)(1)(a) is meant to encompass more than the types of specific items contemplated by the colony holding.‖ the seventh circuit considered bakersfield energy partners v. commissioner, 568 f.3d 767 (9th cir. 6/17/09), and salman ranch ltd. v. united states, 573 f.3d 1362 (fed. cir. 7/30/09), to 358 florida tax review [vol. 12:5 have been erroneously decided. finally, the court addressed the parties‘ arguments regarding the impact of temp. reg. § 301.6501(e)-1t(a)(1)(a). rather than ruling on the validity of the regulation, however, the court stated that because it did not find colony controlling and reached its decision that the six-year statute of limitations applied on the face of the code section, it would not reach the validity of the regulation. however, in dictum, the court stated that it would be inclined to grant deference to temp. reg. § 301.6501(e)1t(a)(1)(a), even though it was issued without notice and comment, citing barnhart v. walton, 535 u.s. 212 (2002), for the proposition that ―the absence of notice-and-comment procedures is not dispositive to the finding of chevron deference.‖ p. but the fourth circuit relied on colony to find for the taxpayer. home concrete & supply, llc v. united states, 634 f.3d 249 (4th cir. 2/7/11), cert. granted, 132 s. ct. 71 (9/27/11). the fourth circuit (judge wynn) held that colony decided that 1954 code § 6501(e)(1)(a) was unambiguous and that an overstated basis in property is not an omission from gross income that extends the limitations period. it further held that reg. § 301.6501(e)-1(e) by its plain terms did not apply to the tax year in this case because the six-year limitations period had expired before the regulation was issued. judge wynn stated:  like the ninth and federal circuits, we hold that the supreme court in colony straightforwardly construed the phrase ―omits from gross income,‖ unhinged from any dependency on the taxpayer’s identity as a trade or business selling goods or services. there is, therefore, no ground to conclude that the holding in colony is limited to cases involving a trade or business selling goods or services. further, the supreme court‘s discussion of the legislative history behind former § 275(c) is equally compelling with regard to current § 6501(e)(1)(a). the language the court construed in former § 275(c) ―omits from gross income an amount properly includable therein‖—is identical to the language at issue in § 6501(e)(1)(a). because there has been no material change between former § 275(c) and current § 6501(e)(1)(a), and no change at all to the most pertinent language, we are not free to construe an omission from gross income as something other than a failure to report ―some income receipt or accrual.‖ …. thus, we join the ninth and federal circuits and conclude that colony forecloses the argument that home concrete‘s overstated basis in its reporting of the short sale proceeds resulted in an omission from its reported gross income.  judge wynn concluded that the regulation was ―not entitled to deference.‖ 2012] recent developments in federal income taxation 359 q. as did the fifth circuit, which chided the seventh circuit for misinterpreting a fifth circuit case on which it relied in beard. burks v. united states, 633 f.3d 347 (5th cir. 2/9/11). the fifth circuit (judge demoss) also held that an overstatement of basis is not an omission from gross income for purposes of § 6501(e)(1)(a). judge de moss disagreed with the seventh circuit‘s interpretation of phinney v. chambers, 392 f.2d 680 (5th cir. 1968), as limiting colony, stating that ―the seventh circuit failed to note the distinct factual pattern presented in phinney, where the taxpayers had misstated the very nature of the item so that the irs would not have had any reasonable way of detecting the error on the tax return. that is not the case here.‖  in its final footnote, the court stated: although we hold that § 6501(e)(1)(a) is unambiguous and its meaning is controlled by the supreme court‘s decision in colony, we note that even if the statute was ambiguous and colony was inapplicable, it is unclear whether the regulations would be entitled to chevron deference under mayo foundation for medical research v. united states, 131 s. ct. 704, 711 (2011). see, e.g., home concrete & supply, llc v. united states,—f.3d —, no. 092353) 2011 wl 361495, *7 (4th cir. feb. 7, 2011) (declining to afford the regulations chevron deference because the statute is unambiguous as recognized by the supreme court in colony). in mayo, the court held that the principles underlying its decision in chevron ―apply with full force in the tax context‖ and applied chevron to treasury regulations issued pursuant to 26 u.s.c. § 7805(a). id. at 707. significantly, in mayo the supreme court was not faced with a situation where, during the pendency of the suit, the treasury promulgated determinative, retroactive regulations following prior adverse judicial decisions on the identical legal issue. ―deference to what appears to be nothing more than an agency‘s convenient litigating position‖ is ―entirely inappropriate.‖ bowen v. georgetown univ. hosp., 488 u.s. 204, 213 (1988). the commissioner ―may not take advantage of his power to promulgate retroactive regulations during the course of a litigation for the purpose of providing himself with a defense based on the presumption of validity accorded to such regulations.‖ chock full o’ nuts corp. v. united states, 453 f.2d 300, 303 (2d cir. 1971). moreover, mayo emphasized that the regulations at issue had been promulgated following notice and comment procedures, ―a consideration identified . . . as a significant 360 florida tax review [vol. 12:5 sign that a rule merits chevron deference.‖ 131 s. ct. at 714. legislative regulations are generally subject to notice and comment procedure pursuant to the administrative procedure act. see 5 u.s.c. § 553(b)(a). here, the government issued the temporary regulations without subjecting them to notice and comment procedures. this is a practice that the treasury apparently employs regularly. see kristin e. hickman, a problem of remedy: responding to treasury’s (lack of) compliance with administrative procedure act rulemaking requirements, 76 geo. wash. l. rev. 1153, 1158-60 (2008) (noting that the treasury frequently issues purportedly binding temporary regulations open to notice and comment only after promulgation and often denies the applicability of the notice and comment procedure when issuing its regulations because that requirement does not apply to regulations that are not a significant regulatory action, while continuing to assert that the regulations are entitled to legislative regulation level deference before the courts). that the government allowed for notice and comment after the final regulations were enacted is not an acceptable substitute for prepromulgation notice and comment. see u.s. steel corp. v. u.s. epa, 595 f.2d 207, 214-15 (5th cir. 1979). r. finally, a court that read colony very very carefully and understands what colony really said and what it really did not say. grapevine imports v. united states, 636 f.3d 1368 (fed. cir. 3/11/11), rev’g 77 fed. cl. 505 (2007). the federal circuit, in a unanimous panel opinion by judge prost, reversed the court of federal claims holding that the six-year statute of limitations does not apply to an understatement of gross income attributable to a basis overstatement. the court of federal claims had relied on the supreme court‘s decision in colony, inc. v. commissioner, 357 u.s. 28 (1958). however, the court of appeals for the federal circuit applied reg. § 301.6229(c)(2)-1 and reg. § 301.6501(e)-1, after first concluding that the supreme court‘s opinion in mayo foundation for medical education and research v. united states, 131 s. ct. 704 (2011), unambiguously held that a subsequently promulgated treasury regulation could overrule a prior judicial decision (including a supreme court decision), as long as the regulation was valid under the standards of chevron, usa, inc. v. natural resources defense council, inc., 467 u.s. 837 (1984). preliminarily the court found that the regulations, ―state that colony did not conclusively resolve the statutory interpretation issue, and that overstatement of basis (outside the trade or business context) can trigger the extended limitations period.‖ a critical point in the court‘s 2012] recent developments in federal income taxation 361 reasoning was that the decision in colony did not hold that the language in question, which is the language that § 6501(e)(1) has in common with § 275(c) of the 1939 code that was at issue in colony, was unambiguous. [the supreme court expressly found the predecessor statute ambiguous, and turned to the legislative history to resolve the question. ... (―[i]t cannot be said that the language [of the statute] is unambiguous.‖). and while it is true that the court later referred to the updated § 6501(e)(1)(a) as ―unambiguous,‖ it did not rely or elaborate on that statement, nor was the updated statute at issue in that case. ... further, in colony the taxpayer was in the business of land sales, so § 6501(e)(1)(a)(i)‘s test for income ―in the case of a trade or business‖ expressly applied. that is not the case here. the ambiguity concerns what to do outside the trade and business context, and the only language in § 6501(e)(1)(a) applicable outside the trade or business context is the same language from the predecessor statute, ―omits from gross income an amount.‖ the supreme court previously noted that this term was ambiguous as to whether it encompassed an overstated basis. we therefore find colony no bar to our finding that the text of the relevant statutes, standing alone, is ambiguous as to the disposition of this issue.  turning to chevron step one analysis, the court of appeals concluded that §§ 6229(c)(2) and 6501(e) are ambiguous and that the treasury thus ―is entitled to promulgate its own interpretation of these statutes, and to have that interpretation given deference by the courts so long as it is within the bounds of reason.‖ [the tax code‘s use of the term ―omits‖ suggests that the section is primarily addressed to the return where the taxpayer has ―fail[ed] to include or mention‖ or ―le[ft] out‖ some item rather than misrepresenting it (as by an overstatement of basis). ... but without looking beyond the text itself, we cannot say that the statute forecloses the possibility that a taxpayer‘s overstated basis might constitute an omission from gross income.  turning to the second step of the chevron analysis, which asks whether the regulations constitute ―a reasonable policy choice for the agency to make,‖ the court concluded that the regulations are reasonable, even though they depart from the judicial interpretation of colony and salman ranch, ltd. v. united states, 573 f.3d 1362 (fed. cir. 2009). next, the court rejected the taxpayer‘s arguments that the regulations were invalid were because they were ―retroactive,‖ noting that in automobile club of michigan v. commissioner, 353 u.s. 180 (1957), the supreme court 362 florida tax review [vol. 12:5 confirmed that § 7805(b) authorizes retroactive regulations. the court also rejected an argument by the taxpayer – one which we confess not to understand – that the statute of limitation expired upon the entry of judgment by the court of federal claims, notwithstanding rules tolling the period of limitations during a pending appeal. finally, based on supreme court precedent, the court rejected the taxpayer‘s claim that the treasury did not have the power to affect the outcome of the appeal by promulgating regulations after the trial court decision and before the appeal was heard.  the opinion of the court of appeals for the federal circuit does not directly address the question raised in home concrete & supply company, llc v. united states, 634 f.3d 249 (4th cir. 3/11/11) cert. granted, 132 s. ct. 71 (9/27/11), which held that reg. § 301.6501(e)-1(a)(1)(ii) was not applicable because according to the terms of the regulation it applies only to taxable years with respect to which the statute of limitations remained open on and after sept. 24, 2009, and the three-year statute of limitations had expired before that date. again, this is an argument, and a holding, that we simply cannot understand, other than as the taxpayer‘s and court‘s expression of gut feelings that it is ―dirty pool‖ for the commissioner to put his thumb on the regulatory scale to affect an issue pending before a court, even though in mayo foundation for medical education and research v. united states, 131 s. ct. 704 (1/11/11), the supreme court appears to have expressly blessed such a tactic, albeit in litigation over an different issue. s. did anyone really expect the tax court to roll over and play dead just because the irs promulgates regulations that say it wins? carpenter family investments v. commissioner, 136 t.c. 373 (4/25/11). in a reviewed opinion by judge wherry, in which only four other judges joined, but with a number of concurrences and no dissents, the tax court once again held that the six year statute of limitations under §§ 6501(e) and 6229(c)(2) do not apply to understatements of gross income attributable to basis overstatements. in doing so the court held that final reg. §§ 301.6501(e)-1t and 301.6229(c)(2)-1t are invalid, just as it had held in intermountain insurance service of vail v. commissioner, 134 t.c. 211 (5/6/10), that temp. reg. §§ 301.6501(e)-1t and 301.6229(c)(2)-1t were invalid. noting that the case was appealable to the ninth circuit, in which bakersfield energy partners, lp v. commissioner, 568 f.3d 767 (9th cir. 6/17/09), is the controlling precedent, the tax court followed the line of reasoning previously applied by it, bakersfield energy partners, and some other courts, that the supreme court‘s decision in colony, inc. v. commissioner, 357 u.s. 28 (1958), was not limited to situations involving a trade or business and that it controlled the interpretation of § 6501(e)(1)(a). the court then turned to whether reg. §§ 301.6501(e)-1t and 301.6229(c)(2)-1t were entitled to deference under chevron, u.s.a., inc. v. 2012] recent developments in federal income taxation 363 natural res. def. council, inc., 467 u.s. 837 (1984), and mayo foundation for medical research v. united states, 131 s. ct. 704, 711 (1/11/11), and determined that they were not entitled to deference. in this context the court observed that mayo ―focuses exclusively on the statutory text at chevron step one and suggests (by negative implication) a disfavor of using legislative history at that stage. we are not persuaded, however, that after mayo, any judicial construction that examines legislative history is automatically relegated to a chevron step two holding by that fact alone.‖ in proceeding to analyze whether under the authority of nat’l cable & telecomms. ass’n v. brand x internet servs., 545 u.s. 967 (2005), the treasury department and the irs have the power to promulgate regulations overturning prior court decision, the court appears first to have concluded that ―only if an ‗unwise judicial construction‘ represents a policy choice, must it yield to ‗the wisdom of the agency‘s policy.‘‖ in the end, however, the court appears also to have grounded its decision on what it perceived to be ambiguities in the preamble of t.d. 9511, which promulgated the regulations at issue and which the court infers did not strongly enough invoke a power under brand x as the basis for promulgating the regulations. the final passage of its reasoning as follows: even if we read the supreme court‘s recent mayo opinion as a license to categorize most judicial constructions that discuss legislative history as chevron step two decisions, respondent has yet to unabashedly accept the court of appeals for the ninth circuit‘s invitation and issue regulations that unequivocally repudiate the colony holding. unless and until he does so, his hands must remain tied.  judge thornton‘s concurring opinion, with which judges cohen, halpern, holmes, and paris agreed, would have decided the case solely on the grounds that the result ―follows from the unambiguous terms of the statute,‖ and there is no compelling reason for the tax court to abandon its precedents.  judges halpern and holmes joined in another concurring opinion discussing the scope and meaning of chevron and brand x. t. and the tenth circuit also likes the way the irs thinks. salman ranch, ltd. v. commissioner, 647 f.3d 929 (10th cir. 5/31/11). in a case involving a different tax year for the taxpayer, the federal circuit held, see e. and f., above, that the extended statute of limitations did not apply to this partnership for its 1999 year. subsequently, in grapevine imports v. united states, 636 f.3d 1368 (fed. cir. 3/11/11), see r., above, the federal circuit overruled its pro-partnership decision in the 1999 salman ranch case. in this separate case for this partnership‘s 2001 and 2002 years, the tax court had held collateral estoppel required summary 364 florida tax review [vol. 12:5 judgment be granted for the partnership. the tenth circuit (judge seymour) reversed and remanded, holding that collateral estoppel was inapplicable because of an intervening change in law, i.e., the final regulations (see n., above). judge seymour based his decision that the final regulations were entitled to chevron deference based upon the supreme court‘s holdings in mayo found. for med. educ. & research v. united states, 131 s. ct. 713 (1/11/11), and refused to follow contrary authority among the cases discussed above. u. and the government chalks up another victory in front of a panel that really understands the proposition for which colony stands and the propositions for which it really does not stand. intermountain insurance service of vail v. commissioner, 650 f.3d 691 (d.c. cir. 6/21/11). after a thorough examination of the history of § 275(c) of the 1939 code, the pre-colony litigation, the colony decision itself, the enactment of § 6501(e) and the relevant changes from § 275(c), and the recent cases on the issue, and the promulgation of reg. §§ 301.6501(e)-1t(a)(iii) and 301.6229(c)(-1t)(a)(iii), the court of appeals for the district of columbia, in an opinion by judge tatel, reversed the tax court and, with a healthy spread of mayo, upheld the regulations, and dismissed the taxpayer‘s [tautological, in our opinion] argument, which was accepted by the tax court (and a few other courts) that the regulations by the terms of their effective date were inapplicable to the transaction in question. the court‘s opinion carefully explains the source of the statutory ambiguity and why colony did not state that the relevant language was unambiguous, rejecting the less well reasoned opinions of those courts that found colony to have held that the statutory provision was unambiguous. going a step further, the court concluded that colony simply did not apply to either § 6501(e) or § 6229(c)(2), and that under chevron it was an easy call to uphold the substance of the regulations, while under mayo there were no procedural problems with the manner in which the regulations were promulgated. however, the court of appeals remanded the case to the tax court to consider intermountain‘s alternative argument that intermountain avoided triggering the extended statute of limitations by ―adequately disclos[ing] to the irs the basis amount it applied in connection with the transaction at issue. v. let’s play that tune again. utam, ltd v. commissioner, 645 f.3d 415 (d.c. cir. 6/21/11). the court of appeals for the district of columbia, in a very brief opinion by judge randolph, reversed the tax court decision (see l., above) on the basis of the court‘s holding in intermountain insurance service of vail v. commissioner, 650 f.3d 691 (d.c. cir. 6/21/11). although the tax court did not reach the issue of whether § 6229(c) suspends the individual partner‘s § 6501 limitations 2012] recent developments in federal income taxation 365 period when that period is open on the date the irs mailed the fpaa, the court of appeals found that a remand on this issue would not serve a useful purpose. under d.c. circuit‘s opinion in andantech, l.l.c. v. commissioner, 331 f.3d 972 (d.c. cir. 2003), the assessment period suspended by § 6229(d) is the partner‘s open assessment period under § 6501. thus, the statute of limitations had not run. w. the fifth circuit stands by its burks holding, and the government is ready to talk to the supreme court. r and j partners v. commissioner, 441 fed. appx. 271 (5th cir. 9/19/11). in a per curiam opinion the fifth circuit followed burks v. united states, 633 f.3d 347 (5th cir. 2011), to hold that the six year statute of limitations of § 65019e) does not apply to basis overstatements and that reg. § 301.6501(e)-1 is invalid.  the court noted that ―the commissioner agrees that burks controls the law in the circuit on that question and that the tax court correctly applied that law, but took this protective appeal in an effort to obtain a review by the supreme court.‖ however, the supreme court did not grant certiorari in this case. x. and now the supremes will sing † ♬♪ ―nothing but heartaches‖♬♪! but will the song be dedicated to the taxpayer or the government? the supreme court granted certiorari to the fourth circuit in home concrete & supply, llc v. united states, 634 f.3d 249 (4th cir. 2/7/11), 132 s. ct. 71 (9/27/11). it declined invitations from the government to consider cases from the fifth and seventh circuits. 2. ―it takes real chutzpah for donnelley to demand a refund under these circumstances.‖ – j. harvie wilkinson iii. that sentence seems uncharacteristic from a good ol’ virginia boy, but his birth certificate shows he was born in new york city. r.h. donnelley corp. v. united states, 641 f.3d 70 (4th cir. 3/31/11). the taxpayer filed a timely refund claim with respect to 1991 and 1992 resulting from carrying back approximately $11 million of excess credits from 1994. in response the irs conducted an audit and disallowed a large deduction for 1994 and calculated a $43 million deficiency for 1994, which was not assessed because 1994 was a closed year, the taxpayer having filed its refund claim two days before the statute of limitations expired. based on this recalculation, the irs determined that all of the credits had been used in 1994, and none could be carried back. the court of appeals (judge wilkinson) upheld the irs‘s determination, applying the rule of lewis v. reynolds, 284 u.s. 281 (1932). the court observed as follows. 366 florida tax review [vol. 12:5 ... donnelley was not content merely to escape from its tax liability in the first instance. it filed a refund claim two days before the statute of limitations for the assessment of 1994 taxes expired, presumably counting on the fact that the irs could not investigate any underpayment in time to collect it. that refund claim depended on credits that could be carried back only because donnelley had misreported its taxes in the first place. it is true that the statute of limitations may protect donnelley from additional collection, but it does not give donnelley license to claim a second windfall in the form of a refund. to claim otherwise is almost beyond belief.  the court then concluded by stating: no one is entitled a refund who has not actually overpaid his taxes. this axiomatic observation, made first by the supreme court in lewis and recognized by this circuit in estate of michael [v. lulo, 173 f.3d 503 (4th cir. 1999)], defeats this taxpayer‘s claim. here, donnelley has not overpaid its taxes, and we will not allow it to reap where it has not sown. a. although the government can assert underpayments beyond the period of limitations as a defense in refund suits, taxpayers cannot assert overpayments beyond the period of limitations on refunds as a set off against a deficiency. brady v. commissioner, 136 t.c. 422 (4/28/11). in reviewing a cdp determination, the tax court (judge ruwe) held that alleged overpayments in prior years for which the taxpayer had filed timely refund claims, which were denied and with respect to which the taxpayer had failed to file a timely refund suit, could not be taken into account to reduce his liability for the year in question. 3. mitigation of limitations permitted where taxpayer was inconsistent. anthony v. commissioner, t.c. summ. op. 2011-50 (4/18/11). the tax court (judge swift) held that a taxpayer who erroneously overstated the amount of her schedule c closing inventory in the 2004 open year was behaving inconsistently when she asserted that the overstated amount could nevertheless be used as her opening inventory amount in the 2005 year, which had been closed by the statute of limitations. the irs permitted her to correct the overstatement for 2004 as part of a stipulated decision entered on 12/31/09. in a classic mitigation of limitations scenario under §§ 1311-1314, the deficiency asserted by the irs on 1/7/10 based on the corrected opening inventory amount for the otherwise closed 2005 year was upheld. 2012] recent developments in federal income taxation 367 4. a durable power of attorney is a good thing, right? not when § 6511(h) is in play. platt v. united states, 99 fed. cl. 634 (8/19/11). the taxpayer, who suffered from dementia and not able herself to manage her financial affairs, filed a refund claim more than three years after paying the tax. section 6511(h) tolls the statute of limitations on filing refund claims for any period that the taxpayer is unable to manage his financial affairs by reason of a medically determined physical or mental impairment that will result in death or that has lasted or can be expected to last at least twelve months. the statute is not tolled, however, if another person is authorized to manage the taxpayer‘s financial affairs. the court held that the taxpayer was not entitled to § 6511(h) relief, because her son had authority under a durable power of attorney to act on her behalf on financial matters. f. liens and collections 1. the irs has an obligation to cooperate with taxpayers too. azzari v. commissioner, 136 t.c. 178 (2/24/11). in a cdp proceeding the taxpayer requested the irs to subordinate its tax lien for unpaid employment taxes to the third-party lender that was lending the taxpayer funds to pay current employment taxes and to enter into an installment agreement with respect to the back taxes. in reviewing the irs‘s determination not to grant cdp relief, the tax court (judge wells) held that the appeals office had abused its discretion because it had misinterpreted § 6323(c) and the regulations thereunder (governing the priority of liens in certain commercial financing arrangements). ―although the commissioner‘s appeals office has discretion under § 6325(d) to determine whether it is in the government‘s interest to subordinate a federal tax lien, it appears that mr. lee‘s refusal to consider petitioner‘s request to subordinate the lien was based on an error of law. to the extent it was based upon an error of law, his determination constitutes an abuse of discretion.‖ furthermore, the refusal to consider the taxpayer‘s request for an installment agreement also was an abuse of discretion. although the irs‘s refusal to consider an installment agreement when the taxpayer is not satisfying current obligations is not generally an abuse of discretion, in this case the irs‘s refusal to subordinate it tax lien contributed to the taxpayer falling behind on current employment tax payments, and the taxpayer was denied a chance to become current. 2. day trading is dissipation of assets. well, duh! tucker v. commissioner, t.c. memo. 2011-67 (3/22/11). the taxpayer was a day trader, who at a time he owed the irs $39,000, lost $22,645 in his day trading activities. in calculating the reasonable collection potential for purposes of evaluating the taxpayer‘s offer in compromise, the office of appeals considered his day trading to constitute asset dissipation that 368 florida tax review [vol. 12:5 warranted rejection of his oic. the tax court (judge gustafson) upheld the irs‘s determination in a cdp hearing to reject the taxpayer‘s oic. 3. the irs loses a ―battle of the forms.‖ thornberry v. commissioner, 136 t.c. 356 (4/19/11). the taxpayers‘ request for a cdp hearing, though it was a ―boilerplate form‖ copied from an internet website, might have set forth legitimate issues, among those that were not legitimate. the irs‘s response with a ―boilerplate form‖ that did not address those issues was inappropriate. the letter from the appeals office stating that the taxpayers‘ request for a collection due process hearing would be disregarded because the request was frivolous and intended only to delay or impede the collection of tax constituted a ―determination‖ subject to review by the tax court. the court (judge dawson) ordered the taxpayers to identify specific issues and the grounds that they wished to raise before issuing any further orders. 4. what’s a little non-ex parte among friends? hoyle v. commissioner, 136 t.c. 463 (5/23/11). the tax court held that neither the aba model code of judicial conduct nor a state law code of judicial conduct was relevant to communications between personnel of the irs office of chief counsel and an appeals division officer conducting a cdp hearing. rev. proc. 2000-43, 2000-2 c.b. 404, is the relevant authority in nondocketed cases and chief counsel notice cc-2007-006 is the relevant authority in docketed cases, including, as in the instant case, a cdp remand from the tax court. much of the communication in this case was merely ministerial. furthermore, ―[a] request by a hearing officer for legal advice in connection with the remanded cdp case may be handled by the counsel attorney who is handling the docketed tax court case, so long as that attorney did not give legal advice to an originating function (e.g., collection) concerning the same issue in the same case.‖ the counsel attorney provided legal advice on specific issues, such as whether the taxpayer could challenge the underlying liability if he had received a notice of deficiency. the counsel attorney‘s review of the appeals officer‘s draft supplemental notice of determination was meant to ensure that the supplemental notice of determination on remand complied with the tax court‘s order, and was not an impermissible ex parte communication. thus, there was no prohibited ex parte contact. 5. oics must be realistic; the taxpayer must feel the pain. johnson v. commissioner, 136 t.c. 475 (5/31/11). the irs did not abuse its discretion in rejecting the taxpayer‘s offer in compromise of an amount that was based solely on the proceeds available from a single asset, which ignored future disposable income. reasonable collection potential included some amount of future disposable income. 2012] recent developments in federal income taxation 369 6. ―when in doubt, the bank wins.‖ – even against the irs this time. bloomfield bank v. united states, 644 f.3d 521 (7th cir. 5/1/11). reversing a district court decision, the court of appeals (judge posner), held that a mortgage that assigns future rental income to the mortgagee creates a security interest that takes priority over a federal tax lien. the rental income from the property is not a distinct form of property; it is merely proceeds of owning a rented property, as are the sales proceeds. 7. the divorce bought the taxpayer a second bite at a cdp hearing. churchill v. commissioner, t.c. memo. 2011-182 (8/1/11). the tax court (judge holmes) held that it has authority to remand a cdp determination, even though the irs did not abuse its discretion, where there has been a material change in a taxpayer‘s factual circumstances between the time of the hearing and the time of the tax court review. the taxpayer‘s divorce after the cdp hearing with respect to an offer in compromise was such a change in circumstances. 8. the taxpayer won on the evidentiary issue, but that was all. kreit mechanical associates, inc. v. commissioner, 137 t.c. 123 (10/3/11). the taxpayer sought review of the irs‘s cdp determination following the rejection of the taxpayer‘s offer in compromise. the irs‘s determination was based on its conclusion that the entire amount due was collectible after it found that a 75-percent discount of taxpayer‘s accounts receivable was inappropriate in valuing its assets. applying the golsen rule (golsen v. commissioner, 54 t.c. 742 (1970), aff’d, 445 f.2d 985 (10th cir. 1971), following ninth circuit precedent (keller v. commissioner, 568 f.3d 710, 718 (9th cir. 2009), the tax court (judge wherry) limited the review of the administrative determination to the administrative record. however, under an exception to the administrative record rule in the ninth circuit by which ―[t]he extra-record inquiry is limited to determining whether the agency has considered all relevant factors and has explained its decision,‖ friends of the payette v. horseshoe bend hydroelectric co., 988 f.2d 989, 997 (9th cir. 1993), as a preliminary matter, judge wherry allowed into evidence, over the irs‘s objection, a report by an expert witness (a former irs revenue officer and settlement officer, with over thirty years of experience) for the taxpayer that ―opine[d] on other factors that [the expert witness] believed the settlement officer should have taken into account when evaluating [taxpayer‘s] offer-in-compromise and ability to make payments, because ―the report is helpful to the court in understanding respondent‘s administrative procedures and options and assists the court in comprehending the evidence.‖ having done so, the court quickly concluded that the irs had not abused its discretion. 370 florida tax review [vol. 12:5 9. ya gotta tell the court ya want a speedy trial. thompson v. united states, 106 a.f.t.r.2d 2010-6464 (n.d. ill. 9/29/10). the failure of the district court to review a jeopardy assessment within twenty days, as required by § 7429(b)(2) is not alone grounds for entering judgment for the taxpayer. the taxpayer bears the responsibility for informing the district court of the statutory time deadline. the taxpayer failed to do so. a. the seventh circuit echoes the district court: ya gotta tell the court ya want a speedy trial. thompson v. united states, 448 fed. appx. 878 (7th cir. 11/3/11), aff’g 106 a.f.t.r.2d 20106464 (n.d. ill. 9/29/10). the failure of the district court to review a jeopardy assessment within twenty days, as required by § 7429(b)(2) is not alone grounds for entering judgment for the taxpayer. the twenty-day provision is ―‗only a strong admonition for the judiciary to act expeditiously‘ rather than ‗a limitation on the lower courts‘ jurisdiction....‘‖; the levy should not be voiding unless the plaintiff has shown extraordinary diligence in informing the court that the case is ready for a prompt ruling. the taxpayer bears the responsibility for informing the district court of the statutory time deadline. the taxpayer failed to do so. 10. irs mails wrong form, but provides required information. just as in the nba, no harm, no foul. conway v. commissioner, 137 t.c. no. 16 (12/19/11). if the irs fails to comply with the requirement of § 6303(a) that within sixty days of the assessment it notify the taxpayer and demand payment, the irs may be barred from collecting through nonjudicial procedures. in this cdp case involving trust fund taxes owed by a failed airline, the tax court (judge paris) followed hughes v. united states, 953 f.2d 531 (9th cir. 1992), holding that the form on which a notice of assessment and demand for payment is made is irrelevant as long as it provides the taxpayer with all of the information required by § 6303. in the case at bar, with respect to one taxpayer [the failed airline‘s cfo] a levy notice constituted adequate notice under § 6303 because it went beyond the typical notice of intent to levy by including a demand for immediate payment of the specific amounts of the taxes owed, listed by period, within sixty days of the assessment, even though no earlier adequate notice had been provided.  however, with respect to another taxpayer [the failed airline‘s ceo], a lien notice that merely reflected that unpaid taxes were owed, but which did not state the amounts, types, or periods of the unpaid taxes, was not adequate notice under § 6303(a). the court rejected the irs‘s argument that the taxpayer‘s multiple communications with irs appeals before the assessments regarding the amounts of the unpaid taxes had provided him with constructive notice. 2012] recent developments in federal income taxation 371 11. bankruptcy doesn’t prevent the irs from collecting tax shelter based deficiencies. in re vaughn, 463 b.r. 531 (bankr. colo. 12/28/11). the taxpayer‘s tax debts arising from disallowed ―blips‖ tax shelter losses were excepted from discharge under the 11 u.s.c. § 523(a)(1)(c) fraudulent return and/or willful evasion provisions. fraudulent return evidence included facts that despite taxpayer's business experience and savvy, he disregarded numerous red flags about the blips transaction, relied on the promoter's advice, and entered into the transaction without obtaining a truly independent opinion as to its potential and its tax implications. g. innocent spouse 1. that regulation ain’t got no equity and it ain’t got no empathy, so it’s invalid. the tax court majority responds to ―the sound of [congressional] silence.‖ lantz v. commissioner, 132 t.c. 131 (4/7/09) (reviewed, 12-4). the taxpayer sought equitable relief from joint income tax liability under § 6015(f), but the irs denied relief on the ground that she had not requested relief within two years from the irs‘s first collection action, as required by reg. § 1.6015-5(b)(1). consequently, the irs did not reach the substantive issues of the claim. in a reviewed opinion by judge goeke, joined by eleven judges, with four dissents, the tax court held reg. § 1.6015-5(b)(1) to be invalid as applied to § 6015(f) relief. (following the golsen rule, the tax court applied chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984), because the seventh circuit held in bankers life & cas. co. v. united states, 142 f.3d 973, 979 (7th cir. 1998), that regulations issued under general or specific authority of the irs to promulgate necessary rules are entitled to chevron deference; reg. § 1.6015-5 was issued under both a general grant of authority under § 7805 and a specific grant of authority in § 6015(h).) the court focused on the explicit inclusion of a two-year deadline in both § 6015(b) and § 6015(c), in contrast to the absence of any deadline in § 6015(f), to find that the regulation was not a reasonable interpretation of the statute under the chevron standard. ―‗it is generally presumed that congress acts intentionally and purposely‘ when it ‗includes particular language in one section of a statute but omits it in another‘‖. ... we find that by explicitly creating a 2-year limitation in subsections (b) and (c) but not subsection (f), congress has ―spoken‖ by its audible silence. because the regulation imposes a limitation that congress explicitly incorporated into subsections (b) and (c) but omitted from subsection (f), it fails the first prong of chevron. ... 372 florida tax review [vol. 12:5 had congress intended a 2-year period of limitations for equitable relief, then of course it could have easily included in subsection (f) what it included in subsections (b) and (c). however, congress imposed no deadline, yet the secretary prescribed a period of limitations identical to the limitations congress imposed under section 6015(b) and (c).  as a result, the irs abused its discretion in failing to consider all facts and circumstances in the taxpayer‘s case. further proceedings are required to fully determine the taxpayer‘s liability. a. you don’t have to actually know the irs denied § 6015(b) relief for the statute of limitations on seeking review to have expired, but you can always turn to § 6015(f), which for now appears to have an open-ended period for review. mannella v. commissioner, 132 t.c. 196 (4/13/09), rev’d, 631 f.3d 115 (3d cir 1/19/11). the irs sent the taxpayer a notice of intent to levy and notice of the right to a § 6330 cdp hearing on 6/4/04. on 11/1/06, more than two years later, the taxpayer requested § 6015 relief from joint and several liability, which the irs denied on the grounds that the request was untimely. the taxpayer claimed that she did not receive her notice of intent to levy because her former husband received the notices, signed the certified mail receipts, and failed to deliver, or inform her of, the notices. judge haines held that actual receipt of the notice of intent to levy or of the notice of the right to request relief from joint and several liability is not required for the two-year period in which to request relief under §§ 6015(b) and (c) to begin. the taxpayer‘s request for relief under §§ 6015(b) and (c) was not timely. however, the taxpayer‘s claim for relief under § 6015(f), was timely because lantz v. commissioner, 132 t.c. 131 (4/7/09), held that reg. § 1.6015-5(b)(1), requiring a request for relief within two years from the irs‘s first collection action, is invalid as applied to § 6015(f) relief. b. but the irs will fight this one to the bitter end! cc-2010-005, designation for litigation: validity of two-year deadline for section 6015(f) claims under treas. reg. § 1.6015-5(b)(1) (3/12/10). this chief counsel notice states that because the issue of the validity of the two-year deadline in reg. § 1.6015-5(b)(1) for filing a claim for § 6015(f) relief, which was held to be an invalid regulation in lantz v. commissioner, 132 t.c. 131 (2009), has been designated for litigation by the office of chief counsel, the irs will continue to deny claims for relief under § 6015(f) as untimely and will not settle or concede this issue. however, depending on the facts of the case, the merits of the § 6015(f) claim might be conceded. 2012] recent developments in federal income taxation 373 c. and the irs’s bitter-end fight to validate the regulation ended up in the seventh circuit, where judge posner denied the existence of ―audible silence.‖ lantz v. commissioner, 607 f.3d 479 (7th cir. 6/8/10) (lantz ii). the taxpayer was described as ―a financially unsophisticated woman whose husband, a dentist, was arrested for medicare fraud in 2000, convicted and imprisoned. they had been married for only six years when he was arrested and there is no suggestion that she was aware of, let alone complicit in, his fraud.‖ she received a packet that included a notice of a proposed levy on her in 2003, but did not respond because her estranged husband told her ―he‘d deal with the matter.‖ he asked the irs to send the application form for seeking innocent-spouse relief, explaining that his wife was an ―innocent spouse,‖ but he died before filing it. in 2006, the irs applied the taxpayer‘s $3,230 income tax refund for 2005 to her joint and several liability for 1999 of more than $1.3 million. ―unemployed and impecunious, she applied for innocent-spouse relief but the irs turned her down because she‘d missed the two year-deadline ….‖ the seventh circuit (judge posner), sustained the regulation and agreed with the irs‘s denial of relief, stating, ―… any statute of limitations will cut off some, and often a great many, meritorious claims.‖  judge posner denied the existence of ―audible silence‖ in the following words: but even if our review of statutory interpretations by the tax court were deferential, we would not accept ―audible silence‖ as a reliable guide to congressional meaning. ―audible silence,‖ like milton‘s ―darkness visible‖ or the zen koan ―the sound of one hand clapping,‖ requires rather than guides interpretation. lantz‘s brief translates ―audible silence‖ as ―plain language,‖ and adds (mysticism must be catching) that ―congress intended the plain language of the language used in the statute.‖  in sustaining the regulation judge posner reasoned as follows; agencies ... are not bashful about making up their own deadlines[,] ... and because it is as likely that congress knows this as that it knows that courts like to borrow a statute of limitations when congress doesn‘t specify one, the fact that congress designated a deadline in two provisions of the same statute and not in a third is not a compelling argument that congress meant to preclude the treasury department from imposing a deadline applicable to cases governed by that third provision‖; if there is no deadline in subsection (f), the two-year deadlines in subsections (b) and (c) will be set largely at naught because the substantive 374 florida tax review [vol. 12:5 criteria of those sections are virtually the same as those of (f). ... we must also not overlook the introductory phrase in subsection (f) — ―under procedures prescribed by the [treasury department]‖—or the further delegation in 26 u.s.c § 6015(h) to the treasury to ―prescribe such regulations as are necessary to carry out the provisions of‖ section 6015. in related contexts such a delegation has been held to authorize an agency to establish deadlines for applications for discretionary relief.  the opinion concludes with the hope that the irs would grant taxpayer relief under § 6343 from its levy on taxpayer by declaring the taxes ―currently not collectible‖ as follows: ironically, the service declared the taxes owed by lantz‘s husband – the crooked dentist – ―currently not collectible.‖ she is entitled a fortiori to such relief, and there is no deadline for seeking it. we can at least hope that the irs knows better than to try to squeeze water out of a stone.[ 5 ] d. and the tax court responds with a big ―raspberry‖ to judge posner. hall v commissioner, 135 t.c. 374 (9/22/10). in a reviewed opinion by judge goeke, in which seven judges joined, the tax court adhered to its position in lantz, supra, that reg. § 1.6015-5(b)(1) imposing a two-year statute of limitations on claims for relief under § 6015(f) is invalid, notwithstanding the reversal of its decision in lantz by the seventh circuit. five judges dissented. e. the third circuit likes the way judge posner thinks and gives a big ―raspberry’ to the tax court. mannella v. commissioner, 631 f.3d 115 (3d cir. 1/19/11), rev’g 132 t.c. 196 (4/13/09). in a 2-1 decision written by judge greenberg, the third circuit reversed the tax court and upheld the two-year statute of limitations on taxpayers seeking § 6015(f) equitable relief provided in reg. § 1.6015-5(b)(1). according to judge greenberg‘s opinion, ―[w]e cannot say that section 6015, in terms, requires that we embrace any particular view of congress‘s intent with respect to a subsection (f) filing deadline,‖ and ―the absence of a statutory filing deadline in subsection (f) similar to those in subsections (b) and (c) does not require us to conclude that the secretary cannot impose a two-year deadline by regulation.‖ in the course of applying step one of its chevron analysis, the court stated ―[w]e agree with the court of appeals for the seventh circuit that this silence is not made audible by the presence of deadlines in subsections (b) and (c).‖ turning to step two of its chevron 5. but cf., exodus 17:1-7 and numbers 20:1-13. 2012] recent developments in federal income taxation 375 analysis, the court acknowledged that the taxpayer‘s argument that the legislative history of § 66(c), which provides relief similar to § 6015(e) relief for taxpayers in community property states who do not file a joint return and which was enacted at the same time as § 6015(f), suggested that there should not be a rigid statute of limitations on seeking § 6015(f) equitable relief, ―lends some support to [the taxpayer‘s] position,‖ but concluded that ―it fails to overcome the deference that we must give to treasury regulation § 1.6015-5(b)(1) under chevron and it does not clearly demonstrate that congress intended that requests for relief under subsection 6015(f) not be subject to a two-year filing deadline.‖ additionally, the court likewise rejected the taxpayer‘s argument that ―the inclusion of deadline periods in subsections (b) and (c) but omission of such a period in subsection (f) ―demonstrates congressional intent that requests for equitable relief not be subject to a bright-line time limitation, but rather allow the taxpayer to request relief during the 10-year collection period of 26 u.s.c. § 6502.‖ however, the court of appeals remanded the case to the tax court to determine whether the statute of limitations in reg. § 1.6015-5(b)(1) is subject to equitable tolling and, if so, whether the taxpayer met the standards for equitable tolling.  judge ambro dissented. he agreed with the majority, and disagreed with the tax court, on the question of whether congress had spoken directly on the issue of the time frame in which the taxpayer must seek § 6015(f) relief, but would have invalidated reg. § 1.60155(b)(1) in step two of the chevron analysis on the ground that in promulgating the regulation, ―the irs has not advanced any reasoning for its decision to impose a two-year limitations period on taxpayers seeking relief under subsection (f), leaving us no basis to conduct the analysis mandated by chevron step two.‖ he reasoned that ―it is ... a necessary corollary of the deference owed to agencies-that courts may not supplement deficient agency reasoning,‖ and did not find judge posner‘s reasoning in lantz v. commissioner, 607 f.3d 479 (7th cir. 6/8/10), to be convincing. f. stand by your lantz. pullins v. commissioner, 136 t.c. 432 (5/5/11). the tax court (judge gustafson) reaffirmed that it would continue to follow its decision in lantz v. commissioner, 132 t.c. 131 (2009), rev’d, 607 f.3d 479 (7th cir. 2010), that the two-year deadline for seeking equitable relief from joint and several liability under § 6015(f) imposed by reg. § 1.6015-5(b)(1) is invalid, notwithstanding the contrary decisions by the u.s. courts of appeals for the seventh circuit in lantz ii and for the third circuit in mannella v. commissioner, 631 f.3d 115, rev’g, 132 t.c. 196 (2009). on the facts, relief was granted. three factors supported denying relief – (1) the taxpayer‘s failure to prove economic hardship, (2) her lack of a reasonable expectation that her husband would pay the liabilities when she signed the returns, and 376 florida tax review [vol. 12:5 (3) her failure to timely file her returns and pay her taxes since the years in issue. four factors favored granting relief – (1) the taxpayer‘s divorce from her husband, (2) his legal obligation pursuant to the divorce decree to pay the tax liabilities, (3) her lack of significant benefit from the nonpayment, and (4) her poor health. a fifth factor, her lack of knowledge of her husband‘s unreported income, favored relief as to the deficiency for one particular year. judge gustafson found ―especially weighty‖ ―the fact that the divorce court – with the family‘s circumstances set out before it in greater detail than was possible in our tax case – determined that [the taxpayer‘s husband] should pay the taxes, placed proceeds in his hands sufficient to do so, and allocated resources to ms. pullins on the assumption that he would do so and she would not have to.‖ g. but lantz doesn’t allow a mulligan if the tax payer has already litigated denial of relief in another forum. haag v. commissioner, t.c. memo. 2011-87 (4/19/11). the taxpayer had sought § 6015 relief in a district court proceeding in which the government sought to reduce unpaid assessments to judgment, and relief was denied on the ground that her claim was not timely. that decision was affirmed on appeal. in the instant tax court proceeding, the taxpayer sought § 6015(f) relief for the same years, claiming that because lantz invalidated the two-year deadline for seeking equitable relief from joint and several liability under § 6015(f) imposed by reg. § 1.6015-5(b)(1) changed the law, her claim was not barred. the tax court (judge gustafson) held that res judicata barred the taxpayer‘s claim; her claim for relief was an issue in the prior litigation, even though the merits were not reached, and she meaningfully participated. ―[a] change in the law after a matter has been litigated does not change the claimpreclusive effect of the earlier decision.‖ h. another taxpayer loss. jones v. commissioner, 642 f.3d 459 (4th cir. 6/13/11). holds that reg. § 1.60155(b)(1), which mandates a two-year limitations period for persons seeking equitable innocent spouse relief under § 6015(f), is valid. judge niemeyer used a chevron analysis to follow the seventh and third circuit precedents in lantz ii and mannella. i. and the irs demonstrates that it has a heart by throwing in the towel even though it was consistently winning in the courts of appeals. notice 2011-70, 2011-32 i.r.b. 135 (7/25/11). the irs announced that it will no longer enforce reg. § 1.6015-5(b)(1) limiting to two years after the date of the irs‘s first collection activity the period in which it would consider requests for equitable relief under § 6015(f). under the new procedures, the irs will consider requests for relief under § 6015(f) as long as the period of limitation on collection of 2012] recent developments in federal income taxation 377 taxes provided by § 6502 remains open for the tax years at issue, and if the relief sought involves a refund of tax, the period of limitation on credits or refunds provided in § 6511 will govern whether the irs will consider the request for relief for purposes of determining whether a credit or refund may be available. the relief from the truncated period of limitations is retroactive. for requests for § 6015(f) that have already been submitted and are under consideration, the irs will consider the request for equitable relief even if the request was submitted more than two years after the first collection activity was taken if the applicable period of limitation under § 6502 or § 6511 was open when the request for equitable relief was filed. individuals whose requests for equitable relief under § 6015(f) were denied by the irs solely for untimeliness and were not litigated may reapply for § 6015(f) relief, and the original form 8857 will be treated as a claim for refund for purposes of the period of limitation on refunds. for case in litigation, the irs will concede the timeliness issue consistent with the position announced in the notice. for cases that were litigated and in which (1) the validity of the two-year deadline to request equitable relief was at issue, (2) the decision in the case is final, and (3) the irs stipulated in the court proceeding that the individual‘s request for equitable relief would have been granted if the request had been timely, the irs will not seek to collect from the individual any portion of the underlying liability for which equitable relief would have been granted. j. the irs is attempting to be more equitable in granting innocent spouse relief. notice 2012-8, 2012-4 i.r.b. 309 (1/6/12). this notice provides a proposed revenue procedure that will supersede rev. proc. 2003-61, 2003-2 c.b. 296, which provides guidance regarding § 6015(f) relief from joint and several liability. the factors used in making § 6015(f) innocent spouse relief determinations will be revised ―to ensure that requests for innocent spouse relief are granted under section 6015(f) when the facts and circumstances warrant and that, when appropriate, requests are granted in the initial stage of the administrative process.‖ the revenue procedure expands how the irs will take into account abuse and financial control by the nonrequesting spouse in determining whether equitable relief is warranted, because when a requesting spouse has been abused by the nonrequesting spouse, the requesting spouse may not have been able to challenge the treatment of any items on the joint return, question the payment of the taxes reported as due on the joint return, or challenge the nonrequesting spouse‘s assurance regarding the payment of the taxes. furthermore, a lack of financial control may have a similar impact on the requesting spouse‘s ability to satisfy joint tax liabilities. thus, the proposed revenue procedure provides that abuse or lack of financial control may mitigate other factors that might otherwise weigh against granting § 6015(f) equitable relief. the proposed revenue procedure also provides for 378 florida tax review [vol. 12:5 certain streamlined case determinations; new guidance on the potential impact of economic hardship; and the weight to be accorded to certain factual circumstances in determining equitable relief.  until the revenue procedure is finalized, the irs will apply the provisions in the proposed revenue procedure instead of rev. proc. 2003-61 in evaluating claims for equitable relief. but if a taxpayer would receive more favorable treatment under one or more of the factors provided in rev. proc. 2003-61 and so advises the irs, the irs will apply those factors from rev. proc. 2003-61, until the new revenue procedure is finalized. 2. the tax court strikes a blow for greater employment opportunities for tax lawyers. harbin v. commissioner, 137 t.c. 93 (9/26/11). the taxpayer sought § 6015(b) relief for taxes attributable to his former wife‘s gambling activities. the amount of the liability had been determined in a prior proceeding in which the issue of § 6015 relief had not been raised by the attorney who had jointly represented both spouses in both the tax proceeding and their contemporaneous divorce. section 6015(g)(2) bars a spouse who has meaningfully participated in a court proceeding involving the taxable year in issue from subsequently electing innocent spouse relief under § 6015(b) or apportioned liability under § 6015(c). judge kroupa held that § 6015(b) did not bar the taxpayer from seeking § 6015(b) relief because, due to his attorney‘s conflict of interest in the prior proceeding, the taxpayer had not materially participated in the earlier proceeding. the taxpayer and his wife‘s ―financial interests and interests in the allocation of liability for the deficiencies at issue were adverse in the prior deficiency case [and the attorney‘s] joint representation ... in the prior deficiency case created a conflict of interest.‖ the taxpayer‘s wife had exercised control over the prior proceeding and all communication between the irs and the taxpayer and his wife had been through the attorney. the attorney had not explained the conflict or sought a waiver. nor had the attorney informed the taxpayer of the opportunity to seek § 6015 relief. the taxpayer had a ―viable claim‖ for § 6015 relief, but the opportunity to raise that claim ―was obscured and obstructed‖ by the attorney‘s joint representation. after holding that the bar of § 6015(g)(2) did not apply, judge kroupa went on to grant § 6015(b) relief on the facts, because the irs had stipulated that § 6015(b) relief was warranted if the § 6015(g)(2) bar did not apply. 3. an irs levy on a joint account doesn’t trump a spouse’s right to seek § 6015(g) relief. minihan v. commissioner, 138 t.c. no. 1 (1/11/12). at the time the taxpayer was seeking tax court review of the irs‘s denial of § 6015(g) relief, the irs levied on a joint bank account owned by the taxpayer‘s husband and the taxpayer to satisfy the tax liability. 2012] recent developments in federal income taxation 379 at that time collection against the taxpayer was suspended pursuant to § 6015(e)(1)(b). judge gustafson held that because under state law the taxpayer owned one-half of the funds in the bank account, she was not precluded from seeking a refund of one-half of the funds in the account if she prevailed on the § 6015(f) relief issue. while a taxpayer who is relieved from joint and several liability under § 6015(f) in a tax court proceeding is not entitled to a refund under § 6015(g)(1), unless the taxpayer made an overpayment, if the taxpayer prevailed, the levy on her one-half of the bank account funds would constitute an overpayment as defined in § 6402(a). although united states v. nat’l bank of commerce, 472 u.s. 713 (1985), held that the irs can lawfully levy on a joint bank account to satisfy one account holder‘s individual tax liability, that levy is conditional, and it does not extinguish a third party‘s rights in levied property. the court then concluded that the rights of an ―innocent spouse‖ who claims a refund under § 6015(g)(1) survive post-levy in the same way that the rights of a § 7426 or § 6343(b) wrongful levy claimant survive. accordingly, the irs was denied summary judgment, and whether mrs. minihan deserved § 6015(f) relief was a matter for trial. h. miscellaneous 1. congress discovers that corporations as well as unincorporated businesses might cheat less if payors rat them out to the irs. the 2010 health care act amended § 6041 to extend to payments to corporations the information reporting requirement for all payments by a business to any single payee (other than a payee that is a tax exempt corporation) aggregating $600 or more in a calendar year for amounts paid in consideration for property or services. however, the expanded rule does not override other specific code provisions that except payments from reporting, for example, securities or broker transactions as defined under § 6045(a) and the regulations thereunder. the new rule is effective for payments made after 12/31/11. a. this provision was repealed one year later, before it went into effect. on 4/14/11, president obama signed legislation to repeal the burdensome 1099 reporting requirements enacted under health care legislation [ppaca]. 2. irs releases recommendations that paid tax return preparers would be required to register. ir-2010-1, 2010 tnt 2-1 (1/4/10). the irs released a list of recommendations that would require that individuals who sign a tax return as a paid preparer pay a user fee to register online with the irs and obtain a preparer tax identification number [ptin]. all preparers – except attorneys, cpas and enrolled agents – would have to 380 florida tax review [vol. 12:5 pass competency exams and complete 15 hours of annual cpe in federal tax law topics. the irs proposes to expand circular 230 to cover all signing and nonsigning return preparers. registered preparers would be listed on a publicly-searchable data base and would be required to have ptins in 2011. a. we wish we had karen’s confidence in accenture. the irs office of professional responsibility is not at all concerned with the task of registering paid tax preparers. that is because accenture will be the vendor to establish a system for on-line registration, with a target date of 9/1/10. accenture will undoubtedly bring to this task the same thoughtful foresight and judgment it used when it selected tiger woods as its leading spokesperson. 2010 tnt 85-24 (5/4/10). the irs announced that accenture national security services, llc, will be the vendor to establish a system for on-line registration of paid tax return preparers. ―the vendor will develop and maintain the registration application system and address related questions.‖ karen hawkins, director of the irs office of professional responsibility recently stated that she was not worried about registration of paid preparers because accenture would take care of it completely. b. some of us learned about the concept of ―fee simple‖ in school but these will not be ―simple fees‖; instead there will be multiple fees – some of which will be raked off by accenture. reg-139343-08, user fees relating to enrollment and preparer tax identification numbers, 75 f.r. 43110 (7/23/10). registration for an identifying number, together with a $50 fee will be required for all tax return preparers who prepare all, or substantially all, of a return or claim for refund of tax after 12/31/10. accenture may charge a ―reasonable fee‖ that is independent of the $50 user fee.  the irs later confirmed that the user fee for the first year of registration will be $64.25; the excess $14.25 will permit accenture to ―wet its beak.‖ c. the irs issued proposed regulations which would regulate tax return preparers and establish a new class of practitioner – a ―registered tax return preparer‖ – whose qualifications obviously exceed those of any other class of practitioner. reg-13863707, regulations governing practice before the internal revenue service, 75 f.r. 51713 (8/19/10). these proposed regulations would amend circular 230 to apply to all paid return preparers and identify exactly which preparers have a registration obligation. they would also change the general circular standard of contact from ―more likely than not‖ to ―reasonable basis‖ [sic]. specifically, the proposed regulations establish ―registered tax return preparers,‖ as a new class of practitioners. 2012] recent developments in federal income taxation 381 sections 10.3 through 10.6 of the proposed regulations describe the process for becoming a registered tax return preparer and the limitations on a registered tax return preparer‘s practice before the irs. in general, practice by registered tax return preparers is limited to preparing tax returns, claims for refund, and other documents for submission to the irs. a registered tax return preparer may prepare all or substantially all of a tax return or claim for refund, and sign a tax return or claim for refund, commensurate with the registered tax return preparer‘s level of competence as demonstrated by written examination. the proposed regulations also revise section 10.30 regarding solicitation, section 10.36 regarding procedures to ensure compliance, and section 10.51 regarding incompetence and disreputable conduct. proposed regulations under section 6109 of the code (reg134235-08) published in the federal register (75 fr 14539) on march 26, 2010, also implement certain recommendations in the report. the proposed regulations under section 6109 provide that, for returns or claims for refund filed after december 31, 2010, the identifying number of a tax return preparer is the individual‘s preparer tax identification number (ptin) or such other number prescribed by the irs in forms, instructions, or other appropriate guidance. the proposed regulations under section 6109 provide that the irs is authorized to require through other guidance (as well as in forms and instructions) that tax return preparers apply for a ptin or other prescribed identifying number, the regular renewal of ptins or other prescribed identifying number, and the payment of user fees.  just as ―registered‖ mail is ―better‖ than ―certified‖ mail, a ―registered tax return preparer‖ – whose duties focus solely on the preparation of tax returns – seems to be ―better‖ than a ―certified public accountant‖ – whose duties are numerous and varied. additionally, the ―registered‖ practitioner gets his authority from the u.s. government‘s internal revenue service while the ―certified‖ practitioner gets his authority merely from one of the states. d. proposed amendments to circular 230. reg-138637-07, rules governing practice before the internal revenue service, 2010-2 c.b. 581 (8/19/10). these proposed regulations contain standards with respect to tax returns under § 10.34, as well as new rules governing the oversight of tax return preparers under §§ 10.3 through 10.6. there are also proposed revisions to § 10.30 regarding solicitation, § 10.36 https://www.lexis.com/research/buttontflink?_m=6c522dbb5f75cc31ef9c40c5ebeba44f&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2010%20tnt%20161-3%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=21&_butinline=1&_butinfo=ircode%206109&_fmtstr=full&docnum=4&_startdoc=1&wchp=dglzvzz-zskal&_md5=1a3bff3c8603a186616e0d6694786efd https://www.lexis.com/research/buttontflink?_m=6c522dbb5f75cc31ef9c40c5ebeba44f&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2010%20tnt%20161-3%5d%5d%3e%3c%2fcite%3e&_buttype=3&_butstat=2&_butnum=22&_butinline=1&_butinfo=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b75%20fr%2014539%5d%5d%3e%3c%2fcite%3e&_fmtstr=full&docnum=4&_startdoc=1&wchp=dglzvzz-zskal&_md5=9ed853f7605f9e76a6c96b8a11270757 https://www.lexis.com/research/buttontflink?_m=6c522dbb5f75cc31ef9c40c5ebeba44f&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2010%20tnt%20161-3%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=23&_butinline=1&_butinfo=ircode%206109&_fmtstr=full&docnum=4&_startdoc=1&wchp=dglzvzz-zskal&_md5=ffd8000b0ba2521611683a0e6c686e93 https://www.lexis.com/research/buttontflink?_m=6c522dbb5f75cc31ef9c40c5ebeba44f&_xfercite=%3ccite%20cc%3d%22usa%22%3e%3c%21%5bcdata%5b2010%20tnt%20161-3%5d%5d%3e%3c%2fcite%3e&_buttype=4&_butstat=0&_butnum=24&_butinline=1&_butinfo=ircode%206109&_fmtstr=full&docnum=4&_startdoc=1&wchp=dglzvzz-zskal&_md5=ce5e5a997d079d5a4ca55194db8dfa12 382 florida tax review [vol. 12:5 regarding procedures to ensure compliance, and § 10.51 regarding incompetence and disreputable conduct. e. final § 6109 regulations. t.d. 9501, furnishing identifying number of tax return preparer, 75 f.r. 60309 (9/28/10). final regulations amending § 1.6109-2 explaining how the irs will define those required to obtain a ptin as a return preparer, with four examples. f. david williams is to be given ―broad responsibility.‖ ir-2010-107 (10/26/10). in a speech to the aicpa fall meeting, irs commissioner shulman announced the creation of a return preparer office under david r. williams at the irs itself, which office is to have ―broad responsibility‖ for the return preparer initiative. the office will complement the work of the irs office of professional responsibility under karen hawkins. g. register those staff members as ―supervised preparers‖! notice 2011-6, 2011-1 c.b. 315 (12/30/10). this notice provides guidance on the new regulations § 1.6901-2 governing tax return preparers, including the exemption from continuing education requirements and competency exams for non-signing supervised staff members employed and supervised by an attorney, cpa or enrolled agent; however, these ―supervised preparers‖ must obtain ptins and pass the mandatory tax compliance and suitability checks [and pay the $64.25 annual fee]. the notice also contains a list of forms that do not require that their preparer have a ptin, as well as interim rules that permit individuals to obtain provisional ptins before the first offering of competency examinations; the provisional ptins may be renewed until the end of 2013. h. relief for irs delays. notice 2011-11, 2011-7 i.r.b. 497 (1/26/11). this notice temporarily allows certain tax return preparers who have made a good faith effort to obtain a ptin to prepare tax returns for compensation even though they have not received a ptin. any tax return preparer who receives (1) a notice from the irs that it was unable to process his online ptin application or (2) an acknowledgment of receipt of the paper ptin application will be allowed to prepare and file tax returns or claims for refund for compensation after the tax return preparer complies with all instructions provided in the notification or acknowledgment letter. this relief applies only for the 2011 tax return filing season. i. final amendments to circular 230. t.d. 9527, regulations governing practice before the internal revenue service, 2012] recent developments in federal income taxation 383 76 f.r. 32286 (5/31/11). these regulations adopt, with some changes, proposed regulations (reg-138637-07), see d., above. attorneys and cpas are not affected by the amendments to circular 230 §§ 10.3, 10.4, 10.5, 10.7 and 10.9, which relate to rules regarding registered tax return preparers. section 10.30(a) (regarding advertising and solicitation restrictions) provides: ―an example of an acceptable description for registered tax return preparers is ‗designated as a registered tax return preparer by the internal revenue service.‘‖  section 10.34 standards for signing tax returns as preparer. with respect to the standards for tax returns and documents, etc., § 10.34(a)(1)(i) provides that a practitioner may not willfully, recklessly, or through gross incompetence, sign a tax return or claim for refund that the practitioner knows or reasonably should know contains a position that: (a) lacks a reasonable basis; (b) is an unreasonable position as described in section 6694(a)(2) (including the related regulations and other published guidance); or (c) is a willful attempt by the practitioner to understate the liability for tax or a reckless or intentional disregard of rules or regulations by the practitioner as described in section 6694(b)(2) (including the related regulations and other published guidance).  section 10.36 standards for supervisory responsibility. there is supervisory responsibility under § 10.36(b) for overseeing a firm‘s practice of preparing tax returns, claims for refunds and other documents filed with the irs. the firm must take reasonable steps to ensure that the firm has adequate procedures in effect for purposes of complying with circular 230.  it appears that references to the office of professional responsibility were present in the proposed regulations and missing from the final regulations. query: does this mean that attorneys, cpas and enrolled agents would be subject to discipline from the irs return preparer office, and not from the opr, for improprieties in connection with the preparation of returns?  these regulations were effective on 8/2/11. j. there are no registered tax return preparers – yet. notice 2011-45, 2011-25 i.r.b. 886 (5/31/11). because the conditions for becoming a registered tax return preparer are not yet able to be satisfied by any individual – neither the competency examination nor the suitability check are not yet available – no individual may represent that he is a registered tax return preparer. in addition, circular 230 § 10.30 will be amended to require that any individual who represents himself or herself to be a registered tax return preparer in any paid advertising must include the following statement: ―the irs does not endorse any particular individual tax return preparer. for more information on tax return preparers go to irs.gov.‖ 384 florida tax review [vol. 12:5 k. it is only a rumor that the irs return preparer office has put out an rfp for dna matching services. reg116284-11, user fees relating to the registered tax return preparer competency examination and fingerprinting participants in the preparer tax identification number, acceptance agent, and authorized e-file provider programs, 76 f.r. 59329 (9/26/11). these proposed regulations would set fees going to the irs of (1) $27 for taking the registered tax return preparer competency examination testing and (2) $33 for being fingerprinted. these fees are in addition to the unspecified fees that will be paid to the private vendors that administer the examinations and take fingerprints. l. notice 2011-80, 2011-43 i.r.b. 591 (9/21/11). this notice provides guidance for the issuance of provisional ptins and their annual renewal on a calendar year basis. it also states that the irs will not require individuals to be fingerprinted prior to obtaining a ptin until at least 4/18/12. attorneys, cpas, enrolled agents, enrolled retirement plan agents and enrolled actuaries will not be required to be fingerprinted ―at this time.‖ m. reg-140280-09, tax return preparer penalties under section 6695, 76 f.r. 62689 (10/11/11). proposed regulations under § 6695(g), prop. reg. § 1.6695-2, relating to tax return preparer due diligence requirements for determining under earned income credit eligibility. when made final, the regulations will require the completion and submission of form 8867 with each tax return or claim for refund claiming the eic. 3. this whistleblower gets a chance to let the tax court decide whether or not he was whistling in the dark. cooper v. commissioner, 135 t.c. 70 (7/8/10). the tax court (judge kroupa) held that it has jurisdiction under § 7623(b)(4) to review the denial of a claim for a whistleblower award. the court rejected irs‘s argument that the tax court‘s jurisdiction is limited to appeals of a determination of the amount of the award. a. the whistleblower was whistling in the dark. cooper v. commissioner, 136 t.c. 597 (6/20/11). cooper had provided information to the irs regarding an alleged underpayment of tax and sought a whistleblower award. the irs determined not to pursue the matter and denied any award. cooper sought review in the tax court. in an earlier proceeding, cooper v. commissioner, 135 t.c. 70 (2010), the tax court determined that it had jurisdiction to review a denial of any award. in the instant case, the tax court (judge kroupa) held that § 7623(b) does not 2012] recent developments in federal income taxation 385 confer on the tax court jurisdiction to redetermine the tax liability of the taxpayer with respect to whom a claimant is seeking a whistleblower reward.  the senate finance committee‘s version of § 7623 would have permitted the whistleblower‘s lawyer to participate in the audit of the taxpayer. b. was this whistleblower whistling in the dark? kasper v. commissioner, 137 t.c. 37 (7/12/11). in an opinion by judge haines, the tax court reaffirmed its earlier holding in cooper v. commissioner, 136 t.c. 597 (2011), that a letter from the irs rejecting a whistleblower claim constitutes a determination, for which review may be sought in the tax court. the court further held that the 30-day period for seeking review commences upon mailing or personal delivery of the letter, and that the irs must demonstrate either mailing or delivery to the whistleblower‘s last known address. c. the whistleblower made no noise, and keeps his (?) identity secret . whistleblower 14106-10w v. commissioner, 137 t.c. no. 15 (12/9/11). in a reviewed opinion by judge thornton, the tax court granted summary judgment for the irs in this case in which a whistleblower appealed the irs‘s denial of a reward. the irs filed the affidavit of a chief counsel attorney ―declaring, on the basis of his review of respondent‘s administrative and legal files and on the basis of conversations with relevant irs personnel, that the information petitioner provided resulted in respondent's taking no administrative or judicial action against x or collecting from x any amounts of tax, interest, or penalty,‖ and the whistleblower did ―not set forth, by affidavits or otherwise, any specific facts showing that there [was] a genuine issue for trial.‖ the court granted the whistleblower‘s request for anonymity and redaction from the record of any identifying information because the potential harm from disclosing the whistleblower‘s identity as a confidential informant outweighed the public interest in knowing the whistleblower‘s identity in a case decided on summary judgment for the irs denying an award. because granting the request for anonymity and redaction adequately protected the whistleblower‘s privacy interests as a confidential informant, the motion to seal the record was denied. 4. how much is that little tax cheat in the window? reg-131151-10, 76 f.r. 2852 (1/18/11), rewards and awards for information relating to violations of internal revenue laws. the treasury has published proposed amendments to reg. § 301.7623-1 that clarify the definitions of proceeds of amounts collected and collected proceeds for purposes of § 7623. 386 florida tax review [vol. 12:5 a. large whistleblower award announced. an attorney, egan young of egan young attorneys at law in blue bell, pa – not to be confused with blue ball, pa, see ginzburg v. united states, 383 u.s. 463, 467 (1966) – claimed that one of his clients, a cpa, was awarded more than $4.5 million for alerting the irs of a fortune 500 financial services company‘s $20 million unreported tax liability. 2011 tnt 69-4 (4/11/11).  query whether a cpa is subject to professional discipline if he reports a client to the irs? 5. just because there are no longer any district directors doesn’t mean the irs can’t fulfill functions that the regulations still assign to district directors. grunsted v. commissioner, 136 t.c. 455 (5/11/11). the taxpayer, against whom frivolous return penalties had been assessed, argued that because reg. § 301.6203-1 provides for assessment officers to be appointed by district directors, and there are no longer any district directors, therefore no assessment officers have been properly appointed and thus frivolous return penalties could not be validly assessed against him. the tax court was unimpressed by this argument. judge kroupa held that provisions of the internal revenue service restructuring and reform act of 1998, pub. l. 105-206, 112 stat. 685, which required the irs to substantially modify its regional and district organization, keeps in effect regulations that refer to officers whose positions no longer exist, e.g., district directors. the act also provides that nothing in the reorganization plan impairs any right or remedy of the irs to recover any penalty claimed to have been collected without authority. 6. take your time, relax. t.d. 9531, extension of time for filing returns, 76 f.r. 36996 (6/24/11). final regulations §§ 1.6081-2 and 1.6081-6 provide for an automatic five-month extension of time to file returns for partnerships, estates and trusts. the irs rejected extending the extension to six-months because of hardships in completing returns that would be created for individual taxpayers with six-month extension. reg. § 1.6081-2(a)(2) allows a six-month automatic extension for electing large partnerships, which are required by § 6031(b) to provide k-1s to beneficial interest holders by march 15 in any event. 7. the burden is shifted to the irs only if you cooperate. mcneill v. commissioner, t.c. memo. 2011-150 (6/28/11), aff’d per curiam, 451 fed. appx. 622 (1/10/12). if the taxpayer asserts a reasonable dispute with any item shown on an information return on which a proposed deficiency is based, and the taxpayer has fully cooperated with the irs with respect to the production of witnesses, documents, and other information, § 6201(d) requires the irs to produce additional reasonable and 2012] recent developments in federal income taxation 387 probative evidence of the deficiency. in this case, in which the taxpayer filed a ―zero‖ return and did not cooperate with the irs, judge laro held that § 6201(d) did not apply. the irs could rely on information returns and the burden of proof remained on the taxpayer. 8. even if they thought god was on their side, the aia still kept them out of paradise. christian coalition of florida, inc. v. united states, 662 f.3d 1182 (11th cir. 11/15/11). the eleventh circuit held that the § 7421 anti-injunction act barred further proceedings in a case originally filed as a refund suit by an organization claiming tax exemption under § 501(c)(4). after the suit had been filed the irs refunded the taxes in full because the statute of limitations on collection had run before the taxes had been assessed. the district court granted the government‘s motion to dismiss the suit as moot. section 7428 authorizes declaratory judgment actions only for organizations seeking exemption under § 501(c)(3). thus, the plaintiff‘s suit was barred by the aia. 9. new tax court proposed rules (12/28/11). the united states tax court has proposed amendments to its rules of practice and procedure. comments in writing are due by 2/27/12. the proposals include: (1) amending rule 23 to: (a) reduce the number of copies required for papers filed with the court, (b) delete the nonproportional font requirement for papers filed with the court, and (c) revise the language regarding the court's return of documents; (2) deleting rule 175, as the number of copies required for papers filed with the court in small tax cases would be the same as in all other cases; (3) amending rule 26 to require electronic filing by most attorneys; (4) amending rules 70 and 143 to conform the court's rules to rule 26(a)(2)(b) of the federal rules of civil procedure, regarding the contents of expert witness reports, rule 26(b)(3) of the federal rules of civil procedure, regarding work product protections, and revisions to rule 26(b)(4) of the federal rules of civil procedure, limiting discovery of draft expert witness reports and trial preparation communications and materials; (5) amending rule 121, summary judgment, to conform the rule with revisions to rule 56 of the federal rules of civil procedure; (6) amending rule 155 to clarify that computations may be filed in conjunction with dispositive orders; (7) amending rule 241, commencement of partnership actions, so that its notice provisions are consistent with those of reg. § 301.6223(g)1(b)(3); (8) adopting new rule 345 to provide privacy protections in whistleblower cases; 388 florida tax review [vol. 12:5 (9) amending various rules to make conforming changes; and (10) providing new form 18 in recognition of 28 u.s.c. sec. 1746, which allows an unsworn declaration to substitute for an affidavit. xi. withholding and excise taxes a. employment taxes 1. the supremes spread mayo all over the code. national muffler is dead: long live chevron. mayo foundation for medical education and research v. united states, 131 s. ct. 704 (1/11/11). in a unanimous decision, written by chief justice roberts, the supreme court affirmed the court of appeals in what undoubtedly will be one of the most far reaching tax decisions ever rendered by the court. the court applied the two part test of chevron, u.s.a., inc. v. natural resources. defense council, inc., 467 u.s. 837 (1984), to test the validity of the regulation and upheld it. under chevron, the first question is whether congress has directly spoken to the precise question at issue. if the statute has ―directly addressed the precise question at issue‖ the regulation must follow the unambiguously expressed intent of congress. if the statute is silent or ambiguous with respect to the specific issue, the second question is whether the agency‘s answer is based on a permissible construction of the statute. in this second step, according to the supreme court, a court ―may not disturb an agency rule unless it is ‗arbitrary or capricious in substance, or manifestly contrary to the statute.‘‖ thus, a court may not substitute its own construction for the reasonable interpretation of an agency. in mayo, the supreme court held that ―[t]he principles underlying our decision in chevron apply with full force in the tax context.‖ in applying chevron, the court unambiguously overruled its prior decision in national muffler dealers association v. united states, 440 us 472, 477 (1979), rendering the national muffler standards irrelevant in all future cases. under national muffler the inquiry was as follows: in determining whether a particular regulation carries out the congressional mandate in a proper manner, we look to see whether the regulation harmonizes with the plain language of the statute, its origin, and its purpose. a regulation may have particular force if it is a substantially contemporaneous construction of the statute by those presumed to have been aware of congressional intent. if the regulation dates from a later period, the manner in which it evolved merits inquiry. other relevant considerations are the length of time the regulation has been in effect, the reliance placed on it, the consistency of the commissioner‘s interpretation, and the degree of scrutiny congress has devoted to the regulation during subsequent re-enactments of the statute. 2012] recent developments in federal income taxation 389  in overruling national muffler, the court unequivocally stated that ―an agency‘s interpretation of an ambiguous statute does not turn on such considerations.‖ the court specifically stated that ―[a]gency inconsistency is not a basis for declining to analyze the agency‘s interpretation under the chevron framework.‖ quoting its earlier decision in bob jones university v. united states, 461 u.s. 574, 596 (1983), the court stated, ―[i]n an area as complex as the tax system, the agency congress vests with administrative responsibility must be able to exercise its authority to meet changing conditions and new problems.‖ the court also rejected the taxpayer‘s argument that a regulation, like the one question, promulgated under the general authority of § 7805(a) was entitled to less deference than one ―‗issued under a specific grant of authority to define a statutory term or prescribe a method of executing a statutory provision,‘‖ and in so doing overruled its prior decisions in rowan cos. v. united states, 452 u.s. 247, 253 (1981), and united states v. vogel fertilizer co., 455 u.s. 16 (1982), which had so held, stating that the court‘s inquiry does not turn on whether congress‘s delegation of authority was general or specific. furthermore, the court held that ―it is immaterial to our analysis that a ‗regulation was prompted by litigation,‘‖ noting that in united dominion industries, inc. v. united states, 532 u.s. 822 (2001), it had ―expressly invited the treasury department to ‗amend its regulations‘ if troubled by the consequences of our resolution of the case.‖ thus, the supreme court has unambiguously stated that as long as a regulation can withstand chevron analysis, a treasury regulation can reverse case law. finally, however, in upholding the validity of the regulation, the court emphasized that the regulation was promulgated after notice and comment, thus leaving open the possibility that mayo/chevron deference might not apply to a temporary regulation issued without notice and comment. 2. social security is cheaper for 2011, but the deficits grow. the compromise tax relief act of 2010, § 601, reduces the employee portion of the old-age, survivors, and disability insurance tax (oasdi) from 6.2 percent to 4.2 percent for calendar year 2011.  the 4.2 percent rate also applies to the railroad retirement tax. a. congress giveth a little and taketh some of it back. ir 2011-124 (12/23/11). this news release highlights the two month reduction in payroll withholding for social security taxes from 6.2 percent to 4.2 percent and the complimentary reduction in self-employment taxes for the first two months of 2012 under the temporary payroll tax cut continuation act of 2011. the news release indicates that employers should implement the new payroll rate as soon as possible, but in any event no later than march 31, 2012. the news release also highlights the recapture tax that is imposed on employees who receive more than $18,350 in wages during 390 florida tax review [vol. 12:5 the two-month extension period in the amount of an additional 2 percent income tax on wages in excess of $18,350 received during the two-month extension. 3. tax law firm misses on its own special allocation. renkemeyer, campbell & weaver, llp v. commissioner, 136 t.c. 137 (2/9/11). the taxpayer law firm practiced tax law in a kansas limited liability partnership. the partnership consisted of the three lawyers in the firm plus a subchapter s corporation wholly owned by an esop whose beneficiaries were the three attorney partners. the court (judge jacobs) held that the individual partners‘ share of partnership income was subject to selfemployment tax. the court also rejected the partnership‘s argument that the partners of the limited liability partnership were limited partners subject to the § 1402(a)(13) exclusion from self-employment tax the income of a limited partner. the court opined that the purpose of § 1402(a)(13) ―was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership‘s business operations (which was the archetype of limited partners at the time) would not receive credits toward social security coverage.‖ the court concluded that legislative history did not support a holding that the exclusion applied to partners who performed services for the partnership in their capacity as partners. thus, the court held that distributive shares arising from legal services performed in the partners‘ capacity as partners in the law firm were subject to selfemployment tax. 4. attorneys are employees of their professional corporation law firm. donald g. cave a prof. law corp. v. commissioner, t.c. memo. 2011-48 (2/28/11). the court (judge marvel) held that donald cave, the principal attorney for the taxpayer s corporation engaged in law practice, associates of the firm, and a law clerk were employees for employment tax purposes. donald cave was the corporation‘s president, made corporate decisions, and received a percentage of legal fees. the court held that cave‘s management services in the capacity of the corporation‘s president were not provided as an independent contractor. numerous factors supported employment status for associate attorneys, hired by cave in his purported activity as an ―an attorney incubator‖; they were found to be sufficiently under the control of the corporation, the corporation provided facilities, while the associates‘ compensation was on a percentage basis, they bore no risk of loss, the relationship was ―continuous, permanent, and exclusive, there was no evidence that the associate attorneys provided services to anyone else, and the associate attorneys provided everyday professional tasks in the corporation‘s business. the court also denied independent contractor status under the safe harbor of § 530 of the 1978 revenue act finding no reasonable basis for the corporation to have treated 2012] recent developments in federal income taxation 391 the attorneys as independent contractors. the corporation was also required to pay failure to deposit tax penalties under § 6656. 5. employed and self-employed at the same time. rosenfeld v. commissioner, t.c. memo 2011-110 (5/23/11). the taxpayer, who maintained a consulting business advising clients on marketing, accepted a three year full-time appointment with the british consulate general (bcg) to perform services similar to those provided by the taxpayer to private clients. the court (judge dean) held that the taxpayer was an employee of the consulate for withholding purposes and not entitled to separately report income from the engagement on a schedule c. the court found employee status based on the facts that the taxpayer worked under the control of the bcg, the taxpayer received a fixed salary for his services, and the taxpayer‘s services furthered bcg‘s goals. the court described as ―neutral‖ the facts that, although bcg provided an office (whether or not the taxpayer used the office was irrelevant) the taxpayer incurred many costs associated with his work, the taxpayer‘s three year contract was not defined as long term, and that the either party could terminate the relationship without cause. the court also rejected the taxpayer‘s arguments that he was self-employed because the parties defined the relationship as an independent contractor relationship that specifically provided that the bcg would not withhold taxes, and the taxpayer received no employee benefits and concluded that the taxpayer was a common law employee of bcg. 6. part time professor as an independent contractor. robinson v. commissioner, t.c. memo 2011-99 (5/5/11). the taxpayer, a full time criminal justice professor at rowan university, taught vocational classes at temple university in its criminal justice training program. from 1985-1996 temple treated the taxpayer as an independent contractor thereafter reported the taxpayer‘s compensation as an employee. the court (judge wells) focused largely on the control test for employment status and found that the degree of control exercised by temple over the taxpayer as a vocational instructor was less than the control normally exercised over an adjunct professor. the court noted that the taxpayer prepared the curricula for the courses he taught, mostly covering topics mandated by the state police commission that paid temple. the court added that the only control temple exercised over taxpayer‘s work updating curricula was to set deadlines and convey the general topics he was to cover. the court also noted that temple did not provide the taxpayer an office or other space in which to write and update curricula, taxpayer‘s opportunity for profit and loss depended on how many courses he was hired to teach and was not dependent on the level of enrollment in each course (a risk borne by temple), and that the record suggested that the taxpayer was hired for individual jobs thereby being asked to perform discrete tasks under varying 392 florida tax review [vol. 12:5 payment terms. the court further cited that fact that teaching police training courses was not part of temple‘s regular business of teaching for-credit courses to regularly enrolled students. the remaining factors considered by the court included that the taxpayer‘s relationship with temple fluctuated over time rather than constituting a permanent position, the taxpayer was paid an hourly wage for teaching but a flat fee for writing curricula suggesting both an employee relationship and an independent contractor relationship, that temple treated the taxpayer as an employee for reporting purposes, but provided no employment benefits. considering all of the factors, the court found the taxpayer was an independent contractor. the court also denied multiple deductions claimed by both the taxpayer and the taxpayer‘s spouse on schedules c and a for lack of substantiation and imposed § 6662 penalties. 7. litigious attorney liable for employment taxes, no matter how many courts he tries. western management, inc. v. united states, 101 fed. cl. 105 (9/9/11). attorney kovacevich practiced through his wholly owned and operated corporation as an independent contractor. taxpayer withdrew funds from the corporation as needed. in addition the corporation paid multiple personal expenses for the taxpayer and his wife. on instructions from the taxpayer, the corporation‘s accountant treated disbursements to the taxpayer as loans and did not file forms 1099 for any of the payments. in a 2003 decision (t.c. memo. 2003-162, aff’d, 176 fed. appx. 778 (9th cir. 2006)) the tax court held that kovacevich was an employee and the corporation was liable for employment taxes, plus § 6662 penalties for the 1994 and 1995 tax years. the irs subsequently prevailed against the taxpayer in a collection action in which the taxpayer asserted that checks credited against previous employment tax liabilities (also litigated in the court of federal claims) should be applied to the 1994 and 1995 deficiencies. (t.c. memo. 2009-160.) kovacevich and the corporation filed a claim for refund of payments made by kovacevich on the corporation‘s employment tax liabilities. the court granted summary judgment for the irs, holding that the taxpayer could not re-litigate the prior tax court holdings that the taxpayer was an employee of the corporation. in addition, the court granted summary judgment to the government, holding that kovacevich was personally liable for the corporation‘s employment taxes, plus penalties and interest because the taxpayer operated the corporation as his alter-ego. finally, the court held that the taxpayer‘s wife was also liable for the taxes and penalties under washington community property law. there is a moral here. 8. voluntarily reclassify workers and pay less tax for last year. ann. 2011-64, 2011-41 i.r.b. 503 (9/21/11). the irs announced a voluntary classification settlement program that permits 2012] recent developments in federal income taxation 393 accepted applicants to agree to re-classify independent contractors as employees and pay reduced taxes for the prior year. the program augments the existing classification settlement program that allows eligible taxpayers under examination for worker classification issues. the program is available to taxpayers that currently and consistently classify workers as nonemployees and who filed all required forms 1099 for the previous three years. the program is not available to taxpayers currently under audit for worker classification issues. a taxpayer accepted in to the program who agrees to prospectively treat workers as employees for future tax periods will be able to pay 10 percent of the employment tax liability that might have been due on compensation paid to workers in the most recent taxable year and will not be subject to penalties or interest on the liability. the taxpayer will not be subject to an employer tax audit with respect to worker classification for prior years. in addition, the taxpayer must agree to three year extension of the statute of limitations with respect to employment taxes for the first, second, and third calendar years beginning after the date on which the taxpayer has agreed under the program to treat workers as employees. the voluntary program is significantly more generous than the current classification settlement program. 9. disregarded entities are regarded for employment tax purposes, except when they are disregarded. t.d. 9554, extending religious and family member fica and futa exceptions to disregarded entitles, 76 f.r. 67363 (11/1/11). several cases, sustaining the check the box regulations under chevron deference, held that the sole owner of a disregarded entity was liable for the disregarded entity‘s employment taxes. see, e.g., littriello v. united states, 484 f.3d 372 (6th cir. 2007), and mcnamee v. dept. of the treasury, 488 f.3d 100 (2d cir. 2007). in the face of these litigation successes, treasury adopted reg. § 301.7701-2(c)(2)(iv) to provide that a disregarded entity is treated as a corporation for employment tax purposes and related reporting requirements, thereby shifting the liability away from the owner. however, treating the entity as a corporate employer would eviscerate provisions that exempt certain employment among family members and employment among religious persons who believe that social security taxes are contrary to the teachings of the religion or sect. thus, temporary and proposed regulations, §§ 31.3121(b)(3)-1t(d) and 31.3306(c)(5)-1t(d) provide that a disregarded entity treated as a corporation for employment tax purposes will not be treated as a corporation for purposes of §§ 3121(b)(3) and 3306(c)(5), which provide an exemption from employment taxes for certain services performed by and for parents, children and spouses. temporary and proposed regulations § 31.3127-1t(c) provide that a disregarded entity will not be treated as a corporation for purposes of § 3127, which provides an exception from fica taxes where both the employer and employee are members of a religion that opposes participation 394 florida tax review [vol. 12:5 in social security. under each of these provisions, for purposes of applying the exemptions only, the owner of the disregarded entity will be treated as the employer. further, temporary and proposed regulation § 301.77012t(c)(2)(iv)(a) is amended to clarify that that the owner of a disregarded entity remains subject to the backup withholding requirements of § 3406. the changes are effective for wages paid after 12/31/08, the effective date of reg. § 301.7701-2(c)(2)(iv). 10. the economy may be bad, but wages are going up. social security news release (10/19/11). the social security administration announced that the social security wage base will increase in 2012 to $110,100, up from the wage base of $106,800. the $3,300 increase is due to an increase in average total wages. a. but good for the cost of nannies. the social security administration announced online that the exclusion for wages paid for domestic service in the employer‘s home goes up to $1,800 from $1,700 for 2012. 11. ―i’ll gladly pay you tuesday for a hamburger today.‖ t.d. 9566, employer‘s annual federal tax return and modifications to the deposit rules, 76 f.r. 77672 (12/14/11). treasury has published proposed and temporary regulations providing for annual, rather than quarterly, deposits of employment taxes for employers who have estimated employment tax liability for wage withholding, social security and medicare of $1,000 or less. when notified by the irs, employers who qualify are required to file the annual form 944 rather than the quarterly form unless the employer opts out of annual reporting under the procedures of rev. proc. 2009-51, 2009-45 i.r.b. 625. 12. the forms are in the mail doesn’t establish delivery. martinez v. united states, 101 fed. cl. 686 (1/5/12). the taxpayer employed drivers as independent contractors in his sole-proprietorship trucking company. the taxpayer claimed relief from employment taxes for misclassified workers under § 530 of the revenue act of 1978, which requires that the taxpayer consistently treat workers as independent contractors and file appropriate tax returns. the taxpayer asserted that the required forms 1099 were delivered to the irs asserting that the timely delivery date can be established under the common-law mailbox rule, which provides that proof of timely mailing creates a presumption of delivery. the court noted that under § 7502(a) and (c) the only exceptions to requirements that returns be delivered are that a return will be deemed delivered on the date of the postmark, or on the date the mailing is registered [extended by regulation to certified mail]. the court added that even if the taxpayer could 2012] recent developments in federal income taxation 395 invoke a common-law mailbox rule, the evidence was not sufficient to prove a timely and proper mailing. b. self-employment taxes there were no significant developments regarding this topic during 2011. c. excise taxes 1. telephone excise tax trouble for the government ahead. cohen v. united states, 578 f.3d 1 (d.c. cir. 8/7/09) (2-1). in this telephone excise case, judge janice rogers brown‘s majority opinion held that the telephone excise tax challenge litigation violated neither (1) the antiinjunction act, 26 u.s.c. § 7421(a), which provides that ―no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed‖ nor (2) the declaratory judgment act, 28 u.s.c. § 2201(a), which allows for declaratory relief but specifically excludes federal taxes from its reach, because (a) the standalone administrative procedure act, 5 u.s.c. § 702, claim in the instant case is ―the anomalous case where the wrongful assessment is not disputed and the litigants do not seek a refund,‖ and (b) the declaratory judgment act is coextensive with the anti-injunction act (citing circuit precedent). judge brown began her opinion: comic-strip writer bob thaves [creator of frank and ernest (1972)] famously quipped, ―a fool and his money are soon parted. it takes creative tax laws for the rest.‖ in this case it took the internal revenue service‘s (―irs‖ or ―the service‖) aggressive interpretation of the tax code to part millions of americans with billions of dollars in excise tax collections. even this remarkable feat did not end the irs‘s creativity. when it finally conceded defeat on the legal front, the irs got really inventive and developed a refund scheme under which almost half the funds remained unclaimed. now the irs seeks to avoid judicial review by insisting the notice [notice 2006-50] it issued, acknowledging its error and announcing the refund process, is not a binding rule but only a general policy statement.  judge brown stated that the irs position was ―just mean,‖ and that it ―places taxpayers in a virtual house of mirrors.‖ she continued, ―despite the obvious infirmities of [the irs position], the irs still has the chutzpah to chide taxpayers for failing to intuit that neither 396 florida tax review [vol. 12:5 the agency‘s express instructions nor the warning on its forms should be taken seriously.‖  judge brown concluded, however, that ―[a]ppellant neiland cohen filed his refund claim prematurely and, ―[we] thus, affirm the district court‘s dismissal of his refund claim.‖ the case was remanded to the district court for its consideration of the merits.  judge kavanaugh dissented, stating that the appellant could simply have followed the procedures of notice 200650.  the d.c. circuit granted rehearing en banc, 3/11/10. a. a case warning that tax professionals continue to ignore administrative law at their (clients’(?)) peril. the panel holding was upheld on rehearing en banc. cohen v. united states, , 650 f.3d 717 (d.c. cir. 7/1/11) (6-3). in upholding its original panel decision to remand the case to the district court for its consideration of the merits, judge brown wrote the majority opinion that held the suit was not precluded by either the anti-injunction act or the declaratory judgment act. judge kavanaugh‘s dissent emphasized that this suit was merely a prelude to a class action suit seeking monetary relief from the government, and that there was an adequate remedy in individual refund suits following claims for refund under the procedures of notice 2006-50 in which all claims under the administrative procedure act could be asserted.  ―enough, already!‖ the irs cries, ―uncle.‖ notice 2006-50, 2006-1 c.b. 1141 (5/26/06), revoking notice 200579, 2005-2 c.b. 952. the irs announced that it will stop assessing the § 4251 telephone excise tax on long distance services, and that it will provide for refunds of taxes paid on services billed after 2/28/03 and before 8/1/06. these refunds are to be requested on 2006 federal income tax returns, the right to which will be preserved by the irs scheduling overassessments under § 6407. individuals are eligible to receive a safe harbor amount, which has not yet been determined. interest received on the refunds will have to be reported as 2007 income. 2. disregarded entities are regarded as corporations for excise taxes. t.d. 9553, disregarded entities; excise taxes and employment taxes, 76 f.r. 66181 (10/26/11). the treasury has finalized temporary regulations issued in 2009 that provide that a disregarded entity is treated as an entity separate from its owner for purposes of federal tax liabilities of the entity for any period that it was not a disregarded entity, federal tax liabilities of any other entity for which the disregarded entity is liable, and refunds or credits of federal tax. reg. § 301.7701-2(c)(2)(iv)(b) 2012] recent developments in federal income taxation 397 provides that a disregarded entity is treated as a corporation for purposes of employment tax and income tax withholding, and reg. § 301.77012(c)(2)(v)(b) provides that a disregarded entity is treated as a corporation for purposes of excise taxes described in reg. § 301.7701-2(c)(2)(v)(a). the preamble to the regulation states that the ―final regulations retain the rule that excise taxes imposed on amounts paid for covered services (such as air transportation) apply to amounts paid between state law entities for such services (unless a statutory exception applies).‖ thus, for example, payments by the owner for air transportation to a disregarded entity are subject to excise taxes under § 4261. xii. tax legislation a. enacted 1. h.r. 3590, the patient protection and affordable care act (―ppaca‖ – pronounced ―pee-pac-a‖), p.l.111-148, was signed by president obama on 3/23/10, and h.r. 4872, the health care and education reconciliation act of 2010 (―2010 health care act‖ or ―2010 reconciliation act‖), p.l. 111-152, was signed by president obama on 3/30/10. a. the 2010 health care act is constitutional, but the ―penalty‖ is not a ―tax.‖ thomas more law center v. obama, 651 f.3d 529 (6th cir. 6/29/11) (2-1). the sixth circuit court of appeals, in an opinion by judge martin, upheld the constitutionality of the patient protection and affordable care act, pub. l. no. 111-148, 124 stat. 119 (2010), amended by the health care and education reconciliation act of 2010, pub. l. no. 111-152, 124 stat. 1029. the majority opinion upheld the act under the commerce clause. judge sutton‘s concurring opinion, which also ―delivered the opinion of the court in part‖ also concluded that the act was constitutional under the commerce clause, but held that the act was not an exercise of the taxing power – the penalty for not purchasing health insurance was not a tax. an opinion by senior district judge graham, concurring in part and dissenting in part, also held that the act was not an exercise of the taxing power but would have held the act unconstitutional as beyond congress‘s power to regulate commerce. b. but, on the other hand, the eleventh circuit holds that the individual mandate is unconstitutional. florida v. department of health & human services, 648 f.3d 1235 (8/12/11) (2-1). the eleventh circuit held that congress exceeded its authority by requiring americans to buy coverage, but also ruled that the rest of the wide-ranging law could remain in effect. the case stems from a challenge by twenty-six 398 florida tax review [vol. 12:5 states which had argued the individual mandate, set to go into effect in 2014, was unconstitutional because congress could not force americans to buy health insurance or face the prospect of a penalty. the majority stated: this economic mandate represents a wholly novel and potentially unbounded assertion of congressional authority: the ability to compel americans to purchase an expensive health insurance product they have elected not to buy, and to make them re-purchase that insurance product every month for their entire lives. c. does anyone really care what d.c. circuit thinks when the issue is already up on certiorari? seven-sky v. holder, 661 f.3d 1 (d.c. cir. 11/8/11). the court of appeals for the district of columbia (2-1) upheld the constitutionality of the minimum essential health care coverage requirement of § 1501 of the 2010 patient protection and affordable health care act, codified at code § 5000a as an exercise of congress‘s power under the commerce clause. the suit was not barred by the anti-injunction act because the suit involved a penalty unconnected to a tax liability. judge kavanagh dissented as to jurisdiction because he would have held that the aia barred the suit. 2. h.r. 4, the comprehensive 1099 taxpayer protection and repayment of exchange subsidy overpayments act of 2011, was approved by the senate on 4/5/11 following passage by the house. the bill would repeal the requirement that businesses submit a form 1099 for payments made to a single vendor for goods and services totaling more than $600 annually. the bill would be paid for by raising the amount of a healthcare tax credit that can be recaptured from taxpayers in cases of overpayment. president obama called for repeal of the 1099 provision in his state of the union speech, and might actually sign the bill if it is brought to his attention between vacation trips. he did, indeed, sign it into law on 4/14/11. 3. the america invents act of 2011, p.l. 112-29, was signed by president obama on 9/16/11. section 14 of the act provides that ―any strategy for reducing, avoiding, or deferring tax liability, whether known or unknown at the time of the invention or application for patent, shall be deemed insufficient to differentiate a claimed invention from the prior art.‖ this provision does not apply to computer tax return preparation products. it will not affect patents already issued. 4. the three percent withholding repeal and job creation act, p.l. 112-56, was signed by president obama on 11/21/11. 2012] recent developments in federal income taxation 399 5. the temporary payroll tax cut continuation act of 2011, p.l. 112-78, was signed by president obama on 12/23/11. b. pending the american jobs act of 2011 was orally signed by president obama on 9/8/11. it will reduce the unemployment rate to 4 percent, cause the oceans to recede and cure cancer. lacking are a written bill (because the congressional budget office perversely refuses to score speeches) and the trivial detail of congressional voting (rendered irrelevant by president obama‘s multiple repetitions of the necessity of immediate passage of the yet-unwritten bill, which congress perversely failed to do on 9/9/11). florida tax review volume 5 2001 issue 1 the widening gap under the internal revenue code: the need for renewed progressivity vada waters lindsey* i. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 ii. the methodology and equity of progressive taxation. 7 a. the role of fairness in tax policy and the proper measure of taxation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 b. the constitutionality and equity of progressive taxation. 12 c. methods of establishing progressive taxation. . . . . . . . . 14 1. graduated tax rates. . . . . . . . . . . . . . . . . . . . . . 14 2. the earned income tax credit.. . . . . . . . . . . . . . 18 3. the use of phase-outs. . . . . . . . . . . . . . . . . . . . . 18 a. the increased use of ceilings.. . . . . . . . 19 b. phase-out of itemized deductions and personal exemptions. . . . . . . . . . . . . . . . 21 4. income tax exemption for low incomes. . . . . . . 22 5. corporate taxation. . . . . . . . . . . . . . . . . . . . . . . 22 6. estate and gift taxation. . . . . . . . . . . . . . . . . . . . 23 iii. weaknesses inherent in the current progressive taxation methodology and the growing threat. . . . . 25 a. in general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 b. homeownership tax incentives. . . . . . . . . . . . . . . . . . . . . 29 c. corporate taxation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 d. the earned income tax credit. . . . . . . . . . . . . . . . . . . . . 32 e. estate taxation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 f. the use of ceilings and phase-outs. . . . . . . . . . . . . . . . . 34 g. proposed tax legislation’s increased threat.. . . . . . . . . 36 iv. progressive taxation in today’s society. . . . . . . . . . . . . 39 a. the renewed need for progressive taxation. . . . . . . . . . 39 b. globalization and progressive taxation. . . . . . . . . . . . . . 42 c. reduction in the lowest marginal rate. . . . . . . . . . . . . . 44 * assistant professor of law, marquette university law school; b.a., michigan state university 1983; j.d., depaul university college of law 1988; ll.m., georgetown university law center 1992. this author acknowledges the valuable research assistance provided by venus van ness and nicole monet and gratefully acknowledges the receipt of a summer research grant provided by marquette university law school. 2 d. viability of proposal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 1. the fairness of the reduction of the lowest marginal tax rate. . . . . . . . . . . . . . . . . . . . . . . . 46 2. simplicity & compliance. . . . . . . . . . . . . . . . . . . 46 3. economic growth. . . . . . . . . . . . . . . . . . . . . . . . . 47 4. production of revenue. . . . . . . . . . . . . . . . . . . . . 48 5. interference with private economic decisions. . 48 v. conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 3 4 florida tax review [vol. 5:1 “i have never viewed taxation as a means of rewarding one class of taxpayers or punishing another. if such a point of view ever controls our public policy, the traditions of freedom, justice and equality of opportunity, which are the distinguishing characteristics of our american civilization, will have disappeared and in their place we shall have class legislation with all its attendant evils.” andrew mellon (1924)1 i. introduction the words written by andrew mellon more than 75 years ago represent an idealistic view of the tax system. despite the ideas expressed by mr. mellon, it is difficult to devise a tax scheme that conforms to his standards. our present scheme of taxation is intended to promote vertical equity, which means that the higher income taxpayer should pay a higher level of taxes based on an abilityto-pay concept. in theory, this objective is met by the progressive tax structure imposed under the code. arguably, a progressive tax system is inconsistent2 with the principles expressed by mellon because of the purported penalty levied against high-income taxpayers in the form of inflated tax rates and the reward bestowed on low-income taxpayers in the form of lower tax rates. in reality, a progressive tax system does not reward or punish one class of taxpayers over another, but it is necessary to ensure that taxpayers do not pay more tax dollars to finance the government than they can afford. a progressive tax scheme is also necessary to enable every taxpayer to retain sufficient income to live above the poverty threshold. to the extent that a taxpayer lives below the poverty threshold, that taxpayer should not be required to pay income taxes. the current tax scheme is only partially successful in preventing taxpayers’ after-tax income from falling below the poverty threshold. the graduated tax rates represent only a small component of the progressive tax system. progressivity is also established by techniques such as the earned income tax credit, the income tax exemption, phase-out of deductions for high-income taxpayers, corporate taxation and estate and gift taxation. however, the effectiveness of these techniques has been limited in recent years by congressional acts. newly proposed congressional bills and the several presidential platforms result in further eradication of progressivity. whether these proposals represented election year political rhetoric or serious 1. andrew mellon, quoted in sheldon d. pollack, the failure of u.s. tax policy: revenue and politics 243 (1996). 2. presently, there are five marginal tax rates under the code: 15%, 28%, 31%, 36% and 39.6%. irc § 1 (2000). married individuals filing joint returns, heads of households and unmarried individuals are subject to the highest tax rate when their annual taxable incomes exceed $250,000. id. § 1(a),(c). married individuals filing separate returns are subject to the highest tax rate when their taxable incomes exceed $125,000. id. § 1(d). 2001] the widening gap under the internal revenue code 5 tax proposals, they generally provided substantial tax savings to the wealthy and little benefit to lower income taxpayers. for example, president george w. bush’s presidential platform included a substantial tax cut. under this proposal, 52.6% of the tax cuts were geared toward taxpayers in the top 5% income level while only 11% would benefit taxpayers in the bottom 60% income level. prior3 to withdrawing from the election, presidential candidate senator john mccain proposed tax cuts where 34.9% of the benefits would go to taxpayers whose income was in the top 5%. only 6.7% of the benefits would have gone to4 taxpayers in the bottom 60% income level. major tax bills that had received5 favorable votes from congress resulted in the top 1% taxpayers receiving average tax benefits 84 times that of the bottom 80% of taxpayers.6 in light of these proposals and tax legislation that congress has already enacted, the oft-debated issue of whether progressive tax system is optimal needs to be reconsidered. there has always been little agreement amongst scholars on whether the progressive tax system is fair or whether some other system, such as proportional taxation or a consumption-based system is superior. in 1998, professors martin j. mcmahon, jr. and alice g. abreu7 wrote a law review article critically analyzing empirical data on changes in the distribution in income with total taxes paid between 1977 and 1990. the8 empirical data supported a finding that although the income of taxpayers in the top income percentile has increased precipitously, their federal income tax burden has not increased proportionately. the article points out that the after-9 tax income of taxpayers in the top 10% has increased between 1977 and 1990, while it has decreased for all other taxpayers. this apparent trend that results10 in weakened progressivity has continued throughout the 1990s. professors11 3. see richard w. stevenson, mccain to propose middle-class tax cut and private accounts within social security, n.y. times, jan. 11, 2000, at a23 (noting arguments from independent analysts that mccain proposal would favor wealthy taxpayers). 4. see id. 5. see id. 6. john d. mckinnon, white house takes on gop’s tax cuts, says they favor top 1%, balloon later, wall st. j., july 18, 2000, at a24 (reporting treasury contention that republican tax proposal overwhelmingly favored wealthy taxpayers). 7. see infra text accompanying notes 27-34. 8. martin j. mcmahon, jr. & alice g. abreu, winner-take-all markets: easing the case for progressive taxation, 4 fla. tax rev. 1 (1998) [hereinafter mcmahon & abreu]. 9. see id. at 7-8. 10. see id. at 19-20. 11. see internal revenue service, 19 statistics of income bulletin 197 (summer 1999) (illustrating that for tax years 1995 to 1997, lower income taxpayers generally paid an increasing amount of their adjusted gross income in taxes, while higher income taxpayers paid a decreasing amount of their adjusted gross income in taxes). 6 florida tax review [vol. 5:1 mcmahon and abreu further point out that the increase is greater for taxpayers in the top 1%. congress has made several amendments to the code and12 created more progressivity between the middle to upper income bracket and the wealthiest taxpayers through the use of phase-outs. specifically, congress enacted the child tax credit, roth iras, education iras, and hope and lifetime learning credits. all of these tax benefits are phased out based on a taxpayer’s adjusted gross income. with the exception of the child tax credit, these tax benefits primarily benefit the middle to upper income taxpayer. hence, congress has made some inroad toward protecting progressivity between the middle class and the upper class.13 while it is apparent that most of the recently enacted tax benefits do not benefit the wealthiest taxpayers, because of the use of phase-outs, they also do not benefit the lower income taxpayers. one group of taxpayers that is particularly affected by this problem is the low to middle class taxpayer. assume, for example, that a married couple has three children and adjusted gross income of $35,000 during the year. the earned income credit is not available to them because it is completely phased out for earned income levels above $31,152. assume also that the couple does not own their own home. in all likelihood, they will not have sufficient deductions in order to itemize and hence must claim the standard deduction. they are financially unable to invest money in roth or educational iras, even though those accounts are not subject to taxation upon distribution, because they need to use their disposable income to buy disposable diapers. their “tax advisor” advised them to purchase stock because the gain from the disposition is subject to tax rates of 10% if they hold the stock for more than a year and 8% if they hold the stock for at least five years. they informed the tax advisor that they could not afford to buy stock because they needed to stock their cabinets with food and buy clothes instead. hence, the financial status of the low to middle income taxpayers precludes them from capitalizing on the recently enacted tax incentives. while the primary reasons for the recent enactments were to encourage saving and education, congress’s decision to utilize phase-outs implies a secondary objective of increasing progressivity. because low to middle income taxpayers cannot take advantage of these tax benefits, congress’s efforts, therefore, are unsuccessful. 12. mcmahon & abreu, supra note 8, at 19. the basic premise of the article was that there were fundamental differences between the top 10% and top 1% in the distribution of income and tax liability. because of these differences, professors mcmahon and abreu argued that these taxpayers should not be categorized similarly and that the taxpayers in the top 5% in general and the top 1% in particular should be subject to increased progressivity either in the form of an increased rate schedule or through the use of phase-outs and floors. id. at 77. 13. congress has not increased the progressivity between the wealthy and the super-wealthy as advocated by professors mcmahon and abreu. 2001] the widening gap under the internal revenue code 7 many of the lowest income taxpayers receive substantial benefit in the form of the earned income tax credit. the middle class taxpayers are able to exploit many tax incentives, including mortgage deductions, roth iras and educational iras. the wealthy benefit from the favorable capital gain tax rates. this country’s tax system has always been based upon a progressive structure. additional steps need to be taken to ensure progressivity between the lower to middle income taxpayer and higher income taxpayers and to counter other tax benefits provided to the higher income taxpayers that have resulted in a flatter tax structure. additional progressivity would also benefit low income taxpayers that receive negligible earned income tax credits. part ii of this article explores the methodology, constitutionality and equity of progressive taxation. part ii also explores the history of graduated tax rates and the constant fluctuations to establish the proper level of taxation. part iii of the article outlines the failure of the current tax scheme in promoting a progressive tax system. for example, if a wealthy taxpayer purchases a capital asset after december 31, 2000, and holds on to the asset for five years, the taxpayer is subject to a tax rate of 18% upon the disposition of the asset. upon a comparison of that rate with the 15% ordinary income rate for low income and low to middle income taxpayers, the tax system fails to uphold the abilityto-pay principle. either the low income taxpayer’s rate is too high or the high income taxpayer’s rate is too low. part iii also considers the impact of proposed legislation, and explores the increased gap between the wealthy and the lower income taxpayers created under the code. part iv of this article examines the reasons supporting the continued maintenance of progressive taxation in today’s society. this part will also address whether globalization dictates a retrenchment from progressive taxation to protect this country from becoming less competitive with other countries. part iv will also address how the tax scheme should be reformed to strengthen progressivity. this reformation is essential to reverse the negative impact of tax provisions on women and minorities. this part concludes with a proposal to reduce the lowest marginal brackets to ensure that most taxpayers will benefit from the tax cut while adhering to the traditional ability-to-pay and progressive tax principles. ii. the methodology and equity of progressive taxation a. the role of fairness in tax policy and the proper measure of taxation our system of income taxation purports to promote both horizontal and vertical equity under the code. horizontal equity requires similarly situated taxpayers to be treated similarly. vertical equity requires that taxpayers with14 higher incomes pay income taxes at a higher level under an ability-to-pay 14. this article only addresses the vertical equity objective. 8 florida tax review [vol. 5:1 concept. under the ability-to-pay principle, those taxpayers with higher income are presumed to be able to bear a greater share of the tax burdens. the ability-15 to-pay principle has its genesis going as far back as the income tax act of 1913, where the legislative history states that “the tax upon incomes is levied according to ability-to-pay.” the fundamental underpinning for the vertical16 equity concept is fairness. however, there is little agreement as to the true meaning of fairness in tax policy. professors robert e. hall and alvin rabushka rely on definitions of fairness found in dictionaries to define the term. they define a fair income tax as providing the equal treatment to17 taxpayers. professors hall and rabushka do not believe that vertical equality18 has fared well because of partisan politics. specifically, they state: despite attempts to equalize after-tax income through steeply graduated tax rates, one congress after another has riddled the tax code with hundreds of loopholes that permit some millionaires to pay no income tax whatsoever and some high earners to pay low taxes. . . . the reason is that every time tax rates are increased, congress, in response to political pressures from organized interest groups, inserts new deductions and loopholes into the tax code to offset the effects of higher rates. the ideology of vertical equity, or ability-to-pay, runs smack into the economic and political realities of economic distortions and well-organized interests.19 economists have traditionally looked to two principles, the “benefit principle” and the “ability-to-pay principle,” in defining the meaning of a fair tax system and allocating the country’s tax burden. the benefit theory focused20 on allocating tax burdens based on the governmental services provided to the taxpayer. professor graetz restated the oft-quoted definition of fairness under21 the federal income tax laws as taxing similarly situated taxpayers similarly based on an ability-to-pay concept. professor mcmahon believes that the22 debates on fairness of taxation have neglected to incorporate the traditional vertical and horizontal equities and are instead being tied to “a disguised 15. joel slemrod, tax progressivity and income inequality 2 (1994). 16. see robert m. willan, income taxes: concise history and primer 139 (1994) (reviewing legislative history surrounding 1913 act). 17. robert e. hall & alvin rabushka, the flat tax 25 (2d ed. 1995). 18. see id. at 26. 19. see id. at 28. 20. see slemrod, supra note 15, at 2. 21. see id. 22. michael j. graetz, the decline (and fall?) of the income tax (1987). 2001] the widening gap under the internal revenue code 9 complaint” of the level of taxation. professor barbara fried rejects the23 significance of all of these definitions. she believes that no “sensible theory of distributive justice” should focus on whether rate structures are fair or unfair because the effectiveness of rate structures stand or fall on how well they realize “moral commitments about the proper role of government.” finally,24 some scholars consider a fair tax as one that equalizes sacrifices and has its basis in the decreased utility of money. under this theory: an equitable apportioning of sacrifice requires inflicting equal hurt on each taxpayer. it seems likely that a dollar has less “value” for a person with a million dollars of income than for a person with only a thousand dollars of income. to take the same number of dollars from each is not to require the same amount of sacrifice from them. instead a fair tax would take more from the wealthier individual, and this is what a progressive tax does.25 any definition of fairness must incorporate the ability-to-pay concept because the most viable and equitable tax system is one that allocates the tax burden based on the traditional ability-to-pay concept. the benefit principle is far too difficult to measure and results in a subjective evaluation of a multitude of benefits and the inherent difficulty of establishing the proper weight that should be afforded to each benefit. a strong argument exists for providing equal treatment to all taxpayers. however, there is not a viable way to provide equal tax treatment to all taxpayers while creating a structure that generates revenue and adhering to the ability-to-pay concept. conversely, the progressive tax system is fair because it implements the traditional ability-to-pay principle; therefore, it represents an appropriate mechanism for allocating tax burdens. despite the progressive tax structure’s adherence to the ability-to-pay concept, it remains controversial and lacks consensus support. as such, there is a divergence of scholarly opinions as to whether it is appropriate to subject taxpayers to different tax rates. some scholars advocate the use of proportional taxation to allocate tax burdens. other scholars believe that the progressive26 23. martin j. mcmahon, jr., individual tax reform for fairness and simplicity: let economic growth fend for itself, 50 wash. & lee l. rev. 459, 461 (1993). 24. barbara h. fried, the puzzling case for proportionate taxation, 2 chap. l. rev. 157, 158 (1999). 25. walter j. blum & harry kalven, jr., the uneasy case for progressive taxation 39-40 (1953). professors blum and kalven did not support progressive taxation but simply considered and rejected the arguments supporting progressive taxation. 26. see, e.g., hall & rabushka, supra note 18, at 26 (arguing that no definition of “fairness” establishes that a progressive tax system is fairer than a flat tax system); jeffrey a. schoenblum, tax fairness or unfairness? a consideration of the 10 florida tax review [vol. 5:1 tax is the most equitable way to allocate the country’s tax burdens. other27 scholars reject both proportional and progressive taxation in favor of a consumption-based tax system. a consumption tax imposes taxes based on a28 taxpayer’s annual consumption. one argument supporting the consumption tax originates in the writings of thomas hobbes. hobbes believed that the29 consumption tax was the fairest tax. he believed it was unfair that a taxpayer that worked as diligently as another taxpayer, but chose to save his money rather than spend it should be subjected to greater taxes. scholars supporting30 the consumption tax share the hobbesian vision that a fair tax should be not penalize savers. they also believe that the consumption tax is superior to31 other forms of taxation because increased savings will stimulate national productivity and simplify tax administration. a broad-based consumption32 33 tax fits into two different categories: 1) direct or personalized; or 2) indirect or philosophical bases for unequal taxation of individuals, 12 am. j. tax pol’y 221, 225 (1995) (contending that “[t]o the extent that our society continues to adhere to certain traditional liberal principles, in that it elevates the values of the autonomous individual and the equal status of each such individual before the state, any system of taxation that differentiates among taxpayers ought to require a compelling philosophic justification” and that no persuasive theory has been developed). 27. see, e.g., mcmahon & abreu, supra note 8, at 70 (“a progressive income tax can help to preserve equality of opportunity for successive generations of americans. . . by reducing the disparities in after-tax income that dampen opportunity. . . .”); marjorie e. kornhauser, equality, liberty, and a fair income tax, 23 fordham urb. l.j. 607, 608 (1996) (“an ideal flat income tax or an ideal consumption-based tax would be simpler and more coherent than the current progressive tax; however, an ideal progressive tax would be simpler as well.”) 28. see, e.g., richard l. doernberg, a workable flat rate consumption tax, 70 iowa l. rev. 425, 484 (1985) (“the flat rate consumption [tax] offers an impressively straightforward reform of the current system”). 29. barbara h. fried, fairness and the consumption tax, 44 stan. l. rev. 961, 962 (1992). 30. see id. supra note 29, at 962 n.6. 31. see, e.g., william o. andrews, fairness and the personal income tax: a reply to professor warren, 88 harv. l. rev. 947 (1975). 32. see fried, supra note 29, at 962 (reviewing various proponents arguments in favor of consumption tax) but see thomas michael federico, recent congressional consumption tax proposals: a theoretical inquiry into their effects on the declining u.s. saving rate, 7 fla. j. law & pub. pol’y 337, 362 (1996) (opining that there is a lack of evidence supporting increased savings under a consumption tax). 33. see fried, supra note 29. but see deborah l. paul, the sources of tax complexity: how much simplicity can fundamental tax reform achieve?, 76 n.c. l. rev. 151, 181, 193-209 (1997)(arguing that consumption taxes would not lessen complexity and actually creates complexity in an attempt to achieve equity and raise revenue). 2001] the widening gap under the internal revenue code 11 impersonal. indirect tax, such as a retail sales tax or value-added tax, allows34 for businesses to simply add the tax to goods and services sold. a direct tax would require an individual to complete a tax return using methods such as gross receipts or cash flow. under the gross receipts method, taxpayers would35 total their spending amounts at year-end and the tax would be levied on the basis of that consumption. a significant drawback to implementing a consumption type tax is that it leads to regressive taxation. there is a substantial body of scholarship addressing the inequities of a consumption type tax. hence, despite the fact that the consumption tax has several advantages36 over the present income tax scheme, it is inconsistent with the traditional ability-to-pay principles. 37 professors walter j. blum and harry kalven, jr. wrote an essay critically examining the principles and justifications of progressive taxation more than 40 years ago. it continues to be one of the most comprehensive38 studies of the progressive tax system. in their essay, professors blum and kalven correctly pointed out that progressivity could be established under a single rate of taxation by granting exemptions to all taxpayers. according to39 professors blum and kalven, progressivity was inherent where exemptions were used. hence, they considered whether additional progressivity could be40 justified. professors blum and kalven noted that exemptions were necessary 34. charles e. mcclure, jr., the u.s. debate on consumption based taxes: implications for the americas, 29 u. miami inter-am. l. rev. 143, 148 (1998). 35. constitutional concerns and the lack of simplification make the direct tax a less popular alternative to the current income tax system. see erik m. jensen, the apportionment of “direct taxes”: are consumption taxes constitutional?, 97 colum. l. rev. 2334 (1997). 36. see, e.g., graetz, supra note 22, at 204 (stating that a consumption tax would not promote the ability-to-pay concept because it would not tax income that was saved and a flat-rate consumption tax would be regressive). one commentator states as follows: [c]onsumption taxes tend to be regressive, as compared to income taxes. higher income individuals spend a smaller percentage of their income on consumption. higher income individuals have a higher percentage of their income from savings. to achieve the same distribution of burden by income class, the rate structure of a consumption tax must be more progressive than that of an income tax. john s. nolan, the merit of an income tax versus a consumption tax, 12 am. j. tax pol’y 207, 215 (1995). 37. see paul, supra note 33, at 194. 38. see blum & kalven, supra note 25. 39. id. at 4. see charles r. o’kelley, jr., tax policy for the post-liberal society: a flat tax inspired redefinition of the purpose and ideal structure of a progressive income tax, 58 s. cal. l. rev. 727 (advocating a personal exemption in conjunction with a flat tax to ensure progressivity). 40. see blum & kalven, supra note 25, at 4. 12 florida tax review [vol. 5:1 to satisfy a “minimum standard of living.” professors blum and kalven41 presented their question for consideration as “[o]n what grounds is a progressive tax on all incomes over a minimum subsistence exemption to be preferred to a proportionate tax on all incomes over a minimum subsistence exemption?” they also concluded without explanation that “[i]t is so clear42 that no one today favors” a regressive tax because “the term itself has become colored” and, therefore, it is not a serious alternative. other scholars share43 professors blum’s and kalven’s position that the country should not adopt a regressive tax system while other scholars are not quite as dismissive.44 45 b. the constitutionality and equity of progressive taxation the constitutionality of progressive tax rates is long settled. the46 supreme court will invalidate a tax law as a violation of the constitution where it is: * * * so arbitrary as to constrain to the conclusion that it was not the exertion of taxation but a confiscation of property, that is, a taking of the same in violation of the fifth amendment, or, what is equivalent thereto, was so wanting in basis for classification as to produce such a gross and patent inequality as to inevitably lead to the same conclusion.47 one of the earliest supreme court cases addressing the constitutionality of progressive rates was in the context of the estate tax. in a case decided during 1900, the supreme court considered the constitutionality of the war revenue act of 1898 that had imposed a tax on legacies exceeding $10,000. the basis48 of the constitutional attack was that the tax was void because it was not uniform throughout the country as required under article 1, section 8 of the 41. see id. 42. see id. 43. see id. at 3. 44. see joseph bankman & thomas griffith, social welfare and the rate structure: a new look at progressive taxation, 75 cal. l. rev. 1905, 1911 (1987) (noting wide support for analysis & viewpoint expressed in work of blum and kalven). 45. see schoenblum, supra note 26, at 244 (“regressivity and equal, per capita taxation necessarily have to be considered, because the same arguments that stymie progressivity undermine the case for the fairness of proportionality.”). 46. see tyee realty co. v. anderson, 240 u.s. 115, 117-18 (1916); brushaber v. union pac. r.r. co., 240 u.s. 1, 24-25 (1916); knowlton v. moore, 178 u.s. 41, 106-07 (1900); acker v. commissioner, 258 f.2d 568, 575 (1958). 47. john douglas messina v. united states, 202 ct. cl. 155, 160-61 (1973) (citing brushaber, 240 u.s. at 24-25). 48. see knowlton, 178 u.s. at 43. 2001] the widening gap under the internal revenue code 13 constitution. the court determined that the uniformity referred to49 geographical uniformity rather than a “thought of restricting congress to intrinsic uniformity." the supreme court recognized that some commentators50 and economists supported progressive taxation because it was more “just and equal” than proportional taxation, but did not find it necessary to rely on that support. rather, the court stated that in the absence of a constitutional51 limitation, the issue of what was just and equal was a legislative question.52 hence, the court applied a deferential approach to the legislature and stated it would only use its judicial power where the tax was arbitrary and confiscatory.53 in 1916, the supreme court addressed whether the progressive tax feature of the income tax act of 1913 was arbitrary and unreasonable and therefore a violation of due process. specifically, the supreme court54 considered whether the progressive tax was unconstitutional because of the classification based on wealth. the court noted that there was no express55 provision prohibiting progressive taxation in the constitution and held that the statutory provision was not an arbitrary abuse of power. the subsequent56 courts that have addressed the issue summarily dismiss the constitutional attacks and simply rely on the early supreme court decisions upholding progressive taxation.57 49. id. at 77. article i, § 8 of the constitution provides that, “duties, imposts and excises shall be uniform throughout the united states.” u.s. const. art. i, § 8, cl. 1. 50. see knowlton, 178 u.s. at 102. 51. see id. at 122. 52. see id. the court also deferred to an earlier supreme court that addressed whether the progressive rates in the illinois inheritance tax violated the due process and equal protection clauses of the fourteenth amendment. see maguon v. illinois trust & sav. bank, 170 u.s. 283 (1898). 53. see knowlton, 178 u.s. at 122-23. 54. see brushaber, 240 u.s. at 9. 55. see id. at 21. 56. see id. at 24-25. 57. see, e.g., acker, 258 f.2d at 575 (citing knowlton and brushaber for proposition that constitutionality of progressive tax rates is a settled issue); messina, 202 ct. cl., at 160-61 (stating that poor taxpayers are intentionally taxed at lower rates and this alone is insufficient to result in a violation of the constitution). 14 florida tax review [vol. 5:1 c. methods of establishing progressive taxation the progressive tax system is achieved in six primary ways: 1) graduated tax rates; 2) the earned income credit; 3) income tax exemption58 59 for low incomes; 4) phase-out of personal deductions for higher income taxpayers; 5) corporate taxation ; and 6) estate and gift taxes. this section60 61 62 examines how these tax features create progressive taxation. 1. graduated tax rates.—this country’s use of graduated tax rates was apparent upon congress’s enactment of the historic income tax act of 1913.63 congress’s purpose of enacting the act included reducing tariff duties and generating revenue. in the congressional debates preceding the enactment of the 1913 act, representative murray of oklahoma prophesied about the turbulent future of the graduated income tax rates, stating that “in this bill we have a clause we call the income tax, based upon a graduated scale as to the different rates; and i may say that this proper graduation will depend largely upon experiment.” this so-called experiment has resulted in numerous and frequent64 congressional revisions in an effort to develop the proper level of graduation. congress has made a multitude of changes to the graduated rates since the enactment of the 1913 act. the 1913 act imposed a normal tax of 1% and additional taxes ranging from 1% to 6% on net income starting at $20,000.65 the maximum rate was imposed on net income exceeding $500,000. under66 the act of 1916, entitled “an act to increase the revenue and for other purposes”, congress imposed a 2% tax on net income up to $2,000 and an additional tax ranging from 1% for income exceeding $20,000 and 13% for income exceeding $2,000,000. under the war income tax act of 1917,67 68 congress increased the progressivity of the rate structure to defray war expenses and for other purposes. in addition to the 2% tax rate assessed on net income up to $2,000, congress imposed a 4% tax on net income exceeding $2,000. congress further increased the progressivity of the additional tax by69 58. see irc § 1. 59. see id. § 32. 60. see id. § 68. 61. see id. § 11. 62. see id. §§ 2001 & 2010. 63. pub. l. no. 63-16, 38 stat. 166. 64. see willan, supra note 16, at 4. 65. see id. at 5; 1 standard fed. tax rep. (cch) ¶ 140 (2000). 66. see willan, supra note 16, at 5. 67. 1 standard fed. tax rep. (cch) ¶ 140 (2000). 68. pub. l. no. 65-50, 40 stat. 300. 69. 1 standard fed. tax rep. (cch) ¶ 140 (2000). 2001] the widening gap under the internal revenue code 15 enacting ten marginal tax brackets ranging from 1% to 63%. under the70 revenue act of 1918, congress imposed a normal tax of 6% on net income up to $4,000 and a 12% tax on the balance. in 1918, there was also an additional71 tax imposed ranging from 1% to 65% and 54 different rates. congress72 continued its pattern of adjusting the progressivity of the rates when it enacted the revenue act of 1921. the normal tax of 4% and 8% were imposed on income of $4,000 and amounts exceeding $4,000, respectively. for tax year73 1921, the marginal rates did not change from the earlier years, but more substantial changes were made under that act for tax year 1922. under the74 revenue act of 1921, congress eased the progressivity of the surtax by enacting 48 marginal brackets ranging from 1% to 50%. the 1924 revenue75 act lowered the progressivity in both the normal tax and the surtax. congress implemented three brackets for the surtax ranging from 2% to 6% and imposed a surtax ranging from 1% to 40% utilizing 40 different marginal rates. the76 1926 act altered the normal tax brackets again by creating three marginal rates from 1-½% to 5%, but also reduced the maximum rate on the surtax to 20%.77 minor changes to the normal tax were made between 1926 and 1931 but no changes were made to the surtax. however, more significant adjustments to the progressive tax structure were made under the 1932 act corresponding to the financial strain caused by the great depression. congress reinstated the78 same 4% and 8% normal taxes that had been in existence from 1919 through 1923. it also greatly enhanced progressivity in the surtax enacting 53 marginal79 rates ranging from 1% to 55%. under the 1934 and 1935 acts, the normal tax80 was 4%, and there were 29 marginal tax brackets under the surtax ranging from 4% on net income between $4,000 to $6,000 to 59% on net income of $5,000,000 and up. from 1936 to 1939, the number of marginal brackets81 under the surtax increased to 32 and the maximum rate increased to a startling 70. see id. the increase was rather drastic. in 1916, taxpayers with net income above $2,000,000 were subject to an additional tax of 13%, but in 1917, taxpayers with income above $1,000,000 were subject to the maximum rate of 50%. id. in 1916, taxpayers with net income between $1,000,000 and $1,500,000 were subject to a marginal rate of 11% and those with net income between $1,500,000 and $2,000,000 were subject to a marginal rate of 12%. id. 71. see id. 72. see id. 73. see id. 74. see id. 75. see id. 76. see id. 77. see id. 78. see barber b. conable, jr., congress and the income tax 38 (1989). 79. 1 standard fed. tax rep. (cch) ¶ 140 (2000). 80. see id. 81. see id. ¶ 141. 16 florida tax review [vol. 5:1 75%. congress made minor adjustments to the rates during 1940; however,82 beginning in 1941 and continuing for several years, congress greatly increased the progressivity for all income categories. these increases corresponded with the financial constraints caused by world war ii. although congress had83 declined to impose a surtax on income lower than $4,000 to $5,000 under previous acts, congress altered that trend in 1941. under the 1941 act, congress imposed a surtax ranging from 6% to 77% on net income. the84 normal tax increased to 6% under the 1942 act, and congress imposed a surtax ranging from 13% on net income between $0 and $2,000 and 82% on net income of at least $200,000. the dramatic increase in the marginal surtax85 brackets reached its pinnacle in 1944 when congress imposed a surtax ranging from 20% on net income between $0 and $2,000 and 91% on net income exceeding $200,000.86 in 1945, congress once again adjusted the marginal rates and imposed a 17% surtax on net income between $0 and $2,000 and 88% on net income exceeding $200,000. surprisingly, the rates remained constant through 1950.87 from 1951 through 1963, congress only made minor modifications to the marginal surtax brackets and the brackets remained relatively constant.88 taxable year 1964 was the last year that congress imposed the normal tax and surtax. it also represented a year in which congress reduced the marginal89 surtax rates and imposed a new rate structure ranging from 13% for net income between $0 and $500 and 74% for net income above $200,000.90 from 1965 through 1981, the lowest marginal rate was 14% and the highest marginal rate was 70%. while the bottom and top rates remained91 constant, there were fluctuations of the intermediary rates as well as inflationary modifications. in addition, from 1979 through 1986, no tax was92 imposed for income less than $2,200 for 1977 and 1978 and $2,300 for 1979 through 1981. from 1982 through 1986, congress exempted taxable income93 82. see id. 83. see conable, supra note 78, at 38. 84. 1 standard fed. tax rep. (cch) ¶ 141. 85. see id. 86. see id. under the act, congress also reduced the normal tax from 6% to 3%. id. the 3% surtax remained at 3% through 1964. id. ¶ 142. 87. see id. ¶ 142. 88. see id. ¶¶ 142 & 143. after that time, the surtax was phased out completely. 89. cf. id. ¶ 142 with id. ¶ 144. 90. see id. ¶ 143. during 1952 and 1953, however, congress imposed surtaxes ranging from 19.2% to 89%, but congress reduced the rates in 1954 to their pre-1952 percentages. id. ¶ 142. 91. see id. ¶ 144. 92. see id. 93. see id. 2001] the widening gap under the internal revenue code 17 less than a nominal amount. more importantly, congress reduced the highest marginal rate from 70% to 50% but made more modest reductions in the other marginal tax brackets during those same taxable years.94 in the past 15 years, congress has continued its inconsistency in promoting progressive taxation. under the rate structure immediately prior to 1986, the tax rates ranged from 11% to 50%, and there were 15 marginal income rates. in its attempt to simplify the code, congress significantly95 reduced the total number of marginal rates upon the enactment of the tax reform act of 1986. the reduced rate structure was implemented in two96 phases. during taxable year 1987, there were five rates ranging from 11% to 38.5%. beginning in 1988, the greatly compressed marginal rates were 15%97 and 28%. congress also imposed a surtax of 5% on taxable income between98 $43,150 and $89,560 for single taxpayers and $71,900 and $149,250 for married couples filing joint returns. hence, the 1986 act essentially created99 three tax brackets, 15%, 28% and 33%, with the latter phased out for income levels above the designated amounts. the rate structure created under the100 1986 act lasted until congress’s enactment of the omnibus budget reconciliation act of 1990. under that act, congress repealed the 5% surtax101 and introduced the 31% bracket for unmarried individuals with income of over $49,300. the rate structure enacted in 1990 continued to define the graduated102 rate structure until congress enacted the omnibus budge reconciliation act of 1993. in the 1993 act, congress amended the income tax rates for taxable103 year 1994 and established five marginal income tax rates of 15%, 28%, 31%, 36% and 39.6%. surprisingly, given the tumultuous history of the rate104 structure, congress has not altered the rate structure since it enacted the omnibus budget reconciliation act of 1993, and the rate structure enacted under that act continues to represent the graduated rate structure in existence today. although congress has not adjusted the graduated tax rates for105 ordinary income, it has altered the level of progressivity in other ways, including capital gains rates. 94. see id. 95. see id. 96. pub. l. 99-514, 100 stat. 2085. 97. 1 standard fed. tax rep. (cch) ¶ 144 (2000). 98. see id. 99. see willan, supra note 17, at 64. 100. 1 standard fed. tax rep. (cch) ¶ 144 (2000). 101. pub. l. no. 101-508, 104 stat. 1388. 102. see willan, supra note 17, at 69. 103. pub. l. no. 103-66, 107 stat. 312. 104. see id. 105. irc § 1(a) (1995). 18 florida tax review [vol. 5:1 2. the earned income tax credit.—a refundable tax credit is afforded to taxpayers that satisfy certain income limitations. the credit is afforded to106 taxpayers whose income exceeds the threshold floor levels but falls below a threshold ceiling. congress enacted the earned income tax credit in 1975 to counter the regressive nature of the social security taxes and as an antiinflationary measure. in recent years, the earned income tax credit has107 become more important in light of the repeal of the aid to families with dependent children program in 1996. proponents hail the program as both profamily and pro-work, two problems that existed under the now defunct welfare system. the maximum earned income credit amount has increased drastically108 since congress’s enactment of the credit in 1975. at that time, the maximum credit amount was $400. for taxable year 1999, the maximum credit allowed109 was $3,816. in 1975, the total refundable portion provided to taxpayers was110 $886.7 million, and in 1997 the projected figure was $24.6 billion. based on111 these statistics, the earned income tax credit is increasingly satisfying the congressional objectives of progressivity. 3. the use of phase-outs.—the use of phase-outs can be an effective method to achieve a progressive tax structure. the code utilizes two types of phase-outs to achieve progressivity. first, the code employs ceilings to preclude upper income taxpayers from availing themselves of certain 106. see irc § 32. 107. s. rep. no. 94-36, at 22 (1975). according to professor jonathan barry forman, it would be simpler if low-income taxpayers were not subject to the social security tax by either adding standard deductions and personal exemptions to the social security tax or exempting the first $5,000 or $10,000 of income from the tax. jonathan barry forman, simplification for low-income taxpayers: some options, 57 ohio st. l.j. 145, 184-85 (1996). 108. anne l. alsott, the earned income tax credit and the limitations of tax-based welfare reform, 108 harv. l. rev. 533, 534 (1995). professor alsott notes the risk of associating the earned income tax credit with welfare because critics may view it as a handout similar to welfare payments. id. at 537. 109. see id. at 537. 110. rev. proc. 98-61, 1998-52 i.r.b. 18. 111. see supra note 11, at 195. the approximate earned income credit for the stated years was as follows: year amount refunded amount used to offset taxes 1975 $886.7 million $111.0 million 1980 $ 1.4 billion $164.5 million 1985 $ 1.5 billion $209.2 million 1990 $ 5.3 billion $659.3 million 1995 $ 20.8 billion $ 2.0 billion 1996 $ 23.2 billion $ 2.1 billion 1997 $ 24.6 billion $ 2.2 billion id. 2001] the widening gap under the internal revenue code 19 deductions and credits or to reduce the amount of the deductions and credits afforded to upper income taxpayers. second, a taxpayer is required to reduce itemized deductions if their adjusted gross income exceeds a threshold amount adjusted annually for inflation.112 a. the increased use of ceilings.—several recent statutory enactments employ phase-outs that prevent the wealthy taxpayers from availing themselves of the benefits. congress utilized ceilings when it enacted several recent statutory provisions in the code to promote or encourage education. empirical data establishes that college graduates earn higher incomes than individuals who have not attended college. hence, one of the most efficient mechanisms that should be used to combat poverty is by government support of educational programs. united states census bureau statistics establish that there is a substantial difference between the income that a college graduate earns and the income earned by high school graduates. according to the census bureau, median income characteristics for 1998 were as follows: median income of full-time, year-round workers characteristic female male high school grad $21,963 $30,868 bachelor’s degree $35,408 49,982113 because of the correlation between one’s level of education and income level, congress has promoted education to better enable low income and middle income students to attend college. first, a taxpayer is able to contribute $500 to an education individual retirement account each year for beneficiaries younger than age 18. upon distribution, any gain will be excluded from114 income provided that they do not exceed the qualified higher education expenses. the contribution limit is phased out for single taxpayers with115 adjusted gross income more than $95,000 but less than $110,000. second,116 112. see irc § 68. 113. u.s. census bureau, money income in the united states: 1998; current population reports, at xi (sept. 1999). 114. irc § 530(b)(1)(a)(ii) & (iii). 115. see id. § 530(a). “qualified higher education expenses” generally mean tuition, fees, books, supplies and other required equipment to the extent the beneficiary did not claim the hope credit or the lifetime learning credit. id. §§ 529(e)(3)(a) & 530(b)(2)(a). 116. id. § 530(c)(1). for taxpayers filing joint returns, the contribution is phased out where adjusted gross income exceeds $150,000 and less than $160,000. id. 20 florida tax review [vol. 5:1 congress enacted the hope scholarship credit and the lifetime learning credit. the hope scholarship credit provides a nonrefundable credit up to117 $1,500 per student for the first two years of postsecondary education. the118 lifetime learning credit provides a nonrefundable credit up to $1,000 per taxpayer for qualified tuition and related expenses. during a tax year, a119 taxpayer may elect only one of the foregoing tax benefits per student. the120 credits are phased out if the taxpayer’s modified adjusted gross income is between $40,000 and $50,000. congress also enacted a provision that121 allowed taxpayers to deduct interest on educational loans. under this122 provision, taxpayers are able to deduct up to $2,000 for interest paid on any qualified education loan during the first 60 days that interest payments are required. the deduction is phased out if the taxpayer’s modified adjusted123 gross income is between $40,000 and $55,000.124 in addition, congress has also enacted tax incentives to increase the savings rate of lower to middle income taxpayers. congress enacted roth125 iras during 1997 to encourage savings. like other iras, the maximum amount taxpayers can contribute to a roth ira is $2,000 per year. there are several126 differences between traditional iras and roth iras. higher income taxpayers are able to contribute to roth iras but are precluded from making deductible contributions to traditional iras. the yearly contribution amount to roth iras is phased out for individual taxpayers with adjusted gross incomes between 117. see id. § 25a(a). 118. see id. § 25a(b)(1). 119. see id. § 25a(c)(1). 120. see id. § 25a(c)(2) & (e)(2). 121. id. § 25a(d). for taxpayers filing a joint return the credits are phased out where modified adjusted gross income is between $80,000 and $100,000. id. 122. see id. § 221. 123. id. § 221(b)(1) & (d). 124. id. § 221(b)(2). for taxpayers filing a joint return, the deduction is phased out where modified adjusted gross income is between $60,000 and $75,000. id. 125. the current income tax structure encourages savings and investments similar to a consumption tax. under a cash flow method, like the unlimited savings account tax, taxpayers would deduct the amount put into savings or investment vehicles from their gross income, thus avoiding taxation on that income until consumed. j. clifton fleming, jr., the deceptively disparate treatment of business and investment interest expense under a cash-flow consumption tax and a schanz-haigsimons income tax, 3 fla. tax rev. 544 (1997); see lester b. snyder & roger j. higgins, evaluating the consumption tax proposals: changes in the taxation of interspousal transactions, use of trusts, and revising the meaning of “tax planning,” 33 san diego l. rev. 1485, 1487 (1996) (discussing tax proposals that would either exclude investment income from gross income or allow full deduction for investment income). 126. regs. § 1.408a-3, q&a 3(b). 2001] the widening gap under the internal revenue code 21 $95,000 and $110,000, while the maximum contribution amount for ordinary127 deductible iras is phased out where adjusted gross income is between $32,000 and $42,000. a second significant difference between roth iras and128 traditional iras is that no deduction is allowed for amounts contributed to roth iras while deductions are provided for the traditional iras. finally, if a129 payment from a roth ira is made on or after the day the contributor turns 59½ or is made to a beneficiary after the contributor’s death or the individual becomes disabled, the payment is not included in the contributor’s gross income.130 b. phase-out of itemized deductions and personal exemptions.—under the code, taxpayers whose adjusted gross income exceeds the applicable amount must reduce their itemized deductions by a percentage.131 during taxable year 1998, 4.8 million taxpayers were subject to the phase-out resulting in $25.9 billion disallowed itemized deductions. for taxable year132 2000, the applicable amount was $128,950 for married couples filing joint returns and $64,475 for married filing separately. 133 127. irc § 408a(c)(3)(a) & (c). for married couples filing joint returns, the contribution amount is phased out for adjusted gross income between $150,000 and $160,000. id. 128. id. § 219(g)(2)(a) & (b). for married taxpayers filing a joint return, the maximum contribution amount phases out between $52,000 and $62,000. id. 129. see id. § 408a(c)(1). 130. see id. § 408a(d)(1) & (2). 131. see id. § 68(a). the applicable amount is adjusted annually for inflation. see id. § 68(b)(1) & (2). 132. tom herman, backdoor tax increases hit growing numbers of people, wall st. j., july 5, 2000, at a1. 133. rev. proc. 99-42, 1999-46 i.r.b. 568, at 7. 22 florida tax review [vol. 5:1 in addition, the code requires taxpayers with adjusted gross incomes above a threshold amount to reduce the personal exemption amount, and the exemption is completely phased out for some wealthy taxpayers.134 4. income tax exemption for low incomes.—a taxpayer is not required to file a tax return to the extent that gross income does not exceed the allowance for a personal exemption and standard deduction. both of these135 136 allowances are adjusted annually for inflation. for taxable year 2000, the137 personal exemption allowance is $2,800 for each taxpayer and spouse and an additional $2,800 for each dependent. the standard deduction for married138 taxpayers filing a joint return is $7,350 and for single taxpayers it is $4,400.139 based on the standard deduction and allowance for personal exemptions, single taxpayers are exempted from filing a tax return where the gross income does not exceed $7,200 and married couples are not required to file a tax return where gross income does not exceed $12,950. 5. corporate taxation.—the government collects billions of corporate tax dollars annually. under the tariff act of october 3, 1913, corporations were subject to a flat tax of 1% on corporate income. today, the corporate140 tax consists of four marginal brackets ranging from 15% to 35%. generally,141 wealthy taxpayers, rather than lower income taxpayers, own stock in corporations; therefore, any corporate taxes collected by the government will result in increased progressivity. investments held in the corporate form are subject to the so-called double tax because income is taxed at the corporate 134. see id. at 8. for taxable year 2000, the personal exemption begins to phase out and is completely phased out based on the following adjusted gross income levels: filing status threshold phase-out completed phase-out amount amount married filing joint return $193,400 $315,900 heads of household 161,150 283,650 single 128,950 251,450 married filing separately 96,700 157,950 id. 135. see irc § 151. 136. see id. § 63. 137. see id. § 63(c)(4) and irc § 151(d)(4). 138. rev. proc. 99-42, 1999-46 i.r.b. 568, at 8; see irc § 151(b) (allowing personal exemption for taxpayer and spouse); id. § 151(c) (allowing additional personal exemptions for dependents). 139. see rev. proc. 99-42, 1999-46 i.r.b. 568, at 6. 140. see willan, supra note 16, at 5. 141. irc § 11(b)(1). traditionally, the corporate tax rates were higher than the individual rates. however, 1993 legislation reversed this trend. 2001] the widening gap under the internal revenue code 23 level and then at the individual shareholder level upon distribution of the142 profits as dividends. dividend income represents the only stream of income143 that is subject to two levels of taxation. as with other types of taxes, the144 corporate tax is controversial. while opponents of the double tax argue that145 the congress should repeal the corporate tax, supporters believe it is an146 equitable manner of promoting progressivity.147 6. estate and gift taxation.—the estate tax was first enacted during 1898 to help finance the war and “for other purposes.” the progressive tax148 system is firmly established in the estate and gift tax scheme. taxpayers are entitled to make sizeable gifts without being subject to the estate and gift taxes. for the following taxable years the exclusions per taxpayer are as follows: tax year applicable exclusion 2000 and 2001 $ 675,000 2002 and 2003 700,000 2004 850,000 2005 950,000 2006 and thereafter 1,000,000149 the progressive nature of the estate and gift tax is also apparent in the rate structure. upon enactment, the tax imposed increased on the basis of the value of the property. an additional tax was imposed on estates exceeding150 142. irc § 11(a). 143. id. § 61(a)(7). 144. for a discussion on how the corporate tax is inconsistent with “horizontal equity” see jeffrey l. kwall, the uncertain case against the double taxation of corporate income, 68 n.c. l. rev. 613 (1990). 145. see patrick e. hobbs, entity classification: the one hundred-year debate, 44 cath. u. l. rev. 437, 445-46 (1995) (stating that opponents of corporate double taxation do not believe there is substantial difference between corporations and partnerships while proponents believe that the independent legal entitles result in special privileges requiring different treatment). 146. in one study, professor alvin c. warren, jr. considered several alternatives to the current system to resolve the double corporate tax. see alvin c. warren, jr., american law inst., federal income tax project: integration of the individual and corporate income taxes (1993). 147. see kwall, supra note 144, at 633-35 (“[i]f the corporate tax acts as an indirect tax on shareholders, it can be defended on equitable grounds as having a progressive effect.”) 148. war revenue act of 1898, ch. 448, 40 stat. 448. 149. see irc § 2011 (2000). 150. see id. 24 florida tax review [vol. 5:1 $25,000. the maximum additional tax was 3% on estates exceeding151 $1,000,000. today, the tax rates range from 18% to 55% for estates152 exceeding the applicable exclusion. the 55% rate applies to transfers over153 $3,000,000 and was reinstated under the omnibus budget reconciliation act of 1993. the legislative history contains the following reasons for its154 enactment: “to raise revenue, to address the federal deficit, to improve tax equity, and to make the tax system more progressive, the committee believes that the top two estate and gift tax rates which expired at the end of 1992 should be reinstated.” an additional 5% tax is imposed on certain high155 taxable estates. during 1995, only 3.4% of estates were subject to the estate156 tax and presently only 2% of estates are subject to the estate tax. the157 158 reported estate tax liability was $11.8 billion, $14.5 billion and $16.6 billion for tax years 1995, 1996 and 1997, respectively. the estate tax accounted for159 approximately 1% of all tax revenues collected during those years. hence,160 the estate tax accounted for a very small portion of the total tax revenue collected during those years. 151. see id. 152. see id. 153. see id. § 2001(c)(1). 154. see pub. l. no. 103-66, § 13208, 107 stat. 312, 469 (1993). 155. h.r. rep. no. 103-111, at 644 (1993) reproduced at 1993 u.s.c.c.a.n. 378, 875. the act increased rates retroactively. as a result, the taxpayers in quarty v. united states, asserted that the retroactivity was unconstitutional because it violated the fifth amendment’s due process clause and the takings clauses. quarty v. united states, 170 f.3d 961, 964 (4th cir. 1999). the court rejected the taxpayer’s due process argument and concluded that the retroactive aspect of the legislation was rationally related to a legitimate legislative purpose. id. at 967. it also rejected the taxpayer’s argument that a taking had occurred because it was not arbitrary. id. at 969-70. 156. see irc § 2001(c)(2). 157. barry w. johnson & jacob m. mikow, federal estate tax returns, 19951997, 19 statistics of income bulletin 69, 71 (summer 1999) [hereinafter johnson & mikow]. 158. jackie calmes and jim vandehei, house votes to repeal the ‘death tax’: clinton veto is expected on measure affecting 2% of all estates, wall st. j., june 12, 2000, at a2. 159. see johnson & mikow, supra note 157, at 82. 160. see id. 2001] the widening gap under the internal revenue code 25 iii. weaknesses inherent in the current progressive taxation methodology and the growing threat a. in general the after-tax income of taxpayers in the top 10% of income earners, particularly the top 1%, has increased between 1977 and 1990. in professors161 mcmahon’s and abreu’s comprehensive law review article, they critically analyzed empirical data on changes in the distribution of income compared with the total taxes paid between 1977 and 1990. they noted that during 1990162 families in the top one percentile had the same share of income as those in the bottom 40 percentile. according to professors mcmahon and abreu, theth 163 increase in the income of the top 1% has exceeded the increase in their tax liability. other tax experts have found similar patterns extending to tax year164 1993. between 1980 and 1993, while the total effective rate for all families hovered around 23%, it declined by approximately 10% for families in the top 1% income bracket. the increase in the disparity between the income levels165 of the top 1% taxpayers and lower income taxpayers has not resulted in a proportional increase in the tax burden to the wealthy.166 between 1991 and 1997, the tax as a percentage of adjusted gross income has fluctuated in part as a result of changes in the marginal rates. however, since 1995 the rates have remained unchanged, but the tax as a percentage of adjusted gross income continues to fluctuate. in particular, as the income of the taxpayers comprising the highest tax brackets increased, their tax as a percentage of adjusted gross income decreased each year. this phenomenon was evident where the adjusted gross income of the taxpayers was $1,000,000 or more.167 161. see martin j. mcmahon, jr. & alice g. abreu, winner-take-all markets: easing the case for progressive taxation, 4 fla. tax rev. 1 (1998) [hereinafter mcmahon & abreu]. professors mcmahon and abreu derived this data from the distribution of income and tax burdens by household, appendix k in the committee on ways and means, overview of entitlement programs, 103d cong., 1st sess. (comm. print 1993). id. at 5, n.7. 162. see id. 163. see mcmahon & abreu, supra note 161, at 5. 164. see id. at 8. 165. see richard kastey, et al., trends in federal tax progressivity, 1980-93, in tax progressivity and income inequality 10 (joel slemrod, ed., 1994). 166. see mcmahon & abreu, supra note 161, at 8-9. one of the basic premises under the mcmahon & abreu article was that when you isolate the top 1% from other wealthy individuals, you uncover the disproportionate reduction in tax rates afforded to taxpayers in the top 1%. 167. see internal revenue service, 15 statistics of income bulletin 141, 197 (fall 1995). 26 florida tax review [vol. 5:1 the tax as a percentage of adjusted gross income for high income taxpayers decreased by more than two percentage points between 1995 and 1997. with the exception of adjusted gross incomes between $200,000 and168 $1,000,000, every other income level saw negligible changes in the percentages. more significantly, there was even a slight increase in the tax169 as a percentage of adjusted gross income between 1995 and 1997 for taxpayers at the lower adjusted gross income levels.170 the decreased progressivity is the result of a combination of factors. professor sharon nantell provided a possible justification for the disproportionate increase in the tax burden. professor nantell noted the following: the most glaring consequence of a system of tax laws created by and for wealthy, white males is the exacerbation of ‘a growing gap in the relative economic positions between rich and poor, the latter disproportionately represented by women, children and people of color.’ tax provisions such as the mortgage interest deduction and the preferential tax treatment for capital gains primarily benefit taxpayers in the upper-income brackets.171 consequently, in determining whether the code is effective in promoting a progressive tax system, consideration must be given to the tax benefits associated with personal residences, capital assets and other tax incentives. the tax-favored treatment of capital gains accounts for a substantial portion of the tax savings afforded to the wealthy, and has been the subject of substantial debate and statutory modification. under the code, the maximum172 168. see id. 169. for taxpayers with adjusted gross income between $200,000 and $1,000,000, the tax as a percentage of adjusted gross income decreased by an average of 1%. see id. 170. for taxpayers with adjusted gross income between $1 and $1,000 the tax as a percentage increased from 2.9% to 7%, and taxpayers with adjusted gross income between $1,000 and $7,000 had their tax as a percentage of adjusted gross income increase by 0.6%. see id. 171. sharon c. nantell, a cultural perspective on american tax policy, 2 chap. l. rev. 33, 67 (1999) (citing nancy e. shurtz, gender equity and tax policy: the theory of “taxing men,” 6 s. cal. rev. l. & women’s stud. 485, 528 (1997)). 172. for example, professor martin j. mcmahon, jr. disfavors the preferential capital gain rates because of the discriminatory effect, negative impact on the progressive rate structure and increased complexity. martin j. mcmahon, individual tax reform for fairness and simplicity: let economic growth fend for itself, 50 wash. & lee l. rev. 459, 470-73 (1993). see also 143 cong. rec. h6623-04, h6628 (daily ed. july 31, 1997) (“[t]he lowering of the capital gains rate benefits the wealthy in this country, and it is clear that will happen when we get the rate down to 18% which is almost the lowest tax rate on regular income, that this will have thrown gasoline on the whole class warfare issue”). 2001] the widening gap under the internal revenue code 27 tax rate for net capital gains is 20%. where a taxpayer purchases an asset173 after december 31, 2000, and holds on to the capital asset for at least five years, the maximum tax rate is reduced to 18%. during taxable year 1997,174 net capital gain represented a substantial portion of adjusted gross income and was second only to salaries and wages. according to statistics published by175 the internal revenue service, net capital gain totaled $347.9 billion, an increase of 38.1% from the previous tax year. of the total $347.9 billion figure,176 $232.5 billion was reported on tax returns with adjusted gross income of $200,000 or more and $44.9 billion was reported on tax returns with adjusted gross income between $100,000 and $200,000. consequently, taxpayers177 earning $100,000 or more reported approximately 80% of all net capital gain during taxable year 1997. the obvious effect of this empirical data is that the178 primary beneficiaries of the favored rates are wealthy taxpayers, and a substantial portion of taxable income earned by upper income taxpayers was taxed at rates below or only slightly above income earned by lower income taxpayers. specifically, table i based on irs statistics, depicts the form of assets held by the wealthiest males and females.179 173. see irc § 1(h). 174. see id. §1(h)(2)(b). where a taxpayer is taxed at the 15% rate on ordinary income, the maximum rate for assets held for 5 years is 8% irrespective of the holding period. id. § 1(h)(2)(a). 175. see bulletin board, 18 statistics of income bulletin 2, 3 (spring 1999). 176. see id. 177. see revision to winter 1998-1999 issue, 18 statistics of income bulletin 6, 143 (spring 1999). 178. interestingly, taxpayers reporting adjusted gross income of $100,000 or more, reported only 21% of the net capital losses. id. because no more than $3,000 of capital losses can be deducted against ordinary income, they are generally considered less favorable than ordinary losses. see irc § 1211(b). 179. see internal revenue service, statistics of income 71-73 (winter 199798). 28 florida tax review [vol. 5:1 table i males females $600,000 $1,000,000 $600,000 $1,000,000 financial assets 21 percent financial assets 27 percent other real estate 20 percent other real estate 20 percent personal residence 17 percent personal residence 17.5 percent retirement accounts 13 percent cash 14.5 percent cash 10 percent retirement accounts 7.5 percent $1,000,000 or $10,000,000 $1,000,000 or $10,000,000 financial assets 26 percent financial assets 39 percent other real estate 18 percent other real estate 18 percent closely-held stock 12.5 percent cash 12 percent cash 11 percent personal residence 10 percent personal residence 7.5 percent closely-held stock 7 percent retirement accounts 5 percent retirement accounts 6 percent $10,000,000 or more $10,000,000 or more financial assets 33 percent financial assets 53.4 percent closely-held stock 28 percent closely-held stock 11.6 percent other real estate 9.5 percent other real estate 9 percent cash 5 percent cash 6 percent personal residence 2 percent personal residence 2 percent the irs statistics show that a substantial portion of the top wealthholders’ net wealth was attributable to investments in financial assets such as stocks and mutual funds. the statistics also show that there is a sizeable increase in the percentage of assets held in the form of financial assets as the wealth increases. with respect to males, the percentage of assets held in the form of financial assets increased from 21% to 33% as the wealth grew. similarly, with respect to females, the percentage of assets held in the form of financial assets increased with the level of wealth from 27% to 53%. given the status of stocks, mutual funds and other financial assets as capital assets, the 2001] the widening gap under the internal revenue code 29 disposition of these assets has the obvious benefit of taxing the gain at very favorable rates. another category of assets where the percentage of assets increases as wealth increases is closely held stock. consistent with the treatment of financial assets, the disposition of closely held stock may receive favorable tax treatment. under the code, taxpayers that satisfy the statutory requirements are able to exclude 50% of the gain from the disposition of “qualified small business stock” held for more than five years. the maximum amount of the180 exclusion is the greater of $10,000,000 or ten times the taxpayer’s adjusted basis in the stock. the empirical data establishes that for both males and181 females as the net worth increases so does the possibility that the sale or other disposition will result in tax-favored treatment in the form of an exclusion or lowered capital gain rates. assuming that the taxpayers could satisfy all statutory requirements, the percentage of assets disposed of that would be afforded favorable treatment was: net worth males females $ 600,000 $ 1,000,000 38 percent 44.5 percent182 $ 1,000,000 – $10,000,000 46 percent 57 percent $10,000,000 or more 63 percent 67 percent b. homeownership tax incentives another tax incentive that limits the effectiveness of the progressive structure pertains to homeownership. the mortgage interest deduction results in the code discriminating in favor of homeowners. the code allows for gain183 not exceeding $250,000 ($500,000 for married coupled filing a joint return) to be excluded from gross income where the taxpayer resided in the home for at least two years during a five year period. the code also allows a deduction184 for interest paid on indebtedness incurred on the acquisition or improvement 180. irc § 1202(a)(1). in order to qualify as a qualified small business, the aggregate gross assets must not exceed $50,000,000. id. § 1202(d). 181. see id. §§ 1(h)(4) & (5) and 1202(b). 182. the percentages are based on the application of the exclusion on gain from the sale of a personal residence provided under irc § 121, the tax-favored capital gain rates of irc § 1, and the exclusion for gain from the disposition of qualified small business stock under irc § 1202. 183. there is a disparity between whites and other ethnic groups in home ownership. only 46.3% of african americans and 45.5% of hispanics own their homes while 73.2% of whites own theirs. u.s. census bureau, housing vacancies and homeownership annual statistics: 1999, table 20 (last visited feb. 14, 2001) available at http://www.census.gov/hhes/www/housing/hvs/annual99/ann99t20.html. 184. irc § 121(a) and (b)(1). where a husband and wife file a joint return, the amount of the exclusion is $500,000. id. § 121(b)(2). 30 florida tax review [vol. 5:1 of a personal residence and interest paid on home equity up to $100,000 of185 indebtedness. for taxable year 1993, the home mortgage deduction resulted186 in total tax savings of $45.1 billion. although some scholars advocate the187 total repeal of the home mortgage deduction, the deduction attributable to188 home equity indebtedness creates the greater problem. the proceeds from home equity indebtedness may be used for any purpose. homeowners are able to deduct mortgage interest payments indirectly made for the purchase of automobiles, boats, tuition and vacations even though the tax reform act of 1986 repealed a deduction for personal interest.189 c. corporate taxation. there is evidence suggesting that the corporate tax is ineffective in taxing corporate income because of numerous corporate tax breaks.190 according to the congressional budget office, in 1952 corporate income taxes accounted for 32% of total federal revenues but only 9% in 1995. the actual191 amount of total income tax after deductions and credits consistently increased from 1991 through 1996. however, the deductions and credits considerably exceeded the total income tax after deductions and credits, and the percentage increase in deductions and credits was disproportionately greater than the increase in the total income tax during most of those taxable years. the disparity was greatest in 1995 and 1996. the results are provided in table ii. 185. id. § 163(h)(3)(a)(i), and (b). 186. id. § 163(h)(3)(a)(ii), and (c). 187. senator pete v. domenici, the unamerican spirit of the federal income tax, 31 harv. j. on legis. 273, 293 (1994). 188. see mcmahon, supra note 23, at 487. 189. several legal scholars have criticized the mortgage interest deduction as being discriminatory. according to professor joseph a. snoe, congress enacted the mortgage interest deduction provisions to lighten the burden associated with borrowing for education, health care and unforeseen emergencies. see joseph a. snoe, my home, my debt: remodeling the home mortgage interest deduction, 80 ky. l.j. 431, 437-40, 491 (1992). according to professor snoe, these policy concerns justify a deduction for all taxpayers that borrow funds to satisfy these expenses. id. at 491. see also william t. mathias, curtailing the economic distortions of the mortgage interest deduction,” 30 u. mich. j.l. reform 43 (1996) (because of inequalities favoring the upper-income taxpayers, interest deduction should either be curtailed or eliminated). 190. in 1984, a publication was issued establishing that 128 out of 250 of the largest corporations did not pay any federal income taxes at least once between 1981 and 1983. see steven m. sheffrin, perceptions of fairness in the crucible of tax policy in tax progressivity and income inequality 309, 322 (joel slemrod ed., 1994). 191. christopher st. john, tax breaks and corporate responsibility, me. l. r e v . ( f e b . 4 , 1 9 9 8 ) , ( l a s t m o d i f i e d m a r . 2 , 2 0 0 0 ) http://www.mecep.org/news2/980304.shtml. 2001] the widening gap under the internal revenue code 31 32 florida tax review [vol. 5:1 table ii year total income tax % change deduction % change credit % change 1991 $ 92.6 billion $122.6 billion $28.5 -192 1992 $101.5 billion 9.69 $117.6 billion -4.09 $29.7 4.29193 1993 $119.9 billion 18.1 $136.5 billion 16.1 $34.5 16.0194 1994 $135.5 billion 13.0 $142.3 billion 4.2 $37.3 8.0195 1995 $156.4 billion 15.0 $205.2 billion 44.2 $42.4 13.8196 1996 $170.6 billion 9.1 $216.7 billion 5.6 $53.1 25.2197 another problem with the corporate tax is that it is unclear who actually bears the tax burden. the four possible contenders for bearing the burden are: 1) owners or shareholders of the corporation; 2) owners of capital in general; 3) consumers through inflated prices; or 4) workers through reduced wages. some businesses might shift such an expense to consumers by198 increasing costs, but too much shifting would be inflationary. based on this practice, one could easily conclude that consumers actually bear the cost of the corporate tax expense because it is similar to any other business expense. it is also conceivable that corporate directors protect earnings and profits by reducing expenses, including workforce downsizing, reduced wages and increased operations in third world countries, which would place the onus of 192. see internal revenue service, 15 statistics of income bulletin 14-15 (summer 1995). 192. see id. 193. see michael g. selders, corporation income tax returns, 1993, stat. income bull., summer 1996, at 43-44. 194. see madeline deming boerner, corporation income tax returns, 1994, stat. income bull., summer 1997, at 58-59. 195. see matthew scoffic & patrick treubert, corporation income tax returns, 1996, stat. income bull., summer 1999, at 57-58. 196. see id. 198. see joseph a. pechman, federal tax policy, 144, 142 (5th ed. 1987). one professor at the university of california at davis posed the question to his introductory microeconomics class of 150 and received the following responses: 1) 6% believed workers borne the corporate tax 2) 9% believed that shareholders borne the tax burden; 3) 30% believed that all investors in the economy borne the tax; and 4) 55% believed that consumers borne the tax. see sheffrin, supra note 189, at 323. 2001] the widening gap under the internal revenue code 33 the corporate tax on the employees. in theory, the corporate tax is borne199 entirely by the shareholders. in practice, the corporate tax is actually borne by all four contenders with the more difficult question being the proper allotment. to the extent that the corporate tax is borne by consumers, it is a regressive tax because lower-income taxpayers spend a larger portion of their incomes on consumable products. d. the earned income tax credit superficially, the increase in the refundable portion of the earned income credit since its enactment establishes its success in meeting congress’s objective of countering the regressive nature of the social security tax and serving as an anti-inflationary measure. at first glance, the earned income tax credit is an effective means of alleviating poverty. the earned income tax credit lifts some low-income taxpayers above the poverty level but does not lift all taxpayers above the poverty level. for example, during taxable year 1988, twothirds of all poor taxpayers did not receive earned income credit benefits. for200 1999 the maximum earned income tax credit that could be received by a single taxpayer with two or more children or a married couple filing a joint return with two or more children was $3,816. in order to receive the maximum201 credit, the taxpayer’s earned income could not exceed $12,460. hence, when202 you combine the earned income with the earned income credit, the effective income for the year is $16,276. for 1999, the poverty threshold for a family of 199. if the corporate tax is borne by employees in the form of lower compensation, the ceos and other high-ranking corporate executives seem to escape this financial burden. during 1999, the median salary including bonuses for top executives of 350 consulting firms was about $1.7 million and $120,000 higher than during 1998. david s. brader, of janitors and billionaires, wash. post, apr. 16, 2000, at b7. the highest paid executive made $170 million in salary, bonuses and stock options. id. the article pointed out that the janitors cleaning the offices where the executives worked requested $1 an hour raises for each of the next three years and that the $1.7 million would have funded the combined requested salaries of 80 striking janitors during the third year. id. there is also evidence that even corporations with low earnings and weak stock performance are rewarding their ceos generous compensation packages. while coca-cola shares dropped by 13%, the exiting ceo received a total compensation package of $70 million, and while bank of america’s shares dropped by 17%, the ceo received a compensation package totaling $49 million. gary strauss, the billionaires club new economy rockets ceo pay into the stratosphere, usa today, apr. 15, 2000, at 1b. 200. saul d. hoffman & laurence s. seidman, the earned income tax credit: antipoverty effectiveness and labor market effects, 28 (1990). 201. see rev. proc. 98-61, 1998-2 c.b. 811. 202. see id. 34 florida tax review [vol. 5:1 four with two children in the household was $16,895. the family remains203 below the poverty threshold by $619. the analysis is incomplete because the taxpayer is also liable for social security tax and a tax for medicare. wages are subject to social security tax of 6.2% and medicare tax of 1.45%. the entire204 tax liability for payroll taxes would total $953. consequently, after factoring in the payroll taxes, the taxpayer’s after-tax income remains $1,572 below the poverty threshold. a different result would obtain where the household205 consisted of two children and was headed by a single parent. the poverty threshold for a single parent with two children was $13,423 during 1999.206 when you combine the earned income with the earned income credit, the effective income for the year is $16,276. as a result of the earned income tax credit, the low-income taxpayer’s effective income is $2,853 above the poverty threshold. the maximum earned income tax credit that could be received by a single parent with one child was $2,312 for 1999, and the maximum income to receive that amount was $12,460. the poverty threshold for this family was207 $11,483 in 1999. hence, the effective income for the taxpayer is $14,772 and208 $3,289 over the poverty level. the earned income credit, however, does not enable a taxpayer to move above the poverty level where the taxpayer does not have any children. the 203. u.s. census bureau, poverty 1999 (last visited apr. 17, 2000) http://www.census.gov/hhes/poverty/threshold/thresh99.html. 204. irc § 3101(a), (b). the earned income tax credit was enacted to offset the regressive nature of the social security and medicare taxes. see s. rep. no. 94-36, at 22 (1975). many low-income taxpayers must pay state income taxes as well. some states waive the state income taxes for low-income taxpayers, but approximately one-half of the states require payment of income taxes irrespective of poverty level. tax report, wall st. j., mar. 29, 2000, at a1. 205. these results are based in part of the marriage penalty that affects some households. the house of representatives and senate had passed the “marriage tax penalty relief act of 2000” which would have reduced the so-called marriage penalty for most taxpayers and reduced the marriage penalty inherent in the earned income tax credit. see hr 6m 106th cong. (2000). president clinton vetoed the bill because of its expected benefit primarily to upper income taxpayers. see jim vandehei, senate passes bill to dump marriage tax: with clinton vowing to veto, hastert seeks a deal to show off for voters, wall st. j., july 19, 2000, at 24. republicans attempted to override the presidential veto but failed by 16 votes, see jim vandehei, g.o.p. reloads with marriage tax, debt payment, wall st. j., sept. 14, 2000, at a1. see also vada waters lindsey, the burden of being poor: increased tax liability? the taxation of self-help programs, 9 kan. j.l. & pub. pol’y 225, 259-60, n.161 (1999) (opining that if the marriage penalty is eliminated, the marriage bonus must be eliminated as well). 206. poverty in the united states: 1998, current population reports, u.s. census bureau, at 1 (sept. 1999). 207. see rev. proc. 98-61, 1998-2 c.b. 811. 208. poverty in the united states: 1998, current population reports, u.s. census bureau, at 1 (sept. 1999). 2001] the widening gap under the internal revenue code 35 maximum earned income tax credit that could be received by a taxpayer with no children was $347 for 1999, and the maximum income to receive that amount was $5,670. the poverty threshold for a single individual was $8,480209 in 1998. the total income for a taxpayer earning the maximum income and210 therefore receiving the maximum earned income credit would be $6,017. as a result, the taxpayer’s income would be $2,463 lower than the poverty threshold established for 1998. e. estate taxation the internal revenue service projects that the estate tax liability will be reduced by $1.8 billion and $8.6 billion between years 2001 and 2007 because of the increase in the unified credit and other changes enacted under the taxpayer relief act of 1997. the effect of these changes is to reduce the211 progressivity in our overall tax structure. significantly, the house of representatives in a 279-136 vote passed the “death tax elimination act of 2000” to phase out the tax altogether over a ten year period of time. the212 213 senate in a 59-39 vote also passed the measure. as expected, former214 president clinton vetoed the bill, but it is likely that efforts to repeal the tax will continue. president bush’s tax plan includes the complete repeal of the215 federal estate tax. therefore, if a new tax bill includes the elimination of the216 federal estate tax, it is unlikely president bush will veto the bill as did his predecessor. if the federal estate tax is eliminated, there will be additional strain on the integrity of our progressive tax system. f. the use of ceilings and phase-outs there are several weaknesses inherent where ceilings are employed to promote progressivity. first, it is unlikely that progressivity is achieved between low-income taxpayers and those taxpayers who are unable to avail themselves of tax incentives because their income levels run afoul of a ceiling. if you consider roth iras, high-income taxpayers can easily afford to set aside 209. see rev. proc. 98-61, 1998-2 c.b. 811. 210. poverty in the united states: 1998, current population reports, u.s. census bureau, at 1 (sept. 1999). 211. see johnson & mikow, supra note 157, at 87. 212. see calmes & vandehei, supra note 158, at a2. 213. see hr8, 106th cong. (2000). 214. see jim vandehei, despite veto threat, senate is expected to clear marriage-penalty relief plan, wall st. j., july 17, 2000, at a36. 215. see tax report, wall st. j., sept. 6, 2000, at al. 216. see glenn kessler & mike allen, bush to contend both taxes, debt can be reduced, wash. post, feb. 25, 2001, at a1. 36 florida tax review [vol. 5:1 $2,000 per year and are able to exclude from income future accessions to wealth. conversely, low-income taxpayers can theoretically invest in roth iras as well, but they are essentially foreclosed from the investment option because all their disposable income is consumed by basic necessities. while low-income taxpayers are essentially foreclosed from contributing to the roth iras, many high-income taxpayers are eligible to make the contributions. for 1998, households in the upper 95 percentile earned income of $132,199 andth households in the upper 80 percentile earned income of $75,000. theth 217 median income for that same year was $38,885. the roth iras are phased218 out for single individuals between $95,000 and $110,000 and for married couples between $150,000 and $160,000. the significance of these statistics is that the phase-outs do preclude the wealthiest taxpayers from availing themselves of tax-free accession to wealth, as advocated by professors mcmahon and abreu, but a sizeable portion of wealthy taxpayers can, in219 fact, take advantage of the roth ira tax benefits. hence, as noted by professors mcmahon and abreu, there is some widening to the level of progressivity between the very wealthy and the moderately wealthy but not to the level of progressivity between the lower to middle income taxpayer and the wealthiest taxpayers.220 a similar conclusion is reached when you consider educational iras, hope scholarship credit and lifetime learning credit. while the u.s. census bureau empirical data complements the government’s promotion of higher education, there is an issue as to whether the education should be promoted as a direct expenditure or tax incentive. the recent legislation and budget establish that congress supports education by combining the two approaches. however, the trends in federal student financial assistance indicate that the u.s. department of education is providing students with declining amounts of awards. during fiscal year 1999, federal student aid awards totaled $53.2 billion. during fiscal year 2000, federal student aid awards totaled $50.6221 billion. conversely, congress has increased the use of tax incentives as a222 means of supporting education by enacting legislation that allows for an exclusion from income of gains from distributions from educational iras, a nonrefundable credit for certain educational expenses, and a deduction for 217. u.s. census bureau, money income in the united states: 1998, xv (1999). 218. see id. 219. see mcmahon & abreu, supra note 8, at 77. 220. see id. at 76-77. 221. interim performance objectives, final report fiscal year 1999, student financial assistance http://www.ed.gov/pdfdocs/finalquarterly.pdf, (last visited july 20, 2000). 222. see id. 2001] the widening gap under the internal revenue code 37 interest paid on educational loans. the problem with the legislation that223 promotes education is that the taxpayers with the most to gain from obtaining a college degree are not able to either establish an educational ira or pay for qualified tuition and related expenses. it is highly unlikely that a low-income224 taxpayer would be able to benefit from these tax incentives. deductions and credits are useless without sufficient income to offset. it is not realistic to expect a lower to middle class family with three children and household income of $25,000 to also be able to set aside $500 per child for an educational ira. hence, the only families who are able to benefit from these tax incentives are middle to upper income families. in addressing the effectiveness of these tax incentives, it is important to recognize these severe limitations. the most effective way for the government to subsidize education is a combination of the tax incentives and direct expenditures. the department of education must continue to subsidize college for low-income to middle-income individuals by providing grants primarily and low-interest loans secondarily. the phase-out of itemized deductions is also an ineffective method of ensuring progressivity. although a substantial amount of itemized deductions were excluded, the phase-out is ineffective in protecting the integrity of the progressive tax structure for two reasons. first, most taxpayers in the lowest tax bracket claim the standard deduction, and it is probable that even the phased225 out itemized deduction is substantially greater than the standard deduction. second, wealthy taxpayers are fully able to claim above the line deductions such as business deductions. conversely, the phase-out of the personal exemption is more successful in maintaining a progressive tax structure. g. proposed tax legislation’s increased threat the very partisan tax legislation enacted in recent years has resulted in generous tax savings to the wealthy. congress has also proposed legislation that headed toward a weakening in the progressive tax structure. for example, during the summer of 1999, congress passed a ten year $792 billion tax cut. included in the package were reductions in the capital gain rates and increases of contribution and annual limits on iras. although congress proposed a reduction in all of the marginal rates, the package as a whole discriminated in 223. see supra text accompanying notes 108-24. 224. another unexpected problem with the hope credit and the lifetime learning credit is that they are underutilized. during taxable year 1998, taxpayers claimed a total of $3.5 billion in the educational credits rather than the predicted $6.7 billion in savings. thomas a. fogarty, juicy educational tax credits go unused: some say code’s too complex for students to cash in, usa today, mar. 31, 2000, at 1b. 225. most taxpayers in all tax brackets claim the standard deduction. for example, for taxable year 1998 the irs reported that only 30.5% of tax returns claimed itemized deductions. see tax report, wall st. j., july 5, 2000, at a1. 38 florida tax review [vol. 5:1 favor of the wealthy. the package was not discriminatory on its face, but its impact was discriminatory because low-income taxpayers do not have sufficient disposable income to make capital investments. as expected, president clinton vetoed the tax-cut package. while congress proposed additional tax breaks226 for the wealthy, it also considered limiting the nonrefundable earned income tax credits received by many low-income taxpayers. in the congress’s fiscal 2000 budget, house republican leaders proposed converting the earned income credit payments from lump sum to 12 installment payments as a way to raise $8.7 billion for labor, health and education programs. the measure did not227 pass; however, it exemplified the direction of the tax policy of the current228 congress, because it contemplated severely limiting benefits to the poor as a way to fund appropriations. several republican and democratic representatives also introduced the “national retail sales tax act of 1999” and the “fair tax act of229 1999”. both bills propose the elimination of the federal income tax and the230 imposition of a consumption-type sales tax. on april 15, 1999, several representatives introduced the “national retail sales tax act of 1999” that would eliminate the income tax and impose a 15% on consumption. on july231 14, 1999, representative john linder (r-ga) and representative collin peterson (d-mn) introduced the “fair tax act of 1999” that also eliminates the current income tax and replaces it with a 23% tax on consumption. the232 stated purpose of both bills was “[t]o promote freedom, fairness, and economic opportunity for families by repealing the income tax, abolishing the internal revenue service, and enacting a national retail sales tax to be administered primarily by the states.”233 consistent with other election years, each candidate’s platform usually includes modifying the code. whether the tax platforms represent political rhetoric or valid proposals, they play a significant role in enticing voters to vote for a particular candidate. according to a poll conducted by the national republican congressional committee, 69% of 1000 voters in 41 contested congressional districts indicated that they would vote for candidates who 226. see bob davis & jacob m. schlesinger, clinton vetoes $792 billion tax cut, seeks to lure gop toward compromise, wall st. j., sept. 24, 1999, at a16. 227. see david rogers, divided gop leans toward making broad spending cuts at year’s end, wall st. j., oct. 4, 1999, at a32. 228. see id. 229. h.r. 1467, 106th cong. (1999). 230. h.r. 2525, 106th cong. (1999). 231. h.r. 1467, 106th cong. (1999). 232. h.r. 2525, 106th cong. (1999). under the bill, the 23% figure is only in place during the year 2001. after that year, the bill sets out a formula to determine the tax rate. see id., § 101(b)(2) & (3) (1999). 233. see h.r. 2467, 106th cong. (1999) and h.r. 2525, 106th cong. (1999). 2001] the widening gap under the internal revenue code 39 supported the marriage penalty relief plan recently passed by the house.234 representative charlie stenholm, a conservative democrat from texas, stated “[t]his is nothing more than a political document that is clearly an effort to push a touchy-feely tax cut.” presidential candidates had proposed more235 aggressive tax cuts than the tax package that was vetoed by former president clinton. republican presidential candidate gary bauer proposed a 16% flat-tax on individuals and corporations. president george w. bush proposed a $483236 billion tax cut over a five-year period and now proposes a $1.6 trillion tax cut237 over a ten year period. a significant component of president bush’s proposal was the implementation of four flatter marginal rates ranging from 10% to 33% replacing the current five marginal rates ranging from 15% to 39.6%. for238 single taxpayers, the 10% rate would apply to taxable income up to $6,000 and for married taxpayers, the 10% rate would apply to the first $12,000. under president bush’s proposal, taxpayers currently taxed at the 36% and 39.6% rates would be taxed at a 33% marginal rate. former presidential candidate239 senator john mccain of arizona had proposed a $240 billion tax cut over a five-year period that expands the 15% tax bracket to cover higher incomes.240 critics of the proposal indicate that preliminary analysis of the proposal showed that 34.9% of the tax cuts would benefit taxpayers whose income was in the top 5% and that only 6.7% of the benefits would go to taxpayers in the bottom 60% income level. the same critics also pointed out that president bush’s241 proposal would give 52.6% of the tax cuts to taxpayers in the top 5% level while 11% would benefit taxpayers in the bottom 60% income level. former242 democratic candidate al gore proposed a $500 billion tax cut over the next ten years. mr. al gore’s plan was targeted toward the low-income and middle-243 234. see jim vandehei, house passes gop marriage tax-cut bill,” wall st. j., feb. 11, 2000, at a16. 235. see id. 236. see rogers, supra note 226. under the proposal, all corporate deductions would be disallowed. see id. 237. see jackie calmes, bush’s tax-cut plan focuses on people at bottom as well as top, and comes with hugh price tag, wall st. j., dec. 1, 1999, at a28. 238. see id. 239. see id. 240. richard w. stevenson, mccain to propose middle-class tax cut and private accounts within social security, n.y. times, jan. 11, 2000, at a21. under senator mccain’s proposal, up to $70,000 of taxable income for married couples filing joint returns and $35,000 for single taxpayers would be subject to the lowest tax bracket of 15%. currently, the ceiling for the 15% tax bracket is $36,900 for married couples filing joint returns and $22,100 for single taxpayers. see irc § 1(a) and (c). 241. see stevenson, supra note 239. 242. see id. 243. see richard w. stevenson, democrats drawn to tax cuts, but parties still split over size, n.y. times, july 10, 2000, at a1. 40 florida tax review [vol. 5:1 income taxpayers, and taxpayers earning more than $100,000 would see marginal tax relief. with the election finally decided, the debate shifts from244 election year rhetoric to serious consideration of president bush’s tax plan. while it is unlikely that the entire $1.6 trillion tax proposal will become law, it is probable congress will pass a substantial tax-cut during this year and enact some of the president’s $1.6 trillion tax cut plan. the endorsement of alan greenspan, the federal reserve board’s chairperson, to a tax cut increases the likelihood of tax relief. the only significant issue remaining is whether the245 tax cut will safeguard the progressive tax structure or whether it will continue the trend of eroding the progressive tax structure. iv. progressive taxation in today’s society a. the renewed need for progressive taxation in a recent article, professor michael a. livingston stated that any progressivity research should address topics such as impact of tax legislation and tax rates on women and minority taxpayers. empirical data establishes246 that many women and minorities are living below the poverty threshold. the poverty threshold for a family of four was $16,660 in 1998. at that time, the247 poverty rate was 12.7%, and the total number of families living below the poverty level was 34.5 million. although the percentage of people living248 below the poverty line is generally shrinking, the disparity between the249 wealthy and the poor has steadily increased since 1967. 244. see john d. mckinnon, pocketbook politics: how plans would affect you, wall st. j., oct. 4, 2000, at c1. 245. david e. sanger, the president’s budget: the context; surplus feast: will tax-cut appetizer leave room for debt-slice dessert?, n.y. times, mar. 21, 2001, at a23. mr. greenspan approves of a tax cut in principle, but he has not expressly endorsed president bush’s $1.6 trillion tax cut. id. 246. see michael a. livingston, blum and kaven at 50: progressive taxation, “globalization,” and the new millennium, 4 fla. tax rev. 731, 737 (2000) [hereinafter livingston]. 247. see u.s. census bureau, poverty in the united states: 1998, current population reports, at 1 (sept. 1999). 248. see id. 249. the poverty rate increased in 1998 for residents in the northeast and west. see id. at viii. 2001] the widening gap under the internal revenue code 41 in 1998, households in the upper 95 percentile earned income 8.2 times greaterth than those in the lowest 20 percentile compared to 6.3 in 1967. the povertyth 250 level was substantially higher for several metropolitan areas and for families251 headed by females. females headed 53% of families living below the poverty threshold, and the poverty rate for families headed by females was 29.9%.252 the percentage of children under the age of six living below the poverty level is 20.6%. in the case of children under the age of six residing in households253 headed by females with no husband present, the poverty rate was a staggering 54.8%. the poverty level was also high for blacks (26.1%) and for hispanics254 (25.6%). the median income was $25,351 for blacks and $28,330 for255 hispanics. this empirical data supports the longstanding trend that females256 continue to earn substantially less than males. the ratio of female-to-male257 250. see u.s. census bureau, money income in the united states: 1998, current population reports, (sept. 1999). between 1967 and 1998, the disparity in the household income between the highest and lowest income levels is as follows: upper 95% lowest 20% earned income earned income disparity 1998 $132,199 $16,116 8.20 1997 128,521 15,640 8.22 1996 124,187 15,342 8.09 1995 120,860 15,402 7.85 1990 118,163 15,589 7.58 1985 110,984 15,149 7.33 1980 101,999 14,965 6.82 1975 94,787 14,574 6.50 1970 91,477 14,552 6.29 1968 85,824 14,367 5.97 1967 85,317 13,471 6.33 251. for example, the poverty level in some major metropolitan areas was as follows: houston (28.1); new york city (24.3), washington, dc (23.8); los angeles (22.5); detroit (22.4); boston (22.1); chicago (17.3) and dallas (17.1). see nina bernstein, poverty rate persists in city despite boom, n.y. times, oct. 7, 1999. 252. see u.s. census bureau, supra note 247, at vi. 253. see id. 254. see id. 255. see id. at viii. 256. see u.s. census bureau, supra note 250, at vi. 257. it is beyond the scope of this article to address the issues surrounding the gap in earnings between males and females. for in-depth analyses see daniel r. fischel & edward p. lazear, comparable worth and discrimination in labor markets, 53 u. chi. l. rev. 891 (1986) (arguing that comparable worth remedy is insufficient because it does not remove barriers to entry in male-dominated jobs); michael selmi, family leave and the gender wage gap, 78 n.c. l. rev. 707 (2000) (creation of wage equality is tied to encouraging more men to take leave upon the birth of their children). 42 florida tax review [vol. 5:1 earnings for both high school graduates and college graduates is approximately 71%. significantly, 12.7 million households, 12% of all households, were headed by females. the median income of these households was $24,393258 compared to $38,885 for all households.259 many minorities and females represent the classic scenario set forth in the introduction. when you consider the empirical data, the level of progressivity necessary to promote a reasonable standard of living has far reaching implications. while it is alarming that so many minorities, women and children live far below the poverty threshold, our capitalistic society permits varied levels of wealth resulting competition in the free market. whether the economic advantages are earned by effective competition or inherited from a relative, our system permits the unequal distribution of wealth. as a result, it would be inconsistent with our capitalistic society to mandate a massive redistribution of wealth under the code. however, the country as a whole should share a role in alleviating poverty, particularly with respect to children to at least prevent a cycle of poverty from generation to generation. the progressive tax structure allows the low-income families to retain most of their income and prevents many families’ after-tax income from falling below the poverty level. there have not been any radical changes in society altering this conclusion. the progressive tax system remains viable even in today’s society. hence, the tax system should not be structured to allow for the wealthy taxpayers’ after-tax income to increase while taxpayers in every other experience a decrease in their after-tax income. moreover, the tax system cannot be structured to allow the tax as a percentage of adjusted gross income to decrease for the wealthiest taxpayers while remaining proportionate for most taxpayers in other income brackets and even increasing for some low-income taxpayers. part ii of this article establishes that the progressive income tax structure has permeated our tax system since the enactment of the income tax act of 1913. professor livingston opined that changes in the modern world “impose significant practical obstacles to the maintenance of a progressive tax system”. societal changes do not require a complete overhaul of our tax260 structure. rather, societal changes should only impact the level of progressivity. for example, to combat the economic adversity surrounding the see also lucy b. bednarek, note: the gender wage gap: searching for equality in a global economy, 6 ind. j. global leg. stud. 213 (1998) (inequality in gender wages must be addressed by considering effects of globalization); wynn r. huang, article: gender differences in the earnings of lawyers, 30 colum. j.l. & soc. probs. 267 (1997) (female attorneys work in lower paying specialties and do not receive the same income premiums as men). 258. see u.s. census bureau, supra note 250, at vi. 259. see id. 260. see livingston, supra note 246, at 737. 2001] the widening gap under the internal revenue code 43 great depression, congress increased the surtax on the maximum marginal brackets from 20% to 55%. congress imposed the highest marginal rate of 91% during the world war ii. congress slowly reduced the astounding 91% rate, and the maximum marginal rate is substantially lower today than it was when professors blum and kalven wrote their notable critique of the progressive tax system. it is inconceivable that the rates would ever rise to the astronomical levels of yesteryear. professor livingston correctly points out that “increasing conservatism of american politics.” a more accurate question is whether261 progressive taxation can be sustained at all in light of the increasing conservatism. stated another way, is the progressive tax structure inherent throughout history appropriate in light of today’s society? that question must be answered affirmatively. irrespective of the method of taxation adopted by this country, it cannot conflict with the traditional ability-to-pay principles expressed in the legislative history of the historic income tax act of 1913. it is unlikely that congress could enact marginal rates approaching the rates in the past. however, the progressive tax structure is the most effective manner of satisfying revenue concerns while adhering to the ability-to-pay concept. the consumption tax favors the wealthy taxpayers that obviously are in a better position to save large amounts of money over long periods of time. proportional taxation has several advantages, but is inappropriate to convert to such a system of taxation because revenue shortfall considerations. any viable proposal for a proportional tax system would result in a tax increase for many middleincome taxpayers to sustain the revenue demands. of course, progressivity would still be a part of proportional taxation in the form of exemptions to prevent low-income taxpayers from being subjected to a hefty tax burden. b. globalization and progressive taxation professor livingston argues that globalization precludes a country from maintaining inflated tax rates because of a probable loss in business to competing nations. arguably, developed countries might lose business to262 developing countries due to lower wages in those developing countries, more costly environmental controls and labor protection laws. if those developing countries also maintain lower tax rates, that only represents one additional factor in contributing to a loss in business to those countries. however, these countries lack sufficient resources to pose bona fide threats to developed countries. moreover, many developing countries actually maintain progressive rate structures. taiwan’s marginal rates for personal income ranges from 6% 261. see id. 262. see id. at 742. 44 florida tax review [vol. 5:1 to 40%.” capital gains are taxed in the same manner. in mexico, the263 264 marginal rates range from 3% to 40%. capital gains are also subject to the265 mexican income tax.266 a more significant question raised by professor livingston concerns whether this country could lose business to developed countries. while professor livingston was concerned with the competitive disadvantages a country might encounter by maintaining high tax rates, he was particularly apprehensive about the impact on a country that taxed capital because of the ease of shifting capital to countries with lower taxes. professor livingston267 raises valid issues. nevertheless, many developed countries that possess sufficient resources to put forth a serious competitive threat also maintain progressive rate structures, and they also tax capital. japan has been a leader in the manufacture of electronic equipment and automobiles. in japan, individuals are assessed a national income tax. the marginal tax rates are 10%, 20%,268 30% and 37%. the tax is imposed on various forms of income, including269 business income. generally, japan also imposes a local enterprise tax on270 business and rental income at a flat rate of 5%. in addition, japan imposes a271 corporate income tax at a 34.5% tax rate for large corporations and 25% tax rate for small corporations. gains from the disposition of corporate stock and272 other corporate securities are not subject to the progressive ordinary income tax rates but are subject to a flat tax rate of 26%. in germany, the graduated273 income tax rates range from 22.9% to 51%. income derived from the274 investment of capital is also subject to taxation but are no longer entitled to lower capital gain rates as had existed in the past. canada also has a system275 of progressive taxation. the three marginal rates vary from 17% to 29%.276 while the top marginal rate is substantially lower than the maximum rate 263. see coopers & lybrand, 1998 international tax summaries, a guide for planning and decisions, at t-2. 264. id. at t-3. 265. see del castillo, solano & wolf, 972-2nd t.m., business operations in mexico, at a-65. 266. see del castillo, solano & wolf, tax management foreign income business operations in mexico, at a-65. 267. see livingston, supra note 244, at 742. 268. see way, brockman, otsuka & takagi, 969 t.m., business operations in japan, at a-136-37. 269. see id. at a-137. 270. see id. at a-140. 271. see id. at a-137. 272. see id. at a-30. 273. see id. at a-146. 274. see killius, 962-2nd t.m., business operations in germany, at a-66. 275. see id. at a-60, a-64. 276. see couzin, 955-2nd t.m., business operations in canada, at a-51. 2001] the widening gap under the internal revenue code 45 imposed under the code, taxpayers are subject to a surtax of 3%, and income exceeding $12,500 is subject to a surtax of 5%. income realized from capital277 ventures is also subject to capital gain taxation. in australia, the progressive278 rate schedule for the tax years 2000 through 2001 ranged from 0% for taxable income up to $6,000 to 47% for taxable income above $60,000. capital279 assets purchased after 1985 and held for over 12 months are subject to a capital gain tax rate that is 50% of the taxpayer’s income tax rate. hence, it is280 premature to emphasize globalization as a reason to lower taxes because many countries’ tax structures continue to tax capital and maintain progressive income tax rates. c. reduction in the lowest marginal rate congressional members have the authority to determine whether they should enact legislation to adjust the rate structure as a result of economic or social conditions affecting the country. however, there are several reasons why any restructuring of the tax system should conform to the progressive tax principle. irs statistics establish that upper income taxpayers have been retaining a larger share of their after-tax income than taxpayers in lower income brackets. as a result, our tax system has become less progressive than it has been in the past. it is likely that this pattern will continue based on the various congressional tax proposals. congress needs to improve its method of distributing tax benefits and reapportioning the budget surplus. in reversing the erosion of the progressive tax system, it is not necessary to limit the tax benefits afforded to the wealthy, but tax benefits to the lower income taxpayer need to be enhanced. the use of deductions and nonrefundable credits is inadequate. in order to balance the tax benefits allocated to the lower income taxpayers and the upper income taxpayers, the lowest marginal rate should be reduced. the alternative approach of increasing the tax costs of the wealthy is less appealing. the most equitable and simplest way to protect the progressive tax structure is to lower the lowest marginal tax rate or to expand the 15%281 bracket to include higher incomes. presently, the lowest marginal rate is 15%. 277. see id. 278. see id. at a-45. 279. see http://www.ato.gov.au. 280. see id. 281. see bankman & griffith, social welfare and the rate structure: a new look at progressive taxation, 75 cal. l. rev. 1905, 1945 (1987) (stating that progressive tax is best implemented through declining marginal rates rather than through increasing marginal rates). 46 florida tax review [vol. 5:1 the lowest marginal rate should be reduced to 10%. if a single taxpayer had282 taxable income of $15,000, that taxpayer’s tax would be $2,250 under the current marginal rate structure. alternatively, if congress reduced the lowest marginal rate to 10%, that taxpayer’s tax would be $1,500. this represents an annual tax saving of $750. the tax liability is 33% lower than the liability under the current rates. by comparison, if you assume that the single taxpayer reported taxable income of $300,000, under the current rate structure the tax liability would equal $99,572. if, however, the lowest income tax bracket were lowered to 10%, that taxpayer tax liability would be $98,467. the integrity of the progressive tax system would be protected as the higher income taxpayer’s annual tax saving is $1,105, but the tax liability is reduced by only 1%. if a taxpayer had $50,000 of taxable income, the tax liability under the current scheme would equal $11,127. alternatively, under the proposed scheme, the tax liability would equal $10,022. the taxpayer’s liability is reduced by 10%. consequently, the higher income taxpayer will receive an annual tax savings in the same amount as any taxpayer with taxable income of at least $22,100, but the percentage of tax savings is higher for lower income taxpayers. d. viability of proposal professor graetz has stated that five principles must be addressed to establish whether a particular tax is viable: whether the tax is fair, easy to comply and administer, conducive to economic growth, produce adequate revenue and provide little interference with private economic decisions. in283 282. president george w. bush’s plan includes a reduction in the lowest rate to 10%, but the income ceilings are $6,000 for single taxpayers and $12,000 for married taxpayers filing joint returns. see pocketbook politics: how tax plans would affect you, wall st. j., oct. 4, 2000, at c1, c21. 283. michael j. graetz, the decline (and fall?) of the income tax 10 (1997) [hereinafter graetz]. it is difficult to conceive a tax system that is fair but does not conflict with the other 4 tax principles. as professor graetz points out: [b]oth economic efficiency and equity generally support uniform income tax treatment of sources and uses of income. in other circumstances, however, equity and efficiency conflict. for example, tax fairness might support taxing all sources of income when economic efficiency argues for taxing consumption or wages. likewise, the disincentives for earning income may be greater under a progressive rate structure that applies higher rates to greater amounts of income, but a society’s sense of tax justice may demand such progressivity. see graetz, supra, at 12. see also deborah l. paul, the sources of tax complexity: how much simplicity can fundamental tax reform achieve?, 76 n.c. l. rev. 151, 155 (1997) (“[c]omplexity is a by-product of a tax regime’s reconciliation of the lofty aspiration to distribute tax burdens equitably and the mundane requirement that the tax be susceptible to administration and compliance.”). 2001] the widening gap under the internal revenue code 47 determining whether the proposal to alter the income tax rates, these five principles will be addressed. 1. the fairness of the reduction of the lowest marginal tax rate.—as already noted in this article, there is no consistent interpretation of fairness under the tax statute. while an amendment to the income tax laws may be considered fair to one individual, it also may be considered to be a most inequitable amendment to another individual. any amendment of a tax statute to increase the tax burden of the wealthy in order to reverse the erosion of the progressive tax system would raise issues of fairness. furthermore, it would provide no tangible tax benefit to the lower income taxpayers. alternatively, if congress expanded the earned income tax credit to make it more inclusive, it would not survive the inevitable criticism that it went beyond its intended purpose and unfairly reallocated wealth. a more practical approach of increasing progressivity is to either lower the lowest marginal bracket or to increase the lowest marginal tax bracket to include more lower to middle income taxpayers. while the increase in the lowest marginal rate would provide a substantial tax savings to the lower to middle class taxpayers, it would also provide a minimum benefit to upper income taxpayers by a slight reduction in their effective tax rates. it would not, however, provide any benefit to lowincome taxpayers. this is particularly problematic for the category of lowincome taxpayers that are unable to take advantage of the earned income tax credit. hence, while the increase in the 15% bracket has its advantages, it is not entirely equitable because it prevents a small class of taxpayers from sharing in the benefits. conversely, a reduction of the lowest progressive rate would benefit taxpayers in every income bracket. in reversing the past erosion of the progressive tax system, every taxpayer, irrespective of the taxable income, will enjoy the tax benefits by sharing in the tax cut. 2. simplicity and compliance.—during 1989, former representative and house ways and means committee member barber conable reflected on his days in congress and causal forces behind the code’s complexity. he284 coined the phrase “abc syndrome” to explain the complexity underlying the tax code. based on his experience, the abc syndrome unfolds upon the285 enactment of a tax provision and the subsequent interaction with constituents complaining about the inequitable impact of the provision. the constituent states “[w]hat you have done in the tax system is fundamentally all right, but i have a very unusual situation, you see, and it is not fair for me to have to be taxed this way just because my neighbor thinks it is all right.” upon286 284. see barber b. conable, jr., congress and the income tax (1989). 285. see id. at 40-41. 286. see id. at 41. 48 florida tax review [vol. 5:1 reflection, members of the house ways and means committee are persuaded that an exception should be created for all a’s who qualify. subsequently,287 another constituent, b, approaches a congressional member and expresses concern about the adverse effect of the exception created for a. in288 recognizing the inequity impacting b and those similarly situated, another exception is created. the phenomenon continues and eventually spirals into289 tax complexity.290 some scholars have argued that the very nature of progressive taxes complicate the tax system and encourage tax avoidance. concededly, the291 progressive tax system is inordinately complex; however, it does not follow292 that every amendment will be difficult to administer. one advantage to a tax cut in the form of a rate reduction or an increase in the 15% tax bracket is tax simplification. it would be easy to administer, and congress would circumvent the “abc syndrome”. it is much more practical to reduce taxes by lowering the tax rates rather than enacting additional deductions, exclusions and credits. by simply lowering the marginal bracket, congress is able to cut taxes without the necessity of a complex set of instructions, schedules and regulations. 3. economic growth.—one of the criticisms of a progressive tax system is that results in a disincentive for taxpayers to maximize their income opportunities. if the highest marginal rates are increased, an argument could293 be made that it impedes income generation and economic growth. the argument revolves around a purported disincentive for taxpayers to increase 287. see id. 288. see id. 289. see id. 290. see id. another factor contributing to complexity in the tax statute is congress’s promotion of social policy. many tax experts believe that the promotion of social policy thwarts the objective of raising revenue and has made the code inordinately complex. see, e.g., sheldon d. pollack, the failure of u.s. tax policy: revenue and politics 243 (1996); stanley s. surrey, tax incentives as a device for implementing government policy: a comparison with direct government expenditures, 83 harv. l. rev. 705 (1970) 291. see blum & kalven, supra note 25, at 14. 292. this article is not intended to provide a recommendation as to how the tax statute could be reformed to make it simpler. professor jonathan barry forman conducted an in-depth project on how the taxing statute could be revamped to simplify it for low-income taxpayers. see jonathan barry forman, simplification for lowincome taxpayers: some options, 57 ohio st. l. j. 145 (1996). professor forman stated that it might not be possible to for all taxpayers, but it was possible to simplify the taxing scheme for low-income taxpayers and outlined several proposals to carry out that objective. 293. see blum & kalven, supra note 25, at 21. 2001] the widening gap under the internal revenue code 49 their earnings because of the graduated tax rates. while this argument is worthy of consideration, the empirical data does not lend support to this theory.294 4. production of revenue.—if revenue production were irrelevant, equity and efficiency would result in the repeal of all taxes. however, the295 primary purpose of the income tax is to generate income for government operations. the lowering of the bottom tax bracket is not cost prohibitive. based on the irs statistics from 1997, the projected annual cost of the rate reduction would be approximately $36 billion per year.296 with a projected surplus of $1.9 trillion for the next ten years, implementation of the proposal would have little impact. moreover, the projected cost of implementation is substantially less than the projected $792 billion proposal vetoed by former president clinton and the proposals submitted by the frontrunners in the recent presidential election. 5. interference with private economic decisions.—the code is replete with numerous provisions designed to encourage desired behavior. it is,297 therefore, difficult to enact tax provisions that do not interfere with private economic decisions. however, the lowering of the bottom tax bracket or expansion of the bottom tax bracket would not interfere with private economic decisions. v. conclusion when the historic income tax act of 1913 was enacted, congress implemented a progressive tax structure. the fundamental principle underlining the progressive tax structure is that responsibility for the federal tax burden should be based on an ability-to-pay concept. that principle has continued vitality today. there is considerable evidence establishing that congress has been eroding the progressive tax structure. this is particularly apparent between the lower to middle income level taxpayers and upper income 294. for example, after congress increased the graduated rates during 1993, adjusted gross income for individuals earning $1,000,000 or more increased each year after the amendment. see supra notes 161-70 and accompanying text. 295. see jeffrey l. kwall, the uncertain case against the double taxation of corporate income, 68 n.c. l. rev. 613, 633-34 (1990). 296. during taxable year 1997, the income tax after nonrefundable credits totaled $729 billion. see internal revenue service, 19 statistics of income bulletin 194 (summer 1999). upon reducing the lowest marginal rate by 5%, the income tax would total $693 billion. 297. see, e.g., irc § 1(h) (favorable capital gain rates designed to encourage long-term investments); irc § 163(h)(1), (2) (mortgage interest deductible which effectively encourages homeownership over renting), irc § 170 (charitable contribution deduction provides an incentive for charitable giving). 50 florida tax review [vol. 5:1 taxpayers. it is probable that congress has protected some progressivity between the middle to upper income taxpayers and the wealthiest taxpayers. the middle to upper income taxpayers are readily able to benefit from the numerous tax cuts enacted during the 1990’s such as roth iras, educational iras, hope and lifetime learning credits and student loan interest deduction. the current system fails because it does not adhere to the ability-to-pay principle because many taxpayers’ after tax income leaves them with incomes below the poverty level. for taxpayers that do not qualify for the earned income tax credit, they will be able to retain a greater portion of their income that will enable them to move closer to the poverty level. taxpayers that are in the lower to middle income level who have been unable to share in recent tax cuts undoubtedly will be able to benefit under this proposal. the proposal to reduce the lowest tax rate is fair because most taxpayers will be able to share in the tax cut. the proposals submitted by both the frontrunners in the presidential election fail to satisfy the concept of fairness. president george w. bush’s proposal is unfair because he targets the wealthy taxpayers. former vice-president gore’s proposal was equally unfair because it targets the low-income and middle-income taxpayers. one of the most important aspects of the proposal is that it is consistent with the progressive tax structure that is inherent in the code. table ii a tax morale approach to compliance: recommendations for the irs florida tax review volume 8 2006 number 6 a tax morale approach to compliance: recommendations for the irs by marjorie e. kornhauser summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601 i. introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602 ii. methodology and its limitations. . . . . . . . . . . . . . . . . . . . . . . . 604 a. methodology. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604 b. limitations of the literature. . . . . . . . . . . . . . . . . . . . . . . . . . . 605 iii. literature review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 606 a. cognitive and affective processes. . . . . . . . . . . . . . . . . . . . . . 607 1. framing: prospect theory. . . . . . . . . . . . . . . . . . . . . . 609 2. short cuts/worlds views. . . . . . . . . . . . . . . . . . . . . . . 610 b. social norms and personal values. . . . . . . . . . . . . . . . . . . . . 612 c. impact of external factors on internal motivations. . . . . . . . 617 d. demographic factors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620 e. using tax morale to increase compliance. . . . . . . . . . . . . . . 622 f. summary of tax morale literature. . . . . . . . . . . . . . . . . . . . . 625 iv. recommendations.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 626 a. establish behavioral science unit. . . . . . . . . . . . . . . . . . . . . . 627 1. scope. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627 2. personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627 3. functions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 628 a. research and analysis. . . . . . . . . . . . . . . . . . 628 b. educational/training component.. . . . . . . . . 629 b. adopt “tax morale” model. . . . . . . . . . . . . . . . . . . . . . . . . . . 630 c. establish educational and media programs. . . . . . . . . . . . . . 630 1. rationale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630 2. goals of education.. . . . . . . . . . . . . . . . . . . . . . . . . . . 632 3. examples of specific educational programs. . . . . . . . 634 d. design curriculum for schools. . . . . . . . . . . . 634 b. “deliberation day” discussions. . . . . . . . . . 634 c. annual income statement. . . . . . . . . . . . . . . . 634 599 600 florida tax review [vol. 8:6 4. suggestions regarding media media campaigns. . . 634 a. public service ads using marketing principles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635 b. using the internet and videos. . . . . . . . . . . . . 636 c. creative use of the media and media talent . 636 d. additional specific suggestions. . . . . . . . . . . . . . . . . . . . . . . . 636 1. demographic factors. . . . . . . . . . . . . . . . . . . . . . . . . 636 2. irs procedures to improve procedural justice. . . . . . 637 3. reconsideration of nomenclature: customer v. taxpayer. . . . . . . . . . . . . . . . . . . . . . . . . . . 637 4. compensatory measures, including apologies. . . . . . 638 5. shaming/publicity. . . . . . . . . . . . . . . . . . . . . . . . . . . . 638 6. rewards. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639 7. tax preparer education and/or registration requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639 v. conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640 2007] a tax morale approach to compliance 601 a tax morale approach to compliance: recommendations for the irs by marjorie e. kornhauser* summary why do people follow the law? the answer, under the traditional theory of compliance, is fear of detection and punishment. the deterrence model, however, accounts for only a minor portion of actual compliance levels. it has such poor explanatory power because it assumes that the decision to comply is based solely on a rational cost-benefit analysis in which people weigh the benefits of non-compliance against the costs of detection and penalties. recent literature reveals, however, that the decision to comply is not purely rational. rather, personal values, social norms, and non-rational cognitive processes also strongly affect the decision. what holds true for law in general holds true for tax compliance specifically. traditional methods of enforcement through audit and penalties explain only a small fraction of voluntary tax compliance. theorists and researchers attribute the vast majority of compliance to what they loosely describe as internal motivations or “tax morale.” the field is still young, the subject complex, and some of the empirical data is inconclusive. nevertheless, the literature clearly indicates that tax morale plays a major role in tax compliance. although neither the exact components of tax morale nor the precise mechanisms by which they work have yet been fully delineated the literature has identified certain elements. research shows that tax compliance is affected by (social and personal) norms such as those regarding procedural justice, trust, belief in the legitimacy of the government, reciprocity, altruism, and *©marjorie e. kornhauser, professor of law, sandra day o’connor college of law, arizona state university. this article appeared in the december 31, 2007 annual report to congress of the national taxpayer advocate, which commissioned this research. 602 florida tax review [vol. 8:6 identification with the group. cognitive processes, such as prospect theory, also influence an individual’s reaction to tax issues. studies also indicate that certain demographic factors such as age, gender and education correlate with the tax morale. the components of tax morale, like internal motivators in other areas of the law, are not static. they interact with each other and the environment and are influenced by each individual’s own cognitive framework. consequently, an external agent, such as the irs, can influence tax morale norms and thereby tax compliance. it can activate compliance norms in a variety of ways including education, properly framing communications, fair procedures, and a regulatory framework that incorporates current and future findings of tax morale research into its operations and dealings with taxpayers. the report makes three major recommendations. first, the irs should establish a department devoted solely to exploring tax morale issues and implementing the findings. second, the irs should adopt a tax morale approach to tax compliance that recognizes the importance of taxpayers’ internal motivations and the effects on these motivations of societal conditions and institutions (such as the irs) that interact with them. third, using behavioral science research, the irs should implement ongoing educational (long term and short term) programs and media campaigns. since the subject of this report is tax compliance of individual taxpayers, both the literature review and the recommendations focus on individuals. both the tax morale concept and this report, however, are relevant for all taxpayers. i. introduction if people hate taxes so much why do they pay them? the common, seemingly obvious, answer – fear of being caught cheating – is only a partial answer. in fact, the “obvious” answer – based on the rational cost/benefit analysis of traditional economic theory – explains so little of tax compliance that “[t]he puzzle of tax compliance is why people pay taxes instead of evading them.” the key to the puzzle is “tax morale,” the collective name for all the1 non-rational factors and motivations – such as social norms, personal values and various cognitive processes – that strongly affect an individual’s voluntary 1. lars p. feld & jean r tyran, tax evasion and voting: an experimental analysis, 55 kylkos 197, 197 (2002). the traditional model of deterrence, based on detection and penalties, states that compliance with the law is a function of enforcement levels; a rational individual weighs the costs of non-compliance against the benefits. in the tax evasion context, this model states that a risk-averse taxpayer will engage in an amount of tax evasion that will maximize expected utility of income which is a function of “(i) the probability of detection, (ii) the penalty tax rate applied when tax evasion has been detected, (iii) the marginal tax rate, and (iv) the level of true income.” werner w. pommerehne & hannelore weck-hannemann, tax rates, tax administration and income tax evasion in switzerland, 88 pub. choice 161, 162 (1996). 2007] a tax morale approach to compliance 603 compliance with laws. higher tax morale correlates with higher tax2 compliance. although the exact components of tax morale are not yet fully delineated, congress and the irs should begin now to shape and administer income tax laws in accordance with tax morale findings. delay can only increase the chance that voluntary compliance will deteriorate given the interaction of an individual’s tax morale with elements of the external environment, such as other people and institutions. the tax gap, for example, is more than a problem of lost revenue; it is a visible sign of non-compliance that can create a downward spiral. non-compliance among other taxpayers can decrease an individual’s own tax morale and compliance. once tax morale dips,3 it is hard to restore it to prior levels. ironically, then, the more the tax gap is4 publicized, the greater this danger becomes. congress and the irs must act now to narrow the tax gap and to foster compliance generally. this report offers the irs several concrete suggestions for improving individual taxpayer compliance based on the tax morale literature. part ii discusses methodology and the limitations of empirical research. part iii briefly 2. “voluntary” in this context, of course, means compliance without any actions taken by the tax collection agency. the literature is vast. tax morale research is part of the more general field of inquiry into why people comply with laws generally. two seminal books in the larger field are: robert c. ellickson, order without law: how neighbors settle disputes (1991); tom tyler, why people obey the law (1990). in the tax evasion context, the traditional deterrence model states that a riskaverse taxpayer will engage in an amount of tax evasion that will maximize expected utility of income which is a function of “(i) the probability of detection, (ii) the penalty tax rate applied when tax evasion has been detected, (iii) the marginal tax rate, and (iv) the level of true income.” michael allingham & agnar sandmo, income tax evasion: a theoretical analysis, 1 j. pub. ec. 323 (1972); kim m. bloomquist, tax evasion, income inequality and opportunity costs of compliance, nat’l tax ass’n proc., ninety-sixth ann. conf. 2003, 19 (2004). the literature on tax morale alone is large. some literature reviews include: james andreoni, brian erard & jonathan feinstein, tax compliance 36 j. econ. lit. 818, 835 (1998)(only a few empirical studies on tax compliance before 1980); benno torgler, speaking to theorists and searching for facts: tax morale and tax compliance in experiments 16 j. econ. surv. 657 (2002). that the majority of knowledge in this area has occurred only in the past 5-7 years is evidenced by the rudimentary knowledge provided in the 1998 andreoni et al. review of the literature , as compared to later research. 3. bruno s. frey & benno torgler, tax morale and conditional cooperation, 35 j. comp. econ. 136, 153 (2007). 4. see, e.g., jon s. davis, gary hecht & jon d perkins, social behaviors, enforcement, and tax compliance dynamics, 78 acc. rev. 39, 39 (2003); ernst fehr & armin falk, psychological foundations of incentives. 46 european econ. rev. 687 (2002); jan schnellenbach, tax morale and the taming of leviathan, 17 const. pol. econ. 117, 130 (2006); michael wenzel, misperceptions of social norms about tax compliance: from theory to intervention, 26 j. econ. psychol. 862 (2005). 604 florida tax review [vol. 8:6 describes the tax morale literature, focusing on the main findings regarding: 1) cognitive and affective processes; 2) personal and social values/norms, especially procedural justice, legitimacy, reciprocity, and trust; 3) external activation and suppression of tax morale; 4) demographic factors, and 5) a new tax morale model for tax administration. part iv contains recommendations for the irs. it presents three major recommendations and several more specific proposals for the irs to improve individual taxpayers’ voluntary compliance. first, the irs should establish a department devoted solely to exploring tax morale issues and implementing the findings. second, the irs should adopt a tax morale model of operation that incorporates the findings of the research and seeks to respond to, and strengthen taxpayers’ internal motivations to comply. third, using tax morale research, the irs should implement ongoing educational (long term and short term) programs and media campaigns. although sticks as well as carrots are needed to ensure compliance, this report examines only the carrots. part v provides a short conclusion. ii. methodology and its limitations a. methodology this report surveys recent literature concerning the “tax morale” model of tax compliance. it examines some of the cognitive processes involved, such as framing, but it concentrates on the moral, psychological, and social factors influencing tax compliance. the report reviews a large quantity of tax morale literature but it is not comprehensive. it focuses on literature published in the last 5 years, which builds on and refines the first wave of literature. within this time period, the report reviews a substantial amount of the existing literature but not all since a comprehensive review would be both extremely lengthy and repetitive. the report examines empirical tax compliance literature in a variety of related fields such as behavioral economics and psychology, cognitive psychology, social psychology, and law, paying particular attention to tax morale (sometimes called taxpayer ethics.) some of the studies pertain to other5 countries, or are comparative in nature. in order to provide greater context, the reviewer also briefly examined literature pertaining to norms, cognition, and the law generally. 5. benno torgler & friedrich g. schneider, what shapes attitudes toward paying taxes? evidence from multicultural european countries (may 2006). iza discussion paper no. 2117 at http://ssrn.com/abstract=901247, at 3 (citing earlier studies). 2007] a tax morale approach to compliance 605 for added perspective, the reviewed literature includes materials in the fields of compliance with environmental laws and advertising/marketing. compliance with environmental law has many similarities to tax compliance. although some environmental laws do contain traditional “stick” deterrents such as fines, enforcement at the individual level largely depends on voluntary compliance, as in tax. moreover, environmental and tax compliance share common collective action problems since the individual’s benefits from compliance are often attenuated and individual behavior is largely not visible to others. marketing/advertising literature – with its long history of researching and applying knowledge of the psychological and social aspects of human behavior– is also relevant to tax compliance. moreover, unlike the artificial environment of a controlled lab experiment, marketing occurs in the real world. consequently, results in this field allow for the interplay of a variety of influences and may be observed over time. the literature was obtained through searches on various databases such as: lexis, westlaw, science direct, econlit, and jstor as well as various web pages such as that of the irs and ato. in addition to the literature review, the writer interviewed several professionals in the uk – both in treasury and hmrc – in order to obtain an overview of the uk perspective on compliance. these interviews occurred in may 2007. b. limitations of the literature both theoretical and empirical research have limitations. theories, of course, are limited by their point of view and their assumptions. empirical research also has limitations. for example, how questions are phrased, and in what order, can affect responses. the gap between belief, intention and action can also result in unreliable responses. self-reporting creates problems – there is a difference between what people report they believe and/or would do and what they actually believe or would do. this results from a variety of factors ranging from the fact that people often imperfectly perceive their own motivations, to the fact that people often report what they think the interviewer wants or what they think (or are told) the topic is.6 6. self-perception theory, in fact, is based on the assumption that people have imperfect knowledge of their motivations. see, e.g. fehr & falk, supra note 4, at 714 (“a crucial assumption of self-perception theory is that individuals do not have perfect knowledge about the reasons for performing a task.”). accord, eric kirchler, apolonia niemirowski & alexander wearing, shared subjective views, intent to cooperate and tax compliance. similarities between australian taxpayers and tax officers, 27 j. econ. psychol. 502, 514 (2006)(imperfect self-perceived motivation); torgler & schneider, supra note 5, at 11 (people overstate their compliance); viswanath umashanker trivedi, mohamed shehata & stuart mestelman, attitudes, incentives, and tax compliance, 53 canadian tax j. 29, 60 (2005)(lab experiments do not reflect real606 florida tax review [vol. 8:6 sampling issues also influence emprical results. the population studied may not be representative. different groups have different characteristics (e.g., age, gender) which may obscure the causes of the results. did the subjects, for example, respond in the way they did simply because of the apparent variable (e.g. presentation of numbers of taxpayers who evade) or were their reactions also influenced by the fact that the majority of the sample population was a particular age or gender. results can also be skewed by what is called the “isolation” effect which causes people to focus on the information presented to them and ignore that which is not. as a consequence people’s decisions7 frequently do not form a consistent whole. in the experimental context this means that a different outcome might occur if the survey question, or experiment, were presented in a different context with different salient facts. one of the more important limitations of empirical research regarding compliance is the fact that much of the research has been conducted in a controlled laboratory situation. although this allows researchers to isolate individual effects, it also weakens the results. in any controlled experiment, there is always the question of whether what the subject does in the controlled environment represents what s/he would do in the real world. this is amplified in the tax compliance area because it is often the confluence of a variety of factors that influence compliance. moreover, many aspects of tax compliance8 develop over time so that even a laboratory study that involves a sequence of “games” or interactions may not capture the effects that develop over time. it is important to keep these limitations in mind when reading this literature review. iii. literature review tax morale refers to taxpayer attitudes and beliefs – not behaviors – but researchers are investigating the connection between the former and the latter. at its broadest, tax morale is an imprecise term – encompassing all the nonenforcement aspects of tax compliance. current research is deconstructing this undifferentiated black box into its components. some of these components are9 life decisions, self-presentation problems ranging from poor memory of past behavior to desire to look good in eyes of experimenters). 7. edward mccaffery & jonathan baron, the political psychology of redistribution, 52 ucla l. rev. 1745, 1752,1791 (2005). 8. see, e.g., robert b. cialdini, social motivations to comply: norms, values, and principles in 2 taxpayer compliance 200, 201 (jeffrey a. roth & john t. scholz eds., 1989). 9. richard m. bird, jorge martinez-vasquez & benno torgler, tax performance in developing countries: the role of demand factors, nat’l tax ass’n, proc. ninety-seventh ann. conf. 2004, 284, 287 (2005).(tax morale is the “intrinsic motivation to pay taxes”); lars p. feld, & bruno s. frey, trust breeds trust: how taxpayers are treated, 3 econ. of governance 87, 88-9 (2002); torgler & schneider, supra note 5, at 3. (tax morale as the “moral obligation to pay taxes, a belief in 2007] a tax morale approach to compliance 607 intrinsic factors – individual traits that motivate a person to comply such as a personal sense of integrity or degree of altruism. others more directly relate to external conditions or societal norms such as procedural justice, trust in government, or the form of government. external and internal factors,10 however, interact and researchers are examining the ways in which internal motivations interact with external ones, each influencing and affecting the other and how cognitive processes can influence both. this part provides a short overview of three major areas in the rapidly growing field of tax morale research: cognitive and affective processes, social norms, personal values/norms, and demographic factors. it then briefly describes a new model of a tax authority, frequently called a responsive or selfregulatory model, based on tax morale findings. a. cognitive and affective processes cognitive and affective processes are unconscious mechanisms that influence a person’s perception and response to information, people, and the environment. two cognitive processes are of particular importance to compliance. one is “framing.” the manner in which acts, stimuli, or situations are presented – or framed – can affect a person’s reaction to it. this effect is evident in surveys that result in different responses depending on what order questions are posed, for example, or whether the question is posed in the positive or negative. labels also matter. for example, people generally react more favorably when a payment is called a fee rather than a tax. framing also11 affects various other tax attitudes such as preferences for progressive or flat rates, levels of taxes, and government spending. one of the most important12 types of framing involves prospect theory, described below. contributing to society by paying taxes.”) schnellenbach defines tax morale ‘pragmatically’ ‘as the phenomenon that taxpayers (1) on average evade less taxes than an optimization calculus incorporating only expected judicial punishment and reasonable levels of risk aversion would predict and (ii) systematically adjust their evasion levels according to how satisfied they are with public policy, processes of collective decision-making and the quality of their relationship to authorities.” schnellenbach, supra note 4, at 118. 10. see, e.g., james alm & benno torgler, culture difference and tax morale in the united states and in europe, 27 j. econ. psychol. 224, 226 (2006)(arguing that “tax morale is likely to be influenced by such factors as perceptions of fairness, trust in the institutions of government, the nature of the fiscal exchange between taxpayers and government, and a range of individual characteristics.” 11. mccaffery & baron, supra note 7, at 1760. this is not true, however, in regards to existing services that are funded by a general tax. in that situation, respondents do not prefer a fee because they perceive it as paying for a service/good that they are already getting for “free.” id. 12. id. 608 florida tax review [vol. 8:6 the other important cognitive process is what this report labels “shortcuts.” shortcuts encompass a variety of overlapping, somewhat amorphous, concepts variously called heuristics, cultural cognitions or13 14 schemas. collectively, they are the mechanisms that allow people to respond quickly to the otherwise overwhelming amount of stimuli that bombard them daily. shortcuts create general “rules of thumb” that allow individuals to efficiently acquire, store, organize and retrieve knowledge; they influence a person’s perception of new data and his/her reactions to it. shortcuts involve both cognitive and affective processes and are the product of various factors such as cognitive processes (such as framing), psychological traits, prior experiences, social and personal norms. different world views or cultural cognition shortcuts incorporate different norms and values. a person with an individualist world view, for example, strongly incorporates the norms of self-reliance, independence, and effort whereas the values of a person holding the opposite collectivist view would emphasize equality, reciprocity, cooperation, and so forth. some world views (cultural cognitions or schemas) are associated with particular demographic groups – racial, religious, regional, gender, or age-based for example. shortcuts generally do not change in the face of new information because they are based on values not information. as a consequence, kahan15 and braman argue that successful policies must be framed so as to appeal to people with different views. tradable emission permits are an example of such a policy. individualists like the permit policy, they claim, because its market16 mechanism appeals to their belief in private enterprise; “hierarchists” support it because it leaves power in the hands of powerful commercial entities, and egalitarians and collectivists support it because it recognizes their goal of improving air pollution and the need to constrain industry.17 13. see, e.g. john t. scholz & neil pinney. duty, fear, and tax compliance: the heuristic basis of citizenship behavior, 39 am. j. pol. sci. 490, 491 (1995).(heuristic as cognitive short cut). 14. dan kahan & donald braman, cultural cognition and public policy. 24 yale l. & policy, 149 (2005). 15. id, at 152-3. 16. id. at 169. 17. id. french abortion reform that ‘conditioned abortion on an unreviewable certification of personal “distress”is another example. that policy made it possible for both religious traditionalists, who interpreted certification as symbolizing the sanctity of life, and egalitarians and individualists, who interpreted unreviewability as affirming the autonomy of women, to see their commitments affirmed by the law.” id. at 168. 2007] a tax morale approach to compliance 609 1. framing: prospect theory prospect theory is probably the framing effect most relevant to tax compliance. the theory, which explains how people evaluate risk, holds that18 people are risk averse in regards to gains but risk-seeking in regards to loss. consequently, the manner in which a decision is framed will affect a person’s willingness to take risks. in income tax, for example, whether an issue is framed as a bonus for those with children (such as a child credit) or a penalty for the childless will affect a taxpayer’s attitude toward the provision. it also means19 that a taxpayer will be more willing to take risks (not comply) when the issue is framed as a loss (penalty from an audit) than as a gain (a bonus from a refund). consequently, the manner in which information is communicated to20 a taxpayer can have a major impact on his willingness to comply with the tax laws. according to prospect theory, tax compliance should increase if paying taxes is seen as a gain not a loss. if a taxpayer views his situation as interconnected with the nation’s either because s/he is a collectivist (see world view below) and/or through identification with the nation, then taxpaying is more likely to be viewed as a gain than a loss. one study suggests that if a21 taxpayer views taxes as a national obligation, then after tax income is the taxpayer’s reference point and therefore tax compliance decisions are made in the gain domain, which leads taxpayers to pursue risk averse behavior. on the other hand, if the taxpayer considers paying taxes as loss, then his/her reference point would be their income before tax. in this case, the taxpayer will be likely to engage in risk-seeking behavior.”22 18. john cullis, philip jones & alan lewis, tax framing, instrumentality and individual differences: are there two different cultures? 27 j. econ. psychol. 304, 306 (2006). see, generally, choices, values, and frames (daniel kahneman & amos tversky eds., 2000). 19. mccaffery & baron, supra note 7, at 1758. 20. cullis et al., supra note 18, at 306. 21. see, phillip hansen, taxing illusions, taxation, democracy and embedded political theory 16 (2003)(for citizens “the issue of what politics means and what kind of democracy is desirable turns on a fundamental question…: to what extent can my purposes be fulfilled only together with others; indeed to what extent are my purposes our purposes. . . . with respect to taxation, this raises the question of whether taxes are charges imposed on us by remote political authorities we are always reluctant to pay and do so only because we are coerced, or whether they are self-imposed levies, expressions of our commitment to the well-being of all.”). 22. viswanath umashanker trivedi, mohamed shehata & bernadette lynn, impact of personal and situational factors on taxpayer compliance: an experimental analysis 47 j. bus. ethics 175, 179 (2003). 610 florida tax review [vol. 8:6 2. short cuts/worlds views several world views with deep roots in america are especially relevant to tax compliance. two interrelated ones involve the twin political foundations of american democracy: equality and liberty. the first world view concerns the relationship of the individual to the group (individualistic versus collective orientation; the second view concerns the nature of society (hierarchical versus egalitarian). individualistic, hierarchical people emphasize negative liberty23 more than equality and therefore look to the individual, not the government, to solve social problems. such a taxpayer will be less likely than a collectivist/egalitarian taxpayer – who emphasizes equality and positive liberty – to support higher or redistributive taxes. a collectivist-oriented and/or egalitarian individual will be more willing to pay taxes even if her tax burdens exceed her individual benefits (i.e., no material fiscal exchange equity) if the taxes help the group. moreover, this person might consider the reduction of inequality and the provision of goods to others a benefit when determining whether there is fiscal equity. she will see24 paying taxes as a gain, fulfilling personal desires and civic obligations and not just a loss of personal income. as a result, according to prospect theory, she will be risk-averse and more willing to comply. two other “schemas” or “world views” with deep historical roots in american history and politics can negatively influence tax compliance – a general anti-tax schema and an anti-establishment schema. as to the first, although tax compliance – and tax morale – is relatively high in the united states compared to other countries, many americans harbor strong anti-tax sentiments which are part of a national anti-tax schema that reaches back to the founding of the nation and forward to the present. protesting a tax by dumping tea in the boston harbor was patriotic in the 18th century and this symbolic gesture resonated in the 20th century when the internal revenue code was dumped into the harbor. many tie freedom from tax to liberty and to be anti-tax is seen as patriotic. there is some evidence that an anti-establishment schema,25 23. see, e.g., kahan & braman, supra note14, at 153 (citing mary douglas and political scientist aaron wildavsky, risk and culture (1982)); daniel w. barrett, wilhelmina wosinska, jonathan butner, petia petrova, malgorzata gornik-durose & robert b. cialdini, individual differences in the motivation to comply across cultures: the impact of social obligation, 37 personality and individual differences 19 (2004). 24. see, e.g., barrett, et al., supra note 23. accord, michael wenzel, an analysis of norm processes in tax compliance, 25 j. econ. psychol. 213, 222(2004) (finding that social norms that are internalized as personal norms positively affect compliance, but otherwise do not have a significant effect). 25. president reagan, for example, on the signing of the tax reform act of 1986, called the prior code “un-american” stating that “throughout history, the oppressive hand of government has fallen most heavily on the economic life of the individuals. and, more often than not, it is inflation and taxes that have undermined livelihoods and constrained their freedoms.” president reagan’s remarks during tax 2007] a tax morale approach to compliance 611 perhaps more prevalent with those who have an anti-tax and/or individualistic view, is significantly related to tax compliance. like the anti-tax schema the26 anti-establishment schema – a jeffersonian belief that small government is the best government – has deep roots in the american psyche. logically, a person operating under this schema might support a small tax that pays for the small amount of necessary government. however, in practice, antipathy to government and antipathy to tax frequently accompany each other, especially if the tax and the government are larger than one prefers. world views not only affect attitudes towards a substantive policy, but also affect responses to methods of enforcing the policy. a policy may be consistent with a person’s world view, but the method of enforcement may not. shaming is an example of such a policy. recently, shaming has gained attention in several legal areas such as criminal law as an alternative to more traditional enforcement techniques such as imprisonment. it is also being used in the tax area. several states, such as alabama, california, north carolina and wisconsin have used shaming devices by publicizing the names of delinquent taxpayers. even the internal revenue code has a limited amount of shaming: section 6039g(d) publicizes in the federal register the names of taxpayers who expatriate for tax reasons. in some situations, however, shaming sanctions may not only be ineffective but they may also backfire. they are ineffective on individuals who are not ashamed of their behavior and/or are not concerned for other reasons such as reputation that others know they have violated a compliance norm. shaming may also be ineffective for a person who has internalized the norm but has an individualistic world view. such a person will be hostile to shaming, which is based on a collectivist, communal world view, and that hostility may even undermine support for the underlying policy.27 people with different world views/cultural cognitions may have some social norms and personal norms that are the same, but others that differ. a bill signing ceremony (oct. 22, 1986) reprinted in 33 tax notes 413 (oct. 27, 1986). see also, excerpts from the president’s 1988 legislative and administrative message to congress, 38 tax notes 499 (feb. 1, 1988) (“if individuals are to possess genuine autonomy then they must be free to control their own resources, to enjoy the fruits of their labor, and to keep what they earn, free from excessive government taxation and spending.”). see generally marjorie e. kornhauser, legitimacy and the right of revolution: the role of tax protests and anti-tax rhetoric in america, 50 buff. l. rev. 819 (2002). 26. trivedi, shehata & lynn, supra note 22, at 177, 187 (finding that a taxpayer’s level of anti-establishment is statistically significantly related to tax compliance). 27. dan m. kahan has recanted his support of shaming in the criminal law area because of its divisive nature. dan m. kahan, what’s really wrong with shaming sanctions (2006) ssrn 914503, at http://papers.ssrn.com/abstract=914503. (arguing that sanctions, like the policies they enforce, must be devised in as ambiguous a way as possible so as to appeal to people with diverse world views; shaming is too divisive). 612 florida tax review [vol. 8:6 taxpayer with an individualistic world view, for example, is less likely to have egalitarian values than a collectivist. both, however, may follow the same norm of procedural fairness. the next section examines some of the social norms and personal values that affect tax morale generally. b. social norms and personal values both social and personal norms affect tax morale. social norms – shared beliefs concerning the manner in which people should behave – are enforced by informal social sanctions. they are external to individuals28 whereas personal (moral, ethical) norms or values are internal. when a person internalizes a social norm, it becomes a personal one. internalized personal norms are more likely to affect behavior in large groups, especially in situations where an individual’s actions are not readily observable by others. social norms are less influential in this type of situation because of the problems of freeriding and the difficulty of imposing sanctions.29 some internal norms have strong positive impacts on tax compliance. values indicating high moral reasoning – honesty and altruism, for example – provide internal rewards that can positively affect tax compliance. a person30 may act on this personal norm regardless of what others are doing. however, 28. see, e.g., ivar kolstad, the evolution of social norms: with managerial implications, 36 j. socio-econ. 58 (2007). accord ernst fehr & urs fischbacher, social norms and human cooperation, 8 trends in cognitive sciences 185,185 (2004)(“social norms are standards of behaviour that are based on widely shared beliefs how individual group members ought to behave in a given situation.”). 29. studies show, for example, that people are more likely to recycle – an action that may not be easily observable or have much effect if others do not similarly recycle – if they believe it is good for the environment or a civic duty. see, e.g., thomas c. kinnaman, explaining the growth in municipal recycling programs: the role of market and nonmarket factors, 152 in the economics of household garbage and recycling behavior (don fullerton & thomas c. kinnaman eds, 2002)(respondents were more likely to participate in recycling if they believe that recycling was good for the environment than if they thought it was their civic duty); ann e. carlson, recycling norms, 89 cal.. l. rev. 1231 (2001)(arguing that commitment to recycling influences recycling behavior but mostly in small groups requiring little effort); georgina davis, paul s. phillips, adam d. read & yuki iida, demonstrating the need for the development of internal research capacity: understanding recycling participation using the theory of planned behaviour in west oxfordshire, uk, 46 resources, conservation and recycling 115 (2006) (finding that an intention to recycle influenced by belief that it was good for the environment). 30. see nina mazar & dan ariely, dishonesty in everyday life and its policy implications, 25 am. marketing ass’n 117, 124 (2006); trivedi, shehata & lynn, supra note 22, at 187 (an increase in the p score – a measure of the level of moral reasoning – increased compliance while a decrease in the p score decreased compliance). 2007] a tax morale approach to compliance 613 norms are not static; they interact with each other and with the environment.31 for example, a taxpayer may initially follow her own personal norm of integrity and file accurate tax returns regardless of the social norm which tolerates cheating. however, the taxpayer’s perception that others are cheating can influence her norms, lower tax morale, and change compliance behavior. norms of conformity or reciprocity, for example, can alter her norm of integrity to justify some cheating as can the desire not to be seen as a “chump” who follows the law when everyone else doesn’t. identification with the group plays a crucial role in norm formation and influence. the more a person identifies with a group, the more likely s/he is to internalize its norms and therefore cooperate, that is, follow them. some32 studies suggest that if a taxpayer does not identify with the group holding the social norm, the norm can actually negatively affect compliance. however,33 even if a person does not identify with a group norm, s/he may comply with its norms for rational based reasons such as reputation. compliance with laws “signals” that the person is trustworthy, honest or reliable. for example,34 politicians engage in signaling when they open their tax returns to public scrutiny. normally, however, signaling does not occur in the income tax context because tax returns are generally confidential. signaling would occur,35 however, if there were some publicity of tax information, such as publicizing the names of delinquent taxpayers.36 identification with a group encourages individuals to be collectively oriented, and therefore, more likely to forgo immediate self interest for the sake of the public good. a taxpayer who is strongly identified with the group is more likely to see a tax not simply as coercion, but as “self-imposed levies, expressions of our commitment to the well-being of all.” in other words,37 identification with the group either decreases the importance of fiscal exchange 31. wenzel, supra note 24. 32. tom r. tyler, why people obey the law (1990); tom r. tyler & steven l. blader, the group engagement model: procedural justice, social identity, and cooperative behavior, 7 personality and social psychol. rev. 349, 355 (2003). torgler makes the same point in many articles. 33. see, e.g., wenzel, supra note 24. 34. alex raskolnikov, crime and punishment in taxation: deceit, deterrence, and the self-adjusting penalty, 106 colum. l. rev. 569 (2006). 35. dan m. kahan, signaling or reciprocating? a response to eric posner’s law and social norms. 36 u. rich. l. rev. 367, 378 (2003). but see eric a. posner, law and social norms: the case of tax compliance, 86 va. l. rev. 1781 (2000). 36. but see, raskolnikov, supra note 34 (tax compliance as reputational signaling device) and kahan, supra note 35 (reciprocity is better explanation of compliance). my conversation with karl knapp of the north carolina department of revenue says there was anecdotal evidence that the mere threat of publication increased compliance. e-mail from karl knapp to author mar. 2, 2007. this is some evidence that shaming could perform a signaling function. 37. hansen, taxing illusions supra note 21, at 16. 614 florida tax review [vol. 8:6 – an element of procedural justice, as discussed below – or is more broadly defined to include others. identification with a group smaller than the nation also can positively influence internal motivations to comply with tax laws. if business leaders, for example, emphasize the importance of paying taxes (personally and at the corporate level), then other business-oriented people will see that as the norm. similarly, having an important person in a group (a minister, for example) or a person that people admire or respect (e.g., celebrity) emphasize tax compliance could strengthen compliance. strengthening the identification of tax professionals with the integrity of the tax system can improve their willingness to cooperate with the irs. this would decrease aggressive tax planning directly since much of such advice is “supply” driven by the professionals. it would also signal to clients a tax38 compliance norm that could have a ripple affect on their clients, who respect and identify with these professionals. a major reason people join groups and cooperate is because they obtain a sense of identity (self-worth, esteem) from the group. consequently the more39 one identifies with the group the more one internalizes norms and cooperates. identification with the group is therefore crucial to cooperation and procedural fairness is crucial to forming that identification.40 procedural fairness, or justice, is a major determinant of tax morale generally, not just in the fostering of identification. key components of procedural justice are: voice (participation in the process and belief authorities41 “hear” the individual); belief in the neutrality of the decision; belief in the neutrality of the decision-maker; and being treated with respect, politeness and dignity by tax authorities. a belief in the legitimacy of the authority and trust42 in it, which a sense of procedural fairness augments, also increase identification with the group and compliance with its norms. 38. john braithwaite, markets in vice: markets in virtue 50-66 (2005); dennis j. ventry, jr., from competition to cooperation: imagining a new tax compliance norm (2007 forthcoming). 39. tyler & blader, supra note 32, at 353. 40. e.g., id. at 355. 41. see, e.g., alm & torgler, supra note 10, at 230; feld & frey, supra note 9, at 88-89; benno torgler, tax morale and direct democracy, 21 eur. j. pol. econ. 525, 526-27 (2005). 42. see, e.g., tom tyler, why people obey the law 71-74 (1990); lars p. feld & bruno s. frey, tax compliance as the result of a psychological tax contract: the role of incentives and responsive regulation, 29 law & pol’y 102, 104 (2007); torgler, supra note 2, at 676; tyler & blader, supra note 32; tom r. tyler & david de cremer, process-based leadership: fair procedures and reactions to organizational change, 16 leadership q. 529, 542 (2005); tom r. tyler, promoting employee policy adherence and rule following in work settings, 70 brook. l. rev. 1287, 1310 (2005). 2007] a tax morale approach to compliance 615 although a belief in the legitimacy of the tax system is ultimately tied to the greater issue of legitimacy of the government which the taxes support, individuals’ direct contacts with the tax authority greatly influence their perception of whether an authority is legitimate and procedurally fair. the43 more an individual believes s/he is heard and treated fairly, the more s/he believes the authority is responsive and therefore procedurally just. the lack44 of responsiveness, according to some scholars, is a major cause of the ultimate act of non-compliance in the tax area – revolt.45 procedural justice builds trust, loyalty, identification, and commitment that can survive the occasional negative interaction with the authority. commercial companies, for example, devise complaint procedures which preserve customer loyalty even in the face of negative experiences. procedural46 justice can work similarly in the tax context. by strengthening normative bonds, 43. see, e.g., natalie taylor, explaining taxpayer non-compliance through reference to taxpayer identities: a social identity perspective 39, 51 in size, causes and consequences of the underground economy: an international perspective (christopher bajada & friedrich schneider eds. 2005). 44. see, e.g., kent w. smith, reciprocity and fairness: positive incentives for tax compliance 223, 228 in why people pay taxes (joel slemrod ed., 1992)(although procedural justice and responsiveness are different, “the two components may be cumulative in such regulatory areas as tax administration, in the sense that responsive service may be viewed by many as a precondition for procedural fairness in decision making and the administration of the laws.” therefore, it is “reasonable to expect that perceptions of pf are an intervening variable between perceptions of responsive service and normative commitment.”). kent also highlights the (probable) importance of reciprocity and legitimacy. 45. see, e.g., jack citrin, introduction at 19 in california and the american tax revolt: proposition 13 five years later (terry schwadron, ed; paul richter, principal writer1984), (“a failure on the part of elected officials to meet burgeoning complaints about high taxes at least partway was critical to the success of the tax revolt. the rebels won their greatest victories, in california and massachusetts, where the political system was unresponsive to an obvious problem – in other words, where democratic processes broke down.”). lack of responsiveness by officials also played an important role in other tax revolts in the united states such as shays’ rebellion and the whiskey rebellion. see kornhauser, supra note 25. 46. consumer research indicates that in order to build a long-lasting connection between a customer and a brand, the customer must be “committed” to the brand. this relationship exceeds the usual “brand loyalty” marketers discuss; loyalty is functional, arising from satisfaction with the brand whereas commitment is personal and based, in the consumer’s trust in the brand. a committed customer is “slightly more forgiving of the brands foible since the relationship has escaped the limitations of a straightforwardly utilitarian nature.” jeff hess & john story, trust-based commitment: multidimensional consumer-brand relationships, 22 j. consumer marketing 312, 321 (2005). see, also, hooman estalami, competitive and procedural determinants of delight and disappointment in consumer complaint outcomes, 2 j. service res. 285, 289 (2000)(promptness, politeness and empathy improve commitment). 616 florida tax review [vol. 8:6 it can help maintain compliance even in the face of important negatives such as fiscal exchange inequities, irs mistakes, or taxpayer complaints. theoretically, certain existing structural aspects of the tax process, such as the taxpayer bill of rights and the national taxpayer advocate, should have a positive effect on compliance. the more the irs strengthens its own norms of honesty, fairness, and politeness in its communications and interactions with taxpayers, the more taxpayers will view the irs and its decisions as fair. this increased perception47 of procedural justice should improve tax morale and tax compliance. the norm of reciprocity, like procedural justice, improves tax morale. acting under this norm an individual will respond to another’s act in the same way in which that person treated him. if another person is generous or honest,48 for example, the individual feels obligated to respond in kind and is more likely to do so. however, if the other person acts negatively – such as cheats or shirks – the individual will respond in a similarly negative fashion. acting under a norm of reciprocity, a person may voluntarily comply with tax laws even if s/he does not personally experience fiscal equity in the tax/government benefit exchange because s/he is helping the collective good. strong norms of reciprocity, therefore, increase cooperative behavior. reciprocity and cooperation increase when people trust that others will indeed reciprocate. several studies indicate that trust and reciprocity hold true in the tax area as well as generally. an individual taxpayer’s compliance after the tax reform act of 1986 correlated, according to one study, with exposure to other taxpayers’ positive attitudes to the act, rather than the amount of personal benefit from the reforms (i.e. decreased taxes). positive attitudes indicated49 greater willingness to comply, which in turn “trigger[ed] the disposition to reciprocate in kind. in effect, the enactment of popular reforms generates an environment of face-to-face assurance giving that builds trust, and a resulting disposition to cooperate, in much the same way that discussion does in public goods experiments.” learning that most people pay their taxes can similarly50 reinforce trust and reciprocity.51 reciprocity theory implies that a very effective method of promoting cooperative behavior is “to promote trust – the shared belief that others can in fact be counted on to contribute their fair share to public goods, whether or not 47. organizations also have norms which, like individual norms, can be changed. kolstad, supra note 28; tyler & de cremer, supra note 42 (leaders can motivate others in the organization to accept change through fair procedures). 48. see, e.g, dan m. kahan, logic of reciprocity, 102 mich. l. rev. 71 (2003); kahan posner response, supra note 35; dan m. kahan, trust, collective action, and law, 81 b.u. l. rev. 333, 333 (2001) (hereinafter kahan trust). 49. kahan trust, supra note 48, at 341, citing marco r. steenbergen et al., taxpayer adaptation to the 1986 tax reform act: do new tax laws affect the way taxpayers think about taxes?, in why people pay taxes 9 (joel slemrod, ed., 1992). 50. kahan trust, supra note 48, at 343. 51. see kahan supra note 35 at 379. 2007] a tax morale approach to compliance 617 doing so is in their material self-interest.” the best ways to promote trust is to52 promote procedural justice, legitimacy, and identification. c. impact of external factors on internal motivations although tax morale is internally motivated, the outside world affects it. some external factors – such as contextual clues, rewards, education, and the framing of communications – can weaken (“crowd-out”) internal motivators while other external factors strengthen (“crowd-in”) internal motivations. irs actions may have either effect – often unintentionally. by understanding the workings of tax morale, the irs can maximize positive effects and minimize those that crowd out tax morale. the commoditization of a behavior crowds out positive normative influences on that behavior. thus, setting a price or giving an economic incentive for behavior motivated by social, non-pecuniary motives such as reciprocity can actually decrease the desired behavior. in the environmental field, for example, subsidies, some argue, crowd out normative behaviors. in53 tax, it is possible that commodification occurs when taxpayers are called “customers.” the effects of crowding out can be permanent so that decreased compliance remains even after the discontinuance of the economic incentive or other commoditizing event.54 the manner in which a communication is framed can either activate or suppress internally motivated normative behavior. in one experiment, subjects received $18. half the group was told that $2 had been given to a charity of their choice; the other half was told that they had been given $20 but the government had taken $2 in taxes which was then given to the charity of their choice. when asked if they wanted to make additional charitable55 contributions, those that had been “taxed” did not, but those subjects who had simply been told $2 had gone to charity contributed more. although neither56 group had a choice whether to give the initial $2, the “tax” situation highlighted the compulsory aspect (or alternatively framed the situation as a loss situation 52. id. at 369. 53. andrew green, you can’t pay them enough subsidies: environmental law and social norms, 30 harv. envtl. l. rev. 407 (2006)(subsidies put a price on environmental behavior and crowd out behavior based on responsibility). but see, carlson, supra note 29, at 1297 (market mechanisms do decrease “bad” recycling behavior and increase “good” behavior). 54. fehr & falk, supra note 4, at 713-18. 55. id at 1548-57. 56. id. catherine c. eckel, philip j. grossman & rachel m. johnston, an experimental test of the crowding out hypothesis, 89 j. pub. econ. 1543, (2005). 618 florida tax review [vol. 8:6 since $2 of their money had been taken from them). this crowded out the57 voluntary charitable behavior.58 phrasing norms positively generally encourages or activates normative behavior (at least for women). for example, stating that most people comply with tax laws reminds people what the norm is and encourages them to follow it. this crowding in effect may be due to the effect of conformity and reciprocity norms. on the other hand, framing communications negatively, by emphasizing the number of people who violate the norm, crowds out normative behavior. for example, theft of petrified wood at the petrified forest national park decreased when a sign – with a line through it – showed only one person stealing wood as opposed to three. when college students are told that the59 average student consumes 4 drinks on a saturday night, those who consume more decrease their drinking, but those who drink less than 4 increase their consumption. similarly, communications stating how many people are evading60 taxes might decrease compliance among formerly compliant taxpayers because their perception about the strength of the norm and how many taxpayers follow it (reciprocity) diminishes. laws can influence behavior and activate personal norms in various ways. “expressive” provisions, such as shaming, signal socially approved behavior, as well as increase the costs (penalties) of disapproved behavior. they, therefore, have the potential to shape social norms and increase compliance. they work best, however, if individuals identify with the group61 and have a similar world view, as discussed previously. consequently, shaming, a technique with which several states are experimenting by publicize tax delinquents, may not only be ineffective for those who do not identify with the norm (paying taxes), but may backfire and indicate to those who are compliant that the norm is not followed by many people.62 crowding-in can occur through internal rewards. for example, being treated respectfully – an aspect of procedural fairness – can activate internal motivations. moreover, seeing examples of the desired behavior can activate63 57. id. 58. id at 1557. 59. robert b. cialdini, descriptive social norms as underappreciated sources of social control, 72 psychometrika 263, 266 (2007) (arguing theft actually increased when the sign showed 3 thieves). 60. robert b. cialdini, talk at asu college of law (january 29, 2007). 61. see michael s. kirsch, alternative sanctions and the federal tax law: symbols, shaming, and social norm management as a substitute for effective tax policy, 89 iowa l. rev. 863 (2004). politics itself can be seen as symbolic. for the classic exposition of this theory see, murray edelman, the symbolic uses of politics (1964). 62. see supra notes 27 and 58 and accompanying text, regarding ineffectiveness of shaming. 63. see, e.g., feld & frey, supra note 42 at 105-06. 2007] a tax morale approach to compliance 619 a person’s norms. for example, when people hear, see, or read about polite behavior, they will act more politely, or they will donate more to a box in the64 museum if the box already has money in it. these external cues activate the65 norm of reciprocity or perhaps the norm of conformity in which people act as others do even though there is no chance of receiving a reciprocal benefit.66 several opportunities to provide external cues to activate tax compliance norms occur at the time returns are filed. for example, mazar and ariely suggest that the irs could ask taxpayers to sign an “honor code” just before they fill out their returns. cialdini suggested that taxpayers be given the67 opportunity on their tax form to contribute a nominal sum to fighting tax evasion. such a fund is framed negatively and therefore might backfire and68 decrease compliance, but the idea, framed more positively, is intriguing. for example, the contribution could be to fund irs tax advice to the public or a segment of the public (such as the poor) or to fund special tax education programs. another possibility, borrowed from campaigns to get out the vote at election time, is to provide taxpayers with stickers that say “i paid my taxes today.” this visible sign of compliance might activate norms of reciprocity and trust that would encourage others to similarly pay their taxes. education can strengthen norms. since norms and morality are acquired through a process of socialization, education can strengthen norms that are positively correlated with tax compliance such as honesty, morality, national pride, concern for others, and fairness. policy makers and administrators can69 develop programs that not only provide tax information but also “reinforce the concept of fairness of the tax system among tax payers; and develop programs 64. e.g., malcolm gladwell, blink: the power of thinking without thinking 25 (2005). 65. frey & torgler, supra note 3. 66. nicholas bardsley & rupert sausgruber, conformity and reciprocity in public good provision, 26 j. econ. psychol. 664 (2005). 67. see mazar & ariely, supra note 30. 68. cialdini, supra note 8. the federal government currently allows taxpayers to contribute to the federal election campaigns and some states allow taxpayers to contribute to various funds. 69. see, e.g., mazar & ariely, supra note 30 at 123 (asserting “likely possibility” that critical period for developing these norms is in youth); trivedi, shehata & lynn supra note 22, at 193 policymakers, . . . should develop programs that help enhance these characteristics in the general population to raise the level of tax compliance. encouraging education can be one such measure, given the finding in prior research that education and age are the most important determinants of moral reasoning. thus, education with an emphasis on ethics, and the ethics of taxation specifically, may improve tax compliance. furthermore, the results also highlight the importance of encouraging and maintaining a positive attitude towards governments amongst the general population to achieve a tax compliant population. thus, policies that encourage/emphasize education and ethical behavior may be an effective method of increasing the level of taxpayers’ compliance.” id. (citation omitted). 620 florida tax review [vol. 8:6 that enhance and appeal to a taxpayer’s moral conscience and reinforce social cohesion.”70 although it is clear that external factors can activate or suppress tax morale, laboratory studies and field experiments with actual taxpayers produce mixed results regarding normative appeals to pay taxes. some studies show71 no impact or even a negative one. these results, however, do not necessarily mean that external factors cannot activate norms. peculiarities of the studies themselves may be the cause. for example, the normative appeal may fail because there was too long a time lag between the communication and the compliance decision, or because the communication was a “one-shot” deal or was not framed properly. moreover, as discussed below, normative appeals72 appear to work better with some segments of the population than other segments. d. demographic factors various demographic factors correlate with tax compliance behavior, such as age, gender, and religiosity. these are correlations not causations and may reflect different world views, schemas, framing, or a combination of these. although the precise reasons for the correlations are not known, knowledge that they exist is useful in devising compliance tactics. what helps one population may be a detriment to another. studies have found these major demographic correlations: gender: although some of the study results are mixed, in general the evidence suggests that women are more compliant than men (perhaps because they are more risk averse), respond better to positive appeals (whereas men respond better to negative ones) and respond better to normative appeals.73 70. trivedi, shehata & lynn, supra note 22, at 175. 71. e.g. see. fpr example, various studies of effect of letters sent to minnesota taxpayers: marsha blumenthal, charles christian & joel slemrod, do normative appeals affect tax compliance? evidence from a controlled experiment in minnesota, (2001) 54 nat’l tax j. 125; jon hasseldine, peggy a. hite, simon james & marika toumi, carrots, sticks, sole proprietors, and tax accountants, recent research in tax administration and compliance, proceedings of the 2005 irs research conference 191(2006); joel slemrod, marsha blumenthal, charles christian, taxpayer response to an increased probability of audit: evidence from a controlled experiment in minnesota, 79 j. pub. econ. 455 (2001). 72. see, e.g..blumenthal, christian & slemrod, supra note 71, at 135. 73. e.g., cullis, jones & lewis, supra note 18 at 315 (study of uk college students showed male students declared less income when the question was framed as a loss); janne chung & viswanath umashanker trivedi, the effect of friendly persuasion and gender on tax compliance behavior, 47 j. bus. ethics 133 (2003); klarita gerxhani & arthur schram, tax evasion and income source: a comparative experimental study, j. econ. psychol. 27 402 (2006); john hasseldine & peggy a. hite, 2007] a tax morale approach to compliance 621 age: older individuals are generally more compliant than younger ones. this could be due to a variety of factors such as older individuals have74 more social capital (more willing to follow or internalize social norms), have more at risk, and/or have more knowledge of tax. education: findings regarding the correlation of education and compliance have been mixed. as with other factors, however, mixed findings75 may be the product of the measurement tools – both how compliance is defined and education measured. education may correlate with compliance because the internalization of social norms occurs through a process of socialization and education influences that process. education may also correlate with76 compliance because higher moral reasoning positively correlates and higher moral reasoning can be taught. marital status: findings regarding the effect of marital status are mixed.77 religion: a study of the correlation between tax compliance and religion in more than thirty countries, found a positive correlation for all the main religions but found different correlations with different religions. for example, agreeing with an earlier study, torgler found that those with a strong framing, gender, and tax compliance, 24 j. econ. psychol. 517, 521 (2003); robert w. mcgee & michael tyler, tax evasion and ethics: a demographic study of 33 countries, ssrn abstract #940505 (oct. 2006) (arguing women more likely to oppose tax evasion than men); benno torgler, tax morale and tax compliance a crosscurlture comparison, national tax assoc. annual proceedings 96th annual conference 2003, 63, 71 (females report a higher compliance than males). 74. see, e.g., mcgee & tyler, supra note 73 (finding that older people tend to be more opposed to tax evasion than younger people); benno torgler, the importance of faith: tax morale and religiosity. 61 j. econ. behav. & org. 81, 87-88 (2006)(using data from the wvs 1995-7 for more than 30 countries at individual level). but see, torgler & schneider, supra note 5 (arguing after age 64 tax compliance decreases). 75. torgler, supra note 73 (arguing education has a positive effect on tax compliance.); but see, mcgee & tyler, supra note 73 (less well educated more opposed to evasion). kirchler, et al., supra note 6 at 514 (willingness to cooperate – measured by intent to file correct, timely tax returns – was significantly related to higher self reported tax knowledge. “several studies using education as a proxy for knowledge or measuring objective or subjective knowledge confirm the positive relationship between knowledge and willingness to cooperate or comply [].” id. (citation omitted). 76. mazar & ariely, supra note 30. 77. torgler, supra note 74, at 94 (singles had lower compliance than married couples and those living together); andreoni et al., supra note 2, at 840 (tcmp found greater noncompliance among married couples). 622 florida tax review [vol. 8:6 protestant work ethic were more likely to oppose taxation. the correlation may78 exist because religion acts as a “supernatural police” or because it is a proxy79 for such traits as work ethic and trust. income: the evidence regarding the correlation between income and compliance is mixed.80 e. using tax morale to increase compliance recently several tax authorities have switched their approach to tax administration from a one-size-fits-all enforcement model to a model that builds on the lessons of tax morale research. frequently called a self-regulatory or responsive regulation model, this model adopts “carrots,” as well as “sticks,” in a manner that matches the tax authority’s response to that of the regulated individuals (taxpayers), saving the sticks for those who are non-compliant. the australian taxation office (ato) has been the leader in responsive regulation in the tax field. this model has now been adopted by other countries (uk, new zealand, timor lese, indonesia and the state of pennsylvania).81 78. torgler, supra note 74, the importance of faith: tax morale and religiosity. 61 j. of economic behavior & organization 81, 91 (2006). accord benno torgler, to evade taxes or not to evade: that is the question, 32 j. socio-econ. 283 (2003) (“ . . . strong evidence has been found that trust in government, [national] pride, and religiosity have a systematic positive influence on tax morale. . . [and] [t]his effect tends to persist even after controlling for age, income, education, gender, marital status, employment status.”) 79. torgler & schneider, supra note 5, at 10. 80. gërxhani & schram, supra note 73 (compliance increases with higher income); torgler, supra note 73. but see mcgee & tyler, supra note 73 (poorer are more opposed to evasion than wealthier, but authors are skeptical of result). 81. the australian taxation office and australian researchers have been leaders in responsive regulation from a tax standpoint. see e.g., australian taxation office at http://www.ato.gov.au/ and centre for tax system integrity at http://ctsi.anu.edu.au/index.html; see generally valerie braithwaite, responsive regulation and taxation: introduction, 29 law & pol’y 1 (2007); see also, john braithwaite, supra note 38; valerie braithwaite, dancing with authorities, in taxing democracy: understanding tax avoidance and evasion (valerie braithwaite ed., 2003); sagit leviner, a new era of tax enforcement: from ‘big stick’ to responsive regulation at http://ssrn.com/abstract=940911); tony morris & michele lonsdale, translating the compliance model in to practical reality, the irs res. bull.: recent research on tax administration and compliance, pub. no. 1500, 57, 59 (2005) (new zealand bisep – business; industry; sociological; economical; psychological). kristina murphy, the role of trust in nurturing compliance: a study of accused tax avoiders 8 law & human behav. 187 (2004) (one of the first papers to provide empirical evidence to support a regulatory strategy based on trust); kathleen carley & daniel t. maxwell, understanding taxpayer behavior and assessing potential irs 2007] a tax morale approach to compliance 623 valerie braithwaite, a leading researcher in the field, describes the responsive regulation, or “tax morale,” model – at least as currently practiced by the ato – as follows: [responsive regulation] . . . refers to the practice of (a) influencing the flow of events (b) through systematic, fairly directed and fully explained disapproval (c) that is respectful of regulatees, helpful in filling information gaps and attentive to opposing or resisting arguments, (d) yet firm in administering sanctions (e) that will escalate in intensity in response to the absence of genuine effort on the part of the regulatee to meet the required standards. responsive regulation . . . deliberates on shared community goals and understandings, it enforces agreed upon standards, preferably through teaching, persuading and encouraging those who fall short, but it uses punishment when necessary to achieve its regulatory objectives.”82 the core of responsive regulation is the dynamic partnership it creates between the tax authority and the taxpayer. it encourages taxpayers to “think about their obligations and accept responsibility for regulating themselves in a manner that is consistent with the law” and the tax authority agrees to respond appropriately. recently, feld and frey have extended the ato tax morale83 based model by proposing a “psychological tax contract” which includes positive rewards for compliant taxpayers in a manner that does not undermine internal motivations to comply. since the psychological contract is premised84 on the idea of improving tax morale, especially by means of fair procedures and respectful treatment (in other words, procedural justice), it rewards – rather than punishes – taxpayers. the authors broadly conceive “reward” to extend beyond the traditional fiscal exchange of receiving material goods and services for taxes – which, in fact, commoditize taxes – to include “the political procedures that lead to this exchange . . . and the personal relationship between the taxpayers interventions using multiagent dynamic-network simulation, the irs res. bull.: recent research on tax administration and compliance, pub. no. 1500, 93 (2006) at http://www.irs.gov/pub/irs-soi/06carley.pdf. 82. valerie braithwaite, responsive regulation and taxation: introduction, 29 law & pol’y 1, 5 (2007); see also j. braithwaite, supra note 38, at 71 (four “prongs of the ato compliance model are: (a) understanding taxpayer behavior; (b) building community partnerships; (c) increased flexibility in ato operations to encourage and support compliance; and (d) more and escalating regulatory options to enforce compliance”). 83.v. braithwaite, supra note 81, at 6. 84. feld & frey, supra note 42, at 104-05. 624 florida tax review [vol. 8:6 and the tax administrators.” although their model applies traditional85 deterrence when necessary, the authors believe that because “genuinely rewarding taxpayers in an exchange relationship will increase tax compliance, [i]t should thus be considered as the tax authority’s dominant strategy to approach taxpayers in order to enhance their tax compliance, while at the same time being able to resort to punishment if that strategy fails.”86 the responsive regulation model is a positive step towards improving tax compliance by recognizing internally motivated tax morale factors and the role of the tax authority in promoting them. nevertheless, this model poses several problems. first, a tax authority following the model must navigate a narrow strait between scylla and charbydis: being too lenient (or soft) and being too hard – both of which can decrease tax compliance by eroding tax morale. moreover, a flexible system, necessary for responsive regulation to work, can also decrease tax morale if the necessary discretion creates arbitrary decisions that undermine a sense of procedural fairness. several commentators have suggested that the way to avoid both problems is through “institutional integrity” which goes beyond “mere procedure” to encompass “the whole matrix of values, purposes and sensibilities that should inform a course of conduct.” authorities must not only deal fairly with taxpayers but effectively87 – authorities must conduct themselves in a manner that appears both competent and honest, using procedures that taxpayers view as sensible and efficient.88 this will require both training and diligence on the part of the taxing authority. another problem of the ato model is that is does not require the tax authority to know the actual attitudes and motivations of the taxpayer. it assumes that taxpayer attitudes/motivations are reflected in their behavior, and it responds according to that behavior. this assumption, however, is not89 always true. first, attitudes do not always translate into behavior. consequently, it is still important for the taxing authority to understand the attitudes and motivations of its taxpayers in order to transform positive attitudes into positive actions and not crowd-out these positive attitudes. moreover, since different attitudes and motivations may produce the same behavior, the more the tax authority understands about actual attitudes and motivations, the more it can respond accurately and positively to taxpayers. that is, if taxpayer b complies because of a social norm that people should comply and taxpayer c complies because of deterrents such as penalties, the same irs action (e.g., publishing statistics regarding rate of convictions) may affect the two taxpayers’ behavior 85. id. at 115. 86. id. at 116. 87. vivienne waller, the challenge of institutional integrity in responsive regulation: field inspections by the australian taxation office, 29 law & pol’y 67, 69 (2007) (citing philip selznick, the moral commonwealth: social theory and the promise of community 333 (1992). 88. see, e.g., id. 89. see, e.g., leviner, supra note 81. 2007] a tax morale approach to compliance 625 differently. taxpayer b may decrease her compliance whereas as taxpayer c might increase his compliance. mark burton argues that another problematic aspect of responsive regulation is that tax law – contrary to the model’s premise – is not wholly determinate. since people disagree as to what the law is, it is difficult to agree90 on mutual goals, the proper interpretation of laws (or who is the proper interpreter), or to form partnerships to achieve them. f. summary of tax morale literature tax morale research, a subset of general research into why people obey laws, has made great strides in understanding tax compliance, but much is still to be learned. it has identified key components of tax morale such as procedural fairness, trust, legitimacy, identification with the group, and reciprocity. it has also identified key mental and affective factors influencing tax morale – such as framing issues – and has begun isolating ways in which external factors can encourage or depress tax morale. although research has yielded much information, much is still to be learned. further research will help explain some of the conflicting results in empirical research and provide better guidance for tax agencies to improve compliance. although tax morale is a work in progress, enough is known to suggest that tax authorities abandon traditional regulatory models that focus solely on one-size-fits-all enforcement and adopt a “tax morale” model. several countries, such as australia, have already done so. although the tax morale model uses traditional enforcement mechanisms such as fines and audits, it emphasizes taxpayers’ internal motivations – social norms, personal values, and cognitive processes. recognizing that external factors – including actions by the tax authority – can affect norms and values in either positive or negative ways, a tax morale-based tax authority abandons a one-size-fits-all approach to taxpayers and develops more individualized methods to match the differing attitudes and behaviors of different types of taxpayers. current tax morale models, such as the ato’s, are a step forward in improving tax compliance, but they do have several limitations. first, they can be vague as to exact implementation. second, the model’s flexibility in dealing with taxpayers, which is an advantage, is also a potential disadvantage in that it may lead to inconsistent administrative response. third, it has the potential of backfiring and lowering tax morale (and compliance) because inconsistent administrative responses may impair the taxpayer’s sense of procedural fairness. similarly, the taxpayer may lose trust in the tax agency if it views the agency’s actions to improve morale as manipulative. 90. mark burton, responsive regulation and the uncertainty of tax law – time to reconsider the commissioner’s model of cooperative compliance?, 5 journal of tax research 71, 73 (2007). 626 florida tax review [vol. 8:6 a tax morale model can work only as well as the tax agency’s understanding of the attitudes and behaviors (always recognizing that the two are not the same) of both compliant and non-compliant taxpayers so that the former may be strengthened and the latter changed. in order to do this, the agency must research tax morale and develop strategies and programs that apply current and future findings to taxpayers and to its own personnel and procedures. the following part iv recommends the establishment of a structure within the irs to perform this function and provides some specific recommendations based on existing findings. iv. recommendations the application of tax morale research to the formulation of tax laws and their application by the irs must be an essential part of any successful plan to narrow the tax gap and improve and maintain taxpayer compliance. the findings have broad applicability for congress and the irs: they can help shape both laws and procedures; they can apply to both carrots (incentives) and sticks (enforcement/penalties), and they are relevant for all types of taxpayers. these recommendations, however, focus only on the irs, only positive incentives, and only on individual taxpayers. this report makes three major recommendations and several specific suggestions. the three major recommendations are: 1. the irs should establish a permanent department or other structure within its organization devoted solely to voluntary compliance issues. although this structure should address all type of taxpayers, these recommendations cover only individual taxpayers. this report labels the structure the behavioral science unit (bsu). 2. the irs should adopt a “tax morale” model of compliance that incorporates internal taxpayer motivations and emphasizes a more individualized carrot and stick approach than traditional tax collection models. 3. the irs should implement longand short-term educational and media programs to encourage voluntary compliance that incorporate the findings of behavioral research. the first three sections of this part describe the major recommendations generally. the final section suggests several more particular topics to be explored or implemented by the bsu. although some recommendations can be broadly phrased and have widespread effects, there can be no one-size-fits-all recommendation that will improve all taxpayer compliance. since the amounts, 2007] a tax morale approach to compliance 627 types, and causes of individual noncompliance are so varied, some recommendations can only target certain types of noncompliance. a. establish a behavioral science unit 1. scope although the bsu derives its name from a similarly named unit within her majesty’s revenue and customs (hmrc), this report envisions a broader scope than that currently engaged in by the british unit. ideally, the bsu should encompass many functions, such as evaluating third party research, conducting its own independent research, advising other parts of the irs, and helping implement research findings. whatever its scope, for maximum effectiveness, the bsu should be a permanent feature of the irs with resources and personnel dedicated to compliance issues. compliance involves many disciplines and many types of tasks such as research, developing irs procedures and strategies; educating the public; and educating and training irs officials. although behavioral research can enhance both the positive (carrot) and negative (stick) tools which the irs needs for compliance, these recommendations focus on the positive aspects. the next sections sketch a description of the types of personnel the bsu should hire and the functions it should perform. 2. personnel ideally, a full-time director should head a full-time staff composed of persons with expertise in a variety of fields such as economics (especially behavioral economics), psychology, sociology, education, marketing, and even moral philosophy. the multi-disciplinary approach serves a dual function. first, it increases the breadth, depth, and sophistication of expertise since different fields have different strengths and perspectives. the multi-disciplinary approach, however, also increases the chance that other irs personnel will accept the findings and assistance of the bsu since different people value different disciplines.91 the bsu should also hire outside consultants, when necessary, to perform a variety of functions such as research or designing educational and marketing campaigns. many projects will require collaboration not just with irs officials outside the bsu, but with people in other disciplines as well as other government, private, and non-profit organizations – and the public generally. 91. interviews with various personnel at hm revenue and customs (london, may 23, 2007) (importance of hiring non-economists as well as economists because some people are suspicious of, or uncomfortable with, economics). 628 florida tax review [vol. 8:6 given the diversity of tasks, the staff as a whole should have theoretical, empirical, and practical capabilities. some people must be able to design or evaluate empirical studies; others must be able to design (or help design in conjunction with outside experts) educational and training materials; still others must have the interpersonal skills to interface with people within the irs and with the general public, as well as other agencies. 3. functions the bsu ideally should perform many functions including research, analysis, advising the irs, education, and training. some of this work may be initiated by the bsu itself while other projects may be contracted for by other portions of the irs in the furtherance of some strategy or procedure it is developing. the following sections generally describe some of these functions. the final section of this part suggests some more particular areas of inquiry, but many more exist or will develop as research continues. a. research and analysis knowledge in motivational and behavioral aspects of taxpayer compliance draws from a variety of fields including law, psychology, political science, and economics. some of this research is specific to tax; other research deals with laws that have similar compliance issues, such as recycling, while some concerns compliance generally – such as research regarding the role of shaming. still other research is not directly related to law but is relevant to tax compliance because it involves cognitive behavior generally, such as education (how people learn), political science (what makes people vote for certain candidates/policies), moral philosophy/reasoning (stages of moral reasoning), and marketing/advertising, (issues of vital concern to tax: framing, trust, and loyalty). the bsu should perform original research, evaluate research of others, and also apply that research, creating practical solutions to compliance problems. its personnel should engage in a variety of research tasks including reading existing theoretical and empirical studies; consulting with tax authorities in other developed countries; and conducting empirical studies. the latter, which might be done in conjunction with outside consultants, should draw on both the vast amount of data the irs possesses as well as using knowledge garnered from existing literature. it should help other irs units evaluate their problems, suggest appropriate research, and help translate that research. empirical studies should extend beyond laboratory and survey experiments to include developing new methods to increasing compliance. this task involves designing and executing field studies with actual taxpayers, such 2007] a tax morale approach to compliance 629 as those done in minnesota, or in australia. as the bsu gains more experience92 and knowledge, more of its efforts should be devoted to implementing its findings; designing and conducting these experimental studies would be a first step towards doing so. these trial experiments should cover all aspects of compliance such as designing forms, procedures for personnel, and educational material. b. educational/training component although tax morale has strong affective components, education can still play a major role in maintaining and improving compliance. knowledge increases taxpayers’ sense of control of their tax situation and also increases the chances of filing accurate and timely returns. consequently, knowledge can decrease feelings of frustration as well as decrease the actual amount of time a taxpayer must spend on taxes. education is also a powerful tool for increasing taxpayer morale by strengthening feelings of identity, reciprocity, fairness, procedural justice. furthermore, education can ensure that irs personnel act – and are perceived as acting – in a fair manner which is essential for tax morale. in light of education’s importance, the bsu must be involved in both internal and external education to meet the varying needs of taxpayers and personnel. internal education includes revising irs procedures and forms; training irs personnel in behaviors that increase compliance, and developing recommendations for congress. external education spans a vast spectrum of long-term and short-term educational programs for all ages of people, from children to the elderly, and all types of taxpayers – from unsophisticated individuals to tax preparers. the irs needs a range of educational programs to meet the various needs of taxpayers. different portions of the population not only have different learning styles, but different tax issues, different psychological motivations, and differing social norms. the bsu should develop some of these programs in cooperation with other institutions. for example, it could partner with university departments such as an education department to design curriculum or it could work with law school organizations such as georgetown’s street law program. it could also work with professional accounting and legal organizations such as the tax or legal education sections of the aba. the irs already engages in some educational programs and literature. for example, it has published a series of “fact sheets” on topics that affect many taxpayers such as travel/entertainment expenses, the eitc, tax tips (such as for the treatment of a child’s investment income) as well as radio public service announcements (in english and spanish, as well as country and western 92. see michael wenzel, a letter from the tax office: compliance effects of informational and interpersonal justice, 19 soc. just. res. 345 (2006). 630 florida tax review [vol. 8:6 format). education and outreach programs developed in connection with93 outside experts could improve the focus and effectiveness of these programs. b. adopt a “tax morale” model the irs should adopt a regulatory model that incorporates the findings of behavioral compliance research. unlike the traditional compliance model, focused on enforcement via penalties, this model, acknowledging internal taxpayer motivation for compliance, emphasizes a more individualized carrot and stick approach. it recognizes that different taxpayers have different taxpaying attitudes and behaviors; that these attitudes and behaviors change over time, and that these attitudes and behaviors are affected by interactions with others, including the tax authority. the model seeks to make compliance easier for taxpayers, but strictly enforce penalties when they fail to comply. in devising its model the irs should not only evaluate the tax morale literature but consult other tax authorities that have instituted such models (such as australia and new zealand). c. establish educational and media programs 1. rationale knowledge of mere facts does not necessarily change people’s attitudes nor increase their compliance with norms or laws since people are often guided by heuristics, cognitive processes and other short cuts or rules of thumbs rather than by rational thought. at first glance, then, it might seem that there is little role for education. this is not the case. people can be trained to think logically. furthermore, the more they know about a subject, the easier it is for them to think and act based on logic and information and not on unexamined biases, frames, and other unconscious cognitive processes. more importantly, information can influence these very processes as well as both social and personal norms. education enhances compliance in a variety of ways. most obviously, people make fewer unintentional mistakes the more they know. they also will be less frustrated when trying to comply with the tax laws. knowledge gained from education should also decrease a taxpayer’s time spent on taxes which should also decrease frustration and increase compliance. research shows that 93. see e.g., irs fact sheet fs-207-10 (jan. 2007, updated 2/14/07), deducting travel, entertainment and gift expenses at www.irs.gov (following “newsroom” hyperlink; then follow “fact sheet” hyperlink); irs radio psas at www.irs.gov (follow “newsroom” hyperlink; then follow “207 irs radio psas” hyperlink); tax tips at www.irs.gov (follow “newsroom” hyperlink; then follow tax tips). 2007] a tax morale approach to compliance 631 education also enhances compliance in more complicated ways that increase tax morale. various techniques can encourage tax morale in the short term, but as the literature review has shown, many of the attitudes and personal norms that are components of tax morale begin to form early and accumulate over time. consequently, efforts to improve tax morale must be ongoing and begin in a person’s formative years – childhood. one education program will not suit all taxpayers. people have different learning styles – some learn better visually; others aurally, and so forth. different audiences also require different content. in some contexts this is obvious; a program for elementary school children must differ from one for adults, for example. a program for native speakers will be different than one for taxpayers whose primary language is not english. a program for tax preparers94 should be different than one for individual taxpayers. taxpayers differ on the type of tax information they need, as well as their level of sophistication. there are other differences among audiences, however, that are more subtle, but often not addressed, such as various norms across subcultures. gender, too, must be taken into account since studies indicate wide differences between genders in risk aversion, moral reasoning, and even responses to compliance appeals. women, for example, respond more to “friendly persuasion” whereas men respond slightly negatively to this type of appeal.95 the irs must also conduct internal education and training because the literature indicates that taxpayers’ perceptions of the tax authority’s procedural fairness is an essential component of tax morale. consequently, training all irs personnel – especially those dealing directly with the taxpaying public – to be as neutral, objective, polite, respectful, and fair as possible is just as important as training them in the technical aspects of the tax law. moreover, the adoption of any new procedures, especially those that move from the traditional model with which many irs personnel are familiar (and so comfortable) to a tax morale model (with which they are less familiar) must be accompanied by intensive personnel training. this training should include not just the specifics of new procedures, but should ensure that personnel understand the reasons for the switch to these procedures and that they commit to them. although internal education is vital, the remainder of this section focuses on external education of taxpayers – both current and future ones. 94. christine c. bauman, david luna & laura a. peracchio, improving tax compliance of bilingual taxpayers with effective consumer communication, 2005 irs research conference 247 (2006)(pictures increased accuracy of bilingual taxpayers). 95. see chung & trivedi, supra note 73. 632 florida tax review [vol. 8:6 2. goals of education the goals of educational programs should be both general and specific. they must provide specific knowledge about the role of tax and how the tax system works. additionally, they should encourage attitudes and behaviors that compliance research indicates are associated with higher tax morale and compliance, such as a sense of civic duty, trust, altruism, integrity. providing factual knowledge is fundamental to any educational program because americans generally are very ignorant about taxation. for example, a 2003 survey by the kaiser foundation and harvard kennedy school for npr on taxes revealed that 34% of respondents did not know whether they paid more social security/medicare taxes or income taxes, and only 50% of respondents knew that there had been a tax cut in the past 2 years. consequently, the irs,96 public agencies, schools, and non-profits have a great opportunity to provide information about the tax system generally, including information on changes in legislation, as well as specific information about certain tax provisions. this information could be provided at different levels of complexity to different audiences ranging from elementary school children to tax preparers. people cannot think rationally about fiscal policy without linking taxation and expenditures. similarly, they cannot think rationally about taxation without talking about its benefits as well as its burdens. currently, both politicians and the media emphasize the burdens. politicians, for example, often claim that the tax burden has increased or is too heavy and, therefore, congress needs to cut taxes. they rarely mention, however, the benefits of taxation, or the fact that tax burdens are relatively low both historically and relative to other nations. they often talk about taxes generally without differentiating between federal taxes and state/local taxes. the news media treat taxation in a similar way to the politicians. the media usually fails to differentiate between marginal and effective rates. as another example, nbc nightly news has a segment called the fleecing of america that highlights programs that waste taxpayer money; it does not have a segment mentioning programs that benefit the taxpaying public. when a government agency, for example, tracks down the cause of an e coli outbreak, the media does not praise the use of tax dollars, but it will criticize the agency for taking so long to do so – even if the agency’s budget has been cut. in short, media and the politicians focus on the negative aspects of taxation for the individual and society, but usually fail to mention the positive good they create. although studies show that there is a connection between the perception of public goods and tax compliance, there are grave dangers in linking taxation97 96. questions 63 and 11 at http://www.npr.org/news/specials/polls/taxes2003/ 20030415_taxes_survey.pdf (33% said there had not been and 17% didn’t know). 97. see, e.g., james alm, betty r. jackson & michael mckee, fiscal exchange, collective decision institutions and tax compliance, 22 j. econ. behav. & org. 285 (1993). 2007] a tax morale approach to compliance 633 to specific expenditures. first, such a linkage may create a strict benefits or fiscal exchange view of tax. a narrow fiscal exchange view may lead some taxpayers to perceive exchange inequality which, in turn, may cause them to see taxation as unfair. once they see the tax itself as unfair, they may be less willing to pay. second, people frequently do not agree on whether a particular expenditure is worthwhile. consequently, linking a certain amount of tax to a certain good or service may decrease a taxpayer’s willingness to pay the tax if s/he does not value that particular program. there are ways to minimize this danger. general discussions about the concept of “public goods” might, for example, make citizens more amenable to taxation. other possible solutions are listed below. some of them relate specifically to tax; others encompass the role of government, generally. most of them require sustained educational campaigns because components of tax morale, such as trust, take a long time to build – even though they may deteriorate quickly. since many tax morale components involve schemas and affective qualities that develop early in life; some educational programs should be directed at youth – long before they become taxpayers. various school curricula in social studies or economics, for example, are ideal places for children to learn about the role of taxes in society and to become tax literate. people acknowledge that voting and jury service are civic responsibilities (although often honored in the breach), but rarely think of taxation as one. education campaigns could help change this view. once paying tax is viewed in this light, people could be encouraged to take pride in doing so, just as they take pride in voting or helping their place of employment reach united way goals. for example, taking a cue from get-out-the vote-campaigns, they could also have stickers saying “i paid my taxes today.” the literature indicates that certain characteristics correlate with higher tax compliance, such as trust, reciprocity, a sense of national identity and altruism. the irs could incorporate aspects of this research into its educational campaigns. research indicates that high moral reasoning correlates with higher tax compliance and that education is an important factor in increasing moral reasoning. these connections suggest that education in ethics and moral reasoning could improve compliance. at least one study suggests this: “[e]ducation . . . may improve tax compliance. further, the results also highlight the importance of encouraging and maintaining a positive attitude towards governments amongst the general population to achieve a tax compliant population. thus, policies that encourage/emphasize education and ethical behavior may be an effective method of increasing the level of taxpayers’ compliance.” 98 98. trivedi, shehata & lynn, supra note 22, at 193. 634 florida tax review [vol. 8:6 3. examples of specific educational programs a. design curriculum for schools states and school districts prescribe curricular guidance for grades k-12 in various subjects including civics, social studies, and economics. although taxes are integral to all these topics, taxation usually plays little or no role in the curriculum. the irs, in conjunction with educational and curricular experts, could devise curriculum appropriate for all ages. there are various less traditional ways to present this information. for example, many law schools have a street law program in which law students teach high school students about various aspects of the law. media popular with the young – such as videos and the internet – could also be used. in 1998, for example, the federal reserve bank of new york published a comic book describing how foreign trade works.99 b. “deliberation day” discussions in their book deliberation day, bruce ackerman and james s. fishkin propose town hall type meetings before presidential elections to discuss the candidates and issues. similar type of meetings could occur at the start of tax season, in town hall meetings, and/or on television, radio and the internet. c. an annual income statement every year the social security administration provides a short explanation of how social security works and a summary of a taxpayer’s past contributions and potential benefits. a similar pamphlet distributed annually by the irs might help taxpayers both understand the system better and feel more ownership.100 4. specific recommendations regarding media campaigns the irs should conduct an extensive media campaign regarding taxes in order to reach the widest number of the public. some of these campaigns should focus generally on taxes while others could concentrate on specific tax issues. the eitc outreach program is a good start for a model, but the suggested campaign must go beyond that in terms of media outlets, content, and purpose. the campaign’s goal should be to encourage values and norms that enhance tax compliance not simply to convey tax information. the campaign 99. cedric fan. the story of foreign trade and exchange (1998). 100. marjorie e. kornhauser, doing the full monty: will publicizing of tax information increase compliance?, 18 can. j. l. & juris. 95 (2005). 2007] a tax morale approach to compliance 635 should seek to develop those values and norms, discussed in the literature review, that are connected with high compliance including trust in the government and a sense of civic duty to pay taxes. it should also stress the competency of the irs. many taxpayers may not question the honesty of irs officials, but they may doubt the efficiency and/or ability of irs personnel. the danger of a media campaign, like the danger of an education campaign, is that it could backfire. it might cause taxpayers to feel manipulated, which would increase cynicism and potentially more non-compliance. in order to prevent (or minimize) these negative consequences the irs must move cautiously and with the aid of outside experts.101 successful marketing engages many of the same principles that enhance tax morale, such as reciprocity, norms, and trust in authority. marketing102 campaigns also use many tactics that would be helpful in campaigns to improve tax compliance, such as formulating suggestions in the positive not negative. the following suggestions indicate some of the possibilities of a marketing campaign. a. public service ads using marketing principles public service campaigns should target specific market so that different types of taxpayers receive different ads. ads would vary in both form and content. content could be varied to target the characteristics of different demographic taxpayers, as shown in the research. the form should also match the target audience in language and media use. appropriate language is not just limited to whether the campaign should be in english or another language, such as spanish. even within a group that speaks the same language, word style and slogans appropriate for one sub-population – such as the elderly – will not be the most effective usage for a group in their early 20s, for example. similarly, the most effective media for one group (e.g. newspapers) will not be the most effective media for the internet-savvy younger generation. ads should harness the power of particular people to influence others. politicians, advertisers and even charities know that a celebrity spokesman can influence others to support their project (or buy their product). the irs should use similarly influential people to support paying taxes.103 101. see, e.g., tax report to the treasurer and minister of revenue by a committee of experts on tax compliance (1998) chapter 16 relationship with taxpayers, ¶¶ 16.33-16.36 at www.taxpolicy.ird.govt.nz/publications/files/html/coe/ chapter16.htm. 102. see, e.g., cialdini, supra note 8, at 205-220 and cialdini, supra note 56. 103. see, e.g., malcolm gladwell, the tipping point: how little things can make a big difference (2000) (discussing what he calls the “law of the few” in which the messenger is as important as the message.) 636 florida tax review [vol. 8:6 b. use the internet and videos tax campaigns should employ the internet’s well-known ability to reach large numbers of people. for example, in 2007 turbo tax made unique use of the internet and fascination with youtube during the 2006 filing season by sponsoring a rap video contest, with an award of $25,000 for the best tax video. (interestingly, no mention is made on the webpage that the prize is taxable.) the contest was introduced in a rap video called turbo tax mojo by vanilla ice, urging people to pay their taxes (on time!) and of course use104 turbo tax to do so. less than one week after the contest started (8 february) 37 videos were posted. c. creative use of the media and media talent in world war ii, the government used donald duck to persuade americans to pay their income taxes. the irs could similarly encourage the development of tax themes in tv shows or other mass media, either as a small segment or even the theme of an episode, as occurred a few years ago on the simpsons. people acquire a great deal of information from entertainment on television, not just from news programs. they also act upon it. for example, after viewing episodes about breast cancer on er, one study showed that viewers were more likely to schedule a breast screening exam than nonviewers. in 1989 robert cialdini suggested a tv special, which he labeled,105 the national tax test, airing one month before april 15th after the earlier television show, the great american values test. today, with the reality and106 game shows so popular, his idea could be expanded into a series of episodes modeled either as a reality show or a game show. d. additional specific recommendations there are many promising areas of research – some basic research and others more narrow implementation of theoretical findings. the following focus on the more practical aspects and are in no way meant to be comprehensive. 1. demographic factors the irs and theoretical research have already begun identifying various segments of the taxpaying population that have different characteristics. 104. available at http://www.youtube.com/watch?v=y2hzs_zrzhy. (viewed 13 february 2007). for the rules see www.youtube.com/contest/thetaxrap. 105. see, e.g. stephen smith, the doctor is on. boston globe, 12 dec. 2006 at c1. 106. cialdini, supra note 8, at 209. 2007] a tax morale approach to compliance 637 the bsu should continue this work and then devise strategies that build on this new knowledge. 2. irs procedures to improve procedural justice the literature contains many studies concerning the importance of procedural justice in tax morale. some experimental research has already been conducted in the field of communications with taxpayers, such as the effect of various form letters on compliance. the bsu should continue to explore and experiment with various procedures and strategies that would improve taxpayers’ sense of fairness. these range from improving irs contact with taxpayers (whether by letter, in-person or phone contact) to training personnel to treat taxpayers with more respect and politeness – factors that influence tax morale. the following suggestions are illustrative of a few of the many issues the bsu might investigate. 3. reconsider nomenclature: customer v. taxpayer the literature on behavioral compliance suggests that the irs should reevaluate the term it uses for a person who pays taxes. in recent years, many collection agencies, such as the irs have emphasized the term “customer” instead of “taxpayer.” the two terms may provide different signals and therefore influence taxpayers and irs officials differently. the term taxpayer may have both positive and negative effects on irs personnel. on one hand, using the term customer may improve how personnel107 treat taxpayers because it lessens any bureaucratic or authoritarian impulses. on the other hand, calling taxpayers customers has negative effects. first, given the often poor state of customer service, irs officials may simply treat taxpaying customers with the same poor service they may have received as customers in stores. furthermore, “customer” transforms a taxpayer into an isolated purchaser and not a citizen performing a civic obligation. this devalues the civic duty aspects of paying taxes and the greater identification with the nation as a whole which, research has shown, makes a taxpayer more likely to comply. by turning paying taxes into a commodity like buying pizza, the term customer may decrease tax morale by “crowding out” internally motivated compliance behavior that derives from intrinsic personal norms, such as integrity and patriotism. if the taxpayer is merely a customer, then paying taxes is no different than paying off a car loan, except that the irs may be viewed more hostilely than other creditors because it carries a bigger stick. moreover, if a tax debt is no different from a car debt, the individual will see these greater 107. see, e.g., new zealand’s tax report to the treasurer and minister of revenue by a committee of experts on tax compliance, supra note 101. 638 florida tax review [vol. 8:6 enforcement powers as unfair or even evil and violating the individual’s constitutional rights and therefore un-american. the term taxpayer, on the other hand, emphasizes the civic responsibility of taxpaying and confers dignity and respect on the taxpayer. being treated in this manner can heighten a taxpayer’s sense of fairness, according to research, and therefore increase tax morale and tax compliance. a taxpayer is different from a customer buying a pizza. the term taxpayer distinguishes the two transactions and adds both seriousness and a dignity to the individual and the transaction. 4. compensatory measures, including apologies taxpayers can develop especially negative feelings about the irs and taxes when there is a dispute about the proper amount of tax owed, or even if there is just an unpleasant interaction with irs personnel. marketing studies of complaint procedures provide insight regarding efforts that help reduce negative attitudes towards firms and improve customer loyalty. although the irs, being a monopoly with which all taxpayers must deal, need not worry about its customers abandoning it for a competitor, the irs must still worry about taxpayer satisfaction. discontented taxpayers may minimize what they owe, pay their bills only after lengthy (and expensive) irs procedures, and some taxpayers may fail to pay any taxes at all. dissatisfaction with irs procedures, in short, decreases tax morale which adversely affects compliance. the irs can apply knowledge and techniques that firms have developed to increase to customer satisfaction and brand loyalty when confronted with complaints. positive procedures identified through research and experience include (1) compensation measures (e.g. refunds, replacements, repairs), (2) responsive employee behavior (especially “empathy, politeness, and an effort to listen”), and (3) prompt responses. the last two factors are easily applicable108 in the tax context, but even the first – compensation measures – may be applicable in the tax situation, especially if compensation is broadly construed to include emotional compensation such as apologies, or extra help, or faster service next time. apologies can range from simply acknowledging a taxpayer’s inconvenience or regretting the inconvenience to an admission of negligence or even wrongdoing. both the irs and the taxpayer will react differently to different types of apologies. this is an area worth investigating. 5. shaming/publicity some states now publicize the names of delinquent taxpayers as a “shaming” device. although the literature indicates that shaming may have 108. estalami, supra note 46, at 289. 2007] a tax morale approach to compliance 639 mixed results, the bsu should both investigate the results states have produced and research the implications and effectiveness of shaming more generally. 6. rewards although economic incentives can backfire and decrease compliance by “crowding out” internally motivated behavior, rewards – broadly construed – may still have a role to play, if carefully constructed. monetary rewards, such as rebates of a percentage of the tax, can be counterproductive. they may decrease (crowd out) internal motivations to comply because the taxpayer may consider them discounts, like rebates in a commercial setting, and thus ones to which s/he is entitled. on the other hand, a taxpayer may view a non-monetary reward which is not based on the amount of tax paid more favorably and see it simply as an acknowledgment of good behavior. this type of reward, research suggests, may not decrease morale. some compliance experts have suggested various types of these rewards that would indicate appreciation of good citizenship without commoditizing taxpaying and decreasing tax moral, such as reduced public transportation fares, or free admission to museums and cultural events.109 there are other possible rewards of this nature. taxpayers who have paid the correct amount of taxes in a timely fashion for a stated amount of time, for example, might be given faster access to assistance such as special phone lines that have a shorter wait. this approach is less drastic, and perhaps more acceptable, than professor joshua rosenberg, university of san francisco school of law, recent suggestion of rewarding taxpayers who provide extended reporting, with lower tax rates.110 it is possible to integrate rewards with sticks. hmrc, for example, is toying with the idea of requiring individuals to show a certificate of tax compliance to renew certain licenses like taxi licenses. certainly, all federal111 employees and independent contractors could be required to show that they are current with all taxes, and perhaps, have not been delinquent for a specified amount of time. 7. tax preparer education and/or registration requirements many professions require continuing legal education. california is now requiring preparers to register with the california tax education council, which 109. feld & frey supra note 42, at 111. 110. tax gap stakeholders debate tax gap elements, differ on methods to improve compliance, bna daily tax report, june 25, 2007 at g-8. 111. interview with simon norris, head of review of hmrc powers team in hmrc business unit (central policy) and gordon smith, deputy director of debt management & banking, and georgina halligan, process & strategy of debt management & banking, may 23, 2007. 640 florida tax review [vol. 8:6 requires continuing education and maintains a code of conduct. although112 many preparers – such as accountants – are members of a profession that already requires cle, that education may not address tax compliance issues specifically or in a manner that focuses appropriately on the topic. cle specifically targeting preparers might better improve compliance. cle has many critics, including those who claim it is ineffective; people attend, for example, but read the newspaper instead of listening. certain types of cle address these deficiencies more than others. for example, those requiring the practitioner to pass a test should improve knowledge better than those that merely require attendance. v. conclusion behavioral research about compliance generally and tax compliance specifically holds much promise for improving voluntary tax compliance. since it is a rapidly growing and complex field, the irs can best take advantage of its findings by dedicating – on an ongoing basis – time, money and personnel to it. this report contains three major recommendations: 1) the irs establish a behavioral research unit which would keep abreast of current developments, conduct independent research, supervise contract research, and help implement findings throughout the irs; 2) the irs adopt a tax morale model of tax compliance that recognizes that taxpayers have varying attitudes and behaviors regarding tax, and match irs behavior with that of taxpayers; and 3) the irs engage in educational efforts aimed at all segments of the population to improve taxpayer knowledge, attitudes, and behaviors. the report also suggests, as examples, several areas that merit further exploration. applying the findings of behavioral research is essential to maintaining and improving compliance, but it also carries a grave danger: the possibility that the public – or portions of it – will interpret the use as manipulation. in the commercial setting, people are cynical about manipulation through behavioral research, but accept it as part of the marketplace. they are less accepting in the public sphere and cynicism here can backfire and cause a decrease in compliance. in order to forestall such cynicism, the irs must both act and be seen as acting sincerely. research indicates that strict adherence to procedural justice and to respectful modes of communication will help. the bsu, however, must continue to research this aspect, too. 112. speakers support multifaceted approach, incremental steps to combat the tax gap, bna daily tax report, june 25, 2007 at g-10. a tax morale approach to compliance: recommendations for the irs florida tax review volume 5 2001 number 3 avoiding phantom income in bankruptcy: a proposal for reform gregory l germain* 1. introduction the problem of phantom income in bankruptcy cases ................................ 251 u. the existing methods for avoiding phantom income in bankruptcy are inadequate ........................ 257 a. the net operating loss carryback rules provide only limited relief from the accounting method distortion in bankruptcy ................................ 257 1. discharge of indebtedness upon plan confirmation will often eliminate the net operating loss carryback ............................ 258 2. phantom income does not always result in a net operating loss ........................ 263 b. the dsf and qsf rules provide only limited relief from accounting method distortion in bankruptcy ........ 265 1. the history of deductions under the accrual method of accounting .......................... 265 2. the time value of money problem ......... 266 3. congress enacts section 461(h) to prevent accrual method taxpayers from structuring transactions to take advantage of the time value of money .. 271 4. congress enacts section 468b to provide a method for structuring tort settlements ............ 272 5. the treasury prohibits the use of a qsf to pay bankruptcy trade claims ................ 274 6. section 468b funds were not designed to benefit cash method taxpayers .................. 276 m11. contested liability funds provide only limited relief from phantom income in bankruptcy .............. 279 a. creation of contested liability funds ............. 280 * ll.m. in taxation, university of florida levin college of law 2001; partner, landels ripley & diamond, llp, san francisco, california (1999-2000); b.a.,university of californiasanta cruz 1982; j.d., universityof california, hastings college of law 1985. this author is grateful for the helpful comments of professor martin j. mcmahon, jr., the clarence j. teselle professor of law, university of florida levin college of law. 250 florida tax review [vol. 5:3 b. the signature requirement for contested liability funds ...................................... 281 c. limiting the use of contested liability funds by accrual method taxpayers ............................ 284 d. the maxus energy test ........................ 286 iv. the "grantor trust" rules impose an additional limitation on using trusts to avoid accounting method distortion in bankruptcy .......................... 288 a. when payments to a trust are deductible as ordinary business expenses ............................. 290 v. summary of analysis and recommendation for reform ........................................ 292 avoiding phantom income in bankruptcy i. introduction the problem of phantom income in bankruptcy cases chapter 11 of the bankruptcy code' was designed to give the debtor a breathing spell from creditors by granting the debtor time to formulate a reorganization plan without having to fend off creditor claims. both the senate and house reports accompanying the bankruptcy code state that the purpose of the automatic stay is to provide the debtor with "a breathing spell from his creditors." 2 many courts have cited this language in describing the purpose of the automatic stay.3 during this breathing spell, a debtor continues to collect and accumulate money from pre-petition sales and services. absent extraordinary circumstances, however, the debtor is not allowed to use those receipts to pay pre-petition claims until a plan of reorganization is confirmed.4 while designed to benefit the debtor, the breathing spell can also have severe adverse tax consequences for the debtor. for example, a cash method debtor would be taxed on its net income in year one, which would include all revenues collected, but would not be reduced by the offsetting deductions that would normally result from the payment of pre-petition liabilities. this results in phantom income in year one for funds received which are earmarked to pay pre-petition creditor claims, but which cannot be paid due to the bankruptcy prohibition on payment prior to plan confirmation, and mismatched deductions in year two when the plan of reorganization is confirmed and the claims of 1. all references to the "bankruptcy code" are to the bankruptcy reform act of 1978, as amended, codified at 11 u.s.c. § 101 et seq. all unspecified section references, and all references to the "irc" or the "code" are to the internal revenue code of 1986, as amended, codified at 26 u.s.c. § 101 et seq. 2. s. rep. no. 95-989 at 54-55 (1978); h.r. rep. no. 95-595 at 340 (1977). 3. in re commonwealth oil ref. co., 805 f.2d 1175, 1182 (5th cir. 1986) ("the purpose of the automatic stay is to give the debtor a 'breathing spell' from his creditors, and also, to protect creditors by preventing a race for the debtor's assets.") cert. denied, 483 u.s. 1005 (1987). see also krystal cadillac oldsmobile gmc truck, inc. v. gmc, 142 f.3d 631 (3rd cir. 1998); in re javens, 107 f.3d 359 (6th cir. 1997); jove eng'g v. irs, 92 f.3d 1539 (llth cir. 1996). 4. see e.g., fed. r. bankr. § 3021 (mandating that distributions to be made to creditors after confirmation of the plan of reorganization); in re conroe forge mfg. corp., 82 b.r. 781, 784 (bankr. w.d. penn 1988) (stating that "[tihe general rule is that distribution should not occur except pursuant to a confirmed plan of reorganization, absent extraordinary circumstances"); air beds, inc. v. i.r.s., 92 b.r. 419, 424 (9th cir. b.a.p. 1988) (denying debtor's request to distribute proceeds from sale of assets to internal revenue service in satisfaction of pre-petition priority claims prior to plan confirmation); howe v. equitable gas co., 112 b.r. 754, 759 (bankr. w.d. penn. 1990) (denying distribution to secured creditor because "[d]istribution to all but oversecured creditors must await distribution pursuant to a confirmed plan"). 2001] florida tax review creditors are paid. thus, in many cases, if the bankruptcy debtor is not able to confirm a plan of reorganization and make creditor payments during a single tax year, the debtor's tax accounting method is distorted. not all chapter 11 debtors have phantom income. debtors are allowed in the ordinary course of business to use cash receipts to pay the on-going postpetition expenses of their businesses5. many debtors spend all of their cash receipts on the continuing cash needs of their businesses and would not set aside funds for creditor payment even if allowed to do so. because of their on-going cash needs, debtors who would not set aside excess funds earmarked for payment of pre-petition creditor claims do not suffer from accounting method distortion, and no relief is needed. however, in other cases, especially liquidation cases,6 a debtor may quickly accumulate cash in excess of its operating requirements. many debtors would use this excess cash to pay pre-petition claims if they could, in order to deduct the payments from their income to minimize their taxes and thereby prevent the distortion of their accounting method. however, the bankruptcy restrictions on payment of pre-petition claims prior to plan confirmation prevent debtors from arranging their own affairs to minimize their income taxes. while some distortion in the matching of revenues and expenses is inherent in the cash method,7 the gross distortion that can result in bankruptcy 5. 11 u.s.c. § 363(c)(1). 6. liquidating chapter 11 cases are a proper use of chapter 11 of the bankruptcy code. see e.g. 11 u.s.c. § 1123(a)(5)(d) (permitting a plan of reorganization to provide for "the sale of all or any part of the property of the estate... or the distribution of all or any part of the property of the estate among those having an interest in such property of the estate"); sandy ridge dev. corp. v. louisiana nat'l bank, 881 f.2d 1346, 1352 (5th cir. 1989) (stating that "mt is clear from these statutory provisions that although chapter 11 is titled 'reorganization,' a plan may result in the liquidation of the debtor"); air beds, inc., supra note 4, at 423; in re whet, inc., 12 b.r. 743, 750 (bankr. d. mass. 1981); in re river village assocs., 181 b.r. 795, 805 (e.d. pa. 1995). 7. from a financial accounting prospective, the cash method of accounting does not paint an accurate picture of the taxpayer's net income for an accounting period. instead, financial reporting is governed by the accrual method of accounting, under which an attempt is made to match expenses to the revenues generated thereby. see shalala v. guernsey mem'l hosp., 514 u.s. 87, 104 (1995) (recognizing that there are many different forms of the accrual method). in its purest form, the cash method of accounting requires recognition of income and allows deduction of expenses only when received or paid. there is no attempt to match expenses to the accounting period in which the income generated by the expense is earned. see fong v. commissioner, 48 t.c. memo (cch) 689, 716, t.c. memo (p-h) 84,402, 84-1590 (1984) ("respondent seizes upon mr. grays testimony that the cash method did not accurately match income and expenses pertaining to any given year. respondent's argument is misplaced. such matching is the purpose of accrual basis accounting and not of the cash method."). many courts have recognized that the cash method distorts the taxpayer's true accounting position, but is permitted for tax accounting purposes for ease of administration. see e.g., zaninovich v. commissioner, 616 f.2d 429 (9th cir. 1980). in zaninovich, the ninth circuit allowed a cash [vol. 5:3 avoiding phantom income in bankruptcy cases deserves special relief. bankruptcy debtors are often unable to control the timing of pre-petition payments. indeed, the debtor's only real control is its right to propose a plan of reorganization during the exclusivity period.8 in many cases, that control is illusory because the debtor is simply not in a position to propose a confirmable plan during the first tax year in which its bankruptcy case is filed. the bankruptcy laws prohibit the debtor from paying pre-petition claims prior to plan confirmation in order to assure ratable distributions to similarly situated creditors, and to assure fair creditor treatment through the plan confirmation process. the restrictions on pre-petition claim payment are not designed to benefit the debtor but to protect creditors. the debtor does not elect to take advantage of the restriction for its own benefit. because the restriction is imposed on the debtor, the restriction on creditor payments should not come at a tax cost to the debtor. while the accounting method distortion has the most severe impact on cash method taxpayers, accrual method taxpayers are also affected. the accrual method9 of tax accounting is not a purely accrual system. it is a hybrid system method taxpayer to deduct pre-paid rent which extended eleven months beyond the end of the year of payment for ease of administration, even though the expense does not properly match revenues. "moreover, if there was a distortion of income in every situation in which an accounting method did not precisely match items of expense and income, the cash basis method would not be a permissible method of accounting, as a certain degree of imprecision is built into the method." id. at 432. see also, bonaire dev. co. v. commissioner, 679 f.2d 159, 162 (9th cir. 1982) (stating that "we also recognized [in zaninovich] that proration was not needed to reflect income fairly, because the distortion was simply the imprecision built into the cash method, which does not precisely match items of expense and income"); osterloh v. lucas, 37 f.2d 277, 278-79 (9th cir. 1930) (requiring that method of accounting shall clearly reflect income is not absolute; cash method kept fairly and honestly, year after year, "will approximate equality as nearly as we can hope for in the administration of a revenue law"). 8. 11 u.s.c. § 1121(b). the exclusivity period is the 120 day period following the filing of the bankruptcy petition during which only the debtor may file a plan of reorganization. the exclusivity period is extended for an additional 60 days to obtain confirmation if a plan is filed during the 120 day period. id. § 1121(c)(3). 9. while the cash method is inherently imperfect from a financial reporting prospective, the accrual method of accounting is also not a perfect science. in shalala, the united states supreme court recognized that there is no single accrual method, and that even accepted accrual methods for financial reporting do not bind the government in collecting taxes from accrual method taxpayers. the shalala court stated: [generallyaccepting accounting principles] "do[es] not necessarilyparallel economic reality." financial accounting is not a science. it addresses many questions as to which the answers are uncertain and is a "process [that] involves continuous judgments and estimates." in guiding these judgments and estimates, "financial accounting has as its foundation the principle of conservatism, with its corollary that possible errors in measurement [should] be in the direction of understatement rather than overstatement of net income and net assets." this orientation may be consistent with the objective of informing investors, but it still serves the needs of medicare 20011 florida tax review under which traditional accrual accounting methods are used for some liabilities and modified cash methods are used for other liabilities. unlike cash method taxpayers, accrual method taxpayers can deduct most trade debts when incurred, rather than when paid.' ° obviously, there is no distortion of an accounting method caused by a payment restriction where the taxpayer can deduct the liability without making payment. however, accrual method taxpayers cannot deduct many liabilities until payment is made. for example, accrual method taxpayers may deduct liabilities for workers' compensation, torts, breaches of contract, violations of law, rebates and refunds, awards, prizes and jackpots, insurance warranty and service contracts, most taxes, and all other liabilities for which an earlier deduction is not specifically permitted, only when these liabilities are paid." reimbursement and its mandate to avoid cross-subsidization.... there are 19 different gaap sources, any number of which might present conflicting treatments of a particular accounting question. when such conflicts arise, the accountant is directed to consult an elaborate hierarchy of gaap sources to determine which treatment to follow. shalala, supra note 7, at 100-01. 10. the code contains a somewhat labyrinthine way of stating this simple concept. § 461 (a) states the general rule that a deduction or credit is allowed for the proper taxable year under the method of accounting used by the taxpayer in computing taxable income. the code provides that, for an accrual method taxpayer, debts are incurred when the "all events test" is satisfied. see § 461(h)(1) (codifying the traditional "all events" test for accrual accounting); regs. § 1.461-1(a)(2). the all events test is satisfied when all events have occurred to enable the taxpayer to determine the fact of, and with reasonable accuracy the amount of, the liability. § 461(h)(4). however, under the general rule, the "all events" test is not met until "economic performance" occurs with respect to the item. § 461(h)(1); regs. § 1.461-4(a)(1). with respect to trade debts (for goods and services received or used by the taxpayer) "economic performance" occurs when the goods or services are received or the property is used. § 461(h)(2)(a); regs. § 1.461-4(d)(2)(i) (stating that economic performance occurs when services are provided to a taxpayer); regs. § 1.461-4(d)(3)(i) (stating that economic performance for property used by a taxpayer occurs ratably over period used). thus, under the general rules in the code and the treasury regulations, trade debts are generally deductible when the taxpayer receives the property or services, or uses the property, giving rise to the liability regardless of when payment is made. 11. see § 461(h)(2)(c) (workers compensation and tort liabilities); § 461(h)(2)(d) (providing that with respect to other liabilities not mentioned in the code, economic performance occurs "at the time determined under regulations prescribed by the secretary"); regs. § 1.461-4(g)(2) (workers compensation, tort, breach of contract or violation of law liabilities); regs. 1.461-4(g)(2)(i) (stating that breach of contract liability means claim for incidental, consequential or liquidated damages, but not for direct contract damages); regs. § 1.461-4(g)(3) (rebate and refund liabilities); regs. § 1.461-4(a)(4) (award prize or jackpot liabilities); regs. § 1.461-4(b)(5) (insurance, warranty or service contract liabilities); regs. § 1.461-4(g)(6)(i) (tax liabilities, including estimated taxes); regs. § 1.461-4(g)(6)(ii) (governmental license fee liabilities); regs. § 1.461-4(g)(7) (catch-all for all other liabilities "for which economic performance rules are not provided elsewhere in this section or in any other internal revenue regulation, revenue ruling or revenue procedure"). [vol. 5:3 avoiding phantom income in banknptcy deferred wage claims present special problems. under section 404(a), an accrual method taxpayer may not deduct wage claims which are accrued and unpaid, unless the payment is made by the time the taxpayer's return is due.12 while section 404 was originally enacted to limit traditional deferred compensation arrangements, it has been interpreted broadly to prevent both cash and accrual method taxpayers from deducting compensation payments until the year of actual receipt by the employee or independent contractor, 3 subject to a limited exception for accrual method taxpayers who make payment prior to the timely filing of their tax return in the year following accrual. like the cash method economic performance rules applicable to accrual method taxpayers, section 404 operates to further distort the accrual method of a debtor in bankruptcy, because even priority wage claims cannot normally be paid until plan confirmation. thus, debtors who use the accrual method for tax purposes suffer the same distortion as cash method taxpayers with respect to liabilities that cannot be deducted until paid, such as most non-trade debts. although distortion in the matching of revenues and expenses is inherent in both the traditional cash method and the modified accrual method used for tax accounting, the distortion that results from the bankruptcy prohibition on creditor payments is deserving of relief. the distortion that results in bankruptcy is not the result of the inherent limitations in a calendar year system or the policy decisions made by congress to assure a steady stream of revenue and prevent abuse. 14 those accepted distortions are already reflected in the cash and accrual methods of tax accounting. outside of bankruptcy, taxpayers can learn the rules 12. see § 404(a) (stating the general rule that allows deduction for wages only when paid); § 404(a) (6) (providing exception to general rule for payments made by an accrual method taxpayer not later than the time prescribed by law for the filing of the return for the taxable year of accrual (including extension); regs. § 1.404(a)-1(c) (same). 13. see boris l bittker & martin j. mcmahon, jr., federal income taxation of individuals, 39.4[5] (2d. ed. 1995 & supp. 2001). 14. as discussed in greater detail in part iii, the economic performance rules of § 461(h) were designed to prevent accrual method taxpayers from obtaining the time value of money benefits of a full deduction now for liabilities that would not be paid for many years. see e.g., h.r. rep. no. 98-432, pt. ii, at 1254 (1984) (house ways and means committee report on deficit reduction act of 1984, containing language which became § 461(h) (noting that "the rules relating to the time for accrual of a deduction by a taxpayer using the accrual method of accounting should be changed to take into account the time value of money"); see also mooney aircraft, inc. v. united states, 420 f.2d 400, 410 (5th cir. 1969) (disallowing current deduction by aircraft manufacturer for liability to pay $1,000 upon retirement of aircraft); ford motor co. v. commissioner, 71 f.3d 209, 216-17 (6th cir. 1995) (allowing a deduction of only the discounted present value of the structured tort settlement). 20011 and can arrange their affairs in legitimate ways so as to minimize their taxes.' 5 for example, outside of bankruptcy, the taxpayer can prevent the distortion by simply paying the liabilities in the appropriate tax year. but in bankruptcy, it is the accounting method itself that is distorted by the restriction on payment. the debtor's hands are tied. the debtor is not free to arrange its affairs in such a way as to minimize its taxes. the bankruptcy court has the ultimate control over the timing of payments through its power to deny confirmation of a plan. further, the creditors have significant say in the timing and structure of the plan of reorganization through their votes and through their rights to object to plan confirmation. congress and the treasury have recognized the need for relief in similar situations in which the taxpayer's hands are tied in making payments due to legitimate non-tax restrictions. for example, congress and the treasury have provided relief for taxpayers who are unable to pay asserted but contested liabilities. the taxpayer may take a deduction without paying the disputed claim by placing the funds outside of the taxpayer's control until the dispute is resolved. section 461 (f) permits a deduction, by both cash and accrual method taxpayers, for contested liabilities if the taxpayer transfers money or property "to provide for" satisfaction of the contested liability, as long as the payment would be deductible but for the contest. section 461 (f) does not specify to whom the payment must be made. as discussed in part iv, while the treasury has taken the position that the payment must be made to the creditor, to a qualified trust or fund under an agreement signed by the creditor, or pursuant to a court or government order, 16 several courts have been far more liberal in allowing payments even to secret trusts, as long as distribution from the trust can be made only upon resolution of the contest. 7 similarly, where there is a dispute over who is entitled to payment, but the taxpayer admits the liability, the treasury has proposed permitting a deduction for payment to a disputed ownership fund. this would enable a taxpayer to take a deduction upon interpleading funds with a court with jurisdiction to resolve conflicting claims of entitlement. 8 congress has also granted relief from the harsh economic performance rules by allowing deductions for payments to a designated settlement fund (dsf) 15. in the famous case of helvering v. gregory, judge learned hand stated: "any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the treasury; there is not even a patriotic duty to increase one's taxes." 69 f.2d 809, 811 (2d cir. 1934), aff'd 293 u.s. 465 (1935). 16. regs. § 1.461-2(c)(1). 17. see varied invs., inc. v. united states, 31 f.3d 651, 655 (8th cir. 1994); edison bros. stores, inc. v. commissioner, 69 t.c. memo (cch) 2897, 2899-900, t.c. memo (ria) 95,262, 95-1659. 18. prop. regs. § 1.468b-9, 64 f.r. 4801 (2/1/99) (disputed ownership fund). florida tax review [vol 5:3 avoiding phantom income in bankruptcy established under section 468b, and the treasury has granted significantly broader relief for payments made to a qualified settlement fund (qsf) pursuant to the section 1.468b of the treasury regulations. broadly speaking, the dsf statute and the qsf regulations combine to allow accrual method taxpayers to avoid the economic performance limitations by permitting deductions for payments made to a desiguated fund for satisfaction of disputed and undisputed tort and violation of law liabilities. a full review of the dsf and qsf rules follows in part iii. while the available relief is limited, especially for bankruptcy debtors, the dsf and qsf rules provide a mechanism for relieving the distortion caused by the economic performance rules in many situations in which they would otherwise unintentionally penalize and discourage legitimate non-tax business activities, such as structured tort settlements. this paper explores the limitations and uncertainties of the current methods available to accrual method and cash method bankruptcy debtors to attempt to avoid taxation on phantom income which is earmarked for the payment of creditor claims, and points out the need for regulatory reform. ii. the existing methods for avoiding phantom income in bankruptcy are inadequate a. the net operating loss carryback rules provide only limited relieffrom the accounting method distortion in bankruptcy the code allows a taxpayer to carry back a net operating loss to its prior two years. 9 a net operating loss is defined generally as deductions in excess of gross income.20 however, section 172(d) prevents most personal deductions, including itemized personal deductions, personal and dependency exemptions and investment expenses, from being carried back as net operating losses. moreover, no deduction is allowed for capital losses in excess of capital gains. 21 in essence, the net operating loss is the excess of business deductions over business income, to the extent that the taxpayer does not receive any tax benefit from the excess business deductions.2' however, the excess business deductions result in a tax 19. §§ 172(a), (b)(1)(a). longer carrybacks are allowed in specified circumstances. see e.g., § 172(b)(1)(c) (10 year specified liability loss carryback); § 172 (b)(1)(d) (10 year carryback for commercial bank bad debt losses); § 172(b)(1)(f) (3 year carryback for casualty losses, small business losses and farming losses). 20. § 172(c). 21. corporations are not allowed to deduct losses from the sale or exchange of capital assets to the extent they exceed gains from the sale or exchange of capital assets. § 1211 (a). individuals are allowed to deduct up to $3,000 of excess capital losses over capital gains. § 1211(b). however, this excess deduction of up to $3,000 is excluded from the net operating loss calculation. § 172(d)(2). 22. see bittker & mcmahon, supra note 13, at 19.212]. 20011 florida tax review benefit to the extent they offset capital gains or other personal income, and in such event cannot be carried back.23 when the deferred deductions in year one result in an equal amount of net operating loss carrybacks upon confirmation of the plan of reorganization in year two, the net operating loss carryback does provide relief from the distortion of the accrual and cash method of accounting in bankruptcy cases. for example, if the debtor received all of its income in year one, and took all of its deductions in and had no income in year two, the net operating loss would work as intended by allowing the deductions to be carried back and matched against the year one income. the only loss to the taxpayer from the distortion would be the time value of the taxes paid for year one and later refunded for year two.24 1. discharge of indebtedness upon plan confirmation will often eliminate the net operating loss carryback-but in the real world, the net operating loss carryback does not work perfectly. the first limitation arises out of the discharge of indebtedness rules. in many bankruptcy cases, the debtor's plan of reorganization provides for the discharge of indebtedness because creditor claims are not to be paid in full, and are discharged upon confirmation of the reorganization plan. 5 as a general rule, discharge of indebtedness results in 23. id. 24. when a net operating loss is carried back to an earlier year, the taxpayer's tax liability for the earlier year must be recomputed. the taxpayer must then file a request for a refund of the difference between the amount paid in the earlier year and the amount properly due after taking into consideration the carryback. see internal revenue service, u.s. dep't. of treas., pub. no. 536, net operating losses (nol's) for individuals, estates and trusts, 7 (2000). a request for refund must be filed within three years after the date prescribed by law for the filing of the return for the loss year. § 6511 (d)(2). the code disallows any claim for interest on the overpayment in the carryover year unless the treasury fails to pay the refund within 45 days after filing the request for refund, and then only allows interest from the date of the filing of the return for the loss year (not the carryback year) to the date payment is made. § 661 1(e)(1). these rules are set forth in several different subsections in the code. first, for purposes of computing interest on the overpayment of tax, the "overpayment" for the carryback year is deemed not to have been made prior to the filing date of the return for the year in which the net operating loss occurred. § 6611 (f)(1). this permanently eliminates anyclaim for interest between the later of the due date or filing date of the return for the carryback year and the due date or filing date of the return for the loss year. second, §§ 661 1(e) and 661 l(f)(4) combine to disallow any interest between (1) the later of the time for filing or the due date of the return for the loss year, and (2) 45 days after the filing of the claim for refund, if the refund is made within 45 days after the claim for refund is filed. § 661 l(e) & (f)(4). therefore, whether or not the treasury refunds the overpayment for the carryback year within the statutory 45 day period, if the debtor's deductions are deferred from year one to year two or three, and a carryback is allowed from year two or three to year one, the deferral has resulted in a time-value-of-money loss to the debtor because the refund is made without interest for the time of the deferral. 25. 11 u.s.c. § 1141(d)(1)(a). relief from indebtedness income does not occur in all chapter 11 bankruptcy cases. first, if the debtor is solvent and provides for the full payment of all creditor claims, the debtor may still receive a formal discharge in bankruptcy, but no [vol 5:3 avoiding phantom income in bankruptcy income to the taxpayer.26 however, when the discharge of indebtedness occurs in a bankruptcy case, no discharge of indebtedness income is recognized.27 there is, however, a tax cost to the relief from discharge of indebtedness income in a bankruptcy case. the debtor is required to reduce its tax attributes for the full amount of discharge of indebtedness income which is not recognized.28 unless the debtor can and does make a valid election to reduce the debtor's basis in depreciable property, and is able to absorb the full discharge of discharge of indebtedness for tax purposes results. second, a corporate bankruptcy debtor who liquidates and does not have post-confirmation operations does not receive a discharge. id. § 1141(d)(3). the creditors' claims may be worthless, but are not discharged (the liability against the shell entity remains). finally, discharge of indebtedness is unlikely in a partnership bankruptcy case unless the partners are themselves insolvent. in order to confirm a plan of reorganization, each creditor must either affirmatively accept the plan or receive property not less than the holder would receive in a chapter 7 liquidation. id. § 1129(a)(7). in a chapter 7 case, the trustee has a claim against the general partners for the deficiency in the estate to pay all creditors, to the extent the partners are liable for the deficiency under applicable law. id. § 723. therefore, in a chapter 7 case, solvent general partners would normally be required to pay to the trustee the deficiency in the estate to pay all creditors, and all creditors would receive full payment of their claims. a chapter 11 plan proposing less than full payment could not be confirmed in such circumstance over the objection of a single creditor. only where the partners are themselves insolvent, are not personally liable for the particular discharged debts, or where the creditors for some reason all voted to accept less than fll payment would a partnership debtor with solvent partners be able to confirm a plan of reorganization and obtain a discharge. even if the confirmed plan of reorganization provided for the discharge of claims against the partnership, solvent partners may not receive the benefits of non-recognition under § 108(a)(1)(a). see also § 108(d)(6) (providing that the § 108 rules are to be applied to a partnership at the partner level) and § 108(d)(2) (providing that a "title 11 case" means a case under the bankruptcy code, "but only if the taxpayer is under the jurisdiction of the court in such case"). presumably, a non-debtor partner in a debtor partnership would not be under the "jurisdiction of the court," and the discharge of the partnership's debts would not devolve to the partner for the purpose of excluding discharge of indebtedness income under § 108(a)(1). this is contrasted with § 108(d)(7) which requires application of the § 108 rules at the corporate level for an s corporation. § 108(d)(2). in gitlitz v. commissioner, the supreme court, in connection with the insolvency exception in § 108(a)(1)(b), suggested that, outside of the s corporation context, no solvent entity can benefit from the non-recognition provisions of § 108. gitlitz, 121 s.ct. 701,710 n.10 (2000). thus, partners in a partnership can likely benefit from the non-recognition provisions of §§ 108(a)(1) and (2) only if they themselves are debtors in bankruptcy or insolvent at the time of the discharge. 26. "income from discharge of indebtedness" is included in the definition of "net income" under § 61(a)(12). in the famous case of united states v. kirbylumber co., the united states supreme court held that a corporation realizes discharge of indebtedness income when it purchases its own bonds on the open market at a price lower than par, because it has realized within the year an accession to income. 284 u.s. 1, 3 (1931). 27. § 108(a)(1)(a). 28. § 108(b)(1). 20011 indebtedness income as a reduction in the basis of depreciable property,29 the unrecognized discharge of indebtedness income will be used first to reduce any net operating loss for the taxable year and any carryover to the taxable year.30 in many bankruptcy cases, the unrecognized discharge of indebtedness income in the year of plan confirmation will swamp any net operating loss for the year. therefore, because plan confirmation will often both allow the deferred creditor payments to be made (resulting in a potential net operating loss) and result in discharge of indebtedness income, the potential benefit of a net operating loss carryback in bankruptcy is significantly diminished if the attribute reduction occurs before the net operating loss can be carried back. the timing of the attribute reduction is thus crucial to the effectiveness of the net operating loss carryback in bankruptcy cases. the statute provides that the net operating loss and capital loss attribute reductions "shall be made after the determination of the tax imposed by this chapter for the taxable year of the discharge.",31 it would appear, then, that the statutory issue is whether the carryback is a "determination of tax for the year of discharge," or a re-determination of a prior year's tax. section 108(b)(4)(a) was added by the bankruptcy tax act of 1980.32 according to the report of the joint committee on taxation, the purpose of the provision was to reduce the attributes immediately after the computation of the current year's tax: thus in the case of net operating loss and capital loss, the debt discharge amount first would reduce the current year's loss and then would reduce the loss carryovers in the order in which they arose. the investment credit carryovers would be reduced on a fifo basis, and the other credit carryovers also would be reduced in the order they would be used against taxable income. these reductions would be made after the computation of the current year's tax.33 the report does not mention the distinction between carryovers and carrybacks. no court has analyzed the effect of this timing provision on a net operating loss carryback. 29. § 108(b)(5) (giving the debtor the election to reduce the basis of the debtor's depreciable property in lieu of reducing other tax attributes such as the debtor's net operating losses). however, the debtor must have sufficient adjusted basis remaining in its depreciable property to absorb the entire amount of unrecognized discharge of indebtedness income otherwise the excess unrecognized discharge of indebtedness income will reduce the debtor's net operating losses. § 108(b)(5)(b). 30. § 108(b)(2)(a). 31. § 108(b)(4)(a). 32. pub. l. no. 96-589, 94 stat. 3,389 (1980). 33. joint committee on taxation, 96 t" cong., description of h.r. 5043 (bankruptcy tax act of 1980) 12 n.13 (jt. comm. print 1980). [vol. 5:3florida tax review avoiding phantom income in bankruptcy however, due to the existence of a potential tax loophole, section 108(b)(4)(a) has come under great scrutiny in connection with the pass-through of income from subchapter s corporations to their shareholders. this scrutiny has resulted in a number of recent circuit court opinions reaching inconsistent results and using inconsistent analysis, followed by the recent opinion of the united states supreme court in gitlitz v. commissioner.34 the actual issue addressed in these opinions is not relevant to this article.35 however, in analyzing the specialized s corporation issues, one circuit 34. 121 s.ct. 701 (2000); witzel v. commissioner, 200 f.3d 496 (7th cir. 2000); farley v. commissioner, 202 f.3d 198 (3rd cir. 2000); pugh v. commissioner, 213 f.3d 1324 (11 th cir. 2000); guadiano v. commissioner, 216 f.3d 524 (6th cir. 2000). for a recent article discussing the history, outcome and likely congressional remedy to the gitlitz issue, see richard m. lipton, supreme court hands taxpayers a victory in gitlitz, but will congress take it away?, 94 j. tax'n 133 (2001). 35. subchapter s corporations pass through items of income and loss to their shareholders, who pay any resulting tax liabilities. § 1366(a)(1). passed-through items of income increases the s corporation's shareholders' stock basis, and passed-through items of loss decrease the s corporation's shareholders' stock basis. § 1367(a). if the passed-through losses of the s corporation exceed the shareholder's stock basis, the s corporation's losses are not passed-through to the shareholder, and are carried-over indefinitely until the shareholder recovers basis. § 1366(d). the suspension of pass-through losses in excess of basis under § 1366(d) set the stage for the series of cases leading to the supreme court's decision in gitlitz. in all of these cases except pugh, the shareholders of insolvent s corporations sought to passthrough discharge of indebtedness income in order to increase their basis so that suspended losses could be passed-through to and recognized by them. because the s corporations were insolvent, the discharge of indebtedness income was not recognized under § 108(a)(1)(b). the issue in these cases was whether the reduction of net operating losses required by § 108(b)(2)(a) as a result of the non-recognition of discharge of indebtedness income occurs before or after the pass-through of income from the discharge of indebtedness for purposes of the basis adjustment. prior to the supreme court's opinion in gitlitz, the circuit courts came to conflicting results. the farley court held that the attribute reduction required by § 108(b)(2)(a) was to take place in the year after the discharge, allowing the shareholders to deduct suspended losses without recognizing any taxable income. farley, 202 f.3d at 205-06. similarly, the pugh court allowed an upward basis adjustment without recognition of gross income. pugh, 213 f.3d at 1328. the other courts to consider the issue disallowed a basis increase for the unrecognized discharge of indebtedness income on various different theories. see lipton, supra note 34 at 34-35. the supreme court agreed with the result in farley and pugh, but did not adopt the farley court's reading of § 108(b)(4). rather, the supreme court simply held, consistent with the wording of the statute, that the pass-through of losses by an s corporation to its shareholders was part of the "determination of the tax imposed ... for the taxable year of discharge" within the meaning of the statute. gitlitz, 121 s.ct. at 708-09; "in order to determine the 'tax imposed,' an s corporation shareholder must adjust his basis in his corporate stock and pass through all items of income and loss. consequently, the attribute reduction must be made after the basis adjustment and pass-through." id. at 709 (emphasis in original, citation omitted). the supreme court permitted the s corporation shareholders to recognize a double benefit, noting that the "s" shareholders "would be exempted from paying taxes on the full amount of the discharge of indebtedness income, and they would be able to increase basis and deduct their previously suspended losses. because the code's plain text 20011 florida tax review court concluded that section 108(b)(4)(a) "clearly" provides for the reduction of net operation losses to occur at the beginning of the year following the year of discharge. the language in section 108(b)(4)(a) clearly indicates that tax attributes are reduced on the first day of the tax year following the year of the discharge of indebtedness. the statutory language is unambiguous, and the operation of the statutory language is straightforward.36 the supreme court in gitlitz, did not adopt or reject this characterization of section 108(b)(4)(a). instead, the supreme court made two statements concerning the meaning of section 108(b)(4)(a) that point in different directions. first, the supreme court interpreted the language of section 108(b)(4)(a) to allow the s corporation to pass-through the discharge of indebtedness income to its shareholders for the year of discharge prior to the reduction of attributes, because the s pass-through was a determination of the shareholders taxes for the year of discharge. in gitlitz, the court stated that "in order to determine the 'tax imposed,' an s corporation shareholder must adjust his basis in his corporate stock and pass through all items of income and loss."" thus, the court concluded that "the attribute reduction must be made after the basis adjustment and pass-through., 38 conspicuously absent from the supreme court's language is any suggestion that the attribute reduction occurs at the beginning of the year following discharge, as suggested by the third circuit in farley. however, after fitting its case neatly into the statutory language, the supreme court threw a curve: "see also § 1017(a) (applying the same sequencing when § 108 attribute reduction affects basis of corporate property.), 39 section 1017(a) does not contain the same sequencing language as permits the taxpayers here to receive these benefits, we need not address this policy concern." id. at 709-10 (citations omitted). the court noted that this loophole only applies in the s corporation context. id. at 710 n. 10. the s corporation loophole does not apply to partnerships because § 108(d)(6) provides that the § 108 rules apply at the partner level, not at the partnership level. unlike the s corporation shareholder, the partner in an insolvent partnership is entitled to exclude cod income under § 108(a)(1)(b) only if the partner is insolvent. lipton, supra note 34, at 134 n.3. because the supreme court did not specifically adopt or reject the interpretation of§ 108(b)(4)(a) made by the third circuit in farley (that the attribute reduction is to occur in the year following the year of discharge, rather than in the year of discharge after determining the tax for the year of discharge), the supreme court's decision in gitlitz does not aid in determining whether the reduction occurs before or after carrying back a net operating losses to years prior to the discharge. 36. farley, 202 f.3d at 205-06. 37. 121 s.ct. at 709. 38. id. (emphasis in original, citation omitted). 39. id. (emphasis added). [vol. 5:3 avoiding phantom income in banknptcy section 108(b)(4)(a). for purposes of basis reduction, section 1017(a) provides that the amount of unrecognized discharge of indebtedness income that is to be applied to reduce basis "shall be applied in reduction of the basis of any property held by the taxpayer at the beginning of the taxable year following the taxable year in which the discharge occurs." '4 did the supreme court mean by its offhand comment that the section 1 08(b)(4)(a) net operating loss attribute reduction is to take place in the year following discharge as section 1017(a) requires for basis reduction, or did it merely mean that both the net operating loss attribute reduction and the basis reduction would take place after the pass-through of discharge of indebtedness income to s corporation shareholders? the answer is uncertain. in applying section 108(b)(4)(a) to a net operating loss carryback, it is difficult to ignore the very different language used by congress in sections 108(b)(4)(a) and 1017(a). 41 the difference in language can be rationally explained by congress' desire to prevent the carryback of net operating losses to years prior to the year of discharge before the attribute reduction is made. it appears that none of the courts that considered the s corporation issue had the net operating loss carryback question in mind when they wrote their opinions. because the net operating loss carryback results in a refund of the prior years' taxes (requiring a formal claim for refund) rather than an adjustment to the taxes owing for the year of discharge,4 2 only a skilled linguistic contortionist could interpret section 108(b)(4)(a) to allow the carryback before the attribute reduction takes place. the carryback simply does not result in the determination of the taxes imposed for the taxable year of discharge. under a plain interpretation of the language, the attribute reduction should reduce the carryback. thus, in many bankruptcy cases, the postponement of deductions to the year of plan confirmation will in many cases eliminate the potential benefit of a net operating loss carryback due to the reduction in attributes required by the discharge of indebtedness rules. 2. phantom income does not always result in a net operating loss.-the net operating loss carryback rules only apply if there is, in fact, a net operating loss to carry back. if the debtor has income in both year one and year two, the deductions properly attributed to year one but postponed until 40. § 1017(a). 41. § 108(b)(4)(a) provides "the reductions described in paragraph (2) shall be made after the determination of the tax imposed by this chapter for the taxable year of the discharge." § 1017(a) provides that the discharge of indebtedness income which is excluded from recognition and is to be applied to reduce basis "shall be applied in reduction of the basis of any property held by the taxpayer at the beginning of the taxable year following the taxable year in which the discharge occurs." 42. see supra note 24. 20011 florida tax review confirmation of the plan of reorganization in year two will be used to reduce year two income before constituting a net operating loss. for example, suppose that a debtor had both $20x of income in years one and two, and $1 ox of deductible expenses in each year which, absent the bankruptcy restrictions, would have been paid and deducted in years one and two. due to the deferral required by the bankruptcy rules, instead of having $ 1ox of taxable income in years one and two, the debtor would have $20x of taxable income in year one and no taxable income in year two. no carryback would result in year two, because the deductions properly attributable to year one were used to offset year two income. the value of the deductions in year two may be very different from the value of the deductions in year one for several reasons. first, the debtor would likely be in a higher tax bracket in year one than in year two due to the deferred deductions. in the example above, the debtor could be pushed into a higher tax bracket in year two due to the extra $ 1ox of taxable income, while the savings of $1 ox in year two may result in a lower tax bracket benefit. the debtor's year two income may be substantially reduced due to scaled down operations, further reducing the applicable year two bracket and the value of the deferred year one deduction. second, there could be differences in tax rates between years one and two. finally, lower capital gains rates may also increase the tax cost of the phantom income. the postponement of deductions properly attributed to year one would be used to reduce year two capital gains before constituting a net operating loss.4 3 in many bankruptcy cases, including most liquidation cases, capital gains are incurred at the end of the case when assets are liquidated. the value of the deduction to reduce ordinary income in year one may be significantly higher than the value of the deduction in year two to reduce capital gains, because capital gains are taxed at much more favorable marginal rates than is ordinary income." in summary, while the net operating loss carryback, when it applies, could mitigate the distortion caused by the bankruptcy restrictions on payment of creditor claims, it does not provide a bankable solution to the phantom income problem. in all cases, the debtor suffers a one-year time value of money loss by paying excess taxes for year one which are refunded for year two. in many bankruptcy cases, the carryback will be eliminated in the year the plan of 43. a net operating loss is defined as "the excess of the deductions allowed by this chapter over the gross income." § 172(c). capital gains are included in gross income. § 61(a)(3) (gains from "dealings in property" are included in "gross income"). 44. for individuals, the highest marginal tax rate on capital gains is 20%, while the highest marginal tax rate on ordinary income is 39.6%. §§ 1 (h)(1)(e), 1(a). for all individuals, applicable capital gains rates will be lower than taxpayer's marginal rate on ordinary income. § 1(h)(1)(a). corporations do not receive preferential rates on capital gains. see § 11. therefore, it is irrelevant to a corporation whether the deferred expenses offset ordinary income or capital gains. [vol. 5:3 avoiding phantom income in bankruptcy reorganization is confirmed by the reduction required by the discharge of indebtedness rules. finally, where the debtor has sufficient income in year two to utilize the deductions so that they are not carried back, the value of the deductions may be significantly less than the value of the deductions would have been in year one, due to differences in the taxpayer's applicable marginal tax rates and the unfavorable use of the year one deductions to offset year two capital gains rather than year one ordinary income. b. the dsf and qsf rules provide only limited relief from accounting method distortion in bankruptcy dsfs were created by congress in 19884' to relieve some of the hardships caused by the hybrid accrual method accounting system created by congress with the enactment of section 461(h) in 1984.46 in order to understand the need for dsfs and the significant expansion made by the treasury in the qsf regulations, it is necessary to understand the history of the hybrid tax accounting system created by section 46 1(h). 1. the history of deductions under the accrual method of accounting.-prior to 1916, income taxes in the united states were generally based on the cash method of accounting, although some accrual method accounting principles were allowed in 1913 for inventory accounting.47 in 1916, congress first expressly permitted accrual method tax accounting for taxpayers who used the accrual method for keeping their financial books. this act specifically allowed reserves for liabilities accrued but not yet due. in 1919, congress added the predecessor of current sections 446(a) and (b), which allowed taxpayers to consistently use the method of accounting that they used in keeping their financial books, as long as the method employed correctly reflected income.48 this is the same basic statutory standard used today under section 446. 45. section 468b, (providing for the use of dsfs, was enacted in the technical and miscellaneous revenue act of 1988, §§ 1018(f)(4)(a)-(b), 26 u.s.c. § 468b). pub. l. no. 100647. according to the joint committee on taxation, the provision was enacted to allow accrual method taxpayers under limited circumstances to deduct payments made to a dsf even though the payments would not otherwise qualify for a deduction under § 461 (h) because they were not made directly to the creditor. see joint committee on taxation, explanation of technical corrections to the tax reform act of 1984 and other recent tax legislation, jcs-1 1-87 (part 1 of 17 parts) (may 13, 1987). 46. section 461(h) was created in the deficit reduction act of 1984, § 91, 26 u.s.c. § 461(h). 47. the early history of income tax accounting methods was summarized by the solicitor general in united states v. anderson, 269 u.s. 422,423-25 (1926). 48. id. 20011 florida tax review the supreme court first considered the problems of accrual method tax accounting in united states v. anderson.49 in anderson, a munitions manufacturer kept its books and reported its taxes under the accrual method. the manufacturer deducted a munitions excise tax, which it had paid in 1917, from its 1917 income. the government argued that under the accrual method employed by the manufacturer in accounting for all other items of income and expense, the taxes should have been deducted in 1916, because the taxes were computed on 1916 sales. the issue in the case was when the excise taxes "accrued." in deciding that the excise taxes accrued in 1916, the supreme court announced what has become known as the "all events" test for accrual of income and expenses a test which would be used without substantial change for the next 60 years: [i]n advance of the assessment of a tax, all the events may occur which fix the amount of the [excise] tax and determine the liability of the taxpayer to pay it. in this respect, for purposes of accounting and of ascertaining true income for a given accounting period, the munitions tax here in question did not stand on any different footing than other accrued expenses appearing on appellee's books.5" there were few statutory changes in accrual method rules between 1919 and 1985. while the sections were renumbered, the basic rules were (1) section 446(a), which allows a taxpayer to use the method of accounting regularly used in computing income on the taxpayer's books, (2) section 446(b), which allows the commissioner to reject a method of accounting which does not clearly reflect income, and (3) section 461 (a), which allows the taxpayer to take a deduction in the proper tax year under the taxpayer's method of accounting used to compute taxable income. 2. the time value of money problem.-under a strict interpretation of the "all events test," a structured settlement would be deductible at its face amount, even though the payments may be made over a long period of time without stated interest. the "all events test" ignores the time value of money both income and expenses are recognized when accrued, rather than when received or paid. when interest which could be earned on the money is taken into account, the discounted present value of this stream of payments would be significantly less than the arithmetic sum of the payments. the first important case to recognize the potential for present-value abuseby accrual method taxpayers was mooneyaircraft, inc. v. united states." 49. id. 50. id. at 441. 51. 420 f.2d 400 (5th cir. 1969). [vol. 5:3 avoiding phantom income in bankruptcy in mooney, an aircraft manufacturer sold its aircraft together with so-called "mooney bonds" redeemable for $1,000 upon retirement of the aircraft. the manufacturer sought to deduct the entire $1,000 redemption price of the bonds upon issuance, arguing that under the "all events" test the liability had accrued, and the amount of the liability could then be determined with reasonable certainty. the court agreed with the manufacturer that the "all events" test had been satisfied because the fact and amount of the liability were known, only the timing of the liability was uncertain. but the court also accepted the government's argument that the manufacturer's method of accounting for the bonds did not "clearly reflect income" within the meaning of section 446(b), because the manufacturer would not be called upon to redeem the bonds for many years. the court reasoned that it would be unfair to allow a current deduction for a liability that would not be paid for many years, especially in light of the risk that mooney's future obligation might never be paid due to insolvency.52 therefore, the court did not allow the manufacturer to deduct any portion of the bond liability until the year of actual payment. although the mooney court was correct in concluding that the deduction of the full $1,000 redemption price of the bond at issuance did not accurately reflect income, the position adopted by the courtdisallowing the deduction until payment is subject to the same criticism. to correctly analyze any deferred payment problem, it is necessary to properly separate the investment component of the transaction involving imputed interest. in the mooney case, the purchaser of the aircraft bought more than just an aircraft. the purchaser bought both an aircraft and a bond. as a matter of economics, seller did not give the bond away for free the cost to seller of the bond (and possibly a profit component as well) was included in the purchase price. a bond is evidence of a loan the purchaser pays the issuer money in return for the issuer's promise to repay a greater sum upon maturity (in the case of mooney upon retirement of the aircraft).53 if instead of lumping the two transactions together, the seller in mooney had sold the aircraft for a lower price without the bond, and in a separate document had borrowed the discounted present value of the bond in return for a promise to pay the face amount of the 52. id. at 410. 53. the mooney court used the term "bond" in its colloquial sense to mean a document evidencing an obligation to pay a specific amount at a specific time or upon the occurrence of a particular event. see § 171(d) (defining "bond" for purposes of § 171 as a "bond, debenture, note or certifice or other evidence of indebtedness... "); § 150(a)(1) ("bond" includes "any obligation.") the encyclopaedia britannica, defines a bond as follows: "in finance, a loan contract issued by local, state, and national governments and by private corporations specifying an obligation to return borrowed funds." 2 encyclopaedia britannica 354 (15th ed. 1987). 2001] bond upon retirement of the aircraft, the economics of the transaction would be apparent. in mooney, the seller should have been taxed on the segregated amount received for the aircraft, and should have been allowed to receive the loan proceeds tax free, since they would have to be repaid upon the obligation's maturity.54 then each year the issuer would be entitled to a deduction for the accrued interest on the bond.55 in the final year of redemption, the total of the accrued interest owing on the bond and the purchase price of the bond would equal the $1,000 redemption payment.56 thus, the seller/issuer would have received an exclusion from income for the discounted present value of the bond at the time of issuance, and would receive interest deductions each year until the maturity of the bond. no deduction would be available upon payment of the bond at maturity. for the accrual method taxpayer, the value of the initial exclusion and the annual deductions would significantly exceed the value of the final redemption payment, because the taxpayer would be able to obtain a return on the tax savings from the exclusion and the deductions in the applicable years. the court's solution of allowing a deduction only in the year of payment improperly deprives an accrual method taxpayer of the earnings on the properly matched deductions. in mooney, both the taxpayer's proposed method of deducting the full future value of the obligation now, and the court's method of allowing a deduction only at the time of payment, distort the economically correct method of accounting for the transaction. 54. see e.g., commissioner v. tufts, 461 u.s. 300, 307 (1983) (stating that "when a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date. because of this obligation, the loan proceeds do not qualify as income to the taxpayer. when he fulfills the obligation, the repayment of the loan likewise has no effect on his tax liability.") 55. under current law, if the issuance of the bond was properly viewed in its economic sense as a loan, the bond would be an "original issue discount" obligation because the discounted present value of the bond would be less than the redemption amount of the bond. § 1273(a)(1). the issuer would be allowed a deduction under § 163(e) for the accrued daily portion of the original issue discount. see also § 1272(a)(3) (discussing the method for calculating daily interest on original issue discount obligation); regs. § 1.461-4(e) (stating that "in the case of interest, economic performance occurs as the interest cost economically accrues in accordance with the principles of relevant provisions of the code."). however, if instead of viewing the bond as a loan, the bond were to be treated as a "rebate, refund or similar payment" connected to the sale of the aircraft, then a deduction would be available to the issuer only upon payment of the obligation. regs. § 1.461-4(g)(3). therefore, the characterization of the transaction (and very likely the form of the transaction) may result in very different tax consequences. 56. this is a function of mathematics. the original issue discount rules compute the daily amount of interest based on the yield to maturity of the instrument, using the adjusted issue price as the present value of the instrument and the redemption price at maturity as the future value. § 1272(a)(3)(a); regs. § 1.1272-1(b)(i). the difference between the present and future values is the amount of interest that accrues under the instrument. florida tax reviewv [vol 5:3 avoiding phantom income in bankruptcy when interest rates rose to double-digit heights in the late 1970s and early 1980s, congress recognized the need to statutorily address the crack in the accrual method system identified by the mooney court. the house report on what would later become section 46 1(h) states: "the rules relating to the time for accrual of a deduction by a taxpayer using the accrual method of accounting should be changed to take into account the time value of money."' congress' concern that accrual method taxpayers would attempt to take advantage of the potential time value of money loophole in the accrual method was well founded. for example, in 1980, the ford motor company entered into 20 structured settlements of product liability tort claims for payouts totaling $24,477,699 over as long as 58 years. ford paid only $4,424,587 for annuities to cover all of the payments required under the settlement terms, yet attempted to deduct on its 1980 return the entire $24,477,699 future liability. the tax court found that, if allowed, the tax savings from the deduction would more than offset the entire cost of the annuities, allowing ford to make a net after-tax profit on the settlement of its tort liabilities. the case was heard by the tax court in 1994, nine years after the enactment of section 461(h), but was decided under the law in effect in 1980 before the enactment of section 461 (h). ford argued that the "all events" test was met, and that therefore there was no basis for the court to disallow the entire deduction. like the mooney court, the tax court and the sixth circuit agreed with ford that the "all events" test had been met, but they also agreed with the government that the accrual method as applied to these settlements did not "clearly reflect income" as required by section 446(b). unlike the mooney court, however, the court in the ford motor company case determined that ford would be required to use a judicially-created hybrid accounting system, under which ford was allowed to deduct the amount paid for the annuities (which represented the discounted present value of the settlement payments), and was allowed not to recognize income as the annuities were paid and the payments remitted to the tort claimants.5 8 the accounting system created by the court in ford motor company was a thoughtful approach to the problem. the court reached the correct economic result, even though its methodology was erroneous. the correct way to analyze a structured settlement like that in ford motor, is to separate the tort settlement from the investment aspects of the structured payout. as a matter of economics, ford agreed to pay the victim the discounted present value of the structured settlement in satisfaction of its tort liability for the current year. ford should have been indifferent to structuring the transaction as a structured payout 57. h.r. rep. no. 98-432, pt. 2 at 1254 (1984). 58. ford motor company v. commissioner, 71 f.3d 209, 217 (6th cir. 1995), aff'g 102 t.c. 87 (1994). 20011 funded with annuities, or as a direct payment to the victim for the cost of the annuities.59 if ford had made this settlement payment in cash, it would have been entitled to deduct the payment at the time of payment.6" the tort victim, however, wanted structured payments rather than a lump sum payment at settlement. in essence, the victim lent ford the present value of the tort settlement in return for ford's promise to make future structured payments. the future payments included unstated imputed interest. commentators are in general agreement that the proper way to analyze a structured settlement as a matter of economics is as a cash settlement from the tortfeasor to the victim of the discounted present value of the structured settlement, followed by a loan of the present value from the victim to the tortfeasor in return for the structured payments. 6' there is disagreement, however, on how the transaction should be taxed.62 59. this assumes, of course, that it would not be able to accelerate its deductions for future imputed interest, as it sought in the ford motor case. 60. the all events test would be met because the liability had accrued (the fact and amount of the liability were determined). even under the current rules, economic performance under § 461(h)(2)(c) is met with respect to tort claims upon payment. 61. mary louise fellows, a comprehensive attack on tax deferral, 88 mich. l. rev. 722, 795 (1990) ("a deferred payment agreement, such as a deferred tort settlement, is economically equivalent to the parties entering into two agreements: (1) the payment of damages to compensate the victim for losses and (2) the victim loaning the tortfeasor the amount of damages to be repaid at some specified date"); daniel i. halperin, interest in disguise: taxing the "time value of money", 95 yale l.j. 506, 526 (1986) ("the 1984 legislation, however, defers the entire deduction until payment. as we have seen, this approach is equivalent to allowing a deduction for the present value of the liability in... the year of settlement, and thus effectively denies the [tortfeasor] a deduction for interest."). 62. in an influential article, professor halperin argued that it was appropriate to deny the tortfeasor a deduction for imputed interest on a structured settlement because the tort victim might not have to recoguize income resulting from the imputed interest. "congress, however, has recently enacted legislation that specifically exempts the recipient of a deferred tort settlement from taxation of any component due to interest. limitations on the deductions allowed to [the tortfeasor] can be seen as a way of subjecting her to tax on income accruing for the benefit of the patient, who would otherwise avoid tax on this investment income." halperin, at 526. see also, fellows, at 795 ("the thrust of halperin's argument regarding the proper treatment of a deferred tort settlement pertains to the borrowing component. he reasons that code rules excluding the interest income from the loan from the victim's tax base explains why section 461(h) denies the tortfeasor a deduction for the interest cost by postponing the deduction for damages until payment." the theory behind these arguments is that tax treatment between the parties should be parallel so as not to deprive the treasury of revenue. other commentators reject professor halperin's thesis that the distortion of the accrual method for one taxpayer is fair because of a possible counter-matched distortion to the taxpayer on the other side of the transaction. see e.g., donald w. kiefer, the tax treatment of a "reverse investment," 26 tax notes 925 (1985); emil m. sunley, observations on the appropriate tax treatment of future costs, 22 tax notes 719 (1984). these philosophical debates are beyond the scope of this paper. it is important to keep in mind, however, that the deferral of properly matched deductions for financing costs until the year of payment would deter tortfeasors from entering into structured florida tax reviewv [vol 5:3 avoiding phantom income in bankruptcy viewed from an economic perspective, an accrual method taxpayer should receive a deduction at the time of settlement for the discounted present value of the settlement, should be deemed to borrow back the settlement payment from the victim in return for the structured loan payout, and should be entitled to deduct the imputed interest on the deemed loan as it economically accrues.63 the tortfeasor's purchase of an annuity xvith the loan proceeds should be viewed as a separate investment transaction. as with any investment, the tortfeasor would be required to recognize as income the interest earned on the annuity.' 4 since the interest accrued under the terms of the structured settlement and the interest earned on the annuity contract would be the same amount each year (because the annuity matched the structured settlement payouts), and would thus offset each other on tortfeasor's tax return, the court in fordmotor reached the economically correct result by excluding the annuity earnings from income and disallowing deductions for the imputed interest on the structured loan payout. while reaching the correct economic result, the court cited no legal basis for excluding interest earned on the annuity. the court's ruling in ford motor was limited to the abusive situation before them. the court did not attempt to fashion a system that would apply generally to all structured tort settlements.65 3. congress enacts section 461(h) to prevent accrual method taxpayers from structuring transactions to take advantage of the time value of money.-in contrast to the limited approach taken by the court in ford motor, congress took a meat ax to the time value of money problem. in 1984, congress enacted section 461(h), which imposes on an accrual method taxpayer the concept of "economic performance" in addition to the "all events" test before settlements which in many cases are created at the request of the victim for legitimate non-tax reasons, such as planning for future medical or personal care. dsfs and qsfs were created to mitigate the effects of the deferral without allowing the tortfeasor to recover a windfall. 63. see supra note 61. 64. see § 1272(a)(1). it is worth noting that the original issue discount rules do not applytocertain annuities governed by § 72. § 1275(a)(1)(b). however, thespecial annuityrules in § 72 only apply to annuities held by natural persons. § 72(u)(1)(a). because the ford motor company is a corporation and not a natural person, the special annuity exceptions to the original issue discount rules would not apply, and ford would, under existing law, have to recognize as income accrued interest under the annuity contract. 65. in rejecting ford's argument that, by enacting § 461(h), congress recognized the right of taxpayers to deduct the full amount of future tort payments at the time of settlement, the fordmotor court stated: "section 461(h) was a congressional effort to remedy an accounting distortion by placing all accrual method taxpayers on the cash method of accounting for tort liabilities, regardless of the length of the payout period and without any consideration of whether accrual of an expense in an earlier year would distort income. its enactment does not preclude the commissioner from applying the clear reflection standard of section 446(b) on a case-by-case basis to taxpayers in tax years prior to 1984." id. at 214. 20011 a deduction is allowed.66 the most significant change brought about by the new economic performance rules was the imposition of a cash-method deduction system for accrual method taxpayers with respect to workers' compensation and tort claims. under section 461 (h)(2)(c), workers' compensation and tort claims can only be deducted when actually paid to the creditor.67 the treasury has made it clear that payment to a third party, including payment to a trust, escrow, court administered fund, or any other arrangement, does not constitute payment to the creditor unless the creditor is required to recognize the payment as income.68 similarly, the debtor cannot deduct the cost of an annuity contract purchased to fund a structured settlement, unless the annuity contract is transferred to (and presumably taxable at the time of transfer to) the creditor. 69 4. congress enacts section 468b to provide a method for structuring tort settlenzents.-to mitigate the harshness of the rule preventing accrual method taxpayers from deducting liabilities for structured tort settlements prior to receipt by the tort claimant, in 1986 congress added section 468b to provide for designated settlement funds ("dsfs").7° section 468b allows an accrual method taxpayer to deduct payments made to a dsf to satisfy present and future tort liabilities for personal injury, death, and property damage. 71 the dsf must be established by court order, it must completely extinguish the taxpayer's tort liability (preventing use of a dsf for contested claims), 72 it must be administered by persons who are independent 66. § 461(h)(1); deficit reduction act of 1984, § 91, 26 u.s.c. § 461(h)(1). 67. § 461(h)(2)(c). the statute provides: "if the liability of the taxpayer requires a payment to another person and (i) arises under any workers' compensation act, or (ii) arises out of any tort, economic performance occurs as the payments to such person are made." § 461(h)(2)(c) (emphasis added). thus, the statute appears to require a direct payment to the creditor before a deduction can be taken. 68. regs. § 1.461-4(g)(1)(i). 69. regs. § 1.461-4(g)(1)(ii)(b). 70. technical and miscellaneous revenue act of 1988, §§ 1018(f)(4)(a)-(b), 26 u.s.c. § 468b; joint committee on taxation, explanation of technical corrections to the tax reform act of 1984 and other recent tax legislation, jcs-1 1-87 (part 1 of 17 parts) (may 13, 1987) ("the 1984 act provides that liabilities are not treated as incurred prior to the time when economic performance occurs. in the case of the taxpayer's liability to another person, arising under any workers compensation act or any tort, economic performance occurs as payments to such person are made, except to the extent provided in regulations. it is unclear whether an irrevocable payment to a court ordered settlement fund, which extinguishes the tort liability of the taxpayer to a person (or class of persons), constitutes economic performance under that act.... the act clarifies that under certain limited circumstances, an irrevocable payment to a court-ordered settlement fund that extinguishes tort liability of the payor (the "taxpayer") constitutes economic performance with respect to such liability. this provision applies only to qualified payments made to a desiguated settlement fund.") 71. § 468b(d)(2)(d). 72. § 468b(e). florida tax review [vol. 5:3 avoiding phantom income in bankruptcy of the taxpayer, and the taxpayer may hold no beneficial interest in the income or corpus of the fund.73 the taxpayer must also elect to treat the trust or escrow as a designated settlement fund.74 the fund is treated as a corporation, but is taxed on its taxable income at the maximum rates under section 1(e) rather than under section 11.' the language of the statute suggests that congress intended dsfs to rule the field. section 468b(f) provides that, except as otherwise allowed by regulations, a dsf is the exclusive method for accrual method taxpayers to obtain a deduction for payments made to a fund to resolve or satisfy personal injury, death or property damage claims.76 however, due to the limited scope of dsfs,7 7 that dominance was short lived. in connection with the enactment of section 468b, congress gave the treasury broad authority to prescribe regulations providing for the taxation of escrow accounts, settlement funds or other "similar funds. '78 in 1992, the treasury responded to criticism regarding section 461(h) by promulgating regulations for the establishment of qualified settlement funds ("qsf"). 79 like dsfs, qsfs must be established by a government or court order. while broader than the dsf statute, the qsf regulations also limit the types of liabilities for which a qsf can be used. a qsf is limited to environmental liabilities, tort liabilities, breach of contract liabilities,8" liabilities for other "violations of law," and other liabilities allowed by the commissioner in revenue 73. § 468b(d)(2)(e). 74. § 468b(d)(2)(f). 75. § 468b(b)(1). 76. § 468b(f). 77. the most important limit was the requirement that the liability be uncontested. § 468b(e). the limitation to "personal injury, death and property damage" claims was also significantly expanded by the treasury in the qsf regulations, as discussed infra. see supra notes 81-82. 78. § 468b(g). 79. regs. § 1.468b-1 et seq. like a dsf, a qsf is taxed as a separate entity at the highest rates applicable under § 1(e). regs. § 1.468b-2(a). aqsf must use a calendar year and the accrual method of accounting. regs. § 1.468b-2(j). if property is transferred to a qsf, the transferor must recognize gain or loss under § 1001. regs. § 1468b-3(a)(1). the treasury has proposed new regulations to allow an election for dsfs and qsfs to be taxed as grantor trusts rather than as separately taxed corporations at the highest bracket rates. prop. regs. § 1.468bl(k). 80. the qsf regulations were designed to use the same language for qualified claims as used in the regulations under § 461 (h). compare regs. § 1.461-4(g) (2) (stating a "tort, breach of contract or violation of law.") with regs. § 1.468b-1(c)(2)(ii) (same). the regulations under § 461(h) make it clear that the term "breach of contract" refers only to incidental, consequential or liquidated damages. regs. § 1.461-4(g)(2) (stating that "[a] liability to make payments for services, property, or other consideration under a contract is not a liability arising out of a breach of that contract unless the payments are in the nature of incidental, consequential, or liquidated damages...."). 20011 rulings or procedures.81 dsfs are more limited, permitting only "personal injury, death or property damage" liabilities.12 the broader definition of tort claims in the qsf regulations is greatly expanded by allowing a qsf to be used for both contested and uncontested liabilities. 3 in responding to public comments concerning the proposed qsf regulations, the treasury made it clear that a contested liability fund satisfies the "resolve and satisfy" requirement of the final qsf regulations. 84 however, certain liabilities are excluded from qsf qualification. liabilities for workers' compensation and self-insured health plans, 5 product warranty obligations,86 and other liabilities designated by the commissioner in a revenue ruling or procedure, are excluded.87 5. the treasury prohibits the use of a qsf to pay bankruptcy trade clahns.-most importantly for this article, a liability to "general trade creditors or debtholders that relates to a title 11 or similar case or workout" is excluded from qsf eligibility.88 the treasury has given no meaningful explanation for its decision to exclude bankruptcy trade debt and other general liabilities from qsf eligibility. in the preamble to the regulations, the treasury gives the following reason for its decision to preclude the use of a qsf to satisfy general trade claims in bankruptcy: the proposed regulations invited comments regarding the extent to which qualified settlement funds should be available for the claims of general creditors and security holders in bankruptcy. generally, commentators stated that the qualified settlement fund rules should not be imposed in the bankruptcy context. some commentators recommended that the qualified settlement fund rules be applied to a bankruptcy fund on an elective basis. the service and the treasury department have concluded that the application of the regulations should not be elective. the final regulations exclude claims of general trade creditors and debtholders that relate to the title 11 or similar case, or to a workout. however, qualified settlement fund treatment remains available for other liabilities such as tort liabilities 81. regs. § 1.468b-1(c)(1). 82. § 468b(d)(2)(d). 83. regs. § 1.468-1(c)(2). 84. preamble to regs. § 1.468b-1 qualified settlement funds, public comments, t.d. 8459, 57 fed. reg. 60983 (12/18/92). 85. regs. § 1.468b-1(g)(1). 86. regs. § 1.468b-1(g)(2). 87. regs. § 1.468b-l(g)(4). 88. regs. § 1.468b-1(g)(3). florida tax review [vol. 5:3 avoiding phantom income in bankruptcy irrespective of whether the liability, for example, relates to a title 11 case. for instance, if a corporation is a defendant in a class action involving a tort liability and subsequently files a petition for bankruptcy, the defendant's bankruptcy will not affect the qualified settlement fund treatment of a fund, account or trust established to resolve or satisfy the tort liability.89 the treasury's only stated basis for limiting the use of qsfs to solve bankruptcy distortion that the qsf regulations would somehow become elective does not make sense.9" the creation of a segregated fund to pay claims is always elective. someone has to elect to create the fund device in the first place. the tax treatment of the device once elected may be mandatory. but the device itself is always elective. allowing bankruptcy debtors to elect to use the fund device, with bankruptcy court approval, is no different than allowing anyone else to elect to use the fund device for a permitted purpose. the treasury's apparent concern that, without the limitation, the qsf device would be "imposed" on debtors in bankruptcy appears unfounded. even without the limitation, it would be inconsistent with the general scheme of bankruptcy estate taxation to automatically treat a bankruptcy estate as a qsf. under section 1398, the bankruptcy estate of an individual debtor under chapters 7 and 11 is treated as a separate taxable entity from the debtor, but remains owned by the debtor. no separate taxable entity is created for partnerships and corporations. 91 the separate estate is taxed at individual rates, not at estate rates.92 the service's apparent concern with the automatic application of qsfs to bankruptcy estates is inconsistent with the specific rules governing bankruptcy taxation and thus appears entirely unfounded. moreover, a bankruptcy estate would not meet the general requirements of a qsf. for example, a qsf cannot be used for the operation of a business. according to the preamble to the section 468b regulations: 89. preamble to regs. § 1.468b-1 qualified settlement funds, public comments, t.d. 8459, 57 fed. reg. 60983 (12/18/92) (emphasis added). 90. the treasury's concern about an election may relate not to the qsf itself but to the possibility that the debtor would abuse the benefits of the qsf by transferring assets to the fund in excess of the true amount of claims in an attempt to obtain an inappropriate deferral of taxes, or would attempt to obtain deductions for non-deductible liabilities by manipulating the contributions to the fund. as is discussed in part vi, infra, safeguards are needed to assure that the transfers to the fund are not excessive, and that deductions are limited to the properly allocable portion of the contributions to the fund which constitute deductible liabilities. in addition, because the bankruptcy court would not permit any fund transfers unless all similarlysituated creditors are treated the same way, the rules for funding a qsf should follow the bankruptcy rules requiring equality of treatment for similar claims. 91. § 1399. 92. compare § 1398(c) (bankruptcy estate taxed at individual rates); regs. § 1.468b2(a) (qsf taxed at rates under § l(e)). 2001] florida tax review commentators requested that a qualified settlement fund be allowed to deduct all expenses incurred in operating a trade or business, including its distributive share of partnership expenses. the service and the treasury department believe that the operation of a trade or business is inconsistent with the general nature of a qualified settlement fund. therefore, the final regulations do not adopt the suggested modification. 93 the regulations could easily protect against abuse by limiting the use of the qsf to specially created and segregated trusts approved by the bankruptcy court, established to set aside excess funds earmarked for payment of claims upon plan confirmation. thus, the treasury has failed to articulate a meaningful reason for precluding bankruptcy debtors from using qsfs to resolve and satisfy general bankruptcy claims during the period that claim payments are prohibited by the bankruptcy laws. 6. section 468b funds were not designed to benefit cash method taxpayers.-another major question is whether the qsf regulations allow a deduction for cash method taxpayers who make payments to a qsf. because qsfs arose out of an attempt to mitigate the harshness on accrual method taxpayers of the "economic performance" requirements in section 461(h), the benefit of a qsf is simply that the payments to the fund constitute "economic performance" within the meaning of section 461 (h).94 accrual method taxpayers can thus deduct payments to a qsf if the "all events test" is otherwise met at the time of payment,9" so long as the qsf is properly established.96 however, both the "all events test" and the "economic performance test" are irrelevant to the cash method taxpayer. 97 although the "economic 93. preamble to regs. § 1.468b-1 qualified settlement funds, public comments, t.d. 8459, 57 f. r. 60983 (12/18/92). 94. regs. § 1.468b-3(c). 95. see regs. § 1.461-1(a)(2) (stating traditional rule allowing deduction by accrual method taxpayer when "all events" test is met). 96. a transfer to a qsf does not constitute "economic performance" if the transferor has an unrestricted right to obtain a refund of the funds transferred. the treasury regulations provide that qualified transfers to a qsf constitute "economic performance" within the meaning of § 461(h) unless: (1) the transferor has an unrestricted right to obtain a refund without the agreement of an independent or adverse party (including a court), or (2) the refund right is based on an event that is certain to occur. see regs. § 1.468b-3(c)(2)(a) and (b). a properly created qsf will provide for the return of the funds to the transferor only on the resolution of the contest. 97. section 461 (h)(1) provides that "all events" test not treated as met until "economic performance" occurs. the "all events" test applies only under the accrual and not the cash method. compare regs. § 1.461-1(a)(1) (cash method deductions allowed upon payment), regs. § 1.461-1(a)(2) (accrual method deductions allowed when "all events" test met). thus, economic performance is irrelevant to a cash method taxpayer. [vol. 5:3 avoiding phantom income in bankruptcy performance' requirements have the effect of putting an accrual method taxpayer on the cash method for purposes of the enumerated liabilities, the qsf regulations by their own terms do no more than to put the accrual method taxpayer back on the regular accrual method in connection with payments to a qsf. this is no help to a cash method taxpayer. the only authority concerning the effect of the qsf regulations on cash method taxpayers is contained in an example in treasury regulations section 1.468b-3(g). in the example, a cash method taxpayer transfers $1 million to a qsf to satisfy securities law claims. the regulation recognizes that the "economic performance" rules do not apply to the cash method taxpayer. "therefore, whether, when and to what extent individual a [the taxpayer] can deduct the transfer is determined under applicable provisions of the internal revenue code, such as sections 162 and 461 '98 nothing in sections 162 or 461 provide any help in determining whether a transfer to a qsf by a tax method taxpayer constitutes a deductible payment. the treasury was likely incorporating the general rules governing deductions by cash method taxpayers. the general rule is that cash method deductions are only allowed when a payment discharging the debtor's liability is made to the creditor, unless an earlier deduction is specifically authorized by statute or regulation. in sebring v. commissioner,99 a cash method bail bondsman sought to deduct payments made to a fund to secure the bondsman's obligation to indemnify the surety on the bail bonds issued by the surety. the court held that the payments to the fund are a reserve for future liabilities, not payment of a current liability, and therefore not deductible. the court noted that deductions for reserves are only allowed when specifically permitted by statute, such as deductions to contested liability funds under section 461(f). according to the court: [i]f payments to reserves for contested liabilities are deductible only as prescribed by special statutory provision, it would seem a fortiori that payments made in respect of liabilities that do not exist are not deductible. indeed, the case law has long followed the principle that a contribution to a reserve for future liabilities is not deductible; only actual payment out of the reserve to satisfy a definite liability can give rise to a deductible expense. 100 the sebring court cited the longstanding rule of commercial liquidation co. v. commissioner,"1 in which the court denied a deduction for a collection agency's payments to a reserve fund held by a surety to protect against 98. regs. § 1.468b-3(g). 99. 93 t.c. 220 (1989). 100. id. at 225. 101. 16 b.t.a. 559 (1929). 20011 florida tax review contingent liabilities. the sebring court also cited the fifth circuit's opinion in hradesky v. commissioner,'0 2 which held that a cash basis taxpayer could not deduct a payment made into an escrow to satisfy unpaid real estate taxes until the taxes are paid from the escrow to discharge the taxpayer's liability. the rules for cash method deductions for payments to reserve funds thus mirror the rules for deductions for payments to trusts by accrual method taxpayers 3 unless the payment discharges the taxpayer's underlying liability, the payment is not deductible. 0 4 thus, the reference in the regulations to the general rules governing cash method deductions suggests that no deduction would be available for a cash method taxpayer's payments to a qsf, because under the cash method no deduction is allowed for fund payments unless the taxpayer's underlying liability to the creditor is discharged as a result of the transfer. in conclusion, there are two main reasons that the existing qsf regulations do not provide a clear mechanism for solving the accounting method distortion that occurs in a bankruptcy case when the debtor has the ability and desire to segregate funds for the payment of creditor claims. first, with respect to both accrual and cash method taxpayers, a qsf cannot be used by its specific terms to satisfy ordinary trade debt and most other non-tort claims. it would be difficult to obtain bankruptcy court approval for establishing a pre-confirnmation fund for the payment of certain tort claims without establishing an equivalent fund for the payment of non-tort trade claims. the bankruptcy court would be concerned that the transfer to the fund for the benefit of certain creditors could result in disparate treatment of similarly-situated creditors, violating the cardinal rule of equal treatment for similar claims. 05 102. 540 f.2d 821 (5th cir. 1976). 103. see discussion, part iv, infra. 104. there is also a significant limitation on the deductibility of refundable payments made to reserve funds which may be used to benefit the taxpayer in future tax years. the supreme court in commissioner v. lincoln sav. & loan ass'n., 403 u.s. 345 (1971), held that a savings and loan association could not deduct mandatory reserve payments made to the federal savings and loan insurance corporation ("fslic"), which were credited along with earnings to the savings and loan association's account, and were refundable if the institution ceased operating. the court held that the payments to the fund constituted a capital investment rather than a deductible expense because the reserve fund would continue to benefit the institution in future years. the court would allow a deduction only when the amounts in the reserve fund were applied to a non-refundable general fund for the payment of the fslic's current expenses and liabilities. see id. at 358-59. 105. the principle of equality of distribution runs throughout the bankruptcy code. with respect to a plan of reorganization that has not been accepted by all classes of creditors, the so-called "cramdown" provisions specifically require the court to find that the plan does not discriminate unfairly in the treatment of creditors. see 11 u.s.c. § 1 129(b)(1) (2000). with respect to a plan of reorganization that has been accepted by all classes of creditors, the rules forbidding discrimination are implied. the plan of reorganization must provide that all claims in the same class be treated the same way, unless the claimant agrees to less favorable [vol. 5:3 avoiding phantom income in bankruptcy second, it is unclear whether (and, if so, how) the qsf regulations would provide any assistance to cash method taxpayers who are the ones most directly affected by the phantom income problem. indeed, the reference to the general rules of cash method deductions suggest that no deduction would be available for payments made by cash method taxpayers to a qsf. the existing qsf regulations could only be used in a limited way by accrual method taxpayers seeking deductions for funds segregated to pay tort liabilities, if the debtor could convince a bankruptcy court that the segregation would not favor the tort and creditors at the expense of the debtor's other creditors. outside of this limited circumstance, the existing qsf regulations do little to mitigate the distortion caused by the bankruptcy prohibition on payment of pre-petition creditor claims prior to plan confirmation. iii. contested liability funds provide only limited relief from phantom income in bankruptcy early cases held that accrual method taxpayers could not deduct the payment of contested liabilities. in dixie pine products company v. commissioner, 106 the state of mississippi asserted that the taxpayer owed a gasoline use tax on a solvent used in its manufacturing business. after paying the tax for several years, the taxpayer obtained a determination from the mississippi supreme court that the gasoline tax could not be imposed on the use of the solvent. after the mississippi supreme court's determination but before the lower court entered an injunction, the taxpayer deducted from its federal income taxes the "accrued" but unpaid state gasoline taxes, which were disputed. on remand, the state and the taxpayer stipulated to the disallowance of future gasoline taxes, so that the amounts that had been accrued would not ever have to be paid. upon entry of a judgment on the stipulation, the taxpayer recognized as income the accrued but unpaid gasoline taxes which had been deducted earlier. the supreme court held broadly that the "all events" test is not met in connection with a contested liability, whether paid or not, and therefore no deduction should have been allowed: treatment. see 11 u.s.c. § 1123(a)(4) (2000). while there is some leeway in the bankruptcy code for separately classifying similar claims, bankruptcy courts generally will not permit separate treatment of claims having similar priority. as stated by the leading bankruptcy treatise: "one of the cardinal principles underlying bankruptcy law is equality of treatment of similarly situated creditors." 7 matthew bender, collier on bankruptcy, 1122.03 (15th ed. revised, 2000). see e.g., in re granada wines, inc., 748 f.2d 42 (1st cir. 1984) (the general rule regarding classification is that "all creditors of equal rank with claims against the same property should be placed in the same class."), quoting in re los angeles land and investments, ltd., 282 f. supp. 448,453 (1968), affd, 447 f.2d 1366 (9th cir. 1971) and in re scherk, 152 f.2d 747 (10th cir. 1945). 106. 320 u.s. 516 (1944). 2oo01 florida tax review it has long been held that in order to truly reflect the income of a given year, all the events must occur in that year which fix the amount and the fact of the taxpayer's liability for items of indebtedness deducted though not paid; and this cannot be the case where the liability is contingent and is contested by the taxpayer. here the taxpayer was strenuously contesting liability in the courts and, at the same time, deducting the amount of the tax, on the theory that the state's exaction constituted a fixed and certain liability. this it could not do. it must, in the circumstances, await the event of the state court litigation and might claim a deduction only for the taxable year in which its liability for the tax was finally adjudicated." °7 in united states v. consolidated edison company,'08 the supreme court re-affirmed the dixie pine products decision in a case involving actual payment of a contested liability. consolidated edison paid property taxes under protest, and sued to recover the overpayments. the court held that no income tax deduction would be allowed until the contest was finally determined, at which time consolidated edison could deduct the amount which had been properly paid. similarly, since the amount paid was not deductible, consolidated edison did not have to recognize as income the portion of the taxes which were refunded. a. creation of contested liability funds in 1964, congress enacted section 461(f) to allow the deduction of contested liabilities that have been paid."19 section 461(f) also allows both cash and accrual method taxpayers, in the year that the taxpayer transfers money or other property in satisfaction of a contested liability, to deduct a payment if, but for the contest, a deduction would be allowed for the year of transfer."' the statute requires only a "transfer of money or property to provide for the satisfaction of the asserted liability." '1 unlike the economic performance rules applicable to tort claims under section 461 (h)(2)(a), the contested liability statute does not require a direct payment to the creditor before a deduction can be taken. however, the treasury regulations promulgated under section 461 (f) allow a deduction only if payment is made to the creditor, to a trust or escrow pursuant to a written agreement with the creditor, or pursuant to a court or governmental order.112 107. id. at 519. 108. 366 u.s. 380 (1961). 109. revenue act of 1964, pub. l. no. 88-272, 78 stat. 19 (1964). 110. § 461(f). 111. § 461(f)(2). 112. regs. § 1.461-2(c)(1). [vol. 5:3 avoiding phantom income in bankruptcy b. the signature requirement for contested liability funds the language in the treasury regulation suggests that the creditor must actually sign an agreement before the debtor can deduct the payment of a contested liability which is not made directly to the creditor or pursuant to a court order. this language has spawned a number of conflicting opinions, in which some courts have virtually ignored the language of the regulation. two courts have denied deductions where the creditor did not sign the trust agreement. the only court to fully accept the language of the regulation is rosenthal v. united states."3 the case arose out of a partnership dispute. the partnership, which was controlled by one of the partners, refused to pay the other partner's expenses. the partnership set funds aside in a trust to cover the claims asserted by the other partner, and deducted the fund payments. the court held that section 1.461-2(c)(1) of the treasury regulations requires the signature of the claimant. since the claimant was unaware of the trust and did not sign the trust agreement, the deductions were not allowable. the court in poirier & mclane corp. v. commissioner,1 4 also disallowed a deduction for payments to a secret trust for the benefit of the claimants, but did not accept the treasury regulation wholesale. in poirier, a construction contractor was sued for trespass by the owners of an apartment building on adjoining land who claimed that the construction damaged the foundation of their apartment building." 5 the contractor established a secret trust to cover the asserted trespass claims.116 the claimants were not aware of the creation of the trust.1 7 the litigation was resolved without any significant liability by the contractor, and the funds were returned by the trust to the contractor. 8 the tax court allowed the deduction because the funds were transferred beyond the taxpayer's control." 9 on appeal, however, the second circuit disallowed the deduction, emphasizing that a contrary conclusion would give the taxpayer complete control over the timing of the deposit and deduction, which would not be related to the accrual of the liability.120 it is unclear how the poirer court would have ruled if the creditors had been aware of the trust but had not been signatories to the trust agreement, or if the timing of contributions was not solely within the taxpayer's control. 113. 11 c1. ct. 165 (1986). 114. 547 f.2d 161 (2d cir. 1976). 115. id. at 163. 116. id. 117. id. at 165. 118. id. at 163. 119. 63. t.c. 570 (1975). 120. 547 f.2d 161 (2d cir. 1976). 20011 the ninth circuit held in consolidated freightways, inc. v. commissioner, 12 1 that payments made on account of potential future liabilities that had not arisen are not deductible. 122 a trucking company sought to deduct payments made to a liability bonding company. the trucking company was selfinsured for liability, but was required to post a bond with the interstate commerce commission to assure payment to potential tort claimants. 123 in order to obtain the bond, the trucking company was required to post a security deposit with the bonding company. 2" the amount of the security deposit was determined by the agreement of the taxpayer and the bonding company, based on their joint estimate of the liability and did not match the amount of asserted liabilities.'5 because the transfers for security could exceed the amount of all asserted liabilities (which would open the door for unlimited tax deferral), 126 and because the purpose of the transfers was to protect the bonding company rather than to provide for the satisfaction of tort liabilities, the court denied a deduction for the payments. 1 27 the remaining courts to consider the issue have not followed either the language or the manifest intent of the regulation. in chem aero, inc. v. united states, 128 the ninth circuit allowed a defendant, who had posted a bond to obtain a stay pending appeal, 129 to deduct the value of collateral transferred to the bonding company to secure the defendants' indemnity obligations to the bonding company. 130 the court held that the transfer limitations in section 1.461-2(c)(1) of the treasury regulations only stated a general rule, and that the court was free to make exceptions to the general rule where the funds were placed beyond the taxpayer's control for the satisfaction of an asserted liability.' 3' the chem aero court distinguished the poirier case on the grounds that the creditor in chem aero knew of the posting of the bond, while the poirier transfer was to a secret trust. 132 however, there was in fact no evidence in chem aero that the 121. 708 f.2d 1385 (9th cir. 1983). 122. id. at 1394. 123. id. 124. id. 125. id. 126. id. at 1394. 127. id. 128. 694 f.2d 196 (9th cir. 1982). 129. id. at 197. 130. id. at 197; 200. 131. id. at 198. ("the italicized prase 'in general' [in regs. § 1.461-2(c)(1)] preceding the listed methods of transfer, suggests that they are merely illustrative, not all-inclusive. the regulation demands only that in order for money or other property to be beyond the control of a taxpayer, the taxpayer must relinquish all authority over such money or other property.") 132. id. at 198-99. florida tax review [vol. 5:3 avoiding phantom income in bankruptcy creditor knew of the transfer of security to the bonding company, which was the basis for the deduction. similarly, in varied invs., inc. v. united states, 133 the taxpayer deducted payments to a bonding company to secure an appeal bond.m the eighth circuit rejected the language of the regulation requiring the claimant to be a party to the trust, holding that "[a] claimant's assent can be inferred when the claimant is the beneficiary of a trust or escrow because such arrangements in effect carry the same power of enforcement."' 35 the court also distinguished poirier on the grounds that the timing of the appeal bond was mandated by court rules, and was thus not within the taxpayer's discretion. 136 in a memorandum opinion, the tax court in edison bros. stores v. commissioner, 137 purporting to follow the eighth circuit's opinion in varied,138 rejected the poirier analysis entirely, allowing deductions for payments made to a secret trust for the benefit of a claimant. 13' edison bros. stores involved a trust established without the knowledge of the united states 40 to cover potential contested liabilities for non-rubber footwear import duties. even though the taxpayer had complete control over the timing of the transfers, and even though the beneficiary of the trust lacked knowledge of the trust,141 the court allowed the deduction under section 461 (f) for payments made to the trust because there was no showing that the petitioner engaged in tax abuse by its use of the trust.142 in chernin v. united states,143 the court held that a judicial garnishment, and a subsequent agreement to deposit funds in a trust account, were the equivalent of a section 461 (f) fund. the taxpayer had appropriated more than $1 million from his employer, which he claimed were bonus payments owing to him.'" when his employer learned about the appropriation, the employer sued the taxpayer for embezzlement and garnished the funds. 45 ultimately, the jury determined that the taxpayer was entitled to the funds and had been wrongly terminated. 146 in allowing a deduction, the court attempted to distinguish section 1.461-2(c)(1) of the treasury regulations as follows: 133. 31 f.3d 651 (8th cir. 1994). 134. id. at 652. 135. id. at 655. 136. id. at 654. 137. 69 t.c.m. (cch) 2897, 1995 t.c. memo. lexis 263 (1995). 138. 1995 t.c. memo. lexis 263 at 5. 139. id. at 4, 9. 140. id. at 9. 141. id. 142. id. at 17. 143. 149 f.3d 805 (8th cir. 1998). 144. id. at 807. 145. id. 146. id. 20011 florida tax review section 461(f) is silent on the mechanics of the transfer requirement. and, in such situations, deference is generally accorded the interpretation of the agency charged with enforcing the statute. see, e.g., commissioner v. south texas lumber co., 333 u.s. 496, 501, 92 l. ed. 831, 68 s. ct. 695 (1948) (stating that treasury regulations in particular are entitled to deference as administrative interpretations of a statute). we agree and substantively do give deference to the existing regulation. yet, this is not the end of the matter. the subtitle to the regulation explicitly begins, "[in] general." treas. reg. 1.461-2(c)(1). both this circuit and the ninth circuit have reflected on the nomenclature preceding the regulation and reasoned that the provision thereby offers only an illustrative, rather than exhaustive, list of events that should be considered "transfers" for purposes of section 461(f)(2). 147 in a recent field service advisory, the service cites with approval both chemaero, andedison brothers stores for the proposition that a transfer which is made beyond the control of the taxpayer is sufficient, even though the creditor has not signed an agreement.'48 thus, while the cases are far from consistent with each other, the more recent cases have not followed the letter of the treasury regulations. as long as the transfer is made to cover specific liabilities, and the amount of the transfer is not subject to manipulation, the more recent cases have allowed a deduction even though the creditor was not a party to the agreement. c. limiting the use of contested liability funds by accrual method taxpayers in 1984, congress made an important amendment to section 461(f), which has received little comment but would appear to significantly limit an accrual method taxpayer's ability to deduct contested liabilities which are not paid to the claimant. the amendment provides that both the "all events" test and the "economic performance" test must still be met before an accrual method taxpayer can deduct a contested liability. the statute now requires that, "but for the fact that the asserted liability is contested, a deduction would be allowed for the taxable year of the transfer (or for another taxable year) determined after application of subsection (h).' 49 it was this emphasized language that was added in 1984.,'5 147. 149 f.3d at 810. 148. field serv. adv. no. 200106005 (2001). 149. § 461(f)(4) (emphasis added). 150. deficit reduction act of 1984, see supra note 46. f[vol. 5:3 avoiding phantom income in bankruptcy section 461(h)(2)(c) provides that "economic performance" is not met in connection with a tort claim until payment is made to the creditor. since section 461(f)(4) allows a deduction for contested liabilities only if all of the requirements of section 461(h) are met, and section 461(h) in turn requires a direct payment to the creditor, any payment to a trust would not appear to meet the technical requirements of the statute unless, of course, another provision of the code or regulations would establish "economic performance" prior to the time specified in section 461(h). the only relevant exception to the "economic performance" rules contained in section 461(h)(2)(c) relating to contested tort claims is the dsf/qsf rules. therefore, the current statute appears to require an accrual method taxpayer to comply with the qsf regulations in order to deduct a contested liability which is not paid directly to the creditor. the regulations support this technical interpretation. treasury regulations section 1.461-4(g)(1)(i) provides that "economic performance occurs when, and to the extent that, payment is made to the person to which the liability is owed. thus... economic performance does not occur as the taxpayer makes payments in connection with such a liability to any other person, including a trust, escrow account, court-administered fund, or any similar arrangement, unless the payments constitute payment to the person to which the liability is owed under paragraph (g)(1)(ii)(b) of this section." regulations section 1.4164(g)(1)(ii)(b) of the treasury regulations provides that the transfer constitutes a payment only if the payee would have to recognize income upon receipt of the payment if the payee were on the cash method. the statute and the regulations thus appear to prohibit accrual method taxpayers from deducting payments to a contested liability fund unless the fund meets the stringent dsf/qsf requirements. the technical reading of the amendment would prevent the use of a contested liability fund for payments which do not qualify for dsf/qsf treatment. for example, even with court approval, an accrual method taxpayer could not deduct payments to a contested liability fund for the satisfaction of contested breach of contract claims for general damages.' this has significant implications for bankruptcy cases, both because it would limit the accrual method taxpayer's ability to address the pre-confirmation distortion problem which is the subject of this article, and also would perpetuate the distortion by preventing deductions for funds required to be held back under a plan of reorganization until the resolution of a contest.152 151. see supra note 80. 152. in order to meet the requirements for plan confirmation, the plan proponent must provide for equal treatment of disputed claims in the event they are ultimately allowed by the court. therefore, most reorganization plans with which the author is familiar provide that the distribution which would be owing to a disputed claimant if the claim were to be allowed in full 20011 florida tax reviev d. the maxus energy trust the one court to consider the issue has rejected the technical reading of section 461(f)(4). in maxus energy corporation v. united states,'53 the manufacturer of agent orange entered into a class action settlement calling for the payment of slightly less than $22 million to a trust for the benefit of the class upon court approval of the settlement.'54 the manufacturer had the right to back out of the settlement prior to the hearing on approval if it believed that too many class members opted out of the settlement. '55 the deadline to withdraw was july 19, 1984.156 the settlement was approved by the court on january 7, 1985.157 the settlement fund was not eligible to be treated as a dsf because many of the class members' claims were disputed. 58 the government argued that the payment to the settlement fund was not deductible because the fund did not qualify as a dsf and the payment was not made directly to the claimants as required by section 461(h)(2)(c). 5 9 according to the government, the only exception to the rule forbidding deductions for tort settlements not paid directly to the claimant is a qualified payment to a dsf.160 the court disagreed with the government's argument. the court first held that the dsf rules were entirely inapplicable, because the issue before the court concerned contested liabilities and the dsf statute only applied to uncontested liabilities.' 6' the court did not consider the effect of the new qsf regulations, which permit contested liabilities. because the opinion is based on the inapplicability of dsfs to contested liabilities, it is unclear whether the opinion will be held in a reserve account pending the resolution of the dispute. a cash method taxpayer would be able to deduct payments to a disputed claims fund established in conformity with § 461(f). however, under this technical interpretation of the amendment to § 461(f)(4), an accrual method debtor would not be able to deduct payments to a disputed claims reserve account because the payments have not been made to the creditors. while the accrual method debtor could deduct such payments if made to a qsf, payments on account of liabilities for general breach of contract are not "qualified payments" and thus would not constitute "economic performance." see regs. § 1.468b-1(c)(2)(ii) (limiting qsf use for tort, breach of contract or violation of law liabilities); regs. § 1.461-4(g)(2)(i) (providing that "breach of contract" damages means incidental, consequential or liquidated damages, not direct "liability to make payments for services, property or other consideration provided under the contract"). 153. 31 f. 3d 1135 (fed cir. 1994). 154. id. at 1137. 155. id. 156. id. 157. id. 158. id. at 1144. the court did not discuss the qsf regulations which had not been enacted at the time of the settlement (although they had been enacted by the time of the hearing). 159. id. at 1144. 160. id. 161. id. at 1144. [vol. 5:3 avoiding phantom income in bankruptcy would survive given the expanded qsf rules. the court also seems to have missed the thrust of the government's argument. the government was not arguing that the liabilities were eligible for dsf treatment. rather, the government was arguing that the only exception to the direct creditor payment rule is a dsf, and that exception did not apply to maxus energy.6 without an applicable exception, the general rule would have prevented the deduction. this portion of the opinion seems of dubious validity. second, however, the court held that upon entry of the judgment approving the settlement, the claims of the class were merged into the settlement fund. '63 thus, the fund became the "person" entitled to the payment under section 461(h)(2)(c), and the payment by the manufacturer to the fund constituted a direct payment to the "person" entitled to be paid."64 this argument is on a much more firm footing than the court's first argument. the merger theory of maxus energy should apply equally to a cashmethod taxpayer, since the "economic performance" rule of section 461(h)(2)(c) applicable to tort claims is, in essence, the same as the cash-method rule a deduction is not available until actual payment of the claim. it is unclear whether maxus energy is still good law after the qsf regulations. the qsf regulations provide that a fund set up for disputed payments under section 461(f) will be treated as a qsf if it meets the requirements for a qsf.165 the settlement fund created in maxus energy would likely qualify as a qsf, and thus, would likely be taxed as a qsf. the more interesting question for this article is whether the maxus energy theory could be used to set up a fund for contested liabilities that would not qualify for qsf treatment, such as trade and warranty liabilities. the preamble to the new (1999) proposed section 468b regulations suggest that additional room exists for section 46 1(f) disputed payment funds: the proposed regulations provide rules relating to the taxation of amounts transferred to an escrowee, trustee, or court in connection with a contested liability within the meaning of section 461(f) (i.e. a transfer to a "461(f) fund"). commentators provided numerous comments concerning the proposed regulations. after reviewing these comments, the service and the treasury department believe it is appropriate to address economic performance for 461(f) funds after final guidance is provided concerning funds under section 468b. therefore, the final regulations reserve the treatment of 461(f) funds. 166 162. id. 163. id. at 1144-45. 164. id. at 1145. 165. regs. § 1.468b-l(b). 166. prop. regs. § 468b (reg. § 209619-93) (2/1/99). 20011 florida tax review the final regulations under section 46 1(f) do indeed reserve space for future regulations dealing with "payments to other funds or persons that constitute economic performance.', 167 thus, the section 461 (f) regulations and the new proposed section 468b regulations appear to recognize that additional vehicles will need to be considered for contested liability funds. until this area of the law is settled, maxus energy may still be alive in the cracks of the qsf regulations. the next section considers the possible use of a maxus energy or general trust to avoid the distortion resulting from the restriction on bankruptcy payments prior to plan confirmation. iv. the "grantor trust" rules impose an additional limitation on using trusts to avoid accounting method distortion in bankruptcy one possibility for solving the gross mismatch between revenues and expenses in bankruptcy cases would be for the debtor to establish a trust for the benefit of creditors without relying on any specific statutory or regulatory authorization. for example, if the debtor could deduct payments made in year one to a general trust account established for the benefit of trade creditors, it could avoid the accounting method distortion caused by the restriction on creditor payments in bankruptcy. the "grantor trust" rules contained in sections 671-679, however, would likely prevent a deduction for payments to a general trust account. it seems axiomatic that if the trust is treated as owned by the debtor under the grantor trust rules, a payment to the trust would not be deductible any more than a deposit into the debtor's own bank account. in order to avoid being characterized as a grantor trust, the debtor would have to retain no reversionary interest,168 no power to control the beneficial enjoyment of the trust corpus, 169 no forbidden administrative powers, 170 no powers of revocation, 'and no retained interest in the income or corpus of the trust. '72 the regulations contain an additional requirement to avoid grantor trust status. according to section 1.677(a)-i (d) of the treasury regulations, in order to avoid being characterized as a grantor trust, the income from the trust cannot 167. regs. § 1.461-6(c). 168. § 673. 169. § 674. 170. § 675. 171. § 676. 172. § 677. [vol. 5:3 avoiding phantom income in banknptcy be used to "discharge' 7 3 the grantor's legal obligations. "under section 677 a grantor is, in general, treated as the owner of a portion of a trust whose income is, or in the discretion of the grantor or a non-adverse party, or both, may be applied in discharge of a legal obligation of the grantor. ... ' the regulations 173. the use of the word "discharge" in thisregulation caused one author to suggest that a trust established under a plan of reorganization to liquidate all of the debtor's assets and make pro-rata payments to creditors should not be treated as a grantor trust because a debtor who proposes a liquidation plan is not entitled to a chapter 11 discharge. john d. howard, the taxation of liquidatingtrusts, escrows and settlement funds in chapter 11 bankruptcy cases, 64 am. bankr. l.j. 403 (1990) (stating that "[f]rom a bankruptcy standpoint, however, trust income will not be used to "discharge" a legal obligation of the grantors because the consolidated debtors are not entitled to and should not receive a chapter 11 discharge .... thus, it can be argued that the liquidating trust in holywell does not qualify as a grantor trust under either the internal revenue code or the regulations.") it appears that the author confused the concept of a chapter 11 discharge (which involves the discharge of debts not to be paid under the plan) with the discharge of debts that occurs as a matter of state lav upon payment. indeed, taken in a vacuum, the correct analysis is the opposite of the one hypothesized by the author. if the debtor does not receive a bankruptcy discharge and remains liable for the debts, then the payments from the trust will discharge the debtor's liabilities. under these facts, the trust would be treated as a grantor trust. on the other hand, if the debtor receives a bankruptcy discharge, then payments from a trust created by the plan of reorganization would not serve to discharge the debtor's liability, because that liability has already been discharged by the confirmation order. see 11 u.s.c. § 1141(d)(1)(a). the language of the grantor trust regulation deals with the discharge or satisfaction of an obligation that occurs as a matter of law upon payment, not the bankruptcy discharge. the regulations are simply applying the theory of established cases like old colonytrust co. v. commissioner ofinternal revenue, 279 u.s. 716 (1929), tograntor trusts by recognizing that a grantor retains an interest in the income of a trust when that income can beused to satisfythe grantor's obligations. for tax purposes, the satisfaction of the grantor's obligations is treated as a transfer from the trust to the grantor, followed by a subsequent paymentby the grantor to the creditor. douglas v. willcuts, 296 u.s. 1 (1935) ("the transaction is regarded 'as being the same in substance as if the money had been paid to the taxpayer and he had transmitted it to his creditor."') the supreme court in in re holywell corp., 503 u.s. 47 (1992), without any real analysis, held that a liquidating trust created under a plan of reorganization for the sole benefit of creditors did not constitute a grantor trust of the debtor, because the trust was not created or funded by the debtor. according to the supreme court, the debtor "himself did not contribute anything to the trust, and we thus fail to see how the respondents can characterize him as the grantor." id. at 57. the court did not analyze the grantor trust issues in any further detail. the key issue in determining whether a trust created under a plan of reorganization will be treated as a grantor trust is not whether the debtor receives a general discharge. rather, the key issue is whether the plan provides that the claims of creditors will be transferred from being a personal liability of the debtor to being an in rem liability of the fund, as inmaxus energy, 31 f. 3d 1135 (fed cir. 1994). section 1141(a) of the bankruptcy code provides that the terms of a confirmed plan of reorganization bind creditors. this is true whether or not the debtor receives a discharge under § 1141(d)(1)(a) of the bankruptcy code. thus, if the confirmed plan transfers the liability to a trust, and the debtor retains no reversionary interest in the trust, the payments from the trust will not be used to discharge the debtor's liability to the creditor because that personal liability was already substituted for the in rem liability of the trust. 174. regs. § 1.677(a)-1(d). 20011 provide that the distribution to the grantor may be actual or constructive. 175 if the income of the trust can be used without the consent of an adverse party to satisfy a liability of the grantor, then the grantor is treated as in constructive receipt of the income, and will be treated as the owner of the trust.'76 a. when payments to a trust are deductible as ordinary business expenses in a series of administrative rulings, the service has applied these grantor trust principals to determine whether payments made to a fund for the benefit of third party claimants are deductible. in revenue ruling 85-158,'77 the service held that a trust created by a commodities futures exchange clearing house, the principal and interest of which was used as security for the exchange's indemnity obligations on futures contracts, was a grantor trust because the payments from the fund would discharge the exchange's indemnity obligations. thus payments by the exchange to the trust were not deductible. on the other hand, in a series of private letter rulings arising out of trusts set up by stock and commodity exchanges to provide financial assistance to customers who incurred losses as a result of insolvent exchange members, the service allowed the exchanges to deduct payments to the fund where the exchanges that created the funds were not legally liable for the customer claims. 78 the funds were established to increase investor confidence, not to satisfy the exchange's own liability. the payment by the funds would not discharge the exchange's liability because the exchange had no liability to begin with. therefore, the payments to the fund were deductible because the trusts were not "grantor trusts." the court in johnson v. commissioner179 used the grantor trust rules to reject an automobile dealer's attempt to exclude from income a portion of the proceeds received from the sale of a vehicle service contract which were transferred to a fund to secure the dealer's future obligations under the service contract. finding the fund to be a grantor trust because payments from the fund would reduce the dealer's liability and because the dealer held a reversion, the court denied the exclusion for the portion of the purchase price transferred to the grantor trust, and also held that the income from the trust was taxable to the dealer. 175. regs. § 1.677(a)-1(c). 176. regs. § 1.677(a)-l(d). 177. 1985-2 c.b. 175 (1985). 178. priv. ltr. rul. no. 6407145030a, priv. ltr. rul. no. 6707186030a, priv. ltr. rul. no. 6905071230a, priv. ltr. rul. no. 7012291000a and 1994 f.s.a. lexis 41. 179. 108 t.c. 448 (1997), aff'd in part rev'd in part, 184 f.3d 786 (8th cir. 1999). floida tax review [vol. 5:3 avoiding phantom income in banknptcy likewise, in anesthesia service medical group, inc. v. commissioner,180 the court held that a medical group could not deduct payments to a trust for the benefit of potential future malpractice claimants. the trust was created in lieu of medical malpractice insurance, and provided that the funds in the trust could never revert to the medical group any funds remaining in the trust at the conclusion of the trust would be donated to charity. nevertheless, the court held that the payments to the trust were not deductible because any distributions by the trust to tort claimants would be used to discharge the medical group's malpractice liability and thus constituted a grantor retained interest. in summary, if the grantor remains liable on the creditors' claims after the transfer to the trust, the trust will be treated as a grantor trust and no deduction will be allowed. in order for there to be a possibility of a deduction, the transfer to the trust must completely satisfy the grantor's obligation to the creditor for the amount of the transfer.181 moreover, because there must be no possibility of a reversion, the trust could not be used for contested liabilities. short of an order transferring the liability for the claimants' uncontested claims from the debtor to the fund (as in maxus energy), the trust will likely be treated as a grantor trust and any deduction disallowed. at least in theory, the requirement that the debtor's liability be discharged upon transfer to the fund could be addressed using the theory of the maxus energy case to create a fund, with bankruptcy court approval, for the payment of trade claims. the bankruptcy court has broad equitable power under section 105 of the bankruptcy code to issue orders necessary or appropriate to carry out the bankruptcy laws. however, it would be extremely difficult to convince a bankruptcy judge to wade through uncharted tax waters by authorizing such a trust.'82 a maxus energy trust requires the complete transfer 180. 85 t.c. 1031 (1985). 181. while § 677 focuses on the potential for the trustor to benefit from the income of the trust, similar rules apply to trust corpus. see § 673 (providing that a grantor is treated as the owner of a trust if there is a possibility of reversion); § 674 (providing that a grantor is treated as owner of a trust if the grantor retains power to control beneficial enjoyment of income or corpus); § 676 (providing that a grantor is treated as owner of a trust if the grantor retains power to revoke transfer to trust). the same constructive receipt rules should apply to corpus as apply to income. therefore, an attempt by a debtor to take a deduction for payments to a trust fashioned in such a way that the corpus would be used to satisfy the trustor's creditor claims but the income would be paid to some third party should be treated as a grantor trust, because the corpus is subject to reversion or revocation. 182. there are no reported cases in which a bankruptcy debtor sought authority to create and fund a trust for the payment of certain creditor claims after plan confirmation for the purpose of avoiding phantom income. on the other hand, bankruptcy courts are familiar with the creation of liquidating trusts. however, liquidating trusts exist for an entirely different purpose than a trust designed to hold cash for distribution to creditors upon plan confirmation. a liquidating trust is designed to hold non-financial assets for orderly liquidation after plan confirmation. regs. § 301.7701-4(d). in order to be taxed as a liquidating trust, the trust cannot 20011 florida tax review of the debtor's personal liability to the trust. the maxus energy court had jurisdiction to effectuate the release and transfer in connection with approval of the class action settlement, in which the class members had the due process right to "opt out" of the settlement. in all probability a bankruptcy judge would refuse to consider such extraordinary action outside of a plan of reorganization, where the statutory guidelines for confirmation are in place. bankruptcy courts have been loathe to approve de facto reorganization plans outside of the formal plan confirmation process.'8 3 v. summary of analysis and recommendation for reform phantom income is a serious problem in bankruptcy cases. bankruptcy laws designed to assure ratable distributions to creditors force the debtor to defer paying claims, resulting in phantom income which is taxed to the debtor but earmarked for the payment of creditor claims upon confirmation of the debtor's reorganization plan. the problem affects both cash and accrual method taxpayers with respect to those liabilities that cannot be deducted until paid. because bankruptcy laws prevent the debtor from arranging its own affairs in such a way as to minimize its taxes, some relief from the phantom income problem is in order. the only automatic error correction device applicable to the phantom income problem is the net operating loss carryback. the carryback rules provide relief only in ideal circumstances. the rules do not apply when the debtor has sufficient income in the year of plan confirmation to offset the operating loss. yet, the value of the deduction in the year of confirmation may be significantly less than the value of the deduction in the appropriate year due to the time value of money, and the possibility of creeping rate brackets, differing tax rates, and the reduction of more favorably taxed capital gains rather than ordinary income. moreover, the discharge of indebtedness rules require any surviving net operating exist any longer than is reasonable to complete the liquidation of the assets, and cannot hold liquid assets like marketable securities, cash or cash equivalents in excess of a reasonable amount to meet trust expenses and contingent liabilities. rev. proc. 94-45, 1994-2 c.b. 684 (1994) (setting forth the requirements for an advance ruling that a trust will be taxed as a liquidating trust.). a liquidating trust is thus not designed to hold cash prior to confirmation of a plan for the purpose of avoiding phantom income. 183. see e.g., n re lionel corp., 722 f.2d 1063 (2nd cir. 1983) (requiring good faith business reason for sale of assets outside of plan); in re braniff airways, inc., 700 f. 2d 935 (5th cir. 1983) (refusing to approve transfer of substantially all assets outside of plan of reorganization); in re continental airlines, inc., 780 f.2d 1223, 1227 (5th cir. 1986) (refusing to authorize debtor to enter into leases which constituted "creeping reorganization plan" outside requirements for plan confirmation); in re first south say. assn., 820 f.2d 700, n.15 (5th cir. 1987) (denying proposed financing because it would "significantly effect the terms of any plan that may be proposed in the future.") [vol. 5:3 avoiding phantom income in bankruptcy losses to be reduced by the amount of unrecognized discharge of indebtedness income occurring upon plan confirmation before being carried back to earlier years. thus, the net operating loss carryback rules do not provide a reliable device for correcting the phantom income problem in bankruptcy cases. there are also inadequate methods for the debtor to avoid phantom income through careful tax planning. the dsf and qsf rules likely only benefit accrual method taxpayers, and are limited-to tort claims (and specifically exclude bankruptcy trade claims). likewise contested liability funds can only be used for contested liabilities, and apparently only by cash method taxpayers (unless the more stringent qsf rules are complied with). a general trust could only be used if the transfer to the trust extinguished the debtor's liability to the creditor, as in maxus energy. each of the potential funds or trusts has specific limitations which prevent generalized use in bankruptcy to avoid phantom income. although in theory the various trusts could be used in combination by some debtors to eliminate some phantom income in bankruptcy, in the real world it would be nearly impossible to convince a bankruptcy court to allow special trust fund deposits for certain creditors without providing similar protections for all creditors. since none of the potential trust devices would permit a deduction for the full panoply of creditor claims, the existing devices provide no real shelter for bankruptcy debtors facing the problem of phantom income. the code or the regulations should be amended to permit bankruptcy debtors to establish a single trust for the payment of all types of pre-petition creditor claims upon confirmation of a plan of reorganization. the trust should pay income taxes on its income in the same manner as a qsf or dsf. the trust should be established only with the approval of the bankruptcy court, after notice to the internal revenue service and an opportunity for a hearing. the debtor should be required to show that, but for the bankruptcy restrictions on the payment of pre-petition claims prior to plan confirmation, the debtor would in the ordinary course of business use the assets to be contributed to the trust to pay creditor claims (or to reserve for contested creditor claims). the trust assets should be segregated in a separate account under the control of an independent trustee or the court. the amount set aside in the trust should be limited to the amount of the claims of the legitimate claims creditors, and any contested claims exceeding a threshold value should be estimated by the court for the purposes of being included in the trust. the debtor should be specifically allowed to deduct the appropriate portion of the payments to the trust. the amount of the deduction should depend on the amount that would be deductible if the contribution to the trust constituted a distribution to creditors under the liquidation provisions of chapter 7 of the 20011 bankruptcy code at the time the contribution to the trust is made. 84 an allocation of the contributions to the trust between claims is necessary for several reasons. first, a deduction would not available for payment for some of the debtor's liabilities, such as principal loan repayments 8 5 or consumer purchases,'86 while payment of other liabilities would be deductible. without an allocation, the debtor could pick and choose to fund only those liabilities that would be deductible. this would distort the debtor's true financial picture because the debtor is required in bankruptcy to treat all creditors having the same priority in the same way.'87 the phantom income distortion is caused by the debtor's inability to make payments during the bankruptcy case until confirmation of a reorganization plan. that distortion should be cured by allowing the debtor to take appropriate deductions for payments made to the trust which would have been deductible if the debtor were permitted to make those same payments directly to creditors. since all creditors in bankruptcy must be paid pro rata according to the priority of their claims, 88 a deduction should be 184. chapter 7 is the so-called "straight bankruptcy" provision of the bankruptcy code. it provides for the liquidation of the debtor's assets under the supervision of a courtappointed trustee, and the payment of claims in accordance with the rules established by congress for bankruptcy liquidations in § 726 of the bankruptcy code. see 11 u.s.c. § 701 (appointment of interim trustee); id. § 704 (duty of trustee to collect and reduce to money property of estate and close estate as expeditiously as is compatible with the best interests of parties in interest); id. § 726 (distribution rules). it is appropriate to use the chapter 7 distribution scheme for the hypothetical interim distribution to creditors for two reasons. first, it is the scheme that would apply if the case were to be converted from chapter 11 to chapter 7 upon the debtor's inability to confirm or effectuate a plan of reorganization. see 11 u.s.c. § 1112(b). second, the chapter 7 distribution scheme is incorporated into the chapter 11 plan confirmation requirements through the best interests of creditors test in § 1 129(a)(7)(ii) of the bankruptcy code. the best interests of creditors test prevents confirmation of a chapter 11 reorganization plan without the express vote of each creditor unless the plan proponent can prove that each creditor will receive under the plan at least the amount that such creditor would receive in a liquidation under chapter 7. this fundamental test is designed to assure that all creditors who do not specifically accept the plan are at least as well off as they would be in a chapter 7 liquidation. therefore, the hypothetical interim distribution will be allocated in accordance with the procedure required both in the event of a conversion or for meeting the fundamental best interests of creditors test at plan confirmation. 185. commissioner v. tufts, 461 u.s. 300 (1982) (stating that "[w]hen a taxpayer receives a loan, he incurs an obligation to repay the loan at some future date. because of this obligation, the loan proceeds do not qualify as income to the taxpayer. when he fulfills the obligaton, the repayment of the loan likewise has no effect on his tax liability.") 186. § 262(a). 187. see 11 u.s.c. § 726(b) (providing that distribution in chapter 7 liquidation prorata to creditors holding claims of the same priority); id. § 1 123(a)(4) (requiring same treatment for all claims in the same class in chapter 11 plan); see also supra note 105. 188. section 726 of the bankruptcy code contains the applicable chapter 7 distribution rules. these rules require claims entitled to priority to be paid in the order specified in § 507 of the bankruptcy code before the claims of general unsecured creditors are paid. florida tax review [vol. 5:3 avoiding phantom income in bankruptcy allowed only for the portion of the payments that would have been deductible if the payments were made directly to the creditors. second, appropriate adjustments must be made for the claims of secured creditors. in a chapter 7 case, fully secured creditors would be entitled to distributions only from the proceeds of their collateral, and would have an entitlement to those proceeds before other creditors. a fully secured creditor would not be entitled to any payment from the debtor's other funds in a chapter 7 liquidation. therefore, if cash collateral" 9 is contributed to the trust, it should be separately accounted for and properly allocated first on account of the secured creditor's claim (and if multiple secured creditors on account of the secured creditors' claims according to their state-law priority) with any excess allocated to the payment of the claims of other creditors according to the chapter 7 priority rules. if no cash collateral is contributed to the trust, then no portion of the trust funds would be allocated to the claims of fully secured creditors. the claims of under-secured creditors who have full recourse' 90 are treated as two separate claims under the bankruptcy code a secured claim for the amount of the debt up to the value of the security, and an unsecured claim for the amount of the debt exceeding the value of the security.'9 ' the secured portion of the claim should be treated in the same manner as a fully secured creditor, and the unsecured portion of the claim should be treated as a general unsecured claim. creditors holding non-recourse under-secured claims would be treated in the same manner as fully secured creditors and excluded from treatment in the trust, since they would not have the right to participate in distributions of the debtor's other assets. 192 claims of the same class are paid pro-rata in accordance with the amounts of the claims. 11 u.s.c. § 726(b). 189. cash collateral is defined in § 363(a) of the bankruptcy code as cash in which both the estate and a secured creditor have an interest. it includes the proceeds from the sale of the lender's collateral to the extent the lender's security interest extends to such proceeds. 190. under applicable non-bankruptcy law, the debtor is personally liable for the claims of secured creditors who have full recourse, and is not personally liable for non-recourse secured claims. the debtor's liability for non-recourse claims is in rem only against the security for the loan. 191. 11 u.s.c. § 506(a). 192. chapter 11 contains special rules for a non-recourse secured creditor to be treated as a recourse creditor if the collateral is to be retained by the debtor rather than sold. 11 u.s.c. § 111l(b). the creditor, in turn, has the right to elect to be treated as a fully secured creditor and not receive distributions as an unsecured creditor. id. § 1l11 (b)(2). these rules create peculiar strategic issues that must be considered by secured creditors in connection with the proposed treatment of the particular secured claim in connection with a specific proposed plan of reorganization. since these special rules only apply in connection with confirmation of a reorganization plan, and since the debtor always has the ability to avoid liability for the deficiency claim of a non-recourse creditor by disposing of the property, the deficiency claim of a non-recourse creditor should not be an eligible claim under the bankruptcy claims trust. 2001] florida tax review finally, any applicable priorities should be honored. if payments were made to creditors under chapter 7, claimants holding higher priority claims would be entitled to full payment before any distribution is made to claimants holding lower priority claims. 193 these basic rules can be illustrated with a simple example. suppose a cash-method debtor contributes $300x to a creditor trust at a time when the debtor owes $1 00x in priority tax claims, $50x on unsecured loans, $200x on a recourse loan secured by real property valued at $150x, and $300x in ordinary business expenses. in a chapter 7 liquidation, the first $1 00x would be used to pay the priority claims. the $200x balance would be allocated to the remaining unsecured claims pro-rata. priority unsecured recourse business utscued loantoaloans dfcn expenses claims deficiency claim amount $10ox $50x $50x $300x $500x allocation of contribution to $100x $25x $25x $150x $300x trust ii__i_ deductions $100x $150x $250x allowed____________________________ because both of the loan repayments would not be deductible, the debtor would be allowed to deduct only the allocable share of the contribution for priority tax claims and business expenses. tax adjustments will be required if any claims covered by the fund are ultimately disallowed. the portion of the trust representing amounts attributable to the disallowed claim must be treated as recovered by the debtor in the year of disallowance, whether withdrawn from the trust or not. the character of the disallowed claim would determine the appropriate tax treatment. if the disallowed claim relates to a loan, the debtor would have discharge of indebtedness income subject to non-recognition under section 108(a)(1)(a). if the disallowed claim represents amounts previously deducted, income would be recognized in the year of recovery under the tax benefit rule.'94 in the event that funds in the trust are used to pay different obligations upon plan confirmation than originally designated (such as administrative expenses in an insolvent bankruptcy estate), 193. 11 u.s.c. § 726. 194. the tax benefit rule requires the inclusion in income of amounts recovered which were beneficially deducted in a prior year. hillsboro national bank v. commissioner and united states v. bliss dairy, inc., 460 u.s. 370 (1983); § 111 (a) (providing exception to judiciallycreated tax benefit rule for recovery of amounts deducted in a prior year which did not reduce the taxpayer's taxes in the prior year). [vol. 5:3 2001] avoiding phantom income in bankruptcy 297 appropriate adjustments would be required for deductions taken for amounts which are not ultimately paid (resulting in taxable income), and for payments actually made which are subject to deduction (resulting in additional deductions). distributions from the trust should only be allowed under specific limited circumstances. prior to plan confirmation, distributions should be allowed only upon final disallowance of a disputed claim. if the case is converted to chapter 7, the funds should be available for distribution in accordance with the priorities established for chapter 7 distribution. any appropriate tax adjustments would be required for payments to parties different than originally designated. upon plan confirmation, distributions would be made in accordance with the plan. if the plan permits the use of the trust funds for any purpose other than to pay the designated claims, appropriate tax adjustments would be required. these provisions would assure that the fundamental purposes of bankruptcy are served without exposing the debtor to adverse tax consequences. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe tcharity really does begin at home: florida tax review volume 10 2011 number 10 763 transparency in private collection of federal taxes t. keith fogg∗ i. introduction.................................................................................... 764 ii. history of disclosure laws ......................................................... 770 iii. collecting taxes for the united states ................................... 776 iv. disclosure policy considerations ............................................. 781 a. irc section 6103 ........................................................................ 787 b. section 6104 ................................................................................ 799 c. placement of collected taxes within disclosure regime ........... 806 v. changes to current return forms ............................................ 810 vi. how mechanics of disclosure should take place ................. 813 vii. disclosure policy aspects of proposal ..................................... 813 a. shaming ...................................................................................... 816 b. disclosing some returns containing collected tax information ................................................................................. 828 viii. conclusion ...................................................................................... 831 ∗ associate professor, villanova university school of law. thanks to rachel zuraw and fleming ware for their exceptional research assistance. thanks to professor les book of villanova university and the villanova junior faculty workshop for their review and guidance. 764 florida tax review [vol. 10:10 abstract most federal taxes are collected from taxpayers by business entities, held in a public trust for the united states, and then paid over to the internal revenue service (the irs). while the vast majority of business entities pay over the taxes held in trust in a timely and appropriate manner, a sizeable amount, in dollar terms, does not get paid. the amount of unpaid “collected” taxes in 2008 created a $58 billion tax gap item. disclosure law governing federal taxes defaults to non-disclosure for most tax returns. this general rule of non-disclosure governs the returns reporting the taxes collected by business entities even though the information on these returns is information concerning a public trust. this article analyzes the federal tax disclosure laws and concludes that the amount of taxes collected on behalf of the united states and the amount of these collected taxes paid over to the irs should be disclosed. rather than coming under the general rule of non-disclosure which applies to income tax returns and other returns reporting the liability of an individual or entity for the payment of taxes, these returns should be treated like the returns of pension plans, which are open for the public to see. in addition to approaching the issue from the perspective of disclosure policy, the article also looks at the collection policy issues presented by the disclosure of this information. for the same policy reasons that congress has decided compliance is enhanced by the disclosure of pension plans and the returns of exempt organizations, the article concludes that compliance would be enhanced by this proposal and the tax gap reduced. i. introduction most federal taxes in the united states are collected by business entities as a routine part of their operations.1 in order to promote efficiency, employers collect income taxes and social security taxes, while telephone companies, airlines, and certain other businesses collect federal excise taxes. the practice of using business entities to collect federal taxes has a long history in the united states.2 1. irc § 3102(a) (“the tax imposed by § 3101 shall be collected by the employer of the taxpayer, by deducting the amount of the tax from the wages as and when paid.”); irc § 3402(a) (“except as otherwise provided in this section, every employer making payment of wages shall deduct and withhold upon such wages a tax. . . .”). collecting taxes from employees represents one form of collected taxes and the most common form. taxes are collected for the government by business entities in other situations as well. the definition of collected taxes for purposes of this article is set out in note 13, infra. 2. the use of business entities to collect employment taxes, for example, dates back to 1943, when president roosevelt signed into law the current tax 2011] transparency in private collection of federal taxes 765 although private entities are continuously entrusted with enormous sums of money, there has been little debate concerning this collection process. however, when congress passed internal revenue code (irc) section 6306 in 2004,3 which permitted private debt collectors to pursue unpaid taxes, privacy debates surprisingly abounded.4 no part of these debates addressed the fact that business entities5 regularly perform preassessment collection.6 similarly, in the debates concerning disclosure law, the special nature of the pre-assessment collection, and the reporting of that payment act, which authorized withholding taxes. current tax payment act, ch. 120, 57 stat. 126 (1943). some excise taxes were collected even prior to this, leading to the passage of the criminal tax provision which was the antecedent of the current trust fund recovery penalty found in irc § 6672. see gerald p. moran, willfulness: the inner sanctum or unnecessary element of section 6672, 11 u. tol. l. rev. 709, 723 (1980). 3. all references and citations to sections hereinafter are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. 4. the bush administration persuaded congress that private tax collectors could bring into federal coffers money going unattended by the irs. the irs struggled through a period of setting rules for these private collectors before entering into contracts permitting them to begin collection. critics of the program, including the national treasury employees union and the national taxpayer advocate, complained loud and long before passage of irc § 6306, during the writing of the regulations and the contracts, and after the private collectors began. the complaints ultimately led to the cancellation of the contracts. currently, there is no postassessment collection by business entities. 5. this discussion focuses on collection by business entities, but it must be acknowledged that pre-assessment collection of federal taxes occurs by any employer in the united states which, of course, includes local, state, and federal governments, as well as tax-exempt entities. 6. the term pre-assessment collection is used here to describe collection of federal taxes before the irs has made an assessment of those taxes. this circumstance can easily be seen in the employment tax context. when abc, inc. pays john smith wages, it withholds $100 each week from john’s wages to pay that amount over to the irs. this amount is credited toward john’s income and social security tax liability for the tax year in which the wages are paid. at the time the taxes are collected by abc, inc. from john’s wages, john has not filed a tax return for the tax year relating to the withholding, and the irs has not made an assessment against john for those taxes. the amount withheld is simply placed into john’s account for that tax year as a credit which will be applied when john does file his tax return at a later time. contrast this with the post-assessment collection of taxes by a private collector. the post-assessment collection occurs after john has filed his tax return or otherwise had a federal tax assessment occur with respect to his liability. his account balance for the year at issue shows that john has not paid into the account sufficient funds to satisfy the tax liability. so, the irs or a private tax collector seeks additional funds from john at that point to satisfy the outstanding debt. 766 florida tax review [vol. 10:10 collection, was not discussed. this recent situation highlights the fact that if the public is so concerned with individuals being pursued by private debt collectors for tax liabilities, the same level of concern should exist when other private entities collect taxes on the irs’s behalf.7 this article does not suggest changing the system by which business entities collect federal taxes in the pre-assessment context. the current system generally works very well. rather, this article seeks to show how the current system of pre-assessment collection of federal taxes by private parties would benefit from disclosure and align this activity with other situations in which disclosure policy has determined that transparency, rather than confidentiality, is important. the collection of federal taxes by business entities creates public trusts, where the business entities act as trustees and the united states becomes the beneficiary.8 despite the public nature of these trusts, tax returns filed by business entities reporting these trust receipts and dispositions are kept confidential under current disclosure laws. the current law shields information about these public trusts, treating returns filed by business entities similarly to returns from taxpayers that report income taxes or other private tax information. this article proposes that current disclosure law and policy treats these collected tax returns incorrectly, and instead should acknowledge the benefit of publishing returns reporting money held in trust for the united states.9 section 6103 provides for the non-disclosure of most tax information reported to the irs. certain narrow exceptions exist within this section when the benefits of disclosure outweigh the costs. this article does not recommend creating another exception to section 6103 with respect to collected tax returns. instead, this article proposes that the provision requiring the disclosure of taxes held in trust should rest in section 6104, which governs the return information of tax-exempt organizations, pension plans, and political organizations. for almost 150 years since the enactment of the first income tax in 1861, congress has grappled with the disclosure policy it should employ 7. this characterization of the debates surrounding the enactment of irc § 6306 is not meant to ignore the complexity of issues associated with the statute. it is merely meant to shed light on the fact that the debates concerning private debt collection have not addressed pre-assessment collection by business entities. 8. irc § 7501. 9. the returns that business entities file concerning collected tax information should contain only information about the taxes collected and paid over to the government and not other tax information. as discussed in more detail below, the proposal here also includes a recommendation that returns reporting money held in trust should only report information about the money held in trust and not blend that information with matters on which the business entities are directly liable for taxes and on which they are entitled to the full protection of the disclosure laws. 2011] transparency in private collection of federal taxes 767 with respect to tax information.10 disclosure policy seeks to strike a balance between privacy interests and the benefits derived from publicity. the policy debate has primarily centered on individual and corporate income taxes,11 with some attention, starting in 1950, 12 on tax-exempt organizations. almost no attention during this debate has focused on collected taxes,13 which businesses must hold in a statutory or public trust for the united states.14 10. in 1998 congress mandated in § 3802 of the revenue reform act that the joint committee on taxation and the treasury department prepare reports on disclosure law. the joint committee on taxation (jct) report was issued in three volumes: volume i covers more general issues, volume ii discusses issues involving exempt organizations, and volume iii contains letters from states and tax authorities on the costs and benefits of disclosure. the jct report, staff of the joint committee on taxation, study of present-law taxpayer confidentiality and disclosure provisions as required by § 3802 of the internal revenue service restructuring and reform act of 1998, (2000) [hereinafter jct report (vol. i)], contains a thorough history of disclosure laws in the united states in volume i at pages 246-79. while some disclosure history will be briefly summarized below, a more detailed summary of the history exists in volume i of the jct report, study of general disclosure provisions. although volume i of the treasury department report (treasury report) notes that a volume ii will be published focusing on irc § 6104, no volume ii was published by the treasury department. documented in email dated july 7, 2010 from channprett singh, irs office of the chief counsel (on file with the author). dep’t of the treasury, office of tax policy, report to the congress on scope and use of taxpayer confidentiality and disclosure provisions (2000) [hereinafter treasury report]. therefore, all references to the treasury report herein are to volume i. 11. see jct report (vol. i), supra note 10, at 5-6, 127-33; treasury report, supra note 10, at 33-37; see also paul schwartz, the future of tax privacy, lxi, nat’l tax j. 883, no. 4, 2, (2008); and marc linder, tax glasnost’ for millionaires: peeking behind the veil of ignorance along the publicity-privacy continuum, 18 n.y.u. rev. l. & soc. change 951 (1990-91). 12. pub. l. no. 81-814, § 341, 64 stat. 906, 960 (1950); see staff of the joint committee on taxation, jcs-1-00, study on present-law confidentialist, and disclosure provisions as required by section 3802 of the internal revenue service (vol. ii) (2000) 124 (“this provision, § 153(c) of the 1939 code, was the earliest version of § 6104. section 153(c) was codified as § 6104(a) of the 1954 code without amendment. pub. l. no. 83-591 (1954).”) [hereinafter jct report (vol. ii)]. 13. the term “collected taxes” will be used in this article to describe taxes that an individual or entity must collect on behalf of the united states and hold for payment over to the united states at some future point. the most common collected taxes are employment taxes that consist of two parts: withheld income taxes and withheld social security taxes. although employment taxes receive the most attention, in some ways they do not fit as neatly into the definition of collected taxes since the employer does not actually receive any money from its employees, but simply sets aside money it would otherwise have paid to them in order to pay that money over to the irs. the fiction in this analysis is that often the employer never has the money allegedly set aside. contrast this type of collected tax with excise 768 florida tax review [vol. 10:10 given the amount of collected money withheld and not remitted to the united states, and the compelling governmental interest in ensuring that the united states receives these funds, this neglect is a serious policy mistake, and has contributed to the billions of dollars of withheld taxes that businesses have not paid over to the united states. this article discusses the relationship between collected taxes and relevant disclosure law and determines that collected tax information more closely resembles the information of tax-exempt organizations and pension plans than that of individuals or corporations reporting income taxes and other types for which those entities are directly liable. as discussed below, this insight is crucial, as it reveals that the disclosure policy considerations for tax-exempt organizations and pension plans start with a bias for disclosure, while the policy for income tax liabilities starts with a bias for confidentiality.15 this article concludes that tax returns concerning collected taxes fall onto the tax-exempt and pension plan side of the line for purposes of determining disclosure policy, and consequently recommends a wholesale revision of the disclosure statutes, particularly section 6104, to provide for disclosure of collected tax returns. this recommendation is based principally on disclosure policy. because disclosing collected tax returns benefits the collection process, the article will taxes, in which entities actually collect money from their customers on behalf of the united states and hold the money so collected for the benefit of the united states until the filing of the excise tax return. common examples of excise taxes are the communications excise tax, which the phone company collects from its customers each month, and the airline excise tax, which the airline collects as it sells the ticket. these excise taxes essentially equate with the sales taxes imposed in most states. as will be discussed below, many states draw a distinction between sales taxes and employment taxes. the basis for this distinction must lie in the fact that a third party has physically given to the seller the actual tax dollars due to the government, in contrast to employment taxes, where the employer should set aside those dollars from its general operating account. this is the same description of the term collected taxes used in a previous article, t. keith fogg, in whom we trust, 43 creighton l. rev. 357 (2010) [hereinafter fogg, trust]. 14. “whenever any person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the united states, the amount of tax so collected or withheld shall be held to be a special fund in trust for the united states.” irc § 7501(a) (emphasis added). this statutory provision creates a trust in which the collected or withheld taxes are kept. 15. this bias in favor of disclosing tax information of tax-exempt organizations is described in the jct report: “thus, the joint committee staff believes that the general principle governing disclosure of information regarding taxexempt organizations is that such information should be disclosed unless there are compelling reasons for nondisclosure that clearly outweigh the public interest in disclosure.” jct report (vol. i), supra note 10, at 6. see also infra part iv.b. 2011] transparency in private collection of federal taxes 769 also discuss the positive influence that revising disclosure policy will have on collection policy with respect to these returns. in addition to revealing the policy flaws in current disclosure law, this article recommends a straightforward solution to the problem. to effectuate the disclosure of collected tax information, this article recommends changing the design of collected tax returns by creating return forms that specifically require business entities to report collected taxes. these forms would contain some information similar to the information reporting found on the forms for tax-exempt organizations. the information would then be publicly posted in a manner similar to posting returns of taxexempt organizations in section 6104. the specifics of this aspect of the proposal will be discussed in detail below. as i have discussed in prior articles,16 the failure to pay collected taxes represents a significant, if not highly publicized, segment of the tax gap.17 the prior articles focused on attacking this corner of the tax gap by improving the functionality of the responsible person penalty18 and by creating a better structure for promoting payment of collected taxes.19 this article focuses on the impact that greater transparency can have on the collected tax issue. with greater transparency of the collection and payment of collected taxes, the potential exists for improved compliance in this area. this article will first briefly examine the history of disclosure laws over the past 150 years. second, it will discuss the current system of using business entities to collect taxes for the united states and how the collected monies are held and paid over to the united states. third, the article will look at the policy behind sections 6103 and 6104 and propose placing returns reporting collected taxes within the policy considerations behind those two code sections. fourth, it will recommend changes in current tax returns forms to cause the forms to separate collected tax information from other entity tax obligations. fifth, it will discuss the mechanics involved and how the disclosure of information should take place. lastly, the article will examine how this proposed change to disclosure policy might positively impact collection issues, including an examination of current law regarding publicity of outstanding liabilities and numerous state provisions regarding shaming. 16. see fogg, trust, supra note 13; t. keith fogg, leaving money on the table and providing an incentive not to pay—the story of a flawed collection device, 5 hastings bus. l.j. 1 (2009) [hereinafter fogg, leaving money on the table]. 17. u.s. gov’t accountability office, gao-08-617, tax compliance: businesses owe billions in federal payroll taxes (2008). 18. see generally fogg, leaving money on the table, supra note 16. 19. see generally fogg, trust, supra note 13. 770 florida tax review [vol. 10:10 ii. history of disclosure laws almost since the adoption of an income tax system, congress has debated the appropriateness of publishing the returns of individuals and entities reporting that income.20 in addition to income taxes, congress has imposed several other types of taxes in its quest to gather enough money to satisfy its spending appetite.21 most of the taxes reported to the irs fall under the disclosure provisions of section 6103, which prohibits the irs from disclosing the information on those returns except in specifically prescribed situations.22 while the united states initially experimented with public disclosure of tax returns and return information, it evolved fairly early in the income tax era into a restrictive posture with respect to the general availability of information from tax returns.23 this more restrictive posture treated returns as public documents but subject to disclosure rules established by the president.24 under this system, public disclosure of returns generally did not occur. broad disclosure of returns and return information, however, took place within the federal government. in the disclosure provisions prior to 1977, congress deferred to the executive branch to create rules governing this area. within this context, a significant shift occurred in 1977 in reaction to president richard nixon’s use of tax information. 25 the nixon white house used tax return information to attack the president’s “enemies,” and consequently congress began more carefully to 20. see jct report (vol. i), supra note 10, at 246-79 for a comprehensive discussion of the history of the disclosure laws. this section does not seek to provide comprehensive information concerning this history but only to assist the reader in understanding the policy debates that have occurred concerning disclosure of tax information. 21. see, e.g., irc § 1 (imposing income tax on individuals); § 11 (imposing income tax on corporations); § 1201 (outlining capital gains tax on corporations); § 2001(a) (imposing tax on transfers of estates); § 2501 (imposing tax on gifts); § 4001 (imposing tax on luxury vehicles); § 4051 (imposing tax on heavy trucks and trailers); § 4064 (imposing tax on gas guzzlers); § 4191 (imposing tax on medical devices); § 4261(a) (imposing tax on taxable transportation); § 4261(b) (imposing tax on air transportation); § 4375 (imposing fee on health insurance); § 4401 (imposing tax on wagers); § 4471 (imposing tax on covered voyages); § 4611 (imposing tax on petroleum); § 5701 (imposing tax on cigarettes). 22. the general rule of non-disclosure of tax information is set out in § 6103(a), which provides in part that “[r]eturns and return information shall be confidential,” and except as provided in 6103 the information cannot be disclosed. 23. see robert p. strauss, state disclosure of tax return information: taxpayer privacy versus the public’s right to know, 5 state tax notes 24, 25 (1993). 24. id. at 25-26. 25. id. at 26. 2011] transparency in private collection of federal taxes 771 monitor the use of tax information.26 its review of the situation resulted in a significant revamping of section 6103 in 1976 to the statutory structure that exists today.27 through the tax reform act of 1976, congress set out to eliminate the ability of the executive branch to obtain and use tax information, and it successfully terminated that practice by removing the president’s control of disclosure exceptions.28 instead of granting broad discretion to the executive branch, congress took the disclosure power upon itself and created a series of narrow exceptions to govern disclosure of tax information. these limited exceptions produced a scheme in which nondisclosure of tax information now serves as the guiding premise.29 the debate over privacy of returns has not uniformly marched toward keeping private all tax information, but rather has meandered as different types of tax information came under scrutiny. disclosure of individual income tax information came up for debate with the revenue act of 1864, which provided that tax lists would be public.30 this debate continued in 1870 when the commissioner ended publication in newspapers, but the information remained open to inspection.31 congress stepped into the debate in 1894 with the reenactment of the income tax by prohibiting publishing of tax information and imposing criminal sanctions for violations.32 26. id.; david lenter, joel slemrod, & douglas shackelford, public disclosure of corporate tax return information: accounting, economics, and legal perspectives, lvi national tax journal 813 (2003). 27. the privacy protection study commission, created as part of the privacy act of 1974, recommended that congress make major changes to the disclosure of federal tax information. the watergate scandal and ensuing disclosure policy recommendations caused congress to evaluate access to taxpayer records. jct report (vol. i), supra note 10, at 256. 28. tax reform act of 1976, pub. l. no. 94-455, § 1202(a)(1), 90 stat. 1667; irc § 6103(a). 29. compare irc § 6103 (1976) with § 6103 (effective 1977). 30. lenter, slemrod, & shackelford, supra note 26, at 807. 31. act of july 14, 1870, 16 stat. 256, 259 (“[n]o collector, deputy collector, assessor, or assistant assessor shall permit to be published in any manner such income returns, or any part thereof, except such general statistics, not specifying the names of individuals or firms, as he may make public, under such rules and regulations as the commissioner of internal revenue shall prescribe.”). 32. 28 stat. 509, 557 ch. 349 (“sec. 34. that . . . the revised statutes of the united states as amended are hereby amended so as to read as follows: sec. 3167. that it shall be unlawful for any collector, deputy collector, agent, clerk or other officer or employee of the united states to divulge . . . the amount or source of income. . . .”). 772 florida tax review [vol. 10:10 the issues surrounding the disclosure of returns by business entities did not surface until much later.33 in 1909 the payne–aldrich tariff passed, which imposed an excise tax on corporations.34 this law contained conflicting provisions on the public nature of corporate returns, with one paragraph explicitly making them public records and the next punishing the divulgence of information.35 the confusion caused by the conflicting provisions of the 1909 legislation resulted in an amendment to the provision in 1910 which stated that “any and all such returns shall be open to inspection only upon the order of the president under rules and regulations to be prescribed by the secretary of the treasury and approved by the president.”36 this language essentially created a compromise between those who thought that corporate returns should be fully open to the public and those who did not.37 the amendment also left the corporate returns as “public records,” but only open to public inspection with the president’s authorization.38 after the passage of the sixteenth amendment permitting income taxes, congress passed tax legislation in 1913 to exercise its newly created 33. see jct report (vol. i), supra note 10, at 248-49. the joint committee on taxation report does not discuss any debate concerning disclosure of these types of returns, suggesting that returns filed by business entities did not become an issue until later. 34. act of aug. 5, 1909, ch. 6, § 38, 36 stat. 11, 112. 35. the sixth and seventh paragraphs of § 38 of the legislation read as follows: sixth. when the assessment shall be made, as provided in this section, the returns, together with any corrections thereof which may have been made by the commissioner, shall be filed in the office of the commissioner of internal revenue and shall constitute public records and be open to inspection as such. seventh. it shall be unlawful for any collector, deputy collector, agent, clerk, or other officer or employee of the united states to divulge or make known in any manner whatever not provided by law to any person any information obtained by him in the discharge of his official duty, or to divulge or make known in any manner not provided by law any document received, evidence taken, or report made under this section except upon the special direction of the president; and any offense against the foregoing provision shall be a misdemeanor and be punished by a fine not exceeding one thousand dollars, or by imprisonment not exceeding one year, or both, at the discretion of the court. 36 stat. 11, 116-17. 36. appropriations act of 1910, ch. 297, 36 stat. 468, 494. 37. irs disclosure and privacy law reference guide 1-3 to 1-4, available at http://www.irs.gov/pub/irs-pdf/p4639.pdf. 38. id. at 1-4. 2011] transparency in private collection of federal taxes 773 taxing authority.39 in this legislation congress essentially adopted the compromise on disclosure adopted in the 1910 provision.40 the debate surrounding the confidentiality of tax return information continued for two more decades with each side citing the policy reasons for and against publicity.41 in 1924 congress ordered the commissioner to prepare and make publicly available the names, addresses, and amounts of tax of individuals and corporations filing returns.42 in 1934 congress enacted further disclosure and then repealed it less than a year later.43 concerns over 39. the 16th amendment states that “[t]he congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” u.s. const. amend. xvi. 40. section g(d) of the tariff act of 1913 provided: when the assessment shall be made, as provided in this section, the returns, together with any corrections thereof which may have been made by the commissioner, shall be filed in the office of the commissioner of internal revenue and shall constitute public records and be open to inspection as such: provided, that any and all such returns shall be open to inspection only upon the order of the president, under rules and regulations to be prescribed by the secretary of the treasury and approved by the president. . . . 38 stat. 144, 177. 41. compare harrison on tax dodging, n.y. times, feb. 23, 1898 (reporting statement of president benjamin harrison before the union league club of chicago in 1898: “each citizen has a personal interest, a pecuniary interest in the tax return of his neighbor. we are members of a great partnership, and it is the right of each to know what every other member is contributing to the partnership and what he is taking from it,” with paul schwartz, the future of tax privacy, 41 nat’l tax j. 883, 891 (2008) (with the statement of secretary of the treasury, mellon: “[w]hile the government does not know every source of income of a taxpayer and must rely upon the good faith of those reporting income, still in the great majority of cases this reliance is entirely justifiable, principally because the taxpayer knows that in making a truthful disclosure of the sources of his income, information stops with the government. it is like confiding in one’s attorney”). 42. lenter, slemrod, & shackelford, supra note 26 (citing revenue act of june 2, 1924, ch. 234, § 257(b), 43 stat. 293). 43. section 55(b) of the revenue act of 1934, 48 stat. 680, 698 provided: “every person required to file an income return shall file with his return, upon a form prescribed by the commissioner a correct statement of the following items shown upon the return: (1) name and address, (2) total gross income, (3) total deductions, (4) net income, (5) total credits against net income for purposes of normal tax, and (6) tax payable. . . . such statements or copies thereof shall as soon as practicable be made available to public examination and inspection in such manner as the commissioner, with the approval of the secretary, may determine, in the office of the collector with which they are filed, for a period of not less than three years from the date they are required to be filed.” 774 florida tax review [vol. 10:10 kidnapping, resulting from the publicity of individual income, overrode concern for the public’s need for this information, causing repeal of the 1934 disclosure provisions in 1935.44 from 1935 until 1976, little changed in tax disclosure provisions, with presidential order controlling disclosure of return information.45 during this period, presidential decree inhibited the publicity of tax return information, but availability of this information increased among government agencies.46 in 1976 congress enacted sweeping changes to section 6103, severely restricting the use of tax return information.47 essentially, through legislation congress assumed the role of determining which information to disclose, removing this authority from the executive branch.48 since the 1976 revisions to section 6103, merely cosmetic changes have occurred. in section 3802 of the revenue reform act of 1998, congress provided for a major study of the disclosure laws.49 that section ordered the joint committee on taxation and the treasury department to submit reports to congress on the state of the disclosure laws and any needed changes. these reports provide a significant overview of the disclosure laws from both historical and policy perspectives and also outline legislative proposals.50 nothing in these reports or in any legislative history specifically addresses the recommendation of this article that returns of collected taxes present different issues than income tax returns and other returns reporting taxes of taxable entities. in addition to section 6103, which provides the primary directives on disclosure issues, two other statutes exist in the internal revenue code which provide significant guidance concerning disclosure issues—sections 6104 and 6110. section 6104 got its legislative start in 1950 when congress first gave legislative attention to the different disclosure considerations 44. act of april 19, 1935, ch. 74; 49 stat. 158 (repealing the pink slips). 45. jct report (vol. i), supra note 10, at 254 & n.1056 (“in 1939, the disclosure provisions were codified at § 55 of the internal revenue code. in 1954, the disclosure provisions moved to their present location in § 6103. no material change was made from existing law.”) 46. see id. at 255-56. 47. tax reform act of 1976, pub. l. no. 94-455 § 1202(a)(1), 90 stat. 1667. 48. see generally staff of joint committee on taxation, 94th cong., 2d sess., general explanation of the tax reform act of 1976 313-316 (comm. print 1976), available at 1976-3 c.b. (vol. 2) 325-328. 49. “the joint committee on taxation and the secretary of the treasury shall each conduct a separate study of the scope and use of provisions regarding taxpayer confidentiality, and shall report the findings of such study . . . to congress.” revenue reform act of 1998, pub. l. no. 105-206, § 685. 50. the jct report and the treasury report are so thorough that they must be read by anyone with an interest in this area. as discussed below, this article takes off from the point of many of the disclosure policies stated in the joint committee report. 2011] transparency in private collection of federal taxes 775 regarding returns of tax-exempt organizations.51 essentially, section 6104 takes the opposite approach to section 6103 and provides for disclosure of the tax information of tax-exempt organizations.52 this disclosure occurs because of the tax benefits received by the tax-exempt organizations and a perceived need for public awareness of the affairs of organizations that receive a public subsidy.53 section 6110 resulted from litigation under the freedom of information act (foia)54 seeking disclosure of private letter rulings.55 in 1976, as congress revised section 6103, it added section 6110 to create a more open system for parties trying to understand the irs positions on specific transactions. prior to section 6110 certain law firms that regularly made private letter ruling requests had significant information on irs ruling positions that was unavailable to the general public.56 section 6110 opened up the irs decision making process. the irs removes taxpayer identifying information and certain other data in the published rulings before the data is made public.57 the inclusion of chief counsel advice in 1998 significantly expanded the scope of section 6110.58 litigation by tax analysts has 51. revenue act of 1950, 64 stat. 906, 960, pub. l. no. 81-814, § 341. section 153(c) of the 1939 code was the earliest version of § 6104. section 153(c) was later codified as § 6104(a) of the 1954 code, without amendment. jct report (vol. ii), supra note 12, at 124 (citing pub. l. no. 83-591 (1954)). 52. unlike irc § 6103, which starts with a blanket statement prohibiting disclosure without an exception, § 6104 outlines what will be open to the public, addressing first tax-exempt organizations in § 6104(a)(1) and then pension plans in (a)(2). 53. see jct report (vol. ii), supra note 12, at 5-6, 121. 54. pub. l. no. 89-487, 80 stat. 250. 55. see jct report (vol. i), supra note 10, at 82 & n. 293 (citing tax analysts & advocates v. irs, 505 f.2d 350 (d.c. cir. 1974) and fruehauf corp. v. irs, 75-2 u.s.t.c. ¶ 16,189 (6th cir. 1975)). 56. see id. 57. treasury report, supra note 10, at 27. 58. internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, § 3509, 112 stat. 685, 772-74 (codified at irc § 6110(i)); h.r. rep. no. 105-599, at 298-99 (1998) (conf. rep.), reprinted in 1998 u.s.c.c.a.n. see mitchell rogovin & donald l. korb, the four r’s revisited: regulations, rulings, reliance, and retroactivity in the 21st century a view from within, 46 duq. l. rev. 323, 357 at n. 60 (2007-08) (“the act also added chief counsel advice to the definition of a “written determination” in irc § 6110(b). by including chief counsel advice within the disclosure framework of irc § 6110, . . . congress intended to remove the advice from disclosure under the freedom of information act, 5 u.s.c. § 552 (2000 & supp. v 2005). see irc § 6110(m) (2000) (providing that “written determinations” are not subject to mandatory disclosure); h.r. rep. no. 105-599, at 302 (1998) (conf. rep.), reprinted in 1998 u.s.c.c.a.n.”). 776 florida tax review [vol. 10:10 increasingly expanded the interpretation of 6110’s disclosure provisions, as it constantly pushes for disclosure of more information.59 the history of the disclosure provisions demonstrates a fairly broad consensus that privacy interests trump publicity of most tax returns and return information except in narrowly drawn circumstances. broad exceptions to that consensus exist with respect to the returns of tax-exempt organizations, political organizations, and pension plans. this article argues that the private collection of federal taxes should trigger application of the broad exception to the general rule of privacy. to understand why, it is necessary to understand how the private collection of federal taxes operates. iii. collecting taxes for the united states using business entities to collect taxes for the government results in efficient and often seamless tax collection as demonstrated by the significant percentage of federal taxes collected in this manner.60 incorporating the collection of taxes into the purchase price of goods and services, a process which occurs with sales and excise taxes, requires little additional time or effort to collect the tax beyond making payment for the underlying item. similarly, using employers to collect income and social security taxes directly out of employees’ wages produces efficiencies and reduces compliance concerns because the taxpayer never sees the money but merely receives a net paycheck. by collecting taxes through such transactions, the government uses efficient structural tax principles which increase compliance while simultaneously lowering both the collection costs and the bitterness associated with making tax payments.61 59. see, e.g., tax analysts v. irs, 350 f.3d 100 (d.c. cir. 2003). 60. see written testimony before the senate comm. on homeland security and governmental affairs permanent subcomm. on investigations on the collection of federal employment taxes, 110th cong. 2 (2008) (statement of linda stiff, deputy commissioner, services and enforcement, irs) (“today, employment taxes represent the largest portion of total tax dollars collected by the irs. in fy 2007 for example, of the $2.7 trillion in taxes collected by the irs, $1.7 trillion was payroll taxes. this means that approximately two out of every three dollars collected by the irs are from required withholding on employment tax returns. of this $1.7 trillion collected in withholding and fica taxes approximately $778 billion was collected for social security and medicare and approximately $992 billion was collected for individual withholding taxes.”) 61. see generally, e.g., edward k. cheng, structural laws and the puzzle of regulating behavior, 100 nw. u. l. rev. 655 (2006); leandra lederman, statutory speed bumps: the roles third parties play in tax compliance, 60 stan. l. rev. 695 (2007); richard h. thaler & cass r. sunstein, nudge: improving decisions about health, wealth, and happiness (2008); erich kirchler, the economic psychology of tax behavior (2007). 2011] transparency in private collection of federal taxes 777 one of the most common ways in which businesses collect excise taxes on the government’s behalf involves telephone companies. for example, telephone companies collect most of the communications excise tax62 as they collect telephone bill payments from their customers, simply adding the excise tax to the amount of the bill.63 the bill clearly details the amount of the excise tax, separating the amount from the bill’s total. upon receipt of payment, the telephone company sets aside the portion of the payment that represents the tax. the telephone company then reports the excise tax to the irs on a form 720, which is filed by the telephone company on a quarterly basis. payments of the communications excise tax occur along with the filing of the form 720.64 at present the form 720 reports both excise taxes collected by the entity from others as well as excise taxes for which an entity has its own liability. proposed revisions to form 720 to create a new form specifically for reporting collected taxes are discussed in more detail below. the most important taxes commonly collected by business entities are employment taxes—social security taxes and medicare taxes—and income taxes on wages of employees withheld by their employer for the benefit of the united states. with respect to these taxes, the employer calculates the amount of taxes it should withhold from each employee’s paycheck. each time the employer pays its employees, it pays them the net amount of wages after withholding income and social security taxes and any other deductions.65 the employer should set aside the money it holds back from the employees for payment of their income and social security taxes.66 unlike excise taxes, where the entity actually collects the taxes from a third party, the employer “collects” these taxes from itself. the theory is that an employer with a gross payroll of $10,000 will have $10,000 with which to pay the wages. it will pay $7,000 to its employees and place the other $3,000 62. irc § 4251 imposes a tax on communications services, including local telephone service, toll telephone service, and teletypewriter exchange service. 63. irc § 4291 (“[e]very person receiving any payment for facilities or services on which a tax is imposed upon the payor thereof under this chapter shall collect the amount of the tax from the person making such payment.”). airlines use a similar system as they collect the airline excise tax from their customers. the amount of the excise tax is added to the cost of the ticket and collected at the time of purchase. 64. irs, instructions for form 720 (rev. july 2010) (“use form 720 and attachments to report liability by irs no. and pay the excise taxes listed on the form.”). 65. irs, publication 15: (circular e), employer’s tax guide, available at http://www.irs.gov/pub/irs-pdf/p15.pdf. 66. id. there may be instances in which the entity need not set this money aside in a separate account, but can continue to hold it in the entity’s general account. 778 florida tax review [vol. 10:10 into a trust account and in such a manner collect the taxes.67 since some employers may have only have $7,000 at the time of the payment of payroll, the concept of collected taxes sometimes breaks down when cash poor employers lack the resources necessary to satisfy the tax obligations of its employees. the law, however, does not distinguish between taxes collected from third parties as part of an excise tax and taxes collected from employees to satisfy the employees’ income and social security taxes.68 the public nature of the trust comes not only from the description of the monies held in section 7501 but also in the manner in which the money is treated once collected. when a taxpayer pays a telephone bill that includes the communications excise tax, the taxpayer’s liability ends there because that taxpayer receives credit for the payment of the excise tax regardless of whether the telephone company actually pays over the tax.69 similarly, the employee whose wages are withheld does not need to worry about whether the employer pays the withheld income and social security taxes over to the irs because that employee receives credit for the payment regardless of whether the employer pays over the withheld taxes.70 in essence the entity 67. see infra note 183 (providing discussion of begier v. irs, 496 u.s. 53 (1990)). 68. irc §§ 6672, 7501 (both addressing collected taxes, but neither provision specifying which type of collected taxes). states do make distinctions between sales taxes and withholding taxes which can ultimately only be attributed to this difference. see, e.g., fogg, trust, supra note 13, at 418 app. (listing states which have adopted bonding laws for unpaid sales taxes with no complimentary bonding laws for unpaid withholding taxes); see also fogg, leaving money on the table, supra note 16, at 44-45 (discussing how certain states charge interest to responsible officers from due date of sales tax return but not due date of withholding tax return). 69. irc § 31(a)(1) provides that “[t]he amount withheld as tax under chapter 24 shall be allowed to the recipient of the income as a credit against the tax imposed by this subtitle.” no parallel credit provision exists for excise taxes such as the communication or airline excise taxes; however, the same rules of principal and agent govern the transaction. when a taxpayer pays their phone bill, including the communications excise tax, that taxpayer expects credit for such payment and would not welcome an appearance by the irs seeking to collect the tax from the taxpayer for a second time. this circumstance is acknowledged by robert schriebman in his text irs tax collection procedures, where he stated that “[i]f a collecting agency (other than a partnership or sole proprietorship) has failed to pay over excise taxes it has collected from patrons or members, the irs will explore the possibility of asserting the trust fund recovery penalty against the collecting agency’s responsible persons.” robert s. schriebman, irs tax collection procedures: a manual for practitioners ¶ 1309-1 (3rd ed. 2005). his statement acknowledges the liability of the collecting entity for the excise tax. 70. irc § 31(a)(1) (“the amount withheld as tax under chapter 24 shall be allowed to the recipient of the income as a credit against the tax imposed by this subtitle.”). 2011] transparency in private collection of federal taxes 779 collecting the taxes becomes an agent of the united states. it does not hold the collected money for the benefit of the individuals whose taxes are collected but rather for the benefit of the united states treasury. because the funds are held for the public benefit, the public nature of the trust exists not only by virtue of the statutory language which labels it a trust71 but also because of the operation of the trust and the monies it holds.72 the legislative history of the disclosure provisions does not contain a discussion concerning why public trusts such as those held by business entities with collected tax dollars are subject to the same disclosure laws, or rather, non-disclosure laws, as income tax returns. congress did, however, provide for disclosure of certain types of returns and identified the reason for its, treatment of those returns. the benefits that tax-exempt organizations receive often serve as a basis for the policy argument behind disclosing their tax return information.73 while business entities holding these trusts of collected taxes do not receive the same subsidies received by tax-exempt organizations,74 some similarities exist between the benefits these entities receive and the benefits received by tax-exempt organizations and pension plans. first, the businesses do control funds for days or weeks, depending on their size, as the money passes from the taxpayer to the irs.75 for businesses with a high number of employees or large amounts of excise tax, the cash flow benefit could be substantial, even if short lived. temporary control of this money helps to offset the cost of administering the tax, even though many businesses may not view it as much of a subsidy. second, businesses are granted the right to operate subject to certain obligations that exist regardless of whether the business is tax-exempt. the grant of authority to operate a business is the grant of a potentially valuable benefit which should not entirely be overlooked. collecting taxes is a price the business must pay for the privilege of operating. third, the money held in trust for the public in the collected tax situation is not unlike the money held in trust by a pension for its beneficiaries. it also bears similarities to other public trusts which keep their records open to the public.76 71. see irc § 7501. 72. see infra note 183 (providing discussion of begier v. irs, 496 u.s. 53 (1990)). 73. jct report (vol. ii), supra note 12, at 6. 74. tax-exempt organizations also must comply with the employment tax provisions. many tax-exempt organizations have large employee bases and collect vast amounts of taxes from their employees. 75. the payment of excise taxes generally occurs semimonthly, with several narrow exceptions. irs, publication 510: excise taxes 41, available at http://www.irs.gov/pub/irs-pdf/p510.pdf. 76. the code currently provides for eleven public trust funds: irc § 9501, black lung disability trust fund, § 9502, airport and airway trust fund, § 9503, 780 florida tax review [vol. 10:10 other reasons exist for disclosing returns of collected taxes, particularly employment tax returns reporting withheld income and social security taxes. the first of these ancillary reasons stems from the peculiar circumstances of employment tax returns. many of these returns are prepared by “payroll tax providers.” these providers prepare the returns, sign the returns, pull the money from taxpayers’ checking accounts, and file the returns and the required remittances. taxpayers essentially turn everything about payroll taxes over to firms that provide this service.77 if collected tax returns were publicly posted, the accessibility of information on a public website would allow taxpayers who rely on payroll providers to pay their taxes to ensure that their taxes were paid. of course, these taxpayers could go to the irs now and make a request for their transcripts, but the availability of a website with an easy search feature might help to reduce the problem caused by payroll providers with a bent to steal— a small collateral benefit to this proposal. a second ancillary reason for disclosing collected tax returns involves the federal government and its relationships with federal contractors. the federal government has a goal of not contracting with those who do not pay their federal taxes.78 on january 20, 2010, president obama signed a memorandum directing government officials to recommend how to ensure that no new federal contracts were awarded contractors delinquent in paying their federal taxes.79 one obvious way to accomplish this goal would be to publish the delinquent collected tax data in a form easily retrieved by highway trust fund, § 9504, sport fish restoration and boating trust fund, § 9505, harbor maintenance trust fund, § 9506, inland waterways trust fund, § 9507, hazardous substance superfund, § 9508, leaking underground storage tank trust fund, § 9509, oil spill liability trust fund, § 9510, vaccine injury compensation trust fund, and § 9511, patient-centered outcomes research trust fund. the treasury website contains monthly financial reports for trust funds administered by the treasury department. treasury direct, trust fund financial reporting, http://www.treasurydirect.gov/govt/reports/tfmp/tfmp.htm. 77. because of the “trusting” nature of taxpayers who rely on payroll providers, a number of these providers have perpetrated ponzi style schemes in which they take the money from the taxpayers’ accounts and use some of it for personal gain rather than using the money to pay the taxes. by the time the schemes collapse, potentially thousands of taxpayers who actually had money drawn out of their accounts to pay over the collected taxes find themselves with a tax bill. see, e.g., in re firstpay, inc., nos. 09-1076, 09-1107, 2010 wl 3199858 (4th cir. aug. 13, 2010). see also fogg, trust, supra note 13, at 384. 78. see u.s. gov’t accountability office, gao-05-637, financial management: thousands of civilian agency contractors abuse the federal tax system with little consequence, at intro (2005), [hereinafter gao 2005 report]. 79. see michael joe, obama seeks to block tax debtors from receiving federal contracts , 2010 tax notes today 13-3 (jan. 21, 2010). 2011] transparency in private collection of federal taxes 781 federal contracting officers since collected taxes comprise over 90% of the unpaid federal tax debts of contractors seeking federal contracts.80 this article does not seek to change the practice of having third parties collect taxes for the irs or the method by which third parties collect these taxes. rather, it seeks to shed light on that process by changing the disclosure law regarding these taxes. amending current disclosure law will not only significantly enhance the chances of closing the multi-billion dollar tax gap that exists because of the failure to pay over these collected taxes, but this change will also correctly align the disclosure laws with their policy considerations. iv. disclosure policy considerations disclosing tax return information brings together competing policies of openness and transparency against privacy rights, fiercely held individualism, and concerns for unnecessary government intrusion. disclosure also brings up competing claims concerning the benefits of openness. proponents of opening up more information to the public cite the positive effects they perceive such openness will have on compliance.81 opponents, on the other hand, cite it as a concern, suggesting that it will detract from compliance as taxpayers become fearful that accurately reporting their taxes will negatively affect other aspects of life.82 in order to determine when transparency should trump privacy and vice versa, it is necessary to examine the benefits and concerns raised on each side of the policy coin. privacy concerns heighten when disclosure of tax information: (1) concerns individuals rather than entities; (2) may disclose trade secrets or other information that might damage the taxpayer’s business; (3) discourages rather than promotes accurate reporting of information; (4) results in associated costs which outweigh the benefits of 80. gao 2005 report, supra note 78, at intro. 81. see christopher s. rizek, taxpayer privacy and disclosure issues will continue to touch us all, in the future of american taxation: essays commemorating the 30th anniversary of tax notes 81, 89, available at http://www.aei.org /doclib/20021222_conf021210d.pdf (“the short answer is, unfortunately, that no one really knows as a factual matter what the link is between the confidentiality of taxpayer information and voluntary compliance. the claim that confidentiality fosters compliance is rather, something like an article of faith, for or against which only anecdotal and not particularly conclusive evidence can be offered.”). 82. see generally treasury report, supra note 10 (making the concern for collateral non-reporting a basis for its recommendations concerning correct policy in this area, and placing much more emphasis on this factor than the jct report). 782 florida tax review [vol. 10:10 the information so disclosed; (5) fosters misunderstanding; and (6) politicizes the process.83 concerns for the need to disclose information heighten when disclosure of tax information involves (1) an entity that receives significant tax subsidies, such as a tax-exempt organization, (2) an entity that is reporting information about funds held in trust for others such as pension plans, (3) an entity that, while receiving tax subsidies, exerts influence without adequate accountability of those exerting the influence, such as the concerns driving section 527(j),84 or (4) the tax returns containing information valuable to other government entities under circumstances where further release of the information can be controlled.85 the joint committee on taxation report (jct report), which congress directed the joint committee on taxation to prepare on disclosure law, describes presumptions either for or against disclosure.86 the general recommendation of the staff of the joint committee with respect to returns and return information was that information “should not be provided unless the requesting agency can establish a compelling need for the disclosure that clearly outweighs the privacy interests of the taxpayer.”87 in contrast to this 83. see jct report (vol. i), supra note 10, at 127-33 and treasury report, supra note 10, at 33-37 for a policy discussion on the last two points. see also mark boyle, tei opposes public disclosure of corporate tax returns, 2006 tax notes today 115-18 (june 12, 2006) (discussing the last two factors). mr. boyle strongly opposed disclosure of corporate tax returns, citing many reasons for his opposition. interestingly, one reason was that “public disclosure of corporate tax returns would effectively represent the outsourcing of a core governmental function—the examination of tax returns—to the public or the media.” that comment provides an interesting bookend to the discussion of disclosure surrounding private tax collectors, below. 84. see jct report (vol. ii), supra note 12, at 5-9 (providing policy discussion related to the three points listed above). 85. for example, the department of justice may access returns and return information for use in tax administration proceedings. irc § 6103(h)(3). the department of the treasury may access returns and return information when a need to know is demonstrated. section 6103(h)(1). the department of commerce, the federal trade commission, and the department of agriculture all may access returns and return information upon written request to the irs. see jct report (vol. i) supra note 10, at 43-44; see also rizek, supra note 81, at 86-87 (discussing heavy use by outside sources of incredible database maintained by irs, which each claimant for exception sees as important resource). 86. compare jct report (vol. i), supra note 10, at 5 (discussing irc § 6103), with jct report (vol. ii), supra note 12 at 4 (discussing § 6104). 87. jct report (vol. i), supra note 10, at 6 (emphasis added). emphasis is added to the word “agency” because the jct’s use of that word makes an important statement as a part of this policy. that term basically speaks of disclosures to government entities and not to individuals. yet, two of the exceptions contained in § 2011] transparency in private collection of federal taxes 783 general rule with respect to tax returns stands the policy recommendation concerning tax-exempt organizations, stating that “disclosure of information regarding tax-exempt organizations . . . should be disclosed unless there are compelling reasons for nondisclosure that clearly outweigh the public interest in disclosure.”88 tax-exempt organizations, pension plans, and political organizations thus receive a presumption for, instead of against, disclosure. as a starting point, this article adopts the two general principles89 set out by the joint committee staff that a presumption of non-disclosure of return information governs most return information and that a presumption of disclosure governs the information of tax-exempt organizations. these principles fit the consensus on disclosure matters that has essentially controlled disclosure rules during the modern era of tax administration and certainly reflects the consensus in effect since 1934 and the repeal of the “pink slips.”90 exploring the reasons behind these general principles provides an opportunity to determine where the returns of collected taxes should fall, and allows a testing of these principles against a specific type of tax information that has received very little, if any, attention in the policy debates surrounding disclosure. the joint committee report identifies the principal reason for the general rule of non-disclosure: privacy. the right to privacy is a bedrock principle in the united states. 91 it has driven the policy debate concerning disclosure from its inception. a second reason for the rule of non-disclosure is the view that confidentiality promotes accuracy on the returns submitted because taxpayers do not need to worry about collateral effects of reporting 6103 concern disclosures to individuals and not to government entities. section 6103(c), (e). the essential exclusion of these two exceptions in the jct report’s conclusion concerning disclosure policy reflects, as discussed below, that disclosures to individuals almost always occur only in the absence of privacy interests. 88. jct report (vol. ii), supra note 12, at 6. 89. perhaps the better view of the second principle is that it is simply a broad exception to the first and not really a second principle unto its own. many exceptions to the general rule of non-disclosure exist in § 6103, and the disclosure of tax-exempt returns in § 6104 simply represents one of those exceptions, albeit a broad one. 90. act of apr. 19, 1935, ch. 74, 49 stat. 158. 91. although privacy has a strong foundation in this country, individuals arguably have severely diminished privacy expectations due to the advances of the internet age. a simple search in a search engine of an individual’s name may produce results detailing that individual’s political party affiliation, locations where the individual owns property and how much each is worth, phone numbers and even relatives of the individual, and a link to the individual’s facebook profile. with all of this information “floating” around and easily accessible by the public, privacy considerations for tax return information, which may reveal less than what an internet search may uncover, are potentially worth less than they used to be. 784 florida tax review [vol. 10:10 accurate information if they know that the returns stay within the irs.92 the principal countervailing interest to privacy in this debate is the benefit that disclosure provides by shedding light on corrupt practices. this was a principle that weighed heavily for progressives in the early part of the 20th century and drove the disclosure provisions enacted in 1909, 1924, and 1933, discussed above. while privacy eventually defeated the progressive position and the presumption of non-disclosure won with respect to most tax returns, the victory has not meant complete confidentiality. as the jct report states, the showing of a compelling interest can overcome the general principle.93 the table below clearly outlines the disadvantages and benefits of disclosing tax return information. disadvantages of disclosure benefits of disclosure 1. tax returns contain private information which the government compels taxpayers to report, and when disclosed, the individual may lose significant privacy protections.94 1. the disclosure of information may be necessary in order to protect taxpayer rights.95 2. tax return information that concerns individuals implicates greater privacy concerns.96 2. the informational value of the data from the return may outweigh the privacy concerns and safeguards exist to protect privacy to the greatest extent possible.97 92. jct report, (vol. i), supra note 10, at 5; treasury report, supra note 10, at 34; see also rizek, supra note 81, at 89. 93. jct report (vol. i), supra note 10, at 238. 94. id. at 5. 95. without disclosure of the existence of the federal tax lien, the government cannot perfect its lien interest with respect to certain competing creditors. irc § 6323. alternatively, if the lien of the government can defeat competing creditors without their ability to know of the lien, lending would dry up as creditors feared for the security of their loans. 96. see united states v. morton salt co., 338 u.s. 632, 652 (1950) (holding that “corporations can claim no equality with individuals in the enjoyment of a right to privacy”); s. rep. no. 94-938, at 328 (1976). (“the committee decided that the information that the american citizen is compelled by our tax laws to disclose to the internal revenue service was entitled to essentially the same degree of privacy as those private papers maintained in his home.” this discussion focused on the ability to obtain tax information in non-tax criminal matters and highlights the kind of sensitivity surrounding tax information of individuals.) 2011] transparency in private collection of federal taxes 785 disadvantages of disclosure benefits of disclosure 3. tax return information that contains trade secrets of a business implicates greater privacy concerns.98 3. the disclosure of information assists in closing the tax gap.99 4. when the disclosure of return information would discourage accurate reporting of information, the benefits of disclosure must overcome the concerns of inaccuracy.100 4. when an entity is publicly traded, certain information on the return could influence investor behavior.101 97. statistical disclosures and state matching programs fall into this benefit category. 98. in a letter from michael p. boyle, international president of tax executives institute, to senators grassley and baucus dated june 12, 2006, mr. boyle expressed concerns about expanded disclosure of corporate tax returns, listing several reasons. one of his concerns specifically addressed the issue of proprietary information: “public disclosure of tax returns of publicly traded corporations would also reveal confidential and proprietary data not currently contained in consolidated financial statements, including revenue and expense information by legal entity, jurisdiction, and functional category (e.g., sales, dividends, cost of sales). although much if not all of the information in a tax return would be confusing to the majority of investors, disclosure would clearly aid a company’s competitors enormously in understanding the taxpayer’s business practices. where a company’s competitors are not subject to u.s. taxing jurisdiction (and, hence, not subject to the same disclosure rules), the comparative disadvantage would be even more pronounced.” boyle, supra note 83, at 4. see also strauss, supra note 23, at 29 (stating that disclosure “in this instance could disadvantage the individual company as competitors learn the private details of the company’s activities. for small public companies, and for companies with foreign competitors this problem is most pronounced, because for small companies there will be a close relationship between their state and federal return and what they provide to the massachusetts secretary of state for public review. they would now have their private financial affairs subject to competitive scrutiny. foreign competitors of a domestic firm would not have to disclose the financial circumstances of their offshore parent companies, while now gaining access to information about the financial circumstance of the domestic firm.”). 99. states have used this in adopting their shaming provisions. 100. jct report (vol. i), supra note 10, at 5. 101. see joe thorndike, tax history: promoting honesty by releasing corporate tax returns, 96 tax notes 324, 324 (july 15, 2002); marjorie e. kornhauser, letter to the editor: more historical perspective on publication of 786 florida tax review [vol. 10:10 disadvantages of disclosure benefits of disclosure 5. when the costs of disclosure outweigh the benefits, the decision to disclose becomes impractical.102 6. disclosure has the potential to foster misunderstanding of the information in a manner that disadvantages the tax system or the taxpayer whose information was disclosed.103 the two statements from the jct report setting out the policies governing disclosure create several factors against which to test a request for a disclosure exception. the application of these tests permits a reasonable determination of whether a new proposed change to disclosure laws follows established policies. these policies are embedded in the subparagraphs of corporate returns, 96 tax notes 745 (july 29, 2002). these articles describe the perceived benefits of disclosing corporate tax returns as a means of informing investors. in arguing that publication of corporate tax shelter participation may have the opposite effect desired by proponents of such publication, joshua blank points out that investors have been positively motivated to invest in corporations seen as aggressively seeking to lower their taxes. joshua d. blank, what’s wrong with shaming corporate tax abuse, 62 tax l. rev. 539, 560, 561 & n. 116 (2009) (citing michelle hanlon & joel slemrod, what does tax aggressiveness signal? evidence from stock price reactions to news about tax shelter involvement, 93 j. pub. econ. 126, 128 (2009)). 102. see lederman, supra note 61, at 725 n. 174 (citing theodore p. seto, the assumption of selfishness in the internal revenue code: reframing the unintended tax advantages of gay marriage 6 (loyola law sch. l.a., legal studies paper no. 2005-33, 2005), available at http://ssrn.com/abstract=850645). of course, a cost-benefit analysis is essential in every policy decision. the benefits listed below are simply a part of this analysis. 103. in comments on taxpayer confidentiality submitted to the joint committee on taxation and the treasury department, the tax executives institute (tei) stresses the necessity of the confidentiality of taxpayer information to “the integrity of the tax system.” see charles w. shewbridge, “taxpayer confidentiality must remain paramount,” tei says, 1999 tax notes today 206-60 (oct. 21, 1999). this is a big concern of tei. tei has also expressed concern that public disclosure of corporate tax returns would implicate the need to protect taxpayers from their return information being misused for political purposes. boyle, supra note 83. of course, this is a big concern in general about the disclosure of return information and is essentially reflected in the first reason. 2011] transparency in private collection of federal taxes 787 section 6103 that contain the exceptions to the general rule of nondisclosure.104 a. irc section 6103 section 6103 outlines the disclosure principles regarding tax information, beginning with the general rule of confidentiality. the code section then creates exceptions to this rule through a series of four basic steps, detailed below. first. does the disclosure contain a “return” or “return information?”105 if the information sought is not a return or return information, then more general federal laws concerning disclosure of information take over.106 if the information sought is return or return information, however, then the general rule of non-disclosure takes effect, with no disclosure absent an exception. second. does disclosure of the information raise privacy concerns? if the disclosure is to the taxpayer or to the taxpayer’s proxy, privacy concerns are not implicated. in this situation, the reason for disclosure need not be compelling and may be simply that a taxpayer wants to view his own tax return. when disclosure is to someone other than the taxpayer or the taxpayer’s proxy, the next inquiry is whether the tax information concerns individuals. an individual’s tax information has the greatest presumption of 104. the rules listed here do not include the disclosure exceptions carved out in § 6104, which will be discussed separately below: 1) the entity receives substantial subsidies from the government such as taxexempt organizations. 2) the entity exists to hold funds in trust for the public, such as pension plans. 3) the entity exerts political influence without adequate accountability, such as the political organizations described in § 527. 105. these terms are defined in § 6103(b)(1) & (2) and are discussed below at note 110. 106. around the same time congress amended the disclosure provisions in the internal revenue code in 1976 to usher in the modern era, it was also looking at similar issues from a broader perspective. in 1966, congress passed the freedom of information act (foia), pub. l. no. 89-487, 80 stat. 250 (1966), and in 1974 it passed the privacy act, pub. l. no. 93-579, 88 stat. 1896 (1974). foia established a right to access certain information held by the federal government. the purpose was to allow citizens of the united states to be better informed so they could fight corruption and hold those governing accountable. nlrb v. robbins tire and rubber co., 437 u.s. 214, 242 (1978). the privacy act created rules to govern the use of personnel information concerning individuals working for the federal government. all of these changes occurred as the government recognized the massive databases that it maintained and the good or evil that could result from the dissemination of information in those databases. 788 florida tax review [vol. 10:10 non-disclosure and requires the greatest showing of a compelling interest. a business entity’s tax information also requires the demonstration of a compelling interest, but not quite as high as is needed for individuals.107 other factors enter into this step of the privacy analysis as well: (1) the nature of the tax information sought affects privacy concerns. disclosure of a taxpayer’s entire return will implicate greater privacy concerns than a discreet portion of the return. (2) the type of disclosure also impacts privacy concerns. if the tax information clearly identifies the taxpayer and is published in a public place, then privacy concerns are elevated. passing tax information to a limited group with restrictions on further publication creates less of a privacy concern. (3) the potential for publication of the tax information to reveal trade secrets will implicate a greater level of privacy concerns. (4) the potential for disclosure of the information to discourage accurate reporting on the return will create a stronger presumption of nondisclosure. (5) the potential for disclosure of the information to foster misunderstanding will also implicate greater privacy concerns. each of these factors affecting privacy can be seen as moving the needle on a dial, with one side of the dial representing complete nondisclosure and the other representing full disclosure. the needle sits on the non-disclosure side of the dial for disclosure of most tax information. when more of these factors are present and greater privacy interests are involved, the dial moves even further onto the non-disclosure side of the dial and the more compelling the reasons must be to move the needle over to the disclosure side of the dial. third. do the benefits of the disclosure outweigh the privacy concerns? this step requires an analysis of the disclosure’s purpose and the gains derived from disclosing information. many benefits can result from disclosing tax information, which serve as the basis for the numerous exceptions that currently exist to the rule of non-disclosure. disclosing tax information can help close the tax gap, catch criminals, protect the rights of others, and serve many other useful purposes. each exception represents an example of successful arguments for the benefits that disclosing tax information can bring.108 fourth. if the disclosure is to an “agency,” are adequate safeguards in place to limit disclosure of the information beyond that agency? clear limitations on the use of the information must accompany any disclosure 107. united states v. dickey, 268 u.s. 378, 387 (1925). 108. reading the letters from the state taxing authorities to the joint committee provides an easy source of the benefits which stem from disclosing tax information to state taxing authorities. staff of the joint committee on taxation (jcs-1-00) study of present-law taxpayer confidentiality and disclosure provisions as required by § 3802 of the internal revenue service restructuring and reform act of 1998, volume iii: public comments and general accounting office reports, (2000). [hereinafter jct report (vol. iii)] 2011] transparency in private collection of federal taxes 789 outside the irs that is not to the taxpayer or the taxpayer’s proxy. in addition to the general admonition against further disclosure contained in section 6103(a), almost every subsection of section 6103 involving disclosure to an agency contains explicit safeguards regarding further disclosure as well as citations to agreements regarding disclosure, which will also contain restrictions on further disclosure.109 these four steps encompass the inquiry necessary to implement the disclosure policy on section 6103 stated in the jct report. section 6103 currently contains 13 exceptions to the non-disclosure principle, representing instances in which congress found a compelling reason to override the principle. congress has also created exceptions for tax-exempt returns through section 6104, opinions through section 6110, and information concerning political organizations through section 527. examining the situations in which congress has applied the four-step test and determined to create exceptions provides the basis for a system to test further exceptions to the rule of non-disclosure. testing the policy: (1) section 6103(a) provides that “[r]eturns and return information shall be confidential, and except as authorized by the title,” no official or anyone else with access to this information “shall disclose any return or return information . . .” this very broad statement prohibiting disclosure follows the rule that absent a compelling showing of a need for disclosure, the information remains inside the irs. due to its breadth, this rule does not distinguish between individuals and entities. (2) the second test first concerns disclosure to the taxpayer or the taxpayer’s proxy. this portion of the test drives two of the exceptions set out in section 6103. (a) section 6103(c) disclosure to taxpayer or taxpayer’s designee. although almost unnecessary, congress created this exception with a limitation that the secretary can restrict the disclosure of return information if such disclosure would “seriously impair federal tax administration.”110 permitting disclosure upon the request of a taxpayer 109. “the irs maintains standing agreements with the states and the district of columbia for disclosure of returns and return information. the basic agreement, agreement on coordination of tax administration, provides for the mutual exchange of returns and “return information between a specific state tax agency and the irs.” jct report (vol. i), supra note 10, at 28. 110. the limiting language requires an explanation of terms. the terms “return” and “return information” are defined terms in the statute. irc § 6103(b)(1)(2). a “return” is “any tax or information return, declaration of estimated tax, or claim for refund required by, or provided for or permitted under” title 26 of the united states code. the term “return information” is much longer, comprising four subparts. essentially, return information encompasses all of the data associated with a taxpayer’s file for a particular return. 790 florida tax review [vol. 10:10 avoids policy concerns because the taxpayer waives his right to privacy. no policy reasons for non-disclosure stand as a barrier to this exception and, therefore, there is no need to analyze the benefits side of the equation.111 the limitation within section 6103(c) stems principally from the government’s interest in protecting the identity of informants.112 if a taxpayer or a taxpayer’s designee could access all information in a taxpayer’s file, then the taxpayer could learn the identity of any irs informants who may have instigated investigation of the taxpayer’s return. (b) section 6103(e) disclosure to persons having a material interest. this exception covers a variety of persons who have a material interest in a return filed by a taxpayer,113 viz., the taxpayer himself, the taxpayer’s spouse114 and children,115 administrators of estates,116 trustees 111. while the policy issue here presents little challenge, the administration of this provision does provide some challenges for the irs. it must determine the form of adequate consent and the execution of such consent. see huckaby v. irs, 794 f.2d 1041 (5th cir. 1986) (unlawful disclosure based on oral consent); olsen v. egger, 594 f. supp. 644 (s.d.n.y. 1984) (consent in divorce decree not binding on irs); tierney v. schweiker, 718 f.2d 449, 455 (d.c. cir. 1983) (open-ended consent not valid; consents were coerced based on fear of losing social security benefits); hefti v. loeb, 1992 u.s. dist. lexis 12644 (c.d. ill. 1992) (disclosure to one spouse of other spouse’s separate return for year between years in which spouses filed joint returns did not violate § 6103(a), because revenue agent reasonably believed that spouse whose return was disclosed had authorized the other spouse to receive information); ward v. united states, 973 f. supp. 996 (d. colo. 1997) (disclosure in public form during radio broadcast unauthorized because consent did not designate persons to whom disclosure could be made). 112. irc § 6103(d)(1) (“[s]uch return information shall not be disclosed to the extent that the secretary determines that such disclosure would identify a confidential informant or seriously impair any civil or criminal tax investigation.”). another concern is disruption if taxpayer invites persons to participate in a meeting whose goal in the meeting might be to impair tax administration. see also united states v. finch, 434 f. supp. 1085 (d. colo. 1977); reg. § 301.6103(c)-1(c); delegation order no. 156; 1976-2 c.b. 624. 113. it includes return information “if the secretary determines that such disclosure would not seriously impair federal tax administration.” irc § 6103(e)(7). 114. irc § 6103(e)(1)(b) (regarding joint income tax returns filed by the spouses, but not other returns). 115. irc § 6103(e)(1)(a)(iii) (regarding those portions of returns filed by the child’s parents which contain information necessary for the child to comply with § 1(g). 116. irc § 6103(e)(1)(e)(i). heirs can also obtain tax information from an estate tax return to the extent that the heirs demonstrate a material interest in the estate to the irs. section 6103(e)(1)(e)(ii). 2011] transparency in private collection of federal taxes 791 of trusts,117 trustees or guardians of incompetent individuals,118 executors and administrators,119 receivers and bankruptcy trustees,120 attorneys in fact,121 former spouses,122 and responsible officers.123 due to the lack of a need to protect privacy, the policy basis for the exception follows a similar path as that in section 6103(c), which involves the taxpayer’s own information. most of the persons with a material interest in the tax return essentially step into the taxpayer’s shoes, have a direct connection with the return, or have an interest in knowing the information in order to make reasoned decisions.124 since few, if any, privacy concerns exist, little effort is needed to move the needle from the non-disclosure side to the disclosure side of the dial. (3) the remaining exceptions to the rule of non-disclosure set out in section 6103(a) and the policy explained by the jct report all raise privacy concerns. therefore, they require applying a combination of factors: the party seeking disclosure must demonstrate a compelling interest; benefits 117. irc § 6103(e)(1)(f). beneficiaries of trusts can also obtain tax information from a trust tax return to the extent that the beneficiaries demonstrate a material interest in the trust to the irs. id. 118. irc § 6103(e)(2). 119. irc § 6103(e)(3). heirs can also obtain tax information concerning deceased individuals to the extent that the heirs demonstrate a material interest in the information contained in those income tax returns. id. 120. irc § 6103(e)(4)-(5). these individuals can receive the returns filed by the estate being administered or prior returns of the individual or entity whose estate they administer if they can demonstrate a material interest in the information contained in the prior returns. 121. irc § 6103(e)(6). 122. irc § 6103(e)(8). this exception allows a former spouse to receive information concerning collection action with regard to a tax liability for which the former spouse is jointly liable with the taxpayer. 123. irc § 6103(e)(9). this exception allows a person responsible for taxes pursuant to § 6672 to learn if others have also been held liable for the same penalty and, if so, the collection actions taken with respect to the other responsible officers. 124. this last basis applies to responsible officers. the § 6672 liability does not strictly relate to a tax return. no return is filed that reports such a liability. rather, the liability is derivative, resulting from a failure of certain persons to meet their statutory obligations to collect and pay over certain taxes. this provision, like § 6103(e)(8), which addresses collection information on former spouses, was added to § 6103 in 1996. by adding this provision, congress acknowledged that joint liability creates a need to know that overrides individual privacy concerns. the policy reasons behind this provision are distinct from most other material disclosures in that the need for information actually outweighs the individual’s privacy concerns, rather than the requesting party eliminating privacy concerns by stepping into the taxpayer’s shoes. while the information disclosure is based on a material interest, the nature of the material interest here differs from that of most of the persons on this list. (disclosure to a child for compliance with § 1(g) and disclosure to a spouse concerning collection on a joint return also fall within this basis for an exception.) 792 florida tax review [vol. 10:10 must exceed the costs; and rules must exist to limit further disclosure. these tests are met in each of the exceptions to the general rule of non-disclosure set out in the subsections of section 6103. because these disclosures implicate privacy interests, the reason for disclosure must be sufficiently compelling to move the dial over to the disclosure side. as will be seen with each exception discussed below, applying the four-step test outlined above provides a clear demonstration of the underlying policy reasons for disclosure: (a) section 6103(d) disclosure to state tax officials and law enforcement agencies.125 this exception fully discloses both returns and return information, the broadest possible array of information, to a limited party—state and local taxing agencies. disclosure to this limited party fully implicates all privacy concerns and has drawn many lawsuits over concerns of lost privacy.126 the privacy issues here affect both individuals and entities, implicating heightened scrutiny of this exception. the cost of this disclosure does not outweigh the benefits because the taxpayer incurs no direct dollar cost. the information transfer takes place directly, usually electronically, between the irs and the receiving state or local entity.127 the states perceive a significant benefit in receiving this information.128 this disclosure will not cause misunderstanding because the recipients of the information are tax collectors with specific knowledge and interest in the information. disclosure of tax return information to the state taxing authorities raises the traditional privacy concerns; however, none of the other factors 125. see irs, disclosure litigation reference book 8-2 to -5 (providing cases and details on form of disclosure); see also jct report (vol. i), supra note 10, at 163. 126. see, e.g., long v. united states, 972 f.2d 1174 (10th cir. 1992); smith v. united states, 964 f.2d 630 (7th cir. 1992); bator v. irs, 89-1 u.s. tax cas. ¶ 9138 (d. nev. 1988), aff’d without published opinion sub nom, bator v. united states, 899 f.2d 1224, 1990 wl 40300 (9th cir. 1990); rueckert v. irs, 775 f.2d 208 (7th cir. 1985); taylor v. united states, 106 f.3d 833 (8th cir. 1997); white v. commissioner, 537 f. supp. 679 (d. colo. 1982); loomis v. irs, 81-1 u.s. tax cas. ¶ 9341 (d. colo. 1981); davis v. united states, 80-2 u.s. tax cas. ¶ 9794 (d. mass. 1980). 127. see irs, electronic data exchange pilot project (eds), http://www.irs.gov/privacy/article/0,,id=132017,00.html (last visited oct. 16, 2010). 128. california uses federal tax information to “[l]ocate tax debtors, especially those who are out of state and cannot be located through the post office or other skip tracing methods,” to “[i]dentify the amount and sources of tax debtors’ assets,” and to “[v]erify the accuracy of taxpayer-supplied information. . . .” jct report (vol. iii), supra note 108, at 120. colorado stated that the federal tax information is the “cornerstone of our income tax compliance program” and that it is used for statistical analysis for informed economic decision-making. id. at 124. hawaii also states that it uses federal tax information on individuals and businesses for “statistical and compliance purposes.” id. at 131. 2011] transparency in private collection of federal taxes 793 suggest that this information should remain within the irs and not be shared with states. the states perceive a significant benefit from the receipt of this information as demonstrated by their many letters to the joint committee on taxation.129 for ease of tax administration, most states have chosen to base their income taxes on the federal model.130 one consequence of this conformity is that states rely heavily on federal tax information to confirm the limited data they require from taxpayers.131 currently, the state returns ask for less information from taxpayers because the states know that they can obtain additional information from the federal government.132 this system creates efficiencies because it keeps taxpayers from duplicating information in two parallel systems. because the states could ask for the same information that appears on the federal return, their willingness to obtain this information through the disclosure exchange does not really subject taxpayers to a greater intrusion. in addition to the overall benefits this disclosure provides to the tax system, other reasons exist in support of disclosure. the states must carefully safeguard the tax information they receive from the irs as a part of this bargain.133 this safeguarding represents an integral part of this policy decision to allow disclosure, because this exception is so broad that state failure to safeguard the information could compromise the integrity of the entire taxpayer information database. the exception limits the use of the information, stating that the disclosure is “for the purpose of, and only to the extent necessary in, the administration of such laws, including any procedures with respect to locating any person who may be entitled to a refund.”134 additionally, the use is limited by the agreement entered into between the irs and the state or local agency.135 129. see supra note 128. in addition to the letters from the individual states, the federation of tax administrators submitted a detailed letter addressing the need for states to “use tax return information and the adequacy of present-law protections governing taxpayer privacy.” see jct report (vol. iii), supra note 108, at 41. 130. jct report (vol. iii), supra note 108, at 41. 131. id. at 42. 132. see id. 133. irc § 6103(d)(6). those safeguards are detailed in irs publication 1075, tax information security guidelines for federal, state and local agencies (2010). states safeguard confidential taxpayer data in accordance with irs guidelines. many states implement training and education programs to instruct employees on proper procedures to protect this data. see, e.g., jct report (vol. iii), at supra note 108, at 33, 117, 119, 124, 132, 142, 162, 166, 170. 134. irc § 6103(d)(1). 135. jct report (vol. i), supra note 10, at 28 (“a prerequisite to disclosure is a written request by the head of the agency, body or commission. the irs maintains standing agreements with the states and the district of columbia for disclosure of returns and return information. the basic agreement, agreement on 794 florida tax review [vol. 10:10 looking at how this provision would affect the needle on the disclosure dial, the needle would start on the non-disclosure side, but no specific privacy concerns would push it further to that side of the dial. the importance of the material to the states coupled with the elimination of duplication by sharing this information pulls the needle over to the disclosure side of the dial. (b) section 6103(j) disclosure of information for statistical purposes.136 this exception fully discloses both return and return information to some federal agencies, and discloses only return information to other agencies.137 the exception permits disclosure to allow certain agencies to use the tax information to create statistics,138 specifically limiting the disclosure to this purpose.139 even though the disclosure implicates privacy concerns by releasing information about individuals and entities to the agencies, the overall effect of the disclosure here moves the needle to the disclosure side of the dial. the implication of the privacy concerns initially moves the needle further toward non-disclosure; however, the limited use of the information by the agencies, the protection from further disclosure, and the importance of the data pull the needle to the disclosure side. similar to the reasoning for release of data to the states, the release of this data may also have the effect of reducing burden on taxpayers by keeping them from receiving duplicate data requests from different government agencies. coordination of tax administration, provides for the mutual exchange of returns and return information between a specific state tax agency and the irs.”). 136. for a general discussion of these provisions, see general accounting office, gao-gdd-99-164, taxpayer confidentiality: federal, state, and local agencies receiving taxpayer information, (1999); see also jct report (vol. i), supra note 10, at 43-45. 137. compare the disclosure to the department of commerce for the bureau of the census, which allows both return and return information, with the disclosure to commerce’s bureau of economic analysis, which only releases return information. section 6103(j)(1)(a) (census bureau); § 6103(j)(1)(b) (bureau of economic analysis). 138. these agencies are the commerce department, the congressional budget office, the federal trade commission, the treasury department, and the agriculture department. the exceptions granted here do not reach all federal agencies, but only agencies that demonstrated a specific need related to the statutorily mandated tasks governed by that agency’s directives. 139. regarding the commerce department the statute says, “for the purpose of, but only to the extent necessary in, the structuring of censuses and national economic accounts and conducting related statistical activities authorized by law.” irc § 6103(j)(1). regarding the treasury department the statute says, “only to the extent necessary in, preparing economic or financial forecasts, projections, analyses, and statistical studies and conducting related activities.” irc § 6103(j)(3). each grant to an agency has similar limiting language. 2011] transparency in private collection of federal taxes 795 the cost of this disclosure does not outweigh the benefits because there is no direct dollar cost to the taxpayer. the information transfer takes place directly, usually electronically, between the irs and the receiving agency. disclosure of this rich database of information benefits all taxpayers by aiding the economy in running more smoothly and reducing intrusions on privacy by the census data collectors. in addition, the statistical information that these agencies produce must protect the privacy of individual taxpayers.140 the importance of the data to the specific programs satisfies the compelling need test, even where, as here, many of the agencies receive data about individuals as well as entities. (c) section 6103(k) disclosure for tax administration purposes. this subsection contains a number of discrete circumstances in which disclosure occurs, only one of which will be discussed here.141 this provision permits disclosure to the public of specific taxpayer information, including information about individual taxpayers.142 the information disclosed by filing a notice of federal tax lien (nftl) is very specific, and therefore economically harmful to the named taxpayer.143 because of the sensitive and private nature of the tax data and the public nature of the disclosure, the filing of the nftl would move the needle far to the non-disclosure side of the dial. only the compelling need to protect the lien interest of the government allows the needle to swing to the disclosure side. the compelling need to disclose taxpayer information by filing an nftl comes under the umbrella of tax administration. an nftl is filed only when a federal tax lien exists, and the lien exists only when taxes remain unpaid. to collect the unpaid taxes, congress created the federal tax lien to protect the united states’ interest in the taxpayer’s assets. the administrative problem with the lien is that without publication, only the irs and the taxpayer know of its existence. creditors remain unaware of the 140. irc § 6103(j)(4) provides that “[n]o person who receives a return or return information under this subsection shall disclose such return or return information to any person other than the taxpayer to whom it relates except in a form which cannot be associated with, or otherwise identify, directly or indirectly, a particular taxpayer.” 141. irc § 6103(k)(2). 142.i.r.m. exhibit, available at http://www.irs.gov/irm/part1/irm_01002149.html. 143. national taxpayer advocate, report to congress: fiscal year 2011 objectives 14, available at http://www.irs.gov/pub/irs-utl/nta2011objectivesfinal.pdf; (“[t]he filing of the nftl in the public record might actually prevent the taxpayer from borrowing money to fully pay the outstanding tax liability.”) national taxpayer advocate, report to congress: fiscal year 2010 objectives 54, available at http://www.irs.gov/pub/irs-utl/fy2010_objectivesreport.pdf (“filing an nftl on outstanding liabilities may create serious consequences for a taxpayer, including making it more difficult to obtain credit.”). 796 florida tax review [vol. 10:10 existence of the lien until its publication. in the 1966 federal tax lien act, congress acknowledged that most creditors would defeat the federal tax lien unless a notice of the lien was properly filed.144 it devised a system of filing as a mechanism for fairly treating creditors competing with the federal tax lien.145 filing the lien, however, discloses the taxpayer’s identity and address, the existence of an outstanding tax liability, the amount and type of that liability, and the year(s) related to the liability.146 the costs associated with filing the nftl do not outweigh the benefits because the irs secures its interest in the taxpayer’s assets by filing the lien.147 even though this disclosure enables the availability of damaging information in an unlimited fashion, it meets the compelling need to disclose test. the only alternative to disclosure that would protect the irs’s secured status is a law that would make competing creditors vulnerable to losing their secured claims, without the opportunity to know of the competing tax lien.148 here, the benefit to the irs and to competing creditors outweighs the privacy interests of the taxpayer. this exception to the rule of non-disclosure only occurs because of the compelling need to disclose the lien to protect the interests of the government and competing creditors. (d) proposed shaming laws. even though congress has not passed laws similar to the shaming provisions enacted by some states, applying this test to shaming laws provides insight into congress’ failure to follow the lead of the states. shaming laws would greatly implicate privacy concerns. the shaming laws of most states do so in the broadest way by listing the names of individuals as well as entities. the proposals of the past decade seeking to shame corporations engaged in tax shelters still invoke privacy concerns, although not at the same level. broad shaming laws, such as those many states have adopted, create a level of privacy concern similar 144. see william t. plumb, jr., federal tax liens 53-75 (3rd ed. 1981). 145. see id. 146. irc § 6323(f); reg. § 301.6323(f)-1(d)(2) (“a form 668 must identify the taxpayer, the tax liability giving rise to the lien, and the date the assessment arose regardless of the method used to file the notice of federal tax lien.”). 147. irs, file a notice of federal tax lien, http://www.irs.gov/businesses /small/article/0,,id=108339,00.html (last visited oct. 17, 2010). 148. a vulnerability of this type currently exists with respect to liens for unpaid real estate taxes. in most, if not all, jurisdictions, these liens can jump ahead of mortgages and other liens created prior in time. to protect themselves, mortgage lenders require borrowers to escrow their real estate taxes. in this manner, mortgage lenders protect themselves from nasty surprises. if federal tax liens could, without notice, similarly defeat lenders, lenders would either be required to fashion some type of protective mechanism as with mortgage liens, be exposed to defeat or forego lending. the problem with fashioning a protective mechanism is that unlike real estate taxes, which are relatively easily ascertained and predicted, federal taxes could be assessed for very unpredictable amounts. 2011] transparency in private collection of federal taxes 797 to the level created by filing the nftl – essentially the highest level of concern short of publishing an individual’s return. given the privacy interests presented by the proposal, proponents need to show a very compelling need for such a proposal to pass. as noted by the jct report, a more in-depth study on the benefits of shaming is needed to make a compelling case for such a law.149 in 2000 when the jct report was written, insufficient empirical data existed to support a compelling case for the benefit of disclosing information in this manner. the same concerns still exist today based on some of the articles discussing corporate shaming.150 nothing like the compelling case presented by the filing of the nftl exists with respect to shaming. until it does, shaming should continue to stand on the sidelines of federal disclosure law.151 assuming that returns containing collected tax information contain only information about collected taxes and the entity, the disclosure of these returns can be tested similarly to the exceptions under section 6103. making these returns public would not implicate privacy concerns of individuals 149. jct report (vol. i), supra note 10, at 238-242. the specific proposal before the jct staff concerned publication of the names of persons who did not file tax returns. the jct staff’s concerns extended beyond whether such a proposal would reap collection benefits and into the area of the reliability of the data concerning who had not filed a return. the combination of both concerns effected the view of the staff on the failure of such a shaming provision to demonstrate a compelling interest for disclosure. the concerns about the reliability of the data listing persons with unfiled returns raises issues on the benefits side of the test since disclosure of incorrect data could destroy any benefits received even if collection from some persons increased as a result of the disclosure. 150. see blank, supra note 101. 151. the way shaming laws can meet the tests necessary to qualify as an exception to the rule of non-disclosure is to ride on the back of the exception allowing the publication of the notice of lien. several of the states that permit shaming have explicitly stated this as their basis for publishing the shaming lists. see, e.g., maryland, south carolina, and virginia, listed below in appendix a. essentially, these states have determined that the taxpayer has little or no privacy interest in the information because the information already exists in the public domain. since it exists in the public domain and no privacy interests are implicated, the benefits derived by publishing the information need not be as great in order to move the needle over to the disclosure side. these states view the shaming provision as merely a formatting issue more than a disclosure issue. the reasoning used some by states, an absence of privacy interests in the disclosed information, in adopting shaming laws would not work for corporate shaming provisions. with corporate shaming, the taxpayer’s privacy interests have not been removed by the public filing of an nftl. while the corporate interests in privacy may not equal those of individuals, these interests remain substantial. the benefits side of the equation would need to pull full weight in order to move the needle on the dial over to the disclosure side. 798 florida tax review [vol. 10:10 because all of the information concerns a business entity. so, this disclosure is not deserving of the strongest possible protections. still, the proposal in this article is to fully disclose the return, making all of the entity information about the collected taxes available to anyone seeking information about the entity. because the collected tax information is information about others paying their taxes through the entity, the information does not directly provide private tax information about the entity. if viewed strictly in that light, it is possible to argue that privacy concerns are not implicated. nor does the disclosure involve privacy information about the individuals whose taxes have been collected because the reporting of collected tax data would occur only in an aggregate form. the inquiry does not stop here, however. the tax information on a collected tax return does reveal entity information about the number and, potentially, the compensation levels of employees. more specifically, the excise tax information reveals information about sales by the entity. this indirect revelation of information deserves some protection or at least a basis for disclosure. the revelation of this information may cause the entity to make an incorrect tax filing for the purpose of hiding trade secrets. it is also possible that an entity, knowing that the information would become public, would fail to file a return in order not to reveal the extent to which it was not paying taxes. even though the privacy interests of the entity may be weak, the entity has privacy interests in the conclusions that could be drawn from the tax data and the seriousness of those privacy interests push the needle onto the non-disclosure side a reasonable distance. it may not be possible to overcome these concerns from a section 6103 perspective. the reasons for disclosing the collected tax returns derive from both the disclosure perspective and a collection perspective. from a disclosure perspective, the nature of the information serves as the basis for disclosing the collected tax returns. the information concerns money held in trust, and the public has a right to know what is happening to its money. this argument is unlike the reasons for other exceptions to section 6103 and is the reason that this article proposes that the change instead be made to permit this information to become public pursuant to section 6104. this argument, if persuasive, could move the needle on the dial from the non-disclosure position to disclosure. this article will next examine the broadest exception to the rule of non-disclosure, section 6104. this provision provides further background for this proposal concerning collected taxes and their placement within the internal revenue code. unlike the exceptions to section 6103 discussion in this section, section 6104 takes the view that certain returns have a different starting point from a disclosure perspective. 2011] transparency in private collection of federal taxes 799 b. section 6104 section 6104 begins, with the governing principle that tax information should be disclosed unless a reason exists for non-disclosure, which is the opposite of the presumption in section 6103.152 the tax-exempt organizations, pension plans, and political organizations governed by section 6104 relinquish their privacy rights, in large part, because of the tax benefits they receive.153 the public has a legitimate interest in the information on the tax returns and applications of these organizations. this interest outweighs the privacy concerns and other policy concerns driving the non-disclosure policy behind section 6103. the history of section 6104 starts later than that of section 6103, in part because the history of tax-exempt organizations, pension plans, and political organizations trails the income taxes that these organizations receive exemptions from paying.154 tax-exempt status was first formally recognized in 1939.155 reporting requirements for these organizations followed in 1943.156 concerns about abuses in the charitable sector resulted in passage of additional reporting requirements for these organizations in 1950157 and additional disclosure provisions.158 in 1958, applications for tax-exempt status became available after an amendment to section 6104.159 pension plans 152. see jct report (vol. ii), supra note 12, at 6. 153. see id. at 63. (“the present-law rules requiring disclosure of returns and return information relating to tax-exempt organizations reflect a determination that, because such organizations are supported by the public, both through the tax benefits associated with tax-exempt status and, in some cases, direct contributions, such organizations have a different expectation of privacy than taxable persons and the public has a strong interest in information regarding such organizations.”). 154. for a general discussion of the history of § 6104, see jct report (vol. ii, appendix a), supra note 12 at 120-129. 155. see irc § 101 (1939). 156. revenue act of 1943, pub. l. no. 78-235, § 117, 58 stat. 21, 36-37 (1943). 157. revenue act of 1950, pub. l. no. 81-814, 64 stat. 906 (1950). s. rep. no. 81-2375, at 125 (1950). 158. form 990, already in existence at that time, was opened to public inspection. obtaining the form required a written request to the irs. public law 81814 became § 153(c) of the 1939 code which then became § 6104 of the 1954 code. internal revenue code of 1954, pub. l. no. 83-591, 68 stat. 730 (1954). 159. technical amendments act of 1958, pub. l. no. 85-866, § 75, 72 stat. 1606. “the committee believes that making these applications available to the public will provide substantial additional aid to the internal revenue service in determining whether organizations are actually operating in the manner in which they have stated in their applications for exemption.” h.r. rep. no. 85-262, at 41-42 (1957). 800 florida tax review [vol. 10:10 were added to section 6104 in 1974 as part of the passage of erisa.160 as discussed further below, political organizations were added in 2000.161 the jct report cited four reasons for increased disclosure of information concerning tax-exempt organizations:162 “(1) increasing public oversight of tax-exempt organizations; (2) increasing compliance with federal tax and other applicable laws; (3) promoting the fair application and administration of the federal tax laws; and (4) advancing the policies underlying the federal tax rules regarding such organizations.”163 to the extent that the basis for presumption of disclosure of tax information of the entities described in section 6104 rests on the benefits they receive, as the joint committee staff cited with respect to tax-exempt organizations, it is difficult to draw a parallel to the returns reporting collected taxes. while entities that collect taxes on the government’s behalf receive some small benefits for holding the taxes, the argument that those benefits outweigh the burdens has little merit.164 therefore, the reason for categorizing returns reporting collected taxes under section 6104 comes from policies creating section 6104 that extend beyond simply the grant of benefits to tax-exempt organizations. for that reason, other types of taxpayers and returns that section 6104 involves are discussed here as well. one type of tax-exempt organization with a special return that receives partial disclosure pursuant to section 6104 is the trust for black lung patients.165 black lung benefits trusts (blbts) collect money for beneficiaries held in a public trust for them administered by the treasury department.166 the money paid into blbts comes from coal mine operators 160. employee retirement income security act of 1974, pub. l. no. 93406, § 1022(g)(1), 88 stat. 820 (effective for applications filed after sep. 2, 1974). 161. act to amend internal revenue code of 1986, pub. l. no. 106-230, § 1(b)(a)(a)(i)-(vi), 114 stat. 477 amended irc § 6104 to include political organizations, effective july 1, 2000. 162. volume ii of the jct report, which specifically deals with irc § 6104, did not address issues concerning pension plans or political organizations but only tax-exempt organizations. the reasons for pension plans may not mirror those of exempt organizations because of the trust nature of the pension plans. the jct report also did not discuss the black lung trust information made public under irc § 6104, which is discussed elsewhere in this report. 163. jct report (vol. ii), supra note 12, at 6. 164. the benefits are discussed briefly at notes 74-75 and accompanying text. 165. see generally bruce hopkins, the law of tax-exempt organizations 406, 408 (8th ed. 2003) (discussing the tax-exempt organizations created under irc § 501(c)(21) called “black lung benefits trusts”); see also john lopatto iii, the federal black lung program: a 1983 primer, 85 w. va. l. rev. 677 (1983) (discussing the general law of black lung benefits with a discussion in § xi of the creation of the public trust under irc § 9501). 166. hopkins, supra note 165, at 406. 2011] transparency in private collection of federal taxes 801 seeking to “self-insure for liabilities under federal and state black lung benefits laws.”167 these trusts file a return on form 990-bl, portions of which are public pursuant to section 6104. the money paid by coal mine operators into blbts is not a collected tax.168 blbts serve a different purpose than most exempt organizations. they do, however, have a certain quasi-government aspect demonstrated by their ability to pour money into a trust administered by the treasury department, the black lung disability trust fund.169 congress created blbts for the benefit of coal mine operators who had a requirement to pay black lung benefits.170 unlike most tax-exempt organizations which receive public benefits, blbts instead serve a benefit to coal mine operators. the jct report did not address blbts and the policy issues behind their creation as tax-exempt organizations. in this case the policy argument for disclosing a blbt’s return information cannot easily derive from the grant of government benefits as with most tax-exempt organizations and particularly the taxexempt organizations that existed in 1950. the trust created here more resembles a public trust than a tax-exempt organization. in this regard it represents an instance of disclosure not unlike the disclosure proposed in this article for collected taxes. blbts are singled out for discussion here because they have a different policy foundation than most tax-exempt organizations. the policy basis for blbts as organizations whose returns face a presumption for disclosure more closely mirrors the basis for making public collected tax returns, since both circumstances involve trusts in which the public has an interest. moving from tax-exempt organizations, even those such as blbts, 167. id. section 4121 imposes the excise tax on extraction of coal. see also 30 u.s.c. § 934 for creation of the trust into which the excise is paid. 168. money paid into blbts is not considered a collected tax because black lung benefits trusts are not funded by taxes. rather, the mine operators pay this money as an alternative to commercial insurance coverage or state workers’ compensation for pneumoconiosis. the payments by the mine operator to this trust are deductible under § 192. see hopkins, supra note 165, at 406-08. 169. irc § 9501. the black lung disability trust fund was established on the books of the treasury in fiscal year 1978 according to the black lung benefits revenue act of 1977 (public law 95-227). the black lung benefits revenue act of 1981 (public law 97-119) reestablished the fund in § 9501. the black lung disability trust fund is one of ten public trusts created in the internal revenue code. see irc §§ 9501 9510. it is the only one of these ten to accept a portion of its contributions from a tax-exempt organization. irc § 9501(a)(2)(c) provides that a portion of the receipts of this trust fund can come from black lung disability trust funds described in irc § 501(c)(21). 170. “congress established this form of self-insurance program, with similar tax consequences (from the point of view of the operator) as would result if the operator had purchased non-cancellable accident and health insurance.” hopkins, supra note 165, at 406-07 (citing s. rep. no. 95-336, at 11-12 (1978)). 802 florida tax review [vol. 10:10 to pension plans makes this parallel more apparent. the reasons for disclosing pension plan information do not mirror those for tax-exempt organizations, although some overlap exists.171 pension plans hold money paid by employers into a trust for their employees. the public trust created by pension plans more closely resembles the public trust created by collected taxes than the circumstances of most tax-exempt organizations.172 the disclosure of the tax return information of pension plans increases public oversight just as with tax-exempt organizations. publication allows plan beneficiaries to observe the finances of their pension plan. even though pension plans serve a defined population of employees and former employees of a business, the health of the plan implicates significant public interest. a failed pension plan invokes the intervention of the pension benefit guarantee corporation (pbgc), a quasi-government agency that pays pension benefits when a pension plan fails.173 because the government is standing behind the pension plan, the interest of the general public in the information about pension plans is heightened. publication of pension plan information also, arguably, increases compliance with federal tax laws because plan administrators know that they are being watched. in addition to tax-exempt organizations and pension plans, political organizations174 described in section 527 also have their returns disclosed under section 6104.175 political organizations only came under the disclosure provisions of section 6104 in 2000176 as a result of congressional desire to make public both contributors to political organizations and the expenditures of political organizations.177 when the supreme court struck down and 171. pension plans are subject to public inspection so that participants may comment on employer plan submissions and to ensure compliance with certain antidiscrimination rules. see david s. preminger, e. judson jennings, and john alexander, what do you get with the gold watch? an analysis of the employee retirement income security act of 1974, 17 ariz. l. rev. 426 (1975). 172. some overlap exists between disclosing pension plan information under irc § 6104 and the disclosure exception under irc § 6103(c)(1)(f) to beneficiaries of trusts. see duncan v. n. alaska carpenters ret. fund, 1991 wl 165052 (w.d. wash. 1991). 173. how pbgc operates, http://www.pbgc.gov/about/operation.html (last visited oct. 10, 2010); pension benefit guaranty corporation, http://www.pbgc.gov /docs/egovrept2008.pdf. 174. for a general description of political organizations, see hopkins, supra note 165, at 411-17. 175. irc § 6104(a)(1)(a). 176. act to amend internal revenue code of 1986, pub. l. no. 106-230, § 1(b)(a)(a)(i)-(vi), 114 stat. 477 amended irc § 6104 to include political organizations (effective july 1, 2000). 177. the information required to be made public is set out in irc § 527(j). for a general discussion of the history of irc § 527 and the history leading to its 2011] transparency in private collection of federal taxes 803 limited as unconstitutional some of the reporting requirements of the federal election campaign act of 1971 (feca),178 congress relied on section 6104 as a mechanism for shining light on those who stood behind the curtain of political organizations. this use of section 6104 served more to benefit campaign finance law than to promote tax disclosure.179 using section 6104 and section 527(j) to publicly name donors to political organizations stands in contrast to the shielding of donors to section 501 organizations by section 6104.180 while the information disclosure with respect to political organizations that occurs under section 6104 differs significantly from the disclosure of information about collected taxes proposed in this article, the use of section 6104 for the purpose of disclosing donations and expenditure information of political organizations demonstrates that section 6104 does not exist solely to shine a light on charities. here, congress used it for primarily a non-tax purpose. another possible reason cited by the jct report as a basis for publication of the tax information of tax-exempt organizations is the fact that these organizations often fill a void that a government organization would otherwise fill. the governmental nature of the operation of these tax-exempt inclusion in the list of organizations subject to the disclosure rules of irc § 6104, see donald b. tobin, anonymous speech and section 527 of the internal revenue code, 37 ga. l. rev. 611 (2003). the political organization provision of section 527 came into existence in 1974 as recognition that organizations engaged strictly in political activity did not fit under irc § 501, but were also not traditional taxable entities. by 2000 these organizations had morphed into something very different than congress initially envisioned. 178. see buckley v. valeo, 424 u.s. 1 (1976). 179. senator lieberman, a sponsor of the changes to §§ 527 and 6104 to permit disclosure of information about the political organizations stated: “none of us should doubt that the proliferation of these groups—with their potential to serve as secret slush funds for candidates and parties, their ability to run difficult-to-trace attack ads, and their promise of anonymity to those seeking to spend huge amounts of money to influence our elections—poses a real and significant threat to the integrity and fairness of our elections.” 146 cong. rec. s5995 (daily ed. june 28, 2000) (statement of sen. lieberman). 180. some have criticized this distinction, arguing that some 501(c) organizations can engage in limited political activity and the inability to see the donors of those organizations leaves the public in the same place it was before irc § 6104 required publication of the donors of political organizations. see recent legislation: campaign finance reform – issue advocacy organizations – congress mandates contributions and expenditure requirements for section 527 organizations, 114 harv. l. rev. 2209 (2001), and note, the political activity of think tanks: the case for mandatory contributor disclosure, 115 harv. l. rev. 1502 (2002). 804 florida tax review [vol. 10:10 organizations provides a reason for opening up their records, just as the records of the government are accessible to all.181 the jct report contained a quote from senator carl curtis made in 1969 during the legislative debates that led to significant overhaul and restructuring of the tax-exempt sections of the internal revenue code. the language used by senator curtis provides a powerful argument for placing the returns of collected taxes into the same category as tax-exempt returns: [t]ax exemption is a high privilege. i believe the operation of a tax-exempt foundation is public trust; and starting from the premise, i believe that all the business, all the transactions, all the receipts, all the investments, all the grants and all contributions made by the foundation to individuals or to institutions, are of public concern. (emphasis added)182 this quote helps to tie the returns of tax-exempt organizations and the policy driving their disclosure with the returns reporting collected taxes. senator curtis’ use of the term “public trust” very accurately describes the effect of section 7501.183 that statute provides, in part, that “[w]henever any 181. jct report (vol. ii), supra note 12, at 63. 182. statement of senator carl t. curtis, cong. rec. s15646 (daily ed. dec. 4, 1969) 183. the language of § 7501 describes what can fairly be described as a public trust in function but it does not lay out the terms of that trust. see supra, note 8 and accompanying text. the supreme court tried to do that in begier v. irs, 496 u.s. 53 (1990). the court sought to describe the res of the trust created under irc § 7501 where the monies paid to the irs for the collected taxes came from the general account of the entity that collected the tax rather than from a specifically designated trust account. this inquiry was important because the payment to the irs came less than 90 days before bankruptcy. if the payment represented trust funds held for the united states then the payment would not get pulled back into the bankruptcy estate under the preference rules. on the other hand, if the payment came from the taxpayer’s money rather than a trust, then a preference payment would exist. the court held the receipt of the collected taxes created the trust res at the moment of payment. the fact that the funds were held in the corporation’s general account did not destroy the trust res and payment of the money to the irs for purposes of satisfying the collected tax obligation identified the trust res. therefore, it held that the payment to the irs was not a preferential payment. as mentioned above, the internal revenue code specifically establishes eleven trust funds in §§ 9501 through 9511 that definitely fit the description of public trusts. one of these trusts is the black lung disability trust, described above. three of these trusts are funded in whole or in part with collected taxes – the airport and airway trust fund in § 9502; the highway trust fund in § 9503; and the sports fish restoration and boating trust fund of irc § 9504. these public trusts are 2011] transparency in private collection of federal taxes 805 person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the united states, the amount of tax so collected or withheld shall be held to be a special fund in trust for the united states.”184 the statutory language describes a public trust held by the business entity. the monies so held are certainly of public concern. as described above, the persons paying the taxes receive credit whether or not the entity holding the funds in trust pays over the taxes to the irs.185 therefore, the public has a direct concern with the public trust created when business entities hold collected taxes, since the persons whose taxes are collected received credit for those payments whether or not the irs ever receives the money.186 the nature of the public trust created when business entities hold these taxes and the quasi-governmental nature of this activity can perhaps more easily be seen if viewed through the lens of the policy debate in recent years surrounding private debt collectors. during the past decade congress has enacted section 6306 which established “qualified tax collection contracts,” the statutory language for private debt collectors.187 even though the authority to enter into private collection contracts still exists in the code, the irs has recently decided not to renew any contracts and does not plan to renew. one of the biggest concerns with private debt collectors was that detractors of the program viewed collection of taxes as an inherently government function.188 even though the program did not allow private debt collectors to handle any managed by treasury’s office of public debt accounting – trust funds management branch which maintains a website where it discloses the management of these funds. the fact that some collected taxes end up in public trust managed by the treasury department, some taxes with social security and some taxes go into the general fund of the treasury department does not change the fact that entities collecting this tax hold it in trust as described in § 7501 and in begier. 184. irc § 7501(a). 185. see irc § 31(a)(1), supra note 69. 186. id. 187. for a general overview of private debt collection see gary guenther, crs updates report on private debt collection program, 2007 tax notes today 236-21 (nov. 15, 2007). 188. see hearing on the internal revenue service’s use of private debt collection companies to collect federal income taxes: hearing before the h. comm. on ways & means, 110th cong. 43 (2007) (statement of nina e. olson, the national taxpayer advocate). see also internal revenue service budget for fy 2008: hearing before the h. appropriations subcomm. on fin. serv. & gen. gov’t, 110th cong., 1st sess., 2 (2007) (statement submitted by colleen kelley, president of the national treasury employees’ union); use of private collection agencies to improve irs debt collection: hearing before the h. subcomm. on oversight of the comm. on ways & means, 108th cong., 1st sess., 21 (2003) (statement of earl pomeroy, member, h. comm. on ways and means). 806 florida tax review [vol. 10:10 money,189 the actions of these companies in assisting the irs to collect taxes was viewed as too closely tied to government action to permit their actions to continue.190 it is interesting how the post-assessment use of private collectors could be such a hot topic because of the inherently governmental nature of the activity while most pre-assessment taxes are collected by “private collectors” without even a whisper of complaint and without public disclosure of what they collected and whether they paid over the taxes. while the carefully vetted private debt collectors were not permitted to handle any dollars, business entities handle over a trillion collected tax dollars every year with no vetting prior to assumption of that responsibility.191 the point here is not that the collected tax system requires dismantling in the same manner that the private debt collection program has been dismantled, but rather that the collected tax system is one of an inherently governmental function – the collection of taxes. further, the collected tax system allows private parties to hold tax dollars which even the private tax collectors could not do. the governmental nature of the action coupled with the holding of large amounts of federal tax dollars makes the returns reporting collected taxes like the returns currently listed in section 6104. c. placement of collected taxes within disclosure regime while most of the businesses submitting returns to report collected taxes do not receive subsidies in the same manner as tax-exempt organizations, they operate as businesses with the understanding that they have an obligation to collect federal taxes as a part of the grant of the right to do business. in this sense their role as tax collectors, while not subsidized, is a role in which they carry out a government function. in addition to carrying 189. guenther, supra note 187 (stating that “all revenue collected through the efforts of pcas has to go into a revolving fund. pcas are not allowed to receive or process any of this money; only the irs can do so. the irs may use up to 25% of the money in the fund to compensate pcas for their services – though irc § 6306 offers no guidance on the factors the irs should consider in compensating a pca for its services. in addition, the irs may transfer up to 25% of the revenue in the revolving fund to its budget for tax law enforcement.”). 190. david lawder, u.s. irs to end contracts with private tax debt collectors, reuters (mar. 2009), available at http://www.reuters.com/article /idusn0536345520090306, quoting sen. richard durbin, “until private debt collectors can prove they can do the job . . . more efficiently and do it at a lower cost than the irs, there is no reason we should continue this program.” senator durbin agreed with the irs decision not to renew contracts with the private tax debt collectors, arguing that tax collection is a “core government function.” id. 191. see statement of deputy commissioner linda stiff, supra note 60. 2011] transparency in private collection of federal taxes 807 out a government function, these businesses also receive the benefits of holding this money as well as the burden of reporting on it. the jct report cited two reasons for public disclosure that would apply equally to reporting collected taxes as to the entities listed in section 6104: (1) disclosure enables the public to provide oversight, and (2) disclosure allows the public to determine which organizations to support.192 if tax returns reporting collected taxes became public through section 6104, the public would have the opportunity to view those returns and report anomalies. the public would also have the opportunity to decide whether to support businesses that did not properly treat the collected taxes they held. businesses and government agencies, seeking to contract with the taxpayer would have an easy means of checking on this important measure of tax compliance.193 compliance or lack of compliance could form an important part of the decision to contract with the taxpayer. a few states have opted to disclose certain collected tax information such as sales tax, excise tax, use tax, and gasoline tax data.194 the policies of these states essentially reach the same result as the result proposed here that disclosure of collected tax data is beneficial. a close look at these state laws and the policies behind those laws is warranted. 192. jct report (vol. ii), supra note 12, at 64. 193. see statement of commissioner linda stiff, supra note 60; u.s. gov’t accountability office, gao-07-742t, tax compliance thousands of federal contractors abuse the federal tax system, 3-4, april 2007; u.s. gov’t accountability office, gao-05-637, financial management: thousands of civilian agency contractors abuse the federal tax system with little consequence, 2, june 2005. 194. ark. code ann. § 26-18-303(b)(18) (west 2010) (“for the purpose of the timely and accurate collection of local sales and use tax and state income tax withholding for employees, disclosure of the name and address of a taxpayer that has failed three (3) times within any consecutive twenty-four-month period to either report or remit state or local gross receipts or compensating use tax or state income tax withholding for employees and has been served with a business closure order under § 26-18-1001 et seq.”); fla. stat. § 213.053(8)(d) (2010) (“the department may provide . . . [n]ames, addresses, and sales tax registration information, and information relating to a hotel or restaurant having an outstanding tax warrant, notice of lien, or judgment lien certificate, to the division of hotels and restaurants of the department of business and professional regulation in the conduct of its official duties.”); ind. code § 6-8.1-7-1(n) (2010); mass. gen. laws ch. 62c § 21(b)(3) (lexisnexis 2010); nev. rev. stat. § 366.160(1) (lexisnexis 2010) (“all records of mileage operated, origin and destination points within nevada, equipment operated in this state, gallons or cubic feet consumed, and tax paid must at all reasonable times be open to the public.”); utah code ann. § 59-1-403(3)(e) (lexisnexis 2010) (“[a]t the request of any person, the commission shall provide that person sales and purchase volume data reported to the commission on a report, return, or other information filed with the commission under . . . motor fuel or . . . aviation fuel”). 808 florida tax review [vol. 10:10 wisconsin, home of the progressives who lead the early 20th century charge to disclose tax returns, has permitted disclosure of some aspects of its income tax returns since 1923.195 in 1953 access to the entire return was paired back to access to the net taxes paid.196 public access to the amount of income tax paid extends to individuals as well as corporations; however, the information is available only upon a specific request to the wisconsin department of revenue satisfying certain conditions.197 while the wisconsin disclosure provisions do not cover returns of collected taxes, other states do. vermont allows disclosure of a number of taxes.198 specifically, the plain language of the statute allows for anyone to obtain information about an entity holding money in trust concerning the compliance of that entity. the publicity of this tax data closely correlates with the collected tax data for which disclosure is proposed here. vermont permits oral or written requests. the tax department responds by advising the requester whether the taxpayer is in “good standing,” which is the code phrase for fully paid upon the collected taxes, or is “not in good standing,” which is the phrase for a delinquent taxpayer. vermont does not allow the public to view the returns. massachusetts passed a law in 1992 making public a host of tax information regarding publicly traded corporations, banks, and insurance companies.199 businesses are currently required to disclose the following: (1) name; (2) address of principal office; (3) massachusetts taxable income; (4) total massachusetts excise tax due; (5) non-income excise tax due; (6) gross receipts or sales; (7) either gross profit or credit carries over to future years; 195. 1923 wis.laws 39. 196. 1953 wis.laws 303. 197. wis. stat. ann. § 71.78(2) (west 2010). 198. vt. stat. ann. tit. 32, § 3102 (west 2010) (providing that “the commissioner shall disclose a return or return information . . . to any person who inquires, provided that the information is limited to whether a person is registered to collect vermont income withholding, sales and use, or meals and rooms tax; whether a person is in good standing with respect to the payment of these taxes; whether a person is authorized to buy or sell property free of tax; or whether a person holds a valid license . . .”). the practical explanation of vermont’s application of this provision is based on a conversation between the author and molly bachman, vermont’s general counsel for the tax department. telephone conversation with molly bachman, vermont’s general counsel for the tax department (aug. 18, 2010). 199. mass. gen. laws. ch. 62c, § 83(c) (1992); currently mass. gen. laws ann. ch. 62c, § 83(c) (west 2010). 2011] transparency in private collection of federal taxes 809 (8) income subject to apportionment.200 the massachusetts provisions require reporting of both income taxes and the sales and excise taxes more like the collected tax which are the focus of this article. one problem with the massachusetts statute is its focus on publicly traded companies. as will be discussed more fully below, companies of this size are very unlikely to have problems with reporting and paying collected taxes. the purpose for disclosing the liabilities in massachusetts appears driven by a somewhat populist desire to insure that large companies pay their “fair share.” to the extent a goal exists for reporting collected taxes aside from the goal of aligning collected taxes with the proper disclosure provisions, limiting the reporting of collected taxes to public corporations would serve no collection purpose. the reporting of this information has now been in place for almost two decades with little data gathered showing any negative impact from this reporting.201 the returns reporting collected taxes differ from almost all other tax returns because they do not contain information about a tax liability incurred by the taxpayer.202 rather, they contain information about taxes collected and held in trust for the united states. these returns do not calculate a tax rate nor do they contain “secret” information about a business that would enable competitors to obtain an advantage. these returns simply report the amount of money held in trust by the tax collecting entity. this type of return information should not raise privacy concerns that drive the underlying secrecy of federal tax information.203 rather, this type of information should 200. id. 201. not only is there little data that evidences any negative impact, but there is little data concerning the beneficial effects of the disclosure. see richard pomp, the disclosure of state corporate income tax data: turning the clock back to the future, 22 cap. u. l. rev. 373 (discussing benefits of disclosure at state level). 202. current employment tax returns do reflect the liability of the employer portion of the social security tax. as discussed below, this article recommends removing that section from returns reporting collected taxes. 203. in some ways the debate on disclosure of tax information has become less important since 1976 when the last great debate occurred. tax information no longer exists as the single greatest source of information about an individual or an entity. tax information has been replaced by a host of other information sources including, but not limited to, the bank secrecy act, the sec rules, and other broad rules seeking transparency in corporate affairs. interestingly, the irs even uses third party data gathering sources such as choicepoint, which is built upon publicly available data as it tries to gather information about taxpayers. the irs’s use of this information provider serves as a poignant statement of where much information lies today – it lies in a wide array of public venues available to those who know how to mine such data. additionally, other rich sources of information about individuals and entities exist in the public domain, provided by the federal government through such 810 florida tax review [vol. 10:10 exist in the public domain in order that everyone has a transparent view of the money collected on our behalf by the entities serving as agents of the federal government. the disclosure policy reasons behind the decision to make public the returns reporting tax-exempt and pension return information should apply to the returns reporting collected tax information. because the money is held in trust, there is no basis for distinguishing between the various entities reporting this information.204 the information should be readily available in an unfiltered manner and posted on the internet so that it is easily accessible. reporting all of the information in an unfiltered manner would make the task administratively easier for the irs and allow those using the data to access it all without limitations on size of business or other limiting criteria. the reasons for disclosing the returns apply to all returns containing collected taxes. disclosing all returns fits with the collection aspect of the policy consideration as well as the disclosure piece. by disclosing all returns, businesses filing these returns know from the outset that the information on these returns differs from the information on other tax returns of the business. knowing that it is different helps them understand why this debt obligation differs from other debt obligations of the business which should make it more likely that businesses would pay this debt, or go out of business, rather than paying the debts of trade creditors in an attempt to stay afloat. v. changes to current return forms currently, returns reporting money held in trust contain information about both money held in trust and tax liabilities that do not stem from a trust relationship.205 those returns should be split into two parts: one part sources as pacer, which provides public information on individuals filing bankruptcy or other court proceedings. again, far more data about an individual can readily be accessed electronically through pacer than is found on the individual’s income tax return. 204. while disclosure policy provides no basis for distinguishing among different taxpayers whose information will be disclosed, collection policy with respect to collected taxes suggests that the most likely taxpayers to fail to pay over collected taxes are small and newly formed businesses. with this in mind, an alternate proposal, discussed below, addresses the disclosure of collected tax returns for certain smaller entities or entities that have experienced difficulties fulfilling their collected tax obligations. 205. take, for example, form 941 which reports three different types of information: withheld income taxes (trust information); withheld social security taxes (trust information); and the employer’s portion of the social security taxes (not trust information). similarly, form 720 sets out a reporting mechanism for a variety of excise taxes, some of which result from a trust relationship where the entity filing 2011] transparency in private collection of federal taxes 811 reporting the collected taxes (the collected taxes return) and the other reporting the taxes directly due from the entity (the entity liability return). the collected taxes return should become publicly available while the entity liability return would remain subject to the current disclosure provisions.206 the collected taxes return should report not only the obligation for the taxes the form 720 has collected the excise taxes from third parties and some of which result from excise taxes directly imposed on the entity. 206. this article focuses on policy reasons for changing the disclosure laws to provide for disclosure of the returns reporting collected taxes. those policy reasons come both from the policy reasons driving the disclosure laws as well as policy reasons related to effective collection strategies. other reasons exist for disclosing returns of collected taxes, particularly employment tax returns reporting withheld income and social security taxes. the first of these ancillary reasons stems from the peculiar circumstances of employment tax returns. many of these returns are prepared by “payroll tax providers.” these providers prepare the returns, sign the returns, pull the money from taxpayer’s checking accounts, and file the returns and the required remittances. taxpayers essentially turn over everything about payroll taxes to these firms that provide this service. because of the “trusting” nature of taxpayers who rely on payroll providers, a number of these providers have perpetrated ponzi style schemes in which they take the money from the taxpayers’ accounts and use some of it for personal gain rather than using the money to pay the taxes. by the time the schemes collapse, potentially thousands of taxpayers who actually had money drawn out of their accounts to pay over the collected taxes find themselves with a tax bill for these taxes. see, e.g., in re firstpay, inc., 09-1076, 2010 wl 3199858 (4th cir. aug. 13, 2010). see fogg, trust, supra note 13, at 384. if collected tax returns were publicly posted, the accessibility of information on a public website would allow taxpayers who rely on payroll providers to pay their taxes to ensure that their taxes were paid. of course, these taxpayers could go to the irs now and make a request for their transcripts, but the availability of a website with an easy search feature might help to reduce the problem that payroll providers with a bent to steal cause – a small collateral benefit to this proposal. a second ancillary reason for disclosing collected tax returns involves the federal government and its relationships with federal contractors. as discussed in gao 2005 report (u.s. gov’t accountability office, gao-05-637, financial management: thousands of civilian agency contractors abuse the federal tax system with little consequence, 2, june 2005), and in statements by senator grassley, the federal government has a goal of not contracting with those who do not pay their federal taxes. on jan. 20, 2010, president obama signed a memorandum directing government officials to recommend how to ensure that no new federal contracts were awarded contractors delinquent in paying their federal taxes. see president barak obama directs agencies to deny business to tax-delinquent contractors, 2010 tax notes today 13-36 (jan. 20, 2010); see also michael joe, obama seeks to block tax debtors from receiving federal contracts, 2010 tax notes today 13-3 (jan. 21, 2010). one obvious way to accomplish this goal would be to publish the delinquent collected tax data in a form easily retrieved by federal contracting officers since collected taxes comprise over 90% of the unpaid federal tax debts of contractors seeking federal contracts, according to the gao report. 812 florida tax review [vol. 10:10 but also the amount of payments made toward that obligation during the return period and with the return itself. this would allow anyone viewing the return to ascertain if the trust obligation had been fulfilled or remained partially or fully unmet.207 two return forms require revision in order to accomplish this result. first, the employment tax return, form 941, must be modified. form 941, due on a quarterly basis, currently reports three primary tax liabilities of the entity having employment tax obligation. these tax liabilities consist of the amount of income taxes withheld from employees, the amount of social security tax withheld from employees, and the entity’s own liability for social security taxes.208 instead of one form that reports both collected taxes and the entity’s own obligation, two forms should exist. one form would report the collected taxes, described here as form 941t (the t stands for “trust”) and the other would report the entity’s obligation, described here as form 941e (the e stands for “entity”). form 941t should contain relatively little information in order to limit the disclosure of information and avoid confusion for anyone reading it. it should report the total amount of income taxes collected from its employees, the total amount of social security taxes collected from its employees, and the total amount of taxes paid to the irs during the quarter. some additional information could be placed on the return similar to the information currently reported on form 990 with respect to tax-exempt organizations.209 this information is general information about the entity such as the type of organization, year of formation, and state of domicile. certain information required on the form 990-bl might also provide some benefit such as “the books are in the care of: [fill in the blank],” “phone number: [fill in the blank],” and “located at: [fill in the blank].”210 form 941e should track the information on the current form 941, but will exclude the information on the collected taxes reported on the companion form 941t. the second return requiring revision is the form 720, which is used to report excise taxes. like the form 941, this form currently reports excise taxes directly owed by the employer as well as excise taxes collected from others. two forms, the form 720t and form 720e, should replace the current form 720. the form 720t should report only the excise taxes 207. see following discussion below for a detailed discussion of what should be on the collected tax return. 208. irs form 941 and instructions. 209. form 5500, used for returns of pensions, requires extensive information; however, the information sought on form 5500 seems irrelevant to the information that would make form 941t and form 720t useful. 210. as discussed above, form 990-bl concerns the type of tax most closely related to collected taxes of all of the returns made public pursuant to irc § 6104 at present. 2011] transparency in private collection of federal taxes 813 collected from others, identify the type of tax collected, and report the total amount paid to the irs during the reporting period for the form. some additional information could be placed on the return similar to the information reported on form 941t discussed above. the form 720e should retain the information on the current form 720, but will exclude the information on the collected taxes reported on the companion form 720t. vi. how mechanics of disclosure should take place the disclosure of the collected tax information should take place through posting every filed form 941t and form 720t on the internet. the posting should adopt a format that is easily searchable. section 6104(a)(3) currently contemplates posting on the internet certain returns disclosed under section 6104 and 527. that same mechanism for dissemination of information should apply with respect to the returns reporting collected taxes. the posting of returns should occur as soon as possible after receipt. neither the business entity nor the irs should be required to produce copies of the returns posted on the internet. the irs should post any failure to receive a return on the internet. individuals interested in collected tax returns of an entity should not be forced to guess whether or not a return was filed and not posted. to incorporate suggestions made in this article, provisions substantially similar to those that follow should be added to section 6104: proposed change to section 6104(a)(1)(e) – “returns reporting collected taxes – if a business is required to collect taxes for the united states and holds the collected taxes in trust pursuant to section 7501(a), the returns of the business reporting the collection and payment of the collected taxes shall be open to public inspection and posted on the internet.” proposed change to section 6104(a)(3)(c) – information available on the internet– “the secretary shall make publicly available on the internet the tax returns described in 6103(a)(1)(e).” vii. disclosure policy aspects of proposal while disclosure policy drives the recommendation in this article that collected tax returns should be disclosed under section 6104 rather than kept private under section 6103, the decision to disclose these returns could impact collection policy as well. this article proceeds with the belief that the disclosure of collected tax returns would benefit compliance. in this unsubstantiated belief, the article adopts the unsubstantiated position of the 814 florida tax review [vol. 10:10 jct report that disclosing tax-exempt organization information increases compliance whereas disclosing returns and return information with respect to taxable persons generally compromises voluntary compliance.211 assuming that disclosing collected tax returns will have the beneficial compliance effect that such disclosures controlled by section 6104 currently have, the next issue concerns the costs associated with publishing this information. under this proposal the taxpayer would bear little direct costs. the cost of preparing the returns would increase, if at all, only marginally. the irs would bear the cost of publication. the real costs of this proposal would potentially consist of a decrease in compliance, as a result of publishing the returns. this disclosure proposal must then consider whether a taxpayer’s likelihood of filing returns and reporting accurate information will decrease because of fears that information on these returns would disclose proprietary information or otherwise harm the business. publication is unlikely to impact the accuracy of the withholding tax returns because of the direct link between these returns and the social security/withholding benefits of the employees including the employees responsible for filing the returns. this accuracy is checked each year for employment tax returns under the cawrs program.212 while it is possible that some taxpayers would react to publication by failing to file returns, this failure also has a detrimental effect on those responsible for filing the returns since it indefinitely extends the statute of limitations on assessment of their liability as responsible officers 211. see jct report (vol. ii), supra note 12, at 65 and accompanying footnotes. see also rizek, supra note 81, at 88-90 for a pragmatic view that may represent the only realistic point of view on this subject in the absence of credible supporting data for either point. 212. i.r.m. 1.15.19, 1.15.35, available at http://www.irs.gov/irm /part1/irm_01-015-019.html; http://www.irs.gov/irm/part1/irm_01-015-035.html ... (last visited oct. 18, 2010). the combined annual wage reporting (cawr) falls under the division of small business/self-employed (sb/se). cawr ensures that employers accurately report annual wage data on irs forms in the 940 series to the irs and form w-3 to the social security administration (ssa). when there is a discrepancy between the two forms, a case is created and worked within the sb/se campuses. the cawr system consists of five tier 1 sub-projects maintained by national office modernization and information technology services (mits) and one tier 2 system maintained by ogden development center mits. cawr runs on both the tier 1 ibm platform and on the teir 2 sun platform. the tier 1 processing is known as combined annual wage reporting mainframe (cawr mainframe). the tier 2 processing is known as the combined annual wage reporting automation program (cap). the cap system houses the cawr for cases for a three year period, it allows notice/letter generation and user updates, monitors cases for responses/no responses etc., and creates reports. 2011] transparency in private collection of federal taxes 815 for the trust fund recovery penalty.213 although no definitive answer exists on possible detriments to publication of collected tax returns, no specific negative consequences immediately appears. creating collected taxes returns that report only the money held in trust and then making those returns public would enable everyone to determine if a business entity meets its basic obligation to properly handle the public’s money with which it was entrusted. publishing this information would also allow the public to make decisions concerning businesses entrusted with public funds just as everyone makes decisions concerning public officials entrusted with public funds. the monies reported on these returns do not belong to the taxpayers filing the returns and implicate few of the reasons for protection that ordinary tax information carries. publishing this information facilitates informed decision-making regarding which businesses to support, which businesses have a strong likelihood of failure, and which competing businesses have gained an improper competitive advantage. once this information becomes public, those entities failing to pay over the collected taxes should find a non-receptive public just as public officials would find a non-receptive public if they improperly handled public monies. the pressure caused by this situation should encourage entities to properly report and pay collected taxes, thereby improving compliance in this segment of the tax gap. the proposal in this article to disclose all returns reporting collected taxes under the regime of section 6104 turns on an interpretation of disclosure policy that places collected taxes into public view because of the trust nature of these returns.214 it is possible to approach this problem based on the collection policy perspective rather than disclosure policy, by considering possibilities of increasing transparency without moving collected tax returns under section 6104. one such possibility would be to use tools essentially available already under section 6103, which would require minor changes in that statute to the manner of publication of information about taxpayers who owe collected taxes. this article does not recommend the collection policy approach but addresses it below as a potential path to 213. see lipsig v. united states, 187 f. supp. 826. (e.d.n.y. 1960); michael i. saltzman, irs practice and procedure, ¶ 17.09[4] (warren, gorham & lamont, 2nd ed. 2002). 214. publishing all returns of collected taxes, as recommended in this article, does go further in disseminating information than allowed under § 6103(k)(2). in some ways such disclosure mirrors the disclosure exception in § 6103(e)(1)(f) which permits disclosure of information to trust beneficiaries. here the disclosure of information benefits the beneficiaries of the trust on collected taxes created under § 7501. the beneficiaries are the people of the united states. the exception to disclosure concerning the nftl is discussed in notes 141-48 and accompanying text. 816 florida tax review [vol. 10:10 increased compliance with a smaller change in the approach to disclosure policy with respect to collected taxes. a. shaming as discussed below, the ability to disclose information concerning unpaid collected taxes already exists in almost all instances.215 once the irs files an nftl, the taxpayer’s liability for collected taxes (or at least for liabilities on returns on which collected taxes are reported) becomes a matter of public record. this public record will be quickly found by credit reporting agencies and others tracking the filing of the federal tax lien.216 disclosure of this information is currently permitted under section 6103(k)(2). this information goes to the county clerk’s office where the taxpayer resides or where the taxpayer has property.217 if the taxpayer is a corporation or partnership, the nftl is filed as designated by the state where the entity’s principal executive office is located.218 given that the information of an unpaid collected tax can become public through the filing of an nftl as soon as ten days after the assessment 215. collected taxes fall outside the deficiency tax procedure of § 6213. when collected taxes go unpaid, the irs can, if it has not already done so based on a return with insufficient remittance, assess the taxes due on the collected tax return and almost immediately begin collection. because these taxes can go immediately or almost immediately into the collection stream, the federal tax lien exists once the liability goes unpaid. the existence of the federal tax lien occurs when a federal tax assessment has taken place, followed by notice and demand pursuant to § 6303, followed by ten days (the usual period the irs gives taxpayers to pay as a policy matter) in which the taxes remain unpaid. if this sequence occurs, a federal tax lien exists as described in §§ 6321 and 6322. if a federal tax lien exists, then the irs can make the liability public when it wants by filing an nftl pursuant to § 6323(f). the publication of the liability to the world through the nftl represents one of the many exceptions promulgated in § 6103. see irc § 6103(k)(2). since the collected tax liabilities in almost all instances fit this disclosure exception, publishing these liabilities presents few hurdles from a disclosure perspective if a liability exists. 216. based on correspondence to clients of the villanova federal tax clinic for whom federal tax liens are filed, a number of business organizations track federal tax lien filings in order to offer taxpayers assistance in working out their debts with the irs. 217. irc § 6323(f)(1)(a). 218. irc § 6323(f)(1)(a); i.r.m. 5.12.2.8, available at http://www.irs.gov /irm/part5/irm_05-012-002.html (last visited oct. 12, 2010) (“the principal executive office is deemed to be the residence of the corporation or partnership. it is the place where the major management decisions are made. do not confuse the principal executive office with the principal place of business.”) 2011] transparency in private collection of federal taxes 817 of the tax,219 the next collection policy question is whether a more public pronunciation of the liability should occur in order to more effectively convince taxpayers with unpaid collected taxes (or potentially any unpaid taxes) to quickly satisfy the obligation. starting in the late 1990s and continuing as an increasing trend, states have turned to further publicity.220 in a tight market, one business may be able to hold a business advantage over its competitors if it avoids paying to the irs the taxes collected from or on behalf of others. publicizing the names of entities that fail to pay these taxes could potentially serve to level the playing field in such business areas. a business advantage obtained in this manner should instead become a business liability if competitors have knowledge of the situation and can use it in the marketplace. much of the literature in this area characterizes this type of disclosure as “shaming.”221 shaming seeks to alter taxpayer behavior through the use of social pressure.222 in recent years over half of the states have adopted a limited disclosure exception allowing publication of the names of certain delinquent taxpayers.223 states enact such statutes with the hope that the individual or entity, seeking to avoid the negative publicity associated with this publication, will ultimately comply.224 this article does not recommend that the united states government should adopt a shaming policy as a basis for the publication of taxpayers delinquent in paying their collected taxes. however, the relatively recent policy debate surrounding the state shaming provisions provides a basis for examining one relevant policy reason for creating an exception to disclosure that would cover those taxpayers who were delinquent in paying over collected taxes. if the united states were to adopt shaming as a basis for addressing unpaid collected taxes, it has several models to choose from as it reviews the 219. as discussed in note 215, above, assessment triggers issuance of the notice and demand letter under irc § 6303 giving the taxpayer 10 days to pay. if the taxpayer does not pay within the 10 days, the assessment lien arises automatically. once the assessment lien exists, it is up to the irs to decide when to make that lien public with the filing of an nftl. 220. section 3802 of the revenue reform act of 1998 directed the joint committee on taxation and the treasury department to comment on the feasibility of shaming among many other disclosure issues. the jct report addresses shaming, recommending against a federal shaming program for non-filers and expressing concern that publishing non-filer information might incorrectly identify individuals with no filing requirement. see jct report (vol. i), supra note 10, at 238-40. as of 2000 only five jurisdictions had adopted shaming provisions. contrast that number with the twenty-six states and the district of columbia that now use shaming, listed in appendix a. 221. see blank, supra note 101, at 539, 547-48. 222. id. 223. see appendix a, infra. 224. jct report (vol. i), supra note 10, at 238. 818 florida tax review [vol. 10:10 statutes adopted by the states. the most common shaming provisions choose a numerical limit, such as the 100 taxpayers with delinquent collected taxes who owe the most outstanding liabilities, and publish the names of those taxpayers on a website or other prominent location. another common method involves publishing the names of all delinquent taxpayers whose outstanding liabilities exceed a selected dollar amount. the dollar level for publication of an entity with debt should reflect an amount high enough to avoid information overload from all of the published names but low enough to provide meaningful information to competitors and consumers. using abc, inc. to illustrate the proposal, the irs would consider posting the name of abc, inc. on its website at a special location designed to publicize delinquent taxpayers. the irs would only publish abc’s name if abc owed a sufficient amount, for example $25,000, of unpaid collected taxes. once abc crossed the dollar threshold, the irs would enter abc’s name onto the list of tax delinquents. the list would be available to anyone with internet access. currently, the irs may not disclose tax information about any taxpayer without specific authorization under section 6103. no exception exists for listing the names of entities that do not pay taxes, whether the taxes are income, excise, employment, or some other type. in many instances entities with unpaid collected taxes find themselves saddled with a filed federal tax lien; however, even when the lien is filed, their competitors and companies with whom they do business might not know about the existence of the federal tax lien.225 at present, one exception to this general rule of non-disclosure in the internal revenue code fairly could be characterized as a shaming provision,226 rather than simply a disclosure exception based on one of the traditional reasons. in 1996 congress enacted section 6039g.227 this section 225. the failure to pay collected taxes creates a competitive advantage for the company that fails to pay over related companies that do pay these taxes. this competitive advantage creates a strong reason for publishing this information. if competitors learn of the failure to pay, they may be able to publicize that fact and potentially remove the advantage. some discussion of the competitive advantage has surfaced although little has been written on the scope of this advantage. 226. the disclosure under § 6039g is the disclosure of the taxpayer’s name. although the filing of the § 6039g information return acts as the triggering mechanism for the disclosure, the disclosure itself simply consists of the listing of the taxpayer’s name with no identifying tax information. in this respect, the § 6039g disclosure differs from other disclosure exceptions described in irc §§ 6103, 6104, or 6110. 227. section 6039g provides that any individual to whom § 877(b) or § 877a applies for any taxable year shall provide a statement for such taxable year which includes the following information: (1) the taxpayer’s tin, (2) the mailing address of such individual’s principal foreign residence, (3) the foreign country in 2011] transparency in private collection of federal taxes 819 addresses a problem perceived by congress when an individual renounces u.s. citizenship for the purpose of avoiding the payment of u.s. taxes.228 the shaming remedy created by congress to address this situation appears to be both too broad and too obscure.229 the remedy reaches too broadly because shaming, or publication of the names of individuals renouncing u.s. citizenship, occurs for all who renounce, rather than just those who renounce for tax motivated reasons. the breadth of this reach diminishes the effectiveness of the publication of the names, because inclusion on this list does not tie directly to improper tax behavior. the remedy is also too obscure because the names of the shamed individuals are published in the federal register on a quarterly basis. the federal register seems a rather remote and inaccessible place to publish names if its purpose is to have the individuals ostracized by their community of peers.230 which such individual is residing, (4) the foreign country of which such individual is a citizen, (5) information detailing the income, assets, and liabilities of such individual, (6) the number of days during any portion of which that the individual was physically present in the united states during the taxable year, and (7) such other information as the secretary may prescribe. the statute also provides that an individual who is required to file a statement under subsection (a) for any taxable year, and fails to file such a statement, fails to include all required information, or includes incorrect information, must pay a penalty of $10,000 unless it is shown that such failure is due to reasonable cause and not to willful neglect. finally, the statute provides that any federal agency or court which collects the statement under subsection (a) shall provide to the secretary a copy of any such statement, and the name (and any other identifying information) of any individual refusing to comply with the provisions of subsection (a). the secretary of state shall provide to the secretary a copy of each certificate as to the loss of american nationality under § 358 of the immigration and nationality act which is approved by the secretary of state, and the federal agency primarily responsible for administering the immigration laws shall provide to the secretary the name of each lawful permanent resident of the united states whose status has been revoked or abandoned. no later than 30 days after the close of each calendar quarter, the secretary shall publish in the federal register the name of each individual losing united states citizenship with respect to whom the secretary receives information under the preceding sentence during such quarter. 228. see michael s. kirsch, alternative sanctions and the federal tax law: symbols, shaming, and social norm management as a substitute for effective tax policy, 89 iowa l. rev. 863 (2004) for a detailed discussion of this law and of the policies behind the law as well as the shortcomings of the law. 229. the remedy also appears ineffective, as more and more american citizens renounce their citizenships in order to avoid this taxation. see ellen kelleher, americans forfeit citizenship to avoid tax, financial times, july 17, 2010, available at http://www.ft.com/cms/s/0/bab42a32-9126-11df-b29700144feab49a.html. 230. kirsch, supra note 228, at 888 (discussing the effectiveness of shaming sanctions). 820 florida tax review [vol. 10:10 regardless of its effectiveness, section 6039g demonstrates a congressional willingness to resort to shaming as an enforcement technique.231 more recently congress has flirted with the idea of using shaming to identify corporate taxpayers who seek to reduce or eliminate their tax liability by employing “abusive” tax shelters.232 while numerous states 231. the irs and the department of justice use a form of shaming in some of their information releases and website postings. the irs publishes a “dirty dozen” list of transactions it finds abhorrent and contrary to the law. the list serves both to “shame” the promoters and investors in the promotion as well as to inform prospective investors of the toxic tax nature of the transaction. internal revenue service, beware of irs’ 2010 “dirty dozen” tax scams, http://www.irs.gov/newsroom/article/0,,id=220238,00.html. similarly, but in less of a shaming mode, the irs publishes “listed transactions” in an effort to let people know that certain transactions have gained the attention of the irs in such a way that settlement of the cases is no longer an option. the listing of a transaction serves to shame those engaged in that transaction although not by name as well as to inform. internal revenue service, recognized abusive and listed transactions, http://www.irs.gov/businesses/corporations/article/0,,id=120633,00.html. the service sometimes back-ends the shaming provisions on these transactions by requiring a disclosure waiver in settlements it reaches with taxpayers engaged in such transactions so it can publicize the concession by the offending taxpayer. see blank, supra note 101, at 82-85. the department of justice regularly publicizes the convictions that it obtains and the civil injunctions that it obtains in promoter and return preparer cases. see, e.g. press release, u.s. department of justice, cincinnati area return preparer pleads guilty to tax crimes (june 8, 2010), available at http://www.justice.gov/tax/txdv10671.htm; press release, u.s. department of justice, federal jury convicts local tax preparer – faces up to 33 years in federal prison (mar. 12, 2010), available at http://www.justice.gov/usao /txn/pressrel10/watson_tax_convict_pr.html. the publication of the name of the person convicted or enjoined serves not only to shame the individual so named but to deter others who might engage in similar behavior. here, the shaming comes after enforcement so the shaming does not motivate the convicted or enjoined individual to change their behavior. the enforcement activity, hopefully, accomplishes that purpose. 232. jumpstart our business strength (jobs) act, s. 1637, 108th cong., 2d sess., 402, 150 cong. rec. s. 5622, 5643 (may 18, 2004). for a detailed discussion of this provision, see blank, supra note 101, at 553 & n.74. blank argues that shaming corporations that use tax shelters would not promote tax compliance for a variety of reasons. in many ways the proposal to shame corporations in this context carries many of the symbolic but ineffective concerns expressed by kirsch about expatriate shaming. kirsch, supra note 228, at 921. congress feels a need to express displeasure about certain behavior but chooses to make its expression in a manner that does not affect future behavior in the manner in which it seeks. 2011] transparency in private collection of federal taxes 821 have adopted shaming as a means of increasing revenue, no state has yet adopted shaming based on corporate tax shelter activity.233 the concept of shaming has received much attention among writers seeking ways to promote tax compliance.234 earlier writing concerning shaming addressed its effectiveness in the criminal context.235 toni massaro provided a critical analysis of shaming in this context and identified five conditions that a shaming statute should meet to be an effective remedy: (1) offenders should be members of an identifiable group; (2) sanctions must compromise social standing within the group; (3) group awareness of the sanctions and withdrawal from offenders; (4) offenders must fear withdrawal by the group; and (5) offenders must have means to regain social standing.236 massaro concludes that these tests are rarely met in modern america so she does not favor shaming as an effective remedy for criminals. her article demonstrates that shaming fell from grace as an appropriate sanction because it lost its effectiveness as a punishment tool as american society evolved over the past 200 years.237 because the factors for effective shaming in a 233. see appendix a for a listing of states with shaming laws and, where used, their websites. all of the state shaming provisions focus on collection of unpaid taxes rather than corporate shaming. 234. see dennis j. ventry, jr., cooperative tax regulations, 41 conn. l. rev. 431 (2009); maryann richardson & adrian sawyer, a taxonomy of the tax compliance literature: further findings, problems and perspectives, 16 austl’n tax forum 137, 168 (2001); leandra lederman, the interplay between norms and enforcement in tax compliance, 64 ohio st. l. j. 1453, 1493 (2003); susan cleary morse, using salience and influence to narrow the tax gap, 40 loy. uni. chi. l. j. 483 (2009); dan a. kahan, the logic of reciprocity: trust, collective action, and law, 102 mich. l. rev. 71 (2003); marjorie kornhauser, tax compliance and the education of john (and jane) q. taxpayer, 121 tax notes 737 (nov. 10, 2008); joshua rosenberg, narrowing the tax gap: behavioral options, 117 tax notes 517 (oct. 29, 2007); jay soled and dennis ventry, jr., a little shame might just deter tax cheaters, usa today, apr. 10, 2008. 235. toni m. massaro, shame, culture, and american criminal law, 89 mich. l. rev. 1880 (1991); dan m. kahan & eric a. posner, shaming white collar criminals: a proposal for reform of the federal sentencing guidelines, 42 j.l. & econ. 365 (1999); john b. owens, have we no shame?; thoughts on shaming, “white collar” criminals, and the federal sentencing guidelines, 49 am. u. l. rev. 1047 (2000); james q. whitman, what is wrong with inflicting shame sanctions?, 107 yale l.j. 1055 (1998). for more recent discussion continuing this debate see dan kahan, what’s really wrong with shaming sanctions, 84 tex. l. rev. 2015 (2006) and the articles cited therein. 236. massaro, supra note 235, at 1883. 237. one concern with shaming provisions is that shaming not publicize a general failure of society to comply with the tax law. shaming should not cause less compliance by alerting the compliant to the fact they may constitute a disadvantaged minority of individuals complying with present laws. this circumstance graphically displayed itself in bankruptcy courts around the county in the 1980s and 1990s as the 822 florida tax review [vol. 10:10 criminal case do not currently exist in america, she concludes that a reprise of shaming as a tool for effective criminal punishment and rehabilitation would be a mistake. the concerns expressed by massaro have validity for analyzing whether shaming would work in certain tax contexts, but they also fail to address certain issues presented by civil tax issues.238 kirsch identified some of the shortcomings of shaming in the tax context, at least as applied to the expatriate situation currently adopted in the code.239 assuming that massaro’s often cited tests provide the most appropriate structure for determining the effectiveness of shaming, how do these tests apply to the context of the failure to pay over taxes held in trust by an entity? is it worthwhile to consider the publication of the names of entities that fail to pay their trust fund taxes, or would such publication fail to motivate the named entities to pay the taxes while broadcasting to the world that the government has been unsuccessful in fixing the problem in this area of noncompliance?240 many of the concerns raised about the effectiveness of shaming in the criminal context do not apply to the naming of liable entities in the trust fund context. arguably, the publishing of names in the trust fund context serves not so much to shame the offending party as to inform competitors and potential customers. if the principal function of publishing names is to inform rather than to shame, then the tests for effectiveness would be quite irs and department of justice sought to hold up plan confirmation of individuals who had not filed their tax returns. it did so by objecting to every chapter 13 plan in which the debtor had outstanding tax returns. the bankruptcy judge in richmond, virginia before whom the author practiced, initially took the time to publicly berate each chapter 13 debtor coming before him who failed to file their tax returns explaining to the individual how the failure to file the tax returns was a federal crime for which the individual could be sent to jail, etc. after seeing these motions in case after case, the judge eventually gave up on the failure to file return lecture almost undoubtedly after realizing the extent of the problem and the lack of effect his lectures were having. the problem eventually led to changes in the bankruptcy law in 2005 theoretically preventing debtors from moving forward in chapter 13 cases without the submission of the prior four years returns. 11 u.s.c. § 1308. 238. the irs engages in some publication that could be classified as shaming as it publicizes the “dirty dozen” most offensive tax shelters which plays the dual role of shaming the transaction and warning people away from the transaction. the irs listed transactions could be viewed as a similar type of shaming as is the irs publication of certain settlements with corporations engaged in tax shelters. see blank, supra note 101, at 554. the department of justice regularly publicizes the names of individuals whom it successfully prosecutes or whom it successfully enjoins from promoting tax shelters or improperly preparing tax returns. see supra note 231. 239. kirsch, supra note 228, at 908-12. 240. massaro, supra note 235, at 1930-32. 2011] transparency in private collection of federal taxes 823 different than those set out in massaro’s article. the focus moves from the impact of publication on the offender’s feelings to the impact of publication on the behavior of its customers and, in their reaction, on the offender. other than the few anecdotal consequences cited herein, the effect of the knowledge of an entity’s failure to pay over its trust fund taxes is not known. in addition to the concerns about shaming in the criminal context, kirsch raised concerns about shaming in the civil context because of the way in which it was handled in section 6039g.241 his concerns raise slightly different issues than the ones identified by massaro and likewise need to be addressed in deciding whether to pursue publication as an effective remedy for failing to pay over trust fund taxes. perhaps the largest single distinction between the expatriation statute and the proposal to publish names of entities not paying trust fund taxes is the failure of the definite link between having a tax motivated purpose for expatriation and the publication of the individual’s name in the federal register implying that such a link may exist.242 the link between non-payment of trust fund taxes and publication would clearly exist. the employment or excise tax that gives rise to the trust fund liability is not a tax situation in which uncertainty exists. this is a situation with a straightforward tax and an unpaid liability that is almost always a certainty. the issue for trust fund taxes turns on non-payment and not the sometimes ambiguous language of the internal revenue code in which the existence of a liability itself can be in play.243 241. kirsch, supra note 228, at 889-90. 242. the manner in which states publish the names of the individuals and entities provides a good insight into effective use of publication of non-payment. some states, such as wisconsin, create an easy to use link right on the front page of their website. this model makes it quite easy to locate entities that fail to pay. other states bury the listing of names well into the website making it very difficult, if not impossible to locate the names. for the same reason that publication only in the federal register does not make much sense in this context, neither does publication on a website that is relatively inaccessible. 243. the uncertainty of the liability created one of the concerns expressed by joshua blank in his article. see blank, note 101, at 544. with corporate tax shelters, the government may believe that the claims abuse the tax code but until case law settles the issue, the alleged abuse lacks certainty. uncertainty is also one of the problems with the publication of the names of the expatriates since the list sweeps up all expatriates and even if it were targeting only those who left for tax motivated reasons, it would be difficult to determine those situations in which the tax motive was the sole or primary reason for renouncing citizenship. none of that uncertainty exists with unpaid collected taxes. the liability is almost always a certainty usually stemming from self-assessment but even when it results from adjustments by the irs the dollar amount of the assessment is rarely at issue. 824 florida tax review [vol. 10:10 knowledge that an entity has failed to pay its employment taxes could modify the behavior of competitors of that entity or its customers.244 competitors would seek to find ways to exploit that information and would feel disadvantaged that prior competition occurred on a non-level playing field. in addition, customers might make decisions about entering into longterm contacts with an entity that could not keep current on its employment 244. the failure of federal contractors to pay their collected taxes was the subject of a gao report, u.s. gov’t accountability office, thousands of federal contractors abuse the federal tax system, gao-07-742t, apr. 2007. this report not only found that entities contracting with the united states owed billions of dollars in unpaid employment taxes but determined that the united states had not previously requested information that would allow it to factor such behavior into its decision making process. as a result of this gao report, the federal government proposed to revise the information that contractors must disclose as they seek to contract with the federal government. this caused proposed changes to the federal acquisition regulation (far) – representations and certifications – tax delinquency, 72 fed. reg. 15,093 (mar. 30, 2007). the gao report represents a clear example of how knowledge of the failure to pay collected taxes impacts a potential customer. with that type of customer reaction, one would expect that in the area of federal contractors the incidence of failure to pay collected taxes should significantly decrease. this gao report was one of several on a similar theme. a follow up report was issued later in 2007. u.s. gov’t accountability office, gao-07-563, thousands of organizations exempt from federal income tax owe nearly $1 billion in payroll and other taxes, june 2007. this report shows how the failure to pay collected taxes could impact charitable organizations and the entities making donations to those organizations. this is yet another example of how knowledge of the failure to pay the collected taxes could impact behavior. see, e.g., farah stockman, shell companies in cayman islands allow kbr to avoid medicare, social security deductions, the boston globe, march 6, 2008, available at http://www.boston.com/news/world/articles/2008/03/06/top_iraq_contractor_skirts_ us_taxes_offshore/ (“payroll taxes can be a significant cost, he said, speaking on the condition of anonymity. if you are bidding against [rival construction firms] fluor and bechtel, it might give you a competitive advantage.”) the issue in this article is not so much brown & roots’ failure to pay employment taxes as its setting up a foreign entity to employ individuals in a manner in which it would have no employment tax obligation whatsoever; see also u.s. gov’t accountability office, gao-07-742t, thousands of federal contractors abuse the federal tax system, 34 (april 2007) (“[f]or wage-based businesses that provide goods and services, federal contractors with unpaid federal taxes have an unfair advantage in price competition when competing against other businesses for federal contracts. companies that do not pay their payroll tax, which is typically over 15 percent of the employees’ wages, would have a significantly lower costs advantage and therefore have a substantive competitive advantage over similarly situation businesses that pay their taxes. for example, we identified instances in which companies that had unpaid payroll taxes were competitively awarded contracts over companies that had paid their federal taxes.”) 2011] transparency in private collection of federal taxes 825 taxes since this failure would suggest a lack of financial stability.245 the information could assist both competitors and customers in making decisions.246 many states have embraced shaming as a basis for altering taxpayer behavior in a manner resulting in greater success in tax law enforcement.247 the movement toward shaming in tax laws has increased significantly in the 245. the author knows of one situation in which knowledge that the entity had outstanding collected tax obligations had a direct impact on a potential customer’s decision and drove the customer away. the potential customer was the irs. the irs sought to contract with a hotel in which it would hold a continuing professional education conference for its employees in one state. the contracting officer chose a hotel that had a longstanding problem with the payment of its collected taxes. when the revenue officers knowledgeable about the outstanding taxes learned of the potential contract with the hotel, they became quite vocal about how improper contracting with that hotel would be. their voices were heard and another location was selected. perhaps this example is extreme because of the close nature between the potential customer and the unpaid collected taxes; however, it is not hard to imagine other circumstances in which a potential customer would make a decision not to contact with an entity that did not pay its collected taxes. indeed, the hope in publicizing this information is to assist in creating a culture in which not paying these taxes makes the entity somewhat of a pariah and causes entities in general to want to pay these taxes in order to avoid the stigma that would come from failure to pay. 246. while slightly different in its factual underpinnings, the actions of kellogg, brown & root (kbr) with respect to its workers in iraq provides some insight into how information can impact customer and competitor decisions. based on the information provided in an article in the boston globe on mar. 6, 2008, by farah stockman, kbr apparently avoided paying employment taxes altogether with respect to approximately 20,000 employees it had in iraq by treating the individuals as employees of a cayman island subsidiary. kbr’s customer, the defense department, knew “since at least 2004 that kbr was avoiding taxes by declaring its american workers as employees of cayman islands shell companies, and officials said the move allowed kbr to perform the work more cheaply, saving defense dollars.” the reaction of kbr’s customer is somewhat surprising because of the overall losses to the united states and its citizens from the employment tax maneuver executed by kbr but at least it shows a reaction from a customer aware of the situation. a former executive at halliburton, the parent of kbr, said “payroll taxes can be a significant cost, . . . speaking on the condition of anonymity. ‘if you are bidding against [rival construction firms] fluor and bechtel, it might give you a competitive advantage.’” the article did not contain statements from the competitors but one can imagine what they might say. farah stockman, shell companies in cayman islands allow kbr to avoid medicare, social security deductions, the boston globe, mar. 6, 2008, available at http://www.boston.com/news /world/articles/2008/03/06/top_iraq_contractor_skirts_us_taxes_offshore/. 247. see appendix a for a list of states that have shaming provisions. 826 florida tax review [vol. 10:10 past decade.248 state shaming laws generally follow a pattern of disclosing the 100 or 200 largest delinquent accounts or disclosing accounts exceeding a certain dollar amount.249 they generally do not distinguish between types of taxes. no state, however, focuses its shaming laws on collected taxes. balanced against providing a list that discloses outstanding tax obligations is the general policy that tax information has privacy protections other types of information about an entity do not. the question becomes whether protecting an entity’s privacy with respect to its tax information should extend to money it holds in trust for the united states. the money held in trust for the united states does not reveal any business secrets about an entity. because this type of shaming would occur with respect to an unpaid liability, an exception for disclosure of the information already exists in section 6103(k)(2). in this way, congress has already demonstrated a willingness to reveal this information in a format designed to alert competing creditors of the existence of the liability making the issue of shaming or other disclosure listing of this information one of formatting rather than disclosing.250 shaming seeks to modify behavior by targeting specific taxpayers with the highest unpaid taxes or some other identifying negative tax trait. while some states have expressed what they characterize as success through 248. compare the current list of states engaged in shaming from appendix a with the five states that had adopted this practice in 1999 at the time the joint committee on taxation report to congress was prepared in 2000. see p. 231 of that report; see also u.s. gov’t accountability office, gao-gdd 99-164, federal, state, and local agencies receiving taxpayer information (aug. 1999). like the joint committee report, this gao report was ordered by congress as a result of § 3802 of the revenue reform act of 1998. while the states felt the disclosure of delinquent taxpayers was aiding in the collection of outstanding taxes, no studies quantified the impact of the disclosure. 249. several states have provisions that disclose the greatest delinquent accounts: california, delaware, and rhode island. see infra, appendix a. several other states have provisions that disclose accounts exceeding a certain dollar amount: colorado, illinois, indiana, massachusetts, and wisconsin. see infra appendix a. 250. the irs can file an nftl against any taxpayer with an assessed liability which is unpaid. upon assessment of a tax, the irs computer searches a taxpayer’s account for credits with which to satisfy the assessed liability. if insufficient credits exist on the account, the irs sends the taxpayer a notice and demand letter pursuant to § 6303 demanding payment of the outstanding liability within ten days. if payment is not forthcoming within the ten-day period, §§ 6321 and 6322 cause the creation of a lien against all of the taxpayer’s property and rights to property. this lien, known only to the taxpayer and the irs, is sometimes called the secret lien or assessment lien. in order for this secret lien to defeat certain creditors described in § 6323(a), the irs must file a public notice of the lien pursuant to § 6323(f). that notice is available to the world. the filing of an nftl has serious consequences for credit and financial well-being. 2011] transparency in private collection of federal taxes 827 their shaming laws, shaming has limitations in a modern society as discussed by massaro. the theory underpinning shaming applies equally to all types of unpaid taxes and, in fact, is applied by states adopting shaming laws to a broad spectrum of delinquent taxes.251 because no proof exists that shaming laws succeed, because they represent a departure from the disclosure laws for a somewhat penal reason, and because they represent a broad based exception to the disclosure laws rather than one targeted to collected taxes, this article does not propose shaming laws as the remedy for increasing collected tax compliance.252 in addition to broader policy implications for rejecting shaming as a remedy for collecting collected taxes, a more specific reason exists for the circumstances of these taxes. shaming would not serve as an adequate deterrent to individuals and entities considering the improper use of collected taxes. tax shaming occurs well after the use of this money in a circumstance in which the money is frequently faced with a more immediate and real form of shaming, business failure. while some persons may fail to pay collected taxes motivated purely by the personal gain of “embezzling” collected taxes,253 the majority of persons using collected taxes do so because of liquidity issues with the business. when collected taxes become the operating capital of businesses with liquidity issues, the people making the decision to do so already face very real shaming issues. these people face the shame of losing their business and perhaps losing their home and other personal assets.254 the 251. r.i. gen. laws § 44-1-34 (2010). rhode island’s division of taxation website lists the top 100 delinquent taxpayers which includes all types of state tax delinquencies, including personal, sales, withholding, corporate and inheritance taxes. 252. although articulated almost solely on the unproven aspect of the success of shaming, the joint committee on taxation reached the same conclusion in its 2000 report. see jct report (vol. i), supra note 10, at 238-40. at the time of that report only five states had shaming laws. obviously, the allure of shaming to states has grown since that time. because of the difficulty of separating the positive effect that shaming has on compliance from other causes, the empirical case for shaming still lacks a strong underpinning. the concerns voiced by the joint committee and others as cited above, still raise a cautionary flag to this approach. it also has some disconnects with the policy reasons underlying disclosure unless you view the shaming provisions solely as an extension of the lien filing as discussed further below. 253. shaming serves as an unlikely deterrent to those setting out to cheat. for those persons, strong enforcement measures must deter. 254. the stress of these types of situations also leads to the loss of relationships. financial difficulties of the type encountered by those running failing businesses frequently lead to the dissolution of marriages which further serves to drag individuals in this circumstance down a financial and emotional hole. in this 828 florida tax review [vol. 10:10 shame of having their name published on a list by the irs at some distance point in the future may come far down the list of matters causing them deep personal pain. the shaming remedy when applied to collected taxes seeks to shame the individual or entity responsible into paying the taxes at a point when the business has often failed and the individual is broke. no amount of shame can bring money into the government when the party shamed has no ability to pay the taxes. publication of the information of non-payment must come at an earlier stage when business decisions concerning the use of the trust fund money still have meaning.255 while shaming might deter a large corporation from investing in a tax shelter that will marginally improve its profits,256 the issues facing most entrepreneurs who tap collected taxes for working capital differ significantly and suggest that the shame from publication of non-payment of taxes may pale in comparison to the shame they seek to avoid by using the collected tax dollars. for this specific reason, as well as for the more general reasons discussed here, shaming is not recommended as a better policy alternative to broad disclosure of collected tax returns. b. disclosing some returns containing collected tax information as discussed above the failure to pay over collected taxes occurs in small businesses, usually during their start up phase when working capital needs achieve acute status. since large businesses almost never have issues with failure to pay over collected taxes, should these businesses suffer the requirement of disclosure of their collected tax return information when such information will rarely disclose anything other than the timely filing and payment of the required taxes. given the realities of when the failure to pay collected taxes occurs, would a disclosure provision targeted at the businesses most likely to have difficulty be preferable to the broad disclosure of these tax returns? through a targeted use of disclosure the possibility exists that the benefits of making information available could exist without burdening all entities that collect taxes with disclosure. disclosure could occur for those entities in the target group which failed to timely file or pay their collected taxes.257 this approach would resemble shaming in the sense that it would situation shaming will not cause the person to pay over the money. it simply puts more fuel on the fire of a life situation going up in flames. 255. the publication of returns of collected taxes comes at this early stage and would seem a much more effective mechanism for effecting behavior of those making decisions about this money than the much later publications of shaming lists. 256. not everyone would agree with this point. see blank, supra note 101, at 540. here, it serves merely as an illustration in contrast. 257. ark. code ann. § 26-18-303(b)(18) (2010) (“for the purpose of the timely and accurate collection of local sales and use tax and state income tax 2011] transparency in private collection of federal taxes 829 not publish all entities, only the names of the “bad” entities. it would also resemble general disclosure from the perspective that it would provide information about all entities because it would provide information about all entities within the target group. the exceptions to the rule of disclosure for tax-exempt organizations, political organizations, and pension plans do not provide for disclosure of only a part of the group of impacted entities. in each of those exceptions, all of the returns of exempt organizations or pension plans are displayed openly. no effort exists in the provisions opening those returns to the public to distinguish between good and bad taxpayers or large and small taxpayers.258 such a distinction would not make sense in the disclosure of the returns of exempt organizations, political organizations, or pension plans since the goal of disclosure stems from a broad desire for knowledge about all of the organizations. one distinction, however, between pension plans and collected taxes is that the information on the pension plan return provides a picture into a complex investment situation. the payment or non-payment of collected taxes, however, is a black and white situation—either they were paid or they were not paid; the same simplicity of compliance does not exist in the pension plan situation. the amount necessary to properly fund a pension plan, while calculated by actuaries, does not represent the same type of clearcut picture presented by collected taxes. for this reason publication of all pension returns provides information beyond the payment or non-payment situation presented with collected taxes. therefore, it makes sense to publicize all pension plan returns because of the information such publication provides where a similar publication of the returns of collected taxes does not serve the same function. if not all collected tax returns were published, the next issue concerns how to make the division between publishing and not publishing. this decision could rest on whether the return has unpaid taxes. the policy withholding for employees, disclosure of the name and address of a taxpayer that has failed three (3) times within any consecutive twenty-four-month period to either report or remit state or local gross receipts or compensating use tax or state income tax withholding for employees and has been served with a business closure order under § 26-18-1001 et seq.”) see arkansas department of finance & administration revenue division, sales tax business closures update, state revenue tax quarterly, volume xi, no. 1 (2005), at 3-4 (describing this provision with respect to sales taxes). 258. there are some distinctions concerning the publication of pension plan information which leaves out some of the information of the smaller plans in an apparent recognition that the smaller plans do not raise the same overall concerns as the large ones. i.r.m. 11.3.10.3. (“documents relating to plans with 25 or fewer participants are available only to plan participants, the plan sponsor, or their authorized representatives.”) 830 florida tax review [vol. 10:10 decision made along such grounds would parallel, in many ways, the policies present with respect to shaming. as mentioned above, at least one of those policy decisions has already been made in the area of federal tax liens. a decision to publish all collected tax returns on which the taxpayer has an outstanding balance in actuality provides little more information to the public, if any, than would already exist with the nftl.259 such a decision involves small policy issues of the formatting of information but not broader policy issues of whether to allow such information into the public realm.260 another way to limit publication of collected tax returns would be to publish all collected tax returns of entities of a certain size or age. size 259. as discussed above in notes 128-31 and accompanying text, the irs can decide to make public the outstanding liability on any collected tax by simply filing an nftl. irc §§ 6323(f), 6103(k)(2). filing an nftl notifies the “world” that a taxpayer has an unpaid federal tax liability. because credit reporting agencies almost always search for filings of the nftl, these filings generally have significant negative consequences to the taxpayers against whom the liens are filed. see 2010 nta annual report, supra note 143, at 54 (discussing effect of filing an nftl and urging for more measured approach to filing of nftl). despite the fact that the world knows about the lien when the nftl occurs, many people do not know because of where the lien filing occurs. section 6323(f) requires filing of the notice in the place where the taxpayer resides in order to perfect the lien as to personalty and in the location of any real property with respect to such property. unless one frequents courthouses or their online databases, where available, knowledge of the filing of the nftl would require some searching. public knowledge would come easier if a national tax lien registry were adopted. t. keith fogg, national tax lien registry, 120 tax notes 783 (aug. 25, 2008). still, even a national registry would lump all types of taxes together not highlighting collected taxes. some states take the position that the existence of a published lien allows them to highlight liabilities in their shaming websites. e-mail from va tax customer service, to fleming ware, research assistant, villanova university school of law (july 9, 2009, 09:19 est) (on file with author). the irs could not take that approach because of the uncertain state of the law regarding the public records exception. the circuits have split on the issue of whether allowable public disclosure of information in one setting allows publication of that same information by the irs in other settings. see jct report (vol. i), supra note 10, at 70-81 (citing lampert v. united states, 854 f.2d 335, 338 (9th cir. 1988), cert. denied, 490 u.s. 1034 (1989) (holding that “if a taxpayer’s return is lawfully disclosed in a judicial proceeding . . . [t]he information is no longer confidential and may be disclosed again without regard to § 6103”); rowley v. united states, 76 f.3d 796 (6th cir. 1996) (holding that once return information becomes public through filing and recording of judicial lien, it is no longer confidential); mallas v. united states, 993 f.2d 1111 (4th cir. 1993) (holding that the united states is liable when is discloses return information that was previously made part of public records). 260. the debate over the public disclosure exception seems like a “small” policy issue of the format and procedure for disclosure rather than the larger policy decision of whether to disclose. 2011] transparency in private collection of federal taxes 831 measurement could occur in a number of ways; however, the ideal method for such a limitation would turn on finding the break point at which entities, based on size or some similar criteria, no longer fail to pay over the collected taxes. disclosure of all returns reporting collected taxes would occur below that break point. this method, like the reporting of all entities, might create administrative simplicity while avoiding publishing information about collected taxes that in almost all instances would simply report that they were paid. the internal revenue code contains many numerical cut off points that base reporting, and other decisions, on size or similar criteria. creating another such break point would not create precedent but would add a small layer of complexity in administration that simply reporting all returns would not create. while placing a limit on reporting holds some allure because it avoids dumping information into the public with very limited benefit, the simplicity of a policy decision that requires publication of all returns of collected taxes holds the greater allure. for that reason, the limited publication of returns reporting collected taxes is not recommended. viii. conclusion returns reporting collected taxes differ from other tax returns both in the type of information they report and the underlying nature of that information. disclosing these returns is consistent with current disclosure policy when these returns are viewed as similar to the returns disclosed under section 6104. disclosing these returns is consistent with good collection policy because their disclosure informs the taxpayer of the important and different nature of collected taxes as well as informing the public of compliance regarding collected taxes. for these reasons, the returns of collected taxes should move from the restrictive circumstances of section 6103 to the openness of section 6104. 832 florida tax review [vol. 10:10 appendix a states with shaming laws and their websites (as of august, 2010) alabama ala. code § 40-5-23 (lexisnexis 2010) the tax collector must publish twice during the month of july a list of delinquent taxpayers. the publication shall be made in a daily newspaper printed and published in the county in which the taxpayer lives. if no such paper is published, a weekly paper will suffice. if there is neither a daily nor a weekly newspaper of any sort published in said county, the tax collector shall publish the list in the courthouse and in other conspicuous places in said county. the tax collector must keep said posting available for the public during the entire month of july. alaska alaska does not have a shaming statute. arizona arizona does not have a shaming statute. arkansas ark. code ann. § 26-36-203 (2010) no later than december 1 of each year, the county tax collector shall prepare a list of delinquent personal property taxes and deliver a copy of the list to a legal newspaper in the county. the newspaper shall publish the list within seven days. the list must be in at least seven-point font. the list shall show the name of the taxpayer, the taxpayer’s school district, and the total amount of taxes delinquent. california cal. rev. & tax. code § 19195 (deering 2010) the franchise tax board shall make available as a matter of public record each calendar year a list of the 250 largest delinquencies in excess of $100,000 as of december 31 of the preceding year. colorado colo. rev. stat. § 24-35-117 (2010) the executive director of the department of revenue shall annually disclose a list of all taxpayers delinquent in the payment of tax liabilities collected by the department. the list shall include only those taxpayers with total delinquent final liabilities for all taxes collected by the department in an amount 2011] transparency in private collection of federal taxes 833 greater than $20,000 for a period of six months from the time that a distraint warrant issues or may issue. the list shall contain the name, address, types of taxes, month and year in which each tax liability was assessed, the amount of each tax outstanding of each delinquent taxpayer, and, in the case of a corporate taxpayer, the name of the current president of the corporation. connecticut conn. gen. stat. § 12-7a (2010) the commissioner of revenue services shall prepare and maintain a list related to each type of tax levied by the state, containing the name and address of any person or corporation liable for payment of any such tax and the amount thereof which tax is unpaid and a period in excess of ninety days has elapsed following the date on which such tax was due. such lists shall be available to the public for inspection by any person. delaware del. code ann. tit. 30, § 359(b) (2010) the secretary of finance shall prepare, maintain, and publish on the division of revenue internet website, two lists of taxpayers owing unpaid tax and additions to tax finally determined to be due under title 30 for personal income tax and business taxes administered by the department of finance. each list shall consist of the 100 taxpayers owing to delaware the greatest amount of unpaid tax and shall contain the name and address of each such taxpayer, the total type and amount of tax and additions to tax due and the date the amount was finally determined to be due. in the case of entities other than natural persons, the list may also name any persons who were at least 25% owners or beneficial owners or who were responsible officers of such entity at or after the time the liability was created. district of columbia district of columbia office of tax and revenue, delinquent taxpayers, http://otr.cfo.dc.gov/otr/cwp/view,a,1330,q,593715, otrnav_gid,1679,otrnav,|33288|.asp (last visited aug. 9, 2010). 834 florida tax review [vol. 10:10 the district of columbia publishes a list of its delinquent taxpayers as part of an overall program to encourage voluntary compliance with the district’s tax laws. the list contains the taxpayer's name, address, and amount owed. in the case of a business, the responsible officer and his/her address is listed. florida florida does not have a shaming statute. georgia ga. code ann. § 48-3-29 (2010) the commissioner may publish in the media or on the internet for public access any or all information with respect to executions issued for the collection of any tax, fee, license, penalty, interest, or collection costs due the state which are recorded on the public records of any county. hawaii haw. rev. stat. ann. § 231-32 (lexisnexis 2010) hawaii department of taxation, list of delinquent taxpayers with large balances, http://www6.hawaii.gov/tax/a2_b2_2delinq.htm (last visited aug. 9, 2010). the department of taxation shall prepare and maintain, open to public inspection, a complete record of the amounts of taxes assessed in each district that have become delinquent with the name of the delinquent taxpayer in each case. this list may be published on the internet after taxpayers have had a final opportunity to settle their debt. idaho idaho does not have a shaming statute. illinois 20 ill. comp. stat. ann. 2505/2505-425 (lexisnexis 2010) state of illinois department of revenue public list of delinquent taxpayers, http://www.revenue.state.il.us/aboutidor/delinquent list.html (last visited aug. 9, 2010). the director may annually disclose a list of all taxpayers that are delinquent in the payment of tax liabilities collected by the department. the list shall include only those taxpayers with total final liabilities for all taxes collected by the department 2011] transparency in private collection of federal taxes 835 in an amount greater than $1,000 for a period of six months from the time that the taxes were assessed. the list shall contain the name, address, types of taxes, month and year in which each tax liability was assessed, the amount of each tax outstanding of each delinquent taxpayer, and, in the case of a corporate taxpayer, the name of the current president. illinois is in the process of creating a website for publication of this list. indiana ind. code ann. § 6-8.1-3-16 (lexisnexis 2010) the department shall compile each month a list of the taxpayers subject to tax warrants that were issued at least twenty-four months before the date of the list and are for amounts that exceed $1,000. the list must identify each taxpayer liable for a warrant by name, address, and amount of tax. the department shall publish the list on access indiana and make the list available for public inspection and copying. the department may not publish a list that identifies a particular taxpayer unless at least two weeks before the publication of the list the department sends notice to the taxpayer. iowa iowa does not have a shaming statute. kansas kansas does not have a shaming statute. kentucky ky. rev. stat. ann. § 131.650 (lexisnexis 2010) the department may publish a list or lists of taxpayers that owe delinquent taxes of fees administered by the department of revenue. a taxpayer may be included on the list if the taxes owed remain unpaid at least forty-five days after the dates they became due and payable and a tax lien or judgment has been filed of public record against the taxpayer. if the listed taxpayers are business entities, the department of revenue may also list the names of responsible persons assessed. notice must be given to the affected taxpayers before any list is published. louisiana la. rev. stat. ann. § 47:1508 (2010) 836 florida tax review [vol. 10:10 the secretary may disclose the name and address of the taxpayer, the type of delinquent taxes due, and the total amount of tax, penalty, and interest due. if the taxpayer is a business entity, the secretary may additionally name any owner who owns at least a 50% ownership interest in the entity. the disclosure may be made in a newspaper, magazine, or in electronic media, such as television or the internet. the secretary must provide written notice by registered mail to the taxpayer. maine maine does not have a shaming statute. maryland comptroller of maryland caught in the web, http://compnet.comp.state.md.us/compliance_divisi on/collections/general_collections_information/ca ught_in_the_web.shtml (last visited aug. 9, 2010). maryland publishes the names of businesses, individuals, and corporate officers having large unresolved liabilities (including individuals who have large unresolved personal income tax liabilities). all of the information is public, because liens and judgments have been recorded in the judgment dockets of one or more circuit courts of maryland. massachusetts mass. ann. laws ch. 62c, § 21(b)(11) (lexisnexis 2010) massachusetts department of revenue, public disclosure, https://wfb.dor.state.ma.us/dorcommon/publicdisclo sure/disclosure.aspx (last visited aug. 9, 2010). massachusetts allows disclosure by the commissioner of a list of all taxpayers that are delinquent in the payment of their tax liabilities in an amount greater than $25,000 for a period of six months from the time the taxes were assessed. the list shall contain the names, address, types of taxes, month and year assessed, and amounts outstanding of said delinquent taxpayer. massachusetts publishes this list online. michigan michigan does not have a shaming statute. 2011] transparency in private collection of federal taxes 837 minnesota minnesota no longer has a shaming statute. mississippi mississippi does not have a shaming statute. missouri email from kathy mantle, collections and tax assistance, state of missouri, to fleming ware, research assistant, villanova university school of law (july 8, 2009, 14:11 est) (on file with author). missouri publishes a list of businesses that have had their sales licenses revoked for failure to remit sales tax, but does not publish a list of the state’s largest delinquent taxpayers. montana email from russ hyatt, accounts receivable and collections bureau, business and income tax division, state of montana, to fleming ware, research assistant, villanova university school of law (july 8, 2009, 14:09 est) (on file with author); mont. code ann. §§ 3-5-508-09 (2010). the montana department of revenue publishes a list of the state’s delinquent taxpayers. the list includes only taxpayer's names for tax debts that montana has filed a warrant for distraint against them for the tax debt they owe. authority is derived from cited statute. nebraska nebraska does not have a shaming statute. nevada nev. rev. stat. ann. § 361.300 (lexisnexis 2010) on or before january 1 of each year, the county assessor shall transmit to the county clerk, post at the front door of the courthouse and publish in a newspaper published in the county a notice that the tax roll is complete and open for public inspection. additionally, the list may be posted in public areas of public libraries, in public areas of courthouses, and on a website. new hampshire new hampshire does not have a shaming statute. new jersey email from new jersey taxation, to fleming ware, research assistant, villanova university school of law (july 8, 2009, 13:00 est) (on file with author); new jersey division of taxation’s largest 838 florida tax review [vol. 10:10 judgmented taxpayer listing, http://www.state.nj.us/treasury/taxation/jdgdiscl.sht ml (last visited aug. 9, 2010). new jersey publishes a list of delinquent taxpayers; however, the website is currently under construction. new mexico new mexico no longer has a shaming website. new york new york does not have a shaming statute. north carolina north carolina tax debtors, http://www.dor.state .nc.us/collect/debtor_info.html (last visited aug. 9, 2010). north carolina publishes a list of delinquent taxpayer’s names, the type of tax owed, and the amount of the tax. north dakota north dakota does not have a shaming statute. ohio ohio rev. code ann. § 5719.04 (lexisnexis 2010) ohio prepares a tax list containing the name of the person charged and the amount of such taxes and the penalty. the auditor shall cause a copy of the delinquent personal and classified property tax list to be published twice within sixty days in a newspaper published in the english language in the county and of general circulation thereof. oklahoma email from tim rudek, oklahoma tax division account maintenance division, to fleming ware, research assistant, villanova university school of law (july 13, 2009, 08:25) (on file with author). oklahoma tax commission, http://www.tax .ok.gov/top100.html (last visited aug. 9, 2010). oklahoma publishes a hard list of delinquent taxpayers owing taxes for which a warrant has been issued. oregon oregon does not have a shaming statute. pennsylvania pennsylvania no longer has a shaming website. 2011] transparency in private collection of federal taxes 839 rhode island r.i. gen. laws § 44-1-34 (2010); rhode island division of taxation, top 100 tax delinquents, http://www.tax.ri.gov/misc/top100.php (last visited aug. 9, 2010). the tax administrator is authorized by statute to prepare a list of names of the 100 delinquent taxpayers who owe the largest amount of state tax and whose taxes have been unpaid for a period in excess of ninety days following the date their tax was due. south carolina south carolina’s debtor’s corner, http://www.sctax. org/delinquent/delinquent.shtml (last visited aug. 9, 2010). the south carolina department of revenue publishes information pertaining to some of the largest uncollected liabilities owed to the citizens of south carolina. all of the information provided on the list is public information as a result of the department of revenue’s having filed a tax lien with the clerk of court/register of deeds in the county of residence. debt information may also be obtained directly for the department of revenue. the list includes the name of the taxpayer, the taxpayer’s address, and the amount owed. south dakota south dakota does not have a shaming statute. tennessee tennessee does not have a shaming statute. texas texas does not have a shaming statute. utah utah does not have a shaming statute. vermont vermont does not have a shaming statute. virginia email from va tax customer service, to fleming ware, research assistant, villanova university school of law (july 9, 2009, 09:19 est) (on file with author); virginia delinquent taxpayer list, http://www.tax.virginia.gov/site.cfm?alias=delinque ntdebtors (last visited aug. 9, 2010). virginia publishes the names of businesses having unresolved tax liabilities. the list includes 840 florida tax review [vol. 10:10 the name of the business, address, and amount of tax owed. the information contained in the list is public information as a memorandum of lien has been filed on the debts listed in the circuit court. washington wash. rev. code ann. § 82.32.330(3)(c) (lexisnexis 2010). washington may publish the names of taxpayers against whom a warrant has been either issued or filed and remains outstanding for a period of at least ten working days. west virginia west virginia does not have a shaming statute. wisconsin wis. stat. § 73.03(62) (2010). it shall be the duty of the department of revenue, and it shall have the power and authority to prepare and maintain a list of all persons who owe delinquent taxes to the department, in excess of $5,000, which are unpaid for more than ninety days after all appeal rights have expired. the department shall post the names of persons from this list on the internet at a site that is created and maintained by the department for this purpose. the department shall distribute the posted information to internet search engines so the information is searchable. the internet site shall list the name, address, type of tax due, and amount of tax due, and the internet site shall contain a special a special page for the 100 largest delinquent taxpayer accounts. wyoming wyoming does not have a shaming statute. i. introduction ii. history of disclosure laws iii. collecting taxes for the united states iv. disclosure policy considerations a. irc section 6103 b. section 6104 c. placement of collected taxes within disclosure regime v. changes to current return forms vi. how mechanics of disclosure should take place vii. disclosure policy aspects of proposal a. shaming b. disclosing some returns containing collected tax information viii. conclusion 539 florida tax review volume 8 2007 number 5 tax consequences when a new employer bears the cost of the employee’s terminating a prior employment relationship by douglas a. kahn jeffrey h. kahn i. introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540 ii. the tax consequences of each of the three approaches that are available to the new employer and the employee. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542 a. the tax consequences when the new employer makes the buy out payment or reimburses the employee. . . . . . . . . . . . . . 542 1. deductibility of the employee’s payment of the buy out. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543 2. the employer’s payment or constructive payment constitutes a nonitemized deduction. . . . . . . . . . . . . . . 545 3. the employer’s payment is excluded from the employee’s income because the employee is merely an incidental of that payment. . . . . . . . . . . . . . . . . . . . . . . 549 b. the tax consequences when the new employer pays greater wages to the employee to help him make the buy out payment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553 c. the employee makes the buy out payment and receives nothing from the new employer to offset that payment . . . . 554 ii. conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 554 540 florida tax review [vol.8:5 * paul g. kauper professor, university of michigan law school. ** professor, pennsylvania state university, dickinson school of law. the authors wish to thank professor gregg polsky for his helpful comments on the piece. 1.for example, steve alford is leaving the university of iowa to coach new mexico state, john pelphrey is leaving south alabama to coach arkansas, billy gillispie is leaving texas a&m to coach kentucky, bob huggins is leaving kansas state to coach west virginia, tubby smith is leaving kentucky to coach minnesota, john beilein is leaving west virginia to coach at michigan, and todd lickliter is leaving butler to coach at the university of iowa. 2. both huggins (under contract at kansas state) and beilein (under contract at west virginia university) were required to pay the university in order to terminate the contract. 3. under the employment contract with west virginia university, beilein was required to pay $500,000 per year for the number of years remaining on the contract. beilein had five years remaining and thus most news stories reported the payout amount as $2,500,000, but considering the time-value of money, an up-front payment should be less. tax consequences when a new employer bears the cost of the employee’s terminating a prior employment relationship by douglas a. kahn * jeffrey h. kahn** i. introduction the next few months will be busy ones for moving companies that have ncaa basketball coaches as customers. in the past few months, several men’s college basketball coaches have accepted jobs at different schools. several of1 those coaches, who were still under contract at their former institution, had buy out provisions that allowed them to terminate their relationship for a set price.2 john beilein is a prominent example of this since his buy out price was so high. last season, beilein was the head basketball coach at west virginia university where he was under contract with the school until 2012. on april 3 of this year, the university of michigan hired beilein to become the head coach of its men’s basketball team. under his contract with west virginia university, if beilein left that position before the contract term expired, he was required to pay a specified amount to the university. initially, it was reported that the amount to be paid was in the vicinity of $2,000,000 to $2,500,000.3 subsequently, it was reported that west virginia and beilein agreed that 2007] tax consequences when a new employer bears the cost 541 4. see nathan fenno, “beilein, west virginia reach deal on buyout,” the ann arbor news, apr. 27, 2007, p. b5. the report does not indicate whether any interest is payable on the installment payments nor does it indicate why west virginia agreed to settle for less than the contract amount. note that the cancellation of a portion of beilein’s debt does not cause him to recognize any income. see jeffrey kahn & joshua fershee, tax magic: did billy donovan pull income out of a hat?, 116 tax notes 389 (2007). 5. see, michael rosenberg, “ball appears in beilein’s court,” detroit free press, mar. 29, 2007 (“early in the process, beilein’s $2.5 million buyout looked like a potential deal-killer. not anymore. the buyout has been the one constant in the whole process martin [michigan’s athletic director] knew from the beginning that he would have to write a big check to get beilein.”) 6. see “beilein’s buyout price has variables” ann arbor news, mar. 31, 2007. 7. according to university of michigan officials, the university of michigan did not pay the buy out which was viewed by the university of michigan as a personal obligation between beilein and west virginia university. see “beilein to earn more than $1 million a year” ann arbor news, apr. 4, 2007 (“no language about beilein’s $2.5 million buyout with west virginia is included in the contract. the athletic beilein would pay the university $1,500,000 over a five-year period in full settlement of his obligation.4 prior to beilein’s hiring, there was speculation in the media that the university of michigan would pay west virginia university the amount owed under beilein’s contract. the question then arose as to the tax consequences5 to beilein that such a payment would engender. 6 the determination of the tax consequences to an employee whose new employer makes the buy out payment owing to the employee’s prior employer raises issues that can arise in numerous circumstances and so warrants consideration. while we focus on beilein’s facts in this article, that is merely for convenience; and the issue is of much wider significance. the tax treatment of buy out obligations is merely a subset of the broader question of how to tax a new employer’s payments of personal obligations of the new employee that are connected to the commencement of the new employment. for example, a new employer’s payment of the fee owed by the new employee to an employment agency for locating the job raises similar issues. there were three possible methods for the university of michigan to address beilien’s buy out provision: (1) the university of michigan could pay, or reimburse beilein for, the required buy out; (2) while the university of michigan would neither pay the required buy out amount nor specifically reimburse beilein, the university could pay beilein a higher salary in order to offset or mitigate his buy out expense and (3) the university of michigan could neither pay the buy-out nor reimburse beilein, and no additional compensation would be paid to beilein to offset his expense. according to reports, the deal between the university of michigan and beilein adopts the third option.7 542 florida tax review [vol.8:5 department official said michigan won’t be responsible for the sum.”) and “contract buyout was not an issue” ann arbor news, apr. 5, 2007 (“michigan won’t be responsible for any of beilein’s $2.5 million buyout with west virginia.. ‘it never came up, and there’s no way michigan would have ever paid it,’ [athletic director bill] martin said.”) 8. for example, both beilein and huggins have buy out provisions in the contracts with their new schools. 9. see regs. §§ 1.62-2(d)(1), and 1.162-17(b)(1). while regs. § 1.62-1t(e)(5) refers the reader to irc § 132 and the regulations thereunder for the treatment of an expense which is paid directly by the employer, it does not say that § 132 is the exclusive provision that deals with that situation; and it leaves open the possibility that the nonitemization provision of irc § 62(a)(2)(a) can also apply. moreover, any inference in that temporary regulation that § 132 might be the exclusive provision that applies to direct payments by the employer is contradicted by the final regulation, regs. § 1.62-2(d)(1), that was adopted in a subsequent year. the subsections of § 132 that apply to direct payments are § 132(a)(3), and (d), the working condition fringe provision. but § 132(d) is not restricted to an employer’s direct provision of property or services to an employee; it also can apply to cash paid to an employee to be used to this article will examine the possible tax consequences for each of the three options. ii. the tax consequences of each of the three approaches that are available to the new employer and the employee a. the tax consequences when the new employer makes the buy out payment or reimburses the employee originally, the media assumed that the university of michigan would either pay the buy out directly or reimburse beilein for the payment. as noted above, contrary to that assumption, the parties have asserted that the university of michigan will not bear any of that cost. nevertheless, it is useful to determine what would have been the likely tax consequence if the university of michigan had paid or reimbursed that liability. since buy out provisions are common in certain types of employment contracts, that issue is likely to arise8 in the future. of the three available options, the question of the tax treatment of a new employer’s payment or reimbursement of the buy out expense is the most interesting and potentially the most controversial. in determining the tax consequences when the new employer bears the buy out liability, it makes no difference whether the employer makes the buy out payment directly or reimburses the employee for making it since the substance of those two circumstances are identical. the tax law will treat those two circumstances the same; that is, even if the new employer makes the buy out payment directly to the old employer, it will be treated as a payment by the employee followed by a reimbursement from the new employer. 9 2007] tax consequences when a new employer bears the cost 543 pay for property or expenses. regs. § 1.132-5(a)(1)(v). it is therefore highly unlikely that regs. § 1.62-1t(e)(5) seeks to make § 132(d) exclusive since that would mean that it would be the exclusive provision applicable to direct payments by an employer, but would not be the exclusive provision that applies to reimbursements. since § 132(d) applies to both, what reason could there be for making it exclusive as to one and not as to the other? 10. old colony trust co. v. comm’r, 279 u.s. 716 (1929). see rev. rul. 70282, 1970 -1 c.b. 16, and rev. rul. 66-41, 1966-1 c.b. 233. beilein’s buy out obligation arose out of his employment relationship with west virginia university. it is his personal obligation. there is considerable authority that an employer’s payment of an employee’s personal obligation constitutes gross income to the employee. it is very likely,10 therefore, that the service would contend that the new employer’s payment of the buy out obligation is additional compensation to the employee and taxable to him. contrary to that view, the authors contend that there are several strong and independent reasons why the employee will not bear any tax liability for such payments, and would likely prevail on that issue if it were litigated. 1. deductibility of the employee’s payment of the buy out before examining the tax liability issues, a preliminary issue must be resolved – that is, whether an unreimbursed buy out payment made by the employee to terminate his employment relationship with the former employer is a deductible business expense of the employee under irc section 162. as we shall see, the resolution of that question is crucial to the resolution of one of the issues concerning the proper tax treatment of the payment by the new employer. note that if the employee’s payment were fully deductible by him, then it would not matter whether the employer’s payment or reimbursement constitutes income to the employee since any income recognized by the employee would be washed out by the deduction allowed to him. if the employer’s payment or reimbursement is included in the employee’s income, it is reduced to zero by the full deduction that the employee would receive; and that nets out to zero net income. if a payment or reimbursement is not income to the employee, then the employee would not be allowed a deduction since he would not then be treated as having made the payment. in either case, the net result is that the employee would have no tax liability. indeed, since many reimbursed business expenses of an employee are nonitemized deductions for the employee, the service allows the employee to omit those reimbursements from income and take no deduction for the expense rather than to bother reporting the income and the offsetting deduction on the employee’s tax 544 florida tax review [vol.8:5 11. regs. § 1.162-17(b)(1). to qualify for this permission to exclude both the income and the deduction, the employee must be required to account to the employer for the expenses, and must do so. this provision applies to expenses that are paid directly by the employer as well as to those that are paid by an employee who is reimbursed by the employer. 12. steger v. comm’r, 113 t.c. 227, 231 (1999) (quoting pacific coast biscuit co. v. comm’r, 32 b.t.a. 39, 43 (1935)). since, in addition to being a cost of terminating a business relationship, the fee could also be viewed as a cost of facilitating the creation of a new contract, the question arises as to whether it should be treated as a nondeductible capital expenditure for the creation of a new contract. reg. § 1.263(a)-4(e)(1)(ii) expressly provides that the “amount paid to terminate (or facilitate the termination of) an existing agreement does not facilitate the acquisition or creation of another agreement ... .” thus, the payment to terminate an existing employment agreement is deductible. see rev. rul. 2000-7 (the cost of removing existing telephone poles in order to replace them with new poles is a deductible expense). the authors wish to thank professor gregg polsky for making this point. 13. irc §§ 62(a)(1), 67(b); regs. § 1.62-1t(e)(3). 14. irc § 67(a). 15. irc § 68. the overall limitation of § 68 is being phased out by the economic growth and tax relief reconcilliation act of 2001, but is scheduled to revive with full force beginning with the year 2011. see irc § 68(f), (g); but see economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, § 901(a), 115 stat. 38, 150 (2001). return. as we shall see, while an employee’s unreimbursed payment is11 deductible under irc section 162, it is not fully deductible; and so further analysis is required. a payment made by an employee to terminate an employment contract constitutes a business expense that is deductible under section 162. “it has long been established that the cost of dissolution and termination of a business constitutes ‘an everyday happening in the business world,’” and so “constitutes an ordinary and necessary . . . expense” that is deductible under irc section 162 as a business expense when “‘directly connected with, or, as otherwise stated . . . proximately resulted from the taxpayer’s business.’” in the beilein12 circumstance, the employee’s prior employment constituted a business and so the cost of terminating that employment was a business expense that is deductible under section 162. however, an unreimbursed employee business expense is a miscellaneous itemized deduction.1 3 miscellaneous itemized deductions are deductible only to the extent that the aggregate of such deductions exceeds 2% of the taxpayer’s adjusted gross income. moreover, the amount of the deduction is subject to the overall14 limitation on most itemized deductions imposed by section 68. in the case of15 a large payment, such as the amount payable under beilein’s contract to west virginia university, those limitations are not likely to matter because 2007] tax consequences when a new employer bears the cost 545 16. irc § 56(b)(1)(a)(i). 17. to make matters worse, if the employer pays the tax that the employee incurred from the employer’s payment of the termination fee, the payment of that tax will also be included in the employee’s gross income. old colony trust. co. v. comm’r, 279 u.s. 716, 729 (1929). moreover, if the employer then pays the income tax due on its payment of the employee’s tax liability, that payment also will be included in the employee’s gross income, and so on. regs. § 1.61-14(a); safe harbor water power corp. v. u.s., 303 f.2d 928 (ct. cl. 1962). 18. regs. § 1.62-1(c)(2). miscellaneous itemized deductions are not deductible at all for purposes of the alternative minimum tax; and the presence of a large miscellaneous16 itemized deduction makes it a virtual certainty that beilein would be subject to taxation under that system. consequently, if the employee’s deduction cannot be excluded from the miscellaneous itemized deduction category, the employee will derive little or no benefit from it. if the employer’s payment of the termination fee constitutes gross income to the employee, the employee will incur a large tax liability since little or none of his deduction for that payment will be of any use to him.17 contrary to that unfavorable tax situation, it is the view of the authors that the new employer’s payment of the termination fee that the employee owed will not cause any tax liability to the employee. there are two independent reasons why that is so. while each of those reasons can be questioned, if either one of them is held to be valid, the employee will not have any tax liability. 2. the employee’s payment or constructive payment constitutes a nonitemized deduction a nonitemized deduction is one that is taken into account in determining adjusted gross income (agi) and so is fully deductible under both the regular and the alternative income tax systems. none of the limitations that are imposed on itemized deductions is applicable to it. in the beilein type situation, the employee is reimbursed by the new employer for his payment (or constructive payment) of the buy out. as noted above, the payment qualifies as an employee business expense that is deductible under section 162; and, unless reimbursed by the employer, the deduction will be a miscellaneous itemized deduction. however, if reimbursed by the employer under a reimbursement arrangement, the payment or constructive payment of the employee will constitute a nonitemized deduction under section 62(a)(2)(a) if certain conditions are satisfied. let us consider those18 conditions. for an employee business expense to qualify for nonitemization treatment, the statute requires that the expense be incurred in connection with 546 florida tax review [vol.8:5 19. irc § 62(a)(2)(a). 20. regs. § 1.62-2(b). that same restriction is stated in regulations involving related statutory provisions. see generally regs. §§ 1.132-5(a)(2)(i) (involving working condition fringe benefits), 31.3121(a)-1(h) (involving fica taxes), and 31.3401(a)1(b)(2) (involving withholding taxes). 21. see leandra lederman, statutory speed bumps: the role third parties play in tax compliance, 60 stanford l. rev. (forthcoming 2007). 22. the miscellaneous itemized deduction concept was added to the code by the tax reform act of 1986, pub. l. no. 99-514, § 132, 100 stat. 2085, 2113-16 (1986). in the general explanation provided by the staff of the joint committee (the socalled blue book) for that act, the staff said: “congress concluded that the prior-law treatment of employee business expenses . . . have characteristics of voluntary personal expenditures. . . . the use of a deduction floor also takes into account that some miscellaneous expenses are sufficiently personal in nature that they would be incurred apart from any business or investment activities of the taxpayer.” staff of the joint comm. on tax’n, 100th cong., 1st sess., general explanation of the tax reform act of 1986 78-79 (comm. print 1987). the performance of services as an employee under a reimbursement plan with his employer and that the expense be deductible by the employee under one of the provisions in sections 161 to 199. the problem with applying that19 provision to beilein’s situation is that the services for which the expense was incurred were services to a different employer than the one who makes the reimbursement. can the provision apply in that circumstance? treasury regulation section 1.62-2(b) indicates that the services must be provided by the employee in his capacity as an employee of the employer who is reimbursing the costs. the question is how strictly that requirement20 should be construed. before answering that question, one should consider what rationale could explain why congress has chosen to provide nonitemized treatment only for reimbursed employee expenses while subjecting the deduction of unreimbursed employee expenses to such severe restrictions. why is an employee expense that is reimbursed by an employer treated so much more favorably than an identical expense that is not reimbursed? there seems to be only one possible reason for such dramatically different tax treatments of identical expenditures. the employer’s reimbursement provides a third party verification that the expenditure had legitimate business purposes. presumably, congress is concerned that an21 employee might claim a business purpose for what was primarily a personal expenditure, and so it severely restricted the deductions for such expenses unless they were verified by an employer’s having determined that they were sufficiently beneficial to its business to warrant its bearing the cost. one22 might question the appropriateness of requiring third party verification only 2007] tax consequences when a new employer bears the cost 547 23. see, jeffrey kahn, beyond the little dutch boy: an argument for structural change in tax deduction classification, 80 wash. l. rev. 1, 20-25, 62-63 (2005); jeffrey kahn, the mirage of equivalence and the ethereal principles of parellilism and horizontal equity, 57 hastings l. j. 645, 677-679 (2006). 24.1992-2 c.b. 51 25. id. (citing regs. § 1.132-5(a)(2)(i)). 26. id. at 53. when an employee’s expenses are involved, and one of the authors has previously done so, but that is the path that congress has chosen. 23 a reimbursement alone by an employer does not verify the business purpose of the employee’s expense. an employer could reimburse an employee as a means of providing additional compensation to the employee. so, the statement in the regulations that the expense must be made in the employee’s role as an employee of the reimbursing party serves to separate compensatory payments from those reimbursements of expenses that were beneficial to the reimbursing party. how then should the regulatory requirement that the expense be incurred in connection with the employee’s conduct of the employer’s business be construed? a reasonable construction is that the expenditure must provide a significant business benefit to the employer, other than the benefit of compensating the employee. that construction was adopted by the service in a similar context involving the application of irc section 132(a)(3) and (d), the working condition fringe benefit exclusion. in revenue ruling 92-69, the24 service held that expenses incurred and paid by an employer to assist terminated employees to locate work elsewhere were excluded from the employee’s income by irc section 132(a)(3) as a working condition fringe benefit. the service quoted from the regulations under irc section 132 that for the exclusion to apply, the expense must be “allowable as a deduction with respect to the employee’s specific trade or business of being an employee of the employer.” the service then construed that language as follows:25 this requirement is generally satisfied if, under all the facts and circumstances, the employer derives a substantial business benefit from the provision of the property or services that is distinct from the benefit that it would derive from the mere payment of additional compensation, and the employee’s hypothetical payment for the property or services would otherwise be allowable as a deduction by the employee under section 162 of the code. 26 similarly, the proper construction of the language of the regulations under irc section 62 that the expense should be incurred in the employee’s conduct of the employer’s business is that the expense should have a significant 548 florida tax review [vol.8:5 27. of course, since the university is a tax exempt entity, it would be of no consequence to the university whether the expense is deductible or not. 28. see also, regs. § 1.162-17(b)(1). business benefit to the employer other than a benefit of compensating the employee. the purpose of the requirement to distinguish compensatory payments from reimbursements of expenses incurred on behalf of the employer is satisfied by requiring that there be a substantial business benefit to the employer, other than a benefit derived from compensating the employee. in the beilein case, what was the business benefit to the new employer? the university of michigan wished to employ beilein. they could not do so because beiliein was contractually prevented from leaving his current employment. however, beilein’s employer was willing, indeed contractually obligated, to release beilein if it received a termination fee. the university of michigan could obtain beilein’s services if it paid his employer a fee for terminating the contract. it would not be a deductible expense for the university of michigan, but rather would be a capital expenditure. however, for purposes27 of verifying the business purpose of the expenditure, it does not matter whether the expenditure was a deductible expense or a capital expenditure. in either event, it would be of substantial benefit to the new employer. while beilein also would benefit from the payment in that he would be freed to take new employment, his benefit should not affect the characterization of the payment as one made primarily for the benefit of the university of michigan. an employee often benefits from payments of employee expenses that are made primarily for the employer’s benefit, and that does not cause them to be income to the employee. for example, an employee can be reimbursed by his employer for business travel to paris, france, and the expense is still a nonitemized deduction for the employee even though he may have enjoyed his time in paris. as previously noted, temporary regulations section 1.62-1t(e)(5) could be construed to mean that there is a difference in treatment for expenses directly paid by the employer from those paid by the employee who is then reimbursed by the employee. since the substance of those two circumstances are identical, there is no rational reason why they should be treated differently. as stated in footnote 9, supra, a more reasonable construction of that temporary regulation is to refer the reader to irc section 132 as an additional provision addressing this circumstance rather than as an exclusive provision. in any event, as noted in footnote 9, in the unlikely event that the temporary regulation were read to mean that irc section 132 is the exclusive provision that applies, it would be contradicted by regulations section 1.62-2(d)(1) which is a final regulation and was adopted two years after the temporary regulation was promulgated. 28 the question of exclusivity turns on whether irc section 132 was intended by congress to preempt the nonitemization provision or merely to 2007] tax consequences when a new employer bears the cost 549 provide an additional means of relief for the employee. section 132(a)(3), (d) is not identical to the nonitemization provision of irc section 62(a)(2)(a). section 132(d) applies only to expenses that would be deductible by the employee under irc sections 162 or 167. in contrast, irc section 62(a)(2)(a) applies to employee expenses that are deductible under irc sections 161 to 199. since the nonitemization provision still requires the taxpayer to report both the income from the reimbursement and the deduction for the payment or constructive payment (subject to an exception for exclusion in certain specified circumstances), it is not surprising that it has a broader scope than does the exclusionary provision of irc section 132(d). section 132(d) is merely a codification of that part of the nonitemization provision that applies in circumstances where exclusion from income is appropriate as contrasted to circumstances where both income and an offsetting full deduction are to be reported. treasury regulations section 1.132-5(a)(2)(i) states that a working condition fringe exclusion from income will apply only if the hypothetical payment made by the employee would be allowable as a deduction as an expense of the employee’s conduct of the business of being an employee of the employer who provided the property or service. an employee in the beilein type situation could not qualify for a working condition fringe since the employee’s deduction for the buy out payment is attributable to his prior employment. this creates another important distinction between the nonitemization provision and the working condition fringe exclusion. as noted above, the application of the nonitemization provision should not be restricted to expenditures that would be deductible as having been incurred in the conduct of the new employer’s business. instead, it should be sufficient that the principal motive of the employer in reimbursing the amount is to obtain a benefit for the employer and not to compensate the employee. it is appropriate that the nonitemization provision have a broader scope than does the working condition fringe benefit exclusion. in sum, beilein’s deduction for the payment should be a nonitemized deduction since it was reimbursed by a current employer for a business purpose other than to compensate beilein. as a nonitemized deduction, it would wash out any income he would have recognized from the reimbursement. 3. the employer’s payment is excluded from the employee’s income because the employee is merely an incidental beneficiary of that payment if a taxpayer incurs an expense on behalf of another person, the reimbursement to the taxpayer will not be included in the taxpayer’s income even though the taxpayer may have also benefitted from the expenditure. for example, while the expenses of seeking employment in a business in which the taxpayer was not previously employed are not deductible, if a taxpayer is 550 florida tax review [vol.8:5 29. rev. rul. 63-77, 1963-1 c.b. 177. 30. 401 f.2d 118 (5th cir. 1968). 31. id. at 123. reimbursed for his expenses by a prospective employer who invited the taxpayer to travel to be interviewed, the reimbursement is not income to him regardless of whether he is hired. the taxpayer clearly benefits from having29 the opportunity to interview the firm. he has an opportunity to convince the firm to offer him employment, and he has the opportunity to see whether he would wish to work for that firm. but, the purpose of the firm in reimbursing the taxpayer is not to compensate him. rather, it is to provide the firm the opportunity to see if it wishes to hire the taxpayer and to convince the taxpayer to accept the offer, if one is made. the service has agreed that the taxpayer is not taxed in that circumstance regardless of whether the taxpayer is offered a position and accepts it. the service, however, is likely to question whether the incidental beneficiary exclusion applies to a taxpayer who is employed by the person who makes the reimbursement. the leading case in support of applying that exclusion, even when the taxpayer is employed by one of the reimbursers, is the fifth circuit’s decision in united states v. gothcher.30 in gotcher, the taxpayer was an employee of a volkswagen dealership in texas. the taxpayer was offered the opportunity to purchase an interest in his employer. to help taxpayer determine whether to invest in a volkswagen dealership in this country, his employer and volkswagen of germany and volkswagen of america paid the expenses of taxpayer and his wife to travel to germany and view volkswagen manufacturing plants there. upon returning from his trip, taxpayer invested in the dealership. the court held that the reimbursement of the taxpayer’s expenses was not income to him, but the reimbursement of his wife’s expenses was taxable. the purpose of the employer and the manufacturers in reimbursing the taxpayer was to have him see the manufacturing plants in order to convince him that the investment in the company would be a good choice. in holding that the reimbursements were excluded from the taxpayer’s income, the court cited cases that held that such expenses are taxable only when made primarily for the employee’s personal pleasure. “on the other hand, when it has been shown that the expenses were paid to effectuate a legitimate corporate end and not to benefit the officer personally, the officer has not been taxed though he enjoyed and benefited from the activity.” it is noteworthy that, in gotcher, the benefit31 to the employer was to convince the taxpayer to invest in the employer’s business. the reimbursements would be capital expenditures of the employer. similarly, in the case of a beilein-type reimbursement, the new employer’s purpose in making the reimbursement would be a capital expenditure to acquire the services of the taxpayer. 2007] tax consequences when a new employer bears the cost 551 while, in gotcher, the court noted that the taxpayer had no realistic choice to turn down the offer of the trip, that does not mean that the principle applies only when the taxpayer had no option to reject the offer. regardless of whether the employee’s acceptance was required, the primary motive for making the reimbursement was to accomplish the corporate purposes of the reimbursers rather than to compensate the employee; and that is the crux of excluding the item from income. moreover, in gotcher, the employee was not required to accept the trip as a condition of his employment; at most, the court indicated that it was an implied condition of the company’s accepting him as an investor (and even that seems dubious). in field service advice memorandum 200137039 (june 19, 2001), the service concluded that, in 1984, when congress added the term “fringe benefits” to irc section 61(a)(1) and adopted irc section 132, it intended that thereafter any fringe benefit would be taxable to the beneficiary unless excluded by a statutory provision. the service further concluded that since gotcher represents a common law exclusion from income that preceded the 1984 act, it did not apply to benefits provided to employees after 1984. that conclusion is questionable to the extent that it suggests that any non-wage benefit that an employee receives from his employer is a “fringe benefit.” to the contrary, if an expenditure is not given in connection with the taxpayer’s performance of his duties as an employee, as was the case in gotcher, the fact that the taxpayer is employed by the reimburser should not cause the taxpayer to be treated differently from a non-employee in the same position. consider the following example: x is employed as a bookkeeper by the bilt rite corporation which owns and operates a retail clothing store. in response to the consequences of a natural disaster that occurred in f city, which is located in another state, bilt rite decides to collect food and distribute it to needy people in f who have suffered losses. bilt rite seeks volunteers to help it conduct this project. x volunteers to travel to f and to assist in the distribution of the food. this project is not part of x’s employment, and there was no expectation that he would participate. none of the volunteers, including x, is compensated for their participation; but bilt rite will reimburse the volunteers for their out of pocket expenses in traveling to f and living there while the food is being distributed. if the service’s 2001 fsa were correct, the reimbursement of those expenses would be income to x who might have no deduction for his expenses. the reimbursement of the expenses incurred by the volunteers who were not employees of bilt rite is excluded from their income. surely, 552 florida tax review [vol.8:5 32. 1966-1 c.b. 233. 33. 1973-2 c.b. 323. the reimbursement of x’s expenses should not be income to him merely because he is employed by bilt rite in a capacity that has nothing to do with his work at f. there is no reason to treat x differently from the other volunteers. while the reimbursement in the beilein situation would be related to his employment, they would not be made for actions taken in connection with the employment, which is the focus of the working condition fringe provision. rather, they would be to make beilein available to be hired by the university. this type of payment is outside the scope of section 132, therefore, the tax treatment of those payments should not be deemed to have been preempted by that section. in revenue ruling 66-41, the taxpayer incurred a liability to pay an32 employment agency a fee for locating a job that the employee accepted. the fee was a personal obligation of the taxpayer. the new employer agreed that if the taxpayer performed satisfactorily in his work for a stated period of time, the employer would reimburse the taxpayer for the fee. the service ruled that the payment by the employer was income to the employee. this ruling was distinguished by the service in its 1973 ruling on a similar event. in revenue ruling 73-351, an employer contracted with an33 employment agency to pay a fee for any person it hired through the agency, and the employee would have no liability for the fee. the service ruled that the payment of the fee by the employer was not income to an employee who had been hired through the agency. since the employee never had any personal liability for the fee, the service ruled that revenue ruling 66-41 was not applicable and was distinguishable. at first blush, the differences between the facts of the 1966 and the 1973 rulings might appear to be of little substance. in both cases, it might seem that the payment was made by the employer to acquire the services of the employee. there is, however, a significant difference between the two sets of facts. in revenue ruling 66-41, the employee was required to work and perform satisfactorily for a period of time before the employer would agree to make the reimbursement. that clearly was a payment made for a compensatory purpose. in contrast, the payment in the 1973 ruling was made to acquire the services of the employee rather than to compensate him. what would be the result then if the employer did not contract with the agency to pay the fee before selecting the employee? what result if, instead, the fee had been payable by the employee, but the employer agreed to pay it without any requirement that the employee perform services for any period of time? the payment of the fee benefits both the employer and the employee. it is of mutual benefit to both. 2007] tax consequences when a new employer bears the cost 553 34. irc § 368(a)(1)(b). in the case of a so-called triangular “b” reorganization, voting stock of a parent corporation of the acquiring corporation can be used. id. 35. rev. rul. 73-54, 1973-1 c.b. 187. the payment should not be treated as consideration paid to the employee. the tax treatment should not rest on the formulaic difference as to which had the obligation to make the payment. in this regard, it is instructive to consider the tax law’s treatment of mutually beneficial expenditures in circumstances that arise in connection with corporate reorganizations. a so-called “b” reorganization is an acquisition of stock of a target corporation from its shareholders in exchange for voting stock of an acquiring corporation. one of the requirements for obtaining nonrecognition treatment for the exchange is that no consideration be paid to the shareholders of the target other than voting stock of the acquiring corporation. the reorganization34 expenses incurred by the shareholders of the target are the personal liability of those shareholders. those reorganization expenses can include legal and accounting fees incurred by the shareholders provided that they are directly related to the reorganization. incurring those reorganization expenses benefits both the shareholders and the acquiring corporation. since they are of mutual benefit, the service has ruled that the acquiring corporation’s payment of those expenses does not constitute consideration to the target’s shareholders, and thereby does not prevent the exchange from qualifying for nonrecognition treatment. similarly, an employer’s payment of an employee’s fee should not35 be income to the employee unless the payment is made for a compensatory purpose. in summary, the university’s payment of the buy out for beilein should not cause beilein to incur any tax liability either: (1) because the reimbursement should elevate beilein’s payment or constructive payment into a nonitemized deduction, or (2) because it should be excluded from his income as a noncompensatory payment of which he is merely an incidental beneficiary. b. the tax consequences when the new employer pays greater wages to the employee to help him make the buy out payment from a tax viewpoint, this option is much less attractive than having the university pay or reimburse the buy out. in this case, there is no question, but that the extra compensation will be income to the employee, and the deduction the employee has for making the payment will be a miscellaneous itemized deduction. if the university were instead to pay the buy out directly or reimburse the employee for it, there is a reasonable prospect for its not causing the employee to incur tax liability, albeit he might not prevail on the issue. if, 554 florida tax review [vol.8:5 instead, payment is made in the form of additional wages, the additional income tax liability is a certainty. c. the employee makes the buy out payment and receives nothing from the new employer to offset that payment it appears that this is the option that the parties adopted in the actual beilein case. there are no special tax consequences to this choice. the employee received no income from the employer so he incurs no income tax liability therefrom. the payment made by the employee will be a miscellaneous itemized deduction which will be subject to the restrictions noted earlier in this article. iii. conclusion the only option that has any significant tax issues is the one in which the employer either pays the buy out directly or reimburses the employee. there are two independent grounds for contending that the employee incurs no tax liability therefrom. one contention is based on the ground that the reimbursement by the employer (or the constructive reimbursement if the new employer were to pay the former employer directly), converts the deduction the employee obtains for actually or constructively making the buy out payment into a nonitemized deduction. as a nonitemized deduction, it would wash out the income recognized by the employee because of the new employer’s payment. a second contention rests on the position that the payment made by the new employer is not income to the employee because it was made for the employer’s own commercial benefit and was not intended as compensation to the employee. the authors refer to this proposition as an incidental beneficiary exclusion. both of the above contentions are vulnerable to attack. the authors believe that a taxpayer who litigates this issue will prevail, but there are no guarantees that that will be so. the policy considerations favor the taxpayer on this issue, and that is the reason for the authors’ optimism. good policy does not always prevail however. florida tax review florida tax review volume 9 2008 number 2 corporate expatriation: a case analysis by steven h. goldman i. introduction .................................................................................... 72 ii. the transactions ............................................................................ 73 a. the merger ................................................................................ 73 1. the facts ...................................................................... 73 2. tax-related objectives ................................................. 76 b. the transfer of assets ............................................................... 77 1. the facts ...................................................................... 77 2. tax-related objectives ................................................. 81 iii. tax consequences under prior law ......................................... 84 a. the merger ….. . ........................................................................ 84 1. general corporate tax provisions .............................. 85 2. section 367 ................................................................... 89 b. the transfer of cfc stock ........................................................ 92 1. introductory issues ....................................................... 92 2. corporate non-recognition provisions ....................... 92 3. section 367 ................................................................... 93 a. section 367(a) ................................................. 93 b. section 367(b) ................................................. 96 c. result under section 367 ................................ 98 c. future tax consequences ......................................................... 99 1. ir-ltd., the new parent company .............................. 99 2. dividends on the ir-ltd. class a stock........................ 99 3. the ir-ltd. class b nonvoting stock ......................... 101 4. dividends on the ir-nj stock ..................................... 102 5. the debt ..................................................................... 103 d. tax policy issues………………………………….. ............... 108 iv. consequences under new section 7874. ................................. 110 a. description of new provision. ................................................ 110 1. section 7874(b) transactions ..................................... 110 2. section 7874(a) transactions ..................................... 111 b. effect of section 7874(b) ......................................................... 111 c. effective date & proposed amendment .................................. 113 v. conclusion……………. .................................................................... 116 72 florida tax review [vol. 9:2 corporate expatriation: a case analysis by steven h. goldman * i. introduction during the 1990s and early 2000s, several large u.s. companies reincorporated abroad. 1 corporate expatriations can take many different forms. one form is a stock inversion. in an inversion, a u.s.-based multinational corporate group forms a foreign subsidiary, typically in a country that imposes little or no corporate income tax. 2 then the group reorganizes. the new foreign subsidiary becomes the parent of the group, and the existing u.s. parent becomes a subsidiary. 3 as the term suggests, the corporate structure inverts. the parent’s place of incorporation changes to a foreign country. an inversion involves only a change in the group’s legal structure. it has little or no effect on the company’s operations. 4 the group does not need to move its headquarters or its other business operations. 5 this article describes a typical stock inversion, using the 2001 ingersoll-rand reorganization as a model. the article examines how, under the law at that time, the transaction saved substantial taxes, immediately and into the future. this article does not describe the history of inversions. nor does it address all the tax policy issues associated with inversions. many authorities have previously covered those topics. 6 the purpose of this article is simply to explore the major u.s. international tax issues by analyzing one inversion. * ll.m. in taxation, boston university school of law; j.d., boston university school of law; shgoldmanlaw@aol.com. the author would like to thank brainard patton of the graduate tax program, boston university school of law, for his helpful comments on earlier drafts of this article. 1. see office of tax pol’y, dep’t of treasury, corporate inversion transactions: tax policy implications 1, 3 (2002) at www.treas.gov/press/releases/docs/ inversion.pdf [hereinafter treasury inversion study]. 2. see id. at 1. 3. see id. 4. id. 5. id. at 15. 6. see michael s. kirsch, the congressional response to corporate expatriations: the tension between symbols and substance in the taxation of multinational corporations, 24 va. tax rev. 475 (2005); elizabeth chorvat, you can’t take it with you: behavioral finance and corporate expatriations, 37 u.c. davis l. rev. 453 (2003); hal hicks, overview of inversion transactions: selected 2008] corporate expatriation 73 the ingersoll-rand reorganization consisted of two main transactions: a merger, and an exchange of assets for stock. sometimes this article refers to the two transactions combined as the “inversion.” part ii of this article describes the transactions. part ii also explains some international tax concepts necessary to understand the purposes of the transactions. part iii analyzes the tax consequences of the transactions under the law that was in effect at the time. part iv examines how the 2004 american jobs creation act (ajca) eliminated the potential tax benefits of inversions. finally, part v concludes that the ajca has stopped inversions. however, the act did not address some flaws in the u.s. international tax system that drove companies to expatriate. further, the act did not address abusive practices such as earnings stripping through related company debt. ii. the transactions a. the merger 1. the facts ingersoll-rand company was incorporated and based in new jersey. 7 this article refers to this corporation as ir-nj. ir-nj was the original u.s. parent of the multinational corporate group. ir-nj formed a subsidiary, ingersoll-rand company limited (ir-ltd.), a bermuda company. 8 before the reorganization ir-ltd. had no significant assets, and had not engaged in any business or other activities. 9 ir-ltd. in turn formed ir merger corp., a new jersey subsidiary, specifically for purposes of the merger. 10 see figure 1. historical, contemporary, and transactional perspectives, 30 tax notes int’l 899 (jun. 2, 2003); john m. peterson & bruce a. cohen, corporate inversions: yesterday, today and tomorrow, 81 taxes 161 (mar. 2003); treasury inversion study, supra note 1; gregg d. lemein & john d. mcdonald, taxable inversion transactions, 80 taxes 7 (mar. 2002); carol p. tello, the upside down world of corporate inversions, 30 tax mgm’t int’l j. 161 (2001); willard b. taylor, corporate expatriations – why not? 78 taxes 146 (mar. 2000); boris i. bittker & lawrence lokken, fundamentals of international taxation ¶ 66.2, warren, gorham & lamont, (2006-07 edition) [hereinafter bittker & lokken]. 7. ingersoll-rand company, proxy/prospectus, at 6-7 (nov. 2, 2001), available at www.shareholder.com/ir/downloads/proxybermuda.pdf [hereinafter ir proxy/prospectus]. 8. id. at 6. 9. id. at 6-7. 10. id. at 2, 6-7. 74 florida tax review [vol. 9:2 public shareholders before ir nj ir ltd. (bermuda) figure 1 stock inversion ir merger corp.(nj) merger ir nj stock ir ltd. class a stock on december 31, 2001, ir merger corp. merged into ir-nj. 11 the outstanding ir-nj common shares automatically converted into ir-ltd. class a common shares. 12 ir-ltd.’s shares in ir merger corp. converted into irnj shares. 13 ir-nj, the surviving entity, became a wholly owned, indirect subsidiary of ir-ltd. 14 11. ingersoll-rand co. ltd. 2001 financial report 35 (2002). 12. ir proxy/prospectus, supra note 7, annex i at 2-3 (agreement and plan of merger, articles 3.1(a), 3.2(a)). 13. ir proxy/prospectus, supra note 7, annex i at 3 (agreement and plan of merger, article 3.1(d)). 14. ir proxy/prospectus, supra note 7, at 7, 17. for the purposes of analysis, this article treats the transaction as though ir-nj became a direct subsidiary of ir-ltd. as a result of the merger. the transaction, as described in the prospectus, appeared to cause that result. the company apparently did some additional restructuring, not mentioned in the prospectus, that caused ir-nj to be an indirect subsidiary. one common strategy is to interpose a corporation, located in a jurisdiction with a favorable u.s. tax treaty, between the new foreign parent and the u.s. group. therefore the dividends that the u.s. group pays to the next tier corporation are subject to a relatively low withholding tax. peterson & cohen, supra note 6, at 176. 2008] corporate expatriation 75 as a result of the merger, ir-ltd., a foreign corporation, replaced ir-nj as the parent of the multinational corporate group. see figure 2. public shareholders after ir ltd. (bermuda) ir nj figure 2 stock inversion ir ltd. class a stock according to the company’s prospectus, the reorganization was to have “no material impact” on the company’s day-to-day operations. 15 irltd.’s principal executive offices were located at ir-nj’s headquarters in new jersey. 16 after the reorganization ir-ltd. and its subsidiaries would continue to conduct the businesses that ir-nj and its subsidiaries previously conducted. 17 all of the directors and executive officers of ir-nj would become directors and officers of ir-ltd. 18 also following the merger, irltd. class a stock would trade on the new york stock exchange under the ticker symbol “ir,” the symbol that previously represented the ir-nj stock. 19 the change of domicile to bermuda would not affect the company’s status as a member of the s&p 500 index. 20 15. ir proxy/prospectus, supra note 7, at 4. 16. see id. at 7. 17. id. at cover page, before table of contents on page i. 18. id. at 20. 19. id. at 10. 20. id. at 22. 76 florida tax review [vol. 9:2 2. tax-related objectives the purpose of this transaction was to relocate the parent of the multinational group to a tax haven. bermuda does not impose a corporate income tax on resident corporations. 21 before the merger ir-nj, a domestic corporation, was the parent of the group. a corporation is a domestic corporation if it is created or organized under the law of the u.s. or of a state. 22 domestic corporations are subject to u.s. tax on their worldwide income. 23 to alleviate double taxation, the u.s. allows domestic corporations a credit for the foreign taxes they pay on their foreign source income. 24 however, this credit is subject to limitations. 25 by contrast, many other countries do not tax resident corporations on their worldwide income. instead, they use a territorial system of taxation. 26 under that system, a country only taxes income from domestic operations. 27 active business income earned outside the country is exempt. 28 commentators have argued that the u.s. international tax rules impose a heavier overall tax burden on u.s. multinational corporations than that borne by foreign multinationals. 29 this places u.s. multinationals at a competitive disadvantage. 30 many u.s. companies, including ingersoll-rand, expatriated to lower their overall effective tax rates and remain competitive. ir-ltd., the new parent of the group, was a foreign corporation. foreign corporations are only subject to u.s. tax on their nonbusiness income from u.s. sources and income effectively connected with the conduct of business in the u.s. 31 21. see id. at 3; 2008ard 059-111, congressional research service report for congress firms that incorporate abroad for tax purposes: corporate “inversions” and “expatriation,” updated mar. 11, 2008 (mar. 24, 2008) [hereinafter crs corporate inversion report]. 22. 26 u.s.c. § 7701(a)(4) (cch 2008). all section references are to the internal revenue code of 1986 [hereinafter irc or the code], as amended, unless otherwise indicated. 23. bittker & lokken, supra note 6 ¶ 65.3.1. 24. see irc § 901. 25. irc § 904. 26. charles h. gustafson, robert j. peroni & richard c. pugh, taxation of international transactions ¶ 1070 (3rd ed. 2006). 27. see treasury inversion study, supra note 1, at 28. in addition, most countries with territorial systems tax resident corporations on certain types of foreign source income, such as passive income. gustafson, et al, supra note 26 ¶ 1070. 28. treasury inversion study, supra note 1, at 28. 29. id. at 29. 30. id. 31. bittker & lokken, supra note 6 ¶ 65.3.1. see irc §§ 881 & 882. 2008] corporate expatriation 77 ir-nj was a domestic corporation. to limit ir-nj’s u.s. tax exposure, the company did some additional restructuring, described below. b. the transfer of assets 1. the facts also on december 31, 2001, as part of the same plan of reorganization, ir-nj and certain of its subsidiaries transferred shares of certain existing ir-nj subsidiaries (the “transferred assets”), and issued certain debt (the “debt”), to ir-ltd. 32 in exchange ir-ltd. issued to ir-nj and the transferring subsidiaries ir-ltd. class b common stock. 33 these transfers occurred before the merger transaction. 34 however, to facilitate understanding, part iii analyzes the tax consequences of the merger first. 35 the company’s prospectus did not specify which particular subsidiaries ir-nj transferred to ir-ltd. this article assumes that ir-nj transferred its foreign subsidiaries, particularly those that were controlled foreign corporations (cfcs). the following section discusses cfcs. transferring a u.s. subsidiary to a foreign parent would not save any tax. as a domestic corporation, a u.s. subsidiary is subject to u.s. taxation on its worldwide income regardless which entity is the parent of the group. see figures 3 and 4. 32. ir proxy/prospectus, supra note 7, at 7, 17. 33. id. the company stated that the b stock would not dilute the ownership interest of the class a common stockholders because only ir-nj and other wholly owned subsidiaries of ir-ltd would hold the b stock. id. at 2. 34. ingersoll-rand co. ltd. 2001 financial report, supra note 11, at 35. 35. other commentators generally address the merger transaction before the transfer of cfc stock. see, e.g., peterson & cohen, supra note 6, at 164-171 (discusses inversions first, but later says that the transfer of cfcs commonly occurs before the inversion). a subsidiary’s ownership of parent company stock can raise some complex tax issues, not necessarily confined to the international tax field, that are outside the scope of this article. see peterson & cohen, supra note 6, at 172; peter c. canellos, acquisition of issuer securities by a controlled entity: peter pan seafoods, may department stores, and mcdermott, 45 tax law. 1 (1991); stephen b. land, strange loops and tangled hierarchies, 49 tax l. rev. 53 (fall 1993). 78 florida tax review [vol. 9:2 public shareholders before ir nj ir ltd. (bermuda) figure 3 transfer of cfc stock & debt stock in cfcs, plus debt class b nonvoting stock cfc1 cfc2 cfc3 the company expected that the class b shares ir-nj received in exchange for the assets and debt would represent up to approximately 45% of the total value of the ir-ltd. shares. 36 the class b stockholders were not entitled to vote, except in certain circumstances specified under bermuda law. 37 only ir-nj and other wholly owned subsidiaries of ir-ltd. would hold the b shares. 38 holders would not transfer the b shares outside the group. 39 the b shares would not be registered with the sec, nor would they be publicly traded. 40 if a holder transferred b shares to any person or entity other than a wholly owned, direct or indirect subsidiary of ir-ltd., the shares would automatically convert into ir-ltd. class a common shares on a one 36. ir proxy/prospectus, supra note 7, at 14. 37. id. at 26. under the bermuda companies act, each share of ir-ltd. carried the right to vote regarding an amalgamation or merger. id. ir-nj and ir-ltd. entered into a voting agreement. the agreement provided that in those limited instances where the class b shares had the right to vote, ir-nj or any other ir-ltd. subsidiary holding the class b shares would vote (or abstain from voting) the shares in the same proportion as the holders of ir-ltd. class a common shares. therefore the class b shares would not dilute the voting power of the class a shares. id. 38. id. at 28. 39. id. 40. id. at 22. 2008] corporate expatriation 79 for-one basis. 41 the company expected the class b shares to pay “comparable dividends to the class a common shares.” 42 public shareholders after ir nj ir ltd. (bermuda) figure 4 transfer of cfc stock & debt class b nonvoting stock cfc1 cfc2 cfc3 debt the class b shares were convertible into class a shares if they were (1) used in connection with a stock or deferred compensation plan of ir-ltd. or its affiliates; or (2) used as consideration in an acquisition. 43 holders of class b shares had “the right at any time following the issuance thereof upon notice to ir-limited to require ir-limited to purchase for cancellation any or all of the ir-limited class b common shares for cash at the per share fair market value of the ir-limited class a common shares as of the date of such notice.” 44 considering the above features of the class b stock, especially the convertibility and the redemption at the holders’ option, the company apparently believed that the b shares were worth about the same as the a shares at the time of the reorganization. 45 41. id. at 28. 42. ingersoll-rand co. ltd. 2001 financial report, supra note 11, at 35. 43. ir proxy/prospectus, supra note 7, at 28. 44. id. 45. in its prospectus, issued on nov. 2, 2001, almost 2 months before the effective date of the reorganization, the company said it expected that ir-nj would receive class b shares representing up to approximately 45% of the total value of the 80 florida tax review [vol. 9:2 figure 5 shows the group’s structure after the company completed all the steps of the reorganization. ir-ltd. shares. ir proxy/prospectus, supra note 7, at 14. ir-ltd. had 168,003,884 class a common shares issued as of dec. 31, 2001. ingersoll-rand co. ltd. 2001 financial report, supra note 11, at 35. the company issued 135,250,003 class b shares to ir-nj and its subsidiaries in the reorganization. id. therefore the b shares comprised 44.59959% of the total number of ir-ltd. shares outstanding immediately after the reorganization. if the b shares represented approximately 45% of the number of shares, and as predicted represented approximately 45% of the total market value of the shares, then it follows that the company considered the a and b shares to be nearly equal in value. also supporting this view is the following statement in the prospectus: “the number of ir-limited class b common shares owned by ir-new jersey and other ir-limited subsidiaries will reflect the fair market values as of the effective time of the merger of the transferred assets and ir-new jersey, based on the market value of ir-new jersey common stock at that time. we currently estimate the aggregate number of ir-limited class b common shares to be issued for the transferred assets and for the debt to be approximately 140,000,000 shares.” ir proxy/prospectus, supra note 7, at 7, 17. this statement was rather obscure. it seemed to say that, to determine how many class b shares to issue in exchange for the transferred assets and debt, the company intended to use the market value of ir-nj stock as a reference point. and it was reasonable to assume that immediately before the merger the ir-nj stock was equal in value to the ir-ltd. class a common stock received in exchange for the irnj common stock. indirectly, therefore, the company felt that the b stock’s value closely correlated to the value of the a stock. public shareholders result at end of day on dec. 31, 2001 ir ltd. (bermuda) ir nj figure 5 stock inversion class b nonvoting stock fc1 fc2 fc3 former foreign subs of ir-nj debt class a voting stock 2008] corporate expatriation 81 2. tax-related objectives the purpose of transferring the assets was to move ir-nj’s foreign subsidiaries out from under the u.s. parent. under a foreign parent, those subsidiaries are no longer controlled foreign corporations (cfcs) subject to the regime of subpart f. 46 generally, the u.s. treats a corporation as a separate taxpayer from its shareholders. 47 if a u.s. corporation forms a foreign subsidiary to conduct business abroad, the u.s. tax law generally respects the foreign corporation as a separate entity from its shareholder, the u.s. parent. 48 the u.s. does not tax the parent on the subsidiary’s income. 49 and the u.s. does not tax the foreign corporation on its foreign source income. 50 as discussed above, the u.s. only taxes a foreign corporation on certain income connected to the u.s. 51 therefore the foreign subsidiary’s foreign earnings are not subject to u.s. tax until the subsidiary repatriates those earnings as dividends to the parent. 52 commentators call this concept the deferral principle. 53 absent an exception to this principle, a u.s. parent could defer u.s. tax on a foreign subsidiary’s earnings indefinitely simply by not paying itself a dividend. 54 to deal with perceived abuses of the deferral principle, congress enacted several “anti-deferral” regimes. 55 the most significant regime is subpart f. 56 under the subpart f rules, if a foreign subsidiary is a cfc, then certain income of the cfc is taxable to the u.s. parent, whether distributed or not. 57 the term “controlled foreign corporation” means any foreign corporation if “u.s. shareholders” own directly, indirectly or constructively more than 50% of either (i) the total combined voting power of all classes of stock entitled to vote, or (ii) the total value of the stock. 58 46. see peterson & cohen, supra note 6, at 170. 47. kirsch, supra note 6, at 486. 48. gustafson, et al, supra note 26 ¶ 6000. 49. kirsch, supra note 6, at 487. 50. gustafson, et al, supra note 26 ¶ 6000; kirsch, supra note 6, at 487. 51. kirsch, supra note 6, at 487. 52. see treasury inversion study, supra note 1, at 11. 53. see gustafson, et al, supra note 26 ¶ 6000. 54. kirsch, supra note 6, at 487. 55. gustafson, et al, supra note 26 ¶ 6000. 56. kirsch, supra note 6, at 487-88. 57. treasury inversion study, supra note 1, at 11-12; see irc § 951(a). the term “subpart f” refers to where the rules are located within the internal revenue code: subpart f of part iii of subchapter n of chapter 1 of subtitle a. 58. irc § 957(a). the constructive ownership rules of § 318, with some modifications, apply for determining stock ownership for this purpose. irc § 958. 82 florida tax review [vol. 9:2 a u.s. shareholder is a u.s. person who owns directly, indirectly or constructively 10% or more of the foreign corporation’s voting stock. 59 a u.s. person includes an individual, corporation, partnership, estate or trust. 60 note that the definition of “u.s. shareholder” only includes u.s. persons that own 10% or more of the stock. if the foreign corporation is publicly held, and no shareholder owns 10% or more of the voting stock, then the corporation cannot be a cfc, even if most of the shareholders are u.s. persons. if the foreign corporation is a cfc, then each person who is a u.s. shareholder and who directly or indirectly owns stock in the foreign corporation on the last day of the year must include in income his pro rata share of the corporation’s subpart f income. 61 such shareholders must also include in income their pro rata share of the foreign corporation’s earnings that are invested in “u.s. property.” 62 subpart f income includes various types of income that taxpayers can easily shift to low-tax or no-tax foreign jurisdictions. 63 one type of subpart f income is passive income, such as dividends, interest, royalties and rents. 64 subpart f income also includes “certain business income that does not have sufficient connection to the foreign country in which the foreign subsidiary is incorporated.” 65 before the reorganization ingersoll-rand’s foreign subsidiaries were cfcs because ir-nj, a u.s. corporation, owned more than 50% of their stock. therefore ir-nj had to pay u.s. tax currently on the cfcs’ subpart f income. after the reorganization ir-ltd., a foreign corporation, owned irnj’s former foreign subsidiaries. therefore u.s. shareholders did not directly own any of the subsidiaries’ stock. but our analysis does not end there. we must also analyze the indirect ownership. see figure 6. 59. irc § 951(b). 60. irc §§ 951(b), 957(c), 7701(a)(30). 61. irc § 951(a)(1)(a). 62. irc § 951(a)(1)(b). 63. see bittker & lokken, supra note 6 ¶ 69.1. 64. irc § 954(c) (foreign personal holding company income). 65. kirsch, supra note 6, at 489. see, e.g., irc § 954(d) (foreign base company sales income); § 954(e) (foreign base company services income). for the definition of subpart f income, and a list of its components, see irc §§ 952-954. 2008] corporate expatriation 83 public shareholders ir ltd. (bermuda) ir nj figure 6 – post-reorganization subpart f analysis class b nonvoting stock 45% by value fc1 fc2 fc3 former foreign subs of ir-nj class a voting stock the public shareholders, shown at the top right of figure 6, indirectly owned stock in ir-nj’s former foreign subsidiaries by reason of owning the ir-ltd. class a stock. 66 but the class a stock was widely held by the public. it was extremely unlikely that any class a shareholder owned 10% or more of the a stock. so it was unlikely that any class a shareholder indirectly owned 10% or more of the subsidiaries. therefore none of the public shareholders was a u.s. shareholder of the subsidiaries. 67 ir-nj, shown at the top left of figure 6, indirectly owned 45% of its former foreign subsidiaries by reason of owning the nonvoting b stock. 68 so ir-nj was a u.s. shareholder of the subsidiaries. 69 but ir-nj was the only u.s. shareholder. it indirectly owned less than 50%. after the reorganization u.s. shareholders directly or indirectly owned less than 50% of the subsidiaries’ stock. ir-nj’s former foreign subsidiaries were no longer cfcs. 70 therefore the foreign subsidiaries’ earnings were no longer potentially subject to subpart f. further, ir-ltd. itself was not a cfc. although most of its class a public shareholders were probably u.s. persons, it was extremely unlikely that any of them were “u.s. shareholders” (that is, owned 10% or more of the ir-ltd. voting stock). ir-nj was not a u.s. shareholder because it did 66. see irc § 958(a)(2). 67. see irc § 951(b). 68. see irc § 958(a)(2). 69. irc § 951(b). 70. irc § 957(a). 84 florida tax review [vol. 9:2 not own any voting stock. 71 so ir-ltd. had no u.s. shareholders. therefore it was not a cfc. 72 in addition, if ir-ltd. expanded into new foreign markets in the future, those new foreign operations, as subsidiaries or branches of ir-ltd., would similarly be outside the reach of subpart f. the existence of the class b nonvoting stock could present some additional issues that might affect the above analysis. part iii discusses those issues. generally, however, the reorganization effectively removed ir-ltd. and its foreign subsidiaries from the reach of subpart f. after the reorganization the group’s foreign operations were not subject to u.s. corporate level tax. 73 the purpose of issuing the intercompany debt was, at least in part, so that ir-nj could deduct the interest payments on the debt. the deduction enables ir-nj to shield some of its u.s. earnings from u.s. taxation. 74 using debt and other related party transactions to shift taxable income away from a domestic corporation is often referred to as “earnings stripping.” 75 part iii discusses earnings stripping via intercompany debt. in the proxy and prospectus sent to shareholders before the reorganization, the company stated that it expected to save $50 $60 million in taxes in the fourth quarter of 2001 as a result of the transactions, and an additional $40 million annually thereafter. 76 the company also said that irnj would not incur significant u.s. federal income or withholding tax as a result of the merger or the related reorganization transactions. 77 iii. tax consequences under prior law this part examines the tax consequences of the transactions under the law before the american jobs creation act added section 7874 to the internal revenue code. a. the merger on december 31, 2001, ir merger corp. merged into ir-nj. the outstanding ir-nj common shares converted into ir-ltd. class a common 71. see irc § 951(b). 72. see irc § 957(a). 73. see treasury inversion study, supra note 1, at 14; kirsch, supra note 6, at 490. 74. see h.r. rep. no. 108-755, at 527 (2004) (conf. rep.), as reprinted in 2005 u.s.c.c.a.n. 1341, 1625. 75. see kirsch, supra note 6, at 491-94. 76. ir proxy/prospectus, at 18. 77. id. at 3. 2008] corporate expatriation 85 shares. ir-ltd.’s shares in ir merger corp. converted into ir-nj shares. irnj, the surviving entity, became a subsidiary of ir-ltd. the tax law treats the ir-nj shareholders as if they exchanged their ir-nj shares for the ir-ltd. shares. 78 next we need to determine the consequences of that exchange. 1. general corporate tax provisions generally, whenever a person sells or exchanges property, he must recognize gain or loss on the transaction. 79 the amount of gain is the excess of the amount realized over the adjusted basis of the property sold or exchanged. 80 the amount realized is the sum of any money received plus the fair market value of any property received. 81 the taxpayer’s adjusted basis of the property is generally his cost, with certain adjustments. 82 to facilitate business restructuring, the internal revenue code provides some exceptions to the rule that one must recognize gain or loss on an exchange of property. if the transaction satisfies certain requirements, then the code defers recognition of gain or loss until a later time. 83 if an exception did not apply, then the ir-nj shareholders had to recognize gain or loss when they exchanged their shares for the ir-ltd. class a shares. therefore we must determine whether a corporate nonrecognition provision applied to the merger transaction. the following analysis might seem extraneous to an article on international taxation. however, we need to address these issues before we discuss section 367, which deals with foreign corporations. sections 367(a) and (b) apply only when a corporate nonrecognition provision applies. several provisions potentially applied to the transaction. 78. see hicks, supra note 6, at 909 (states that the stock in the domestic parent converts into stock in the new foreign parent, then analyzes whether the transaction qualifies as a tax-free exchange under irc §§ 351, 354, 367 and 368); peterson & cohen, supra note 6, at 164 (same); see also ir proxy/prospectus, at 7-9 (states that ir-nj shares will automatically become ir-ltd. class a shares, then describes the tax consequences of the “exchange” to the shareholders). 79. irc § 1001(c). 80. irc § 1001(a). the amount of loss is the excess of the adjusted basis over the amount realized. id. 81. irc § 1001(b). 82. irc §§ 1011, 1012. 83. irc § 351 provides that no gain or loss shall be recognized when property is transferred to a controlled corporation. section 354 provides that, under certain conditions, a shareholder recognizes no gain or loss when stock or securities are exchanged in a reorganization. similarly, § 361 provides that, under certain conditions, a corporation recognizes no gain or loss when stock or securities are exchanged in a reorganization. a reorganization is defined in § 368. 86 florida tax review [vol. 9:2 the merger, combined with the asset transfers, qualified as a section 351 transfer. section 351 provides that “no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control … of the corporation.” 84 “control” means “the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.” 85 a threshold issue is that section 351 requires a transfer to the controlled corporation. but the public shareholders did not actually transfer their ir-nj shares to ir-ltd. ir-ltd. acquired the ir-nj shares indirectly as a result of the merger. however, the end result of all the steps in the transaction was the same as if the ir-nj public shareholders actually transferred their shares to ir-ltd. we disregard the transitory existence of ir-merger corp. 86 the merger was merely a means of transferring the ir-nj stock to ir-ltd., 87 and a means of transferring the ir-ltd. class a stock to the ir-nj shareholders. therefore we analyze the transaction as though the ir-nj shareholders actually transferred their ir-nj shares to ir-ltd. in exchange for ir-ltd. shares. 88 standing alone, this exchange did not qualify as a section 351 transfer because the public shareholders alone were not in control of ir-ltd. immediately after the exchange. the public shareholders owned all of the voting stock, but none of the other classes of stock. on the same day, before the merger, ir-nj acquired all of the class b nonvoting stock in exchange for the assets and debt. however, the merger and asset transfer were parts of an integrated plan. the step transaction doctrine applies to collapse both exchanges into one integrated transaction. under the step transaction doctrine, “an integrated transaction must not be broken into independent steps.” 89 conversely, “the separate steps must be taken together in attaching tax consequences.” 90 84. irc § 351(a). 85. irc § 368(c). 86. rev. rul. 67-448, 1967-2 c.b. 144; peterson & cohen, supra note 6, at 164. rev. rul. 67-448 is an application of the step transaction doctrine, discussed below. the ruling involved a b reorganization, but its rationale applies to § 351 transfers as well. see p.l.r. 200049026 (dec. 11, 2000). 87. see peterson & cohen, supra note 6, at 164. 88. see id. 89. boris i. bittker & james s. eustice, federal income taxation of corporations and shareholders ¶ 1.05[2][d] (warren, gorham & lamont, 7th ed. 2000) [hereinafter bittker & eustice]. 90. id. 2008] corporate expatriation 87 ir-nj and the public shareholders collectively transferred property to ir-ltd. solely in exchange for stock. the public shareholders transferred their ir-nj shares in exchange for class a stock. ir-nj transferred the assets and debt in exchange for class b stock. immediately after the transfers, the public shareholders and ir-nj collectively were in control of ir-ltd. the public shareholders owned 100% of the ir-ltd. class a voting stock. ir-nj owned 100% of the b stock, the only other class of stock. therefore all the transfers to ir-ltd. qualified under section 351. 91 the merger, standing alone, also likely qualified as a b reorganization. section 368(a)(1)(b) defines a “b” reorganization as the acquisition by one corporation, in exchange solely for all or a part of its voting stock or its parent’s voting stock, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of the other corporation. 92 we need to address a threshold issue similar to the issue discussed above regarding section 351. typically, a b reorganization involves a stockfor-stock exchange between the target shareholders and the acquiring corporation. 93 but the ir-nj shareholders did not actually transfer their shares to ir-ltd. ir-ltd. acquired the ir-nj shares indirectly as a result of the merger. however, the end result of all the steps in the transaction was the same as if the ir-nj public shareholders actually transferred their shares to ir-ltd. in exchange for the ir-ltd. class a shares. we disregard the transitory existence of ir-merger corp. 94 the merger was merely a means of transferring the ir-nj stock to ir-ltd., 95 and a means of transferring the irltd. class a stock to the ir-nj shareholders. therefore we analyze the transaction as though the ir-nj shareholders actually transferred their ir-nj shares to ir-ltd. in exchange for ir-ltd. shares. 96 ir-ltd. acquired stock in ir-nj in exchange for its own voting stock. after the transaction ir-ltd. had control of ir-nj. the transaction met the statutory definition of a b reorganization. there is another possible issue. for an exchange to qualify as a “b” reorganization, the acquiring corporation must acquire the stock of the target “solely for all or a part of its voting stock.” 97 on the same day as the purported reorganization, ir-ltd. issued class b stock to ir-nj and its 91. see peterson & cohen, supra note 6, at 171 & n.71. 92. irc § 368(a)(1)(b). 93. bittker & eustice, supra note 89 ¶ 12.23[4]. 94. rev. rul. 67-448, 1967-2 c.b. 144; peterson & cohen, supra note 6, at 164; hicks, supra note 6, at 909. 95. peterson & cohen, supra note 6, at 164. 96. see id. 97. irc § 368(a)(1)(b) (emphasis added). 88 florida tax review [vol. 9:2 subsidiaries. the class b stockholders could not vote, except in limited circumstances specified under bermuda law. 98 the irs might argue, using the step transaction doctrine, that using the nonvoting b stock disqualified the transaction as a b reorganization. but ir-ltd. did not acquire any ir-nj stock in exchange for the b stock. it acquired other assets, namely stock in ir-nj’s subsidiaries and a note. the exchange of assets and debt for the b stock should not affect the status of the b reorganization. 99 besides meeting the definition in the statute, a reorganization must satisfy some judicially created requirements. 100 one requirement is the continuity of business enterprise (cobe). 101 the acquiring corporation must continue the business enterprise of the target under modified corporate form. 102 on the same day as the purported reorganization, ir-nj transferred stock in its foreign subsidiaries to ir-ltd. using the step transaction doctrine, the irs might argue that this transfer disqualified the b reorganization because ir-nj disposed of some of its business assets before the reorganization, partially destroying the continuity of the business. 103 but ir-nj transferred the stock to ir-ltd., the acquiring corporation. this transfer should not violate the cobe requirement. 104 therefore the merger likely qualified as a b reorganization. the merger also appeared to qualify as an a reorganization pursuant to section 368(a)(2)(e). 105 that provision authorizes a merger using the 98. ir proxy/prospectus, supra note 7, at 26. 99. see bittker & eustice, supra note 89 ¶ 12.23[3] (the acquiring corporation can use consideration other than voting stock to acquire various properties owned by the target corporation without affecting the b reorganization). 100. id. ¶ 12.60. 101. see id. ¶ 12.61[2]. 102. treas. reg. § 1.368-1(b); bittker & eustice, supra note 89 ¶ 12.61[2][a]. 103. the cobe requirement applies to type b reorganizations. rev. rul. 81-92, 1981-1 c.b. 133. 104. see treas. reg. § 1.368-1(d)(5), example 1. target sold 2 of 3 equally sized businesses to an unrelated third party before a c reorganization. the acquiring corporation continued to operate the third business after the reorganization. the transaction met the cobe requirement. if the target can sell two-thirds of its assets to an unrelated third party before the reorganization, then arguably it should be allowed to transfer stock in some of its subsidiaries to another member of the corporate group (the new parent company) in a partially or fully taxable transaction without violating cobe. 105. lee a. sheppard, ingersoll-rand’s permanent holiday, 93 tax notes 1528, 1530 (dec. 17, 2001). an “a” reorganization is a statutory merger or consolidation. irc § 368 (a)(1)(a). section 368(a)(2)(e) provides that a transaction otherwise qualifying as a statutory merger or consolidation shall not be disqualified 2008] corporate expatriation 89 voting stock of a corporation controlling the merged subsidiary. ir merger corp. merged into ir-nj. the ir-nj shareholders received voting stock in ir-ltd., the corporation that controlled ir merger corp. however, section 368(a)(2)(e)(i) requires that the surviving corporation (ir-nj) continue to hold “substantially all of its properties” after the transaction. 106 on the same day as the merger, ir-nj transferred stock in its subsidiaries to ir-ltd. therefore the irs could use the step transaction doctrine to argue that the merger failed to satisfy that provision. in summary, the merger qualified for nonrecognition of gain or loss under at least one provision. the merger, combined with the asset transfers, definitely qualified as a section 351 transfer. the merger probably also qualified as a b reorganization. it might also have qualified as an a reorganization pursuant to section 368(a)(2)(e). before applying section 367, we determined that the ir-nj shareholders did not have to recognize gain or loss when they exchanged their ir-nj shares for the ir-ltd. shares. next we need to determine whether section 367 changed this result. 2. section 367 section 367(a)(1) provides that, for purposes of determining gain, if a u.s. person transfers property to a foreign corporation in an otherwise qualifying exchange, the foreign corporation shall not be considered a corporation. 107 this provision effectively denies nonrecognition of gain treatment for such transactions. section 367 imposes a tax, or “toll charge,” when a u.s. person transfers appreciated property beyond the u.s. taxing jurisdiction. 108 section 367(a)(6) authorizes the treasury to except certain transfers by regulations. 109 treasury regulations section 1.367(a)-3(c)(1) applies when u.s. persons transfer stock or securities of a domestic corporation to a foreign corporation. 110 the regulations provide that a transfer will not be subject to section 367(a)(1) if the following four conditions are satisfied: 111 if stock of a corporation controlling the merged corporation is used in the transaction, provided certain other requirements are satisfied. irc § 368(a)(2)(e). 106. irc § 368(a)(2)(e)(i). 107. irc § 367(a)(1). the statute is artfully drafted so that losses are not recognized. treas. reg. § 1.367(1)-1t(b)(3)(ii). 108. see gustafson, et al, supra note 26 ¶ 10,000. 109. irc § 367(a)(6). 110. treas. reg. § 1.367(a)-3(c)(1). the treasury promulgated these regulations in response to the 1994 helen of troy inversion. hicks, supra note 6, at 905-07. 111. treas. reg. § 1.367(a)-3(c)(1). in addition, the domestic corporation (target company) must comply with certain reporting requirements. id. 90 florida tax review [vol. 9:2 (i) u.s. transferors, in the aggregate, receive in the transfer 50% or less of the total voting power and value of the transferee corporation’s stock (the 50% ownership threshold); 112 (ii) u.s. persons that are officers, directors or 5% shareholders, in the aggregate, own 50% or less of the total voting power and value of the transferee corporation’s stock immediately after the transfer; 113 (iii) the transferor is either (a) not a 5% transferee shareholder; or (b) must enter into a 5-year gain recognition agreement; 114 and (iv) the active trade or business test is satisfied. 115 this test requires that (a) the transferee or its qualified subsidiary be engaged in an active trade or business outside the u.s. for the entire 36-month period immediately before the transfer; (b) at the time of the transfer, neither the transferors nor the transferee have an intention to substantially dispose of or discontinue such trade or business; and (c) the substantiality test is satisfied. 116 this last test requires that, at the time of the transfer, the fair market value of the transferee corporation is at least equal to the fair market value of the u.s. target company. 117 the ingersoll-rand inversion obviously failed the first and fourth requirements. it failed requirement (i) because the ir-nj public shareholders acquired 100% of the ir-ltd. class a voting stock, violating the 50% ownership threshold. it failed requirement (iv) because ir-ltd. did not engage in an active trade or business before the merger. 118 112. treas. reg. § 1.367(a)-3(c)(1)(i). 113. treas. reg. § 1.367(a)-3(c)(1)(ii). 114. treas. reg. § 1.367(a)-3(c)(1)(iii). 115. treas. reg. § 1.367(a)-3(c)(1)(iv). 116. treas. reg. § 1.367(a)-3(c)(3)(i). 117. treas. reg. § 1.367(a)-3(c)(3)(iii). 118. see ir proxy/prospectus, at 6-7. the merger transaction presents one additional minor issue. section 367(a)(1) literally applies when a u.s. person transfers property to a foreign corporation. but the shareholders did not actually transfer anything to ir-ltd. as explained above, the ir-nj stock converted automatically into ir-ltd. class a stock without any need for an actual exchange. the regulations, however, make it clear that section 367(a)(1) “applies to such a transfer whether it is made directly, indirectly or constructively.” treas. reg. § 1.367(a)-1t(c)(1). 2008] corporate expatriation 91 therefore section 367(a)(1) applied to the merger. each shareholder recognized gain to the extent that the fair market value of the ir-ltd. stock he received exceeded his basis in the ir-nj stock. 119 but if a shareholder’s adjusted basis in the ir-nj stock was higher than the fair market value of the ir-ltd. stock received, he did not recognize the loss. 120 instead, the shareholder’s basis in the new ir-ltd. stock received was equal to his basis in the old ir-nj stock. 121 therefore the shareholder could recognize the loss, or less gain, when he later sold the ir-ltd. stock. 122 when the treasury adopted the above quoted regulations in the 1990s, commentators assumed that the potential tax on shareholder level gain was sufficient to deter most inversion transactions. 123 however, stock values declined in the early 2000s. this decline meant that shareholders would recognize only a modest gain, or no gain, in the inversion transaction, making an expatriation more feasible. 124 in addition, shareholders that are either “tax-exempt, such as pension funds, or tax-indifferent, such as mutual funds” own a significant amount of stock of u.s. multinationals. 125 there were no tax consequences at the corporate level. the merger between ir-nj and ir merger corp. was between two domestic corporations, so section 367(a) did not apply. 126 ir-nj, the surviving corporation, did not undergo any corporate level transaction in the merger, so it recognized no gain or loss. 127 ir-ltd., the acquiring corporation, was not subject to any meaningful u.s. tax consequences. 128 119. irc §§ 367(a), 1001. 120. treas. reg. § 1.367(a)-1t(b)(3)(ii). section 367(a) only applies for the “purposes of determining the extent to which gain shall be recognized.” irc § 367(a)(1) (emphasis added). if the shareholder realized a loss, § 367(a) did not apply. therefore the normal corporate nonrecognition provisions, such as §§ 351 or 354, still applied, so that the loss was not recognized. 121. irc § 358(a). 122. in its proxy and prospectus, the company stated that the above would be the tax consequences of the reorganization to the shareholders. ir proxy/prospectus, supra note 7, at 8-9, 48-49. 123. see hicks, supra note 6, at 906-07; peterson & cohen, supra note 6, at 165. 124. see kirsch, supra note 6, at 495-96. 125. peterson & cohen, supra note 6, at 165. also, foreign taxpayers are exempt from tax on the gain. kirsch, supra note 6, at 495-96. 126. see bittker & lokken, supra note 6 ¶ 71.1.3, example 4a. 127. see peterson & cohen, supra note 6, at 165; hicks, supra note 6, at 909. the transaction should not have caused the ir-nj u.s. consolidated group to terminate. see hicks, supra note 6, at 909. 128. see hicks, supra note 6, at 909. 92 florida tax review [vol. 9:2 b. the transfer of assets 1. introductory issues in the reorganization ir-nj and certain of its subsidiaries transferred shares of certain existing ir-nj subsidiaries (the “transferred assets”), and issued certain debt, to ir-ltd. in exchange, ir-ltd. issued “that number of ir-limited class b common shares that” had “an aggregate value equal to the fair market value of the transferred assets and the amount of the debt.” 129 as noted above, these transfers occurred before the merger. 130 this exchange had to be for fair market value. 131 section 482 requires that exchanges between commonly controlled entities be at arm’s length. 132 if the u.s. transferor receives stock that has less value than the assets transferred, the irs could attempt to characterize the shortfall as a deemed dividend to the foreign parent, which would be subject to withholding tax. 133 in this case the transfer occurred before ir-nj became a subsidiary of ir-ltd. therefore the irs would have to use the step transaction doctrine or another theory to characterize any shortfall as a dividend. nevertheless, the company acknowledged in its prospectus that there was a possibility of u.s. withholding tax if the irs successfully disputed the value of the transferred assets. 134 2. corporate nonrecognition provisions the next step is to determine whether a nonrecognition provision covered this exchange. the exchange qualified under section 351. ir-nj transferred assets to ir-ltd. in exchange for ir-ltd. stock. immediately after the exchange ir-nj owned all the ir-ltd. stock, so ir-nj was in control of ir-ltd. 135 (recall that the asset transfer occurred before the merger.) 129. ir proxy/prospectus, supra note 7, at 7, 17. 130. ingersoll-rand co. ltd. 2001 financial report, supra note 11, at 35. 131. see peterson & cohen, supra note 6, at 170; treasury inversion study, supra note 1, at 10-11. 132. see bittker & lokken, supra note 6 ¶ 79.1.1. in the case of two or more organizations owned or controlled directly or indirectly by the same interests, § 482 authorizes the secretary of the treasury to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among such organizations if he determines that such reallocation is necessary to prevent the evasion of taxes or clearly to reflect income. irc § 482. 133. treasury inversion study, supra note 1, at 10-11. 134. ir proxy/prospectus, supra note 7, at 14. 135. see irc §§ 351(a), 368(c). alternatively, since the company executed the merger and the accompanying transfers all on the same day pursuant to an integrated plan, the step transaction doctrine could apply to collapse the merger with 2008] corporate expatriation 93 the exchange did not qualify for nonrecognition under any other provision. 136 3. section 367 before applying section 367, we determined that ir-nj did not have to recognize gain or loss on the exchange. 137 next we need to examine whether section 367 changed this result. a. section 367(a) section 367(a)(1) provides that, for purposes of determining gain, if a u.s. person transfers property to a foreign corporation in an otherwise qualifying exchange, the foreign corporation shall not be considered a ir-nj’s transfer of subsidiary stock and debt into one integrated transaction. when the doctrine applies, both the public shareholders and ir-nj are “transferors,” and both are included in the “control group.” therefore all the transfers to ir-ltd. qualify under § 351. part iii.b.3 below discusses the application of the step transaction doctrine to the asset transfers. one might ask if § 304 applied to this exchange. that section provides that, if one or more persons are in control of each of two corporations, and in return for property, one of the corporations acquires stock in the other corporation from the person in control, then the property shall be treated as a distribution in redemption. irc § 304(a)(1). before the inversion ir-nj was in control of its cfcs and of irltd. then ir-ltd. acquired stock of the cfcs from ir-nj. but ir-ltd. used its own class b stock to acquire the cfc stock. stock in the corporation making the distribution is not “property” within the meaning of § 304. irc § 317(a). therefore § 304 did not apply. see bittker & eustice, supra note 89 ¶ 12.63[4][d]. 136. at first glance, the exchange of assets and debt for b stock might have qualified for nonrecognition as a d reorganization. a “d” reorganization is “a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders…, or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356.” irc § 368(a)(1)(d). ir-nj transferred part of its assets to ir-ltd., a corporation that ir-nj controlled immediately after the transfer. so the exchange satisfied the first phrase of the statute. but the exchange did not satisfy the last phrase because ir-nj did not distribute any of the b stock that it received from ir-ltd. therefore the exchange did not qualify as a d reorganization. 137. even if § 351 did not apply, ir-nj could not recognize a loss upon transferring the assets, because § 267 denies recognition of losses on certain transfers between related parties. treasury inversion study, supra note 1, at 10. ir-ltd. recognized no gain or loss on the exchange. irc § 1032. 94 florida tax review [vol. 9:2 corporation. 138 section 367(a)(2) provides that, except as provided in regulations, the general rule of section 367(a)(1) does not apply to the transfer of stock or securities of a foreign corporation which is a party to the exchange. 139 section 1.367(a)-3(a) of the regulations provides that a u.s. person’s transfer of foreign stock or securities to a foreign corporation is taxable unless the exceptions provided in section 1.367(a)-3(b) apply. 140 that section states that a u.s. person’s transfer of stock or securities of a foreign corporation to a foreign corporation shall not be subject to section 367(a)(1) if either: (i) the u.s. person owns less than 5% of both the total voting power and value of the transferee corporation’s stock immediately after the transfer; or (ii) the u.s. person enters into a five-year gain recognition agreement (gra). 141 in its prospectus, the company stated that after the transfer, ir-nj’s class b common shares would constitute up to approximately 45% of the total value of the ir-ltd. shares. 142 ir-nj obviously owned more than 5% of ir-ltd., by value, after the exchange. therefore clause (i) of the above regulations did not apply. however, under clause (ii), ir-nj could avoid gain recognition by entering into a gra, if it chose to do so. 143 if the company did not enter into a gra, it would have recognized gain, but no loss, on the exchange. 144 if the company recognized gain, section 1248 probably applied to the gain. 145 section 1248 applies if a u.s. person sells or exchanges stock in a foreign corporation, and the u.s. person owned 10% or more of the voting power of the stock at any time during the 5-year period ending on the date of the sale or exchange, when the foreign corporation was a cfc. 146 section 138. irc § 367(a)(1). 139. irc § 367(a)(2). 140. treas. reg. § 1.367(a)-3(a). 141. treas. reg. § 1.367(a)-3(b)(1). 142. ir proxy/prospectus, supra note 7, at 14. 143. see peterson & cohen, supra note 6, at 171. gain recognition agreements present an interesting planning opportunity. generally, the corporate tax provisions are not elective. if a nonrecognition provision covers a transaction, the taxpayer recognizes no gain or loss, whether that result is to his advantage or not. but in some circumstances, under § 367, if a taxpayer is eligible for a gra, he can effectively choose to recognize gain (but not loss), if that is to his advantage, by simply not entering into an agreement. 144. irc § 367(a). 145. see treas. reg. § 1.367(a)-3(b)(2)(ii), example, part (ii). 146. irc § 1248(a). 2008] corporate expatriation 95 1248 recharacterizes the gain as a dividend to the extent of the cfc’s earnings and profits, attributable to the stock transferred, which were accumulated while the u.s. person held the stock and while the subsidiary was a cfc. 147 the purpose of section 1248 is to ensure that undistributed earnings and profits of the cfc that were not previously taxed to the shareholder under subpart f are taxed as a dividend, rather than as capital gain. 148 if ir-nj recognized gain, section 1248 likely characterized some of that gain as a dividend from the cfcs. this dividend income was foreign source income. 149 the dividend came with an important tax benefit. under section 902, if a domestic corporation receives a dividend from a foreign corporation, and it owns at least 10% of the foreign corporation’s voting stock, then the domestic corporation is eligible for an indirect foreign tax credit. 150 the domestic corporation is deemed to have paid a portion of the foreign corporation’s foreign income taxes. 151 the domestic corporation can claim a credit for the foreign taxes deemed paid, subject to the same limitations that apply to foreign taxes actually paid. 152 the domestic corporation computes the foreign tax deemed paid by multiplying the foreign corporation’s foreign tax by a fraction. 153 the numerator of the fraction is the amount of the dividend. 154 the denominator is the foreign corporation’s undistributed earnings. 155 the indirect credit is also available when another code section characterizes an amount as a “dividend,” even though there was no actual distribution. 156 a deemed dividend under sections 367(b) or 1248 is treated as a dividend for purposes of section 902. 157 therefore, if ir-nj recognized dividend income under section 1248, the company could claim a credit for the foreign taxes that the cfcs paid on the earnings deemed distributed. 158 147. id. 148. bittker & lokken, supra note 6 ¶ 69.14. 149. see id. ¶ 73.6.5 (general source rules for gain on disposition of foreign stock do not apply to any amount characterized as a dividend under § 1248 because the source rules for dividends apply to this amount). dividends from a foreign corporation are generally foreign source income. id. ¶ 73.3. 150. see irc § 902(a). 151. id. 152. bittker & lokken, supra note 6 ¶ 72.9.1; see irc § 901(a). 153. bittker & lokken, supra note 6 ¶ 72.9.3. 154. id.; see irc § 902(a). 155. bittker & lokken, supra note 6 ¶ 72.9.3; see irc § 902(a). 156. bittker & lokken, supra note 6 ¶ 72.9.2. 157. id.; treas. reg. § 1.902-1(a)(11). 158. see irc § 902(a); treas. reg. § 1.1248-1(d); bittker & lokken, supra note 6 ¶ 69.14. 96 florida tax review [vol. 9:2 gain in excess of the dividend portion would have been capital gain. under section 865, when a u.s. corporation sells or exchanges stock in a foreign corporation, the capital gain is u.s. source, unless the exceptions in sections 865(f) or 865(h) apply. 159 if the capital gain was significant, it might have been to the company’s advantage to enter into a gra. b. section 367(b) but even if the company entered into a gra, section 367(b) probably required ir-nj to recognize income anyway. 160 the regulations state that certain transfers might be subject to both sections 367(a) and 367(b). 161 section 367(b) provides that in the case of an otherwise qualifying exchange where “there is no transfer of property described in” section 367(a)(1), “a foreign corporation shall be considered to be a corporation except to the extent provided in regulations … .” 162 therefore we need to determine whether the section 367(b) regulations applied to the exchange. section 1.367(b)-4 of the regulations requires a shareholder to include in income as a deemed dividend the “section 1248 amount” when an exchange results in the loss of status as a section 1248 shareholder. 163 the section 1248 amount is the net positive earnings and profits that would have been attributable to the cfc stock and includible in income as a dividend under section 1248 if the transferor had sold the stock. 164 the purpose of this 159. irc § 865(a)(1), (i)(2). section 865(f) provides that if (1) a u.s. resident sells stock in an affiliate which is a foreign corporation, (2) such sale occurs in a foreign country in which the affiliate is engaged in the active conduct of a trade or business, and (3) more than 50% of the affiliate’s gross income for the previous 3 years was derived from the active conduct of a trade or business in such foreign country, then any gain from such sale shall be sourced outside the u.s. in this case, the transfer took place at ingersoll-rand’s new jersey headquarters, not in a foreign country. therefore § 865(f) did not apply. section 865(h) provides that if gain would otherwise be u.s. source, but under a treaty would be foreign source, the taxpayer may elect to follow the treaty source rule. 160. even if a transferor enters into a gra, the concurrent application of the section 367(b) regulations might require the transferor to recognize the “section 1248 amount” on the exchange. treas. reg. § 1.367(a)-3(b)(2)(ii), example. this example uses a b reorganization. however, the last sentence of the explanation states that the result would be unchanged if the exchange qualified as a § 351 exchange. id. at (iii) in the example. 161. treas. reg. § 1.367(a)-3(b)(2)(i). 162. irc § 367(b)(1). the regulations seem to take the approach that, if the taxpayer enters into a gra, then the transfer is “not described in” § 367(a)(1), thereby triggering further scrutiny under § 367(b). 163. treas. reg. § 1.367(b)-4(b)(1). 164. treas. reg. § 1.367(b)-2(c)(1). 2008] corporate expatriation 97 rule is “to prevent nonrecognition transactions from erasing the potential for applying section 1248 to u.s. shareholders’ stock sales.” 165 a section 1248 shareholder is a u.s. person that owns directly, indirectly or constructively 10% or more of the voting stock of the foreign corporation at any time during the 5-year period ending on the date of the sale or exchange, when the corporation was a controlled foreign corporation. 166 a loss of status as a section 1248 shareholder occurs if the exchanging shareholder was a section 1248 shareholder before the exchange, but after the exchange the stock he received is not stock in a corporation that is a cfc, as to which he is a section 1248 shareholder. 167 before the asset transfer, ir-nj was a section 1248 shareholder with respect to its former cfcs. in exchange for the assets and debt, ir-nj received the ir-ltd. b stock. immediately after this transfer, but before the merger, ir-ltd. was still a cfc of ir-nj. so ir-nj was still a section 1248 shareholder with respect to ir-ltd. therefore the asset transfer alone did not cause ir-nj to lose its status as a section 1248 shareholder. in a 2003 article peterson & cohen pointed out that the irs could use the step transaction doctrine to argue that the section 367(b) regulations applied to the exchange. 168 the merger and the accompanying transfers both took place on the same day, pursuant to an integrated plan. under the step transaction doctrine, we collapse the two transactions together into one transaction. 169 this integrated transaction still qualified as a section 351 exchange. ir-nj and the public shareholders collectively contributed property to ir-ltd. in exchange for stock. 170 immediately thereafter, ir-nj and the public shareholders collectively controlled ir-ltd. 171 after this integrated section 351 exchange, ir-ltd. was not a cfc. as a public company, it likely had no u.s. shareholders (that is, no u.s. persons owning 10% or more of the voting stock). 172 using the step transaction doctrine to collapse the two transactions into one integrated exchange, the irs could successfully contend that the section 367(b) regulations applied to the exchange. before the exchange irnj was a section 1248 shareholder with respect to its former cfcs. in the exchange, ir-nj received the b stock in ir-ltd., which was not a cfc. therefore ir-nj lost its status as a section 1248 shareholder. consequently, 165. bittker & lokken, supra note 6 ¶¶ 71.2.1; see generally id. ¶ 71.2.3. 166. treas. reg. § 1.367(b)-2(b); irc § 1248(a)(2). 167. treas. reg. § 1.367(b)-4(b)(1). 168. peterson & cohen, supra note 6, at 171. 169. id. 170. see irc § 351(a). 171. see irc § 368(c); peterson & cohen, supra note 6, at 171 n.71. 172. see irc §§ 951(b), 957(a). 98 florida tax review [vol. 9:2 ir-nj had to include the section 1248 amount in income as a deemed dividend, even if the company entered into a gra. 173 the deemed dividend from the cfcs was foreign source income. a deemed dividend is treated as a dividend for all purposes of the internal revenue code. 174 therefore, under section 902, ir-nj could claim an indirect credit for the foreign taxes that the cfcs paid on the earnings deemed distributed. 175 c. result under section 367 without access to the company’s tax returns and other relevant details, it is difficult to know for sure whether ir-nj (a) recognized gain under section 367(a), and then recharacterized some or all of that gain as dividend income under section 1248; or (b) recognized the section 1248 amount as dividend income under section 367(b). the company probably recognized significant dividend income under one provision or the other. however, under section 902, the company could claim an indirect credit for the foreign taxes that the cfcs paid on the earnings deemed distributed. in its 2001 financial report, the company stated “as a result of the reincorporation from new jersey to bermuda, the company recorded a one time tax benefit of $59.8 million related to the utilization of previously limited foreign tax credits and net operating loss carryforwards in certain non-u.s. jurisdictions.” 176 173. treas. reg. § 1.367(a)-3(b)(2). the actual transactions were more complex. besides transferring its own direct subsidiaries, ir-nj transferred some lower-tier subsidiaries. ir proxy/prospectus, supra note 7, at 7. the regulations provide that “a deemed dividend coming from earnings and profits of a lower-tier subsidiary is deemed distributed through the chain of ownership.” bittker & lokken, supra note 6 ¶ 71.2.6; treas. reg. § 1.367(b)-2(e)(2). 174. treas. reg. § 1.367(b)-2(e)(2); bittker & lokken, supra note 6 ¶ 71.2.6. 175. see irc § 902(a); treas. reg. § 1.367(b)-2(e)(4), example 1; bittker & lokken, supra note 6 ¶ 71.2.6. 176. ingersoll-rand co. ltd. 2001 financial report, supra note 11, at 39. the company’s 2007 annual report disclosed that, in the audit of tax years 2001 and 2002, the internal revenue service proposed some adjustments. the service did not contest the validity of the reincorporation transactions. however, the irs proposed to treat the intercompany debt as equity. as a result, the irs disallowed the deduction for interest paid on the debt. the irs recharacterized the interest payments as dividends, and it imposed dividend withholding taxes on those payments. the company has filed a formal written protest. ingersoll-rand co. ltd. 2007 annual report (form 10-k), at 12 (feb. 29, 2008). 2008] corporate expatriation 99 c. future tax consequences 1. ir-ltd., the new parent company as a result of the reorganization, ir-ltd., a foreign corporation, became the parent of the multinational group. a foreign corporation is only subject to u.s. tax on its nonbusiness u.s. source income and income effectively connected with the conduct of business in the u.s. 177 ir-ltd. owned the group’s foreign operations. as discussed in part ii, those foreign operations were not subject to u.s. corporate level tax. and bermuda has no corporate income tax. 178 further, bermuda does not impose a withholding tax on dividends that a bermuda corporation pays to its foreign shareholders. 179 ir-nj, a domestic corporation, is potentially subject to u.s. tax on its worldwide income. 180 but after the reorganization, ir-nj held only the domestic operations. therefore only the domestic operations were subject to u.s. tax. 2. dividends on the ir-ltd. class a stock for u.s. stockholders, dividends from ir-ltd., a foreign corporation, are generally foreign source income. 181 the source of income is an important issue if a taxpayer claims the foreign tax credit. even though no bermuda tax is withheld from the dividends on ir-ltd. stock, the shareholder might claim the credit if he has other foreign source income that is subject to foreign tax. u.s. taxpayers are subject to u.s. tax on their worldwide income. 182 to alleviate double taxation, the u.s. allows u.s. taxpayers a credit for the foreign income taxes they pay on their foreign source income. 183 this credit is limited to the u.s. tax on the income from foreign sources. 184 the taxpayer 177. bittker & lokken, supra note 6 ¶ 65.3.1. 178. crs corporate inversion report, supra note 21; ir proxy/prospectus, supra note 7, at 52. 179. ir proxy/prospectus, supra note 7, at 52. 180. see bittker & lokken, supra note 6 ¶ 65.3.1. 181. bittker & lokken, supra note 6 ¶ 73.3. before the inversion, ir-nj withheld a 30% u.s. tax from dividends paid to foreign shareholders, subject to reduction by any applicable treaty. see treasury inversion study, supra note 1, at 15; irc §§ 871(a)(1)(a), 881(a)(1), 1441, 1442. after the inversion, dividends that irltd. paid to foreign shareholders were no longer subject to u.s. withholding tax. see treasury inversion study, supra note 1, at 15. 182. bittker & lokken, supra note 6 ¶ 65.3.1. 183. see irc § 901. 184. bittker & lokken, supra note 6 ¶ 72.6.1. 100 florida tax review [vol. 9:2 computes the limitation by multiplying his u.s. tax by a fraction. 185 the numerator of the fraction is the foreign source taxable income. 186 the denominator is the worldwide taxable income. 187 the higher the proportion of income that a u.s. taxpayer receives from foreign sources, the greater is his potential foreign tax credit. section 904(h) treats some dividends from a foreign corporation as u.s. source income in certain circumstances. 188 the section applies if u.s. persons own 50% or more of the stock, 189 and if the corporation derives a certain amount of income from u.s. sources. 190 ingersoll-rand expected that section 904(h) would apply to ir-ltd. after the reorganization. 191 in its prospectus, the company stated that “only a portion of the dividends received by a u.s. holder … will be treated as foreign source income for purposes of calculating” the foreign tax credit limitation. 192 but as a practical matter the source of the dividends on ir-ltd. class a stock has become a non-issue. since the inversion, the company has characterized much of its distributions to shareholders as nontaxable returns of capital, not as dividends. 193 under section 316, a distribution to shareholders constitutes a “dividend” only to the extent of the corporation’s earnings and profits. 194 for this purpose, a foreign corporation computes its earnings and profits in the 185. id.; see irc § 904(a). 186. bittker & lokken, supra note 6 ¶ 72.6.1; see irc § 904(a). 187. gustafson, et al, supra note 26 ¶ 5220. 188. treasury inversion study, supra note 1, at 14 n.32. section 904(h), entitled source rules in case of u.s.-owned foreign corporations, was formerly § 904(g). the ajca re-designated it as § 904(h). american jobs creation act of 2004, pub. l. no. 108-357, § 402(a), 118 stat. 1418, 1491 (2004). 189. irc § 904(h)(6). 190. irc § 904(h)(4), (5). 191. see ir proxy/prospectus, supra note 7, at 50. 192. id. 193. for 2007, distributions were 100% nontaxable. ingersoll-rand investor relations website, available at http://investor.shareholder.com/ir/dividend_info.cfm? land=dividendinfo (last visited sept. 29, 2008). they were 100% nontaxable in 2006, 96% nontaxable in 2005, 92% nontaxable in 2004, and 100% nontaxable in 2003. cch capital changes reporter, online subscription service. distributions in 2002 were 47% nontaxable. letter from ingersoll-rand in-house tax counsel, dated mar. 3, 2003, on file with author. other expatriated companies have also characterized a significant portion of their distributions as non-taxable. for example, cooper industries’ 2005 2007 distributions were 100% nontaxable. wall street concepts, online subscription service. regarding the 2007 distributions, see also cooper industries ltd. investor relations website: http://www.cooperindustries.com/ common/investorcenter/dividendsfaq.cfm (last visited sept. 29, 2008). 194. irc § 316(a). 2008] corporate expatriation 101 same manner as a domestic corporation, with a few differences. 195 apparently ir-ltd. characterized much of the distributions on its stock as nontaxable returns of capital because the company had little or no earnings and profits. a distribution that is not a dividend is excluded from the shareholder’s income, to the extent of the shareholder’s basis in the stock. 196 therefore the distribution is not included in either the numerator or the denominator of the fraction used to calculate the limitation on the foreign tax credit. 197 in summary, for determining a u.s. stockholder’s foreign tax credit, the source of such nondividend distributions is simply not relevant. a shareholder must reduce his basis in the stock by the amount of the nontaxable distribution. 198 this means that the shareholder will recognize more gain when he eventually sells the stock. the law does not permanently exempt the income; it merely defers recognition. however, this deferral benefits the shareholder due to the time value of money. unfortunately, without access to more detailed, inside financial data, it is impossible to determine why the company has so little earnings and profits. immediately after the reorganization ir-ltd. was a brand new company with no earnings and profits. as a holding company, its main source of earnings and profits is the dividends it receives from its subsidiaries. it is possible that some subsidiaries made distributions to irltd. that were not derived from earnings and profits. but to support the cash distributions that ir-ltd. has consistently paid to its shareholders since 2002, ultimately some members of the group must earn a profit and must remit those earnings to the parent. 3. the ir-ltd. class b nonvoting stock in the reorganization ir-ltd., a publicly held foreign corporation, became the new parent of the group. it was unlikely that any u.s. person held 10% or more of the ir-ltd. class a voting common stock. therefore ir-ltd. had no u.s. shareholders. ir-ltd. was not a controlled foreign corporation (cfc). 199 also in the reorganization, ir-nj’s former foreign subsidiaries became subsidiaries of ir-ltd. as explained above, those 195. see joel d. kuntz & robert j. peroni, us international taxation ¶ b6.02[11] (warren, gorham & lamont 2008). 196. see irc § 301(c)(2). 197. see irc § 904(a); bittker & lokken, supra note 6 ¶ 73.3. 198. irc § 301(c)(2). if nontaxable distributions exceed the shareholder’s basis, the excess is treated as gain from the sale or exchange of property. irc § 301(c)(3)(a). 199. see irc § 957(a). 102 florida tax review [vol. 9:2 subsidiaries were no longer cfcs. the foreign subsidiaries’ earnings were no longer potentially subject to subpart f. in the reorganization ir-nj received class b shares that represented approximately 45% of the total value of the ir-ltd. shares. 200 the company knew that this structure entailed some risks. 201 refer again to figure 6 on page 1015. through its ownership of the b stock, ir-nj indirectly owned 45% of ir-ltd.’s newly acquired foreign subsidiaries. 202 therefore ir-nj was a u.s. shareholder of those subsidiaries. 203 if another u.s. person accumulated 10% or more of the class a stock, then u.s. shareholders would indirectly own more than 50% of the subsidiaries’ voting stock. this would cause the subsidiaries to become cfcs, 204 thereby defeating a major purpose of the reorganization. 205 another risk was that the irs might attempt to classify the b stock as voting stock for purposes of section 951(b). 206 if the irs were successful, then ir-nj, directly owning 45% of the voting stock, would become a u.s. shareholder of ir-ltd. 207 if another u.s. person accumulated 10% or more of the a stock, then ir-ltd. itself would become a cfc, defeating a major purpose of the reorganization. 4. dividends on the ir-nj stock the u.s. imposes a 30% withholding tax on dividends that a u.s. corporation pays to its foreign shareholders. 208 if a shareholder is a resident of a country that has a treaty with the u.s., the treaty might reduce or eliminate the tax. the u.s. does not have a tax treaty with bermuda. therefore ir-nj would have to withhold the 30% tax from dividends it pays to ir-ltd., its foreign parent. typically, however, companies have structured inversions so that the new foreign parent or a subsidiary qualifies as a resident of a country such as barbados, which has a treaty with the u.s. the treaty reduces the withholding tax, typically to 5 percent. 209 meanwhile, by taking advantage of the barbados international business companies (ibc) act, the company 200. ir proxy/prospectus, supra note 7, at 14. 201. id. 202. see irc § 958(a)(2). 203. irc § 951(b). 204. irc § 957(a). 205. see peterson & cohen, supra note 6, at 171. 206. ir proxy/prospectus, supra note 7, at 14. 207. irc § 951(b). 208. see irc §§ 871(a)(1)(a), 881(a)(1), 1441, 1442. 209. treasury inversion study, supra note 1, at 12-13. 2008] corporate expatriation 103 pays barbados tax at a rate of only 1% to 2.5%, depending on the income subject to tax. 210 but under a new protocol to the u.s.-barbados tax treaty, 211 irltd. will likely fail to qualify for the lower withholding rate. 212 the new protocol tightens the limitation on benefits article of the treaty, effective february 1, 2005. 213 the protocol makes it more difficult for a foreign company such as ir-ltd. to qualify as a barbados resident. if the company does not qualify, then it is not eligible for the reduced withholding rates under the interest or dividends articles of the treaty. therefore ir-nj might have to withhold u.s. tax at the general 30% rate. 214 5. the debt in the reorganization ir-nj transferred certain subsidiaries and issued certain debt in exchange for ir-ltd. class b stock. the debt was an intercompany note for about $3.6 billion. 215 the note had an 11% fixed interest rate. 216 in 2002 ir-ltd. contributed the note to a subsidiary, which subsequently contributed portions of the note to several other subsidiaries. 217 the interest that ir-nj pays to ir-ltd. or its foreign affiliates on the debt is potentially subject to 30% u.s. withholding tax. 218 the “portfolio interest” exception to the withholding rule does not apply because ir-ltd. (or under the attribution rules, another subsidiary holding the debt) is a 10% 210. id. at 12-13 & n.27; michael j. miller, pending protocol will prevent inverted corporations from accessing the barbados treaty, 33 tax mgm’t int’l j. 643 (nov. 12, 2004). 211. second protocol amending the convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, u.s.-barb., jul. 14, 2004, s. treaty doc. no. 108-26. 212. see janette zive, ian bristol, steve fernandes, and james payne, new protocol to u.s.-barbados income tax treaty may mean restructuring for some foreign multinationals, 16 j. int’l tax’n 38, 41 (may 2005); dep’t of treasury, report to the congress on earnings stripping, transfer pricing and u.s. income tax treaties 80-81 (nov. 2007), available at www.treas.gov/offices/taxpolicy/library/ajca2007.pdf [hereinafter 2007 treasury earnings stripping report]. 213. zive et al., supra note 212, at 40. 214. a thorough discussion of this topic would constitute another article. for more in-depth analysis, see zive et al., supra note 212; miller, supra note 210. 215. ingersoll-rand co. ltd. 2002 financial report 52 (2003). the exact amount of the note was $3,647.4 million. ingersoll-rand co. ltd. 2001 financial report, supra note 11, at 46 (condensed consolidating balance sheet). 216. ingersoll-rand co. ltd. 2002 financial report 52 (2003). 217. id. 218. irc §§ 881, 1442. 104 florida tax review [vol. 9:2 shareholder of the debtor, ir-nj. 219 a lower withholding rate might apply if the note holder is a resident of a country with a favorable treaty with the u.s. if the interest that ir-nj pays on the note is deductible, then the group can effectively strip earnings from the u.s. tax base. meanwhile the interest that ir-ltd. or a subsidiary earns on the note might be subject to little or no tax in the foreign creditor’s country of residence. 220 section 163(j) limits a corporation’s ability to deduct interest paid to a related person. 221 the section applies if the payor corporation’s debt to equity ratio as of the end of the tax year exceeds 1.5 to 1, and if it has “excess interest expense.” 222 excess interest expense means the amount by which the corporation’s net interest expense exceeds 50% of its adjusted taxable income. 223 section 163(j) disallows a deduction for “disqualified interest” to the extent it does not exceed the corporation’s excess interest expense. 224 a corporation may carry disallowed interest forward to a subsequent year and deduct it if the corporation does not exceed the limit in that year. 225 disqualified interest includes interest that is paid to a related person and that is not subject to u.s. tax. 226 interest is not disqualified if it is subject to u.s. withholding tax. 227 if related party interest is subject to a reduced rate of withholding pursuant to a treaty, then a portion of the interest is disqualified. 228 the debt to equity ratio is the ratio which the total indebtedness of the corporation bears to the sum of money and all other assets of the corporation reduced (but not below zero) by the taxpayer’s debt. 229 assets are included at their adjusted basis. 230 for the purpose of computing the ratio, the proposed regulations exclude short-term liabilities and commercial financing liabilities from debt. 231 however, the corporation must reduce its equity by the amount of the liabilities so excluded. 232 short-term liabilities means accrued operating expenses, accrued taxes payable, and any account 219. irc §§ 881(c), 871(h); see miller, supra note 210, at n.30. 220. see treasury inversion study, supra note 1, at 13. 221. see bittker & lokken, supra note 6 ¶ 66.6. 222. irc § 163(j)(2)(a). 223. irc § 163(j)(2)(b)(i). 224. irc § 163(j)(1)(a). 225. irc § 163(j)(1)(b). 226. irc § 163(j)(3); see treasury inversion study, supra note 1, at 22. 227. irc § 163(j)(3)(a). 228. irc § 163(j)(5)(b). 229. irc § 163(j)(2)(c). 230. irc § 163(j)(2)(c)(i). 231. prop. reg. § 1.163(j)-3(b)(2). 232. prop. reg. § 1.163(j)-3(c)(3). 2008] corporate expatriation 105 payable for the first 90 days of its existence, if no interest accrues for any portion of such 90 day period. 233 generally, under the proposed regulations, an affiliated group determines its debt to equity ratio as if all the members are a single taxpayer. 234 however, a foreign corporation cannot be part of an affiliated group. 235 accordingly, an example in the proposed regulations suggests that a nonincludible foreign corporation is not included in the computations for the various tests under section 163(j). 236 this presumably means that, to calculate ir-nj’s affiliated group debt to equity ratio, we must exclude irltd. and its foreign subsidiaries. (unfortunately, the proposed regulations do not provide any examples of the debt to equity ratio calculation in the affiliated group context.) 237 the debtor calculates its debt to equity ratio as of the end of the tax year. 238 ir-nj issued the intercompany note on dec. 31, 2001. so ir-nj only accrued one day’s interest expense on the note in 2001. applying the above principles, i reviewed ir-ltd.’s condensed consolidating balance sheet as of december 31, 2002 to estimate whether ir-nj exceeded the 1.5 to 1 limit for 2002. see figure 7. 233. prop. reg. § 1.163(j)-3(b)(2)(i). 234. prop. reg. § 1.163(j)-5(d); see also irc §163(j)(6)(c); prop. reg. § 1.163(j)-5(a). 235. irc § 1504(b)(3). 236. see prop. reg. § 1.163(j)-5(a)(3). 237. bittker & eustice, supra note 89 ¶ 13.23[8]. 238. irc § 163(j)(2)(a). 106 florida tax review [vol. 9:2 figure 7 condensed consolidating balance sheet december 31, 2002 irirother consolidating ir-limited in millions limited new jersey subsidiaries adjustments consolidated current assets: cash and cash equivalents -$ 209.00$ 133.20$ -$ 342.20$ accounts and notes receivable, net 113.60 1,291.70 1,405.30 inventories, net 136.10 1,053.70 1,189.80 prepaid expenses and deferred income taxes 55.20 325.90 381.10 assets held for sale 1.40 792.60 794.00 accounts and notes receivable affiliates 1.30 10,554.30 (10,555.60) total current assets 1.30 515.30 14,151.40 (10,555.60) 4,112.40 investment in affiliates 3,768.60 12,239.10 3,313.60 (19,321.30) property, plant and equipment, net 265.00 1,014.90 1,279.90 intangible assets, net 173.30 4,723.10 4,896.40 note receivable affiliate other assets 0.10 (37.80) 558.60 520.90 total assets 3,770.00$ 13,154.90$ 23,761.60$ (29,876.90)$ 10,809.60$ current liabilities: accounts payable and accruals -$ 104.30$ 2,243.10$ -$ 2,347.40$ loans payable 1,073.20 82.30 1,155.50 liabilities held for sale 295.20 295.20 accounts and note payable affiliates 291.80 3,236.70 7,027.10 (10,555.60) total current liabilities 291.80 4,414.20 9,647.70 (10,555.60) 3,798.10 long-term debt 1,854.80 237.30 2,092.10 note payable affiliate 3,647.40 (3,647.40) other noncurrent liabilities 95.60 1,345.60 1,441.20 total liabilities 291.80 10,012.00 11,230.60 (14,203.00) 7,331.40 shareholders' equity: class a common shares 169.20 169.20 class b common shares 135.30 (135.30) common shares 2,362.80 (2,362.80) other shareholders' equity 8,551.70 4,040.80 15,034.20 (23,804.60) 3,822.10 accumulated other comprehensive income (191.60) (418.90) (158.60) 256.00 (513.10) 8,664.60 3,621.90 17,238.40 (26,046.70) 3,478.20 less: contra account (5,186.40) (479.00) (4,707.40) 10,372.80 total shareholders' equity 3,478.20 3,142.90 12,531.00 (15,673.90) 3,478.20 total liabilities and equity 3,770.00$ 13,154.90$ 23,761.60$ (29,876.90)$ 10,809.60$ period end: dec 31, 2002 date filed: mar 05, 2003 ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------created by edgar online, inc. ingersoll rand co ltd table66 -------------------------------------------------------------------------------------------------------------form type: 10-k admittedly, the publicly filed financial statements are only a rough substitute for the corporation’s tax returns. first, the financial statements show assets at their book values for financial accounting purposes, not at their adjusted bases for tax purposes. second, column 3 of the consolidated balance sheet, entitled “other subsidiaries,” may have 2008] corporate expatriation 107 included data for both domestic and foreign members of the corporate group. if it did mingle the domestic and foreign subsidiaries, then it would be impossible to determine the combined ratio for all the u.s. members of the corporate group. ir-nj had a debt to equity ratio of 2.12 to 1 on december 31, 2002. 239 see figure 8. therefore section 163(j) might have disallowed some of the company’s related party interest for 2002. figure 8 ingersoll-rand nj debt to equity ratio calculation dec. 31, 2002 (in millions) ir-nj total liabilities $10,012.0 exclusions: accounts payable & accruals (104.3) accounts & note payable affiliates (3,236.7) a net liabilities 6,671.0 total assets 13,154.9 reductions: net liabilities (6,671.0) reduction for excluded liabilities, per prop. regs. § 1.163(j)-3(c)(3). (3,341.0) b net equity 3,142.9 ratio (a/b) 2.12 in a 2004 article seida & wempe analyzed the publicly filed financial statements of several inverted companies, including ingersoll-rand, to determine whether the inversions reduced the companies’ effective tax 239. in the column for ir-nj on the balance sheet, “accounts and note payable affiliates” totaling $3,236.7 million were lumped together as a single line item. ingersoll-rand co. ltd. 2002 annual report (form 10-k), at 70 (march 5, 2003) (condensed consolidating balance sheet as of dec. 31, 2002). under the definitions in the proposed regulations, accounts payable are excluded from the debt to equity ratio calculation, but notes payable are not, unless they constitute commercial financing liabilities. prop. reg. § 1.163(j)-3(b)(2)(i). however, even if the entire item is excluded from ir-nj’s liabilities, ir-nj exceeded the 1.5 to 1 limit. 108 florida tax review [vol. 9:2 rates. 240 the article concluded that earnings stripping through intercompany debt reduced effective tax rates. 241 the article also concluded that section 163(j) likely did not apply to ingersoll-rand for 2002 or 2003. 242 seida & wempe did not explain how they calculated the debt to equity ratio. if they included data for both ir-nj and the “other subsidiaries” in the computation, then the ratio for 2002 would have been under 1.5 to 1. d. tax policy issues the exchange of cfcs and debt for the ir-ltd. class b stock raises some serious tax policy issues. one issue is whether a subsidiary’s acquisition of parent company stock in exchange for a note represents a real economic investment. the debt-financed portion of this exchange had some indicia of a sham. when ir-nj transferred its foreign subsidiaries to ir-ltd., the company used the occasion to load up with as much debt as possible. the only limit on the amount of debt was that the face amount of the debt, plus the fair market value of the transferred assets, could not exceed 50% of the company’s value. issuing b stock that was worth more than 50% of the company’s value would have caused ir-ltd. to become a cfc. 243 to be safe, ir-ltd. issued to ir-nj class b stock representing 45% by value, just a few percentage points less than 50%. the value of that b stock was about $5.6 billion. 244 the accountants probably calculated the value of the “transferred assets” at about $2 billion. 245 ir-nj transferred those assets to ir-ltd. then ir-nj gave ir-ltd. a $3.6 billion note for the balance. 240. jim a. seida & william f. wempe, effective tax rate changes and earnings stripping following corporate inversion, 57 nat’l tax j. 805 (dec. 2004). 241. id. at 825. 242. id. at 821. 243. irc § 957. 244. on dec. 31, 2001, the a stock was worth $41.81 per share. ingersollrand investor relations website, available at http://files.shareholder.com/downloads/ir/234349907x0x84384/7c2a60ca-153544e3-8d60-980393782036/generaltaxinformation.htm (last visited sept. 29, 2008). as discussed in part ii.b, the company considered the a and b shares to be about equal in value. ir-ltd. issued 135,250,003 b shares in the reorganization. ingersollrand co. ltd. 2001 financial report, supra note 11, at 35. using a value of $41.81 per share of b stock, this works out to a total value of $5,654,802,625. 245. the value of the “transferred assets” must have been about $2,007,402,625, the value of the b stock, $5,654,802,625, minus the face amount of the $3,647,400,000 note. 2008] corporate expatriation 109 there is a consensus that sections 163(j) and 482 are insufficient to prevent such aggressive earnings stripping. 246 as part of the american jobs creation act, congress considered strengthening section 163(j) for inverted corporations. 247 the proposal would have eliminated the 1.5 to 1 debt to equity threshold for such corporations, and would have reduced the 50% threshold for “excess interest expense” to 25%. 248 however, in response to extensive lobbying by multinational corporations, the house dropped the provision tightening section 163(j). 249 as discussed below, congress enacted a provision that narrowly targeted inversion transactions, leaving the earnings stripping issue for another day. the potential for earnings stripping through related party debt is not unique to inversion transactions. 250 if congress is not inclined to strengthen section 163(j) in general, then it should at least address the problem of a subsidiary that acquires stock in its parent company using related party debt. one possible solution would be a provision that denies a deduction for interest on any related party debt used to acquire stock in a corporation that directly or indirectly controls the debtor. another approach might be to amend section 163(j) to provide that, for purposes of determining the debt to equity ratio, stock in a corporation that controls the debtor shall have a zero basis. 251 this provision would apply only to the extent of the corporation’s related party debt. stock acquired in exchange for property other than debt would have a basis. assigning a zero basis to the debt-financed stock would reduce the debtor’s equity for purposes of computing its debt to equity ratio. 252 this, in turn, would make it 246. treasury inversion study, supra note 1, at 21-25; kirsch, supra note 6, at 493; 2007 treasury earnings stripping report, supra note 212, at 8, 26. see also lee a. sheppard, turbo-charged income stripping, tax notes today (dec. 6, 2002) (lexis, fedtax lib., tnt file, elec. cit., 2002 tnt 235-4) (suggesting that interest deductions should be disallowed for all intercompany debt). 247. h.r. rep. no. 108-755, at 531 (2004) (conf. rep.), as reprinted in 2005 u.s.c.c.a.n. 1341, 1629, 2004 wl 2335174 (2004). 248. id. 249. kirsch, supra note 6, at 518-19. 250. treasury inversion study, supra note 1, at 22. 251. the treasury has the regulatory authority to prescribe adjustments in the debt to equity ratio calculation. irc § 163(j)(2)(c)(iii); see also § 163(j)(8). but this authority probably does not extend to treating an asset that has a basis for all other purposes of the code as having no basis. congress would have to amend the statute. 252. to avoid dividing by zero, however, in no event could total equity be reduced below $1.00 by reason of the recommended provision. cf. prop. reg. § 1.163(j)-3(c)(1) (equity means the sum of money and the adjusted basis of all other assets of the corporation reduced (but not below zero) by the taxpayer’s debt). 110 florida tax review [vol. 9:2 more likely that the debtor will exceed the 1.5 to 1 limit. if the debtor exceeds the limit, then the related party interest might be nondeductible. iv. consequences under section 7874 a. description of provision as part of the 2004 american jobs creation act (ajca), congress added section 7874 to the internal revenue code. 253 this section removes the potential tax benefits of an inversion. 254 the provision defines two types of corporate inversion transactions, with a different set of consequences for each type. 255 1. section 7874(b) transactions section 7874(b) applies if, pursuant to a plan or a series of related transactions: (i) after march 4, 2003, a foreign corporation directly or indirectly acquires substantially all the properties held directly or indirectly by a domestic corporation; (ii) after the acquisition, the former shareholders of the u.s. corporation hold, by reason of holding stock in the domestic corporation, at least 80% of the foreign corporation’s stock (by vote or value); and (iii) after the acquisition, the expanded affiliated group 256 which includes the foreign corporation does not have substantial business activities in its country of incorporation compared to the total worldwide business activities of the group. 257 if the above conditions apply, then the foreign corporation is a “surrogate foreign corporation.” 258 section 7874(b) denies the intended tax 253. pub. l. no. 108-357, § 801(a), 118 stat. 1418, at 1562 (2004). 254. kirsch, supra note 6, at 506-07; see generally bittker & lokken, supra note 6 ¶ 66.2. 255. h.r. rep. no. 108-755, at 532 (2004) (conf. rep.), as reprinted in 2005 u.s.c.c.a.n. 1341, 1629. the provision also potentially applies when a u.s. partnership expatriates. irc § 7874(a)(2)(b). 256. the expanded affiliated group is an “affiliated group” as that term is defined for purposes of the consolidated return provisions, except that foreign corporations are included, and the ownership threshold is “more than 50%” instead of “at least 80%.” irc § 7874(c)(1); see bittker & lokken, supra note 6 ¶ 66.2.2. 257. h.r. rep. no. 108-755, at 532 (2004) (conf. rep.), as reprinted in 2005 u.s.c.c.a.n. 1341, 1629-30. 258. irc § 7874(a)(2)(b), 7874(b). 2008] corporate expatriation 111 benefits of this type of inversion by deeming the top-tier foreign corporation (the surrogate foreign corporation) to be a domestic corporation for all purposes of the code. 259 section 7874(b) is “a significant departure from the long-standing place-of-incorporation rule for determining corporate residence.” 260 for determining whether a transaction meets the 80% continuity of ownership test in (ii) above, section 7874 disregards stock held by members of the expanded affiliated group that includes the foreign incorporated entity. 261 also for this purpose, the statute disregards stock sold in a public offering related to the transaction. 262 2. section 7874(a) transactions section 7874(a) covers a transaction that would meet the definition of an inversion transaction described above, except that the transaction does not meet the 80% continuity of ownership threshold. in that case, section 7874 respects the inversion transaction (that is, it treats the foreign corporation as foreign). 263 however, if there is at least a 60% continuity of ownership, then the domestic corporation, and any u.s. person related to it, is an “expatriated entity.” 264 an expatriated entity cannot use tax attributes such as net operating losses or foreign tax credits to offset any corporate level income or gains incident to establishing the inverted structure. 265 these measures generally apply for a 10-year period following the inversion transaction. 266 b. effect of section 7874(b) if section 7874(b) applies, then the new foreign parent of the group (the surrogate foreign corporation) is treated as a domestic corporation for all purposes of the code. 267 if a u.s. person transfers property to the surrogate foreign corporation, section 367 does not apply to the transaction because 259. h.r. rep. no. 108-755, at 532 (2004) (conf. rep.), as reprinted in 2005 u.s.c.c.a.n. 1341, 1629-30. 260. kirsch, supra note 6, at 546. 261. irc § 7874(c)(2)(a); h.r. rep. no. 108-755, at 532 (2004) (conf. rep.), as reprinted in 2005 u.s.c.c.a.n. 1341, 1630. 262. irc § 7874(c)(2)(b). 263. h.r. rep. no. 108-755, at 533 (2004) (conf. rep.), as reprinted in 2005 u.s.c.c.a.n. 1341, 1630. 264. irc § 7874(a)(2)(a). 265. h.r. rep. no. 108-755, at 533 (2004) (conf. rep.), as reprinted in 2005 u.s.c.c.a.n. 1341, 1630. 266. id. at 533, as reprinted in 2005 u.s.c.c.a.n. 1341, 1631. 267. irc § 7874(b). 112 florida tax review [vol. 9:2 there is no transfer to a foreign corporation. 268 further, section 367(a) does not apply to the shareholders’ exchange of stock in the inversion transaction. 269 the surrogate foreign corporation is subject to u.s. tax on its worldwide income. 270 further, if the surrogate foreign corporation directly or indirectly owns more than 50% of the stock, by vote or value, in another foreign corporation, then the other foreign corporation is a cfc. 271 the cfc’s subpart f income is taxable to the surrogate foreign corporation. if section 7874(b) had been in effect when ingersoll-rand completed its inversion, then the above tax consequences would have applied to it. first, ir-ltd., a foreign corporation, directly or indirectly acquired all the properties held by ir-nj, a domestic corporation. second, for purposes of computing whether the transaction met the 80% ownership threshold, section 7874 would disregard the b stock held by ir-nj. 272 therefore the former shareholders of ir-nj acquired 100% of the ir-ltd. stock. 273 third, it is unlikely that the group’s bermuda activities after the inversion were substantial when compared to the group’s worldwide activities. 274 ir-ltd. had operating subsidiaries in bermuda after the inversion. but it also had dozens of subsidiaries in numerous countries throughout the world. 275 the company’s 2001 annual report did not contain a detailed country-bycountry breakdown of its international activities. however, according to that report, the company had sales in over 100 countries. 276 approximately 32,000 of its 56,000 employees worked in the u.s. 277 if section 7874(b) applied, then ir-ltd., the acquiring corporation, would have been a surrogate foreign corporation. it would have been taxable 268. bittker & lokken, supra note 6 ¶ 66.2.3. 269. h.r. rep. no. 108-755, at 532 n.432 (2004) (conf. rep.), as reprinted in 2005 u.s.c.c.a.n. 1341, 1630; temp. reg. § 1.7874-2t(h). 270. bittker & lokken, supra note 6 ¶ 66.2.3. 271. id. 272. see irc § 7874(c)(2). 273. see treas. reg. § 1.7874-1(f), example (1). 274. the determination of whether, after the acquisition, the expanded affiliated group (eag) has substantial business activities in the foreign country in which, or under the law of which, the acquiring foreign entity is created or organized, when compared to the total business activities of the eag, shall be made on the basis of all of the facts and circumstances. temp. reg. § 1.7874-2t(d). a proposed amendment, however, would change this standard. h.r. 2937, 110th cong. § 1 (2007); see 153 cong. rec. e1455-04, 2007 wl 1875731 (june 29, 2007) (remarks of rep. neal). 275. ingersoll-rand co. ltd. 2001 annual report (form 10-k), at exhibit 21 (list of subsidiaries) (march 13, 2002). 276. id. at 5 (part i, item 1, business operations by geographic area). 277. id. at 6 (part i, item 1, business employees). 2008] corporate expatriation 113 on its worldwide income, like a domestic corporation. further, its foreign subsidiaries would have been cfcs. but this discussion is academic. if section 7874 had been in effect when the company was contemplating the inversion, the company would not have completed the transaction in the first place. ingersoll-rand completed its inversion on december 31, 2001, before the march 4, 2003 effective date. therefore section 7874 does not apply to it. 278 further, the proposed amendment discussed below would not apply to it because the company completed the inversion before march 20, 2002. c. effective date & proposed amendment section 7874 applies to companies that completed inversion transactions after march 4, 2003, 279 for taxable years ending after march 4, 2003. 280 under a proposed amendment, section 7874(b) would apply to companies that completed inversions after march 20, 2002, for taxable years beginning after the date the amendment becomes law. 281 278. in its 2006 annual report, the company stated “we completed our reincorporation in bermuda on dec. 31, 2001, and therefore our transaction is grandfathered by the american jobs creation act.” ingersoll-rand co. ltd. 2006 annual report (form 10-k), at 12 (march 1, 2007). 279. irc § 7874(a)(2)(b). 280. pub. l. no. 108-357, § 801(c), 118 stat. 1418, at 1566 (2004). 281. american infrastructure investment and improvement act of 2007, s. 2345, 110th cong. § 209 (2007); see staff of joint comm. on taxation, 110th cong., description of the american infrastructure investment and improvement act, jcx79-07 (2007), at 38 [hereinafter jcx-79-07], available at http://www.house.gov/jct/x-79-07.pdf. on feb. 14, 2008, sen. klobuchar introduced a bill containing a provision that was the same as § 209 of s. 2345, except that it would apply to tax years beginning after dec. 31, 2006. american renewable energy act of 2008, s. 2642, 110th cong. § 272 (2008). for another recent version of this proposal, see the aviation investment and modernization act of 2008, h.r. 2881, 110th cong. § 819 (2008). for some prior versions of this same proposal in the current congress, see energy advancement and investment act of 2007, h.r. 6, 110th cong. § 892 (2007), available at http://finance.senate.gov/sitepages/leg/leg%202007/leg%20110%2062007a1.pdf; h.r. 1591, 110th cong. § 532 (mar. 29, 2007); and s. 554, 110th cong. § 215 (feb. 12, 2007). the senate proposed a similar change as part of the 2005 tax increase prevention and reconciliation act, but the proposal was not included in the final version of pub. l. no. 109-222, enacted in may 2006. see h.r. rep. 109-455, 109th cong., 2nd sess., 2006 u.s.c.c.a.n. 234, at 435; crs corporate inversion report, supra note 21. 114 florida tax review [vol. 9:2 congress considered many anti-inversion tax bills before it passed the ajca. 282 one of those bills, the 2002 reversing the expatriation of profits offshore (repo) act, contained a provision similar to current section 7874(b). 283 the provision would have applied to companies that completed inversions after march 20, 2002. 284 none of those earlier bills became law. however, the senate finance committee believes the bills put companies on notice “that eventual legislation on this issue could be effective after march 20, 2002.” 285 companies that completed inversions after march 20, 2002 did so at their own risk. 286 therefore the committee believes it is not unfair at this point to move the applicable date back from march 4, 2003 to march 20, 2002. if this proposal becomes law, it will be a setback for companies that completed inversions from march 21, 2002 through march 4, 2003. 287 for tax years beginning after the date of enactment, section 7874(b) will treat those companies as domestic corporations. 288 under the amendment the foreign corporation will be treated, at the close of its first taxable year ending after the date of enactment, as transferring all of its assets, liabilities, and earnings and profits to a domestic corporation in a nontaxable reorganization. 289 this repatriation of the foreign parent corporation would be an f reorganization. an f reorganization is “a mere change in identity, form, or place of organization of one corporation, however effected.” 290 282. see kirsch, supra note 6 at 504-05 & n.92. 283. s. 2119, 107th cong. § 2 (2002). 284. id. on march 21, 2002, senators wellstone and dayton introduced another bill that would have treated inverted corporations as domestic corporations for taxable years beginning after dec. 31, 2002, without regard to whether the corporation became an inverted domestic corporation before, on, or after such date. s. 2050, 107th cong. (2002). 285. see s. rep. 110-228, at 32, “reasons for change” (2007), available at http://frwebgate.access.gpo.gov/cgibin/getdoc.cgi?dbname=110_cong_reports&docid=f:sr228.110.pdf. in fact, the pending bills may have been a factor when stanley works canceled its proposed inversion in august 2002. see kirsch, supra note 6, at 529-30. 286. see kirsch, supra note 6, at 545 n.234 (“any corporation considering expatriation after march 20, 2002 would have had to consider the possibility that the desired tax benefits would be lost if the senate proposal eventually were enacted.”). 287. for example, cooper industries completed its inversion on may 22, 2002. seida & wempe, supra note 240, at 811. 288. s. 2345, 110th cong. § 209 (2007); jcx-79-07, supra note 281, at 38. 289. s. 2345, 110th cong. § 209 (2007); jcx-79-07, supra note 281, at 38. 290. irc § 368(a)(1)(f). 2008] corporate expatriation 115 under current law, the section 367 regulations that govern repatriations of foreign corporate assets would apply to such a transaction. 291 u.s. shareholders would include as a deemed dividend the “all earnings and profits” amount with respect to their stock in the foreign corporation. 292 the term “u.s. shareholder” for this purpose has the same meaning as in subpart f. 293 exchanging shareholders that are u.s. persons but who are not u.s. shareholders (that is, less than 10% shareholders), however, would recognize gain, but not loss, on the exchange. 294 a de minimis rule provides that such a shareholder does not have to recognize gain if his stock is worth less than $50,000 on the date of the exchange. 295 fortunately, according to the joint committee on taxation report, the transfer of earnings and profits “is not a deemed dividend and does not result in a tax upon the domestic corporation or its shareholders.” 296 the deemed repatriation of the surrogate foreign corporation is not a taxable event at either the corporate or shareholder level. 297 291. hicks, supra note 6, at 924-25; see also bittker & lokken, supra note 6 ¶¶ 71.2.5 (reincorporations of foreign corporations), 71.2.2 (repatriations of foreign assets). the temporary regulations under § 7874 address an analogous situation. if § 7874(b) causes an existing foreign corporation to be converted to a domestic corporation, then the conversion shall be treated as a reorganization under § 368(a)(1)(f) occurring immediately before the acquisition described in § 7874(a)(2)(b)(i). temp. reg. § 1.7874-2t(g)(1). 292. treas. reg. § 1.367(b)-3(b)(3)(i). such shareholders may elect instead to recognize the gain (but not loss) that they realize in the deemed exchange. treas. reg. § 1.367(b)-3t(b)(4)(i). 293. treas. reg. § 1.367(b)-3(b)(2). 294. treas. reg. § 1.367(b)-3(c)(2). but under certain conditions those shareholders may elect to include the all earnings and profits amount instead of recognizing gain. treas. reg. § 1.367(b)-3(c)(3). 295. treas. reg. § 1.367(b)-3(c)(4). 296. jcx-79-07, supra note 281, at 38; s. rep. 110-228, at 33 (2007). but any foreign taxes attributable to the transferred earnings and profits are not creditable. jcx-79-07, supra note 281, at 38; s. rep. 110-228, at 33 (2007). 297. the special rules regarding the deemed repatriation provide: (i) the foreign corporation shall be treated, as of the close of its last taxable year after the date of enactment of the american infrastructure investment and improvement act of 2007, as having transferred all of its assets, liabilities, and earnings and profits to a domestic corporation in a transaction with respect to which no tax is imposed under this title; (ii) the bases of the assets transferred in the transaction to the domestic corporation shall be the same as the bases of the assets in the hands of the foreign corporation, subject to any adjustments under this title for built-in losses; 116 florida tax review [vol. 9:2 setting aside the general tax policy issues regarding anti-inversion legislation, the fairness of retroactively changing the applicable date is debatable. true, companies that completed inversions after march 20, 2002 knew that the law might change. however, those companies and their shareholders paid the section 367 “toll charges” associated with the inversion transactions. under the proposal the government gets to keep the taxes it collected as a result of the inversion transactions, but the companies do not achieve the intended future tax benefits. v. conclusion ingersoll-rand and other u.s. multinationals cleverly used stock inversions to lower their overall effective tax rates. congress responded with legislation that removed incentives for companies to invert. further, the government has taken concrete measures to thwart treaty shopping by renegotiating its tax treaties with barbados and other countries. section 7874 has stopped inversions for now. however, the american jobs creation act did not address some flaws in the u.s. international tax system that drove companies to expatriate. commentators have suggested that the u.s. reexamine its reliance on the place-of-incorporation rule to determine corporate residence. 298 an alternative approach, used by many countries, looks to where the corporation is “managed and controlled” to determine whether it is a resident. 299 another suggestion has been to lower the corporate tax rate. 300 a more radical suggestion is that the u.s. should stop taxing the worldwide (iii) the basis of the stock of any shareholder in the domestic corporation shall be the same as the basis of the stock of the shareholder in the foreign corporation for which it is treated as exchanged; and (iv) the transfer of any earnings and profits by reason of clause (i) shall be disregarded in determining any deemed dividend or foreign tax creditable to the domestic corporation with respect to such transfer. s. 2345 § 209(a), 110th cong. 1st session, nov. 13, 2007. 298. see kirsch, supra note 6, at 580-86. 299. see peterson & cohen, supra note 6, at 183-84. for a proposal in the current congress adopting the “management and control” standard, see the manufacturing, assembling, development, and export in the usa tax act, s. 3162, 110th cong. § 211 (2008) [made in the usa tax act]. 300. see hale e. sheppard, fight or flight of u.s.-based multinational businesses: analyzing the causes for, effects of, and solutions to the corporate inversion trend, 23 nw. j. int’l l. & bus. 551, 571-72 (2003). 2008] corporate expatriation 117 income of resident corporations and adopt a territorial system. 301 whatever the merits of this proposal, such major reform is not likely to occur soon. 302 but congress can take some steps without making major changes to the u.s. international tax system. in particular congress should reconsider measures to reduce earnings stripping through related party interest payments. the most comprehensive approach is to generally strengthen section 163(j). 303 however, if such an approach is not politically feasible, then as suggested in part iii, congress should consider other measures. congress should disallow a deduction for interest expense on related party debt used to acquire stock in a corporation that directly or indirectly controls the debtor. alternatively, congress could amend section 163(j) to provide that, for purposes of determining the debt to equity ratio, debtfinanced stock in a corporation that controls the debtor shall have a zero basis. such a provision would increase the taxpayer’s debt to equity ratio, making it more likely that the related party interest will be nondeductible. 301. see steven v. melnik, corporate expatriations – the tip of the iceberg: restoring the competitiveness of the united states in the global marketplace, 8 n.y.u. j. legis. & pub. pol’y 81, 116 (2005). 302. see kirsch, supra note 6, at 550-51 (assuming that the u.s. will retain a residence-based tax system that taxes domestic corporations, however defined, on their worldwide income, and providing a foreign tax credit to alleviate the potential for double taxation). 303. a proposal in the current congress would, among other things, eliminate the 1.5 to 1 debt to equity ratio threshold, and lower the 50% threshold for “excess interest expense” to 25%. made in the usa tax act, s. 3162, 110 th cong. § 224 (2008). the president’s proposed fiscal 2009 budget contained a provision that would tighten § 163(j) for expatriated entities. staff of joint comm. on taxation, 110 th cong., description of revenue provisions contained in the president’s fiscal year 2009 budget proposal, jcs-1-08 no. 6, 2008 wl 2485227 (2008). 118 florida tax review [vol. 9:2 florida tax review florida tax review volume 14 2013 number 1 1 suppose firpta was repealed by willard b. taylor∗ abstract this article argues, as others have before, that the foreign investment in real property tax act of 1980 (or “firpta”), or at least the provisions of firpta relating to “united states real property holding corporations,” should be repealed. their enactment in 1980 was misguided and in any event changes in the internal revenue code since then have made the provisions obsolete. but if firpta is repealed, in whole or in part, the article argues that the lack of parity between foreign investment in real property that is made directly or through a partnership, on the one hand, and foreign investment in a real estate investment trust (or a regulated investment company that invests in shares of real estate investment trusts) should be dealt with. otherwise, repeal will exacerbate existing distortions (which were already pushed further by firpta) resulting from the choice of the entity used to make an investment in us real property. the article also suggests that repeal of firpta would provide an opportunity to look at the taxation of foreign investment in the united states more broadly and in particular the rules that tax income from u.s. real property. the tax treatment of inward investment is a generally neglected subject. the article concludes by arguing against legislation that would keep the firpta rules and simply expand provisions of present law that favor foreign investment through real estate investment trusts, such as the real estate jobs and investment act of 2011. i. introduction ........................................................................................ 2 ii. summary of firpta ...................................................................... 5 a. how did firpta change the law?..................................................... 7 ∗ adjunct professor, new york university law school. the article was presented in october 2012 at the 8th annual international tax symposium of the university of florida levin college of law’s graduate tax program and reflects comments from other participants, including professors yariv brauner, omri marian and martin j. mcmahon. 2 florida tax review [vol. 14:1 b. why was firpta enacted? .............................................................. 10 c. how did firpta respond to these issues? ..................................... 13 d. firpta and income tax treaties ................................................... 16 e. firpta and “pass-throughs” ........................................................ 17 1. fixed investment trusts .............................................................. 18 2. partnerships .............................................................................. 19 3. reits ......................................................................................... 21 4. rics ........................................................................................... 27 f. do the rules that apply to business intermediaries make sense? ...................................................................................... 28 iii. repealing the firpta rules ...................................................... 29 a. real estate investment trusts ........................................................... 31 b. repealing the firpta rules for usrphcs .................................... 33 c. repeal of all of firpta .................................................................... 35 d. tax treaties ...................................................................................... 38 iv. legislation other than repeal .................................................. 41 i. introduction the foreign investment real property tax act of 1980 (“firpta”) amended the internal revenue code to provide that gain realized by a nonresident alien individual or foreign corporation on the sale or other disposition of an interest in u.s. real property would always be income “effectively connected” with the conduct of a u.s. business and thus would be subject to regular rates of tax and possibly also to branch profits tax if the interest was sold or disposed of by a foreign corporation. it also defined u.s. real property to include land, buildings and improvements, whether acquired as a personal investment or to produce income, personal property “associated” with the use of real property, and equity and certain other interests in a u.s. corporation if 50 percent or more by value of its business assets and interests in real property were (or in the last five years had been) interests in real property located in the united states.1 in its perfect world, the u.s. real estate industry would repeal firpta, arguing that it discourages foreign investment.2 so would some 1. i.r.c. § 897 firpta which applies to dispositions of interests in u.s. real property after june 18, 1980 (and also provides a carryover basis for certain related party transfers after december 31, 1979 and before the effective date). this paper deals with firpta as in effect today and, with a few exceptions, does not discuss amendments made since 1980. all citations in the text to sections are to the internal revenue code of 1986, as amended. 2. see statement of jeffrey d. deboer on behalf of the real estate roundtable before the subcommittee on select revenue measures, real estate 2013] suppose firpta was repealed 3 more disinterested commentators.3 and the late senator wallup, one of the driving forces behind firpta’s enactment, seemed amenable to repeal, other than with respect to farm land, when the senate took up the issue four years after the enactment of firpta.4 the firpta tax on shares of a u.s. real property holding corporation (hereafter, a “usrphc”) — which has been a particular focus of critics — has also been classified as a “negative” tax expenditure, i.e., as a deviation from a “normal” income tax that collects more tax than would be collected under a “normal” income tax system.5 since real property includes infrastructure projects such as roads, tunnels and railroads, critics of firpta cite the need to encourage investment in u.s. infrastructure as another argument for repeal.6 nonetheless, while firpta roundtable (june 23, 2011.), www.rer.org/firpta-testimony-june2011.aspx (“firpta has succeeded beyond its enactors wildest dreams in discouraging foreign investment in u.s. real property. it is a deterrent to foreign investors, an administrative drain . . . , and without policy justification. if budgetary constraints were not a factor, the roundtable would recommend that firpta be repealed in its entirety now.”) 3. see, e.g., richard l. kaplan, creeping xenophonia and the taxation of foreign-owned real estate, 71 geo. l.j. 1091, 1095, 1128 (1983) [hereinafter kaplan, creeping xenophonia] (“for reasons of tax complexity, international relations, and economic policy . . . firpta should be repealed in its entirety posthaste.” and firpta “is an unmitigated disaster.”); fred brown, wither firpta?, 57 tax law. 295, 296–97, 302 (2004) [hereinafter brown, wither firpta] (“an area that is ripe for . . . a deadwood analysis is . . . [firpta] . . . . this article suggests that the repeal of portions of firpta may be in order. . . .” and concluding that “fundamental policy considerations call for the retention of [the firpta treatment of directly held interests, but] . . . serious consideration should be given to eliminating the rules that apply to dispositions of stock in certain u.s. real property holding corporations. . . .”). 4. repeal of the foreign investment in real property tax act: hearing before the subcomm. on energy and agric. taxation of the comm. on fin. united states senate, 98th cong. 22 (1984) (statement of senator wallop) (“. . . i . . . feel reluctant at this point to advocate repeal of firpta as it effects farmlands, but with respect to other investments . . . the case for repeal may be more apparent.”). the result of the hearing seems to have been the enactment of the section 1445 withholding tax. 5. staff of the joint comm. on taxation, estimates of federal tax expenditures for fiscal years 2008-2012, 110th cong. 5, 23 (2008) [hereinafter 2008-2012 estimates]. this was “scored” as costing $50 million or less a year. see id. at table 3. the most recent estimate omitted firpta. see staff of the joint comm. on taxation, estimates of federal tax expenditures for fiscal years 2011-2015, 112th cong. (2012). see also congressional research service, tax expenditures – compendium of background materials on individual provisions, comm. on the budget united states senate, 111th cong. 75 (2010). 6. in announcement 2008-115, 2008-2 c.b. 1228, the irs stated its intention to issue regulations that would define an interest in real property to include 4 florida tax review [vol. 14:1 has been amended over the years, none of the changes have altered its basic structure or its premise that gain from the disposition by a foreign person of an investment in u.s. real property, whether made directly or through a partnership or a u.s. corporation, should generally be taxed as gain from a u.s. trade or business. are the critics of firpta right? would repeal make sense? there are dissenters,7 but repeal is certainly worth considering, and the revenue loss would seem to be small.8 firpta was enacted in 1980, more than thirty years ago, by amendment to an internal revenue code which in important respects was different from what we have today or had even ten years after the enactment of firpta and on the basis of arguments, such as “horizontal equity” between u.s. and foreign investors, that are difficult to accept. but if firpta is repealed, whether in its entirety or in part, are there issues in the taxation of foreign investment in u.s. real property that should be addressed? certainly one issue is the significant difference between the rules that now, and would then, apply to an investment made directly or through a partnership and one made through a real estate investment trust (“reit”) or a regulated investment company (“ric”) that invests in shares of reits. why should the tax treatment of foreign investment turn on the entity that makes the investment or, put differently, should there be a single system that does not distinguish between direct investment and investment made through any “pass-through” entity? other issues raised by a repeal of firpta would be the definition of real property, whether there should be a distinction between an investment that is part of a u.s. trade or business and one that is not, and the apparent international consensus that income and gain government granted permits and similar rights with respect to infrastructures, such as toll roads. this would be consistent with the position the irs has taken with respect to government permits for purposes of section 856 (see, e.g., plr 9843020 (oct. 23, 1998)), and the definitions of real property for purposes of sections 897 and 856 are for this purpose the same. there are, however, dissenters who argue that such an investment should be bifurcated between an intangible and real property. see, e.g., kimberly s. blanchard, infrastructure and firpta: advance notice of proposed rulemaking, 38 tax mgm’t int’l j. 166 (2009). 7. see a.l.i., fed. income tax project: int’l aspects of united states income taxation: proposals of the american law inst. on united states taxation of foreign persons and of the foreign income of united states persons 38 (1987) (that the usrphc and other firpta rules “seem appropriate. while the line between real property interests and non-real property interests may be somewhat arbitrary, nothing measurably better than current law suggests itself. . . . accordingly, this study recommends the retention of the provisions of current law in this area.”). 8. see 2008-2012 estimates, supra note 5, at table 3 (estimate of the joint committee staff of less than $50 million a year). 2013] suppose firpta was repealed 5 from real property should always be fully taxed in the country where it is located. repeal might also offer an opportunity to evaluate the u.s. taxation of inward investment more generally. part ii of this article summarizes what firpta does, why it was enacted, how it changed the law and affected u.s. income tax treaties, and how it applies to direct investments and investments made through partnerships, reits and other pass-through entities. part iii considers, first, the consequences of repealing the usrphc provisions of firpta and, second, the consequences of repealing the other firpta rules. part iv evaluates legislation that has recently been introduced that would change, but not repeal, the firpta rules, such as the real estate jobs and investment act of 2011. ii. summary of firpta what does firpta do? broadly, firpta treats gain from the disposition of any interest in u.s. real property other than an interest solely as a creditor (hereafter, an interest in “usrp”)9 by a foreign person, whether acquired for personal reasons or to produce income, as gain that is “effectively connected” with the conduct of a u.s. trade or business10 (or, if a tax treaty applies, is attributable to a u.s. permanent establishment), and thus as taxable at regular rates and possibly subject to branch profits tax if the investor is a foreign corporation and the interest in usrp is not an interest in a usrphc.11 firpta also defines an interest in usrp to include shares of and other interests in a usrphc or a u.s. corporation that was 9. real property for this purpose includes (1) land and unsevered products of the land, (2) improvements and (3) personal property associated with the use of real property. regs. § 1.897-1(b)(1). improvements, such as buildings and inherently permanent structures, are defined by reference to the definition of a building or other inherently permanent structure in the now-repealed investment tax credit, i.e., section 48(a)(1)(b), but the definition for purposes of the reit rules in section 856 is also relevant since the definition of real property in section 897(c)(6) is word-forword the same as the definition in section 856(c)(5)(c), except that it does not exclude mineral and oil or gas royalties but does exclude foreign real property. regs. § 1.897-1(b)(3). 10. i.r.c. § 897(a)(1) (providing that gain or loss of a nonresident alien individual or a foreign corporation from the disposition of an interest in usrp “shall be taken into account . . . as if the taxpayer were engaged in a trade or business within the united states during the taxable year and as if such gain or loss were effectively connected with such trade or business.”) 11. earnings from the disposition of an interest in usrp, whether derived directly or as a partner, may result in branch profits tax for a foreign corporation; but under section 884(d)(2)(c) gain from the sale of shares of a usrphc is excluded from earnings that are subject to branch profits tax. 6 florida tax review [vol. 14:1 such a corporation in the five years preceding the disposition of the interest.12 logically (because this is the rule that applies to gain recognized by a partnership), it also provides (with exceptions) that distributions by a reit or a ric which, because invests in shares of reits, is a usrphc to a foreign shareholder of gain from the sale of an interest in usrp are taxable as though the shareholder had sold the interest and recognized the gain.13 firpta does not affect sales of shares of a foreign corporation, regardless of the extent to which the corporation holds interests in usrp, and thus draws a sharp distinction between investing through a u.s. and through a foreign corporation.14 with exceptions and limitations, however, firpta does tax a foreign corporation on a distribution to a shareholder of interests in usrp, including of shares of a usrphc, in an otherwise tax-free spin-off, reorganization or liquidation.15 originally a self-assessed tax with extensive reporting requirements,16 firpta is now enforced by complex withholding tax rules that were added in 1984 and, broadly, require withholding by the transferee from the proceeds of a sale of an interest in a usrphc or of an interest in a partnership or trust holding interests in usrp unless they are publicly-traded or otherwise exempt; withholding by the corporation from distributions to shareholders of interests in usrp by foreign or in certain circumstances domestic corporations; and withholding by a partnership, a reit or a ric that is a usrphc because it invests in shares of reits from distributions of gain from sales of interests in usrp by the partnership, reits and rics . under the statute, the base for withholding (e.g., gain realized, amount realized or fair market value) and the rate of withholding (10 percent to 35 12. i.r.c. § 897 (c)(1)(a)(ii). 13. i.r.c. § 897(h)(1). the interpretation of this rule is a source of dispute. see infra note 103 and accompanying text. 14. the absence of a step up in the basis of the underlying asset no doubt affects the pricing for the shares of a foreign corporation (as it would for the shares of a usrphc that were acquired in a transaction in which there was no basis step up). at one point, the legislation that ultimately became firpta would have taxed shareholders of a foreign corporation that invested in usrp interests. 15. i.r.c. § 897(d). under temporary regulations section 1.897-5t(c), recognition of gain is generally required unless the distribution is to a foreign parent corporation in an section 332(a) liquidation, the foreign parent acquires the interest in usrp with a carryover basis and certain other requirement are met; and, in the case of an section 355 distribution of shares of a usrphc by a foreign corporation, the gain that is recognized is limited to the basis step up to the distributees. 16. thus, reporting was required by non-publicly traded usrphcs with respect to foreign shareholders and by foreign corporations, partnerships, trusts and estates with respect to substantial investments in usrp. 2013] suppose firpta was repealed 7 percent) vary depending on the transaction.17 the withholding tax, of course, is a prepayment of a liability that may be more or less than the amount withheld and it does not always eliminate the need for a foreign person that is subject to the firpta tax to file a tax return.18 the separate firpta reporting rules were largely eliminated when the withholding tax was added in 1984.19 a. how did firpta change the law? gain from the sale of u.s. real property was u.s. “source” income before firpta.20 but before firpta there was no u.s. tax on gain from a sale by a foreign person of personal, or non-business, real property, such as a personal residence, because the gain, although u.s. source, was not “effectively connected” with a u.s. trade or business (or, if a tax treaty applied, was not “attributable to” a u.s. permanent establishment). the same rule applied to a business investment in real property except that, because such an investment often involved the conduct by the investor of significant activities in the united states, it would often result in income that was “effectively connected” with a u.s. trade or business. even if that was not the case, because the activities in the united states were occasional or minimal, the foreign investor would frequently elect under the internal revenue code or a tax treaty to treat the income as effectively connected in order to take a current deduction for expenses, such as interest, depreciation and real estate taxes, and not be subject to a 30 percent withholding tax on 17. i.r.c. § 1445. thus the rates of withholding vary from 10 percent of the amount realized (e.g., by a foreign person on the disposition of an interest in usrp or an interest in a partnership or trust that owns an interest in usrp) or of the fair market value (on a taxable distribution of an interest in usrp by a partnership or trust to a foreign partner or beneficiary) to 35 percent of the gain realized (e.g., on gain from a disposition of an interest in usrp by a partnership, trust or estate that is attributable to a foreign partner or foreign beneficiary), and the rules are further modified by a complex set of regulations. see kimberly s. blanchard, firpta in the 21st century, installment four: firpta withholding mechanics, 37 tax mgm’t int’l j. 402 (2008) (for comments on limited aspects of the withholding tax regulations); david r. herzig, rethinking firpta, 4 colum. j. tax l. ____ (2013) [forthcoming]. 18. see regs. § 1.1445-1(f)(1) (in the case of tax withheld on a sale of an interest in a usrphc or a partnership or a trust). 19. section 6039c now requires a foreign person who directly owns and interest in usrp to report if the value is $50,000 or more and ownership is not a u.s. trade or business, but reporting is only “[t]o the extent provided by regulations” and there are no regulations. proposed regulations under the original section 6039c were withdrawn when the withholding tax was enacted. 20. i.r.c. § 861(a)(5). 8 florida tax review [vol. 14:1 gross rental income.21 apart from the withholding tax on non-effectively connected rents or royalties, the tax on u.s. real property income or gain was, before firpta, self-assessed. while gain from the sale or other disposition of an interest in usrp is, with specific exceptions, always “effectively connected” income under firpta, firpta did not change the different treatment of rent, mineral royalties or other current income from a investment in real property that is a u.s. trade or business (taxation at regular rates on the taxable income) or a business investment that is not a u.s. trade or business (30 percent tax on the gross income). it thus retained the statutory election to treat income from a non-trade or business investment in real property held for the production of income as “effectively connected” income.22 whether ownership of an interest in real property is or is not a trade or business is sometimes simple (for example, ownership of an interest in a royalty trust that is a fixed investment trust would not be) and sometimes more complicated (for example, where a foreign person owns and leases one or more commercial properties), turning in such a case on the level and continuity of the owner’s u.s. activities.23 before firpta, there was no tax on gain from the sale of shares of a reit, ric or other u.s. corporation, regardless of the nature of its 21. sections 871(d) and 882(d), which apply to “income . . . from real property held for the production of income and located in the united states,” and thus exclude a personal investment in real property, such as a residence, and permit an election “to treat all such income as income which is effectively connected with the conduit of a trade or business within the united states.” the same election is provided by u.s. tax treaties. see, e.g., united states dep’t of treasury, united states model income tax convention of november 15, 2006, art. 6, ¶ 5 [hereinafter 2006 u.s. model treaty]. once made, the election can be revoked only with the consent of the irs. regs. § 1.871-10(d). 22. the election does not apply, of course, to real property not held for the production of income, such as a personal residence. 23. in revenue ruling 73-522, 1973-2 c.b. 226, the irs held that a nonresident alien who leased u.s. real property on a long-term basis, net of expenses, and who was in the u.s. only for one week during the year for the purpose of supervising the negotiation of new leases was not engaged in a u.s. trade or business. it summarized prior court decisions as holding that there was a trade or business when the u.s. activities of a nonresident alien individual, or the individual’s agents, went beyond the mere receipt of income and the activity was “considerable, continuous, and regular,” which was not the case in the ruling because the leases were net and the u.s. activity not considerable, continuous or regular. see also lewenhaupt v. commissioner, 20 t.c. 151 (1953), aff’d, 221 f.2d 227 (9th cir. 1955); herbert v. commissioner, 30 t.c. 26 (1958); and de amodio v. commissioner, 34 t.c. 894 (1960), aff’d, 299 f.2d 623 (3rd cir. 1962). the ruling also holds that expenses paid by the lessee and netted against the rent are expenses of the lessee and not income and deductions of the lessor. 2013] suppose firpta was repealed 9 underlying assets. gain from a disposition of shares of what would under firpta be a usrphc was treated no differently than gain from the sale of shares of any u.s. corporation. likewise, the tax free reorganization and other nonrecognition provisions of the internal revenue code applied without regard to the nature of the corporation’s underlying assets. whether gain from the sale of a partnership interest was taxable was arguably unsettled at the time. some took the view that gain from the sale of a partnership interest was from the sale of personal property and was sourced on the basis of the title-passage rule which then applied.24 whatever the merits of that position then, the irs now views a partnership, whether foreign or domestic, as an aggregate, not an entity, for the purpose of determining the source of a partner’s income, and this is consistent with case law.25 as a consequence, a foreign partner that sells an interest in a partnership is taxed on the partner’s distributive share of the unrealized gain the partnership’s assets that are effectively connected with a u.s. trade or business (or attributable to a permanent establishment), whether under firpta or otherwise. 24. see arthur a. feder & lee s. parker, the foreign investment in real property tax act of 1980, 34 tax law. 545, 548 n.18 (1981) [hereinafter feder & parker, foreign investment]. 25. revenue ruling 91-32, 1991-1 c.b. 107 (which may have been inspired in part by section 897(g), although it deals only with partnership property that is not an interest in usrp, leaving interests in usrp held by a partnerships to section 897), sources a foreign partner’s gain from the sale of an interest in a partnership, whether u.s. or foreign, on the basis of the partner’s distributive share of unrealized gain or loss that would be effectively connected with a u.s. trade or business (or attributable to a united states permanent establishment) or not. in applying revenue ruling 91-32, there is a presumption that the gain from the sale of an interest in a partnership that is engaged in a trade or business in the u.s. (or has a permanent establishment there) is u.s. source effectively connected income, but that a loss from the sale of such an interest is foreign source and not effectively connected. id. see also tech. adv. mem. 200811019 (mar. 14, 2008) (taking an aggregate approach to the determination of the extent to which a foreign partner’s distributive share of partnership investment income was, or was not, income effectively connected with a u.s. trade or business). the result in revenue ruling 91-32 seems entirely consistent with cases that have considered other aspects of the treatment of foreign partners, such as unger v. commissioner, 936 f.2d 1316 (d.c. cir. 1991) and donroy v. united states, 301 f.2d 200 (9th cir. 1962), but revenue ruling 91-32 has nonetheless been criticized and doubt expressed as to whether the ruling would apply to the sale of an interest in a publicly-traded partnership. see stuart e. leblang, robert p. rothman & daniel j. paulos, rationalizing inbound taxation of passive portfolio investments, 121 tax notes 693, 696 n.25 (nov. 10, 2008) [hereinafter leblang, rothman & paulos, rationalizing]. revenue ruling 91-32 is also consistent with the authority of the irs under regulations section 1.701-2(e). 10 florida tax review [vol. 14:1 firpta provided a comprehensive definition of real property (land, buildings and other improvements, personal property associated with the use of real property, leaseholds, and certain options) and, separately, of “interests” in real property. broadly, “interests” include any interest other than an interest solely as a creditor.26 while many provisions of the internal revenue code now turn on what is or is not real property, before firpta there was much less guidance for purposes of determining the source of gain from a sale or disposition of real property;27 and there was no authority for extending the definition for purposes of the source rules to options on real property or real property based rights or derivatives — that is, to “interests other than solely as a creditor” — or to personal property associated with the use of real property. b. why was firpta enacted? firpta was preceded by a congressionally-mandated study by the treasury department (hereafter, the “treasury study”) of the taxation of foreign investment in u.s. real estate, which in turn apparently grew out of congressional concerns about increasing foreign ownership of u.s. agricultural or farm land.28 while the treasury study found that foreign 26. while the words “any other interest (other than an interest solely as a creditor)” are used in section 897 only with respect to a usrphc, the regulations extend the “other than” rule to all interests in real property and to interests in partnerships, trusts and estates. regs. § 1.897-1(d)(2)(i), (d)(3). 27. section 861(a)(5) simply treated as u.s. source any gain derived from the disposition of “real property located in the united states,” without any further definition in the code or regulations. see regs. § 1.861-6; t.d. 6258, 1957-2 c.b. 368. the few authorities dealing with source looked to local law definitions of real property. see texas-canadian oil corp. v. commissioner, 44 b.t.a. 913, 916–18 (1941) (accepting the irs’ argument that texas law determined whether oil and gas leases were real property and citing other cases that had invoked state law). there are now many other situations in which it is important to know what is or is not real property. these include the rules in section 856 with respect to reit qualification, the rules in section 860g with respect to remic qualification, the like-kind exchange rules in section 1031, the exception to the publicly-traded partnership rules in section 7704(d), and the cost recovery rules of section 168. 28. united states dep’t of the treasury, taxation of foreign inv. in u.s. real estate (1979) [hereinafter treasury study]. see also staff of the joint comm. on taxation, 96th cong., description of s. 192 and s. 208 relating to the tax treatment of foreign investment in the united states (comm. print 1979), which largely repeats the treasury study. the senate version of the revenue act of 1978 would have taxed gain from the sale of agricultural land. because the house or treasury had not considered this, the conference committee did not agree on that provision and only included a provision in the final bill that 2013] suppose firpta was repealed 11 ownership of u.s. farm land or other real property was not significant,29 it also concluded that, while most foreign-owned real estate was used in a u.s. trade or business, “foreign persons rarely incur capital gains tax on the disposition of their u.s. property holdings,”30 principally because of the use of a corporation to own the real property and the ability in such a case, before the 1986 repeal of the general utilities doctrine,31 to provide a stepped-up basis to a purchaser without gain to the seller. and it went on to suggest legislative solutions. starting with the treasury study’s premise that there should be parity between the tax treatment of gain of a foreign and u.s. person from the disposition of a business investment in u.s. real estate (or “horizontal” equity), since otherwise foreign investors had an unfair advantage,32 there were two defects in the pre-firpta rules. first, in the case of directlyowned real estate, current tax on rent was largely eliminated through deductions for interest, depreciation and like expenses but the end-of-the-day tax on the gain from the later sale or other disposition could be avoided by an installment sale in which most of the gain was deferred to years after the u.s. trade or business was terminated or by a tax-free like-kind exchange of u.s. for foreign real property. second, in the case of real property held by a foreign or u.s. corporation, the corporation could likewise deduct current expenses and then could later sell the real property and liquidate without tax on the corporation or its shareholders (or its shares could be acquired and then it could be liquidated with the same result).33 additionally, a few u.s. tax treaties made the election to treat income from real estate as “effectively connected” an annual, rather than a one-time, election with the consequence that the election would only be made for years before the year in which the property was sold or disposed of.34 hostility to foreign ownership of real estate may have played an important role in the enactment of firpta, notwithstanding the conclusion of the treasury study that foreign investment in u.s. real estate was not required the treasury study. see michael knott, firpta then and now: a selective review, pli – the corporate tax practice series (2009). 29. it was less than one half of one percent of u.s. farmland. the legislation introduced by senator wallup in response to concerns about foreign ownership of agricultural land would have affected only agricultural land. treasury study, supra note 28, at 47. see also id. at 65 appendix c. 30. see id. at 1. 31. for a discussion of the general utilities doctrine and its 1986 repeal, see boris i. bittker, james s. eustice & john p. steines, jr., federal income taxation of corporations and shareholders ¶ 8.21 (7th ed. 2012). 32. treasury study, supra note 28, at 48–52 (setting out the perceived advantages). 33. id. at 30–31, 46. 34. id. at 31. 12 florida tax review [vol. 14:1 significant.35 the stated congressional objective, however, was not to deter or penalize foreign investment but simply to achieve parity, or “horizontal equity,” between the tax treatment of gain from the disposition of a business investment in real property by a u.s. person and by a foreign person. the concern was that foreign persons, while treating the income as effectively connected (and thus deducting expenses, such as depreciation and interest), escaped tax on the sale or other disposition of the investment.36 thus, the report of the committee on finance says that “the committee believes that it is essential to establish equity of tax treatment in u.s. real property between foreign and domestic investors,” and that the united states “should not continue to provide an inducement through the tax laws for foreign investments in u.s. real property which affords the foreign investor a number of mechanisms to minimize or eliminate his tax on income from the property while at the same time effectively exempting himself from u.s. tax on the gain realized on disposition of the property.”37 it went on to identify “a number of planning techniques . . . [which] offer the opportunity to avoid tax on the capital gain which would result on the sale of . . . property” by a foreign person who treated the current income as effectively connected, and stated that the usrphc rules were necessary because “[o]therwise, a foreign investor could, as under present law, avoid tax on the gain by . . . disposing of his interest in that entity rather than having the entity itself sell the real estate.”38 35. see kaplan, creeping xenophonia, supra note 3, at 1128 (“the clear intention of [firpta], therefore, is not to eradicate inequities, but rather to discourage foreign investment in united states real estate. . . .[,] manifest[ing] a disturbing xenophobia that lacks any economic rationale or common sense foundation.”) 36. see william d. metzger, foreign investors real property tax act: historical perspective and critical evaluation, 5 w. new eng. l. rev. 161 (1982); feder & parker, foreign investment, supra note 24 (discussing the background to firpta). see also repeal of the foreign investment in real property tax act: hearing before the subcomm. on energy and agric. taxation of the comm. on fin. united states senate, 98th cong. 22-23 (1984) (statement of senator wallup on the purpose of firpta). 37. s. rep. no. 96-504, at 6 (1979). like the treasury study, the committee on finance report then listed (1) an installment sale in which most payments are received after the sale, and thus the end of the trade or business, occurs; (2) a like kind exchange of the u.s. real property for foreign real property; and (3) an investment made by a leveraged foreign corporation that is entitled to a reduced rate of withholding tax on dividends and interest and then, at the point of sale, used then section 337 or sold to a us corporation which then liquidated and stepped up the basis of the underlying real estate. id. at 4–7. 38. id. at 4, 6. 2013] suppose firpta was repealed 13 c. how did firpta respond to these issues? the first two transactions that the treasury study and congress identified were dealt with by amending the like kind exchange rules to specify that foreign real property is not of a like kind with u.s. real property39 and by amending the “effectively connected” rules to specify that gain recognized in a year after a taxpayer ceases to have a u.s. trade or business with respect to an asset used in that business is nonetheless “effectively connected.”40 the third was addressed by the firpta rule that taxes dispositions of interests in usrphcs. firpta also provided for gain recognition in some situations not specifically identified by the treasury study or congress but consistent with their overall approach — i.e., it provides that a foreign corporation will generally recognize gain on the distribution of an interest in usrp to a foreign shareholder41 or on a capital contribution of an interest in usrp to a foreign corporation;42 and it also provides more general rules for overriding non-recognition provisions of the internal revenue code in cases where there would otherwise be an arguable avoidance of the firpta tax.43 under firpta, an interest in a usrphc is any interest in a u.s. corporation other than an interest “solely as a creditor” if at the time of disposition, or in the five preceding years, usrp interests were 50 percent or more in value of the sum of the corporation’s interests in real property, whether u.s. or foreign, and its assets used in a trade or business.44 interests “solely as a creditor” do not include obligations that share, directly or indirectly (e.g., through interest indexed to real property values), in the appreciation or income from real property.45 the interests in real property of a u.s. corporation are determined by looking through partnerships and 39. i.r.c. § 1031(h) (which also provides that personal property predominantly used within the united states is not of a like kind with personal property predominantly used outside the united states, and section 897(e) which denies nonrecognition of gain or loss for an exchange of an interest is usrp for property whose disposition would not be subject to tax) 40. i.r.c. § 864(c)(6)–(7). 41. i.r.c. § 897(d). 42. i.r.c. § 897(j). 43. i.r.c. § 897(e). there were a number of different legislative proposals before firpta, with differences including enforcement by withholding as opposed to information reporting; a narrow focus on transactions identified as involving tax avoidance as opposed to a broader proposal to tax all gains from dispositions of usrpis; and a proposal to tax sales of shares of foreign corporations investing in usrp as well as u.s. corporations. see feder & parker, foreign investment, supra note 24, at 547–49. 44. i.r.c. § 897(c)(1)(a)(ii), (c)(2). 45. regs. § 1.897-1(d)(2). 14 florida tax review [vol. 14:1 “controlling interests” in lower-tier corporations and taking into account the corporation’s proportionate share of their assets.46 there is a so-called “cleansing” rule that shuts down the five-year waiting period, but it is strictly limited since it is generally available only if all of the interests in usrp held by the corporation have been disposed of in transactions in which gain is recognized (or have ceased to be interests in usrp).47 as an exception to the definition of an interest in usrp, an interest in usrp does not include shares of a class of stock of a usrphc that is regularly traded on a securities market48 if at the time of disposition the holder owns, and in the last five years, has owned no more than 5 percent of the class, directly or constructively.49 in the case of a reit or a ric that is a usrphc, there is a further exception if the reit or ric is “domestically controlled.” the firpta regulations relax the rules for determining whether a u.s. corporation is or is not a usrphc, limiting the “determination dates” to the last day of the corporation’s taxable year and any date on which the corporation acquired an interest in usrp or disposed of an interest in the other assets taken into account in the calculation (i.e., interests in foreign real property or in business assets)50 and establishing a rebuttable presumption that a corporation is not a usrphc if on a determination date the book value of its interests in usrp is 25 percent or less of the book value of its interests in real property, whether u.s. or foreign, and its business assets.51 the relaxations are helpful but hardly eliminate the pain of determining, in a case that is at all close, whether a corporation is or is not a usrphc or possible foot faults (resulting, for example, from the sequence in which a u.s. corporation acquires “good” and “bad” assets); and the regulations do not meaningfully relax the five-year waiting period for dispositions of shares of corporations that are no longer usrphcs.52 the only relaxation of the cleansing rule is one that permits a corporation to be “cleansed” although it 46. i.r.c. § 897(c)(4)–(5). 47. i.r.c. § 897(c)(1)(b). and thus is not available if the sales are on an installment basis unless the seller foregoes the benefit of installment sale reporting and recognizes all of the gain. 48. regulations section 1.897-9t(d) set out when shares will be “regularly traded,” using different tests for trading in domestic and foreign markets. 49. i.r.c. § 897(c)(3). see kimberly s. blanchard, firpta in the 21st century – installment two: the 5% public shareholder exception, 37 tax mgm’t int’l j. 44 (2008) [hereinafter blanchard, installment two]. 50. regs. § 1.897-2(c)(1). or alternatively, on a monthly basis with certain adjustments to the acquisition/disposition determination date rules. regs. § 1.8972(c)(3). 51. regs. § 1. 897-2(b)–(c). 52. regs. § 1.897-2(f). 2013] suppose firpta was repealed 15 retains a lease on real property if the lease has no fair market value and is used in the conduct of a trade or business.53 taking the pursuit of foreign investment in usrp further, firpta provided that, subject to regulations, the nonrecognition provisions of the internal revenue code would not apply to an exchange of an interest in usrp for other property unless a sale of the other property would be subject to u.s. tax.54 as a consequence, for example, gain would be recognized on an exchange of shares of a usrphc for shares of a u.s. corporation that is not a usrphc or for shares of a foreign corporation, notwithstanding that the exchange would otherwise be tax free under section 351 or as part of a tax-free reorganization. the implementation of these rules is one of the most complicated parts of firpta, requiring, first, an analysis of the internal revenue code provisions generally relating to liquidations, reorganizations and other non-recognition transactions; and, then, an analysis of how those rules are affected by the separate firpta rules.55 most of the guidance, both published and private, with respect to firpta has been with respect to the impact of firpta on the nonrecognition rules, often in cases where shares of a usrphc are simply being moved around within a group of related corporations, the potential tax is not reduced, and the abuse, if any, is not apparent.56 the override of the non-recognition provisions may also affect partnership transactions.57 the definition of real property in firpta tracked to a large degree what u.s. tax treaties permitted the united states to treat as real property, although before firpta that authority had not been fully exercised.58 the 53. regs. § 1.897-2(f)(2). 54. i.r.c. § 897(e), which is sometimes referred to as the “hot-to-hot” requirement. 55. regs. § 1.897-5t, -6t. 56. see david f. levy, nonrecogniton transactions involving firpta companies, 2008 tnt 107–32 (june 3, 2008) [hereinafter levy, nonrecognition transactions]; jeffrey farrell & charles cope, the application of § 304 to a disposition of shares in a u.s. real property holding corporation, 38 tax mgm’t int’l j. 155 (2009). 57. see regs. § 1.897-6t(a)(2)–(3) (for example, in the case of a section 721 contribution of an interest in usrp to a partnership for a partnership interest, limit the gain on the transferred that is not recognized to the amount that would be taxed on a disposition of the partnership interest received in the exchange). 58. e.g., united states dep’t of treasury, united states model income and capital tax convention, may 17, 1977, art. 6, ¶ 2 [hereinafter 1977 model treaty] which, while defining “immovable” or “real” property to “have the meaning which it has under the law of the contracting state in which the property in question is situated,” said that “[t]he term shall in any case include property accessory to immovable property, livestock and equipment used in agriculture and forestry, rights to which the provisions of general law respecting landed property apply, usufruct[s] of immovable property and rights to variable or fixed payments as consideration for 16 florida tax review [vol. 14:1 definition obviously provides clarity, but the inclusion of options to acquire land or improvements or leaseholds on land or improvements is odd, since options are not ordinarily viewed as ownership; and the inclusion in an “interest” of any interest other than an interest solely as a creditor (which obviously duplicates the inclusion of options) took the potential scope of firpta far beyond what had been the rule before. d. firpta and income tax treaties firpta diverged sharply from existing u.s. law, including from u.s. tax treaties. treaties commonly exempted gain of a resident of one state from the sale of shares of a corporation resident in the other state from tax by the state of the corporation’s residence.59 the exemption was in both the u.s. and the oecd model treaties.60 the treasury study noted that taxing foreign investors on gain from the disposition of directly-held real property was consistent with international standards (and, indeed, that the pre-firpta exemption for non-effectively connected gain from the disposition of real property was “unusual by international standards.”)61 it also stated, however, that taxing a foreign person on gain on the sale of shares of a u.s. corporation “would not be justified by general international practice and would, in fact, run contrary to u.s. tax treaties.”62 congress nonetheless proceeded to override tax treaties that would otherwise have barred the taxation of sales by foreign persons of shares of a usrphc. picking up on a suggestion in the treasury study,63 however, the working of, or the right to work, mineral deposits, sources and other natural resources . . .” and also that the right to tax income derived from immovable property “shall apply to income derived from the direct use, letting, or use in any other form” of the property. 59. e.g., convention between the united states of america and canada with respect to taxes on income and on capital, sept. 26, 1980; convention between the united states of america and the kingdom of the netherlands for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, dec. 18, 1992. and the extension of the tax to options and other non-ownership “interests” in real property might also be viewed as inconsistent with treaty obligations. 60. e.g., 1977 model treaty, supra note 58, at art. 13, ¶ 4; organization for economic co-operation and development, model tax convention on income and on capital, art. 13, ¶ 4 (apr. 11, 1977). 61. treasury study, supra note 28, at 52 62. id. at 52–53. 63. id. at 54 (“[t]here should be considerably less international objection to a prospective override of . . . treaties, coupled with a sufficient time lag so that reciprocal international agreements on limited taxation of shares can be negotiated.”). 2013] suppose firpta was repealed 17 firpta sought to mitigate the treaty override by deferring for some four plus years the effective date of firpta in a case where taxing gain from the sale of shares in a usrphc would be inconsistent with a treaty and by allowing treaties renegotiated during the four year window to defer the effective date for a further two years.64 firpta’s treaty override was nonetheless criticized by the subsequent oecd report on treaty overrides.65 the treatment of foreign corporations under firpta (for example, the recognition of gain by a foreign corporation that distributed an interest in usrp to a shareholder), because it did not conform to the treatment of u.s. corporations, could also be seen as violating the general anti-discrimination of provisions of u.s. tax treaties.66 firpta addressed this by allowing a foreign corporation to elect to be a u.s. corporation.67 it thus provided that in such a case (that is, where “the foreign corporation is entitled to nondiscriminatory treatment with respect to” an interest in the usrp) the corporation could elect to be a u.s. corporation (and thus waive treaty protection) and that this would be “the exclusive remedy” for any corporation asserting discrimination.68 64. omnibus reconciliation act of 1980, pub. l. no. 96-499, § 1125(c), 94 stat. 2599 (1980) (which in effect deferred to the treaty override from june 18, 1980 to december 31, 1984). 65. see oecd committee on fiscal affairs, report on tax treaty overrides, 2 tax notes int’l 25 (jan. 1, 1990); reuven avi-yonah, tax treaty overrides: a qualified defense of u.s. practice, in tax treaties and domestic law, 65–80 (guglielmo maisto ed., 2006). the oecd model treaty was revised in 2003 to permit the taxation of gain of a resident of one state from the disposition of shares of a corporation of the other state if 50 percent or more in value of the corporation was attributable to immovable property. organization for economic cooperation and development, model tax convention on income and on capital, art. 13, ¶ 4 (jan. 1, 2003) 66. e.g., 1977 model treaty, supra note 58, at art. 24, ¶ 1 (which provides that “[n]ationals of a contracting state shall not be subjected in the other state to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of that other state in the same circumstances are or may be subjected.”). 67. i.r.c. § 897(i). 68. i.r.c. § 897(i)(1), (4). 18 florida tax review [vol. 14:1 e. firpta and “pass-throughs” apart from a direct investment or an investment in shares of a “regular” u.s. corporation (that is, one subject to subchapter c and not subchapter m) that invests in usrp, a foreign person may invest in usrp as a partner in a partnership that makes the investment, as shareholder of a reit that invests in usrps, a shareholder of a ric that invests in shares of reits, or as the owner of an interest in a “fixed investment trust” that holds interests in usrp. how did firpta affect these investments in usrp? before firpta, there was no tax on gain from the sale of shares of a u.s. corporation, whether it was a usrphc or not; but it was unclear whether this was so in the case of an interest in a partnership.69 firpta created inconsistencies in the treatment of gain from sales of shares. on the one hand, the firpta exemption for sales of interests in publicly-traded entities by a foreign investor who owns 5 percent or less of the publicly-traded interests applies to publicly-traded fixed investment trusts, partnerships and corporations, including reits, and rics. on the other hand, the exception for shares of an entity that is “domestically controlled” is available only for shares of a reit and shares of a ric that is a usrphc, and the exemption from firpta for distributions of gain from sales of interests in usrp is available to 5 percent of smaller holders of a class of publicly-traded shares of a reit or a ric that is a usrphc but not for partners in a publiclytraded partnership. the rules for fixed investment trusts, partnerships, reits, and rics are discussed further below. 1. fixed investment trusts there are a meaningful number of publicly-traded trusts that own royalties (typically, overriding royalties measured by net profits) on oil and gas and other minerals in the united states.70 these are “fixed investment,” 69. see leblang, rothman & paulos, rationalizing, supra note 25, at 696 n.25. 70. oil and gas royalty trusts include bp prudhoe bay royalty trust, cross timbers royalty trust, dominion resources black warrior trust, easter american natural gas trust, hugoton royalty trust, marine petroleum trust, mesa royalty trust, mv oil trust, panhandle royalty trust, permian basin royalty trust, sabine royalty trust, sandridge mississippian royalty trust, san juan basin royalty trust, tidelands royalty trust, and torch energy royalty trust. there are also trusts that hold royalties on other minerals, including mesabi trust, great northern iron ore trust, penn virginia resources and williams coal seam gas royalty trust. 2013] suppose firpta was repealed 19 and therefore “grantor,” trusts.71 as a consequence, a unit holder is treated as directly owning the unit holder’s share of the trust’s assets and deriving directly the unit holder’s share of trust income and expense. a foreign unit holder would not be engaged in a trade or business in the u.s. on account of such an investment — the trust assets are “fixed” and the trustee has no power to vary the assets — and the royalty income would therefore be subject to withholding tax at a 30 percent rate unless the holder elected under the internal revenue code or a treaty to treat the income as “effectively connected” so that expenses, such as cost depletion, were deductible. whether or not an election is made, however, gain on the disposition of the interest would ordinarily be taxed under firpta as “effectively connected” income. if any class of interests in the trust is regularly traded on an established securities market, however, the firpta regulations provide, as they do in the case of publicly-traded partnerships, that for firpta purposes the trust is a corporation.72 as a consequence, under the publicly-traded shares exception that applies to sales of shares of corporations, there is no tax on gain from a sale or other disposition of an interest in the trust by a person who owned 5 percent or less of the publicly traded class at the time of sale or in the preceding five years, directly or constructively; but, in the case of a more than 5 percent owner, the trust would have to determine whether it would, as a notional corporation, be a usrphc or not and, if it is, the entire gain of the unit holder would be treated as gain from the disposition of an interest in usrp and subject to tax. an acquisition from a foreign person of a publicly-traded interest in a publicly-traded trust is generally not subject to withholding.73 2. partnerships whether a partnership is u.s. or foreign or the partner is a general or limited partner, a foreign partner is engaged in a trade or business in the 71. fixed investment trusts are classified as grantor trusts. regs. § 1.6712(e)(3). qualification as a fixed investment trust requires that the trust have a single class of ownership interests and that there be no power under the trust agreement to vary the investment of the certificate holders. regs. § 301.7701-4(c)(1). because of the no power to vary requirement, the assets of the trust must be “passive” (e.g., royalties or securities) and cash receipts must be periodically distributed to the certificate holders (since owning operating assets would mean there was a power to vary the investment by making operating decisions and the retention of cash would likewise vary the assets). 72. regs. § 1.897-1(c)(2)(iv). 73. regs. § 1.1445-2(c)(2), but cross-referencing reserved regulations in regs. § 1.897-1(c)(2)(iii)(b). 20 florida tax review [vol. 14:1 united states if the partnership is so engaged.74 that would normally be the case if the partnership has significant activities in the united states. the foreign partner would as a consequence be currently taxed on the partner’s distributive share of the income or gain of the partnership, including gain from the disposition of interests in usrp or other assets of the u.s. trade or business. if the partnership is not publicly traded, the tax on the foreign partner’s shares of partnership income or gain is collected from the partnership, i.e., by requiring the partnership to withhold on the income at the highest rate applicable to the partner (individual or corporate, as the case may be), and pay over the tax withheld on a quarterly basis during the year that the income is earned and whether or not it is distributed.75 gain of a partner in a non-publicly traded partnership from a sale or other disposition of the partner’s interest in the partnership would also be subject to tax to the extent attributable to interests in usrp76 or assets of a u.s. trade or business. for purposes of the withholding tax, an interest in a partnership that is not publicly traded is treated in its entirety as an interest in usrp if 50 percent or more of the value of the gross assets of the partnership are interests in usrp and 90 percent or more of the value of its assets are interests in usrp and cash or cash equivalents.77 the person acquiring the interest is required to withhold 10 percent of the amount realized by the transferring partner. different rules apply to publicly-traded partnerships.78 the foreign partner’s share of the income or gain of a publicly-traded partnership is 74. likewise, the partner would have a permanent establishment in the united states if the partnership had a permanent establishment there. see unger v. commissioner, 936 f.2d 1316 (d.c. cir. 1991); donroy v. united states, 301 f.2d 200 (9th cir. 1962). under section 871(a), the same rule applies to foreign beneficiaries of a trust. see portanova v. united states, 690 f.2d 169 (ct. cl. 1982). 75. regs. § 1.1446-3. under the specific circumstances set out in regulations section 1.1446-6, losses and deductions of the partner that are effectively connected with a u.s. business may be taken into account by the partnership in determining the amount to be withheld. 76. i.r.c. § 897(g). 77. regs. § 1.897-7t(a). 78. a publicly-traded partnership is classified as a partnership, and not as an “association,” only if it meets the “good” gross income test of section 7704 for each year in which it is publicly traded. i.r.c. § 7704(c). the credit suisie equity research, reports that there are now about nintey “traditional” publicly-traded partnerships (and more if those traded over the counter or otherwise not on a public exchange are included) with an aggregate market capitalization of more than $220 billion. see credit suisse equity research, cs mlp primer – part duex (nov. 23, 2011), http://www.naptp.org/documentlinks/investor_relations/cs_mlp_primerpart_deux.pdf. these consist generally of publicly-traded partnerships in the oil and gas, other natural resources, pipeline, fuel distribution and marine transportation businesses. the national association of publicly traded partnerships represents the 2013] suppose firpta was repealed 21 subject to withholding tax only when distributed, again at the highest applicable rate.79 in addition, in the case of a sale or other disposition of a partnership interest, the regulations treat a publicly-traded partnership as a u.s. corporation for firpta purposes.80 as a consequence, under the rule that applies to publicly-traded corporations, there is no tax on gain from the sale of a 5 percent or smaller interest in a class of publicly-traded interests, but a more than 5 percent interest in the partnership would be treated in its entirety as an interest in usrp if the notional corporation was a usrphc.81 the 5 percent or less exception is important because many if not most publicly-traded partnerships invest heavily in assets that are interests in usrp, such as mineral properties or “inherently permanent” structures, such as pipelines, storage facilities and the like.82 the exception for sales of interests in publicly-traded partnerships does not eliminate the need for a 5 percent or smaller partner to file on the basis that the partner is engaged in a u.s. trade or business or eliminate u.s. tax on the partner’s share of partnership income, including gain from the disposition of interests in usrp.83 the firpta rules that turn off non-recognition provisions of the code that might otherwise eliminate or dilute the firpta tax apply to partnership non-recognition provisions such as sections 721 and 731.84 it is not clear, however, that the turn off will always be successful in the case of a privately-held partnership.85 “traditional” publicly-traded partnerships in lobbying matters, and its membership does not include the more recent publicly-traded partnerships in the investing and asset management businesses, such as fortress investment group llc, apollo global management llc, the blackstone group l.p., kkr financial holdings llc, or och-ziff capital management group llc. ptps currently traded on u.s. exchanges, national association of publicly traded partnerships, http://www.naptp.org/ptp101/currentptps.htm (last visited feb. 5, 2013). 79. regs. § 1.1446-4. 80. regs. § 1.897-1(c)(2)(iv). 81. regs. § 1.897-1(c)(2)(iv), example. 82. see infra note 131. 83. the notional u.s. corporation rule seemingly applies whether the partnership is u.s. or foreign, and taxes the holder of a non-publicly traded interest in the partnership as a holder of a usrphc if the partnership would be a usrphc. see kimberly s. blanchard, firpta in the 21st century, installment three: firpta and foreign ptps, 37 tax mgm’t int’l j. 176 (2008) (for criticism of the rule). 84. temp. regs. § 1.897-6t(a)(2). 85. the override of section 721, for example, addresses the transfer of an interest in usrp that has a built-in gain to a partnership that holds foreign real property or other assets whose disposition would not be effectively connected with a u.s. trade or business, but it would not effectively deal with a case in which the partnership held appreciated interests in usrp and then issued partnership interests 22 florida tax review [vol. 14:1 3. reits a u.s. corporation that meets certain income, asset, ownership, and dividend distribution requirements may elect to be a reit.86 if the election is made, the reit may deduct dividends to shareholders; and, since reits generally distribute all ordinary income and capital gain,87 they generally pay no entity-level tax.88 the original concept of the reit rules, when enacted in 1960, was that reits would be essentially passive investors in portfolios of real estate and/or in mortgages secured by real property. distributions by a reit to a foreign shareholder that are not distributions of gain from a sale or other disposition of interests in usrp are, to the extent out of earnings and profits, subject to the 30 percent withholding tax that applies to dividends paid by any u.s. corporation. under the distribution “look through” rule of section 897(h)(1), distributions of gain from a sale or other disposition of an interest in usrp are treated as gain from a disposition by the shareholder and thus are generally subject to tax as effectively connected income (regardless of whether or not the reit is a usrphc or the gain is capital gain). this is subject to an exception for distributions paid on a class of shares that is regularly traded on an established securities market in the united states to a foreign shareholder that owns 5 percent or less of the class.89 although exempt from firpta, the distribution would be subject to withholding tax as a regular dividend to the extent out of earnings and profits.90 a “wash sale” rule targets sales or in exchange for foreign real property or other assets whose disposition would not be effectively connected with a u.s. trade or business. 86. see generally robert j. staffaroni, foreign investors in rics and reits, 56 tax law. 511 (2003) [hereinafter staffaroni, foreign investors]. 87. capital gain of the reit, whether or not distributed as a dividend, is taxed to a shareholder as though realized by the shareholder. if distributed, the tax is on the shareholder (under section 857(b)(3)(b), which provides that “[a] capital gain dividend shall be treated by the shareholders . . . as a gain from the sale or exchange of a capital asset held for more than 1 year”); and, if retained, the tax is paid by the reit (under section 857(b)(3)(d)), but the shareholders are entitled to refundable credits for the tax and an adjustment to the basis for their shares in the reit for the after-tax gain recognized by the reit. 88. reits may have taxable reit subsidiaries (which, as the name implies, are taxed on their income), and there are also a series of taxes that may be imposed on specific transactions or items of income (e.g., on income from foreclosure property). while a reit need not distribute capital gain and may also retain 10 percent of its real estate investment company taxable income, in practice reits distribute all real estate investment company taxable income and capital gain. 89. i.r.c. § 897(h)(1). 90. i.r.c. § 857(b)(3)(f). in the case of a ric, see section 852(b)(3)(d). section 897(h) provides that a distribution of an interest in usrp by a domestically– controlled reit or ric to its shareholders will result in the recognition of gain to 2013] suppose firpta was repealed 23 other dispositions of reit shares in anticipation of distributions of gain from the reit’s disposition of an interest in usrp.91 equity (as opposed to mortgage) reits would ordinarily be usrphcs because they primarily invest in interests in usrp. as a consequence, gain from a sale by a foreign shareholder of shares of the reit would generally be taxable under firpta. there are, however, two exceptions to this rule. first, shares of a reit that is a usrphc may be covered by the rule that applies to any u.s. corporation (and also, under regulations, to publiclytraded partnerships and fixed investment trusts) and excludes from the definition of an interest in a usrphc shares of a class that is regularly traded on a securities market if the holder owns, and in the last five years has owned, no more than 5 percent of the class, directly or constructively.92 second, the statute also provides a separate exception for dispositions of shares of a domestically-controlled reit, defined for this purpose as a reit that was for the five years preceding the sale owned to the extent of more than 50 percent in value by u.s. persons. the domesticallycontrolled exception is available only to reits and rics that are usrphcs. no constructive ownership rules apply for this purpose, which is odd, given that they do for purposes of the exception for a 5 percent or smaller holder of shares of a class that is publicly traded; and so the more than 50 percent owned by u.s. persons might, for example, be owned by a subsidiary of the foreign corporation that directly owned the less than 50 percent interest.93 while the statute says that the domestically-controlled test is whether foreign persons “held (directly or indirectly)” 50 percent or more during the fiveyear period, it looks only at the actual owner, and under the regulations this the extent of the “foreign ownership percentage” of the reit or ric. it is not clear what this provision accomplishes, given the subsequent enactment of section 3l1(b). 91. under the wash sale rule in section 897(h)(5), gain from the sale of shares of a reit or ric during the thirty-day period preceding the ex-dividend date for a distribution that would in whole or in part be treated as a sale or exchange of an interest in usrp by the shareholder is treated as gain from the sale of a usrpi to the extent of the amount of the distribution that would be so treated if the shareholder acquires or enters into a contract or option to acquire a substantially identical interest in the entity during the sixty-one-day period beginning on the first day of the thirty-day period. similar rules apply to substitute dividend or similar payments. 92. i.r.c. § 897(c)(3). see blanchard, installment two, supra note 49. 93. see plr 200923001 (feb. 26, 2009). see also seth j. entin, irs provides important guidance for inbound investments in reits, 129 tax notes 215–22 (oct. 11, 2010). 24 florida tax review [vol. 14:1 is the person who is required to include dividends on the shares in gross income.94 the exception for domestically-controlled reits allows a foreign investor to structure investments in u.s. real estate that in effect permit it to elect out of almost half of the firpta tax that would otherwise be due on a sale of its entire interest. changes in the regulations that define what is “portfolio interest” in the case of a partnership, and therefore exempt from withholding tax, exacerbate the distortions from the rule that applies to domestically-controlled reits.95 for example, suppose a foreign entity forms a reit, or several reits, to invest in u.s. real estate and elects to be a partnership, and then the reit (or reits) borrows from the partnership. although the reit is (or the reits are) directly or indirectly wholly owned by the foreign entity, the interest paid by the reit (or reits) will be exempt from withholding tax as portfolio interest so long as there is no 10 percent or greater partner in the partnership (if there is, the interest paid by the reit will be subject to withholding tax only in respect of such a partner’s share of the interest).96 measuring ownership at the partner level makes no sense if the purpose of the exclusion from portfolio interest of interest paid to 10 percent or greater owners was to exclude interest in cases where the debtor held sufficient equity to affect the terms of the debt. the distribution look through rule in section 897(h)(1) treats distributions of gain by a reit as recognized by the shareholders to the extent attributable to gains of the reit from sales or other dispositions of interests in usrp. how this rule should be interpreted in the case of a 94. regs. § 1.897-1(c)(1)(ii), (c)(2)(i) (referring to the “actual owners of stock,” as determined under regs. § 1.857-8, which in turn defines the actual owner as the person required to include dividends in income). some believe this is unclear in the case of shares held by a reit or ric, suggesting that the shareholders of the reit or ric might also be regarded as owners because they will take the income into account when it is distributed by the reit or ric. see levy, nonrecognition transactions, supra note 56. 95. portfolio interest, which is exempt from u.s. withholding tax, is defined by sections 871(h) and 881(c) to exclude interest received by a 10 percent or greater shareholder. 96. under regulations section 1.871-14(g)(3), the determination of whether the interest is portfolio interest, and therefore exempt from withholding tax, is made on a look through basis, i.e., at the partner level. interest is thus portfolio interest to any partner who, looking through the partnership, is not a 10 percent or greater shareholder of the reit. the reit’s deduction for interest would be subject to the earnings stripping limitation in section 163(j), but the benchmark (“adjusted taxable income”) adds all depreciation back to taxable income; and taxable income would, unlike reit taxable income, not be reduced by dividends. the portfolio interest rule is, of course, not limited to reits, although in practice that may be the most common application. 2013] suppose firpta was repealed 25 liquidation or a redemption is a source of disagreement.97 some reits took the view, apparently bolstered by a private letter ruling which was later withdrawn,98 that section 897(h)(1) did not apply to a distribution of gain in the complete liquidation of a reit, since that was a sale or exchange of the reit shares; and, therefore, if the reit was domestically controlled, a foreign shareholder recognized no taxable gain from the liquidating distribution. the theory, if correct, would also extend to a distribution in redemption of shares of a foreign shareholder by a domestically-controlled reit if the redemption was treated as a sale or exchange by the shareholder. and a foreign shareholder of a reit that was not domestically controlled might take the view that the liquidation of a reit did not result in tax because of the “cleansing exception” that excludes from the definition of usrphc a u.s. corporation which no longer owns interests in usrp and has disposed of all of the interests that it did own in gain recognition transactions. in notice 2007-55, the irs disagreed with the view that the section 897(h)(1) look through does not apply to liquidating distributions and said that it applied to any distribution, whether as a dividend, in redemption of shares or in complete liquidation.99 the notice promised that regulations would be issued, retroactive to the date the notice was issued, which would apply section 897(h)(1) to distributions to a foreign shareholder in a complete liquidation or in a redemption that is treated by the shareholder as a sale or exchange. the notice was limited to distributions in the liquidation of, or in the redemption of shares of, a domestically-controlled reit and did not address liquidating distributions to, or a redemption of shares of, a shareholder holding a 5 percent or smaller interest in a regularly traded class of shares. the irs subsequently concluded that such a redemption or distribution 97. there are also other interpretive issues, such as (1) whether it is limited to capital gain distributions, (2) whether distributions of capital gain previously taxed to the reit are covered, (3) whether losses are netted against gains of the reit in determining what is taxed, and (4) how to determine what part of a distribution is attributable to gains from the disposition of interests in usrp when the reit has other capital gains that are not attributable and less than all the gains are distributed. see elaine platt, using u.s. reits in cross-border transactions, 31 tax notes int’l 147–57 (july 14, 2003) [hereinafter platt, cross-border transactions]; see also, stanley l. blend, aba members comment on guidance addressing distributions between foreign governments, reits, 2008 tnt 114-23 (june 12, 2008) [hereinafter blend, aba members comment]. 98. plr 9016021 (jan. 18, 1990) (dealing with the liquidating distributions of a foreign-controlled reit that was largely owned by two foreign pension trusts, and was withdrawn by plr 200453008 (sept. 27, 2004)). 99. 2007-2 c.b. 13. more precisely, the notice applies to any distribution covered by sections 301, 302, 332 or 332. 26 florida tax review [vol. 14:1 would not be subject to tax100 because of the exclusion from the section 897(h) distribution look through rule for distributions of gain to a holder of a 5 percent or smaller interest and because it was a sale or exchange by the shareholder and not a dividend.101 the notice has been criticized by the national association of real estate investment trusts, the aba section on taxation, and others,102 largely on the basis that it misinterprets the words of the statute (specifically, what is a “distribution”) or does not conform the treatment of distributions to shareholders to the exemption provided for sales of shares of a domesticallycontrolled reit. none seem to suggest that the result is bad tax policy and, indeed, it is hard to see how a persuasive policy argument can be made for exempting the distributions targeted by the notice from tax if the starting point is a comparison with the treatment of direct investment or investment through a partnership.103 if gain from an investment in usrp that is made directly or through a partnership is taxed, why should the result differ for an investment in a reit? the only argument seems to be that a reit is just different.104 100. see i.r.s. advice memorandum 2008-03 (feb. 15, 2008) (dealing with a complete liquidation under section 331). 101. see, e.g., i.r.c. §§ 857(b)(3)(f), 852(b)(3)(d) (treating capital gain distributions by a reit or ric to a shareholder eligible for the 5 percent or smaller interest in regularly traded shares as ordinary dividends). 102. e.g., jeffrey d. deboer, real estate group seeks withdrawal of guidance on treatment of some liquidating distributions, 2012 tnt 114-13 (june 13, 2012). 103. separately, notice 2007-55 concluded that, if a foreign government was a shareholder, section 892 did not exempt gain from a liquidating distribution from the tax that would result from applying section 897(h)(1) to the distribution. this too provoked dissent. see, e.g., benita warmbold, canada’s pension investment board comments on guidance on distributions between foreign governments, reits, 2008 tnt 215-10 (nov. 5, 2008); ng kok song, investment company criticizes guidance addressing distributions between foreign governments, reits, 2008 tnt 161-15 (aug. 19, 2008); roger robineau, canadian pension association criticizes guidance on distributions between foreign governments, reits, 2008 tnt 248-20 (dec. 24, 2008). 104. see kimberly s. blanchard, is there a firpta tax on reit distributions, 112 tax notes 1071, 1072 (sept. 18, 2006) (arguing that “[a] reit is not a partnership or passthrough entity. it is a corporation and thus a character converter, in the sense that regardless of the type of income it earns, its distributions are treated as corporate distributions . . . .”); kimberly s. blanchard, notice 2007-55 rules liquidating distributions from reits are taxable under § 897(h)(1), 36 tax mgm’t int’l j. 381, 381 (2007) (saying the notice is “clearly incorrect . . . and should be withdrawn”); robert hanson, ernst & young, seeks withdrawal of guidance on forthcoming regs on distributions between foreign governments, reits, 2007 tnt 225-11 (nov. 21, 2007) (urging withdrawal of notice 2007-55). 2013] suppose firpta was repealed 27 comments on the notice pointed out that, unless the notice was correct (and wholly apart from distributions in a liquidation or redemption of shares of a domestically-controlled reit), foreign shareholders of a foreigncontrolled reit could arguably avoid firpta under the “cleansing” rule if the reit disposed of all of its interests in usrp in gain recognition transactions and there was then a complete liquidation of the reit. even critics of the notice thought that result went too far.105 4. rics a u.s. corporation may elect to be a ric if it is registered under the investment company act of 1940 (ʼ40 act) as a management company or unit investment trust106 and it meets certain income, assets and dividend distribution tests. a ric may deduct dividends to shareholders and pass through to shareholders capital gains and certain other items.107 like reits, rics generally pay no tax on their income or gains because of the deduction allowed for dividends paid to shareholders. some rics — so-called “mutual funds for real estate,” although there are also closed-end and exchange traded funds that make the same investments — invest significantly in shares of reits,108 and as a consequence may be usrphcs if 50 percent or more of their assets are interests in usrp (determined without regard to the exclusions for shares of domestically-controlled reit or publicly-traded shares of a reit held by a 5 percent or smaller shareholder).109 in 2004, the distribution look through rule that applies the firpta tax to distributions of gain realized by a reit from the disposition of interests in usrp, the exception to that rule for distributions to 5 percent or 105. see blend, aba members comment, supra note 97 (describing this as “a clear loophole” and recommending that notice 2007-55 be limited to this case or that the treasury seek a legislative remedy); tony edwards, nareit recommends topics for irs’s guidance priority list, 2012 tnt 95-23 (may 16, 2012) (expressing the view that “notice 2007-55 should be reversed except” in the cleansing exception case identified by the aba section on taxation, and arguing that in other cases there should be no firpta tax on distributions on shares that could be disposed of without tax because of the domestically–controlled exception). 106. or as a business development company. certain common trust or similar funds may also qualify. i.r.c. § 851(a)(1). 107. see generally staffaroni, foreign investors, supra note 86. other pass through items are “qualified” dividend income, the foreign tax credit, the dividends received deduction, tax-exempt interest and, in the case of foreign shareholders, before the end of 2011, short term capital gain and interest income. 108. see list of reit funds, reit.com, http://www.reit.com/investing/ listofreitfunds.aspx (last visited feb. 3, 2013). 109. see i.r.c. § 897(h)(4)(a)(i)(ii). 28 florida tax review [vol. 14:1 smaller holders of a class of publicly traded shares, and the exception from firpta for sales of shares of a domestically-controlled reit were extended to rics that were usrphcs (with reits and rics then being included in the definition of a “qualified investment entity”).110 the wash sale rule was also extended to ric shares.111 a ʼ40 act registered investment company that invests in shares of reits may sometimes qualify as a ric or a reit at its election, but all (or most) elect to be rics. there are tax differences: among others, securities other than shares of a reit would be “good” assets for a ric but not for a reit (unless they are mortgages secured by real property); withholding on ric dividends paid to foreign investors is generally reduced from 30 percent to 15 percent by treaty, without the treaty restrictions that apply to the withholding tax reduction on reit dividends; and short-term capital gain and interest related dividends of a ric are exempt from withholding tax altogether.112 f. do the rules that apply to business intermediaries make sense? under firpta, there are significant differences between investments by foreign persons in usrp that are made directly, through a fixed investment trust, or through a partnership and those that are made through a reit or a ric. there is, for example, no domestically-controlled exception for fixed investment trusts or partnerships and no exemption for a partner’s share of the partnership’s gain from the disposition of an interest in usrp if the partner owns 5 percent or less of a class of publicly-traded interests. gain from sales of shares in a usrphc is excluded from the branch profits tax, but gain from the sale of an interest in a partnership or trust that holds interests in usrp is not.113 direct investors and partners in partnerships must file returns, notwithstanding that the income of the partner that is effectively connected with the partnership’s business is subject to withholding tax.114 are these differences the result of a thoughtful process or simply an inadvertent by-product of legislative changes? the ric provisions were enacted in 1936, and the reit provisions followed in 1960. investors in reits plainly benefitted from the exclusion from the definition of a usrphc of a domestically-controlled reit and later benefitted from the exclusion of distributions to 5 percent or smaller holders of shares of a 110. see i.r.c. § 897(h)(4). 111. see i.r.c. § 897(h)(5). 112. i.r.c. §§ 871(k), 881(e). 113. i.r.c. § 884(d)(2)(c). 114. under either section 1445 or 1446. 2013] suppose firpta was repealed 29 publicly traded class of shares of gain of a reit from the disposition of interests in usrps. but those amendments came much later, in 1980 and 2004, and there is no reason to conclude that foreign investment was a focus when the basic reit rules were enacted in 1960 and that there was a congressional consensus that foreign investment in reits should be given preferential treatment. likewise, the rules that treat foreign partners in partnerships as engaged in a business in the united states if the partnership is so engaged came in long before there were publicly-traded or even widelyheld partnerships and before the enactment of the rules in section 1446 (as well as section 1445) that require partnerships to withhold on foreign partner’s share of effectively connected income. given the withholding tax rules (which are in effect an entity level tax), is it necessary to treat foreign partners as engaged in a trade or business in the united states? u.s. income tax could be made simpler if there was a top-to-bottom reevaluation of the rules that apply to entities such as reits and publicly-traded partnerships; but short of that, there should at least be an effort to limit the distortions that result from the rules. iii. repealing the firpta rules with the benefit of hindsight, are the firpta rules with respect to usrphcs sensible? the arguments used to justify the usrphc rules made no sense then and certainly do not after the repeal of the general utilities doctrine115 and other statutory changes since 1980.116 all that the usrphc rules in firpta do now is to accelerate the tax due on the disposition of an interest in usrp, and, contrary to the purpose of firpta, which was to ensure one tax, possibly result in double taxation — once to the shareholder and again to the corporation.117 that creates an obvious disparity between the possible double tax on an investment made through a u.s. corporation and one made through a foreign corporation, in which case there is only the tax upon a sale by the entity. and repeal would not cost that much.118 the argument that the usrphc rules were needed to achieve “horizontal equity” between u.s. and foreign business investment in real 115. see supra note 31. 116. see generally cynthia blum, how the united states should tax foreign shareholders, 7 va. tax rev. 583 (1988); alan l. feld, is firpta (partially) obsolete?, 35 tax notes 607 (may 11, 1987); kaplan, creeping xenophonia, supra note 3. 117. that one tax was the purpose of the usrphc rules seems clear, not only from the legislative history, but also from the “cleansing” exception and from the exceptions from gain recognition where basis was preserved and the ownership remained unchanged. see i.r.c. §§ 897(c)(1)(b), 897(d)(2), 897(e)(1). 118. the estimate of the staff of the joint committee was less than $50 million a year. see supra note 5. 30 florida tax review [vol. 14:1 estate was misguided. in the first place, that is not the standard by which the taxation of foreign investment is tested. horizontal equity would, for example, imply the repeal of the portfolio interest exemption (since no such exemption applies to interest received by a domestic lender), reducing the withholding tax on dividends paid to nonresident aliens to 15 percent (since that is the rate that applies to u.s. residents and citizens), and so on.119 “horizontal equity” is simply not the rule applied to investments other than in interests in usrp. nor does the conventional understanding of the “source” rules justify taxing gain from the disposition of an interest in a usrphc. there is no other place in the internal revenue code where the source of gain from the sale of shares of a u.s. corporation is based on the assets of the corporation. then there is the enormous complexity involved in identifying and taxing interests in usrphcs and the distortions that result from the domestically-controlled reit (or ric) rules. consider, for example, the definition of a usrphc (e.g., the identification of “determination dates,” the methods of valuation, etc.) or of an interest “other than a creditor” in a usrphc. and, having applied firpta to sales and other taxable dispositions of interests in usrphcs, the legislation went on to apply firpta to any transactions in which an interest in a usrphc was exchanged unless the exchange was for an interest in a usrphc or unless regulations provided further exceptions.120 presumably the concern was that, absent such rules, the unrecognized gain could in a section 351 exchange or a tax-free reorganization be shifted to someone else.121 the regulations start with the already complex rules relating to tax-free reorganizations and section 351 transfers, often involving a foreign corporation (and thus section 367) and layer on top of that a whole new set of rules intended to implement firpta. many of the transactions addressed are relevant to publicly-traded corporations that restructure operations which may include an usrphc, not the closely-held corporations that firpta seems to have been focused on; and most of the firpta guidance in the last ten years has been with respect to these transactions.122 119. for a defense of the horizontal equity argument, see brown, wither firpta, supra note 3, at 301. 120. i.r.c. § 897(e). 121. section 897(d) provides that a distribution of a usrpi by a foreign corporation will result in the recognition of gain as though the interest had been sold at fair market value unless there was a carryover basis to the shareholder and the shareholder would be taxed on a subsequent distribution or unless the regulations provided a further exemption. additionally, section 897(j) provides that a contribution of an interest in usrp to the capital of a foreign corporation would be taxed as a sale at fair market value. 122. see levy, nonrecognition transactions, supra note 56, (recommending the use of “a simple rule that permits any foreign corporation to rely 2013] suppose firpta was repealed 31 a. real estate investment trusts the exception for sales of shares of domestically-controlled reits is bizarre. why was this enacted? there is no meaningful legislative history.123 starting with the premise that the purpose of firpta was to quash “planning techniques” of foreign investors then it is possible that the concern that a reit could be used for that purpose would be mitigated if the reit was domestically controlled. it may also have been that reits were just not as important in 1980 for investing in u.s. real estate as they are now. but if the exception was good for reits, why not for others? it was ultimately extended to rics that were usrpcs and domestically controlled, but not to other usrphcs or to partnerships. and was the premise — that domestic control would prevent “planning techniques” and “mechanisms” to avoid tax — correct? because reits can easily be controlled by one or a few investors, they are from a planning perspective not really a more complicated choice than a privatelyheld partnership or a corporation. this seems evident from some of the uses to which reits have been put, both in the case of foreign investment in usrp and in other contexts. indeed, one point that the debate on firpta repeal neglects is the treatment of pass-throughs. some seem to assume that there is either direct investment in usrp or investment by a corporation, whether u.s. or foreign, and thus do not consider the central importance of reits to foreign investment in u.s. real property.124 although promoted as “mutual funds for real estate” when the reit rules were enacted in 1960, that view misses the point that today a large part of the reit population consists of reits created by a few investors for the purpose of making specific investments. while reit qualification requires that there be 100 or more beneficial owners (presumably by analogy to the trigger for ʼ40 act registration in the case of a ric),125 the ownership of the shares needed to meet this requirement can be nominal in both voting power and value; and if there is on any nonrecognition provision in connection with the transfer of any usrpi to any other corporation (whether foreign or domestic) as long as the recipient corporation of the usrpi takes a carryover basis in the usrpi, and that the recipient would be subject to u.s. tax on . . . a disposition of the usrpi.”). on the regulations, see generally kimberly s. blanchard, firpta in the 21st century – installment one: a closer look at regs. §1.897-5t(c), 36 tax mgm’t int’l. j. 520 (2007). 123. see h.r. rep. no. 96-1479, at 188 (1979) (conf. rep.) (stating simply that “[i]n the case of reits which are controlled by u.s. persons, sales of the reit shares by foreign shareholders would not be subject to tax (other than in the case of distributions by the reit).”). 124. see, e.g., brown, wither firpta, supra note 3, at 300. 125. see i.r.c. § 856(a)(5) (requiring that “the beneficial ownership . . . is held by 100 or more persons”). 32 florida tax review [vol. 14:1 no other way to scrape up the needed shareholders, they can be found online — as one organization says, “call us today. you’ll be amazed at how easy we make it.”126 thus, a reit can be largely owned by a single investor127 and can be created solely for the purpose of a specific investment; indeed this has facilitated some of the more abusive uses of reits over the years, not only in the case of foreign investment in u.s. real property128 but also in other areas. for example, reits have been used in “abusive” transactions (most famously, to issue so-called fast-pay stock)129 and in state and local tax planning.130 126. the fastest, most economical and easiest way to fulfill the 100 shareholder requirement, reit funding, llc, http://www.reit-funding.com (last visited feb. 3, 2013) (reporting that since it “pioneered the third-party approach to helping reits obtain accommodation shareholders over ten years ago . . . reit funding has provided shareholders for over 900 private reits . . . .”). see also, e.g., reit inv. grp., http://www.reitinvestmentgroup.com (last visited feb. 3, 2013). 127. under section 856(a)(6), a reit may not be “closely held,” but this looks only at ownership by individuals and certain tax-exempt organizations. 128. some of the roles that reits play in structured investments in u.s. real property is clear from the transactions described in notice 2007-55 — a domestically-controlled reit with a foreign government shareholder which liquidated in order to enable the shareholder to take the view that the liquidating distributions were exempt from firpta or in any event not taxed under section 892. 129. the reit would issue preferred stock to tax indifferent holders and use the proceeds to make a mortgage loan (or buy mortgages from) a corporation that owned its common stock. the preferred stock would pay dividends at an extraordinarily high, off-market rate for a period and, at the end of the period, at an extraordinarily low, off-market rate. the corporation would deduct the interest on its mortgage (or exclude the income on the transferred mortgages from its income), which would be taxed entirely to the holders of the preferred stock and then, at the end, the preferred could be cashed-out for much less than issue price — in effect allowing the corporation to deduct principal on a financing. the treasury put an end to this by issuing notice 97-21, 1997-1 c.b. 407, and then regulations section 1.7701(l)-3. the regulations entitle the irs to treat the transaction as though it was a loan from the holder of the fast-pay stock, i.e., the preferred, to the holder of the benefited stock, i.e., the corporation that holds the common. 130. for example, the autozone litigation in kentucky and louisiana involving an out-of-state affiliate qualifying as a reit that leased in-state facilities to an operating affiliate and took the view that it had no in-state income after the dividends paid deduction. kentucky v. autozone dev. corp., no. 2006-ca-002175mr, 2007 ky. app. lexis unpub. lexis 1130 (ky. ct. app. oct. 12, 2007); bridges v. autozone props., inc., 900 so. 2d 784 (la. 2005). see also, hmn fin., inc. v. commissioner, 782 n.w.2d 558 (minn. 2010) (the minnesota commissioner of revenue could not on “economic substance” or “business purpose” grounds disregard a captive reit); bankboston corp. v. commissioner, 861 n.e.2d 450 (mass. 2007). states increasingly deal with this through legislation that restricts “captive” reits. 2013] suppose firpta was repealed 33 consideration of how foreign investments in reits should be treated should also focus on the fact that, today, reits are not simply part of the real estate sector of the u.s. economy but are significant in other economic sectors that do not primarily reflect the value of real estate. these include timber, wireless communication facilities, data storage facilities, lodging and health care facilities, and, most recently, gaming casinos.131 off shore drilling oil and gas platforms may be next.132 the expansion of reits into these businesses is essentially attributable to the ability, after a 1999 amendment to the internal revenue code, to carry on any activity through a taxable reit subsidiary;133 to the view that real property is not limited to land, buildings and improvements to buildings but includes any “inherently permanent structure” and its structural components;134 and to the ability to convert a “c” corporation to a reit with limited tax costs.135 b. repealing the firpta rules for usrphcs suppose, then, that we repealed the firpta rules relating to interests in usrphcs? if the repeal was limited to the usrphc rules (and leaving aside questions about other firpta rules, such as the definition of real property, that are addressed below), gain on the disposition by a foreign person of a direct investment in usrp, including an interest in a fixed 131. such as weyerhauser company and rayonier inc. (timber); american tower (cellular tower); penn national gaming (casino); and iron mountain inc. (data storage facility). others that have announced or completed conversions to reits are the companies in the business of outdoor advertising (lamar advertising), conference centers (gaylord entertainment) and correctional facilities (corrections corp. of america). see amy s. elliott, the expanding universe of reits, 2012 tnt 219-1 (nov. 13, 2012). 132. see plr 201250003 (dec. 14, 2012) (concluding that income from the lease of an offshore oil and gas drilling platform and related machinery and equipment was rent from real property for purposes of section 7704(d), based on the definitions in the regulations under section 856). 133. the restrictions on taxable reit subsidiaries are in the asset and income tests for reit qualification — i.e., that not more than 25 percent in value of a reit’s assets can be securities of taxable reit subsidiaries, see i.r.c. § 864(c)(4)(b)(ii), and that dividends and interest from taxable reit subsidiaries are not real estate income described in section 856(c)(3). 134. regs. § 1.856-3(d). see also rev. rul 75-424, 1975-2 c.b. 269; rev. rul. 73-425, 1973-2 c.b. 222; rev. rul. 71-220, 1971-1 c.b. 210; rev. rul. 69-94, 1969-1 c.b. 189. 135. a reit that was previously a c corporation (or was spun off by a c corporation) must distribute its earnings and profits in a taxable dividend (which is usually effected by a taxable stock dividend), see i.r.c. § 857(a)(2), and will recognize any built in gain in its assets that is recognized in the gain recognition period specified by regulations under section 337(d). 34 florida tax review [vol. 14:1 investment trust that held such an interest, or of an interest in a partnership that held interests in usrp, would still be subject to tax,136 as would a foreign partner’s share of gain of a partnership from a disposition of an interest in usrp. there would, however, be no tax on gain from the sale of shares of a reit (or a ric that invests in shares of a reit) or any other corporation that would have been a usrphc before repeal or on distributions by a reit (or a ric that invests in shares of a reit) of gain from the disposition of an interest in usrp. other dividends of a reit (or a ric that invests in shares of a reit) would be subject to withholding tax, but even that would be reduced under tax treaties to a level that is likely lower than the tax paid on a direct investment in interests in usrp or investment through a partnership in usrp. if the usrphc rules were repealed, therefore, it would make sense at the same time to enact consistent rules for foreign investments in usrp that are made directly or through a partnership or through a reit (or a ric that invests in shares of a reit). the argument for doing so is not an argument for horizontal equity between u.s. and foreign investors but rather for uniform treatment of foreign investors and the elimination of the distortions that result from the choice of the entity that makes an investment. if a foreign person who invests directly or through a partnership in usrp would be subject to current tax on income from the investment and to tax on its sale, why should the result differ if the investment is made through a reit (or a ric that invests in shares of a reit)?137 put differently, if there is to be no tax on sales by foreign persons of shares of a reit (or a ric that invests in shares of a reit) or distributions by a reit (or such a ric) of gain to shareholders, why should there be a tax on dispositions of investments made through a partnership or made directly? but conforming the treatment of investments made directly or through a partnership with investments made through a reit (or a ric that invests in shares of a reit) poses a dilemma. which set of rules are to be changed? should the taxation of investments through a reit (or a ric that 136. with the repeal of firpta and with it the rule that excepts sales by 5 percent or smaller holders of interests in a publicly-traded partnership, a foreign partner would be taxed on the partner’s share of the current income or gain of the partnership from the investment in u.s. real property and would also (assuming an aggregate view of partnerships for this purpose) be taxed at the time an interest was sold on the partner’s share of the appreciation in the value of the real estate and any other assets of the u.s. trade or business. 137. the tax on the current income of reits is diminished by very generous deductions for depreciation that came in after firpta, and distributions in excess of earnings and profits simply reduce a shareholder’s basis and, unlike the gain from the sale of an interest in a partnership that is attributable to depreciation or depletion deductions, are not recaptured as ordinary income on a sale of shares. 2013] suppose firpta was repealed 35 invests in shares of a reit) be conformed to the taxation of investments made directly or through a partnership or vice versa? there are a number of alternatives. one might be to accept the distortion that results from taxing investments through reits (or a ric that invests in shares of reits) differently from other investments, but to narrow the extent that private reits can be used for this purpose. arguably, the main objection to not treating investments in reits like investments made directly or through partnerships is the use of private reits to in effect avoid, or significantly limit, any u.s. tax on investments in u.s. real estate. the requirement that a reit have 100 or more beneficial owners could be made meaningful, for example, by excluding small shareholders if the reit is not predominantly publicly traded. the domestically-controlled exception would be repealed. another alternative, which does not preclude the first, would be to conform the treatment of reits to partnerships and tax foreign persons on sales of shares of reits and on distributions of gain by reits. the same rules would apply to rics that predominantly invest in reits. this would leave in place some of the withholding tax and other complexities of the usrphc rules, but would limit their application. in the case of publiclytraded entities, an argument might be made on administrative grounds for an exemption for sales by and distributions to small shareholders (e.g., something similar to the present exemption for sales of 5 percent or smaller interests in publicly-traded usrphcs, partnerships and trusts). if there was such an exception, however, it would seem sensible to extend it to allocations of gain by a publicly-traded partnership to foreign partners (as well as continuing the exception for sales of partnership interests). since tax on the effectively connected income of a foreign partner is now collected withholding under section 1446, it would also be sensible to consider whether a partner eligible for the small holder exception should be required to file a return on the basis that the partner was engaged in a trade or business in the united states and whether the withholding tax reductions provided by treaties to dividends from reits and rics be extended to distributions by publicly-traded partnerships. c. repeal of all of firpta suppose we went further and the other firpta provisions, i.e., those other than the rules relating to interests in usrphcs, were also repealed. in other words, we threw all of section 897 out the window. first, what about the definition of real property for purposes of the source rules? it would plainly make sense to retain the basic firpta definition in the case of property held for the production of income — land (including interests in natural deposits), buildings and other improvements — and to treat leaseholds as well as ownership or co-ownership as interests 36 florida tax review [vol. 14:1 in real property. if we stopped there, however, reverting to the pre-firpta rules would, in contrast to firpta, (1) eliminate tax on the disposition of personal (or non-business) real property by a foreign person; (2) exclude from real property options to acquire land or improvements or leaseholds of land or improvements; (3) exclude from the definition of real property interests in personal property associated with the use of real property; and (4) limit the source of gain rule to ownership interests, rather than any interest other than solely as a creditor. are any of these changes objectionable?138 firpta includes in the definition of real property “options to acquire land or improvements . . . [or] leaseholds . . . thereon.”139 separately, the regulations provide that an “interest” in real property includes any interest other than solely as a creditor.140 the scope of the definitions — of an “option” and of an “interest”— is uncertain. convertible debt of a usrphc or a shared appreciation mortgage on usrp are quite obviously “interests” not solely as a creditor,141 but there is a no comprehensive guidance, for example, on whether an “interest” would include real-estate based on notional principal contracts or other derivatives.142 leaving that aside, the inclusion of options in the definition of real property is odd since options are generally not treated as ownership interests in the optioned property (unless on the particular facts the option amounts to such an interest because, for example, it is deep in the money), and gain from the sale of options, futures and other derivatives is generally sourced on a residence basis unless the gain is effectively connected with a u.s. trade or business.143 the inclusion of options on real property and on leaseholds of real property seems to have come about simply because firpta borrowed its definition of real property from the reit provisions.144 the inclusion in “interest” of 138. for a contrary view, see brown, wither firpta, supra note 3, at 304 (citing the ability in the absence of firpta to avoid tax on the disposition of real estate that was not used in a u.s. trade or business, including personal residences, and also on options and some non-creditor interests). 139. i.r.c. § 897(c)(6)(a). 140. regs. § 1.897-1(d)(2)(i) (providing that an interest other than as a creditor “also includes any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property”). 141. regs. § 1.897-1(d)(3)(d). 142. rev. rul. 2008-31, 2008-1 c.b. 1180 (holding that a notional principal contract based on broad based index on commercial or residential real estate was not an option to acquire within the meaning of section 897 because the index was broad based). 143. i.r.c. §§ 865, 988; regs. § 1.861-7. 144. i.r.c. § 856(c)(5)(c). 2013] suppose firpta was repealed 37 any interest other than solely as a creditor is in part simply regulatory zeal.145 eliminating the rule that includes options on real property or real property leaseholds from the definition of real property, and cutting back on the breadth of the definition of an interest other than a creditor, would be sensible. firpta also adds “personal property associated with the use of real property” to the definition of real property, even though that property would not by itself be real property for reit or any other purposes.146 the inclusion of personal property “associated with the use of real property” seems simply to have borrowed from what the language of u.s. and other oecd tax treaties then in effect permitted the source country to tax. personal property associated with the use of real property is included in the definition of real property, however, only “where both the personal property and the united states real property interest with which it is associated are held by the same person or by related persons”147 and, generally, where the disposition of the personal property is within one year on either side of the disposition of the real property.148 before firpta, real property did not include personal property associated with the use of real property, and thus the repeal of firpta would, without more, narrow the definition. but as a practical matter, personal property used in connection with u.s. real property that produced effectively connected income (or income attributable to a permanent establishment), by election or otherwise, would be an asset of the trade or business if owned by the owner of the real property, and thus any gain would be subject to tax on its disposition.149 the main function of including such personal property in the firpta definition is to increase the likelihood that a u.s. corporation would be a usrphc or, put the other way around, prevent the ownership of personal property from allowing a u.s. corporation to escape the usrphc. with the repeal of the usrphc rules this would no longer be relevant. there seems to be no reason why personal property associated with the use of real property should be treated any 145. while the statute includes interests in a usrphc other than solely as a creditor, i.r.c. § 897(c)(1)(a)(ii), it does not apply that concept to other interests in real property or to interests in other entities. 146. i.r.c. § 897(c)(6)(b) (including in the definition “movable walls, furnishings, and other personal property associated with the use of real property”). 147. regs. § 1.897-1(b)(4)(i). 148. regs. § 1.897-1(b)(4)(ii). 149. before firpta, section 861(a)(5) defined real property for purposes of sourcing gain on its disposition as “real property located in the united states.” income from personal property associated with the use of real property is not treated as income effectively connected with a u.s. trade or business by virtue of an election to treat the income from the real property as effectively connected. see regs. § 1.871-10(b). 38 florida tax review [vol. 14:1 differently from any personal property and certainly that would be a simplification of the rules. repeal of firpta would also restore the different treatment of gain from the disposition of real property that was a u.s. trade or business and one that was not. does the different treatment make sense? with the present levels of individual and corporate tax, it is unlikely that there will be many situations in which a 30 percent tax on gross income is better for an investor than a tax on effectively connected taxable income, and this argues for a single rule under which the tax on income from real property (as redefined) would be on taxable income, whether or not it is effectively connected with a u.s. trade or business.150 in order to avoid the need to file returns, the tax should be collected by withholding and, subject to treaties, imposed at a single rate that takes into account the likelihood that any investment in real property involves expenses. d. tax treaties u.s. tax treaties do not limit the firpta tax on gains from sales of shares of usrphcs or of distributions by reits or rics of gains from sales of interests in usrp. nor do they reduce the 30 percent withholding tax on rents or oil, gas and other mineral royalties that are not effectively connected with a u.s. trade or business. more recent treaties do reduce the 30 percent u.s. withholding tax on regular dividends paid by a reit to zero in the case of a foreign pension fund and to 15 percent in the case of other shareholders, but only in the case of a pension fund or individual shareholder owning 10 percent or less of the reit, a shareholder owning 5 percent or less of any class of stock of a reit if the dividend is paid on a class of shares that is publicly traded, and for a shareholder who holds an interest of 10 percent or less in the reit if the reit is “diversified” (which requires that no single property held by the reit exceed 10 percent in value of the value of its total interests in real property).151 a few u.s. tax treaties extend the 15 percent reduction to shareholders that are the equivalent of reits under foreign law without regard to the amount of shares owned.152 the reason for not allowing 150. others have suggested this. see brown, wither firpta, supra note 3, at 311 nn.87–88. 151. see platt, cross-border transactions, supra note 97 (noting that before the 1996 model, reit dividends were treated like any dividends (and thus could be taxed at a 5 percent or 15 percent rate) but in the model convention released that year, and in subsequent treaties, the 5 percent rate was eliminated and the 15 percent rate was limited to dividends paid to specified foreign shareholders). 152. for example, article 10 of the united states-australia treaty reduces the rate to 15 percent for dividends paid to a listed australian property trust, or lapt, but to the extent there are 5 percent or greater owners of the lapt, it applies the usual treaty provisions to that part of the dividend (treating the shares held by the 2013] suppose firpta was repealed 39 a 5 percent rate and for restricting the 15 percent rate for reit dividends is to reduce the disparity in the treatment of current income from a direct investment and from an investment through a reit.153 on a somewhat different theory — that “small” investments in reits are simply portfolio investments — the oecd’s model convention on income and capital seems also to be going in the direction of reducing the tax imposed on dividends by the country in which the reit is resident.154 lapt as publicly traded for this purpose). 1982 income tax convention, u.s.austl., aug. 6, 1982, http://www.irs.gov/businesses/international-businesses/ australia-tax-treaty-documents. article 10 of the united states-netherlands treaty reduces the rate to 15 percent for dividends paid to a belegginsinstelling, regardless of how much of the reit it owns. 1992 income tax convention, u.s.-neth., dec. 18, 1992, http://www.irs.gov/businesses/international-businesses/netherlands--tax-treaty-documents. 153. thus, the treasury department’s technical explanation of article 10 of the 2006 model, which is somewhat muddled because it confuses the taxation of current income and gain from a disposition, says that the “restrictions [on the reductions in withholding tax on dividends paid by a ric or reit] . . . are intended to prevent the use of [reits or rics] to gain inappropriate u.s. tax benefits. . . . [a] resident of the other contracting state directly holding u.s. real property would pay u.s. tax upon the sale of the property either at a 30 percent rate of withholding tax on the gross income or at graduated rates on the net income. . . . [b]y placing the real property in a reit, [a foreign] investor could, absent a special rule, transform income from the sale of real estate into dividend income from the reit, taxable at the rates provided in [the dividend article of the model treaty], significantly reducing the u.s. tax that otherwise would be imposed. paragraph 4 [of that article] prevents this result and thereby avoids a disparity between the taxation of direct real estate investments and real estate investments made through reit conduits. in the cases in which paragraph 4 allows a dividend from a reit to be eligible for the 15 percent rate of withholding tax, the holding in the reit is not considered the equivalent of a direct holding in the underlying real property.” u.s. dep’t of the treasury, united states model technical explanation accompanying the united states model income tax convention of november 15, 2006, at 36, (nov. 15, 2006), http://www.treasury.gov/press-center/press-releases/documents/hp16802.pdf. 154. the july 2008 version of the oecd model tax convention on income and on capital took the view that reit distributions to “small investors” might be considered portfolio dividends, i.e., not dividends from an investment in immovable property, but that it “would not seem appropriate to restrict the source taxation of” reit dividends in the case of a “larger investor.” it thus suggested that states which agreed might extend the 15 percent withholding tax rate to distributions by a reit to a shareholder that held “directly or indirectly” at least 10 percent of the value of the capital of the reit and that this might apply to capital gain as well as other distributions. organization for economic co-operation and development, model tax convention on income and on capital, art. 10, ¶ 67.3, 67.4 (july 17, 2008). the commentary to article 13 (gains) also suggests that states may want to exempt from tax the gain of a small foreign investor from the sale of an interest in a reit, 40 florida tax review [vol. 14:1 repeal of firpta would eliminate the need to exclude shares of usrphcs, and the other country’s equivalent, if any, from treaty provisions that exempt gains from the sales of shares from tax in the country in which the corporation is resident. repeal might also open up the question of whether the united states should tax rents and royalties and other income from real property that is not effectively connected with a u.s. trade or business at a 30 percent rate rather than a lower rate. before firpta, there were treaties that reduced the rate to 15 percent.155 other u.s. source income from capital — interest, royalties for the use of intangible property, dividends — generally benefit from the elimination or reduction in withholding taxes. why shouldn’t the same principal be considered in the case of real estate? if repeal of firpta led to a review of the treatment of inward investment generally, and was not limited to foreign investment in u.s. real property, would it make sense to consider the rates of withholding on, and the deductions allowed to u.s. persons for, interest, royalties (both for minerals and intangibles), and other payments made to related foreign persons? the mobility of capital and of intangibles has plainly enabled u.s. corporations to reduce taxes imposed by the country of use or consumption, as well as by the united states,156 and there is every reason to believe that foreign corporations investing in the united states likewise use royalties, as well as interest expense, to reduce the u.s. tax base.157 repealing or modifying firpta would provide an opportunity to evaluate the current rules. notwithstanding the general rule in article 13 which allows the taxation of sales of shares if “more than 50 percent of their value [is derived] directly or indirectly from immovable property situated in the” state. id., art. 13, ¶ 28.3. the july 2010 version of the oecd model convention on income and on capital takes the same approach. in the 2008 version, reits were “loosely described as a widely held company, trust, or contractual or fiduciary arrangement that derives its income primarily from longterm investment in immovable property, distributes most of that income annually and does not pay income tax on the income related to immovable property that is so distributed.” id., art. 10, ¶ 67.1. 155. for example, see the united states–united kingdom tax treaty involved in herbert v. commissioner, 30 t.c. 26 (1958). 156. see edward d. kleinbard, stateless income’s challenge to tax policy, 132 tax notes 1021–42 (sept. 5, 2011); edward d. kleinbard, stateless income’s challenge to tax policy, part 2, 136 tax notes 1431–48 (sept. 17, 2012). 157. see bret wells, what corporate inversions teach about international tax reform, 127 tax notes 1345 (june 21, 2010). 2013] suppose firpta was repealed 41 iv. legislation other than repeal what would not make sense, if there is to be no repeal of firpta, would be to enact some of the more modest proposals that have been put forward, such as the real estate jobs and investment act which was introduced in the house of representatives in september of 2011.158 the real estate jobs and investment act would keep the usrphc provisions of firpta but, broadly, make four changes in the present rules. first, the act would increase from 5 percent to 10 percent the exception for sales of shares of a class of stock of a reit that was regularly traded on an established securities market and, correspondingly, increase from 5 percent to 10 percent the exception to the firpta tax for distributions by a reit of gain from the sale or other disposition of united states real property interests. the distribution would be treated as an ordinary distribution and would be taxed as a dividend, to the extent out of earnings and profits, at the 30 percent or lower treaty rate. these changes would only apply to reits — the exception for sales of regularly traded shares of other usrphcs would stay at 5 percent. second, the act would reject notice 2007-55 and not treat a distribution by a reit of gain to a shareholder as a taxable distribution if the distribution was in the complete liquidation of the reit or in a redemption of its shares that was treated as a sale by the shareholder if the reit was domestically controlled or if the distribution was on a class of regularly traded shares and the shareholder held 10 percent or less of the class. third, in determining whether a reit is or is not domestically controlled, the act would expand the definition of u.s. ownership by providing that, in the absence of actual knowledge to the contrary, a reit or a ric could assume that less than 5 percent owners of shares of stock of a class that was traded on an established securities market in the united states were u.s. persons; but it would narrow the definition of u.s. ownership by excluding from u.s. ownership shares of the reit owned by another reit 158. h.r. 2989, 112th cong., 1st sess. (2011). the substantially same bill was introduced in the senate as the real estate investment and jobs act of 2011. the house bill had been previously introduced as the real estate jobs and investment act of 2010, h.r. 5901, and passed the house in july of that year. for a technical explanation, see staff of the joint committee on taxation, jcx-4110, technical explanation of the revenue provisions of h.r. 5901, the “real estate jobs and investment act of 2010” (2010). see, e.g., statement of jeffrey d. deboer on behalf of the real estate roundtable before the subcommittee on select revenue measures, real estate roundtable (june 23, 2011), www.rer.org/firpta-testimony-june2011.aspx. short of repeal, the statement advocates increasing from 5 percent to 10 percent the exception for sales of publiclytraded shares of a u.s. corporation, including a real estate investment trust, and withdrawal of notice 2007-55. 42 florida tax review [vol. 14:1 or by a ric unless the owner (taking into account the presumption described above) was itself domestically controlled. finally, in a provision that seems to benefit only australian investment, the act would eliminate the firpta tax on gain from sales or other dispositions of shares of a reit held by a “qualified entity” that owns 10 percent or less of the reit and correspondingly eliminate the firpta tax on distributions of gain by a reit to such a shareholder. a distribution would be taxable as an ordinary distribution, to the extent out of earnings and profits, at the 30 percent or lower treaty rate. the definition of a qualified entity would seem to cover only listed australian property trusts (or so-called “lapts”) that own (directly or through other lapts) 10 percent or less of the shares of a reit — i.e., only a foreign shareholder that is eligible for a tax treaty reduction in the withholding tax on reit dividends without regard to the amount of reit shares that it owns and if the foreign shareholder’s principal class of interests is listed and publicly traded on a “recognized” stock exchange (within the meaning of the treaty). is the real estate jobs and investment act of 2011 a good idea? any reconsideration of firpta requires an evaluation of whether investments in reits should be given better tax treatment than any other form of investment in u.s. real estate. for example, why there is an exemption for shares of domestically-controlled reits? the real estate jobs and investment act, of course, does not do this. thus, it does not reconsider the fundamentals of firpta but simply makes changes at the margin which would give reits a further advantage over other forms of investment. nor does it address the concerns that prompted the issuance of notice 2007-55, which was that, absent the position taken in the notice, no u.s. tax would be due if a reit sold all its assets and distributed the proceeds in complete liquidation. and the provision that benefits listed australian property trusts should quite clearly be taken up in a revision of the united states-australia tax treaty, not by changes to the internal revenue code. the real estate revitalization act of 2010159 would repeal the usrphc provisions of firpta and treat any reit or ric distribution of gain from the dispositions of interests in usrp (including the gain distributed in a liquidation or redemption that was treated as a sale or exchange) as an ordinary dividend (limited in the case of a liquidating distribution to shareholder’s gain under section 331) that would be subject to withholding at the 30 percent rate or the lower treaty rate that applies to other reit or ric distributions. this deserves more consideration than the real estate jobs and investment act, but it leaves in place the firpta definition of real property (and also the tax rate distinction between “effectively connected” and non “effectively connected” income) and, more importantly, does not fully 159. h.r. 4539, 111th cong., 2d sess. (2010). 2013] suppose firpta was repealed 43 address the different treatment of investments made through reits and direct investment or investment through a partnership. the act would tax all current income or gain of a reit or ric at no less than the 30 percent or lower treaty rate that applies to dividends,160 but there still would be no tax on gain from a sale of shares by a foreign investor. because the sale will step-up the basis of the shares, the gain will not be taxed on a subsequent liquidation of the reit. 160. reits and rics are required to distribute at least 90 percent of real estate investment company or regulated investment company taxable income. the reit or ric would be taxed on any such income not distributed. it would also be taxed on any capital gain not distributed, but the shareholder would be entitled to a refundable credit for the tax paid by the reit or ric on the retained capital gain. 44 florida tax review [vol. 14:1 indeed, one point that the debate on firpta repeal neglects is the treatment of pass-throughs. some seem to assume that there is either direct investment in usrp or investment by a corporation, whether u.s. or foreign, and thus do not consider the ce... florida tax review volume 7 2005 number 1 is the nation of immigrants punishing its emigrants: a critical review of the expatriation rules revised by the american jobs creation act of 2004 eva farkas-dinardo† i. introduction. ......................................................................................... 7 ii. normative principles: coherence and distributive justice. .. 9 a. nonresident aliens. ....................................................................... 9 1.u.s. income taxation. ....................................................... 9 2. u.s. estate and gift taxation......................................... 10 b. u.s. persons................................................................................ 11 1. u.s. income taxation. .................................................... 11 2. u.s. estate and gift taxation. ....................................... 19 c. summary. .................................................................................... 20 iii. an alternative method of taxation – taxation of expatriates . ...................................................................................... 20 a. background................................................................................. 20 b. expatriation provisions under fita.......................................... 21 c. expatriation provisions under hipaa. ..................................... 23 1. individuals subject to the alternative method of taxation. .................................................................... 23 2. exceptions to treatment as an expatriate...................... 25 3. the alternative method of taxation............................... 27 4. coordination with immigration rules............................ 29 5. procedural rules and requirements. ............................. 29 6. need for change?. ......................................................... 30 7. summary. ....................................................................... 30 iv. expatriation provisions under the jobs act............................ 31 a. individuals subject to the alternative method of taxation. ........ 31 b. exceptions to treatment as an expatriate. ................................. 32 c. the alternative method of taxation. .......................................... 36 d. tax rules for determining citizenship and residency termination. ............................................................................... 37 e. procedural rules. ....................................................................... 38 †associate, alston & bird llp, new york. b.s., 1995 fordham university; j.d., 2002, fordham university; ll.m. (taxation), may 2005, new york university. i would like to thank edward tanenbaum, kevin rowe, and gideon alpert for their support. 5 6 florida tax review [vol.7:1 f. coordination with immigration provisions. ............................... 38 g. summary..................................................................................... 38 v. a fair system of taxation for expatriates................................ 39 a. mark-to-market regime would end expatriation for the purpose of tax avoidance. .............................................. 40 b. mark-to-market regime would be applied on the basis of the expatriate’s ability to pay. ............................................... 40 c. mark-to-market regime would reduce economic inefficiency. ................................................................................. 40 d. mark-to-market regime would reduce unequal treatment of expatriates. ............................................................................. 41 e. mark-to-market regime would be easier to manage. ............... 41 f. mark-to-market regime would eliminate the need for alternative estate and gift tax provisions. ................................ 42 g. additional considerations.......................................................... 42 vi. conclusion. ........................................................................................ 42 2005 is the nation of immigrants punishing its emigrants 7 i. introduction the thesis of this article is that the revised u.s. tax expatriation provisions fail to correct the most important defects of the prior u.s. tax expatriation regimes. under the new rules, expatriating u.s. citizens and1 resident aliens subject to the u.s. tax expatriation rules can still avoid u.s. tax on items properly taxable by the u.s. on the other hand, they remain subject to u.s. tax on income that should fall outside of u.s. tax jurisdiction. during the last forty years, the u.s. has undertaken several attempts to capture what it sees as its rightful share of the income and gain of taxmotivated expatriates. in carrying out this policy, congress developed a set of alternative u.s. tax rules applicable only to tax-motivated expatriates, subjecting them to an alternative method of u.s. taxation. from the perspective of the u.s., the necessity for an alternative method of taxation arises because of the bifurcated structure of the u.s. tax system, applying one set of rules to u.s. persons and another, generally more favorable set of rules to nonresident aliens. the u.s. imposes residence-based taxation on u.s. persons, subjecting them to u.s. income tax on their worldwide income, to u.s. estate tax on their worldwide estates, and to u.s. gift tax on their worldwide gifts. on the other hand, the u.s. imposes source-based and2 business-based taxation on nonresident aliens, subjecting them to u.s. income tax on u.s.-source passive and business income, and to u.s. estate and gift tax on u.s. situs property. in both situations, income is subject to3 u.s. tax only upon the occurrence of a recognition event. the divergence in the scope of the two tax regimes creates a situation in which the u.s. tax liability of an individual calculated under one tax regime could be markedly different from the individual’s u.s. tax liability determined under the other tax regime, with nonresident alien status generally rendering the less “taxing” result. the financial benefits of nonresident alien tax status may encourage wealthy u.s. persons to expatriate and be taxed by the u.s. as nonresident aliens. the challenge posed by expatriation is especially acute because it involves moving from residence-based taxation to source-based taxation, potentially causing some unrealized gain to escape u.s. tax as certain gains are not subject to u.s. tax under source-based taxation. such tax-motivated expatriation is what congress has been trying to prevent, first with the enactment of the foreign investors tax act of 1966 1. for the purposes of this article, “to expatriate” means to renounce u.s. citizenship or to terminate u.s. resident alien status. 2. see irc § 1(covering u.s. income taxes); irc § 2001(covering u.s. estate taxes); irc § 2501(covering u.s. gift taxes). 3. see irc § 871(covering u.s. income taxes); irc § 2101(covering u.s. estate taxes); irc § 2501(covering u.s. gift taxes). 8 florida tax review [vol.7:1 (“fita”), followed by the changes introduced in the health insurance4 portability and accountability act of 1996 (“hipaa”). pursuant to the5 alternative tax regime established by fita, u.s. citizens who renounced their u.s. citizenship remained subject to u.s. income tax on u.s.-source income, as defined for that purpose, and to u.s. estate and gift tax on transfers of u.s. situs property, for a period of ten years if their expatriation was motivated in part by the avoidance of u.s. taxes. hipaa extended the alternative method of taxation to certain u.s. resident aliens who terminated their u.s. residency with a purpose of such tax avoidance. both the fita and hipaa rules provided some relevant exceptions from the application of the alternative regime. the american jobs creation act of 2004 (“jobs act”), signed into law on october 22, 2004, introduced four key changes to6 the expatriation provisions that affect all u.s. persons contemplating expatriation but does not completely eliminate the potential for tax-motivated expatriation. under the revised tax expatriation rules, an expatriate’s actual motivation for termination of residency or renunciation of citizenship is no longer relevant and the alternative method applies if one of three bright-line tests is met. one of the three tests is independent of the expatriate’s income or tax liability, thus completely eliminating the presumption of tax avoidance. in addition, the jobs act removed practically all meaningful exceptions from the application of the alternative method, in fact limiting the exceptions to a narrow group of u.s. citizens. the jobs act also adopted taxbased rules for determining whether, for u.s. tax purposes, an individual has in fact expatriated. last but not least, the alternative tax regime no longer applies to an expatriate otherwise subject to the alternative regime who, in any given year within the ten-year period following expatriation, spends more than thirty days in the u.s. instead, the jobs act subjects such returning u.s. persons to full u.s. taxation. in this article, i argue that the revised rules do not fully eradicate the potential for tax avoidance through tax-motivated expatriation. instead, the amended rules create new problems. the abandonment of the tax avoidance motive, the elimination of the ruling request procedure, the addition of a bright-line test, and the use of tax rules for determining whether one has expatriated may be viewed as positive developments. these changes reduce the potential for subjective judgment calls, lessen the administrative burden on the internal revenue service (“irs”), and broaden the taxpayer base subject to the alternative method. however, the revised provisions still 4. pub. l. no. 89-809, 80 stat. 1539 (1966) (codified as amended in scattered section of 26 u.s.c.). 5. pub. l. no. 104-191, 110 stat. 1936 (1996) (codified as amended in scattered section of 26 u.s.c.). 6. pub. l. no. 108-357, 118 stat. 1418 (2004) (codified as amended in scattered section of 26 u.s.c.). 2005 is the nation of immigrants punishing its emigrants 9 subject expatriates to u.s. tax on certain gains that should be free of u.s. tax. in addition, expatriates can still avoid u.s. tax on accrued gain by holding on to property with accrued gain for the ten-year period during which the alternative method applies. this also creates unequal tax treatment among similarly situated expatriates. moreover, the revised rules treat u.s. citizens and resident aliens unequally, allowing some exceptions to u.s. citizens that technically cannot be extended to u.s. resident aliens. last but not least, the expatriation provisions are out of step with international norms, in particular by taxing former u.s. citizens and resident aliens subject to the alternative regime as u.s. persons in any one year during the ten-year period in which they return to the u.s. for as little as thirty-one days a year. part ii of this article provides a brief overview of the u.s. taxation of u.s. persons and nonresident aliens and highlights the areas relevant in triggering tax-motivated expatriation. part iii examines the alternative method of taxation developed in response to tax-motivated expatriation and compares the fita and hipaa expatriation provisions. part iii also examines the problems that plagued the fita and hipaa expatriation provisions and ultimately triggered reform. part iv analyzes the expatriation provisions of the jobs act by detailing the u.s. tax effects on expatriating individuals and by highlighting areas in need of reform. part v argues that congress should consider adopting a mark-to-market approach for taxing expatriates because such an approach would eliminate the potential for tax avoidance, prevent the u.s. taxation of income accrued after expatriation, eliminate economic inefficiencies caused by the dissimilar tax treatment of u.s.-source and foreign-source income, and would conform to international tax norms. part vi provides a summary of the key characteristics of the current expatriation regime and briefly outlines the most compelling reasons for the adoption of a mark-to-market regime. ii. taxation of individuals the u.s. has developed two distinct systems of taxation, one applicable to u.s. persons and the other to nonresident aliens. therefore, the first step that must be taken in resolving whether and to what extent a certain person is subject to u.s. tax is determining whether she is a u.s. person or a nonresident alien. a. nonresident aliens 1. u.s. income taxation – a nonresident alien is a non-u.s. citizen individual who does not qualify as a u.s. resident alien under the residency rules. in general, the extent to which a nonresident alien is subject to u.s.7 7. irc § 7701(b)(1)(b). 10 florida tax review [vol.7:1 tax depends on the source and the type of the income. nonresident aliens are generally subject to u.s. income tax at a flat rate of 30% on u.s.-source fixed or determinable annual or periodical income that is not effectively connected with a u.s. trade or business. nonresident aliens are also subject8 to a 30% u.s. tax on capital gain, but only if they are present in the u.s. in a given year for a period aggregating 183 days or more. the 30% tax is based9 on the gross amount of income and is generally collected through withholding under section 1441 of the code. in addition, nonresident aliens10 are subject to u.s. income tax, at graduated rates under section 1 of the code, on income that is effectively connected with the conduct of a u.s. trade or business. effectively connected income includes gain on the sale of11 a u.s. real property interest. foreign-source income earned by nonresident12 aliens is generally not subject to u.s. income tax. the u.s. income taxation of a nonresident alien may be modified by an applicable bilateral income tax treaty if the nonresident alien qualifies for benefits under the treaty. a nonresident alien generally qualifies for treaty benefits only if she is a bona fide tax resident of the u.s. treaty partner.13 2. u.s. estate and gift taxation – nonresident aliens are also subject to u.s. estate tax on u.s. situs property, which generally includes real property and tangible personal property located in the u.s., as well as stock 8. irc § 871(a)(1). 9. irc § 871(a)(2). 10. irc § 1441. 11. irc § 871(b). a detailed examination of what constitutes income that is effectively connected with the conduct of a u.s. trade or business is beyond the scope of this article. courts generally hold that profit-oriented activities in the u.s. will be considered to constitute a trade or business only if such activities are regular, substantial, and continuous. see comm’r v. spermacet whaling & shipping co., 281 f.2d 646 (6th cir. 1960) (a foreign corporate taxpayer engaged in a whaling expedition off the coast of south america for the purpose of obtaining sperm oil and selling it to a u.s. refinery for resale was not engaged in a u.s. trade or business because the activity was not regular, substantial, and continuous). 12. irc § 897(a). before the enactment of the foreign investment in real property tax act of 1980, nonresident aliens investing in u.s. real estate often paid no tax on gain derived from the disposition of u.s. real property held for investment or personal use as such gain did not qualify as fixed or determinable annual or periodical income or gain, or as income effectively connected with the conduct of a u.s. trade or business. 13. pursuant to article 4 of the u.s. model income tax convention, only those persons will be considered residents of a state who, under the laws of that state, are liable to tax therein on her worldwide income by reason of domicile, residence, place of incorporation, place of management or any other criterion of a similar nature. see u.s. model income tax convention, art. 4 (1996). 2005 is the nation of immigrants punishing its emigrants 11 in a u.s. corporation. to prevent nonresident aliens from escaping u.s.14 estate taxes by simply giving away during their lifetime all of their assets otherwise subject to u.s. estate tax, the u.s. subjects nonresident aliens to u.s. gift tax on transfers of real or tangible personal property located in the u.s. of course, these u.s. estate and gift tax rules are also subject to15 bilateral estate and gift tax treaty modifications, which may provide some significant benefits to residents of certain treaty countries.16 the limited u.s. taxation of nonresident aliens reflects sound tax policy. as a general rule, nonresident aliens have an insubstantial connection to the u.s. and their worldwide income should not be subject to u.s. taxation. on the other hand, imposing u.s. tax on u.s.-source income and on income connected with a u.s. trade or business makes sense because the u.s. provided the particular benefit, e.g., the sales that generated the income. 17 b. u.s. persons 1. u.s. income taxation – on the other hand, the u.s. subjects all u.s. persons to u.s. income tax on their worldwide income, regardless of the source of the income. accordingly, all of the income that a u.s. citizen or u.s. resident alien earns generally is subject to u.s. individual income tax at graduated rates under section 1 of the code, even if the individual does not reside or spend time in the u.s. and the income is entirely from foreign sources. most countries tax their residents, including resident citizens, on18 their worldwide income, but the u.s. may be the only country that taxes all of its citizens, including those residing in other countries, on their worldwide 14. irc §§ 2101, 2106. 15. irc § 2501. 16. pursuant to article 5 of the u.s.-german estate tax treaty, immovable property that forms part of the estate of a u.s. domiciliary but is located in germany generally will be subject only to german estate tax instead of both u.s. and german estate taxes. see convention between the united states of america and the federal republic of germany for the avoidance of double taxation with respect to taxes on estates, inheritances, and gifts, june 27, 1986, art. 5, t.i.a.s. 11082. 17. as a practical matter, the u.s. refrains from taxing all u.s.-source income so as to encourage foreign investment in the u.s. for example, pursuant to irc § 871(i)(2)(a), nonresident aliens are generally exempt from u.s. tax on interest from deposits not effectively connected with the conduct of a u.s. trade or business. similarly, irc § 871(h) exempts from u.s. tax portfolio interest paid to nonresident aliens. 18. irc § 61. gross income is defined as income from all sources. thus, foreign-source items of income are subject to u.s. income tax unless specifically excluded by another section of the code. 12 florida tax review [vol.7:1 income. the supreme court held in cook v. tait that the u.s. taxation of a19 u.s. citizen’s worldwide income is in fact constitutional and is in compliance with international law. 20 the worldwide taxation of u.s. persons is often viewed as necessary because an individual’s total income, wherever earned or sourced, affects her ability to pay u.s. taxes. in addition, if in the hands of u.s. persons21 foreign-source income were exempt from u.s. tax or were taxed at a lower rate than u.s. source income, it would encourage the shifting of capital abroad and potentially reduce investment in the u.s. on the other hand, taxing foreign-source income at a higher rate than u.s.-source income would be detrimental to the free flow of capital and would have a negative effect on free trade. although u.s. persons are subject to u.s. tax on their worldwide income, u.s. tax on their income is deferred because the u.s. taxes income only upon the occurrence of a recognition event. for example, a u.s. shareholder of a u.s. corporation is not taxed on the income of the corporation until the corporation makes a distribution of income to the shareholder in the form of a dividend. similarly, a u.s. shareholder of a22 u.s. corporation is not taxed on the appreciation in the value of her stock in that corporation until she disposes of the stock. consequently, u.s. persons23 with such accrued but unrecognized gain could avoid u.s. tax through the use of various tax planning techniques, including transfers of appreciated property to a foreign corporation that could sell the appreciated property free of u.s. tax. to prevent such abuses and protect residence-based taxation, congress has enacted various provisions to ensure that income and gain attributable to u.s. shareholders are in fact taxed to u.s. shareholders.24 19. see generally boris i. bittker & lawrence lokken, federal taxation of income, estates, and gifts, § 65.1. (5th ed. 1999) (providing a comprehensive overview of the u.s. taxation of u.s. citizens and resident aliens). 20. 265 u.s. 47 (1924). 21. see jeffrey m. colon, changing u.s. tax jurisdiction: expatriates, immigrants, and the need for a coherent tax policy, 34 san diego l. rev. 1, 10 (1997) (analyzing the bases for the worldwide taxation of u.s. citizens and resident aliens). 22. irc § 61(a)(7). 23. irc § 1001. 24. see irc § 367 (transfer of property from the u.s.); irc § 551-558 (foreign personal holding company regime, repealed by the jobs act); irc § 951-964 (controlled foreign corporation regime); irc § 1291-1298 (passive foreign investment company regime). a detailed discussion or these provisions is beyond the scope of this article. for in-depth analysis, see joel d. kuntz & robert j. peroni, u.s. international taxation, ¶ b2 (1991). 2005 is the nation of immigrants punishing its emigrants 13 a) tests for u.s. residency as the term u.s. person includes u.s. resident aliens, the u.s. income taxation of a non-u.s. citizen individual depends on whether she is considered a u.s. resident alien or a nonresident alien for u.s. tax purposes. a non-u.s. citizen may be considered a u.s. resident alien for u.s. tax purposes, but remain a nonresident alien for immigration purposes. for example, a non-u.s. citizen holding a nonimmigrant “h” visa and working in the u.s. on a full-time basis is a nonresident alien under u.s. immigration law but is likely to be considered a u.s. resident alien under u.s. tax law. if a non-u.s. citizen is a nonresident alien for u.s. tax purposes, the rules detailed in the previous section of this article will apply. on the other hand, if a non-u.s. citizen meets the definition of a u.s. resident alien, she will be taxed in the same manner as a u.s. citizen. the code provides that a non-u.s. citizen will be treated as a u.s. resident alien for u.s. income tax purposes if she fall into one of three categories. 25 (1) u.s. permanent resident test first, a non-u.s. citizen will be considered a u.s. resident alien for tax purposes if she has been lawfully admitted to the u.s. for permanent residence. a person lawfully admitted to the u.s. for permanent residence26 is a u.s. resident alien for both u.s. income tax and u.s. immigration purposes. this test for u.s. permanent residence is sometimes referred to as the “green card test.” consequently, if a non-u.s. citizen is treated as a u.s. landed resident for u.s. immigration purposes, she will be treated as a u.s. resident alien for u.s. tax purposes.27 (2) substantial presence test in addition, a non-u.s. citizen will be considered a u.s. resident alien for u.s. tax purposes if she is physically present in the u.s. for at least thirty-one days during the current calendar year and has been present in the u.s. for at least 183 days during the three-year testing period, including the current year, using weighted counting. under this method, each day of28 presence in the u.s. in the current year is treated as a full day, each day of presence in the u.s. in the immediately preceding year is treated as one-third of a day, and each day of presence in the u.s. in the second preceding year is 25. irc § 7701(b)(1)(a). 26. irc § 7701(b)(1)(a)(i), regs. § 301.7701(b)-1(b)(1). 27. a u.s. resident who meets the green card test may be able to claim nonresident alien status pursuant to the tie-breaker provisions of a bilateral u.s. income tax treaty. 28. irc § 7701(b)(3)(a); regs. § 301.7701(b)-1(c). 14 florida tax review [vol.7:1 treated as one-sixth of a day. if the individual is not present in the u.s. in29 the current year for at least thirty-one days, she will not be considered a u.s. resident alien under this test, even if she otherwise satisfies the 183-day average. generally, if a nonresident alien is never present in the u.s. for30 more than 120 days in any one year, she will be able to avoid u.s. resident alien status under the weighted counting method. this test is designed to31 capture nonresident aliens who establish solid connections to the u.s. warranting their taxation as u.s. persons. for the purpose of applying the substantial presence test, an individual is considered to be present in the u.s. if she is present during any part of the day. however, certain days of presence in the u.s. are ignored32 for this purpose. first, the days of presence of an individual in the u.s. as a result of a medical condition that arose while such individual was present in the u.s. will not count as days of presence. similarly, days of presence in33 the u.s. by mexican and canadian residents as regular commuters from34 those countries will not count as days of presence for the purpose of this test, and neither will days of presence in the u.s. by a nonresident alien for less than twenty-four hours, provided that their presence in the u.s. is merely incidental to their travels between two foreign points. there are also certain35 categories of individuals who are considered exempt and none of their days of presence in the u.s. count for the purpose of the substantial presence test. exempt individuals include employees of foreign governments, employees36 29. irc § 7701(b)(3)(a)(ii). 30. irc § 7701(b)(3)(a)(i). 31. if a nonresident alien is present in the u.s. for exactly 120 days every year, she will not be considered a u.s. resident alien under the substantial presence test because her physical presence in the u.s. will not reach 183 days: she is deemed to be physically in the u.s. on 120 days in the current year, forty days (one-third of 120) in the immediately preceding year, and twenty days (one-sixth of 120) in the second preceding year, totaling 180 days over the three-year testing period. 32. irc § 7701(b)(7)(a). 33. regs. § 301.7701(b)-3(c). if a nonresident alien travels to the u.s. for the purpose of receiving medical treatment, none of the days spent in the u.s. for that purpose is exempt. 34. irc § 7701(b)(7)(b), regs. § 301.7701(b)-3(e). 35. irc § 7701(b)(7)(c), regs. § 301.7701(b)-3(d). pursuant to this exception, if a nonresident alien comes to the u.s. for the purpose of conducting business at an airport while traveling to another foreign point, an argument can be made that she is present in the u.s. on that day for the purpose of the substantial presence test because her presence in the u.s. is not merely incidental to travels between two foreign points. 36. regs. § 301.7701(b)-3(b)(2). this means that an ambassador or an employee of a consulate or embassy can remain in the u.s. for an unlimited period of time without ever becoming a u.s. resident. 2005 is the nation of immigrants punishing its emigrants 15 of international organizations, teachers and trainees, students, as well as37 38 39 professional athletes who are temporarily present in the u.s. in order to compete in charitable sports events. crewmembers of foreign vessels are40 also exempt, provided they do not conduct any other trade or business in the u.s. during their presence. individuals falling into the exempt categories41 are treated as being temporarily present in the u.s., as evidenced by their nonimmigrant visa status, and their temporary presence does not warrant residence-based u.s. taxation. (3) first year election a non-u.s. citizen can make an affirmative election to be treated as a u.s. resident alien for u.s. tax purposes. eligibility for making this election is limited to any non-u.s. citizen who is a nonresident alien in the current year and in the preceding year, but is a u.s. resident alien under the substantial presence test during the following year. in addition, a non-u.s. citizen making this election must be present in the u.s. for at least thirty-one consecutive days in the year for which she is making the election and must be present in the u.s. for a period that includes 75 or more of the days starting with the first day of the thirty-one day period and ending with the last day of the year. this test is also referred to as the “first-year election”42 because the nonresident alien would be considered a u.s. resident alien in the following year in any case, subjecting her to u.s. tax on her worldwide income. this election affords a nonresident alien the opportunity to be treated as a u.s. resident alien sooner and take advantage of any applicable deductions or credits not available to person subject to u.s. taxation as nonresident aliens. b) exceptions to treatment as a u.s. tax resident two of the three tests for treatment as a u.s. resident alien for u.s. tax purposes require an affirmative election by the non-u.s. citizen. on the other hand, under the substantial presence test, u.s. residency is “forced” on a person who, for u.s. immigration purposes, is a nonresident alien. 37. id. 38. regs. § 301.7701(b)-3(b)(3). however, the regulations limit the number of years for which the exemption may be claimed by teachers and trainees. regs. § 301.7701(b)-3(b)(7). 39. regs. § 301.7701(b)-3(b)(3). however, the regulations limit the number of years for which the exemption may be claimed by students. regs. § 301.7701(b)-3(b)(7). 40. regs. § 301.7701(b)-3(b)(5). 41. irc § 7701(b)(7)(d). 42. irc § 7701(b)(4). 16 florida tax review [vol.7:1 nonetheless, an individual who meets the substantial presence test may still be able to avoid u.s. residency in one of two ways. (1) closer connection exception under the so-called closer connection exception, a nonresident alien who is a u.s. tax resident under the substantial presence test can avoid u.s. resident alien status if she can establish that she was present in the u.s. for less than 183 days during the current calendar year and has a “tax home” in43 a country to which she has a “closer connection” than to the u.s. an44 45 individual’s tax home is located at her regular or principal place of business, or, if she is not engaged in any business or occupation, her tax home will be her regular place of abode. an individual can establish that she has a closer connection to such a tax home by demonstrating that she has maintained “more significant contacts” with that country, including the location of her permanent home, family, personal belongings, personal bank accounts and similar criteria. the closer connection exception can be especially useful46 for individuals who do not qualify for income tax treaty benefits and cannot claim nonresident status under the treaty tie-breaker rules. however, the exception is not available for any nonresident alien who applies for u.s. permanent resident status during a given taxable year as an application for permanent residency clearly negates the person’s closer connection to the foreign country. 47 an individual who is deemed a u.s. resident alien by virtue of the substantial presence test and who wants to claim nonresident alien status pursuant to the closer connection exception must claim such status on form 8840 (closer connection exception statement for aliens) and attach it to her form 1040nr tax return for the year.48 (2) treaty tie-breakers similarly, if an individual is considered a u.s. resident alien under one of the three residency tests and she is also considered a tax resident of another country under that country’s internal laws, she can utilize the tiebreaker rules of the applicable income tax treaty to determine her country of residence for income tax purposes. accordingly, by applying the treaty tiebreaker rules, a dual resident can claim nonresident alien status for u.s. tax 43. irc § 7701(b)(3)(b), regs. § 301.7701(b)-2(c). 44. irc § 7701(b)(3)(b), regs. § 301.7701(b)-2(d). 45. irc § 7701(b)(3)(b), regs. §§ 301.7701(b)-2(c), (d). 46. regs. § 301.7701(b)-2(d). 47. irc § 7701(b)(3)(c). 48. regs. § 301.7701(b)-8. 2005 is the nation of immigrants punishing its emigrants 17 purposes. the tie-breaker rules generally determine a person’s residence by49 first determining the permanent home of the individual. “permanent home” generally means a dwelling that is continuously available to the individual if her stay at the home is intended to be permanent. if the individual has a permanent home in both states, her “center of vital interests” determines her residency status. a center of vital interests takes into account the location of the individual’s family, employment, friends, personal possessions, political and cultural activities, and other similar criteria. if the individual’s center of vital interests cannot be determined, the state in which she has a habitual abode will be determinative in assigning residency for this purpose. “habitual abode” is the place where the individual stays more frequently. if the habitual abode element of the test also fails to render a clear result, the citizenship of the individual is the next factor. should that fail as well, the authorities of both states can make a mutual determination as to the person’s residence. however, in most cases, it should be fairly easy to determine the50 location of a person’s permanent home or, if she has more than one permanent home, the location of her center of vital interests. if a “dual-resident” u.s. resident alien takes the position that she is, in fact, a nonresident alien of the u.s. pursuant to a treaty tie-breaker provision and is a resident of the treaty partner, she must file form 8833 (treaty-based return position disclosure under sections 6114 or 7701(b)) with her form 1040nr nonresident alien income tax return. however, such51 a dual resident who is treated as a nonresident alien pursuant to a tie-breaker provision will still be considered a u.s. resident alien for all purposes of the code, other than the calculation of her u.s. income tax liability. for52 example, a dual resident tie-breaker in favor of a treaty partner will continue to be treated as a u.s. tax resident for the purpose of determining whether a certain foreign corporation is a controlled foreign corporation (“cfc”) for the purpose of applying the cfc rules.53 (3) effects of the exceptions both exceptions will allow a bona fide resident of another country to avoid u.s. resident alien status for u.s. income tax purposes. on the other hand, the exceptions will not help a wealthy individual avoid full u.s. income taxation if she cannot satisfy either exception because she spends a limited amount of time in various countries for the purpose of avoiding full 49. regs. § 301.7701(b)-7. 50. see, e.g., income tax treaty, july 19, 2002, u.s.-u.k., volume 4 art. 4(5), tax treaties (cch) ¶ 10,901.04. 51. regs. § 301.7701(b)-7(b)-(c). 52. regs. § 301.7701(b)-7(a)(3). 53. id. 18 florida tax review [vol.7:1 taxation in any one country and, as a result, does not have a closer connection to or a center of vital interests in any other country. the “center of vital interests” element of the tie-breaker provisions resembles the “closer connection exception” to the substantial presence test. such similarity makes sense as both tests are used to determine a dualresident individual’s tax status. as previously noted, the closer connection test is generally relied upon only if a person cannot benefit from a treaty and, therefore, cannot rely on the treaty tie-breaker rules to claim non-u.s. resident status. reliance on an income tax treaty is more advantageous because it carries certain other benefits. for example, under the german-u.s. income tax treaty, german-source interest derived and beneficially owned by a resident of the u.s. is generally taxable in the u.s. only. without54 reliance on the treaty, the interest income could be taxed in both countries and the individual would have to rely on foreign taxation credits to avoid double tax on this income.55 although an individual who is considered a u.s. resident alien under domestic tax law may rely on the tie-breaker provision of a tax treaty to claim non-u.s. status, the u.s. reserves the right to tax its residents on their worldwide income. most bilateral tax treaties contain a “saving clause” providing that the u.s. reserves the right to tax its citizens and residents, as residence is determined by the treaty, on their worldwide income. it is56 unclear what purpose the reference to u.s. residents serves in treaties with this type of saving clause because if the individual tie-breaks in favor of the treaty partner, she will be considered a nonresident alien of the u.s. under the tie-breaker provision and, therefore, under the saving clause as well.57 u.s. citizens, of course, are always “fair game” and generally will be subject to u.s. tax on their worldwide income regardless of whether or not they reside in the u.s. the definition of u.s. citizens, for this purpose, also58 includes former citizens subject to u.s. taxation under section 877. however, 54. income tax treaty, august 21, 1991, u.s. – frg, vol. 2 art. 11(1), tax treaties (cch) ¶ 3203.23. 55. irc § 904(a). foreign tax credits provide limited relief only, as the amount of foreign taxes paid that can be used to reduce u.s. tax is limited to an amount equal to the pre-credit u.s. tax on the individual’s foreign source income. 56. see generally income tax treaty, july 19, 2002, u.s.-u.k., vol. 4 art. 1(4), tax treaties (cch) ¶ 10,900; see also income tax treaty, august 21, 1991, u.s. – frg, vol. 2 protocol art. 1(a), tax treaties (cch) ¶ 3210. 57. income tax treaty art. 1(4), july 19, 2002, u.s.-u.k., tax treaties (cch) ¶ 10,901.1. most treaties contain a savings clause that defines u.s. resident with reference to the treaty definition of u.s. resident. 58. see e.g., priebe v. comm’r, 51 t.c.m. (cch) 907 (t.c. 1986) (a u.s. citizen residing and working in canada as a minister was subject to u.s. selfemployment tax on income earned in canada by operation of the saving clause of the u.s.-canada income tax treaty). 2005 is the nation of immigrants punishing its emigrants 19 as a practical matter, other treaty provisions often limit the reach of treaty saving clauses. 59 2. u.s. estate and gift taxation – u.s. citizens and u.s. resident aliens are also subject to u.s. gift tax on transfers of property by gift,60 regardless of where the property is actually located, and to u.s. estate tax on the value of their taxable estate at the time of their death, regardless of where the property is situated. the definition of u.s. resident alien for u.s. estate61 and gift tax purposes differs from the definition of u.s. resident alien for u.s. income tax purposes. for u.s. estate tax purposes, a u.s. resident alien is a decedent who, at the time of her death, had her “domicile” in the u.s. domicile means a place where the individual lives, for even a brief period of time, with no definite present intention of later moving from such location. residence without the “requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.” the definition of62 u.s. resident alien for u.s. gift tax purposes is the same as for u.s. estate tax purposes, except that the domicile of the person is tested at the time of the making of the gift. if a decedent or donor is considered a domiciliary of the u.s. under u.s. law and the domiciliary of another country under that country’s internal laws, the tie-breaker rules of an applicable estate and gift tax treaty may be utilized to determine the residence of the decedent or donor. estate and gift tax treaty tie-breaker provisions are similar to the tie-breaker provisions of income tax treaties. bilateral estate tax and gift tax treaties provide specific63 rules for the taxation of certain types of properties owned by decedents and donors. a review of the applicable u.s. estate tax rates demonstrates why a wealthy u.s. citizen or resident alien might want to avoid paying u.s. tax on her worldwide estate. at present, u.s. citizens and resident aliens are64 59. for example, article 1(5) of the u.k.-u.s. income tax treaty provides that the right to tax residents and citizens on their worldwide income does not affect article 24, which provides relief from double taxation. see income tax treaty, july 19, 2002, u.s.-u.k., tax treaties (cch) ¶ 10,901.1. 60. irc § 2501(a). 61. irc §§ 2001, 2031. 62. regs. § 20.0-1(b)(1). 63. see, e.g., estate tax treaty, june 27, 1986, u.s.-frg, vol. 2 art. 4(5), tax treaties (cch) ¶ 3259.05. 64. see richard a. westin, expatriation and return: an examination of taxdriven expatriation by united states citizens, and reform proposals, 20 va. tax. rev. 75, 80-85 (2000) (analyzing the driving forces behind expatriation, including u.s. estate tax). 20 florida tax review [vol.7:1 subject to a 47% u.s. estate tax, with a $1,500,000 exclusion amount.65 although this rate is less than it has been in the past, citizens and residents66 of certain other countries pay significantly less in estate taxes. switzerland, for example, has no federal estate tax, providing a financial incentive to wealthy u.s. persons to become swiss residents or citizens and be subject to u.s. estate taxes only on their u.s. situs property. 67 c. summary the u.s. taxes its citizens and resident aliens on their worldwide income, estates, and gifts, whereas nonresident aliens are subject to limited u.s. taxation only. consequently, an individual’s classification as a u.s. person or as a nonresident alien for u.s. tax purposes can have a significant effect on the individual’s u.s. tax liability. such differences in u.s. tax liability may motivate some wealthy u.s. persons to expatriate and be taxed as nonresident aliens. to prevent tax-motivated expatriation that results in the avoidance of u.s. taxes, the u.s. has developed an alternative method of taxation applicable only to expatriates who meet certain criteria. this alternative method of taxation is examined in the next part of this article. iii. an alternative method of taxation – taxation of expatriates a. background the alternative method of taxation developed as a result of the immense differences between the u.s. income, estate and gift taxation of u.s. citizens and resident aliens and the u.s. income, estate, and gift taxation of nonresident aliens, as explained above. the need for a special method of taxation became pressing in 1966, when fita eliminated the progressive income tax rates on the u.s.-source income of nonresident aliens that was not effectively connected with a u.s. trade or business and, thus, made nonresident alien tax status more attractive. u.s. individual income and estate tax rates under the 1954 code68 65. irc § 2001(c). 66. id. for example, for estates of decedents dying in 2003, the applicable estate tax rate was 49%. 67. see, official swiss ministry resources, at http://www.ch.ch. swiss cantons impose estate tax, but rates are very low compared to rates imposed by other countries and states. 68. pub. l. no. 89-809, 80 stat. 1541 (1966). prior to 1966, nonresident aliens engaged in a u.s. trade or business were subject to u.s. income tax at graduated rates on all income derived from u.s. sources, including dividends, interest and other fixed or determinable, annual or periodical income. nonresident aliens were also subject to 2005 is the nation of immigrants punishing its emigrants 21 were quite high – an individual with $200,000 in annual income was subject to u.s. income tax at a rate of approximately 90%. similarly, a u.s.69 decedent leaving an estate of $2 million was subject to u.s. estate tax at a rate of approximately 50%.70 without the existence of a “special” method of taxation, wealthy u.s. citizens could potentially renounce their citizenship and u.s. resident aliens could terminate their u.s. residency, transfer their assets accumulated in the u.s. to their new home country, potentially without recognizing any of the accrued gain, and later return to the u.s. for up to 120 days a year and be subject to u.s. taxation as nonresident aliens only. these tax-motivated expatriates could leave all of their non-u.s.-source income and assets outside of the taxing power of the u.s., and yet continue to spend a significant amount of their time in the u.s. with family and friends and enjoy the benefits offered by their former home country. consequently, to avoid such perceived abuses, an alternative method of taxation was developed to apply for a limited time period to those u.s. citizens who renounce their u.s. citizenship and to those u.s. resident aliens who terminate their u.s. residency (and meet certain other requirements), with the purpose of avoiding u.s. taxes. b. expatriation provisions under fita fita introduced the expatriation provisions in section 877, subjecting former u.s. citizens to u.s. income tax on u.s.-source income and on income effectively connected with a u.s. trade or business for a period of ten years following termination of u.s. citizenship if such termination had as one of its principal purposes the avoidance of u.s. taxes.71 gains from the sale or exchange of property (other than stock or debt obligations) located in the u.s. and gains from the sale or exchange of stock of a u.s. corporation or a debt obligation of a u.s. person were considered u.s. sources for the purpose of the expatriation provisions. in addition, fita added ection 2107 to the expatriation provisions, discouraging u.s. citizens from renouncing their u.s. citizenship to become nonresident aliens for u.s. estate tax purposes. congress felt that it was “doubtful that many citizens would expatriate for this reason,” but noted that u.s. estate tax on u.s. situs property (real or intangible), and to u.s. gift tax on u.s. situs tangible property. however, nonresident aliens were not subject to u.s. tax on any foreign-source income, even if such income was earned by a u.s. business. see h.r. rep. no. 89-1450, pt. 4, at 22-23 (1966), reprinted in 1966 u.s.c.c.a.n. 965, 9991000. 69. irc § 1 (1954). the 1954 code, as amended, was in effect in 1966. 70. irc § 2001 (1954). 71. irc § 877 (1966). 22 florida tax review [vol.7:1 the removal of such incentive is desirable nonetheless. consequently,72 section 2107 imposed u.s. estate tax on the gross estate, comprised of u.s. situs property, of every former u.s. citizen who renounced her u.s. citizenship with a principal purpose of avoiding u.s. estate taxes and provided for a look-through rule to expand u.s. estate taxes on u.s. situs assets held by the expatriate through a cfc. with respect to u.s. gift tax,73 fita added section 2501(a)(3), which provided that the intangibles exception ordinarily available to nonresident aliens under section 2501(a)(2) was not applicable to those former u.s. citizens who terminated their u.s. citizenship with a principal purpose of avoiding u.s. taxes. 74 these new income, estate, and gift tax provisions reflected congress’s desire to prevent the loss of u.s. tax revenues caused by switching from residence-based taxation to source-based taxation. however, the expatriation regime suffered from a basic design flaw from its inception. the source-conversion rules treated as u.s.-source income certain income and gain that accrued following expatriation and should have been free of u.s. tax. on the other hand, the ten-year rule created a potential for tax avoidance by encouraging expatriates to postpone recognition events until the expiration of the ten-year period. these two features are irreconcilable. although the goal of the expatriation provisions is justified, the means is not suited for achieving that goal. these design flaws created the numerous problems that afflicted the fita expatriation provisions. the broad application of the alternative method and its dependence on the facts and circumstances of each case of expatriation made the regime difficult to administer. similarly, the presumption rules were relaxed, placing the burden on the government to establish that it is reasonable to believe that a person’s loss of citizenship would result in the substantial reduction of their u.s. income tax liability.75 only after the government met this burden was the burden shifted to the expatriate to show that the purpose of expatriation was not the avoidance of u.s. taxes. the presumption rules were not properly coordinated and a tax76 avoidance motive established for u.s. income tax purposes did not necessarily establish a tax avoidance motive for u.s. estate or gift tax purposes. the burden again rested with the government to show that the loss of an individual’s u.s. citizenship resulted in a substantial reduction of her u.s. estate taxes. similarly, the existence of a tax avoidance motive for77 u.s. income or estate tax purposes did not automatically establish tax 72. h.r. rep. no. 89-1450, supra note 66, at 22-23, reprinted in 1993 u.s.c.c.a.n. at 999-1000. 73. irc § 2107 (1966). 74. irc § 2501(a)(2)-(3) (1966). 75. irc § 877(e) (1966). 76. see id. 77. irc § 2107(e) (1966). 2005 is the nation of immigrants punishing its emigrants 23 avoidance for u.s. gift tax purposes and the burden rested with the government to show that the loss of an individual’s u.s. citizenship resulted in a substantial reduction of her u.s. gift taxes. 78 in addition, u.s.-source income could be converted to non-u.s. source income with relative ease. as a result of residing outside of the u.s.,79 most of the income and gain of expatriates is expected to be foreign source. since only u.s.-source income was subject to u.s. income tax under the alternative tax regime, most of the income of an expatriate fell outside the taxing power of the u.s. however, with the use of certain tax planning80 techniques, an expatriate’s u.s. tax burden could have been minimized even on u.s.-source income, which, for this purpose, included gain on the sale or exchange of property located in the u.s. and gain on the sale or exchange of u.s. stock or u.s. debt obligations. for example, an expatriate who81 purchased stock in a u.s. corporation while still a u.s. citizen and continued to own such stock following her expatriation was subject to u.s. income tax on the gain resulting from the sale of the u.s. stock during the ten-year period. however, if the expatriate contributed the stock to a foreign corporation not engaged in a u.s. trade or business, the gain escaped u.s. income tax and the foreign corporation was able to sell the stock free of u.s. income tax and pay foreign-source dividends to the expatriate. thus, the82 expatriate completely avoided u.s. tax on the gain that accrued while she was a u.s. citizen. the glitches and problems of the fita regime spurred reform, but the amended hipaa expatriation provisions suffered from the same faulty construction that did not allow the right amount of u.s. tax to be captured. c. expatriation provisions under hipaa 1. individuals subject to the alternative method of taxation – the hipaa version of section 877 continued to subject to u.s. income tax on u.s.-source income for the ten-year period those u.s. citizens who terminated their citizenship with a principal purpose of u.s. tax avoidance.83 78. irc § 2501(a)(4) (1966). 79. colon, supra note 21, at 53-54. 80. irc § 877(c) (1966). 81. id. 82. see, e.g., david s. zimble, expatriate games: the u.s. taxation of former citizens, 93 tnt 226-165 (nov. 1, 1993) (highlighting the tax planning techniques that allowed u.s. persons to achieve significant tax saving despite the application of the alternative tax regime). 83. irc § 877(a)(1). 24 florida tax review [vol.7:1 it also extended the same tax treatment to those u.s. resident aliens who were considered long-term u.s. resident aliens.84 the addition of section 877(e) was a major amendment to section 877, extending the expatriation rules to a group of u.s. resident aliens who were previously free to terminate their u.s. residency and return to their country of citizenship without any adverse u.s. tax consequences. the code did not provide tax-based rules for determining when a u.s. citizen was considered to have relinquished her citizenship or a longterm u.s. resident terminated her long-term u.s. residency for u.s. tax purposes. in the absence of tax-based rules, the code relied on the immigration and nationality act (“ina”) to determine whether, for the85 purpose of the expatriation provisions, a u.s. citizen relinquished her u.s. citizenship or a long-term u.s. resident alien terminated her u.s. residency. the ina provides that a u.s. citizen can relinquish her citizenship by performing one of the following acts with the intention of relinquishing u.s. nationality: (1) obtain naturalization in a foreign state upon reaching age 18; (2) take an oath of allegiance to a foreign state upon reaching age 18; (3) enter or serve in the armed forces of a foreign state if that foreign state is in conflict with the u.s.; (4) accept employment with a foreign government; (5) formally renounce u.s. citizenship before a u.s. diplomatic or consular officer in a foreign state; (6) formally renounce in writing u.s. citizenship in the u.s. in a form prescribed by the attorney general; or (7) commit an act of treason. on the other hand, a long-term u.s. resident alien’s u.s.86 residency is terminated if she ceases to be a lawful permanent resident of the u.s. or commences to be treated as a resident of a foreign country under the87 provisions of a bilateral income tax treaty between the u.s. and the foreign country and does not waive the benefits of that treaty. 88 if an individual performed an act of expatriation, the new presumption rules of section 877(a)(2) determined whether the person did so with a principal purpose of avoiding u.s. taxes. an individual was deemed89 to have expatriated with a principal purpose of avoiding u.s. taxes if (1) her average annual u.s. federal income tax liability for the five taxable years 84. irc § 877(e). a long-term u.s. resident alien is a person who is a lawful permanent resident of the u.s. in at least eight years of the 15-year period ending at the time of residency termination. however, a person is not considered a long-term u.s. resident for those years in which such person is treated as a resident of a foreign country under the provisions of a tax treaty between that foreign country and the u.s. 85. 8 u.s.c. 1101. 86. 8 u.s.c. 1481. 87. irc § 877(e)(1)(a). irc § 877(e)(1)(a) references irc § 7701(b)(6), which incorporates u.s. immigration laws for determining a person’s status as a u.s. resident alien for u.s. tax purposes. 88. irc § 877(e)(1)(b). 89. irc § 877(a)(2). 2005 is the nation of immigrants punishing its emigrants 25 ending before the date of loss of u.s. citizenship or termination of u.s. residency was greater than $ 100,000 (the “tax liability test”), or (2) her net worth as of the date of such loss or termination was $ 500,000 or more (the “net worth test”). this provision supplied many of the “teeth” that were90 missing under the fita version, which included no automatic presumption rules and placed the initial burden of proof on the government. it also underscored the purpose of the expatriation rules, focusing on individuals with the potential for tax-motivated expatriation. under hipaa provisions, u.s. citizens and long-term u.s. residents subject to section 877 were unable to fully benefit from bilateral tax treaties even if they were considered bona fide residents of the treaty partner. as noted in part ii of this article, saving clauses in most, if not all, u.s. bilateral income tax treaties provide that persons subject to u.s. taxation under section 877 are subject to u.s. taxation for a period of ten years as if the treaty had not come into effect. 2. exceptions to treatment as an expatriate – by adding the automatic presumption rules, the hipaa expatriation provisions allowed less affluent individuals to completely avoid the application of the alternative tax regime upon expatriation. in addition, certain individuals who were considered to have expatriated with a principal purpose of tax avoidance by meeting the tax liability or net worth tests had the opportunity to overcome this presumption by submitting a complete and good faith ruling request to the irs within one year of expatriation for a determination by the irs that the loss of u.s. citizenship was not motivated by tax avoidance. before the91 enactment of hipaa, only a limited exception was available to certain dual residents, with no option of filing a ruling request. as previously noted, the92 existence of such exceptions allowed some expatriates to avoid u.s. tax on income accrued during the period of u.s. citizenship or residency. under hipaa, a former u.s. citizen was qualified to submit a request for a ruling if the person was (1) an individual born with dual citizenship who remained a citizen of the other country, (2) an individual who became a citizen of the country of birth, spouse’s birth or parents’ birth, within a reasonable time following loss of citizenship, (3) an individual who was not present in the u.s. for more than thirty days each year in the ten-year period immediately preceding the date of loss of citizenship, (4) an individual who relinquished her citizenship before reaching the age of 18 ½, or (5) an individual that fell into any other category of individuals designated 90. irc § 877(a)(2). after 1996, the numbers were adjusted for inflation. 91. irc § 877(c). 92. irc § 877(d) (1966). pursuant to § 877(d), the alternative method of taxation did not apply to a nonresident alien who acquired dual citizenship at birth and resided in the country of her other citizenship. 26 florida tax review [vol.7:1 by the treasury regulations. while these categories contemplated a close93 connection to the country to which the individual was moving, lessening the chance that the move was indeed motivated by tax avoidance, they did not require an insubstantial link to the u.s. despite the limited categories of eligible individuals, the documentation required to be submitted as part of the ruling request was quite extensive and included statements such as the individual’s reasons for termination of residency or loss of citizenship, foreign countries where the individual is a resident or intends to be a resident, a balance sheet setting forth the individuals assets, and many additional items. the requirements were set out in detail in notice 97-19,94 with some modifications provided in notice 98-34. 95 while section 877(e) subjected long-term u.s. resident aliens to the alternative method of taxation, it did not provide such long-term u.s. resident aliens with the opportunity to submit a ruling request to show that their termination of u.s. residency was not motivated by tax avoidance. consequently, to grant fair treatment to similarly situated long-term u.s. resident aliens who, as a group, were no more likely than u.s. citizens to expatriate for the purpose of avoiding u.s. taxes, the irs extended virtually the same exceptions to long-term u.s. resident aliens. under notice 97-19, as modified by notice 98-34, a long-term u.s. resident was eligible to submit a ruling request if the resident (1) became, within a reasonable period following expatriation, a resident fully liable to income tax in the country in which the individual was born, in the country where the individual’s spouse was born, or in the country where either of the individual’s parents were born, (2) was not present in the u.s. for more than thirty days each year in96 the ten-year period immediately preceding the date of residency termination, or (3) prior to reaching age 18 ½, ceased to be taxed as a lawful permanent resident, or commenced to be treated as a resident of another country under an income tax treaty and did not waive the benefits of such treaty. the submission of such a complete and good faith ruling request was sufficient to overcome the presumption of tax avoidance, but the irs was always free to subsequently make a substantive determination based on the individual’s u.s. income, estate or gift tax returns that the principal purpose of expatriation was, in fact, the avoidance of u.s. taxes. if the irs determined that the request was complete and in good faith, the alternative method of taxation did not apply and the individual was considered a nonresident alien following the individual’s expatriation. as a nonresident alien, the individual could benefit from a bilateral income tax 93. irc § 877(c)(2)(a)-(d). 94. i.r.s. notice 97-19, 1997-1 c.b. 394. 95. i.r.s. notice 98-34, 1998-2 c.b. 29. 96. prior to the modifications of notice 98-34, notice 97-19 required that a long-term resident become a citizen of the country to which she expatriated. see notice 97-19, 1997-1 c.b. 394. 2005 is the nation of immigrants punishing its emigrants 27 treaty between the u.s. and another country and from all of the generally applicable u.s. tax rules without any “source conversions.” if a bilateral income tax treaty applied, the nonresident alien was subject to u.s. tax in accordance with that treaty, which generally meant that she was subject to u.s. tax on the sale of u.s. real estate, on the sale of shares in a u.s. real estate holding company, on income derived from u.s. real property, on dividends received from a u.s. company, and on profits earned by an enterprise if the enterprise was engaged in a u.s. trade or business through a permanent establishment in the u.s., such as an office. thus, the hipaa exceptions perpetuated an existing problem by allowing wealthy u.s. persons to avoid u.s. taxes by expatriating to an “approved” country. 3. the alternative method of taxation – the method of taxation was significantly changed by hipaa. if a former u.s. citizen or long-term u.s. resident alien was determined to have expatriated with a principal purpose of tax avoidance, the alternative method of taxation applied for the ten-year period following expatriation. for u.s. tax purposes, the expatriate was neither a u.s. citizen nor a u.s. resident alien. pursuant to the alternative regime, the expatriate was subject to u.s. tax on her u.s.-source income at the rates applicable to u.s. persons rather than at the rates applicable to other nonresident aliens. however, unlike in the case of a u.s. person, the expatriate was not taxed on her foreign-source income and she was allowed to take deductions only to the extent such deductions were connected with the gross income taxable under section 877, except that no capital loss carryover was allowed. this limitation imposing u.s. tax only on u.s.-97 source income at first blush may appear to be benign, but, in fact, the range of income items treated as u.s.-source for the purpose of section 877 was,98 and still remains, more expansive than the range of items generally considered u.s.-source income under the code. section 877(d)(1) contains99 the so-called “source conversion” rules and provides that the following items of gross income will be treated as income from sources within the u.s.: gains on sale or exchange of property (other than stock or debt obligations) located in the united states; gains on sale or exchange of stock issued by a domestic corporation or debt obligation of a u.s. person, the u.s., or a state; and income or gain derived from controlled foreign corporation if certain ownership tests are met. in the case of nonresident aliens, these items of income are generally not subject to u.s. tax, but section 877(d)(1) treats these items as u.s.-source and, within the context of section 877, they are taxed to nonresident aliens. in addition, pursuant to section 877(d)(2), 97. irc § 877(b)(1)-(2). 98. irc § 861(a). 99. irc § 877(d)(1). 28 florida tax review [vol.7:1 individuals subject to section 877 were taxed on exchanges of property that generated u.s.-source income for property that would have generated foreign source income. similarly, under section 877(d)(4), as modified by notice100 97-19, income or gain from property contributed to a foreign corporation101 by an expatriate during the 15-year period commencing five years prior to expatriation was treated as u.s.-source, and the expatriate was taxed on such income or gain as though she continued to own such property. this subsection applied if the corporation would have been a controlled foreign corporation at the time of the contribution and the taxpayer would have been a u.s. shareholder, ignoring the fact of the expatriation. in addition, the taxable estate of a decedent who expatriated with a principal purpose of avoiding u.s. taxes was subject to u.s. estate tax if the decedent lost her u.s. citizenship or terminated her long-term u.s. resident alien status within the ten-year period immediately preceding her death.102 the taxable estate of an expatriate subject to the alternative tax regime included her u.s. situs assets, plus stock of certain controlled foreign103 corporations. more specifically, the u.s. estate of a tax-motivated expatriate included a percentage of the fair market value of the stock of a foreign corporation of which the expatriate owned, at the time of her death, 10% or more of the combined voting power and owned (directly, indirectly, or constructively) more than 50% of the combined voting power or value of the stock of that foreign corporation. however, the expatriate could benefit104 from limited u.s. foreign tax credits for estate, inheritance, or legacy taxes paid to a foreign country with respect to stock in such controlled foreign corporations. similarly, under section 2501(a)(3)(a), the transfer of105 intangible property by a nonresident alien was not exempt from u.s. gift tax if, within the ten-year period immediately preceding date of a transfer, the nonresident lost her u.s. citizenship or terminated her u.s. resident alien status, but section 2501(a)(3)(d) provided that u.s. gift tax imposed under this section could be credited with the amount of gift tax that was paid to a foreign country with respect to that gift. 106 100. irc § 877(d)(2). this subsection provides that on an exchange during the ten-year period beginning on the date of expatriation, exchanged property will be treated as sold for its fair market value on the date of exchange if generally, on such exchange gain would not be recognized, income derived from the property was from u.s. sources, and income derived from the property so acquired would be from non-u.s. sources. an exception was available to individuals who entered into an agreement with the irs. 101. notice 97-19, 1997-1 c.b. 394, at 401. 102. irc § 2107(a)(1). the estate tax provisions affecting expatriates remain the same under the jobs act. 103. irc §§ 2103, 2106. 104. irc § 2107(b). 105. irc § 2107(c)(2). 106. irc § 2501(a)(3). 2005 is the nation of immigrants punishing its emigrants 29 these hipaa amendments to the source rules were quite significant because under the fita version of section 877, only gains from the sale or exchange of property located in the u.s. (other than stock and debt obligations) and gains from the sale or exchange of stock in a u.s. corporation or debt obligations of u.s. persons were treated as u.s.-source. the new “source conversion” rules ensured that former u.s citizens and long-term u.s. residents no longer escaped u.s. tax on certain other u.s.source items that had accrued but unrecognized gain at the time of expatriation. the fact that under these rules, income accrued on u.s.-source items following expatriation remained subject to u.s. tax was not addressed. the source conversion rules also encouraged investment in foreign assets and assets producing foreign-source income and, thus, fostered economic inefficiency. 4. coordination with immigration rules – section 1182(a) of the immigration and nationality act (“ina”), which is effective as of september 30, 1996, also increased the drawbacks of expatriation, at least for u.s. citizens. section 1182(a)(10)(e) of the ina provides that a former u.s.107 108 citizen who officially renounced her u.s. citizenship in order to avoid u.s. taxation and who is determined by the attorney general to have expatriated with the purpose of avoiding u.s. taxes, would not be allowed to re-enter the u.s. pursuant to section 1481 of the ina, official renunciation appears to109 encompass only the making of a formal written renunciation in the u.s. using a method designated by the attorney general, or a formal renunciation in a foreign state before a u.s. diplomatic or consular officer. consequently, a former u.s. citizen treated as an expatriate pursuant to the alternative method was subject not only to u.s. income, estate, and gift taxes, but was also unable to re-enter the u.s. if her expatriation was “formal” in nature. the language of the ina suggests that a former u.s. citizen who merely obtained naturalization in a foreign country and, thus, did not formally renounce her u.s. citizenship, could be allowed to-reenter the u.s. under u.s. immigration rules. the definition of tax avoidance for u.s. immigration purposes was not coordinated with the principal purpose test established for u.s. tax purposes. as a result, even though the tax avoidance standard has been eliminated from the revised section 877, a tax avoidance standard is still in effect for u.s. immigration purposes and there is no indication at present of any change in these immigration rules. 5. procedural rules and requirements – a u.s. citizen who renounced her u.s. citizenship pursuant to the ina provisions was required 107. 8 u.s.c. § 1182 (1995). 108. id. 109. 8 u.s.c. § 1481 (1995). 30 florida tax review [vol.7:1 to file an information statement under section 6039g of the code. a longterm u.s. resident alien who terminated her u.s. residency was also required to provide this information. the information statement filing requirement was satisfied by the filing of form 8854 (expatriation initial information statement). in addition, former u.s. citizens and former long-term u.s. resident aliens subject to section 877(b) were also required to annually file u.s. individual income tax returns on form 1040nr.110 6. need for change? – the hipaa rules contained the same basic design flaw as the initial expatriation provisions, perpetuating the shortcomings of the existing regime. the possibility of tax-motivated expatriation persisted. for example, an expatriating u.s. citizen determined to avoid full u.s. taxation could have done so by marrying a nonresident alien, submitting a ruling request to the irs indicating the intention to renounce her u.s. citizenship, and moving to the country of the spouse’s birth. the underlying difficulty is obvious as it is impossible to know an individual’s true motives beyond assessing that individual’s financial and family circumstances. likewise, an expatriate was able to avoid the alternative regime by holding on to property with accrued gain until the expiration of the ten-year period. these tactics prolonged inequality among similarly situated expatriates as some expatriates would sell their u.s. property within the ten-year period and pay the applicable u.s. tax, while others would wait and dispose of their u.s. property without paying any u.s. tax. the irs also continued to assess the subjective intent of the expatriating individual and was also burdened by the ruling request process. these persistent problems prompted congress to consider several proposals to revise the expatriation provisions. 7. summary – for over forty years, congress has been trying to develop an alternative tax regime applicable to expatriates whose change in status is motivated by the avoidance of u.s. taxes. the initial expatriation provisions established the basic structure of the alternative tax system pursuant to which tax-motivated u.s. citizen expatriates were subject to u.s. income tax on u.s.-source income and to u.s. estate and gift tax on transfers of u.s. situs property for a period of ten years following expatriation. however, the laxness of the presumption rules and the simplicity with which u.s.-source income could be converted to foreign-source income made the initial provisions ineffective. the hipaa amendments introduced the “source-conversion” rules of section 877(d), subjecting a wider range of items to u.s. taxation. the amended rules also increased the pool of potential expatriates by extending the application of the expatriation provisions to long-term u.s. resident 110. notice 97-19, 1997-1 c.b. 394, at 403-04. 2005 is the nation of immigrants punishing its emigrants 31 aliens and by providing automatic presumption rules. on the other hand, the monetary thresholds and the ruling request process provided exceptions for persons who may have been less likely to expatriate for tax reasons. although the revised expatriation provisions improved some aspects of the initial expatriation rules, they retained the flawed design of the original rules. both the fita and the hipaa regimes subjected to u.s. tax u.s.-source income accrued following the renunciation of citizenship or termination of long-term residency. yet the amended provisions failed to eliminate the potential for tax avoidance. expatriates could refrain from selling their u.s. assets during the application of the alternative regime. likewise, u.s. tax could be avoided by filing a ruling request and moving to a country to which the expatriate had the requisite connections. iv. expatriation provisions under the jobs act congress considered various alternatives in amending the expatriation provisions, including the mark-to-market exit tax system proposed by senators grassley and baucus in 2003. in 2004, congress111 again rejected the mark-to-market approach to the taxation of expatriates. however, the mark-to-market regime resurfaced in the current congress. 112 the expatriation provisions of the jobs act follow the overall structure of the hipaa expatriation provisions and subject expatriates to u.s. income, estate, and gift taxes for a period of ten years following expatriation. however, the new rules introduced some drastic changes without completely eliminating the potential for tax avoidance through expatriation. a. individuals subject to the alternative method of taxation revised section 877(a)(2) replaces the subjective determination of tax avoidance with three bright-line tests. under the revised rules, a former113 u.s. citizen or long-term u.s. resident alien is subject to the alternative method of taxation under section 877 for a period of ten years if (i) her average annual net income tax liability for the five years preceding 111. see jumpstart our business strengths act, s. 1637, 108th cong. § 442 (2003). this mark-to-market exit tax system was another option that had been considered in the revision of the expatriation provisions. pursuant to a mark-to-market system, expatriates would be subject to u.s. tax on the net unrealized gain in their property as if such property were sold for its fair market value the day before expatriation. certain properties, such as u.s. real property interests, would be exempt because such interests are subject to u.s. tax in the hands of nonresident aliens as well. 112. highway reauthorization and excise tax simplification act of 2005. h.r. 3, 109th cong. (2005). 113. irc § 877(a)(2). 32 florida tax review [vol.7:1 expatriation exceeds $124,000, (ii) her net worth is $2 million or more on114 the date of expatriation, or (iii) she fails to certify under penalties of perjury that she complied with all of her u.s. tax obligations for the five preceding years or fails to provide evidence of such compliance if requested by the secretary of treasury. these three tests are now used to conclusively determine whether an expatriate is subject to the alternative method of taxation. the individual’s motivation for expatriation is no longer relevant – if an expatriate falls within this group and does not satisfy any of the exceptions, she will be subject to u.s. taxation pursuant to section 877. the third test for applying the alternative method of taxation is a new test that underscores the complete elimination of the tax avoidance motive from section 877. pursuant to this test, a former u.s. citizen who earns $40,000 per year and has no independent source of income or wealth can be subject to the alternative method of taxation if she fails to fulfill the certification obligation or provide evidence of such compliance, even if requested following the expatriation. although this requirement appears relatively easy to meet, it may be burdensome for a naturalized u.s. citizen or resident alien who lacks english language skills or the funds necessary to afford professional tax advice. the new rules for subjecting an expatriate to the alternative tax regime are clear and objective, reducing the potential for tax avoidance by subjecting all expatriates to section 877(a). however, u.s. taxes may still be avoided if the former u.s. citizen or resident alien does not sell her u.s. source property within the ten-year period following expatriation. b. exceptions to treatment as an expatriate the ruling request system for obtaining an exception has been eliminated and the alternative method of taxation can be avoided only if certain objective criteria are satisfied. first, an expatriate will avoid being taxed under section 877 if she falls below the $2 million net worth and $124,000 u.s. income tax liability thresholds and certifies that she has complied with all u.s. tax obligations for the five-year period preceding the expatriation and provides evidence thereof (if requested).115 second, even if an expatriate meets at least one of the monetary thresholds, she can avoid the application of the alternative tax regime if she falls into one of two very narrowly defined categories of individuals. a former u.s. citizen can avoid the application of the alternative tax regime if (i) the individual was born a u.s. citizen and a citizen of another country and remained a citizen of that other country and (ii) had no “substantial contacts” 114. irc § 877(a). this amount is adjusted for inflation after 2004. 115. irc § 877(a). 2005 is the nation of immigrants punishing its emigrants 33 with the u.s. a person will be deemed as having no “substantial contacts”116 with the u.s. if she was never a resident of the u.s., never held a u.s.117 passport, and was not present in the u.s. for more than thirty days during118 any calendar year in the ten-year period preceding her loss of u.s. citizenship. alternatively, a former u.s. citizen can avoid the application119 of the alternative tax regime if (i) she was born a u.s. citizen, (ii) neither of the parents was a u.s. citizen at the time of birth, (iii) she lost her u.s. citizenship before reaching 18 ½ years of age, and (iv) was not present in the u.s. for more than thirty days during any calendar year in the ten-year period preceding the loss of citizenship. in the case of either exception, the120 expatriate must certify under penalties of perjury that she has complied with all of the u.s. tax obligations for the five-year period preceding the expatriation. if an expatriate can satisfy one of these exceptions, she will be subject to u.s. tax as a nonresident alien and will be able to benefit from an applicable u.s. bilateral income tax treaty. the lack of exceptions for long-term u.s. resident aliens is striking, but not unusual. the former version of section 877 did not include an exception for long-term u.s. resident aliens either, although the irs extended the exception to long-term u.s. resident aliens using the same tests applicable to u.s. citizens. with the current structure of section 877, such extension seems difficult without deviating from apparent congressional intent. the current exceptions to the alternative tax regime are available only to “accidental” u.s. citizens who did not seek out a close connection to the u.s. it could be challenging to apply this standard to long-term u.s. resident aliens because long term u.s. resident aliens, by definition, sought out a close connection to the u.s. by applying for a green card and remained in the u.s. long enough to be considered long-term u.s. resident aliens. an argument may be made that persons who chose to accept the benefits of u.s. residency should not be allowed to retract and leave the u.s. without “paying 116. irc § 877(c)(2). 117. irc § 877(c)(2)(b)(i). a u.s. citizen will not be deemed a u.s. resident pursuant to the substantial presence test if she never spent more than 120 days in the u.s. in any given year. see irc § 7701(b)(3)(a). 118. irc § 877(c)(2)(b)(ii). 119. irc § 877(c)(2)(b)(iii). 120. irc § 877(c)(3). pursuant to 8 u.s.c. § 1481(a), a native born or naturalized citizen of the u.s. must be at least 18 years of age when renouncing u.s. citizenship. however, a minor over the age of 14 may be able to renounce her u.s. citizenship before a u.s. consular officer but only if she is able to persuade the u.s. consular officer that she fully understands the nature and the consequences of renunciation and is voluntarily seeking to renounce her u.s. citizenship. parents are not authorized by these provisions to renounce their minor children’s u.s. citizenship. see 8 u.s.c. § 1481(a). 34 florida tax review [vol.7:1 for” any of the benefits resulting from their stay in the u.s. however, there is no sound reason for treating u.s. resident aliens differently from u.s. citizens. this discrepancy places a heavy burden on many potential immigrants who now will have to seriously contemplate their long-term future and determine whether they want to remain in the u.s. permanently or at some point return to their home country. tax advisors should take great care in explaining to their nonresident alien clients the ramifications of becoming a u.s. resident alien. although section 877(c) provides two exceptions for u.s. citizens, these exceptions are extremely limited. in practice, only those u.s. citizens who were born to one u.s. parent or to two non-u.s. parents and resided almost exclusively outside of the u.s., can be exempt from the alternative method of taxation following the loss of u.s. citizenship. a u.s. citizen121 who is a dual citizen and chose to accept the advantages offered by the country of her other citizenship seems to lack the requisite connection to the u.s.122 the revised exceptions are an improvement over the hipaa exceptions in that they eliminate significant administrative burdens present under the ruling request system and reduce the potential for granting exceptions to persons who have the intention of avoiding u.s. taxes. however, the revised exceptions subject similarly situated u.s. citizens and resident aliens to different standards for no apparent reason. a minor renouncing her u.s. citizenship before the age of 18 ½ could have resided in the u.s. for up to eight years and still qualify for the exception, whereas a long-term u.s. resident residing in the u.s. for eight years would not qualify for the exception. to further complicate the expatriation provisions, new section 877(g) subjects those expatriates subject to the alternative method of taxation who return to the u.s. and remain here for more than thirty days in any given calendar year to full u.s. taxation for that year. up to thirty days spent in123 the u.s. for employment purposes by (1) an expatriate who becomes a citizen or resident of a country in which such person, her spouse or either of her parents was born, provided that the person is fully liable for income in that county, or by (2) a person who was present in the u.s. for no more than thirty days during each year in the ten-year period ending on the date of citizenship relinquishment or residency termination, will not be counted for 121. irc § 877(c)(2). under the dual citizen exception, a u.s. citizen with two u.s. citizen parents who have not resided in the u.s. can technically qualify if all the other requirements are met. irc § 877(c)(2). 122. see irc § 877(c)(2). 123. irc § 877(g). 2005 is the nation of immigrants punishing its emigrants 35 determining the individual’s physical presence. this is a dramatic change124 from the prior rules, which generally followed the substantial presence test for subjecting an expatriate to full u.s. taxation. subjecting former u.s. citizens and long-term u.s. resident aliens to u.s. tax on their worldwide income is fundamentally unfair. most, if not all, former u.s. citizens and long-term u.s. resident aliens will be bona fide tax residents of their chosen countries of residence and will be subject to full taxation in that country. subjecting them to full u.s. taxation on the basis of such limited presence in the u.s. will strongly discourage former u.s. persons from returning to visit friends or family or to conduct business. this provision in particular cannot be viewed as comporting with international tax policy standards. in fact, the existence of an expatriation regime in itself breaks with international tax standards. the u.s. taxation of an expatriate’s worldwide income is also125 likely to result in double taxation, although some limited u.s. tax credits are available to remedy the double-tax effect. 126 section 877(g) has the potential to be a true revenue raiser. the threshold for triggering u.s. taxation as a u.s. person is so low that it will be practically impossible for any former u.s. citizen with family, friends, or business connection in the u.s. to avoid. the language of section 877(g) makes it clear that those expatriates who are subject to section 877 only as a result of their failure to certify that they have met their u.s. tax obligations for the five years preceding expatriation will also be taxed as u.s. resident aliens in any calendar year in which they spend more than thirty days in the u.s. during the ten-year period following expatriation. 127 there is one practical way a long-term u.s. resident alien contemplating the termination of her u.s. residency may be able to avoid 124. id. for the purpose of this provision, days an individual spends in the u.s. as a result of a medical condition that arose while such individual was present in the u.s. will not be counted. this exception is similar to the exception allowed under the substantial presence test. 125. most countries do not have an expatriation tax regime, allowing their citizens and residents to expatriate without a tax cost. germany has a limited expatriation regime pursuant to which those german citizens who were german tax residents for at least five years during the ten-year period preceding expatriation and who emigrate to a tax haven or fail to take up tax residence in another country while retaining strong economic ties with germany will be subject to german tax on income that is considered german source income. see aussensteuergesetz, v. 20.12.2001 (bgbl. i s. 3858). spain has a limited expatriation regime as well, pursuant to which spanish citizens who emigrate to a tax haven, as specifically defined for this purpose, will be taxed as spanish residents for the year in which the emigration taxes place and for the following four years. see art. 9.3, ley del impuesto sobre la renta de personas fisicas. 126. irc § 877(b) (credit for income tax); irc § 2107(c)(2) (credit for foreign estate tax); irc § 2501(a)(3)(b) (credit for foreign gift tax). 127. irc § 877(g)(1). 36 florida tax review [vol.7:1 treatment as an expatriate under revised section 877. if a long-term u.s. resident alien files as a nonresident alien for the 2004 taxable year under an applicable treaty tie-breaker provision and does not waive the benefits of the treaty, she will be treated as a nonresident alien for all of 2004, as she will be considered to have terminated her u.s. residency on january 2004, avoiding the application of the new rules with the june 3, 2004 effective date.128 consequently, she would be subject to the prior section 877 rules and presumably would be able to submit a ruling request pursuant to the rules in effect under the hipaa version of section 877. some commentators suggest that in some cases long-term u.s. resident aliens may be able to avoid the application of the new rules even by filing amended returns for open years to claim foreign residence under a treaty. in addition, it is also possible that129 late filing will not at all deprive a nonresident alien of her ability to claim nonresident status pursuant to a treaty tie-breaker as the regulations under sections 6114 and 7701 do not suggest that late filing will result in loss of ability to claim nonresident status. c. the alternative method of taxation the revised rules generally retain the same income tax rules in effect under the hipaa expatriation provisions. in addition, the modified provisions also preserve the alternative estate and gift taxation rules, with some minor changes. for example, u.s. gift tax will be imposed on a gift made by an expatriate subject to the alternative method of taxation at the time of making the gift, with a credit for foreign gift taxes paid. in130 addition, a gift of stock of a foreign corporation made by an expatriate subject to the alternative method will be subject to u.s. gift tax if the gift is made during the ten-year period. this rule mirrors u.s. estate tax section131 2710(b) and applies only if the expatriate, prior to making the gift, owned, directly or indirectly, 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation and if they are also considered to own, under the attribution rules, in excess of 50% of either the total combined voting power of all classes of stock entitled to vote in the foreign corporation or of the total value of the stock of the corporation. if132 128. an individual’s tax status is determined on a calendar year basis. irc § 7701(b)(1)(a)(i) provides that a nonresident alien will be considered a u.s. resident with respect to any calendar year if she was admitted as a permanent resident at any time during the calendar year. see irc 7701(b)(1)(a)(i); see also regs. § 301.61141(a)(1)(ii). 129. see generally marco blanco & john kaufmann, the noose tightens: the new expatriation provisions, 2005 tnt 2-36, (jan. 4, 2005). 130. irc § 2501(a)(3). 131. irc § 2501(a)(5). 132. id. 2005 is the nation of immigrants punishing its emigrants 37 the gift is taxable under these tests, the taxable gift includes that portion of the fair market value of the stock transferred which the fair market value of any asset owned by that corporation and situated in the u.s. bears to the total fair market value of all assets owned by the foreign corporation. it is133 irrelevant whether the stock is situated in or outside of the u.s. 134 the revised expatriation provisions continue to subject to u.s. income tax u.s.-source income accrued after the expatriation. there is no sound reason for subjecting former u.s. citizens and long-term u.s. resident aliens to u.s. tax on gain resulting from the sale of u.s. stock or other property generally sourced under section 865 if they purchased such property following their expatriation and all of the gain accrued while they were nonresident aliens. in such situations, expatriates should be taxed in the same manner as other nonresident aliens because there is no actual u.s. tax avoidance. taxing only the gain that accrued during the period of u.s. citizenship or residence could be a significant administrative burden on the taxpayer and the irs in situations where the expatriate holds on to the property following expatriation. this problem could have been solved only by adopting a mark-to-market system, but such proposals have been rejected by congress.135 d. tax rules for determining citizenship and residency termination the revised provisions define the termination of u.s. citizenship or long-term u.s. residency for u.s. tax purposes. in effect, under new section 7701(n), a u.s. citizen or long-term u.s. resident alien who otherwise performs an act of expatriation will retain her u.s. status for u.s. income tax purposes until she gives notice to the secretary of state or to the secretary of homeland security of the act of expatriation and provides a statement in accordance with section 6039g. this section abandons the use of136 immigration-based residency rules and instead requires the use of tax-based rules for determining a u.s. citizen’s or long-term u.s. resident alien’s tax status. the irs published notice 2005-36 to clarify the reporting requirements. the notice provides that form 8854 has been revised so that137 expatriates can use it to satisfy both the notice requirement of new section 7701(n) and the reporting requirement under section 6039g. consequently, following an act of expatriation, an expatriate not subject to the alternative regime must file form 8854 only once, whereas an expatriate subject to the 133. irc § 2501(a)(5)(c). 134. irc § 2501(a)(5)(a)(i). 135. see, e.g., s. 1637, 108th cong. § 4422 (2003). 136. irc § 7701(n). 137. irs notice 2005-36, 2005-19 i.r.b. 1007. 38 florida tax review [vol.7:1 alternative regime must file form 8854 each year during the ten-year period the alternative regime applies. e. procedural rules u.s. citizens and long-term u.s. resident aliens subject to section 877 must file annual returns for each of the ten years during which the alternative method applies, even if no u.s. federal income tax is due for any of those years. the information to be provided under section 6039g138 remains essentially the same as under the prior rules, with the exception that expatriates must indicate the number of days spent in the u.s. in a given taxable year. the penalty for failure to file a statement under section 6039g is increased to $10,000, unless the individual can show that the failure is due to reasonable cause and not to willful neglect. f. coordination with immigration provisions the jobs act expatriation provisions fail to address the discrepancies between the u.s. immigration and tax rules applicable to expatriates. such failure perpetuates opposing preferences between former u.s. citizens and former long-term u.s. resident aliens. under u.s. tax law, only u.s. citizens may be able to avoid the application of the alternative regime, provided they satisfy the requirements of section 877(c). under u.s. immigration law, only former long-term u.s. resident aliens can freely return to the u.s. following expatriation because former u.s. citizens who are determined to have renounced their u.s. citizenship for tax avoidance purposes (as determined under immigration rules) can be excluded from the u.s. this discrepancy between u.s. immigration and u.s. tax rules needs to be addressed as it creates an apparent discrepancy in the treatment of u.s. citizen and longterm u.s. resident alien expatriates, with the tax rules favoring former u.s. citizens and the immigration rules favoring former long-term u.s. resident aliens. g. summary the expatriation provisions of the jobs act introduced some vital changes to the existing expatriation provisions of the code, affecting expatriating u.s. citizens and long-term u.s. resident aliens in four principal ways. first, the motivation for expatriation is now inconsequential and any expatriate who meets any one of the three bright-line tests, but none of the limited exceptions, is subject to the alternative method of taxation for the ten-year period following expatriation. second, the exceptions from the 138. irc § 6039g(a). 2005 is the nation of immigrants punishing its emigrants 39 application of the alternative tax regime are very limited and are available to certain dual citizens only. third, the termination of u.s. residency or the renunciation of u.s. citizenship is insufficient to terminate such status for u.s. tax purposes and additional steps must be taken to finalize tax expatriation. fourth, former u.s. citizens and long-term u.s. resident aliens returning to the u.s. for more than thirty days in any given year are treated as u.s. persons for that year and are subject to full u.s. taxation. the revised rules are an improvement over the existing rules in that they lessen the administrative burden on the irs by eliminating the ruling request procedure and by lessening the potential for tax avoidance. however, u.s. citizens and long-term u.s. resident aliens may still be able to avoid u.s. tax on certain items by refraining from any sale or exchange during the ten-year period for which the alternative method of taxation applies. this potential for tax avoidance also creates inequality in the treatment of similarly situated expatriates, as some will pay u.s. tax on the gain resulting from the sale of u.s.-assets while others will wait for the expiration of the ten-year period and pay no u.s. tax on such gain. in addition, the imposition of u.s. income tax on u.s.-source income accrued after the expatriation results in economic inefficiency. moreover, u.s. citizens and long-term u.s. resident aliens are not treated equally because long-term u.s. resident aliens do not have any exceptions from the application of the alternative regime. last but not least, the imposition of full u.s. taxation on expatriates returning to the u.s. for as few as thirty-one days a year in any one of the ten years to which the alternative method applies is out of step with international norms. v. a fair system of taxation for expatriates? as the history of the expatriation provisions demonstrates, the taxation of former u.s. citizens and long-term u.s. resident aliens is a considerable challenge to the u.s. tax system. on the one hand, the u.s. has the right to tax accrued but unrealized gain that would otherwise be taxable to the expatriate upon realization if she remained a u.s. person. on the other hand, the u.s. should refrain from taxing gain that accrues during a period when the expatriate is a nonresident alien for all practical purposes and, as such, would not be subject to u.s. tax on those gains. in creating a better expatriation tax regime, congress should reconsider a mark-to-market expatriation regime. under a mark-to-market139 system, expatriates would be subject to u.s. tax on the net unrealized gain in their property as if such property were sold for its fair market value the day 139. colon, supra note 21, at 30-33 (providing an in-depth analysis of the benefits of a mark-to-market expatriation tax regime). 40 florida tax review [vol.7:1 before expatriation. such a system would apply to all of the property140 owned by the expatriate, with the exception of u.s. real property interests, which would be subject to u.s. tax on disposition. some mark-to-market141 expatriation proposals rejected by congress in the past subjected such gain to u.s. tax only to the extent the gain exceeded a threshold. 142 a. mark-to-market regime would end expatriation for the purpose of tax avoidance under the expatriation rules currently in effect, tax avoidance is still possible by holding on to property with accrued but unrealized gain for the ten year period during which the alternative tax regime applies. although market forces may make it unrealistic for many expatriates to wait that long to dispose of properties that would otherwise be subject to u.s. tax, in many cases it may be an option and in those situations it may deprive the u.s. of a significant amount of revenue to which it is entitled. under a mark-to-market regime, all unrealized gain would be subject to u.s. tax, with the exception of unrealized gain in u.s. real property interests, which are subject to u.s. tax in any event. b. mark-to-market regime would be applied on the basis of the expatriate’s ability to pay under the current expatriation structure, expatriates face ten years of u.s. tax on a variety of income the u.s. unilaterally deems u.s.-source income. such income is likely subject to tax in the expatriate’s country of citizenship or residence as well, subjecting such income to the burden of double taxation, with some limited tax credits. a mark-to-market regime would subject the expatriate to a one-time u.s. tax on gain that has already accrued and income that has already been earned, at tax rates that would generally apply to the expatriate if she remained a u.s. person. this system would preclude double taxation of gain or income in the future. c. mark-to-market regime would reduce economic inefficiency the current rules encourage expatriates to invest in foreign assets or in assets that generate foreign-source income because such assets and income are free from u.s. tax. this distorts the free flow of capital and hampers the decision making process by forcing expatriates to make investment decisions based purely on tax considerations and not on economic efficiency. a mark140. see, e.g., s. 1637, 108th cong. § 442 (2003). 141. id. 142. id. 2005 is the nation of immigrants punishing its emigrants 41 to-market system would encourage investments based on economic efficiency and sound business judgment. the expatriate would be subject to u.s. tax at the time of expatriation on gain that accrued while the individual was a u.s. person. following expatriation, the individual would be able to make investment decisions based on market factors and would be free to invest in u.s. assets or assets producing u.s.-source income because she would be subject to u.s. tax on any such income or gain in the same manner as other nonresident aliens. d. mark-to-market regime would reduce unequal treatment of expatriates under the current system, similarly situated expatriates may be subject to unequal treatment. for example, an expatriate holding stock of a u.s. corporation with substantial accrued but unrealized gain will be subject to u.s. tax if she sells the stock during the ten year period the alternative tax regime applies. on the other hand, a similarly situated expatriate holding stock of a u.s. corporation with the same amount of accrued but unrealized gain will not be subject to u.s. tax if she holds the stock until the expiration of the ten year period. under the mark-to-market system, both expatriates will be subject to the same amount of tax on the deemed sale of the u.s. stock at the time of expatriation. this method is not perfect as it may be difficult for some expatriates to procure the amount of liquid assets needed to cover their u.s. tax liability on the deemed disposition, but it would be a more equitable way to impose the expatriate tax. e. mark-to-market regime would be easier to manage the current expatriation regime requires the u.s. to closely follow the “taxable” activities of expatriates for ten years following their expatriation. this involves tracking the transfer of real, tangible, and intangible property by sale, gift, or other disposition, reviewing u.s. tax returns, and conducting audits if necessary, all of which increase the administrative burden placed on the irs. it may be impossible to track every relevant activity that could have a tax effect as the expatriate and, presumable, most of her property, will be located in her new home country. in addition, extensive and close cooperation with foreign tax authorities may be required for the sake of efficiency and effectiveness. the mark-to-market regime would allow a one-time accounting with respect to all the property owned by the expatriate, with the exception of u.s. real property interests. 42 florida tax review [vol.7:1 f. mark-to-market regime would eliminate the need for alternative estate and gift tax provisions the current structure of the expatriation provisions requires a set of tax rules governing the u.s. income taxation of u.s.-source property and a separate set of tax rules regulating the u.s. estate and gift taxation of expatriates. under a mark-to-market system, this multi-tiered approach would be replaced with a one-time accounting at the time of expatriation and would eliminate the need for a separate set of u.s. estate and gift tax expatriation rules. g. additional considerations although a recent bill includes provisions for the mark-to-market taxation of expatriates, congress is unlikely to change the current rule.143 congress should at least address the inequality caused by the section 877(c) exceptions being available only for u.s. citizens and either completely eliminate the exceptions or make them available to similarly situated longterm u.s. resident aliens. in addition, congress should repeal section 877(g), which drastically subjects to full u.s. taxation any expatriate for any calendar year in the ten-year period in which the expatriate spends more than thirty-one days in the u.s. a former u.s. citizen or long-term u.s. resident alien who spends thirty-one days in the u.s. lacks the requisite connection to the u.s. that would warrant u.s. taxation of their worldwide income and assets. vi. conclusion congress should re-evaluate the approach it has taken to the u.s. taxation of expatriates and should reconsider other possibilities, including the mark-to-market approach it has repeatedly rejected. the current expatriation regime perpetuates the potential for tax avoidance, as expatriates are subject to the alternative u.s. tax system only for a period of ten years following expatriation and, thus, have the potential to avoid u.s. taxes by postponing the realization event triggering u.s. tax. the ten-year period of application also causes similarly situated expatriates to be taxed and, therefore, treated unequally, depending on whether the expatriate decides to sell her u.s. assets during the ten year period or whether she decides to hold on to the u.s. assets until the expiration of the ten year period. in addition, the current rules impose u.s. tax on gain that accrued after expatriation and, as a result, should not be subject to u.s. tax. 143. highway reauthorization and excise tax simplification act of 2005. h.r. 3, 109th cong. (2005). 2005 is the nation of immigrants punishing its emigrants 43 in fact, the present regime taxes gain that should be free from u.s. tax but allows gain that should be subject to u.s. tax to escape. the expatriation provisions also treat u.s. citizens and long-term u.s. resident aliens unequally, allowing some exceptions to u.s. citizens that cannot be extended to similarly situated long-term u.s. resident aliens. moreover, the expatriation provisions are out of step with international norms, in particular by taxing former u.s. citizens and long-term u.s. resident aliens as u.s. persons if they return to the u.s. for as little as thirty-one days a year. the mark-to-market approach would be preferable to the current system as it would terminate the potential for tax avoidance through expatriation, treat similarly situated expatriates equally, subject to u.s. tax the right amount of gain, reduce economic inefficiency, eliminate the need for separate estate and gift tax expatriation provisions, and it would be easier to administer. it would be a system that could actually work. leaving money on the table(s): * adjunct professor of accounting & taxation, university of hartford barney school of business; cpa; b.s., university of connecticut (1991); m.s.t., university of hartford (1996); j.d. with certificate in tax studies candidate, university of connecticut school of law (expected 2004). my sincere thanks to richard d. pomp, alva p. loiselle professor of law at the university of connecticut, for inspiring the topic and for his insightful comments on several earlier drafts of this article; avi brisman for his many helpful suggestions; and peter m. haberlandt for his persistent encouragement. with much appreciation, i dedicate this article to the brightest and most hard-working professionals i have ever collaborated with, my fellow members of the connecticut law review. without their generous support, this article would not have been possible. 345 florida tax review volume 6 2004 number 4 leaving money on the table(s): an examination of federal income tax policy towards indian tribes mark j. cowan* i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347 ii. current federal income taxation of indian tribes: avoid the issue and lose the revenue . . . . . . . . . . . . . . . 351 a. the ruling trinity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 1. revenue ruling 67-284 . . . . . . . . . . . . . . . . . . . . . . . 353 a. taxation of individual indians . . . . . . . . . . . 353 b. taxation of indian tribes . . . . . . . . . . . . . . . 355 2. revenue ruling 81-295 . . . . . . . . . . . . . . . . . . . . . . . 356 3. revenue ruling 94-16 . . . . . . . . . . . . . . . . . . . . . . . . 359 b. tribal provisions in the irc . . . . . . . . . . . . . . . . . . . . . . . . . . 361 1. section 7871: general provisions . . . . . . . . . . . . . . . 361 2. section 7871: application of the unrelated business income tax to tribes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364 3. provisions shutting down indian tax shelters . . . . . 367 c. summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368 iii. federal taxation of states . . . . . . . . . . . . . . . . . . . . . . . . . . . 368 a. implied constitutional immunity . . . . . . . . . . . . . . . . . . . . . . 370 b. section 115 and implied statutory immunity . . . . . . . . . . . . . 374 1. legislative history of section 115 . . . . . . . . . . . . . . . 374 2. the irs view of section 115: general counsel memorandum 14,407 and beyond . . . . . . . . . . . . . . . . . 375 346 florida tax review [vol.6:4 iv. ability of congress to tax the indian tribes . . . . . . . . . . . . 381 a. the regulation of indian gaming . . . . . . . . . . . . . . . . . . . . . 381 b. proposed income tax on gaming income . . . . . . . . . . . . . . . 383 v. should indian tribes be subject to the federal income tax? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388 a. indian tribes should be treated like governments – and taxed as such . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388 1. introduction: the classification issue . . . . . . . . . . . . 388 2. the states like gambling too . . . . . . . . . . . . . . . . . . 390 3. tribes are considered governments under federal indian policy . . . . . . . . . . . . . . . . . . . . . . . . . . 393 4. lessons from the indian governmental tax status act of 1982 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394 5. summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396 b. other concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396 1. the perception problem . . . . . . . . . . . . . . . . . . . . . . 396 2. measuring the revenue . . . . . . . . . . . . . . . . . . . . . . . 397 vi. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398 2004] leaving money on the table(s) 347 1. vine deloria, jr., quoted in jason kalish, note, do the states have an ace in the hole or should the indians call their bluff? tribes caught in the power struggle between the federal government and the states, 38 ariz. l. rev. 1345, 1345 (1996). 2. ronald reagan, remarks to state chairpersons of the national white house conference on small business, august 15, 1986, in ronald reagan: the wisdom and humor of the great communicator 60 (frederick j. ryan, jr. ed., 1995). 3. obviously, not all indian tribes have benefited from gaming operations. some tribes are located in remote areas where the operation of gaming facilities would not be feasible. see william c. canby, jr., american indian law 282 (3d ed. 1998). other tribes have decided not to engage in such gaming activities for moral reasons. id. for example, the navajo nation, which is based on the largest indian reservation in the united states (180,000 members living on 27,000 square miles in the southwest), has steadfastly refused to move into gaming out of fear of addiction and a lack of faith in their tribal government. steve schmidt, the tribe that won’t play, san diego uniontrib., oct. 20, 2002, at a1, lexis, news library, sdut file. the navajo also avoid gambling because, according to an ancient tribal legend, the tribe was once ruled by an evil “great gambler” who vowed to return someday to enslave the tribe. id. while certain tribes operate high profile casinos (foxwoods operated by the mashantucket pequot tribe in ledyard, connecticut and the mohegan sun casino – the largest casino in the world – operated by the mohegan tribe in nearby uncasville, connecticut), many tribes operate more modest gaming venues. see e.g., jerry useem, the big gamble, fortune, oct. 2, 2000, at 222, 226, 230 (describing, for example, the modest – but sorely needed – business generated by the spokane indian’s two rivers resort & casino in washington state). 4. nat’l indian gaming ass’n, indian gaming facts, at http://indiangaming.org/library/index.html (last visited june 26, 2003) (on file with the author). to put these numbers in perspective, there are currently 562 federally recognized tribes. id. therefore, approximately 35% of the tribes are engaged in gaming operations. see id. “when asked by an anthropologist what the indians called america before the white man came, an indian said simply, ‘ours’” 1 “[g]overnment’s view of the economy could be summed up in a few short phrases: if it moves, tax it. if it keeps moving, regulate it. and if it stops moving, subsidize it.” 2 i. introduction indian tribes are on the move. at least those that have opened casinos. following decades of abject poverty, the advent and rapid expansion of indian gaming has finally provided tribes with a viable economic development opportunity. approximately 201 tribes run 321 gaming facilities that employ3 over 300,000 people. in 2001, tribal gaming operations generated revenue of4 348 florida tax review [vol.6:4 5. id. this represents less than 10% of the total revenue generated by the gaming industry as a whole. id. for a somewhat dated, but more comprehensive report on indian gaming (including a listing of indian casinos), see u.s. general accounting office, report to the chairman, committee on ways and means, house of representatives, tax policy: a profile of the indian gaming industry, gao/ggd-9791 (1997). based on 1995 financial data, net income from indian gaming operations ran about 38% of gross revenue. id. at 3. assuming arguendo that this profit percentage was the same for 2001, the indian tribes in total would have generated approximately $4.8 billion in net income ($12.7 billion gross income x 38% estimated profit percentage). a detailed review of tribal financial data similar to that performed by the general accounting office in its 1997 report would need to be performed to confirm these numbers. profit percentages can obviously vary greatly by tribe. for example, the mohegan sun casino in uncasville, ct reported net income from continuing operations of $205.4 million on $786.6 million of revenues for the fiscal year ended september 30, 2001, or a 26% net profit margin. mohegan sun, 2001 annual report 48 (2002), available at http://www.mohegansun.com/about/pdf/moh_sun_ar_financial.pdf. 6. e.g., rev. rul. 67-284, 1967-2 c.b. 55, rev. rul. 81-295, 1981-2 c.b. 15; rev. rul. 94-16, 1994-1 c.b. 19. see discussion infra part ii.a. 7. see infra part ii.a. 8. the fact that congress closely regulated indian affairs and controlled tribal funds may have also been a practical factor behind the irs finding the tribes to fall outside the irc. the department of the interior, which is responsible for indian affairs, has also historically taken the position that tribes should not be subject to tax given their control by the federal government. m. maureen murphy, congressional research service memorandum: constitutionality of taxing gambling income of indian tribes, oct. 10, 1995, reprinted in kathleen m. niles, commentator says tax on tribal gaming would be unconstitutional, tax notes today, nov. 30, 1995, lexis, 95 tnt 233-40. for a rare example of a tribe that did have a significant amount of income prior to the advent of indian gaming see bob drogin, maine indians; poverty still grips newly rich tribes, l.a. times, sept. 3, 1985, at 1. the article describes how certain maine tribes were using some $81.5 million in land claim settlements to acquire timber $12.7 billion. this income goes untaxed at the tribal level since, for nearly5 forty years, the internal revenue service (“irs”) has taken the position that the income of indian tribes is not subject to federal income taxation. the irs rulings in this area provide little analysis or support for their6 conclusions. they appear to be based, however, on the theory that congress did not designate indian tribes as taxable entities in the internal revenue code (“irc”) and thus did not intend for them to be taxed. given the activities and7 financial status of indian tribes at the time of the earliest rulings, the issue of whether indian tribes could or should be subject to federal income taxation was unimportant. presumably there was simply not enough tax revenue at stake to warrant the irs spending time and resources attempting to interpret an ambiguous irc in light of the vast body of statutes, treaties, case law, and constitutional issues dealing with indian law. today, however, with the income8 2004] leaving money on the table(s) 349 and blueberry barrens, radio stations, a cement factory, and other commercial ventures – which the tribes were able to operate free of federal income tax. 9. see infra part iv. 10. much of the commentary surrounding indian taxation in general tends to dispose of the federal taxation of tribes in a couple of brief paragraphs—basically concluding, “tribes are not taxed” – before quickly moving on to other, more heavily litigated subjects of the day. see, e.g., russel lawrence barsh, issues in federal, state, and tribal taxation of reservation wealth: a survey and economic critique, 54 wash. l. rev. 531, 553-54 (1979) (providing only two out of fifty-three pages of analysis on the federal taxation of tribes); jose j. monsivais, the return of the white buffalo: taxation issues facing american indian tribes conducting gambling enterprises on tribal lands, 20 am. indian l. rev. 399, 401-02 (1995-1996) (providing two paragraphs on the subject before presenting a comprehensive review of individual indian, federal excise tax, and state tax issues); scott a. taylor, an introduction and overview of taxation and indian gaming, 29 ariz. st. l.j. 251, 252-53 (1997) (providing two paragraphs on the federal taxation of tribes as part of a survey of tax issues in indian country). only one commentator has provided a detailed analysis of the question of whether the indian tribes could be subjected to federal income tax, concluding that congress has the power to do so. stephanie dean, getting a piece of the action: should the federal government be able to tax native american gambling revenue?, 32 colum. j.l. & soc. probs. 157, 159 (1999). see discussion infra part iv. dean’s article also briefly suggests a few reasons as to why indian tribes should be subject to income tax. id. at 178-85; see also discussion infra part v. dean’s piece does not, however, address federal tax policy issues and indian policy issues. this article probes the federal taxation of indian tribes for the first time in detail, in light of increased tribal commercial activity. furthermore, this article explores the tax and indian policy arguments for and against extending the federal income tax to the indian tribes. specifically, this article for the first time comprehensively compares the tax treatment of tribes to that of states. 11. see infra part iv. provided by indian gaming and the rapid expansion of tribal economic activities, the issue of whether indian tribes could or should be taxed merits more attention. much to the chagrin of the indian tribes, congress has been eyeing indian gaming as a potential source of revenue. on two occasions in the past several years, congress has proposed subjecting the tribes to federal income tax on their gaming earnings. these proposals, and the continued expansion of9 indian gaming, call for a critical look at federal tax policy as it applies to indian tribes.10 this article addresses whether indian tribes should be subject to federal income taxation from both a tax policy and indian policy perspective. underlying the debate over whether the tribes should be taxed is the tribe’s unique relationship to the federal government. congress’s power over the indian tribes is plenary and there is no provision in the constitution reserving certain powers to the tribes.11 350 florida tax review [vol.6:4 12. see infra part iv. 13. see, e.g., rev. rul. 81-295, 1981-2 c.b. 15. 14. for example, states, unlike tribes, enjoy a level of constitutional immunity from federal taxation that the tribes do not. also, states have certain protections through the political process, such as representation in congress, that tribes do not. these limit to some extent the ability of the federal government to tax the states. see infra part iii.a. because there are no constitutional constraints to prevent congress from taxing indian tribes, the decision of whether to tax the tribes primarily12 involves fundamental concerns of fairness and equity. a tribe simultaneously acts as a sovereign government and a business entity. whether the current tax13 treatment of tribes is appropriate from a tax policy perspective depends on which of these roles one views as controlling. viewing a tribe as a business entity and comparing it to other similar business entities that are subject to the federal income tax raises policy concerns (for example, the tax system’s impact on fair competition). no such concerns are present, however, when viewing a tribe as a government and comparing it to another subfederal government – i.e., a state – which can, free of federal taxation, operate proprietary business activities in addition to operating a government. of course, even here we are still left with the issue of whether it is appropriate for subfederal governments in general (both states and tribes) to have tax exemptions while private businesses do not. in order to properly understand and analyze this issue, part ii reviews in detail what little the irs and congress have said about the taxation of indian tribes. since some of the current and proposed tax rules regarding tribes are based on the federal tax treatment of non-profit, tax-exempt organizations (such as charities), part ii also provides a primer on the federal tax treatment of these entities. non-profit organizations are generally exempt from tax, but may be subject to federal income taxes on their earnings from commercial ventures that are unrelated to their non-profit mission. part iii summarizes the complex and often perplexing topic of the federal taxation of the states. states, like tribes, are subfederal governments that escape taxation even as they increasingly engage in such traditional private sector activities as running liquor stores, convention centers, insurance pools, and, of course, gambling in the form of state lotteries. even though tribes and states are treated differently under the constitution, the federal tax policy14 towards the states provides at least some concepts that should be applicable to the federal taxation of tribes. as will be seen, the treatment of states is plagued by fundamental consistency problems. specifically, states escape taxation on their commercial ventures even though non-profit, tax-exempt organizations are taxed on such ventures. with this as background, part iv briefly analyzes whether indian tribes could be subjected to federal income tax. to facilitate this analysis, this part examines a 1995 congressional proposal to tax tribal gaming income and the 2004] leaving money on the table(s) 351 15. 25 u.s.c. §§ 2701-2721 (2000). 16. while indian tribes are considered “sovereign,” such sovereignty exists at the pleasure of congress, and congress can and has interfered with tribal sovereignty on numerous occasions. see infra part iv. 17. this exception relates to the taxation of certain income earned by tribal colleges. see infra part ii.b.2. 18. for example, see the discussion on non-profit entities desiring tax-exempt status infra at part ii.b.2. see also the discussion on the complexity and confusion surrounding the federal tax treatment of states and state-owned entities infra at part iii. reaction to this proposal by the indian tribes. part iv also provides an overview of the regulation of indian gaming, as embodied in the indian gaming regulatory act (“igra”), which is necessary in order to understand the 199515 proposed tax. while indian tribes posit that there are constitutional constraints which prevent congress from subjecting them to tax, it is clear that congress has plenary power over the indian tribes and is free to pass legislation taxing the indian tribes. 16 while it is clear that congress could tax the tribes, the more important question is whether it is prudent to do so from a tax or indian policy perspective. part v analyzes in detail whether tribes should be subject to federal income tax based on principles of tax policy and current federal indian policy. while there are appealing arguments in favor of taxing the tribes, doing so would put tribes and states on different footings from a tax standpoint. this raises concerns of horizontal equity by treating similarly situated entities in dissimilar ways. in fact, a tribal tax would have the effect of adding more inconsistency to a taxing regime already plagued by horizontal equity problems – namely the inconsistent treatment of state commercial ventures (not taxed) and non-profit commercial ventures (generally subject to tax). it would also frustrate long-standing federal indian policy favoring the economic independence and sovereignty of the tribes and end congress’s recent movement towards treating indian tribes as states for many purposes of the tax code. ii. current federal income taxation of indian tribes: avoid the issue and lose the revenue perhaps the most exciting thing about the current federal income taxation of indian tribes is the simplicity: tribes, with one very narrow exception, are not subject to federal income taxation – regardless of the nature17 or location of their activities. this simple conclusion is rare in fields so complex and baffling as tax law, let alone indian law. virtually every other entity that desires tax-exempt status has to navigate through a complex thicket of tax provisions in order to ensure exemption. in contrast, a tribe must satisfy only18 one requirement to escape tax – the federal government (not merely a state 352 florida tax review [vol.6:4 19. rev. rul. 94-16, 1994-1 c.b. 19. the recognition process can be long, complicated, and unpredictable. see, e.g., canby, supra note, 3 at 3-7; rick green & william weir, a single tribe, hartford courant, june 25, 2002, at a1 (reporting the federal recognition of two historically separate tribes as one integrated tribe). once a tribe is recognized, however, it is beyond the reach of the federal income tax provisions of the irc and thus is automatically exempt from the federal income tax. rev. rul. 9416, 1994-1 c.b. 19. the discussion in this article deals only with tribes that have been formally recognized by the federal government. 20. “a ‘revenue ruling’ is an official interpretation by the service which has been published in the internal revenue bulletin.” reg. § 601.201(a)(6) (1967). 21. irc § 1. all section references in this article are to the internal revenue code (title 26 of the u.s. code) unless otherwise indicated. 22. irc § 11. 23. irc § 7701(a)(3). the regulations elaborate a bit more, stating that a corporation includes a business entity incorporated under state, federal, or tribal law. regs. § 301.7701-2(b). 24. while there is no formal definition of the term “association” in the irc, it generally refers to a group of persons operating as a corporation, but which has not been formally incorporated. see hecht v. malley, 265 u.s. 144, 157 (1924) (defining an association as “a body of persons united without a charter, but upon the methods and forms used by incorporated bodies for the prosecution of some common enterprise”). 25. the irc does provide a separate definition for indian tribal governments: “[t]he governing body of any tribe, band, community, village, or group of indians, or (if applicable) alaska natives, which is determined by the secretary [of the treasury], after consultation with the secretary of the interior, to exercise governmental functions.” irc § 7701(a)(40)(a). this definition, however, is of no help in determining whether indian tribes could be considered taxable associations under the irc. section 7701(a)(40) was not added to the irc until 1982, as part of the indian tribal government) must formally recognize it. while the tax-free status of indian19 tribes is clear enough, the rationale and analysis behind it is far from obvious. this part reviews three of the major revenue rulings in which the irs has20 found tribes to be non-taxable, speculates as to the rationale behind the rulings, and explores areas of the irc in which congress has directly addressed the treatment of indian tribes. a. the ruling trinity the irs has issued three major rulings on the income tax status of tribes, which are analyzed in detail below. first, however, it is important to understand the general structure of the irc. section 1 imposes an income tax on single and married individuals and on estates and trusts. section 11 imposes21 an income tax on “every corporation.” the definition of a corporation22 “includes associations, joint-stock companies, and insurance companies.” one23 could argue that tribes are considered “associations” and thus taxable as corporations under section 11. as the rulings discussed below show, however,24 the irs has never read the irc in this manner.25 2004] leaving money on the table(s) 353 governmental tax status act. see pub. l. no. 97-473, § 202, 96 stat. 2605, 2611, reprinted in 1982 u.s.c.c.a.n. the main provisions of the indian tribal governmental tax status act of 1982 are codified in irc § 7871. section 7871 provides that indian tribal governments are to be treated as states under the irc for certain enumerated purposes. the definition of indian tribal governments provided under § 7701(a)(40) thus exists primarily to determine which groups of indians will qualify for treatment as states for certain purposes under § 7871. a detailed discussion of § 7871 is provided at infra part ii.b. a review of the legislative history behind § 7871 is provided at infra part v.a.4. 26. rev. rul. 67-284, 1967-2 c.b. 55. 27. irc § 61(a). 28. normally, a specific fact pattern is set forth because a revenue ruling is supposed to “be directly responsive to and limited in scope by the pivotal facts stated in the revenue ruling.” regs. § 601.601(d)(2)(v)(a). fact patterns in revenue rulings usually are taken from such sources as taxpayer suggestions, irs technical advice, or court decisions. id. 29. rev. rul. 67-284, 1967-2 c.b. 55. 30. the belief that individual indians are exempt from the federal income tax stokes a backlash against indian gaming in general. see national indian gaming a s s o c i a t i o n , t r i b a l g a m i n g m y t h s a n d f a c t s a t http://indiangaming.org/info/pr/myths.shtml (last visited june 26, 2003) (on file with the author) (listing the belief that indians pay no taxes as one of the great “myths” of indian gaming); jerry useem, the big gamble, fortune, oct. 2, 2000, at 222, 230 (quoting the manager of a fledgling spokane indian casino in washington: “there’s a perception that indians are getting rich off the casinos; [t]hey feel like we don’t pay taxes, we can have casinos, and we get checks from the government.”). the fact that individual indians pay federal income tax becomes important in analyzing whether gaming income should be taxed at the tribal level. see discussion infra part v. for further reading on the taxation of individual indians, see rev. rul. 67-284, 1967-2 c.b. 55; see also monsivais, supra note 9, at 403-07. 1. revenue ruling 67-284 – revenue ruling 67-284 was issued under26 section 61, which defines gross income broadly as “income from whatever source derived . . . .” this ruling was unusual in that it was based on a general27 question rather than a specific set of facts. the ruling simply stated that the28 irs had been asked “to set forth the general principles applicable to the federal income tax treatment of income paid to or on behalf of enrolled members of indian tribes.” the ruling dealt both with the taxation of individual indians and29 with indian tribes. a. taxation of individual indians most of revenue ruling 67-284 addressed the tax treatment of individual indians. while a detailed review of the taxation of individual indians is beyond the scope of this article, a summary is provided here to dispel the widely held belief that indians do not pay any income tax. the supreme court30 in 1956 made the general tax status of indians clear: “we agree with the 354 florida tax review [vol.6:4 31. squire v. capoeman, 351 u.s. 1, 6 (1956). 32. rev. rul. 67-284, 1967-2 c.b. 55. 33. 351 u.s. at 8. in capoeman, an indian couple claimed they were exempt from federal tax on profits from the sale of timber on land that was held in trust for them by the federal government. id. at 4-5. after noting that indians are generally subject to the federal income tax, the court found that the timber sale income was tax-exempt under the gaa. id. at 10. 34. 25 u.s.c. § 348 (2000). 35. rev. rul. 67-284, 1967-2 c.b. 55. 36. 25 u.s.c. § 349 (2000). 37. capoeman, 351 u.s. at 8. 38. the irs lays out the following five part test to determine whether income is exempt under the gaa: (1) the land in question is held in trust by the united states government; (2) such land is restricted and allotted and is held for an individual noncompetent indian, and not for a tribe; (3) the income is ‘derived directly’ from the land; (4) the statute, treaty or other authority involved evinces congressional intent that the allotment be used as a means of protecting the indian until such time as he becomes competent; and (5) the authority in question contains language indicating clear congressional intent that the land, until conveyed in fee simple to the allottee, is not to be subject to taxation. rev. rul. 67-284, 1967-2 c.b. 55. the income will be taxable if any one of the five tests is not met. id. the interpretive issues mainly arise over whether the income at issue is “derived directly” from the allotted land. for a summary of the problems in this area, see monsivais, supra note 10, at 403-07. at least one issue here has been resolved: the income earned from the reinvestment (outside of the allotted land itself) government that indians are citizens and that in ordinary affairs of life, not governed by treaties or remedial legislation, they are subject to the payment of income taxes as are other citizens.” this general rule that individual indians31 are subject to federal income taxation is subject to a couple of exceptions. first, income derived by an indian directly from allotted lands held in trust by the federal government is not subject to the federal income tax. this was based on32 the supreme court’s interpretation of the general allotment act (“gaa”) in squire v. capoeman. the gaa, passed in 1887 and reflecting prevailing33 federal indian policy at that time, provided that certain tribal lands were to be allotted to individual indians but were to be held in trust by the federal government for a period of years. the purpose in doing so was to “protect the34 indians’ interest and to prepare the indians to take their place as independent qualified members of the modern body politic.” at the end of the trust period,35 the government was to grant a patent in fee simple to the individual indian allottees, at which time “restrictions as to sale, incumbrance, or taxation” would be removed. the supreme court read this language as manifesting a36 congressional intent to exempt income derived directly from these trust lands until the allottee received the land in fee simple. while this appears to be a37 straightforward exemption, numerous interpretive problems have arisen.38 2004] leaving money on the table(s) 355 of income exempt under the five-part test remains taxable. rev. rul. 67-284, 1967-2 c.b. 55. 39. rev. rul. 67-284, 1967-2 c.b. 55. 40. irc § 7873. this is the only special income tax exemption for individual indians that is actually included in the irc. other targeted exemptions for members of enumerated tribes for narrow types of income (such as judgments received for claims against the federal government) are included in title 25 of the u.s. code. e.g., 25 u.s.c. § 589 (2000) (exempting certain payments made to members of the shoshone tribe out of a judgment settlement fund). these exemptions are numerous, but very narrow and are well beyond the scope of this article. for a summary of the tribes affected by these miscellaneous exemptions, see james edward maule, gross income: overview and conceptual aspects, a-193-96 (bna 501-2d 2001). 41. irc § 7873. 42. e.g., erik m. jensen, american indian law meets the internal revenue code: warbus v. commissioner, 74 n.d. l. rev. 691 (1998) (taking issue with the tax court’s ruling in warbus v. commissioner, 110 t.c. 279 (1998) that § 7873 does not cover cancellation of debt income realized by an indian on the foreclosure of his fishing boat). 43. rev. rul. 67-284, 1967-2 c.b. 55. 44. congress and the irs may not be the only ones ignoring the issue: “an odd thing occurs in the minds of americans when indian civilization is mentioned: little or n o t h i n g . ” c r e a t i v e q u o t a t i o n s f r o m p a u l a g u n n a l l e n , a t http://www.creativequotations.com/one/1079.htm (last visited june 26, 2003). second, indians are exempt from federal income taxes where such treatment is provided by statute or treaty. revenue ruling 67-284 did not39 elaborate further on these exemptions, but one example is section 7873. this40 provision exempts income derived by an indian from fishing rights that have been recognized under a treaty. this too seems like a straightforward41 exemption, but its narrow interpretation by the courts has been subject to criticism. 42 thus, an indian is taxed like any other individual under section 1. only if the income at issue was earned from allotted lands or from some special activity protected by a treaty or a statute will the tax treatment of individual indians deviate from the norm. b. taxation of indian tribes after dealing with the taxation of individual indians, revenue ruling 67-284 only summarily addressed the taxation of tribes in part v: “income tax statutes do not tax indian tribes. the tribe is not a taxable entity.” no analysis43 was provided to support this conclusion. one can speculate that the irs was unwilling to say that a tribe was taxable in the absence of a clear statement by congress to that effect. in the irs’s view, the irc does not contain any provisions taxing indian tribes. this44 was not actually articulated in revenue ruling 67-284 or in the rulings 356 florida tax review [vol.6:4 45. e.g., internal revenue service guide to indian taxation issues (draft) (1993), reprinted in tax notes today, mar. 3, 1994, lexis, 94 tnt 42-19. other governmental agencies have used the same analysis. e.g., u.s. general accounting office, supra note 5, at 24 (citing senate committee reports for this same proposition). 46. this irs developed rationale—that states fall outside the provisions of the irc—exists despite the presence of irc § 115, which appears to directly address the taxation of states. see the discussion on this issue in part iii, infra. 47. rev. rul. 81-295, 1981-2 c.b. 15. 48. see supra note 28. 49. rev. rul. 81-295, 1981-2 c.b. 15. the ira is codified at 25 u.s.c. § § 461-479 (2000). 50. rev. rul. 81-295, 1981-2 c.b. 15. 51. id. for some unknown reason, the ruling did not cite rev. rul. 67-284, which was directly on point. one explanation may be that, as noted in supra part ii.a.1., rev. rul. 67-284 only provided the conclusion that tribes are not taxable without any analysis. instead, rev. rul. 81-295 cites as support mescalero apache tribe v. jones, 411 u.s. 145 (1973), holding that new mexico may assess sales tax on a tribal ski lift located outside of the tribe’s reservation. while this was a state sales tax case, the court did state that the constitution itself did not automatically prevent the state from taxing reviewed below. in other, unofficial documents, however, the irs has stated its position that a tribe is neither an individual taxable under section 1, nor an association or corporation taxable under section 11. thus, tribes, in the irs’s45 view, fall outside the scope of the federal income tax provisions of the irc. as this article will describe in part iii, this same rationale also applies to exempt states from taxation.46 2. revenue ruling 81-295 – revenue ruling 81-295 dealt with the tax treatment of a federally chartered indian corporation. unlike revenue ruling47 67-284, revenue ruling 81-295 was based on a specific set of facts. a tribe48 established a corporation to further its economic development activities as allowed under section 17 of the indian reorganization act of 1934 (“ira”).49 the stock of the tribal corporation was to be owned by all present and future members of the tribe and was not transferable. the corporation was charged with, inter alia, managing the leasing and other uses of tribal lands, granting loans for housing and farming, promoting tourism activities including an annual fair and rodeo, and the operation of a catfish hatchery. 50 the ruling first reiterated that the tribes themselves are not subject to federal taxation: no constitutional or statutory provision expressly exempts indian tribes from federal income taxation. generally, however, the political entity embodied in the concept of an indian tribe has been recognized and no tax liability has been asserted against a tribe with respect to tribal income carried on within the boundaries of the reservation. 51 2004] leaving money on the table(s) 357 the tribe. mescalero, 411 u.s. at 150. rather it was up to congress to determine the extent to which the states could tax the indian tribes. id. the irs has apparently extracted from this case the idea that if congress could allow the states to tax the tribes, certainly congress could impose a federal tax on the tribes that would be constitutional. see discussion infra part iv. a detailed review of the complexities of the state taxation of indian tribes is beyond the scope of this article. 52. see mescalero, 411 u.s. at 150 (indicating the tribes enjoy no constitutional protection from taxation). see also the discussion at infra part iv. 53. rev. rul. 81-295, 1981-2 c.b. 15. 54. id. the ruling quoted mescalero for the proposition that “the question of tax immunity cannot be made to turn on the particular form in which the tribe chooses to conduct its business.” mescalero , 411 u.s. at 157 n. 13. again, this was meant to refer to state taxes, but the irs used the concept in ruling on a federal tax matter. 55. see supra note 51. 56. this is the same issue that arises in the federal income taxation of states. see infra part iii for a discussion of whether states can be subject to federal income tax, even though they are “political entities,” on their non-governmental commercial activities. as discussed in infra part iii, states generally can be subject to income tax on their commercial activities, but with one exception the irc has been interpreted as not imposing an income tax on any activities of the states. this seems to imply that tribes could be viewed as taxable under the irc, but that in practice they are not taxed under some sort of an intergovernmental immunity doctrine. this immunity must be administrative, rather than constitutional. thus, the conclusion remains the same as in52 revenue ruling 67-284, but some additional analysis is added which only serves to create more confusion in this already ambiguous area. the ruling then stated that the federally chartered tribal corporation would be treated the same as the tribe and therefore not subject to federal income taxation with respect to activities conducted on the tribe’s reservation.53 the ruling based its reasoning on the fact that the tribe could conduct the commercial activities listed directly and escape taxation. the mere fact that the businesses were now being run in corporate solution should make no difference from a tax perspective. 54 by resting its conclusion on the fact that the tribal corporations are exempt because they would have been exempt outside of the corporate solution, the irs seems to have contradicted its earlier statement that the tribes are not subject to federal income tax because of the “political entity” embodied in the tribe. it would seem that running a fish hatchery and a rodeo would not be55 considered part of the tribe’s political duties, but rather proprietary/commercial enterprises. if tribes are not automatically tax exempt but are not taxed because they are political entities, it would seem that they could be taxed on their nongovernmental commercial ventures. given the facts before it, the irs seemed56 to have a clear opportunity to draw a line between proprietary and nonproprietary activities, but declined to do so. instead, the irs took the position 358 florida tax review [vol.6:4 57. yet outside the realm of indian tribes, incorporation does in fact carry with it serious tax consequences. an individual who operates a sole proprietorship, for example, will be the taxed on the business profits under irc § 1. if the individual incorporates the business (e.g., to limit liability or as a prelude to an initial public offering), she will be subject to two layers of tax – the new corporation will pay tax under irc § 11 and the individual stockholder will then pay tax on any dividends received from the corporation under irc § 1. the irs will not waive these rules simply because “nothing has changed.” of course, the individual operating the sole proprietorship in this example, unlike the indian tribe in rev. rul. 81-295, was at least subject to tax to begin with. this example does show, however, that the irs does not, absent abuse, generally disregard the form in which a business is conducted when assessing taxes – yet it did just that in rev. rul. 81-295. 58. see rev. rul. 81-295, 1981-2 c.b. 15. the ruling cites maryland cas. co. v. citizens nat’l bank of w. hollywood, 361 f.2d 517 (5th cir. 1966); parker drilling co. v. metlakatla indian cmty., 451 f. supp. 1127 (d. alaska 1978). unfortunately, the issue of sovereign immunity is not as straightforward as the irs believes. see canby, supra note 3, at 87-95. 59. rev. rul. 81-295, 1981-2 c.b. 15 (quoting s. rep. no. 1080, 73rd cong., 2d sess. 1 (1934)). 60. in addition, another purpose of the ira was to allow for more tribal selfgovernment, albeit under the close supervision and approval of the department of the interior. canby, supra note 3, at 23-25. that nothing has changed by the incorporation and therefore the tax answer should not change either.57 the irs also relied on a couple of federal court cases which held that the incorporation of certain tribal activities under the ira did not constitute a waiver of the tribe’s sovereign immunity with respect to those activities. since58 the incorporation did not change the sovereign immunity status, the irs felt that the tax status of those activities did not change either. the irs’s refusal to bifurcate the commercial from the governmental activities of the tribe may be attributed to the cost and difficulty of doing so in relation to the amount of revenue that would be generated. it is doubtful that many of the activities of the tribal corporation listed in the ruling would generate much taxable income. the ruling can also be understood in light of the purposes of the ira. in that legislation, congress made it clear that the purpose was to “permit indian tribes to equip themselves with the devices of a modern business organization, through forming themselves into business corporations,” thus fostering the59 economic well being of the tribes. taxation of what had not been taxed when outside the corporate solution would defeat the purpose of the legislation by making it less lucrative for the tribes to engage in commercial activities. if the tribal corporations were subject to tax, tribes would simply not incorporate – rendering section 17 of the ira ineffective. in this light, the irs’s stance is more defensible. 60 2004] leaving money on the table(s) 359 61. see rev. rul. 67-284, 1967-2 c.b. 55. 62. see helvering v. winmill, 305 u.s. 79, 83 (1938) (stating that “treasury regulations and interpretations long continued without substantial change, applying to unamended or substantially reenacted statutes, are deemed to have received congressional approval and have the effect of law”). certain provisions of the ira, which are beyond the scope of this article, deal with exemptions from state taxation. nothing in the ira itself directly addresses issues of federal taxation. in fact, see united states v. anderson, 625 f.2d 910, 915 (9th cir. 1980), which held that the provisions of the ira did not give rise to a federal tax exemption for individual indians. 63. see, for example, the data provided in supra note 5. 64. rev. rul. 94-16, 1994-1 c.b. 19. of course, the irs could have also held tribes taxable on their commercial activities whether in corporate solution or not. this would have put corporate and non-corporate tribal activities on equal footing from a tax standpoint and thus would not contravene the policy of the ira. such a move, however, would have overturned implicit irs policy in place since the birth of the income tax and explicit irs policy in place since at least since 1967. thus,61 it would be troublesome for the irs to go back and draw the line between commercial and governmental activities after so many years of administrative practice without congressional action. also, since the irs has never asserted taxation against the tribes, it would seem that congress would have been aware of this when it passed the ira and thus assumed that tribes would not be taxed whether or not in corporate solution. 62 given all these potential problems and the limited revenue at stake, it is understandable that the irs would simply decline to change its simple, but largely unexplained position that tribes and tribal corporations are not subject to the federal income tax. of course, now that a number of tribes are making substantial sums of money from their gaming operations, the irs decision to63 avoid the issue is perhaps resulting in a much more substantial amount of lost revenue. 3. revenue ruling 94-16 – revenue ruling 94-16 summarized the taxation of tribes in slightly more detail and expressly stated that tribal activities both on and off the reservation are considered non-taxable. therefore, the tax64 exemption follows the tax treatment of the tribe – and is not based on the specific activities (governmental or commercial) engaged in by the tribe. the ruling cited revenue ruling 67-284 and stated that tribes are not taxable on any commercial activities conducted on or off the reservation. the ruling then cited revenue ruling 81-295 for the proposition that federally chartered tribal corporations share the same tax status as tribes and therefore are not subject to federal income taxation regardless of the location (on or off the reservation) of their activities. finally, the ruling stated, without analysis, that state chartered tribal corporations are subject to federal income taxation: “a corporation organized by an indian tribe under state law does not share the same tax status 360 florida tax review [vol.6:4 65. id. 66. see, e.g., roberta romano, the state competition debate in corporate law, 8 cardozo l. rev. 709, 709 (1987) (describing delaware as “the most successful state in the market for corporate charters”). 67. 25 u.s.c. § 477 (2000). 68. it could be that the irs decided to rule so as to put it in a position of having the least amount of explaining to do. it could have found federally chartered tribal corporations non-taxable to avoid offending the ira and it could have found state chartered tribal corporations taxable to avoid offending traditional notions of what constitutes a taxable corporation. another possible theory is that the irs read the ira as allowing the secretary of the interior to limit the powers of the corporation being created – a potential safeguard that may or may not exist in the creation of statechartered corporations. see id. whatever the answer, it does seem the irs worried about the implications of its finding that state tribal corporations were subject to tax: it chose to apply the provision of rev. rul. 94-16 that subjects state-chartered tribal corporations to taxation prospectively. rev. rul. 94-16, 1994-1 c.b. 19. only income earned from on-reservation activities was given prospective treatment. id. the irs has the authority to decide which rulings it will apply prospectively and which it will apply retroactively. irc § 7805(b)(8). the use of this authority here presumably allowed tribes operating on-reservation activities through state-chartered corporations to avoid tax by reincorporating under the ira. the irs may have chosen prospective treatment out of fairness (the law was unclear up until that point) or out of a desire to avoid negative reaction to the ruling by tribes operating through state chartered corporations. it is unclear why the prospective treatment was limited to on-reservation activities of statechartered corporations. one explanation may be that rev. rul. 81-295 only addressed exemptions for on-reservation activities (although it did not address the tax status of tribal activities conducted through state chartered corporations) – thus the case for protecting a reliance interest is somewhat weaker for off-reservation activities than for on-reservation activities. as the tribe for federal income tax purposes and is subject to federal income tax on any income earned, regardless of the location of the business activities that produced the income.” thus the irs established an “all or nothing” approach65 based on the corporate status of the tribal entity rather than the nature of its activities. there is no analysis as to why a state tribal corporation was singled out for taxation. it could be that a state chartered corporation is so obviously taxable under section 11 that it would be difficult to justify creating an exemption for state corporations that happen to be owned by tribes. after all, the classic taxable corporation is an entity incorporated under state law, usually delaware. 66 while it is hard to justify disparate treatment for state and federally chartered corporations, there is at least one plausible explanation. the ira authorized the creation of federally chartered, federally approved corporations.67 it did not speak of state chartered entities. it could be that irs felt constrained by the ira from finding federally chartered corporations taxable. it confronted no such constraints when it came to ruling on state chartered corporations. 68 2004] leaving money on the table(s) 361 69. rev. rul. 67-284, 1967-2 c.b. 55. 70. rev. rul. 81-295, 1981-2 c.b. 15. 71. rev. rul. 94-16, 1994-1 c.b. 19. 72. irc § 7871. popularly known as the indian tribal governmental tax status act of 1982. the definition of an indian tribal government is provided in irc § 7701(a)(40). this definition requires that the tribe exercise governmental functions. see supra note 25. the irs periodically publishes a list of tribes that exercise governmental functions and thus qualify for treatment as tribal governments under irc § 7701(a)(40) (and thus reap the benefits of § 7871). e.g., rev. proc. 2001-15, 2001-1 c.b 465. tribes that are unsure of their status may apply for a ruling from the irs. regs. § 305.77011(a) (1984). 73. irc § 7871(a)(5). revenue rulings 67-284, 81-295, and 94-16, taken together, shed69 70 71 little light on why tribes are exempt from the federal income tax. they reflect reluctance on the part of the irs to interpret the irc as taxing any activities of indian tribes or their federally chartered corporations. there was just no need to deal with such ambiguous and politically controversial issues when the revenue at stake was minimal. at least the conclusion seems clear today – indian tribes fall outside the scope of the federal income tax provisions of the irc. b. tribal provisions in the irc since indian tribes are considered to fall outside of the basic income tax provisions of the irc, it is important to note where they are in fact mentioned explicitly. the most important place is section 7871, which treats indian tribal governments as states for certain purposes of the irc. part ii.b.1 reviews the72 general provisions of this section and how it works. part ii.b.2 then reviews the provision of section 7871 that subjects federal indian tribes to tax on certain activities with respect to tribal colleges. in order to understand this provision73 – which is the only part of the irc that specifically subjects tribes to the federal corporate income tax – it is first necessary to explain the basics of the taxation of tax-exempt organizations. finally, part ii.b.3 provides an introduction to recent regulations that have sought to foreclose the use of indian tribes as parties to abusive tax shelters. 1. section 7871: general provisions – before reviewing the details of section 7871, it is important to understand what it does not do. the presence of section 7871 makes it clear that a tribe will not automatically be treated as a state under the irc except for the purposes actually enumerated in section 7871. while section 7871 puts tribes and states on equal footing for most purposes, it is silent regarding the application of the federal income tax to income earned by tribes. states, as will be seen, are exempt from tax under separate irs rulings (which in part interpret section 115 of the irc) that go 362 florida tax review [vol.6:4 74. as will be seen, the rulings on states employ a similar rationale to the rulings on tribes in that the irs views states as falling outside the scope of the federal income tax. the exemption for states, however, was developed in separate rulings against a backdrop of unique constitutional limitations and an ambiguous provision in the irc (§115) that are not germane to an analysis of tribal tax issues. see discussion infra at part iii. 75. the legislative history to § 7871, however, did acknowledge that both states and tribes were generally exempt from the federal income tax – albeit under different authorities – prior to the enactment of § 7871 and stated that § 7871 did nothing to alter the tax exempt status of indian tribes under existing authority (i.e., rev. rul. 67-284). s. rep. no. 97-646, at 8, 12 (1982), reprinted in 1982 u.s.c.c.a.n. 4580, 4586, 4590. for further discussion see infra part v.a.4. 76. see supra part ii.a.1-3. 77. despite this, irc § 7871 is occasionally cited as the source of the tax-free status of tribes. e.g., ann mccullogh, indian tribal taxation: a cornerstone of sovereignty, in native american sovereignty 179, 185 (john r. wunder ed., 1996) (stating that “[t]he special significance of [irc § 7871] was not simply that it gave indian tribes exemption from federal taxation, but that it did so in a very broad manner”); monsivais, supra note 10, at 401 (citing § 7871 as the provision exempting the income of indian tribes from taxation). these references to irc § 7871 as the fountain of exemption for indian tribes shows the confusion that is rampant regarding the authority for not taxing indian tribes. if irc § 7871, which entered the irc in 1982, were dispositive of the taxation of tribes, the irs in rev. rul. 94-16 would have referred to it. the irs, quite properly, did not. it is also clear from the legislative history that § 7871 was not intended to address the federal income taxation of indian tribes: “the bill does not amend the present income tax treatment of indian tribal governments specified in rev. rul. 67-284 . . . .” s. rep. no. 97-646, at 12 (1982), reprinted in 1982 u.s.c.c.a.n. 4580, 4590. the legislative history is reviewed in further detail in infra part v.a.4. back to 1935. section 7871 does not say that a tribe is treated like a state for74 purposes of the federal income tax in general – i.e., section 7871 does not apply the exemption from federal income taxation enjoyed by states to tribes. section 7871 therefore does not address, and is not the source of, the exemption from federal income taxes enjoyed by indian tribes. rather, tribes and federally75 chartered tribal corporations are protected from taxation by the rulings cited above. as will be seen, the exemptions for tribes and states are quite similar,76 but they did not spring from the same rulings and they certainly did not result merely from the enactment of section 7871.77 2004] leaving money on the table(s) 363 78. subdivisions of tribes will also be treated like subdivisions of states for purposes of irc § 7871, but only if the subdivision exercises “substantial governmental functions of the indian tribal government.” irc § 7871(d). the irs initially released a list of tribal subdivisions that qualify as subdivisions of states for purposes of irc § 7871. rev. proc. 84-36, 1984-1, c.b. 510. tribal subdivisions include such entities as local governing councils or districts, housing authorities, and water and sewage committees. id. a tribal subdivision not on the original list may file a request for a private letter ruling to determine whether it will qualify for the benefits of irc § 7871. rev. proc. 84-37, 1984-1 c.b. 513. in seeking a ruling, the subdivision must show that it has been delegated at least one of the three major sovereign powers of the tribe: the power to tax, the power of eminent domain, or the police power. id. this would indicate that an entity such as federally chartered tribal corporation engaged only in commercial activities (and which has not been delegated any sovereign powers) would not be considered a subdivision of a tribe and thus would be excluded from the provisions of § 7871. this is in spite of the fact that such entities have been granted the same general exemption from federal income taxes enjoyed by tribes under rev. rul. 81-295, 1981-2 c.b. 15. 79. irc § 7871(a)(1). 80. irc § 7871(a)(3). 81. irc § 7871(a)(6). 82. irc § 7871(a)(4), (c). 83. while there is no explicit essential governmental function requirement that applies to states in this area, tax-exemption for obligations issued by both tribes and states is limited by the private activity bond rules in irc § 141. a discussion of these provisions is beyond the scope of this article. 84. irc § 7871(a)(2), (b). while section 7871 is not the source of exemption, it does treat tribes78 as states for several purposes. for example, charitable gifts to tribes are deductible for income and estate tax purposes; taxes paid to tribes are79 deductible like state taxes under section 164; and tribal accident and health80 plans are treated like those of states. 81 tribes are also treated as states in two other ways under section 7871 but with the added requirement that the tribes be engaged in an “essential governmental function.” first, tribes may issue tax-exempt bonds under section 103, but only if the proceeds are used to fund an essential governmental function. states are not subject to an essential governmental function82 requirement in issuing their tax-exempt obligations. second, tribes enjoy83 exemption from certain enumerated excise taxes, but only where such taxes are associated with a transaction involving an essential governmental function of the tribe. here again, states are not subject to an essential governmental84 function requirement in receiving exemption from federal excise taxes. an essential governmental function does not include any “function which is not customarily performed by state and local governments with general taxing 364 florida tax review [vol.6:4 85. irc § 7871(e). 86. since irc § 7871 is not the source of the general tax exemption enjoyed by states, the essential governmental function test does not apply to the income taxation of tribes in general. the test only applies in determining whether the tribe can issue taxexempt bonds or is exempt from certain enumerated excise taxes. issues surrounding whether indian tribes should be taxable on activities that are not related to an essential governmental function are discussed in infra part v. powers.” thus, in these two narrow areas, the tribes are subject to the same85 86 treatment as the states so long as they are doing something normally done by the states. these rules are summarized in table 1. table 1: summary of irc section 7871 tribes are treated as states tribes are treated as states only if engaged in an “essential governmental function” in determining whether a contribution to the tribe is deductible by the donor for income or estate tax purposes in establishing exemption from certain excise taxes (for example, the tax on special fuels, manufacturers excise taxes, communication excise taxes, and the tax on the use of certain highway vehicles) in determining whether taxes paid to the tribe are deductible to the payor in determining whether the tribe can issue bonds that generate taxexempt interest in determining the tax status of tribal accident and health plans for purposes of taxing the unrelated business income of tribal colleges and universities (see part ii.b.2) 2. section 7871: application of the unrelated business income tax to tribes – one final area of section 7871 is quite narrow but merits attention because it is the only provision in the irc that specifically subjects certain income of indian tribes to the federal income tax. indian tribes are treated like states for purposes of section 511(a)(2)(b), which deals with the taxation of 2004] leaving money on the table(s) 365 87. irc § 7871(a)(5). 88. for more on the procedures for obtaining tax-exempt status, see irs publication 557, tax-exempt status for your organization (2001) available at www.irs.gov (last visited feb. 24, 2003). 89. irc § 501(a). 90. irs publication 557, supra note 88, at 4. 91. irc § 511. 92. irc §§ 513(a), 512. 93. irc § 513(a). 94. compare the irs’s treatment of the states (using a destination of income test) at infra part iii. 95. adapted from regs. § 1.513-1(d)(4)(i) ex. 1 (as amended in 1983). state colleges and universities. before explaining section 511(a)(2)(b), it is87 important to understand how non-profit corporations are generally treated under the irc. non-profit entities such as charities, private schools, social clubs, etc., must apply for tax-exempt status under section 501(a). generally, only88 organizations described in sections 501(c), (d), or 401(a) are eligible to apply for tax-exempt status. until the irs approves the organization’s tax-exempt89 status, the entity is technically subject to federal income tax – usually as a corporation or association under section 11. once an exemption is granted, however, it is usually retroactive to the date of organization. 90 even if tax-exemption is granted, the organization may still be subject to the section 11 federal corporate income tax on their “unrelated business taxable income” (“ubti”). (the tax itself is commonly called the unrelated91 business income tax, or “ubit”). the concept of ubti is complex, but it essentially means income, less related deductions, earned from a business “the conduct of which is not substantially related . . . to the exercise or performance [of the organization’s] charitable, educational, or other purpose or function” for which exemption was granted in the first place. tax will be imposed even if92 all of the profits are used to fund the organization’s exempt function activities.93 thus, the tax law uses a “source of income” rather than a “destination of income test” in determining whether income is ubti. 94 for example, assume an organization’s exempt function is to operate a school of performing arts for children. as part of the children’s education, they are required to participate in certain public performances. the school charges admission to the performances, thus earning income to help fund the school. because this income was earned in an activity that contributed to the organization’s exempt purpose, the income is not ubti. the source of the funds was an activity central to the school’s exempt purpose. if the same95 organization were to sell computers and then use the profits to fund its performing arts educational programs, the income would be ubti. this is because the source of the funds was not rooted in the school’s exempt purpose. 366 florida tax review [vol.6:4 96. ellen p. aprill, excluding the income of state and local governments: the need for congressional action, 26 ga. l. rev. 421, 466 (1992). one of the driving forces behind the enactment of ubit was the business activity of colleges and universities. before the advent of ubti, the third circuit found a charitable subsidiary of new york university to be exempt from tax. c.f. mueller co. v. commissioner., 190 f.2d 120 (3d cir. 1951). the subsidiary had acquired the stock of the c.f. mueller company, a producer and seller of macaroni. id. at 121. the profits of the business were used by the subsidiary for the benefit of the new york university school of law. id. congress was outraged and feared that if tax-free treatment of such activity were allowed to continue “all the noodles produced in this country will be produced by corporations held or created by universities.” aprill, supra, at 447 n. 111 (quoting remarks of rep. dingell, revenue revision of 1950: hearings before the house comm. on ways and means, 81st cong., 2d sess. 579-580 (1950)). 97. aprill, supra note 96, at 466 (quoting h.r. rep. no. 2319, at 36 (1950)). 98. see aprill, supra note 96, at 467 n. 206 (reviewing the literature criticizing the tax on ubti). 99. id. 100. id. at 468. 101. certain state owned entities might qualify, however, as exempt organizations under § 501 in addition to being exempt from tax under irc § 115. aprill, supra note 96, at 445. 102. irc § 511(a)(2)(b). 103. aprill, supra note 96, at 447. 104. it is not clear why congress was so concerned about putting state institutions on par with private institutions when it has failed to provide such equivalent treatment for other state and § 501 organization businesses. see the discussion of the federal taxation of states in part iii, infra. the fact that the funds were ultimately used to further the school’s educational mission is of no consequence. ubit was enacted to address concerns over unfair competition. “the96 tax-free status of . . . [section 501(c)] organizations enables them to use their profits tax-free to expand operations, while their competitors can expand only with the profits remaining after taxes.” there is little empirical evidence,97 however, that unfair competition would be rampant in the absence of ubit.98 this has led some commentators to question its efficacy. there is some99 evidence, however, that ubit promotes efficiency and accountability. 100 states are not considered section 501 tax-exempt organizations but rather claim exemption under irs policy as explained in part iii. states,101 however, are subject to ubit with respect to the activities of their colleges and universities. this is the only explicit place in the irc in which the states are102 subjected to the federal income tax. the reason for subjecting the ubti of state colleges and universities to tax was to put them on equal footing with private institutions of higher learning. such private institutions are already subject to103 the tax on ubti by virtue of gaining their tax exemption under section 501.104 determining the ubti of colleges can be rather complex and often involves a 2004] leaving money on the table(s) 367 105. see, e.g., iowa state univ. of science and tech. v. united states, 500 f.2d 508 (ct. cl. 1974) (holding the income from a state college’s television station was subject to ubit); rev. rul. 80-296, 1980-2 c.b. 195 (holding that income from the sale of broadcasting rights to athletic events was not subject to ubit because the games were related to the entity’s exempt educational purpose and ticket sales to a live game would have been exempt); priv. ltr. rul. 97-20-035 (feb. 19, 1997) (holding that income from the use of a state university’s golf course by students and faculty was not ubti but that use by family and alumni was ubti). 106. irc § 7871(a)(5). 107. the creation of indian colleges is a fairly recent development. most tribal colleges have been in existence less than 25 years. as of february 1999, there were 31 tribal colleges spread across 12 states and serving nearly 25,000 students. american indian higher education consortium & the institute for higher education policy, tribal colleges an introduction a2-a3, c1 (1999). 108. modern corporate tax shelters are currently stimulating much interest. it is often difficult to draw a line between legitimate tax planning and abusive tax shelters. for detailed commentary on this subject, see symposium, corporate tax shelters, 55 tax l. rev. 125 et seq. (2002). 109. peter a. glicklich & abraham leitner, loss importation—opportunities and limitations, tax notes today ,paragraph 41, feb. 16, 1999, lexis, 1999 tnt 30138. certain amount of line drawing between those activities that are related to education and those that are not.105 indian tribes are treated like states when states are treated like section 501 tax-exempt organizations with respect to their colleges and universities.106 thus, indian tribes are subject to the corporate income tax (i.e., ubit) on any ubti earned by tribal colleges or universities. this is the only explicit place in the irc that specifically subjects indian tribes to the corporate income tax. this is a narrow area to be sure, but may become more important as tribes use their new income streams from gaming to expand tribal education programs.107 3. provisions shutting down indian tax shelters – with the exception of ubit on tribal colleges and universities, it should be abundantly clear by now that tribes are not subject to federal income taxation. while the irs has recognized this status, it has been vigilant in preventing tribes from taking advantage of their tax-free status to aid in tax shelter transactions. tribes are108 in a unique position to act as accommodating parties in transactions among taxpaying entities. the goal of such transactions is to shift the unpleasant tax consequences of a deal on to the indian tribe, which, since it does not pay taxes, is indifferent to such consequences. the tribe, of course, receives a fee for its part in the deal. an example of such a shelter that was popular in recent years involved the indian tribe acting as an intermediary between the seller and the buyer of a business. a seller of an incorporated business with a high stock basis, but low109 asset basis, would prefer to sell stock rather than assets in order to minimize his 368 florida tax review [vol.6:4 110. regs. § 1.337(d)-4 (as amended in 1998). 111. id. 112. regs. § 1.337(d)-4(c)(2)(iv) (as amended in 1998). tribes, presumably in an attempt to protect their fee income, complained that treating tribes as “tax exempt entities” for this narrow purpose would be the first step towards subjecting tribes to ubit on all of the their unrelated activities (not just on the ubti of tribal colleges) and thus was beyond the rule-making power of the treasury. see letter from hans walker jr., attorney for mississippi band of choctaw indians, to commissioner, internal revenue service (april 15, 1997) reprinted in tax notes today, may 22, 1997, lexis, 97 tnt 99-29. gain. a buyer, on the other hand, would prefer to buy assets rather than stock in order to take a stepped-up, fair market value basis in the assets. to accomplish both goals, the seller would sell the stock to an indian tribe. the indian tribe would then liquidate the corporation and sell the assets of the business to the buyer. thus, the seller minimized his gain by selling his high basis stock. the buyer received the stepped up basis he desired – along with the resultant increase in depreciation or amortization deductions. in 1998, the treasury department issued regulations under section 337 to shut down this transaction. under the new regulations, a corporation that110 transfers assets to a tax-exempt entity (such as upon its liquidation) must recognize any built in gain inherent in its assets as if the assets had been sold for their fair market value immediately before the transfer. a tribe is treated as111 a “tax exempt entity” for this narrow purpose. while this tax shelter has been112 shut down, certainly there is the possibility that other shelters may be operating to take advantage of the tax-exempt status of indian tribes. c. summary indian tribes and federally charted tribal corporations are not subject to federal income taxes on any of their activities – governmental or proprietary and on or off reservation. this is the result of the irs’s interpretation that tribes are not embraced by the irc and thus are not subject to income tax. the only exception is that the federal corporate income tax applies to any ubti of tribal colleges. in addition, state chartered tribal corporations are fully subject to the corporate income tax. analysis and support for these positions are lacking. iii. federal taxation of states given the confusion over the rationale behind the non-taxation of indian tribes, it is instructive to review the federal taxation of another type of subfederal government – that of the states. here the record is much more developed, yet still filled with confusion. like indian tribes, states have engaged in commercial/non-governmental activities over the years. states engage in such lucrative businesses as lotteries, pension funds, liquor stores, utilities, and hotel 2004] leaving money on the table(s) 369 113. e.g., aprill, supra note 96, at 479-96. for a discussion on state lotteries, see infra part v.a.2. whenever tax revenues shrink, states may attempt to make up the shortfall by entering into innovative (and humorous) commercial enterprises. see, e.g., david brunori, the politics of state taxation: vinny, viagra, and vegas, state tax today, oct. 21, 2002, lexis, 2002 stt 203-12 (reporting a florida town’s plan to pay for new police cars by renting advertising space on the cars for commercial products and facetiously recommending that the town tailor each ad to the particular offense being committed: “if you’ve got a drunk driver or public drunkenness problem, you would send in the budweiser police car. if you have a traffic accident, you can send in the allstate insurance police car. the possibilities are endless.”). 114. this one exception is, of course, the imposition of ubit on the ubti of state colleges and universities. irc § 511 (a)(2)(b). see supra part ii.b.2. 115. irc § 115. note that the “essential governmental function” test (discussed infra at parts iii.a. and iii.b) applies only to the states and not to possessions of the united states. see id. the reason for sparing possessions from the test is unknown. see aprill, supra note 96, at 425 n. 10. one commentator has speculated, “[p]erhaps being a possession is itself an essential function in relation to the federal government.” id. 116. see stefan f. tucker & robert a. rombro, state immunity from federal taxation: the need for reexamination, 43 geo. wash. l. rev. 501, 512-13 (1975). the conclusions of this article on irc § 115 were criticized in david m. richardson, federal income taxation of states, 19 stetson l. rev. 411, 507-08 (1990). and convention centers. as this part will describe, states, with one113 exception, are not subject to federal income tax on any of their activities –114 governmental or proprietary. thus, they are treated similarly to tribes under the irc. the rationale behind this exemption, however, is based on a constitutional and statutory backdrop that is unique to states. the federal taxation of states appears deceptively simple. section 115 appears to be directly on point: gross income does not include – (1) income derived from any public utility or the exercise of any essential governmental function and accruing to a state or any political subdivision thereof, or the district of columbia; or (2) income accruing to the government of any possession of the united states, or any political subdivision thereof.115 the presence of section 115 would seem to indicate that states in general are subject to tax but that certain of their income – those generated from essential governmental functions – is exempt. under this view, a state will not pay taxes on its tax revenue but may be subject to taxes on non-governmental activities – such as the operation of a lottery or a liquor store. while at least one commentator has embraced this view, the interpretation of section 115 and the116 taxation of states has been much different in practice: “what has emerged behind [section 115’s] not unpleasant façade is a daliesque world in which 370 florida tax review [vol.6:4 117. richardson, supra note 116, at 509. 118. 17 u.s. 316, 436-37 (1819). 119. id. at 424-25. 120. id. at 436. see also, u.s. const. art. vi., cl. 2 (“this constitution, and the laws of the united states which shall be made in pursuance thereof . . . shall be the supreme law of the land . . . any thing in the constitution or laws of any state to the contrary notwithstanding”). 121. mcculloch, 17 u.s. at 431. 122. aprill, supra note 96 at 428 n. 27; michael wells & walter hellerstein, the governmental-proprietary distinction in constitutional law, 66 va. l. rev. 1073, 1080-85 (1980). the tenth amendment provides: “the powers not delegated to the united states by the constitution, nor prohibited by it to the states, are reserved to the states respectively, or to the people.” u.s. const. amend. x. metamorphosing constitutional doctrine and misshapen statutory analysis can be seen gnawing the cadaver of sound jurisprudential reasoning.”117 with that ominous preview in mind, this part of the article attempts to summarize two overlapping doctrines – one constitutional, the other statutory/administrative – that underlie the federal taxation of the states. before exploring the statutory landscape, it is important to understand to what degree the constitution insulates the states from federal taxation. therefore, part iii.a examines the implied immunity of the states from federal taxation under the constitution. part iii.b then reviews the statutory immunity from the federal income tax that the states enjoy thanks to the irs’s interpretation of the irc and section 115. a. implied constitutional immunity there are two areas of intergovernmental tax immunity under the constitution. first, there is federal immunity from state taxation. mcculloch v. maryland established that the states may not tax the federal government when it is executing one of its delegated powers. mcculloch held that congress had118 the power to create a national bank and set up a branch of that bank in maryland. if congress has power over something under the constitution, its119 power in that area is plenary and thus supreme to that of the states. thus the120 states cannot interfere with that exercise of power. it follows that maryland could not tax the bank because such a tax would interfere with the federal government’s exercise of its power: “[t]he power to tax involves the power to destroy.” thus the primary drivers of this immunity are the powers delegated121 to congress in the constitution combined with the supremacy clause. the second area of constitutional immunity, and the focus of this section of the article, is state immunity from federal taxation. this immunity is not based on a specific clause in the constitution but rather is implied based on the constitutional nature of the relationship between the federal government and the state governments and the tenth amendment. this implied immunity122 2004] leaving money on the table(s) 371 123. 78 u.s. 113 (1870). 124. id. at 128. 125. see id. 126. id. at 125-26. 127. of course, under our modern version of the federal income tax, all individuals are subject to taxation under irc § 1 regardless of whether they are employed by a state government. the federal government collects income tax from state employees and state governments collect state income tax from federal employees living or working within their jurisdiction. thus, collector v. day was overruled in graves v. new york, 306 u.s. 466 (1939). graves actually dealt with an attempt by a state to tax the salary of a federal employee. the court held in graves, however, that a state could subject a federal employee to its income tax and concomitantly that the federal government could tax the salary of a state employee. id. at 487. graves was based on the reasoning that the taxation of federal employees by states or state employees by the federal government was “but the normal incident of the organization within the same territory of two governments, each possessing the taxing power” and the burden of this tax affected the federal or state governments only indirectly or incidentally. id. the tax was indirect, and therefore not barred by the constitution. despite this overruling, the basic premise established in collector v. day – that the states have an implied constitutional immunity from certain federal taxation—remains valid to this day. 128. 199 u.s. 437 (1905). 129. id. at 463. today, state liquor stores, like any other state activity, are not subject to the federal income tax. see discussion infra part iii.b. 130. id. at 455. 131. id. was first sanctioned in collector v. day, where the court held that the federal government could not tax the salary of a massachusetts judge. while the123 federal government has the power to tax, it cannot exercise this power so as to interfere with a state’s exercise of its reserved powers. the power to establish124 state courts to enforce state laws was not delegated to the federal government in the constitution. thus, it was reserved to the exclusive jurisdiction of the states under the tenth amendment. as such, the federal government could125 not interfere with the state’s exercise of its power by taxing it. day126 established a broad understanding of the implied immunity of states in that almost any tax on a state would be unconstitutional – even an indirect one that only taxed the salary of a state employee. 127 this broad reading was narrowed in 1905 in south carolina v. united states. the court found that the sale of liquor by a state is subject to federal128 excise taxes. the court was concerned that absolute immunity of states from129 taxation would endanger the ability of the federal government to raise revenue. at the time, the federal government relied primarily on excise taxes130 for revenue. if the states were to take over the activities that were subject to the excise taxes – such as the sale of liquor – and then claim immunity from tax, the federal government’s revenue would dwindle, impairing its ability to exercise its power. to balance the need of the states to operate without federal131 372 florida tax review [vol.6:4 132. id. at 463 (“…whenever a state engages in a business which is of a private nature that business is not withdrawn from the taxing power of the nation”). 133. id. 134. id. at 457. for a critique of the court’s ruling, see wells & hellerstein, supra note 122 at 1083 (stating that “…the governmental-proprietary distinction had no solid analytical justification…”). 135. 220 u.s. 107 (1911). 136. id. at 172. 137. “the congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” u.s. const. amend. xvi. 138. the legislative history of irc § 115 is discussed at infra part iii.b.1. interference and the need of the federal government to have revenue for it to operate, the court crafted a proprietary/governmental distinction. activities132 of the states that are governmental in nature may not be taxed but proprietary activities may be taxed. the court did not provide much analysis for this conclusion, other than to note that this distinction was akin to that used to determine whether a municipality could be sued for negligence. the court did133 take comfort, however, in the theory that the framers of the constitution did not believe that the states would engage in proprietary activities and thus did not intend to create a constitutional tax exemption for state commercial ventures.134 in a subsequent case, flint v. stone tracy co., which upheld a federal135 excise tax on businesses – including state controlled railroad corporations – the court articulated the south carolina governmental-proprietary distinction as follows: it is no part of the essential governmental functions of a state to provide means of transportation, supply artificial light, water, and the like. these objects are often accomplished through the medium of private corporations, and though the public may derive a benefit from such operations, the companies carrying on such enterprises are nevertheless private companies, whose business is prosecuted for private emolument and advantage. for the purpose of taxation they stand upon the same footing as other private corporations upon which special franchises have been conferred.136 this was the state of the intergovernmental immunity doctrine at the time the sixteenth amendment, giving the federal government the power to impose an income tax, was ratified in 1913. it was flint’s “essential137 governmental function” language that was codified in section 115 when the income tax was enacted. while this language has survived in section 115 to138 2004] leaving money on the table(s) 373 139. irc §115 and the statutory “essential governmental function” requirement are discussed at infra part iii.b. 140. 326 u.s. 572 (1946). this was a plurality opinion with the court’s decision announced by justice frankfurter. 141. id. 142. id. at 580. 143. id. at 582. 144. id. at 584-85. (rutledge, j., concurring). 145. see richardson, supra note 116, at 424-31. richardson also notes that it has been established that indirect taxes that fall on states are also judged for constitutionality based on discrimination. for example, there is no constitutional problem with “nondiscriminatory income taxes imposed by one government on this day, the constitutional immunity doctrine continued to evolve beyond this simple distinction.139 in fact, the essential governmental function requirement was abandoned entirely in 1946 in new york v. united states. the court held that the sale of140 bottled water from the state-owned saratoga springs was subject to federal excise tax. while this result seems appropriate in light of south carolina –141 if the sale of liquor could be taxed, surely the sale of water could be taxed as well – the court used a different analysis. the court found the essential governmental function requirement to be unworkable: “to rest the federal taxing power on what is ‘normally’ conducted by private enterprise in contradiction to the ‘usual’ governmental functions is too shifting a basis for determining constitutional power and too entangled in expediency to serve as a dependable legal criterion.” the role of states continues to evolve over time142 and it is difficult to tell at any given point whether a state is engaging in a governmental function or in a commercial enterprise. for example, the sale of liquor by a state may be commercial, but it also may represent the exercise of the state’s police power in regulating the distribution of alcoholic beverages. instead of focusing on whether or not a state activity is governmental, the court in new york focused on whether the tax at issue is discriminatory: only a state can own a statehouse; only a state can get income by taxing. these could not be included for purpose of federal taxation . . . without taxing the state as a state. but so long as congress generally taps a source of revenue by whomever earned and not uniquely capable of being earned by a state, the constitution does not forbid it merely because its incidence falls also upon a state. 143 thus the concern of the intergovernmental tax immunity doctrine is protecting the states from being “singled out” for taxation. this basic144 discrimination based test remains the crux of the current intergovernmental immunity doctrine. 145 374 florida tax review [vol.6:4 employees of another government; imposed on the income derived by private parties from oil and gas leases acquired from the other government; or imposed by one government on sales to persons dealing with the other government.” id. at 431. further discussion on indirect federal taxes that may affect states is beyond the scope of this article. 146. garcia v. san antonio metro. trust auth., 469 u.s. 528, 552-55 (1985). 147. one commentator has noted that process protection has worked even better in the area of taxation than in the area of regulation: “notwithstanding enormous pressure on congress to raise revenue, and the fact that a number of state activities are proprietary in nature, congress has never imposed the income tax on states except in one narrow area.” richardson, supra note 116, at 452. this will become evident in part iii.b., infra. 148. irc § 511(a)(2)(b) applying ubit to the ubti of state colleges and universities. see discussion supra part ii.b.2. 149. the predecessor to irc § 115 was first passed as part of the tariff act of 1913. richardson, supra note 116, at 460. as originally enacted, the statute read as follows: “[t]here shall not be taxed under this section any income derived from any public utility or from the exercise of any essential governmental function accruing to any state, territory, or the district of columbia, or any political subdivision of a state, territory, or the district of colombia . . . .” tucker, supra note 116, at 514-15 n. 96. (there was also some transitional language relating to certain utility contracts and bridge acquisitions that are not relevant to the discussion in this article. id.) before leaving the constitutional area, one should note that recently at least one case regarding the federal regulation (not taxation) of states has stated that there may not be as much of a need for broad immunity because the states have political power and thus can protect themselves from oppressive regulation through their representation in congress. it remains to be seen whether this146 “process protection” rationale will be imported into the realm of taxation and thus weaken the intergovernmental immunity doctrine. 147 b. section 115 and implied statutory immunity the constitutional immunity discussed above establishes the limits of what congress could do in taxing states. congress (at least in the view of the irs) has never gone as far as the constitution allows. note that the constitutional cases above dealt with federal excise taxes, not income taxes. this is because, at least in the irs’s view, congress, with one narrow exception, has never imposed the federal income tax on the states. this148 section briefly reviews the history of section 115 and then reviews in detail how the irs has determined that the states should be treated under the irc. 1. legislative history of section 115 – as noted above, section 115 codified the implied constitutional intergovernmental immunity doctrine as it existed at the passage of the sixteenth amendment. thus, under south149 2004] leaving money on the table(s) 375 the language in the modern version of the statute is essentially the same as the version passed in 1913: gross income does not include – (1) income derived from any public utility or the exercise of any essential governmental function and accruing to a state or any political subdivision thereof, or the district of columbia; or (2) income accruing to the government of any possession of the united states, or any political subdivision thereof. irc § 115. the only notable difference is that the essential governmental function test does not apply to the district of columbia or to united states possessions under today’s version of the statute. there is no record of why this is so. see supra note 115. 150. south carolina v. united states, 199 u.s. 437, 463 (1905); flint v. stone tracy co., 220 u.s. 107, 172 (1911). 151. richardson, supra note 116, at 461-65. the states were also concerned about getting a tax exemption for their utility operations. id. irc § 115 explicitly states that income from public utilities is exempt. irc § 115. 152. u.s. const. amend. xvi (emphasis added). 153. richardson, supra note 116, at 461-62. 154. at least one commentator has concluded that irc § 115 should have no operative effect since all it did was codify the then-existing version of the intergovernmental immunity doctrine. richardson, supra note 116, at 473. as will be seen, the irs disagrees and uses irc § 115 (often incorrectly in richardson’s view) when determining whether state activities conducted though separate entities are exempt from tax. richardson posits that irc § 115 was never meant to provide a tax exemption for such entities. id. for an opposing viewpoint, see aprill, supra note 96, at 427 n. 19. 155. new york v. united states, 326 u.s. 572, 582 (1946). 156. id. at 580. carolina and flint, congress could not tax income derived from an essential governmental function but could tax other income earned by states. scholarly150 examinations of the legislative history indicate that the states were worried that the constitutional intergovernmental immunity doctrine may have been swept away by the broad language of the sixteenth amendment: “congress shall151 have the power to lay and collect taxes on incomes, from whatever source derived . . . .” at the same time, congressional lawmakers wanted to avoid152 any constitutional challenges to the new tax. by simply codifying the implied153 constitutional immunity doctrine, whether or not it was really necessary,154 congress addressed both concerns. since 1913, the constitutional intergovernmental immunity doctrine has evolved (starting with new york) to a discrimination-based test, but the155 essential governmental function test lives on in section 115. if this standard was “too shifting” for constitutional review, is it also too shifting for statutory156 purposes? fortunately, courts rarely need to answer that question because of the irs’s longstanding interpretation of section 115. 2. the irs view of section 115: general counsel memorandum 14,407 and beyond – since 1935, the irs has taken the position that congress did not 376 florida tax review [vol.6:4 157. gen. couns. mem. 14,407, 1935-1 c.b. 103,107 (jan. 28, 1935). technically, the gcm was superseded by rev. rul. 71-131, 1971-1 c.b. 28, which provided an updated tax exemption for montana’s liquor stores. rev. rul. 71-131 was issued pursuant to the irs’s project to update rulings made before 1953. this updating project is set forth in rev. proc. 67-6, 1967-1 c.b. 576. rev. rul. 71-131, however, simply laid out the facts regarding montana’s liquor stores and then summarily concluded that the income from the stores was exempt from the federal income tax. rev. rul. 71-131 included no legal analysis. therefore, the extensive legal analysis in the gcm continues to represent the foundation of the irs’s treatment of states and it is frequently cited. see, e.g., rev. rul. 77-261, 1977-2 c.b. 45 (citing the gcm as providing support for its holding that a state fund to invest excess cash balances of towns is exempt from tax despite the fact it was “superseded” by rev. rul. 71-131). it is appropriate that gcm 14,407 involved a liquor store—since by the time you are done reading it, you really feel the need to visit one. 158. irc § 1. 159. irc §11. 160. gen. couns. mem. 14,407, 1935-1 c.b. 103,104 (jan. 28, 1935). 161. id. this should sound familiar since this was the same explanation given as to why tribes are not subject to tax. for states, this analysis was stated explicitly. for tribes, it was an unofficial explanation given after the fact to explain prior cryptic rulings. for tribes, the explanation is at least plausible. for states, however, the presence of irc § 115 makes the conclusion that states are not covered by the irc more unsettling. 162. throughout this discussion, i refer to irc §115. the gcm itself referred to the predecessor to § 115, § 116. the two provisions are substantially the same. 163. gen couns. mem. 14,407, 1935-1 c.b. 103,104 (jan.28, 1935). intend to impose the federal income tax on the states. in general counsel memorandum 14,407 (“gcm”), the irs concluded that liquor stores run by the state of montana were not subject to the federal income tax. the irs did not157 perform a constitutional analysis but rather reached this result by reviewing the structure of the irc. the federal income tax is imposed on married and single individuals and corporations. the gcm first stated that a state was not an158 159 “individual” under the irc “if for no other reason than that the credits and exemptions provided for an individual are obviously not applicable to a state.” the gcm then concluded that a state was not a “corporation” under160 the irc either: “clearly, with the possible exception of section 116(d) [predecessor to current irc section 115], there is nothing . . . to indicate that states should be taxed as corporations, and the proper interpretation of that section indicates rather that states should not be so taxed.” 161 this conclusion seems unusual because if states were in fact not taxed under the irc, then there would be no need to exempt certain of their income under section 115. the irs dealt with this in the gcm by analyzing the language of section 115. in short, the irs determined that section 115 was not162 meant to apply to the income of states, but to income earned by corporations established by states to carry out state functions. a state is not taxed by the163 2004] leaving money on the table(s) 377 164. id. 165. id. 166. id. at 105. 167. id. 168. id. 169. id. see, e.g., south carolina v. united states, 199 u.s. 437, 438-39 (1905). 170. gen. couns. mem. 14,407, 1935-1 c.b. 103,106 (jan. 28, 1935). irc at all and thus all of its income – whether from taxes, liquor stores, or wherever – is not taxed. this would be the case whether section 115 existed or not. only when a state chooses to engage in activities through an investment in a corporation will the essential governmental function test of section 115 be invoked. this somewhat startling revelation is based primarily on two modes of analysis. first, the irs reviewed the language of section 115 and determined that if that provision had been intended to exempt income earned by a state directly, it would have stated that any income “derived by a state” from an essential governmental function would be exempt. instead, section 115 says164 that any income “accruing” to any state derived from the exercise of any essential governmental function would be exempt: [t]he words ‘accruing to’ connote the receipt of income from a contract or investment rather than from an act of the recipient. the use of these words serves, if not to make clear that the income referred to must have been derived by an entity other than a state . . . at least to raise an ambiguity. 165 second, in an attempt to deal with this “ambiguity,” the irs reviewed how it has treated states for income tax purposes in the past. since 1913, the irs has construed section 115 as applying to corporations owned by or contracting with the states and has “failed to tax the direct income of any state.” furthermore, the irs has “made no effort to obtain income returns166 from states . . . or to determine by any other means whether any state . . . has had income of this nature.”167 the gcm then concluded that this “tacit construction” of the federal income tax as not applying to states on their income earned directly is not the result of oversight. the irs cited the fact that it has fought to collect federal168 excise tax from states on proprietary activities, such as liquor sales. thus, the169 irs was well aware that states were engaging in proprietary activities, yet made no attempt to collect federal income tax on earnings from such activities. further, the tax law was reenacted several times over the years without change, perhaps indicating approval of the irs’s stance towards the states. finally, the170 gcm reviewed the legislative history of section 115 and concluded that the 378 florida tax review [vol.6:4 171. id. 172. id. 173. see supra note 157. 174. rev. rul. 71-131, 1971-1 c.b. 28. 175. rev. rul. 77-261, 1977-2 c.b. 45. 176. priv. ltr. rul. 2001-16-009 (jan. 4, 2001). 177. e.g., city of bethel v. united states, 594 f.2d 1301 (9th cir. 1979). see discussion of this case starting at infra note 184 and accompanying text. 178. compare the treatment of non-profit corporations under § 501. such corporations are tested for ubti under a source of the funds test. see supra part ii.b.2. this creates a disconnect when state owned corporations are also treated as 501 organizations or when state colleges and universities are subject to ubit under irc § 511(a)(2)(b). aprill, supra note 96, at 444-48. 179. gen. couns. mem. 14,407, 1935-1 c.b. 103 (jan. 28, 1935). see text accompanying supra note 172. states and congress were primarily concerned with public utilities and with corporations – not with the activities of the states themselves. 171 all of this led the irs to conclude, in language that would play a large part in the irs’s future interpretation of section 115: it may be assumed that congress did not desire in any way to restrict a state’s participation in enterprises which might be useful in carrying out those projects desirable from the standpoint of the state government which, on a broad consideration of the question, may be the function of the sovereign to conduct . . . .172 while gcm 14,407 was technically superseded, it stands as the only detailed authoritative statement by the irs on its interpretation of section 115 and remains the irs’s position to this day. the irs will only deal with173 section 115 issues when a state is operating through a separate corporation. even in the realm of state-owned corporations, the irs has taken a very broad view of what constitutes an “essential governmental function.” without much in the way of analysis, it has concluded, for example, that a state run liquor store, an investment fund, and even a hotel associated with a174 175 convention center are not subject to tax. it is rare for the irs to find such176 corporations taxable. this is because the irs over the years has looked at the177 destination of the funds generated from the activity rather than the source of the funds.178 the destination of funds test applied in the rulings just discussed on state-owned corporations flowed in part from gcm 14,407’s deference to the states in establishing the proper scope of their activities. the gcm dealt with179 activities performed directly by the state and not through a corporation—and thus section 115 was not at issue. this broad deference to the states was 2004] leaving money on the table(s) 379 180. rev. rul. 77-261, 1977-2 c.b. 45. 181. id. 182. note that even though the fund was found to be exempt from income taxes, it was still required to file a federal tax return because it was, after all, a corporation. id. 183. the irs also took a liberal view of the “accruing to” requirement of irc § 115. rev. rul. 77-261, 1977-2 c.b. 45. since the participants in the fund had “an unrestricted right to receive in their own right their proportionate share of the investment fund’s income as it is earned, the fund’s income accrues to them within the meaning of section 115(1).” id. this was the result even though the fund income was not immediately distributed to the participating towns. id. cf. city of bethel v. united states, 594 f.2d 1301, 1303 (9th cir. 1979), discussed in note 184 and accompanying text, infra, in which the court took a stricter view of the accrual requirement by requiring actual receipt of the income by the town. 184. 594 f.2d 1301 (9th cir. 1979). 185. id. at 1302. 186. id. at 1303. 187. id. at 1302. 188. it is unclear why the irs, given their liberal position on irc §115, did not give up or otherwise settle the case. it should be noted that the liquor store entity in city of bethel actually filed tax returns and paid taxes and then only later sued for a refund expanded to cover state activity conducted through a separate entity, and thus subject to the requirements of section 115, in revenue ruling 77-261. there,180 the irs ruled that an investment fund established by a state to hold and invest the excess cash balances of municipalities was tax-exempt. even though the181 income was investment income – rather than tax receipts – it was exempt182 because states and towns ultimately used the income earned to fund183 government services. this destination of income test would come to be used, explicitly or implicitly, in other rulings. the use of this test virtually guarantees that so long as the income earned by the state-owned corporation is ultimately available to the state, it will be considered derived from an essential governmental function and thus exempt under section 115. one rare contrary example, however, is city of bethel v. united states, where an entity owned by an alaskan town was found to be subject to184 the federal income tax on profits from its liquor store. the issue was not whether the operation of a liquor store was an essential governmental function, but rather whether the income “accrued to” the town. the entity did not remit185 the net profits of the store to the town and did not otherwise reflect any amount payable to the town on its books. while the corporation running the liquor186 stores was ultimately closed down and all of the assets were distributed to the town, this was not enough to meet the accrual requirement in the court’s view.187 thus, the courts appear to take the requirements of section 115 seriously – at least with respect to the accrual requirement. with the irs’s liberal views in this matter, however, it is unlikely that many cases like city of bethel will wind their way to court. 188 380 florida tax review [vol.6:4 claiming exemption under irc § 115. city of bethel, 594 f.2d at 1302. perhaps with the revenue in hand the irs was more inclined to take a harder stance in this case. given the irs’s reliance on the destination of funds test in these cases, the irs may also have been concerned that the money earned by the liquor store would never end up accruing to the town treasury. if the cash would never go to the town, then even the liberal destination of funds test would be failed. 189. new york v. united states, 326 u.s. 572, 580-81 (1946). 190. this is similar to the irs’s stance with respect to indian tribes. the irs likely avoided the tribal tax issue given the complexity of indian law and the little revenue at stake. the irs likely avoided the state tax issue given the constitutional issues and the ambiguity surrounding irc § 115. 191. aprill, supra note 96, at 497. there is at least one major problem with taxing states—it would deplete their revenue, presumably forcing them to assess higher taxes. if the state chooses to use an income tax or a property tax to make up the revenue, such amounts may be deductible by the payor in calculating her federal income tax. irc §164. thus, federal revenues will go up by the assessment of tax on the states, but would go down by the increased deductions for state taxes. whether there is a net gain or loss to the fisc would need to be determined. whether this would be an efficient flow of funds through the various governments would also need to be considered. 192. aprill, supra note 96, at 468. thus, states can do pretty much anything they want and not be subject to federal income tax since states fall outside the scope of the income tax provisions of the irc. the only exception is the application of the unrelated business income tax (“ubit”) to state colleges and universities. state-owned corporations are not automatically exempt but will likely be considered exempt under the irs’s very broad interpretation of the “essential governmental function” and “accrue to” tests of section 115. the irs stance can perhaps be explained by a desire to avoid constitutional concerns in light of the ambiguity in the irc as to how states should be treated and to avoid difficult line-drawing problems in interpreting the essential governmental function requirement embodied in section 115. the irs may not want to deal with this issue since even the supreme court ultimately discarded it as a defining principle in the constitutional immunity area. thus it seems that the irs avoided the issue189 from the inception of the income tax and continues to avoid it to this day.190 given the volume of commercial activities that states engage in on a tax-free basis, at least one commentator has suggested that the federal government should consider subjecting the states to ubit on all of their unrelated activities. of course, it will be quite difficult to determine exactly191 which activities are unrelated to the broad purposes of a state government.192 given the long-standing administrative practice of the irs to not tax states, such a tax would certainly require an act of congress rather than a mere change in administrative interpretation of the irc. any tax would need to fall into the constitutional limitations explained above. thus, it could not be targeted at state activities or discriminate against the states as states. 2004] leaving money on the table(s) 381 193. tribes, unlike states, have no representation in congress, which puts them at a disadvantage. this does not mean, however, that tribes are powerless in political matters. to the contrary, many tribes have used their new income streams to become politically active, hiring lobbyists to protect their interests. see, e.g., american indian tribes fight casino tax provision, state tax today, oct. 18, 1995, lexis, 95 stn 201-29, (reporting that the national indian gaming association has hired a former house ways and means committee lawyer and a former senate finance committee lawyer to fight a proposed tax on indian tribes); david lightman & jon lender, gaming tax faces fierce criticism, rowland joins opposition to plan, hartford courant, june 11, 1997, at a1 (reporting that indians have a “powerful lobby,” that the mashantucket pequots (owners of foxwoods casino) have a full time lobbying office in washington, ties to the clinton administration, and have contributed to both the democratic and republican parties). despite this new political power, the tribes are not afraid to play the “poverty card.” see robert pear, small items in budget bills yield big benefits for special interests, n.y. times, nov. 6, 1995, at a1 (quoting a spokeswoman for the national indian gaming association (which represents 140 tribes): “they think they can tax us because indian people don’t have a lot of votes and are among the poorest people in the united states”). 194. see infra part iv.b. 195. codified at 25 u.s.c. §§ 2701-2721 (2000). 196. this failure resulted from the supreme court’s ruling in california v. cabazon band of mission indians, 480 u.s. 202 (1987), which held that california (or counties within california) may not regulate federally approved bingo and card games taking place on indian reservations located within the borders of the state (or county). id. at 221-22. indian tribes have a sovereign status that is subordinate to the federal government, but not to the state government. id. at 207. therefore, the federal government must authorize state regulation of indian activities for them to be valid. the iv. ability of congress to tax the indian tribes congress has even more power to tax the indian tribes than it does to tax the states. indian tribes have less political clout than states – rendering it more difficult for them to protect their interests in congress. furthermore, the193 tribes are not protected by intergovernmental constitutional immunity, as are the states. two major attempts were recently made to tax the gaming operations of indian tribes – one in 1995 and a second in 1997. the debate over these194 proposals sheds some light on the power of congress to impose a tax on indian tribes. a. the regulation of indian gaming while tribes are not subject to the federal income tax, they are subject to regulation by the federal government. before reviewing the 1995 proposed tribal tax, it is important to understand the regulation of indian gaming. the key law is the indian gaming regulatory act (“igra”). this law was passed to195 pacify the states, which had failed in their attempt to prohibit gambling on indian reservations within their borders. a detailed review of the regulation196 382 florida tax review [vol.6:4 federal government has granted the states the ability to regulate certain criminal acts on indian reservations within their borders, but has not given the states broad jurisdiction to regulate civil matters on indian reservations. see canby, supra note 3, at 284-85. the court in cabazon viewed the regulation of indian gaming as civil/regulatory in nature rather than criminal in nature – and thus beyond the power of the states. cabazon, 480 u.s. at 211-12. the court emphasized the fact that the gaming activities were consistent with federal policy encouraging the self-sufficiency and economic development of indian reservations. id. at 216. thus, state regulation of indian gaming was prohibited and pre-empted by federal law. id. at 221-22. cabazon set the stage for the expansion of indian gaming and led to the passage of the igra – which “provided novel responses to the competing regulatory claims of the federal government, the states, and the tribes” over indian gaming. canby, supra note 3, at 287. under the igra, the states were given a voice in tribal gaming taking place within their borders via the chance to negotiate a tribal-state compact with the tribes wishing to operate casinos. see infra note 204. 197. for a comprehensive analysis of the igra and a history of indian gaming in general, see william e. horwtiz, scope of gaming under the indian gaming regulatory act of 1988 after rumsey v. wilson: white buffalo or brown cow?, 14 cardozo arts & ent. l.j. 153, 155-66, 172-74 (1996). 198. 25 u.s.c. § 2703(6) (2000). 199. 25 u.s.c. § 2710(a) (2000). 200. canby, supra note 3, at 288. 201. 25 u.s.c. § 2703(7) (2000). 202. 25 u.s.c. § 2703(8) (2000). 203. 25 u.s.c. § 2710(a)(2), (d) (2000). 204. 25 u.s.c. § 2710(d)(1) (2000). a detailed discussion of tribal-state compacts is beyond the scope of this article. one point is relevant, however, to the discussion of policy issues in infra part v. compacts may include provisions whereby the tribe agrees to make certain payments to the state government (not called “taxes”). kevin k. washburn, indian gaming: a primer on the development of indian gaming, the nigc and several important unresolved issues, a.b.a. center for continuing legal education (feb. 7-8, 2002), wl n02genb aba-lgled d-1. these are generally allowed only where there is consideration for the payment—for example, where the state grants the tribe a monopoly to operate slot machines. id. payments can be significant. for example, connecticut is entitled to 25% of the monthly slot machine revenue earned at the foxwoods and mohegan sun casinos under its compacts with the mashantucket pequot and the mohegan tribes. rick green, slots revenue rises 5.4% , of indian gaming is beyond the scope of this article, but some of the key provisions are summarized here. 197 first, the igra divides gaming into classes. class i gaming includes ceremonial or traditional indian games. such games are not regulated by the198 igra and tend to generate insignificant revenues. class ii gaming includes199 200 bingo and related games and certain card games. class iii gaming includes201 all other games. thus, class iii includes most casino type games, such as202 blackjack, craps, slot machines, etc. both class ii and class iii gaming are subject to regulation under the igra. class iii gaming may only be203 conducted with the consent of the state in which the tribe is located under a tribal-state compact. 204 2004] leaving money on the table(s) 383 hartford courant, nov. 16, 2002, at b5. since the casinos opened (foxwoods in 1992 and mohegan sun in 1996), the tribes have remitted approximately $2.3 billion to the state of connecticut. id. 205. 25 u.s.c. § 2710(b)(2)(b) (2000) (referring to class ii gaming); 25 u.s.c. § 2710(d)(1)(a)(ii) (2000) (applying § 2710(b) to class iii gaming). 206. 25 u.s.c. § 2710(b)(3) (2000) (referring to class ii gaming); 25 u.s.c. § 2710(d)(1)(a)(ii) (2002) (applying § 2710(b) to class iii gaming). procedures for requesting department of interior approval of revenue allocation plans is set forth at 25 c.f.r. § 290 (2002). as of february, 2002, the secretary of the interior had approved approximately sixty tribal revenue allocation plans. washburn, supra note 204. 207. 25 u.s.c. § 2710(b)(3)(d) (2000). the tribe must notify the tribe members of this tax obligation when the payments are made. id. 208. irc § 3402(r). only distributions with respect to class ii & iii gaming revenue are subject to withholding. this presumably means that such revenue should be tracked separately from class i and other revenue. as noted above, however, class i revenue is usually not material. 209. 25 u.s.c. §§ 2705(a)(1)-(2); 2713(a)(1)-(b)(1), 2706(a)(5) (2000). see, e.g., united states v. santee sioux tribe of nebraska, 135 f.3d 558 (8th cir. 1998) (upholding an order of the national indian gaming commission to close a gaming facility that was being operated by the santee sioux tribe without a state-tribal compact as required by the igra). 210. the information on the proposed tax was taken from kathleen m. nilles, commentator says tax on tribal gaming would be unconstitutional, tax notes today, nov. 30, 1995, lexis, 95 tnt233-40 [hereinafter foxwoods memo]. nilles’s piece was commissioned by the mashantucket pequot tribe, which operates the foxwoods casino in connecticut. id. attached to the foxwoods memo was a reprint of m. tribes are restricted in how they may spend the net revenues from class ii or class iii gaming operations. such net revenue may only be used: 1) to fund tribal government programs or operations; 2) to provide for the general welfare of the tribe and its members; 3) to promote tribal economic development; 4) to donate to charitable organizations; or 5) to help fund the operations of local government agencies. if a tribe creates a revenue allocation plan to fund these205 items and the secretary of the interior approves the plan, the tribe may distribute any excess funds to members of the tribe on a per capita basis. such206 distributions are taxable to the individual tribal members receiving them. in207 fact, the distributions are subject to withholding at the source. 208 these provisions provide broad latitude to the tribes as to how to spend their gaming revenue while attempting to ensure that the tribe or tribal members benefit from the net revenues rather than private individuals. if a tribe is in substantial violation of the igra, the national indian gaming commission – the federal agency charged with overseeing the igra – may assess civil fines or shut down the tribe’s casino operations temporarily or permanently. 209 b. proposed income tax on gaming income against this regulatory backdrop, congress in 1995 considered imposing the ubit on indian tribes. under the proposed law, indian tribes210 384 florida tax review [vol.6:4 maureen murphy, congressional research service memorandum: constitutionality of taxing gambling income of indian tribes, october 10, 1995 [hereinafter crs memo]. the crs memo concluded that there was no constitutional bar to the proposed tax. as will be seen, the foxwoods memo took issue with the crs memo’s conclusions. the tax proposed in 1995 died in the senate. david lightman, indian casino taxes rejected, hartford courant, june 13, 1997, at a1. the tax proposal, however, reemerged in 1997. id. although it had the strong support of house ways and means committee chairman bill archer, the bill failed to make it out of the house ways and means committee. id. the bill was defeated in a 22-16 vote when several republican members broke ranks with the chairman, largely out of concern for treading on the sovereignty of the tribes. id. 211. crs memo, supra note 210. in general, the idea was that tribes would be treated like tax exempt organizations with respect to their gaming revenue just as they (and states) are treated like tax exempt organizations on any unrelated income of colleges and universities that they operate under irc § 7871(a)(5) & irc § 511(a)(2)(b). 212. crs memo, supra note 210. other tax-exempt organizations that are required by law to expend income on charity are allowed to deduct such payments against their ubti – effectively eliminating the ubit. see south end italian independent club, inc. v. commissioner, 87 t.c. 168, 177 (1986) (holding that required payments to charity be deducted as a business expense under irc § 162 rather than as charitable contributions—which would be limited under § 170). indian tribes, under the igra, are required to use the class ii and iii gaming revenue primarily in governmental or charitable endeavors. even though the law requires these contributions, the proposed tax would limit deductions for payments under the igra to 10% of net gaming revenues. crs memo, supra note 210. if this limitation were not in the proposed law, much of the tribe’s “taxable income” would be eliminated and the tax would fail to raise much revenue. 213. “the congressional research service is the public policy research arm of the united states congress. as a legislative branch agency within the library of congress, crs works exclusively and directly for members of congress, their committees and staff on a confidential, nonpartisan basis.” congressional research service, about crs, at http://www.loc.gov/crsinfo/whatscrs.html (last visited feb. 25, 2003) (on file with the author). its opinions, therefore, represent nonpartisan research reports rather than binding legal precedent. would, in general, have still been considered beyond the income tax provisions of the irc, but would have been subject to ubit on net revenue from class ii and class iii gaming operations. unlike some other tax-exempt organizations,211 however, they would only be allowed to deduct ten percent of their net gaming revenues for charitable and other required contributions. 212 the congressional research service (crs) reviewed the proposed gaming tax for constitutional issues and concluded that there was no constitutional bar to taxing the tribes on their gaming revenue. much of the213 discussion in this section is taken from the crs memorandum (“crs memo”) 2004] leaving money on the table(s) 385 214. see supra note 210. 215. see cherokee nation v. georgia, 30 u.s. 1, 17, 19 (1831) (describing indian tribes as “domestic dependent nations” and finding that the power over the indian tribes is vested exclusively in the federal government). 216. canby, supra note 3, at 85-87. “as yet, however, no court has found a constitutionally protectible interest in tribal sovereignty by itself, and numerous examples exist of federal statutes limiting it.” id. at 85. canby cites the major crimes act as just one example of interference with tribal self-government. the igra could be viewed as another. “[s]overeignty exists entirely at the sufferance of congress. political restraints may, of course, keep congress from eliminating or greatly diminishing tribal sovereignty, but legal restraints do not.” id. at 87. “the sovereignty that the indian tribes retain is of a unique and limited character. it exists only at the sufferance of congress and is subject to complete defeasance.” united states v. wheeler, 435 u.s. 313, 323 (1978). this would suggest that congress could even abolish the indian tribal system if it so desired. of course, in doing so congress would have be sure to structure matters so as not that to run afoul of the just compensation and due process clauses of the fifth amendment. see conference of western attorneys general, american indian law deskbook 8 (julie wrend & clay smith eds., 2d ed. 1998). 217. cherokee nation, 30 u.s. at 19. 218. id. at 17. 219. united states v. dion, 476 u.s. 734, 740 (1986). 220. dean, supra note 10, at 159. on the proposed tax and the national indian gaming association’s response (“foxwoods memo”). 214 underlying the debate over whether the tribes can be taxed is the tribe’s unique relationship to the federal government. first, it is important to note that congress’s power over the indian tribes is plenary. while indian tribes are215 considered “sovereign,” congress can and has interfered with that sovereignty on numerous occasions. there is no provision in the constitution reserving216 certain powers to the tribes. therefore, the tribes have no developed constitutional intergovernmental tax immunity like that enjoyed by states. to the contrary, the constitution provides for congressional control over indian affairs through the indian commerce clause. the relationship between the217 tribes and the federal government is a unique one that “resembles that of a ward to his guardian.” 218 tribes do enjoy a level of self-government either by statute or by treaty. any statue or treaty, however, can be overturned by an act of congress. in order to do so, there must be “clear evidence that congress actually considered the conflict between its intended action on the one hand and indian treaty rights on the other, and chose to resolve that conflict by abrogating the treaty.” a recent219 review of the cases in this area concluded, “because the notion of indian sovereignty is flexible it does not bar [federal] taxation.”220 there are no rulings confirming congress’s power to apply the federal income tax to the tribes. at least one supreme court case dealing with state taxation, however, may shed some light on congress’s ability to subject the 386 florida tax review [vol.6:4 221. 411 u.s. 145, 157-58 (1973). 222. id. at 145 223. id. at 146. 224. id. at 155. 225. id. at 157. 226. crs memo, supra note 210. see also supra note 51. 227. foxwoods memo, supra note 210. 228. see supra note 216. 229. foxwoods memo, supra note 210. it should be remembered that equal protection jurisprudence is often invoked when nothing else will work—it has been called “the usual last resort of constitutional arguments.” buck v. bell, 274 u.s. 200, 208 (1927). 230. see supra note 212. 231. foxwoods memo, supra note 210. tribes to federal taxation. in mescalero v. jones, the court ruled that states can subject tribes to taxation on their off-reservation activities. specifically, the221 tribe in mescalero was found to be taxable on the operation of its offreservation ski resort. the tribe had leased the land underlying the ski resort222 from the federal government pursuant to the ira. the ira provided that any223 land acquired by tribes under its provisions would be exempt from state and local taxation. the court found that congress, in drafting the ira, only224 intended the land acquired under its provisions to be exempt from state taxes.225 the exemption did not extend to income earned from the land. since congress did not exempt the income from state taxation, the crs memo concludes that congress affirmatively permitted such taxation and “if congress may subject the proceeds of tribal activity to state taxes, it certainly may subject them to the federal income tax.” mescalero, however, addressed taxes assessed on off-226 reservation activities. most of the gaming operations at issue in the proposed federal tax are on-reservation activities. the crs memo does not address this distinction. the foxwoods memo counters with two basic arguments. first, it argues that congress can only interfere with indian tribal self-government when it is consistent with the government’s trust function over the indian tribes and that imposing a tax on the tribes would be a violation of the trust function. as227 noted above, however, congress’s power over the indians in plenary and congress is free to interfere in tribal affairs when it sees fit. 228 the foxwoods memo also claims that the proposed tax would create an equal protection violation in that tribes would be treated differently from states and differently from tax-exempt organizations engaging in gaming activities. they would be treated differently from states in that state gambling229 operations (e.g., lotteries) used to fund governmental activities would not be subject to the tax. tribes would also be treated differently from tax-exempt organizations in that they would not be allowed to deduct payments that they are required to make under the igra. “to ignore this difference is to suggest230 that congress could impose a tax on automobiles made by general motors, but not ford, and sustain its constitutionality.”231 2004] leaving money on the table(s) 387 232. 534 u.s. 84 (2001). 233. id. at 87-88. 234. simplifying greatly, the arguments in the case were primarily over statutory construction. the igra included provisions subjecting tribes to the same treatment as states with respect to certain withholding and reporting obligations. id. at 87. the igra, however, listed the federal excise tax on gaming as an example of one of those “withholding and reporting” obligations even though the provision listed had nothing to do with withholding and reporting. id. since states were exempt from the excise tax to which the igra referred, the tribe claimed that the igra exempted them from the tax as well. id. the court ruled that the reference to the excise tax was a bad one but that it should not invalidate the statute or establish an exemption from taxation. id. at 90-91. in doing so, the court favored the canon of construction that tax exemptions must be clearly expressed if they are to be respected over the canon that assumes that congress generally intends to benefit the tribes in its legislation. id. at 95. thus, under the court’s interpretation of the igra, tribes are subject to the excise tax but states are exempt from the excise tax. id. at 87-88. 235. while congress has the power to enact such a tax, it is unlikely that such a tax would ever be enacted given the political clout of the states and their longstanding, near-total tax-exempt status. see supra part iii. see also supra note 147. for further discussion on state lotteries, see infra part v.a.2. first, this statement compares two governmental entities (tribes and states) earning money in the same way (gambling) and using the funds for the same purpose (to fund governmental services). neither the crs memo nor the foxwoods memo, however, addresses another area of equity: whether it is appropriate for the federal government to tax the casino operations of private enterprises such as mgm grand and the mirage, but not to tax the mohegan sun casino or the foxwoods casino simply because they are owned by indian tribes. second, the supreme court in chickasaw nation v. united states232 recently sanctioned such a difference in treatment between states and tribes. there, the supreme court found that indian tribes were subject to certain gaming excise taxes from which the states are exempt. no equal protection233 arguments were addressed by the court. while a detailed discussion of234 chickasaw and federal excise taxes is beyond the scope of this article, suffice it to say that if a federal waging tax could be assessed against tribes but not states, it would seem that the same could be said for a federal income tax. finally, even assuming arguendo that an equal protection argument would work in this context, the proposed tax could be modified to eliminate the problem. for example, the states could be subjected to ubit on their lottery income. then states and tribes (and private gambling enterprises) would be235 treated equally. of course, this outcome is unlikely given the political muscle of the states. thus, there appears to be no blanket constitutional protection for indian tribes. furthermore, congress could overturn any previously granted treaty or statutory immunity so long as it is explicit in doing so. in addition, mescalero 388 florida tax review [vol.6:4 236. dean, supra note 10. dean’s piece is primarily on indian sovereignty and whether the federal government has the power to tax the tribes. in closing, however, she offers a few arguments for taxing the tribes. she makes no arguments against taxing the tribes. the following is a summary of dean’s arguments and some brief reactions to them: (1) a tax would redistribute wealth from the rich (casino-owning) tribes to the poor tribes. id. at 178-182. it is doubtful, however, in the absence of some sort of earmarking that the revenue raised would be used to help the poorer indian tribes. the proceeds from such a tax would likely go into general revenue. (2) a tax would address unfair competition between indian tribes and commercial casinos. id. at 182-83. this is a genuine concern and it is therefore discussed in this part. dean makes no comparison, however, between the treatment of state lotteries and the indian casinos. (3) a tax would help pay for the negative social consequences of gambling. id. at 183-84. these include traffic and crowding costs incurred by surrounding towns. id. this seems to be more of a local (rather than federal) taxation issue, however, that is presumably better addressed in the state/tribe compact required by the igra than by a tax imposed on indian tribes. 237. david lightman & jon lender, gaming tax faces fierce criticism, rowland joins opposition to plan, hartford courant, june 11, 1997, at a1. see also david lightman, some see tax jackpot at indian casinos, hartford courant, july 19, 1994, at a1 (reporting earlier discussions of taxing the tribes and quoting senator joseph lieberman (d-ct): “this is nothing against the tribes. this is a matter of may provide at least some support specifically in the tax area. thus it appears clear that congress could tax the indian tribes if it desired to do so. v. should indian tribes be subject to the federal income tax? it now appears fairly certain that congress can tax the indian tribes. the bigger and more provocative issue is, should it? to date, only one commentator has broached this issue, concluding that tribes should be taxed. while taxing236 the tribes would address unfair competition issues between the tribes and private commercial enterprises, doing so would interfere with current and long-standing federal indian policy and tax policy. this part explores these policy concerns and concludes that, in light of these policies, the tribes should retain their taxfree status. part v.a reviews whether tribes should be treated as states or businesses for tax purpose, concluding that treatment as states would be more appropriate. part v.b then explores other issues – including the impact on federal, state, and tribal revenues – that should be considered in deciding whether to tax the tribes. a. indian tribes should be treated like governments – and taxed as such 1. introduction: the classification issue – the push to tax the tribes was driven by two motivations. first, the tribes were seen as an easy target for taxation – an easy source of revenue. second, the proposed tax was meant to237 2004] leaving money on the table(s) 389 looking for money”). the issue of the amount of revenue a tribal tax would generate is discussed at infra part v.b. 238. see david lightman & jon lender, gaming tax faces fierce criticism, rowland joins opposition to plan, hartford courant, june 11, 1997, at a1 (reporting that “[t]hose pushing for the gaming tax [on tribes] include many private gaming companies, which have long thought the tribal casinos have an unfair advantage, and some small business interests, which see tribes gaining a financial edge in other areas”); robert pear, small items in budget bills yield big benefits for special interests, n.y. times, nov. 6, 1995, at a1 (quoting the reaction of itt corporation (owner of caesars palace and other casinos) chairman rand v. araskog to the proposed ubit on tribes: “hurrah, it’s terrific. tax-free indian casinos are springing up all over the place. indians operate some of the most profitable casinos in the world. if they were not tax-free, a lot of these gaming operations would not have gotten started”); robert whereatt, are casinos holding an unfair tax advantage?, star trib., dec. 27, 1992, at a1, lexis, majpap file (reporting that owners of small businesses located near a minnesota indian reservation cannot compete with the tribe because indian tribes “enjoy a government-sanctioned, unfair advantage: a lower tax burden”). 239. the tribes argue that in fact 100% of their profits are taxed – either because the profits must go to meet governmental or other expenditures listed in the igra or because per capita payments are taxable to the recipients. see id. (reporting that tribal casino operators view their profits as “the same thing as corporate taxes”). address complaints by the commercial gambling industry and small business interests of unfair competition. private business corporations pay federal238 income tax at rates up to 35 percent, thus retaining only 65 percent of their net profits. tribes pay no federal income tax and thus keep 100 percent of their net profits. this clearly creates a competitive advantage for indian tribes. this239 also violates horizontal equity – the idea that two similarly situated taxpayers should pay the same amount of tax. this is only true, however, if tribes are properly viewed as business enterprises. if they are viewed as governments – like states (which are free to engage in substantial commercial activities free from tax) – then taxing the tribes would create a horizontal equity problem. the problem here is one of classification: indian tribes are not pure governments and they are not pure business enterprises. if they must be forced to be viewed as one or the other, however, they should be viewed as governments – and treated like states for tax purposes. this is not because the constitution requires it, but because indian policy respecting the sovereignty of the indian tribes demands it. the discussion below makes this clear. first, part v.a.2 examines how states are just as aggressive as tribes in running their proprietary gambling operations and concludes that it would not be fair to tax the tribes, and yet leave the states untaxed. part iv.a.3 then reviews the current status of federal indian policy – which is based on recognizing the tribes as governments. taxing the tribes would frustrate this important and long-standing policy. finally, part iv.a.4 reviews the legislative history of the indian governmental tax status act of 1982, which brought state and tribal taxation closer together in light of federal indian policy. 390 florida tax review [vol.6:4 240. as noted in supra part iii, states are engaged in a variety of commercial enterprises in addition to gambling. the discussion here focuses on gambling, however, since it represents a classic example of how the tribes and states operate similarly. similar arguments could be made for other commercial ventures engaged in by tribes and states. 241. national indian gaming association, indian gaming facts, at http://indiangaming.org/library/index.html (last visited feb. 25, 2003) (on file with the author). for more financial information on indian gaming, see supra note 5. 242. rick green, playing games: states manipulate lottery dreamers; scratch-off tickets aimed at vulnerable targets, hartford courant, oct. 6, 2002, at a1. thirty-eight states have lotteries. id. most of the growth in state lotteries has been the result of instant “scratch-off” games. id. such games, traditionally sold for $1, are now offered in “higher-stakes” versions. see id. for example, connecticut recently celebrated its lottery’s thirtieth birthday by offering a $30 scratch-off ticket. id. players have a one in fifty-five chance of recouping their investment and a one in a million chance to win $300,000. id. these higher-end offerings result from the state’s need to compete with the two major indian casinos in connecticut (foxwoods and the mohegan sun) for its share of its citizens’ gambling dollar. id. 243. see id. the hartford courant recently researched the marketing techniques of state lotteries throughout the united states, obtaining confidential marketing plans in the process. id. it found that states increasingly hire outside marketing firms to survey the public and conduct focus groups to gather data on consumer preferences. id.. this information is then used in designing games and marketing campaigns to increase purchases. id. some states, such as oregon, have chosen to target younger players. id. other states, such as wisconsin, have targeted those with lower education and income. id.. states often employ “manipulative” techniques to boost sales – by focusing ad campaigns on the “fun” of playing the lottery and by emphasizing the benefit to the state treasury. id. 244. id. even nevada, the home of the world-famous las vegas casinos, is currently considering implementing a lottery even though it may compete with private gaming interests in the state. nevada task force votes to recommend lottery, state tax today, oct. 8, 2002, lexis, 2002 stt 195-18. 245. jack dolan & rick green, playing games: the poor play more, hartford courant, oct. 7, 2002, at a1 (quoting duke university economist charles clotfelter for these propositions). 2. the states like gambling too – reviewing the gambling activities of states shows that states and tribes operate in a similar manner – and therefore should be taxed in a similar manner. most states, like indian tribes, raise revenue through gambling. while indian gaming is a $12.7 billion industry,240 241 state lotteries have become a $40 billion industry. states increasingly have242 operated their lotteries just like businesses – employing sophisticated marketing techniques to increase sales. in fact, the states have carefully copied the243 tactics of “the lucrative private-sector gambling industry . . . .” states are244 directing their lottery officials to “view their mission like any other business” and to “go out and make money” – leading lotteries to engage in “activities that are inconsistent with the broader goals of state government.” yet, congress245 2004] leaving money on the table(s) 391 246. rick green, playing games: states manipulate lottery dreamers; scratch-off tickets aimed at vulnerable targets, hartford courant, oct. 6, 2002, at a1. 247. id. 248. id. the hartford courant notes that “[u]nlike [indian] casinos in connecticut, the lottery’s ‘convenience store gambling’ is available nearly everywhere, at 2,800 locations statewide.” id. the advantage that states enjoy over indian casinos is even more evident when it comes to poorer customers: “because many [poor people] can’t hop into a reliable family car to test their luck at one of the casinos in southeastern connecticut – which give much better odds – the availability of lottery tickets in thousands of bars, gas stations and corner stores gives the state a substantial monopoly on legal gambling among the poor.” jack dolan & rick green, playing games: the poor play more, hartford courant, oct. 7, 2002, at a1. casino games generally pay out between 80% and 90% of the amount wagered while the connecticut lottery only returns approximately 65%. id. see also david brunori, the politics of state taxation: my favorite martians, state tax today, oct. 15, 2002, lexis, 2002 stt 199-2 (musing that “your chances of winning powerball are about as good as your chances of being elected prime minister of mars”). 249. see supra part iv.a for a discussion of the igra. 250. rick green, slots revenue rises 5.4% , the hartford courant, nov. 16, 2002, at b5. 251. id. 252. in fact, the tribe is regulated in how it could spend the money under the igra. see supra part iv.a. has chosen to target indian gaming for taxation, while leaving state lotteries untouched. states lotteries view themselves as competing with indian casinos. as246 indian gaming has grown, “[state] lotteries across the country have become more aggressive designing their instant or ‘scratch’ games to mimic slot machines and table games . . . .” states already have one advantage over247 indian casinos in that state lottery tickets are available at the corner convenience store – no travel to an indian reservation is required. taxing indian gaming248 profits – but not lottery profits – would give states yet another advantage over the indians in competing for consumers’ gambling dollar. while the states compete with indian casinos, they also benefit from them. states often negotiate to receive a percentage of casino revenue as part of the tribal-state compact required by the igra. for example, connecticut249 receives 25 percent of the slot machine revenue earned at the two indian casinos in the state under its compact with the tribes. to date, connecticut has250 received over $2.3 billion from the tribes under the compact. this is simply251 gambling income. yet, if tribes were subjected to the unrelated business income tax, their 75 percent share of slot machine income would be subject to tax while the 25 percent that went to the state would be exempt from tax. this is true even though the state and the tribe would use the income for the same purpose – to fund governmental activities. 252 while states are just as aggressive as indian tribes in pursuing gambling revenue, they in fact receive most of their revenue from taxation. thus, states 392 florida tax review [vol.6:4 253. the use of state lotteries has been severely criticized as being a highly regressive manner in which to raise funds. see brunori, supra note 248 (stating that there is no justice in a system where most of the money “is coming from poor folks who stand in line at the 7-11 waiting for the numbers that will never come in”); david brunori, the politics of state taxation: vinny, viagra, and vegas, state tax today, oct. 21, 2002, lexis, 2002 stt 203-12 (stating that the “government brings the [gambling] vice right to your door by inundating you with advertisements” and that “lotteries are all about raising revenue from people who do not realize they are being taxed”). 254. barsh, supra note 10, at 553-54. 255. california v. cabazon band of mission indians, 480 u.s. 202, 218-19 (1987). this case is discussed at supra note 196. 256. of course, with established casinos and associated businesses, many tribes now have a much greater tax base. its members are employed and could pay tribal taxes. thus, gambling has improved the possibility of maintaining a tax base. therefore, it is possible that the costs of taxing gaming revenue may be passed on to tribal members in the form of reduced per-capita payments or in some form of a tribal tax. t rib es h a ve complained of a double taxation problem that makes it difficult to attract business. the state taxes businesses and so does the tribe – discouraging business development on indian reservations. see testimony of peterson zah, president of the navajo nation, before the committee on ways and means (march 16, 1993) reprinted in tax notes today, mar. 17, 1993, lexis, 93 tnt 61-109. the presence of a casino, however, is likely to attract business regardless of any additional tribal tax. this double tax problem could be reduced if the state allows a deduction (or better yet, a credit) for taxes paid by corporations to indian tribes. most states, however, require taxes measured by income to be added back to federal taxable income in calculating state taxable income. cch, 2002 state tax handbook 252-53 (2001). the add-back is usually referred to as state or foreign income taxes but presumably, in the absence of a special statute on the subject, this could encompass income taxes paid to indian tribes. a detailed review of are less likely to need to rely on gambling and other commercial income in funding governmental activities. the situation is much different for indian253 tribes. in the absence of casino gambling or other commercial enterprises, it could be very difficult for tribes to fund government activities. “economically depressed, with little tax base . . . tribes, however, have little alternative for public finance.” the supreme court has also taken note of this situation in254 california v. cabazon band of mission indians: the tribal games at present provide the sole source of revenues for the operation of the tribal governments and the provision of tribal service. they are also the major sources of employment on the reservations. self-determination and economic development are not within reach if the tribes cannot raise revenues and provide employment for their members.255 thus, it may be that taxing a tribe’s casino profits would be akin to taxing a state’s tax revenue. it would be patently unfair to tax tribes on their256 2004] leaving money on the table(s) 393 tribal taxation powers and its interrelationship with state taxation is beyond the scope of this article. 257. canby, supra note 3, at 29-32. a detailed recounting of the history of federal indian policy is beyond the scope of this article. for an overview of this history, see id. at 10-32. a couple of points should be noted for background, however. the indian reorganization act of 1934 (“ira”) was the first major step taken by the federal government to recognize that tribes should be preserved (permanently) and should be self-governing. id. at 23-25. the ira is discussed at supra part ii.a.2. the ira was designed to “stabilize the tribal organizations” and to “permit indian tribes to equip themselves with devices of modern organization, through forming themselves into business corporations.” felix s. cohen, handbook of federal indian law 84 (1942). this emphasis on self-government was abandoned, however, in the 1950s and was replaced with an “assimilation” approach in which tribes were to be terminated and indians assimilated into the general population. canby, supra note 3, at 25. the assimilation policy was viewed as a failure, and thus in the 1970s federal policy towards the indians returned to one of encouraging self-determination and self-government. id. at 29-32. this remains the cornerstone of federal indian policy to this day. id. at 32. see also california v. cabazon band of mission indians, 480 u.s. 202, which is discussed in supra note 196. in cabazon, the court acknowledged that it must “proceed in light of traditional notions of indian sovereignty and the congressional goal of indian selfgovernment, including its ‘overriding goal’ of encouraging tribal self-sufficiency and economic development.” id. at 216. 258. ronald reagan, indian policy: statement of ronald reagan, january 24, 1983, reprinted in documents of united states indian policy 301 (francis paul prucha ed., university of nebraska press 1990). 259. id. this “government to government” relationship was also reaffirmed by president clinton in 1994, ironically just one year before the first ubit on indian tribes was proposed in congress. canby, supra note 3, at 31-32. sole source of revenue while allowing states to generate supplemental funds through lotteries on a tax-free basis. 3. tribes are considered governments under federal indian policy – current federal indian policy also favors treating tribes like states. congress should not exercise its plenary power and tax the indian tribes if it would frustrate important goals of federal policy towards the indians. tax policy should not be decided independently of indian policy. while federal indian policy has varied over the years, since the early 1970s a cornerstone of federal policy has been economic development of the tribes through tribal self-determination. in reaffirming this policy, president257 reagan noted that “responsibilities and resources should be restored to the governments which are closest to the people served. this philosophy applies not only to state and local governments but also to federally recognized american indian tribes.” under federal indian policy, there is a “government-to-258 government” relationship between the tribes and the federal government. 259 thus, the federal government views tribes like governments. if congress is to follow this policy, it should treat the tribes as governments for tax purposes. since state governments, with one narrow exception, are not 394 florida tax review [vol.6:4 260. see supra part iii. 261. see supra note 216 for examples. 262. cohen, supra note 257, at 87. see also william l. raby, indian tribes and income tax exemption: “they can’t take that away from me?” tax notes today, june 10, 1992, lexis, 92 tnt 120-70 (speculating that the federal government may someday decide to tax indian tribes, and that if they did “[i]t would not be the first time washington has tried to take something away from the indians”). 263. see supra note 257. 264. codified primarily at irc § 7871. see supra part ii.b.1 for a discussion of § 7871. 265. s. rep. no. 97-646, at 10 (1982), reprinted in 1982 u.s.c.c.a.n. 4580, 4588. taxed, indian tribes should not be either. taxing the tribes would be a real and260 symbolic attack on this concept of a government-to-government relationship. a federal income tax would trample on traditional and modern notions of indian sovereignty and self-determination. while congress has used its plenary power to interfere with indian sovereignty in the past, imposing an income tax on the261 tribes would take such interference to a new level. the tax treatment of states and tribes would be so different that it would be difficult for the federal government to continue to claim that it was truly in a government-togovernment relationship with the indian tribes. taxing the tribes would provide a solid “no” to the question posed many years ago by indian law expert felix s. cohen: “will the promises of self-government . . . actually be fulfilled or will these promises be treated like so many earlier promises of the united states embodied in solemn treaties with the indian tribes?”262 obviously, the federal government is free to change its indian policy, as it has done in the past. if federal policy were changed to view the tribes as263 businesses rather than governments, then certainly a tax on the tribes would be appropriate. to date, this change has not occurred. until it does, tax and indian policy can only be aligned by exempting the tribes from the federal income tax. 4. lessons from the indian governmental tax status act of 1982 – congress has, in the past, recognized the importance of aligning tax policy with indian policy. the indian governmental tax status act of 1982 (“the 1982 act”) illustrates this. prior to this law, indian tribes were not treated like264 states for any purposes of the irc in enacting the 1982 act, congress felt that265 because indian tribes were viewed as sovereign governments under prevailing federal indian policy, they should be treated like states for certain tax purposes: indian tribal governments have responsibilities and needs quite similar to those of state and local governments. . . . increasingly, indian tribal governments have sought funds with which they could assist their people by stimulating their tribal economies and by providing governmental services. 2004] leaving money on the table(s) 395 266. id. at 11 (1982). 267. see supra note 77 and accompanying text. the 1982 act did, however, treat tribes as states for purposes of applying ubit to the unrelated income of tribal colleges and universities. see supra part ii.b.2. 268. for the states, the legislative history lists § 115 as providing the exemption. s. rep. no. 97-646, at 8 (1982), reprinted in 1982 u.s.c.c.a.n. 4580, 4586. of course, this is an overly simplistic view of how states obtained their tax exemptions. see discussion at supra part iii. for the tribes, rev. rul. 67-284 is listed as providing the exemption. s. rep. no. 97-646, at 8 (1982), reprinted in 1982 u.s.c.c.a.n. 4580, 4586. 269. rev. rul. 67-284, 1967-2 c.b. 55. see discussion at supra part ii.a.1. 270. s. rep. no. 97-646, at 12 (1982), reprinted in 1982 u.s.c.c.a.n. 4580, 4590. 271. the one finishing touch that congress did feel was necessary to align the tax treatment of tribes and states was the provision of § 7871 treating tribes as states for purposes of applying ubit to the unrelated income of tribal colleges and universities. see discussion at supra part ii.b.2. the committee has concluded that, in order to facilitate these efforts of the indian tribal governments that exercise such sovereign powers, it is appropriate to provide these governments with a status under the internal revenue code similar to what is provided for the governments of the states of the united states.266 of course, the 1982 act did not address the federal income tax treatment of tribes – and thus did not state that tribes would be treated like states for purposes of the federal income tax. congress, however, did not need to267 say anything on this front. the legislative history acknowledged that both states and tribes were both generally exempt from the federal income tax (under different authorities) prior to the 1982 act. further, congress made it clear268 that revenue ruling 67-284, acknowledging the tax-exempt status of the269 tribes, remained untouched by the 1982 act. thus, congress noted that tribes270 and states both enjoyed similar exemptions from the federal income tax – albeit under different authorities – and chose to leave those separate – but substantially equal – exemptions in place. this seems to imply that congress, in aligning the tax treatment of the tribes and the states, did not feel it was necessary to explicitly align these exemptions in the 1982 act since they were already, in reality, aligned. reading the legislative history in this way, it271 appears that congress, in light of federal indian policy, wanted tribes and states to be on an equal footing for federal tax purposes, even though a provision to that effect was not included in the 1982 act. in the twenty years since the 1982 act became law, overall federal indian policy has not substantially changed. as noted above, sovereignty and self-determination are still the hallmarks of modern federal indian policy. therefore, taxing the indian tribes would disrupt the alignment of indian policy and tax policy in place since the 1982 act. 396 florida tax review [vol.6:4 272. see supra notes 147 and 235. 273. see supra note 30. 274. see supra note 30. aside from the tax issue, a broader perception problem should be noted. there is a perception that certain tribes (particularly newly recognized tribes in the east) with large casinos are not “real” indians but rather are “phony indians . . . fronting for gambling interests.” rick green, tribal leaders decries ‘scare tactics’, hartford courant, nov. 13, 2002, at b1. this notion was advanced by a recent book questioning the heritage of the mashantucket pequot tribe (which owns the foxwoods casino in ledyard, connecticut). see jeff benedict, without reservation 1-4 (2000) (reporting, for example, that a future tribal chairman listed himself as being “white” on a 1969 marriage license application). for an opposing viewpoint on this 5. summary – tribes are really more like states than they are private businesses. states are just as aggressive as (and compete with) indian tribes in their commercial endeavors – particularly when it comes to gambling. furthermore, federal indian policy views tribes as self-determinative governments that should have the opportunity to pursue economic development activities. tax policy – evidenced by the 1982 act – has and should continue to follow this federal indian policy of self-determination. all of this shows that tribes should be taxed like states. since states are not taxed under current law, neither should tribes. of course, keeping tribes and states aligned from a tax standpoint fails to address the unfair competition problem that admittedly exists between tribes and commercial businesses. however, this problem has existed for years between states and commercial businesses – and yet congress, with one exception, has never sought to tax the states. the unfair competition problem cannot be solved by singling out tribes for taxation. rather, both states and tribes would need to be subject to taxation on their commercial income to truly address the issue. if states were subjected to tax, tribes should be as well. this is very unlikely to happen, given the political clout of the states. therefore,272 the best we can hope to do at this point is to simply keep tribes and states on an equal tax footing. to do otherwise would add more inconsistency to a taxing regime already plagued by horizontal equity problems – namely the inconsistent treatment of state commercial ventures (not taxed) and private commercial ventures (taxed) and non-profit commercial ventures (generally taxed under the unrelated business income tax regime). b. other concerns aside from major issues of tax policy and indian policy, there are also a couple of other issues that should be considered when it comes to taxing the tribes. this section briefly explores these issues. 1. the perception problem – there is a widespread belief that indians do not pay taxes at all. the public sees indian gaming expanding and comes273 to resent the fact that indians can “get rich” off of gaming but then pay no tax.274 2004] leaving money on the table(s) 397 issue, and a critique of benedict’s book, see david cournoyer, can’t indians be successful?, denver post, june 7, 2000, at b11. arguments over this matter will no doubt continue, and they will somewhat influence public attitude towards indians with successful gaming interests. for purposes of this article, however, it should be recalled that all tribes that have been recognized by the federal government are entitled to federal tax exemption—regardless of whether their legitimacy is in question by critics. see supra part ii. therefore, this issue will not be discussed further. 275. see supra part iv.a. 276. see supra part ii.b.3. 277. this was exactly what was done with the shelter described in supra part ii.b.3. 278. david lightman, indian casino taxes rejected, hartford courant, june 13, 1997 at a1. 279. 25 u.s.c. § 2710(b)(3)(d) (2000). people will only comply with a self-assessment tax system – such as we have in the united states – if they believe the system is fair and equitable. thus, exempting tribes from tax may pose challenges to the tax system itself. this problem, however, is based on a fundamental misconception. individual indians in fact pay federal income tax – and are clearly taxed on the per capita payments they receive out of tribal gaming income. tribal governments operate like state governments – whose tax-free status is rarely questioned. furthermore, tribal gaming income is subject to regulation under the igra and per capita payments must be approved by the department of interior. therefore, the solution to275 this “perception” problem is not a tax, but rather education and awareness of the true tax status of indians and tribes. related to the perception problem is the concern over tribes using their tax-free status in tax shelters. while one tax shelter has been shut down,276 others may be on the horizon. wide-open, unchecked exemption as is currently in place may stoke a fire that may already be out of control. subjecting the tribes to ubit would effectively end tribes’ participation as accommodating parties in tax shelter transactions. it could, of course, turn the tribes into actual purchasers of tax shelters! standing on its own, however, tax shelter participation is not strong enough a reason to warrant the imposition of a tax. indian tax shelters can be attacked just like any other tax shelter – by specific, targeted legislation or enforcement.277 2. measuring the revenue – finally, the amount of revenue that is lost by exempting the tribes should be determined. this will be necessary in order to determine whether taxing the tribes is worth the trouble. the 1997 version of the proposed tax on tribes was estimated to raise approximately $1.9 billion in revenue over five years. it is unclear how this estimate was calculated,278 however, and whether it considered all of the complexities involved. one complexity is that gaming revenue is already taxed once when distributed as per capita payments to individual indians. thus, the fisc is only279 missing the potential corporate tax at the tribal level. if a tax were to be 398 florida tax review [vol.6:4 280. irc § 164. as noted in supra part ii.b.1., the deduction is allowed for taxes paid to indian tribes courtesy of § 7871(a)(3). 281. see david lightham & jon lender, gaming tax faces fierce criticism; rowland joins opposition to plan, hartford courant, june 11, 1997, at a1 (reporting the state of connecticut’s unquantified concern that the 1997 proposed federal income tax on tribal income would reduce the state’s share of revenue from indian casinos under the state’s compact with the mashantucket pequot and the mohegan tribes). imposed, presumably the tribes would reduce their per-capita payouts to tribe members to make up the difference. this would reduce the tax collected from the individual tribe members. alternatively, the tribes could impose a tax to make up the shortfall in revenue. such taxes are deductible by the payor under section 164. this also would lower the amount of tax collected by the federal280 government. the impact of a tax on payments made under state-tribal compacts would also need to be factored into the equation. in the end, an empirical281 analysis is required – one that takes account of the effect of a tax on tribes, tribal members, states, and the federal government. vi. conclusion a lot has changed in indian country. not much has changed in tax country. despite the economic growth of many indian tribes brought about by indian gaming, there has been no major overhaul to the federal tax treatment of indian tribes. the tax story remains the same – indian tribes, with one minor exception, are not subject to the federal income tax. states have a similar status, although they escaped the grip of the irc by a much more heavily documented, but extremely confusing path. this article has attempted to expose and highlight the complexities underlying these statuses and to revisit them in light of the realities of the new millennium. despite the changes in indian country, it appears that federal tax policy towards indian tribes is best kept at the status quo. tribes, while increasingly commercial in nature, are governments and should be treated as such under the tax system. therefore, tribes should continue to be exempt from the federal income tax – just like states. while congress has the power to tax the tribes, to do so would frustrate long-standing federal indian policy favoring the economic independence and sovereignty of the tribes and end congress’s recent movement towards treating indian tribes as states for many purposes of the tax code. unless and until there are major changes in tax policy towards states or federal policy towards indian tribes, imposing the federal income tax on tribes would not be justifiable. we have not heard the last of this issue. as indian gaming expands and the government searches for new sources of tax revenue, there will no doubt be pressure to impose some sort of an income tax on the tribes. when this issue reemerges, any new proposals must be evaluated, as done here, in light of prevailing indian policy and tax policy. in addition, empirical studies of the complex revenue impact on tribes, states, and the federal government would 2004] leaving money on the table(s) 399 need to be done to properly measure the true amount of potential tax revenue at stake. only then can we, like the weekend gambler, know how much money we are leaving on the table, and whether we are better off for having done so. trust parity florida tax review volume 7 2006 number 8 taxing middle class trust(s) by pamela champine* i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507 ii. trusts and the middle class taxpayer . . . . . . . . . . . . . . . . . . 510 a. the relevance of taxes paid on trust income to middle class taxpayers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511 1. direct interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511 2. horizontal equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515 b. tax equity between trust beneficiaries and outright owners .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519 1. the distribution deduction .. . . . . . . . . . . . . . . . . . . . 520 2. other adjustments to the formula for taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523 iii. how the middle class slipped through the cracks in the two percent floor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526 a. the two percent floor on miscellaneous itemized deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526 1. the dilemma about trusts . . . . . . . . . . . . . . . . . . . . . 529 2. the statutory resolution . . . . . . . . . . . . . . . . . . . . . . . 531 b. judicial interpretations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532 1. the profit-maximizing taxpayer v. the cost-averse taxpayer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533 2. incremental costs v. categorical costs . . . . . . . . . . . 537 3. the weight of authority . . . . . . . . . . . . . . . . . . . . . . . 542 *professor of law, new york law school. b.s., univ. of illinois, j.d., northwestern univ. school of law; ll.m., new york university. 505 506 florida tax review [vol.7:8 iv. filling in the cracks in the two percent floor . . . . . . . . . 545 a. statutory grounding of the contextualized interpretation . . . 545 1. the reasonable taxpayer standard . . . . . . . . . . . . . . 546 2. asset use as the determinative criterion . . . . . . . . . . 547 3. accumulation-distribution distinction as proxy for asset use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 b. the argument for judicial adoption . . . . . . . . . . . . . . . . . . . . 552 1. quantitative analysis . . . . . . . . . . . . . . . . . . . . . . . . . 552 2. qualitative analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 555 3. judicious allocation of resources . . . . . . . . . . . . . . . 559 v. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563 2006] taxing middle class trust(s) 507 i. introduction the internal revenue code is, by all accounts, the inequitable revenue1 code. the middle class bears a disproportionately high percentage of the2 overall tax burden, in part, because complex interactions of various provisions of the code produce unintended results. tax simplification addresses this3 aspect of inequity, and so it is a centerpiece of tax reform. simplification itself,4 1. in this article, the “code,” unless otherwise specified, refers to the internal revenue code of 1986, as amended. 2. public opinion about tax equity has changed dramatically in the past 50 years. see, michael j. graetz, the u.s. income tax: what it is, how it got that way, and where we go from here 3-4 (w. w. norton and co.) (1999) (from the period following world war ii until 1972 americans considered the income tax to be the fairest tax in the nation, but since 1980 they have viewed it as the least fair). part of this change may be attributed to the popular press, which has increased public awareness of tax inequity. see, e.g., david cay johnston, perfectly legal: the covert campaign to rig our tax system to benefit the super rich – and cheat everyone else 11 (portfolio) (2003) (citing studies at www.taxpolicycenter.org): . . . [w]hen all federal taxes are considered – from those on gasoline and beer to social security taxes as well as income and estates taxes – the top 1%’s share [of taxes] drops to about a fourth of the total tax bill. that is not much more than their share of reported income. if you tally up the economic benefits to the top 1% that do not show up in income statistics – for reasons of written law and because of tax tricks of lawyers . . . – then the richest 1% are taxed more lightly than the middle class. the same data show that the poor are taxed almost as heavily as the rich are – and even more heavily than the super rich. another factor that may have contributed to this change is the increasing disparity in income among americans, see, e.g., isaac shapiro, new irs data indicate rising income inequality, 200 tax notes 18 (oct. 17, 2005), and the forthright acknowledgment by government agencies of tax improprieties. see, e.g., financial management: thousands of civil agency contractors abuse the federal tax systems with little consequence, gao-05-637 (jun. 16, 2005), at www.gao.gov. (last visited july 6, 2006). 3. see, e.g., robert w. wood, will the irs pursue attorney fees post-banks?, 108 tax notes today 133-36 (jul. 11, 2005) (discussing complexities involved in determining whether contingent attorneys’ fees are includible in the successful plaintiff’s gross income that remain after the supreme court addressed the issue). see generally, kathryn j. ball, comment, horizontal equity and the tax consequences of attorney-client fee agreements, 74 temp. l. rev. 387 (2001). 4. president bush appointed an advisory panel to study tax reform alternatives, which issued a set of far-reaching tax reform proposals. report of the president’s advisory panel on federal tax reform, simple, fair and pro-growth: proposals to fix 508 florida tax review [vol.7:8 however, can produce unintended complexity and exacerbate inequity if the drafting and interpretation of the simplification provisions are removed from the realities to which they will apply. a prime example of unintended inequity brought about by tax simplification is section 67(e). section 67 denies individuals a deduction for5 specified expenditures (labeled “miscellaneous itemized deductions”) except to the extent that they exceed 2% of that individual’s adjusted gross income.6 section 67(e) extends this “deduction reduction” to trusts except for expenditures that “. . . would not have been incurred if the property were not held in [trust].” the purpose of section 67(e), as its language suggests, was to7 assure that section 67’s “deduction reduction” could not be circumvented by placing income producing assets in trust. yet section 67(e), as it is presently interpreted, affords a tax advantage to trusts established by taxpayers wealthy enough to accumulate income for future generations and at the same time disadvantages those who establish smaller trusts for non-tax purposes as well as outright owners.8 this inequity has come about because of the interplay between the specialized provisions of the code that govern the income taxation of trusts and courts’ interpretations of section 67(e). congress recognized the need to integrate these two parts of the code, but it did not engage in the technical analysis required to achieve integration. instead, congress articulated a general principle embodying its objective, and relied on treasury and the courts to translate the statutory principle so that it would achieve the intended result. in9 the 20 year history of section 67, however, treasury has not issued regulations explaining how the 2% floor on miscellaneous itemized deductions applies to america’s tax system (nov. 2005), at http://www.taxreformpanel.gov/final-report. (last visited july 6, 2006). this has sparked dialogue about different conceptions of equity. see, e.g., reuven s. avi-yonah, the report of the president’s advisory panel on federal tax reform: a critical assessment and a proposal, at http://www.ssrn.com/sol3/papers.cfm?abstract_id=870578 (last visited july 6, 2006); aicpa, understanding tax reform: a guide to 21st century alternatives, at http://www.tax.aicpa.org/resources/tax+advocacy+for+members/taxlegislationandpolicy (last visited july 6, 2006); leonard e. berman & william g. gale, a preliminary evaluation of the tax reform panel’s report, 109 tax notes 1349 (2005). 5. tax reform act of 1986, pub. l. no. 99-514, 100 stat. 2085 (1986). 6. irc § 67(a). 7. irc § 67(e). 8. see infra part iv.b. 9. see infra notes 106-107, and accompanying text. 2006] taxing middle class trust(s) 509 trusts and estates. this left courts to interpret the scope of the exception with10 no technical guidance. they struggled to achieve an equitable result, yet unintentionally failed to do so in every case even as the circuits split on the meaning of section 67(e).11 the purpose of this article is to explain how courts came to such an inequitable interpretation of section 67(e) even as they tried to avoid that result; to present an interpretation of section 67(e) based on the principle that underlies the code’s scheme for taxing trust income; and to illustrate how this interpretation produces optimal equity among trust beneficiaries as well as between trust beneficiaries and outright owners. the code’s scheme for taxing trust income, set forth in subchapter j of the code, recognizes that the12 existence of a trust does not necessarily signify wealth or high income. the use of the trust income, however, does indicate whether the trust benefits a wealthy family or an individual with a modest income. applying this principle of subchapter j to the interpretation of section 67(e) is the key to achieving equity between trust beneficiaries and outright owners. to explain the significance of this technical issue to larger issues of tax equity, part ii describes the relevance of taxes paid by trusts to middle class taxpayers. the specialized tax scheme of subchapter j affects individuals who13 fall outside any notion of “wealthy” or “rich.” it directly affects individuals at every income level because the taxing scheme that governs trusts also applies to decedents’ estates. in addition, individuals of modest means will experience direct effects of the tax treatment of trusts in the many situations where such an individual establishes a trust to manage property that will support his or her dependents or others. most importantly, the equity of the tax burden borne by individuals depends upon the relative burden borne by other taxpaying entities. trusts and estates are particularly significant in this analysis because they 10. treasury has issued regulations addressing matters other issues arising under § 67. temp. regs. §§ 1.67-1t (2% floor on miscellaneous itemized deductions); 1.67-2t (treatment of pass through entities); 1.67-3 (allocation of expenses by real estate mortgage investment conduits); 1.67-3t (same). there is a regulation reserved for the allocation of expenses by trusts and estates, § 1.67-4t, but no regulation has been issued to date. 11. see infra notes 112-166, and accompanying text. 12. irc §§ 641-692. 13. see infra notes 17-86, and accompanying text. 510 florida tax review [vol.7:8 account for almost three quarters of the aggregate gross income reported by taxpayers. 14 part iii discusses the negative effect that the 2% floor on miscellaneous itemized deductions had on the equity that subchapter j had previously produced. the problem stemmed from differences in the pre-existing formulas15 for computing taxable income of individuals, on the one hand, and trusts and estates, on the other. the formula for computing taxable income of trusts, unlike the formula for computing taxable income of individuals, could not incorporate the 2% floor without a modification. section 67(e), which created an exemption for certain trust expenses, defined the result that the formula for computing taxable income should produce but not the technical rules for bringing about that result. when courts interpreted section 67(e), they attempted to achieve equity between trusts and outright owners. they failed to do so, however, because their interpretations did not account for either the diversity in the beneficiaries of trusts and estates or the similarity of costs incurred by trusts, estates and outright owners. to achieve equity in the application of the 2% floor, the interpretation of the 2% floor must reflect the diversity of beneficiaries in the same way that the basic scheme of taxing trusts and estates does. part iv presents a contextualized interpretation of section 67(e) that brings about this result, shows how it fits within the statutory language as well as any of the multiple “plain meaning” interpretations adopted by courts, and explains how it achieves greater equity than any other existing interpretation.16 ii. trusts and the middle class taxpayer the stereotypical middle class taxpayer works to earn income, and pays a significant portion of that income in federal income taxes. the tax rules17 applicable to trust income have no role in the computation of the taxes due on the wages this taxpayer earns. nevertheless, the tax treatment of trust income has both direct and indirect effects on the segment of the taxpaying population who consider themselves (and would be considered by others to be) middle 14. jacob m. mikow, fiduciary income tax returns, 1997 at 77 (internal revenue service 2005) gross income for trusts and estates accounted for 73.8 % of aggregate gross income in 1997). 15. see infra notes 87-166, and accompanying text. 16. see infra notes 167-216 and accompanying text. 17. scott a. hodge, is anyone left in the middle class?, at www.taxfoundation.org/news/show/92.html (last visited july 6, 2006). 2006] taxing middle class trust(s) 511 class. these effects make the seemingly narrow applicability of section 67(e)18 of general interest. a. the relevance of taxes paid on trust income to middle class taxpayers trusts serve a variety of objectives relating to property management and ownership. the defining feature of a trust is its division of title to property into a legal interest, held by the trustees, and an equitable interest held by the beneficiaries. in many situations it is advantageous, and sometimes necessary,19 to separate the legal and equitable interests in property. although some of20 these situations have relevance only for the wealthiest of individuals, others apply to middle class taxpayers as well. in addition to direct interests as trust beneficiaries or as the grantor of a trust for others, individuals have an indirect interest in the taxation of trust income. the fairness of the tax burden borne by any individual depends, in large part, on how that burden compares to the tax burden borne by others. thus, the fairness of the tax burden borne by the wage earner depends upon the tax burden borne by those whose income consists of distributions from trusts. the growing sense that middle class taxpayers bear a disproportionate burden of taxes makes the treatment of trust income, which is typically associated with wealthy individuals, particularly relevant to both perceptions and reality about equity in the apportionment of the income tax. 1. direct interests some types of trusts serve objectives that have relevance only for the wealthiest individuals. a “dynasty trust,” for example, is designed to preserve 18. there is no commonly accepted definition of “middle class.” see, who is t h e m i d d l e c l a s s , a t www.wksu.organews/features/familyseries/middleclass_transcript.html. (last visited july 6, 2006). in this article “middle class” refers to individuals whose wealth is not extensive enough to merit contemplation of objectives beyond providing for the needs of current family members. 19. 1 austin w. scott & wm. fratcher, the law of trusts § 2.3 (4th ed. 1987) [hereinafter “scott on trusts”] (describing trust as a fiduciary relationship with respect to property in which the legal title holder owes equitable duties to another). 20. id. at 1 (describing the purposes of trusts to be “as unlimited as the imagination of lawyers”). see also, 1 a.j. casner & jeffrey n. pennell, estate planning § 4.0 (6th ed. 1995) (“nothing serves as many functions for estate planners as trusts because settlors literally may write their own rules”). 512 florida tax review [vol.7:8 and increase family wealth for successive generations. the idea of providing21 for unborn generations of descendants is not a serious possibility for most individuals, because their own needs together with the needs of their existing family members would be more than adequate to consume the individual’s assets. similarly, trusts designed to minimize generation skipping transfer taxes have no relevance to middle class taxpayers because those trusts, like dynasty trusts, contemplate the accumulation of wealth for the benefit of future generations. however labeled or characterized, the hallmark of these trusts is22 that they exist to accumulate income rather than distribute it. in many situations, however, the division of property into separate legal and equitable interests is as necessary or helpful to the middle class taxpayer as it is to wealthier individuals. one situation of wide applicability is the division23 of title into legal and equitable interests that occurs upon the death of an individual. whether a decedent dies intestate or leaves a will, the property of the decedent vests in a personal representative who manages the property during the administration of the estate and ultimately distributes the property to the beneficiaries named in the will, or the intestate heirs, as the case may be. the24 21. jerome a. manning et al., estate planning ch. 4 at 4-6 (5th ed. 1995) (describing the dynasty trust as a trust “which is designed to continue for the benefit of successive generations for the maximum period that local law permits the trust to endure free of estate, gift and generation-skipping taxes”). 22. the generation skipping transfer (“gst”) tax is applicable to transfers for the benefit of descendants and others who are at least two generations removed (as defined for gst purposes) from the transferor. irc § 2601 (imposing tax) and § 2611 (defining generation-skipping transfer). the exemption from gst tax is equal to the exemption equivalent for the estate tax, which rises incrementally until 2010, when either reinstatement or repeal of the estate tax is scheduled to take effect. irc § 2631(a), (c). the exemption is $1.5 million for 2005, $2 million for 2006-2008, and $3.5 million for 2009. thus, gst trusts and gst planning in general is irrelevant only for individuals who have millions of dollars above and beyond whatever is left to their surviving spouse and children. see, carol a. harrington et al. generation-skipping transfer tax, ¶ 4.01 (2d ed. 2003). 23. see, e.g., carolyn t. geer, trust a trust, forbes, aug. 14, 1995, at 168 (describing trusts as “necessary” for the middle class and citing statistics indicative of the prevalence of these trusts); doug h. moy, inequitable taxation of estate and trusts, 39 the nat’l public accountant 14 (aug. 1994) (listing the following reasons the owner of a modest estate might consider creating a trust: “(1) to provide for asset management for a surviving spouse and ensure preservation and continuity of assets for the family . . . unit; (2) to protect and provide for the special needs of . . . children; (3) to avoid . . . conservatorships for [minor or disabled individuals]; and (4) to [relieve] beneficiaries from the burdens of managing property). 24. patricia cain et al., family wealth management 75 (william j. turnier & grayson m.p. mccouch eds. 2005). 2006] taxing middle class trust(s) 513 decedent does not affirmatively choose to divide property into legal and equitable interests, but the law imposes this arrangement in order to facilitate efficient administration of estates. the property of the estate itself is not25 subject to income tax, but the income earned by the decedent’s estate during the course of the estate administration is. the taxation of estate income is26 governed by the same general scheme applicable to trusts because both involve fiduciaries who hold legal title to property for the benefit of other equitable owners. thus, the tax rules applicable to trust income will be relevant for27 middle class taxpayers who inherit property in intestacy or receive a bequest under a will.28 an important use of trusts involves situations where an individual wishes to give property to a donee who would be unable to manage the property. in these situations, outright ownership is not an option, and a trust is often the best alternative. a classic situation in which a middle class taxpayer29 would create this type of trust is the death of a taxpayer who has dependents. if the sole parent, or surviving parent, of a minor child, dies, for example, the will of the parent often will create a trust to hold all of the parent’s property for the benefit of the child. the assets of the trust will consist of the parent’s property – accumulated savings, the survivorship benefit in a pension plan, or a life 25. id. 26. irc § 102(a) and (b). 27. estates and trusts, though they both involve fiduciary ownership, differ in important respects. some of these differences justify or require different tax treatment, and for this reason subchapter j treats estates and trusts differently for some purposes. see, e.g., irc §§ 642(b) (personal exemption), 642(c)(2) (set aside of income for charitable purposes) 644 (taxable year of trusts). it has been argued that the differences between estates and trusts are so significant that it is not necessarily appropriate to apply even the same general scheme to both types of entities. joseph m. dodge, simplifying models for the income taxation of trusts and estates, 14 am. j. tax pol’y 127, 127128 (1997). 28. typically, only residuary beneficiaries would bear the income tax consequences of estate taxation because bequests of property are exempt from income tax. irc §§ 102, 663. 29. an outright bequest of property to a minor generally will require appointment of a guardian to hold the property even if the minor has a living parent. see, e.g., n.y. surr. ct. proc. act § 1701 (mckinney 2005). guardianships involve extensive court supervisions and commensurate limitations on the guardian’s discretion to manage the minor’s property and use funds for the minor’s benefit. 3 warren’s heaton on surrogate’s court procedure § 48.01 (matthew bender & co. 2005). see also, wayne m. gazur & robert m. phillips, case studies in estate planning 137-139 (aspen 2004) (discussing benefits of trust as compared to alternative arrangements for minors). 514 florida tax review [vol.7:8 insurance policy. in effect, the income from the trust assets replaces the income stream of the parent, who would have provided for the child if he or she had survived. similarly, individuals who recover damages after suffering debilitating injuries often place the recovery in trust in order to secure the benefit of asset management that the individual is incapable of providing. the recovery may30 be large in absolute dollar terms, but the medical expenses and other needs that the recovery must satisfy may well leave little or no additional income. for31 that reason, trusts funded with personal injury recoveries will tend to be property management devices rather than wealth accumulation vehicles. another reason that middle class taxpayers use trusts is to provide for support of multiple beneficiaries with a limited fund. during the taxpayer’s lifetime, a trust typically would be unnecessary because the taxpayer would support the beneficiaries directly. the taxpayer could continue support for adults by leaving them outright bequests, but the property of the taxpayer might be insufficient to provide outright bequests for multiple beneficiaries in an amount necessary to cover anticipated needs. one example of this type of situation involves the decedent who wishes to provide for both a surviving spouse and children. if the estate were large enough, the decedent could achieve both goals by leaving outright bequests to the spouse and the children. where the estate is more modest, however, a trust is a better alternative because it assures that all assets will be available for the spouse’s support and at the same time gives the children all of the property that is not necessary for this purpose. 30. even if the individual is capable of managing assets, a trust may be desirable to secure the benefits of medicaid coverage while allowing the individual to use the trust income and assets to cover other needs. for an overview of these types of trusts, see, e.g., jule e. stocker et al., stocker & rikoon on drawing wills & trusts § 3.14 (pli 1999). see also, wesley e. wright et al., planning effectively to cope with medicaid estate recovery, 32 est. plan. 20 (aug. 2005); david j. correira, disability trusts that allow a client to qualify for medicaid, 30 est. plan. 233 (may 2003). 31. these trusts do not impose a serious burden on medicaid’s resources because medicaid is entitled to reimbursement from the trust assets upon the death of the beneficiary in an amount equal to the costs it paid for that beneficiary. in re barkema trust, 690 n.w.2d 50 (iowa 2004); estate of de martino v. division of medical assistance and health services, 861 a.2d 138 (n.j. 2004); accord, ellen o’brien, medicaid’s coverage of nursing home costs: asset shelter for the wealthy or essential safety net? georgetown univ. long term care financing project, may 2006 at 6, (concluding that there is little evidence the elderly engage in abusive wealth transfers in order to qualify for medicaid). 2006] taxing middle class trust(s) 515 another example involves the decedent who paid the college tuition of multiple children (or grandchildren) who are still incurring educational expenses at the time of the decedent’s death. if the decedent’s priority is to cover the educational expenses of the children (or grandchildren) and the decedent cannot predict who will continue their educations or how much the cost will be, outright bequests will be unsatisfactory. a trust, on the other hand, would allow the decedent to fulfill her objective because the trustee could be directed to make distributions only for educational purposes. these examples illustrate some of the possible uses of trusts by middle class taxpayers. the common theme in these uses, as compared to the dynastic32 trust used by the very wealthy, is that they provide for current rather than future needs. 2. horizontal equity some middle class taxpayers have no direct stake in the taxation of income received by a trust. these taxpayers do have an indirect stake in the tax treatment of trusts, however, because the tax treatment of others defines the allocation o f the tax burden among all taxpayers. evaluation of tax equity depends on the tax treatment of individual tax payers (or groups or taxpayers) relative to other individual taxpayers (or groups of taxpayers). 32. all of the examples discussed in the text involve carrying out the wishes of a donor who makes a gratuitous transfer. in some instances, however, a trust serves the interest of the grantor who created the trust. the most common example of this situation is the “living trust” created to avoid probate. this type of trust, a revocable trust, is not taxed as a trust. instead, the income of such a trust is taxed directly to the grantor. irc § 676. this is but one of many situations in which subchapter j disregards the trust entity based on the substantial interest or control that the grantor retains over trust assets. 516 florida tax review [vol.7:8 generally, tax equity is a highly subjective concept. the more limited33 principle of horizontal equity, however, is universal. horizontal equity posits34 that similarly situated taxpayers ought to bear similar tax burdens. in order to satisfy horizontal equity, there must be a justification for treating income from different sources, such as wage income as compared to trust income, differently.35 the taxing scheme applicable to trust income, located in subchapter j of the code, reflects the principle of horizontal equity by paralleling, in a general way, the tax results that would occur if the trust property were owned outright by the beneficiaries. carrying out this principle for trust income36 33. the issue of progressivity in tax rates is one of many examples. many equate progressivity with equity based on the conviction that those who have a proportionately greater share of the income ought to pay a proportionately higher percentage of that income in taxes. c. eugene steurle, contemporary u.s. tax policy 11-12 (describing different conceptions of vertical equity). see generally, edward j. mccaffery, fair no flat 22 (2002); edward j. mccaffrey, a new understanding of tax, 103 mich. l. rev. 807, 829-32 (2005); joseph bankman & thomas griffith, social welfare and the rate structure: a new look at progressive taxation, 75 cal. l. rev. 1905 (1987). yet a contrary conception of equity supports a “flat tax” that would exact a fixed rate of tax regardless of income level. walter j. blum & harry kalven, jr., the uneasy case for progressive taxation, 19 u. chi. l. rev. 417 (1952). 34. see steurle, supra note 33, at 10. disagreements about how to assess equivalence preclude definitive judgments about horizontal equity on a broad range of questions, but definitive judgment will be possible for those cases in which there can be no legitimate disagreement about the equivalence of two situations. thomas d. griffith, should “tax norms” be abandoned? rethinking tax policy analysis and the taxation of personal injury recoveries, 1993 wisc. l. rev. 1115. 35. there is no definitive source outside of law for evaluating the propriety of tax treatment of any particular item of income. cf., thor power and tool co. v. comm’r, 439 u.s. 522 (1979) (holding that methods of accounting that satisfied the standards of financial accounting would not necessarily satisfy federal income tax standards). this affords wide flexibility to treat different categories of income differently in the pursuit of particular policy objectives. capital gains, for example, often enjoy a favorable tax rate as compared to ordinary income. irc § 1(h). other categories of income are excluded from the income tax base altogether. see, e.g., irc § 103 (interest on state and local bonds); irc § 104 (personal injury recoveries); irc § 117 (scholarships for tuition and related expenses). as long as there is a legitimate basis for distinguishing a particular type of income, special treatment for that type of income will not definitively violate horizontal equity. 36. see infra notes 48-63 and accompanying text. 2006] taxing middle class trust(s) 517 involves complexities that are inherent in any situation where an individual owns an interest in an income-producing entity. 37 trusts involve an additional unique complication, which is that not all of the owners (beneficiaries) hold present interests in the trust. beneficiaries38 who hold future interests may have no resources to pay taxes assessed currently, and may never succeed to trust assets. consequently, trust income cannot39 “simply” flow through to the trust beneficiaries, as income earned by partnerships and s corporations flows through to their owners. 40 instead, trust income is allocated between the trust and the beneficiaries who receive distributions of trust income. the premise of subchapter j’s41 37. clearly, the income earned by an entity should bear tax, and an individual who receives that income should directly or indirectly bear the burden of that tax. this general principle leaves many questions unanswered, however, including whether the tax should be paid at the entity level, the individual level, or both; whether the individual should bear tax when the income is earned by the entity or when it is distributed to the individual; how the rate of tax for entity income should coordinate with the tax rates for individuals; and many others. the code resolves these issues differently for different types of entities. for example, the code establishes distinct schemes for partnerships as compared to corporations, but it allows corporations meeting specified requirements to elect a third scheme of taxation that largely, though not entirely, parallels the scheme for partnership taxation. irc §§ 301-385 (comprising subchapter c, which governs distributions from corporations), §§ 701-777 (comprising subchapter k, which governs partners and partnerships) §§ 1361-1379 (comprising subchapter s, which governs corporations that elect ‘s’ status). 38. a present interest in trust stands in contrast to the future interest, which though legally recognized at the inception of the trust, becomes distributable, if ever, at a future time. see generally, thomas f. bergin & paul g. haskell, preface to estates in land and future interests 123 (1966). restatement (third) trusts § 5, comment b. (noting that trusts bear a close resemblance to relationships between legal life tenants and remainder beneficiaries and to other relationships involving successive legal estates). 39. many trusts condition a remainder beneficiary’s entitlement on surviving to the time the trust terminates. a typical example would be a trust created for the life benefit a spouse, with the remainder distributable to the children of the grantor who survive the grantor’s spouse and the issue of any deceased child. conditioning entitlement on survivorship is so desirable that the 1993 revisions to the uniform probate code impose a condition of survivorship on future interests held in trust, which requires the beneficiary to survive until the time the future interest takes effect in enjoyment or possession. unif. prob. code § 2-707, 8 u.l.a. 194-196 (west 1998). 40. m. carr ferguson, james j. freeland & mark l. ascher, federal income taxation of estates, trusts, & beneficiaries ¶ 5.01 (3d ed. 2005). 41. in this sense, the taxation of trust income is distinguishable from the treatment of income earned by c corporations, which is subject to double taxation, and similar to the treatment of income earned by a partnership or an s corporation. compare 518 florida tax review [vol.7:8 taxing scheme for trusts is that trusts should compute taxable income under the same rules that apply to individuals, and then allocate that taxable income between the trust entity and its beneficiaries in proportion to the allocation of the trust’s actual income for the year. to the extent income is distributed to42 trust beneficiaries, they pay tax on the income at their respective marginal rates so that trust income in the hands of the beneficiary is treated like any other income received by the beneficiary. to the extent income of the trust is retained by the trust rather than distributed, the trust itself pays tax. the tax imposed43 on income retained by trusts follows a compressed rate structure to preclude the possibility of using trusts to avoid the progressive rate structure of the code.44 this assures that recipients of trust income pay tax on that income at rates commensurate with the rates paid by individuals with the same amount of income from non-trust sources. at the same time, it assures that undistributed trust income is taxed on an annual basis at rates that preclude the opportunity to defer income tax for extended periods by simply placing income producing assets in trust. the overall effect is to assure that trust beneficiaries have no45 unfair advantage over individuals who earn all of their income or receive it from other non-trust sources. irc § 11 (imposing tax on corporations) and § 301(c) (defining corporate dividends as gross income in the hands of shareholders) with (imposing income tax on partners but not the partnership entity). jonathan g. blattmachr & arthur m. michaelson, income taxation of estates and trusts § 2:1 (14th ed. 2003). see also, kamin, infra note 46, at 215 (noting that the conduit structure for taxing trusts, estate and their beneficiaries was introduce in 1916). 42. irc § 641(b). 43. irc §§ 652, 662. the overview of the income taxation of trusts that follows is intended to illustrate the general framework of subchapter j for purposes of understanding how the 2% floor on miscellaneous itemized deductions altered the preexisting equity between trust beneficiaries and other individuals. for a more thorough yet readily accessible summary of subchapter j, see jeffrey g. sherman, all you really need to know about subchapter j you learned from this article, 63 mo. l. rev. 1 (1998). 44. compare irc § 1(a)-(d) (tax rates for individuals); with § 1(e) (tax rates for trusts and estates). 45. deferring taxation of trust income until distributed would afford a substantial benefit to trusts as a result of the time value of money. the value of deferral is a central feature of tax planning. see generally, stephen f. gertzman, federal tax accounting ¶¶ 1.01, 11.01 (2nd ed. 1993 & supp. 2005). 2006] taxing middle class trust(s) 519 this general scheme has been in place since 1954. amendments to46 this scheme have occurred from time to time, but they have refined rather than replaced the basic view of horizontal equity between trust beneficiaries and other individuals. the stability of this framework is a testament to its basic47 equity. in order to understand how § 67(e) disturbed the pre-existing equity between trust beneficiaries and other individuals, it is necessary to understand something about the formula for computing a trust’s taxable income. b. tax equity between trust beneficiaries and outright owners the specific rules that translate the premise of horizontal equity between trust beneficiaries and other individuals into a taxing scheme for trusts fall into two general categories: (1) rules that modify the requirements for deductibility of specific expenditures in order to express those requirements in the contextual terms of trusts rather than individuals, and (2) rules that alter48 46. subchapter j is not immune from criticism, however. the complexity of subchapter j has been a principal source of concern. see, dodge, supra note 27; sherwin kamin, a proposal for the income taxation of trusts and estates, their grantors, and their beneficiaries, 13 am. j. tax pol’y 215 (1996). 47. examples of changes designed to advance the basic objective of subchapter j include the “separate share rule” under which a single trust or estate is treated as creating multiple trusts or estates in order to produce more appropriate allocations of the entity’s taxable income, codified at irc § 663(c), and extended to estates by the taxpayer relief act of 1997, p.l. 105-34, § 1307(a)(1)-(2), 111 stat. 788 (1997); the treatment of multiple trusts as a single trust for tax purposes where the trusts have substantive the same grantor, the same primary beneficiaries, and a principal purpose of the trusts is income tax avoidance, codified at irc § 643(f), first introduced by the deficit reduction act of 1984, p.l. 98-369, § 82(a); and the compression of tax brackets for trusts introduced by the tax reform act of 1986, p.l. 99-514, 100 stat 2065 (1986) (codified at irc § 1(e)). one of the most significant changes to subchapter j’s scheme, the expansion of the definitions of principal and income to include state law definitions that departed from traditional definitions, was made by regulation rather than statutory change. regs. § 1.643(b)-1 (amended by t.d. 9102, 69 fed. reg. 12-01). 48. some of these rules may amount to little more than a technical adjustment. see, e.g., irc §§ 167(h), 611(e), 642(f) (allocating depreciation deduction, depletion deduction and amortization deductions, respectively, between the current beneficiaries and the trust, which receives a portion of the deduction for the benefit of the remaindermen). if, however, trusts and individuals differ significantly in the specific attributes relevant to the requirements of the particular deduction, the substantive content of the deduction’s requirements will differ as well. the deduction for charitable contributions is a prime example. the charitable deduction available to individuals applies only to contributions to charities recognized as tax exempt organizations and not to payments for charitable purposes made to needy individuals or entities that are not 520 florida tax review [vol.7:8 the formula for computing taxable income to bring about the allocation of trust income between the trust entity and its beneficiaries. both types of rules49 contribute to equity, but it is the formula adjustments that express the general vision about how to create equity between individuals who have income from trusts and those who do not. 1. the distribution deduction in order to allocate taxable income of a trust between the trust itself and the trust’s beneficiaries, the code allows trusts a deduction for distributions of income to beneficiaries. correspondingly, the code requires the trust50 beneficiaries to include these distributions in their personal taxable income.51 the code treats distributions as constituting income to the extent the trust has income, and treats any additional distributions as non-taxable principal. the52 actual source of the distribution is irrelevant. if the trust has $1000 of income, and distributes an asset worth $1000 to a beneficiary, that is a distribution of income even though the asset itself may have been principal rather than income in the hands of the trustee.53 themselves tax-exempt organizations. irc § 170(a). trusts, in contrast, may deduct payments made for charitable purposes whether or not the recipient is a tax-qualified charity because the purpose of the trust may be to advance such charitable objectives. see generally, zaritsky & lane, the federal income taxation of trusts, estates and beneficiaries § 2.04 (3d ed. 2004) (discussing the differences between the charitable deduction available to individuals under § 170 and the charitable deduction available to trusts under § 642(c)). 49. irc §§ 651, 661. 50. id. 51. irc §§ 652, 662. 52. this generalization disregards the special provisions applicable to bequests or gifts of principal from trusts and estates. the income tax applies only to the income earned by trusts and estates and not to their original corpus. consequently, the code must distinguish the original principal from the income subsequently generated by the entity. the essential provisions creating this distinction are irc § 102 (excluding gifts and bequests of principal from gross income of individuals) and irc § 663(a) (excluding gifts and bequests from the operation of the rules allocating trust income between the entity and its beneficiaries). 53. the alternative approach, tracing distributions to particular assets from the trustee, was followed by the code prior to the enactment of subchapter j. this approach was abandoned because it afforded the trustee an unacceptable level of control over trust assets and also created enormous complexity. see, harkness v. united states, 199 cl. ct. 721, 469 f.2d 310 (1972). 2006] taxing middle class trust(s) 521 the major issue involved in this allocation is determining whether, or to what extent, a distribution constitutes income as opposed to (non-taxable) distributions of trust principal. the code defines the trust’s income for federal income tax purposes, but state law defines the income of a trust, known as “fiduciary accounting income” or “fai,” for purposes of defining the rights of current income beneficiaries in the trust property. the two definitions classify many common receipts in the same way; stock dividends, rental income and taxable interest income are classified as income under both sets of law. the54 primary differences are capital gains, which typically are classified as principal for state law purposes but as income for purposes of the code, and tax-exempt55 interest, which is classified as income for state law purposes but outside the definition of income for purposes of the code.56 to allocate the trust’s taxable income fairly between the beneficiaries who receive current distributions and the trust, which holds assets for beneficiaries who will receive future distributions, the distribution deduction must account for the fact that capital gains and other income allocable to principal will not pass to income beneficiaries. the concept of “distributable net income” (“dni”) brings the taxable income of the trust closer to fai.57 to compute dni, the trust first computes its taxable income but for the distribution deduction, and then adjusts that figure by reversing the treatment58 of several items the tax treatment of which differs from treatment under state law. thus, capital gains, allocable to principal under state law but included in taxable income under the code, would be deducted from taxable income to compute dni. conversely, tax-exempt income, allocable to income under state law but excluded from taxable income under the code, would be added to taxable income in the computation of dni. the personal exemption claimed by the trust, a proper offset to income under the code but not under state law, would be added back to taxable income as well. these adjustments bring dni59 54. compare unif. prin. & inc. act §§ 401(b) (dividends), 405 (rent), 406(a) (interest), 7b u.l.a. 160, 166, 167 (west 2000) with irc § 61(a)(4) (dividends), (5) (interest) and (7) (rent). 55. compare unif. prin. & inc. act § 404(2) , 7b u.l.a. 165 (west 2000) with irc §§ 61(a)(3). 56. compare unif. prin. & inc. act § 406(a), 7b u.l.a. 167 (west 2000) with irc § 103. 57. zaritsky et al., supra note 48, at § 3.02, citing s. rep. no. 1622, 83d cong., 2d sess. 343 (1954). 58. sherman, supra note 43, at 16. 59. irc § 643(a). 522 florida tax review [vol.7:8 closer to fai, but the two concepts are distinct. consequently, dni may exceed fai or vice versa.60 61 the distribution deduction may never exceed dni. for “simple62 trusts,” which include trusts that distribute all of their income, distribute no principal, and have no charitable beneficiaries, the distribution deduction will be the lesser of dni or fai. by denying simple trusts a deduction for63 distributions in excess of fai, the code assures that receipts allocable to principal under state law will not be taxed to beneficiaries who are not entitled to those receipts. for all other trusts, known as “complex trusts,” the distribution deduction may exceed fai because the distributions of those trusts do not benefit income beneficiaries exclusively; principal beneficiaries and charitable beneficiaries may receive distributions as well. to the extent the trust has dni, the distribution will be subject to tax. to illustrate, suppose that a simple trust has stock dividends of $1000 and capital gains of $500, and that applicable state law allocates capital gain to principal. in that case, fai will equal $1000 and the taxable income before accounting for the distribution deduction would be $1200 (the sum of the $1000 stock dividends and the $500 capital gains less the $300 personal exemption). the dni of the trust will be $1000, representing the taxable income before accounting for the distribution deduction less the capital gains plus the personal exemption. in this case, dni will equal fai and the income beneficiaries will be taxed on the distributions of income (as determined under state law) that they actually receive. 60. zaritsky et al., supra note 48, at ¶ 3.05[2] (citing the following examples of receipts that may cause dni to exceed fai: depreciation recapture on the sale of depreciable assets under §§ 1245 and 1250; recapture of intangible drilling cost deductions under § 1254; undistributed income of an s corporation of which the trust is a shareholder, irc §§ 1361-1368; undistributed income realized by a controlled foreign corporation of which the trust is a shareholder, irc §§ 951-964; items of income in respect of a decedent which are allocable to principal under state law, irc § 691; and imputed income under the original issue discount rules. irc §§ 1271-1275). 61. id. note 48, at § 3.05[3] (citing deductible business expenses under § 162, investment expenses under § 212 and deductible losses as examples of expenditures that may cause fai to exceed dni). 62. irc §§ 651(a) and (b), 661(a). for purposes of computing the distribution deduction, dni excludes items which are not included in the gross income of the trust and deductions allocable to those items. irc §§ 651(b), 661(c). 63. the term “simple trust” is not used in the code, but it is used in the regulations. see regs. § 1.651(a)-1. 2006] taxing middle class trust(s) 523 2. other adjustments to the formula for taxable income apart from the distribution deduction, the formula for computing taxable income established in subchapter j differs from the formula for computing taxable income of individuals in two respects. first, the personal exemptions available to trusts are lower than those available to individuals.64 second, the standard deduction is unavailable to trusts. these allowances,65 provided to taxpayers without regard to whether the taxpayer actually incurs expenditures that they exist to cover, define how the code equates the situation of trust beneficiaries to other individuals. the personal exemption for trusts differs from the personal exemption for individuals in both amount and in underlying rationale. for individuals, the personal exemption is allowed in an amount indexed for inflation, which is66 $3200 for 2005. the personal exemption for trusts is meager, in contrast,67 either $300 or $100, neither being indexed for inflation.68 the rationale of the personal exemption for individuals is to exempt from the tax base the income consumed by basic living expenses and thus unavailable to pay tax. the financial benefit afforded by the personal69 exemption has varied over time, but the symbolic value of acknowledging that subsistence itself requires consumption has remained unchanged. this70 rationale is inapplicable to trusts because trusts, by definition, incur no living expenses.71 the justification for granting a personal exemption to trusts is to eliminate the need for tax filings when the income of the trust is de minimus.72 the amount of the personal exemption is $600 for an estate, $300 for a trust that 64. compare irc § 151 (personal exemptions for individuals) with irc § 642(b) (personal exemptions for trusts and estates). 65. irc § 63(c)(6)(d). 66. irc § 151(d)(4)(a). an individual can claim additional personal exemptions for a spouse with whom the individual files a joint return and certain dependents. irc § 151(d)(4). an additional personal exemption is available for 2005 and 2006, up to a cumulative total of $2000, for individuals who house victims of hurricane katrina. katrina emergency tax relief act of 2005, p.l. 109-73, § 302, 199 stat. 2016 (2005). 67. rev. proc. 2004-71, 2004-2 c.b. 970. 68. irc § 642(b). 69. see, thomas m. humbert, ending the tax code’s anti-family bias by increasing the personal exemption to $6300, the heritage foundation, jan. 30, 1989. 70. id. 71. zaritsky, et al., supra note 48, at ¶ 2.03 n.7. 72. id. 524 florida tax review [vol.7:8 distributes all of its income, and $100 for all other trusts. the differences in73 these amounts are negligible financially, but important symbolically. the involuntary nature of an estate, as contrasted with the voluntary nature of a trust, justifies a larger exemption for estates. similarly, the difference between74 the personal exemptions for trusts reflects a difference in the degree of necessity for each type of trust. a trust that distributes all of its income serves current beneficiaries’ needs, whereas a trust that accumulates some or all of its income serves (at least in part) the purely discretionary objective of accumulating wealth for the future.75 like the personal exemption, the standard deduction is fixed in amount, with no documentation requirements. the amount of the basic standard76 deduction, which is indexed for inflation, ranges in 2005 from $5,000 to $10,000, depending on the filing status of the taxpayer. the purpose of the77 standard deduction is to eliminate the need for individuals who incur only typical expenditures to maintain records that establish entitlement to specific itemized deductions. in addition to alleviating an administrative burden, the78 standard deduction confers an economic benefit on individuals to the extent that the standard deduction exceeds the amount of their actual deductible expenditures. these benefits are available only to individuals who do not claim any itemized deductions; an individual cannot claim both the standard deduction and itemized deductions.79 the rationale of the standard deduction is inapplicable to trustees, who have an obligation to keep records of their expenditures and other transactions.80 the effect of denying the standard deduction to trusts is to maintain equity 73. irc § 642(b). 74. zaritsky, et al., supra note 48, at ¶ 2.03 n.7. 75. id. 76. james edward maule and lisa maria starcewki, deductions: overview and conceptual aspects, 503-2nd tax mgmt,(bna) at a-25. 77. irc § 63(c)(2). an additional standard deduction in the amount of $1,000 for 2005 ($1,250 for an unmarried taxpayer who is not a surviving spouse qualified to use the rates that apply to joint return filers) is available to taxpayers based on advanced age or blindness; taxpayers qualifying under both categories are entitled to two additional standard deductions. irc § 63(c)(3), (f). the amounts adjusted for inflation for 2005 are set forth in rev. proc. 2004-71, 2004-50 i.r.b. 970. 78. maule & starczewski, supra note 76, at a-25. 79. irc § 63(b)(1). 80. unif. trust code § 810, 7c u.l.a. 300 (west supp. 2005). 2006] taxing middle class trust(s) 525 between trust beneficiaries and other individuals by allowing the economic benefit of the standard deduction to both in equal amounts.81 the availability of the standard deduction to individuals requires them to compute adjusted gross income (“agi”). agi is a benchmark that separates82 deductions into two categories: the “above the line deductions” that are available to all individual, and the itemized (or “below the line”) deductions that are unavailable to individuals who claim the standard deduction. computation of agi clarifies whether the standard deduction or the itemized deductions provide a greater tax benefit. thus, the formula for computing taxable income83 of an individual is: gross income (above the line deductions) adjusted gross income (below the line deductions or standard deduction) taxable income84 for trusts, which are not entitled to elect the standard deduction, computation of agi had no relevance until section 67(e) was enacted. before 81. see ferguson, supra note 40, at § 5.02[c] (allowing trusts a standard deduction would unfairly duplicate the benefit of the standard deduction for trust beneficiaries). 82. adjusted gross income is equal to gross income less “above the line” deductions, which are allowable regardless of whether the taxpayer itemizes or claims the standard deduction. these preferred deductions include: trade and business deductions, certain trade and business deductions of employees, losses from the sale or exchange of property, deductions attributable to rents and royalties, alimony, retirement contributions by self-employed individuals, moving expenses, and a handful of other deductions. irc § 62(a). 83. in addition to facilitating the decision whether to claim the standard deduction, agi serves as a threshold for determining the availability of a few of the itemized deductions. see, irc §§ 170, 213 (itemized deductions for charitable contributions and medical expenses). 84. irc § 63. 526 florida tax review [vol.7:8 that time, the formula for computing the income of a trust that would be allocated between the trust entity and its beneficiaries was:85 gross income (deductions for documented expenditures) (personal exemption) tentative taxable income86 iii. how the middle class slipped through the cracks in the two percent floor the concept of agi became relevant to trusts when the most recent overhaul of the code, the tax reform act of 1986 (“tra 1986”), introduced87 sweeping changes in most areas of income taxation. this overhaul left subchapter j’s basic framework for computing taxable income of trusts and their beneficiaries intact, but alterations to the basic formula for computing88 taxable income of individuals raised the question of how to maintain the preexisting horizontal equity between trust beneficiaries and other individuals. a. the two percent floor on miscellaneous itemized deductions the change in the formula for computing taxable income of individuals added a limitation on the amount of itemized deductions that individuals could claim. this provision, codified in section 67 of the code and known as the 2% floor, disallowed deductions for a portion of a taxpayer’s expenditures that otherwise would have qualified under specific deduction provisions of the code in an amount equal to 2% of the taxpayer’s adjusted gross income (agi).89 section 67 had no bearing on the standard deduction, which is available to those 85. irc § 641(b). 86. the final step in the computation would be the deduction for distributions to beneficiaries. this deduction would allocate the taxable income of the trust between the beneficiaries, who would be taxed to the extent of distributions received, and the trust, which would be taxed on the income it retained. see supra notes 49-63 and accompanying text. 87. the tax reform act of 1986, p.l. 99-514, § 132(a), 100 stat. 2085, 211316. 88. see jonathan g. blattmachr & arthur m. michaelson, income taxation of estates and trusts 2.1, at 2.2 n.2. (14th ed. 2003). 89. see supra note 84. 2006] taxing middle class trust(s) 527 individual taxpayers who choose not to itemize deductions, nor did it affect90 above the line deductions that are subtracted from gross income in order to arrive at agi. instead, section 67’s limitation applied only to “miscellaneous91 itemized deductions,” a new category of deductions that included all but 12 of the itemized deductions.92 section 67’s 2% floor is the converse of the standard deduction: whereas the standard deduction affords a tax benefit for undocumented expenditures, the 2% floor denies a tax benefit for documented expenditures. consequently, the net effect of section 67 is to decrease the benefit of itemizing deductions and correspondingly increase the likelihood that individuals will forego the itemized deductions, instead claiming the standard deduction. to illustrate, assume taxpayer has gross income of $120,000, “above the line” deductions of $20,000, resulting in agi of $100,000. documented itemized deductions, all of which fall within the definition of “miscellaneous itemized deductions” amount to $4,500, and the available standard deduction is equal to $3,000. in the absence of section 67, taxpayer would choose to itemize deductions rather than claiming the standard deduction, reporting taxable income of $95,500 rather than $97,000. with section 67, taxpayer would claim the standard deduction because section 67 would reduce the itemized deductions to $2,500 ($4,500 documented deductions less $2,000 (2% of $100,000)). the principal purpose of section 67 is to curtail perceived overuse and abuse of itemized deductions, particularly those that serve policy objectives other than accurate measurement of net income. rather than amending93 90. irc § 67(a). 91. irc §§ 63(b), 63(d)(1), 67(a). 92. the 12 itemized deductions that are outside the definition of miscellaneous itemized deductions included deductions for: (1) interest (irc § 163), (2) taxes (irc § 164), (3) certain casualty, theft and wagering losses (irc § 165), (4) charitable contributions (irc § 170 for individuals and irc § 642(c) for fiduciaries), (5) medical expenses (irc § 213), (6) impairment related work expenses (available under multiple code sections), (7) estate taxes paid that are attributable to items that are also subject to income tax after the date of the decedent’s death (irc § 691(c)), (8) person al property used in a short sale (available under multiple code sections), (9) items previously included in gross income and subsequently refunded by the taxpayer to the original payor (irc § 1341), (10) cessation of annuity payment before full recovery of investment (irc § 72(b)(3)), (11) amortizable bond premium (irc § 171), and (12) certain expenditures of cooperative housing corporations (irc § 216). 93. the overuse of the included deductions stemmed in part from taxpayer errors and in part from the dual business-personal nature of many miscellaneous expenses. see, staff of the joint committee on taxation, 100th cong., 1st sess., 528 florida tax review [vol.7:8 problematic deduction provisions of the code or increasing enforcement of tax laws, congress chose to simply deny a small percentage of the targeted deductions. this approach, undoubtedly simpler for congress to enact than the alternatives, was billed as a simplification measure for taxpayers as well. by94 raising the threshold at which itemizing deductions would be tax effective, section 67 would channel a greater number of taxpayers into the standard deduction. finally, the 2% floor was justified as a means to offset the revenue95 losses that other aspects of the 1986 overhaul of the code were expected to produce.96 general explanation of the tax reform act of 1986, 78-79 (comm. print 1987) [hereinafter “tra 1986 bluebook”]. common errors mentioned included disregard of restrictions on home office deductions, disregard of limitations on the deduction for educational expenses, claiming deductions for safe deposit box fees that were used solely for personal purposes; and deducting the cost of subscriptions to business publications that had an insufficient business or investment purpose. id. at 78 n.52. elaborating on the overlap between business and personal interests, the bluebook states: the [2% floor] takes into account that some miscellaneous expenses are sufficiently personal in nature that they would be incurred apart from any business or investment activities of the taxpayer. for example, membership dues paid to professional associations may serve both business purposes and also have voluntary and personal aspects; similarly, subscriptions to publications may help taxpayers in conducting a profession and also may convey personal and recreational benefits. taxpayers presumably would rent safe deposit boxes to hold personal belongings such as jewelry even if the cost, to the extent related to investment assets such as stock certificates, were not deductible. id. at 79. 94. id. at 78 (noting that deduction for investment expenses and other miscellaneous itemized deductions fostered significant complexity and imposed enforcement burdens on the irs for relatively small amounts). the 2% floor, along with the alternative minimum tax and the phase out of itemized deductions under § 68, all increase taxes without repealing specific deductions. this “budget gimmickery” is inconsistent simplification. cf, john buckley, the tangled web of the individual amt, 108 tax notes 347. (july 18, 2005). 95. see tra 1986 bluebook, supra note 93, at 78. (“[the 2%] floor will relieve taxpayers of the burden of recordkeeping unless they expect to incur expenditures in excess of the floor.”) 96. the estimated budget effects of tra 1986, set forth in the tra 1986 bluebook, group the changes to all miscellaneous itemized deductions together with employee business expenses, hobby losses, and business use of homes. see id. at 1360, table a-2. the revenue increase attributable to these changes for the period 1987-1991 was projected to be $19,447,000,000. id. 2006] taxing middle class trust(s) 529 1. the dilemma about trusts the formula for computing taxable income for trusts, as it existed prior to the enactment of section 67, created a policy dilemma about the applicability of the 2% floor to trusts. trusts computed taxable income by deducting the personal exemption, and other expenditures that qualified under the provisions of the code, to arrive at tentative taxable income that would then be allocated between the trust and its beneficiaries. the income remaining after the97 allocation to beneficiaries was the income taxable to the trust. this formula required no computation of agi, because the principal function of agi is to segregate above the line and below the line deductions in order to facilitate the decision whether to elect to itemize rather than claim the standard deduction.98 trusts were (and are) ineligible for the standard deduction, and so they simply claim the deductions to which they are entitled, however modest they might be. the inverse relationship between the standard deduction and the 2% floor might seem to suggest that trusts ought not to be subject to the limitations of section 67. if trusts cannot claim the standard deduction, the 2% floor cannot serve the purpose of reducing recordkeeping by channeling these taxpayers into the standard deduction. moreover, section 67’s rationale of curtailing use of deductions serving policy objectives other than accurate measurement of net income is largely inapplicable to trusts because trusts, by their nature, exist to99 produce income (or at least returns on property) and correspondingly incur100 97. irc § 641(b). 98. see supra note 82. 99. see supra note 93. 100. the obligation of trustees traditionally required production of income, and preservation of principal as well, in order fulfill duties to income beneficiaries and remaindermen. this income-principal dichotomy distorted investment decisions, because the trustee was obliged to generate “income” as defined under state law (e.g., dividends, interest) rather than maximizing the total return from the trust. to avoid this distortion, the modern trend is to define “income” for state law purposes as a fixed return on trust assets (e.g., 4%) so that the trustee can invest for total return without jeopardizing the interests of either income beneficiaries or remaindermen. see, e.g., ny est. powers & trusts law § 11-2.4 (mckinney supp. 2006) (authorizing election to define income as a fixed percentage). see generally, w. brantley phillips, jr., chasing down the devil: standards of prudent investment under the restatement (third) of trusts, 54 wash. & lee l. rev. 335 (1997). 530 florida tax review [vol.7:8 expenses for the purpose of producing income rather than to serve consumptive ends.101 on the other hand, it would be inequitable to impose a limitation on deductions of individuals without imposing the same limitation on trusts. although trusts do not incur the type of personal (non-income producing) expenditures that prompted enactment of section 67, trusts could (and can) claim any itemized deduction (as well as any above the line deduction) for which they qualify, including the miscellaneous itemized deductions to which section 67’s limitation applies. if the code were to subject individuals to102 deduction limitations while exempting trusts from the identical limitations, it would discriminate on its face in favor of existing trusts and those individuals who were positioned to transfer their assets in trust to secure this income tax advantage. to avoid this possibility, congress extended the applicability of103 section 67 to trusts.104 the decision to subject trusts to section 67 advanced the goal of horizontal equity between trust beneficiaries and other individuals by assuring the same type of expenditure would be subject to the same deduction limitations regardless of who incurred the expenditure. a policy question remained, however, about how to define horizontal equity with respect to expenditures by trusts that did not parallel expenditures by individuals.105 101. examples of deductions serving consumptive ends include the deductions for and interest on home mortgages and medical expenses. see irc §§ 163(h)(2)(d), (3), and 213. 102. irc §§ 641(b), 642. 103. it seems unlikely that the tax savings would ever exceed the cost of creating and administering the otherwise unnecessary trust. stanford l. stevenson iii, note, the standard for fully deductible trust expenses under section 67(e): o’neill irrevocable trust v. comm’r, 46 tax law 655, 661 (1993). nevertheless, the appearance of fairness supports the application of the floor to trusts so long as it does not produce actual unfairness. 104. see, tra 1986 bluebook supra note 93, at 81. 105. this is a policy question because agi is not a theoretically pure concept. the code’s basic division of deductions as above the line or below the line reflects, in at least a general way, the distinction between business expenses that reduce the income available to individuals to pay for their living expenses and other personal consumption, on the one hand, and other deductions which the code allows for a variety of policy and political reasons. boris i. bittker et al., federal income taxation of individuals ¶ 2.1[3] (3d ed. 2002). the classification of several deductions, however, violates this conceptual distinction. see, e.g., irc § 62(a)(17) and (18) (deductions for interest on education loans and higher education expenses under §§ 221 and 222 classified as “above the line deductions); irc § 212 (deduction for expenses incurred for the production of income classified as an itemized deduction). 2006] taxing middle class trust(s) 531 one view of horizontal equity would subject all expenditures of trusts qualifying for deductibility under a section of the code identified as a miscellaneous itemized deduction to the 2% floor. although trusts might incur expenditures that had no analogue in the context of outright ownership of income-producing property, the expenditures arguably would be analogous nevertheless to expenditures of individuals because the code would classify them analogously based upon the attributes that cause the expenditures to fall within the parameters of a miscellaneous itemized deduction. the alternative view, equally viable as an implementation of horizontal equity, would allow full deductibility for expenditures of trusts that had no analogue in the context of outright ownership of income producing property. the absence of analogous expenses in the context of outright ownership would justify differential treatment. the deduction provisions of the code would not identify these expenditures, but this category of expenditures undoubtedly did exist by virtue of the fact that holding property in trust costs more than holding property outright. these additional costs would not need to be subjected to the 2% floor in order to prevent individuals from using trusts to circumvent the 2% floor because an individual, by definition, would not incur them. when two alternative views of horizontal equity are justifiable, the choice of which to adopt depends upon other considerations. in this context, the principal consideration is how important it is to subsidize the cost of holding property in trust. if trusts serve important objectives, or benefit individuals particularly meriting relief, a full above the line deduction for costs that do not parallel individual expenditures is appropriate. conversely, if the purpose of trusts is not particularly important from a societal perspective, or they benefit individuals who hold no particular claim to tax relief, then subjecting all trust expenses falling within the ambit of the miscellaneous itemized deductions to the 2% floor would be appropriate. 2. the statutory resolution congress chose to exempt from the 2% floor expenditures of trusts that had no analogue in the context of outright ownership, reflecting the view that trusts serve important objectives. to this end, section 67(e) provides: for purposes of this section, the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual, except that – 532 florida tax review [vol.7:8 (1) the deductions for costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate, and (2) the deductions allowable [for the personal exemption and distributions to beneficiaries] shall be treated as allowable in arriving at adjusted gross income. under regulations, appropriate adjustments shall be made [to subchapter j] to take into account the provisions of this section. this statutory framework identifies congress’ view of equity as between trust beneficiaries and other individuals in a general way, but it offers no detailed guidance as to how to bring about the intended result. recognizing the need to coordinate the 2% floor with subchapter j’s elaborate provisions for taxing the income of trusts and their beneficiaries, congress authorized the treasury to issue legislative regulations to achieve this coordination. on the106 less technical question of what “[expenditures] would not have been incurred if the property were not held in [trust],” congress relied upon the availability of interpretive guidance, through either administrative promulgation or judicial decision, to provide the necessary elaboration.107 b. judicial interpretations the exemption from the 2% floor for costs that “would not have been incurred if the property were not held in [trust]” covers the costs attributable to trust ownership, as contrasted with the costs an outright owner would have incurred to manage the property. this statutory standard offers no direct108 guidance about how to determine which costs are attributable to trust ownership. the preexisting concept of agi offers no guidance either, because that concept differentiates business from personal expenditures. under this109 bifurcation, all trust expenses should be above the line deductions because the function of a trust is to manage assets, and the only expenses trusts can incur 106. irc § 67(e) (flush language). 107. irc § 67(e)(1). 108. see id. 109. see supra note 105. 2006] taxing middle class trust(s) 533 relate, directly or indirectly, to asset management. yet expenses incurred for110 the production of income and asset management are deductible under section 212, which is classified as an itemized deduction, and under section 67(b), a miscellaneous itemized deduction. this conceptual conflict between agi and111 the classification of section 212’s deduction for asset management expenses precludes any reasoned differentiation in the types of expenditures that trusts incur. not surprisingly, in the 20 year history of section 67(e) courts have splintered in their interpretations of the scope of the exemption for trust expenditures. these include seven decisions by six courts that produced,112 among them, three different tests for determining which expenditures of trusts would be exempt from the 2% floor. all three tests focus on attributes of113 expenditures, but none identify the expenditures that are common to trusts and outright owners in a substantive, workable way. 1.the profit-maximizing taxpayer v. the cost-averse taxpayer the first case to arise, o’neill v. comm’r, involved the smallest trust, a fund in excess of $4.5 million established in 1965 for subsequent generations of the grantor’s family. the trustees, individuals who had no expert114 110. see supra note 19. a trust never incurs expenses for its own personal consumption because the trust entity cannot itself consume. a trustee may use assets of the trust to pay personal expenses of beneficiaries, but these payments are equivalent to distributions to the beneficiaries rather than costs of the trust. see, e.g., alfred i. dupont testamentary trust v. comm’r, 514 f.2d 917 (5th cir. 1975) (expense of maintaining beneficiary’s residence was not expense incurred for the conservation of property within the meaning of irc § 212). 111. see supra note 92. 112. scott v. us, 186 f. supp. 2d 664 (e.d. va. 2002), aff’d, 328 f.3d 132 (4th cir. 2003); mellon bank, n.a. v. u.s., 47 fed. cl. 186 (2000), aff’d, 265 f.3d 1275 (fed. cir. 2001); o’neill v. comm’r, 98 t.c. 227 (1992), rev’d, 994 f.2d 302 (6th cir. 1993); rudkin testamentary trust v. comm’r, 124 t.c. 304 (2005), app. pend. (2nd cir.). 113. these include a plain meaning interpretation classifying expenditures by their label, rudkin testamentary trust v. comm’r, 124 t.c. 304 (2005); a plain meaning interpretation classifying expenditures based on the incremental difference in the amount of expenses expected by trusts and those expected by individuals, mellon bank, n.a. v. u.s., 47 fed. cl. 186 (2000), aff’d, 265 f.3d 1275 (fed. cir. 2001); and an interpretation that determines deductibility based on whether the expenditure is mandatory for trusts but discretionary for individual. o’neill irrevocable trust v. comm’r, 994 f.2d 302 (6th cir. 1993), rev’d 994 f. 2d 302 (6th cir. 1992). 114. 98 t.c. at 228. 534 florida tax review [vol.7:8 knowledge about investment, declined trustees’ commissions and instead hired an investment advisor. the tax court concluded that an individual would incur investment advisory expenses, and accordingly. held that those expenses were subject to the 2% floor. on appeal, the 6th circuit reversed.115 116 in the tax court’s view, the plain meaning of section 67(e) exempts from the 2% floor only expenditures that are unique to trusts. as a different117 court later expressed the tax court’s interpretation, the question is whether the expense at issue is “commonly incurred outside the administration of trusts.”118 trustees’ fees, for example, would be fully deductible according to dictum in the tax court’s o’neill decision, because individuals, by definition, would not pay trustees’ fees. investment advisory fees, in contrast, would be subject to119 the 2% floor because individuals routinely incur this type of expense.120 this standard is an objective standard, in the tax court’s view, because subjective considerations cannot influence the scope of the exemption of trust expenses from the 2% floor. thus, the outright owner contemplated by121 section 67(e) cannot be an actual individual associated with the trust (the beneficiary, the trustee, or the grantor). instead, the outright owner who defines the scope of the exemption must be a hypothetical taxpayer. the tax court did not explicitly discuss the attributes of the hypothetical taxpayer that would influence expenditure decisions, but the holding seems most consistent with a standard defined by a hypothetical taxpayer who would incur any and all discretionary expenses that would produce income and maximize return (a “profit-maximizing taxpayer”). the tax court’s holding in o’neill precludes the possibility that the outright owner 115. id. at 231. 116. o’neill, 994 f. 2d at 304-05. 117. o’neill, 98 t.c. at 230. 118. scott, 328 f.3d at 140. 119. 98 t.c. at 230. in addition to fiduciary commissions, fees for a trust accounting mandated by state law or the trust agreement also would qualify as unique to trusts and estates, and thus qualify for the exemption from the 2% floor in the view of the tax court. id. 120. id. at 230. 121. id. at 231. the tax court discussed the need for objectivity in the § 67(e) standard in the course of rejecting the argument that the fiduciary duty to invest prudently, imposed by state law, obliged the trustees to hire an investment advisor. id. at 230-31. after rejecting the argument that state law compelled expertise in the management of trust assets, the tax court stated that discretionary judgments of trustees could not define the scope of the exemption of trust costs from the 2% floor. id. at 231. the objection to subjectivity, though framed in terms of the trustee, would apply equally to a standard defined by any actual individual. 2006] taxing middle class trust(s) 535 contemplated by section 67(e) is a hypothetical taxpayer who refuses to incur any non-compulsory expenditures (a “cost-averse taxpayer”). the holding does not preclude a standard defined by a reasonable taxpayer, the most intuitive choice. the tax court’s rationale, however, is inconsistent with a reasonable taxpayer standard because a reasonable taxpayer would not necessarily incur expenses that other individuals routinely incur. instead, a reasonable taxpayer would make decisions based on his or her own financial situation. the 6th circuit, the first appellate court to interpret section 67(e), rejected the tax court’s “plain meaning” interpretation, as well as its underlying factual assumption that an outright owner would incur investment advisory fees. rather than attempting to analyze what expenses an outright122 owner would avoid, the 6th circuit analyzed what expenses a trust could avoid. discretionary expenses incurred by trusts would be analogous to expenses incurred by individuals, in the 6th circuit’s view, because both taxpayers would have the freedom to incur or avoid them. compulsory expenditures incurred by trustees to fulfill the fiduciary duties established by state trust law, however, had no analogue in the outright ownership context. the 6th circuit held that123 investment advice fell into the compulsory category in the case of the o’neill trust because applicable state law required expertise in the investment of trust assets. the trustees did not have this expertise, and did not receive124 compensation for providing this service as a result of their decision to waive fiduciary commissions. consequently, the court held that investment125 advisory fees for this trust were exempt from the 2% floor.126 this interpretation implicitly assumes that the outright owner contemplated by section 67(e) is a cost-averse taxpayer, who avoids all discretionary expenditures. although the 6th circuit framed its interpretation in terms of costs that a trust could avoid, as opposed to costs that an outright 122. o’neill, 994 f.2d at 304-05. 123. id. at 304. 124. id. the 6th circuit rejected the tax court’s conclusion that the trustees had no obligation to seek investment advice because the tax court erroneously relied on ohio’s statutory list of prudent investments to support its conclusion that investing in those assets would fulfill the duty to invest prudently. id. as the 6th circuit noted, prudent investment requires diversification as well as continuing judgment about specific investments on an ongoing basis. id. see also, craig d. bell & julie a. king, sweeping up the two percent floor: scott v. united states and the deductibility of investment advisory fees, 38 real prop. prob. & tr. j. 589, 606-07 (2003). 125. o’neill, 994 f.2d at 303. 126. id. at 304. 536 florida tax review [vol.7:8 owner would avoid if he or she were cost averse, the results under both formulations are identical. the two formulations seemingly produce different results for two categories of expenditures: (1) those that would be compulsory for both trusts and individuals, and (2) expenditures never incurred by individuals that could be incurred voluntarily by trusts. the reason these two categories of expenditures do not produce different results under the 6th circuit’s interpretation and a cost-averse taxpayer interpretation is that both categories of expenditures are empty sets. neither category of expenditure describes any actual cost because asset management expenses (the only type of expenses that come within the scope of section 67(e)), are never compulsory for individuals and never voluntary for127 trusts. the specific amount of the expenses that a trust will incur depends128 upon who provides services to the trust and the compensation arrangements for those service providers. state law does not mandate any particular choice, but129 it does impose the obligation to ensure that the necessary services are provided at reasonable cost. hiring an investment advisor to perform services for which the trustee is already receiving compensation, for example, would be a breach 127. the reason that only asset management expenses come within § 67(e) is that the only function of a trust is to hold assets for the benefit of others, and thus the only costs trusts can incur and costs that advance this purpose. see supra note 19. 128. trust expenditures may fall within deduction provisions other than § 212, such as interest (deductible under § 163) and taxes (deductible under § 164). apart from those two items, neither of which are miscellaneous itemized deductions subject to the 2% floor, § 67(b), fiduciary fees and payments to other service providers are the only significant categories of deductible items paid by trusts. see, fiduciary returns filed for tax year 2002: income source, deductions, and tax liability, classified by size of gross income, at http://www.irs.gov/pub/irs-soi/02fi01gi.xis. see also, donald m. etheridge, jr. the 2% solution for miscellaneous deductions after tra_86, prob. & prop. jan.-feb. 1989, at 28, 29. (noting that the principle expenses of trusts are fees to service providers). 129. the professional corporate fiduciary typically offers more services and charges larger commissions than an individual trustee. see, e.g., in re estate of prankard, 723 n.y.s. 2d 315, 324 (surr. ct. 2000) (discussing the nature of services provided by corporate fiduciaries and the justifications for compensating them more generously than individual trustees). 2006] taxing middle class trust(s) 537 of fiduciary duty. every legitimate expenditure of a trust, in other words, is130 traceable to a fiduciary duty. the voluntary-discretionary distinction crafted by the 6th circuit captures one, if not the only, defining difference between expenditures of trusts and those of outright owners. furthermore, this distinction correlates with the business-personal distinction that separates above the line and below the line deductions. like business expenses, trust expenses reduce the amount of income that the taxpayer actually receives from income-producing activities. these expenses have no personal or consumptive element to them because fiduciary duties limit expenditures to those that will produce a financial benefit. the problem with this interpretation is that it amounts to a justification for treating all asset management expenses as above the line deductions. this is inconsistent with the classification of section 212 as a below the line deduction, as well as the statutory mandate to exempt some, but not all, trust expenses from the 2% floor. recognizing this, all of the cases arising after131 o’neill rejected that approach, and its corollary assumption that the cost-averse taxpayer defines the expenditures that “would not have been incurred if the property were not held in [trust].”132 2. incremental costs v. categorical costs the cases following o’neill each involved long-term multi-million dollar trusts, a context in which the profit-maximizing taxpayer, the reasonable taxpayer, and the trustee who actually incurred the expenses would be 130. a well-respected treatise states: a trustee should not receive credit for payments made to obtain the services of others for the trust, when the duties thus delegated should have been performed by the trustee himself. he cannot delegate the various tasks of the trusteeship to specialists, make payments from the trust funds to them for their services, reserve to himself merely the positions of employer and supervisor, and still collect a full commission for being trustee. george gleason bogert & george taylor bogert, the law of trusts and trustees, § 972 at 433-35(2d ed. rev. 1983). 131. see supra note 105. despite the similarities between asset management expenses and business expenditures, the differential treatment has a long history of support. higgins v. us, 312 u.s. 212 (1941), superceded by irc § 212(i). 132. see mellon bank, 47 fed. cl. a t 186, scott, 186 f. supp. 2d at 664; rudkin, 124 t.c. at 304. 538 florida tax review [vol.7:8 synonymous. the profit-maximizing taxpayer would incur all expenses133 designed to maximize income. the reasonable taxpayer would do the same because the assets would produce income greater than the outlays necessary to meet that taxpayer’s expenses. the trustee, of course, did incur the expenses at issue, and so those expenses would be expenses incurred by an outright owner if the trustee’s expenditures defined the expenses an outright owner would incur. these later cases did not consider how, if at all, a reasonable taxpayer would differ from either a profit-maximizing taxpayer or the trustee who incurred the expenses, nor did the later cases consider the circumstances that would lead a reasonable individual to incur (or avoid) particular expenditures. rather than searching for a basis to determine what costs an individual would incur, the courts analyzed trust expenditures in an attempt to find something about the expenditure that would reveal whether, or to what extent, an individual who owned the trust property outright would have incurred the same cost. two different approaches emerged from this analysis: an incremental approach to identifying trust expenses exempt from the 2% floor articulated by the court of federal claims, and a categorical approach to identifying those134 trust expenses essentially identical to the tax court’s formalistic approach.135 in the first case to arise after o’neill, mellon bank, n.a. v. u.s., the court of federal claims considered whether section 67(e) would allow 13 trusts created for the benefit of members of the richard k. mellon family to deduct fees paid to private investment advisors for investment strategy advice, as well as fees paid to richard k. mellon & sons for accounting, tax preparation, and management services rendered to the trusts. these deductions were claimed136 in addition to a deduction for trustees’ commissions paid to manufacturers’ hanover, a professional trustee.137 the famously wealthy family, the sheer number of trusts involved, and the utilization of a family-owned entity to provide services typically provided by corporate trustees, highlighted the financial privilege that this trust 133. scott, 328 f.3d at 136 (trust valued at $25 million); brief for appellant at 4, mellon bank, n.a. v. u.s., 265 f.3d 1275 (fed. cir. 2001) (no. 01-5015) (combined trusts assets worth more than $500 million). for the rudkin case, publicly available documents do not state the value of the trust, but the decision does state that the trust’s total income was $624,816 for the year 2000). rudkin, 124 t.c. at 306. 134. mellon bank, 47 fed. cl. at 189. 135. o’neill, 98 t.c. at 227. 136. 47 fed. cl. at 188. 137. id. 2006] taxing middle class trust(s) 539 represented. a reasonable taxpayer who held this wealth outright would138 pursue long term wealth maximization and, consequently, would incur profitmaximizing expenditures. recognizing this, the court of federal claims followed the tax court in adopting the uniqueness test, and in using the profit-maximizing taxpayer as the implicit benchmark for comparing the expenditures of trusts and individuals. the court of federal claims differed from the tax court,139 however, because it sought to identify the uniqueness of trust expenditures based on the underlying services received by the trust in exchange for particular payments, rather than the label applied to the payments: [t]he fact that costs can be characterized as trustee fees in a trust context says nothing about whether those costs would not have been incurred in a non-trust context. when a trustee assumes responsibility over trust property, the trustee must perform a variety of tasks, some of which are unique to a trust and some of which would have to be performed even if the property were not held in trust. hence, characterizing the fees paid for the performance of these tasks as trustee fees and determining whether or not those fees would have been incurred in the absence of a trust are independent and not logically related inquiries. whether costs for particular services can be characterized as trustee fees is not mentioned as a factor in irc section 67(e)(1) and is simply not relevant to the application of the statute’s plain meaning.140 under the tax court’s more formalistic view, the expenditure would be exempt from the 2% floor if the label of the expenditure connoted a trust relationship, such as trustees’ commission or trust accounting fees. in141 contrast, the court of federal claims’ approach would scrutinize the content of the services received in consideration for the trust’s payment to determine whether individuals would be likely to incur similar expenses. this approach142 would require an analysis of the functions performed by the trustees, and a 138. the history of the financial institutions founded by the mellon family is summarized at www.mellon.com/aboutmellon/history.html. 139. 47 fed. cl. at 190. 140. id. 141. o’neill, 98 t.c. at 230. 142. mellon bank, 47 fed. cl. at 189-90. 540 florida tax review [vol.7:8 parceling of the deduction for trustees’ fees based upon that task-based analysis.143 the court of federal claims’ approach avoids the form over substance problem that the tax court’s approach creates, recognizing that the difference between trust costs and outright ownership costs are a matter of degree rather than a difference in kind. another virtue of the court of federal claims’ approach is that its rationale is more consistent with an interpretation of section 67(e) based on expenditures that a reasonable taxpayer would incur rather than those that a profit-maximizing taxpayer would incur. specifically, the court observed that the prudent person standard imposed by law on fiduciaries paralleled the investment behavior of a prudent individual. this suggests that144 the hypothetical individual who defines the scope of section 67(e) would incur all of the expenditures that the trustees of the mellon trusts incurred because compliance with state trust law requires adherence to a standard of prudence which a reasonable person would follow. the problem with this approach is that it is inordinately, indeed impossibly, complex, without the addition of simplifying assumptions that have no basis in the code. a simple example is the cost of preparing income tax returns. a trust may incur deductible expenses for the preparation of its income tax return (form 1041), but an individual with similar assets would incur similar expenses for the preparation of an individual income tax return (form 1040).145 the collective costs for income tax return preparation typically will be greater when assets are held in trust, because both the trust and the beneficiaries have to prepare returns whereas the individual owner has only a single return to prepare. on the other hand, the amount of work required to prepare an income tax return (and thus the cost) depends much more on the income produced and the assets that produce it than on the owner of those assets. no existing conceptual framework or empirical data suggest how to balance these factors. continuing with the example of tax return preparation, there is no existing data that quantifies the difference between the cost of a fiduciary income tax return and the additional cost that would have been incurred by the beneficiaries if they had held the trust assets in their own names. 143. id. at 190. 144. id. at 191. 145. regs. § 1.212-1(a)(l) (cost of preparing income tax returns is deductible under § 212). etheridge, supra note 128, at 28 (discussing similarity of and differences between preparation of fiduciary returns and individual returns). see also, stevenson, supra note 103, at 662 (discussing the similarity between trust accounting fees and costs of record-keeping incurred by individuals). 2006] taxing middle class trust(s) 541 segregating the portion of these expenses attributable to the trust form of ownership requires some legitimate basis, which presently is non-existent. in the absence of regulations, the court of federal claims’ interpretation requires such unguided balancing in every case. this would146 involve expenditure of time and money by the trust to establish, and by the irs to verify. disputes about the hypothetical data are easy to imagine, particularly because they would involve a set of questionable assumptions. under a subjective approach, simplifying assumptions would be unwarranted. instead, each trust would have to be analyzed individually. one trust might require a significant amount of investment advice that would have been incurred by a reasonable individual who held that level of wealth outright. another trust might require a significant amount of discretionary judgment, which would not be incurred by a reasonable individual who held that level of wealth outright. addressing these factual variances on a case by case basis would be wholly disproportionate to the amounts at issue under section 67(e).147 to avoid the burden of this factual inquiry, the parties in mellon bank entered into a stipulation for purposes of advancing the case to the federal circuit court of appeals. that stipulation, which provided that the trust148 would not submit proof of the expenditures that an individual would have incurred, established the facts necessary to grant the irs’ summary judgment motion. the circuit court affirmed the court of federal claims, but it did not149 address the differences between the tax court and the court of federal claims. instead, it characterized its interpretation as “plain meaning” of the150 statute as if it were consistent with these divergent interpretations.151 146. without an existing conceptual or empirical framework, any of the simplifications that a regulation might adopt would be baseless. the number and magnitude of other pressing issues affecting the integrity of the income tax system suggests that the use of treasury’s resources to develop a conceptual framework or empirical database for the interpretation of a provision that is directly applicable only to trusts and estates would be highly unlikely, if not irresponsible. 147. in o’neill, the amount of tax in dispute was $3534, based on an expenditure for investment advisory fees of $15,374 for a $4.5 million in trust. 98 tax ct. at 229. 148. mellon bank, n.a. v. c.i.r., 86 aftr 6432 (fed. cl. 2000). 149. id. 150. although the irs, the trustee, and amicus all expressed a desire to avoid these complexities, the court of federal claims stated that policy of achieving simplicity could not color the interpretation of the statute. the remedy for complexity, the court’s view, would be statutory amendment or regulatory interpretation that adopted simplifying assumptions. 47 fed cl. at 190. 151. 265 f.3d at 1276. 542 florida tax review [vol.7:8 the tax court’s categorical approach to analyzing trust expenditures would work rough justice in mellon bank because the only expenditures at issue in that case were investment advisory fees, tax preparation fees and management expenses. each of these expenditures involved a relatively small incremental amount attributable to the trust form of ownership, so subjecting these expenditures to the 2% floor on a categorical basis would constitute a reasonable approximation for purposes of section 67(e). if all trust expenditures could be classified as predominantly analogous to costs of outright ownership or predominantly different from costs of outright ownership, the categorical approach could work. the 100 pound gorilla that makes the categorical approach unworkable is trustees’ fees. the government did not challenge the trustees’ claim to a full deduction for their own trustees’ fees in mellon bank (or any of the other cases). if it had, the federal circuit would have had to explain how its substantive approach could apply to trustees’ fees without obviating section 67(e)’s purpose of allowing some, but not all, trust expenditures to qualify for full deductibility. trustees’ fees present this problem because professional trustees typically offer comprehensive services, including investment analysis and strategy, recordkeeping, and the exercise of discretionary judgments about distributions of income and principal. if trustees’ fees qualify for exemption from the 2% floor, then trusts employing corporate fiduciaries receive investment advice and other services that will qualify for full deductibility even though individuals paying for similar services would be subject to the 2% floor. yet subjecting trustees’ fees to the 2% floor would deny full deductibility for services such as the exercise of discretionary judgment about distributions, which have no direct analogue in the context of outright ownership. those services are analogous in a loose sense to estate planning or financial planning that an individual might seek in order to provide for herself or her future beneficiaries, but the scope of the services (and thus the cost attributable to them) is quite different. if these costs are subject to the 2% floor, then virtually nothing qualifies for full deductibility. 3. the weight of authority the next case to arise after mellon, scott v. us, involved a $25.5 million testamentary trust held for the benefit of the settlor’s granddaughters, who were the fourth generation of income beneficiaries of the trust. like the152 152. 328 f.3d at 136. 2006] taxing middle class trust(s) 543 corporate trustee in mellon bank, the three lawyers who served as trustees in scott claimed commissions and also paid custodian fees, investment advisory fees and fees for the preparation of income tax returns and trust accountings.153 like the trustees in o’neill, these trustees had no experience in managing large amounts of assets and declined to serve as trustee unless the services of an investment adviser would be available. the trustees brought this case in154 federal district court, the eastern district of virginia, a jurisdiction not bound by any of the existing precedent interpreting section 67(e).155 the district court chose to follow the existing precedent, applying both the uniqueness test adopted in mellon bank and the legal compulsion test adopted in o’neill. under either test, the district court concluded, the trust’s expenditure for investment advisory fees would be subject to the 2% floor.156 distinguishing the mandates of virginia trust law from those of ohio trust law applicable in o’neill, the district court concluded that the trustees were not compelled to secure investment advice in discharge of their fiduciary duties.157 consequently, the court said, the fees would be subject to the 2% floor under either the federal circuit or the 6th circuit interpretation of section 67(e).158 the district court’s analysis highlighted two problems inherent in the 6th circuit’s incorporation of state law into the interpretation of section 67(e) that had not surfaced in o’neill. first, the incorporation of state law contravenes the general objective of simplifying the treatment of itemized deductions by adding another body of law to consider. second, this approach would159 encourage forum shopping for newly established trusts as well as existing trusts that would seek to change situs or governing law in order to achieve a tax advantage.160 153. 186 f. supp. 2d 664 (2002). 154. id. at 665. 155. taxpayers have the option of litigating disputes in the united states tax court, the federal district courts or the united states court of federal claims. bankruptcy courts occasionally address federal tax issues as well. camilla e. watson & brookes d. billman, jr., federal tax practice & procedure 67 (west 2005). 156. 186 f. supp.2d at 667. 157. id. at 667-668. 158. id. at 660. 159. danielle m. hohos, note, fees paid by trustees for investment strategy advice and management services are not deductible under section 67(e)(1): mellon bank, n/a. v. united states, 54 the tax lawyer 693 (2001). 160. trusts have significant flexibility in the selection of governing law and situs. see generally, 11 eve preminger et al., trusts and estates practice in new york §5:1.42 (lexis 1998). 544 florida tax review [vol.7:8 the 4th circuit rejected the 6th circuit’s interpretation as inconsistent with the plain meaning of the statute, and in that way avoided all of the complications that a state law analysis would have involved. this decision161 added support for the tax court’s interpretation, which identified costs attributable to trust ownership based upon a plain meaning reading of the statute.162 the tax court’s plain meaning interpretation avoids complexity but it creates inequity and opportunities for manipulation that section 67(e) exists to prevent. categorizing expenses based on the label of the expenditure, as the tax court’s approach does, allows trusts to circumvent the 2% floor with ease by bundling their investment advisory fees and similar expenditures into trustees’ compensation. this, in turn, may distort the decision about who should serve163 as trustee. virtually all trust costs will be fully deductible if a professional fiduciary manages the trust, whereas division of responsibilities between nonprofessional trustees and other service providers will cause the fees for investment advice and most other services to be subject to the 2% floor.164 this weakness in the tax court’s approach, addressed in the initial o’neill decision, does not trouble the tax court. tax consequences often turn on the structure of an arrangement that the taxpayer chooses, the tax court noted in o’neill. the tax court re-affirmed its view in 2005 in rudkin v.165 comm’r, a case appealable to the 2nd circuit, which has not yet ruled on the interpretation of §67(e). neither rudkin nor o’neill nor the decisions of the166 4th and the federal circuits that followed the tax court’s interpretation explained how such a formalistic approach would square with the plain intention to prevent the applicability of the 2% floor from turning on the form of ownership. this gap in reasoning undermines the tax court’s approach, both as a matter of statutory interpretation and as a matter of equity. with no 161. 328 f.3d at 132. 162. see supra notes 114-121 and accompanying text. 163. stevenson, supra note 103 at 666. 164. this result cannot be avoided by claiming commissions and then paying investment advisors personally. an individual trustee who takes this approach would have to include commissions in income, but could offset income with the payment of investment advisory fees only to the extent that payment together with the individual’s other miscellaneous itemized deductions exceeded the 2% floor. james l. boring, trusts and the 2% floor, 29 actec notes 98 (2003). 165. 98 t.c. at 231. in the words of the tax court: “we must consider the tax consequences of the events as they actually transpired. the fact that some other method of meeting the trust objectives might conceivably have a different tax result is irrelevant here.” 166. 124 t.c. 304 (2005). 2006] taxing middle class trust(s) 545 alternative interpretation that produces better results, however, it remains the predominant interpretation of section 67(e). iv. filling in the cracks in the two percent floor the fundamental problem with section 67(e) is that it describes a category of expenses (expenses other than those an outright owner would incur) that are not readily identifiable. the difficulty in identifying these expenses is that outright owners exercise choice as to whether or not to incur asset management expenses, and so the statute requires assumptions (or information) about the exercise of this discretion. the challenge that section 67(e) presents is to identify a set of supportable assumptions that produces equitable results with minimal administrative effort. the interpretation that meets this challenge defines expenses attributable to trust ownership as expenses of trusts that distribute all of their income in the taxable year for which expenses are incurred. correspondingly, expenses of trusts that do not distribute all of their income in a given taxable year would be treated as asset management expenses analogous to those incurred by individuals, and thus would be subject to the 2% floor. under this interpretation, the 2% floor applies to all of a trust’s asset management expenses incurred in a taxable year, or none of them, depending upon whether or not the trust distributes all of its income. this interpretation, referred to in the balance of this article as the contextualized interpretation, differs from other interpretations of section 67(e) because it focuses on the use of trust income rather than the character, label, amount or other attribute of a particular expense. although it is less intuitive than the “plain meaning” interpretation, it fits the statutory text at least as well and it produces greater equity with less administrative effort. a. statutory grounding of the contextualized interpretation section 67(e) invites a wide range of interpretations because it articulates a desired end rather than a means to achieve that end. the exemption from the 2% floor for “[expenses] that would not have been incurred if the property were not held in [trust]” requires uniform treatment for asset management expenses incurred by trusts and outright owners. the quoted167 167. cf., irc § 67(e) (flush) (mandating application of the standard in a way that maintains the equity that subchapter j produces for trust beneficiaries and other individuals without regard to the 2% floor). 546 florida tax review [vol.7:8 phrase cannot function as a self-contained standard to achieve the articulated equitable objective, however, because it describes a hypothetical decision by an unidentified owner. the content of the standard depends upon the criteria that would influence the outright owner’s expenditure decisions. to the extent that the criteria involve factual circumstances, those facts (or a process for determining those facts for the owner described in section 67(e)) would be an additional element of the substantive content of the standard. when a statute articulates its objective rather than specifying a standard to achieve that objective, textual and purposive approaches to statutory construction coalesce rather than conflict. there is no conflict between168 statutory text and legislative purpose of section 67(e) because both express a desired result and neither specifies how to achieve it. in this situation, there can be a singular “plain meaning” for the statute only if there is but one means of achieving the statutorily articulated objective. the prevailing “plain meaning” interpretation of section 67(e) assumes that the outright owner will incur all of the expenses incurred by the trustee whose deductions are at issue other than expenses labeled as applicable to trusts only, such as “trustee commissions.” an equally plausible, and arguably superior, set of assumptions underlies the contextualized interpretation. these assumptions, explained and supported below, are: (1) the outright owner contemplated by section 67(e) is a reasonable taxpayer; (2) the reasonable taxpayer will incur asset management expenses for assets that are invested but not for assets that will be consumed; and (3) the trust’s distribution or accumulation of trust income signifies whether the reasonable taxpayer would invest or consume the trust assets if he or she held those assets outright. 1. the reasonable taxpayer standard assumptions about expenditure decisions of the outright owner contemplated by section 67(e) begin with an assumption about the identity of 168. see generally, michael sinclair, guide to statutory interpretation 155-172 (matthew bender & co. 2000). it might be expected that the courts would have settled on an approach, or at least narrowed the spectrum of possible approaches, to interpret the code. despite the thoughtful consideration given to the interpretation of this unique statute, interpretive approaches are as varied for this statute as for any other. see, e.g., rene matteotti, struggling with words in tax jurisprudence – a plea for an equal treatment mode of analysis in construing tax statutes, 108 tax notes 247 (2005); deborah a. geier, textualism and tax cases, 66 temp. l. rev. 445 (1993); lawrence zelenak, thinking about nonliteral interpretations of the internal revenue code, 64 n.c.l. rev. 623 (1986). 2006] taxing middle class trust(s) 547 the outright owner whose expenditure decisions define the scope of section 67(e). in order to produce an objective standard, this owner must be a hypothetical individual as opposed to an actual person associated with the trust whose deductions are at issue. this hypothetical individual cannot be the costaverse taxpayer, who avoids all discretionary expenditures, because this standard would exempt every trust expense from the 2% floor rather than a subset of trust expenses that section 67(e) requires. the opposite hypothetical individual, the profit-maximizing taxpayer, produces a standard that arbitrarily categorizes expenses based on labels rather than substance. this is equally169 unacceptable. the only remaining hypothetical outright owner is the reasonable taxpayer. the reasonable taxpayer will take into account all relevant circumstances to reach decisions. the contextualized nature of the reasonable taxpayer standard is intuitively attractive in terms of fairness, but intuitively objectionable in terms of administrative simplicity. the crux of the challenge presented by section 67(e) is to identify a criterion drawn from the reasonable taxpayer’s circumstances that indicates with reasonable accuracy the expenditure decisions that the reasonable taxpayer would make. 2. asset use as the determinative criterion the reasonable taxpayer will decide whether or not to incur asset management expenses based on his or her anticipated use of the assets. if the assets will be invested for the long term, the reasonable taxpayer will incur investment advisory fees and other asset management expenses because asset management services advance the goal of maximizing wealth. conversely, assets needed to meet current needs will not justify expenditures for asset management services because current consumption obviates wealth maximization objectives (and leaves no income available to pay for asset management expenses). 169. the approach of the court of federal claims, which contemplates a pyramid of hypothetical facts, is as arbitrary as the formalism of the tax court’s approach. the irrationality of the distinctions drawn under the “plain meaning” interpretations of the tax court and the court of federal claims arguably violate horizontal equity. a definitive violation of horizontal equity occurs, however, only if there is no legitimate basis for the distinction drawn. see supra note 34. for example, if the rate of tax due depended upon the number of letters in the taxpayer’s name, the tax rates would violate horizontal equity because there would be no legitimate basis for the different rates of tax. 548 florida tax review [vol.7:8 if a trust is large enough, the size of the trust alone will establish that the reasonable taxpayer would invest for the long term and consequently incur the asset management expenses that advance that objective. the value of the mellon trusts, for example, represented such significant wealth that it would be difficult to imagine a situation in which a reasonable outright owner would consume all of the income produced by the assets rather than using a portion of the income to purchase professional services devoted to maximizing the long term value of the assets. similarly, all of the other cases involved multi-170 million dollar trusts whose trustees determined that it would be cost-effective to litigate the disallowance of 2% of their investment advisory fees (and in the case of mellon bank, certain other expenses). those facts alone suggest a171 level of wealth that would compel an outright owner to incur asset management expenses. when a trust is not so large as to preclude any reasonable possibility that the reasonable taxpayer would consume the trust assets rather than investing them, trust size alone offers no information about the use of the trust’s assets by a reasonable taxpayer. a very small trust could be devoted to longterm wealth accumulation if the outright owner had other sources of income and no unusual expenses. other aspects of the individual’s financial situation, however, could change the reasonable taxpayer’s analysis. if, for example, the trust is the sole source of income and the individual has unusually high expenses or other financial obligations, the assets might be depleted in a short period. in that situation, a reasonable individual might choose to avoid discretionary expenditures for asset management. 172 the divergent conclusions reached by the tax court and 6th circuit in o’neill support the contention that trust size is important only if it compels the conclusion that the trust assets would be invested rather than consumed by a reasonable outright owner. the trust in that case, worth $4.5 million, would173 justify expenditures for asset management by a reasonable individual in many circumstances. yet it is possible to envision circumstances that would cause174 a reasonable taxpayer to consume all of the trust income and thus avoid 170. appellant’s opening brief at 4, mellon bank, n.a. v. us, 265 f.3d 1275 (2001) (no. 01-5015) (combined trusts assets worth more than $500 million). 171. id. scott, 328 f.3d at 136 (trust valued at $25.5 million); for the rudkin case, publicly available documents do not state the value of the trust, but the decision does state that the trust’s total income was $624,816 for the tear 2000). rudkin, 124 t.c. at 307. 172. see supra notes 29-30, and accompanying text. 173. o’neill, 98 t.c. 227. 174. id. 2006] taxing middle class trust(s) 549 incurring asset management expenses. if, for example, the trust supported 10 beneficiaries each of whom had significant expenses and no other source of income, the reasonable taxpayer might conclude that it would be more desirable to invest in no-load mutual funds or utilize other arrangements that did not require expenditure of trust assets. if it is difficult to envision a reasonable taxpayer choosing to avoid asset management expenses, the reason is that a trust fund is, by definition, money set aside for others or for one’s own future use. if the reasonable taxpayer had such funds to set aside, albeit not in trust, it would be clear that those funds would be held for wealth accumulation rather than current consumption. this conception of the reasonable taxpayer – one who owns the entire trust fund outright – equates the reasonable taxpayer with the profitmaximizing taxpayer. the flaw in this conception of the reasonable taxpayer is that no one connected with the trust necessarily has, or could have had, access to or control over the entire trust fund. the existence of the trust prevents anyone from having such control because a trust divides ownership of into legal and beneficial interests. beneficiaries enjoy the value (beneficial ownership) of trust property and bear the consequences of asset management decisions, but beneficiaries have no control over those decisions. trustees have control but no beneficial ownership. the grantor of the trust has less control than the outright owner, and often no control at all over trust assets. by establishing the trust, the grantor divests himself or herself of ownership and retains rights only as provided in the trust instrument.175 the grantor of the trust bears a close resemblance to the reasonable taxpayer, however, in the sense that the grantor owned all of the trust assets outright before creating the trust. as an outright owner, the grantor had the opportunity to hold the trust assets outright with no obligation to incur asset management expenses. the difference between the grantor of the trust and the reasonable taxpayer is that the grantor does not necessarily have an opportunity to retain outright ownership to the point in time when the asset management expenses are incurred. testamentary trusts, for example, commence upon the death of the grantor and thus do not constitute an alternative to outright ownership by the grantor. outright ownership by a different individual, a beneficiary named in the 175. the roles of beneficiary, trustee and grantor may overlap but the overlap can never vest an individual with complete beneficial and legal ownership of trust property. if it did, that individual would possess outright ownership and a trust would not exist. 550 florida tax review [vol.7:8 grantor’s will (or an intestate heir in the case of a grantor who leaves no will), may be possible but this is not necessarily so. a testamentary trust may be established because an outright bequest to the selected beneficiary is impossible or impracticable. a trust for a minor child, for example, is not an alternative to an outright bequest but rather an alternative to guardianship, a fiduciary relationship that typically is more cumbersome than a trust arrangement. in other situations, a grantor may choose to establish a176 testamentary trust rather than leaving outright bequests in order to minimize transfer taxes borne by descendants. if the purpose of the trust is long term wealth maximization, it is appropriate to conceive of the reasonable taxpayer as outright owner of the entire trust fund because an individual connected with the trust (the grantor or his or her successor in interest) could have owned the trust assets outright. if, however, the purpose of the trust is to provide for the current needs of a beneficiary, then the trust assets are not akin to a fund that an individual would hold. instead, the fund would be more analogous to the income stream that an outright owner (like the reasonable taxpayer) would use to cover living expenses and other current consumption. for example, a trust for the benefit of a minor child that is funded with insurance proceeds paid as a result of the grantor’s death covers expenditures that the grantor would have paid from current earnings had he or she survived. this trust represents the liquidation of the grantor’s income producing years. if the grantor had not died, there would be no income producing asset with respect to which the grantor might have contemplated asset management services. an outright owner, like the reasonable taxpayer, would have an income stream rather than a fund holding assets equivalent to the present value of a lifetime of earnings. 3. accumulation-distribution distinction as proxy for asset use the purpose of a trust is a simplified basis for drawing conclusions about the expenditures that a reasonable taxpayer would incur, but it is not simple enough. one problem with the purpose criterion is that the purpose of a trust may change over time. a trust originally established for long term wealth accumulation, for example, may eventually function as a support trust if the 176. see supra note 29. 2006] taxing middle class trust(s) 551 beneficiaries’ circumstances change for the worse. moreover, many trusts177 serve more than one objective, such a trust established to support a disabled child and to accumulate wealth for other issue that will be distributed at the death of the disabled child or some later time. section 67(e) would require178 only a determination whether a trust fit into one of two categories (long term wealth accumulation or current consumption), but even this generalized categorization is not executable without undue complexity.179 a good proxy for the distinction between support trusts and long term wealth accumulation trusts is the distinction subchapter j draws between trusts that distribute all of their income (“distribution trusts”) and those that do not (“accumulation trusts”) for purposes of determining the applicable personal exemption. the distinction between distribution trusts and accumulation trusts180 evidences the use of the trust assets and thus signifies whether or not an outright owner would incur asset management expenses. accumulation of trust income connotes financial privilege available only to those whose income exceeds their consumption. distribution trusts do not carry the same connotation, however, because the beneficiaries who receive the trust income may need, or choose, to consume it. it is possible, of course, that the beneficiaries of a distribution trust may be wealthy enough to save all of the trust income. in that situation, however, the income distributed to them will be taxed at a rate that reflects their privileged position to the same extent that income from other sources would be 177. estate planners often recommend drafting trusts flexibility to permit the trust to change its function as circumstances change. see stocker et al., supra note 30, at 3-25. 178. id. 179. the extent of the difficulty involved in defining the purpose of a trust in such general terms is well illustrated by the history of the “grantor trust rules,” a highly detailed set of objective rules that define whether a trust will be recognized as a separate taxable entity. irc §§ 671-679. in an earlier era, the grantor’s subjective purpose for establishing a trust determined whether the trust was recognized as a separate taxable entity or disregarded so that its income was taxed to the grantor. see helvering v. clifford, 309 u.s. 331 (1940). the gestalt approach to ascertaining subjective intent produced such unsatisfactory results that it was replaced first with detailed regulations, and later with even more detailed statutory rules that identify with particularity trust terms indicative of a purpose to retain control over the assets so substantial that the grantor ought to be taxed as if she owned the assets herself. regs. § 29.22(a)-1 (“clifford regulations” issued after the clifford decision and before the promulgation of the grantor trust rules in subchapter j); irc §§ 671-679 (current grantor trust rules). although the grantor trust rules serve a different specific objective than does § 67(e), they amply illustrate the need for objective criteria to serve as a proxy for an inquiry into the purpose of a trust. 180. irc § 642(b). see supra note 75. 552 florida tax review [vol.7:8 taxed. the accumulation-distribution distinction thus effectively captures the181 essential difference between support trusts and wealth accumulation trusts. although the distribution-accumulation distinction is a fairly accurate proxy for achieving horizontal equity in the taxation of trust income, it is decidedly imperfect. trusts that accumulate income do not always serve long term wealth accumulation goals and trusts that distribute all of their income sometimes do contribute to long term wealth accumulation. a small trust for the benefit of an orphaned minor child, for example, would accumulate trust income for the child’s college education or other adult expenditures if the current support expenses of the child are minimal and simply absorbed into the household expenses of the child’s guardian. conversely, a dynasty trust could provide for distribution of its income without jeopardizing its transfer tax objectives if the trust generates little income (as opposed to capital gain that is allocable to corpus and thus, by definition, not distributable to the income beneficiary). these imperfections are necessary, however, to achieve the182 degree of administrative simplicity that §67(e) requires. 183 b. the argument for judicial adoption the textual analysis of the contextualized interpretation set forth in section a, addresses the threshold question whether this interpretation is viable as a matter of statutory construction. after crossing that threshold, the question becomes whether this interpretation produces results at least as satisfactory as those produced by the prevailing interpretation. this section addresses that question by comparing results of the two interpretations based on several criteria. 1. quantitative analysis any interpretation of section 67(e) that is administratively feasible must incorporate simplifying assumptions. simplifying assumptions create the possibility, if not probability or certainty, that a particular taxpayer would be treated differently if actual facts rather than simplifying assumptions determined tax treatment. the “plain meaning” approach assumes that a label including the term “trust” or “trustee” connotes a service that an individual could not 181. see supra note 51. 182 see supra notes 51-63 and accompanying text. 183 cf., harkness v. us, 199 cl. ct. 721, 459 f.2d 310 (1972), cert. den., 414 u.s. 820 (1973) (illustrating situation in which subchapter j’s use of distributable net income rather than income as defined under state law produced unfairness that would not have occurred under the more complex scheme for taxing trusts that was in force prior to enactment of subchapter j). 2006] taxing middle class trust(s) 553 purchase. the contextualized interpretation incorporates a different simplifying assumption, namely that the trust’s accumulations of some or all of the trust income signifies that an outright owner would hold the trust assets for investment and incur asset management expenditures. the existence and effect of the simplifying assumption incorporated in the contextualized interpretation is more apparent than the simplifying assumption inherent in the plain meaning interpretation. this difference in transparency may create the false impression that the simplifying assumption in the plain meaning interpretation is less significant. a quantitative comparison illustrates the fallacy of this assumption. trusts that distribute all of their income and pay commissions to fiduciaries rather than paying other service providers (e.g., investment advisors) would be treated exactly the same under both approaches: the commissions would be exempt from the 2% floor. trusts that accumulate income and pay other service providers in lieu of commissions would be treated exactly the same under both approaches as well. in that case, the payments to other service providers would be subject to the 2% floor. different results would occur in two cases. the first would be where a trust distributed all of its income but paid other service providers in lieu of commissions. the other would be where a trust accumulated income and paid commissions rather than outside service providers. the charts below show the taxable income of a $1 million trust and184 $10 million trust under the “plain meaning” interpretation and the contextualized interpretation based on the following assumptions: (1) the $ 1 million trust pays $12,000 for services, whether to an outside service provider or a professional fiduciary; and (2) the $10 million trust pays $61,000 for services, whether to an outside service provider or a professional fiduciary. 184. if the trust accumulates its income (as is the case for the trusts shown in the right hand column of the charts), the income shown is the taxable income of the trust. if the trust distributes its income, the income shown is passed out to the beneficiaries (to the extent of distributable net income as described in part i.b). 554 florida tax review [vol.7:8 $1 million trust: trust distributes income and pays outside service providers trust accumulates income and pays commissions “plain meaning” $987,941 $987,900185 186 contextualized $987,700 $987,700187 188 for a trust of $1 million that distributes income, the difference between the results of the two interpretations is negligible. if the trust pays outside service provider, the contextualized interpretation produces $241 less income than does the “plain meaning” interpretation. if the trust pays commissions rather than outside service providers the results, as noted, are identical. the difference between the two interpretations is noteworthy if the trust pays “commissions” and accumulates income rather than distributing it. as the chart above illustrates, the “plain meaning” interpretation would treat the commissions as fully deductible whereas the contextualized interpretation would treat the commissions as management expenses equivalent to those an outright owner would incur. this amounts to a $12,000 difference in taxable income, representing the full amount of commissions paid. 185. the “plain meaning” interpretation creates inordinate complexity in the computation of taxable income whenever the trust distribution can reasonably be expected to exceed the trust’s distributable net income (“dni”). a set of interrelated computations is required, which is explained for tax preparers. 2005 instructions for form 1041 and schedules a, b, d, g, i, j and k-1 at 18-19. the computations for the scenario described in the text would be: amid=$12,000-.02agi agi=$1 million – dni – 300 agi=$999,700-dni amid=$12,000-(.02[999,700-dni]) dni=$1 million – amid amid=$12,000-(.02[999,700-($1million-amid)])=$11,759 tti=$1 million $11,759-$300=987,941 186. $1 million less $12,000 commissions (deductible above the line) less $100 (personal exemption) = $987,900. 187. $1 million less $12,000 commissions less $300 personal exemption = $987,700. 188. $1 million less $12,000 commissions less $300 personal exemption = $987,700. 2006] taxing middle class trust(s) 555 $10 million trust: trust distributes income and pays outside service providers trust accumulates income and pays commissions “plain meaning” $9,939,902 $9,938,900189 190 contextualized $9,938,700 $9,999,900191 192 for the $10 million trust, the difference between the contextualized interpretation and the “plain meaning” interpretation remains negligible for trusts that distribute all of their income. the difference between the two interpretations remains significant for trusts that accumulate income. this quantitative analysis illustrates that only trusts that accumulate income have a real stake in the interpretation of section 67(e). this places a premium on the equitable arguments favoring distribution trusts over accumulation trusts. 2. qualitative analysis the primary equitable argument for the contextualized interpretation of section 67(e) rests on the proposition that trusts serving current needs and trusts established to accumulate wealth for future use or future beneficiaries differ in their social value. managing property for current use serves the important social function of providing for individuals who otherwise might need government support. trusts for long term wealth accumulation, on the other hand, do not serve the same immediate support function, and arguably create a social harm that the tax law ought to discourage rather than encourage.193 distinguishing trust expenditures on this basis alleviates some of the 189. amid=$61,000-.02agi agi=$10 million – dni – 300 agi=$9,999,700-dni amid=$61,000-(.02[9,999,700-dni]) dni=$10 million – amid amid=$61,000-(.029,[999,700-($10 million-amid)])=$59,798 tti=$10 million $59,798-$300=9,939,902 190. $10 million less $61,000 less $100 = $9,938,900. 191. $10 million $61,000-$300=$9,938,700. 192. $10 million less $100 $9,999,900. 193. see ira mark bloom, the gst tail is killing the rule against perpetuities, 87 tax notes 569 (2000) (describing perpetual trusts as interfering with societal objectives, including keeping property responsive to current needs, facilitating productive use of wealth, and affording living individuals some degree of control over property). 556 florida tax review [vol.7:8 financial burden of the trust form of ownership for property management trusts without creating the possibility that the tax system would make use of a trust more cost effective than outright ownership. the contextualized interpretation of section 67(e) achieves equity between outright owners and trust beneficiaries in the same measure that subchapter j creates equity between these two groups with respect to other elements of the income tax computation. subchapter j’s integration of the accumulation-distribution distinction in the taxation of trust income evidences congress’ support for this objective. in addition to the equity of taxing trusts that serve the wealthiest individuals more heavily than other trusts, the contextualized interpretation serves equity by assuring equal treatment for similarly situated trusts. the standard’s grounding in the code’s accumulation distribution distinction is independent of state law and impervious to manipulations by taxpayers. a costbased interpretation runs the risk that the applicability of the 2% floor would depend on state law. even more objectionable is the ability of taxpayers to secure full deductibility of asset management expenses by bundling necessary services as fiduciary commissions as opposed to payments for outside service providers.194 194. for different reasons, both the “plain meaning” interpretation” and the discretionary-mandatory interpretation of the 6th circuit classify fiduciary compensation as exempt from the 2% floor. scott. v. us, 328 f.3d at 136 (the plain meaning of § 67(e) exempts trustees’ commissions from the 2% floor); o’neill v. us, 994 f.2d at 305 (all expenses that are mandatory for trustees are exempt from the 2% floor); rudkin v. us, 124 t.c. at 305 (plain meaning of § 67(e) exempts trustees’ commissions from the 2% floor). the court of federal claims’ interpretation would have denied deductibility for an increment of trustees’ commissions, but the federal circuit’s decision on appeal expressly states that the treatment of costs turns on form rather than substance: the supreme court has “observed repeatedly that, while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, . . . and may not enjoy the benefit of some other route he might have chosen to follow but did not.” nat’l alfalfa dehydrating & milling co., 417 u.s. at 148; see also rite aid corp. v. united states, 255 f.3d 1357, 1360 (fed. cir. 2001) (“a taxpayer is free to organize his affairs as he chooses, but once organized, he must accept the tax consequences of his choice.”). mellon bank chose to hire outside consultants to satisfy their fiduciary duty as trustees. the plain meaning of irc § 67(e)(1) prevents the deduction of fees thus incurred unless they satisfy the general requirement of irc § 67(a). mellon bank, n.a. v. u.s, 265 f.3d at 1281-1282. although trustees’ fees were not at issue in the case, this language strongly suggests that trustees’ fees would be treated categorically rather than incrementally. 2006] taxing middle class trust(s) 557 incorporation of state law into federal tax standard presents perplexing, often unavoidable issues. in some instances, the code specifically defers to195 state law in the determination of tax consequences. in subchapter j, for example, the definition of trust income under state law (and the governing instrument) plays an integral role in determining the allocation of taxable income between the trust and its beneficiaries. where the code does not itself196 expressly defer to state law, however, the recent trend has been to avoid reliance on state law in the interest of jurisdictional uniformity in the application of federal tax law. this assures equity between similarly situated beneficiaries197 who reside in different jurisdictions. moreover, this approach has the virtue of protecting state law from the pressure to evolve in a manner that produces optimal tax results rather than optimal protection for those who hold property in trust.198 the role of state law is most apparent in the 6th circuit’s interpretation, which turns on whether applicable trust law compels the expenditure. state199 law also plays a role, however, in the tax court’s interpretation. under that200 interpretation, treatment of trust accounting fees under § 67(e) depends upon whether the accounting is mandated by the governing instrument or applicable state law. every trustee has the obligation to account to beneficiaries, but the201 195. riggs v. del drago, 317 u.s. 95 (1942). 196. see supra notes 49-63 and accompanying text (discussing the role of fiduciary accounting income, a state law concept, in the federal income taxation of trusts). 197. see, e.g., comm’r v. banks, 523 u.s. 426 (2005) (holding that gross recovery, including contingent legal fees owed to the plaintiff’s attorney, constitute gross income, despite attorney’s security interest in the fee under state law). 198. a good example of this phenomenon is the pressure tax law exerted on state courts to reform wills that failed to qualify for tax benefits. the enactment of retroactive changes to requirements for tax benefits made it all but impossible for courts to adhere to the historic interpretation of the statute of wills which precluded reformation. the change in will reformation doctrine instigated by the code began with tax cases but eventually spread to others until the reformation doctrine was turned on its head. to be sure, this development has its advocates. restatement (third) of prop: donative transfers §§ 12.1, 12.2 (2005) (adopting the view that wills should be subject to reformation in any type of case, and creating a doctrine of modification to give courts extensive to make changes that advance tax purposes). john h. langbein & lawrence w. waggoner, reformation of wills on the ground of mistake: change in the direction of american law?, 130 u. pa. l. rev. 521 (1982) (advance the argument for reversing the historic prohibition on reformation of testamentary instruments). but see, pamela r. champine, my will be done: accommodating the erring and the atypical testator, 80 neb. l. rev. 387 (2001) (advocating limits on reformation of wills). the motivation for it, however, is unfortunate. 199. see supra note 116. 200. see supra note 119. 201. bogert, supra note 130, at §975. 558 florida tax review [vol.7:8 timing, form, extent and expenses of fiduciary accountings vary from jurisdiction to jurisdiction.202 another example of state law’s effect on the tax court’s interpretation of section 67(e) relates to fiduciary compensation. some states establish a commission rate for trustees based on asset value, and require the trustee to provide necessary services or pay for them out of commissions. in a different203 jurisdiction, a trustee may receive compensation based upon the time spent on trust matters and the authority to secure outside service providers to cover services not personally rendered. under the tax court’s interpretation trusts204 in the first jurisdiction would be entitled to a larger deduction than would trusts in the second jurisdiction even if the total amounts expended and the services received for those expenditures were identical. apart from jurisdiction differences, cost-based interpretations produce different treatment for similarly situated trusts that use different fiduciary compensation arrangements. the extent of a trust’s expenditures to outside (i.e., non-trustee) service providers depends, in large part, upon the compensation arrangement with the trustee. professionally-managed trusts, for example, will incur few outside expenses because the trust companies and banks that serve as trustees offer comprehensive services for which they charge a higher rate of trustees’ commissions than would be chargeable by an individual.205 conversely, trusts managed by individual trustees who choose to serve without compensation, tend to incur higher expenditures for outside service providers because the uncompensated trustee may not perform management or recordkeeping services that would be within the scope of the trustee’s responsibilities.206 under a nature of the expenditure approach, trustee’s commissions are treated as fully deductible whereas expenditures for services that some trustees provide (e.g., investment advisory fees) may be subject to the 2% floor. this207 202. 2a scott on trusts, supra note 19, at §164. 203. bogert, supra note 130, at §975, footnote 61. 204. id. 205. matter of prankard, 723 n.y.s.2d 315 (west. surr. 2000) (discussing compensation of corporate fiduciaries). presently, fees charged by professional fiduciaries in new york city for a $1 million trust range generally from $19,200 to $42,500. internal memorandum of the bank of new york (on file with the author). this contrasts sharply with the statutory annual commission due to an individual trustee for a $1 million trust, which would be $6,900. ny scpa § 2309 (mckinney 2004). even for a trust of $10 million, the differential in fees is significant: $36,900 for an individual trustee as compared to $61,900 to $89,000, depending upon the particular bank or trust company. 206. in the case of a trust managed by an individual trustee who receives compensation, expenditures for outside service providers will be appropriate to the extent the services are outside the scope of the trustee’s responsibilities. 207. see mellon bank, n.a. v. us, 47 fed. cl. 186, 189 (2000). 2006] taxing middle class trust(s) 559 benefits professionally managed trusts like those involved in mellon bank, which offer comprehensive fiduciaries in exchange for fiduciary compensation, and correspondingly disadvantages trusts for which a family member or friend is willing to serve without compensation but requires assistance with investments, tax preparation or other aspects of fiduciary responsibilities. the208 professionally managed trust is much more likely to be a wealth accumulation trust because the fees charged by professional fiduciaries are cost prohibitive for all but the largest trusts. the trust-based interpretation avoids this regressive result, treating expenditures as fully deductible or not on a basis independent of the compensation structure for the trust. 3. judicious allocation of resources from the broader perspective of taxpayers generally, as opposed to taxpayers directly affected by the taxation of trust income, the contextualized interpretation offers an important advantage. unlike the “plain meaning” interpretation, which is not tethered to any existing legal or empirical framework, the contextualized interpretation derives from subchapter j. the existing framework creates a basis upon which interpretations, whether judicial or regulatory, can build with ease. the benefit to taxpayers as a group is that the legal system, including the courts, treasury and congress, can devote their limited resources to larger issues rather than parsing or revising § 67(e). to read § 67(e) in a way that requires such an effort is ironic, if not altogether selfdefeating. the extent of the analysis required to arrive at the contextualized interpretation suggests that the adoption of a regulation embodying this interpretation would be helpful. the underpinning in subchapter j, however,209 makes the regulatory project far less costly than it otherwise would be. with the judicial adoption of the contextualized interpretation of § 67(e), it would be efficient and effective for treasury to address the specific issues that the contextualized interpretation does not expressly cover. the treatment of expenses incurred by estates would be the most important of these issues. the accumulation-distribution distinction applicable 208. michael r. o’malley, deductibility of investment advisory fees, 8 prob. & prop. 23 (1994). see also, david h. kirk: note, to be or not to be: a trust’s investment expense deduction subject to the 2% limitation under irc § 67, 1 pitt. tax rev. 223, 247-8 (2004) (suggesting trusts convert asset based investment fees to transaction based fees in order to secure full cost recovery through basis addition rather than having a deduction subject to the 2% floor). 209. as a practical matter, treasury regulations typically withstand challenge, whether they are interpretive regulations issued under § 7805(a) or legislative regulations issued pursuant to a specific directive to in the code. geir, supra note 168, at footnote 51. 560 florida tax review [vol.7:8 to trusts is not directly applicable to estates because estates are intended to be short term entities that distribute all of their property within a few years.210 retention of estate income by the personal representative does not signify an objective of long term wealth accumulation, and distribution does not signify a support objective. instead, retention or distribution of estate income depends upon the details of the estate administration, such as whether the estate has satisfied or provided for obligations that take priority over distribution to beneficiaries; whether the estate assets are liquid or alternatively in a form that allows the personal representative to make distributions in kind; and whether there are probate or constructional issues that raise questions about the identity of the beneficiaries of the estate. income tax planning is sometimes possible in the distribution of estate income, but the short term nature of estates limits the significance of this possibility.211 there would be a justification for either subjecting estate expenses to the 2% floor or to exempting them from the floor. estates could be analogized to accumulation trusts on the grounds that subchapter j subjects estates to the provisions applicable to accumulation trusts regardless of whether the estate distributes all of its income or not. on the other hand, estates could be212 analogized to distribution trusts on the ground that estates cannot themselves serve the objective of long term wealth accumulation. a third alternative213 would be to determine the treatment of estate expenses based on whether the estate actually distributed all of its income or not in the taxable year in which the expenses were incurred. the involuntary nature of estates together with the limitations on the ability to exploit income tax advantages from them suggests that the most equitable resolution would be to exempt estate expenditures from 210. regs. § 1.641(b)-3 (providing that an estate is considered terminated for federal income tax purposes after a reasonable period for the performance by the executor of all the duties of administration regardless of whether the estate is actually terminated). 211. without the limitation on the duration of estates, the opportunities to minimize income tax would be of concern. for a discussion of these opportunities, see generally, preminger supra note 160, at §§ 11:76, 11:92-96, 11:129, 11:172, 11:146-158, 11:208-209 (discussing post-mortem income tax planning opportunities for qualified plan and individual retirement account elections, fiduciary compensation, exercise of the election to claim particular expenses on the estate tax return or the income tax return, timing of distributions, and choice of taxable year); marc s. bekerman, postmortem planning – income tax issues (pli 2004) (discussing limitations on estate duration, allocation of appreciation in the estate, treatment of income in respect of a decedent and other issues). 212. estates do not necessarily distribute all of their income and thus do not necessarily encounter the double tax problem that distribution trusts encounter are classified as “complex trusts” because they, by definition, cannot required to distribute their income on an annual basis. see supra note 27. 213. see supra note 24. 2006] taxing middle class trust(s) 561 the 2% floor. the short term duration of estates limits the importance of the issue for all taxpayers, however, suggesting that certainty is as, or more, important that the actual resolution of the issue. another issue that it would be useful for the regulations to address would be the treatment of expenses incurred by a trust in a year that the trust had no net income. this could occur if the trust investments performed poorly; the trust invested in assets that produced gains attributable to principal rather than returns classified as income such as dividends and interest; or the trust incurred extraordinary expenses. in these types of situations, the accumulation distribution distinction would not determine the treatment of expenses because there would be no net income either to accumulate or distribute. as with the treatment of expenditures of estates, the treatment of the expenditures of these trusts could be justified whether the resolution was to subject them to the 2% floor or to exempt them from the floor. this is more difficult to resolve than the estate income issue, however, because exempting expenses of these trusts would create an opportunity for a trust that served the objective of long term wealth accumulation to secure a full deduction for its expenditures by investing in assets that returned income classified as principal for fiduciary accounting purposes. on the other hand, a trust subjecting these expenditures to the 2% floor would penalize beneficiaries of support trusts whose income was already reduced by poor returns, extraordinary expenses or other economic circumstances. this type of issue is particularly suited to regulatory resolution, because regulations can create a series of detailed rules that address the most typical situations. the regulation could provide, for example, that trusts mandated to distribute income would be entitled to exemption from the 2% floor even if there was no income to distribute. this would allow trusts that, by their terms must function as support trusts, to benefit from the exemption from the 2% floor. regulations also could provide presumptions that would provide clear guidance for trustees, but at the same time preserve an opportunity for the irs to challenge abusive practice. such a regulatory provision might provide that trusts with no income for taxable would be classified as a distribution trust or an accumulation trust based upon the use of trust income in the last year in which the trust had income to distribute or accumulate. this provision could be limited by a time period, after which the trust would be denied exemption for expenses from the 2% floor, either absolutely, or subject to showing that the trust was not functioning as an accumulation trust. a third issue that regulations, if issued, should address is the treatment of trusts that are required to, but do not, distribute income. this situation arises when there is a question about who is entitled to trust income or an income214 214. see, e.g., estate of mildred bruchman, 53 t.c. 403 (1960). 562 florida tax review [vol.7:8 beneficiary refuses to accept a distribution. these trusts should be entitled to215 deduct expenses because the terms of the trust indicate that the trust does not serve the objective of long term wealth accumulation. other situations could justify regulatory treatment as well if they would arise with sufficient frequency to merit special consideration. the objective216 of regulations, if issued, should be to clarify the application of the accumulation-distribution distinction rather than to create a new standard for determining the scope of the 2% floor or to accommodate every idiosyncratic situation that might arise. the amounts involved in this issue simply do not merit extensive attention by treasury. if they merit extensive attention by the trustees of a particular trust, then the trust is probably large enough to justify subjecting its expenses to the 2% floor. the following text, which addresses the issues discussed above, could serve as a regulatory standard for section 67(e): general rule. for purposes of section 67(e), costs “that would not have been incurred had the property not been held in trust or by an estate” include all costs incurred by trusts that distribute all of their income within the meaning of section 641(c) for the taxable year in which such expenditures are incurred, and no costs incurred by trusts that distribute less than all of their income. estates. for purposes of section 67(e), expenses incurred by an estate shall be treated as exempt from section 67(a) for as long as the estate is recognized as a separate taxable entity under regs. section 1.641(b)-3. trusts with no income for a taxable year. the treatment of expenses incurred by a trust that has no income to distribute in a given taxable year shall depend upon the use of the trust income in the last year that the trust had income. if, however, the trust has not earned income in its last three consecutive taxable years, the trust expenses shall be subject to the limitations of section 67(a). 215. see, e.g., seligson v. comm’r, 63 t.c.m. (cch) 3101 (1992), aff’d mem . 15 f.3d 1089 (9th cir. 1994). 216. the treatment of deductions in the year of the termination of a trust or estate is another issue that perhaps might merit regulatory treatment. etheridge, supra note 128, at 28. the general rule permits deductions in excess of income to pass through to beneficiaries in the year of termination. irc § 642(h)(2). under the trust-based interpretation, there would be no reason to deviate from the general rule. 2006] taxing middle class trust(s) 563 trusts required to distribute all of their income. the treatment of expenses incurred by a trust that is required to distribute all of its income within the meaning of section 641(c) shall be treated as exempt from section 67(a), whether or not the trust actually distributes all of its income in the taxable year that expenses are incurred. v. conclusion the inequity brought about by section 67(e) happened because the adoption of that provision and subsequent interpretations of it assumed that trusts had no relevance to middle class taxpayers. this issue is important to equity both substantively and symbolically. substantively, trusts established by wealthy individuals for long term wealth accumulation to benefit descendants in the future would contribute more to tax revenues and the burden on other taxpayers would be relieved in a corresponding amount. the symbolic importance of the issue is that it highlights the need to understand who tax provisions affect and what that effect is. without this understanding, tax reform can never move beyond the simplistic rhetoric that has brought the once respected internal revenue code into disrepute. florida tax review vol ume 8 2007 number 6 hidden foreign aid by david e. pozen* intro d uc tio n ......................................................................................... 642 i. hidden sources of a id ..................................................................... 643 a. nonprofit tax expenditures ..................................................... 647 b. other tax expenditures ........................................................... 651 ii. estim ating the expense ................................................................. 657 a . c avea ts .................................................................................... 65 7 1. m easurem ent issues .................................................... 657 2. incom e eff ects ............................................................. 660 b. a rough cut at the numbers ................................................... 662 iii. w hy it m atters .............................................................................. 665 a . r edefining od a ....................................................................... 665 b. the value of proper counting ................................................. 668 1. g eneral relevance ...................................................... 668 2. statistical relevance ................................................... 669 3. two unpersuasive objections ..................................... 671 c. for (and against) tax expenditure aid .................................. 672 c o n c lu sio n ............................................................................................ 679 * for the 2007-2008 academic year, the author is serving as special assistant to senator edward m. kennedy under the yale law school heyman fellowship program. for helpful comments, he is grateful to alicia bannon, ilan benshalom, evelyn brody, john colombo, michael graetz, allan samansky, simon scott, john simon, and burt weisbrod. this article builds on a student comment, tax expenditures as foreign aid, 116 yale l.j. 869 (2007); the author thanks the yale law journal for permission to use some of that material. florida tax review introduction few issues in global politics are as contentious as foreign aid how much rich countries should give, in what ways, to whom. for years, it has been a commonplace that u.s. policies are stingy. the organization for economic cooperation and development (oecd) routinely ranks the united states far behind its industrialized peers in official development assistance (oda), measured as a percentage of gross national income (gni).' an endless parade of critics has implored the government to do more; some suggest that the bush administration's support for the monterrey consensus, which sets a goal of increasing assistance to 0.7% of gni, commits it to do more.2 against these allegations of miserliness, executive officials and certain sympathetic scholars have begun to argue that the published statistics are misleading because they fail to account for individual and corporate philanthropy. what the oecd misses, this argument runs, is the exceptional extent of americans' private generosity.' what both sides of the debate have missed, this article proposes, is not the role of the private sector in generating foreign aid but the role of tax expenditures in subsidizing it. better known as tax breaks or loopholes, tax expenditures are deviations from the normal tax structure "designed to favor a 1. see, e.g., richard manning, org. for econ. cooperation & dev., development co-operation report 2005, at 16 tbl. 1.1 (2006) (ranking the united states second to last in 2004 and last in 2006, with an oda/gni ratio less than half the european union average). in 2004 the united states gave $19.7 billion, or 0.17% of gni. id. 2. see, e.g., jeffrey d. sachs, the end of poverty: economic possibilities for our time 329, 337-40 (2005) (asserting that questions about solving global poverty are "particularly american questions these days" and urging the u.s. government to fulfill its monterrey consensus pledge); united nations dev. programme, human development report 2005, at 86 (2005) (describing the monterrey consensus and the united states' explicit refusal to "see the 0.7% target as an operational budget commitment"). 3. perhaps the most influential work in this vein has been that of carol adelman and her colleagues at the hudson institute. see, e.g., carol c. adelman et al., hudson inst., america's total economic engagement with the developing world: rethinking the uses and nature of foreign aid (2005), available at http://www.hudson.org/files/publications/rethinkingforeignaid.pdf, hudson inst., the index of global philanthropy 2007 (2007), available at http://gpr.hudson.org/files/publications/indexglobalphilanthropy2007.pdf; see also u.s. agency for int'l dev., foreign aid in the national interest: promoting freedom, security, and opportunity ch. 6 (2002) (echoing the hudson institute's arguments that oda fails to capture "the full measure of foreign aid"); editorial, privatize foreign aid?, wall st. j., july 7-8, 2007, at a6 (citing hudson institute statistics for the proposition that "[a]ll this generosity [from the private sector] counters the claim the u.s. isn't pulling its weight in foreign aid"). [vol. 8:6 hidden foreign aid particular industry, activity, or class of persons."4 they take the form of deductions, exemptions, exclusions, deferrals, credits, or preferential rates. economically, these "expenditures" may be seen as equivalent to direct government outlays: if u.s. taxpayers saved $70 billion last year from, say, the mortgage interest deduction, the government therefore gave a $70 billion (implicit) subsidy to homeownership.' stanley surrey pioneered the theory of tax expenditures in the late 1960s, and the concept is now widely, though not universally, credited.6 since 1974, congress has required the annual publication of a tax expenditure budget.7 although not immediately evident from the budget data, in recent years a growing amount of expenditure has gone toward foreign aid. the reason lies in america's tax treatment of nonprofit organizations. whenever u.s. charities and foundations spend money overseas as they have increasingly been doing some portion of this spending can be attributed to the support they receive from numerous state and federal tax privileges. more controversially, several other domestic tax expenditures, such as the deferral granted to foreign source active business income, might also be seen as providing foreign assistance. unlike traditional oda, these tax expenditure funds are privately organized and distributed, yet unlike voluntary transfers they are paid for by the public fisc. this is not private aid; it is privatized aid. the basic, descriptive goal of this article is to show, in parts i and ii, how nonprofit tax policies have shaped the content of american aid. this analysis implies that the definition of oda should be revised, as the next part explains. the broader goal is to begin to connect these insights, in the balance of part iii, with the literatures on tax expenditures and international development and, in so doing, to illuminate some attractive and unattractive features of using tax expenditures in the foreign aid context. while my focus throughout is on the united states, the central argument can be generalized to any country with broadly analogous international tax policies. i. hidden sources of aid tax expenditures that arguably provide foreign aid fall into two main buckets: those aimed primarily at the nonprofit sector and those aimed primarily at the for-profit sector. section a of this part describes the former, section b the latter. 4. stanley s. surrey & paul r. mcdaniel, tax expenditures 3 (1985). 5. this is the simplest and most common way to quantify tax expenditure costs, but it is not the only one. see infra text accompanying notes 69-73 (explaining the standard methods used for calculating tax expenditures). 6. see infra notes 16-18 and accompanying text. 7. congressional budget and impoundment control act of 1974, pub. l. no. 93-344, § 601(a), 88 stat. 297, 323 (codified as amended at 31 u.s.c. § 1105(a)(16) (2006)). 20071 florida tax review the idea that u.s. tax policy can serve as a vehicle for fostering economic development overseas, i should note at the outset, is not a new one. john f. kennedy promoted various tax measures to encourage american enterprise in developing countries early in his administration,8 and robert hellawell was able to write uncontroversially in 1966 about the tax code's "favoritism toward investment in less developed countries" as "an important part of our foreign aid program." 9 president kennedy, professor hellawell, and many others have debated the propriety and efficacy of tax subsidies designed to promote foreign investment. hardly any commentators, however, have addressed the international developmentand welfare-enhancing potential of tax provisions not designed with commercial investment in mind the nonprofit sector provisions discussed in section a.' 0 this oversight is curious because 8. see michael j. graetz, taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 54 tax l. rev. 261, 273-75 (2001) (describing these efforts). most notably, in 1961 the kennedy administration proposed eliminating deferral for all foreign source active business income, except for income earned by certain corporations in developing countries. see message from the president of the united states relative to our federal tax system, h.r. doc. no. 87-140, at 6-7, 51-56 (1961). this proposal would have had the obvious effect of making investment in developing countries relatively more attractive. 9. robert hellawell, united states income taxation and less developed countries: a critical appraisal, 66 colum. l. rev. 1393, 1393-94 (1966). as professor hellawell notes, this "favoritism" had another important purpose: to help develop new foreign markets for american exports, investments, and other commercial interests. id. in this cold war period, it seems likely that the desire to spread american values and political influence provided an additional rationale. more recent examples of scholarship that has made the comparison between foreign-investment-related tax expenditures and foreign aid include j. clifton fleming, jr. et al., fairness in international taxation: the ability-to-pay case for taxing worldwide income, 5 fla. tax rev. 299, 344-46 (2001) (arguing on foreign policy grounds against a general exemption or deferral system as a substitute for direct aid); mitchell a. kane, risk and redistribution in open and closed economies, 92 va. l. rev. 867, 927-28 (2006) (considering tax-generated "divergence" in financial risk across states as a form of implicit foreign aid); daniel lubetzky, incentives for peace and profits: federal legislation to encourage u.s. enterprises to invest in arab-israeli joint ventures, 15 mich. j. int'l l. 405, 419 (1994) (asserting that corporate tax incentives are more efficient than direct grants in foreign aid); yoram margalioth, tax competition, foreign direct investment and growth: using the tax system to promote developing countries, 23 va. tax rev. 161,201 (2003) (suggesting that "rich countries should replace some of their foreign direct aid with an equity-based tax expenditure policy"); and robert j. peroni, response to professor mcdaniel's article, 35 geo. wash. int'l l. rev. 297, 297 (2003) (questioning "the wisdom of using the federal income tax system as a means of providing economic assistance to developing nations"). 10. cf. david roodman & scott standley, tax policies to promote private charitable giving in dac countries 3 (ctr. for global dev., working paper no. 82, 2006), available at http://www.cgdev.org/files/6303_filewp_82.pdf ("cross-country [vol. 8:6 hidden foreign aid these latter expenditures have the better conceptual claim to being aid (on account of their charitable purpose) and, quite possibly, have had more profound effects on the life of developing countries. what should count as "official development assistance" the most commonly used measure of foreign aid or "official assistance" is a contentious issue. the oecd formula serves as the international benchmark, and i adopt it as the reference point for my analysis. it defines official assistance as grants, technical support, or submarket-rate loans in foreign countries that are "undertaken by the official sector[] with the promotion of economic development and welfare as the main objective."" oda must satisfy the further criterion that it goes to loweror middle-income countries, both of which, following oecd and world bank practice, i will refer to throughout as "developing countries."' 2 the oecd definition of aid leaves out all private spending, including both charitable donations and remittance payments, as well as all military spending and tax effects. critics have questioned each of these exclusions;" in this article, i take aim only at the last one. private spending and military spending have functional, purposive, and expressive characteristics that differentiate them in significant ways from public nonmilitary spending, and, so long as they are tallied somewhere as they are 4 it seems reasonable that they not be considered part analyses of the impact of tax policy on giving for development ... are virtually nonexistent .... [t]ax policy, as it affects international private giving, is an important yet largely ignored aspect of aid policy."). 11. manning, supra note 1, at 260. 12. id. for the most recent list of countries that qualify as oda recipients, see org. for econ. cooperation & dev., dac list of oda recipients, http://www.oecd.org/dataoecd/43/51/35832713.pdf(last visited apr. 12,2007). the list comprises all of africa, most of south america and central america, and a smattering of countries in asia, europe, and the middle east. a brief discussion of the origins and evolution of the list may be found at org. for econ. cooperation & dev., history of dac lists of aid recipient countries, http://www.oecd.org/document/ 55/0,2340,en_2649_34447_35832055_111_1 ,00.html (last visited apr. 12, 2007). 13. see, e.g., adelman et al., supra note 3 (questioning the exclusion of private contributions and remittance payments); u.s. agency for int'l dev., supra note 3, ch. 6 (questioning the exclusion of private contributions, remittance payments, and certain defense expenditures); richard posner, should the united states provide foreign aid?, the becker-posner blog, jan. 21, 2007, http://www.becker-posnerblog.com/archives/2007/0 1/should the unit.html (questioning the exclusion of private contributions and defense expenditures); see also infra notes 98-107 and accompanying text (discussing oecd member countries' debate over counting the value of deductions for gifts to development organizations). 14. most importantly, the oecd itself, through its development cooperation directorate (dac), collects and publishes the most comprehensive data available on private cross-border charitable flows. see generally dev. cooperation directorate, org. for econ. cooperation & dev., aid from dac members, 2007] florida tax review of oda. by contrast, the tax expenditures discussed below are not tallied anywhere, nor do they play any discernible role in the foreign aid conversation.15 they are the one major source of foreign aid that remains truly hidden. and yet, these tax expenditures approximate much more closely the activities that people tend to think of as aid: they too represent a form of state fiscal intervention in the civilian sphere. more so than private spending and military spending, i would argue, the exclusion of these expenditures from oda lacks a principled basis. either way, they alone are the focus of this inquiry. what, if anything, should count as a tax expenditure is also a contentious issue. some tax scholars reject the entire notion of tax expenditures arguing, for example, that there is no such thing as a value-neutral "normal" or "normative" tax base from which deviations can be reliably identified and measured 6 while others would construe these expenditures quite differently than the mainstream practice. 7 i cannot engage with this decades-old debate in this article; if you believe that tax expenditures are bogus, you presumably will not be very interested in the argument here. my hope (and assumption) is that most readers do not so believe, even if they have some doubts about the precise nature and proper usage of this concept.18 http://www.oecd.org/dac/stats/dac (last visited apr. 12, 2007); see also roodman & standley, supra note 10, at 3-10 (describing the dac's and other groups' data collection initiatives). 15. tax expenditures, for example, make no appearance in the hudson institute's latest index of global philanthropy, which purports "to comprehensively detail the sources and magnitude of private giving to the developing world," hudson inst., supra note 3, at 3, or in the u.s. agency for international development's leading report on the subject, which purports to reveal "the full measure of[u.s.] foreign aid," u.s. agency for int'l dev., supra note 3, at 129. 16. for an early, powerful criticism to this effect, see boris 1. bittker, accounting for federal "tax subsidies" in the national budget, 22 nat'l tax j. 244 (1969). for more recent iterations, see bruce bartlett, the end of tax expenditures as we know them?, 92 tax notes 413 (july 16, 2001); and douglas a. kahn & jeffrey s. lehman, tax expenditure budgets: a critical view, 54 tax notes 1661 (mar. 30, 1992). 17. significant reconceptualizations include daniel n. shaviro, rethinking tax expenditures and fiscal language, 57 tax l. rev. 187 (2004) (arguing that tax expenditures are better defined as allocative rules than as government spending and that tax expenditure budgeting ought to be more flexible in its classifications); and victor thuronyi, tax expenditures: a reassessment, 1988 duke l.j. 1155 (proposing "substitutable tax provisions" as an alternative to the normative tax as a baseline for tax expenditure analysis). 18. despite its detractors, the tax expenditure concept has become a widely accepted tool for tax and budgetary analysis across the world, used by national and subnational governments, the oecd, and the world bank alike. see, e.g., international aspects of tax expenditures: a comparative study 5 (paul r. mcdaniel & stanley s. surrey eds., 1985) [hereinafter international aspects] (providing a template for [vol. 8:6 hidden foreign aid a. nonprofit tax expenditures no other tax system is as generous to its nonprofit organizations as that of the united states; 9 u.s. nonprofit law is, in large measure, a coordinated regime of tax privileges. many nonprofits are exempt from income, property, sales, and franchise taxes at all levels of govemment. ° contributions to charities may be deductible under state and federal income, gift, and estate taxes. section 501(c)(3) nonprofits are allowed to issue tax-exempt bonds.2, not everyone agrees that these tax privileges constitute tax expenditures. the joint committee on taxation (jct) and the office of management and budget (omb), for example, include the charitable contributions deduction but not the income tax exemption in their annual tax expenditure compilations.2 2 because of the special nature of charitable giving and nonprofit enterprise, one might view the forgone revenue from these provisions as a necessary concession to measurement difficulties, donor equity, comparative analysis and noting that "[t]he fact that tax and budget experts from different countries have been able to identify and quantify tax expenditures within their respective tax systems gives considerable support to the experience of this study group that there exist broadly shared views as to the elements that constitute a normative income, value added or wealth tax"); org. for econ. cooperation & dev., tax expenditures: recent experiences (1996) [hereinafter oecd tax expenditure report] (surveying tax expenditure usage and reporting in fourteen oecd countries); world bank, tax expenditures shedding light on government spending through the tax system: lessons from developed and transition economies (hana polackova brixi et al. eds., 2004) (examining seven tax expenditure systems and suggesting implications for developing countries). 19. see john simon et al., the federal tax treatment of charitable organizations, in the nonprofit sector: a research handbook 267, 267 (walter w. powell & richard steinberg eds., 2d ed. 2006). 20. exempt organizations must pay taxes on their unrelated business income (ubit), irc § 511 (2006), but commentators have frequently suggested that the ubit rules permit broad underreporting and are structurally more generous than the rules faced by for-profit competitors. see evelyn brody, charities in tax reform: threats to subsidies overt and covert, 66 tenn. l. rev. 687, 702-03 (1999); ethan stone, adhering to the old line: uncovering the history and political function of the unrelated business income tax, 54 emory l.j. 1475, 1494-97 (2005). 21. nonprofit organizations also receive many lesser tax privileges. for a thorough discussion of their tax treatment, see generally james j. fishman & stephen schwarz, nonprofit organizations: cases and materials pts. 3-4 (3d ed. 2006); and bazil facchina et al., privileges and exemptions enjoyed by nonprofit organizations, 28 u.s.f. l. rev. 85 (1993). 22. see, e.g., staff of joint comm. on taxation, 109th cong., estimates of federal tax expenditures for fiscal years 2006-10, at 7-8 (comm. print 2006); office of mgmt. & budget, analytical perspectives: budget of the united states government, fiscal year 2008, at 287-90 tbl. 19-1 (2007). 2007] florida tax review or the conceptual integrity of the tax base. among tax scholars, however, it is common to view both the deduction and the exemption as tax expenditures as government subsidies justifiable, if at all, on consequentialist grounds." the supreme court seems to concur.24 almost everyone who believes in the existence of tax expenditures believes that the charitable deduction is one." this is significant because, as we will see in the following part, it is this provision above all others that accounts for hidden foreign aid. if one acknowledges the nonprofit tax preferences (or some subset thereof) to be tax expenditures, it follows that the government acts as an indirect fiscal sponsor of the beneficiary organizations, in all that they do. when the organizations expend funds on grants, technical support, or submarket-rate loans in developing countries "with the promotion of economic development and welfare as the main objective, 26 it is hard to see why, analytically, the tax expenditure portion of these funds the portion effectively paid for by the government should not count as oda.27 23. see fishman & schwarz, supra note 21, at 329 ("under traditional theory, tax exemptions and charitable deductions are viewed as government subsidies to the organizations and their donors."); developments in the lawnonprofit corporations, 105 harv. l. rev. 1578, 1620 (1992) ("the subsidy theory is the traditional rationale for the [nonprofit] tax exemption."); see also surrey & mcdaniel, supra note 4, at 220 (arguing that the "omission [of the nonprofit income tax exemption] from the u.s. tax expenditure lists is a serious one and should be rectified"). 24. see bob jones univ. v. united states, 461 u.s. 574, 591 (1983) ("when the government grants exemptions or allows deductions all taxpayers are affected; the very fact of the exemption or deduction for the donor means that other taxpayers can be said to be indirect and vicarious 'donors."'); regan v. taxation with representation of wash., 461 u.s. 540, 544 (1983) ("both tax exemptions and tax deductibility are a form of subsidy that is administered through the tax system."). but see walz v. tax comm'n, 397 u.s. 664, 675 (1970) (distinguishing between a "direct money subsidy" and a grant of tax-exempt status for creating government involvement in religion). 25. see brody, supra note 20, at 691 n.5; john d. colombo, the marketing of philanthropy and the charitable contributions deduction: integrating theories for the deduction and tax exemption, 36 wake forest l. rev. 657, 682 (2001). but see william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309, 344-75 (1972) (disputing this characterization). 26 this is the oecd's definition of oda. see supra notes 11-12 and accompanying text. 27. if it helps to put this claim in algebraic terms, here is how burt weisbrod has explained it with respect to the charitable deduction: [w]ith tax-deductible donations, whether for domestic or foreign purposes, a donation by person x of $y to organization z has the following direct effects: (1) z receives $y, (2) person x gives up $y(1-t) -where t = x's marginal income tax rate, and (3) all other members of society, as a whole, give up $y(t). i believe your point, with which i agree, is that when t > 0, society (the "public") is a [vol. 8:6 hidden foreign aid with the charitable deduction, the foreign aid subsidy occurs any time individuals or corporations make contributions to a u.s.-based nonprofit that runs or supports appropriate programs outside the country. federal income tax deductions are not available for gifts made directly to foreign recipients, but the rules allow full deductibility for gifts made through an american intermediary.2" with the various entity-level exemptions, the foreign aid subsidy can occur whenever a u.s.-based organization sends abroad money it would have otherwise lost to taxes. many private individuals and organizations contribute to international development causes without regard for tax incentives, and the federal government often uses private contractors to implement its aid programs 9 phenomena that have both been referred to as the "privatization of foreign aid" but tax expenditures are different in that the first phenomenon, on the one hand, does not deprive the government of revenue it would have otherwise collected, while the second phenomenon, on the other hand, involves explicit state action. the charitable tax expenditures have a governmental source, one might say, but they never flow through any governmental entity. they are more contributor. when the foreign aid is directly from government, t = 1; if, on average, private donations are deductible at a marginal rate of, say, 0.3, then society as a whole, excluding person x, pays 0.3 times the donation by person x. in short, using these illustrative numbers, $1 of governmental aid plus $1 of private donations = $1.30 of "public" aid. e-mail from burton weisbrod, john evans professor of economics, northwestern university, to david pozen (dec. 14, 2006) (on file with author). it might be objected that even if the promotion of economic development and welfare abroad is the main objective of these nonprofit organizations, it is not the main objective of the u.s. government, and the latter's motives are what matters under the oecd definition. this objection seems like splitting hairs, though. the u.s. government places no geographic restrictions on the property and income tax exemptions or the gift and estate tax deductions, and it allows full deductibility for cross-border gifts under the income tax so long as the gifts pass through a domestic intermediary. see david e. pozen, remapping the charitable deduction, 39 conn. l. rev. 531, 537-42 (2006) (summarizing these rules). these rules put the united states toward the more internationalist end of the spectrum in the generosity of its tax policies affecting foreign giving. see anthony c. infanti, spontaneous tax coordination: on adopting a comparative approach to reforming the u.s. international tax regime, 35 vand. j. transnat'l l. 1105, 1223-26 (2002); pozen, supra, at 546 n.67, 594. surely a central objective of this policy regime is to support the work that the recipient charities do across the globe. 28. irc § 170(c)(2)(a). under the gift and estate taxes, these geographic restrictions do not apply. id. §§ 2055, 2522. 29. see curt tamoff& larry nowels, cong. research serv., foreign aid: an introductory overview of u.s. programs and policy 26 (2004); u.s. agency for int'l dev., supra note 3, at 140-41. 20071 florida tax review public than unsubsidized private spending, but less public than conventional government spending. as the u.s. nonprofit sector has grown larger and more international, it stands to reason that tax expenditures on foreign aid have swelled correspondingly. of the 2,078 public charities classified by the irs in 1998 as "international and foreign affairs" entities, 88% were founded in 1970 or later and 62% were founded in 1985 or later.3° internationally focused charities and foundations currently make up about 2% of the nonprofit sector, in numerical and revenue terms, and this figure is expected to rise.31 warren buffett's recent $31 billion pledge to the gates foundation in itself ensures that "international [foundation] giving can be expected to grow at a healthy pace" over the next decade.32 many of the domestically focused organizations, moreover, have expanding overseas roles.33 these trends reflect a distinctive feature of tax expenditures as compared to direct expenditures: once the triggering tax preference is established, the expenditure becomes a function of exogenous factors and can grow or shrink dramatically without any government action. 30. murray s. weitzman et al., the new nonprofit almanac and desk reference 133 tbl.5.4 (2002). 31. janelle a. kerlin & supapom thanasombat, urban inst., the international charitable nonprofit subsector: scope, size, and revenue 1, 6 (2006), available at http://urban.org/uploadedpdf/311360_nonprofit subsector.pdf. as of2003, the median age of these internationally focused organizations was only seven years. elizabeth j. reid & janelle a. kerlin, urban inst., the international charitable nonprofit subsector in the united states: international understanding, international development and assistance, and international affairs 10 tbl.2 (2006), available at http://urban.org/uploadedpdf/411276 nonprofit subsector.pdf. 32. loren renz & josie atienza, found. ctr., international grantmaking update: a snapshot of u.s. foundation trends 7 (2006), available at http://foundationcenter.org/gainknowledge/research/pdf/intlupdate 2006.pdf. the foundation center reports that international gifts represented 18% of overall giving by u.s. foundations in terms of grant dollars and 8% in terms of number of grants in 2004, up from 5% on both measures in 1982. id. at 2. in a recent study on the role of foundations in international development work, the oecd observed that "united states foundations are by far the most important in the development field," owing to their size and experience. dev. assistance comm., org. for econ. cooperation & dev., philanthropic foundations and development co-operation 30 (2003); see also id. at 49 tbl. 1 & 52 tbl.3 (indicating that international giving by u.s. foundations grew from $0.8 billion in 1990 to $3.1 billion in 2000, with approximately 30% of the 2000 amount attributable to the gates foundation). for a detailed discussion ofu.s. tax laws that bear on foundations' international philanthropy, see nina j. crimm, through a postseptember 11 looking glass: assessing the roles of federal tax laws and tax policies applicable to global philanthropy by private foundations and their donors, 23 va. tax rev. 1 (2003). 33. see pozen, supra note 27, at 568-70 (describing the growing international role of u.s. charities, foundations, and donors and providing further statistics). [vol. 8:6 hidden foreign aid indeed, the recent growth in america's tax expenditure aid cuts in the opposite direction of its post-marshall plan secular decline in official aid.34 b. other tax expenditures beyond the nonprofit sector tax privileges, a number of other tax expenditures might have a claim to providing hidden foreign aid. an obvious place to start looking is the list of tax expenditures in the "international affairs" section of the jct and omb budgets: the exclusion of income earned abroad by u.s. citizens, the exclusion of certain allowances for federal employees abroad, the exclusion of extraterritorial income, the deferral of active income of controlled foreign corporations, the deferral of certain active financing income, and the inventory property sales source rule exception. 35 all of these tax expenditures generate extraterritorial economic benefits by making it more likely that american citizens and companies will want to earn income in foreign countries and to keep it there. not included in the list of international affairs tax expenditures is the foreign tax credit3 6 "the cornerstone of u.s. international tax policy" for nearly a century37 though some have argued that it deserves a place. the foreign tax credit encompasses a complex web of rules, but its basic function is to allow u.s. residents a credit against their income tax bill for the income taxes they have already paid to a foreign source country. most tax scholars see this provision not as a tax expenditure designed to incentivize foreign source income-earning activities, but rather as a mechanism for avoiding double taxation and thereby safeguarding the structure of the normative tax base and accommodating the goal of capital export neutrality.38 the desire 34. see tarnoff & nowels, supra note 29, at 15 figs.7 & 8, 30-31 tbl.5 (charting the decline in official aid in real dollars and as a percentage of gdp). 35. staff of joint comm. on taxation, supra note 22, at 30 tbl.1; office of mgmt. & budget, supra note 22, at 287 tbl. 19-1. the treasury report provides a brief explanation of these expenditures in office of mgmt. & budget, supra note 22, at 300. the extraterritorial income exclusion was repealed in 2004 but remains partly in place for a transitional period. id. the exclusion of foreign earned income, it bears noting, may benefit nonprofit organizations (foreign as well as domestic) that employ u.s. citizens abroad. i omitted this provision from the previous section because it is in no way aimed at the nonprofit sector. 36. irc § 901, 904. 37. michael j. graetz, foundations of international income taxation 157 (2003). professor graetz provides a detailed overview of the foreign tax credit in id. ch. 4. 38. see, e.g., surrey & mcdaniel, supra note 4, at 162; russell k. osgood, the ages and themes of income taxation: savings and investment, 68 cornell l. rev. 521, 525 (1983); robert j. peroni, a hitchhiker's guide to reform ofthe foreign tax credit limitation, 56 smu l. rev. 391, 391 (2003); thuronyi, supra note 17, at 1164 n.55. capital export neutrality refers to the principle that resident taxpayers should be made 2007] florida tax review to avoid double taxation, michael graetz and michael o'hear have shown, was the animating goal behind the introduction of the foreign tax credit in 1918 3 9 a time when no other countries offered similar tax relief.4" some commentators have argued that the foreign tax credit should be considered a tax expenditure, at least in part, because there are other means to prevent double taxation that would be less generous to the resident taxpayer, namely a deduction for source-country taxes.4' (note, though, that there are also means that would be more generous: exempting source-country income from u.s. taxation altogether.)42 notwithstanding this line of dissent, i will follow mainstream practice in this article and decline to count the foreign tax credit as a tax expenditure. however one construes the aforementioned provisions, it is not clear that any of them meet the oda requirement of having as their main objective the promotion of economic development and welfare abroad.43 the drafters of these provisions and the authorizing congresses may have had this objective in mind, but they plainly sought to pursue other goals as well: the economic goal of helping u.s. multinational companies develop foreign markets and the geopolitical goal of spreading american influence. as daniel shaviro remarks in a recent paper, the idea that u.s. tax policy to feel indifferent, economically, between domestic and foreign investments providing the same pretax expected rate of return. it is thought by many to be essential for worldwide economic efficiency. 39. see michael j. graetz & michael m. o'hear, the "original intent" ofu.s. international taxation, 46 duke l.j. 1021, 1043-54 (1997) (explaining the arguments and aims of t.s. adams, the key champion of the early legislation). a concern to promote international trade and to help rebuild europe after world war i, graetz and o'hear indicate, also contributed to the passage of the foreign tax credit. id. at 1049-53. 40. see id. at 1045 ("the ftc represented what was an extraordinarily generous measure for its time: the united states was assuming sole responsibility for the costs of reducing the double taxation of its residents and citizens."). 41. although a staunch critic ofthe tax expenditure concept, boris bittker once suggested this line of argument. see bittker, supra note 16, at 250 n. 15. a deduction would be less generous than a credit because it would limit tax reliefto the foreign taxes paid, multiplied by the taxpayer's domestic marginal tax rate. treasury has acknowledged that, under some views, the revenue loss generated by use of foreign tax credits instead of mere deductions might be considered a tax expenditure, see, e.g., office of mgmt. & budget, supra note 22, at 316, but it has never, to my knowledge, included any such item in an official tax expenditure list. 42. see graetz, supra note 37, at 157-58 (explaining the distinction between a deduction, credit, and exemption system for foreign source income taxes). in practice, however, it may be the case that low source-country tax rates or lengthy deferral periods often lead the foreign tax credit to function like an exemption. see hugh ault et al., comparative income taxation: a structural analysis 381 (1997); graetz & o'hear, supra note 39, at 1064-65. 43. see supra notes 11-12 and accompanying text (explaining the oecd's definition of oda). [vol. 8:6 hidden foreign aid regarding outbound investment was not fashioned to advance the interests of the american people "begs credulity."" when president kennedy proposed on humanitarian grounds that the united states limit to developing countries the deferral of foreign source active business income by far the largest of these tax expenditures, in terms of fiscal impact congress rejected his proposal.45 the u.s. business community has for years vigorously opposed efforts to eliminate or reduce this deferral; 46 surely this lobbying effort reflects the companies' concern for their bottom line, not some turn to global altruism. many other tax expenditures may benefit multinational corporations in some way (for example, the exclusions allowed for employer pension plans and employer contributions to medical insurance) or otherwise yield benefits for the world beyond our borders (for example, tax subsidies for the development of clean energy technologies). should these expenditures also be counted as "foreign aid"? the idea would offend most people's intuitions about aid and risk diluting the concept beyond recognition. perhaps nothing the government does is ever purely altruistic47 perhaps nothing anyone does is ever thus but as compared to the nonprofit sector tax expenditures, the international affairs expenditures seem to reflect a mix of altruistic and self44. daniel shaviro, why worldwide welfare as a normative standard in u.s. tax policy?, 60 tax l. rev. (forthcoming 2007) (manuscript at 3, available at http://ssm.com/abstract--966256). professor shaviro goes on to argue that worldwide welfare, in the guise of capital export neutrality or capital import neutrality, is not truly the motivating norm behind u.s. international tax policy, but rather, "cen and cin are in fact tools for promoting national welfare in the broader setting of a global prisoner's dilemma." id. at 35. 45. see supra note 8; robert f. hudson, jr. & gregg d. lemein, u.s. tax planning for u.s. companies doing business in latin america, 27 u. miami inter-am. l. rev. 233, 241 (1995). professor karen brown has recently tried to revive a variation on this proposal, in which the united states would exempt, rather than merely allow deferral of, all foreign source income earned in developing countries. see karen b. brown, missing africa: should u.s. international tax rules accommodate investment in developing countries?, 23 u. pa. j. int'l econ. l. 45 (2002). 46. see graetz, supra note 37, at 25, 245. such lobbying is a good sign that the provision functions as a tax expenditure. for a vigorous critique of this deferral on fairness and efficiency grounds, see robert j. peroni, back to the future: a path to progressive reform of the u.s. international income tax rules, 51 u. miami l. rev. 975, 986-89 (1997). 47. cf. kane, supra note 9, at 927 n.97 ("most, perhaps almost all, foreign aid from the outset has been understood as bringing to the united states some type of quid pro quo, ranging from containing communism in the years after world war ii to fighting terrorism today.") (citing tarnoff& nowels, supra note 29, at 1 & n. 1); posner, supra note 13 ("of course we do not [serve as the "world's policeman"] from the goodness of our heart, but to protect our national security -but then very little that government does is motivated by altruism toward foreigners."). 20071 florida tax review interested motive much more skewed toward the latter. in a globalized world, few tax policies will have no economic consequences for other countries. that does not mean that the entire code can be fruitfully assessed under the rubric of aid. even if, among those tax expenditures not related to the nonprofit sector, the international affairs group has the strongest if still fairly weak conceptual claim to providing foreign aid, it is not necessarily the case that these expenditures actually help developing countries. for one thing, very little u.s. foreign direct investment (fdi) makes its way to developing countries: out of more than $6 trillion in u.s.-owner assets earned abroad in 2001, paul mcdaniel reports, only $16 billion or so was earned in africa and $114 billion in the developing countries of asia.48 in addition, commentators have suggested that income tax incentives offered by wealthy governments may not do much to stimulate fdi in developing countries, 49 and that our deferral of foreign source active business income may lead these countries into harmful tax competition by increasing the sensitivity of u.s. taxpayers to foreign rates.50 to the extent that host-country tax expenditures do 48. paul r. mcdaniel, the u.s. tax treatment of foreign source income earned in developing countries: a policy analysis, 35 geo. wash. int'l l. rev. 265, 265 (2003) (citing bureau of economic analysis statistics). 49. see allison d. christians, tax treaties for investment and aid to subsaharan africa, 71 brook. l. rev. 639, 700-01 (2005) (discussing recent findings that multinational firms "can use debt financing and transfer pricing manipulation to achieve tax neutrality in investment location decisions" and that "non-tax factors dominate [these firms'] location decisions"); mcdaniel, supra note 48, at 279-85 (summarizing the empirical literature on the determinants of fdi). professor mcdaniel has expressed skepticism that even reforms aimed specifically at increasing fdi in developing countries for example, allowing an exemption for or imposing a lower corporate tax rate on income earned there would achieve the desired results. mcdaniel, supra note 48, at 285-95. recent empirical research suggests that once u.s. multinationals have decided to invest abroad, source-country tax policies may be more significant than residencecountry policies in determining the allocation of fdi. see, e.g., mihir a. desai et al., foreign direct investment in a world of multiple taxes, 88 j. pub. econ. 2727 (2004); michael p. devereaux & harold freeman, the impact of tax on foreign direct investment: empirical evidence and the implications for tax integration schemes, 2 int'l tax & pub. fin. 85 (1995); james r. hines, tax policy and activities of multinational corporations, in fiscal policy: lessons from academic research 401 (alan auerbach ed., 1997). the international community, however, has largely condemned developing countries' efforts to lure fdi through tax concessions, seeing these policies as distortionary for investment decisions and, ultimately, as counterproductive. see mcdaniel, supra note 48, at 283-84 (noting that the oecd, the international monetary fund, the world bank, the world trade organization, and the united nations, along with many economists, are all on record as opposing such concessions). 50. see christians, supra note 49, at 684. [viol. 8:6 hidden foreign aid stimulate fdi, some commentators have also expressed skepticism that this investment truly benefits the developing country recipients5 a kind of leftist analogue to the perverse-consequences arguments that some, mostly politically conservative, writers have leveled against (official) foreign aid.52 these views remain largely on the contrarian fringe, however, and i will assume in this article that both fdi and foreign aid do more good than harm for the developing countries that receive them. separate from the international affairs list, there is one other main type of u.s. tax expenditure that seems to me to have a colorable claim to providing hidden foreign aid: concessions in tax treaties with developing countries.53 these treaty concessions may take a variety of forms, but as a rule they are provisions that surrender greater-than-usual amounts of u.s. residence-based taxing jurisdiction in favor of broader source-country taxation.54 the united nations model tax treaty incorporates such 51. see dirk willem te velde, overseas dev. inst., policies towards foreign direct investment in developing countries: emerging best-practices and outstanding issues 6-7 (2001), http://www.odi.org.uk/iedg/fdiconference/dwpaper.pdf (synopsizing arguments in the literature that fdi can lead to income inequality, reduced environmental and labor standards, erosion of the tax base, and crowding out of local capabilities). 52. the classic account of foreign aid as ineffectual, if not perverse, is william easterly, the elusive quest for growth: economists' adventures and misadventures in the tropics (2001). easterly's analysis and prescriptions remain deeply contested in the development community. see, e.g., jeffrey d. sachs, up from poverty, wash. post, mar. 27, 2005, at bw12 (calling easterly a "notorious... cheerleader for 'can't-do' economics" whose "simplistic approach fits well with many conservatives in washington, who would rather blame the poor than help them"). 53. from its title, the orphan drug credit might sound like a promising candidate, but by its terms it will only subsidize research into rare diseases or conditions afflicting persons "in the united states." irc § 45c(d) (2006). for those who would prefer to count some portion of the defense budget as aid, see supra notes 13-14 and accompanying text (explaining, and bracketing, this argument), all of the tax expenditures targeted at the military the exclusion ofbenefits and allowances to armed forces personnel; the exclusions of veterans' death benefits, disability compensation, pensions, and housing bond interest; and the like might also have a claim to providing hidden foreign aid. 54. see christians, supra note 49, at 664,673-78 (explaining these concessions and citing to u.s. treaties into which they are incorporated); philip r. west, int'l tax counsel, u.s. dep't of the treasury, testimony to the senate comm. on foreign relations (oct. 27, 1999), available at http://www.treas.gov/press/releases/lsl77.htm (observing, in a discussion of a proposed tax treaty with venezuela, that "[a]lthough the withholding rates under the proposed treaty are generally higher than those in the u.s. model, the rates are comparable to those found in other u.s. tax treaties with developing countries"); see also international aspects, supra note 18, at 149 (asserting that preferential tax treatment by treaty should be considered a tax expenditure). 2007] florida tax review concessions, 55 and while the united states has long declined to include tax sparing provisions in any of its tax treaties,56 it has applied less explicit concessions numerous times in recent decades.57 what motivates these concessions, however, appears to be economic self-interest as much as anything else.58 it therefore seems more reasonable to view them as bilateral contract terms, rather than as unilateral acts of largesse. some tax sparing provisions may look more like the latter, but the united states, again, categorically refuses to use them, and their efficacy has been sharply challenged in recent years.59 moreover, as of 2005, the united 55. the very first sentence of the u.n. model treaty refers to the "desirability of promoting greater inflows of foreign investment to developing countries," and the introduction later acknowledges that the treaty "gives more weight to the source principle than does the oecd model convention." united nations dep't of econ. & soc. aff., united nations model double taxation convention between developed and developing countries 1, 17, at vi, xiv (2001), available at http://unpan l.org/intradoc/ groups/un/unpan002084.pdf. 56. see deborah toaze, tax sparing: good intentions, unintended results, 49 can. tax j. 879, 880, 883-88 (2001) (explaining tax sparing credits and the united states' longstanding refusal to apply them). tax sparing is a term for policies that "prevent[] residence-country taxation of income exempted from tax by source countries, by providing that if a source country refrains from taxing income derived in its jurisdiction (usually pursuant to a tax holiday), the residence country nevertheless grants a tax credit for the nominally imposed tax." christians, supra note 49, at 692-93 (internal citation omitted). it is typically promoted as a means to encourage foreign investment in developing countries, but the critical tide seems to have turned toward the u.s. position; many now see tax sparing as irrelevant, or even detrimental, to the economic well-being of the intended beneficiaries. see generally org. for econ. cooperation & dev., tax sparing: a reconsideration (1998); christians, supra note 49, at 692-95; toaze, supra, at 914. 57. see christians, supra note 49, at 673 & n.135. 58. consider, for example, staff of joint comm. on taxation, 108th cong., explanation of proposed income tax treaty between the united states and the democratic socialist republic of sri lanka (comm. print 2004). in this background paper, jct staff devote several pages to a discussion of the "developing-country concessions" that appear in the proposed tax treaty with sri lanka. id. at 64-66. the authors candidly acknowledge that in several respects "the proposed treaty allows higher rates of source-country tax than the u.s. model allows," id. at 65, and that "[t]here is a risk that the inclusion of these concessions... could result in additional pressure on the united states to include such concessions in future treaties negotiated with developing countries," id. at 66. yet nowhere do the authors cite a desire to help sri lanka as a motivation for these concessions. instead, they argue that concessions "arguably are necessary in order to conclude tax treaties with developing countries" and that, even with these concessions, such treaties "can be in the interest of the united states because they provide reductions in the taxation by [developing] countries of u.s. investors and a clearer framework for the taxation of u.s. investors," as well as dispute-resolution mechanisms, nondiscrimination rules, and information-exchange procedures that likewise benefit u.s. investors. id.; see also id. at 2 (explaining the treaty's overall purpose in similar terms). 59. see supra note 56. [vol. 8:6 hidden foreign aid states only had in place sixteen tax treaties with developing countries.60 as with the international affairs tax expenditures, the efficacy of treaty concessions has also been called into question. given the dramatic global disparities in infrastructure, labor force skill level, and purchasing power; the tax incentives that the code already provides for foreign investment; and the low average tax rates applied in most of the developing world, some scholars have argued that new treaties and new concessions would do little to stimulate additional trade or investment in the poorest countries.6 ' the discussion in this section has explored a number of tax expenditures not aimed at the nonprofit sector that might plausibly be understood as a type of foreign assistance. despite the good they may do in developing countries, i conclude that these tax expenditures should not qualify as aid (as defined by the oecd) because they lack the requisite degree of other-regarding motive. my primary focus from here on out, accordingly, will remain on the nonprofit sector tax expenditures. ii. estimating the expense so how much does the united states "spend" in tax expenditures on foreign aid? separate from the question of which tax expenditures should qualify as potential sources of aid, there are numerous obstacles, practical and theoretical, to divining a reliable figure. subsection a. 1 of this part identifies six such obstacles, while subsection a.2 addresses the deeper concern that it might be unhelpful or inappropriate to compare the tax expenditures of high-tax and low-tax jurisdictions. section b takes a stab at quantifying the amount of hidden u.s. aid. a. caveats 1. measurement issues even if one accepts the argument that some tax expenditures can and should be counted as foreign aid, it is no easy matter to derive an estimate of the expense. the first and most basic stumbling block is the aforementioned debate about which tax preferences (if any) should count as tax 60. christians, supra note 49, at 640 n.4. 61. see id. at 666-712 (using ghana as a case study in expounding this argument); supra note 56 (discussing the growing disillusionment with tax sparing); see also s.m.s. shah & j.f.j. toye, fiscal incentives for firms in some developing countries: survey and critique, in taxation and economic development: twelve critical studies 269, 285 (j.f.j. toye ed., 1978) (asserting that, irrespective of the formal international tax policy regime, powerful foreign firms can often extract their own tax concessions from developing country governments). 2007] florida tax review expenditures.62 some amount of agreement on this issue is a necessary precondition for any figure to be viewed as legitimate. second, those who want to count sub-national tax expenditures may find the relevant information hard to come by. many u.s. states do not produce tax expenditure estimates, and when they do, their methodologies often differ.63 third, not all of american organizations' cross-border activity can reasonably claim to be foreign aid.' some corporate projects for instance, projects that hire few locals, lack technological and knowledge spillovers, or extract precious resources at concessionary terms may do little to foster economic development. some nonprofit projects support religious or cultural causes, or causes in other wealthy countries, that would not satisfy most people's understanding of "aid." separating out the tax expenditure allocated to these activities from the expenditure allocated to true foreign aid activities would require difficult definitional choices, extensive recordkeeping, and fine-grained quantitative analysis. those who would take a functional approach to measuring tax expenditure aid including all spending that ultimately serves an aid-related end, irrespective of the spending's underlying rationale would find these allocative classifications even more challenging. many nonprofit organizations benefit indirectly from a wide range of tax expenditures beyond the charitable deduction, debt-financing exclusion, and standard 61exemptions. many multinational companies and foreign investors likewise benefit to some degree from a broad patchwork of tax expenditures. the aid contribution of all these expenditures would also need to be tabulated. fourth, there is the issue of aid quality. should aid figures be weighted in some way to reflect their efficacy or other features? for example, should "tied aid" aid that comes with the condition that recipients must spend it on the donor country's own goods rather than shop around for the lowest price be taken at a discount? 66 the center for global development, in the aid component of its commitment to development index, penalizes donor countries for giving assistance to corrupt 62. see supra text accompanying notes 16-18, 22-25, 36-42. 63. see christopher howard, tax expenditures, in the tools of government: a guide to the new governance 410, 420 (lester m. salamon ed., 2002). as of may 2002, the tax policy center counted twenty-three states that produce tax expenditure reports. tax pol'y ctr., tax facts: state tax expenditure reports (2002), http://www.taxpolicycenter.org/taxfacts/state/statelinks.cfm. 64. i believe that virtually none of the tax expenditures aimed at foreign commercial investment should count as aid, see supra section i.b, but i include forprofit activity in this discussion for those who would disagree. 65. colleges and universities, for instance, likely capture at least some of the value of students' tuition credits. see brody, supra note 20, at 695. many nonprofits, of course, also benefit substantially from direct government expenditures and nontax legal policies. 66. for a forceful critique of tied aid as exploitative and inefficient, see united nations dev. programme, supra note 2, at 8-9, 76-77, 102-03. [vol. 8:6 hidden foreign aid governments, overburdening recipients with lots of small projects, and tying aid.67 the influential economist jeffrey sachs has argued that the most important type of foreign assistance focuses on "transformational development," on facilitating long-term infrastructure building as opposed to emergency relief, technical cooperation, or debt forgiveness.68 should transformational development aid be taken at a premium? an ideal measure of tax expenditures on foreign aid might well control for quality and impact along these lines. but for whatever it might add in richness and robustness, making any such adjustments would introduce a highly contestable qualitative element into the figures and vastly increase the informational demands of the enterprise. fifth, there are several different ways in which the expense of a tax expenditure might be counted. revenue forgone is an ex post measure of the loss in government revenue induced by a particular provision, ignoring possible behavioral effects. revenue gain is an ex ante measure of the increase in revenue expected from repeal of the provision, taking into account behavioral considerations. outlay equivalent is the cost of providing the same monetary benefit to taxpayers through direct spending, assuming, as with revenue forgone, that behavior is unchanged.69 virtually every country that estimates tax expenditures uses the revenue forgone method;" the united states is notable in that its treasury also provides outlay equivalent estimates and present value estimates for certain deferrals.71 with the charitable deduction, revenue forgone may be expected to lag outlay equivalent if donor tax-price elasticities exceed 1.0 in absolute value, as many studies have suggested they do.72 these findings imply that charitable deductions stimulate more in donations than they consume in tax revenue. just having a deduction, it seems, leads people to give in excess of the monetary discount they receive. 67. see david roodman, an index of donor performance (ctr. for global dev., working paperno. 67,2005), available at http://www.cgdev.org/files/3646_file_ wp67nov.pdf. 68. see, e.g., jeffrey d. sachs, the development challenge, foreign aff., mar.-apr. 2005, at 78, 82. 69. see oecd tax expenditure report, supra note 18, at 14; zhicheng li swift et al., tax expenditures: general concept, measurement, and overview of country practices, in world bank, supra note 18, at 1, 7-8. 70. see oecd tax expenditure report, supra note 18, at 14. 71. see, e.g., office ofmgmt. & budget, supra note 22, at 286; see also oecd tax expenditure report, supra note 18, at 14 (identifying the united states as the only oecd country surveyed in 1996 to use the outlay equivalent method). julie roin provides a brief discussion of the evolution in treasury's methods for counting tax expenditures in julie roin, truth in government: beyond the tax expenditure budget, 54 hastings l.j. 603, 609-10 (2003). 72. see pozen, supra note 27, at 556-57 (summarizing these studies). i am not aware of any empirical research that tries to estimate donor tax-price elasticities specifically for international giving, but it seems plausible that these too exceed 1.0 (in absolute value) on average. see id. at 574, 580. 2007] florida tax review a further source of methodological variation concerns whether estimates are derived using a cash basis, which estimates the effects on government cash flow, or an accrual basis, which estimates the tax liabilities accruing to the government in a particular period. the united states uses only a cash basis. many oecd countries use only an accrual basis.73 sixth, as the omb ritually points out in its analytical perspectives reports, even when applying the relatively straightforward revenue forgone method, the overall revenue impact of a set of tax expenditures cannot be determined through simple addition.74 because tax expenditure policies generate behavioral incentives and complex interdependencies, changes to one policy may have firstand second-order consequences for other tax expenditures and for the public fisc more generally. were the charitable deduction to be eliminated, to take just one example, the resultant decline in private contributions would make the exclusion of interest income more valuable if organizations responded by issuing more bonds, and it would put pressure on the government to compensate for the shortfall.75 2. income effects even if one accepts the argument that the tax expenditure component of private philanthropy represents a form of government spending, one could still challenge the idea that the remaining portion is entirely private. this challenge could be raised two main ways with respect to the charitable deduction. first, as noted above, behavioral evidence suggests that charitable giving is tax-price elastic, meaning itemizing taxpayers tend to pay out more in donations than they would have paid out in taxes in the absence of a deduction (a phenomenon referred to as "treasury efficiency"). the discrepancy between these two sums, one might argue, ought to be credited to the government. the outlay equivalent method does this; revenue forgone does not. more important, one could argue that because the united states is a relatively low-tax jurisdiction compared to its oecd counterparts, american individuals and corporations are left with greater disposable income with which to make donations. that is, in addition to the price effect of the targeted subsidies that make donations less expensive for the donor, there is an income effect caused by our low average tax rates that also deserves some 73. oecd tax expenditure report, supra note 18, at 14. 74. see, e.g., office of mgmt. & budget, supra note 22, at 286. this has not stopped many tax experts from adding and subtracting them. see howard, supra note 63, at 418. 75. the standard deduction also raises measurement problems. at present, only itemizing taxpayers can claim the charitable deduction. if the standard deduction were set at a lower rate, though, more taxpayers who donate would choose to itemize, which implies that some portion of the standard deduction acts as a tax expenditure in support of these marginal taxpayers' gifts. see brody, supra note 20, at 695 n. 18. [vol. 8:6 hidden foreign aid of the credit for motivating private philanthropy. the u.s. government is, in this sense, underwriting even the donor who never claims a deduction. the most thorough analysis of this idea that i have seen appears in a working paper by david roodman and scott standley of the center for global development.76 roodman and standley calculate that this income effect increases u.s. private charitable giving by 67%." they derive their estimate by comparing the united states' ratio of tax revenue to gdp against that of sweden, the oecd country with the highest such ratio, and by assuming an income elasticity of 1.1 78 given the magnitude of this estimate, one might think it fundamentally illegitimate to compare the tax expenditures of the united states with the tax expenditures of a high-tax, high-oda jurisdiction such as sweden (or, at least, to do so without controlling for income effects). maybe swedes do not do much private giving because they know that part of their heavy tax bill will go toward relatively generous government aid. maybe americans do not agitate for greater government aid because they know that as private individuals the nation is quite generous. culturally, too, americans' relatively low tax burden may be linked to its relatively robust tradition of private philanthropy and decentralized charitable provision. this line of argument illuminates one risk of cross-country tax expenditure comparisons and reinforces the need for a multifaceted approach to evaluating foreign aid spending. but i do not think it undermines the value of tax expenditure analysis in this context. tax expenditures, and the price effects they engender, are fundamentally different from income effects. income effects result from the basic structure of an income tax system and apply categorically to all taxpayers within a given bracket; to call them an aspect of foreign aid is to call everything the government does an aspect of foreign aid. tax expenditures, by contrast, represent an affirmative state decision to favor a particular activity or class of taxpayers. merely having a low average tax rate does not generate private charitable giving with anything like the purpose, immediacy, or symbolism of a charitable deduction. and regardless, tax expenditures are a distinct form of policymaking that deserves scrutiny on its own terms. it may also be worth noting that the empirical evidence does not support the view that either lower tax burdens or lower levels of official foreign aid spending leads to higher levels of private charitable giving to developing countries. across the wealthy donor countries, roodman and standley find, there is no significant correlation between tax/gdp ratios and levels of private cross-border charitable giving, while there is a strong positive correlation between the latter and levels of official foreign aid spending.79 76. roodman & standley, supra note 10. 77. id. at 20 tbl.8. 78. id. at 20. 79. id. at 32-35. 2007] florida tax review b. a rough cut at the numbers bracketing all of these caveats, casual empiricism can give us a rough sense of the expenditure's magnitude. let's start with the nonprofit sector provisions. the most significant foreign aid tax expenditure is occasioned by the charitable deduction. the omb estimates that the total revenue loss attributable to the federal income tax deduction will exceed $324 billion over the next five years, or roughly $65 billion per year.80 the annual revenue loss from the federal gift and estate tax deductions, according to the omb, had been running at roughly $5 billion before recent reforms. 8' not counting any of the state deductions, these figures suggest a total tax expenditure of $70 billion per year on the charitable deduction. if we estimate, conservatively, that 2% of u.s. donations head overseas and make no adjustment for the possibility that higher-bracket taxpayers are more likely to support international causes it would mean that around $1.4 billion of these funds is currently allocated to cross-border charity. raise the estimate to a more realistic 4%,2 and the figure would be $2.8 billion. these numbers might be revised not only to reflect better data and various approaches to the caveats listed above, but also to reflect different views on whether and how to deduct administrative expenses or to include donations that stay in the country but serve international purposes, such as donations to a u.s. group that researches malaria prevention. apart from whatever incentive effects they might have had, federal deduction expenditures of $2.8 billion would have accounted for roughly a quarter of u.s. nonprofits' total giving to developing countries in 2003,83 in an amount equal to 17% of america's oda ($16.3 billion).84 given that up to 60% of u.s. nonprofits' total cross-border spending has been going to 80. office of mgmt. & budget, supra note 22, at 296 tbl.19-3. these figures include the revenue loss attributable to deductions for contributions to education and health, which the omb tallies separately. 81. office of mgmt. & budget, analytical perspectives: budget of the united states government, fiscal year 2002, at 93 tbl.5-6 (2001). this figure is shakier than the income tax deduction figure both because it does not incorporate post-2001 policy changes and because transfer tax deductions may have a somewhat weaker case for being tax expenditures inasmuch as they shelter particular gifts or bequests from taxation on the ground that these are not properly included in the tax base, rather than to provide a separable tax benefit. 82. see pozen, supra note 27, at 569-70 (reporting recent findings that 2.2% of americans' giving goes to international affairs charities and suggesting that roughly 2% more heads overseas through other types of nonprofits). 83. see roodman & standley, supra note 10, at 6 tbl.1 (reporting dac statistics that u.s. nongovernmental organizations gave $6.3 billion to oda-eligible loweror middle-income countries and $4.3 billion to higher-income countries in 2003). 84. manning, supra note 1, at 172 tbl.8. this $16.3 billion figure was up from $10.6 billion in 2000. id. [vol. 8:6 hidden foreign aid these countries," approximately $1.68 billion of that sum could be a candidate for "development assistance" classification.86 the other major nonprofit sector tax expenditures are tougher to quantify and flow mainly to hospitals and universities s 8 two types of nonprofits unlikely to dispense much foreign charity (though some hospitals run international programs, and certain university policies, such as scholarships for international students and drug development for global diseases, might be so characterized). for the exclusion of interest income, the jct and the omb do not keep statistics beyond those for hospitals and educational facilities.88 enterprising tax scholars recently estimated the annual state and federal aggregate expenditure on the income tax exemption and the property tax exemption at $10.1 billion and $8 to $13 billion, respectively.89 if even 1% of the lower bound of this sum ($18.1 billion) had gone toward international development, it would represent an additional $181 million in aid spending. the real figure could easily be double this: recall that internationally focused charities and foundations currently make up about 2% of the nonprofit sector, in numerical and revenue terms, and that this proportion has been rising.9° the calculations just proffered are crude, and much more work must be done to derive satisfactory estimates of, first, the total tax expenditure allocated to the nonprofit sector and, second, the portion thereof allocated to foreign causes deserving of the "aid" label. but the cocktail-napkin math suggests that annual tax expenditures on foreign aid, as delivered through private nonprofits and measured as revenue forgone, are currently running 85. see supra note 83. 86. see supra notes 11-12 and accompanying text (explaining the oecd's definition of oda). 87. the charitable deduction expenditure is not skewed in this way. if contributions to education and health were excluded, treasury's projection ofthe annual revenue loss on the federal income tax deduction would come to approximately $53 billion per year over the next five years. see supra note 80 and accompanying text. 88. see, e.g., staff of joint comm. on taxation, 109th cong., estimates as federal tax expenditures for fiscal years 2006-10 at 30-42 tbl. 1; office of mgmt. & budget, supra note 22, at 287-90 tbl. 19-1. 89. evelyn brody & joseph j. cordes, tax treatment of nonprofit organizations: a two-edged sword?, in nonprofits and government: collaboration and conflict 141,149, 150 & tbl.4.5 (elizabeth t. boris & c. eugene steuerle eds., 2d ed. 2006). 90. see supra notes 31-33 and accompanying text. on the other hand, the internationally focused organizations tend to be significantly more constrained in their ability to generate fees for services or payments for goods than other types of nonprofits, which limits their capacity to take advantage of the income tax exemption. see pozen, supra note 27, at 570-71. evelyn brody and joseph cordes found that in 2002, public charities focused on "international affairs" garnered less than $50 million in income tax savings from the exemption. brody & cordes, supra note 89, at 150 tbl.4.5. this finding does not entail that the aid-related tax expenditure occasioned by the exemption must have been this amount or lower, as many private foundations and many charities not classified as international affairs entities do some amount of development work abroad. 2007] florida tax review somewhere in the range of $1.6 to $3.2 billion, of which as much as $2 billion might reasonably be deemed oda. beyond the nonprofit sector provisions, what about the other u.s. tax expenditures that might serve as foreign aid the international affairs expenditures and the concessions granted to developing countries in bilateral tax treaties? how much assistance do they provide? this calculation is even more vexed. to my knowledge, the treaty concessions have never been systematically compiled, much less tabulated; as a result, i cannot offer an estimate of them here. the international affairs tax expenditures have been compiled and tabulated, but they suffer from the more basic problem that, by the standards of the field, they do not deserve to be counted as aid.9 taking these expenditures as a potential source of aid, though, how much of their revenue cost is attributable to income earned in developing countries? the omb estimates the total revenue loss from the international affairs provisions over the next five years at approximately $110 billion, or $22 billion per year.92 bureau of economic affairs statistics indicate that as of 2005 approximately 18% of u.s. fdi was located in loweror middleincome countries eligible for oda receipt under oecd rules.93 taking these two figures together the first as a proxy for the amount of money these tax expenditures have freed up for investment abroad, the second as a proxy for the percent of this money allocated to oda-eligible jurisdictions we arrive at a figure of $4 billion. this is roughly the amount of money that american individuals and corporations living or operating in developing countries would have lost each year to taxes in the absence of the international affairs tax expenditures. it is not at all clear that these individuals and corporations reinvest this entire sum in the source country where they earn it or in other developing countries;9 4 for those who prefer to see the international affairs tax expenditures as a form of foreign assistance, four billion dollars might be taken as an absolute upper bound of what they generate annually in hidden aid. even more so than with the nonprofit sector tax expenditures, my numbers here are quite speculative and meant only to kickstart a conversation. 91. see supra section i.b. 92. office of mgmt. & budget, supra note 22, at 287 tbl.19-1. 93. calculated from jennifer l. koncz & daniel r.yorgason, bureau of econ. analysis, direct investment positions for 2005, at 33 tbl. 1.2 (2006) (reporting estimates of u.s. direct investment positions abroad on a historical-cost basis). this 18% estimate is marginally on the high end, because where the table does not specify a particular country (labeled "other"), i assume the countries represented to be oda-eligible. 94. over the past thirty years, u.s. companies have repatriated roughly half of the after-tax income earned by their foreign subsidiaries, council of econ. advisers, econ. rep. of the president 209 (2003), and those companies and individuals located in developing countries may choose to invest the income they earn there in other, richer foreign countries, or nowhere at all. [vol. 8:6 hidden foreign aid iii. why it matters if one accepts the argument above, then government spending on foreign aid is somewhat larger, and substantially different in character, than most commentators seem to have realized." what to make of this insight is a question large enough for a book; in this part, i just try to sketch a few implications. section a recommends the inclusion of tax expenditures in oda accounting. section b further explores the merits and effects of this prescription. section c offers a qualified defense of using tax expenditures to finance foreign aid. a. redefining oda perhaps the most obvious takeaway from the prior analysis is that the oecd and the u.s. government should start to classify tax expenditures on foreign aid as foreign aid, collect data thereon, and adjust their statistics accordingly. estimating these tax expenditures will not be easy, as explained in part ii, and comparing them across countries will only increase the difficulties, given differences in tax structures, measurement and reporting methodologies, and expected behavioral responses.96 yet tax expenditure scholars have been developing templates for comparative analysis since at least 1985, 97 and the oecd has the competence and credibility to formulate a reasonably reliable, if not entirely valid, methodology. as long as the oecd methodology is transparent, it should greatly advance public understanding of this form of aid. 95. while commentators have described certain of the foreign-investmentrelated tax expenditures noted in section i.b as "foreign aid," see supra notes 8-10 and accompanying text, i have been unable to find any systematic analysis of these expenditures' role as aid. and i have been unable to find any sustained discussion whatsoever of the nonprofit sector expenditures' relationship to aid. the closest i have seen appears in roodman & standley, supra note 10, in which the authors identify the charitable deduction as a "de facto aid policy," id. at 35, and thoughtfully explore its incentive effects on private cross-border giving. roodman and standley do not, however, identify this "aid" as a tax expenditure, try to quantify its revenue cost, address possible implications of conceptualizing the deduction as aid, or consider the other nonprofit tax privileges. 96. for an extreme statement of these difficulties, see vjekoslav bratic, tax expenditures: a theoretical review, 30 fin. theory & prac. 113 (2006) (arguing that meaningful cross-country tax expenditure comparisons are impossible). 97. see international aspects, supra note 18. important international tax expenditure studies from the years since include oecd tax expenditure report, supra note 18; and world bank, supra note 18. another useful template is offered by the center for global development's commitment to development index. see supra note 67 and accompanying text. the index's aid component, on which the united states ranked third to last in 2006, includes both controls for aid quality and measures of private giving attributable to tax incentives. see ctr. for global dev., commitment to development index 2006: aid (2006), available at http://www.cgdev.org/section/ initiatives/_active/cdi/_components/aid/. 2007] florida tax review it turns out the oecd has in recent years considered and rejected the proposal that it count certain charitable tax expenditures as oda.98 at present, the oecd measures aid spending only at the point of expenditure from revenue and never at the point of tax collection, thus disregarding all tax effects. a 2002 report remarks that "[i]nformal discussions suggest that some members might wish to change this so as to count as oda the value of deductions or rebates for private contributions to ngos." 99 (no member, it seems, has ever raised the issue of counting additional tax expenditures as oda, which lends further support to the argument in part ii that only the nonprofit sector expenditures have a reasonable conceptual claim to being aid.) apparently the reformers did not win out. if tax expenditures were to be allowed as oda, the report goes on to note, "the following considerations would need to be addressed:" implications for measuring other flows: at present, the taxation process is entirely excluded from dac statistics. to count tax deductions for contributions to ngos would open other tax-related questions, e.g. should tax exemptions for ngos' own operations also be oda? should sales tax exemptions on aid inputs be oda? on the other hand, should tax paid in the donor country on oda activities be deducted from oda: for example, the tax paid by aid agency staff or consultants hired on oda programme budgets, or any taxes paid by aid sponsored students? * presentational issues: ngos might see extending oda eligibility to tax deductions as cheating, especially since oda claimed would have to be deducted in reporting their own net outflows. accounting issues: members that do not have a specific line on tax returns devoted to contributions to developmental ngos will have no data on the amounts of revenue forgone through these incentives."' 0 98. i am grateful to simon scott, principal administrator of the oecd development cooperation directorate's statistics and monitoring division, for bringing my attention to this internal debate. 99. dev. cooperation directorate, org. for econ. cooperation & dev., possible changes in the recording of oda 9, at 4 (2002). 100. id. 13, at 5. my own views on these considerations are that: yes, tax exemptions for ngos' own operations should be counted as oda, see supra section i.a; but no, taxes paid in the donor country on oda activities should not be deducted from oda, for there is nothing punitive about these taxes and every tax dollar collected on these activities is a dollar not counted toward tax expenditure aid. the presentational and accounting considerations, meanwhile, could be addressed simply through better data collection and reporting. [vol. 8:6 hidden foreign aid in a report issued the following year, the oecd names names: spain supported counting tax deductions for private contributions to developmental ngos as oda; france and italy were on the fence; belgium, norway, and switzerland opposed such a change. i' surprisingly, the united states joined ranks with this latter group.'02 when spain characterized the objections to its proposal as merely technical, "[t]he united states disagreed, stating that the underlying issue was a question of principle: namely, which flows were official and which were private. ' given that the oecd development assistance committee already counts private flows separately, the united states argued, there is no need to include tax incentives in oda; nongovernmental organizations, moreover, "would resent the intrusion into them of the tentacles of government."' ' (how a purely definitional reform would have subjected ngos to these tentacles is not elaborated.) this was a curious argument for the united states to make, considering that we have for many years been a leader in tax incentives for foreign giving"' and a laggard in official aid spending."0 6 just one year previously, the state department had released a major report decrying oda's failure to capture "the full measure of u.s. aid., 107 it is time to follow spain's lead. the spanish oecd representative was right: the considerations that would be raised by adding tax expenditure aid to oda are technical in nature. it is not necessary for the oecd to address these considerations perfectly satisfactorily for this reform to make oda figures richer and more meaningful and more favorable for the united states. if the u.s. government has a principled concern to respect the distinction between official aid and private aid, this concern actually cuts 101. dev. cooperation directorate, org. for econ. cooperation & dev., summary record ofthe 53rd meeting of the dac working party on statistics 50-53, at 10-11 (2003). spain adduced the following arguments in favor of counting these tax expenditures as oda: 1. deductions stimulated private flows for development 2. they suited members that favoured low taxes, rather than raising taxes to meet aid needs 3. recent changes to spanish law on deductions involved a clear sacrifice of revenue 4. the spanish finance ministry could readily calculate the sums involved 5. although deductions were not flows, other non-flows still counted as oda. id. 50, at 10. 102. id. 52-53, at 10-11. 103. id. 53, at 11. 104. id. 105. see roodman & standley, supra note 10, at 19-22 (finding u.s. tax policies among the most potent at both subsidizing and stimulating private overseas giving); see also supra note 27 (describing the comparative laxity of u.s. tax rules concerning cross-border philanthropy). 106. see supra notes 1-2 and accompanying text. 107. u.s. agency for int'l dev., supra note 3, ch. 6. 2007] florida tax review against its position, not in favor of it: it is precisely because the government is committed to the view that tax expenditures are a form of official spending that treasury must produce a tax expenditure budget each year. tax expenditures do not magically lose their governmental character when they cross the border. b. the value of proper counting 1. general relevance the significance of changing the way we count and conceptualize foreign aid is more than just academic. incorporating tax expenditures into this field can allow us to draw more meaningful comparisons with the aid budgets of other countries; to clarify what exactly is governmental and what is not in the pool of money that americans collectively send abroad; and to receive more credit for our overseas spending while undercutting hudson institute-style claims that the united states is vastly more generous than it has been portrayed."' 8 on several levels, then, tax expenditure analysis can rationalize the debate on foreign aid. more ambitiously, keeping track of tax expenditure aid can allow the government to coordinate its activities more tightly with those of ngos and to evaluate the allocation and impact of its aid spending in a more holistic and useful framework. each of the oecd countries could benefit similarly. both within and across the world's donor nations, adding tax expenditures to the official aid figures could help all parties, public and private, to see more clearly what the others are doing and to what effect. revising oda to include "hidden foreign aid" may also have implications for domestic tax policy debates, as it would enhance taxpayers' ability to gauge the nature and magnitude of policy priorities embedded in the code. for example, the data suggest that the charitable contributions deduction is our major engine of hidden foreign aid,1°9 and that much of this aid comes from a small number of rich donors."0 voters who come to comprehend these features of the deduction might find them particularly 108. see supra note 3 and accompanying text. 109. see supra section ii.b. 110. 1 do not know of any statistics that specifically address the distribution of taxpayer savings from cross-border charitable contributions. the claim above is intuitive, however, given that some amount of disposable income is needed to make any significant contribution; only itemizing taxpayers may claim a deduction; the size of the deduction varies with the taxpayer's marginal rate, meaning higher earners get to deduct at higher rates; wealthier individuals have consistently polled as being more committed to internationalism than the rest of america, jack l. goldsmith & eric a. posner, the limits of international law 216 (2005); and several fantastically wealthy individuals such as bill gates, warren buffett, and george soros are known to have made massive contributions to global philanthropy in recent years. cf. supra note 32 and accompanying text (discussing the work of the gates foundation). [vol. 8:6 hidden foreign aid elitist or undemocratic."' this could lead to increased support for extending the deduction to non-itemizers or otherwise making it more progressive, with respect not only to cross-border giving but also to domestic giving. on the other hand, voters would find that we have been spending around forty times more on the mortgage interest deduction than on all tax expenditure aid policies combined,'12 which might temper any concerns about excessive internationalism. unmasking hidden foreign aid can thus enrich the conversation on tax policy as well as foreign aid policy, among the general public as well as specialists. this reconceptualization can yield not only new descriptive clarity but also, as i elaborate in the following section (c), new normative insights into the desirability of using tax incentives in this arena. 2. statistical relevance but first, would this change in oda reporting affect the united states' comparative aid performance? i cannot give a precise answer, both because of the difficulties adumbrated in part ii and, more basically, because no organization has compiled the relevant tax expenditure figures from donor countries.1 3 it seems safe to say that the united states would rise on the donor league table, given its relatively generous tax subsidies for charitable giving and relatively minor constraints on their cross-border distribution. but would we rise to any significant degree? as the figures below indicate, the answer is no. using data from the governments of australia, canada, ireland, the united kingdom, and the united states oecd countries that regularly report their tax expenditures in english i present estimates of each country's "tax expenditure aid," alongside the better-known oda figures.' the estimates are crude. they 111. see infra text accompanying notes 123-128 (suggesting potential democratic and foreign policy objections to tax expenditure aid). 112. i base this ratio on treasury's estimate that the deductibility of mortgage interest on owner-occupied homes cost almost $80 billion in lost revenue in 2007, office of mgmt. & budget, supra note 22, at 292 tbl. 19-2, and on my $2 billion upperbound estimate of the annual revenue forgone to charitable tax expenditures that might qualify as oda, see supra section ii.b. 113. i say "no organization" because i think it unrealistic that an individual researcher would be able to collect and interpret this information, over time, in a rigorous way. language barriers alone pose a major obstacle. again, the oecd is the obvious body to be leading this data collection effort. 114. my tax expenditure aid calculations are based on commonwealth of austl., tax expenditures statement: 2005 (2005); dep't of fin. can., tax expenditures and evaluations: 2006 (2006); hm revenue & customs, charities: costs of tax relief (2006), available at http://www.hmrc.gov.uk/stats/charities/tablel0-2.pdf, office of mgmt. & budget, analytical perspectives: budget of the united states government, fiscal year 2005, at 287-89 tbl. 18-1 (2004); and tax strategy group, ir. dep't of fin., major tax incentives/expenditures (2006), available at http://www.finance.gov.ie/documents/tsg/2006/tg1905.pdf. i also use brody& cordes, 20071 florida tax review represent 4% of the sum of all reported national-level tax expenditures, measured as revenue forgone, that are targeted at nonprofit organizations. (any tax sparing credits used by the other countries are therefore not captured.) charitable contributions deductions and credits and income tax exemptions are responsible for the vast majority of the sums. the estimates are also generous. while the proportion will vary from country to country and from year to year, it seems likely that 4% is at the high end of the percentage of charitable tax expenditures that head to developing countries. 5 still, these figures give a sense of how, even though the united states provides more tax expenditure aid than any other country, this aid amounts only to a small fraction of oda. its inclusion in oda, consequently, would do little to move the united states up in the rankings. figure 1: foreign aid spending (2004 $u.s. m) 103 net oda n net oda + tax expenditure aid 25,000 20,000 15,000 -----10,000 --5,0000 australia canada ireland united united states kingdom supra note 89, at 149-50, for the u.s. income tax exemption estimate, discounted to exclude state-level exemptions. the oda data come from manning, supra note 1, at 16 tbl. 1.1. in trying to construct a comparative table and to encourage the systematic development and usage of more robust such tables in the future, my project is similar to two prior efforts to uncover the "hidden" nature of u.s. government spending, via tax expenditures, on a particular social issue: christopher howard's treatise on the tax privileges that make up america's "hidden welfare state" and michael graetz and jerry mashaw's analysis of u.s. spending on social insurance. see michael j. graetz & jerry l. mashaw, true security: rethinking american social insurance 299-303 (1999); christopher howard, the hidden welfare state: tax expenditures and social policy in the united states (1997). professors graetz and mashaw found that once tax expenditures are included, u.s. spending on social insurance as a proportion of gdp rises from being at the bottom of the oecd ladder to being relatively close to most other nations. graetz & mashaw, supra, at 302 fig. 14.1. 115. see supra notes 82, 90 and accompanying text (examining this proportion for the u.s. case). [vol. 8:6 hidden foreign aid figure 2: oda performance (2004) e3 oda i gni e (oda + tax expenditure aid) i gni 0.45% 0.40% ---------------___0.35% -m -------_ 0.30% -0.25% ----------....... -0.20% --------0.10% _-. 0.05% ----------1 0.00% -'-----------0.00% 1 1. . . . . .... australia canada ireland united united states kingdom 3. two unpersuasive objections separate from the technical complications involved in counting tax expenditure aid, two further, more substantial arguments might be raised against revising the definition of oda along these lines. first, classifying anything other than direct government spending as aid might be seen to start us down a slippery definitional slope. if tax expenditures on foreign charity should be added to the official figures, should tax expenditures (and u.s. subsidies more broadly) on agriculture expenditures known to have devastating effects on developing-world farmers" 6 be subtracted from the figures?" 7 although i believe that agricultural subsidies profoundly undermine the united states' good works in international development, i would resist such a move, so as to preserve conceptual clarity. development116. see united nations dev. programme, supra note 2, at 130 (summarizing recent studies estimating that developing countries lose between $24 billion and $72 billion a year in agricultural income from the farm subsidies and other protectionist policies of wealthy countries). 117. numerous commentators have noted the hypocrisy ofthese subsidies, see, e.g., martin wolf, why globalization works 215-16 (2004); mcdaniel, supra note 48, at 279, though i have never seen anyone else consider this precise question. the center for global development penalizes rich countries for domestic farm subsidies in its commitment to development index, but only with respect to the countries' trade rating, not their aid rating. see ctr. for global dev., commitment to development index 2006: trade (2006), http://www.cgdev.org/section/initiatives/ active/cdi/_components/trade/. pushing this idea a little further, would counting foreign charity tax expenditures as oda strengthen the case for counting agricultural tax expenditures as illegal farm subsidies under world trade organization rules? the u.s. government would presumably be even more averse to drawing this inference. i am grateful to john colombo for suggesting this point. 2007] florida tax review degrading tax expenditures can be tallied on a separate list, as can military spending and purely private contributions, and scrutinized just as intensively. whether and to what extent these activities complement or cancel out the development-promoting tax expenditures is plainly a debatable proposition. practically and analytically, however, it is useful to preserve some bright lines between foreign aid and all of the many other things rich countries do that bear on the developing world's welfare. one could also raise a pragmatic argument for excluding tax expenditures from the official aid figures. for those who want the u.s. government to give much more, there is a risk that any upward revaluation of its largesse will make americans feel more confident in their generosity and thus lead to complacency. (in stark contrast to the united states, sweden, the darling of the international development community, provides zero tax subsidies for foreign charity.)" 8 militating against this argument, however, are both the demands of intellectual honesty and the equally plausible prospect that, by stimulating increased attention to foreign aid, a public conversation on tax expenditures will help americans see just how ungenerous their policies really are." 9 adding two billion dollars to annual oda would still leave the united states far below its peers in proportional terms. specifically, it would have increased 2006 spending from 0.19% to 0.2 1% of gni less than half the european union's unadjusted average and possibly insufficient to move the united states out of last place in the oecd rankings. 2 ° even adding twenty-two billion dollars to annual oda would have increased 2006 spending only to 85% of the european union total and this without crediting the eu countries with any tax expenditure aid of their own. in a foreign aid debate so focused on perceptions of generosity, it is damaging that the u.s. government does not receive full credit for its spending. but full credit would not mean high marks. c. for (and against) tax expenditure aid beyond simply acknowledging and keeping track of tax expenditures on foreign aid, how might we begin to evaluate them as tools of legal and public policy? one useful framework is offered by tax expenditure theory. from its inception, this literature has had a clear prescriptive aim: to convert most tax expenditures into direct expenditures or repeal them altogether.' 2' following stanley surrey, critics have flagged a host of concerns. tax expenditures increase tax complexity and compliance burdens (administrative concerns); they are more opaque and esoteric than direct 118. roodman & standley, supra note 10, at 15. 119. note in this regard that recent studies have found americans, on average, to believe that foreign aid accounts for 20% of the federal budget, around thirty times the actual figure. sachs, supra note 68, at 80. 120. see manning, supra note 1, at 16 tbl.1.1. 121. see shaviro, supra note 17, at 187. [vol. 8:6 hidden foreign aid expenditures and so relatively more immunized from public debate or scrutiny (visibility concerns); they are more likely than direct expenditures to have regressive first-order effects (equity concerns); their uses may evolve in unexpected ways (predictability concerns); and they may stimulate unproductive activity or reward behavior that would have occurred anyway (efficiency concerns).1 22 at first glance, tax expenditures on foreign aid appear to exaggerate each of these defects. most obviously, their transnational character raises special problems of oversight and transparency. voters will find it tougher to perceive these expenditures; officials will find it tougher to monitor them to make sure they reach their intended beneficiaries (and instead do not support, say, private inurement or other noncharitable activities). given that wealthier americans have consistently polled as being more committed to internationalism, savings from the charitable deduction may be even more concentrated among this group when cross-border giving is concerned.'23 with foreign aid, there is an especially acute tension between the value of fostering "pluralism, volunteerism, and compassion ' 24 through preferential treatment of the nonprofit sector, and the potential to save money and pursue a unitary policy vision through centralized planning and administration. tax expenditures are much less likely than direct expenditures, one assumes, to be allocated to foreign governments or public international institutions such as the world bank 25 bodies that are uniquely equipped to implement largescale projects and reforms. whereas traditional oda will inevitably reflect the government's political and strategic goals,'26 a decentralized patchwork 122. see, e.g., surrey & mcdaniel, supra note 4, chs. 3-4. as christopher howard explains it, "[t]he consensus [in the tax literature] is that tax expenditures are bad public policy: they are economically inefficient; they complicate the tax system; their growth is uncontrollable; and, because they are rarely deliberated over or reviewed, they lack the legitimacy of direct spending programs." howard, supra note 114, at 6. professor surrey would have been gratified to hear howard's synopsis, one assumes, but mortified at the utter failure of this academic consensus to beat back the growth of tax expenditures. 123. see pozen, supra note 27, at 573. 124. u.s. agency for int'l dev., supra note 3, at 141 (discussing the advantages of private organizations in financing foreign charity). 125. i have been unable to find a good estimate of the percentage of total u.s. foreign aid spending allocated to these categories of recipient. however, the fact that the u.s. agency for international development tracks its aid expenditures by recipient country and region, see, e.g., u.s. agency for int'l dev., u.s. overseas loans and grants: obligations and loan authorizations, july 1, 1945 september 30, 2005 (2005), would appear to suggest a significant degree of coordination with foreign governments. out of $31.4 billion appropriated by congress in fiscal year 2006 for "international affairs" activities, the state department and usaid together received $1.6 billion for multilateral economic assistance meant to be passed on to international institutions. u.s. agency for int'l dev. & u.s. dep't of state, congressional budget justification: foreign operations, fiscal year 2008, at 12, 154 (2007). 126. for empirical verification of this point, see alberto alesina & david dollar, who gives foreign aid to whom and why?, 5 j. econ. growth 33 (2000). 2007] florida tax review of tax expenditures may serve very different objectives missionary agendas, for instance and even contrary objectives.'27 these features of tax expenditures on foreign aid raise problems not only of administration, visibility, vertical equity, targeting, and efficacy, but also, one could argue, of democratic legitimacy. they conjure up the old notion, dating back to the world war ii era, of the nonprofit sector as a locus of liberal internationalism, disconnected from, if not downright opposed to, the u.s. national interest.'28 yet at the same time, tax expenditures on foreign aid possess some distinctive virtues not captured by standard tax expenditure analysis. 29 most fundamentally, they diversify aid spending and increase the total amount of aid. there is little reason to think that they crowd out explicit government giving when their uses are so unpredictable, voters often fail to identify tax expenditures with direct outlays, 3 ° and no relevant officials appear to have noted them. across the wealthiest countries, moreover, the empirical evidence suggests that private and public cross-border giving are not substitutes but complements: countries that have high per-capita levels of net aid transfers tend to have high levels of private overseas donations as well.'31 private and public cross-border giving should also be complements in a functional sense to the extent that the two sets of recipients pursue nonrival goals. for those who want the united states to give more foreign assistance either as a moral or strategic matter or because they believe that democratic-process pathologies are responsible for the present low levels of oda the relative opacity of tax expenditures may therefore seem innocuous, if not a good thing.' 127. see pozen, supra note 27, at 597-99 (describing this tension yet defending deductibility for cross-border gifts that may contravene executive branch policies such as the "global gag rule"). tax expenditures on foreign aid, like tax expenditures on domestic charity, may also in some cases conflict with each other, as when two nongovernmental donees use their tax expenditure funding to pursue rival social-change strategies. the potential for this type of intra-tax-expenditure offset raises efficiency concerns more than democratic or foreign policy concerns. 128. see peter dobkin hall, a historical overview of the private nonprofit sector, in the nonprofit sector: a research handbook 3, 19 (walter w. powell ed., 1987). 129. in a previous paper, i argued at length for allowing (and indeed strengthening) deductions for cross-border charitable donations. pozen, supra note 27, at 574-601. readers interested in a more extended discussion of the arguments in the surrounding paragraphs, from the perspective of charitable deduction theory, may wish to consult that source. 130. see graetz & mashaw, supra note 114, at 301 (discussing the "benign political status" of tax expenditures, which are widely viewed as decreasing the size of government even though direct spending toward the same ends would be viewed as increasing the size of government). 131. see roodman & standley, supra note 10, at 34-35. 132. but see peroni, supra note 9, at 297 n.4 ("in a democratic society, the fact that using the tax system to provide aid to developing countries is less transparent and, therefore, more politically palatable is not a reason to favor such use. rather, the [vol 8:6 hidden foreign aid these expenditures, furthermore, help develop both the u.s. nonprofit sector and global civil society. the expenditures serve an educative function by connecting more americans, via the beneficiary nonprofits, to issues and events around the world. they empower certain minority views in foreign policymaking and invigorate the "market" in development strategies. they cordon off one segment of the aid budget from the vicissitudes of constituent politics and thereby help correct for possible governmental failures, such as a tendency to underserve populations or causes that lack a domestic lobby and to underweight long-term threats.1 33 because a large amount of americans' foreign giving goes toward issues of economic development, environmental protection, health, and human rights, these tax expenditures often end up supporting causes that are both morally compelling and well-suited to generate positive interspatial externalities that, over time, may redound to the benefit of the united states. 3 4 although contrary is true the lack of transparency of tax expenditure programs is one of the reasons to disfavor their use."). 133. cf. kane, supra note 9, at 927 ("[e]ven if one views foreign aid strictly in strategic terms, it is quite plausible that, given current levels of public misinformation, legislators are essentially precluded from delivering an optimal amount of aid."); saul levmore, taxes as ballots, 65 u. chi. l. rev. 387, 428-30 (1998) (suggesting that foreign aid appropriations might be a good area in which to use a "taxes as ballots" taxpayer checkoff strategy, given the perceived electoral cost to politicians who vote for increased aid and the strong likelihood that congress is susceptible to cycling preferences with respect to these appropriations). but cf. fleming, jr. et al., supra note 9, at 346 (arguing that "a tax expenditure scheme [for economicdevelopment-related foreign aid] should not be substituted for the direct aid program unless the tax expenditure plan allows the kinds of nuanced distinctions between candidate countries that would be features of a direct aid program"). although focused on a different group of tax expenditures, christopher howard has demonstrated that the politics of tax expenditures differ markedly from the politics of regular tax and budget items, across a wide range of dimensions. see howard, supra note 114, ch. 9. even if u.s. charitable tax expenditures can help correct for certain governmental failures concerning foreign aid, it is possible that these expenditures might play a role in exacerbating a different form of governmental failure: the nearpathological inability to undertake fundamental tax reform. by placating particular interest groups and classes of voters, some scholars have argued, tax expenditures can undercut momentum for systemic change. see, e.g., michael j. graetz, 100 million unnecessary returns: a fresh start for the u.s. tax system, 112 yale l.j. 261,273-76 (2002). while i take this concern seriously, the political economy of foreign aid tax expenditures does not seem to fit this pattern, on account of their general absence from the conversation on tax policy and the relatively diffuse, politically powerless nature of their ultimate beneficiaries abroad. 134. see pozen, supra note 27, at 572, 592-93. because foreign aid tax expenditures have these public good characteristics, it is possible that even a diehard isolationist, concerned only with the welfare of compatriots, could find reason to embrace them. see id. at 579-87, 593. but most americans are not diehard isolationists; in assessing a given tax policy, most will care to at least some extent how it affects people in other countries. although i cannot prove this, it also seems likely that americans will tend to be particularly universalistic when assessing policies that 2007] florida tax review private international contributions may be especially difficult to monitor and the public bodies typically bypassed by tax expenditure aid may have greater scope and authority to foster development, nongovernmental grantmakers and recipients may nevertheless be more effective because of their relative freedom from political and bureaucratic constraints and, often, corruption.'35 pluralism in foreign aid financing need not conflict with, and may even better support, fiscal accountability, economic efficiency, and u.s. national welfare. this point-counterpoint contains many contestable (and rarely addressed) empirical and normative claims. it could be elaborated, formalized, and assessed any number of ways. developing an appraisal of these tax expenditures is by no means straightforward; there is clear merit to having both centralized aid and decentralized aid,'36 and striking the optimal balance between them will never be an exact science. yet given america's comparatively paltry levels of oda, the transnational public good characteristics of much foreign charity, and the well-known limitations intuitionistic, psychological, biological, practical on individuals' capacity to show moral regard for distant strangers,'37 i submit that tax expenditures serve a valuable function in institutionalizing and expanding our commitment to foreign charity. the analysis above shows that on concern charity. moral arguments for helping others do not stop easily at the national border. 135. although corruption in the developing world "is an emerging priority for the international community" and is the subject of many new reform initiatives, susan rose-ackerman, corruption and government: causes, consequences, and reform 177 (1999), it has long plagued foreign aid provision. see eric a. posner, international law: a welfarist approach, 73 u. chi. l. rev. 487, 531 (2006) ("it is widely agreed that much perhaps most foreign aid has been squandered because it has been confiscated by donee governments, lost to corruption, or misused in some way."). 136. this is assuming, of course, that there is merit to having aid at all. i believe this, and most informed observers seem to believe this, but there exists a significant corps of dissenters. see, e.g., supra note 52 and accompanying text (identifying william easterly as a leading foreign aid skeptic); see also evan osborne, rethinking foreign aid, 22 cato j. 297, 314 (2002) (asserting that development assistance "is at best a distraction and quite possibly harmful in terms of promoting prosperity"); posner, supra note 13 (analogizing foreign aid to domestic welfare provision and stating that "[m]y own, unfashionable view is that charitable giving, both governmental and private, is more likely to increase than to alleviate the poverty, ill health, and other miseries of the recipient populations"). 137. see jack goldsmith, liberal democracy and cosmopolitan duty, 55 stan. l. rev. 1667, 1670-75 (2003) (summarizing the philosophical literature on "plausibility constraints" that make cosmopolitan moral duties too demanding for individuals and more appropriately assigned to institutions); see also reuven s. avi-yonah, bridging the north/south divide: international redistribution and tax competition, 26 mich. j. int'l l. 371, 372-74 (2004) (arguing that legislators' incentives, localist sentiment, and the concern that aid dollars will be misspent together make it unlikely that rich democracies will substantially increase foreign aid spending or implement globally redistributive taxes in the foreseeable future). [vol. 8:6 hidden foreign aid consequentialist, moral, and political-process grounds, the use of tax expenditures on foreign aid is at least defensible. sweden probably does have a more targeted, consistent, and efficient aid program, but in a society as large and heterogeneous (and skeptical of big government) as the united states, a more pluralistic, mixed-funding approach may be appropriate. and regardless, transitioning to a unified aid budget would be extremely costly. there is no way to decouple the tax expenditures on nonprofits' foreign activities from the tax expenditures on their domestic activities without upending the current system of tax preferences and severely compromising the autonomy of the nonprofit sector. 1 3 8 to see just how subtle america's tax expenditures on foreign aid are, an interesting comparison might be drawn with the globally redistributive taxes that cosmopolitan political theorists have recently been advocating. many of these theorists have endorsed thomas pogge's proposal for a "global resources tax," a 1% consumption tax on all natural resources the proceeds of which would be "used toward the emancipation of the present and future global poor."'39 in the same vein, numerous academics and 138. consider some examples. congress might decree that charitable donations that wind up abroad will receive a lesser deduction, or no deduction at all. this would create both investigative difficulties, because regulators would need to figure out which parts of which gifts have crossed the border, and civil liberties concerns, because this oversight would require the tracking and sorting of all deductible gifts over time. more basically, it would skew donors' incentives away from international causes (even more so than the requirement of a u.s.-based intermediate donee already does). congress might, instead, deny deductions or exemptions to organizations with overseas operations that it deems excessively large or liable to conflict with foreign policy goals. this would not only decimate the internationally focused component of the u.s. nonprofit sector; it would also require controversial line-drawing as to which organizations would be covered. pick another example if you do not like these. all such "decoupling" reforms would compromise the nonprofit sector's autonomy because the current tax rules respect this autonomy so fully: as long as an organization is found to be legitimately charitable (and non-political) in nature, the deduction and the exemptions are made available to it without any inquiry whatsoever into the precise purpose, quality, or location of its work. 139. thomas w. pogge, an egalitarian law of peoples, 23 phil. & pub. aft. 195, 201 (1994); see also thomas w. pogge, world poverty and human rights: cosmopolitan responsibilities and reforms ch. 8 (2002) (expanding on this idea, now dubbed a "global resources dividend"). representative expressions of support for pogge's proposal include martha c. nussbaum, frontiers of justice: disability, nationality, species membership 320 (2006); kok-chor tan, justice without borders: cosmopolitanism, nationalism, and patriotism 80-81, 94-95, 159 (2004); edward b. foley, the elusive quest for global justice, 66 fordham l. rev. 249, 258-60 (1997); and will kymlicka, territorial boundaries: a liberal egalitarian perspective, in boundaries and justice: diverse ethical perspectives 249, 271 (david miller & sohail h. hashimi eds., 2001). for an excellent dissenting view, see joseph heath, rawls on 20071 florida tax review development organizations have endorsed some version of a redistributive "tobin tax," an excise tax on cross-border currency transactions the proceeds of which would likewise be devoted to the world's poor.14 global taxes such as these would in many respects be the inverse of our tax expenditures on foreign aid: they would be highly visible, administered by a central international body, purposefully and unabashedly redistributive, subject to ceaseless intergovernmental politicking, and coordinated to the last decimal point with other countries. both functionally and symbolically, tax expenditures have much less capacity than global taxes to effectuate development ideals. politically and programmatically, however, tax expenditures are nowhere near as demanding or as disruptive of the existing economic order. as michael graetz notes, "[t]he idea that international tax policy should be used to redistribute income internationally... certainly has not become a widely accepted norm" in the tax community.' 4' for those who would like to see greater international redistribution, the beauty of the foreign aid tax expenditures is that, for many years, they have been used for just this purpose without provoking much controversy or even much notice that they are, in fact, a form of international tax policy. i should be clear, though, that the argument here is meant only as a qualified defense of foreign aid tax expenditures, in two senses. first, i do not mean to suggest that these tax expenditures are a preferable or adequate substitute for direct aid. compared with these expenditures, direct aid spending has greater scope to produce growth and redistribution, can be coordinated and monitored more effectively, can take advantage of economies of scale and non-public information, carries more expressive and symbolic force, and has a more obvious democratic pedigree. i believe that the tax expenditures identified in section l.a are similar enough to direct aid expenditures in substance and procedure that they should be recognized as global distributive justice: a defence, in global justice, global institutions 193 (daniel weinstock ed., 2007). 140. see paulette l. stenzel, why and how the world trade organization must promote environmental protection, 13 duke envtl. l. & pol'y f. 1, 40 (2002) ("support for the tobin tax, which was first proposed about thirty years ago, is growing around the world."); ctr. for envtl. econ. dev., tobin tax initiative, http://www.ceedweb.org/iirp/ (last visited apr. 12, 2007) (providing links to tobin tax campaigns and publications). prominent academic endorsements include tan, supra note 139, at 80-81, 94-95; and michael walzer, governing the globe: what is the best we can do?, dissent, fall 2000, at 44, 52. a related line of activism, also heating up as of late, has been pushing for the creation of a worldwide taxing authority. see ned shelton, interpretation and application oftax treaties § 9.8, at 535 (2004) ("the idea of a world tax body has been mooted quite seriously in recent years, in particular since the zedillo report in 2001. the idea is gaining momentum.... ."). the actual creation of any such authority, however, still seems highly unlikely to materialize in the near future. see reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1649 (2000). 141. graetz, supra note 37, at 11. [vol. 8:6 hidden foreign aid foreign aid; that does not mean they are interchangeable with conventional oda. second, i do not mean to imply that our foreign aid tax expenditures are perfect as is. given the background conditions against which they are operating widespread use of tax expenditures to address a seemingly endless array of social problems, 4 2 notoriously low official aid spending, massive global need i think it is better that they exist than that they not exist. but it is possible that any number of reforms, including fairly radical ones such as replacing the charitable deduction with refundable credits, would have greater virtues in the realm of foreign aid. indeed, it would be surprising if our current system of tax expenditures turned out to be ideally structured to generate and channel foreign aid activities, considering that no one has been talking about these policies in foreign aid terms. conclusion this article has tried to suggest a new way to think about the relationship between tax policy and foreign aid policy. while previous commentators have referred to certain tax measures aimed at promoting extraterritorial investment as "foreign aid," i made the case that only tax subsidies aimed at the nonprofit sector have a good claim to this title. within this set of subsidies, i then offered a preliminary methodology for appraising how much should qualify as oda, and a rough estimate of the current figure. this descriptive analysis can, i hope, shed new light on the debate over how foreign aid can and should be financed and administered. finally, i argued that the oecd should include tax expenditure aid in its definition of oda, i explained what differences this reform would make, and i offered a normative defense of the united states' use of this form of aid. although tax expenditures generally, and cross-border tax expenditures in particular, may raise a number of problems, i tried to show how these policies can serve as useful complements to our oda program. readers unconvinced by this cursory defense of tax expenditures on foreign aid need not be too alarmed. if these expenditures are politically safe from radical retrenchment, they are constrained from radical expansion for a more basic, structural reason: they are not scalable like regular expenditures. although further internationalization of the nonprofit sector should keep driving up the subsidies, by design they will never be more than fractional supplements to private charity. nonprofit organizations cannot realistically benefit any more from exemptions because they already pay nothing, in most jurisdictions, in mission-related income, property, sales, or franchise taxes. the charitable deduction might be extended to nonitemizers and to direct cross-border gifts,'43 but if individual and corporate donors were 142. cf. supra note 133 (discussing, in the second paragraph, the concern that tax expenditure growth has undercut momentum for fundamental tax reform). 143. see pozen, supra note 27, at 595-96 (recommending possible reforms to facilitate greater international deductibility). 2007] florida tax review to receive significantly more generous tax breaks on top of what are already the most generous such policies in the world it could undermine the deduction's popular support, if not the tax base itself. and it would be a political nonstarter, not to mention a communitarian nightmare, to provide stronger incentives for foreign giving than for domestic giving. for those who seek a jeffrey sachs-style foreign aid revolution in which the united states delivers on its monterrey consensus pledge,'" it would therefore be a mistake to see tax expenditures as a possible panacea. tax expenditures are destined to be a limited, though important, vehicle for addressing the world's most urgent problems. 144. see supra note 2 and accompanying text. [vol. 8:6 florida tax review volume 6 2004 number 7 book tax conformity for financial instruments yoram keinan i. the book-tax conformity debate. . . . . . . . . . . . . . . . . . . . . . . . 678 ii. pros and cons of conformity for financial instruments. . 683 a. arguments for conformity. . . . . . . . . . . . . . . . . . . . . . . . . . . . 683 1. advantages of the mark-to-market method. . . . . . . . . 683 2. the advantages of the financial accounting system.. 684 3. reducing administrative burden. . . . . . . . . . . . . . . . . 685 4. book-tax conformity for financial instruments in other countries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 685 5. reduce incentives to enter into tax shelters. . . . . . . . 686 b. arguments against conformity. . . . . . . . . . . . . . . . . . . . . . . . . 688 c. alternative routes to achieve conformity. . . . . . . . . . . . . . . . 690 1. mandatory conformity. . . . . . . . . . . . . . . . . . . . . . . . . 690 2. mandatory for a specific type of instrument and elective to others. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 691 3. all taxpayers may elect to apply book-tax conformity. . . . . . . . . . . . . . . . . . . . . . . . . . . . 692 iii. current relationship between book and tax rules. . . . . . 693 a. clear reflection of income. . . . . . . . . . . . . . . . . . . . . . . . . . . . 693 b. reportable transactions regulations. . . . . . . . . . . . . . . . . . . . 694 iv. relevant accounting bodies and guidance. . . . . . . . . . . . . . 695 a. financial accounting standards board (fasb).. . . . . . . . . . . 695 b. international accounting standards committee (iasc). . . . . . 696 c. guidance on financial instruments. . . . . . . . . . . . . . . . . . . . . 696 v. key issues in analyzing financial instruments. . . . . . . . . . . 697 a. general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 697 b. substance over form. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 698 c. classification of financial instruments. . . . . . . . . . . . . . . . . . 700 1. overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700 2. basic (non-derivatives) instruments: distinguishing between debt (liability) and equity. . . . . . . . . . . . . . . . 701 3. conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 715 d. timing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 716 1. cash and accrual accounting methods. . . . . . . . . . . . 716 2. current timing rules for basic (non-derivative) instruments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718 3. timing rules for derivatives. . . . . . . . . . . . . . . . . . . . 723 676 2004] book tax conformity for financial instruments 677 4. mark-to-market for dealers and traders. . . . . . . . . . 728 5. contingent payment instruments. . . . . . . . . . . . . . . . . 735 6. hedging transactions. . . . . . . . . . . . . . . . . . . . . . . . . 740 e. valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 744 1. fair market value v. fair value. . . . . . . . . . . . . . . . . 744 2. valuation of swaps: gaap v. section 475.. . . . . . . . . 746 3. valuation of other derivatives. . . . . . . . . . . . . . . . . . 748 4. the bifurcation approach. . . . . . . . . . . . . . . . . . . . . . 749 5. conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750 vi. summary of the proposal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 751 a. proposed timing rules for non-derivatives (debt instruments).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 751 b. proposed timing rules for non-derivatives (equity securities). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 751 c. proposed timing rules for derivatives. . . . . . . . . . . . . . . . . . 751 d. proposed valuation principles. . . . . . . . . . . . . . . . . . . . . . . . 752 vii. conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 752 678 florida tax review [vol.6:7 book tax conformity for financial instruments yoram keinan* i. the book-tax conformity debate since the introduction of the corporate income tax in the united states in 1909, both lawyers and accountants have discussed whether to allow corporate taxpayers to use income reported by corporations to their shareholders on their financial reports under generally accepted accounting principles (“gaap”) as the basis for imposing corporate income tax. similar discussions1 have taken place in other countries, particularly in europe in recent years. as 2 * yoram keinan is an adjunct professor at georgetown law in tax and a manager with ernst & young’s financial services industry group and the capital markets tax practice of the national tax department in washington, d.c. as a manager at ernst & young, he specializes in united states taxation of financial products and institutions. he received his m.p.a. and i.t.p. (international taxation) from harvard, l.l.m. (taxation), and s.j.d. from the university of michigan. the author wishes to thank reuven avi yonah, joeseph bankman, john buckley, yoseph edrey, david garlock, viva hammer, david hasen, doug kahn, yoram margalioth, deborah schenk, reed shuldiner, joel slemrod, lewis steinberg, matthew stevens, william toomajian, dana trier and david weisbach, participants in the conference “new financial contracts and the federal tax system – an interim assessment” (apr. 15-17, 2004), at the university of michigan law school, and his colleagues at ernst & young, for their extremely useful comments. the opinions expressed in this article represent the author’s sole opinion an ddo not represent ernst & young’s opinion. 1. mitchell l. engler, corporate tax shelters and narrowing the book/tax “gaap,” 2001 colum. bus. l. rev. 539; terry shevlin, symposium on corporate tax shelters part ii: commentary: corporate tax shelters and book-tax differences, 55 tax l. rev. 427 (2002); george k. yin, business purpose, economic substance, and corporate tax shelters: getting serious about corporate tax shelters: taking a lesson from history, 54 smu l. rev. 209 (2001); calvin johnson, using gaap instead of tax accounting is a bad idea, 83 tax notes 425 (april 19, 1999); alvin d. knott and jacob d. rosenfeld, book and tax: a selective exploration of two parallel universes, 99 tax notes 865 (may 12, 2003); anthony j. luppino, the enron end-runs and other trick plays: the book-tax accounting conformity defense, 2003 colum. bus. l. rev. 35, 108, 144; john ensminger, concerto for piano vs. orchestra: can tax and financial accounting harmonize on hedges? 16 akron tax j 23 (2001). 2. sabine d. selbach, the harmonization of corporate taxation & accounting standards in the european community and their interrelationship, 18 conn. j. int’l l. 523 (2003). see also victor thuronyi, what can we learn from comparative tax law? 103 tax notes 459 (apr. 26, 2004) (“in a number of countries, there has in recent 2004] book tax conformity for financial instruments 679 of today, several countries apply general book-tax conformity, while several3 others apply it only to financial instruments. in the united states, limited book-4 tax conformity already exists, to some extent, in the tax law, under the clearreflection-of-income principle contained in section 446, and in other specific5 provisions. commentators agree, however, that currently, a general book-tax6 years been a partial movement in favor of greater reliance of tax on financial accounting.”) 3. for example, belgium, japan the netherlands and switzerland have common tax and financial accounting standards. see secretary to the treasury and the commissioner of taxation, taxation of financial arrangements, an issue paper (december 1996), appendix 4.1. in germany, there is an almost complete identity between tax and financial accounting. see thuronyi (2004), supra note 2. according to thuronyi, civil law countries tend to apply book-tax conformity more than common law countries. id. 4. as thuronyi indicates: in many developing and transition countries the answer will be found in the financial accounting rules, because the rules for taxation of business enterprises are based on these accounting principles. those rules tend to be more flexible than accounting rules set forth in the tax laws themselves and may provide a basis for dealing sensibly with new financial instruments in such a way that there is not a significant threat to erosion of the tax base from use of such instruments. by contrast, in countries that formulate their tax rules independently of accounting principles, it may be necessary to provide detailed rules for the taxation of financial instruments so that taxpayers cannot use them to avoid taxation. thuronyi, victor, taxation of new financial instruments, 24 tax notes int’l 261, 26364 (1999). for a discussion on book-tax conformity for financial instruments in other developed countries, see robert moncrieff, next steps for debt and derivatives: the u.k. finance act 2002, 4(1) journal of taxation of financial products (winter 2003); ruano, spain: general nonresident tax treatment of financial products, 4(2) journal of taxation of financial products (spring 2003); australian issue paper, supra note 3. 5. all references are to the internal revenue code of 1986, as amended. 6. for example, in regs. § 1.471-2(b), treasury has followed congressional intent in irc § 471 by focusing on the need to “give effect to trade customs which come within the scope of the best accounting practice in the particular trade or business,” and has authorized the use of values as shown in taxpayers’ books to determine the cost of goods on hand for tax purposes. similarly, in regulations concerning the last-in, first-out method of accounting, treasury has conditioned the use of that method on book-tax conformity. regs. § 1.472-2(e). finally, under irc § 166(a)(2), the amount of a business bad-debt deduction for partial worthlessness of a security is limited to the amount “charged off within the taxable year” for accounting purposes. see knott and rosenfeld, supra note 1, § iii(b). 680 florida tax review [vol.6:7 conformity regime for corporate tax is not feasible. in addition, courts often7 discuss the different roles of tax and accounting rules, generally concluding that tax does not have to follow books in all cases.8 congress and treasury have recently realized that non-conformity of certain items could be viewed as abusive to a significant extent; therefore, in9 the reportable transactions regulations, treasury set forth rules that would require taxpayers to disclose if they have treated a transaction differently for book and tax purposes. the joint committee’s report on enron also reveals10 that in certain transactions discussed therein, enron was seeking accounting rather than tax benefits.11 this article does not endorse utilizing general book-tax conformity for corporations in the united states but rather discusses current conformity and 12 7. see generally johnson, supra note 1, cf., generally yin, supra note 1. 8. as emphasized by the u.s. supreme court in thor power tool co. v. comm’r, 439 u.s. 522, 542-43 (1979): the primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. the primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the internal revenue service is to protect the public fisc. consistent with its goals and responsibilities, financial accounting has as its foundation the principle of conservatism, with its corollary that “possible errors in measurement [should] be in the direction of understatement rather than overstatement of net income and net assets.” in view of the treasury’s markedly different goals and responsibilities, understatement of income is not destined to be its guiding light. given this diversity, even contrariety, of objectives, any presumptive equivalency between tax and financial accounting would be unacceptable. see also pnc bancorp, inc. v. comm’r, 212 f.3d 822, 832 (3d. cir. 2000), discussing the application of fas 91 for tax purposes. 9. yin, supra note 1, at 225. 10. t.d. 9046, 68 f.r. 10161 (mar. 4, 2003). 11. see joint committee on taxation, report on investigation of enron corporation and related entities regarding federal tax and compensation issues, and policy recommendations, executive summary (feb. 2003) available at http://www.gpo.gov/congress/joint/jcs-3-03/vol1/index.html. 12. support for the idea that only limited conformity is desired could be found in a statement made by former treasury secretary paul o’neill: “eliminating some of the myriad differences between book and tax accounting would go a long way toward demystifying both corporate financial statements and the book/tax reconciliation on schedule m-1 of corporate returns.” see o’neill letter to grassley on public disclosure 2004] book tax conformity for financial instruments 681 non-conformity between tax and accounting rules for financial instruments and explores possible alternatives to conform the non-conforming aspects. i do not13 suggest that gaap will substitute tax law but only provide guidance pertaining to financial instruments. this article presents three major examples of code14 provisions in which congress’s specific intent was to conform tax rules to the then existing gaap: section 1256, section 475, and the original issue discount (oid) rules. generally, there are five key tax issues involved with financial instruments: (i) classification; (ii) timing; (iii) valuation; (iv) character; and (v) source. nevertheless, only the first three are important for gaap, and only15 these three are therefore discussed herein. as of today, not only is the tax treatment of financial instruments often different from gaap, but it is also incoherent and based on various criteria. in addition to the traditional cash and accrual tax accounting methods for financial instruments, there are various other methods of taxing financial instruments. in particular, while several types of taxpayers, such as dealers,16 must mark financial instruments to market, other instruments, such as futures contracts, are marked-to-market based on the instrument’s identity. finally, instruments used for hedging are subject to special timing rules.17 the financial accounting standards board’s (fasb) increasing focus on financial instruments in recent years and, most notably, the issuance of fas 133 (a comprehensive set of accounting standards for derivatives and hedging of corporate tax returns 2002 tnt 196-18 (aug. 16, 2002). see also engler, supra note 1, at 559-61, presenting a non-comprehensive approach pursuant to which only specified items will be subject to conformity. 13. for a similar view, see generally ensminger, supra note 1. 14. for a proposed comprehensive regime pursuant to which gaap would be the single set of rules for public corporations, and corporations would pay tax equal to the tax rate times their book income, see engler, supra note 1, at 541. another alternative suggested by engler is that book income would become the tax base only if it exceeds taxable income calculated under the existing tax rules (i.e, a “floor approach”). 15. the general report (plambeck, rosenbloom and ring) in tax aspects of derivative financial instruments, cahier de droit fiscal international, vol. 80b, ifa, 1995. 16. notional principal contracts, for example, are taxed annually on the basis of their periodic and non-periodic cash flows. see generally regs. § 1.446-3. 17. steve rosenthal and mark price, time for reconciliation of tax and accounting for derivatives, 84 tax notes 895 (aug. 9, 1999). 682 florida tax review [vol.6:7 transactions), as amended by fas 138 and fas 149, provide an18 19 20 opportunity for congress and treasury to revisit their positions regarding the tax treatment of financial instruments, particularly those of hedging transactions and derivatives. this article explores potential harmonization between fas21 133 (and other relevant accounting guidance) and the taxation rules for similar transactions.22 may 2003 saw the occurrence of two significant events relating to conforming mark-to-market valuations rules under section 475 with those used for financial accounting purposes: (i) the issuance of a decision in bank one23 corp. v. comm’r and (ii) the issuance of an advance notice of proposed24 rulemaking (“anprm”) to request comments on a possible safe harbor that25 would allow financial statement values of securities to be used on tax returns.26 the irs’s growing interest in book tax conformity for financial instruments is also reflected in the recently proposed regulations on contingent notional principal contracts (npc), in which the irs provided for an elective mark-tomarket treatment for certain npcs that are being marked to market for accounting purposes.27 this article will proceed as follows: part ii discusses arguments for and against book-tax conformity in general, and for financial instruments in particular, and the alternative routes to achieving conformity. part iii discusses 18. fas 133: accounting for derivative instruments and hedging activities. (june 1998). 19. fas 138: accounting for certain derivatives instruments and certain hedging activities (an amendment to fasb statement no. 133) (june 2000). 20. fas 149: amendment of statement 133 on derivatives instruments and hedging activities (apr. 2003). 21. commentators have argued that with fas 133, the accounting system comes much closer to satisfying the clear reflection of income standard. see ensminger, supra note 1, at 95, citing david s. miller, reconciling policies and practice in the taxation of financial instruments, 77 taxes 236, 244 n.122 (1999). 22. id. see also rosenthal and price, supra note 17. 23. see, generally alan b. munro and yoram keinan, the case for book-tax conformity for mark-to-market valuation, 16(6), journal of taxation of financial institutions 5 (july/august 2003). 24. 120 t.c. 174 (2003). 25. safe harbor for satisfying statutory requirements for valuation under § irc 475 for certain securities and commodities, 26 cfr part i, reg-100420-03. 26. the rules under fas 133 and related gaap pronouncements are expected to play a key role in the valuation guidance because the main purpose of the anprm has been to explore possible use of those accounting rules for purposes of § irc 475. 27. reg-166012-02, 69 f.r. 8886 (feb. 26, 2004). the proposed regulations also resolve certain character issues relating to notional principal contracts, which are beyond the scope of this article. for an in-depth discussion on the proposed regulations, see david garlock, the proposed notional principal contract regulations – what’s fixed? what’s still broken? 102 tax notes 1515 (mar. 22, 2004). 2004] book tax conformity for financial instruments 683 the current relationship between book and tax rules in the united states pursuant to the clear-reflection-of-income doctrine under section 446 and provides a brief overview of the reportable transactions regulations. part iv provides a brief description of the accounting bodies and guidance that will be discussed herein. part v explores the three key issues involved in financial instruments that are relevant for both books and tax, namely classification, valuation, timing and valuation, valuation; provides an in-depth discussion on current conformity and non-conformity for financial instruments; and suggests various alternatives for conforming the non-conforming elements. finally, part vi shows how book-tax conformity for financial instruments enhances simplicity, certainty, neutrality, and administrability of the u.s. federal income tax rules for financial instruments. ii. pros and cons of conformity for financial instruments a. arguments for conformity 1. advantages of the mark-to-market method adoption of book-tax conformity for financial instruments will move the u.s. tax system much closer to a mark-to-market regime and further from the realization principle. commentators have regularly discussed the28 superiority of mark-to-market accounting in measuring income and the significant defects of competing systems. in bank one, the tax court stated29 that: “mark-to-market accounting has for decades been considered by academia and other commentators to be the most theoretically desirable of all the various systems of taxing income in that mark-to-market accounting 28. david a. weisbach, a partial mark-to-market tax system, 53 tax l. rev. 95 (1999) (“haig-simons taxation generally is viewed as the ideal form of income taxation.”); david a. weisbach, tax response to financial contract innovation, 50 tax l. rev. 491 (1995) (“a mark-to-market system, for example, would solve many timing problems presented by financial contracts.”); deborah h. schenk, taxation of equity derivatives: a partial integration proposal, 50 tax l. rev. 571 (1995) (“the global approach that holds the most appeal for a system that seeks to tax both consumption and accumulation is accretion taxation or universal mark-to-market accounting.”); alvin c. warren, jr., commentary, financial contract innovation and income tax policy, 107 harv. l. rev. 460 (1993) (“one potential policy response to the issues discussed here would be to expand further the category of assets that are marked-to-market for tax purposes.”) 29. haig, the concept of income – economic and legal aspects, the federal income tax (1921), in readings in the economics of taxation, at 68-69 (musgrave & shoup eds. 1959); simons, personal income taxation 103 (1938). 684 florida tax review [vol.6:7 consistently measures and levies tax on a taxpayer’s economic (or haig-simons) income. (footnote omitted)”30 in that respect, conforming books and tax rules for financial instruments on the basis of a mark-to-market timing treatment will be a welcomed change. fasb has stated in fas 133 that its long-term objective is to require mark-tomarket treatment to all financial instruments. in addition, fasb has31 considered applying mark-to-market regime to liabilities. commentators,32 however, have also warned of the potential drawbacks of the mark-to-market regime, particularly the liquidity concern.33 2. the advantages of the financial accounting system in rev. rul. 74-223, (involving futures contracts that commodities34 dealers entered into as hedges) the irs stated that: [t]his system of bookkeeping is the only accurate and correct system that has been devised that truly reflects the net profit or loss of any given year’s business, either fiscal or calendar. it is the system in use, approved by auditors who certify to the correctness of his financial statements which are the basis of his credit, and is the system accepted by his bankers for all his financial transactions and the only item which would not be false and misleading. the securities industry association (“sia”) suggested that: [t]he methods used for financial accounting and other substantive non-tax commercial purposes have been developed on an objective basis, without systematic bias, and clearly reflect the taxpayer’s income.35 these statements are particularly true with respect to financial instruments, because financial accounting rules for financial instruments are 30. bank one, 120 t.c. at 228-230 (citing various commentators). 31. fas 133, supra note 18, ¶ 216. 32. see reporting financial instruments and certain related assets and liabilities at fair value, fasb preliminary views (norwalk, conn.: fasb, 1999). 33. cf. david weisbach (1999), supra note 28, at 105 (“the problems of valuation and liquidity are not sufficient to overcome the benefits.”) 34. 1974-1 c.b. 23. 35. sia comments on possible securities and commodities safe harbor, 2003 tnt 177-39 (sept 12, 2003), ¶ 28. 2004] book tax conformity for financial instruments 685 more simple, neutral, and coherent than are tax rules. in particular,36 37 accounting rules apply a uniform approach to financial instruments, as38 opposed to tax rules, where different taxpayers and different instruments are subject to different rules. as three leading accounting commentators indicate: “debt securities are reported at fair value not only because the information is relevant, but also because it is reliable.”39 3. reducing administrative burden from a tax compliance perspective, book-tax conformity for financial instruments is welcomed. one of the arguments for conformity that was made by the international swaps and derivatives association (“isda”) in its comments to the anprm is the reduction in costs associated with the adoption of conformity rules. in particular, banking and financial institutions will40 greatly benefit from using gaap as the basis for the taxation of financial instruments because it will alleviate some of the hardship involved in valuation of different types of securities and commodities by setting forth a unified standard. accounting for financial instruments requires a tremendous amount41 of time and expertise, and creating one single reporting mechanism for book and tax will alleviate the burden of formulating two separate statements. 4. book-tax conformity for financial instruments in other countries in addition to the growing convergence in accounting and tax principles, several countries have particularly moved towards book-tax conformity for financial instruments. 36. former assistant treasury secretary for tax policy pamela olson, in emphasizing the need for tax simplification, stated that “[w]e have complicated compliance by legislating detailed rules on the calculation of taxable income that differ from the rules used to calculate book income, creating inevitable disparities that undermine confidence in our tax and financial accounting systems.” see olson’s tax policy speech at tei in new york, 2002 tnt 244-35 (dec.18, 2002). 37. rosenthal and price, supra note 17, at 906. 38. for example, all derivatives are subject to mark-to-market. 39. donald kieso, jerry weygandt and terry warfield, intermediate accounting (11th ed. 2004) at 837. 40. isda comments on possible securities and commodities safe harbor, 2003 tnt 189-22 (aug. 04, 2003), ¶ 21. isda believes that allowing book-tax conformity for over-the-counter (otc) derivatives contracts will avoid substantial costs for both the irs and dealers. if dealers are not permitted to value their otc derivatives in the same way they do under gaap for financial reporting purposes, the result will be endless disputes as to the value of particular positions and the propriety of particular valuation practices. 41. see generally munro and keinan, supra note 23. 686 florida tax review [vol.6:7 as stated by isda: [a] number of other major industrial countries require securities dealers to compute their income for tax purposes based on their income as determined for financial reporting purposes. if the united states uses the same approach, it will be starting with the same base these other countries do in allocating income of a global dealing operation among the different jurisdictions in which the operation is conducted. if the united states does not start with the same base as its trading partners, a securities dealer would be subject to tax on more (or less) than 100% of its worldwide income in a particular year, even if all jurisdictions use the same method for allocating that income. in contrast, use by all countries of the same base would eliminate one major potential source of over or under taxation of a dealer taxable in a number of different jurisdictions.42 most notably, recent tax legislation in england has aligned tax treatment of financial instruments with that reported in the financial statements. in spain, corporate tax rules follow accounting principles, and one43 commentator suggested that when the accounting guidelines for financial instruments are finalized, the tax rules would follow. finally, a similar44 approach has been proposed in australia.45 5. reduce incentives to enter into tax shelters in its july 1999 report on tax shelters, treasury indicated that certain book-tax differences may be viewed as tax shelters. in addition, the joint46 committee’s report on enron reveals that many transactions described therein were entered into for purposes of obtaining a benefit from a book-tax difference. as a commentator indicated: “an ideal tax shelter . . . is one that47 permanently reduces taxable income without a similar reduction in book income. that is, the ideal corporate tax shelter gives rise to permanent differences.”48 42. isda comments, supra note 40, ¶ 27. 43. this approach is reflected in the recently enacted finance act of 2002. see, generally, moncrieff, supra note 4. 44. see generally ruano, supra note 4. 45. australian issue paper, supra note 3, at 44-45. 46. treasury dep’t, the problem of corporate tax shelters: discussion, analysis and legislative proposals (july 2, 1999), at 21, reprinted in 1999 tnt 127-12. 47. see joint committee on taxation report on enron, supra note 11. 48. shevlin, supra note 1, at 433. 2004] book tax conformity for financial instruments 687 another commentator concluded: the entire class of shelters with this common characteristic [book-tax difference] would end if corporations were taxed on their adjusted book income. [footnote omitted] by linking taxable income to book income, congress would eliminate the ability of corporations to explore unintended and undesirable deviations between the two measures. congress would gain greater control over the corporate tax base; intended book-tax disparities could be specifically authorized but unintended ones would essentially end.[footnote omitted] the rule would have similar characteristics to section 469: it would be broad, reasonably clear, and very outcomes-oriented, with tax consequences literally being determined by the “bottom line.” tax results would not depend upon taxpayer intent, motive, or similar factors.49 another commentator also emphasized the limited role of disclosure as opposed to a substantive change in law: better disclosure of book-tax differences is only a first, though critical, step in more effective use of book-tax comparative analysis to identify and eliminate abusive tax and financial accounting practices. regulatory actions in addition to the imposition of improved disclosure requirements – such as book-tax consistency requirements imposed from both the tax and securities regulation perspective for potentially abusive transactions – also merit consideration.50 thus, a significant class of tax shelters will be eliminated if book and tax rules for financial instruments are conformed. as set forth below, recent reportable transactions regulations would generally require taxpayers to report book-tax differences of more than $10 million. nevertheless, this is only a reporting rule, and does not, substantively, eliminate the potential problem. generally, commentators agree that reporting rules will not significantly reduce 49. yin, supra note 1, at 225. see also weisbach (1999), supra note 28, at 106. 50. anthony j. luppino, supra note 1, at 48. 688 florida tax review [vol.6:7 the use of tax shelters. to significantly reduce potential tax shelters, book-tax51 differences must be eliminated.52 b. arguments against conformity book-tax conformity is easier said than done. there are a number of reasons why this article proposes not applying a general book-tax conformity in the united states federal income tax system (or, in other words, why it does not propose creating a federal income gaap tax), but applying it only for financial instruments. first, and most important, the roles of the accounting and tax systems differ; while the former are designed to verify that the valuation methodology is reasonable and to test whether it has been applied on a sample basis, the53 purpose of the latter is to reach the most accurate reflection of the taxpayer’s income. as commentators indicated, “conforming the two systems is at odds54 with the two very different functions that the systems are designed to perform.” in addition, as the u.s. supreme court indicated in thor power,55 51. id. see also david. a. weisbach, the failure of disclosure as an approach to shelters, 54 smu l. rev. 73 (2001); treasury, the problem of corporate tax shelters, supra note 46, at 15 (“although some disclosure of book-tax disparities is required both for federal income tax and gaap purposes, the amount of detail is limited and provides the irs with little evidence concerning the existence of corporate tax shelters.”) 52. see engler, supra note 1, at 540. 53. a natural tension exists under gaap between the company’s managers, who generally prefer that financial statements reflect high net income, and the company’s auditors, who tend to question the acceleration of income or the deferral of expenses. see yin, supra note 1, at 227. see also, johnson, supra note 1, at 425. 54. thor power, supra note 8. 55. shevlin, supra note 1, at 434, elaborating that: [t]he objective of financial accounting is to provide information relevant to decisionmakers such as investors (shareholders), lenders, suppliers, and other interested external parties. the objective of the code is first and foremost to raise revenue to fund government operations and programs, to achieve social objectives (such as income redistribution), to achieve economic goals (such as encouraging desirable economic activities through tax incentives), and, in my opinion not the least important, to maintain popularity of the political parties and to assist in re-electing individual members. i simply do not see how these conflicting objectives can be achieved within one set of rules. and if we allow modifications to book income as a starting base, how long will it be before we are back to the current system (which already could be characterized as book income being the starting base with many modifications to arrive at taxable income)? 2004] book tax conformity for financial instruments 689 accounting guidance constitutes relatively flexible “principles,” which may not ensure identical treatment of identical transactions, while tax law strives for more accuracy. nevertheless, in my view, accounting and tax’s different roles56 should not prevent policy makers from conforming the rules only for financial instruments.57 second, accounting rules are not sufficiently comprehensive to form the rules required for financial instruments. for example, gaap do not deal with the character of income, an element that is important in jurisdictions where the rates for capital gains differ from the ordinary income rates. thus, conforming book and tax rules would still leave the character issue unsettled.58 third, as of today, the private sector (i.e., fasb), rather than congress, sets forth the accounting principles. generally, commentators agree that accounting principles need to be independent from government interference.59 as one commentator indicated, the accounting profession has been very clear in asserting that the government should not “have a hand in determining the application or formulation of the principles to which the tax law was being 56. thor power, 439 u.s. at 544. 57. as engler indicates: “[d]espite their stated differences, taxable income and book income share a common core: net income as a barometer of profitability.” see engler, supra note 1, at 558. 58. if character of income from financial instruments will be ordinary in all circumstances, as david garlock suggests, this would eliminate this problem. see, generally garlock (2004), supra note 27. alternatively, the capital gains preference could be eliminated. see weisbach (1999), supra note 28, at 123. 59. see generally selbach, supra note 2, on the eu directive approach. for an in-depth discussion on the reaction of the accounting profession to book-tax conformity, see anthony j. luppino, supra note 1, at 119-131. see also terry shevlin, supra note 1, at 436, stating that: if taxable income were to be more closely linked to book income rules, how would the standards be determined? would the fasb need to consult with congress every time the fasb debated an accounting issue that had book income consequences? would congress not meddle in the setting of standards but alternatively separately consider the income and tax consequences of any book income rule change and issue a modification for purposes of calculating taxable income? i believe that this would become very cumbersome and the standard setting process would become even more cumbersome than at present. 690 florida tax review [vol.6:7 asked to conform.” for this reason, i suggest below that tax rules will follow60 gaap and not vice versa, so that gaap will remain independent.61 fourth, conforming book and tax rules would limit the accounting and tax institutional ability and authority to initiate changes to the systems. in62 particular, assuming tax rules will follow gaap, conformity may limit the tax authorities’ response to new instruments because congress and treasury will have to wait for fasb’s reaction when a new instrument is introduced. fifth, some commentators have indicated that book-tax conformity will motivate reporting entities to report lower earnings simply to reduce their tax bill and it might have the effect of degrading the quality of financial reporting.63 as professor johnson indicates, “[d]riving down reported income would be terrible for the efficiency of the stock market.”64 finally, applying a mark-to-market regime to most financial instruments could have some adverse impact. in particular, it has been argued that liquidity is a major drawback of a mark-to-market regime.65 c. alternative routes to achieve conformity 1. mandatory conformity congress and treasury may set forth mandatory book-tax conformity for financial instruments that will apply to all taxpayers. mandatory conformity could be achieved in two ways. the first alternative is for congress to set forth in the tax code a broad provision pursuant to which taxpayers must follow, for tax purposes, the classification, timing, and valuation principles they use for financial accounting purposes. the benefit of this alternative is that when a66 certain relevant accounting principle changes, it would not be necessary to 60. anthony j. luppino, supra note 1, at 123. 61. as set forth below, i suggest that congress and treasury revise current tax rules for financial instruments to conform them to corresponding accounting principles. i do not, however, suggest that a taxpayer will be required, or allowed, to apply its particular financial accounting treatment for tax purposes. 62. knott and rosenfeld, supra note 1, § iv,a(2)(a). 63. johnson, supra note 1, at 427. 64. id. 65. see reed shuldiner, a general approach to the taxation of financial instruments, 71 tex. l. rev. 243 (1992); noel cunningham and deborah schenk, taxation without realization: a “revolutionary” approach to ownership, 47 tax l. rev. 725 (1992); edward d. kleinbard, equity derivative products: financial innovation’s newest challenge to the tax system, 69 tex. l. rev. 1319 (1991). cf. weisbach (1999), supra note 28, at 105. 66. see generally yin, supra note 1, at 225, suggesting a broad provision similar to irc § 469. under this approach, taxpayers will follow their book treatment of financial instruments in their returns. id., at 224. 2004] book tax conformity for financial instruments 691 change the corresponding tax rules, because taxpayers would, automatically, apply this treatment in their tax return. the disadvantage of this alternative, however, is that identical entities may be subject to different tax rules, because conformity will be applied on an entity-by-entity basis rather than uniformly. in particular, not all taxpayers are subject to gaap, and if taxpayers follow their book treatment, taxpayers who are not subject to gaap may be subject to different tax treatment than are taxpayers who are subject to gaap. alternatively, congress and treasury may decide to re-write the tax rules pertaining to financial instruments based on current corresponding gaap. in other words, financial accounting principles pertaining to financial instruments, including fas 133, will guide congress and treasury in formulating such rules. under this alternative, tax rules will be similar for all67 taxpayers, regardless of whether they are subject to gaap or not. the68 disadvantage of this alternative is that tax law will be less flexible in reacting to changes in financial accounting principles. for example, as discussed in greater detail below, fasb may decide in the near future to expand mark-tomarket treatment to issuers of debt instruments. if and when this change in accounting treatment of liabilities occurs, and assuming the tax authorities wish to maintain conformity, it will require a comprehensive change in tax law pertaining to the tax treatment of liabilities. generally, the difference between the two alternatives pertains to neutrality. in my view, the latter alternative is preferred because it will be applied to all taxpayers and will enhance neutrality in the tax system. on the other hand, because of the relative flexibility of financial accounting principles, it is possible that two identical reporting entities will be subject to69 different financial accounting treatment, but only one will be subject to a conforming tax rule. 2. mandatory for a specific type of instrument and elective to others under this approach, some types of taxpayers will be required to follow book-tax conformity for financial instruments, while others will do it on an elective basis. for example, banking and financial institutions will be required to conform books and tax, while other types of taxpayers will do it on an elective basis. under this approach, tax law pertaining to financial instruments70 67. for a similar view, see, generally ensminger, supra note 1. 68. cf. engler, supra note 1, at 598, suggesting that only public corporations will be subject to tax in accordance with their book income. 69. thor power, 439 u.s. at 544. 70. as of today, most banks constitute “dealers” in securities and, therefore, are subject to mark-to-market treatment for both tax and financial accounting purposes, under irc § 475 and fas 115, respectively. 692 florida tax review [vol.6:7 will not be revised because not all taxpayers will be subject to conformity. the problem with such an approach is that the current piecemeal tax rules will remain effective, and it will create more complexity in the form of parallel tax regimes, one for electing taxpayers, and another for non-electing taxpayers. 3. all taxpayers may elect to apply book-tax conformity under an elective approach, taxpayers will be able to elect conformity for financial instruments. for example, in the recently proposed contingent71 npc regulations, the irs stated in the preamble that: [t]axpayers who use a mark-to-market method for financial reporting purposes may adopt the elective mark-to-market method to reduce their tax and accounting administrative burden for npcs. 72 this provision, however, applies only to notional principal contracts with non-periodic payments. the irs acknowledged that it is considering the expansion of the scope of the proposed regulations (and presumably, the markto-market election) to other instruments.73 in addition, in recent years, the irs has stated in different contexts that allowing taxpayers to elect a tax accounting method in accordance with their financial reporting methods would greatly benefit not only the taxpayers but also the irs. the anprm suggested a safe harbor that would allow taxpayers74 to use, for purposes of section 475, the values used on their financial statements. it is expected that the future regulations will adopt this approach in accordance with the anprm.75 the main disadvantage of an elective approach is that not only will current incoherent tax rules for financial instruments remain effective, but some taxpayers will still apply these old rules, while others will follow their books. this kind of dual system again, will just increase complexity. in my view, congress and treasury should consider revisiting the current tax rules for financial instruments and use current corresponding gaap for this purpose. otherwise, the benefit from having some taxpayers apply conformity might be outweighed by the additional complexity resulting from the 71. in certain cases, congress and irs allow an elective mark-to-market treatment, but not necessarily in accordance with the accounting treatment. see generally irc§ 475(f) (election for traders) and irc§ 1296 (mark-to-market election for pfic stock). 72. reg-166012-02, supra note 27. 73. id. 74. see reg-100420-03, supra note 25. 75. see generally munro and keinan, supra note 23. 2004] book tax conformity for financial instruments 693 creation of a dual system. the only way, therefore, to improve the current piecemeal tax rules for financial instruments, is to revise them. iii. current relationship between book and tax rules a. clear reflection of income section 446(b) requires that a taxpayer use a method of accounting that clearly reflects income. section 446(a) requires a taxpayer to compute its taxable income under the method of accounting used in keeping the taxpayer’s books. an accounting method that is acceptable under gaap might be76 unacceptable for federal income tax purposes, because it does not clearly reflect income. however, the tax court indicated that an important factor in the77 clear-reflection-of-income determination is whether the taxpayer is consistently using an established method of accounting that is consistent with gaap and is prevalent in the relevant industry.78 nevertheless, it is clear that as of today, the starting tax base for all taxpayers is not book income. as set forth above, several discussions have been made to use book income as the starting tax base; however, so far,79 netherneither congress nor treasury has accepted any of them. nevertheless, for financial instruments, tax rules that are based on prevailing financial accounting principles could be viewed as reflecting income more clearly than do the current piecemeal tax rules.80 76. the term “books” for purposes of irc § 446(a) has been interpreted so as to include memorandum journal entries and accounting work papers containing accounting adjustments necessary to convert the items of income and expense recorded in the taxpayer’s books to the tax accounting method. see patchen v. comm’r, 258 f.2d 544, 546 (1958). this interpretation is necessary because financial accounting and tax accounting have different criteria for income inclusion and expense deduction. 77. bank one, 120 t.c. at 226-27, citing thor power tool co. v. comm’r, 439 u.s. at 538-44; am. auto ass’n v. united states, 367 u.s. 687 6 l. ed. 2d 1109, 81 s.ct. 1727 (1961); (1961); hamilton ind., inc v. comm’r, 97 t.c. at 128 (1991); sandor v. comm’r, 62 t.c. 469, 477 (1974), aff’d 536 f.2d 874 (9th cir. 1976). 78. id. regs. § 1.446-1(a)(2) states that a method of accounting “ordinarily” will clearly reflect income when it “reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business.” 79. see yin, supra note 1, at 224. 80. see ensminger, supra note 1, at 95. 694 florida tax review [vol.6:7 b. reportable transactions regulations in recent years, treasury and irs have issued regulatory and administrative guidance in connection with tax shelters. the most significant81 guidance focuses primarily on requiring disclosure of transactions that may be considered abusive. the irs has also implemented certain organizational82 changes designed to improve the agency’s collection, utilization, and dissemination of information regarding tax shelters. the fundamental purpose83 of the reportable transactions regulations is to require disclosure of transactions that might be viewed as “tax shelters.” in the regulations, treasury set forth rules that would require taxpayers to disclose if they treated a transaction differently for book and tax purposes. pursuant to regs. section 1.6011-4(b)(6), the existence of a book-tax difference of $10 million or more, by itself, may render a transaction “reportable” for tax purposes. nevertheless, there are numerous exceptions to this rule.84 a significant book-tax difference is defined in the regulations as: a transaction where the amount for tax purposes of any item or items of income, gain, expense, or loss from the transaction differs by more than $ 10 million on a gross basis from the treatment of the item or items for book purposes in any taxable year.85 as of today, numerous such differences exist, some of which are permanent (i.e., the amount of income or deduction differs), while others are temporary (i.e., the timing of income or deduction differs). as opposed to86 permanent differences, temporary differences arise when items of income and deductions are includable in income or deductible as expenses for tax and financial reporting purposes at different times. a taxpayer reports such 81. for example, the reportable transaction regulations (regs. § 1.6011-4, t.d. 9046, 68 fed. regs. 10161, mar. 3, 2003) and proposed amendments to circular 230 (reg-122379-02, 68 f.r. 75186-75191, dec. 30, 2003). 82. t.d. 9046, 68 fed. reg. 10,161 (mar. 4, 2003). the six types of transactions that constitute “reportable” are: listed transactions, confidential transactions, transactions with contractual protection, loss transactions, transactions with a significant book-tax difference, and transactions involving a brief asset holding period. 83. see john d. mckinnon, irs, reorganizing, to sharpen fight against abusive corporate tax shelters, wall st. j., feb. 3, 2000, at a4. 84. rev. proc. 2003-25, 2003-1 c.b. 601. a discussion of these exceptions is beyond the scope of this article. 85. regs. § 1.60114(b)(6)(i). 86. gil b. manzon, jr. and george a. plesko, the relation between financial and tax reporting measures of income, 55 tax l. rev. 175, 183 (2002). 2004] book tax conformity for financial instruments 695 differences on its schedule m-1 the federal corporate tax return. in addition,87 88 pursuant to fas 109, a reporting entity must report in its financial statements89 information concerning deferred tax assets and liabilities.90 iv. relevant accounting bodies and guidance a. financial accounting standards board (fasb) the fasb was created in 1973 and is the professional organization primarily responsible for establishing financial reporting standards in the united states. generally, the securities and exchange commission (“sec”), which91 was created pursuant to the securities exchange act of 1934, has recognized92 guidance issued by fasb as authoritative. fasb issues the following types93 of guidance: (i) statements of financial accounting standards (sfass), each of which addresses a specific topic in financial accounting; (ii) interpretations of statements or pronouncements of predecessor bodies; and (iii) technical bulletins. fasb has also issued seven statements of financial concepts (sfacs), the purpose of which is to set forth a conceptual framework for financial reporting.94 87. reconciliation of income (loss) per books with income per return. 88. irs form 1120, u.s. corporation income tax return (2001). the schedule m-1 will be revised and titled “schedule —3” starting from december 31, 2004. see rev. proc. 2004-45, 2004-31 irb 1; ir-2004-91, irs announces release of schedule m-3 for corporations (july 7, 2004), printed in 2004 tnt 131-16. 89. fas 109, accounting for income taxes (fasb 1992). see generally manzon and plesko, supra note 86, at 183-184; david a. weisbach, ten truths about tax shelters, 55 tax l. rev. 215, 227 (2002). 90. a temporary difference creates deferred tax asset or liability, while a permanent difference is reported on either the equity section of the balance sheet or the income statement. see manzon and plesko, supra note 86, at 182. 91. bank one, 120 t.c. at 216-17. 92. securities exchange act of 1934, ch. 404, 13(b), 48 stat. 881, 894-95. generally, publicly-traded companies in the united states, including non-u.s. companies, are required to file financial statements with the sec that are prepared in accordance with u.s. gaap. nevertheless, many nonpublicly traded companies not subject to the sec supervision also employ gaap. see sia comments, supra note 35, ¶ 71. 93. knott and rosenfeld, supra note 1, at footnote 22, citing, sec 1973 policy statement (principles promulgated in fasb statements and interpretations considered by sec to have substantial authoritative support). see also sia comments, supra note 35, ¶ 70. 94. knott and rosenfeld, supra note 1, § i(d). 696 florida tax review [vol.6:7 b. international accounting standards committee (iasc) the accountancy bodies of a number of industrialized countries established the iasc in 1973. the iasc enhances improvement and harmonization of accounting standards by formulating and publishing accounting standards that are intended to be acceptable worldwide. the standards set forth by the iasc are titled international accounting standards (“ias”), and have acquired a status as indicators of internationally acceptable practice.95 c. guidance on financial instruments as part of its financial instruments project, the fasb has issued several statements. in 1990, the fasb issued fas 105, which required a footnote96 disclosure of the extent, nature, and terms of financial instruments such as swaps, which contain off-balance-sheet risk. in 1991, the fasb issued fas 107, which required a footnote disclosure of the fair value of financial97 instruments for which it was practicable to estimate fair value but did not require formal recognition of such instruments in the financial statements. the term fair value was defined as: [t]he amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. if a quoted market price is available for an instrument, the fair value to be disclosed for that instrument is the product of the number of trading units of the instrument times that market price.98 95. see generally selbach, supra note 2, at 553-55. 96. fas 105, disclosures of information about financial instruments with offbalance-sheet risk and financial instruments with concentrations of credit risk (mar. 1990). 97. fas 107, disclosures about fair value of financial instruments (dec. 1991). 98. fas 107 allowed a variety of methodologies for estimating fair values, including the use of midmarket values if any adjustments thereto were likely to be negligible or not cost effective to estimate reliably. the fasb recognized in fas 107 that quoted market prices did not exist for custom-tailored instruments such as swaps and recommended that “an estimate of fair value might be based on the quoted market price of a similar financial instrument, adjusted as appropriate.” the valuation issue is discussed in greater detail below. 2004] book tax conformity for financial instruments 697 fas 115, issued in 1993, addresses the accounting rules for99 investments in equity securities that have readily determinable fair values (i.e., marketable securities) and for all investments in debt securities. in 1994, the fasb issued fas 119, which required a footnote disclosure of the nature,100 terms, and fair values of derivatives. in 1998, the fasb issued fas 133, which requires all derivatives to101 be recorded on the balance sheet at fair value (i.e., marked-to-market) and sets forth special accounting standards for hedging transactions. fas 133, has been revised several times, particularly by fas 149. fas 133 replaced the disclosure requirements under fas 105 and fas 119. finally, fas 150, issued in 2003,102 sets forth standards for how an issuer should classify and measure certain instruments with characteristics of both liabilities and equity. in addition to the above statements, numerous other documents have been issued by accounting bodies on financial instruments. this article,103 however, discusses only the most important ones. v. key issues in analyzing financial instruments a. general the tax treatment of a financial instrument can be determined in accordance with (i) the identity of the instrument and its associated cash flows; (ii) the identity of the taxpayer; or (iii) the purpose for which the transaction is entered into by the particular taxpayer. ideally, the tax treatment of a particular instrument should be determined by considering all three elements. nevertheless, as a practical matter, it is very hard to apply all three elements at the same time. as of today, the taxation rules for financial instruments in the united states do not follow a consistent pattern. specifically, while some rules emphasize the identity of the instrument (e.g., notional principal contracts regulation and section 1256), other rules emphasize the identity of the taxpayer (e.g., section 475). finally, some rules focus on the purpose of the transactions 99. fas 115, accounting for certain investment in debt and equity securities (may 1993). 100. fas 119, disclosures about derivative financial instruments and fair value of financial instruments (oct. 1994). 101. fas 133, supra note 18. 102. fas 150, accounting for certain financial instruments with characteristics of both liabilities and equity (may 2003). 103. for example, the emerging issues task force of the fasb (the “eitf”) issued guidance in early 2003 to address valuations of energy derivatives. this guidance is commonly viewed as an authority for valuation of all derivatives. see eitf issue no. 02-3, “issues involved in accounting for derivative contracts held for trading purposes and contracts involved in energy trading and risk management activities.” 698 florida tax review [vol.6:7 (e.g., hedging rules). some current regimes apply more than one approach to some extent, but incoherently.104 by contrast, financial accounting rules are more coherent and generally apply a uniform approach for financial instruments. generally, fas 133105 requires all derivatives to be mark-to-market, while fas 115 requires all securities that are not held to maturity to be marked-to-market. b. substance over form in many cases, taxpayers develop transaction forms that facially differ from their real economic substance in order to obtain the resulting tax benefits. under the substance-over-form doctrine, the irs and the courts have the power to re-characterize a transaction in accordance with its substance if such substance is demonstrably contrary to its outward form. in some cases,106 taxpayers have successfully challenged their own transaction form, subject to limitations under the “danielson” doctrine.107 similarly, under gaap, the substance of a transaction rather than its form should be reported in financial statements, especially if presenting the form rather than the substance would be misleading.108 fasb concepts statement no. 2 states: substance over form is an idea that also has its proponents, but it is not included because it would be redundant. the quality of reliability, and, in particular, of representational faithfulness, leaves no room for accounting representations that subordinate 104. for example, irc § 1256, which generally applies the first approach, excludes from its application hedging transactions. similarly, the notional principal contract regulations generally do not apply to transactions that are subject to mark to market treatment under irc § 1256 or irc § 475. finally, the hedging regulations do not apply to § 475 transactions. see rosenthal and price, supra note 17, at 901-05. 105. id. at 906. 106. joseph isneberg, musing on form and substance and form in taxation, 49 chi. l. rev. 859 (1982). 107. comm’r v. danielson, 378 f. 2d 771 (3rd cir. 1967) cert. denied, 389 u.s. 858 (1967); helvering v. lazarus, 308 u.s. 252 (1939); estate of weinert v. comm’r, 294 f.2d 750, 755 (5th cir. 1961). 108. for an-depth discussion on the accounting substance-over-form concept, see rick stephan hayes and richard baker, the concept of substance over form: a d i s c u s s i o n b a s e d o n t h e c i n d e r e l l a s t o r y ( 1 9 9 9 ) , http://panopticon.csustan.edu/cpa99/html/hayes.html (critical perspectives on accounting conference, 1999). 2004] book tax conformity for financial instruments 699 substance to form. substance over form is, in any case, a rather vague idea that defies precise definition.109 the iasc has also indicated that “prudence, substance over form, and materiality should govern the selection and application of accounting policies.”110 international accounting standard (ias) no. 1 states that: transactions and other events should be accounted for and presented in accordance with their substance and financial reality and not merely their legal form.111 the iasc specifically refers to substance over form in standards dealing with finance leases, joint ventures, and related party transactions.112 113 114 109. fasb concept statement no. 2, appendix b, ¶ 160. in addition, accounting principles board’s statement no. 4 provides that: financial accounting emphasizes the economic substance of events even though the legal form may differ from the economic substance and suggest different treatment. . . . although financial accounting is concerned with both the legal and economic effects of transactions and other events and many of its conventions are based on legal rules, the economic substance of transactions and other events are usually emphasized when economic substance differs from legal form. . . .usually the economic substance of events to be accounted for agrees with the legal form. sometimes, however, substance and form differ. accountants emphasize the substance of events rather than their form so that the information provided better reflects the economic activities represented. see hayes and baker, supra note 108. 110. id. 111. id. as the ias framework ¶ 35, elaborates: the substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. for example, an enterprise may dispose of an asset to another party in such a way that the documentation purports to pass legal ownership to that party; nevertheless, agreements may exist that ensure that the enterprise continues to enjoy the future economic benefits embodied in the asset. in such circumstances, the reporting of a sale would not represent faithfully represent the transaction entered into (if indeed there was a transaction). 112. ias 17, ¶ 3 and 13. substance over form is explained in regard to leases: while the legal form of a lease agreement is that the lessee may acquire no legal title to the leases asset, in the case of finance leases 700 florida tax review [vol.6:7 finally, in england, u.k. accounting standards board’s (asb) financial reporting standard 5 sets forth that: (i) the substance of transactions should be recorded; (ii) greater weight should be given to aspects that are likely to have an economic effect; (iii) complex transactions should be analyzed to see whether the entity’s assets or liabilities have been affected; and (iv) if assets and liabilities are identified then general tests need to be applied to see whether they should be recognized.115 c. classification of financial instruments 1. overview an entity’s balance sheet contains three categories: assets, liabilities and equity. the value of an entity’s assets must be equal to the sum of its116 liabilities and equity. each item in the balance sheet must be reported in one117 of these categories. as a result, it is important for financial accounting118 purposes to classify each item and report it in the appropriate section of the balance sheet. the classification issue becomes even more important with respect to financial instruments, because different instruments are subject to different treatments.119 classifying financial instruments that are composed of several basic instruments, or instruments with characteristics of both debt and equity, is not an easy task. one alternative is to adopt an integrative approach pursuant to which different positions are aggregated and the combined instrument is subject the substance and financial reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of the useful life. 113. ias 31, ¶ 18 and 26. in addition, the iasc states that when reporting an interest in a jointly controlled entity in consolidated financial statements, it is essential that a venture reflects the substance and economic reality of the arrangement, rather than the joint venture’s particular structure or form. in considering each possible related party relationship, attention is directed to the substance of the relationship, and not merely the legal form. 114. ias 23 ¶ 3. 115. see hayes and baker, supra note 108. 116. “elements of financial statement of business enterprises,” statement of financial accounting concepts no. 6 (stamford, conn.: fasb 1980), ¶ 35. 117. id. 118. id. 119. see, generally “reporting income, cash flows and financial positions of business enterprises,” proposed statement of financial concepts (fasb 1981), ¶ 51. 2004] book tax conformity for financial instruments 701 to a certain treatment according to its combined identity. another alternative120 is to disaggregate the taxpayer’s position into its basic ingredients and to impose a certain treatment on the overall position on the basis of the basic ingredients’ treatment. a third alternative is to simply treat the instrument on the basis of121 its legal distinction (i.e., form over substance). while the first two approaches are economic-based approaches, the third one focuses on the form rather than the substance. in this article, i attempt to neither revisit the debt v. equity rules nor decide whether integration or bifurcation is superior. instead, i suggest that financial accounting and tax classification rules be conformed so that an instrument is not treated differently for book and tax purposes. to facilitate such conformity, i suggest that financial instruments be divided into two groups: derivatives and non-derivatives (i.e., basic instruments). in turn, each group122 will also be divided into two sub-categories: while a position in a derivative will constitute either an asset or a liability, non-derivative instruments will be classified as either debt or equity instruments. a holder of a non-derivative instrument will be viewed as holding an “asset,” while its issuer will be viewed as owing either a liability (for issuing a debt instrument) or equity (for issuing an equity security). thus, each instrument will be classified for both financial accounting and tax purposes as an asset, liability, or equity, in accordance with accounting concepts. finally, the so-called “hybrid instrument” class should be eliminated for both tax and accounting purposes.123 2. basic (non-derivatives) instruments: distinguishing between debt (liability) and equity (i) exploiting book and tax differences debt provides certain tax advantages to its issuer because business interest expenses are deductible. nevertheless, the issuance of debt also tends124 120. for an in-depth discussion on integration and bifurcation, see, weisbach (1995), supra note 28, jeff strnad, commentary – taxing new financial products in a second best world: bifurcation and integration, 50 tax law rev. 545 (1995); schenk, (1995), supra note 28. 121. id. 122. for purposes of this distinction, i suggest that the definition of a “derivative” for both financial accounting and tax purposes be conformed under the principles of fas 133, as set forth in greater detail below. 123. see, generally, fas 150, ¶ b56, which suggests that presentation between the liabilities and equity sections of the balance sheet is inappropriate. 124. see, generally, irc § 163(a) (2004). 702 florida tax review [vol.6:7 to depress the issuer’s stock price and credit ratings. as a result, under certain125 circumstances, corporations prefer to obtain equity financing for financial accounting purposes, and debt financing for tax purposes. generally, financial126 accounting rules for classifying an instrument as a liability or equity do not conform to the corresponding tax rules, and corporations may enjoy various opportunities to achieve such a benefit. (ii) section 385 section 385 addresses the treatment of certain interests in corporations and provides authority to the irs to set forth regulations to determine whether an instrument constitutes debt or equity, or part debt and part equity. in 1981,127 treasury issued regulations under section 385, that proved to be controversial and finally were withdrawn. in the absence of regulatory guidance, the characterization of an instrument as debt or equity has been determined pursuant to case law.128 125. see david. c. garlock, taxation of debt instruments (2004), at § 1.01[b], footnote 72. see also ceo tax group backs dividends-paid deduction, 86 tnt 168-51 (aug. 12, 1986). 126. mipss, for example, are securities with which corporations can achieve this result. garlock, supra note 125, at § 1.01[b][3]. the basic idea behind mips and similar products is that an intermediate entity is interposed between the investors and the borrower, which is treated as a pass-through entity for tax purposes but is consolidated with the issuer and hence effectively disregarded for financial accounting purposes. the intermediate entity issues nonvoting preferred interests to the investors (and a small voting common interest to the issuer or a third party) and uses the proceeds to purchase a long-term debt instrument from the issuer. as long as the entity is respected for tax purposes as separate from the issuer, the debt is given effect for tax purposes and so the issuer gets an interest deduction. if the entity is consolidated with the issuer under gaap, then the debt is ignored for that purpose and the issuer is simply treated as having issued some form of preferred interest to the public. accountants have generally been comfortable that this interest need not be shown on the balance sheet as debt, but rather as a form of “mezzanine” equity. id. 127. section 385 lists factors that such regulations may take into account in determining whether a debtor-creditor or a corporation-shareholder relationship exists, including; (i) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest; (ii) whether there is subordination to or preference over any indebtedness of the corporation; (iii) the ratio of debt to equity of the corporation; (iv) whether there is convertibility into the stock of the corporation; and (v) the relationship between holdings of stock in the corporation and holdings of the interest in question. 128. an equity interest has traditionally been defined as embarking on a corporate venture and taking the risks of loss attendant upon it, so that one might share in the profits of its success, whereas debt has been defined as an unqualified obligation 2004] book tax conformity for financial instruments 703 courts have developed guidance in this area by identifying factors that are relevant to the characterization of an obligation as debt or equity for u.s. federal income tax purposes, including: (i) whether there is an unconditional129 promise on the part of the debtor to pay a sum certain; (ii) whether the creditor has the right to enforce the payment of principal and interest; (iii) whether the rights of the creditor are subordinated to those of general creditors; (iv) whether the instrument gives the creditor the right to participate in the management of the debtor; (v) whether the debtor is thinly capitalized; (vi) whether there is identity between the creditor and shareholders of the debtor; (vii) whether funds are repaid on the due date; (viii) the intent of the parties; (ix) the presence of a maturity date; (x) the payments’ source; (xi) the instrument’s label placed by the parties; (xii) the ability of the debtor to obtain loans from outside lenders; and (xiii) the use of the proceeds by the debtor.130 the irs also attempted to set forth in notice 94-47 its own debt v.131 equity guidelines which generally are consistent with the above common law principles. (iii) accounting classification rules “liabilities” are defined for financial accounting purposes as: [p]robable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.132 to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor’s income or lack thereof. see garlock, supra note 125 at § 1.01[b], citing farley realty corp. v. comm’r, 279 f.2d 701 (2d cir. 1960); united states v. title guarantee & trust co. 133 f.2d 990, 993 (6th cir. 1943). 129. some courts have placed more weight on certain factors than on others, and not all factors have been considered by every court in analyzing a debt-equity characterization issue. however, courts have been consistent in finding that no particular factor is conclusive in making such a determination. 130. plumb, the federal income tax significance of corporate debt: a critical analysis and a proposal, 26 tax l. rev. 369 (1971). see also laidlaw transportation, inc. v. comm’r, t.c. memo. 1998-232. 131. 1994-1 c.b. 357. 132. sfac. no.6, ¶ 35. 704 florida tax review [vol.6:7 “assets” generally mirror liabilities and, accordingly, are defined as: [p]robable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.133 finally, “equity” is defined as: [t]he residual interest in the assets of an entity that remains after deducting its liabilities. in a business enterprise, the equity is the ownership interest.134 fas 150 was developed in response to concerns expressed by135 preparers, auditors, regulators, investors, and other users of financial statements about issuers’ classification of certain financial instruments with characteristics of both liabilities and equity that have been presented either entirely as equity or between the liabilities section and the equity section of the statement. fas136 150 sets forth standards for how should an issuer classify and measure several types of such instruments. pursuant to fas 150, the relationship between the parties to the transaction, in addition to the transaction’s form, should govern in determining whether the instrument constitutes a liability or equity. an issuer is required137 to classify the following instruments as liabilities (or assets in some circumstances): (i) mandatorily redeemable financial instruments; (ii) an138 obligation to repurchase the issuer’s equity shares by transferring assets; and139 133. id., ¶ 25. 134. id., ¶ 49. 135. fas 150, supra note 102. 136. id., ¶ b2. 137. fas 150 does not apply to (i) features that are embedded in a financial instrument, such as conversion and conditional redemption features, which do not constitute derivatives in their entirety, and (ii) convertible bonds, puttable stock, or other outstanding shares that are conditionally redeemable. id., ¶ 16-17 pg. 5. 138. id., ¶ b20. 139. an instrument, other than stock, that, at issuance, embodies an obliga-tion to repurchase the issuer’s equity shares, or is indexed to such an obligation, and that requires or may require the issuer to settle the obligation by transferring assets (e.g., forward purchase contracts and written put options on the issuer’s stock, that are to be physically settled or net cash settled). such contracts constitute liabilities because they (i) embody an unconditional obligation to repurchase the issuer’s stock (or instruments that are indexed to such an obligation) and (ii) require or may require the issuer to settle the obligation by transferring assets. id., ¶ 11, b26-b29. 2004] book tax conformity for financial instruments 705 (iii) an obligations to issue a variable number of shares. while fas 150140 determines that all three instruments should be classified as liabilities and not equity, only the first one could be viewed as equivalent to indebtedness.141 mandatorily redeemable financial instruments are instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur. such instruments are142 classified as liabilities under fas 150, although in form they are equity, because they: (i) embody a current obligation that entails settlement by future transfer of assets at a specified or determinable date or on occurrence of a specified event; (ii) provide the issuer with no discretion to avoid a future sacrifice of assets; and (iii) result from a transaction – the issuance of the instrument – that has already happened. although fas 150 did not specifically state that such instruments constitute “indebtedness,” it did state that payments or accrual of “dividends” payable to holders are reported as interest costs.143 140. an instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares, if, at inception, the monetary value of the obligation is based solely or predominantly on any of the following: (i) a fixed monetary amount known at inception (e.g forward contract to issue a variable number of shares so that the value to be issued is pre-determined and not subject to changes in the stock’s value); (ii) variations in something other than the fair value of the issuer’s equity shares (e.g., a financial instrument indexed to the s&p 500 and settleable with a variable number of the issuer’s equity shares); or (iii) variations inversely related to changes in the fair value of the issuer’s equity shares, for example, a written put option that could be net share settled. although this type of instrument does not satisfy the definition of “liabilities” under sfac no. 6, the relationship between the parties constitutes debtor-creditor relationship and, therefore, if the above requirements are met, they are classified as liabilities under fas 150. id., ¶ a22 b32. 141. the second and third types of instruments do not constitute indebtedness but rather constitute derivatives. 142. see fas 150, appendix d1. an example of such an instrument is a trust preferred security issued in the following manner: a trust issues preferred securities to outside investors and uses the proceeds to purchase from a financial institution an equivalent amount of debentures having stated maturities. the debentures are the trust’s only assets. when interest payments are made on the debentures, the trust distributes the cash to the preferred securities’ holders. the trust preferred securities must be redeemed upon the debentures’ maturity. para a4-a5. 143. id., ¶ a5. 706 florida tax review [vol.6:7 pursuant to fas 150, the most important aspect of a “liability” is the existence of an unconditional “obligation.” in addition, to be classified as a144 liability rather than equity, an obligation must not expose its holder to certain risks and benefits to which an owner of equity interests is normally exposed.145 in that respect, exposure to changes in the fair value of the issuer’s stock is a characteristic of equity.146 both accounting and tax principles, in attempting to identify what constitutes indebtedness, apply three related but distinct terms: “indebtedness,” “liability” and “obligation.” the u.s. supreme court held in deputy v.147 dupont that an obligation to return borrowed stock pursuant to a securities148 lending arrangement does not constitute “indebtedness” for tax purposes. in rev. rul. 95-26, the irs ruled that such an obligation constitutes “liability”149 for purposes of section 752. thus, for tax purposes, an obligation to return the150 borrowed stock under a short sale constitutes a “liability” but not “indebtedness.”151 fas 150 applies to instruments that constitute “liabilities” and not necessarily “indebtedness.” thus, its scope is broader than the particular debt v. equity classification issue. nevertheless, in my view, fas 150 is an important step in conforming tax and book principles for distinguishing between debt and equity because it emphasizes some of the important elements that have been used by courts and the irs in such determinations. in particular, with respect to the mandatorily redeemable financial instruments, the following elements suggest that it could be viewed as indebtedness for tax purposes: (i) an unconditional obligation; (ii) to pay a sum certain; (iii) on a fixed maturity date; (iv) with the intention to create a debtor-creditor relationship. on the other hand, the form of the instrument is stock, and there is no discussion in fas 150 on 144. id., ¶ b 33. a similar approach was taken by the iasc. in june 2002, the iasc issued an exposure draft, amendment to ias 32, financial instrument: disclosure and presentation, and ias 39, financial instruments: recognition and measurement. pursuant to ¶ 22 of ias 32, when a preferred share provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the shares at or after the particular date for a fixed or determinable amount, the instrument meets the definition of a financial liability and is classified as such. fas 150, ¶ b78. 145. id., ¶ b36. 146. id., ¶ b37. 147. see, garlock, supra note 125, at § 1.01[a]. the first term is the narrowest, while the last is the broadest because every debt is a liability, and every liability is an obligation, but the converse statements are not true. 148. deputy v. dupont, 308 u.s. 488 (1940). 149. 1995-1 c.b. 131. 150. see also, salina p’ship lp, fpl group, inc. v. comm’r, 80 tc (c.h.) 686 (2000). 151. garlock, supra note 125, at § 1.01[a]. 2004] book tax conformity for financial instruments 707 creditors rights, subordination, participation in management or thin capitalization. the tax treatment of mandatorily redeemable preferred shares is uncertain. on the one hand, in united states v. south georgia ry. co., the152 court held that preferred shares were equity, stating the “entire absence here of the most significant, if not the essential feature of a debtor and creditor as opposed to a stockholder relationship, the existence of a fixed maturity for the principal sum with the right to force payment of the sum as a debt in the event of default.” on the other hand, “although a fixed maturity date appears to be153 essential to a finding that an instrument constitutes debt, the presence of a fixed maturity date clearly does not by itself preclude an instrument with such a feature from being treated as stock.”154 nevertheless, fas 150 was intended to neither set forth general guidance for distinguishing between debt and equity nor conform such rules to existing tax classification rules. accordingly, as of today, neither gaap nor tax law contain an adequate set of rules for distinguishing between debt and equity. table i below summarizes the differences between the common law elements for distinguishing between debt and equity and the ones used by fasb in fas 150. 152. 107 f.2d 3, 5 (5th cir. 1939). 153. see, garlock, supra note 125, at § 1.01[b]. 154. id. at 1.10, citing rev. rul 78-142, 1978-1 c.b. 111, as an example. 708 florida tax review [vol.6:7 table i element common law fas 150 unconditional promise/obligation x x sum certain (not connected to equity’s value) x x creditor’s rights x subordination x participation in management x thin capitalization x creditors/shareholders identity x repayment of funds on the due date x intent of the parties to create creditor-debtor relationship x x fixed maturity date x x source of payments x the label of the instrument x obtaining loans from outside lenders x use of the proceeds x (iv) integration/bifurcation while tax law combines limited integration and bifurcation elements (although it prefers integration on the grounds that the substance of the taxpayer’s activities will be more apparent if those activities are viewed collectively), fasb clearly rejected the integration approach in fas 133 and 150 and adopted a bifurcation approach on the grounds that the latter is more155 accurate.156 a. integration of debt instruments with certain hedging transactions regulation section 1.1275-6 provides for the integration of a debt instrument with a hedge. a section 1.1275-6 hedge is any financial instrument if such combined cash flows permit the calculation of a yield to maturity under the principles of section 1272, or the right to the combined cash flows would qualify as a variable rate debt instrument that pays interest at a qualified floating rate or rates.157 155. see fas 133, supra note ¶ 12-16; fas 150, supra note 102, ¶ 15. 156. see ensminger, supra note 1, at 24. 157. the synthetic debt instrument has the following characteristics: (i) its issue date is the first date on which the taxpayer entered into its components; (ii) its term is the period beginning on the issue date and ending on the maturity date; (iii) its issue price is the adjusted issue price of the debt instrument on the issue date; (iv) its adjusted issue price is determined in the manner of a debt instrument subject to the general oid rules; and (v) its stated redemption price at maturity is the sum of all amounts paid or 2004] book tax conformity for financial instruments 709 similarly, pursuant to regulation section 1.988-5(a), an “integrated economic transaction” consists of a “qualifying debt instrument” and a “section 1.988-5(a) hedge.” the two components are integrated into a synthetic instrument that reflects the underlying components of both the debt and the hedge. a “qualifying debt instrument” is any debt instrument, regardless of158 whether the payments under the debt are denominated in, or determined by reference to, a nonfunctional currency. a “section 1.988-5(a) hedge” includes159 a spot contract, futures contract, forward contract, option contract, notional principal contract, currency swap, and similar transactions160 for financial accounting purposes, integrated transactions under regulations section 1.1275-6 or section 1.988-5 are treated as separate transactions. issuers have been benefitting from such book tax difference by161 integrating a debt instrument and a call option for tax purposes (thereby securing oid deductions) while keeping the instruments separate for book purposes. as discussed below, this book-tax difference, as opposed to a book-162 tax difference arising from a contingent payment debt instrument, is permanent. to be paid on the debt instrument and the hedge, reduced by all amounts received or to be received on the hedge. see regs. § 1.1275-6(f). 158. a “qualifying debt instrument” and a “§ 1.988-5(a) hedge” form an “integrated economic transaction” if all of the following requirements are met: (i) all payments to be made or received under the debt instrument (or amounts determined by reference to a nonfunctional currency) are fully hedged such that a yield to maturity in the currency in which the synthetic debt instrument is denominated can be calculated; (ii) the hedge is identified on or before the date it is settled or closed; (iii) none of the parties to the hedge are related; (iv) in the case of a qualified business unit with a residence outside of the united states, both the debt instrument and the hedge are properly reflected on the books of such qualified business unit throughout the term of the hedging transaction; (v) both the debt instrument and the hedge are entered into by the same entity; and (vi) if the taxpayer is a foreign person engaged in a u.s. trade or business and enters into the debt instrument and hedge in the course of such trade or business, then all items of interest or expense would have been effectively connected with such u.s. trade or business throughout the term of the transaction had integration treatment not been available under the regulations. see regs. § 1.988-5(a). 159. regs. § 1.988-5(a)(3)(i). 160. regs. § 1.988-5(a)(4)(i). 161. ensminger, supra note 1, at 69. 162. for example an issuer of a convertible note may purchases a call with a strike price that is identical to the conversion price of the convertible bond. the premium paid for the call is economically equivalent to discount on the convertible debt. the taxpayer can integrate the call with the convertible debt and may deduct the premium as oid. to achieve this goal, the call must have maturity date and number of shares similar or identical to those on the convertible debt, so that the convertible debt is fully hedged. see regs. § 1.1275-6(b)(4). 710 florida tax review [vol.6:7 the purpose of the tax integration rules has been to properly match the timing and character of the hedging transaction with these of the hedged item. as i suggest below, mark-to-market treatment will apply to all hedging transactions and to certain hedged items (including issued debt instruments). thus, the tax integration provisions will be unnecessary, because taxpayers will simply mark both the hedge and hedged item to market in accordance with fas 133. b. investment units (synthetic convertibles) v. convertible debt although the conversion feature of a convertible debt instrument could be viewed as a call option on the issuer’s stock, a convertible debt is not bifurcated into the debt and the option for tax purposes. therefore, for tax163 purposes, the issue price of the convertible bond is not allocated between the debt and the implicit call option.164 on the other hand, if a debt instrument is issued with other property (such as warrants to purchase the issuer’s stock), the combined issuance constitutes an “investment unit” the issue price of which is allocated between the debt and the warrants. the allocation is based on the relative fair market165 values of the components that comprise the unit. once the issue price has been allocated between the debt and the warrants, the two components take separate paths; the debt is governed by sections 1272 and 1273, and subsequent transactions affecting the warrants are governed by section 1032 for the issuer and section 1234 for the holder.166 in rev. rul. 2003-97, among other things, the irs set forth guidance167 pertaining to separability of financial instruments for tax purposes. the irs ruled that a debt instrument and a forward contract issued together as an investment unit will be treated as separate financial instruments, provided the following four conditions are met: (i) the holder has the unrestricted legal right to separate the debt instrument from the forward contract, and is not168 economically compelled to keep the unit un-separated; (ii) the forward contract provides that, in the event of issuer’s bankruptcy, it will terminate and the holder of the unit will be treated as a creditor of the issuer; (iii) the notes will remain outstanding after the remarketing for a significant period (disregarding 163. see generally jeff strnad, taxing convertible debt, 56 smu l. rev. 399 (2003). 164. chock full o’nuts corp. v. u.s., 453 f.2d 300 (2d cir. 1971); garlock, supra note 125, at § 10.01[c][1]. 165. irc § 1273(c)(2) and regs. § 1.1273-2(h). 166. see generally garlock, supra note 125, at § 10.01[b]. 167. 2003-34 i.r.b. 380. 168. the holder can do it either by substituting a treasury strip as collateral or by settling the purchase contract for cash and retaining the note. 2004] book tax conformity for financial instruments 711 any period during which the notes are callable by the issuer); and (iv) on the issue date, it is substantially certain that the remarketing of the notes will succeed. apb opinion no. 14 sets forth principles for distinguishing between investment units (particularly debt issued with a warrant) and convertible debt. for gaap purposes, the proceeds from the sale of a debt instrument with a “detachable stock warrant” are allocated between the two securities because169 two separate instruments are involved each of which can be separately traded.170 by contrast, a convertible debt is not viewed for gaap purposes as two separate instruments and the value of the “option” component of the instrument is not separately allocated.171 note that apb opinion no. 14 focuses only on the right to trade the instruments separately. thus, it appears that the standard under rev. rul. 200397 is stricter than the corresponding financial accounting principle. accordingly, two instruments may be treated as a single instrument for tax purposes but as an investment unit for financial accounting purposes if they can be traded separately, but do not satisfy the other three requirements of rev. rul. 2003-97. for example, if the maturity dates of the debt instrument and the warrant are very close, the irs may take the view that they are inseparable, under rev. rul. 2003-97. i suggest, therefore, that rev. rul. 2003-97 will be limited to its facts, and that treasury will set forth, in regulations, general guidance on separability of instruments for tax purposes that are consistent with corresponding financial accounting guidance. c. embedded derivatives a financial instrument is bifurcated for tax purposes only in limited circumstances. under fas 133, on the other hand, some financial instruments172 are bifurcated into two components: the basic instrument and the “embedded 169. a “detachable warrant” is a warrant that can be traded separately from the bond. see apb opinion no. 14. 170. while the debt instrument remains outstanding until its maturity, the warrant to purchase the issuer’s stock could be exercised prior to the debt instrument’s maturity. id. 171. id. but cf. kieso et. al., supra note 39, at 780, (challenging fasb’s distinction between convertible debt and debt issued with a warrant and arguing that they should be treated similarly). 172. for example, regs. § 1.446-3(g)(4)( providing that a significant nonperiodic payment made under a notional principal contract is viewed as an embedded loan for tax purposes). 712 florida tax review [vol.6:7 derivative.” generally, if the economic characteristics and risks of embedded173 derivative are not clearly and closely related to those of the host instrument, the embedded derivative should be separated and accounted for under fas 133 on a mark-to-market basis. for example, if a debt instrument is convertible into174 a specified number of shares of the debtor or another entity’s common stock, the conversion option is separated from the host contract and marked-to-market as a derivative under fas 133.175 clearly, the embedded derivative rules in fas 133 are inconsistent with current tax rules. as of today, tax law has not yet recognized the possibility of taxing embedded derivatives separately from their host contract. to conform the book and tax rules, therefore, tax policy makers must consider adopting the embedded derivative approach for contingent payment debt instruments and similar instruments with embedded derivatives.176 (v) derivative instruments: assets or liabilities generally, with respect to traditional instruments such as debt instruments or stock, financial accounting and tax rules follow a similar approach pursuant to which an issuer of a debt instrument owes a liability, while the holder of the instrument holds an asset. in addition, an issuer of a stock is viewed as issuing an equity interest, while the holder of the stock holds an asset. the question of asset v. liability arises with respect to derivatives. there are at least two parties to a financial transaction. a transaction that is177 consummated at market rates cannot be objectively profitable to all the parties if the transaction is “zero-sum,” as is frequently the case with derivatives. for178 example, a plain vanilla swap with a fixed rate that is equal to the current midmarket rate is said to be “at market” and has a zero value to both parties (this179 is the situation at the inception of the contract). if the fixed rate is above the180 173. an example of an embedded derivative is a debt instrument the interest payments on which fluctuate with changes in the s&p 500. see fas 133, supra note 18, ¶ 12-16. on the other hand, an embedded option allowing the issuer to call, or the holder to put, a debt instrument is “clearly and closely related” to the host contract and, therefore, does not constitute an embedded derivative. id., ¶ 60(d). 174. fas 133, ¶ 12-16. 175. id., ¶ 60(k). 176. ensminger, supra note 1, at 95-96, citing weisbach (1995), supra note 28. 177. nicholas gunther, economics and compaq v. comm’r, 2002 tnt 209-28 (october 28, 2002). 178. id. see also kevin d. dolan, notice 98-5 foreign tax credit arbitrage, 455 pli/tax 1029, 1049-1050 (1999). 179. the mid-market rate is the midpoint of the bid and ask rates for a specified maturity, which equals the fixed rate for which the present value of the cash flows from the fixed leg equals the present value of the projected cash flows from the floating leg. 180. bank one corp. v. comm’r, 120 tc 174, 202 (2003). 2004] book tax conformity for financial instruments 713 current mid-market rate, the swap is said to be “above market” and has positive value to the party that receives the fixed payments. conversely, an interest rate swap with a fixed rate below the current mid-market rate is “below market” and has negative value to the party that receives the fixed payments. thus, when the swap has a positive market value for one party, it must have an identical negative market value for the counterparty.181 for example, on january 1, 2004, corporation x issues $1,000 of 10year, 10% fixed-rate bonds. to protect against risk of loss if the market interest rate drops, corporation x enters into a swap with counterparty z pursuant to which x will receive fixed payments at 10% on a notional amount of $1,000 and pay z a variable rate that is based on the mid-market rate in effect. thus, at inception, the mid-market rate is presumed to be also 10%, and each party’s initial value is zero. at the end of 2004, interest rates drop to 8%, so the midmarket rate is below 10%. thus, at the end of 2004, corporation x has positive value with respect to the swap, while counterparty z has an identical negative value. a similar analysis applies to forward contracts. option contracts are182 generally not “zero-sum” contracts because a premium is paid; however, the same asset/liability analysis could be applied to options.183 it is unclear whether derivatives such as swaps constitute “property” for tax purposes because they have zero value at inception, and either positive or negative value throughout their term. various statutory provisions and court184 185 decisions indicate that derivatives could be viewed, under particular circumstances, as “property.” in fsa 1999-985, the irs relied on ferrer in186 187 ruling that an interest rate swap is viewed as “property” because it constitutes a “bundle of rights and obligations.” the irs also indicated that forward and futures contracts constitute “property.” 181. david m. schizer, frictions as a constraint on tax planning, 101 colum. l. rev. 1312, 1358 (2001) (“since firms could either owe or be entitled to a payment, this value could be negative or positive”). 182. see notice 98-5, 1998-1 c.b. 334. for example, on 1 january 2003, taxpayer a, a producer of oil, enters into a forward contract with purchaser b, for the delivery of 1,000 barrels of crude oil in 18 months (on 1 july 2004) at a price of $20 per barrel. if on dec. 31, 2003 the price of crude oil is $18 per barrel, a will have a profit of $2 per barrel, and b will suffer an identical loss. similarly, if on dec. 31, 2003 the price of crude oil is $24 per barrel, a will suffer a loss of $4 and b will have an identical gain. 183. rev. rul. 78-182, 1978-1 c.b. 265; rev. rul. 58-234, 1958-1 c.b. 279. 184. see garlock (2004), supra note 27, at 1518-19. 185. see regs. § 1.1092(d)-1(c) (treating npcs as “personal property” for purposes of the straddle rules.) 186. field s. adv. mem. 1999-985 (aug. 6, 1992). 187. comm’r v. ferrer, 304 f. 2d 125, 131 (2d cir. 1962). 714 florida tax review [vol.6:7 it is less clear, however, whether a position in a derivative contract that becomes “underwater,” also constitutes “property.” in stavisky v. comm’r, the188 tax court held that: [p]etitioner was a party to a bilateral contract with mutual rights and obligations, not a mere obligor. had the market price of mo-pac shares “when issued” declined instead of risen, his rights under his contract would have outweighed his liabilities . . . and he would have been the payee to sell rather than the payor as the result of the transaction of december 1951. . . . we think it clear that in such case he would have been in the position of having sold a portion of his rights under the contract . . . and are not prepared to hold that a given transaction is or is not a sale or exchange from day to day depending on the vagaries of the securities market. . . . the transaction of december 1951 was in form and substance a transfer to sutro of petitioner’s rights and liabilities under the contract, not a mere cancellation or release from liability.189 until today, however, stavisky has not been applied outside of the “when issued” contracts context. in bank one, the court indicated that the190 contract becomes a liability when it is “underwater.” several commentators191 have expressed a similar view. the tax court’s decision in bank one on this192 point is consistent with fundamental accounting and tax rules. accordingly, at any given time, one party to a derivative transaction should be viewed as holding an asset while the counterparty should be viewed as owing a liability. for gaap, the answer is certain. as set forth above, pursuant to sfac 6, an entity’s “liabilities” constitute “probable future sacrifices of economic benefits . . . to transfer assets or provide services to other entities in the future 188. 34 t.c. 140 (1960), aff’d, 291 f.2d 48 (2d cir. 1961). 189. id. at 142-43. see also, gen. couns. mem. 35,475 (sept. 11, 1973) (“the mere fact that the obligations outweighed the rights thereunder in terms of comparative values does not prevent the transaction from constituting a sale or exchange.”) (citing stavisky). 190. see kirk van brunt, tax aspects of remic residual interests, 2 fla. tax rev. 149, 207 (1994), note 193, citing the new york state bar ass’n, tax section, comm. on financial instruments, report on proposed regulations on methods of accounting for notional principal contracts (jan. 6, 1992), reprinted in 24 highlights & documents 633, 656 n.84 (jan. 16, 1992). 191. bank one, 120 tc at 217. 192. see garlock (2004), supra note 27, at 1518-1519, note 24. see also aba tax section members comment on hedging regulations, 94 tnt 66-19 (february 10, 1994) text accompanying note 57; edward d. kleinbard and suzanne f. greenberg, business hedges after arkansas best, 43 tax l. rev. 393 (spring, 1988), note 139. 2004] book tax conformity for financial instruments 715 as a result of past transactions or events,” while its “assets” constitute “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” accordingly, if at a given point in time, an entity holds a position the expected cash flows from which exceed its carrying costs, such an entity holds an “asset.” by contrast, if the contract’s carrying cost exceeds the expected cash flows from the contract, the holder should be viewed as owing a liability. pursuant to fas 133, derivatives represent rights or obligations that meet the definition of “assets” (future cash inflows due from another party) or “liabilities”(future cash outflows owed to another party) and should be reported in the financial statement as either assets or liabilities.193 thus, an “underwater” derivative contract constitutes a liability for accounting purposes, while an “overwater” contract constitutes an asset. as i suggest194 below, both liabilities and assets will be marked-to-market for tax purposes, in accordance with fas 133. 3. conclusions as summarized below in table ii, for both tax and financial accounting purposes, financial instruments should be classified as follows: table ii assets liabilities equity holder of a debt instrument issuer of a debt instrument holder of an equity interest issuer of an equity security holder of a position in a derivative with a positive value holder of an “underwater” position in a derivative with respect to the debt/equity distinction, i do not expect that fasb will set forth debt/equity guidance in the near future. in addition, a statutory set 193. fas 133, supra note 18, ¶ 3. 194. id. 716 florida tax review [vol.6:7 of debt/equity classification rules is not expected in u.s. tax law. fasb and195 treasury should work together to issue such guidance and conform the rules. d. timing a tax accounting method is any method or practice that affects the timing of recognition of income and deductions. generally, a taxpayer can utilize one of the following accounting methods for tax purposes: (i) cash method; (ii) accrual method; or (iii) special methods such as original issue discount, notional principal contracts, contingent payment debt instruments and mark-to-market. as of today, recognition of income and expenses on financial196 instruments may be different for book and tax purposes. for example, a taxpayer may be required to mark some instruments to market for tax purposes but not for book purposes and vice versa.197 1. cash and accrual accounting method under the accrual accounting method, a reporting entity must determine when it must recognize revenues, gains, expenses, and losses. as opposed to198 the cash method, an entity under the accrual method reports the effects of events in the periods in which those events occur rather than in the periods in which 195. some countries, however, have successfully enacted such rules in re-cent years. in australia, the new business tax system (debt and equity) bill 2001, which was passed by the federal parliament, and received royal assent on october 1, 2001, set forth rules for hybrid instruments. the new standards classify instruments as debt or equity for tax purposes based on their economic substance rather than on their legal form. the underlying policy of the new measures is that the key feature that distinguishes debt from equity is that debt involves the effective obligation of the issuer to return to the investor an amount equal to at least the amount received by the issuer. see hayes, daniel appleby, and emanuel hiou, australian tax wrap-up, 13 j. int’l tax’n 18 (2002). 196. irc § 446(c)(3); regs. § 1.446-1(a)(1). 197. for example, while fas 133 requires companies to mark derivatives to market, for tax purposes, hedging transactions match the timing of income, expense, gain or loss on the hedging transaction with that of the hedged item, under regs. § 1.446-4. in addition, some hedged items, including issued debt instruments, are markedto-market under fas 133 but not for tax purposes. finally, some marketable equity securities that are not held for sale to customers are marked-to-market for accounting purposes under fas 115 but not for tax purposes. in contrast, securities purchased from customers and held to maturity may be subject to mark-to-market for tax purposes under § 475 but not for accounting purposes. 198. financial accounting standards board, statement of financial accounting concepts no. 5: recognition and measurement in financial statements of business enterprises ¶ 36 (1984), available at http://www.fasb.org/pdf/con5.pdf (“sfac 5”). 2004] book tax conformity for financial instruments 717 cash is received or paid. for financial accounting purposes, “revenues” and199 “gains” are defined, respectively, as “inflows or other enhancements of assets” and “increases in net assets” of the entity. similarly, “expenses” and200 201 “losses” are also defined, respectively, as “outflows or other using up of assets” and “decreases in net assets.”202 203 for financial accounting purposes, income is recognized only when it is both realized (or realizable) and earned. for tax purposes, however, income204 is included in gross income for the tax year in which it is actually or constructively received, unless other specific method (such as mark-to-market) applies. accrual method taxpayers recognize income when all the events have205 occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.206 the following concepts guide financial accounting treatment of expenses: (i) allocating costs to the appropriate period so as to match them with the revenues they help to generate; and (ii) recognizing losses when they are probable. by contrast, for tax purposes, pursuant to section 461(h)(1), a207 liability is incurred, and may be deducted, only when all events have occurred that establish the fact of liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred. this article suggests that book and tax timing rules for financial instruments be conformed in accordance with prevailing financial accounting concepts. in particular, with respect to derivatives, it is suggested that both assets and liabilities be marked-to-market at the end of the year, in accordance with fas 133. with respect to non-derivatives, transactions entered into for investment purposes will be subject to the taxpayer’s regular accounting208 method (i.e., cash or accrual), while all other instruments will be subject to mark-to-market.209 199. id., ¶ 139. 200. id., ¶ 78. 201. id., ¶ 82. 202. id., ¶ 80. 203. id., ¶ 83. 204. id., ¶ 36 205. irc § 446(c)(3); regs. § 1.446-1(a)(1). 206. regs. § 1.451-1(a). 207. sfac 5, supra note 198, ¶ 86; sfac 6, supra note 132, ¶ 146-149. 208. section 475 excludes securities held-for-investment from mark-to-market, while gaap does so for “held-to-maturity” debt securities. irc § 475. i recommend herein that these two standards be conformed. 209. under fas 133, cash flow hedges are measured at fair value, but changes in the fair value are reported under “other comprehensive income,” as opposed to fair value hedges for which changes in the fair value are reported in the net income. similarly, available-for-sale securities are reported at fair value, but, again, changes in 718 florida tax review [vol.6:7 2. current timing rules for basic (non-derivative) instruments (i) debt instruments a cash-method taxpayer must recognize interest income in the year in which it is actually or constructively received, while interest expense is210 generally recognized in the taxable year in which it is actually paid. pursuant211 to the accrual method, interest income is generally recognized when all of the events have occurred to fix the right to receive the interest income, and the amount of that income can be determined with reasonable accuracy. interest212 deduction is generally recognized in the taxable year in which it is accrued.213 accrual of expenses occurs when: all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.214 generally, financial accounting concepts pertaining to recognition of interest are similar. most corporations use the accrual basis of accounting:215 they recognize interest income when it is earned, and recognize expense in the period incurred. cash basis entities recognize income only when it is received, and expense upon payment of such an expense. interest income is recognized216 as revenue. the fair value are reported under “other comprehensive income,” as opposed to trading securities for which changes in the fair value are reported in the net income. the irs and most commentators, however, agree that both methods constitute a mark-to-market method, even though the changes in the fair value are reported under different sections. see ensminger, supra note 1, at 25, for fas 133. see. rev. rul 93-76, 1993-2 c.b. 235. 210. irc § 451(a); regs. § 1.451-1(a). income is constructively received by a taxpayer in the year in which it is credited to the taxpayer’s account, set apart for him, or otherwise made available so that the taxpayer may draw upon it at any time, or could have drawn upon it during the taxable year if notice of intention to withdraw had been given. see regs. § 1.451-2(a). 211. irc § 163 (a); regs. § 1.461-1(a)(1). 212. regs. § 1.451-1(a). 213. to accrue, a liability must be: (i) binding and enforceable, (ii) may not be contingent on the occurrence of a future event, and (iii) the debtor must have a reasonable belief that the liability will be paid in due course. superior garment co. v. comm’r., tc 1965-283. 214. regs. § 1.461-1(a)(2). 215. compare contingent payment debt instruments, which are discussed in greater detail below. 216. sfac 5, supra note 198, ¶ 139. 2004] book tax conformity for financial instruments 719 as set forth in greater detail below, for tax purposes, a holder of a debt instrument recognizes changes in the instrument’s value under the mark-tomarket method only if the instrument is held for dealing/trading purposes pursuant to section 475. for financial accounting purposes, a debt instrument is marked-to-market unless it is held-to-maturity, or, in some circumstances, if a “fair value” hedge under fas 133 hedges it. the issuer of the debt instrument, however, does not mark its liability to market for tax purposes, but may be required to do so for financial accounting purposes if the debt is hedged by a fair value hedge under fas 133. in addition, as discussed above, fas 150 requires that the instruments discussed therein (which are classified as liabilities) be reported at fair value. (ii) original issue discount (oid) in theory, there are generally three possible ways to recognize oid:217 (i) the constant yield method pursuant to which, the issuer and holder of the discount obligation accrue the portion of the discount as interest income and expense based on a constant method; (ii) accrual of interest income and218 expenses based on a straight line using a ratable accrual; and (iii) account for219 oid income and expenses only at maturity. the legislation of the modern oid rules is an example of congress’s attempt to conform tax timing rules to corresponding gaap. prior to 1981, oid 217. a debt instrument has oid equal to the excess, if any, of its stated redemption price at maturity over its issue price. thus, oid is the excess of what a borrower is obligated to repay when the loan becomes due over the amount borrowed. see garlock, supra note 125, at § 2.01. 218. this approach was adopted by congress in § 1272(a)(1). interest income received and interest expense paid are recognized annually under a yield-to-maturity method, regardless of whether it is actually received or paid. an important advantage of that method is that it is consistent with market practice. however, its main disadvantage is that it is complex to administer and might not be suitable to all taxpayers. another disadvantage of that method is that it normally taxes holders prior to the time in which they actually receive the income, potentially infringing the “ability to pay” principle. lawrence lokken, taxation of derivatives and new financial instruments, in united nations, international cooperation in tax matters, 1998, at 53. 219. this method had been utilized in the united states between 1969 and 1982. according to that method, the discount income is computed and then allocated in equal portions along the holding period. the ratable accrual method has few advantages including its computation simplicity, when compared with the constant accrual method. nevertheless, it also suffers from the same disadvantages of the constant accrual method, that is, recognizing income well before the actual cash payments are received. lokken, supra note 218, at 54. 720 florida tax review [vol.6:7 tax rules had been inconsistent with those applied under gaap. in particular,220 former section 1232 provided that an amount received by a holder on retirement of corporate debt instruments was treated as an amount received in exchange of such debt. in 1969 (p.l. 91-172), congress amended § 1232 to provide for the221 inclusion of oid (measured on a straight-line basis) in the holder’s income irrespective of the holder’s regular method of accounting. this rule applied, however, only to corporate debt instruments, which constituted capital assets in the hands of the holder.222 in 1982, former sections 1232a and 1232b were enacted to change the straight-line accrual into a yield-to-maturity method in measuring oid.223 former section 1232a applied to all debt instruments that were capital assets in the holder’s hands other than those issued by natural persons. in the deficit reduction act of 1984 (defra), p.l. 98-369, the rules for the measurement and timing of oid as well as the treatment of stripped bonds were extensively revised. defra also added rules addressing similar time value of money224 issues including sections 1276 through 1278 (measurement and timing of market discount), sections 1281 through 1283 (treatment of discount on certain short-term obligations), section 1286 (treatment of stripped bonds), and section 1288 (oid on tax-exempt obligations). one of the purposes of enacting the above comprehensive set of rules was to conform tax rules to the corresponding principles that had been developed over the years for financial accounting purposes. gaap, however,225 generally do not distinguish between oid, market discount or bond premium, but treat them all as discount (or premium) to be currently accrued. for226 financial accounting purposes, oid, market discount and bond premium are computed under an “effective interest method,” which is similar to the yield-tomaturity method. this is different than the corresponding tax treatment227 220. see peter c. canellos and edward d. kleinbard, the miracle of compound interest: interest deferral and discount after 1982, 38 tax l. rev. 565, 567 (1983). 221. id. 222. id., at 568. 223. id., at 568-569, discussing the tax equity and financial respon-sibility act of 1982, pub. l. no. 97-248, 96 stat. 324 (1982). 224. former §§ 1232, 1232a and 1232b were repealed, and the revised oid rules were enacted under §§ 1271 through 1275. 225. see canellos and kleinbard, supra note 220, at 567-69. 226. financial accounting standards board, statement of financial accounting standards, no. 91, accounting for nonrefundable fees and costs associated with originating or acquiring loans and initial direct costs of leases (1986); available at http://www.fasb.org/st/#fas91 (fas 91). 227. pursuant to accounting principles board opinion 12: the objective of the interest method is to arrive at a periodic interest rate (including amortization) which will represent a level effective 2004] book tax conformity for financial instruments 721 pursuant to which bond premium is recognized currently (unless the taxpayer elects to recognize an allocable portion of the premium as an offset to the interest income from the bond), and market discount is included when228 principal payments are made, unless the taxpayer elects a current inclusion.229 in my view, to simplify the tax rules and conform them to financial accounting principles, oid, market discount and bond premium should be treated similarly, and be currently accrued on a yield-tomaturity basis. generally, current bond premium rules are already equivalent to the flip-side of the oid rules with respect to the issuers (but still elective for holders), except for minor differences. on the other hand, the legislative history of the market230 discount rules reveals that although congress was aware of the fact that oid and market discount are economically indistinguishable, it enacted a separate set of rules for market discount to address various complexities and perceived abuses that existed twenty years ago.231 during the past twenty years, several legislative proposals have been made to conform the tax oid and market discount rules. in october 1987, the232 house of representatives passed a bill that generally would have required the current accrual of market discount. the senate version, however, omitted this233 proposal and it was never enacted. in its budget for the years 2000 and 2001,234 rate on the sum of the face amount of the debt and (plus or minus) the unamortized premium or discount and expense at the beginning of each period. the difference between the periodic interest cost so calculated and the nominal interest on the outstanding amount of the debt is the amount of periodic amortization. 228. irc § 171(a). 229. irc §§ 1276-1278. the difference between oid and market discount is that a holder is not required to accrue market discount currently. instead, the market discount rules generally require holders, including accrual basis holders, to take market discount into account only upon the receipt of the proceeds of a disposition or retirement or a principal payment, and then only to the extent accrued. see garlock, supra note 125, § 11.01 (citing s. rep. no. 98-169, at 155 (1984)). 230. garlock, supra note 125, § 12.01. 231. id., § 11.01, indicating that “[t]he 1984 committee reports show that congress also knew that taxpayers were purchasing market discount bonds with borrowed funds, deducting interest on such indebtedness currently and ultimately receiving the difference between the purchase price and the total principal payments as capital gain” (citing s. rep. no. 98-169, at 155 (1984)). in addition, congress was concerned that “holders would have difficulty determining annual inclusions without information reporting, which is required in the case of oid.” id. § 11.01 n.6. 232. id., § 11.01 n. 6. 233. id. (citing omnibus budget reconciliation act of 1987, h.r. 3545, 100th cong., 1st sess., § 10118). 234. id. (citing h.r. rep. no. 100-391, at 1056-57 (1987) and h.r. rep. no. 100-495, at 932-33 (1987)). 722 florida tax review [vol.6:7 the clinton administration set forth a similar proposal pursuant to which, holders that use an accrual method of accounting would have to include market discount in income on a constant-yield basis as it accrues. to address the concern of debt instruments with a deep discount, the instrument’s yield for this purpose would have been limited to the greater of (i) the original yield-tomaturity of the debt instrument plus five percentage points, or (ii) the applicable federal rate at the time the holder acquired the debt instrument plus five percentage points. the proposal was never enacted. in my view, it is time235 236 to re-introduce a similar proposal and conform the book and tax rules for oid, market discount and bond premium. (iii) equity securities for tax purposes, dividend income is recognized as received as cash or other property when it is unqualifiedly made subject to the shareholder’s demands. no corresponding deduction is allowed for the payor, unless the237 recipient is a corporation.238 for financial accounting purposes, the holder recognizes dividend income in accordance with its normal accounting method (i.e., cash or accrual). dividend income is recognized as revenue. with respect to the239 issuer, when the board of directors declares a cash dividend, the amount of declared dividend is recorded as a liability to the issuer (dividend payable). upon payment, the liability is reversed, and the credit is recorded for cash. with respect to dividends in property (non-cash), when such a dividend is declared, the issuer must restate at fair value the property to be distributed, recognizing 235. id. such a limitation is equivalent to the high yield debt obligation (“hydo”) limitation rules. section 163(e)(5) provides special rules for oid on applicable hydos. in general, an interest deduction could be deferred until paid or even permanently disallowed in part if the debt instrument is a hydo. irc § 163(e)(5)(a). an applicable hydo is defined in § 163(i)(1) as any debt instrument (i) that has a maturity date more than five years from the issue date, (ii) where the yield to maturity on the instrument equals or exceeds the sum of the applicable afr in effect on the issue date plus five percentage points, and (iii) the instrument has “significant oid.” a debt instrument is treated as having significant oid for this purpose if, at the end of any accrual period ending after the fifth year from the issue date, the cumulative accrual of interest and oid on the instrument exceeds the sum of the actual interest paid from the issue date until the end of that accrual period and the product of the yield to maturity and the instrument’s issue price. irc § 163(i)(2) 236. garlock, supra note 125, § 11.01 n.6. 237. regs. § 1.301-1(b). 238. see generally § 246. 239. see generally recognition and measurement in financial statements of business enterprises, statement of financial accounting concepts no. 5 (financial accounting standards bd. 1984), available at http://www.fasb.org/pdf/con5.pdf. 2004] book tax conformity for financial instruments 723 any gain or loss as the difference between the property’s fair value and carrying value at the date of declaration. as a result, the amount of dividend is recorded as a debit to retained earnings.240 as discussed in greater detail below, changes in the security’s value are subject to different tax rules. pursuant to section 475, a holder of a stock is subject to mark-to-market treatment if the stock is held for dealing/trading purposes, while the issuer is never subject to mark-to-market. for financial accounting purposes, a holder of a nonmarketable equity security is subject241 to the cost method pursuant to which: [a]n investor records an investment in the stock of an investee at cost, and recognizes as income [only] dividends that are distributed from net accumulated earnings of the investee since the date of acquisition by the investor. dividends received in excess of earnings subsequent to the date of investment are considered a return of investment and are recorded as reductions of cost of the investment.242 a holder of marketable equity securities is generally subject to mark-tomarket treatment under fas 115, if the holding is less than 20% of the issuer’s stock (i.e., passive investment). with respect to a holder of more than 20%, the stock is generally not subject to mark-to-market. the issuer, on the other243 hand, is not subject to mark-to-market for financial accounting purposes, for both marketable and non-marketable equity securities. 3. timing rules for derivatives (i) options, forwards and futures some derivatives are subject to mark-to-market treatment if they fall under section 1256 (“section 1256 contracts”). an option that constitutes either 240. see generally kieso et. al, supra note 39, ch. 15. 241. a non-marketable equity security is a security for which there is no readily available pricing information. see the equity method of accounting for investments in common stock, accounting principles board opinion no. 18, ¶ 6a (1971). 242. id. 243. a discussion of the financial accounting principles pertaining to holding of more than 20% is beyond the scope of this article. generally, i suggest below that if an investor holds more than 20% of a corporation, the stock will not be subject to markto-market. 724 florida tax review [vol.6:7 a “dealer equity option,” or a “non-equity option” is marked-to-market as244 245 a section 1256 contract. pursuant to section 1234(b), a grantor of an option that is not a section 1256 option does not recognize income until the option expires, lapses, is exercised, is sold, or is disposed of; such an option constitutes an “open transaction.” a premium paid or received is recognized when sale,246 exchange, expiration, or closing (offsetting) transaction occurs. when the247 option is exercised this event is, generally, treated as non-taxable purchase of the underlying asset.248 similarly, a non-section 1256 forward contract constitutes an “open transaction.” a forward contract is a privately negotiated contract that249 provides for the sale and purchase of property for a specified price on a specified date. until a non-section 1256 forward contract is sold, exchanged,250 settled, or allowed to lapse, the transaction is treated as open, and any gain or loss to the parties is correspondingly deferred.251 futures contracts, in general, are economically similar to forward contracts except that they are: (i) standardized; (ii) traded at regulated futures exchanges; (iii) used by clearing organizations; (iv) subject to the mark-tomarket system; and (v) able to be closed before maturity. futures contracts are252 generally subject to section 1256. the legislation history of section 1256 provides another example of congress’s willingness to follow gaap pertaining to financial instruments. section 1256 was added to the code as part of the economic recovery tax act of 1981. the legislative history indicates that section 1256 was enacted to253 244. a “dealer equity option” is any option that is (1) an equity option, (2) purchased or granted by an options dealer in the normal course of its activity in dealing with options, and (3) listed on the qualified board or exchange on which such options dealer is registered. irc § 1256(g)(4). an “equity option” is an option (i) to buy or sell stock or (ii) the value of which is determined, directly or indirectly, by reference to (a) any stock, (b) group of stocks, or (c) stock index. irc § 1256(g)(6). 245. a “non-equity option” is any listed option that is not an equity option. 246. rev. rul. 78-182, 1978-1 c.b. 265; rev. rul. 58-234, 1958-1 c.b. 279. 247. rev. rul. 78-182, 1978-1 c.b. 265; rev. rul. 58-234, 1958-1 c.b. 279. 248. rev. rul. 88-31, 1988-1 c.b. 302; rev. rul. 70-598, 1970-2 c.b. 168; rev. rul. 78-182, 1978-1 c.b. 265. 249. see lucas v. north tex. lumber co., 281 u.s. 11 (1930). see, generally, steven m. rosenthal & liz r. dyor, prepaid forward contracts and equity collars: tax traps and opportunities, 2 j. tax’n fin. prod. 1, 35 (winter 2001). 250. see lewis r. steinberg, using otc equity derivatives for high-networth individuals, reprinted in the use of derivatives in tax planning (frank j. fabozzi ed., 1998) 210, 217. 251. see rosenthal & dyor, supra note 249, at 35. 252. see kevin m. keyes, federal taxation of financial instruments and transactions (3d ed.), § 13.02[1]. 253. pub. l. no. 97-34, § 503(a), 95 stat. 327 (1981). 2004] book tax conformity for financial instruments 725 overcome the tax sheltering impact of certain commodity futures trading strategies and to harmonize the tax treatment of commodities futures contracts with the realities of the marketplace under what congress referred to as the doctrine of constructive receipt. when section 1256 was enacted, futures254 transactions were marked-to-market for accounting purposes. pursuant to the255 technical corrections act of 1982 (“1982 tca”) and the deficit reduction act of 1984 (“defra”), congress expanded the applicability of the operational rules of section 1256 to apply to certain foreign currency contracts and options.256 section 1256(a) provides for the basic tax consequences applicable to the acquisition and holding of a position in a section 1256 contract. a section 1256 contract constitutes either “regulated futures contract,” “foreign257 currency contract” or “dealer securities futures contract.” pursuant to258 259 section 1256, a contract held by a taxpayer at the close of the taxable year is marked-to-market on the last business day of each taxable year, and any gain or loss is then taken into account. as stated above, the rationale behind this rule260 is that in a futures contract, the parties have immediate access to the funds every day (through the margin accounts).261 254. s. rep. no. 97-144, at 156-57 (1981), reprinted in 1981 u.s.c.c.a.n. 105, 255-256. 255. although accounting for futures contracts statment of financial accounting standards no. 80 was issued by the financial accounting standards board in 1984, accountants had been utilizing a mark-to-market method for futures contract prior to 1981. 256. h.r. conf. rep. no. 97-986, at 24-27 (1982); h.r. conf. rep. no. 98861, at 898-917 (1984) reprinted in 1984 u.s.c.c.a.n. 1445, 1586-1605; s. rep. no. 98-169, at 284-97 (1984). 257. a contract “with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and . . . which is traded on or subject to the rules of a qualified board or exchange.” irc § 1256(g)(1). 258. a negotiated contract, traded in the interbank market, requiring the delivery of a foreign currency, or which can be settled with reference to the value of a foreign currency. irc § 1256(g)(2)(a). 259. a futures contract that a dealer enters into in the normal course of trade or business activity of dealing in such contracts and that is traded on a qualified board or exchange. irc § 1256(g)(9). 260. forty percent of the gain or loss is treated as short-term capital gain or loss, and 60% is treated as long-term capital gain or loss. see irc § 1256(a)(3)(a) and (b). 261. stephen b. land, defeating deferral: a proposal for retrospective taxation, 52 tax l. rev. 45, 60 (1996) (“the realization requirement is meaningless for futures contracts that are marked-to-market, because the exchange rules impose a sort of realization event on a daily basis”). 726 florida tax review [vol.6:7 as noted above, one of the stated goals of section 1256 was to promote book-tax conformity for instruments covered thereunder. nevertheless, as of today, the scope of section 1256 is much narrower than that of fas 133; while fas 133 requires all derivatives to be marked-to-market, section 1256 requires only limited types of derivatives to be marked-to-market. thus, to conform book and tax timing rules for derivatives, the scope of section 1256 should be broadened to include all derivatives (both “underwater” and “over-the-water” positions). (ii) notional principal contracts a notional principal contract is defined in regulations section 1.4463(c) as: [a] financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.262 notional principal contracts include interest rate swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, and similar agreements. section 1256 contracts, debt instruments, options and forward contracts do not constitute notional principal contracts.263 the notional principal contracts regulations group all payments under notional principal contracts into three categories: (i) periodic payments; (ii) nonperiodic payments; and (iii) termination payments. a party to a notional principal contract must annually include in gross income any “net income” from the contract or is allowed to deduct any net cost.264 all taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a periodic payment and a non-periodic payment265 266 for the taxable year to which such portions relate. a non-periodic payment must 262. regs. § 1.446-3(c)(1)(i). 263. regs. § 1.446-3(c)(1)(ii). 264. regs. § 1.446-3(d). the timing regulations may be overridden by (i) irc § 475, which requires dealers to account for notional principal contracts under the markto-market method, (ii) irc § 446, if the notional principal contract is part of a hedging transaction, (iii) irc § 1092, if a notional principal contract is part of a straddle; and (iv) irc § 956, if the deemed payments on a loan embedded in notional principal contracts having significant non-periodic payments are deemed to constitute loans, and, to this extent, interest income or expense would arise and would be accounted for under the interest accrual rules. 265. regs. § 1.446-3(e)(2)(i). 266. regs. § 1.446-3(f)(2)(i). 2004] book tax conformity for financial instruments 727 be amortized and recognized over the contract term in a manner that reflects the economic substance of the contract. where the contract term is subject to267 extension or termination, amortization must be made over the reasonably expected term of the contract. a termination payment is recognized by the268 original party to the contract as income or deduction when the contract is extinguished, assigned, or exchanged. an assignee must treat a termination269 payment as a non-periodic payment made or received under the contract as in effect immediately after the assignment.270 on february 26, 2004, the irs released proposed regulations pertaining to timing and character of notional principal contracts with contingent nonperiodic payments. in the proposed regulations, the irs stated that with271 respect to any notional principal contract with a non-periodic payment (contingent or not contingent), a taxpayer that marks such instruments to market for book purposes could elect to do so for tax purposes.272 fas 133 requires all derivatives, including notional principal contracts, to be marked-to-market. accordingly, the financial accounting treatment of notional principal contracts differs from their tax treatment, unless section 475 applies. because notional principal contracts constitute “derivatives” pursuant to fas 133, effectively, all taxpayers who are subject to gaap reporting principles will be able to elect a mark-to-market treatment for notional principal contracts with non-periodic payments. as david garlock indicates: perhaps because of the complexity of the noncontingent swap method, or perhaps because marking to market is arguably the best way to clearly reflect income, the proposed regulations permit most taxpayers to elect mark-to-market accounting for npcs with nonperiodic payments.273 thus, if the proposed regulations are adopted in this form, a partial elective timing conformity would be achieved for notional principal contracts with non-periodic payments. in my opinion, however, the tax authorities should go one step further and provide for conformity with respect to all notional principal contracts, in accordance with fas 133. under this view, the npc timing rules, including the proposed contingent npc regulations will become 267. id. 268. regs. § 1.446-3(f)(3). 269. regs. § 1.446-3(h)(2). 270. regs. § 1.446-3(h)(3). 271. 69 fed. regs. 8886 (feb. 26, 2004). 272. id., prop. regs. § 1.446-3(i). 273. garlock, (2004) supra note 27, at 1522. 728 florida tax review [vol.6:7 unnecessary, because all notional principal contracts will be subject to mark-tomarket. 4. mark-to-market for dealers and traders (i) general since 1973, gaap have required securities firms to prepare their financial statements by employing mark-to-market accounting for their dealer operations. these rules are currently set forth in fas 115. for tax purposes,274 section 475 requires securities dealers to mark their securities to market, and allows securities traders, commodities dealers and commodities traders to elect a mark-to-market treatment. thus, as a general matter, both gaap and the tax275 code require the use of mark-to-market accounting for dealers in securities.276 nevertheless, this conformity is incomplete; while section 475 focuses on the taxpayer’s identity (i.e, dealer/trader) fas 115 focuses on the purpose of the transaction. another reason for the non-conformity is the difference between the tax standard of “held-for-investment” and the financial accounting standard of “held-to-maturity.” finally, available-for-sale securities, which are markedto-market under fas 115, may not be subject to the same treatment under section 475, because traders are subject to mark-to-market only if they elect so. as a result, as illustrated in table iii below, certain securities could be subject to mark-to-market for accounting purposes and not for tax purposes, and vice versa. table iii security section 475 treatment fas 115 treatment marketable equity security (held less than 20%) could be held-forinvestment and not markedto-market generally markedto-market negligible sales of trading securities not marked-to-market marked-to-market securities purchased from customers and held-tomaturity marked-to-market not-marked-tomarket debt instrument held not for sale to customers, but no intention to hold until maturity not marked-to-market unless the holder elects to be subject to section 475 marked-to-market as “available-for-sale” security commodities could be marked-to-market if an election is made not marked-tomarket 274. sia comments supra note 35, ¶ 6. 275. irc § 475(f). 276. dep’t of the treasury, summary of the administration’s revenue proposals for fiscal year 1994, at 46 (feb. 1993). 2004] book tax conformity for financial instruments 729 in revenue ruling 93-76 the irs specifically addressed the277 relationship between fas 115 and section 475 and ruled that: the classification of a security under financial accounting principles is not dispositive of the treatment of the security for federal income tax purposes. for example, for purposes of section 475 of the code, a security may in certain cases qualify for the held-for-investment exception to the mark-to-market rules even though, under applicable financial accounting principles, the security is classified as available for sale. (ii) section 475 the objective of the mark-to-market method under section 475 is achieving “clear reflection of income” within the meaning of section 446. in278 advocating book-tax conformity, treasury noted in 1992 that the mark-tomarket method used by securities dealers: [r]epresents the best accounting practice in the trade or business of dealing in securities and is the method that most clearly reflects the income of a securities dealer.279 congress also indicated that section 475 would move tax rules pertaining to dealers in securities closer to the already accepted accounting treatment principles.280 pursuant to section 475(a), all securities held by a dealer are marked-tomarket unless they are specifically identified as being excluded from mark-tomarket treatment. under section 475(b)(1), the mark-to-market rules do not apply to securities that are identified by the dealer as being exempt from markto-market in the following situations: (1) any security held for investment; 281 277. 1993-2 c.b. 235. 278. joint comm. on tax’n, tax reform proposals: accounting issues, jcs39-85, at 6 (sept. 13, 1985). 279. u.s. dep’t of the treasury, general explanations of the president’s budget proposals affecting receipts (jan. 1992). 280. see bank one corp. v. comm’r 120 t.c. 174, 296-97 (2003) (citing h. rept. 103-111, at 661, 1993-3 c. b. at 237) (“inventories of securities generally are easily valued at year end, and, in fact, are currently valued at market by securities dealers in determining their income for financial statement purposes.”); dep’t of the treasury, general explanations of the president’s budget proposals affecting receipts 36 (feb. 1993); dep’t of the treasury, general explanations of the president’s budget proposals affecting receipts 89-90 (jan. 1992). 281. irc § 475(b)(1)(a). 730 florida tax review [vol.6:7 (2) any debt instrument acquired or originated by the taxpayer in the ordinary course of its trade or business, which is not held for sale; and (3) any security282 that is a hedge with respect to either a security not subject to the mark-to-market rules or to any position, right to income, or liability that is not a security in the hands of the taxpayer.283 for purposes of section 475, a “dealer in securities” is a taxpayer who regularly purchases securities from, or sells securities to, customers in the ordinary course of a trade or business, or regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. whether one is a dealer in securities284 will be determined on the basis of all the facts and circumstances. the statute285 is disjunctive; therefore the purchasing of securities alone, or the sale of securities alone, if purchased or sold to customers in the ordinary course of business could cause a taxpayer to be considered a dealer. certain categories286 of taxpayers who would otherwise be dealers in securities are exempt from dealer status.287 the term “security” is very broad, and includes: (1) share of stock in a corporation; (2) partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; (3) note, bond, debenture, or other evidence of indebtedness; (4) interest rate, currency, or equity notional principal contract; (5) evidence of an interest in, or a derivative financial instrument in, any security described above, or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security 282. irc § 475(b)(1)(b). 283. irc § 475(b)(1)(c). 284. irc § 475(c)(1). 285. regs. § 1.475(c)-1(a). 286. note that this definition may create a mismatch between tax and book treatment of securities, because a taxpayer who regularly purchases securities from customers, but holds them to maturity, may be required to mark these securities to market under § 475, but will be viewed as holding them to maturity (and therefore, not subject to mark-to-market) for financial accounting purposes under fas 115. 287. for example, taxpayers whose principal activity consists of selling nonfinancial goods and services for which they extend credit to the purchasers of such goods and services are not dealers in securities under irc § 475, even if the taxpayer subsequently sells the evidences of indebtedness so acquired. regs. § 1.475(c)-1(b). in addition, a taxpayer that regularly purchases securities from customers in the ordinary course of business is not a dealer in securities under irc § 475 unless it sells more than a “negligible” portion of the loans or securities so acquired. regs. § 1.475(c)-1(c)(1)(i). a negligible amount of sales is either: (a) selling all or part of fewer than sixty loans, or (b) selling all or part of loans, the total adjusted basis of which is less than 5% of the total basis of the debt instruments acquired in the year. regs. § 1.475(c)-1(c)(2). these exceptions can create a book-tax mismatch because holders of such instruments may be required to mark them to market under fas 115. 2004] book tax conformity for financial instruments 731 or currency (excluding any contract to which section 1256(a) applies); and (6) a position that (i) is not a security described in (1), (2), (3), (4), or (5), (ii) is a hedge with respect to such a security, and (iii) is clearly identified in the dealer’s records as being described in this subparagraph before the close of the day on which it was acquired or entered into (or such other time as the secretary may by regulations prescribe). certain items are excluded from the definition of288 a security for purposes of section 475. most notably, the term security does289 not include the taxpayer’s liabilities, the taxpayer’s stock and debt instruments issued by the taxpayer. a trader in securities or a dealer or a trader in commodities may elect to be governed by section 475. if a trader in securities makes an election290 under section 475(f), it follows most of the rules of section 475. the rules of section 475 apply to commodities held by an electing commodities dealer in the same manner as they apply to securities held by a securities dealer. note that291 the application of section 475 to physical commodities creates another book-tax difference, because commodities are not marked-to-market for gaap purposes. (iii) fas 115 fas 115 sets forth principles for (i) nvestments in equity securities that have readily determinable fair values (i.e., “marketable securities”), and (ii) for all investments in debt securities. these investments are to be classified in292 three categories and accounted for as follows: 288. irc § 475(c)(2). 289. those items include: (1) a security if § 1032 prevents the taxpayer from recognizing gain or loss with respect to that security (includes stock of the taxpayer and any options on the stock e.g., a mutual fund would not be treated as a dealer in securities because it sells and redeems its own shares); (2) liabilities of the taxpayer; (3) a remic residual interest acquired on or after january 4, 1995, and negative value remic residuals acquired before january 4, 1995; (4) synthetic debt that is treated as integrated debt under regs. § 1.1275-6; and (5) non-financial customer paper as defined in irc § 475(c)(4). regs. § 1.475(c)-2. 290. irc §§ 475(e) and 475(f). 291. irc § 475(e)(1). a commodity is: (a) a commodity which is actively traded; (b) a notional principal contract with respect to a commodity described in (a); (c) an evidence of an interest in a derivative in a commodity such as an option, forward contract, futures contract, short position, or similar instrument in a commodity; and (d) any position which is not a commodity described in subparagraph (a), (b), or (c), but is a hedge of such commodity. irc § 475(e)(2). 292. non-marketable equity securities are subject to the cost method under apb opinion 18, ¶ 6a. 732 florida tax review [vol.6:7 trading securities: debt and marketable equity securities that are bought and held principally for the purpose of selling them in the near term.293 for this purpose, “trading” means: (i) frequent and active buying and selling; (ii) used to generate profits; (iii) from short-term differences in prices.294 trading securities are reported at fair value, with unrealized gains and losses included in net income. an unrealized holding gain or loss constitutes the net295 change in the fair value of a security from one period to another, exclusive of dividends or interest revenue recognized but not received. held-to-maturity: debt securities that the investor has the positive intent and ability to hold to maturity are reported at amortized cost and not fair value. a security is classified as held-to-maturity if the reporting entity has296 both (i) the intent and (ii) the ability, to hold the security to maturity. an297 entity should not classify a security as held-to-maturity if it intends to hold the security for an indefinite period. as commentators indicate, by definition, equity securities have no maturity date and cannot be treated as held-to-maturity.298 available for sale: debt and equity securities not classified as either held-to-maturity or trading securities are also reported at fair value, with unrealized gains and losses related to changes in the fair value of the instruments reported as “other comprehensive income” and as a separate299 component of shareholders’ equity. thus, changes in the security’s fair value300 are not reported as part of the entity’s net income until the security is disposed of. table iv summarizes the basic accounting principles pertaining to investment in non-derivative securities:301 293. accounting for certain investments in debt and equity securities, statement of financial accounting standards no. 115, ¶ 12a (financial accounting standards bd. 1993). 294. id. 295. id. ¶ 13. 296. id. ¶ 7. 297. id. 298. kieso et. al, supra note 39, at 920. 299. “comprehensive income” includes all changes in equity during a reporting period except those resulting from investment by owners and distributions by owners. thus, it includes all the elements reported in net income and gains and losses that bypass net income but affect shareholders’ equity. the items that bypass net income constitute “other comprehensive income.” reporting comprehensive income statement of financial accounting standards no. 130 (financial accounting standards bd. 1997). 300. accounting for certain investments in debt and equity securities, statement of financial accounting standards bd. no. 115) ¶¶ 12b and 13. 301. see generally kieso et. al., supra note 39 at 859. 2004] book tax conformity for financial instruments 733 table iv category valuation unrealized holding gains and losses other income effects nonmarketable equity securities amortized cost not recognized dividend when declared. gain/loss when security is sold held-tomaturity (only debt) securities investment shown at amortized cost not recognized interest when earned. gain/loss when security is sold trading (debt and equity) securities investment shown at fair value recognized in net income interest when earned. dividend when declared available-forsale (debt and equity) securities investment shown at fair value recognized as “other comprehensive income” and as separate component of equity. interest when earned. dividend when declared equity securities (holding more than 20%) investment shown at amortized cost, and adjusted by proportionate share of investee’s net income and reduced by dividend received not recognized dividend is recognized to the extent of the investee’s earnings or losses reported subsequent to the date of investment. gain/loss when security is sold transfers between any of the categories are accounted for at fair value. for example, when available-for-sale securities become held-to-maturity, the investment is recorded at the day of transfer at fair value. this rule ensures that a reporting entity cannot escape fair value recognition by transferring investment to the held-to-maturity group.302 to conclude, under fas 115, any security that is not held-to-maturity is marked-to-market. thus, the standard for determining which securities must be marked-to-market may not conform to the section 475 standard. in my view, the purpose of section 475, particularly after the enactment of section 475(f) 302. id. at 857. 734 florida tax review [vol.6:7 (the trader election), is to apply a mark-to-market treatment to all securities except for the ones held for investment. in general, this is also the purpose of fas 115. the best way to achieve conformity on that issue is to follow a purposive approach. accordingly, section 475 should be revised to change the303 focus from the taxpayer to the purpose of holding the instrument. put broadly,304 an instrument that is held for investment will be subject to the cash or accrual method, while all other types of investments will be marked-to-market. it is305 necessary, therefore, to set forth a clear and consistent definition for the term “held-for-investment,” because, as of today, this standard is not entirely similar to the held-to-maturity standards under fas 115. to conform these two306 standards, it may be assumed that an investor in securities must have the positive intent and ability to hold them until maturity. under this assumption, a security held-to-maturity will be viewed as held for investment, and such a security will be subject to the accrual or cash method and not marked-to-market. in addition, it is important to distinguish between investments in debt and equity securities. investments in debt instruments will be subject to the above treatment (i.e., except for held-to-maturity securities, all other securities are marked-to-market). equity securities, on the other hand, will be subject307 to cash or accrual method, unless (i) the taxpayer holds less than 20% of the issuing corporation, and (ii) the securities are marketable. as a result, most investments in debt instruments will be subject to mark-to-market (i.e., cash and accrual methods will be the exception) while most investments in other corporations, except for the ones that are clearly passive investments, will continue to be subject to the cash or accrual method of accounting. (iv) treatment of issuers fas 115 applies only to investment in securities. similarly, section 475 does not apply to liabilities of the taxpayer as well as stock and debt instruments issued by the taxpayer. the issuing of a debt instrument is treated as a liability308 303. a purposive approach would apply a certain tax treatment in accordance with the taxpayer’s subjective intent in entering into the transaction. 304. for the advantages of a purposive approach to financial instruments, see australian issue paper, supra note 3. 305. under this proposal, the elective mark-to-market for traders under § 475(f) will become mandatory. see § 475(b)(1)(a), (c)(2). 306. most notably, under fas 115’s standard, a marketable equity security cannot be defined as held-to-maturity, because, by definition, a stock does not have an identified maturity date. on the other hand, a holder of stock may be viewed, for tax purposes, as holding it for investment purposes, and not be subject to § 475. 307. cf., weisbach at 110-11, supra note 28,(suggesting that all investments in debt instruments will be marked-to-market). 308. regs. § 1.475(c)-2(a)(1), (2). 2004] book tax conformity for financial instruments 735 for financial accounting purposes, while the issuance of equity securities is reported under the “equity” portion of the balance sheet. the issuer reports debt instruments on a cash or accrual basis rather than fair value basis. similarly,309 the issuer’s equity is not reported on a fair value basis either. accordingly, from an issuer’s perspective, mark-to-market treatment does not apply to nonderivative transactions. note, however, that in a recent report concerning310 valuation of financial instruments, the fasb indicated that in the future, this approach may be revisited, and certain liabilities will be subject to mark-tomarket.311 the purpose of issuing a non-derivative instrument (debt or equity) is to obtain funding for the issuer. this purpose could be viewed as the flip side of investment purpose. thus, issuers of non-derivative instruments should be treated similarly (opposite side) to holders of the same instrument who hold the instruments to maturity. accordingly, unless the rules of fas 133 pertaining to hedged items apply (see below), issuers of non-derivative instruments should be subject to the cash or accrual method with respect to the recognition of deductions.312 5. contingent payment instruments generally, the tax treatment of financial instruments that contain contingent payments does not conform to the financial accounting treatment of such instruments. the reason for the non-conformity is treasury’s attempts to create innovative methods to tax such instruments, in contrast to the accounting principle of conservatism. in particular, whereas treasury issued contingent313 payment debt instruments (cpdi) regulations in 1996 and, recently, proposed314 regulations pertaining to contingent swaps, no such developments have occurred in the accounting world. as a result, contingent payment instruments are generally subject to tax in accordance with their expected schedule of payments, 309. id. 310. a notable exception is a hedged item that is hedged with a “fair value” hedge under fas 133, which must be marked-to-market. in addition, fas 150 requires that the instruments discussed therein be reported at fair value, and as discussed above, a mandatorily redeemable financial instrument can be viewed as a debt instrument. 311. see reporting financial instruments and certain related assets and liabilities at fair value, fasb preliminary views (norwalk, conn.: fasb, 1999). 312. cf. weisbach , supra note 28, at 111-14, (suggesting that issuers of debt instruments should be subject to mark-to-market). for a similar argument from the financial accounting profession, see kieso et. al., at 858. 313. accounting for contingencies, statement of financial accounting standards no. 5, ¶¶ 82-84 (financial accounting standards bd. 1975). 314. t.d. 8674, 61 fed. regs. 30,133 (june 14, 1996) (codified 26 c.f.r. pt. 1). 736 florida tax review [vol.6:7 while gaap imposes a wait-and-see approach to such instruments (with potential bifurcation of the contingent component, if it constitutes an “embedded derivative” under fas 133). (i) contingent payment debt instruments (cpdi) a cpdi that is publicly traded at issuance, or is issued for money or publicly traded property, must be accounted for under the noncontingent bond method. under this method, interest accrues in the first instance as if the315 cpdi were a comparable fixed-rate debt instrument and then appropriate adjustments are made to account for the difference between the actual payments on the cpdi and the assumed payments on the comparable noncontingent bond. applying the noncontingent bond method requires the following steps:316 (i) determine the comparable yield as of the issue date; (ii) determine the projected payment schedule as of the issue date; (iii) determine the daily317 portions of interest; and (iv) adjust the amount of income or deductions for differences between projected and actual contingent payments. if the actual318 amount of a contingent payment becomes fixed at an amount that differs from the projected amount of the payment, the difference results in either a positive or negative adjustment.319 a cpdi that is issued for non-publicly traded property is taxed under a different method. under this alternative, the contingent and non-contingent320 components are separated and accounted for separately; while the latter portion is taxed under the oid rules (assuming no qualified stated interest), the former is subject to the wait-and-see method.321 315. regs. § 1.1275-4(b). 316. regs. § 1.1275-4(b)(2). 317. regs. § 1.275-5(b)(3)(i), (ii). the projected payment schedule consists of all noncontingent payments and a projected amount for each contingent payment. regs. § 1.1275-4(b)(4)(ii). the payment schedule is determined as of the debt instrument’s issue date and remains fixed throughout the term of the debt instrument. regs. § 1.12754(b)(3)(ii). 318. regs. § 1.1275-4(b)(3)(iii)-(iv). 319. regs. § 1.1275-4(b)(6). a net positive adjustment in a tax year is trea-ted by the taxpayer as additional interest for the taxable year. regs. § 1.1275-4(b)(6)(ii). a net negative adjustment first offsets the interest that accrued on the debt instrument for the taxable year based on the projected payment schedule. regs. § 1.12754(b)(6)(iii)(a). if the net negative adjustment exceeds the amount of interest accrued on the debt instrument for the tax year under the projected payment schedule, then generally, the excess is treated as an ordinary loss by the holder (and as ordinary income by the issuer) subject to certain limitations. regs. § 1.1275-4(b)(6)(iii)(b). 320. regs. § 1.1275-4(c). 321. regs. §1.1275-4(c)(4)(i). 2004] book tax conformity for financial instruments 737 (ii) contingent notional principal contracts the proposed contingent npc regulations adopted a variation on the322 noncontingent swap method described in notice 2001-44 (which is generally323 similar to the non-contingent bond method under the cpdi regulations). the noncontingent swap method requires (1) projecting initially what the contingent payment will be; (2) accounting annually for the appropriate portions of the projected contingent amounts; (3) re-projecting the contingent amounts annually; and (4) reflecting amounts attributable to the difference between projected and re-projected amounts through adjustments that are spread over a one-year period. as an alternative, the proposed regulations also provide an324 elective mark-to-market method for notional principal contracts with nonperiodic (contingent or non-contingent) payments.325 the major difference between the non-contingent bond method and the non-contingent swap method is the annual adjustment of the projection in the latter method. as set forth above, the non-contingent swap method is closer to a mark-to-market regime that the non-contingent bond method.326 (iii) accounting conservatism a “contingency” is defined in fasb statement no. 5 as: [a]n existing condition, situation, or set of circumstances involving uncertainty as to possible gain . . . or loss . . . to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.327 322. see reg-166012-02, supra note 27; see also garlock, supra note 27. 323. 2001-2 c.b. 77. 324. reg-166012-02, supra note 27 at 69 fed. reg. 8887; see also garlock (2004), supra note 27. 325. reg-166012-02, supra note 27 at 69 fed. reg. 8887-88. 326. garlock (2004), supra note 27, at 152. 327. fas 5, supra note 313, ¶ 1. the principle of conservatism is stated in sfac 5, ¶ 81: in assessing the prospect that as yet uncompleted transactions will be concluded successfully, a degree of skepticism is often warranted. moreover, as a reaction to uncertainty, more stringent requirements historically have been imposed for recognizing revenues and gains than for recognizing expenses and losses, and those conservative reactions influence the guidance for applying the recognition criteria to components of earnings. 738 florida tax review [vol.6:7 generally, under gaap, a contingency is accrued only when the following condition is met: the amount of the gain or loss can be reasonably estimated.328 revenues and gains are recognized for financial accounting purposes only when (a) they are realized or realizable and (b) they are earned. expenses329 and losses are recognized when the benefits are used up in delivering or producing goods or services or when previously recognized assets are expected to provide reduced or no further benefits.330 accordingly, for financial accounting purposes, issuers of cpdis generally recognize payments actually paid, and holders recognize income actually received, while for tax purposes, recognition of income and expenses is made under a projected payment schedule. nevertheless, if the contingent component constitutes an “embedded derivative” under fas 133, this component is marked-to-market, while the host debt instrument is subject to the cash or accrual method. the timing difference between book and tax, which331 is reported on the taxpayer’s schedule – 1, is temporary, but could become permanent under certain circumstances. under fas 109, this temporary tax332 difference creates a deferred tax liability, because taxes to be paid will be higher in the future.333 i suggest that the embedded derivative rules contained in fas 133 should apply for tax purposes (for both the holder and the issuer). put broadly,334 if an instrument could be bifurcated into a host contract and embedded derivatives (i.e., the economic characteristics and risks of embedded derivative are not clearly and closely related to those of the host instrument), tax law should follow fas 133, and impose a mark-to-market treatment on the embedded derivative component, and a wait-and-see method for the host contract. on the other hand, if the contingency does not satisfy the embedded derivative standard, the whole instrument will be subject to the taxpayer’s normal accounting method. to illustrate, in rev. rul. 2002-31, the description of the instrument335 was as follows: on january 1, 2002 the issuer issued for $625 a 20-year debt instrument with a stated principal amount of $1,000. beginning after january 1, 2005, contingent interest would be payable for any six-month period ending 328. fas 5, supra note 313, ¶¶ 8-9. see also knott and rosenfeld, supra note 1, at § ii(a)(2)(b)(i). 329. sfac no. 5, supra note 198, ¶ 83. 330. id. ¶ 85. 331. fas 133, supra note 310, ¶ 12; see also weisbach (1999), supra note 28, at footnote 47. 332. fas 109, supra note 89. 333. id. 334. for a similar view, see ensminger, supra note 1, at 37-38. 335. 2002-1 c.b. 1023. 2004] book tax conformity for financial instruments 739 on june 30 or december 31 if the average market price of the debt instrument were greater than 120% of the instrument’s accreted value. the amount of the contingent interest payable would be equal to the greater of (1) the regular cash dividend per share of the issuer’s common stock for the six-month period multiplied by the number of shares into which the debt instrument could be converted, or (2) a certain percentage of the average market price of the debt instrument for the measurement period. except for the contingent feature, the instrument did not provide for any stated interest. the contingent component of the instrument could be bifurcated and accounted for separately. the cpdi regulations have recognized a bifurcation method for debt instruments issued for non-publicly traded property (but applied a different method). such bifurcation could be used for purposes of separating the contingent component and taxing it as an embedded derivative. nevertheless, even if the contingent component is bifurcated, its economic characteristics and risks must not clearly and closely relate to those of the host instrument. in the above example, the test should be applied to the336 contingent interest trigger (i.e., 120% of the instrument’s accreted value) and semi-annual amounts. in my view, if both the trigger and amount are based on the instrument’s value (for example, if only the second alternative for the amount of contingent interest is relevant), the contingent component may not be treated as an embedded derivative under fas 133. on the other hand, if both the trigger and amount of contingent interest are based on the value of the issuer’s stock, the contingent component should be viewed as an embedded derivative. in this case, the cpdi should be bifurcated for tax purposes, and337 each component should be taxed separately. the irs may take the view that section 163(l) applies to this type of instrument on the grounds that it is a “disqualified debt instrument” because amount of the contingent interest on the notes and the threshold for determining when the interest is required to be paid is determined by reference to the value of the issuer’s stock. nevertheless, in338 336. fas 133, ¶ 11(a). 337. under ¶ 61(h) of fas 133, the changes in fair value of a stock and the interest yield on a debt instrument are not clearly and closely related. on the other hand, fas 133 precludes embedded derivative accounting for issuers of convertible debt, because the embedded derivative in this case is indexed to the issuer’s stock. see fas 133, supra note 18, ¶ 11(a), 199 (ex.3). 338. section 163(l) applies to deny a deduction for interest on a debt instrument having a substantial amount of principal or interest payable in or required to be determined by reference to the value of the issuer’s stock (either mandatorily or at the issuer’s option). section 163(l)(3)(b). a “disqualified debt instrument” is defined as any indebtedness of a corporation which is payable in equity of the issuer or a related party. section 163(l)(2). indebtedness is treated as payable in equity of the issuer or a related party if: (a) a substantial amount of the principal or interest is required to be paid or converted, or at the option of the issuer or related party is payable in, or convertible into 740 florida tax review [vol.6:7 my view, if the bifurcation approach of fas 133 is imported into tax law, section 163(l) should not apply to the cpdi because the contingent component (or the equity component in this case), is accounted for on a mark-to-market basis. this approach is consistent with rev. rul. 2003-97 in which the irs339 ruled that the debt instrument component of the investment unit is not a disqualified debt instrument under section 163(l) on the grounds that it is separate from the forward contract. finally, with respect to contingent swaps, such instruments will be subject to the mark-to-market treatment, in accordance with fas 133.340 6. hedging transactions fas 133 requires companies to record derivatives at their fair value (i.e., marked to market). tax hedging rules, on the other hand, match the timing of income, expense, gain or loss on the hedging transaction with that of the hedged item. generally, tax hedging rules do not result in marking the341 hedging transaction to market, unless the hedged items are subject to mark-tomarket. this article will suggest that book and tax hedging rules be342 conformed by the adoption of the principles of fas 133 for tax purposes.343 (i) tax hedging rules in 1994, the irs issued regulations concerning the tax treatment of hedging transactions. these regulations include timing rules (regs. section344 1.446-4) and character rules (regs. section 1.1221-2). the definition of a345 the issuer’s stock; (b) a substantial amount of the principal or interest is required to be determined, or at the option of the issuer or a related party is determined, by reference to the value of the stock; or (c) the indebtedness is part of an arrangement which is reasonably expected to result in payment of the debt with or by reference to the stock. section 163(l)(3)(a)-(c). 339. 2003-34 i.r.b. 380. 340. fas 133 ¶¶ 57b, 59e. 341. regs.§ 1.446-4(b). 342. regs. § 1.446-4(e)(2). 343. for a similar view, see ensminger, supra note 1; rosenthal and price, supra note 17. nevertheless, while these two commentators focused primarily on hedging transaction, this article takes a much broader perspective. 344. see t.d. 8555, 59 fed. reg. 36,360 (for reg. § 122-2); t.d. 8554, 59 fed. reg. 39,356 (for reg. § 1.446-4). 345. the character of a hedging transaction is determined under regs. § 1.1221-2(a), which provides that the term “capital asset” does not include property that is part of a hedging transaction. therefore, any item of income, deduction, gain, or loss stemming from a hedging transaction is ordinary. in this article, i discuss only the timing aspects of the hedging rules. 2004] book tax conformity for financial instruments 741 “hedging transaction” includes two elements: (i) it must be a transaction that a taxpayer enters into in the normal course of its trade or business, primarily to manage the risk of interest rate changes, price changes, or currency fluctuations; and (ii) the risk being managed must relate to ordinary346 obligations incurred or to be incurred, or borrowings made or to be made by the taxpayer.347 under the hedging timing rules, the taxpayer’s method of accounting for a hedging transaction must “clearly reflect income.” accordingly, the348 accounting method used must “reasonably match” the timing of income, deduction, gain, or loss from the hedging transaction with that from the hedged item. for example, where the hedged item is marked-to-market under the taxpayer’s method of accounting, marking the hedge to market clearly reflects income.349 (ii) fas 133 fas 133 requires all derivatives to be recorded on the balance sheet at fair value and sets forth special accounting standards for the following three different types of hedging transactions: (i) hedges of changes in the fair value of assets, liabilities, or firm commitments (“fair value hedges”) are recorded350 at fair value in the balance sheet, with any unrealized gains and losses recorded in net income; (ii) hedges of the variable cash flows of forecasted transactions (“cash flow hedges”) are also recorded at fair value in the balance sheet, but351 unrealized gains and losses are recorded in equity, as part of “other comprehensive income” and (iii) hedges of foreign currency exposures of net investments in foreign operations (“foreign currency net investment hedges”) are special cases of the above two types of hedges. derivatives used for352 346. if an asset is not acquired primarily to manage risk, the purchase or sale of that asset is not a hedging transaction, even if the terms of the asset happen to manage the taxpayer’s risk with respect to other assets or liabilities. reg. § 1.1221-2(d)(5). 347. section 1221(b)(2)(a). regs. § 1.1221-2(b). 348. regs. § 1.446-4(b). 349. regs. § 1.446-4(e)(2). 350. generally, fair value hedges protect against changes in value caused by fixed terms, rates, or prices. fas 133 requires corporations to recognize in income, in the period that a change in value occurs, gains or losses from a derivative designated as a fair value hedge. in addition, changes in the fair value of the hedged item (i.e., the asset, liability, or firm commitment), to the extent they are attributable to the risk, are also marked to market. 351. a cash flow hedge involves hedging the exposure of an asset or liability, or a forecasted transaction, to variability in expected future cash flows attributable to a particular risk. fas 133, supra note 18, ¶ 4. 352. fas 133, supra note 18, ¶ 4. 742 florida tax review [vol.6:7 speculation (or non-hedging) purposes are recorded at fair value, with unrealized gains and losses recorded in net income.353 a hedging instrument generally can only be a derivative that satisfies the following requirements: (i) cash flows or fair value from the instrument must fluctuate and vary based on changes in one or more underlying variables; (ii) the instrument must be based on one or more notional amounts and/or payments; (iii) the instrument requires no, or insignificant, initial net investment; and (iv) the instrument can readily be settled by a net cash payment.354 in addition, if the hedge is a fair value hedge, the reporting entity must mark the hedged item to market to the extent changes in the fair value of the hedged item are attributable to the risk designated as being hedged.355 to constitute a qualified hedging transaction under fas 133, a derivative must be “highly effective” in offsetting exposure to risk due to changes in fair value of cash flows from the hedged item. thus, to the extent356 the hedge is effective, the standard for fair value hedges results in offsetting changes in the fair values of cash flows on the hedge and the hedged item.357 353. id. at summary. 354. see id. ¶ 9.61-f. examples of derivatives that satisfy these requirements include swaps, options, futures, forwards, swaptions, caps, collars and floors. id. ¶ 6. “regular way” securities trades such as purchases or sales of securities that settle in the normal course for the particular security do not constitute “derivatives” under fas 133. id. ¶ 10(a). 355. id. ¶ 36, 4, et al. 356. id. ¶¶ 389-95. 357. id. 2004] book tax conformity for financial instruments 743 table iv summarizes the basic principles of fas 133:358 table iv derivative use accounting for derivative accounting for hedged item common examples speculation fair value, with unrealized gains/losses recorded in net income not applicable call or put options on a stock fair value hedge fair value, with unrealized gains/losses recorded in net income fair value, with unrealized gains/losses recorded in net income interest rate swap hedge of a fixed-rate debt instrument cash flow hedge fair value, with unrealized gains/losses recorded in other comprehensive income, and reclassified in income when the hedge’s cash flows affect earnings general accounting principles use of a futures contract to hedge a forecasted purchase of inventory as of today, book and tax hedging rules do not conform. while tax rules generally match the timing of income and deductions from the hedging transaction with that of the hedged item, fas 133 requires that all hedging derivatives be marked-to-market, and in some circumstances (fair value hedges), the timing of the hedge will be matched to the hedged item by marking both of them to market.359 to conform book and tax timing rules for hedging transactions, the revised tax hedging rules should state that derivatives used for hedging (and that satisfy the risk management standard) should be marked-to-market. with respect to the hedged items, this rule applies only to fair value hedges under fas 133. as of today, tax hedging rules do not distinguish between the three types of hedges described in fas 133. to allow conformity on this point, the tax hedging rules must first define “fair value hedge” in accordance with fas 133 and specify that only hedged items that are being hedged with a fair value hedge will be marked-to-market. 358. kieso, supra note 39 at 876. 359. in addition, except for the timing mismatch, not all gaap hedges are tax hedges (e.g., capital asset hedges) and not all tax hedges are gaap hedges (e.g., certain hedges that fail the gaap effectiveness requirement). see, e.g., ensminger, supra note 1, at 28-30. 744 florida tax review [vol.6:7 e. valuation360 commentators have considered valuation as a significant obstacle for applying a mark-to-market regime in u.s. tax law. in bank one, the tax361 court held that the treatment of an item for financial accounting and tax purposes may differ, and a method of accounting that is acceptable for accounting purposes may be unacceptable for tax purposes because it does not clearly reflect income. nevertheless, the tax court held it was acceptable for362 the bank to use its accounting mark-to-market method for purposes of section 475 as long as such method actually arrived at the swaps’ fair market value.363 1. fair market value v. fair value the tax court asserted that a taxpayer could use its accounting markto-market method for purposes of section 475, but only if the value for book purposes meets the tax fair market value standard. the term “fair market364 value” is not specifically defined for purposes of section 475. the tax court365 reviewed the evolution of the term “fair market value” and summarized it as follows: the primarily judicially developed standards as to fair market value are: (1) the buyer and the seller are a willing buyer and a willing seller; (2) neither the willing buyer nor the willing seller is under a compulsion to buy or to sell the item in question; (3) the willing buyer and the willing seller are both hypothetical persons; (4) the hypothetical willing buyer and the hypothetical willing seller are both reasonably aware of all relevant facts involving the item in question; (5) the item in question is valued at its highest and best use; and (6) the item in question is valued without regard to events occurring after 360. for an in-depth discussion of this issue, see munro and keinan, supra note 23. 361. see, generally, commentary supra note 55. cf. weisbach, supra note 28, at 105 (“the problems of valuation and liquidity are not sufficient to overcome the benefits”). 362. 120 tc 174, 290-91 (2003). 363. id. at 291. 364. id. 365. see § 475. for purposes of other code sections, the courts generally define the term as: “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” see mcdonald v. comm’r, 764 f.2d 322 (5th cir. 1985). (u.s. v. cartwright, 411 u.s. 546, 551 (1973)). 2004] book tax conformity for financial instruments 745 the valuation date to the extent that those subsequent events were not reasonably foreseeable on the date of valuation.366 pursuant to fas 133, “fair value is the most relevant measure for financial instruments and the only relevant measure for derivatives.” fair367 value represents the amount at which an asset (liability) could be purchased (incurred) or sold (settled) in a current transaction between willing parties. (i.e., a transaction other than a forced or liquidation sale).368 the tax court held that the terms “fair market value” and “fair value” differ primarily for the following reasons: (i) under the fair market369 value standard, the buyer and seller must be reasonably aware of all facts relevant to the property to be valued, while no such requirement exists with respect to the fair value standard; (ii) under the fair market value standard, neither the buyer nor the seller can be under a compulsion to buy or sell the property, while under the fair value standard, the property must not be the subject of a forced sale or liquidation (i.e., a narrower requirement); (iii) under the fair market value standard, the buyer and seller are both considered to be hypothetical rather than actual persons, while no such requirement exists with respect to the fair value standard; and (iv) under the fair market value standard, the property to be valued must be valued by viewing the property in its highest and best use, and no such requirement exists with respect to the fair value standard370 table vi below summarizes the differences between the two standards, as indicated by the tax court:371 366. bank one, 120 tc at 306. 367. fas 133, supra note18, ¶ 17. 368. see fas 107, supra note 97, ¶¶ 5-6. see also munro and keinan, supra note 23. 369. as the tax court indicated in footnote 66 of the bank one decision: for purposes of financial accounting, the term “fair value” denotes primarily: (1) value determined by bona fide bargain between wellinformed buyers and sellers; the price for which an asset could be bought or sold in an arm’s-length transaction between unrelated parties; value in a sale between a willing buyer and a willing seller, other than in a forced or liquidation sale. (2) an estimate of such value, in the absence of sales or quotations (e.g., the approximation of exchange price in nonmonetary transactions). kohler’s dictionary for accountants 211 (6th ed. 1983). 370. 120 tc at 309 n. 66 (quoting kohler’s dictionary for accounts 211 (6th ed. 1983)). 371. see id. 746 florida tax review [vol.6:7 table vi element fair market value fair value willing buyer and seller x x neither party is compelled to buy or sell x the property must not be the subject of a forced sale or liquidation x the buyer and seller are both hypothetical persons x the buyer and the seller are both reasonably aware of all relevant facts x x the item in question is valued at its highest and best use x the item in question is valued without regard to events occurring after the valuation date x these differences should not limit taxpayers’ ability to use financial statement values of securities on tax returns. under both definitions, the372 predominant element is the willing buyer and seller principle, and in my opinion, applying each standard in most cases should result in closely similar (if not identical) values. as a practical matter, valuation of derivatives can never be completely accurate. therefore, in my view, the definition of “fair market value” for purposes of the tax mark-to-market rules should conform to the definition of “fair value” under gaap. 2.valuation of swaps: gaap v. section 475 the most significant issue in bank one was the appropriate valuation method of interest rate swaps (and potentially, other derivatives) for section 475 purposes. the tax court suggested that valuation methods used for book373 purposes might not satisfy the required valuation method for tax purposes.374 fas 133 was not effective for any of the years under dispute in bank one.375 during the relevant years, however, the common practice in the financial derivatives industry had been to mark swaps and other derivatives to market. to value its swaps, the taxpayer utilized an adjusted mid-market method, which is 372. weisbach, supra note 28, at 107-108, (indicating that requiring valua-tion for both tax and accounting would help both systems by creating a tension that prevents underor over-valuation and by simplifying the system through uniformity.”) 373. 120 t.c. 174 (2003). 374. id. at 290-91. 375. id. at 220. 2004] book tax conformity for financial instruments 747 economically similar to the bid-ask method in most cases. under such a376 method, the bank calculated each swap’s mid-market rate, and then calculated377 credit and administrative cost adjustments for the swaps and added or378 379 subtracted those amounts to arrive at the swaps’ values.380 the adjusted mid-market method, a common method used by dealers to value their portfolios, was also recognized as a valid method by the g-30.381 376. id. at 244. the bid-ask method is a market-based method, which generally requires a comparison of the subject property with a comparable property, sold in an arm’s-length transaction under comparable circumstances. under this method, each swap generally is valued by: (i) identifying a comparable transaction; (ii) ascertaining the bid or ask price for that comparable swap; and (iii) adjusting the ascertained price to reflect any differences between the comparable swap and the swap being valued. the bid price is the fixed interest rate that a swap dealer is ready to pay in exchange for a specified floating rate. the ask price is the fixed interest rate that the dealer demands to receive in exchange for paying a specified floating rate. the ask rate is greater than the bid rate, and the dealer’s maximum net profit when taking the opposite sides on two identical swaps is the difference between the fixed rate it receives and the fixed rate it pays. see munro and keinan, supra note 23, at 12. 377. mid-market is an income-based method that values property by computing the present value of the estimated future cash flow generated from that property. the mid-market rate is the midpoint of the bid and ask rates for a specified maturity, which equals the fixed rate for which the present value of the cash flows from the fixed leg equals the present value of the projected cash flows from the floating leg. as a practical matter, dealers do not use this method, because adjustments are necessary to reflect true income. see munro and keinan, supra note 23, at 13. 378. a credit adjustment is required to the extent that it properly reflects the change to the swap’s mid-market value on account of the actual parties’ respective creditworthiness, taking into account all the facts and circumstances that would enhance or diminish each party’s creditworthiness. munro and keinan, supra note 23, at 13-14. 379. the swaps’ fair market value should include an administrative costs adjustment. munro and keinan, supra note 23, at 14. 380. bank one, 170 tc at 243. 381. id at 221; see also munro and keinan, supra note 23, at 13. the g-30 is a private, nonprofit international entity composed of very senior representatives of the private and public sectors and academia. it was organized to deepen understanding of international economic and financial issues and to examine the choices available to market practitioners and policymakers. in july 1993, one of the g-30’s working groups issued a report titled “derivatives: practices and principles,” which focused on bank regulatory concerns and generally defined a set of sound risk management practices for dealers and end users. recommendation 3 of the g-30 report stated: derivatives portfolios of dealers should be valued based on midmarket levels less specific adjustments, or on appropriate bid or offer levels. mid-market valuation adjustments should allow for expected future costs such as unearned credit spread, close-out costs, investing and funding costs, and administrative costs. munro and keinan, supra note 23, at 13 n. 24. 748 florida tax review [vol.6:7 the tax court held that it was acceptable for the bank to have used its mark-tomarket method for purposes of section 475 as long as the method actually arrived at the fair market value of its swaps.382 the (“anprm”), which was issued on the same day the tax court’s383 decision in bank one was released, suggests a safe harbor that would allow the taxpayer to elect to use the same values used on its financial statements for purposes of section 475, subject to the following eligibility standards: (i) any mark-to-market methodology used on the financial statement would have to be sufficiently consistent with the mark-to-market methodology required under section 475; (ii) the financial statement would have to be one for which the taxpayer has a strong incentive to report values fairly; and (iii) if requested,384 the taxpayer would have to “timely provide” the irs with the information and documents necessary to verify the relationship between the values reported on the financial statement and the values used for purposes of section 475.385 3. valuation of other derivatives primarily, bank one discussed valuation of swaps; however, in footnote 68 of the decision, the tax court indicated that its decision may apply more broadly to other derivatives subject to section 475: we hereinafter limit our analysis to the treatment of interest rate swaps. we believe on the basis of our understanding of the other financial derivatives at issue that the tax treatment of those derivatives follows naturally from our decision as to 382. 120 tc at 291. 383. reg-100420-03, supra note 25. 384. id. pursuant to the anprm, two factors are relevant in establishing that the taxpayer has a strong incentive to report the value of securities and commodities fairly in its financial statements: (i) reporting of values on a financial statement required to be filed with the sec (e.g., a 10-k) or with any other federal (or state, local or foreign, in limited circumstances) government agencies; and (ii) significant use of reported values in the taxpayer’s business, including risk management activity and employee compensation. id. 385. id. the treasury and the irs requested comments regarding the following issues: (i) potential differences between mark-to-market treatment for financial reporting and § 475; (ii) whether the “fair value” standard used for accounting purposes may be used as a proxy for the “fair market value” standard required under § 475; (iii) whether gaap (and, as suggested, § 475) permits valuation of securities at bid price; (iv) whether adjustments for administrative and credit risk costs should be allowed; and (v) what other types of adjustments should be permitted in valuation of securities and commodities. id. 2004] book tax conformity for financial instruments 749 fnbc’s interest rate swaps. if we are mistaken on that point, then either party may bring this to our attention.386 in addition, treasury asked for comments regarding possible application of the rules to securities traders as well as to commodities dealers and traders.387 in my opinion, it is necessary to set forth one single valuation standard for all instruments that are marked-to-market. this single definition should be consistent with fas 107’s definition of “fair value.” generally, the bid-ask388 method is applicable to both derivatives and non-derivatives, because it simply determines the value of an instrument in accordance with the bid-ask prices of a comparable instrument in the market. this method has been viewed by389 gaap as reflecting the “fair value” of a financial instrument. alternatively,390 for large banks and financial instruments, it could be more feasible to apply the adjusted mid-market method (which is economically equivalent to the bid-ask method). 4. the bifurcation approach as the tax court in bank one explained, economically, an interest rate swap is analogous to back-to-back loans. by entering into the swap, the391 parties exchange a fixed-rate bond for a floating-rate bond of the same maturity and face value. accordingly, the tax court suggested that with respect to an392 interest rate swap, rather than identifying a comparable transaction, an interest rate swap could be bifurcated into two debt instruments, each of which could be separately compared to a comparable hypothetical debt instrument. under this393 analogy, the fair market value of a swap should be equal to the difference between: (i) the price at which a willing buyer and seller would agree to buy/sell the fixed leg and (ii) the price at which a willing buyer and seller would agree to buy/sell the floating leg.394 the bifurcation approach may be helpful in applying the bid-ask method not only to swaps but also to other types of securities. economically, a 386. bank one 120 t.c. at 211 n. 68. 387. reg-100420-03, supra note 25. 388. see fas 107, supra note 97, ¶ 5. 389. id. at 919. 390. id. 391. bank one, 120 tc at 190-91. 392. id. the fixed leg may be viewed as a bond issued by the fixed-rate payor, the interest rate of which equals the fixed rate payable on the swap. id. the floating leg may be viewed as a bond issued by the floating-rate payor, the interest rate of which is the agreed upon floating rate on the swap. id. 393. id. 394. id., at 311. 750 florida tax review [vol.6:7 derivative can be bifurcated into different instruments each of which is a security under section 475. thus, if the regulations to be issued ultimately395 reject book-tax conformity (or offer guidelines for securities outside the safe harbor), they should at least set forth a method for valuation of the basic building blocks of financial instruments – debt, forwards and options. these basic valuation standards could apply to almost any type of security or derivative.396 5. conclusions neither the irs nor taxpayers want to determine valuations through expensive litigation. therefore, there is pressure from both sides that treasury set forth, by regulations, clear and unambiguous valuation standards for section 475 purposes.397 as a starting point, the regulations should make it clear that fas 107’s “fair value” is equivalent to the “fair market value” standard used for tax purposes. in providing for book-tax conformity safe harbor, the irs may take one of the following approaches:398 1. pure conformity: the regulations can simply state that the method used by the taxpayer for accounting purposes is appropriate for tax purposes. this method is the most simple for taxpayers and the easiest to verify by the irs. 2. mid-market plus adjustments: the regulations can allow proprietary adjustments to the mid-market method in accordance with bank one, which, as set forth above, reflects the common practice among derivatives dealers. 3. pure bid-ask method: this method may be nearly equivalent to mid-market with adjustments for plain vanilla securities with little inception gain and is consistent with administrative practice for traditional debt and equity securities. for taxpayers that use this method for books it would be less expensive to comply with and easier for the irs to verify given the lack of adjustments; however, for large-scale derivative dealers, the adjusted mid-market method may be more efficient. 4. alternative tests: finally, the regulations may determine that taxpayers would be allowed to apply any method that clearly reflects 395. for example, the irs has argued that a swap could be viewed as a series of forward contracts. see notice of proposed rulemaking (fi-16-89), 1991-2 c.b. 951, 952; see also tam 9730007 (april 10, 1997). 396. see munro and keinan, supra note 23. 397. id., at 17. 398. id. 2004] book tax conformity for financial instruments 751 income pursuant to section 446 (for example, apply the bid-ask and adjusted mid-market method and report values at the lower of the two amounts).399 vi. summary of the proposal a. proposed timing rules for non-derivatives (debt instruments) 1. debt instruments held as assets will be marked-tomarket,unless they are held for investment. 2. debt instruments issued by a taxpayer will be subject to the taxpayer’s normal accounting method (cash or accrual), unless they constitute “hedged items.” 3. cpdis will be bifurcated if the contingency portion constitutes an “embedded derivative.” b. proposed timing rules for non-derivatives (equity securities) 1. marketable equity securities held as assets (less than 20% holding) will be marked-to-market. 2. non-marketable equity securities held as assets will be viewed as held-to-maturity and, therefore, will be subject to the taxpayer’s normal accounting method (cash or accrual). 3. equity securities issued by a taxpayer will be subject to the taxpayer’s normal accounting method (cash or accrual), unless they constitute “hedged items.” c. proposed timing rules for derivatives 1. all derivatives will be marked-to-market in accordance with fas 133. 2. embedded derivatives will be separated and accounted for on a mark-to-market basis. 3. a hedging instrument can only be a derivative. 4. all hedging transactions will be marked-to-market. 5. hedged items that are being hedged with a “fair value” hedge will be marked-to-market. 399. id. 752 florida tax review [vol.6:7 d. proposed valuation principles 1. valuation for gaap purposes will be used for tax purposes. 2. valuation of derivatives and non-derivatives will be based on the “fair value” concept. 3. non-derivative instruments will be valued in accordance with the bid-ask method. 4. derivatives will be valued in accordance with either the bidask method or the adjusted mid-market method. vii. conclusions the proposal set forth in the article is that gaap would generally form the basis for classification, timing and, valuation rules pertaining to financial instruments. in particular, this proposal will incorporate certain features of gaap, including substance-over-form, mark-to-market, and valuation methods, into the relevant tax rules, thereby achieving greater conformity in the tax and accounting rules treatments of financial instruments. once these elements are incorporated into the tax law, taxpayers who are not subject to gaap (such as individuals and small businesses) will also be able to follow these principles. from a tax policy perspective, my proposal will enhance simplicity, certainty, neutrality, and administrability. on the other hand, the tax system may become less flexible in responding to new financial instruments. in general, the tax law should be as simple as possible for taxpayers to understand and to apply to the applicable circumstances. under my proposal, simplicity will be achieved because most instruments will be subject to mark-tomarket, and as professor weisbach indicates, it will significantly eliminate “complex, realization-based rules and the uncertainty created by realizationbased taxation.” on the other hand, some taxpayers, especially small400 businesses (which may not be subject to gaap reporting principles), may find mark-to-market treatment more complicated. in my view, the majority of taxpayers who will be subject to mark-to-market under my proposal (i.e., noninvestors in non-derivative instruments and parties to derivatives) will be sophisticated taxpayers that are generally subject to gaap. thus, the overall result will be a simplification of the rules. certainty will be achieved through a comprehensive set of rules that reflects the substance, rather than the form, of an instrument.401 a neutral tax system is one that does not distort the economic decisions of taxpayers. in the case of financial instruments, neutrality will be achieved because most financial instruments will be subject to mark-to-market as a result, 400. weisbach, supra note 28 at 122. 401. see schenk, supra note 28, at 574, (defining this element as “universality.”) 2004] book tax conformity for financial instruments 753 instruments with the same substance will be taxed consistently. in addition,402 adoption of a bifurcation approach would enhance consistency because all the building blocks of derivatives will be taxed similarly. one major goal of the proposed conformity is to reduce compliance costs. following a taxpayer’s financial accounting treatment for tax purposes would greatly increase compliance. therefore, administrability will be achieved because the conforming rules will be easier to comply with and administer.403 402. weisbach, supra note 28, at 131-32. this element can also be defined as consistency. (see also strnad, supra note 28, at, 548.) 403. see, e.g., yin, supra note 1. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe further, one may ask why, if the government does not like the tax co florida tax review volume 4 2001 number 12 when charity aids tax shelters darryll k. jones* i. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 770 ii. the status quo ante: explicating normative assumptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 774 iii. the need for intervention: the end does not justify the means. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 789 iv. ubit as the protypical response: chasing our own tail. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 794 v. towards an effective response: the private benefit and public policy doctrines. . . . . . . . . . . . . . . . . . . . . . . . . . . . 803 vi. implementing an effective response: theory meets practice. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 819 vii. epilogue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 827 appendix a. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 829 appendix b. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 830 * assistant professor of law, university of pittsburgh school of law. the author wishes to thank professors larry frolik and welsh white at the university of pittsburgh school of law, and professor david brennen at the university of richmond for their very helpful comments on earlier drafts of this article. 769 770 florida tax review [vol. 4:12 i. introduction “furthermore, one may ask why, if the government does not like the tax consequences of such sales, the proper course is not to attack the exemption rather than to deny the existence of the ‘real sale’ or exchange.”1 how to deal with societal vice is always an interesting question. the body politic must first achieve a level of maturity that allows it to formulate a consensus regarding precisely what constitutes “vice.” by its nature, vice is an activity to which some ascribe no harm and others view as inherently harmful. achieving consensus is therefore no easy task, and then, recognizing that supply would not exist but for demand, and vice-versa, the body politic must determine whether enforcement resources are best directed towards consumers, towards producers, or equally towards both. here, questions of fairness and efficiency arise. is it fair, for example, to direct enforcement measures towards the producer when other socio-economic factors prevent the producer from satisfying its needs in a more legitimate manner? does it make sense to bring enforcement measures solely against the consumer and not at all against the producer of vice? a war on consumers might be absurdly ineffective if the enforcement resources devoted thereto pale in comparison to the enforcement resources devoted to producers. this article is not about the war on drugs or the campaign against big tobacco, nor does it concern the debate regarding the world’s oldest profession. it is about a tax vice. tax jurisprudence is quickly approaching a mature consensus that tax shelters constitute a definable societal vice – something in2 which many individual taxpayers might participate if given the opportunity, but which is invariably harmful to the whole. the question then becomes how3 1. commissioner v. brown, 380 u.s. 563, 580 (1965) (harlan, j., concurring). 2. congressional concern regarding tax shelters can be traced to the tax reform act of 1969, 83 stat. 487 (1969). see mortimer caplin, tax shelter disputes and litigation with the internal revenue service—1987 style, 6 va. tax rev. 709, 712 (1987). in 1984, congress began to look upon tax shelters as a criminal vice, of sorts. see id. at 715 (stating “[the 1984] provisions represent a major shift in emphasis under our tax law, moving away from concepts of voluntary compliance and self-assessment and shifting toward a codification of what might be called ‘crime and punishment’.”). 3. for now, a working definition of tax shelter is implicit in the following recent comment relating to financial assets: [t]here are two kinds of tax benefits that travel with financial assets. the first is intended to encourage specified investment behavior (e.g., investment in business, low-income housing, or public facilities). taxpayers abuse this kind of benefit when they obtain the benefit in the absence of the investment behavior that congress sought to encourage. the second kind of benefit is designed to exempt specific persons or entities from taxation under specific circumstances (e.g., the dividends received deduction, the foreign tax credit, and the treatment of exempt organizations). taxpayers abuse this kind of benefit when they obtain the benefit in the absence of the specified circumstances. david p. hariton, tax benefits, tax administration, and legislative intent, 53 tax law 579, 2001] when charity aids tax shelters 771 society should allocate it’s enforcement resources to eliminate tax shelters. presently, tax law is disproportionately concerned with directing enforcement resources against “consumers” of tax shelters (e.g., taxable individuals or entities that essentially buy tax benefits) and insufficiently concerned with “producers”(e.g., charities and other “zero-bracket taxpayers”) that willingly4 put tax benefits on the market. some producers, foreign taxpayers, in particular, are beyond tax law’s jurisdictional reach and that fact explains the5 lack of enforcement measures against those producers. but this is most certainly not the case for charity. charity has been within regulatory jurisdiction at least6 since the day it began operating a macaroni factory in competition with taxable entities. there is not even an purely logistical reason why tax law should7 ignore charity’s role in the tax shelter market. if shelters constitute a vice that 580 (2000). as will be explained in greater detail below, a shelter occurs when a taxpayer emulates but does not actually achieve or engage in a status or behavior for which a tax benefit is available, and then claims the tax benefit. see infra notes 20-23 and accompanying text. 4. the term “zero bracket taxpayer” generally refers to persons or entities that are exempt from taxation, such as charities, qualified plans, native american tribal governing bodies, and foreign persons or entities. joseph bankman, the new market in corporate tax shelters, 83 tax notes 1775, 1777 (june 21, 1999). charities and qualified plans are tax exempt by virtue of irc § 501. tax exemption of native american governing bodies is generally provided for in irc § 7871, which is intended to provide the same tax exemption to such governing bodies as is enjoyed by state governments. see generally, robert a. williams, jr. small steps on the long road to self-sufficiency for indian nations: the indian tribal governmental tax status act of 1982, 22 harv. j. on legis. 335, 356-370 (1985). prior to the 1982 enactment of 7871, the service declared that native american tribes, per se, were not subject to federal taxation. see id. at 359, citing rev. rul. 67-284, 1967-2 c.b. 55. foreign persons or entities are taxed by the united states generally only to the extent income can be said to be derived from the united sates. see generally, rufus von thulen rhoades & marshall j. langer, u.s. international taxation and tax treaties, ¶ 1.01-1.02 (2000). 5. under a clinton administration proposal regarding corporate tax shelters, foreign parties would incur a tax liability for participating in tax shelter transactions, but if a treaty gave the foreign party tax exemption the tax liability would be collected from the domestic corporate participant. see department of the treasury, general explanations of the administration’s fiscal year 2001 revenue proposals 128 (2000) (hereinafter, “fy 2001 budget proposal”). native american governing bodies are not beyond tax law’s jurisdiction, but are instead granted tax exemption as a matter of legislative and executive grace. see williams, supra note 4, at 356-70. of course, there are complex social and historical reasons why native american governing bodies are granted exemption from taxation and it may be that taking enforcement actions against such entities would thwart other more important goals. see id. the clinton administration proposal states that native american governing bodies would incur a tax liability for participating in tax shelters, but that the liability would be collected only from the corporate participant. see fy 2001 budget proposal, at 128. in other words, native american governing bodies would not be subject to enforcement action. 6. the use of the word “charity” in this article refers only to those organizations exempt from federal income taxation under irc § 501(c)(3). throughout this article, i use the word as a pronoun for clarity and ease of comprehension. 7. see, c.f. mueller co. v. commissioner, 190 f.2d 120 (3rd cir. 1950). mueller is generally credited with providing the impetus for the unrelated business income tax under irc §§ 511-513, and the feeder provision of irc § 502. 772 florida tax review [vol. 4:12 threatens core values of our taxing system, tax law should focus its enforcement efforts against all participants, not just consumers. this article therefore introduces a “drug-war” thesis that deems the enforcement focus on consumers insufficient. when charity “produces” tax8 shelters, tax law should not only enforce its displeasure against the consumer, but against charity as well. in part ii, the article discusses the normative9 assumptions that require action against charities that engage in tax shelters if charities are to remain valid. in particular, the article articulates the emergence of a consensus definition of tax shelters, workable in the practical world. that consensus definition forms the basis of the first normative assumption – that tax shelters are readily distinguishable from legitimate transactions that should not give rise to a penalty. it is possible, then, for the law to take action upon the10 occurrence of such transactions without fear that legitimate transactions will be inadvertently discouraged. the second normative assumption is that tax shelters are always harmful to the tax system. shelters undermine voluntary compliance and erode the progressive tax rates. finally, the third normative assumption is that tax exemption is never harmful to the tax system. as a normative matter, tax exemption does not create inefficiency nor unfairness. if society believes these assumptions to be true, then it makes sense that activities that violate the assumptions be prohibited and that such prohibitions be enforced against all who engage in such activities. in part iii, the article addresses one of the potential objections to a proposal to sanction charity when it aids tax shelters. the article shows that the end of charity’s participation in tax shelters – increased capital by which to achieve charitable goals – does not justify the means. this is particularly so since there are better means of accomplishing the end. more fundamentally, 8. in its study of corporate tax shelters, the department of treasury conceptualizes illegitimate tax benefits as market commodities produced and consumed by market participants. see department of treasury, the problem of corporate tax shelters: discussion, analysis and legislative proposals, (purpose) (1999) (hereinafter, “the problem of corporate tax shelters”). its articulation of the market conceptualization, though, tellingly omits any reference to producers: as deputy secretary lawrence summers recently stated, the administration’s proposals are intended to “change the dynamics on both the supply and demand side of this ‘market’ – making it a less attractive one for all participants – ‘merchants’ of abusive tax shelters, their customers, and those who facilitate the transaction.” see id. 9. the clinton administration proposal would impose an unrelated business income tax (ubit) on charities that participate in tax shelters. see id. at xvi, 116-117. i argue later that imposing ubit is ineffective and insufficient. see infra notes 134-50 and accompanying text. 10. this is not to say that a distinction between tax shelters and legitimate transactions has yet been sufficiently articulated. criticisms of current proposals, in fact, focus on the fear that proposed definitions of the phrase “tax shelter” sweep too broadly and thereby threaten legitimate transactions. see charles w. shewbridge, ii, comments on finance committee’s corporate shelter discussion draft, 88 tax notes 695, 697 (july 31, 2000) (“the tax executive institute is very much concerned about the ambiguity and expansive scope of the proposed definition of corporate tax shelter.”). nevertheless, the tax community’s decision to directly address the problem of tax shelters presupposes the ability to distinguish tax shelters from legitimate transactions even though the ability to articulate the distinction has not yet been achieved. 2001] when charity aids tax shelters 773 turning a blind eye to charity’s participation in tax shelters will eventually erode the political consensus underlying the grant of tax exemption. the law should act against those particular charities that engage in tax shelter transactions because those charities taint the whole concept of charity and chip away at the “halo” which justifies tax exemption. in part iv, the article discusses the traditional response when charity aids tax shelters. almost invariably, congress reacts by imposing an ordinary tax via the unrelated business mechanism. that is, income derived by charity via a tax shelter is treated as unrelated and taxed at corporate rates. this approach is insufficient for several reasons, but primarily because it merely restores the status quo without punishing or otherwise discouraging charity from seeking out new tax shelter transactions. the latter assertion is proven through a brief summary of certain provisions enacted in response to charity’s participation in tax shelters. then in part v, the article discusses two presentlaw theories that would provide theoretical bases from which to adequately respond to charity’s participation in tax shelters. in short, charity’s participation in tax shelters violate the private benefit prohibition and the requirement that charity’s actions not contravene established public policy. finally, in part vi, the article acknowledges and then addresses some of the logistical problems that must be overcome before imposing sanctions when charity aids tax shelters. a legislative scheme that implements the theory asserted in this article must ensure that charity is not held vicariously liable for illegitimate tax positions asserted by its trading partners. charity should be held responsible only for its knowing and intentional assistance to tax shelters. on the other hand, a strict knowledge requirement might effectively prevent enforcement against charity, since charity will rarely have sufficient facts from which to conclude that a taxable trading partner will assert an illegitimate tax position made possible by charity’s involvement. the article therefore proposes that charity be made a participant in present law disclosure requirements. certain provisions now exist which require tax shelter promoters, for example, to inform investors or otherwise disclose the fact that certain transactions constitute tax shelters. charity could be made a recipient of such information and required to take certain actions in response to prevent the abuse of an asset, tax exemption, entrusted to its care. overall, then, the article asserts that there is no logical reason why a known participant in tax shelters should be immune from enforcement action. secondly, there are existing theories which address that participant’s role in such transactions in a better way than that which is presently relied upon. finally, the article offers solutions to the logistical objections that might be raised in opposition to the new response to charity’s participation in tax shelters. 774 florida tax review [vol. 4:12 ii. the status quo ante: explicating normative assumptions it seems almost like the ultimate heresy that an entity endowed with a “halo” and, in many instances, a large supply of cash and property already11 exempted from taxation, might willingly participate in tax code manipulations12 more commonly associated with taxable entities, and presently under attack throughout the tax profession. indeed, the phrase “charitable tax shelter”13 11. professor brody points out that society’s treatment of charitable organizations is largely based upon a romanticized view of the nature of charities: so far, charities have enjoyed a “halo effect” in our political economy. the rationalized myth of charities as selfless, donative, and volunteer-run deliverers of services to the poor has never entirely been true, but it underlies society’s grant of tax exemption and tax deductibility for contributions. to the extent, however, that this quid depends on the idealized quo, should charity’s core myth change – in a way that becomes visible to the public – society’s willingness to alter the subsidies could also change. evelyn brody, hocking the halo: implications of the charities’ winning briefs in camps new-found/owatonna, inc., 27 stetson l. rev. 433, 452 (1997). indeed, the analysis and proposal set forth in this article are based upon the view that when charities participate in tax shelter transactions, they expose a side of themselves which contradicts the romanticized view and thereby forfeit the justification for tax exemption. 12. as of september 30, 1999, organizations exempt from federal income tax under irc § 501(c) had $880 billion in gross receipts and $1.3 trillion in total assets. joint committee on taxation, study of present-law taxpayer confidentiality and disclosure provisions as required by section 3802 of the internal revenue service restructuring and reform act of 1998, vol. ii: study of disclosure provisions relating to tax exempt organizations, 21 (2000). of the approximately 1.3 million organizations granted tax exemption under irc § 501(c), “more than half of those organizations, or 776,557 are charitable, educational, religious, and other organizations described in section 501(c)(3).” see id. at 18, 20 (table 1). 13. the clinton administration took up a vigorous campaign against tax shelters in 1999 by way of legislative proposals. see staff of the joint committee on taxation, description of revenue provisions contained in the president’s fiscal year 2000 budget proposal 161-201 (1999). the administration’s fy 2000 proposals were not adopted but were resubmitted as part of the administration’s fy 2001 budget. see fy 2001 budget proposal, supra note 5, at 122-37. a bill designed to attack all forms of tax shelters is pending before congress. see abusive tax shelter shutdown act of 1999, h.r. 2255, 106th cong., 1st sess. (1999). there has also been a rash of administrative guidance regarding tax shelter transactions. see, e.g., rev. rul. 99-14, 1999-1 c.b. 835 (relating to “lease-in, lease out” transactions); regs. § 1.7701(l)-3 (regarding the “step-down-preferred” transaction, discussed in infra notes 22-31 and accompanying text). at the same time, the judiciary has taken a more active role in upholding the disallowance of tax benefits arising from tax shelters. see compaq computer corp. v. commissioner, 113 t.c. 214 (1999); winn-dixie stores, inc. v. commissioner, 113 t.c. 254 (1999); saba partnership v. commissioner, 78 t.c. memo (cch) 684 (1999); acm partnership v. commissioner, 157 f.3d 231 (3rd cir. 1998). a broad and extremely helpful theoretical discussion of tax avoidance in general is contained in joshua d. rosenberg, tax avoidance and income measurement, 87 mich. l. rev. 365 (1988). a contemporary debate regarding tax shelters and the need for remedial legislation can be found in kenneth j. kies, a critical look at the administration’s “corporate tax shelter proposals,” 83 tax notes 1463 (june 7, 1999), joseph bankman, the new market in corporate tax shelters, 83 tax notes 1775 (june 21, 1999), and joseph bankman challenges kies to back up assertions with facts, 83 tax notes 1813 (june 21, 1999). 2001] when charity aids tax shelters 775 seems oddly oxymoronic when one really thinks about it. according to14 contemporary usage, the beneficent, “charity,” is antithetical to the pejorative,15 “tax shelter,” suggesting that the same entity cannot be both charitable and16 engaged in a tax shelter. yet the use of an otherwise legitimate charitable organization for tax avoidance purposes is not unknown to history. so just17 how should tax law respond when charity, the favorite child of the tax code 14. i have not found the phrase in judicial nor scholarly literature. the phrase, “charitable contribution tax shelter” is used and refers to a transaction described in greater detail below. see infra notes 244-54 and accompanying text. 15. “charities had their origin in the great command, to love thy neighbor as thyself.” perin v. carey, 65 u.s. (24 how.) 465, 498 (1860) cited in lars g. gustafsson, the definition of “charitable” for federal income tax purposes: defrocking the old and suggesting some new fundamental assumptions, 33 hous. l. rev. 587, n.38 (1996). in western cultures the term “charity” revolves around judeo-christian notions of “interpersonal activity through which one individual helps a less fortunate one, or more broadly a community rallies to the aid of those of its members in need.” laura brown chisolm & dennis r. young, symposium: what is charity? implications for law and policy (introduction), 39 case w. res. l. rev. 653, 654 (1988-89). in the greek tradition, the term “charity” “focuses on broad-scale contributions to the public infrastructure and to a society’s institutions of education, culture, and other aspects of its general well-being and quality of life.” see id. at 654-55. 16. the phrase, “tax shelter” has not always carried exclusively negative connotations. instead, the phrase “abusive tax shelter” has been used to connote illegitimacy. nonabusive tax shelters involve transactions with legitimate economic reality, where the economic benefit outweigh the tax benefits. such shelters seek to defer or minimize taxes. abusive tax shelters involve transactions with little or no economic reality, inflated appraisals, unrealistic allocations, etc., where the claimed benefits are disproportionate to the economic benefits. such shelters typically seek to evade taxes. roscoe l. egger, warning: abusive tax shelters can be hazardous, 68 a.b.a. j. 1674 (1982). “it should, but may not, go without saying that the term ‘tax shelter’ is not, in essence one that should have any inherent pejorative connotations. . . . an abusive tax shelter, on the other hand, is formed primarily to obtain tax benefits without regard to the economic viability of the investment.” robert a. weiland, tax-exempts and tax shelters: should the same person invest in both?, 34 cath. u. l. rev. 101, 101 n.3 (1984). today, the term “tax shelter” connotes illegitimacy, even to those who recognize that certain transactions may be legitimate only because of the tax benefits obtained thereby. see, e.g., arthur b. willis, et al., partnership taxation ¶ 19.01[2] (6 ed. 1997). (“although the term ‘tax shelter’ has acquiredth an aura of opprobrium, not everything that falls within the description of a tax shelter is disgraceful.”) 17. see, e.g., smith v. commissioner, 50 t.c. memo (cch) 1444 (1985) (georgetown university entered into a purported partnership in order to generate tax losses for taxable limited partners); grove v. commissioner 490 f.2d 241 (2nd cir. 1973) (taxpayer’s contribution of stock in his wholly owned corporation to charitable organization was followed shortly thereafter by complete redemption of contributed stock, resulting in a charitable contribution deduction from the use of untaxed funds). in grove, the taxpayer was successful in employing the charity “as a tax-free conduit for withdrawing funds from the corporation” for his personal use without incurring tax liability. see id. at 242. 776 florida tax review [vol. 4:12 after all, participates in a transaction that might reasonably be described as a18 tax shelter? certain normative assumptions important to the resolution of that question should first be made explicit. first, reasonably informed taxpayers can generally agree on what constitutes a “tax shelter,” even if a universal definition remains elusive. it is tempting to leave the issue at that, but my purpose is to19 18. in addition to exemption from income tax under irc § 501, charities enjoy contributions deductible under irc § 170, access to below market rate financing under irc §§ 145-50, exemption from certain employment taxes under irc § 3306(c)(8), and preferential treatment with respect to pension plans under irc § 403(b). 19. “there is no consensus definition of a ‘tax shelter’ in the law or legal literature.” calvin h. johnson, what is a tax shelter?, 68 tax notes 879 (aug. 14, 1995). professor johnson’s “favorite” definition of a tax shelter is “an investment that is worth more after tax than before tax.” see id. at 883. professor bankman agrees that there is no precise definition of tax shelter. see bankman, supra note 12, at 1776. instead, he describes characteristics commonly associated with tax shelters: in general, however, a tax shelter is marked by the following characteristics: (1) the shelter provides a certain tax loss for an investment with little or no risk of economic loss; (2) the shelter involves a domestic corporation and a person in the zero tax bracket. most commonly, the zerobracket taxpayer is a foreign person not subject to u.s. tax, but native american tribes, domestic companies with unusable net operating losses, and exempt organizations have also been used as zero-bracket taxpayers; (3) the shelter often takes advantage of a flaw in the tax law that allocates income in excess of economic income. the over-allocated income is absorbed by the zero-bracket taxpayer, leaving the domestic corporation with a loss in excess of economic loss; (4) shelters that do not take advantage of the flaw described in (3), above, play on structural flaws involving the taxation of corporate or partnership income, or the interaction of the u.s. tax system with foreign tax systems; (5) the shelter is not designed solely for use by any specific taxpayer but instead marketed to fortune 500 companies and large closely-held concerns; and (6) the shelter is likely to be shut down by legislative or administrative change soon after it is detected. see id. at 1777. the elusiveness of definition may be waning, however. the two legislative proposals adopt the essence of professor johnson’s preferred definition and professor bankman’s description: a corporate tax shelter would be an entity, plan, or arrangement . . . in which a direct or indirect corporate participant attempts to obtain a tax benefit in a tax avoidance transaction. a tax benefit would be defined to include a reduction, exclusion, avoidance, or deferral of tax, or an increase in a refund, but would not include a tax benefit clearly contemplated by the applicable provision . . . . a tax avoidance transaction would be defined as any transaction in which the reasonably expected pre-tax profit (determined on a present value basis. . .) of the transaction is insignificant relative to the reasonably expected net tax benefits (i.e., tax benefits in excess of the tax liability arising from the transaction, determined on a present value basis) of such transaction. a financing transaction would be considered a tax avoidance transaction if the present value of the tax benefits of the taxpayer to whom financing is provided are significantly in excess of the present value of the pre-tax profit or return of the person providing the financing. fy 2001 budget proposal, supra note 5, at 124. the abusive tax shelter shutdown act of 1999 would have defined a tax shelter essentially as any transaction, not resulting in a 2001] when charity aids tax shelters 777 construct a prototype for responding to charities that participate in tax shelters. it is therefore necessary to define that which charity should eschew. as a theoretical matter, a tax shelter is a transaction or series of transactions20 whereby a taxable participant, usually with the help of a charity or other zerobracket taxpayer, creates the appearance of a status or the illusion of behavior without actually achieving that status or engaging in that behavior. as a21 meaningful change in the taxpayer’s economic position, in which the present value of the reasonably expected income is insubstantial in relationship to potential tax benefits. h.r. 2255, 106th cong., 1st sess. (1999). “in a financing transaction, any deduction claimed with respect thereto must not be significantly in excess of the economic return for such period realized by the person lending the money or providing the financial capital.” see id. the bill makes the presence of a zero-bracket taxpayer and the over-allocation of loss evidence of a tax shelter transaction. see id. 20. the definition about to be offered is useful in explaining the intended result of a tax shelter, but i later settle upon the more functional definitions offered by johnson and bankman, since those describe the qualities indispensable to the theoretical definition in a practically useful manner. see infra note 224. 21. see hariton, supra note 3. see also rosenberg, supra note 12. professor rosenberg’s twelve year old article demonstrated an amazing degree of prescience and analytical acuity with regard to tax shelters. his thesis is essentially as follows: the tax code imposes taxes and grants tax benefits by reference to distinct transactions. that is, the completion of a particular transaction signals the accretion of economic wealth, the attainment of a particular status, or the engaging in of a particular behavior to which tax consequences then attach. but it is not the transaction, per se, that defines or measures income. instead, income is measured by the underlying economic accretion, status or behavior. accurately measuring those underlying factors would be far too difficult. transactions (i.e., realization events) are therefore looked upon as easily observable substitutes for accurate measurement. thus, transactions provide reliable indication that a certain accretion or status has been achieved, or that a certain behavior has occurred, and should at that point result in tax consequence. reliable yes, foolproof no. though actually occurring (i.e., not a sham), a transaction does not always accurately reflect or signal the accretion, status or behavior which ultimately measures income. transaction taxation forfeits a degree of accuracy in favor of administrative convenience. to the extent that a transaction, though used as the signal for a certain tax consequence, is not coterminous with the accretion, status, or behavior it is thought to indicate, tax avoidance is possible since the completion of the transaction is nevertheless presumptively viewed as the achievement of the accretion, status or behavior. see id. at 365-384, 445-474. professor rosenberg argued that defining tax avoidance (which is, in this context synonymous with tax shelter) by reference to whether tax profit – i.e., the increase in wealth resulting solely from a reduction in tax liability – outweighs economic income is inadequate because there are many provisions that encourage taxpayers to enter into transactions that result primarily in tax profit. see id. at 443. the legislative proposals account for this possibility either by specifically exempting those particular provisions, in the case of the abusive tax shelter shutdown act of 1999, or, in the case of the clinton proposal, broadly exempting those provisions designed to encourage such transactions. see supra note 9. the clinton administration proposal is thus closer to rosenberg’s definition, although rosenberg’s has the advantage of elasticity. it may be that tax shelters are properly defined solely by reference to the pursuit of profit, as necessarily implied by the legislative proposals. in case it is not, though, rosenberg’s definition is applicable to the possible existence of a tax 778 florida tax review [vol. 4:12 practical matter, the transaction technically meets the requirements of a statute that grants a tax benefit but it does not compose the economic substance underlying the statute. the lack of economic substance, then, is a convenient and fairly accurate signal of a tax shelter transaction. the opposite result also22 constitutes a tax shelter. that is, a tax shelter occurs when a taxpayer disguises its actual status or behavior. in either case, the taxpayer then claims the tax benefit – i.e., a deduction, exclusion, credit, or “any other tax consequence that may reduce a taxpayer’s federal income tax liability by affecting the timing, character or source of any item of income, gain, deduction, loss or credit” –23 meant for taxpayers actually occupying, engaging in, or avoiding the intended status or behavior. the familiar step-down preferred transaction provides a ready example. the transaction involves a taxable corporation that forms a real24 estate investment trust (reit). the reit issues common stock to the25 corporate sponsor and “fast-pay” preferred stock to an exempt organization.26 each stockholder pays $1000 for its stock. the exempt organization’s stock calls for preferred dividends at above market rates for a relatively short period of time. with the cash transferred in exchange for the common and preferred stock, the reit makes a $2000 low-risk qualified investment yielding just enough to pay the dividends on the preferred stock. the aggregate dividends paid to the exempt organization are equal to its initial capital investment, plus a better than market return on capital. the result, economically, is the27 preferred stockholder’s fast recovery of capital and earnings, hence the term “fast-pay.” thereafter, preferred dividends are reduced to zero percent and the terms of the original issue allow for redemption of the preferred stock at its then low market value. although the exempt organization’s contribution seems more shelter which does not involve a clear lack of profit motive. 22. hence, professor’s johnson and bankman’s definitions, supra note 19, have greater practical utility than professor rosenberg’s theoretical articulation. 23. regs. § 1.6111-2t(b)(1). 24. the following example is based upon that set forth by the treasury department. see the problem of corporate tax shelters, supra note 8, at 149-51. the “step-down preferred” is also known as “fast-pay” and is described in bankman, supra note 13, at 1779. 25. a reit is essentially an investment entity formally taxed like a c corporation, but in computing its taxable income the reit may deduct amounts paid as dividends. the general result is that the reit avoids the corporate level tax. irc §§ 856-59. for readers who want to know more about the complicated provisions pertaining to reit’s, see peter m. fass, et al., tax aspects of real estate investments § 3.04 (1997). 26. the exempt investor is most likely to be a pension or profit sharing plan, rather than a charity, although large educational institutions exempt from tax under irc § 501(c)(3) often hold stock in reits. the transaction would not differ, though, whether the exempt investor were a charity or a pension or profit sharing plan. 27. charities act as “accommodation parties who are paid a fee or an above-market return on investment for the service of absorbing taxable income or otherwise ‘leasing’ their taxadvantaged status.” the problem of corporate tax shelters, supra note 8, at 17. 2001] when charity aids tax shelters 779 like a self-amortizing loan (i.e., debt,) and the “dividend” payments more like28 payments against principle and interest, the exempt organization is indifferent to the classification of the payments as “dividends” because it pays no tax in any event. the taxable corporation, on the other hand, prefers the dividend classification because the reit receives a dividend paid deduction and thus29 eliminates income otherwise taxable at normal corporate rates. the foregone30 corporate tax would have reduced the amount later distributed to the common shareholder. in the meantime, the value of the corporation’s common stock appreciates (because the preferred stockholder’s relative ownership in the reit’s $2000 investment decreases as dividends are paid) and, by liquidating the reit after causing the redemption of the preferred stock, the corporation31 realizes that appreciation without any tax liability. the step-down preferred32 constitutes an easily recognizable tax shelter under our theoretical definition because the taxable corporation successfully disguised its true status of debtor and was thereby able to deduct what was essentially both principal and interest payments on a loan from the exempt organization.33 the second normative assumption is that tax shelters cause harm to a tax system characterized by self-assessment and dependent upon a shared sense of fairness. to the extent the grant of a tax benefit is intended to accurately34 28. “the fast-pay preferred stock performs economically much like 10-year, selfamortizing debt instrument. that is, payments on the fast-pay preferred stock reflect in part recoveries of the amount originally invested by the exempt participants and in part a market yield on the unamortized portion of the original investment. the economic self-amortization of the fast-pay preferred is conceptually inconsistent with characterizing the full amount of each payment as a ‘dividend’ (and thus income on an investment).” notice 97-21, 1997-1 c.b. 407. “the net effect of the transaction was to borrow [cash] from the zero-braket taxpayer and to pay off that taxpayer over ten years, a transaction economically equivalent to a 10-year selfamortizing loan.” bankman, supra note 13, at 1779. 29. see irc § 857(b)(2)(b). 30. see irc § 857(a)(1). 31. the redemption essentially takes the form of the exempt holder selling all of its stock back to the reit. see irc § 302(b)(3). 32. see irc § 337(a) (providing that no gain or loss is recognized to the sole corporate parent upon distributions made in complete liquidation). 33. upon learning of the transaction, the service took steps to prevent such results in the future. it first issued notice 97-21, in which it stated its intention to treat the transaction essentially as a debtor-creditor relationship between the two shareholders. see notice 97-21 1997-1 c.b. 407. the service later issued comprehensive regulations discussing the manner in which the transaction would be recharacterized to deny the sought after status and accompanying tax benefits. regs. § 1.7701(l)-3. 34. it is almost universally agreed that perception, per se, (quite independent of reality) of inequity in the tax code is harmful. in his famous treatise, henry simons stated: so, in the study of policy, it is proper to focus attention especially upon those shortcomings of tax methods which give rise to opportunities for systematic evasion. the taxpayer will frequently be able, without impairing his income much, if at all, to order his affairs in such manner as to take advantage of imperfections in the tax system. where such opportunities are numerous and are open to many taxpayers, fiscal machinery is seriously defective. nor are the unfortunate consequences merely those of the 780 florida tax review [vol. 4:12 measure taxable income, or at least what is within the code’s definition of income at the present moment, and thus tax liability, the illegitimate taking of35 that benefit distorts the measurement and contributes to a perception that some taxpayers pay less than their fair share. when tax law inadequately responds36 to that perception, it undermines the voluntary self-assessment and sense of fairness upon which it is dependent. the failure to adequately respond to a tax37 shelter transaction inevitably erodes the tax base. similarly situated taxpayers38 will likely structure transactions using the tax shelter technique, for to do moment. as evasive practices become more and more widespread and reach the attention of the community at large, the task of administration becomes increasingly difficult, merely because of changes in attitudes of persons as taxpayers . . . . administrators may not concern themselves greatly about considerations of justice; but they should be vitally concerned as to whether levies like the income tax are generally felt to be clearly inequitable. this feeling, we venture, is more likely to arise where persons are seen to pay very different taxes for no good reasons. henry c. simons, personal income taxation, 108-09 (1938). 35. certain concessions in the definition of income, such as the deduction provided under irc § 162 for ordinary and necessary business expenses, are made because they account for costs incurred by the taxpayer in earning or producing income and thus decrease income. stanley s. surrey and paul r. mcdaniel, tax expenditures 186-87 (1985). other concessions are made as an indirect form of government spending to achieve a government objective related to a taxpayer’s status or behavior. see id.; staff of the joint committee on taxation, estimates of federal tax expenditures for fiscal years 2000-2004, reprinted in 86 tax notes 103, 104 (jan. 3, 2000). 36. one contemporary writer, however, argues that attempting to tailor the code so that taxpayers believe it to be fair is nothing more than a silly waste of time, and perhaps actively harmful, since public opinion regarding the code is largely based upon “fiscal illusion.” daniel n. shaviro, uneasiness and capital gains, 48 tax l. rev. 393, 415 (1993). the argument seems to be that public perception be damned if the tax is, in truth, efficient from an economic perspective. see id. at 416. although it is tempting to confront the argument, my purpose here is merely to set forth generally agreed upon assumptions. suffice it to say that professor shaviro’s views are not generally accepted. 37. “[t]he viability of our tax administration system depends to a great extent on taxpayers’ perceptions that the system is fair and equitable and is administered in a fair but firm manner. when abusive, illegal, and fraudulent tax shelters are openly touted as proper investments, public confidence in the tax system declines rapidly, producing the likelihood of reduced revenues and voluntary compliance and all that that implies.” see egger, supra note 15, at 1675. 38. see id. 2001] when charity aids tax shelters 781 otherwise would result in an unfair tax burden. the harm caused by tax39 shelters is therefore a compounding one.40 the third normative assumption, and one which is most relevant to the present discussion, is that the existence of charities and the grant of tax exemption to such entities is invariably beneficial and, unlike tax shelter transactions, results in neither unfairness nor erosion of the aggregate income pool from which taxes are levied. that is, the charitable tax exemption does41 not decrease the aggregate wealth that ought to be available for public use nor impede any of the several debated goals of taxation. thus, if haig-simons income is the ideal tax base and is defined as the algebraic sum of consumption 39. fairness is normally measured by reference to “horizontal” and “vertical” equity. see generally louis kaplow, horizontal equity: measures in search of a principle, 42 nat’l tax j. 139 (1989). horizontal equity is said to embody the command that “equals be treated equally.” see id. vertical equity embodies the notion that the law make appropriate distinctions, i.e., impose different but relatively appropriate tax burdens, between unequals. see id. at 141. the problems, of course, are first in determining when two taxpayers are equal, and second, determining whether and when social justice overrides the constraint to treat equals identically and unequals differently. the text uses “unfair burden” to refer to the imposition of higher taxes on two taxpayers identical in all aspects with the exception that one engages in a tax shelter. 40. the department of treasury states: corporate tax shelters breed disrespect for the tax system – both by the people who participate in the tax shelter market and by others who perceive unfairness. a view that well-advised corporations can and do avoid their legal tax liabilities by engaging in these tax-engineered transactions may cause a “race to the bottom.” if unabated, this could have long-term consequences to our voluntary tax system far more important than the shortterm revenue loss we are experiencing. the problem of corporate tax shelters, supra note 8, at iv. 41. this conclusion is as much a result of serious tax philosophy as it is a function of the romanticized notion of charity. see brody, supra note 11, at 425-53. tax expenditures, for example, are defined by reference to the “normal income tax structure,” a statutory term of art based on the “ideal tax base,” and the notion that any tax exclusion, exemption or deduction represents a departure from the ideal tax base. see surrey & mcdaniel, supra note 35, at 184-88; staff of the joint committee on taxation, supra note 35, at 104. the ideal tax base is essentially defined as all increases in wealth during an annual period, whether immediately consumed or stored for later consumption. see surrey & mcdaniel, supra note 35, at 186. thus, employerprovided educational benefits represent a portion of the ideal tax base, and the exclusion of those benefits under irc § 127 represents a tax expenditure and therefore a departure from the ideal tax base. see staff of the joint committee on taxation, supra note 35, at 105. significantly, the grant of tax exemption is not considered a tax expenditure, suggesting that foregoing tax on charitable institutions does not represent a departure from the normal tax base. see staff of the joint committee on taxation, supra note 35, at 107. surrey & mcdaniel, however, assert that the grant of tax exemption should be viewed as a tax expenditure for two reasons. first, some “charities” (hospitals, in particular) operate just like taxable corporations. surrey & mcdaniel, supra note 35, at 219. that argument is legitimate, but it really addresses the need to redefine charity, not whether a charity has income in the haig-simon sense. the second argument is that charities subsidize private consumption. see id. at 219-20. that is essentially an argument for taxing those who ultimately exercise private consumption, not one which proves that charities exercise rights of private consumption. 782 florida tax review [vol. 4:12 plus the increase in the value of stored rights (hoarding), a charitable42 organization has no income. in the haig-simons formulation, consumption43 and hoarding imply the exercise of rights in property to the exclusion of all others. consumption, in particular, refers to private use or appropriation, a44 removal of valuable rights from the public domain. a charitable organization45 is essentially a public body and therefore engages in no instances of private consumption or hoarding. which is to say, a charitable organization neither consumes nor hoards in the haig-simons sense. it is axiomatic, too, that46 charitable tax exemption is inconsistent with private “ownership” of valuable rights or the appreciation therein. instead, rights to capital and appreciation are47 held in public trust. tax exemption for charitable organizations, then, takes nothing from the ideal tax base. furthermore, the normative tax rate is one which increases with income (i.e., progressive taxation), based on one of two theories revolving around the idea of wealth redistribution. the first is the notion that those who derive the most benefit from society should pay the most. the second is that the burden of taxation should be equally felt amongst taxpayers. thus, more tax is exacted from higher income taxpayers in order that they will feel the same burden as a taxpayer who pays less tax but who also has less income to spare. if follows48 from both theories that those who derive the least benefit should pay the least. those who derive no benefit from society at all, but universally provide benefit to society, ought to pay no formal tax. stated with reference to the overall redistributive goal of taxation, a charity redistributes income from individuals 42. the haig-simons definition of income is generally viewed as the ideal definition. see victor thuronyi, the concept of income, 46 tax l. rev. 45 (1990). the formulation was first articulated by henry simons, but the definition is referred to as “haig-simons” to acknowledge the prior contribution of robert haig. see id. at 46. see also simons, supra note 34, at 61. 43. in fact, the exemption from tax provided in irc § 501(c) is not considered a tax expenditure. see staff of the joint committee on taxation, supra note 35, at 107. (“in general, the imputed income derived from [charitable] activities conducted by individuals or collectively by certain nonprofit organizations is outside the normal income tax base.”). 44. see simons, supra note 34, at 49, 89. 45. see id. 46. professor thuronyi extends this rationale to all entities, arguing that only individuals can have income and that “[a] corporation cannot have income, any more than it can have a blood type.” see thuronyi, supra note 41, at 78. the distinction, though, between taxable and tax-exempt corporations is that a taxable corporation exercises dominion to the exclusion of the public (i.e., consumption) even without later consumption by individuals. charity (i.e., a taxexempt corporation) cannot exercise rights in consumption since it cannot hold property to the exclusion of public use. 47. see evelyn brody, agents without principals: the economic convergence of the nonprofit and for-profit organizational forms, 40 n.y.l. sch. l. rev. 457, 466 (1996). 48. see generally, jeffrey a. schoenblum, tax fairness or unfairness? a consideration of the philosophical bases for unequal taxation of individuals, 12 am. j. tax pol’y 221 (1995). identifying and attacking the different justifications for the use of progressive tax rates. 2001] when charity aids tax shelters 783 to other individuals. charity exists in a quasi-governmental role to “pass-thru”49 wealth from the individual to the public, albeit informally instead of through50 the formal government treasury. therefore its exemption from the formal income tax neither erodes the tax base nor otherwise harms the public wealth. the public loses nothing and nobody bears an unfair burden by exemption from taxation granted to charitable entities. an historical case study suffices to put a fine point on the issue and inform our further discussion. in commissioner v. brown, representatives of51 a charity devoted to cancer research approached clay and dorothy brown with a proposition to buy the browns’ lumber mill corporation. at the time, the52 browns had neither the intent nor desire to sell their business. after being53 informed of the significant tax savings that could be had by use of a “bootstrap sale”–information developed and provided by the charity’s board chairperson,54 –the browns agreed to sell the business. the charity purchased all the stock owned by the browns in the lumber business and liquidated the corporation. the charity sold a portion of the corporation’s assets and paid a small down payment to the browns from the proceeds. the balance was represented by a55 ten year, non-interest bearing note which, in turn, was secured by a mortgage on the remaining assets. the charity then leased the remaining assets to a56 newly formed corporation that continued the lumber mill business (in the same building and with the same personnel as before the transaction) under a management contract allowing the original sellers to act as general manager for the full term of the lease. the lease payments amounted to 80% of the profits57 derived from the lumber business. the charity, in turn, paid 90% of those lease58 payments over time to the original sellers as payment on the ten-year note. the59 charity was not at any risk beyond the lease payments derived from the new corporation. using the installment method, the sellers successfully reported a portion of each payment as long term capital gain. thus, while continuing to60 own all but title with respect to the property, the sellers were able to withdraw 49. this does not mean that charities necessarily redistribute wealth from rich persons to poor persons. for example a tax exempt-corporation organized for the arts redistributes wealth from personal consumption to a different type of consumption, largely for the benefit of those in the upper economic classes. 50. the individual’s formal tax liability is likewise decreased as a result of her provision of benefit to society, payable via charity. see irc § 170. 51. 380 u.s. 563 (1965). the facts discussed in the text are taken from the tax court opinion. 52. see brown v. commissioner, 37 t.c. at 461, 464 (1961). 53. see id. at 464-65. 54. see id. at 465. 55. see id. at 472, 474. 56. see id. at 472-73. 57. see id. at 475-76. 58. see id. at 475, 477. 59. see id. at 477. 60. see id. at 482. 784 florida tax review [vol. 4:12 earnings over a ten-year period and have those earnings taxed at preferential capital gain rates, and all at the initiation of the charitable organization. that61 is, the brown’s were able to assume the appearance of having completed a recognition event – a sale – with respect to a capital asset, without actually engaging in that behavior. the familiar story would not be complete without62 noting that at the end of the ten year period, the charity would own the lumber business without ever having paid any of its own funds. it could then liquidate the business completely and apply the proceeds towards cancer research. the successful conduct of the bootstrap sale in clay brown exemplifies the first two assumptions and creates a serious challenge to the third. even during its heyday, the charitable bootstrap was candidly recognized as a tax shelter. the supposed harm was the conversion of what should have been treated as ordinary income into capital gain income. given an understanding63 of the policy underlying the capital gains preference, it is easy to see how the taking of the capital gains benefit in the bootstrap transaction distorts the ideal tax base. the capital gains tax rate is designed principally to alleviate two problems. the first, bunching, refers to the realization in one year of appreciation occurring over several years and thereby requiring a taxpayer to pay tax at a suddenly higher rate than that which is accurate, assuming a taxpayer’s average rate over time is most accurate. the reduction in tax rate64 for capital gain is said to alleviate that sudden spike and thereby ameliorate 61. see id. at 483-84. 62. that the supreme court eventually upheld the transaction as a true sale does not negate the conclusion that the transaction amounts to a tax shelter under the definition adopted in this article. see supra notes 19-23 and accompanying text. indeed, one of the requirements for a tax shelter transaction is that the taxpayer successfully attain the label attached to a transaction without actually achieving the underlying status or engaging in the behavior for which the label is a convenient shorthand and to which the tax benefit attaches. see id. in fact, contemporary judicial opinions and legislative proposals acknowledge, explicitly or implicitly, that a taxpayer has actually engaged in a transaction, the label of which triggers tax benefit. contemporary judicial opinions and legislative proposals go further by disallowing the tax benefit when the transaction, or the label thereof, does not accurately signal the achievement of a status or the engagement in a certain behavior to which the sought-after tax benefit attaches. see supra note 12 and the cases and legislative proposals cited therein. 63. writers of the era generally agreed that achieving a “sale” transaction in such cases was misleading to the extent such achievement triggered the benefits of capital gains taxation. see james a. moore & david h.w. dohan, sales, churches, and monkeyshines, 11 tax l. rev. 87, 87 (1955-56); geoffrey j. lanning, tax erosion and the”bootstrap sale” of a business, 108 u. pa. l. rev. 623, 623 (1960). even contemporary authors note that a “sale” was achieved, but in name only. see suzanne ross mcdowell, taxing leveraged investments of charitable organizations: what is the rationale?, 39 case w. res. l. rev. 705, 709 (1988-89) (“the seller treated the sale price as a capital gain, and continued to operate the business.”). but, as discussed below, the harm was not embodied in the conversion of ordinary income to capital gains income, since that result is condoned by congress and could be achieved without charity’s involvement. see infra notes 69-76 and accompanying text. the real harm was the avoidance of the corporate level tax on income earned at the corporate level. see id. 64. see noel b. cunningham & deborah h. schenk, the case for a capital gains preference, 48 tax l. rev. 319, 328-330 (1993). 2001] when charity aids tax shelters 785 whatever unfairness results from progressive taxation. lock-in is closely65 related and refers to the disincentive to engage in a sale or disposition of a capital asset because the nonrecurring gain will result in a sudden increase in tax liability. the lock-in concern is broader, though, in that it references not only66 the burden on the individual taxpayer, but society as well. society is burdened by the immobility of capital from one investment to another caused by the high tax “exit fee.” the reduction in tax rate for capital gain is said to alleviate that67 societal burden. thus, the capital gain tax rate is conditioned upon the actual divesting of capital from its owner and the owner’s severing and taking the appreciation therefrom. in a charitable bootstrap transaction, the progressive tax rates are compromised to the seller’s benefit, but the societal benefit from that compromise is nonexistent or is at best deferred for some years after the progressive rates are relaxed. the seller neither realizes unexpected “bunched” gain justifying the deviation from progressive rates, nor has she forsaken the lock-in phenomenon and its negative effects on society.68 but the seller’s taking of the capital gains preference is not a harm unique to charity’s involvement in the transaction. the seller could have69 legitimately obtained that benefit without charity’s involvement. which is to say that whatever distortion results from the capital gains preference is one which congress allows without regard to whether the buyer is a charitable organization. nothing prevented the seller from taking a note from a taxable70 buyer and reporting the taxable portion of each payment as capital gain, while also continuing to manage the company under a management agreement.71 indeed, the law seems to explicitly authorize the purchase of a business using earnings from that business, and the seller’s treatment of the proceeds as gain from a capital asset. hence, charity is not engaging in a tax shelter to the72 65. see id. 66. see cunningham & schenk, supra note 64, at 344-351. 67. see id. 68. see lanning, supra note 63, at 693-697. 69. this point seems lost in much of the literature. much of the literature assumes the harm to be manifested by the seller’s conversion of what looks like ordinary income – the corporate profit ultimately used to finance the purchase – into capital gain. see lanning, supra note 63, at 692-697; see also moore & dohan, supra note 63; note, bootstrap acquisitions: the next battle, 51 iowa l. rev. 992 (1966). 70. scholars readily admit the unstable theoretical basis upon which a capital gains preference rests. see, e.g., cunningham & schenk, supra note 64, at 320. 71. seller could sell the stock in his corporation to buyer and buyer could give seller a note for the purchase price with the intent to pay the note from corporate distributions. see william h. kinsey, bootstraps and capital gain – a participant’s view of commissioner v. clay brown, 64 mich. l. rev. 581, 582. seller could treat the profit as capital gain even though the payments are made from ordinary corporate profit. see id. 72. for a modern discussion of the legitimate use of bootstrap sales, see robert i. keller, returning to form: untangling the tax jurisprudence of bootstrap acquisitions, 16 va. tax rev. 557 (1997). one accepted bootstrap sale involves a buyer who forms a corporation. the new corporation buys the stock of a target corporation, making a small down payment and giving a note for the remainder. the purchasing corporation liquidates the target corporation and takes the assets with no tax consequences and a carryover basis. see irc § 332; irc § 334. the 786 florida tax review [vol. 4:12 extent the seller achieves capital gains treatment. however much a misnomer the term “sale” is with regard to the bootstrap transaction, congress intended to treat the transaction as such and to grant the capital gains preference in response. in cases not involving a charitable buyer, however, the proceeds by73 which the seller provides financing are first subjected to ordinary tax as profit earned at the corporate level. a corporation may thus finance the purchase of74 its own stock, but only with money previously taxed at ordinary rates. the shelter and, in fact, the harm unique to charity’s participation in bootstrap transactions is the disguising of corporate profit, from which a tax is normally extracted and financing is later provided. charity helps make it appear that earnings never arrive in corporate solution but instead the corporation is merely distributing previously taxed capital. the seller is thereby able to provide75 financing (which ultimately redounds to the seller’s benefit) using untaxed profit. charity has thus aided in disguising the corporation’s realization of76 profit. it wasn’t just miserly government tax collectors who recognized harm caused by the charity’s knowing involvement in clay brown. congress,77 78 liquidating corporation will have no gain from the distribution. see irc § 337. the new corporation uses the income from the operation of the liquidated corporation’s previous business to pay the remaining purchase balance in installments. the seller gets capital gain treatment, while the sole shareholder of the new corporation avoids current tax liability on the proceeds used to purchase liquidating corporation. see kinsey, supra note 71, at 581-82. 73. which conclusion serves only to bolster arguments that the capital gains preference cannot be theoretically justified. see generally, cunningham & schenk, supra note 64. 74. see keller, supra note 72, at 562-567. 75. the amount paid to charity as rent in a charitable bootstrap transaction is deducted against earnings, resulting in little or no corporate level tax. 76. cf. grove v. commissioner 490 f.2d 241, 246-47 (2nd cir. 1973) (taxpayer was successful in employing the charity “as a convenient conduit for withdrawing funds from the corporation for his personal use without incurring tax liability.”). 77. the government suspected but ultimately misperceived the real harm in clay brown. the real thrust of the opinion in clay brown was not that the charity did not cause any harm. rather, the seller could have obtained capital gains treatment with the same transaction but without charity’s involvement. the government misperceived the harm and therefore sought an inappropriate remedy. see commissioner v. brown, 380 u.s. at 563, 579 (1965). the court stated “the commissioner’s position here is a clear case of overkill if aimed at preventing the involvement of tax-exempt entities in the purchase and operation of business enterprises . . . . and if the commissioner’s approach is intended as a limitation upon the tax treatment of sales generally, it represents a considerable invasion of current capital gains policy.”. see id. 78. the congress expressed general disapproval of such transactions prior to clay brown. the legislative history regarding the revenue act of 1950 suggested the general impropriety of a charity’s participation: there are three principal objections to the lease-back arrangements where borrowed funds are used. first, the tax-exempt organization is not merely trying to find a means of investing its own funds at an adequate rate of return but is obviously trading on its exemption, since the only contribution it makes to the sale and lease is its tax exemption. therefore, it appears reasonable to believe that the only reason why it receives the property at no expense to itself is the fact that it pays no income tax on the rentals received. 2001] when charity aids tax shelters 787 courts, commentators and even charities candidly understood the charity to79 80 be aiding and abetting in a malevolent transaction and yet the charity suffered no penalty. consider the following remarks made by one writer of the time: in effect charity is selling a portion of its tax exemption. that is particularly apparent where an excessive price can be proved to the court. of course, the income available to pay the notes is much larger if it is tax-free, and the high price was set because it was anticipated that feeder would be held exempt by virtue of nominally paying its income over to charity. even where an excessive price cannot be proved, there is the very substantial advantage of more secure and more rapid payment of the notes out of tax-free income. during the whole period of the pay-off to owner, funds which were given tax exemption so that they could be used for charitable and public purposes are going directly into owner’s pocket. and the tax advantages of having made a “sale” are granted on the assumption that there has been a substantial present change in owner’s economic relationship to the business. but owner continues to run the business and the second objection to the lease-back is that it is altogether conceivable that if its use is not checked, exempt organizations may own the great bulk of commercial and industrial real estate in the country. this, of course, would lower drastically the rental income included in the corporate and individual income-tax bases. a third reason for proposing the taxation of lease-backs is the possibility which exists in each case that the tax exempt organization has in effect sold part of its exemption. s. rep. no. 81-2375, at 31 reprinted in 1950 u.s.c.c.a.n. 3053, 3084. the revenue act of 1950 resulted in the enactment of the “business lease” provision. see irc § 514 (1954). in general, that provision taxed as unrelated business income rentals received from property if the property was financed with borrowed funds. a significant exception, however, applied if the lease term was for five years or less (the short term lease exception). see irc § 514(c)(1) (1954). thus, charities continued to obtain the benefits of clay brown transactions for themselves and owners of taxable business simply by limiting the lease term to five years or less. see mcdowell, supra note 63, at 710-11. in finally closing the short term lease loophole, the congress stated: during the past several years a device has been developing which exploits weaknesses in the taxation of unrelated business income of taxexempt organizations. the net effect is the use of the tax exemption to reduce taxes for owners of a business by converting ordinary income to capital gain and eventually to the acquisition of the business by a tax-exempt organization entirely out of the earnings of that business. s. rep. no. 91-552, at 62 (1969), reprinted in 1969 u.s.c.c.a.n. 2027, 2091. 79. see commissioner v. brown, 380 u.s. 563 (1965). 80. see kinsey, supra note 70 (author, counsel to the taxable participant in clay brown, nevertheless acknowledges that charity’s involvement should be addressed); note, tax problems of bootstrap sales to exempt foundations: a comprehensive approach, 18 stan. l. rev. 1148 (1966); note, bootstrap acquisitions: the next battle, 51 iowa l. rev. 992 (1965-66); note, a charitable armageddon: commissioner v. clay brown, 13 u.c.l.a. l. rev. 167 (1965-66). 788 florida tax review [vol. 4:12 to receive its profits much as he always did. in brief, it can only be the public who ultimately pays for the pleasant arrangement between charity and owner.81 the universal though not quite accurate recognition of harm caused82 by the “selling” of the tax exemption thus brings into focus justice harlan’s question asked in response to the clay brown transaction: why not attack the exemption? it is, of course, precisely the tax exemption and charity’s willing83 participation that made possible the transaction. and by contemporary thought, the presence of charity in what seems or proves to be a nonsensical transaction is considered evidence that the transaction is a tax shelter. given universal84 recognition of fundamental harm and charity’s responsibility therefor, is the present approach sufficient? is it sufficient that what might be viewed as theft of public wealth is rectified by the mere recouping of that benefit from the85 taxable party, while the charitable citizen who aided and abetted in that theft simply walks away untouched by any consequence? it might be argued that86 charity’s intention to devote whatever gain arises from the transaction to charitable purpose justifies the lack of any real imposition – a sort of ends justifying the means argument. or should the grant of tax exemption be viewed as the public’s expression of an almost religious faith, to be violated only on pains of substantial penalty? and if the latter approach is preferable, how shall the penalty be administered? how can such a prohibition be practically enforced 81. see lanning, supra note 63, at 637. the author’s reference to a “feeder” concerns an organization that engaged in a regular commercial enterprise but, under prior law, was exempt from taxation because all of its income was dedicated to charity. see, e.g., roche’s beach, inc. v. commissioner, 96 f.2d 776 (2nd cir. 1938) (holding that the corporation which operated a beach resort was tax-exempt since all of its income was paid to a charitable foundation). a “feeder” organization is no longer entitled to tax exemption. see irc § 502. 82. the writer focuses on the seller’s treatment of the proceeds as capital gains and ignores the avoidance of the corporate level tax. we have seen that the real harm attributable to charity’s involvement was the avoidance of corporate tax. see supra note 69-78 and accompanying text. 83. see brown, 380 u.s. at 580. 84. see the problem of corporate tax shelters, supra note 8, at 16-17. (“another significant characteristic found in many, but not all, corporate tax shelters is the participation of tax-indifferent parties [such as charitable organizations]”). 85. “one might analogize tax avoidance to robbery from the public fisc.” rosenberg, supra note 13, at 444. 86. the treasury department acknowledges that charities and other zero-bracket taxpayers should be held accountable for aiding a tax shelter: a tax-indifferent party has a special status conferred upon it by operation of statute or treaty. to the extent such person is using this status in an inappropriate or unforseen manner, the tax system should not condone it. imposing a tax on the income allocated to tax-indifferent persons could be used to eliminate the inappropriate rental of their special tax status, eliminate their participation in corporate tax shelters, and thus eliminate the use of tax shelters that arbitrage their tax-preferred treatment. the problem of corporate tax shelters, supra note 8, at 115. the treasury nevertheless proposes a remedy that fails to create a disincentive for charities. see infra notes 130-48 and accompanying text. 2001] when charity aids tax shelters 789 without, in effect, making charity its brother’s keepers? that is, by what method can the law hold charity responsible for the illegitimate tax positions assumed by taxable trading partners? let us briefly address the “ends justify the means” argument, prove that the latter approach is preferable – that government ought to attack the exemption when charity aids a tax shelter – then consider the possible legal theories from which an attack might be sustained and the methods by which theory can be implemented in practice. iii. the need for intervention: the end does not justify the means. the notion implicit in justice harlan’s exasperated question – why not attack the exemption? – is that substantively the law neither objected nor responded to charity’s involvement in tax shelters. before addressing the87 continuing accuracy of that notion, it is appropriate to consider whether the88 law ought to be indifferent to such involvement. the question might be answered by comparing the benefit derived by exempting charity from tax89 with the harm caused by charity’s occasional folly in engaging in a tax shelter transaction. had the charity in clay brown been subject to judicial action, or90 had charities in general been faced with proposed legislation sanctioning involvement in tax shelters, they might have argued that such transactions result in more assets being devoted to beneficial use and therefore should not result in a sanction. undoubtedly, that is always the case. charity is invariably paid91 87. clay brown, as the government prosecuted the case, was exclusively about a taxpayer’s illegitimate taking of the capital gains preference. see supra note 77. prior to clay brown, however, the objection to such transactions appeared to be based exclusively on the fear that exempt organizations would grow too large by “selling” their exemption. see s. rep. no. 81-2375, at 31 reprinted in 1950 u.s.c.c.a.n. 3053, 3084 (quoted supra note 78). there was no apparent concern that charity’s participation was fundamentally inconsistent with the notions supporting the grant of tax exemption. see id. 88. the 1969 enactment of the unrelated debt financed income provision, in what is now irc § 514, was ostensibly aimed at the taxable participant’s conversion of ordinary income to capital gains – the issue specifically addressed in clay brown. see tax reform act of 1969, 83 stat. 487 (enacting irc § 514); see also s. rep. no. 91-552, at 62 reprinted in 1969 u.s.c.c.a.n. 2027, 2091 (discussing the reasons for enacting irc § 514). in the next section, i show why the law nevertheless remains effectively indifferent to charity’s participation in tax shelters. 89. according to one estimate, in 1996 nonprofit organizations spent $460 billion providing charitable services, with health care and educational institutions accounting for 83% of that figure. see lester m. salamon, america’s nonprofit sector: a primer (2d ed. 1999). 90. one reporter estimates aggregate 1999 loses from corporate tax shelters at approximately $10.6 billion, but admits that the estimate is hard to verify. see martin a. sullivan, a revenue estimate for corporate tax shelters, 85 tax notes 981 (nov. 22, 1999). 91. because there has never been a proposal attacking tax exemption, one can only speculate as to how the charitable community might respond. assuming, though, that even charities that would never consider engaging in a tax shelter transaction would nevertheless object to any rule that might conceivably jeopardize exempt status, i can think of only two arguments by which charity might make to try to thwart such a rule. first, charity could argue that the benefits it provides to the public are so great that the harm caused by charity’s 790 florida tax review [vol. 4:12 a fee for its participation and, assuming charity complies with statutory92 mandates, the gain derived necessarily increases the benefit to charitable goals.93 the precise assertion, then, is that the law shouldn’t attack the exemption if the revenue loss resulting from the tax shelter is compensated by a greater amount transferred to public purposes. accordingly, to the extent94 charity is supplanting or supplementing government in the provision of public goods or services, societal well-being is not harmed by charity’s participation in tax shelters. under this approach, charity’s participation in tax shelters does not become harmful until the government’s revenue loss exceeds the value of goods and services otherwise provided by charity. this purely empirical95 approach, though, is ultimately a fool’s refuge for two reasons. first, the detriment to society will always be understated, since the essential nature of a tax shelter is disguise and illusion. to the extent the disguise or illusion is96 participation in tax shelters is negligible and not worth the added complexity of new legislation. i address and reject this argument in the text. second, charity might argue that its involvement in tax shelter transactions is so infrequent that the government’s monitoring cost for new legislation aimed at charity would far exceed the costs from those infrequent occasions. to that, i adopt professor weisbach’s assertion that “uncommon transactions that are taxed inappropriately become common as taxpayers discover how to take advantage of them.” david a. weisbach, formalism in the tax law, 66 u. chi. l. rev. 860, 869 (1999). 92. see the problem of corporate tax shelters, supra note 8, at vi. 93. one writer notes a similar argument with regard to the imposition of corporate tax on charities that engage in noncharitable trades or businesses: “critics of the ubit respond that all returns from unrelated business must ultimately be spent on their related activities and that this justifies exemption for the unrelated business.” henry b. hansmann, unfair competition and the unrelated business income tax, 75 va. l. rev. 605, 624 (1989). 94. such an argument was made in response to proposals to limit the tax benefit arising from sale-leaseback transactions involving tax exempt organizations. see william l. vallee, jr. sale-leaseback transactions by tax exempt entities and the need for congressional guidelines, 12 fordham urb. l.j. 349, 351, 354 n.24 (1983-84) (arguing that “although causing a revenue loss, [sale-leaseback transactions] are a useful device for providing certain tax-exempt entities with the financial means to maintain services in the face of rising costs and the withdrawal of federal funding.”). sale-leaseback transactions are a type of tax shelter transaction under which a taxable party purchases a building with funds borrowed from a tax exempt organization and then leases the building back to the entity under a net lease arrangement (i.e., an arrangement that requires the lessee to pay all maintenance costs in addition to rent equal to buyer’s payments on the purchase money note). in terms of our definition, by achieving the status of “borrower” and “owner” for tax purposes (without really occupying the position of “borrower” or “owner” in a true economic sense), the taxable participant can claim interest expense and depreciation deductions. 95. see dennis zimmerman, corporate title sponsorship payments to nonprofit college football games: should they be taxed? (congressional service report) 5 exempt org. tax rev. 438 (1992) (asserting that whether a charitable organization should be taxed on unrelated business should be determined by comparing the economic benefit derived from allowing charities to engage in those activities without taxation with the revenue loss to the government. 96. “it is difficult to estimate the federal government’s revenue loss from corporate tax shelters. one reason is that the tax shelter transactions are shrouded in secrecy to prevent detection by the irs – and in the case of shelter promoters – to prevent detection by competitors and by taxpayers who are not paying clients. another reason is that it is difficult for the irs to 2001] when charity aids tax shelters 791 successful (in the sense that the transaction is never challenged, nevermind exposed and addressed ex post facto), the quantitative detriment to society via revenue loss will necessarily be understated. indeed, confidentiality is a97 frequent condition of tax shelter marketing and that condition necessarily results in an understatement of the quantitative revenue loss. second, even assuming98 the detriment is small by economic measure, the assumption would not justify tolerance of charity’s participation in tax shelters. a cost-benefit analysis, such as is implied by comparing detriment to benefit, assumes a cost necessarily incurred. if, in fact, the cost is necessarily incurred, it is appropriate to ask whether the cost is so small relative to the benefit that the law should be unconcerned. but if the cost is unnecessarily incurred, cost-benefit analysis is irrelevant. increasing the monies devoted to charity could certainly be better accomplished, as opposed to formal indifference to charitable tax shelters, by direct government grants to charitable organizations or directly to beneficiaries. at least this would accomplish the goal implicit in the actions99 of charities that engage in tax shelters without the manifest harm of tax shelters. hence, the end from charity’s viewpoint – increased financial assets devoted to charitable causes – cannot justify the means – contributing to the erosion of the tax system and the assumption underlying the grant of tax exemption. the intentional indulgence of unnecessary cost, per se, is sufficient to rebut the assertion that the end justifies the means. the preceding discussion exposes the fallacy of the end justifying the means argument – the quantitative means can never be accurately measured and are justified by the end, if at all, only when there is no better alternative. if there identify tax shelters even when they were used by corporations in tax years under audit. the impact of a tax shelter may appear on only a few lines of a return that is as thick as a telephone book and as complex as a textbook on advanced physics.” sullivan, supra note 90, at 981. 97. but see university hill foundation v. commissioner, 51 t.c. 548 (1969), rev’d 446 f.2d 701 (1971) (charitable foundation’s participation in 24 charitable bootstrap sales over a fourteen year period resulted in revenue loss in excess of $10 million – not including the revenue loss from the seller’s claiming of capital gains tax rate preference; amount paid to charitable purpose over same time period was approximately $2 million.) 98. see the problem of corporate tax shelters, supra note 8, at 20-22. 99. congress accepted this argument when it enacted rules under irc § 168(h) designed to limit the tax benefit available to taxable entities who engage in sale leasebacks with exempt entities: [t]he committee believes that federal aid to tax-exempt entities (above and beyond their tax exemption) should be made by appropriations rather than by tax benefits transferred through tax system. the tax benefits in leasing are open-ended and hence uncontrollable in amount and composition, whereas appropriations are limited and adjustable to current priorities from year to year. moreover, tax benefits appear in the federal budget only as reduced tax collections, unassociated with any particular public purpose. thus, with federal aid conveyed through the tax system, it is very difficult to discover what tax-exempt purposes have been federally assisted, by how much they have been assisted, and whether the assistance has been rendered in ways consistent with other objectives of public policy. h.r. rep. no. 98-432, at 1141 (1984) reprinted in 1984 u.s.c.c.a.n. 697, 815. 792 florida tax review [vol. 4:12 are other fairer and more efficient means to an end, the uncertain, unfair and inefficient means ought to be avoided. the unfairness and inefficiency of indifference to charity’s role in tax shelters arise from the corrosive effect such transactions have on the tax base and progressive tax rates, and the distorting effect such transactions have on potential sellers’ preferences as between taxable and tax exempt buyers of market assets. indulging this compounding100 effect contradicts the normative assumptions identified earlier. two of our normative assumptions hold that tax shelters erode the tax base, create unfairness as between individual taxpayers, and breed disrespect for a tax system dependent upon a sense of fairness. consequently, tax shelters are not101 to be tolerated. the third assumption holds that charitable tax exemption does no harm whatsoever. but charity’s unchallenged participation in tax shelters violates that assumption. if those normative assumptions are to be violated, the decision to violate them should be in response to a situation requiring a choice between lesser evils. that is certainly not the case with regard to charity’s participation in tax shelters. there is, perhaps, an even more fundamental reason why the government should not be indifferent to charity’s participation in tax shelters. that reason can be succinctly articulated. charity, for all its positive connotations, has already been so bastardized that one must cynically wonder whether it is worthy of the religious reverence and higher values that justify tax exemption. with relatively simple planning under the present system, for102 example, charity can engage in any type of business it pleases, distribute the103 100. with regard to the effect of not having the unrelated business income tax as it relates to tax avoidance, one writer states: in the absence of the [unrelated business income tax], the value of an otherwise taxable business would be higher in the hands of an exempt nonprofit than it would be in the hands of ordinary taxable entrepreneurs or shareholders. thus, there would be potential gain from the sale of a business to a nonprofit equal to the discounted present value of all the future taxes that the business would otherwise pay. leveraged financing should therefore be readily available for such a purchase, and nonprofits would likely often borrow a very large fraction, and in many cases perhaps close to 100%, of the capital needed for the acquisition of an unrelated business. the increased net income resulting from tax avoidance would provide the return necessary to cover the increased agency and transaction costs involved in such highly leveraged financing. as a consequence, even nonprofits with modest net assets could hold large portfolios of business firms. henry b. hansmann, unfair competition and the unrelated business income tax, 75 va. l. rev. 605, 622 (1989). 101. see supra notes 19-40 and accompanying text. 102. for a history of the definition of the term “charity” for tax purposes, see lars g. gustafsson, 33 hous. l. rev. 587 (1996). 103. a charity that engages in a business unrelated to the purpose for which it was granted tax exemption is subject to normal corporate tax rates with respect to that unrelated business. see irc § 511. if the unrelated business is substantial, relative to those activities that are related to the charitable purpose, the charity may lose its tax exemption. regs. § 1.501(c)(3)1(c); better business bureau of washington, d.c., inc. v. united states, 326 u.s. 279, 283 (1945). (“[t]he presence of a single [noncharitable] purpose, if substantial in nature, will destroy 2001] when charity aids tax shelters 793 economic equivalent of profit to, and make millionaires of, its stewards all104 without ever forfeiting tax exemption. this is to be contrasted with the notion of charity as characterized by selfless love of humanity and disdain of the profit motive. it is perhaps an idealized goal that charity should have no bounds. but that which constitutes charity ought to have bounds, lest true charity lose its revered status. if, as is the present case, charity may sometimes include greed, fraud, secrecy and illusion such as is concomitant with the idea of tax shelters, then the law really has no bounds on its definition of charity. hence, the105 question of whether charity should be permitted to engage in tax shelters without sacrificing its status ultimately begs the question, what is charity. one cannot prove that charity is this activity or that, for ultimately the answer rests upon value judgment, not empirical proof. but society ought to possess the106 ability and intellectual wherewithal to identify that which most certainly is not charity, if not by broadly applicable definition then by particularized recognition. in fact, society has done so. charity is neither criminal behavior107 nor racial discrimination. those latter conclusions are implicitly, if not108 explicitly, based upon the enforcement of accepted normative assumptions: crime and racial discrimination harm society. likewise, the enforcement of the normative assumptions relating to tax policy require that charity be not a tax shelter participant. the result of charity’s participation in tax shelters – more capital devoted to charitable goals – does not justify the harm caused thereby. the goal would be better achieved via direct grants to charity or even to those normally served by charity. moreover, charity should not be defined only by its good109 result. as a concept, charity ought also to be defined by the manner in which the exemption.) but even though the trade or business is subject to taxation, it nevertheless enjoys a publicly funded advantage caused by the spill-over of goodwill and other intangibles from the organization’s tax exempt (i.e., publicly funded) activities.” 104. revenue sharing arrangements, under which an employee is paid a percentage of charity’s net revenue are now permissible if properly structured. see prop. regs. § 53.4958-5 (august 4, 1998). 105. i will admit to indulging in a small degree of hyperbole here. for it is ultimately a debatable question whether tax shelters and those who engage in such transactions ought to be described by reference to words that imply immorality and i do not wish to tackle such a broad philosophical question here. see gregory v. helvering, 69 f.2d 809, 810 (2nd cir. 1934) (“anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the treasury; there is not even a patriotic duty to increase one’s taxes.”) aff’d 293 u.s. 465 (1935). 106. see generally lars g. gustafsson, the definition of “charitable” for federal income tax purposes: defrocking the old and suggesting some new fundamental assumptions, 33 hous. l. rev. 587 (1996). 107. see, e.g., rev. rul. 75-384, 1975-2 cb 204. 108. see bob jones university v. united states, 461 u.s. 574 (1983). 109. in fact, the trend is toward direct grants to persons who might otherwise be charity’s beneficiaries. see evelyn brody, charities in tax reform: threats to subsidies overt and covert, 66 tenn. l. rev. 687, 688 (1999) (stating, “[i]n recent years, however, congress has increasingly shifted its focus from helping the charitable sector to helping individuals in need of specific social services.”) 794 florida tax review [vol. 4:12 that result is achieved. if that is so, charity should not engage in certain actions – crime, discrimination, nor even tax shelters. iv. ubit as the protypical response: chasing our own tail clay brown represents charity’s loss of innocence. theretofore, charity had “survive[d] with the luster of its public service emblem untarnished.” charity enjoyed a relatively unregulated existence as far as the110 code was concerned. since clay brown, charity – like he who had once111 tasted of the forbidden fruit – has been subject to ever more regulation, as congress continually reacts on a case-by-case basis to new manifestations of a singular problem. the particular reaction to clay brown was the expansion of the unrelated business income tax (ubit) and that reaction has served as the112 model for most subsequent congressional responses to charity’s participation in tax shelters. it is as though charity’s occasional but regular participation113 110. university hill foundation v. commissioner, 51 t.c. 548, 573 (1969) rev’d 446 f.2d 701 (1971). 111. there are three explicit statutory rules applicable to charities. the first is the prohibition against private inurement, first enacted in 1909. tariff 1909, ch. 6, § 38, 36 stat. 11, 113 (1909) (current version at irc § 501(c)(3)). the second rule, which prohibits charity’s “substantial” involvement in attempts to influence legislation was added in 1934. revenue act of 1934, ch. 277, § 101(6), 48 stat. 680, 700 (1934). the third rule, added in 1954, is that charity may not participate or intervene in political campaigns on behalf of or in opposition to a candidate for public office. revenue act of 1954, ch. 736, § 501(c)(3), 68a stat. 163 (adding the prohibition against intervening in political campaigns). the unrelated business income tax was added in 1950. revenue act of 1950, ch. 994, § 422, 64 stat. 906, 947-50 (1950). 112. see irc § 514, added by the tax reform act of 1969, § 121(d), 83 stat. 487, 54348 (1969). irc § 514 would have classified the rent payments as “unrelated debt-financed income” and thus unrelated business taxable income under irc § 511. 113. one exception to this general pattern is found in irc § 170(f)(10) recently enacted by the tax relief extension act of 1999. see 113 stat. 1860, 1936 (1999). in notice 99-36, the service described the prototypical transaction addressed by irc § 170(f)(10): [a] charitable split-dollar insurance transaction involves a transfer of funds by a taxpayer to a charity, [and the donor claiming a charitable contribution deduction equal to the amount of the transfer] with the understanding that the charity will use the transferred funds to pay premiums on a cash value life insurance policy that benefits both the charity and the taxpayer’s family. typically, as part of this transaction, the charity or an irrevocable life insurance trust formed by the taxpayer (or a related person) purchases the cash value life insurance policy. the designated beneficiaries of the insurance policy include both the charity and the trust. members of the taxpayer’s family (and, perhaps, the taxpayer) are beneficiaries of the trust. in a related transaction, the charity enters into a split-dollar agreement with the trust. the split-dollar agreement specifies what portion of the insurance policy premiums is to be paid by the trust and what portion is to be paid by the charity. the agreement specifies the extent to which each party can exercise standard policyholder rights, such as the right to borrow against the cash value of the policy, to partially or completely surrender the policy for cash, and to designate beneficiaries for specified portions of the 2001] when charity aids tax shelters 795 in tax shelters, and congress’ response, have both become matters of unthinking routine rather than appropriate moments for rethinking the normative assumptions underlying tax exemption – particularly the assumption that charity does no harm – and congress’ method of policing those assumptions. irc sections 168(g), 514(c)(9), 337(d), and 1245(b)(3) are typical responses to charity’s participation in tax shelters. a brief description of each provision follows in order to highlight problems common to the present approach. irc section 168(g) attacks the sale-leaseback transaction by114 denying the accelerated cost recovery deduction to the taxable participant. in a sale-leaseback, charity sells depreciable property to a taxable buyer who oftentimes finances the purchase. immediately thereafter, charity leases the115 property, usually under a net lease arrangement, from the buyer. the buyer116 uses the depreciation deduction to offset (i.e., shelter) other income. under section 168(g), more of the taxable participant’s income is subject to current taxation because the buyer/lessee is allowed a smaller depreciation deduction.117 the section 168(g) rule does not apply, however, if the property involved in the sale-leaseback creates unrelated business taxable income. that is, if the118 death benefit . . . . although the terms of these split-dollar agreements vary, the common feature is that over the life of the split-dollar agreement, the trust has access to a disproportionately high percentage of the cash-surrender value and death benefit under the policy, compared to the percentage of premiums paid by the trust. 1999-26 i.r.b. 3 (june 28, 1999). see also, s. rep. no. 106-2077, at 72 (1999). (senate finance committee report regarding irc § 170(f)(10)). irc § 170(f)(10) not only denies the charitable deduction to the donor, but also imposes an excise tax on charity equal to the amount of premiums charity pays. thus, unlike ubit, the tax under irc § 170(f)(10)(f) does more than merely recoup the tax avoided by the taxable participant. 114. see generally william l. vallee, jr. sale-leaseback transactions by tax exempt entities and the need for congressional guidelines, 12 fordham urb. l.j. 349 (1983-84). the abusive impact of sale-leaseback transactions was described by the treasury in its testimony before congress: during the early 1980’s, a number of charitable organizations again became involved in leasing transactions with taxable entities. due to the investment tax credit and accelerated depreciation, certain types of property were subject to a negative tax, generating credits or losses that would offset income from other investments. because tax exempt organizations could not benefit from these incentives directly, a number of exempt organizations . . . . sold part of their assets to taxable businesses that could make use of the tax incentives and would then lease the property back on a long-term basis. unrelated business income tax: hearings before the subcommittee on oversight of the committee on ways and means, house of representatives, 100th cong., 1st sess. 31 (1987) (statement of o. donaldson chapton, deputy assistant secretary (tax policy), u.s. department of treasury) (hereinafter, “hearings”). 115. see vallee, supra note 114, at 352-355. 116. see id. 117. in general, irc § 168(g) requires the buyer to take depreciation deductions over 40 years. irc § 168(g)(2)(c). 118. see irc § 168(h)(1)(d). 796 florida tax review [vol. 4:12 property is used in a non-charitable activity, the activity will generate income not exempt from taxation. the imposition of ubit allows the government to119 impose the regular corporate tax and thereby recoup the revenue otherwise avoided by the taxable participant. irc section 514(c)(9) operates for a similar purpose in the partnership context by imposing the ubit on tax exempt educational institutions that participate in partnerships owning debt-financed real property. in general, the120 ubit will apply if a partnership effectively over-allocates income to charity.121 119. see irc § 513(a) (defining “unrelated trade or business”). 120. for a very good discussion of this extremely complicated provision, see william b. holloway, jr. structuring real estate investment partnerships with tax-exempt investors, 87 tax notes 1517 (june 12, 2000). 121. in its testimony before congress regarding the over-allocation of depreciation deductions to a taxable participant, the treasury gave the following example: [a]ssume that a taxable entity and [a] tax-exempt organization form a partnership to acquire property for $1 million, that all depreciation deductions are allocated to the taxable partner, and that any gain on the sale of the property is allocated to the taxable partner to the extent of his depreciation deductions and then divided equally between the partners. assume that the property is sold after 20 years. under current law, the partnership would be required to use 40-year straight line depreciation and thus the taxable partner would have taken depreciation deductions of $500,000 by the time of the sale. if 40-year straight line depreciation is an accurate measure of true economic depreciation, then in theory the building would be sold for $500,000 ($1 million less $500,000 depreciation) and no gain would be realized. in that case, the entire sales proceeds would be allocated to the tax-exempt partner and the taxable partner would have suffered a true economic loss of $500,000. in practice, however, because of inflation and because 40 years may not represent true economic depreciation for some buildings, the building could be expected to be sold for more than its basis. thus, for example, if the building was sold for $1 million, the gain of $500,000 would be allocated to the taxable partner. in this case, the taxable partner would have received the benefit of deducting depreciation allowances in the early years which would be offset by gain deferred until the later years. because there is a common expectation that real estate will not decline, in nominal value, the gain on the property will equal or exceed depreciation deductions. hearings, supra note 114, at 52. the taxable partner’s taking of all depreciation deductions essentially results in more income being allocated to the exempt organization. that allocation is disproportionate to the extent it exceeds allocations of losses. the example appears to be based on a transaction in which georgetown university contributed depreciable debt-financed property to a partnership and then sought to allocate the depreciation to the taxable partners. see smith v. commissioner, 50 t.c. memo (cch) 1444 (1985). the court sidestepped the partnership allocation issue by simply deciding that the partnership never actually owned the property. see id. under subchapter k as presently written, the allocations would not have been considered insubstantial (i.e., the allocations would have been respected and the tax benefit allowed) because the assumption that the property’s fair market value will be higher than basis and therefore result in gain to the taxable participant is precluded by the “fair market value equals basis” presumption. see regs. § 1.704-1(b)(2)(iii)(c) (flush language). irc § 514(c)(9) would essentially recapture the sheltered tax by imposing ubit on the exempt organizations allocable share of income from the property. 2001] when charity aids tax shelters 797 the effective over-allocation of income, of course, is the economic equivalent of transferring losses unusable by charity to taxable participants. by allocating more income to charity, rather than taking its proper share of income, the taxable partner shelters income and pays less tax. the ubit essentially122 recaptures the avoided tax from charity and restores to the government revenue avoided by the taxable participant.123 irc section 337(b) and (d), the latter as implemented by treasury regulations section 1.337(d)-4, operate in the corporate context to prevent the circumvention of the general utilities repeal. the transactions to which irc124 section 337(b)(2) and treasury regulations section 1.337(d)-4 are aimed involve the distribution of appreciated assets by a controlled corporation. if the appreciated assets are distributed to the controlling corporate shareholder, no gain is recognized by the liquidating corporation and the recipient corporation takes a carryover basis, and gain is merely deferred. if the appreciated assets125 are distributed to a charitable organization, however, the gain will be entirely foregone since the charitable organization will likely report no gain on the later disposition of the property. that is, the gain will be sheltered by the126 organization’s tax exemption. irc section 337(b)(2) prevents this result by treating the transaction as though the assets were first sold for their fair market value, resulting in a taxable event for the liquidating corporation, and then distributed to charity. in effect section 337(b) and treasury regulations section 1.337(d)-4 accelerate the tax the shareholders would have indirectly paid if they had sold their stock to a taxable purchaser. the deemed sale does not occur, however, if the charitable recipient will use the assets in an unrelated trade or business. yet again, imposing the ubit allows the government to recoup revenues otherwise lost. irc section 1245(b)(3) and (7) operate in conjunction with ubit to prevent what is essentially the “conversion” of ordinary income into capital gains income via the use of charity. for economic policy reasons, taxpayers are allowed depreciation deductions that exceed the actual economic decline in an 122. cf. rev. rul. 99-43, 1999-42 i.r.b. 506 (over-allocation of income from the discharge of indebtedness to an exempt taxpayer (exempt from tax on discharge of indebtedness income by virtue of irc § 108(a)(1)(b)) resulted in reduced tax liability to taxable partner and therefore was disregarded.) 123. irc § 514(c)(9) would essentially recapture the sheltered tax by imposing ubit on the exempt organization’s allocable share of income from the property. 124. in general utilities & operating co. v. helvering, a corporation was not required to recognize gain upon the distribution of appreciated property to shareholders. 296 u.s. 200 (1935). the general utilities ruling was reversed by the tax reform act of 1986 and now corporations must generally recognize gain (but not loss) on the distribution of appreciated property. see irc § 311(b). 125. see irc § 334(b). 126. see irc § 501(c)(3); see also, irc § 512(b)(5) (unrelated business taxable income does not include gain from disposition of non-inventory property or property not held primarily for sale to customers in the ordinary course of business). 798 florida tax review [vol. 4:12 asset’s value. if the asset is later sold at a gain (i.e., fair market value exceeds127 adjusted basis), the selling taxpayer must report a portion of the gain otherwise taxable at capital gains rates as ordinary income. in this manner, the code128 recoups the tax benefit resulting from accelerated depreciation. that benefit is best described as the payment of less tax at the ordinary rate, under the assumption that the asset actually declined in value by the amount of the accelerated depreciation deduction. to the extent the asset is sold at a gain, that assumption is proven false and the government is “owed” the foregone tax. if the gain is taxed at capital gains rate, because of the operation of irc section 1231, the government does not fully recoup the undeserved benefit.129 thus, irc section 1245 imposes ordinary income rates on the gain to the extent that gain is attributable to previous depreciation deductions. the section 1245 rules provide an exception, however, when property is distributed to a controlling corporation. in such cases, the controlling corporation will return the undeserved amount when it sells or disposes of the property. if the controlling corporation is a charitable organization, however, the government may never recoup the undeserved benefit because the gain, if any, upon the subsequent disposition of the property will be exempt from tax. irc section 1245(b)(3)130 therefore requires recognition of ordinary gain, not to exceed previous depreciation allowed, when the property is distributed to a charitable organization. for the same recuperative reasons previously noted, recognition131 is not required if the charitable organization’s use of the property results in the ubit. finally, the question of how the law should respond when charity aids a tax shelter arises implicitly, if not explicitly, in contemporary discussions with regard to tax shelters. under the clinton administration’s proposal, charity’s income from participation in a tax shelter transaction would be classified as ubit. a separate proposal would deny the taxable party the tax benefit132 arising from a tax shelter transaction and make charity’s involvement evidence 127. see generally, jeff strnad, tax depreciation and risk, 52 smu l. rev. 547, 547 (1999) (“although some parts of u.s. law aim to replicate economic depreciation, tax depreciation is normally allowed at a rate that is faster than economic depreciation.”). 128. see irc § 1245(a). 129. “the taxpayer who has taken excessive depreciation deductions and then sells an asset, therefore, has in effect converted ordinary income into a capital gain.” s. rep. no. 1881, 87th cong., 2nd sess. 95 (1962). 130. see irc § 512(b)(5) (unrelated business taxable income does not include gain from disposition of non-inventory property or property not held primarily for sale to customers in the ordinary course of business). 131. the tax avoidance effect will most likely arise when charity itself is attempting to avoid taxation. for example, charity might create a wholly owned subsidiary to engage in an unrelated trade or business. to zero-out the subsidiary’s gross income, the charity could contribute a depreciable asset to the subsidiary. the subsidiary can use accelerated depreciation deductions to shelter its taxable income. later, the subsidiary can be liquidated into its charitable parent and, in the absence of irc § 1245(b)(3) essentially pay no taxes on the unrelated business. 132. see the problem of corporate tax shelters, supra note 8, at 116; fy 2001 budget proposal, supra note 13, at 127-28. 2001] when charity aids tax shelters 799 that the transaction is indeed a tax shelter. both approaches are rather133 consistent in their approach of merely chasing and then recouping the government’s lost revenue, although the second is a bit more lenient from charity’s standpoint. by now, then, the pattern should be all too, and rather painfully familiar. when charity aids in the unintended grant of a tax benefit, the code essentially follows the money and, at the point the money rests with the charitable organization, imposes tax at ordinary rates via the ubit provisions. this approach raises at least two substantive objections and two related procedural objections. first, since the money ultimately taxed originates with the taxable participant, the ubit imposition is economically moot with regard to charity. that is, no real tax or other toll is imposed on charity. rather,134 charity’s return from its participation is reduced and the opportunity for further such participation is eliminated since the imposition of ubit means the plan is no longer attractive to the taxable participant. the ubit imposition is economically a mere restoration of the status quo. if charity were simply an innocent bystander, such an approach might be appropriate. the transaction’s occurrence, in such cases, could not reasonably be viewed as an appropriate occasion on which to impose upon charity’s tax exempt status. charity’s actions would have neither contributed to a distortion of income nor could charity’s actions be traced to the imposition of an unfair burden on another taxpayer. charity, consistent with its halo, ought to be ready and willing to assist the tax collector in recouping illegitimate tax benefits and that is the sole effect of imposing ubit. to otherwise work an imposition on charity’s tax exemption, though, serves no purpose but to aggravate the harm to both the public in general and charities in particular. history proves, unfortunately, that charity is oftentimes more than an innocent bystander. when, instead, charity aids and abets a tax shelter, merely recouping the tax benefit without impacting the tax-exempt status is singularly unproductive. a mere recoupment does nothing to alter charity’s motivations135 for engaging in the transaction in the first place, and thus provides no protection from future harm caused by charity’s participation in new tax shelters. the imposition of ubit is ultimately a tax on the taxable participant’s income, just as is the mere denial of the sought-after tax benefit, particularly since the role of charity is generally that of a money launderer. that is, the taxable participant’s income is passed through charity in order to change its character, 133. see abusive tax shelter shutdown act, h.r. 2255, 106th cong. § 3 (1999). 134. “tax-indifferent parties often are interposed into corporate tax shelter transactions to absorb taxable income from the transaction, leaving offsetting deductions or losses to be used by a taxable corporate participant.” the problem of corporate tax shelters, supra note 8, at 115. 135. after congress enacted the business lease provisions in 1950, for example, university hill foundation simply planned around the specific rules by limiting future leases to five years or less and continued participating in charitable bootstraps until it finally lost in court more than 20 years later. see university hill foundation, 51 t.c. 548 (1969) rev’d 446 f.2d 701 (9th cir. 1971). 800 florida tax review [vol. 4:12 or decrease taxable income (by understatement of gain, or overstatement of loss) to the taxable party. imposing ubit does nothing to charity because it136 puts at risk none of its own funds and ultimately none of its funds are affected by the tax. in substance, and despite the lessons of history, imposing ubit137 treats charity as though it is invariably an innocent bystander to tax shelters when quite the opposite is often true. thus, the present approach to charity’s participation in tax shelters may thwart the money-laundering goal and thereby put an end to a particular tax shelter. but the imposition of ubit does nothing to address charity’s responsibility for that particular tax shelter transaction, nor does it provide an effective deterrent to charity’s involvement in new tax shelters.138 the foregoing analysis should not be surprising considering the objectives of the ubit. from its inception, ubit has been neither a preventive nor a punitive measure. ultimately, the imposition of ubit is a restorative139 136. in a sale-leaseback for example, the taxable buyer is merely funneling money into a depreciable charitable asset to obtain the depreciation deduction not otherwise available to the charitable seller/lessee. see supra notes 114-17 and accompanying text. in the charitable bootstrap sale, the taxable payer is “paying” earnings to itself after those earnings have been funneled through the charitable buyer in order to purge the corporate tax. see supra notes 63-65 and accompanying text. in a partnership involving taxable and charitable partners, the taxable partner would be able to avoid tax by over-allocating income to the charitable partner if irc § 514(c)(9) were not enacted. and finally, without irc § 337(b), shareholders could use an exempt organization to withdraw appreciation untaxed at the corporate level. 137. ubit is imposed, of course, only on net gain. see irc § 512(a)(1). in most, if not all such tax shelters, charity will not have put any of its assets, at risk but instead will be “trading” on its tax exemption. see commissioner v. clay brown, 380 u.s. 563, 580 (harlan, j., concurring) (“since its exemption is unlimited, like the magic purse that always contains another penny, the [charitable organization] gave up nothing by trading on it.”). “the treasury department believes that the current nothing ventured, nothing gained attitude, coupled with little downside risk to many participants has, in part, led to the proliferation of corporate tax shelters.” the problem of corporate tax shelters, supra note 8, at 118. 138. the clinton administration’s proposal recognizes the appropriateness of penalizing the exempt organization as opposed to merely restoring the status quo: proposals to deter the use of corporate tax shelters could provide sanctions or remedies on these parties as a penalty for engaging in inappropriate behavior. more importantly, such remedies or sanctions would lessen or eliminate the economic incentives for these parties to participate in sheltering transactions, thus having a dampening effect on the transactions themselves to the extent they are facilitated by the participation of these parties. finally, the potential for remedies or sanctions on all participating parties will multiply the number of eyes that will scrutinize a transaction for its integrity. the problem of corporate tax shelters, supra note 8, at 112. still, the imposition of the ubit hardly serves that purpose. 139. the problem at which the tax on unrelated business income is directed is primarily that of unfair competition . . . . in neither the house bill nor your committee’s bill does this provision deny exemption where the organizations are carrying on unrelated active business enterprises, nor require that they dispose of such businesses. both provisions merely impose the same tax on income derived from an unrelated trade or business as is borne 2001] when charity aids tax shelters 801 device that merely eliminates the unintended advantage charity has relative to taxable entities in an identical commercial transaction. consider again, for140 example, the bootstrap transaction in clay brown. the sale to a taxable purchaser, as opposed to charity, could have been structured to avoid one, but not both levels of tax normally applicable to corporations and shareholders.141 the unique advantage of bootstrap sales to charity is that both levels of tax can be avoided, because charity is tax exempt, and the buyer can realize a greater and faster return. the real effect of ubit is therefore only to eliminate the market distortion caused by tax exemption. that distortion manifests itself142 in an actor’s preference for engaging in transactions with charity rather than taxable entities. without intervention, charity could conceivably eliminate taxable buyers’ ability to obtain market resources because taxable buyers could not offer as attractive a return as charity. whenever it is imposed, then, ubit143 does nothing more than eliminate the competitive advantage or market distortion unintentionally caused by tax exemption. ubit restores an appropriate status quo but does not address charity’s willing distortion of that status quo nor its self-interested motivation to do so in future cases. the second substantive objection to the present approach is a bit less pragmatic and much more philosophical. failing to address charity’s involvement in the transaction allows for a present harm separate and apart from the erosion of the tax base – the degradation of the political and social consensus that justifies tax exemption. to the extent charity aids and abets a tax shelter, and does so without consequence, it tarnishes the halo that justifies granting tax exemption not just to the particular charity involved, but to all charities. there will thus come a time when charity’s occasional but regular144 folly of engaging in tax shelters will define charity, however inaccurate that definition may be. in effect, such actions constitute a substantive attack on society’s understanding of the charitable concept and that attack should not be allowed to persist without response, lest the problem grow to such an extent that an inevitable, but long-delayed response manifest itself by a wholesale elimination of the charitable tax exemption. two procedural objections are undoubtedly apparent with respect to the use of ubit to attack charity’s participation in tax shelters. first, the imposition of ubit, particularly on a case by case basis, adds to the already by their competitors. in fact, it is not intended that the tax imposed on unrelated business income will have any effect on the tax-exempt status of any organizations. s. rep. no. 81-2375, 81st cong., 2nd sess. at 3081 (1950) reprinted in 1950-2 c.b. 483, 50405 140. see id. 141. see supra notes 69-70 and accompanying text. 142. for a broad-ranging summary of market distortions caused by the tax treatment of charities, see charles t. clotfelter, tax induced distortions in the voluntary sector, 39 case w. res. l. rev. 663 (1988-89). 143. see supra note 99 and accompanying text. 144. see brody, supra note 11 and accompanying text. 802 florida tax review [vol. 4:12 significant degree of complexity and transaction costs contained in or resulting from the code. the anti-avoidance goal of irc section 514(c)(9), for example, presents formidable challenges to the human capacity to comprehend substance and monitor compliance. indeed, the detailed requirements of that provision are imposed as an addition to the already complex substantial economic effect rules of irc section 704(b). they require not only present compliance, but145 prospective compliance as well. that is, all current and all possible allocations under the partnership agreement must comply with the “fractions rule” if the ubit “penalty” is to be avoided. the second objection applies just as much146 to the overall approach to tax shelters. tax shelters result, perhaps, from overparticularized rules. such rules attempt to address the entire universe of transactions that fall within a certain illegitimate purpose. in doing so, they147 impose inflexible definitions. that inflexibility works both ways. it imposes complexity and transaction costs on taxpayers whose transactions are entirely unconcerned with illegitimate tax avoidance. on the other hand, a transaction148 might be fraught with illegitimate tax avoidance indicators and yet the inflexibility of the over-particularized rule leaves the public without remedy.149 congress’s historical reaction in the latter instance has normally been to impose yet another particularized rule, as though the unaccounted-for transaction was the only one possibly omitted from the first rule. the result, with respect to both procedural objections, is a predictable cycle characterized by spiraling complexity and endless detail. the analogy of a dog chasing its own tail is150 145. see irc § 514(c)(9). 146. the “fractions rule” requires that, in a partnership having both taxable and nontaxable partners and which holds debt-financed property, allocations to the nontaxable partner “cannot result in that partner having a percentage share of overall partnership income for any partnership taxable year greater than that partner’s” overall partnership income or loss for the taxable year in which that partner’s share of overall partnership loss will be the smallest. regs. § 1.514(c )-2(b)(1)(i). the fractions rule must be complied with “both on a prospective basis and on an actual basis for each taxable year of the partnership.” regs. § 1.514(c)-2(b)(2)(i). thus, the partnership must determine the charitable partner’s potentially smallest loss share and then determine whether it is possible that an allocation of income throughout the life of the partnership might possibly exceed that smallest loss share. 147. “[r]ules are not good at regulating infrequent transactions because their content must be determined ex ante. if there are 1000 possible rare transactions, and only 10 actually will occur absent the opportunity to evade taxes, rules must anticipate all 1000 transactions and do so accurately.” david a. weisbach, supra note 91, at 870 (1999). 148. see generally, arthur a. feder and joel scharfstein, leveraged investments in real property through partnerships by tax exempt organizations after the revenue act of 1987 – a lesson in how the legislative process should not work, 42 tax law. 55 (1988) (discussing what the authors view as unnecessary compliance burdens created by irc § 514(c)(9)). 149. see weisbach, supra note 91, at 871. (“[r]ules apply to their complete domain even if at the borders they are inaccurate. this type of inaccuracy makes an easy target for tax planning, which both loses revenue and distorts transactions.”) 150. a good example involves a charity that operates a taxable enterprise via a subsidiary and attempts to shelter the income from ubit’s anti-sheltering intent. ubit, of course, was ultimately imposed to tax noncharitable activities escaping taxation under the shelter of tax exemption. to avoid ubit, charity could conduct unrelated activities via a subsidiary. 2001] when charity aids tax shelters 803 finally appropriate. the dog may catch its tail once in awhile but it can hold on for only a brief moment. and when he lets go, the chase starts all over again. the objections to the use of ubit as the prototypical response to charity’s participation in tax shelters prove the need for a better approach. a better approach is suggested by contemporary proposals related to taxable participants in tax shelters. those proposals generally call for an articulated anti-tax shelter standard applicable to taxable participants and designed to address a broad range of transactions having common characteristics though distinguished by diverse facts and circumstances. there should be a similar151 standard specifically related to charity’s participation in tax shelters, accompanied by an effective penalty for violations of that standard. one current proposal imposes ubit when charity assists a taxable person in violating the broad anti-shelter standard. that approach, however, only generalizes a152 remedy already shown to be ineffective in particular situations, since ubit merely recoups what the taxable person should have paid and has no effect on charity. perpetuation of the present approach leaves an indispensable party to an illicit transaction free to search out yet another tax shelter opportunity. what is required, instead, is a standard-based prohibition supported by an effective deterrent. v. towards an effective response: the private benefit and public policy doctrines charity is never precisely defined in tax law. 153 if the activities were conducted directly by the charity, the income would be unrelated business taxable income. see irc § 511. likewise, operation of the enterprise via a subsidiary results in a corporate tax on the subsidiary. but if the charity caused the subsidiary to pay rent for the use of the charity’s fixed assets and the rent is approximately equal to the subsidiary’s gross earnings, the subsidiary can “zero-out” its income and avoid the corporate tax altogether. the charity could thus avoid the anti-sheltering intent of ubit. in further response to such transactions, though, the code chases the money and imposes the ordinary corporate tax (via the ubit provisions) on the rents received by the charity from a controlled corporation. see irc § 512(b)(13); see also unrelated business income tax: hearings before the subcommittee on oversight of the committee on ways and means, house of representatives, 100th cong., 1st sess. 30 (1987) (statement of o. donaldson chapton, deputy assistant secretary (tax policy), u.s. department of treasury) (“the controlled subsidiary rule was imposed to discourage charitable organizations from ‘renting’ part of their physical plants to taxable subsidiaries, thereby reducing or eliminating the [unrelated business] taxable income of the subsidiaries.”). 151. see abusive tax shelter shutdown act, h.r. 2255, 106th cong., 1st sess. (1999); fy 2001 budget proposal, supra note 13, at 124-128. 152. see fy 2001 budget proposal, supra note 13, at 127-28. 153. the closest thing to a formal tax definition of “charity” is found in regs. § 1.501(c)(3)-1(d)(2) which states: the term "charitable" is used in section 501(c)(3) in its generally accepted legal sense and is, therefore, not to be construed as limited by the separate enumeration in section 501(c)(3) of other tax-exempt purposes which may fall within the broad outlines of "charity" as developed by judicial decisions. such term include: relief of the poor and distressed or of 804 florida tax review [vol. 4:12 that is, the affirmative requirements for tax exemption are not specifically articulated. to the extent charity is defined, it is primarily by negative154 implication. thus, charity may not distribute profit to its stewards, though155 that prohibition appears waning; it may not operate for “private benefit,”156 157 nor engage in political activity, and it must function in a manner that does not158 violate “clearly established public policy.” otherwise, the definition of159 charity is by reference to historical standards, as opposed to precise the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency. the judicial approach to the task of defining “charity” has been one whereby the trust law definition of charity is incorporated into tax law. see lars g. gustafsson, the definition of “charitable” for federal income tax purposes: defrocking the old and suggesting some new fundamental assumptions, 33 hous. l. rev. 587 (1996). some commentators have decried that approach and have instead set forth what might fairly be described as socio-economic theories of charity for purposes of tax exemption. see rob atkinson, altruism in nonprofit organizations, 31 b.c. l. rev. 501 (1990) (proposing that charity, for purposes of tax exemption, is the act of engaging in altruistic economic behavior); see also john d. colombo & mark a. hall, the charitable tax exemption (1995) (proposing that charity is altruistic economic behavior, but defining “altruism” differently from professor atkinson’s definition); nina j. crimm, an explanation of the federal income tax exemption for charitable organizations: a theory of risk compensation, 50 fla. l. rev. 419 (1998) (proposing that “charitable” for purposes of tax law is the provision of pure and mixed “public” goods and services). 154. the regulations define “educational” and “scientific,” but not all educational or scientific purposes are charitable. see regs. § 1.501(c)(3)-1(d)(3), (4). 155. see irc § 501(c)(3) provides charitable tax exemption for: corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve [sic] the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office. 156. for an in-depth discussion of the history and future of the prohibition against profit distribution see darryll k. jones, the scintilla of individual profit: in search of private inurement and excess benefit, 19 va. tax rev. 575 (2000). 157. see regs. § 1.501(c)(3)-1(d)(1)(ii) (“an organization is not organized or operated exclusively for [charitable purposes] unless it serves a public rather than a private interest.”) 158. see irc § 501(c)(3), quoted supra note 155. 159. see bob jones university v. commissioner, 461 u.s. 574, 1591 (1983). 2001] when charity aids tax shelters 805 articulation. as an affirmative matter, charity is essentially what it has always160 been thought to be. the failure of precise definition, though, is not fatal. 161 quite the opposite is true. ultimately precision is the cause of tax shelters and imprecision will be the cure. it is only an imprecise yet recognizable162 conceptualization of charitable tax exemption that will redress charity’s participation in tax shelters, and perhaps all other deviations from the notions justifying tax exemption. in this section, then, the analysis focuses on how the broad conception of charity excludes such participation. the section begins with the prohibition against private inurement, the statutory doctrine that bars charity from distributing profit. it then addresses the only affirmatively stated163 requirement for tax exemption – that charity’s activities must be primarily directed towards achieving “exempt purposes.” neither of these first two164 requirements is sufficient to prevent charity’s involvement in tax shelters. both are relatively fixed, quantitative doctrines that do not allow for an evolutionary standard fairly responsive to an evolved form of qualitative abuse. two of the165 three remaining doctrines, private benefit and clearly established public policy, 160. see gustafsson, supra note 107; see also nina j. crimm, an explanation of the federal income tax exemption for charitable organizations: a theory of risk compensation, 50 fla. l. rev. 419, 425-427 (1998). 161. i don’t mean to be facetious here, but my purpose is only to show that whatever the definition of charity may be, it certainly does not include participation in tax shelters. for attempts at affirmatively defining charity see supra note 153, and sources cited therein. 162. see weisbach, supra note 91, at 875-882 (discussing the advantages of broad tax standards as opposed to complex particularized rules). 163. see irc § 501(c)(3), quoted supra note 155. 164. see regs. § 1.501(c)(3)-1(c)(1). irc § 501(c)(3) limits tax exemption to those organizations “exclusively” engaged in charitable activities. the word “exclusively,” however has been interpreted to mean “primarily.” see id. see also world family corporation v. commissioner of internal revenue, 81 t.c. 958 (1983) (“although section 501(c)(3) uses the words ‘operated exclusively,’ an organization will be regarded as satisfying the operational test if it engages primarily in activities which accomplish one more exempt purposes in section 501(c)(3).”). 165. the ultimate concern of the private inurement prohibition is the diversion of resources from charitable beneficiaries in favor of individual private gain. see jones, supra note 156. that doctrine, applies, though, only when private gain is diverted to “insiders” (those who exercise power of ownership with respect to the entity). see united cancer council, inc. v. commissioner, 165 f.3d 1173, 1176 (7th cir. 1999) (insider is director or trustee, chief executive officer, chief financial officer, or other high level manager). the primary purpose requirement, too, is ultimately concerned with whether, on the whole, the good that charity does so outweighs any other effects that tax exemption is justified. my premise is that even if resources are not diverted to individual gain and even if the organization is “primarily” charitable, the participation in tax shelters should still be precluded. the private inurement and primary purpose doctrines do not legitimately support such a notion. 806 florida tax review [vol. 4:12 are evolutionary and thus legitimately respond to charity’s evolving166 participation in tax shelters. a singular finding of fact, of sorts, is necessary before addressing the theoretical justifications for prohibiting charitable tax shelters. contrary to early notions, an attack against charity’s participation in tax shelters cannot be sustained on the notion that charity is paying an above market rate in any particular tax shelter transaction. in neither the fast-pay, bootstrap nor167 leaseback transactions, for example, is it logical to assume that charity is lending money at below market rates, (in the case of the fast-pay transaction), or paying an above market purchase or rental price (in the case of a bootstrap or leaseback transaction). the economic benefit necessitating charity’s involvement is solely a tax gain. that is, charity’s tax-exempt status allows the 166. two scholars deride the fact that “courts and commentators find themselves repeatedly forced to rest on the unilluminating platitude that ‘charity is an evolving concept which must be allowed to change and expand in response to the needs of society.” see columbo & hall, supra note 153, at 38 citing john p. persons, et al., criteria for exemption under section 501(c)(3), in research papers sponsored by the commission on private philanthropy and public needs, at 1909 (u.s. dep’t. of the treasury, ed. 1977). i rather think that the whole of law, particularly tax law (though i admit to being partial) is evolutionary. 167. see supra note 81 and accompanying text. on at least one occasion, even congress has explicitly assumed such a result: a third reason for proposing the taxation of lease-backs is the possibility which exists in each case that the tax exempt organization has in effect sold part of its exemption. this can occur either by the exempt organization paying a higher price for the property or by charging lower rentals than a taxable business could charge. proof, of course, is difficult to obtain because the purchase price, or rental charge which a taxable business would agree to pay, is unknown. in the case of ordinary investments there is no reason why an exempt organization could be expected to make an offer which would be much better, if any, than that which would be made by a taxable business. however, in the case of the lease-back arrangements the sellers seem to take the position that they will not sell at all unless they receive better terms than a taxable business can offer, and the exempt organization, because of its tax-free status, can afford to pay the higher price and still make a profit on the transaction. s. rep. no. 2375, 81st cong., 2nd sess. 31 reprinted in 1950 u.s.c.c.a.n. 3053, 3084. the dissent in clay brown accepted the assumption as well: indeed, this supposition [that charity is paying too much or charging too little] is highly likely, for the institute was selling its tax exemption, and this is not the sort of asset which is limited in quantity. though the institute might have negotiated in order to receive beneficial ownership of the corporation as soon as possible, the institute, at no cost to itself, could increase the price to produce an offer too attractive for the seller to decline. thus, it is natural to anticipate sales such as this taking place at prices on the upper boundary of what courts will hold to be a reasonable price – at prices which will often be considerably greater than what the owners of a closed corporation could have received in a sale to buyer who were not selling their tax exemption. commissioner of internal revenue v. clay brown, 380 u.s. 563, 588 (1965) (goldberg, j. dissenting). 2001] when charity aids tax shelters 807 taxable participant to avoid a tax cost and thereby obtain a premium not available elsewhere. the avoidance of that tax cost is uniquely available168 through the use of charity. thus, the taxable participant is in no position to demand, and charity need not pay, an inflated price. moreover, charity’s tax exemption, and therefore the taxable participant’s premium, is unnecessarily jeopardized when charity pays an inflated price. payment of an inflated price would implicate and likely violate the prohibition against private inurement or private benefit. the taxable participant therefore has an economic interest in ensuring that charity pay no more than market rate. if, indeed, charitable tax shelters were really a function of a higher than market payment, the answer would be readily apparent; the private inurement or private benefit doctrines would be adequate enforcement tools. the taxable participant’s economic169 yield is instead entirely dependent upon charity’s reasonable, rather than unreasonable, payment. the foregoing discussion, then, eliminates the prohibition against private inurement as a basis for attacking charitable tax shelters. that prohibition requires two findings. the first is that the taxable participant be an “insider” with respect to the charitable participant. the second is that the170 charity transfer wealth unnecessarily to the insider. the second requirement171 manifests itself, as a general matter, when charity makes an unreasonable payment. the tax shelter purpose would fail completely in such172 168. in the fast-pay tax and bootstrap shelters, charity allows the taxable participant to avoid the corporate tax. see supra notes 24-33 and accompanying text (with regard to fast-pay) and notes 51-68 and accompanying text (with regard to bootstrap sales). in a leaseback transaction, charity allows the taxable participant to avoid the corporate or individual tax. see supra notes 114-19 and accompanying text. in a partnership owning debt financed property, charity’s participation likewise allows a taxable participate to avoid tax. see supra notes 120-23 and accompanying text. although congressional statements most often assume charity pays too much or charges too little, on another occasion congress has accepted that charity probably pays less than market rate: the committee believes that reform of the tax law is essential, insofar as it relates to property used by tax-exempt entities under a lease, a lease formulated as a service contract, or other similar arrangements. when tax-exempt entities use property under these arrangements, they pay reduced rates rents that reflect a pass-through of investment tax incentives from the owner of the property. tax-exempt entities thereby benefit from investment incentives for which they do not qualify directly, and effectively gain the advantage of taking income tax deductions and credits while having no corresponding liability to pay any tax on income from the property. h.r. report no. 432, 98th cong., 2nd sess. 1138 (1984), reprinted at 1984 u.s.c.c.a.n. 697. 169. see id. 170. see united cancer council, inc. v. commissioner, 165 f.3d 1173 (7th cir. 1999) (excessive price paid to outside fundraiser was not private inurement because fundraiser was not an insider). 171. see generally jones, supra note 156 (providing an in-depth discussion of the theory and categories of private inurement). 172. see id. see, e.g., birmingham bus. college, inc. v. commissioner, 276 f.2d 476 (5th cir. 1960) (charity paid an unreasonable salary to an insider). 808 florida tax review [vol. 4:12 circumstances, and it is therefore illogical to assume that charity pays more173 than a reasonable amount. even in a transaction not involving an insider, charity need not pay an above market rate because charity possesses the rare asset, tax exemption, needed by the taxable participant. as a purely economic matter, charity can demand a return that results in charity’s enrichment and therefore the private inurement doctrine will not apply to charity’s participation in tax shelters. an unreasonable payment is not a condition precedent to charity’s violation of the sole affirmative requirement for tax exemption. to qualify for tax exemption, charity must be “primarily” engaged in activities that “accomplish one or more exempt purposes specified in section 501(c)(3).”174 thus, for example, a charity may make reasonable payments in the operation of a manufacturing business but, despite the making of reasonable payments, nevertheless forfeit the right to tax exemption if the conduct of the manufacturing business constitutes its primary activity. as used in this sense, “primary” is a relevant term requiring first a determination as to whether an activity accomplishes an exempt purpose. assuming the particular activity is175 not conducive to the accomplishment of the exempt purpose, the primary purpose requirement then requires a quantitative comparison of that activity with other activities that are conducive to an exempt purpose. if the176 nonexempt activity is “substantial” in relation to the exempt activities, the organization is not primarily engaged as required and therefore is not entitled 173. if, in a transaction with an insider (whether the transaction is a tax shelter or not), charity makes an unreasonable payment, tax exemption is forfeited. see id. the asset of value to the taxable participant to a tax shelter would then be lost. 174. see regs. § 1.501(c)(3)-1(c)(1); see also b.s.w. group, inc. v. commissioner, 70 t.c. 352 (1978). 175. see world family corporation v. commissioner, 81 t.c. 958 (1983) (organization’s research activity did not accomplish an exempt purpose). 176. see id. at 966-67 (organization’s noncharitable research activities were insubstantial in comparison to its charitable missionary activities). the court in world family corporation was careful to note that the relative amount spent on each activity was not determinative. instead, all the facts and circumstances must be considered in determining whether an activity is “substantial.” see id. at 967, n.10. there is no general rule for determining when the level of an activity becomes high enough that it is no longer incidental and instead becomes substantial; however, the courts will examine various factors in determining whether an activity is incidental to the organization’s primary activities, including (1) the amount of income derived from the activity in comparison to total income, (2) the amount of expenditures for the activity in comparison to total expenditures; and (3) the amount of time the organization’s employees devote to the activity in comparison to total hours worked. frances r. hill & barbara l. kirschten, federal and state taxation of exempt organizations, ¶ 2.02[3] (1994 & 1998 supplement). 2001] when charity aids tax shelters 809 to tax exemption. hence, the primary purpose requirement is not a function177 of charity making an unreasonable payment. to rely, though, on the primary purpose requirement as a response to charity’s participation in tax shelters is essentially to condone such participation. the second part of the primary purpose requirement allows tax shelter participation if, for example, charity unquestionably engages in exempt purpose activities and only occasionally participates in a tax shelter. suppose for example that a well-established, centuries-old university engages in tax shelter transactions on average once or twice every three years. it produces hundreds or thousands of graduates each year in many different disciplines and its faculty conduct important research year round. engaging in the tax shelter transaction is not an exempt purpose activity, but one certainly cannot178 conclude that the activity constitutes the university’s primary activity. the primary purpose test would therefore be ineffective in addressing the problem. and if every charitable organization were permitted to infrequently participate in tax shelters, there would be nothing preventing charity’s participation in tax shelters. the private benefit doctrine is occasionally referred to in the same breath, or as a “corollary” to the affirmative requirement that charity operate primarily for the achievement of exempt purposes. indeed, the formal179 articulation of the private benefit doctrine occurs within the context of a discussion of the affirmative requirement. but the private benefit doctrine is180 not always a corollary in the sense that a violation of the affirmative "primary purpose" requirement is the invariable result of a violation of the private benefit doctrine. private benefit requires a two-step analysis, only the second of which correlates to, and yet differs from, the primary purpose requirement. the first step holds that charity may confer a private benefit when doing so is a necessary consequence of achieving an overall charitable goal. private benefit181 177. see better business bureau v. united states, 326 u.s. 279, 283 (1945) (“the presence of a single [nonexempt] purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly [exempt purposes].”). better business bureau did not involve irc § 501(c)(3) but has been adopted as the appropriate standard in cases that involve irc § 501(c)(3). see copyright clearance center v. commissioner, 79 t.c. 793, 804, n.11 (1982). 178. see infra notes 193-97 and accompanying text. 179. see, e.g., patrick h. lucas, the service’s latest attempt to regulate hospitalphysician relationships: a critical analysis, 9 akron tax j. 13, 27 (1992) (referring to the private benefit doctrine as a “corollary” to the primary purpose requirement.); see hill & kirschten supra note 176, at ¶ 2.03[2] (“[t]he private benefit prohibition is defined by reference to the requirement that the organization operate ‘exclusively’ for an exempt purpose in light of the regulatory definition of ‘exclusively’ as all but an ‘insubstantial part’ of the organizations activities.”). 180. see regs. § 1.501(c)(3)-1(d)(1)(ii). 181. see american campaign academy v. commissioner, 92 t.c. 1053, 1066 (1989) (“occasional economic benefits flowing to persons as an incidental consequence of an organization pursuing exempt charitable purposes will not generally constitute prohibited private benefits.”) 810 florida tax review [vol. 4:12 includes any “advantage, profit, fruit, privilege, gain, or interest.” the quoted182 words seem only roughly synonymous and the search for common meaning is somewhat elusive. in practice, though, private benefit results when charity183 provides a special dispensation to a noncharitable person or select group of persons. if the benefit is not an inherent consequence of achieving a184 charitable purpose – i.e., if the purpose can be achieved without the special dispensation – the conferral of the benefit results in a violation of the private benefit doctrine, regardless of the overall public benefit provided by the organization. the second part of the private benefit prohibition holds that if185 182. see id. at 1065-66. 183. certainly, though, the charity must somehow “enrich” private interest, rather than simply engage in noncharitable quid pro quo transactions with noncharitable private interests. otherwise, the private benefit doctrine would prevent charity from engaging in any unrelated trade or business, and that result would render irc §§ 511-13 (the provisions which allow charity to engage in limited unrelated trade or business) meaningless. 184. for a more in-depth discussion of my formulation of the private benefit doctrine see darryll k. jones, private benefit and the unanswered questions from redlands surgical services, 89 tax notes 121 (oct. 2, 2000). in american campaign academy, the tax court distinguished between inherent benefits to individual students who enrolled in a charitable educational institution, and unnecessary benefits to a particular organization (the republican party, since it appeared that the organization served as a training program for republican party campaign workers). 92 t.c. 1053, 1074 (1989). the former benefits are inherently necessary to accomplish the educational goal, the latter are not. see id. cf. rev. rul. 70-186, 1970-1 c.b. 129 (1970) (organization formed to preserve and improve a lake could not achieve its purpose without conferring special benefit on lake-front property owners and therefore did not violate the private benefit prohibition). 185. the first part of this statement is fairly derived from american campaign academy which assumes that the private benefit occurs as an “incidental consequence” of charity’s “pursuing exempt charitable purposes.” see supra note 181. the second part of the statement – that if charity is not pursuing an exempt charitable purpose the relative amounts of public and private benefit are irrelevant – seems entirely logical but nevertheless more difficult to place within the language of relevant caselaw. in fact, american campaign academy stated that prohibited private benefit must be measured against the overall public good (in a manner similar to the “primary purpose” analysis) and that only if the private benefit is substantial will tax exemption be justified. 92 t.c. 1066. the service holds to the view stated in the text: any private benefit arising from a particular activity must be “incidental” in both a qualitative and quantitative sense to the overall public benefit achieved by the activity if the organization is to remain exempt. to be qualitatively incidental, a private benefit must occur as a necessary concomitant of the activity that benefits the public at large; in other words, the benefit to the public cannot be achieved without necessarily benefitting private individuals. such benefits might also be characterized as indirect or unintentional. to be qualitatively incidental, a benefit must be insubstantial when viewed in relation to the public benefit conferred by the activity. it bears emphasis that, even though exemption of the entire organization may be at stake, the private benefit conferred by an activity or arrangement is balanced only against the public benefit conferred by that activity or arrangement, not the overall good accomplished by the organization. gen. couns. mem. 39,862 (dec. 2, 1991) (emphasis added). both major treatises regarding tax exempt organizations take a rather agnostic approach. see bruce r. hopkins, the law of tax-exempt organizations § 19.10 (7th ed. 1998) (describing the approach articulated in gen. 2001] when charity aids tax shelters 811 a benefit is a necessary consequence, it must be insubstantial in relationship to the public gain derived from the same activity. at this point, the doctrine186 seems identical to the primary purpose requirement. the significant difference, though, is that only the single activity resulting in private gain is relevant. the187 analysis looks to whether the private benefit from the single activity is insubstantial relative to the public gain from that same activity. the analysis188 does not compare private gain from the single activity with public gain derived from all of charity’s other activities. thus, for example, an exempt hospital that treats thousands of patients per year and continuously supports scientific research does not violate the affirmative primary purpose requirement merely because it also enters into a joint venture with, and thereby provides special dispensation to, a taxable physician practice group that serves no charitable purpose. obviously, a189 quantitative comparison shows that the hospital is “primarily” operated to achieve exempt purposes. though the hospital does not violate the primary purpose requirement, it still forfeits the privilege of tax exemption because it confers an unnecessary benefit on the taxable joint venturer in a transaction not inherent to a charitable accomplishment. that is, the benefit conferred on the190 taxable joint venturer is not an unavoidable consequence of the hospital’s pursuit of the purpose for which it was granted tax exemption. private benefit results but its occurrence does not necessarily prove a violation of the primary purpose requirement.191 couns. mem. (gcm) 39,862, but not addressing whether that approach is consistent with american campaign academy); see hill and kirschten, supra note 175 at ¶ 2.03[2] (describing the gcm 39,862 approach as the “service’s position”). one commentator plainly asserts that the gcm 39,862 approach is incorrect. see lucas, supra note 179, at 29. in my view, the gcm 39,862 approach is correct for two reasons: first, the private benefit doctrine is entirely a creature of the service’s making, though it does have logical connection to the primary purpose requirement. putting aside whether the service has properly promulgated its approach and assuming the approach is not an abuse of discretion, it is the service’s meaning that one seeks in applying the private benefit doctrine. american campaign academy purports to interpret the service’s regulation, not the statute. see 92 t.c. 1053. second, it is manifestly counter-intuitive to think that charity may give away part of the store without jeopardizing its tax exemption simply because it doesn’t give away all or most of the store. yet that would be the result under an approach that treated the private benefit prohibition in a manner exactly as the primary purpose requirement. 186. see gen. couns. mem. 39,862 (dec. 2, 1991). 187. see id. (relevant portion of which is quoted in footnote 185). 188. see id. 189. see also gen. couns. mem. 39,862 (nov. 22, 1991). 190. see id. 191. of course, when an organization engages in only one activity, the fact that the activity results in private benefit (the private gain is substantial relative to the public benefit in that one and only activity), necessitates also a finding that the organization is not operated primarily for exempt purposes because the nonexempt activity is the only activity and by definition is substantial. see redlands surgical services v. commissioner, 113 t.c. 47 (1999) (organization’s sole activity was to participate in a health care joint venture that conferred a private benefit, therefore organization violated primary purpose test); american campaign academy, 92 t.c. 1053, 1078 (1978) (sole activity of operating an educational institute for 812 florida tax review [vol. 4:12 the relevance of the foregoing discussion is not quite apparent without two other supported assertions. the first is that the pursuit of capital via a trade or business, though perhaps necessary to accomplish other exempt goals, is not itself an exempt activity. it is instead a nonexempt activity. to hold192 193 otherwise would be to revive the statutorily discredited “destination of income” doctrine. that doctrine allowed an entity to claim tax exemption without regard to the nature of the activities in which the entity actually engaged. if the capital obtained thereby was devoted to charitable activities, the entity achieved tax exempt status. thus, a macaroni factory that paid all of its profits to new york university and a beach resort that devoted all its profits to a home for women194 and orphans were both previously entitled to tax exemption. the law has long195 since rejected the destination of income doctrine and, in doing so, established that the pursuit of capital, per se, is not an exempt activity. the second196 assertion is not as well established, but nevertheless logically correct and defensible. charity confers a private benefit by lending itself to a taxable person’s pursuit of a tax benefit. such a holding, though explicitly articulated197 only once, is entirely logical with the notion that private benefit may be198 manifested in the form of an “advantage, profit, fruit, privilege, gain, or interest.” tax benefits are, in a real sense, valuable economic assets and199 charity’s conferral of that asset can be a special dispensation for the benefit of a select party. these two assertions, combined with the recognition that the private benefit doctrine is a distinct requirement of tax exemption not mitigated by charity’s other activities, finally bring us to the first theoretical basis upon which to address charity’s participation in tax shelters. when charity aids a tax shelter it is engaging in a nonexempt activity that confers a benefit on a select, noncharitable beneficiary. the private benefit is composed of the tax benefit conferred by charity’s participation. it might still be operating primarily for exempt purposes if its many other activities outweigh republican campaign workers resulted in private benefit, was therefore a nonexempt activity, and therefore caused a violation of the private benefit and primary purpose requirement); kj's fund raisers, inc. v. commissioner, 74 t.c.m. (cch) 669, 671-72 (1997) (the operation of a charitable bingo was an exempt activity, but the manner of operation conferred private benefit and thus caused a violation of the primary purpose requirement). 192. see irc § 502; irc § 513(a). both provisions are based on the notion that an ordinary trade or business does not become an exempt purpose activity merely because the profits derived therefrom are used to support charitable activities. 193. university hill foundation v. commissioner, 446 f.2d 701, 704, 708 (9th cir. 1971) (the trade or business of engaging in bootstrap sales is a nonexempt activity). 194. see c.f. mueller co. v. commissioner, 190 f.2d 120, 123 (3rd cir. 1950). 195. see roche’s beach , inc. v. commissioner, 96 f.2d 776, 778 (2nd cir. 1938). 196. irc §§ 502 and 511-13 were added by the revenue act of 1950. 197. see housing pioneers, inc. v. commissioner, 65 t.c.m. (cch) 2191, 2195 (1993) aff’d 58 f.3d 401 (1995). (charitable organization’s participation in a joint venture to develop low-income housing allowed “significant federal income tax benefits” to flow to the non-exempt partners in violation of the private benefit doctrine). 198. see id. 199. american campaign academy, 92 t.c. 1066. 2001] when charity aids tax shelters 813 its one-time participation in a tax shelter. but in that single activity, there is no public gain since the pursuit of capital, per se, is presumptively a nonexempt activity. by definition, then, the private benefit resulting from the tax shelter200 is unnecessary. charity thereby violates the private benefit doctrine and should forfeit its tax exemption. by this theory, the law has the present ability to impose a real sanction when charity aids tax shelters. the second theoretical basis for attacking charity’s participation in tax shelters is the requirement that tax exemption should be denied or withdrawn if charity acts in a manner contrary to “established public policy.” the notion201 seems almost entirely intuitive and that is what causes nervousness concerning use of the public policy doctrine. intuition may at first be the evidence of202 universally accepted belief, but having once been used it may later become the basis for the imposition of policy with insufficient basis or support. it is a fact203 of human nature, for example, that people often assume that all right minded people think as “i” think. and sometimes it is true that there is only an insignificant deviation of thought amongst the body politic. that significant uniformity thus supports a finding that one person’s intuition evinces universally accepted belief. and the more individual intuition is articulated by 200. at least one court has held that a purpose to assist “another party in tax avoidance” is not even a valid business purpose for a taxable corporation. see asa investerings partnership v. commissioner, 201 f. 3d 505, 514 n.6 (1999). in asa investerings, the court upheld the reallocation of capital gains away from a foreign (essentially tax exempt) partner and to the taxable domestic corporation on the grounds that as an economic matter no partnership was formed. see id. at 516. a similar theory was relied upon to hold that allocation of losses to a limited partner should not be respected when the charitable general partner had not, in substance, transferred the loss generating asset to the partnership. see smith v. commissioner, 50 t.c.m. (cch) 1444 (1985). in smith, the court found no that “no valid business reasons were served by georgetown [university’s] purported joint venture with [taxable parties].” see id. at 1451. 201. see bob jones university v. united states, 461 u.s. 574 (1983). in articulating the public policy requirement, the court referred to “clearly defined” public policy, “clearly declared” public policy, “established public policy, and “fundamental public policy.” see id. at 582, 584, 586. i treat all modifiers as synonymously implying that the public policy must be virtually indisputable. 202. for example, in the absence of its explicit articulation, congress seems particularly reticent to permit the disallowance of an otherwise deductible irc § 162 expense based upon sharply defined public policy. see s. rep. no. 552, 91st cong., 1st sess. 274 (1969) (“public policy [in circumstances not identified in irc § 162(c), (e), (f), and (g)] is not sufficiently clearly defined to justify the disallowance of deductions.”). the supreme court, too, has indicated that the denial of a tax deduction based on public policy not articulated by congress is an action to be undertaken “in extremely limited circumstances.” see commissioner v. tellier, 383 u.s. 687, 693 (1966). 203. professor david a. brennen argues, for example, that although the result in bob jones university was correct, the department of treasury was the wrong entity to make the public policy decision. see david a. brennen, the power of the treasury: racial discrimination, public policy and “charity” in contemporary society, 33 u.c. davis l. rev. 389 (2000). it is his fear that now that the “public policy” rubric is out of the bag, it may be used to deny tax exemption to educational institutions that have affirmative action admission policies. see id. at 4 (“[c]ould the treasury revoke an organization’s tax-exempt charitable status on the ground that the organization engages in raced-based affirmative action?”). 814 florida tax review [vol. 4:12 the body politic – preferably but not necessarily through its elected representatives – the less discomfort one should feel in its enforcement, even204 if enforcement is accomplished by indirect or implicit delegation. in its most famous articulation of the public policy requirement, the supreme court held that the service could deny or withdraw tax exemption when charity practices racial discrimination. the court articulated a certain205 unmistakable intuition. tax exemption is conferred under the assumption that charity eases the burdens of government. charity must ease, but never206 increase, societal burdens. racial discrimination increases societal burdens and the recognition of that fact came after a rather difficult maturation process. thus, public policy, rather than explicitly stated prohibition, properly denies or revokes tax exemption in certain instances. although the court’s application of the public policy requirement was not intended as sui generis to cases of racial discrimination, applying the207 doctrine in a more purely tax context is nevertheless discomforting. in the broadest sense, the code is itself a massive and detailed articulation of public policy. it might legitimately be asserted that only when the code explicitly articulates an individual intuition does that intuition gain the imprimatur sufficient for “established public policy.” tax law’s folly, though, is that it208 has assumed for so long that words can and always will accurately capture the socio-economic theorem underlying a particular provision. but why should tax legislation assume an ability rarely, if ever, present in any other walk of life? if a speaker complains, for example, that there is so much in life she must see and do before she can finally settle down, although settling down now is tempting, the listener might generally empathize with her need to work a few more years before retiring. but the listener might know better the depth of her life’s thirst and her simultaneous weariness in life’s travel if she were to state: 204. see commissioner v. tellier, 383 u.s. 687, 693-94 (1966) (“[w]here congress has been wholly silent, it is only in extremely limited circumstances that the court has countenanced [denial of an otherwise available tax deduction]). 205. see bob jones university v. united states, 461 u.s. 574 (1983). 206. “charitable exemptions are justified on the basis that the exempt entity confers a public benefit – a benefit which the society or community may not itself choose or be able to provide, or which supplements and advances the work of public institutions already supported by tax revenues. history butresses logic to make clear that, to warrant exemption under regs. § 501(c)(3), an institution must fall within a category specified in that section and must demonstrably serve and be in harmony with the public interest. the institution’s purpose must not be so at odds with the common community conscience as to undermine any public benefit that might otherwise be conferred.” see id. at 591-92. 207. in contemporary times, the public policy rationale has not been used or implicated as a justification for denying tax exempt status. in one recent case, though, the service came under attack for a letter which implied, according to the applicant organization’s legal counsel, that “being gay is wrong” and therefore a potential basis to deny tax exemption to an organization organized to provide support for homosexual youth. see fred stokeld, irs letter to youth group raises concern in gay community, 76 tax notes 324 (1997). 208. see weisbach, supra note 91, at 871 (noting that tax rules “apply to their complete domain”). 2001] when charity aids tax shelters 815 the woods are lovely, dark and deep, but i have promises to keep, and miles to go before i sleep, and miles to go before i sleep.209 words only rarely capture the whole of thought, and then only by those with rare gifts indeed. this seems especially true with tax legislative pronouncements, which are invariably accompanied by reams of legislative history, implemented by an army of regulation drafters and occasionally interpreted by a host of judges. acting as though words really can and do capture the whole, particularly when widely held intuition is inconsistent with the literalism of sections and subsections, allows for anti-intuitive results. ultimately, tax shelters are anti-intuitive results thriving only in a system that embraces literalism and disclaims intuition. such results ought to cause more discomfort than a system that judiciously applies public policy. establishing the legitimacy of public policy as a rule of law is one thing, actually identifying a certain public policy is quite another. this is especially so with regard to taxation, as opposed to more thoroughly social issues. for one thing, identifying public policy with respect to taxation requires one to imagine a populace composed of persons who actually understand, or at least have more than once-a-year exposure to the code – a nonexistent nirvana to some tax professors. public policy is a quantitative notion, requiring evidence that the overwhelming majority of individuals composing the public hold identical beliefs. most taxpayers probably haven’t given the slightest thought to tax shelters, although they might ascribe to the populace notion that rich individuals and large corporations pay little or no tax. there are legitimate surrogates for the actual numbers necessary to achieve public policy. newspaper editorials and tax professionals might legitimately speak on behalf210 of the public. still, there must be some indication through the legislature that211 a certain activity contravenes public policy and should be prohibited, otherwise the danger that individual intuition passes for public policy is too great. the212 congress, of course, is the public’s quintessential “voice.” congress might simply assert that tax shelters are against public policy. it could go further and213 209. robert frost, stopping by woods on a snowy evening, in the poetry of robert frost 224 (edward connery lathem ed., 1969). 210. see, e.g., david ignatius, billion-dollar tax cheats, washington post, may 14, 2000 at b7 (decrying the rise in tax shelters and the professionals who plan them). 211. see, e.g., report on corporate tax shelters of new york state bar association tax shelters, 83 tax notes 879 (1999). 212. see commissioner v. tellier, 383 u.s. 687, 693 (1966). 213. section 2 of the abusive tax shelter shutdown act of 1999 is entitled “findings and purpose,” and states: a) findings.—the congress hereby finds that: (1) many corporate tax shelter transactions are complicated ways of accomplishing nothing aside from claimed tax benefits, and the legal opinions justifying those transactions take an inappropriately narrow and restrictive view of well-developed court doctrines under which– (a) the taxation of a transaction is determined in accordance with its 816 florida tax review [vol. 4:12 attempt to define tax shelters or it might leave that task to the service and the courts. the judiciary, too, can decide that a certain public policy is implicit in congressional actions that do not explicitly articulate that policy. in such circumstances, the judiciary can at least assert that congress has spoken, albeit indirectly, to the particular issue. the judiciary need not await an explicit articulation from congress before finding that a properly presented issue effects public policy. and as a practical matter, the service has as much a role as the214 judiciary in identifying public policy. it is the service that must first discern and enforce a certain congressional intuition before the judiciary is able to confirm or deny the existence of a public policy. identifying public policy may be215 presumed difficult, but there is nevertheless an orderly process by which public policy can be correctly discerned. the foregoing analysis supports an approach that would deny tax exemption to charities that participate in tax shelters. the best way, of course, substance and not merely its form, (b) transactions which have no significant effect on the taxpayer's economic or beneficial interests except for tax benefits are treated as sham transactions and disregarded, (c) transactions involving multiple steps are collapsed when those steps have no substantial economic meaning and are merely designed to create tax benefits, (d) transactions with no business purpose are not given effect, and (e) in the absence of a specific congressional authorization, it is presumed that congress did not intend a transaction to result in a negative tax where the taxpayer's economic position or rate of return is better after tax than before tax. (2) permitting aggressive and abusive tax shelters not only results in large revenue losses but also undermines the sense of voluntary compliance with the internal revenue code of 1986. (b) purpose.—the purpose of this act is to eliminate abusive tax shelters by denying tax attributes claimed to arise from transactions that do not meet a heightened economic substance requirement and by repealing the provision that permits legal opinions to be used to avoid penalties on tax underpayments resulting from transactions without significant economic substance or business purpose. h.r. 2255, 106th cong., 1st sess. (1999). 214. sometimes congress will explicitly state that it does not want the service or judiciary to deny a tax benefit on public policy grounds unless that public policy is explicitly articulated in the statute. see s. rep. no. 552, 91st cong., 1st sess. 274 (1969) (stating that trade or business deductions should not be denied on public policy grounds except as specified in irc § 162(c), (f), & (g)). see also regs. § 1.162-1(a) (“a deduction for an expense paid or incurred after december 30, 1969, which would otherwise be allowable under section 162 shall not be denied on the grounds that allowance of such deduction would frustrate a sharply defined public policy.”) 215. “guided, of course, by the code, the irs has the responsibility, in the first instance, to determine whether a particular entity is ‘charitable’ for purposes of irc §§ 170 and 501(c)(3). this in turn may necessitate later determinations of whether given activities so violate public policy that the entities involved cannot be deemed to provide a public benefit worthy of ‘charitable’ status. we emphasize, however, that these sensitive determinations should be made only where there is no doubt that the organization’s activities violate fundamental public policy.” bob jones university, 461 u.s. at 597-98. 2001] when charity aids tax shelters 817 would be for congress to formally and precisely declare that tax shelters are contrary to public policy, and charity’s participation therein provides sufficient reason to deny or withdraw tax exemption. if congress adopts one of the two proposed tax shelter measures, it should preface its adoption with a declaration that tax shelters contravene public policy. charities that aid tax shelters would then be placed on sufficient notice that doing so jeopardizes tax exemption. for its part, the judiciary seems ready to support such a public policy, perhaps even in the absence of a specific congressional declaration. in fact, there are216 already a whole host of provisions from which the service might derive a public policy prohibiting tax shelters. the nagging problem with this approach,217 ironically, is that the provisions already on the books unintentionally lend themselves to an argument that congress meant to better manage, rather than completely prohibit, tax shelters. imposing what are essentially disclosure and administrative record-keeping requirements with respect to tax shelters, as current provisions do, implies management rather than prohibition of those218 transactions. since public policy is the elevation of intuition as unarticulated law, it might reasonably be argued that public policy should not be used in cases involving ambiguity. the notion that congress is exercising grudging219 tolerance of tax shelters is severely undercut, though, by unmistakable legislative history expressing a desire to prohibit, not just manage, tax shelters. it is therefore more accurate to say that congress has expressed a220 216. for a contemporary discussion of judicial attempts to eliminate tax shelters see, david p. hariton, sorting out the tangle of economic substance, 52 tax law. 235 (1999). 217. see irc § 6111 (requiring the registration of certain tax shelters); irc § 6112 (requiring organizers and sellers of “potentially abusive” tax shelters to maintain lists of investors); irc § 6662 (accuracy related penalty applicable to tax shelters and other transactions); irc § 6700 (penalty for promoting “abusive” tax shelters). irc § 6708 (penalty for failure to maintain list of investors in potentially as required by irc § 6112). 218. see supra note 217 and accompanying text. 219. see tellier, 383 u.s. 687, 693 (1966). 220. a former irs commissioner states that congress’s “anti-shelter drive” has been in “high gear” since 1978. see mortimer caplin, tax shelter disputes and litigation with the internal revenue service – 1987 style, 6 va. tax rev. 709, 714 (1987). the legislative history of the deficit reduction act of 1984 states: the second objective of the bill is to prevent further erosion of the tax base as a result of tax sheltering activity. the budget deficit has been aggravated by the growth of tax shelter partnerships and creative use of structural tax rules to achieve tax benefits far in excess of those intended by congress . . . the committee believes that the proliferation of tax shelters has seriously eroded the tax base and has adversely affected the efficiency and equity of the tax system. the increase in tax shelter activity has aggravated the nation’s deficit problem, particularly in the case of “abusive” shelters where the tax write-offs are several times larger than the equity investment. the proliferation of tax sheltered investments shifts the tax burden to those taxpayers who do not or cannot participate in such investments, and the organization and promotion of tax shelters diverts thousands of skilled professions from more productive activities. h.r. report no. 98-432, 98th cong., 2nd sess. 1094, 1095 (1984). caplin describes the 1984 act as one which represents a change in emphasis from voluntary compliance with regard to 818 florida tax review [vol. 4:12 clear public policy against tax shelters but has been unable, to date, to articulate a way to absolutely prohibit tax shelters due to heretofore impossible task of defining tax shelters. that is, an outright prohibition would have required a221 precise definition of tax shelters and tax law had not yet reached a level of wisdom allowing for such precision. hence, congress adopted statutory provisions implying management of tax shelters, imprecisely defined, as a222 second best solution rather than with the intent to tolerate tax shelters.223 the service may not have to draw such a broad conclusion though. that is, the service need not discover and articulate a public policy rule that addresses the entire tax shelter problem. it may instead address the improper use of the tax exemption asset congress grants to charity. certainly, congress has clearly stated that charity acts improperly, so far as tax law is concerned, when it “sells” or “rents” its tax exemption. thus, the service and judiciary can224 legitimately assert that charity acts against established public policy when it engages in a transaction that serves no charitable purpose, but merely pursues capital, and the only asset offered in consideration of that capital is a tax benefit made possible only as a result of charity’s tax exemption. such an assertion would be much more limited and supported by entirely unambiguous congressional declarations. tax law, then, is not without the theoretical means to attack charity’s participation in tax shelters. and to the extent such transactions are rendered impossible without charity’s participation, it makes sense that the law should mount such an attack. if the problem of tax shelters really is serious, the law should not leave such an obvious stone unturned. after all, tax exemption is an expression of societal trust in charity’s implicit oath to do good always. the tax shelters to one which focused on “crime and punishment” as it relates to tax shelters. see caplin at 715. to the extent that description is accurate, it only makes the argument that tax shelters contravene a clearly established public policy all the more stronger. the same unmistakable anti-tax shelter concerns were explicitly voiced again when congress passed the tax reform act of 1986. see s. rep. no. 313, 99th cong., 2nd sess. 4, 713-718 (1986); h.r. rep. no. 426, 99th cong.., 1st sess. 54-55 (1985); joint committee on taxation, general explanation of the tax reform act of 1986 6-7, 209-212 (1987). 221. see supra note 19 and accompanying text. 222. under current law, the term tax shelter is generally defined as “any entity, investment plan or arrangement, or other plan or arrangement which is of a type which the secretary determines by regulations as having a potential for tax avoidance or evasion.” irc § 6112(b)(2). irc § 6111 provides what seems like a particularly unworkable definition which relies upon representations of “potentially allowable” deductions and credits. irc § 6111(c). 223. caplin describes the congressional approach to tax shelters as one designed to “throttle” and “sound the death knell” for the tax shelter industry. see caplin, supra note 220, at 725. 224. see s. rep. no. 2375, 81st cong., 2nd sess. 31 reprinted in 1950 u.s.c.c.a.n. 3053, 3084 (relating to the predecessor of irc § 514); see also s. rep. no. 552, 91st cong., 1st sess. 62 (1969) reprinted in 1969 u.s.c.c.a.n. 2027, 2091 (relating to irc § 514); h.r. report no. 432, 98th cong., 2nd sess. 1138 (1984) (relating to irc § 168(h)); staff of the joint committee on taxation, general explanation of the revenue provisions of the deficit reduction act of 1984, at 1151 (relating to irc § 514(c)(9)). 2001] when charity aids tax shelters 819 private benefit and public policy doctrines are available to enforce that expression of trust and tax exemption should be revoked when that trust is violated. vi. implementing an effective response: theory meets practice incumbent upon the one who articulates and asserts the adoption of theory is the duty to explain how that theory might be implemented in practice. it would be disingenuous, indeed, to neatly articulate theory without acknowledging whatever practical barriers exist to its implementation. the theory set forth in the preceding discussion is that charity should forfeit its tax exemption when it aids and abets a tax shelter. support for the theory can be found in the public benefit and public policy doctrines. there are certain surmountable difficulties, however, in implementing the theory and those difficulties are acknowledged and addressed in this section. this section puts forth one example that demonstrate how the theory would apply to particular facts. the first difficulty involves what seems like an unfair vicarious responsibility imposed on charity for the bad acts of another taxpayer. charity may legitimately assert that it is unfair to exact punishment against it for another taxpayer’s asserted tax position. such an argument, of course, is axiomatic. implicit in the notion that charity should be subject to an enforcement action when it aids and abets a tax shelter is the requirement that charity’s actions be undertaken with knowledge of and the intent to aid a tax shelter. in the absence of facts proving that requirement, charity is but an innocent bystander and, at most, the mere recuperative response of imposing ubit is appropriate. the theory espoused is not that charity suffer a sort of strict liability whenever its tax exemption is used by another party to obtain unjustified tax benefits. charity must instead intend to abuse the grant of tax exemption before a sanction is applied. the knowledge requirement must be carefully balanced to protect against both unjustified sanction and public inertia. in some instances the requirement to prove charity’s knowledge and intent might be easily met. in the bootstrap and leaseback transactions, for example, charity must be intimately involved in the tax planning if the shelters are to work. even some contemporary tax shelters, such as the charitable split-dollar transaction, are such that objective facts are available by which to prove charity’s knowledge and active involvement. but most other contemporary shelters are much more225 sophisticated, often times not requiring charity’s knowing participation, and226 imposing a sanction under a standard requiring proof of charity’s knowledge 225. the “charitable split-dollar life insurance” transaction is one example. see supra note 113. 226. see bankman, supra note 14. 820 florida tax review [vol. 4:12 would be nearly impossible. in the step-down preferred transaction, for227 example, charity would not necessarily know or have reason to know that a corporate taxpayer will assert an unjustifiable tax position. an actual knowledge requirement, then, would prevent unwarranted imposition of a sanction against charity, but might also prevent justifiable sanctions. effective implementation requires something between perfect hindsight, which would impose unjustifiable sanctions against charity, and perfect foresight, which would effectively immunize charity from justifiable sanction. a related imperative is that the theory must be implemented in a manner that distinguishes between charity’s knowing and intentional assistance to tax shelters, and its participation in legitimate transactions which nevertheless unintentionally assist tax shelters, whether knowingly or not. charity’s pursuit of its legitimate goals should not be discouraged by an overly broad remedy that frightens charity away from normal markets. even when charity knows that its participation in a transaction might assist a taxable person in taking an unjustifiable tax position, it should nevertheless escape sanction if the transaction is motivated entirely by charity’s intent to accomplish a charitable purpose. it might be argued in the latter instance that when charity knows its228 legitimate participation in a transaction is aiding a tax shelter, it should be required to seek out an alternative transaction. but this would place too much of the societal burden to eliminate tax shelters on charity’s shoulders. charity’s quasi-governmental, public benefit role should not include a duty to participate in an embargo against taxpayers who assert unjustified tax positions with charity’s unintentional help. charity would be precluded from legitimate transactions simply because other taxpayers might assert unjustified positions in response. that, too, would act as an unnecessary discouragement of the pursuit of charitable goals, since it would introduce a market distortion. in short, the theory should not impose a punishment when charity’s participation is legitimate solely from charity’s viewpoint. a more troublesome issue, related to the legitimacy of charity’s participation in certain transactions, cannot be resolved by looking to the extent to which those transactions are conducive to a charitable purpose. congress explicitly condones certain passive investment activities, – collecting interest, dividends, rent from real property, or royalties from the use of its intangible property – which do not necessarily lend themselves to justification as229 accomplishing charitable purposes. those activities therefore cannot be distinguished from activities that purposefully aid tax shelters on the ground that holding the investment achieves an exempt purpose. instead, the activities represent only the pursuit of capital, though not through a trade or business. with regard to those activities, the pursuit of a charitable purpose is not an 227. see supra notes 24-33 and accompanying text. 228. such a rule would be consistent with the private benefit analysis. see supra notes 179-91 and accompanying text. 229. see irc § 512(b)(1)-(3). 2001] when charity aids tax shelters 821 objective distinction between legitimate and illegitimate transactions since the passive activity need not be related to the achievement of an exempt purpose. another method must therefore be identified to distinguished between legitimate passive investments on the one hand, and passive investments which are intended to assist tax shelters on the other. the two main barriers, then, to the implementation of a theory which punishes charity for its participation in a tax shelter are: (1) proving the requisite knowledge such that charity is not made vicariously liable for another party’s illegitimate taking of a tax benefit, and (2) formulating an enforcement mechanism that responds precisely to the vice sought to be prevented. of course, proving charity’s knowing and intentional complicity by objective facts is a perfectly acceptable approach in cases when such facts are readily available (such as when charity actively participates in the planning and execution of the tax shelter). but practical evidentiary barriers prevail when the facts are230 exclusively within the taxable participant’s control and charity is but a passive, though perhaps knowing, participant. it would be overly burdensome and unwise to impose upon charity the duty to know the tax attributes or motives pertaining to its every taxable trading participant. and any penalty that is contingent upon charity actually knowing such attributes, in the absence of such a duty, would simply encourage charity to intentionally maintain an ignorance concerning a taxable participant’s motivation for transacting with charity. current law suggests a solution to this seemingly insurmountable practical barrier. there are, for example, several provisions that require selfdisclosure by taxpayers who organize, manage or participate in tax shelters.231 one statute, in particular, requires sellers of tax shelters to inform investors that they are participating in a tax shelter. it would be a minor extension of the law232 to require, or at least strongly encourage, charity to inquire whether a transaction in which charity is participating will trigger, in whole or in part, a disclosure obligation under any provision of existing law for one or more233 taxable participants. taxable participants are already required to know the answer and would only be required to convey that answer without stating reasons or opening its books to inspection by charity. the law should be formulated such that charity should make such an inquiry prior to closing the 230. see, e.g., supra note 113 (describing charity’s role in the charitable split-dollar life insurance transaction). 231. see irc § 6011 (requiring taxpayers participating in tax shelters to file a disclosure statement to that effect with the service); irc § 6111 (requiring the registration of tax shelters and the disclosure of the tax shelter identification number to those who invest in such shelters); irc § 6112 (requiring organizers of tax shelters to maintain lists of those persons who invest in such tax shelters). 232. see irc § 6111(b)(1) (requiring sellers of tax shelters to furnish each investor therein with the tax shelter identification number assigned by the secretary). 233. a “disclosure obligation” would include the obligation to maintain investor lists under irc § 6112. 822 florida tax review [vol. 4:12 transaction. by this device, charity will be relieved of the unfairness resulting from its inability to know whether a taxable participant is perpetrating a tax shelter with charity’s assistance or even whether a transaction constitutes a tax shelter in light of another taxpayer’s tax attributes or motives. likewise, the234 service will not be rendered powerless by charity’s practical inability to know, or its self-preserving desire to maintain ignorance with respect to important facts. the knowledge problem can be solved by requiring that charity make a simple inquiry prior to entering into certain transactions. to eliminate the minimal nuisance cases, an inquiry might only be required in cases involving amounts above a certain threshold level. 235 if charity so inquires and a taxable participant responds negatively, charity should be immune from liability even if the transaction is later determined to be a tax shelter. if, on the other hand, a taxable participant responds affirmatively, there ought to be another step acknowledging that charity may have legitimate reasons for participating in the transaction wholly apart from the potential bad acts of one or more taxable participants. thus, charity should be allowed to proceed in the transaction, even after receiving an affirmative response, if it can demonstrate that the transaction is part of charity’s ordinary operations and that charity would have so participated irrespective of the motives and actions of a taxable party. in this manner,236 charity will not be punished for the bad acts of another taxpayer. the potential distortion caused by prohibiting charity’s legitimate transaction merely because of the potential for abuse by another taxpayer would also be eliminated. implementation, of course, is dependent upon charity making an inquiry and its proving that the transaction, though known to support a tax shelter, is consistent with charity’s legitimate purpose for which tax exemption is granted. one way of encouraging charity to make the inquiry is by granting immunity when the inquiry is answered in the negative. because charity can still avoid liability under the proposal by proving a legitimate purpose, it might still forego the inquiry despite the potential for complete immunity. this would unnecessarily eliminate one level of discouragement. a way to counteract this 234. in general, the disclosure provisions define tax shelters consistent with the definitions described by professors johnson, see supra note 19, and bankman, supra note 4. for example, regs. § 301.6111-2t uses the economic substance definition preferred by professor johnson (i.e., present value of taxpayer’s expected pre-tax profit is insignificant relative to taxpayer’s tax savings from the transaction). regs. § 1.6011-4t(a)(3) defines tax shelters by reference to a list of factors similar to those outlined by professor bankman, including the participation of a tax exempt entity. 235. cf. regs. § 301.6111-4t(b)(4) (excluding from the definition of tax shelters certain transactions if the reasonably expected tax benefits do not exceed $5 million in a single year or $10 million in any combination of years). the threshold level should not be selected arbitrarily, of course, but with an eye towards eliminating the nuisance, de minimis cases without also providing loopholes for the more serious cases. 236. cf. regs. § 1.6011-4t(b)(3)(ii) (transaction is not a tax shelter with respect to a taxpayer if the taxpayer entered into the transaction in the ordinary course of business and would have done so irrespective of federal income tax benefits). 2001] when charity aids tax shelters 823 effect would be by use of a burden-shifting tool. if charity makes the inquiry, and the response is in the affirmative, no sanction should apply unless the government proves by clear and convincing evidence that the transaction is unrelated to the accomplishment of a charitable purpose. the making of the inquiry should create a presumption, however the inquiry is answered, that the transaction is legitimate from charity’s viewpoint and therefore not an appropriate occasion for sanction. if the answer to the inquiry is in the negative, the presumption should be irrebuttable. if the answer is in the affirmative and charity proceeds nevertheless, the presumption should be rebuttable, but only in compliance with the service’s meeting a high standard. on the other hand, if charity makes no such inquiry, and the transaction proves to be a tax shelter, charity should be subject to sanction unless it proves by a preponderance of the evidence that the transaction is entirely legitimate solely from charity’s perspective. the burden in cases when charity essentially fails in its small237 civic duty by making no inquiry should be on charity. the final barrier to practical implementation involves charity’s passive investment activities. as noted earlier, investment activities are condoned even though they do not necessarily achieve an exempt purpose. practical238 implementation therefore requires another way to distinguish charity’s legitimate investment activities from activities that knowingly assist a tax shelter. perhaps one method would be to require, rather than simply encourage, charity to inquire whether by its investment, it is participating in a tax shelter. something about another procedural requirement seems objectionable though.239 granted, it would be a minor imposition but the code contains hundreds of minor impositions. for that reason alone, one should hesitate to impose yet another “minor” imposition. but there seems no other practical way to prevent charity from intentionally sticking its proverbial head in the sand and thereafter disclaiming responsibility because of a lack of knowledge. and after all, charity is a trustee with fiduciary responsibility to the public. it should not object to a requirement that it take affirmative steps to prevent the abuse of a trust granted upon charity’s own request. one of the disclosure requirements already enacted require the seller or transferor of a tax shelter investment to have the required information available in any event. requiring, rather than240 encouraging charity’s inquiry in the case of passive investments does not seem 237. appendix a contains a flowchart showing the analytical steps in the enforcement of charity’s duty to prevent the use of its tax exemption in a nonpassive, tax shelter transaction. 238. see supra note 228 and accompanying text. 239. charitable organizations are subjected to relatively few administrative requirements. see staff of the joint committee on taxation, study of present-law taxpayer confidentiality and disclosure provisions as required by section 3802 of the internal revenue service restructuring and reform act of 1998, vol. ii: study of disclosure provisions relating to tax exempt organizations, 24-42 (2000). other than the application for exemption from tax required under irc § 508, charity is only required to file an annual information return. see irs form 990 (2000). irc § 6104 provides for public inspection and copying of the application for exemption and annual returns. 240. see irc § 6111(b)(1). 824 florida tax review [vol. 4:12 unfair. to alleviate some of the burden, the threshold amount below which inquiry is not required might be set at an even higher level than the threshold amount in non-passive investment cases. in any event, the harm to be prevented, charity’s participation in a tax shelter, coupled with the lack of any countervailing factor related to charity’s efficient accomplishment of its mission, justifies requiring that charity inquire whether a passive investment constitutes a tax shelter for which disclosure is required. if, upon inquiry, charity is informed that disclosure is not required, it should have complete immunity if the investment is later determined to be a tax shelter. but what would charity’s obligation be upon being informed of its participation in a tax shelter via a passive investment? i have argued, with respect to charity’s participation in a tax shelter transaction involving nonpassive investments, that charity should be allowed to proceed if doing so is legitimate solely from charity’s perspective. that is, if a transaction furthers a charitable purpose, charity should not be precluded from that transaction simply because a taxable participant might abuse charity’s involvement. to require charity to forego all such transactions might eliminate efficient transactions. that argument does not apply, though, with respect to charity’s passive investments. those activities serve only to obtain capital and therefore serve no charitable purpose that cannot be achieved without assisting in a tax shelter. the logical conclusion then, is that charity should be precluded from participating in passive investment tax shelters. this seems rather harsh, but it is consistent with the notion that the law should not take one step forward – assisting charity to obtain capital for quasi-governmental purposes – and two steps backwards – allowing charity to assist in greater harm to the tax system in its pursuit of capital. again, the harshness might be alleviated somewhat by imposing the requirement only with respect to transactions involving amounts over an intentionally high dollar value.241 the final portion of the implementation discussion involves an application to actual facts. assume, for example, that an investment manager develops a financial plan where the benefits are exclusively tax related. the242 plan calls for the formation of a limited liability company that elects to be taxed as a partnership. all the investors are individuals. the partnership’s activities243 consist of purchasing medical equipment offered at bankruptcy auctions, holding the property for one year and one day, and then donating the property244 241. appendix b contains a flowchart showing the analytical steps in the enforcement of charity’s duty to prevent the use of its tax exemption in a passive tax shelter transaction. 242. the following facts are based on weitz v. commissioner, 56 t.c.m. (cch) 1422 (1989) and herman v. united states, 73 f. supp. 2d 912 (e.d. tenn. 1999). 243. see regs. § 301.7701-3. cf. herman, 99-2 ustc ¶ 50,899 (individuals formed a limited liability company to purchase medical equipment to be later donated to a charitable hospital). 244. irc § 170(e)(1)(a) limits the charitable contribution to the taxpayer’s basis in the property if the donated property is other than long term capital gains property. to be long-term, the property must be held for more than one year. see irc § 1222(3). 2001] when charity aids tax shelters 825 to tax exempt hospitals. the hope is that the equipment will be purchased at distress sale prices significantly below fair market value and then contributed at the fair market value available in non-distress-sale transactions. the245 investors would then claim their share of the flow-through charitable contribution deduction (determined by reference to fair market value, rather than cost) and that share would far exceed their capital contribution (i.e., their share of the distress sale purchase price). the result would be a charitable246 contribution deduction used to shelter other income to an extent that results in a better economic position than if the investor had not participated. a charitable hospital would be an indispensable participant in the plan, although the hospital may be unaware of the plan when offered the donated items. suppose that the llc purchases medical equipment valued at247 $1,500,000 for only $40,000 and, to decrease transaction costs, seeks to248 donate all the equipment to a single charitable hospital. assume also that the threshold value at which the inquiry requirement applies is $1,000,000. that is, no sanction will ever be imposed on charity for its participation in a tax shelter if the value of the transaction does not exceed $1,000,000. here, the transaction value exceeds the threshold amount and the hospital conscientiously inquires whether the transaction of which the donation is a part will result in a disclosure obligation. if the investment manager responds in the negative, the hospital249 can accept the donation without any further thought concerning its civic responsibility vis-a-vis tax shelters. if the investment manager responds in the 245. irc § 170(e) allows a deduction equal to the fair market value of property as long as the sale of the property would result in long term capital gain, and would not be used for purposes unrelated to the hospital’s exempt purposes. 246. this is precisely what the taxpayers in herman successfully accomplished. see 73 f. supp. 2d at 915. 247. in weitz, the tax court relied, in part, upon the hospital’s involvement in the purchasing of equipment from bankruptcy auctions to disallow the claimed deduction. see 56 tcm (cch) 1422 (1989). the court reasoned that since the hospital frequently purchased equipment from bankruptcy auctions, and because a hospital representative assisted the donors in locating a bankruptcy auction and accompanied the donors to the auction from which the equipment was purchased, the “market” for purposes of determining the donated equipment’s value was the bankruptcy market and not the resale market. see id. but if the long term holding period is met, congress grants a tax deduction based upon the amount for which the donor could have sold the property. see irc § 170(e). the deduction is not otherwise based on the amount the donee would have paid for the property. 248. in herman, the llc purchased medical equipment for $40,000 and later successfully claimed a charitable contribution deduction of more than $1,000,000. see 73 f. supp. 2d at 916. 249. regs. § 301.6111-2t(b)(5)(i) allows a corporate taxpayer to avoid registration and notification to investors if the seller “determines there is no reasonable basis to deny the expected federal income tax benefits from the transaction.” here, of course, the llc is a partnership for tax purposes. a similar rule should apply for any transaction where, as with the charitable contribution deduction, the taxpayer’s expected gain is primarily the result of an intended tax benefit. cf. fy 2001 budget proposal, supra note 13 at 124 (a tax benefit clearly contemplated by an applicable provision would not support the finding that a transaction is a tax shelter). 826 florida tax review [vol. 4:12 affirmative, however, the hospital must then determine whether accepting the250 donation is a legitimate activity, solely from the hospital’s viewpoint and without regard to any tax position that might be asserted by any other party. in this respect, the hospital is in a relatively safe position since the code specifically intends that charity be supported by donations. thus, the hospital251 can accept the donation and provide documentation showing the receipt of medical equipment to the donor without fear that its doing so will result in252 sanctions based upon the tax positions asserted by the donors. suppose, however, the investment manager divides the medical equipment into two groups and donates $750,000 in value to each of two separate charitable hospitals. here, the threshold value amount is not exceeded and charity is not at jeopardy of sanction under the proposal. there is an obvious tension between the goal of eliminating charity’s participation in a tax shelter transaction, while simultaneously avoiding undue administrative burdens. the investment manager can still obtain the exact tax benefit by simply making two donations rather than one. charity, on the other hand, might be overburdened by yet another ministerial duty. thus, the variation in this example raises the issue whether the threshold value at which the sanction potential would exist should be lowered. it may be no more burdensome to encourage or require charity to make inquiries when a single donation exceeds $100,000 than it is when a single donation exceeds $1,000,000. the potential tax benefit to investors, however, might be eroded by transaction costs (i.e., shipping, insurance, storage, etc), if the investment manager had to divide donations amongst several charitable recipients in an effort to avoid the threshold. the foregoing discussion doesn’t militate against the theory, but merely points to the need for careful calibration of the threshold amount. thus, theory always has its practical difficulties and the theory discussed in this article is no exception. but the theory relates to a subject about which congress has already determined to be of high importance and, indeed, has implemented a certain workable statutory approach. there are several provisions already mandating the same disclosures that are necessary to the implementation of a theory making charity responsible for the knowing misuse of its tax exemption. requiring charity to inquire of certain trading partners whether the transaction in which charity participates, by itself or in conjunction with other transactions, will trigger a disclosure obligation is but a minor extension of existing law. granted, too, that almost every minor duty imposed by the code aggregates with other such minor duties to create higher transaction costs. the harm caused by charity’s participation in tax shelters, to the tax base 250. although the tax benefit resulting from the charitable contribution might be intended by congress, irc § 6111(c) might still require that the transaction be registered since the definition of tax shelter in that provision does not exclude transactions resulting in intended tax benefits. 251. see irc § 170. 252. irc § 170(f)(8) requires the donee provide a written acknowledgement of the donation containing a description of the property donated. 2001] when charity aids tax shelters 827 and to the concept of charity, and the trust embodied in the grant of tax exemption, justifies another imposition as a condition of tax exemption. the final practical notion not yet discussed is the nature of the sanction when charity aids and abets a tax shelter. this is not entirely a matter of analysis so much as it is a matter of one’s “sentencing” philosophy. mine is essentially that a miscreant be offered a means of rehabilitation, particularly when the harm is serious but nonrecurring with regard to the individual taxpayer. but, as implied throughout this article, the penalty ought to be severe enough that it actually discourages future participation in tax shelters. the ubit penalty does not do that. it follows that charity should forfeit its entire tax exemption but only for the year in which the violation occurs. there might also be provisions for abatement of that harsh penalty in cases involving serious mitigation. those might include the wholesale revamping of charity’s253 governance structure or an undoing of the transaction where possible. when254 the sanction is imposed, however, charity should be required to undergo a stringent reapplication process by which it demonstrates an awareness of the special trust underlying the grant of tax exemption. any violation thereafter ought to be grounds for permanent revocation of tax exemption. vii. epilogue it is difficult to regulate vice because, while the public may be harmed thereby, those who engage in vice often consider themselves benefitted. in many respects, the potential benefit is available to every individual composing the public. therefore, every individual has at least a dormant interest in doing nothing about the vice. defeating vice first requires a wisdom and maturity255 that allows every individual to forsake the potential for individual gain for the good of the whole. tax law appears to be approaching a certain mature recognition that the notion of ordering one’s affairs to pay as little tax as possible is no absolute right. vice thrives in an indulging consensual environment. that is, vice requires a willing producer, a willing supplier and a system that indulges one or the other. it is therefore logical that enforcement actions be taken against producer as well as consumer. so long as one is available, the other will be too. it makes little sense that the law take no enforcement action against “zero bracket taxpayers” – i.e., those who might be considered “producers” or “suppliers” of the tools necessary for tax shelters. some zero-bracket taxpayers 253. cf. irc § 4958(b) (providing for abatement of certain excise taxes imposed in response to violations of the private inurement/excess benefit prohibitions.) see also irc § 4961. 254. see irc § 4958(f)(6) (defining “correction” for purposes of abatement to include “undoing the [transaction] to the extent possible”). 255. this assertion might be proven by making reference to kenneth kies, who, after resigning as chief of staff of the joint committee on taxation, began working as a co-managing partner for pricewaterhousecoopers where he promptly began to campaign against proposals designed to curb tax shelters. see kies, supra note 13. 828 florida tax review [vol. 4:12 are beyond enforcement for either legal or policy reasons. charity, though, is well within the code’s regulatory jurisdiction. moreover, charity is akin to trustees in the asylum. charity occupies an exalted position in tax law and should reasonably be expected to act accordingly. when charity violates the trust embodied in the grant of tax exemption, the harm caused thereby is arguably greater than the harm caused by the inmates themselves one need not precisely define the concept of charity in order to know it does not include participation in tax shelters. there are, indeed, theoretically sound reasons to know that charity is inconsistent with tax shelter participation. the private benefit doctrine prevents charity from unnecessarily benefitting private parties. when charity participates in tax shelters solely in the pursuit of capital, and not as part of the pursuit of a charitable purpose, it conveys an unnecessary benefit and therefore violates the private benefit doctrine. a more theoretical, but equally valid assertion is that charity should not act in a manner inconsistent with public policy. that is, charity should never increase the burdens of society. tax exemption is granted precisely on that assumption. charity should alleviate societal burdens. when charity participates in tax shelters, it exacerbates societal burdens and society should not pay charity for doing so. tax exemption should therefore be withdrawn. theory is most often easier said than done. the theory offered in this article, as with most theories, creates certain difficulties in implementation. first, the theory requires a means by which charity’s knowing participation in another party’s unjustified tax position be shown. second, the theory requires a means by which enforcement may be enacted without interfering with charity’s legitimate activities. charity might therefore thwart the theory’s intent by maintaining an intentional ignorance regarding another party’s tax motives. this would not be hard since charity has no independent need to know the tax position of a party with whom it enters a transaction. without more, the theory would be useless. current provisions suggest a solution. those provisions require tax shelter organizers or sellers to disclose the fact of the tax shelter in one way or another. it would be a minor extension of that duty to require charity to inquire whether certain transactions in which it is about to participate are subject to any of those disclosure requirements. having made the inquiry, charity may therefore know whether it is allowing an asset granted to it in trust – tax exemption – to be used for harmful purposes. charity’s failure to make such an inquiry would be a factor to be considered in deciding whether to impose sanctions on charity. all citizens owe a duty to enforce the tax laws, even if enforcement is manifested merely by their annual filing of individual tax returns. charity is a special tax citizen, and holds a special place in tax law. it undertakes to assist not aggravate public burdens and is, for that reason, granted tax exemption. the implicit trust in the grant of tax exemption is violated, however, when charity aids and abets tax shelter transactions. when charity aids and abets tax shelters it belies the lofty justifications for tax exemption and thereby makes a case for denying or withdrawing tax exemption. florida tax review florida tax review volume 11 2011 number 8 683 exclusion from income of compensation for services and pooling of labor occurring in a noncommerical setting by douglas a. kahn* i. implied agreement to exchange services ............................. 684 ii. noncommercial zone of activity ............................................. 686 iii. joint activity differentiated from a barter transaction ..................................................................................... 691 a. joint activity .................................................................................. 691 b. non-marital exchange of services not connected with a trade or business .......................................................................... 693 c. barter club for child-care ........................................................... 695 d. a cooperative nursery school ...................................................... .695 e. home schooling ............................................................................. 696 iv. conclusion ........................................................................................ 697 when cash is received for services, it typically will constitute gross income to the recipient.1 but what if the payments are made in a noncommercial setting such as the payment by a parent to a child for mowing the lawn or performing household chores? as discussed later in this essay, there are reasons to conclude that such payments do not constitute income. the problem of how to treat receipts from a noncommercial activity frequently arises in the context of an exchange of services. a similar problem arises when services are provided by several persons pursuant to a pooling of labor to accomplish a common noncommercial goal. the regulations state that if a taxpayer receives services from another as payment for services rendered by the taxpayer, each party will realize gross * paul g. kauper professor of law, university of michigan. the author thanks professors james hines and jeffrey kahn for their extremely helpful comments and criticisms. 1. i.r.c. § 61(a)(1). 684 florida tax review [vol. 11:8 income equal to the value of the services received from the other.2 if services were received as full or partial payment for property, the value of the services received would be included in the amount realized on the sale of the property. the tax problems that arise in connection with the receipt of services mostly occur when services are exchanged, and this essay addresses that situation and will deal only incidentally with a payment of cash or other property for services. i. implied agreement to exchange services a fundamental issue in determining whether the receipt of services from another has income tax consequences is whether the services received were rendered as compensation for services performed (or to be performed) by the taxpayer. if, instead, the received services were rendered gratuitously, there would be no income tax consequence.3 when there is an explicit agreement that one service will be exchanged for another, then it is clear that they were undertaken pursuant to a bargained-for exchange. there are, however, many situations in which there is a factual question whether services were exchanged or whether there were mutual gifts of services. consider the following illustrations. helen, an attorney, is told that she needs to undergo surgery. she employs ralph to perform the surgery. ralph tells her that he is in need of an attorney to represent him in a divorce proceeding. he proposes that he perform the surgery in exchange for helen’s representing him in the divorce. helen agrees, and neither party bills the other for the services performed. clearly, that constitutes an exchange of services in which each party realizes gross income equal to the value of services received. now, let us change the facts. helen and ralph have been good friends since childhood. when helen visited ralph, he had no reason to believe that his marriage would end in a divorce; and so he had no reason to anticipate that he would need helen’s services. after performing the surgery, ralph tells helen that he will not bill her for his services because they have been such good friends for so long. if nothing else occurred, the services that helen received would be gratuitous, and there would be no tax consequence. two years later, ralph asked helen to represent him in a divorce. after doing so, helen wanted to charge ralph for her services, but felt constrained 2. reg. §1.61-2(d)(1). 3. section 102 of the code excludes from income property received as a gift. there is no statutory provision excluding the gift of services. there is no reason to treat the receipt of a gift of services differently from a gift of property, and the receipt of gratuitous services has never been subjected to taxation. this is part of the common law of taxation. indeed, the gratuitous performance of services for another is not even subject to gift taxation. see rev. rul. 66-167, 1966-1 c.b. 20. 2011] exclusion from income of compensation 685 not to charge him because of having accepted the gift of ralph’s services two years earlier. in the view of the author, helen’s provision of legal services to ralph was not made out of “detached and disinterested generosity.”4 the transfer was not motivated by love, affection, or sympathy. the value of her services should therefore be income to ralph. does helen’s nondonative purpose in not charging ralph for her services convert ralph’s “gift” to her into being one side of an exchange so that her receipt of ralph’s services is income to her? that would require helen to file an amended return. can the character of a transfer be changed retroactively? ralph’s intention to provide his medical services gratuitously is determined as of the time of his donation and is not affected by helen’s actions, but the subsequent event does put the matter into a different light. in the view of the author, ralph’s gift to helen should not lose its donative character and so should not be taxed to her. so, we are left with the strange result that ralph is taxed on the receipt of helen’s services, but helen is not taxed. in effect, one side of the transaction is treated as a taxable exchange, and the other side is treated as an independent transfer that is not part of the exchange. when each of two parties receives services from the other but there is no explicit agreement to exchange services, a question can arise as to whether there was an unstated understanding that services would be provided by each party to the other. should all or some of those services be treated as compensation for the other? for example, george and pat room together and divide the household chores. george cooks their meals, and pat cleans the dishes. george does the laundry, and pat cleans the house, etc. in those 4. see commissioner v. duberstein, 363 u.s. 278, 285 (1960) (quoting commissioner v. lobue, 351 u.s. 243, 246 (1956)) (establishing the “detached and disinterested generosity” standard for determining a gift). that standard is not applied literally because very few transfers are totally devoid of any selfish purpose, even if it is no more than to enjoy the gratitude of the donee. in goodwin v. united states, the court said: many courts nevertheless give talismanic weight to a phrase used more casually in the duberstein opinion — that a transfer to be a gift must be the product of “detached and disinterested generosity.” . . . to decide close cases using this phrase requires careful analysis of what detached and disinterested generosity means in different contexts. thus, the phrase is more sound bite than talisman. goodwin, 67 f.3d 149, 152 n.3 (8th cir. 1995) (citation omitted). there is a substantial question as to whether the moral constraint that prevented helen from charging ralph precludes gift treatment, but the author believes that it does. her transfer was not motivated by affection or a concern for ralph. 686 florida tax review [vol. 11:8 circumstances, even if the parties did not explicitly divide the chores, it would be reasonable to conclude that there was an implicit understanding that the chores would be divided so that one can be seen as done in exchange for the other. as we will see, even if the arrangement is treated as an exchange of services, there will be no income tax consequence. ii. noncommercial zone of activity although there is no explicit authority on the subject, it is a reasonable conclusion from a study of the field of taxation that the income tax operates only on commercial transactions.5 that is, the income tax applies only to transactions in which the taxpayer has, either voluntarily or involuntarily, entered into a commercial transaction. income derived from noncommercial activities has not been taxed, and yet the principle for excluding such income has never been articulated. it is the contention of the author that the principle underlying the exclusion of such income is that the income tax applies only to commercial activities and that income produced from noncommercial activities is not taxable. at first glance, it might appear that there is one instance in which noncommercial income is taxed, but upon closer examination, it is clear that the provision is not an exception to the principle proposed above. alimony is taxed to the recipient, but alimony is not derived from a commercial venture. the taxation of alimony serves a specific purpose that has nought to do with the measurement of income. prior to 1942, alimony was not included in a recipient’s gross income.6 after the outbreak of world war ii, tax rates were increased significantly, which made it more difficult for a payor of alimony to meet his obligations with after-tax dollars. to provide relief, congress decided to allow a divorced couple to split some of their income between each other so that they could take advantage of the lower tax rates that one of them had. the splitting of income was accomplished by making the receipt of alimony taxable to the recipient and by allowing a tax deduction to the payor for the 5. there is a 1917 decision of the supreme court in which there is a mild suggestion that taxation does not apply to noncommercial transactions. in holding that alimony was not taxable to the recipient, the supreme court stated: “alimony does not arise from any business transaction, but from the relation of marriage.” gould v. gould, 245 u.s. 151, 153 (1917) (quoting audubon v. shufeldt, 181 u.s. 575, 577 (1901)), superseded by statute, i.r.c. § 71(a). for an interesting and thoughtful discussion of some aspects of this view, see tsilly dagan, itemizing personhood, 29 va. tax rev. 93 (2009). professor dagan builds on scholarship dealing with the question of the commodification of personal attributes and interactions. 6. gould, 245 u.s. 151 at 154. see also douglas v. willcuts, 296 u.s. 1, 8 (1935). 2011] exclusion from income of compensation 687 amount of alimony paid.7 the effect of these income and deduction provisions is to shift the incidence of the tax on the amount paid from the payor spouse to the payee spouse and thereby utilize the payee’s marginal tax bracket. if x owns jewelry as personally used property, the sale of that jewelry would be a commercial transaction, and so would be the receipt of insurance for a theft of the jewelry. while the jewelry was not held for commercial purposes, its purchase and sale (or involuntary conversion to cash) would be a commercial transaction. x had to engage in a commercial market to purchase or sell the jewelry or to collect a reimbursement for its loss. in addition, the use of property or services to purchase consumption for the taxpayer constitutes a commercial activity. what then can constitute a noncommercial transaction? it is a transaction that, although causing economic consequences, occurs in a personal, noncommercial setting. stating it differently, there are noncommercial zones of activity, and economic benefits derived from those activities are not subjected to the income tax. where to draw the line separating commercial from noncommercial activities is a difficult question. there are activities that are clearly commercial and those that are clearly noncommercial. but, as is true for many distinctions that need to be made, there are grey areas the characterization of which will turn upon the judgment of the decision maker. over time, precedents will establish how specific items in that grey area are to be characterized. the clearest examples of benefits received in a noncommercial zone of activity involve a married couple. typically, there will not be an explicit agreement allocating tasks to each spouse, but there will be an implicit understanding that each spouse will do his or her share. the author knows of one marriage in which the allocation of tasks was explicit. the couple undertook to determine the weight to be accorded to each task and carefully allotted the tasks so that neither spouse obtained an advantage over the other. even in that unusual situation, there would be no income tax consequence. there never has been an effort to tax a married couple for an exchange of services of that nature. why is that so when there is clearly an exchange of services? one consideration is that taxing an exchange of services performed in a marital community would pose huge administrative difficulties, and avoidance of that administrative burden is likely one factor in the decision not to impose a tax. in addition to difficult valuation issues, it would not be easy to discover the events where one spouse performed a service for the other; and many of the services performed will be of a highly personal nature. 7. i.r.c. §§ 71(a), 215(a). 688 florida tax review [vol. 11:8 but administrative inconvenience is not the only reason for excluding those services from taxation. a tax regime that would require the discovery of services performed within the marital community would constitute an invasion of privacy and an intrusion into an individual’s private noncommercial life, and that would be unacceptable in a free society. even when identification and valuation of marital services does not pose a problem, the value of these services nevertheless will be excluded from income. the personal private lives of individuals should not be subjected to disclosure by the government unless there is a compelling public reason to require it. stating it differently, the primary reason for the exclusion is that the household tasks performed in a marital community are in a noncommercial zone and are excluded from the income tax because those activities are insulated from governmental oversight. another way of viewing the conduct of the spouses is to treat them as engaged in a joint venture in which there is a division of labor. the exchange of services by roommates pat and george in the illustration above similarly would not be income to either. part iii of this essay discusses whether a pooling of services to accomplish a common goal should be excluded from income tax consequences. this view of a noncommercial zone does not mean that a married couple can never engage in a commercial venture together. for example, if a wife owns a shoe store and hires her husband to be a salesman, they would be engaged in a commercial activity, and the wages paid to the husband would be income to him. taxation of that transaction does not involve a violation of privacy nor an intrusion into an individual’s private noncommercial affairs. not taxing services performed in a family setting is analogous to not taxing imputed income from the services one performs for himself. an individual is not taxed on the wealth produced by cooking his own meal, shaving himself, mowing his own lawn, building a bookcase for his own use, etc. the reasons for not taxing such imputed income are the same as those that apply to the decision not to tax events occurring in a noncommercial zone. a tax on such imputed income would pose difficult valuation and identification problems and would constitute an invasion of privacy and an intrusion into an individual’s private life. moreover, it would be undesirable to have the tax law deter an individual from using his own labor to improve his household, himself, or his family. if such imputed income were taxable, an individual might choose not to shave or have his wife cut his hair or make household improvements and repairs. that is not to say that a person would necessarily refrain from such actions, but the imposition of a tax liability would be a factor to be weighed in determining whether the net benefit to be gained is worth the effort. while there is no statutory provision excluding imputed income from taxation, it is excluded under the common law. 2011] exclusion from income of compensation 689 for some limited purposes (but certainly not for all purposes) members of a family are treated as a single unit.8 therefore, services performed for the family by an individual member can be seen as services performed by the family unit for its own benefit and thus excluded from tax as imputed income. another area where the noncommercial zone concept should apply arises when a child of the family is paid cash for doing chores. for example, robert jones pays his twelve year old son, willie, $20 a week to mow the lawn. should that payment be income to willie? while the issue does not seem to have arisen, perhaps because the child does not earn enough to require filing a tax return, the author concludes that the $20 payment is not income to willie. consider these alternative circumstances. robert pays willie $20 a week as an allowance, and willie performs chores as his share of household responsibilities. the weekly payment to willie is a gift and is not included in his income.9 the exchange of services that willie received from his parents for the services he performed is not income under the noncommercial zone concept described above. so, willie has no income. instead, robert wishes to instill work habits in willie for earning his living later in life. so, rather than give willie an allowance, robert agrees to pay willie $20 a week for the chores that willie performs. it is the author’s view that the characterization of the payment does not alter its noncommercial attribute. in effect, willie receives an allowance and is required to do household chores; the characterization of the payment as wages does not represent its actual function. while a number of courts have adopted a doctrine that makes it difficult for a taxpayer to repudiate the form in which a transaction was cast,10 that doctrine should not apply to this situation. this is not a case where the taxpayer could manipulate the tax consequence by adhering to the form of the transaction if such adherence proves desirable, but pointing out the different substance of the transaction if characterization subsequently proves to be more desirable. in the instant case, there is no tax advantage to treating the payment as a wage, and the parent’s purpose in so characterizing it has no tax motivation. a similar situation has arisen in connection with welfare benefits, and the internal revenue service has excluded the payments from income in 8. for example, for some purposes, stock owned by one person is treated as also owned by certain other members of the owner’s family. e.g., i.r.c. §§ 267(c)(2), (4), 318(a)(1), 544(a)(2). for other purposes, a group of related persons are aggregated and treated as a single person. i.r.c. §§ 355(d)(7)(a), (e)(4)(c)(i). 9. i.r.c. § 102. 10. see, e.g., commissioner v. danielson, 378 f.2d 771 (3d cir. 1967) (en banc); see also douglas kahn & jeffrey kahn, federal income tax 817–18 (6th ed. 2011). 690 florida tax review [vol. 11:8 that circumstance. amounts received as distributions from a general welfare fund (typically a distribution made by a state or federal agency pursuant to a statute to provide help for needy persons for the promotion of the general welfare) are excluded from the recipient=s gross income.11 to further its goals, some welfare agencies require a recipient to perform services as a condition of receiving benefits. the purpose of that requirement may be to inculcate work habits that will encourage the recipient to find gainful employment. an additional purpose may be to provide training for the recipient to learn a trade. the payments may be based on an hourly wage for work performed. as a policy matter, the payments should not be income to the recipient if the agency’s purpose was to rehabilitate the recipient as contrasted to obtaining the benefit of his services. in such a case, the payments should be treated the same as welfare payments in which no work is required. the service ruled in revenue ruling 71-42512 and notice 99-313 that such payments are not income to the recipient if the following conditions are satisfied: (1) the recipient’s participation in the work program must be arranged and financed by a public agency that provides welfare benefits; and (2) the total amount of payments received by the worker must not exceed the sum of the welfare benefits the worker would have received if he were unable to work plus out of pocket expenses incurred in performing the work. in other words, the number of hours worked must not exceed the number of hours needed to provide the worker with subsistence for his needs. as previously noted, the code expressly excludes gifts from income.14 a principled policy justification for that exclusion is described in a previous co-authored article of the author’s.15 if gifts are deemed to be made within a noncommerical zone, that would be an additional policy justification for their exclusion from income. it is a close question whether a donative transfer lies outside of the commercial sphere. on the one hand, a donative transfer of property bears some similarity to a sale of that property. on the other hand, a donative transfer is noncommercial in that the donor obtains no financial benefit or consumption from the transaction. on balance, a donative transfer appears more like a noncommercial transaction, and so that is an additional policy justification for its exclusion from income. 11. see, e.g,. rev. rul. 73-7, 1973-1 c.b. 39; rev. rul. 63-36, 1963-2 c.b. 19; rev. rul. 57-102, 1957-1 c.b. 26; priv. ltr. rul. 9351017 (sept. 24, 1993). 12. 1971-2 c.b. 39. 13. 1999-1 c.b. 271. 14. i.r.c. § 102. 15. douglas a. kahn & jeffrey h. kahn, “gifts, gafts, and gefts” — the income tax definition and treatment of private and charitable “gifts” and a principled policy justification for the exclusion of gifts from income, 78 notre dame l. rev. 441 (2003). 2011] exclusion from income of compensation 691 iii. joint activity differentiated from a barter transaction while an income tax system is not comfortably applied to a bartered transaction, it is necessary to do so to prevent wholesale tax avoidance. consequently, as a general rule, exchanges of property or services will be subjected to taxation. barter clubs have been formed pursuant to which one member provides goods or services to another member in exchange for credits or points that can be used to pay for services or property received from another member.16 the value of the credits or points received constitutes income to the recipient.17 if, instead of using points or credits, services are received directly from the other member of the club in exchange for service performed, the value of the services received is income to each party.18 if the barter club has at least 100 transactions in a calendar year, it is required to file form 1099-b with the service to report the transactions.19 if there is an exchange of services in which the service received is an expense of conducting the recipient=s business, and if the value of the service received equals $600 or more, the recipient must file forms 1096 and 1099 to report the transaction.20 notwithstanding the tax law’s treatment of barter transactions, when an exchange takes place in a noncommercial setting, there is good reason to conclude that it is not subject to the income tax. however, as noted above, while the characterization of an activity as commercial or noncommercial often is clear, there are grey areas where it is difficult to make that determination. over time, many of those grey areas will become clear as precedents are established classifying them. a. joint activity several persons can join together to pool their labor to accomplish a common goal. their joint efforts should not be treated as an exchange of services but rather as a jointly conducted activity. when the common goal has no business connection, the exclusion of joint activity services from income can be seen as a corollary to the proposed principle that income arising out of a noncommercial activity is not taxable. the application of this proposed “pooled labor” principle requires that there be a standard for determining what constitutes a “common goal.” 16. see rev. rul. 80-52, 1980-1 c.b. 100; korpi v. united states 84-1 u.s. tax cas. (cch) ¶ 9203, 53 a.f.t.r.2d 84-1048 (d. mass. 1984). 17. see rev. rul. 80-52, 1980-1 c.b. 100. 18. rev. rul. 79-24, 1979-1 c.b. 60. 19. reg. § 1.6045-1(e)(2)(ii). 20. rev. rul. 85-101, 1985-2 c.b. 301. 692 florida tax review [vol. 11:8 how broadly described can such a goal be? if the common goal is defined broadly enough, virtually every exchange of services could be classified as serving it and thereby excluded from income. unless limits are imposed on the concept of a common goal, no exchange would be taxable, and that would create a large loophole in the tax system. for example, if x repaired y’s car in exchange for y’s performing surgery on x’s leg, could both services be classified as furthering the common goal of “fixing things?” the answer is that “fixing things” is too broad a concept to be used in this context. the definition of a “common goal” must be restricted if it is to be a useful concept for this purpose. the common goal must be the product of a single activity that is regarded as such by the public. the services involved must be so related that they are commonly regarded as in furtherance of that activity. the limitation on the breadth of a common goal rests on a common sense approach to whether the public would consider that goal to be the purpose of conducting an activity as contrasted to stretching the concept to incorporate the services in question. the limitation of the concept rests on a factual issue as to what is commonly regarded as a single activity. there is nothing unusual about having a tax law characterization rest on a factual determination of the common understanding of a concept. there are numerous examples of that approach. several are described below. the determination of whether an item of clothing qualifies as a uniform, the cost of which can be deducted or depreciated, depends upon whether the item is adaptable for general use so that it could be used in place of regular clothing.21 the test for whether an item is so adaptable for general use turns on community standards.22 the question of whether the expenses of seeking new employment are deductible depends upon whether the new employment is in the same trade or business as the taxpayer’s old job.23 the deductibility depends upon a factual determination as to what constitutes a new trade or business. as is true of the common goal concept, the trade or business standard should not be defined too broadly. for example, a taxpayer’s trade or business could be said to be that of being an employee without regard to the type of work performed. obviously, the concept is not applied that broadly. the determination of whether a taxpayer’s educational expenses qualify as a business expense can rest on whether the education qualifies the taxpayer for a new trade or business. as to what qualifies as a new trade or business, the tax court has said that it compares the types of tasks and 21. rev. rul. 70-474, 1970-2 c.b. 34. 22. pevsner v. commissioner, 628 f.2d 467, 470 (5th cir. 1980). 23. rev. rul. 75-120, 1975-1 c.b. 55. 2011] exclusion from income of compensation 693 activities involved and essentially applies a common sense test as to whether the new position is different from the old.24 as a matter of societal policy, the tax law should not operate to deter the formation of cooperative ventures in which people pool their labor for a common personal goal. the tax law expressly provides for such pooling of labor and property for business purposes in its rules for dealing with partnerships.25 the partners’ exchange of services does not cause them to recognize income.26 the same treatment should be accorded to the pooling of labor in a joint activity that is not connected with a business. consider the following illustration. john and robert live in different parts of manhattan. both of them wish to have a vegetable garden but have no land in manhattan to use for that purpose. they each purchase land on long island, and the two plots are within a few blocks of each other. each individual plants vegetables on his plot. rather than having each of them travel to long island four times a week to tend to his garden, they agree to take turns so that each will travel to long island only twice a week and will tend both gardens on each trip. in the author’s view, john and robert should not be taxed on an exchange of services. instead, they should be treated as pooling their labor to accomplish a common goal — namely, the maintaining of their vegetable gardens. the arrangement should be treated as combining the two gardens into a single activity. there should be no income tax consequence. the exchange of services by the roommates, george and pat, in an example set forth earlier in this article also should be excluded from income as a joint activity. b. non-marital exchange of services not connected with a trade or business let us consider the treatment of a direct exchange of services that are not connected with either party’s trade or business. one question is whether the tax consequences will depend upon whether the parties are jointly engaged in a single activity. consider the following two examples. paul is a shoe salesman who is handy at making repairs and improvements to his house and household goods. paul’s neighbor, frank, is a 24. glenn v. commissioner, 62 t.c. 270, 275 (1974). 25. i.r.c. §§ 701-777. 26. while partners are treated as mutual agents, that does not entirely distinguish their situation from those engaged in a noncommercial joint activity. for example, architect and builder form a partnership to purchase land and construct a ten-unit apartment building. the two partners contribute an equal amount of cash. architect designs the building, and builder constructs it. the mutual agency concept does not distinguish their exchange of services from the pooling of labor by those engaged in a noncommercial common activity. 694 florida tax review [vol. 11:8 college professor who has no talent for making repairs. frank is an amateur chess player who has a master’s ranking. a window in frank’s house is broken by a storm. paul offers to repair it and does so. if nothing more occurred, paul’s provision of a service would be a gift, and there would be no tax consequence. instead, when frank accepted paul’s offer, frank offered to give chess lessons to paul=s daughter, megan, to compensate paul for his work. frank gives chess lessons to megan. should paul and frank be taxed on the exchange of services? neither service that was provided was connected with the business or profession of the service provider; nor was the service received connected with the business or profession of the recipient. nevertheless, the exchange of services can be seen as occurring in a commercial zone. frank could have charged for giving chess lessons, and the amount received would have been income to him even though he is not a professional chess player. by offering to provide chess lessons as payment for the service that paul performed, frank has placed his service into the commercial market. the same is true for paul. under any reasonable construction, there is no common goal for the two services, and so they cannot be characterized as a pooling of services for a common goal. given the isolated aspect of this exchange (i.e., it was not part of a pattern of exchanging services), the administrative costs of taxing it are such that the government might be better advised to ignore it. nevertheless, a proper application of the tax law would tax the exchange. the exchanged services were not provided to achieve a common goal. it just may not be worth the government’s effort to enforce the tax. if one or both of the parties engage in a number of such exchanges, then the government should enforce the tax. in that regard, note the requirement that a barter club whose transactions in a calendar year exceed ninety-nine must file information forms with the service.27 consider a second example. mildred and allen have a three-year old son. their neighbors, susan and peter, have two children ages two and five. on short notice, susan and peter need a baby sitter and ask for either mildred or allen to sit for their two children. in return, they offer to sit for mildred and allen’s son when needed. both babysitting services take place. should each be taxed on the service received? should it matter if both families agree to exchange babysitting services on a regular basis and do so? while it is a close question, the author believes that the exchange of services comes within the joint activity exception described above in connection with the tending of the vegetable gardens. the parents are tending children instead of vegetables, but the same principle applies. there is a difference in that the babysitting activity deals with the other family’s children as contrasted to caring for all the children together. that difference should not matter. if instead of going to the other’s home to sit, the child or children were brought to the home of the sitter, the sitter would be caring for 27. see reg. § 1.6045-1(e)(2)(ii). 2011] exclusion from income of compensation 695 all the children at the same time. the tax result should not rest on that distinction. the goal of the arrangement is to provide for the care of all of the two families’ children, and that constitutes a single activity. c. barter club for child-care a barter club can be a commercial enterprise from which a proprietor derives a profit. there also are cooperative barter clubs in which the members themselves operate the club. one such type that is fairly common is a babysitting club. a child-care barter club can operate very much the same way as other barter clubs do. the babysitting is performed by the members, who are parents of young children. points are allotted for each hour that a member sits for another child. additional points may be granted for sitting after midnight and on holidays. a member’s points are reduced when he uses the babysitting services of another member. one member serves as a secretary who maintains a record of the points earned and used by the members. one possibility is that, as with other barter club programs, a member could be taxed on the receipt of points or on the receipt of babysitting services. how should this arrangement be treated? a significant difference between the child-care barter clubs and other barter clubs is that the services that are obtained through the club are all of the same type and serve the same function. the only service obtained is babysitting for a young child. in other types of clubs, a member might choose to get legal services from another member or he could choose to obtain an entirely different type of service. consequently, in contrast to other barter clubs, a child-care barter club can be seen to be a cooperative joint venture to engage in a single activity — that is, the tending to young children. although conducted on a larger scale, the circumstances of the club are similar to those in the situation described above of the two manhattan residents who shared the burden of tending to the vegetable gardens on long island. in the author’s view, the members of the club should not be taxed. d. a cooperative nursery school cooperatives can take many forms. one element that they often have in common is that they utilize a pooling of labor by members of the venture. cooperative nursery schools are a popular program. a group of parents form a nursery school and hire a professional teacher. parents who place a child in the school have an option either to pay $x or to assist the teacher for a set number of hours, in which case they will pay $x minus $y. when assisting a teacher, the parent will serve all of the students in the class. the reduced cost to the parent could be seen as an implicit payment for the parent’s services. alternatively, and more realistically, the parent’s 696 florida tax review [vol. 11:8 supplying of services can be seen as eliminating a cost of conducting the school that otherwise would have been necessary. the reduced cost to the parent is a form of imputed income from providing services for the parent’s own benefit (and the benefit of his own child), and imputed income is not taxable. however, by tending to all of the children in the class, each participating parent effectively exchanges his services for the services his child receives from other participating parents. the situation is similar to the example above of the two manhattan residents who take turns tending their gardens in long island. as stated in discussing that situation, the author concludes that the cooperative nursery does not constitute a taxable exchange of services but rather is a pooling of labor to accomplish a common goal. e. home schooling some parents choose not to send their children to public or independent schools. instead, these parents teach their children at home. in many cases, the children of several families are combined into a single class and taught by several parents. the parents divide the subjects among themselves so that each parent teaches different subjects.28 are the teaching services performed by one parent compensated by the teaching service performed by the other parents? given the approach adopted in this essay, there is no exchange of services and thus, no income tax consequence. the parents pool their services to achieve the common goal of educating their children. the activity of educating children is one that is commonly conducted and so there is no difficulty in finding that the common goal requirement is satisfied. would the result be different if the exchange of teaching services were limited to two subjects? consider this example. john would like his child to learn french, but french is not taught in the local school. robin would like her child to learn latin, but latin is not taught in the local school. john agrees to teach robin’s child latin in exchange for robin teaching john’s child french. is that a pooling of services for a common goal? the common goal could be to teach a foreign language or more broadly to educate the children. in the author’s view, neither goal is too broad to serve for this purpose; and so the exchange is not taxable. the situation is distinguishable from home schooling in that it does not involve all of the children’s education, but is limited to a single subject for each child. a common activity is tutoring of children, and the instant situation fits that category. in any event, the types of services performed by both parties are sufficiently similar that they should be regarded as furthering the same goal. the instant situation is comparable to the exchange of 28. some families also hire a professional to teach a specific area, such as science or latin. 2011] exclusion from income of compensation 697 gardening services by john and robert and to the exchange of child-care services by mildred and allen with susan and peter in examples discussed above. iv. conclusion taxation is a practical enterprise for the purpose of raising revenue for the government to pay for its costs. the system that is applied must be workable and, to the extent feasible, should not conflict with other governmental and societal policies. the thrust of the income tax system is to tax income earned from commercial activity. there are good reasons not to tax income generated from noncommercial activities, and generally taxes have not been applied in that situation even though no specific exception for noncommercial income has ever been articulated. as a corollary to the proposed rule excluding income from noncommercial activity, the combining of the labor of several persons to reach a common noncommercial goal should be regarded as noncommercial and so should not be taxed as an exchange of services. there are several reasons to exempt noncommercial activities, which should be defined to include the exchange of services that occurs when there is a pooling of labor for a common noncommercial goal. in many cases, there would be significant difficulty in discovering the events and in valuing them. moreover, the transactions often would be of a personal nature, and the identification of what occurred in order to tax it would entail an invasion of privacy and an intrusion into an individual’s private affairs. just as the tax law does not tax the pooling of labor in a partnership, it should not tax the pooling of labor in furtherance of a common noncommercial goal. florida tax review florida tax review volume 14 2013 number 6 watching the watchers: preventing i.r.s. abuse of the tax system samuel d. brunson * abstract as a result of broad outcries against the incompetence and aggressiveness of the i.r.s., congress reined in its behavior, requiring it to focus on treating taxpayers as customers. congress also created oversight bodies to ensure that the i.r.s. would comply with the new mandate. though those oversight bodies face some difficulties — most notably, the unwillingness of congress to adequately fund them — they nonetheless have proven effective at checking the i.r.s.’s misbehavior with regard to taxpayers. congress has not, however, been as solicitous to the tax law itself. the i.r.s. can act in ways that violate both the letter and the intent of the tax law. where such violations either provide benefits to select groups of taxpayers without directly harming others, or where the harm to taxpayers is de minimis, nobody has the ability or incentive to challenge the i.r.s. and require it to enforce the tax law as written. congress could control the i.r.s.’s abuse of the tax law. using insights from the literature of administrative oversight, this article proposes that congress provide standing on third parties to challenge i.r.s. actions. if properly designed and implemented, such “fire-alarm oversight” would permit oversight at a significantly lower cost than creating another oversight board. at the same time, it would be more effective at finding and responding to i.r.s. abuse of the tax system and would generally preserve the i.r.s.’s administrative discretion in deciding how to enforce the tax law. * assistant professor of law, loyola university chicago school of law. i would like to thank the participants at the central states law schools association 2012 annual conference, the participants in the chicago junior faculty workshop, the participants in the junior tax roundtable, and the faculty at marquette university law school. i would also like to thank jamie brunson for her support. 224 florida tax review [vol. 14:6 i. introduction ............................................................................. 224 ii. how the irs abuses the tax system ................................... 228 a. reading and as or ........................................................... 228 b. political campaigning ...................................................... 232 c. commodity mutual funds .................................................. 235 iii. current oversight of the i.r.s. .......................................... 244 a. the office of the taxpayer advocate ................................ 245 b. the internal revenue service oversight board ................ 248 iv. suboptimal oversight ............................................................ 249 a. congress cannot provide effective oversight .................. 249 b. the office of the taxpayer advocate does not have the resources to protect the tax system .................. 250 c. the internal revenue service oversight board is not constituted to protect the tax system .................... 253 d. if we want an oversight board, congress could form a new one ............................................................... 254 v. fire alarm oversight ............................................................ 259 a. deputizing the public ........................................................ 260 b. standing and fire-alarm standing ................................... 262 c. prudential considerations ................................................ 265 vi. conclusion .................................................................................. 272 i. introduction taxpayers dislike and distrust tax collectors. these feelings transcend time and culture. in ancient egypt, for example, the government leased tax collection to the highest bidder; the tax collector had to remit a set amount to the government, irrespective of its collections. to prevent abuse, the government required these tax collectors to provide receipts to taxpayers. 1 the authors of the new testament categorized tax collectors alongside extortioners, adulterers, and the unjust. 2 a thousand years later, byzantine peasants fled the “merciless tax collector.” 3 in eighteenth-century wales, tax men attempting to collect the excise tax on spirits found 1. william harms, chicago demotic dictionary refines knowledge of influential language, uchicagonews, sept. 17, 2012, http://news.uchicago.edu/ article/2012/09/17/chicago-demotic-dictionary-refines-knowledge-influential-lang uage. 2. william o. walker, jr., jesus and the tax collectors, 97 j. biblical literature 221, 229 (1978). 3. charles m. brand, two byzantine treatises on taxation, 25 tradition 35, 38 (1969). 2013] preventing i.r.s. abuse of the tax system 225 themselves attacked, horsewhipped, robbed, killed, and disfigured. 4 and, in the united states in the nineteenth century, tax collectors earned the public’s disdain through incompetence and corruption. 5 modern tax regimes have not overcome this dislike and distrust. in contemporary tanzania, taxpayers hide in the bush to evade tax collectors and, when tax collectors use more coercive means to collect taxes, taxpayers reciprocate by, among other things, attacking tax collectors and burning their offices. 6 anecdotal evidence suggests that tax collectors broadly accept bribes in taiwan, india, nepal, and thailand. 7 the dislike and distrust of tax collectors in the modern era extends beyond the taxpayers of developing economies. the american public, for example, generally dislikes the i.r.s. 8 for a select few, this dislike leaves the world of the reasonable and extends itself into the hyperbolical. 9 but dislike and distrust of the i.r.s. is not the exclusive realm of the conspiracy theorist and the tax protestor. taxpayers remain aware that president nixon attempted to use the i.r.s. to harass his political enemies. 10 and they remain aware that, should they be unlucky enough to catch the i.r.s.’s notice, it could bring its full administrative powers to bear against them. in september of 1997, the senate judiciary committee heard three days of testimony about the unchecked abuses of taxpayers at the hands of the i.r.s. 11 a retired priest testified that the i.r.s. wrongly assessed $18,000 in taxes from his mother’s estate. 12 a california woman testified that $7,000 in back taxes ballooned to $16,000 while the i.r.s. sent notices only to her 4. thomas p. slaughter, the whiskey rebellion 13 (1986). 5. harry edwin smith, the united states federal internal tax history from 1861 to 1871 282 (1914). 6. odd-helge fjeldstad, taxation, coercion and donors: local government tax enforcement in tanzania, 39 j. mod. afr. stud. 289, 295 (2001). 7. jean hindricks, michael keen & abhinay muthoo, corruption, extortion and evasion, 74 j. pub. econ. 395, 396 n.1 (1999). 8. see pat widder, fairness & abuse: a delicate balance, chi. trib., sept. 28, 1997, at c1 (“the irs is a tax collector, and nobody likes the tax collector.”). 9. see, e.g., erika hayasaki, evading death and taxes, l.a. times, jul. 20, 2007, at a1 (tax protestor ed brown calls the i.r.s. “the most brutal, ruthless organization out of all there is.”). 10. see, e.g., joseph j. darby, confidentiality and the law of taxation, 46 am. j. comp. l. 577, 579 (1998) (stating that the nixon administration used i.r.s. information to harass political opponents). 11. tom herman, irs staffers tell of wrongdoing by fellow aides, wall st. j., sept. 26, 1997, at a4 [hereinafter herman, irs staffers tell of wrongdoing]. 12. john m. broder, director of i.r.s. issues an apology for agent abuses, n.y. times, sept. 26, 1997, at a1 [hereinafter broder, director of i.r.s. issues apology]. 226 florida tax review [vol. 14:6 ex-husband. 13 i.r.s. employees, their identities hidden, testified that “they had witnessed colleagues bullying taxpayers into submission, using unethical tactics to collect money, and retaliating against irs workers who tried to correct mistakes.” 14 the hearings revealed that i.r.s. agents reviewed the tax records potential witnesses and of jurors in tax cases. 15 congress also heard that i.r.s. agents had browsed the tax returns of celebrities, relatives, and potential dates, that agents were evaluated based on their total tax collections, and that managers routinely covered up abusive behavior by collection agents. 16 these alleged abuses by the i.r.s. 17 were salient enough to the legislators and public to lead to a number of reforms of the i.r.s., including the idea of splitting the i.r.s. into two agencies, one of which would collect tax returns and provide advice to taxpayers and the other which would be responsible for audit and enforcement. 18 ultimately, congress responded to the horror stories it had heard with the taxpayer bill of rights 3, a collection of over seventy provisions intended to make the i.r.s. more “customerfriendly.” 19 these reforms attempted to keep the i.r.s. in check, preventing future abuses and requiring the i.r.s. to treat taxpayers fairly. in general, these changes have made the i.r.s. into a friendlier agency, albeit one with a diminished ability to enforce the tax law. 20 although congress managed to largely check the i.r.s.’s abuse of taxpayers, it has done nothing to prevent the i.r.s. from abusing 21 the tax 13. albert b. crenshaw, senate panel told of irs abuses, wash. post, sept. 25, 1997, at e03. 14. herman, irs staffers tell of wrongdoing, supra note 11, at a4. 15. ralph vartabedian, irs will review complaints, end quotas for audits, l.a. times, sept. 26, 1997, at a1 [hereinafter vartabedian, irs will review complaints]. 16. broder, director of i.r.s. issues apology, supra note 12, at a1. 17. the “abuses” are “alleged” because subsequent investigations by the government demonstrated that many of the allegations were either untrue or exaggerated. see leandra lederman, tax compliance and the reformed irs, 51 u. kan. l. rev. 971, 979 (2003) [hereinafter lederman, tax compliance and reformed irs]. 18. vartabedian, irs will review complaints, supra note 15, at a1. 19. lederman, tax compliance and reformed irs, supra note 17, at 980– 81. 20. id. at 982–83 (“not surprisingly, the post-rra ‘98 reallocation of resources resulted in (or at least coincided with) a significant decline in enforcement activity.”). 21. “abuse” is a strong term, but i have chosen it deliberately. the i.r.s., like any administrative agency, needs a certain amount of flexibility in determining how it will apply its finite resources in enforcing the tax law. see infra note 264 and accompanying text. but sometimes it exercises its discretion in a manner that goes beyond choosing how to deploy its resources in the most effective way and, instead, 2013] preventing i.r.s. abuse of the tax system 227 system. if the i.r.s.’s abuse of the tax system also harms one or more taxpayers, those taxpayers may have recourse to challenge the i.r.s. (though they may have limited incentive to do so), but where no taxpayer suffers direct harm, nothing in the tax law prevents the i.r.s. from misinterpreting or ignoring the law as written. this article will examine the i.r.s.’s ability to ignore, misapply, and otherwise abuse the tax law, and propose a way for the tax law to constrain this ability, much as the various taxpayer bills of rights constrained the i.r.s.’s ability to abuse individual taxpayers. part ii presents three examples of i.r.s. abuse of the tax law. in the first, its interpretation harmed specific taxpayers. even though they had an incentive to challenge the i.r.s.’s interpretation, however, the cost of doing so may have outweighed the potential benefits. in the other two examples, on the other hand, the i.r.s.’s interpretation benefited certain taxpayers, while taxpayers collectively bore the costs, leaving nobody with the incentive or the ability to challenge the i.r.s. part iii discusses the principal way in which congress oversees the i.r.s. — through oversight boards. the tax law currently provides for the office of the taxpayer advocate, which is charged with highlighting how the i.r.s. can provide better service to taxpayers, and the internal revenue service oversight board, which broadly oversees the i.r.s.’s operations. part iv then looks at how well an oversight board would fit with the goal of protecting the tax system from i.r.s. abuse. ultimately, it concludes that, although the taxpayer advocate and the i.r.s. oversight board are relatively effective in discharging their current mandates, adding the mandate of protecting the tax law to either would be burdensome and ineffective. congress could create a new oversight board, but such a board would provide suboptimal enforcement. in part v, this article will suggest, instead, that congress delegate enforcement to taxpayers in general. this type of “fire-alarm oversight” can provide an effective, low-cost method of overseeing the i.r.s. where it interprets the internal revenue code in a way that imposes diffuse cost on taxpayers in general. to effectively delegate such authority will require congress to provide standing to taxpayers and create both incentives to encourage meritorious claims and disincentives to dissuade frivolous claims. properly designed, though, such oversight will help rein in i.r.s. abuse of the tax system. undermines congress’s purpose in enacting a provision. though it may not always be clear where to draw the line between discretion and abuse, just like it can be difficult to draw the line between zealous enforcement of the tax law and taxpayer abuse, this article focuses on ways to prevent abuse while preserving the i.r.s.’s necessary discretion. 228 florida tax review [vol. 14:6 ii. how the irs abuses the tax system a. reading and as or the story of the i.r.s. adopting an incorrect reading of the tax law is not complicated to tell or, theoretically, to resolve. the tax law is complicated and, in places, ambiguous. at times, the i.r.s. errs in its interpretation of the interplay between the language of the code and what congress intended for the code. when it does and uses that misinterpretation to impose a higher tax burden on taxpayers, the affected taxpayers will sue and the courts will overturn the i.r.s.’s misinterpretation. while the process of correcting an i.r.s. misreading of the tax law can follow this narrative, however, the process is often less clean and more problematic than the story would indicate, as illustrated by the i.r.s.’s attempted misapplication of the telephone excise tax. in 1898, congress enacted a telephone excise tax to help fund the spanish-american war. 22 initially, the one-cent tax applied to long-distance calls that cost more than fifteen cents. 23 congress repealed the telephone excise tax in 1902, but reinstated it in 1914, as the country began to prepare for world war i. 24 repealed again in 1924, it once again reappeared in 1932 to make up for diminished federal revenues resulting from the great depression. 25 though congress has altered its rate structure and base in the years since 1932, the telephone excise tax has continuously applied since then. 26 today, the telephone excise tax imposes a three percent tax on three types of “communication services:” 27 local telephone service, toll telephone service, and teletypewriter exchange service. 28 although the code specifically defines each type of communication service, 29 the i.r.s. has not seen itself as bound by the code’s definitions. 22. louis alan talley, cong. research serv., rl 30553, the federal excise tax on telephone service: a history 1 (2005), http://assets.opencrs.com/rpts/rl30553_20050630.pdf. 23. id. 24. id. 25. id. 26. id. 27. i.r.c. § 4251(a)(1), (b)(2). 28. i.r.c. § 4251(b)(1). 29. i.r.c. § 4252(a)–(c). 2013] preventing i.r.s. abuse of the tax system 229 in 1979, the i.r.s. released a ruling addressing whether the telephone excise tax applied to satellite calls from ships or other offshore locations to landlines in the united states. 30 the service provider charged callers a per-minute amount, irrespective of their location (and, thus, irrespective of the call’s distance). 31 the code defines toll telephone service as telephone service where the telephone company calculates the price of a call based on the distance and elapsed time of the call. 32 the i.r.s. acknowledged that the satellite phone service did not “[l]iterally . . . come within the definition of ‘local telephone service’ or ‘toll telephone service’ as those terms are currently defined in section 4252 of the code.” 33 nonetheless, it determined that such calls were subject to the tax because the legislative history underlying the tax “indicates that the type of service at issue here is within the intended scope of taxable ‘toll telephone service.’” 34 during the 1990s, telephone companies began to broadly offer flat-rate long distance telephone service, with rates based solely on the elapsed time of the call. 35 based on its earlier revenue ruling, the i.r.s. imposed the telephone excise tax on these calls even though distance played no part in determining the cost of calls. 36 in a series of cases in the mid-2000s, taxpayers challenged the i.r.s.’s application of the telephone excise tax and demanded refunds of the telephone excise taxes they had paid on services. 37 the i.r.s. argued that 30. rev. rul. 79-404, 1979-2 c.b. 382. 31. id. 32. i.r.c. § 4252(b)(1). 33. rev. rul. 79-404, 1979-2 c.b. 382. 34. id. 35. timothy deering, note, a taxing statute: costly conjuncts and their logical fallout, 7 cardozo pub. l. pol’y & ethics j. 207, 210 (2008) [hereinafter deering, a taxing statute]. 36. rev. rul. 79-404, 1979-2 c.b. 382 (“the service in this case is essentially ‘toll telephone service’ as described in section 4252(b)(1) of the code, even though the charge for calls between remote maritime stations and stations in the united states vary with elapsed transmission time only.”); see also notice 2005-79, 2005-2 c.b. 952; notice 2004-57, 2004-2 c.b. 376. 37. see mbna am. bank, n.a. v. united states, 97 a.f.t.r.2d (ria) 2006-2766 (d. del. 2006); pnc bank, n.a. v. united states, 97 a.f.t.r.2d (ria) 2006-2425 (w.d. penn. 2006); servicemaster co. v. united states, 2006-1 u.s. tax cas. (cch) ¶ 70,254, 97 a.f.t.r.2d (ria) 2006-2511 (n.d. ill. 2006); america online, inc. v. united states, 64 fed. cl. 571 (fed. cl. 2005); honeywell int’l, inc. v. united states, 64 fed. cl. 188 (fed. cl. 2005); hewlett-packard co. v. united states, 2005-2 u.s. tax cas. (cch) ¶ 70,244, 96 a.f.t.r.2d (ria) 2005-5953 (n.d. cal. 2005); reese bros. v. united states, 94 a.f.t.r.2d 2004-7229 (w.d. penn. 2004); nat’l r.r. passenger corp. v. united states, 338 f. supp. 2d 22 (d.d.c. 2004); fortis, inc. v. united states, 420 f. supp. 2d 166 (s.d.n.y. 2004); office max, inc. v. united states, 309 f. supp. 2d 984 (n.d. ohio 2004); am. 230 florida tax review [vol. 14:6 congress’s use of and in the definition of toll service was ambiguous and could function either as a conjunctive or disjunctive. 38 it even issued a proposed regulation that would officially read the and in the code as an or. 39 although the i.r.s. won in the first decided case, 40 it lost each of its subsequent cases. 41 moreover, the i.r.s.’s sole victory was reversed at the appellate level. 42 ultimately, taxpayers won in every court of appeals that heard challenges to the i.r.s.’s application of the telephone excise tax. 43 in may 2005, after its string of losses, the i.r.s. announced that it would no longer litigate these telephone excise tax cases. 44 in 2006, it announced that it would acquiesce to the courts’ rulings. 45 in that announcement, it also informed taxpayers of the process they had to follow to request and receive a refund of their overpaid excise tax. 46 the i.r.s. stated that it would refund the tax on nontaxable telephone services billed after february 28, 2003, and before august 1, 2006. 47 individuals could request either a safe harbor amount or the actual amount of telephone excise tax that they had overpaid. 48 business entities had no safe harbor, but could claim a refund for the amount they had overpaid. 49 however, taxpayers had to claim the refund on their 2006 tax return. 50 bankers ins. grp., inc. v. united states, 308 f. supp. 2d 1360 (s.d. fla. 2004), rev’d, 408 f.3d 1328 (11th cir. 2005). 38. see, e.g., national r.r. passenger corp., 338 f. supp. at 26 (“the irs does not really contest this point, instead focusing on why the court should construe ‘and’ to mean ‘or’ (so that the definition is fulfilled when a toll charge varies in amount with distance or time).”). 39. 68 fed. reg. 15690 (apr. 1, 2003) (“for a communications service to constitute toll telephone service described in section 4252(b)(1), the charge for the service need not vary with the distance of each individual communication.”). 40. am. bankers ins. group, inc., 308 f. supp. 2d at 1373 (“for the foregoing reasons, the court finds that the statutory language of 26 u.s.c. § 4252(b)(1) is ambiguous and that the clear intent of congress from before the 1965 amendment up to the present day has been to tax all long-distance telephone service, regardless of whether the toll rate for that service varied only by distance, only by elapsed time, or by both.”). 41. deering, a taxing statute, supra note 35, at 211. 42. am. bankers ins. group v. united states, 408 f.3d 1328, 1330 (11th cir. 2005). 43. annette nellen, what’s new in telecom challenges what’s old in taxes, bus. entities, jul.–aug. 2006, at 3, 8. 44. id. at 10. 45. notice 2006-50 § 1, 2006-1 c.b. 1141. 46. id. § 5(a)(1). 47. id. § 5(b). 48. id. § 5(c)(1). 49. id. § 5(d)(3)(i). 50. id. § 5(a)(2). 2013] preventing i.r.s. abuse of the tax system 231 the i.r.s.’s misreading of the tax law here differs in certain significant ways from those cases in which it wrongly grants an extralegal benefit to specific taxpayers. 51 most saliently, its misreading — in this case, the extra-statutory imposition of the telephone excise tax — not only abused the tax system, it also increased taxpayers’ tax bills. as such, some taxpayers had both incentive and standing to challenge the i.r.s.’s position. 52 in many cases, however, merely having overpaid taxes and possessing standing may prove insufficient incentive for affected taxpayers to police the i.r.s. only large corporations challenged the imposition of the telephone excise tax, likely because only large corporations paid enough to justify taking the challenge to court. although it would be difficult to determine how much the i.r.s.’s interpretation of the telephone excise tax cost non-corporate taxpayers, the tax rate was only 3 percent of the cost of the long-distance service. 53 the i.r.s. set its safe harbor refund amount at not more than $60 per year. 54 assuming that the $60 represented a reasonable estimate of the amount an individual taxpayer overpaid, the potential for getting a refund or credit of $180 would not justify the time and expense of bringing suit for individual taxpayers. the code imposes a $60 filing fee on taxpayers who file a case in the tax court. 55 if the taxpayer would prefer to file her refund suit in a federal district court or the court of federal claims, she would have to pay a filing fee of $350. 56 civil litigation does have mechanisms to ameliorate the problems of low-value claims. if litigants meet certain requirements, they can file class action suits, which aggregate similar low-value harms, making it worth the litigants’ (and their attorneys’) time and money to file a suit. 57 in the tax 51. see infra sections ii.b. and ii.c. 52. contrast this with the case of the i.r.s.s treatment of tax-exempt entities that endorse candidates and commodities mutual funds, where nobody who has standing has reason to challenge the i.r.s.’s position. see infra notes 83–86 and 121–122 and accompanying text. 53. i.r.c. § 4251(a)(1), (b)(2). 54. notice 2007-11 § 3(b)(2), 2007-1 c.b. 405. the i.r.s. based a taxpayer’s safe harbor amount on the number of exemptions on her 2006 tax return. id. § 3(b)(1). a taxpayer with one exemption could request a credit or refund for $30, with two exemptions could request $40, with three could request $50, and with four or more could request $60. id. § (3)(b)(2). 55. i.r.c. § 7451. 56. 28 u.s.c. §§ 1914(a), 1926(a). 57. see owen m. fiss, the political theory of the class action, 53 wash. & lee l. rev. 21, 24 (1996) (“in short, the class action could be viewed as a device to fund the private attorney general and is able to play that role because of the aggregation of the claims of a large number of persons who have similar or identical claims, none of which — standing alone — would justify the suit.”). 232 florida tax review [vol. 14:6 world, however, because of the individualized and fact-specific nature of tax refund suits, courts resist certifying class action refund claims. 58 even corporations with significant potential refunds may not find a challenge to the i.r.s.’s interpretations worth the cost, however. after the i.r.s. released its refund procedures, several taxpayers sued the i.r.s., arguing that its refund procedure was inadequate because it undercompensated many taxpayers and because it failed to comply with the administrative procedure act’s (“apa”) notice-and-comment requirements. 59 the court held that the i.r.s. had violated the apa’s procedural requirements. 60 it prospectively vacated the i.r.s. notice and remanded the matter to the i.r.s. 61 although the plaintiffs won, however, their victory proved costly. the court ultimately denied plaintiffs’ interim request for $6.5 million in attorney’s fees. 62 without attorney’s fees, plaintiffs won a procedural, but not a financial, victory. although the suits started as refund suits, the refund portion of the suits had “long since been dismissed.” 63 as a result, the taxpayers’ victory in having the i.r.s. process vacated was counterbalanced by the cost to the plaintiffs of achieving that result. the story of the telephone excise tax demonstrates that taxpayers can police the i.r.s. when it incorrectly interprets the tax law, provided the i.r.s.’s interpretation increases the taxpayers’ tax liability in comparison to what they should have paid. but it also demonstrates that such policing imposes a cost — potentially significant — on taxpayers. as a result of this cost, they may not have sufficient incentive to challenge the i.r.s.’s misinterpretations, even when they have a strong case. if, instead, congress provided for some sort of i.r.s. oversight that focused on ensuring that the i.r.s. respected the tax law and preventing it from abusing the law, congress could limit the expense to taxpayers and the government of litigating the case, and ameliorate the harm to the tax system. b. political campaigning congress has exempted certain public charities from the tax rolls. the code lays out criteria that an organization must meet to qualify for the 58. see, e.g., saunooke v. united states, 8 cl. ct. 327, 330 (1985) (“this case is particularly ill-suited for class certification by virtue of its status as a tax refund claim.”). 59. in re long-distance tel. serv. fed. excise tax refund litig., 853 f. supp. 2d 138, 141 (d.d.c. 2012). 60. id. at 143. 61. id. at 146. 62. in re long-distance tel. sev. fed. excise tax refund litig., 110 a.f.t.r.2d 2012-6492 (d.d.c. oct. 29, 2012). 63. id. at 2012-6496. 2013] preventing i.r.s. abuse of the tax system 233 exemption. an organization that meets these requirements is generally exempt from filing returns and paying taxes. moreover, because of the unique situation of public charities, donors to these exempt organizations can deduct the amount of their donations in calculating their taxes. 64 together, the tax exemption and the charitable deduction provide a significant subsidy to public charities. to qualify for this special treatment, public charities must meet both an organizational and an operational test. 65 to meet the organizational test, a public charity must be organized exclusively for one or more enumerated exempt purposes. 66 the operational test, on the other hand, looks to whether the public charity’s primary activities further its exempt purposes. 67 if a public charity fails either the organizational or operational test, it must pay taxes on its income and donors can no longer deduct their donations. 68 a public charity that campaigns for or against a candidate for office fails the operational test. 69 and the campaigning prohibition is a strict liability provision: even de minimis support of a candidate causes a taxexempt organization to fail. 70 the i.r.s. is the administrative body responsible for enforcing the tax law. 71 when an entity no longer qualifies as tax-exempt, the tax law requires the i.r.s. to revoke its tax exemption. 72 in 64. a taxpayer’s ability to deduct charitable contributions is not, of course, unconstrained. because charitable contributions are an itemized deduction, taxpayers must first itemize to get a tax benefit from their contributions. moreover, individuals cannot deduct more than 50 percent of their adjusted gross income (with certain modifications), and corporations cannot deduct more than 10 percent of their taxable income. i.r.c. § 170(b)(1)(a), (2)(a). 65. reg. § 1.501(c)(3)-1(a)(1). 66. reg. § 1.501(c)(3)-1(b)(1)(i). 67. reg. § 1.501(c)(3)-1(c)(1). 68. reg. § 1.501(c)(3)-1(a)(1). 69. reg. § 1.501(c)(3)-1(c)(3)(iii); see also i.r.c. § 501(c)(3). 70. anne berrill carroll, religion, politics, and the irs: defining the limits of tax law controls on political expression by churches, 76 marq. l. rev. 217, 229 (1992) (“the house obra report explicitly affirmed that the bar on campaign intervention by churches is absolute and that any amount of such conduct renders an organization wholly ineligible for exemption from federal income taxes and receipt of tax-deductible contributions.”). 71. see donald b. tobin, political campaigning by churches and charities: hazardous for 501(c)(3)s, dangerous for democracy, 95 geo. l.j. 1313, 1358 (2007) [hereinafter tobin, political campaigning by churches and charities) (“the irs is charged with enforcing the tax laws and therefore is the federal agency with discretion over whether to begin an examination of a 501(c)(3) organization.”). 72. see rev. rul. 78-248, 1978-1 c.b. 154 (“organization c is participating in a political campaign in contravention of the provisions of section 501(c)(3) and is disqualified as exempt under that section”). the treasury department requested that congress permit it to have the ability to impose an excise tax on a tax-exempt 234 florida tax review [vol. 14:6 addition, the i.r.s. can impose an excise tax on tax-exempt organizations that violate the campaigning prohibition in certain circumstances. 73 in spite of the prohibition, however, tax-exempt organizations regularly endorse candidates for elective office. 74 anecdotal evidence, however, suggests that the i.r.s. frequently chooses not to revoke a taxexempt organization’s exemption. 75 in 2004, the i.r.s. examined several cases of alleged campaigning by tax-exempt organizations; in fifty-three of those cases, it determined that the tax-exempt organization had violated the campaigning prohibition, but, rather than revoke the exemption or impose a penalty, it issued a closing letter to the organizations. 76 in four cases, the i.r.s. revoked the tax-exempt organizations exemption, and in three it imposed the excise tax. 77 even when faced with a tax-exempt organization’s deliberate and flagrant violation of the campaigning prohibition, the i.r.s. often fails to enforce the campaigning prohibition. in 2008, the alliance defense fund created pulpit freedom sunday. 78 on pulpit freedom sunday, participating pastors deliberately flout the campaigning prohibition, preaching a sermon endorsing or opposing a candidate for office. 79 often, the pastors will then send their sermons directly to the i.r.s., a move which would provide the i.r.s. with evidence of the violation. 80 the number of churches participating in pulpit freedom sunday has grown from thirty-three in 2008 to more than 1,500 in 2012. 81 notwithstanding the blatantness with which these churches act, however, the i.r.s. has not revoked any exemptions as a result of pulpit freedom sunday. 82 although the i.r.s. refuses to fulfill its duty by enforcing the campaigning prohibition, there is no reasonable way to require it to act. organization’s campaigning in lieu of revoking its exemption, but congress demurred. see a. mark christopher, political activities become more risky for taxexempts due to ra ’87, 68 j. tax’n 136, 138–89 (1988). 73. i.r.c. § 4955. 74. see, e.g., samuel d. brunson, reigning in charities: using an intermediate penalty to enforce the campaigning prohibition, 8 pitt. tax rev. 125, 150 (2011) [hereinafter brunson, reigning in charities]. 75. see, e.g., lloyd hitoshi mayer, grasping smoke: enforcing the ban on political activity by charities, 6 first amend. l. rev. 1, 12–13 (2007). 76. brunson, reigning in charities, supra note 74, at 151. 77. id. 78. stephanie strom, the political pulpit, n.y. times, oct. 1, 2011, at b1 [hereinafter strom, political pulpit]. 79. david skeel, politicking from the pulpit and the tax man, wall st. j., nov. 22, 2012, at a13 [hereinafter skeel, politicking from the pulpit]. 80. strom, political pulpit, supra note 78, at b1. 81. skeel, politicking from the pulpit, supra note 79, at a13. 82. strom, political pulpit, supra note 78, at b1. 2013] preventing i.r.s. abuse of the tax system 235 recently, the freedom from religion foundation filed a suit requesting the courts to require the i.r.s. to revoke the tax exemption of churches that participated in pulpit freedom sunday, or who otherwise have violated the campaigning prohibition. 83 but such suits are difficult to maintain. to have standing to bring the suit, a taxpayer would need to demonstrate a causal link between the i.r.s.’s refusal to revoke the exemption and a demonstrable harm to the taxpayer. 84 however, unlike the case of the telephone excise tax, the i.r.s.’s refusal to enforce the campaigning prohibition does not harm any particular taxpayer. rather, the harm is imposed on the tax system itself. as a result, no taxpayer has standing to sue the i.r.s. and force it to enforce the campaigning prohibition. 85 without standing to sue, a concerned taxpayer can inform the i.r.s. of the violation. but once the taxpayer has informed the i.r.s., the taxpayer has no further involvement in the case. 86 the i.r.s. will do what it chooses and, if history is any guide, it is unlikely to enforce the prohibition. because there is no overseer who can require the i.r.s. to do its duty, the i.r.s. has the power to refuse to enforce clear tax law rules. c. commodity mutual funds the i.r.s. deliberately misreading “and” as “or” in the telephone excise tax is a simple and straightforward story. likewise, the campaigning prohibition, though controversial, operates in an easily understood manner. by contrast, the story of commodities mutual funds is complicated and 83. complaint at 8, freedom from religion foundation, inc. v. commissioner, no. 12-cv-818 (w.d. wis. 2012) (“ordering the defendant shulman and the irs to forthwith comply with necessary steps to designate an irs official legally authorized to initiate action against churches and other religious organizations that are reasonably believed to have violated the electioneering restrictions of § 501(c)(3).”). 84. see allen v. wright, 468 u.s. 737, 757 (1984) (“the line of causation between [the i.r.s.’s grant of tax exemption to racially discriminatory private schools] and desegregation of respondents’ schools is attenuated at best. from the perspective of the irs, the injury to respondents is highly indirect and ‘results from the independent action of some third party not before the court.’”). 85. see tobin, political campaigning by churches and charities, supra note 71, at 1358. 86. id. (“thus, parties who believe a 501(c)(3) organization is violating the political campaign ban send information to the irs notifying it about the alleged violation. this type of notification is no different than if a person notified the irs that a neighbor was cheating on her taxes. once a party informs the irs about allegedly improper activity, the third party presumably has no further involvement with the complaint.”). 236 florida tax review [vol. 14:6 requires significantly more explanation, both to understand what happened and why the result harms the tax system. corporate shareholders face two levels of taxation on the corporation’s income. corporations pay taxes on their income, then, when they distribute the after-tax income to shareholders, those shareholders pay taxes on the dividends. 87 because mutual funds are domestic corporations, 88 this double taxation would put mutual fund investors at a significant disadvantage compared with investors who own their investments directly or through an investment partnership. 89 to make a mutual fund investment similar to a direct investment, the tax law permits qualifying mutual funds to deduct from their taxable income the amount of dividends they pay. 90 a mutual fund does not automatically qualify for this quasipassthrough tax treatment, however. rather, it must meet certain criteria imposed by the tax law. 91 a mutual fund that fails to meet these requirements loses its tax-favorable status and pays an entity-level tax, without the ability to deduct its dividends. 92 among other things, to qualify for the special tax treatment afforded mutual funds, a mutual fund must earn circumscribed types of income. in essence, a mutual fund must derive at least 90 percent of its income from securities and foreign currencies. 93 it can earn interest or dividends, it can realize gains from the sale of securities, and it can even earn derivative income, as long as that income is related to an investment in securities. 94 prior to 1986, though the tax law required mutual funds to derive a significant portion of their income from securities, it contained no definition of “securities.” 95 to fill the gaps left by such an important undefined term, the i.r.s. had “often gone beyond the literal terms of the statute,” permitting mutual funds to earn money not specifically sanctioned by the code. 96 to end the i.r.s.’s gap-filling, congress added a definition of sorts to the code. 87. i.r.c. §§ 11(a), 67(a)(7). 88. i.r.c. § 851(a). 89. see samuel d. brunson, mutual funds, fairness, and the income gap 8–9, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2131405 (last visited mar. 26, 2013). 90. i.r.c. § 852(b)(2)(d). 91. see i.r.c. § 851(b). 92. id. 93. i.r.c. § 851(b)(2)(a). 94. id. 95. see, e.g., i.r.c. § 851(b)(2) (1954) (to qualify as a ric, “at least 99% of its gross income is derived from dividends, interest, and gains from the sale or other disposition of stock or securities”). 96. letter from j. roger mentz, acting assistant secretary (tax policy), to the hon. ronnie g. flippo, house of representatives, 132 cong. rec. 4047, 4047– 48 (1986) [hereinafter mentz, letter to the hon. ronnie g. flippo]. 2013] preventing i.r.s. abuse of the tax system 237 rather than directly define “securities,” though, congress chose to insert a cross-reference to the definition from the investment company act of 1940 (the “1940 act”). 97 the 1940 act defines “security” to include, among other things, notes and other evidences of indebtedness, stock and other evidences of equity interest, and certain derivatives linked to securities. 98 congress apparently intended this cross-reference to exclude commodities from the set of investments that produces qualifying income. 99 the legislative history of the mutual fund provisions does not explain why congress wanted to limit mutual funds’ ability to invest in commodities. 100 still, the law makes clear that congress intended to prevent 97. tax reform act of 1986, p.l. 99-514, § 653(b). 98. “‘security’ means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘security,’ or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” 15 u.s.c. § 80a-2(a)(36). 99. see, e.g., mentz, letter to the hon. ronnie g. flippo, supra note 96, at 4048 (“[w]e would generally not treat as qualifying income gains from trading in commodities, even if the purpose of that trading is to hedge a related stock investment.”); rev. rul. 2006-1, 2006-1 c.b. 261 (“the foregoing indicates that congress did not intend for the cross-reference to the ’40 act to incorporate into section 851(b)(2) an expansive construction of the term ‘securities.’”). 100. it is possible, however, to speculate as to congress’s reasoning. perhaps, for example, congress believed that trading in commodities constituted a trade or business. see lee a. sheppard, mutual fund taxation: putting square pegs in round holes, 108 tax notes 58, 60 (2005) [hereinafter sheppard, mutual fund taxation]. because mutual funds are passive investment vehicles, congress could view commodity income as antithetical to the passive nature of mutual funds. alternatively, congress may have believed that limiting permissible mutual fund investments to securities kept mutual funds within the realm of expertise of the securities and exchange commission, which regulates both securities and mutual funds. see, e.g., donald c. langevoort, the sec, retail investors, and the institutionalization of the securities market, 95 va. l. rev. 1025, 1032 (2009) (“sec regulation of the securities industry is often described as heavy-handed, overly intrusive and enforcement dominated.”); roberta s. carmel, mutual funds, pension funds, hedge funds and stock market volatility—what regulation by the securities and exchange commission is appropriate?, 80 notre dame l. rev. 909, 912 (2005) (“[t]he sec regulates mutual funds . . . .”). if mutual funds could 238 florida tax review [vol. 14:6 mutual funds from investing extensively in commodities. in spite of congress’s concerns, however, retail investors wanted access to commodity returns. 101 historically, mutual funds had provided investors with indirect exposure to commodities by investing in the stock of companies that dealt in those commodities. 102 however, the return on commodity companies deviates significantly from the return on commodities futures. 103 research in the mid-2000s, however, suggested that direct commodity investments dampened the volatility generally associated with commodities. 104 and by the mid-2000s, a number of mutual funds had stepped in to fill that demand. 105 only invest in securities, their investments would line up with their key regulator. still, even if the securities and exchange commission could not regulate a mutual fund’s commodities investments, those investments would not go unregulated. instead, they would fall under the jurisdiction of the commodities futures trading commission, just like any other investor’s commodities investments. see jerry w. markham, prohibited floor trading activities under the commodity exchange act, 58 fordham l. rev. 1, 4 (1989). congress may, instead, have acted with a paternalistic impulse. “mutual funds are designed for unsophisticated investors who cannot assemble a diversified portfolio or evaluate the mutual fund’s portfolio.” mark j. roe, a political theory of american corporate finance, 91 colum. l. rev. 10, 20 (1991). as a result, the regulation of mutual funds intends to “protect[] the public, whose funds have been intrusted to the investment managers.” comm. on banking and currency, stock exchange practices, s. rep. no. 73-1455, at 363 (1934). commodities markets tend to be volatile and risky. robert s. pindyck, volatility and commodity price dynamics, 24 j. futures mkts. 1029, 1029 (2004). congress may have decided to protect mutual fund investors from the volatility inherent in commodities investments by preventing mutual funds from significantly investing in commodities. 101. see, e.g., tim gray, sold on pork bellies (and other commodities), n.y. times, oct. 10, 2010, at bu13 (stating that “commodities have become an investing vogue”); conrad de aenlle, have commodities become the new tech stocks?, n.y. times, feb. 5, 2006, § 3, at 5. 102. tim gray, is it too late to ride the energy bandwagon?, n.y. times, oct. 9, 2005, § 3, at 25 [hereinafter gray, too late to ride the energy bandwagon] (“he says he has reduced the fund’s ups and downs by allocating fewer dollars to oil-related stocks than many of his peers, instead favoring such companies as newmont mining, a gold producer, and even nucor, a steel maker.”). 103. gary gorton & geert rouwenhorst, facts and fantasies about commodity futures, 62 fin. analysts j. 47, 60 (mar.-apr. 2006) ([t]he correlation between [commodities futures and commodity companies] was only 0.40.”). 104. id. (“[t]he historical risk of an investment in commodity futures has been relatively low . . . .”). 105. see, e.g., gray, too late to ride the energy bandwagon, supra note 102, at 25 (“several companies, including pimco in newport beach, calif., and oppenheimerfunds in new york, offer mutual funds that invest in commodities.”). 2013] preventing i.r.s. abuse of the tax system 239 though mutual funds faced significant impediments on their ability to invest in commodities, they attempted to circumvent the prohibition by investing in swaps on commodity indices. a commodity index is essentially a measure of the value of a basket of commodities, with each commodity assigned a certain weight within the basket. 106 the index reflects the value of the specified commodities; it does not, however, constitute an ownership interest in those commodities. 107 a swap is a financial instrument that seeks to provide synthetic (though not legal) ownership of a financial asset or index. one party to the swap — the long party — believes that the asset will increase in value, while the other — the short party — bets that its value will fall. 108 under the terms of these commodity index swaps, a commodity mutual fund would take the long position in the swap, agreeing to pay its counterparty interest and any depreciation on the index. in return, the counterparty would pay the amount of any appreciation in the index to the mutual fund. 109 by investing in these swaps, a commodity mutual fund synthetically recreates an investment in the basket of commodities represented by its chosen index. its investors have direct exposure to the value of the commodities, rather than an indirect approximation of their return through equity investments in commodity-producing companies. of course, this strategy only works if the commodity index swaps qualify as “securities” for tax purposes. otherwise, a mutual fund cannot derive more than 10 percent of its income from such swaps (and from any other assets it owns that do not qualify as securities). while the sec did not rule on whether commodity index swaps qualified as securities under the 1940 act, it had issued no-action letters that permitted funds to treat certain commodity-related dividends as securities for 1940 act purposes. 110 the 106. ke tang & wei xiong, index investment and financialization of commodities 6 (nat’l bureau econ. res., working paper no. 16385, 2010), http://papers.nber.org/tmp/16489-w16385.pdf. 107. see, e.g., wai mun fong & kim hock see, modelling the conditional volatility of commodity index futures as a regime switching process, 16 j. applied econometrics 133, 136 (2001) (“the gsci is an index of ‘spot prices’ or, more precisely, prices of nearest futures contracts for a basket of commodities representing all commodity sectors such as energy, metals, livestock and agricultural products.”). 108. samuel d. brunson, elective taxation of risk-based financial instruments: a proposal, 8 hous. bus. & tax l.j. 1, 8 (2007) (“very generally, swaps call for . . . payments between counterparties, based on the movement of an objective financial reference.”). 109. sheppard, mutual fund taxation, supra note 100, at 61. 110. see, e.g., mallory randall corp., sec no-action letter, fed. sec. l. rep. (cch) no. 102080058 (oct. 3, 1980) (treating options on commodities as securities for purposes of section 2(a)(36) of the 1940 act); thomas beard, sec no240 florida tax review [vol. 14:6 commodity mutual funds received opinions of counsel, based on this sec precedent, that they could treat commodity index swaps as securities for tax purposes, and that they produced qualifying income. 111 however, commodity mutual funds received a blow at the beginning of 2006. the i.r.s. issued a revenue ruling in which it held that commodity index swaps did not qualify as securities for purposes of the tax law. 112 because the returns on commodity index swaps derived from the value of commodities, not securities, excluding them from the set of assets that produced qualifying income fit comfortably within congress’s intent. thus, the i.r.s. disqualified such swaps. within the year, however, the funds figured out two paths they could use to gain direct exposure to commodities for their investors: commoditylinked notes and wholly-owned tax-haven subsidiaries. and not only did the i.r.s. not object to these investments, it explicitly permitted mutual funds to count such investments as securities for purposes of mutual fund qualifications. in doing so, it ignored the plain language of the tax law. like commodity index swaps, commodity-linked notes provide investors with a return based on an index of commodities. formally, a commodity-linked note is a debt instrument issued by a corporation. unlike a plain-vanilla note, however, a commodity-linked note does not necessarily pay an investor its face amount upon maturity. instead, when it matures, the owner of a commodity-linked note can exchange that note for the face amount of the bond or the value of the underlying commodities. 113 like commodity index swaps, commodity-linked notes allow investors to gain exposure to individual commodities or baskets of commodities. corporations issue commodity-linked notes in order to share the potential appreciation in commodities with investors in exchange for paying a lower interest rate. 114 on april 10, 2006, the i.r.s. released a private letter ruling holding that commodity-linked notes would qualify as securities for purposes of mutual fund qualification. 115 and between 2006 and 2011, the i.r.s. issued at action letter, fed. sec. l. rep. (cch), 1975 wl 367603 (may 8, 1975) (same); far west futures fund, sec no-action letter, fed. sec. l. rep. (cch), 1974 wl 351250 (sept. 4, 1974) (same). 111. sheppard, mutual fund taxation, supra note 100, at 60. 112. rev. rul. 2006-1, 2006-1 c.b. 262. 113. peter carr, a note on the pricing of commodity-linked bonds, 42 j. fin. 1071, 1071 (1987). 114. eduardo s. schwartz, the pricing of commodity-linked bonds, 37 j. fin. 525, 525 (1982). 115. priv. ltr. rul. 2006-28-001 (apr. 10, 2006). the fact that the i.r.s. issued a private letter ruling does not mean that the tax law recognizes commoditylinked notes as a security for purposes of mutual fund qualification. a private letter ruling is merely a ruling issued by the i.r.s. to a specific taxpayer in response to that taxpayer’s request. see julie a. d. manasfi, the global shadow bank — systemic 2013] preventing i.r.s. abuse of the tax system 241 least thirty-seven more private letter rulings blessing mutual funds’ investments in commodity-linked notes. 116 shortly after the i.r.s. began permitting mutual funds’ investments in commodity-linked notes, funds began to explore investing in wholly-owned foreign subsidiaries that, in turn, invested in various commodity-linked instruments. 117 as with commodity risk and tax policy objectives: the uncertain case of foreign hedge fund lending to u.s. borrowers and transacting in u.s. debt securities, 11 fla. tax rev. 643, 658 n.49 (2011) (“private letter rulings are taxpayer specific rulings furnished by the irs in response to requests made by taxpayers and cannot be used as precedent.”). a private letter ruling issued to one taxpayer has no precedential value to another taxpayer. i.r.c. § 6110(k)(3); see also rev. proc. 2012-1 § 11.02 (“a taxpayer may not rely on a letter ruling issued to another taxpayer.”); goodstein v. commissioner, 267 f.2d 127, 132 (1st cir. 1959) (“[t]o hold that the commissioner is bound by rulings specifically addressed to a taxpayer other than the one whose return is questioned would severely limit the usefulness of the long established practice of private administrative rulings.”). still, private letter rulings provide an indication of the i.r.s.’s current position on the law. see, e.g., id. (“the taxpayer contends that although these letters were not addressed to him they were shown to him by livingstone and he relied upon their approval of transactions which would seem to be essentially undistinguishable from that presented here.”). moreover, given the number of private letter rulings the i.r.s. has issued on this point, it appears to be a position in which the i.r.s. believes. 116. see priv. ltr. rul. 2011-35-001 (may 23, 2011); priv. ltr. rul. 201131-001 (apr. 18, 2011); priv. ltr. rul. 2011-13-015 (dec. 8, 2010); priv. ltr. rul. 2011-08-003 (nov. 15, 2010); priv. ltr. rul. 2011-08-018 (nov. 15, 2010); priv. ltr. rul. 2011-04-013 (oct. 20, 2010); priv. ltr. rul. 2011-03-019 (oct. 14, 2010); priv. ltr. rul. 2011-03-033 (oct. 12, 2010); priv. ltr. rul. 2011-02-055 (sept. 22, 2010); priv. ltr. rul. 2011-07-012 (sept. 21, 2010); priv. ltr. rul. 2010-43-016 (july 15, 2010); priv. ltr. rul. 2010-39-002 (june 22, 2010); priv. ltr. rul. 201037-012 (june 4, 2010); priv. ltr. rul. 2010-30-004 (apr. 28, 2010); priv. ltr. rul. 2010-34-011 (apr. 23, 2010); priv. ltr. rul. 2010-31-007 (apr. 13, 2010); priv. ltr. rul. 2010-25-031 (feb. 23, 2010); priv. ltr. rul. 2009-52-019 (sept. 13, 2009); priv. ltr. rul. 2009-46-036 (july 8, 2009); priv. ltr. rul. 2009-39-017 (june 4, 2009); priv. ltr. rul. 2009-31-003 (apr. 16, 2009); priv. ltr. rul. 2009-31-008 (apr. 16, 2009); priv. ltr. rul. 2009-12-003 (nov. 19, 2008); priv. ltr. rul. 200845-013 (july 30, 2008); priv. ltr. rul. 2008-42-014 (july 17, 2008); priv. ltr. rul. 2008-40-039 (june 13, 2008); priv. ltr. rul. 2008-31-019 (apr. 18, 2008); priv. ltr. rul. 2008-22-012 (feb. 12, 2008); priv. ltr. rul. 2007-45-008 (aug. 2, 2007); priv. ltr. rul. 2007-26-026 (mar. 16, 2007); priv. ltr. rul. 2007-20-011 (feb. 2, 2007); priv. ltr. rul. 2007-05-026 (oct. 31, 2006); priv. ltr. rul. 2007-01-020 (sept. 26, 2006); priv. ltr. rul. 2006-47-017 (aug. 10, 2006); priv. ltr. rul. 2007-45-021 (june 20, 2006); priv. ltr. rul. 2012-06-015 (june 13, 2006); priv. ltr. rul. 200637-018 (june 1, 2006). 117. because the wholly-owned subsidiaries are organized in tax haven jurisdictions, they owe no local taxes on their commodities income. see samuel d. brunson, repatriating tax-exempt investments: tax havens, blocker corporations, 242 florida tax review [vol. 14:6 linked notes, the i.r.s. proved willing to issue private letter rulings holding that income from such subsidiaries constituted qualifying income. 118 through and unrelated debt-financed income, 106 nw. u. l. rev. 225, 239 (2012). as such, holding an investment through a tax haven corporation does not produce an additional layer of taxes. moreover, because the subsidiary is wholly owned by the commodity mutual fund, its existence is unlikely to provide any downside protection to investors, who already have limited liability by virtue of the mutual fund itself. what protection it does offer, moreover, is more illusory than real. while a counterparty cannot compel the mutual fund parent to make it whole, in most cases it does not need to. rather, derivatives clearinghouses generally require parties to derivatives — including commodities-related dividends — to put money into a margin account when they enter into a transaction. see adam h. rosenzweig, imperfect financial markets and the hidden costs of a modern income tax, 62 smu l. rev. 239, 255 (2009) (“[t]he clearinghouse requires investors to post margin with the clearinghouse prior to investing in a derivative, which serves as security on the embedded contingent liability in the derivative position.”). the margin account serves to ameliorate the risk that the subsidiary will not meet its obligations. and, while a margin account does not undo limited liability, it does require that the commodities mutual fund capitalize its subsidiary sufficiently to meet the margin requirement. because the mutual fund has to capitalize its subsidiary at a higher rate, it puts more of its own capital at risk, and, as such, more of its assets are at risk on the commodities transactions. 118. see priv. ltr. rul. 2012-06-015 (feb. 10, 2012); priv. ltr. rul. 201134-014 (aug. 26, 2011); priv. ltr. rul. 2011-32-008 (aug. 12, 2011); priv. ltr. rul. 2011-31-001 (aug. 5, 2011); priv. ltr. rul. 2011-29-002 (july 22, 2011); priv. ltr. rul. 2011-28-022 (july 15, 2011); priv. ltr. rul. 2011-22-012 (june 3, 2011); priv. ltr. rul. 2011-20-017 (may 20, 2011); priv. ltr. rul. 2011-16-014 (apr. 22, 2011); priv. ltr. rul. 2011-13-018 (apr. 1, 2011); priv. ltr. rul. 2011-08-018 (feb. 25, 2011); priv. ltr. rul. 2011-08-008 (feb. 25, 2011); priv. ltr. rul. 2011-07-012 (feb. 18, 2011); priv. ltr. rul. 2011-04-013 (jan. 28, 2011); priv. ltr. rul. 2011-03033 (jan. 21, 2011); priv. ltr. rul. 2011-03-009 (jan. 21, 2011); priv. ltr. rul. 2011-03-017 (jan. 21, 2011); priv. ltr. rul. 2011-02-047 (jan. 14, 2011); priv. ltr. rul. 2011-02-055 (jan. 14, 2011); priv. ltr. rul. 2010-51-014 (dec. 23, 2010); priv. ltr. rul. 2010-49-015 (dec. 10, 2010); priv. ltr. rul. 2010-48-021 (dec. 3, 2010); priv. ltr. rul. 2010-48-022 (dec. 3, 2010); priv. ltr. rul. 2010-43-017 (oct. 29, 2010); priv. ltr. rul. 2010-42-015 (oct. 22, 2010); priv. ltr. rul. 2010-42-001 (oct. 22, 2010); priv. ltr. rul. 2010-41-033 (oct. 15, 2010); priv. ltr. rul. 2010-39-002 (oct. 1, 2010); priv. ltr. rul. 2010-37-012 (sept. 17, 2010); priv. ltr. rul. 2010-37014 (sept. 17, 2010); priv. ltr. rul. 2010-34-011 (aug. 27, 2010); priv. ltr. rul. 2010-30-004 (july 30, 2010); priv. ltr. rul. 2010-26-017 (july 2, 2010); priv. ltr. rul. 2010-25-031 (june 25, 2010); priv. ltr. rul. 2010-24-003 (june 18, 2010); priv. ltr. rul. 2010-24-004 (june 18, 2010); priv. ltr. rul. 2010-20-003 (may 21, 2010); priv. ltr. rul. 2010-07-044 (feb. 19, 2010); priv. ltr. rul. 2010-05-023 (feb. 5, 2010); priv. ltr. rul. 2009-47-026 (nov. 20, 2009); priv. ltr. rul. 2009-47-032 (nov. 20, 2009); priv. ltr. rul. 2009-46-036 (nov. 13, 2009); priv. ltr. rul. 200939-017 (sept. 25, 2009); priv. ltr. rul. 2009-36-002 (sept. 4, 2009); priv. ltr. rul. 2009-32-007 (aug. 7, 2009); priv. ltr. rul. 2009-31-003 (july 31, 2009); priv. ltr. 2013] preventing i.r.s. abuse of the tax system 243 these subsidiaries, mutual funds could access the commodities market using instruments that would not have produced qualifying income if held directly by the mutual funds, including the commodity index swaps the i.r.s. had previously disallowed. 119 the i.r.s. never explained why it considers commodity-linked notes to qualify as securities, while it does not consider commodity index swaps to so qualify. likewise, it never explained why it does not permit a direct investment in commodity index swaps, but is comfortable with an indirect investment through a wholly-owned subsidiary. though the details of the investments differ, they present essentially the same risk and the same reward. even if the economics of the two instruments differed radically, though, that would not justify treating them differently. the revenue ruling held that a commodity index swap did not qualify as a security “because the underlying property is a commodity (or commodity index).” 120 the property underlying a commodity-linked note is exactly the same as the property underlying a commodity index swap. commodity mutual funds invest in commodity-linked notes precisely because such notes provide them with exposure to commodities. because both the economics and the underlying property of commodity index swaps and commodity-linked notes differ only formally, if at all, it would seem incumbent on the i.r.s. to explain its disparate treatment of the two. but it has provided no such explanation. the problems of policing the i.r.s. in cases like the commodities mutual funds presents even more problems than examples like the telephone excise tax and the campaigning prohibition. here, the i.r.s. is not merely refusing to enforce the tax law: by issuing favorable private letter rulings, it has indicated that it considers the taxpayer’s position to be acceptable. if it finds the position acceptable it will not challenge the position. because the i.r.s. functions both as the promulgator of the rulings and the enforcer of the tax law, it will be ineffective at preventing itself from enforcing the tax law incorrectly. rul. 2009-31-008 (july 31, 2009); priv. ltr. rul. 2009-23-011 (june 5, 2009); priv. ltr. rul. 2009-22-010 (may 29, 2009); priv. ltr. rul. 2009-12-003 (mar. 20, 2009); priv. ltr. rul. 2008-42-014 (oct. 17, 2008); priv. ltr. rul. 2008-40-039 (oct. 3, 2008); priv. ltr. rul. 2008-22-010 (may 30, 2008); priv. ltr. rul. 2007-43-005 (oct. 26, 2007); priv. ltr. rul. 2007-41-004 (oct. 12, 2007); priv. ltr. rul. 2006-47017 (nov. 24, 2006). 119. see, e.g., priv. ltr. rul. 2012-06-015 (june 13, 2006) (“each subsidiary will invest primarily in commodity index swap agreements and fixed income securities, and may also invest in other commodity-linked instruments, including swap agreements on commodities, options, futures contracts, options on futures, and commodity-linked notes.”). 120. rev. rul. 2006-1, 2006-1 c.b. 261. 244 florida tax review [vol. 14:6 recipients of the private letter rulings are also in no position to police the i.r.s. the recipient taxpayer has expended significant time and resources in applying for and receiving the ruling. 121 moreover, private letter rulings allow the taxpayer to structure her transaction in a specific way, knowing that the i.r.s. will not generally challenge her anticipated tax treatment. 122 inasmuch as a successfully-obtained private letter ruling provides a benefit to the taxpayer who received it, that taxpayer has no incentive to challenge the ruling. moreover, non-party taxpayers also lack standing to challenge these private letter rulings. though the i.r.s.’s commodity mutual fund rulings “are arguably more generous than [the] statute, resulting in forgone revenue to the federal fisc, for which we all pay indirectly,” such indirect harm does not provide non-party taxpayers with standing. 123 instead, to have standing to challenge an i.r.s. tax ruling, a taxpayer “must suffer a tangible injury.” 124 iii. current oversight of the i.r.s. as the prior section has demonstrated, the i.r.s. does not always enforce the tax law as written. sometimes the i.r.s.’s departure from the law as written harms taxpayers; even when it does not, however, it harms the tax system and violates congress’s intent. the i.r.s.’s departure from congressional intent is a standard principal-agent problem. 125 congress, as the principal, promulgates the tax law. it does not, however, actively participate in the law it has promulgated; rather, it leaves the administration and enforcement to the i.r.s. which, in 121. a private letter ruling can cost a taxpayer tens of thousands of dollars to obtain. to request a private letter ruling, a taxpayer must pay a fee (which, in 2012, was $18,000). rev. proc. 2012-1, 2012-1 i.r.b. 1, 69. on top of the fee to the i.r.s., a taxpayer must pay the professionals that prepare the ruling request. moreover, in addition to the cost, private letter rulings take time to process, which delays a mutual fund’s ability to engage in its desired transactions. see thomas kelley, law and choice of entity on the social enterprise frontier, 84 tul. l. rev. 337, 356 (2009). 122. treas. reg. § 601.201(l)(6) (“a ruling issued to a taxpayer with respect to a particular transaction represents a holding of the service on that transaction only.”). 123. leandra lederman, what do courts have to do with it?: the judiciary’s role in making federal tax law, 65 nat’l tax j. 899, 910 (2012). 124. greg d. polsky, can treasury overrule the supreme court?, 84 b.u. l. rev. 185, 239 (2004). 125. see, e.g., sanford j. grossman & oliver d. hart, an analysis of the principal-agent problem, 51 econometrica 7, 7 (1983). 2013] preventing i.r.s. abuse of the tax system 245 spite of being an executive agency, functions as congress’s agent. 126 congress does not, however, have the resources to fully oversee the i.r.s., and must therefore establish incentives to ensure that the i.r.s. enforces the tax law in the manner congress desires. 127 although the i.r.s. generally succeeds in fulfilling its duties in administering the tax law, the current incentive system functions imperfectly. whatever the reason, at times the i.r.s. will misinterpret or ignore wholesale the law it has been charged with administering. 128 to prevent such behavior, congress needs to modify the i.r.s.’s incentives. in the past, congress has established boards and offices to oversee the i.r.s. the principal oversight mechanisms congress has established are the office of the taxpayer advocate and the internal revenue service oversight board. a. the office of the taxpayer advocate with proper design, the i.r.s. itself could fulfill the necessary oversight role. in response to various taxpayer complaints about the i.r.s., congress has enacted various reforms over the last three decades intended to check the i.r.s.’s purported abuses of taxpayers. 129 in 1979, the i.r.s. created the office of the taxpayer ombudsman to coordinate its problem resolution program and to act as an advocate for taxpayers. 130 in 1988, congress enacted the taxpayer bill of rights, which, among other things, codified the taxpayer ombudsman and gave it the ability to issue a taxpayer 126. archie parnell, congressional interference in agency enforcement: the irs experience, 89 yale l.j. 1360, 1360 (1980) [hereinafter parnell, congressional interference in agency enforcement] (“[t]he relationship remains one of interdependence, in which congress depends on the irs to execute the internal revenue code and collect the revenues necessary to fund the federal government and the irs depends on congress to fund and authorize its operations . . . .”). 127. david e. m. sappington, incentives in principal-agent relationships, 5 j. econ. persp. 45, 45 (1991) (“incentive theory, however, generally focuses on tasks that are too complicated or too costly to do oneself. thus, the ‘principal’ is obliged to hire an ‘agent’ with specialized skills or knowledge to perform the task in question.”). 128. at times, of course, congress itself may impede the i.r.s. from doing its job appropriately, forbidding it to enforce certain provisions of the code rather than legislatively changing the code. see, e.g., parnell, congressional interference in agency enforcement, supra note 126, at 1361 (“second, congress has shown a recent tendency to use a variety of techniques to prohibit the irs from executing certain aspects of the code, rather than changing the code itself.”). 129. see supra notes 17–20 and accompanying text. 130. bryan t. camp, what good is the national taxpayer advocate?, 126 tax notes 1243, 1247 (2010) [hereinafter camp, national taxpayer advocate]. 246 florida tax review [vol. 14:6 assistance order. 131 a taxpayer assistance order could require the i.r.s. to release taxpayer property it had levied, prevent collection, and otherwise protect taxpayers suffering significant hardship as a result of the i.r.s.’s administration of the tax law. 132 in addition, congress required the taxpayer ombudsman to make an annual report to the senate finance committee and the house ways and means committee on the quality of taxpayer services. 133 in 1996, congress replaced the office of the taxpayer ombudsman with the office of the taxpayer advocate. 134 the office of the taxpayer advocate was supervised by the taxpayer advocate, who reported directly to the commissioner of internal revenue. 135 the code continued to require the office of the taxpayer advocate to make an annual report to congress and to help taxpayers resolve problems with the i.r.s. 136 in addition, the taxpayer bill of rights 2 charged the newly-created office of the taxpayer advocate with identifying problem areas in taxpayer interaction with the i.r.s. and proposing administrative and legislative changes that could fix those problem areas. 137 in spite of these changes, many in congress did not believe that that the taxpayer advocate functioned independently from the i.r.s. as it advocated for taxpayers. 138 their incredulity stemmed, at least in part, “on the placement of the advocate within the irs and the fact that only career employees have been chosen to fill the position.” 139 in 1998, congress further tweaked the office of the taxpayer advocate in an attempt to ensure the taxpayer advocate’s independence. 140 the head of the office of the taxpayer advocate was rechristened the national taxpayer advocate. 141 though she continues to report directly to the commissioner of internal revenue, 142 congress attempted to ensure her independence by prohibiting the appointment as national taxpayer advocate of anybody who had worked 131. technical and miscellaneous revenue act of 1988 (“tamra”), pub. l. no. 100-647, title vi, 102 stat. 3342, 3733 (1988). 132. i.r.c. § 7811(b). 133. tamra, pub. l. no. 100-647, sec. 6235 (b), 102 stat. 3342, 3737 (1988). 134. taxpayer bill of rights 2, 104 p.l. 168, § 101(a), 110 stat. 1452, 1453 (1996). 135. id. 136. id. 137. id. 138. nat’l comm’n on restructing the i.r.s., a vision for a new irs 48 (june 25, 1997) [hereinafter nat’l comm’n, vision]. 139. id. 140. i.r.s. restructuring and reform act of 1998, pub. l. no. 105-206, § 1102, 12 stat. 685, 697 (1998). 141. i.r.c. § 7803(c)(1)(b)(i). 142. id. 2013] preventing i.r.s. abuse of the tax system 247 for the i.r.s. in the prior two years. moreover, the national taxpayer advocate must agree not to accept a job with the i.r.s. for five years after her appointment as national taxpayer advocate ends. 143 as a result of these limitations, the national taxpayer advocate cannot view her service as “just another assignment . . . , with the commissioner viewing . . . her performance as determining the next position.” 144 in addition, congress provided for local taxpayer advocates, including one for each state. 145 each of these local offices must have its own phone, fax, and other electronic communication, separate from the i.r.s. 146 each must inform taxpayers of its independence from any other i.r.s. office at the beginning of its consultation and, importantly, each has the discretion not to disclose to the i.r.s. the fact that a taxpayer had contact with the office or any information provided by the taxpayer. 147 the office of the taxpayer advocate claims to be the “voice of the taxpayer.” 148 does it manage to effectively pursue taxpayer interests, even where those interests conflict with the i.r.s.’s goals? though the data is limited, anecdotally, it appears to work. practitioners praise the taxpayer advocate for “get[ing] things done despite the impediments of the systems within the irs.” 149 moreover, in spite of the tensions inherent in an ombudsman-type role, 150 the taxpayer advocate’s customer service surveys indicate that even taxpayers who do not obtain the results they wanted feel better about the i.r.s. after working with the taxpayer advocate. 151 current national taxpayer advocate nina olson sees the office of the taxpayer advocate successfully navigating the tension between being an insider and an outsider in part because the taxpayer advocate is just that — an advocate, not a decision-maker. 152 143. id. § 7803(c)(1)(b)(iv). 144. nat’l comm’n, vision, supra note 138, at 48. 145. i.r.c. § 7803(c)(2)(d)(i)(i). 146. id. § 7803(c)(4)(b). 147. id. § 7803(c)(4)(a). 148. nat’l taxpayer advocate, fiscal year 2013 objectives i-3 (2012), http://www.taxpayeradvocate.irs.gov//usersfiles/file/fy13objectivesreport tocongress.pdf. 149. larry jones, customer service—we all want it, but do we get it?, j. tax prac. & proc., aug.-sept. 2003, at 5, 8. 150. see, e.g., camp, national taxpayer advocate, supra note 130, at 1250 (“few people like being criticized, and there is an inherent distrust within a bureaucracy of a subcomponent like the tas whose very function is to highlight problems in the system, whether case specific or systemic.”). 151. nina olson, the taxpayer advocate service: independence within the irs, 126 tax notes 1257, 1261 (2010) [hereinafter olson, taxpayer advocate]. 152. id. at 1260. 248 florida tax review [vol. 14:6 b. the internal revenue service oversight board congress can also place the oversight duty and authority outside of the i.r.s. itself. for example, congress created the internal revenue service oversight board in the same 1998 law that restructured the office of the taxpayer advocate. 153 the oversight board consists of nine members. 154 the president appoints seven members with the advice and consent of the senate; of those seven, six cannot be federal officers or employees. 155 these board members were to be “high stature, nonpartisan professionals, with experience particularly relevant to a 100,000 employee organization.” 156 the seventh board slot appointed by the president is filled by a full-time federal employee or a representative of federal employees. 157 the secretary of the treasury department and the commissioner of internal revenue fill the other two board seats. 158 the oversight board is non-partisan, and its members must have experience and expertise in, among other things, federal tax law, including compliance and administration. 159 the code charges the oversight board with overseeing the i.r.s. “in its administration, management, conduct, direction, and supervision of the execution and application of the internal revenue laws or related statutes and tax conventions to which the united states is a party.” 160 more specifically, the oversight board must review the i.r.s.’s strategic and operational plans, recommend and oversee the commissioner of internal revenue, review and approve the i.r.s.’s budget, and ensure that i.r.s. employees treat taxpayers properly. 161 153. i.r.s. restructuring and reform act of 1998, pub. l. no. 105-206, § 1101(a), 12 stat. 685, 691 (1998). 154. i.r.c. § 7802(b)(1). 155. id. § 7802(b)(1)(a). 156. nat’l comm. on restructuring the internal revenue service, report of the nat’l comm. on restructuring the internal revenue service: a vision for a new irs 13 (1997) http://www.house.gov/ natcommirs/report1.pdf, [hereinafter nat’l comm., restructuring]. 157. i.r.c. § 7802(b)(1)(d). 158. id. § 7802(b)(1)(b)-(c). 159. id. § 7802(b)(2)(a)(iii). 160. id. § 7802(c)(1)(a). 161. id. § 7802(c)(2)-(5). congress has not limited its use of oversight committees to the world of tax. an alternative model comes from bankruptcy. in 1978, congress established the office of the united states trustee to handle the administrative functions of bankruptcy, while also reducing certain abuses within the bankruptcy system as a whole. greg m. zipes, discovery abuse in the civil adversary system: looking to bankruptcy’s regime of mandatory disclosure and third-party control over the discovery process for solutions, 27 cumb. l. rev. 1107, 1160 (1996). the u.s. trustee has the authority both to monitor bankruptcy cases, but to take action when, for example, a case risks undue delay or when parties 2013] preventing i.r.s. abuse of the tax system 249 iv. suboptimal oversight although congress has traditionally used oversight committees to keep the i.r.s. in check, in protecting the tax law from i.r.s. abuse, these traditional oversight techniques would prove suboptimal. congress cannot directly oversee the i.r.s., which explains why it has established oversight boards. but although the taxpayer advocate and the i.r.s. oversight board are effective in their current duties, neither encapsulates exactly what is needed to protect the tax system from i.r.s. abuse. if congress wanted to protect the tax system from i.r.s. abuse through formal oversight, it would need to create a new oversight body. a. congress cannot provide effective oversight congress could, of course, legislatively counter i.r.s. decisions with which it disagrees. but it “cannot (and should not) engage in detailed oversight of the entire operation of the service.” 162 congress does not have the time or expertise to review every decision that the i.r.s. makes. in 2010 alone, the i.r.s. issued approximately 1,874 private letter rulings. 163 and private letter rulings only represent a small portion of the i.r.s.’s activities during the year. requiring congress to become aware of each position the i.r.s. takes and to change the law every time it disagrees with the i.r.s.’s administration or interpretation is an unattractive position to take. 164 moreover, it assumes that congress has the ability to act as an effective overseer. congress’s track record, however, belies its effectiveness. fail to meet deadlines. mary jo heston, the united states trustee: the missing link of bankruptcy crime prosecutions, 6 am. bankr. inst. l. rev. 359, 383 (1998). unlike the office of the taxpayer advocate or the internal revenue service oversight board, the u.s. trustee can intervene in litigation in cases where such intervention would help protect the bankruptcy system. in re a-1 trash pickup, inc., 802 f.2d 774, 776 (4th cir. 1986). 162. stephanie hoffer, hobgoblins of little minds no more: justice requires an irs duty of consistency, 2006 utah l. rev. 317, 330 (2006). 163. the number of private letter rulings comes from searching (advanced: “private letter ruling” & “irs plr” & da (aft 12-31-2009 & bef 01-01-2011)) on westlawnext. 164. in fact, a number of congressional representatives have weighed in on the commodities mutual fund private letter rulings, almost universally criticizing the i.r.s. for the rulings. see jeremiah coder, top tax officials grilled on mutual fund commodity investments, 134 tax notes 524, 524 (2012) (senators carl levin and tom coburn “sent a letter to the irs urging it to permanently extend its moratorium and to ‘reevaluate the tax treatment of all mutual funds currently allowed to treat indirect commodity investments as income derived from “securities” under section 851.’”). but congress itself has not acted to correct the i.r.s.’s course. 250 florida tax review [vol. 14:6 congress has, for example, repeatedly found itself unable to pass timely tax legislation that is broadly seen as both necessary and important. in 2008, and again in 2012, it has had difficulties passing an alternative minimum tax patch, in spite of the fact that failure to pass such a patch would increase the tax bills of millions of middle-class americans. 165 in fact, some senators have noticed — and objected to — the i.r.s.’s position on commodities mutual funds. in december of 2011, two senators sent a letter to the i.r.s. requesting that it extend its moratorium on issuing commodity mutual fund private letter rulings. 166 in january 2012, the senate’s permanent subcommittee on investigations held a hearing on the i.r.s.’s issuance of commodity fund private letter rulings. 167 but outside of letters and hearings, congress has done nothing that would require the i.r.s. to enforcing the tax law. with no reason to believe congress will change to become a better overseer, using congress to provide oversight will not serve to protect the tax system. b. the office of the taxpayer advocate does not have the resources to protect the tax system in many ways, the office of the taxpayer advocate provides an excellent model for how to police the i.r.s. unlike congressional representatives, i.r.s. employees have the time and expertise to focus 165. see, e.g., jeffrey h. birnbaum, patch approved for alternative minimum tax; early filers to wait for refunds as irs applies fix to computers, wash. post, dec. 20, 2007, at d01 (“congress gave final approval yesterday to a bill that would protect about 20 million households from a tax increase caused by the alternative minimum tax, but the legislation passed so late in the year that 15 million americans will probably have to wait longer than usual to get their refunds in 2008.”); william hoffman, olson predicts up to 3 filing seasons in wake of fiscal cliff, 137 tax notes 1162, 1162 (2012); wesley elmore, failure to pass amt patch would be disastrous, potter says, 137 tax notes 859, 859 (2012) (“failing to pass an alternative minimum tax patch during the lame-duck session of congress would be a ‘real recipe for disaster’ resulting in delayed processing of tax returns and economic harm, a former irs official said november 14.”). 166. jeremiah coder, top tax officials grilled on mutual fund commodity investments, 134 tax notes 524, 524 (2012). the i.r.s. had temporarily stopped issuing the rulings, not because it believed they were wrong, but because it was exploring whether it should issue broader guidance on which taxpayers in general could rely. id. 167. compliance with tax limits on mutual fund commodity speculation: hearing before the permanent subcomm. on investigations of the senate comm. on homeland security and governmental affairs, 112th cong. 5 (2012) (“by issuing the private letter rulings that it has issued in the mutual fund area, the irs is undermining its own longstanding efforts to go after sham corporations and transactions that are used to avoid paying a tax.”). 2013] preventing i.r.s. abuse of the tax system 251 specifically on issues of tax administration. moreover, i.r.s. employees would not face the major issues (besides standing) that would impede third parties from challenging the i.r.s.’s placing form over substance. because the i.r.s. does not manage mutual funds, employees in a watchdog office could not decide to pursue their own private letter ruling rather than challenging the i.r.s.’s promulgation of such rulings. in addition, they would not face the costs of litigating such a case, with no hope of monetary relief. moreover, placing enforcement in an office in the i.r.s. would present certain advantages over either congressional or third-party enforcement. if taxpayers challenged the i.r.s. every time it recognized a taxpayer’s compliance with formal requirements that had no substance, administering the tax law could become unwieldy and overly-expensive. the convenience and efficiency of permitting taxpayers to, for example, make entity elections for tax purposes would dissolve, and, in spite of their complexity, the previous facts-and-circumstances test may become a more efficient process. an office in the i.r.s., on the other hand, could develop the expertise necessary to differentiate between permissible and impermissible situations for permitting purely formal actions. 168 an office within the i.r.s. charged with challenging the i.r.s.’s administration of the tax law would, of course, face significant problems, especially the inside-outside problem and the dissonance of challenging the organization of which it is part. 169 the history of the office of the taxpayer advocate demonstrates that these problems are real and significant. but the current success of the taxpayer advocate demonstrates that they are not insuperable. the office must, however, be designed carefully to take into account both the conflicts and the appearance of conflicts. although the office of the taxpayer advocate provides a model for creating a watchdog within the i.r.s., the taxpayer advocate, as it currently stands, cannot function as that watchdog for a number of reasons. the office of the taxpayer advocate is charged with improving taxpayers’ experience in dealing with the i.r.s.; the national taxpayer advocate not only needs to have experience with the tax law, but she must have “a background in customer service.” 170 preventing the i.r.s. from recognizing substance-free transactions does nothing to improve an individual taxpayer’s interaction with the i.r.s. it maintains the integrity of the tax law, which provides a collective benefit to taxpayers, but the office of the taxpayer advocate was created to provide individual, not collective, benefit. 168. for the group to be able to differentiate permissible and impermissible formal primacy, it necessarily must be composed of individuals with significant knowledge of the tax law and practice. see infra section v.b. 169. see supra note 152 and accompanying text. 170. i.r.c. § 7803(c)(1)(b)(iii)(i). 252 florida tax review [vol. 14:6 moreover, the office of the taxpayer advocate would lack the ability to enforce its decisions even if it took on the proposed watchdog role. currently, the office of the taxpayer advocate essentially does two things: it helps taxpayers resolve their problems with the i.r.s., and it makes an annual report to congress detailing areas in which taxpayers and the i.r.s. clash and proposing administrative and legislative changes that would ameliorate these clashes. 171 the office of the taxpayer advocate cannot, however, sue the i.r.s. to halt the problems or enforce its proposed solutions. 172 and the limitations on the office of the taxpayer advocate’s litigation are not limited to its inability to engage counsel. the taxpayer advocate cannot file amicus curiae briefs that relate to taxpayer rights. 173 moreover, although the taxpayer advocate can comment on proposed rules and regulations promulgated by the i.r.s., the i.r.s. has no obligation to consider the taxpayer advocate’s comments. 174 in light of its limited recourse, any success the taxpayer advocate enjoys is a testament to its persuasive abilities. and while the taxpayer advocate has successfully pursued its mission, its success probably relies at least in part on the fact that the taxpayers it supports provide a sympathetic picture to other taxpayers. the i.r.s. knows that mistreating taxpayers can lead to a popular backlash, and potentially to legislation such as the two taxpayer bills of rights. the problems of the tax system at large, however, are more metaphysical than personal, and are thus less sympathetic. without a sympathetic taxpayer to provide the threat of backlash, the taxpayer advocate would have less leverage to encourage change. 171. id. § 7803(c)(2)(a). 172. see, e.g., 28 u.s.c. § 516 (“except as otherwise authorized by law, the conduct of litigation in which the united states, an agency, or officer thereof is a party, or is interested, and securing evidence therefor, is reserved to officers of the department of justice, under the direction of the attorney general.”); 5 u.s.c. § 3106 (“except as otherwise authorized by law, the head of an executive department or military department may not employ an attorney or counsel for the conduct of litigation in which the united states, an agency, or employee thereof is a party, or is interested, or for the securing of evidence therefor, but shall refer the matter to the department of justice.”). congress has authorized the chief counsel of the i.r.s. to represent the secretary of the treasury department, but only in the tax court. i.r.c. § 7452. but this authorization does not extend to the taxpayer advocate’s being represented by non-department of justice counsel. 173. national taxpayer advocate, 2011 annual report to congress 573 (2012), http://www.irs.gov/pub/irs-utl/irs_tas_arc_2011_vol_1.pdf. 174. id. at 573–74. 2013] preventing i.r.s. abuse of the tax system 253 even if the office of the taxpayer advocate could find a way to reconcile a mission to protect the integrity of the tax system with its current mission to protect taxpayers and could effectively do so in light of its constraints on litigation, this watchdog duty should not be imported into the office of the taxpayer advocate. currently, congress underfunds the i.r.s. 175 as it currently stands, the taxpayer advocate lacks the resources to deal with its increasing workload without sacrificing quality and timeliness. 176 adding an additional mandate to an office of the taxpayer advocate already stretched thin would force the taxpayer advocate either to further cut their services to taxpayers in need or to limit its watchdog work. c. the internal revenue service oversight board is not constituted to protect the tax system in terms of its composition and its mission, the oversight board seems like the ideal outside group to police the i.r.s. and protect the tax system. its members have the expertise both in tax law and its administration that allows the oversight board to understand the i.r.s.’s actions in light of the code. the majority of the oversight board consists of individuals who are not employed by the i.r.s., and therefore do not face the inside-outside tensions that could bedevil an oversight board located within the i.r.s. moreover, the oversight board has the time and resources to oversee the i.r.s.’s issuance of private letter rulings and other administrative actions. although the oversight board is only obligated to meet quarterly, 177 it can engage the staff necessary to fulfill its duties. 178 still, as currently constituted, the oversight board cannot meet the responsibilities necessary to protect the tax system. congress specifically carved out of the oversight board’s purview the authority to “direct tax policy or administration.” 179 these carve outs exist because congress intended that the oversight board play a governance, not a management, role within the i.r.s. 180 and, in fact, the oversight board functions more like an advisory board than any type of governing board. 181 175. id. at vi (“and despite a huge expansion in the irs’s workload, congress has reduced the irs’s funding in each of the last two years.”). 176. id. at 693. 177. i.r.c. § 7802(f)(2). 178. id. § 7802(e)(3)(a). 179. eric a. lustig, irs, inc.—the irs oversight board—effective reform or just politics? some early thoughts from a corporate law perspective, 42 duq. l. rev. 725, 739 (2004) [hereinafter lustig, irs oversight]. 180. nat’l comm., restructuring, supra note 156, at 14. 181. lustig, irs oversight, supra note, at 768. 254 florida tax review [vol. 14:6 d. if we want an oversight board, congress could form a new one although a new oversight board would add complexity and require additional resources, it is the oversight method with which congress appears most familiar, at least in the tax context. as such, even though it is a secondbest solution at best, congress may prefer it to a new and unfamiliar oversight method. if congress created a new oversight board, though, it would have to design a new oversight office carefully, taking the parts of the current oversight entities that work and altering the parts that do not. a new oversight office, properly designed, could go a long way toward protecting the tax system from i.r.s. abuse. 1. the mandate any new oversight board should have authority to review and comment upon proposed regulations. while the treasury department has broad authority to enact regulations, 182 in some circumstances, those regulations can harm the tax system. 183 in many cases, the oversight board would not be the only one commenting on regulations; the administrative procedure act of 1946 (“apa”) 184 generally requires a notice-and-comment process for proposed regulations. 185 it accepts interpretive regulations from the notice-and-comment requirement, however. 186 and, although the i.r.s. generally solicits comments when it proposes a regulation, it maintains that most of its regulations qualify as interpretive regulations, and are thus technically exempt from the notice-and-comment requirement. 187 moreover, even if all regulations were subject to notice-andcomment procedures, the oversight board would be tasked with a different goal than others who comment. presumably, interested taxpayers will comment on how the proposed regulations will affect their business. the office of the taxpayer advocate will highlight the way a proposed regulation will affect taxpayers in their interaction with the i.r.s. but neither is expressly looking at how the proposed regulation affects the tax system as a whole. moreover, to the extent the proposed regulation is taxpayer-favorable, neither has an incentive to oppose a regulation that violates established tax 182. i.r.c. § 7805(a) (“[t]he secretary shall prescribe all needful rules and regulations for the enforcement of this title.”). 183. see supra note 39 and accompanying text. 184. pub. l. no. 79-404, 60 stat. 237 (codified as amended in scattered sections of 5 u.s.c.). 185. 5 u.s.c. § 553(b)-(c). 186. id. § 553(b). 187. matthew h. friedman, reviving national muffler: analyzing the effect of mayo foundation on judicial deference as applied to general authority tax guidance, 107 nw. u. l. rev. colloquy 115, 122 (2012). 2013] preventing i.r.s. abuse of the tax system 255 law. but this would be the oversight board’s express purpose: to make sure the regulation does not harm the tax system, especially by violating the tax law as it currently stands. the authority to simply comment on proposed regulations would be insufficient. the office of the taxpayer advocate is currently pressing for a requirement that the i.r.s. actually consider its comments. 188 but it is possible that other taxpayers, out of their own self-interest, will echo the taxpayer advocate’s view on how the proposed regulation will affect taxpayers’ interaction with the i.r.s. because the new oversight board would be the only group commenting from the perspective of protecting the tax system, it is even more important that congress require the i.r.s. to consider its recommendations. the ability to review and comment on proposed regulations would, standing alone, do very little to protect the tax system. regulations generally already face notice-and-comment, and interested parties have the ability to object to proposed regulations that veer too far afield of their statutory basis. but, as the i.r.s.’s treatment of commodities mutual funds demonstrates, the i.r.s. can also use other rulings, not subject to notice-and-comment, in a way that damages the tax system. 189 the oversight board charged with protecting the tax system would need the authority to review the i.r.s.’s less-formal rulings, as well, and should also have the authority to look at other i.r.s. actions. 190 2. the composition for the oversight board to protect the tax system, members would have to have a deep knowledge and understanding of the tax system, while also having some degree of independence from the i.r.s. the office of the taxpayer advocate, for example, ensures the appropriate familiarity with the tax law by appointing to its head a person with significant experience in the tax law. 191 188. see supra note 174 and accompanying text. 189. see supra section iii.c. 190. the oversight board would not have the resources to look at everything that the i.r.s. does, of course. rather, it would have to prioritize its reviews. its method of prioritization should include both stricter scrutiny of areas that have had problems in the past and a random assortment of unproblematic areas. see infra note 198 and accompanying text. 191. prior to her appointment, nina olson, the current national taxpayer advocate, worked in private practice representing taxpayers in tax litigation. she also owned a tax planning and preparation firm, and chaired the american bar association section of taxation’s low income taxpayers committee. national taxpayer advocate bio, http://www.taxpayeradvocate.irs.gov/media-resources/ national-taxpayer-advocate-bio. 256 florida tax review [vol. 14:6 it would be essential that the members of the oversight board have significant knowledge of and familiarity with the tax law. for example, they would need the ability to differentiate between respecting form at the expense of substance (e.g., permitting mutual funds to invest in commoditylinked notes) and respecting form because determining the underlying substance is unimportant or administratively infeasible (e.g., entity election). 192 in addition to the knowledge base members must have, members of the oversight board would need to both be and appear impartial. some of the i.r.s. actions they challenge would likely favor the government, while others would favor taxpayers. to prevent the board from tilting toward or against the government’s interests, the board should be split between government employees and individuals working in the private sector. the members who worked for the government would ideally be selected from the i.r.s., the treasury department, or another governmental agency that worked extensively with the tax system. such individuals would potentially face pressure to act in ways that favored the i.r.s., but such pressure could be counterbalanced by implementing procedures shielding them. in creating the national taxpayer advocate, congress demonstrated that it could provide such shielding. moreover, the board members employed in private industry would provide a counterbalance to an overly-government-favorable approach. and from where would the oversight board draw these private industry members? many tax professional organizations include, in their mission statements, the promotion of an equitable tax system. for example, the american bar association’s section of taxation works to provide “leadership to support the development of an equitable, efficient and workable tax system.” 193 the tax section of the new york state bar association works to further “the public interest in a fair and equitable tax system.” 194 ensuring that the i.r.s.’s actions do not harm the tax system fits comfortably with these missions. 192. see 61 fed. reg. 21,989, 21,990 (may 13, 1996) (“treasury and the irs believe that it is appropriate to replace the increasingly formalistic [entity determination] rules under the current regulations with a much simpler approach that generally is elective.”). 193. aba section of taxation, about us, http://www.americanbar.org/ groups/taxation/about_us.html. 194 . new york state bar association, new york state bar association tax section purpose, http://www.nysba.org/am/template.cfm?section=mission_ statement4. 2013] preventing i.r.s. abuse of the tax system 257 3. the method recently, congress has shown no interest in properly funding the i.r.s. 195 given its antipathy toward funding the i.r.s., there is no reason to believe that congress will provide significant funding to oversee the i.r.s., especially where such oversight does not obviously protect a particular constituency. as a result, the oversight board will not have the resources to review every i.r.s. action to make sure it does no harm to the tax system. even with sufficient funding, however, an oversight model that required the overseer to look at every i.r.s. action would be undesirable. it would significantly impact the i.r.s.’s efficiency, and, because the i.r.s. follows the tax law in most cases, such oversight would be unnecessarily broad. instead, the oversight board would need to audit the i.r.s.’s actions. some of its audits should be reactive, based on flags raised by, among other things, the i.r.s.’s past behavior. various flags for this type of reactive oversight could include, among other things, the i.r.s.’s attempting to promulgate rulings or regulations in response to judicial losses. and once a category of ruling or an i.r.s. office that promulgates problematic rulings has been flagged as an issue, the oversight board could look more closely at that category or that office. the reactive model is backward-looking, however, and does not entirely solve the problem of the i.r.s. harming the tax system. as long as it only looks at areas that have had problems in the past, it will be unable to prevent novel problems that arise. to capture those problems, in addition to its reactive audits, the oversight board should engage in random audits. in selecting taxpayers to audit, the i.r.s. largely depends on statistical profiling to ensure that it focuses its scarce resources auditing taxpayers who are likely to owe more than they paid. 196 however, it also selects a small number of taxpayers to audit randomly. 197 these random audits serve a different purpose than its statistical choices: with these random audits, the i.r.s. can gather information about the effectiveness of its enforcement, the size of the tax gap, and other information that will help improve its statistical choices. 198 similarly, the oversight board would need to choose at random some i.r.s. actions. doing so would allow it to find 195. see, e.g., william hoffman, panelists acknowledge irs challenges, consider funding, 135 tax notes 44, 44 (2012) (“the irs faces myriad challenges posed by the global economy and new mandates from congress, but its biggest test will be finding the funding that will enable it to meet its increasing workload . . . .”). 196. sarah b. lawsky, fairly random: on compensating audited taxpayers, 41 conn. l. rev. 161, 165 (2008). 197. id. at 166. 198. id. 258 florida tax review [vol. 14:6 new problems that fire-alarm oversight would miss. it also would send a message to the i.r.s. that a department or individual may be subject to oversight, even with no red flags pointing in that direction. 4. the location the various models demonstrate that an oversight body can successfully be located within or without the i.r.s. itself. congress located the office of the taxpayer advocate within the i.r.s., but instituted firewalls to ensure its independence. those firewalls included protections against the national taxpayer advocate using her office to advance her status and ability. they demonstrate, for example, that such oversight can occur from within the i.r.s. itself, if the office is properly designed and insulated from internal pressures. alternatively, an outside group can be created and charged with oversight, if the group consists of competent individuals who are familiar with the tax law they are protecting. while the oversight board could function in either place, locating it outside of the i.r.s. would be preferable or provide it with any other significant benefit. being part of the i.r.s. would not guarantee that the i.r.s. would cooperate with the oversight board. 199 congress would have to take extra care to insulate the board from i.r.s. pressure. and, although the federal government can technically end up on opposite sides of a lawsuit, that door is rarely opened. 200 an oversight board not housed within the agency it seeks to oversee does not face the same potential pressures. it has more ability to act independently, even without congressional protection. and, although congress would have to specifically give it standing and authority to bring cases to court, it would not require permitting the i.r.s. to sue itself. as a result, even though the oversight board could be located within the i.r.s., creating it separately from the i.r.s. makes practical and administrative sense. 199. see, e.g., heather b. conoboy, note, a wrong step in the right direction: the national taxpayer advocate and the 1998 irs restructuring and reform act, 41 wm. & mary l. rev. 1401, 1416 (2000) (“releasing negative statistics about irs abuses could, if opposed by the irs, result in a lack of cooperation between the main collection agency and the office of the nta.”). 200. michael herz, united states v. united states: when can the federal government sue itself?, 32 wm. & mary l. rev. 893, 896–97 (1991) (“because doj controls most agency litigation, it is able to keep numerous potential interagency suits from reaching the courts.”). 2013] preventing i.r.s. abuse of the tax system 259 v. fire alarm oversight although congress could create a new oversight board to protect the tax system, that would not constitute the best form of oversight. even though congress is comfortable with delegating oversight of the i.r.s. to formal boards and offices, this type of direct oversight is flawed at best. even a perfectly designed oversight board would face significant problems in protecting the tax system. for one thing, having a dedicated oversight board would not necessarily ensure complete oversight. the board would not necessarily be aware of everything the i.r.s. did, and, with a finite number of people and a finite budget, could only look at some of what the i.r.s. does. 201 that it cannot look at every decision does not, of course, disqualify an oversight board. using an audit approach, where the oversight board examines a subset of the i.r.s.’s decisions, could prevent the i.r.s. from abusing the tax law. 202 especially where the board chose its audit targets at random, a small number of audits could have a much larger effect on the i.r.s.’s compliance with the tax law. 203 potentially even more damaging to the effectiveness of a new oversight board is the fact that congress has not shown any interest in properly funding the i.r.s. 204 and congress underfunds the i.r.s. in spite of the fact that, historically, every additional dollar the i.r.s. has spent on enforcement programs has netted the federal government between $3 and $14 of additional revenue. 205 but the oversight i propose would not necessarily raise revenue. in fact, in the three examples presented in this article, successful oversight may have lowered federal revenues. if an oversight board had prevented the i.r.s. from imposing the telephone excise tax, it would have eliminated litigation costs, but it would have also prevented the i.r.s. from collecting taxes in the first place. even where the oversight would prevent the i.r.s. from creating a taxpayer-favorable rule, moreover, its actions would not necessarily increase federal revenue. if the i.r.s. made clear, for example, that it would not 201. see supra sections iv.b., c. 202. mariano-florentino cuellar, auditing executive discretion, 82 notre dame l. rev. 227, 252 (2006). 203. id. at 255 (“indeed, if regulators avoided random auditing techniques altogether, they would face at least two problems. existing knowledge about where problems lie may prove deficient or outdated. perhaps more important, strategic actors can simply evade review by avoiding domains where enforcement is already occurring.”). 204. see supra note 175 and accompanying text. 205. budgeting to fight waste, fraud and abuse: hearing before the comm. on the budget h. of rep., 110th cong. 37 (2007). 260 florida tax review [vol. 14:6 countenance mutual funds investing, directly or indirectly, in financial instruments that reflected the value of commodities, the funds would not suddenly become taxable. instead, they would change their investment strategy. likewise with tax-exempt organizations: if they believed that they would become taxable, they would likely change their behavior to comply with the rule. 206 a. deputizing the public mathew mccubbins and thomas schwartz have christened the type of oversight illustrated by the i.r.s. oversight board, and by the office of the taxpayer advocate, “police-patrol oversight.” 207 they define policepatrol oversight as “congress examin[ing] a sample of executive-agency activities, with the aim of detecting and remedying any violations of legislative goals and, by its surveillance, discouraging such violations.” 208 police-patrol oversight requires active participation by congress or its agent. congress can hold hearings, can read documents or commission studies, but police-patrol oversight requires time and effort from congress. 209 it also requires congress to have the ability to find problems and realize that they are problems. in contrast to police-patrol oversight, mccubbins and schwartz discuss “fire-alarm oversight.” fire-alarm oversight is less centralized and less active than police-patrol oversight. 210 instead of congress or its agent examining administrative decisions and actions, “congress establishes a system of rules, procedures, and informal practices that enable individual citizens and organized interest groups to examine administrative decision (sometimes in prospect), to charge executive agencies with violating congressional goals, and to seek remedies from agencies, courts, and congress itself.” 211 legislators generally like fire-alarm oversight. 212 police-patrol oversight requires significant time and effort, much of which goes to 206. there would undoubtedly be exceptions, of course. but those exceptions would be entities making a political statement, and would not produce any substantive stream of federal revenue. 207. mathew d. mccubbins & thomas schwartz, congressional oversight overlooked: police patrols versus fire alarms, 28 am. j. pol. sci. 165, 166 (1984) [hereinafter mccubbins & schwartz, congressional oversight]. 208. id. 209. id. 210. id. 211. id. 212. congress has used fire-alarm oversight broadly, for example, to enforce “[v]irtually all modern civil rights statutes . . . .” pamela s. karlan, disarming the private attorney general, 2003 u. ill. l. rev. 183, 186 (2003). 2013] preventing i.r.s. abuse of the tax system 261 exploring acts that do not violate congressional intent. 213 even where congress or an oversight board finds a problem, moreover, the violation may not harm any particular constituent and, as such, may not provide political benefits to the congressional representatives involved. 214 in fact, for the oversight this article proposes, correcting the i.r.s. would rarely aid a particularized constituency. though ending the i.r.s.’s abuse of the tax system helps taxpayers generally, the benefits are diffuse, and no legislator is likely to benefit politically from engaging in such oversight. fire-alarm oversight, then, provides legislators with significant benefits. they do not have to waste time tracking down abuses that will provide them with some political benefits. instead, they can wait until constituents come to them with bad behavior, and then can attempt to remedy the problem and reap the political rewards. 215 but, for purposes of policing the i.r.s., properly-designed fire-alarm oversight may provide an even more important benefit to legislators: they can shirk the political costs of unpopular oversight. 216 because fire-alarm oversight delegates at least some enforcement ability to third parties, legislators never need to get their hands dirty in the enforcement, instead permitting motivated third-parties to ensure that the i.r.s. enforces the law. 217 213. mccubbins & schwartz, congressional oversight, supra note 207, at 168 (“[c]ongressmen engaged in police-patrol oversight inevitably spend time examining a great many executive-branch actions that do not violate legislative goals . . . .”). 214. id. (“they might also spend time detecting and remedying arguable violations that nonetheless harm no potential supporters. for this they receive scant credit from their potential supporters.”). 215. id. (“[u]nder a fire-alarm policy, a congressman does not address concrete violations unless potential supporters have complained about them, in which case he can receive credit for intervening.”). 216. id. (“a congressman’s responsibility for [oversight] costs is sufficiently remote that he is not likely to be blamed for them by his potential supporters.”). 217. note that congress’s implementing fire-alarm oversight of the i.r.s. does not mean that it fully divests itself of its oversight responsibility and authority. fire-alarm oversight versus police-patrol oversight is not a zero-sum game; rather, congress “can choose either form or a combination of the two.” id. at 166–67. that is, congress can delegate authority to third parties to watch the i.r.s., but can, nonetheless, step in (with hearings, changes in law, or any other type of police-patrol oversight) when it becomes aware of bad behavior either that third parties are unaware of or uninterested in, or when it would be to legislators’ political benefit to become involved. 262 florida tax review [vol. 14:6 b. standing and fire-alarm standing standing remains a significant impediment to congress’s implementing fire-alarm oversight. admittedly, when the i.r.s. misapplies the tax law in a manner beneficial to a specific taxpayer, other taxpayers suffer an injury. 218 but such small, indirect injuries have not, historically, provided standing for taxpayers to challenge i.r.s. actions. 219 and, in fact, providing standing to third-party taxpayers may prove challenging for congress. as a practical matter, a generalized ability to challenge i.r.s. discretion would create significant problems in the administration of the tax law. the diffuseness of the harm could allow any taxpayer to challenge any i.r.s. decision. 220 the government needs revenue, however, and the i.r.s. needs some amount of flexibility in interpreting and enforcing the tax law. 221 a constant and omnipresent threat of lawsuits at its every move would impede the i.r.s.’s ability to exercise this flexibility. 222 the constitutionality of third-party taxpayer standing could pose an even more-significant impediment to fire-alarm standing. courts have generally rejected taxpayer standing for failing to meet the “case or controversy” requirement of article iii of the constitution. 223 congress has faced this case-or-controversy requirement previously. in the 1970s, congress began to allow environmental citizen suits. 224 these citizen suits came in two versions: one empowered private individuals to sue private corporations that were violating environmental laws, while the other allowed private citizens to sue the government agency responsible for enforcing the environmental law, alleging that it has failed in its duties. 225 by the late 1980s, hundreds of environmental citizen suits were pending in various courts. 226 but in 1992, with the supreme court’s decision 218. matthew a. melone, a leg to stand on: is there a legal and prudential solution to the problem of taxpayer standing in the federal tax context?, 9 pitt. tax rev. 97, 140 (2012) [hereinafter melone, a leg] (“the victims reside on the circumference — all harmed in the same way.”). 219. see supra notes 83–85 and accompanying text. 220. melone, a leg, supra note 218, at 146. 221. see, e.g., cass r. sunstein, is tobacco a drug? administrative agencies as common law courts, 47 duke l.j. 1013, 1055–56 (1998) (stating that administrative agencies have flexibility to interpret ambiguous statutes). 222. rachel e. barkow, insulating agencies: avoiding capture through institutional design, 89 tex. l. rev. 15, 22 (2010) (“all else being equal, agencies would prefer not to become mired in legal challenges . . . .”). 223. see generally melone, a leg, supra note 218, at 132–34. 224. frank b. cross, rethinking environmental citizen suits, 8 temp. envtl. l. & tech. j. 55, 55 (1989). 225. id. 226. id. at 55–56. 2013] preventing i.r.s. abuse of the tax system 263 in lujan v. defenders of wildlife, 227 citizen suits became significantly more difficult. 228 in lujan, the supreme court held that citizens who brought a citizen suit under the endangered species act lacked standing to bring an action. 229 the court held that a plaintiff could not maintain standing if she “claim[ed] only harm to [her] and every citizen’s interest in proper application of the constitution and laws, and seeking relief that no more directly and tangibly benefits him than it does the public at large. . . .” 230 if a direct statutory grant of standing in the environmental area is insufficient to provide third parties with article iii standing, it seems unlikely that such a grant of standing would work in the tax area. moreover, congress’s ability to overcome this deficiency statutorily is not clear. though the supreme court has never categorically stated that congress cannot create an expansive standing in some circumstances, 231 even an explicit statutory grant of standing may not be sufficient to overcome the article iii case-orcontroversy rule. 232 in spite of the necessity of direct and tangible harm and benefit for article iii standing, though, congress may be able to design a review procedure that permits third parties who face no tangible harm to nonetheless litigate on behalf of the tax law. rather than federal district courts, though, congress could require that such suits be brought in the tax court. congress established the tax court under article i of the constitution. 233 because “standing is formally an article iii doctrine that does not constrain legislative courts and similar non-article iii tribunals,” it 227. 504 u.s. 555 (1992). 228. will reisinger, trent a. dougherty, & nolan moser, environmental enforcement and the limits of cooperative federalism: will courts allow citizen suits to pick up the slack?, 20 duke envtl. l. & pol’y f. 1, 34 (2010). 229. lujan, 504 u.s. at 578. 230. id. at 573–74. 231. michael e. solimine, congress, separation of powers, and standing, 59 case w. res. l. rev. 1023, 1049 (2009) (“supreme court doctrine on the scope of congressional power to influence standing in federal court is not a model of clarity. no justice has suggested that congress lacks any power in this regard, and . . . congress may statutorily bless injuries to provide standing where those injuries would not have been recognized at common law. but beyond those generalities, the level of congressional authority to authorize departures from the private rights model is not clear.”). 232. david krinsky, how to sue without standing: the constitutionality of citizen suits in non-article iii tribunals, 57 case w. res. l. rev. 301, 304 (2007) [hereinafter krinsky, how to sue]. 233. i.r.c. § 7441 (“there is hereby established, under article i of the constitution of the united states, a court of record to be known as the united states tax court.”). 264 florida tax review [vol. 14:6 should be possible for congress to permit the tax court to hear “noncases.” 234 of course, the fact that the article iii standing requirement does not apply to the tax court does not mean that congress has an unfettered ability to assign jurisdiction to the tax court. 235 although the supreme court has not established “formalistic and unbending rules” to determine when congress can authorize non-article iii tribunals to have jurisdiction, it has laid out factors that are essential to the judicial power, over which nonarticle iii tribunals cannot have jurisdiction. 236 for example, non-article iii tribunals cannot exercise broad jurisdiction; instead, they must deal with a “particularized area of law.” 237 suits claiming private rights fall within the core of matters reserved for article iii courts. 238 on the other hand, congress can use non-article iii tribunals to resolve questions about which they possess “obvious expertise.” 239 granting jurisdiction to the tax court over fire-alarm oversight suits should fit within the bounds the supreme court has established to grant standing in non-article iii tribunals. congress would not add a broad grant of jurisdiction to the tax court. instead, it would receive jurisdiction to hear claims from uninjured taxpayers that the i.r.s. blatantly violated the tax law, to the detriment of the tax system. moreover, the claims would not attempt to validate a private right of the plaintiff. protecting the tax system is a public, not a private, right. 240 in addition, because there is no case or controversy, article iii courts could not exercise jurisdiction over the case. as such, permitting these fire-alarm oversight cases would not remove from article iii courts cases that belong there. finally, the tax court has specific expertise in the area of tax law. even though the contours of congress’s authority to vest jurisdiction in article i courts remain unclear, its ability to grant the tax court jurisdiction 234. krinsky, how to sue, supra note 232, at 308. 235. see, e.g., thomas v. union carbide argricultural products co., 473 u.s. 568, 584 (1985) (“congress may not vest in a non-article iii court the power to adjudicate, render final judgment, and issue binding orders in a traditional contract action arising under state law, without consent of the litigants, and subject only to ordinary appellate review.”). 236. commodity futures trading commissioner v. schor, 478 u.s. 833, 851 (1986). 237. id. at 852. 238. id. at 853. 239. id. at 855–86. 240. cf. n. pipeline constr. co. v. marathon pipe line co., 458 u.s. 50, 69 (1982) (“[a] matter of public rights must at a minimum arise ‘between the government and others.’”). 2013] preventing i.r.s. abuse of the tax system 265 over these fire-alarm oversight cases seems to fit comfortably within the scope established by the supreme court. c. prudential considerations empowering third parties to sue the i.r.s. creates several practical problems. from the i.r.s.’s perspective, the unfettered ability of taxpayers to sue about matters with which they have no involvement potentially creates an avalanche of lawsuits, absorbing i.r.s. time and money, and distracting from its administrative and tax-collection duties. moreover, this additional burden would not redound solely on the i.r.s. the specter of third-party challenges could raise the cost, both in money and in time, of receiving a ruling. moreover, because the ruling could not be challenged until after it became public, it would reduce the taxpayer’s certainty in relying on the ruling. but private letter rulings improve the efficiency of administering and of complying with the tax law, especially in areas where the law is unclear as applied to a particular transaction. such a broad grant of standing would significantly reduce the efficiency of administering the tax law, and could impede taxpayers from engaging in beneficial, but new, transactions. of course, this added expense assumes that non-party taxpayers do challenge the i.r.s. in many cases, third parties would have at best little incentive to challenge a private letter ruling. a competitor to the taxpayer may want to remove from the taxpayer a potential advantage. but to the extent that a transaction favoring substance provides a competitive advantage, the competitor may gain more by imitating the strategy and obtaining its own private letter ruling than by challenging the existing private letter ruling. if, on the other hand, the competitor did not believe the strategy provided any advantages to the taxpayer, the competitor could allow the taxpayer to keep pursuing the strategy. non-competitor third parties would have even less incentive to challenge private letter rulings. because they do not compete with the taxpayers who receive the ruling, they would gain no competitive advantage by preventing the taxpayers from pursuing the strategy. in order to launch the challenge, though, these third parties would need to expend the time to review private letter rulings and the money to launch a challenge. in the end, though, they would receive no upside from the termination of a bad strategy. 241 241. in fact, when the tax law tries to enlist other taxpayers to assist the i.r.s. in its enforcement, it recognizes the incentive problem. as a result, for example, whistleblowers who disclose tax evasion by others are entitled to between 15 and 30 percent of the proceeds collected as a result of her information. i.r.c. § 7623(b)(1). 266 florida tax review [vol. 14:6 if congress grants third parties standing to challenge i.r.s. actions, it must circumscribe that standing to prevent such suits from paralyzing the i.r.s. in addition, it must create incentives for third parties to become involved. this section will provide a blueprint for how an effective grant of third-party standing could be designed. 1. third-party challenges to the i.r.s. although congress should be able to create jurisdiction for the tax court to hear these challenges, it should not permit taxpayers to initially raise their claims at the tax court level. instead, it should mandate that any challenge by a third party to an i.r.s. action must first be raised at the i.r.s. level. such a rule would provide symmetry with taxpayers suing on their own behalf: a taxpayer cannot file a suit against the i.r.s. for a refund until the taxpayer has exhausted her administrative remedies. 242 if the i.r.s. finds against the taxpayer, though, she should have the ability to appeal the i.r.s.’s determination to the tax court. if the tax court ruled against the taxpayer, its determination would be final. because congress would authorize these fire-alarm oversight cases without a case or controversy, taxpayers would lack standing to appeal an adverse ruling to an article iii court. 243 requiring administrative review before a taxpayer can go to court slows the process and raises the costs to the taxpayer of challenging i.r.s. practice. by raising the costs, both financially and temporally, the extra layer of review should diminish the number of suits faced by the i.r.s. in addition to this indirect additional expense, though, taxpayers who file these suits should face a refundable upfront cost. 2. impediments to a landslide of litigation taxpayer standing, which provides standing based on the more general harm inflicted on all taxpayers by the i.r.s.’s incorrect action, raises the possibility of a flood of litigation. 244 though history suggests that such a 242. i.r.c. § 7422(a). 243. arizonans for official english v. arizona, 520 u.s. 43, 64 (1997) (“the standing article iii requires must be met by persons seeking appellate review, just as it must be met by persons appearing in courts of first instance.”). if, on the other hand, the i.r.s. lost at the tax court level, it would probably have standing to appeal. see krinsky, how to sue, supra note 232, at 313–14. although this asymmetry may appear unfair, the fact that the taxpayers haven’t suffered a cognizable harm, and that the i.r.s. should have some discretion in how it administers the tax law, helps ameliorate the unfairness. 244. see, e.g., d.c. common cause v. d.c., 858 f.2d 1, 6 (d.c. cir. 1988) (“frothingham’s bar on federal taxpayer standing derived from concerns both about 2013] preventing i.r.s. abuse of the tax system 267 flood would not follow the expansion of taxpayer standing, 245 any such flood would wreak havoc on the i.r.s.’s ability to administer that tax law and collect revenue. to prevent a potential flood of litigation from disrupting the i.r.s., congress must include some roadblocks to taxpayers’ broad ability to challenge the i.r.s. one simple way to limit the quantity of fire-alarm oversight suits is to not publicize the possibility. the internal revenue code is a long and complex law, 246 filled with specialized provisions that do not impact most americans, provisions about which most americans are unaware. 247 though the complexity of the tax law exacts costs on taxpayers, both in the financial and time commitments necessary to comply with the law, 248 here, obscurity could serve a gatekeeping purpose. if only motivated taxpayers with knowledge of the tax law know about the grant of broad taxpayer standing, only such relatively sophisticated taxpayers will file suits. in addition to not publicizing the availability of fire-alarm oversight, congress should raise the cost of filing meritless suits. if a potential litigant knows that filing a suit will potentially cost her money unless her suit is meritorious, she will presumably think twice before filing the suit. taxpayers already must pay a fee to access certain services provided by i.r.s. for example, the i.r.s. charges a fee to taxpayers who request a private letter ruling. in 2013, that fee is $18,000. 249 if a third-party taxpayer’s ability to challenge i.r.s. actions were predicated on first paying an $18,000 the attenuation of the federal taxpayer’s interest in federal expenditures and about the flood of litigation that would otherwise result.”); pub. citizen, inc. v. simon, 539 f.2d 211, 218 (d.c. cir. 1976) (“what was wrought by the flast opinion in opening the door to taxpayer actions, yet opening it only part way was pragmatic in result, avoiding the flood of all manner of taxpayer actions.”). 245. see, e.g., kenneth culp davis, standing: taxpayers and others, 35 u. chi. l. rev. 601, 634 (1968) (“supreme court law from 1899 to 1923 allowed federal taxpayers to challenge federal disbursements, with no resulting flood of litigation . . . .”). 246. in 2000, the code contained approximately 1.4 million words, while the treasury regulations added another 8 million words. michael j. graetz, 100 million unnecessary returns: a fresh start for the u.s. tax system, 112 yale l.j. 261, 273–74 (2002). in addition, in 2000, the i.r.s. published thousands of pieces of administrative guidance. id. at 274. 247. see united states v. second nat’l bank of n. miami, 502 f.2d 535, 549 (5th cir. 1974) (“this case has required us to explore one of the lesser known chambers in a labyrinthine internal revenue code honeycombed with obscure passageways.”). 248. joel slemrod & jon bakija, taxing ourselves: a citizen’s guide to the debate over taxes 160 (4th ed. 2008) (“[the i.r.s.’s administrative costs in enforcing the code are] dwarfed by the costs borne directly by taxpayers, known as compliance costs.”). 249. rev. proc. 2013-1, 2013-1 i.r.b. 1, 68. 268 florida tax review [vol. 14:6 fee, even assuming the fee would be refunded if the taxpayer won, taxpayers would face a serious impediment to suing. only taxpayers with sufficient resources would be able to sue, and they would only do so if they believed their case meritorious. limiting the pool of potential litigants is in line with the goals of this article. there are a number of groups, across the political spectrum, that are interested in the proper administration of the tax law, including tax analysts, 250 americans for tax reform, 251 the tax policy center, 252 and the tax foundation. 253 ideally, groups such as these, with knowledge of and interest in the tax law, should pursue i.r.s. abuse of the tax system in this fire-alarm oversight regime. charging a fee would be a rough method of ensuring that only such highly-motivated organizations became involved. a fee to challenge the i.r.s. is significantly problematic, however. while the government can charge fees, even where the service provided redounds to the benefit of the public at large, those who pay the fees must receive “a special benefit, above and beyond that which accrues to the public at large. . . .” 254 it is not clear what special benefit, over and above an improved tax system, a third-party challenger would receive. rather than imposing a fee, then, perhaps it would make more sense to impose a fine on a taxpayer-challenger who loses the challenge. the code allows the tax court to impose a penalty of up to $25,000 on taxpayers who maintain proceedings primarily for delay, who advance frivolous claims, or who have failed to pursue available administrative remedies. 255 the tax law could similarly provide for penalties where a third-party’s challenge of the i.r.s. was not reasonably likely to succeed. 256 though the risk of penalty provides a less-direct deterrent to frivolous actions than an upfront fee 250. tax analysts “was established to defend the public interest in a policy arena shot through with private influence.” tax analysts, history of tax analysts, http://wwwtaxanalysts.com/www/website.nsf/web/historyoftax analysts?opendocument (last visited may 29, 2013). 251. americans for tax reform lobbies for a “system in which taxes are simpler, flatter, more visible, and lower than they are today.” americans for tax reform, about americans for tax reform, http://www.atr.org/about. 252. the tax policy center “provides timely, accessible analysis and facts about tax policy to policymakers, journalists, citizens, and researchers.” tax policy center, about us, http://www.taxpolicycenter.org/aboutus/index.cfm. 253. the tax foundation is a non-partisan think tank that advocates “for simple, sensible tax policy at the federal, state, and local levels.” tax foundation, about us, http://taxfoundation.org/about-us. 254. ayuda, inc. v. attorney gen., 848 f.2d 1297, 1301 (d.c. cir. 1988). 255. i.r.c. § 6673(a)(1). 256. and, in fact, it would make sense for an additional penalty to apply if the taxpayer loses at the i.r.s. appeals level and then appeals to the tax court, where it loses again. 2013] preventing i.r.s. abuse of the tax system 269 would, the risk of paying a significant penalty should cause potential litigants to think carefully before filing their complaints. and a penalty for frivolous suits seems fairer than a fee to access the adjudicative system. 3. incentives to sue while congress needs to place some impediments in the way of third-party taxpayers suing the i.r.s., ultimately, the purpose behind providing broad taxpayer standing is to permit third-party taxpayers to effectively police the i.r.s. as a result, congress must also include inducements to taxpayer suits. the traditional inducements do not exist in the context of third parties protecting the tax system. taxpayers generally sue the i.r.s. because they believe they have paid more taxes than they owed, and they want the court to order the i.r.s. to refund the excess taxes. third-party litigants, on the other hand, have not overpaid their taxes, and, upon winning, will not receive damages. as a result, such third-party litigants would bear the whole cost of policing the i.r.s. without any benefit other than improving tax administration. to the extent they have the budget, some of the groups mentioned previously 257 may be willing to bear such costs. tax analysts, for example, has pursued freedom of information act requests against the i.r.s. to get access to, among other things, private letter rulings, and against the department of justice to gain access to records of federal district court opinions. 258 still, even though some groups may be willing to act, at their own expense, solely to improve the tax system, these non-party litigants perform a service for taxpayers in general. as a result, if they had to bear to full cost of litigating with the i.r.s., they would be less likely to litigate and, as a result, creating third-party standing would still leave taxpayers with insufficient oversight. to rectify the potential under-enforcement, then, along with thirdparty standing, congress should provide that a successful third-party litigant receives an award of reasonable attorney’s fees. though u.s. litigants generally bear their own costs, victorious or not, 259 hundreds of statutes provide for awarding attorney’s fees to “plaintiffs who successfully sue to 257. see supra notes 250–253 and accompanying text. 258. mark a. segal, tax data disclosure under the freedom of information act: evolution, issues and analysis, 9 akron tax j. 79, 82–83 (1992). 259. mark s. stein, the english rule with client-to-lawyer risk shifting: a speculative appraisal, 71 chi.-kent l. rev. 603, 603 (1995) [hereinafter stein, english rule] (“in america, parties to civil litigation generally bear their own attorney fees.”). 270 florida tax review [vol. 14:6 enforce the statutes.” 260 this type of “[o]ne-way fee shifting can help congress monitor the activities of the executive branch [and] deter continued agency misconduct . . . .” 261 by providing reasonable attorney’s fees for a successful litigant, congress diminishes the cost to that litigant of overseeing the i.r.s. reducing this cost is essential if congress wants this type of oversight to work. from an economic perspective, a plaintiff decides whether or not to sue based on three factors: the amount of money she will receive if successful, the probability of her being successful, and the costs of bringing the suit. 262 to the extent that the amount of money multiplied by the probability of success exceed her costs, bringing the suit has an expected value. but because the third-party litigants who will bring these suits have not suffered any direct loss, they have no expected return, even with a 100 percent certainty of winning; they will, on the other hand, face costs associated with appealing to the i.r.s. and to the tax court. as a result, from an economic perspective, brining such a suit makes no sense. the various tax think tanks and watchdog groups mentioned above may still have some non-economic interest in the proper administration of the tax law. even if they do, though, they face real litigation costs, which may discourage them from providing the optimal amount of fire-alarm oversight. if, however, they can recoup their costs in a successful suit, their expected loss grows closer to zero, providing more incentive to act. providing this type of fee-shifting should generally encourage watchdog groups to litigate in cases where they believe they will win, while the proposed penalty for frivolous suits should discourage litigation where they have less faith in their chances. 263 an unsuccessful plaintiff would not, of course, receive an award of attorney’s fees. and this would mitigate another potential problem with firealarm enforcement: its impingement on the i.r.s.’s administrative discretion. the i.r.s. has finite resources, and needs discretion in determining which tax laws to vigorously enforce; courts generally will not “quarrel with an agency’s rational allocation of its administrative resources.” 264 260. bruce l. hay, fee awards and optimal deterrence, 71 chi-kent l. rev. 505, 505 (1995). 261. harold j. krent, explaining one-way fee shifting, 79 va. l. rev. 2039, 2045–46 (1993) [hereinafter krent, explaining]. 262. henry n. butler & jason s. johnston, reforming state consumer protection liability: an economic approach, 2010 colum. bus. l. rev. 1, 94 (2010). 263. stein, english rule, supra note 259, at 604 (“the english rule, more than the american rule, tends to encourage a risk-neutral party to pursue litigation about which it is optimistic and tends to discourage such a party from pursuing litigation about which it is pessimistic.”). 264. haverly v. united states, 513 f.2d 224, 227 (7th cir. 1975). 2013] preventing i.r.s. abuse of the tax system 271 but allowing third parties to challenge the manner in which the i.r.s. enforces or refuses to enforce the tax law does not necessarily impinge on this important discretion. in the first instance, if challenged, the i.r.s. can explain why it chose to act as it did. the i.r.s. appeals office or the tax court can determine that it made an acceptable choice. moreover, the economics of such a third-party suit discourage all but the most meritorious challenges. if the plaintiff to a fire-alarm oversight case loses — even if her challenge was not frivolous — she does not receive an award of attorney’s fees. as such, her challenge has cost her money. without attorney’s fees, her expected recovery is negative. as a result, she should be unwilling to bring a borderline case, and the i.r.s. should generally have the ability to maintain its administrative discretion. of course, providing for attorney’s fees to a successful fire-alarm oversight plaintiff has its own problems. awarding attorney’s fees would, at the margins, provide the i.r.s. with incentive to decide meritorious cases against plaintiffs (because the initial challenge must be brought to the i.r.s. itself) and to appeal deserved losses to the tax court. the incentive for making wrong decisions arises because, if the plaintiff loses, the i.r.s. does not pay attorney’s fees. on the margins, then, an award of attorney’s fees encourages i.r.s. intransigence, increasing the amount of litigation. 265 and awarding attorney’s fees distorts more than just the i.r.s.’s decisions. knowing the i.r.s. will pay a party’s fees increases litigation costs, often in socially-unproductive ways. 266 attorneys who reasonably expect to win will get paid more if they do more work, and their clients, who will not bear the expense of the additional fees, have no incentive to control their attorneys’ costs. and because the award of attorney’s fees changes the plaintiff’s expected gain and the government’s expected loss, it reduces the incentive for either party to settle. 267 the i.r.s.’s incentive to incorrectly find against the plaintiff and to unnecessarily and unwisely appeal may be overstated. as a government agency, the i.r.s. does not fully internalize the cost of paying attorney’s fees. 268 moreover, to the extent the i.r.s. does internalize the cost, either financially or in terms of loss of pride or prestige, its evaluation of the cost of further litigation should still prevent it from unnecessarily extending litigation. further appeals mean the plaintiff will incur additional costs, costs that the tax court will award to the plaintiff if successful. thus, if the 265. krent, explaining, supra note 261, at 2081. 266. id. at 2081. 267. id. at 2080. 268. id. at 2075. for the same reason, providing a victorious litigant with an award of attorney’s fees should not lead to overdeterrence. id. 272 florida tax review [vol. 14:6 plaintiff has a decent shot of winning on appeal, the i.r.s. should factor those future costs into its analysis of whether to proceed or not. 269 to combat the incentives the watchdog groups’ attorneys face to pad their hours, judges need some discretion in how they calculate attorney’s fees. and generally, in federal cases, judges have that discretion. broadly speaking, federal courts calculate attorney’s fees using the lodestar method, in which the attorney receives an amount determined by multiplying a reasonable number of hours by a reasonable billing hourly billing rate. 270 to the extent that the judge finds the number of hours or the billing rate unreasonable, she can adjust those in the calculation. providing for judicial discretion reduces certainty and increases the judge’s workload, but seems unavoidable. different cases will require different expertise and different amounts of work; setting a bright-line cap on the billing rate or the number of hours that will be allowed in calculating attorney’s fees would discourage watchdog groups from pursuing complex i.r.s. misconduct, and would lead to underenforcement. moreover, if attorneys know in advance that their fee award may be reduced, they will have incentives to do necessary work, but not to pad the amount that they bill. provided the law takes into account the distortions in the parties’ incentives, though, awarding attorney’s fees to victorious plaintiffs will provide some incentive for watchdog groups to police the i.r.s. attorney’s fees permit the fire-alarm oversight to function, constraining the i.r.s.’s actions without overburdening it. vi. conclusion in general, the i.r.s. does an effective job administering the tax system. it manages to process tax returns and refunds, find and prevent fraud, and otherwise make the tax system function, and does so with relatively few major problems. 271 moreover, it manages to provide the high level of 269. if these general considerations prove insufficient for deterring i.r.s. intransigence, congress could increase the amount of attorney’s fees by a multiplier in cases where, for example, the tax court found the i.r.s. appeals office’s decision insupportable, or found the i.r.s.’s appeal frivolous. 270. see matthew d. klaiber, a uniform fee-setting system for calculating court-awarded attorneys’ fees: combining ex ante rates with a multifactor lodestar method and a performance-based mathematical model, 66 md. l. rev. 228, 236 (2006). 271. see generally treasury inspector general for tax administration: the majority of individual tax returns were processed timely, but not all tax credits were processed correctly during the 2012 filing season (sep. 26, 2012), http://www.treasury.cov/tigta/ auditreports/2012reports/201240119fr.pdf. 2013] preventing i.r.s. abuse of the tax system 273 customer service that congress intended in enacting the various taxpayer bills of rights. 272 in spite of its effectiveness at guarding against taxpayers’ abuse of the tax system and its ability to treat taxpayers well, though, the i.r.s. has the unique ability to abuse the tax system itself. and, in many circumstances, it faces almost no constraints on its ability to do so. sometimes it violates long-standing tax principles to confer a benefit on specific taxpayers, and nobody has standing to challenge the benefit. at other times, it can apply the tax law incorrectly in a manner that hurts taxpayers, but where the benefit to the individual taxpayers does not justify the expense of challenging its interpretation. either way, no current method exists of preventing the i.r.s. from abusing the tax system. no currently constituted oversight board exists with this charge, and no distinct constituency exists to hold the i.r.s.’s feet to the fire. to protect the u.s. tax system, then, congress needs to provide for such oversight. although it could use its current fallback method, delegating authority to an oversight board, oversight boards have finite capability, especially where congress seems unwilling to increase i.r.s. budgets. better, then, would be to provide a system that permits — and even encourages — third parties interested in the efficient administration of the tax law to challenge the i.r.s. when it attempts to abuse the tax system. allowing this type of fire-alarm oversight broadens the scope of oversight while reducing its costs. fire-alarm oversight has proven an effective regulatory tool. interested taxpayers and taxpayer watchdogs will have the ability to act for the tax law itself, ensuring that the i.r.s. acts as an agent of congress and, thus, ensure the continued integrity of the u.s. tax system. 272. id. at 9–11. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 3 1997 number 8 towards equal tax treatment of economically equivalent financial instruments: proposals for taxing prepaid forward contracts, equity swaps, and certain contingent debt instruments david f. levy' i. introduction ........................ ........ 474 h". background on derivatives .................... 476 a. capital assets in general ......................... 477 1. income generated by the asset: timing, character, and source ...................... 477 2. sale: timing, character, and source ............ 477 b. forward contracts .............................. 478 1. introduction ............................. 478 2. pricing of forward contracts ................. 481 3. taxation of forward contracts ................ 483 a. timing and character ................ 483 b. source ........................... 484 c. options ...................................... 485 1. rights and obligations ..................... 485 2. timing and character of income from options .... 488 3. source of income from options ............... 490 m. contingent debt instruments and equity swaps ... 490 a. contingent debt instruments ....................... 491 1. noncontingent debt instruments generally ........ 491 2. background on cdis ....................... 492 3. taxation of cdis ......................... 495 * associate, o'melveny & myers, washington, dc. the author wishes to thank hal gann, michael schultz, and sang ji for their thoughts and suggestions. the author also wishes to thank his wife, doreen, for her endless patience with this weekend-eating project. all of the mistakes in this article are those of the author. florida tax review a. background ........................ 495 b. the cdi regulations ................. 496 c. problems with the cdi regulations ....... 499 i. treating similarly situated taxpayers differently ........... 499 ii. the big questions go unanswered.. 499 b. notional principal contracts ....................... 502 1. introduction ............................. 502 2. taxation of npc income .................... 506 a. timing ........................... 506 b. character ........................ 507 c. source ........................... 508 iv. economic equivalencies ....................... 509 a. ownership, forwards, gold notes, and equity swaps ...... 510 b. put-call parity ................................. 511 c. economic equivalencies and tax discrepancies .......... 512 v. recommendations ............................ 514 a. recommendations for prepaid forward contracts ........ 516 1. nature of the problem ...................... 516 2. accounting for interest: fully prepaid forward contracts ........................ 517 3. computing gain or loss .................... 519 a. basis computation ................... 519 b. gain or loss on sale prior to forward date ...................... 519 c. gain or loss on cash-settlement or subsequent sale of the underlying property .......................... 519 4. what about partially prepaid forward contracts? ....................... 521 a. the time value issue ................. 521 b. anti-abuse ........................ 521 b. recommendations for gold notes .................... 521 1. gold notes with fully contingent principal and interest ............................. 522 2. gold notes with fully contingent principal and noncontingent interest ................... 523 3. gold notes with partially contingent principal .... 524 a. introduction ........................ 524 b. the modified bifurcation approach ....... 526 [vol 3:8 1997] economically equivalent financial insitnients 473 i. introduction .................. 526 ii. application of the modified bifurcation approach ........... 527 iii. critique of the modified bifurcation approach ........... 529 4. effect of the straddle rules .................. 530 a. background ........................ 530 b. fully contingent gold note ............ 531 c. gold notes with ncp ................. 532 c. recommendations for equity swaps .................. 533 1. recommendations ......................... 533 a. introduction ........................ 533 b. character ......................... 533 c. source ........................... 534 2. effect of the straddle rules .................. 535 d. second best problems ............................ 535 1. economic equivalencies between a long forward contract and ownership .............. 535 2. and what about prepaid rent and services? ...... 541 vi. conclusion .................................... 542 florida tax review i. introduction in recent years, many commentators have debated the merits of various proposals regarding the taxation of financial derivatives.' the internal revenue service (the "service") has, in the case of certain derivatives, attempted to settle that debate by issuing regulations that address the taxation of notional principal contracts and contingent debt instruments.2 the debate, however, continues, mainly because many financial instruments are economically equivalent to one another and yet give rise to different tax results.3 rather than proposing changes in the tax treatment of specific instruments, commentators now call for the complete overhaul of all of the rules governing the taxation of all financial instruments. while many of those proposals certainly have merit, it seems as though the congress is not likely to completely overhaul the internal revenue code (the "code") any time soon. a good deal of the debate concerning the taxation of financial derivatives has centered on the corporations that issue these derivatives (the "issuers").4 in the author's opinion, many of the problems and abuses cited by those commentators should be solved not by focusing on the issuer, but by focusing on the investor who purchases these derivatives. that conclusion stems from the following four facts: first, issuers develop complex financial instruments such as contingent debt instruments in order to accommodate the demands of investors.5 second, issuers of complex financial instruments often enter into hedging transactions that leave them in the same position in which they would have been, with respect to both economic result and tax treatment, had they issued traditional fixed or floating rate debt instruments. third, investors will be taxed differently depending on the type of derivative that they purchase. fourth, so long as issuers can save money by issuing 1. the term "derivative" encompasses financial instruments whose value varies in accordance with the movement in value of some other asset or index. kpmg, solving the mystery of derivatives 1 (1994). for example, an option on x co. stock is a derivative, because the value of the option will vary in accordance with the value of x co. stock, which is the underlying property. see id. at 6. see generally roberta romano, a thumbnail sketch of derivative securities and their regulation, 55 md. l. rev. 1 (1996) (discussing and analyzing various derivative instruments). 2. see infra notes 203-207 and accompanying text. hereafter, the term "service" will include the treasury department. 3. see infra parts il-iv. 4. e.g., edward d. kleinbard, beyond good and evil debt (and debt hedges): a cost of capital allowance system, 67 taxes 943 (1989) (proposing overhaul of rules pertaining to issuers of contingent debt instruments); lee a. sheppard, adding pep to the constructive sale debate, 70 tax notes 1592 (mar. 18, 1996) [hereinafter sheppard, adding pep]; lee a. sheppard, things that go bump in the portfolio, news analysis, 60 tax notes 1423 (sept. 13, 1993) [hereinafter sheppard, things that go bump]. 5. see infra notes 69-71 and accompanying text. [vol 3:8 economically equivalent financial instnuments financial derivatives such as contingent debt instruments, they will continue to do so. thus, issuers usually design derivatives to save money by accommodating a particular investor profile. in light of that fact, the government should focus its reform efforts on investors. a good deal of the above mentioned debate revolves around the appropriate classification and taxation of three derivatives: prepaid forward contracts; certain contingent debt instruments ("cdis"); and equity swaps, which are one type of notional principal contract. a prepaid forward contract is an executory contract that (1) entitles the purchaser to delivery of the underlying property on a particular date in the future, and (2) requires the purchaser to pay for the underlying property at the time the contract is executed.6 a contingent debt instrument, in the most basic terms, is a promissory note, the repayment of the principal and/or interest on which is contingent upon the value of the underlying property. an equity swap is, in the most basic terms, a bilateral contract that provides for periodic payments which replicate the financial returns generated by an ownership interest in the underlying property each of the above three instruments possess the same economic characteristics. the first two instruments expose the investor to identical credit risks (assuming they are purchased from the same counterparty), while the credit risk attendant to equity swaps is reduced each of those instruments is, however, taxed differently."0 the character, timing, and source rules applicable to forward contracts have been established. for the most part, the tax rules applicable to cash-settled forward contracts have also been established. prepaid forward contracts, as discussed below, are but one type of forward contract. as discussed below, however, there does not currently exist a coherent set of rules governing the taxation of cash settled, prepaid forward contracts which have a capital asset as the underlying property. instead, a patchwork system of rules applicable to each derivative fitting that description has evolved. this patchwork system simply creates as many discontinuities as it resolves. perhaps that is why so many commentators now call for the complete overhaul of the tax rules applicable to financial derivatives. until that overhaul occurs, however, we need to develop an interim system that synchronizes, to the maximum extent possible, the tax treatment of economically equivalent derivatives. as a necessary first step in developing that 6. see infra notes 25-28 and accompanying text. 7. regs. § 1.1275-4(a)(1). 8. see infra notes 96-100 and accompanying text. 9. the use of periodic payments to reduce credit risk by parties to an equity swap is discussed below in note 102. 10. see infra parts h-iv. 19971 florida tax review interim system, we need to construct a coherent set of rules governing the taxation of prepaid forward contracts, particularly those prepaid forward contracts that are settled in cash. once we do that, we need to classify as prepaid forward contracts all financial derivatives that are economically equivalent to prepaid forward contracts and which have a capital asset as the underlying property. finally, this interim solution must: (1) contain practical rules, (2) produce sound results from the standpoint of tax policy, (3) work within the debt/equity and capital/ordinary distinctions, and (4) not require the service to withdraw or rewrite existing regulations. although an interim solution is by definition imperfect, we need to cure as many tax discontinuities as possible while keeping in mind that a complete overhaul of the code is, for the time being, not an option. this article is thus intended to: (1) develop a set of rules governing the taxation of prepaid forward contracts, with particular emphasis on prepaid forward contracts that are settled in cash; and (2) develop a set of rules that accords identical tax treatment to those forward contracts and derivatives, such as equity swaps and certain cdis, that are economically equivalent to prepaid forward contracts. this article is divided into five parts. part ii will provide the reader with a brief overview and critique of the tax treatment of capital assets, option contracts, and forward contracts. part iii will: (1) explore the past and present tax treatment of cdis; and (2) analyze the tax treatment of notional principal contracts, which is the class of derivatives into which equity swaps fall. part iv will analyze the equivalencies in economic characteristics and the discrepancies in tax treatment among the financial instruments discussed in parts ii and iii. part v will: (1) offer recommendations as to the proper tax treatment of prepaid forward contracts, certain cdis, and equity swaps; (2) analyze the effects of these recommendations; and (3) address their shortcomings. ii. background on derivatives this section serves two purposes. first, this section provides the reader with background information on the legal rights and economic characteristics of the two "basic" derivatives that are relevant to the instant discussion-forward contracts and options. second, this section analyzes the tax treatment of these two types of derivatives. as will be discussed below, the derivatives upon which this article focuses produce economic returns that are identical to the economic returns generated by ownership interests in capital assets. thus, one must, in order to analyze the tax treatment of those derivatives, review the economic rights and tax treatment generated by ownership interests in capital assets. [vol 3:8 economically equivalent financial instruments a. capital assets in general 1. income generated by the asset: timing, character, and source.-the owner of a capital asset recognizes ordinary income on the receipt of money, such as rent or dividends, generated by that asset." the source of dividend income is generally determined by reference to the nationality of the payor corporation. 2 the source of rental income is generally determined by reference to the location of the property that generated the rental income. 3 section 871(a) imposes a withholding tax of 30% on u.s. source dividend and rental income received by nonresident alien individuals. 2. sale: timing, character, and source.-when a taxpayer sells or exchanges a capital asset, she realizes and, subject to exceptions not relevant here, 5 recognizes capital gain or loss in an amount equal to the difference between the amount realized on the sale or exchange and the adjusted basis of that capital asset. 6 as a general matter, the gain or loss on the sale or exchange of personal property will be sourced to the taxpayer's country of residence. 7 if, however, a nonresident alien individual sells an "interest in real property" located in the united states, then the gain or loss on that sale will be sourced in the united states. 8 if that sale of real property produces a gain, that gain will be subject to u.s. withholding tax under sections 871 and 1441.19 in certain instances, items of loss from the sale of a capital asset may be deferred under the rules contained in section 1092.2' 11. irc § 61(a)(7). dividends do not qualify for capital gains treatment because § 1222 states that, in order to obtain capital gain treatment, a taxpayer must sell or exchange a capital asset. 12. see irc § 861(a)(2). for example, dividends paid by a u.s. corporation are generally u.s. source income. 13. irc § 861(a)(4). 14. irc §§ 871(a)(1)(a); 1441. 15. e.g., irc §§ 351, 721, 1031. 16. irc §§ 1001, 1221, 1222. the gain or loss will be characterized as long term capital if the taxpayer held that asset for more than one year. irc § 1222(3). (4). if the taxpayer held the asset for less than one year, then the gain or loss will be characterized as short term capital. irc § 1222(1), (2). 17. irc § 865(a). 18. irc § 897(a)(1)(a). the term "interest in real property" includes fee ownership of land, options to acquire land, and "any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property." regs. § 1.897-1(c)(1), (d)(2)(i). 19. irc § 871(a). 20. see infra notes 180-186 and accompanying text. 1997] florida tax review b. forward contracts 1. introduction.-a forward contract is a privately-negotiated, unregulated executory contract that entitles the purchaser to delivery of an asset at some time in the future.2' a forward contract contains a fixed price term (the "forward price") and a fixed delivery date (the "forward date"). 22 some taxpayers enter into forward contracts in order to eliminate the risk of movement in the price of an asset that the taxpayer will have to purchase or sell at some point in the future. 21. see clifford w. smith, jr., et al., managing financial risk 45 (1990). forward contracts are identical in form to futures contracts. futures contracts, like forward contracts, obligate a purchaser to purchase a specified asset, and a seller to sell a specified asset, at a particular price on a particular date in the future. id. at 46. there are, however, for purposes of this article, two material differences between forward contracts and futures contracts. first, the purchaser of a futures contract is subject to less credit risk than the purchaser of a forward contract. that is because, as a futures contract increases in value, that increase is conveyed to that purchaser on the same day on which the increase occurs. id. that is, futures contracts are "marked-to-market daily." id. that increase in value is conveyed to the purchaser through the use of a margin account. id. at 47. a margin account consists of deposits (usually of cash) that both parties to a futures contract must make in order to participate in the futures market. perry j. kaufman, handbook of futures markets: commodity, financial, stock index, and options, 2-10 (1984). as a purchaser's contract increases in value, the futures exchange will add that increase to the purchaser's margin account. likewise, if a purchaser's contract decreases in value on a particular day, the futures exchange will subtract an amount of money equal to that decrease from the purchaser's account and then add that same amount of money to the margin account of the purchaser's counterparty. smith et al., supra, at 47. thus, a futures contract is actually a series of cash-settled forward contracts. that is, in a futures contract, the parties, in essence, enter into a forward contract on day 1, settle that contract on day 2, enter into a new contract on day 3 that has the same price and delivery terms as the contract executed on day 1, and then repeat those steps over and over until the delivery date arrives. see smith et al., supra, at 47. as will be discussed below, futures contracts are practically identical in form and substance to commodity swaps. see infra notes 103-106 and accompanying text. the other difference between forward contracts and futures contracts is that futures contracts are subject to § 1256. congress enacted § 1256 in part because it viewed the markto-market system employed by the futures market as giving rise to constructive receipt of income on a daily basis. see s. rep. no. 144, 97th cong., 1st sess. 156 (1981), reprinted in 1981 u.s.c.c.a.n. 105, 255. congress felt that the reporting of that income should not be deferred in light of the fact that the purchaser of a futures contract can withdraw increases to her margin account to the extent that her margin account balance exceeds a certain minimum established by the futures exchange. see id. the constitutionality of § 1256 was sustained in murphy v. united states, 992 f.2d 929 (9th cir. 1993), on the ground that a purchaser of a futures contract, by virtue of the margin account system, constructively receives income on the futures contract during each taxable year. 22. see smith et al., supra note 21, at 45. [vol 3:8 economically equivalent financial insrtments example. part 1: jack is a wheat farmer. he plans to harvest and sell 1,000 bushels of wheat in 9 months. jack is concerned that the sale price of wheat may go down in the next 9 months. in order to insulate himself from a decline in the sale price of wheat, jack agrees to sell his entire wheat harvest to jill for $10 a bushel, with delivery in 9 months. jack has insulated himself from any movement in the sale price of wheat because, regardless of any increase or decrease in the price of wheat, jack has the right to sell his wheat for $10 a bushel. part 2: jill owns a bread company which purchases 1,000 bushels of wheat each year. jill knows that she will need to purchase wheat in 9 months and believes that the price of wheat will increase in the next 9 months. therefore, in order to lock in the purchase price of wheat, jill agrees to purchase all of jack's wheat for $10 a bushel. jill has insulated herself from any movement in the purchase price of wheat because, regardless of any changes in the price of wheat, she has the right to purchase wheat at a price of $10 a bushel. in the above example, jack will benefit economically from a downward movement in the price of wheat. for example, if the price of wheat declines to $5 a bushel, jack will be able, nonetheless, to sell that wheat at a price of $10 a bushel. jack will suffer an economic loss if the price of wheat increases beyond $10 a bushel. in that case, jack will be forced to sell wheat at a price below its fair market value. jill will benefit economically from an increase in the price of wheat. for example, if the price of wheat increases to $20 a bushel, jill will be able to purchase wheat for $10 a bushel. jill will suffer an economic loss if the price of wheat decreases below $10 a bushel. in that case, jill will have to purchase wheat at a price in excess of its fair market value. in tax parlance, jack's position is known as a "short forward contract," which is economically equivalent to selling the underlying property-' jill's position is known as a "long forward contract," which is economically equivalent to owning the underlying property.24 unlike jack and jill, who entered into a forward contract to guard against price fluctuations in a business asset, some taxpayers enter into forward contracts to speculate about the movement in the value of a particular asset. example. john, who is a law professor, is married to jane, who is a professional meteorologist. jane believes that there will be a devastating drought in the midwest united states in the next 18 months. 23. see smith et al., supra note 21, at 45. 24. see smith et al., supra note 21, at 45. 1997] florida tax review john accordingly believes that the price of wheat will skyrocket once the drought destroys most wheat crops. the forward price of a two year forward contract on wheat is currently $15 a bushel. john believes that that price could easily increase to $50 a bushel should the drought be as severe as jane predicts. therefore, john enters into a forward contract to purchase 10,000 bushels of wheat in two years at a price of $10 a bushel. parties can enter into a forward contract using any asset as the underlying property. for example, if a real estate developer believes that the government is going to build a major road in a certain area in the next five years, she can enter into five-year forward contracts to purchase commercial real estate in that area. one must remember that the parties to a forward contract can settle their obligations under the forward contract in cash. for example, if jack and jill decided to settle their forward contract in cash: (1) jill would pay jack $10,000 on the forward date (1,000 bushels of wheat x $10 a bushel); and (2) jack would simultaneously pay jill an amount of money equal to the product of the prevailing spot (current) price of a bushel of wheat and 1,000 (the number of bushels he agreed to sell). in practice, jack and jill would net their payments, and the party that stands to lose economically would make a payment to the counterparty equal to the difference between the spot price of the underlying property and the forward price of the contract. example. on the forward date of the forward contract between jack and jill, wheat is trading at a price of $20 a bushel. the forward price of that contract was $10 a bushel, and the contract called for the delivery of 1,000 bushels of wheat. in order to settle the contract in cash, jill must pay jack $10,000 ($10 forward price x 1,000 bushels) and jack must pay jill $20,000 ($20 spot price x 1,000 bushels). rather than exchange checks, jack pays jill $10,000. that amount represents jack's economic loss on the transaction and jill's economic gain on the transaction. one must also remember that the parties to a forward contract can agree in advance to settle their obligations in cash (a "cash-settled forward contract"). for example, john (our law professor) would most likely enter into a cash-settled forward contract, because a law professor would probably be unwilling to take delivery of 10,000 bushels of wheat. that analysis indicates that, at the inception of a cash-settled forward contract, neither party to that contract needs to own the underlying property or have any intention of ever acquiring it. hence, taxpayers can use cash-settled forward contracts as bets. that is, instead of betting on the outcome of the next major sporting event, taxpayers can bet on the future values of various assets. [vol 3:8 economically equivalent financial lnstniments 2. pricing of forward contracts.-the forward price is generally determined under a "cash and carry" model. the parties add to the current spot price of the underlying property: (1) the costs that the seller will incur in holding the underlying property until the date of delivery (i.e., insurance, storage, and interest), and (2) any anticipated movement in the spot price of the underlying property. the purchaser of a forward contract typically has the right to extinguish her obligation to pay the forward price on the forward date by making a lump sum payment of a lesser amount of money on the date the forward contract is executed. that arrangement will be referred to in this article as a "prepaid forward contract." ignoring foregone interest on alternative investments, the purchaser of a prepaid forward contract will pay less money out-of-pocket than the pur25. the underlying assumption of the cash and carry pricing model is that, if an investor wishes to purchase the underlying property at some time in the future, she has two choices. first, she can purchase that property at today's spot price and then store it until that time in the future. second, she can wait until that time arrives and purchase the underlying for the then-prevailing spot price of the underlying. the first alternative requires that investor to incur the costs of storing and insuring the underlying property. the second alternative subjects the investor to changes in the spot price of the underlying property. the interest component of the price term indicates that, in a sense, the purchaser of a forward contract receives valuable property (viz., a forward contract) for which she did not pay money. that is, that purchaser received that contract on credit from the seller of the contract, and must accordingly pay interest on that loan. see gregory may, flying on instruments: synthetic investments and withholding tax avoidance, 73 tax notes 1225, 1226 (dec. 9, 1996) ("the buyer under a forward contract has the right to receive property and the obligation to pay the purchase price. betwecn the contract date and the forward date, the buyer has the use of his money, and the seller receives [income] ... from the property. the forward price reflects those facts. in theory, it should be the current fair market value of the property plus interest on the implicit loan that the seller extends to the buyer and minus the [income from the property] ... that the buyer concedes to the seller.") (emphasis added). the existence of the implicit loan is confirmed by the fact that the purchaser of a forward contract receives a basis in that contract. section 1012 provides that the basis of property is its cost. the cost of property includes funds expended for the purchase of property, regardless of the source of these funds, even funds borrowed from the seller of the property by way of a purchase on credit. see, e.g., mayerson v. commissioner, 47 t.c. 340, 349 (1966) ("lt is well accepted that a purchase-money debt obligation for part of the price will be included in basis. this is necessary in order to equate a purchase-money mortgage situation with the situation in which the buyer borrows the full amount of the purchase price from a third party and pays the seller in cash."). a purchaser of a nonprepaid forward contract does not advance money in exchange for the contract. thus, if one is to treat that purchaser as having anything other than a zerobasis in that contract, one must also acknowledge the existence of a loan from the seller of the contract to that purchaser. another way to think about the interest component is to view the seller of the forward contract as having incurred interest expense in order to hold the underlying property until the forward date. 19971 florida tax review chaser of a nonprepaid forward contract. for example, if the forward price in a two-year forward contract on a barrel of oil is $20, a purchaser may be able to purchase that contract with an immediate payment of $18. that is, the purchaser can either (1) pay $18 today and receive one barrel of oil in two years, or (2) pay $20 two years from now and then receive one barrel of oil. put in these terms, a prepaid forward contract looks very much like a loan from the purchaser to the seller accompanied by a nonprepaid forward contract between the purchaser and the seller.26 that is because the purchaser of the prepaid forward contract in the above example incurs an obligation to make a $20 payment on the forward date and makes preparations to satisfy that obligation by depositing a lesser sum of money with the seller. that conclusion is supported by the fact that the forward price is determined by reference to the spot price and carrying costs of the underlying property, neither of which decrease as the result of a prepayment. thus, any "discount" that the purchaser receives by virtue of the prepayment must necessarily represent interest received by the purchaser in exchange for letting the seller use her money between the date of the prepayment and the forward date.27 put differently, the purchaser decided that she could make more money ($2 after tax in the above example) by lending her cash to the seller than she could make through other investments.2 under a cash-settled forward contract, the purchaser of the contract is only entitled to receive a payment on the forward date equal to the spot price of the underlying property. thus, in a cash-settled, prepaid forward contract, the purchaser makes a payment today and receives the right to a payment on the forward date equal to the prevailing spot price of the underlying property. a cash-settled, prepaid forward contract, therefore, looks like a loan from the "purchaser" to the "seller," the repayment of which is 26. see david a. weisbach, tax responses to financial contract innovation, 50 tax l. rev. 491, 498 (1995). the existence of a loan becomes readily apparent when one realizes that the seller, by receiving the prepayment from the buyer, has eliminated the credit risk of the buyer. that is, the seller need not worry that the buyer will not perform on the forward date. 27. interest is defined as payment received in return for the use of borrowed money. see deputy v. dupont, 308 u.s. 488,497 (1940); old colony r.r. v. commissioner, 284 u.s. 552, 560 (1932). 28. for example, assume that x wishes to enter into a one-year forward contract calling for delivery of one barrel of oil. y informs x that the price term of that contract is $20. x currently has $18 in her possession. if x enters into that forward contract today, she will have to figure out a way to turn that $18 into $20 in one year. if x determines that she may not be able to earn over 10% after tax through the other investments available to her, she can simply lend the $18 to y in exchange for $2 of interest. when y "repays" the $18 of principal and $2 of interest to x, x will simultaneously transfer that $20 to y in satisfaction of her obligations under the forward contract. [vol 3:8 economically equivalent financial instruments wholly contingent upon the spot price of the underlying property on the forward date. as will be discussed below, there exists a whole class of cdis that are practically identical to cash-settled, prepaid forward contracts in both form and economic substance. 3. taxation of forward contracts a. timing and character.-the tax treatment of forward contracts varies in accordance with two factors: (1) the method by which the parties terminate their rights or obligations under the forward contract, and (2) the nature of the underlying property in the hands of the taxpayer in question. under current law, the tax treatment of a prepaid forward contract does not vary from the tax treatment of a nonprepaid forward contract.y9 that is, the tax system does not take account of the fact that a portion of the money (or, if the purchaser takes delivery of the underlying property, a portion of the value of that property) received by the purchaser of a prepaid forward contract is, in substance, interest.30 there are four ways for a taxpayer to terminate her rights or obligations under a forward contract, only two of which are relevant here: (1) the purchaser can take delivery of the underlying property,31 (2) the parties can enter into offsetting contracts,32 (3) the parties can sell or assign their rights in the forward contract, and (4) the parties can settle the contract in cash (i.e., the losing party can make a termination payment to her counterparty). 29. see weisbach, supra note 26, at 498. 30. some government officials believe that the time value component of prepaid forwards is already taxable as interest, but other government officials disagree. juliann avakian martin, irs attempting to identify time-value-of-money in hybrids, 66 tax notes 1767 (mar. 20, 1995) ("[tihere is no consensus among government officials [regarding the treatment of the time value component of prepaid forward contracts] .... some believe that, even without regulations, a prepaid forward contract is, in part, debt that should generate interest income and deductions. others believe that regulations are needed allowing this treatment."). 31. if the seller delivers the underlying property to the purchaser. then the seller recognizes gain or loss under § 1001 at the time she delivers that property. the character of the gain or loss will depend on the nature of the underlying property in the hands of the seller. irc § 1222. the purchaser in a forward contract takes a basis in the underlying property equal to the purchase price of that property. irc § 1012. 32. if the parties enter into offsetting contracts, then the parties are treated as having consummated back-to-back sales of the same asset. they will recognize gain or loss accordingly under § 1001. example. x and a enter into a forward contract that obligates x to purchase one barrel of oil on july 1, 1998, for $20. the price of oil on july 1. 1998, turns out to be $10. on that date, x and a enter into an offsetting contract under which x agrees to sell one barrel of oil to a for $10. thus, x purchased a barrel of oil from a for $20, and then immediately sold that barrel of oil to a for $10. thus, x recognizes a $10 loss, and a recognizes a $10 gain. 1997] florida tax review if one party sells or assigns her rights under the forward contract, she will recognize gain or loss at the time of the sale or assignment of the contract.3" the character of that gain or loss will turn on the nature of the contract in the hands of the particular taxpayer. 4 the character of the gain or loss recognized upon the cash settlement of a forward contract will be capital if the underlying property would qualify as a capital asset in the hands of the taxpayer in question.35 in certain instances, items of loss from forward contracts may be deferred under section 1092.36 b. source.-forward contracts are personal property in the hands of most investors.37 the source of income from the sale of personal property is determined by reference to the residence of the owner of that property.38 thus, a foreign investor who sells a forward contract,39 or otherwise terminates her rights or obligations thereunder,n" will normally 412recognize foreign source income' on which she will not pay u.s. tax.42 the exception to that rule applies to long forward contracts pertaining to u.s. real property; those forward contracts generate u.s. source income.43 33. irc § 1001. the question of whether the counterparty of the person who assigned the contract will recognize gain or loss under cottage savings, inc. v. commissioner, 499 u.s. 554 (1991), is beyond the scope of this article. 34. irc § 1222. 35. irc § 1234a. as this article was about to go to press, the president signed into law the taxpayer relief act of 1997, contained in h.r. 2014, which, among other things, contained an amendment to irc § 1234a. that amendment eliminated the reference to § 1092(d) and made § 1234a applicable to all property. taxpayer relief act of 1997, h.r. 2014 § 1003(a)(1), reprinted in 46 highlights & documents, 1519, 1577 (august 6, 1997) ("paragraph (1) of section 1234a (relating to gains and losses from certain terminations) is amended by striking 'personal property (as defined in section 1092(d)(1))' and inserting 'property.' "). that amendment will apply to all terminations occurring more than 30 days after august 5, 1997. after that date, the character of the gain or loss attributable to the cancellation, lapse, or other termination of a forward contract on any capital asset will be capital, regardless of whether that asset qualifies as actively traded personal property. 36. the straddle rules contained in § 1092 are discussed below in notes 180-186 and accompanying text. 37. see irc § 1221. 38. irc § 865(a). the service has not exercised its authority under § 865(j)(2) to issue regulations governing the source of income from forward contracts. 39. see irc § 1001. 40. section 1234a supplies the missing sale or exchange in the case of certain options. see supra text accompanying note 35. 41. irc § 865(a)(2). 42. irc § 871(a)(1) (imposing tax on u.s. source income). 43. irc § 897(a)(1), (c)(6)(a); regs. § 1.897-1(d)(2)(ii)(b) ("an option, a contract, or a right of first refusal to acquire any interest in real property ... will itself constitute an interest in real property other than solely as a creditor."). [vol 3:8 economically equivalent financial insmtnnents c. options 1. rights and obligations.-an option evidences the right, but not the obligation, to purchase or sell an asset at a specified price (the "strike price"). for every option, there exists (1) a person who has the right (but not the obligation) to require another person to purchase or sell an asset, and (2) a person who is obliged to either purchase or sell an asset upon the request of her counterparty. the person who has the right to purchase an asset from her counterparty, or force her counterparty to purchase an asset, is known as the option holder.' the person who is obligated to purchase or sell an asset upon the request of his counterparty is known as the option writer.45 the holder of an option usually pays money (the "option premium") to the writer in exchange for the option. an option that accords the holder the right to purchase an asset from her counterparty is known as a "call option." an option that accords the holder the right to sell an asset to her counterparty is known as a "put option." parties can use option contracts to guard against, or speculate about, the movement in value of a particular asset. a taxpayer will. typically purchase a put option in order to guard against a downward movement in the price of the underlying property. a taxpayer will typically purchase a call option to guard against an upward movement in the price of the underlying property. the following paragraphs will explore the economic characteristics of put and call options. a person who must sell goods at some point in the future can purchase a put option in order to guard against a downward movement in the sale price of the underlying property. example. the forward price of a 9 month forward contract on a bushel of wheat is $10. jack is not entirely convinced that the price of wheat is going to fall in the next 9 months. because he is not entirely convinced that the price of wheat will fall, jack does not want to sell all of his wheat in advance. jack therefore calls jill and offers to pay her $2,000 today in return for the right to sell her 1,000 bushels of wheat in 9 months at a price of $12,000. (that is, the option premium is $2 a bushel and the strike price of the put option is $12 a bushel.) jack thinks that this is a good deal because, if he exercises his rights under the put option, he will receive $12,000 on the sale to jill and will thus receive a net amount of $10 on the sale of each bushel of wheat ($12,000 sale price for 1,000 bushels of 44. rev. rul. 78-182, 1978-2 c.b. 265. 45. 1 andrea s. kramer, financial products: taxation, regulation, and design 100 (1991). 19971 florida tax review wheat minus the $2,000 total option premium). jill thinks that the option contract is a great deal for her. jill believes that the price of wheat will increase exponentially. thus, she believes that jack will let the put option expire because he will not force her to purchase wheat at a price below its fair market value. if jack lets the put option expire, jill gets to keep the option premium. jack has only placed at risk the option premium.46 jack has insulated himself from a downward movement in the price of wheat. if the spot price of wheat falls below $10 a bushel, jack will exercise his rights under the put option. jack will suffer an economic loss if, in 9 months, wheat is trading at a price between $10 and $12 a bushel. in that case, jack will not want to let the put option expire, because he will forfeit the $2 a bushel option premium and will only receive between $10 and $12 a bushel on the open market. in that case, jack will receive, net of the forfeited option premium, between $8 and $10 a bushel. if, however, in 9 months, wheat is trading at a price in excess of $12 a bushel, jack will be able to let the option expire and sell his wheat in the market. for example, if the price of wheat rises to $15 a bushel, jack will let the option expire and sell his wheat for $15 a bushel; he will receive, net of the forfeited option premium, $13 a bushel ($15 a bushel on the open market minus the $2 a bushel forfeited option premium). in that case, jack will be able to reap some economic benefit from an increase in the spot price of wheat. from the above discussion, one can see that a put option will enable the holder to eliminate the risk of downward movement in the underlying property while preserving some of the economic benefits of an upward movement in the price of the underlying property. all of the benefits and risks of a put option do not, however, go to the holder. the writer of a put option keeps the option premium. thus, jill stands to gain $2,000 simply by writing a put option. jill's down side is limited to $10 a bushel. that is because she received an option premium of $2 a bushel, and the strike price of the put option is $12 a bushel. in a worst case scenario, jack can exercise the put option when the spot price of wheat is $0 a bushel. thus, net of the option premium, jill stands to suffer a maximum loss of $10 a bushel, or $10,000. 46. henry d. shereff, introduction to the taxation of financial instruments 148 (1990) ("the risk on a purchased option is limited to the cost of the premium."). see rev. rul. 78-182, 1978-1 c.b. 265 ("the holder of the [call] option is not obligated to purchase the stock that is the subject of the option. thus, if the market value of such stock were to fall below the price specified in the option contract, the holder normally would not exercise the option and would allow it to lapse."); shereff, supra, at 148 ('the risk inherent in a purchased put is limited to the premium paid for the put no matter how high the price of the stock rises."). for a review of the economic risks and rewards generated by options, see francis d. feeney, a guide to international financial derivatives part a (1991). [vol. 3:8 economically equivalent financial instruments call options serve the same basic purposes as put options. call options are, however, the economic opposite of put options. whereas jack purchased a put option to guard against a downward movement in the sale price of the underlying property, the purchaser of a call option wants to guard against an upward movement in the price that she will have to pay to purchase the underlying property at some point in the future. example. lilly is a baker. she will have to purchase wheat in 9 months. she believes, but is not entirely convinced, that the price of wheat will increase in the next 9 months. therefore, she does not want to agree to purchase large quantities of wheat in advance. lilly goes to larry, a local wheat farmer, and offers him a $2 a bushel option premium in exchange for the right to purchase wheat in 9 months at a price of $8 a bushel. larry thinks that this is a good deal for him, because he is convinced that the price of wheat will fall in the next 9 months. larry believes that lilly will let the option expire. lilly has only placed at risk the option premium. lilly has eliminated the risk that the price of wheat will increase in the next 9 months. that is because, regardless of the fair market value of wheat in 9 months, lilly will be able to purchase wheat from larry at a price of $10 a bushel, including the $2 paid for the option premium. if, however, in 9 months, wheat is trading at a price between $8 and $9 a bushel, lilly wvill suffer an economic loss. that is because, if she lets the option expire and purchases wheat in the open market, she will pay between $10 and $11 a bushel, including the amount paid for the expired option. in that case, lilly will likely exercise her option and purchase wheat for a total price (including option premium) in excess of its fair market value. in contrast, if wheat is trading at a price below $8 a bushel, lilly will be economically able to let the option expire and purchase wheat in the open market. for example, if the spot price of wheat is $2 a bushel, lilly can let the call option expire and purchase wheat in the open market. in that case, the total purchase price of wheat would be $4 a bushel, including the premium on the expired option. thus, a call option insulates the holder from upward movement in the price of the underlying property and also allows the holder to reap some benefits from a downward movement in the price of the underlying property. once again, the option writer stands to gain or lose economically. larry will keep the option premium. if the price of wheat rises beyond $10 a bushel, larry will suffer an economic loss, because lilly will, in all likelihood, exercise her option. that means that larry will be forced to sell wheat at a price below its fair market value. taxpayers can enter into option contracts using any asset as the underlying property. it is important to note that, like the parties to a forward contract, the parties to an option contract can settle their obligations in cash. 19971 florida tax review that means that, if the option writer is the losing party, she must make a payment to her counterparty equal to the difference between the strike price of the option and the fair market value of the underlying property. if the option holder is the losing party, then the option writer simply keeps the option premium. example. part 1: assume that, on the expiration date of the option contract between lilly and larry, wheat is trading at a price of $25 a bushel. lilly and larry agree to settle the option contract in cash. larry stands to lose $17, because he is obligated to sell wheat for $8 a bushel when it is worth $25 a bushel. larry therefore pays lilly $17. larry has lost a total of $15 on the contract ($17 payment to lilly minus $2 option premium received). lilly has made a total of $15 on the option contract ($17 payment received from larry minus $2 option premium paid to larry). part 2: assume that, on the forward date, wheat is trading at a price of $2 a bushel. lilly and larry settle their obligations in cash. in an option contract, the purchaser only places at risk the option premium. thus, lilly lets larry keep the option premium. because taxpayers can enter into cash settled option contracts, it follows that a taxpayer need not own the underlying property in order to write an option contract. it also follows that a taxpayer can purchase or sell an option in order to speculate about the price movement in an asset. thus, a person could purchase cash-settled call options on wheat instead of purchasing a cash-settled forward contract on wheat. 2. timing and character of income from options.-the parties to an option contract do not recognize gain or loss upon the receipt or payment of the option premium.47 in general, the parties to an option contract will only recognize gain or loss by virtue of that contract upon the expiration, cancellation, or transfer of their rights and obligations under that contract.48 in general, the character 47. see virginia iron coal & coke co. v. commissioner, 37 b.t.a. 195 (1938), aff'd, 99 f.2d 919 (4th cir. 1938), cert. denied, 307 u.s. 630 (1939); rev. rul. 58-234, 19581 c.b. 279, 283 ("it is manifest, from the nature and consequences of 'put' or 'call' option premiums and obligations, that there is no federal income tax incidence on account of either the receipt or the payment of such option premiums, i.e., from the standpoint of either the optionor or the optionee, unless and until the options have been terminated .... ."). for a comprehensive analysis of the taxation of income from options, see bruce kayle, realization without taxation? the not-so-clear reflection of income from an option to acquire property, 48 tax l. rev. 233 (1993). 48. most options on publicly traded property are settled in cash. kayle, supra note 47, at 236. [vol 3:8 economically equivalent financial instunments of that gain or loss will be capital, although that character may vary between long term capital and short term capital.49 if the holder exercises her rights under the option contract, then the parties to that contract will take account of the option premium in determining the amount realized on the sale of the 49. there are three regimes governing the taxation of options. first. § 1234 addresses the taxation of certain option writers and holders. second, § 1256 provides rules for the taxation of certain publicly traded and currency options. third, § 1234a provides rules for the taxation of certain option writers and holders not covered by §§ 1234 and 1256. section 1234(b)(1) provides that if the taxpayer writes an option (either a call or a put) on stock, securities, commodities, or commodity futures, she will recognize short term capital gain or loss on any "closing transaction" with respect to that property. the term "closing transaction" means "any termination of the taxpayer's obligation ... other than through the exercise or lapse of the option." irc § 1234(b)(2)(a). thus, if an option writer enters into a cash settlement agreement with respect to an option on one of the properties to which § 1234(b) applies, then this writer will recognize short term capital gain or loss on the transaction. if a taxpayer writes an option which is classified as a § 1256 contract (a § 1256 option), then the option will be "marked to market" at the end of each taxable year. notwithstanding any other provision of law. that means that that option will be treated as having been sold on the last day of the taxable year, and the option writer will recognize gain or loss accordingly. irc § 1256(a)(1). in addition, the writer of a § 1256 option will recognize gain or loss upon any termination of the writer's obligations under the option. irc § 1256(c)(1). any gain or loss recognized by virtue of § 1256 is 40% short term capital, and 60% long term capital. irc § 1256(a)(3). the parties to a § 1256 option will receive appropriate basis adjustments to the option. irc § 1256(a)(2). in the most general terms, in order for an option to qualify as a § 1256 option, it must: (1) be publicly traded, and (2) qualify as either (a) a nonequity option (e.g., the value of the option must not be determined by reference to stock or a group of stocks), or (b) a foreign currency contract which is traded on the interbank market and requires delivery of (or settlement in relation to the value of) a foreign currency in which positions are traded through regulated futures contracts. irc § 1256(b). section 1234a will apply to an option writer if: (1) the property subject to the option does not fall under §§ 1234 or 1256; or (2) the property subject to the option does fall under § 1234, but the method of terminating that option does not qualify as a "closing transaction" under § 1234(b)(2). section 1234a(1) provides that any gain or loss with respect to the "cancellation, lapse, expiration, or other termination of ... a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer ... shall be treated as gain or loss from the sale of a capital asset." see supra note 35 regarding recent changes to irc § 1234a. the same basic regime that applies to option writers applies to option holders. section 1234(a) provides that gain or loss attributable to the sale, exchange, or lapse of an option shall be treated as gain or loss from the sale or exchange of property "which has the same character as the property to which the option relates in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him)." section 1234(a) does not apply to, among other things, options that are, essentially, inventory in the hands of the taxpayer and certain put options where the taxpayer owns the property to which the option relates. aside from those limitations, the term "property" in § 1234(a) encompasses all property. if a taxpayer holds an option to which § 1256 applies, then she must mark the option to market at the end of the taxable year. irc § 1256(a)(1). 19971 florida tax review underlying property and the adjusted basis of the underlying property in the hands of the purchaser.50 in certain instances, items of loss from options may be deferred under section 1092.5' 3. source of income from options.-options are capital assets in the hands of most investors. the source of income from the sale of personal property is determined by reference to the residence of the owner of that property.52 thus, a foreign investor who sells an option, or otherwise terminates her rights or obligations thereunder,53 will generally recognize foreign source income,' on which she will not pay u.s. tax.55 m. contingent debt instruments and equity swaps this article focuses on the proper tax treatment of certain cdis and equity swaps. equity swaps are one of the many derivatives that fall under the definition of "notional principal contract." this section of the article will analyze the tax treatment of cdis and notional principal contracts. 50. in general, if the writer of a call option is forced to sell the underlying property, then she must add the option premium that she received to the amount realized on the sale of that property (i.e., the strike price) to determine the amount of gain or loss recognized on the sale. rev. rul. 78-182, 1978-1 c.b. 265, 267. if the writer of a put option is forced to purchase the asset subject to the put option, then she must subtract the option premium that she received from the basis of the underlying property (i.e., the strike price). id. at 268-269. if the holder of a call option exercises her right to purchase the underlying property, then she adds the option premium to the adjusted basis of that property. id. at 266. if the holder of a put option exercises her right to sell the underlying property, then, in computing the amount of gain or loss on the sale of that property, she must subtract the option premium from the amount realized on that sale. id. at 268. the above rules do not apply to § 1256 options. section 1256(c)(1) provides that the exercise of a § 1256 option is a realization event. therefore, the writer of an exercised option subject to § 1256 must recognize gain or loss as if she sold the option at the time the holder exercised it. the writer of the exercised option computes her amount realized on the sale of the underlying property (or, in the case of an exercised put option, her basis in the underlying property) without regard to the option premium. 51. the straddle rules contained in § 1092 are discussed below in notes 180-186 and accompanying text. 52. irc § 865(a). 53. section 1234a supplies the missing sale or exchange element in the case of certain options. see supra text accompanying note 49. 54. irc § 865(a)(2). the service has not exercised its authority under § 8650)(2) to issue regulations governing the source of income from option contracts. 55. irc § 871(a)(1) (imposing tax on u.s. source income). the exception to that rule relates to long call options, the underlying of which is u.s. real property. in that case, the foreign investor will recognize u.s. source income upon the sale of that option. irc § 897(a)(1), (c)(6)(a); regs. § 1.897-1(d)(2)(ii)(b) ("an option, a contract, or a right of first refusal to acquire any interest in real property ... will itself constitute an interest in real property other than solely as a creditor."). [vol 3:8 economically equivalent financial instruments a. contingent debt instrwnents 1. noncontingent debt lnstnunents generally.-before reviewing the tax treatment of cdis, this article will review the tax treatment of conventional (i.e., noncontingent) debt instruments. a noncontingent corporate debt instrument will fall into one of three classes,5 6 depending on (1) the way in which interest payments are computed, and (2) the timing of those interest payments-5 the only type of noncontingent debt instrument relevant to the instant discussion is the zero coupon bond. 56. regardless of the class into which a debt instrument falls, all holders of debt instruments ("bondholders") generally share the same rights vis-a-vis the issuer and other bondholders with equal seniority. see infra note 57. bondholders are creditors of the corporadon that issued the bonds. 6a victoria a. braucher, fletcher cyclopedia on the law of private corporations 5 (rev. ed. 1997). generally, bondholders lend money to the corporation in exchange for the corporation's promises to pay interest and return the principal. id. bondholders do not have the right to vote on matters that require shareholder approval. id. also, bondholders generally do not share in the economic appreciation or depreciation of the corporation. id. a bondholder's return is generally limited to the interest and principal payments. id. 57. bonds that provide for interest payments fall into three basic categories: fixed rate, floating rate, and zero coupon. see generally david c. garlock, federal income taxation of debt instruments (3d ed. 1996). a holder of a fixed rate bond agrees to loan the company a certain sum of money; in return, the company agrees to return the principal and pay the bondholder, on a periodic basis, interest based on a fixed rate. richard a. brealey & stewart c. myers, principles of corporate finance 319 (4th ed. 1991). a holder of a floating rate bond also agrees to loan the company money; in return, the company generally agrees to return the principal and pay the bondholder, on a periodic basis, an amount of interest determined by reference to the short term interest rate prevailing at the time of the interest payment. id. holders of fixed and floating rate bonds must report periodic interest payments in income as these holders either receive or accrue those periodic interest payments, depending on their method of accounting. irc § 451 (a). cash method taxpayers include interest payments in income in the taxable year in which those taxpayers actually or constructively receive those interest payments. regs. § 1.451-1(a). accrual method taxpayers include interest payments in income in the taxable year in which all the events occur that fix their right to receive interest payments, and the amount of those payments can be determined with reasonable accuracy. regs. § 1.451-1(a). those bondholders recognize ordinary income upon receipt of the interest payments. irc § 61. if a bondholder sells or exchanges a debt instrument, she is. subject to exceptions not relevant here, entitled to a capital gain or loss. the source of interest payments is generally determined by reference to the nationality of the borrowing corporation. irc § 861 (a)(l). interest on corporate bonds received by a nonresident alien individual who is not engaged in a trade or business in the united states is generally exempt from the 30% tax imposed by § 871(a). irc § 871(h). corporations do not recognize income upon the receipt of borrowed funds. e.g., falkoff v. commissioner, 62 t.c. 200, 206 (1974). corporations are generally allowed a deduction with respect to interest. irc § 163(a). the source of those interest deductions is generally determined through the use of a formula that takes into account all of a taxpayer's assets and liabilities, regardless of where they are situated. 19971 florida tax review a holder of a zero coupon bond agrees to loan the issuer money in return for one payment at maturity.58 holders of zero coupon bonds are not entitled to periodic interest payments from the borrowing corporation. rather, the holder of a zero coupon bond recovers both interest and principal in one payment at maturity. the difference between the issue price of a zero coupon bond and the amount that the holder is entitled to receive at maturity is called original issue discount ("old").59 holders of zero coupon bonds must, pursuant to sections 1272 through 1275 (the "oid rules"), include in income a portion of that oid for each taxable year between the issuance and maturity of the zero coupon bond.' the amounts included in income by virtue of the oid rules are added to the basis of the zero coupon bond.6 the holder of the zero coupon bond will accrue the entire amount of oid prior to maturity.62 thus, at maturity, any money that that holder receives will qualify as a tax-free return of basis. interest payments are classified as ordinary income. the source of an interest payment is generally determined by reference to the nationality of the borrowing (payor) corporation.63 in general, interest payments are, in the hands of a private investor who is a nonresident alien individual, exempt from the 30% withholding tax imposed by sections 871(a)(1) and 1441. 64 items of loss from debt instruments are not subject to the loss deferral rules contained in section 1092.65 2. background on cdis.-cdis can provide for contingent interest and guaranteed principal,66 contingent principal and guaranteed interest,67 58. 2 andrea s. kramer, financial products: taxation, regulation, and design 874 (rev. ed. 1991). 59. irc § 1273(a)(1). 60. irc § 1272(a)(1). 61. irc § 1272(d)(2). 62. the issuer of a zero coupon bond is permitted periodic interest deductions equal to the amount of oid included as interest income by the bondholders. irc § 163(e). 63. irc § 861(a)(1). 64. irc § 871(h). 65. the straddle rules contained in § 1092 are discussed below in notes 180-186 and accompanying text. 66. an example of a cdi that provides for contingent interest and guaranteed principal is the stock-index growth note ("sign"). see alvin c. warren, jr., financial contract innovation and income tax policy, 107 harv. l. rev. 460,483 (1993). in a sign, an investor lends money to a borrower. in return, the investor will receive, at maturity, (1) the principal and (2) an amount of interest equal to the appreciation in some stock index, such as the standard and poor's 500 (the s&p 500). id. for example, in 1992, merrill lynch issued debt securities that had a five-year term and entitled the lender to the return of principal plus 115% of the appreciation, if any, in the s&p 500. louis s. freeman & richard m. lipton, tax consequences of business and investment-driven uses of derivatives, 72 taxes 947, 967 (1994). [vol. 3:8 economically equivalent financial instr uments or contingent interest and principal. this article will focus primarily on cdis that (1) are contingent as to both interest and principal and (2) track the value of a capital asset, group of assets, or index.' one variation of the sign is the mitts. which stands for "standard & poor's 500 market index target-term securities." mitts, which are a trademarked financial product of merrill lynch, are five-year notes that provide for one payment at maturity equal to the issue price of the mits or a payment equal to the sum of the issue price of the mitts plus a payment calculated by reference to the appreciation of the s&p 500. kenneth heitner & jonathan kushner, to bifurcate or not to bifurcate: the answer becomes less clear. 46 tax law. 43, 84 (1992). another variation of the sign is the lyon, or "liquid yield option note." in 1990, walt disney company issued $1.5 billion of lyons, each of which had an issue price of $411.99 and a yield to maturity of 6%. holders of a lyon were entitled to receive $1,000 at maturity. those holders were also entitled to exchange the lyon at any time for an amount of cash equal to the market price of a fixed number of shares of an affiliate of walt disney company. thus, the lyon issued by disney was a zero-coupon bond with an embedded call option on the affiliate's stock. id. at 79. issuers can, however, issue derivatives such as the lyon that track the value of shares of stock of corporations that are unrelated to the issuer. freeman & lipton, supra, at 952 (salomon, inc., issued a derivative that tracked the value of the common stock of digital equipment corporation, inc., a corporation that was unrelated to salomon). 67. an example of a cdi with guaranteed interest and contingent principal is the a/s eksportfinas 14.5% gold-indexed notes. freeman & upton, supra note 66, at 958. those notes provided for periodic interest payments and a payment at maturity calculated by reference to the amount of change in the price of gold between the issue date and the maturity date. id. 68. this article will not focus on instruments such as contingent installment obligations, which are commonly referred to as "earn-out notes." under the cdi regulations, earn-out notes are taxed under the rules applicable to nonpublicly traded cdis that were issued for nonpublicly traded property. under these rules, all contingent payments are taxed under a "wait and see" approach in which a payment, once made, is characterized as part principal and, based on the applicable federal rate (afr), part interest. regs. § 1. 1275-4(c)(4). the main problem with that rule is that it encourages the seller of a business to use an earn-out note. rather than a note with a fixed face amount, to finance the sale of her business. that is because the seller/lender in an earn-out note will recognize less ordinary income, and thus more capital gain, than a seller/lender who accepts as payment a noncontingent promissory note. example. in transaction one, a sells her business to b. a believes that her business is worth 100x dollars, but b will not pay that amount up front. a's basis in her business assets is zero. b's borrowing rate is 10%. b agrees to pay a 5% of each year's gross receipts for a period of five years. over five years, b pays a a total of 150x dollars in five yearly payments. assume that the afr is 6%. in transaction two, d sells her business to e. d's basis in her business assets is zero. e gives d a five-year promissory note providing for five annual payments equaling 100x dollars, plus 10% interest. over five years, e pays d a total of 150x dollars. the sellers in transactions one and two both sell business assets worth 100x dollars and receive therefor a total of 150x dollars over five years. these two transactions will be taxed differently, because a is allowed to compute her interest income using the lower afr interest rate. that means that she will recognize less ordinary income and more capital gain than d. 19971 florida tax review for purposes of simplicity, this article will define and discuss one type of cdi that is contingent as to both principal and interest. that cdi will be referred to as a "gold note." this article will use the gold note as a paradigm of the many cdis that are contingent as to both principal and interest. note: for purposes of this article, a gold note is defined as a note that (1) has a $1,000 issue price, and (2) provides for one payment in 10 years (the date of maturity) that is equal to the prevailing spot price of 4 ounces of gold. thus, the lender in a gold note may never receive funds from the borrower. on the other hand, that lender may receive an amount of money that far exceeds the issue price. in reality, a lender and a borrower can construct an instrument such as the gold note using any asset or index as the underlying property. as defined herein, a gold note is economically equivalent to a cash-settled, prepaid forward contract on gold. issuers typicauy69 develop cdis such as the gold note for two that problem can be remedied by using the borrower's interest rate to determine the amount of each earn-out note payment that is allocable to principal. david hariton has suggested a set of rules for determining the yield on instruments such as the gold note, and that approach could be extended to the earn-out note: first, interest would accrue currently on the outstanding revised issue price of a contingent debt instrument, at a "reasonable rate." if the debt is issued by a corporation that has outstanding publicly traded noncontingent debt with a remaining life no less than 33 percent shorter, and no more than 50 percent longer, than the term of the contingent debt, then the reasonable rate would equal the yield to maturity of the noncontingent debt on the date the noncontingent debt was issued. otherwise, the reasonable rate would be determined by a table that, for any given term and established issuer credit rating ... would set out a percentage of the applicable federal rate of interest (e.g., 125 percent of the applicable federal rate of interest). david p. hariton, contingent debt: putting the pieces together, 58 tax notes 1231, 1242 (mar. 1, 1993) [hereinafter hariton, contingent debt]. there are, however, some very good reasons to use the afr in determining the amount of accrued interest on a financial instrument: "as a practical matter, the [afr] has all the advantages. it is simple, unambiguous, and easy to administer." david p. hariton, new rules bifurcating contingent debt-a mistake?, 51 tax notes 235, 239 (apr. 15, 1991) [hereinafter hariton, new rules]. the author, however, believes that, in the context of earn-out notes, the use of the afr leads to abuses that can be cured only through the use of the borrower's borrowing rate. other commentators have also complained about the shortcomings of the afr. see lawrence lokken, new rules bifurcating contingent debt-a good start, 51 tax notes 495, 503-04 (apr. 29, 1991). 69. issuers can also use cdis such as the gold note to accomplish certain goals which, for regulatory reasons, they would be unable to obtain in the absence of cdis. see edward d. kleinbard, equity derivative products: financial innovation's newest challenge to the tax system, 69 tex. l. rev. 1319 (1991). for example, times mirror co. recently acquired a 2.3% interest in netscape communications in a private placement. because of certain provisions of the federal securities laws, times mirror was unable to sell that stock for two years. times mirror did, however, issue a five-year bond, the repayment of which was [vol 3:8 economically equivalent financial instruments purposes. first, issuers issue gold notes in order to accommodate the needs of investors. second, issuers issue gold notes in order to lower their total financing costs.7 taxpayers will purchase cdis for the same reasons for which they will purchase long cash-settled forward contracts on the underlying property. in some cases, taxpayers may purchase cdis because forward contracts with similar terms are not available in the market. for example, assume that (1) a group of investors wishes to purchase 15-year forward contracts on crude oil, and (2) the commodity markets do not offer such contracts. because xyz co. knows that that group of investors exists, it offers a contingent debt instrument having a $1,000 issue price and providing for one payment in 15 years equal to the spot price of 20 barrels of crude oil. thus, xyz co. provides these investors with a financial instrument that they would have otherwise been unable to purchase-a 15-year forward contract on crude oil. in any event, a debt instrument that is fully contingent on the value of the particular underlying property will not vary in either form or economic substance from a long cash-settled, prepaid forward contract on the underlying property. 3. taxation of cdis a. background.-section 1275(d) grants the service broad discretion to promulgate regulations that address the taxation of cdis.n the pegged to the price of netscape stock. times mirror recovered its profit in the netscape stock when it received the "borrowed" money; the risk of a downward movement, and most of the benefits of upward movement, in the price of netscape stock was transferred to the purchasers of the bonds. see sheppard, adding pep, supra note 4. 70. kleinbard, supra note 4, at 954 ("one of the most interesting aspects of the new financial products marketplace is that financial product exotica typically are developed in response to investor demands, not issuer needs."). for example, if there exists a group of investors who wish to purchase 15-year forward contracts on crude oil, and the commodity markets do not provide such contracts, an issuer can construct a cdi that provides for one payment in year 15 equal to the spot price of some quantity of crude oil. 71. matthew p. haskins, can the irs maintain the debt-equity distinction in the face of structured notes?, 32 harv. j. on legis. 525, 531, 543 (1995) ("a complex structured note may represent an exotic equity-linked market play to the investor while merely being a cheaper source of plain vanilla financing to the issuer."; "issuers of structured notes expect savings of about twenty basis points when compared with traditional financing."); heitner & kushner, supra note 66, at 44 ("in a similar vein, companies, in their never-ending search to lower their cost of borrowing, increasingly are issuing debt securities containing conversion or exchange features. these sweeteners lower the interest rate and provide the investor with an opportunity to participate in the appreciation of the issuer, its affiliates, or the equity markets generally .... ); kelley holland et al., a black hole in the balance sheet bus. wk., may 16, 1994, at 81 (analyzing an issuer's ability to reduce financing costs by issuing equity flavored debt instruments). 72. section 1275(d) states, "[t]he secretary may prescribe regulations providing that where, by reason of... contingent payments ... the tax treatment under this subpart ... does 19971 florida tax review service wrestled with the problem of developing a tax regime for cdis for ten years before issuing final regulations in 1996 that govern the taxation of cdis (the "cdi regulations").73 between 1986 and 1996, the service wrote four sets of proposed regulations addressing the taxation of cdis,74 only one of which is relevant here. in 1991, the service issued a set of proposed regulations that called for the "bifurcation" of cdis in certain instances (the "bifurcation regulations").75 the bifurcation regulations (1) treated certain cdis as two separate instruments, namely a zero coupon bond and a property right (such as an option or a forward contract);76 (2) allocated the issue price of those cdis between the hypothetical zero coupon bond and the property right; and (3) treated the holder of that cdi as having purchased separately that zero coupon bond and that property right.77 thus, the holder of a cdi to which the bifurcation regulations applied would recognize a certain amount of oid income on the hypothetical zero coupon bond and a certain amount of capital gain or loss on the hypothetical property right.78 b. the cdi regulations.-the cdi regulations79 provide different rules for (1) publicly traded cdis that were issued for cash or publicly traded property (e.g., the gold note), and (2) nonpublicly traded cdis not carry out the purposes of this subpart .... such treatment shall be modified to the extent appropriate to carry out the purposes of this subpart ...... 73. garlock, supra note 57, at 6-1 to 6-2. 74. id. for an in-depth analysis of the various sets of proposed cdi regulations, see new york state bar association tax section & aba tax section, report and recommendation for the treatment of contingent debt instruments under proposed regulation section 1.1275-4, 61 tax notes 1241, 1242-47 (dec. 6, 1993). 75. prop. regs. § 1.1275-4(g), 56 fed. reg. 8308 (1991). 76. prop. regs. § 1.1275-4(g)(2)-(3), 56 fed. reg. 8308 (1991). 77. prop. regs. § 1.1275-4(g)(4), 56 fed. reg. 8308 (1991). 78. the bifurcation regulations applied to cdis that met all of the following requirements: (1) the cdi was issued for cash or publicly traded property; (2) the cdi provided for noncontingent payments at least equal to the issue price; and (3) the amount of the contingent payments was determined, in whole or in part, by reference to the value of publicly traded property. prop. regs. § 1.1275-4(g)(1), 56 fed. reg. 8308 (1991). the bifurcation regulations did not apply to certain instruments, such as cdis covered by prior sets of proposed regulations, where the cdis provided for contingent payments that were determined by reference to the value of nonpublicly traded property. in addition, the bifurcation regulations would not have applied to gold notes because these notes do not provide for noncontingent payments at least equal to their issue price. 79. the final regulations are contained in regs. §§ 1.1272-1, 1.1274-2, 1.1275-2, -4 to -6. for purposes of simplicity, this article will refer to the portions of these regulations that address the taxation of cdis as "the cdi regulations." [vol 3:8 economically equivalent financial !nstntments that were issued for nonpublicly traded property. the latter class of cdis is not relevant to the instant discussion.s with respect to publicly traded cdis that were issued for cash or publicly traded property, the cdi regulations require the parties to these cdis to: (1) compute the comparable yield of the cdi by reference to the amount of interest that the issuer would reasonably be expected to pay on a noncontingent fixed rate debt instrument;8 and (2) accrue interest income and expense based on estimates of the amount of the future contingent payments, which estimates, in the end, produce the comparable yield.' the cdi regulations also contain new rules that allow taxpayers to integrate a cdi with certain other positions and treat the integrated position as a single debt instrument for federal tax purposes."' that is, if one of the parties to a cdi enters into a "perfect hedge" of the cdi, and the cash flows produced by the combination of the cdi and the perfect hedge replicate the cash flows of a fixed or variable rate debt instrument, then that party will be treated for all purposes of the code as having issued (or purchased, as the case may be) a fixed or variable rate debt instrument. in order for a financial instrument to fall within the loss deferral rules of section 1092, the instrument must, among other things, constitute a "position" in property within the meaning of section 1092.8 some commentators contend that a cdi qualifies as a position in personal property within the meaning of section 1092.86 one can, however, argue that under current law, gold notes are not positions in personal property within the meaning of section 1092." there is no clear primary authority supporting either 80. see sources cited supra note 68. 81. regs. § 1.1275-4(b)(3)(i), (b)(4)(i)(a). 82. regs. § 1.1275-4(b)(3)(ii), (b)(4)(ii)(c); see also daniel shefter, a brief intro to the contingent payment debt instrument regs., 72 tax notes 479, 479-80 (july 22, 1996) (the cdi regulations employ "a relatively complex approach that generally requires issuers and holders to accrue interest deductions and interest income over time based on a projected payment schedule that is derived from the issuer's cost of capital for fixed-rate noncontingent debt instruments."). if the actual payments on a cdi, when received by the holders, differ from the estimated payment schedule applicable to that cdi, the issuer and holders of that cdi must adjust their interest deductions and income accordingly. 83. regs. § 1.1275-6. 84. id.; see also edward d. kleinbard et al., final tax regulations governing contingent payment debt obligations, 72 tax notes 499, 504 (july 22, 1996) (providing a detailed discussion of the hedging provisions of the final regulations). 85. see infra notes 180-186 and accompanying texl 86. e.g., sheppard, adding pep, supra note 4, at 1594-96. 87. in order for a financial instrument to fall within § 1092, that instrument must constitute a "position" in personal property. section 1092(d)(2) states that "the term 'position' means an interest (including a futures or forward contract or option) in personal property." the 19971 florida tax review regulations are not particularly helpful in defin*ng the scope of the term "position," as they simply provide that the term "position" means "position" as that term is used in § 1092(d)(2). e.g., temp. regs. § 1.1092(b)-5(h). section 1092(c)(3)(a)(iii) indicates that debt instruments can be personal property, and that a taxpayer who has positions in certain debt instruments may be subject to the straddle rules; that provision, however, is not authority for the proposition that a debt instrument itself can qualify as a position in the underlying personal property. moreover, § 1092(d)(7) provides that a debt instrument that is denominated in a currency other than the taxpayer's functional currency (a "nonfunctional currency") will be treated as a position in that nonfunctional currency within the meaning of § 1092(d)(2). section 1092(d)(2) makes clear that a forward contract or option on a nonfunctional currency will qualify as a position in personal property. thus, one must determine why, if debt instruments already qualify as positions in personal property, congress enacted a "special rule" for debt instruments denominated in a nonfunctional currency. perhaps congress was simply clarifying the law. on the other hand, congress could have been expressing its belief that debt instruments are not positions in personal property within the meaning of § i092(d)(2), but that debt instruments denominated in nonfunctional currency were so similar to forward contracts on nonfunctional currency that they should both be treated as positions in personal property. once again, § 1092 does not clearly indicate whether debt instruments are positions in personal property. the legislative history to § 1092 does not indicate whether an instrument such as the gold note can qualify as an interest in property. the legislative history does, however, indicate that a convertible debt instrument can qualify as a position in property for purposes of determining whether the stock of the corporation that issued the debt is part of a straddle. conference committee report on p.l. 98-369, at 907-08. that rule may derive, however, from the fact that convertible stock has an actual call option embedded in the debt instrument, rather than a right to payments that behave economically like a cash-settled call option. that interpretation would be in keeping with the definition of "position" as an interest in property. the service has also been less than clear on whether a gold note is a position in property. for example, the service recently finalized regulations which provide that notional principal contracts are positions in personal property within the meaning of § 1092(d)(2). regs. § 1.1092(d)-i (c). given the similarities between gold notes and equity swaps, one must wonder why, if the former already qualifies as a position in property, the latter needs specific regulatory authority in order to so qualify. in light of those regulations, one must also wonder whether the service believes that debt instruments qualify as positions in personal property. after all, if the service took the trouble to issue a regulation including notional principal contracts as personal property, why did it not issue a similar regulation for contingent debt instruments? thus, the § 1092 regulations also illustrate the ambiguities regarding the status of contingent debt instruments under § 1092. in addition, rulings made by the service do not shed any light on the issue of whether a contingent debt instrument can qualify as a position in personal property. for example, in rev. rul. 88-31, the service ruled that an investment unit consisting of a share of common stock and a contingent payment right was a straddle consisting of that share of common stock and a cash-settled put option. 1988-1 c.b. 302. it is important to note, however, that the service classified the contingent payment right as a cash-settled put option, which is a position in personal property, rather than as a debt instrument whose value increased as the value of the underlying property decreased. although that ruling may not provide any guidance as to whether a cdi is a position in personal property, it may be authority for the proposition that a gold note is in fact a cash-settled, [vol 3:8 economically equivalent financial insiruments position. consequently, the proper treatment of gold notes under the loss deferral rules of section 1092 is unsettled. c. problems with the cdi regulations i. treating similarly situated taxpayers differently.--one of the basic problems inherent in the cdi regulations is that those regulations may allow taxpayers, through the use of cdis, to manipulate the timing, source, and character of the income resulting from certain investments. for example, although the gold note is identical in both form and substance to a cash-settled, prepaid forward contract on gold, it is potentially subject to a different set of tax rules.' in addition, in certain cases, a purchaser of a cash-settled, prepaid forward contract on gold will be subject to the loss deferral rules contained in section 1092, whereas the purchaser of a gold note may not be subject to those rules.89 ii. the big questions go unanswered.-as the service struggled to construct a system for taxing cdis, it apparently abandoned all hope of answering "the big questions": first, will a particular cdi qualify as debt for federal tax purposes? second, if a particular cdi is not a debt instrument, then what is it?9' prepaid forward contract on gold. although that analysis would subject gold notes to the straddle rules, the service would be unlikely to take that position because, as discussed above. there does not currently exist a coherent set of rules that taxes the interest that accrues on the prepayment amount. after all that, one must return to the same conclusion: there is no clear primary authority that indicates whether a cdi can qualify as a position in property within the meaning of § 1092. 88. example. x enters into a cash-settled, prepaid forward contract with y. under that contract, x pays y $1,000 today, and y agrees to pay, in 10 years, the spot price of 4 ounces of gold. a lends money to b. in return for that loan. b agrees to repay, in 10 years, the spot price of 4 ounces of gold. assume that the transaction between a and b qualifies as debt under the cdi regulations. in the above example, x and a have entered into transactions that are virtually identical to one another. the only difference between the two transactions is that one transaction is called a cash-settled, prepaid forward contract, and the other transaction is called a gold note. yet, x will not recognize income until y pays her money. the character of that income will be capital, and the source of that income will be determined by reference to x's country of residence. a, on the other hand, will recognize income each year. based on a projected payment schedule that reflects b's cost of capital for fixed-rate noncontingent debt instruments. that income will be ordinary interest income, and the source of that income will be determined by reference to b's nationality 89. see infra notes 180-186 and accompanying text. 90. the cdi regulations: (1) indicate that the rules contained therein only apply to instruments properly classified as "debt" under general principles of tax law: and (2) express no opinion as to which cdis, if any, will qualify as "debt" under those general principles. 19971 florida tax review one can infer from the service's ten year struggle to construct a tax regime for cdis that the service believes that some cdis are debt instruments.91 as many commentators have pointed out,' there is a dearth of authority pertinent to the classification of cdis such as the gold note. it 91. see shefter, supra note 82, at 486. 92. e.g., david p. hariton, distinguishing between equity and debt in the new financial environment, 361 pli/tax 1015, 1022-1024 (westlaw, pli-tax) (1994) ("despite a specific statutory mandate to issue regulations under irc § 385, there are still no regulations to offer practitioners guidance, and the principal authority for distinguishing between equity and debt is still found under case law. it is no surprise that case law is of limited use in the new financial environment."); sheppard, adding pep, supra note 4, at 1594 ("the treasury has not addressed the classification of securities that are linked to the shares of an unaffiliated corporation."); sheppard, things that go bump, supra note 4 (indicating that prominent tax practitioners cannot agree as to the proper classification of certain derivatives akin to the gold note: "[e]xisting government pronouncements about contingent debt-effective and otherwise-are not especially helpful on the classification question."); see also james s. eustice, 'debt-like' equity & 'equity-like' debt: treasury's anti-hybrid proposals, 71 tax notes 1657, 1657 (june 17, 1996) ('the [debt-equity] issue has been a major engine of subchapter c turmoil for most of the 20th century, and will probably continue into the 21st so long as corporate equity capital is subjected to double taxation while debt capital is not."). 93. for purposes of this article, cdis that are contingent as to principal fall into one of two classes. in the first class fall cdis whose repayment is linked to the value of the issuer's own stock. in the second class fall cdis whose repayment is linked to the value of a capital asset, such as gold, or an equity interest in a corporation that is unrelated to the issuer of the cdi. the service has made little, if any, headway in developing an analytical framework that can be used to classify cdis that fall into the first class. the service has made absolutely no headway in developing such a framework for cdis that fail into the second class. cdis that provide for payments that vary in accordance with the value of the stock of the issuing corporation are analogous to debt instruments that are convertible into stock of the issuer. in rev. rul. 83-98, the service ruled that adjustable rate convertible notes ("arcns") were equity instruments of the issuer of those notes. 1983-2 c.b. 40. the arcns were issued at a price of $1,000 cash or a price equal to 50 shares of the issuer's stock (also $1,000). id. the arcns provided for quarterly interest payments at a rate based on dividend payments made on the issuer's common stock. id. upon maturity of an arcn, a holder had a right to receive either (1) $600 cash or (2) 50 shares of the issuer's common stock. id. the arcns were subordinated to all present and future senior and general creditors of the issuing corporation. id. the service noted that: (1) the holders of the arcns would most likely exercise their conversion right at maturity because they would only opt to receive the $600 cash payment if the price of the issuer's common stock dropped by more than 40%; and (2) it would be advantageous in many circumstances for the issuer to force conversion of the arcns into common stock of the issuer. id. the service stated: because of the very high probability that all of the arcn's issued will be converted into stock, the arcn's do not in reality represent a promise to pay a sum certain. rather, the $600 face value is a figure calculated primarily to ensure conversion into stock; its only other function is to provide a floor for purposes of loss that will become material only if the [vol 3:8 economically equivalent financial instruments does, however, appear that cdis that guarantee the return of principal will be classified as debt for federal tax purposes. 94 an analysis of the proper classification of cdis by analogy to equity swaps would be pointless because, price of [the issuer's] ... common stock declines by more than 40 percent from its price at the time the arcn's are issued. id. at 41. in rev. rul. 85-119, a domestic bank holding company ("hc") issued certain notes (the "hc notes") for cash. 1985-2 c.b. 60. the hc notes had a 12-year maturity, provided for quarterly interest payments, and did not accord holders the right to vote or participate in the management of hc. id. upon maturity or redemption of the hc notes, the holders thereof were entitled to receive either (1) an amount of cash equal to the principal amount of the notes; or (2) a number of shares of hc stock, the aggregate fair market value of which was equal to the principal amount of the notes. id. the service held that the hc notes were debt for federal tax purposes. id. at 61. the key facts relied upon by the service were (1) that the holders of the hc notes were entitled to receive cash at maturity of those notes and (2) that hc and the holders of the hg notes intended "to create a debtor-creditor relationship." id. the service did, however, limit rev. rul. 85-119 to its facts. id. in notice 94-47, the service stated that it would "scrutinize" instruments that are designed to be treated as debt for federal tax purposes and as equity for regulatory, rating agency, or financial accounting purposes. 1994-1 g.b. 357. the service again set forth a laundry list of factors relevant to the debt/equity analysis. id. notice 94-47 does not include in the list of debt/equity factors the issue of whether payment of the instrument is linked to the value of the issuer's stock id. the fact that notice 94-47 does not analyze the effect of payments that vary in accordance with the stock of the issuer is troubling, to say the least, because that factor "is arguably the most important factor in distinguishing between equity and debt." hariton, supra note 92, at 1064 ("[aii debt-equity characterization can be described as an effort to determine whether (at least in relation to someone else) an investor is participating in the issuer's profits and risks."). thus, it is unclear whether a cdi that provides for contingent payments linked to the value of an issuer's stock is debt. from the above rulings, in conjunction with rev. rul. 88-31. discussed at supra note 87, one could reasonably conclude that a gdi that is wholly contingent on the value of the issuer's stock is a cash-settled forward contract on that stock and that such a cdi is akin to ownership in that stock. 1988-1 g.b. 302. the correct answer does, however, remain unclear. there is virtually no authority for the proposition that cdis whose repayment is linked to the value of a capital asset other than the issuer's stock are anything other than debt instruments. there is likewise no authority for the proposition that such gdis are debt. thus, it appears that the proper classification of cdis whose repayment is linked to the value of a capital asset is, to coin a phrase, "up in the air." 94. some cdis provide for (1) a guaranteed return of principal and (2) interest payments that are contingent on the value of some asset or index. these gdis are economically equivalent to a zero-coupon bond stapled to a cash-settled call option on the underlying property. the service and the courts, however, have not been prone to bifurcating debt instruments into zero-coupon bonds and call options. see freeman & lipton, supra note 66, at 954-55 (discussing two cases in which the courts bifurcated a financial instrument into debt and equity components; the authors note that there are "few exceptions" to the rule that an instrument is either debt or equity). thus, it appears that, so long as a debt instrument guarantees the return of principal, courts will most likely characterize that instrument as debt. 19971 florida tax review as will be discussed below, the classification of equity swaps is as uncertain as the classification of cdis.9 rather than pondering the classification of cdis under current law, this article, in part iv, will provide the author's views on the appropriate classification of certain cdis. b. notional principal contracts 1. introduction.-a notional principal contract ("npc") is a financial instrument that obligates each party to make periodic payments that are computed with reference to the value of a specified index on a "notional" sum of money (the "notional principal amount").96 the notional principal amount is, for purposes of this article, never exchanged. 97 some common examples of npcs are interest rate swaps, caps, floors,98 commodity swaps, 99 and equity swaps."° the only npcs rele95. compare kleinbard, supra note 69, at 1338-39 (indicating that equity swap payments may give rise to capital gain or loss) with david p. hariton, equity swaps, new regulations, and ed kleinbard's article, 52 tax notes 1221, 1222 (sept. 2, 1991) (expressing skepticism as to mr. kleinbard's views on the proper character of income from equity swaps). regulations section 1.446-3 provides no help on the classification issue. this regulation merely states that an instrument will not qualify as a notional principal contract if the instrument qualifies as debt under federal tax law. regs. § 1.446-3. some commentators suggest that, under current case law, equity swaps are not "equity" interests because the purchaser of equity in an equity swap does not obtain an ownership interest in the underlying property. kevin dolan & carolyn dupuy, equity derivatives: principles and practice, 15 va. tax rev. 161, 178-79 (1995). 96. regs. § 1.446-3(c)(1) (an npc is a "financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts."). 97. the parties to a currency swap do exchange the underlying currencies at the end of the swap agreement. john hull, options, futures, and other derivative securities 125 (2d ed. 1993). currency swaps, however, are beyond the scope of this article. 98. interest rate swaps are economically equivalent to a series of cash settled forward contracts. warren, supra note 66, at 487. in a fixed for floating interest rate swap, a company may agree to pay a bank 8% multiplied by a notional principal amount of $1,000 for five years, while the bank in turn agrees to pay the company libor multiplied by a notional principal amount of $1,000 for five years. see smith et al., supra note 21, at 205. caps and floors are economically equivalent to a series of cash-settled options. see warren, supra note 66, at 488 ("just as [a] ... swap ... can be disaggregated into a series of cash settlement forward contracts, [a cap] ... can be disaggregated into a series of cash settlement options."). taxpayers can use caps and floors to guard against significant movement in interest rates. see warren, supra note 66, at 487-88. for example, assume a company borrows $1,000 for ten years at libor when libor was at 6%. the company decides to protect itself against a dramatic upward move in the libor. therefore, the company pays a bank a set amount of money in return for the bank's promise to pay the excess, if any, of libor over 10%. a floor is simply the flip-side of a cap. thus, in a floor, the company, in [vol. 3:8 economically equivalent financial instrnzents vant to the instant discussion are commodity swaps and long equity swaps.' ° ' commodity swaps and equity swaps are economically equivalent to a series of cash-settled forward contracts. 02 in a commodity swap, one party (the "first party") agrees to pay a fixed sum of money on each payment date.'13 the counterparty agrees to make periodic payments equal to the spot price of a given commodity on each payment date.14 thus, the first party is in the same economic position in which she would have been had she entered into a series of long cashsettled forward contracts, each having a different forward date."° taxpayers exchange for a payment or series of payments from the bank, would agree to pay the bank the excess, if any, of 6% over libor. caps and floors are economically equivalent to options because the "writer" of a cap exposes itself to a downside in return for a premium. and the "holder" of a cap or floor pays a premium in exchange for a potential upside. in the floor discussed above, the company has sold its upside in libor in return for a premium from the bank. that is, the company's upside is limited to the amount it received for the floor, and the company can no longer benefit from downward movement in its interest rate. a company that purchases a cap has a downside limited to the "premium" used to purchase that cap, but has a potentially unlimited upside because there is theoretically no limit on the extent to which interest rates can rise. 99. 1 kramer, supra note 45, at 139. 100. regs. § 1.446-3(c)(1)(i); see also 2 kramer, supra note 58, at 1421. 101. hereafter, all references to swaps will be limited to commodity and equity swaps. 102. smith et al., supra note 21, at 48-49. swaps are akin to a string of cash-settled forward contracts because the parties to a swap make periodic payments to one another to reflect any changes in the value of the underlying property. in essence, swaps are forward contracts that are marked-to-market and then reestablished on a periodic basis. see id. in this sense, a swap is analogous to a futures contract on the underlying property. id. because of the periodic payments, equity swaps expose the parties to less credit risk than forward contracts. id. 103. 1 kramer, supra note 45, at 139. 104. 1 kramer, supra note 45, at 139. a commodity swap is similar to an interest rate swap, in that one party must make variable payments and another party must make fixed payments. in the commodity swap, however, the underlying property is a commodity. 105. 1 see kramer, supra note 45, at 139. kramer provides the following example of a commodity swap: for example, an airline that buys its oil on the spot market makes an agreement with a bank to fix its oil costs over five years. the airline agrees that every six months it will owe the bank $20 million, representing the price of one million barrels of oil at $20 each. at the same time, the bank agrees that every six months it will owe the airline the price of one million barrels of oil in the spot market. if the spot price is above s20 a barrel, the bank pays the airline the difference. if the spot price is lower, the airline pays the bank the difference. 1997] florida tax review typically purchase commodity swaps to reduce the risk of price movements in a particular commodity that the taxpayer produces or must purchase.' °6 in a long equity swap, the purchaser makes periodic payments equal to the sum of (1) the decline in value of a particular share of stock or group of stocks, and (2) a certain amount of interest. in return, that taxpayer receives periodic payments equal to the sum of (1) the dividends paid on that stock or group of stocks, and (2) the economic appreciation in that stock or group of stocks."° one can think of an equity swap as a series of cash-settled forward contracts. that is because, like the parties to a cash-settled forward contract, the parties to an equity swap must make payments to one another to take account of the movement in the value of the underlying property. because these payments are made periodically, these parties are in the same position in which they would have been had they (1) entered into a forward contract, (2) settled that contract in cash after a short period of time, (3) reopened a new cash-settled forward contract with identical financial terms, and (4) repeated steps (1) through (3) over and over again. hence, equity swaps are akin to a series of cash-settled forward contracts. some investors find equity swaps to be more advantageous than cashsettled forward contracts for a simple reason: the parties to an equity swap must make periodic payments to one another to take account of price changes in the underlying property. this means that the parties to an equity swap assume less credit risk than do the parties to a cash-settled forward contract. put differently, the parties to an equity swap do not have to sit around for a number of years wondering whether their respective counterparties will actually make the payments required under the agreement. an equity swap will, however, produce the same economic returns as a cash-settled forward contract. that is because, by the end of the equity swap agreement, the net amount of the payments made by each party to the equity swap will equal the net amount of the payments that these parties would have made had they entered into a cash-settled forward contract that had the same underlying property and quantity terms as the equity swap in question. taxpayers enter into equity swaps for the same economic reasons that taxpayers enter into cash settled forward contracts. some taxpayers may be attracted to equity swaps because of the diminished credit risk. also, some taxpayers enter into equity swaps rather than forward contracts because they 106. 1 kramer, supra note 45, at 139. 107. erika w. nijenhuis, taxation of notional principal contracts, in reuven s. avi-yonah et al., taxation of financial instruments § 3:41, at 3-83 (1996) [hereinafter aviyonah et al.]. equity swaps can also contain terms different than those referenced in the text. id. [vol 3:8 economically equivalent financial instruments are unable to either sell, purchase, or enter into a forward contract with respect to, the underlying property.'" example. pension fund owns 8% of x co. stock. pension fund thinks that x co. stock will decrease in value in approximately one year. pension fund has found it impossible to sell all of its interest in x co. without adversely affecting the price of x co. stock. insurance co. believes that x co. stock will increase in value in the next year. for regulatory reasons, insurance co. cannot purchase stock in x co. therefore, pension fund and insurance co. enter into an agreement with the following terms: every six months, pension fund will pay insurance co. an amount of money equal to the dividends paid on x co. stock and any appreciation of x co. stock that occurred between the payments. insurance co. will pay pension fund an amount of money equal to the depreciation in x co. stock and an amount of interest. in the above example, pension fund will lose money if x co. stock increases in value. in that case, pension fund will have to pay insurance co. an amount of money equal to that appreciation. if x co. stock decreases in value, pension fund will make money because insurance co. will have to pay pension fund an amount of money equal to that depreciation. economically, pension fund is in the same position in which it would have been had it entered into a short cash-settled forward contract on the x co. stock. insurance co. will make money if x co. stock increases in value. in that case, insurance co. will receive a payment from pension fund. if x co. stock decreases in value, insurance co. will have to make a payment to pension fund, and will therefore lose money. thus, insurance co. is in the same economic position in which it would have been had it purchased a long cash settled forward contract on x co. stock. investors can enter into an equity swap using any asset as the underlying property, and that asset need not be publicly traded."t given the similarities between long equity swaps and commodity swaps, it is sufficient 108. kleinbard, supra note 69, at 1330-31. institutional investors, some of whom find it difficult to liquidate their equity holdings profitably, often sell equity swaps in order to "improve equity returns or change their bets on the stock market's direction." lee a. sheppard et al., panels hone in on financial instruments, corporate issues. 54 tax notes 1314, 1314 (mar. 16, 1992). 109. for example, a taxpayer can enter into a long equity swap that: (1) entities her to receive the appreciation of, and rent from, a storage warehouse; and (2) obligates her to make payments equal to the sum of (a) an interest rate and (b) the decline in value of that storage warehouse. 19971 florida tax review for purposes of this article to treat commodity swaps as a subset of long equity swaps." 0 2. taxation of npc income a. timing.-the timing of income from npcs is governed by regulations section 1.446-3. when a taxpayer purchases a swap, she generally has the option of making payments at intervals of one year or less over the term of the swap agreement ("periodic payments") or making one lump-sum payment either at the inception of the swap agreement or at some point during the period in which the swap agreement remains open ("nonperiodic payment"). that is, the purchaser of an equity swap or commodity swap, like the purchaser of a cash-settled forward contract, can prepay the purchase price of the contract."' regulations section 1.446-3 treats periodic and nonperiodic payments differently. regulations section 1.446-3(e)(2)(i) states: "all taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a periodic payment for the taxable year to which that portion relates."'" 2 subsections (f) and (g) of regulations section 1.446-3 provide rules for the taxation of swaps where the purchaser makes one nonperiodic payment at the inception of the swap agreement (a "prepayment"). if that prepayment is "significant," the following rule applies: the parties must treat the swap as two separate transactions consisting of an on-market, level payment swap and a loan. the loan must be accounted for by the parties to the contract independently of the swap. the 110. as discussed above, commodity swaps resemble a series of cash-settled forward contracts. commodity swaps differ from equity swaps in form only. the relevant question in both cases remains the same: should the purchaser of the swap, by virtue of the form of the transaction and the economic benefits and risks of the transaction, be treated as having an ownership interest in the underlying? therefore, it is appropriate, for purposes of simplicity, to treat commodity swaps as a subset of equity swaps. 111. presumably, the prepayment price of the equity swap or commodity swap will be less than the total amount of periodic payments that the investor would be required to pay over the life of the swap. if that were not the case, an investor would have no incentive to pay for the swap in advance. 112. regs. § 1.446-3(e)(2)(i). thus, the npc regulations place cash method taxpayers on the accrual method with respect to items of income and deduction arising from npcs. for example, assume a cash method, calendar year, taxpayer is entitled to receive an npc payment on february 15, 1998, and that payment covers the period between november 1, 1997, and january 31, 1998. under regs. § 1.446-3, that cash method taxpayer must include in her 1997 taxable income the portion of the february 1998 payment that relates to the 1997 months. [vol 3:8 economically equivalent financial instruments time value component associated with the loan is not included in the net income or net deduction from the swap ... but is recognized as interest for all purposes of the internal revenue code."3 regulations section 1.446-3 does not provide a definition of the term "significant." 114 for purposes of this article, however, it is sufficient to note that a complete prepayment of a swap constitutes a significant nonperiodic payment within the meaning of the regulations. thus, the tax law currently recognizes and takes account of the time value component of a prepayment on an equity swap, but does not recognize or take account of the time value component of a prepayment on a forward contract. regulations section 1.446-3 also provides some fairly complicated rules governing the tax treatment of payments that terminate an npc. for purposes of this article, it suffices to say that taxpayers can terminate their obligations under an npc without subjecting themselves to these rules. items of loss from equity swaps may, in certain instances, be deferred under section 1092."' b. character.-there are no set rules governing the character of npc income." 6 in certain cases, gains or losses resulting from the termination of an npc will be classified as capital pursuant to section 1234a.' 7 section 1234a, however, does not explicitly apply to periodic payments. thus, the character of those payments is still an open question. 113. regs. § 1.446-3(g)(4) (emphasis added). if that prepayment is not "significant." then the parties must, in general, (1) recognize items of income or deduction with respect to that prepayment over the life of the swap and (2) assign those items of income or deduction to the taxable years to which they relate. regs. § 1.446-3(o(2)(i). 114. the examples contained in regs. § 1.446-3 indicate that a prepayment equal to 10% of the present value of all payments due under the contract is not significant, whereas a prepayment equal to 40% of the present value of all payments due under a contract is significant. the regulations, however, do not indicate where the "line" is between a 10% prepayment and a 40% prepayment. compare examples 2 and 3 of regs. § 1.446-3(g)(6). 115. the straddle rules contained in § 1092 are discussed below in the text accompanying notes 180-186; see also david p. hariton, the tax treatment of hedged positions in stock: what hath technical analysis wrought?. 50 tax l. rev. 803, 812-13 (1995). 116. mary l. harmon & daniel p. breen, the changing world of equity derivatives, 378 pli/tax 475,482 (westlaw, pli-tax) (1995) ("significant uncertainties with regard to the character of equity swap payments continue to exist."); see also hariton. supra note 115, at 809-11. 117. see irc § 1234a(l). npcs qualify as "personal property" within the meaning of § 1092 if "contracts based on the same or substantially similar specified indices are purchased, sold, or entered into on an established financial market." regs. § 1.1092(d)-l(cf(l). 19971 florida tax review some commentators argue that, because periodic payments do not result from a sale or exchange, the character of those payments must be ordinary." 8 other commentators state that such payments may give rise to capital gain or loss." 9 many commentators, however, simply acknowledge that the question remains open. 20 c. source.-section 1.863-7(b) provides the general rule that npc income is sourced to the residence of the recipient.12 ' thus, although gold notes and equity swaps may be identical to one another in economic substance, the income from these two derivatives are subject to different sourcing rules. the sourcing rule applicable to equity swaps may give rise to inappropriate results in certain situations.'2 for example, assume that a foreign investor enters into a long equity swap on gm stock. that swap entitles the foreign investor to the appreciation and dividends on gm stock. if that investor had purchased gm stock, these dividend payments would be subject to u.s. withholding tax. however, because the regulations provide that swap payments are sourced to the residence of the payee, the foreign investor will not be subject to u.s. tax when he receives a swap payment equal to the amount of dividends declared on gm stock."2 the preamble to regulations section 1.446-3 indicates that the service is aware of this potential abuse and is considering altering the sourcing rules applicable to certain npcs. 24 118. harmon & breen, supra note 116, at 482. 119. kleinbard, supra note 69, at 1341-44. 120. see harmon & breen, supra note 116, at 482. 121. regs. § 1.863-7(b); see also 2 kramer, supra note 58, at 1466. 122. see may, supra note 25, at 1228 (analyzing the way in which foreign investors can manipulate the sourcing rules of regs. § 1.863-7(b) to avoid withholding taxes). 123. see regs. § 1.863-7(b). 124. t.d. 8491, 1993-2 c.b. 215. the preamble states: [t]he final [section 1.446-3] regulations provide that a specified index may be almost any fixed rate or variable rate, price, or amount based on current, objectively determinable financial or economic information. in light of the broad definition of specified index, the irs is considering whether notional principal contracts involving certain specified indices (e.g., one issuer's stock) should be excluded from the general sourcing rules of sections 861 through 865 .... id.; see also hariton, supra note 95, at 1222-23 ("the ... conclusion that income from an equity-index swap qualifies for sourcing under the residence rule raises some troubling questions, however. the withholding tax on u.s.-source dividends ... can be avoided through the issuance, by foreign financial institutions, of 'surrogate stock' of u.s. corporations."); may, supra note 25, at 1225 (indicating that foreign investors can avoid u.s. withholding taxes by entering into equity swaps). [vol 3:8 economically equivalent financial instnnenis another discrepancy in the npc sourcing rules concerns long equity swaps into u.s. real property. the disposition of long forward contracts on u.s. real property gives rise to u.s. source income, because a forward contract qualifies as a u.s. real property interest.'2 a long equity swap into u.s. real property may not qualify as a u.s. real property interest, because the purchaser of that equity swap does not acquire a direct ownership interest in that land. the service can argue that a long equity swap is an interest in u.s. real property because a long equity swap constitutes a "direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by [the underlying real property]," which right is classified by the regulations as an ownership interest in u.s. real property.12 6 that argument will likely fail, however, because the purchaser of a long equity swap does not actually share in the appreciation in, or in the proceeds generated by, the underlying real property. put differently, the owner of u.s. real property can sell a thousand different equity swaps, each of which entitles the counterparty to the rent and appreciation of that u.s. real property. it would be quite difficult for the service to contend that all 1,000 counterparties share in the rent and appreciation when each counterparty has a right to 100% of these items. 27 thus, it appears that income from long equity swaps into u.s. real property will be sourced to the residence of the payee. the service acknowledges that this result is problematic,ts but has yet to address the problem through regulations. iv. economic equivalencies derivatives are financial instruments that increase or decrease in value in relation to the movement in value of the underlying property. the value of the underlying property can move in only two directions-up or down. because there are more than two types of derivatives, one must conclude that certain derivatives are economically equivalent to one another."'2 one must 125. see supra notes 38-43 and accompanying text. 126. regs. § 1.897-1(d)(2)(i) (emphasis added). 127. one could make the same argument with respect to a cash-settlcd forward contract on the underlying real property. the fact remains, however, that all forward contracts pertaining to real property are interests in real property within the meaning of § 897. whereas equity swaps into u.s. real property must, in order to qualify as an interest in real property. satisfy all of the requirements contained in the regulations promulgated under § 897. 128. see t.d. 8491, 1993-2 c.b. 215 (stating that the service is considering whether § 897 applies to equity swaps into u.s. real property). 129. smith et al., supra note 21, at 58. smith notes: forwards, futures, swaps, and options--to the novice, they look very different from one another... however, it turns out that forwards. futures, swaps, and options are not really unique constructions but 1997] florida tax review also conclude that, to the extent that derivatives can track the value of the underlying property, some derivatives must be economically equivalent to ownership interests in the underlying property. 3' this section of the article analyzes some of the basic economic equivalencies relevant to the instant discussion.' 13 a. ownership, forwards, gold notes, and equity swaps a long forward contract on the underlying property (i.e., a contract to purchase the underlying property) is the economic equivalent of a direct ownership interest in that property.3 2 the above discussion establishes that a gold note is economically equivalent to a cash-settled, prepaid forward contract. that discussion also indicates that long equity swaps are economically equivalent to a series of long cash-settled forward contracts on the underlying property.'33 if gold notes and equity swaps are economically equivalent to long forward contracts, and long forward contracts are economically equivalent to direct ownership interests in the underlying property, then gold notes and long equity swaps resemble those plastic building blocks that children snap together into complex creations. . . . as we have seen: (1) futures are built by "snapping together" a package of forwards. (2) swaps are similarly built by "snapping together" a package of forwards. (3) options can be built by "snapping together" a forward and a riskless security. (4) options can be "snapped together" to yield forward contracts; conversely, forwards can be "unsnapped" to yield a package of options. id. 130. see mark fichtenbaum, the forms of equity investments produce disparate tax effects, 14 j. tax'n inv. 12, 12 (1996) ("over the years, many financial products have been introduced that allow investors to use alternative means to achieve similar economic results. the most basic method of investing-purchasing equity in a publicly traded company--can be accomplished in at least four different ways."). 131. this article will only discuss the two most basic financial equivalencies that are relevant to the instant discussion. the remaining financial equivalencies are beyond the scope of this article. for a discussion of certain financial equivalencies, see randall k.c. kau, carving up assets and liabilities-integration or bifurcation of financial products, 68 taxes 1003, 1004-05 (dec. 1990) (listing 13 transactions which replicate the cash flows of fixed-rate debt). 132. see smith et al., supra note 21, at 47 n.4. 133. smith et al., supra note 21, at 48-49 ("[a] swap contract is in essence nothing more complicated than a series of forward contracts strung together."). the only difference between a cash-settled forward contract and an equity swap is that the parties to an equity swap choose to eliminate some of the credit risk attendant to a cash-settled forward contract through the use of periodic payments. for purposes of this discussion, it suffices to say that an equity swap is the economic equivalent of a cash-settled forward contract. [vol 3:8 economically equivalent financial instruments must also be economically equivalent to direct ownership interests in the underlying property. although forward contracts, gold notes, equity swaps, and ownership interests in the underlying property are economically equivalent positions, they are taxed differently. given the ease with which an investor can acquire any of the above four positions, an investor can enjoy the economic benefits of ownership of the underlying property and also remain free to choose the timing, source, and character of the income (or deductions) from her investment. b. put-call parity the final economic equivalency relevant to our discussion is "put-call parity."' put-call parity is best explained through examples, such as the following: example. assume that z co. does not pay dividends on its stock, and that, on day 1, z co. stock is currently trading at $100 a share. further assume that, on day 1, an investor can purchase a call option on z co. stock at a strike price of $100, and sell a put option on z co. stock at a strike price of $100. also assume that an investor can purchase a one-year, $100 zero coupon bond for $90.135 if an investor, on day 1, purchases both the zero-coupon bond and the call option, and sells the put option, she will be, at the maturity date of the zero coupon bond, in the same economic position in which she would have been had she purchased one share of z co. stock for $100 on day 1. that is because, on the maturity date of the zero-coupon bond, the investor will receive $100. if z co. is trading at more than $100, the investor will exercise her call option and obtain the stock for $100. if z co. is trading at less than $100, the party to whom she sold the put option will exercise that put and force the investor to pay $100 for stock that is worth less than $100. thus, in each case, the investor will pay $100 (including the net option premium) and will be subject to the economic risks and benefits of ownership of z co. stock. that is why the combination of a zero coupon bond, a long call option, and a short put option, is referred to as "synthetic stock." that combination, however, can also be used to create synthetic ownership positions in any asset.136 134. see warren, supra note 66, at 465-66. 135. see warren, supra note 66, at 466. this example was adapted (i.e., simplified) from an example contained in alvin c. warren's article. 136. see smith et al., supra note 21, at 55-56. 19971 florida tax review if an investor only wishes to enjoy the economic risks and benefits of ownership of z co. stock without actually purchasing the zero coupon bond (which funds the stock purchases pursuant to the options), an investor can simply purchase a call option with a strike price of $x and, at the same time, sell a put option with a strike price of $x on z co. stock. that option combination (an "option pair") at all times will expose the investor to the same economic risks and benefits attendant to ownership of z co. stock.'37 again, an investor can enter into an option pair using any asset as the underlying property. although synthetic stock and an option pair generate the same economic returns as an ownership interest in the underlying property, these positions are taxed differently than an ownership interest in the underlying property. in fact, synthetic stock and the option pair are themselves taxed differently. that is because the holder of a zero coupon bond must periodically accrue ordinary interest income. 3 c. economic equivalencies and tax discrepancies the economic equivalencies and tax discrepancies discussed above can be summarized in the following table: 137. see smith et al., supra note 21, at 56 ("consider a portfolio constructed by buying a call and selling a put with the same exercise price .... [t]he resulting portfolio ... has a payoff profile equivalent to that of buying a forward contract on the asset."). 138. this point is relevant only for an investor who does not have enough money to purchase a zero coupon bond at the time she purchases the option pair. if she does have enough money to purchase that zero coupon bond, however, she will likely be taxed in the same way that she would have been taxed had she purchased a share of synthetic stock. this is because the investor will presumably do something with her money that will generate taxable income. [vol 3:8 economically equivalent financial instnments financial instrument timing character source underlying income from sale capital. income from sale property taxed upon sale or determined by (e.g., stock exchange. reference to owner's or real nationality. exception estate) may be subject to for interests in u.s. section 1092. real property. prepaid income from sale or capital. determined by forward termination taxed reference to owner's contract upon sale or nationality. exception termination, for forward contracts on u.s. real estate.prepayment not treated as a loan. may be subject to section 1092. gold note interest accrued ordinary. determined by over life of the note. reference to borrower's nationality. generally may not be subject exempt from withholdto section 1092. ing under section 871(h)(4)(c)(v). effect is to treat as foreign source income in the hands of a foreign investor. prepaid prepayment treated character of loan determined by equity as loan. periodic payments is ordireference to owner's swap payments accrued nary. character nationality. over life of swap. of periodic payno exception to sourcments unsettled. may be subject to character of ing rule if underlying section 1092. ter of p is u.s. real estate.termination payments is capital. synthetic income accrued part ordinary and determined in part by stock over life of zero part capital. reference to borrower's coupon bond. innationality and in part come from options by reference to recognized upon owner's nationality. sale or termination exception to nationof the options, unality rule for options less exercised. exon u.s. real estate. ception for section 1256 option. may be subject to section 1092. 19971 florida tax review option pair income from sale or capital. determined by termination taxed reference to owner's upon sale or nationality. exception termination, unless for options on u.s. exercised. exception real estate. for options subject to section 1256. may be subject to section 1092. with these financial equivalencies and tax discrepancies in mind, this article now turns to the recommendations for prepaid forward contracts, contingent debt instruments, and equity swaps. v. recommendations the root cause of much of the debate surrounding the proper tax treatment of cdis and equity swaps is the absence of a coherent tax regime applicable to cash-settled, prepaid forward contracts.'39 as the above discussion indicates, there is no difference, in either form or economic substance, between a cash settled, prepaid forward contract and a gold note. also, there is no difference, in either form or economic substance, between a series of cash settled, prepaid forward contracts and a prepaid equity swap. given these equivalencies, one would assume that the decisionmakers in the service would want to classify and tax gold notes and prepaid equity swaps as cash settled, prepaid forward contracts. these decisionmakers, however, cannot do that because current law does not provide a coherent method for taxing prepaid forward contracts. the above discussion indicates that many of the tax policy problems presented by financial derivatives can only be solved through a comprehensive overhaul of our current tax system. 40 specifically, many of those tax 139. see aba section of taxation committee on financial transactions, taxexempt financing, and foreign activities of u.s. taxpayers, report on proposed regulations regarding debt instruments with contingent payments, 49 tax law. 195, 202 (1995) [hereinafter aba report] ("[t]he taxation of [certain] financial products in some cases is presently unknown and, in other cases, is well-established but inconsistent with the [principles behind the oid rules]. prepaid forward contracts fall into the former category, while options fall into the latter."); weisbach, supra note 26, at 498 (indicating that there is no set of tax rules specifically applicable to prepaid forward contracts). 140. e.g., haskins, supra note 71, at 526, 543-44 (suggesting that equity-flavored debt instruments strain the service's ability to maintain the distinction between debt and equity); lokken, supra note 68, at 500 ("economically, there is no difference between interest accruing on a bond and the change in value of a share of stock, except that the former is quite certain and the latter is highly uncertain. this difference disappears once a contingency is [vol. 3:8 economically equivalent financial instiments policy problems are the result of the discontinuities in tax treatment resulting from the debt/equity and capital gain/ordinary income distinctions. until these distinctions are eliminated, we will never completely end the current practice of treating economically equivalent financial instruments differently. for example, until these distinctions are eliminated, a share of stock in x co. will always be treated differently than a share of synthetic stock having x co. as the underlying property. we cannot, however, escape the fact that congress is not likely to eliminate the debt/equity and capital/ordinary distinctions any time soon.'4' while we wait for the time, if ever, that congress will eliminate these distinctions, we should develop an interim system that synchronizes, to the maximum extent possible, the tax treatment of economically equivalent derivatives.142 as a necessary first step in developing this interim system, we need to construct a coherent set of rules governing the taxation of prepaid forward contracts, particularly those prepaid forward contracts that are settled in cash. as stated above, once these recommendations are in place, we should classify and tax as a forward contract (or a prepaid forward contract) all financial derivatives that are economically equivalent to a forward contract (or a prepaid forward contract). the interim system should (1) contain practical rules, (2) produce sound results from the standpoint of tax policy, (3) work within the debt/equity and capital/ordinary distinctions, and (4) not require the service introduced into a debt instrument, and the issue of categorization inevitably becomes a quagmire."); kleinbard, supra note 4, at 946; william d. andrews, reporter's study of the taxation of corporate distributions, 1982 a.l.i. fed. income tax project 327, 367-70; daniel shaviro, risk-based rules and the taxation of capital income. 50 tax l rev. 643 (1995). 141. see jeff stmad, taxing new financial products: a conceptual framework. 46 stan. l. rev. 569, 604 (1994) ("repairing the major discontinuities and inconsistencies in current law is a task that would require fundamental reform. these discontinuities and inconsistencies arise from aspects of current law that are central to the statutory scheme, such as the debt/equity distinction, the distinction between capital assets and ordinary assets, and the differential treatment of gains and losses by holding period."). 142. cf. kau, supra note 131, at 1004: the "conversion" of the timing, source and character of an item of income or deduction into one with different timing, source, or character consequences through financial instruments is undoubtedly the root cause of the confusion in [the financial derivatives taxation] area just as it is the inevitable consequence of a tax regime in which distinctions are made between long and short positions in various financial instruments. the confusion arises because of the intuitive sense among tax policymakers and tax practitioners that economically identical transactions should be taxed identically in a rational tax system, a goal not possible to meet under current law where economic arbitrage permits replication of the same cash flow consequences with a variety of instruments each of which is governed by different rules with respect to timing, source and character. 1997] florida tax review to withdraw or rewrite existing regulations. although an interim solution is, by definition, imperfect, we need to cure as many tax discontinuities as possible while keeping in mind that a complete overhaul of the code is, for the time being, not an option. as the title suggests, this article will only recommend specific changes to the tax treatment of prepaid forward contracts and the classification of equity swaps and certain cdis.143 the following recommendations should apply to investors and issuers alike, although the recommendations are geared to eliminate the tax discrepancies which investors, under current law, most often use to their advantage. the recommendations are not, however, designed to apply to securities dealers, who must currently recognize gains and losses on all financial instruments on a mark-to-market basis.' 44 a. recommendations for prepaid forward contracts 1. nature of the problem.-in a prepaid forward contract, the purchaser advances funds to the seller in exchange for the seller's promise to either (1) deliver the underlying property on the forward date or (2) make a payment on that date equal to the spot price of the underlying property. 45 143. this portion of the article does not address cdis that are only contingent as to interest. if the holder of a cdi is entitled to a return of the principal amount of the note, and the only contingent portion of the holder's return is the interest component of the note, then the note should be taxed in accordance with the cdi regulations, as indicated in the examples contained in these regulations. this treatment is appropriate for two reasons. first, under the present system, the primary alternative to that treatment is a return to the bifurcation regulations. a return to those regulations would be ill-advised because they were both manipulable, as well as complex. see, e.g., hariton, supra note 68, at 237. second, and more importantly, there is no significant debt/equity problem in the case of cdis with contingent interest. admittedly, one can argue that a cdi that promises the return of principal plus any appreciation in the s&p 500 index looks very much like a zero coupon bond stapled to a cashsettled call option on that index. one must keep in mind, however, that the code contains provisions that impute interest on obligations for which there is no stated interest. e.g., irc § 483. these provisions do not question the nature of those obligations as debt. thus, if the code does not question the characterization of debt instruments that provide for no interest, it would be illogical for the cdi regulations to question the characterization of obligations that provide for contingent interest. therefore, cdis that are contingent only as to the payment of interest should be treated as debt under the cdi regulations. 144. see irc § 475(a). this article does not recommend changes to the tax treatment of securities dealers. securities dealers must, with certain exceptions not relevant here, mark all of their positions to market at the end of each taxable year. irc § 475(a). thus, securities dealers are not in a position to benefit from the deferral of income and capital gains treatment available to certain holders of derivatives. 145. one of the fundamental questions raised by prepaid forward contracts concerns the proper classification of these contracts. a prepaid forward contract can, in theory, be classified and taxed as a forward contract, an in-kind debt instrument, or a purchase of the [vol 3:8 economically equivalent financial instruments in an arm's length agreement, the purchase price of a prepaid forward contract will be less than the forward price of a nonprepaid forward contract; otherwise, the purchaser will have no incentive to pay for the forward contract in advance.' 6 as a policy matter, to the extent that the purchaser of a prepaid forward contract receives a "discount" in return for advancing funds to the seller prior to the forward date, she should recognize interest income. after all, that purchaser incurred an obligation to make an expenditure in the future and funded that obligation thorough a current payment made at a discount. this purchaser should not be allowed to characterize interest income as capital gain simply because she loaned money to the seller of the contract and not to an independent third party.'47 2. accounting for interest: fully prepaid forward contracts.-this article recommends that the purchaser of a prepaid forward contract should recognize interest income on the amount of that prepayment. the purchaser should be treated as simultaneously acquiring two financial instruments-a underlying property. as can be seen from the debate concerning decs. reasonable minds can differ on the classification issue. e.g., sheppard, things that go bump, supra note 4; sheppard, supra note 108. in the author's opinion, much of the debate concerning the proper classification of prepaid forward contracts derives from the fact that current law provides no mechanism for taxing the interest that accrues on the amount of the prepayment. because the recommendations in this article provide a method for taxing this interest component, this article will forego a discussion of the issue of classification of prepaid forward contracts under current law. 146. after all, if an investor made a prepayment and did not receive a discount on the forward price, she would be giving up the time value of the prepaymenl 147. the following example serves to illustrate this point: transaction 1: x only possesses $18. x and y enter into a two-year forward contract with a price term of $20. x lends $18 to xyz co. for two years. xyz co. agrees to pay x $1.50 of interest each year and repay the principal at the end of two years. x pays $.50 tax on each of the $1.50 interest payments. at the end of 2 years, x receives her $18 from xyz and uses that $18 and the $2 of interest remaining after tax to pay the forward price. transaction 2: l only possesses $18. l pays n $18 for a two year forward contract which, except for the forward price, is identical to the forward contract between x and y in transaction 1. under current law, x will recognize interest income as she receives interest payments from xyz co. l, however, will not recognize interest income; rather, assuming the parties settle the contract in cash, l will recognize capital gain or loss under § 1234a computed with reference to her $18 basis in the contract. thus, l has converted ordinary interest income into capital gain. these results are inappropriate because, in both transactions, one party lent money to another party, assumed that party's credit risk, and received compensation therefor. it is inappropriate to ignore the loan from l to n simply because n is the party with whom l entered into a forward contract. 19971 florida tax review zero coupon bond and a nonprepaid forward contract. 14 that is, that purchaser should be treated as: (1) loaning money to her counterparty in return for her counterparty's promise to repay those funds, with interest, on the forward date; (2) simultaneously entering into a nonprepaid forward contract; and (3) satisfying her obligations under that nonprepaid forward contract with the proceeds she receives upon repayment of the loan. a two-step approach should be used to determine the amount of interest that the purchaser should recognize on the zero coupon bond component of the prepaid forward contract. first, if one can compute the forward price of the contract in the absence of a prepayment (the "true forward price"), then the purchaser should be treated as purchasing a zero coupon bond that guarantees a payment on the forward date equal to the true forward price. the purchaser should then be subject to tax under the oid rules without regard to the exceptions contained in section 1271(b)(1) (relating to obligations issued by natural persons) and section 1272(a)(2)(e) (relating to loans between natural persons). 49 second, if the true forward price cannot be determined with reasonable accuracy, then one must reconstruct the true forward price. in order to do so, one must, logically, add to the amount of the prepayment the total amount of interest that the seller would have to pay had he borrowed the prepayment amount from the purchaser in an independent transaction. 50 thus, if the true forward price cannot be determined, the purchaser of the 148. requiring a lender of money to accrue interest income on the issue price of an instrument is by no means a revolutionary idea. cf. david p. hariton, the taxation of complex financial instruments, 43 tax l. rev. 731, 786 (1988) ('the amount of money which unrelated parties pay each other for the use or forbearance of money follows objectively from the application of market rates of interest to the issue price of the instrument and not from the timing and variations of the payments under the instrument or from how taxpayers characterize them."). the suggestion that the prepayment amount on a prepaid forward contract represents a loan is likewise no revolutionary statement. see stephen b. land, contingent payments and the time value of money, 40 tax law. 237, 246 (1987) ("an implicit loan arises whenever an item of income or expense is paid in a period other than the period in which the income can fairly be said to have been earned, or the expense incurred, in an economic sense."). 149. irc §§ 1271(b)(1), 1272(a)(2)(e). these recommendations should be limited to forward contracts with a duration of one year or more, because the administrative burden to compute the interest on a short term obligation would be excessive. 150. although somewhat inexact, one must recognize that any approach to the taxation of financial instruments will have drawbacks. see hariton, contingent debt, supra note 68, at 1239 ("[ilt is not going to be easy to determine a reasonable rate of return for any contingent debt instrument, regardless of the issuer's size. the service would do well to base the reasonable rate of return on the yield of noncontingent debt of the same issuer, where that is available, and provide some percentage of the applicable federal rate (taking term, even credit rating, into account) as a fallback."). [vol 3:8 economically equivalent financial instnments prepaid forward contract should be treated as purchasing a zero coupon bond that provides for interest at the borrower's interest rate. 51 as an alternative, the purchaser should be treated as purchasing a zero coupon bond that provides for interest equal to the afr or some multiple thereof. 3. computing gain or loss a. basis computation.-the purchaser of a prepaid forward contract will receive a basis in the zero coupon bond component of the contract equal to the amount paid for that bond (i.e., the prepayment amount).'52 that basis will be increased periodically to reflect the accrual of interest income.153 b. gain or loss on sale prior to fonvard date.-if the purchaser of a prepaid forward contract sells that contract prior to the forward date, then she should recognize ordinary interest income to the extent of the accrued but unrecognized oid on the zero coupon bond.'4 any excess of recognized gain over the amount of accrued but unrecognized oid should be treated as capital gain, as that gain represents an increase in the projected forward price of the underlying property, which upon acquisition would be a capital asset in the hands of the purchaser.' any loss on the sale of the prepaid forward contract should likewise be treated as capital. c. gain or loss on cash-settlement or subsequent sale of the underlying property.-if the purchaser does not sell the forward contract prior to the forward date, then she will be deemed to: (1) receive the entire amount of principal and interest upon maturity of the zero coupon bond; and (2) simultaneously make a payment, equal to the deemed amount received, in satisfaction of her obligations under the hypothetical nonprepaid forward contract. the purchaser will not be subject to tax upon receipt of the principal and interest components of the zero coupon bond, because the adjusted basis 151. for a logical approach to determining the borrower's interest rate, see hariton, contingent debt, supra note 68, at 1242. 152. see irc § 1012. 153. see irc § 1272(d)(2) ("the basis of any debt instrument in the hands of the holder thereof shall be increased by the amount included in his gross income pursuant to this section."). 154. see regs. § 1.61-7(d) ("when bonds are sold between interest dates, part of the sales price represents interest accrued to the date of the sale and must be reported as interest income. amounts received in excess of the original issue discount upon the retirement or sale of a bond... may under some circumstances constitute capital gain instead of ordinary income."). 155. regs. § 1.61-7(d). 19971 florida tax review of that bond will be equal to the sum of the principal and interest payments made at maturity.'56 if the parties settle the forward contract in cash, then the purchaser will recognize gain or loss under section 1234a;.. 7 her basis for purposes of section 1234a will be the amount of principal and interest received upon maturity of the zero-coupon bond.'58 if the purchaser takes delivery of the underlying property, then she will take a basis in that property equal to the sum of the principal and interest payments that she received upon maturity of the zero coupon bond. 5 9 156. see irc § 1272(d)(2). 157. see supra notes 32-35 and accompanying text. 158. irc § 1012. 159. irc § 1012. the cost of the underlying property is equal to the true forward price of the contract which, in turn, is equal to the sum of the principal and interest payments received by the purchaser upon maturity of the zero-coupon bond. these basis computations must be made to avoid double taxation. many commentators suggest that the service should promulgate regulations under § 446(b) that require the purchaser of a prepaid forward contract to recognize interest income on the prepayment amount. e.g., aba report, supra note 139, at 203; lee a. sheppard, clear reflection for contingent payment securities, 70 tax notes 1411 (mar. 4, 1996). as will be discussed below, however, simply requiring the purchaser of a prepaid forward contract to recognize interest income may prove to be inequitable. the only drawback to § 446(b) regulations is the possibility that these regulations may result in double taxation of income. the above recommendations (1) attempt to reconstruct the true forward price of a fully prepaid forward contract, and then (2) treat the purchaser of a prepaid forward contract as if she purchased a zero coupon bond and a nonprepaid forward contract at the true forward price. thus, these recommendations take account of the fact that, under current law, purchasers of prepaid forward contracts and purchasers of nonprepaid forward contracts compute gain or loss under § 1234a using different cost bases. the recommendations simply (1) recharacterize a portion of the former purchaser's capital gain as ordinary income and (2) require that purchaser to accrue that ordinary income during the period between the prepayment date and the forward date. under the § 446(b) approach, however, purchasers of prepaid forward contracts would accrue interest on the prepayment amount. unless these purchasers are entitled to increase their bases in their forward contracts by the amount of interest accrued on the prepayment amount, they will be subject to double taxation. example. f purchases a two-year prepaid forward contract from g for $18. the true forward price is $20. f is required under § 446(b) to accrue $2 of interest income over the two year period. assume that the pertinent § 446(b) regulations do not provide for a basis adjustment to reflect the amount of interest included in income. on the forward date, f receives a $22 payment from g. f must recognize $4 of capital gain ($22 amount realized minus $18 basis). f recognizes a total of $6 of income from that transaction: $2 of interest income and $4 of capital gain. two dollars of that $4 gain represent compensation to f for the use of f's money. thus, x is taxed twice on the same income. [not. 3:8 economically equivalent financial instruments 4. what about partially prepaid forward contracts? a. the time value issue.-in certain cases, an investor may be able to partially prepay a forward contract. in such a case, the forward contract will likely contain a price term that is less than the true forward price. the difference between the true forward price and the actual forward price of the partially prepaid forward contract represents interest received by the purchaser of the partially prepaid forward contract. this purchaser should be required to accrue that interest under the same rules applicable to fully prepaid forward contracts. she should recognize gain or loss upon the sale or termination of the contract using the same basis calculations applicable to prepaid forward contracts. b. anti-abuse.-although this article does not address the taxation of options, it is necessary to deal with deep in the money call options. a deep in the money option is an option contract in which the holder pays an unusually large option premium in return for receiving an option contract that has a strike price that is significantly less than the current trading price of the underlying property. in order to prevent taxpayers from structuring their way out of these recommendations, deep in the money call options should be classified and taxed as partially prepaid forward contracts. example. x co. stock is currently trading at $20 a share. a pays b $17 in return for a call option on x co. stock that has a strike price of $1. the option expires in two years. the option in the above example closely resembles a partially prepaid forward contract, because a has an economic obligation to purchase the stock and that economic obligation is, for all practical purposes, a real obligation. this is because a has paid $17 for the "right" to purchase an asset that he will, in all likelihood, purchase. under current law, a will not recognize any example. assume the same facts above, except that the recommendations in this article are in effect. f must accrue $2 of interest income during the two year period between the contract date and the forward date. that $2 of interest is, by operation of the oid rules, added to f's $18 basis in the forward contract. upon receipt of the $22 payment, f recognizes $2 of capital gain (sf2 amount realized minus $20 basis). f recognizes a total of $4 of income from that transaction: $2 of interest income and $2 of capital gain. the double taxation that results under the first example is unfair. the problem with prepaid forward contracts is that the purchaser is free to defer the receipt of interest income and then treat that interest income as capital gain. these problems should be solved by correcting these timing and character distortions without subjecting the same item of income to double taxation. thus, if the service promulgated regulations under § 446(b) that adopted the above recommendations, it would have to be cognizant of the potential double taxation issue. 19971 florida tax review interest income on that option premium. thus, a could effectively avoid the above recommendations. there is no real distinction between a deep in the money option and a partially prepaid forward contract. we should draw a bright line between deep in the money options and in the money options, perhaps based on the percentage of the current trading price that is paid as an option premium, and treat deep in the money call options as partially prepaid forward contracts. b. recommendations for gold notes the following section of this article will (1) provide a set of rules for the taxation of gold notes and two cdis that constitute variations of the gold note, and (2) apply these rules to the gold note and the two variations. 1. gold notes with fully contingent principal and interest.-where the principal and interest components of an obligation are contingent upon the value of some other asset, the obligation should not be treated as debt. contingent principal should be viewed as the antithesis of debt. that does not mean, however, that the obligation should be viewed as equity in the issuer of the obligation in question. 60 when analyzing the tax treatment of the purchaser of a gold note, one must determine the nature of the purchaser's investment.16' a gold note is practically identical to a cash-settled, prepaid forward contract on gold. an investor who purchases a gold note receives the same legal rights that she would have received had she purchased a cash-settled, prepaid forward contract on the underlying property. that is, neither the purchaser of a gold note, nor the purchaser of a cash-settled, prepaid forward contract on gold, is entitled to receive the underlying property. rather, the purchaser of a gold note and the purchaser of a cash-settled, prepaid forward contract on gold 160. the issues in this article center, for the most part, around the timing and character of income from cdis. the source issue has, for the most part, been relegated to the back burner. the timing and character issues have, however, been the subject of much debate among the commentators. new york state bar association tax section & aba tax section, supra note 74, at 1242-45. the author believes that much of this debate results from the absence of a framework for the taxation of cash-settled, prepaid forward contracts. under current law, at least some portion of the gain or loss from the sale or cancellation of a prepaid forward contract will, in the hands of a private investor, qualify as capital. irc § 1234a. therefore, the classification of some portion of the return from a cdi that resembles a cashsettled, prepaid forward contract as capital gain should not spark controversy. the only question is the extent to which that return should be classified as capital. 161. to the extent that the gold note does not have an underlying property, it seems fair to say that the purchaser of such a note has made a loan followed by a bet. for example, if y lends $1,000 to z in return for either $1,000 or $0, depending on the roll of a dice on the maturity date of the loan, y has really loaned z $1,000 for adequate interest and then wagered the proceeds of that loan. see hariton, supra note 148, at 733-38. [vol 3:8 economically equivalent financial instruments both receive the same thing-the right to a payment in the future equal to the spot price of a certain amount of gold. hence, both of these purchasers receive only creditors' rights against their respective counterparties.'62 the gold note should be classified and taxed as a cash-settled, prepaid forward contract on gold. 63 the basis for this assertion does not lie in the realm of "form over substance." because a gold note and a cash-settled, prepaid forward contract on gold are identical in both form and substance, the label that the parties attach to the gold note should be disregarded. simply put, the code should not permit an investor to manipulate the timing, character, and source of her income simply by altering the label attached to (as distinguished from the form of) her investment. 2. gold notes with fully contingent principal and noncontingent interest.-a gold note could conceivably provide for periodic interest payments followed by a payment at maturity equal to the value of a certain amount of gold (a "guaranteed interest gold note"). because the repayment of principal on a guaranteed interest gold note is fully contingent, that instrument should be treated as a loan coupled with a cash-settled, nonprepaid forward contract."6 if the recommendations in this article were adopted, a guaranteed interest gold note would not be taxed any differently than a gold note. this is because the purchaser of a gold note will be required to accrue interest income between the purchase date and the forward date. because the guaranteed interest gold note already provides for periodic interest payments, the purchaser of that note will include these interest payments in income as they are received. the amount of gain or loss recognized by a purchaser of a guaranteed interest gold note upon the maturity of that note should not differ from the amount of gain or loss recognized by the purchaser of a gold 162. this analysis raises an interesting question: are cash-settled, prepaid forward contracts cdis subject to the cdi regulations? the author believes that we should focus on recharacterizing the gold note as a cash-settled, prepaid forward contract rather than the reverse, because investors may agree to cash settle a forward contract at some time after the execution of the contract. drawing a distinction between the situation where the parties agree upon execution of the contract to settle the contract in cash and the situation where the parties agree at some later time to settle the contract in cash would further open the door to selective taxation. 163. as will be discussed below, this recommendation takes account of the capital contract component of the gold note, see hariton, contingent debt, supra note 68. at 1231, while at the same time insuring that economically equivalent rinancial instruments give rise to income that is identical as to character and source. 164. this rule should apply even if the sum of the interest payments equals the issue price of the note. in that case, the purchaser would be required to accrue the interest over the life of the loan and then recognize capital gain or loss on maturity. this is the easiest way to tax the time value component of the note. 19971 florida tax review note, because the amount of gold underlying the guaranteed interest gold note would be reduced to reflect the fact that the issuer of that note must make periodic interest payments to the purchaser. 3. gold notes with partially contingent principal a. introduction.-assurming that the above recommendations represent sound tax policy, one must address a much harder question: what is the appropriate tax treatment of an instrument with respect to which only a portion of the principal is contingent (a "gold note with ncp" (noncontingent payments))? in order to answer that question, one must first classify a gold note with ncp as either debt or something other than debt. that classification is difficult to determine because, so long as there are different rules for contingent and noncontingent principal obligations, investors will be able to subject themselves to the set of rules that is most advantageous to them. 65 one must keep in mind, however, that the current state of affairs is both unacceptable (insofar as it accords different tax treatment to instruments that are identical in both form and substance) and unlikely to undergo any significant changes in the foreseeable future."6 the best course of action is to identify the minimum amount of principal that the issuer must be obligated (by the terms of the note) to return in order for a gold note with ncp to qualify as debt. if, for example, 90%167 were chosen 165. cf. hariton, new rules, supra note 68, at 235 (criticizing the bifurcation regulations as inadequate, because, under those regulations, it is so easy "to steer in and out of bifurcated treatment that the [bifurcation regulations] may prove a bonanza for financial engineers"). 166. but see haskins, supra note 71, at 544 (suggesting that congress may reform the tax treatment of corporations and eliminate the distinction between debt and equity). mr. haskins' suggestion came in the wake of the 1994 congressional elections, when it appeared that tax reform might actually occur. given the results of the 1996 elections, however, the possibility of significant tax reform along the lines suggested by mr. haskins seems remote (at best). 167. the author acknowledges that this number is completely arbitrary. one must, however, draw the line somewhere. after analyzing the debt/equity cases, and reading the seminal "plumb article" on the debtequity distinction, the author's opinion is that a bright line is superior to a facts-and-circumstances analysis. this bright line test will hopefully eliminate some of the uncertainty that plagues other financial instruments. see, e.g., robert willens, unbundling securities: searching for a coherent policy, 53 tax notes 1513, 1513 (dec. 30, 1991) ("two securities which have gained widespread popularity, namely percs and so-called 'r&d... units,' are heavily penalized by the lack of certainty attending the manner in which they are properly taxed. in fact, this lack of clarity is a pervasive problem faced by investment bankers and their counsel charged with the responsibility of designing and marketing new financial products."); cf. david p. hariton, more on bifurcation of contingent debt, letters to the editor, 51 tax notes 1075, 1076 (may 27, 1991) ('the very thought of writing a public [vol. 3:8 economically equivalent financial instruments as the minimum amount of principal, a gold note with ncp with a $1,000 issue price and minimum return of $900 of principal would be treated as a debt instrument; if that note promised a minimum return of $989 or less of principal, then the instrument would be treated as something other than debt. once it is established that a gold note with ncp is "something other than debt," one must determine exactly what that note is."r at this point, three alternatives arise. first, one could simply ignore the noncontingent component of the note and treat the note as a standard gold note. second, one could treat the instrument as consisting of a zero coupon bond coupled with a cash-settled call option on the underlying property. that solution ("the bifurcation approach") is an extension of the bifurcation regulations. third, one could treat the instrument as consisting of a cash-settled, prepaid forward contract on the underlying property coupled with a cash-settled put option on that property. that alternative is an offshoot, rather than an extension, of the underlying rationale of the bifurcation regulations. the first alternative, although simple, is unacceptable. one cannot ignore a noncontingent payment for the purpose of convenience. this is because, as will be discussed below, the purchaser of a gold note with ncp most likely paid for the noncontingent payment right by foregoing a certain amount of interest on the money that she loaned to the issuer.'6 from the standpoint of accurately determining the purchaser's income, it would be imprudent to ignore the noncontingent payment right. there are three reasons why the bifurcation approach should not be adopted. first, under the bifurcation approach, the purchaser will allocate a portion of the purchase price of the note to a hypothetical zero coupon bond and the remaining portion of the purchase price to premium on a hypothetical call option. under current law, the purchaser will accrue interest on the portion of the purchase price allocated to the zero coupon bond, but will not accrue interest on the portion of the purchase price allocated to the call option. thus, under the bifurcation approach, the purchaser will not accrue interest on the entire amount of money actually advanced to the issuer. second, the parties to a cdi can manipulate the amount of basis allocated to disclosure setting out the 10 possible ways in which an instrument can be divided into component parts and how each component part would be taxed if it was among those chosen by the internal revenue service (only to have someone burst into my office with an eleventh) makes me shudder. as for the success of the common law approach in lucas v. earl, the supreme court's decision in arkansas best, and the myriad cases fleshing out the distinction between equity and debt are better examples of how this [common law] approach [to classifying financial instruments] works in the realm of complex financial transactions."). 168. the proper classification and taxation of gold notes with ncp is of practical importance because issuers of publicly traded commodity-indexed obligations typically provide for a minimum fixed principal payment at maturity. see land, supra note 148. at 238 n.5. 169. see infra note 177. 19971 florida tax review the long call option, and thereby maximize the portion of the issue price on which interest will not accrue, simply by manipulating computation of the present value of the hypothetical zero coupon bond. 170 there exists a third, and more compelling, reason for not applying the bifurcation concept in connection with the recommendations espoused in this article: the above recommendations would treat the gold note as a cashsettled, prepaid forward contract for all purposes of the code. this means that gold notes would qualify as positions in property within the meaning of section 1092. the hypothetical zero coupon bond contained in the gold note with ncp would not be subject to section 1092. thus, if the bifurcation approach were to apply to gold notes with ncp, taxpayers would be free, to a certain extent, to structure their way out of section 1092 simply by purchasing a gold note with ncp. 171 therefore, the author would apply the third alternative to gold notes with ncp. b. the modified bifurcation approach i. introduction.-the third alternative (hereafter, the "modified bifurcation approach") is similar to the bifurcation approach insofar as it classifies a gold note with ncp as a combination of two positions. as will be discussed below, however, the modified bifurcation approach is superior to the bifurcation approach for two reasons. first, the modified bifurcation approach provides a simpler method for allocating the purchase price of the gold note with ncp between the prepaid forward contract and put option components of that note. second, the modified bifurcation approach will not permit taxpayers to structure their way out of section 1092. under the modified bifurcation approach, the prepaid forward contract and the hypothetical long put option would be treated as a single position. that is, the purchaser of a gold note with ncp would not recognize capital gain or loss on the note until either the sale or maturity of the note. the amount of that gain or loss would be computed with reference to the 170. see lokken, supra note 68, at 498-99 (indicating, through examples, that the bifurcation approach leads to inappropriate results in certain instances). for example, as the present value of the guaranteed payment decreases, the amount of basis assigned to the zero coupon bond decreases and the amount of basis assigned to the option increases, and vice versa. thus, under the bifurcation approach, the parties could manipulate the amount of ordinary income and capital gain recognized by the purchaser by distorting the calculation of the present value of the zero coupon bond component of the gold note with ncp. 171. one must distinguish the hypothetical zero coupon bond referenced above from the zero coupon bond component of a prepaid forward contract. the former exists separately from any other contractual right, and is therefore not subject to the straddle rules. the latter only exists as one component of a prepaid forward contract, which contract, in and of itself, is potentially subject to the straddle rules. [vol. 3:8 economically equivalent financial instnrments combined basis of the forward contract and the put option, and the character of that gain or loss would be determined by reference to the nature of the underlying property."' ii. application of the modified biftircation approach.-in applying the modified bifurcation approach, one need not confront the allocation problems that plague the bifurcation approach. under the modified bifurcation approach, the entire purchase price of the gold note with ncp is allocated to the prepaid forward contract component of the note. this allocation rule is premised on the notion that, in order to obtain the noncontingent payment right (i.e., the put option), the purchaser of a gold note with ncp gives up a portion of the return to which she would have otherwise been entitled. in order to account for the fact that the purchaser of a gold note with ncp pays for the put option by forfeiting a portion of her future return, the purchaser should be treated as: (1) purchasing a prepaid forward contract in cash, (2) purchasing the long put option on credit from the seller of the gold note with ncp,'i and (3) paying for the put option with a portion of the interest that accrues on the prepayment amount (i.e., that amount of interest that the purchaser gave up in order to obtain the noncontingent payment right). thus, the entire purchase price of the gold note with ncp is allocated to the forward contract component of that note. 174 therefore, no difficulty would be encountered 172. irc §§ 1234(a) (with respect to a purchased option contract, character of gain or loss is determined by reference to the nature of the underlying property in hands of the holder), 1234a (with respect to forward contracts, the nature of gain or loss on cancellation of the contract is determined by reference to the nature of the underlying property in hands of the taxpayer). 173. one may inquire as to the basis of the put option. the basis of that option could only be relevant where the purchaser sells the gold note with ncp prior to the maturity date of that note. in theory, because the purchaser of a gold note with ncp acquired the put option on credit from the seller, she should be required to include in her amount realized the remaining "principal amount" on the "purchase money note" with which she acquired the put option. the purchaser need not do that, however, because, as discussed infra notes 175-177 and accompanying text, she will, over time, allocate a portion of the interest that accrues on the issue price of the note to the long put option. thus, where the purchaser sells the gold note with ncp prior to maturity, she simply gives up her right to future unaccrued interest on the issue price of the note and does not experience a cancellation of indebtedness in the conventional sense. thus, the purchaser need not include in her amount realized any portion of the future interest that would be allocated to the put option, as that interest amount will be realized by the transferee of that note and then allocated to the put option. 174. this recommendation is similar in some ways to the suggestions made by other commentators. see, e.g., hariton, new rules, supra note 68, at 238 (suggesting that holders of cdis should (1) accrue interest on the entire purchase price of the cdi, and (2) recognize capital gain or loss on the difference between the amount received on maturity of the cdi and 19971 florida tax review in determining the prepayment amount of the prepaid forward contract. more importantly, the purchaser would be required to accrue interest on the entire amount of money that she advanced to the issuer.'75 example. b purchases a gold note with ncp from z co. for $1,000. the note provides for one payment at maturity equal to the greater of $500 or 3.5 ounces of gold. b is treated as purchasing a prepaid forward contract for $1,000 and a put option on credit. b accrues interest income on the $1,000 prepayment over the life of the gold note with ncp. b is treated as receiving the interest income and then allocating a portion of the interest payments to the "purchase money note" used to acquire the put option. upon maturity, b's basis in the put option is equal to the sum of the interest payments allocated to the put option. upon maturity, b's basis in the forward contract is equal to the sum of the purchase price of the gold note with ncp and the interest payments that were not allocated to the put option. upon maturity, b will recognize gain or loss with reference to the combined basis of the forward contract and the put option. the basis will be equal to the sum of (1) the issue price of the gold note with ncp and (2) the amount of imputed interest income on the zero coupon bond component of the forward contract. 76 the sum of the issue price and accrued interest amounts); hariton, supra note 167, at 1075; reed shuldiner, a general approach to the taxation of financial instruments, 71 tex. l. rev. 243 (1992) (addressing timing problems raised by complex financial instruments through the use of an expected value taxation system). these approaches did not, however, address the sourcing issues posed by cdis. more importantly, they apparently would not treat a gold note, or any of the gold note variations discussed in this article, as a "position in personal property" within the meaning of § 1092. see supra note 87. this means that, unless gold notes are positions in personal property under current law, an investor would potentially be free, under the above approaches, to structure her way out of the straddle rules by moving from a cashsettled, prepaid forward contract on gold to a gold note. see supra note 87. for these two reasons, the recommendations in this article, although somewhat more complicated, are superior from a policy perspective to the above approaches. 175. in determining the amount of interest to be accrued on the prepayment amount (i.e., the zero coupon bond component of the prepaid forward contract), one would have to disregard the quantity of the underlying property referenced in the gold note with ncp. this is because that quantity was (most likely) decreased by the issuer of the note to reflect the fact that the holder is entitled to a guaranteed minimum payment. 176. the author would treat the purchaser of a gold note with ncp as receiving the put option on credit from the seller, and then repaying that loan with a portion of the imputed interest payments that the purchaser receives on the zero coupon bond component of the prepaid forward contract. this approach, in essence, requires the purchaser of a gold note with ncp to allocate a portion of the interest payments between the basis of the put option and the basis of the zero coupon bond. this approach results in an understatement of the basis of the zero coupon bond. moreover, an allocation of basis such as the one above would not occur [vol. 3:8 economically equivalent financial insntmenis iii. critique of the modified bifurcation approach.-the main weakness in the modified bifurcation approach is that it treats the purchaser as purchasing an option on credit. this is a somewhat novel approach, because the holder of an option usually must pay an option premium up front. there is no reason, however, why a holder cannot purchase an option with an installment obligation.'" the main disadvantage of this approach, from the standpoint of the purchaser, is that the purchaser will be required to recognize more interest income than she is actually entitled to receive under the terms of the gold note with ncp. however, this treatment is appropriate because the purchaser of a gold note with ncp necessarily forfeits future interest (on the zero coupon bond component of the prepaid forward contract) in return for a guaranteed minimum payment.' 78 otherwise, the issuer of the note would have no incentive to offer such a payment. it therefore is appropriate to treat a purchaser of a gold note with ncp as (1) receiving all of the interest to which she would otherwise be entitled, and (2) purchasing the right to noncontingent payments (i.e., the long put option) with a portion of that interest. in the end, this approach will accord the purchaser of a gold note with ncp a higher integrated basis than she would have had if she had been if the forward contract and the put option components of the gold note with ncp were purchased separately. however, the issuer of the gold note with ncp understated the payment to which the purchaser is entitled at maturity because, in the absence of the noncontingent payment right, that payment at maturity would have been larger. because this approach would not require the parties to a gold note with ncp to gross up the payment at maturity to reflect the fact that it has been artificially reduced, no adjustment is necessary to the basis of the zero coupon bond component of the forward contract to reflect the fact that it too has been artificially reduced. in essence, given the integrated nature of the forward contract and the put option, the discrepancies in basis will come out in the wash. 177. in fact, many commentators note that investors who purchase debt instruments with embedded options often receive less interest income than they would have received had they purchased a debt instrument without the embedded option; that is, investors can purchase embedded options with foregone interest. kau, supra note 131. at 1004 ("because convertible debt can be economically analyzed as straight debt with an option, a holder can be viewed as having paid for the [embedded] option by foregoing a market rate of interest for the term of the bond."); hariton, supra note 148, at 780 ("under current law, less is deemed to be paid for the use or forbearance of money when it is borrowed under a convertible debt obligation."). in addition, where an investor purchases a share of preferred stock, such as a perc, which is the equivalent of a share of common stock and a short call option, the investor will not receive an option premium for that short call option; rather, that investor will receive more dividend income from that instrument than she would have received had she purchased a share of stock that did not have an imbedded short call option. edward d. klcinbard, what's new with financial products?, 334 pli/tax 9, 37 (westlaw, pli-tax) (1992). 178. see supra note 177 (purchasers of debt instruments that contain embedded options typically forego interest income in return for that embedded option). 19971 florida tax review required to bifurcate the purchase price of that note between the forward contract and the put option. this means that the purchaser will, upon maturity of that note, recognize less capital gain or more capital loss than she would have recognized had she been required to bifurcate the purchase price between the forward contract and the long put option. that potential advantage, however, is effectively eliminated through the periodic accrual of interest on the full issue price of the gold note with ncp.17 9 4. effect of the straddle rules a. background.-a less obvious effect of the above recommendations is that gold notes will definitely constitute "positions" in property and will, in certain cases, be subject to the straddle rules contained in section 10922"° the term "straddle" refers to the situation in which a taxpayer holds two or more positions in the same property that, economically, 179. it may be prudent, however, to include an anti-abuse rule in the rules applicable to gold notes with ncp. after all, the service learned the hard way that taxpayers can, for tax avoidance reasons, structure their way into regulations that front load income and back load basis recovery. for example, the service recently won a tax court case in which a partnership known as "acm," which was formed by the colgate-palmolive company [hereinafter colgate) and merrill lynch, entered into a series of transactions that were designed to take advantage of temp. regs. § 15a.453-1(c). acm pship., southhamptonhamilton co. v. commissioner, 73 t.c. memo (cch) 2189, t.c. memo (ria) t 97,115 (1997); see steven m. surdell, the role of business purpose in complex financial transactions-acm partnership v. comr., special edition, corporate tax and business planning review, 37 tax mgmt. memo. s-311 (nov. 25, 1996). that regulation provides for ratable basis recovery in the case of installment sales that contain a contingent sales price. by providing for ratable basis recovery, that regulation will mandate a large gain recognition in early years and large loss recognition in later years where the taxpayer receives a large noncontingent payment in an early year and a small contingent payment in a later year. acm wanted to generate present income and future losses, and it therefore structured its way into temp. regs. § 15a.453-l(c). the service was forced to litigate the issue of whether a taxpayer must show some bona fide business purpose in order to fall within that regulation. lee a. sheppard, colgate's corporate tax shelter showdown, 71 tax notes 1284 (june 3, 1996); lee a. sheppard, court hears final arguments in colgate tax shelter case, 96 tnt 107-3 (may 31, 1996) (lexis, fedtax library, tnt file). perhaps, if that regulation had contained an anti-abuse rule, the service would have had an easier time litigating its case. the author is not clever enough to envision every case in which a taxpayer would want to recognize large amounts of interest income presently and large amounts of capital losses in the future. in that corporations can act as investors, one realizes that it is not terribly difficult to envision a handful of such situations. for example, a taxpayer may wish to front load ordinary income in order to use up expiring net operating losses and then defer a capital loss into the future in order to soak up capital gains. therefore, the author would include an anti-abuse rule in the above recommendations. 180. see supra note 87 (under present law, it is unclear whether gold notes are positions in personal property within the meaning of the straddle rules). [vol 3:8 economically equivalent financial insiniments behave in opposite ways.' in a straddle, one position will reduce the risk of loss (or opportunity for gain) inherent in the other position.' ° for example, if a taxpayer enters into a long forward contract to purchase a barrel of oil for $10 and then enters into a short forward contract to sell that barrel of oil to someone else for $10, the taxpayer is in a straddle. that is because, as the value of that barrel of oil increases beyond $10, the taxpayer's long forward contract (i.e., the purchase contract) increases in value, whereas the short forward contract (i.e., the sale contract) decreases in value; as the value of that barrel of oil decreases below $10, the taxpayer's long forward contract decreases in value, and the short forward contract increases in value. section 1092(a) defers the recognition of certain realized losses in cases where the taxpayer has an unrecognized gain in one or more offsetting positions. 181 thus, if a taxpayer is in a straddle, she will not be able to recognize loss on one position in that straddle to the extent that there exists unrecognized gain in another position in that straddle." 4 it is important to note that the straddle rules apply to positions in property for which there is an established market. therefore, even if a particular gold note is executed by private parties and is not an actively traded security, that gold note will be subject to the straddle rules if the underlying property is an actively traded asset. b. fully contingent gold note.-under the above rules, if a taxpayer holds both a gold note and an offsetting (viz., short) position with respect to gold, then the taxpayer will not be able to recognize any loss on either of these two positions to the extent that there is unrecognized gain in the other position. 181. see 2 kramer, supra note 58, at 1211. 182. see 2 kramer, supra note 58, at 1211. 183. irc § 1092(a)(1). section 1092(c)(2)(a) provides: a taxpayer holds offsetting positions with respect to personal property if there is a substantial diminution of the taxpayer's risk of loss from holding any position with respect to personal property by reason of his holding 1 or more other positions with respect to personal property (whether or not of the same kind). 184. irc § 1092(a). section 1092(d)(2) provides that "the term 'position' means an interest (including a futures or forward contract or option) in personal property." section 1092(d)(1) defines personal property as "any personal property of a type which is actively traded." regulations section 1.1092(d)-1(a) states, "[a]ctively traded personal property includes any personal property for which there is an established financial markel" subsection (b) of that regulation states that the term "established financial market" includes: (1) a national securities exchange, (2) an interdealer quotation system. (3) a domestic board of trade designated as a contract market by the commodities futures trading commission. (4) certain foreign securities exchanges, (5) an interbank market, (6) an interdealer market, and (7) (solely with respect to debt instruments) a debt market. regs. § 1. 1092(d)-l(b). 19971 florida tax review example. b purchases a gold note with a ten year maturity for $1,000. that note entitles b to the value of 4 ounces of gold. b then enters into a short, cash-settled forward contract on gold. prior to the maturity date of the gold note, b cancels the short forward contract for a $500 loss. section 1092(a)(1) defers that loss to the extent of the unrealized gain in the gold note. that is, if, on the last business day of the taxable year in which b canceled the short forward contract, the fair market value of the gold note exceeds b's basis therein, then the loss on the forward contract will be deferred to that extent. 185 c. gold notes with ncp-the following paragraphs will analyze the application of the straddle rules to investors who purchase a gold note with ncp and then subsequently (1) purchase a put option on gold or (2) sell a call option or forward contract on gold. this article recommends that gold notes with ncp be treated as a single position consisting of a long forward contract and a long put option. if the purchaser of a gold note with ncp enters into another position, such as a freestanding long put option, that is offsetting with respect to the long forward contract component of the gold note with ncp, then the purchaser will not be able to recognize loss on the freestanding long put option to the extent there is unrecognized gain in the gold note with ncp, and vice versa. 186 185. if the offsetting positions in the above example were gold futures contracts subject to § 1256, then the taxpayer could elect to have § 1256 not apply with respect to those futures contracts. if the taxpayer did not make that election, then any losses recognized under the mark-to-market regime would be deferred under § 1092 unless the taxpayer elected to utilize straddle-by-straddle identification or a mixed straddle account under § 1092(b)(2). either of those alternatives are beyond the scope of this article. 186. see irc § 1092(c)(2)(a). the long put option imbedded in the gold note with ncp decreases at least some of the risk of loss inherent in holding a long forward contract on gold. an investor can encounter straddle problems if she purchases a gold note with ncp and then subsequently purchases a put option on gold ("free-standing put option"). if the freestanding put option eliminates the risk of loss remaining in the gold note with ncp, then the free-standing put option should be subject to the straddle rules. if, however, the free-standing put option has a strike price that exceeds the difference between the price paid for the gold note with ncp and the noncontingent payment on that note, then (1) the taxpayer has increased her risk of loss to the extent of the premium paid for that excess, and (2) the taxpayer should not be subject to the straddle rules for the loss recognized with respect to that excess premium. these conclusions employ the word "should" instead of "will" for a simple reason. section 1092(c)(2)(b) provides "[i]f 1 or more other positions offset only a portion of i or more positions, the secretary shall by regulations prescribe the method for determining the portion of such other positions which is to be taken into account for purposes of this section." [vol. 3:8 economically equivalent financial instnmenis an investor can also enter into a position that eliminates her opportunity for gain (i.e., a short position) on the forward contract component of the gold note with ncp. for example, an investor could purchase a gold note with ncp and then either (1) write a cash-settled call option on gold or (2) enter into a short, cash-settled forward contract on gold. if that investor terminates either of these short positions at a loss, then she will not be able to recognize that loss to the extent there is unrecognized gain in the gold note with ncp, and vice versa.'8t c. recommendations for equity swaps 1. recommendations a. introduction.-the main difference between gold notes and equity swaps is that there exists a system governing the timing of income from equity swaps. this article does not recommend changing that timing system. rather, this article only recommends changes to the rules governing the character and source of income from equity swaps. with respect to a private investor who purchases a long equity swap from another private investor, the main issue will center on whether that other private investor liquidated any investment that she may have had in the underlying property."r that issue is beyond the scope of this article. b. character.-long equity swaps should be treated for tax purposes as a series of cash-settled forward contracts. therefore, the character of items of income, as well as loss, from equity swaps should be determined under section 1234a. if the purchaser of a long equity swap also purchases the right to receive a minimum amount of income from her counterparty, then the equity swap should be treated in the same way as a gold note with ncp.'89 these two recommendations will insure that equity swaps receive the same tax the service has yet to issue regulations under that section. thus, it appears that, if a position, such as the free-standing put option, is only offsetting with respect to a portion of another position (e.g., a long forward contract), any loss on such position will be deferred to the full extent of the unrecognized gain in that other position. 187. see supra note 186. 188. see bruce kayle, will the real lender please stand up? the federal income tax treatment of credit derivative transactions, 50 tax law. 569. 579 (1997). 189. the right to receive a specific amount of money under a notional principal contract is known as a "floor." a floor is economically equivalent to a series of cash-settled put options. for that reason, where an investor enters into an equity swap that entitles him to a minimum return on each swap payment (or the equity swap as a whole), the swap and the floor should be coupled, and any gain or loss on that position should be treated as capital under §§ 1234(a) and 1234a. 19971 florida tax review treatment accorded gold notes, and that equity swaps with floors will receive the same tax treatment as gold notes with ncp. c. source.-equity swaps should be subject to the same sourcing rules applicable to forward contracts. for example, a long equity swap into u.s. real estate should be sourced in the same manner as a long forward contract on u.s. real estate. to the extent that the sale or exchange of a forward contract would give rise to foreign source income, then the payments received under an equity swap should give rise to foreign source income. the above discussion indicates that sourcing all equity swap income to the residence of the recipient can give rise to abuse. 9 ' this article recommends that the portion of an equity swap payment that represents income from the underlying property (e.g., dividends) should be (1) treated as a separate payment outside the equity swap and (2) sourced in the same way as the income from the underlying property would otherwise be sourced.19' this treatment is appropriate for two reasons: first, an equity swap is supposed to be the economic equivalent of a series of cash settled forward contracts, and forward contracts do not entitle the purchaser to income from the underlying property. second, foreign investors should not 190. example. j, a nonresident alien individual, purchases stock in l co., a u.s. corporation. j also purchases an equity swap on the stock of y co., a u.s. corporation. the equity swap entitles j to the appreciation and dividends on y co. stock; in return, j agrees to pay the counterparty the depreciation on y co. stock and interest at a specified rate. l co. declares a dividend, and j pays a 30% tax on that dividend. irc §§ 861(a)(2) (dividends from a u.s. corporation are u.s. source income), 871(a) (a nonresident alien individual must pay 30% tax on u.s. source dividend income). y co. declares an equally large dividend, and the counterparty to j's equity swap makes a payment to j in an amount equal to that dividend. under the current sourcing rules, j does not pay any u.s. tax on the dividend equivalent payment under the equity swap. 191. one might argue that it is inappropriate to tax both the holder of a share of stock and the purchaser of an equity swap into that stock on the same dividend declaration. consider the case, however, of a tax-exempt entity, such as a pension fund, or a tax-exempt person, such as a foreign national who lives in a country that has a tax treaty with the u.s. that exempts dividend income from taxation. see sheppard, supra note 108, at 1314-15 (institutional investors often sell equity swaps in order to "improve equity returns or change their bets on the stock market's direction."). either of these parties could purchase stock and then sell an equity swap on that stock for a small fee; in such a case, neither the party who really wanted the stock (i.e., the purchaser of the equity swap) nor the actual purchaser of the stock (i.e., the tax exempt party who sold the equity swap) will be subject to u.s. tax on that dividend income. thus, the recommendations set forth in this article are designed to protect the fisc from the above transaction at the risk of taxing the same dividend declaration twice in certain nonabusive situations. [vol 3:8 economically equivalent financial instruments be able to structure their way out of u.s. tax simply by changing the label attached to their investments. 2. effect of the straddle rules.-notional principal contracts already qualify as positions in personal property." thus, equity swaps on a particular underlying property are already subject to section 1092 to the same extent as forward contracts on that same property. therefore, the recommendations in this article will simply force the straddle rules to treat equity swaps and gold notes in the same manner. d. second best problems 1. economic equivalencies between a long forward contract and ownership.-this article recommends changes to the timing, character, and source of income generated by three broad categories of financial derivatives and suggests that these recommendations also be applied to any new derivatives that are economically equivalent to the derivatives which are the subject of this article. the goal of this article is to develop interim changes to our current system with the idea that they will solve many of the tax policy problems presented by financial derivatives while at the same time providing a segue to a system in which holders of financial instruments accrue yearly the economic income generated by these instruments. these interim changes should, to the maximum extent possible, synchronize the tax treatment of economically equivalent financial instruments so that financial instruments that produce identical cash flows receive identical tax treatment. the merit of this article's recommendations should not be evaluated from the standpoint of normative "first best" tax principles, but rather through an analysis of the trade-offs and inconsistencies that are inherent in any "second best" solution. the theory of second best states that "if one or more constraints prevents the attainment of optimal conditions, one cannot predict in the abstract whether removing any other constraints will improve or worsen conditions."'93 if one views the haig-simons definition of income as the normative first best system, and thus the "optimal condition," then the recommendations in this article at most will move us closer to that optimal condition. this is because this article does not suggest that a taxpayer should accrue the economic income generated by capital assets such as stock or gold prior to the time that she disposes of that asset in a realization event. the 192. regs. § 1.1092(d)-i (c). for a discussion of the application of the straddle rules to equity swaps, see avi-yonah et al., supra note 107, § 3:47. 193. daniel n. shaviro, selective limitations on tax benefits, 59 u. chi. l rev. 1189, 1203-04 (1989) (citing r.g. lipsey & kelvin lancaster, the general theory of second best, 24 rev. econ. stud. 11 (1956)). 19971 florida tax review article's adherence to the realization requirement stems from the reality that congress presently will not require taxpayers to accrue income on capital assets and has therefore precluded the immediate attainment of the "optimal condition." thus, in evaluating the recommendations in this article, the proper question is whether they "would bring an already defective system closer to the ideal."'" in answering that question, one must, among other things, answer the related question of whether, even if the recommendations in this article do bring us closer to the ideal system, they produce more harm than good. the recommendations in this article are admittedly second best solutions that are designed to function within, rather than eliminate, the current law distinctions (artificial though they may be) between debt and equity on the one hand and ordinary income and capital gain on the other. in doing so, these recommendations simply utilize the principles of current law to require purchasers of certain financial instruments to recognize for tax purposes the interest income that they are recognizing economically. for example, assume that a and b enter into a cash-settled forward contract that requires a to pay b $100 in year 2 and requires b to pay a the spot price of one share of x co. stock in year 2. further assume that a currently owns $85. at this point, a has incurred an obligation to pay $100 in year 2, and can satisfy that obligation in one of two ways. first, a can lend $85 to a third party and hope to earn $15 after tax over two years. second, a can advance $85 to b and extinguish her liability to pay $100 in year 2. this article asserts that a should not be taxed differently depending on the identity of the party to whom she advances the money with which she will ultimately satisfy her obligation to pay b $100. (perhaps the use of certain principles of current law which require taxpayers to recognize for tax purposes their economic income provides sufficient justification for the implementation of this article's recommendations.) one could, however, easily argue that the proper paradigm of the above transaction is a direct ownership interest in x co. stock, on which a need not accrue income under current law. that is not, however, the correct analysis. the critical difference between a direct ownership interest in x co. stock and a cash-settled, prepaid forward contract on x co. stock is that, in the latter case, the purchaser receives an immediate and certain economic benefit by virtue of the prepayment, which economic benefit results from the advance that she makes to the seller. for example, suppose that the two year forward price of one share of x co. stock is $100, and that a pays b $85 today in exchange for such a two year forward contract. in that case, a 194. noel b. cunningham & deborah h. schenk, colloquium on capital gains: the case for a capital gains preference, 48 tax l. rev. 319, 325 (1993). [vol. 3:8 economically equivalent financial instrniments receives a guaranteed economic benefit of $15 as a result of the advance of $85 to b, because that advance extinguished her obligation to pay $100. as discussed above, that $15 benefit is properly characterized and taxed as interest. the purchaser of a share of x co. stock may expect a future benefit of $15. that benefit, however, is wholly contingent on the value of x co. stock in two years. that contingent benefit must not be confused with the economic benefit realized by a on the prepayment of the forward contract on x co. stock, because that latter benefit is determined solely by reference to the forward price of x co. stock, which is fixed. put differently, by coming out of pocket with $85 today, a need not come out of pocket with $100 in two years, which means that a will, in all events, receive an economic benefit of $15. in the context of our current system, where the key distinction is between debt, which connotes a fixed obligation to receive a sum certain on a given date, and equity, which connotes a wholly contingent investment of money in an enterprise, it seems logical to analyze a contractual arrangement between two parties by first determining whether that arrangement, or a component of that arrangement, is debt or equity. having concluded, as above, that a cash-settled, prepaid forward contract contains an embedded loan, it becomes easier to justify the taxation of the interest component of that loan. in that sense, the recommendations in this article certainly move us closer to the "optimal condition." once one accepts the notion that the recommendations in this article accomplish what they set out to do (i.e., bring us closer to the haig-simons definition of income while working within our current tax regime), one must ask two more questions: first, what makes the recommendations in this article better than any of the other second best solutions, such as bifurcation, integration, and mark-to-market accounting, that have already been proposed? second, will the recommendations in this article do more harm than good? in responding to the first question, one must keep in mind two points: first, the recommendations in this article are easy to apply, in that they merely require the purchaser of an instrument to accrue interest income on any prepayment and to source and characterize the income from that instrument in a manner consistent with the taxation of the forward contracts to which those instruments are economically equivalent. second, the recommendations in this article apply with equal ease to both publicly-traded and nonpublicly-traded assets. the recommendations in this article are superior to the bifurcation approach for two reasons. the bifurcation approach would reduce a financial derivative into its component parts and then tax these components accordingly.195 for example, the bifurcation approach would treat a gold note with 195. weisbach, supra note 26, at 507. 1997/ florida tax review ncp as a combination of a zero coupon bond that has an issue price equal to the present value of the guaranteed payment and a long call option that has a basis in the purchaser's hands equal to the difference between the issue price of the instrument and the present value assigned to the zero coupon bond. that approach is inadequate because, as discussed above, the purchaser of a gold note with ncp receives an economic benefit with respect to the entire issue price of the note and, under current law, the purchaser would not be required to accrue interest on the portion of the issue price allocated to the option premium. thus, the bifurcation approach, in part, substitutes one tax preferred instrument (the long call option) for another. although the recommendations in this article do not require accrual of interest on non deep-in-the-money options, they do move us closer to a system of economic accrual by classifying instruments as forward contracts to the maximum extent possible. another reason why the bifurcation approach is inferior is that, by characterizing a portion of the gold note with ncp as a zero coupon bond, it allows taxpayers, to a certain extent, to structure their way out of the straddle rules, as zero coupon bonds are not positions in property within the meaning of section 1092. using a mark-to-market system to measure the gains and losses from holding capital assets at the end of each year would certainly move us much closer to the haig-simons definition of income. thus far, congress, most likely due to a combination of administrability and political concerns, has only been willing to apply that system to securities dealers 96 and holders of certain publicly traded options and futures contracts. 7 those limitations highlight one of the key drawbacks of a mark-to-market system-it is quite difficult to value nonpublicly-traded assets each year. by requiring taxpayers to accrue income on any prepayment made in connection with an instrument properly classified as a forward contract, the recommendations in this article avoid the valuation problems inherent in a mark-to-market approach. the integration approach requires the taxpayer and the service to group the taxpayer's financial instrument holdings into larger units for which the tax treatment is (supposedly) settled.' the integration approach may work well in the case of a taxpayer who purchases a share of synthetic stock. the integration approach becomes quite difficult to apply, however, where the taxpayer's holdings do not permit the exact replication of other instruments. for example, if a taxpayer owns a two-year long call option on x co. stock with a strike price of $135, a three-year short put option on x co. stock with a strike price of $60, and a seven year zero coupon bond with an issue price 196. irc § 475. 197. irc § 1256. 198. weisbach, supra note 26, at 526. [vol. 3:8 economically equivalent financial instruments of $150 and a redemption price of $300, it becomes difficult for the service and the taxpayer to integrate these three positions into a share of synthetic stock.' 99 one of the key virtues of the instant recommendations is their simplicity and ease of application. through the mechanisms of accrual of interest and the classification of instruments, we can synchronize the tax treatment of almost all financial derivatives (non deep-in-the-money options remain the exception) and at the same time tax the interest income that accrues economically on financial instruments with respect to which the purchaser makes a prepayment. assuming that the recommendations in this article provide a superior and acceptable second best solution, one must determine whether they will do more harm than good. on the "good" side, these recommendations will insure, to the maximum extent possible, that economically equivalent financial instruments are taxed in the same way. thus, they will further the goals of equity and fairness, thus moving us closer to a tax system embodying the haig-simons definition of income. on the "harm" side, one must acknowledge that the above recommendations will expand the discontinuity in tax treatment between an investment in a financial derivative and a direct investment in the underlying property of that financial derivative. that is, although a cash-settled, prepaid forward contract on x co. stock will always be the economic equivalent of a direct ownership interest in x co. stock, a purchaser of the former instrument will be required to accrue income over the life of the investment while a purchaser of the latter instrument will enjoy the deferral of economic gain. this discontinuity will undoubtedly affect the price of either capital assets (such as shares of stock), which would under the instant recommendations be 199. see may, supra note 25, at 1233 (full integration approach is "impossible to enforce."); see also haskins, supra note 71, at 543 ("although integration may seem more attractive in theory, it relies on the ability of the service to recognize often complex financial equivalencies in taxpayers' portfolios-including 'negative' financial equivalencies that could create complex straddles---and to decide which near-equivalencies are near enough to trigger integrating rules."); kleinbard, supra note 69, at 1361 ("even if a generalized doctrine of tax integration of financial instruments did exist, it is by no means clear that the doctrine could be sufficiently responsive to the pace of financial innovation. the dynamism of contemporary financial strategies means that a financial position might appropriately be viewed as part of a larger synthetic unit today, and a stand-alone position tomorrow."); strnad, supra note 141, at 574 ("integration methods suffer from ... ambiguities. there is more than one way to aggregate sets of instruments into groups, and the overall tax results may depend on the particular choice of groupings. in addition, the proper way to characterize a particular aggregate of instruments may not be clear in a system replete with distinct and sometimes contradictory tax approaches."); jeff strnad, commentary, taxing new financial products in a second-best world: bifurcation and integration, 50 tax l. rev. 545. 563 (1995) (analyzing problems with bifurcation and integration approaches). 19971 florida tax review tax-advantaged products, or financial derivatives, which would be taxdisadvantaged products. the precise effect of these recommendations on the stock market would be difficult to predict.2" one could no doubt find an economist to support any possible result, and an economic analysis of the effect of accrual of income from financial derivatives on the price of stock and other capital assets is beyond the scope of this article. that does not mean that we cannot determine, from a policy standpoint, whether the recommendations in this article do more harm than good. these recommendations promote fairness, consistency, and equality in the tax system in so far as the tax treatment of economically equivalent derivatives is concerned. to the extent that unwarranted tax benefits, such as deferral of gain, may affect the price of instruments that enjoy these benefits, then the proper solution is to remove the unwarranted benefit from these instruments, regardless of the political cost of doing so. we should not let the incorrect tax treatment of certain financial instruments dictate the tax treatment of all financial instruments, particularly where the proper tax treatment of many instruments is attainable under current law principles. in sum, the recommendations in this article would draw a line between the taxation of a financial derivative and the taxation of an ownership interest in the underlying property. to the extent that these interests may be economically equivalent to one another, one must question the appropriateness of that line. in the context of recommendations which are admittedly interim solutions designed to function in a second best world, one must accept the line between the underlying property and the derivative and then determine whether it is a good idea to tax everything on the derivative side of the line in the same way. the answer to that question is yes. with the exception of an option, each derivative discussed above mimics the cash flows generated by a cash settled forward contract. to the extent that one party to one of those derivatives advances money to her counterparty prior to the time at which her counterparty is required to make a payment, the party making the advance payment will receive compensation therefor in the form of an adjustment to the price terms of the derivative. that adjustment represents compensation for the use of money and should be taxed as interest. in keeping with our capital/ordinary distinction, the difference between the amount ultimately realized on the contract and the sum of the advance payment and the accrued interest should be treated as capital gain or loss. a system in which economically identical derivatives receive the same tax treatment and economic benefits received in return for advance payments are treated as interest increases both equality and fairness in tax treatment among 200. cf. calvin h. johnson, why is stock so bloody profitable?, 75 tax notes 1893 (june 30, 1997). [vol 3:8 economically equivalent financial instnments the holders of financial derivatives. until congress overhauls the code, however, we will be left with a potential discrepancy between the tax treatment of a derivative and the tax treatment of its underlying property. we should not, however, leave the whole system in disrepair simply because we are politically unable to fix a portion of it. 2. and what about prepaid rent and services?-one problem with the above recommendations is that, taken to their logical conclusion, they will require purchasers of rent or services (collectively, "services") to accrue interest income whenever they make a prepayment.z" that would lead to a serious discontinuity because, under current law, prepayments for services are treated as income to the recipient at the time of the prepayment. if that rule were applied in conjunction with the above recommendations, then an advance of money from a taxpayer to a service provider would be treated as a loan with respect to the taxpayer and income with respect to the service provider. that, to say the least, would be a unique result. where a taxpayer pays for services prior to the time the services are performed, the taxpayer will most likely receive a discount on the cost of these services just as the purchaser of a prepaid forward contract receives a discount on the forward price in exchange for making a prepayment. the purchaser of prepaid services should be required to account for that discount as interest income for the same reason that the purchaser of a prepaid forward contract should be required to recognize interest income. thus, the law should be changed so that the purchaser of prepaid services is treated as making a loan to the service provider equal to the prepayment amount and then using the loan proceeds to pay for the services as the service provider earns her fee economically. the service provider should recognize ordinary income and interest expense as those items are earned or incurred economically over the life of the service agreement. in cases where the payment for services is fully deductible by the purchaser, the inclusion of interest income will be offset by the deduction of "the true forward price" of the services, which will be equal to the sum of the prepayment and the amount of interest imputed on that prepayment. where the cost of the services is not deductible by the purchaser, e.g., an airline ticket purchased for personal use, the purchaser will be required to recognize interest income without the availability of an offsetting deduction. in the interests of simplicity and administrability, the purchaser of prepaid services should not be required to accrue interest income on the 201. after all, a prepaid contract calling for the performance of services in the future is in essence a prepaid forward contract with services as the underlying property. 19971 florida tax review prepayment amount unless the services are to be performed more than one year after the prepayment.m vi. conclusion the recommendations in this article may go a long way toward resolving the discrepancies in tax treatment among gold notes, equity swaps, and cash-settled, prepaid forward contracts. these recommendations also solve many of the abuses presented by prepaid forward contracts. if applied to other instruments that are economically equivalent to forward contracts or prepaid forward contracts, then the recommendations in this article will eliminate many more discrepancies in the tax treatment of economically equivalent financial instruments. however, these recommendations represent one more plug in a hopelessly cracked dam. by plugging the hole created by prepaid forward contracts, equity swaps, and gold notes, the recommendations will only shift pressure to another point in the dam, and that point will eventually spring a leak. the code has long strived to treat economically identical transactions in the same way. for example, the old rules were enacted to insure that zero coupon bonds received the same tax treatment as the fixed rate bonds to which they were equivalent economically. the oid rules cured a very simple problem. that problem concerned the disparate timing of income from different debt instruments that were economically identical. derivatives such as the gold note, however, give rise to discrepancies between economically identical instruments that relate to the timing, character, and source of income.203 as long as the code insists on drawing distinctions between equity and debt instruments and ordinary income and capital gains, these discrepancies will remain.2° until the code eliminates 202. cf. hal gann & roy strowd, the enormous complexity of being fair, 66 tax notes 1711, 1711-12 (mar. 13, 1995) ("sometimes, when the level of precision sought by the statute fails to justify the complexity it causes, the irs and treasury can rebalance the two. in treas. reg. section 1.55-1, the irs and treasury got some support for simplifying the individual amt, even in a way that cost many taxpayers money."); see generally john a. miller, indeterminacy, complexity, and fairness: justifying rule simplification in the law of taxation, 68 wash. l. rev. 1 (1993). 203. see warren, supra note 66, at 461 ("[o]ur realization-based income tax has relied on a dichotomy between fixed and contingent payments that has never been completely coherent. recent innovations in financial contracts allow taxpayers to further exploit that incoherence,"). 204. see warren, supra note 66, at 467 ("owning a share of stock will always yield the same result as owning a zero-coupon bond, buying a call, and writing a put when the strike prices are equal to the amount due under the zero, and the exercise date of both options is also the due date of the zero.... at this point, the theoretical challenge presented by put-call [vol 3:8 economically equivalent financial instnunents these distinctions, (1) issuers will continue to develop products that satisfy the tax needs of particular investors, and (2) the service will continue to develop rules that target these products. the only comprehensive solutions to the problems posed by derivatives involve radical changes to our current tax system. most commentators offer five possible alternatives to our current system: (1) mark-tomarket taxation of more financial instruments,2 (2) full integration of financial instruments, (3) limitations on deductions, (4) disaggregation of financial instruments, and (5) taxation of financial contracts based on formulas that reflect the economic substance of a particular contract.m6 a discussion of the merits of those five approaches is beyond the scope of this article. it suffices to say, however, that the discrepancies in the tax treatment of different financial instruments result from tax law distinctions that the financial markets have rendered meaningless.20 perhaps it goes too far to suggest that the debt/equity and ordinary/capital distinctions are meaningless. after all, investors still use these distinctions to determine which financial instruments, on an after-tax basis, best suit their needs. in the years to come, commentators will undoubtedly stress the need for significant changes in the tax treatment of derivatives. this article questions not the merit of, or need for, these proposed changes, but, rather, the ability of the government to effect these changes. therefore, this article posits that some change is better than no change at all. parity to the income tax distinction between fixed and contingent returns should be apparent. if modem financial practice will permit the creation of such synthetic shares of stock, we will have two positions that yield identical results apart from taxes, but which are subject to different taxing regimes."). 205. some commentators suggest that the expansion of mark-to-market taxation would (1) give rise to administrative burdens and (2) be limited in scope. warren. supra note 66, at 474. in addition, the expansion of the mark-to-market system would not address the disparities in the character and source of income discussed above. warren, supra note 66, at 474. 206. warren, supra note 66, at 492; strnad, supra note 141. 207. see warren, supra note 66, at 492 ("recent innovations in financial contracts have exacerbated the difficulties of applying the dichotomy [between fixed and contingent payments] in practice because contracts can be devised that produce substantially identical returns, but fall on opposite sides of the traditional distinction [between debt and equity]."). the development of new financial instruments has only served to further weaken the already tenuous line between debt and equity. see hariton, supra note 92, at 1033-35 (discussing the similarities between preferred stock and debt; "[o]ne faces the enigma that, given its fixed payment schedule, preferred stock is itself a hybrid, and one that is arguably closer to debt than it is to common stock."). 19971 florida tax review volume 4 1999 number 4 taxation of electronic commerce: federal income tax issues in the establishment of a software operation in a tax haven david r. tillinghast* i. introduction ................................ 341 11. basic issues that will recur ................... 341 i. hypothetical fact pattern ..................... 343 iv. united states taxation of softco under domestic law ................................ 344 a. is softco engaged in a u.s. trade or business? .... 345 b. does sofico derive income effectively connected with a u.s. business? ...................... 348 1. sales hicome ....................... 348 2. hcomne from the production of personal propert. .......................... 350 3. rental incone. ...................... 351 4. royalty hicome ..................... 353 5. sen,ices .......................... 354 6. sununar".......................... 355 c. is the income of softco subject to u.s. withholding tax? .................................. 355 v. u.s. taxation of softco under the irish treaty ... 358 a. qualification of sofico under the treaty.......... 358 b. taxation of softco's business profits ............ 359 c. taxation of sofico's royalty income ............ 360 vi. taxation of sofrco's u.s. shareholder(s) under the u.s. tax haven regimes ..................... 360 a. taxation of u.s. parent on income of softco under subpart f ............................... 360 1. sales income ....................... 361 2. rental and royalty income ............. 365 3. sen'ices income ...................... 367 4. passive investment incone. ............. 368 5. summnarv. ......................... 368 * partner with baker & mckenzie. new york. new york. 340 florida tax review [vol. 4:4 b. taxation of u.s. individual shareholders controlling softco ......................... 369 c. taxation of u.s. individual owning 25% of softco's stock ............................ 372 d. summary of the application of the tax haven regimes ................................ 373 viii. what does all of this prove? . . . . . . . . . . . . . . . . . . 374 a. income characterization .................... 374 b. what constitutes the production of property? ..... 375 c. the cacophony of tax haven rules ............ 376 ix. some modest suggestions ...................... 376 taration of elecironic conmmerce i. introduction the advent of the internet and other electronic means of conducting commercial transactions has created a new galaxy of ways to structure business operations and a concomitant range of novel tax issues.' it is commonly said that, because of the diminished need for a vendor to have a physical presence in the country of the customer, one of the likely effects of electronic commerce will be to shift revenues away from source jurisdictions and towards residence jurisdictions.2 in fact, this may be only partially true. income may be shifted away from the customers' countries all right, but into a tax haven jurisdiction rather than into the enterprise's home jurisdiction. a major issue for enterprises that use the internet and their residence tax jurisdictions, therefore, will be whether controlled foreign corporation or similar legislation will operate to impose tax on any revenues that are shifted in this manner. the purpose of this paper is to consider how a hypothetical business operation structured to operate in a tax haven might be treated under united states federal income tax law, both under provisions taxing income at the source and under provisions taxing u.s. persons on tax haven income of foreign corporations, and then to reflect on what, if anything, this tells us about the need for change. because the internal revenue service has issued a regulation discussed below, specifically characterizing income derived from transactions in computer software (and not other types of transactions in electronic commerce), the paper will focus on a company delivering software over the internet; but many of the issues presented will arise in the case of other internet providers. ii. basic issues that will recur many of the federal income tax issues raised by electronic commerce depend upon the characterization of items of income or transactions giving rise to income under definitions and concepts born in the age of bricks and 1. see generally william c. benjamin & michael j. nathanson. conducting business using the internet: gauging the threat of foreign taxation. j. int'l tax'n. march 1998, at 29; daniel j. langin, the economics of the internet: insurance and risk management, advertising and other business models. valuation and tax issues. first annual internet law institute, at 447 (pli patents. copyrights. trademarks and literary property course handbook series no. 482, 1997). peter a. glicklich et al., internet sales pose international tax challenges, 84 j. tax'n 325 (1996): amy hamilton. former new york revenue chief outlines emerging tax issues in electronic commerce. 96 tax notes today 213-14 (oct. 31, 1996) (lexis, fedtax library. tnt file). 2. see, e.g., david r. tillinghast. the impact of the internet on the taxation of international transactions, 50 bull. int'l. fiscal doe. number 11/12 524. 525 (1996). 19991 florida tax review mortar. in some cases these do not readily adapt themselves to the world of electronic commerce. in addition, the same, or cognate, issues may arise in different contexts; and it is difficult in some cases to decide whether interpretations should vary according to context or whether they should be harmonized. in our tax law, much depends upon the characterization of income. as relevant to this discussion, critical decisions include the differentiation of items of income as being derived from: (i) sales; (ii) rentals; (iii) royalties; or (iv) services. the internal revenue service (irs) has issued a regulation (the "regulation") addressing these issues in the case of computer software;3 but the scope and application of these rules is not yet well established.4 additional distinctions may turn on whether, when an enterprise is deemed to transfer a product (a copy of a software program, for example) to a customer, the "thing" that it delivers is tangible or intangible property5 and whether it is inventory.6 as another example, it may be critical to determine whether an enterprise which is deemed to make a sale of a product has "manufactured" or "produced" that product.7 with respect to the ephemera in which electronic commerce deals, what does this mean? if an enterprise either creates or acquires a software program and then provides copies of that program to customers, it may deliver the final product in a variety of ways. it may encode the program on a cd or simply deliver it by downloading it onto the customer's computer. 8 is the creation of the cd the "production" of the property sold? if so, has the enterprise also "produced" the copy of the software program which it delivers by downloading it onto the customer's computer? or is it the creation of the original software program which constitutes the "production" of property? 3. see regs. § 1.861-18. 4. for comments made when the regulation was in proposed form, see ned maguire et al., deloitte & touche l.l.p., deloitte & touche offers comments on tax policy implications of global electronic commerce, 15 tax notes int'l 1483 (nov. 3, 1997); attorneys offer additional input on computer classification regs., public comments on proposed regs., 15 tax notes int'l 1345 (oct. 27, 1997) (comments of gary l. sprague, robin a. chester, and john m. peterson of baker & mckenzie); software group answers questions on u.s. computer program regs., public comments on proposed regs., 15 tax notes int'l 1078 (oct. 6, 1997) (comments of kenneth a. wasch of software publishers association). 5. see infra text accompanying notes 42-44. 6. see infra text accompanying notes 39-40. 7. see infra text accompanying note 24. 8. howard e. abrams & richard l. doernberg, how electronic commerce works, 14 tax notes int'l 1573, 1585 (may 12, 1997). [vol. 4:4 t1ration of electronic comnerce m. hypothetical fact pattern softco is an irish public limited company which is a corporation for u.s. tax purposes and which operates out of a branch in bermuda. softco enters into agreements with usco, a u.s. corporation, under which usco grants softco rights to distribute software programs developed by usco.' in one category of such transactions, usco grants to softco exclusive rights for the life of the subject copyrights, in consideration of a fixed payment. in a second category, usco grants to softco nonexclusive rights in consideration of a periodic royalty based on its sales. in addition, softco enters into contracts with a number of individuals, some of whom are resident in the united states and some of whom are employees of usco, to develop additional software programs on its behalf, which they do as independent contractors on an ongoing basis. in some cases, these individuals modify programs previously created by usco either to improve them or to adapt them for foreign markets. softco also acquires the rights to some programs from unrelated non-u.s. persons. the programs acquired by softco are downloaded onto servers which softco maintains in bermuda. softco owns the intellectual property rights for programs developed for it. softco licenses the software programs it acquires in various ways to unrelated customers, in the united states and in other countries. in most cases, softco's customers are businesses which typically acquire the right to use softco's programs at multiple locations and sometimes acquire the right to relicense to others. in all of these cases, softco receives an up-front lump sum payment as the only consideration for the transfer. in addition, softco licenses programs to a cyprus company, russco, owned by the same shareholder(s) that own(s) softco, for distribution in eastern europe. to the extent that softco owns or has an exclusive license of rights to a software program, it grants to russco exclusive rights in the countries in which it operates. in other cases, softco grants russco nonexclusive rights. in all of these transactions, russco pays softco royalties based on russco's net sales. softco offers its customers (and the customers of russco) a "'hot line" service; a customer that experiences difficulties in operating a softco program can telephone for assistance, which is provided either by employees of softco located in bermuda or by one or more of the independent contractors who create, modify or adapt programs for softco. this service is provided without 9. if, as we will hypothesize later, softco and usco are related persons. the amount of the royalty receivable by usco is subject to adjustment by the irs under the "commensurate with income" standard of § 482 of the code. the very difficult problems which are encountered in making such a determination are beyond the scope of this article. 19991 florida tax review charge for the first year and thereafter at a specified hourly rate. in addition, if a customer's requirements indicate an adaptation of a standard program, softco will undertake (through its independent contractors) to provide the necessary revision or addition. to facilitate analysis, we will first assume that none of the independent contractors providing the above services is located in the united states. we will then make the assumption that u.s. contractors are involved. softco employs six persons, all of whom are located in bermuda. two of them actively solicit customers by telephone and on the internet; two are technicians who operate the "hot line," fielding questions or complaints received from customers and when necessary referring them to independent contractors; the last two perform administrative functions. softco also advertises its programs on the internet, on television and in magazines in the united states and other countries. all orders are placed by customers through the internet, and deliveries of software, customer assistance and program adaptations are made by downloading the necessary codes from softco's servers in bermuda directly onto customers' computers. customers make payments via the internet to accounts maintained by softco in bermuda. for purposes of analysis, it will be assumed sequentially that softco is owned: (i) 100% by usco, which is wholly owned by u.s. persons; (ii) 100% by four u.s. individual shareholders who control usco; and (iii) 25% by a u.s. individual and 75% by non-u.s. persons. iv. united states taxation of softco under domestic law wholly apart from the u.s. rules taxing u.s. shareholders on their shares of the undistributed income of foreign corporations, to be considered below,' softco itself may be subject to u.s. tax if it either: (i) is engaged in the conduct of a trade or business in the united states" (through a permanent establishment, if an income tax treaty applies) and derives income which is effectively connected with that trade or business 3 (and attributable to the permanent establishment, if a treaty applies); 4 or (ii) derives income which constitutes fixed or determinable annual or periodical 10. see infra, part vi, text accompanying notes 106-65. 11. see irc § 882(a). 12. see, e.g., convention between the government of the united states of america and the government of ireland for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, july 28, 1997, arts. 5, 7 [hereinafter u.s.-ir. treaty] (business profits and permanent establishment). 13. see irc § 882(a). 14. see, e.g., u.s.-ir. treaty, supra note 12, art. 7 (business profits). [vol 4:4 taxation of electronic comnerce income subject to withholding tax' 5 (and not exempted by applicable treaty). 6 since many tax haven companies are not entitled to the benefits of any u.s. income tax treaty, the discussion will first focus on u.s. domestic law and them turn to the impact of an applicable treaty. a. is softco engaged hz a u.s. trade or business? whether a foreign corporation is engaged in trade or business in the united states under u.s. domestic law is always a difficult question. it is a factual question, and therefore one on which the internal revenue service does not issue advance rulings. 7 moreover, the available authority, while considerable, dates largely from the 1950s or earlier." therefore, it is difficult to reach a definitive conclusion in many cases, although in general a rather low level of activity seems to be required. all that is required is that the activity be "considerable, continuous and regular."' 9 on the assumption that u.s. independent contractors are not involved in performing "hot line" or other services offered by softco to customers, there are two possible bases for finding softco to be engaged in a u.s. trade or business: it advertises to and deals with u.s. customers, and it retains u.s. persons to create software programs for it.2' although nothing in this area is clear, it seems likely that softco's advertising and dealings with u.s. customers, without the intervention of any person or facility located in the united states, would not by itself be enough to cause softco to be engaged in business in the united states. in the piedras negras case,2 a mexican company which broadcast radio programs from mexico into the united states and collected advertising revenues from u.s. advertisers was held not to have u.s.-taxable income. although the opinion intermixes the concept of "doing business" with the concept of what 15. see irc § 881(a). 16. see, e.g., u.s.-ir. treaty, supra note 12. art. 12 (royalties). 17. see rev. proc. 98-7, 1998-1 i.r.b. 222. 18. see, e.g., higgins v. commissioner. 312 u.s. 212 (1941); continental trading, inc. v. commissioner, 265 f.2d 40 (9th cir. 1959) cert. denied, 361 u.s. 827 (1959): herbert v. commissioner, 30 t.c. 26 (1958), acq., 1958-2 c.b. 6. 19. moore v. commissioner, 56 t.c. memo (cch) at 1150. 1155. t.c. memo (ph) 89,038, at 89-174 (1989). 20. although the author has found no authority on the point, it seems doubtful that softco's activities in acquiring fights to software from usco would be considered to constitute engaging in business in the united states. cf. regs. § 1.864-6(a)(2)(i) ex. i (income derived by foreign corporation from licensing outside the united states patent rights acquired through office in the united states is not attributable to that office for purposes of § 864(c)(4flb)1. 21. piedras negras broadcasting co. v. commissioner, 43 b.t.a. 297 (1941). nonacq., 1941-1 c.b. 18, aff'd, 127 f.2d 260 (5th cir. 1942). 1999] florida tax review constitutes u.s.-source income, the court basically held that the company was not engaged in business in the united states. 2 here, however, softco has also entered into contracts with u.s. individuals, as well as others, for the creation of software programs. presumably, at least, the u.s. persons will do most of their work in the united states, possibly in facilities maintained by usco. the fact that they are independent contractors rather than employees of softco does not prevent their activities from being attributed to softco in making the necessary determination.23 a threshold question is whether these u.s. activities are to be characterized as the "manufacturing" or "production" of property by softco. if it is considered to be engaged in manufacturing in the united states, softco will be considered to be engaged in business in the united states.24 the answer is not clear but, as discussed below, under existing law the programmers' activities will apparently not be taken into account in determining whether softco has any u.s.-taxable income; and this may mean that it should not be deemed engaged in trade or business on account of the activities. assuming that the u.s. programming activities do not constitute "manufacturing," it is not clear whether softco will be deemed to be engaged in a u.s. trade or business. although it dealt with services performed in the united states on behalf of a foreign corporation, the leading modem case on the "doing business" question, the tax court's decision in inverworld inc. v. 26commissioner, is not particularly helpful in answering the question of whether the individuals' activities cause softco to be engaged in business. apart from the fact that inverworld involved financial transactions which are the subject of specific regulatory rules, 27 the united states activities consisted of the execution of specific market transactions on behalf of the foreign corporation's customers, rather than the creation of an underlying capital asset to be used in the foreign corporation's business. moreover, the 22. see id. for a discussion of the case law addressing this issue, see nancy h. kaufman, common misconceptions: the functions and framework of "trade or business within the united states," 25 vand. j. transnat'l l. 729, 782-786 (1993). 23. see, e.g., lewenhaupt v. commissioner, 20 t.c. 151, 162-63 (1953), aff'd, 221 f.2d 227 (9th cir. 1955); de amodio v. commissioner, 34 t.c. 894 (1960), aff'd, 299 f.2d 623 (3d cir. 1962). 24. the author has been unable to find any authority expressly so holding. this almost certainly reflects the fact that the proposition is considered self-evident. ongoing manufacturing activity in the united states is certainly the type of "considerable, continuous and regular" activity that constitutes engaging in business. see moore, 56 t.c. memo (cch) at 1155, t.c. memo at 89-174; supra text accompanying note 19. 25. see infra text accompanying notes 50-51. 26. 71 t.c. memo (cch) at 3231, t.c. memo (ria) 1 96,301 (1996). 27. see inverworld, 71 t.c. memo (cch) at 3237-5, t.c. memo (ria) at 96-2806 to 96-2807. [vol 4:4 taxation of electronic coninnwrce u.s. activities carried on in that case constituted essentially all of the business activities of the foreign corporation;2 and while the point is unspoken in the rather turgid opinion rendered by judge wells, this circumstance could hardly have failed to influence the decision. in softco's case, although its business activities are rather limited, a substantial portion of them will be carried on outside the united states. from the facts stated above, we do not know what portion of the programming will be done in the united states and what portion will be done elsewhere. let us suppose that it will vary, but that substantial amounts will be done both inside and outside the united states. in addition, of course, on the first assumption stated above, all of the marketing, delivery, "hot line," adaptation, financial and administrative functions of softco will be performed outside the united states. perhaps the closest precedent is the balanovski case. -9 there an argentine partner in an argentine partnership came to the united states and over a substantial period of time carried on extensive activities connected with procuring military equipment which the partnership resold to the argentine government. obviously, not all of the partnership's activities were carried on in the united states, since the partner who remained in argentina was responsible for procuring the government's orders and arranging for payment. nevertheless, the united states component seemed to be the more critical part of the partnership's total activities.30 the partnership was held to be engaged in trade or business in the united states." the case is analogous to the softco case in the sense that the activity carried on in the united states was the procurement of goods which were to be marketed outside the united states, while in softco's case it is the creation of programs to be marketed by softco outside the united states (although in some instances to u.s. customers). all of this does not lead to a firm conclusion. to this author it seems possible, however, that if the programming that is done for softco in the united states continues on a regular basis and constitutes a substantial portion of the total, softco could be considered to be engaged in business in the united states. whether this conclusion leads to the imposition of tax depends on whether softco would be deemed to derive income effectively connected with its u.s. business, an issue discussed below. 28. see inverworld, 71 t.c. memo (cch) at 32.17-22, t.c. memo (ria) at 96-2110 (no fixed facility other than in the united states). 29. united states v. balanovski, 236 f.2d 298 (2d cir. 1956). cert. denied, 352 u.s. 968 (1957). 30. see balanovski, 236 f.2d at 305 (extensive purchasing activities in the united states; title to goods passed in the united states). 31. see id. at 306-07. 1999] florida tax review we now relax the initial assumption and consider that the individual u.s. programmers, in addition to creating software programs for softco, participate in providing "hot line" and other services to customers of softco. in this event, softco will probably be considered to be engaged in trade or business in the united states, although a recent tax court case may cast some doubt on this conclusion.3" b. does softco derive income effectively connected with a u.s. business? the answer to this seemingly simple question is one of byzantine complexity. we encounter here, as we shall encounter again, the fundamental need to determine the character of the income items we are talking about. in addition, based upon the income characterization, we must determine the source of each item. 1. sales income.-the regulation provides that income derived from the provision of software will be considered income from the sale of personal property if it is derived from a permanent transfer of a "copyrighted article" as opposed to a transfer of a "copyright right., 33 in the most general terms, the distinction is between a case where a customer buys a copy-or a number of copies-of a software program for its own use and one where the transferee also gets the right to sublicense or otherwise provide the software to others.34 the sale characterization rule applies whether the medium of delivery of the program is physical or electronic.35 given the nature of softco's operations, it is likely that much of its income will be characterized as sales income under the regulation.36 if this income had a u.s. source, it would always be considered effectively connected income.37 if the sales income had a foreign source, it could also be effectively connected income, but only under very limited circumstances: among other things the foreign corporation would be required to have an office in the united states through which the sales are effected.38 although softco retains u.s. individuals to create software programs (and 32. see discussion of the miller case at text accompanying notes 86-89. 33. regs. § 1.861-18(c)(1). 34. see regs. § 1.861-18(c)(2). 35. see regs. § 1.861-18(g)(2). 36. under the regulation, a transaction in which a customer acquires the right to make even a large number of copies for its own internal use will be treated as a sale, so long as the customer does not obtain the right to retransfer rights to use to others. see regs. § 1.861-18(h) ex. 10. 37. income derived from the sale of property is not fixed or determinable annual or periodical income. see regs. §§ 1.871-7(a)(1), 1.1441-2(a)(3). therefore, the "per se" rule of § 864(c)(3) applies. 38. see irc § 864(c)(4)(b). [vol 4:4 taxation of electronic conmmerce possibly perform other services) for it, they play no part in the marketing of the programs, and softco has no sales facilities in the united states. therefore, it should not be taxable on foreign-source sales income. it seems likely that sales income of softco would be characterized as income from the sale of "inventory property."" if so, its source depends upon where title to the property sold passes." if it passes outside the united states, the income is foreign-source income; if it passes in the united states, it is u.s.-source income. the passage of title in turn depends on when and where the risk of loss passes from seller to buyer." when one is dealing with the physical shipment of tangible goods-the situation contemplated when the passage of title rule was adopted, this distinction (whether or not sensible from a policy perspective) is not difficult to make. well established commercial law rules (relating to such things as f.o.b. and c.i.f. contracts) specify where title and risk of loss pass.42 in the case of transactions entered into by softco, however, the passage of title rule is essentially meaningless. in fact, most software transactions are licenses for intellectual property purposes, so that title in fact does not pass to the customer.43 moreover, how can one say where "risk of loss" passes when softco, having presumably received payment, transmits the code of a software program over the telephone line which connects its server in bermuda with its customer's computer in the united states? literally, the 39. the regulation declines to address this question directly. it implies, however, that copies of software programs will constitute inventory property in at least some cases by referring to determining the source of income from sales of program copies under § 861(a)(6). see regs. § 1.861-18(f)(2). it seems doubtful that the inventory rules of §§ 471-474 can be applied in this context. softco does not produce or acquire individual items of property and then resell them. nevertheless, what softco sells would presumably be considered "'property held by the taxpayer primarily for sale to customers in the ordinary course of [its] trade or business" within the meaning of § 1221(1), and as such constitutes "inventory property" under § 865(ijt i). 40. under § 865(b), income from the sale of inventory property is sourced under the passage of title rules of §§ 861(a)(6), 862(a)(6). and 863. in softco's case, if the inventory property rule did not apply. the sales income would be foreign-source under § 865(a)(2). since softco would not seem to have an office or fted place of business in the united states to which the sales income is attributable, the special rule of § 865(e)(2) should not apply in making either of these determinations. if softco entered into transactions which were sales under the regulation but received payments which were contingent on the customer's use of the program transferred, it is possible that the "royalty" source rule of § 865(d) would apply even though the transaction was not characterized as a license. 41. see regs. § 1.861-7(c). 42. see u.c.c. §§ 2-319, 2-323, and 2-401. 43. see, e.g., ned mcguire et al., deloitte & touche llp, deloitte & touche offers comments on tax policy implications of global electronic commerce, 15 tax notes int'l 1483 (nov. 3, 1997). 1999] florida tax review "goods" cannot be "lost." if there is a malfunction in the telephone transmission, softco will simply transmit the program again. even if there could be a "loss," it is impossible to say "where" this loss occurred; since the transmission is instantaneous, there is no period of time separating the "shipping of the goods" and their "delivery." the regulation declines to resolve this question. the preamble refers to the issue of determining the place of sale under the passage of title rule, notes that "the parties in many cases [apparently referring to transactions in physical goods] can agree on where title passes" and concludes that transactions in computer programs "will be sourced under similar principles."44 this indicates that the sensible answer is to treat title as passing from softco to the customer when softco transmits the program in bermuda. as the treasury white paper states,45 it is undesirable to have transactions effected on the internet treated differently from transactions effected by traditional means; and no doubt if softco had delivered the program by shipping it on an encoded cd, for example, it would have specified that title would pass to the customer in bermuda. if necessary, softco can add to its transmission a blurb to the effect that for tax purposes, title is deemed to pass in bermuda. 2. hicome from the production of personal property.-income from the production and sale (as opposed to the purchase and resale) of personal property has a split source. a portion is considered to be sourced where the personal property is produced and a portion where the sales income is derived. income attributable to the production of personal property in the united states is u.s.-source income,46 and will be treated as effectively connected income.47 the term "produced" in the united states is defined to include "created, fabricated, . . . processed ... [or] manufactured. . .. "" this suggests the possibility that some portion of the income derived by softco from sales-to either u.s. or foreign customers-of software created (or modified) on its behalf in the united states could be taxable as effectively connected income. in the present context, it is interesting to note that this issue arises only with respect to income which is characterized as derived from sales, and 44. t.d. 8785, 1998-42 i.r.b. 5, 7. 45. u.s. dep't of the treasury, office of tax policy, selected tax policy implications of global electronic commerce (1996) (visited july 21, 1997) <http://www.treas.gov/taxpolicy/internet.html>. 46. see irc § 863(b)(2). 47. since manufacturing income is not fixed or determinable annual or periodical income, the "per se" rule of § 864(c)(3) applies. 48. regs. § 1.864-1. [vol 4:4 taxation of electronic commerce not income characterized as rental or royalty income, which is sourced without regard to where the leased or licensed property was produced." it appears, however, that softco will not be considered to derive income from manufacturing or production in the united states. the applicable regulation provides that, in determining whether income is derived in part from production in the united states, "the only production activities that are taken into account ... are those conducted directly by the taxpayer.""0 this is intended to preclude consideration of the activities of contract manufacturers:' if so, the activities of the u.s. programmers are not to be attributed to softco; and the income of softco is to be characterized in its entirety as income from the sale of personal property. based on the foregoing, one would at least tentatively conclude that softco does not derive income from the production of personal property in the united states. (of course, to the extent that softco deals in software programs which it does not develop or develops outside the united states, there can be no u.s.-source production income.) 3. rental inconze.-under the regulation, income derived from transferring a "copyrighted article" (as opposed to a "copyright right") can be treated as rental income if the customer is granted the right to use the program for only a limited period of time."2 although the regulation is not clear on this point, a transaction which is treated as a rental of a copyrighted article is apparently to be treated as the rental of tangible personal property. this is intuitively correct in the case of the delivery of a "shrink-wrap" product, embodied on a cd,-3 and the regulation is crystal clear that the mode of delivery will not make a difference!' we will proceed on the assumption, therefore, that this type of income is characterized as income from the rental of tangible personal property; if this were not the case, the rules discussed below with respect to royalties would apply." income from the rental of tangible personal property will be considered effectively connected income if it is u.s.-source income, and then only if either (i) it is derived from assets used or held for use in the conduct of the united states business (the "asset use" test) or (ii) the activities of the 49. for a discussion of this anomaly and the possible reason for it, see proposals on united states taxation of foreign persons and of foreign income of united states persons, international aspects of united states income taxation. 1986 a.l.i. fed. income tax project 34-37 (may 14, 1987) [hereinafter all study). 50. regs. § 1.863-3(a)(1)(i)(a). 51. see rev. rul. 97-48, 1997-2 c.b. 89. 52. see regs. § 1.861-18(f)(2), (h) ex. 3-4. 53. see regs. § 1.861-18(h) ex. 1. 54. see regs. § 1.861-18(g)(3). 55. see infra text accompanying notes 64-69. 19991 florida tax review u.s. business were a "material factor" in the production of the income (the "business activities" test).56 if the rental is foreign-source income, it is not effectively connected.57 income from the rental of tangible property has a u.s. source if the property is located in the united states.58 to the extent that the income is received for the use of property located outside the united states, the income is foreign-source income.59 this source rule creates an almost insoluble problem. in many transactions characterized under the regulation as the transfer of a "copyrighted article"-as opposed to many typical licensing transactions-there is no geographical limitation on the customer's use of the program. therefore, the use may occur either within or without the united states. softco will have no way to determine at the time of the transaction (which, on the facts given, is when it receives the single payment made by the customer) where the customer will use the program. indeed, the customer itself may not know the answer at that time, since its plans may change; even an individual customer is likely to take a laptop along whenever he or she works in another country. there is some precedent of dubious provenance for presuming that a u.s. person uses property in the united states unless the taxpayer can prove otherwise;' and it may be tempting to presume a u.s. location if the customer is located in-i.e., the software is delivered to-the united states (and, presumably, a non-u.s. use when the customer is outside the united states). in fact, however, any such rule would be unworkable. the provider will often not know the geographical location of its customer; and any such rule could be avoided by arranging for delivery at one location followed by immediate retransmission to another. assuming that rental income derived by softco is found to have a u.s. source, it will nevertheless be effectively connected only if it meets either the asset-use test or the business activities test. the asset-use test ordinarily applies to passive income arising not from the corporation's business activities as such but from investment of funds or deployment of 56. u.s.-source rental income is fixed or determinable annual or periodical income. see irc § 881(a)(1)(a). as such, it is effectively connected income only to the extent so determined by applying the factors set forth in § 864(c)(2), which embodies the "asset use" and "business activities" tests. 57. see § 864(c)(4)(b) (enumerating types of foreign-source income that may be effectively connected, does not refer to income from the rental of tangible property). 58. see irc § 861(a)(4). 59. see irc § 862(a)(4). 60. see molnar v. commissioner, 4 t.c. memo (cch) at 951, t.c. memo (p-h) 45,317 (1945), affd, 156 f.2d 924 (2d cir. 1946); rohmer v. commissioner, 153 f.2d 61 (2d cir. 1946). [vol 4:4 taxation of electronic conmnerce capital assets held for use in the business.6' this would not seem to fit softco's case. the business activities test seems more likely to apply, since it is directed at, among other things, cases in which income which is generally considered passive (royalties are the example referred to in the regulations) are derived in the conduct of an active business. -62 the test seems to be focussed, however, on activities directly related to earning the particular items of income involved-principally marketing activities conducted in the united states.63 in softco's case, there are no such u.s. activities; and the efforts of the u.s. programmers retained by softco seem too indirectly related to the earning of any particular item of income to count. tentatively, therefore, one would conclude that any rental income derived by softco would not be subject to tax as effectively connected income. 4. royalty hzcome.-under the regulation, income derived from the transfer to a customer of a "copyright right" (as opposed to a "copyrighted article") is considered royalty income.' this has a u.s. source to the extent that the payment is made for the use of, or the right to use, the intangible property in the united states;65 otherwise the source is foreign. if the royalty has a u.s. source it will be effectively connected or not, based upon the same factors discussed above with respect to rental income.' unlike rental income, however, in limited circumstances royalty income can be considered effectively connected income even if it is foreign-sourced. the income must be attributable to a u.s. office or fixed place of business of the foreign corporation and it must be derived in the "active conduct of [the u.s.] trade or business." 67 it seems doubtful that softco could be deemed to have a fixed place of business in the united states because of its retention of u.s. individuals to create programs. 68 moreover, the regulations seem to contemplate that 61. see regs. § 1.864-4(c)(2)(i). 62. see regs. § 1.864-4(c)(3)(i)(c). 63. see regs. § 1.864-4(c)(3)(ii) ex. 2. 64. see regs. § 1.861-18(c)(l)(i), (f)(1). a transfer of substantially all of the rights in a copyright will be treated as a sale or exchange of that item of intangible property. id. in this case, the rules discussed above with respect to sales would apply. as to the imposition of withholding tax in such cases, see the discussion in the text accompanying infra notes 76-89. 65. see irc § 861(a)(4). 66. see supra text accompanying notes 52-63. 67. irc § 864(c)(4)(b)(i). if income characterized as rental income under the regulation were considered to be derived from the rental of intangible, rather than tangible, property, the rule described here would apply, since by its terms it applies to "rents or royalties for the use of... intangible property." id. (emphasis added). 68. see supra text accompanying note 38. 19991 florida tax review income will be attributable to a u.s. place of business only if that office has some direct relationship to the earning of specific items of income-again, generally, marketing activities.6 9 softco certainly carries on no such activities in the united states. therefore, foreign-source royalties should not be considered effectively connected income. as in the case of rentals, however, determining where the intangible property is used will be a major problem. 5. services.-to the extent that softco adapts or modifies its programs to suit the needs of particular customers or performs "hot line" functions, it may derive income from the performance of services.7" under the first assumption set forth above, all of such services are performed outside the united states. under these circumstances, the income will not be u.s.source income;71 and foreign-source services income is never effectively connected income.72 the alternative assumption set forth above is that some of these services are performed by programmers located in the united states. we concluded above that in that case softco could be considered to be engaged in trade or business in the united states. since the income attributable to such services would be sourced where the services are performed,73 one would expect such income to be taxable effectively connected income. this conclusion may, however, be put in question by the opinion in the miller case, discussed below in connection with the imposition of withholding taxes. if tax is imposed, the basis of the tax must be ascertained. presumably, softco will maintain records documenting the occasions on which u.s. programmers have performed services.74 in the absence of better information, the division of softco's income between u.s. and foreign sources may be based on the amount of time spent by u.s. programmers compared to the amount of time spent by programmers located elsewhere.75 69. see regs. § 1.864-6(a)(2)(i). 70. see regs. § 1.861-18(b)(1)(iii), (d). 71. see irc § 862(a)(3). 72. section 864(c)(4)(b) makes no reference to services income. 73. see irc §§ 861(a)(3), 862(a)(3); cf. rev. rut. 70-424, 1970-2 c.b. 150 (activities of agent in u.s. attributed to principal). 74. softco presumably pays its u.s. programmers according to how much they work and/or how much revenue it derives from the programs which they create. 75. see regs. § 1.861-4(b); cf. tipton & kalmback, inc. v. commissioner, 480 f.2d 1118 (10th cir. 1973) (income for services apportioned to within and without the united states on a time basis); stemkowski v. commissioner, 690 f.2d 40 (2d cir. 1982) (determining time periods to be counted in apportioning to the united states income earned by canadian hockey player). [vol 4:4 taxation of electronic conmerce 6. summiary.-in summary, it appears that (i) softco should not be deemed to derive effectively connected income from the production of property in the united states; (ii) sales income derived by softco should be foreign-source and therefore not effectively connected; (iii) rental and royalty income will not be effectively connected because, as to rentals and u.s.source royalties, the "asset use" and "business activities" tests are not met and, in the case of foreign-source royalties, softco has no u.s. place of business to which royalties are attributable; and (iv) services income may be taxable but only to the extent that services are performed on behalf of softco by programmers located in the united states. accordingly, even in the absence of an applicable income tax treaty, softco would appear to be exposed to u.s. corporate income tax only in this last situation. c. is the income of softco subject to u.s. withholding tax? income which is not effectively connected with a u.s. business may nevertheless be subject to u.s. withholding tax at the statutory rate of 30% if (i) it is u.s.-source income and (ii) it constitutes "fixed or determinable annual or periodical" (fdap) income.76 income derived from the sale of personal property is not considered fdap income,77 and therefore is not subject to withholding tax regardless of its source.78 income from production of property will not be subject to withholding. 79 rental or royalty income having a u.s. source is fdap income subject to the withholding tax, however!" thus, even if it is not engaged in business in the united states, softco will be subject to withholding tax if it makes temporary transfers of "copyrighted articles," or transfers "copyright rights," to customers for use in the united states. even if softco is liable to tax in principle, the tax may be uncollectible as a practical matter. each customer that pays softco for a software progam or rights to a program is a withholding agent, technically 76. irc §§ 871(a), 881. 77. see regs. §§ 1.871-7(a)(1), 1.1441-2(a)(3). 78. there is one exception. gain from the sale or exchange of intangible property is treated for withholding tax purposes as royalty income to the extent the consideration paid is contingent on the productivity, use or disposition of the property. see irc § 871(aj( 1)(d). a u.s.-source will also be established under the royalty rule. see irc § 865(dfl i tb). 79. if any portion of softco's income is deemed to arise from the production of property in the united states, it will be deemed to be engaged in a u.s. trade or business. and the income will be considered effectively connected with that business. income from production carried on outside the united states is not subject to withholding because it is not u.s.-source income. see irc § 863(b)(2); regs. § 1.863-3. 80. see irc §§ 871(a)(1), 881(a)(l); regs. § 1.871-7(b(1i). 1999] florida tax review liable to collect the tax owed by softco.8' large business purchasers may know who softco is and where it is located; they will presumably insist on withholding." other purchasers, however, will not be in a position to withhold. the customer may not even know where softco is organized or where it operates. in addition, the practical difficulties of enforcing withholding obligations against a large number of persons making relatively small purchases are formidable." the application of withholding tax to amounts received by softco attributable to services provided to customers is unsettled at the moment. to the extent that such services are performed, whether by softco's own employees or by independent programmers, outside the united states the resulting income does not have a u.s. source and therefore is not subject to withholding.84 if the income has a u.s. source, however, the statute and the regulations appear to subject it to the tax unless it is considered effectively connected income,85 in which case the income would be subject to corporate tax in the hands of softco. in miller v. commissioner,6 however, the tax court held in closely analogous circumstances that no tax needed to be withheld. in miller, u.s. partnerships had paid fees to a related hong kong corporation for the performance of research services. the hong kong corporation in turn subcontracted with u.s. subsidiaries, among others, to perform a portion of the required services. the irs asserted that the u.s. payors were liable to withhold tax from the payments they made to the hong kong corporation to the extent that these were attributable to the research conducted in the united states. the taxpayer pleaded that at the time of payment (which was in advance), it did not know to what extent the services it paid for would be performed in the united states. the irs took the position that, when in doubt, the u.s. payor should withhold on the entire amount, and the hong kong corporation should apply for a refund if the withholding turned out to be excessive. noting that the u.s. subsidiaries were subject to tax on the income they earned and that, in the facts presented, the irs could apply section 482 to adjust the amounts received by the u.s. subsidiaries if necessary to reflect 81. see irc § 1461. 82. as to possible exemption from withholding tax under an income tax treaty, see the discussion at text accompanying notes 103-05. 83. see, e.g., tax and the internet, discussion report of the australian taxation office electronic commerce project team on the challenge of electronic commerce to tax administration §§ 7.2.8, 7.2.18 (1997). see australian taxation office web page (visited august 3, 1999) <http://www.ato.gov.au/ecp/>. 84. see supra text accompanying note 76. 85. see regs. § 1.1441-4(a)(1). 86. 73 t.c. memo (cch) 2319, t.c. memo (ria) 97,134 (1997). [vol 4:4 taxation of electronic commerce their true income, the court held that the payments made to the hong kong corporation were not u.s.-source income subject to withholding because the hong kong corporation performed no services in the united states. the court stated: "in order for [the hong kong corporation] to be considered as having u.s. source income by virtue of the performance of services, [the corporation] itself would have to perform the services through agents or employees of its own." 87 it is difficult to know exactly what to make of the quoted statement. foreign corporations, like softco, often retain u.s. persons, both individuals and entities, as subcontractors to assist them in performing their contract obligations. as surely would be true in softco's case, the amount that the foreign corporation charges its customer for what is done in the united states will typically exceed the amount paid to the u.s. subcontractor(s), since the foreign corporation will be doing marketing, supplying working capital, taking risk, and performing administrative services and other functions. one would have thought that-passing for the moment the narrow question of withholding liability (an issue which the miller court found it unnecessary to consider) 88-what the foreign corporation earned would be treated as income from sources within the united states because the services provided were performed there. if not (contrary to the miller court's footnoted suggestion),89 the income could not constitute effectively connected income and would escape tax altogether. one can sympathize with the hardship imposed on a taxpayer when, as in the miller case and in softco's circumstances, a payment is made at a time when the payor has no way of knowing what portion of the payment will turn out to represent u.s.-source income; but this seems an insufficient reason for holding that no tax is payable at all. surely, the correct solution is to consider that all amounts paid to a softco for services performed for a customer in the united states constitute u.s.-source, and therefore effectively connected, income in its hands. softco must report it (and argue with the irs about its proper amount), but the payor will be free of withholding responsibility. in this sense, services income is easier to deal with than rents and royalties, which will in most cases not give rise to effectively connected income regardless of source. 87. miller, 73 t.c. memo (cch) at 2323. t.c. memo (ria) at 97-854. 88. see miller, 73 t.c. memo (cch) at 2324. t.c. memo (ria) at 97-855. 89. see miller, 73 t.c. memo (cch) at 2323 n.1 1. t.c. memo (ria) at 97-854 n.11. ("if [the corporation] did perform services, it is possible that it could be considered as carrying on a trade or business in the united states."). 19991 florida tax review v. u.s. taxation of sofrco under the irish treaty a. qualification of softco under the treaty softco will be entitled to claim the benefits of the treaty only if (a) it is a resident of ireland for irish tax purposes and (b) it is a "qualified person" under article 23, the limitation of benefits article. under article 4 of the treaty a company will be considered a resident of ireland if it is subject to tax in ireland by reason of its place of incorporation or management. 90 it is assumed in this discussion that softco is both incorporated and managed and controlled in ireland. it will therefore be treated as an irish resident. under article 23 of the treaty, a company may be considered a "qualified person" under any one of several tests, only two of which are potentially applicable to softco. under the "active business test," if softco were engaged in the active conduct of a substantial trade or business in ireland, it could claim benefits of the treaty with respect to u.s.-source income items connected with that trade or business.91 however, on the facts given it is not engaged in business in ireland. if softco did carry on business activities in ireland-such as marketing activities-it might qualify under this rule if its business activities in ireland were deemed substantial.92 under the "ownership and base erosion" test, a company will be considered a qualified person if: (a) at least 50% of the voting power and value of its stock is owned by "qualified persons" or united states citizens or residents and (b) amounts deductible for irish tax purposes which it pays to persons other than "qualified persons" or united states citizens or residents do not exceed 50% of its gross income.93 since softco is owned by usco, a united states resident as defined in the treaty,94 it satisfies the "ownership" prong of this test. the question is whether it will satisfy the "base erosion" prong. this in turn depends on whether payments made by softco are "deductible for income tax purposes ... in [softco's] state of residence. ' 95 in fact, no payments made by the bermuda branch are 90. see u.s.-ir. treaty, supra note 12, art. 4, para. l(a). 91. see u.s.-ir. treaty, supra note 12, art. 23, para. 3. 92. the business in ireland would have to be substantial in relation to the income derived from the united states for which treaty benefits were claimed. this determination would be based on all of the facts and circumstances, but taking into account such factors as asset values, gross income and payroll expense. see u.s.-ir. treaty, supra note 12, art. 23, para. 3(b)(ii). 93. u.s.-ir. treaty, supra note 12, art. 23, para. 2(c). 94. see u.s.-ir. treaty, supra note 12, art. 4, para. l(a). 95. u.s.-ir. treaty, supra note 12, art. 23, para. 2(c)(ii)(b). [vol 4:4 taration of electronic conmerce deductible in ireland because the income of the branch is not taxable there. is the quoted phrase to be read in this context as meaning "'deductible in ireland if the income to which the payments related were taxable in ireland?" if so, softco's qualification might depend on the extent to which it made payments to u.s. or irish persons, since these would not be counted as base eroding payments. it is assumed in this discussion that softco will not be taxable in ireland on income attributable to its branch in bermuda. this raises an important additional issue under paragraph 7 of article 23, which embodies an "exempt branch" rule of the type first adopted in connection with the u.s.dutch treaty. under this rule, if a resident of ireland derives income from the united states which is (a) attributable to a permanent establishment which the company maintains in a third country and (b) exempt from tax in ireland, the income will not qualify for benefits under the treaty unless it is "income... connected with... the active conduct of a trade or business carried on by [a] permanent establishment [of softco] in [a] third state." it appears that softco has a "permanent establishment" in bermuda; however, is that establishment engaged in an active trade or business? despite the fact that it has few employees and relatively little in the way of capital equipment, it seems difficult to characterize softco's activities in any other way." b. taxation of softco's business profits under the treaty, business profits of softco cannot be taxed in the united states unless softco is deemed to have a u.s. permanent establishment to which such profits are attributable.97 in brief, softco could be deemed to have a permanent establishment in the united states if it had an agent in the united states (other than an independent agent) who had and habitually exercised authorized to enter into contracts on it s behalf." on the facts given this is not the case. softco could also be deemed to have a permanent establishment in the united states if it maintained an office or 96. regulations section 1.355-3(b) contains an extensive discussion of what constitutes the active conduct of a trade or business for purposes of applying the § 355 rules relating to tax-free spin-offs and other corporate divisions. softco would appear to qualify under these rules. specific rules apply in determining whether, for subpart f purposes, rents and royalties received by softco are derived in the active conduct of a trade or business. see infra text accompanying notes 127-32. even if softco did not qualify under these rules, it would seem strange to apply them here, among other things because the determination made here will potentially affect all categories of softco's income, and these rules would not be relevant in determining the treaty status of a foreign corporation which is not a controlled foreign corporation. 97. see u.s.-ir. treaty, supra note 12. art. 7. 98. see u.s.-ir. treaty, supra note 12. art. 5, para. 5. 1999] florida tax review other fixed place of business in the united states.99 it is possible that the fixed places of business of individuals who write programs for softco could be attributed to it. this seems unlikely, however. they are independent contractors using whatever facilities they normally use for their work, if any. softco has neither control over those facilities nor the right to occupy them for its own use.' ° it therefore seems unlikely that, even if softco were deemed to be engaged in trade or business in the united states, as discussed above, it would be deemed to have a permanent establishment."" therefore, its business profits should be exempt from u.s. tax. the exempt profits should include sales, rental and services income."2 c. taxation of softco's royalty income royalty income would be differently treated, however. if exempt under the business profits article of the treaty, as discussed above, it could still be subject to withholding tax under article 12.103 article 12 generally provides that royalties received by a resident of ireland will be exempt from u.s. withholding tax.' however, paragraph 7 of article 23 (the "exempt branch" disqualification rule) must be taken into account here as well. if that rule applies, the united states is authorized to impose a 15% withholding tax. the application of the rule again depends on whether softco is engaged in an active trade or business, which it appears to be. 5 if so, royalties will also be exempt. vi. taxation of softco's u.s. shareholder(s) under the u.s. tax haven regimes a. taxation of u.s. parent on income of softco under subpart f assuming that softco is wholly owned by usco, softco is a controlled foreign corporation (cfc). 06 as a result, u.s. parent can be 99. see u.s.-ir. treaty, supra note 12, art. 5, para. 1. 100. see k. vogel, vogel on double taxation conventions 286-87 (3d ed. 1997). 101. see taisei fire & marine ins. co. v. commissioner, 104 t.c. 535 (1995) (u.s. independent contractor did not cause taxpayer to have a permanent establishment). 102. such income, unlike royalty income, is not covered by any other article of the treaty. 103. items of income dealt with in a specific article of the treaty may be taxed under that article even if exempt under article 7. see u.s.-ir. treaty, supra note 12, art. 7, para. 8. 104. see u.s.-ir. treaty, supra note 12, art. 12, para. 1. 105. see supra text accompanying note 94. 106. under § 957(a), a foreign corporation is a controlled foreign corporation if more than 50% of the total combined voting power of all classes of stock entitled to vote or more than 50% of the total value of the stock is owned (or deemed to be owned under attribution rules) by united states shareholders. [vol 4:4 taxation of electronic conmerce subjected to tax on a current basis on softco's "subpart f income.""t 7 whether softco's income constitutes subpart f income once again depends on how that income is characterized. 1. sales income.-foreign base company sales income, which constitutes subpart f income,"' is defined, as relevant here, as income from the purchase of personal property from a related person and its sale to any person, or the purchase of such property from any person and its sale to a related person if: (i) the property is manufactured or produced outside the country in which the cfc is incorporated; and (ii) it is sold for use, consumption or disposition outside such country."0° since the rule applies only to the purchase and resale of property, it does not apply if the cfc acquires personal property, uses it to manufacture or produce a product and sells the manufactured product, regardless of the identity of the parties with which it deals or the geographical destination of the sales."" at least some of the income derived by softco will undoubtedly be characterized as sales income." although the issue is not entirely clear, it seems that the regulation treats such income as resulting from the sale of tangible property. thus, it may constitute foreign base company sales income.! 12 except in the case of russco (discussed below),' we are assuming that softco's customers are unrelated persons. a threshold question, therefore, is whether softco has "purchased" the personal property which it sells from a related person. the software programs which softco delivers to its customers fall into four categories: (i) those which have been created for its own account; (ii) those which it has acquired from unrelated persons; (iii) those which it has acquired from usco; and (iv) those which it has acquired from usco and adopted or modified. (a) programs not acquired from usco. it seems clear that the programs which softco has had created for its own account or acquired from unrelated persons have not been purchased from a related person, and 107. irc § 951(a)(1)(a). subpart f income is defined in irc § 952. 108. see irc §§ 952(a)(2), 954(a)(2). 109. see irc § 954(d)(1). 110. see regs. § 1.954-3(a)(4)(i). 111. sales made by softco give rise to an element of services income, because the base price includes the right to "hot line" sen'ices for one year. under the regulation, this requires the transaction to be bifurcated into two elements unless the services element is de minimis. see regs. § 1.861-18(b)(2). 112. it is not clear whether the foreign base company sales income rules. which were patently designed to apply to transactions in tangible goods. could be applied to the sale of exchange of intangible property. 113. see infra text accompanying note 126. 19991 florida tax review therefore sales of these should not give rise to foreign base company sales income. (b) programs acquired from usco. an issue arises, however, whether the acquisition of programs from usco is to be treated as a purchase of personal property from a related person. in some cases, softco has not purchased software from usco but merely licensed it; these transactions are technically not "purchases." moreover, the fact is that softco has not purchased from anyone the copy of the software program which it delivers to its customer; it has generated this copy on its servers in bermuda. softco has acquired "copyright rights" from usco, a related person, but has not resold those rights as such.'" 4 the situation is unlike the traditional case in which a large number of individual tangible objects are physically produced in the united states, shipped abroad and individually delivered to customers. one can think of a software program as a design which is used by softco's servers in bermuda to create replicas (in potentially infinite numbers); and it is the replicas that are sold to customers. a possible analogy would be the manuscript of a novel and the copies of the books which are sold. on a technical reading of the statute, therefore, one could argue that income derived by softco from sales of programs to unrelated persons is not foreign base company sales income, even if the programs have been acquired or licensed from usco. however, this conclusion seems too glib. the foreign base company sales income rules were adopted to deal with cases where a u.s. person artificially inserted a tax haven entity between the creator of a product and the customer for that product and thus insulated from both u.s. and foreign tax income which did not have its "natural business locus" in the tax haven." 5 allowing for the very different circumstances under which software is created, acquired and delivered, as compared with tangible goods, by incorporating softco usco could be said to be achieving exactly the proscribed result. the fact is that by transferring or licensing software to softco and allowing softco to sell it to customers, usco has avoided both u.s. and foreign tax on at least a portion of the resulting income. if, for example, usco shipped to softco cds encoded with the requisite programs and softco sold these to its customers, the resulting income of softco would constitute foreign base company sales income. it is doubtful that the differences in the mode of delivery should spell a difference in result here. (c) "manufacture" or "production" by softco. even if, as this analysis suggests, softco were deemed to have "purchased" the software which it sells to unrelated customers, its sales income would nevertheless not 114. softco's transactions with russco are an exception and are discussed below. 115. see all study, supra note 49, at 257. [vol 4:4 taration of electronic conunerce constitute foreign base company sales income if softco were deemed to have "manufactured" or "produced" the personal property which it sells. the applicable regulation states that a cfc will be deemed to produce property if the property it sells "is in effect not the property which it purchased."" 6 it also specifies that "[iln no event will packaging, repackaging, labeling, or minor assembly operations" constitute production activities." t7 none of the available precedents, which deal with tangible goods, is particularly helpful in determining how softco would be treated under these regulatory rules. 8 the analogy to the packaging of goods is intriguing, however. if usco shipped cds to softco and softco put them in packages and sold the packages to customers, softco would derive foreign base company sales income. how different is the situation when softco puts uscogenerated software programs on its servers and thereafter delivers copies to its customers? one would think that the irs might consider the two situations to be comparable and conclude that softco derived foreign base company sales income. the fourth category of software programs which softco sells consists of programs acquired from usco which independent contractors then modify or adapt for softco. as to these, the issue is whether softco is deemed to have "manufactured" the property sold. a critical threshold question is whether the activities of the independent contractors are to be attributed to softco. in revenue ruling 75-7,"9 the irs originally ruled that if a cfc retained a contract manufacturer to process property which the cfc owned, the activities of the manufacturer would be attributed to the cfc; if those activities constituted manufacturing, the cfc was deemed to manufacture the property for purposes of applying the foreign base company sales income rules. some years later, in the ashland oil case, u the irs sought to blunt the impact of this rule by arguing that when the contract manufacturer was located in a country other than the country in which the cfc was organized, it constituted a "manufacturing branch" of the cfc under section 954(d)(2); the result would have been that the cfc would be deemed to have purchased the property it resold from a separate, related manufacturing corporation, thus "restoring" its profit to the status of foreign base company sales income. 116. regs. § 1.954-3(a)(4)(i). 117. regs. § 1.954-3(a)(4)(iii). 118. see dave fishbein mfg. co. v. commissioner, 59 t.c. 338 (1972), acq.. 19731 c.b. 1 (manufacturing portable bag closing machines): bausch & lomb inc. v. commissioner, 71 t.c. memo (cch) 2031. t.c. memo (ria) j 96.057(1996) (manufacturing sunglasses). 119. 1975-1 c.b. 244. 120. ashland oil, inc. v. commissioner. 95 t.c. 348 (1990). 19991 florida tax review the government lost the ashland oil case; and rather than litigate the issue further, the irs published revenue ruling 97-48.121 this ruling accepts the holding of ashland oil but reverses the conclusion of revenue ruling 75-7, holding that manufacturing activities of a contract manufacturer located in another country are not to be attributed to a cfc for purposes of determining whether it has derived foreign base company sales income. the treasury has recently proposed a regulation confirming this rule by specifying that a cfc will be considered to have manufactured or produced property only if, "as a result of operations conducted by such selling corporation in connection with the property that it purchased and sold," the property it sold is in effect not the property it purchased. 22 the ashland oil transactions and similar arrangements involve contracts between two business organizations, each with its own facilities and staff of employees. the arrangements in softco's case are different in that softco separately contracts with a number of individuals for personal services. does this distinction make a difference? does the requirement of the proposed regulation that the "operations" be "conducted by such selling corporation" require that they be carried out by employees? elsewhere in the regulations under section 954, the conduct of business by employees is expressly required. 123 the thrust of revenue ruling 97-48 and the proposed regulation seems aimed at cases in which a cfc claims exemption from the foreign base company sales income rule on the basis of activities carried on by other persons in non-tax haven countries in which the cfc is not taxable. if the relationship which softco entered into with the programmers who develop its programs were deemed an employer-employee relationship, the contract manufacturer rule would not seem to apply; but there are any number of reasons why it might be unacceptable for softco to enter into such employment arrangements. among other things, the cfc might well be considered to be engaged in trade or business in the united states (as well as other countries) and therefore subject to tax.12 4 since it is not clear that the activities of the independent contractors retained by softco are to be disregarded, it may be useful to consider whether softco would be deemed to have "produced" the modified programs if those activities are taken into account. 121. 1997-2 c.b. 304. 122. prop. regs. § 1.954-3(a)(4)(i) (effective for taxable years beginning on or after the date the final regulations are published in the federal register). 123. see, e.g., regs. § 1.954-2(c)(1)(ii), (d)(1)(ii) (marketing activities relating to rents and royalties). 124. rev. rul. 70-424, 1970-2 c.b. 150 (principal-agent relationship causes foreign principal to be engaged in u.s. trade or business). [vol. 4:4 taxation of electronic conmerce the applicable regulation sets forth two tests. property will be deemed to be produced by the cfc if what is purchased is "substantially transformed" or if it is a component of the property sold and the processes performed by the cfc with respect to it "are substantial in nature and are generally considered to constitute the manufacture, production or construction of property."'" the regulations illustrate these rules by examples relating to such physical objects as paper, screws and bolts, fish, engines and automobiles; these are again not of much help. one is left to speculate on the extent to which softco would be required to modify or adapt programs it has acquired from usco before it would escape the foreign base company income category. presumably, extensive modification should be deemed sufficient; but what this means would depend on an analysis of a highly technical nature. (d) softco's transactions with russco. in addition to its dealings with the public, softco enters into transactions with russco. in some of these transactions, softco grants to russco substantially all of the rights to its software programs in eastern europe. even though the consideration paid by russco is in the form of royalty-like contingent payments, for u.s. tax purposes these transactions are characterized as sales of the underlying "copyright rights."126 since russco is a related person, such sales will give rise to subpart f income (regardless of whether softco has acquired the programs from usco) unless, under the analysis presented above, softco is treated as having "produced" the programs. 2. rental and royalty inconie.-whether rental and royalty income of softco constitutes subpart f income depends on a different set of statutory and regulatory rules. rents and royalties generally constitute subpart f income." there is an exclusion, however, for rents and royalties derived in the active conduct of a trade or business and received from unrelated persons.'2 amounts received by softco from russco which are not characterized as sales income will be characterized as royalties; and since russco is a related person, the "active business" exclusion cannot apply. royalty income received by softco from russco will therefore constitute subpart f income. to the extent that income which softco derives from transactions with unrelated persons is characterized as rental or royalty income, however, the "active business" exclusion may be available. 125. regs. § 1.954-3(a)(4)(i)-(iii). 126. see, e.g., rev. rul. 54-409, 1954-2 c.b. 174: rev. rul. 75-202, 1975-1 c.b. 170; rev. rul. 84-78, 1984-1 c.b. 173. 127. see irc § 954(c)(1)(a). 128. see irc § 954(c)(2)(a). 1999] florida tax review at the outset, it is important to note that nothing in the ensuing analysis turns on whether the programs licensed by softco were acquired from usco or from an unrelated person. the inquiry involves solely the business activities of softco. under the applicable regulations, softco could be considered to derive "active business" rents or royalties if it regularly performed marketing functions through a staff of its own employees which is "substantial in relation to the amount of royalties derived .... this determination is based on all of the facts and circumstances, but under a "safe harbor" rule a marketing organization will be deemed to be "substantial" if "active licensing expenses" equal or exceed 25% of "adjusted licensing profit." "active licensing expenses" include amounts deductible under section 162 as ordinary and necessary business expenses, other than compensation to shareholders, persons related to them or agents or independent contractors. "adjusted licensing profit" refers to a gross profit figure-the rents or royalties received less royalties paid, amounts of deductible deprecation or amortization and payments made to agents or independent contractors. 13 we do not have sufficient facts to know whether softco could meet this test, but since it employs only two persons in its marketing function, it would have to incur rather substantial advertising expenses in order to satisfy this "safe harbor" rule. we will assume that the test is not met. softco could also qualify for the "active business" exclusion of rents and royalties if the property leased or licensed is property that it has manufactured or produced, or has acquired and added substantial value to, so long as if it regularly engages in these activities. 31 we will assume that softco will meet the "regularly engaged" criterion, so that the question is whether it has "manufactured or produced" or "acquired and added substantial value to" the property leased or licensed. in the case of programs acquired from usco or from unrelated persons (and not modified and adopted), softco would not be considered to have produced the programs, and it seems unlikely that softco would be deemed to "add substantial value" by reason of its marketing activities alone. with respect to the computer programs that softco has contracted to have created for it, it would be deemed to have produced the property which it licenses if the activities of independent contractors located in countries other than bermuda are not to be disregarded. the rules relating to contract manufacturing, discussed above, apply by their terms only to transactions 129. regs. § 1.954-2(c)(1)(ii), (d)(1)(ii). 130. regs. § 1.954-2(c)(2)(ii)-(iv), (d)(2)(ii)-(iv). 131. see regs. § 1.954-2(c)(1)(i), (d)(1)(i). [vol 4:4 taxation of electronic commerce analyzed under the foreign base company sales income rules. it is unclear whether they should be applied here. it is noteworthy that to qualify royalties as "active business" royalties under the marketing activities rule, the marketing organization must consist of employees, and payments made to independent contractors are disregarded in applying the "safe harbor" rule. there is no such express provision in the rule relating to the production of intangibles. should this be implied, or is the omission to be taken as an intended difference? in cases where softco has retained independent contractors to modify or adopt programs originally acquired from usco or unrelated persons, the same questions arise; but in such cases, the additional question is whether these activities have "added substantial value" to the acquired programs. this seems to call for an analysis similar to the analysis of whether softco has "produced" programs for purposes of applying the foreign base company sales income rules. 32 3. services hcomne.-if a cfc performs services "for or on behalf of' a related person and these are performed outside the country in which the cfc is organized, the resulting income can constitute foreign base company services income,133 which constitutes subpart f income.' except to the extent that any of the independent contractors retained by softco are located in ireland, the services supplied by softco to customers (in the form of "hot line" services or customer-requested adaptations or modifications) are performed outside its country of organization. in general, however, these services will be supplied to unrelated customers. the services nevertheless could be considered to constitute services performed on behalf of a related party if usco were deemed to provide "substantial assistance" to softco in connection with their performance.'35 on the facts given, usco is not itself participating in the supply of services. at least tacitly, however, it is supplying assistance to softco by permitting individuals who are its employees to create software programs and perform "hot line" and other services for softco. in economic substance, this represents a diversion of usco's resources for the benefit of softco.1an example in the applicable regulation deems a u.s. parent to provide substantial assistance to its cfc 132. see supra text accompanying notes 116-25. 133. irc § 954(e). 134. see irc § 954(a)(3). 135. see regs. § 1.954-4(b)(1)(iv). 136. to the extent that individuals perform services for and are compensated by softco, this is presumably with the consent of usco, and an alternative would be for usco to contract with softco for the services of softco's employees. 19991 florida tax review subsidiary when persons who are "regular employees" of the parent are "temporarily employed" by the subsidiary. 137 to the extent that softco performs services for customers of russco, these may be considered to be performed for or on behalf of russco to the extent that russco pays softco to perform them or softco's performance fulfills an obligation of russco.138 this might be true with respect to any "hot line" services which russco has included in the price it charges to its customers. on the other hand, if russco customers separately contract and pay for services to be supplied by softco, such services should not be deemed to be performed on behalf of russco. 4. passive investment income.-since softco is a cfc, usco remains potentially subject to tax on any other types of subpart f income which softco earns. for example, if softco reinvested its earnings in assets producing passive income, such as dividends and interest, those income items could result in a current tax on usco under subpart f.'3 9 5. summary.-to summarize how softco would be likely to be treated under subpart f with respect to its software operations, it is useful to distinguish between its transactions with the public and its transactions with russco. with respect to its transactions with the public: 1. as to programs which softco acquires from usco and does not modify, income from sales, rents and royalties will constitute subpart f income. 2. as to income from programs which softco itself develops: (a) income from sales will not constitute subpart f income; (b) income from rents and royalties will constitute subpart f income if the activities of the independent contractor programmers are disregarded; otherwise it will not. 3. as to programs which softco acquires from usco and modifies, income from sales, rents and royalties will produce subpart f income if the activities of the independent contractor programmers are disregarded; if not, the outcome would depend upon whether the modification is sufficient to result in a "transformation" of the property. 137. see regs. § 1.954-4(b)(3) ex. 2. 138. see regs. § 1.954-4(b)(1)(i)-(ii). 139. see irc § 954(a)(1). [vol 4:4 taration of electronic comnmerce 4. services income will constitute subpart f income only if usco is deemed to be providing "substantial assistance" to softco by permitting its programmers to work for softco and then only in cases where usco personnel have actually assisted in performing the services. with respect to transactions with russco: 1. exclusive licenses of programs, characterized as sales, will constitute subpart f income unless softco is deemed to have "produced" the programs. 2. nonexclusive licenses of programs, giving rise to income characterized as royalties, will constitute subpart f income. 3. income from the performance of services for customers of russco will constitute subpart f income if the services are paid for, or discharge a warranty or other obligation of, russco; otherwise it will not. b. taxation of u.s. individual shareholders controlling softco in the second scenario set forth at the beginning of this paper, softco is wholly-owned by four u.s. individuals. under these circumstances, softco will not only be a cfc, but potentially a foreign personal holding company (fphc) as well.1"' if softco were a fphc, its u.s. shareholders would be required to include currently in taxable income their respective shares of softco's entire undistributed income.' 4 ' softco would still be a cfc; usco and russco would remain related persons with respect to it; "2 and subpart f would apply in essentially the same way as discussed above. amounts taxable to the individuals as subpart f income will be includible by them under the cfc rules and not under the fphc rules,'4 but amounts which are not subpart f income may be includible under the fphc rules even if not includible under the cfc rules. softco will be a fphc only if more than 60% (in the first applicable year, and 50% thereafter) of its gross income consists of foreign personal holding company income.'" income from sales or the performance of 140. a foreign corporation may be a fphc if more than 50% of the voting power or value of its stock is owned directly or indirectly by five or fewer u.s. individuals. see irc § 552(a)(2). 141. see irc § 551. 142. under § 954(d)(3), a person or entity is a related person with respect to a cfc if it owns, directly or indirectly, more than 50% of the voting power or value of the cfc's stock, or both it and the cfc are controlled by the same person or entity. 143. see irc § 951(d). 144. see irc § 552(a)(1). 19991 florida tax review services does not constitute fphc income under any circumstances. 45 accordingly, if the gross income derived by softco from transactions which are characterized as sales or services constitutes more than 40% of softco's gross income, softco will not be a fphc without regard to any "active business" or "production" tests. if this is not true, the status of softco as a fphc will depend upon the characterization of its royalty income. (rental income constitutes fphc income unless it constitutes 50% or more of total gross income,"46 which seems at least highly unlikely in the softco case.) royalties generally constitute fphc income, but there is an exception for "active business computer software royalties.' 47 it would be too much to hope that this "active business" royalty exception would bear some resemblance to the similar exception from subpart f income, and it does not. the rule was added by the tax reform act of 1986148 to apply in a domestic context and was extended to foreign corporations without any apparent thought. the bounds of the rule are hardly clear. no implementing regulations have been proposed or adopted. there are, however, four statutory requirements. 49 first, active business computer software royalties must constitute at least 50% of the corporation's gross income for the year. 5 ' if softco's gross income includes substantial income from sales and services (although this constitutes 40% or less of gross income), it is likely that this condition will be satisfied if-but only if-all or most of the royalties received by softco qualify as active business computer royalties, an issue discussed below. if rental income and/or nonqualifying royalties constituted more than 10% of gross income, softco might find itself with gross income of less than 40% from sales and services and less than 50% from either rents or qualifying royalties, in which case this condition would not be satisfied and softco would be a fphc. the second condition is twofold. the royalties taken into account must first be received by a corporation which is "engaged in the active trade or business of developing, manufacturing, or producing computer software."'' in the absence of regulatory guidance, one would think that softco would meet this test as long as it continues to have software programs 145. see irc § 553 (defining foreign personal holding company income). 146. see irc § 553(a)(7). 147. see irc § 553(a)(1). 148. see staff of the joint comm. on tax'n, 99th cong., general explanation of the tax reform act of 1986 371-74 (comm. print 1987). 149. these are set forth in § 543(d), relating to domestic personal holding companies, and incorporated in § 551(a)(1) by cross-reference. 150. see irc § 543(d)(3). 151. irc § 543(d)(2)(a). [vol 4:4 taxation of electronic coimmerce created for it by contractors on an ongoing basis-although it is not clear why activities of independent contractors should be taken into account in this context if they are to be disregarded in the subpart f contexts discussed above.1 52 the second prong of the test requires that the royalties be attributable to software which is either (i) developed, manufactured, or produced by the corporation "in connection with" that trade or business; or (ii) "directly related to" that trade or business. 153 the additional question posed by (ii) is whether royalties attributable to software which softco has acquired from usco qualify as "directly related," and it is not clear how that question is to be answered. perhaps it makes a difference whether the software developed by softco accounts for most of the royalty income and the software provided by usco is less important and merely fills out a line of products offered by softco or whether, on the contrary, the royalties from usco-developed software are the dog and the royalties from softco-developed software are the tail. the extent to which softco modifies usco software programs may be relevant. there does not appear to be a clear answer. the third condition is that certain deductions allowable to the corporation under sections 162, 174 and 195 (generally speaking, ordinary and necessary business expenses other than items such as depreciation and amortization, interest and compensation paid to shareholders) which relate to the royalties must equal at least 25% of the royalties. on the facts given, there is no way of knowing whether softco would meet this test. finally, if softco derives foreign personal holding company income other than the royalties (e.g., rents or dividends and interest derived from investing earnings) and such income exceeds 10% of total gross income, it must pay out an amount equal to the excess as dividends. notably, in determining whether royalties derived by softco constitute "active business computer software royalties," nothing turns on whether the royalties are received from a related person, so that royalties received by softco from russco are counted. as in the case of a cfc, if, by reinvesting its earnings in passive assets, softco earned dividends, interest or other passive income, the resulting amounts would have to be taken into account in determining whether softco is a fphc. c. taxation of u.s. individual owning 25% of sofico's stock in the third scenario set forth at the beginning of this paper, softco is owned 25% by a u.s. individual and 75% by non-u.s. persons. under 152. see supra text accompanying notes 119-24. 129-32. 153. irc § 543(d)(2)(b). 1999] florida tax review these circumstances, neither the controlled foreign corporation nor the foreign personal holding company rules will apply.'54 the u.s. individual will, however, be subject to the passive foreign investment company (pfic) rules. if a foreign corporation is a pfic, a u.s. shareholder will be subject to a special tax regime under which the shareholder pays income tax plus an onerous interest charge upon receipt of an "excess distribution" from the corporation or upon gain realized upon disposition of the corporation's shares "'55 unless the shareholder elects, under certain conditions, to include in income currently the shareholder's pro rata share of the corporation's entire income.'56 a foreign corporation is a pfic if either: (i) 75% or more of its gross income consists of passive income; or (ii) 50% or more of its assets produce or are held for the production of passive income. 5 7 the asset test is based, in general, on the fair market value of the assets and is based on the average of quarter-end values. 58 passive income is defined by cross-reference to the definitions of foreign personal holding company income set forth in the cfc provisions.'59 in general, therefore, whether income derived by softco is passive will depend upon the analysis set forth in the prior discussion. sales income will not be passive income, and the treatment of rental and royalties would depend upon whether they constitute "active business" rents or royalties. the pfic rules modify the cfc rules in certain ways. among others, rents or royalties received by the foreign corporation are not considered to be passive income if they are: (i) received from a related person; and (ii) are attributable to income of that person which is not passive income." softco will receive royalties from russco which may not be active business royalties. such royalties will not be considered passive income for pfic purposes if they are attributable to active business income of russco. this could be case if, for example, russco's income consisted of income from sales, rather than rents or royalties. if softco derived a significant portion of its total income in the form of sales income, it is unlikely that 75% or more of its total gross income will be passive income, so it is unlikely to be a pfic on this ground. it is more likely to fall afoul of the rule which makes it a pfic if 50% or more of its assets are held for the production of passive income. it does not appear that softco will own substantial tangible assets. receivables from customers will 154. see supra text accompanying notes 106 and 140. 155. irc § 1291. 156. see irc § 1295. 157. see irc § 1297. 158. see irc § 1297(a)(2). 159. see irc § 1297(b)(1) (referring to § 954(c)). 160. see irc § 1297(b)(2). [vol 4:4 taxation of electronic commerce constitute assets producing active income to the extent that they are generated by sales or the performance of services but not, apparently, if they represent royalty receipts. 6' cash and other amounts representing working capital are treated by the irs as assets which produce passive income. " whether the 50% test is met is likely to depend, therefore, not only on how the software assets which it holds are valued-not an easy task-but also how they are characterized. assets are characterized by reference to whether they produce or are held for the production of passive income.16 in softco's case it appears that the same assets (the computer programs and the rights protecting them) are held to produce both active and passive income; in this case, the assets will be treated as partly active and partly passive in proportion to the amounts of income (presumably gross income) generated by them.y" again, as when softco is a cfc or a fphc, investment of retained earnings of softco in passive assets may turn softco into a pfic even if it would not be one based upon its operating assets. d. sunmnary of the application of the tax haven regimes the cfc rules are fundamentally different in their application from the fphc and pfic rules. the former are aimed at an operating company, presumably generating active business income in the main, that attempts to "sliver" its income into discrete segments that can be shifted into tax havens. thus, under subpart f, even if the cfc's subpart f income is only a fraction of total income it will be counted; but (subject to de mininis and "de mnaxinis" rules),165 only the portion of the cfc's income which constitutes subpart f income is taxed through to the u.s. shareholder(s) on a current basis. this may produce a tax even if the subpart f income is only a fraction of the cfc's total income. moreover, sales and services income can give rise to tax. by contrast, the fphc and pfic rules were addressed to offshore investment companies and others deriving predominantly passive investment income. therefore, whether a foreign corporation is a fphc or a pfic is an "all or nothing" proposition; if the foreign corporation rings the definitional 161. see notice 88-22, 1988-1 c.b. 489. 162. see id. 163. see irc § 1297(a)(2). 164. see id. gross income, rather than net income, should presumably be used because the 75% passive income test is based on gross income. 165. under § 954(b)(3)(a), if the sum of foreign base company income (without regard to deductions) and gross insurance income for a taxable year is less than the lesser of 5% of gross income or $1,000,000, then no part of such income will be treated as foreign base company income or insurance income. if this sum exceeds 70% of gross income, then the entire gross income will be treated as either foreign base company income or insurance income under § 954(b)(3)(b). 1999] florida tax review bell, the u.s. shareholder must account for his pro rata share of all of the foreign corporation's income; otherwise, none of it is taken into account. moreover, only passive income is "bad," and this does not include sales and services income. under both types of regimes, rents or royalties may constitute active or passive income based upon a determination whether they are derived in the conduct of an active business, although the determination is based, in the case of the fphc, on rules wholly different from those which apply under the cfc and pfic regimes. not surprisingly, if the bulk of softco's income consists of sales and services income, its income will be taxable, if at all, only under the cfc rules. on the other hand, if softco's income were derived predominantly in the form of royalty income, it might become subject to tax under the fphc and/or pfic rules depending upon how much of the income failed to qualify under the applicable "active business" rule. viii. what does all of this prove? surely the reader has long since been numbed into oblivion by the bewildering array of rules that have to be considered in analyzing the u.s. tax treatment of a very simple business operation. beyond this, it must have become obvious that current law requires the making of a large number of distinctions that: (i) are difficult if not impossible to make when dealing with electronic "goods" such as software programs; and/or (ii) just don't make much sense in this context. a. income characterization to begin at the beginning, one must question whether the treasury department is correct in believing that existing law, and particularly the existing income characterization rules, can adequately deal with the new environment of nonphysical commerce. when softco transfers a "copyrighted article" to a customer, should the taxability of its income-either direct taxation at the source or the indirect taxation of its u.s. shareholders-really depend upon whether the customer's right to use the software program is limited in time? what is the policy which supports this distinction? one supposes that the original distinction struck between sales and rental income was based on the idea that the sale was a final transaction in which property was permanently transferred to the buyer, with the seller retaining no interest, while the lease was a temporary arrangement under which the lessor would:(i) "retain an interest" in the property; (ii) receive an ongoing stream of income; and (iii) at some point retake possession of the property, perhaps then redelivering it to another lessee. in the case of transfers of electronic "goods" [vol 4:4 taxation of electronic conmerce none or few of these suppositions are true: the "property" is infinitely replicable (and therefore the "lessor" has no particular "interest" in any individual copy), payment is often made in a lump-sum, and the "leased" item is seldom if ever returned or used by another (although the copy which the lessee has may be destroyed). in addition, the product life of software programs or many other types of electronic "goods" may be short enough that "permanence" is not a very meaningful reference. similarly, when softco receives payments from russco for the transfer of "copyright rights," why should the taxability of those that relate to the grant of substantially all of the rights in a program be tested under one set of rules (for sales and exchanges) while those that relate to nonexclusive transfers are tested under another (for royalties)? in the case of withholding tax, we have partially recognized this anomaly by treating contingent payments, at least, the same way in both cases."' should not the same considerations dictate that, for purposes of the cfc, fphc and pfic regimes, the same rules should apply in both cases? b. what constitutes the production of proper'? in determining when to apply the tax haven regimes (and in making the related determination of when u.s.-source production income arises) we really need a complete re-assessment of what constitutes the production of property and what the significance of that activity is. as long as any portion of the income derived by a company like softco is treated as sales income it is necessary under existing law to determine whether softco has "produced" the property it has sold, both to determine whether there is u.s.-source income taxable directly to the company and whether the company (if a cfc) has generated foreign base company sales income. by contrast, if the income is characterized as rental or royalty income, it does not matter for purposes of taxation at the source whether, where or by whom the property giving rise to the income was produced, while under the subpart f rules, it matters whether the corporation involved "produced" or "added value" to the property. (under the "active business computer royalty" rules applicable for fphc purposes, the analogous "active business" tests are "overall," rather than "item specific" tests.) generally speaking, but also specifically in the case of nonphysical goods, there is a companion need to re-think the significance of activities that are carried on behalf of the enterprise by independent contractors. the "contract manufacturing" ruckus has arisen in the context of the foreign base company sales income rules, but from a policy perspective the same or analogous issues arise in other contexts. 166. see irc §§ 871(a)(1)(d), 865(d)(l)(b). 1999] florida tax review c. the cacophony of tax haven rules although the problem is not unique to the present context, the overlapping, inconsistent and often impenetrable rules which apply to cfcs, fphcs and pfics are in desperate need of rationalization and simplification. surely the "active business software royalty" rule, for example, applies to fphcs and not to cfcs or pfics simply through the historical accident that the rule was originally written for domestic companies that would otherwise be personal holding companies and, probably without thought, mirrored in the foreign personal holding company rules. in addition, it is not clear why the pfic rules, which-like the fphc rules-are designed to define a corporation which derives predominantly passive income, treat rents and royalties under the cfc rules rather than the fphc rules-and then also with a carve-out for rents and royalties received from related persons, which seems to have much more to do with cfc relationships (and f6reign tax credit baskets) than with passive income determinations. ix. some modest suggestions it is easier to identify the problems of existing law than it is to figure out whether or how the law ought to be changed. at a minimum, however, there are areas which are clear candidates for clarification or possible change. the fundamental problem is that, when we deal with computer programs or other kinds of information that can be transmitted by electronic means, the traditional distinctions among tangible personal property (a machine) and intangible personal property (a patent) and services breaks down. we should surely spare the tax court the need to dance on the head of a pin all of the angels that were danced in the norwest and sprint cases, 167 in which the court struggled to apply a pre-electronic commerce "tangible property" rule to computer software. in polar cases, one can still distinguish among, say, the sale of a widget, the license of a patent and the provision of a legal opinion. more and more transactions, however, will fall into the muddled middle ground; and the best response to this is to make the characterization of the resulting income matter as little as possible. this means that, with all due respect for my colleagues at the treasury department, a good place to start would be in eliminating major distinctions which flow from applying traditional income characterization rules. to begin with-and this is a recommendation which predates the age 167. norwest corp. v. commissioner, 108 t.c. 358 (1997); sprint corp. v. commissioner, 108 t.c. 384 (1997). [vol. 4:4 taxation of electronic conmerce of electronic commerce' 6 -the distinction between the sale and the license of intangible property should be eliminated, regardless of whether the consideration received is contingent or fixed. in addition, while there may (or may not) be a continuing role for a distinction between income derived from the sale and the lease of tangible property, this is not a useful distinction when applied to any kind of property which can be delivered by downloading information on to the customer's computer. it is unlikely that in the real world deliveries of electronic information characterized as "sales" will be taxed at the source, and therefore, the attempt to impose tax on "temporary" transfers should be abandoned. there is also room for clarifying the meaning of "services" in characterizing income from the provision of "goods" over the internet. 1 69 another fundamental characterization rule that needs rethinking is the rule that decrees that income derived from the production and sale of tangible property is to be split, with a portion of the resulting income attributed to the production activity and a portion to the sales activity, whereas this is not done in the case of income derived in the form of rents of tangible property or royalties or other amounts derived from the disposition of intangible property. there are some very real problems in applying a split characterization rule in circumstances in which contingent payments will be received over a substantial period of time,17 0' but in transactions of a similar nature (for example, the delivery of a copy of a computer program for either a temporary period or for use forever in consideration of a one-time charge), it is difficult to justify the critically different tax consequences which may ensue from the characterization. a parallel, but equally important, task is to clarify and rationalize the rules that make the current taxability of u.s. shareholders of a tax haven corporation depend upon whether the corporation has "manufactured" or "produced" property which it markets-whether through sales, rentals, royalties or dispositions. the underlying policy seems to be that if the foreign corporation derives the income in an active business-defined by referring to whether the corporation has "produced" the property involved, there is no current tax, while the opposite is true if there has been no "production." in the case of software programs and similar information delivered to customers, there is a major ambiguity as to whether the "production" which makes the difference is the creation of the copy--of a software program, a book or a series of data-delivered to a customer or the creation of the program, book or data itself. since rather little investment in facilities or personnel is 168. see ali study, supra note 49. at 43-50. 169. see glicklich et al, supra note i. 170. see ali study, supra note 49, at 34-36, 48. 19991 florida tax review involved in reproducing on a server copies of information downloaded into it, the "active business" policy represented by the requirement that property be "produced" by the foreign corporation might be most appropriately implemented by requiring that the corporation itself generate for its own account the software program, the book or the compilation of data. once the required "production" process has been determined, the test should be uniformly applied to sales, rental and royalty income of a cfc. in order to eliminate anomalies based on income characterization, consideration should be given to excluding income derived from transactions involving "produced" property regardless of whether the customer is a related person; this is now the rule for foreign based company sales income but not for rents and royalties. as has been noted many times before, there is a seemingly needless overlap between the fphc and pfic regimes. this of course involves a variety of rules; but in the current context the issue is whether there is any possible reason for applying a completely separate (and hardly simple) test-the "active business computer software royalty" rules-for fphc purposes, instead of adopting for that purpose as well as for pfic purposes the cfc "active business" tests. finally, we should come to closure on the extent to which the activities of independent contractors, whether contract manufacturers or others performing services or carrying on other activities for the account of a corporation (or other entity), are taken into account in characterizing its income. for purposes of determining whether rents and royalties should be considered to be derived from the conduct of an active business and therefore not subpart f income, marketing activities of independent contractors are not taken into account. this reflects the view, evident in other provisions of the tax law,' 7 ' that the active conduct of a business implies having officers and employees that do the business. the issue is simply whether the answer is to be different when it is not marketing but production activities (including the performance of services) which form the asserted business activity-or whether the rents and royalties rule should be changed. while the task is probably less urgent, the same questions need to be answered in determining when a foreign corporation or entity will be deemed to be deriving u.s.-source income from production (and services) activities. the regulatory rule which disregards the activities of nonemployees in apportioning income from the manufacture and sale of personal property may well have been influenced by the apportionment formula it seeks to apply, which involves the extent to which manufacturing assets are located in and outside the united states. it is not clear to this author, at least, that the 171. see, e.g., regs. § 1.355-3(b)(2)(iii). [vol 4:4 1999] taxation of electronic commerce 379 draftsman was consciously excluding from u.s. tax altogether foreign entities which supply the services of, or have production activities carried out by, independent contractors in the united states. tcharity really does begin at home: florida tax review volume 16 2014 number 6 325 concentrated enforcement by leigh osofsky abstract when enforcement resources are limited, how should the scarce enforcement resources be allocated to increase compliance with the law? the answer to this question can determine to what extent the law on the books translates to the law in practice. a dominant school of thought in the tax literature suggests that they should be allocated based on a “worst-first” method, whereby the individuals likely to be most noncompliant are targeted. however, while “worst-first” methods can encourage all individuals to increase compliance so as not to be deemed the “worst,” they can also provide cover to engage in noncompliance that is perceived moderate for the relevant population. this dynamic can become most problematic in highly noncompliant populations. in such populations, existing, high levels of noncompliance, and underlying, structural causes of the high noncompliance can serve as coordinating mechanisms, providing mutual assurance of low compliance. moreover, “worst-first” theories do not provide a comprehensive explanation for the group and project-based enforcement practices that are found in a number of actual enforcement settings. in response to these deficits, this article draws on work from across different disciplines to develop a new theory for the allocation of scarce tax enforcement resources. this article suggests that, under certain conditions,  associate professor of law, university of miami school of law, j.d., stanford law school. many thanks to caroline bradley, paul caron, michael doran, joseph dugan, david gamage, pat gudridge, david herzig, jonathan kalinski, leandra lederman, elliott manning, ajay mehrotra, susie morse, jason oh, katie pratt, shu-yi oei, zachary osofsky, eric rasmusen, tom robinson, andres sawicki, hendrik schneider, ted seto, kirk stark, scott sundby, alexander wu, eric zolt, attendees of presentations at ucla, pepperdine, indiana, loyola, and miami law schools, and participants at the 2013 national tax association annual conference on taxation, the 2013 southeastern association of law schools conference, the 2013 junior tax scholars workshop, the 2014 internal revenue service and urban-brookings tax policy center research conference, and the 2014 columbia tax policy workshop for helpful thoughts. finally, thank you to the university of miami school of law reference librarians and, in particular, to sue ann campbell. 326 florida tax review [vol. 16:6 deterrence can be enhanced by allocating scarce enforcement resources among a low-compliance population of taxpayers through a process called concentrated enforcement. after setting forth the theoretical case for concentrated enforcement, this article examines how it might apply in the cash business tax sector, a highly noncompliant sector that presents particular challenges for “worst-first” methods. this article concludes that concentrated enforcement may increase compliance, meriting its application and empirical evaluation. i. introduction ............................................................................. 326 ii. classic deterrence theory and “worst-first” methods ...................................................................................... 329 a. classic deterrence theory ............................................... 329 b. “worst-first” theories .................................................... 333 iii. project-based enforcement in practice ......................... 338 iv. concentrated enforcement ................................................ 344 a. description of concentrated enforcement ....................... 344 b. economic base case ......................................................... 347 c. feedback loops between noncompliance and enforcement ...................................................................... 353 d. norms ................................................................................ 354 e. uncertainty aversion ........................................................ 357 f. availability bias ................................................................ 360 g. nodes of noncompliance .................................................. 362 v. application to cash business tax sector ........................ 362 a. the cash business tax sector .......................................... 363 b. difficulties for “worst-first” approaches ....................... 365 c. the case for concentrated enforcement .......................... 368 d. objections and responses ................................................. 380 i. introduction classic deterrence theory, the foundational economic theory frequently relied upon by legal scholars to describe how to use enforcement to increase deterrence and therefore compliance with the law, offers two basic prescriptions for increasing legal compliance: increasing the likelihood of detection and increasing the penalty for noncompliance. 1 guided by this theory, law and economics scholars have focused for decades on setting the optimal likelihood of detection and penalties for noncompliance. 2 however, when practical constraints limit both the likelihood of detection and penalties 1. see infra text accompanying notes 14–16. 2. see infra note 34 and accompanying text. 2014] concentrated enforcement 327 to suboptimal levels, these two levers offer little by way of useful prescriptions for increasing compliance in practice. focusing on the practical constraints on enforcement, a strain of thought in the tax literature and other enforcement contexts suggests that scarce enforcement resources should be allocated based on a “worst-first” method, which targets enforcement toward individuals likely to be most noncompliant. 3 indeed, this “worst-first” method seems to underlie the wellknown discriminant index function score, or “dif” score, 4 which many think is the principal means of determining which taxpayers to audit. 5 however, this “worst-first” theory does not provide a comprehensive approach to the allocation of scarce enforcement resources. while “worstfirst” approaches may be a good way to select the most noncompliant individuals, using only a “worst-first” approach may not be the best means of incentivizing voluntary compliance. 6 indeed, “worst-first” methods are least likely to work well as a means of incentivizing voluntary compliance when noncompliance in a given population is particularly high—the very situations in which allocation of scarce enforcement resources are most important. 7 moreover “worst-first” theories do not provide an explanation for the project-based enforcement that often exists in practice. 8 in response to these deficits in existing theory, this article sets forth a theory for the allocation of scarce tax enforcement resources, which this article calls concentrated enforcement. concentrated enforcement is an initial process for allocating scarce enforcement resources among a highly noncompliant population. it is a method of segmentation and rotation. it breaks a highly noncompliant population into subsectors and addresses the population’s compliance problem through strategic, concentrated “enforcement projects” in the subsectors. enforcement projects in particular subsectors are necessarily matched by decreases in enforcement in others. the enforcement projects rotate through the subsectors, with their initiation announced, but their withdrawals unannounced. if particularly high noncompliance nodes can be identified, they receive heightened attention. concentrated enforcement is different than a purely “worst-first” approach because concentrated enforcement segments an overall population and focuses on enforcement projects within the population, even if individuals outside of the enforcement project might exhibit higher noncompliance. the intuition behind concentrated enforcement is that, under certain circumstances, concentrated enforcement can increase compliance as a result 3. see infra text accompanying notes 38–40. 4. see i.r.m. § 4.1.3.2(2) (2007). 5. see infra text accompanying notes 41–45. 6. see infra text accompanying notes 54–55. 7. see infra text following note 55. 8. see infra part iii. 328 florida tax review [vol. 16:6 of (1) increasing marginal returns to enforcement and (2) psychological factors that can support concentrated enforcement. this article develops the theoretical case for concentrated enforcement by drawing on, and integrating research from, a number of different disciplines. first, by drawing on and amplifying recent economic theory, this article argues that if compliance incentives are inadequate if enforcement is spread uniformly, a base case for concentrated enforcement can apply. 9 informed by criminology, behavioral economics, and psychology, this article then argues that, under a number of different circumstances, the case for concentrated enforcement grows. the case for concentrated enforcement grows when there are feedback loops between noncompliance and enforcement, when norms can yield and sustain compliance but themselves depend on rates of compliance, and when the regulated parties exhibit the availability bias or uncertainty aversion. 10 finally, when particular nodes of noncompliance exist, concentrated enforcement works best by focusing on such nodes. 11 after setting forth the theory behind concentrated enforcement, this article examines how it might apply to the cash business tax sector. the cash business tax sector is an important sector for innovation, because cash business taxpayers engage in extensive violations of the tax law, which are difficult to address with classic deterrence theory or “worst-first” methods. this article concludes that, for a number of reasons, concentrated enforcement may increase the total amount of compliance in the cash business tax sector. 12 on the other hand, there are some potential problems with the application of concentrated enforcement to the cash business tax sector. these include: fundamental difficulties with auditing cash business taxpayers, potential compliance decay, potential taxpayer entrenchment to tax evasion positions, and possible backlash as a result of perceived targeting of taxpayers. 13 despite these potential problems, this article suggests that the case for concentrated enforcement in the cash business tax sector is strong enough to merit experimental application and evaluation. the claim of this article is not that concentrated enforcement would work best in the cash business tax sector, as compared to alternative sectors. rather, this article seeks to set forth the conditions under which concentrated enforcement may increase compliance and examine how it might apply in a particularly difficult compliance environment: the cash business tax sector. whether the conditions necessary for the success of 9. see infra text accompanying notes 96–117. 10. see infra text accompanying notes 133–46. 11. see infra page part iv.g. 12. see infra text accompanying notes 179–24. 13. see infra text accompanying notes 225–68. 2014] concentrated enforcement 329 concentrated enforcement in fact exist in any particular sector, including in the cash business tax sector, is ultimately an empirical question. however, understanding which conditions would make concentrated enforcement successful and whether the available evidence suggests the existence of such conditions is the first, necessary step in making informed decisions about when to test concentrated enforcement in an experimental application. moreover, the question addressed in this article of when concentrated enforcement will work is not merely theoretical. as explored in this article, project-based enforcement already exists in practice. better understanding of when and why such enforcement might work is essential in order to guide and improve the existing project-based tax enforcement. this article proceeds as follows: part ii examines the existing tax scholarship regarding deterrence and “worst-first” methods for the allocation of scarce enforcement resources. part iii illustrates how, in practice, recent criminal and tax enforcement has relied on project-based enforcement. part iv explores the conditions under which concentrated enforcement can increase compliance. part v examines how concentrated enforcement would apply to the cash business tax sector and concludes. ii. classic deterrence theory and “worst-first” methods this article builds upon existing theories of deterrence, including classic deterrence theory and “worst-first” methods for allocating scarce enforcement resources. as a result, this part provides background regarding classic deterrence theory and “worst-first” methods. this part also illustrates how neither of these theories provide a comprehensive approach to the allocation of scarce tax enforcement resources. a. classic deterrence theory legal scholars have traditionally relied upon classic deterrence theory to explain how to use enforcement to increase compliance with the law. in modern legal scholarship, classic deterrence theory dates back to the work of gary becker. 14 becker described that deterrence is a function of two factors: the likelihood that a violation of the law is detected, and the penalties if the violation is detected. 15 as a result, becker’s work dictates that the two 14. becker’s work had its roots in earlier work by beccaria, bentham, and others. see, e.g., cesare beccaria, of crimes and punishments, in alessandro manzoni, the column of infamy prefaced by cesare beccaria’s of crimes and punishments (kenelm foster & jane grigson trans., oxford univ. press 1964) (1764); jeremy bentham, an introduction to the principles of morals and legislation 158–59 (j.h. burns & h.l.a. hart eds., athlone press 1970) (1789). 15. gary s. becker, crime and punishment: an economic approach, 76 j. pol. econ. 169 (1968) [hereinafter becker, crime and punishment]. 330 florida tax review [vol. 16:6 principal means of increasing deterrence are: increasing the likelihood of detection (principally through greater enforcement resources) and increasing the severity of penalties for violating the law. this basic theory (“classic deterrence theory”) and the two factors at the heart of it have spawned decades of scholarship. 16 tax compliance scholarship reflects the heavy influence of classic deterrence theory, with numerous articles written on how to increase the likelihood of detection for tax noncompliance, 17 and what the penalties should be for noncompliance. 18 to be sure, an important line of tax scholarship (and compliance scholarship generally) has argued that deterrence and its accompanying facilitator, enforcement, are not the only means of increasing compliance with the law. in vast literature, scholars have suggested that a variety of nondeterrence based theories are important in understanding and engendering compliance. 19 for example, scholars have suggested that norms, 20 morale, 21 16. see, e.g., a. mitchell polinsky & steven shavell, the theory of public enforcement of law, in 1 handbook of law & economics 404, 405 (a. mitchell polinsky & steven shavell eds., 2007) [hereinafter polinsky & shavell, the theory of public enforcement of law] (discussing the importance of becker’s work to the development of law enforcement); chris william sanchirico, detection avoidance, 81 n.y.u. l. rev. 1331, 1345 (2006) (explaining that becker’s “neoclassical approach to public enforcement has constituted one of the most extensively farmed fields in law and economics”). 17. see, e.g., joshua d. blank, overcoming overdisclosure: toward tax shelter detection, 56 ucla l. rev. 1629, 1671 (2009) [hereinafter blank, overcoming overdisclosure] (examining ways to solve overdisclosure, which interferes with irs’s ability to detect problematic transactions); alex raskolnikov, crime and punishment in taxation: deceit, deterrence, and the self-adjusting penalty, 106 colum. l. rev. 569, 599 (2006) [hereinafter raskolnikov, crime and punishment in taxation] (examining how to increase likelihood of detection for inconspicuous noncompliance). 18. see, e.g., mark p. gergen, uncertainty and tax enforcement: a case for moderate fault-based penalties, 64 tax l. rev. 453 (2011); sarah b. lawsky, probably? understanding tax law’s uncertainty, 157 u. pa. l. rev. 1017 (2009) [hereinafter lawsky, probably]; kyle d. logue, optimal tax compliance and penalties when the law is uncertain, 27 va. tax rev. 241 (2007) [hereinafter logue, optimal tax compliance]; daniel shaviro, disclosure and civil penalty rules in the u.s. legal response to corporate tax shelters, in tax and corporate governance 229 (wolfgang schön ed., 2008). 19. for good summaries of this literature, see michael doran, tax penalties and tax compliance, 46 harv. j. legis. 111, 131–38 (2009); alex raskolnikov, revealing choices: using taxpayer choice to target tax enforcement, 109 colum. l. rev. 689, 697–701 (2009) [hereinafter raskolnikov, revealing choices]. 20. cass r. sunstein, social norms and social roles, 96 colum. l. rev. 903, 914 (1996). 21. bruno s. frey & benno torgler, tax morale and conditional cooperation, 35 j. comp. econ. 136, 137 (2007). 2014] concentrated enforcement 331 reciprocity, 22 signaling, 23 and a variety of other mechanisms are important. however, the non-deterrence theories have, if anything, complemented, but not supplanted, the importance of deterrence as a principal means of ensuring compliance with the law. 24 the problem is that classic deterrence theory’s traditional, and hugely influential, formulation of deterrence often does not work well in practice. 25 while increasing the likelihood of detection or the size of penalties may be very sensible theoretical means of increasing compliance, practical limitations often seriously constrain the ability to do so. increasing the likelihood of detection can sometimes be done through clever enforcement innovations, such as information reporting regimes. indeed, for the many taxpayers who only have income that is subject to information reporting and withholding, or both, these mechanisms can ensure extremely high levels of compliance. 26 but, for the remaining taxpayers, such as cash business taxpayers, who cannot be reached by these information reporting regimes, increasing the likelihood of detection often requires the allocation of additional enforcement resources. 27 yet, like many enforcement agencies, 22. dan m. kahan, trust, collective action, and law, 81 b.u. l. rev. 333, 343 (2001). 23. eric a. posner, law and social norms: the case of tax compliance, 86 va. l. rev. 1781 (2000). 24. while the relationship between deterrence and non-deterrence theories is outside the scope of this article, it is worthwhile to note that a strong argument exists that deterrence still does much of the work in motivating tax compliance. see joel slemrod, cheating ourselves: the economics of tax evasion, 21 j. econ. persp. 25, 38–39 (2007) [hereinafter slemrod, cheating ourselves]. moreover, to the extent that non-deterrence theories operate, they seem to work in conjunction with, and, to some extent, depend on, the functionality of deterrence. see, e.g., leandra lederman, the interplay between norms and enforcement in tax compliance, 64 ohio st. l.j. 1453, 1484–89 (2003) (making this argument) [hereinafter lederman, the interplay] (making this argument). 25. these practical constraints are by no means limited to the tax context, although the tax context provides a useful illustration. see, e.g., michael g. faure & marjolein visser, law and economics of environmental crime, in new perspectives on economic crime 57, 61 (hans sjögren & goran skögh eds., 2004) (review of law and economics of environmental crime describing “relatively low detection rate of environmental pollution and . . . the fact that the maximum punishments provided for in legislation are almost never imposed by judges in western european countries”). 26. internal revenue serv., overview of tax gap for tax year 2006, http://www.irs.gov/pub/newsroom/overview_tax_gap_2006.pdf [hereinafter, overview of tax gap] (net misreporting percentage of one percent for income subject to substantial information reporting and withholding). 27. becker, crime and punishment, supra note 15, at 180–84. an alternative approach to increasing information reporting for these taxpayers would 332 florida tax review [vol. 16:6 the internal revenue service (“irs”) is perpetually underfunded. 28 the staggeringly low individual audit rate of approximately one percent is a symptom of these enforcement limitations. 29 indeed, becker himself anticipated such problems, prescribing that raising penalties can be a substitute for increasing the likelihood of detection. 30 however, in many situations, noncompliance penalties in practice are quite low, and certainly too low to make up for the low probability of detection. for example, the size of tax penalties is far too low to make up for the low likelihood of detection, and political unease with substantially higher penalties suggests that they are likely to remain inadequate. 31 moreover, while tax scholars have engaged in extensive discussions of whether tax penalties should be strict liability or fault-based, 32 the history of tax penalties and strong adherence to a fault-based system suggest that a wholesale move to strict be the introduction of a value-added tax (“vat”), which can create a paper trail that may increase compliance. itai grinberg, where credit is due: advantages of the credit-invoice method for a partial replacement vat, 63 tax l. rev. 309, 314 (2010) (discussing how “vat invoices create a paper trail that gives tax authorities an independent source of information . . . [that] can help the tax authorities enforce the vat”). this article operates within existing political constraints which, at least at present, have not been consistent with the creation of a vat in the united states. additionally, the vat is not a compliance panacea. rather, enforcement problems remain, which have to be policed. graeme cooper, the discrete charm of the vat 14–16, social science research network, nov. 27, 2007, http://papers.ssrn.com/sol3 /papers.cfm?abstract_id=1027512. the allocation of scarce enforcement resources discussed in this article is an issue that would apply regardless of the underlying tax base. 28. see, e.g., 1 taxpayer advocate serv., national taxpayer advocate: 2012 annual report to congress 34–41 (2012), http://www. http://www.taxpayeradvocate.irs.gov/2012-annual-report/fy-2012-annual-reportto-congress-full-report (identifying chronic underfunding of irs and the resulting limitations on its enforcement and other capabilities). 29. internal revenue serv., publication 55b, internal revenue service data book 2012, at 22 tbl.9a, http://www.irs.gov/pub/irs-soi/12databk.pdf [hereinafter irs data book 2012]. 30. becker, crime and punishment, supra note 15, at 193. 31. see, e.g., logue, optimal tax compliance, supra note 18, at 292 (“although it is an interesting theoretical possibility, congress will never in fact adopt a tax penalty regime that would impose a $9900 penalty for a tax underpayment of $100. given this fact, we are probably limited to tax penalties that are far lower than the bentham-becker ideal, though it is difficult to deny that the normal penalty should be greater than the current 20 percent of the tax underpayments.”). this penalty dynamic applies in situations in which there is not adequate information reporting, as is the case in the cash business tax sector. 32. see, e.g., sources cited supra note 18. 2014] concentrated enforcement 333 liability penalties is unlikely. 33 as a result, classic deterrence theory’s persistent focus on determining optimal enforcement levels and penalties, rather than contemplating deterrence in light of suboptimal enforcement parameters, 34 leaves unanswered the crucial question of how to allocate scarce, and suboptimal, enforcement resources. tax scholars have suggested a number of innovative means of optimizing the use of constrained enforcement resources. for instance, leandra lederman has suggested allocating low levels of enforcement, potentially combined with norms-based appeals, to wage and investment income taxpayers, but high levels of enforcement to cash businesses, because of the two groups’ observable and significantly different levels of compliance. 35 joshua blank has explored the potential gains from publicizing successful enforcement efforts against celebrities and other prominent taxpayers in order to capitalize on salience and anchoring effects. 36 alex raskolnikov has advocated creating different taxpayer regimes because of different taxpayers presumably being motivated by different compliance incentives. 37 however, all of these ideas depend, to some extent, on differences between taxpayers, and they suggest allocating enforcement resources (or publicity, or incentives) based on such differences. they leave open the question of how resources should be allocated among the remaining population of highly noncompliant, not necessarily distinguishable taxpayers, such as cash business taxpayers who do not opt into a cooperative regime. b. “worst-first” theories in answering this question, the tax compliance literature (as well as scholars in other, similar enforcement contexts) 38 has focused on a “worst 33. leigh osofsky, the case against strategic tax law uncertainty, 64 tax l. rev. 489, 516–19 (2011) [hereinafter osofsky, the case against strategic tax law uncertainty]. 34. see, e.g., polinsky & shavell, the theory of public enforcement of law, supra note 16, at 412 (assuming away such limitations and suggesting, in response to suboptimal enforcement and penalties, that “society probably should raise levels of deterrence”). 35. lederman, the interplay, supra note 24, at 1500–13. 36. joshua d. blank, in defense of individual tax privacy, 61 emory l.j. 265, 294, 297–98, 302 (2011) [hereinafter blank, in defense of individual tax privacy]. 37. raskolnikov, revealing choices, supra note 19. 38. for instance, margaret lemos and alex stein have developed a strategy called “strategic enforcement,” whereby enforcement resources are used to target the worst violators. rather than focusing on particular locations or particularly problematic sectors, strategic enforcement targets the worst offenders, or outliers. margaret h. lemos & alex stein, strategic enforcement, 95 minn. l. rev. 9, 18 334 florida tax review [vol. 16:6 first” method. “worst-first” methods seek to target the individuals who are likely to be most noncompliant. these methods can take a number of different forms, such as focusing on taxpayers who fail to report at least some threshold of tax liability, 39 focusing greater retroactive or future audit attention on taxpayers found to have evaded, or focusing on taxpayers whose tax profiles are sufficiently outside of expectations. 40 indeed, the last (2010) [hereinafter lemos & stein, strategic enforcement]; see also rachel a. harmon, promoting civil rights through proactive policing reform, 62 stan. l. rev. 1 (2009) (advocating a “worst-first” policy of suing the worst, large police departments). lemos and stein even explicitly describe how the use of a dif score to “red flag” taxpayers is a prime example of strategic enforcement. lemos & stein, strategic enforcement, supra, at 28–29. scholars often apply “worst-first” analysis in related contexts, such as environmental regulation. see, e.g., winston harrington, enforcement leverage when penalties are restricted, 37 j. pub. econ. 29 (1988). 39. it is possible to characterize the threshold approach as “worst-first” or not as “worst-first,” depending on the outcome. if all taxpayers who have tax liability in excess of the threshold report tax liability that exceeds the threshold, then the irs would only be auditing taxpayers who truly have tax liability below the threshold, arguably not a “worst-first” approach. but see michael j. graetz et al., the tax compliance game: toward an interactive theory of law enforcement, 2 j.l. econ. & org. 1, 6 (1986) [graetz et al., the tax compliance game] for a discussion of problems with the irs’s ability to commit to an audit rule. however, if some taxpayers with tax liability in excess of the threshold nonetheless report tax liability below the threshold, then the irs would only be auditing (and assessing additional tax and penalties owed for) taxpayers who did not at least report the threshold and who could be considered the “worst” underreporters. 40. a wide array of literature has examined variations of these tactics. for instance, an early line of literature focused on interactions between taxpayer reporting decisions and irs auditing decisions and modeled various “worst-first” strategies. see, e.g., james alm et al., tax compliance with endogenous audit selection rules, 46 kyklos 27 (1993) (comparing conditional audit rules and random audit rules); graetz et al., the tax compliance game, supra note 39 (introducing game-theoretic approach whereby the irs, as a strategic actor, conditions its audit rules on taxpayer reports); joseph greenberg, avoiding tax avoidance: a (repeated) game-theoretic approach, 32 j. econ. theory 1 (1984) (applying game-theoretic approach whereby taxpayers are placed in one of three audit groups, based on audit status); michael landsberger & isaac meilijson, incentive generating state dependent penalty system, 19 j. pub. econ. 333 (1982) (analyzing audit results determining probability of future audits); jennifer f. reinganum & louis l. wilde, income tax compliance in a principal-agent framework, 26 j. pub. econ. 1 (1985) (setting forth cutoff method); j.a. rickard et al., a tax evasion model with allowance for retroactive penalties, 58 econ. rec. 379 (1982) (examining a system whereby audit results determine whether back audits occur). more recent literature has also focused on “worst-first” methods. see, e.g., james alm & michael mckee, tax compliance as a coordination game, 54 j. econ. behav. & org. 297, 298 (2004) [hereinafter alm & mckee, tax compliance as a coordination game] (examining audit policy when returns are selected based 2014] concentrated enforcement 335 mentioned iteration of this method (auditing those whose tax profiles are sufficiently outside of expectations) is often cited as the irs’s principal means of choosing which taxpayers to audit through the dif score. while the irs’s auditing strategies are shrouded in secrecy, 41 various government authorities have indicated that the irs uses the dif score as a primary method to determine which taxpayers to audit. 42 the dif score employs a “worst-first” approach by focusing on taxpayers who are likely to be the most noncompliant, as determined by deviation from others. 43 the irs has described that the dif score rates tax returns based on their “potential for [tax] change, based on past irs experience with similar returns.” 44 the general accounting office, now the government accountability office (“gao”), has explained that dif scores “are automatically calculated for all filed individual returns” and that this “calculation is based on a series of formulas developed by the irs that are on deviation from average and exploring impact of taxpayer communication); kim bloomquist, tax compliance as an evolutionary coordination game: an agentbased approach, 39 pub. fin. rev. 25, 40 (2011) [hereinafter bloomquist, tax compliance] (modeling tax compliance in an agent-based framework, using a modified-dif approach); scott m. gilpatric, regulatory enforcement with competitive endogenous audit mechanisms, 42 rand j. econ. 292 (2011) (examining (in related, environmental context) endogenous audit mechanisms in experimental setting and finding benefits of contemporaneous relative comparisons); dmitri romanov, costs and benefits of marginal reallocation of tax agency resources in pursuing the hard-to-tax, in taxing the hard-to-tax 187 (james alm et al. eds., 2004) [hereinafter taxing the hard-to-tax] (exploring means of determining marginal assessments for different enforcement strategies). 41. see i.r.m. § 4.19.11.1.5.1(8)-(9) (2007) (describing that “dif mathematical formulas are confidential in nature and are distributed to irs personnel only on a need-to-know basis” and that “dif formulas are for official use only and will not be discussed with unauthorized personnel”). 42. u.s. general accounting office, gao/ggd-99-30, tax administration irs’ return selection process (1999) [hereinafter irs’ return selection process] (indicating that 59% of the closed books and records audits of returns received in 1992, 1993, and 1994 were selected using the dif score); internal revenue serv., fact sheet 2006-10, the examination (audit) process, (january 2006), http://www.irs.gov/uac/the-examination(audit)-process [hereinafter the examination (audit) process]; see also william hoffman, irs doesn’t target small businesses for audits, werfel says, 2013 tax notes today 138-2 (july 18, 2013) [hereinafter hoffman, irs doesn’t target] (recently discussing use of dif score). 43. bloomquist, tax compliance, supra note 40, at 40 (“the goal of irs dif methodology is the same—to identify the least compliant taxpayers for audit.”). 44. the examination (audit) process, supra note 42; see also i.r.m. § 4.19.11.1.5.1 (2007) (describing how dif score works). 336 florida tax review [vol. 16:6 designed to indicate the returns that have the highest probability of a tax change if audited.” 45 as implied from the above description, the dif score focuses on the direct revenue yield from audit, allocating resources based on the tax liability that would be paid as a result of audit. 46 evidence suggests that the dif score is likely a cost effective way to allocate audit resources toward taxpayers likely to owe the most on audit. prior to the dif score, the irs had no systematic way to determine which returns were likely to produce the highest yield on audit, and the irs used significant time and resources to make these determinations. 47 early evaluations of the dif score revealed that it significantly raised the average yield per return audited. 48 the same research showed the dif score vastly superior to random selection, again as measured in terms of average tax yield per return audited. 49 however, the more important (and unanswered) question is whether the dif score maximizes overall compliance (inclusive of individuals not actually audited). 50 researchers have concluded that the indirect yield from 45. irs’ return selection process, supra note 42, at 2. 46. comptroller general of the united states, ggd-76-55, how the internal revenue service selects individual income tax returns for audit 28 (nov. 5, 1976) [hereinafter how the irs selects]; irs’ return selection process, supra note 42, at 2; the examination (audit) process, supra note 42 (indicating that “irs personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review”); james andreoni et al., tax compliance, 36 j. econ. lit. 818, 826 (1998) [hereinafter andreoni et al., tax compliance] (explaining that “the irs develops its infamous dif score for the explicit purpose of identifying those returns within a given audit class with the highest potential audit yield”). 47. irs’ return selection process, supra note 42, at 3–4 (describing how, before the advent of the dif score, the “irs had no systematic way to evaluate which among all filed returns had the greatest potential for changes to the reported tax if audited,” and instead had to rely “on its auditors across the country to identify which returns to audit by using their experience and judgment in reviewing returns” which was a time consuming and resources intensive process). 48. how the irs selects, supra note 46, at 29, 34. 49. id. at 31, 34. 50. this article is focused on the compliance within a particular tax sector, such as, for example, cash business taxpayers. this article does not address allocations of resources between different sectors of taxpayers. as a result, when discussing maximizing overall compliance, this article is focused on maximizing the overall compliance of taxpayers within the particular tax sector. the assumption is that there is a fixed amount of enforcement resources that can be applied to the given tax sector, and the question is how to allocate the enforcement resources within that tax sector so as to maximize the compliance of taxpayers within that tax sector. for reasons that will be fleshed out in footnote 107 and the accompanying text, maximizing overall compliance is also assumed to maximize revenue from that particular tax sector. 2014] concentrated enforcement 337 audit (from taxpayers who are not audited increasing their tax liability) is many times the direct yield from audit. 51 additionally, the total amount of revenue collected from all taxpayers dwarfs the amount collected as a result of enforcement. 52 as a result, determining that the dif score does a good job of maximizing direct yield from audit does not necessarily establish that the dif score is the best tool to allocate scarce enforcement resources, because it does not address the other, more significant question of voluntary compliance. focusing on maximizing direct revenue from audit, to the exclusion of voluntary compliance, may be quite counterproductive. 53 “worst-first” methods do not necessarily maximize overall compliance. while “worst-first” methods (such as the dif score) can, under certain circumstances, incentivize all regulated individuals to increase their compliance, so as not to be the “worst,” 54 they can also convey the relative safety of engaging in moderate levels of evasion with little likelihood of 51. see, e.g., jeffrey a. dubin, criminal investigation enforcement activities and taxpayer noncompliance, 2012, http://www.irs.gov/pub/irssoi/04dubin.pdf [hereinafter dubin, criminal investigation] (estimating indirect effect of doubling the audit rate to be almost 94 percent of the total revenue effect); alan h. plumley, the determinants of individual income tax compliance: estimating the impacts of tax policy, enforcement, and irs responsiveness 35, 1996, http://www.irs.gov/pub/irs-soi/pub1916b.pdf [hereinafter plumley, the determinants of individual income] (estimating that indirect yield from audit is 11.6 times the direct yield from audit); see also james alm et al., getting the word out: enforcement information dissemination and compliance behavior, 93 j. pub. econ. 392, 394 (2009) [hereinafter alm et al., getting the word out] (finding indirect effect on compliance 4.4 times the direct effect in an experimental setting). 52. for instance, in 2012, gross collection of tax, net of refunds, was approximately $2.15 trillion. irs data book 2012, supra note 29, at 3 tbl.1. the total recommended additional tax after examination for returns examined in 2012 was approximately $38.7 billion. id. at 23 tbl. 9a. 53. see, e.g., janet g. mccubbin, optimal tax enforcement: a review of the literature and practical implications 20–21 (ota working paper no. 90, 2004), http://www.treasury.gov/resource-center/tax-policy/tax-analysis/documents/ ota90.pdf [hereinafter mccubbin, optimal tax enforcement] (discussing how irs enforcement policies are designed to minimize the number of audits that produce no change in tax liability, but how such a policy might be misguided because an enforcement policy that increased total compliance may also increase the no change rate); see also norman gemmell & marisa ratto, behavioral responses to taxpayer audits: evidence from random taxpayer inquiries, 65 nat’l tax j. 33, 34 (2012) [hereinafter gemmell & ratto, behavioral responses] (“despite an extensive literature on tax evasion in general, the literature on how taxpayers’ compliance behavior responds to auditing is more limited.”). 54. lemos & stein, strategic enforcement, supra note 38. this has roots in the economics of tournaments literature. see, e.g., edward p. lazear & sherwin rosen, rank-order tournaments as optimum labor contracts, 89 j. pol. econ. 841 (1981). 338 florida tax review [vol. 16:6 getting caught. 55 this dynamic can be particularly problematic when compliance is very low, because, in such cases, regulated individuals can safely engage in high noncompliance, without attracting attention. additionally, if the regulated individuals can coordinate on noncompliance, they can defeat the effectiveness of “worst-first” methods. indeed, james alm and michael mckee examined experimentally how regulated individuals may communicate with each other to keep compliance low, thereby disabling the power of a “worst-first” method to produce compliance. 56 one (unexplored) implication of this finding is that when certain underlying features of a compliance landscape (such as high difficulty in detecting noncompliance) make enforcement difficult, the regulated individuals may be able to rely on each other not to comply, or to comply at low levels, without having to directly coordinate their noncompliance. in other words, these features may serve as a substitute for direct communication regarding noncompliance. as a result, somewhat paradoxically, compliance landscapes most in need of enforcement innovations may be least affected by “worst-first” strategies. iii. project-based enforcement in practice notwithstanding the extensive focus on “worst-first” methods in the tax literature, actual enforcement practices both in and outside of the tax context rely not only on “worst-first” methods, but also on group or projectbased enforcement. this part explores examples of group or project-based enforcement found in a number of different contexts. perhaps the most empirically tested, recent example of group or project-based enforcement comes from the criminology context, in the form of “hot spots policing.” as defined by criminologists anthony braga and david weisburd, hot spots policing “is the application of police interventions at very small geographic units of analysis.” 57 braga and weisburd explain that “[i]t does not sound like a very radical innovation, but indeed it represents a major reform not only in how the police organize to do something about crime, but also in how scholars define and understand the crime problem.” 58 hot spots policing arose out of empirical evidence that crimes tend to concentrate in particular places. based on this insight, 55. gemmell & ratto, behavioral responses, supra note 53, at 53–54 (exploring based on uk data how eliminating random audits, in favor of risk-based audits, could substantially reduce revenue as a result of essentially immunizing lowrisk taxpayers). 56. alm & mckee, tax compliance as a coordination game, supra note 40. 57. anthony a. braga & david l. weisburd, policing problem places 9 (2010) [hereinafter braga & weisburd, policing problem places]. 58. id. at 9–10. 2014] concentrated enforcement 339 criminologists have shown that concentrating police patrol on small crime hot spots can significantly decrease crime. 59 indeed, in addition to finding that hot spots policing can prevent crime in the hot spots, 60 studies have found that hot spots policing can also decrease crime in surrounding areas. 61 these findings have been particularly encouraging, in contrast to an early policing study in kansas city. the kansas city study found that increasing 59. for a small sample of this literature, see anthony a. braga & brenda j. bond, policing crime and disorder hot spots: a randomized controlled trial, 46 criminology 577 (2008); anthony braga et al., problem-oriented policing in violent crime places: a randomized control experiment, 37 criminology 541 (1999) [hereinafter braga et al., problem-oriented policing]; rafael di tella & ernesto schargrodsky, do police reduce crime? estimates using the allocation of police forces after a terrorist attack, 94 amer. econ. rev. 114 (2004); lorraine green & jan roehl, civil remedies and crime prevention: an introduction, in civil remedies and crime prevention (lorraine green mazerale & jan roehl eds., 1998) [hereinafter green & roehl, civil remedies]; christopher koper, just enough police presence: reducing crime and disorderly behavior by optimizing patrol time in crime hot spots, 12 just. q. 649 (1995); lawrence sherman & david weisburd, general deterrent effects of police patrol in crime hot spots: a randomized controlled trial, 12 just. q. 625 (1995); david weisburd & lorraine green, policing drug hot spots: the jersey city dma experiment, 12 just. q. 711 (1995) [hereinafter weisburd & green, policing drug hot spots]. a number of independent, meta research studies have synthesized the various work done on hot spots policing. lawrence w. sherman et al., preventing crime: what works, what doesn’t, what’s promising, a report to the united states congress, prepared for the national institute of justice (1997), www.ncjrs.gov/works/; fairness and effectiveness in policing: the evidence (wesley skogan & kathleen frydl eds., national research council 2004); anthony braga et al., the campbell collaboration, hot spots policing effects on crime (2012). 60. see, e.g., braga & weisburd, policing problem places, supra note 57, at 100 (2010) (“using scientific evaluation evidence as a criterion, we find substantial support for the crime prevention effectiveness of hot spots policing.”); robert apel & daniel s. nagin, general deterrence: a review of recent evidence [hereinafter apel & nagin, general deterrence], in crime and public policy 411, 421 (james q. wilson & joan petersilia eds., 2011) [hereinafter crime and public policy] (citing hot spots policing as a method that has been shown to be effective at preventing crime); bernard e. harcourt & jens ludwig, broken windows: new evidence from new york city and a five-city social experiment, 73 u. chi. l. rev. 271, 314 (2006) (“[t]argeting police resources against the highest-crime ‘hot spots’ can also help prevent criminal activity.”). 61. see, e.g., braga et al., problem-oriented policing, supra note 59; ronald v. clarke & david weisburd, diffusion of crime control benefits: observations on the reverse of displacement, in 2 crime prevention studies 165 (1994); green & roehl, civil remedies, supra note 59; lawrence sherman & dennis rogan, effects of gun seizures on gun violence: ‘hot spots’ patrol in kansas city, 12 just. q. 673 (1995); weisburd & green, policing drug hot spots, supra note 59. 340 florida tax review [vol. 16:6 police patrol across large patrol beats did not have a substantial, preventative effect on crime. 62 the combination of the hot spots policing research and the kansas city study suggests that concentration, and not just the level, of enforcement can be critical in producing deterrence. a separate line of criminological work has developed more anecdotal evidence that focusing enforcement resources on particular problems at particular times can be an effective allocation of enforcement resources. criminologist mark kleiman has described a number of such examples. for instance, in the early 1990s, the illegal practice of “squeegeeing,” or cleaning windshields and then asking to be paid, plagued new york city. the problem seemed both too rampant and, at the same time, insignificant, to be controlled by the use of normal enforcement resources. 63 however, new york city announced a highly publicized zerotolerance policy for squeegeeing, in which the police would use all enforcement resources necessary to stop the squeegeeing. 64 as kleiman describes it, the heightened enforcement pressure stopped the squeegeeing, not only on a short-term basis, but over the long term as well. 65 drastically reducing the amount of squeegeeing allowed the police to maintain compliance through the use of normal, low-enforcement resources. 66 kleiman has described similar successes in other contexts, including, for example, with h.o.p.e., or hawaii’s opportunity probation with enforcement. 67 facing a constrained probation system that lacked the capacity to punish and therefore deter drug use by probationers, one judge created h.o.p.e. the program notified chronic parole violators that they would be punished for all of their probation infractions, in contrast to the prior practice of punishing only persistent and severe violations, or both. 68 62. the kansas city preventive patrol experiment: a summary report, george l. kelling et al., police foundation, 1974, http://www.policefoundation.org/ content/kansas-city-preventive-patrol-experiment-0. 63. mark a.r. kleiman, when brute force fails 41−42 (2009) [hereinafter kleiman, when brute force fails]. 64. id. this policy is different than the well-known “broken windows” policy that the new york city police department put in place in the 1980s. broken windows policing is based on the notion that stopping minor offenses could discourage more serious offenses. james q. wilson and george l. kelling, broken windows: the police and neighborhood safety, atlantic monthly, mar. 1982, at 29. the zero-tolerance policing with squeegeeing, on the other hand, was based on the notion that promising to stop squeegeeing on a short-term basis would ensure that it would be stopped on a longer-term basis. kleiman, when brute force fails, supra note 63, at 43. 65. kleiman, when brute force fails, supra note 63, at 43. 66. id. 67. hope probation, hawaii state judiciary, http://www.courts.state. hi.us/special_projects/hope/about_hope_probation.html (last visited may 1, 2013). 68. kleiman, when brute force fails, supra note 63, at 34–39. 2014] concentrated enforcement 341 the warnings alone did much of the work for the program, which resulted in more than a 90 percent reduction in violation rate among h.o.p.e parolees, as compared to an increase in violations for probationers not in the program. 69 stories like these also helped inspire the work of david kennedy. kennedy instituted programs to stop gang violence in cities around the united states. begun as operation ceasefire in boston, kennedy’s program relied on heavy, focused concentrations of enforcement resources, combined with advance announcements to stop gang violence. while it has been hard to develop strong empirical evidence regarding kennedy’s work, 70 it again highlights the use and potential benefits of strategies that rely on groups or projects, rather than a purely individual, “worst-first” method. to be clear, instead of focusing on the “worst” offenders (i.e., the biggest drug dealers, the most frequent squeegeers, the most severe parole violators), these efforts focused on particular groups or projects. 69. id. at 39–41. 70. for extensive description of this work, see david m. kennedy, don’t shoot 44−75 (2011) [hereinafter kennedy, don’t shoot]. while operation ceasefire, and various iterations of it in other cities, were often accompanied by a decline in the crime at issue, the large number of variables has made it difficult to say, with certainty, whether operation ceasefire and its progeny actually caused the declines in crime. id. at 80 (explaining some of the academic skepticism about the program); anthony a. braga & christopher winship, partnership, accountability, and innovation: clarifying boston’s experience with pulling levers, in police innovation, 171, 174–78 (david weisburd & anthony a. braga eds., 2006) (discussing doubts about empirical proof for kennedy’s pulling levers strategy); apel & nagin, general deterrence, supra note 60, at 422 (discussing some of the ambiguity about whether operation ceasefire caused a decline in crime but coming to the conclusion that it played a role, and also suggesting that operation ceasefire “illustrates the potential for combining elements of both certainty and severity enhancement to generate a targeted deterrent effect”). similarly, a line of work regarding drug market enforcement projects has claimed some success, though not without question regarding the empirics of the successes. mark a.r. kleiman, crackdowns: the effects of intensive enforcement on retail heroin dealing, in street-level drug enforcement: examining the issues 3, 4–17 (marcia r. chaiken, u.s. department of justice ed., 1988) [hereinafter street-level drug enforcement] (discussing apparent successes of drug market enforcement projects in lynn, massachusetts and alphabet city, new york city, but also apparent failure in lawrence, massachusetts); arnold barnett, drug crackdowns and crime rates: a comment on the kleiman report, in street-level drug enforcement, supra, at 35 (questioning apparent success in lynn, massachusetts); anthony v. bouza, evaluating street-level drug enforcement, in street-level drug enforcement, supra, at 43 (offering a much more pessimistic account); see also lawrence w. sherman, police crackdowns: initial and residual deterrence, 12 crime & just. 1, 19–34 (1990) [hereinafter sherman, police crackdowns] (providing mixed empirical evidence). 342 florida tax review [vol. 16:6 even in the tax enforcement context, individual “worst-first” methods do not comprehensively explain auditing practices, which include an element of project-based approaches, in addition to use of the dif score. indeed, as this article will discuss in more detail later, the irs has engaged in enforcement projects directed at various groups of taxpayers and at specific tax issues. 71 in accordance with this practice, the irs has publicly indicated that it “may identify returns for examination in connection with local compliance projects.” 72 other countries, such as the united kingdom, have been engaging in tax enforcement projects that are perhaps most consistent with concentrated enforcement. 73 for instance, in 2007, the united kingdom’s tax authority, her majesty’s revenue and customs (“hmrc”), began a series of highly publicized tax campaigns, which focused the tax authority’s resources on specific populations. 74 the campaigns give members of the population subject to focused enforcement a chance to come forward and declare noncompliance. 75 while the possibility of reduced penalties exists, the campaigns do not guarantee such an outcome, and ultimate penalty application depends on the circumstances. 76 hmrc uses the information gathered from the campaigns to conduct focused investigations and, in some cases, prosecutions. 77 many campaigns have been narrow, focused on particular subsectors in particular locations. for instance, to name just a few, campaigns have included: a taskforce focused on security guards, bouncers, and their employees in london and the south east; 78 a taskforce focused on construction workers in london; 79 a taskforce focused on hauliers in the midlands; 80 a taskforce focused on the holiday industry in the lake 71. see infra text accompanying notes 208–13. 72. the examination (audit) process, supra note 42. 73. i thank caroline bradley for bringing this example to my attention. 74. hm revenue and customs et al., reducing tax evasion and avoidance, last accessed oct. 8, 2013, https://www.gov.uk/government/policies/reducing-taxevasion-and-avoidance/supporting-pages/hmrc-campaigns. 75. id. 76. see, e.g., hm revenue and customs, health and wellbeing tax plan at 3.12 penalties, last accessed oct. 7, 2013, http://www.gov.uk/government/ publications/health-and-wellbeing-tax-plan-your-guide-to-making-a-disclosure/heal th-and-wellbeing-tax-plan-your-guide-to-making-a-disclosure (discussing potential penalties in the context of health and wellbeing tax plan voluntary disclosure program). 77. hm revenue and customes, et al., reducing tax evasion and avoidance, supra note 74. 78. hm revenue and customs & david gauke, tax crackdown for security industry, last accessed sept. 19, 2013, https://www.gov.uk/government/ news/tax-crackdown-for-security-industry. 79. id. 80. hm revenue and customs & david gauke, crackdown on hauliers in the midlands, last accessed july 10, 2013, https://www.gov.uk.government/news/ 2014] concentrated enforcement 343 district, north wales, devon and cornwall; 81 a taskforce focused on restaurants in yorkshire and humber; 82 and a taskforce focused on the fishing industry in scotland. 83 hmrc has indicated that “[t]askforces are specialist teams that undertake intensive bursts of activity in specific highrisk trade sectors and locations in the uk.” 84 government officials in the uk have actively publicized the campaigns and emphasized their importance for a fair tax system. for instance, david gauke, exchequer secretary to the treasury indicated, “[w]e are determined to support hardworking people who want to get on, but the people being targeted by these taskforces have no intention of playing by the rules . . . . [w]e will not tolerate tax evasion and we have provided hmrc with the resources to crack down on those who break the rules.” 85 hmrc’s jennie granger, director general of enforcement and compliance, has said, “[i]f you have declared all your income, you have nothing to worry about. but, if you haven’t, we will find you, investigate you and not only could you face a heavy fine, but a criminal prosecution as well.” 86 media and tax preparer coverage of hmrc’s use of such campaigns has been widespread. 87 in sum, the uses in practice of group and project-based approaches to enforcement suggest that “worst-first” theories, particularly popular in the scholarly tax literature, may be leaving something important out of the analysis. while the mere existence of project-based approaches does not prove they work, their existence should at the least trigger an examination of why and when such approaches may increase compliance. moreover, as discussed previously, the combination of the hot spots policing research and the kansas city policing study suggests that the concentration, and not merely the level, of enforcement can be essential. the relatively unexplored question is: what circumstances might justify the use of enforcement crackdown-on-hauliers-in-the-midlands [hereinafter hmrc & gauke, crackdown on hauliers]. 81. id. 82. id. 83. id. 84. id. 85. id. 86. hmrc & gauke, crackdown on hauliers, supra note 80. 87. e.g., acca, another hmrc campaign – direct selling, last accessed oct. 11, 2013, http://www.accaglobal.com/uk/en/technical-activities/technical resources-search/2013/february/hmrc-direct-selling.html; bkl tax, hmrc campaigns, last accessed oct. 11, 2013, http://www.bkltax.co.uk/hmrc-campaigns .htm; kyle caldwell, pay your tax or face the consequences, minister tells buyto-let investors, telegraph, sept. 19, 2013, http://telegraph.co.uk/finance/ personalfinance/investing/10320504/buy-to-let-landlords-warned-over-unpaid-taxon-rental-income.html. https://www.gov.uk/government/news/crackdown-on-hauliers-in-the-midlands http://www.accaglobal.com/uk/en/technical-activities/technicalhttp://www.bkltax.co.uk/hmrc-camp 344 florida tax review [vol. 16:6 projects in the tax context? in the next part, this article examines this question by setting forth a theory of concentrated enforcement. iv. concentrated enforcement in this part, a number of different disciplines are drawn from to set forth concentrated enforcement, which can serve as a first cut for allocating scarce enforcement resources across a large, highly noncompliant population of taxpayers. this article suggests that a base case for concentrated enforcement may apply when enforcement is costly and limited and the level of violations is high. this article then suggests that the case for concentrated enforcement can increase under a number of circumstances: when there are feedback loops between noncompliance and enforcement, when norms or other non-economic mechanisms can increase compliance but themselves depend on rates of compliance, and when regulated parties exhibit uncertainty aversion or the availability bias. finally, this article argues that, to the extent that particular nodes of noncompliance can be identified, concentrated enforcement works best by focusing resources on such nodes. a. description of concentrated enforcement as used in this article, concentrated enforcement means breaking apart a large, low-compliance population into smaller subsectors and applying substantially 88 intensified application of enforcement resources to at least one subsector. the subsector subject to the substantially intensified application of enforcement resources can be said to be subject to an “enforcement project.” implicit in concentrated enforcement theory is the assumption that total enforcement resources are limited. as a result, the application of substantially intensified enforcement resources (i.e., an enforcement project) in one subsector must be offset by reduced enforcement resources in another. the enforcement projects are applied on a rotating basis throughout the population, with enforcement project applications announced, but enforcement project withdrawals unannounced. 89 to the extent that particular nodes of noncompliance can be identified, such nodes receive particular enforcement attention. 88. of course, “substantially” is a vague term that does not indicate precisely how great the increase of enforcement resources is. at this point, the use of the term “substantially” is meant to distinguish enforcement projects from small increases in enforcement resources, which are not part of a plan to shock compliance by reallocating resources. see sherman, police crackdowns, supra note 70, at 8 (distinguishing reallocations “focused on specific target problems . . . outside the usual formula” from “normal police personnel allocation decisions”). 89. for discussion of announcement of enforcement projects and quiet withdrawals, see infra text accompanying notes 91–94. 2014] concentrated enforcement 345 by way of example, imagine that there are 100,000 cash business taxpayers and there are 30 tax auditors. 90 assume that, in any given year, one tax auditor can audit 100 cash business taxpayers. if the enforcement resources (the 30 tax auditors) were spread evenly across all cash business taxpayers, then each cash business taxpayer would have a three percent chance of being audited a year. under concentrated enforcement, the 100,000 cash business taxpayers would be split into different groups, with at least one group receiving substantially intensified enforcement resources. this group would be subject to the “enforcement project.” the remaining taxpayers would face a correspondingly lower percentage chance of being audited in that year. imagine, for example, that 10,000 of the cash business taxpayers, who sell dry cleaning services, make up a dry cleaning subsector of cash business taxpayers. under concentrated enforcement, the dry cleaning subsector may be subject to an enforcement project. instead of three auditors being allocated to the dry cleaning subsector in a given year (as would occur if enforcement resources were spread evenly among all cash business taxpayers), perhaps 12 auditors are allocated to the dry cleaning subsector. this allocation means that the taxpayers in the dry cleaning subsector now face a 12 percent chance of being audited. the cash business taxpayers outside the dry cleaning subsector face a concomitantly lower percentage chance of being audited. if the remaining auditor resources are spread evenly among these remaining taxpayers, then each cash business taxpayer outside the dry cleaning subsector would face a two percent chance of being audited. concentrated enforcement involves announcement of particular enforcement projects. the announcement occurs so that the members of any given enforcement project know they are subject to the enforcement project and can quickly change their behavior accordingly. 91 additionally, 90. the discussion of audit in this example is meant only to be illustrative of how enforcement resources are allocated, not a suggestion that audit in particular is how noncompliance by cash business taxpayers should be addressed. see infra text accompanying notes 240–242 for further discussion of how the method of enforcement (not the subject of this article) is distinct from the allocation of enforcement resources (which is the subject of this article). 91. henrik lando & steven shavell, the advantage of focusing law enforcement effort, 24 int'l rev. l. & econ. 209, 215 (2004) [hereinafter lando & shavell, the advantage]; edward p. lazear, speeding, terrorism, and teaching to the test, 121 q.j. econ. 1029, 1030 (2006) [hereinafter lazear, speeding]; mccubbin, optimal tax enforcement, supra note 53, at 28 (suggesting that the irs “should perhaps consider making more (or more specific) announcements about its audit plans”). of course, even without announcement, the subjects of the enforcement project may determine, over time, that they are subject to an enforcement project. see kleiman, when brute force fails, supra note 63, at 51 (describing how a potential offender “gets the message” from experience). the announcement nonetheless is an efficient way of providing members of the 346 florida tax review [vol. 16:6 announcement serves as a means of assuring the subjects of the enforcement projects of each others’ likely compliance. for reasons fleshed out in more detail below, coordinating their expectations about each others’ likely compliance can help trigger higher compliance. 92 taking the dry cleaning example, prior to the start of tax reporting season, the irs announces (on its website and directly to affected taxpayers) that the dry cleaning subsector will be subject to the enforcement project. the irs may also alert tax advisors who have historically served the affected taxpayers. however, the irs does not make any official announcement that it is withdrawing, or concluding, an enforcement project. the quiet withdrawal may allow the irs to free ride for some time off of the perceived increased enforcement, even after the enforcement project resources have been withdrawn. 93 while fully informed taxpayers may surmise that the announced initiation of a new enforcement project means that the dry cleaning enforcement project has subsided, taxpayers are not likely to be fully informed. for instance, dry cleaners may not be searching the irs website to determine when the irs initiates new enforcement projects. additionally, even if taxpayers knew when all enforcement projects were starting, they likely would not have enough information about the irs’s total enforcement budget (or perhaps even the calculation abilities) to be able to determine that a given number of enforcement projects at a given time meant that their enforcement project was over. 94 as a result, quiet withdrawals may extend the compliance benefits of enforcement projects. 95 enforcement project with this information, and thereby garnering their compliance quickly. 92. a countervailing consideration is that announcement reduces uncertainty and therefore the compliance that may flow from uncertainty aversion. notwithstanding this result, announcement is still important to communicate the high likelihood of detection (and thereby the sufficient economic incentive to comply) and to coordinate expectations of compliance among the subjects of the enforcement project. moreover, announcement may decrease, but should not eliminate uncertainty from concentrated enforcement. see infra text accompanying note 140. 93. see sherman, police crackdowns, supra note 70, at 3 (suggesting potential “‘free bonus’ residue of deterrence” from enforcement crackdowns but pointing out empirical ambiguity). 94. see andreoni et al., tax compliance, supra note 46, at 844–46 (providing some evidence of taxpayers overestimating likelihood of audit and discussing explanations). 95. but see james alm & michael mckee, audit certainty, audit productivity, and taxpayer compliance, 59 nat’l tax j. 801 (2006) [hereinafter alm & mckee, audit certainty]. this experiment found that informing some individuals that they would be audited increased their compliance, but informing others that they would not be audited reduced the latter group’s compliance, resulting in a net reduction in compliance. however, in contrast, concentrated 2014] concentrated enforcement 347 b. economic base case why and when might concentrated enforcement increase compliance? as an initial matter, a base case for concentrated enforcement can exist when uniform enforcement would result in inadequate compliance incentives across the population. 96 in such circumstances, compliance may increase by concentrating resources in a subset of the population, even if this leaves part of the population with very low incentives to comply. 97 for example, imagine that 10,000 manufacturing businesses exist in a given city. assume that every business in the city will violate local rules regarding disposal of contaminants, as long as the expected benefit (measured by the probability of not getting caught, multiplied by the monetary gains from violating) from doing so exceeds the expected cost (measured by the probability of being caught, multiplied by the penalty the individual has to pay if caught). 98 the benefit from violating the rules is enforcement would not provide direct information to individuals that they would not be subject to an enforcement project. additionally, even those not subject to an enforcement project would face some chance of enforcement. finally, the experiment did not explore the potential gains from concentrated enforcement (as opposed to an individual approach) or flesh out the potential implications of existing levels of enforcement being insufficient. for further discussion of this experiment, see infra note 112. 96. it is not necessary for the yield (i.e. tax dollars) from audit to be high. concentrated enforcement allocates scarce enforcement resources within a given sector and does not change the total amount of enforcement resources applied to the sector. 97. jan eeckhout et al., a theory of optimal random enforcement projects, 100 amer. econ. rev. 1104, 1104 (2010) [hereinafter eeckhout et al., a theory of optimal random enforcement]; mark a.r. kleiman & j.p. caulkins, heroin policy for the next decade, annals am. acad. pol. & soc. sci., at 163, 167 (1992) (“and as the market grows, the ratio of enforcement to market size decreases, so enforcement-imposed costs shrink, making the market all the more appealing.”); mark a.r. kleiman & kerry d. smith, state and local drug enforcement: in search of a strategy, 13 crime & just. 69, 88 (1990); lando & shavell, the advantage, supra note 91; lazear, speeding, supra note 91. for less formal support for this theory, see, for example, kennedy, don’t shoot, supra note 70, at 95 (discussing the utility of picking off “a bite-size piece, something you can handle”). but see alm & mckee, audit certainty, supra note 95, at 814 (concluding that, under certain parameters, pre-announcing the subjects of audit is bound to result in a “fall in overall compliance”). 98. of course, some regulated parties will take into account more than just expected monetary benefits and costs in determining whether to comply. nonetheless, an economic case for concentration applies, even when the parties in the population have different inclinations toward compliance. see eeckhout et al., a theory of optimal random enforcement, supra note 97, at 1105 (setting forth an example in which half of the population will never violate a law and half of the 348 florida tax review [vol. 16:6 $1,250. the city has $100,000 to spend on catching violators. it costs the city $50 to catch a violator. based on these constraints, the police force has enough resources to be able to catch 2,000 violators. 99 any given business’s probability of being caught violating is therefore 20 percent. 100 if a violator is caught, the violator will have to pay back the $1,250 benefit, plus a fine of $250. 101 each business’s expected benefit from violating is $1,000, 102 and each business’s expected cost from violating is $50 (relative, in each case, to the amount that the business would have paid without violating). 103 the expected cost from violating is less than the expected benefit. as a result, assuming that the businesses take into account solely expected monetary benefits and costs, 104 every business will violate. given the benefits and costs of violating, a prospective violator must have a greater than 83.3 percent chance of being caught in order to choose not to violate. 105 when the city’s resources are spread across the entire population uniformly, the city cannot create an 83.3 percent chance of being caught. this problem can be solved by concentrating the city’s resources on a smaller subset of the population, so that at least that subset has sufficient disincentives to violate. for example, the city could announce that it is going to use all of its resources on 2,399 businesses in the population. 106 the businesses that the city concentrates all its resources on can be called the “enforcement project.” if the city uses all of its $100,000 of resources on this enforcement project, then each business in the enforcement project will have a just greater than 83.3 percent chance of getting caught. as a result, none of the 2,399 businesses in the enforcement project will violate! of course, assuming that they are solely motivated by the expected benefits and costs of violating, the remaining businesses in the population will violate. since they face no chance of being caught, they have no expected monetary cost from population will violate a law unless certain to be caught). additionally, the regulated parties clearly may face variable, rather than the same, expected monetary benefits and costs from violating the rules. this example is meant to illustrate the basic economic base case for concentration. discussion in the text will generalize the point. 99. $100,000 / $50 = 2,000. 100. 2,000 / 10,000 = 20 percent. 101. this fine is not meant to capture the social cost from violating. rather, by assumption, the fine is limited to a suboptimal amount. 102. 80 percent x $1,250 = $1,000. 103. 20 percent x $250= $50. 104. this assumption will be complicated further in other parts of this article. 105. to reach this conclusion, solve for p in the equation: ($1,250 x (1-p)) < (p x $250). 106. to reach this number, solve for n in the equation 2,000 / n > 83.3 percent. 2014] concentrated enforcement 349 violating. however, by assumption, they were already violating because, without the concentration of the city’s resources, no business in the population had sufficient disincentive to violate. as a result, even though the concentration of resources on the enforcement project gives the businesses outside the enforcement project free license to violate, the concentration nonetheless caused 2,399 fewer businesses to violate. 107 107. readers might notice that translating this example into the tax context presents some issues. if the example in the text were applied in the tax context, the concentrated enforcement would maximize compliance (by causing 2,399 fewer businesses to violate). however, strictly speaking, the concentration would actually produce slightly less revenue. without concentration, all businesses would violate. however, 2,000 businesses would still get caught violating, and such businesses would have to pay back the $1,250 tax liability avoided plus the $250 fine. the no concentration scenario would thereby produce revenue of $3.00 million for the government (2,000 x $1,500). when enforcement resources are concentrated, all the businesses in the enforcement project comply, which means they pay their tax liability and no fine. as a result, their compliance produces revenue of $2,998,750 (2,399 x $1,250). however, there are a number of reasons to believe that this complication does not actually undermine the economic base case for concentrated enforcement in the tax context. first, the irs and treasury department have made clear on numerous occasions that the tax penalties should be used as a means of ensuring compliance and that penalties should not be viewed as a direct means of raising revenue. see, e.g., commissioner’s executive task force on civil penalties, internal revenue serv., report on civil tax penalties 1 (february 21, 1989), 89 tnt 45–36, doc 89-1586; office of tax policy, dep’t of the treasury, report to cong. on penalty and interest provisions of the internal revenue code 36, 1999, http://www.treasury.gov/resource-center/taxpolicy/documents/intpenal.pdf [hereinafter penalty and interest provisions]. for instance, the treasury department indicated in a report to congress that: in general . . . penalties should not be created or designed for revenue raising purposes. penalties may raise revenue collaterally but this should not be a deliberate objective of penalty design and doing so can create perverse incentives. rather, the penalty regime should raise revenue by encouraging taxpayers to remit the appropriate amount of tax in the proper fashion. thus, although it is appropriate to consider the cost to the government associated with noncompliance in designing penalties, fostering compliance and deterring noncompliance should be the overriding goals. penalty and interest provisions, supra, at 36. translating this philosophy into the example in the text, the $250 penalty should not be taken into account in determining how much revenue the government receives in each scenario. absent the concentrated enforcement, then, the government would collect $2,500,000 (2,000 x $1,250) of revenue. with concentrated enforcement, the government would collect $2,998,750 (2,399 x $1,250) of revenue. as a result, by not taking into account penalties in calculating revenue raised, the concentrated enforcement would raise more revenue. 350 florida tax review [vol. 16:6 abstracting a bit from this clearly simplified example (in which all potential violators faced the same expected costs and benefits of violating and therefore the same on−off switch), the lesson is that when enforcement resources are inadequate to yield a substantial level of compliance across the population, concentrated enforcement can increase overall compliance. steven shavell and henrik lando have recently offered a more generalized economic model to explain this phenomenon. based on the notion that there is an optimal social return per policeperson, they showed that when the optimal level of policing resources exceeds the resources that are available, the policing resources should be concentrated so that the largest possible group of regulated parties in the population face the optimal level of enforcement, leaving no enforcement in the rest of the population. 108 this approach is consistent with the irs’s and treasury department’s stated goal of using penalties to maximize compliance, not as an independent means of revenue collection. moreover, even putting aside the choice to disregard penalties as a source of revenue, the extent to which voluntary compliance dwarfs direct revenue raised from audit in the real tax compliance world, sources cited supra notes 51−52, suggests that the oversimplified example in the text leaves something important out of the analysis. namely, the oversimplified example in the text assumes that an extremely high rate of detection (83.3 percent) is needed to ensure compliance in the enforcement project. the extent by which voluntary compliance dwarfs direct revenue raised from audit in the real tax compliance world suggests that taxpayers comply in response to a much lower rate of detection. as a result, in the real world, the enforcement project very likely could be significantly bigger than that in the example. by focusing on a larger group, concentration could thereby yield substantially more revenue. this is all to say that while the example, on its own terms, suggests that concentration may maximize voluntary compliance but not revenue, in the real world it remains fair to assume that maximizing voluntary compliance of taxpayers will also maximize revenue. a countervailing consideration is that the irs is often judged based on its direct enforcement yield per cost ratios. see, e.g., u.s. gov’t accountability office, gao-13-151, tax gap: irs could significantly increase revenues by better targeting enforcement resources (2012) [hereinafter tax gap]. as a result, the irs might be criticized if it were actually to put in place a method of enforcement that reduced direct revenue from enforcement to zero (as a result of 100 percent voluntary compliance). this practical consideration makes it reasonable to assume that the irs cares about both voluntary compliance and direct revenue. this article does not seek to resolve the tension between direct revenue and voluntary compliance in terms of the irs’s mission. rather, the article focuses on the benefits of concentrated enforcement, primarily in terms of voluntary compliance. as will be discussed later in the text, by focusing on low compliance nodes (to the extent they can be identified), concentrated enforcement may also take into account direct revenue. 108. lando & shavell, the advantage, supra note 91, at 214 (“[s]o long as p* is positive, it is always desirable to focus enforcement effort in one region of http://web2.westlaw.com/find/default.wl?mt=lawschoolpractitioner&db=100297&rs=wlw13.04&tc=-1&rp=%2ffind%2fdefault.wl&findtype=y&ordoc=0349380844&serialnum=0302650202&vr=2.0&fn=_top&sv=split&tf=-1&pbc=5b03c678&utid=2 2014] concentrated enforcement 351 spreading enforcement resources across the population in such situations would not maximize the return per policeperson. 109 moving away from a binary violate or comply choice, one could also model a situation in which individuals in a given population can exhibit varying levels of compliance (i.e., they can report a range of the tax liability they owe). if there is a nonlinear response with multiple equilibria, then, under cetain circumstances, concentating enforcement resources may increase overall compliance. 110 for instance, imagine that when enforcement is low, individuals exhibit low compliance, but when enforcement reaches some level, individuals exhibit high compliance. 111 prior to concentrated enforcement, compliance across the population may be uniformly low. in such a situation, the compliance gains from concentration on an enforcement project in an announced fashion may be high (because they were previously complying at low rates), and the losses from the individuals no longer subject to enforcement may be low (because only their prior, low levels of compliance could be lost). as a result, the compliance gains from the enforcement project may outweigh the losses by the remainder of the population. 112 indeed, when the probability of getting caught is otherwise quite low (for example, the general audit rate of one percent faced by individual the city and not to use any police elsewhere when the available police resources are such that p is less than or equal to the threshold p*.”). 109. id. 110. on the other hand, overall compliance should not increase if there is a linear response (i.e., if an increase in compliance in one group is offset exactly by a decrease in compliance by the same amount in another group). 111. various factors explored in other parts of this article may help explain why such a situation would exist. for instance, feedback loops between noncompliance and enforcement norms may help explain such a phenomenon. it is useful to illustrate how these explanations can be integrated into an economic model or case for concentrated enforcement. for some evidence of potential equilibriums of compliance within the cash business tax sector, in the form of nodes of low compliance, see research cited infra note 224. 112. on the other hand, if rates of compliance are high across the population, the compliance gains from the enforcement project could be relatively low (because the enforcement project was already complying at a high rate), but the losses from the individuals now no longer subject to enforcement could be high (because the individuals no longer subject to enforcement were previously complying at a high rate). see alm & mckee, audit certainty, supra note 95, for a model (and accompanying set of circumstances) in which concentration reduces net compliance. relevant factors would be the differing rates of compliance that would be exhibited by the enforcement project versus the rest of the population and the sizes of the two groups. the point here is not to suggest that concentration always increases compliance, but rather to examine the circumstances under which concentration increases compliance. 352 florida tax review [vol. 16:6 taxpayers), 113 probability neglect may minimize compliance losses in the part of the population outside of the enforcement project. 114 probability neglect is characterized in part by a lack of responsiveness to variations in small probabilities. 115 many studies have shown evidence of relative irresponsiveness to variations in probability when determining willingness to pay to protect against low probability hazards. 116 as a result, whereas the enforcement project may be very responsive to an increase in the probability of getting caught from a very low amount (say one percent) to a significantly higher probability, the remainder of the population may have a lower, relative responsiveness to a reduction in probability of getting caught from a very low amount (say one percent) to a slightly lower, very low amount (say 0.9 percent). 117 this phenomenon would support the potential benefits of concentrated enforcement. the bottom line is that a number of different economic models (perhaps combined with probability neglect) can support an economic base case for concentrated enforcement when compliance incentives are inadequate if spread throughout the population. 113. irs data book 2012, supra note 29. 114. i thank andres sawicki for pointing out the potential role of probability neglect. 115. cass r. sunstein, probability neglect: emotions, worst cases, and law, 112 yale l.j. 61, 71–74 (2002) [hereinafter sunstein, probability neglect]. 116. e.g., young sook eom, pesticide residue risk and food safety valuation: a random utility approach, 76 am. j. agric. econ. 760, 769 (1994) (finding insignificant variation in willingness to pay for reductions of risk from pesticides on food when variation in relative risk was substantial but total risk was low); howard kunreuther et al., making low probabilities useful, 23 j. risk & uncertainty 103 (2001) (finding relative insensitivity in willingness to pay insurance premiums with respect to low risk hazards, at least when the risks were not highly contextualized). 117. cf. sunstein, probability neglect, supra note 115, at 75 (“when a risk probability is below a certain threshold, people treat the risk as essentially zero and are willing to pay little or nothing for insurance in the event of loss. but when the risk probability is above a certain level, people are willing to pay a significant amount for insurance, indeed an amount that greatly exceeds the expected value of the risk.”); kevin m. stack & michael p. vandenbergh, the one percent problem, 111 colum. l. rev. 1385, 1401 (2011) (suggesting that probability neglect might explain appeal of arguments to ignore one percent contributions to environmental problems). it is worth stating explicitly that paying higher taxes in order to avoid the potential consequences of an adverse tax audit can be seen as equivalent to willingness to pay an insurance premium. this is not to say that the reduction in probability of getting caught would have no effect on the remainder of the population. rather, the claim is that the tendency to ignore very low probabilities may reduce the responsiveness to a 0.1 percent chance in likelihood of getting caught. 2014] concentrated enforcement 353 c. feedback loops between noncompliance and enforcement layered onto this base case for concentrated enforcement are a number of circumstances that can strengthen the case for concentrated enforcement. first, the case for concentrated enforcement grows when there are feedback loops between noncompliance and enforcement. feedback loops between noncompliance and enforcement can exist when (1) increasing the overall rate of compliance increases the expected monetary costs of any individual instances of noncompliance, and (2) commonalities in nonenforcement create significant returns from enforcement expertise. as an initial matter, a feedback loop between noncompliance and enforcement can exist when increasing the overall rate of compliance increases the expected monetary costs of any individual noncompliance. this dynamic can exist when enforcement is costly and limited and it is insufficient to punish the existing noncompliers. as mark kleiman has explained, when authorities lack sufficient resources to punish the existing number of noncompliers, widespread noncompliance can “swamp” enforcement resources, making it unlikely that any particular noncomplier will be punished. 118 conversely, if the overall rate of compliance is higher, then any isolated noncomplier would face a higher risk of being punished, and would consequently face a higher expected monetary cost of noncompliance. 119 in such a situation, to the extent that the overall population is severable into subsectors, an enforcement project in a subsector can raise the rates of compliance in such subsector. the increased compliance in that subsector may then increase the expected costs of engaging in the same amount of noncompliance in the subsector. the enforcement project can thereby reduce the likelihood of noncompliance in the subsector, even after that enforcement project concludes. 120 118. mark a.r. kleiman, enforcement swamping: a positive-feedback mechanism in rates of illicit activity, in mathematical & computer modelling, 65, 66–68 (1993) [hereinafter kleiman, enforcement swamping]; raaj k. sah, social osmosis and patterns of crime, 99 j. pol. econ. 1272 (1991); joel schrag & suzanne scotchmer, the self-reinforcing nature of crime, 17 int’l rev. law & econ. 325, 326 (1997). for a (rare) discussion of this phenomenon in the tax context, see graetz et al., the tax compliance game, supra note 39, at 25. 119. david a. boyum et al., drugs, crime, and public policy, in crime and public policy, supra note 60, at 393 (“the key observation is that being the only dealer, or one of a few dealers, in a flagrant market is dangerous; the risk of arrest for each remaining seller goes up as the number of other dealers goes down. if it were possible to rapidly shift the expectations of dealers about one another’s behavior, it might be possible to make the market collapse quickly.”). 120. kleiman, when brute force fails, supra note 63, at 4, 54–55. of course, some violations will continue. as kleiman describes: “[i]n a world of uncertainty there will always be some violations and therefore some use of actual 354 florida tax review [vol. 16:6 a feedback loop between noncompliance and enforcement also can exist when commonalities in nonenforcement make enforcement expertise valuable. take, for instance, tax shelters, or abusive tax schemes that produce tax benefits in ways that congress did not intend. tax shelters are often (by design) quite difficult to detect, because they are reported in a manner that makes them look much like run of the mill business schemes. 121 auditing a particular taxpayer in order to identify a tax shelter not only produces tax liability from that audit, but also allows the irs to identify the tax shelter on others’ returns and assess resulting tax liability. 122 for this reason, concentrating enforcement enough to develop expertise about a particular tax shelter can have significant returns to scale. in situations in which compliance problems are common across a subpopulation, concentration can allow the regulator to develop the expertise necessary to produce the returns to scale from enforcement. d. norms the second circumstance that can enhance the case for concentrated enforcement is when norms or other non-economic compliance mechanisms can increase compliance but themselves depend on a minimum, local rate of compliance. 123 scholars have discussed how relatively high compliance may be necessary in order to create norms of compliance, which can then foster future compliance. 124 relatedly, some scholars have suggested that norms sanctions . . . . [t]here is some maximum number of offenders who can be controlled by a given sanctions capacity. but that number is much larger than the number that can be effectively controlled by the same capacity when sanctions are handed out at random.” id. at 65. 121. see blank, overcoming overdisclosure, supra note 17, at 1635–37 (describing difficulty in detecting tax shelters). 122. indeed, commentators have suggested that one reason to support a regime in which taxpayers have to report certain suspected tax shelters is that the information provides essential intelligence to the irs, which can be used against other taxpayers. see, e.g., blank, overcoming overdisclosure, supra note 17, at 1637 (“without help from taxpayers and the individuals who advise them, the irs would face significant obstacles in detecting tax strategies like the contingent liability transaction discussed above. current law, consequently, imposes an obligation on taxpayers and their advisors to raise red flags for the irs when they participate in transactions that bear tax shelter traits.”). 123. thomas c. schelling, micromotives and macrobehavior 101– 02 (1978) [hereinafter schelling, micromotives and macrobehavior]; malcolm gladwell, the tipping point 9, 12 (2000). though malcolm gladwell has popularized the notion of “tipping points,” its intellectual roots are more readily associated with thomas schelling (and others, such as morton grodzins). 124. see, e.g., susan c. morse, tax compliance and norm formation under high-penalty regimes, 44 conn. l. rev. 675, 683 (2012) [hereinafter morse, 2014] concentrated enforcement 355 may be subject to tipping points, becoming much more widespread once some threshold is reached. 125 the problem is that reaching the threshold level of compliance may not be possible with limited enforcement resources. importantly, the relevant rate of compliance for norm activation is often the rate of compliance within small subsectors of an overall population. for instance, as thomas schelling describes, whether one wears a turtleneck likely depends on the proportion of the relevant population wearing a turtleneck, with relevant often meaning local. 126 when local rates of compliance are particularly influential for norm formation, concentrated enforcement can segregate noncompliant populations into local subsectors and apply rotating, enhanced enforcement in the subsectors to help create and sustain compliance norms (and, as a result of such norms, actual compliance) throughout the population. 127 initially, use of enhanced enforcement resources in a particular subsector can raise the expected monetary costs of noncompliance within that subsector, to generate a higher rate of compliance. subsequently, this higher rate of compliance may yield a norm of compliance in this subsector, which can help sustain compliance going forward (even absent increased enforcement). 128 sequential enforcement projects throughout the population may raise compliance substantially across the entire population. tax compliance and norm formation] (explaining that “signaling has a virtuouscircle quality: as more people signal compliance as a positive reputation signal, the positive reputation signal grows in strength”). 125. robert d. cooter, decentralized law for a complex economy: the structural approach to adjudicating the new law merchant, 144 u. pa. l. rev. 1643, 1674–75 (1996) [hereinafter cooter, decentralized law]; alex geisinger & michael ashley stein, a theory of expressive international law, 60 vand. l. rev. 77, 118 (2007) (describing a “norm cascade,” whereby announcement of a norm can yield compliance, which increases the power of the norm); lederman, the interplay, supra note 24 at 1509–10. see infra text accompanying note 197 for lederman’s treatment of this in the tax context. 126. schelling, micromotives and macrobehavior, supra note 123, at 109. what “local” means, of course, depends on the context. local may mean individuals who live or work nearby, or individuals who work in a similar industry or on a similar issue. in any event, whatever local means in a given case should dictate how any authority, or police force, segregates the population for the purposes of concentrated enforcement. 127. id. 128. see, e.g., cooter, decentralized law, supra note 125, at 1675 (discussing situations in which state enforcement of a norm is necessary in order to tip behavior into compliance with the norm); lederman, the interplay, supra note 24, at 1509–10 (discussing potential use of heavy enforcement in tax evasion context to tip into a norm of compliance). the mechanism can also be a bit more complicated. the existence of a norm may feed into expectations regarding the likelihood of others complying, which may then inform individuals’ beliefs about the 356 florida tax review [vol. 16:6 the following example illustrates this possibility. imagine that 100 employers exist throughout city b. workplace safety laws apply to these employers and city b needs to determine how best to use its resources so as to encourage the employers to comply with the laws. the employers are concentrated in five different areas of the city. for simplicity’s sake, imagine that the employers are divided equally between these areas, so that there are 20 employers in each area. it is costly to monitor an employer to prevent the employer from violating workplace safety laws and this cost does not decrease as the rate of employers complying increases. city b only has enough resources to monitor (and therefore insure compliance of) ten employers at any given time. however, for a variety of reasons, norms affect compliance. 129 in particular, each employer will comply with the law, as long as the employer perceives that at least 50 percent of other employers comply with the law. 130 employers tend to focus on the other employers in their geographic area in making this norm determination. as a result, if city b applies all of its enforcement resources to one of the five areas (“area 1”), all employers within area 1 will comply. the reason is as follows: by concentrating all of its enforcement resources on area 1, city b can monitor (and ensure compliance of) ten area 1 employers. since, at that point, 50 percent of area 1 employers will be complying with the workplace safety laws, then, by assumption, the remaining ten employers in area 1 will also comply with the laws. in other words, by breaking apart city b into smaller subsectors, defined by area, and then using its enforcement resources in a concentrated manner, city b can engender the level of compliance necessary to obtain compliance by all area 1 employers. 131 if this compliance norm is likelihood of being punished for not complying. as explained by schelling (with reference to tax evasion): “[i]f appropriate mutual expectations exist, people will expect evasion to be on a scale small enough not to overwhelm the authorities and may consequently pay up either out of a sense of reciprocated honesty or out of fear of apprehension, thus together justifying their own expectations.” thomas c. schelling, the strategy of conflict 92 (1980) (emphasis added). 129. these reasons could include relationships with workers, relationships with the public, or personal norms of a variety of sorts. 130. of course, the idea that all employers have the same threshold for compliance (or that they have the same benefits from noncompliance, for that matter) is a simplification. the same analytical point applies even if the example becomes more complicated. the math and exposition would become more complicated as well. 131. this simplified example can be made much more complex in any number of ways. for instance, it might be the case that 1,000 employers and ten large areas exist, and that city b can monitor only ten employers at one time. as a result, city b would only be able to monitor ten percent of the employers in any given area. in such a case, under the parameters of this example, insufficient resources would exist to tip into a norm of compliance. however, a number of options might exist. the areas might be divisible and, as a result, additional 2014] concentrated enforcement 357 durable, 132 then city b can remove its enforcement resources from area 1 and move on to area 2 to obtain compliance, and on to area 3, and so on. the bottom line is that, when a norm that exhibits tipping properties exists, concentrated enforcement offers the potential to obtain substantially higher compliance across a population. e. uncertainty aversion the base case for concentrated enforcement also can be enhanced when the regulated population exhibits uncertainty aversion, and concentrated enforcement makes the population perceive greater uncertainty. 133 the foundation for this argument is the distinction between risk and uncertainty. a risk can be defined as a gamble with known probabilities. 134 for instance, in the contaminant disposal example, above, when enforcement resources were spread uniformly across the population, concentrations of enforcement resources could create compliance norms in subareas, on a rotating basis. alternatively, employers in a given area may relay information to each other about being monitored, which would enhance the effectiveness of monitoring. media attention (discussed in more detail below) to the monitoring strategy may also make monitoring more effective. in any event, this article does not suggest that concentrated enforcement can always tip into norms of compliance. when insufficient, total resources exist to tip into a norm of compliance for any divisible subsector (or subarea) and concentrated enforcement is not more effective for any other reason, tipping into a compliance norm simply may not be possible. however, concentrated enforcement underscores the potential benefits of segregating a large population into small, divisible portions in order to tip into norms of compliance. moreover, while the irs resources to audit cash business taxpayers (examined below) may seem highly suboptimal, there is nonetheless a very large, total pool that could be drawn upon in order to address small subsectors of the population. 132. cf. dan m. kahan, gentle nudges vs. hard shoves: solving the sticky norms problem, 67 u. chi. l. rev. 607, 615–16 (2000) (“[w]hen an individual perceives that the group of individuals engaging in a behavior is relatively small, she is likely to cease engaging in the behavior; that reduces the size of the group, thereby inducing even more individuals to refrain from the behavior, and so forth and so on.”). 133. concentrated enforcement could also increase the perceived (though not actual) risk of enforcement across the population. the actual risk of enforcement would not increase because the total amount of enforcement resources would remain the same. only its allocation across the population would change. however, to the extent that the strategy of using announced enforcement projects and quiet withdrawals convinces more individuals that they are subject to enhanced enforcement than they actually are at any given time, the total perceived risk of enforcement would be higher. i thank susie morse for this point. 134. frank h. knight, risk, uncertainty and profit 214–15 (1921); lawsky, probably, supra note 18, at 1026. 358 florida tax review [vol. 16:6 each violator faced a two percent chance, or risk, of getting caught. however, not all gambles present known probabilities. 135 many times, a regulated party faces uncertainty, or a gamble in which the probabilities are not known. the classic example of such a gamble is the chance of pulling a red ball from an urn when the urn is filled with black and red balls, but in an unknown ratio. 136 in the compliance context, a regulated party may know there is some chance of getting caught for breaking the law, but not know the percentage chance of getting caught. in such a situation, the regulated party faces uncertainty regarding the likelihood of getting caught or, in other words, the regulated party faces uncertainty regarding the compliance gamble. uncertainty is important because research suggests that individuals often exhibit an aversion to uncertainty itself. daniel ellsberg famously posited the notion with the urn example, alluded to above. imagine a gamble in which an individual bets $100 and wins a prize if a red ball is drawn from an urn. imagine that the individual can make the bet either for an urn that is filled with 50 red balls and 50 black balls, or for an urn that is filled with 100 red and black balls in unknown ratios. if the individual prefers the urn with 50 red balls and 50 black balls, then the individual is uncertainty averse, because the individual has a disinclination toward gambles with unknown probabilities. 137 researchers in the compliance context have found evidence that individuals frequently exhibit uncertainty aversion, which can increase compliance. for instance, in an experiment regarding choices between two payouts, one of which was higher but subject to a potential fine (which, if applied, would make the payout lower than the “safe” choice), researchers found that uncertainty regarding the probability of detection (or regarding the size of the fine) decreased the likelihood of choosing the option subject to the fine (the gamble). 138 135. indeed, it would be possible to argue that few to no gambles in fact present risk, rather than uncertainty. for example, when tossing a coin, a 50 percent chance of getting heads only applies if the coin is not rigged. nonetheless, some circumstances (i.e., coin tosses) can be said (and, more importantly, are perceived) to present risk, rather than uncertainty, whereas other can be said (and are perceived) to present uncertainty. lawsky, probably, supra note 18, at 1026–27. 136. daniel ellsberg, risk, ambiguity, and the savage axioms, 75 q. j. econ. 643, 650-51 (1961). 137. id. 138. tom baker et al., the virtues of uncertainty in law: an experimental approach, 89 iowa l. rev. 443, 457–68 (2004); see also thomas a. loughran et al., on ambiguity in perceptions of risk: implications for criminal decision making and deterrence, 49 criminology 1029 (2011) (finding that, for no-one-around crimes (hypothesized to be more likely motivated by factors such as likelihood of detection), there was evidence of uncertainty aversion for low probabilities of detection and uncertainty seeking for high probabilities of detection, but reaching 2014] concentrated enforcement 359 concentrated enforcement offers the possibility of leveraging uncertainty aversion to increase compliance. it can do so by making the enforcement parameters more uncertain. consider a population of 1,000 largely noncompliant individuals and scarce enforcement resources. imagine that there are only sufficient enforcement resources to subject one percent of the population to enforcement. three possibilities exist for allocating the scarce enforcement resources: random allocation across the population, a “worst-first” method, or a concentrated enforcement approach (with decisions about which particular individuals in a given subsector to examine based on a “worst-first” method). the first possibility, random allocation of the scarce enforcement resources, would result in a determinate risk of being subject to enforcement of one percent. the second possibility, a “worst-first” method, would create greater uncertainty. some individuals would have a higher risk of audit, and some individuals would have a lower risk of audit. whether the risk of audit was higher or lower would depend on the “worstfirst” method used as a trigger to flag individuals, and whether any given individual exhibited that trigger. to the extent that either the triggers were not public knowledge, or individuals could not be sure whether or not they exhibited the triggers, they would face uncertainty regarding their chance of being subject to enforcement. introducing concentrated enforcement would arguably enhance this uncertainty. with concentrated enforcement, an individual’s likelihood of being subject to enforcement would depend not only on enforcement triggers, but also on whether or not the individual’s subsector was subject to an enforcement project. whether or not an individual’s subsector was subject to an enforcement project would be out of the individual’s control. as a result, even individuals who could minimize their audit triggers under a “worst-first” method would still face an enhanced chance of audit under concentrated enforcement. additionally, uncertainty regarding the application of enforcement projects could be layered onto uncertainty flowing from continued, secondary use of the “worst-first” method to allocate resources within an enforcement project. to the extent that the different results for more emotive, face-to-face crimes). recently, gregory deangelo and gary charness found that uncertainty regarding the enforcement regime significantly reduced speeding violations. gregory deangelo and gary charness, deterrence, expected cost, uncertainty and voting: experimental evidence, 44 j. risk & uncertainty 73 (2012). however, they created “uncertainty” through compound lotteries, which they argued induced true uncertainty as a result of bounded rationality. id. at 77–78. for an interesting discussion of the relationship between cognitive biases and subjective probabilities, see charles yablon, the meaning of probability judgment: an essay on the use and misuse of behavioral economics, 2004 u. ill. l. rev. 899 (2004). 360 florida tax review [vol. 16:6 individuals in the population are uncertainty averse, concentrated enforcement may increase compliance. 139 one counterargument is that announcement of the application of particular enforcement projects would significantly cut down on the uncertainty of the enforcement. while this is certainly the case, there is reason to believe that the concentrated enforcement regime would nonetheless introduce uncertainty, relative to the alternatives. as an initial matter, while, as suggested previously, announcement of an enforcement project’s initiation in a particular subsector would be important in order to garner a rapid compliance response to the enforcement project, the conclusion of the enforcement project (the “withdrawal”) would not be announced. as a result, taxpayers would not have complete certainty that they were done with an enforcement project at any given time. 140 additionally, in compliance contexts, such as tax, in which compliance is not a one-time event, but rather lack of compliance at one point in time (i.e., in an earlier year) can be detected in a later period of time (i.e., audit of a later year), the possibility of being subject to an enforcement project in the future could give a potential noncomplier pause even if one is not subject to a current enforcement project. as a result, while concentrated enforcement does not present complete detection uncertainty and while announcement of enforcement projects reduces uncertainty, it nonetheless offers a means of injecting greater uncertainty into the compliance system. f. availability bias the base case for concentrated enforcement similarly may be enhanced when the regulated parties exhibit the availability bias. the availability bias, which is a cognitive bias, is a tendency for individuals to rely more heavily on information that is more readily available, in order to assess the probability, or frequency, of an event. 141 a number of factors influence whether information is readily available, including familiarity with the information, as well as the salience, or prominence, of the information. 142 for instance, as described by amos tversky and daniel kahneman, seeing a car accident tends to increase the subjective probability of car accidents, and 139. cf. sherman, police crackdowns, supra note 70, at 11–23 (discussing uncertainty aversion and enforcement projects). 140. cf. id. (discussing quiet backoff strategy and some evidence of residual deterrence after crackdowns, although cautioning that more empirical evidence is needed). 141. shelley e. taylor, the availability bias in social perception and interaction, in judgment under uncertainty: heuristics and biases 190, 190 (amos tversky & daniel kahneman eds., 1982). 142. amos tversky & daniel kahneman, judgment under uncertainty: heuristics and biases, 185 sci. 1124 (1974). 2014] concentrated enforcement 361 watching a house burn down likely increases the subjective probability of a house burning, relative to reading about a house burning in the newspaper. 143 indeed, in the tax context, researchers have produced evidence of individuals underreacting to taxes when taxes are not included in the stated sales price and not otherwise publicized in a prominent way. 144 by operating through enforcement projects, concentrated enforcement could produce more salient stories of enforcement, because a subsector-wide enforcement project would often yield newsworthy stories of enforcement. indeed, news stories frequently focus on enforcement projects in a variety of different contexts. 145 as alluded to above, hmrc’s use of compliance projects has resulted in extensive coverage by media and tax 143. id. 144. raj chetty, adam looney & kory kroft, salience and taxation: theory and evidence, 99 am. econ. rev. 1145 (2009); see also amy finkelstein, ez-tax: tax salience and tax rates, 124 q.j. econ. 969 (2009) (similar findings in context of tolls). but see david gamage & darien shanske, three essays on tax salience: market salience and political salience, 65 tax l. rev. 19, 33 (2011) (cautioning that the empirical evidence regarding salience at issue in these studies (referred to by the authors as spotlighting) is in an early stage of development). somewhat relatedly, in the tax compliance context, researchers have produced some evidence that stories of audit can serve as substitutes for statistical information communicating a threat of audit. alm et al., getting the word out, supra note 51, at 401. however, in the absence of reliable statistical information regarding the probability of audit, individuals might quite rationally try to derive the probability of audit from stories of others being audited. nonetheless, whether as a result of the availability bias or as a result of some rational updating mechanism, evidence exists of taxpayers increasing compliance in response to stories of audit (at least when reliable audit statistics are not available). 145. for a very small handful of samples of such coverage over a short period in april 2013, see police to crack down on underage drinking, kearny courier, apr. 25, 2013, http://m.kearneycourier.com/mobile/news/article_ df18242c-b2dc-5921-9b18-a6d0e173f837.html; police crack down on distracted driving, w. va. trucking ass’n (apr. 9, 2013), www.wvtrucking.com/latestnews/police-crack-down-on-distracted-driving.html; county law enforcement to crack down on speeders, tomah j., apr. 8, 2013, http://lacrossetribune .com/tomahjournal/news/local/county-law-enforcement-to-crack-down-on-speeders/ article_450cde16-a071-11e2-b740-001a4bcf887a.html; mass., local police vow crackdown on welfare fraud, bos. herald, apr. 11, 2013, bostonherald.com/ comments/1062646846; scott signs internet cafe ban, local police have strengthened tools for crackdown, miami herald, apr. 10, 2013, http://miamiherald.typepad.com/nakedpolitics/2013/04/scott-signs-internet-cafe-banclarifications-on-machines-now-in-effect.html; michael n. price, 10 arrested in chesco heroin crackdown, mercury news, apr. 23, 2013, http://www. pottsmerc.com/article/20130423/news01/130429858/10-arrested-in-chesco-heroinenforcement project. 362 florida tax review [vol. 16:6 preparers. 146 to the extent that concentrated enforcement made enforcement more newsworthy, it could increase the perceived costs of noncompliance, without requiring additional enforcement. g. nodes of noncompliance finally, to the extent that nodes of noncompliance can be identified, concentrated enforcement would be most effective if enforcement concentrated on such nodes in particular. this intuition was central to hot spots policing, discussed in part ii and (at least according to hmrc’s own publicity) has motivated the choice of hmrc’s particular campaigns. while the general case for concentrated enforcement (as set forth above) does not depend on the regulated parties exhibiting differing, observable levels of compliance, if differing levels of compliance do exist, and they can be detected, then project resources should be concentrated in problem areas. focusing on nodes of noncompliance can help ensure the greatest voluntary compliance gains from concentrated enforcement, by increasing rates and norms of compliance where such increases are most needed. at the same time, focusing on nodes of noncompliance can help keep direct revenue from audit as high as possible under a concentrated enforcement approach. additionally, focusing on nodes of noncompliance may help assure the public that enforcement projects are being selected in a sensible and fair fashion. ideally, enforcement projects would be chosen through a highly automated system designed to focus on nodes of noncompliance. 147 the result would be a concentrated enforcement system designed to maximize the combination of voluntary compliance and direct revenue. v. application to cash business tax sector this part applies concentrated enforcement to the cash business tax sector and explores reasons why concentrated enforcement might help stem evasion, as well as potential problems. the cash business tax sector is a particularly apt setting for analysis of concentrated enforcement, because neither classic deterrence theory nor “worst-first” methods (at least on their own) offer much hope of stemming the tide of cash business tax evasion. 146. see sources cited supra note 87. 147. some might question how well the regulator will be able to identify nodes of noncompliance. inaccurate information about nodes of noncompliance may weaken concentrated enforcement, but not relative to the alternative, a pure “worstfirst” approach, because the latter would similarly suffer from inaccurate information. 2014] concentrated enforcement 363 a. the cash business tax sector “cash business” is a common way of referring to small businesses, which receive a large portion of their receipts in the form of cash. 148 unlike wage and salary income, which is subject to employer information reporting and withholding, the cash revenue received by cash businesses generally is neither reported nor withheld by a third party and is very difficult for auditors to find. 149 while, as a result of a new law, financial intermediaries must report to the irs various credit card payments made to small businesses, these rules do not yield any reporting of cash receipts. 150 additionally, while cash payments greater than $600 made from a trade or business to an unincorporated service provider are subject to information reporting, these rules have limited reach and are often violated. 151 for example, service providers can incorporate in order to avoid the reach of the reporting requirement. 152 complying with the reporting requirements is also arguably quite burdensome, and many service recipients simply do not comply. 153 crucially, cash payments for goods are not subject to information reporting rules at all. 154 the cash business tax sector is a striking example of how real-world limitations on probability of detection and penalties can leave classic deterrence theory with few useful prescriptions for addressing the most 148. see, e.g., susan cleary morse et al., cash businesses and tax evasion, 20 stan. l. & pol’y rev. 37, 37–38 (2009) [hereinafter morse et al., cash businesses] (describing small business tax evasion and attributing problem largely to cash payments). 149. robert a. kagan, on the visibility of income tax law violations, in 2 taxpayer compliance 76, 81–83 (jeffrey a. roth & john t. scholz eds., 1989) [hereinafter kagan, income tax violations] (discussing visibility of various sources of income and concluding that visibility “appears to be an enormously important factor – and perhaps the most important factor – in shaping compliance rates”). 150. i.r.c. § 6050w; leandra lederman, reducing information gaps to reduce the tax gap: when is information reporting warranted?, 78 fordham l. rev. 1733, 1757 (2010) [hereinafter lederman, reducing information gaps]. 151. see i.r.c. § 6041a. 152. u.s. gov’t accountability office, gao-07-1014, tax gap: a strategy for reducing the gap should include options for addressing sole proprietor noncompliance 17 (2007) [hereinafter strategy for reducing the gap]. 153. id. at 17 (discussing difficulties in filing information returns and various exemptions, which reduce the compliance with the information reporting requirements). 154. a recent attempt to require businesses to report cash payments for goods in excess of $600 was quite unpopular, and it was quickly repealed. comprehensive 1099 taxpayer protection and repayment of exchange subsidy overpayments act of 2011, h.r. 4, 112th cong. (2011). 364 florida tax review [vol. 16:6 pressing compliance problems. the significant limitations on information reporting discussed above make detecting cash income underreporting quite expensive, thereby limiting the likelihood of detection, the first arm of classic deterrence theory. 155 making the problem worse, the cash business tax sector is quite large, relative to the available irs enforcement resources. for instance, the gao reported in 2007 that the irs’s enforcement programs annually contact less than five percent of estimated noncompliant sole proprietors. 156 a principal explanation for this statistic is that finding cash business evasion requires intensive and expensive audits, which the limited enforcement resources cannot yield in sufficient quantities. 157 penalties, the second arm of classic deterrence theory, do not nearly make up for this deficiency in the probability of detection. while civil fraud penalties exist for underpayments of tax due to fraud, 158 and criminal penalties for tax evasion are possible, 159 tax penalties are imposed surprisingly rarely. 160 participants in the cash business tax sector report a correspondingly low fear of penalties. 161 the result of these practical constraints has been massive tax evasion by cash business taxpayers. in 2006, individual business income tax liability alone was underreported by $122 billion on top of additional payroll, employment, and self-employment tax underreporting. 162 the net misreporting percentage for nonfarm proprietor income (here, referred to as 155. see kathleen delaney thomas, presumptive collection: a prospect theory approach to increasing small business tax compliance, 66 tax l. rev. 111 (2013) (cataloguing the limitations of information reporting as a means of increasing compliance by cash businesses). 156. strategy for reducing the gap, supra note 152, at 3. 157. u.s. gov’t accountability office, gao 09-815, tax gap: limiting sole proprietor loss deductions could improve compliance but would also limit some legitimate losses (2009); see also morse et al., cash businesses, supra note 148, at 63–64 (2009) (describing limited audit threat for cash business taxpayers). 158. i.r.c. § 6663. 159. i.r.c. § 7201. 160. see, e.g., treasury inspector gen. for tax admin., dep’t of the treasury, reference no. 2010-30-059, accuracy-related penalties are seldom considered properly during correspondence audits (2010), http://www.treasury.gov/tigta/auditreports/2010reports/201030059fr.pdf. 161. morse et al., cash businesses, supra note 148, at 64 (describing limited audit threat for cash business taxpayers and relaying experience of cash business tax return preparer who reported: “[i]n a typical year only a handful of his 300 or so clients were audited and while audits produced additional payments they did not lead to civil penalties. he had never had a client threatened with criminal penalties.”). 162. internal revenue serv., irs tax gap map for tax year 2006 (2011), http://www.irs.gov/pub/newsroom/tax_gap_map_2006.pdf. 2014] concentrated enforcement 365 small business income) was 56 percent, as compared to a net misreporting percentage of one percent for wage and salary income. 163 while the 56 percent net misreporting percentage of course implies a reporting percentage of 44 percent, which is significantly better than nothing, the 44 percent reporting percentage can be explained in large part by structural mechanisms that help ensure reporting. namely, this 44 percent reporting percentage applies to all nonfarm proprietor income (or small business income), whether the income is actually received in cash or not. 164 as alluded to above, some small business income is received in the form of credit card payments, which are traceable and, more recently, actually reported to the irs. 165 as a result of the perceived visibility of such payments, small business taxpayers indicate that they report their credit card receipts. 166 the 44 percent reporting percentage, then, likely significantly overstates the rate of compliance with respect to cash income, which is both the root and bulk of the cash business tax compliance problem. 167 as to the cash income, the existing enforcement resources seem woefully inadequate to incentivize compliance. b. difficulties for “worst-first” approaches the widespread evasion makes “worst-first” methods, at least by themselves, ill-equipped to substantially increase cash business tax compliance. 168 “worst-first” methods, such as the dif score, work best when most individuals are complying, thereby making it easy to spot a noncomplier. 169 for instance, imagine that in a given sector, most taxpayers reported honestly and reported their actual business deductions, which were approximately equal to 30 percent of their gross income. in such a case, if any one taxpayer reported a much higher percentage of business deductions, the irs could easily spot the taxpayer as suspicious. on the other hand, 163. overview of tax gap, supra note 26, at 1–2. 164. id. at 3 (including all nonfarm proprietor income in the amounts subject to little or no information category, which has a net misreporting percentage of 56 percent). 165. see supra text accompanying note 150. 166. see, e.g., morse et al., cash businesses, supra note 148, at 50–51. 167. see lederman, reducing information gaps, supra note 150, at 1757 (relying on similar research to conclude that cash is the “core of the noncompliance problem for small businesses”). 168. cf. irs’ return selection process, supra note 42, at 4 (suggesting that cash businesses may be subject to non-dif score analysis). 169. see jeffrey a. dubin & louis l. wilde, an empirical analysis of federal income tax auditing and compliance, 41 nat’l tax j. 61, 71 (1988) (theorizing that “high level of noncompliance [in specific audit classes may make] the dif score a poor predictor of the expected return from an audit, at least relative to other returns in a given audit class”). 366 florida tax review [vol. 16:6 higher levels of noncompliance mean that the irs has a lower ability to spot noncompliers. using the same example, widespread noncompliance means that the irs has a much less reliable picture of what percentage of business deductions is standard. as a result of having less reliable information, the irs is less able to identify anomalies and focus on them as likely noncompliers. 170 complicating the situation, the root causes of the noncompliance can also serve as means of coordinating on noncompliance. the lack of information reporting and withholding in the cash business tax sector, which make noncompliance so difficult to catch, also serve as a signal that taxpayers have strong reasons not to comply. this signal may then mutually assure taxpayers that other taxpayers are likely not to comply with their taxpaying obligations, even absent any explicit conversations or agreements. 171 coordinated noncompliance lowers the effectiveness of the dif score, making room for even more noncompliance. structural enforcement deficiencies can thereby create a noncompliance spiral. 172 the importance of coordinating mechanisms comes into sharper focus when contrasting the high level of compliance exhibited by taxpayers who have income subject to third party reporting. 173 third party reporting is not only important because it creates a high likelihood of getting caught, or probability of detection, if a taxpayer fails to report the income but also because the third party reporting serves as a coordinating mechanism, informing taxpayers of the likelihood that other taxpayers with income subject to third party reporting are likely to report their income. 174 as a result, the irs is in a good position to pursue any given taxpayer who does not report income subject to third party reporting. imagine, instead, that 170. lemos & stein, strategic enforcement, supra note 38, at 26 (discussing difficulties with “worst-first” method” when “number of violators is extraordinarily high”). 171. indeed, these structural features may be substitutes for actual noncompliance communication. 172. cf. kleiman, enforcement swamping, supra note 118, at 67 (describing downward compliance spiral). 173. overview of tax gap, supra note 26, at 3 (amounts subject to substantial information reporting have an approximately 92 percent compliance rate). 174. cf. lederman, reducing information gaps, supra note 150, at 1738– 39 (“what likely makes information reporting so successful in spurring compliance in the first instance is that, like “red light cameras” that snap pictures of vehicles failing to stop for a red light, the taxpayer is aware that the government is watching.”). the argument being made in the text is a bit different. the argument in the text deals with how information reporting provides information about the likely compliance of others, and therefore serves as a means of coordinating levels of compliance. 2014] concentrated enforcement 367 taxpayers with income subject to third party reporting generally did not report such income. despite the third party reporting, the irs likely would not have the resources to examine and punish a large portion of the taxpayers not reporting such income. 175 as a result, taxpayers would face a low likelihood of being punished for not reporting income subject to third party reporting, notwithstanding the high likelihood of detection. 176 the cash business tax sector presents this coordinated noncompliance problem. the heterogeneity of cash business taxpayers makes this problem even worse. “worst-first” methods work particularly well when differences from an average reflect likely noncompliance. 177 for instance, “worst-first” methods can apply particularly well in the context of speeding, because it is easy to identify who is the most noncompliant based on who is going the fastest. but cash business taxpayers are in some ways the quintessential examples of taxpayer heterogeneity. as a result, low reported income by cash business taxpayers is not necessarily a reliable indicator of tax evasion. for instance, a particular taxpayer who reports low income may just be a bad businessperson and, as a result, actually experience business losses, even though all other taxpayers in the subsector are experiencing gains. alternatively, a very profitable taxpayer in the subsector may be able to report and pay more tax liability than all other taxpayers in the subsector and still greatly underreport actual tax liability owed. this heterogeneity means that the irs cannot easily rely on straightforward comparisons between taxpayers in order to determine who is likely to be the “worst.” this inability severely hampers the power of a “worst-first” method. 178 175. see supra text accompanying notes 28–29 discussing enforcement resources limitations of irs. the fact that the tax liability would be clear would not necessarily change this constraint. cf. david cay johnston, i.r.s. enlists outside help in collecting delinquent taxes, despite the higher costs, n.y. times, aug. 20, 2006, at a12 (reporting that “[t]he private debt collection program is expected to bring in $1.4 billion over 10 years, with the collection agencies keeping about $330 million of that, or 22 to 24 cents on the dollar,” whereas “[b]y hiring more revenue officers, the i.r.s. could collect more than $9 billion each year and spend only $296 million -or about three cents on the dollar”). 176. see sources cited supra note 118. 177. steven klepper & daniel nagin, the anatomy of tax evasion, 5 j.l. econ. & org. 1, 12–13 (1989) (“[t]he smaller the variation in the true amount on a line item within homogeneous classes of taxpayers relative to the mean true amount on the line item, the easier it will be for an auditor to establish a prima facie case of noncompliance.”). 178. lazear, the advantage, supra note 91, at 1054 (“[i]t is a general principle in incentive theory that when noise is high relative to the signal, incentives are diminished.”); lemos & stein, strategic enforcement, supra note 38, at 26 (“[w]here it is even more difficult to apply a relative performance measure than an absolute one . . . a [“worst-first”] approach to enforcement will be inappropriate.”). 368 florida tax review [vol. 16:6 c. the case for concentrated enforcement so, what conditions of the cash business tax sector, if any, suggest that concentrated enforcement might help improve cash business tax compliance? first, as described previously, a base case for concentrated enforcement can apply when compliance incentives are insufficient if enforcement resources are spread uniformly through the population. 179 the cash business sector is a good example of a situation in which enforcement capacity is very limited and violations are very high. the low rate of compliance reflects the very low expected monetary costs of noncompliance that cash business taxpayers face if enforcement resources are allocated across the entirety of the population. the very limited enforcement resources available for the cash business tax sector and the high levels of violations suggest that insufficient incentives for compliance may exist if enforcement resources are spread throughout the population. these circumstances indicate potential benefits from concentrated enforcement under the economic base case for concentration. layered onto this base case for concentrated enforcement are other aspects of the cash business tax sector, which may strengthen the case for concentrated enforcement. the first feature of the cash business tax sector that may bolster the case for concentrated enforcement is the fact that there appear to be feedback loops between noncompliance and enforcement. as discussed above, enforcement resources for the cash business tax sector have historically been quite suboptimal. moreover, as a result of the dif score, the irs analyzes what the tax profiles of particular cash business taxpayers should look like in order to identify taxpayers who have profiles that are sufficiently outside of expectations. 180 whether a cash business taxpayer is likely to get audited, and the taxpayer’s resulting, expected monetary costs of noncompliance depend on a comparison between the taxpayer and other relevant taxpayers. 181 the result is that, if the rate of compliance could be 179. see supra text accompanying notes 96–112. 180. see supra text accompanying notes 43–45. 181. the dif score is a particular manifestation of a more general phenomenon: the more information the irs has regarding what a taxpayer’s tax profile should look like, the easier it is for the irs to detect noncompliance, the higher the expected costs to taxpayers of noncompliance, and, therefore, the more likely taxpayers are to comply. for general discussions of the importance of information to rates of tax compliance, see, for example, ilan benshalom, taxing cash, 4 colum. j. tax l. 65, 78 (2012-13) [hereinafter benshalom, taxing cash] (discussing importance of information reporting); dina pomeranz, no taxation without information: deterrence and self-enforcement in the value added tax 5 (working paper no 13-057), http://www.hbs.edu/faculty/publication%20/files/ pomeranz_no_taxation_without_information_c2f18227-578f-4259-b75b-f62f2ell32 17.pdf (discussing, in the context of the value added tax, how “it is the interaction of 2014] concentrated enforcement 369 increased, the likelihood of getting punished for a particular instance of noncompliance would increase. imagine, for instance, that a cash business taxpayer, a, is considering underreporting tax liability by $5,000. relative to paying the tax liability, the expected benefit from underreporting this tax liability would be the tax liability evaded, $5,000, multiplied by the probability of not getting caught. the expected cost would be the penalty for evasion, multiplied by the probability of detection. to the extent that all other cash business taxpayers underreport the same amount, the likelihood of that particular cash business taxpayer getting caught and punished is low, because this reporting would not appear out of the ordinary. however, if all other cash business taxpayers are underreporting only $2,000 of tax liability, a faces a higher likelihood of getting caught and punished for underreporting $5,000, because a is now an outlier, more likely to trigger review. as a result of this higher likelihood of detection, a faces a higher expected cost from underreporting $5,000 and a lower expected benefit. in other words, the higher overall rate of compliance would increase the expected monetary costs and lower the expected monetary benefits of a’s own noncompliance, thereby increasing the likelihood of a complying. indeed, in a recent article, fangfang tan and andrew yim offered evidence of this dynamic from a tax experiment they conducted. 182 in one treatment in the experiment, experimental taxpayers were told that the tax agency would conduct a set amount of audits. 183 this auditing rule made any given taxpayer’s likelihood of audit depend on other taxpayers’ compliance. 184 when more taxpayers had high incomes, reducing their likelihood of reporting low tax liability, the incidence of noncompliance (through taxpayers with high income reporting low) decreased significantly. 185 importantly for concentrated enforcement, the compliance of other cash business taxpayers in a cash business taxpayer’s own subsector is likely to be particularly determinative of a taxpayer’s own expected monetary costs of noncompliance. 186 for instance, in judging the tax report of a dry cleaner information with deterrence that leads to effective tax enforcement”); slemrod, cheating ourselves, supra note 24, at 37 (discussing how information reporting relates to compliance). 182. fangfang tan & andrew yim, can strategic uncertainty help deter tax evasion? an experiment on auditing rules, 40 j. econ. psych. 161 (2013). 183. id. at 165. 184. id. 185. id. at 168–69. 186. this is consistent with (early) findings that audits of taxpayers tend to have the highest voluntary compliance impact on taxpayers within the same class. ann d. witte & diane f. woodbury, the effect of tax laws and tax administration on tax compliance: the case of the u.s. individual income tax, 38 nat’l tax j. 1, 8 (1985). 370 florida tax review [vol. 16:6 in manhattan, the tax profiles of other dry cleaners in manhattan are likely to be more indicative of what the dry cleaner at issue should look like, rather than dry cleaners in brooklyn, dry cleaners in miami, or food vendors in manhattan, brooklyn, or beyond. 187 as a result, an enforcement project on manhattan dry cleaners may substantially raise the expected monetary costs of noncompliance, and therefore the compliance, of manhattan dry cleaners. 188 this raised rate of compliance may help sustain compliance to some extent even after the enforcement project moves on. relatedly, focusing on an enforcement project may provide the irs with a better picture of tax profiles in the enforcement project. this expertise may increase the comparative analysis of the dif score to better detect noncompliance. this would provide a second feedback loop between noncompliance and enforcement. some evidence of cash business taxpayers trying to benchmark their noncompliance suggests that concentrated enforcement may allow the irs to develop expertise regarding noncompliance tactics used in particular cash business tax sectors, which expertise may then produce high returns. for instance, in interviews, some cash business tax return preparers reported stories of taxpayers backing into what they reported earning, based on what they spent. 189 similarly, cash business tax return preparers were reported to plug in national averages to calculate the deductions that taxpayers claimed and manipulate taxpayer reporting based on industry averages and profit margins. 190 to the extent that there are commonalities in noncompliance in enforcement projects, concentrated enforcement may provide the irs with enough information to identify such tactics and capitalize on this knowledge. norms potentially also offer additional, enhanced support for concentrated enforcement. at a very broad level, cross-country attitudes regarding the acceptability of tax evasion vary considerably, and these differing attitudes toward evasion appear to be associated with actual levels of evasion. 191 however, simply appealing to norms of compliance has not 187. cf. charles t. clotfelter, tax evasion and tax rates: an analysis of individual returns, 65 rev. of econ. & stat. 363, 366 (1983) [hereinafter clotfelter, individual returns analysis] (suggesting that, although irs audit formula is secret, “[w]hat seems to be clear is that all taxpayers in a given audit class face the same enforcement regime, in the form of the audit formula for that class”). 188. but see bloomquist, supra 40, at 44 (using results from modeling as “indication that the level of tax reporting compliance by small business owners in the real world does not necessarily result from taxpayers observing and mimicking others’ reporting behavior”). however, this result is, of course, dependent on the auditing method (and whether it makes neighbors’ reporting behavior relevant). 189. morse et al, cash businesses, supra note 148, at 53, 59, 61. 190. id. 191. slemrod, cheating ourselves, supra note 24, at 40–41. 2014] concentrated enforcement 371 been shown to have a significant impact on compliance. 192 rather, it seems that compliance rates themselves may affect norms, which may then feed back into compliance. for instance, susan morse, stewart karlinsky, and joseph bankman reported on interviews with cash business taxpayers. 193 in these interviews, cash business taxpayers reported learning norms and means of noncompliance from family and friends in the sector, who passed on “shared wisdom” such as never depositing cash and never taking cash in front of employees. 194 based on this research, a follow-on paper suggested that one plausible hypothesis is that high noncompliance in the cash business sector affects norms, which help sustain and perhaps increase noncompliance. 195 through survey evidence, michael wenzel concluded that perceived norms had a causal effect on tax compliance and affected personal tax ethics for individuals who strongly identified with the group. 196 indeed, a number of scholars have discussed how high levels of enforcement may play an important role in activating norms in the tax context. this insight was at the heart of leandra lederman’s suggestion that heavy enforcement focused on cash business taxpayers might help tip cash businesses into a norm of compliance. 197 jon davis, gary hecht, and jon perkins had earlier explored how increased enforcement can yield social norms of compliance, which can reduce evasion. 198 the open question is how 192. see, e.g., marsha blumenthal et al., do normative appeals affect tax compliance? evidence from a controlled experiment in minnesota, 54 nat’l tax j. 125 (2001) (finding no evidence that appeals to conscience significantly affected compliance in real world experiment in minnesota); benno torgler, moral suasion: an alternative tax policy strategy? evidence from a controlled field experiment in switzerland, 5 econ. of governance 235 (2004) (similar finding in switzerland). 193. morse et al., cash businesses, supra note 148, at 65–66. 194. id.; see also kagan, income tax violations, supra note 149, at 90 (exploring how cash business taxpayers have often learned from relatives, other business owners, or even accountants how best to evade both taxes and detection). 195. morse et al., cash businesses, supra note 148, at 41; cf. caroline adams & paul webley, small business owners’ attitudes on vat compliance in the uk, 22 j. econ. psych. 195, 205 (2001) [hereinafter adams & webley, vat compliance in the uk] (reporting from interview results of small business proprietors in the united kingdom that a “norm exists of minimising [vat tax liability] by any means”). 196. michael wenzel, motivation or rationalisation? causal relations between ethics, norms and tax compliance, 26 j. econ. psychol. 491, 504 (2005). wenzel also found some evidence that norms served as rationalizations, because taxpayers’ own compliance also appeared to affect norms. id. 197. lederman, the interplay, supra note 24, at 1503–13. 198. jon s. davis et al., social behaviors, enforcement, and tax compliance dynamics, 78 acct. rev. 39 (2003). a number of recent articles have begun building on davis et al. to better understand how multiple agents interact. see, e.g., bernard fortin et al., tax evasion and social interactions, 91 j. pub. econ. 372 florida tax review [vol. 16:6 to allocate scarce enforcement across a large population of highly noncompliant and not easily distinguishable taxpayers, such as cash business taxpayers, in order to raise compliance and activate norms. concentrated enforcement offers a potential answer to this question. while (by assumption) heavy enforcement across the entire cash business tax sector is not possible, given the limited resources available, concentrated enforcement could enable rotating enforcement projects in local subsectors of the cash business sector. if norms are at least in part local, subsector based (such as the norms of dry cleaners in manhattan, or even all cash business taxpayers in new york city), then an enforcement project in a given subsector may be enough to generate higher compliance and a higher norm of compliance. this norm could then help sustain higher compliance after the enforcement project moves onto the next cash business taxpayer subsector (such as dry cleaners in the next borough, or all cash business taxpayers in the next city, or the like). a variety of research indicates that individuals tend to cooperate with, and enforce norms of cooperation toward, one’s own local group, even when group assignments are random, 199 and that individuals are often influenced by local group norms. 200 to the extent that local norm 2089 (2007) (this was an experiment regarding the effect of social interactions on taxpaying. the experiment had mixed, and some counterintuitive, results including some evidence of an anti-conformity effect. however, the experiment used different audit rates for different participants in each group, and audit rates did not depend on reporting behavior. the knowledge of different audit rates faced by other group members may have affected the response to others’ behavior. additionally, the fact that audit rates did not respond to behavior may have reduced concerns about the potential for one’s relative underreporting to increase the likelihood of getting caught.); korobow et al., an agent-based model of tax compliance with social networks, 60 nat’l tax j. 589 (2007) (finding, in part, that low levels of enforcement, combined with high weights given to neighbors’ payoffs, result in very high levels of evasion); georg zaklan et al., analysing tax evasion dynamics via the ising model, 4 j. econ. interaction & coordination 1 (2009) (modeling tax evasion decisions in the presence of various levels of network effects). as acknowledged by scholars in the field, this work is in its infancy. see, e.g., korobow et al., tax compliance with social network, supra note 148, at 609 (indicating as much). 199. see, e.g., lorenz goette et al., the impact of group membership on cooperation and norm enforcement: evidence using random assignment to real social groups, 96 am. econ. rev. 212, 216 (2006) (finding that individuals cooperate with group members and enforce a norm of cooperation toward group members, even when group assignments are random and short-term). 200. see, e.g., michael wenzel, the multiplicity of taxpayer identities and their implications for tax ethics, 29 law and pol’y 31, 35 (2007) [hereinafter wenzel, multiplicity of taxpayer identities] (discussing and citing accompanying research); see also susan c. morse, narrative and tax compliance 5 (uc hastings legal studies research paper series no. 14), http://papers.ssrn.com/sol3/papers. 2014] concentrated enforcement 373 groups are particularly powerful in the cash business tax sector, 201 concentrated enforcement may provide a realistic means of norm activation. taxpayer uncertainty aversion and media attention to tax enforcement projects provide the final, potential support for rotating, subsector enforcement projects as a means of increasing tax compliance across the cash business sector. as indicated in part iii, concentrated cfm?abstract_id=2191216 (discussing importance of small group norms to tax compliance); richard l. revesz, environmental regulation, ideology, and the d.c. circuit, 83 va. l. rev. 1717 (1997) (finding through empirical study that d.c. circuit court judges’ own votes on cases were greatly influenced by the identity (and party affiliation) of other judges on the panel, and that this influence was even greater than the voting judge’s own party affiliation). other research suggests that compliance may respond to more universal factors, such as perceptions of good governance. see, e.g., ronald g. cummings et al., tax morale affects tax compliance: evidence from surveys and an artefactual field experiment, 70 j. econ. behav. & org. 447 (2009). this research does not necessarily contradict the particular, or additional, importance of local groupings and local group norms. see wenzel, multiplicity of taxpayer identities, supra, at 36 (discussing multiple, possible levels of identification). 201. some recent evidence suggests this might be the case. see 2 taxpayer advocate service, national taxpayer advocate, 2012 annual report to congress, factors influencing voluntary compliance by small businesses: preliminary survey results 19-20 (2012), http://www. taxpayeradvocate.irs.gov/userfiles/file/full-report/research-studies-factors-influen cing-voluntary-compliance-by-small-businesses-preliminary-survey-results.pdf, [hereinafter factors influencing voluntary compliance] (reporting that small businesses that were low-compliance (as determined (imperfectly) by the dif score) “were more likely to participate in local organizations” and “were more likely to report that other members of local organizations view tax laws and the irs negatively”). while this report did not find differing perceptions of deterrence to be a persuasive explanation for differing levels of compliance (and therefore counseled that increasing deterrence may be counterproductive), it is perhaps more notable for identifying low-compliance groups and observable characteristics of them, such as higher involvement in local organizations and particular geographical concentrations. indeed, the report explained that it could not make strong conclusions about the impact of deterrence on compliance, because some lowcompliance taxpayers may have been motivated by a desire not to implicate their own noncompliance. id. at 38. additionally, low-compliance taxpayers had more experience with irs examination than high-compliance taxpayers, which may have skewed the reported perceptions of deterrence. id. at 26. finally, low-compliance taxpayers may have had stronger incentive to provide justifications (i.e., unfairness of irs) for their low compliance. id. at 28. as a result, while this report does not support application of enforcement projects, it does provide some evidence of the importance of local groupings of taxpayers, and the potential benefits from allocating resources (whether they are in the form of deterrence, outreach, or something else) in accordance with local groupings. 374 florida tax review [vol. 16:6 enforcement may increase the perceived uncertainty of enforcement, thereby eliciting greater compliance to the extent that the regulated parties are uncertainty averse. evidence indeed exists that taxpayers may be averse to uncertainty, particularly when the likelihood of getting detected is otherwise low. jeff casey and john scholz ran an experiment in which subjects had to determine whether or not to take a questionable tax deduction. the subjects received probability estimates that the irs would spot check their returns and disallow the deduction. these probability estimates were subject to various levels of uncertainty as a result of disclaimers regarding the reliability of the probability estimates. in situations in which the estimated probability of detection was low, the subjects exhibited uncertainty aversion (or a lower likelihood of taking the deduction as the level of uncertainty increased). 202 in other words, greater uncertainty about the likelihood of detection increased the amount of taxes paid. this research was consistent with an earlier simulation by nehemia friedland, in which uncertainty regarding the probability of a tax audit increased the deterrent effect of low rates of audit. 203 concentrated enforcement may leverage taxpayer uncertainty aversion to yield higher compliance. additionally, media attention to tax enforcement projects may activate taxpayers’ availability bias. a subsector-wide enforcement project will often produce more newsworthy stories of enforcement than a low, and uniform, application of enforcement resources across the population. the dif score does have some of its own salient benefits. indeed, news outlets and tax advisors frequently highlight potential audit triggers. 204 on the other 202. jeff t. casey & john t. scholz, boundary effects of vague risk information on taxpayer decisions, 50 organizational behav. & hum. decision processes 360, 369–75 (1991). on the other hand, casey and scholz found that, when the stated probability of detection was high, the subjects exhibited uncertainty seeking (or a higher likelihood of taking the deduction as the level of uncertainty increased). id. casey and scholz’s results also appear consistent with the experimental result obtained by michael w. spicer and j. everett thomas, that increasing the audit rate is not as strong of a deterrent when greater uncertainty exists around the audit rate. michael w. spicer & j. everett thomas, audit probabilities and the tax evasion decision: an experimental approach, 2 j. econ. psychol. 241 (1982). james alm, betty jackson, and michael mckee also found that uncertainty regarding the probability of detection generally increases compliance, but also found that a link between tax payments and government benefits leads to less compliance. james alm et al., institutional uncertainty and taxpayer compliance, 82 am. econ. rev. 1018, 1024–25 (1992). 203. nehemia friedland, a note on tax evasion as a function of the quality of information about the magnitude and credibility of threatened fines: some preliminary research, 12 j. applied soc. psychol. 54, 58 (1982). 204. see, e.g., kay bell, what triggers an irs audit?, msn money, apr. 8, 2013, http://money.msn.com/tax-tips/post.aspx?post=9563ea68-b39c-49b5-b2bdbd55d2a99c1f [hereinafter bell, irs audit trigger]; joy taylor, 14 irs audit red 2014] concentrated enforcement 375 hand, while news media tend to highlight the audit triggers, their doing so also tends to either implicitly or explicitly convey the message that “[s]imple, plain-vanilla returns are fairly safe.” 205 as a result, publicity regarding the dif score alone may convince taxpayers that if they avoid audit triggers, then they need not worry much about the possibility of audit. publicity regarding concentrated enforcement may enhance the perceived likelihood of audit without similarly conveying a sense of safety. 206 as alluded to previously, the irs has used some local compliance projects to focus on taxpayers. 207 media attention has flagged and highlighted many such projects, including employers classifying employees as independent contractors, 208 tax shelters, 209 misuse of the ira rules, 210 fraud and identity theft, 211 and offshore tax evasion, 212 to name a few examples. news outlets also recently reported that the irs sent letters to a group of 20,000 small business owners questioning whether they had understated their cash receipts. 213 additionally, as suggested previously, hmrc’s use of tax flags, kiplinger, last accessed sept. 2014, http://www.kiplinger.com/article/ taxes/t054-c000-s001-irs-audit-red-flags-the-dirty-dozen.html; the top ten tax audit triggers, h&r block, mar. 8, 2013, http://blogs.hrblock.com/2013/03/08/ the-top-10-tax-audit-triggers/; robert w. wood, shhh, home office and other irs audit trigger secrets, forbes, jan. 25, 2013, http://www.forbes.com/sites/ robertwood/2013/01/25/shhh-home-office-and-other-irs-audit-trigger-secrets/. 205. bell, irs audit trigger, supra note 204. 206. cf. morse et al., cash businesses, supra note 148, at 64 (suggesting more publicity of cash business taxpayer audits). 207. the examination (audit) process, supra note 42. limited information exists about how and when the irs uses such projects. for an older explanation, see irs’ return selection process, supra note 42. 208. angus loten & emily maltby, payroll audits put small employers on edge, wall st. j., mar. 13, 2013, at b6. 209. andrew zajac & jesse drucker, ray lane rode tech boom taxshelter wave broken by irs, bloomberg news, jun. 8, 2013, http://www. businessweek.com/news/2013-06-07/ray-lane-rode-tech-boom-tax-shelter-wave-bro ken-by-irs-enforcement project#p2. 210. ashlea ebeling, the new threat to your ira: an irs crackdown, forbes, sept. 9, 2010, http://www.forbes.com/forbes/2010/0927/investingwithdrawal-penalty-irs-new-threat-to-ira.html. 211. phyllis furman, money matters: the irs is on strict crackdown of taxpayers who attempt fraud, identity theft, daily news, apr. 9, 2011, http://www.nydailynews.com/news/money/money-matters-irs-strict-enforcementpro ject-taxpayers-attempt-fraud-identity-theft-article-1.111868. 212. ubs tax crackdown widens, cnbc, aug. 17, 2009, http://video.cnbc.com/gallery/?video=1217031897. 213. bernie becker, small business panel presses irs over outreach, hill, aug. 9, 2013, http://thehill.com/blogs/on-the-money/domestic-taxes/316301small-business-panel-presses-irs-over-outreach; critics question irs initiative targeting small businesses, foxnews.com, aug. 10, 2013, http://www.foxnews. http://www.nydailynews.com/news/money/money-matters-irs-strict-en 376 florida tax review [vol. 16:6 campaigns has garnered substantial media coverage of its enforcement efforts. 214 it is difficult to determine the extent to which the media has covered the irs’s projects in the absence of information about how many projects the irs has engaged in and publicized versus how many projects the irs has engaged in and not publicized. 215 nonetheless, evidence of the media attention to perceived enforcement projects suggests concentrated enforcement is likely to increase the saliency of irs enforcement. 216 one potential, perverse side effect of media attention to irs enforcement projects could be that taxpayers notice the enforcement projects, but believe that, as long as they are not subject to an enforcement project at any given time, they are less likely to be subject to enforcement. however, when cash business taxpayers underreport their tax liability, they typically are underreporting tax liability clearly owed in a manner that constitutes intentional tax fraud. there is no statute of limitations on such fraud. 217 if a taxpayer engages in fraud and the irs can prove the fraud, then a future enforcement project could cover the tax fraud as well. as a result, the general possibility of being subject to an enforcement project would be relevant for cash business taxpayers and not just being subject to an enforcement project at a particular time. by making the possibility of irs enforcement more salient, cash business taxpayer compliance may increase. as a final matter, it is worth noting that, to the extent that nodes of particularly high noncompliance can be identified within the cash business tax sector, application of concentrated enforcement should focus on these nodes. even though a widespread norm of tax noncompliance appears to exist across the cash business sector, 218 some taxpayers in this sector profess com/politics/2013/08/10/critics-question-irs-initiative-targeting-small-businesses/; john d. mckinnon & siobhan hughes, small business in irs sights, wall st. j., aug. 9, 2013, at a1. 214. see supra text accompanying note 87. 215. a useful study of the extent of media coverage of irs enforcement could examine the percentage of irs press releases that receive media coverage. 216. indeed, for this reason, the irs intentionally attempts to obtain media coverage of its enforcement efforts. jeremiah coder, conversations: eileen mayer, 116 tax notes 738, 740 (2007) (describing concerted efforts to get media coverage of enforcement efforts). cf. blank, in defense of individual tax privacy, supra note 36, at 290 (“cognitive psychology research suggests that individuals are much less likely to be influenced by tax-enforcement statistics than by specific tax-enforcement examples involving real people.”); dubin, criminal investigation, supra note 51, at 4, 21 (hypothesizing that the media plays “an important role in disseminating information to the public”). 217. i.r.c. § 6501(c)(1)-(2). 218. morse, tax compliance and norm formation, supra note 124, at 679 (citing tax evasion as the “norm” in the cash business sector). 2014] concentrated enforcement 377 (somewhat sheepishly) to report their tax liability honestly, 219 and government statistics indicate that a small portion of cash business taxpayers is responsible for the majority of the underreporting. 220 indeed, the gao has recently reported that 10 percent of sole proprietors 221 are responsible for more than 61 percent of all sole proprietor underreporting. 222 squaring the above statistic with taxpayer indications that they hew to industry reporting averages 223 suggests that perhaps there are industries of cash business taxpayers that are particularly noncompliant. recent research has suggested that there may be nodes of noncompliance based on geography and industry group. 224 for the reasons suggested previously, being able to focus enforcement projects on noncompliant nodes may maximize the voluntary compliance and direct revenue benefits of concentrated enforcement, while also helping its perceived fairness. to be sure, not all of the features of the cash tax business sector discussed above suggest that enforcement projects be applied in the same way. for instance, in order to make the dif score’s comparative analysis stronger, enforcement projects should occur by dif group. if the dif score looks at dry cleaners in manhattan together, then the enforcement project should focus on manhattan dry cleaners. doing so may (1) concentrate enforcement resources enough to make them effective (the base case economic argument for concentrated enforcement) and (2) increase compliance among manhattan dry cleaners (the relevant dif group), which may create a feedback loop between noncompliance and enforcement. on the other hand, the relevant norm groups may not correspond exactly with the relevant dif group. in forming norms, taxpayers may pay attention to their neighbors, who may or may not be in their dif groups. for instance, a dry 219. joseph bankman, eight truths about collecting taxes from the cash economy, 117 tax notes 506, 508 (2007) [hereinafter bankman, eight truths]; morse et al., cash businesses, supra note 148, at 52–53. 220. strategy for reducing the gap, supra note 152, at 15 (“[t]he 11.2 million sole proprietors at and below the 90th percentile understated their taxes by a cumulative $14.3 billion. the remaining 10 percent (1.25 million) above the 90th percentile understated a cumulative $22.6 billion in taxes, accounting for 61 percent of the total.”). 221. the gao defines sole proprietors as individuals who “own unincorporated businesses by themselves.” id. at 4. while this is a slightly narrower group than cash businesses (which are generally small businesses with large amounts of cash receipts), there is substantial overlap between the two groups. 222. id. at 15. 223. see, e.g., morse et al, cash businesses, supra note 148, at 53, 59, 61. 224. factors influencing voluntary compliance, supra note 201, at 10–11 (identifying geographic clusters of low-compliance communities, albeit by using the dif score as a means of determining low compliance), 23 (identifying lowcompliance industries through same methodology). 378 florida tax review [vol. 16:6 cleaner in greenwich village may adopt a norm of compliance based on the behavior of all other cash businesses in greenwich village, rather than the behavior of manhattan dry cleaners. various arguments could be made about which type of enforcement project would be most salient. the manhattan dry cleaner enforcement project is likely to be more salient for some groups of taxpayers (i.e., brooklyn dry cleaners) and the greenwich village enforcement project for others (i.e., east village businesses). however, the above discussion does not defeat the argument for concentrated enforcement but rather clarifies when it is strongest. concentrated enforcement would work best when all of the theories that support concentrated enforcement apply and when they all suggest the same enforcement project groups. for instance, if all of the supports for concentrated enforcement apply and manhattan dry cleaners are not only the relevant group for the dif score, but also for norms, and if an enforcement project on this group is likely to be quite salient, and manhattan dry cleaners are a particularly noncompliant node, then an enforcement project on manhattan dry cleaners is likely to be very powerful. however, even absent perfect overlap, the group that is relevant for one purpose is likely to have at least some relevance for others. for instance, even if manhattan dry cleaners look to taxpayers outside their dif group for the purposes of group norms, the taxpayers in their dif group (i.e., potentially other manhattan dry cleaners) are likely to be influential from a norms perspective as well. as a result, if manhattan dry cleaners are the relevant group for dif score purposes, then an enforcement project on that group is likely to tap into some form of group norms (as well as salience and uncertainty aversion), even if a manhattan dry cleaner enforcement project is not the optimal enforcement project to affect group norms. in any event, while concentrated enforcement would be stronger to the extent that all of the factors work together, an enforcement project that meets the base case for concentrated enforcement and activates some of the enhanced factors for microdeterence may produce deterrence gains. moreover, it is worth emphasizing that this article does not definitively establish that concentrated enforcement will raise compliance in the cash business tax sector. rather, it fleshes out why concentrated enforcement may increase compliance. indeed, application of concentrated enforcement would be quite problematic if concentrated enforcement drastically lowered compliance in subsectors not subject to enforcement projects and such decreases were not offset by compliance gains from subsectors subject to enforcement projects. however, the concern that concentrated enforcement could lower overall compliance does not show that the existing allocation of scarce enforcement resources across cash business taxpayers (or any other sector of taxpayers) gets the allocation right. rather, the concern affirms the need to think deeply about the issues posed in this article and whether and when concentrated enforcement (or some alternative 2014] concentrated enforcement 379 scheme for allocating scarce enforcement resources) may increase compliance. additionally, while any application of concentrated enforcement should be subject to rigorous empirical evaluation to determine its effects (as exemplified by the hot spots policing empirical research, which built upon the theoretical case for hot spots policing), informed intuition can help determine when it makes sense to try concentrated enforcement. imagining the two ends of an enforcement spectrum can help guide this process. on one end of the spectrum, a uniform allocation of enforcement resources leaves every taxpayer with just enough incentive to comply. as a result, concentrated enforcement may lead to a plunge in compliance in all subsectors not subject to enforcement projects (and a corresponding plunge in expected monetary costs of noncompliance and norms of compliance), which may not be outweighed by increases in compliance in subsectors subject to enforcement projects. at the other end of the spectrum, the enforcement resources are yielding little to no deterrence when applied in a uniform fashion, suggesting large, potential benefits from concentration. concentrated enforcement may lead to large gains in the enforcement project subsectors and few losses in the other subsectors. the more an enforcement environment resembles the latter, rather than the former end of the spectrum, the more sensible experimental application of concentrated enforcement would be. additionally, the greater the uncertainty aversion, availability bias, and concentration in nodes of noncompliance, the better advised experimental application of concentrated enforcement would be. for the reasons outlined above, a number of aspects of the cash business tax sector suggest that the cash business tax sector may be closer to the latter, rather than the former, end of the spectrum. the compliance that does exist in the cash business tax sector can be explained at least in large part by the visibility of credit card receipts. as a result, reporting of credit card receipts may persist even if a particular subsector is not subject to an enforcement project. indeed, dropping from a one percent chance of audit to a slightly lower chance of audit, combined with probability neglect, may provide a reasonably high incentive to continue to report credit card receipts and some minimal amount of cash income, even for subsectors not subject to enforcement projects. in other words, there may be little compliance to lose in subsectors not subject to enforcement projects. on the other hand, the very low reporting of cash receipts and the very limited enforcement resources suggests that there may be much to gain from concentrated enforcement. a variety of mechanisms, including the role of the dif score in creating feedback loops between noncompliance and enforcement and the potential role of local norms in making compliance sticky suggest additional reasons why the gains in subsectors subject to enforcement projects may more than outweigh the losses elsewhere. evidence of taxpayer uncertainty aversion, media attention to tax crackdowns, and seeming nodes of noncompliance 380 florida tax review [vol. 16:6 enhance the case for concentrated enforcement in the cash business tax sector. put simply, this article suggests that the theoretical case for concentrated enforcement in the cash business tax sector is strong enough to merit empirical testing. d. objections and responses aside from this inherent empirical question, a number of potential objections to the application of concentrated enforcement to cash business tax sector also may exist. as an initial matter, in discussing the potential gains from concentrated enforcement, this article has focused on gains from concentrating audit resources on subsectors of cash business taxpayers. as a result, the first potential objection to concentrated enforcement is that audits of cash business taxpayers are problematic for a number of reasons: they do not detect all evasion, they are expensive and low yield, and even heavy concentrations of resources may not produce high rates of audits for the cash business taxpayers in an enforcement project. indeed, the frequent lack of a paper trail associated with cash business tax evasion, combined with these taxpayers’ own evasion sophistication does make cash business tax evasion very difficult for auditors to find. 225 as described by joseph bankman, evasion techniques include “special cash registers, ringing up sales as estimates, the use of two sets of books, [and] paying suppliers in cash to avoid paper trails.” 226 additionally, cash business taxpayers frequently hoard cash business proceeds or reinvest them in the business so as not to create a discrepancy between income and spending. 227 as a result, even after a comprehensive audit, the irs may fail to detect some (or much) cash business tax evasion. in terms of expense and yield from audits, the gao has observed that audits of sole proprietors filing schedule cs with their tax returns (which include cash business audits) are quite time consuming relative to other types of audits. 228 since audits of sole proprietors are often field audits, rather than correspondence audits, they also must be conducted by more experienced 225. clotfelter, individual returns analysis, supra note 187, at 366, 367; joel slemrod, an empirical test for tax evasion, 67 rev. econ. & stat. 232, 233 (1985). for a general discussion of the difficulty of determining the amount of noncompliance actually detected by auditors, see raskolnikov, crime and punishment in taxation, supra note 17, at 584 (discussing the problem and concluding that the rate of detection on audit is probably below (and perhaps well below) 50 percent). 226. bankman, eight truths, supra note 219, at 508; see also kagan, income tax violations, supra note 149, at 79–80 (making some similar observations in description of informal suppliers). 227. morse et al., cash businesses, supra note 148, at 51–54. 228. strategy for reducing the gap, supra note 152, at 22. 2014] concentrated enforcement 381 irs officials, adding to the expense of the audits. 229 compounding these difficulties, cash business tax audits produce relatively low tax revenue yields from audits. 230 perhaps as a result of some of the above factors, heavy concentrations of auditing resources may nonetheless leave even the cash business taxpayers subject to enforcement projects with an unreasonably low likelihood of being audited. take, for instance, the cash business dry cleaner considering evading tax liability by $5,000. prior to concentrated enforcement, the dry cleaner would face an approximately one percent chance of being audited, 231 and evasion of tax liability would be subject to a penalty of 75 percent of the amount of tax evaded. 232 as a result, relative to paying the tax liability, the dry cleaner would have an expected benefit from evading of $4,950 ($5,000 taxes saved x 99 percent likelihood of not getting caught) and an expected cost of $37.50 (fine of $3,750 x one percent chance of getting caught). the result is that, under an expected benefits and costs analysis, the dry cleaner should evade. now imagine that, after application of concentrated enforcement, the dry cleaner is subject to an enforcement project. the enforcement project increases the dry cleaner’s possibility of being audited to ten times what it was previously, such that the dry cleaner now has a ten percent chance of being audited. the dry cleaner nonetheless still faces an unreasonably low chance of being audited. the expected cost of evading would increase substantially, to $375 ($3,750 x ten percent chance of being audited). however, the expected benefit from evading, now $4,500, ($5,000 taxes saved x 90 percent likelihood of not getting caught) is still many times higher. as a result, an expected benefits and costs analysis suggests that the dry cleaner should still evade. this result might suggest to some that the application of concentrated enforcement is fruitless. 233 229. id. 230. id.; see also jeffrey a. dubin et al., the changing face of tax enforcement, 1978-88, 43 tax law. 893, 900–01 (1990). 231. see supra text accompanying note 29. 232. i.r.c. § 6663(a). as discussed previously, criminal sanctions are possible but penalties in general, much less criminal penalties, are imposed surprisingly rarely. see supra text accompanying note 160. 233. one response to this problem would be to engage in even more concentration of resources to increase the likelihood of the enforcement project group(s) being audited. while the overall level of enforcement resources, relative to all cash business taxpayers, is quite low if all resources available were concentrated on very few subsets of taxpayers at any given time, the likelihood of being audited could be quite (and prohibitively) high. indeed, for reasons suggested in this article, such an approach should be strongly considered. for the sake of argument, though, we can contemplate the situation set forth in the text where audit likelihood remains too low even after concentration. 382 florida tax review [vol. 16:6 a number of responses to this line of argument are in order. as an initial matter, while it is true that audits in the cash business tax sector present a number of problems to the extent that concentrated enforcement can nonetheless improve the use of these audits, it is a worthwhile innovation. as the gao has indicated, the massive underreporting by cash business taxpayers suggests that, notwithstanding the relatively low direct yields from cash business taxpayer audits, these audits may play a crucial role in increasing tax revenues by increasing voluntary compliance. 234 at a broader level, failing to audit cash business taxpayers would sanction the widespread evasion in the cash business tax sector. it would also compound the inefficient flow of even more economic activity to the cash business tax sector, in order to take advantage of the seemingly sanctioned, lower tax liability. 235 because congress has not endorsed this outcome, and significant fairness and efficiency reasons counsel against it, auditing cash business taxpayers will remain part of the irs’s enforcement arsenal. 236 with audits of cash business taxpayers here to stay, the admitted, fundamental problems with auditing these taxpayers are beside the point. if concentrated enforcement can better allocate auditing resources, then it can help improve tax compliance. along the same lines, the important question in evaluating concentrated enforcement is not whether concentrated enforcement causes every taxpayer to comply, but rather whether concentrated enforcement can improve compliance, relative to alternative allocations of enforcement resources. take the dry cleaner example, discussed above. as explained, an expected benefits and costs calculus may suggest that even after application of concentrated enforcement, the dry cleaner may evade the $5,000 of tax liability. however, there is more to the story. tax scholars have suggested a number of reasons why taxpayers do not engage in a simple comparison of expected benefits and costs in making their compliance decisions. perhaps most notably, risk aversion causes taxpayers to overweigh the expected 234. tax gap, supra note 107 (cautioning against drastic decreases of auditing in a particular sector because of unknown effects on voluntary compliance); strategy for reducing the gap, supra note 152, at 22–23. 235. see bankman, eight truths, supra note 219, at 507 (describing how cash economy swells to reflect low effective tax rate). 236. this is not to say that auditing resources should not be lower in the cash business tax sector than in other sectors to take into account the particular costliness of cash business taxpayer audits and relatively low yields from such audits. see, e.g., slemrod, cheating ourselves, supra note 24, at 44 (suggesting that evasion should be higher in the cash business tax sector to account of these features of the sector). indeed, nothing in this article suggests that the allocation of enforcement resources between different sectors of taxpayers should be changed. rather, the article focuses on the allocation of enforcement resources within the cash business taxpayer sector. 2014] concentrated enforcement 383 costs. 237 taxpayers may systematically overweigh the likelihood of audit. 238 taxpayers may also wish to avoid the cost of audit itself and fear criminal penalties, even though the possibility of their application is remote. 239 additionally, as suggested previously, non-economic reasons, such as norms and the like, may affect the calculation, causing taxpayers to comply even when a standard economic formulation may suggest otherwise. finally, as indicated in this article, the expected benefits and costs calculation does not take into account the fact that, as compliance increases, other mechanisms are likely to kick in to make noncompliance more costly: norms of compliance are likely to become stronger, the likelihood of getting caught for not complying within the particular subsector may increase, and the perception of audit rate may seem even higher than it actually is because of the salience of the enforcement project. putting these factors together, the expected monetary cost of evading probably significantly understates the perceived cost to the dry cleaner of evading. as a result, if concentrated enforcement can move the compliance calculus in the right direction, then it may increase compliance. additionally, while this article has often discussed concentrating auditing resources, it has done so as an illustration of how concentrated enforcement can concentrate enforcement resources, not as an endorsement of audits in particular. put another way, concentrated enforcement speaks generally to the allocation of enforcement resources, not necessarily the particular method of enforcement. 240 tax scholars have suggested a number of innovative means of detecting noncompliance in the cash business tax sector other than relying exclusively on intensive audits. for instance, joseph bankman has suggested potentially cross-checking tax returns and real property or transfer tax records and rooting out influential tax preparers who encourage extensive tax evasion. 241 alternatively, concentrated enforcement could be used to focus attention on tax return preparers aiding cash business tax evasion. this article stands for the proposition that, whatever form of enforcement the irs uses, allocation of enforcement resources is crucial, and under certain circumstances, concentrated enforcement may improve this allocation. put another way, the allocation of enforcement resources at the heart of this article can extend beyond auditing cash business taxpayers and, 237. michael g. allingham & agnar sandmo, income tax evasion: a theoretical analysis, 1 j. pub. econ. 323, 327–30 (1972). 238. michele bernasconi, tax evasion and orders of risk aversion, 67 j. pub. econ. 123, 131 (1998). 239. i thank leandra lederman for this point. 240. as a result, while alternative tax regimes such as a vat are outside the scope of this article, the allocation of scarce enforcement resources at the heart of this article could be applied to alternative regimes, including a vat. 241. joseph bankman, tax enforcement: tax shelters, the cash economy, and compliance costs, 31 ohio n.u. l. rev. 1, 8–9 (2005). 384 florida tax review [vol. 16:6 indeed, beyond the cash sector entirely to many other tax compliance problems. 242 similarly, a number of objections might apply to the application of concentrated enforcement to cash business taxpayers in particular. for instance, cash business taxpayers might not be particularly worried about their compliance reputations and therefore might be less likely to respond to new norms of compliance than more institutional actors. 243 enforcement projects focused on tax return preparers, to name just one example, might be better able to tap into concern about relative reputation in order to increase compliance. enforcement action directed against tax return preparers may also allow the irs more leverage to publicize instances of noncompliance, thereby offering the potential for greater signaling and reputational effects flowing from increasing compliance spirals. however, these concerns about application to cash business taxpayers in particular, while helpful in flagging considerations that should be taken into account in choosing the best settings for concentrated enforcement, do not undermine the concept of concentrated enforcement altogether. moreover, while groups other than cash business taxpayers may be even better suited for concentrated enforcement, cash business taxpayers do have to be subject to some amount of enforcement. to the extent that concentrated enforcement improves cash business tax enforcement, it should be applied. this article should be understood as making the case for experimental application of concentrated enforcement in the particularly difficult cash business tax sector, not as making the case that this setting is the optimal one for concentrated enforcement. indeed, a continuing, broader contemplation of when concentrated enforcement works and why would be a positive development. another potential, even predictable, problem, with concentrated enforcement is compliance decay. imagine that the irs engages in a wildly successful enforcement project on dry cleaners in manhattan. as a result, all dry cleaners in manhattan comply fully with their tax obligations. norms of tax compliance now pervade the subsector. prices for dry cleaning in new york city rise to reflect tax compliance. the irs can more easily identify noncompliers. however, after the enforcement project subsides, the 242. an analysis of how concentrated enforcement might extend to other tax compliance contexts (and how, if at all, it might need to be reformed as applied in other contexts) is beyond the scope of this article. if concentrated enforcement were applied in a situation in which noncompliance was more likely to reflect sincere mistakes or confusion, then greater concern might exist about compliance backlash, discussed in more detail infra text accompanying notes 255–256. in such cases, the concentrated enforcement approach may benefit from being framed more as a compliance, rather than a deterrence, initiative. 243. cf. morse, tax compliance and norm formation, supra note 124, at 694–95 (contrasting reputation sensitive and reputation insensitive tax evaders). 2014] concentrated enforcement 385 incentives to evade tax liability will return predictably. 244 although honest taxpayers can now compete in the market and still make a profit, this does not reduce the incentive to evade. as time passes, improved comparative analysis gained from the enforcement project may erode because changed economic conditions and changes in the market will weaken the comparative analysis. as more manhattan dry cleaners make the decision to evade in response to these conditions, compliance will decrease further, it will be harder to compete as an honest taxpayer, and compliance will spiral downward. in some ways, then, the likelihood of eventual decay may seem to undermine the enforcement project. however, as dismal as the eventual, even likely, decay may seem, it does not necessarily undermine the case for concentrated enforcement. recall that the base case for concentrated enforcement is that, when enforcement is limited and costly and violations are high, total compliance may increase when enforcement resources are concentrated on a smaller portion of the overall cash business taxpayer sector. this can be true even if the concentration leaves the remainder of cash business taxpayers with very low incentives to comply. in this regard, focusing on compliance decay is somewhat beside the point. the most important question is whether concentrated enforcement increases overall compliance. it may be able to do so by increasing compliance in the subsectors actually subject to enforcement projects at any given time, even if the other subsectors exhibit drastically low rates of compliance. for instance, to take the extreme case, even if manhattan dry cleaners do not comply at all after the manhattan dry cleaner enforcement project ends, concentrated enforcement would still make sense if the compliance in the subsectors subject to enforcement projects made up for the dry cleaners’ (and other non-enforcement project subsectors’) lack of compliance. additionally, as suggested previously, there are reasons to think that compliance might be sustainable, to some extent, after an enforcement project subsides. improved (if not perfect) comparative analysis, norms, uncertainty aversion, and media attention to enforcement projects all serve as independent, and yet, reinforcing reasons why some amount of compliance in the dry cleaning subsector might remain after the enforcement project. for instance, if norms of compliance are high enough to keep compliance at a higher level in the dry cleaning subsector after the enforcement project, then the higher compliance may interact with the other mechanisms to help maintain compliance, which may keep norms higher. in 244. this result could be exaggerated by a “bomb crater” effect, whereby being subject to an enforcement project (or being audited) makes taxpayers believe that the likelihood of being subject to a subsequent enforcement project (or being audited) is very low, making room for evasion. boris maciejovsky et al., misperceptions of chance and loss repair: on the dynamics of tax compliance, 28 j. econ. psych. 678 (2007). 386 florida tax review [vol. 16:6 short, while compliance decay may occur, compliance decay alone would not undermine concentrated enforcement, and concentrated enforcement may actually help stem the decay. another potential problem is taxpayer entrenchment to tax evasion positions. an underlying assumption of much of the discussion about concentrated enforcement has been that taxpayers would respond to an announced enforcement project by reporting more tax liability as a result of the greater probability of detection. however, in response to an enforcement project, cash business taxpayers may report lower tax liability to create greater bargaining leverage with the irs. additionally, the multi-year nature of audits may give taxpayers some incentive not to raise tax liability reporting in response to an enforcement project because doing so may signal to the irs that the taxpayer was previously evading, thereby flagging the taxpayer’s prior years as ripe for irs review. while this entrenchment is certainly possible, some evidence suggests that, at least across cash business taxpayers, the more likely response to an enforcement project is higher reporting of tax liability. the high correlation between information reporting and tax compliance, 245 and the strong relationship between higher audit rates and higher voluntary reporting of tax liability, 246 suggests that taxpayers heavily weigh the likelihood of getting caught in their calculus of how much tax liability to report. with respect to a higher chance of being audited, researchers ran an experiment in minnesota in which taxpayers received a letter indicating that the tax returns they were going to file would be “closely examined.” in response to this letter, high-income taxpayers actually lowered their reported tax liability, but medium and low income taxpayers raised their tax liability. 247 while the researchers could not conclude with certainty what explained this behavior, they hypothesized that the high-income taxpayers (now freed of the belief that they should report a high enough tax liability to evade audit altogether) may have lowered their reported tax liability to increase their bargaining leverage with the irs. 248 this is a tactic that makes some sense when the tax law is uncertain, as is often the case for highincome taxpayers engaged in complex tax planning, because uncertainty breeds a fair amount of room for potential bargaining between taxpayers and the irs, and aggressive, low reporting has fewer downsides for taxpayers 245. see sources cited supra note 181. 246. plumley, the determinants of individual income, supra note 51, at 35 (finding that “audits have a strong, positive impact on reporting compliance”); see also alm & mckee, audit certainty, supra note 95 (finding that informing individuals that they would be audited increased their compliance). 247. joel slemrod et al., taxpayer response to an increased probability of audit: evidence from a controlled experiment in minnesota, 79 j. pub. econ. 455, 457 (2001). 248. id. at 482. 2014] concentrated enforcement 387 when the tax law is uncertain. 249 however, cash business taxpayers engaging in tax evasion are not dealing in uncertain tax law. instead, they are flouting clear obligations, such as an obligation to include in income all payments they receive. 250 as a result, they are unlikely to gain much bargaining leverage by lowering their reported tax liability. additionally, unlike in the minnesota experiment, cash business taxpayers subject to an enforcement project would not be totally sure they would be audited. as a result, in response to an enforcement project, taxpayers may feel additional pressure to report high enough tax liability to avoid the very high chance of audit attention resulting from the enforcement project. finally, concentrated enforcement could present some compliance or political backlash. some scholars have worried that strong enforcement strategies can produce compliance backlash by crowding out taxpayers’ nondeterrence motivations for compliance. 251 the uproar (by some) over the irs’s alleged targeting of tea party groups has also underscored the serious political liabilities that can accompany perceived targeting of taxpayers. 252 in the cash business context, it might be easy to take sincere (or less sincere, politically motivated) offense at the irs engaging in focused enforcement projects on hard-working small businesses. 253 indeed, in an apparent 249. osofsky, the case against strategic tax law uncertainty, supra note 33, at 532–34 (exploring how “[r]eporting less tax liability becomes more attractive as a negotiation tactic in case an audit actually occurs as uncertainty increases”). 250. i.r.c. § 61. 251. an oft-cited study of crowding out is uri gneezy & aldo rustichini, a fine is a price, 29 j. leg. stud. 1, 3 (2000) (detailing crowding out in daycare pickups). more generally, tax compliance scholars have worried that increasing deterrence mechanisms might crowd out nondeterrence motivations for tax compliance. see, e.g., raskolnikov, revealing choices, supra note 19, at 704–05 (discussing crowding out as a “real concern” in tax enforcement). 252. any number of recent press stories underscore this point. for early coverage of and reaction to the events, see, for example, john d. mckinnon & corey boles, irs apologizes for scrutiny of conservative group, wall st. j., may 11, 2013, at a1, republicans slam irs targeting of tea party as ‘chilling,’ a form of intimidation, foxnews.com, may 12, 2013, http://www.foxnews.com/politics/ 2013/05/12/rogers-irs-targeting-tea-party-and-other-political-groups-intimidation, and jonathan weisman, i.r.s. apologizes to tea party groups over audits of applications for tax exemption, n.y. times, may 11, 2013, at a11. 253. small businesses often serve as an effective rallying cry. see, e.g., mirit eyal-cohen, why is small business the chief business of congress?, 43 rutgers l.j. 1 (2012) [hereinafter eyal-cohen, chief business of congress] (discussing small business favoritism). 388 florida tax review [vol. 16:6 response to the tea party scandal, an irs official recently felt compelled to declare that the irs uses a “highly automated” system. 254 beginning first with compliance backlash, in some ways this concern would be a bit misguided in response to concentrated enforcement. as stressed previously, concentrated enforcement does not involve increasing total enforcement against cash business taxpayers. nor does it involve increasing penalties. instead, concentrated enforcement is actually premised on the assumption that neither can be increased substantially. nonetheless, part of the appeal of concentrated enforcement is that it may make enforcement seem more salient, which for all intents and purposes may be perceived as an increase in enforcement. assuming that concentrated enforcement would be perceived as an increase in enforcement by cash business taxpayers, it is difficult to know how much to make of the concern that enforcement could crowd out nondeterrence motivations to comply. some scholars have expressed significant concern about enforcement crowding out non-deterrence motivations. 255 on the other hand, leandra lederman has made a persuasive case that enforcement can be consistent with, and necessary for, maintaining norms of compliance. 256 the high evasion in the cash business tax sector provides some indication that cash business taxpayers currently are not highly motivated by norms of compliance and that compliance backlash may not be great, or at least not as great as in other sectors. 257 perhaps the most troubling concern is not the potential for compliance backlash, but rather political backlash, arising out of distaste for a non-uniform enforcement approach. in some ways, the application of concentrated enforcement in the cash business tax sector does not seem particularly likely to raise concerns over focused enforcement. cash businesses are profit-making enterprises. they are not engaged in the type of political activity that some believed made perceived targeting particularly offensive in the tea party context. additionally, concentrated enforcement 254. hoffman, irs doesn’t target, supra note 42; cf. adams & webley, vat compliance in the uk, supra note 195, at 205–07 (registering complaints in the united kingdom that vat may unfairly burden small businesses). 255. see, e.g., dan m. kahan, signaling or reciprocating? a response to eric posner’s law and social norms, 36 u. rich. l. rev. 367, 380–81 (2002); dan m. kahan, trust, collective action, and law, 81 b.u. l. rev. 333, 340 (2001); raskolnikov, revealing choices, supra note 19, at 704–05; richard d. schwartz & sonya orleans, on legal sanctions, 34 u. chi. l. rev. 274, 299–300 (1967). 256. lederman, the interplay, supra note 24, at 1484–99; see also bruno s. frey, tertium datur: pricing, regulating and intrinsic motivation, 45 kyklos 161, 176 (1992) (suggesting that crowding out is less of a concern if enforcement efforts are concentrated on dishonest taxpayers). 257. see supra note 242 for a discussion of potentially greater concerns about compliance backlash in other sectors and potential responses. 2014] concentrated enforcement 389 would operate through rotating enforcement projects throughout the cash business tax sector, meaning that cash business taxpayers (or at least cash business taxpayers who are in relatively high risk subsectors, should such nodes of noncompliance be identifiable) may receive relatively equal enforcement attention over the long run. 258 moreover, the dif score, which has not been subject to particular political criticism or concern regarding targeting, itself uses a targeted approach, focusing on individual taxpayers believed to be most noncompliant. as a result, while concentrated enforcement would broaden the focus of enforcement from individuals to groups, it would be applying a new type of non-uniform enforcement, rather than introducing it altogether. nonetheless, whether for self-serving reasons, or as a result of genuine outrage, some may react swiftly and strongly to even the perception of irs targeting. 259 for instance, the recent initiative by the irs alluded to previously, which involved sending letters to 20,000 small business owners questioning whether they had underreported their business income, received prompt media coverage. 260 the media coverage highlighted various objections by small businesses and their accountants, who indicated that they found the initiative “alarming,” that they “really work hard . . . to . . . not only follow the law, but follow the letter of the law,” and that the initiative “created some heartache for the small business community.” 261 on the one hand, rhetoric alone should not be persuasive, to the extent that it is opportunistic. powerful rhetoric about the need to protect small businesses has historically been used to gain political traction to defeat tax reforms. 262 for instance, rhetoric regarding the need to protect small businesses and family farms proved particularly effective in opposing the estate tax at the beginning of george w. bush’s presidency, even though the rhetoric was notoriously overblown. 263 one lesson from the estate tax 258. cf. lando & shavell, the advantage, supra note 91, at 216 (suggesting that “concern about inequity can presumably be met by focusing enforcement effort first on one group and then on another, so as to achieve equal treatments of individuals over time”). 259. for an interesting discussion as to what might animate distaste for strong enforcement against cash business taxpayers in particular, see bankman, eight truths, supra note 219, at 510 (“what may play a role in our moral intuitions is . . . that some portion of the benefit of underreporting in the cash sector is realized by consumers.”). 260. see, e.g., john d. mckinnon & siobhan hughes, small business in irs sights, wall st. j., aug. 9, 2013, at a1. 261. id. 262. see eyal-cohen, chief business of congress, supra note 253. 263. michael j. graetz & ian shapiro, death by a thousand cuts: the fight over taxing inherited wealth 50–51, 62–66 (2005); karen c. burke 390 florida tax review [vol. 16:6 experience (and the many other experiences in which protecting small businesses has been used as a rallying cry) is that simply cowing to the rhetoric may undermine reasonable tax policy discourse. tax policy or, in the case of concentrated enforcement, tax enforcement, that makes sense should not be foresworn simply because of calls of unfairness toward small businesses, especially when such calls may not be justified. 264 additionally, in the compliance context, if the calls of unfairness are largely bluster, outweighed by increased compliance and perhaps general confidence in the irs, the calls should not merit much of a response. 265 in terms of defending the program, to the extent that nodes of noncompliance can be identified, the irs can explain that enforcement projects are determined efforts against particularly noncompliant groups of taxpayers. the irs could explain that it had gone through extensive analysis in deciding which subsectors were most noncompliant and therefore would be subject to enforcement projects at any given time. 266 doing so may weaken adverse reaction by the public, but not provide so much information so as to inoculate any cash businesses subsector from concentrated enforcement. on the other hand, some might have deeper concerns about concentrated enforcement as it relates to administration of the law. in particular, one might reasonably worry about the impact of concentrated enforcement on compliant taxpayers who are nonetheless part of an enforcement project. this concern is far from straightforward. such taxpayers may feel a fair amount of distress regarding the prospect of being subject to an enforcement project, even if they are fully compliant. however, to the extent that concentrated enforcement ensures significantly greater compliance, that significantly greater compliance may outweigh the prospect of such taxpayer distress. greater compliance can ensure greater fairness in relative tax burdens and provide compliant taxpayers a greater opportunity to & grayson m.p. mccouch, turning slogans into tax policy, 27 va. tax rev. 747, 754–55 (2008). 264. cf. roy bahl, reaching the hardest to tax: consequences and possibilities, in taxing the hard-to-tax, supra note 40, at 337, 354 (stating in concluding remarks on volume regarding the “hard-to-tax” that “everything depends on the willingness of the government to enforce the tax system”). 265. cf. adams & webley, vat compliance in the uk, supra note 195, at 205–07 (reporting from interviews with small business proprietors in the united kingdom that most believed strong agency powers were necessary for compliance). 266. cf. factors influencing voluntary compliance, supra note 201 (using dif analysis to identify low-compliance communities). this report was able to identify low-compliance communities by geography and to identify industry groups with high noncompliance. see id. at 23 (identifying industries that tended to be noncompliant), 31 (mapping low-compliance communities based on geography). 2014] concentrated enforcement 391 compete in markets they might otherwise be priced out of. 267 government officials can emphasize that concentrated enforcement is an important means of ensuring that taxpayers pay their tax obligations and that it is designed to root out tax evasion, not honest taxpayers. 268 the irs could also indicate that, even for taxpayers in subsectors subject to enforcement projects, if they are compliant, then they will not be subject to enforcement penalties. indeed, to the extent that the irs continues to focus on taxpayers in a given enforcement project based on “worst-first” methodologies, compliant taxpayers may not even be subject to scrutiny. even more broadly, concentrated enforcement may raise questions about when it is justifiable for a tax enforcement agency to engage in innovative compliance campaigns, rather than simply act as a revenue collection agency. 269 however, this last, intriguing question can be left for another day. this article has made the case that, under certain circumstances, concentrated enforcement can increase tax compliance, and has fleshed out how concentrated enforcement might apply to the particularly problematic cash business tax sector. considering when concentrated enforcement might increase compliance is a pressing question in light of the project-based enforcement that exists in practice. by considering the compliance benefits of concentrated enforcement, this article has taken the first, but certainly not the last, step in evaluating concentrated enforcement. future work and experimentation should follow. 267. see bankman, eight truths, supra note 219, at 507–08 (describing consumers, rather than cash business tax evaders, as beneficiaries of evasion); benshalom, taxing cash, supra note 181, at 74 (“[ta]x-evasion practices force otherwise honest taxpayers who operate in cash-sector activities to misreport their income to align with market practices or to seek different employment opportunities where they can compete without evasion.”). 268. see supra text accompanying notes 85–86 for examples of strong defenses of the hmrc campaigns and their importance in a fair tax system. 269. for some (preliminary) discussion of this issue, see supra note 107. florida tax review volume 2 1995 number 9 a consumed income worldthe low income and prospects for simplificationreplies to professors fleming and yin charles 0. galvin* i. introduction as chair of the committee on tax structure and simplification of the section of taxation of the american bar association, i invited professors fleming and yin to lead a discussion with members of the committee on the effects of various proposed consumed income tax models. splendid scholars as they are, each converted his informal remarks into a published article.' meanwhile, the airwaves have been surfeited with talk shows, interviews, and panel discussions dealing ad nauseam with flat, and flatter, taxes, a consumed income tax, a national sales tax, and various proposals for taxation of business income. the general obfuscation of important and critical issues often seems intentionally deliberate, and in any case, however presented, does little to inform the public. of all the issues we have on our national platter-abortion, gun control, educational policy, crime in the streets-taxation is the most emotionally supercharged because it affects us all. we all pay taxes, direct and indirect; taxes pervade and permeate our lives. why can we not have clear and direct demonstrations of what various proposals would accomplish? some years ago, louis eisenstein wrote that the problem is not that the american people do not understand the tax system; rather, the problem is that they may come to understand it too well.2 professors yin and fleming ably serve us by their analyses of current proposals. nothing would be achieved by repeating their excellent exposi* centennial professor of law, emeritus, vanderbilt university; adjunct professor of law, university of texas; of counsel, haynes and boone, dallas, texas; m.b.a. 1941, j.d. 1947, northwestern university; s.j.d. 1961, harvard university. 1. j. clifton fleming, jr., scoping out the uncertain simplification (complication?) effects of vats, bats and consumed income taxes, 2 fla. tax rev. 390 (1995); george k. yin, accommodating the "low income" in a cash-flow or consumed income tax world, 2 fla. tax rev. 445 (1995). 2. louis eisenstein, the ideologies of taxation 227 (1961). a consuned income world tions. some history and statistics, however, may be offer further perspectives on their presentations. ii. the politics of tax proposals both political parties have pandered to the public in offering a smorgasbord of tax benefits, each seemingly trying to outdo the other. the entire process has been overpoliticized. consider by contrast some events of the past. in 1977, a conservative republican secretary of the treasury, william e. simon, in his introduction to blueprints,3 urged that it was time to start from scratch with a tax system designed on purpose and not left to constant tinkering. two models were offered: a comprehensive income tax and a cash flow tax.4 the comprehensive model followed closely, but not exactly, the haig-simons model, which was recognized as the ideal. the differences between the haig-simons and comprehensive models were explained; most of the deviations from haig-simons were offered as more nearly administratively feasible. the cash flow model generally tracked the comprehensive income model but excluded from the base all savings and investment and income, gains, and losses thereon until such amounts were consumed. under both models the corporate tax would be eliminated by integration with the personal income tax.5 in 1984, president reagan directed his secretary of the treasury, donald regan, to develop proposals for major tax reform. regan, also a conservative republican, produced treasury l,6 which called for broadening the base, reducing or denying the benefits of deductions for upper income taxpayers, and eliminating tax benefits for various industries; it also included other proposals consistent with a haig-simons model. the white house found treasury i too far reaching and directed secretary regan to tone down the proposals. this he did in treasury 11,7 which the president endorsed and which became the forerunner of the tax reform act of 1986. that act was the product of a bipartisan effort in both 3. william e. simon, forward to david f. bradford. u.s. dep't of treasury, blueprints for basic tax reform at xxi-xxii (1984) [hereinafter blueprintsl. 4. david f. bradford, u.s. dep't of treasury, blueprints for basic tax reform (1984). 5. for an excellent analysis of both models and a plea for a hybrid. see edward j. mccaffery, tax policy under a hybrid income-consumption tax, 70 tex. l. rev. 1145 (1992). 6. 1 dep't of the treasury, tax reform for fairness, simplicity and economic growth: overview at vii-viii [hereinafter treasury i]. 7. the president's tax proposals to the congress for fairness. growth, and simplicity (1985). treasury ii is also known as reagan 1. 19951 florida tax review houses, supported by the president.' it is fair to say that the 1986 act, which moved in the direction of a haig-simons model, was praised by tax professionals, both conservative and liberal, throughout the country. 9 bipartisanship in tax legislation seems at an end, however, following the 1994 elections. we seem to have lost our moorings to the ideal of either a pure haig-simons model or a pure consumed income model; yet the consumed income model has achieved considerable current popularity, however mangled the versions may be. iii. some statistics-haig-simons or consumed income; flat or progressive rates assume that a pure haig-simons system is in effect. assume also that the interest rate is 10% and the tax rate is 20%. taxpayer has $10,000 of income in year 1 and, at the end of year 1, invests the entire amount after taxes. at the end of year 2, taxpayer cashes in the investments. year 1 year 2 income $10,000 investment earnings (10%) $800 less: tax (20%) 2,000 less: tax (20%) 160 available to invest $ 8,000 after-tax income $640 results: taxpayer's total resources at the end of year 2: $ 8,640 government's total tax collections both years: 2,160 total taxpayer's income accounted for $10,800 now assume that a pure cash flow, or consumed income, system is in effect: year i year 2 income $10,000 investment earnings: (10%) $1,000 less: investment 10,000 withdrawal from account 10,00 taxable income -0taxable income $11,000 less: tax (20%) 2,200 after-tax income $ 8,800 8. for accounts of events leading to the tax reform act of 1986, see jeffrey h. birnbaum and alan s. murray, showdown at gucci gulf: lawmakers, lobbyists, and the unlikely triumph of tax reform (1987); c. eugene steuerle, the tax decade (1992). 9. see., e.g., henry j. aaron, the impossible dream comes true: the new tax reform act, brookings rev., winter 1987 at 3. [vol 2:9 a consumed income world results: taxpayer's total resources at the end of year 2: $ 8,800 government's total tax collections both years: 2.200 total taxpayer's income accounted for $11,000 the $200 difference between the two systems ($11,000 versus $10,800) is the result of the taxpayer's retention of an additional $2,000 from year 1 to invest at 10%.io the government gains $40 in taxes (20% of the additional $200 of income), and the taxpayer gains a net of $160. my own view is that under either a pure haig-simons regime or a pure consumed income regime," all income should be accounted for at some time during the taxpayer's life. assume that taxpayer acquires no assets by gift or inheritance and earns $1 million during life. under the haigsimons model, the $1 million is taxed as it is earned, and if any of the $1 million is saved, invested, and transferred by gift or at death, taxpayer is taxed on gains and losses in the transferred property at the time of transfer.'2 under a consumed income model, the $1 million is taxed as consumed, and my contention is that any part not consumed by taxpayer should be taxed when transferred by gift or at death. 3 taxpayer, by electing to save rather than consume, has made a decision to consume less in order that his family or others can consume more. moreover, in either regime, gifts and inheritances should be income to the donee or beneficiary,"4 although, in a consumed income regime, the donee or legatee could immediately offset the income by investment. in either regime, wealth transfer taxes could, and should, be eliminated, i contend, because all income is taxed to the taxpayer earning it.'5 10. a value added tax (vat) on all consumption would apply to the same tax base as the consumed income tax in the illustration. thus, a 20% vat would produce the same result as the 20% consumed income tax. 11. there is an abundance of literature on both models. professors fleming and yin have cited many of the principal authorities. see especially mccaffery, supra note s. 12. see lawrence zelenak, taxing gains at death, 46 vand. l rev. 361 (1993); charles 0. galvin, taxing gains at death: a further comment. 46 vand. l rev. 1525 (1993); joseph m. dodge, further thoughts on realizing gains and losses at death, 47 vand. l. rev. 1827 (1994). 13. the treatment of gifts and bequests under a consumed income tax is not without controversy. see blueprints, supra note 3, at 30-39. 14. the concept of the marital deduction could be continued. 15. see charles 0. galvin, to bury the estate tax, not to praise it. 52 tax notes 1413 (sept. 16, 1991); robert b. smith, burying the estate tax without resurrecting its problems, 55 tax notes 1799 (june 29, 1992); charles 0. galvin. more reasons to bury the estate tax, letter to the editor, 59 tax notes 435 (april 19, 1993). 19951 florida tax review how practical is all of the above? just the maunderings of a superannuated academic? hard statistics demonstrate otherwise. the vast majority of our citizenry is already taxed by the haig-simons or consumed income model. the commissioner's statistics of income for 1992 show that almost 83% of filers reported less than $50,000 of adjusted gross income, and the income of this group is principally from wages and salaries.' 6 these are people who live from paycheck to paycheck, consuming their income to defray ordinary living expenses. they do not have large investments in securities, rental properties, limited partnerships, 401(k) plans, and the like. nor do they have substantial deductions for home mortgage interest, taxes, and charitable contributions; most rely on the standard deduction. 7 for this large group of filers, call it what you like, haig-simons or consumed income; their adjusted gross income, essentially cash with no accruals, is consistent with either model. other statistics show that the bottom 50% of filers received about 15% of all income and paid about 5% of the taxes. 8 with respect to all federal, state, and local taxes, the tax foundation's has found that a typical two-earner couple with two dependent children paid an overall effective tax rate in 1980 of 40.7% on median income of $26,879 and that for 1994, the effective rate is 39.5% on a median income of $53,354. ]9 for the years in between (1981-1993), the effective rate on median income did not vary more than two percentage points. the empirical data demonstrate that the more load we take off the federal system the more the states have to pick up. at the median, the overall load changes practically not at all. the sales pitch from politicians for a federal flat tax often ignores the important factor of the regressivity of state and local systems. iv. recommendations 1. for all the fine work that professor yin and his colleagues have done on the earned income tax credit (eitc),2° statistics suggest that we 16. chris r. edwards, who pays federal income taxes? 66 tax notes 105, 108 (jan. 2, 1995); edward b. gross, jr., individual income tax returns, preliminary data, 1992; i.r.s. stat. of income bull., spring 1994 at 10, 11. 17. for 1992, the basic standard deduction was taken on 80,257,000 returns out of a total of approximately 114,000,000 returns (processed at the time of the report). of the returns claiming the standard deduction, 76,654,000, over 90%, reported adjusted gross income under $50,000. gross, supra note 16, at 12, 24. 18. see edwards, supra note 16, at 106. 19. chris r. edwards, typical american family pays 40 percent of income in taxes, 66 tax notes 735, 736 (jan. 30, 1995). 20. see george k. yin et al., improving the delivery of benefits to the working poor: proposals to reform the earned income tax credit program, 11 am. j. tax pol'y, 225 (1994); george k. yin & jonathan b. forman, redesigning the earned income tax credit [vol 2:9 a conswned income world might, without substantial loss in tax revenues, drop the bottom half of the filing group completely, eliminating one half the returns, one half the paperwork, and substantial administrative costs.2' the eitc is a worthy and commendable concept, but for the filing group affected, it is too complicated. moreover, it has led to some fraudulent practices, difficult to audit, in which low-income taxpayers overstate their income in order to obtain larger refundable credits. 2. with the utmost respect for professor fleming's concern about a vat,2 concerns which i share, i have become persuaded to the view that everyone ought to pay some federal taxes, even if it is a few pennies on a cake of soap or a tube of toothpaste. we have been warned by the irs that compliance is down, audits are down, and the tax gap is rising. as a nation, we have also been made aware of groups who believe that the federal government is in a conspiracy against them. as i watch the accounts of these groups on the evening news, i find it difficult to believe that any one of their members sits down before each april 15 and conscientiously completes and signs a form 1040. as if that were not enough, we are advised by the irs that some of our most distinguished professionals-yea, even tax professionals-are not filing returns; as a consequence, the irs proposes to increase the examination of partnership returns to assure, inter alia, that income allocated to partners is correctly reported.' frankly, i worry about the tax gap. we are not going to close it. it may get even wider, and this has got to be a morale factor for honest citizens who comply. some form of national sales tax on all consumables might at least assure that everyone is contributing something to the cost of the central government. 3. broadly stated, i favor the haig-simons model over the cash flow model, as described in blueprints. with sophisticated computer technology and with the elimination of 50% of the filers, could we not require taxpayers to recognize gain or loss on readily marketable assets by a mark-to-market system? with respect to assets not readily marketable, could we not defer recognition of gain or loss until sale or other disposition (including transfers by gift and at death) and then average back the gain or loss over the holding program to provide more effective assistance for the working poor, 59 tax notes 951 (may 17, 1993). 21. see edwards, supra note 16, at 106. 22. see fleming, supra note 1, at 395. 23. barbara kircheimer, irs plans to double staffing for partnership examinations, 65 tax notes 391 (oct. 24, 1994). 19951 florida tax review period, perhaps as we now do for complex trusts in applying the throw back rule?24 4. in regard to encouraging savings, has not our experience since 1981 demonstrated that we cannot grow ourselves out of deficits by lowering taxes? does anyone remember that from the middle 30s until 1964, individual income tax rates ranged from 20% to 91%, corporate income tax rates were as high as 54% (with a rate of 95% on excess profits during world war ii and the korean conflict), and estate tax rates ran to 77% (gift tax rates to 5734%)? with that structure, we paid the cost of world war ii and the korean conflict, financed the marshall plan to rebuild post-war europe, and were a creditor nation to all the world. the country had low inflation and good productivity. how did we get mesmerized into believing that low taxes with high deficits would lead us to the promised land? 5. finally, i concede that we cannot have haig-simons or cash flow, but must have some hybrid. in this connection, therefore, could we not draw upon some of the literature on pareto optimality, kaldor-hicks efficiency, and mirrlees models to demonstrate econometrically desirable systems of income distribution?25 to be sure, any popular discussion of these matters through talk shows, panels, op-ed columns, and the like would invoke yawns and glazed eyes, but in a complex economy, it is just this kind of thoroughgoing research and analysis which we require before plunging headlong into more tinkering that a former conservative republican secretary of the treasury said we should avoid.26 we are indebted to professors fleming and yin for their thoughtful disquisitions on complex subjects which continue to occupy such important positions on our national agenda. 24. the throwback rule is now an anachronism as the compression of rates on trust income usually militates in favor of distributing trust income rather than retaining it in trust for later years. 25. see, e.g., mccaffery, supra note 5, at 1156; joseph bankman & thomas griffith, social welfare and the rate structure: a new look at progressive taxation, 75 cal. l. rev 1905, 1946 (1987). 26. william e. simon, forward to blueprints, supra note 3, at xxi. [vol 2:9 florida tax review volume 2 1995 number 8 accommodating the "low-income" in a cash-flow or consumed income tax world george k. yin' abstract ......................................... 447 i. introduction ................................ 448 ii. overview of a cash-flow tax systei ............ 449 a. cash-flow tax in contrast to other broad-based consumption taxes ........................ 449 b. illustrative cases ......................... 452 1. low-wage worker ................... 453 2. student ........................... 453 3. altruistic middle-income worker ......... 453 4. middle-income investor ............... 454 5. senior citizen ...................... 454 c. some rationales for cash-flow tax ............ 454 1. neutrality in treatment of present versus future consumption .................. 454 2. ease of administration ................ 456 a. realization ................... 457 b. capital recovery deductions ...... 457 c. inflation ..................... 457 d. corporate taxation ............. 458 * professor of law, university of virginia. b.a. 1970. michigan; m.ed. 1972, florida; j.d. 1977, geo. wash. i presented an outline of this paper to a meeting of the tax structure and simplification committee of the tax section of the american bar association in august, 1993, and a draft of the paper to a university of virginia law school workshop. my thanks to the participants of that meeting and workshop, to cliff fleming for reviewing a prior version of this paper, to alice baker for her research assistance, and to the university of virginia school of law for research support. copyright © 1995 by george k. yin. all rights reserved. florida tax review iii. should progressivity concerns be addressed within the contours of a new consumption tax? . . . . . . . . 458 a. distributional impact of change ............... 459 b. avenues other than cash-flow tax for addressing progressivity concerns ............. 461 iv. accommodating the low-income in a cash-flow or consumed income tax world ................. 466 a. nunn-domenici proposals affecting the low-income. 466 b. implementation issues ...................... 469 1. eligibility for negative tax subsidy ....... 469 2. problems associated with larger negative tax subsidy ........................ 474 3. implementing the payroll tax credit ...... 477 4. proper taxable unit ................. 480 5. proper size of family living allowance .... 485 6. graduated tax rates ................. 486 v. summary and conclusion ........................ 490 [vol. 2:8 acconmtodating the "low-income" abstract this article concerns a tax policy issue of keen current interest: the possible replacement of the income tax with a broad-based tax on consumption. the leadership of the new 104th congress has promised early scrutiny of consumption tax proposals. the weak link of most consumption tax plans relates to how they would distribute the tax burden across income classes. critics charge that consumption taxes are regressive or at least not as progressive as the existing income tax. many theorists believe, however, that one form of broad-based consumption tax, a cash-flow or consumed income tax, is immune to such criticism because it is an individualized consumption tax and could be implemented in a manner very similar to the income tax. supporters of the cash-flow tax assert that it is flexible enough to attain any desired degree of progressivity. in this article, i examine that proposition. focusing on the impact of the cash-flow tax on low-income taxpayers, i conclude that it would be surprisingly difficult to fashion a cash-flow tax as redistributive at the lower end of the income scale as the current income tax system while still preserving the asserted advantages of the cash-flow tax. although it may still be advisable to move towards a cash-flow tax system, it is important for policymakers to recognize the inherent limitations of such a system for achieving progressivity at the lower end of the income spectrum. 19951 florida tax review i. introduction continuing criticism of the complexity and undesirable incentive effects of the income tax has revived bipartisan talk of the possibility of replacing that tax with a broad-based consumption tax.' among the principal contenders are a transactions-based consumption tax, such as a european-style value added tax (vat), and an individualized consumption tax, such as a "consumed income" or cash-flow tax. a transactions-based tax offers several advantages: it is widely used, it would permit millions of taxpayers to avoid filing tax returns, and it would enhance the government's ability to tax economic activity taking place in the "informal" sector. it also has an important disadvantage: its inflexibility in adjusting the burden of the tax to taxpayers' income or consumption levels or other indications of taxpaying capacity. concern about that lack of flexibility has led some policymakers to consider an individualized consumption tax. for example, the center for strategic and international studies' strengthening of america commission, chaired by senators nunn (d.-ga.) and domenici (r.-n.m.), is reportedly developing a cash-flow or consumed income tax to replace the income tax and a portion of the employer and employee payroll taxes.2 according to the i. immediately after the 1994 midterm election, new house ways & means committee chairman bill archer (r.-tx.) expressed support for moving in that direction. see bill archer, america's agenda, 94 tnt 228-32 (nov. 22, 1994) (lexis, fedtax library, tnt file) (transcript of press conference held nov. 10, 1994); laura saunders, archer's agenda, forbes, dec. 5, 1994, at 45; jeff shear, a new ball game, 26 nat'l j. 2781 (1994). also, ways and means committee ranking minority member sam gibbons (d.-fi.) has long been an advocate of a value added tax. see william h. morris, a "national debate" on vat: the gibbons proposal, 60 tax notes 1259 (aug. 30, 1993); statement of acting chairman sam gibbons (d.-fi.), house comm. on ways & means, before the bipartisan commission on entitlement and tax reform, 94 tnt 198-36 (oct. 7, 1994) (lexis, fedtax library, tnt file) (testimony in favor of subtraction method vat). finally, new house majority leader dick armey (r.-tx.) introduced a bill in the 103d congress that in some circumstances, would be equivalent to a broad-based tax on consumption. his bill, modeled after a plan proposed by robert hall and alvin rabushka, would enact a 17% flat tax on earned income and cash-flow business income as a substitute for the existing individual and corporate income taxes. h.r. 4585, 103d cong., 2d sess. (1994). see dick armey, review merits of flat tax, wall st. j., june 16, 1994, at a-16. for bipartisan interest in the senate in a broadbased consumption tax, see infra note 2 and accompanying text. 2. see center for strategic and int'l studies, the csis strengthening of america commission 96-102 (1992); sen. pete v. domenici, the unamerican spirit of the federal income tax, 31 harv. j. on legis. 273 (1994). in addition, during the 103d congress, former senators danforth (r.-mo.) and boren (d.-ok.) introduced a bill to enact a cash-flow corporate consumption tax to supplant the corporate income tax and reduce individual income and payroll taxes. s. 2160, 103d cong., 2d sess. (1994). [vol. 2:8 accommodating the "lo'-incoine" conventional wisdom, a cash-flow tax, unlike a transactions-based consumption tax, is flexible enough to attain any desired degree of progressivity.3 i examine that proposition in this article. my purpose is not to question the wisdom of income redistribution in the first instance or the relative merits of consumption and income taxes. rather, my focus is on whether it is possible to design a cash-flow or consumed income tax that mitigates the tax burden of low-income taxpayers-perhaps the one objective of current redistribution policy that enjoys a broad consensus-while preserving the asserted advantages of the cash-flow tax. the feasibility of accomplishing that goal should be a prime factor in evaluating the tax's viability as a policy option. i use as my backdrop the cash-flow tax proposal being formulated by the nunn-domenici commission. my conclusion is that it would be surprisingly difficult to fashion a cash-flow tax as redistributive at the lower end of the income scale as the income tax without compromising the benefits of the cash-flow tax. indeed, one of the principal tools for achieving that redistribution under current law-the earned income tax credit-is virtually incompatible with a cash-flow tax. thus, although it may still be advisable to move towards a broad-based consumption tax, policymakers should recognize the inherent limitations of both transactions-based and individualized consumption taxes for achieving progressivity at the lower end of the income spectrum. in part ii, i sketch out what a cash-flow tax is, how it differs from other broad-based consumption taxes, and some of the reasons why its supporters favor it over the income tax. part iii briefly explores some threshold issues relating to whether progressivity concerns would have to be addressed within the contours of a new consumption tax. readers who are familiar with a cash-flow tax and the various tax and expenditure options for achieving progressivity can easily skip to part iv, which identifies the principal difficulties in designing a cash-flow tax to accommodate the lowincome. finally, part v contains a brief summary and conclusion. ii. overview of a cash-flow tax system a. cash-flow tax in contrast to other broad-based consumption tares the most common form of broad-based consumption tax is a transactions-based tax that is not individualized, such as a european-style, 3. see david f. bradford, u.s. treas. tax policy staff, blueprints for basic tax reform 122-23 (2d ed. 1984) [hereinafter blueprints]; david f. bradford, untangling the income tax 162 (1986) [hereinafter bradford-untangling]; nicholas kaldor. an expenditure tax 48-49 (1955); william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1174-75 (1974). 19951 florida tax review credit-method vat or a retail sales tax. either of those taxes is on a consumption base and arises at the point of the consumption transaction. neither tax is individualized in the sense that there is no accounting for the total amount spent on consumption by any individual over any period of time. in theory, such an accounting could be required. when sales taxes were deductible for federal income tax purposes, taxpayers had the option of either deducting the sales taxes actually paid or using a table to estimate that amount. conceivably, taxpayers could be required to keep account of their consumption expenditures and make annual reports on the amounts so spent. quite clearly, however, the mandate would be highly impractical; a large majority of those claiming the deduction for sales taxes used the tables. moreover, it would be difficult to protect against the underreporting of consumption expenditures, a concern not present when the purpose of the accounting was to justify the size of a claimed deduction. the infeasibility of individualizing a transactions-based consumption tax is a significant design flaw. policymakers concerned with the distribution of the tax burden need to be able to adjust the tax borne by individuals based upon their consumption, income, or other indication of taxpaying capacity, but cannot do so if there is no accounting for those amounts.4 a related problem is the absence of a mechanism for delivering desired adjustments to particular individuals. 5 to address this issue, non-individualized broad-based consumption taxes sometimes include exemptions or varying rates for various categories of consumption "necessities," such as food, clothing, shelter, and medical expenses. but these special provisions provide only rough solutions 4. see richard a. musgrave & peggy b. musgrave, public finance in theory and practice 215 (5th ed. 1989) (arguing that in rem taxes, which are imposed on activities or property independently of the characteristics of the persons carrying on the activity or owning the property, are inferior to personal taxes in their ability to adjust the burden of the tax among people). 5. if an income tax were retained along with a broad-based consumption tax, a refundable income tax credit could be used to rebate consumption taxes to particular taxpayers. however, i generally assume for purposes of this paper that the broad-based consumption tax will replace, and not merely supplement, the income tax, making a refundable income tax credit mechanism unavailable. see joel b. slemrod, the simplification potential of alternatives to the income tax, 66 tax notes 1331, 1335 (feb. 27, 1995) ("the united states may be in the unique position of being able to replace the income tax entirely, and stay within the range of vat collections that has proven viable in other countries"). in some states, taxpayers may, by filing claims with the state's department of revenue, obtain refunds of portions of the sales taxes they pay. see kan. stat. ann. §§ 79-3632 to 79-3639 (1989); s.d. codified laws ann. §§ 10-45a-i to 10-45a-8 (1989 & supp. 1994). if these procedures were followed at the federal level in conjunction with a transactions-based consumption tax, they would defeat a principal advantage of that tax-the elimination of tax returns for millions of individual taxpayers. [vol 2:8 acconmiodating the "'low-hicome" for distributional concerns. indeed, an exemption for clothing may actually reduce the progressivity of such taxes.6 a cash-flow or consumed income tax offers the potential for overcoming that shortcoming.7 from a cash-flow standpoint, all of an individual's receipts of money or in money value can be thought of as used for one of the following general purposes: personal consumption, savings, profit-making expenses, taxes (including levies for social insurance), and gifts and bequests made (including support payments). the cash-flow sources of such receipts can be classified as gross income (including the full proceeds from the sale of assets), plus gifts and bequests received (including government transfers and support receipts): uses sources personal consumption (c) gross income (gi) savings (s) gifts and bequests received (gbr) profit-making expenses (e) taxes (t) gifts and bequests made (gbm) because cash-flow sources must be equivalent to cash-flow uses, then: c + s + e + t + gbm = gi + gbr rather than trying to monitor purchases of goods and services for consumption, a cash-flow tax uses the foregoing equivalence to measure consumption indirectly through a combination of cash-flow sources and uses. solving the equation for personal consumption (c) shows that consumption for a period equals the sum of an individual's gross income and net gifts and bequests received (ngbr), less savings, profit-making expenses, and taxes over that period: c = gi + (gbr gbm) s e t c = gi + ngbr s e t further, if gross income and profit-making expenses are netted to produce the existing concept of income (y), consumption equals: c = (gi e) + ngbr s t c = y + ngbr s t 6. see david f. bradford, what are consumption taxes and who pays them'? 39 tax notes 383, 389-90 (apr. 18, 1988). 7. for more detailed descriptions of cash-flow taxes and the theory underlying them, see blueprints, supra note 3, at 25-31, 101-28; andrews, supra note 3. 8. for a particular period, savings may be a negative amount if, for example, an individual consumes amounts previously saved or amounts borrowed. 19951 florida tax review with the possible exception of the treatment of gifts and taxes, this formulation is identical to the haig-simons definition of individual income as the sum of consumption and the change in the individual's net worth (anw) over the period: y=c+,anw where anv = s.9 solving the foregoing equation for c: c=yanw the principal difference, then, between an income tax base and the base under a cash-flow tax is the deduction for savings under the latter. indeed, the equivalent of a deduction for savings is already allowed under the income tax in selected instances, such as the exclusion from income of employer contributions to pension funds, the deductibility of certain contributions to ira, 401(k), and 403(b) plans, and the tax exemption of earnings on those accounts. a cash-flow tax might therefore be thought of as an income tax under which unlimited deductible contributions can be made to iras, with no withdrawal restrictions. because of its similarity to the income tax, a cash-flow tax could be administered in much the same way as current law. individual taxpayers would be required to calculate their tax bases periodically based upon the sources and uses of their monetary receipts. they would determine their tax liabilities from rate schedules and report those liabilities on periodic tax returns. it is generally believed that the individualized nature of the tax would afford the same flexibility as under the income tax to tailor the level of taxation to the consumption levels and other characteristics of the taxpayer. at the same time, however, unlike a transactions-based consumption tax, a cash-flow tax would neither reduce the tax return filing burden nor make any inroad into taxing economic activity currently escaping the scrutiny of the income tax authorities. b. illustrative cases the following highly simplified cases may be useful in illustrating the theoretical application of a cash-flow tax to lowand middle-income taxpayers: 9. under present law, federal taxes are not deductible and are therefore included in the income tax base. also, gifts and bequests made are not deductible, but gifts and bequests received are excluded from income. thus, the current law definition of income might be represented by the following: y = c + s + t ngbr which is consistent with the definition of consumption for purposes of the cash-flow tax. [vol 2:8 acconwtodating the "low-income" 1. low-wage worker.-mr. a works 2,000 hours annually at $7.00 per hour, for total earnings of $14,000. his only other income is $1,000 in alimony. barely able to make ends meet, he consumes every bit of his aftertax income and is unable to save anything. with a 15% cash-flow tax rate, no exemption amount, and no other taxes,' 0 he pays $2,250 in cash-flow tax (15% of $15,000) and consumes $12,750 ($15,000 less $2,250)." 2. student.-ms. b is a full-time student. her receipts for the year consist of a $13,000 gift from her parents, a $12,000 student loan, and $5,000 of wages from a summer job. she consumes all amounts after payment of her tuition ($15,000) and taxes. if the tuition payment is treated as consumption and the tax rate is 15%, she pays $4,500 in cash-flow tax (15% of $30,000), pays $15,000 in tuition, and consumes the balance of $10,500. if the tuition is treated as savings or a profit-making expense, her tax is only $2,250 (15% x $15,000), and she consumes the balance of $12,750.12 in either case, the amount borrowed is treated as dissavings and is therefore included in the student's consumption tax base along with the amount of the gift received. 3. altruistic middle-inconme worker.-mr. c, who earns $30,000 in wages and $5,000 in dividends, contributes $5,000 to a pension plan during the year, pays off outstanding loans of $4,000, and makes contributions to his church of $11,000. he consumes all remaining amounts after payment of taxes. if the contribution to the church is not treated as consumption, he pays $2,250 in taxes (15% of $15,000) and consumes the balance of $12,750. the loan pay-off and the pension contribution are both treated as deductible savings. 10. these assumptions apply to all of the illustrations. 11. as in this example, all tax rates are expressed in a "tax-inclusive" way; that is, the rate is applied to the consumption base inchsive of the cash-flow tax to be paid. in theory, a "tax-exclusive" rate is more appropriate because the amount paid as cash-flow tax cannot be spent on consumption. (in contrast, because income is defined to include amounts paid as income tax, tax-inclusive rates are proper under the income tax.) however, tax-exclusive rates are higher than tax-inclusive ones and are difficult for taxpayers to understand and apply. in the example, a tax rate of approximately 17.6% of the amount of consumption exclusive of taxes paid ($12,750) produces a tax liability of about $2,250 (17.6% x s12,750 = s2,250) and is therefore equivalent to a 15% tax-inclusive rate. a tax-inclusive rate of 50% is equivalent to a tax-exclusive rate of 100%, and tax-exclusive rates in excess of 100% would certainly be possible. in general, if r is the tax-inclusive rate, then rl(l r) is the tax-exclusive rate. see institute for fiscal studies, the structure and reform of direct taxation 28-29 (1978) [hereinafter meade report]; michael j. graetz, implementing a progressive consumption tax, 92 harv. l. rev. 1575, 1582-84 (1979). 12. see graetz, supra note 1i, at 1589 ("items such as educational expenses ... which do not tend to provide current consumption benefits would probably be more generally deductible [under a cash-flow tax] than under the income tax"). 19951 florida tax review 4. middle-income investor.-ms. d earns $15,000 in wages, $10,000 in dividends from various mutual funds, and $10,000 of interest accruals on zero-coupon bonds she owns. the dividends are reinvested in additional shares of the mutual funds. she also sells stock investments for $50,000, makes new stock investments for $46,000, and makes a $4,000 gift to her child.'3 she consumes all other amounts after payment of her cash-flow tax. her tax base is $15,000, consisting of $15,000 of wages, $10,000 of dividends, $10,000 of interest, and $50,000 of proceeds from stock sales (basis is irrelevant), less the sum of $10,000 of dividends reinvested, $10,000 of interest accrued on the zero-coupon bonds, $46,000 of new stock investments, and the $4,000 gift. her tax liability is $2,250 (15% of $15,000), and her consumption is $12,750. 5. senior citizen.-mr. e receives $6,000 from social security, receives $5,000 from his pension, and withdraws $4,000 from personal savings, all of which, after payment of taxes, is consumed. he pays $2,250 in taxes (15% of $15,000) and consumes $12,750. the withdrawal from savings, the social security, and the pension payments are all included in mr. e's tax base. 4 c. some rationales for cash-flow tax many arguments have been raised in favor of replacing the income tax with a broad-based consumption tax like the cash-flow tax, and it is not my intention to review and debate those positions in this article. two arguments, however, relate to later portions of this article and i therefore describe them briefly here.'5 1. neutrality in treatment of present versus future consumption.-according to its advocates, a cash-flow tax is more neutral than the income tax in its treatment of present versus future consumption. 6 this 13. the stock sold is assumed to have been purchased when the cash-flow tax was in effect. issues relating to the transition from the income tax to a cash-flow system are ignored in these examples and throughout this paper. 14. it is assumed the savings were accumulated after the adoption of the cash-flow tax and were therefore deducted as accumulated. 15. for a description of the potential welfare gains resulting from such a switch, see don fullerton et al., replacing the u.s. income tax with a progressive consumption tax, 20 j. pub. econ. 3 (1983). 16. see, e.g., blueprints, supra note 3, at 36-39; bradford-untangling, supra note 3, at 162-66; meade report, supra note 11, at 35-37; andrews, supra note 3, at 1167 ("[the most sophisticated argument in favor of a consumption-type tax is that ... it ultimately imposes a more uniform burden on consumption, whenever it may occur, than does an [vol 2:8 acconunodating the "low-income" argument is expressed in various ways, but can be illustrated by the following example. saver and spender each earn $100. spender immediately spends the $100 on personal consumption; saver invests her earnings at a 10% annual return. in a world without taxes, saver would have about $200 in seven years and, at that time, could therefore consume about twice as much as spender. in present value terms, the two would consume the same amount, regardless of when they decide to consume. assume, instead, saver and spender are subject to a 40% tax on income. each pays a $40 tax when the $100 is earned. spender, who consumes the remaining $60, is taxed no more. saver, in contrast, continues to pay tax on the earnings from her savings. the 40% income tax reduces the after-tax annual yield from 10% to 6%. after seven years, saver has only about $90. consumption of that amount in year seven results in no further tax to saver, but the $90 is only one and one half times the amount consumed by spender, not twice spender's consumption. in other words, relative to a no-tax world, saver is disadvantaged by her decision to save in an income tax world. in present value terms, saver can no longer consume as much as spender. now assume a 40% cash-flow tax is substituted for the income tax. spender again has $60 to consume after payment of a $40 tax and bears no further tax. saver can invest the full $100 in year 1-there being no consumption and therefore no immediate tax liability-and this amount grows to about $200 by year seven. (the earnings similarly bear no tax because they are reinvested.) consumption of the savings and accumulated earnings in year seven requires saver to pay a 40% tax ($80), leaving saver with $120 for consumption, twice as much as spender or the same amount as spender in present value terms. in short, a cash-flow tax reduces the amount both saver and spender may consume but is neutral regarding the choice of saving or spending. with the tax, as in the world without taxes, saver can consume roughly twice as much as spender (or the same amount in present value terms) if saver defers her consumption for seven years. the same cannot be said of an income tax, which diminishes saver's position relative to spender's. accretion-type tax"). for arguments challenging the propositions that an accretion-type tax disadvantages savers relative to spenders and is therefore unfair, see barbara h. fried. fairness and the consumption tax, 44 stan. l. rev. 961 (1992); joseph bankman & thomas griffith, is the debate between an income tax and a consumption tax a debate about risk? does it matter?, 47 tax l. rev. 377 (1992). 19951 florida tax review 2. ease of administration.-another argument for a cash-flow tax is that it would be easier to implement than the income tax. 7 at first blush, that assertion might seem to be rather dubious, given the close resemblance between a cash-flow tax and the income tax. indeed, many of the administrative difficulties under current law would continue in a cash-flow tax world. for example, both systems have the problem of identifying and measuring income from labor, such as fringe benefits," and both have to distinguish between consumption and profit-making expenses. the cash-flow tax would have the new problem of separating consumption from savings, as evidenced by the treatment of tuition in the student's example. there is also an issue of whether a gift to a family member or to an unrelated beneficiary such as a charity should be treated as consumption by the donor (see the altruistic middle-income worker and the middle-income investor). 19 advocates of a cash-flow tax argue, however, that the most intractable issues under current law arise from the accumulation end of the income definition-the measurement of changes in net worth. 2 ' a cash-flow 17. see andrews, supra note 3, at 1149 ("a [cash-flow] tax would avoid all the difficulties that arise from the failure of money income to provide a satisfactory reflection of real accumulation"); david f. bradford, the case for a personal consumption tax, in what should be taxed: income or expenditure? 75, 77 (joseph a. pechman ed. 1980) ("because a satisfactory income base is so much more difficult to implement than a satisfactory consumption base, the former should be chosen only if there is some compelling reason to do so"); george n. carlson & charles e. mclure, jr., pros and cons of alternative approaches to the taxation of consumption, 1984 nat'l tax assn.-tax inst. of am. proceedings 147, 15152 ("probably more important than [the] economic arguments for a consumed income tax are its administrative advantages"). michael graetz relates the story of chester jordan who testified in 1921, when the present version of the income tax was only eight years old, that he could reduce the size of his accounting practice from eight to three people if congress would replace the income tax with a consumption tax. michael j. graetz, revisiting the income tax vs. consumption tax debate, 57 tax notes 1437, 1437 (dec. 7, 1992) [hereinafter graetzrevisiting]. for a comprehensive critique of these issues, see committee on simplification, aba sec. of tax'n, complexity and the personal consumption tax, 35 tax law. 415 (1982); graetz, supra note 11. 18. under current law, a roundabout way of taxing fringe benefits is to disallow the employer's deduction for the benefits' cost. it is not clear whether the taxation of businesses under a cash-flow tax system would provide the same opportunity for imposing such a proxy tax. 19. one argument is that the voluntary nature of the gift suggests a benefit to the donor equivalent to personal consumption and that the gift should therefore be taxable to both the donor and the donee (whose standard of living is tangibly enhanced if and when the gift is consumed). a different, more pragmatic argument in favor of treating a gift to charity as consumption by the donor is that it is not practical to include the gift in the tax bases of the beneficiaries of the gift (as opposed to the charity, which is a mere intermediary) and that taxing the donor may be the best available alternative. see blueprints, supra note 3, at 104-05. 20. see andrews, supra note 3, at 1115, 1139-40. [vol. 2:8 acconmiodating te "'low-income" tax basically brushes this problem away by exempting net worth changes from the tax base until such amounts are consumed. accordingly, a cash-flow tax base can be measured more accurately and simply than an income tax base. the difficulties under current law that would be avoided by a cash-flow tax, according to its proponents, include the following: a. realization.-as a result of the realization principle, changes in net worth are generally taxed only when realized by, for example, a sale of appreciated or depreciated property or savings from cash income. the principle therefore creates a basic inequity depending upon how savings are accumulated and managed. furthermore, it creates the need to determine when realization, and therefore taxation, occurs. the tax system contains a slew of nonrecognition provisions that basically reflect the judgment that technical realization should not result in immediate taxation if the original investment essentially continues. additional difficulties created by the realization principle include the lock-in effect and the potential bunching of gains, which introduce the need for a preferential tax rate on realized gains and, therefore, a distinction between capital gains and ordinary income. a cash-flow tax would avoid these problems. unrealized gains, realized gains, and current income from savings would all go untaxed until consumed. indeed, the very notion of gain is foreign to a cash-flow tax system because all amounts invested in savings would be deductible and the full sales proceeds from an investment would be included in the tax base if not reinvested.21 b. capital recovery deductions.-the income tax system also has difficulty taking into account decreases in value due to wear, tear, and obsolescence of productive assets because there is no money transaction to provide a measure of the decline. the income tax provides conventions for computing capital recovery allowances, but the conventions necessarily produce only estimates of economic depreciation. under a cash-flow tax, amounts invested in productive assets are immediately deductible, making capital recovery deductions unnecessary. c. inflation.-related to both of the foregoing is the problem of inflation. the failure of the income tax law to take inflation into account 21. for other income timing predicaments plaguing the income tax but avoidable under a cash-flow tax system, see william a. klein, tailor to the emperor with no clothes: the supreme court's tax rules for deposits and advance payments. 41 ucla l rev. 1685, 1706-09, 1711 (1994); william a. klein, timing in personal taxation. 6 j. legal studies 461. 479 (1977). 19951 florida tax review systematically results in mismeasurement of real net worth changes.22 inflation is often dealt with ad hoc and has been used as a justification for accelerated capital recovery deductions, preferential capital gains rates, and other special provisions in the income tax system. inflation also distorts the income tax treatment of debt to both debtor and creditor. because a cash-flow tax would apply only to current consumption, it would not be affected by inflation.23 d. corporate taxation.-the tax treatment of corporatesource income presents a daunting problem under current law. an allocation of all undistributed corporate income among shareholders is generally viewed as too difficult to implement for corporations with complex capital structures. but separate taxation of the income to the corporation, the solution under current law, results in double taxation. exempting corporate-source income from taxation would create an open-ended tax shelter. various proposals for integrating the corporate and individual income taxes would all introduce considerable complexity.24 at least in theory, a cash-flow tax could avoid the necessity of taxing corporate flows: contributions to a corporation could be deductible as savings, transactions involving amounts remaining within corporate solution could all be ignored as savings reinvestments, and only amounts leaving corporate solution would be taxable if not reinvested. ml. should progressivity concerns be addressed within the contours of a new consumption tax? a chief concern about broad-based consumption taxes is their effect upon the progressivity of the tax system. in the next part of this paper, i discuss whether a cash-flow tax could be designed to address that concern and analyze provisions that might be adopted to mitigate the impact of the tax on the low-income. but a threshold question, which i discuss briefly in this part, is whether any special accommodation for the low-income should be incorporated into a new consumption tax. this threshold inquiry raises two issues. first, what would be the impact on the distribution of the tax burden 22. for changes that might be required to make the tax system sensitive to inflation, see reed shuldiner, indexing the tax code, 48 tax l. rev. 537 (1993). 23. if a cash-flow tax were adopted with graduated rates, there would be the potential problem of "bracket creep" as consumption levels of taxpayers increase due to inflation, but that problem could be easily addressed by indexing tax brackets as under current law. irc § 1(f). 24. see george k. yin, corporate tax integration and the search for the pragmatic ideal, 47 tax l. rev. 431, 436-49 (1992) (describing complications of the shareholder-credit form of integration offered by the american law institute reporter). [vol. 2:8 accommodating the "'low-income" of a switch from the income tax to a broad-based consumption tax? second, what avenues outside of the consumption tax might be available to deal with the progressivity issue? a. distributional inpact of change the distributional effect of switching to a consumption tax depends upon the uncertain resolution of several empirical and theoretical issues. because a consumption tax base excludes savings, whereas the income tax base generally does not, a principal consideration is the estimated rate of savings or consumption by income class. a common intuition is that lowincome families consume a greater proportion of their incomes than wealthier families and that changing the tax base from income to consumption would therefore have a regressive impact on the distribution of the tax burden. thus far, empirical analyses of household survey data have generally borne out that intuition, but the magnitude of the results has varied. for example, where savings was defined as the residual amount after consumption, taxes, and gifts are subtracted from income and other receipts during a year, a recent study found savings to be -72.5% of cash income for families in the bottom income quintile (that is, there was significant net borrowing or dissavings by these families) and 16.8% of cash income for families in the top income quintile.25 in contrast, where savings was defined as the change in family net worth during a year, savings rates were found to be considerably flatter6.7% and 5.7% of cash income for the bottom and top income quintiles. -' a consumption tax thus appears to be less regressive under a net worth analysis of savings rates than under a residual analysis, but both studies found some degree of regressivity.27 the possibility of negative savings rates for a particular class of individuals raises another issue. presumably, individuals cannot continue to live beyond their means indefinitely. many economists believe that data indicating negative savings rates reveal a fundamental error in snapshot comparisons of consumption to income. according to this view, an individual who is temporarily unemployed, and therefore has a low level of income, may not adjust spending patterns to that income level. the same might be 25. see john sabelhaus, what is the distributional burden of taxing consumption? 46 nat'l tax j. 331, 336 (table 2) (1993). 26. id.; see also barry bosworth et al., the decline in saving: evidence from household surveys, in i brookings papers on economic activity 183, 207 (table 5) (william c. brainard & george l. perry eds., 1991) for a similar finding involving different years. 27. a puzzle is why these two approaches yield such different results. at least in theory, the results should be identical. sabelhaus concluded that the data from the net worth approach may be more reliable than that from the residual method. sabelhaus, supra note 25, at 342-43. 1995] florida tax review true for those with temporarily high incomes. more generally, people may attempt to smooth lifetime spending by living beyond their means in their low-income youth (in anticipation of future, higher earnings) and saving more in high-income years to finance consumption in retirement years when income again is relatively low. thus, comparisons of consumption to current income may overstate the degree of regressivity of a broad-based consumption tax, and comparisons should instead be made over the lifetime of particular taxpayers or classes of taxpayers. 2 however sound theoretically, lifetime incidence analyses conflict with the reality that taxes are collected annually to fund current government operations. hence, if the lifetime pattern of consumption described above is accurate, a broad-based tax on consumption would be imposed fairly evenly over a taxpayer's life and may therefore create considerable financial stress during the valleys (youth and old age) of the income earning pattern.29 an ideal solution might be to link the timing of tax payments to income, even if tax liability is based on consumption, by permitting taxpayers, at their option, to make early and late payments of consumption tax with appropriate interest credits and charges.3" 28. see don fullerton & diane lim rogers, who bears the lifetime tax burden? 17-21 (1993); andrews, supra note 3, at 1175; bradford, supra note 6, at 389-90. though constrained by the five-year budget window, the staff of the joint committee on taxation utilizes a methodology to assess the distributional impact of general consumption taxes that approaches a lifetime incidence calculation. see staff of joint comm. on taxation, methodology and issues in measuring changes in the distribution of tax burdens 51 (comm. print 1993) [hereinafter jct methodology]; alan j. auerbach, public finance in theory and practice, 46 nat'l tax j. 519, 523-24 (1993); r. glenn hubbard, on the use of "distribution tables" in the tax policy process, 46 nat'l tax j. 527, 532-33 (1993). even using that methodology, however, the joint committee has concluded that general consumption taxes are "substantially more regressive than the existing federal income tax." jct methodology, supra, at 58. for some qualms about the staff's methodology, see richard goode, "economics in the policy process": a comment, 47 nat'l tax j. 403, 404-05 (1994). 29. witness the potential impact of the cash-flow tax on the student and the senior citizen in my earlier examples. 30. in effect, the government would be an available lender or borrower. for example, the student might opt to delay paying her current year tax until some future year when her resources are greater. with advance planning, the senior citizen may have prepaid his taxes during his productive market work years and therefore not owe anything in the current year. tax liability would always be based upon the law for the taxable year of the consumption. thus, the choice in timing of tax payments would not provide an opportunity for taxpayers to manipulate their tax liabilities through predictions of likely law changes. there might also be a rule that if aggregate tax receipts are insufficient for a particular year, and the government therefore incurs borrowing costs greater than anticipated, an additional interest charge would apply to all taxpayers opting to make late payments of taxes for that year. this rule might protect against excessive tax payment deferrals for unforeseen reasons. [vol 2:8 accommodating the "'low.income" also, the focus on savings or consumption rates of individuals in different income quintiles, whether in the short-run or over a lifetime, assumes, perhaps incorrectly, that the incidence of a consumption tax falls on consumers. for example, if the introduction of a transactions-based consumption tax causes a general increase in prices, an individual whose income is indexed to price changes, as is the case for many recipients of government transfer payments, would effectively be insulated from the tax unless the indexing mechanism is adjusted to prevent the price effect of the tax from increasing the individual's income. hence, the burden of a consumption tax may really be borne by those whose incomes and other receipts are unindexed, who may or may not consist disproportionately of the low-income." other incidence uncertainties relate to some of the taxes being replaced or modified as a result of the new consumption tax. for example, how should repeal of the corporate income tax be taken into account for distributional purposes? incidence shifting possibilities, due to changes in behavior or other factors, are also present for taxes on labor, such as payroll taxes and the individual income tax, as well as personal income taxes on capital returns. finally, distributional analyses of tax law changes necessarily focus on observable income, including imputed income from observable assets. yet a fair measure of an individual's well-being may encompass much more than that. a good example of this problem is unreported income. according to the irs, there may be as many as 10 million taxpayers who improperly fail to file returns, and the "tax gap"-the difference between the taxes collected and the amounts that should be paid-may be over $120 billion annually.' to whom should all of the unreported income be attributed for distributional purposes? if substitution of a cash-flow or other broad-based consumption tax for the income tax would simplify the tax system, as advocates contend, compliance levels may change with resulting distributional consequences. b. avenues other thatz cash-flow tar for addressing progressivity concerns in this section, i assume the change to a cash-flow tax would result in an unacceptable loss of progressivity. the question remains whether there 31. see edgar k. browning & william r. johnson. the distribution of the tax burden 2-5 (1979). depending upon federal monetary policy, a consumption tax could result in a decrease in wages rather than a price rise, in which case individuals receiving non-indexed government transfers would not necessarily be burdened. see jct methodology, supra note 28, at 51-60. 32. see george guttman, increasing voluntary compliance to over 90% is unlikely, 63 tax notes 146 (apr. 11, 1994); catherine hubbard, dolan outlines irs efforts to close tax gap, expand electronic filing, 60 tax notes 154 (july 12, 1993). 19951 florida tax review might be ways to deal with progressivity concerns other than through the cash-flow tax. after all, replacement of the income tax with a cash-flow tax would be a major shift, and many other things might also change. consider, for example, a change in the expenditure side of the federal budget. at least in theory, an objection to raising revenue in a manner less progressive than before might be overcome if the money raised were spent in a more progressive way. greater progressivity might be achieved, for example, by increasing the level of expenditures for existing means-tested programs or by means-testing programs that are not yet so limited. unfortunately, distributional analyses of proposed changes in the tax laws typically ignore the incidence of expenditures.33 some artificiality necessarily results from that practice, particularly in a world where the tax and transfer systems are increasingly integrated. a good illustration of that artificiality is the treatment for distributional purposes of the earned income tax credit (eitc). the eitc is a federal program administered through the tax system to provide cash subsidies primarily to low-income workers with family responsibilities. program beneficiaries must file tax returns to claim the credit. some beneficiaries use the credit to offset federal income and self-employment taxes otherwise due, but most take advantage of the fact that the credit is "refundable," meaning that if the credit exceeds income and self-employment tax liability, the beneficiary receives a cash outlay from the government equal to the excess. it is estimated that about 84% of the benefits provided by the program for 1994 consisted of such cash outlays.'m the eitc program, therefore, is partly a tax expenditure but mostly a government spending program administered through the tax system." despite that, the entire program, not just the credits applied to reduce taxes otherwise owed, is taken into account in measuring the distribution of the tax burden because it is classified as a "tax" provision. in other words, even an increase in the spending aspect of the eitc program'is treated as enhancing 33. see jct methodology, supra note 28, at 2-3. 34. house comm. on ways & means, 103d cong., 2d sess., overview of entitlement programs: 1994 green book: background material and data on programs within the jurisdiction of the committee on ways and means 702 (comm. print 1994) [hereinafter 1994 green book]. 35. the congressional budget office classifies the refundable portion of the eitc program as a "means-tested income support program" along with the supplemental security income (ssi) program, which pays cash benefits to elderly and disabled poor people, the aid to families with dependent children (afdc) program, which benefits low-income families with children, and the food stamp program. see congressional budget office, reducing entitlement spending 20 (1994) [hereinafter cbo entitlement report]. if the eitc is viewed as a reimbursement of employee payroll taxes, more of the benefit might be treated as a tax expenditure, and less might constitute "spending." [vol 2:8 acconmmodating the "'low-income" the progressivity of the tax system. in contrast, an identical increase in other government spending programs for the low-income, such as food stamps, is treated as having no effect on tax progressivity because it is ignored in determining the tax burden distribution. quite clearly, the distributional treatment of the eitc program, along with other factors, may well explain its recent popularity among policymakers relative to other spending programs for the poor.36 although the incidence of many government expenditures is difficult to ascertain, it is possible to estimate the incidence of some expenditures, including federal entitlement programs.37 so long as the distributional impact of proposed changes in the law continues to be important to policymakers, sensitivity to the distribution of federal benefits as well as federal burdens would provide greater flexibility in implementing policy.' if tax law changes must be the sole focus, progressivity concerns could be addressed by accompanying the enactment of a cash-flow tax with 36. the following table compares the growth in total federal expenditures for the major means-tested income support programs between 1986 and 1996: growth in federal expenditures for means-tested income support programs, 1986-96 total federal expenditures (s billions) and growth rates 1986 1993 1986-93 1996 1986-96 program spending spending increase spending increase (proj.) (proj.) etc 2.0 13.2 5601% 25.1 1155% ssi 9.5 20.3 114% 27.0 184% food stamps 12.5 24.8 981% n/a n/a afdc 9.2 13.8 50% 14.8 61% source: 1994 green book, supra note 34, at 262 (table 6-25), 389 (table 10-21). 704 (table 16-13), 782 (table 18-11). all spending figures are in current dollars. the phenomenal growth in the eitc program is attributable to three major expansions adopted in 1986, 1990 and 1993. see janet holtzblatt ct al., promoting work through the eitc, 47 nat'l tax j. 591, 591-95 (1994). 37. see cbo entitlement report, supra note 35, at 28-29 (table 10); musgrave & musgrave, supra note 4, at 246 (table 14-2). in 1993, federal spending for entitlement programs totaled more than $750 billion, or more than half of the federal budget. the major entitlement programs include cash social insurance programs such as social security, health insurance programs (medicare and medicaid), pension programs for retired civilian and military personnel, and means-tested income assistance programs such as ssi, afdc, food stamps, and the refundable portion of the eitc program. see cbo entitlement report. supra note 35, at 1-4 (table 1). 38. some federal programs-for example, afdc-have significant state and local components. ideally, changes at that level should also be taken into account in estimating the distribution of burdens and benefits. alternatively, state and local expenditures might be ignored on the theory that federal policymakers should only worry about distributional issues at that level. 19951 florida tax review other modifications to the tax laws. for example, some commentators have suggested that if a cash-flow tax were to replace the income tax, there should be a contemporaneous boost in the wealth transfer taxes (the estate, gift, and generation-skipping taxes).39 the reason is that unlike the income tax, a cash-flow tax may not reach wealth accumulations that are never liquidated for consumption.n however, modifications to the wealth transfer taxes would probably do little to affect the distribution of the overall tax burden because only a small percentage of all wealth is transferred in a taxable manner each year.4 also, the rate structure of that tax is already quite graduated, reaching a maximum rate of 55% for taxable gifts or estates in excess of $3 million.42 the existing exemption level could be lowered, but at the cost of extending a highly complex tax system to many more taxpayers with little improvement in the tax burden distribution. taxing wealth transfers more heavily has another, more fundamental disadvantage. an individual's decision to save may be motivated, in part, by a desire to leave a bequest, and bequest savings may be relatively sensitive to tax rules.4 3 if this is true, taxing wealth transfers more severely conflicts with the desire of consumption tax advocates to increase savings." a more ambitious solution would be to enact a wealth tax that is imposed periodically, rather than on a transfer. such a tax could have a significant impact on the overall distribution of the tax burden. it also might not adversely affect the level of savings if, as some have suggested, individuals save mostly with specific dollar targets in mind. however, such a tax would raise obvious liquidity and valuation problems and would 39. see richard goode, the superiority of the income tax, in what should be taxed: income or expenditure? 49, 71 (joseph a. pechman ed., 1980); gordon d. henderson, alternatives to the income tax, in options for tax reform 78, 89-90 (joseph a. pechman ed., 1984); cf. blueprints, supra note 3, at 125; andrews, supra note 3, at 1172-73. 40. a cash-flow tax can be designed to reach wealth accumulations by treating gifts and bequests as taxable receipts to the donees and consumption to the donors. see blueprints, supra note 3, at 125; henry j. aaron & harvey galper, assessing tax reform 66-67 (1985). 41. presently, estate and gift taxes generate only about one percent of total federal collections. see internal revenue service, 1992 annual report 25 (table 1). of course, the small amount of revenue produced may mask a large behavioral effect of the tax. 42. irc § 2001(c)(1). 43. see edward j. mccaffery, the uneasy case for wealth transfer taxation, 104 yale l. j. 283, 308 (1994) [hereinafter mccaffery-uneasy case] (reporting that at least onefourth of national wealth is held as intergenerational, or bequest, savings); edward j. mccaffery, tax policy under a hybrid income-consumption tax, 70 tex. l. rev. 1145, 1208 (1992), [hereinafter mccaffery-hybrid] (bequest savings may be rather elastic to tax law changes). 44. see mccaffery-uneasy case, supra note 43, at 337-38. there is no firm evidence that replacement of the income tax with a broad-based consumption tax would actually enhance overall savings levels. [vol 2:8 accotmnodating the "'low-income" encounter the technical difficulty of having to make sure the same wealth is not repeatedly taxed. it would also be of questionable constitutional validity in the absence of state apportionment. another, more effective possibility is to introduce greater progressivity into the federal payroll taxes-a move that would be quite easy to implement if these taxes are not repealed in conjunction with the adoption of a consumption tax. for example, to reduce the impact of the taxes on those with low wage incomes, congress could exempt a minimum amount of wages earned each year from the payroll taxes. to enhance progressivity at the upper end of the wage income spectrum, congress could lift the existing cap on taxable wages for purposes of the old-age and survivors and disability insurance taxes.45 however, changes such as these face strong political resistance because they might alter the perception of the social security program as a giant pension plan.' a last possibility is to retain the income tax while adopting a broadbased consumption tax." some have argued that because a consumption tax is ineffective at reaching upper-income taxpayers, an income tax would still be necessary in a consumption tax world.4" others have suggested that if a consumption tax were adopted, an income tax should be retained as a vehicle to deliver benefits to the low-income.49 whatever the reasons advanced for maintaining an income tax, it seems highly unlikely that congress would retain it and enact in addition an individualized broad-based consumption tax like the cash-flow tax. 45. see george k. yin et al., improving the delivery of benefits to the working poor. proposals to reform the earned income tax credit program, ii am. j. tax pol'y 225, 280-86 (1994); george k. yin & jonathan b. forman, redesigning the earned income tax credit program to provide more effective assistance for the working poor, 59 tax notes 951, 958 (may 17, 1993). 46. considering contributions and benefits together, the social security system might already be quite progressive. 47. see william d. andrews, a supplemental personal expenditure tax. in what should be taxed: income or expenditure 127 (joseph a. pechman ed.. 1980) (suggesting adoption of a cash-flow tax as a supplement to the existing income tax). 48. see graetz-revisiting, supra note 17, at 1439; morris, supra note 1. at 1264 (describing vat proposal that would retain a progressive income tax for the very wealthy). 49. for example, some vat proposals, although designed to replace the income tax system, would retain a portion of that system to facilitate delivery of an eitc-type benefit to low-income taxpayers. see kathleen a. matthews, conference examines benefits of u.s. vat, 60 tax notes 255, 256 (july 19, 1993) (describing proposal being developed by congressman gibbons (d.-fi.)); cf. u.s. treas. dep't., tax reform for fairness, simplicity, and economic growth, vol. 3x: value-added tax 44, 100-02 (1984). in other words, the income tax, in all its glory, would be maintained not primarily to collect revenue but rather to make government transfer payments! 19951 florida tax review iv. accommodating the low-income in a cash-flow or consumed income tax world in this part, i assume that some accommodation for low-income taxpayers will be made within the contours of a new cash-flow tax. a goal of senators nunn and domenici, for example, is to craft their cash-flow tax proposal to have the same degree of progressivity as the current income tax, as measured by the distribution of tax burden among income quintiles. 5° my focus is on how the accommodation might take place and the problems it might present. the following sections outline for illustrative purposes how nunn and domenici would try to achieve this objective with respect to taxpayers in the lower income quintiles, and describe some of the difficulties presented by their recommendations.5' a. nunn-domenici proposals affecting the low-income the nunn-domenici cash-flow tax proposal employs three techniques to ensure that the tax is as redistributive at the lower end of the income spectrum as existing law. first, it would use the tax system to effect positive government transfers to low-income taxpayers by means of a negative tax provision, the earned income tax credit (eitc). second, it would exempt many low-income taxpayers from paying positive taxes through both a refundable payroll tax credit and a family living allowance. finally, it would permit those few low-income taxpayers obligated to pay positive taxes to determine their liabilities at the lowest bracket of a graduated tax rate structure. all three methods are presently utilized in the income tax. as previously described, the eitc is a program within the income tax that provides cash subsidies primarily to low-income working families with children. in most instances, the subsidies exceed the beneficiaries' tax liabilities; in those cases, the refundable feature of the credit provides the beneficiary with a cash outlay equal to the excess. the nunn-domenici plan would include an eitc and, based upon the prototype of the plan examined by the congressional budget office, the size of the credit would be roughly 50. see domenici, supra note 2, at 288, 295. 51. there are many other possible ways to accomplish this objective, but all likely involve some variation of one or more of the techniques utilized by the nunn-domenici proposal. for this proposal, see center for strategic and int'l studies, note 2; background materials, a new paradigm for tax reform: the saving exempt income tax (oct. 1993) [hereinafter seit background materials]; congressional budget office, estimates for a prototype saving-exempt income tax (mar. 1994) [hereinafter cbo seit estimates]; domenici, supra note 2; john hakken & frank sammartino, measuring the burden of consumption taxes, 94 tnt 234-60 (dec. 1, 1994) (lexis, fedtax library, tnt file); alliance usa, unlimited savings allowance (usa) tax system, 66 tax notes 1485 (mar. 10, 1995). as of this writing, no legislation has been introduced. [vol 2:8 acconunodating the "low-income" 30% to 100% larger than the existing credit after all of the 1993 act changes to it are fully phased in.5 2 thus, by 1996, the maximum nunn-domenici eitc would be between $4,628 and $7,120 for a qualifying family with two or more children. 3 the credit would be refundable, as under current law. in addition to an eitc, the nunn-domenici plan includes a payroll tax credit that would permit taxpayers to reduce the cash-flow tax, dollar-fordollar, by a portion of any payroll taxes paid, thereby effectively creating a partial exemption from the payroll taxes.' this credit, which would also be refundable, would phase out for taxpayers with "taxable incomes" between $25,001 and $50,001. apart from this credit, the employee portion of payroll taxes would apparently continue as under existing law. the nunn-domenici plan also includes a "family living allowance" to replace the personal and dependency exemptions and the standard deduction. according to senators nunn and domenici, the allowance "recognizes that every family's budget includes necessities and that the federal government should not tax the first dollars earned and spent to maintain a minimal standard of living."55 thus, like the combination of exemptions and the standard deduction under the income tax, the family living allowance would establish a base amount that the taxable unit could consume during the year without payment of any cash-flow tax. senators nunn and domenici expect that the family living allowance will be 170% of the federal poverty guideline. therefore, the allowances for 1994 would be as follows: taxable unit allowance unmarried individual $12,512 family of two $16,728 family of three $20,944 family of four $25,160 family of five $29,376 the additional allowance for each family member beyond the first one is $4,216, with that adjustment being permitted for any size family.' 52. see cbo seit estimates, supra note 51, at 23; domenici, supra note 2. at 29697. 53. as a result of changes enacted by the omnibus budget reconciliation act of 1993 (pub. l. no. 103-66, 1993 u.s.c.c.a.n. (107 stat.) 436). the maximum eitc benefit for a family with two or more children is projected to be s3,560 by 1996. see 1994 green book, supra note 34, at 700 (table 16-11 ). 54. see overview of the nunn/domenici tax proposal, in seit background materials, supra note 51, at 3; domenici, supra note 2, at 296. 55. see domenici, supra note 2. at 295. 56. id. at 295 n.73. the allowance would be indexed to inflation. the figures are based on the 1994 poverty guidelines. see annual update of the hhs poverty guidelines, 59 fed. reg. 6277 (1994). 19951 florida tax review finally, the nunn-domenici cash-flow tax would be implemented with graduated tax rates. the combination of the eitc, payroll tax credit, and family living allowance should ensure that virtually all low-income taxpayers would be exempt from paying positive cash-flow taxes. for any low-income taxpayers not so exempted, the tax would be determined at the lowest of the graduated rates. the congressional budget office estimated that a prototype of the cash-flow tax being considered by senators nunn and domenici might require tax rates in the following ranges for a married couple filing a joint return: 5 7 prototype cash-flow tax taxable income58 current law high range low range 0-$38,000 15% 16% 14% $38,000 $91,850 28% 38% 28% $91,850 $140,000 31% 49% 36% $140,000 $250,000 36% 55% 36% over $250,000 39.6% 55% 36% a later description of the nunn-domenici plan suggests that the family living allowance will only substitute for the standard deduction, with the personal and dependency exemptions being retained. see alliance usa, supra note 51, at 1522. furthermore, taxpayers will be entitled to claim a few itemized deductions in addition to the family living allowance. the combined benefit from the family living allowance and personal and dependency exemptions would, however, be somewhat smaller than the allowance described in the text. for example, the tax-free consumption amount for a family of four wold be only $20,000, not $25,160. id. congressman armey's bill would also establish a base amount below which no taxes would be due. it would provide a standard deduction of $24,700 for a married couple filing jointly, smaller amounts for taxpayers filing as heads of household or unmarried individuals, and an additional $5,000 deduction for each dependent. thus, a married couple with two children and earned income of $34,700 or less would owe no tax under this proposal. all amounts would be indexed to inflation. see h.r. 4585, 103d cong., 2d sess. § 101 (1994). finally, last year's danforth-boren bill proposed to increase the standard deduction for taxpayers filing joint returns by $8,650 (to a total of $15,200 if applicable for 1994). smaller increases were provided for other tax filers. however, the increases only applied to low-income filers and would have been phased out beginning at agi levels of $45,000 for joint filers and $27,000 for single filers. once again, all dollar amounts would have been indexed to inflation. see s. 2160, 103d cong., 2d sess. § 202 (1994). 57. cbo seit estimates, supra note 51, at 22-23 (tables 2 and 3). the ranges depend on the assumed incidence of current taxes and whether the savings rate is determined by the residual or net worth method. see supra note 27 and accompanying text. 58. "taxable income" means taxable consumed income for purposes of the prototype cash-flow tax. also, the "zero-bracket" level-the amount of income that would escape tax altogether due to either the combination of exemptions and the standard deduction under current law or the proposed family living allowance under the cash-flow tax proposal-would not be the same under the proposal and current law. thus, the rate structures of current law and the proposal are not comparable. the figures are provided only to give a flavor for the type of rate structure that might be necessary under the cash-flow tax. [vol. 2:8 accommodating the "low-income" b. implementation issues 1. eligibility for negative tax subsidy.-under current law, the eitc is intended in part to be a work incentive, particularly for people making the transition from welfare to work 59 consequently, the credit is calculated as a percentage of the taxpayer's "earned income," which generally means wages, salaries, and other income from employment, including selfemployment. despite being poor, a taxpayer without earned income gets no benefit at all. moreover, the credit is gradually phased in, meaning that up to some level of income, taxpayers in the phase-in range experience increased benefits as income increases. however, the credit is restricted to those taxpayers with relatively low incomes. t' it is not intended to be a demogrant available to all taxpayers or to all working taxpayers. this additional goal is achieved by gradually taking the credit away from taxpayers (phasing it out or clawing it back) as income (no matter from what source) increases beyond a certain level.6 if these two objectives are also to be satisfied by the eitc provision in the nunn-domenici cash-flow tax proposal,62 the work incentive aspect 59. see s. rep. no. 313, 99th cong., 2d sess. 43 (1986); s. rep. no. 1263, 95th cong., 2d sess. 51-52 (1978), reprinted in 1978 u.s.c.c.a.n. 6761, 6814-15; s. rep. no. 36, 94th cong., 1st sess. 33 (1975), reprinted in 1975 u.s.c.c.a.n. 54, 84. 60. see s. rep. no. 36, supra note 59; s. rep. no. 938, 94th cong., 2d ses. 119 (1976), reprinted in 1976 u.s.c.c.a.n. 3439, 3554. 61. for example, under existing law by 1996, families with two or more children earning not more than $8,900 will be entitled to an eitc benefit equal to 40% of each dollar earned, those with incomes between $8,900 and si 1,620 will receive the maximum benefit of $3,560, and families with incomes between $11,620 and $28,534 will lose their bencfits at the phase-out rate of 21.06% of income in excess of $11,620. all dollar amounts are based on 1994 projections. see 1994 green book, supra note 34, at 700 (table 16-i 1). 62. the nunn-domenici plan is for the eitc to "accomplish the same objectives" as the existing credit. see domenici, supra note 2, at 296. some have argued that because a consumption tax burdens all consumers, not just those with earned incomes, a refundable tax credit should be available more broadly to all poor persons. such a provision would require millions more people to file tax returns to get this benefit. see joseph j. minarik. making tax choices 88 (1985). to mitigate the effects of its corporate cash-flow tax on the low-income, the danforth-boren bill included a refundable "individual tax credit" calculated as a percentage of adjusted gross income, not earned income. see s. 2160, 103d cong., 2d sess. § 203(a) (1994). david bradford has proposed that a provision similar to the earned income credit should be included in a cash-flow tax to compensate for the denial of a deduction at the firm level for salaries paid to workers. see bradford, supra note 6, at 387; david f. bradford, an uncluttered income tax: the next reform agenda? (july 1988) (unpublished discussion paper). ed mccaffery has suggested that such a provision might relieve some of the burden of a cash-flow tax on current period earnings and might shift more of the burden to consumption funded out of savings. see mccaffery-hybrid, supra note 43, at 1195. in this 19951 florida tax review of the eitc could be accomplished by continuing to base the credit on the taxpayer's earned income. but how should the benefit be restricted to the low-income? indeed, who are the "low-income" in a cash-flow tax world: taxpayers with low consumed income or some other group entirely? consider two taxpayers with the profile previously described for the low-wage worker, whose annual income consists of $14,000 in wages and $1,000 in alimony. one of them, like the low-wage worker, consumes every bit of her income whereas the other is more frugal and manages to save $1,000 for the year. thus, before taxes, the first taxpayer has $15,000 of consumed income, and the more frugal taxpayer has $14,000 of consumed income. if they had much higher levels of income, the more frugal taxpayer would bear a lower cash-flow tax than the other taxpayer in recognition of the frugal taxpayer's decision to consume less and save more. assume, however, that because of their low consumption levels and the availability of a minimum consumption allowance, neither owes any tax, and the only question is how much eitc each should receive. consistent with how they would be treated if they had positive tax liability, it might be appropriate for the more frugal taxpayer to obtain the larger subsidy, thereby rewarding her for her thrift. in that case, and assuming they are both in the phase-out range of the credit, "low-income" should mean "low consumed income." the two taxpayers have the same income before savings, but the more frugal one has less consumed income. that being the case, less of the eitc would be clawed back from the more frugal taxpayer.63 but consider a third taxpayer, such as the middle-income investor, who has $15,000 in wages, $20,000 in interest and dividend income, and $50,000 in proceeds from the sale of stock investments. because she reinvests or makes a gift of all of her capital income and proceeds, her consumed income for the year before taxes is only $15,000. assume that because of her frugality and the availability of a minimum consumption allowance, she owes no positive cash-flow tax. should she be entitled to the eitc? if, as suggested above, "low-income" is defined as "low consumed income," she might get a substantial eitc. on the other hand, if "low-income" is defined paper, i do not consider any of these alternative rationales for an earned income credit in a cash-flow tax world. 63. the consequences would be exactly the opposite if the two taxpayers were in the phase-in range of the credit. in that case, if consumed income were the base for calculating the eitc, the more frugal taxpayer, with less consumed income, would get a smaller credit. i have assumed, however, that in the phase-in range, the credit would be solely a function of earned income, as under current law. see supra note 61 and accompanying text. hence, if the two taxpayers have the same low level of earnings ($14,000) and are in the phase-in range, they would get the same credit. [vol 2:8 accommodating the "'low-income as income before savings, the taxpayer probably would not receive any subsidy. which result is more appropriate? to frame the question slightly differently, should this taxpayer obtain the same eitc as one with $15,000 in wages, no capital income, and no savings?' in part, these questions raise one of the fundamental issues in the income tax versus consumption tax debate: what should the tax base be? supporters of the income tax argue that income is a better measure of a taxpayer's overall resources and, therefore, ability to pay. consumption tax proponents respond with several related arguments.' 5 they argue that consumption reflects the taxpayer's chosen lifestyle-his or her standard of living-and that what a taxpayer withdraws from the "common pool" is a more appropriate standard for taxation than what the taxpayer contributes to the pool. further, they argue that consumption is a better measure of a taxpayer's lifetime ability to pay because tax liability would be based on the present value of the taxpayer's total lifetime resources. finally, proponents assert that a cash-flow tax is preferable to an income tax because it more closely resembles an endowments tax; it would place a similar tax burden on taxpayers with equal opportunities, as opposed to those who simply have equal outcomes. however one resolves the debate about the proper base for imposing positive tax liability, the eitc adds an additional wrinkle. under an integrated view of the tax and transfer systems, the eitc may simply be one end of the spectrum of low and high taxation, with "low taxation" dipping into negative amounts. under this view, if consumption is the proper base for positive taxation, it should also be the proper base for negative taxation (or 64. the three other sample taxpayers, the altruistic middle-income worker, the student, and the senior citizen, have different amounts of earned income and therefore, from a work incentive standpoint, should have different eitc benefits. under certain assumptions, however, each has $15,000 of consumed income for the year. thus, from strictly an income security standpoint, should they be entitled to the same amount of eitc, and should this amount be the same as for the taxpayers described in the text? 65. for some of the debate on this issue, see blueprints. supra note 3. at 35-39; bradford-untangling, supra note 3, at 154-56, 165-66, 315; kaldor, supra note 3. at 46-53; andrews, supra note 3, at 1165-77; william d. andrews, fairness and the personal income tax: a reply to professor warren, 88 harv. l. rev. 947 (1975); don fullerton. the consumption tax: an idea whose time has come? 27 tax notes 435 (apr. 22, 1985); goode, supra note 39, at 49-73; mark kelman, time preference and tax equity. 35 stan. l rev. 649 (1983); alvin c. warren, jr., fairness and a consumption-type or cash-flow personal income tax, 88 harv. l. rev. 931 (1975) [hereinafter warren-fairnessl; alvin warren, would a consumption tax be fairer than an income tax?, 89 yale l j. 1081, 1094-95, 1098-1101 (1980) [hereinafter warren-would]. 19951 florida tax review positive transfers).66 in other words, if consumption levels are low enough, one should get the credit.67 however, the prospect of negative taxation may introduce a different perspective altogether.6 ' federal welfare programs, for example, uniformly base eligibility on income levels, resource levels, or both, not consumption levels.69 moreover, in contrast to a lifetime, or even an annual, time frame, 66. cf. william a. klein, the definition of "income" under a negative income tax, 2 fla. st. u. l. rev. 449, 458-59 (1974). 67. under this approach, taxpayers should be required to return their eitcs to the government if their consumption levels are subsequently sufficiently high. if all receipts are eventually consumed, any amounts saved (and therefore not taxed) will be consumed (and taxed) at a later time, and the income versus consumption tax issue is simply one of timing. the negative tax system would reach the same result only if all subsidies are eventually returned when consumption levels become high. 68. some of these points have been discussed in the negative income tax (nit) literature. in general, commentators have argued that the tax base for purposes of the nit should be much more comprehensive than that for the positive income tax system, potentially encompassing such items as the imputed net rental value of owner-occupied homes, the value of food grown and consumed on a farm, and other non-monetary forms of income. see, e.g., sheldon s. cohen, administrative aspects of a negative income tax, 117 u. pa. l. rev. 678, 683-87 (1969); klein, supra note 66; william a. klein, familial relationships and economic well-being: family unit rules for a negative income tax, 8 harv. j. on legis. 361, 366-67 (1971) [hereinafter klein-family unit rules]; william a. klein, some basic problems of negative income taxation, 1966 wis. l. rev. 776, 782-86 (1966); william d. popkin, administration of a negative income tax, 78 yale l.j. 388, 389-92 (1969); james tobin et al., is a negative income tax practical? 77 yale l.j. 1, 11-14 (1967). see also anne l. alstott, the earned income tax credit and some fundamental institutional dilemmas of taxtransfer integration, 47 nat'l tax j. 609, 611 (1994) [hereinafter alstott-fundamental dilemmas]; anne l. alstott, the earned income tax credit and the oversimplified case for tax-based welfare reform, 108 harv. l. rev. 533, 571-76 (1995) [hereinafter alstottoversimplified case]. 69. there are three income-related eligibility tests for afdc, with "income" generally being defined very broadly to include, for example, support and maintenance assistance and, at state option, items such as food stamp coupons and the value of government housing subsidies. see 42 u.s.c. § 602(a)(7), (18) (1994); 45 c.f.r. § 233.20(a)(1)(i), (3)(ii)(a), (xi), (xii), (xvi) (1993); center on social welfare policy, afdc program rules for advocates: an overview 8 (welfare law ctr. publ. no. 160, june 1993) [hereinafter afdc program rules]. afdc recipients also generally may not have more than $1,000 in resources, not including the value of their home and certain other basic maintenance items. see 42 u.s.c. § 602(a)(7)(b) (1994); 45 c.f.r. § 233.20(a)(3)(i)(b) (1993); 1994 green book, supra note 34, at 331; afdc program rules, supra, at 8, 11-12. the food stamp and ssi programs have similar income and resource limitations. for food stamps, see 7 u.s.c. § 2014(a)-(g) (1994); 7 c.f.r. §§ 273.8, 273.9 (1994); 1994 green book, supra note 34, at 763-66. for ssi, see 42 u.s.c. §§ 1381a, 1382(a), (d), 1382a, 1382b (1994); 20 c.f.r. §§ 416.202(c), (d), 416.1102 to 416.1104, 416.1201 to 416.1266 (1994); 1994 green book, supra note 34, at 213-17. [vol 2:8 accommodating the "low-income" welfare benefits are typically determined on a month-to-month basis.7 thus, if the eitc is analogous to a welfare program, eligibility for the credit should be based on a standard of need that refers to current resources (as opposed to standard of living) and current outcomes (as opposed to lifetime expectations). a taxpayer who chooses a low standard of living ought not, by that reason alone, to receive a government outlay. indeed, the purpose of the subsidy is, in part, to raise the consumption levels of beneficiaries to some minimal level. taxpayers with low levels of consumption who have the resources to consume at higher levels should be required to use those private resources, rather than the government's resources, if they wish (or need) to consume more.7 1 a welfare perspective of the eitc has three important policy implications. first, a cash-flow tax system is particularly ill-suited as a vehicle for delivering an eitc that is viewed as a welfare program. as previously noted, an important advantage of the cash-flow tax is that it avoids the necessity of calculating income from capital. but all of the problems of capital income computations would be revived by a cash-flow tax system containing an eitc with eligibility criteria based on economic income. the middle-income investor, for example, would need to know not only the amounts received in selling stock investments (a cash-flow concept) but also the amount of gain or loss realized in the sales (an economic income concept).72 thus, the presence of the eitc in a cash-flow tax system might require dual tax base determinations: one that measures consumed income for purposes of the positive tax system and another that measures economic income for purposes of the negative tax system. because taxpayers move 70. see 45 c.f.r. §§ 233.31, 233.36 (1993) (afdc); 7 c.f.r. § 273.10(a)(1)(i) (1994) (food stamps); 20 c.f.r. §§ 416.1100, 416.1207(a) (1994) (ssi). an annual, or even a lifetime, time frame would help to target the program's benefits for the long-term poor. rather than just the temporarily poor. on the other hand, a monthly test is more responsive to the need of the beneficiary. see cbo entitlement report, supra note 35, at 25; michael r. asimow & william a. klein, the negative income tax: accounting problems and a proposed solution, 8 harv. j. on legis. 1, 6-10 (1970). 71. more than 25 years ago, professors tobin. pechman. and mieszkowski, in discussing whether a negative income tax benefit should be provided to a taxpayer with ample resources but little income, argued that "the mere possibility that the public might be obliged to such a capitalist could discredit the program." see tobin et al., supra note 68, at 17. it remains to be seen whether public attitudes have changed enough to allow that outcome under a cash-flow tax. 72. indeed, one would want to know even more about the middle-income investor, including the amount of the unrealized appreciation or depreciation in her assets during the year. see klein, supra note 66, at 464. this example epitomizes the inherent conflict between a tax subsidy like the eitc, which may require reliance upon comprehensive income principles to be effective, and the cash-flow tax, which is a step away from such principles. 19951 florida tax review between the two systems from period to period, many of them might be required to do double calculations. second and more generally, a cash-flow tax system would restrict the ability of both the tax and the transfer systems to respond to policymakers' desires to distribute federal benefits to low-income households. with a cashflow tax system, means-tested government transfer programs would lose the yardstick of economic income now roughly available under the income tax law, and would have to rely more on an economic resources standard for determining eligibility.73 as one commentator has stated, "[r]ather than attempt to improve an existing accounting system, a [cash-flow] tax would require the development of an additional accounting system for federal income tax purposes only." 74 finally, a welfare view of the eitc suggests that even under current law, the method of clawing back the benefit may be incorrect. after all, the existing income tax is not a pure income tax; it has significant consumption tax components, with various forms of savings being excluded from the tax base. eligibility for the eitc as a welfare program should ignore those consumption tax elements and should be based upon economic income and/or economic resource levels of potential beneficiaries, not their adjusted gross incomes as under current law.75 2. problems associated with larger negative tax subsidy.-as noted, the nunn-domenici proposal would substantially increase the negative 73. for some purposes, the definition of "income" used in the ssi program refers to the federal income tax meaning of the term. see, e.g., 42 u.s.c. § 1382(d) (1994). also, the irs is required to furnish the social security administration with certain nonwage information about ssi recipients to help identify bank accounts that may contain balances exceeding the resources limitation. see 1994 green book, supra note 34, at 216. thus, adoption of a cash-flow tax system might jeopardize the ability of nontax agencies to measure and verify economic resources. 74. c. eugene steuerle, taxes, loans and inflation: how the nation's wealth becomes misallocated 173 (1985). 75. see alstott-oversimplified case, supra note 68, at 574-76 cherie j. o'neil & linda b. nelsestuen, the earned income credit: the need for a wealth restriction for eligibility determination, 63 tax notes 1189 (may 30, 1994) (reporting that taxpayers with "portfolio income" in excess of $299,000 and capital gains as high as $677,900 were eligible for the eitc); yin et al., supra note 45, at 268 n.153. president clinton's fy 96 budget proposes to preclude a taxpayer from obtaining the eitc if his or her aggregate interest and dividend income exceeds $2,500. according to the proposal, such taxpayers can draw upon their significant private resources to meet the needs of their family. see u.s. dep't of treasury, general explanations of the administration's revenue proposals, 95 tnt 25-37 (feb. 7, 1995) (lexis, fedtax library, tnt file); h.r. 981, 104th cong., 1st sess. § 102 (1995) (house bill version of president's proposal); s. 453, 104th cong., 1st sess. § 102 (1995) (senate bill version). [vol 2:8 acconmmnodating ihe "'low-incomne" tax subsidy provided through the tax system, apparently as an antidote to the regressive nature of the cash-flow tax. experience with the eitc suggests, however, that any such increase should be implemented with great caution. one cause for concern is the difficulty of mitigating the credit's work disincentive effects on those in the phase-out range of the credit. taxpayers within that range face unambiguously negative work incentives: the diminution of the credit as income rises creates a negative "substitution effect" by decreasing the reward for working more instead of choosing leisure, yet the existence of the credit continues to provide a negative "income effect" by permitting taxpayers to attain a given level of income with less work.76 if the existing contours of the eitc are retained, a larger maximum credit would force policymakers to make one of three difficult choices. first, they could maintain the parameters of the current phase-out range and claw back the larger benefit within that range at a faster rate. this option would create higher marginal tax rates and greater work disincentive effects for those in the phase-out range. these effects would need to be evaluated in conjunction with similar consequences arising from the phase-out of other tax and transfer benefits, both federal and state.' a second option would be to maintain the existing phase-out rate, with the result that the phase-out would be completed at a higher income level and many more taxpayers would 76. see saul d. hoffnan & laurence s. seidman, the earned income tax credit: antipoverty effectiveness and labor market effects 37-42 (1990): holtzblatt, ct al., supra note 36, at 593-94; marvin h. kosters, the earned income tax credit and the working poor. 4 am. enterprise 64 (may/june 1993). the labor supply effects would potentially be mixed for those in the phase-in range of the credit as well as those who must pay higher taxes to finance the credit. the former group would experience a positive substitution effect but a negative income effect; if the credit is financed through higher tax rates, the opposite combination of effects would arise for those in the latter group. to be sure, in the absence of empirical evidence, one cannot say whether the existence of the credit has any actual effect on the work/leisure decision. but if the credit does discourage work for those in the phase-out range of the credit, then increasing the size of the credit will likely make that effect more pronounced. 77. two recent studies have examined the cumulative burden of explicit and implicit taxes on low-income households resulting from federal and state tax and transfer programs. one study found that typical tax rates for such households rarely exceed 407c and concluded that "tax rates are not so high as to dismiss the possible effectiveness of policies ... that try to make work more attractive than welfare." stacy dickert et al., taxes and the poor. a microsimulation study of implicit and explicit taxes, 47 nat'l tax j. 621, 636 (1994). another study of cumulative tax rates faced by afdc recipients reached a less optimistic conclusion. it found that in deciding whether to work at a full-time minimum wage job or to increase their work effort beyond some minimal level, a significant portion of these recipients face tax rates of 100% or more. it concluded that welfare reforms providing modest incentives with a gradual phase-out of benefits may no longer be viable options. linda giannarelli & eugene steuerle, it's not what you make, it's what you keep: tax rates faced by afdc recipients 13-14 (oct. 1994) (draft manuscript). 19951 florida tax review become eligible for some eitc. this choice would make the credit less targeted toward the low-income and would extend the work disincentive effects of the clawback to a larger group of people.78 third, the phase-in rate could be increased, causing benefits to rise more sharply for those in the phase-in range and the maximum benefit amount to be reached at a lower income level. the phase-out of the benefit could then take place more or less at the same rate and up to the same income level as under current law. the problem with a higher phase-in rate is that it increases an incentive for fraud. irs studies have shown a consistently high noncompliance rate for the eitc program, with between 30% and 40% of claimants being ineligible for any benefit.79 the revenue loss attributable to eitc ineligibility has been estimated to be as high as $5 billion annually." until recently, there has been little hard evidence of the proportions of the noncompliance attributable to inadvertent errors due to the complexity of the eitc rules, on the one hand, and to intentional errors, on the other. at a 1994 congressional hearing, however, the commissioner of internal revenue testified that based upon an irs study conducted in january of 1994, about 50% of the eitc errors appeared to result from "intentional misrepresentations."'" intuitively, one assumes that the larger the credit, the greater the incentive to commit fraud to obtain it. a prominent feature of the credit-that it increases with greater earnings over the phase-in range-makes the program unusually susceptible to fraudulent claims. when taxpayers in that range overstate earned income to obtain a larger benefit, it is difficult for the irs to identify and disprove the false claims, especially if the overstatement is of income from self-employment.82 a higher phase-in rate would increase the amount by which the eitc benefit resulting from an income overstatement exceeds the income and payroll taxes on the fictitious income. hence, 78. in 1990, before major increases to the eitc program enacted in 1990 and 1993, one-tenth of all families and one-fourth of all families with children received the credit. see cbo entitlement report, supra note 35, at 22-23. current projections are that by 1996, the eitc will be received by about 18.7 million families with incomes up to $28,524. see 1994 green book, supra note 34, at 700 (table 16-1 1), 704 (table 16-13). most of the recipients are already in the phase-out or clawback range of the credit. see kosters, supra note 76, at 68. 79. see yin et al., supra note 45, at 247-48, 296 (table 1). 80. see george guttman, improper refunds sapping billions; irs, treasury, hill seek answers, 65 tax notes 19, 22 (oct. 3, 1994). 81. see hearing before the senate committee on governmental affairs on high risks and emerging fraud: irs, student loans, and hud, s. hrg. 103-975, 103d cong., 2d sess. 17 (1994) (testimony of irs commissioner margaret m. richardson). 82. see gene steuerle, the irs cannot control the new superterranean economy, 59 tax notes 1839 (june 28, 1993); yin et al., supra note 45, at 259-60. [vol. 2:8 acconzwdating ie "low-izcone" a higher phase-in rate would likely make this particular form of fraud more common. 8 3 finally, a larger credit would aggravate its effect on the decision to marry. under present law, the same eitc eligibility rules (including the phase-in and phase-out income cut-off points) apply to married couples filing joint returns and to unmarried individuals.' hence, two unrelated individuals, either or both of whom are eligible for the eitc by themselves, may suffer a loss of most or all of that benefit if they marry and are thereafter required to pool their incomes in determining eligibility. the marriage penalty under existing law from the eitc alone can be as high as $5,686; the penalty would be even greater with a larger credit. 3. implementing the payroll tax credit.-the nunn-domenici plan includes a refundable credit against the cash-flow tax for some portion of the taxpayer's payroll taxes. viewed in isolation, this credit might seem to be a useful device to reduce the tax burden of low-income taxpayers. it could logically be phased in and out based on the taxpayer's taxable wages, the tax base for the payroll taxes.s6 the phase-out would create a work disincentive, but this effect would be mild, given the relatively low rate of the payroll taxes and credit.' if the credit is available to all individuals, including both partners to a marriage, there would be no marriage penalty. (on the other 83. to illustrate, assume that in a nunn-domenici cash-flow tax world, the phase-in rate is increased so that a taxpayer with $8,900 of earned income is entitled to a maximum eitc of $7,120. (under current law, it is projected that by 1996, a maximum benefit of s3,560 will be available to a taxpayer with income of $8,900. the illustration assumes a doubling of the phase-in rate to 80% in order to permit a 100% increase in the size of the nunn-domenici credit.) a taxpayer with no earned income who, nevertheless, reports s8,900 of such income would have to pay $1,362 in self-employment tax (15.3% of s8,900) but no cash-flow tax. hence, by so overstating earned income, the taxpayer would obtain a net cash benefit of $5,758 ($7,120 less $1,362) plus credit toward social security retirement benefits. 84. the credit is denied to married individuals who file separately. irc § 32(d). 85. [author's calculations] see daniel r. feenberg & harvey s. rosen. recent developments in the marriage tax, (natural bureau of economic research) working paper no. 4705, 1994) (apr. 1994). 86. it is unclear what senators nunn and domenici intend in basing the proposed phase-out of the credit on "taxable income." see supra note 54 and accompanying text. as previously described, in a cash-flow tax system, "taxable income" would presumably be consumed income--the taxpayer's taxable consumption. if the phase-out is to be based on economic income, that amount would have to be ascertained from elements not part of the normal cash-flow tax system. 87. the credit rate would presumably be no higher than either 7.65 or 15.3%. depending upon what portion of payroll taxes are to be rebated and whether the rebate applies only to the employee's share of payroll taxes or to both the employee's and employer's shares. see irc §§ 3101(a), (b), 311 l(a), (b). 19951 florida tax review hand, two-worker married couples might be advantaged over couples with only one person working outside the home.) the credit might be relatively easy to administer since the information needed to compute the credit and its phase-out-the taxable wage base and the amount of payroll taxes paid-would ordinarily be available from the form w-2 payroll statement. however, if enacted in conjunction with the eitc just described, a payroll tax credit makes much less sense. it raises many of the questions presented by the eitc regarding the mechanics and effect of the credit phaseout. indeed, the payroll tax credit would seem to be wholly subsumed by the eitc, which originated in large part as a partial rebate of payroll taxes. s it is unclear why two separate credits are required or desirable. it would be far simpler for both the irs and taxpayers to offer only one credit. a more fundamental question is why payroll tax relief should take the form of a credit against the cash-flow tax. the easiest way to mitigate the payroll tax burden of low-income taxpayers is to exempt a certain level of wages from the tax. 9 an exemption ensures virtually 100% participation without the need for beneficiaries to file tax returns, and compliance with an exemption rule could be expected to be high. a possible disadvantage of an exemption, as opposed to a credit against income taxes, is that the resulting subsidy may not be as well-targeted to the poor. to function simply, an exemption would have to be available to all taxpayers, both rich and poor. by raising the payroll tax rate on wages above the exemption amount or lifting the cap on taxable wages for purposes of the oasdi portion of the tax, congress could recapture the benefit of the exemption from middleand upper-income wage earners, but neither of these approaches would affect taxpayers with low wage income but large amounts of capital income. including a payroll tax credit in a cash-flow tax, however, does not overcome that objection because the cash-flow tax base also excludes income from capital. in other words, if the payroll tax credit is phased out based on either consumed income or wages, it would be no better targeted than an exemption, while being much more cumbersome. to be sure, there is an appealing political reason for adopting a payroll tax credit rather than a social security tax exemption. by leaving the social security system as it is, politicians may be better able to assert that the integrity of that system is unaffected. indeed, in explaining the payroll tax 88. see s. rep. no. 938, 94th cong., 2d sess. 119 (1976), reprinted in 1976 u.s.c.c.a.n. 3439, 3554-55; s. rep. no. 36, 94th cong., 1st sess. 32-33 (1975), reprinted in 1975 u.s.c.c.a.n. 54, 82-83. 89. for a detailed discussion of these issues, see yin & forman, supra note 45; yin et al., supra note 45, at 280-86. [vol 2:8 acconunodating the "low-incone" credit, senator domenici made exactly that claim." but the claim is political chicanery. the reality is that with the proposed payroll tax credit (as well as with the existing eitc), the link between social security taxes and benefits would be decoupled for low-income wage earners. they would ostensibly pay social security taxes, and therefore get to count their wages in computing social security benefits, even though they would be reimbursed for the taxes through the proposed refundable payroll tax credit. roughly the same result could be accomplished more simply by not collecting social security taxes from those workers, preserving their social security benefits, and transferring (for accounting purposes) the revenue cost of the exemption from general revenues to the trust funds. a final issue affecting the eitc and, particularly, the proposed payroll tax credit is the manner in which those benefits would be delivered to their intended beneficiaries. under current law, a portion of the eitc benefit may be received by qualifying individuals during the year through increases in their paychecks, a form of negative withholding." congress believed that "advance payment" of the benefit during the year serves as a better work incentive and provides the assistance at the time the beneficiary is more likely to need it.92 this goal is especially important for the proposed payroll tax credit because payroll taxes are withheld throughout the year. unfortunately, the eitc advance payment system has thus far been an abysmal failure due, in part, to the difficulty of ascertaining the proper amount to award in advance. 93 that determination would be even more difficult in a cash-flow tax system if the negative withholding amount is computed taking into account the taxpayer's projected savings for the year.' 90. see domenici, supra note 2. at 296 ("[the payroll tax credit] facilitates our goal of retaining the progressivity of the current income tax and helps neutralize the regressive nature of the current payroll tax while maintaining the financial integrity of the social security trust fund"); cf. rudolph g. penner, outline of discussion of individual selt, in seit background materials, supra note 51, at 2 (under the nunn-domenici plan, -[a) credit would be provided for the employee share of the payroll tax. social security accounting would not be affected. there would still be a payroll tax levied and deposited in the oasdi trust funds."). 91. irc § 3507. 92. see s. rep. no. 1263, 95th cong., 2d sess. 52 (1978). reprinted in 1978 u.s.c.c.a.n. 6761, 6815. 93. see general accounting office, earned income tax credit: advance payment option is not widely known or understood by the public (gao/ggd-92-26) (1992); yin et al., supra note 45, at 246-47, 257-58. 94. determining the proper withholding amount would also be a problem for the positive cash-flow tax system. see committee on simplification, supra note 17, at 421; graetz, supra note 11, at 1595-96. 19951 florida tax review 4. proper taxable unit.-as is the case with the income tax, many factors affect the choice of taxable unit for the cash-flow tax, and there is no completely satisfactory solution to this issue. in this section, i briefly describe a few of the considerations particularly affecting low-income taxpayers.95 under current law, the basic taxable unit is the individual, although there are important exceptions for married couples, heads of households, and taxpayers with dependents. 96 for example, the so-called "kiddie tax," under which certain unearned income of a minor child is taxed at the parent's marginal rate, requires a tax result comparable to joint filing. 7 however, there is no general rule requiring or permitting aggregate reporting for all members of a family or household. a welfare perspective of the negative cash-flow tax system supports a broad definition of the taxable unit, perhaps encompassing the taxpayer's "family" or "household. '9 8 in determining need-based entitlement to the negative tax subsidy, it would make sense to consider the economic status of the taxpayer's entire support group. for example, it would not be appropriate to award the subsidy to a low-income taxpayer who can look for support to a spouse, parent, or other relative with sufficient resources and income.99 a broad definition of the taxable unit is consonant with federal welfare programs."° 95. for comprehensive analyses of this question in connection with the income tax, see staff of joint comm. on tax'n, the income tax treatment of married couples and single persons, 96th cong., 2d sess. (1980) [hereinafter jct married couple report]; boris i. bittker, federal income taxation and the family, 27 stan. l. rev. 1389 (1975); marjorie e. kornhauser, love, money, and the irs: family, income-sharing, and the joint income tax return, 45 hastings l.j. 63 (1993); edward j. mccaffery, taxation and the family: a fresh look at behavioral gender biases in the code, 40 ucla l. rev. 983 (1993); michael j. mcintyre & oliver oldman, taxation of the family in a comprehensive and simplified income tax, 90 harv. l. rev. 1573 (1977); martin j. mcmahon, jr., expanding the taxable unit: the aggregation of the income of children and parents, 56 n.y.u. l. rev. 60 (1981); stanley s. surrey, family income and federal taxation, 24 taxes 980 (1946); lawrence zelenak, marriage and the income tax, 67 s. cal. l. rev. 339 (1994). 96. irc §§ l(a), (b), 151(c). 97. irc § l(g). under certain circumstances, the parent may elect to have the child's income reported on the parent's return, thereby relieving the child of the need to file a return. irc § 1(g)(7). 98. see alstott-fundamental dilemmas, supra note 68, at 611; alstott-oversimplifled case, supra note 68, at 576-79; klein-family unit rules, supra note 68, at 370-72; popkin, supra note 68, at 403-04. 99. see zelenak, supra note 95, at 398-99. 100. for afdc, where the recipient is technically the dependent child, the income and resources of any parent or sibling of the child living in the same home is considered. 42 u.s.c. § 602(a)(38) (1994). in addition, under certain circumstances, the income and resources of other persons living in the home is included. see id. at § 602(a)(39) (deemed inclusion of grandparent's income and resources); afdc program rules, supra note 69, at 101l. for food [vol 2:8 accommodating the "'low-income in theory, household consumption should be apportioned among the members of the household by including gifts and support transfers in the donee's cash-flow tax base and allowing the donor a deduction for those amounts. thus, a taxpayer who is supported by others, and is therefore not needy, should report enough consumed income to be disqualified from the negative tax benefit, even if the taxpayer files individually. but it may be difficult to enforce accurate reporting of many common forms of support, including food, housing, and clothing. moreover, as previously discussed, it may be appropriate to use economic income, not consumed income, as the measuring stick for testing eligibility for the negative tax subsidy, and gifts and support transfers may not be treated as economic income. at first blush, a family or household taxable unit might also seem to be a necessary feature of the positive cash-flow tax system because of the likely pooling of consumption expenditures within the family or household. however, because the positive cash-flow tax system measures consumption indirectly (generally, by subtracting savings from economic income), no allocation of joint consumption expenditures would necessarily have to be made if the basic taxable unit were individual-based as under current law. if people tend to save as individuals rather than through joint investments with other family members, the cash-flow tax base could in theory be determined from the taxpayer's individual income and savings for the taxable period, without any allocation of items among family members. however, as a conceptual matter, the joint nature of consumption expenditures among family or household members supports a taxable unit consisting of the family or household. consider two two-person low-income families, each with $15,000 of consumed income before deduction of living allowances. in one family, the consumed income is divided unequally$10,000 belongs to one member and only $5,000 to the other-whereas in the other family, each member has $7,500 of consumed income. if the family were the taxable unit with a living allowance of $7,500 for each family member, neither family would owe any cash-flow tax. in contrast, if the individual were the taxable unit with a $7,500 per person living allowance, the family in which the consumed income is split unequally would have to stamps, eligibility is based on the income and resources of the "'household." a broad concept that includes, for example, a "group of individuals who live together and customarily purchase food and prepare meals together for home consumption." 7 u.s.c. §§ 2012(i)(2). 2014(a) (1994). see 1994 green book, supra note 34, at 762-63. for ssi. the income and resources of the recipient and his or her spouse living in the same home is counted. 42 u.s.c. § 1382c(f)(1) (1994). see 1994 green book, supra note 34, at 220-21. in addition, a recipient living in another person's household who receives in-kind support from such person is only entitled to reduced benefits. 42 u.s.c. § 1382a(a)(2)(a) (199 4 ). see 1994 green book. supra note 34, at 217-18. 19951 florida tax review pay some tax because one of the individual living allowances would not be fully utilized. if standard of living is the proper basis for taxation, there seems to be little policy rationale for taxing the two families differently.' in a cash-flow tax world, the family whose members consume unequally could resort to self help through the simple expedient of deductible support transfers from the higher consuming member to the lower one. but that fact also supports a family or household taxable unit rule. individual filing would encourage the reporting of real or fictitious intra-household transfers to even out consumption patterns within the household.102 rather than foist that degree of tax planning upon taxpayers, with the only losers being the ill-advised, and rather than require the irs to sort out true consumption patterns within a household, it would be better to mandate a family/household taxable unit rule, allowing intra-household transfers to be ignored altogether."' the problem of intra-household transfers could be avoided, as it is under current law, by treating gifts as consumption by the donor, denying any deduction from the donor's cash-flow tax base for a gift. however, such a rule would be inconsistent with the theory of the cash-flow tax, and it would cause a gift of an amount previously saved to be taxable to the donor, in contrast to the nontaxation of continued or reinvested savings.?° moreover, to avoid taxing the gift twice, gifts would have to be excluded from the donee's cash-flow tax base, regardless of whether the donee saves or consumes the amount of the gift. equity concerns might surface if gifts could be consumed without tax consequences but sweat-of-the-brow income could 101. the argument in the text is equally applicable to higher income families because of the progressive tax rate structure. indeed, the same issue arises under the income tax, where the argument is used to justify the joint tax return for married couples. see bittker, supra note 95, at 1392-95. however, because pooling of consumption is probably more common than pooling of income (the chief difference being whether savings is made jointly or individually), the case for a family/household taxable unit in a cash-flow tax world may be more compelling than under the income tax. see zelenak, supra note 95, at 354-58. 102. see graetz, supra note 11, at 1625. for some low-income households, the incentives may run in the other direction. for example, it might be advantageous to report uneven consumption patterns within a household to maximize the negative tax subsidy available to the lower consuming member. the strategy would be beneficial if the additional subsidy to the lower consumer is greater than the additional tax liability borne by the higher consumer. 103. in blueprints, the treasury recommended a family taxable unit for both the cash-flow tax and a proposed comprehensive income tax. blueprints, supra note 3, at 92-94, 104. the latest description of the nunn-domenici proposal, however, seems to indicate that it will not change the tax filing unit rules of current law. see alliance usa, supra note 51, at 1489, 1522-23 (required tax filing by individuals, with permissible joint filing by married couples). 104. see graetz, supra note 11, at 1625. [vol. 2:8 acconunodating the "low-income" not be. on the other hand, if the gift were saved, the donee might unfairly be taxed at some later time when the savings is consumed, in the absence of a complicated earmarking scheme."'0 the illustrations highlight the potential risks of deviating too far from the basic cash-flow tax theory once that tax is adopted.1°6 in short, for both positive and negative cash-flow tax purposes, there are distinct policy reasons for having the family or household be the taxable unit.' 7 unfortunately, such a rule also has severe drawbacks." the most obvious is the need to develop a workable definition of "family" or "household." even the current law concept of married individuals' has been criticized as ambiguous."0 any attempt to categorize the extended family living arrangements that are perhaps more common among low-income households would be extremely problematic."' moreover, the self-assessment feature of the tax system, along with an inconsequential rate of audit, would virtually guarantee a haphazard application of the law and resulting 105. see domenici, supra note 2, at 303. 106. another possibility is to tax the same gift twice. but this approach would have the effect of converting the cash-flow tax into a lifetime income tax. see aaron & galper, supra note 40, at 66-67. it also would be difficult to administer because neither the donor nor the donee would have any incentive to report the gift. for a more complete discussion of the issues raised by the cash-flow tax treatment of gifts and bequests and the resulting problems of consumption-splitting, see committee on simplification, supra note 17. at 427-31 -1. clifton fleming, jr., scoping out the uncertain simplification (complication?) effects of vats, bats, and consumed income taxes, 2 fla. tax rev. 390 (1995); graetz, supra note 11, at 1624-29. the latest description of the nunn-domenici plan indicates that it will treat a gift as nondeductible consumption by the donor and an exempt receipt by the donee. see alliance usa, supra note 51, at 1489, 1518, 1569. 107. whether for these or other reasons, in view of its proposal for a family living allowance, the original nunn-domenici plan would apparently have adopted a family taxable unit. as previously noted, however, the latest description of the plan indicates no change in the tax filing unit rules of current law. see supra note 103. 108. indeed, the recent trend in the academic literature has been to favor elimination of joint filing for married couples. see kornhauser, supra note 95, at 65; mccaffery, supra note 95, at 987; zelenak, supra note 95, at 342-44. 109. irc § 1(a). 110. see toni robinson & mary moers wenig, marry in haste. repent at tax time: marital status as a tax determinant, 8 va. tax rev. 773, 788-833 (1989). 111. see popkin, supra note 68, at 404 ("the problem of defining a household to take account of economies of scale and pooling of resources is the most difficult problem in designing a [negative income tax]"); tobin, et al., supra note 68, at 9 ("definition of family units for [negative income tax] purposes may be the single most difficult legal and administrative problem"). 19951 florida tax review inequities. irs efforts to enforce rules in this area would no doubt be highly intrusive." 1 2 the definitional problem is compounded by the fact that whatever line is drawn would be a two-edged sword. some families and householdsespecially those with only one earner-would find it advantageous to be treated as a unit, thereby maximizing the size of their collective living allowance. others-typically, families and households with multiple earnersmay find it beneficial to splinter themselves into several taxable units in order to avoid aggregating incomes." 3 intractable problems would also arise when a family or household unit breaks apart. consider, for example, a child who leaves home to establish his or her own household. if the child and a parent previously constituted a taxable unit, any transfers between them would have been disregarded for purposes of the cash-flow tax. once the child establishes a new taxable unit, however, any unconsumed, accumulated transfers would need to be accounted for. at least in theory, all such amounts should be treated as income to the child and deductible by the parent when the separation occurs." 4 (to the extent the prior gifts continue to be saved by the child, there would be an offsetting deduction.) such a rule would not be manageable, and could result in an artificial bunching of income to the child and deductions to the taxpayer.1 5 a taxable unit based on the family or household would also create potentially undesirable incentives. for example, if the definition of family included a relatedness requirement, there might be a disincentive to marry." 6 a definition incorporating a common residency requirement might discourage that manner of living arrangement. a household taxable unit rule could discourage members of a household other than the primary earner from seeking or continuing work." 7 because of the additional effects of the 112. see bittker, supra note 95, at 1398-99. with potentially greater oversight, the welfare system can be highly intrusive but may at least achieve a more even application of the law. 113. see klein-family unit rules, supra note 68, at 366. 114. see blueprints, supra note 3, at 123. 115. moreover, the mere identification of the proper event for terminating the joint taxable unit would present theoretical and administrative difficulties. see mcmahon, supra note 95, at 131-39. 116. see bittker, supra note 95, at 1416-20. if tax rates are graduated, a tax system cannot tax couples alike, no matter how the tax base is split between the individual members, without violating neutrality between married and unmarried couples. see bradford-untangling, supra note 3, at 278; jct married couple report, supra note 95, at 26 n. 1; michael c. lovell, on taxing marriages, 35 nat'l tax j. 507 (1982). 117. see jct married couple report, supra note 95, at 34-37; mccaffery, supra note 95, at 993-94; mcmahon, supra note 95, at 93-95; zelenak, supra note 95, at 365-72. [vol, 2:8 accomnodating the "low-income'" phase-out of the negative tax subsidy (eitc) and the payroll tax credit, the work disincentive and marriage penalty effects on low-income households could be particularly severe." 8 finally, treating the family or household as the taxable unit would affect legal rights of persons within the unit. for example, family or household members may be reluctant to share income and savings information with one another on a joint tax return. 19 5. proper size of family living allowance.-by basing the amount of their family living allowance on the federal poverty guideline, senators nunn and domenici would permit a larger allowance for the first person in the taxable unit ($12,512 for 1994) than for each additional person in the unit ($4,216 for 1994). that feature of their proposal presumably reflects the economies of scale that can be achieved by persons sharing common consumption expenditures. 20 it would, however, place an additional premium on identifying the members of the taxable unit. consider, for example, a taxpayer with an adult child or elderly parent living in the home. if the two-person household is considered a single taxable unit, the household would be entitled to a two-person family living allowance of $16,728 (sum of $12,512 and $4,216). if the household is treated as two separate units, these units would be entitled to living allowances of $25,024 ($12,512 times 2). if the example instead involved two unrelated individuals thinking about getting married, it would illustrate another aspect of the marriage penalty potentially created by a joint filing requirement. because it is unlikely that the membership of the taxable unit can be determined with precision, it may be preferable to disregard possible economies of scale and allow the same, flat living allowance for each person in the unit. thus, a two-person unit would have the same allowance as the total of the allowances for two single-person units. alternatively, if taking account of economies of scale is considered the more important policy objective, the taxable unit definition should be based on the household (and 118. see mccaffery, supra note 95, at 1014-1020; supra notes 76. 77, 85 and accompanying text. 119. in advocating that a minor child's income should be included on the parents' tax return, deborah schenk has argued that there should be no confidentiality concern in requiring disclosure of the child's income to the parents. deborah h. schenk. simplification for individual taxpayers: problems and proposals, 45 tax l. rev. 121, 157 (1989). however, if a family return had to be signed (and, in theory, reviewed) by all members of the family, some disclosure of the parents' tax information to the children would be required. a tax return requiring inclusion of information for other adult members of the family or household would present even greater concerns. 120. see bittker, supra note 95, at 1422-25. 19951 florida tax review the sharing of common household expenses) rather than the family. further, some continuing reduction in the size of the allowance might be appropriate for larger households to reflect additional economies of scale available to them. aside from the question of economies of scale, there is another aspect of the proposed nunn-domenici allowances that may be inconsistent with horizontal equity principles. 12' consider two households: one, consisting of three members, has $29,944 of consumed income for the year, and the other, which has two members, has $25,728 of consumed income. after deduction of the living allowance,122 each household would have $9,000 in taxable consumed income. based upon the theory of the living allowance, each household might be said to have spent $9,000 on discretionary, and therefore taxable, consumption. should they therefore pay the same cash-flow tax? perhaps not. the two households, after all, are of different sizes. under an income tax, if the $9,000 represents the discretionary income of each household, it may be appropriate to tax the two alike because the focus is on income-the power to consume. each household could be viewed as having the same power to consume, regardless of how many members there are in the household. under a consumption tax, the proper judgment may be different. if the tax base is the amount actually consumed, the number of consumers should presumably make a difference. splitting $9,000 of discretionary consumption among three people is different from splitting that amount among two because per person consumption is higher in the latter case. if tax rates are graduated, the latter household should perhaps pay more cash-flow tax.'23 the argument is not that the taxable unit should be the individual rather than the household. for theoretical and administrative reasons, it may be best to have the basic taxable unit be the household, but in determining the amount of tax owed by any given household, perhaps household size should count. such an adjustment (which could be incorporated into the rate schedule) would be needed in addition to the adjustment in the size of the household living allowance. 6. graduated tax rates.-i conclude this section with a few comments about the rate structure under the nunn-domenici plan and its 121. i ignore in this discussion the argument that because the decision to have children is a voluntary one, expenditures for children are not consumption "necessities" and ought not be reflected in a proposed living allowance for necessities. see lawrence zelenak, children and the income tax, 49:3 tax l. rev. (forthcoming 1995). 122. $20,944 for the three-person household, and $16,728 for the two-person one. 123. see zelenak, supra note 121; cf. george k. yin, summary of eitc conference proceedings, i i am. j. tax pol'y 299, 3 14-15 (1994) (statement of jane gravelle). [val 2:8 acconunodating the "low-income'" potential effects. although most low-income taxpayers would apparently be exempted from the cash-flow tax by the combination of the proposed eitc, payroll tax credit, and family living allowance, it is possible that the final version of the tax will not achieve that outcome. moreover, many taxpayers may only temporarily have low-incomes, and may therefore be subject to positive taxes in other years. as previously described, the cbo has provided an estimated rate structure for the cash-flow tax based on a prototype of the nunn-domenici plan."2 those estimates-rates in the low range of 14% to 36% and in the high range of 16% to 55%--depend upon a host of assumptions, including how comprehensive the tax base will be, how to measure and compare family economic status, and how transitional issues will be dealt with. in the legislative process, all of those questions will no doubt be scrutinized. however, if one assumes that political considerations will preclude a major expansion of the tax base, the principal impact of the adoption of a cash-flow tax would be to shrink the income tax base by amounts saved in ways not currently deductible, a change that would surely require higher and more sharply graduated rates, at least in the short term." a cash-flow tax that raises no more revenue than the existing income tax, but accomplishes that result by means of higher and more graduated rates on labor income, could be expected to have an adverse impact on labor supply. 26 it may also increase the time spent on "tax planning"-the financial and legal structuring of economic affairs for tax purposes-and similar, unproductive pursuits. 27 for these and other reasons, optimal tax theorists have concluded that a policy of redistributing benefits to the lowincome should ideally be executed by means of a flat rate or even slightly 124. see supra note 57 and accompanying table. 125. see graetz, supra note 11, at 1581; mccaffery-hybrid, supra note 43, at 1170; warren-fairness, supra note 65, at 935-36 n.21. 126. with average tax rates remaining about the same (because the same amount of revenue would be collected) but with marginal rates on labor income increasing (due to the smaller tax base), the change would have an adverse substitution effect with no improvement in the income effect of the tax. thus, more taxpayers could be expected to substitute leisure for work. see edgar k. browning & jacquelene m. browning, public finance and the price system 359-63 (4th ed. 1994). 127. see bradford-untangling, supra note 3, at 276-77; committee on simplification, supra note 17, at 420; graetz, supra note 11. at 1581-82. joel slemrod has concluded that "elasticity pessimism" may be overstated and that labor supply and savings may not be as sensitive to taxes as previously thought. on the other hand, taxes do seem to have an important influence on the amount of tax planning and the timing of economic activity. see joel slemrod, introduction, in tax progressivity and income inequality 6 (joel slemroid ed., 1994); joel slemrod, do taxes matter? lessons from the 1980's, 82 am. econ. rev. 250. 254-55 (1992). 19951 florida tax review declining marginal tax rates, exactly the opposite from the proposed cashflow tax. 2 graduated rates pose another difficulty for the cash-flow tax: they upset the neutrality of the tax as between present and future consumption. consider again spender and saver, who earn $100 each; spender consumes the $100 immediately, but saver invests the money at a 10% annual return. as previously described, in a tax-free world, saver would see his money grow to about $200 in seven years, and could then consume twice as much as spender, or the same amount as spender in present value terms.'29 these proportions are preserved under a flat cash-flow tax, but not under an income tax. hence, it is argued that the cash-flow tax, unlike the income tax, is neutral in the choice between saving and spending. consider the same example under a cash-flow tax imposed at 15% on the first $100 of consumed income and 30% on consumed income greater than $100. spender's consumption is reduced to $85 ($100, less $15 of tax), but he will incur no further tax.' 30 saver could still invest the $100 and have it grow to about $200 in seven years, but there would then be a $45 tax upon consumption of the savings, leaving saver with $155 for consumption, less than twice what spender could consume and less than spender's consumption in present value. in short, just like the income tax, a cash-flow tax with graduated rates would bias the decision to save or consume relative to the choices available in a no-tax world.' 31 128. even with flat or declining marginal tax rates, redistribution in favor of the low-income could be achieved by also awarding demogrants to all citizens. see joseph bankman & thomas griffith, social welfare and the rate structure: a new look at progressive taxation, 75 calif. l. rev. 1905, 1945-58 (1987). for concise and critical reviews of the optimal tax literature, see joel slemrod, optimal taxation and optimal tax systems, 4 j. econ. perspects. (no. 1) 157, 163-66 (1990); joel slemrod, do we know how progressive the income tax system should be? 36 nat'l tax j. 361 (1983). a recent study concluded that the efficiency costs of increased progressivity can be minimized by raising tax rates in intermediate brackets to finance an increase in the eitc. robert k. triest, the efficiency cost of increased progressivity, in tax progressivity and income inequality 137, 138 (joel slemrod ed., 1994). other options, which resulted in higher efficiency costs, included raising rates in top brackets, providing a demogrant, and increasing the value of the personal exemption. the study was based, however, on the much lower 1987 eitc phase-in and phase-out rates, before major increases to that program enacted in 1990 and 1993, and assumed that beneficiaries were ineligible for food stamps and afdc and faced no fixed costs associated with working. id. at 149. 129. see text accompanying note 16. 130. i assume that the tax rates are expressed in a "tax-inclusive" way. see supra note 11. 131. see warren-fairness, supra note 65, at 944-45. in some situations, graduated rates can create a bias toward savings. for example, if the taxpayers' lifetime incomes are bunched into a few years and spender spends her income on consumption as it is earned, whereas saver spreads his consumption evenly over time, spender may be exposed to rates [vol 2:8 acconmmodating the "low-income" in blueprints, treasury's proposed solution to this problem was to provide taxpayers with the option of prepaying the cash-flow tax. in the example, if saver were allowed to pay tax as though he immediately consumed the earnings, with no further tax consequences from the savings in year 1 or the consumption in year 7, saver could obtain the identical tax result as spender, and saver would not be disadvantaged by the initial decision to save rather than consume. saver, in effect, would "prepay" the cash-flow tax on the amount saved in year i and be excused from tax on consumption of the savings in later years. 3 2 treasury's suggestion was based on a familiar mathematical relation, sometimes known as the "immediate-deductionlyield-exemption equivalence." under certain circumstances, a deferred tax on an item (and earnings thereon) has the same present value as an immediate tax on the item with no tax on the earnings. 33 as applied to the cash-flow tax, the rule means that a deduction of $100 in savings in the current year (and inclusion of that amount and accumulated earnings in income when consumed) is the same as including the $100 in income initially (forgoing the savings deduction) and exempting it and the future yield from tax when consumed.' various commentators have questioned the feasibility of the tax prepayment option because of the potential for manipulation by taxpayers to the detriment of the fisc. 35 another problem is that it would permit anyone able to achieve an above-average return on an investment to pay lower cashflow taxes by electing the prepayment option with respect to the investment. 36 finally, even aside from its flaws, the option would not provide a complete solution to the problem created by graduated rates. in particular, if there is an intertemporal decrease in tax rates, the tax prepayment choice does not result in neutrality of the cash-flow tax in its treatment of present versus future consumption. a decrease in rates might occur as a result of higher than those ever experienced by saver, with the result that the present value of saver's tax liabilities may be less than that of spender's. 132. see blueprints, supra note 3, at 103, 112-15; bradford-untangling, supra note 3, at 91-92. 133. see e. cary brown, business-income taxation and investment incentives, in income, employment and public policy: essays in honor of alvin h. hansen 11948). reprinted in readings in the economics of taxation 525-37 (richard a. musgrave & carl s. shoup eds., 1959); stanley s. surrey, pathways to tax reform 120-25 (1973). 134. see blueprints, supra note 3, at 11011; bradford-untangling, supra note 3. at 68-69. for the conditions under which this equivalence holds true, see gracta, supra note 11, at 1602. 135. see committee on simplification. supra note 17, at 423-26; gractz, supra note 11, at 1603-09. 136. see graetz, supra note 11, at 1600-01; steucrle, supra note 74, at 174; warrenwould, supra note 65, at 1097-1109. 19951 florida tax review statutory changes or, more likely, simply because a taxpayer is subject to a lower marginal rate in a future year. oddly, low-income taxpayers who move up the income scale might find themselves in that situation-facing lower marginal rates in the future-if the cumulative effect of tax benefit and transfer phase-outs during the period they have low incomes are taken into account. 1 37 to illustrate this last point, assume in saver and spender's example that cash-flow tax rates are a flat 30% in year 1 and a flat 15% in year 7. under those circumstances, spender could consume $70 in year 1 after payment of $30 of cash-flow tax. if saver invested the $100 and watched it grow to about $200 in year 7, he could then consume $170 ($200, less tax of 15% thereof), which is more than the present value of what spender consumed. spender is now disadvantaged and unless he is allowed to postpay his taxes until year 7, there is no way to equalize the two situations. v. summary and conclusions in this article, i have described some of the difficulties in designing a cash-flow tax to be as redistributive at the lower end of the income spectrum as the current income tax. i have shown that two asserted advantages of a cash-flow tax-administrative simplicity and neutrality in the treatment of present versus future consumption-would be seriously compromised by provisions intended to mitigate the tax burden of lowincome taxpayers. a good illustration of the difficulty is the implementation of a negative tax subsidy like the eitc as part of a cash-flow tax. to determine eligibility for such a subsidy, one would ordinarily need to know the economic income and resources of potential beneficiaries. however, under a cash-flow tax system, the economic income yardstick would be lost because the tax would be based on consumption, not income. thus, it would be extremely difficult to determine in a cash-flow tax world who is low-income and therefore entitled to the negative tax subsidy. the switch to a cash-flow tax, and the resulting loss of the economic income measurement, would also impede the administration of other means-tested government transfer programs. my review suggests that a cash-flow tax would be much less flexible in achieving progressivity than is often claimed. policymakers interested in replacing the income tax with a broad-based consumption tax should therefore move toward this goal with considerable caution. if low-income taxpayers are to be accommodated within such a system, there is a great risk that many of 137. see supra note 77. [vol 2:8 19951 accoinnodating the "low-income" 491 the undesirable features of the income tax would have to be replicated in the cash-flow tax. it would be senseless to incur the sizable transition costs of changing tax systems if that were the ultimate outcome. on the other hand, if low-income taxpayers are not to be accommodated, or are accommodated in some manner outside of the tax system, a transactions-based consumption tax like a vat would seem to be the preferable policy choice. unlike a cashflow tax, vats are widely used. substitution of a vat for the income tax would eliminate tax returns for millions of taxpayers, and would increase the government's ability to tax economic activity taking place in the informal sector. volume 18 2016 number 6 florida tax review article tax compliance as a wicked system j.t. manhire florida tax review volume 18 2016 number 6 i article tax compliance as a wicked system j.t. manhire 235 florida tax review volume 18 2016 number 6 ii the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states, plus sales tax where applicable and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117634, gainesville, florida 32611-7627. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352)273-0904 or email ftr@law.ufl.edu. copyright © 2016 by the university of florida florida tax review volume 18 2016 number 6 iii editor-in-chief martin j. mcmahon, jr. james j. freeland eminent scholar in taxation university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar in taxation dennis a. calfee professor of law michael k. friel professor of law david m. hudson professor of law emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar in taxation charlene luke professor of law grayson mccouch professor of law adam smith visiting assistant professor samuel c. ullman adjunct professor of law board of advisors hugh j. ault boston college bradley t. borden brooklyn law school j. martin burke university of montana charlotte crane northwestern university jasper l. cummings, jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina kerry a. ryan st. louis university graduate editors alisa french paul hankin john hodnette laura michael hughes m. blair james young hei jo michael schwartz mark westenberger executive assistant keyosha r. monroe florida tax review volume 18 2016 number 6 iv information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: “articles,” “commentaries,” and “book reviews.” the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, 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number 6 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. microsoft word fl tax rev 9-special text-2.doc florida tax review volume 9 2009 special issue 275 recent developments in federal income taxation the year 2008 martin j. mcmahon, jr.* ira b. shepard** daniel l. simmons*** i. accounting .............................................................................. 279 a. accounting methods ................................................................ 279 b. inventories ................................................................................ 282 c. installment method .................................................................. 282 d. year of inclusion or deduction ................................................ 283 ii. business income and deductions ................................ 284 a. income...................................................................................... 284 b. deductible expenses versus capitalization .............................. 286 c. reasonable compensation ....................................................... 293 d. miscellaneous deductions........................................................ 295 e. depreciation & amortization ................................................... 302 f. credits ...................................................................................... 306 g. natural resources deductions & credits ................................. 312 h. loss transactions, bad debts, and nols ................................ 315 i. at-risk and passive activity losses ........................................ 319 iii. investment gain .................................................................... 320 a. capital gain and loss .............................................................. 320 b. interest...................................................................................... 325 c. section 121 .............................................................................. 325 d. section 1031 ............................................................................ 327 e. section 1033 ............................................................................ 329 f. section 1035 ............................................................................ 329 g. miscellaneous........................................................................... 329 iv. compensation issues .......................................................... 330 a. fringe benefits ......................................................................... 330 b. qualified deferred compensation plans .................................. 332 c. nonqualified deferred compensation, section 83, and stock options ..................................................................................... 332 * clarence teselle professor of law, university of florida college of law. ** professor of law, university of houston law center. *** professor of law, university of californiadavis. 276 florida tax review [vol. 9:si d. individual retirement accounts ............................................... 333 v. personal income and deductions ............................... 333 a. rates......................................................................................... 333 b. miscellaneous income .............................................................. 334 c. profit-seeking individual deductions ...................................... 336 d. hobby losses and § 280a home office and vacation homes ...................................................................................... 340 e. deductions and credits for personal expenses ........................ 341 f. divorce tax issues ................................................................... 345 g. education ................................................................................. 348 h. alternative minimum tax ........................................................ 349 vi. corporations ......................................................................... 351 a. entity and formation ................................................................ 351 b. distributions and redemptions ................................................ 351 c. liquidations ............................................................................. 354 d. s corporations ......................................................................... 354 e. reorganizations ........................................................................ 360 f. corporate divisions ................................................................. 364 g. affiliated corporations and consolidated returns................... 365 h. miscellaneous corporate issues ............................................... 373 vii. partnerships ........................................................................... 376 a. formation and taxable years .................................................. 376 b. allocations of distributive share, partnership debt, and outside basis ........................................................................... 376 c. distributions and transactions between the partnership and partners .................................................................................... 379 d. sales of partnership interests, liquidations and mergers ......... 379 e. inside basis adjustments ......................................................... 380 f. partnership audit rules ........................................................... 380 g. miscellaneous........................................................................... 386 viii. tax shelters ........................................................................... 388 a. tax shelter cases ..................................................................... 388 b. identified “tax avoidance transactions.” ................................... 408 c. disclosure and settlement ........................................................ 408 d. tax shelter penalties, etc. ....................................................... 409 ix. exempt organizations and charitable giving .... 415 a. exempt organizations .............................................................. 415 b. charitable giving ..................................................................... 415 x. tax procedure ....................................................................... 420 a. interest, penalties and prosecutions ......................................... 420 b. discovery: summonses and foia ........................................... 433 c. litigation costs ........................................................................ 436 d. statutory notice of deficiency ................................................. 436 e. statute of limitations ............................................................... 436 2009] recent developments in federal income taxation 277 f. liens and collections ............................................................... 438 g. innocent spouse ....................................................................... 443 h. miscellaneous........................................................................... 446 xi. witholding and excixe taxes ....................................... 459 a. employment taxes ................................................................... 459 b. self-employment taxes ............................................................ 464 c. excise taxes ............................................................................ 464 xii. tax legislation ..................................................................... 465 a. enacted..................................................................................... 465 278 florida tax review [vol. 9:si recent developments in federal income taxation† the year 2008 by martin j. mcmahon, jr. ira b. shepard daniel l. simmons this recent developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during 2008 — and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide dan and marty the opportunity to mock our elected representatives. the outline focuses primarily on topics of broad general interest (to the three of us, at least) – income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. any mistakes in this outline are marty’s responsibility; any political bias or offensive language is ira’s; and any useful information is dan’s. †we are deeply indebted to professor larry zelenak, duke university school of law, for his assistance in synopsizing the provisions of the earnings assistance and relief tax act of 2008, the heartland, habitat, harvest, and horticulture act of 2008, and the housing assistance tax act of 2008. all of his work was axiomatically perfect, and he is not to blame for any inaccuracies that we introduced in rewriting it and for any of our offensive commentary (including headlines and footnotes). 2009] recent developments in federal income taxation 279 i. accounting a. accounting methods 1. accountant’s persistent omission of a step in the computation of the lifo value of inventories required a change of accounting method to correct. on appeal, held that the commissioner’s interpretation of the applicable regulation is “entitled to controlling weight.” huffman v. commissioner, 518 f.3d 357 (6th cir. 4/4/08), aff’g 126 t.c. 322 (2006). generally, corrections to the taxpayer’s inventory accounting method constitute a change of accounting method. furthermore, correction of a systematic erroneous method of calculating inventories on a recurring basis, without a change in the overall inventory method, constitutes a change of accounting method rather than the correction of a computational error. the tax court (judge halpern) held that correction to an inventory method employed by the accountant for s corporation automobile dealerships that reached an erroneous result over a 10to 20-year period by omitting a computational step required by reg. § 1.472-8, related to the link-chain, dollar-value method of pricing lifo inventories, constituted an accounting method change that requires a § 481 adjustment, and was not simply the correction of a mistake in arithmetic. this was an accounting method change because the original method caused understatements and overstatements in the lifo value of inventories but did not result in the permanent omission of gross income. • the sixth circuit (judge rogers) affirmed the holding of the tax court. reg. § 1.446-1(e)(2)(ii)(a) provides that “[a] change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan;” reg. § 1.446-1(e)(2)(ii)(c) specifically provides that “a change in the treatment of any material item used in the overall plan for identifying or valuing items in inventory is a change in method of accounting;” and reg. § 1.446-1(e)(2)(ii)(a) provides that a “material item” is “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.” according to judge rogers “‘[t]he essential characteristic of a “material item” is that it determines the timing of income or deductions.’” (quoting knight-ridder newspapers, inc. v. united states, 743 f.2d 781, 798 (11th cir. 1984).) “in this case, the change from the accountant’s erroneous method to the proper dollar-value, link-chain method does just that.” • judge rogers added that his conclusion was bolstered by the fact that the case involved interpretation of a regulation — whether the correction of a specific accounting error constitutes a “change in method of accounting,” as that phrase is defined in the regulations. he reasoned that in “dealing with the interpretation of rules of inclusion and exclusion that are ‘creatures’ of the treasury department’s own making,” the irs’s interpretation of 280 florida tax review [vol. 9:si the regulation is “controlling” where the interpretation reflects a “fair and considered judgment” and is not “plainly erroneous or inconsistent with the regulation.” the commissioner’s interpretation of what constituted a “‘change in method of accounting’ (and therefore not ‘mathematical’ or ‘computational’ error) is [not] ‘plainly erroneous or inconsistent with the regulation,’ and the commissioner’s interpretation is accordingly entitled to controlling weight.” 2. judge haines writes a treatise on defective claims to automatic consent to change an accounting method. capital one financial corp. v. commissioner, 130 t.c. no. 11 (5/22/08). following the enactment in 1997 of § 1272(a)(6)(c)(ii), which provides that credit card late-fee receipts create or increase original issue discount rather than constituting an income item when they accrued under the all events test, the taxpayer claimed to have received the irs’s consent to change its accounting method, pursuant to an automatic consent procedure, by filing form 3115 with its 1998 tax return. however, the taxpayer did not change its accounting method for 1998 and 1999. in the tax court, the taxpayer sought to retroactively change its method for 1998 and 1999. judge haines, held that § 446(e) prohibited the taxpayer from retroactively changing its treatment of income from credit card late-fees for years 1998 and 1999 from the current-inclusion method to the method under § 1272(a)(6)(c)(iii) that requires late-fee receipts to create or increase original issue discount, even though the oid method was mandatory under the statute, because the taxpayer did not file a form 3115 to notify the irs of the change of accounting method with its 1997 return. because the form 3115 was not timely filed and did not specifically mention “late fees,” automatic consent had not been granted. “[a] taxpayer forced to change its method of accounting under section 448 must still file a form 3115 with its return for the year of change. [reg. § 1.448-1(h)(2)] if the form 3115 is not filed timely, a taxpayer forced off the cash method must comply with the requirements of [reg. § 1.446-1(e)(3)] in order to secure the consent of the commissioner. reg. § 1.448-1(h)(4). pursuant to [reg. § 1.446-1(e)(3)], a taxpayer requesting to change its method of accounting is required to file a form 3115 during the year in which it intends to make the change.” 3. new and improved automatic consent procedures for changes of accounting methods. rev. proc. 2008-52, 2008-36 i.r.b. 587 (8/19/08). this revenue procedure provides automatic consent procedures for a wide variety of accounting method changes. rev. proc. 2002-9, 2002-1 c.b. 327, as modified and clarified, is clarified, modified, amplified, and superseded. 4. a little more help for the housing industry buried in more important proposed changes to changes in methods of accounting for long-term contracts. reg-120844-07, rules for home construction contracts, 2009] recent developments in federal income taxation 281 73 f.r. 45180 (8/4/08). currently, a taxpayer that uses the percentage-ofcompletion method or the exempt-contract percentage of completion method, that elects the 10-percent method or special alternative minimum taxable income method, or that adopts or elects a cost allocation method of accounting (or changes to another method of accounting with the irs’s consent) must apply the method(s) consistently for all similarly classified contracts until the taxpayer obtains consent under § 446 to change to another method of accounting. prop. reg. § 1.460-4(g) would provide that taxpayer-initiated change in method of accounting will be permitted only on a cut-off basis, i.e., for contracts entered into on or after the year of change, only for changes from a permissible percentage of completion to another permissible percentage of completion method for long-term contracts for which percentage of completion is required and for changes from a cost allocation method of accounting that complies with the cost allocation rules of reg. § 1.460-5 to another cost allocation method of accounting that complies with those rules. all other taxpayer-initiated changes in method of accounting under § 460 would be made with a § 481(a) adjustment. prop. reg. §§ 1.460-6(c)(3)(vii) and 1.460-6(d)(2)(iv) would provide that in determining the hypothetical underpayment or overpayment of tax for any year as part of the look-back computation, § 481(a) adjustments would be taken into account in the tax year or years they are reported. the taxpayer would use amounts reported under its old method for the years the old method was used and would use amounts reported under its new method for the years the new method was used, netted against the amount of any § 481(a) adjustments under prop. reg. § 1.460-6(c)(3)(vii) and prop. reg.§ 1.460-6(d)(2)(iv). as a result, a lookback computation would not be required upon contract completion simply because the taxpayer changed its method of accounting. but, a look-back computation would be required upon contract completion if actual costs or the contract price differ from the estimated amounts notwithstanding the fact that a change in method of accounting occurred. prop. reg. § 1.460-3(b)(2) would expand what is considered a townhouse or rowhouse, for purposes of the home construction contract exemption in § 460(e) to include an individual condominium unit, and expand the types of contracts eligible for the home construction contract exemption by providing that a contract for the construction of common improvements is considered a contract for the construction of improvements to real property directly related to the dwelling unit(s) and located on the site of such dwelling unit(s), even if the contract is not for the construction of any dwelling unit. the amendments to the regulations will be effective when finalized. 5. you’ve got to be really, really busy trading to be in the trade or business of being a stock trader. holsinger v. commissioner, t.c. memo. 2008-191 (8/11/08). the taxpayer was not eligible for mark-tomarket treatment of securities under § 475(f) because he was not a “trader” in 282 florida tax review [vol. 9:si securities. whether a person is a “trader” rather than an investor depends on a number of nonexclusive factors: (1) the taxpayer’s intent, (2) the nature of the income to be derived from the activity, and (3) the frequency, extent, and regularity of the taxpayer’s securities transactions. “for a taxpayer to be a trader the trading activity must be substantial, which means frequent, regular, and continuous enough to constitute a trade or business.” activities constitute a trade or business where (1) “[t]he taxpayer’s trading is substantial, and (2) the taxpayer seeks to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holding of investments.” [emphasis added] in the relevant years, 2001 and 2002, the taxpayer executed approximately 289 trades in 2001 on 63 days and 372 trades on 110 days, respectively. judge vasquez found it “doubtful whether the trades were conducted with the frequency, continuity, and regularity indicative of a business.” judge vasquez found further that the taxpayer did not seek to catch the swings in the daily market movements. he rarely bought and sold on the same day, and a significant amount of his holdings was held for more than 31 days. accordingly, he was an investor, not a trader. 6. hindsight is poor sight when looking for § 9100 relief. acar v. commissioner, 545 f.3d 727 (9th cir. 9/23/08). the taxpayer was a financial planner and part-time securities trader. he attempted to make a § 475(f) mark-to-market election for 1999 and 2000 in 2002 by submitting amended returns. the election was untimely under rev. proc. 99-17, 1999-1 c.b. 503 and the irs refused to grant relief under reg. § 301.9100-3(c). the court upheld the irs’s denial of § 9100 relief because he had used hindsight in making the late election and thus pursuant to reg. § 301.9100-3(b)(3)(iii) did not satisfy the “good faith requirement. the court of appeals distinguished the tax court’s decision in vines v. commissioner, 126 t.c. 279 (2006), granting § 9100 relief for a late § 475(f) election on the ground that in vines, unlike in the instant case, there had been no trading between the time the election should have been made and the time it was made, and thus vines obtained no hindsight advantage. b. inventories there were no significant developments regarding this topic during 2008. c. installment method there were no significant developments regarding this topic during 2008. 2009] recent developments in federal income taxation 283 d. year of inclusion or deduction 1. thirty-five percent is not substantial here, even though it might be elsewhere in the code. nelson v. commissioner, 130 t.c. 70 (2/28/08) section 451(d) permits a cash method farmer who normally reports income from the sale of his crops in the year following crop production to elect to defer treating as income crop insurance proceeds received in a year until a following year. the taxpayers, who routinely reported only 65 percent of income realized from the sale of crops in the year of sale and 35 percent the following year [which the irs stipulated was an acceptable accounting method], were not permitted to defer reporting 100 percent of the proceeds of crop insurance until the following year. the court (judge swift) applied rev. rul. 74-145, 1974-1 c.b. 113, which allowed deferred recognition of crop insurance proceeds under § 451(d) to a farmer who, under his normal method of accounting for crop income, deferred to the following year not all but more than 50 percent of his crop income, a percentage which the ruling referred to as a “substantial portion” of the farmer’s annual crop income, and concluded that because the taxpayers did not normally defer a substantial portion of their crop income – 35 percent not being “substantial” for this purpose – § 451(d) was inapplicable. 2. auto parts remanufacturer can’t anticipate return of “cores” and accrue only price net of future rebates. bigler v. commissioner, t.c. memo. 2008-133 (5/19/08). the taxpayer’s s corporation (bbb) remanufactured automobile alternators and starters and sold the remanufactured parts to retailers. for each remanufactured part purchased, the customers were entitled to return a core for a credit equal to a core price listed on the invoice. because there was no time limit on returning a core, at the close of the year bbb did not know how many cores would be returned, and when the cores would be returned. bbb essentially accrued only the invoiced amounts net of the anticipated credit for return of the cores. the tax court (judge vasquez) agreed with the irs that bbb was required to accrue the gross amount of the invoiced price of the parts. “after the sale the amount stated was fixed, and bbb had the right to collect the entire amount stated on the invoice. the fact that bbb might have to credit the customer at some point in the future does not mean that income has not accrued. thus the all events test was satisfied for the entire amount of the invoice.” • in an earlier case involving remanufactured auto parts, judge chiechi wrote a treatise on taxpayer’s impermissible use of lifo inventory. consolidated manufacturing, inc. v. commissioner, 111 t.c. 1 (1998), aff’d in part, rev’d in part, 249 f.3d 1231 (10th cir. 2001). 284 florida tax review [vol. 9:si ii. business income and deductions a. income 1. share the company’s name and credit with “friends,” then pay tax on the friends’ income. industrial electrical and instrumentation, inc. v. commissioner, t.c. memo. 2008-84 (4/3/08). the taxpayer corporation’s principal shareholder and officer qualified the company to perform electrical contracting services in the state of florida. through various arrangements stewart and lance penny, who could not obtain the requisite contractor’s license, became minority shareholders of the taxpayer and performed services in the name of the taxpayer company. the pennys obtained supplies on the company credit and employed workers in the company name. however, numerous checks for services and contracts performed by the pennys were not recorded on the company’s books, but cashed directly by the pennys. these amounts were not reported as income on the company’s return. the tax court (judge vasquez) found that this arrangement was undertaken with the company’s support. the company had knowingly made its credit and license available to the pennys to enable them to perform work. thus, the court concluded that the amounts paid to the pennys represented income to the company. the court also sustained fraud penalties for the understatement of income. 2. the irs changes position on the tax treatment of rebates. rev. rul. 2005-28, 2005-1 c.b. 997 (4/25/05). this ruling holds that a payment made by a seller to a purchaser, the purpose and intent of which is to reach an agreed-upon net selling price, is treated as an adjustment to the sales price rather than a deduction item. therefore, medicaid rebates incurred by a pharmaceutical manufacturer are purchase price adjustments that are subtracted from gross receipts in determining gross income. • rev. rul. 76-96, 1976-1 c.b. 23, which held that an automobile manufacturer’s rebates paid to retail customers are deductible as ordinary and necessary business expenses under § 162, is suspended in part because the issue is being reconsidered by the irs. a. medicaid rebates paid by pharmaceutical company reduce gross receipts. rev. rul. 2008-26, 2008-21 i.r.b. 985 (5/9/08), clarifying and superseding rev. rul. 2005-28, 2005-1 c.b. 997. under the medicaid reimbursement program pharmaceutical manufacturers pay a rebate to state medicaid agencies to reduce the cost of prescription medicine purchased through state programs. the irs ruled that these payments are a reduction of sales price that reduces gross receipts rather than ordinary business expenses, but the ruling notes that “this holding is limited to medicaid rebates that a 2009] recent developments in federal income taxation 285 pharmaceutical manufacturer pays pursuant to the medicaid rebate program established by the act.” • the ruling also noted: whether a rebate of the type described in rev. rul. 76-96 is an ordinary and necessary business expense or, alternatively, is an adjustment to the sales price in calculating gross receipts, is an issue under reconsideration. therefore, pending the service’s reconsideration of the issue and publication of subsequent guidance, the service will not apply, and taxpayers may not rely on, the conclusion of rev. rul. 76-96 that rebates made by the manufacturer are ordinary and necessary business expenses deductible under § 162. 3. “taxation * * * is eternally lively; it concerns ninetenths of us more directly than either smallpox or golf, and has just as much drama in it; moreover, it has been mellowed and made gay by as many gaudy, preposterous theories.” — h.l. mencken, “the dismal science,” smart set, june 1922, at 42. monk v. commissioner, t.c. memo. 2008-64 (3/17/08). for many years, the taxpayer had reported his interest in a baltimore bar, called chuck’s place, as a sole proprietorship on his tax returns. his name was on the bar’s liquor license, his name on the bar’s checking account, and he was recognized by maryland as the bar’s lottery agent. during the course of an audit, the taxpayer’s accountant ascertained that the true economic relationship between the taxpayer and the operator of the bar was a lease that provided for a set monthly rent and an allocation of maintenance and repair expenses; the taxpayer did not share in profits or bear any risk of operating losses. the reason the arrangement was structured as it appeared to be was that the bar operator, an old friend of the taxpayer’s believed that his 40-year-old felony conviction would prevent a liquor license and state lottery agency from being issued to him, so the taxpayer filed the paperwork for him. • the tax court (judge haines) held that an arrangement that was in substance a valid oral lease of real property to the true operator of the bar business and should be treated as such, even though the taxpayer appeared to be the owner of the business on all of the relevant documentation. “[w]here there is written documentation which contradicts the reality of a situation, we disregard the documents to properly tax the person actually earning the income. ... ‘[i]n a labor-intensive business with no employees, there is a strong suggestion that the individuals performing the labor own the business.’” (quoting malone v. commissioner, t.c. memo. 2005-69 (2005)). • the court observed, “[t]hough we assert no expertise in maryland administrative law, it seems unlikely that either monk or maney will benefit from the position on the true ownership of chuck’s place that 286 florida tax review [vol. 9:si they have taken in this case when maryland authorities learn of it, further bolstering their credibility on this point.” • judge haines demonstrated his wit and literacy by including the quotation from mencken in the opening paragraph of his opinion. 4. the housing assistance tax act of 2008, § 3022(a)(1), removes from treatment as tax preferences for alternative minimum tax purposes interest from exempt facility bonds where 95% or more of the proceeds of the issue are used to provide qualified residential rental projects, qualified mortgage bonds, and qualified veterans’ mortgage bonds. tax exempt interest on these instruments also is removed from corporate amt adjustments in determining adjusted current earnings. • a rental project is qualified under § 142(d) if either 20 percent or more of the project’s units are occupied by persons whose gross income is 50 percent or less of the area median gross income, or 40 percent or more of the units are occupied by persons whose income is 60 percent or less of the area median gross income. • a bond qualifies as a qualified mortgage bond under § 143(a) if it is part of an issue all of the proceeds of which are used to finance owner-occupied residences for first-time home owners with a purchase price not exceeding 90 percent of the average area purchase price. • a bond is a qualified veterans’ mortgage bond under § 143(b) if it is part of an issue 95 percent of which is used to provide residences for veterans. 5. pate v. commissioner, t.c. memo. 2008-272 (12/9/08). the tax court (judge cohen) disregarded the taxpayer’s purported joint venture and s corporation as having no economic substance and held the taxpayer liable to report income from working as an “independent contractor” on the taxpayer’s individual return. the taxpayer was also responsible for employment taxes. further, the court refused to treat the taxpayer’s cattle operation as having a profit motive. b. deductible expenses versus capitalization 1. at long last, the long-promised tangible property proposed regulations are out. reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 71 f.r. 48590 (8/21/06). the treasury department published comprehensive proposed regulations dealing with the capitalization of amounts paid or incurred to acquire or produce real or personal property, including transaction costs, and 2009] recent developments in federal income taxation 287 to distinguish repairs from improvements subject to capitalization. the proposed regulations excepted from capitalization expenditures for property that had a useful life of one year or less, but did not have any de minimis rule (although the preamble stated that the absence of a de minimis rules would not change the current practice of permitting agreements between taxpayers and irs examining agents not to select assets with minimal cost for review). the proposed regulations adopted a “unit-of-property” concept for purposes of distinguishing repairs from improvements. amounts paid that materially increase the value of a unit of property must be capitalized, as must be amounts paid that substantially prolong economic useful life. the proposed regulations included a repair allowance system that would permit expenditures on each class of property up to a specified percentage of cost to be deducted as repairs, with any excess required to be capitalized; the percentage is to be determined based on the principle that a taxpayer will spend 50 percent of cost on repairs over the macrs recovery period. a. the old proposed rules capitalized too much – at least according to commentators. new regulations are proposed for the acquisition, production, or improvement of tangible personal property. reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 73 f.r. 12838 (3/10/08). new proposed regulations withdraw and replace the 2006 proposed regulations under § 263 regarding the acquisition, production or improvement of tangible personal property [reg-168745-03, guidance regarding deduction and capitalization of expenditures related to tangible property, 71 f.r. 48590 (8/21/06)]. the new proposed regulations retain many of the provisions of the 2006 proposed regulations, including the proposed format changes in which § 1.263(a)-1 provides general rules for capital expenditures, § 1.263(a)-2 provides rules for amounts paid for the acquisition or production of tangible property, and § 1.263(a)-3 provides rules for amounts paid for the improvement of tangible property. however, these new proposed regulations provide many additional rules. the new proposed regulations define material and supplies to treat as deductible (1) the cost of any property with a useful life that does not exceed one year and (2) any item that cost not more than $100. they add a book-conformity de minimis rule, a safe-harbor for routine maintenance, and an optional simplified method for regulated taxpayers. the proposed regulations modify the provisions in the first version regarding a unit of property and restorations. the new proposed regulations do not provide for a detailed repair allowance rule, but do provide for future i.r.b. guidance regarding industry-specific repair allowance methods. 288 florida tax review [vol. 9:si • acquisition and production costs. these proposed regulations [reg. § 1.263(a)-2] would expressly provide that a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property (as determined under prop. reg. § 1.263(a)-3(d)(2)), including leasehold improvement property, land and land improvements, buildings, machinery and equipment, and furniture and fixtures.” amounts paid to create intangible interests in land would be treated as capital expenditures. the preamble specifically invites comments on this provision. transaction costs to facilitate the acquisition of property also are expressly required to be capitalized, even if the property is not acquired. [reg. § 1.263(a)-2(d)(3)] amounts paid to defend or protect title to property must be capitalized. • selling expenses. the proposed regulations [prop. reg. § 1.263(a)-1(d)] provide for the capitalization of selling expenses as an offset against sales proceeds (except in the case of dealers). • investigation costs. although expenditures to produce or acquire tangible property, including expenses incurred to facilitate the acquisition, must be capitalized, the proposed regulations would provide an exception for pre-decisional investigative costs with respect to the acquisition of real property, similar to the provisions applicable to investigating the acquisition of intangible property that are treated as deductible business expansion costs. • employee compensation and overhead. except as required by § 263a, employee compensation and overhead are not treated as transaction costs facilitating the acquisition of property, unless the taxpayer elects to so treat them. [prop. reg. § 1.263(a)-2(d)(3)(d)]. • materials and supplies. as under current provisions, prop. reg. § 1.162-3 would allow a deduction for nonincidental materials and supplies in the year the property is consumed, and allow a deduction for incidental material and supplies in the year the expenditure is incurred. materials and supplies include tangible property that is (i) not a unit of property or acquired as part of a unit of property, or (ii) tangible property that is a unit of property with (a) an economic useful life to the taxpayer of not more than 12-months, or (b) that costs not more than $100 (an embedded de minimis rule). taxpayers would be allowed an election to capitalize the cost of each item of material or supply. the de minimis rule also applies to property produced by the taxpayer, but items used in the production of other property remain subject to the uniform capitalization rules of § 263a. prop. reg. § 1.263a-1(b)(14). rotable spare parts (parts installed temporarily in a unit of property) would be treated as used, and therefore deductible, in the year the part is disposed of. • financial accounting de minimis rules. the proposed regulations [prop. reg. § 1.263(a)-2(d)(4)] would allow a taxpayer to deduct expenditures to acquire or produce property (other than property produced for resale) if the taxpayer expenses the cost on a certified audited 2009] recent developments in federal income taxation 289 financial statement (or certain financial statements filed with regulatory agencies) pursuant to an accounting procedure adopted by the taxpayer that treats as expenses amounts paid for property costing less than a specified dollar amount, as long as the aggregate amount deducted does not materially distort the taxpayer’s income for purposes of § 446. a safe-harbor would provide that the deductions will not distort income if the amounts deducted under the second de minimis rule, plus deductions for materials and supplies, i.e., amounts deducted under the first de minims rule, are do not exceed the lesser of 0.1 percent of the taxpayer’s gross receipts or 2 percent of the taxpayer’s total depreciation and amortization expense reflected in its financial statement. • unit of property. prop. reg. § 1.263(a)3(d)(2). the unit of property concept is central to the proposed regulations’ requirement that improvements to a unit of property must be capitalized. the unit of property standards in the 2008 proposed regulations differ substantially from the standards in the 2006 proposed regulations. a building and its structural components (as defined in reg. § 1.48-1(e)(2)) would be treated as a unit of property. however, fixtures attached to a building that pursuant to a cost segregation study are depreciated as tangible personal property, rather than real property, are separate units of property. for property other than buildings, all the components that are functionally interdependent comprise a single unit of property. components of property are functionally interdependent if the placing in service of one component is dependent on the placing in service of the other component. however, a component that is recorded on the taxpayer’s books as having a different economic useful life or which is in a different class of property for macrs depreciation would be treated as separate unit of property. thus, for example, all of the component parts of a railroad locomotive constitute a single unit of property, as does a truck trailer and its tires (unless the taxpayer’s financial statements treat them as separate property). a special rule applies to “plant property,” which is a functionally integrated collection of equipment and machinery used to perform an industrial process; each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent machinery or equipment constitutes a separate unit of property. • capitalize improvements. expenditures to improve a unit of property must be capitalized. prop. reg. § 1.263(a)-3(d)(1). amounts expended for repairs and maintenance of tangible property would be deductible if they are not required to be capitalized under prop. reg. § 1.263(a)-3. prop. reg. § 1.162-4. expenditures that improve tangible property, and that are required to be capitalized, include expenditures that: (1) result in a “betterment” to a unit of property (replacing the term “material increase in value” used in the original proposal); (2) restore a unit of property; or 290 florida tax review [vol. 9:si (3) adapt the unit of property to a new or different use. • betterment. prop. reg. § 1.263(a)-3(f). an expenditure would result in a betterment of a unit of property if it (1) ameliorates a material condition or defect that existed prior to acquisition of the property or arose during production of the property, (2) results in a material addition to a unit of property, or (3) results in a material increase in capacity. determination of whether an expenditure results in a betterment is factual and requires a comparison of the condition of the property immediately prior to the circumstance necessitating the expenditure (or the condition of property the last time the taxpayer corrected for normal wear and tear) with the condition of the property after the expenditure. • restoration. prop. reg. § 1.263(a)-3(g). an expenditure would be capitalized as a restoration if it (1) replaces a component for which the taxpayer has deducted a loss, (2) replaces a component the adjusted basis of which has been accounted for in realizing gain or loss on a sale or exchange of the component, (3) repairs damage for which the taxpayer has deducted a casualty loss under § 165, (4) returns the property to its ordinary operating condition after the property as fallen into a state of disrepair and is no longer functional, (5) results in rebuilding the property to a like-new condition at the end of its economic useful life (not macrs recovery period) to the taxpayer, or (6) is for the replacement of a major component or structural part of the unit of property. replacement of a major component or structural part occurs if the cost is more than 50 percent of the replacement cost of the property or the replacement compromises more than 50 percent of the physical structure of the property and the replacement does not occur during the macrs recovery period for the property. • new use. prop. reg. § 1.263(a)-3(h). a unit of property would be treated as adapted to a new or different use if the adaptation is not consistent with the taxpayer’s “intended ordinary use of the unit of property at the time originally placed in service by the taxpayer.” • rehabilitation doctrine is no more. prop. reg. § 1.263(a)-3(d)(4) would eliminate the judicially created rehabilitation doctrine by providing that, “repairs and maintenance that do not directly benefit or are not incurred by reason of an improvement are not required to be capitalized under section 263(a), regardless of whether they are made at the same time as an improvement.” but the proposed regulations provide that if otherwise deductible repairs benefit or are incurred by reason of an improvement, the cost of the repairs must be capitalized under § 263a. • routine maintenance safe harbor. prop. reg. § 1.263(a)-3(e) would provide a safe harbor from the capitalization requirement for “the recurring activities that a taxpayer expects to perform as a result of the taxpayer’s use of the unit of property to keep the unit of property in its ordinarily efficient operating condition.” the safe harbor would apply to activities 2009] recent developments in federal income taxation 291 that the taxpayer reasonably expects to perform more than once during the class life of the property, as determined under the macrs alternative depreciation schedule of § 168(g). routine maintenance includes maintenance with respect to and the use of rotable spare parts. routine maintenance excludes activities that follow a basis recovery event similar to the items that are described as restorations. • repairs. prop. reg. § 1.162-4 would allow as a deductible repair any costs that are not required to be capitalized under prop. reg. § 1.263(a)-3. o repair allowance. the 2006 proposed regulations would have provided a comprehensive elective repair allowance rule under which all amounts paid for materials and labor during the taxable year to repair, maintain, or improve tangible property for which depreciation is computed under § 168 would be deductible under § 162 to the extent they did not exceed the “repair allowance amount,” determined separately for each macrs property class. the new proposed regulations do not provide any such rule, but prop. reg. § 1.263(a)-3(j) permits taxpayers to use a repair allowance method that would be subsequently published in either the federal register or the internal revenue bulletin, suggesting that such rules will be forthcoming. • examples. the new proposed regulations are full of examples that seem to cover most of the litigated cases and rulings addressing capitalization versus repair. the examples are necessary to understand the substantive provisions, which, although intended to provide clarity, are not so clearly applied. 2. lease termination expenses are deductible and not capitalized into the basis of an acquired building. abc beverage corp. v. united states, 577 f.supp.2d 935 (w.d. mich. 8/27/08). after settlement of a dispute over past due rent and the purchase price under a purchase option in the lease contract, the taxpayer acquired a property it was leasing from the landlord. in a refund claim, the taxpayer asserted that $6.25 million of its $11 million payment was deductible as a lease termination payment, and it capitalized $2.75 million into the basis of the building. (the taxpayer’s calculation was based on what it considered the minimum purchase price under the option agreement.) the irs asserted that under § 167(c)(2) the entire payment was allocated to acquisition of the fee interest, and that no part of the acquisition cost is therefore available as a deduction for termination of the lease. following what it considered to be the law of the circuit, the court followed cleveland allerton hotel, inc. v. irs, 166 f.2d 805 (6th cir. 1948) and allowed the deduction. the court held that § 167(c)(2), which provides that upon acquisition of a property subject to a lease no basis is allocated to the lease, did not apply in the case of an acquisition of a property by the tenant. in that case the leasehold interest and the fee interest are merged. the district court rejected the reasoning of the tax 292 florida tax review [vol. 9:si court’s contrary holding in union carbide foreign sales corp. v. commissioner, 115 t.c. 423 (2000). • note that cleveland allerton hotel was decided before § 167(c)(2), or any analogous provision, was added to the code. 3. not all the “green in” the emergency economic stabilization act of 2008 is federal money the emergency economic stabilization act of 2008, division c, § 318, extends the deduction allowed by § 198 for environmental remediation expenses (which might otherwise be capital expenditures) to expenditures through 2009. to qualify, a site must be certified by the appropriate state environmental agency to be an area at or on which there has been a release (or threat of release) or disposal of a hazardous substance; sites that are identified on the national priorities list under cercla do not qualify. a. the act, § 322 also extends the incentives for investment in the district of columbia to expenditures in 2009. 4. legal fees incurred resisting states’ attorney general challenges to the privatization of blue shield are capital expenses. wellpoint, inc. v. commissioner, t.c. memo. 2008-236 (10/27/08). the taxpayer provides health insurance coverage through operating subsidiaries that are licensees of the blue cross and blue shield association and are a result of mergers with blue cross and blue shield organizations that were once characterized as tax-exempt charitable entities. several state attorneys general brought cy-pres or charitable trust actions against the taxpayer claiming assets of the charitable organizations that were impressed with charitable trusts. the taxpayer made payments of nearly $200 million to settle these actions. the court (judge kroupa) held the taxpayer’s legal fees and settlement payments were incurred in a dispute over the equitable ownership of assets allegedly impressed with charitable trust obligations, and that the fees and payments were thus required to be capitalized. the court rejected the taxpayer’s argument that the payments were incurred to protect its business practices. 5. west covina motors, inc. v. commissioner, t.c. memo. 2008-237 (10/27/08). taxpayer was required to capitalize legal fees paid on behalf of its related party lessor in protecting the taxpayer’s interest in leased property on which the taxpayer’s auto dealership was located. the taxpayer’s related party lessor declared bankruptcy and the bank holding the mortgage on the leased property threatened to remove the taxpayer. the court (judge kroupa) held that the fees were incurred in defense of title and not subject to an exception that allows deduction of legal fees paid to benefit another where adverse 2009] recent developments in federal income taxation 293 consequences to the taxpayer’s business are direct and proximate. the court also required capitalization of legal fees incurred in the acquisition of the assets of another auto dealership consisting largely of inventory. the court also upheld accuracy-related substantial underpayment penalties. 6. those fancy pyrex® and oneida® branded kitchen products are made by robinson knife manufacturing, which is required to capitalize license fees. robinson knife manufacturing company, inc. v. commissioner, t.c. memo. 2009-9 (1/14/09). the taxpayer designs and produces kitchen tools for sale to large retail chains. to enhance its marketing, the taxpayer paid license fees to corning for use of the pyrex trademark and oneida for use of the oneida trademark on kitchen tools designed and produced by the taxpayer. the taxpayer’s production of kitchen tools bearing the licensed trademarks was subject to review and quality control by corning or oneida. the irs asserted that the taxpayer’s licensing fees were subject to capitalization into inventory under § 263a under reg. § 1.263a-1(e)(3)(ii)(u), which expressly includes licensing and franchise fees as indirect costs that must be allocated to produced property. agreeing with the irs, the court (judge marvel) rejected the taxpayer’s argument that the licensing fees, incurred to enhance the marketability of its produced products, were deductible as marketing, selling, or advertising costs excluded from the capitalization requirements by reg. § 1.263a-1(e)(3)(iii)(a). the court noted that the design approval and quality control elements of the licensing agreements benefited the taxpayer in the development and production of kitchen tools marketed with the licensed trademarks. the court rejected the taxpayer’s argument that rev. rul. 2000-4, 2000-1 c.b. 331, which allowed a current deduction for costs incurred in obtaining iso 9000 certification as an assurance of quality processes in providing goods and services, was applicable to the quality control element of the license agreements. the court noted that although the trademarks permitted the taxpayer to produce kitchen tools that were more marketable than the taxpayer’s other products, the royalties directly benefited and/or were incurred by reason of the taxpayer’s production activities. the court also upheld the irs’s application of the simplified production method of reg. § 1.263a-2(b) to allocate the license fees between cost of goods sold and ending inventory as consistent with the taxpayer’s use of the simplified production method for allocating other indirect costs. c. reasonable compensation 1. the irs takes a swipe at deducting generous executive severance packages. rev. rul. 2008-13, 2008-10 i.r.b. 518 (2/21/08). section 162(m)(1) limits the deduction for compensation paid to a covered employee [as defined in § 162(m)(3)] by a public company to $1 million 294 florida tax review [vol. 9:si unless under § 162(m)(4)(c) the compensation is based on meeting performance goals. reg. § 1.162-27(e)(2)(v) provides that compensation does not fail to be qualified performance-based compensation merely because the plan allows the compensation to be payable upon death, disability, or change of ownership or control. the irs ruled that compensation is not excepted from the $1 million deduction limitation as “remuneration payable solely on account of attainment of one or more performance goals” under § 162(m)(4)(c) if in addition to providing for payment upon attainment of a performance goal, the plan or agreement also provides that the compensation will be paid, without regard to whether the performance goal has been attained, if either: (1) the employee’s employment is involuntarily terminated by the corporation without cause or the employee terminates his or her employment for good reason, or (2) the employee retires. neither termination without “cause” or for “good reason” nor retirement is listed as a permissible payment event under reg. § 1.162-27(e)(2)(v). involuntary termination without “cause” or voluntary termination for “good reason” (e.g., a reduction in title or base salary) might result from the employees failure to meet performance goals. thus the compensation is not “remuneration payable solely on account of the attainment of one or more performance.” • this ruling is not effective for existing arrangements or for performance periods beginning on or before 1/1/09. 2. interim ceo is not “an outside director.” rev. rul. 2008-32, 2008-27 i.r.b. 6 (6/16/08). section 162(m)(4)(c) allows deductible compensation in excess of the $1,000,000 limitation of § 162(m) if the compensation is based on performance goals and approved by a compensation committee of the board of directors that is made up of two or more outside directors. the irs ruled that that a member of the board of directors who served as interim ceo during a search for the permanent ceo is not qualified to serve as an outside director on the compensation committee. 3. the price of a bail-out includes limitations on compensation. emergency economic stabilization act of 2008, act § 301(a), adding § 162(m)(5). the limit on deductible compensation is reduced to $500,000 for the ceo and cfo, plus the three highest paid employees of an employer for the tax year in which more than $300 million of troubled assets are acquired under the “troubled assets relief program” (tarp”) under the bail-out act. the limitation includes deferred deductions for compensation to a covered executive for services during an applicable employer taxable year. note that the limitation is not limited to corporations, but covers any employer who sells troubled assets under tarp. a. and the rip-cord is pulled on golden parachutes that are replaced by a tarp. the emergency economic 2009] recent developments in federal income taxation 295 stabilization act of 2008, act § 301(b), added new § 280g(e). the deduction disallowance and 20 percent excise tax imposed on golden parachute payments (compensation contingent on a take-over exceeding three times an executive’s average compensation in the preceding five years) has been extended to severance payments by reason of involuntary discharge from an employer participating in the troubled assets relief program. b. notice 2008-94, 2008-44 i.r.b. 1070 (10/14/08), provides detailed guidance and definitions regarding the application of new §§ 162(m) and 280g(e), enacted as part of the emergency economic stabilization act of 2008, to limit deductions on compensation paid to executives of employers accepting bail-out funds. taxpayers may rely on the guidance in the notice until further guidance is issued. any future guidance that is more restrictive will be prospective only. d. miscellaneous deductions 1. the irs responds to high gasoline prices. announcement 2008-63, 2008-28 i.r.b. 114 (6/24/08), modifying rev. proc. 2007-70. the irs announced that the business mileage rate for the second half of 2008 will be 58.5 cents per mile – an increase of 8 cents per mile – and that the medical/moving rate will also increase by 8 cents per mile to 27 cents per mile. the statutory rate for charitable mileage under § 170(i) remains at 14 cents per mile. a. but gas prices abruptly declined in fall 2008. rev. proc. 2008-72, 2008-50 i.r.b. 1286 (11/24/08). the business mileage rate for 2009 will be 55 cents per mile – a decrease of 3.5 cents per mile – and that the medical/moving rate will decrease by three cents to 24 cents per mile. the statutory rate for charitable mileage under § 170(i) remains at 14 cents per mile. 2. captive insurance subsidiary of one corporation doesn’t provide insurance, but the captive subsidiary of an affiliated group does. rev. rul. 2008-8, 2008-5 i.r.b. 340 (1/15/08). under the facts of situation 1 of this ruling “protected cell company” (a form of entity known as a protected cell company, a segregated account company, or segregated portfolio company) is formed by a sponsor, a domestic corporation, in jurisdiction a to provide insurance against professional liability risks. the sponsor owns the common stock of the protected cell company. protected cell company establishes multiple accounts, or cells, each of which has its own name and is identified with a specific participant, but which are not treated as separate entities. the capital of protected cell x is provided by x, which holds preferred stock in cell x. cell x 296 florida tax review [vol. 9:si only insures x’s risks and collects premiums from x. in situation 2, y corporation holds the preferred stock in cell y, to insure professional liability of y’s twelve subsidiaries, which operate independently on a decentralized basis. the irs ruled that there is no risk distribution, between x and its wholly owned protected cell and thus the payments to the protected cell are not deductible insurance premiums. in the y cell situation, because risks and premiums are pooled among the various subsidiaries the arrangement does involve distribution of risk among the subsidiaries and the premiums are treated as deductible insurance premiums. a. compare, rev. rul. 2005-40, 2005-2 c.b. 4 (6/17/05). this revenue ruling concluded that the elements of risk shifting and risk distribution must be present for an arrangement to be considered insurance for federal income tax purposes, citing helvering v. le gierse, 312 u.s. 531 (1941). four situations are set forth. the first three situations were held to be “not insurance” and they involved an unrelated person receiving premiums to insure the risk of a single taxpayer that operated a large fleet of automotive vehicles in the courier transport business, including (in situation 3) 12 singlemember llcs of approximately equal size owned by the same person which are classified as disregarded entities. in situation 4, each of those llcs elected to be classified as an association, and the arrangement was considered to be “insurance.” 3. the third circuit cans alcoa’s claim of right doctrine benefits. alcoa, inc. v. united states, 509 f.3d 173 (3d cir. 11/28/07). alcoa’s production of aluminum products produced substantial waste. under heightened environmental clean-up standards enacted in the comprehensive environmental response, compensation, and liability act of 1980 (cercla), and others, alcoa was forced to incur substantial environmental remediation expense to clean up several of its manufacturing sites. alcoa deducted these expenses in 1993 then filed a $12 million claim for refund in the district court. alcoa cleverly argued that its 1993 expenses should have been included in its cost of goods sold in manufacturing operations for the years 1940-1987. its reduced cost of goods sold for those years had generated excess income, received under a claim of right, which it was forced to return in the form of the deductible environmental remediation expenses incurred in 1993. alcoa then claimed under § 1341 that, rather than taking the deduction in 1993 for the expense, it was entitled to a return of the taxes paid in 1940-1987 on its increased gross income resulting from the under-inclusion of disposal costs in its cost of goods sold. the third circuit concluded that alcoa’s obligation to return gross income in the form of increased remediation expenses “did not arise from the same circumstances, terms, and conditions as the initial failure to spend additional funds on environmental clean-up. rather, the obligations were created by new 2009] recent developments in federal income taxation 297 circumstances, terms, and conditions, namely, by an intervening change in environmental legislation.” thus, there is no nexus between the income asserted to have been received under a claim of right, and the expenditure claimed as a refund of that income. the court ultimately concluded that the § 1341 benefits were not available “because alcoa’s expenditure of funds in 1993 was not the restoration of particular moneys to the rightful owner and did not arise from the same circumstances, terms, and conditions as alcoa’s original acquisition of the income.” a. mitigation proves slippery for pennzoil as well. pennzoil-quaker co. v. united states, 511 f.3d 1365 (fed. cir. 1/8/08), rev’g 62 fed. cl. 689 (2004). quaker state, later acquired by pennzoil, was sued by suppliers in a class action for price fixing resulting in a large settlement payment to the suppliers. pennzoil originally claimed the settlement payments as a deduction on its 1995 and 1996 tax returns, which was not challenged by the irs. on amended returns, pennzoil claimed a refund of taxes paid in prior years under § 1341 on the theory that it received overstated gross income in the earlier years because the lower prices paid to suppliers understated its cost of goods sold, which income was restored by virtue of the settlement payment. the court of federal claims, 62 fed. cl. 689 (2004), allowed the refunds, but the federal circuit reversed and held for the government. the circuit court held that the settlement payments failed the “same circumstances test” because the earlier income and the settlement payments were not complementary in terms of the theory of deductibility, the taxpayer’s tax treatment, and the underlying transactions. in the prior years the taxpayer’s treatment of the original payments to suppliers as cost of goods sold was not an item included in income. the court thus concluded that, “there is thus a disconnect between the purported item included in gross income (understatement of cogs) and the item restored (a negotiated lump sum payment to settle a lawsuit). this problem is intractable: cogs cannot be deducted, and settlement payments are not included in gross income.” the court also concluded that there was no restoration of an item previously included in gross income to the same party on account of the same transaction or series of transactions. finally, the court concluded alternatively that the inventory exception of § 1341(b)(2) precludes § 1341 relief for a refunded item that was included in gross income because of a sale of inventory. b. and yet another circuit slaps down a taxpayer’s claim for the application of § 1341. texaco v. united states, 528 f.3d 703 (9th cir. 6/13/08). between 1973 and 1981, texaco sold crude oil and refined petroleum products at prices that exceeded the price ceilings set by federal petroleum price regulations. as a result of subsequent department of energy administrative proceedings, texaco was required to pay $1,250,000,000 plus interest. texaco claimed a refund based on the application of § 1341, in lieu 298 florida tax review [vol. 9:si of simply deducting the amount paid on its tax return for the year of the payment. the court (judge callahan) held that § 1341 was not available, because § 1341(b)(2) specifically provides that the relief provision does not apply to refunds and allowances with respect to inventory sold in prior years. • although the court found that the plain meaning of § 1341(b)(2) precluded texaco’s claim to its benefits, the court added that if there was some ambiguity it would have deferred to the irs’s position in rev. rul. 2004-17, 2004-1 c.b. 516, which, although it involved different facts (the ruling held that § 1341 does not apply to environmental remediation expenditures arising from prior years’ manufacturing operations), includes the statement: “section 1341(b)(2) provides that § 1341(a) does not apply to any deduction allowable with respect to an item included in gross income by reason of the sale or other disposition of the taxpayer’s stock in trade (or other property of a kind that would have been included in the taxpayer’s inventory if on hand at the close of the prior taxable year) or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business.” the court noted that the ninth circuit accords revenue rulings skidmore deference, under which agency rulings “while not controlling upon the courts by reason of their authority, do constitute a body of experience and informed judgment to which courts and litigants may properly resort for guidance.” [skidmore v. swift co., 323 u.s. 134, 140 (1944)]. 4. notice 2008-40, 2008-14 i.r.b. 725 (3/11/08). this notice provides guidance to supplement notice 2006-52, 2006-1 c.b. 1175, with respect to certification of the installation in commercial buildings of energy efficient equipment for purposes of the § 179d deduction. the notice addresses allocation of the deduction in the case of government buildings, describes the requirements for approved software for calculating energy use and cost, and provides requirements for the interim energy efficient lighting rule of notice 2006-52. a. the emergency economic stabilization act of 2008 [division b], the energy improvement and extension act, § 303, extends the § 179d current deduction for installation of certain energy efficient property in a commercial building to property placed in service before 1/1/14. 5. irs determines who gets run over by the disallowed portion of leased driver’s meal expenses. rev. rul. 2008-23, 2008-18 i.r.b. 852 (4/14/08). in transport labor contract/leasing, inc. v. commissioner, 461 f.3d 1030 (8th cir. 2006), the court held that a leasing company that provided employee truck drivers to clients was not subject to the § 274(n) 50 percent limitation on deduction of expense for meals because the leasing company had a reimbursement arrangement with its clients under § 274(e)(3) that exempted the 2009] recent developments in federal income taxation 299 leasing company from the limitation. § 274(n)(2). the ruling provides three situations to explain who gets the § 274(n) haircut. • situation 1: the limitation applies to the leasing company where the driver accounts to it for meals and incidental expenses and the leasing company sends a lump-sum bill to the client. • situation 2: the limitation applies to the client where the driver accounts to the leasing company for meal and incidental expenses, the leasing company pays the driver, receives payment on a lump sum bill from the client, but then accounts to the client for the meal and incidental expenses by forwarding the driver’s substantiation, which is accepted by the client who also acknowledges that the substantiated meal and incidental expenses are paid under a reimbursement arrangement with the leasing company and are subject to the § 274(n) limitation. • situation 3: the limitation applies to the client where the driver submits substantiation to the client who forwards copies to the leasing company. the leasing company pays the driver, including reimbursed meals and incidentals, and sends the client a bill that indicates reimbursed meals referring to the driver’s substantiation submitted to the client. the client acknowledges that its payments to the leasing company equal to the reimbursement of the driver’s meals and incidental expenses is paid under a reimbursement arrangement with the leasing company and is subject to the § 274(n) limitation. • undoubtedly the most important fact in situations 2 and 3 that shifts the burden of the § 274 limitation is the client’s acknowledgement that the limitation applies to limit its deduction. thus, the ruling seems to permit employee leasing companies to negotiate application of the limitation, leaving the issue open only with respect to the uninformed. 6. does the treasury department care that local taxpayers might not approve of it making it easier for government employees to have tax-free “take-home” cars? reg-106897-08, qualified nonpersonal use vehicles, 73 f.r. 32500 (6/9/08). the treasury has published prop. reg. §§ 1.132-5 and 1.274-5. a qualified nonpersonal use vehicle, defined in § 274(i) as a vehicle because of its nature is not likely to be used for personal purposes beyond a de minimis amount, is not subject to the substantiation requirements of § 274(d), and the use of a qualified nonpersonal use vehicle is treated as a working condition fringe. the proposed regulations would treat a clearly marked public safety vehicle used by a government worker as a qualified nonpersonal use vehicle even though, unlike the existing regulations, the user is not employed by a police or fire department. 7. frozen on the ship, and frozen out of half of his meal deductions. kurtz v. commissioner, t.c. memo. 2008-111 (4/22/08). section 274(n)(2)(e) exempts from the 50-percent limitation on deductions for 300 florida tax review [vol. 9:si meal expenses any expenses for food or beverages “required by any federal law to be provided to crew members of a commercial vessel.” judge cohen ruled that § 274(n)(2)(e) did not apply to meal expenses incurred by the taxpayer as an independent contractor on the crew of a commercial fishing boat in the bering sea, because federal law does not require commercial fishing boats to provide meals to crew members. 8. have you documented that your own cell phone is used for business rather than personal purposes? tash v. commissioner, t.c. memo. 2008-120 (4/29/08). among the many deductions claimed by a lawyer that judge haines disallowed was the deduction claimed for his cellular telephone, because “[t]he record did not indicate whether petitioner used his cellular telephone for business and/or personal calls.” inasmuch as cell phones are listed property, reg. § 1.274-5(a), (c) requires substantiation for the deduction. 9. wouldn’t it just have been easier to cut rates in october 2004? no. was it because that’s what the french-looking vietnam war veteran was proposing? no, it was a replacement for the fsc/eti export subsidies. section 102 of the american jobs creation act of 2004 added new code § 199, which provides a magical 9 percent deduction of a percentage of taxable income attributable to domestic manufacturing activities. a. proposed regulations. reg-105847-05, income attributable to domestic production activities: deduction, 70 f.r. 67220 (11/4/05). the treasury has published massive [224 pages] proposed regulations [§§ 1.199-1 through -8] relating to the deduction for u.s. manufacturing income under § 199. the “shrinking back” concept of taking the deduction for only the value of the beans in a cup of brewed coffee, or for the value of the u.s.-manufactured shoelaces on a pair of foreign-manufactured sneakers is much discussed. b. finally, final regulations! final § 199 regulations are out and are 247 pages long, but that is only 137 pages in lexis and 55 pages in the federal register. t.d. 9263, income attributable to domestic production activities, 71 f.r. 31268 (6/1/06). you have to be addlepated if you expect a summary. c. only a masochist would bother to read these regulations unless billable hours were involved. t.d. 9381, tipra amendments to section 199, 73 f.r. 8798 (2/15/08), corrected, 73 f.r. 16518 2009] recent developments in federal income taxation 301 (3/28/08). the irs has promulgated a raft of amendments of the already incomprehensible § 199 regulations. d. emergency economic stabilization act of 2008, act § 502(b), treats compensation to actors, production personnel, directors and producers for film-making services in the u.s. as w-2 compensation for purposes of the § 199 deduction. e. emergency economic stabilization act of 2008 [division b], act § 401, would freeze the § 199 domestic manufacturing deduction for oil and gas producers at 6 percent, rather than increasing to 9 percent in 2010 as scheduled under current law. 10. “no man’s life, liberty or property is safe while the legislature is in session.” but the legislators’ “away from home” deductions are safe. reg-119518-07, travel expenses of state legislators, 73 f.r. 16797 (3/31/08). prop. reg. § 1.162-24 incorporates the holdings of rev. rul. 82-33, 1982-1 c.b. 28, which will be obsoleted when the proposed regulations are finalized. further, prop. reg. § 1.162-24 would provide that a taxpayer becomes a state legislator on the day the taxpayer is sworn into office and ceases to be a state legislator on the day following the day on which the taxpayer’s term in office ends. a legislature is in session when the members of the legislature are expected to attend and participate as an assembled body of the legislature. legislative days include a day on which the legislator’s attendance at a meeting of a committee of the legislature is formally recorded. 11. the tax code comes to the rescue of endangered species. the heartland, habitat, harvest, and horticulture act of 2008, amended § 175 applies to extend current deductibility to expenses incurred after 12/31/08 by farmers to achieve site-specific management actions pursuant to the endangered species act of 1973. 12. some folks in the heartland might not like this provision. section 461(j), added by the heartland, habitat, harvest, and horticulture act of 2008 and effective for years beginning after 12/31/09, limits the deductibility of farming losses in any year in which the taxpayer receives either (1) a direct or counter-cyclical payment under title i of the food, conservation, and energy act of 2008 (or any payment in lieu of such a payment), or (2) any commodity credit corporation (ccc) loan. the allowable farm loss is limited to the greater of (1) $300,000 ($150,000 in the case of a married taxpayer filing a separate return) or (2) the taxpayer’s total net farm income for the five preceding taxable years. disallowed losses may be carried 302 florida tax review [vol. 9:si forward indefinitely. for partnerships and s corporations, § 461(j) applies at the partner or shareholder level. 13. rev. proc. 2008-59, 2008-41 i.r.b. 857 (9/25/08). this revenue procedure updates per-diem rates that may be claimed without substantiation for travel after october 1, 2008. allowable per diem rates are at www.gsa.gov. 14. yearout mechanical & engineering, inc. v. commissioner, t.c. memo. 2008-217 (9/24/08). the taxpayer was a construction company that expanded into high-tech buildings during boom years in albuquerque, new mexico. due to its financial position and the difficulty of reliably obtaining rental equipment, the taxpayer entered into rental equipment leases with its shareholders. the tax court (judge gale) rejected the commissioner’s assertion that rental payments under long-term lease contracts, which also contained actual use provisions, were excessive and allowed the taxpayer’s deductions for the rental payments. the court found that the unique nature of equipment required for “clean room” construction and the general business climate in which the taxpayer operated established a business reason for the unique leasing arrangements. 15. since we are not willing to pay school teachers a living wage, let’s give them a tax break worth less than $2 a week at their tax brackets. the emergency economic stabilization act of 2008 [division c], act § 203,extended through 2009 the § 62(a)(2)(d) above-the-line deduction for up to $250 paid by an eligible educator for books, supplies, computer equipment (including software), other equipment, and supplementary materials used by the eligible educator in the classroom. e. depreciation & amortization 1. using the tax code for subsidies where direct action has failed: first-year depreciation recovery for specified gulf opportunity zone extension property. notice 2007-36, 2007-17 i.r.b. 1000 (3/29/07). this notice provides guidance with respect to the 50 percent original first year deprecation deduction provided under § 1400n(d). a 50 percent first year depreciation allowance is provided for property placed in service in the so-called go zone. the tax relief and health care act of 2006, § 120, adding code § 1400n(d)(6), extends the placed in service date for go zone extension property to 12/31/10. go zone extension property is property the substantial use of which is on one or more portions of the go zone (listed in the notice) and which is either nonresidential real property or residential rental property, or 2009] recent developments in federal income taxation 303 personal property that is used in such real property and is installed within 90 days of the date the building is placed in service. otherwise, property eligible for the 50 percent first year depreciation must have been placed in service by 12/31/07, or 12/31/08, for qualified nonresidential real property and residential rental property. the notice also explains the requirement that original use of the property must commence with the taxpayer. a. go zone depreciation recapture, or not, for like-kind exchanges and involuntary conversions. notice 2008-25, 2008-9 i.r.b. 484 (2/11/08). section 1400n(d)(5) requires recapture of tax benefits for go zone property that ceases to be go zone property. if go zone property is transferred by a taxpayer in a like-kind exchange or as a result of an involuntary conversion and the replacement property is go zone property in the taxpayer’s hands, there is no recapture. if go zone property is transferred by a taxpayer in a like-kind exchange or as a result of an involuntary conversion and the replacement property is not go zone property in the taxpayer’s hands and is not substantially used in the go zone or in the active conduct of a trade or business by the taxpayer in the go zone, there is recapture. if go zone property is transferred by a taxpayer in a like-kind exchange or as a result of an involuntary conversion and the replacement property is not go zone property in the taxpayer’s hands but is substantially used in the go zone and in the active conduct of a trade or business by the taxpayer in the go zone, there is no recapture. but, if the replacement property subsequently ceases to be substantially used in the go zone or in the active conduct of a trade or business by the taxpayer in the go zone, there is recapture. b. the housing assistance tax act of 2008, § 3082(b), extends the date for commencing construction of self-produced property eligible for go zone depreciation. formerly the 50 percent depreciation allowance was available for gulf opportunity zone property only if the taxpayer began construction of the property before january 1, 2008. the 2008 act deletes the january 1, 2008 date, but retains all other deadlines. 2. rev. proc. 2008-22, 2008-12 i.r.b. 658 (3/13/08). for cars subject to the limitations of § 280f placed in service in 2008, to which the 50-percent additional first year depreciation does not apply, the limit is $2,960 for the first year, $4,800 for the second year, $2,850 for the third year, and $1,775 for each succeeding year; for trucks and vans placed in service in 2008 the limit is $3,160 for the first year, $5,100 for the second year, $3,050 for the third year, and $1,875 for each succeeding year; for cars placed in service in 2008, to which the 50-percent additional first year depreciation applies, the limit is $10,960 for the first year, $4,800 for the second year, $2,850 for the third year, and $1,775 for each succeeding year; for trucks and vans placed in service in 304 florida tax review [vol. 9:si 2008, to which 50-percent additional first year depreciation applies, the limit is $11,160 for the first year, $5,100 for the second year, $3,050 for the third year, and $1,875 for each succeeding year. 3. the economic stimulus act of 2008, p.l. 110-185, reinstated the first year 50 percent depreciation allowance of § 168(k) for property placed in service in 2008. a. the irs says that the old regulations still apply. i.r. 2008-58 (4/11/08). the irs has indicated that reg. § 1.168(k)-1, promulgated under the earlier provision, will apply to bonus depreciation claimed for 2008. the irs promises new guidance regarding additional issues raised under the current provision and covering increased first year deductions under § 179 (watch for the 2009 version of this outline). b. stimulating deductions. rev. proc. 2008-54, 2008-38 i.r.b. 722 (8/29/08). this revenue procedure provides guidance regarding amendments in the economic stimulus act of 2008 to § 168(k) allowing a 50-percent additional first year depreciation for certain new property acquired and placed in service during 2008 and to § 179 increasing the dollar limitations for expensing depreciable property for taxable years beginning in 2008. specifically, the revenue procedure clarifies: (1) how the stimulus § 179 deduction interacts with the increased § 179 amounts provided under § 1400n(e) for certain § 179 go zone property. (2) how the stimulus additional first year depreciation deduction interacts with the go zone additional first year depreciation deduction for go zone property. (3) how the stimulus § 179 deduction interacts with the increased § 179 amounts applicable to the kansas disaster area. (4) how the stimulus additional first year depreciation deduction interacts with the 50-percent additional first year depreciation deduction applicable to the kansas disaster area. • the irs and the treasury department also intend to amend reg. § 1.179-5(c) to permit taxpayers to make a § 179 election without irs consent on an amended return for taxable years beginning after 2007. 4. automatic deemed election for fifteen-year amortization of start-up expenditures. t.d. 9411, elections regarding startup expenditures, corporation organizational expenditures, and partnership organizational expenses, 73 f.r. 38910 (7/8/08). the treasury has promulgated temporary regulations regarding elections to amortize start up expenditures under § 195, corporate organizational expenses under 2009] recent developments in federal income taxation 305 § 248, and partnership organizational expenses under § 709. the temporary regulations reflect changes in the american jobs creation act of 2004 increasing the amortization period from 60 months to 15 years. in addition, under temp. reg. § 1.195-1t, a taxpayer is deemed to have elected to amortize start-up expenditures for the taxable year in which the active trade or business to which the expenditures relate begins, but may forgo the deemed election “by clearly electing to capitalize its start-up expenditures on a timely filed federal income tax return (including extensions) for the taxable year in which the active trade or business to which the expenditures relate begins.” either way, the election is irrevocable and applies to all start-up expenditures related to the active trade or business. a change in the characterization of an item as a start-up expenditure is a change in an accounting method, subject to § 446 consent of the irs and § 481 adjustments, if the taxpayer treated the item consistently for two or more taxable years. similar rules apply to corporate and partnership organizational expenses. temp. reg. §§ 1.248-1t, 1.709-1t. 5. folks in the bluegrass region of the heartland like this provision. the heartland, habitat, harvest, and horticulture act of 2008 provides that for 2009 through 2013, a three-year § 168 cost recovery period applies to a race horse that is two years old or younger at the time that it is placed in service. 6. farm machinery is treated as five-year recovery property. emergency economic stabilization act of 2008, act § 505(a), amended § 168(e)(3)(b). farm machinery, the original use of which commences with the taxpayer, and which is placed in service in 2009, is treated as five-year recovery property for macrs. the provision does not apply to a grain bin, ginning equipment, fences or other land improvements. a. there is something for nascar fans. the emergency economic stabilization act of 2008, act § 317, extends sevenyear recovery for motorsports facilities defined in § 168(i)(15) to property placed in service in 2009. b. and for film lovers. the emergency economic stabilization act of 2008, act § 502(b), extends the expensing option of § 181 for qualified film and television production to costs incurred in production commencing before january 1, 2010. in the case of production costs exceeding $15 million ($20 million for production in low income communities or in areas of distress [will this result in more episodes of the wire]), the first $15 million (or $20 million) of production costs may be expensed. 306 florida tax review [vol. 9:si 7. emergency economic stabilization act of 2008, act § 305(a), amending § 168(e)(3)(e), extends fifteen-year amortization for qualified leasehold improvement property (improvements constituting § 1250 property made more than three years after a nonresidential building is placed in service) and qualified restaurant property (more than 50% of square footage devoted to food preparation and seating) placed in service before january 1, 2010. 8. emergency economic stabilization act of 2008, division b, § 308, adds § 168(m) to provide a 50 percent first year depreciation allowance of the adjusted basis of qualified reuse and recycling property acquired after august 31, 2008, which is reuse and recycling property with at least a five year useful life the original use of which commences with the taxpayer. the allowance is available under the amt. 9. the emergency economic stabilization act of 2008 extended through 2009 § 179e permits, which allows a taxpayer to elect to treat 50 percent of the cost of any “qualified advanced mine safety equipment” as a current expense. 10. on boxing day, the irs privately provides for the creation of depreciable interests in land. plr 200852013 (12/26/08). in this private letter ruling three sellers separately owned interests in a building with residential and commercial units, a parking structure and a surface parking lot. the sellers sold a remainder interest to an unrelated buyer, and a term interest in the land, buildings and other improvements and fixtures to the taxpayer. the sellers, the remainder interest holder, and the taxpayer are unrelated. citing reg. § 1.167(a)-1(b), gordon v. commissioner, 85 t.c. 309, 322-323 (1985), and lomas santa fe, inc. v. commissioner, 74 t.c. 662, 683 (1980), aff’d, 693 f.2d 71 (9th cir. 1982), the irs held that the taxpayer may claim depreciation deductions for the cost allocated to the term interest in land over the term of the interest. the taxpayer is allowed to claim capital recovery for the buildings and parking structure under the rules of § 168. f. credits 1. t.d. 9401, alternative simplified credit under section 41(c)(5), 73 fr 34185 (6/17/08). treasury issued temp. regs. §§ 1.41-6t, -8t, and -9t, which contain rules for calculating § 41 research credits under the alternative simplified research credit provided by § 41(c)(5) enacted in the tax relief and health care act of 2006. although the research credit expired after 2007, if past history is any indication of future behavior, congress will re-extend 2009] recent developments in federal income taxation 307 the credit – in all likelihood retroactively. the 2006 act added a third, “simplified”, method for calculating the credit. under § 41(c)(5) the credit may be determined as equal to 12 percent of qualified research expenditures as exceeds 50 percent of the average qualified research expenditures for the previous three years, or 6 percent of qualified research expenditures if the taxpayer does not have qualified research expenditures in each of the previous three years. 2. corporate taxpayers need spreadsheet net present value analysis to figure out this election. the housing assistance tax act of 2008, § 3081, provides for an increase in available § 38 credits for increased research activity in lieu of the § 168(k) 50 percent first year allowance for property placed in service in 2008. for property placed in service after march 31, 2008, a corporation may elect to forego the additional deduction under § 168(k) and increase the research credit or minimum tax credit limitation of §§ 38(c) and 53(c) (amt credits are limited to the excess of regular tax over tentative tax) by 20 percent of the bonus depreciation amount. the increase in credits may provide refundable credits against regular tax liability. for eligible property the bonus depreciation amount is the amount of increased depreciation deductions available under §168(k). the bonus depreciation amount is limited to the lesser of $30 million or six percent of the sum of research credit carryforwards from years beginning after january 1, 2006 and minimum tax credits attributable to adjusted minimum tax for years after january 1, 2006. depreciation for eligible property for both regular tax and amt purposes is computed under the straight line method. this provision is included in a section of the act entitled “revenue provisions.” • this amendment allows corporate (but not individual) taxpayers to elect to accelerate the amt credit and the research credit in lieu of claiming bonus depreciation. a. jesus chrysler? and the pork takes a drive in a new car – powered by corn. the housing assistance tax act of 2008, § 3081, also provides that “an applicable partnership” may elect to be treated as making a deemed tax payment in the amount of the least of (1) the bonus depreciation that would be allowed if an election were in effect for the partnership, (2) the amount of the partnership’s research credit for the year, or (3) $30 million (reduced by any deemed payment for a prior taxable year). an applicable partnership is “a domestic partnership that was formed on august 3, 2007, and will produce in excess of 675,000 automobiles during the period beginning on january 1, 2008, and ending on june 30, 2008.” there must be a lot of qualified partnerships out there.☺ 308 florida tax review [vol. 9:si b. and it’s all explained by the irs. rev. proc. 2008-65, 2008-44 i.r.b. 1082 (10/14/08). section 168(k)(4) allows an election to treat the 50 percent bonus depreciation amount (over regular depreciation) as an increase in the limitation of § 38(c) on the general business credit or as an increase in the § 53(c) limitation on the amount of credit against regular tax liability for lower tentative minimum tax (refundable). the increases are allowed to corporations and the chrysler llc (not identified by name in the revenue procedure). the election is available for qualified property placed in service between 3/31/08 and 1/1/10. the revenue procedure defines eligible property under the various provisions of the housing and economic recovery act of 2008, provides rules for making the election, determining the bonus depreciation amounts, and allocating the bonus depreciation amount between the limitations of §§ 38(c) and 53(c). 3. the housing assistance tax act of 2008, § 3022(b), provides that for housing placed in service after 12/31/07, the low-income housing tax credit of § 42 and the rehabilitation credit of § 47 will offset alternative minimum tax liability. before the amendment, these credits, along with general business credits, were limited to an amount not in excess of the taxpayer’s regular tax liability over the tentative minimum tax. sections 38(b)(4)(b)(ii) and (v) are amended to treat the tentative minimum tax as zero for purposes of determining the allowable low-income housing and rehabilitation credits. 4. we guess that the intent of this one is to bring food prices down. the heartland, habitat, harvest, and horticulture act of 2008 reduces the § 40 alcohol fuels credit amount for ethanol production from 51 cents per gallon to 45 cents per gallon for 2009 and 2010, subject to a delayed effective date if ethanol production and importation do not reach 7,500,000,000 gallons in 2008. 5. how many tax professionals know what “lignocellulosic” and “hemicellulosic” matter are? section 40(b)(6), added by the heartland, habitat, harvest, and horticulture act of 2008, adds the cellulosic biofuel producer credit as a new component of the §40 alcohol fuels credit. generally, the amount of the credit is $1.01 for each gallon of qualified production after 12/31/08 and before 1/1/13. if a cellulosic biofuel is alcohol, the amount of the credit is reduced by the amount of credit allowable under other parts of §40. cellulosic biofuel is liquid fuel which is derived from any renewable lignocellulosic or hemicellulosic matter; examples of such matter include dedicated energy crops, wood, plants, grasses, animal wastes, and municipal solid waste. 2009] recent developments in federal income taxation 309 a. the emergency economic stabilization act of 2008 [division b], the energy improvement and extension act, § 201, amends § 168(l)(3), which provides a 50 percent first year allowance for qualified cellulosic biomass ethanol plant property to provide a definition of cellulosic biofuel to include, “any liquid fuel which is produced from any lignocellulosic or hemicellulosic matter that is available on a renewable or recurring basis.” this definition replaces “cellulosic biomass ethanol.” 6. helping reservists by helping their employers. why not just have uncle sam increase their pay while on active duty? section 45p, added as part of the general business credit by the heroes earnings assistance and relief tax act of 2008, creates a new credit for a “small business employer” (defined as an employer with an average of less than 50 employees on business days during the year) that pursuant to a written plan provides “eligible differential wage payments” to every “qualified employee” (defined as a person who has been employed by the taxpayer for the 91-day period immediately preceding the period for which the differential wage payment is made). “differential wage payments” are defined (by cross-reference to § 3401(h)(2)) as payments made while a qualified employee of the employer is on active duty with the united states military for a period of more than 30 days, which represent all or some of the wages that the employee would have received from the employer if the employee were performing services for the employer. credit-eligible differential wage payments are limited to $20,000 per employee per year. the credit amount is 20 percent of credit-eligible payments. section 280c(a) provides that the employer is not entitled to a business expense deduction for the portion of its wage expense that is equal to the amount of its credit under §45p. the credit is not available with respect to payments made after 12/31/09. 7. the tax code is enlisted to fight terrorists trying to make fertilizer bombs. section 45o, added as part of the general business credit by the heartland, habitat, harvest, and horticulture act of 2008, provides a credit equal to 30 percent of “qualified chemical security expenditures” (including expenditures on employee security training, and on a wide range of security devices) incurred by an “eligible agricultural business.” the amount of the credit (not the amount of credit-eligible expenditures) with respect to any one facility is limited to $100,000 (with the ceiling reduced by the total amount of credits allowed with respect to that facility over the five preceding years), and the total annual credit per taxpayer per year (again, not total credit-eligible expenditures) is limited to $2,000,000. “eligible agricultural businesses” are those that sell pesticides or certain fertilizers at retail to farmers and ranchers, and those which manufacture, formulate, distribute or aerially apply pesticides or certain fertilizers. the taxpayer’s deductible business expense 310 florida tax review [vol. 9:si must be reduced by the amount of the credit claimed under §45o. the credit is not available with respect to expenditures paid or incurred after 12/31/12. 8. credits for saving the spotted owl, or is it to increase the amount of timber that the forest service can sell off at bargain prices? sections 54a and 54b, added by the heartland, habitat, harvest, and horticulture act of 2008, create a credit for holders of qualified forestry conservation bonds (qfcbs). a qfcb is a bond issued by a state or a §501(c)(3) organization to finance a “qualified forestry conservation project” (which is defined as the acquisition of land adjacent to united states forest service land, subject to the requirement that at least half of the acquired land must be transferred to the forest service at no net cost, and several other requirements). the national limitation on qfcbs is $500 million, with allocations among qualified projects to be determined by the treasury department. all the available project proceeds of a qfcb must be used within the three-year period beginning on the date of issuance, except that unspent proceeds may be used within 90 days from the end of the three-year period to redeem bonds. the holder of a qfcb is entitled to a credit determined by multiplying the face amount of the holder’s bond by the credit rate of the bond, with the credit rate having been determined by the treasury department at issuance; the credit rate is to be the rate necessary to permit the issuance of qfcbs without discount and without interest cost to the issuer. a recipient of the credit must include the amount of the credit in gross income as interest. 9. the low-income housing credit gets better temporarily. the housing assistance tax act of 2008 made numerous changes in the low-income housing credit. (1) to qualify for the 70-percent credit base [new housing that is not federally subsidized], rehabilitation expenditures must equal or exceed the greater of (1) 20 percent of the adjusted basis of the building being rehabilitated, or (2) $6,000 (indexed for post-2008 inflation) per low-income unit in the building being rehabilitated. (2) the 70percent credit increases to a 91-percent credit base, and the 30-percent credit base [housing that is either existing or federally subsidized] increases to a 39percent credit base, in the case of buildings (a) located in specified types of highcost areas, and (b) designated by a state housing credit agency as requiring the larger credit in order to be financially feasible. (3) for buildings placed in service after 7/30/08, neither (a) direct or indirect federal loans bearing interest rates below the afr, nor (b) certain assistance provided under the home investment partnerships act or the native american housing assistance and self determination act of 1996, are treated as federal subsidies that reduce the credit from 70 percent to 30 percent; tax exemption of bond interest under § 103 continues to reduce the credit percentage. (4) for non-federally subsidized buildings placed in service after 7/30/08 and before 12/31/13, the actual credit 2009] recent developments in federal income taxation 311 percentage will not be less than 9 percent. (5) the annual per-resident credit allocated to each state housing credit agency is temporarily increased to $2.20 for calendar years 2008 and 2009. (6) the election post a bond to avoid recapture has been replaced by an extension of the statute of limitations until three years after the taxpayer notifies the irs of any noncompliance with the low-income housing credit rules resulting from a disposition. 10. notice 2008-68, 2008-34 i.r.b. 418 (8/21/08). the notice provides guidance on the fuel cell credit and microturbine credit. the notice covers technical requirements for claiming the credit computation issues, and extension of the credit to a lessor. 11. the emergency economic stabilization act of 2008 [division b], the energy improvement and extension act, § 306, amends § 168(e)(3)(d) to treat qualified smart electric meters and a smart grid system, as defined in § 168(i)(18) and (19), as ten-year property, but limits the depreciation method in § 168(b)(2)(c) to 150 percent declining balance. 12. the “temporary” research credit that never sunsets is extended again. the emergency economic stabilization act of 2008, [division c] § 301, extended the § 41 credit for increased research activities for amounts paid or incurred through december 31, 2009. the act also increased the § 41(c)(5) alternative simplified credit to 14 percent for years ending after december 31, 2008, and amended § 41(c) to provide that the an election to claim the § 41(c)(4) alternative incremental credit shall not apply to years beginning after december 31, 2008. 13. indian credit. the emergency economic stabilization act of 2008 [division c], § 314, extended the § 45a indian employment credit for taxable years beginning on or before december 31, 2009. 14. marketing credit. the emergency economic stabilization act of 2008 extended the § 45d new markets tax credit through 2009, permitting up to 3.5 billion in qualified equity investments for that calendar year. 15. schoolhouse credit. the emergency economic stabilization act of 2008 provides that the § 1397e qualified zone academy bond credit does not apply to any bond issued after october 3, 2008, but added new § 54e, which provides a virtually identical credit for, and authorizes issuance of, up to $400 million of new qualified zone academy bonds issued after october 3, 2008 and before 2010. 312 florida tax review [vol. 9:si 16. katrina employee credit. the emergency economic stabilization act of 2008 extended the work opportunity credit through aug. 28, 2009 for certain employees hired in the core disaster area of hurricane katrina. the credit for katrina employees hired to a new place of employment outside of the core disaster area was not extended. 17. historic new orleans credit. the emergency economic stabilization act of 2008 extended §1400n(h) through december 31, 2009. section 1400n(h), was added by the gulf opportunity zone act of 2005, to increase the 10 percent credit § 47 rehabilitation to 13 percent, and the 20 percent credit to 26 percent, for qualified expenditures incurred on or after august 28, 2005, and before january 1, 2009, with respect to structures and buildings located within the katrina-related gulf opportunity zone. 18. the emergency economic stabilization act of 2008 [division c] contains other credit provisions: a. section 302, extends the § 45d credit for equity investment in qualified active low-income community business. b. section 316, extends the railroad track maintenance credit of § 45g to expenditures made in 2009 and allows the credit for amt purposes. c. section 320 extends the rehabilitation credit through 2009. g. natural resources deductions & credits 1. safer mines credit. the emergency economic stabilization act of 2008, act § 310, extended through 2009 the $10,000 § 45n credit for expenses incurred in training “qualified mine rescue team employees.” 2. safer mines deduction. emergency economic stabilization act of 2008, act § 311, extends the § 179e 50 percent expensing provision for mine safety equipment to include equipment placed in service before january 1, 2010. 3. the emergency economic stabilization act of 2008 [division b], the energy improvement and extension act, § 209, extends the 50 percent expensing allowance by two years for qualified refinery property to 2009] recent developments in federal income taxation 313 property placed in service before 1/1/11. the definition of a qualified refinery in § 179c(d) is expanded to the refining of fuel directly from shale or tar sands. 4. the emergency economic stabilization act of 2008 [division b], the energy improvement and extension act, extends several credits and adds a few new twists. • section 101 extends the § 45 credit for wind and refined coal facilities for property placed in service before 1/1/10. the credit is extended for certain other facilities to include property placed in service in 2009 and 2010. • the energy credit contains special rules for energy produced from refined coal. section 101(b) changes the definitions of qualified refined coal to eliminate the requirement of § 45(c)(7)(a)(i)(iv) that the fair market value of refined coal be increased by 50 percent over the value of feedstock coal, and increases the requirement of § 45(c)(7)(b) for emissions reduction from 20 percent to 40 percent. section 108 of the act amends the § 45(c)(7)(a) definition of refined coal to include fuel produced from coal that is sold with a reasonable expectation that the fuel will be used to produce steam, is certified as resulting in a qualified emission reduction, and is produced in a manner that results in a 50 percent increase in value over feedstock coal or is steel industry fuel. steel industry fuel is produced by liquefying coal waste sludge and distributing it on coal that is used for the manufacture of coke. • section 101(c) changes the definitions of trash facilities, biomass facilities, and facilities for hydropower production of § 45(c) and (d). • section 102 adds facilities for production of electricity from waves, tides and ocean currents. • section 103 extends the solar energy credit to include property placed in service in periods ending before 1/1/17, for fuel cell property and microturbine property in periods ending after 12/31/16. • section 103(b) allows the § 46 energy credit as an offset against the amt, adding § 38(c)(4)((b)(v). • section 103(c) expands the § 48 energy credit to include power systems that combine power generation with steam generation for heat. • section 103(d) increases the credit limitation of § 48(c) for qualified fuel cell property from $500 for each 0.5 kilowatt capacity to $1500. • section 103(f)(2) allows the § 48 energy credit as an offset against the amt, adding § 38(c)(4)((b)(v). • section 104(a) adds qualified small wind energy property to the 30 percent energy credit of § 48. 314 florida tax review [vol. 9:si • section 105 adds geothermal heat pump to the list of energy property available for the § 48 energy credit. • section 106 expands the credit for residential energy efficient property by extending the credit to 12/31/16, eliminating the $2,000 limitation for solar electric property expenditures, adding a 30 percent credit for small wind energy property limited to $500 for each half kilowatt of capacity not to exceed $4,000, adding geothermal heat pump property to the list of eligible expenditures (limited to $2,000), and allows the credit against the alternative minimum tax. • section 111 expands the investment credit under § 48 for qualifying advanced coal projects. the credit is allowed for projects certified by the irs in consultation with doe under a competitive bidding process. amended § 48a(d)(3)(a) expands the amount of available credits from $1.3 billion to $2.55 billion. section 48a(a)(3) is added to provide a 30 percent credit for projects described in § 48(d)(3)(b), which include greenhouse gas capture capability, increased by-product utilization, applicants who have a partnership with an educational institution, and other benefits. the irs is also directed in § 48a(d)(3)(b) to direct specified amounts to particular types of projects. section 48a(e)(1) is amended to direct the irs to give priority to projects that capture and sequestrate carbon dioxide emissions. • section 112 increases the coal gasification credit of § 48b from 20 percent to 30 percent and expands the total amount of available credits to $3.5 billion. section 48b(f) is added to provide for recapture of the credit for any project that fails to meet the carbon dioxide separation and sequestration requirements of § 48b(d)(1). • section 115 adds a new credit to § 38 business credits for carbon dioxide sequestration. section 48q provides a credit of $20 per metric ton of qualified carbon dioxide which is captured by the taxpayer and disposed of in secure geological storage and $10 per ton of captured carbon dioxide that is used as a tertiary injectant in a qualified enhanced oil or natural gas recovery project. • and the scientists are to tell us whether any of this works to reduce hot air. section 117 requires the secretary of the treasury to enter into an agreement with the national academy of sciences to undertake an audit of the code to determine which provisions have the greatest affect on carbon dioxide and other greenhouse gas emissions. • section 202 increases the § 40a credit for biofuel from 50 cents to $1 for each gallon of biofuel used in the production of a qualified biodiesel mixture. the credit is extended to biofuel used in the production of aviation jet fuel. (southwest may find a new use for its peanuts, gas production.) the credit is not available for fuel produced using feedstock that is not biomass. 2009] recent developments in federal income taxation 315 • section 203 restricts the fuels credits under §§ 40 (alcohol), 40a (biodiesel), 6426 (excise tax), by excluding fuels produced outside of the united states for use outside of the united states. • section 210 extends exclusion from the 100 percent of income limitation on percentage depletion that is provided for production from marginal properties for one year to include production in a tax year beginning before 12/31/09. • section 304 extends the energy efficient home credit of § 45l through 2009. • section 305 extends the § 45m credit (part of the § 38 investment credit) for production of energy efficient dishwashers, clothes washers, and refrigerators to products manufactured in 2009, with different dates for different products. 5. notice 2008-72, 2008-43 i.r.b. 998 (10/27/08). the § 43 enhanced oil recovery credit for taxable years beginning in the 2007 calendar year is phased out completely, because the reference price for the 2006 calendar year ($66.52) exceeds $28 multiplied by the inflation adjustment factor for the 2006 calendar year ($41.06) by $25.45. 6. notice 2008-89, 2008-43 i.r.b. 999 (10/27/08). the applicable percentage under§ 613a to be used in determining percentage depletion for marginal oil and gas properties for the 2007 calendar year is 15 percent. h. loss transactions, bad debts, and nols 1. bynum v. commissioner, t.c. memo. 2008-14 (1/28/08). the tax court (judge foley) held that cash payments by an individual for start-up expenses and routine business expenses of his controlled corporation were capital contributions and not deductible as business bad debts. the taxpayer had no debtor-creditor relationship with his incorporated businesses and there was no enforceable obligation of the corporations to make fixed payments of principal or interest. 2. proposed regulations that threatened the ordinary loss treatment of bank loans are withdrawn. reg-109367-06, section 1221(a)(4) capital asset exclusion for accounts and notes receivable, 73 f.r. 21861 (4/22/08). prop. reg. § 1.1221-1(e) (2006), reg-109367-06, section 1221(a)(4) capital asset exclusion for accounts and notes receivable, 71 f.r. 44600 (8/7/06), would have provided that notes or receivables would be treated as capital assets outside of the § 1224(a)(4) exclusion if the notes were acquired 316 florida tax review [vol. 9:si for more than a de minimis consideration in addition to services or inventory property. commentators raised concern with respect the ordinary loss treatment of devalued notes issued for mortgage loans, contrary to the position in cases such as burbank liquidating corp. v. commissioner, 39 t.c. 999 (1963), acq. sub nom. united assocs., inc., 1965-1 c.b. 3, aff’d in part and rev’d in part on other grounds, 335 f.2d 125 (9th cir. 1964). in withdrawing the proposed regulations the irs announced that it would not challenge reporting positions consistent with existing case law treating bank loans as ordinary loss assets. 3. when congress gives the irs authority to promulgate procedures, the deadlines stick. tualatin valley builders supply, inc. v. united states, 522 f.3d 937 (9th cir. 4/10/08). the job creation and worker assistance act of 2002, enacted on 3/9/02, amended § 172 to allow a five year carryback of net operating losses for 2001 and 2002 tax years. the act authorized the irs to prescribe procedures to claim adjustments with respect to returns filed for 2001. in rev. proc. 2002-40, 2002-1 c.b. 1096, the irs provided that taxpayers were required to change their 2001 reporting positions before 10/31/02. the court denied the taxpayer’s claim for refund based on amended returns filed on 1/7/03, attempting to apply the 5-year carryback allowed in the 2002 act rather than the 2-year carryback of the taxpayer’s 2001 nols originally reported and allowed. the court held that the specific grant of authority provided in § 172(j) authorized the revenue procedure, which was entitled to deference under chevron, u.s.a., inc. v. natural resources defense council, inc., 467 u.s. 837 (1984). 4. duh! stock that is still trading is not worthless yet. rendall v. commissioner, 535 f.3d 1221 (10th cir. 8/5/08), aff’g t.c. memo. 2006-174. the taxpayer lent $2 million to a publicly traded company that he had founded. the loan was secured by stock of the company held by the lender, merrill lynch. the loan proceeds were used to partially fund construction of a plant in canada to extract crude oil from oil shale. in 1997 the corporation declared bankruptcy in canada and the united states. merrill lynch sold a portion of the taxpayer’s pledged stock to satisfy the debt. the company arranged to sell most of its assets, but retained rights to certain of its patented technologies. at the close of the 1997 tax year the company stock was traded over-the-counter for $3 per share. the court affirmed the tax court holding denying a deduction in 1997 for worthless debt. the court agreed with the tax court’s conclusion that at the end of 1997 the taxpayer had not met the standard for treating the debt as worthless, which it described as “fixed by identifiable events that form the basis of reasonable grounds for abandoning any hope of recovery.” 2009] recent developments in federal income taxation 317 • a debt owed to the taxpayer by a bankrupt corporation, that possibly was insolvent and which had agreed to sell all of its operating assets, was not worthless where the stock was still trading for $3 per share and the corporation still owned numerous technologies, patents, office space, a research facility, and land and continued to employ a team of engineers. “‘where a debtor company continues to operate as a going concern the courts have often concluded that its debts are not worthless for tax purposes despite the fact that it is technically insolvent.’” (quoting roth steel tube co. v. commissioner, 620 f.2d 1176, 1182 (6th cir. 1980)). • the court also rejected the taxpayer’s claim that it realized no gain on the disposition of its pledged stock. the taxpayer argued that merrill lynch sold the stock without permission and that any income should be taxed to merrill lynch which obtained the stock by theft. the court also upheld the tax court’s allocation of basis to the sold shares on a fifo basis. 5. ordinary gain and loss on sale of fannie mae and freddie mac preferred stock. the emergency economic stabilization act of 2008, act § 301, contains an off-code provision allows an applicable financial institution to treat losses on the sale of fannie mae or freddie mac preferred stock held on september 6, 2008, as ordinary losses. the eesa allows the secretary to treat transferred basis stock as held on the requisite date. applicable financial institutions are defined in § 582(c)(2) and include banks, savings banks, a small business investment company, and a business development corporation. the eesa also allows depository institutions to treat losses as ordinary. a. benefits extended to partners and subsidiaries. rev. proc. 2008-64, 2008-47 i.r.b. 272 (10/30/08). the ordinary loss treatment is extended to the distributive share of loss of a qualified financial institution partner in a partnership that held qualified fannie mae or freddie mac preferred stock on 9/6/08, and sold the stock after that date, and to the sale of a partnership interest by a qualified financial institution if 95% of the partnership’s assets consisted of qualified preferred stock or cash equivalents. a qualified financial institution that receives a distribution of qualified preferred stock from a partnership 95% of whose partnership’s assets consisted of qualified preferred stock or cash equivalents, is treated as holding the qualified preferred stock on 9/6/08. sales of qualified preferred stock of subsidiaries of a qualified financial institution are treated as ordinary gain or loss. qualified preferred stock held by a qualified financial institution whose basis is determined from the basis of the person who transferred the stock and who held the stock on 9/6/08, is also treated as having held the stock on 9/6/08. 318 florida tax review [vol. 9:si 6. jojoba partnership investment may have been worthless from the outset, but not enough to claim a loss deduction. helbig v. commissioner, t.c. memo. 2008-243 (10/29/08). the taxpayer invested in contra costa jojoba research partners, an investment in jojoba beans promoted by charles b. toepfer. deductions from the partnership investment were denied for 1983, 1984, and 1985 in utah jojoba i research v. commissioner, t.c. memo. 1998-6, to which the taxpayer had agreed to be bound. the court (judge wherry) denied taxpayer’s additional claim that the investment was worthless from the outset giving rise to loss deductions in 1983-1985. the court noted that the taxpayer continued to pursue the investment through 1993. • the court also upheld negligence penalties under § 6653(a) and substantial understatement penalties under § 6661. a. heller v. commissioner, t.c. memo. 2008-232 (10/20/08). the court upheld negligence penalties under § 6653 and substantial understatement penalties under § 6661 on investors in the contra costa jojoba bean shelter. the court held that the hellers had been negligent in their failure to consult a tax expert before taking the large deductions from contra costa’s research and development efforts. 7. worthless stock is not theft, even though it may feel like it. electronic picture solutions, inc. v. commissioner, t.c. memo 2008-212 (9/8/08). the corporate taxpayer purchased publicly traded novatek stock through a california broker. the sec filed a civil complaint alleging massive fraud on novetek investors. the taxpayer claimed a theft loss under § 165(a) (instead of a capital loss for worthless securities). in denying the deduction the court (judge thornton) observed that under california law that a purchaser of securities on the open market cannot support a claim of theft because there is no privity between the perpetrator and the victim. 8. a bad investment in an abusive shelter is a theft loss, but the taxpayer has to prove no possibility of recovery. vincentini v. commissioner, t.c. memo 2008-271 (12/8/08). the taxpayer in 1999 invested in an international tax fraud scheme on the basis of listening to audio tapes produced by keith anderson, founder of anderson ark and attending an anderson ark conference in costa rica. in a petition challenging the irs assessment of a deficiency for 1999 denying losses claimed from the taxpayer’s anderson ark investment, the taxpayer claimed a theft and casualty loss from the investments in 2001 or 2002 that could be carried back to taxpayer’s 1999 taxable year. in 2002 the anderson ark promoters were convicted of money laundering and/or conspiracy to commit money laundering by the district court for the eastern district of california (united states v. anderson, 391 f.3d 970, 974 (9th cir. 2004).) in 2004 the same defendants were convicted in the 2009] recent developments in federal income taxation 319 washington district court on charges of conspiracy to commit wire and mail fraud and to defraud the united states. the judgment of the washington district court ordered the anderson ark defendants to provide restitution to anderson ark investors, including the taxpayer. the tax court (judge marvel) held that since the government in the anderson ark criminal cases took the position that the taxpayer was a victim of fraud and was entitled to restitution, judicial estoppel prevented the government from asserting in the tax court that the taxpayer did not suffer a theft loss. however, the court also held that the taxpayer failed to establish that it was reasonably certain at the end of 2001 that the taxpayer would not recover his loss from anderson ark. thus, the casualty loss deduction was denied. in addition, the taxpayer was assessed penalties under § 6662 with respect to losses claimed from the anderson ark investment. the court rejected the taxpayer’s assertion of reasonable reliance on the advice of a tax professional noting that, reliance on the advice of an accountant who was referred to the taxpayer by the promoter was not reasonable reliance. i. at-risk and passive activity losses 1. this deficit restoration obligation was not at-risk. hubert enterprises v. commissioner, t.c. memo. 2008-46 (2/28/08), on remand from 230 fed. appx. 526 (6th cir. 4/27/07). the taxpayer held 99 of 100 units of a wyoming llc that purchased equipment financed with recourse debt. the taxpayer amended the llc agreement to provide a requirement for restoration of a deficit capital account on liquidation of the llc in order to pay creditors and restore the positive balance of a member’s capital account. relying on the ultimate liability standard of emershaw v. commissioner, 949 f.2d 841 (6th cir. 1991), the tax court (judge laro) held that the taxpayer had no personal liability because repayment of any deficit was contingent on liquidation of the llc and no creditor had a right to force a liquidation under state law. 2. due process does not protect this tax attorney’s pre1986 real estate investments from the passive activity loss rules. ziegler v. commissioner, 282 fed.appx. 869 (2d cir. 6/26/08). the second circuit, in a summary opinion, affirmed the tax court’s decision (t.c. memo. 2007-166 (6/27/07)), rejecting stephen ziegler’s argument that application of the passive activity loss rules to investment real estate purchased in 1984, two years before the effective date of § 469, was a retroactive application of the law constituting a taking under the due process clause of the fifth amendment. the tax court had observed that tax legislation is not a promise and that the taxpayer has no vested right in the internal revenue code. the circuit court added that application of § 469 is not an unconstitutional taking under the fifth amendment because the taxpayer did not have a property right to the tax benefits affected by enactment of § 469. 320 florida tax review [vol. 9:si 3. let’s consider changing the requirements for grouping activities under § 469. notice 2008-64, 2008-31 i.r.b. 268 (8/4/08). reg. § 1.469-4(c)(1) provides rules for grouping trade or business activities and rental activities into a single activity for purposes of applying the passive activity loss limitations of § 469. grouping several activities into a single activity might be an advantage if the taxpayer can establish him or herself as a material participant in the group of activities. on the other hand, since disposition of an activity permits deduction of unused losses from the activity, a large grouping may be disadvantageous. the irs is seeking comments on a proposal to require taxpayers to provide a written statement indicating whether one or more trade or business activities are grouped as a single activity or as separate activities. the statement would be required to be filed with a return for the first taxable year in which a grouping is made, in any year the taxpayer adds new activities to a grouping, whenever a taxpayer disposes of an activity from an existing grouping, or when it is determined that existing groupings are inappropriate under the regulations. statements would be required to be filed only in years when there are changes in a taxpayer’s grouping of activities. failure to file the required statements would cause each of the taxpayer’s activities to be treated as a separate activity. comments are requested by 11/4/08. the proposal would be effective on the date that final guidance is published. 4. a closing agreement does not override the passive activity loss rules. shelton v. united states, 102 a.f.t.r.2d 2008-6287 (fed. cl. 9/23/08). the taxpayers entered into a closing agreement in a partnership audit that provided that, “any losses disallowed under this agreement are suspended under i.r.c. § 465. such suspended losses may be used to offset the taxpayers’ pro rata share of any income earned by the partnership and/or other income in accordance with the operation of i.r.c. § 465.” the taxpayer asserted that the closing agreement allowed deduction of suspended loss in a year that atrisk amounts are increased, regardless of the passive activity loss limitation of § 469. the claims court (judge miller) held on summary judgment that § 469 always applies after the limitation of § 465 is overcome and that any absence of a reference to § 469 in the closing agreement does not eliminate its application. iii. investment gain a. capital gain and loss 1. the ever-expanding deemed sale or exchange concept limits ordinary loss deductions. reg-101001-05, abandonment of stock and other securities, 72 f.r. 41468 (7/30/07). prop. reg. § 1.165-5(i) would provide that a security that has been abandoned is treated as a wholly 2009] recent developments in federal income taxation 321 worthless security. to abandon a security, a taxpayer must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for it. thus, if the abandoned security (other than a security in an affiliated corporation subject to § 165(g)(3)) is a capital asset, the resulting loss is a capital loss incurred on the last day of the taxable year. all the facts and circumstances determine whether the transaction is properly characterized as an abandonment or other type of transaction, such as an actual sale or exchange, contribution to capital, dividend, or gift. these proposed regulations will be effective after the date of publication of final regulations. a. finalized in the blink of an eye. t.d. 9386, abandonment of stock or other securities, 73 f.r. 13124 (3/12/08). the proposed regulations were adopted as final regulations, without change, and are effective for any abandonment of stock or other securities after 3/12/08. 2. despite repeated tries, insurance agency termination payments continue to be denied capital gains treatment. trantina v. united states, 512 f.3d 567 (9th cir. 1/9/08). the taxpayer was a state farm insurance agent, who sold policies exclusively for state farm as an independent contractor, operating his own agency, developing clients, hiring employees, and paying expenses. upon retirement, the taxpayer returned all of state farm’s property to it, but transferred no identifiable assets of his own, and he received a “termination payment.” the insurance policies he had written were assigned to a successor agent. the taxpayer argued that he realized a capital gain on the transfer to state farm of his insurance agency agreement [the ‘corporate agreement”]. the ninth circuit (judge bybee) denied the taxpayer capital gain treatment with respect to the termination payment. he transferred no assets that owned. a precondition to realizing a long-term capital gain is the ownership of a capital asset. yet under the express terms of trantina’s corporate agreement with state farm, trantina simply had no property that could be sold or exchanged. ... to quote the district court, ‘[t]he suggestion that the corporate agreement is itself an asset, when it declares that all assets pertaining to plaintiffs’ insurance agency belong to state farm, is paradoxical.’ trantina, 381 f. supp. 2d at 1106. it is likewise paradoxical to suggest that the corporate agreement was an asset when the agreement itself stated that it could not be sold or otherwise exchanged. ... instead, the better view of the termination payments is that they were made pursuant to, not in exchange for, the corporate agreement. 322 florida tax review [vol. 9:si the entire termination payment was ordinary income. the facts and analysis were substantially similar to those in baker v. commissioner, 338 f.3d 789 (7th cir. 2003). 3. taxpayer could not prove he sold personal goodwill when the payment was characterized as being for a noncompete agreement. muskat v. united states, 101 a.f.t.r.2d 2008-1606 (d. n.h. 4/2/08). the district court denied taxpayer’s claim for refund on the ground that $1,000,000 paid to corporate ceo and 37% shareholder as payment under a noncompetition agreement was in fact payment for personal goodwill. the taxpayer’s age and lack of interest in competing were not enough to convince the court that the non-competition provision in the agreement was in effect a purchase of goodwill. 4. the tax court makes it a little bit more difficult to claim that it’s shareholder goodwill, not corporate goodwill, that was sold. solomon v. commissioner, t.c. memo. 2008-102 (4/16/08). a corporation (solomon colors), of which the taxpayers (father and son) were dominant shareholders, sold one of its lines of business to a competitor. in connection with the sale, the shareholder–employees entered into covenants not to compete. conflicting provisions in the documentation of the transaction variously described certain payments received by the shareholders as consideration for their ownership interest in the customer list for the line of business and as consideration for their entering into covenants not to compete. the court (judge laro) rejected the irs’s argument that the corporation had distributed an undivided interest in the customer list to the shareholders as a dividend immediately prior to the sale, which would have resulted in corporate level gain under § 311(a) as well as dividend income – then taxable at ordinary income rates — to the shareholders. he also rejected the taxpayer’s argument that, like in martin ice cream co. v. commissioner, 110 t.c. 189 (1998), the payments were consideration for the sale of goodwill owned by the shareholders (which would have been taxed as capital gains). martin ice cream was distinguished because the court found that the value of solomon colors was not attributable to the quality of service and customer relationships developed by the shareholders. because the corporation’s business was processing, manufacturing, and sale of a product, rather than the provision of services, it did not depend entirely on the goodwill of its employee-shareholders for its success. furthermore, unlike in martin ice cream, the shareholders in solomon were not named as the sellers of any asset but were included in the sale in their individual capacities solely to effect the covenants not to compete. finally, that the shareholders were not required to enter into employment or consulting agreements made it unlikely that the buyer was purchasing their personal goodwill. accordingly, judge laro 2009] recent developments in federal income taxation 323 found the payments to be entirely consideration for the shareholders’ covenants not to compete. 5. ♫♪“well, there’s thirteen hundred and fifty two guitar pickers in nashville.”♫♪ t.d. 9379, time and manner for electing capital asset treatment for certain self-created musical works, 73 f.r. 7464 (2/8/08); reg-153589-06, time and manner for electing capital asset treatment for certain self-created musical works, 73 f.r. 7503 (2/8/08). temp. reg. § 1.1221-3t provides procedures regarding time and manner for making an election to treat the sale or exchange of a musical composition or copyright in a musical work created by the taxpayer (or received by the taxpayer from the work’s creator in a transferred basis transaction) as the sale or exchange of a capital asset pursuant to § 1221(b)(3). the election must be made on the tax return filed on or before the due date (including extensions) of the return for the taxable year of the sale or exchange. an election is revocable with the irs’s consent. 6. you have to tell the creditor who holds pledged stock to sell the high-basis stock first. rendall v. commissioner, 535 f.3d 1221 (10th cir. 8/5/08). the debtor taxpayer recognized gain upon a sale by a creditor of stock the taxpayer had pledged to secure the debt. the irs properly applied the fifo principle in reg. § 1.1012-1(c)(2) to determine the taxpayer’s gain upon the sale by the creditor of only a portion of the stock the taxpayer had pledged to secure the debt, because no designation had been made as required to identify another block as the stock that was sold. 7. new rules for determining basis in securities. emergency economic stabilization act of 2008 [division b], act § 403, amends § 1012 to create new rules for determining the basis of securities acquired after december 31, 2010. the fifo or other conventions for determining the basis of securities when sold must be applied on an account-byaccount basis. thus, with respect to a taxpayer who holds the same stock in more than one account, determining the basis of sold securities from any account will be determined from the basis of securities in that account. in addition, § 1012(d) provides for averaging the basis of stock acquired in a dividend reinvestment plan. stock in a dividend reinvestment plan is treated as held in a separate account for purposes of determining basis. a. no more fooling the irs about basis. emergency economic stabilization act of 2008 [division b], § 403, adding § 6045(g), requires brokers to report the customer’s basis in a “covered security” and whether gain or loss is long-term or short-term, in addition to the existing requirement that the broker report gross sales proceeds. in general, the 324 florida tax review [vol. 9:si customer’s basis is to be reported on a first-in first-out method, unless an average basis method is permissible (stock acquired in a reorganization where basis can’t be identified). covered securities include securities acquired through an account with the broker or transferred to the broker from another account on or after an applicable date. the applicable date for stocks is january 1, 2011, for stocks under the average basis method, january 1, 2012, and of any other security, january 1, 2013 or such later date as specified by the treasury department. under § 6045a, a taxpayer transferring securities to a broker will be required to report information required by regulations necessary to permit the broker to meet its reporting requirements. section 6045b requires the issuer of any security to report information describing any organizational action that affects the basis of the security. 8. taxpayer took the position that he was exchanging appreciated stock for a private annuity contract, while the irs asserted that he was instead simply exercising his puts. the irs lost, but would have prevailed had proposed regulations applied. katz v. commissioner, t.c. memo. 2008-269 (12/3/08). taxpayer received publicly held uici stock when his student-loan business was acquired. thereafter, he engaged in an equity swap transaction with merrill lynch to hedge some of that stock by purchasing 200,000 common stock put options at $23.09 per share and selling 200,000 common stock call options at $26.93 per share. these options were europeanstyle options which could be exercised only on 2/3/00. this had the effect of collaring the taxpayer’s uici stock value between those two share prices. pursuant to an arrangement facilitated by merrill lynch on the morning of 2/3/00, taxpayer exchanged the equity swap [i.e., 200,000 shares of uici stock and the put options] for a single lump-sum private variable annuity from a successful canadian businessman’s wholly-owned bahamian corporation (sja). five days later, merrill lynch settled the sale of the uici stock and (after some typical merrill lynchish fumbling around) deposited most of the $4.6 million proceeds in sja’s account. the tax court (judge foley) held that pursuant to rev. rul. 69-74, 1969-1 c.b. 43, when a taxpayer exchanges appreciated property for a private annuity, the “gain should be reported ratably over the period of years measured by the annuitant’s life expectancy and only from that portion of the annual proceeds which is includible in gross income by application of section 72.” • the commissioner argued that the equity swap was exercised before the purchase of the private annuity, which would result in taxpayer being taxed immediately on the gain. judge foley held that stipulations entered into in this case negated the commissioner’s position that the substance of the transaction [i.e., realization of the gain before the purchase of the annuity] trumped the form of the transaction [i.e., transfer of the equity swap to sja in exchange for the annuity]. 2009] recent developments in federal income taxation 325 • note that the result set forth in rev. rul. 69-74 would be reversed when proposed regulations [which will treat taxpayers who exchange property for an annuity as if they had sold the property] become final. reg-141901-05, exchanges of property for an annuity, 71 f.r. 61441 (10/18/06). the treasury has published proposed regulations that provide a single set of rules for the taxation of an exchange of property for an annuity contract. essentially, the proposed rules will treat the transaction as if the property was sold for cash equal to the value of the annuity contract [as determined under § 7520] and the proceeds were used to buy an annuity contract; however, taxpayers may continue to structure transactions as § 453(b) installment sales. these proposed regulations do not change existing reg. § 1.1011-2 for charitable gift annuities, but will change prior law on exchanges of appreciated property for private annuities to the extent it permitted open transaction treatment or ratable recognition as the annuities were paid. the effective date is 10/18/06, with a delayed effective date of 4/18/07 for non-abusive transactions. these proposed regulations would bring the current treatment of exchanges of appreciated property for private annuities into line with the tax treatment of exchanges for commercial annuities. before these regulations are applicable, the law generally postponed tax on the exchange based on the assumption that the value of a private annuity contract could not be determined for federal income tax purposes. b. interest there were no significant developments regarding this topic during 2008. c. section 121 1. here’s a little tax-based financial help for the cia that’s not hidden as a $600 toilet seat. the heroes earnings assistance and relief tax act of 2008 modified the two-out-of-five years principal residence rule in § 121 in several respects. first, with respect to the § 121(d)(9) suspension of the five year period for cia and nsa personnel who are moved to a new duty station, the requirement that the new duty station is outside the united states was removed. second the provision was made permanent. new § 121(d)(12) extends the benefit of the suspension of the running of the five-year period to peace corps volunteers and to peace corps employees on “qualified official extended duty.” 2. ouch, the realtors® in vacation resort areas aren’t going to like this new rule. will the real estate lobby have enough clout to get it retroactively revoked? the housing assistance tax act of 2008 added 326 florida tax review [vol. 9:si § 121(b)(4), which provides that gain on the sale of a personal residence is not excluded from gross income to the extent the gain is allocated to periods of “nonqualified use” of the residence. in general, periods of nonqualified use include any periods in which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse. there are exceptions: (1) use prior to 1/1/09 is not nonqualified use; (2) use after the last date that the taxpayer or the taxpayer’s spouse used the property as a principal residence is not nonqualified use; (3) use while the taxpayer or the taxpayer’s spouse is serving (for up to an aggregate period of ten years) on qualified official extended duty (as defined in § 121(d)(9) [military, cia or nsa]) is not nonqualified use; (4) use during any other period of temporary absence (for up to an aggregate period of two years) is not nonqualified use, if the absence is due to change of employment, health conditions, or other unforeseen circumstances specified by regulations. • the amount of gain not excluded by reason of § 121(b)(4) is determined by allocating gain to periods of nonqualified use based on the ratio of aggregate periods of nonqualified use to the total time the taxpayer owned the property. if any portion of a taxpayer’s gain on the sale of a principal residence is attributable to post-5/6/97 depreciation (and thus not eligible for exclusion under § 121 by reason of § 121(d)(6)), that gain is not taken into account in determining the allocation of gain to periods of nonqualified use. • rental property example: suppose a taxpayer buys a property on january 1, 2009, for $500,000, and uses it as a rental property for one year, claiming $15,000 of depreciation deductions (reducing the property’s basis to $485,000). on january 1, 2010, the taxpayer converts the property to his personal residence. on january 1, 2013, the taxpayer ceases to use the property as his personal residence. on january 1, 2014, the taxpayer sells the property for $600,000. pursuant to § 121(d)(6), the $15,000 of gain attributable to the depreciation deductions is not excluded from gross income. the remaining $100,000 of gain is excluded, except to the extent it is attributable to periods of nonqualified use. the first year of rental use is a period of nonqualified use, but the year after the taxpayer moves out is not. the one-year period of nonqualified use is twenty percent of the taxpayer’s five-year period of ownership, so twenty percent ($20,000) of the $100,000 is allocated to the period of nonqualified use and thus is not eligible for exclusion under § 121. the other $80,000 is excluded from gross income. • vacation home example: in addition to denying nonrecognition to gain attributable to periods the residence was held for rental, § 121(b)(4) denies the exclusion for gains attributable to the period the residence was a secondary residence or vacation home. to illustrate, suppose a taxpayer again buys a property on january 1, 2009, for $500,000, and uses it solely as a vacation home for 12 years. on january 1, 2021, the taxpayer converts the property to his principal residence. on january 1, 2024, the taxpayer sells the 2009] recent developments in federal income taxation 327 property for $800,000. the twelve years of vacation use is a period of nonqualified use that is eighty percent of the taxpayer’s fifteen-year period of ownership, so eighty percent ($240,000) of the $300,000 is allocated to the period of nonqualified use and thus is not eligible for exclusion under § 121. the other $60,000 is excluded from gross income. d. section 1031 1. have you heard about how you can do § 1031 likekind exchanges of vacation homes? don’t drink that kool-aid! and renting it out for a few weeks just before the exchange does not work. moore v. commissioner, t.c. memo. 2007-134 (5/30/07). the taxpayer exchanged land with a mobile home, which the taxpayer used as a vacation residence, for another vacation property, and claimed the transaction qualified for nonrecognition under § 1031 because both vacation properties were acquired and held with the expectation that they would appreciate and thus were “investment” property. the court (judge halpern) held that the exchange did not qualify. the mere expectation that property will appreciate does not establish investment intent if the taxpayer uses the property as a residence. there was no evidence that taxpayer made either property available for rent or held either property primarily for sale at a profit. a. the irs provides a safe harbor for vacation home swappers, but it is a small – very small – crack in the wall denying § 1031 nonrecognition to exchanges of vacation homes. rev. proc. 2008-16, 2008-10 i.r.b. 547 (2/15/08). this revenue procedure provides safe-harbor guidance regarding whether a residential property that the taxpayer held or intends to hold for mixed uses, e.g., personal vacation use and rental / investment purposes qualifies as property held for productive use in a trade or business or for investment under § 1031. under the revenue procedure, the relinquished property qualifies if: (1) the property was owned by the taxpayer for at least 24 months immediately before the exchange, and (2) within that period, in each of the two 12-month periods immediately preceding the exchange, (a) the taxpayer rented the property to another person or persons at a fair rental for 14 days or more, and (b) the taxpayer’s personal use of the property did not exceed the greater of 14 days or 10 percent of the number of days during each 12-month period that the dwelling unit was rented at a fair rental. (for this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).) the replacement property qualifies if (1) the property is owned by the taxpayer for at least 24 months immediately after the exchange, and within that period, in each of the two 12-month periods 328 florida tax review [vol. 9:si immediately after the exchange (a) the taxpayer rents the property to another person or persons at a fair rental for 14 days or more, and (b) the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10 percent of the number of days during each 12-month period that the property is rented at a fair rental. (for this purpose, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12month period begins on the day after the first 12-month period ends.) personal use of a dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes under § 280a(d)(2) (taking into account § 280a(d)(3) but not § 280a(d)(4)). 2. clarifying the treatment of exchange accommodation loans. t.d. 9413, escrow accounts, trusts, and other funds used during deferred exchanges of like-kind property, 73 f.r. 39614 (7/10/08). the treasury promulgated final regulations under § 468b providing rules regarding the taxation of income earned on escrow accounts, trusts, and other funds used during deferred like-kind exchanges of property and under § 7872 regarding below-market loans to facilitators of like-kind exchanges. the regulations affect taxpayers that engage in deferred like-kind exchanges and escrow holders, trustees, qualified intermediaries, and others that hold funds during deferred like-kind exchanges. exchange funds generally are treated as loaned by a taxpayer to the exchange facilitator, and the facilitator takes into account all items of income, deduction, and credit with respect to the funds. there is an exception if the agreement provides that earnings from the exchange funds are payable to the taxpayer. special rules apply when an intermediary commingles exchange funds with other funds. a loan to an exchange facilitator is treated as a compensation-related demand loan under § 7872(c)(1)(b). the regulations generally are effective 10/08/08. 3. we didn’t realize that the mutual ditch, reservoir, or irrigation company lobby had this kind of clout! section 1031(i), added by the heartland, habitat, harvest, and horticulture act of 2008, provides that the general disqualification under §1031(a)(2) of exchanges of stock does not apply with respect to certain shares in mutual ditch, reservoir, or irrigation companies. 4. is it a reverse like-like exchange? is it a deferred like-kind exchange? it’s both! ilm 200836024 (5/12/08). the irs chief counsel’s office concluded that a taxpayer may engage in a “reverse” like-kind exchange under rev. proc. 2000-37, 2002-2 c.b. 308, and a deferred forward like-kind exchange described in reg. § 1.1031(k)-1 using the same relinquished property in both exchanges. this is useful where the surrendered property is more valuable than either replacement property. 2009] recent developments in federal income taxation 329 e. section 1033 there were no significant developments regarding this topic during 2008. f. section 1035 1. rev. proc. 2008-24, 2008-13 i.r.b. 684 (3/18/08) the direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract, regardless of whether the two annuity contracts are issued by the same or different companies, is a tax-free exchange under § 1035 if either (a) no amounts are withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 12 months beginning on the date on which amounts are treated as received as premiums or other consideration paid for the contract received in the exchange (the date of the transfer); or (b) the taxpayer demonstrates that one of the conditions described by § 72(q)(2)(a), (b), (c), (e), (f), (g), (h) or (j), or any similar life event (such as divorce or loss of employment), occurred between the date of the transfer, and the date of the withdrawal or surrender. a transfer that is not treated as a tax-free exchange under § 1035 will be treated as a distribution, taxable under § 72(e), followed by a payment for the second contract. g. miscellaneous 1. tax protection for lenders to over-exuberant shortsellers. rev. proc. 2008-63, 2008-42 i.r.b. 946 (9/26/08). section 1058 provides nonrecognition to a person whose stock or securities is lent to another person to effect a short sale of that stock or securities. technically, the transaction is a transfer of stock or securities in exchange for a contractual right to receive back identical stock or securities, together with any dividends, interest, or other payments receivable with respect to the stock or securities during the period between the initial transfer and the transfer back or replacement securities, which otherwise is a realization and recognition event. this revenue procedure provides that if a securities loan under § 1058 is terminated because of the bankruptcy of the borrower or an affiliate and the lender applies the collateral to the purchase of identical securities as soon as is commercially practicable (but in no event more than 30 days following the default), the irs will treat the purchase as an exchange to which § 1058(a) applies. 330 florida tax review [vol. 9:si iv. compensation issues a. fringe benefits 1. the cafeteria line is better for a military reservist who is called to active duty. section 125(h), added by the heroes earnings assistance and relief tax act of 2008, provides an exception to the cafeteria plan requirement of forfeiture of unused benefits at the year’s end for a “qualified reservist distribution.” a cafeteria plan or a health flexible spending arrangement (fsa) is not disqualified if it permits a distribution to a participant of some or all of his fsa balance if the participant is a military reservist who is called to active duty for a period of at least 180 days (or for an indefinite period). 2. employer housing in alice springs, australia doesn’t qualify for exclusion from gross income. middleton v. commissioner, t.c. memo. 2008-150 (6/11/08). the taxpayer was employed by trw, inc. to work at the joint defense space research facility/joint defense space communication system (joint defense facility), located at the pine gap air force base near alice springs. as a condition of employment the taxpayer was required to live in employer provided housing in alice springs. the housing was in a residential neighborhood. no work was performed for trw in the housing. following its prior decision on similar facts in hargrove v. commissioner, t.c. memo. 2006-159, the tax court (judge chiechi) held that the value of the housing is not eligible for exclusion from gross income under § 119. the court also rejected the taxpayer’s claim that the housing was an excludible allowance under § 912, which excludes foreign area allowances provided to certain civilian officers and employees of the u.s. government. 3. some transit systems need additional time to modify their technology to “get smart.” notice 2008-74, 2008-38 i.r.b. 718 (9/3/08). the irs has delayed the effective date of revenue ruling 2006-57, 2006-2 c.b. 911, which provides guidance to employers on the use of smartcards, debit or credit cards, or other electronic media to provide qualified transportation fringes under §§ 132(a)(5) and 132(f), from 1/1/09 (see notice 2007-76, 2007-40 i.r.b. 735) until 1/1/10. “nevertheless, employers and employees may rely on revenue ruling 2006-57 with respect to transactions occurring prior to january 1, 2010.” 4. six more months to try to get away with buying beer and cigs at the pharmacy with health fsa and hra debit cards. notice 2008-104, 2008-51 i.r.b. 1298 (12/5/08). notice 2007-2, 2007-1 c.b. 254, provided that after 12/31/08, health fsa and hra debit cards could not be used at stores with the drug stores and pharmacies merchant category code unless: (1) the store participates in the inventory information approval system in notice 2009] recent developments in federal income taxation 331 2006-69, 2006-2 c.b. 107, or (2) 90 percent of the individual store’s gross receipts during the prior taxable year were from items that qualify as expenses for medical care under § 213(d) (including nonprescription medications as described in rev. rul. 2003-102, 2003-2 c.b. 559). this notice extends the deadline in notice 2007-2 by six months. after 6/30/09, health fsa and hra debit cards may not be used at stores with the drug stores and pharmacies merchant category code unless the requirements are satisfied. 5. qualifying for disability insurance is not dispositive in determining whether an individual is disabled for purposes of the 10percent additional tax under § 72(t). kowsh v. commissioner, t.c. memo. 2008-204 (8/28/08). the taxpayer took early distributions from a qualified retirement account and did not file a tax return. he did not have an easy life in the period leading up to the distributions. his wife died from cancer at age 53 in june 2001, leaving him to care for their two teenage children and her aged mother. he worked at deutsche bank near the world trade center and lost a number of friends and neighbors in the 9/11 attacks, including several friends who had attended his wife’s funeral. by february 2002, his depression, and sleep apnea that caused him to have narcoleptic episodes, left him unable to work. although the taxpayer received both short-term and long-term disability payments from a disability insurance policy with a private insurer, his doctor was unwilling to provide any certification that he was disabled, and at trial he provided no evidence that he applied for or received social security disability benefits. in addition, to finding him liable for the deficiency, interest, and failure to file and failure to pay penalties, he was held to be liable for the § 72(t) 10percent additional tax for a premature distribution. 6. qualified transportation includes bicycles. emergency economic stabilization act of 2008 [division b], act § 211, adds to the qualified transportation fringe benefit excluded from income under § 132(f), a qualified bicycle commuting benefit. the provision excludes from income an employer reimbursement during the 15 month period beginning on the first day of the taxable year of up to $20 per month of bicycle commuting for the purchase, improvements, repair and storage of a bicycle. a qualified bicycle commuting month is any month during which an employee regularly uses the bicycle for a substantial portion of travel between the employee’s residence and work place and does not receive the benefit of any other qualified transportation fringe benefit. the bicycle benefit is not subject to the cash alternative escape from constructive receipt of § 132(f)(4). 332 florida tax review [vol. 9:si b. qualified deferred compensation plans there were no significant developments regarding this topic during 2008. c. nonqualified deferred compensation, section 83, and stock options 1. section 409a added a new layer of rules for nonqualified deferred compensation. section 885 of the american jobs creation act of 2004 added new § 409a, which modifies the taxation of nonqualified deferred compensation plans for amounts deferred after 2004. section 409a has changed the tax law governing nonqualified deferred compensation by making it more difficult to avoid current inclusion in gross income of unfunded deferred compensation. nevertheless, § 409a has not completely supplanted prior law. the fundamental principles of prior law continue in force but have been modified in certain respects. a. did you know that § 409a will apply for the 2008-2009 school year to teachers who elect to receive their salaries over a 12-month period instead of being paid only during the nine-month school year? remember, this results from an anti-enron provision in the 2004 act. irs [or, should it be congress], give us a break! ir-2007-142 (8/7/07). school districts that offer annualization elections to teachers may have to make some changes in their procedures in the future, but the irs announced that the new deferred compensation rules will not be applied to annualization elections for school years beginning before 1/1/08. (1) notice 2008-62, 2008-29 i.r.b. 130 (7/1/08). the irs has announced its intent to propose regulations under § 457(f), which would exclude from coverage under §§ 457(f) and 409a of most arrangements involving public school employees who provide services during a 9or 10-month school year and elect to be paid ratably over 12 months. b. notice 2008-113, 2008-51 i.r.b. 1305 (12/22/08) this notice provides procedures to obtain relief from the full application of the income inclusion and additional taxes requirements of § 409a with respect to certain operational failures to comply with the requirements of § 409a. 2. emergency economic stabilization act of 2008 [division c], act § 504(c), provides that up to $100,000 of amounts received by 2009] recent developments in federal income taxation 333 a taxpayer engaged in the fishing business from the settlement of exxon valdez litigation can be contributed to retirement accounts in the year of receipt. d. individual retirement accounts 1. penalty-free premature ira distributions for active duty reservists. the heroes earnings assistance and relief tax act of 2008 made permanent § 72(t)(2)(g), which, exempts from the 10 percent penalty tax for premature ira distributions certain distributions to reservists called to active duty for at least 179 days. this exemption originally was scheduled to expire after 2007. 2. limited unlimited contributions of military death benefits to roth iras for survivors of reservists. the heroes earnings assistance and relief tax act of 2008 amended § 408a(e) to permit an individual who receives a military death gratuity payment (excluded from gross income by § 134) or a servicemembers’ group life insurance payment (excluded from gross income by § 101) to contribute the payment to a roth ira without regard to the otherwise applicable annual contribution limit and the income phase-out of the contribution limit. 3. congress encourages retirees to drain their ravaged iras to benefit charities. the emergency economic stabilization act of 2008 extended through 2009 code § 408(d)(8), which permits tax-free distributions up to $100,000 directly to charities that are publicly supported under § 509(a)(1) and (2) (but not § 509(a)(3)) from iras owned by individuals over 70½ years of age. these direct distributions to charities would be applied towards satisfying the § 401(a)(9) required minimum distribution amounts. 4. wrera, § 201, amends code § 401(a)(9) to suspend required minimum distributions (“rmds”) from 401(k) plans, iras and similar retirement accounts for 2009. rmds for the year 2008 were not affected, including rmds for 2008 that are permitted to be made in 2009 by reason of an individual’s required beginning date being 4/1/09. v. personal income and deductions a. rates there were no significant developments regarding this topic during 2008. 334 florida tax review [vol. 9:si b. miscellaneous income 1. forgiven accrued but unpaid interest on a consumer loan is cod income. hahn v. commissioner, t.c. memo. 2007-75 (4/2/07). the tax court (judge wells) held that discharge of indebtedness income can be realized under the kirby lumber co. “freeing of assets” rationale even though the debtor did not receive any cash or other property when he incurred the liability. when a creditor writes off accrued but unpaid interest owed by a cash method debtor, discharge of indebtedness income is realized, unless the interest would have been deductible if it had been paid and thus excludable under § 108(e)(2), because “[t]he right to use money represents a valuable property interest.” taxpayer’s motion for summary judgment was denied because whether the interest expenses incurred in a horse breeding activity was deductible as a trade or business expense was a question of fact on which a trial was necessary. a. more bad tax news for over-burdened consumer credit card debtors who beat the bank. they don’t beat the irs! payne v. commissioner, t.c. memo. 2008-66 (3/18/08). compromise of credit card debt, including interest, incurred for personal living expenses results in realization of cod income for a cash method taxpayer. section 108(e)(5) is inapplicable where the only relationship between the debtor and creditor is the debtor-creditor relationship and there was no property sale and purchase giving rise to the debt. 2. congress provides tax relief for sub-prime mortgage borrowers. the mortgage forgiveness debt relief act of 2007 added new § 108(a)(1)(e), which excludes from gross income the discharge of “qualified principal residence indebtedness” (qpri) that takes place on or after 1/1/07 and before 1/1/10. the provision is, of course, a legislative response to the subprime mortgage loan crisis. qpri is defined as acquisition indebtedness, a loan on a taxpayer’s principal residence, as defined in § 163(h)(3)(b), except that for purposes of § 108(a)(1)(e) the ceilings are $2,000,000 (for married couples filing joint returns) and $1,000,000 (for other taxpayers). qpri does not include (1) indebtedness on a home that is not the taxpayer’s principal residence, or (2) home equity indebtedness. the exclusion is not available if the discharge is not on account of either (1) a decline in the value of the home or (2) the financial condition of the taxpayer. the taxpayer’s basis in the principal residence must be reduced by the amount excluded under § 108(a)(1)(e). if only a portion of the cancelled debt is qpri, the exclusion applies only to the extent the amount discharged exceeds the non-qpri portion of the loan. if a taxpayer qualifies for both the qpri exclusion and the insolvency exclusion of § 108(a)(1)(b), the qpri exclusion applies unless the taxpayer elects the application of the insolvency exclusion. 2009] recent developments in federal income taxation 335 a. anticipating the tax consequences of the next wave of arms and teaser-rate home mortgages that reset interest rates. the emergency economic stabilization act of 2008 extended § 108(a)(1)(e), excluding from gross income discharge of cod that is qualified principal residence indebtedness (qpri) through december 31, 2012. the provision, which was added in the mortgage forgiveness debt act of 2007, had been scheduled to expire after december 31, 2009. 3. ouch! sanford v. commissioner, t.c. memo. 2008158 (6/23/08). damages received as a result of an eeoc proceeding based on claims of work-related sexual harassment were not excluded under § 104(a)(2). the damage award was not on account of personal physical injuries or sickness. 4. section 134(b)(6), added by the heroes earnings assistance and relief tax act of 2008, provides that an excludable qualified military benefit includes “any bonus payment by a state or political subdivision thereof to any member or former member of the uniformed services of the united states or any dependent of such member only by reason of such member’s service in [a] combat zone.” 5. police arrest procedures did not result in “physical injury.” stadnyk v. commissioner, t.c. memo. 2008-289 (12/22/08). the tax court (judge goeke) held that damages received on account of false imprisonment were not excludable under § 104(a)(2), even though the taxpayer was detained, handcuffed and searched, because she suffered no physical harm. the damages received in the settlement compensated the taxpayer for “the ordeal ... suffered as a result of her arrest, detention, and indictment” as the result of her bank erroneously stamping a check “nsf” when it had been stopped for “dissatisfied purchase.” the damages were “stated in terms of recovery for nonphysical personal injuries: emotional distress, mortification, humiliation, mental anguish, and damage to reputation.” judge goeke also rejected summarily the taxpayer’s claim that damages received for personal injuries are not gross income within the meaning of § 61(a) and that “section 104(a)(2) conflicts with section 61(a) and violates the sixteenth amendment to the extent that it taxes compensatory damages received for personal injuries.” • the court did not impose taxpayer penalties because taxpayers had received “disinterested advice” that the damages were not includable in income. the advice came from taxpayer’s lawyer, the bank’s lawyer and the mediator who negotiated the settlement. in holding a § 6662 penalty inappropriate, judge goeke stated, petitioners received unsolicited advice from three separate and independent individuals that the settlement would not be taxed. at least two of those individuals were disinterested parties with 336 florida tax review [vol. 9:si no relationship with petitioners. this advice confirmed petitioners’ previous understanding of the taxation of settlement awards. although none of those individuals had specialized knowledge in tax law, they were experienced in personal injury lawsuits and settlements. petitioners acted reasonably and in good faith when following their advice and preparing their own return as they have done for over 40 years. c. profit-seeking individual deductions 1. when will trust investment advisory fees get up off the § 67 floor? rudkin testamentary trust v. commissioner, 124 t.c. 304 (6/27/05) (reviewed, 18-0), aff’d, 467 f.3d 149 (2d cir. 10/18/06) (2-0), aff’d sub nom. knight v. commissioner, 128 s. ct. 782 (1/16/08). the tax court (judge wherry) held that amounts paid for investment management advice by trusts set up by a family involved in the founding of the pepperidge farm food products company (which was sold to campbell soup company in the 1960s) are not subject to the § 67(e) exception to the § 67(a) floor of 2 percent of agi (which limits the deductibility of employee business expenses and miscellaneous itemized deductions to amounts exceeding that floor). in reaching this result, the court determined that these expenses did not qualify for the exception in § 67(e)(1), under which costs paid or incurred in connection with the administration of a trust that wouldn’t have been incurred if the property weren’t held in the trust are allowed as deductions in arriving at adjusted gross income. the tax court explained that the statutory text of § 67(e)(1) creates an exception allowing for deduction of trust expenditures without regard to the 2 percent floor where two requirements are satisfied: (1) the costs are paid or incurred in connection with administration of the trust and (2) the costs would not have been incurred if the property were not held in trust. • the tax court previously held that a trust’s investment advice costs were subject to the 2 percent floor. o’neill trust v. commissioner, 98 t.c. 227 (1992). however, the sixth circuit reversed the tax court and held that investment counseling fees paid by the trust to aid the trustees in discharging their fiduciary duty to the trust beneficiaries were not subject to the 2 percent floor under the § 67(e)(1) exception. (994 f.2d 302 (6th cir. 1993)). subsequently, the sixth circuit approach was rejected by the irs (nonacq, 1994-2 c.b. 1); the federal circuit (mellon bank, n.a. v. united states, 265 f.3d 1275 (fed. cir. 2001)); and the fourth circuit (scott v. united states, 328 f.3d 132 (4th cir. 2003)). in reaching their decisions, the federal and fourth circuits emphasized the importance of not interpreting the statute so as to render superfluous any portion of it. they said that if courts were to hold that a trust’s investment-advice fees were fully deductible, the second requirement of § 67(e)(1) 2009] recent developments in federal income taxation 337 would have been rendered meaningless. the sixth circuit’s rationale was stated as follows: the tax court reasoned that “[i]ndividual investors routinely incur costs for investment advice as an integral part of their investment activities.” nevertheless, they are not required to consult advisors and suffer no penalties or potential liability if they act negligently for themselves. therefore, fiduciaries uniquely occupy a position of trust for others and have an obligation to the beneficiaries to exercise proper skill and care with the assets of the trust. (994 f.2d at 304). a. the second circuit affirmed rudkin trust and gave a third interpretation of “an unambiguous statute.” 467 f.3d 149 (2d cir. 10/18/06) (2-0). judge sotomayor held that § 67(e) was unambiguous and permitted a full deduction only for those types of trust expenses that an individual could not possibly incur. b. the treasury tried to preempt the supreme court with proposed regulations. reg-128224-06, section 67 limitations on estates or trusts, 72 f.r. 41243 (7/27/07). prop. reg. § 1.67-4 would provide that costs incurred by estates or non-grantor trusts that are unique to an estate or trust are not subject to the 2 percent floor of § 67. under prop. reg. § 1.67-4(b), a cost is unique to an estate or trust if an individual could not have incurred that cost in connection with property not held in an estate or trust. any miscellaneous itemized deductions that do not meet this standard are subject to the 2 percent floor. prop. reg. § 1.67-4(c) prevents circumvention of the limitation by “bundling” investment advisory fees and trustees’ fees into a single fee. if an estate or non-grantor trust pays a single fee that includes both costs that are unique to estates and trusts and costs that are not, the fee must be allocated between the two types of costs. the regulations provide a non-exclusive list of services for which the cost is either exempt from or subject to the 2 percent floor. the regulations will apply to payments made after the date final regulations are published in federal register. • under the reasoning of national cable & telecommunications ass’n v. brand x internet services, 545 u.s. 967 (2005), a court’s interpretation of a statute trumps an agency’s subsequent regulation “under the doctrine of stare decisis only if the prior court holding ‘determined a statute’s clear meaning.’ ... [a] court’s prior interpretation of a statute ... overrides an agency’s interpretation only if the relevant court decision held the statute unambiguous.” otherwise the validity of the regulation is determined under 338 florida tax review [vol. 9:si chevron u.s.a. inc. v. natural resources defense council, inc., 467 u.s. 837 (1984). c. the supreme court issued the writ of certiorari to resolve the conflict between the second and sixth circuits, but decided to follow the federal and fourth circuits. the supreme court affirmed rudkin trust sub nom. knight v. commissioner, 128 s. ct. 782 (1/16/08) (9-0). the court affirmed the second circuit in an opinion written by chief justice roberts but rejected the second circuit test in favour of the test of whether individuals commonly employ investment advisors set forth in mellon bank and scott. this holding leaves the final resolution to a factual inquiry and the results could differ in different cases. d. meanwhile, bundled fiduciary fees may be deducted in full. notice 2008-32, 2008-11 i.r.b. 593 (2/27/08). this notice provides interim guidance on the treatment of investment advisory costs subject to the 2 percent floor of § 67 that are bundled as part of a single fiduciary fee for years beginning before 1/1/08. it provides that the taxpayer may deduct the full amount of the bundled fiduciary fee without regard to the 2 percent floor. e. ditto for the year 2008, except for payments by the fiduciary to third parties for expenses subject to the 2-percent floor. notice 2008-116, 2008-52 i.r.b. 1372 (12/29/08). this notice modifies and supersedes notice 2008-32, 2008-11 i.r.b. 593, extending its relief. taxpayers are not required to determine the portion of a bundled fiduciary fee that is subject to the § 67 2-percent floor for any taxable year beginning before january 1, 2009. the full amount of the bundled fiduciary fee is deductible; however, payments by the fiduciary to third parties for expenses subject to the 2-percent floor are readily identifiable and must be treated separately from the otherwise bundled fiduciary fee. 2. he lost in the casinos but won his bet that he’d beat the irs in tax court with the help of an expert witness named mark nicely. gagliardi v. commissioner, t.c. memo. 2008-10 (1/24/08). gagliardi won the california lottery and was receiving annual payments of approximately $666,500. after winning the lottery, gagliardi spent most of his waking hours at casinos, averaging approximately 10 hours per day playing the slot machines. he was a compulsive gambler, who placed at a minimum four or five bets per minute, averaging $9 per bet. for the years in question he reported wagering losses of up to $500,000 more than his wagering winnings and deducted the excess losses against his lottery winnings. the irs disallowed a substantial portion of his claimed deductions, but the tax court (judge vasquez) held for the taxpayer, finding that the evidence supported the conclusion that gagliardi’s 2009] recent developments in federal income taxation 339 actual losses exceeded the amount he claimed. although gagliardi did not maintain a contemporaneous wagering log, he retained all his receipts and records related to his gambling winnings and losses, including but not limited to atm receipts, copies of checks cashed at the casinos, bank and credit card statements reflecting withdrawals made at the casinos, and forms w-2g he received from the casinos, all of which he provided to his tax return preparer. in addition, taxpayer’s expert witness mark nicely, a casino gaming industry and math expert with an expertise in math and slot machines [who was the head of a department at a slot machine manufacturer responsible for the development of games and gaming math, testing equipment, working with regulators, and training employees on how to design games for casinos], credibly testified that the application of a formula to calculate the likelihood and extent of gagliardi’s gambling losses at slot machines during the years in issue indicated that gagliardi’s total net losses from slot machine play for the years at issue was greater than the total net gambling losses from slot machine play he claimed for the tax years at issue. 3. those union dues helped the taxpayer prove his case. balla v. commissioner, t.c. memo. 2008-18 (1/31/08). the taxpayer was a merchant seaman who incurred mileage, meals and incidental expenses incurred in connection with attending firefighting school, the tuition for which was paid by his union. judge cohen held that even though the taxpayer’s employer did not require him to attend the school, he had adequately substantiated the business purpose of his travel expenses because (1) firefighting was related to his employment as a merchant sailor and engineer, and (2) payment of tuition for the course by his union supported characterization of the related travel expenses as ordinary business expenses. the taxpayer was allowed to deduct as unreimbursed employee business expenses the mileage, meals, and incidental expenses incurred in connection with attending the firefighting school, even though he never sought reimbursement for the mileage, meals and incidental expenses. 4. section 212 deductions for a day trading seminar disallowed even though there wasn’t any fun in the sun. jones v. commissioner, 131 t.c. no. 3 (7/28/08). the taxpayer was a day trader who incurred approximately $6,000 of expenses to attend a 5-day one-on-one course called daytradingcourse.com that consisted of 37 hours of instruction. he stayed in a modest hotel and did not participate in any recreational activities. the seminar was held in cartersville, georgia, approximately 750 miles from the taxpayer’s home in florida. the taxpayer conceded that he was not in the trade or business of day trading, but claimed the deduction under § 212. judge vasquez upheld the irs’s disallowance of the deduction under § 274(h)(7), which disallows any deduction under § 212 for “expenses allocable to a 340 florida tax review [vol. 9:si convention, seminar, or similar meeting, including the costs of registration fees, travel, meals, and lodging, even if the personal benefits of the trip are secondary to the investment benefits.” judge vasquez cited merriam-webster’s collegiate dictionary (9th ed. 1985), which defines a seminar as a “meeting for giving and discussing information,” and concluded that the course was a seminar, or a similar meeting within the scope of § 274(h)(7). 5. hammering employees whose deferred compensation comes from offshore, i.e., hedge fund managers. the emergency economic stabilization act of 2008 added new code § 457a, which provides that any nonqualified deferred compensation (as defined in § 409a) under a plan of a nonqualified entity must be included in gross income in the first year in which there is no substantial risk of forfeiture. nonqualified entities include (1) a foreign corporation unless substantially all of its income is either: (a) effectively connected with the conduct of a u.s. trade or business, or (b) subject to a comprehensive foreign income tax, and (2) any partnership unless substantially all of its income is allocated to persons other than: (a) foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax, or (b) tax exempt organizations. if the amount of the deferred compensation is not determinable when the right to it vests, the deferred compensation will be included when it becomes determinable, but an interest charge at the deficiency rate plus one percent will be added with respect to the period between the year when the compensation was deferred, or vested if later, and the year it becomes includible. to the extent provided in regulations if compensation is determined solely by reference to the amount of gain recognized on the disposition of an investment asset, the compensation will be treated as subject to a substantial risk of forfeiture until the disposition. d. hobby losses and § 280a home office and vacation homes 1. maybe the taxpayer/irs auditor should have hired michael vick as a business consultant to bolster his case. how relevant should it be that he never named the dogs? whitecavage v. commissioner, t.c. memo. 2008-203 (8/27/08). the taxpayer, who was a full-time irs auditor, raised and raced greyhounds. he did not spend time with the dogs except for feeding and cleaning up after them mornings and evenings. he kept the pups at his kennel until they were a little over a year old and then sent them to racing kennels. when they were done racing, the dogs were either sent for adoption or euthanized. the taxpayer had no employees or business advisor and consistently lost money. the tax court (judge thornton) held that the taxpayer’s losses were limited by § 183. 2009] recent developments in federal income taxation 341 certain aspects of petitioner’s activity, such as feeding, grooming, and cleaning up after the greyhounds, generally might not be considered pleasurable, even though they are not so different from the duties of any pet owner. ultimately, however, it seems to us that petitioner’s activity of breeding greyhounds for racing, although conducted by petitioner in a seemingly inhumane manner (for many years keeping numerous dogs confined in crates in his yuma, arizona, garage, while he worked a full-time job at the irs, sending the pups off to “training” that almost a fourth of them would not survive, and ultimately casting off most of the others for possible adoption or destruction) involved recreational elements as are common to other forms of recreational gambling, with those elements being enhanced by such sense of sport or gamesmanship as might derive from having one’s own dogs in the races. this factor weighs against petitioner. e. deductions and credits for personal expenses 1. congress encourages more sub-prime mortgage lending. the tax relief and health care act of 2006 added new § 163(h)(3)(e), providing an itemized deduction for the cost of mortgage insurance on a qualified personal residence. the deduction is phased-out ratably by 10 percent for each $1,000 by which the taxpayer’s agi exceeds $100,000. thus, the deduction is unavailable for a taxpayer with an agi in excess of $110,000. as originally enacted, the provision was effective for amounts paid or accrued (and applicable to the period) after 12/31/06 and before 1/1/08 for mortgage contracts issued after 12/31/06. a. and congress extends the provision encouraging sub-prime mortgage borrowing. the mortgage forgiveness debt relief act of 2007 extended the 12/31/07 termination date for § 163(h)(3)(e) to 12/31/10. 2. the heroes earnings assistance and relief tax act of 2008 made permanent § 32(c)(2)(b)(vi), which permits a taxpayer to elect to treat combat pay excluded from gross income under § 112 as earned income for eitc purposes. the provision had been scheduled to expire after 2007. 3. the deduction for state and local property taxes is only semi-itemized for 2008. we bet this one becomes a permanent fixture in the annual extenders bill until it becomes permanent. section 63(c)(1)(c), 342 florida tax review [vol. 9:si added by the housing assistance tax act of 2008, adds the “real property tax deduction” as a component of the standard deduction, effective only for taxable years beginning in 2008. the amount of the deduction is the lesser of (1) the amount the taxpayer could claim as a state and local real property tax deduction under § 164(a)(1) if he itemized his deductions, or (2) $500 ($1,000 in the case of a joint return). a. congress extends another microscopic and complicating tax deduction. the emergency economic stabilization act of 2008 extended through 2009 the code § 63(c)(1)(c) above-the-line deduction for a limited amount of real property taxes, the amount of the deduction is the lesser of (1) the amount the taxpayer could claim as a state and local real property tax deduction under § 164(a)(1) if he itemized deductions, or (2) $500 ($1,000 in the case of a joint return). the provision originally was effective only for 2008. 4. this “relief” provision is an interest free loan from the government unless your tax bracket increased. section 3082 of the housing assistance tax act of 2008 (an uncodified provision) allows a taxpayer who claimed a casualty loss deduction with respect to his personal residence resulting from hurricane katrina, hurricane rita, or hurricane wilma, and who in a later year receives a federal grant as reimbursement for the loss, to elect to file an amended return for the earlier taxable year (eliminating the casualty loss deduction to the extent of the later reimbursement) in lieu of including the reimbursement in income in the later year. 5. helping entry-level homebuyers invest in the bear housing market. section 36, added by the housing assistance tax act of 2008, provides a refundable credit for a “first-time homebuyer” who purchases a principal residence on or after 4/9/08, and before 1/1/09. the amount of the credit is the lesser of 10 percent of the purchase price or $7,500 ($3,750 in the case of a married individual filing a separate return). if two or more unmarried persons purchase a principal residence together, the total amount of the credit will be allocated among them as prescribed by the irs. the credit is phased out over the modified adjusted income range of $75,000 to $95,000 ($150,000 to $170,000 in the case of a joint return). a person qualifies as a “first-time homebuyer” if neither the person nor the person’s spouse (if any) owned a principal residence at any time during the three-year period ending on the date of purchase of the credit-generating residence. the credit is not available if the taxpayer purchased the property from a related person or acquired it by gift, or if the taxpayer’s basis in the property is determined under § 1014. (persons are related for this purpose if they are related for purposes of § 267 or § 707, except that the family of an individual under § 267(c)(4) is limited for this purpose to 2009] recent developments in federal income taxation 343 his spouse, ancestors, and lineal descendants.) the credit is also not available: (1) if a credit under § 1400c (relating to first-time homebuyers in the district of columbia) has ever been allowable to the taxpayer, (2) if the taxpayer’s financing is from tax-exempt mortgage revenue bonds, (3) if the taxpayer is a nonresident alien, or (4) if the taxpayer disposes of the residence or ceases to use it as his principal residence before the close of the taxable year. • the amount of the credit is recaptured ratably over the 15-year period beginning with the second taxable year following the taxable year in which the credit-generating purchase was made. for example, if a taxpayer properly claimed a credit of $7,500 for a purchase in 2008, the recapture amount would be $500 in 2010, with another $500 recapture amount in each of the next 14 years. thus, the credit actually functions as an interest-free loan from the government to the taxpayer. if, prior to the end of the 15-year recapture period, a taxpayer disposes of the credit-generating residence or ceases to use it as his principal residence, the recapture of any previously unrecaptured credit is accelerated. in the case of a sale of the principal residence to an unrelated person, the recapture amount is limited to the amount of gain (if any) on the sale. there is no recapture (either regular or accelerated) after the death of a taxpayer, and there is no accelerated recapture following an involuntary conversion of a residence if the taxpayer acquires a new principal residence within the next two years. if a credit-generating residence is transferred between spouses or incident to a divorce, in a transaction subject to § 1041, any remaining recapture obligation is imposed solely on the transferee. • although the credit is ordinarily allowed with respect to the year in which the credit-generating purchase occurred, a taxpayer purchasing a home in 2009 (before july 1) may elect to treat the purchase as having been made in 2008, for the purpose of claiming the credit on his 2008 tax return. if the election is made, the first year of the recapture period will be 2010, rather than 2011. 6. congress wants to encourage consumers — at least those in texas and florida and a few other states — to shop in these hard times. the emergency economic stabilization act of 2008 extended through 2009 the § 164(b)(5) itemized deduction for state sales taxes (optionally in lieu of income taxes in those states that have both sales and income taxes). 7. making children more affordable. the emergency economic stabilization act of 2008 added code § 24(d)(4), which provides that for 2008 (and only for 2008) the ceiling on the refundable child credit is 15 percent of the excess of earned income over $8,500 rather than $10,000 (indexed for post-2000 inflation). because the 2008 inflation adjusted $10,000 amount would have been $12,050, this provision increases the by $532.50 the refundable amount. 344 florida tax review [vol. 9:si 8. the emergency economic stabilization act of 2008 [division b], the energy improvement and extension act, extends several credits and adds a few new twists. • section 205 adds a new credit, under § 30d, for qualified electric drive motor vehicles. the credit amount is $2,500 plus $417 for each kilowatt hour of traction battery capacity in excess of 4 kilowatt hours (the minimum required for obtaining the credit). the credit is limited to $7,500 for vehicles weighing less than 10,000 pounds, $10,000 for vehicles weighing between 10,000 and 14,000 pounds, $12,500 for vehicles weighing between 14,000 and 26,000 pounds, and $15,000 for those electric plug-in suvs in excess of 26,000 pounds. the credit begins to phase out after the first 250,000 vehicles are sold. • section 302 extends the § 25c 10 percent credit (limited to $500 in a lifetime) for nonbusiness energy saving property to property placed in service in 2009. the provision contains several changes to the definitions of qualified energy property. 9. there’s no constitutional right to deduct the cost of sexless procreation by a healthy man. the expenses of obtaining eggs from anonymous egg donors, and of the gestational carriers in whom the eggs – after being fertilized with taxpayer’s semen – were implanted, were not deductible. magdalin v. commissioner, t.c. memo. 2008-293 (12/23/08). the court (judge wherry) held that the costs of taxpayer’s fathering two children by use of two egg donors and two gestational carriers were not § 213 medical expenses because taxpayer was medically able to father children, and had previously fathered twins with his ex-wife, born through natural processes and without the use of in vitro fertilization. because (1) there was no causal relationship between an underlying medical condition or defect – taxpayer’s sperm count and motility were found to be within normal limits – and the taxpayer’s expenses, and (2) the expenses at issue were not incurred for the purpose of affecting a structure or function of the taxpayer’s body, the expenses were not “medical care” as defined in § 213(d). judge wherry rejected the taxpayer’s argument that “it was his civil right to reproduce, that he should have the freedom to choose the method of reproduction, and that it is sex discrimination to allow women but not men to choose how they will reproduce.” • the court refused to address the question of whether the fees would have been deductible had taxpayer suffered from a medical condition, e.g., infertility, that left him unable to have children except by use of in vitro fertilization. • in plr 200318017 (1/9/03), the irs ruled that a woman who was unable to conceive using her own eggs and received an implanted fertilized egg was entitled to deduct as medical expenses under § 213 her unreimbursed expenses for the egg donor fee, the agency 2009] recent developments in federal income taxation 345 fee, the donor’s medical and psychological testing, the insurance for postprocedure donor assistance, and the legal fees for preparation of the egg donor contract. f. divorce tax issues 1. final regulations identify which divorced or separated parent can claim the dependency exemption. t.d. 9408, dependent child of divorced or separated parents or parents who live apart, 73 f.r. 37797 (7/2/08). the treasury has finalized proposed regulations [reg149856-03, dependent child of divorced or separated parents or parents who live apart, 72 f.r. 24192 (5/2/07)] interpreting § 152(e), as amended by the 2005 act (goza), to provide that a child of parents who are divorced, separated, or living apart may be claimed as a qualifying child of the noncustodial parent if the child receives over one-half of his/her support from the parents, the child is in the custody of one or both parents during the calendar year, and the custodial parent signs a written declaration that the custodial parent will not claim the exemption (which must be attached to the non-custodial parent’s return), or a pre-1985 instrument allocates the exemption and the noncustodial parent contributes at least $600 for the support of the child during the year. • under reg. §1.152-4: (1) the custodial parent is the parent with whom the child spends the greatest number of nights during the taxable year. a child who is temporarily away is treated as spending the night with the parent with whom the child would have resided. if another person is entitled to custody for a night, the child is treated as spending the night with neither parent. if a child is temporarily absent from a parent’s home for a night, the child is treated as residing with the parent with whom the child would have resided for the night, but if the child resides with neither parent for a night and it cannot be determined with which parent the child would have resided or if the child would not have resided with either parent for the night, the child is treated as not residing with either parent for that night. if because a parent works at night, a child resides for a greater number of days but not nights with that parent, that parent is treated as the custodial parent. on a school day, the child is treated as residing at the primary residence registered with the school. (2) the required written declaration must contain an unconditional statement that the custodial parent will not claim the exemption for the specified year or years. a declaration is not unconditional if it conditions the custodial parent’s release of the right to claim to the exemption on the noncustodial parent meeting a support obligation. the written declaration may be made on form 8332, release/revocation of 346 florida tax review [vol. 9:si release of claim to exemption for child by custodial parent, or a successor form designated by the irs; any declaration not on the form designated by the irs must conform to the substance of that form and must be a document executed for the sole purpose of serving as a written declaration under § 152(e)(2). the original document need not be attached to the tax return; a copy of the written declaration must be attached to the tax return for each year the noncustodial parent claims the exemption. (3) the custodial parent may revoke a revocation by providing written notice to the non-custodial parent specifying the years of the revocation. a revocation will be effective in the first calendar year after the year in which the revoking parent provides notice to the other parent. (4) never-married parents who live apart are entitled to agree by written declaration to transfer the exemption to the non-custodial parent (following king v. commissioner, 121 t.c. 245 (2003)). a. a child who is not a dependent is a dependent for some purposes. rev. proc. 2008-48, 2008-36 i.r.b. 586 (8/18/08). if a child of parents who are divorced, legally separated, or living apart at all times for the last 6 months of the calendar year: (1) receives over onehalf of the child’s support from the parents, (2) is in the custody of one or both parents for more than one-half of the calendar year, and (3) is qualified as a qualifying child or qualifying relative of one of the parents, the child will be treated as a dependent of one or both parents for purposes of (1) the exclusions of § 105 for medical expense insurance reimbursements, (2) § 106 for employer provided health coverage, (3) the definition of covered employees under § 132(h)(2)(b) for purposes of certain excluded fringe benefits, (4) qualifying payments from archer medical savings accounts (§ 220(d)(2)), and (5) qualifying payments from health savings accounts (§ 223(d)(2)), whether or not the custodial parent has released the claim for exemption with respect to the child under § 152(e)(2). (however, absent the filing of a release, only the custodial parent is entitled to claim a dependency exemption with respect to a child.). b. refining the definition of qualifying child and tightening (very modestly) eligibility for the child credit. the fostering connections to success and increasing adoptions act, § 501, amended the definition of a qualifying child to add requirements that a qualifying child must not have filed a joint return with a spouse (other than to claim a refund) [§ 152(c)(3)(a)] and must be younger than the claimant [§ 152(c)(1)(d)]. in addition, if the parents fail to claim their child as a dependent, another taxpayer must have a higher gross income than either of the parents in order to claim the child [§ 152(c)(4)(c)]. finally, § 24(a) was amended to limit the child credit to 2009] recent developments in federal income taxation 347 taxpayers eligible to claim the child as a dependent under § 151. 2. the irs should be sanctioned for pursuing this case. if not, it sends the message that the irs’s lawyers can ignore easy to find unambiguous state law that determines the outcome of the case. le v. commissioner, t.c. memo. 2008-183 (7/30/08). in a divorce proceeding, a kansas court entered a temporary spousal maintenance order pursuant to which the taxpayer was required to pay his soon-to-be ex-wife $12,000. the state court order specifically stated that “said spousal maintenance shall be taxable income to [the soon-to-be ex-wife] and shall be deductible on [taxpayer’s] income tax return,” but it did not specifically provide the obligation to pay the lump sum (in satisfaction of past due temporary support) would be cancelled if the soon-to-be ex-wife died before the payment was made. the irs claimed that the payment was not deductible as alimony because the obligation to make the payment did not terminate upon the death of the obligee. judge vasquez held for the taxpayer, finding that kansas law provided that the obligation to make the payment would terminate upon the death of the soon-to-be ex-wife. in kansas “temporary maintenance ceases when the divorce action terminates”. in re marriage of vientos, 139 p.3d 152 (kan. ct. app. 2006). a divorce action is “purely personal and ends on the death of either spouse.” wear v. mizell, 946 p.2d 1363, 1367 (kan. 1997). in cases where the payor spouse is in arrears on support payments but then later pays the amount in arrears, “the payment retains the characteristics of the original payments for which it is substituted”. davis v. commissioner, 41 t.c. 815, 820 (1964); see also stroud v. commissioner, t.c. memo. 1993-317. the $12,000 of spousal support was temporary maintenance. accordingly, under kansas law the liability to make such payments would have ceased on either petitioner’s or ms. le’s death because the divorce proceeding would have automatically terminated, ending the operation of the temporary orders. • we ask: for gosh sakes, couldn’t the chief counsel’s office have figured this out without a trial? 3. only till death do the payments continue. johanson v. commissioner, 541 f.3d 973 (9th cir. 9/3/08). where state [california] law unambiguously provides for spousal support payments to terminate upon the death of a payee spouse, a payment may be found not to qualify as alimony if under state law a written agreement can waive that termination requirement and the agreement in question does so. if the agreement is ambiguous, extrinsic evidence is admissible to determine the intent of the parties. on the facts, the 348 florida tax review [vol. 9:si payee spouse failed to prove that payments would not terminate upon her death, and the payments were thus alimony. 4. so what’s this otherwise mundane reviewed case really about? mitchell v. commissioner, 131 t.c. no. 15 (12/15/08 ) (reviewed 13-2-0). in what at first blush appears to be a mundane case, the tax court in a reviewed opinion by judge goeke held that amounts paid to the taxpayer from her former spouse’s military retirement pay, pursuant to a qdro based on community property rights, were includible in the payee spouse’s gross income. • the real issue, which the majority ducked, but on which judge holmes wrote a comprehensive concurring opinion (with which judge halpern agreed) was whether the case should have been decided on the merits, as the majority so decided it, or whether the taxpayer ought to have been collaterally estopped as argued by the commissioner. the taxpayer had previously litigated and lost the identical issue for an earlier year in an s case. judge holmes’s exhaustive analysis concluded that collateral estoppel principles should attach to issues previously litigated in an s case if collateral estoppel would have attached if the earlier case had been a regular case. g. education 1. a tax subsidy for newly-minted public interest lawyers. rev. rul. 2008-34, 2008-28 i.r.b. 76 (6/20/08). section 108(f) excludes from gross income cancellation of indebtedness income that would otherwise be realized when a student loan is canceled pursuant to its terms as a result of the former student working for a specified period of time in certain professions for one of a broad class of employers. this ruling held that a law school loan, that refinanced original student loans, made under a “loan repayment assistance program” (lrap) was a “student loan” and satisfied the requirements of § 108(f). the specific facts dealt with an lrap under which to qualify the law school graduate was required to work in a law-related public service position for, or under the direction of, a tax-exempt charitable organization or a governmental unit, including a position in (1) a public interest or community service organization, (2) a legal aid office or clinic, (3) a prosecutor’s office, (4) a public defender’s office, or (5) a state, local, or federal government office. the amount of the lrap loan was based on the graduate’s outstanding student loan debt and annual income. after the graduate worked for the required period in a qualifying position, the law school forgives all or part of the loan. • professor ellen aprill of loyola, los angeles cautions that “because the tax-free status of loan forgiveness under § 108(f) pursuant to the college cost reduction and access act of 2007 may be available for some borrowers, uncertain for others, and unavailable for yet others, 2009] recent developments in federal income taxation 349 supporters of this recent legislation have identified the need for and are seeking legislation extending § 108(f).” • is this a way to encourage law school graduates to go to work for the irs? 2. section 530(d)(9), added by the heroes earnings assistance and relief tax act of 2008, allows an individual who receives a military death gratuity payment (excluded from gross income by §134 or a servicemembers’ group life insurance payment (excluded from gross income by §101), to contribute the payment to a coverdell educational savings account without regard to the otherwise applicable annual contribution limit and the income phase-out of the contribution limit. 3. congress extends the [paltry] deduction for college tuition, and adds ridiculous complexity. the emergency economic stabilization act of 2008 extended through 2009 code § 222, which allows an above-the-line deduction for up to $4,000 of qualified tuition and expenses for higher education for a taxpayer with agi of $65,000 or less ($130,000 or less for a joint return), or up to $2,000 for a taxpayer with agi greater than $65,000 ($130,000) but not greater than $80,000 ($160,000) through 2008. the provision, which was added in 2004 had been scheduled to expire after december 31, 2007. in addition, the act amended § 222 to disallow the qualified tuition deduction to any taxpayer for 2008 and 2009 if in the absence of the alternative minimum tax the taxpayer would have a lower tax liability for that year if he elected the hope or lifetime learning credit with respect to an eligible individual instead of the qualified tuition deduction. • we have no idea how to explain this new limitation. we would need to plug the numbers into turbo tax and just believe the answer it spit out. h. alternative minimum tax 1. making the world safe from the amt, one year at a time. the tax increase prevention act of 2007 provided another one-year “patch” for the amt. the 2007 exemption amounts are $44,350 for unmarried taxpayers and $66,250 for married taxpayers filing joint returns, and $33,125 for married taxpayers filing separately. the act also extended to 2007 the special rule in §26(a)(2) allowing the otherwise nonrefundable personal credits to offset the amt (after taking into account the foreign tax credit). a. congress, save us from the amt! amen, again only for a year at a time. the emergency economic stabilization act 350 florida tax review [vol. 9:si of 2008 provided yet another one-year patch for the amt. • the exemption amount for 2008 is increased to $46,200 for unmarried taxpayers and to $69,950 for married taxpayers filing joint returns ($34,975 for married taxpayers filing separately). (because of the inflation adjustments in § 59(j) the lower ceiling on the amt kiddie tax exemption amount for 2008 will be the sum of the child’s earned income plus $6,400.) • the rule allowing nonrefundable credits (e.g., the dependent care credit, the credit for the elderly and disabled, the adoption credit, the child tax credit, the credit for interest on certain home mortgages, the hope scholarship and lifetime learning credits, the credit for savers, the credit for certain nonbusiness energy property, the credit for residential energy efficient property, and the d.c. homebuyer’s credit) to offset the amt also was extended to 2008. • the refundable credit rules also were modified. first, the refundable credit includes the § 53(f)(2) amt credit for 2008 and 2009 of 50 percent of the aggregate amount of the interest and penalties paid by the taxpayer before october 3, 2008 as a result of failure to report amt liability resulting from application of the § 56(b)(3) treatment of isos requiring taxation under § 83 for amt purposes. second, the $5,000 minimum allowable credit was eliminated. third, as amended, § 53(e) provides a refundable credit amount for a tax year in an amount (not in excess of the long-term unused minimum tax credit for the tax year) equal to the greater of (1) 50% of the long-term unused minimum tax credit for the tax year (instead of 20 percent under prior law), or (2) the amt refundable credit amount (if any) for the taxpayer’s preceding tax year (determined without regard to the increased amt refundable credit amount allowed under § 53(f)(2)). [the change of 20% to 50% means that the long-term unused minimum tax credit can be claimed over a two-year period rather than a five-year period.] fourth, the agi phase-out was eliminated. • new §53(f)(1) abates any underpayment of tax outstanding on october 3, 2008 that is attributable to the application of the § 56(b)(3), requiring taxation of isos under § 83 for amt purposes, for any taxable year ending before january 1, 2008, as well as any interest or penalty with respect to such underpayment. any outstanding amt liability that has been abated under § 53(f)(1) cannot be taken into account in computing the amt credit. 2. more instances of the amt wandering from its original, i.e., 1969, roots; more preferences creep into the amt. the housing assistance tax act of 2008 amended § 57(a)(5)(c) to provide that tax-exempt interest on a bond issued after 7/30/08, is not a tax preference item if the bond is (1) an exempt facility bond issued as part of an issue at least 95 percent of the net proceeds of which are used to provide qualified residential rental projects, (2) a qualified mortgage bond, or (3) a qualified veterans’ 2009] recent developments in federal income taxation 351 mortgage bond. as amended by act § 38(c)(4)(b) allows the low-income housing credit [§ 42] and the rehabilitation credit [§ 47] to be claimed against the amt. vi. corporations a. entity and formation 1. congress gave the irs the power to overrule the statute and the irs accepted the invitation. t.d. 9397, assumption of liabilities, 73 f.r. 26321 (5/9/08). section 358(h) requires that the basis of the stock received in a § 351 transaction be reduced (but not below the fair market value) by the amount of any § 357(c)(3) liability that was assumed by the corporation, but § 358(h)(3) provides that, except as provided in regulations, § 358(h) does not apply if, as part of the exchange (1) “the trade or business with which the liability is associated is transferred to the person assuming the liability,” or (2) “substantially all of the assets with which the liability is associated are transferred to the person assuming the liability.” reg. § 1.358-5, replacing temp. reg. § 1.358-5t, narrows the statutory exception by providing that the exception for a transfer of “substantially all of the assets with which the liability is associated” to the corporation assuming the liability is inoperative. thus, the exception in § 358(h)(3) actually applies if, and only if, the trade or business with which the liability is associated is transferred to the corporation assuming the debt, for example, the specific fact pattern in rev. rul. 95-74, 1995-2 c.b. 36. the exception in § 358(h)(3) does not apply to selective transfers of assets that may bear some relationship to the liability, but that do not represent the full scope of the trade or business with which the liability is associated. b. distributions and redemptions 1. we think the taxpayer should seek attorney’s fees after winning this one. the irs’s constructive dividend claim was off the wall. beckley v. commissioner, 130 t.c. no. 18 (6/30/08). the taxpayer’s wife made a loan to a corporation (ct) in which he was a 50 percent shareholder. ct used the borrowed funds to develop a working model of web-based video conferencing software. subsequently, ct however, had financial problems and was dissolved, and the working model was transferred to a new corporation (vdn) in which the taxpayer was a shareholder (the precise ownership percentage not being a matter of record – taxpayer claimed he owned only 1 percent of vdn’s stock, while the irs claimed he owned 50 percent). vdn made payments to the taxpayer’s wife, a portion of which was reported as taxable interest income and the balance of which was treated as a repayment of 352 florida tax review [vol. 9:si the principal she lent to ct. the irs accepted the taxpayer’s wife’s reporting, but treated 50 percent of the payments she received as taxable constructive dividends to the taxpayer from vdn. before the tax court, the irs argued “that vdn’s payments to [the taxpayer’s wife] were made to satisfy only [his] personal moral obligations,” because vdn did not execute a written loan agreement and that, therefore, under the statute of frauds [oregon] vdn was not liable for the debt. judge swift rejected the irs’s argument, concluding that “the existence of an oral agreement … may cause an oregon court to enforce an oral agreement if unjust enrichment would occur if the oral agreement were not enforced,” and, in any event, “vdn’s conduct in actually making payments to virginia, which related to virginia’s loan to ct and to ct’s transfer of the working model to vdn, establish the loan repayment character of the payments and the principal and interest nature thereof.” 2. section 162(k)’s bite is as loud as its bark. ralston purina co. v. commissioner, 131 t.c. no. 4 (9/10/08). ralston purina claimed a deduction under § 404(k) for payments made to its esop in redemption of ralston purina preferred stock owned by the esop to fund distributions to employees terminating participation in the esop. the commissioner argued the redemption payments were not deductible under either § 404(k)(1) or (5), or alternatively that deduction was barred by §162(k). the tax court, in a unanimous reviewed opinion by judge nims, held that because ralston purina’s payments were “in connection with the redemption of its own stock,” § 162(k) applied to disallow the deduction. the tax court refused to follow the contrary opinion on almost identical facts in boise cascade corp. v. united states, 329 f.3d 751 (9th cir. 2003). in boise cascade the ninth circuit interpreted the phrase “in connection with” to include only expenses that have their origin in a stock redemption transaction, excluding expenses that have their origin in a “separate, although related, transaction”. the tax court previously had rejected the ninth circuit’s narrow interpretation of the phrase “in connection with” in fort howard corp. & subs. v. commissioner,103 t.c. 345 (1994), and did so again in ralston purina. the court rejected ralston purina’s argument that because the payments were an applicable dividend under 404(k), the transaction was excepted from the application of § 162(k) under § 162(k)(2)(a)(ii). the tax court reasoned that the entire transaction potentially deductible as an applicable dividend under § 404(k) — payment from the corporation to the esop and the distribution to the esop participants — must also pass muster under §162(k), and that the “otherwise allowable” deduction was disallowed because the payment was “in connection with” a repurchase of stock. • this is the same result reached in conopco, inc. v. united states, 100 a.f.t.r.2d 2007-5296 (d. n.j. 7/18/07). 2009] recent developments in federal income taxation 353 3. the tax court is bearish on merrill lynch. merrill lynch & co. v. commissioner, 120 t.c. 12 (1/15/03). in 1986 and 1987 merrill lynch structured several transactions to sell certain assets of first-tier and second-tier subsidiaries and not only eliminate any tax on the gains, but to create losses. to take advantage of the interaction of the consolidated return regulations and § 304 [before the promulgation of reg. § 1.1502-80(b), rendering § 304 inoperative in consolidated returns], merrill lynch caused the subsidiaries holding the assets to drop the assets to be retained into new lower level subsidiaries [in § 351 transactions], following which the new subsidiaries were sold cross chain to other merrill lynch subsidiaries. the sales proceeds were then distributed to its parent by the subsidiary to be sold, and that subsidiary was then sold. the plan was that the cross-chain sale would be recharacterized as a dividend under § 304, which would result in a basis increase under reg. §§ 1.1502-32 and -33 [as then in effect] in the stock of the subsidiaries to be sold. the irs did not contest that § 304 applied, but responded that the “distributions” coupled with the sales of the subsidiaries outside the group were part of a firm and fixed plan by the subsidiaries that were sold outside the group to dispose of the stock of the lower tier subsidiaries that had been sold cross chain. therefore, even after applying § 304 the distributions were treated as amounts received in a redemption under § 302(b)(3) [applying zenz v. quinlivan, 213 f.2d 913 (6th cir. 1954)]. the tax court (judge marvel) held that under the principles of niedermeyer v. commissioner, 62 t.c. 280 (1974), a firm and fixed plan existed with respect to every such sale and held for the irs. the record establishes that on the dates of the cross-chain sales, petitioner had agreed upon, and had begun to implement, a firm and fixed plan to completely terminate the target corporations’ ownership interests in the issuing corporations (the subsidiaries whose stock was sold cross-chain). the plan was carefully structured to achieve very favorable tax basis adjustments resulting from the interplay of section 304 and the consolidated return regulations, and the steps of the plan were described in detail in written summaries prepared for meetings of merrill parent’s board of directors. as described in those written summaries, the cross-chain sales of the issuing corporations’ stock and the sales of the target corporations were part of the same seamless web of corporate activity intended by petitioner to culminate in the sale of the target corporations outside the consolidated group. a. as is the second circuit, which affirmed the tax court. 386 f.3d 464 (2d cir. 9/28/04). on appeal merrill lynch argued for the first time that the proceeds of the cross-chain sales should be treated as § 301 dividends, even if the actual and constructive ownership interest in the subsidiary 354 florida tax review [vol. 9:si corporation that was sold was completely terminated, because merrill lynch retained a constructive ownership interest in the purchased subsidiaries for purposes of § 302(b)(3). the second circuit remanded the case for consideration of this issue. b. now the tax court is bearish on bank of america (as well as on ken gideon and marty ginsburg). 131 t.c. no. 19 (12/30/08). on remand, the taxpayer argued that because its ownership interest in the issuing corporations was not completely terminated within the meaning of § 302(b)(3), it properly reported sales proceeds as dividends. the taxpayer’s argument went as follows: (1) immediately before the cross-chain sales, the acquiring corporation was a wholly owned subsidiary; (2) under the § 318 attribution rules, ownership of the issuing corporations was also attributed to it its ownership of their parent; and (3) after the sale of the subsidiaries’ former parent [the seller in the cross-chain sale], the taxpayer continued constructively to own 100 percent of the stock of the issuing corporations through its ownership of the acquiring corporations. the tax court (judge marvel) rejected the taxpayer’s argument and agreed with the commissioner that the rules in §§ 302 and 304 “apply only to the shareholder who, in exchange for stock, actually receives the proceeds of a cross-chain sale. the position that the section 302(b) tests may be applied to a shareholder who indirectly or constructively holds stock but has neither transferred any stock nor received the proceeds of the stock sale cannot be reconciled with the language and structure of section 304(a)(1).” the subsidiary-parent that was sold by the taxpayer was the only “person” who transferred any stock to the acquiring subsidiary corporations in the cross-chain sales, and it was the only shareholder that received property from the acquiring corporations in exchange for stock in the issuing corporations. consequently, it was the only shareholder whose interest in the issuing corporations should be tested under § 302(b)(3). because its interest in the issuing corporations was completely terminated upon its sale outside of the affiliated group, the redemption was a distribution in exchange for stock. c. liquidations there were no significant developments regarding this topic during 2008. d. s corporations 1. proposed regulations implementing the ever-easing standards for qualifying as an s. reg-143326-05, s corporation guidance under ajca of 2004 and goza of 2005, 72 f.r. 55132 (9/28/07). the 2009] recent developments in federal income taxation 355 treasury has published proposed amendments to various regulations under subchapter s, including, among others, prop. regs. §§ 1.1361-1(e) [number of shareholders]; 1.1361-1(h) [special rules relating to trusts eligible to be shareholders]; 1.1361-1(m) [esbts]; 1.1361-4 [inadvertent terminations and inadvertently invalid elections]; and 1.1366-2 [limitations on deduction of passed-though losses]. • the entire state of arkansas counts as one shareholder. section 403(b) of goza amended § 1361(c)(1)(b)(iii) to apply the test for qualifying members of a family with a common ancestor not more than six generations removed to the latest of (1) the date the s election is made, (2) the earliest date an individual who is a “member of the family” holds stock in the s corporation, or (3) october 22, 2004. prop. reg. § 1.1361-1(e)(3) clarifies that the “six generation” test is applied only at the date specified in § 1361(c)(1)(b)(iii) and thereafter has no continuing significance in limiting the number of generations of a family that may hold stock and be treated as a single shareholder. • section 234 of ajca amended § 1361(e)(2) to provide that in determining an esbt’s potential current beneficiaries for any period (pcbs), powers of appointment are disregarded if not exercised by the end of that period. also, the period during which an esbt may safely dispose of s corporation stock after an ineligible shareholder becomes a pcb was increased from 60 days to one year. prop. reg. § 1.1361-1(m)(2)(vi) reflects these changes. all members of a class of unnamed charities permitted to receive distributions under a discretionary distribution power held by a fiduciary that is not a power of appointment, will be considered, collectively, to be a single pcb for purposes of determining the number of permissible shareholders, unless the power is actually exercised, in which case each charity that actually receives distributions will also be a pcb. a power to add beneficiaries, whether or not charitable, to a class of current permissible beneficiaries is generally a power of appointment and thus will be disregarded to the extent it is not exercised. fiduciary powers to spray trust distributions to a class of current beneficiaries or possible current beneficiaries are not “powers of appointment,” and thus every member of the class remains a pcb, whether or not receiving a distribution. • proposed amendments to reg. § 1.13624 implement 1996 amendments to § 1362(f), which provide relief for corporations with inadvertently invalid s corporation elections [in addition to the relief previously available for inadvertent terminations of valid s corporation elections]. section 238 of ajca amended § 1362(f) to provide that qsubs are eligible for relief for an inadvertent invalid qsub election or termination under the same standards applied to an inadvertent invalid s corporation election or termination. the proposed regulations would make conforming changes to reg. § 1.1362-4. • section 235 of ajca amended § 1366(d)(2) to provide that if the stock of an s corporation is transferred between spouses or incident to divorce under § 1041(a), any loss or deduction with respect 356 florida tax review [vol. 9:si to the transferred stock that could not be taken into account by the transferring shareholder in the year of the transfer because of the basis limitation in § 1366(d)(1) is treated as incurred by the corporation in the succeeding taxable year with regard to the transferee. proposed amendments to reg. § 1.1366-2(a)(5) would implement this exception to the general rule of nontransferability of losses and deductions. losses and deductions carried over to the year of transfer that are not used by the transferor spouse in that year will be prorated between the transferor spouse and the transferee spouse based on their stock ownership at the beginning of the succeeding taxable year. a. finalized before you could say “jack robinson.” t.d. 9422, s corporation guidance under ajca of 2004 and goza of 2005, 73 f.r. 47526 (8/13/08). the proposed regulations were finalized, with only ministerial changes. they are effective 8/14/08, with various specific applicability dates. notice 2005-97, 2005-2 c.b. 1164, was obsoleted. 2. short-term beneficial treatment for charitable contributions through an s corporation teaches why you shouldn’t make future charitable contributions of appreciated property through an s corporation unless the law changes. rev. rul. 2008-16, 2008-11 i.r.b. 585 (3/17/08). if an s corporation made a charitable contribution of appreciated property during a taxable year beginning after 12/31/05, and before 1/1/08, the shareholder’s deduction may not exceed the sum of: (1) the shareholder’s pro rata share of the fair market value of the contributed property over the contributed property’s adjusted tax basis, and (2) the amount of the § 1366(d) loss limitation amount that is allocable to the contributed property’s adjusted basis under reg. § 1.1366-2(a)(4). any disallowed portion of the contribution retains its character and is carried over. • the tax technical corrections act of 2007 added § 1366(d)(4), which provides, in effect, that the basis limitation rule of § 1366(d)(1) does not apply to the amount of deductible appreciation in the contributed property in taxable years beginning after 12/31/05, and before 1/1/08. • the pension protection act of 2006 amended § 1367(a)(2) to provide that the decrease in shareholder basis under § 1367(a)(2)(b) by reason of a charitable contribution of property is the amount equal to the shareholder’s pro rata share of the adjusted basis of such property in taxable years beginning after 12/31/05, and before 1/1/08. • the emergency economic stabilization act of 2008 extend through 2009 the application of § 1366(d)(4). • absent further statutory change, charitable contributions made by s corporations in subsequent taxable years are subject to the law in existence prior to these amendments [i.e., stock basis will be reduced by the full amount of the deduction]. the irs and treasury department 2009] recent developments in federal income taxation 357 are considering issuing guidance on the treatment of charitable contributions made by s corporations in subsequent taxable years. 3. f reorganizations of s corporations. rev. rul. 200818, 2008-13 i.r.b. 674 (3/7/08). when an s corporation undergoes § 368(a)(1)(f) reorganization [through a § 351 contribution of the s corporation stock to a holding company or through a downstream merger into a newly formed second tier subsidiary] in which an operating s corporation becomes a qsub of a newly formed holding company that qualifies to be an s corporation, the newly formed parent succeeds to the original s corporation’s election and does not have to make a new s election. see rev. rul. 64-250, 1964-2 c.b. 333. effective 1/1/09, the new parent must obtain its own ein rather than succeed to the qsub’s ein. however, for s corporations that have previously undergone a § 368(a)(1)(f) reorganization in a manner described in the ruling transaction to create the holding company, where the parent took the qsub’s ein, the parent should continue to use that ein and the qsub will have to get a new ein when it is treated as a separate corporation. rev. rul. 64-250, 1964-2 c.b. 333 is amplified. 4. revenge for gitlitz? reg-102822-08, section 108 reduction of tax attributes for s corporations, 73 f.r. 45656 (8/6/08). section 108(d)(7)(a) provides that if an s corporation excludes cod income under § 108(a), the excluded amount reduces the s corporation’s tax attributes under § 108(b)(2); § 108(b)(4)(a) provides that the reduction occurs after the s corporation’s items of income, loss, deduction and credit for the taxable year of the discharge pass through to its shareholders. pursuant to § 108(d)(7)(b), prop. reg. § 1.108-7(d) would treat any § 1366(d)(3) shareholder carryover losses from prior years and any passed through losses from the current year in excess of the shareholders’ bases as a “deemed nol” of the s corporation that would be reduced under § 108(b). where an s corporation has more than one shareholder during the taxable year of the discharge, a shareholder’s disallowed losses or deductions equal a pro rata share of the total losses and deductions allocated to the shareholder under § 1366(a) during the corporation’s taxable year (including losses and deductions disallowed under § 1366(d)(1) for prior years that are treated as current year losses and deductions with respect to the shareholder under § 1366(d)(2)). the proposed regulations will be effective when finalized. 5. section 101(j) meets § 1368(e). rev. rul. 2008-42, 2008-30 i.r.b. 175 (7/1/08). premiums paid by an s corporation on an employer-owned life insurance contract, of which the s corporation is directly or indirectly a beneficiary, do not reduce the s corporation’s aaa. the benefits received by reason of the death of the insured from an employer-owned life 358 florida tax review [vol. 9:si insurance contract that is not taxed under § 101(j), because it meets one of the exceptions under § 101(j)(2), do not increase the s corporation’s aaa. 6. proposed regulations restrict the use of open account debt to increase basis and deduct losses. reg-144859-04, section 1367 regarding open account debt, 72 f.r. 18417 (4/12/07). prop. reg. § 1.1367-2(a), (c)(2), (d), & (e), ex.6, would limit open account debt from an s corporation to a shareholder to debt not evidenced by written instruments for which the principal amount of aggregate advances, net of repayments, does not exceed $10,000 at the close of any day during the s corporation’s taxable year. the proposed regulations will reverse the result in brooks v. commissioner, t.c. memo. 2005-204 (8/25/05), which allowed an s corporation shareholder to borrow money from a bank, advance the funds to the shareholder’s s corporation which increased basis and allowed loss deductions, receive payment of the debt in the subsequent taxable year, repay the bank, then at the end of the year again borrow funds to avoid gain on release from the low basis debt and deduct further losses. thus the taxpayer was able to create endless deferral of gain. the preamble to the proposed regulations indicates that the purpose of the open account debt provisions is administrative simplicity. whenever advances not evidenced by written instruments exceed $10,000, the indebtedness will be treated as a separate indebtedness for which payments and advances are separately determined for purposes of basis and gain recognition on repayment. a. regulations are now final, with relaxing modifications. t.d. 9428, section 1367 regarding open account debt, 73 f.r. 62199 (10/20/08). the final regulations adopt a $25,000 aggregate principal threshold amount per shareholder for open account debt. generally, this determination is to be made at the end of the taxable year – with exceptions for dispositions of shareholder debt and termination of a shareholder’s interest (for which the determination is to be made immediately before the event). 7. gitlitz by analogy? “not,” says the tax court. nathel v. commissioner, 131 t.c. no. 17 (12/17/08). prior to 2001, the taxpayer had claimed losses passed-though from an s corporation in an amount that exceeded his stock basis but which were properly allowable under § 1366(d)(1)(b) because there were outstanding loans to the corporation from the taxpayershareholder. the taxpayer’s basis in the loans to the corporation was reduced under § 1367(d)(2)(a) to $112,547. in 2001 the corporation paid $649,775 on the loan, which exceeded the taxpayer’s $112,547 basis in the loan by $537,228. later in 2001, pursuant to a restructuring of the ownership of the s corporation and two other corporations owned by the taxpayer, his brother, and a third party (which left the taxpayer with no ownership in the corporation), the taxpayer made a capital contribution of $537,228 to the s corporation, which equaled the 2009] recent developments in federal income taxation 359 amount by which the loan repayment exceeded the taxpayer’s basis in the debt. the consideration for the contribution was the assumption by another shareholder of the taxpayer’s obligation on guarantees of loans from banks to the corporation. in calculating the gain realized upon receipt of the loan repayment, the taxpayer treated the capital contribution as income under § 1366(a)(1) to the s corporation, although excludable income under § 118, and therefore as restoring or increasing under § 1367(b)(2)(b) his bases in the outstanding loans before repayment (rather than increasing his stock basis), thus eliminating any gain. relying on gitlitz v. commissioner, 531 u.s. 206, 216 (2001), the taxpayer argued that because § 118 excludes capital contributions from the gross income of an s corporation, capital contributions are “permanently excludible” and are thus “tax-exempt income” under reg. § 1.13661(a)(2)(viii), and that as such it is included as an item of the s corporation’s income to for purposes of § 1366(a)(1) and the resulting § 1367 basis adjustments. the tax court (judge swift) rejected the taxpayer’s argument and upheld the deficiency. by attempting to treat petitioners’ capital contributions to [the corporation] as income to [the corporation], [taxpayers] in effect seek to undermine three cardinal and longstanding principles of the tax law: first, that a shareholder’s contributions to the capital of a corporation increase the basis of the shareholder’s stock in the corporation; ... sec. 1.118-1, income tax regs.; second, that equity (i.e., a shareholder’s contribution to the capital of a corporation) and debt (i.e., a shareholder’s loan to the corporation) are distinguishable and are treated differently by both the code and the courts ... ; and third, that contributions to the capital of a corporation do not constitute income to the corporation; sec. 118; ... sec. 1.118-1, income tax regs. we do not believe that the gitlitz holding or the provisions of subchapter s, namely sections 1366(a)(1), 1367(a)(1)(a), and 1367(b)(2)(b), should be interpreted to override these three longstanding principles of tax law. • reg. § 1.118-1 provides that “if a corporation requires additional funds for conducting its business and obtains such funds through *** payments by its shareholders *** such amounts do not constitute income.” thus, shareholder capital contributions are not treated as items of income to an s corporation under § 1366(a)(1) and are not taken into account in calculating the “net increase” under § 1367(b)(2)(b) for the purpose of restoring or increasing a shareholder’s tax basis in loans a shareholder made to an s corporation. such capital contributions are not “tax-exempt income” under § 1366(a)(1) nor under reg. § 1.1366-1(a)(2)(viii) and do not restore or increase the bases in shareholder loans under § 1367(b)(2)(b). 360 florida tax review [vol. 9:si 8. disregarded qsub is still a bank subject to reduced interest deductions for interest incurred to carry tax-exempt obligations. vainisi v. commissioner, 132 t.c. no. 1 (1/15/09). sections 291(a)(3), (e)(1)(b), and 265(b)((3) disallow interest deductions of a financial institution incurred to carry tax-exempt obligations, but allow an 80 percent deduction for interest on tax-exempt obligations acquired after 12/31/82, and before 8/7/86, and for certain qualified tax exempt obligations as defined in § 265(b)(3)(b). section 1361 allows certain financial institutions to elect to be treated as an s corporation, and further allows an s corporation to treat a financial institution as a qualified s corporation subsidiary (qsub). under § 1361(b)(3)(a), a qsub is not treated as a separate corporation except as provided in regulations. reg. § 1.1361-4(a)(3) provides that in the case of a bank that is an s corporation or a qsub of an s corporation, any special rules applicable to banks will apply to an s corporation or a qsub that is bank. the court (judge foley) held that under these provisions the limitations of § 291(a)(3) are applicable to interest deductions claimed by a parent s corporation for interest expense generated by the s corporation’s qsub bank. the court also held that reg. § 1.1361-4(a)(3) is consistent with the enactment of § 1361(b)(3)(a) and its legislative history. e. reorganizations 1. making post-reorganization intra-group restructurings even easier. t.d. 9361, corporate reorganizations; transfers of assets or stock following a reorganization, 72 f.r. 60552 (10/25/07), making final reg-130863-04, corporate reorganizations; transfers of assets or stock following a reorganization, 69 f.r. 51209 (8/18/04). the treasury has finalized regulations dealing with (1) the continuity of business enterprise requirement (reg. § 1.368-1(d)) and (2) the definition of a “party to a reorganization” requirement (reg. § 1.368-2(f)) to liberalize the rules regarding permissible post-acquisition restructurings of acquiring corporations in a controlled group of corporations. in addition to post-acquisition drops of assets to lower-tier subsidiaries, certain post-acquisition distributions by an acquisition subsidiary that is member of the acquiring corporation’s group to a corporation that controls the acquiring corporation of either the target corporation’s stock (following a § 368(a)(1)(b) or § 368(a)(2)(e) reorganization) or assets (following a § 368(a)(1)(a), § 368(a)(1)(c), or § 368(a)(2)(e) reorganization), and certain cross chain transfers, subsequent to the acquisition, do not disqualify the acquisition from reorganization treatment, even though there is no statutory provision expressly providing that such distributions do not affect the validity of reorganization treatment, provided that the distribution would not result in the distributing corporation being treated as liquidated for income tax purposes. the regulations thus permit the acquiring corporation to significantly rearrange ownership of the target corporation’s assets or stock, as the case may be, among 2009] recent developments in federal income taxation 361 the members of its qualified group (based on § 368(c) control) without disqualifying the reorganization. furthermore, the final regulations (reg. § 1.368-1(d)(4)(ii)), unlike the proposed regulations, permit qualified group members to aggregate their direct stock ownership of a corporation, in a manner similar to aggregation under § 1504(a), in determining whether they have the requisite § 368(c) control of such corporation (provided that the issuing corporation has § 368(c) control in at least one other corporation). a. less than six months later the new regulations require clarification. t.d. 9396, corporate reorganizations; amendment to transfers of assets or stock following a reorganization, 73 f.r. 26322 (5/9/08). reg. § 1.368-2(k), dealing with drop downs and push-ups following reorganizations, which was finalized in october, 2007, has been amended in several respects: (1) the amended regulations clarify that a transfer to the former shareholders of the target corporation (other than the acquiring corporation) is not a safe harbor push-up to the extent it constitutes consideration by the shareholders for their proprietary interests in the target, because it “calls into question” whether the transaction satisfies the continuity of interest requirement, as well as statutory limitations on permissible consideration (such as the “solely for voting stock” requirement in § 368(a)(1)(b) or (c)); however, the safe harbor applies to transfers to the former shareholders that are not consideration for their proprietary interests in the target, for example a pro-rata dividend distribution following the acquisition. (2) the safe harbor is available for an upstream reorganization, e.g., a merger of an eighty percent controlled subsidiary into its parent, followed by a drop-down of the acquired assets. the preamble refers to rev. rul. 69-617, 1969-2 c.b. 57, as an example of this principle. (3) the safe harbor does not apply to a transfer to the issuing corporation or a person related to the issuing corporation by the former shareholders of the target corporation (other than a former shareholder that is also the acquiring corporation) of consideration initially received in the potential reorganization. (4) a transfer to a shareholder is always a push-up described in paragraph (k)(1)(i) even if it also meets the description of a drop-down described in paragraph (k)(1)(ii), e.g., a transfer to a subsidiary that also is a shareholder. (5) the drop-down/sideways safe harbor does not apply if the target or acquisition subsidiary terminates its corporate existence for federal income tax purposes in connection with the transfer. 2. the step-transaction doctrine applies to cause a push-up to defeat tax-free reorganization treatment, but it does not apply to treat the push-up as an asset purchase. rev. rul. 2008-25, 2008-21 i.r.b. 986 (5/27/08). a reverse triangular merger that otherwise would qualify as a tax free reorganization under § 368(a)(2)(e), but which could not qualify as a taxfree reorganization either under § 368(a)(1)(c) because of the mix of 362 florida tax review [vol. 9:si consideration or under § 368(a)(1)(d) because the shareholders of the target did not own sufficient stock of the issuer, followed by an liquidation of the newly acquired subsidiary pursuant to an “integrated plan,” will be treated as a qualified stock purchase of the target corporation’s stock, followed by a § 332 liquidation. because the acquired corporation was liquidated, reg. § 1.368-2(k) does not apply and the first step does not qualify as a § 368(a)(2)(e) tax-free reorganization, because after the acquisition, the target does not hold substantially all of its properties. • note that nonrecognition at the corporate level and the basis of the target’s assets are unaffected by this ruling. the only effect is that shareholders of the target recognize all of their gain or loss. 3. did the irs strike out by swinging for a home run? fisher v. united states, 82 fed. cl. 780 (fed. cl. 8/6/08). the taxpayer (a trust) owned a life-insurance policy issued by a mutual insurance company with respect to which it had paid over $190,000 in premiums. the insurance company converted to a stock company and the taxpayer received 3,892 shares of stock in exchange for its voting and liquidation rights. pursuant to the demutualization plan, it elected to take cash in lieu of the shares and the insurance company sold the shares on the open market for $31,759.00, which was paid to the taxpayer. the irs had issued a private letter ruling to the insurance company stating that the receipt of the shares would be tax free under § 354, but that under § 358 the shares would take a zero basis because that was the basis of the policyholder’s voting and liquidation rights. the taxpayer reported $31,759.00, unreduced by any basis adjustment, on its federal income tax return for 2000, and then sought a refund, claiming that the entire basis of the insurance policy could be offset against the stock sale proceeds under the open transaction doctrine. judge allegra rejected the irs’s position and agreed with the taxpayer. he reasoned that under reg. § 1.61-6(a), the basis of the mutual insurance policy should have been apportioned between the stock received in the demutualization and the continuing insurance policy, but that because it was “impractical or impossible” to allocate the basis of the mutual insurance policy between the insurance benefits and voting and liquidation rights, because they were not alienable apart from the insurance policy, the open transaction doctrine applied. he cited inaja land co. v. commissioner, 9 t.c. 727 (1947), acq., 1948-1 c.b. 2, as his rationale of applying open transaction treatment to the payment. • judge allegra rejected the irs’s argument that the payment represented a “windfall,” stating, “the ‘windfall’ tag, therefore, lacks evidentiary adhesive and does not stick.” • we wonder if the irs might have blown this one by going for a home run and trying to assign a zero basis to the stock on the ground that zero was the basis of the voting and liquidation rights appurtenant to the mutual insurance policy in exchange for which the stock was received. it 2009] recent developments in federal income taxation 363 should have argued that the basis of the mutual insurance policy should have been apportioned between the stock and the continuing insurance policy, although the exact statutory provision to cite for that proposition is not entirely clear. 4. proposed regulations with respect to transfers of property with no net value. the transfer of something worth nothing (or less than nothing) on a net basis is not a transfer of property for purposes of subchapter c. reg-163314-03, transactions involving the transfer of no net value, 70 f.r. 11903 (3/10/05). these proposed regulations deal with the net value requirement for tax-free transactions under subchapter c, and provide that exchanges under §§ 351, 332 and 368 do not qualify for tax-free treatment where there is no net value in the property transferred or received, with exceptions for e, f and some d reorganizations. the proposed regulations also provide guidance on the treatment of creditors of an insolvent corporation will be treated as proprietors to determine whether continuity of interest is preserved. a. this new rule is certain to be applied a lot in the next few years. continuity of interest is satisfied when the target corporation’s creditors get stock in the acquirer. t.d. 9434, creditor continuity of interest, 73 f.r. 75566 (12/12/08). in 2005 the treasury department published proposed regulations describing the circumstances in which a corporation’s creditors will be treated as holding a proprietary interest in a target corporation immediately before a potential reorganization. reg-16331403, proposed rules, transactions involving the transfer of no net value, 70 f.r. 11903-01 (3/10/05). these regulations have been finalized with only minor modifications and clarifications, and they apply for continuity of interest purposes both within and outside of bankruptcy proceedings. the regulations adopt the holding in helvering v. alabama asphaltic limestone co., 315 u.s. 179 (1942), that a transfer of assets pursuant to which creditors of a bankrupt concern became the controlling stockholders of a new corporation provided the requisite continuity of interest for a reorganization. the preamble notes extending the reorganization rules to reorganizations of insolvent corporations outside of bankruptcy is consistent with congress’s intent to facilitate the rehabilitation of troubled corporations. reg. § 1.368-1(e)(6) describes the circumstances in which creditors of a corporation generally, and which creditors in particular, will be treated as holding a proprietary interest in a target corporation immediately before a potential reorganization. in general, the regulation adopts the standard for reorganizations under § 368(a)(1)(g) recommended in the senate finance committee report to the bankruptcy tax act of 1980. claims of the most senior class of creditors that receive a proprietary interest in the issuing corporation and claims of all equal classes of creditors (the senior claims) and all junior claims represent proprietary interests in the target corporation. the value of proprietary interests in the target 364 florida tax review [vol. 9:si corporation represented by the senior claims is calculated with reference to the average treatment for all senior claims. the value of a senior claim’s proprietary interest in the target is determined by multiplying the fair market value of the creditor’s claim by a fraction, the numerator of which is the fair market value of the proprietary interests in the issuing corporation that are received in the aggregate in exchange for the senior claims, and the denominator of which is the sum of the amount of money and the fair market value of all other consideration (including the proprietary interests in the issuing corporation) received in the aggregate in exchange for such claims. the value of the proprietary interest in the target corporation represented by a junior claim is the fair market value of the junior claim. thus, there is 100 percent continuity of interest if each senior claim is satisfied with the same ratio of stock to nonstock consideration and no junior claim is satisfied with nonstock consideration. where only one class of creditors receives stock, more than a de minimis amount of acquiring corporation stock must be exchanged for the creditors’ proprietary interests relative to the total consideration received by the insolvent target corporation, its shareholders, and its creditors, before the stock will be counted for purposes of continuity of interest. 5. some rules designed to trace basis in an era of paper stock certificates no longer work. notice 2009-4, 2009-2 i.r.b. 251 (12/12/08). this notice explains the guidance that the irs contemplates issuing regarding the determination of the transferred basis in stock that has been acquired in a § 368(a)(1)(b) reorganization. rev. proc. 81-70, 1981-2 c.b. 729, which provided guidelines for surveying surrendering shareholders to determine the basis of target stock and sampling and estimation procedures to address administrative burdens and shareholder nonresponsiveness is outdated because at the time rev. proc. 81-70 was published, most stock was registered stock, but now stock of public companies is primarily held in street name, often with several tiers of nominee owners, each subject to confidentiality. f. corporate divisions 1. “hot stock” cools off in a dsag. t.d. 9435, guidance regarding the treatment of stock of a controlled corporation under section 355(a)(3)(b), 73 f.r. 75946 (12/25/08). the treasury has promulgated temp. reg. § 1.355-2t(g), dealing with the “hot stock” rule of § 355(a)(3)(b) to conform to the 2006 amendments of § 335(b)(3), creating the “sag” rules, which treat a corporation’s sag [separate affiliated group] as a single corporation for purposes of determining whether the active trade or business requirements of § 355 have been met. section 355(a)(3)(b) provides that stock of a controlled corporation that has been acquired by the distributing corporation in a taxable transaction within the five year period preceding distribution to 2009] recent developments in federal income taxation 365 stockholders otherwise qualifying under § 355 will be treated as boot taxable to the stockholders. generally speaking, the temporary regulations provide that the hot stock of § 355(a)(3)(b) rule does not apply to any acquisition of stock of controlled where controlled is a dsag [separate affiliated group of the distributing corporation] member at any time after the acquisition (but prior to the distribution of controlled). transfers of controlled stock owned by dsag members immediately before and immediately after the transfer are disregarded and are not treated as acquisitions for purposes of the hot stock rule. (prop. reg. § 1.3553(b)(1)(ii) would apply a similar rule for purposes of the atb requirement.) the temporary regulations also incorporate the exception of former reg. § 1.355-2(g), which provides that the hot stock rule does not apply to acquisitions of controlled stock by distributing from a member of the affiliated group (as defined in reg. § 1.355-3(b)(4)(iv)) of which distributing was a member. the regulations generally apply to distributions occurring after december 15, 2008, but there are a number of transition rules. taxpayers also may elect to apply the regulations to distributions made after may 17, 2006. a. reg-150670-07, guidance regarding the treatment of stock of a controlled corporation under section 355(a)(3)(b), 73 f.r. 75979 (12/15/08). the temporary regulations are also published as proposed regulations. g. affiliated corporations and consolidated returns 1. twenty-two years after the authorizing statute was enacted, the treasury and irs propose regulations to prevent triple taxation resulting from sales, exchanges and distributions of corporate stock resulting from general utilities repeal. reg-143544-04, regulations enabling elections for certain transactions under section 336(e), 73 f.r. 49965 (8/25/08). the irs has published proposed regulations under § 336(e). section 336(e), enacted as part of the tra 1986 repealing the general utilities doctrine, authorizes regulations allowing a corporation that sells, exchanges, or distributes stock in another corporation (target) meeting the requirements of § 1504(a)(2) to elect to treat the disposition as a sale of all of target’s underlying assets in lieu of treating it as sale, exchange, or distribution of stock, as under § 338(h)(10). the purpose of a § 336(e) election is to prevent creation of a triple layer of taxation — one at the controlled corporation level, one at the distributing corporation level and, ultimately, one at the shareholder level. prop. regs. §§ 1.336-0 through 1.336-5, when finalized, will provide the requirements and mechanics for, and consequences of, treating a stock sale, exchange, or distribution that would not otherwise be eligible for a § 338 election. under the proposed regulations, the results of a § 336(e) election generally are the same (with certain exceptions) as those of a § 338(h)(10) election. the structure of the 366 florida tax review [vol. 9:si proposed regulations resembles the § 338(h)(10) regulations regarding the allocation of consideration, application of the asset and stock consistency rules, treatment of minority shareholders, and the availability of the § 453 installment method, although certain definitions and concepts differ to reflect differences between § 336 and § 338(h)(10). unlike under § 338(h)(10), however, a § 336(e) election is a unilateral election by the seller. a transaction that meets the definition of both a qualified stock disposition and a qualified stock purchase under § 338(d)(3) generally will be treated only as a qualified stock purchase and does not qualify for a § 336(e) election. prop. reg. § 1.336-1(b)(5)(ii). • general rules. a qualified stock disposition for which a § 336(e) election may be made is any transaction or series of transactions in which stock meeting the requirements of § 1504(a)(2) of a domestic corporation is either sold, exchanged, or distributed, or any combination thereof, by another domestic corporation in a disposition (as defined in prop. reg. § 1.336-1(b)(4)), during the 12-month disposition period (as defined in prop. reg. § 1.336-1(b)(5)). (all members of a consolidated group are treated as a single transferor. prop. reg. § 1.336-2(g)(2)). stock transferred to a related party (determined after the transfer) is not considered in determining whether there has been a qualified stock disposition. prop. reg. §§ 1.336-1(b)(4)(i)(c) and 1.3361(b)(5)(i). a section 336(e) election is available for qualifying dispositions of target stock to non-corporate transferees, as well as to corporate transferees. prop. reg.§ 1.336-1(b)(2) however, the election is not available with respect to the stock of an s corporation. see prop. reg. § 1.336-1(b)(5). • because the proposed regulations require only that stock meeting the requirements of § 1504(a)(2) be transferred, the transferor (or a member of its consolidated group) may retain a portion of the target stock. prop. reg. §§ 1.336-2(b)(1)(v) and 1.336-2(b)(2)(iv). furthermore, the proposed regulations allow amounts of target stock transferred to different transferees, in different types of transactions to be aggregated in determining whether there has been a qualified stock disposition. for example, the sale of 50 percent of target’s stock to an unrelated person and a distribution of another 30 percent to its unrelated shareholders (who might or might not be the purchasers of the 50 percent that was sold) within a 12-month period would constitute a qualified stock disposition. prop. reg. § 1.336-1(b)(5). • sales or exchanges of target stock. in general, if a seller sells or exchanges target stock in a qualified stock disposition, the treatment of old target, seller, and purchaser are similar to the treatment of old target (old t), s, and p under § 338(h)(10). if a § 336 election is made, the sale or exchange of target stock is disregarded. instead, target (old target) is treated as selling all of its assets to an unrelated corporation in a single transaction at the close of the disposition date (the deemed asset disposition). old target recognizes the deemed disposition tax consequences from the deemed asset disposition on the disposition date while it is a subsidiary of seller. old target is then treated as 2009] recent developments in federal income taxation 367 liquidating into seller which in most cases will be treated as a § 332 liquidation to which § 337 (or § 336) applies. additionally, the deemed purchase of the assets of old target by new target constitutes a deemed purchase of any subsidiary stock owned by target, and a § 336(e) election may be made for the deemed purchase of the stock of a target subsidiary if it constitutes a qualified stock disposition. a § 336(e) election generally does not affect the tax consequences, e.g., stock basis, to a purchaser of target stock. • distributions of target stock not subject to § 355. a § 336(e) election can be made for a taxable distribution of target stock (e.g., dividend, redemption, liquidation), but the election does not affect the tax treatment of the shareholders. special rules assure that the tax consequences to a distributee are the same as if no § 336(e) election was made. if a distribution is a qualified stock disposition, the distributing corporation is treated as purchasing from new target (immediately after the deemed liquidation of old target) the amount of stock distributed and to have distributed the new target stock to its shareholders. the distributing corporation recognizes no gain or loss on the distribution (old target having recognized gain on the deemed asset sale). prop. reg. § 1.336-2(b)(1)(iv). if the distribution is a § 301 distribution, the portion that is a dividend may be affected by the difference between (1) the § 311 gain, and thus e&p, that would have been recognized on a stock distribution and (2) the gain, and thus e&p, that results from the deemed asset disposition and liquidation of target. see prop. reg. § 1.336-2(c). because a distributing corporation cannot recognize loss on the distribution of stock in a § 301 or 302 distribution, losses cannot be recognized on the § 336(e) deemed asset disposition to the extent the qualified stock disposition was the result of a stock distribution; only a portion of the losses may be recognized. only the portion of the loss on stock that was sold or exchanged, rather than distributed, may be recognized. prop. reg. §§ 1.3362(b)(1)(i)(b)(2) and (3). • section 355 distributions. the proposed regulations would allow a corporation that would otherwise recognize gain with respect to a qualified stock disposition resulting, in whole or in part, from a disposition described in § 355(d)(2) or (e)(2) to make a § 336(e) election. however, to preserve the e&p allocation consequences of a § 355 distribution under reg. § 1.312-10, the proposed regulations provide special rules. old target is not deemed to liquidate into the distributing corporation, but is treated as acquiring all of its assets from an unrelated person and the distributing corporation is treated as distributing the stock of the controlled corporation (old target) to its shareholders. prop. reg. § 1.336-2(b)(2)(ii) and (iii). because the controlled corporation (old target) is not treated as liquidated, it will retain its tax attributes despite the § 336(e) election. furthermore, the controlled corporation will take into account the effects of the deemed asset disposition to adjust its e&p immediately before allocating e&p pursuant to reg. § 1.312-10. prop. reg. § 1.336-2(b)(2)(vi). losses from the deemed asset sale will be recognized only in relation to the amount 368 florida tax review [vol. 9:si of stock sold or exchanged in the qualified stock disposition on or before the disposition date. prop. reg. §§ 1.3362(b)(2)(i)(b)(2) and (3). however, if the controlled corporation (old target) has any subsidiaries for which a § 336(e) election is made, the general deemed asset disposition methodology shall apply. this prevents taxpayers from effectively electing whether the attributes of the lower tier subsidiary become those of target, by doing an actual sale of target subsidiary’s assets followed by a liquidation of target subsidiary, or remain with target subsidiary, by making a § 336(e) election for target subsidiary. • intragroup transfers prior to external dispositions. if target stock is transferred within an affiliated group and is then transferred outside the affiliated group, a § 336(e) election is not available for the intragroup transfer (because a qualified stock disposition may not be made between related sellers and purchasers). even if a § 336(e) election is made for the transfer outside of the group, the affiliated group would recognize gain both on target’s assets and the target stock. the proposed regulations do not solve this problem, but the preamble requests comments on how to address this issue, and related issues under § 355(f), which provides that § 355 does not apply to an intragroup distribution prior to a distribution subject to § 355(e)(2). • aggregate deemed asset disposition price (adadp) and adjusted grossed up basis (agub). to calculate old target’s gain under a § 336(e) election, the proposed regulations define a new term, “aggregate deemed asset disposition price” (adadp). new target’s asset basis is determined with reference to adjusted grossed up basis (agub), as used in § 338 and reg. § 1.338-5. under prop. reg. §§ 1.336-3 and 1.336-4, adadp and agub are determined similarly to the way adsp and agub are determined under the § 338 regulations. the proposed regulations account for the lack of an actual amount realized on a stock distribution by treating the grossed-up amount realized as including in the amount realized the fair market value of distributed target stock prop. reg. § 1.336-3(c)(1)(i)(b). in addition, because in the case of a § 336(e) election (unlike in the case of a § 338 election, where there is only one purchasing corporation and it is relatively easy to determine the purchaser’s basis in nonrecently purchased stock in order to determine agub), there can be multiple purchasers or distributees who acquired target stock prior to the 12-month disposition period, the proposed regulations provide that “nonrecently disposed stock,” which has a similar meaning to the term “nonrecently purchased stock” in § 338(b)(6)(b), includes only stock in a target corporation held by a purchaser (or a related person) who owns (with § 318(a) attribution, except §318(a)(4)), at least 10 percent of the total voting power or value of the stock of target that is not recently disposed stock. prop. reg. § 1.336-1(b)(17). • new target is treated as acquiring all of its assets from an unrelated person in a single transaction at the close of the disposition date, but before the deemed liquidation (or, in the case of a § 355 distribution, before the distribution) in exchange for an amount equal to the 2009] recent developments in federal income taxation 369 agub. with certain modifications, prop. reg. § 1.336-4 generally resembles reg. § 1.338-5 to determine target’s agub for target. new target allocates agub among its assets in the same manner as in regs. §§ 1.338-6 and 1.338-7. prop. reg. §§ 1.336-2(b)(1)(ii) and 1.3362(b)(2)(ii). • any stock retained by a transferor (or a member of its consolidated group) is treated as acquired by the seller on the day after the disposition date at its fair market value, which is a proportionate amount of the grossed-up amount realized on the transfer under the § 336(e) election. prop. reg. §§ 1.336-2(b)(1)(v) and 1.336-2(b)(2)(iv). a continuing minority shareholder is generally unaffected by the § 336(e) election. prop. reg. § 1.336-2(d). • a holder of nonrecently disposed stock may irrevocably elect (similarly to under § 338) to treat the nonrecently disposed stock as being sold on the disposition date. prop. reg. § 1.336-4(c). the gain recognition election is mandatory if a purchaser owns (after applying § 318(a), other than § 318(a)(4)) 80 percent or more of the voting power or value of target stock. prop. reg. §§ 1.336-1(b)(15) and 1.336-4(c). • a taxpayer will be allowed to make a protective § 336(e) election if it is unsure whether a transaction constitutes a qualified stock disposition. a protective election will have no effect if the transaction does not constitute a qualified stock disposition, but it will otherwise be binding and irrevocable. prop. reg. § 1.336-2(j). • correction to reg. § 1.338-5. reg. § 1.338-5(d)(3)(ii) is proposed to be corrected to use the grossed-up basis of recently purchased stock in determining the basis amount, rather than the nongrossed-up basis. • effective date. the regulations will apply to any qualified stock disposition for which the disposition date is on or after the date of publication of final regulations. 2. what hath rite-aid wrought? t.d. 9424, unified rule for loss on subsidiary stock, 73 f.r. 53934-01 (9/17/08). the treasury and irs have finalized proposed regulations [reg-157711-02, proposed rules, unified rule for loss on subsidiary stock, 72 f.r. 2964 (1/23/07)] that address the duplication of loss by consolidated groups and completely replace the former basis adjustment and loss suspension rules in former reg. §§ 1.337(d)-2 and 1.1502-35. the final regulations generally follow the proposed regulations with certain modifications. new reg. § 1.1502-36 provides “unified rules for loss on subsidiary stock” when a member transfers a share of subsidiary stock and, after taking into account the effects of all applicable rules, including those that would not be given effect until after the transfer, the share is a “loss share.” (the relevant effects may be attributable to lower-tier dispositions and worthlessness, as well as to the application of the unified loss rule.) see reg. § 1.150236(a)(3)(i). a transfer of stock includes any event in which (1) gain or loss 370 florida tax review [vol. 9:si would be recognized (apart from the rules in the proposed regulations), (2) the holder of a share and the subsidiary cease to be members of the same group, (3) a nonmember acquires an outstanding share from a member, or (4) the share is treated as worthless. the purpose of these rules is twofold, to prevent the consolidated return provisions from creating non-economic losses on the sale of subsidiary stock and to prevent members of the affiliated group filing the consolidate return from claiming more than one tax benefit from a single economic loss. under the proposed regulations, any transfer of a loss share (defined as a share of stock of an affiliate having a basis in excess of fair market value), requires the application in sequence of three basis rules, even if the loss is deferred. however, if a member transfers a share of subsidiary stock to another member and any gain or loss on the transfer is deferred under § 1.1502-13, the unified loss rule, with appropriate adjustments, applies to the transfer when the intercompany item is taken into account.) • first, a basis redetermination rule, under reg. § 1.1502-36(b) is applied to deal with tax losses attributable to investment adjustment account allocations among different shares of stock under reg. § 1.1502-32 that result in disproportionate reflection of gain or loss in a share’s basis. second, if any share is a loss share after application of the basis redetermination rule, a basis reduction rule is applied under reg. § 1.1502-36(c) to deal with loss duplication attributable to investment adjustment account adjustments, but this reduction does not exceed the share’s “disconformity amount.” third, if any duplicated losses remain after application of the basis reduction rule, under reg. § 1.1502-36(d) an attribute reduction rule is applied to the corporation the stock of which was sold to prevent the duplication of a loss recognized on the transfer or preserved in the basis of the stock. if a chain of subsidiaries is transferred (rather than a single subsidiary) the order in which the rules are applied is modified. in this case, basis redetermination rule and basis reduction rule are applied sequentially working down the chain, and the attribute reduction rule is than applied starting with the lowest tier subsidiary and working up the chain. • the basis redetermination rule. — under the basis redetermination rule in reg. § 1.1502-36(b), investment adjustments (exclusive of distributions) that were previously applied to members’ bases in subsidiary stock are reallocated in a manner that, to the greatest extent possible, eliminates basis disparity on all shares. this rule affects both positive and negative adjustments, and thus addresses both noneconomic and duplicated losses. first, positive investment adjustments (except positive adjustments to preferred shares, which reflect only the right to receive distributions) up to the amount of the loss are eliminated from the bases of transferred loss shares. second, to the extent of any remaining loss on the transferred shares, negative investment adjustments are removed from shares that are not transferred loss shares and are applied to reduce the loss on transferred loss shares. third, the positive adjustments removed 2009] recent developments in federal income taxation 371 from the transferred loss shares are allocated to increase basis of other shares only after the negative adjustments have been reallocated. note that those three provisions do not affect the aggregate basis of the shares, and thus have no impact and do not apply if all of the shares of a subsidiary are sold; they are important only when some, but not all, shares are sold. a number of special limitations on basis reallocation also must be considered in various specific circumstances. • the basis reduction rule. — if, after applying the basis redetermination rule in step one, any transferred share is a loss share (even if the share only became a loss share as a result of the application of the basis redetermination rule), the basis of that share is subject to reduction. the basis reduction rule in reg. § 1.1502-36(c) eliminates noneconomic losses that arise from the operation of the investment adjustment account rules. under this rule, the basis of each transferred loss share is reduced (but not below its value) by the lesser of (1) the share’s disconformity amount, or (2) the share’s net positive adjustment. • the “disconformity amount” with respect to a subsidiary’s share is the excess of its basis over the share’s allocable portion of the subsidiary’s inside tax attributes (determined at the time of the transfer) other than credits. every share within a single class of stock has an identical allocable portion. between shares of different classes of stock, allocable portions are determined by taking into account the economic arrangements represented by the terms of the stock. “net inside attributes” is the sum of the subsidiary’s loss carryovers (except carryovers waived under reg. § 1.150232(b)(4)), deferred deductions, cash, and asset basis (including the basis of lower tier subsidiary stock), minus the subsidiary’s liabilities. the disconformity amount identifies the net amount of unrealized appreciation reflected in the basis of the share. • a share’s net positive adjustment is computed as the greater of (1) zero, or (2) the sum of all investment adjustments (excluding distributions) applied to the basis of the transferred loss share, including investment adjustments attributable to prior basis reallocations under the basis reallocation rule. the net positive adjustment identifies the extent to which a share’s basis has been increased by the investment adjustment provisions for items of income, gain, deduction and loss (whether taxable or not) that have been taken into account by the group. special rules apply when the subsidiary the stock of which is transferred itself holds stock of lower-tier subsidiary. • the attribute reduction rule. — if any transferred share remains a loss share after application of the basis reallocation and basis reduction rules, the loss on the transferred share is allowed. however, in this instance, the subsidiary’s tax attributes (including the consolidated attributes, e.g., loss carryovers, attributable to the subsidiary) are reduced pursuant to reg. § 1.1502-36(d). the attribute reduction rule addresses the duplication of loss by members of consolidated groups, and is designed to prevent the group from recognizing more than one tax loss with respect to a single economic loss, 372 florida tax review [vol. 9:si regardless of whether the group disposes of the subsidiary stock before or after the subsidiary recognizes the loss with respect to its assets or operations. • under the attribute reduction rule, the subsidiary’s attributes are reduced by the “attribute reduction amount,” which equals the lesser of (1) the net stock loss, or (2) the aggregate inside loss. the “attribute reduction amount” reflects the total amount of unrecognized loss that is reflected in both the basis of the subsidiary stock and the subsidiary’s attributes. “net stock loss” is the amount by which the sum of the bases (after application of the basis reduction rule) of all of the shares in the subsidiary transferred by members of the group in the same transaction exceeds the value of those shares. the subsidiary’s “aggregate inside loss” is the excess of its net inside attributes over the value of all of the shares in the subsidiary. (net inside attributes generally has the same meaning as in the basis reduction rule, subject to special rules for lower-tier subsidiaries.) however, if the total attribute reduction amount is less than five percent of the aggregate value of the subsidiary shares that are transferred by members in the transaction, the attribute reduction rule does not apply to the transfer, unless the taxpayer elects to apply it. • the attribute reduction amount is first applied to reduce or eliminate to the maximum extent possible items that represent actual realized losses, i.e., capital loss carryovers (category a), operating loss carryovers (category b), and deferred deductions (category c), in that order unless the taxpayer elects a different allocation. any excess attribute reduction amount is then applied to reduce the basis of assets (category d) in the asset classes specified in reg. § 1.338-6(b) other than class i (cash and general deposit accounts, other than certificates of deposit held in depository institutions), but in the reverse order from the order specified in that section. thus, the basis in any purchased goodwill is the first item reduced. however, the category d attribute reduction is first allocated between the subsidiary’s basis in any stock of lower-tier subsidiaries and the subsidiary’s other assets (treating the non-stock category d assets as one asset) in proportion to the subsidiary’s basis in the stock of each lower-tier subsidiary and its basis in the category d assets other than subsidiary stock. only the portion of the attribute reduction amount not allocated to lower-tier subsidiary stock is applied under the reverse residual method. (additional special rules apply to prevent excessive reduction of attributes when the subsidiary itself holds stock of a lowertier subsidiary.) if the attribute reduction amount exceeds all of the attributes available for reduction, that excess amount generally has no effect. if, however, cash or other liquid assets are held to fund payment of a liability that has not yet been deducted but will be deductible in the future (e.g., a liability the deduction for which is subject to the economic performance rules of § 451(h)), loss could be duplicated later, when the liability is taken into account. to prevent such loss duplication, the excess attribute reduction amount will be held in suspense and applied to prevent the deduction or capitalization of later payments with respect to the liability. 2009] recent developments in federal income taxation 373 • the regulations permit taxpayers to make a protective election to reattribute attributes (other than asset basis) and/or to reduce stock basis (and thereby reduce stock loss) in order to avoid attribute reduction. if an election is made and it is ultimately determined that the subsidiary has no attribute reduction amount the election will have no effect (or if the election is made for an amount that exceeds the finally determined attribute reduction amount, the election will have no effect to the extent of that excess). in addition, taxpayers may elect to reduce (or not reduce) stock basis, or to reattribute (or not reattribute) attributes, or some combination thereof, in any amount that does not exceed the subsidiary’s attribute reduction amount. • finally, if the subsidiary ceases to be a member of the consolidated group as a result of the transfer, the common parent of the group can elect to reduce stock basis (thereby reducing an otherwise allowable loss on the sale of the stock), reattribute attributes, or apply some combination of basis reduction and attribute reattribution to alter the otherwise required attribute reduction. • worthlessness. — reg. § 1.150236(d)(7) provides that, if a member treats stock of the subsidiary as worthless under § 165 (taking into account reg. § 1.1502-80(c)) and the subsidiary continues as a member, or if a member recognizes a loss on subsidiary stock and on the following day the subsidiary is not a member and does not have a separate return year following the recognition of the loss, all category a, category b, and category c attributes (i.e., capital loss carryovers, net operating loss carryovers, and deferred deductions) that have not otherwise been eliminated or reattributed, as well any credit carryovers, are eliminated. • built-in loss in § 351 transactions. — new reg. § 1.1502-80(h) makes § 362(e)(2) generally inapplicable to intercompany transactions. thus only the consolidated return provisions address loss duplication in an intercompany § 351 transaction within the group. however, an anti-abuse rule provides for appropriate adjustments to be made to clearly reflect the income of the group if a taxpayer acts with a view to prevent the consolidated return provisions from properly addressing loss duplication. • effective date. — the regulations generally apply to transfers on or after 9/17/08, unless the transfer is made pursuant to a binding agreement between unrelated parties (related party has the same meaning as in § 267(b)) that was in effect before 9/17/08 and at all times thereafter. h. miscellaneous corporate issues 1. taking from the big and contributing to the small does not produce excluded contributions to capital. united states v. coastal utilities, inc., 483 f. supp. 2d 1232 (s.d. ga. 3/28/07). summary judgment was granted to the government denying a utility’s refund claim based on its assertion 374 florida tax review [vol. 9:si that payments received from the universal service administration company and the state of georgia access funds were contributions to capital excluded from gross income under § 118. the payments were part of state and federally mandated programs funded by fees collected from telecommunications carriers based on revenues. payments are made to carriers with high cost obligations to provide universal access to telephone services. based on undisputed facts, and following an in-depth analysis of the relevant authorities distinguishing nonshareholder contributions to capital from gross income, the district court concluded that the purpose of the payments was to supplement income. the court focused on the mechanisms used to calculate the amount of universal support, which, although largely related to investment expenditures, took into account operation, maintenance, administrative, and other expenses that were unrelated to capital investment. a. the irs concludes the same by ruling. rev. rul. 2007-31, 2007-21 i.r.b. 1275 (4/27/07). the irs ruled that universal service support payments received are not a non-shareholder contribution to capital under § 118(a). b. and the eleventh circuit agrees too. coastal utilities is affirmed. united states v. coastal utilities, 514 f.3d 1184 (11th cir. 1/23/08). the eleventh circuit adopted in full the district court’s order. 2. state law is relevant in determining who is performing professional services, but lack of a state law license doesn’t mean you’re not performing professional services. grutman-mazler engineering inc v. commissioner, t.c. memo. 2008-140 (5/21/08). in determining whether a corporation a “qualified personal service corporation” as defined under § 448(d)(2), state law is relevant to determine whether an activity is within a qualifying field. under the relevant state law [california] civil engineering includes submitting designs, plans, tentative tract maps, grading plans, and engineering reports to local governments and coordinating other professionals. a 40 percent shareholder who performed such services in a “planning division,” who had an engineering degree but was not a licensed civil engineer, thus was performing “engineering service.” therefore, because the other conditions of § 448 were met – a 60 percent shareholder was a licensed engineer who performed engineering services for the corporation and oversaw its activities – the corporation’s income was taxed at the flat 35 percent rate under § 11(b)(2), not at the graduated rates claimed by taxpayer. 3. can’t the irs spell fannie mae and freddie mac when $5 trillion is at stake? notice 2008-76, 2008-39 i.r.b. 768 2009] recent developments in federal income taxation 375 (9/7/08). sections 1117(a) and (b) of the housing and economic recovery act of 2008, pub. l. no. 110-289 (2008), authorize the treasury department to purchase obligations and other securities issued by fannie mae and freddie mac – described in the notice as “certain entities” to protect the names of the guilty parties – under the housing and economic recovery act of 2008. the irs and treasury will issue regulations under § 382(m) that will provide that notwithstanding any other provision of the code or the regulations, for purposes of § 382, with respect to a corporation as to which there such an acquisition, the term “testing date” (as defined in reg. § 1.382-2(a)(4)) will not include any date on or after the date on which the united states (or any agency or instrumentality thereof) acquires stock or an option to acquire stock in the corporation. the regulations will apply on or after september 7, 2008. thus, the bailout of fannie mae and freddie mac will not trigger an ownership change invoking the § 382 limitations on nols. • various media outlets attribute the substance of the provisions of the notice to henry paulson, who is reported to have ordered the irs to issue the notice. see http://www.cfo.com/article.cfm/12079734/c_12079931?f=home_todayinfinance 4. who needs congress to legislate billions of tax benefits via loss carryovers from failing banks which have undergone ownership changes? notice 2008-83, 2008-42 i.r.b. 905 (10/1/08). taxpayers which have acquired failing banks will not be limited by § 382(h) in their deductions for losses on loans or bad debts. under this notice, these losses “shall not be treated as a built-in loss or a deduction that is attributable to periods before the [ownership] change date.” this notice applies whether the acquirer is a private investor (including another bank) or is the treasury. 5. again, who needs congress to permit continued use of loss carryovers of corporations whose toxic paper is acquired by treasury? notice 2008-100, 2008-44 i.r.b. 1081 (10/15/08). this notice provides guidance on the application of § 382 to loss corporations whose financial instruments are acquired by treasury as part of the capital purchase program pursuant to eesa. under this program, treasury will acquire preferred stock and warrants from qualifying financial institutions. this notice specifies that treasury will not be treated as a 5 percent shareholder for this purpose. 6. help! stop me before i give away any more money without congressional action. notice 2008-101, 2008-44 i.r.b. 1082 (10/15/08). this notice specifies that tarp funds received by banks for “troubled assets” will not be treated as “the provision of federal financial assistance” within the meaning of § 597. that code section requires that 376 florida tax review [vol. 9:si “federal financial assistance shall be properly taken into account by the institution from which the assets were acquired.” vii. partnerships a. formation and taxable years 1. the 2007 small business tax act, § 8215(a), added code § 761(f), which provides that a husband and wife who operate a qualified joint venture may elect not to treat the joint venture as a partnership. a qualified joint venture is one conducted by a husband and wife both of whom are material participants and who file a joint return. each spouse is required to report the spouse’s share of income and expense items on a separate schedule c. each spouse is individually assessed self-employment tax. i.r.c. § 1402(a)(17), as amended by the 2007 small business tax act. note that rev. proc 2002-69, 2002-2 c.b. 831, permitted a husband and wife to treat a wholly owned llc held as community property as a disregarded entity. a. chief counsel clarifies employment tax rules. chief counsel advice 200816030 (4/18/08). income of husband and wife from real estate rental and dividends, that is excluded from wages for selfemployment tax purposes (§ 1402(a)), does not become subject to employment taxes by virtue of the making of an election under § 761(f) for treatment as a qualified joint venture. 2. i.r. 2008-110 (9/25/08). the irs is considering the issue of guidance regarding technical termination of publicly traded partnerships under § 708(b) resulting in multiple taxable years of an affected partnership due to transfers of more than 50 percent of a partnership’s capital and profits interests in a 12-month period. b. allocations of distributive share, partnership debt, and outside basis 1. final regulations test substantiality of partnership allocations by looking to the tax impact to the owners of look-through entities. t.d. 9398, partner’s distributive share, 73 f.r. 28699 (5/19/08). under § 704(b) partnership allocations provided in a partnership agreement are followed if the allocation has substantial economic effect. an allocation is substantial only if there is a reasonable possibility that the allocation will affect the dollar amounts to be received by the partners independent of the tax consequences of the allocation. reg. § 1.704-1(b)(2)(iii)(a). the regulations 2009] recent developments in federal income taxation 377 provide that an allocation is not substantial if the after-tax economic consequences to one partner are enhanced in present value terms while the aftertax economic consequences to other partners are not diminished. an allocation is not substantial if the economic consequence of the allocation is a shifting allocation (an allocation that merely shifts tax consequences without altering economic consequence) or a transitory allocation (an allocation that will be offset by another allocation so that net increases and decreases in partners’ capital accounts will not differ substantially from what they would have been absent the allocation). • the regulations clarify that the appropriate comparison is the after-tax consequences that result from an allocation with the after-tax consequences that would have resulted if the allocations were determined from the partners’ interests in the partnership. reg. § 1.7041(b)(2)(iii)(a). • the new regulations provide that in determining the economic detriment of an allocation to a look-through entity that is a partner, the effect of the allocation on the tax attributes of the owner of the lookthrough entity must be taken into account. look-through entities include a partnership, s corporation, estate, trust, disregarded entity, and controlled foreign corporation that owns at least 10 percent of the capital or profits of the partnership. in addition, in the case of an allocation to a corporate partner that is a member of a consolidated group, the effect of the allocation on the tax attributes of members of the group is taken into account. reg. § 1.704-1(d). • the regulations contain a de minimis rule that the tax attributes of less than 10 percent partners, or partners to whom less than 10 percent of any item is allocated, need not be taken into account in determining substantiality. reg. § 1.704-1(e). • the new regulations also remove the presumption that if a partnership allocation does not have substantial economic effect, then with respect to the item the partners’ interest in the partnership is per capita. the treasury concluded that “because the per capita presumption failed to consider factors relevant to a determination of the manner in which the partners agreed to share the economic benefits or burdens corresponding to the allocation of partnership items, the correct result was reached in very few cases.” • the final regulations are effective as of may 19, 2008. 2. proposed regulations would expand anti-abuse rules to look at the tax attributes of indirect owners to test allocations of built-in gain or loss. reg-100798-06, contributed property, 73 f.r. 28765 (5/19/08). reg. § 1.704-3(a)(10) provides that an allocation with respect to contributed built-in gain or loss property under § 704(c) (or a reverse allocation in the case of a book-up) is not reasonable if the contribution of property and the allocation is 378 florida tax review [vol. 9:si made with a view of shifting built-in gain or loss among partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability. proposed regulations would provide that in testing for a reduction in aggregate tax liability, the tax consequence to both direct and indirect partners would have to be considered. indirect partners include the owners of an entity that is a partner and is a partnership, s corporation, estate, trust, or controlled foreign corporation that is a ten percent partner. indirect partners include the members of a consolidated group in which the partner is a member. • the proposed regulations would also provide in prop. reg. § 1.704-3(a)(1) that the use of allocation methods with respect to built-in gain or loss property only apply to contributions to a partnership that “are otherwise respected.” the regulation would add that even though an allocation may comply with the literal language of reg. § 1.704-3(b), (c), or (d) (traditional method, curative allocations, or remedial allocations), “the commissioner can recast the contribution as appropriate to avoid tax results inconsistent with the intent of subchapter k.” the proposed regulations would identify remedial allocations among related partners as one factor that may be considered. • the proposed regulations would be effective on publication of final regulations in the federal register. 3. sorting out § 162 from § 212 expenses in upper-tier and lower tier partnerships. rev. rul. 2008-39, 2008-31 i.r.b. 252 (7/4/08). this revenue ruling addressed the treatment of management fees paid by an upper-tier investment partnership (utp) and by lower-tier trader partnerships (ltp) to their respective managers under §§ 162 and 212 where the upper tier partnership’s activities consist solely of acquiring, holding, and disposing of interests in the lower tier trader partnerships and utp’s management fee is not paid or incurred by utp on behalf of any ltp in connection with the trades or businesses of the ltps. the ruling holds that utp’s management fee is not a § 162 deduction and cannot be taken into account in computing utp’s taxable income or loss described in § 702(a)(8). rather, utp’s management fee is a § 212 expense and must be separately stated by utp and separately taken into as a § 212 deduction by an individual limited partner. in contrast, the management fee paid by an ltp is a § 162 expense taken into account in computing the ltp’s § 702(a)(8) bottom-line taxable income or loss. utp’s distributive share of ltp’s bottom-line income or loss is taken into account in computing utp’s bottom-line income or loss, the distributive share of which an individual limited partner in utp takes into account. 4. partnership debt for equity swaps. holy asymmetry! the partners have cod income but the creditor doesn’t have a loss deduction. reg-164370-05, section 108(e)(8) application to 2009] recent developments in federal income taxation 379 partnerships, 73. f.r. 64903 (10/31/08). as amended by the american jobs creation act of 2004, § 108(e)(8) provides that for purposes of determining cod income of a partnership, if debtor partnership transfers a capital or profits interest to a creditor in satisfaction of either recourse or nonrecourse partnership debt the partnership is treated as having satisfied the debt with an amount of money equal to the fair market value of the interest. any cod income recognized under § 108(e)(8) passes through to the partners immediately before the discharge. prop. reg. § 1.108-8 would provide that for purposes of § 108(e)(8), the fair market value of a partnership interest received by the creditor is the liquidation value of that debt-for-equity interest, if: (1) the debtor partnership maintains capital accounts in accordance with reg. § 1.7041(b)(2)(iv), (2) the creditor, debtor partnership, and its partners treat the fair market value of the debt as equaling the liquidation value of the partnership interest for purposes of determining the tax consequences of the debt-for-equity exchange, (3) the debt-for-equity exchange is an arm’s-length transaction, and (4) subsequent to the exchange, neither the partnership redeems nor any person related to the partnership purchases the creditor’s partnership interest as part of a plan that has as a principal purpose the avoidance of cod income by the partnership. if these conditions are not satisfied, all of the facts and circumstances are considered in determining the fair market value of the debtfor-equity interest for purposes of applying § 108(e)(8). prop. reg. § 1.721-1(d) would provide nonrecognition of loss in a debt-for-partnership interest exchange in which the liquidation value of the partnership interest is less than the outstanding principal balance of the debt. the creditor’s basis in the partnership is determined under § 722. however, the proposed regulations provide that § 721 does not apply to the transfer of a partnership interest to a creditor in satisfaction of a partnership’s indebtedness for unpaid rent, royalties, or interest on indebtedness (including accrued original issue discount). in addition, the proposed regulations do not supersede the gain recognition rules of § 453b regarding dispositions of installment obligations. the proposed regulations will be effective when final regulations are published in the federal register. c. distributions and transactions between the partnership and partners there were no significant developments regarding this topic during 2008. d. sales of partnership interests, liquidations and mergers there were no significant developments regarding this topic during 2008. 380 florida tax review [vol. 9:si e. inside basis adjustments there were no significant developments regarding this topic during 2008. f. partnership audit rules 1. individual partners’ reasonable reliance defenses to penalties is not part of tefra partnership proceeding. stobie creek investments, llc v. united states, 101 a.f.t.r.2d 2008-1151 (fed. cl. 3/10/08). the court (judge miller) rejected the motion of non-managing members of a family llc to assert jurisdiction to hear individual defenses to accuracy related penalties based on asserted reasonable reliance on the advice of the managing investment advisor member of the llc. the court held that tefra establishes a two-tier process under which the court in the partnership proceeding has jurisdiction to consider whether the partnership itself has a reasonable cause defense to asserted penalties, but not whether individual partners can assert a reasonable cause defense. citing §§ 6230(c)(1) and 6231(a)(2)(b), the court indicated that individual partners may challenge an erroneous computational adjustment and may raise individual defenses to penalties in a refund action. 2. the statute of limitations tolls for these bean farmers. christopher v. commissioner, t.c. memo. 2008-80 (4/2/08). taxpayers reported partnership losses from an investment in contra costa jojoba research partners in their 1983 and 1985 tax years. the irs sent notices of final partnership administrative adjustment (fppa) on may 30, 1989, and a petition was filed by the tax matters partner on july 13, 1989. the issuance of an fppa suspends the three-year statute of limitations during the period a petition for judicial review may be brought, and until one-year following final decision. i.r.c. § 6229(d)(1) & (2). the tax court entered a decision against the partnership in april 2005, which was not appealed and became final in july 2005. thus, the statute of limitations expired in july 2006, one-year and 90 days after the partnership level decision. an individual partner cannot challenge the timeliness of the fppa issued to the partnership. notices of deficiency issued to the taxpayers on april 17, 2006, were within the statute of limitations. the taxpayers were also held responsible for negligence penalties. reliance on assurances of the tax shelter promoter, without further investigation, was rejected as reasonable reliance on the advice of professionals. the taxpayers were also subject to substantial understatement penalties related to the partnership deductions. 2009] recent developments in federal income taxation 381 3. the partner was a party to a proceeding he didn’t know about. kimball v. commissioner, t.c. memo. 2008-78 (4/1/08). taxpayer disputed liabilities for additional interest in tax motivated transactions in a collection due process hearing. the tax court (judge haines) held that since the taxpayers had not received a notice of deficiency or other opportunity to dispute the tax for the interest increase the tax court would review the case de novo. however, the court held that the taxpayers were liable for the increased interest. even if the tax matters partner failed to notify the taxpayer partner of the partnership proceedings (although the court was satisfied that the taxpayer was notified), the partner is a party to those proceedings, which remain applicable to the partner. enhanced interest under § 6621(c) is a partnership level item so the tax court has limited jurisdiction to reconsider the item outside of the partnership level proceeding. see river city ranches #1 ltd. v. commissioner, 401 f.3d 1136 (9th cir. 2005). the determination in the partnership proceeding that the transaction lacked economic substance was sufficient to establish that the transaction was tax motivated and thus the enhanced interest was appropriate. the taxpayer was also assessed a failure to pay penalty for delayed payment of the deficiency. 4. another reason to not just sit back and let the tmp handle the tefra audit. prati v. united states, 81 fed. cl. 422 (4/16/08, reconsideration denied, 82 fed. cl. 373 (7/1/08)). section 7422(h) bars partners who did not participate in a tefra partnership audit proceeding, but signed forms 870-ad in connection with that proceeding, from pursuing refund claims challenging timeliness of assessments arising from the tefra partnership audit proceeding that were made more than three years after the partnership filed its tax return. (note that § 6229(d) suspends that statute of limitations upon issuance of a fpaa.) pursuant to § 6229(a), the statute of limitations on adjustments to partnership items is itself a partnership item (the statute of limitations on an affected item is partner specific). a determination of the timeliness of the assessment would affect the assessment for all partners and thus is a partnership-level determination, not an affected item determination. 5. proof of mailing suffices. proof of actual receipt is not necessary. mcclaskey v. commissioner, t.c. memo. 2008-147 (6/9/08). proof of mailing of notice of beginning of partnership administrative proceeding (nbap) and final partnership administrative adjustment (fppa) is sufficient to prevent a partner from treating an item as requiring partner level determination under § 6223(e)(2). proof of the actual receipt of the mailing is not required. 6. uncontested fpaa does not act as res judicata to consideration of a partnership tax deficiency in a bankruptcy proceeding. central valley ag enterprises v. united states, 531 f.3d 750 (9th cir. 6/25/08). 382 florida tax review [vol. 9:si the bankruptcy code, 11 u.s.c. § 505(a), allows a bankruptcy court to determine the amount or legality of a tax unless the tax had been contested and adjudicated before a “judicial or administrative tribunal of competent jurisdiction” before commencement of the bankruptcy case. the taxpayer, central valley, wholly owned a subsidiary that invested in the tax shelter partnership. central valley thus was an “indirect partner” under the tefra audit rules. i.r.c. § 6231(a)(2), (9), (10). an fpaa issued to a tax shelter limited partnership was not contested by the tax matters partner or other partners. after the fpaa had become final, central valley filed a bankruptcy proceeding. the court concluded that since the fpaa was never challenged in a court of competent jurisdiction, 11 u.s.c. § 505(a) permits the bankruptcy court to adjudicate central valley’s tax liability attributable to the partnership item. the court held that the appeals conference more closely resembles a settlement conference than a hearing before an administrative tribunal that would preclude bankruptcy court jurisdiction. 7. the $9,500 deposited was only $2.9 million short; that’s a reasonable mistake. kislev partners v. united states, 84 fed.cl. 385 (fed. cl. 8/13/08). the taxpayer, a non-tax matters partner, filed an action seeking review of a final partnership administrative adjustment for kislev partners, which claimed $140 million of losses in an abusive tax shelter known as a distressed asset/debt transaction (dad). in order to invoke jurisdiction in the court of federal claims, a filing partner is required under § 6226(e)(1) to make a deposit of the amount by which the taxpayer’s tax liability would be increased if the partner’s return were filed consistent with the treatment of partnership items in the fpaa. in this case the taxpayer made a deposit of $9,500 reflecting the taxpayer’s potential tax liability for the year in which the claimed losses were passed through from the partnership. the taxpayer did not calculate the deposit based on the taxpayer’s liability for years to which he carried over the losses. the correct amount of the deposit, including claimed tax reductions in the carryover years was $2,905,046, exclusive of penalties and interest. the court held that the deposit amount is to be calculated over multiple taxable years. however, the court was satisfied that the taxpayer made a good faith effort to determine the deposit under the statute and denied the government’s motion to dismiss, as long as the taxpayer has made the additional deposit within 60 days of the date of the opinion. 8. former chief counsel will nelson wins one for a non-tax matters partner against the tax matters partner. imprimis investors, llc v. united states, 83 fed.cl. 46 (fed. cl. 8/7/08). the tax matters partner filed an action challenging an fpaa. the tax matters partner asserted that the tax allocations made on the partnership return should be upheld over the reported inconsistent position taken on its return by the other partner. the court of 2009] recent developments in federal income taxation 383 federal claims (judge horn) granted summary judgment to the intervening partner interpreting the allocation provisions of the llc agreement to include allocations of long-term capital gain income to the intervening partner, and increasing allocations of ordinary income to the tax matters partner. 9. the wrong form letter gives these partners two-bites at litigating their son-of-boss shelter. jt usa lp v. commissioner, 131 t.c. no. 7 (10/6/08). the taxpayers (“the gregorys”) sold their business producing motocross and paintball accessories for a large capital gain. the business was in a family partnership in which the taxpayer husband and wife held both direct and indirect partnership interests (interests as members of an llc that was a member of the partnership being audited). the gregorys were indirect partners, through both an s corporation and a partnership, in a son-ofboss partnership. just before the statute of limitations expired, the irs issued a notice of final partnership administrative adjustment (fpaa) to partnership and its partners without ever having provided to the partners a § 6223(a) notice that a partnership level proceeding was commencing. the irs also sent a form letter notifying the partnership that under § 6223(e)(2) the partners could elect into the tefra partnership proceedings. the form letter was the wrong form letter, but the gregorys responded and elected out as indirect partners but asked to have the “partnership items of the direct partner treated as partnership items.” because there was no advance notice of an audit, but the received notice before the time to challenge the adjustments proposed by the fpaa had run, the default rule of § 6223(e)(3), not § 6223(e)(2), applied, and any partner entitled to receive notice had the right to opt out and not the right to opt in. by the time the partnership engaged in the son-of-boss transaction to which the fpaa proposed adjustments related, the gregorys’ only interest was held as indirect partners. thus, if the election had been valid, the gregorys would not be subject to any deficiency proceedings because any items that become nonpartnership items under § 6223(e) are subject to the standard deficiency procedures of §§ 6211 through 6216, see § 6230(a)(2)(a)(ii), and the irs has one year from the time a partner’s partnership items become nonpartnership items to send a notice of deficiency to that partner, see §§ 6229(f)(1), and the § 6503(a) election was made more than one year before the tax court proceeding. the tax court (judge holmes) held that the gregorys were allowed to make separate elections as direct and indirect partners and that their elections to opt out as indirect partners were valid. the gregorys’ elections to “opt in” in their capacity as direct partners had no effect because the default rule dictates the same result under § 6223(e)(3); a partner is bound by the tefra proceedings unless a proper election is made to opt out. 10. who’s the partner is not a partnership item. sands v. united states, 84 fed.cl. 209 (fed. cl. 10/9/08). robert sands, one of four 384 florida tax review [vol. 9:si equal partners in a limited partnership, transferred partnership interests to four charitable remainder unitrusts. the partnership sold stock and claimed substantial losses. in an fpaa issued to the partnership the irs reduced the partnership’s asserted basis in the sold stock which resulted in a partnership capital gain. the irs also sought to allocate the recognized gain to sands by claiming that the transfers of partnership interest to the charitable remainder trusts were economic shams. the court (judge hewitt) held that the identity of a partner is not a partnership item subject to determination in a tefra partnership proceeding. the court dismissed sands as the filing partner in the proceeding and substituted the charitable remainder trusts. nonetheless, the court refused to refund sand’s deposit as a filing partner. 11. whether it’s a partnership is a partnership item. petaluma fx partners, llc v. commissioner, 131 t.c. no. 9 (10/23/08). petaluma was formed to invest in foreign currency options trading. the investor partners contributed offsetting long and short foreign currency options on 10/10/00. the investor partners increased their partnership bases for the premiums of the long options, but did not offset basis to reflect a reduction of liabilities for the short options. the investors withdrew from the partnership on 12/12/00, claiming a high basis in distributed property. the property was sold for a loss on 12/26/00. in the fpaa issued to the partnerships, the irs claimed that the partnership should be disregarded, and that even if the investors formed a partnership, the partnership had no business purpose other than tax avoidance and lacked economic substance. in granting summary judgment to the irs, the court (judge geoke) held that whether a partnership exists, and whether the partnership has a business purpose or lacks economic substance, are partnership items as described in reg. § 301.6231(a)(3)-1(a) over which the court has jurisdiction in a partnership proceeding. the court noted that because determination whether a partnership is a sham or lacks economic substance underlies all of the partnership’s purported tax items, the determination fits “squarely” within the regulations identification of partnership items. • the court rejected the partnership’s argument that because sham treatment requires an examination of all of the facts and circumstances, including the intent of individual partners, the determination must be made at the partner level. since the partnership indicated that it would not contest the determination on other than the jurisdictional grounds, the court issued summary judgment for the irs that the partnership was disregarded. • the determination of the partners’ outside basis in this case was also treated as a partnership item because, once the partnership was disregarded, no partner-level determinations were necessary. the court also held that it had jurisdiction to determine accuracy related penalties attributable to the determination that the partnership should be disregarded. 2009] recent developments in federal income taxation 385 • finally, the court rejected the taxpayer’s attempt to challenge valuation understatement penalties on the merits because of the taxpayers’ stipulations in the case, but indicated that the taxpayers could challenge the penalties in a refund action. 12. natty bumppo wouldn’t have signed that extension agreement. leatherstocking 1983 partnership v. commissioner, 102 a.f.t.r.2d 2008-6695 (2d cir. 10/20/08) (per curiam), rev’g t.c. memo. 2006-164 (8/14/06). the second circuit held that – inasmuch as the irs knew that the tax matters partner had been placed under criminal investigation – the tax matters partner was laboring under a conflict of interest and could not provide the irs with consents that bound the underlying partners and partnership. this was so even though the irs had not misled the partners about the extent of the criminal conduct of the tax matters partner. 13. treasury regulations defining defenses to penalties that may be raised in partnership proceeding are valid. new millennium trading, l.l.c. v. commissioner, 131 t.c. no. 18 (12/22/08). in a tefra partnership proceeding, the determination of all partnership items is binding on the partners and may not be re-determined in another proceeding. section 6221 provides for determination of penalties at the partnership level and the court may consider reasonable cause defenses of the partnership. section 6230(c)(1)(c) provides that a partner may contest the imposition of penalties in a claim for refund, which includes under § 6230(c)(4) the assertion of partner level defenses to the penalties. temp. reg. §§ 301.6221-1t(c) and (d) provides that partner level defenses to penalties imposed at the partner level, including the reasonable cause exception of § 6664(c), can only be determined through separate refund actions. on summary judgment, the tax court (judge goeke) rejected an individual partner’s argument that the temporary regulations cannot be applied to deprive the tax court of jurisdiction to consider the partner’s reasonable cause defense to penalties, and upheld the validity of the regulations. the court observed that nothing in §§ 6221 or 6226(f) grants jurisdiction to consider partner-level defenses and that the partner’s remedy under § 6230(c)(4) is to assert partner-level defenses in a refund claim. the court also opined that the regulations do not misinterpret the requirement of § 6664(c)(1) that no penalty may be imposed under §§ 6662 or 6663 if it was shown that there was reasonable cause. the court reached this conclusion by applying the deference rule of chevron u.s.a. inc. v. natural res. def. council, inc., 467 u.s. 837, 842-843 (1984), and noting that the court of appeals to which the case is appealable [the d.c. circuit] has indicated that irs regulations are to be given chevron deference. 386 florida tax review [vol. 9:si 14. strunk and white, the elements of style, help identify the statute of limitations as a partnership item. keener v. united states, 103 a.f.t.r. 2d 2009 364 (fed. cir. 1/8/09). the taxpayers invested in tax shelters promoted by amcor in the mid-1980’s. in a partnership audit procedure, following issuance of an fpaa, the partnership entered into a settlement agreement with the irs that allowed a percentage of ordinary deductions, but provided that the irs may assert additional tax liability against individual partners plus interest. subsequently the irs assessed additional tax plus penalties against the taxpayers, which they paid in full. in their refund claim the taxpayers asserted that the statute of limitations had expired on the irs’s assessment of tax. the court affirmed the finding of the court of federal claims that it lacked jurisdiction to determine the refund claims because application of the statute of limitations is a partnership item as defined in § 6231(a) subject to determination in the tefra proceeding. section 6231(a) defines a partnership item as “any item required to be taken into account for the partnership’s taxable year under any provision of subtitle a.” the taxpayers argued that the statute of limitations, provided for under subtitle f, is not a partnership item under this definition. referring to the elements of style, the court concluded that the restrictive phrase “subtitle a” modifies the words that immediately precede it, “taxable year,” and not the words “partnership item.” (following prati v. united states, 81 fed. cl. 422 (2008)). the court added that reg. § 301.6631(a)(3)1(b), which includes as a partnership item any determination of the amount, timing, and characterization of items, is a reasonable interpretation of the statutory ambiguity that is entitled to deference under chevron, u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984). the court also rejected the taxpayers’ claim for refund of additional interest penalties imposed on tax motivated transactions holding that a determination that characterizes a partnership transaction as a sham is a partnership item. g. miscellaneous 1. partnership interest incurred in the business of trading securities is treated as investment interest to a noncorporate limited partner. rev. rul. 2008-12, 2008-10 i.r.b. 520 (2/19/08). the irs ruled that a limited partner in a partnership engaged in the trade or business of trading securities is subject to the investment interest limitation of § 163(d) on the partner’s distributive share of the partnership’s interest deduction. section 163(d)(5)(a)(ii) provides that the term “property held for investment” includes any interest held by a taxpayer in an activity involving the conduct of a trade or business that is not a passive activity and with respect to which the taxpayer does not materially participate. reg. § 1.469-1t(e)(6) provides that trading personal property for the account of owners of an interest in the activity (without regard to whether or not the activity is a trade or business) is not a passive activity. thus, 2009] recent developments in federal income taxation 387 partnership interest of a partner who is not a material participant is investment interest described in § 163(d)(3). as such it is subject to the § 163(d) limitation on the deduction of investment interest. a. but the interest is deductible above the line. rev. rul. 2008-38, 2008-31 i.r.b. 249 (7/3/08). this revenue ruling addressed two issues. first, with respect to an individual limited partner who does not materially participate, interest paid or accrued on indebtedness allocable to investment-type property [see § 163(d)(5)(a)(ii)] by a partnership engaged solely in the trade or business of trading securities for its own account and not for customers is, after the application of the § 163(d)(1) limitation, a deduction described in § 62(a)(1) that is taken into account in determining agi. second, if an individual has both (1) investment interest expense described above, and (2) investment interest expense attributable to indebtedness allocable to investment property held in an activity that is excluded from the definition of a passive activity by § 469(e)(1) [see § 163(d)(5)(a)(i)], e.g. investment assets owned by the same partnership, and (3) the individual partner’s aggregate investment interest expense is greater than his net investment income, the taxpayer must allocate net investment income between the two categories of investment interest expense. a reasonable method of allocation is an allocation proportionate to the relative amounts of interest expense within each category. b. the interest expense is reported on schedule e. announcement 2008-65, 2008-31 i.r.b. 279 (7/4/08). the limited partner described in rev. rul. 2008-12 should include the allowable amount of his distributive share of the trading partnership’s interest expense described in § 163(d)(5)(a)(ii) on schedule e (identified in part ii, line 28, column (a), as “investment interest,” followed by the name of the trading partnership that paid or incurred the interest expense, and the amount of such interest expense should be entered in column (h)) in computing ordinary business income or loss. 2. not “e pluribus unum” but “many out of one.” private letter ruling 200803004 (1/18/08). this plr ruled that each series of a series llc (organized under delaware law) is treated as a separate tax entity and its own tax status will be determined independently of the other series, based upon its own characteristics and elections. some of the series were disregarded entities, some were partnerships, and others were corporations (rics on the facts). 3. publicly traded partnerships that are treated as partnerships are to include partnerships in the business of marketing carbon dioxide or transporting alternative fuels. the emergency economic stabilization act of 2008 [division b], the energy improvement and 388 florida tax review [vol. 9:si extension act, §§ 116 and 208, amending § 7704(d)(1)(e). publicly traded partnerships that derive income from investment, activities, real estate and natural resources are excepted from the requirement that a publicly traded partnership be taxed as an association. the definition of qualifying income is expanded to include income derived from the marketing of industrial source carbon dioxide and income derived from the transportation and storage of alternative fuels (biodiesel, alcohol, etc.). 4. lmsb asserts that the § 118 exclusion does not apply to partnerships. lmsb-04-1007-069, 2007 tnt 202-16 (10/18/07), reaffirming lmsb-04-1106-016 (10/28/06). the § 118 exclusion from income for nonshareholder contributions to the capital of a corporation does not apply to partnerships. the directive contains the following admonition, “this directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.” a. lmsb reiterates this position in a coordinated issue paper for all industries. lmsb-04-1008-051, 2008 tnt 225-14 (11/18/08). the irs has advised that a partnership or any other noncorporate entity cannot use § 118(a) or any common-law “contribution-tocapital” doctrine to exclude from gross income amounts received from persons other than an owner of the entity. • this is a tier 1 issue for litigation purposes, and it arises because of the prevalence of tax increment financing by municipalities. viii. tax shelters a. tax shelter cases 1. notice 2000-44. baby boss is a fraud too! notice 2000-44, 2000-36 i.r.b. 255 (8/11/00). “artificial” capital losses generated by baby boss transactions will not be allowed. (note that notice 99-59, 1999-52 i.r.b. 761, advised taxpayers that losses from “boss” product transactions are not properly deductible.) • scheme #1: the taxpayer purports to borrow at a premium interest rate. for example, a lender gives the taxpayer $3,000 and the parties treat the stated principal amount of the loan as only $2,000, with the remaining $1,000 that must be repaid representing interest. the taxpayer contributes the loan proceeds into a partnership, which assumes the liability, and uses the proceeds to purchase an investment asset worth $3,000. the taxpayer/partner takes the position under §§ 705(a)(2), 722, and 752(b) that his 2009] recent developments in federal income taxation 389 basis in his partnership interest is $1,000 [the $3,000 cash contribution minus the $2,000 assumed liability], even though the value of the partnership interest is zero. the taxpayer then sells the partnership interest for a nominal amount, claiming a $1,000 capital loss. [everyone apparently ignores the $1,000 discrepancy between the cash proceeds of the loan and the $2,000 “principal amount,” which has to produce income to someone sometime.] this short sale variant is also the so-called blips strategy. • scheme #2: the taxpayer simultaneously purchases a call option and writes an offsetting call option, both of which are then contributed to a partnership. the taxpayer takes the position that the basis of the partnership interest equals the basis of the purchased call option, unreduced by the liability associated with the written call option, i.e., that the partnership did not assume a liability when it took responsibility for the written call option. the taxpayer then uses this artificially high basis to claim a capital loss on the sale of his partnership interest. [compare rev. rul. 95-26, 1995-1 c.b. 131, holding that a partnership’s short sale of securities creates a liability.] this offsetting option variant is also the so-called cobra strategy. • notice 2000-44 disallows the losses [under §§165(a) and (c)] produced by both of these baby boss transactions as artificial, citing, in the case of individuals, fox v. commissioner, 82 t.c. 1001 (1984), holding that §165(c)(2) requires a primary profit motive for a loss from a particular transaction is to be deductible. t.c. memo 1988570, in which the government won a summary judgment that commodities straddles were shams despite not having offered evidence of the taxpayers’ offsetting gains. the notice also cites reg. §1.702-2 [the partnership anti-abuse rules]. the government also is reexamining the partnership basis rules. • compound indicia of criminal tax fraud? the government believes that the baby boss transactions were not being individually reported on schedule d, but instead have been buried in grantor trusts. for example, an individual taxpayer with an unrealized capital gain contributes both the appreciated assets and the baby boss partnership interest into a grantor trust, which sells both, and the individual reports only the net gain or loss from the grantor trust’s transactions on his return, rather than breaking out gains and losses separately, as is required [by reg. §1.671-2]. treasury department officials suggest that criminal penalties might apply to this kind of reporting, which willfully conceals the facts. • changes coming to tax shelter disclosure rules. the recently proposed corporate tax shelter disclosure rules will be changed by dropping of the requirement that a shelter be marketed to a corporation to trigger the requirement that a promoter maintain a customer list. under the amended regulations, a customer list would have to be maintained for a shelter that is exclusively peddled to individuals, provided threshold amounts of fees and tax savings are met. 390 florida tax review [vol. 9:si 2. temp. reg. § 1.752-6t. fighting duplication and acceleration of losses through partnerships before june 24, 2003. t.d. 9062, assumption of partner liabilities, 68 f.r. 37414 (6/24/03). temp. reg. § 1.7526t provides rules, similar to the rules applicable to corporations in § 358(h), to prevent the duplication and acceleration of loss through the assumption by a partnership of a liability of a partner in a nonrecognition transaction. under the temporary regulations, if a partnership assumes a liability, as defined in § 358(h)(3), of a partner (other than a liability to which § 752(a) and (b) apply) in a § 721 transaction, after application of §§ 752(a) and (b), the partner’s basis in the partnership is reduced (but not below the adjusted value of such interest) by the amount of the liability. for this purpose, the term “liability” includes any fixed or contingent obligation to make payment, without regard to whether the obligation is otherwise taken into account for federal tax purposes. reduction of a partner’s basis generally is not required if: (1) the trade or business with which the liability is associated is transferred to the partnership, or (2) substantially all of the assets with which the liability is associated are contributed to the partnership. however, the exception for contributions of substantially all of the assets does not apply to a transaction described in notice 2000-44, 2000-2 c.b. 255 (or a substantially similar transaction). • the temporary regulations purport to be effective for transactions occurring after 10/18/99 and before 6/24/03. 3. klamath. district court upholds blips tax shelter on taxpayer’s partial summary judgment motion. klamath strategic investment fund, llc v. united states, 440 f. supp. 2d 608 (e.d. tex. 7/20/06). the court (judge ward) held that the premium portion of the loans received from the bank in connection with the funding of the instruments contributed to a partnership was a contingent obligation, and not a fixed and determined liability for purposes of § 752. the transaction was entered into prior to the release of notice 2000-44, 2000-2 c.b. 255, which related to son-ofboss transactions. judge ward held that a regulation to the contrary, reg. § 1.752-6 (see t.d. 9062), was not effective retroactively, and was therefore invalid as applied to these transactions. judge ward held that there was clear authority existing at the time of the transaction that the premium portion of the loan did not reduce taxpayer’s basis in the partnership. a. klamath on the merits: it does not work because it lacks economic substance, but no penalties. the authorities discussed in the holland & hart and olson lemons opinions provide “substantial authority.” klamath strategic investment fund, llc v. united states, 472 f. supp. 2d 885 (e.d. tex. 1/31/07), on appeal to the fifth circuit (9/19/07). the transactions lacked economic substance because the loans would not be used to provide leverage for foreign currency transactions, but no 2009] recent developments in federal income taxation 391 penalties were applicable because taxpayers passed on a 1999 investment and they thought they were investing in foreign currencies and the tax opinions they received that relied on relevant authorities set forth in the court’s earlier opinion provided “substantial authority” for the taxpayers’ treatment of their basis in their partnerships. b. on government motions, judge ward refuses to vacate partial summary judgment decision on the retroactivity of the regulations under § 752, and he permits the deduction of operational expenses, despite his earlier finding that the transactions lacked economic substance, because the taxpayers had profit motives. klamath strategic investment fund, llc v. united states, 99 a.f.t.r.2d 2007-2001 (e.d. tex. 4/3/07). first, judge ward held that even though the loans lacked economic substance, they still existed, and thus the partial summary judgment on the nonretroactivity of the regulations under § 752 was not premised on invalid factual assumptions. second, he held that the existence of profit motive for deduction of operational expenses was based on the purposes of nix and patterson – and not on the motives of presidio, the managing partner of the partnership. 4. cemco. there is a partnership liability in a short sale: another shelter falls on summary judgment for the irs with penalties, and a fpaa to one is as good as an fpaa to the other. this case differs from klamath because the transaction was entered into following the 8/11/00 release of notice 2000-44 (which made it a listed transaction). cemco investors, llc v. united states, 99 a.f.t.r.2d 2007-1882 (n.d. ill. 3/27/07), aff’d, 515 f.3d 749 (7th cir. 2/7/08)., cert. denied, 129 s.ct. 131 (10/6/08). in this tax shelter scheme, cemco investment trust (cit), a grantor trust, entered into two foreign exchange digital option transactions on december 2, 2000, with deutsche bank. cit simultaneously purchased a $3.6 million digital foreign currency option (the long position) and sold a digital foreign currency option for $3.564 million (the short position). on the following day cit assigned the options to cemco investment partners (cip), a general partnership. a few days later, cip purchased €55,947 for $50,000. cip then entered into a termination agreement with respect to both of the option contracts. on december 21, cip was liquidated with a transfer of the €55,947 and $45,847 to cit. the transfer occurred by moving assets from cip’s account at deutsche bank to cit’s account. on december 26, cit transferred the euros to cemco llc. on december 29, cemco sold the majority of the euros for $51,324 (a non-functional currency treated as property). cemco and cip consisted of two partners, steven kaplan and forest charter holdings, ltd. forest was a shell company to orchestrate the transactions. forest’s sole shareholder and president, paul daugerdas, was the trustee of cit. kaplin and forest were the cit beneficiaries. 392 florida tax review [vol. 9:si • cemco claimed a $3.53 million loss on the sale of the euros. cip claimed a $3.6 million basis in the long currency position, and that the contingent obligation of the short position is not treated as a liability for § 752 purposes, which would otherwise have reduced basis on termination of the contracts. (see helmer v. commissioner, t.c. memo. 1975160.) cemco asserted that while cip had a total tax basis of $3.6 million, its only assets were the euros and cash in its possession. thus, the basis of the euros distributed in liquidation would be $3.6 million less the $47,847 cash, producing a loss on the sale of euros. the district court held that notice 2000-44, 2000-2 c.b. 255, which was issued on 9/5/00 [predating the transaction], and reg. § 1.7521(a)(4)(ii), issued in june 2003, established that the contingent obligation represented by the short sale would be treated as a liability to prevent the creation of artificial basis in transactions designed to create artificial tax losses by overstating basis. thus, cemco’s losses were disallowed. • cemco’s major claim was that that the fppa should have been issued to cip, which was the partnership that executed the transactions and thereby generated the basis figure with respect to property distributed to cemco. agreeing with the government, the district court held that, although the basis of the euros was a partnership item of cip, cemco was also required to correctly determine the basis of the euros contributed to it and could not merely carry over the basis as determined by either cit or cip. thus, the fpaa issued to cemco was not premised on cip’s errors. • the summary judgment also affirmed imposition of the § 6662(a) accuracy related penalty, increased to 40% under § 6662(e) for a gross valuation misstatement. a. affirmed, with very strong support for the authority of the irs to issue retroactive regulations. 515 f.3d 749 (7th cir. 2/7/08). judge easterbook upheld the retroactive application of temp. reg. § 1.752-6t to reduce the basis of the partnership interest by the contingent obligation. he reasoned that § 309(d)(2) of the 2000 act specifically provided that the basis reduction regulations for partnerships authorized by that act could be retroactive to october 18, 1999, and “[t]hat’s the power the commissioner used when promulgating treas. reg. §1.752-6.” judge easterbrook rejected what he read as the holding of the district court in klamath [440 f. supp. 2d 608] – that although a retroactive application of the regulation could have been grounded on the 2000 act, the irs had not properly availed itself of that power. • judge easterbrook reasoned: but if the irs was not using that authority, why in the world does the regulation reach back to october 18, 1999? retroactivity requires justification; to make a rule retroactive is to invoke one of the available justifications; and the choice of date tells us that the justification is the one supplied by the 2009] recent developments in federal income taxation 393 2000 act (in conjunction with §7805(b)(6)). a regulation’s legal effect does not depend on reiterating the obvious. so treas. reg. §1.752-6 applies to this deal and prevents cemco’s investors from claiming a loss. judge easterbook added that cemco was “scarcely in a position to complain – not only because this tax shelter was constructed after the warning in notice 2000-44, but also because all the regulation does is instantiate the pre-existing norm that transactions with no economic substance don’t reduce people’s taxes.” finally, judge easterbook rejected cemco’s procedural argument that an fppa should have been issued to cip. such an action was not required because cemco never had been partner of cip, and thus its basis in the euros was not a partnership item of cip, even if the basis of the euros in the hands of cit, which contributed them to cemco was the same as in the hands of cip. • note that unlike judge easterbrook, we read the holding of klamath to be that the retroactive application of temp. reg. § 1.752-6t was invalid under the fifth circuit precedent in snap-drape inc. v. commissioner, 98 f.3d 194, 202 (5th cir. 1996), because the retroactivity to a transaction before the date of notice 2000-44 was an abuse of discretion. 5. jade trading. the court of federal claims follows coltec on the economic substance issue. jade trading llc v. united states, 80 fed. cl. 11 (12/21/07). the court of federal claims (judge williams) held that, although they literally complied with the code, digital options spread transactions lacked economic substance. she relied upon coltec industries, inc. v. united states, 454 f.3d 1340 (fed. cir. 2006), to reach that conclusion. judge williams stated, in sum, this transaction’s fictional loss, inability to realize a profit, lack of investment character, meaningless inclusion in a partnership, and disproportionate tax advantage as compared to the amount invested and potential return, compel a conclusion that the spread transaction objectively lacked economic substance. • the 20 percent and 40 percent penalties were applied although the § 6664 reasonable cause exception issue was postponed to possible partner-level proceedings. a. reconsideration denied. 81 fed.cl. 173 (3/20/08). the taxpayer argued that the negligence penalty should not have been applied at to the partnership, because the inaccurate reporting occurred on the individual partner’s tax returns, not on jade’s. judge williams responded as follows: 394 florida tax review [vol. 9:si the code dictates that the court assess the applicability of the negligence penalty with respect to the partnership in the context of this partnership proceeding. first, section 6621, “tax treatment determined at partnership level,” directs that the tax treatment of any “partnership item” and the applicability of any penalty which “relates to” an adjustment to a “partnership item” shall be determined at the partnership level. ... the negligence penalty clearly related to the inflated basis the spread transaction in the partnership generated on the [partner’s] individual returns ... . although typically accuracy-related penalties are applied at the partnership level based upon the partnership return’s inaccurate reporting, it would be inappropriate to eliminate the penalty here solely because there are no numerical inaccuracies on jade’s partnership tax return. applying the negligence penalty to the partnership here is particularly appropriate because it was only the construct of forming the partnership and contributing the spread to the partnership that permitted the tax losses to be realized. had the ervin llcs simply done the spread transactions on their own without contributing them to jade there would have been no substantial losses. as the court recognized: “packaging the investment in the partnership vehicle was an absolute necessity for securing the tax benefits.” jade, 80 fed. cl. at 14. ... [s]ections 6621, 6226(f) and 6662(b) and (c), read together permit the court to determine whether an underpayment on an individual partner’s tax return is “attributable to” negligence that “relates to” partnership items. in doing so, the court is free to analyze the conduct at the partnership level which generated the losses. (emphasis in original) 6. colm. this decision might have a “colming” effect on the irs. colm producer, inc. v. united states, 460 f. supp. 2d 713 (n.d. tex. 10/16/06). the court (judge godbey) upheld the disallowance of a loss of about $102.7 million on the sale of a limited partnership interest in december 1999. the partnership interest was funded by the ettman family trust with $2 million plus the contribution of the $102.5 million proceeds of the short sale of $100 million (face value) of u.s. treasury notes subject to the obligation to replace the borrowed t-notes. the partnership interest was then sold to an unrelated third party for $1.8 million. judge godbey held that the obligation to 2009] recent developments in federal income taxation 395 replace the borrowed t-notes [on the closing of the short sale] should have been treated as a liability under § 752. although contingent liabilities were not included as liabilities under § 752, the obligation to close the short sale was a “liability” based upon his reading of the black’s law dictionary definition [“the quality or state of being legally obligated or accountable” or, “a financial or pecuniary obligation”]; he reinforced his conclusion by citing rev. rul. 95-26, 1995-1 c.b. 131, and salina partnership lp v. commissioner, t.c. memo. 2000-352. a. affirmed sub. nom. kornman & associates inc. short sale obligations in son–of-boss transaction are indebtedness under § 752(b). kornman & associates inc. v. united states, 527 f.3d 443 (5th cir. 5/12/08). this variant of the son-of-boss shelter involved the taxpayer entering into a short-sale of treasury notes, followed by contribution of the $102.5 million of cash proceeds and the obligation to replace the borrowed treasury notes to a partnership. the taxpayer then sold the partnership interest for a $1.8 million promissory note from the buyer claiming a basis of $102.5 million and a capital loss. the taxpayer claimed that relief from the obligation to replace the treasury bills was a contingent liability based on closing the short sale and therefore not release of indebtedness includible in amount realized on sale of the partnership interest under § 752(b). the fifth circuit affirmed summary judgment for the government holding that the obligation to close a short sale is a liability for purposes of § 752. (see reg. § 1.752-1(a)(4)(i), effective may 26, 2005). • the court followed rev. rul. 88-77, 1988-2 c.b. 128; rev. rul. 95-26, 1995-1 c.b. 131; and rev. rul. 95-45, 1995-1 c.b. 53, in holding that short sale obligations are taken into account in computing basis. the court held that the revenue rulings are not entitled to deference under chevron usa, inc. v. natural res. def. council, inc., 467 u.s. 837, 844 (1984), but, although not controlling, the rulings are entitled to some deference depending on the power to persuade. skidmore v. swift & co., 323 u.s. 134, 140 (1944). • the court also held that the open transaction treatment applied to short sales under § 1233 applies to recognition of capital gains and losses and has no role in determining basis under § 752. 7. marriott international. short sale obligations are treated as liabilities under § 752. marriott international resorts, l.p. v. united states, 83 fed.cl. 291 (fed. cl. 8/28/08). the taxpayer, marriott resorts was a limited partnership consisting of marriott international jbs corporation (jbs), the general partner, and marriott ownership resorts, inc. (mori), the limited partner. jbs was the general partner of mori. the limited partner in mori was marriott international capital corporation. mori sold timeshare units in resort properties and subsequently transferred the buyer’s promissory notes to tiaa. 396 florida tax review [vol. 9:si mori entered into a short sale of five-year treasury notes and invested the proceeds of the short sale in repurchase obligations (repos) yielding a fixed return. mori contributed the repurchase obligations and some mortgage notes to the taxpayer partnership for a 99 percent limited partnership interest. the partnership assumed mori’s obligation on the short sale. (this is similar to a son of boss transaction but predates the retroactive effective date of reg. § 1.752-6.) the partnership closed the short sales by using funds from the repurchase obligations to acquire treasury securities. mori then transferred its partnership interest to marriott international capital corporation, which caused a termination and re-formation of the partnership under § 708(b). all of the parties claimed a basis in partnership interests and partnership assets from the cost of the repurchase obligations unreduced by the obligation under the short sale, and used this basis to claim losses on the ultimate disposition of partnership assets (done through a grantor trust). the partnership claimed a loss on the sale of the contributed mortgage notes. the claims court (judge lettow) held on summary judgment that the obligation under the short sale was a liability for purposes of § 752(b) that reduced the partnership’s basis in its assets, and thereby eliminated the claimed losses. the court followed the result in salina partnership v. commissioner, t.c. memo 2000-352, and rejected arguments based on holdings in la rue v. commissioner, 90 t.c. 465 (1988); long v. commissioner, 71 t.c. 1 (1978); and helmer v. commissioner, t.c. memo 1975-160. citing rev. rul. 88-77, 1988-2 c.b. 128, the court noted that the taxpayer was on notice that the irs would assert that symmetry is required under § 752 on the transfer of property that creates basis and offsetting contingent obligations that should reduce basis. 8. sala. interest is suspended under § 6404(g) because of the absence of fraud. sala v. united states, 552 f.supp.2d 1157 (d. colo. 5/1/07). if an individual files a timely return (including extensions) and the irs has not sent the taxpayer a notice of additional liability (e.g., a math error notice of deficiency), including an explanation of the basis for the liability, within one year following the later of (1) the due date of the return (without regard to extension), or (2) the date on which the taxpayer filed the return, § 6404(g)(1) suspends the accrual of interest for the period beginning one year after the due date (or filing, if applicable) of the return. interest resumes running twenty-one days after the irs sends a notice to the taxpayer. section 6404(g) does not apply at all if an underpayment is due to fraud. in this case, the district court held that the fraud exception to § 6404(g) does not apply to a deficiency from a tax shelter transaction [“baby boss”] that lacked economic substance, unless the government shows that the taxpayer engaged in some act of concealment or misrepresentation. even though the taxpayer entered into the transaction knowing that it was a listed transaction [notice 2000-44], and knowing that it would not be registered with the irs in order to conceal his participation, 2009] recent developments in federal income taxation 397 because taxpayer relied on a “more likely than not opinion” by r.j. ruble that the tax results of the transaction would be upheld, the taxpayer acted in good faith and the government could not prove that the taxpayer had fraudulent intent. summary judgment was entered for the taxpayer. a. was it a “qualified amended return”? sala v. united states, 99 a.f.t.r.2d 2007-3011 (d. colo. 5/30/07). on plaintiff’s motion for partial summary judgment, judge babcock held that the amended 2000 return filed by sala on 11/18/03 was possibly not a “qualified amended return” because the date that the irs notified kpmg that it was under a § 6700 examination was 10/17/03. the resolution of this issue depended upon the scope of the § 6700 examination at the time the amended return was filed, and an issue of fact existed that precluded summary judgment. the court refused to stay the case pending the availability of testimony from sala’s kpmg accountant, tracie henderson, and from r.j. ruble, both of whom indicated they would invoke their fifth amendment rights, because the delay would be substantial and would prejudice sala. b. sala v. united states, 100 a.f.t.r.2d 20075097 (d. colo. 7/3/07). judge babcock reiterated his holding that there is an issue of fact as to whether the 11/18/03 amended return was a qualified amended return. c. district court holds for the taxpayer on the merits in an options transaction for which r.j. ruble provided the tax opinion. sala v. united states, 552 f. supp. 2d 1167 (d. colo. 4/22/08). the district court (judge babcock) held that taxpayer was entitled to a $60 million ordinary loss on 24 long and short currency options entered into in november 2000 as part of a deerhurst program, in which the options were contributed to a partnership. the basis of that partnership interest was increased by the cost of the long options but was not reduced by the contingent liability on the short options under helmer v. commissioner, t.c. memo. 1975-160 (1975). this was based upon judge babcock’s finding of fact that the long and short options were separate instruments for tax purposes. the court found that the regulations issued in 2003, reg. § 1.752-6, retroactive to october 1999, which contained an “exception to the exception” for transactions described in notice 2000-44, exceeded treasury’s authority. judge babcock held that the regulations were not legislative because the “exception to the exception” was not comparable to the rules for corporations described in § 358(h). judge babcock concluded that the corporate rules were only “to prevent acceleration or duplication of losses,” which were not involved in the transactions described in notice 2000-44. he refused to follow cemco investors, llc v. united states, 515 f.3d 749 (7th cir. 2008). 398 florida tax review [vol. 9:si • judge babcock analyzed the complex transaction under the step transaction doctrine and found the doctrine inapplicable. • he found the losses deductible under § 165(c)(2) because they were incurred in a transaction entered into for profit, which was to be determined at the time taxpayer entered into the transaction, and not in hindsight. in this, judge babcock credited sala’s testimony that “he expected his investment in deerhurst to be profitable above and beyond the expected tax loss . . . .” • he found the taxpayer was “an extremely cautious investor who invested a great deal of time and energy carefully researching and choosing his investments” and that he had a business purpose other than tax avoidance for structuring his investment as he did. • judge babcock further held that sala’s amended return filed on 11/18/03 was a “qualified amended return” because kpmg had not been contacted regarding deerhurst prior to that date, although it had been previously contacted regarding transactions similar to deerhurst. d. government motion on 6/10/08 for new trial based upon affidavit given in connection with decision not to prosecute investment manager. andrew j. krieger, a key witness for the taxpayer, stated in an affidavit dated 5/22/08 that a portion of the testimony he gave at deposition was false, in that there was no “test period” for an “investment program” but merely an effort to obtain tax savings. 2008 tnt 114-15. the motion was opposed by the taxpayer because krieger gave his affidavit only after the government granted him immunity from prosecution by executing a nonprosecution cooperation agreement in connection with a criminal investigation unrelated to this case, i.e., the coplan criminal case pending in the southern district of new york. 2008 tnt 130-62, 7/1/08. e. government motion for new trial denied. 251 f.r.d. 614, 102 a.f.t.r.2d 2008-5292 (7/18/08). judge babcock denied the motion, holding that the evidence submitted by the government was not new. he stated, “rather than implying diligence, the timing of this “new” evidence instead implies a deliberate attempt on the part of the government to further delay and derail this case for tactical gain.” 9. stobie creek. the court of federal claims denied retroactive application of the regulations, but slammed the door on the digital options strategy on economic substance grounds and upholds penalties. stobie creek investments, llc v. united states, 82 fed. cl. 636 (fed. cl. 7/31/08). the welles family recognized substantial capital gain on disposition of 50 percent of the family residential entry door business for $455 million. prior to sale the family transferred their stock holdings in the family 2009] recent developments in federal income taxation 399 corporation, therma-tru, to a family investment partnership, stobie creek. the partnership, through single member llcs, participated in the jenkens & gilchrist digital options strategy, to no avail according to the court of federal claims. in an extraordinarily detailed and lengthy opinion, the court held: • helmer v. commissioner, t.c. memo. 1975-160, establishes that the contingent nature of the short sold position in foreign currency prevents a reduction in basis for a reduction in partnership liabilities on distribution of property from the partnership. thus the potential liability on the open currency option did not reduce the taxpayers’ basis in distributed therma-tru stock, whose basis was increased by the purchase price of the short options. • retroactive application of reg. § 1.7526 is not justified by § 309 of the community renewal tax relief act of 2000, pub. l. no. 106-554, § 309, 114 stat. 2763a-587, -638. that provision was aimed at corporate transactions and is focused on the use of contingent liabilities to accelerate or duplicate losses. the court opined that, “the transfers of the contingent liabilities in the cases at bar resulted in increasing each partner’s outside basis, but did not cause any acceleration or duplication of losses.” • judge miller held that the long and short digital options were two options, not one as contended by the government. • judge miller dismissed notice 2000-44, which was issued in august 2000, after the transactions occurred but before they were reported by taxpayers in 2001, as follows: [the government’s] argument misunderstands the import of irs notices. as a general proposition, irs notices are press releases stating the irs’s position on a particular issue and informing the public of its intentions; such notices do not constitute legal authority. …. whether [taxpayers] had “notice” that their transactions would be subject to scrutiny has no bearing on whether a treasury regulation, seeking retroactively to effect a change in the law, can serve to disallow [taxpayers’] reporting position. • nonetheless, under coltec industries, inc. v. united states, 454 f.3d 1340 (fed. cir. 2006), the partnership transaction in options lacked economic substance. the court indicated that in coltec, “the federal circuit thus adopted a disjunctive test for determining whether a transaction should be disregarded as an economic sham: the doctrine should apply and a transaction should be disregarded either if the transaction lacks objective economic substance or if it is subjectively shaped solely by tax avoidance motivations.” after an exhaustive analysis of conflicting expert opinions, the court found that, “the weight of the evidence overwhelms plaintiffs’ claim that the transactions were investments motivated by a business purpose to return a profit.” the court also interpreted coltec as holding that, “if a transaction was shaped solely by a tax-avoidance purpose, the fact that the transaction may have some 400 florida tax review [vol. 9:si objective economic reality cannot save it from being disregarded as an economic sham.” as to the taxpayers’ subjective purpose, the court found that, “plaintiffs’ limited evidence of non-tax avoidance subjective motivation does not imbue the transactions with economic substance.” • the court also applied the step transaction doctrine to deny the claimed tax benefits. the court stated, “trial established that, under either the interdependence test or the end result test, the step transaction doctrine applies to plaintiffs’ transactions. accordingly, the tax consequences must turn on the substance of the transaction and not on the form by which plaintiffs engaged in it. in disregarding the predetermined steps of the j&g strategy, stobie creek is unable to claim a basis increase in the therma-tru stock, and the capital gains must be taxed according to the reality of the transaction.” • the court upheld accuracy and negligence penalties and rejected the taxpayers’ claims that they reasonably relied on the advice of counsel. the court concluded that because of the built-in conflict of interest of the lawyers promoting the transaction that was known to the taxpayers, reliance on the legal opinions was not reasonable. 10. countryside. a major partnership razzle dazzle that defers real estate gains with liquidation distributions survived economic substance scrutiny by the tax court, but there is much more to come. countryside limited partnership v. commissioner, t.c. memo. 2008-3 (1/2/08). the tax court (judge halpern) granted summary judgment to limited partners holding that distributions of non-marketable securities held by a disregarded llc in liquidation of limited partners’ interests were respected as distributions of non-marketable securities that did not trigger recognition of gain under § 731. the partnership borrowed $17 million (guaranteed by one of the distributee partners) which it used to acquire a 99 percent interest in two llcs. the llcs borrowed an additional $3.4 million and purchased non-traded notes from aig. the interest payable on the notes was less than the interest paid on the debt. the llc interests were distributed to two limited partners in liquidation of their interests in 2000. the reduction in the liquidated partners’ share of partnership liability did not exceed the basis generated by the liabilities. the partnership sold its highly appreciated real estate in 2001. the proceeds of sale were used to repay the partnership’s liabilities. the aig notes were redeemed in 2003. the tax court rejected the irs’s claim that the economic substance of the transaction was a distribution of cash. the court was satisfied that, although the transaction was structured to avoid tax, in economic substance the transaction represented a conversion of the taxpayers’ investments in the partnership to investments in 10-year promissory notes, “two economically distinct forms of investment.” the issue of the partnership’s step-up in basis under § 734(b) as a result of the liquidation distributions remained at issue in a separate case addressing the partnership’s 2001 taxable year. 2009] recent developments in federal income taxation 401 11. 7050 ltd. son-of-boss deal fails because a few thousand c$ were left behind in a bank account. 7050 ltd. v. commissioner, t.c. memo 2008-112 (4/23/08). the son-of-boss transaction relies on a partnership liquidation distribution of property that takes an inflated exchanged basis under § 732(b). one of the issues in the government’s partial summary judgment motion in this son-of-boss tax shelter case was whether a distribution of property (foreign currency) from the partnership was a liquidating distribution, resulting in an exchanged basis for the property determined with reference to the partnership interest pursuant to § 732(b) (which the taxpayer partner claimed was determined with respect to a high basis option contributed to the partnership), or a current distribution, resulting in a transferred basis from the partnership pursuant to § 732(a). the tax court (judge holmes) granted summary judgment for the commissioner, holding that liquidation of a partner’s interest on dissolution of a partnership requires a complete termination of all partnership activities, including the distribution to the partners of all the partnership’s assets. the presence of a few thousand canadian dollars in an account belonging to the partnership, distributed in the next taxable year, caused a distribution of property to a partner in the prior year to be treated as a current distribution to the partner in which the distributee partner’s basis in the distributed property was the transferred partnership’s basis under § 732(a), rather than the higher exchanged basis from the partner’s outside partnership basis. property distributed in complete liquidation of a partner’s interest takes the partner’s outside basis in the partnership interest under § 732(b). in addition, the court refused to grant summary judgment to the commissioner on the issue of whether options originally contributed to the partnership had expired by the date of the contribution indicating that the issue depended on questions of fact that could not be settled on summary judgment. the tax court also reserved judgment on penalty issues pending resolution of whether temp. reg. § 301.6221-1t(c), treating reasonable reliance as a partner-level defense, is valid. • this is a more appropriate way of attacking tax shelters than by the government relying on amorphous judicial doctrines and on whether a black muumuu wearer is “shocked, shocked” by the result of congressional language plainly interpreted. 12. lilo. hi-lili, hi-lili, lilo! district court grants summary judgment to the government in a lilo transaction. bb&t corp. v. united states, 99 a.f.t.r.2d 2007-376 (m.d. n.c. 1/4/07). the taxpayer, a financial services corporation, leased equipment from a wood pulp manufacturer [a head lease] and re-leased it back to the wood pulp manufacturer in a “leasein/lease-out” (“lilo”) transaction and claimed substantial rent and other deductions. the court held that the form of the transaction should not be respected for tax purposes because taxpayer did not acquire a current leasehold 402 florida tax review [vol. 9:si interest in the equipment and incurred no risk of loss. the reciprocal offsetting obligations were disregarded because, in substance, the taxpayer acquired only a future interest in the right to use and possess the equipment – and acquired that interest only if the owner-sublessee did not exercise its option to buy-out taxpayer’s interest in the head lease. the transaction did not substantially affect the wood pulp manufacturer’s rights to use and possess the property. a. affirmed, 523 f.3d 461 (4th cir. 4/29/08). in this “typical” lilo transaction entered into in 1997 – the tax benefits of which were largely eliminated by regulations that became effective in 1999 [reg. § 1.467-1 to -5] – the court (judge williams) found that the transaction was a financing arrangement, not a genuine lease and sublease, distinguishing frank lyon co. v. united states, 435 u.s. 561 (1978). 13. silo. same result in a silo. awg leasing trust v. united states, 101 a.f.t.r.2d 2008-2397 (n.d. ohio 5/28/08). a lilo transaction evolved into a sale-in-lease-out (silo), which is essentially the same transaction but the head lease was longer term so that the initial acquisition was claimed to be treated as a sale and purchase by the taxpayer. not so, says judge gwin of the u.s. district court for the northern district of ohio. in this case the taxpayer acquired a german municipal incineration and power generation facility with a nonrecourse loan from german banks and leased the facility back to the seller with an option for the seller to purchase the plant. the court concluded that the “small, but guaranteed, pre-tax profit [was] sufficient to show that the transaction had some ‘practicable economic effects other than the creation of income tax losses’” and refused to disregard the transaction under the economic substance doctrine. however, finding that substance controls over form, the taxpayer was denied depreciation and amortization deductions on the grounds that the transaction was a financing arrangement, rather than a purchase of property, because the transaction was structured to avoid transfer of the substantive rights and liabilities associated with ownership. the court also denied interest deductions on the nonrecourse loan. the circular flow of funds involved with the loan proceeds in an escrow arrangement to fund the lease payments that were equal to obligations on the note meant that the loan was a sham. the court described the loan as a “‘loop debt’ in which the loan proceeds are used solely for the purpose of paying the purported debt.” 14. enbridge. as the old saying goes, “there’s no tax free basis step-up without a funeral.” this “midco” tax shelter was rejected by the court. enbridge energy co., inc. v. united states, 553 f. supp. 2d 716 (s.d. tex. 3/31/08). in a transaction substantially similar to the transaction described in notice 2001-16, 2001-1 c.b. 730, the taxpayer (midcoast) acquired the assets of a selling corporation (bishop) through an intermediary (k-pipe). 2009] recent developments in federal income taxation 403 midcoast desired to acquire the bishop assets with a cost basis, but bishop’s shareholder (langley) was unwilling to engage in an asset sale, insisting on a stock sale and purchase. midcoast’s tax advisor, pwc, arranged for the formation of an intermediary, k-pipe merger, and the financing necessary for kpipe merger to purchase the bishop stock, with the loan to k-pipe merger being secured by midcoast assets. after a downstream merger of k-pipe merger into bishop, bishop, which changed its name to k-pipe group, sold the bishop assets to midcoast. (k-pipe purportedly offset the gain with built-in loss on assets contributed to it by its shareholder in a pre-§ 362(e) year.) thereafter, kpipe engaged in no business activity and was merely a shell. on cross motions for summary judgment, the district court (judge harmon) upheld the irs’s treatment of the transaction from midcoast’s perspective as a stock sale followed by a § 332 liquidation, which resulted in denying the step-up in basis on which midcoast’s claimed depreciation deductions were based. after disregarding kpipe because it had no substance other than as a vehicle to allow midcoast to claim a cost basis in the bishop assets in a stock sale transaction without a § 338 election, the court addressed what was the real substance of the transaction: a sale of stock or a sale of assets. because langley would not agree to a direct sale of bishop’s assets, “the only way in which midcoast could have obtained the bishop assets was to purchase the bishop stock and liquidate.” assessment of the § 6662(d) substantial understatement penalty was upheld, and because the transaction was a “tax shelter,” neither the substantial authority nor adequate disclosure exceptions applied. alternatively, there was not substantial authority because the weight of authority in supreme court and fifth circuit cases was held to have required disregarding k-pipe. 15. shell. judge werlein holds that the transfers by shell western e&p inc. to shell frontier oil & gas inc. of assets that had declined in value, followed by sales of the subsidiary’s stock to unrelated parties at a loss, were not part of a tax-motivated “shell game.” the lesson to take from this case is that top management likes being kept in the dark; this is because the case turned on testimony believed by judge werlein that the vp of tax “intentionally refrained from discussing the … tax implications [of the transaction] with shell’s top management or [the ceo].” shell petroleum inc. v. united states, 102 a.f.t.r.2d 2008-5085 (s.d. tex. 7/3/08). in 1992 shell western transferred high-basis assets that had declined in value to a newly-created subsidiary, shell frontier. following that, shell western sold so-called “dutch auction rate preferred stock” for $110 million to unrelated parties, which constituted more than 20 percent of the value of shell frontier stock. this sale created a loss of more than $353 million. the high-basis property transferred to shell frontier was described by judge werlein as follows: 404 florida tax review [vol. 9:si the term “frontier property” is commonly used by shell to describe an asset that is not currently commercially competitive, but which has the potential to become commercially competitive if technological, political, economic, or other factors change. • the idea of the transaction originated in shell’s tax department. judge werlein described it as follows: the government makes much of the fact that the creation of shell frontier was proposed by steve stryker, shell’s vice president of tax. the evidence is that shell’s ceo frank richardson had set overarching goals for the company to improve its return on investment, to reduce costs, and to raise cash without incurring new debt. a variety of recommendations were made by executives and managers, from which at least seven major initiatives were adopted and executed by the company. only one of these seven approved recommendations came from the tax department. when stryker presented the proposal, however, he intentionally refrained from discussing the specific tax implications of the § 351 exchange with shell’s top management or richardson, who ultimately approved the shell frontier plan, in order to assure that the ultimate decision to form shell frontier would be made on non-tax business grounds. the testimony of shell’s decision-makers is that shell frontier was formed to raise cash, preserve long-term properties, and increase management efficiency. these proffered business purposes are consistent with shell’s contemporaneous overall strategy of improving its return on investment and increasing cash flow by investing strategically to increase production and by restructuring some of its assets. indeed, a taxpayer’s restructuring of a going-concern is a recognized, valid business purpose. see united parcel serv. of am., 254 f.3d at 1020 (holding a transaction that “simply altered the form of an existing, bona fide business” possessed an adequate business purpose). that the shell frontier idea originated with shell’s tax department, which anticipated the beneficial tax consequences that might also be realized, does not undercut the testimony of shell’s executives that their authorization of shell frontier’s formation, including the transfer of some of shell western’s non-producing assets, was based on their legitimate cash raising, asset preservation, and management objectives. 2009] recent developments in federal income taxation 405 • in his opinion, judge werlein held that the transaction should be respected. he rejected arguments that the transaction lacked economic substance and refused to apply coltec industries, inc. v. united states, 454 f.3d 1340 (fed. cir. 2006), to the § 351 transaction taken out of its context. • the government argued that assets with no discounted net cash flow value did not constitute property and judge werlein responded as follows: under the government’s construction of the term, “property” does not include assets such as the shell western nonproducing properties because, while not producing, they had no discounted net cash flow value. but the statute itself contains no such limitation. at least one court has implicitly construed § 351(a) not even to require that the transferred property have a fair market value in excess of zero. see abbrecht v. comm’r, t.c. memo 1987-199, 53 t.c.m. (cch) 611 (1987) (holding § 351 applied to debt exchanged for stock, although the value of the debt was not shown to have a fair market value greater than zero). *** in sum, even if the court were to accept the government’s unsupported view that real property is not “property” within the meaning of § 351 if it is lacking in value, the evidence establishes that the non-producing properties transferred by shell western to shell frontier did in fact have some value and unquestionably qualify as “property” entitled to non-recognition under § 351. • note that in 2004, § 362(e) was added to the code, and, as stated in footnote 1 of the opinion, congress has since changed the law so that in section 351 exchanges occurring after october 22, 2004, transfers of property with built-in losses require that either the transferee’s basis in the transferred property, or, if the transferor so elects, the transferor’s basis in the stock received, is reduced to fair market value. see pub. l. 108-357, 118 stat. 1596 (codified as amended at 26 u.s.c. § 362(e)(2) (2004)). hence, as shell points out, shell western’s transfer to shell frontier of its producing and non-producing properties had occurred under the 2004 amendment, shell western still would have had the right to take the stock it received with a cost basis equal to that of the properties it transferred to shell frontier, just as shell claims here. by making that election, however, under the 2004 406 florida tax review [vol. 9:si amendment shell frontier’s basis in the properties would be reduced to fair market value as of the date of exchange. regardless, shell frontier’s tax liability is not at issue in this case, and, of course, this case is governed by the pre-2004 statute. 16. government misconduct amounting to fraud does not require a showing of prejudice to justify relief. tax shelter investors entitled to the same deal received by the taxpayers who cooperated with the government. dixon v. commissioner, 316 f.3d 1044 (9th cir. 1/17/03), remanding t.c. memo. 2000-116 and t.c. memo. 1999-101. the ninth circuit reversed the tax court finding that misconduct by irs attorneys during the trial of test cases [secretly allowing the deduction of attorney’s fees in exchange for taxpayer cooperation] constituted harmless error. the tax shelter was one designed and administered by honolulu businessman henry kersting, in which participants purchased stock with loans from entities financed by two layers of promissory notes, resulting in their being enable to claim interest deductions on their individual returns. judge hawkins held that the taxpayers demonstrated fraud and that a demonstration of prejudice was unnecessary. the tax court was directed to enter judgment in favor of taxpayers on terms equivalent to the secret settlement agreements entered into with the test case taxpayers who cooperated with the government. • three lawyers from the houston area represented various taxpayers. they were henry binder of porter & hedges, michael louis minns, and joe alfred izen, jr. a. chief counsel notice cc-2003-008 (2/3/03). this notice reminds chief counsel attorneys of their obligation to adhere to the highest ethical standards in all aspects of their responsibilities, including representation of the commissioner before the tax court. aba model rules 3.3 [candor to tribunals], 3.4 [fairness to opposing party and counsel], 4.1 [truthfulness in statements to third persons], and 8.4 [misconduct] were discussed in the notice. b. on remand to the tax court, it really hits the fan for the commissioner – and deservedly so. the misconduct of the government lawyers involved and the commissioner’s failure to fully disclose the misconduct to all taxpayers who had been bound by the outcome of the kersting project test cases infested the stipulated decisions in all of the hundreds of cases settled in accordance with the outcome of the test cases. hartman v. commissioner, t.c. memo. 2008-124 (5/1/08). in a 137page opinion, the tax court (judge beghe) held that all of the hundreds of kersting tax shelter cases in which stipulated decisions had been entered and 2009] recent developments in federal income taxation 407 which had became final many years ago had to be re-opened and the taxpayers’ accounts had to be adjusted administratively in accordance with the settlements received by the taxpayers in the test cases. 17. transactions underlying a tax shelter are just done for grins in the real world; you can take that to the bank, man! hoosier homer judge grants injunctive relief to tax-indifferent party to a tax shelter contract without requiring the plaintiff to disgorge the $20 million it pocketed for entering into the tax shelter in the first place. hoosier energy rural electric cooperative, inc. v. john hancock life insurance co., 2008 wl 5068649, case no. l:08-cv-1560-dfh-dml (s.d. ind. 11/25/08). hoosier energy rural electric cooperative (“hoosier energy”) was the tax indifferent party in a sale-in/lease-out transaction of one of its generating plants for which it received $20 million for its participation. professor joseph bankman of stanford law school furnished an expert opinion in affidavit form that this type of salein/lease-out transaction was an abusive tax shelter, leading the court to find that the “deal was an attempt to create an appearance of a sale but without any real economic substance.” pursuant to the documentation of the arrangement, hoosier energy was required to maintain specified adequate security for its obligation to make future lease payments, i.e., provide a credit default swap from a party with at least an aa rating – failing which, it was required to make the agreed-upon termination payment of $120 million to a third-party which was obligated to pay the amount to john hancock life insurance co. (“john hancock”). hoosier energy maintained this security in the form of a guarantee from aig and it did timely make each of its lease payments. upon the falling of aig’s credit rating below the contractually-required standard, hoosier energy sought unsuccessfully to secure an equivalent guarantee. on hoosier energy’s request, chief judge hamilton granted an injunction against enforcement of hoosier energy’s obligation to make the $120 million termination payment to the third party on the ground that the arrangement was entered into solely for tax benefits and was somehow unenforceable against hoover. • chief judge hamilton did state that hoosier energy might some time in the future be required to give back the $20 million, but that there was no hurry about that. • professor bankman’s affidavit stated that the transaction was similar to that in awg leasing trust v. united states, 101 a.f.t.r.2d 2008-2397 (n.d. ohio 5/28/08), supra, viii.a.13. a. in a later proceeding, judge hamilton pretends to require hoosier energy to give john hancock adequate security to cover the possibility that his 11/25/08 injunction was incorrectly issued. hoosier energy rural electric cooperative, inc. v. john hancock life insurance co., 2008 wl 5216027 (s.d. ind. 12/11/08). judge hamilton, in addition to a 408 florida tax review [vol. 9:si $2 million cash bond, required hoosier energy “to post its own [i.e., meaningless] undertaking to pay john hancock up to an additional $130 million in damages it might suffer from an improper injunction.” b. identified “tax avoidance transactions.” 1. a new listed transaction: this time the irs isn’t just toi-ing. notice 2008-34, 2008-12 i.r.b. 642 (2/27/08) this notice describes as a listed transaction certain transactions entered into in an attempt to avoid the effect of the amendments to §§ 704, 734 and 743 in the american jobs creation act of 2004 designed to prevent taxpayers from shifting a built-in loss from a tax indifferent party to a u.s. taxpayer through the use of a partnership. [the 2004 amendments to §§ 704, 734 and 743 generally (1) require that a builtin loss may be taken into account only by the contributing partner and not other partners, and (2) make the basis adjustment rules mandatory in cases with a substantial basis reduction or substantial built-in loss.] in the transaction, a tax indifferent party directly or indirectly contributes one or more distressed assets (for example, a creditor’s interest in debt) with a high basis and low fair market value to a trust or series of trusts and sub-trusts, and a u.s. taxpayer acquires an interest in the trust (and/or series of trusts and/or sub-trusts) for the purpose of shifting a built-in loss from the tax indifferent party to the u.s. taxpayer that has not incurred the economic loss. this transaction (referred to as a distressed asset trust or dat transaction) and substantially similar transactions are listed transactions for purposes of reg. § 1.6011-4(b)(2) and §§ 6111 and 6112. 2. a safe cove (not big enough to be a harbor) for some taxpayers in the tax shelter war. notice 2008-111, 2008-51 i.r.b. 1299 (12/1/08). this notice clarified notice 2001-16, 2001-1 c.b. 730, and superseded notice 2008-20, 2008-6 i.r.b. 406, regarding intermediary transaction tax shelters. a transaction is treated as an intermediary transaction with respect to a particular person only if that person engages in the transaction pursuant to a plan, the transaction contains the four objective components indicative of an intermediary transaction, and no safe harbor exception applies to that person. c. disclosure and settlement there were no significant developments regarding this topic during 2008. 2009] recent developments in federal income taxation 409 d. tax shelter penalties, etc. 1. these “value ideas” did produce extraordinary results for e&y tax partners, but not the results they expected. united states v. coplan. two current and two former partners of ernst & young – all members of its viper [value ideas produce extraordinary results] group – were indicted on 5/30/07 in the southern district of new york for crimes relating to tax shelters promoted by e&y. the shelters included cds (“contingent deferred swap”); cobra (“currency options bring reward alternatives”); cds add-on; and pico (“personal investment corporation”). 2007 tnt 105-1 (5/31/07). a. more defendants. 2008 tnt 35-23 (2/21/08). the indictment was expanded to add david l. smith, private capital management, and charles bolton to the list of alleged co-conspirators. smith is alleged to have introduced the cds strategy to e&y and is further alleged to have licensed the cds transactions to bolton and a group of bolton companies who implemented the transactions. 2. liechtenstein! ir-2008-26 (2/26/08). the irs announced that it is initiating enforcement action involving more than 100 u.s. taxpayers in connection with accounts in liechtenstein. according to a story in the 2/19/08 wall street journal, (a) heinrich kieber, a former employee of liechtenstein’s largest bank, lgt group, has offered confidential client data to tax authorities on several continents over the past 18 months, and (b) the german government paid roughly €4.2 million ($6.4 million) to an unnamed individual for the same type of information. 3. the court of federal claims isn’t particularly fussy about who the taxpayer relies on for bad tax advice. allison v. united states, 80 fed. cl. 568 (2/27/08). in december 1982 the taxpayers invested in a limited partnership to place plastics recycling machines with businesses generating polystyrene scrap in order to recycle the scrap into a reusable form of resin pellets, for which they claimed the energy and investment tax credits. the case involved investors in the masters plastic recycling tax shelters, which were found not to have economic substance in the test case, provizer v. commissioner, t.c. memo.1992-177. this case decided by the court of federal claims (judge wolski) related solely to negligence penalties imposed by the irs under former § 6653(a). when the issue is whether a taxpayer was negligent in claiming deductions from a tax shelter that are ultimately disallowed for lack of economic substance, reliance on the advice of a professional investment adviser, who is neither a lawyer nor accountant that an investment can be expected to be 410 florida tax review [vol. 9:si profitable, is reasonable, even if the adviser lacks knowledge and experience in the relevant industry, if the adviser investigated the investment in question. 4. the kpmg deal: the price of settling goes up dramatically. ir-2005-83 (8/29/05). the irs and the justice department announced that kpmg llp has admitted to criminal wrongdoing and agreed to pay $456 million in fines, restitution, and penalties as part of an agreement to defer prosecution of the firm. nineteen individuals, chiefly former kpmg partners including the former deputy chairman of the firm [jeffrey stein], as well as a new york lawyer [r.j. ruble] were indicted in the southern district of new york in relation to the “multi-billion dollar criminal tax fraud conspiracy.” several of those indicted were partners in kpmg’s washington national tax group and several of those indicted were practice partners at kpmg. a. judge kaplan refuses to find prosecutorial misconduct in the deferred prosecution agreement. united states v. stein, 428 f. supp. 2d 138 (s.d.n.y. 4/4/06). judge kaplan denied a motion to dismiss based upon alleged prosecutorial misconduct by reason of the alleged manipulation of kpmg in the deferred prosecution agreement. this dpa required the firm “upon pain of corporate death, [to] espouse a governmentapproved version of [the] facts.” judge kaplan based his decision on the ethical provision applicable to all attorneys that prohibits them from coercing witnesses to give false testimony. he further held that nothing in the dpa pressures individual kpmg employees to testify in any particular way, but that the dpa merely requires the firm to disavow any assertion by an affiliated individual that is inconsistent with the dpa’s statement of facts. b. in its post-enron war against white collar crime, the justice department’s notion that what is fair against organized crime is also fair against white collar crime receives a [temporary?] setback. judge kaplan finds prosecutorial misconduct in the use of the thompson memorandum to prevent kpmg from continuing its customary practice of paying attorney’s fees for individuals caught up in controversy by reason of their affiliation with the firm. united states v. stein, 435 f. supp. 2d 330 (s.d.n.y. 6/26/06), as amended, 7/14/06. the court held that the justice department’s thompson memorandum policy [continued from the holder memorandum] of basing a determination of whether a firm is “cooperating” with the government on its refusal (unless compelled by law) to advance legal fees for affiliated individuals unless they in turn fully cooperated with the government, as it was applied by the prosecutors in this case, was an unconstitutional interference with defendants’ ability to use resources that – absent the government’s misconduct – would be otherwise available to them for payment of attorneys’ fees. the resources in question were funds that would have 2009] recent developments in federal income taxation 411 customarily been received by these defendants from kpmg to pay their attorneys. • judge kaplan suggested that the constitutional violation could be rendered harmless if the defendants could successfully force kpmg to pay their legal expenses, and sua sponte instructed the clerk of the district court to open a civil docket number for an expected contract claim by the defendants against kpmg for payment of their defense costs. judge kaplan stated that the court would “entertain the claims pursuant to its ancillary jurisdiction over this case.” the defendants subsequently filed the anticipated complaints against kpmg. • judge kaplan subsequently refused to eliminate from his opinion a statement that prosecutors in the case were “economical with the truth.” he also refused to eliminate from his opinion the names of the prosecutors involved. 2006 tnt 130-10. c. judge kaplan indefinitely postponed the federal criminal trial against 16 former kpmg employees, an outside investment adviser, and a lawyer. united states v. stein, 461 f. supp. 2d 201 (s.d.n.y. 11/13/06). judge kaplan reaffirmed his earlier holding that ancillary jurisdiction existed over the contractual fee dispute between the defendants and kpmg. he rejected kpmg’s argument that the defendant’s claims were foreclosed by written agreements, and found that enforcement of any applicable arbitration clause would be contrary to public policy, because it might interfere with the ability to ensure a speedy trial, could lead to a dismissal of meritorious criminal charges, would endanger the defendants’ rights to a fair trial, and might impose unnecessary costs on taxpayers if the defendants became indigent. judge kaplan cited fears that defendants may be unable to pay their lawyers in further postponing the trial. d. stein v. kpmg, llp, 486 f.3d 753 (2d cir. 5/23/07). the second circuit vacated the district court orders in united states v. stein to the extent that they found jurisdiction over the complaint against kpmg and dismissed the defendants’ complaint against kpmg. the prejudice to kpmg in having these claims resolved in a proceeding ancillary to a criminal prosecution in the southern district of new york is clear. at stake are garden variety state law claims, albeit for large sums. kpmg believed that contractual disputes between it and the appellees would be resolved by arbitration. instead, kpmg is faced with a federal trial of more than a dozen individuals’ multi-million dollar “implied-in-fact” contract claims. moreover, because such a 412 florida tax review [vol. 9:si proceeding is governed by no express statutory authority, the district court has indicated its intention to apply to this expedited undertaking an ad hoc mix of the criminal and civil rules of procedure determined on the fly, as it were. ... first, “the interrelationship of the factual issues underlying the finding of constitutional violations and the asserted contract claims is marginal. ... second, while the ancillary proceeding is a major undertaking, its contribution to the efficient conclusion of the criminal proceeding is entirely speculative. ... third, even if there were constitutional violations and even if kmpg is contractually obligated to advance [defendants’] attorneys’ fees and costs, creating an ancillary proceeding to enforce that obligation was not the proper remedy. ... finally, on the present record, a proceeding ancillary to a criminal prosecution was not necessary either to avoid perceived deficiencies in ordinary civil contract actions to enforce the alleged advancement contracts or to remove some barrier to the [defendants’] bringing of such actions. e. indictment against 13 kpmg defendants dismissed because the government interfered with their sixth amendment right to secure counsel which would have been available to them absent government interference. united states v. stein, 495 f. supp. 2d 390 (s.d.n.y. 7/16/07). judge kaplan dismissed the indictment as to 13 of the 16 defendants who had been affiliated with kpmg at the time of their alleged conduct because the u.s. attorney’s office interfered with their ability to receive payment of their attorneys’ fees from kpmg. the government announced its intention to appeal the dismissal of the 13 defendants, and judge kaplan indicated his intention to proceed with the trial of the remaining five defendants in october 2007. this trial was postponed until 2008. f. judge kaplan’s dismissal of the indictment against 13 former kpmg partners was affirmed by the second circuit. united states v. stein, 541 f.3d 130, (2d cir. 8/28/08). in a resounding opinion, chief judge jacobs agreed with judge kaplan’s analysis that the actions taken by kpmg to “condition[ ], cap[ ] and ultimately cease[ ]” to advance legal fees to defendants constituted “state action” which deprived defendants of their sixth amendment right to counsel because they were the result of the prosecutors’ 2009] recent developments in federal income taxation 413 (mis?)use of the thompson memorandum to overwhelmingly influence kpmg to not follow its past practice “to advance legal fees for employees facing regulatory, civil and criminal investigations without condition or cap” upon pain of a possible indictment of the firm. g. the mcnulty memorandum is not much better than the thompson memorandum. the thompson memorandum [which was based upon the holder memorandum] was replaced on 12/12/06 by the mcnulty memorandum which requires threats to prosecute entities “unless” they do something [e.g., waive attorney client privilege] or “if” they do something [e.g., advance legal fees] to emanate from a higher level of the justice department. • the filip memorandum is close, but no cigar. the mcnulty memorandum was, in turn, replaced on 8/28/08 with the filip memorandum, which purportedly removes the requirements that a firm must waive attorney-client privilege and work product protection in order to receive “cooperation credit.” instead, that determination should be based on “whether the corporation has provided the facts about the events [which putatively constituted misconduct].” also, “mere” participation in a joint defense agreement is to be permitted but such participation should not disable the firm from providing [all] relevant facts to the government. payment of legal fees for employees is permissible unless such payment is “used in a manner that would otherwise constitute criminal obstruction of justice.” • eric holder has been nominated for the post of attorney general in the obama administration. in the era of new politics, it is unlikely that he will receive even half as much scrutiny as did joe the plumber.1 but see, arlen specter & edwin meese iii, “even businessmen deserve a lawyer,” wall street journal, 1/15/09 at a11. 5. jerry cohen outsmarts the government and mitigates taxpayer penalties. alpha i lp v. united states, 102 a.f.t.r.2d 2008-7073 (fed. cl. 11/25/08). the irs issued fpaas that adjusted the partners’ capital gains and losses based on five theories: “(1) section 752; (2) treas. reg. § 1.752-6 (the ‘retroactive regulation’); (3) the transaction or entities were a sham or lacked economic substance; (4) treas. reg. § 1.701-2 (the partnership anti-abuse regulation); and (5) ‘none of the transactions of the partnership increases the amount considered at-risk for an activity under i.r.c. § 465(b)(1).’” the partners “conceded the adjustments on the ground that none of the transactions of the partnerships increased the amount considered at-risk for any activity under section 465(b)(1) and that the at-risk rules would disallow losses and require the partnerships and their partners to recognize gain on the 1. only ira subscribes to this paragraph of the outline. 414 florida tax review [vol. 9:si transactions as set forth in the fpaas.” in addition, the irs asserted that the § 6662 substantial valuation misstatement penalty should apply, but the taxpayers did not concede that issue. rather, the taxpayers argued that valuation misstatement penalties were inapplicable as a matter of law because “any underpayment of tax was not ‘attributable to’ a valuation misstatement, but instead would be attributable to plaintiffs' concession that [the irs’s] adjustments were correct under [§ 465(b)(1)].” the court (judge hewitt) agreed with the taxpayers and held that where adjustments are made on grounds unrelated to valuation, valuation penalties do not apply. the court also rejected the irs’s argument the court lacked jurisdiction to accept the taxpayer’s concession because “there are not any partnership level determinations to be made with respect to § 465.” the court found that the “concession obviate[d] the need to conduct a trial on valuation issues and therefore achieve[d] the very efficiencies and economies that the elimination of penalties sought to encourage. ... to go behind the concession and attempt to assign to it a specific ground would be to engage in an activity that the elimination of penalties is intended to prevent.” the court also refused to accept the irs’s argument that it should consider on the merits the irs’s alternative grounds for the adjustments that were based on valuation, i.e., basis, misstatements, solely for the purposes of determining the applicability of penalties. the court agreed with the taxpayers’ argument “that forcing a ‘trial on alternative grounds for adjustments plaintiffs have already conceded violates the purpose and policy behind the valuation misstatement penalties and is simply a waste of the court’s and the parties’ resources.’” 6. another irs weapon in the tax shelter war. reg160872-04, section 6707 and the failure to furnish information regarding reportable transactions, 73 f.r. 78254 (12/22/08). prop. reg. § 301.6707-1 would reflect the amendments to § 6707 in the american jobs creation act of 2004. a § 6707 penalty may be assessed against each material advisor required to file a return under § 6111 who fails to file a timely return as required under reg. § 301.6111-3(e) or files a return with false or incomplete information. if more than one material advisor is responsible for filing a return under § 6111 with respect to the same reportable transaction, a separate penalty under § 6707 may be assessed against each material advisor who fails to timely file a return or files a return with false or incomplete information. incomplete information means a form 8918, “material advisor disclosure statement” (or successor form), filed with the irs that does not provide the information required under reg. § 301.6111-3(d). failure to timely file or the submission of false or incomplete information is intentional if (1) the material advisor knew of the obligation to file a return, and knowingly did not timely file a return, or (2) filed a return knowing that it was false or incomplete. the proposed regulations provide factors that the irs should take into account during the 2009] recent developments in federal income taxation 415 determination whether to rescind all or a portion of a § 6707 penalty. the list of factors generally follows rev. proc. 2007-21, 2007-9 i.r.b. 613. the regulations will apply to returns the due date of which is after the final regulations are published in the federal register. ix. exempt organizations and charitable giving a. exempt organizations there were no significant developments regarding this topic during 2008. b. charitable giving 1. the potential tax benefits of a charitable contribution “described as offering a ‘huge [tax] windfall’ of ‘150k,’” morphed into a 40% gross valuation misstatement penalty. bergquist v. commissioner, 131 t.c. no. 2 (7/22/08). prior to 2001, the taxpayers provided medical services to the oregon health & science university hospital (ohsu) through their medical professional corporation (ua). following the announcement by ohsu that it would terminate its contracts with various medical professional corporations through which physicians provided services and form its own organization, the oregon health & science university hospital medical group (ohsumg), which thereafter would employ the physicians, the taxpayers contributed most of the stock of ua to ohsumg. the corporation [ua] had no assets other than accounts receivable and had never paid any dividends. after the consolidation was completed, ua would have no doctors and no patients, and ua would not operate other than to collect accounts receivable outstanding as of the date of the consolidation. according to the court’s fact findings, “ohsumg’s executive management accepted the donation of ua stock as a professional courtesy to the ua stockholders. at the time of donation, ohsumg’s management did not expect to derive any economic benefit from the donated ua stock. ohsumg management did not expect to receive and in fact did not receive from ua any dividends or distributions.” ohsumg advised the taxpayers that it was valuing the contribution at zero. twenty six of twenty eight shareholders claimed charitable contributions deduction of $401.79 per share, based on an appraisal. judge swift found that ua was not a going concern at the time of the contribution and allowed a deduction of $37 per share for voting stock and $35 per share for nonvoting stock, which had been conceded by the commissioner based on its expert’s appraisal. the substantial valuation misstatement penalty of § 6662(e) and gross valuation misstatement penalty of § 6662(h) applied, depending, taxpayer-by416 florida tax review [vol. 9:si taxpayer, on whether the deficiency exceed $5,000. the taxpayers did not act in good faith: from the beginning, the plan to donate ua stock on the brink of the january 1, 2002, consolidation was presented to ua stockholders as a way to reap a potential “150k” windfall. petitioners are well educated and surely were cognizant of the imprudence of valuing the ua stock at such a high value given the likelihood that by 2002 ua would no longer be an operating entity. ... petitioners were aware of the january 8, 2002, letter from ohsumg’s president stating that ohsumg had decided to book the donated stock at zero ... . [a] taxpayer will not be considered to have reasonably relied in good faith on advice from an adviser if the advice is based on an ‘unreasonable’ assumption the “taxpayer knows, or has reason to know, is unlikely to be true”. this would appear to be particularly applicable where no adviser is sought out who is truly independent of the planned transaction. 2. proposed regulations on contributions of used underwear, oh yeah and also substantiation requirements. reg-140029-07, substantiation and reporting requirements for cash and noncash charitable contribution deductions, 73 f.r. 45908 (8/7/08). the treasury department has published proposed regulations [prop. regs. §§ 1.170a-15 through 1.170a-18] regarding substantiation and reporting requirements for cash and noncash charitable contributions to reflect the enactment of provisions of the american jobs creation act of 2004 [§ 170(f)(11) and (12)] and the pension protection act of 2006 [§ 170(f)(16) and (17)]. • prop. reg. § 1.170a-15(a) would provide that the substantiation requirements of § 170(f)(17) regarding cash contributions could be met by a monthly bank statement and a photocopy or image obtained from the bank of the front of the check indicating the name of the donee and that a written communication from the charity sufficient to meet the requirement must show the name of the donee, the date of the contribution, and the amount of the contribution. the written communication may be electronic. a contribution made by payroll deduction can be substantiated by (1) a pay stub, form w-2, or other document furnished by the employer that sets forth the amount withheld during the taxable year for payment to a donee, together with (2) a pledge card or other document prepared by or at the direction of the donee organization that shows the name of the donee organization. a receipt is not required for contribution to a charitable remainder trust of less than $250 or for unreimbursed expenses of less than $250 incurred incident to the rendition of services to a charitable organization, but taxpayers should maintain records of the gifts or expenses. prop. reg. § 1.170a-16(c) would provide that for claimed noncash 2009] recent developments in federal income taxation 417 contributions of more than $500 but not more than $5,000, the donor must obtain a contemporaneous written acknowledgment required by § 170(f)(8) and reg. § 1.170a-13(f) and must file a completed form 8283 (section a) with the return on which the deduction is claimed. for claimed contributions of more than $5,000 but not more than $500,000, the donor must obtain (a) a contemporaneous written acknowledgment required by § 170(f)(8) and prop. reg. § 1.170a-13(f), and (b) a qualified appraisal as defined in prop. reg. § 1.170a-17(a)(1) (prepared by a qualified appraiser, as defined in prop. reg. § 1.170a-17(b)(1)), and must file a completed form 8283 (section b), which requires very detailed information about the contribution and the property contributed, with the return on which the deduction is claimed. • prop. reg. § 1.170a-17(a) elaborates on the § 170(f)(11)(e) definition of a qualified appraisal. a qualified appraisal is an appraisal document that is prepared by a qualified appraiser in accordance with generally accepted appraisal standards. under the proposed regulations, generally accepted appraisal standards are the substance and principles of the uniform standards of professional appraisal practice, as developed by the appraisal standards board of the appraisal foundation, see title xi of the financial institutions reform, recovery, and enforcement act of 1989, public law 10173, 103 stat. 183 (12 u.s.c. §§3331-3351). the fee for a qualified appraisal cannot be based to any extent on the appraised value of the property. a qualified appraisal must contain the following declaration by the appraiser: “i understand that my appraisal will be used in connection with a return or claim for refund. i also understand that, if a substantial or gross valuation misstatement of the value of the property claimed on the return or claim for refund results from my appraisal, i may be subject to a penalty under section 6695a of the internal revenue code, as well as other applicable penalties. i affirm that i have not been barred from presenting evidence or testimony before the department of the treasury or the internal revenue service pursuant to 31 u.s.c. section 330(c).” in addition to the statutory exceptions providing that a qualified appraisal is not required for (1) publicly traded securities, and (2) qualified vehicles, if certain conditions have been met, i.r.c. § 170(f)(11)(a)(ii), (3) prop. reg. § 1.170a-16(d)(2) provides exceptions for certain intellectual property (described in §170(e)(1)(b)(iii)), and (4) inventory and property held by the donor primarily for sale to customers in the ordinary course of the donor’s trade or business. • prop. reg. § 1.170a-17(b) would provide a detailed definition of “qualified appraiser” including minimum educational requirements. prop. reg. § 1.170a-16(f)(6) would provide that to satisfy the “reasonable cause” exception to the noncash substantiation requirements, a donor must (1) submit with the return a detailed explanation of why the failure to comply was due to reasonable cause and not to willful neglect and (2) obtain (i) a contemporaneous written acknowledgment and (ii) a qualified appraisal, if applicable. 418 florida tax review [vol. 9:si • prop. reg. § 1.170a-18 would provide more detailed rules regarding limitations under § 170(f)(16) for contributions of used underwear, as well as other clothing and household items. food, paintings, antiques, and other objects of art, jewelry, gems, and collections are not household items. 3. the tax code continues to try to green-up america. the heartland, habitat, harvest, and horticulture act of 2008, extended § 170(b)(1)(e) though 2009. section 170(b)(1)(e) allows an individual (other than a qualified farmer or rancher) to claim a charitable contribution deduction for a qualified conservation contribution to the extent of the excess of 50 percent of the taxpayer’s contribution base over the amount of all other allowable charitable contributions. for an individual who is a qualified farmer or rancher, qualified conservation contributions are allowed up to 100 percent of the excess of the contribution base over the sum of all other allowable charitable contributions. the ceiling for a privately held corporation that is a qualified farmer or rancher is 100 percent of the excess of the corporation’s taxable income over the sum of all other allowable contributions. in all cases, any disallowed qualified conservation contributions may be carried forward for up to 15 years. 4. more computers and books for school children. the emergency economic stabilization act of 2008 extend through 2009 the application of code § 170(e)(6), which permits a corporation to deduct an amount equal to the lesser of (1) basis plus one-half of the item’s appreciation (i.e., basis plus one half of fair market value in excess of basis) or (2) two times basis, for a contribution of computer software, equipment, and peripherals to educational institutions for use in kindergarten through twelfth grade education. the equipment must be previously unused and not more than two years old. the act also extends § 170(e)(3)(d) which provides a similar enhanced charitable contribution deduction for contributions of book inventory by c corporations. 5. whitehouse hotel limited partnership v. commissioner, 131 t.c. no. 10 (10/30/08). the tax court (judge halpern) held that, as a precondition to using the replacement cost approach to valuing real estate, the taxpayer must show that the property is unusual in nature and other methods of valuation, such as comparable sales or income capitalization, are not applicable. the income approach to valuation is favored only where comparable market sales are absent. on the facts, the value of the contribution of a conservation facade easement for an historic structure on the edge of the french quarter in new orleans was overstated. the accuracy-related penalty for gross overvaluation was proper because there was no good faith investigation into the value. 2009] recent developments in federal income taxation 419 6. try again, but the kids’ religious school education is still not deductible even if the irs made a deal with the scientologists. sklar v. commissioner, 549 f.3d 1252 (9th cir. 12/12/08). the ninth circuit (judge wardlaw) followed its prior decision involving different taxable years (sklar v. commissioner (sklar i), 282 f.3d 610 (9th cir. 2002)) and denied the taxpayers’ claimed deductions of a portion of tuition and fees paid to orthodox jewish day schools for the education of their children. the taxpayers argued that deduction of a portion of their tuition payments as charitable contributions for strictly religious services is allowed under the closing agreement with the church of scientology. after convincing the supreme court that fees for training and auditing sessions provided by the church of scientology were paid as a quid pro quo for services rather than deductible charitable contributions (hernandez v. commissioner, 490 u.s. 680 (1989)), the irs allowed the individuals involved to deduct 80 percent of the fees. • the court held under hernandez that tuition paid for religious education is a payment for services that is not deductible as a charitable contribution. the court pointed to statements in hernandez that attempts to distinguish payments for religious benefits from secular services would involve the court in impermissible entanglements between church and state. • the court rejected the taxpayers’ argument that 1993 amendments to §§ 170(f)(8) and 6115 (requiring reporting of the value of benefits received from quid pro quo payments to charities) overruled the hernandez holding that a portion of payments for services are not allowable as a charitable contribution. quoting from sklar i, the court noted that these are procedural provisions that do not revise substantive law. • the taxpayers failed to establish that the fees and tuition payments represented dual payments that included a portion in excess of the value of the education benefit provided by the schools which represented a gift to the religious schools as charitable originations. • finally, the court held that the scientology closing agreement does not require the irs to allow charitable contribution deductions for the taxpayers’ tuition payments. again quoting from sklar i, the court expressed reservations under the establishment clause of the first amendment about the impact of the closing agreement that discriminates among religions. the court also indicated concern that allowing deductions for tuition for attending religious schools would create a preference for religion that is questionable under the establishment clause. in addition, the court concluded that the tuition payments for the taxpayers’ children were not similar to the auditing, training and other qualified religious services provided by the church of scientology. thus, the taxpayers in sklar could not assert an administrative inconsistency claim that the irs favored scientologists over adherents to other religions. 420 florida tax review [vol. 9:si x. tax procedure a. interest, penalties and prosecutions 1. the standard for preparer penalties is broadened to include preparers of all tax returns, and is heightened from “realistic possibility of success” to “more likely than not.” the 2007 small business tax act, § 8246, amended code §§ 6694 and 7701 to expand the applicability of the § 6694 return preparer penalties from “income tax return preparers” to all tax return preparers. it also heightened the standards of conduct to avoid the imposition of the return preparer penalty for undisclosed positions with a requirement that there be a reasonable belief that the tax treatment of the position was “more likely than not” the proper treatment. for disclosed positions, the standard was increased from “non-frivolous” to “reasonable basis.” penalty amounts were increased from $250 to the greater of $1,000 or 50 percent of the income to be derived by the preparer under § 6694(a) [negligent], and from $1,000 to the greater of $5,000 or 50 percent of the income to be derived by the preparer under § 6694(b) [willful or reckless]. these changes are effective for tax returns prepared after 5/25/07. a. but practitioners were given a pass under the new rules for 2007. notice 2007-54, 2007-27 i.r.b. 12 (6/11/07). this notice provided transitional relief for all returns, amended returns and refund claims due on or before 12/31/07, to estimated tax returns due on or before 1/15/08, and to employment and excise tax returns due on or before 1/31/08. the transitional relief was that the standards set forth under previous law and current regulations would be applied in determining whether the irs would impose penalties under § 6694(a), but the transitional relief was not available for penalties under § 6694(b), which applies to return preparers who exhibit “willful or reckless conduct.” b. placeholder proposed circular 230 regulations. reg-138637-07, regulations governing practice before the internal revenue service, 72 f.r. 54621 (9/26/07). these proposed regulations would amend the circular 230 standards of practice, § 10.34 to conform with the § 6694 provisions in the 2007 small business tax act. deborah butler, irs associate chief counsel (procedure and administration), has stated that the proposed regulation contains merely “placeholder language,” and that the government will first get out § 6694 guidance before considering whether the historical linkage between § 6694 and circular 230 remains appropriate. c. three subsequent notices clarified notice 2007-54. 2009] recent developments in federal income taxation 421 (1) 2007 tax advice given by nonsigning preparers. notice 2008-11, 2008-3 i.r.b. 279 (1/2/08). this notice provides that advice given before 1/1/08 by nonsigning preparers will be governed by standards under former § 6694. (2) which returns require a preparer signature? notice 2008-12, 2008-3 i.r.b. 280 (1/2/08). this notice specifies which returns require a preparer signature and which returns do not. (3) a notice temporarily relaxes the requirements on practitioners, but it is puzzling in places and is not a free pass. notice 2008-13, 2008-3 i.r.b. 282 (1/2/08). this notice provides interim guidance on the application of the tax return preparer penalties as amended by the 2007 small business tax act. these amendments did not modify the exception to liability under § 6694 that is applicable when it is shown, considering all the facts and circumstances, that the tax return preparer has acted in good faith and there is reasonable cause for the understatement. d. proposed tax return preparer regulations anticipated to be effective after 2008. reg-129243-07, tax return preparer penalties under sections 6694 and 6695, 73 f.r. 34560 (6/17/08). proposed regulations under §§ 6694 and 6695 (as well as under §§ 6060, 6107, 6109, 6696 and 7701(a)(36)) would implement the amendments made by § 8246 of the small business and work opportunity tax act of 2007. the proposed regulations provide that the “reasonable belief that the position would more likely than not be sustained on its merits” standard is satisfied if the tax return preparer analyzes the pertinent facts and authorities and, in reliance upon that analysis, reasonably concludes in good faith that the position has a greater than 50 percent likelihood of being sustained on its merits. prop. reg. § 1.66942(b)(1). the test is applied on the date the return is prepared. prop. reg. § 1.6694-2(b)(6). whether a tax return preparer met this standard is determined based upon all the facts and circumstances, including the tax return preparer’s due diligence. the conclusion cannot be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. prop. reg. § 1.6694-2. the possibility that the position will not be challenged by the irs, because the taxpayer’s return may not be audited or because the issue may not be raised on audit, cannot be considered. • substantial authority plus a chat is all that will be required. the more-likely-than-not rule is administratively relaxed, as it was in notice 2008-13, and is replaced by a standard of a position that will not result in taxpayer penalties plus a discussion with the client about taking a position that would not result in a preparer penalty provided that the discussion is memorialized in a non-boilerplate manner. 422 florida tax review [vol. 9:si • if a signing tax return preparer does not believe that a position is more likely than not, the requirements of § 6694 could be satisfied by disclosure in one of five ways. prop. reg. § 1.6694-2(c)(3)(i). (1) the position may be disclosed on a properly completed and filed form 8275, disclosure statement, or form 8275-r, regulation disclosure statement, as appropriate, or on the tax return in accordance with the annual revenue procedure. [see, e.g., rev. proc. 2008-14, 2008-7 i.r.b. 435]. (2) if there is a “reasonable basis” (as defined in reg. § 1.16623(b)(3)) but there is not “substantial authority” (as defined in reg. § 1.66624(d)) for the position, disclosure is adequate if the tax return preparer provides the taxpayer with a prepared tax return that includes the appropriate disclosure. (3) if there is “substantial authority” for the position, disclosure is adequate if the tax return preparer advises the taxpayer of all of the penalty standards applicable to the taxpayer under § 6662. (4) if the position involves a tax shelter, as defined § 6662(d)(2)(c), or a reportable transaction to which § 6662a applies, disclosure is adequate if the tax return preparer advises the taxpayer that (i) there must be “substantial authority” for the position, (ii) the taxpayer must possess a “reasonable belief that the tax treatment [on the return] was more likely than not” the proper treatment, and (iii) disclosure will not protect the taxpayer from assessment of an accuracy-related penalty. (5) for tax returns or claims for refund that are subject to penalties other than the accuracy-related penalty for substantial understatements under sections § 6662(b)(2) and (d), the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer under § 6662. the fifth rule addresses situations in which the penalty standard applicable to the taxpayer is based on compliance with requirements other than disclosure on the return. • if the position was not actually disclosed on the return, to establish that the tax return preparer’s disclosure obligation was satisfied under alternatives (2) through (5), the tax return preparer must contemporaneously document in his files that the required information or advice was provided to the taxpayer. • in the case of a nonsigning tax return preparer (as defined in prop. reg. § 301.7701-15(b)(2), a position that is not more likely than not correct, but for which there is a reasonable basis, may be disclosed in one of three ways. prop. reg. § 1.6694-2(c)(3)(ii). (1) the position may be disclosed on a properly completed and filed form 8275, disclosure statement, or form 8275-r, regulation disclosure statement, as appropriate, or on the tax return in accordance with the annual 2009] recent developments in federal income taxation 423 revenue procedure. (2) the nonsigning tax return preparer advises the taxpayer of all opportunities to avoid penalties under § 6662 that could apply to the position and advises the taxpayer of the standards for disclosure to the extent applicable, and contemporaneously documents in his files that this advice was provided. (3) the nonsigning tax return preparer advises another tax return preparer that disclosure under § 6694(a) may be required, and contemporaneously documents in his files that this advice was provided. • for both signing and nonsigning return preparers, if a position for which there is a “reasonable basis” but for which the tax return preparer does not have a “reasonable belief that the position would more likely than not be sustained on the merits” is not disclosed on or with the return, each return position must be addressed by the tax return preparer. prop. reg. § 1.6694-2(c)(3)(iii). the advice to the taxpayer with respect to each position must be particular to the taxpayer and tailored to the taxpayer’s facts and circumstances. • a signing tax return preparer is any tax return preparer who signs or who is required to sign a return or claim for refund as a tax return preparer. prop. reg. § 301.7701-15(b)(1). a “nonsigning return preparer is a person who renders tax advice on a position that is directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim for refund will be regarded as having prepared that entry, even if the person does not sign the return. prop. reg. § 301.7701-15(b)(2) and (3). whether a schedule, entry, or other portion of a return or claim for refund is a substantial portion is determined based upon whether the person rendering the tax advice knows or reasonably should know that the tax attributable to the schedule, entry, or other portion of a return or claim for refund is a substantial portion of the tax required to be shown on the return or claim for refund. prop. reg. § 301.770115(b)(3). a de minimis exception applies for nonsigning preparers if the item giving rise to the understatement is less than (1) $10,000, or (2) less than $400,000 if the item is also less than 20 percent of the taxpayer’s gross income (or, for an individual, the individual’s adjusted gross income). reg. § 301.7701-15(b)(3)(ii). • write up your hours heavily during the planning process, but bill by the minute after the events have occurred. time spent on advice that is given after events have occurred that represents less than 5 percent of the aggregate time incurred by such individual with respect to the position(s) giving rise to the understatement is not taken into account in determining whether the individual is a return preparer. prop. reg. § 301.770115(b)(2). like the current regulations, the proposed regulations provide that the § 6694 penalty can be avoided if, considering all the facts and circumstances, the preparer demonstrates that the understatement was due to reasonable cause and that the tax return preparer acted in good faith. prop. reg. § 1.6694-2(d). the proposed 424 florida tax review [vol. 9:si regulations provide that one of the factors that can avoid the penalty is that the preparer “reasonably relied in good faith on generally accepted administrative or industry practice in taking the position that resulted in the understatement.” prop. reg. § 1.6694-2(d)(6). this factor does not appear in the current regulations. “[f]or purposes of determining whether the tax return preparer has a reasonable belief that the position would more likely than not be sustained on the merits, a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, advisor, other tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer’s firm).” a preparer may rely in good faith without verification upon a tax return that has been previously prepared by a taxpayer or another tax return preparer and filed with the irs, but may not ignore implications of information actually known by the preparer; preparer may not rely on information provided by a taxpayer with respect to legal conclusions on federal tax issues. prop. reg. § 1.6694-2(b)(1); prop. reg. § 1.6694-1(e). “[a] position must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. for example, a position must not be based on a representation or assumption that the tax return preparer knows, or has reason to know, is inaccurate.” prop. reg. § 1.6694-2(b)(2). • the proposed regulations provide that a tax return preparer has not recklessly or intentionally disregarded a rule or regulation if the position contrary to the rule or regulation has a “reasonable basis” and is adequately disclosed as provided in the proposed § 6694 regulations. reg.§ 1.6694-3(c)(2). a position contrary to a regulation must represent a good faith challenge to the validity of the regulation and the return preparer must identify the regulation being challenged. in the case of a position contrary to a revenue ruling or notice, a tax return preparer also is not considered to have recklessly or intentionally disregarded the ruling or notice if the preparer reasonably believes that the position would more likely than not be sustained on its merits. reg. § 1.6694-3(c)(3). • simplicity is replaced by complexity in determining who within a firm is the preparer. the one-preparer-per-firm rule will be abolished in favor of a one-preparer-per-position scheme. a signing tax return preparer will be considered to be the person who is primarily responsible for all the positions on the return unless another person within that same firm was primarily responsible for the positions. similarly, for a nonsigning tax return preparer, the person with overall supervisory responsibility for the position(s) giving rise to the understatement is the tax return preparer. this substitutes a “facts and circumstances” inquiry for a clear rule. e. “god’s in his heaven, all’s right with the world.” the tax extenders and alternative minimum tax relief act of 2009] recent developments in federal income taxation 425 2008, § 506, brings the standard for the § 6694 tax return preparer penalty for undisclosed positions into line with the taxpayer standard, i.e., substantial authority. it penalizes the taking of an “unreasonable position,” which is defined as a position “unless there is or was substantial authority for the position” or is a disclosed position “unless there is a reasonable basis for the position.” for tax shelters and reportable transactions, the position is an “unreasonable position … unless it is reasonable to believe that the position would be more likely than not be sustained on its merits.” the provision contains a reasonable-cause-and-goodfaith exception. it is retroactive to 5/22/07, except that the tax shelter provision applies to returns prepared for taxable years ending after 10/3/08. f. notice 2009-5, 2009-3 i.r.b. 309 (12/15/08), modifying and clarifying notice 2008-13, 2008-3 i.r.b. 282. this notice provides guidance on the implementation of the tax return preparer penalty as amended by the tax extenders and alternative minimum tax relief act of 2008. • the notice states that “‘substantial authority’ has the same meaning as in [reg.] § 1.6662-4 (d) (2)” and that “[s]olely for purposes of section 6694(a), a tax return preparer nevertheless will be considered to have met the standard in section 6694(a)(2)(a) if the tax return preparer relies in good faith and without verification on the advice of another advisor, another tax return preparer, or other party.” • for tax shelter transactions, until further guidance is issued, solely for purposes of section 6694(a), a position with respect to a tax shelter (as defined in section 6662(d)(2)(c)(ii)) will not be deemed an “unreasonable position” described in section 6694 (a) (2) (a) through (c) if there is substantial authority for the position and the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer in the event that the transaction is deemed to have a significant purpose of federal tax avoidance or evasion. this advice to the taxpayer must explain that, if the position has a significant purpose of tax avoidance or evasion, then there needs to be at a minimum substantial authority for the position, the taxpayer must possess a reasonable belief that the tax treatment was more likely than not the proper treatment in order to avoid a penalty under section 6662(d) as applicable, and disclosure in accordance with § 1.66624(f) will not protect the taxpayer from assessment of an accuracy-related penalty if section 6662(d)(2)(c) applies to the position. the tax return preparer must contemporaneously document the advice in the tax return preparer’s files. 426 florida tax review [vol. 9:si if a nonsigning tax return preparer provides advice to another tax return preparer regarding a position with respect to a tax shelter (as defined in section 6662 (d) (2) (c) (ii)), the position will not be deemed an “unreasonable position” described in section 6694 (a) (2) (a) through (c) if there is substantial authority for the position and the nonsigning tax return preparer provides a statement to the other tax return preparer about the penalty standards applicable to the tax return preparer under section 6694. contemporaneously prepared documentation in the nonsigning tax return preparer’s files is sufficient to establish that the statement was given to the other tax return preparer. if a nonsigning tax return preparer and other tax return preparer are employed by the same firm, then contemporaneous documentation of advice provided by any tax return preparer in that firm to the taxpayer regarding applicable penalty standards, as described in the immediately preceding paragraph, is also sufficient to establish that the statement was given by a nonsigning tax return preparer to the other tax return preparers within the firm. the above interim penalty compliance rules do not apply to a position described in section 6662a (a reportable transaction with a significant purpose of federal tax avoidance or evasion or a listed transaction). • the effective dates of this notice are as follows. for positions other than tax shelters and reportable transaction positions, this notice is effective for all advice rendered or returns, amended returns, and claims for refund prepared after may 25, 2007. the interim guidance in this notice for tax shelters (within the meaning of section 6662(d)(2)(c)(ii)) and reportable transactions to which section 6662a applies is effective for tax shelter and reportable transaction positions on tax returns for taxable years ending after the 2008 act’s date of enactment, october 3, 2008. g. despite the amended statute, irs and treasury still release final tax return preparer penalty regulations. t.d. 9436, tax return preparer penalties under sections 6694 and 6695, 73 f.r. 78430 (12/22/08). the proposed regulations were largely left intact, with provisions reserved for the changes made in 2008, i.e., the reduction of the standard for undisclosed positions to one of “substantial authority.” 2009] recent developments in federal income taxation 427 • preparer per position. the final regulations maintain a framework defining “a ‘preparer per position within a firm’” with a presumption that “the nonsigning tax return preparer within the firm with overall supervisory responsibility for the position(s) giving rise to the understatement generally will be considered the tax return preparer who is primarily responsible for the position.” if the information presented “would support a finding that either the signing tax return preparer or a nonsigning tax return preparer within a firm is primarily responsible,” then the irs may assess the penalty against either, but not against both. • may rely on taxpayer’s legal conclusions. the rule that a tax return preparer may not rely on legal conclusions regarding federal tax issues furnished by taxpayers was removed from the final regulations with the caveat that tax return preparers nevertheless have to meet the diligence standards otherwise imposed. • estimates. the final regulations will not include any general rule regarding the use of estimates. • opportunity for disclosure. nonsigning preparers must advise clients of the opportunity to avoid penalties for positions for which there is a reasonable basis but not substantial authority by making appropriate disclosure. • anti-abuse exception to 5-percent rule. the final regulations contain an anti-abuse rule which provides that if a tax professional is abusing the 5-percent rule to avoid tax return preparer status by deliberately performing all the return preparation work before the transaction takes place, then the rule is inapplicable. 1. rev. proc. 2009-11, 2009-3 i.r.b. 313 (12/15/08). this revenue procedure identifies the returns that are subject to the § 6694(a) penalty. it is effective 1/1/09 and renders obsolete notice 2008-12 and notice 2008-46 and modifies and supersedes the list of forms in notice 2008-13. 2. increased penalty for failure to file on time. for returns required to be filed after december 31, 2008, the heroes earnings assistance and relief tax act of 2008 increases the minimum penalty failure to file a return on time to the lesser of $135 or 100 percent of the tax required to be shown on the return. 3. you do the crime, you do time! one year in a halfway house, five years probation, and a $10,000 fine is too lenient. united states v. taylor, 499 f.3d 94 (1st cir. 8/17/07). in an opinion by judge torruella, the first circuit vacated a tax return preparer’s sentence of one year in a half-way house, five years probation and a $10,000 fine as unreasonably lenient, and remanded the case for resentencing. the tax return preparer, who 428 florida tax review [vol. 9:si was a full time school teacher and part time return preparer, was convicted on sixteen counts of aiding and abetting the filing of false returns, resulting from false claims of charitable contributions in amounts ranging from $9,000 to $16,000, about which he advised his clients to lie to irs agents. the court noted, that the “offense ... is a serious crime ... at its heart, it is theft, specifically theft of money to which the public is entitled,” and that “the tax fraud committed here was not part of an indigent’s effort to avoid personal tax liability, but rather, the supplemental business of a moderately successful man who misled his clients.” a. then again, maybe you don’t have to do time for a tax crime. taylor v. united states, 128 s. ct. 8783 (1/7/08). the supreme court vacated the judgment and remanded the case to the first circuit court of appeals for further consideration in light of gall v. united states, 128 s. ct. 586 (2007), which held that there is no rule that requires “extraordinary” circumstances to justify sentence outside guidelines range. 4. déjà vu. united states v. carlson, 498 f.3d 761 (8th cir. 8/20/07). a non-prison sentence for a conviction [pursuant to a guilty plea] under § 7202 for willful failure to pay over trust fund taxes was vacated as too unreasonably lenient under the sentencing guidelines. the case was remanded for resentencing. 5. and baby makes three. united states v. tomko, 498 f.3d 157 (3d cir. 8/20/07). a sentence of one year of home confinement, “the very mansion built through the fraudulent tax evasion scheme at issue,” a $250,000 fine, three years probation, and 250 hours of community service for evading taxes of $228,557, was vacated as unreasonably lenient. the case was remanded for resentencing. a. but the court has second thoughts about jailing tax cheats. rehearing granted and opinion vacated, 513 f.3d 360 (3d cir. 1/17/08), rehearing, en banc granted, 538 f.3d 644 (3d cir 8/19/08). 6. but will he be a “survivor” in the u.s. court for the district of rhode island? a justice department news release, dated 9/8/05, announced that richard hatch was indicted on charges of tax evasion for failing to report about $1,037,000 dollars of income from the television reality series and about $391,000 of income from other sources. he was convicted on 1/25/06, 2006 tnt 17-6. a. the first circuit says “down the hatch,” or is it “up the chute”? united states v. hatch, 514 f.3d 145 (1st cir. 2/1/08), cert. denied 129 s. ct. 103 (10/6/08). the first circuit (judge campbell) 2009] recent developments in federal income taxation 429 affirmed survivor richard hatch’s convictions on three counts of filing false tax returns omitting his winnings from survivor in violation of §§ 7201 and 7206(1), as well as his sentence of 51 months. hatch never supplied any predicate evidence or testified at trial about why he believed he had a deal with the show’s producers that they, rather than he, would pay the taxes on his winnings. his sentence was also affirmed. the court of appeals rejected his argument that the trial court otherwise erred by imposing a perjury enhancement; the record showed multiple instances of perjury. 7. it is not criminal tax fraud if you intended to cheat but after the fact discover a rationale that might disprove the existence of any deficiency. justice souter emphasizes that transactions should be treated in accordance with their substance, regardless of the intent of their participants. boulware v. united states, 128 s. ct. 1168 (3/3/08) (9-0). michael boulware was convicted on nine counts of tax evasion and filing a false income tax return, stemming from his diversion of funds from hawaiian isles enterprises (hie), a closely held corporation of which he was the president, founder, and controlling (though not sole) shareholder. the supreme court emphasized the necessity of a tax deficiency as an essential element of tax evasion under § 7201 in reversing the taxpayer’s conviction. boulware involved a shareholder of a closely held corporation who failed to report millions of dollars from the corporation. “[h]e siphoned off this money primarily by writing checks to employees and friends and having them return the cash to him, by diverting payments by hie customers, by submitting fraudulent invoices to hie, and by laundering hie money through companies in the kingdom of tonga and hong kong.” the funds were used to support his “lavish lifestyle,” and were treated as distributions of property to him from the corporation. boulware sought to introduce evidence that hie had no earnings and profits in the relevant taxable years and because the amount diverted did not exceed his basis for his stock, there was no dividend under §§ 301(c)(1) and 316, and the entire amount was a return-of-capital treatment under § 301(b)(2). boulware’s argument was that because the return of capital was nontaxable, the government could not establish the tax deficiency required as an element of criminal tax fraud. the trial court refused to admit the proffered evidence, and the ninth circuit affirmed, reasoning that the return of capital theory could be advanced only if at the time the distribution occurred the corporation intended it to be a return of capital, following its prior decision in united states v. miller, 545 f.2d 1204 (9th cir. 1976). the supreme court (justice souter) vacated the conviction. the court concluded: there is no criminal tax evasion without a tax deficiency, ... and there is no deficiency owing to a distribution (received with respect to a corporation’s stock) if a corporation has no earnings 430 florida tax review [vol. 9:si and profits and the value distributed does not exceed the taxpayer-shareholder’s basis for his stock. • with respect to the intent question the court reasoned as follows: miller’s view that a criminal defendant may not treat a distribution as a return of capital without evidence of a corresponding contemporaneous intent sits uncomfortably not only with the tax law’s economic realism, but with the particular wording of §§ 301 and 316(a), as well. as those sections are written, the tax consequences of a “distribution by a corporation with respect to its stock” depend, not on anyone’s purpose to return capital or to get it back, but on facts wholly independent of intent: whether the corporation had earnings and profits, and the amount of the taxpayer’s basis for his stock. • the court stated the test to be “that economic substance remains the right touchstone for characterizing funds received when a shareholder diverts them before they can be recorded on the corporation’s books,” and that they “may be seen as dividends or capital distributions for purposes of §§ 301 and 316(a).” it analyzed the treatment of distributions received with respect to a corporation’s stock under § 301(a) and concluded that an exception for criminal cases was improper, and concluded the implausibility of a statutory reading that either creates a tax limbo or forces resort to an atextual stopgap is all the clearer from the ninth circuit’s discussion in this case of its own understanding of the consequences of miller’s rule: the court openly acknowledged that “imposing an intent requirement creates a disconnect between civil and criminal liability,” 470 f.3d at 934. in construing distribution rules that draw no distinction in terms of criminal or civil consequences, the disparity of treatment assumed by the court of appeals counts heavily against its contemporaneous intent construction (quite apart from the circuit’s understanding that its interpretation entails criminal liability for evasion without any showing of a tax deficiency). • in footnote 7 to the opinion the court cited isenbergh, “review: musings on form and substance in taxation,” 49 u. chi. l. rev. 859 (1982), for the proposition that the tax consequences of a transaction should depend on what was actually done, and not on whether alternative routes would have offered better or worse tax consequences. • the court declined to address the government’s alternative argument that diversion was an unlawful act akin to embezzlement, rather than a distribution with respect to the corporation’s stock, 2009] recent developments in federal income taxation 431 which would result in §§ 301 and 316 being irrelevant and give rise to deficiency for failure to report the proceeds of a theft, because that question had not been considered by the court of appeals. 8. lying in the oic got the taxpayer 46 months in the big house. united states v. miller, 520 f.3d 504 (5th cir. 3/18/08), cert. denied 129 s. ct. 185 (10/6/08). the fifth circuit (judge higginbotham) upheld the taxpayer’s [nontaxpayer’s?] conviction under § 7201 for attempting to evade payment of his tax liabilities. the taxpayer owed over $2 million of taxes, interest and penalties. after surreptitiously transferring over $1 million of assets to offshore accounts, he filed an offer in compromise based on doubt as to collectability, in which he claimed that because he had insufficient assets and income he could only afford to pay $7,500. even though after the fact the taxpayer discovered that the $1 million had “disappeared” – maybe you can’t trust people who promise to hide your money for you while you’re committing tax fraud – at the time he filed the offer in compromise, “he believed he had $1 million squirreled away overseas.” • query whether making a statement that is literally true, i.e., that the transferred money was not available to pay his tax obligations, can be criminal? 9. it’s no defense to a criminal failure to pay charge that you squandered the money and couldn’t have paid it you wanted to. united states v. easterday, 539 f.3d 1176 (9th cir. 8/22/08). the defendant was convicted under § 7202 for willful failure to pay over withheld employee payroll and income taxes. he had requested “an ‘ability to pay instruction’ in order to contend to the jury that his failure to pay over the taxes he owed was not ‘willful,’ because he had spent the money on other business expenses and therefore could not pay it to the government when it was due,” but the district court refused to give the instruction. the ninth circuit affirmed, overruling its prior decision to the contrary in united states v. poll, 521 f.2d 329 (9th cir. 1975), on the ground that the subsequent supreme court decision in united states v. pomponio, 429 u.s. 10 (1976), by implication repudiated any requirement of proving ability to pay as an element of the crime of willful failure to pay. possession of sufficient funds to pay the tax is not an element of the crime of under § 7202 (or § 7203). a conviction will be sustained without any showing of the taxpayer’s ability to pay and a taxpayer is not entitled to a jury instruction that to support a conviction the government must prove that the taxpayer could have paid the tax. 10. steven n.s. cheung, inc. v. united states, 545 f.3d 695 (9th cir. 9/23/08). the flush language of § 6621(a)(1) provides for a one and a half point reduction in the overpayment rate, from 2 points above the 432 florida tax review [vol. 9:si federal short term rate to ½ point above the federal short term rate, if an overpayment of tax by a corporation exceeds $10,000. the ninth circuit held that the flush language of § 6621(a)(1) applies to interest payable by the government to a corporate taxpayer pursuant to a wrongful levy judgment. 11. williams v. commissioner, 131 t.c. no. 6 (10/2/08). because § 6404(e) authorizes the commissioner to “abate the assessment” of interest, § 6404(e) operates only after there has been an assessment of interest; thus, tax court has no jurisdiction under § 6404(h) to review the irs’s decision not to abate interest until interest has been assessed and the irs has mailed a “final determination not to abate such interest.” nor does the tax court have jurisdiction to review the assessment of foreign bank account reporting (fbar) penalties imposed under 31 u.s.c. § 5321(a) (and assessed under 31 u.s.c.) for violations of the reporting requirements in 31 u.s.c. under the statute, fbar penalties are assessed without a deficiency notice – a deficiency notice is neither authorized under § 6212(a) nor required by § 6213(a) before the assessment may be made. 12. he was convicted of criminal tax fraud, but in the civil case, the irs couldn’t prove any of over $200,000 deficiency was due to fraud, so judge holmes “estimates” $500 of the deficiency due to fraud in order to avoid inconsistency. barrow v. commissioner, t.c. memo. 2008264 (11/25/08). because the irs issued the deficiency notice more than three years after return filing date, the deficiency notice was timely only if the understatement of tax was fraudulent. the taxpayer had been convicted of criminal tax fraud with respect to taxable years 1985, 1987, and 1988. in the criminal trial, the government’s primary theory was that barrow had cheated on his taxes by not reporting on his individual returns fees that two health care organizations paid to him as the chairman of the board and a trustee. in the civil action, however, the government’s theory was that barrow’s unreported income was income diverted from the incorporated accounting firm that he headed (because the government also was seeking a deficiency against the accounting firm). the government argued that barrow was collaterally estopped from arguing that the understatement was not fraudulent. the tax court (judge holmes) upheld that taxpayer’s argument that because the government’s theory with respect to the unreported fees was different in the civil action than in the criminal action, the issues in that regard were not identical — a requirement for collateral estoppel to apply — with respect to the two actions, but that barrow nevertheless was collaterally estopped from arguing that the understatement was not fraudulent because there were “relatively minor items of unreported income or incorrect expenses whose consequences for barrow’s tax liability are unaffected by the switch in government theories between the cases.” because in the criminal trial, the government established willful tax evasion beyond a 2009] recent developments in federal income taxation 433 reasonable doubt, but the jury was not required to return a verdict detailing which items of income had not reported or which claimed expenses had not been paid, collateral estoppel applied with respect to the entire claimed deficiency. however, on the merits, judge holmes found that even though in the criminal case the government proved beyond a reasonable doubt that some part of barrow’s underpayments for 1987 and 1988 were due to fraud, in the civil case the commissioner failed to prove that any particular underpayments were actually due to fraud. recognizing that “it would be inconsistent to hold no part of the underpayment due to fraud,” judge holmes “estimate[d] that $500 in 1987 and 1988 was due to fraud for purposes of applying the fraud penalty. but because no part of any underpayments for 1984 or 1986 (the accounting firm’s 1988 and 1989 deficiencies) was due to fraud, the commissioner’s determination for those years was not sustained. b. discovery: summonses and foia 1. an attorney can be compelled to testify if the client uses him to submit fraudulent documents to the irs. united states v. cleckler, 265 fed. appx. 850, cert. denied 128 s. ct. 2976 (6/23/08). (11th cir. 2/19/08). in a criminal fraud prosecution, the defendant’s attorney was properly compelled to testify about a conversation he had with the defendant in the course of a civil audit of the taxpayer’s businesses’ incomes that led to taxpayer submitting fabricated documents to the irs through his attorney. the attorney had told the defendant that it would be helpful to document any sales by one of the businesses. the attorney received documentation (including invoices and deposit slips) from the defendant and produced them to the irs. when the irs agent requested additional documentation to support the submitted invoices, the attorney asked the defendant if he had any additional documentation, and the defendant provided the fabricated documentation. the attorney was properly required to testify about the content of the conversation that resulted in the production of the fabricated documentation. 2. the work product privilege claim didn’t work, but the § 7525 privilege claim did. valero energy corp. v. united states, 100 a.f.t.r.2d 2007-6473 (n.d. ill. 8/23/07). valero sought to quash summonses issued by the irs to valero’s tax advisor, arthur andersen, relating to certain branch transactions, foreign currency transactions, dual consolidated losses, overall foreign losses, and hedge positions in connection with fluctuation risks. the court (judge kennelly) rejected valero’s claim that the documents were protected by the work product doctrine. he found that the documents were “best categorized as having been prepared during the ordinary course of business, with the possibility of future litigation being secondary at most.” he concluded that “valero confuse[d] the possibility of litigation with the requirement that to be 434 florida tax review [vol. 9:si protected, a document must have been prepared because of anticipated litigation. the fact that valero hired arthur andersen with an eye toward the complex nature of the transaction, and the possibility that the irs might investigate, does not support a contention that arthur andersen prepared its materials because valero or andersen anticipated actual litigation.” [under seventh circuit precedent, the work product doctrine applies only when “the document can fairly be said to have been prepared or obtained because of the prospect of litigation.” logan v. commercial union ins. co., 96 f.3d 971, 976–77 (7th cir. 1996) (emphasis in original).] however, the documents were protected under the § 7525 tax practitioner’s privilege as “confidential tax advice.” even though it had the effect of avoiding federal income taxes, the tax shelter exception in § 7525(b) did not apply for two reasons. first, “the transactions in question did not involve the promotion of tax shelters;” nothing in the record indicated that arthur andersen had anything to do with “promotion” of participation in a tax shelter. second, the tax shelter exception only applies to a transaction in which tax avoidance is a “significant purpose,” and not where tax avoidance is merely “one of the purposes” of the transaction. nothing in the record indicated the purpose of the transactions. [under seventh circuit precedent, united states v. bdo seidman, llp, 492 f.3d 806 (7th cir. 6/2/07), “the burden rests on the opponent of the privilege to prove preliminary facts that would support a finding that the claimed privilege falls within an exception.”] a. valero energy corp. v. united states, 102 a.f.t.r.2d 2008-5916 (n.d. ill. 8/1/08), on reconsideration, 102 a.f.t.r.2d 2008-5929 (n.d. ill. 8/26/08). on the government’s motion for entry of a further order of an irs summons issued to valero’s tax advisors, arthur andersen, llp, and after an in camera inspection of the requested documents, judge kennelly held that the government “met its burden of showing a foundation in fact that the transactions involved a tax shelter” so the lion’s share of the documents are not privileged. the court refused to construe the word “promotion” in § 7252(b) narrowly, and held that “promotion” includes participation in the organization or sale of a tax shelter. 3. a district court agrees that tax accrual work workpapers are protected by the work product doctrine. regions financial corp. v. united states, 101 a.f.t.r.2d 2008-2179 (n.d. ala. 5/8/08), appeal dismissed on government’s motion, 12/30/08. judge proctor held that the taxpayer’s tax accrual work workpapers were protected by the work product privilege and did not have to be turned over pursuant to an irs summons. he rejected the government’s argument that the eleventh circuit had adopted the fifth circuit’s “primary motivating purpose” test, but nevertheless found that high standard to have been satisfied. he applied the reasoning of the court in united states v. textron, 507 f. supp. 2d 138 (d. r.i. 2007). “were it not for 2009] recent developments in federal income taxation 435 anticipated litigation, regions would not have to worry about contingent liabilities and would have no need to elicit opinions regarding the likely results of litigation. ... it is clear in this case that regions was primarily motivated by litigation when it solicited opinions about the potential outcomes of litigation from alston & bird and e&y. the fact that regions undertook the time and expense of consulting outside firms to assess its potential liabilities shows that it believed litigation to be likely, and this court cannot say that regions’ subjective belief was objectively unreasonable.” he rejected the government’s argument that the workpapers were not protected, i.e., “‘regions has not offered any proof that the [documents] were not created, used by or available for use by the independent auditors of regions’[s] public financial statements,’” on the ground that there is “no support for the conclusion that a party must show that it was motivated by preparation for litigation and nothing else in order to claim that a document is protected work product.” (emphasis in original). 4. t.d. 9395, suspension of statutes of limitations in third-party and john doe summons disputes and expansion of taxpayers’ rights to receive notice and seek judicial review of third-party summonses, 73 f.r. 23342 (4/30/08). the treasury has promulgated final regulations, regs. §§ 301.7603-1, 301.7603-2, and 301.7609-1 through 301.7609-5, regarding the service of third-party record-keepers summonses, the expanded class of thirdparty summonses subject to notice requirements and other procedures, and the suspension of periods of limitations if a court proceeding is brought involving a challenge to a third-party summons, or if a third party’s response to a summons is not finally resolved within six months after service. 5. the irs now permanently can rat out terrorists. the emergency economic stabilization act of 2008 made permanent the § 6103(i)(3) exception for terrorists to the return confidentiality rules. 6. you can’t quash a summons on a tax advisor just because he’s the one who has been referred to the justice department for criminal prosecution. khan v. united states, 548 f.3d 549 (7th cir. 11/20/08). the court upheld the validity of reg. § 301.7602-1(c)(1), which limits the application of the § 7602(d)(1) bar on the irs summons only when there is a justice department referral of the person whose tax liability is at issue. section 7602(d) does not authorize quashing a summons on a third party tax advisor in connection with an investigation of taxpayer’s liability even if there had been a justice department referral with respect to the tax advisor. 436 florida tax review [vol. 9:si c. litigation costs there were no significant developments regarding this topic during 2008. d. statutory notice of deficiency there were no significant developments regarding this topic during 2008. e. statute of limitations 1. existence of a durable power of attorney forecloses tolling of the statute of limitations under § 6511(h). bova v. united states, 80 fed. cl. 449 (2/13/08). section 6511(h) tolls the statute of limitations on filing refund claims for any period that the taxpayer is unable to manage his financial affairs by reason of a medically determined physical or mental impairment that will result in death or that has lasted or can be expected to last at least twelve months, unless another person has been authorized to manage the taxpayer’s financial affairs. the court (judge firestone) held that this exception applied where the taxpayer had executed a durable power of attorney granting another person the power to manage her financial affairs. 2. rock, scissors, paper – code covers constitution. united states. v. clintwood elkhorn mining co., 128 s. ct. 1511 (4/15/08). the taxpayer sought a refund of taxes paid on coal exports under § 4121(a), which had been held unconstitutional as applied to coal exports in ranger fuel corp. v. united states, 33 f. supp. 2d 466 (1998), a decision that the government did not appeal, and in which the irs acquiesced. see notice 2000-28, 2000-1 c. b. 1116. the taxpayers filed timely administrative claims for coal taxes paid in 1997 through 1999, which the irs refunded. the taxpayer filed suit in the court of federal claims seeking a refund of taxes paid between 1994 and 1996, but did not file any claim for those taxes with the irs, because any such claim would have been denied as untimely under § 6511. in an opinion by chief justice roberts, the supreme court held that the code’s provisions override the more lenient six year statute of limitations for claims against the government under the tucker act, 28 u. s. c. § 1491(a)(1), even where the claim is based on the unconstitutionality of the tax in question. 3. the amt statute of limitations is the same as regular tax statue of limitations. nemitz v. commissioner, 130 t.c. no. 9 (5/15/08). the tax court (judge cohen) held that the statute of limitations rule 2009] recent developments in federal income taxation 437 of § 6501(h) – providing “[i]n the case of a deficiency attributable to the application to the taxpayer of a net operating loss carryback * * * such deficiency may be assessed at any time before the expiration of the period within which a deficiency for the taxable year of the net operating loss * * * which results in such carryback may be assessed” – applies for amt purposes where the taxpayer erroneously treated an amt capital loss (incurred with respect to stock acquired pursuant to a qualified stock option) as an amt net operating loss carryback. the court rejected the taxpayer’s argument that § 6501(h) did not apply because “the only situations where the statute of limitations is kept open by reference to a loss year for noncorporate taxpayers is in the case of deficiencies attributable to a net operating loss carryback since such taxpayers cannot have a capital loss carryback,” and that the taxpayer’s loss was a capital loss, not a net operating loss. the court reasoned that § 6501(h) was not applicable to the factual situation in this case because the taxpayers had claimed the carryback as a net operating loss. finally, the court held that the absence of a reference in § 6501(h) to an amt net operating loss carryback specifically did not prevent its application for amt purposes, because the amt net operating loss carryback is itself based on § 172. 4. figure out whether your nol is a specific liability loss or not and the year to which it should be carried back before the statute of limitations expires. barrick resources (usa), inc. v. united states, 529 f.3d 1252 (10th cir. 6/20/08). in 2001, the taxpayer filed a timely refund claim seeking to carryback to 1994 and 1995 net operating losses incurred in 1997. in 2002 and 2003 the taxpayer filed additional refund claims treating the 1997 nols as specified liability losses (with a ten-year carryback under § 172(f)), that carried the losses back to 1991 and 1992, amending that year’s return; and in 2003 the taxpayer filed additional refund claims carrying specified liability losses from 1997 and 1998 back to 1991. the court (judge tymkovich) held that the amended returns for 1991 and 1992, based on treating the 1997 and 1998 nols as specified liability losses, were not amendments of the timely-filed refund claims based on carryback to 1994 and 1995 the 1997 nol but rather were new refund claims filed outside the period of limitations. 5. section 6511(d)(8), added by the heroes earnings assistance and relief tax act of 2008, extends the statute of limitations for the filing of refund claims by retired military personnel who receive disability determinations from the department of veterans affairs (thereby resulting in the retroactive conversion of military retirement benefits from taxable benefits based on length of service to disability benefits excluded under §104(a)(4)). this provision generally extends the period for filing a refund claim until one year after the date of the disability determination. 438 florida tax review [vol. 9:si 6. you have to raise the statute of limitations the first time you get the chance or forever hold your peace. golden v. commissioner, 548 f.3d 487 (6th cir. 11/26/08). settlement of all claims in an earlier tax court proceeding barred the taxpayer from raising a claim in a subsequent cdp proceeding that the original deficiency notice was outside the three-year statute of limitations. principles of res judicata apply to bar consideration of issues, including the statute of limitations, that could have been raised in a prior judicial proceeding. 7. you can’t rely on an unclarified informal refund claim to beat the statute of limitations. greene-thapedi v. united states, 549 f.3d 530 (7th cir. 12/3/08). to satisfy the jurisdictional requirements of § 7422(a) authorizing district court review of the irs’s denial of a refund, the taxpayer’s timely informal refund claim must be followed by a subsequent formal refund claim. “the informal claim doctrine is predicated on the expectation that any formal deficiency will at some point be corrected. ... to hold otherwise would eliminate, as a practical matter, the formal claim requirement.” f. liens and collections 1. ever expanding tax court jurisdiction. rock, scissors, paper: statutory amendment beats old case law. callahan v. commissioner, 130 t.c. 44 (2/5/08). the tax court (judge haines) held that under § 6330(d), as amended in 2006 to confer on the tax court jurisdiction to hear all appeals of cdp determinations, the tax court has jurisdiction to review the irs’s determination to review assessment of § 6702 frivolous return penalties. van es v. commissioner, 115 t.c. 324 (2000), which reached contrary result before the 2006 statutory amendment, is no longer controlling. judge haines denied the irs’s motion for summary judgment. because the validity of the underlying tax liability, i.e., the penalties, was properly at issue, the court reviewed the matter de novo, see sego v. commissioner, 114 t.c. 604, 610 (2000). judge haines denied the irs’s motion for summary judgment. “although petitioners’ form 1040 is confusing and unorthodox, their arguments are not substantially similar to positions previously held to be frivolous or those that display a desire to delay or impede the administration of federal income tax laws. ... until the record is better developed, we cannot say as a matter of law that petitioners have taken a frivolous position or that they desired to delay or impede the administration of federal income tax laws.” 2. “no prior involvement” really means “no prior involvement.” cox v. commissioner, 514 f.3d 1119 (10th cir. 1/30/08), rev’g 2009] recent developments in federal income taxation 439 126 t.c. 237 (5/3/06). the tax court (judge wherry) held that an appeals officer is not disqualified from conducting a collection due process hearing for a later year by virtue of conduct of a prior collection due process hearing for the same taxpayer with respect to an earlier year. judge wherry held that the conduct of the cdp hearing for the prior year was not “prior involvement” within the meaning of § 6330(b)(3) where the record did not otherwise call into question the appeals officer impartiality. the tenth circuit (judge kelly) reversed, holding that “no prior involvement” within the meaning of § 6330(b)(3) must be interpreted broadly. in denying the taxpayers’ challenge to a proposed levy for the earlier year, which involved a determination of their ability to pay the prior year’s tax liability, the appeals officer had considered taxpayers’ tax liability for the subsequent years in question in this case. even though the prior consideration of the tax liability for the subsequent year in question in this case was “not technically ... determination,” because “the statute does not say ‘no prior participation in a hearing or matter with respect to the unpaid tax,’ [and] it simply says ‘no prior involvement with respect to the unpaid tax,’” it was prior involvement. that involvement disqualified the appeals officer from hearing taxpayers’ challenge to proposed levy to collect taxes for the subsequent years. “[c]onsideration of those liabilities during the cdp hearing for [prior years] was a material factor in his decision and constitutes prior involvement.” 3. the last cdp determination is the only cdp determination. kelby v. commissioner, 130 t.c. 79 (4/28/08). in a cdp hearing, appeals makes a single determination, which may or may not be supplemented. when supplemental determinations are issued, the tax court reviews the irs’s decision in the last supplemental determination and does not consider the position stated in prior notices of determination. 4. ♫♪ you say, lien, i say levy, lets call the whole thing off. ♫♪ first american title insurance co. v. united states, 520 f.3d 1051 (9th cir. 3/27/08) the title insurance company paid tax liens to satisfy claim filed by third party purchasers who had acquired the property directly or indirectly from an estate that had not paid all of the estate tax due that was attributable to an assessment after audit. the title insurance company challenged the assessment arguing that the district court had jurisdiction under 28 u.s.c. § 1346 and united states v. williams, 514 u.s. 527 (1995). the ninth circuit affirmed the district court’s decision that it lacked jurisdiction. the title insurer company argued that williams, rather than ec term of years trust v. united states, 127 s. ct. 1763 (2007), which held that § 7426(a)(1) provides the exclusive remedy if the irs levies on property to collect taxes owed by another person; the levy may not be challenged through a refund suit under § 1346(a)(1), because like williams, this case involved a lien. the ninth circuit rejected this argument because § 7426(c) specifically precludes any challenge to the assessment in an 440 florida tax review [vol. 9:si action by a third party to recover taxes. “[a] challenge to an assessment ... , not a levy, ... is a distinction without a difference. ... § 7426 is the sole remedy here, for the same reason that it was in ec term of years.” a. ♫♪ let’s hear that tune again, but it’s a different circuit this time. ♫♪ munaco v. united states, 522 f.3d 651 (6th cir. 4/15/08). the sixth circuit (judge boggs) applied the reasoning of ec term of years trust v. united states, 127 s. ct. 1763 (2007), to hold that a third party who satisfied a tax lien on property acquired from the delinquent taxpayer and who failed to pursue the administrative remedies available under § 6325(b)(4) and judicial remedies under § 7426(a)(4), which were enacted in 1998, could not maintain a refund suit under 28 u.s.c. § 1346(a)(1). the precisely drawn and detailed remedies available in those provisions trump and displace the more generally stated remedies. 5. the irs wants the § 6323 regulations to reflect current law and practice. reg-141998-06, withdrawal of regulations under old section 6323(b)(10), 73 f.r. 20877 (4/17/08). the irs has published proposed regulations to update the regulations under § 6323 regarding the validity and priority of the federal tax lien against persons other than the taxpayer. the proposed regulations also: (1) would provide that a notice of federal tax lien (nftl) relating to real property does not meet the filing requirements until it is both filed and indexed in the office designated by the state if the real property is located in a state where a deed is not valid against a purchaser unless it is recorded in a public index; (2) would provide that the lien will be extinguished if an nftl contains a certificate of release and the nftl is not timely refiled; and (3) would clarify the irs’s authority to file nftls electronically if the state permits electronic filing. 6. bankruptcy doesn’t discharge taxes where bankrupt taxpayer was convicted of criminal tax fraud, and perfected tax lien for penalties, trumps bankruptcy act provision discharging penalties. bussell v. commissioner, 130 t.c. no. 13 (5/29/08). the tax court’s jurisdiction to review a collection action under §§ 6320 and/or 6330 includes the authority to determine whether a taxpayer’s unpaid tax liabilities were discharged in a bankruptcy proceeding. the taxpayer was collaterally estopped from denying that her tax liabilities for the years in issue were excepted from discharge under 11 u.s.c. § 523(a)(1)(c), because she had been convicted of tax evasion under § 7201 for the years at issue. interest accrued on a tax liability excepted from discharge is also nondischargeable. however, penalties assessed for the years in issue were discharged under 11 u.s.c. § 523(a)(7)(b), which provides for the discharge of any tax penalty “imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition,” but 2009] recent developments in federal income taxation 441 because the federal tax lien had been properly filed before the taxpayer filed for bankruptcy, the lien, which was not extinguished by the subsequent bankruptcy discharge, could be enforced by levy. 7. an oic is a prerequisite to challenging a cdp determination on the grounds that the irs failed to consider collection alternatives. kohler v. commissioner, t.c. memo. 2008-127 (5/5/08). the tax court (judge jacobs) held that the irs’s failure to consider collection alternatives in a cdp hearing was not an abuse of discretion because taxpayers admittedly failed to submit an offer-in-compromise. 8. claiming in a cdp hearing that a tax liability was discharged in bankruptcy is not a challenge to the underlying tax liability. imarah v. commissioner, t.c. memo. 2008-137 (5/20/08). the tax court (judge marvel) held that the irs improperly refused to consider the taxpayers’ claim in a cdp hearing that the tax liability had been discharged in an earlier bankruptcy case. their discharge argument was not an argument contesting the underlying liability, but went to whether collection activity was lawful. further, the court held that the tax liabilities had been discharged in bankruptcy. 9. same year, different basis for deficiency, properly assessed this time; taxpayer loses. freije v. commissioner, 131 t.c. no. 1 (7/7/08). in an earlier case involving the same taxpayer for the same year, freije v. commissioner, 125 t.c. 14 (2005), the tax court held that the irs had improperly disallowed certain deductions for 1999 as mathematical or clerical errors under § 6213(b) and barred a levy. the irs disallowed other deductions that were not at issue in freije i and properly sent a notice of deficiency; the taxpayer did not file a tax court petition. in reviewing a cdp determination, with respect to the deficiency, the tax court lacked jurisdiction to consider the merits of the underlying tax liability associated with the second assessment for 1999 based upon the deficiency notice. the issue of that liability was not before the court in freije i and the taxpayer had a previous opportunity to contest the deficiency. 10. the irs can’t pretend a con lives at home with his wife when it knows he’s living in the big house. conn v. commissioner, t.c. memo. 2008-186 (8/5/08). under § 6330(c)(2)(b) and reg. § 301.6330-1(e)(3), q&a-e2, the receipt of a notice of deficiency, not its mailing, is the relevant event. a taxpayer who did not actually receive a properly mailed deficiency notice in time to petition the tax court is entitled to challenge the underlying liability in a cdp hearing. because the commissioner did not introduce into evidence a u.s. postal service form 3877, which would raise the presumption of actual receipt of the deficiency notice, the fact that the taxpayer’s wife filed a 442 florida tax review [vol. 9:si timely petition for innocent spouse relief with respect to the tax liability to which the deficiency notice related (tax on embezzlement income) did not establish actual receipt of the deficiency notice by the husband where his last known address – prison – was different from his wife’s. • the irs should have realized this when it saw his name. 11. timely request a cdp hearing or forever hold your peace. wilson v. commissioner, 131 t.c. no. 5 (9/10/08). the taxpayer failed to timely request a cdp hearing with appeals with respect to a proposed levy. following a late request, appeals held an equivalent hearing and issued a form letter “notice of determination concerning collection action(s) under section 6320 and/or 6330.” the tax court dismissed the taxpayer’s petition for review for lack of jurisdiction. the court held that because the taxpayer did not timely request a hearing, appeals did not make a § 6330 determination pursuant to the equivalent hearing, and thus the letter to the taxpayer was not a valid notice of determination under § 6330 that the taxpayer was entitled to appeal pursuant. 12. present all your claims at the cdp hearing or lose your right of tax court review. brecht v. commissioner, t.c. memo. 2008213 (9/15/08). when reviewing a cdp determination, the tax court will not consider an issue regarding abatement of interest under § 6404(e) if it was not properly raised at the cdp hearing and/or considered in the notice of determination. 13. hoyle v. commissioner, 131 t.c. no. 13 (12/3/08). judge wells held that whether the appeals officer verified as required by § 6330(c)(1) that all procedural requirements, including that a deficiency notice had been properly mailed to the taxpayer, will be considered on tax court review without regard to whether the issue was raised by the taxpayer at the appeals cdp hearing. [giamelli v. commissioner, 129 t.c. 107 (2007), held that in reviewing an appeals officer’s cdp determination the tax court does not consider issues that are not a part of that determination.] because the court was unable to ascertain the basis for the appeals officer’s verification that the requirements of § 6330(c)(1) were met, the case was remanded to appeals to clarify the record. 14. live by your oic or pay up. trout v. commissioner, 131 t.c. no. 16 (12/16/08). the taxpayer entered in a compromise of tax liability pursuant to § 7122(a), pursuant to which he agreed to file his tax returns, and pay any tax due, on time for the next five years. he failed to file returns for two of the required years, and the irs declared him in default and sought to levy 2009] recent developments in federal income taxation 443 on his assets. on review of a cdp hearing sustaining the levy, the tax court, in a reviewed opinion by judge holmes, held that the irs did not abuse its discretion in declaring the oic in default and seeking to levy on taxpayer’s assets. an accepted offer in compromise is a contract and if the taxpayer fails to satisfy the condition that the taxpayer file his tax returns and pay any tax due on time for a specified period of subsequent years, the irs may void the compromise and collect the original tax liability in full. in interpreting the compromise agreement to determine whether its terms have been satisfied or breached, the federal common law of contracts, not any particular state law, applies. judge holmes held that the breach was not immaterial. 15. the government’s rights as a lien-holder under the code trump conflicting state law. russell v. united states, 102 a.f.t.r.2d 2008-7337 (10th cir. 12/19/08) section 7425(b) provides for the discharge of a junior federal tax lien by a nonjudicial sale by a senior lien holder, if proper notice is provided to the government. the tenth circuit reversed a district court opinion that vacated the tax lien because the government did not redeem or purchase the property for the senior lien within the period after the sale of the property as provided by state [colorado] law, even though the government did not receive notice of the sale. the tenth circuit held that § 7425(b) preempts state law and leaves federal tax liens undisturbed where the government did not receive notice of a nonjudicial sale. g. innocent spouse 1. no “plain language” limitation of the tax court’s jurisdiction in this case. ewing v. commissioner, 118 t.c. 494 (5/31/02). the taxpayer and her husband filed a joint return but did not pay all of the tax shown on the return. subsequently, before the irs asserted any deficiency, the taxpayer requested equitable relief from joint and several liability under § 6015(f). the irs denied relief and mailed a notice of determination that was not mailed to the taxpayer’s last known address, but was actually received by the 88th day after it was mailed. the taxpayer’s petition for review was postmarked 92 days after the mailing of the notice, and was received and filed seven days later. the commissioner moved to dismiss on the ground that the petition was not timely filed. the tax court sua sponte raised the issue of whether it had jurisdiction under § 6015(e) to review the irs’s denial of § 6015(f) relief where no deficiency had been asserted. [section 6015(e), granting the tax court jurisdiction to review denials of § 6015 relief, as amended by the consolidated appropriations act of 2001, begins, “in the case of an individual against whom a deficiency has been asserted and who elects to have subsection (b) or (c) apply...”] in a reviewed opinion by judge ruwe, the majority (9-4) held that the tax court has jurisdiction to review a denial of § 6015(f) relief in a stand alone 444 florida tax review [vol. 9:si petition where the taxpayer is seeking relief from liability of tax shown on the return, without a deficiency having been asserted. the court further held that the petition was timely because it was filed more than 6 months after the date the taxpayer submitted her request for relief [see. § 6015(e)(1)(a)], the irs failed to mail the notice of determination to taxpayer’s last known address, and the misaddressed notice prejudiced the taxpayer’s ability to file her petition within 90 days after the mailing of the notice. the court concluded that: [t]he language “against whom a deficiency has been asserted” was inserted into section 6015(e) to *** to prevent taxpayers from submitting premature requests to the commissioner for relief from potential deficiencies before the commissioner had asserted that additional taxes were owed. *** congress was concerned with the proper timing of a request for relief for underreported tax and intended that taxpayers not be allowed to submit a request to the commissioner regarding underreported tax until after the issue was raised by the irs. there is nothing in the legislative history indicating that the amendment of section 6015(e) ***, was intended to eliminate our jurisdiction regarding claims for equitable relief under section 6015(f) over which we previously had jurisdiction. the stated purpose for inserting the language “against whom a deficiency has been asserted” into section 6015(e) was to clarify the proper time for a taxpayer to submit a request to the commissioner for relief under section 6015 regarding underreported taxes. we conclude that the amendment of section 6015(e) does not preclude our jurisdiction to review the denial of equitable relief under section 6015(f) where a deficiency has not been asserted. in the instant case, petitioner filed a claim for relief from joint and several liability for an amount of tax correctly shown on the return but not paid with the return. because respondent has not challenged the tax reported on the return, no deficiency has been asserted. in this situation, petitioner may be entitled to relief under section 6015(f) because subsection (f) applies where “it is inequitable to hold the individual liable for any unpaid tax or any deficiency.” [citations omitted]. • judge laro’s dissent argued that the tax court lacked jurisdiction to review the denial of § 6015 relief in the absence of a deficiency, because he considered § 6015(e)(1) to be a “clear statutory mandate from congress” limiting the tax court’s jurisdiction to review denials of § 6015 relief to deficiency cases. 2009] recent developments in federal income taxation 445 a. ewing v. commissioner, 122 t.c. 32 (1/28/04). in a reviewed opinion by judge colvin, the tax court held that even though the standard for reviewing the commissioner’s failure to grant equitable relief under § 6015(f) is abuse of discretion, the tax court’s review is not necessarily limited to the facts that were in the administrative record. judges halpern, holmes, chiechi, and foley dissented. b. reversed, vacated and dismissed because the tax court did not have jurisdiction over taxpayer’s petition in which she claimed innocent spouse relief. commissioner v. ewing, 439 f.3d 1009 (9th cir. 2/28/06), reversing 118 t.c. 494 (2002) and vacating 122 t.c. 32 (2004). judge tashima held that the tax court did not have jurisdiction to review wife’s petition for equitable relief under § 6015(f) because there was no deficiency asserted against her and she did not elect relief under § 6015(b) or (c), as is required by § 6015(e) in order for the tax court to have jurisdiction on an innocent spouse claim. the phrase in § 6015(e) “against whom a deficiency has been asserted” was added in 2001. the court further held that the tax court could not consider evidence that was not in the administrative record. c. the tax court sticks to its position that it has broad discretion in reviewing denial of innocent spouse relief. porter v. commissioner, 130 t.c. no. 10 (5/15/08) (reviewed, 2 judges dissenting). judge haines held that the tax court continues to follow its holding in ewing v. commissioner, 122 t.c. 32 (2004), vacated on unrelated jurisdictional grounds, 439 f.3d 1009 (9th cir.2006), that (1) its determination whether the irs abused its discretion in denying innocent spouse relief under § 6015(f) is made in a trial de novo, and (2) it may consider evidence introduced at trial which was not included in the administrative record. he rejected the irs’s argument that pursuant to the eighth circuit’s decision in robinette v. commissioner, 439 f.3d 455 (8th cir.2006), rev’g 123 t.c. 85, 2004 (2004), the tax court’s review is limited to the administrative record. judge haines distinguished robinette as involving review of a § 6330 cdp determination: “whereas section 6015 provides that we ‘determine’ whether the taxpayer is entitled to relief, section 6330(d) provides for judicial review of the commissioner’s determination by allowing the taxpayer to ‘appeal such determination to the tax court’ and vesting the tax court with ‘jurisdiction with respect to such matter.’ as discussed above, the use of the word ‘determine’ suggests that we conduct a trial de novo.” 2. duplicative claim for innocent spouse relief does not reopen period for seeking tax court review of irs’s denial or original claim. barnes v. commissioner, 130 t.c. no. 14 (6/11/08). irs letter 3657c (which according to the irm is used to “explain” that a claim for § 6015 relief 446 florida tax review [vol. 9:si “has been previously disallowed”) is not a “final determination” of relief under § 6015. issuance of irs letter 3657c following taxpayer’s filing of a second form 8857 seeking § 6015(f) relief over 5 years after the irs initially denied relief does not extend the period for petitioning the tax court for review of the denial of relief if the taxpayer did not timely seek review after receipt of irs letter 3279 denying initial petition for relief. the second form 8857 did not raise new grounds for relief but merely reiterated the grounds on which relief initially was sought and denied. judge thornton stated, “we do not believe, the 90-day limitations period of section 6015(e)(1)(a) should be defeated or protracted by the simple expedient of filing a succession of duplicative claims.” 3. california community property law comes to the aid of the irs. ordlock v. commissioner, 533 f.3d 1136 (9th cir. 7/24/08), aff’g 126 t.c. 47 (2006) (reviewed, 10-8). even though the taxpayer spouse was entitled to § 6015 relief, she could not obtain a refund of her husband’s tax liability satisfied with her interest in community property, because under california law creditors of either spouse could reach all community assets and thus the federal tax lien under § 6321 attached to 100 percent of the community property. neither § 6015(a) nor §6015(g) preempts community property law for purposes of the issuance of a refund to an innocent spouse. 4. kollar v. commissioner, 131 t.c. no. 12 (11/25/08). judge marvel held that the tax court’s jurisdiction under § 6015(e)(1) to review the denial by the irs of § 6015(f) equitable relief extends to relief solely from liability for interest on a tax deficiency where relief from the principal deficiency is not in issue. sections 6601(e)(1) and 6665(a) provide that “‘tax’ for purposes of the code included interest and penalties, except in certain cases not relevant to [the question of § 6015(e)(1) jurisdiction].” h. miscellaneous 1. burton kanter got in trouble again, and this time it followed him to the grave. investment research associates, ltd. v. commissioner, t.c. memo. 1999-407 (12/15/99). burton kanter was held liable for the §6653 fraud penalty by reason of his being “the architect who planned and executed the elaborate scheme with respect to … kickback income payments . . . .” a. and the tax court’s procedures are vindicated and taxpayer ballard loses on appeal on the fraud issue in the eleventh circuit. ballard v. commissioner, 321 f.3d 1037 (11th cir. 2/13/03), aff’g t.c. memo. 1999-407. the eleventh circuit affirmed the tax court 2009] recent developments in federal income taxation 447 decision and rejected the taxpayers’ argument that changes allegedly made to the original draft opinion from the special trial judge by judge dawson before he adopted it were improper. b. and the tax court’s procedures are vindicated and taxpayer kanter’s estate loses on appeal on the fraud issue in the eleventh circuit. estate of kanter v. commissioner, 337 f.3d 833 (7th cir. 7/24/03) (per curiam) (2-1), aff’g in part and rev’g in part t.c. memo. 1999-407. the court found that the nondisclosure of the special trial judge’s original report was proper, following the eleventh circuit’s ballard opinion. it affirmed the tax court’s findings on the issues of deficiencies, fraud, and penalties, but reversed as to other findings. c. and the tax court’s procedures are vindicated but taxpayer lisle’s estate wins on appeal on the fraud issue in the fifth circuit. estate of lisle v. commissioner, 341 f.3d 364 (5th cir. 7/30/03), aff’g in part and rev’g in part t.c. memo. 1999-407. the fifth circuit (judge higginbotham) followed the eleventh and seventh circuits decisions upholding the nondisclosure of the special trial judge’s original report by the tax court. d. justice ginsburg to tax court judges: “you article i judges don’t understand your own rules, so let me tell you what you meant when you adopted them in 1983.” ballard v. commissioner, 544 u.s. 40 (3/7/05) (7-2), reversing and remanding 337 f.3d 833 (7th cir. 7/24/03) and 321 f.3d 1037 (11th cir. 2/13/03). justice ginsburg held that the tax court may not exclude from the record on appeal nor conceal from the taxpayers the original draft reports of special trial judges under tax court rule 183(b) or under any statutory authority. • chief justice rehnquist’s dissenting opinion, joined in by justice thomas, states that the “tax court’s compliance with its own rules is a matter on which we should defer to the interpretation of that court.” e. the eleventh circuit orders that the special trial judge’s report be added to the record. ballard v. commissioner, 2005-1 u.s.t.c. ¶ 50,393 (11th cir. 5/17/05). f. tax court changes its rules. (9/20/05). the tax court adopted amendments to tax court rules 182 and 183, relating to special trial judges’ reports in cases other than small tax cases. the special trial judge’s recommended findings of fact and conclusions of law are to be served on the parties, who may file written objections and responses. after the 448 florida tax review [vol. 9:si case is assigned to a regular judge, any changes made shall be reflected in the record and “[d]ue regard shall be given to the circumstance that the special trial judge had the opportunity to evaluate the credibility of witnesses, and the finding of fact recommended by the special trial judge shall be presumed to be correct.” g. the eleventh circuit remands the case to the tax court – after reinstating the special trial judge’s report. ballard v. commissioner, 429 f.3d 1026 (11th cir. 11/2/05) (per curiam). the case was remanded to the tax court with the following instructions: (1) the “collaborative report and opinion” is ordered stricken; (2) the original report of the special trial judge is ordered reinstated; (3) the tax court chief judge is instructed to assign this case to a previously-uninvolved regular tax court judge; and (4) the tax court shall proceed to review this matter in accordance with the supreme court’s dictates and with its newly-revised rules 182 and 183, giving “due regard” to the credibility determinations of the special trial judge and presuming correct fact findings of the trial judge. h. estate of lisle v. commissioner, 431 f.3d 439 (5th cir. 11/22/05) (per curiam). the case was remanded to the tax court with orders to: (1) strike the “collaborative report” that formed the basis of the tax court’s ultimate decision; (2) reinstate judge couvillion’s original report; (3) refer this case to a regular tax court judge who had no involvement in the preparation of the aforementioned “collaborative report” and who shall give “due regard” to the credibility determinations of judge couvillion, presuming that his fact findings are correct unless manifestly unreasonable [in dealing with the remaining issues of tax deficiency]; and (4) adhere strictly hereafter to the amended tax court rule in finalizing tax court opinions. i. on remand, in a 458-page opinion judge haines of the tax court pours out kanter and ballard. estate of kanter v. commissioner, t.c. memo. 2007-21 (2/1/07). the tax court (judge haines) found that certain of the special trial judge’s findings of fact were “manifestly unreasonable” because they were “internally inconsistent or so implausible that a reasonable fact finder would not believe [the recommended finding]” or they were “directly contradicted by documentary or objective evidence.” judge haines therefore found that the kanter-related entities were shams, that “kanter, ballard, and lisle participated in a complex, well-disguised scheme to share kickback payments earned jointly by kanter, ballard, and lisle,” and that they earned income during the years at issue which they failed to report. • judge haines found that – based upon factors such as (1) failure to report substantial amounts of income, (2) concealment of the true nature of the income and the identity of the earners of the income, 2009] recent developments in federal income taxation 449 (3) use of sham, conduit, and nominee entities, (4) reporting kanter’s and ballard’s income on iras [and another entity’s] tax returns, (5) commingling of kanter’s and ballard’s income with funds belonging to others, (6) phony loans, (7) false and misleading documents, and (8) failure to cooperate during the examination process by engaging in a “strategy of obfuscation and delay” – the commissioner demonstrated by “clear and convincing evidence” that kanter and ballard filed false and fraudulent tax returns for each of the years at issue. • judge haines held that the tax court is “obliged to review the recommended findings of fact and credibility determinations set forth in the stj report under a ‘manifestly unreasonable’ standard of review, and ... may reject such findings of fact and credibility determinations only if, after reviewing the record in its entirety, [it] conclude[s] that the recommended finding of fact or testimony (1) is internally inconsistent or so implausible that a reasonable fact finder would not believe it, or (2) is not credible because it is directly contradicted by documentary or objective evidence.” furthermore, judge haines held that a special trial judge’s credibility determinations may be rejected under the “manifestly unreasonable” standard of review without rehearing the disputed testimony. • judge haines further found that the appropriate standard for determining whether the assignment of income doctrine should be applied had been appropriately articulated in united states v. newell, 239 f.3d 917, 919-920, as follows: to shift the tax liability, the assignor [taxpayer] must relinquish his control over the activity that generates the income; the income must be the fruit of the contract or the property itself, and not of his ongoing income-producing activity. ... this means, in the case of a contract, that in order to shift the tax liability to the assignee the assignor either must assign the duty to perform along with the right to be paid or must have completed performance before he assigned the contract; otherwise it is he, not the contract, or the assignee, that is producing the contractual income – it is his income, and he is just shifting it to someone else in order to avoid paying income tax on it. j. and the beat goes on. ballard v. commissioner, 522 f.3d 1229, (11th cir. 4/7/08). the eleventh circuit (judge fay) reversed, vacated and remanded the tax court decision, t.c. memo. 200721 (2/1/07), with instructions to “enter an order approving and adopting judge couvillion’s original report as the opinion of the tax court.” the reason assigned was that judge haines “did not presume judge couvillion’s findings to be correct or give judge couvillion’s credibility determinations their due deference,” concluding that 450 florida tax review [vol. 9:si it is no surprise that a knowledgeable tax attorney would use numerous legal entities to accomplish different objectives. this does not make them illegitimate. unfortunately such “maneuvering” is apparently encouraged by our present tax laws and code. k. and on. estate of lisle v. commissioner, 541 f.3d 595 (5th cir. 8/25/08). the fifth circuit followed the eleventh circuit’s decision and reversed and remanded judge haines’s decision. 2. long live the common law mailbox rule. philadelphia marine trade v. commissioner, 523 f.3d 140 (3d cir. 4/15/08). the third circuit held that the application of common law mailbox rule is unaffected by § 7502 where there is evidence that the document was mailed in manner than in the normal course would have resulted in receipt before the deadline. the taxpayer could avail itself of the mailbox rules because it produced evidence of produced evidence of mailing the documents in question on may 8 and june 13 by overnight and first class mail, respectively, which would have resulted in arrival well before the june 25 deadline. • note there is a split in the circuits. the eighth, ninth, and tenth circuits agree with the third circuit that a taxpayer may rely on the common law mailbox rule to prove that a return was timely filed, estate of wood v. commissioner, 909 f.2d 1155 (8th cir. 1990); anderson v. united states, 966 f.2d 487 (9th cir. 1992); sorrentino v. united states, 383 f.3d 1187 (10th cir. 2004), cert. denied, 546 u.s. 812 (2005), but the second circuit, deutsch v. commissioner, 599 f.2d 44 (2d cir. 1979), and sixth circuit, miller v. united states, 784 f.2d 728 (6th cir. 1986) have reached a contrary result, rejecting any application of the common law mailbox rule. 3. according to the third circuit, the tax court just doesn’t understand chevron. swallows holding, ltd. v. commissioner, 515 f.3d 162 (3d cir. 2/15/08), rev’g 126 t.c. 96 (1/26/06). the tax court, in a reviewed opinion (12-2-3) by judge laro, invalidated a regulation [reg. § 1.8824(a)(2) and (3)(i)] issued under § 882(c)(2), because the statute required that a tax return be filed in the “manner” prescribed by statute and regulations, but the regulation denied a substantive tax benefit if the return was not timely filed. in doing so, the tax court analyzed the impact of the supreme court’s decision in chevron u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984) on the application of the national muffler dealers ass’n standard [natl. muffler dealers association v. united states, 440 u.s. 472 (1979)] for reviewing the validity of interpretive regulations issued under the general authority in § 7805(a): 2009] recent developments in federal income taxation 451 the question arises from the timing of these two decisions whether the supreme court intended for [chevron] to replace [natl. muffler dealers ass’n] in the review of a federal tax regulation. we have previously stated with respect to that question: “we are inclined to the view that the impact of the traditional, i.e., national muffler standard, has not been changed by chevron, but has merely been restated in a practical two-part test with possibly subtle distinctions as to the role of legislative history and the degree of deference to be accorded to a regulation.” central pa. sav. association & subs. v. commissioner, 104 t.c. 384, 392 (1995) ... . here, we conclude likewise that we need not parse the semantics of the two tests to discern any substantive difference between them. while we apply a natl. muffler analysis, our result under a chevron analysis would be the same. • the court further noted that a legislative regulation, in contrast to an interpretive regulation, when scrutinized under the chevron standard will be upheld “unless arbitrary, capricious, or manifestly contrary to the statute.” nevertheless, the tax court held that reg. § 1.882-4(a)(2) and (3)(i) was invalid because it failed to pass muster under several of the national muffler factors: (1) the regulation was not a substantially contemporaneous construction of the statute, (2) the regulation evolved after the fourth circuit court of appeals and the board of tax appeals had held that the statute did not include a particular requirement that was imposed by the regulations, (3) the regulations were issued after multiple reenactments of the statutory text, (4) the regulations departed from a prior irs interpretation of earlier regulations, and (5) the statute had been reenacted several times without change to the governing statutory language. • the third circuit reversed the tax court’s decision on the grounds that (1) the tax court erred in applying the national muffler test rather than the chevron test, which the court of appeals held established a different standard, and (2) because the statute was ambiguous and the regulation in question was a permissible construction of the statute, it deserved deference under the chevron test. the third circuit expressly rejected the continuing relevance after chevron of (1) whether regulation had been promulgated contemporaneously with enactment of the statute it interprets, (2) the length of time the regulation had been in force, and (3) whether the statute had been reenacted since the regulation had been promulgated, all of which were relevant inquiries under national muffler. our inquiry would be a simple one if, as the tax court suggested, the result of this case would be the same regardless of which standard we apply. this, however, is not the case. the tax court relied heavily on factors that, although relevant to 452 florida tax review [vol. 9:si the national muffler standard, are not mandatory or dispositive inquiries under chevron. as we set out above, the tax court reasoned that the challenged regulation was not a contemporaneous construction of the statute; the tax court found that the fourth circuit court of appeals and the board of tax appeals had interpreted the statute as not including a timing element, and the tax court relied on the existence of several reenactments of the statute without any change to the governing statutory language. even if we were to assume that all of these observations are true, conclusive reliance on them is misplaced. when chevron deference is owed, chevron’s demands are clear. if the statutory text is ambiguous, an agency is given the discretion to promulgate rules that interpret the ambiguous provisions. judicial deference to an agency’s rule-making authority ends only when the agency’s construction of its statute is unreasonable. • in addition to the third circuit, six other circuits have applied chevron to analyze the validity of treasury regulations. hospital corp. of am. & subs. v. commissioner, 348 f.3d 136 (6th cir. 2004); bankers life & cas. co. v. united states, 142 f.3d 973 (7th cir. 1998); redlark v. commissioner, 141 f.3d 936 (9th cir. 1998); in re craddock, 149 f.3d 1249 (10th cir.1998); beard v. united states, 992 f.2d 1516 (11th cir. 1993); tax analysts v. commissioner, 350 f.3d 100 (d.c. cir.2003). four circuits have applied the national muffler standard (or national muffler with a chevron gloss). snowa v. commissioner, 123 f.3d 190 (4th cir. 1997) (general authority regulations get national muffler review under chevron); nalle v. commissioner, 997 f.2d 1134 (5th cir. 1993); united states v. tucker, 217 f.3d 960 (8th cir. 2000); schuler indus. inc. v. united states, 109 f.3d 753 (fed. cir. 1997). although several courts of appeals have applied the national muffler standard rather than the chevron standard in reviewing interpretive treasury regulations, the third circuit court of appeals reading of the import of chevron is much closer to the mainstream of administrative law generally, and one could expect the tax court to be reversed in the future if it continues to apply national muffler to invalidate regulations that would pass muster under chevron, as that case is generally being interpreted and applied by the courts of appeals. 4. expanding equitable recoupment jurisdiction in the tax court. menard, inc. v. commissioner, 130 t.c. 54 (2/19/08). judge marvel held that the tax court has jurisdiction to apply the equitable recoupment doctrine to allow the taxpayers, an employee [ceo of menard, inc.]/shareholder and his employer [menard, inc.] to offset their income tax deficiencies with fica hospital taxes they overpaid on the portion of the ceo/shareholder’s 2009] recent developments in federal income taxation 453 compensation that the tax court previously had held was a disguised dividend in menard, inc. v. commissioner, t.c. memo. 2004-207 (menard i), and menard, inc. v. commissioner, t.c. memo. 2005-3 (menard ii). even though the tax court lacks jurisdiction to redetermine fica taxes, under the second sentence of § 6214(b), added by the pension protection act of 2006. [“ ... [t]he tax court may apply the doctrine of equitable recoupment to the same extent that it is available in civil tax cases before the district courts of the united states and the united states court of federal claims”], the tax court can apply equitable recoupment doctrine as ancillary to its original jurisdiction over deficiency redetermination. judge marvel rejected the irs’s argument that the tax court’s jurisdiction to apply equitable recoupment is limited to taxes over which it has deficiency or overpayment jurisdiction [income, estate, and gift taxes and excise taxes imposed under chapters 41, 42, 43, and 44] on the ground that the “legislative history underlying the recent amendment to section 6214(b) indicates congress intended to eliminate confusion over the court’s authority to apply the doctrine created by conflicting court of appeals opinions and to provide simplification benefits to both taxpayers and the commissioner.” furthermore, the irs’s narrow construction of the statute was “inconsistent with the central policy underlying the doctrine of equitable recoupment; i.e., to prevent an inequitable windfall to a taxpayer or the government that would otherwise result from the inconsistent tax treatment of a single transaction, item, or event.” however, in computing menard, inc.’s tax liability for the year in question, it was required to reduce its deduction for the fica taxes with respect to which equitable recoupment was allowed. 5. the court didn’t care to hear professor shepard’s analysis of whether this tax shelter worked. stobie creek investments, llc v. united states, 81 fed. cl. 358 (4/1/08). in this tax shelter case, the government filed a motion in limine to exclude the expert witness report and testimony of the taxpayer’s expert witnesses, professor ira b. shepard, university of houston law center and stuart a. smith, a new york tax attorney and former tax assistant to the solicitor general on the grounds that “it ‘impinge[s] on the role of this court’ by testifying as to the law or the application of the law to facts.” the government characterized professor shepard’s report as “‘nothing but legal analysis and application of his view of the law to his view of the facts of this case,’ *** [that] ‘contains lengthy descriptions of numerous cases and sets forth in detail the manner in which [professor] shepard would decide this case if he were the judge.’” the government characterized smith’s report as “‘legal argument dressed up as an opinion of an expert witness’ that amounts to ‘[n]ot only . . . a legal conclusion, [but] a conclusion based on the wrong law.’” the taxpayer asserted that professor shepard “‘will address whether the opinion provided by jenkens & gilchrist to the welles family was an appropriate “more likely than not opinion” at the time that it was issued such that a taxpayer could 454 florida tax review [vol. 9:si reasonably rely on it,’ and that ‘mr. smith will testify as to the quality of the jenkens & gilchrist opinion, which is relevant to the taxpayer’s ability to rely in good faith on that opinion.’” after extensively discussing the nature of the experts’ reports the court (judge miller) granted the government’s motion to exclude the expert witness reports and testimony because “[taxpayer’s] legal experts are applying the law to the facts, rather than permissibly explaining law in a manner that could inform or assist the finder of fact.” • see, wolfman, bernard. “expert testimony on the law, twelfth annual erwin n. griswold distinguished lecture,” 57 tax lawyer 709 (2004), where he stated: in fact, expert legal testimony is usually admissible in standardof-care cases, and it should be. in other types of cases involving domestic law, those in which the parties differ as to the meaning of the law applicable to a case, generally the judge, not the jury, should decide, and generally the parties should present their positions by argument not testimony. if, however, the case is one in which law and fact are significantly intertwined, it may be sensible and helpful to have legal experts offer their understanding of the law that underlies the parties dispute, and so their testimony should be admissible and subject to cross examination. moreover, even in the absence of the significant intertwining of law and fact, a trial judge should have the discretion on his own motion to appoint a legal expert to testify on domestic law, or to allow such testimony when a party proffers it. when the judge believes that the area of law is one that calls for highly specialized legal expertise that he does not have sufficiently, and he thinks that a jury will be more likely to understand the law or legal setting applicable to the facts of the case if it hears the testimony of legal experts for both sides who present their opinions subject to cross examination, the proffered testimony should be admitted. indeed, i think that serious consideration should be given to amending federal rule of civil procedure 44.1 so that it will not be limited to foreign law and will read as follows: “. . . the court, in determining foreign or domestic law, may consider any relevant material or source, including testimony, whether or not submitted by a party or admissible under the federal rules of evidence. . . .” • one of professor mcmahon’s former students was on the government’s trial team and deposed professor shepard in connection with the case. 2009] recent developments in federal income taxation 455 a. the court of federal claims refused to exclude most of stuart smith’s report. murfam farms llc v. united states, 102 a.f.t.r.2d 2008-6319 (fed. cl. 9/19/08). judge damich permitted stuart smith to opine on whether the proskauer rose opinions were of a quality that the taxpayers could reasonably rely on them, but not on whether the proskauer rose opinions were correct. plaintiffs present mr. stuart smith, a tax attorney, to opine on whether the proskauer rose opinions were of the type, character, and quality upon which a taxpayer could reasonably rely. the government makes two primary arguments for the exclusion of mr. smith’s testimony: (1) that, because mr. smith relies on the wrong law (i.e., certain treasury circular 230 and not treasury regulation 1.6664-4), the testimony contained in mr. smith’s report is unreliable, and (2) that mr. smith presents nothing more than legal analysis. the government first asserts that mr. smith’s analysis is unreliable because the only standard by which to properly gauge a reasonable cause defense to accuracy-related penalties is i.r.c. section 6664(c) and the treasury regulations promulgated under that section. in response, plaintiffs assert that mr. smith’s report does not state that treasury circular 230 is the correct standard by which to consider a reasonable cause defense. instead, plaintiffs assert, “mr. smith references the circular 230 standards only in his evaluation of the quality of the tax opinions to demonstrate that such opinions were ‘objectively reasonable.’” the court does not find that mr. smith’s analysis is unreliable under rule 702. the court notes that mr. smith’s report states, quite unmistakably, that “it is plainly not necessary for an opinion to satisfy the particular requirements of this circular for a taxpayer to act reasonably in relying on it.” moreover, it seems reasonable to the court that a tax professional might look to a treasury circular for at least general guidance in determining the level of quality necessary for a tax opinion. as such, the court agrees with plaintiffs that mr. smith’s discussion of treasury circular 230 does not render his report “unreliable” under rule 702. the government also argues that mr. smith’s report simply presents an argument on an issue of law to be decided by the court. as plaintiffs point out, however, mr. smith’s report does not opine that the proskauer rose opinions were legally correct. rather, mr. smith’s report simply opines that the proskauer rose opinions appear to have been prepared 456 florida tax review [vol. 9:si based on a certain standard of care, and are of a threshold quality such that taxpayers such as the plaintiffs could reasonably rely on them. the court finds that only certain portions of mr. smith’s report constitute improper testimony on a legal issue. while discussing the characteristics of the proskauer rose opinions in a section titled “(2) relate law to facts,” mr. smith’s report also analyzes the internal revenue service’s legal position on the cobra transactions at issue, finding it to “lack an objective appearance of reasonableness.” despite mr. smith’s attempt to disguise his legal discussion as an objective analysis of the quality of the proskauer rose opinions, this section of mr. smith’s report appears to be little more than a legal argument that plaintiffs’ analysis of the transactions is correct while the government’s analysis is not. there is a difference between opining that a legal analysis is thoroughenough to be reasonably relied upon and opining that the legal analysis is correct while another is incorrect. the former opinion can be helpful to the court, while the latter is not. in addition, the merit of the internal revenue service’s subsequent legal position on the cobra transactions at issue would play no part in a determination of whether the proskauer rose opinions could reasonably have been relied upon prior to execution of the transactions. similarly, mr. smith provides a discussion of the eastern district of texas’s decision in klamath strategic investment fund v. united states, which was issued well after the proskauer rose opinions were written (citing klamath, 472 f. supp. 2d 885 (e.d. tex. 2007)). mr. smith attempts to use the klamath opinion as subsequent corroboration that the analysis contained in the proskauer rose opinions was correct. neither of these discussions is helpful to the court. 6. the irs makes it easier for its agents to prepare § 6020(b) substitute returns. t.d. 9380, substitute for return, 73 f.r. 9188 (2/20/08). revised reg. § 301.6020-1 provides that a document (or set of documents) signed by an authorized internal revenue officer or employee is a return under § 6020(b) if the document(s) identifies the taxpayer by name and tin, contains sufficient information from which to compute the taxpayer’s tax liability, and the document(s) purports to be a return under § 6020(b). a form 13496, “irc section 6020(b) certification,” or any other form used to identify a document (or set of documents) containing the required information constitutes a valid § 6020(b) return. a name or title of an internal revenue officer or 2009] recent developments in federal income taxation 457 employee appearing on a § 6020(b) return is a sufficient subscription without regard to whether the name or title is handwritten, stamped, typed, printed or otherwise mechanically affixed to the document. the document(s) and subscription may be in written or electronic form. the purpose of these changes was to reverse the result in cabirac v. commissioner, 120 t.c. 163 (2003). a. the irs foot-faulted on preparing a tax protestor’s substitute return and lost the failure to pay penalty. cabirac v. commissioner, 120 t.c. 163 (2003). the taxpayer filed income tax return forms with zeros on the relevant lines for computing tax liability. the irs prepared unsubscribed substitute returns showing zeros, and sent a deficiency notice based on a calculation of taxable income and tax shown in a revenue agent’s report, which had not been attached to the substitute returns. the tax court (judge ruwe) held that the taxpayer was liable for the § 6651(a)(1) failure to file penalty, but not for the § 6651(a)(2) failure to pay penalty. the unsubscribed substitute returns showing zero taxes did not meet the requirements for a § 6020(b) return, and the subsequently prepared notice of proposed adjustments and the revenue agent’s report, which were not attached to the unsubscribed substitutes for return, whether viewed separately or in conjunction with the substitute return, were not an adequate § 6020(b) return. 7. the tax court’s not a court! so says the sixth circuit in affirming the tax court’s own decision to that effect. mobley v. commissioner, 532 f.3d 491 (6th cir. 7/8/08). the sixth circuit affirmed the tax court’s decision that it lacked authority to transfer a refund claim, over which it had no jurisdiction, to a district court under 28 usc § 1631. that provision “‘by its terms applies only to a “court” as defined in 28 u.s.c. sec. 610” and ... the tax court is not included among the courts listed in 28 u.s.c. sec. 610.’” a. and the court of federal claims agrees. dacosta v. united states, 82 fed. cl. 549 (7/11/08). the court of federal claims cannot transfer to the tax court a case filed in the court of claims but over which it lacks jurisdiction because exclusive jurisdiction is vested in the tax court. the tax court is not a “court” for this purpose because the tax court is not listed in 28 u.s.c. § 610 as a court to which a case can be transferred pursuant to 28 u.s.c. § 1631. 8. why rush before april 15th! — wait until october 15th, or is it september 15th? t.d. 9407, extension of time for filing returns, 73 f.r. 37362-01 (7/1/08). the treasury promulgated final regulations relating to extensions of time to file tax returns. individual have an automatic 6month extension if they file an application on or before the return due date. reg. 458 florida tax review [vol. 9:si § 1.6081-4. for partnerships, estates, and trusts, the automatic extension period is only five months. temp. reg. §§ 1.6081-2t (partnerships), 1.6081-6t (estates and trusts). 9. or, wait until january 5th, if you are a hurricane ike survivor. ir-2008-107, sept. 18, 2008. specifically, the relief postpones until jan. 5, 2009, certain deadlines for taxpayers who reside or have a business in the disaster area. the postponement applies to return filing, tax payment and certain other time-sensitive acts due on or after sept. 7, 2008, and before jan. 5, 2009 –– including individual estimated tax returns and corporate tax returns that were due sept. 15, and extended individual returns due oct. 15. in addition, the irs will waive the failure to deposit penalties for employment and excise deposits due on or after sept. 7 and before sept. 22, 2008, as long as the deposits are made on or before sept. 22. 10. complying with irs withholding instructions does not defraud an employee. nino v. ford motor company, 102 a.f.t.r.2d 2008-5837 (e.d. mich. 8/8/08). summary judgment was granted to plaintiff’s employer in a pro se proceeding claiming that the employer defrauded the plaintiff by wage withholding pursuant to irs instructions to disregard the plaintiff’s claimed 99 exemptions. the court indicated that it could find no legal authority requiring an employer to make a determination of a worker’s status before withholding taxes. 11. beware of showing the “real books” to the guy who claims he wants to buy your business. the emergency economic stabilization act of 2008 made permanent the irs’s code § 7608(c) authority to engage in undercover operations. 12. claims for a method for hedging risk in commodities trading are held not to concern patent-eligible subject matter. this leads to the conclusion that tax strategies are not patentable. in re bilski, 545 f.3d 943 (fed. cir. 10/30/08) (9-3), petition for cert. filed, no. 08964 (1/28/09). the federal circuit (judge michel) affirmed a decision of the board of patent appeals and interferences that claims for a method for managing (hedging) the risks in commodities trading did not constitute a patent-eligible subject matter. the meaning of a patentable “process” under 35 u.s.c. § 101 [“whoever invents or discovers any new and useful process, machine [etc.] . . . 2009] recent developments in federal income taxation 459 may obtain a patent therefore . . . .] includes only the transformation of a physical object or substance, or an electronic signal representative of a physical object or substance. 13. a tie goes to the taxpayer, otherwise § 7491 doesn’t count. knudsen v. commissioner, 131 t.c. no. 11 (11/12/08). section 7491 does not require the trial court to decide whether the burden of proof has been shifted to the government in all cases where the issue of a burden shift is raised. where parties have satisfied their burden of production by offering some evidence, the party supported by the weight of the evidence prevails “regardless of which party bore the burden of persuasion, proof or preponderance.” “[a] shift in the burden of preponderance has real significance only in the rare event of an evidentiary tie.” xi. witholding and excixe taxes a. employment taxes 1. wisdom from the mount. medical residents may be students for fica taxes. united states v. mount sinai, 486 f.3d 1248 (11th cir. 5/18/07). section 3121(b)(10) provides that employment taxes are not payable with respect to services performed in the employ of a college or university by a student who is enrolled and regularly attending classes. the government argued that legislative history with respect to the repeal of an exemption for medical interns in 1965 (former § 3121(b)(13)) established as a matter of law that medical residents are subject to employment taxes. the eleventh circuit concluded that § 3121(b)(10) is unambiguous in its application to students and that the statute requires a factual determination whether the hospital is a “school, college, or university” and whether the residents are “students.” a. this is no april fool. the minnesota district court also finds that medical residents at the university of minnesota are students. regents of the university of minnesota v. united states, 101 a.f.t.r.2d 2008-1532 (d. minn. 4/1/08). the university’s summary judgment motion is granted by the district court holding that medical residents at the university of minnesota are not subject to employment taxes under the student exclusion of § 3121(b)(10). the court reiterated its conclusion that the full-time employee exception in reg. § 31.3121(b)(10)-2(d), as amended in 2004, is invalid. 460 florida tax review [vol. 9:si b. the district court finds that the mount sinai medical center is a school and the residents are students. united states v. mount sinai medical center of florida, inc., 102 a.f.t.r.2d 2008-5373 (s.d. fla. 7/28/08). after the decision in minnesota v. apfel, 151 f.3d 742 (8th cir. 1998), mount sinai medical center obtained refunds for fica taxes paid in 1996-1997. the united states filed suit against the medical center for erroneous refunds. following the eleventh circuit’s direction to make a factual determination whether the program qualifies for the § 3101(b)(10) exception, the district court found that the medical center’s residency programs were operated as a “school, college, or university,” that residents were present for training in patient care, which was an intrinsic and mandatory component of the training, that the residents were “students” who were regularly enrolled and attending classes. the court also found that the students’ performance of patient care services was incident to their course of study. c. south dakota medical residents are also students. center for family medicine v. united states, 102 a.f.t.r.2d 20085623 (d. s. dak. 8/6/08). following minnesota v. apfel, 151 f.3d 742 (8th cir. 1998), the south dakota district court held that medical residents in the center for family medicine (cfm) and university of south dakota school of medicine residency program (usdsmrp) were eligible for the student exception to the definition of employment under § 3101(b)(10). the court rejected the government’s assertion that cfm was not a school, college or university because cfm was affiliated with a non-profit hospital. the court found that cfm’s work includes teaching its medical residents the skills required to practice in their chosen profession. the court also concluded that the students were “enrolled” in the institution and that their attendance at noon conferences and medical rounds established that the students regularly attended classes. tossing a small bone to the government, the court held that chief residents in the programs, who are essentially coordinators for the residency programs, were not students. d. residents in chicago are also students. university of chicago hospitals v. united states, 545 f.3d 564 (7th cir. 9/23/08). the court affirmed the district court’s denial of the government’s motion for summary judgment based on the government argument that medical residents are per se ineligible for the student exemption from employment taxes under § 3121(b)(10). the court indicates that a case-by-case analysis is required to determine whether medical residents qualify for the statutory exemption. 2. vacation with pay in a sunny safe harbor, at least for the employer. rev. proc. 2008-25, 2008-13 i.r.b. 686 (3/11/08). the irs originally maintained the position that payroll taxes for year-end wages, including accrued vacation pay, could not be deducted in the year accrued 2009] recent developments in federal income taxation 461 because it was unclear whether the employee would meet the payroll tax threshold in the subsequent year when wages were actually paid. the irs lost the issue in eastman kodak co. v. united states, 534 f.2d 252 (ct. cl. 1976), acq. 1996-2 c.b. 1. this revenue procedure provides a safe harbor method of accounting under the recurring item exception of reg. § 1.446-5 allowing deduction of accrued fica and futa taxes in the taxable year in which all events have occurred that establish the fact of the related compensation liability and the amount of the related compensation liability can be determined with reasonable accuracy. the revenue procedure grants blanket permission for a change of accounting to the safe harbor method. 3. you’re laid off (or fired), here’s a benefits check, but you have to pay your employment taxes. csx corp. v. united states, 518 f.3d 1328 (fed. cir. 3/6/08). with a lengthy analysis of the statute, legislative history, case law and prior irs rulings practice, the court held that supplemental unemployment benefits paid to workers (including management, temporary and unionized employees) who are voluntarily or involuntarily separated from service are treated as wages subject to withholding under fica and the railroad retirement tax act. a. united states v. jps composite materials corp., 101 a.f.t.r.2d 2008-1488 (d. s.c. 3/25/08). summary judgment was granted to the united states in a suit to recover an erroneous refund of fica and medicare taxes paid with respect to supplemental unemployment compensation benefits. the case was being held pending resolution of the issue in csx corp. 4. railroad ties bind a subsidiary to its related rail carrier for purposes of railroad retirement and unemployment taxes. transserve, inc. v. united states, 521 f.3d 462 (5th cir. 3/19/08). commonly controlled subsidiary that derived 75 percent of its income from the manufacture and sale of railroad ties for its related rail carrier was held to provide “service in connection with transportation by rail.” the subsidiary was thus held responsible for railroad retirement act and railroad unemployment act taxes on wages paid to employees. the court affirmed lower court holding rejecting the taxpayer’s claim that it was required only to pay the lower fica and futa taxes on wages. 5. rev. rul. 2008-29, 2008-24 i.r.b. 1149 (6/15/08). the ruling provides rules to determine withholding rates with respect to payment of supplemental wages in nine different situations. 462 florida tax review [vol. 9:si 6. the heroes earnings assistance and relief tax act of 2008 clarified that any amount excludable from gross income under §139b [certain qualified benefits to volunteer firefighters and emergency medical responders] is not subject to social security tax or unemployment tax. 7. truck drivers are employees but relief was granted under § 530 of the revenue act of 1978. peno trucking, inc. v. commissioner, 296 fed.appx. 449 (6th cir. 10/3/08). the taxpayer leased tractor-trailer combinations to another company and supplied the drivers. the drivers entered into agreements with the taxpayer that they were independent contractors and the taxpayer reported the drivers’ incomes on form 1099. the court affirmed the tax court’s holding that the drivers were employees relying on the tax court’s conclusions that (1) the taxpayer oversaw the drivers’ responsibilities, determined the days they could work, and controlled the loads they would haul; (2) made a substantial investment to acquire and maintain the trucks; (3) the drivers did not assume a risk of loss; (4) the taxpayer had the right to discharge its drivers; (5) the drivers performed a service that was essential to the taxpayer’s operations; (6) the drivers worked in the course of the taxpayer’s business rather than having a transitory relationship with the taxpayer; and (7) although the taxpayer and its drivers entered into written agreements which expressly provided that the drivers were independent contractors, the facts indicated otherwise. the appellate court reversed the tax court’s holding that the taxpayer was not entitled to relief under § 530 of the revenue act of 1978, which protected employers from employment tax if there was a reasonable basis for treating workers as independent contractors. the court noted that the taxpayer had consistently treated drivers as independent contractors and that the taxpayer reasonably relied on state workers’ compensation decisions as a basis for that status. 8. section 403(b) salary reduction agreements defined. t.d. 9367, payments made by reason of a salary reduction agreement, 72 f.r. 64939 (11/19/07). treasury has finalized regulations, § 31.3121(a)(5)-2, defining contributions to § 403(b) plans under a salary reduction agreement that are subject to employment taxes. employer contributions to a § 403(b) plan that are not made pursuant to a salary reduction agreement are not subject to employment taxes. a salary reduction agreement exists if the employee elects to reduce compensation pursuant to a cash or deferred election, the employee elects to reduce compensation under a one-time irrevocable election made at or before the time of initial eligibility to participate in the plan, or the employee agrees as a condition of employment (whether imposed by statute or otherwise) to make a contribution that reduces compensation. 2009] recent developments in federal income taxation 463 a. the seventh circuit agrees with the irs position on involuntary plans, with penalties. university of chicago v, united states, 547 f.3d 773 (7th cir. 10/29/08). upholding the district court (100 a.f.t.r.2d 2007-6261 (n.d. ill. 8/21/07)), the appellate court held that contributions to employee § 403(b) plans were subject to fica withholding. the university of chicago required employees to make payments into a § 403(b) plan and referred to the employee contributions as being withheld from salaries. employees were required to sign a “salary reduction agreement.” the university also contributed to the plan on behalf of employees. section 3121(a)(5)(d) excludes from wages subject to employment taxes any payment under a § 403(b) annuity contract, “other than a payment for the purchase of such a contract which is made by reason of a salary reduction agreement.” the university argued that fica taxes are payable only with respect to contributions only if the employee voluntarily agrees to receive a lower stated salary plus payments to the plan in lieu of cash. the court reasoned that § 3121(a)(5)(d) applies to salary supplement arrangements rather than plans that provide for a reduction in employee compensation to fund contributions. • in addition, the court affirmed penalties in the amount of the employee withholding that the university failed to collect and failure to deposit and failure to pay penalties. the court found that the university’s failure to make the deposits was not due to reasonable cause. the university asserted under the “divisible tax doctrine” that its payment of a portion of the tax in order to bring the refund action absolved it of the penalty. the court indicated that the divisible tax doctrine is jurisdictional and does not absolve the taxpayer from applicable penalties. 9. temporary and proposed regulations simplify filing for small employers. t.d. 9440, employer’s annual federal tax return and modifications to the deposit rules, 73 f.r. 79354 (12/29/08); reg148568-04, employer’s annual federal tax return and modifications to the deposit rules, 73 f.r. 79423 (12/29/08); rev.proc. 2009-13, 2009-3 i.r.b. (12/29/08). temp. reg. § 31.6011(a)-1t(a)(5) provides for annual filing of employment tax returns for employers notified by the irs to file annual returns on form 944 (instead of quarterly filings on form 941), generally applicable to employers with less than $1,000 of annual employment tax liability (social security, medicare, and wage withholding). the temporary regulations were revised to make the use of form 944 optional for taxpayers who notify the irs that they will file the quarterly form 941 and permit taxpayers to change their filing method from year-to-year. temp. reg. §§ 31.6011(a)-1t(a)(5) and 31.6011(a)-4t(a)(4) allow taxpayers who estimate that their employment tax liability will be $1,000 or less to contact the irs to express a desire to file form 944 instead of form 941, following which the irs will send a notice to the taxpayer directing the taxpayer to file the form 944 annually. taxpayer in 464 florida tax review [vol. 9:si receipt of this notice must continue to file the form 944 until they contact the irs to change the filing requirement and receive confirmation from the irs that their filing requirement has been changed. rev. proc. 2009-13 contains procedures for changing the filing status. the temporary regulations also modify the “look-back” rules for determining whether form 941 filers with less than $2,500 of employment tax liability in a quarter can file quarterly rather than monthly or semi-weekly deposits. b. self-employment taxes 1. edwards v. commissioner, t.c. memo. 2008-24 (2/7/08). commissions based on insurance renewals paid to a retired insurance agent by his sole proprietorship agency are subject to self-employment tax. the fact that day-to-day operations of the insurance agency had been turned over to employees does not affect the result. 2. failure to meet mandatory electronic filing incurs penalties even though employment taxes in the correct amount are paid on a timely basis. fallu productions v. united states, 101 a.f.t.r.2d 2008-855 (s.d. n.y. 2/13/08). reg. § 31.6302-1(h) requires that certain deposits of employment taxes be made electronically. the taxpayer, a film production company owned by the actor joe pesci paid its employment taxes by deposit in an approved bank, but not electronically. the court granted summary judgment imposing failure to pay penalties under § 6656 for failure to make the deposits in the required electronic fashion. 3. emergency economic stabilization act of 2008, division c, § 504(c), provides that amounts received by taxpayer engaged in the fishing business from the settlement of exxon valdez litigation are not treated as self-employment income. c. excise taxes 1. worldwide equipment v. united states, 546 f.supp.2d 459 (e.d. ky. 2/29/08). summary judgment was granted to the government holding that mack trucks designed primarily to haul coal from the mine to the tipple are subject to the 12% excise tax on the retail sale of heavy truck bodies and chassis. customization activities by the dealer did not make the trucks unsuitable for highway use. 2009] recent developments in federal income taxation 465 2. ahoy mates! emergency economic stabilization act of 2008, act§ 306, retroactively extends the $13.50 per gallon payment of excise tax to puerto rico (up from $10.50) for imported rum. 3. benefits for robin hood’s children hunting pork. emergency economic stabilization act of 2008, act § 503(a), amends § 4161(b)(2)(b) to exempt from excise tax all-natural arrow shafts measuring 5/16 of an inch that are not suited for use with bows drawing more than 30 pounds. 4. the emergency economic stabilization act of 2008 [division b], the energy improvement and extension act, § 113, extends the temporary increase in the coal excise tax of § 4121, funding the black lung disability trust, to 12/31/18. • section 202 extends the gasoline excise tax credit of § 6426 for biodiesel and renewable diesel fuels to fuels produced before january 1, 2010, and increases the biofuel credit from 50 cents to $1 per gallon. • section 206 amends § 4053 by adding an exclusion from the heavy truck excise tax of § 4051 for truck heating and cooling devices that do not require operation of the main engine while the vehicle is parked. xii. tax legislation a. enacted 1. the economic stimulus act of 2008, p.l. 110-185, was signed by president bush on 2/13/08. the bill contains several tax provisions, including an increase for 2008 in the § 179 dollar limitation to $250,000 (phase-out increase to $800,000), and the application of the § 168(k) special allowance of 50 percent to property acquired during 2008. 2. the food, conservation, and energy act of 2008, (the “2008 farm act”), p.l. 110-234, was enacted over president bush’s veto on 5/22/08. the portion of the farm act containing tax provisions are referred to as the heartland, habitat, harvest, and horticulture act of 2008. 3. the heroes earnings assistance and relief tax act of 2008 (the “heart act”), p.l. 110-245, was signed by president bush on 6/17/08. 466 florida tax review [vol. 9:si 4. the housing and economic recovery act of 2008, p.l. 110-289, was signed by president bush on 7/30/08. the tax provisions in that act are referred to as the housing assistance tax act of 2008. 5. the emergency economic stabilization act of 2008 [division a], the energy improvement and extension act of 2008 [division b], and the tax extenders and alternative minimum tax relief act of 2008 [division c], p.l. 110-343 was signed by president bush on 10/3/08. • the provisions of these acts authorize the secretary of the treasury to establish a troubled assets relief program to purchase troubled assets from financial institutions; provide alternative minimum tax relief; extend expiring tax provisions and establish energy tax incentives; and temporarily increase federal deposit insurance limits. 6. the fostering connections to success and increasing adoptions act, p.l. 110-351 was signed by president bush on 10/7/08. 7. “i gets wrera and sick of trying.” the worker, retiree, and employer recovery act of 2008 (“wrera”), p.l. 110-458, was signed by president bush on 12/23/08. florida tax review volume 7 2006 number 9 a new model for indentifying basis in life insurance policies: implementation and deference by mitchell m gans* jay a. soled the life insurance marketplace has changed significantly. many insureds who once held their policy until death or surrendered it to the issuing company during life now instead sell it to a third-party investor. as a result, the computation of a policy's tax basis has become increasingly important. yet, surprisingly, the code fails to provide a methodology for making this determination. the irs has endorsed one approach in its published guidance but has failed to adhere to it in its private letter rulings. this paper calls for a new model. after suggesting legislation, the paper explores alternative implementation strategies against the backdrop of deference jurisprudence. it concludes that, absent legislation, the irs should withdraw its published guidance and incorporate the proposed model in regulations. * mitchell m. gans, steven a. horowitz distinguished professor in taxation, hofstra university school of law and adjunct professor of law, nyu school of law. ** jay a. soled, professor of law, rutgers university. the authors wish to thank jonathan g. blattmacher and stephan r. leimberg for their helpful advice and suggestions. florida tax review i. introduction ............................................ 571 ii. computing tax basis .................................... 572 a. set ofauthorities that generally frame the debate ....... 573 1. analysis of cases in which taxpayers experienced losses ............................ 574 2. analysis of cases in which taxpayers experienced gains ............................ 576 b. survey of the aggregate premium theory ............... 578 c. survey of the policy investment theory ................. 580 iii. the theoretical superiority of the policy investment approach .................................. 582 a. distinguishing between acquisition and upkeep costs .... 583 b. the nature of life insurance ......................... 588 iv. computing tax basis under the policy investment theory ................................... 588 a. mechanism to determine the investment portion of an insurance policy .................................. 589 b. the appropriate tax treatment of insurance commissions 590 v. implementing the hypothetical term method deference . 592 a. revoke revenue ruling 70-38 ......................... 594 b. promulgate a new regulation ........................ 596 1. probable application of the chevron standard ..... 596 2. possible application of a different deference standard in tax cases .......................... 597 vi. dispositions of life insurance policies .................. 605 a. the emergence of the life settlement companies .......... 607 b. premium financing technique ........................ 609 1. determining the amount of the taxable gain ....... 610 2. the character of the gain ..................... 611 vii. conclusion .......................................... 620 [vol. 7:9 a new model for identifying basis in life insurance i. introduction in order to compute the gain or loss on the sale or disposition of an asset, a taxpayer is required to determine the investment's basis.' while ordinarily straightforward, at least as a theoretical matter, making this determination can be particularly problematic in the case of a life insurance policy. since so many taxpayers own life insurance policies, it is somewhat puzzling that the basiscalculation principles in this context are not more fully developed. in the past, this uncertainty did not have practical implications. the vast majority of taxpayers either held their policies until death or allowed them to lapse. in either case, there was often no need to compute gain or loss, mooting the need to determine basis. as a result, the internal revenue service (irs) and the courts had few occasions to consider the issue. in recent years, the function of life insurance has changed, however. whereas it once provided economic protection for surviving family members in the event of a premature death,2 it now also frequently serves an important investment function.' it is thus not surprising that life insurance policies are now, like other investments, often sold in the marketplace.4 as a result of these changes, it is important to reexamine and clarify the application of tax basis principles in the life insurance context. the aim of this paper is to consider these tax basis principles in both descriptive and normative terms. to this end, we have organized the paper into sections. in section ii we explore general tax basis rules and, in particular, the tax basis principles applicable to life insurance. in section iii we argue in favor of 1. irc § 1001(a). for a detailed discussion of irc § 1001, see louis a. del cotto, sales and other dispositions of property under § 1001: the taxable event, amount realized and related problems of basis, 26 buff. l. rev. 219 (1977). for an exhaustive discussion of tax basis rules, see james edward maule, income tax basis: overview and conceptual aspects, 560-2d tax management portfolios. 2. when life insurance policies were first introduced to the marketplace, they had a singular purpose: to protect against the risk of premature death. adam f. scales, man, god and the serbonian bog: the evolution of accidental death insurance, 86 iowa l. rev. 173, 185-90 (2000). see generally j. owen stalson, marketing life insurance: its history in america (harvard univ. press 1942); s.s. huebner & kenneth black jr., life insurance (7th ed. 1969). 3. see the life insurance fact book 85 (2004) ("in 2003, direct purchases of permanent life constituted 53% of u.s. individual policies issued and 30% of the total face amount issued."). see generally, viviana a. rotman zelizer, morals and markets: the development of life insurance in the united states (1979); ben g. baldwin & william g. droms, the life insurance investment advisor: a guide to understanding and selecting today's insurance products (1988). 4. see infra part vi. in addition, because of a confluence of factors, a novel premium-financing technique has developed. the economic viability of this technique may well depend upon how the insured computes the basis in the policy. see infra notes 168-70 and accompanying text. 2006] florida tax review what we call the policy-investment theory. in section iv, we illustrate the application of this theory and call for a code amendment that would eliminate the inequity under current law that treats policy surrenders more tax favorably than policy sales. in the absence of such an amendment, in section v we focus on implementation through a different route, suggesting that the irs withdraw a taxpayer-friendly revenue ruling and that it promulgate a new regulation; we also examine recent developments in deference jurisprudence and the tax court's resistance to the supreme court's administrative law precedents. in section vi, we discuss the changing nature of life insurance and emergence of a new premiumfinancing technique. in section vii, we offer our conclusions. h. computing tax basis accurate tax basis identification is important because gains and losses are measured by the difference between the amount realized and an asset's tax basis.' a higher tax basis is desirable because it translates into smaller taxable gains and larger tax-deductible losses. thus, tax basis determinations directly impact a taxpayer's tax burden. in theory, identifying an asset's tax basis should be relatively easy; after all, tax basis represents the investment a taxpayer has in an asset. for example, if a taxpayer purchases a tractor for $10,000, $10,000 represents the taxpayer's investment in the tractor and is thus the tractor's initial cost basis. in practice, however, determining an asset's tax basis is often quite nettlesome:7 application of the tax basis rules can be extraordinarily complex and time-consuming in the case of life insurance, practical application is not the issue rather, it is the unsettled nature of the law itself that is problematic. to illustrate, consider the following example: suppose a taxpayer purchases a $1 million whole life insurance policy. suppose further that the annual premium associated with maintaining the policy is $10,000 and that the cash surrender value grows $6,000 each year because $4,000 of the premium is attributable to the cost-of-insurance protection.9 at the end of year ten, what should the taxpayer's tax basis be in the life insurance policy if it were sold for $150,000? 5. irc § 1001 (a). 6. irc § 1012. 7. see generally, joseph m. dodge & jay a. soled, debunking the basis myth under the income tax, 81 ind. l.j. 539 (2006). 8. id. at 547-56. 9. actuarially, regarding insurance contracts with fixed-death benefits, the life insurance protection portion of a premium will decrease with each passing year as the cash reserve increases. to make our illustration easier to follow, however, we nevertheless assume the life insurance protection portion of the premium remains constant, disregarding the increase in cash reserve attributable to the earnings buildup within the policy. [vol. 7:9 a new model for identifying basis in life insurance some commentators argue that the taxpayer's tax basis in the policy is $100,000, reflecting the aggregate premiums paid (i.e., 10 x $10,000)hereinafter referred to as the aggregate premium theory." after initially utilizing the aggregate premium theory in published guidance," the irs has begun to argue in private letter rulings that the taxpayer's tax basis in the policy should be $60,000, which reflects the aggregate premiums paid less the annual cost-of-insurance protection (i.e., 10 x ($10,000 $4,000)) hereinafter referred to as the policy investment theory.'2 in part a, we survey the set of authorities that frame the debate; in part b, we describe how those who champion the aggregate premium theory support their point of view; and in part c, we describe how the irs supports the policy investment theory. a. set ofauthorities that generally frame the debate in 1920, before the courts began to grapple with the issue, the government issued an important ruling. in the ruling, office decision 724,3 a corporation sold policies insuring the lives of its officers. emphasizing that no deduction had been taken for the premium payments and that the sales price was less than the aggregate amount of premiums paid, the government ruled that the sales proceeds were not taxable. in doing so, the government in effect endorsed the aggregate premium approach. although the ruling does not explicitly indicate whether gain or loss was at issue, the most natural reading is that a taxpayer in the posited situation should experience neither. in reverend ruling 70-38, 4 the irs indicated that it would continue adhering to the position taken in office decision 724. the ruling posits the same facts as in the office decision except that it makes one additional assumption: the policies were sold at a price equal to their cash value. like the office decision, the ruling emphasizes that the sales price is less than the amount of aggregate 10. see infra part ii.b. 11. see infra part ii.a. 12. see infra part ii.c. 13. c.b. 3,244 (1920). in its entirety, the ruling reads as follows: a corporation which carried insurance policies on the lives of its officers under which it was named as the beneficiary sold the policies for a sum less than the total premiums paid and not deducted from gross income. no part of the amount received for the policies is taxable. 14. 1970-1 c.b. 11. see also chief couns. adv. 2005-04-001 (dated oct. 12, 2004) (in characterizing rev. rul. 70-38, it states that the corporation discussed in the ruling was "not required to include in its gross income the amount received from the sale of the insurance policies"). 2006] florida tax review premiums and goes on to conclude that the sale thus does not generate any gross income. most important, the additional assumption contained in the ruling does not suggest an abandonment of the aggregate premium approach adopted in the office decision 5 having set forth this background, we next analyze the consequences associated with the disposition of life insurance policies, first in those cases in which taxpayers experienced losses and second in those cases in which taxpayers experienced gains. 1. analysis of cases in which taxpayers experienced losses in the context of computing losses, the irs essentially ignored its own administrative rulings and instead gravitated towards adopting the policy investment theory. the policy investment theory, with its elimination of mortality charges from basis (i.e., the annual amount paid for insurance protection), effectively protects taxpayers from converting nondeductible cost-of-insurance into a deductible loss.' 6 the first case, standard brewing co. v. comm 'r, 7 involved facts similar to those in the office decision and the revenue ruling. the corporate taxpayer had taken out a life insurance policy on the lives of its officers. 8 the total premiums paid were $11,178.50, and the policy was subsequently surrendered for its cash value of $6,647.19 the taxpayer attempted to deduct the $4,531.50 difference between these two figures (i.e., $11,178.50 and $6,647).2o the irs disallowed this deduction and the board of tax appeals upheld this position, stating that "[t]o the extent the premiums paid by the petitioner created in it a right to a surrender value, they constituted a capital investment. to the extent they exceeded the surrender value, they constituted payment for earned insurance and were current expenses." 2' in effect, the court held that the taxpayer's basis was equal to the policy's cash surrender value (i.e., $6,647), and the insurance protection portion of the premium 15. a sale at a price equal to cash value could certainly produce a taxable gain in that cash value increases over time as earnings accrue. yet, under the ruling, no gain is produced if the price is less than the amount of aggregate premiums. thus, rev. rul. 70-38 perpetuates the government's endorsement of the aggregate premium approach in the office decision indeed, it would be difficult to read the ruling differently inasmuch as it explicitly acknowledges that it is designed to do nothing more than restate (rather than overrule) the government's initial position. 16. see irc § 264 (denying a deduction for the payment of life insurance premiums). for example, if the taxpayer had paid $10,000 in premiums, sold the policy for $6,000, and then sought to deduct $4,000 as a loss, irc § 264 strongly suggests that this would be an inappropriate outcome. 17. 6 b.t.a. 980, 982 (1927). 18. id. 19. id. 20. id. 21. id. at 984. [vol. 7:9 a new model for identifying basis in life insurance (i.e., $4,531.50) was an extinguished asset. the taxpayer, therefore, did not sustain an allowable loss on the sale. with a single, and ultimately unimportant, exception,' the government handily won every subsequent case on this issue. three cases, namely, keystone consolidated publishing co. v. comm 'r,23 century wood preserving co. v. comm 'r,24 and summers & moore v. comm 'r,25 involved the sale of life insurance polices at a price equal to their cash surrender values, which were far less than the aggregate premiums paid by the taxpayers. in each case, as in standard brewing, the taxpayer sought to deduct as a loss the difference between the (higher) aggregate premiums paid and the (lower) sales proceeds received. the courts, however, uniformly denied the deduction, holding that the taxpayer's basis was equal to the policy's cash surrender value (which, in these cases, equaled the selling price of the policies). echoed in many of these decisions is the following simple principle: "the part of the premiums which represents annual insurance protection has been earned and used. '26 as such, it could not be embedded in the policy's tax basis. court cases that involved the surrender, rather than the sale, of a policy have also denied loss deductions to taxpayers who attempted to invoke the aggregate premium approach. in the context of a policy surrender, the code directs taxpayers to use the aggregate premiums paid as their tax basis forgain purposes;27 in contrast, the code is silent about how to compute tax basis for loss purposes. thus, in the surrender cases as in the sales cases, the courts were required to compute tax basis using conventional principles in determining the amount of the 22. see forbes lithograph mfg. co. v. white, 42 f.2d 287, 288 (d. mass. 1930). the facts of forbes were virtually identical to those of standard brewing co.: a corporation owned life insurance policies on the lives of its officers. when the company surrendered these policies, it sought to take a loss on the difference between the cash value it received and the premiums it had paid. the federal district court of massachusetts held in the taxpayer's favor, ruling that the taxpayer's basis in a life insurance contract was equal to the amount of aggregate premiums it had paid, not the policy's cash surrender value. in reaching this holding, the court relied almost exclusively on lucas v. alexander, 279 u.s. 573 (1929), a united states supreme court decision. while the alexander case addressed the issue of tax basis, its primary focus was the value of certain endowment policies owned on march 1, 1913 (the inception date of the income tax). 23. 26 b.t.a. 1210 (1932). 24. 69 f.2d 967 (3rd cir. 1934). 25. b.t.a.m. (p.h.) 35100 (1935). 26. id. in century wood preserving, the court did not establish a per se rule that basis is equal to cash value. it held instead that basis must be reduced by the costof-insurance protection and that, given the taxpayer's failure of proof, basis should not exceed cash value. see 69 f.2d at 968; see also priv. ltr. rul. 94-43-020 (jul. 22, 1994) (adopting this analysis). 27. see irc § 72(e). 20061 florida tax review taxpayer's loss. in london shoe co. v. comm 'r2a and early v. atkinson," taxpayers surrendered life insurance policies for their cash value, which, as in the sales cases, was far less than the aggregate premiums paid. in both cases, the taxpayers sought to deduct the difference between the (higher) premiums paid and the (lower) amount received on surrender. the courts denied the loss deduction, adopting the same reasoning as in the sales cases, concluding that the portion of the premium attributable to the cost-of-insurance protection should not be included in basis. it is worth emphasizing that in each set of the cases, whether involving a sale or surrender, the denial of the loss deduction served an important policy function. had the taxpayers been successful, they would have effectively subverted the rule denying deductions for the payment of life insurance premiums.30 2. analysis of cases in which taxpayers experienced gains in the context of computing gains,3' however, courts have taken a divergent track: they have uniformly assumed that it is appropriate to use the aggregate premium approach.32 indeed, in cases involving the taxability of gains, the irs did not even suggest the availability of an alternative to the aggregate premium approach. by way of background, in endeavors to minimize their tax liabilities, taxpayers who have experienced gains on the dispositions of their life insurance policies have sought to secure capital gain treatment.33 these taxpayers were anxious to secure the preferential capital gain rates?4 but, as will later be discussed,35 in order to qualify as capital gains these taxpayers had to cast their 28. 80 f.2d 230 (2nd cir. 1935). 29. 175 f.2d 118 (4th cir. 1949). 30. see irc § 264. when formulating its approach in the office decision it issued in 1920 and when restating its position under current law in rev. rul. 70-38, the government may have inadvertently overlooked this concern, failing to appreciate that its tacit endorsement of the aggregate premium approach would eventually be cited by taxpayers who experienced gains on the sale of their policies. 31. for a discussion of loss cases, see supra notes 16-27. 32. see infra notes 35, 38. 33. see david f. shores, reexamining the relationship between capital gain and the assignment of income, 13 ind. l. rev. 463 (1980); charles s. lyon & james s. eustice, assignment of income: fruit and tree as irrigated by the p. g. lake case, 17 tax l. rev. 293 (1961-62); note, distinguishing ordinary income from capital gain where rights to future income are sold, 69 harv. l. rev. 737 (1955-56); note, the p.g. lake guides to ordinary income: an appraisal in light of capital gains policies, 14 stan. l. rev. 551 (1961-62) (explaining the p.g. lake and its implications). 34. see gregg a. esenwein, crs reviews legislative history ofcapital gains income tax, 2005 tnt 123-17 (june 28, 2005) (report indicates that capital gain tax rates have historically been much lower than ordinary income tax rates). 35. see infra part vi.b. [vol. 7:9 a new model for identifying basis in life insurance disposition in the form of a sale or exchange,36 and, second, they had to overcome the so-called substitution doctrine, under which capital treatment is denied in instances when taxpayers experience gains that are in essence a substitute for ordinary income.37 phillips v. comm 'r38 illustrates the difficulties of taxpayers' endeavors to secure capital gain treatment. in phillips, the taxpayer owned an endowment policy.39 the aggregate premiums of this policy totaled $21,360.49, and it had a cash surrender value of $26,973.78.40 the taxpayer sold the policy for $26,750 to two of his partners, twelve days before its maturity value of $27,000. 4 , the issue before the court was the character of the $5,389.51 gain (i.e., $26,750 less $21,360.49) the taxpayer had recognized (not whether the taxpayer's basis in the policy was $21,360.49 or some lesser number to reflect mortality charges).42 the taxpayer argued that long-term capital gain treatment was appropriate because the policy was a capital asset, it was sold, and it was held for the requisite holding period.43 the fourth circuit had an entirely different perspective. relying on several supreme court precedents," it asserted that a "taxpayer may not convert such income into capital gain by a bona fide sale of the contract which is the means of producing such ordinary income."' several other courts reached the identical conclusion on the character-of-gain issue," largely premised on the fourth circuit court's same line of reasoning. while phillips and the other cases involved character-of-income issues,47 all of these courts assumed the taxpayer's basis was equal to the aggregate premiums the taxpayers had paid for the policies in question (e.g., $21,360.49 in the phillips decision). in none of these cases did the irs argue (or even suggest) that amounts paid for the insurance protection feature caused the taxpayer's reported basis to be less, nor did any of the courts unilaterally raise this issue." in the end, one might fairly characterize the decided cases on the issue of tax basis as falling into one of two camps: the loss cases, where the courts applied 36. see irc § 1222 (requiring a "sale or exchange"). 37. see infra part vi.b.2. 38. 275 f.2d 33 (4th cir. 1960). 39. id. at 33. 40. id. 41. id. at 34. 42. id. 43. phillips, 275 f.2d at 36. 44. e.g., hort v. comm'r, 313 u.s. 28 (1941); comm'r v. p.g. lake, inc., 356 u.s. 260 (1958). 45. phillips, 275 f.2d at 35. 46. estate of croker v. comm'r, 37 t.c. 605 (1962); neese v. comm'r, 23 t.c.m. 1748 (1964); avery v. comm'r, 111 f.2d 19 (9th cir. 1940); gallun v. comm'r, 327 f.2d 809 (7th cir. 1964). 47. see supra notes 28-38. 48. see supra notes 35 and 38 and accompanying text. 2006] florida tax review the policy investment approach; and the gain cases, where the courts assumed the application of the aggregate premium approach. what accounts for this confusion? first, the government itself bears responsibility. the 1920 office decision, together with its restatement in reverend rulling 70-38, has made no small contribution in terms of shaping the tax basis issue. remaining faithful to its position in these rulings, the irs has apparently not argued in court that the principle established in the loss cases should be applied in gain cases. second, in permitting taxpayers to use the aggregate premium approach in determining gain on the surrender of a policy,49 the code itself fosters the impression that gain on a sale should likewise be determined under this methodology. and, third, while, as suggested, there is a strong policy undercurrent driving the result in the loss cases,50 the gain cases which have a very different complexion," have not grappled with this difference. b. survey of the aggregate premium theory there are, in essence, three lines of reasoning that support the aggregate premium theory.52 first, the most compelling argument that can be made on behalf of the aggregate premium approach is that the irs itself has embraced it. as indicated, in reverend ruling 70-38, which restates office decision 724, the irs concludes that a sale of a policy for less than the amount of aggregate premiums produces neither gain nor loss.53 while the revenue ruling assumes that the sales price is equal to the policy's cash value, it cannot reasonably be read as implying that gain would be recognized if the price were greater than the cash value but still less than the amount of aggregate premiums.m the ruling merely restates the office decision under current law, and, in the office decision, no mention is made of the policy's cash surrender value; it simply hypothesizes a sale at a price that is less than the aggregate premium amount.5" moreover, a sale of a policy for a price equal to its cash surrender value should, in most instances, under a correct 49. see irc § 72(e)(6). 50. see supra note 16. 51. see supra notes 28-38. 52. for a discussion of these arguments, see, generally, michael j. frankel, life settlements: sale of life insurance policies in the open market, in 39th annual heckerling institute on estate planning (2005); burgess j.w. raby & william l. raby, the tax treatment of life insurance settlements, 19 ins. tax rev. 385 (2000); see also sherwin p. simmons, life-settlements, senior settlements, and other variations on viatical sales, sk020 ali-aba 163 (2004) (mentioning an opinion letter issued by the accounting firm kpmg to viaticus, inc., that endorses this position). 53. see supra note 14 and accompanying text. 54. see priv. ltr. rul. 80-50-045 (sept. 17, 1980) (describing rev. rul. 70-38 as authority for the proposition that taxpayers are not required "to include in [their] gross income the amount received from the sale of the insurance policies"). 55. id. [vol. 7:9 a new model for identifying basis in life insurance application of the policy investment approach, produce gain. more specifically, to the extent that the cash value grows as a result of an earnings buildup in the policy's reserve value, gain should be recognized in the case of a sale for a price equal to the policy's cash value under the policy investment theory, even if the price is less than aggregate premiums. 6 in concluding that gain is not recognized on the facts of the ruling, the irs implicitly disavowed the policy investment approach. the irs's position is, moreover, reflected in its failure to object to the taxpayer's use of the aggregate premium ai)proach in the gain cases where the character of income was at issue.57 as a result, whatever merit the policy investment theory holds, taxpayers ought to be able to rely on its apparent rejection by the irs, at least until its own rulings are withdrawn." the second line of argument supporting the aggregate premium approach is predicated on the treatment of a policy surrender. in the case of a policy surrender, as suggested, the code explicitly permits taxpayers to use the aggregate premium approach for purposes of computing gain.59 thus, the code does lend some indirect support to the proponents of the aggregate premium approach. indeed, there is no other provision in the code directing that a different approach be taken in computing basis in the context of a sale. given this silence in the face of the code's explicit adoption of the aggregate premium payment approach in code section 72, and given the inequity that necessarily results from treating a taxpayer who surrenders a policy differently from one who sells it to a third party,' the argument in favor of applying the aggregate premium approach in both contexts is not entirely unappealing. a final line of argument, made by some of the aggregate premium proponents, is that a life insurance policy is a unitary asset with two integrated components: an investment component in the form of cash reserves and a personalconsumption component in the form of insurance protection. one might analogize life insurance to other personal-use assets, like a home, which also have an 56. to illustrate, assume that, after paying a premium of $10,000, the cash value at the end of one year is equal to $6,300 or the sum of(i) $6,000 (the residual after accounting for the insurance protection charge) plus (ii) the earnings buildup accruing during the year, here assumed to be $300. a sale of the policy for its cash surrender value, $6,300, would produce $300 of gain under the policy investment approach (see supra part iv), but produces no gain under the aggregate premium approach. 57. see supra notes 28-38 and accompanying text. 58. see infra part v. 59. irc § 72(e)(5) provides that "the amount received on the surrender of a life insurance contract is included in gross income to the extent it exceeds the 'investment in the contract."' the code amplifies the meaning of investment in a contract with the following definition: it is the "aggregate premiums paid less amounts received under the contract before the surrender that were not included in gross income." irc § 72(e)(6). 60. see london shoe co. v. comm'r, 80 f.2d 230 (2nd cir. 1935) (acknowledging the lack of parallelism between the predecessor of code § 72 and the provisions in the code that determine basis in the policy). 2006] florida tax review investment and a personal-consumption component.6 as the argument goes, the owner of a home is not required to reduce basis on account of usage.62 so why, the proponents of the aggregate premium approach ask, should life insurance be treated differently? they accordingly maintain that the mortality charges for the cost of life insurance should not result in a tax basis reduction. c. survey of the policy investment theory notwithstanding the formal position it adopted in office decision 724 and reverend ruling 70-38, the irs has begun to flirt with the policy investment theory. it first deviated from its published position in private letter ruling 9443020.63 this ruling discussed the tax implications where a taxpayer afflicted with aids sold an insurance policy on his life to a viatical settlement company. the first issue addressed in this ruling was whether the sale of the policy constituted a taxable event; the second issue was how to compute the taxable amount if this event were taxable. the irs ruled that the proceeds from this sale 61. cf moseley v. comm'r, 72 t.c. 183 (1979). in moseley, the taxpayer purchased a $5,000 twenty-payment life insurance policy. the policy required annual premium payments of $192.40. the policy also contained a special provision establishing that the insurance company would credit to a special reserve account $96.20 of the annual premiums paid from the second to the fifth year of the policy. at the end of the policy's tenth or twentieth year, assuming the policy owner were still living, the policy owner would have the right to receive a dividend distribution essentially equal to the then-value of the special reserve account. twenty years after the policy's inception, the taxpayer exercised his right to receive a dividend distribution and was sent a check equal to $3,561.95. the taxpayer took the position that this amount was not taxable because his aggregate premiums totaled $3,848 and code § 72(e)(1)(b) shielded from tax any amounts received up to this threshold (i.e., the dividend distribution did not exceed the aggregate premium payments). the irs disputed this position: it argued that the special reserve account should be treated separately and apart from the insurance protection part of the policy. therefore, because the taxpayer received a dividend payment in excess of the premium payments allocated to the special reserve account, the taxpayer experienced a taxable event on the difference between the proceeds he received ($3,561.95) and the amount he invested ($384.80, i.e., 4 x $96.20). the underlying premise of the irs's approach was that there were "two distinct and economically independent policies" at work, and thus a bifurcated analysis of each component of the policy was appropriate. id. at 186. the tax court did not see it this way, however. the court pointed out that the two components of the contract were interrelated and, furthermore, that neither of these components could be separately purchased. that being the case, the court held that the phrase aggregate premiums as used in the code applied to the whole contract. id. at 187. in the court's view, "the special reserve provisions [were] inseparable from the insurance provisions of the policy," so the court ruled in the taxpayer's favor. id. 62. see infra notes 66-67 and accompanying text. 63. dated jul. 22, 1994. [viol. 7:9 a new model for identifying basis in life insurance were taxable to the taxpayer under code section 61, noting that the shelter of code section 101(a), which excludes policy proceeds from income, only applies in circumstances when the insured has died.' next, the irs sought to compute the amount of the taxable gain resulting from the sale. to do so, it needed to determine the taxpayer's basis in his life insurance policy. the irs first indicated that the governing code sections were 1011, 1012, and 1016 and then added that the relevant case law included century wood and london shoe. on the basis of these authorities, the irs declared that the taxpayer's basis in his life insurance policy was equal "to the premiums paid less the sum of(i) the cost-of-insurance protection provided through the date of sale and (ii) any amounts (e.g., dividends) received under the contract that have not been included in gross income. ' the controversial part of the irs's ruling was its insistence that, contrary to office decision 724 and reverend ruling 70-38, the policy's tax basis be reduced by the insurance protection portion of the premium (invoking, in effect, the policy investment theory). 6 since issuing private letter ruling 94-43-020 and other private letter rulings, the irs has continued to argue in favor of the policy investment theory.6 7 64. id. this private letter ruling predates the passage of code § 101 (g) (a code section that now excludes the receipt of viatical settlements from income). see also irc § 101(a). 65. priv. ltr. rul. 94-43-020 (jul. 22, 1994). 66. id. to determine the actual amount of the reduction, the irs offered the following guidance: "[t]he cost-of-insurance protection may be approximated using the difference between (i) the aggregate amount of premiums paid and (ii) the cash value of the contract with regard to surrender charges." id. at n.4 (citing century wood preserving co. v. comm'r, 69 f.2d. 967 (3rd cir. 1934)). applying the irs formula to our hypothetical, where the annual premiums are $10,000 but the annual cash surrender value grows by only $6,000, the annual insurance protection cost is $4,000. 67. see field serv. adv. mem. 1999-832, vaugn # 242 (undated), in which the taxpayer in question was a shareholder in an s corporation. the s corporation experienced losses that the taxpayer wished to deduct. the code, however, limits allowable losses to the amount of tax basis shareholders have in their s corporation shares (irc § 1366(d)(1)); all losses in excess of such basis are suspended (irc § 1366(d)(2)). the irs was charged with the duty of determining the taxpayer's basis in his s corporation stock, which, in turn, would determine the amount of the taxpayer's allowable losses. by way of background, a shareholder's basis in an s corporation is generally equal to the shareholder's initial capital investment subject to several annual adjustments. these adjustments are detailed in code § 1367, including one that provides a reduction for "any expense of the corporation not deductible in computing its taxable income and not properly chargeable to capital account." irc § 1367(a)(2)(d). this downward basis adjustment was critically relevant to the question at hand because the s corporation made premium payments to fund several insurance policies on the lives of its key employees. more specifically, the s corporation paid annual premiums of $10,000 (the actual number was redacted from the text), of which $6,000 (again, the 2006] florida tax review for example, in chief counsel advisory opinion 2005-04-001, the irs discussed the tax consequences for a taxpayer who owned a life insurance policy on the life of her ex-spouse.' after five years of owning the policy and paying premiums, the taxpayer was fraudulently enticed by the insurance company underwriting the policy to convert it into a new policy on the life of her exhusband. a court found that the insurance company had misled the taxpayer and granted her a cash award. the portion of the award that related to interest was admittedly taxable. the remaining portion of the award, the taxpayer argued, was a tax-free recovery of the premiums and costs the taxpayer had paid with respect to the policy on her ex-spouse. the irs did not agree: consistent with private letter ruling 94-43-020, the irs argued that the insurance protection portion of the policy had already benefitted the taxpayer. that being the case, this portion of the premium payment could not constitute tax basis in the policy and thereby be used to shelter any of the taxpayer's recovery. ill. the theoretical superiority of the policy investment approach the aggregate premium theory and the policy investment theory are at direct odds; each offers a different outcome insofar as tax basis determinations are concerned. the question to which we turn is whether the policy investment approach or the aggregate premium approach is preferable. but before we answer this question, we explore the nature of life insurance and how, from a property perspective, it should be classified. like other personaluse assets having personal-consumption and investment-type components, life insurance policies engender two different kinds of cost that must be distinguished actual number was redacted from the text) was attributable to the cash surrender value of the policies and was reflected as an asset on the company's books, while the remaining $4,000 (this number represents an extrapolation of the prior two figures) was treated as a nondeductible company expense. code § 264 explicitly states that the premiums paid by a taxpayer for life insurance constitute a nondeductible expense. accordingly, code § 1367 (which, as just indicated, mandates a downward basis adjustment for any nondeductible expense) required that the shareholders reduce the tax basis they had in their shares by the premium payment. but by what number the full amount of the premium paid ($10,000) or the insurance protection portion of the premium ($4,000)? ruling in the taxpayer's favor, the irs limited the taxpayer's downward basis adjustment to $4,000. the irs stated that "the premium payments by [the taxpayer] reduce shareholders' basis to the extent those premiums are truly made in return for life insurance." the other portion of the premium, related to the policy's cash surrender value, "results in the corporation receiving a valuable proprietary right" and therefore has no effect on the shareholder's basis in his s corporation stock. from the irs's perspective, this bifurcated approach towards life insurance policy analysis was the one that best corresponded with economic reality. 68. dated oct. 12, 2004. [vol 7:9 a new model for identifying basis in life insurance for tax purposes: the cost of acquisition and the cost of upkeep. taxpayers can include the former,69 but not the latter,7" in the tax basis of their personal-use assets. distinguishing between acquisition and upkeep costs is thus very important. yet, making this distinction is sometimes challenging, particularly for life insurance policies. in section a we explore the different nature of these expenditures, enabling us from a better vantage point in section b to analyze the correct tax treatment of life insurance policies. a. distinguishing between acquisition and upkeep costs as indicated,7 when taxpayers make expenditures, the code attaches importance to how these expenditures are classified: the cost of acquisition is embedded in an asset's tax basis, whereas the cost of upkeep is extinguished and does not become part of an asset's tax basis. to illustrate this point, consider two examples that entail acquisition and upkeep expenses. the first involves the purchase of a single use asset that for tax purposes is treated as a unitary whole. the second involves the purchase of a dual use asset that for tax purposes is treated as two separate and distinct assets. example 1: single use asset. suppose a husband and wife purchase a home for personal enjoyment and secondarily as a form of investment. consider the tax consequences associated with this purchase. the code permits acquisition costs (including items such as title searches and attorney fees) to be included in the tax basis the taxpayers have in their home;72 by including such costs in basis, at the time of subsequent sale, they can be recouped tax-free as a return of capital. on the other hand, the expenses associated with the cost of upkeep (including items such as painting and plumbing repairs) cannot be added to tax basis because these expenses represent nondeductible personal-consumption;73 by excluding such expenses from basis, they cannot be recouped tax-free at the time of subsequent sale.74 69. irc § 1012. 70. see irc § 1016(a) (does not specify any adjustments that pertain to upkeep or maintenance expenses). 71. see supra notes 60 and 61 and accompanying text. 72. irc § 1016(a). 73. irc § 262. see prop. treas. reg. § 1.263(a)-3(d)(5)(ii) 71 fed. reg. 48590-01 (aug. 2006) (indicating that, as a general rule, repairs to a residence may not be included in basis unless incurred in the context of a remodeling or restoration). 74. to permit these expenses to be embedded into the tax basis of the home would effectively allow taxpayers to transform these expenditures into (deferred) deductible expenses. consider another kind of personal-use asset, namely an automobile. assume a taxpayer purchases a $20,000 automobile, producing a tax basis in the automobile of an equivalent amount (i.e., $20,000). assume further that the taxpayer incurred maintenance costs of $2,000 and then sold the automobile four years 2006] florida tax review as a theoretical matter, taxpayers who use their assets for personal purposes should be required to reduce their basis to reflect the economic decline attributable to such use.7" because the code does not mandate these downward basis adjustments, however, taxpayers are in effect permitted to create tax deductions from their personal-consumption expenditures an incongruous result given the code's general commitment to a denial of deductions for such expenditures.76 to illustrate, suppose a husband and wife purchase a home for $500,000 (with $400,000 of the value attributable to the house and $100,000 attributable to the land). suppose further that they inhabit the home for many years and that, through wear and tear, its value is reduced to $0. (of course, no depreciation deductions are actually allowed because the home is not used in the taxpayers' trade or business.)77 upon the taxpayers' subsequent sale of their home for $1,100,000 (enjoying a profit attributable to the increase in the value of the underlying land),78 in computing their gain, the taxpayers are able to utilize $500,000 as the appropriate tax basis, rather than the $100,000 basis that, as a matter of theory, would be appropriate.79 in permitting the taxpayers a $500,000 basis, the code enables taxpayers to ignore the personal-consumption element of their home use. more specifically, the taxpayers are able to shift the personal-consumption element of their home into the investment component rooted in the land. this shift in basis from the personal to the investment component effects a conversion of consumption-type expenditure later for $12,000. the taxpayer's basis in the automobile would remain $20,000, with the cost of maintenance viewed as a consumption-type expenditure that could not be included in basis; the resulting $8,000 loss would not be deductible because it in effect represents consumption. see irc § 165(c). this loss disallowance rule makes the basis computation academic, though it would have practical significance in terms of computing gain were the automobile to appreciate for some reason above its tax basis of $20,000. 75. see richard a. epstein, the consumption and loss of personal property under the internal revenue code, 23 stan. l. rev. 454, 461 (1971) (argues that taxpayers should have to reduce the basis they have in their personal-use assets to reflect their consumption of such items); victor thuronyi, the concept of income, 46 tax l. rev. 45, 81-85 (1990) (indicating that tax on imputed income from consumer durables is appropriate and suggesting that depreciation deductions would be required under such an approach). 76. notwithstanding the sound theoretical justification for these basis reductions, for reasons of administrative convenience, the code does not mandate basis adjustments such as those proposed. 77. see irc § 168. 78. edward l. glaeser & joseph gyourko, the impact of building restrictions on housing affordability, 9 econ. pol. rev. 21-39 (june 2003) (presenting a study that indicates how zoning laws are a major contributor to higher land values). 79. of course, the taxpayers could seek to exclude a portion of this gain under irc § 121. [vol 7:9 a new model for identifying basis in life insurance into a tax deduction (a basis offset) and is therefore difficult tojustify theoretically. nonetheless, adherents of the aggregate premium theory build upon this example:8" they declare, in the name of parity with these homeowners, that the tax basis taxpayers have in their insurance policies should not be reduced by any personalconsumption on their part, but rather shifted to the investment component of their policies. example 2: dual use asset. suppose a husband and wife instead purchased a two-family home and rented one of the two units. in this example, based a long line of cases82 and treasury regulations,83 the two80. see supra notes 52-53 and accompanying text. 81. id. 82. there is a long history of cases that state it is appropriate for an asset to have two separate tax bases when a particular set of circumstances exist, e.g., mixed businessand personal-use property, and where inequities would arise were the asset deemed to have a singular tax basis. for a complete analysis of instances when courts have invoked a bifurcated basis approach, see james maule, income tax basis: overview and conceptual aspects, 560 tax mgm't portfolios (bna) a102-ai04 (2000). one case that amply illustrates this point is sharp v. united states, 199 f. supp. 743 (dist. ofdel. 1961), aff'd, 303 f.3rd 783 (3rd cir. 1962). in sharp, taxpayers purchased an airplane for $47,000 (to facilitate comprehension, we have generally rounded the numbers enumerated in the decision), made capital expenditures to it of $8,000 (making the airplane's overall tax basis $55,000), and used it for both business and leisure (roughly 24% for business and 76% for leisure). with respect to the business portion of the airplane, over the ensuing years, the taxpayer took depreciation deductions totaling approximately $14,000 and subsequently sold the airplane for $35,380. id. at 744. for tax computation purposes, the taxpayers claimed that the plane's tax basis was approximately $41,000 (i.e., $55,000 initial cost basis less the $14,000 of claimed depreciation deductions). id. the taxpayers therefore claimed that they had experienced an economic loss of approximately $6,000 (i.e., the amount realized of $35,380 less the airplane's adjusted basis of $41,000). id. the irs had a much different perspective. in light of the fact that the airplane was used 24% for business and 76% for leisure, it treated the airplane as if it were two separate planes, one used exclusively for business and the other exclusively for leisure, and accordingly made the following computations: business plane leisure plane cost basis $14,300 $40,700 depreciation ($14,000) ($ 0) adjusted basis $ 300 $40,700 amount realized on sale $ 9,321 $26,058 adjusted basis ($ 300) ($40,700) gain/loss $ 9,021 $14,642 2006] florida tax review family home would be treated as two separate assets: a personal home and a rental unit.' as to the personal-home component, the analysis set forth in the fust example would apply. in contrast, as to the rental-unit component, a different tax treatment results. the rental unit would be classified as "property used in the taxpayer's trade or business." 5 as such, its value would thus be depreciated and the irs claimed that the taxpayers must recognize the gain related to the "business airplane" but denied allowance of the loss due to the fact that it was neither a loss incurred in a trade or business nor a loss incurred in a transaction entered into for profit. sharp, 199 f. supp. at 745. see irc § 165(c). the issue before the sharp court was whether the irs was correct in treating the airplane in question as two airplanes. from the outset of its analysis, the court made clear that the "taxpayers are clearly in error if it is their contention that courts will not regard a thing, normally accepted as an entity, as divisible for tax purposes." sharp, 199 f. supp. at 745. the court offered a myriad of examples when predecessor courts treated a unitary item as two distinct parts. id. the taxpayers nevertheless attempted to distinguish their fact pattern from the cases the court cited. id. the crux of the taxpayers' position was that all of these cases involved two distinct assets. their own case, however, involved one asset. as averred by the taxpayers, an airplane is not capable of separation into business and personal-uses in the same way that a hotel is separable from the land on which it stands, or in the same way that unharvested crop may be separated from the trees of the grove, or the accounts receivable from the other partnership assets. id. at 746. the taxpayers added that "[tihere were not two airplanes, ... a business airplane and a personal airplane there was one airplane. there were not two sales; there was but one sale, one adjusted basis and one selling price." id. although having superficial attraction, the taxpayers' position was dismissed by the court. id. it held that if the taxpayers' theory were to prevail, a lack of uniformity would beset similarly situated taxpayers. id. at 747. in support of its position, the court offered an example of a hypothetical taxpayer who purchased property, used it exclusively for business, depreciated it, and then sold it for a gain. sharp, 199 f. supp. at 747. it then compared the plight of the first hypothetical taxpayer to a different hypothetical taxpayer who purchased a piece of property fourfold the size and cost and used onefourth of the property for business and three-fourths for personal-use. id. the court posited that under a uniform rule, the same tax consequences should befall the first and second hypothetical taxpayers upon the sale of the business-use property. id. under the taxpayers' approach, however, the first and second hypothetical taxpayers would each experience a different tax outcome, making the result inherently inequitable. id. the court also pointed out that the taxpayers' methodology of calculating their depreciation deduction (24% of the airplane rather than the whole) suggested the taxpayers' tacit endorsement that the airplane was really two separate and distinct pieces of property "trapped" in one body. 83. regs. § 1.121-1(e). 84. see supra note 73. 85. irc § 123 1(b). [vol. 7.-9 a new model for identifying basis in life insurance the costs associated with its upkeep would be deductible 6 or capitalized, 7 as the case may be. when the taxpayers subsequently sold the two-family home, the code would treat the sale as if it consisted of two components. 8 an allocation of the sales price would therefore have to be made, and two independent tax analyses would have to be conducted. 9 to illustrate, suppose taxpayers purchased a two-family home for $500,000, with $375,000 of the value allocable to the personal-home component and $125,000 of the value allocable to the rental-unit component of the property. suppose further that the taxpayers were permitted $100,000 of depreciation deductions with respect to the rental-unit component. consider the tax consequences were the two-family home sold for $1.1 million.9 the allocation would be as follows: home rental property cost basis $375,000 $125,000 depreciation ($ 0) ($100,000) adjusted basis $375,000 $ 25,000 amount realized on sale $825,000 $275,000 adjusted basis ($375,000) ($ 25,000) gain $450,000 $250,000 what example 2 illustrates is that tax basis cannot be shifted or "shared" between the personal-use property (i.e., the personal-use component) and the rental-unit component. each component retains its own share of basis.9' like a home, nonterm insurance is typcally acquired for investment and noninvestment reasons. more specifically, they acquire life insurance as a mode of consumption (i.e., a mechanism to alleviate emotional concerns and family turmoil in the event of an untimely death) and also as an investment vehicle (i.e., a ready reserve of assets that the policy owner can borrow from or withdraw against). notwithstanding taxpayers' different motives in acquiring such life insurance, there is no need to decide whether a life insurance policy is a unitary asset (which permits a shift in basis from the personal-use component to the investment component) or a dual use asset (which does not permit a shift in basis). in either case, the cost-of-insurance protection cannot be appropriately viewed as a cost of acquisition; it is instead a cost of upkeep. and, as we elaborate, under either the unitary or dual use model, it cannot be included in basis. 86. irc § 168(a). 87. irc § 263. 88. see supra note 73. 89. id. 90. see supra note 69. 91. see supra note 73. 2006] florida tax review b. the nature of life insurance having decided that classifying life insurance as a unitary or dual use asset is irrelevant to the basis question, the critical issue thus is to distinguish between the acquisition and upkeep costs as they pertain to life insurance. we believe that the portion of the premium allocated to investment, including any commissions incurred in acquiring the investment, should be included in the policy's tax basis. in contrast, the mortality charges associated with the maintenance of the policy should be excluded. adherents to the aggregate premium theory are misguided when they claim that the portion of the premium allocable to the cost of maintaining the insurance can be added to the policy's tax basis. the critical flaw in their argument is that they treat all premium expenses as acquisition costs. yet, this proposition cannot possibly be true: just as a home needs annual repairs to keep it in good working order, a life insurance policy generally needs an annual cash infusion to keep it intact. indeed, where the courts have considered the basis question in the context of a sale at a loss, they have uniformly treated the premium portion allocable to the carrying costs of the policy as an annual upkeep expense.92 as such they have excluded the cost-of-insurance protection from basis and denied the claimed loss deduction.93 and although the irs in both office decision 724 and reverend ruling 70-38 concluded that the cost-of-insurance protection may be included in basis in the context of computing gain, it failed to provide a theory that would justify such a departure from conventional tax-basis principles. in the end, the aggregate premium theory cannot be justified on policy grounds. it rests on the fallacious assumption that premium payments related to the mortality charge must be added to the basis of the investment component. there is, in short, no justification for attributing the cost-of-insurance protection to the investment component. iv. computing tax basis under the policy investment theory having established the superiority of the policy investment theory, we consider its application. insurance companies do not ordinarily provide the insured with a statement allocating a portion of the premium to the cost-of-insurance protection. nevertheless, there are actuarial tables readily available that could fulfill this function (i.e., indicating how much insurance companies would hypothetically charge for term insurance for a comparable insured). the difference between the aggregate premium payments the taxpayer makes and the hypothetical term insurance figures located on these tables should represent the taxpayer's investment 92. see supra notes 16-27 and accompanying text. 93. id. [vol79 a new model for identifying basis in life insurance (tax basis) in the insurance policy. hereinafter, we refer to this methedology for determining basis as the hypothetical term method. 9 a. mechanism to determine the investment portion of an insurance policy when a taxpayer makes premium payments, insurance companies often internally separate these premium payments into different "baskets." that is, they place one portion of the premium into the "basket" that houses the taxpayer's investment (i.e., the policy's reserve account), if any, and they place the other portion of the premium into the "basket" used to pay life insurance. since this is how, for internal bookkeeping purposes, insurance companies handle the receipt of premium payments or contract charges, it seems rather obvious that the identification of tax basis should follow suit. consider, for example, estate of wong wing non v. comm r, a case in which a taxpayer purchased a twenty-year endowment life insurance policy that included, in the case of disability, a waiver-of-premium feature. approximately halfway through the contract's term, the taxpayer became disabled and was no longer obligated to make premium payments. when the policy ultimately matured, the taxpayer received the face amount of the policy along with accumulated mutual insurance dividends and interest. the taxpayer claimed that he was not taxable on the latter portion because the aggregate premiums paid included those that were paid on his behalf when he became disabled. the court disagreed, holding instead that, for tax basis purposes, the premium payments were separable: the premium portion that related to the investment feature of the contract counted towards tax basis; in contrast, the premium portion directed towards disability protection (that was annually exhausted) did not constitute part of the policy's aggregate basis.' to illustrate the point the wing non court made in the life insurance context and application of the hypothetical term method, consider a forty-year-old male who obtains a $1 million whole life insurance policy with annual premiums of $10,000. suppose further that the annual premium payments for a $1 million term life insurance policy would be $4,000. given the premium cost and the hypothetical cost of term insurance supplied by actuarial tables, the taxpayer's basis under the hypothetical term method would be $60,000 after ten years ($100,000 aggregate premium payments less the aggregate term cost of$40,000).97 94. in the context of split-dollar policies, the irs already has instituted this procedure. see irs notice 2002-8, 2002-1 c.b. 398 (permitting an approach similar to the one advocated here). 95. 18 t.c. 205 (1952). 96. estateof wong wingnon, 18 t.c. at 209-10; see rev. rul. 55-349, 1955-1 c.b. 232 (premiums paid that are attributed to other benefits, such as disability, are not includible in computing total premiums paid for an endowment contract). 97. see supra note 9, which points out that as a practical reality, each year, as the internal reserve amount grows in value, the amount of insurance coverage will correspondingly decline. that being the case, each year this method will produce a smaller insurance charge. 20061 florida tax review at least as expressed in its private letter ruling stance, the irs has a somewhat different approach to identify the tax basis of life insurance policy.9" the basic formula is the same: tax basis is equal to the aggregate premiums paid less the cost-of-insurance. as one possibility to determine the cost-of-insurance, the irs instructs taxpayers to subtract the cash surrender value of their policies from the aggregate premiums paid. in effect, under this approach a policy's tax basis will equal the policy's cash surrender value. the irs does, however, anticipate that this formula will not always produce the correct answer, and it reserves the right to compute basis in a different fashion. to illustrate, consider the prior example of the person who purchased a $1 million whole life insurance policy with annual premiums of$ 10,000 and an initial annual insurance cost of $4,000. as previously indicated, at the end often years, the taxpayer's investment in the policy should equal $60,000. yet, depending upon the policy's terms and conditions, the cash surrender value of the policy could be much larger, say $90,000, attributable to unrealized gains, interest, and dividends that the underwriting company may be obligated to credit to the policyholder's account. in this case, the irs would presumably not permit the taxpayer a $90,000 basis (the cash surrender value); for if it did, the accretion would escape tax. b. the appropriate tax treatment of insurance commissions how would the cost of commissions and similar expenses incurred in the course of originating the policy be treated under the hypothetical term method? superficially, these expenditures appear to be extinguished at the moment of their outlay. yet not all of these costs can be attributed solely to the cost-of-insurance protection component. in other words, a portion of these costs is attributable to the policy's investment component, and, as such, should be embedded in the policy's tax basis." the hypothetical term method would properly account for these costs. the term factor supplied by the tables would necessarily include the cost of origination ordinarily incurred in acquiring a term policy. for example, in the prior illustration, the term factor according to the tables was $4,000; this figure would represent the 98. see priv. ltr. rul. 94-43-020, at n.4 (july 22, 1994). 99. consider, for the example, the purchase of a $20,000 automobile along with a $2,000 maintenance contract. it would be inappropriate to attribute a 10% commission paid on the purchase price of the automobile exclusively to the maintenance contract. instead, the automobile should be viewed as having a cost basis of $22,000 ($20,000 purchase price plus 10% commission of$2,000), and the maintenance contract as having a cost basis of $2,200 ($2,000 cost plus $200 commission). similarly, in the case of an insurance policy, the origination costs attributable to the investment component, as opposed to the costs attributable to the protection component, should be reflected in basis for purposes of computing gain. but see chief couns. adv. mem. 2005-04-001 (dated oct. 12, 2004) (concluding that origination costs may not be included in the basis of a policy). [vol 7:9 a new model for identifying basis in life insurance premium for a comparable term policy and would therefore include the cost of originating such a policy. any amount paid in excess of the term factor would be attributable to the policy's investment component. thus, if the actual premium were $10,000, the $6,000 excess would represent the cost of acquiring the investment component and should therefore constitute the taxpayer's basis in the policy. " in the context of so-called split-dollar insurance, the government recently adopted a similar method for differentiating between the costs of these two components. 101 one might question whether the suggested approach tends to improperly inflate the policy's tax basis. this line of reasoning does not, however, take into account the fact that an insured agrees to incur the additional origination costs permanent (nonterm) insurance entails in order to acquire the investment component, not the insurance protection component of the policy. indeed, were it not for the advantages the investment component makes available, the insured would instead presumably have purchased a term policy. thus, to the extent that the permanent insurance costs more to originate than term insurance, the excess costs are properly attributed to the investment component of the policy and should accordingly be reflected in the policy's tax basis. what is evident from this analysis is that the hypothetical term method should be applied to all taxpayers who dispose of a policy, whether by sale to a third party or by predeath surrender to the issuing insurance company. this is appropriate not only because it produces the correct basis, but also because it eliminates the inequity of treating taxpayers who sell their policies differently from taxpayers who surrender their policies. under current law, code section 72 mandates the use of the aggregate premium method in the case of a policy surrender. at the same time, in private letter rulings the irs maintains, despite its 100. in priv. ltr. rul. 94-43-020, invoking century wood preserving co. v. comm'r, 69 f.2d 967 (3rd cir. 1934) for the principle that basis should be reduced by the cost-of-insurance protection, the irs in effect allocated the entire acquisition cost to the insurance-protection component. see also chief couns. adv. mem. 2005-04-001 (adopting the same approach). the difficulty with the irs approach aside from its failure to account for its deviation from its published rulings is that it ignores the reality that acquisition costs are properly allocable to the policy's investment component as well as its insurance-protection component. 101. see regs. § 1.61-22(d)(3); see also irs notice 2002-8, 2002-1 c.b. 398 (permitting taxpayers to value the cost-of-insurance protection based on the table contained in the notice or the amount charged by the insurance company for term insurance). in fact, the regulations go on to provide that, as a general rule, a person paying for the cost-of-insurance protection under a split-dollar arrangement where the so-called economic benefit regime is applicable may not reflect such payment in calculating the amount invested in the contract for purposes of code § 72. see regs. § 1.61-22(g)(4)(iii). although the regulation does not address the basis question in the case of a sale, as distinguished from a surrender, the implication is that payments for insurance protection should similarly be disregarded in this context. 2006] florida tax review published guidance, that the policy investment theory should apply in the case of a policy sale. given the failings of the aggregate premium theory and the inequity under current law of discriminating between sales and surrenders, congress should amend code section 72 to incorporate the hypothetical term method and make it applicable to all predeath policy dispositions. if code section 72 is not amended, and taxpayers who surrender their policies are therefore permitted to continue using the aggregate premium approach in computing gain, instituting the policy investment theory will be problematic. it will result not only in inequity but also in distortion. under the policy investment theory, taxpayers who sell their policies would be required to reduce basis on account of the cost-of-insurance protection. yet taxpayers who surrender their policies to the insurance company would enjoy a higher basis under the aggregate premium approach (which is sanctioned under code section 72(e)). as a result, similarly situated taxpayers would be treated differently. yet, the decision to sell or surrender, in short, should not lead to different tax outcomes. moreover, given this difference in treatment, taxpayers might well feel compelled to surrender a policy even if a sale might command a higher price. this is tantamount to telling the purchaser of an automobile that the government will provide her with a tax advantage if, at the time of disposition, she elects to do a trade-in with the original dealer rather than selling it to a third party. there is no policy justification for giving the dealer such an advantage. likewise, there is no policy justification for taxing a surrender more favorably than a sale and for the resulting advantage to inure to the underwriting insurance company. until congress resolves the current inequity, the irs should consider the second-best strategy outlined in the next section for moving towards universal application of the hypothetical term method." 2 v. implementing the hypolthetical term method deference having explained why the policy investment theory is superior to the aggregate premium theory, we now consider the strategies available to the irs for implementing the hypothetical term method. specifically, we focus on how the courts might respond to the irs instituting the hypothetical term method given the irs's long-standing contrary position. by way of background, when a government agency administering a statute issues an interpretation, the courts are required to assess its validity under one of 102. in the absence of an amendment to irc § 72, the irs has a difficult choice. by regulation it can require taxpayers who sell their policies to reduce basis to account for mortality charges while permitting taxpayers who surrender their policies to use the aggregate premium approach. alternatively, it can level the playing field by permitting selling taxpayers to use the aggregate premium approach. neither alternative is ideal, but unless congress amends irc § 72, the irs must choose between one of these second-best alternatives. [vol 7:9 a new model for identifying basis in life insurance two standards. 13 the more deferential standard, announced by the supreme court in chevron u.s.a. inc. v. natural resources defense council, inc.," governs in cases where congress intended to give the agency authority to issue what the supreme court has called "force-of-law" interpretations and the agency does so in the appropriate manner.0 5 under the so-called chevron standard, an interpretation will be upheld if two conditions are met: (1) the statute is ambiguous, and (2) the agency reasonably resolves the ambiguity."° if both of these conditions are met, a court must defer under this standard even if it is not persuaded that the agency's interpretation is the best reading of the statute.0 7 where the chevron standard does not apply, the validity of the agency's interpretation is analyzed under the less deferential standard announced by the supreme court in skidmore v. swift & co.' under the so-called skidmore standard, an agency interpretation will only be upheld if the court is persuaded that the agency has correctly read the statute. in determining whether an interpretation is persuasive, the courts are required under skidmore to consider a number of subsidiary factors. for example, if the interpretation is inconsistent with an interpretation previously adopted by the agency, the court will be less inclined to find it persuasive. " similarly, an interpretation issued long after the enactment of the statute will be viewed as less persuasive than a promptly issued one." 0 under the chevron standard, the factors enumerated under the skidmore standard are largely irrelevant. as long as the agency has not been arbitrary or capricious, its interpretation will not be invalidated merely because it has been inconsistent; indeed, chevron contemplates that agencies will adjust to evolving circumstances and will therefore be permitted to change position where appropriate; furthermore, under chevron, an agency's delay in issuing an interpretation will not count against its validity."' the tax court refuses to endorse the chevron-skidmore dichotomy, under which the validity of all agency interpretations are evaluated under one of these 103. see united states v. mead corp, 533 u.s. 218 (2001) (summarizing how much deference courts should afford administrative agencies). 104. chevron u.s.a., inc. v. natural res. def. council, inc., et al., 467 u.s. 837 (1984). 105. mead, 533 u.s. at 226-27. for example, assuming for the moment that the irs were to have the authority to issue interpretations having the force of law, it could not secure this effect by issuing a private letter ruling. see irc § 6110. 106. chevron, 467 u.s. at 843-45. 107. id. at 843 n.11. 108. skidmore v. swift & co., 323 u.s. 134 (1944). 109. id. at 140. 110. see, e.g., cathedral candle co. v. u.s. int'l trade comm'n, 400 f.3d 1352, 1367 (fed. cir. 2005) (importance was given to the agency's contemporaneous issuance of ruling). 111. see nat'l cable & telecomms. ass'n v. brand x internet serv., 545 u.s. 967 (2005); see also smiley v. citibank (s.d.) n.a., 517 u.s. 735, 742 (1996). 2006] florida tax review two standards. in swallows holding v. comm 'r,"2 the tax court indicated that a third deference standard may be appropriate in the tax context. similar to skidmore in substance, this standard provides less deference than the chevron standard. it, in effect, permits courts to consider skidmore's subsidiary factors. as such, it could render vulnerable a myriad of treasury regulations (as well as revoking revnue ruling 70-38). should the government seek to implement the hypothetical term method, it will need to navigate the deference question. whether the method would be deemed valid may well depend on the deference standard the courts invoke given the irs's long-standing commitment to a different approach; the lack of contemporaneousness; and congress's reenactment of the underlying code section without disapproving of the irs's rulings. with each of these factors having different significance under the different standards, the irs will have to consider its options, which include (a) revoking reverend ruling 70-38 or (b) promulgating a new regulation. (as well as revoking revenue ruling 70-3 8). a. revoke revenue ruling 70-38 as an initial step, the irs should revoke reverend ruling 70-38. for, as long as the ruling remains outstanding, taxpayers will argue that the irs is precluded from disavowing it. in a trilogy of recent cases, the tax court has held that the irs must respect a taxpayer-friendly ruling and may not deviate from it without first revoking the ruling in question. 113 while it remains to be seen whether other courts will take a similar position," 4 it does seem fundamentally unfair, not 112. swallows holding, ltd. v. comm'r, 126 t.c. 96 (2006). 113. rauenhorst v. comm'r, 119 t.c. 157 (2002), baker v. comm'r, 122 t.c. 143 (2004); dover corp. & subsidiaries v. comm'r, 122 t.c. 324 (2004). in each ofthe three cases, the tax court emphasized that the irs adhered to the position in question, evidenced by private letter rulings where the suspect rulings were referenced. nevertheless, the tax court framed its analysis in terms of the published rulings, citing the private letter rulings only to support its reading of the published revenue rulings. 114. indeed, some courts have suggested that the irs is not bound by concessions made in a revenue ruling. see black & decker corp. v. united states, 436 f.3d 431, 440 (4th cir. 2006) (intimating a willingness to permit the irs to disavow a taxpayer-friendly ruling); vons cos., inc. v. united states, 55 fed. cl. 709, 718 (2003) (in dicta, indicating that the irs cannot be stopped by a revenue ruling). it should be noted that, if the irs were to revoke retroactively a taxpayer-friendly revenue ruling after the transaction was consummated but before the issue reached the courts, a different question would be presented. in these circumstances, assuming the revocation was not an abuse of discretion, the courts might well be inclined to permit the irs to disavow the ruling. see dixon v. united states, 381 u.s. 68, 72-73 (1965) (permitting the irs to disregard a ruling in these circumstances after finding that its revocation was not an abuse of discretion); but see estate of mclendon v. comm'r, 135 f.3d 1017, 1024 n. 15 (5th cir. 1998) (questioning the viability of this aspect of dixon given the fact that the irs is more unequivocal in inviting taxpayer reliance on revenue rulings and [vol 7:.9 a new model for identifying basis in life insurance to mention inefficient, to permit the irs to disregard a ruling after having invited taxpayer reliance. thus, even though, as evidenced by the publication of several private letter rulings, the irs has largely ignored reverend ruling 70-38,' it would seem unlikely that the tax court (or other courts) would be receptive to the hypothetical term method as long as reverend ruling 70-38 remains intact. although none of the decisions in the trilogy alludes to it, there is a narrow context in which a taxpayer-friendly ruling cannot bind the irs. as the supreme court has indicated, where a ruling is contrary to an unambiguous code provision, the ruling must yield;" 6 otherwise, constitutional questions might arise. put differently, where congress clearly expresses itself, neither the judicial nor executive branch can effect an override." 7 it is unlikely that the irs could, under this exception, disavow reverend ruling 70-38, for it seems very doubtful that a court could read the code as unambiguously setting forth a methodology for computing a life insurance policy's tax basis. thus, if the irs should decide to implement the hypothetical term method, a revocation of reverend ruling 70-38 would seem to be an indispensable first step. a revocation of the ruling would not in itself enable the irs to claim deference for its new position. thus, if such a claim is to be made, published guidance that affirmatively adopts the hypothetical term method must be issued. if the irs were to adopt the method in a new ruling, the courts would likely analyze it under the skidmore standard. although the supreme court has not yet clarified whether chevron or skidmore applies to revenue rulings, it is very likely that the courts will apply skidmore rather than chevron in this context."8 and, under skidmore, the courts might well be skeptical about deferring to such a ruling given the irs's long-standing contrary position. distinguishing it on the ground that dixon involved a ruling that was contrary to an unambiguous code section). 115. see, e.g., irs priv. ltr. rul. 94-43-020 (july 22, 1994); and chiefcouns. adv. 2005 04 001 (dated oct. 12, 2004). 116. schleier v. comm'r, 515 u.s. 323, n.9 (1995). 117. see united states v. burke, 504 u.s. 229, 246 (1992) (scalia, j., concurring) ("[t]he secretary ofthe treasury would effectively be empowered to repeal taxes that the congress enacts" if a taxpayer-friendly interpretation were upheld, even if contrary to the code.); see also mitchell m. gans, deference and the end of tax practice, 36 real prop. prob. & tr. j. 731, 797-98 (2002). 118. the mead decision can be read as strongly implying that revenue rulings are to be analyzed under the skidmore framework. see united states v. mead corp., 533 u.s. 218, 229 (2001) (discussing the fact that, under the chevron decision, the court of federal claims had not been giving any deference to revenue rulings). see also john coverdale, chevron's reduced domain: judicial review of treasury regulations and revenue rulings after mead, 55 admin. l. rev. 39, 89-90 (2003) (indicating that, under the mead decision, revenue rulings are reviewed under the skidmore standard); irving salem et al., report of the task force on judicial deference, 57 tax law. 717 (2004) [hereinafter aba task force]. 20061 florida tax review b. promulgate a new regulation the irs should consider instituting the hypothetical term method by promulgating a new regulation." 9 in all likelihood, such a regulation would be entitled to deference under the chevron standard and would, as a result, be upheld in any taxpayer challenge to its validity. although the tax court contemplates the possibility of a third deference standard, close examination shows that the tax court's approach is not likely to be sustained. 1. probable application of the chevron standard a new regulation employing the hypothetical term method should easily satisfy chevron's two-part test. first, the code does not address, let alone unambiguously resolve, the basis-computation question. second, the hypothetical term method would appear to effect a reasonable resolution in that it simply creates an administrable model built on the principle developed by the courts in the context of computing losses that the cost-of-insurance protection is not to be reflected in basis. 20 the application of chevron to a hypothetical term regulation would be consistent with the supreme court's foundational decision delineating the scope of the chevron and skidmore standards in united states v. mead.2 ' in mead, the court clarified that it had intended in chevron to create a dichotomy, requiring all deference claims to be analyzed under one of these two standards.' 22 the court indicated that an interpretation that is subject to chevron and that passes muster under this standard is entitled to force-of-law effect.'" in other words, it is treated as if congress itself had explicitly authorized it. the force-of-law nomenclature is 119. see generally philip gall, phantom tax regulations: the curse of spurned delegations, 56 tax law. 413 (2003) (regulations are the collaborative product of the treasury department and the irs). 120. in addition, a new regulation should not be viewed as effecting an arbitrary or capricious change in position. in the context of the recent marketing of new life insurance products that have substantial potential to result in gain, the irs must be given an opportunity to take a fresh look at the question of basis. indeed, in issuing its earlier rulings decades ago, the irs's focus was on the computation of loss as it was concerned about taxpayers converting nondeductible premiums into a deductible loss. see supra notes 16-27 and accompanying text. it certainly did not, and could not, foresee the basis issue in the gain context that it must now confront. see infra § vi. 121. see mead, 533 u.s. at 218. 122. see also gonzales v. oregon, 126 s.ct. 904, 914-15 (2006). the court provides a circular test for determining which standard is to be applied, focusing principally on whether congress intended the agency to have the authority to issue a chevron-type interpretation. it is circular in the sense that while it nominally makes the issue turn on congress's intent, the court itself must ultimately decide whether congress intended to grant such authority in the case of any given agency. 123. mead, 533 u.s. at 218; see also gonzales, 126 s.ct. at 914-15. [vol 7:9 a new model for identifying basis in life insurance apparently inapt in the skidmore context because if the interpretation is upheld under this standard, it is only because the court finds it persuasive, not because the agency's interpretation is analogous to a mandate from congress. 2. possible application of a different deference standard in tax cases mead cannot be easily read as contemplating the application of different deference standards in different areas of specialty. to the contrary, it is a comprehensive decision that seeks to impose the chevron-skidmore dichotomy across all areas of law involving agency-administered statutes. 24 nonetheless, based on the supreme court's failure to cite chevron with consistency in the tax context, some commentators have suggested that the court may have contemplated the use of a third standard in tax cases. 125 under this view, neither chevron nor skidmore would apply in the case of interpretive tax regulations (i.e., a regulation issued under the general authority of code section 7805, as opposed to a regulation issued under a specific grant of authority contained in the code section to which it relates). rather, regulations would be analyzed under the standard the supreme court announced in national muffler v. comm 'r, 26 in which the ultimate question in determining the validity of an interpretive tax regulation is whether it 124. see kristin e. hickman, need for mead, 90 minn. l. rev. 1537 (2006) (arguing that the chevron-skidmore dichotomy applies to interpretive tax regulations). but see irving salem, supreme court should clarify its deference standard, 112 tax notes 1063 (sept. 18, 2006) (arguing for a different standard in fee tax context). see also mitchell gans, supra note 117 at 749-50; jonathan blattmacher, mitchell gans, and damien rios, the circular 230 desk book, ch. 1 (2006). 125. see, e.g., thomas w. merrill & kathryn tongue watts, agency rules with the force of law: the original convention, 116 harv. l. rev. 467 (2002) (indicating that the skidmore standard may apply in the case of interpretive tax regulations); coverdale, supra note 118, at 83; (arguing that the skidmore standard applies in this context); aba task force, supra note 118 (arguing in favor of using factors enunciated in nat'l muffler v. comm'r (infra note 126) in assessing the validity of interpretive tax regulations); ellen p. aprill, the interpretive voice, 38 loy. l.a. l. rev. 2081 (2005) (same); noel cunningham & james repetti, textualism and tax shelters, 24 va. tax rev. 1 (2004) (summarizing the dispute); gregg d. polsky, can treasury overrule the supreme court?, 84 b.u. l. rev. 185 (2004) (noting the dispute); see also gen. elec. co. v. comm'r, 245 f.3d 149, 154 n.8 (2001) (noting the uncertainty); bankers life & casualty co. v. united states, 142 f.3d 973,982 (7th cir. 1998) (discussing the issue); e.i. du pont de nemours & co. v. comm'r, 41 f.3d 130, 135-36 n.23 (3rd cir. 1994) (indicating less deference than the chevron standard would require is appropriate); snowa v. comm'r, 123 f.3d 190, 197 (4th cir. 1997) (applying the factors enunciated in nat'l muffler v. comm'r (infra note 126)); nalle v. comm'r, 997 f.2d 1134, 1139 (5th cir. 1993) (same); in re craddock, 149 f.3d 1249, 1258 (10th cir. 1998) (same); schuler indus. inc. v. united states, 109 f.3d 753, 755 (fed. cir. 1997) (same). 126. nat'l muffler v. comm'r., 440 u.s. 472, 477 (1979). 2006] florida tax review "harmonizes with the plain language of the statute, its origin, and its purpose."' 127 in national muffler, the court listed various factors that are to be considered in answering this question: whether the regulation was issued contemporaneously with the enactment of the statute, whether the regulation is long-standing, whether there has been taxpayer reliance on the regulation, whether the irs has been consistent in its view of the statute, and whether the regulation has been scrutinized by congress in any postregulation reenactment of the statute.128 the national muffler standard is substantially similar, if not identical, to the skidmore standard. the only difference between the two is that under national muffler, the ultimate question is whether there is sufficient harmony between the regulation and the code, whereas under skidmore the ultimate question is whether the court finds the regulation persuasive 29 in terms of the various subsidiary factors that are to be considered in answering the ultimate question, it is difficult to discern any significant difference between the two standards. 3 ' the similarity is not surprising. after all, as the court indicated in mead, chevron introduced a new standard that was designed to displace in certain contexts the skidmore-type analysis it had implicitly utilized in many of its prior cases. 3' national muffler is therefore best understood as an iteration of skidmore. despite the chevron-skidmore dichotomy articulated in mead, the tax court in dicta in swallows holding, ltd. v. comm 'r, '2 a nonunanimous courtreviewed decision, has indicated that the national muffler standard may remain viable. it then invalidated a regulation on the ground that it could not be sustained under either the chevron or national muffler standards. a. the tax court's questionable analysis a critical difficulty with the tax court's analysis is that, in the course of maintaining that the regulation would be invalid under either standard, it lost sight of the fundamental differences between chevron and the skidmore-like national muffler standard. for example, it emphasized the irs's lack of consistency and the 127. id. at 476-77. 128. id. 129. skidmore v. swift & co., 323 u.s. 134, 140 (1944). 130. see id. (referencing as relevant factors whether the agency was deliberative and engaged in a formal process, whether it was thorough, whether its reasoning was valid, and whether the agency has been consistent as well as all other factors that bear on the question of persuasiveness). 131. united states v. mead corp., 533 u.s. 218, 229 (2001). 132. swallows holding, ltd. v. comm'r, 126 t.c. 96 (2006). much, if not all, of the court's deference analysis in swallows holding is dicta. for once the court concluded that the code was unambiguous, the regulation could not be sustained. irrespective of the applicable deference standard, the meaning of an unambiguous statute cannot be altered by regulation. see general dynamics land systems, inc. v. cline, 540 u.s. 581, 599 (2004). [vol. 7:9 a new model for identifying basis in life insurance fact that the regulation was issued long after the enactment of the section. ' while such failings would have been unquestionably relevant under national muffler, and would remain relevant were skidmore the standard, the supreme court has made clear that they play no role under the chevron standard.'34 thus, the court not only reopened the national muffler question, but also misapplied chevron in forcing the conclusion that the outcome would have been the same irrespective of the deference standard.'35 the tax court's analysis is troubling at an even more fundamental level given its failure to grapple with the supreme court's most recent decision on the applicability of chevron in the tax context. inexplicably, the majority, as well as the dissenting opinions, fails to cite the supreme court's decision in central laborers 'pension fund v. heinz, 36 where the court attributed force-of-law effect to an interpretive tax regulation. 137 while the central laborers' pension fund decision does not cite chevron, or any other deference standard, the court nonetheless implicitly invoked it. 3 ' for, as mead makes clear, force-of-law effect is only granted under the chevron standard. central laborers' pension fund, moreover, dismissed as irrelevant the irs's inconsistency, further indicating that the court implicity applied chevron in that an agency interpretation entitled to force-of-law effect is not weakened by the agency's inconsistency. 139 thus, given the court's grant of force-of-law effect to an interpretive tax regulation in central 133. id. at 137. 134. see smiley v. citibank (s.d.) n.a., 517 u.s. 735 (1996) (under the chevron standard, upholding the validity of a regulation issued 100 years after the enactment of the underlying statute despite the fact that the agency had maintained inconsistent positions about the meaning of the statute); see also gans supra note 117, at 754-55. 135. the court's misunderstanding of how the chevron standard applies is also evident when it implies that less deference is appropriate when an agency construes statutory language that is not grounded in that agency's technical expertise. see swallows holding, 126 t.c. 96, at 144 (making this distinction and referring to constructions that are not based on expertise as "perfunctory"). the court fails to recognize that the chevron decision effected a critical shift. prior to chevron, a critical justification for deference was agency expertise. under the chevron decision, however, agencies are entitled to deference for an entirely separate reason: the executive branch, unlike the judicial branch, is politically accountable, making it the more appropriate forum for resolving doubts about the meaning of statutes. see generally gans, supra note 117. thus, in suggesting that agency interpretations not based on technical expertise are deserving of less deference, the court misunderstands chevron's meaning. 136. central laborers' pension fund v. heinz, 541 u.s. 739 (2004). 137. id. at 748. 138. see united states v. mead corp., 533 u.s. 218 (2001). 139. centrallaborers 'pension fund, 541 u.s. at 748. this, ofcourse, further confirms the court's application of chevron in that the irs's inconsistency could not have been so dismissed under national muffler (or skidmore). 2006] florida tax review laborers' pension fund,"4 it would appear that the court in swallows holding erred in refusing to abandon the national muffler standard and the skidmore-like analysis it produces. 4' b. the tax court's failure to appreciate chevron's breadth the swallows holding court also fails to address properly two important developments that stem from chevron: agencies are to be given more latitude to change their interpretations even if congress has reenacted the underlying statute, and, second, unless the statute is unambiguous, agencies are at liberty to overrule court decisions. first, the court failed to recognize that the chevron decision had a subtle, yet important, impact on the reenactment doctrine. under the doctrine, where an agency has issued an interpretation or the courts have reached a consensus about the meaning of a statute, congress's reenactment may be viewed as a ratification of the earlier construction. 42 the swallows holding court ultimately rested its decision on this doctrine, concluding that the statute's reenactment in effect ratified the pre-reenactment decisions. 43 as a result, according to the court, the code section was rendered sufficiently unambiguous so as to make a regulation adopting a different approach invalid. this analysis ignores, however, a critical aspect of chevron's meaning: while the reenactment doctrine may be used to validate (ratify) an agency interpretation or court decision, it may not be used to undermine chevron's policy 140. the interpretive regulation before the court in centrallaborers 'pension fund related to a section of erisa (pub. l. no. 93-406, 88 stat. 829 (codified as amended in scattered sections of title 26 and 29 of the code)) as the dispute involved a nontax, pension issue. nonetheless, as the court indicated, the same provision appears in the code verbatim, and, according to the court, the regulation is to be applied for tax, as well as pension, purposes. see centrallaborers'pension fund, 541 u.s. at 748 n.4. indeed, in granting force-of-law effect to the regulation, the court indicates that when issuing an interpretive regulation under irc § 7805, the irs speaks in its "most authoritative voice," see central laborers' pension fund, 541 u.s. at 748, further confirming that such regulations are to be reviewed under the chevron standard. 141. indeed, in the mead decision itself, the court cited atl. mut. ins. co. v. comm 'r, 523 u.s. 382 (1998), as an example of an earlier case in which the chevron standard had been properly applied. since atlantic mutual involved an interpretive tax regulation, the mead decision leaves little doubt that the court contemplates the application of the chevron standard in this context. see mead, 533 u.s. at 230. see also united states v. haggar apparel co., 526 u.s. 380 (1999) (indicating that the chevron standard is applicable when a question concerning the code arises in the tax court). 142. see william n. eskridge, jr., interpreting legislative inaction, 87 mich. l. rev. 67 (1988) (discussing the reenactment doctrine); gans, supra note 117, at 76475; robert c. brown, regulations, reenactment, and the revenue acts, 54 harv. l. rev. 377 (1941) (critiquing the doctrine). 143. see swallows holding v. comm'r, 126 t.c. 96 (2006). [vol. 7:9 a new model for identifying basis in life insurance favoring agency flexibility.'" under chevron, in other words, reenactment can expand an agency's ability to claim deference for interpretation while not necessarily contracting its ability to change position: (1) an agency can invoke the reenactment doctrine in instances when congress reenacts a statute after an agency or court has construed it, based on the inference that congress approved of the construction; and (2) an agency can only be precluded from changing its position under the doctrine if it can be determined that congress unambiguously indicated an intent in reenacting the section to freeze in place the outstanding interpretation."' had the court in swallows holding applied chevron, rather than denying the differences between the chevron and pre-chevron standards, it presumably would have reached a different conclusion about the validity of the regulation after first focusing on the correct issue: whether, in reenacting the section, congress had unambiguously expressed an intent to make the existing precedent unalterable."4 second, as recently embellished, chevron permits an agency to overrule judicial precedent. in national cable & telecommunications ass 'n v. brand x internet services,147 the supreme court held that an agency interpretation issued under chevron may overrule a court decision, even including a supreme court decision, provided that the court did not hold the statute to be unambiguous.1 48 thus, under the national cable framework, unless a statute is held unambiguous, 49 the government can convert its defeat in court into victory by 144. nat'l cable & telecomms. ass'n v. brand x internet servs., 125 s. ct. 2688, 2708 (2005). 145. id. 146. lest there be any confusion, the court's attempt in swallows holding to make national cable inapplicable in the tax context is not directly relevant to the validity of a proposed regulation adopting the hypothetical term method. unlike the interpretation in national cable (or swallows holding), the proposed regulation would not overturn a court decision; it would merely overturn the irs's own ruling. the court's analysis of national cable is nonetheless indirectly relevant in it that it reflects the tax court's unwillingness to embrace chevron and all of its implications. 147. national cable, 125 s. ct. at 2688. see lee a. sheppard, tax court flunks the brand x test, 110 tax notes 585 (feb. 6, 2006) (pointing out that the tax court overlooked the importance of the national cable decision). see also stan r. johnson, swallows as it might have been: regulations reversing case law, 112 tax notes 773 (aug. 28, 2006) (critiquing swallows holding on the grounds that it fails to follow national cable). but see richard m. lipton, a divided tax court rejects a regulation and struggles with administrative law in swallows holding, 104 j. tax'n 260 (2006) (arguing that the swallows holding court reached the correct result). 148. see national cable, 125 s. ct. at 2700 ("a court's prior judicial construction of a statute trumps an agency construction otherwise entitled to chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion."). 149. for a discussion of national cable, see note, implementing brand x: what counts as a step one holding? 119 harv. l. rev. 1532 (2006). 2006] florida tax review regulation and thereby render a court nothing more than a provisional decision maker. presumably concerned about its new role, the tax court struggled, not surprisingly, to adopt a reading of national cable that would preclude it from applying in tax cases.150 how did swallows holding support this reading? building on its premise that interpretive tax regulations may not be subject to the chevron standard, the swallows holding court questioned whether national cable could ever be applied to such regulations, given that national cable involved a chevron interpretation.' 5 ' furthermore, the swallows holding court implicitly used a collateral-estoppel type analysis in its attempt to limit the application of national cable, maintaining that an agency can only overturn a court decision if it was not a party in the prior litigation. 52 more specifically, in national cable, the agency had not been a party in the prior litigation; in contrast, when it comes to tax litigation, the irs will always be a party. as a consequence, under swallows holding, the irs will always be precluded from administratively overturning an unfavorable decision. in advancing these arguments, the tax court misreads the supreme court. it is difficult to assert that the supreme court contemplated the application of a third, unique deference standard in tax cases. it is likewise difficult to find even the hint of a suggestion in national cable that tax regulations are to be excluded from 150. see gans (exploring mindset oftax court judges), supra note 117, at 780. see also aprill (exploring mindset of tax court judges), supra note 125 at 2111-12. 151. swallows holding v. comm'r, 126 t.c. 96 (2006). 152. id. at 144-45. it should be noted that there may be limits on an agency's ability under national cable to trump the courts. in general dynamics land systems, inc. v. cline 540 u.s. 581 (2004), the court relied on a lower-court consensus in reaching the conclusion that the statute was unambiguous (indicating as well that congress' failure to overturn the consensus view could be read as acquiescence). see id. at 593-94. see also smiley v. citibank (south dakota) n.a., 517 u.s. 735 (1996) (indicating that disagreement in the lower courts suggested that the statute was ambiguous). thus, assuming that a widely shared consensus develops, the agency may, as a practical matter, forfeit its ability to take a different approach by regulation. whether the lower-court consensus in swallows holding, consisting of the fourth circuit's agreement with the board of tax appeals, is sufficient to satisfy the widelyshared-consensus criterion remains questionable in that, in general dynamics, the court relied on a series of uniform decisions in two circuits courts and numerous district courts as well as an analysis in its own earlier decisions. see id. surprisingly, the tax court in swallows holding fails to cite general dynamics. questions also remain about general dynamics itself. consider, for example, a statute that is construed in a similar fashion by different courts, with each successive decision adopting the reasoning of the first decision as a matter of stare decisis. does the agreement among the courts suggest that the statute is unambiguous or, rather, that courts may, at least in close cases, tend to agree with each other? finally, it is noteworthy that general dynamics gives agencies an odd incentive: to overturn an unfavorable court decision quickly in order to avoid the risk that a consensus might develop, rather than taking time to reflect on the issue before promulgating a regulation. [vol. 7:9 a new model for identifying basis in life insurance its framework. absent some indication from congress that the irs should be singled out in this fashion, the supreme court should not be lightly understood as having intended to create unstated, tax-specific exceptions to the administrative law framework it has established. in short, there is no basis in any of the supreme court's recent decisions to justify such an exception.'53 153. the swallows holding court also emphasized, in seeking to limit national cable, the fact that the irs had not consistently maintained the position taken in the new regulation. swallows holding, 126 t.c. no. 6 at 144. but the majority failed to acknowledge that the court in national cable also indicated that chevron contemplates that agencies can freely change their position as circumstances warrant and that, unless they are arbitrary or capricious, the inconsistency does not undermine the validity of the new interpretation. see nat'l cable & telecomms. ass'n v. brand x internet servs., 125 s. ct. 2688, 2699-2700 (2005). as suggesterd in text, many regulations promulgated for the purpose of overturning court decisions will become vulnerable ifthe tax court's failure to embrace national cable is sustained. the most recent example is a proposed regulation that would substantially alter the income tax treatment of private annuities. see prop treas. reg. § 1.72-6 and § 1.1001-1, 71 fed reg. 61441-01 (oct. 18, 2006). in the preamble, the treasury explains that the approach taken in a 1933 board of tax appeals decision that was based on burnet v. logan, 283 u.s. 404 (1931), as well as the approach taken in rev. rul 69-74, 1969-1 c.b. 43, cannot be followed if taxpayer abuse is to be prevented. see id. whereas this proposal would, in all likelihood, be invalidated if the swallows holding analysis were applied, it would unquestionably be sustained under national cable inasmuch as the neither irc § 1001 nor § 72 unambiguously resolves the issues addressed in the proposal. note, however, that in estate of gerson v. comm'r, 127 t.c. no 11 (2006), decided just before publication of this article, the court sustained a generation skipping tax regulation designed to overturn circuit court precedent. adhering to its decision in swallows holding, the court applied the national muffler standard rather than chevron, indicating, as it did in swallows holding, that the result would be the same under either standard and that there was therefore no need to compare the two standards. in terms of national cable, without acknowledging its shift, the court deviated from swallows holding. it concluded that, under the national cable framework, where the courts are in conflict about the meaning of a code section, an interpretive regulation can resolve the conflict. thus, unlike swallows holding, gerson contemplates that national cable can apply to interpretive tax regulations. unfortunately, however, gerson fails to recognize that only a chevron-type interpretation can overturn a court decision. see national cable, 125 s. ct. at 2701 (indicating that "the court's prior ruling remains binding law" in the case of an "agency interpretation to which chevron is inapplicable"). thus, it would seem that the court erred not only in failing to apply the national cable framework in swallows holding, but also in failing to appreciate in gerson that a non-chevron (national muffler) regulation cannot be used to overturn a court decision. unless the tax court embraces chevron, it will eventually have to confront the reality that, under national cable, a non-chevron regulation cannot interfere with precedent. in short, the tax court must choose between two inconsistent propositions that it advances in gerson: that chevron may not apply to interpretive tax regulations and that interpretive tax regulations can overturn precedent. for a discussion 2006] florida tax review this is not to suggest that, as a matter of policy, such an exception would be inappropriate. indeed, given the irs's interest in vindicating itself after sustaining a defeat in court, one might question whether it would be salutary to permit the government to convert its losses into victory by regulation. " however, unless congress decides to create a special regime for tax interpretations, the national cable framework appears to apply to all agencies issuing interpretations under the chevron standard. the irs must, at the very least, revoke reverend ruling 70-38. it might then adopt the hypothetical term method in a new ruling. however, given the low level of deference such a ruling would receive, the irs should incorporate the hypothetical term method in a new regulation. under a proper application of chevron, the regulation would be virtually invulnerable to challenge. as the supreme court recently reiterated in national cable, chevron contemplates that, over time, agencies be permitted the flexibility to change position. thus, the irs's long-standing commitment should not preclude it from changing course. nor should congress's reenactment of the underlying sections be viewed as a ratification that freezes the irs's prior rulings in place. unless congress has unambiguously directed that an interpretation not be changed, a court operating under the chevron standard must respect the new interpretation. given the need for guidance prompted by the recent marketing of life insurance products creating the potential for gain'55 and given the low standard that agencies must meet when changing position (i.e., not arbitrary or capricious), the regulation should be easily upheld. if, on the other hand, the tax court persists in applying a skidmore-like standard in considering interpretive regulations, the proposed regulation would obviously face a more difficult challenge, at least in the tax court: under such a standard, the irs's long-standing position, maintained both before and after the amendment of the underlying code sections, would cut strongly against the validity of a newly issued regulation. should other courts decide to follow swallows holding, a raft of treasury regulations would become similarly vulnerable.'56 of the deference issues with regard to the generation skipping tax regulation sustained by the court in gerson, see gans supra note 117. 154. timothy k armstrong, chevron deference and agency self-interest, 13 comell j. law & pub. pol'y 203 (2004) (arguing that self-interested agencies should not receive chevron deference). but see hickman, supra note 124 (arguing that deference should be afforded to the irs). 155. see infra part vi. 156. see, e.g., regs. § 1.61-22. the split-dollar regulations also replaced a contrary revenue ruling. in rev. rul. 64-328, 1964-2 c.b. 11, made obsolete by rev. rul. 2003-105, the irs made no distinction between the so-called collateral assignment and endorsement methods. in the split-dollar regulations that replaced this ruling, however, two different regimes apply depending on which method is used. see regs. §§ 1.61-22 & 1.7872-15. [vol. 7:9 a new model for identifying basis in life insurance in the end, the more likely outcome is that the supreme court's chevron mandate will eventually come to be seen as having universal application. in short, swallows holding is less likely to survive than the regulation it invalidated. vi. disposmons of life insurance policies as a matter of policy, congress has historically promoted the purchase of life insurance. this proinsurance bias is reflected in the tax-favored treatment given to life insurance policies and proceeds.157 in general, taxpayers who own life insurance policies may hold them to maturity, let them lapse, or dispose of them. consistent with its policy objectives of promoting life insurance ownership, congress offers very favorable tax treatment to taxpayers who hold their life insurance policies to maturity: when it 157. examples of such favoritism are reflected in the fact that the internal buildup of the cash value of a life insurance policy is not taxed (see, e.g., cohen v. comm'r, 39 t.c. 1055 (1963), acq., 1964-1 c.b. 4 (cash value of policy was deemed not constructively received by taxpayer because to receive such value, the taxpayer would have to surrender the policy)), and life insurance policy proceeds are entirely exempt from income tax. irc § 101(a). these benefits do not come without a price, however; put in terms of dollars, this so-called "tax expenditure" costs the country's coffers billions annually. see, e.g., gao report, governmental performance and accountability: tax expenditures represent a substantial federal commitment and need to be reexamined, gao-05-690, tbl. 2 at 34 (sept. 2005) (shows a revenue loss estimate of $20.1 billion for fiscal year 2004 associated with the income tax exclusion on interest with respect to life insurance savings). from a public policy perspective, query whether a portion of this expenditure was ever intended to benefit those taxpayers who, at some point, seek to sell (or even surrender) their coverage. 2006] florida tax review comes to the receipt of policy distributions, 5 ' loans, 5 9 and withdrawals, 6 ° congress specifically allows taxpayers to use the aggregate premiums they have paid to shelter these proceeds from tax. taxpayers who no longer need or can afford to maintain their life insurance polices and allow them to lapse usually face one of two consequences. on the one hand, if the policy has no outstanding loans, the lapsing event will engender no income tax repercussions. on the other hand, if the policy is subject to outstanding loans, allowing the policy to lapse will be treated as a disposition event.'" ' congress's magnanimous spirit towards the tax treatment of life insurance extends to policy surrenders. for reasons unexplained, the surrender of a life insurance policy enjoys extraordinarily favorable (and, as a matter of policy, undeserved) tax treatment.'62 taxpayers who surrender their policies do not recognize income as long as the amount received does not exceed the aggregate 158. all dividends paid or credited before the maturity or surrender of a contract are deemed a tax-free return of basis. irc § 72(e)(5). the code mandates that for these purposes, the term basis means aggregate basis and includes all premium payments. irc § 72(e)(6). as a corollary to this tax-free treatment reserved for dividends (assuming the dividends received do not exceed aggregate premium payments), the taxpayer must reduce the tax basis in the policy that generated such dividends. regs. § 1.72-6. if, instead, these dividends are used to pay policy premiums, or, alternatively, they are used to purchase additional insurance, such payments will have no net effect upon the policy's tax basis. 159. ordinarily a loan taken on a policy does not generate taxable income. see generally, woodsom assocs., inc. v. comm'r, 198 f.2d 357 (2d cir. 1952) (holding that the act of borrowing does not constitute a recognition event). a policy loan thus has no bearing upon the tax basis taxpayers have in their insurance policies. the issue of consequence will be if the loan in question is still outstanding at the time the policy is surrendered or sold; in either case, the taxpayer is treated as if the borrowed (and still unpaid) sums were received. atwood v. comm'r, t.c. memo. 1999-61. 160. for tax purposes, a policy withdrawal is treated as a cash distribution and is generally protected from tax until the aggregate amount withdrawn exceeds the aggregate premiums paid by a taxpayer. irc § 72(e)(6). however, amounts withdrawn correspondingly decrease a taxpayer's tax basis in the policy. regs. § 1.72-6. this general rule does not apply, for example, if the benefits under a life insurance contract are reduced during the fifteen-year period beginning on the issue date of the contract, and a cash distribution is made to the policyholder as a result of the reduction in benefits. see irc § 7702(0(7). 161. see regs. § 1.1001-2(a) (the amount of the loan is considered an amount received on the transfer); irs priv. ltr. rul. 89-51-056 (sept. 27, 1989) (same). 162. to provide an incentive for taxpayers to maintain their policies, congress should consider eliminating any favorable tax treatment associated with policy surrenders and, in particular, repealing irc § 72(e)(6). indeed, it might even consider going a step further and instituting an excise tax in instances of policy surrenders to capture some of the income tax deferral the taxpayers are able to capitalize upon. [vol. 7:9 a new model for identifying basis in life insurance premiums each of these taxpayers paid.'63 (if, however, the cash surrender value exceeds the aggregate premiums paid, such excess is taxable.) i" the same favorable tax treatment does not extend to other life insurance policy dispositions. this is when proper basis identification is most critical. today, there are several reasons why the disposition of life insurance policies has become increasingly popular. one reason is the emergence of life settlement companies, and another is that a new premium financing technique has arisen that makes the sale of life insurance policies much more attractive. a. the emergence of the life settlement companies over the past decade the sale of life insurance policies has surged. there are several reasons for this trend. one reason is that an increasingly greater percentage of the nation's population is over sixty-five.1 6 1 people in this demographic often attempt to supplement their incomes and maximize economic returns on whatever assets they own. life insurance policies with an investment component that are performance laggards are thus potential targets for taxpayers in this demographic to sell. another reason taxpayers may seek to sell their life insurance policies is that their insurance needs have become obviated. this may occur due to family changes or business transitions. more specifically, in the family context, taxpayers often purchase life insurance to help fund college educations or to provide for the financial needs of their family. at a certain point, however, the taxpayers' children may have completed their formal educations and taxpayers may have accumulated sufficient assets to meet their present and anticipated future financial obligations, thereby negating their insurance needs. in the business context, key employees upon whom the employer held policies may quit, be terminated, or retire. any of the foregoing events may result in taxpayers owning life insurance policies that no longer serve any utility. a final reason that taxpayers may deem retention of their life insurance policies unnecessary is that congress has greatly alleviated the federal estate tax burden that used to haunt many taxpayers. in prior decades, a leading reason for the purchase of life insurance was to offset an anticipated federal estate tax burden. in the economic growth and tax relief reconciliation act of 200 1,1" however, congress dramatically increased the applicable exclusion amount,"' i.e., the amount taxpayers can shelter from the federal estate tax. currently, this amount is 163. see supra note 27 and accompanying text. 164. irc § 61. 165. statistical abstract of the united states: 2006, tbl. 34 at 38 (2006). 166. economic growth and tax reliefreconciliation act of200 1, pub. l. no. 107-16, 115 stat. 38. 167. id. at 71. 20061 florida tax review $2 million, but it is scheduled to increase to $3.5 million in 2009. m16 (in 2010, the federal estate is scheduled to be suspended, and in 2011 the applicable exclusion amount is scheduled to be reduced to $1 million. 69 however, most commentators doubt that either the full repeal of the estate tax or a reduction of the applicable exclusion amount will ever actually occur.) 7° in addition, as part of the same legislation, the federal estate tax rate is scheduled to decrease in the coming years from the prior 55 percent maximum tax rate to a maximum tax rate of 45 percent.' the combination of a significantly higher exclusion amount and a much lower tax rate alleviates much of the potential federal estate tax burden that many taxpayers once faced, mooting their need to maintain life insurance policies as a means of offsetting this perceived erstwhile burden. in the past, when taxpayers owned life insurance policies that they no longer needed, they were essentially presented with an either/or choice: they could either let the policy lapse, or they could surrender the policy for its cash surrender value. the aids epidemic, however, had a profound effect on this either/or choice, opening up a third option: taxpayers now have the opportunity to sell their life insurance policies to the company offering the highest bid. at the start of the aids epidemic in the early 1980s, the medical industry was scrambling to learn about the disease and its treatment. medical treatment and care were scarce and costly; taxpayers who suffered from aids were anxious for both and sought to sell their life insurance policies as a means to cover such expenses. this financial need was the catalyst behind the advent of viatical companies."' 168. id. see generally dennis l. belcher & mary louise fellows, report on reform of federal wealth transfer taxes task force on federal wealth transfer taxes, 58 tax law. 93 (2004) (describing in exhaustive detail that if facets of the economic growth and tax relief reconciliation act of 2001 are made permanent, it will dramatically decrease the percentage of estates subject to federal estate tax). 169. see pub. l. no. 107-16, supra note 137, at § 901, 115 stat. 150 (prescribing "sunset" provisions for estate tax repeal). 170. see, e.g., edward mccaffery, a look into the future of estate tax reform, 105 tax notes 997 (nov. 15, 2004) (arguing that politicians use the prospect of estate tax repeal to generate campaign contributions); edward mccaffery & linda cohen, shakedown at gucci gulch: a tale of death, money and taxes, in usc cleo research paper no. 04-14 (2004), at http://ssm.com/abstract=581084 (same). 171. see pub. l. no. 107-16, supra note 133, § 51 l(a)-(c), 115 stat. 38,70-71. 172. the business model of viatical companies was fairly simple. these companies would buy life insurance policies at a discounted value from patients stricken with aids, who were deemed to have exceedingly short life spans; maintain the policy until the death of the insured; and give company investors a healthy return on their investments. commentators estimate that "between $1.8 billion and $4.0 billion worth of policies were viaticated in 2001, up from $50 million in 1990 and $1.0 billion as recently as 1999." n.a. doherty & h.j. singer, the benefit of a secondary market for life insurance policies, 38 real prop. prob. & tr. j. 449, 451 (2003) (citing erich w. sippel & alan h. buerger, a free market for life insurance, contingencies 17 (mar.[vol. 7:9 a new model for identifying basis in life insurance the "problem" that arose in the viatical company industry is that new aids treatments prolonged life, making investments in insurance policies on the lives of aids patients far less economically attractive than when the epidemic first began.'73 to survive economically, viatical companies gradually changed their business model, transforming themselves into so-called life settlement companies. the business model of life settlement companies shares many of the same attributes of viatical companies. there is, however, one essential difference between the two kinds of companies: whereas viatical companies purchase life insurance policies when death is imminent, life settlement companies do not. in the case of life settlement companies, the insured ordinarily has a health ailment (e.g., cancer) that materially decreases the insured's life expectancy. this condition usually makes the value of the life insurance policy on the insured's life worth far in excess of the policy's cash surrender value. over the last ten years, the life settlement industry has evolved and has become more respected in the business community. such respect has further contributed to the dramatic increase in the number of life insurance policies sold annually. the life settlement industry projects rapid growth, anticipating a tremendous rise in its revenues over the next decade. 74 b. premium financing technique the emergence of the life settlement industry has fostered the establishment of several new estate planning techniques. one popular technique involves premium financing, in which the insured acquires a new policy with funds advanced by an investor.175 albeit somewhat oversimplified, here are the apr. 2002); carrie coolidge, death wish investors in insurance policies for the terminally ill are watching their capital get annihilated, forbes 206 (mar. 19, 2001)). 173. d.w. dunlap, aids drugs alter an industry's math, n.y. times, july 30, 1995, at di; coolidge, supra note 172. 174. see jim connolly, institutions reshape life settlement market, national underwriter 14 (sept. 20, 2004) (estimating that the volume of life settlements will increase to $15 billion annually by the year 2010); m. bryan freeman, life settlements enter the mainstream, nat'l underwriter 20 (sept. 19, 2005) (declaring that the life settlement market has come of age). but see rachel emma silverman, recognizing life insurance's value: study says keeping policy may mean bigger payoff than selling to an investor, wall st. j., may 31, 2005, at d2. 175. some states have questioned the legality of this technique. see, e.g., op. off. gen. counsel, 05-12-15 (dec. 19, 2005) (holding that the owner of the policy did not have a valid insurable interest). insurance companies, too, have expressed misgivings regarding the premium financing technique because they apparently price policies based upon an assumption that a number of the policies will lapse before the insured dies. those who invest in this type of transaction seek to exploit this assumption, acquiring the policy at a reduced cost because of the assumption and then holding it until the insured's death without lapse. 2006] florida tax review technique's salient attributes: an investor seeks a healthy elderly participant who has significant wealth and can secure a large life insurance policy, say in the $5 million range. to entice the participant to partake in this arrangement, the investor promises to pay the policy's premiums for a period of two years. in return, the participant issues a nonrecourse note to the investor secured by the policy. if the participant dies during the first two years of the arrangement, the amount of the advance is repaid to the investor with interest; the participant's beneficiaries retain the proceeds to the extent such proceeds exceed the amount of the debt. alternatively, if the participant is still alive at the end of the two-year term, the participant must decide whether (i) to retain the policy and repay the debt or (ii) to forfeit the policy to the investor in satisfaction of the debt. from an economic perspective, the arrangement is attractive to both the participant and the investor. in terms of the participant, should death occur within the two-year period, her beneficiaries enjoy a windfall. and even if the participant is fortunate enough to still be alive at the end of the two-year period, the participant has no downside economic risk insofar as premium financing was conducted on a nonrecourse basis. in terms of the investor, the transaction is also profitable: if the participant's death occurs during the two-year inception period, the investor recoups the amount invested together with the interest provided for in the note; at the end of the two-year inception period, the investor may be repaid or acquire the policy, the latter of which is apparently a valuable investment in the life settlement industry because of the underwriting insurance company's failure to price the policy appropriately.'76 from a tax perspective, however, the participant does have a downside risk both in terms of the amount of gain the taxpayer recognizes as well as its character. 1. determining the amount of the taxable gain if the participant survives the two-year inception period and chooses to forfeit the policy to the investor rather than repaying the debt, the participant must recognize gain equal to the difference between the amount of the debt and the participant's basis in the policy.'77 depending on the computation of the policy's tax basis, the potential tax liability on this gain could, in many cases, dissuade the participant from entering into the arrangement. if the methodology used by the irs in its private letter rulings were applied in this context, the participant's basis would likely be very low at the twoyear point indeed, near zero since most of the premium is typically devoted to acquisition costs during the policy's early years and would be viewed by the irs 176. see r. marshall, stephen r. leimberg, and lawrence j. rybka, 'free' life insuarnce: risks and costs or non-recourse providing financing, 33 est. plan. 3 (2006); stephan r. leimberg, stranger-owned life insurance: killing the goose that lays the golden eggs! 49 exempt org. tax rev. 93 (2005); rachel emma silverman, letting an investor bet on when you'll die, wall st. j., may 26, 2005, at d1. 177. see regs. § 1.1001-2. [viol. 7:9 a new model for identifying basis in life insurance as a cost-of-insurance.' if, on the other hand, the hypothetical term method were applied, the basis in the policy would be somewhat greater and the gain correspondingly reduced. in contrast, under the aggregate premium approach, the policy's tax basis would likely be sufficient to eliminate all of the participant's gain. thus, the attractiveness, if not the feasibility, of the premium financing technique may well depend on the basis-computation question.'79 2. the character of the gain a transfer of the policy to the investor in discharge of the nonrecourse note should result in gain, not ordinary cancellation-of-debt (cod) income. in anticipation of the supreme court's decision in comm 'r v. tufts, 8' regulations were adopted that make a distinction between recourse and nonrecourse debt. 8' in the case of recourse debt (which is not typically used in the premium financing arrangement), an allocation between cod income and gain must be made based on the value of the asset at the time of surrender:182 to the extent that the amount of the recourse note exceeds the asset's value, cod income is generated, with the balance constituting gain.' in contrast, in the case of nonrecourse debt, the entire difference between the amount of the debt and the taxpayer's basis is gain." 4 thus, a taxpayer who engages in a premium financing transaction via a nonrecourse note will not recognize cod income on account of a transfer of the policy in discharge of the note. we turn now to the question of characterizing the gain. on first examination, one might be inclined to view the gain resulting from the taxpayer's satisfaction of the nonrecourse note as capital in nature. after all, the code does not specifically exclude life insurance policies from the definition of capital assets, 85 178. see supra notes 90-93 and accompanying text. 179. this is not to suggest merely because the hypothetical term method produces less gain that it is theoretically superior. instead, its theoretical superiority stems from the more realistic allocation of origination costs. in short, the point of examining this new arrangement is not to praise the comparative virtues of any basiscomputation method, but simply to explore the practical implications of the different alternatives. 180. 456 u.s. 960 (1982). 181. see regs. § 1.1001-2(c), exs. 7, 8. see also deborah a geier, tufts and the evolution of debt discharge theory, 1 fla. tax rev. 115 (1992) (critiquing this distinction). 182. assume a taxpayer's basis is zero and that it is encumbered by a recourse debt in the amount of $7,500. if, at a time when the asset's value is $6,000, the taxpayer surrenders it to the lender in discharge of the entire debt of $7,500, the taxpayer would have gain of $6,000 and cod income of $1,500. see regs. § 1.1001-2(c), ex. 8. (using a similar example). 183. see regs. § 1.1001-2(c), ex. 7. 184. see regs. § 1.1001-2(c), ex. 7. 185. see irc § 1221. 2006] florida tax review thus suggesting that they qualify as a capital asset.'86 in terms of the sale-orexchange requirement, which is another precondition of capital gain treatment, a transfer of the policy to the investor in discharge of the note will suffice." 7 parenthetically, even a surrender of the policy to the insurance company would be treated as a sale,"s for the code now deems contract terminations a sale for capital gain purposes. 89 nonetheless, upon closer examination, capital gain treatment appears to be inappropriate. under an inveterate line of supreme court decisions, capital gain treatment is denied where the amount received is a substitute for ordinary income.'90 in the face of questions about the continuing viability of the so-called substitution of income doctrine in light of intervening developments,' 9' the lower courts have been resolute in continuing to apply the doctrine. " to be sure, questions do remain as to doctrine's exact boundaries. nonetheless, the supreme 186. see comm'r v. phillips, 275 f.2d 33, 36 n.3 (4th cir. 1960) (in dicta, indicating that a policy may be characterized as a capital asset); see also tech. adv. mem. 200452033 (sept. 27, 2004) (same). 187. see regs. § 1.1001-2. 188. whereas, traditionally, capital gain treatment could only be secured if the asset were sold, the code now permits such treatment even where the asset is surrendered on termination of a contract. see irc § 1234a. thus, it would seem that if the insured were to surrender a policy to the insurance company, capital gain treatment might be available. see tech. adv. mem. 200452033 (sept. 27, 2004) (indicating that capital gain treatment might be appropriate on surrender of a policy). 189. see irc 1234a. even if the sale or exchange is satisfied, to the extent the sale proceeds are attributable to the accretion of earnings within the policy, ordinary income treatment is the result under the substitution doctrine. see, e.g., tech. adv. mem. 200452033 (sept. 27,2004) (indicating that the substitution doctrine requires that the accretion be treated as ordinary income). 190. see united states v. midland-ross corp., 381 u.s. 54 (1965); comm'r v. gillette motor transp., inc., 364 u.s. 130 (1960); comm'r v. p.g. lake, inc., 356 u.s. 260 (1958); hort v. comm'r, 313 u.s. 28 (1941). 191. see, e.g., edward j. roche, jr., lease cancellation payments are capital gain? yes! the tra '97 change to 1234a overturned hort, 102 j. tax'n 364 (2005) (suggesting that congress overruled the substitution doctrine in enacting code § 1234a); see also lattera v. comm'r, 437 f.3d 399, 403 (3rd cir. 2006) (rejecting the taxpayer's argument that the supreme court's decision in ark. best corp. v. comm'r, 485 united states 212 (1988), overruled the doctrine); united states v. maginnis, 356 f.3d 1179, 1185 (9th cir. 2004) (same). 192. see, e.g., maginnis, 356 f.3d at 1185 (rejecting the taxpayer's argument that the supreme court in arkansas best overruled the substitution doctrine); lattera, 437 f.3d at 403; watkins v. comm'r, 447 f.3d 1269, 1272 (10th cir. 2006) (applying the substitution doctrine without discussing arkansas best); wolman v. comm'r, no. 05-9001, 2006 wl 1376899 (10th cir. 2006) (applying watkins to reach a similar outcome based upon a similar set of facts); see also tech. adv. mem. 200452033 (sept. 27, 2004) (applying the substitution doctrine after the enactment of code § 1234a and after the supreme court's decision in arkansas best). [vol. 7:9 a new model for identifying basis in life insurance court has identified a critical criterion that focuses on whether the asset has appreciated over time. 93 in instances where the taxpayer's profit is not attributable to such appreciation, the substitution doctrine is applied and ordinary income results.' 94 this limitation on the capital gain concept makes sense not only as a matter of congress's intent but also as a matter of policy; it reserves the preferential rate on gains for taxpayers who might otherwise be deterred from making a sale in order to ameliorate the lock-in effect that the realization requirement creates. 95 recently, disagreement in the circuit courts has erupted concerning the importance of the appreciation-over-time criterion and the foundational role it plays in the substitution doctrine. in united states v. maginnis,96 the ninth circuit held that a taxpayer who had won a lottery had ordinary income when he sold his right to receive the proceeds. 97 in invoking the substitution doctrine, the court emphasized that the taxpayer did not satisfy the appreciation-over-time criterion. 98 the court reasoned that the difference between the cost of the lottery ticket and the sales price for the right to receive the proceeds could not be viewed as the requisite appreciation. "' analyzing a very similar fact pattern involving the sale of future lottery proceeds, in lattera v. comm 'r,2°° the third circuit took a different approach.2 °1 it deduced a framework from the supreme court's cases that excludes the appreciation-over-time criterion as a relevant variable in the substitution doctrine. °2 it pointed out that the supreme court had applied the substitution 193. midland-ross corp., 381 u.s. at57 (1965); see gillette motor transp., inc., 364 u.s. at 134; p.g. lake, inc., 356 u.s. at 265. 194. see supra note 180. 195. see, e.g., daniel halperin, saving the income tax: an agenda for research, 24 ohio n.u. l. rev. 493 (1998) (indicating that the preferential capital gain rate is designed in part to address the lock-in effect, under which taxpayers are dissuaded from selling assets because of the potential tax liability); see also comm'r v. p.g. lake, inc., 356 u.s. 260, 265 (1958) (explaining that congress was concerned about the deterrent effect on taxpayers inclined to make a sale absent the preferential rate). 196. 356 f.3d 1179 (9th cir. 2004). 197. id. at 1186-87. 198. id. at 1184. 199. id. 200. 437 f.3d 399 (3rd cir. 2006). 201. in disagreeing with maginnis, the third circuit embraced a critique ofthe decision. id. at 404-06. see generally matthew s. levine, comment, lottery winnings as capital gains, 114 yale l.j. 195, 197-202 (2004) (critiquing maginnis); thomas g. sinclair, comment, limiting the substitute-for-ordinary income doctrine: an analysis through its most recent application involving the sale of future lottery rights, 56 s.c. l. rev. 387, 421-22 (2004). 202. under the third circuit framework which, parenthetically, is dicta there is a threshold inquiry as to whether the arrangement more closely resembles a substitution or capital gain type of transaction. lattera, 437 f.3d at 405-06. if the issue 2006] florida tax review doctrine in two cases notwithstanding the fact, from the third circuit's perspective, that the taxpayer's profit could be viewed as attributable to appreciation accruing during the taxpayer's ownership of the asset. 20 3 based on these cases, the court concluded that the appreciation-over-time criterion could not entirely explain the outcome of the supreme court's cases, thus justifying its decision to exclude the criterion from its framework.2 °4 ultimately, applying its own framework, the third circuit nevertheless reached the same outcome as the ninth circuit in maginnis: the sale of the right to receive lottery proceeds produces ordinary income under the substitution doctrine.2 5 the third circuit's failure to incorporate the appreciation-over-time criterion into its framework reflects a misreading of the supreme court's substitution cases. surprisingly, the third circuit does not acknowledge that the is not resolved under this test, it becomes necessary to determine whether, in the court's terminology, the taxpayer has disposed of a vertical slice (i.e., where the taxpayer sells a complete undivided property interest) or a horizontal slice (i.e., where the taxpayer disposes of a part of his property interest and also retains a portion, too). id. at 406-07. where there is a disposition of a horizontal slice, the substitution doctrine is to be applied. id. at 407. on the other hand, in the case of a vertical slice, a further determination must be made: whether the taxpayer disposes of the right to receive income that has already been earned, id. at 407-09, or, instead, the right to receive income to be earned. the doctrine is to be applied in the former but not the latter case. see id. at 409. 203. see id. at 405 (indicating that the supreme court had invoked the substitution doctrine, even though the taxpayers held investment assets capable of appreciation, in comm 'r v. p. g. lake, inc., 356 u.s. 260 (1958), and hort v. comm 'r, 313 u.s. 28 (1941)). it is certainly plausible that, in p. g. lake, the amount received by the taxpayer was attributable in part to appreciation in the taxpayer's investment (i.e., the price the taxpayer received for selling the oil payment right may well have stemmed in part from the appreciation in the underlying investment that had accrued during the time of the taxpayer's ownership). in hort, on the other hand, contrary to the third circuit's characterization, the amount the taxpayer/lessor received from the lessee as consideration for canceling the lease does not appear to reflect appreciation in the underlying investment. 204. lattera, 437 f.3d at 405. in supporting its argument against the use of the appreciation-over-time criterion, the court uses a car as an example. id. at 405. since, the court says, cars tend to decline in value, use of the appreciation-over-time criterion would create an anomalous result in this context: the substitution doctrine would always preclude capital gain treatment on the sale of a car. see id. this is a faulty analysis that is predicated on a lack of understanding of the appreciation-over-time criterion and the substitution doctrine itself. the criterion as well as the doctrine can only have relevance where the transaction produces a profit. the doctrine can have no application where, as in the car example, loss occurs. as properly applied, the substitution doctrine converts profit that would otherwise qualify for capital gain treatment into ordinary gain. thus, in the car example, should it for some reason be sold at a profit, capital gain would result the profit having accrued over the period of the taxpayer's ownership. 205. id. at 405-10. [vol 7:9 a new model for identifying basis in life insurance supreme court, in some of its decisions, explicitly references the appreciationover-time criterion when it invokes the substitution doctrine.2 °6 indeed, inexplicably, the third circuit relies upon one of these cases, comm 'r v. p. g.lake,2 °7 in its attempt to demonstrate the supreme court's failure to apply the appreciation-over-time criterion 20 8 seemingly oblivious to the fact that the p. g. lake decision explicitly alludes to the criterion in explicating the policy rationale underlying the capital gain concept.2 °9 what accounts for the third circuit's resistance to the appreciation-overtime criterion? this illustration should provide some insight: suppose a taxpayer purchases stock at a cost of $10,000 and then one year later, when its value has increased to $15,000, sells the right to receive dividends on the stock for a period of, say, three years. under supreme court precedent, the sale is clearly subject to the substitution doctrine and therefore produces ordinary income.21 ° yet, in what was presumably the third circuit's perception, some of the sales proceeds could be conceivably viewed as attributable to the appreciation accruing during the year of ownership (if, for example, the company prospers and the increase in the value of the stock corresponds with an increased dividend, some portion of the sale proceeds could be seen as related to the appreciation). one can surmise that the third circuit may have been concerned that, if it included the criterion in its framework, capital gain treatment would become available in this example a result that is palpably wrong. contrary to this thinking, however, there is no tension between the appreciation-over-time criterion and ordinary income treatment for such a dividend sale transaction, for the taxpayer in this example would not be able to establish that the entire income (or gain) generated by the sale was attributable to appreciation. at best, the taxpayer might be able to show that a portion of the profit could be so attributed. this can be contrasted with a typical case in which capital gain treatment is appropriate: where the entire gain is clearly the product of appreciation in the investment. thus, the third circuit could have embraced the appreciationover-time criterion without permitting capital gain treatment in the dividend sale example. it could have done so by making the substitution doctrine operative where, as in the example, a taxpayer cannot establish that the entire gain is attributable to appreciation over time. simply put, the third circuit's reading of the 206. see united states v midland-ross corp., 381 u.s. 54, 57 (1965); comm'r v. gillette motor transp., inc., 364 u.s. 130, 134 (1960). 207. see lattera, 437 f.3d at 405 (referencing the supreme court decision in p. g. lake). 208. the court also referenced the supreme court's decision inhort, 313 u.s. at 28. see lattera, 437 f.3d at 405. 209. see p.g. lake, 356 u.s. at 265. 210. see comm 'r v. p.g. lake, 356 u.s. 260 (1958) (involving similar facts conceming the sale of an oil payment right where the taxpayer retained the underlying asset); see also estate of frank d. stranahan v. comm'r, 472 f.2d 867 (6th cir. 1973) (applying p. g. lake in the context of such a dividend sale). 2006] florida tax review supreme court's substitution cases is not a faithful one. a more accurate reading of the cases is as follows: unless a taxpayer is able to establish that the entire gain is attributable to appreciation over time, the substitution doctrine is to be applied and ordinary income results. in the lottery cases, as the ninth circuit in maginnis concluded, the substitution doctrine is properly applied because the appreciation-over-time criterion, as conceived by the supreme court, is not satisfied. concededly, it is arguable that a taxpayer who buys a lottery ticket and holds it until the drawing is in a somewhat similar position to a typical stock investor who hopes that the company in which he invests will be awarded an important government contract. in both cases, the appreciation accrues at the moment of the favorable event (the drawing or the contract award). yet the substitution doctrine applies in the case of the lottery but not the stock investment. so how does the appreciation-over-time criterion permit a distinction to be made between these two cases? in formulating the appreciation-over-time criterion, the supreme court did not intend that it would be applied so that capital gain treatment could be obtained in a case like the lottery. as the court has indicated, the criterion is designed so that capital gain treatment is targeted at taxpayers who might otherwise be deterred from selling their investment;21' the stock investor might well be inclined to continue holding the stock after the favorable contract is awarded to the company in order to avoid paying the tax on the stock's appreciation. in the case of the lottery, in contrast, there is no such deterrent effect. once the taxpayer is chosen as the winner, unlike the stock investor, he or she has no option by which to defer the income. given the absence of any deterrent effect in the case of the lottery winner, a conclusion that the appreciation-over-time criterion is satisfied in this context and that capital gain treatment should therefore be appropriate would be inconsistent with the supreme court's purpose in establishing it. the taxpayers in the lottery cases are therefore appropriately subject to the substitution doctrine.212 the lattera framework fails to capture not only the supreme court's cases but also a widely accepted second circuit decision. by the third circuit's own concession, its framework cannot account for the outcome in mcallister v. comm 'r213 a pro taxpayer decision that even the irs has embraced."' it explains away this difficulty by concluding that mcallister was wrongly decided.2"' the 211. p.g. lake, 356 u.s. at 265. 212. in also holding that the sale of the right to receive the lottery proceeds results in ordinary income under the substitution doctrine, the 10th circuit found it unnecessary to engage in the dispute. see watkins v. comm'r, 447 f.3d 1269 (10th cir. 2006). 213. 157 f.2d 235 (2nd cir. 1946); see lattera v. comm'r, 437 f.3d 399, 409 n.5 (3rd cir. 2006). 214. see rev. rul. 72-243, 1972-1 c.b. 233 (embracing mcallister). 215. see lattera, 437 f.3d at 409 n.5. [vol. 7:9 a new model for identifying basis in life insurance problem, however, is not with mcallister but rather with the lattera court's framework. in mcallister, the taxpayer sold an income interest that she held under a testamentary trust.2 16 the second circuit rejected the irs's substitution doctrine argument, holding that the taxpayer should be treated as having sold a capital asset.217 at an impressionistic level, the third circuit's criticism of mcallister appears to be well-founded, for if the taxpayer had retained the interest instead of selling it, the income received from the trust would have been ordinary in character. thus, based on this view, the sale accelerated the receipt of income and should be taxed no differently than the income itself. more properly viewed, however, the sale of a term interest should, as the court in mcallister held, qualify for capital gain treatment. to illustrate, consider a testamentary trust that is required to pay income to a for life and the remainder to b. assume that at the testator's death the value of the asset bequeathed in trust is $100,000 and that, based on a's life expectancy, the actuarial tables reflect that the value of a's interest and b's interest in the trust is equal to, respectively, 40 percent and 60 percent of the corpus. on these assumptions, a's basis in the income interest would be $40,000, and b's basis in the remainder interest would be $60,000.218 if, shortly after the testator's death, the value of the trust's assets increased to $200,000 and a and b simultaneously sold their interests in the trust for an aggregate price of $200,000 (with a receiving 40 percent, or $80,000, and b receiving 60 percent, or $120,000),2"9 a would recognize a capital gain of $40,000 on the sale; (a's amount realized of $80,000 minus a basis of $40,000). b would recognize a capital gain of $60,000 (b's amount realized of $120,000 minus a basis of $60,000). contrary to lattera, as well as the critique it references,"2 this is the correct result. had the testator instead made an outright bequest to a and b with a receiving a 40 percent interest and b receiving a 60 percent interest as tenants in common, a simultaneous sale of the two interests at an aggregate price of $200,000 would produce the same amount of capital gain for a and b (a's gain would be $40,000, and b's would be $60,000). there is nojustification for treating the simultaneous sale of an income and remainder interest any differently from a sale by tenants in common. 216. id. at 236-37. 217. mcallister, 157 f.2d at 235. 218. see regs. § 1.1014-5(a). 219. in reality, a's interest, and therefore a's basis, would be somewhat less than 40% at the point of sale given that, over time, the income beneficiary's interest in the trust is deemed to be reduced and the remainderman's is deemed to increase concomitantly. see regs. § 1.1014-5(a). in the example, since the sale occurs so shortly after the testator's death, no attempt is made to compute a's reduced interest. 220. see lattera, 437 f.3d at 409 n.5 (referencing marvin a. chirelstein, federal income taxation at 373, at 17.03, (9th ed. 2002), for the proposition that mcallister was wrongly decided). 2006] florida tax review treating the simultaneous sale of the income and remainder interest in this fashion is consistent with the appreciation-over-time criterion. a's and b's gain, an aggregate of $100,000, would be exactly equal to the $100,000 increase in the value of the trust's asset after the testator's death. their gain, in other words, would be entirely attributable to appreciation accruing during their period of ownership as beneficiaries. while, as the lattera court indicates, there may be cases in which extenuating circumstances call for the substitution doctrine to apply where the gain accrues during the taxpayer's ownership, no such circumstances are present in this example."' thus, a (as well as b) should receive capital gain treatment on the sale. in short, the lattera court's difficulty with the outcome in mcallister is directly related to its failure to include the appreciation-over-time criterion in its framework. taxpayers who participate in the premium financing arrangement and transfer the policy to the investor at the time the note matures cannot maintain that their benefit represents appreciation in an asset accruing over time. under a proper application of the substitution doctrine, therefore, ordinary gain should result at the time of transfer. as a matter of substance, such a taxpayer receives in effect free life insurance during the term of the note as compensation for agreeing to acquire the policy; the note being nonrecourse, the taxpayer is under no obligation to repay 221. in comm'r v. p.g. lake, 356 u.s. 260 (1958), see id. at 262, 265, in contrast, where the taxpayer sold a carved-out right and retained the balance of its interest in the investment, the taxpayer could not have established that the entire profit was attributable to appreciation that had accrued during the taxpayer's ownership. while some portion of the profit might have been the result of appreciation in the underlying asset, the taxpayer could not have established that the entire profit was so attributable. 222. the outcome in the trust examples would be different if a and b did not sell their interests simultaneously. in the case of a nonsimultaneous sale, the income beneficiary is not permitted to offset any basis against the amount realized on the sale. see irc § 1001(e). thus, a would be required to recognize as capital gain the entire amount realized on the sale if b did not simultaneously sell the remainder interest. this denial of a basis offset to a is entirely unrelated to the substitution doctrine and its concern about taxpayers converting what is essentially ordinary income to capital gain. rather, it stems from a concern about trust beneficiaries manipulating the basis provisions to manufacture an overstated basis. prior to 1969, it was possible for a trust beneficiary to sell the income interest and claim a basis offset based on the actuarial percentage of the interest at the time of sale and the date-of-death value of the trust's assets. see regs. § 1.1001-5(a). the problem arose if the remainderman subsequently sold the remainder interest. if, for example, the sale were made at approximately the time the income interest terminated, the remainderman could claim as a basis the entire date-of-death value of the trust's assets. see id. this would, of course, permit an income beneficiary and remainderman to enjoy, in the aggregate, a basis offset in excess of 100% of the asset's date-of-death value. to prevent taxpayers from exploiting the basis rules in this fashion, congress added code § 1001(e) in the tax reform act of 1969. tax reform act of 1969, see pub l. no. 91-172, § 516(a) 83 stat. 487, 649 (1969). see also marvin a. chirelstein, federal income taxation, 387-89, at 17.03 (10th ed. 2005) (explaining this rationale for the 1969 amendment). [vol. 7:9 a new model for identifying basis in life insurance the note or to otherwise pay for the insurance provided. from the investor's perspective, at the maturity of the note, the policy is a valuable investment, which could not have been acquired without compensating the taxpayer for agreeing to participate. in somewhat analogous contexts, the courts have held that compensation of this kind constitutes ordinary income.223 the compensatory character of the arrangement cannot be altered by "dressing up" the transaction to look like the sale of an asset.224 the taxpayer's amount realized on the transfer of the policy to the investor would be equal to the 223. see sutter v. comm'r, 76 t.c. memo (cch) 59, t.c. memo (ria) 98,250 (1998); haderlie v. comm'r, 74 t.c. memo (cch) 1254, t.c. memo (ria) 97,525 (1997). in sutter and haderlie, as part of a prearrangement, the taxpayers borrowed money on a nonrecourse basis from an entity controlled by an insurance agent. sutter, 76 t.c. memo (cch) at 59-60, t.c. memo (ria) at 98-1449 to 98-1450; haderlie, 74 t. c. memo (cch)at 1255, t.c. memo (ria)at 97-3500 to 97-3501. the borrowed moneys were then used by the taxpayer to pay premiums on policies sold by the insurance agent. sutter, 76 t.c. memo (cch) at 60, t.c. memo (ria) at 98-1499; haderlie, 74 t.c. memo (cch) at 1255, t.c. memo (ria) at 97-3501. finding the nonrecourse note was illusory, both the sutter and haderlie courts held that the entire amount of the premium advanced to the taxpayer/insured represented compensation for agreeing to acquire the policy (in haderlie, the court held that the entire premium constituted gross income, whereas in sutter the taxpayer conceded that haderlie was correct as to this point). sutter, 76 t.c. memo (cch) at 61-62, t.c. memo (ria) at 981451 to 98-1453; haderlie, 74 t.c. memo (cch) at 1255-57, t.c. memo (ria) at 973501 to 97-3503. it should be emphasized that, in these cases, the parties did not treat the nonrecourse note as if it had legal significance, thus permitting each court to find that it was illusory. in sutter, the court relied on its decision in comm 'r v. wentz, 105 t.c. 1 (1995), where it had held that the entire premium (not simply the cost of comparable term insurance) rebated to the insured must be included in the participating taxpayer's gross income. sutter, 76 t.c. memo (cch) at 61, t.c. memo (ria) at 981451 to 98-1452; wentz, 105 t.c. at 11-12. for a discussion of the contexts in which nonrecourse notes may be disregarded, see, generally, mitchell m. gans, re-examining the sham doctrine: when should an overpayment be reflected in basis?, 30 buff. l. rev. 95 (1981). 224. in some cases, the investor may loan an amount to the taxpayer that is greater than the premiums due during the term of the arrangement. in effect, the taxpayer receives this cash-in-the-pocket inducement, which will not have to be repaid if the policy is transferred to the investor in discharge of the nonrecourse note, in order to equalize the values. in other words, in the judgment of the parties, the life insurance policy is expected to have a value at the maturity of the note that is greater than the amount necessary to pay the premiums during the arrangement thus requiring the investor to provide an additional inducement. the presence of such an additional inducement would not alter the tax consequences. the amount of the taxpayer's ordinary income would now include the amount of the inducement, as well as the amount of the premiums supplied by the investor. both the free-insurance and the cashin-the-pocket inducements represent, in substance, compensation to the taxpayer for agreeing to acquire the policy and should be treated as such. see irc § 61. 2006] florida tax review amount of the note, 5 which would in turn equal the value of the free insurance received by the taxpayer.226 the critical point is that, if at maturity, the taxpayer transfers the policy to the investor, no part of the gain represents appreciation accruing to the taxpayer over time. rather, it represents the value of the free life insurance provided by the investor in order to induce the taxpayer to participate in the transaction. put differently, with the right to the free insurance conferred at the outset, the taxpayer's benefit cannot be attributed to ownership of an appreciating asset. thus, under a proper application of the substitution doctrine, the gain should be ordinary in character. if, on the other hand, the taxpayer decided to retain the policy perhaps because of a decline in health and a concomitant increase in the policy's value there would be no taxable event unless the taxpayer subsequently sold the policy or surrendered it to the insurance company.227 in the event of such a sale or surrender, the gain should be bifurcated; under the substitution doctrine, the portion equal to the amount of free insurance should be ordinary gain, and the balance, attributable to the appreciation in the policy's value, should be capital gain.228 vii. conclusion historically, taxpayers who chose to dispose of their life insurance policies during their lives would surrender them to the issuing company. however, there is now a marketplace in which investors are willing to buy policies that a taxpayer no longer needs or wishes to retain. in addition, a new premium financing method is emerging, which grants taxpayers an option to sell their policies within the first few years after acquiring them. the sale of policies has thus become increasingly prevalent. as a result of this shift, the tax community has begun to focus on the computation of gain, raising questions about the determination of basis. 225. see regs. § 1.1001-2. 226. the amount realized would also include the amount of any accrued interest. see, e.g., catalano, 79 t.c. memo (cch) 1632, t. c. memo (ria) 2000-082 (2000), overruled on other grounds by catalano v. comm 'r, 279 f.3d (9th cir. 2002) (holding that the amount realized on the surrender of an asset in discharge of a nonrecourse note includes accrued interest). the taxpayer would be deemed to pay the interest at the time of the discharge, see id., but no deduction would be available for the deemed payment. see irc § 264. 227. if retained until death, the proceeds would not be taxable. see irc § 101. 228. for a similar bifurcation ofgain in an analogous context, see, e.g., bolnick v. comm'r, 44 t.c. 245, 253-57 (1965), acq., 1980-2 c.b. 1 (applying the supreme court's decision in midland-ross and concluding that, on redemption of a bond, the portion of the proceeds attributable to earned original interest was ordinary income under the substitution doctrine and that any additional gain on the redemption constituted capital gain); see also rev. rul. 80-143, 1980-1 c.b. 19 (embracing the reasoning found in bolnick). with respect to capital gain treatment of the surrender of a policy, see supra note 177. [vol. 7:9 a new model for identifying basis in life insurance while the code mandates the use of the aggregate premium approach in determining gain on a policy surrender, it is silent about the appropriate methodology for determining basis in the case of a sale. in its published guidance on the consequences of a sale, the irs has applied an aggregate premium approach. but, in private letter rulings, the irs has instead applied a policy investment approach, under which a policy's basis is reduced by the cost-of-insurance protection. we argue in favor of the policy investment theory and sketch out a new model (i.e., the hypothetical term method) for its implementation. we call for legislation that would incorporate this theory, making it uniformly applicable to insurance policy surrenders as well as to their sales. short of such legislation, we suggest a second-best strategy for the irs: revocation of its published guidance and promulgation of a new regulation. recognizing that our model deviates from the irs's long-standing commitment to a contrary approach, we consider whether the courts would uphold such a regulation. after examining the supreme court's deference jurisprudence and critiquing the tax court's recent invalidation of a regulation, we conclude that the regulation we propose should withstand taxpayer challenge. 2006] florida tax review volume 19 2016 number 5 article can we clean this up? a brief journey through the united states rules for taxing business entities willard b. taylor florida tax review volume 19 2016 number 5 the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. the subscription rate, payable in advance, is $125.00 in the united states and $145.00 elsewhere for the current volume. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352) 273-0658 or email ftr@law.ufl.edu. copyright c 2016 by the university of florida florida tax review volume 19 2016 number 5 editor-in-chief charlene luke professor oflaw university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar dennis a. calfee professor oflaw patricia e. dilley professor emeritus michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law adam smith visiting assistant professor lee-ford tritt professor of law samuel c. ullman adjunct professor oflaw steven j. willis professor oflaw martin j. mcmahon, jr. james j freeland eminent scholar board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university emily snider carvalho brandon c. gardner devon goldberg leandra lederman indiana university bloomington omri marion university of california, irvine gregg d. polsky university of georgia graduate editors jessica e. griffin william carroll mcdonald james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university ofpennsylvania philip nodhturft, iii benjamin m. parnell katheleen duggn pfahlert florida tax review volume 19 2016 number 5 information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: "articles," "commentaries," and "book reviews." the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word sent via expresso (law.bepress.com/expresso). articles may be emailed to ftr@law.ufl.edu. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow the bluebook: a uniform system of citation (20th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manual. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the florida tax review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the florida tax review. florida tax review volume 19 2016 number 5 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 3 1996 number 2 muffled chevron: judicial review of tax regulations ellen p. aprill" i. introduction ................................. 52 11. framework for analysis ......................... 55 a. interpretive and legislative regulations ........... 55 b. pre-chevron doctrines of judicial deference ....... 57 c. options for judicial review ........ m. the chevron doctrine .............. a. development of the doctrine ....... b. tax court's introduction to chevron .. c. range of possible responses ....... d. impact of chevron ............... iv. implications for interpretation ...... a. the role of legislative histor ...... b. burden on judicial resources ....... v. conclusion ........................ .......... 61 62 62 67 73 75 81 81 87 * professor of law, loyola law school. the author served from 1987-89 in the office of tax legislative counsel in the department of the treasury, from 1981-82 as a clerk for the hon. byron r. white, associate justice, united states supreme court. and from 198081 as a clerk to the hon. john d. butzner, united states court of appeals for the fourth circuit. the author thanks mike asimow, katie pratt, reed shuldiner, and the southern california tax policy discussion group for comments on earlier versions of this paper. robert oliver and susie emerson provided valuable research assistance. florida tax review i. introduction taxpayers and their lawyers frequently express displeasure with tax regulations. some go further and litigate the regulations' validity. the result of such challenges often depends on the degree of deference that reviewing courts give to the regulations. the degree of judicial deference to administrative decision-making in turn raises questions about the division of labor between courts and agencies. it "implicates constitutional concerns about the role of the courts in a government of separated powers," perhaps most importantly, about the ability of courts to serve "as a balance for the peoples' protection against abuse of power by other branches of government."' in recent years, courts facing questions of judicial deference to agency decisions have had to struggle with chevron u.s.a., inc. v. national resources defense council,2 a 1984 supreme court decision that has been described as creating a "revolution in administrative law" by giving controlling effect to administrative decisions.3 this article examines the extent to which chevron has influenced judicial review of tax regulations.4 it concludes that, if chevron has had any effect in this context, it may have been to decrease marginally, rather than increase, deference to treasury regulations. the article also argues that judicial review of tax regulations provides a model for a revised chevron. 1. alfred c. aman, jr. & william t. mayton, administrative law 341 (1993), in part quoting united public workers v. mitchell, 330 u.s. 75, 564-65 (1947). 2. 467 u.s. 837 (1984). 3. kenneth w. starr, judicial review in the post-chevron era, 3 yale j. on reg. 283, 307 (1986). thousands of cases have cited chevron. see paul l. caron, tax myopia, or mamas don't let your babies grow up to be tax lawyers, 13 va. tax rev. 517, 556 (1994) (locating over 2,100 case citations to chevron as of june 29, 1993). i found over 3,400 case citations as of april 14, 1996. this article explores in further detail the intersection of many of the issues raised by prof. caron, including the impact of chevron, the use of legislative history, and the choice of forum. 4. this study resembles in methodology several articles that have examined the supreme court's deference to administrative agencies. see thomas w. merrill, judicial deference to executive precedent, 101 yale l.j. 969 (1992) [hereinafter merrill, judicial deference]; thomas w. merrill, textualism and the future of the chevron doctrine, 72 wash. u. l.q. 351 (1994) [hereinafter merrill, textualism]; patricia m. wald, the sizzling sleeper: the use of legislative history in construing statutes in the 1988-89 term of the united states, 39 am. u. l. rev. 227 (1990). although this study examines decisions of several courts, it is limited to tax and regulations and thus is far narrower than the empirical study of courts of appeals decisions undertaken by professors schuck and elliott. see peter h. schuck & donald e. elliott, to the chevron station: an empirical study of federal administrative law, 1990 duke l.j. 984 (1990). professors schuck and elliott, however, excluded from their study any cases that had come "through specialized tribunals such as the u.s. tax court." id. at 990 n. 15. see also linda r. cohen & matthew l. spitzer, solving the chevron puzzle, 57 law & contemp. probs. 65 (1994). [vol 3:2 muffled chevron: judicial review of tax regulations in some ways, tax regulations are unusual. the regulations interpret a particularly complex, interrelated statutory scheme, which congress frequently revisits and amends. 5 voluminous legislative history accompanies most tax legislation.6 the treasury and irs take the position that almost all tax regulations are interpretive, not legislative,7 but in promulgating these regulations, they routinely follow the notice and comment procedures that the administrative procedure act requires only for legislative regulations.8 the tax court, which is a specialized, article i court, hears most challenges to the regulations. 9 despite these atypical features, tax regulations represent a useful arena for examining the effects of chevron on the approaches of various federal courts to agency interpretation. tax regulations are frequently challenged, but the number of cases is not so large as to prevent consideration of all of them.' the treasury and irs take action in many ways other than promulgating regulations, and questions of chevron deference thus arise in areas other than regulations." as the most carefully considered and reviewed of actions within the treasury and irs,' 2 regulations present the strongest case for deference. furthermore, tax regulations pertain to questions of law, where courts have particular expertise, but involve a technical area, where deference to the administrator has long been counseled." they thus 5. see c. eugene steuerle, the tax decade: how taxes came to dominate the public agenda (1992); richard l. doemberg & fred s. mcchesney. on the accelerating rate and decreasing durability of tax reform, 71 minn. l. rev. 913 (1987). 6. see bradford l. ferguson et al., reexamining the nature and role of tax legislative history in light of the changing realities of the process, 67 taxes 804 (1989); michael livingston, congress, the courts, and the code: legislative history and the interpretation of tax statutes, 69 tex. l. rev. 819 (1991). 7. see infra note 29 and accompanying text. 8. see infra note 30 and accompanying text. 9. see infra part ii.c. 10. this study involved approximately 400 cases. 11. see john coverdale, one size does not fit all: court review of treasury regulations and revenue rulings in the chevron era, 64 geo. wash. l rev. (1996); linda galler, emerging standards for judicial review of irs revenue rulings, 72 b.u. l rev. 841 (1992) [hereinafter galler, emerging standards]; linda galler, judicial deference to revenue rulings: reconciling divergent standards, 56 ohio st. lj. 1037 (1995) [hereinafter galler, judicial deference]. 12. see michael i. saltzman, irs practice and procedure 1 3.02 (2d ed. 1991 & supp. 1993); mitchell rogovin, the four r's: regulations. rulings. reliance and retroactivity, 43 taxes 756 (1965); paul f. schmid, the tax regulations making process-then and now, 24 tax law. 541 (1971). moreover, the tax court, which hears the vast majority of tax cases, has relied on chevron only in the context of regulations. see infra part i1.d. 13. see, e.g., dobson v. commissioner, 320 u.s. 489 (1943). the tax law is complicated, but so are many other areas. chevron itself arose in such an area, environmental law. in many important ways, tax is like other areas of law interpreted and administered by 19961 florida tax review pose neatly conflicting concerns raised by chevron. in particular, decisions regarding tax regulations test the persuasiveness of justice scalia's jurisprudence of interpretation. at the same time that justice scalia positions himself as a key proponent of chevron, he has reinterpreted chevron to argue that the text of the statute frequently provides the interpretive answer and that examination of legislative history should cease. in taxation, as in other areas of the law, justice scalia's views have had influence. many tax opinions, especially recent ones, interpret the language of the code without consideration of legislative history. at the same time, although courts reviewing tax regulations generally consider the statutory text as the first step of analysis, they do not usually find the interpretive answer to be obvious from the language of the statute. as the second step in analysis, these courts undertake a thorough and detailed examination of legislative history. the more specialized the court, the more detailed and lengthy is the examination. thus, this review of tax regulations also offers a useful gloss on theories that both chevron deference and resort to plain meaning labor-saving devices for generalist courts.'4 this article examines trial court and appellate decisions since 1984 that have upheld or struck down tax regulations. although all the cases are post-chevron, chevron has been cited in tax cases only since 19895 and by the tax court only since 1992.16 this period thus offers both preand postchevron approaches to testing the validity of regulatory action. what emerges from this study of challenges to tax regulations is that in the area of taxation, agencies. consider, for example, how well professor pierce's generic description of agencyadministered statutes applies to tax: a typical agency-administered statute consists of over one hundred pages of text, and many extend for several hundred pages. all such statutes are plagued with ambiguities, omission, and internal inconsistencies. an agency's primary task is to construct a workable national ... program that is consistent with the statute that authorizes its creation. many of the hundreds of provisions in an agency-administered statute, including almost all of the provisions that are the subject of litigation, relate to other provisions in complicated ways. richard j. pierce, jr., the supreme court's new hypertextualism: an invitation to cacophony and incoherence in the administrative state, 95 colum. l. rev. 749, 764 (1995). see caron, supra note 3, at 531 ("isolation of tax lawyers from their nontax counterparts has fed the ... myth that tax law is fundamentally different from other areas of law"). of course, there are differences as well. other programs seek directly to regulate or grant benefits. tax law seeks to raise revenue; it regulates only indirectly by imposing taxes with disparate impacts and grants benefits indirectly by offering tax preferences. 14. see infra part iv. 15. see american medical ass'n v. united states, 887 f.2d 760, 770 (7th cir. 1989); knapp v. commissioner, 867 f.2d 749, 752 (2d cir. 1989). 16. georgia fed. bank v. commissioner, 98 t.c. 105, 107-10 (1992). [vol 3:2 muffled chevron: judicial review of tax regulations as in other areas of the law, chevron has not worked the revolution in the balance of powers between agencies and the courts that some commentators feared. it has not displaced judges from a key role in the review of agency regulations. 7 instead, as in other areas of the law, chevron may have decreased deference to administrative action by encouraging courts themselves to decree the meaning of a statute. decisions reviewing tax regulations, however, offer a significant and promising variation on current chevron doctrine. these decisions examine legislative history not to divine congressional intent, but to gauge the reasonableness of administrative interpretation. this approach accommodates a variety of concerns and each of the branches of government: it respects the significance of the text enacted by congress, the position of the executive branch as represented by the agency, and the importance of judicial review to protect against abuses of power. that is, the approach in tax cases offers an alternative model for judicial review of agency interpretations, one that helps courts to preserve a role for legislative history and resist the siren call of resort to plain meaning. part 11 describes the distinction between legislative and interpretive regulations, doctrines of judicial deference, and the various courts that hear tax challenges. part i sketches the development of the chevron doctrine in tax cases and how it has influenced the traditional tests for the validity of tax regulations. part iv compares plain meaning and the use of legislative history as tools of statutory construction. this study concludes by urging courts reviewing regulations, in both tax and nontax cases, to adopt a muffled chevron doctrine that begins but does not end with consideration of plain meaning. h1. framework for analysis a. interpretive and legislative regulations administrative law distinguishes between legislative and interpretive rules.' in general, a legislative rule has the legal effect of a statute. it binds the agency promulgating it, the courts, and private parties. "it creates legally 17. see merrill, judicial deference, supra note 4; merrill. textualism. supra note 4. 18. for purposes of this article, the terms "rule" and "regulation" are synonymous. in other contexts, interpretive rules need not be regulations. see robert a. anthony, interpretive rules, policy statements, guidances, manuals, and the like-should federal agencies use them to bind the public? 41 duke l.j. 1311 (1992); galler, emerging standards, supra note 11; galler, judicial deference, supra note 11, kevin w. saunders, interpretative rules with legislative effect: an analysis and a proposal for public participation. 1986 duke l.j. 346. 19961 florida tax review enforceable duties that did not exist before the rule was promulgated."' 9 thus, asking whether a regulation creates new law or has a self-executing legal effect is one way of determining whether a rule is legislative. 2' a legislative rule, however, is valid as such only if the agency adopting it not only has congressional authority to do so, but also follows the notice and comment procedures required by the administrative procedure act in adopting the regulation.2' interpretive rules, in contrast, do not as a legal matter bind private parties or reviewing courts.22 they do not create new duties, but clarify existing ones, and can be promulgated without following the notice and comment rulemaking procedures.23 however well or badly the "legal effect" standard may work in other areas of law to distinguish legislative from interpretive regulations, 24 tax decisions have not adopted it.' instead, in tax cases, the courts have distinguished between legislative and interpretive regulations according to the source of authority for promulgating the regulation. 26 regulations promulgated under the general authority of section 7805(a) are considered interpretive,27 and regulations promulgated pursuant to a grant of authority under a 19. richard j. pierce, jr. et al., administrative law and process 284-85 (2d ed. 1992). see also saunders, supra note 18. 20. see michael asimow, public participation in the adoption of temporary tax regulations, 44 tax law. 343, 353-54 (1991) [hereinafter asimow, public participation]. determination of whether regulations are interpretive or legislative has been one of the most frequently litigated administrative law issues of the last two decades. id. see also anthony, supra note 18; michael asimow, nonlegislative rulemaking and regulatory reform, 1985 duke l.j. 381 [hereinafter asimow, regulatory reform]; michael asimow, public participation in the adoption of interpretive rules and policy statements, 75 mich. l. rev. 520 (1977) [hereinafter asimow, interpretive rules]; charles h. koch, jr., public procedures for the promulgation of interpretive rules and general statements of policy, 64 geo. l.j. 1047 (1976); saunders, supra note 18. 21. 5 u.s.c. § 553(b) (1994); robert a. anthony, "interpretive" rules, "legislative" rules and "spurious" rules: lifting the smog, 8 admin. l.j. 1, 2 & n.5 (1994); saunders, supra note 18, at 346-47. 22. interpretive rules often bind parties as a practical matter. see anthony, supra note 18; anthony, supra note 21; saunders, supra note 18. 23. see asimow, public participation, supra note 20, at 344 & n.8. see also anthony, supra note 21, at 1-2 & nn.2-3; asimow, regulatory reform, supra note 20, at 381 & n.5; saunders, supra note 18, at 346 & n.5. 24. see asimow, public participation, supra note 20, at 355 n.61; asimow, regulatory reform, supra note 20, at 394. 25. see united states v. vogel fertilizer co., 455 u.s. 16 (1982); rowan cos. v. united states, 452 u.s. 247 (1981). 26. see asimow, public participation, supra note 20, at 358 (calling this distinction a concept "now generally discarded in administrative law"). 27. section 7805(a) authorizes "the secretary [to] prescribe all needful rules and regulations for the enforcement of this title." some cases have suggested that regulations [vol 3:2 muffled chevron: judicial review of tar regulations particular code section are considered legislative.2 the irs takes the position that tax regulations are almost always interpretive and only rarely legislative.29 at the same time that it asserts its regulations are interpretive, however, the irs generally follows the kind of procedures that the administrative procedure act requires only for legislative regulations: notice to taxpayers and the opportunity to comment.' in this regard, tax regulations are unusual; the administrative agency does not claim for them the legal effect of legislative regulations, but it follows the procedures required for legislative regulations. b. pre-chevron doctrines of judicial deference traditionally, courts gave greater deference to administrative agencies construing statutes through legislative rules than through interpretive rules. under the strong deference due legislative regulations," courts tended to uphold legislative rules unless they were "arbitrary, capricious, or manifestly contrary to the statute. '32 in contrast, judicial review of interpretive rules tended to exhibit a weak deference; courts explained that they were free, if they wished, to substitute their own judgment regarding legal issues raised by interpretive rules.33 adopted pursuant to general regulatory authority are not different from those adopted pursuant to specific authority. see fcc v. wncn listeners guild. 450 u.s. 582. 594 (1981). under this approach, regulations adopted pursuant to § 7805(a) are legislative. see asimow, public participation, supra note 20, at 354 & n.56. the irs, however, does not take this position. 28. for example, § 469(1) specifies that the secretary "shall prescribe such regulations as may be necessary or appropriate to carry out provisions of this section." see also irc §§ 337(d), 1504(a)(5). 29. see internal revenue manual §§ 211.212,531.1; asimow, public participation. supra note 20, at 356; asimow, regulatory reform, supra note 20. at 390. some notices of proposed rulemaking cite both § 7805(a) and a specific grant of authority. 30. see 5 u.s.c. § 553(b) (1994) (administrative procedure act); regs. § 601.601. 31. i borrow the terms "strong deference" and "weak deference" from michael asimow, the scope of judicial review of decision of california administrative agencies, 42 ucla l. rev. 1157, 1194 (1995). 32. 1 kenneth c. davis & richard j. pierce, jr., administrative law treatise § 3.2, at 111 (3d ed. 1994); see batterton v. francis, 432 u.s. 416 (1977): kevin w. saunders. agency interpretations and judicial review: a search for limitations on the controlling effect given agency statutory constructions, 30 ariz. l. rev. 769, 770 (1988) (citing 5 u.s.c. § 706(2)(1982)). strong deference to administrative agencies is generally known as hearst review, after nlrb v. hearst publications, inc., 322 u.s. 111 (1944). see pierce, et al., supra note 19, at 348-49 (explaining hearst review). 33. weak deference is sometimes referred to as packard deference, after packard motor car co. v. nlrb, 330 u.s. 485 (1947), or skidmore deference, after skidmore v. swift & co., 323 u.s. 134 (1944). in skidmore, the supreme court wrote that interpretive rules, "while not controlling upon the courts by reason of their authority. do constitute a body of 19961 florida tax review in practice, however, "[t]he approach was instead pragmatic and contextual," and "deference could range over a spectrum from 'great' to 'some' to 'little.' "" in determining the degree of deference to give to an administrative position, courts relied on a variety of factors, including the language of the statute, the legislative history, whether the interpretation was adopted contemporaneously with the statute, how consistently the agency maintained the position, how carefully agency policymakers had considered the interpretation, the extent to which congress delegated authority to the agency, and the need for expertise in writing the rule. 5 nonetheless, "[tihe default rule was one of independent judicial judgment. deference to the agency interpretation was appropriate only if a court could identify some factor or factors that would supply an affirmative justification for giving special weight to the agency views. 36 two factors argued for courts giving special weight to interpretive tax regulations: the expertise needed to understand the complexity of the tax code and the authority given the treasury under section 7805(a) to prescribe all needful rules. thus, it has long been the rule that interpretive tax regulations are to be upheld if they are reasonable.37 in national muffler dealers ass'n v. united states,38 the supreme court explained that the court would uphold an interpretive tax regulation so long as it implemented the congressional mandate in some reasonable manner. to determine reasonableness, the opinion continues, a court should "see whether the regulation harmonizes with the plain language of the statute, its origins, and its purpose."39 the opinion lists many of the standard factors as relevant considerations, including "the length of time the regulation has been in effect, the reliance placed on it, the consistency of the commissioner's interpretation, and the experience and informed judgment." id. at 140. see saunders, supra note 32, at 770, 771 & n.14. the different degrees of deference turn in part on the assumption that for interpretive rules, careful judicial review substitutes for public comment. see galler, emerging standards, supra note 11, at 863 & n.123, 864. 34. merrill, judicial deference, supra note 4, at 972. see coverdall, supra note 11. 35. for further discussion of the multiple factors, see colin s. diver, statutory interpretation in the administrative state, 133 u. pa. l. rev. 549, 562 & n.95 (1985); merrill, judicial deference, supra note 4, at 972-75; david r. woodward & ronald m. levin, in defense of deference: judicial review of agency action, 31 admin. l. rev. 329, 332-41 (1979). 36. merrill, judicial deference, supra note 4, at 972. 37. the supreme court stated recently: "because congress has delegated to the commissioner the power to promulgate 'all needful rules and regulations for the enforcement [of the internal revenue code], 26 u.s.c. § 7805(a),' we must defer to his regulatory interpretations of the code so long as they are reasonable." cottage say. ass'n v. commissioner, 499 u.s. 554, 560-61 (1991) (citation omitted). the issue in cottage savings involved the application of a regulation, not a challenge to its validity. 38. 440 u.s. 472 (1979). 39. id. at 477. [vol 3:2 muffled chevron: judicial review of tar regulations degree of scrutiny congress had devoted to the regulation during subsequent re-enactments of the statute."' in national muffler, the supreme court, in upholding a regulation that defined a business league eligible for exemption under section 501(c)(6), looked principally to the history of the applicable statute and the regulation at issue. it concluded: "in short, while the commissioner's reading of section 501(c)(6) perhaps is not the only possible one, it does bear a fair relationship to the language of the statute, it reflects the views of those who sought its enactment, and it matches the purpose they articulated.... the commissioner's view therefore merits serious deference. ' thus, in tax, deference to the administrative agency rather than independent judicial judgment has been the default rule. when reviewing an interpretive tax regulation, national muffler instructed, courts should consider the standard factors, but should not undertake such consideration in order to justify deference. instead, courts were to presume deference and test the presumption by examining at least some of the standard factors. nonetheless, while interpretive tax regulations have received more deference than other interpretive rules, courts have continued to give legislative tax regulations more deference than interpretive ones. 2 as the supreme court wrote in roivwan cos. i. united states of an interpretive regulation promulgated under the general authority of section 7805(a), "[blecause we... can measure the commissioner's interpretation against a specific provision in the code, we owe the interpretation less deference than a regulation issued under a specific grant of authority to define a statutory term or prescribe a method of executing a statutory provision.' ' 3 that is, legislative tax regulations, like other legislative regulations, were to be given strong deference as compared to the serious deference given to interpretive tax regulations. table i varieties of judicial deference to administrative interpretation weak serious strong deference deference deference interpretative regulations other than tax interpretative tax regulations legislative regulations (tax and non-tax) 40. id. 41. id. at 484. 42. see asimow, public participation, supra note 20. at 357. 43. 452 u.s. 247, 253 (1981). 19961 florida tax review the difference between the strong deference due legislative tax regulations and the serious deference owed to interpretive tax regulations is small; "the distinction between legislative and interpretative regulations is often blurred in practice, and the supposedly diverse standards of judicial review tend to converge and even to coalesce."' accordingly, both cases involving legislative regulations and those considering interpretive regulations cite national muffler.45 like any multiple factor test, the national muffler standard is malleable, and the results of its application are uncertain.46 some cases conclude that inconsistency with any one of its three factors merits invalidation of the regulation; others find consistency with any one sufficient grounds to uphold the validation. yet other cases weigh and balance the various factors. sometimes deference figures prominently, sometimes hardly at all. the opinions of the trial and appellate courts in one recent case expose the flexibility and uncertainty of the national muffler test. in nalle v. commissioner,47 taxpayers challenged a regulation that denied rehabilitation tax credits to buildings that had been relocated. both the tax court and the court of appeals for the fifth circuit invoked national muffler.8 based on the legislative history of the statute, the tax court "conclude[d] that the regulation harmonizes with congressional intent" because "[f]rom its inception, the tax credit for rehabilitation expenditures was intended to provide an economic stimulus for those areas susceptible to economic decline and abandonment. '49 the fifth circuit rejected the tax court's reliance on what it called "selected passages from the credit's legislative history"5 and invalidated the regulation on the basis of what it saw as the plain meaning of an unambiguous statute in which "congress crafted a detailed and reasonably precise means for determining eligibility for the tax credit."'" 44. 4 boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts 110.4.2, at 110-38 (2d ed. 1992) (footnotes omitted). 45. see, e.g., griffin indus., inc. v. united states, 27 fed. cl. 183, 196 (cl. ct. 1992), aff'd, ii f.3d 1072 (fed. cir. 1993); pepcol mfg. co. v. commissioner, 13 f.2d 355, 357 (10th cir. 1993), amended, 28 f.3d 1013 (10th cir. 1994). 46. see generally sidney a. shapiro & richard e. levy, judicial incentives and indeterminacy in substantive review of administrative decisions, 44 duke l.j. 1051 (1995) (describing the post-chevron confusion among courts regarding judicial review of administrative decisions). 47. 99 t.c. 187 (1992), rev'd, 997 f.2d 1134 (5th cir. 1993), aff'd, 55 f.3d 189 (5th cir. 1995). 48. see nalle, 99 t.c. at 191; nalle, 997 f.2d at 1136. 49. 99 t.c. at 195. 50. 997 f.2d at 1137. 51. id. at 1138. [val. 3:2 muffled chevron: judicial review of tar regulations in sum, despite the serious deference afforded interpretive tax regulations under national muffler, the various factors used to test that deference permit courts considerable leeway. in addition, the three different forums available to a taxpayer seeking judicial review complicate application of the standards for judicial review. c. options for judicial review a taxpayer denying the validity of a regulation may bring suit in any of three courts: the tax court, a federal district court, or the united states court of federal claims. 2 only suit in the tax court permits the taxpayer to litigate without first paying the tax." primarily for this reason, 95% of all substantive tax cases begin in the tax court.' the tax court is a national article i court; it has its headquarters in washington, dc, but its 19 judges travel throughout the country to hear cases." the tax court judges, who are appointed to 15-year terms, 6 have tax backgrounds and try only tax cases.57 the chief judge reviews all cases and selects certain cases for review by the full court, including any case in which an opinion proposes to invalidate a regulation. 8 a taxpayer also has the option of paying the tax and suing for a refund in the federal district court where the taxpayer resides or in the united states court of federal claims. 9 the court of federal claims was created as the claims court by the federal courts improvement act of 1982 as a successor to the court of claims and became the court of federal claims in 1992.' a national article i court, it hears claims against the government, and tax comprises approximately one-third of its work.6' district court judges are article i judges, and very few of them are tax experts.' only a small percentage of the docket of federal district courts consists of tax cases. 52. see irc § 6213; 28 u.s.c. § 1346 (1988). 53. see irc § 6213. 54. tax section, executive comm. of new york state bar ass'n, response to proposals for a national tax court of appeals, 46 tax notes 819, 821 (feb. 12. 1990). 55. see irc §§ 7441, 7443, 7445-7446; see also bittker & lokken, supra note 44. § 115.21, at 115-19. 56. irc § 7443(e). 57. tax section, executive comm. of new york state bar ass'n, supra note 54, at 821. some have government background, others come from private practice. 58. see lee a. sheppard, should there be a national court of tax appeals? 46 tax notes 762, 763 (feb. 12, 1990). 59. see irc § 7422; 28 u.s.c. §§ 1346(a)(1). 1402(a)(1) (1988). 60. pub. l. no. 102-572, § 902, 106 stat. 4516. see james w. moore. judicial code, moore's federal practice 7-1, 7-2 (1995). 61. sheppard, supra note 58, at 764. 62. william a. klein & joseph bankman, federal income taxation 47 10th ed. 1995). 1996] florida tax review despite the presence of two national trial courts, conflicts in the circuits do arise in tax cases. decisions of the united states court of federal claims are reviewable by the court of appeals for the federal circuit,63 which hears cases involving claims against the government, including but not limited to taxes, as well as customs and patent cases.64 decisions of both the tax court and the district courts are reviewable by the federal court of appeals in the circuit where the taxpayer resides.65 courts of appeals do not defer to the legal conclusions of the tax court, whose decisions are reviewable by a court of appeals in the same manner and to the same extent as decisions of the federal district courts in civil actions tried without a jury.'m since 1970, the tax court has "follow[ed] a court of appeals decision which is squarely in point where appeal ... lies to that court of appeals and to that court alone. 67 under this rule, the tax court sometimes issues inconsistent decisions. thus, at the trial court level, taxpayers have the choice of a specialized article i court, a semi-specialized article i court, or a generalist article iii court. most tax cases go to the specialized court, which has a specialized bar and its own procedures. that is, at the trial level, most tax cases are argued and decided by specialists in the field. while these specialists have expertise in the tax law, they may not be aware of developments in administrative law generally. all appeals of tax decisions go to an article iii court, although one of those appellate courts, the court of appeals for the federal circuit, has a somewhat specialized jurisdiction. i. the chevron doctrine a. development of the doctrine whatever the judicial forum, tax cases, like other cases reviewing administrative agencies, have distinguished between interpretive and legisla63. "a favorable precedent in the federal circuit enables all subsequent taxpayers, by routing their cases to the claims court, to prevent a conflict among the circuits." bittker & lokken, supra note 44, 115.7, at 115-60. 64. see 28 u.s.c. § 1295 (1988 & supp. 1994). some of the judges on the federal circuit have tax backgrounds. tax section, executive comm. of new york state bar ass'n, supra note 54, at 827. 65. irc § 7482(b). 66. irc § 7482(a)(1). 67. golsen v. commissioner, 54 t.c. 742, 757 (1970), aff'd, 445 f.2d 985 (10th cir. 1971), cert. denied, 404 u.s. 940 (1971). the tax court does not follow the golsen rule if it believes the appellate decision has been outmoded by intervening judicial development or is not squarely in point. see delta metalforming co. v. commissioner, 37 t.c. memo (cch) 1485, 1488-89, t.c. memo (p-h) j 78,354 (1978), aff'd, 632 f.2d 442 (5th cir. 1980), cert. denied, 455 u.s. 906 (1982); kent v. commissioner, 61 t.c. 133 (1973). ['vol. 3:2 muffled chevron: judicial review of tar regulations tive regulations and afforded less deference to the former. some commentators on chevron, however, have read that case as eviscerating this traditional distinction and substituting for it a distinction between clear and ambiguous statutes. the court in chevron upheld a legislative regulation of the environmental protection agency that permitted a plant-wide definition for stationary sources of air pollution, even though this definition changed the policy of the previous administration and made it far easier to satisfy environmental standards. 6s the court observed: first, always, is the question whether congress has directly spoken to the precise question at issue. if the intent of congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of congress. if, however, the court determines congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. rather if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute .... sometimes the legislative delegation [to interpret the statute] ... is implicit rather than explicit. in such a case, a court may not substitute its own construction of a statutory provision for a reasonable interpretation made by the administrator of an agency.' according to the chevron opinion, a court should use "traditional tools of statutory construction," particularly legislative history, to determine 68. as pierce et al., supra note 19, at 350. explain: the environmental protection agency (epa) originally interpreted ,source' in a way that subjected any significant addition or modification of a plant, such as addition of a boiler, the new source review process, as long as the addition or modification produced emissions of pollutants above a relatively low threshold. in 1981, epa changed its interpretation of 'source' to refer to an entire plant. under this much broader definition. a company was required to go through the new source review process only if the net effect of all additions or changes proposed at a plant would be an increase in emissions above the specified threshold. 69. chevron u.s.a., inc. v. natural resources defense council, 467 u.s. 837. 84244 (1984) (footnotes omitted). 19961 florida tax review congressional intent at step one7" and defer to an interpretation of the agency defended on any basis at step two. according to one commentator, chevron made "deference an all-or-nothing matter" by transforming "a regime that allowed courts to give agencies deference along a sliding scale into a regime with an on/off switch."'" chevron released a storm of comment, most of it critical. critics believed that a strong reading of chevron would eliminate the category of interpretive regulations, the category in which courts had traditionally had greater freedom to substitute their judgment for that of the administrative agency.72 they insisted that "the decision would make administrative actors the primary interpreters of federal statutes and relegate courts to the largely inert role of enforcing unambiguous statutory terms. 73 commentators feared that chevron required courts to give at least strong deference, if not controlling weight, to all administrative interpretations. critics expressed particular concern that chevron substantially eroded judicial authority to overturn agency decisions by requiring deference to administrative decisions when the delegation is implicit or the statute silent.74 chevron, commentators believed, undermined the administrative procedure act, which requires that courts "decide all relevant questions of law, interpret constitutional and statutory provisions, and determine the meaning or applicability of the terms of an agency action. early commentators assumed that for most administrative rulings, congressional intent was ambiguous and thus courts would display increased deference to administrative agencies.76 justice scalia, however, has both embraced chevron and reshaped its distinctions to comport with his textualist theory of interpretation.77 he has explained: 70. 467 u.s. at 843 n.9. 71. merrill, judicial deference, supra note 4, at 977. 72. some nontax cases have applied chevron in the context of interpretive rulings. see asimow, public participation, supra note 20, at 352 n.46. see notes 139-176 infra and accompanying text for discussion of chevron and interpretive tax regulations. 73. merrill, judicial deference, supra note 4, at 969-70. see cass sunstein, law and administration after chevron, 90 colum. l. rev. 2071, 2075 & n.26 (1990) ("chevron has altered the distribution of national powers among courts, congress, and administrative agencies"). 74. saunders, supra note 32, at 775-78. 75. id. at 783 (quoting 5 u.s.c. § 706). 76. see merrill, textualism, supra note 4, at 360. 77. see william n. eskridge, jr., the new textualism, 37 ucla l. rev. 621 (1990); michael herz, textualism and taboo: interpretation and deference for justice scalia, 12 cardozo l. rev. 1663 (1991); pierce, supra note 13; william d. popkin, an "internal" critique of justice scalia's theory of statutory interpretation, 76 minn. l. rev. 1133 (1992); nicholas s. zeppos, justice scalia's textualism: the "new" new legal process, 12 cardozo l. rev. 1597 (1991). [vol 3:2 muffled chevron: judicial review of tar regulations in my experience, there is a fairly close correlation between the degree to which a person is (for want of a better word) a "strict constructionist" of statutes, and the degree to which that person favors chevron and is willing to give it broad scope. the reason is obvious. one who finds more often (as i do) that the meaning of a statute is apparent from its text and from its relationship with other laws, thereby finds less often that the triggering requirement for chevron deference exists.78 justice scalia's attitude toward chevron reflects his hostility to the use of legislative history as a tool of statutory construction. he has attacked legislative history on a variety of grounds. the members of congress, he has explained, cannot have a single will or intent. 9 in his view, legislative history is not law because it is not subject to the article 1 requirements of bicameralism and presentment."0 he asserts that legislative history is not read by members of congress and is often written by staffers under the influence of lobbyists.8 1 to him, legislative history represents "legislators at their worst-promoting private interest deals, strategically posturing to mislead judges, or abdicating all responsibility to their unelected staffs."' for all these reasons, he advocates strict construction of statutes based on the language of the text. as professor merrill has recently demonstrated, the textualist revolution led by justice scalia has produced a change in the court's 78. hon. antonin scalia, judicial deference to administrative interpretations of law, 1989 duke lj. 511, 521. scalia continues: it is thus relatively rare that chevron will require me to accept an interpretation which, though reasonable, i would not personally adopt. contrariwise, one who abhors a "plain meaning" rule, and is willing to permit the apparent meaning of a statute to be impeached by the legislative history, will more frequently find agency-liberating ambiguity, and will discern a much broader range of "reasonable" interpretation that the agency may adopt and to which the courts must pay deference. the frequency with which chevron will require that judge to accept an interpretation he thinks wrong is infinitely greater. id. 79. see hirschey v. ferc, 777 f.2d 1.7-8 (d.c. cir. 1985) (scalia, j., concurring). 80. see wisconsin pub. intervener v. mortier, 501 u.s. 597, 615 (199 1) (scalia, j., concurring in the judgment); chisom v. roemer, 501 u.s. 380, 405 (1991) (scalia, j., dissenting); pennsylvania v. union gas co., 491 u.s. 1. 30 (1989) (scalia, . concurring in part and dissenting in part). 81. see blanchard v. bergeron, 489 u.s. 87, 98-99 (1989) (scalia, j., concurring in part and concurring in judgment). 82. daniel a. farber & philip p. frickey, legislative intent and public choice, 74 va. l. rev. 423, 437-38 (1988). 19961 florida tax review formulation of the chevron doctrine.83 in a recent opinion for the court, justice kennedy wrote: if the agency interpretation is not in conflict with the plain language of the statute, deference is due. in ascertaining whether the agency's interpretation is a permissible construction of the language, a court must look to the structure and language of the statute as a whole. if the text is ambiguous and so open to interpretation in some respects, a degree of deference is granted to the agency, though a reviewing court need not accept an interpretation which is unreasonable.84 under this reformulation, step one no longer obligates the court to discern legislative intent through the traditional tools of statutory construction. the first step looks only to the statutory text. neither do the traditional tools, such as legislative history, have any place in step two. in step two, under both the original and this reformulated chevron doctrine, the agency is free to adopt any reasonable interpretation and to defend the interpretation on any basis, including bases asserted only in the course of litigation or bases unrelated to legislative history. professor merrill concludes that chevron is languishing; the supreme court often ignores it.85 in contrast, textualism flourishes. in the 1992 term, for example, over 40 decisions construing statutes contain no reference to legislative history.86 merrill sees an inverse relationship between textualism and use of the chevron doctrine and observes that "the textualist interpreter does not find the meaning of the statute so much as construct the meaning. such a person will very likely experience some difficulty in deferring to the meaning that other institutions have developed."87 that is, under the reformulated chevron doctrine, courts presume a meaning plain to the judge writing the opinion. the reading of chevron as a textualist manifesto can be seen in some recent cases involving tax regulations. however, as discussed in more detail below, while most tax cases reviewing regulations discuss the statute's plain meaning, the analysis seldom ends at that point. tax court opinions do not 83. see merrill, textualism, supra note 4. 84. national r.r. passenger corp. v. boston & maine corp., 503 u.s. 407, 417-18 (1992) (citations omitted). 85. he notes that chevron, whether or not it is cited, has not made a dramatic difference in the frequency with which the supreme court has deferred to agency interpretations of statutes. merrill, textualism, supra note 4, at 359. 86. id. at 356. 87. id. at 372 (emphasis added). [vol 3:2 muffled chevron: judicial review of tar regulations presume that meaning is plain. in the second step of analysis, tax cases continue to rely on legislative history. that is, unlike either the traditional or reformulated chevron doctrine, tax cases use legislative history not at the first step to determine legislative intent, but at the second step of analysis, to judge whether the administrative position is reasonable. tax cases have continued to reflect the standard of serious deference as expounded in national muffler. they treat reasonableness of agency action as a likely but not foregone conclusion. b. tax court's itroduction to chevron although chevron is cited in two 1989 courts of appeals decisions reviewing tax regulations,88 it is first cited by the tax court in 1992 in one of a series of cases involving deductions for loan loss reserves by mutual financial institutions, such as savings banks and savings and loan institutions.89 these opinions, written by the tax court and three circuit courts, all turn on the degree of deference owed to an interpretive regulation. section 593(b) permits mutual financial institutions to take deductions for additions to loss reserves calculated as a specified percentage of taxable income.90 in addition, like other businesses, a mutual financial institution that suffers a net operating loss in a particular year can carry back the loss (nol carryback) to reduce income in prior years, subject to certain limits.9' the issue in these cases was the validity of regulations section 1.5936a(b)(5), an interpretive regulation requiring taxable income for purposes of section 593 to be reduced by any nol carrybacks before calculation of the addition to bad debt reserves. thus, under the regulation, use of a nol carryback requires recalculation and reduction of the loan loss reserve, 88. see cases cited supra note 15. 89. as professor merrill wrote in his first study of the supreme court's use of chevron: [a]dministrative lawyers in specialized areas like tax and labor law were late in coming to an awareness of chevron .... [elven in years when chevron is applied with some frequency, it tends to be invoked less often in areas where there is a particularly rich tradition of pre-chevron precedent on deference. for example, in title vii, labor, tax, social security. and environmental cases, the court (no doubt guided to a degree by the submissions of the parties) still tends to frame the deference standard in the terms expressed in earlier decisions specific to these areas, rather than in terms of chevron. merrill, judicial deference, supra note 4, at 983 & n.56. he lists cottage savings as one of those cases. 90. irc § 593(b)(2)(a). 91. irc § 172. 19961 florida tax review although earlier versions of the regulation specified that loan loss reserves were to be calculated without regard to net operating losses.92 the change in the regulation followed a statutory amendment. the tax reform act of 1969 amended section 593 to reduce the percentage of income permitted for bad debt deductions.93 in 1970, shortly after this amendment, the treasury proposed a regulation to require that loan loss reserves be calculated after application of net operating losses.94 the regulation was not adopted until 1978.95 mutual financial institutions in several circuits challenged the validity of the regulation after deficiencies were assessed against them. the tax court first considered the validity of the revised regulation in a lengthy 13-5 reviewed opinion, pacific first federal savings bank v. commissioner.96 the majority invalidated the regulation, using the national muffler test of harmony with plain language, origin, and purpose.9 7 the opinion, however, divided this test into two parts rather than discussing each of the three parts separately. it first examined briefly the plain language of the statute. the tax court rejected the commissioner's argument that the statute was unambiguous,98 but it also denied that its inquiry was limited to the statutory language. it saw its task as determining the "will of congress, rather than limiting the inquiry to the statutory language." 99 then, in a section of the opinion entitled "origin and purpose of the statute," the majority undertook a detailed, chronological examination of the legislative histories relating to statutes governing such financial institutions. it quoted at length from the 1951 senate report, the 1962 house report, the 1969 house report, and the 1969 senate report. the majority opinion saw the legislative changes as reflecting a desire to "ensure that mutual institutions pay taxes," counterbalanced by a goal of encouraging them to maintain 92. regs. § 1.593-6(b)(2)(iv) (1965); see rev. rul. 58-10, 1958-1 c.b. 246. 93. the allowable deduction was reduced from 60% to 40% over a ten-year period. tax reform act of 1969, pub. l. no. 91-172, §§ 431(b), 432(a), 83 stat. 488, 619-20. the 1969 act also made other modifications to the method of calculating income for purposes of section 593 and extended the nol carryback period from 3 to 10 years for mutual institutions and commercial banks. 94. 36 fed. reg. 15050 (1971). 95. t.d. 7549, 1978-1 c.b. 185, amended as to effective date by t.d. 7626, 1979-2 c.b. 239. 96. 94 t.c. 101 (1990), rev'd, 961 f.2d 800 (9th cir.), cert. denied, 506 u.s. 873 (1992). 97. pacific first fed., 94 t.c. at 106-07. 98. arguing for plain meaning, the commissioner relied on the language of § 593(b)(2)(a) limiting the deduction for additions to bad debt reserve to a percentage of taxable income and on the definition of taxable income in § 63 as gross income less deductions, including the nol deduction. id. at 107-08. 99. id. at 108 (citing united states v. vogel fertilizer co., 455 u.s. 16, 26 (1982)). i[vol 3:2 muffled chevron: judicial review of tar regulations adequate reserves to provide for unexpected losses.1y° the opinion also pointed to the absence of any statement in the legislative history regarding an intention to change the irs rule that nols were to be ignored in calculating loan loss reserves.'' it rejected the commissioner's argument that congress intended the specific modifications to taxable income listed in section 593 to be exclusive. the majority decided that the ordering rule found in the challenged regulation did not harmonize with congressional intent because it increased the effective rate of tax for mutual institutions beyond the extent intended by congress and because it reduced the value of nol carrybacks when congress had granted these institutions more generous nol carrybacks. 10 2 the dissent responded by pointing to the statutory framework, in particular the definition of taxable income, "the bedrock of our income tax system," as the appropriate basis for evaluating the regulation.0 3 the dissenting judges believed that the statutes were unambiguous on their face and did not redefine taxable income so as to ignore the impact of nol carrybacks. according to the dissent, the legislative history was more properly read as showing that "congress did not intend to permit both the largest possible reserve and 7 additional years within which to carry back subsequent losses .... here, in the face of unambiguous statutory provisions, the majority would redefine 'taxable income' based upon its own rationalized view of inexplicit congressional intent.""' while the dissent would have upheld the regulation, nothing in its opinion indicates that it would have done so on the basis of deferring to the agency. instead, the majority and the dissent both looked at the language of the statutory provisions, the legislative history, and their understanding of the purpose of the provisions in light of the code as a whole and the legislative history. both make reasonable arguments about what the regulation should be if it were being written de novo. both approach the task of whether to uphold the regulation as one of deciding whether it is the regulation the judges themselves would have adopted. neither suggests that it is up to the treasury to resolve ambiguities. the majority and dissenting opinions both expose how easily the multiple factors of national muffler can overwhelm the presumption of serious deference. the sixth circuit, the first court of appeals to review this issue, introduced the tax court to the chevron doctrine. in people's federal 100. id. at 110. 101. id. at 113. 102. id. at 112. 103. id. at 119 (gerber, j., dissenting). 104. id. at 120-21. 1996] florida tax review savings & loan ass'n v. commissioner,'0 5 it reversed the tax court and chided it for ignoring chevron. according to the sixth circuit, because the parties and the tax court agreed that congress had not addressed the precise issue, the chevron rule applied; the interpretive regulation issued under the authority of section 7805(a) was the kind of implicit delegation to an agency that required deference under chevron.1 1 6 the sixth circuit concluded that the tax court used the wrong standard to decide the case. "the tax court, employing the 'harmony' standard found in national muffler dealers, engaged in a plenary review of the legislative history of the statutory scheme without granting the commissioner the degree of deference" required by supreme court precedent.'07 subsequently, the ninth circuit and the seventh circuit also reversed the tax court on this issue.' these two circuits, however, rejected the sixth circuit's reliance on chevron in favor of national muffler's test of harmony with the language, origin, and purpose. the seventh circuit, which found the choice between national muffler and chevron a close call, stated that "the difference between these two approaches is negligible at best," but it opted for "the more narrowly tailored holding of national mtffler."1 9 the ninth circuit concluded that "the traditional rule of deference to treasury regulations" required that the challenged regulation be upheld,"' and it rejected what it saw as the apparent determination of the tax court that national muffler required a plenary review of the statute and its legislative history."' instead, the ninth circuit emphasized, the reviewing court's task under national muffler is to ask whether the agency interpretation is a reasonable one." 2 the opinions in the seventh and ninth circuits begin by examining the statutory language and determining that the regulation is a reasonable interpretation of that language. next, each opinion used legislative history to look at the origin and purpose and found the regulation a reasonable interpretation of those factors as well. both courts determined that the treasury had 105. 948 f.2d 289 (6th cir. 1991). the tax court had granted summary judgment in favor of people's federal in a memorandum opinion based on its decision in pacific first federal. people's fed. sav. & loan ass'n v. commissioner, 59 t.c. memo. (cch) 85, t.c. memo (p-h) ii 90,129 (1990), rev'd, 948 f.2d 289 (6th cir. 1991). 106. people's fed., 948 f.2d at 299-300. 107. id. at 304. 108. see bell fed. sav. & loan ass'n v. commissioner, 40 f.3d 224 (7th cir. 1994); pacific first fed. say. bank v. commissioner, 961 f.2d 800 (9th cir.), cert. denied, 506 u.s. 873 (1992). 109. bell fed., 40 f.3d at 227. 110. pacific first fed., 961 f.2d at 803. 111. id. at 804. 112. id. [vol. 3:2 muffled chevron: judicial re'iew of tar regulations sufficiently considered and justified the regulatory change. thus, all the circuit courts that have considered the validity of the regulation by examining both the statutory language of section 593 and its legislative history have found the regulation reasonable. they have instructed the tax court to defer to the commissioner and uphold the regulation. these opinions have highlighted the call to serious deference sounded in national muffler. moreover, they have organized the multiple factors outlined in national muffler into two steps: first, an examination of the language of the statute and then an examination of legislative and regulatory history to gauge purpose and origin. in a decision shortly after the sixth circuit opinion, the tax court adhered to its original position." 3 it purported to apply the chevron deference principle that when a statute is silent or ambiguous with respect to a particular issue, the court must ask "'whether the agency's answer is based on a permissible construction of the statute.""'" the court insisted that the deference required by the chevron standard did not displace judicial review. in particular, the court continued, the reviewing court must "'ensure that the agency engaged in reasoned decisionmaking.' the court concluded that the regulation was invalid because the basis for the change was not wellreasoned" 6 and the regulation was therefore unreasonable. this opinion adds to chevron's substantive requirements a procedural requirement of a reasoned basis for a regulation that changes an earlier one. the agency's explanation for its actions did not go unremarked in chevron. although seldom emphasized in the commentary on chevron,"' the chevron court noted the explanation offered by the environmental protection agency for its change in position." 8 in justifying its adoption of the plantwide standard, the epa had pointed out that this definition would not only 113. georgia fed. bank v. commissioner, 98 t.c. 105 (1992). vacated and remanded by agreement of the parties (lth cir. 1994). the tax court explained that in accordance with the rule of golsen v. commissioner, 54 t.c. 742 (1970). affd. 445 f.2d 985 (10th cir.), cert denied, 404 u.s. 940 (1971). it would follow its view that the regulation was invalid except for cases appealable to the sixth circuit. "after due consideration and with due respect to the sixth circuit, we conclude that our holding in pacific first federal was correct, and we therefore will follow it in cases not appealable to the sixth circuit." georgia fed. bank, 98 t.c. at 107. 114. georgia fed. bank. 98 t.c. at 108 (quoting chevron u.s.a. inc. v. natural resources defense council, inc., 467 u.s. 837, 843 (1984)). 115. id. (quoting united states v. garner, 767 f.2d 104, 116 (5th cir. 1985)). 116. id. at 118. 117. cf. peter l. strauss, one hundred fifty cases per year. some implications of the supreme court's limited resources for judicial review of agency action, 87 colum. l. rev. 1093, 1126-27 (1987). 118. chevron, 467 u.s. at 855 n.27, 857-59. 19961 florida tax review act as an incentive to new investment, but also serve to reduce confusion and inconsistency." 9 the supreme court wrote, "we must recognize that the epa has advanced a reasonable explanation for its conclusion that the regulations serve the environmental objectives as well."' 20 the epa's explanation, however, received only a page of discussion. the thoroughness of the agency's explanation did not decide the issue. the court highlighted not the agency's explanation for the change, but the inconsistent policies embodied in the statute. the court saw in the governing statute a desire "to accommodate the conflict between the economic interest in permitting capital improvements to continue and the environmental interest in improving air quality."'' the task of resolving competing policies belonged to the administrative agency, even if a new administration struck a new balance: "when a challenge to an agency construction of a statutory provision, fairly conceptualized, really centers on the wisdom of the agency's policy, rather than whether it is a reasonable choice within a gap left open by congress, the challenge must fail."'22 thus, under chevron, just as the epa, not the supreme court, had the task of reconciling economic and environmental concerns in the clean air act, so should the irs and not the tax court resolve the conflict between encouraging loan loss reserves and increasing effective tax rates under section 593. although purporting to follow chevron, the tax court's approach adheres more closely to motor vehicle manufacturers ass'n v. state farm mutual automobile insurance co., 23 a supreme court administrative law decision decided the year before chevron. in state farm, the supreme court set out a set of inquiries for courts to use in evaluating the reasoning behind an agency's policy judgments, particularly when the agency changes its former policy. the opinion counseled courts to invalidate an agency's action if it relied on factors which congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation for its decision that [ran] counter to the evidence before the agency, or [was] so implausible that it could not be ascribed to a difference in view or the product of expertise. 124 119. id. at 858. 120. id. at 863. 121. id. at 851. 122. id. at 866. 123. 463 u.s. 29 (1983). 124. id. at 43. [vol. 3:2 muffled chevron: judicial review of tax regulation5 applying these factors, the supreme court invalidated the national highway traffic safety administration's revocation of a rule that would have required all new cars to be equipped with passive restraints. chevron's cursory review and easy acceptance of the change in the epa's definition of stationary source is difficult to reconcile with the approach of state fann."2 as now-justice stephen breyer has written, supreme court doctrine regarding judicial review has been anomalous. "it urges courts to defer to administrative interpretations of regulatory statutes, while also urging them to review agency decisions of regulatory policy strictly.,,' 12 in the case of the section 593 nol regulation, the tax court shifted from strict to deferential review after three circuits upheld the regulation. in central pennsylvania savings ass'n v. conmissioner,2'" the tax court accepted with reservations the holdings of the courts of appeals that "because the legislative trend of section 593 was to decrease the benefit of the bad debt reserve deduction, it was a reasonable purpose, by the change in the regulation, to decrease said benefit even further."' the court was persuaded that it should no longer invalidate the regulation on the basis of what it saw as congress' "implied intent."' -9 nonetheless, the court emphasized "that the legislative history of a statutory provision may be so clear that a finding of implied intent on the part of congress would be in order in a future case involving statutory interpretation."' 0 the court concluded that, in light of its rationale for upholding the regulation, it did not need to "dissect the differences, if any, between chevron and national muffler."'' thus, somewhat reluctantly, the tax court accepted the view of the courts of appeals that required it to defer to the treasury. c. range of possible responses the series of cases involving section 593 sketches out most of the 125. as shapiro and levy observe, state farm "has been all but ignored by agencies and the courts, including the supreme court.' shapiro & levy, supra note 46. at 1052. 126. stephen breyer, judicial review of questions of law and policy, 38 admin. l. rev. 363, 364-65 (1986). 127. 104 t.c. 384 (1995). 128. id. at 396. 129. id. 130. id. at 396-97. judge wells in dissent emphasized this point. he disagreed with "the courts of appeals that it was inappropriate for [the tax court] to engage in a plenary review of the statute and legislative history." he wrote, "[while the approach adopted by the courts of appeals may ease disposition of difficult cases, it does not always produce just results." id. at 400. 131. id. at 392. 19961 florida tax review effects that chevron could have on judicial review of interpretive tax regulations. chevron could ratchet up the deference due to interpretive tax regulations from serious to strong deference, as the sixth circuit suggests. 32 chevron could have no effect on review of interpretive tax regulations because its principles do not apply to interpretive regulations, as the ninth circuit says. chevron could have no significant effect on review of any tax regulations because, as the seventh circuit believes, its standards differ little from those of national muffler. under the ninth circuit and seventh circuit views, courts reviewing interpretive tax regulations can blithely ignore chevron. in contrast, some readings of chevron would result in less deference to irs regulations. after reversal by the sixth circuit on the basis of chevron deference, the tax court upheld its original conclusion by reading chevron as heightening the responsibility of administrative agencies to explain the basis of their regulatory decisions, at least when they change previously established interpretations.'33 such a response decreases deference by increasing judicial scrutiny. the most important way that chevron could result in decreased deference is by emphasis on the plain meaning of the text, as justice scalia has urged.'34 true to his principles, justice scalia did exactly that in united states v. burke,135 a recent case in which the validity of a regulation was not directly at issue. the issue in burke was whether an award of back wages received in settlement of a class-action suit under title vii of the civil rights act of 1964 could be excluded from income under section 104(a)(2) as received "on account of personal injuries or sickness." according to the regulations, the exclusion covers only "an amount received... through prosecution of a legal suit or action based upon tort or tort type rights."'36 the burke majority accepted the validity of the regulation without question, 132. johnson city medical ctr. v. united states, 999 f.2d 973, 977 (6th cir. 1993). indeed, the sixth circuit, unlike any other circuit, has applied chevron in reviewing a revenue ruling. the dissent argued that skidmore rather than chevron should apply to revenue rulings. id. at 980-83. 133. cf. strauss, supra note 120, at 1126: the problem lies in the use of the word "deference" to describe what is to occur at the second stage. that usage suggests an ultimate judicial responsibility for the outcome that the analysis in chevron in other respects repudiates. acceptance subject to reasonableness review, not deference, is the necessary posture here. a change not well explained might be rejected as unreasonable and returned to the agency for further consideration. 134. see supra note 78. 135. 504 u.s. 229 (1992). 136. regs. § 1.104-1(c). i[vol. 3:2 muffled chevron: judicial review of tar regulations but, based on the congressional decision to recompense title vii plaintiffs only for lost wages, it rejected the taxpayer's argument that a suit under title vii of the 1964 civil rights act was a tort-like claim. in a concurring opinion, justice scalia wrote that although the regulation had not been challenged by either party at any stage of the proceeding, it was not entitled to deference under chevron because a reasonable interpretation of the statutory text would limit "personal injury" to physical or mental injuries." 7 as described below, two recent tax court opinions citing chevron appear to adopt the scalia approach of invalidating a regulation by invoking the plain meaning of the statute. d. impact of chevron as judge tannenwald observes in central pennshylvania savings, "chevron has had a checkered career in the tax arena .... [t]he supreme court, as well as other courts, has been inconsistent in applying chevron and national muffler, often ignoring one case and relying on the other."'3s nonetheless, the tax court has come to cite chevron far more than most of the appellate courts in reviewing tax regulations. some appellate courts do turn to chevron when reviewing any tax regulations, whether the regulations are interpretive or legislative. the sixth circuit, as discussed above, urged the tax court to do so.' eighth circuit opinions, beginning as early as 1993,'*" cite chevron for review of interpretive regulations. one recent eighth circuit opinion cites chevron along with 137. 504 u.s. at 242-43. he argued that limiting the term "personal injury" to physical injury was the "more normal meaning" of the phrase and that its pairing w ith "sickness" in the statutory provision strongly supported the use of the narrower meaning for "personal injury." id. at 243-44. 138. central pa. say. ass'n v. commissioner. 104 t.c. 384, 391-92 (1995). as professor merrill has demonstrated, however, chevron has had a checkered career in general, at least in the supreme court. merrill, judicial deference, supra note 4; merrill, textualism, supra note 4. some studies have found that chevron signaled to lower courts the supreme court's desire to allow greater agency discretion. see cohen & spitzer. supra note 4. at 65, 105; schuck & elliott, supra note 4, at 1029-41 (noting initial effect of increasing deference, which has since weakened). 139. the court of appeals for the federal circuit and the united states court of federal claims also have construed chevron to increase deference for interpretive regulations. see lima surgical assocs. inc. v. united states, 944 f.2d 885, 888 (fed. cir. 199 1). in unisys corp. v. united states, 30 fed. ci. 552, 565 (1994), the claims court concluded that under chevron an interpretive regulation was entitled not simply "to deference but to controlling weight." 140. see hefti v. commissioner, 983 f.2d 868, 871 (8th cir. 1993). see also norwest corp. v. commissioner, 69 f.3d 1404 (citing chevron along with national muffler for the proposition that the commissioner's interpretations are entitled to "substantial deference"). 1996] florida tax review national muffler as a justification for a lengthy discussion of legislative history;' 4' another cites chevron for the proposition that if the statutory language is clear, legislative history has no role in the analysis. 42 both of these opinions rely on chevron, but the first looks to the original chevron under which the reviewing court is to look to legislative history to see whether congress had spoken to the issue, and the second to the reformulated chevron under which in which the reviewing court judges plain meaning without recourse to legislative history. however, most appellate courts reviewing interpretive tax regulations do not rely on chevron. as discussed above, the seventh and ninth circuits question the applicability of chevron to interpretive tax regulations. similarly, in nalle v. commissioner,43 the fifth circuit wrote that despite the inconclusiveness of the legislative history, it would have deferred to the treasury's interpretation if the regulation at issue had been legislative, as in chevron.'44 the regulation was interpretive, however, and the court, relying on national muffler, concluded that the regulation was not due as much deference. the court invalidated it as inconsistent with the statute. 45 the third circuit in e.l du pont de nemours & co. v. commissioner,46 finessed the question of whether chevron applies to interpretive tax regulations. it began with a discussion of the deference due a legislative regulation under chevron, 47 but commented that even interpretive regulations are entitled to broad deference under cottage savings and national muffler.14 other appellate opinions, both those reviewing interpretive and those reviewing legislative regulations, do not cite chevron at all. 14 141. miller v. united states, 65 f.3d 687 (8th cir. 1995). 142. western nat'l mut. ins. co. v. commissioner, 65 f.3d 90, 93 (8th cir. 1995). yet another recent eighth circuit opinion upheld an interpretive regulation without citing chevron at all. american mutual life insurance co. v. united states, 43 f.3d 1172 (8th cir. 1994); see also meegan m. reilly, irs tries to stem courts' distaste for legislative history, 69 tax notes 1179 (dec. 4, 1995). 143. 997 f.2d 1134 (5th cir. 1993). 144. id. at 1138. 145. id. at 1138-39. see supra note 78. 146. 41 f.3d 130 (3d cir. 1994). 147. id. at 135. 148. id. at 135-36. the court concluded that the regulation before it was legislative and upheld the regulation. id. at 135, 140. 149. see archer-daniels-midland co. v. united states, 37 f.3d 321 (7th cir. 1994); st. jude medical, inc. v. commissioner, 34 f.3d 1394 (8th cir. 1994); ann jackson family found. v. commissioner, 15 f.3d 917 (9th cir. 1994); pepcol mfg. co. v. commissioner, 13 f.3d 355 (10th cir. 1993); dow coming corp. v. united states, 984 f.2d 416 (fed. cir. 1993); goulding v. united states, 957 f.2d 1420 (7th cir. 1992); brown v. united states, 890 f.2d 1329 (5th cir. 1989). [vol 3:2 muffled chevron: judicial review of tar regulations thus, most circuits emphasize the distinction between chevron's strong deference for legislative regulations and national muffler's serious deference for interpretive regulations. they do not find chevron applicable to interpretive tax regulations. instead, the special rule of national muffler governs for interpretive tax rules, whether or not chevron applies to other kinds of interpretive rules. 50 the tax court, in contrast, emphasizes the similarities between the strong deference of chevron and the serious deference of national muffler. the tax court has come to view chevron simply as another way of phrasing the tests of national muffler. as judge tannenwald has written, "we are inclined to the view that the impact of the traditional, i.e., national muffler standard, has not been changed by chevron, but has merely been restated in a practical two-part test with possibly subtle distinctions as to the role of legislative history and the degree of deference to be accorded to a regulation."'' the tax court understands chevron as a reminder of the deference due tax regulations. it does not see chevron as a revolutionary change from the multiple factor analysis to which it was long accustomed. a 1996 case that invalidated an interpretive regulation demonstrates nicely how the tax court treats chevron review as indistinguishable from reasonableness review under national muffler. in redlark v. commissioner,"'52 the regulation at issue interpreted section 163(h)(2)(a) as denying noncorporate taxpayers any deduction for interest on federal income tax deficiencies. 53 in redlark, the regulation denied a deduction for interest on a federal income tax deficiency that arose in part because of errors in computing income from business. judge tannenwald, writing for the 150. as the third circuit noted in du pont, [a]lthough this court and others have noted that interpretative regulations issued under the internal revenue code are entitled to less deference than legislative regulations, it is not clear whether this rule applies outside the internal revenue code. so far we have declined to decide whether chevron u.s.a. inc. v. natural resources defense council, inc.. which [advised] judicial deference to agency regulations, overruled general electric co. v. gilbert, which held that an agency's interpretative decisions required less judicial deference. e.l du pont de nemours, 41 f.3d at 135 n.23 (citations omitted). the third circuit thus intimates that after chevron, interpretive tax regulations may receive less deference than other interpretive rules, because tax regulations continue to receive only serious deference, while interpretive rules in other areas may now be entitled to strong deference. 151. central pa. sav. ass'n v. commissioner. 104 t.c. 384, 392 (1995). judge tannenwald's references to chevron are to its original formulation, which uses legislative history at step one. see supra text accompanying note 70. 152. 106 t.c. no. 2 (1996). 153. see temp. regs. § 163-9(b)(2)(i)(a). 19961 florida tax review majority, cited united states v. vogel fertilizer co."s for the proposition that less deference is owed to an interpretive than a legislative regulation and then immediately quoted chevron for the standard of judicial review. the majority opinion, based largely on a review of cases decided before the enactment of section 163(h)(2)(a), found that such interest arose in connection with carrying on a trade or business. thus, it concluded, the regulation was unreasonable because section 7805(a) did not give the secretary of treasury authority to construct an allocation formula that "excludes an entire category of interest expense in disregard of a business connection such as that which exists herein."' 55 in light of ambiguous legislative history, the majority did not find the statutory language plain, but it nonetheless concluded that the regulation "constitutes an impermissible reading of the statute and is therefore unreasonable."'' 56 nothing in the majority opinion indicates that the tax court views chevron on limiting its discretion to invalidate a regulation. because it views chevron as a rephrasing of the national muffler test for the validity of tax regulations, the tax court has limited its reliance on chevron to cases involving regulations. it has not cited chevron when reviewing other forms of agency interpretation, such as rulings or notices, 57 but it has cited chevron, as well as national muffler, for both legislative and interpretive regulations. since the sixth circuit's 1991 lecture about chevron, most tax court cases considering the validity of regulations have worked in some kind of citation to chevron,'58 often in passing as one citation among several, including national muffler. in pepcol manufacturing co. v. commissioner, a 1992 case invalidating a legislative regulation that was decided the day after georgia federal bank, only the concurrence cited 154. 455 u.s. 16, 24 (1982) (quoting rowan cos. v. united states, 452 u.s. 247, 253 (1981). 155. id. at 22. 156. id. at 36. 157. one case does allow for the possibility of relying on chevron for other forms of agency interpretation. in csi hydrostatic testers, inc. v. commissioner, 103 t.c. 398, 408 (1994), affd, 62 f.3d 136 (5th cir. 1995), the commissioner argued that under chevron, the courts should defer to the agency's interpretation of a regulation. the tax court rejected this argument, stating that deference is not the rule "in the absence of a contrary published, or at least longstanding, interpretation of the regulation in question." id. at 409. 158. in a few recent cases upholding regulations as reasonable, the tax court did not cite chevron. see schaefer v. commissioner, 105 t.c. 227 (1995); perkin-elmer corp. v. commissioner, 103 t.c. 464 (1994); e. norman peterson marital trust v. commissioner, 102 t.c. 790 (1994), aff'd, 78 f.3d 795 (2d cir. 1996); e.i. du pont de nemours v. commissioner, 102 t.c. 1 (1994), aff'd, 41 f.3d 130 (3d cir. 1994), aff'd sub nom., conoco, inc. v. commissioner, 42 f.3d 972 (5th cir. 1995). [vol. 3:2 muffled chevron: judicial review of tar regulations chevron.'59 an unreviewed 1993 opinion upheld an interpretive regulation in passing, but cited chevron for the proposition that an agency's interpretation must be based on a permissible construction of the statute.' ' a recent decision upholding an excise tax regulation cited chevron as support for the ability of an administrative agency to change its opinion.16 1 one 1995 decision cites chevron several times in the course of a lengthy discussion of legislative history, 62 and in another 1995 decision, chevron is cited for the proposition that "it is well established that considerable weight should be accorded to an executive department's construction of a statutory scheme it is entrusted to administer."' 63 chevron has played a somewhat more prominent role in two recent tax court cases, one invalidating a legislative regulation and the other an interpretive regulation,"6 in each case on the basis of inconsistency with plain meaning.' 65 although plain meaning is the first step of analysis under national muffler, neither of these decisions goes on to consider origin and purpose of the statute. thus, by examining the statutory language in isolation and in declining to rely on legislative history, they adhere to justice scalia's reformulation of chevron. in western national mutual insurance co. v. commissioner, t" the tax court invalidated an interpretive regulation defining "reserve strengthening" under a transition provision of the tax reform act of 1986 designed to limit loan loss reserves for property and casualty insurance companies. 67 159. pepcol mfg. co. v. commissioner. 98 t.c. 127, 138 (1992) (ruwe, j., concurring) (reviewed by court) (invalidating regulation that denied investment tax credit for solid waste recycling equipment), rev'd, 28 f.3d 1013 (10th cir. 1993). 160. cramer v. commissioner, 101 t.c. 225, 247 (1993). aff'd. 64 f.3d 1406 (9th cir. 1995). 161. western waste indus. v. commissioner. 104 t.c. 472, 478, 486 (1995). 162. hachette usa, inc. v. commissioner, 105 t.c. 234 (1995). 163. snap-drape, inc. v. commissioner, 105 t.c. 16. 25-26 (1995). 164. western nat'l mut. ins. co. v. commissioner, 102 t.c. 338 (1994). aff'd. 65 f.3d (1995); tate & lyle, inc. v. commissioner. 103 t.c. 656 (1994). 165. see western nat'l, 102 t.c. at 359, 361; tate & lyle, 103 t.c. at 666, 671. 166. 102 t.c. 338 (1994), aff'd, 65 f.3d 90 (1995). see supra note 142. 167. id. at 361. before the tax reform act of 1986, property and casualty insurance companies could deduct the full amount of their loss reserves. id. at 344. the new provision required them to discount the loss reserves. congress, however, enacted a transition rule that permitted a one-time exemption from the new rule for certain items, but specifically excluded "reserve strengthening" from the exemption. id. at 345-46. the treasury adopted a definition of reserve strengthening that included any increase to a company's prior-year reserve. id. at 346. the taxpayer argued that in the industry, the term "reserve strengthening" had an established meaning, limited to material changes in methodology or assumptions from one valuation date to the next and applicable to aggregate year-end reserves. id. at 346-47. 1996] florida tax review the majority cited chevron"' and asked first whether congress, in the language of the statute, had spoken to the precise question at issue. shortly after citing chevron, it quoted some of justice scalia's critical observations about legislative history. 169 it concluded that despite some contradictory explanations in the legislative history, congress chose a term of art used in an unconditional manner and that the established industry understanding of the term had to prevail over the broader regulatory interpretation. 70 even specialized language has plain meaning; it is the meaning plain to the specialist. in tate & lyle, inc. v. commissioner,'7' the tax court invalidated a legislative regulation deferring a u.s. subsidiary's deduction for interest accrued to a foreign parent because, according to the majority, it contradicted the statutory language. section 267(a)(2) denies deductions for amounts payable to certain related persons until the amounts are paid if, "by reason of the method of accounting of the person to whom the payment is to be made," the recipient does not have to include the amounts in gross income until received. although section 267(a)(2) is not limited to domestic payors and payees, congress enacted section 267(a)(3), authorizing the treasury to promulgate regulations applying the "matching principle" of section 267(a)(2) to cases in which the payee is not a u.s. person. the regulation at issue, promulgated pursuant to this grant of legislative authority, postponed the deduction until payment if the lender was exempted from u.s. tax by a tax treaty. 172 the court concluded that the regulation was invalid, citing chevron among other authorities, 173 because a treaty exemption is not a method of accounting as required by the statute. 74 judge halpern's dissents in both of these cases demonstrate how reliance on the concept of plain meaning gives judges freedom to construct meaning. 75 in western mutual,176 judge halpern pointed to legislative 168. id. at 359. it did not cite national muffler along with chevron. 169. 102 t.c. at 360 (citing hirschey v. ferc, 777 f.2d 1, 7-8 & n.l (d.c. cir. 1985) (scalia, j., concurring)). 170. id. at 355, 360. the majority wrote, "[t]his is not the type of situation which has generated the continuing debate on the amount of deference that should be afforded to the legislative history. this case presents a different perspective because the statute is neither ambiguous nor imprecise." id. at 360 n.25. 171. 103 t.c. 656 (1994). 172. regs. § 1.267(a)-3(c)(2). 173. 103 t.c. at 666, 672, 679. these citations appeared in the context of cases involving regulations promulgated under a specific grant of authority. national muffler is not cited. 174. id. at 670-71. 175. see also ilyse barkan, new challenges to use of the plain meaning rule to construe the irc and regs, 69 tax notes 1403 (dec. 11, 1995). [vol. 3:2 muffled chevron: judicial review of taxc regulations history suggesting that congress was not using the phrase "reserve strengthening" as a term of art. that is, the language is not so plain,'" and, as judge halpern explained, chevron requires that the agency regulation be upheld in such a case if reasonable.' 8 in tate & lyle, judge halpern's dissent called attention to another provision of the same code section,"' which applies the matching principle to exempt income and thus calls into question the majority's conclusion that "method of accounting" cannot include exemption. ' plainness of meaning often depends on narrowness of focus. in tax cases, as in other areas of law, there is a tension between those opinions emphasizing plain meaning and those emphasizing origin and purpose. judges emphasizing the first are less likely to defer to the administrative agency than those emphasizing the second. focus on plain meaning gives judges leeway to declare meaning and invalidate administrative action. it frees them of the obligation to defer to administrative interpretation."' while tax opinions that preceded chevron relied on national muffler to invalidate regulations on the basis of inconsistency with plain meaning, the chevron doctrine as reformulated by justice scalia gives courts additional authority for doing so. iv. implications for interpretation a. the role of legislative histor., as the opinions reviewing the section 593 nol regulations demonstrate, tax opinions often transform the national muffler tripartite test of harmony with the plain language of the statute, its origin, and its purpose into 176. western nat'l mut. inc. co. v. commissioner. 102 t.c. 338, 375 n.2 (1994). 177. "1 believe that all the majority has shown is that, at best. congress has unambiguously settled on an imprecise meaning." id. at 375 n.2. judge halpern also criticizes the majority for failing to heed the lesson of chevron in his dissent in redlark v. commissioner, 106 t.c. no. 2 (1996). 178. western nat'l, 103 t.c. at 376. judge halpern's analysis was premised on the "original" chevron under which legislative history is used to discern congressional intent. see 467 u.s. at 862-64. 179. irc § 267(b)(9). this subsection specifies that § 267(a) applies to a "person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual." 180. tate & lyle, inc. v. commissioner. 103 t.c. 656, 692-95 (1994) (halpern, j., dissenting). he acknowledged that it was possible that § 267(b)(9) was intended to refer only to § 267(a)(1), which denies loss recognition for sales or exchanges between related parties. id. at 694-95. 181. see shapiro & levy, supra note 46, at 1063. 19961 florida tax review a two-step test. the first step looks at the statutory language. the second step considers purpose and origin through the use of legislative history. these two steps differ in important ways from both the original chevron two-step and the two-step as reformulated by justice scalia. this "muffled chevron doctrine"--a combination of national muffler and chevron-offers a model for statutory interpretation and regulatory review applicable beyond tax. as described in chevron itself, step one looked to the intent of congress, discovered through the traditional tools of statutory construction. the chevron court examined legislative history to see whether congress had spoken to the issue at hand. the first step of the reformulated chevron test, in contrast, looks at the text, the "structure and language of the statute as a whole," 82 but not the legislative history or other traditional tools of statutory construction. moreover, supreme court practice under the reformulated chevron doctrine suggests that reviewing courts should presume that the meaning of the statute is plain. in most cases, according to the reformulated chevron, courts should be able to discern the appropriate meaning from reading the text alone. step one of the muffled chevron doctrine resembles the first step of the reformulated chevron by excluding legislative history from this stage of analysis. step one of muffled chevron moves toward what professor eskridge has called a "harder" plain meaning rule under which a "text's clarity is reinforced by arguments of horizontal coherence," which include the whole act and statutory analogues. 183 in the cases involving the section 593 nol regulations, for example, the courts examined the language not only of section 593, but also of section 172 and how the two relate in the code. legislative history played no part in this textual, structural analysis. like the reformulated chevron, step one of the muffled chevron doctrine assigns particular importance to the language and context of the text. it gives that consideration a priority not awarded it under the three-part harmony of national muffler. unlike the reformulated chevron doctrine, however, step one of the muffled chevron doctrine does not presume that the meaning is plain.' 8 plain meaning is the exception, not the rule, 85 and examination of legislative history at step two provides a further check against concluding too quickly that the language is plain. the second step of muffled chevron differs from the second step of both the original and reformulated chevron doctrines by welcoming consider182. national r.r. passenger corp. v. boston & maine corp., 503 u.s. 407, 417 (1992) (citation omitted). 183. eskridge, supra note 77, at 686. 184. id. at 685-88. 185. see barkan, supra note 175, for a description of some of the factors the tax court has required before concluding that language is plain. [vol 3:2 muffled chevron: judicial review of tar regulations ations based on legislative history when judging the reasonableness of administrative action. in chevron, the court discussed the administrative decision in light of the general policy of the clean air act and not in light of particular positions in the statute's legislative history. similarly, the reformulated chevron doctrine, if the court gets beyond step one, permits administrative agencies freely to formulate policy rationales for their interpretations, including post facto rationalizations." in contrast, under step two of what i have dubbed the muffled chevron doctrine, courts turn to the legislative history to set the bounds for administrative action. this use of legislative history at the second step preserves a clear role for the judiciary;8 7 courts must ensure that the agency does not go beyond these bounds.'ss these bounds, however, are capacious and do not constrain the agency too tightly. an examination of legislative history often confronts evidence that the intent of members of 186. see panel discussion, developments in judicial review with emphasis on the concepts of standing and deference to the agency, 4 admin. l.i. 113. 124 (1990) (comments of judge stephen williams); coverdale, supra note 11. 187. in national muffler, the court examined legislative history to discern purpose. 440 u.s. at 477-84. it discussed at length submissions of the u.s. chamber of commerce and the american warehouseman's association to the senate finance committee, explaining that these submissions "assume an importance here beyond that usually afforded such documents [because they are] the only available evidence of the amendment's purpose." id. at 478-79 n.8. some have argued that examination of legislative history is especially important for tax cases. judge posner recently wrote in a tax case: legislative history is in bad odor in some influential judicial quarters .... but it continues to be relied on heavily by most supreme court justices and lower-court judges; and in the case of statutory language as technical and arcane as that of the disc provisions, the slogan that congress votes on the bill and not on the report strikes us as pretty empty. archer-daniels-midland co. v. united states. 37 f.3d 321, 323-24 (7th cir. 1994) (citations omitted). because of this reliance of members and staffs on legislative history for tax, others have argued it should carry special weight for tax legislation. see ferguson et al, supra note 6; livingston, supra note 6, at 826-44. for a critical analysis of the extent to which ferguson et al. would give some legislative history parity with the statute itself, compare james b. lewis, viewpoint: the nature and role of tax legislative history, 68 taxes 442 (1990) with bradford l. ferguson et al., response: adapting to the evolving legislative process. 68 taxes 448 (1990). this article emphasizes the similarity between tax and other areas of law, at least other technical areas, rather than the differences. see caron, supra note 3, at 531: karla w. simon, constitutional implications of the tax legislative process, 10 am. j. of tax pol'y 235, 237-41 (1992) (environmental law, like tax law, is complex). 188. "[i]ntentionalists, in contrast, believe that the text alone will yield a fairly wide range of possible meanings; admit legislative history and the range of possible meanings narrows." merrill, textualism, supra note 4, at 367-68. 1996] florida tax review congress in enacting statutes is amorphous and mixed.'89 the section 593 opinions, for example, recognize that congress sought both to encourage bad debt reserves and to lessen differences between mutual institutions and other corporate taxpayers. under step two of the muffled chevron doctrine, treasury is free to emphasize either of these policies in its regulation, but not to promote an unrelated policy. using legislative history to determine the origin and purposes against which administrative interpretation is tested thus preserves a wide but not unlimited range of permissible administrative action.' 90 table ii varieties of chevron two-step step one step two pre-chevron not applicable-sliding scale not applicable-sliding scale original court determines if congress if congressional intent is chevron has spoken to issue through ambiguous, accept any reause of traditional tools, insonable administrative intercluding legislative history. pretation, defended on any policy basis. reformulated court examines plain meanif language is not plain, chevron ing of statute, through lanaccept any reasonable adguage and structure but not ministrative interpretation, legislative history; apparent defended on any basis, but presumption that language is legislative history suspect. plain. muffled court examines plain meanif language is not plain, chevron ing of statute, through lanreasonableness of adminisguage and structure but not trative interpretation is legislative history; presumpjudged against origin and tion that language is not purpose of statute, particuplain. larly as shown in legislative history. 189. herz has described the theory of chevron as accepting that in passing laws, congress approves a range of possible interpretations. herz, supra note 77, at 1672. a muffled chevron works to ensure that administrative agencies act within that range. 190. indeed, use of legislative history to test the reasonableness of agency action would make consideration of subsequent legislative history appropriate. cf. michael livingston, what's blue and white and not quite as good as a committee report: general explanations and the role of "subsequent" tax legislative history, i 1 am. j. of tax po'y 91 (1994). [vol 3:2 muffled chevron: judicial review of tax regulations the use of legislative history in the muffled chevron doctrine answers what professor eskridge has described as the three types of criticisms of the traditional use of legislative history: the realist, the historicist, and the formalist.'9 ' the realist criticism holds that "legislative intent is an incoherent and indeterminate concept ... because legislatures usually have no determinate collective expectations about many (if any) of the concrete issues posed by their statutes.' 9 2 the realities of the legislative process inevitably produce ambiguity and mixed congressional motives. 193 when legislative history is used to judge administrative action, these weaknesses become strengths. if, as justice scalia has suggested, use of legislative history is "the equivalent of entering a crowded cocktail party and looking over the heads of the guests for one's friends,"'' that is well and good under this approach. it is precisely to the administrative agencies that congress has delegated the choice of the public's friends. 95 such use of legislative history also ameliorates the formalist concern that "judicial reliance on legislative history is inconsistent with the specific structures for legislation in the constitution.'" in the administrative state, legislative regulations promulgated formally and interpretive rules issued informally may bind the public to different degrees,"9 but neither kind requires bicameralism and presentment. moreover, reliance on legislative history to judge the reasonableness of regulatory action helps ensure notice to the public. when the courts use legislative history to divine the intent of congress, members of the public must be able to read the judicial and legisla191. eskridge, supra note 77, at 641-42. 192. id. 193. see daniel a. farber & philip p. frickey, law and public choice (1991); jane s. schacter, metademocracy: the changing structure of legitimacy in statutory interpretation. 108 harv. l. rev. 593 (1995); symposium on the theory of public choice, 74 va. l rev. 167 (1988). if, as professor schacter has suggested. the textualist point of view should be seen as allied to public choice theory, that very theory undermines justice scalia's belief that legislators can enact clear laws. schacter, supra, at 644-45. she suggests that textualists seek a "shrinking of the corpus of regulatory law by imposing an exacting burden of textual clarity that legislators are unwilling or unable to meet." id. at 645. under another branch of public choice theory, decision theory, use of legislative history through delegation to committees and their reports could be seen as a necessary tool for setting agendas and reaching decisions. see id. at 639. 194. conroy v. aniskoff, 507 u.s. 511 (1993) (scalia, j., concurring). 195. if the agency chooses inappropriate friends, congress can act. for one case in which congress acted to reject a regulation, see ellen p. aprill, tribal bonds: indian sovereignty and the tax legislative process, 46 admin. l. rev. 333 (1994). that study suggests that congress expects administrative agencies to attend to the legislative history for keys to interpretation. id. at 367-68. 196. eskridge, supra note 77, at 649. 197. see supra notes 18-23 and accompanying text. 19961 florida tax review tive tea leaves. if legislative history serves to justify a regulation, the public is able to look to a published interpretation for guidance.' 98 and finally, use of legislative history for this purpose eliminates the historicist concern that "an historically situated collective intent cannot be completely 'reconstructed' by even the most 'imaginative' jurist" because current context influences interpretation.'99 the use of legislative history to justify administrative action does not attempt historical reconstruction. it asks instead for the administrative agency to decide how the history and current context should intersect. the muffled chevron doctrine gives administrative agencies discretion but not carte blanche in choosing among possible interpretations.10 to some extent, my muffled chevron resembles the revision of chevron recently advocated by professor mark seidenfeld."0 professor seidenfeld and i would both exclude legislative history from step one. seidenfeld explains: "when an agency administers a regulatory scheme, legislative intent seems too tenuous a concept for reviewing courts to use at chevron's step one to exclude entirely the more technically expert and politically accountable agency from the interpretive process."2"2 both of us see an important role for legislative history at step two. "a statute's legislative history can thereby provide judges with insights into the policy choices entailed by interpretation."' 03 that is, both revisions of chevron seek to accommodate not only the political responsiveness and technical expertise offered by administrative agencies, but also the reasoned decisionmaking and protection against agency abuse provided by judicial reviewj there are, however, some important differences between the two revisions. professor seidenfeld would direct courts to "require the agency to identify the concerns that the statute addresses and explain how the agency's 198. this generalization requires qualification when retroactive regulations are involved. under § 7805(b), "[tlhe secretary may prescribe the extent, if any, to which any ruling or regulation, relating to the internal revenue laws, shall be applied without retroactive effect." there is a large body of literature on retroactivity of tax regulations. see, e.g., toni robinson, retroactivity: the case for better regulation of federal tax regulators, 48 ohio state l.j. 773 (1987); john s. nolan & victor thuronyi, retroactive application of changes in irs or treasury department position, 61 taxes 777, 783 (1983). 199. eskridge, supra note 77, at 644. 200. cf. david w. slawson, legislative history and the need to bring statutory interpretation under the rule of law, 44 stan. l. rev. 383, 406 (1992) (stating that courts rarely find agency's interpretation of legislative history to be unreasonable). 201. mark seidenfeld, a syncopated chevron: emphasizing reasoned decisionmaking in reviewing agency interpretations of statutes, 73 tex. l. rev. 83 (1994). 202. id. at 115-16. 203. id. at 130. 204. see coverdall, supra note 11, describing the particular concern about abuse by tax authorities. [vol. 3:2 muffled chevron: judicial review of tax regulations interpretation took those concerns into account." : his approach thus recalls the tax court's scrutiny of agency reasoning in the nol cases. this approach, however packaged as a reworking of chevron, in fact descends from state fann.2 6 as such, it is subject to the criticisms of the state farm approach, which justice breyer has so well articulated?2°7 as a matter of institutional competence, agencies are better able to gather the range of information needed to set policy for a variety of situations than are judges deciding a dispute between two parties.205 strict review of agency policy may make the agency reluctant to change the status quo.-09 "a remand of an important agency rule (several years in the making) for more thorough consideration may well mean several years of additional proceedings, with mounting costs, and the threat of further judicial review leading to abandonment or modification of the initial project irrespective of the merits." 0 the muffled chevron doctrine avoids these difficulties. rather than mandating a detailed review of agency procedures, it calls for a limited review of the agency's substantive position. it recommends that after a careful examination of statutory language, courts should turn to legislative history and other tools of statutory construction to judge whether a regulation is consistent with the purpose and origin of a statute.2 '" often, as the tax law's experience with national muffler shows, examination of legislative history suffices, and no other sources is needed to establish the regulation's consistency with the statute's origin and purpose. b. burden on the judicial resources the muffled chevron doctrine, however, itself raises questions regarding judicial resources and judicial expertise. by requiring the agency to demonstrate the reasonableness of agency action at step two, it calls for a more searching inquiry than simply deferring to the agency or decreeing the 205. seidenfeld, supra note 201, at 129. 206. professor seidenfeld acknowledges this kinship. id. at 128. 207. see stephen breyer, vermont yankee and the courts' role in the nuclear energy controversy, 91 harv. l. rev. 1833 (1978); breyer. supra note 126. 208. breyer, supra note 126. at 388-89. 209. id. at 391, 393. 210. id. at 383. 211. of course, the muffled chevron doctrine leaves many difficult questions unanswered. it does not explain what a court should do if legislative history flatly contradicts a statute seemingly clear on its face. it does not give a court direction as to the extent it should use legislative history to discern purpose and origin when construing a statute in the absence of an administrative interpretation. it does not address the scope of review w hen the legislative history is silent on the issue or when the legislative history is old and circumstances have changed. 19961 florida tax review meaning of statutory language. both the original chevron doctrine of deference to administrative agencies and the reformulated chevron's reliance on judicial declaration of plain meaning have been described as labor-saving devices for the supreme court. professor strauss has suggested that both stress on statutory language and deference to administrative agencies represent efforts by the court to control the use of resources and the content of opinions in the lower courts. in short, they respond to a management dilemma.212 although both the strong deference to administrative agencies urged by the original chevron and the plain meaning rule promoted by the reformulated chevron can relieve courts of burdens, they do so very differently. judges, like other people, act in their own interest to maximize utility by increasing power or decreasing workload.2"3 strong deference decreases workload but does not increase power. thus, we should expect counsels of deference to come from courts overwhelmed by burdensome dockets or less interested in the subject matter. it is not surprising then that as in the section 593 cases, the generalist appellate courts have reminded the specialized tax court to defer to the administrative agency. plain meaning also limits workload. professor schauer has the impression that the supreme court anchors decision in plain meaning when the cases are technically complex, but lack strong political, moral, or economic valence and thus are not as interesting to the justices.214 "[t]hese did not look like'the kinds of cases to which either the justices or their clerks had much context-sensitive expertise. context is not for dabblers, and it is almost definitional of a context-based inquiry that the inquirer have... expertise..., 2. 5 plain meaning, he explains, is "a way in which people with potentially divergent views and potentially different understandings of what the context would require may still be able to agree about what the 212. strauss, supra note 117, at 1095. 213. see shapiro & levy, supra note 46, at 1053-58 and especially authorities cited in note 6. their theories and data suggest that we will see cycles in which a court will assert authority to interpret rules until such interpretation imposes too great a burden on judicial resources and then will announce a rule that husbands resources. over time, the rule preserving resources will decrease power, and the cycle will begin again. 214. frederick schauer, statutory construction and the coordinating function of plain meaning, 1990 sup. ct. rev. 231, 247-48. 215. id. at 253-54. he notes, my instinct is that these justices with these clerks with this amount of time will make less of a hash of tax law in the long run by trying to rely on plain meaning than by trying to divine and apply the deepest purposes and equities of the internal revenue code. and even if i am wrong about this, it would not surprise me if the justices themselves thought this. id. at 254 n.85. [vol 3:2 muffled chevron: judicial review of tar regulations language they all share requires. '2 6 judicial decisions grounded on purpose and origin require sensitivity to context, as professor schauer observes. thus, a specialized court such as the tax court has welcomed deep excursions into legislative history. tax court judges know tax law, and find it interesting. their decisions on the validity of tax regulations are long and detailed, and because such cases are generally referred by the chief judge to the full court for review, often include concurring and dissenting opinions. those of the court of federal claims, where tax cases represent approximately one-third of the docket, 27 are somewhat shorter, and those of the generalist district courts shorter yet. yet, resort to plain meaning also depends on context. 218 it gives the court freedom to choose the extent to which the language is placed in context. the court can examine the phrase at issue, the entire section of the statute, or the place of the section in the statute as a whole. the court may or may not decide to examine changes in the statutory language over time.219 for example, with the section 593 nol regulation, a court with tax expertise and hearing only tax cases was far more likely than a generalist court to consider and give weight to other statutory limitations on net operating losses and loan loss reserves, the varieties of ordering rules in the code, and the way the various tax rules interact to define income. 0 plain meaning leaves the judge free to make this decision according to background, knowledge, and interest. the judge decrees what meaning is plain, and what is plain depends on the judge's experience. deference to administrative interpretation-the message lower courts garnered from the original chevron doctrine-relieves the court of burdens, but it does so at some cost to judicial power. plain meaning appeals to judges because it both preserves, if not enhances judicial power, and accommodates so easily 216. id. at 254. 217. see sheppard, supra note 58, at 764. 218. thus, professor popkin attributes opposition to a national court of appeals to the likely willingness of such a court "to penetrate the statutory text to apply the statutory structure." william d. popkin, why a court of tax appeals is so elusive, 47 tax notes 1101, 1103 (may 28, 1990). he explains, "a specialized court, confident of its expertise and of not being contradicted by another appellate court, would feel more secure than generalist courts in identifying the underlying statutory structure. the appeal to statutory structure will often (though not inevitably) undermine the more or less clear text... ." id. at 1104. 219. use of statutory context can pose a difficulty in the case of a statute such as the code because it evolves over time, and thus some provisions are far older than others. newer provisions may reflect new understandings, such as the importance of the time value of money. 220. "generalist courts may well fail to see connections between different parts of a statute and render decisions that create inconsistencies within the statute." richard l revesz, specialized courts and the administrative lawmaking system. 138 u. pa. l rev. 111 1, 1168 (1990). 1996] florida tax review judicial differences in background and taste.2 1 it permits but does not require judicial effort. it justifies either cursory or exhausting statutory exegesis. the judge is free to choose. plain meaning can be as fancy as the judge chooses, and therein lies its strong, almost irresistible, appeal. plain meaning permits judges to choose either to enhance power or decrease workload. plain meaning, however, sacrifices the expertise of administrative agencies to the preferences of individual judges. the muffled chevron doctrine strikes a balance. it accepts the appeal and importance of the statutory language, but by presuming that language is unlikely to be plain and by preserving a role for legislative history in determining the reasonableness of administrative action, it cabins the ability of judges to use plain meaning doctrines to construct meaning. the requirement that courts test the reasonableness of administrative action against the origin and purposes as demonstrated in the legislative history preserves a role for the judicial branch without imposing too great a burden on judicial resources. such a test for reasonableness is narrower and less burdensome than reviewing the adequacy of agency explanations or using legislative history to determine congressional intent. if, as under the muffled chevron doctrine, the court's task is limited to identifying support in the legislative history for the position the administrative agency has taken, the court need not consider all possible positions reflected in the legislative history. it need not weigh the competing concerns. under the muffled chevron doctrine, the court leaves the choice of how to balance the competing concerns to the administrative agency. moreover, the muffled chevron doctrine respects separation of powers: the courts ensure that administrative agencies act within bounds set by congress, but let the administrative agency decide how to act within those bounds. v. conclusion the muffled chevron doctrine borrows from both chevron and national muffler. from chevron, it learns the need to give structure to the multiple factors involved in reviewing agency interpretations of law. like the reformulated chevron, it gives the particular importance to the language of 221. judge wald has written: when judges speak about words in "context" and the "structure" of a statute or its "object and purpose," and yet at the same time resist looking at any legislative materials to inform those inquiries, the door is inevitably left open for judicial assumptions, speculation, preferences, and notions of "sound public policy" to fill the vacuum. wald, supra note 4, at 304. [vol. 3:2 1996] muffled chevron: judicial review of tar regulations 91 the statute. national muffler, however, serves as a reminder that the purpose and origin of a statute merit consideration. examination of a provision's language and the place of the particular provision in the overall statutory scheme, although important, seldom ends analysis. legislative history provides context that clarifies meaning, and makes what seemed plain at first glance not so plain at all. a muffled chevron doctrine discourages courts from worshiping the false idol that finds meaning plain from the statutory text alone. it restores the judiciary to its important role of protecting against abuses of power by an administrative agency without encouraging the judiciary to displace the administrative agency. florida tax review volume 7 2006 number 9 comments on the oecd proposal for secret and mandatory arbitration of international tax disputes by michael j. mclntyre* i. introduction .......................................... 622 ii. evaluating the need for mandatory arbitration ....... 624 a. potential costs and benefits of mandatory arbitration .... 624 b. unsettled cases of potential double non-taxation ....... 626 c. addressing the rare cases of double taxation .......... 628 iii. secret arbitration: oecd endorsement of opaqueness . 630 iv. additional flaws in the oecd proposal ............... 637 a. potential bias ofarbitrators ......................... 637 b. participation by non-party taxpayers ................. 638 c. unrealistic time limits ............................. 639 d. lack of procedural rules governing arbitration ......... 640 e. some additional criticisms .......................... 641 v. conclusion ............................................ 645 * professor of law, wayne state university law school. comments on the oecd proposal i. introduction the organization for economic co-operation and development (oecd) has proposed amendments to its model tax convention and commentary that would establish a system for the mandatory arbitration of tax disputes between two treaty countries when the tax officials of those countries have been unable to resolve those disputes within a two-year period.' the proposal is undoubtedly well-meaning and does address a small but significant problem the "rare cases" (as characterized by the oecd)2 of potential double taxation that are unresolved through the existing tax-treaty mechanism.3 nevertheless, as discussed below, the public policy goals of this proposed system are at best obscure, and the risks to sound administration of national tax systems are great. the oecd's goal seems to be to please the international business community when the goal ought to be to advance the public interest in a transparent and unbiased system. although the oecd has aggressively sought comments from the international business community on its proposal and has redesigned its system in accordance with those comments, it has been far less aggressive in obtaining comments from academics and other people more likely to represent the public interest. moreover, the many developing countries not within the oecd's orbit have played little or no role in the development of this proposal. the oecd proposal includes the following three features that have been on the wish lists of multinational companies for a very long time: (1) a forum outside the control of the tax authorities where they can litigate tax disputes in secret; (2) a club they can use to compel the tax authorities to resolve international tax disputes within very tight time deadlines (typically six months); and 1. see oecd, proposals for improving mechanisms for the resolution of tax treaty disputes, (2006), http://www.oecd.org/dataoecd/5/20/36054823.pdf(hereinafter "oecd proposal"). 2. id. at 6, 91, 45 ("this paragraph provides that, in the rare cases where the competent authorities are unable to reach an agreement under paragraph 2, the unresolved issues will, at the request of the person who presented the case, be solved through an arbitration process."). 3. see oecd, articles of the model convention with respect to taxes on income and on capital (2005, http://www.oecd.org/dataoecd/50/49/35363840.pdf (providing that the contracting states shall endeavor to resolve tax disputes arising under the treaty) (hereinafter "oecd model tax convention"). 2006] florida tax review (3) direct involvement by their legal staffs in the competent-authority process. no wonder the arbitration system proposed by the oecd has the strong support of the international business community. the draft proposal barely acknowledges the features listed above and makes no serious effort to defend them. in particular, the oecd fails to explain why a system of dispute resolution that contained these features would advance the public interest. all of these features are ones that many oecd member states have opposed in the past on the ground that they are inconsistent with their national sovereignty.4 the oecd apparently believes that it is in the last stage of developing a robust and workable proposal for resolving international disputes in an appropriate manner. at this point, it seems to be interested simply in fine tuning its proposal to make it even more user friendly to the international business community. this apparent belief is unfounded. the proposal ought to be examined, perhaps for the first time, in terms of its contribution to the public good. in these brief comments, i seek to provoke such an examination. section ii, below, examines the argument that adopting mandatory arbitration is needed in order to guarantee that international tax disputes under tax treaties get resolved. i argue in that section that the costs of resolving all cases through arbitration may exceed the benefits. in many cases, the benefits are modest in that the taxpayer is not seeking to avoid double taxation but instead is seeking to make use of flawed tax-treaty rules to avoid taxation in both of the treaty countries. section iii, below, argues that the secrecy in the arbitration process contemplated in the oecd proposal is contrary to public policy and is inconsistent with the oecd's strong support in other contexts for transparency in international tax matters. i suggest that the arguments against blanket secrecy are so strong and so obvious that the oecd appears to be acting in the interests of the multinational companies rather than in the public interest. section iv provides a brief discussion of a variety of other flaws in the oecd proposal. some of these flaws are relatively minor and easily fixed. 4. if the legislative body in a country concludes that the oecd proposal infringes inappropriately on national sovereignty or otherwise contravenes public policy, it is unlikely to approve a tax treaty that embodies that proposal. several u.s. senators, in a letter to the u.s. secretary of the treasury, recently expressed their concern about various features of the oecd proposal, including its provision for a totally secret proceeding. the letter cites and attaches my comments provided to the oecd. see letter from senators byron l. dorgan, russ feingold, and carl levin to treasury secretary john w. snow, may 16, 2006. [vol. 7:9 comments on the oecd proposal others are more fundamental. a conclusion, with some recommendations for modification in the oecd proposal, is provided in section v. ii. evaluating the need for mandatory arbitration in the materials the oecd has distributed for public comment, the oecd has not explained why it believes that arbitration is an appropriate mechanism for resolving disputes in the "rare cases" in which the appropriate tax officials of the treaty countries (the "competent authorities") are unable to resolve those disputes on their own. the oecd seems to believe (1) that some resolution of the unresolved disputes is needed, and (2) that secret and mandatory arbitration is the only available alternative for resolving them that would be acceptable to the international business community. this practical approach of accommodating the international business community may have some appeal to beleaguered international bureaucrats. it is not a sensible basis, however, for designing a coherent dispute resolution system that will obtain public legitimacy. in subsection h,a, below, i look at the costs of attempting to resolve through mandatory arbitration the relatively few cases that currently are not being resolved by domestic courts or by the competent authorities. subsection ii,b explains why a significant percentage of the unresolved cases are likely to involve situations in which the taxpayer is seeking to avoid taxation in both of the countries that are parties to the dispute. subsection ii,c discusses those cases in which the taxpayer is facing a significant risk of double taxation. i suggest that many of these cases are likely to be transfer-pricing cases cases involving the proper price to charge on transactions between related persons or between branches of a single entity. i argue, inter alia, that the proper solution to transfer-pricing problems is to improve the oecd's transfer-pricing rules, which currently do not yield definitive answers in almost all cases involving the sharing of intellectual property. a. potential costs and benefits of mandatory arbitration resolution of all tax-treaty disputes is not necessarily worth the costs that the attainment of that goal would entail. if the oecd is correct that the cases of non-resolution are rare, then the better part of wisdom may be simply to declare victory. of course, the competent-authority mechanism is needlessly opaque; consequently, those of us on the outside do not have the data needed to evaluate the oecd claim that non-resolution is rare. because the people in position to challenge that claim do not appear to be objecting to it, i am assuming for purposes of this report that the oecd claim is well-founded. no dispute resolution system is perfect, nor can it be expected to be perfect. if perfection could be achieved at little or no cost, then the oecd's 20061 florida tax review purported goal of perfection (resolving all disputes) would make lots of sense. but the oecd has developed a complex, expensive system that undermines national sovereignty and presents serious risks of corruption and unfair dealing. this endeavor is not cost-free. before embarking on a search for perfection, the oecd should have examined the costs of its proposal and compared them to the costs of living with imperfection. one important negative consequence of the oecd proposal is that it would give multinational companies an opportunity to bypass domestic courts and still get their case adjudicated by a tribunal independent of the tax authorities. under the oecd proposal, only cases that bypass domestic courts would go to arbitration because a matter already decided by a domestic court is not subject to arbitration.5 bypassing domestic courts is a serious matter, not to be permitted without compelling reason. many tax-treaty issues depend on an interpretation of domestic law, and that interpretation ought to come from domestic courts.6 the oecd seems to recognize that an international tribunal should not act as a court of review for the decisions of domestic courts. yet, it is prepared to offer multinational companies an opportunity to supplant the domestic courts with a secret tribunal of their own choosing. another negative consequence is the potential for corruption presented by a secret adjudicative system. in a democratic society, the basic check on the integrity of the judiciary is transparency. the oecd would eliminate that check under its proposed secret system. in private arbitration, some check on the integrity of the system is provided by the strong self-interest of the parties. that self-interest is decidedly less strong when the money at stake is the people's money, not the private fortunes of the parties. corruption is always a concern within a tax department, and well-run departments have strict internal procedures to combat it. those internal procedures cannot work effectively to police decisions made outside the department. i do not suggest that corruption is inevitable under the oecd proposal, only that the possibility is cause for serious concern. if the oecd believes that resolution of all treaty disputes referred to the competent authorities is necessary for some reason, it should not favor its 5. see oecd proposal, supra note 1, 14, 51, 53, 62. ideally, an arbitration system should operate only if the taxpayer has agreed to be bound by it. achieving that ideal system is difficult in countries that do not allow for the waiver of court remedies. see hugh j. ault, "improving the resolution of international tax disputes," 7 fla. tax rev. 137, 146-47 (2005) (hereinafter "ault"). professor ault is a senior advisor to the oecd centre for tax policy and administration. 6. the oecd suggests that the arbitration panel might refer certain matters of domestic law to some other arbitration panel having competence in local law. see 91 of oecd report. the likely effect of such referral would be to prevent the arbitration panel from reaching a final resolution of the matters before it. [vol. 7:9 comments on the oecd proposal own proposal. that proposal, by its own terms, will provide for resolution of a dispute only when the taxpayer, at its sole discretion, elects to invoke arbitration. i assume that the oecd did not propose to make arbitration mandatory in all cases because it did not want to provoke opposition from taxpayers. that solicitude for the interests of taxpayers is both unwise and unwarranted. it is unwise because it gives taxpayers one more lever to game the system. it is unwarranted because taxation is not about doing nice things to please taxpayers. if treaty partners have an interest in resolving their treaty disputes, as the oecd alleges, then they should not refrain from doing so simply to please some disgruntled taxpayers. as suggested above, the potential costs of perfection resolving all competent-authority cases are high. in contrast, for reasons discussed below, the costs of tolerating some imperfection in the competent-authority mechanism may be fairly small. not knowing the particulars of any of the actual cases that do not get resolved, i obviously cannot make anything close to a full assessment. still, i can suggest a general framework for analysis. b. unsettled cases of potential double non-taxation the non-resolved competent-authority cases necessarily fall into two categories: (1) cases of potential double taxation, and (2) cases of potential double non-taxation. i suspect that the majority of the unresolved cases fall into the second category. i have no data on unresolved cases, of course, because the whole competentauthority process is secret. but i have known a lot of tax administrators over the years. in general, the ones i have known do not like double taxation, and they do not like double non-taxation. so, it seems plausible to me that they generally would be inclined to compromise with their counterparts to settle double taxation cases but might occasionally dig in their heels when asked to facilitate double non-taxation. double non-taxation cases are themselves common and are often the goal of sophisticated tax planning. as an example, assume that country a exempts capital gains and country b does not. country b, however, has a tax treaty with country a that exempts some but not all capital gains earned in country b by a resident of country a.7 the taxpayer, a resident of country a, 7. see oecd model tax convention, supra note 3, art. 13, 5 ("gains from the alienation of any property, other than that referred to in paragraphs 1, 2, 3 and 4, shall be taxable only in the contracting state of which the alienator is a resident."). 2006] florida tax review earns a capital gain of $100 million in country b, which it claims is exempt from tax in country b under the tax treaty. the tax officials of country b disagree and have a reasonable basis for that disagreement. the taxpayer asks the competent authorities of country a to intervene on its behalf, claiming that taxation by country b is "not in accordance with" the treaty.' if the matter were to go to arbitration and the taxpayer were to win, the result would be international double non-taxation. no one would contend that taxpayers should be denied treaty benefits to which they clearly are entitled on the ground that granting the benefit would result in tax avoidance. if a taxpayer believes that it is entitled to a treaty benefit and the government believes otherwise even after consultation with its treaty partner, the taxpayer has the right to litigate the matter in the domestic courts. the question is whether the taxpayer should be given the additional option of bypassing the domestic courts and bringing the matter to an international arbitration panel. i think that the oecd should require a compelling reason for giving an affirmative answer to that question. facilitating international tax avoidance does not strike me as a compelling reason. the example above illustrates one of the major flaws of the oecd model tax convention its unfortunate role in promoting international double non-taxation. a model tax treaty designed to prevent international tax avoidance should provide that the source country would not relinquish its right to tax unless the residence country, in fact, was exercising its right to tax. the proper long-term solution to that double non-taxation problem is not to devise an arbitration system that guarantees taxpayers the right to avoid taxes even in disputed cases. the better course of action is to revise the model treaty to prevent it from presenting taxpayers with opportunities for double non-taxation. the united nations model tax convention,9 developed to take account of the economic, political, and social circumstances of developing countries, is the only significant competitor to the oecd model. although it is based in part on the oecd model and has incorporated many of its flaws, it does limit to some degree the opportunities for double non-taxation provided by the oecd model. for example, its default rule is that income not addressed by the treaty remains taxable in the source country, whereas the oecd model provides that such income is not taxable in the source country and may not be taxable anywhere. 8. see oecd model tax convention, supra note 3, art. 25, 1. 9. united nations model double taxation convention between developed and developing countries, st/esa/pad/ser.e/21 (2001) http://daccess-ods.un.org/ access.nsf/get?openagent=&ds=st/esa/pad/ser.e/21 &lang=e (last visited, october 16, 2006). [vol 7:9 comments on the oecd proposal many of the double non-taxation cases that arise under tax treaties probably are transfer-pricing cases that is, cases involving a controversy over the prices charged by the taxpayer in dealings with related persons. the oecd proposal indicates that some of the unresolved cases are transfer-pricing cases, although it offers no details. a transfer-pricing case could result in double non-taxation when a high-tax country has a tax treaty with a low-tax country. in such circumstances, a resident of the low-tax country would be inclined to allocate as little income as possible to the high-tax country and as much income as possible to the low-tax country. the tax officials in the high-tax country might disagree with that allocation, and if the tax officials in the low-tax country supported the position of the taxpayer in a competent-authority proceeding, there is at least some chance that the matter would not get resolved. the public policy cost of a failure to resolve such a conflict does not appear to be significant. c. addressing the rare cases of double taxation the oecd, in its discussion of its arbitration proposal, totally ignores the issue of double non-taxation. it seeks to defend its arbitration proposal as a method of preventing double taxation. in general, eliminating such double taxation is a good thing. not all good things, however, are worth the costs of attaining them. one policy question is whether the elimination of double taxation in the rare cases in which it occurs is a good enough thing toj ustify the costs inherent in the oecd's proposal. another policy question is whether some other approach might be taken that would address the problem at lower cost. neither of these policy questions can be answered fully without some information about the rare cases that are not being settled by the competent authorities. as already noted, that information is not being shared with the international tax community. my best guess, nevertheless, is that many of the unsettled cases are transfer-pricing cases. anyone familiar with the transfer-pricing rules, which are promoted with great enthusiasm by the oecd, would anticipate that they would result in some conflicts between taxpayers and tax officials and between the tax officials of different countries. the simple fact is that the transfer-pricing rules are broad guidelines, similar in some respects to the broad guidelines that accountants receive from various accounting-standards boards. the end result is that the applicable "law" is indeterminate it is less like law and more like an invitation to negotiate. the official transfer-pricing guidelines promulgated by the oecd favor three transactional methods the comparable uncontrolled method, the resale-price method, and the cost-plus method. these methods, by their own terms, rarely are applicable to transactions involving intellectual property. 2006] florida tax review because many multinational companies earn most of their income from the exploitation of intellectual property, those transactional methods have limited applicability. the other transfer-pricing methods, begrudgingly endorsed in the oecd guidelines, can be applied in more cases. their application, at best, gives a range of possible transfer prices, not a definitive arm's length price. moreover, the taxpayer is not compelled to pick any particular method and has discretion to invent its own method in many circumstances. in this legal setting, disputes over transfer prices are inevitable. and the stakes are high, sometimes measured in the hundreds of millions of us dollars."0 the oecd finding that unresolved competent-authority cases are rare is exceptionally good news, given the fundamental flaws in the oecd's transfer-pricing rules. still, the oecd wants to eliminate the remaining unresolved cases through its arbitration proposal. as noted above, transfer-pricing cases present problems under tax treaties because the basic rules are indeterminate. the preferred long-term solution is not to make up numbers out of whole cloth. it is to fix the rules. i will not discuss here the many methods that might be employed to reform or replace the transfer-pricing rules." the basic solution is to provide unambiguous default rules that would apply whenever the other rules would produce an indeterminate result. an alternative solution, attractive in the short-term, is simply to leave unresolved the rare cases that are not resolved through the competent-authority procedure. the result would be some possibility of unfairness. no system, however, can expect to eliminate all possibilities of unfairness. moreover, the risk of serious unfairness is small. multinational companies that play clearly within the rules, without engaging in aggressive tax avoidance, are not likely to end up with unrelieved double taxation due to their choice of transfer prices. it is mostly the companies that play the transfer-pricing game aggressively that find themselves at risk. they undoubtedly have calculated that they end up better off by running the 10. the well-publicized case of glaxosmithkline plc, the british pharmaceuticals giant, illustrates the huge amounts that can be at issue in a transfer-pricing case. the case, involving tax years 1989 to 2005, was settled in 2006, with glaxo agreeing to pay the irs $3.4 billion. the u.k. did invoke the competent-authority procedure in the u.s.-u.k. tax treaty. it does not appear, however, that glaxo claimed that it was subject to double taxation. robert guy matthews and jeanne whalen, "glaxo to settle tax dispute with irs over u.s. unit for $3.4 billion," wall street journal, sept. 12, 2006 at a3. 11. the preferred solution is to abandon the arm's length method entirely. see michael j. mcintyre, "the use ofcombined reporting bynation states," 35 tax notes int'l 917 (sept. 6, 2004). many less radical steps can be taken, however, to reform the transfer-pricing rules. [vol. 7:9 comments on the oecd proposal risk of the occasional unrelieved double tax in order to maximize their opportunities for double non-taxation. i am prepared to assume that these very clever people, who have millions of tax-planning dollars at their disposal, have figured the odds correctly. in most transfer-pricing cases, a failure of the competent authorities to reach agreement does not leave the taxpayer without a remedy. the taxpayer can always go to court in the country assessing the allegedly unfair tax and challenge the assessment. it is possible, of course, that the domestic courts in the two countries will produce inconsistent outcomes, ultimately resulting in unrelieved double taxation. from reading many transfer-pricing cases, however, i think that the risk is a modest one. transfer-pricing cases are exceedingly difficult cases for the government to win, for a variety of reasons. among those reasons are that tax departments are typically "outgunned," they have difficulty discovering relevant facts under the taxpayer's control, and they have to contend with rules that were designed to give maximum flexibility to the taxpayer. il. secret arbitration: oecd endorsement of opaqueness the single most objectionable feature of the oecd proposal is its provision for total secrecy. even the names of the taxpayers engaging in the arbitration proceedings would be kept secret. no information would be released about the results of the arbitration or the basis for the decision of the arbitrators without the expressed, written consent of the affected taxpayers. even with taxpayer consent, which can be expected to be withheld in many cases, only a bare outline of the case is likely to be released to the public. the taxpaying public, nevertheless, would be asked to pay all of the costs of the arbitration proceeding. 2 12. tax officials in the u.s. and germany recently negotiated a protocol that would amend the u.s.-germany treaty to provide for arbitration. the arbitration is not fully mandatory in that the parties by mutual agreement may decide not to arbitrate a particular matter. the proposed protocol provides for full secrecy of the proceedings and does not require the arbitrators to prepare a report. instead, the arbitrators simply pick between the settlement proposals made by the two parties. the outcome of the arbitration, however, is disclosed only to the concerned taxpayer and its representatives, again under a requirement ofconfidentiality. only enumerated issues, including transferpricing disputes, are subject to arbitration. see protocol amending the convention between the united states of america and the federal republic of germany for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital and to certain other taxes, june 1, 2006. available at http://www.treas.gov/press/releases/reports/germanprotocolo6.pdf(last visited oct. 17, 2006). 2006] florida tax review in recent years, the oecd has been a champion for transparency in international transactions. a much bloodied champion, i might add. its efforts to open up the secret books of financial institutions that have been enabling tax fraud have brought it under attack in many countries. 3 so, this step back into opaqueness is an unwelcome development. the reason for it, however, is not difficult to divine. my best guess, with no insider information, is that early drafts of the oecd proposal provided for reasonable disclosure. after all, the oecd surely understands that an arbitration system that is viewed by the international tax community as a "black box" will not achieve much credibility and will be useless in providing guidance in related cases. it should be aware of the substantial risks of fraud from a secret procedure. and the obvious model for the oecd to look to in fashioning an arbitration procedure for international tax matters is the highly-regarded arbitration system developed by the world trade organization (wto). the wto arbitration procedures deal with issues at least as sensitive as those to be addressed in resolving international tax disputes. the wto procedures are undoubtedly more refined than would be required for dealing with the rare cases that do not settle through the competent-authority mechanism. these procedures are particularly noteworthy, nevertheless, for providing a commendable degree of transparency. i certainly recognize that multinational companies love secrecy. they pressured the u.s. internal revenue service (irs) to keep its advanced pricing agreements secret, although the law required that redacted version of those agreements be made available to the public. 4 i do not know whether the oecd 13. for example, a contingent of lobbyists representing certain u.s. business interests recently recommended to president george w. bush that the united states eliminate its financial support of the oecd as punishment for the oecd's efforts at curtailing tax-haven abuses. see coalition for tax competition, coalition for tax competition urges white house to defund the paris-based oecd, at http://www.freedomandprosperity.org/press/p02-09-06/ p02-09-06.shtml (feb. 9,2006). 14. the irs litigated the issue, resulting in a decision against it and in favor of transparency. see bureau of nat'l affairs, inc. v. comm'r, 24 f. supp. 2d 90, 93 (d.d.c. 1998). the multinational companies then launched an aggressive lobbying campaign that ultimately led a subservient congress to overtum the courts and provide total secrecy to advance pricing agreements. see irc § 6103(b)(2)(c). for discussion of the importance of transparency in the apa process, see michael j. mcintyre, "irs affirms plans for developing secret tax law on transfer pricing," 3 tax notes int'l 267 (mar. 1991); michael j. mcintyre, "what's in a name?" 3 tax notes int'l 29 (jan. 1991); and michael j. mcintyre, "the case for public disclosure of advance rulings on transfer pricing methodologies," 2 tax notes int'l 1127 (nov. 1990). see also joel d. kuntz & robert j. peroni, 1 u.s. international taxation a3-275 (2005) ("judging by the fear of sunshine, it seems quite possible that this body of secret law contains some special treatment for certain taxpayers."). for an unnerving account of the abuses of a [vol. 7:9 comments on the oecd proposal staff simply anticipated the opposition of the multinationals and compromised in advance or gave ground bit by bit. in any event, the victory for the multinationals has been complete. the normal starting point, in designing an international arbitration system for public institutions, would be total transparency. following the wto model, the hearings should be open to observers, the submissions of the parties should be available publicly, and the decision of the deciding body should be available publicly. by the wto standard, the oecd proposal is wrong in every particular. an alternative model that the oecd undoubtedly looked at is the eu arbitration convention, ," which applies only to transfer-pricing disputes. that convention provides for a secret procedure, with the report of the arbitration panel to be published only with the consent of the taxpayer. i find this model to be objectionable for the same reasons i object to secrecy in the oecd model. few cases have been decided under the eu arbitration convention. 6 taxpayers are not entitled under the convention to obtain the benefits of double non-taxation. 7 that limitation may explain, in part, its lack of use. as noted above, nothing not even the names of the affected taxpayers can be made public under the oecd proposal without the consent of the taxpayer. the taxpayer, of course, is a non-party; the parties to the arbitration are the affected governments. yet, the credibility of the arbitration procedure is held hostage to the desire of the non-party for total secrecy. the rest of the secrecy rules are of limited importance, once the taxpayer is given total control over the release of information. the fact that these additional rules are even in the proposal has led me to speculate that secret tax law, see martin lobel, lee ellen heifrich, henry m. banta, and jeanane m. jiles, u.s. transfer pricing and oil royalties: a cautionary tale, 19 tax notes int'l 177 (july 12, 1999). 15. the official name of that convention is convention on the elimination of double taxation in connection with the adjustment of profits of associated enterprises. it was signed in 1990, went into effect for a five-year period at the start of 1995, and lapsed at the end of 1999. it was renewed retroactively from 2000 to 2004 and then lapsed again. in 2004, it was renewed and extended to new member states of the eu. 16. see eu joint transfer pricing forum, report on the re-entry into force of the arbitration convention, doc: jtpf/019/rev5/2004/en (may 30, 2005) at p. 4, 14 (reporting that only two cases have been referred to an arbitration panel and only one case, between france and italy, has been decided by a panel). 17. see eu arbitration convention, article 14 (providing that double taxation is considered to be eliminated if the profits of the taxpayer are included in the computation of income in one contracting state only or a credit is given in one state for the taxes imposed in the other contracting state). 2006] florida tax review earlier drafts contemplated fuller disclosure. because the taxpayer can prohibit the release of any information, the information that might trickle out with the taxpayer's consent is unlikely to be the least bit interesting to the international tax community. still, it is telling that the oecd is unwilling to foster transparency even with the consent of the taxpayer. all that can be released even with consent is a bare bones report that does not disclose the name of the concerned taxpayer or any identifying information about the taxpayer. with taxpayer consent, a sterile summary of the legal issues, totally useless in a transfer-pricing case without the relevant facts, can be released. surely, the oecd contemplated something more useful when it formulated its initial proposal. i am truly astonished that the oecd believes that the taxpayer has a legitimate interest in maintaining the secrecy of its own identity. even the client-lawyer privilege does not protect a lawyer from having to disclose the identity of his client. the oecd is acting as if a public arbitration procedure, financed with public funds and charged with the obligation to decide major issues of public policy, is actually some kind of internal settlement procedure within the tax department. as a result of that flawed perspective, it has promulgated a proposal that is completely inconsistent with the public nature of the arbitration procedure it hopes to establish. i cannot help thinking that the oecd, in endorsing a secret procedure, is acting under heavy pressure from the multinational companies. i do not discount the possibility, however, that some pressure is also coming from member states. government officials do not always welcome public scrutiny of their work. they may feel that such scrutiny not only may be embarrassing in some cases but also may inhibit them from cutting the kinds of deals that they feel they must make to manage their case load. in addition, there are some important oecd countries where the multinational companies are particularly influential. given the potential bias of tax officials and the international business community in favor of secrecy, they should not be the only people at the table when the degree of secrecy in international tax arbitrations is being decided. the transparency of international tax arbitration is a public policy issue that ought to be decided after full public debate. the oecd is to be commended for inviting public comment on its proposal. the challenge now is to ensure that the desirable debate actually occurs and that the final proposal of the oecd embodies the results of that debate. an argument often made for secrecy in arbitration is that the publication of the details of a multinational company's international tax dispute would provide an advantage to the companies with which it competes. this claim is mostly bogus. there occasionally may be some sensitive material, and some measures might be taken to sanitize it. as holden caulfield would say, however, most of the material that would enter the public domain is as sensitive [vol. 7:9 comments on the oecd proposal as a toilet seat. the reason is that the material is likely to be hopelessly dated by the time it needs to be released in a tax dispute. tax disputes ripe for arbitration typically are not about tax issues for the current year, or the prior year, or the year before that. a typical transferpricing case for a multinational company may involve transactions that occurred many years ago. for example, bausch & lomb,"8 the famous u.s transfer-pricing case, was decided by the tax court in 1989. it dealt with an assessment issued in 1985 with respect to tax years ending between 1979 and 1981. the 1980s were the good old days; the lag between the year of the transaction and the resolution of the dispute in court has increased significantly in the last decade, at least in the united states. although speculating about motives is a bit risky, i strongly suspect that the aversion of multinational companies to public litigation has far more to do with its concerns for public relations, push-back from tax reformers, and audit exposure in third countries than any concerns about competitive advantage. these fears may be rational. after all, the disclosures coming from the bausch & lomb case helped shape new transfer-pricing regulations in the united states, and that regulation project gave impetus to the development of the oecd transfer-pricing guidelines. the oecd, however, should not seek to accommodate these fears of bad publicity, political backlash, and third-country audit exposure. on the contrary, the possibility of these consequences highlights the importance to public welfare of a transparent procedure for resolving public tax disputes. the reason for the oecd's proposal for secrecy is not craven subservience to the multinational corporations. it is a concern that an open procedure would be shunned by the multinational companies. that concern is well-founded. indeed, i strongly suspect that the major motive of the multinationals in promoting arbitration is to obtain a forum outside the control of the tax departments for resolving international tax disputes in secret. if the multinational companies were willing to make their case in public, they would do so in the domestic courts of the country assessing the challenged tax. 9 the basic issue for the oecd to decide is a simple one. should the multinational companies be given a secret forum in which they can litigate their tax disputes? the clear answer, from a public policy perspective, is "no." if that answer means that the oecd's arbitration initiative ends up having no 18. bausch & lomb, inc. v. comm'r, 92 t.c. 525 (1989), aft'd, 933 f.2d 1084 (2d cir. 1991). 19. public litigation of complex transfer-pricing cases has virtually ceased in the united states. to the best of my knowledge, no major transfer-pricing case dealing with rich factual issues has been litigated in the united states since the publication of the revised transfer-pricing regulations in 1994. 2006] florida tax review caseload, so be it. the oecd frankly acknowledges that the cases not resolved under the existing mechanism are rare. as discussed above, it is highly unlikely that grave injustice is occurring with any frequency even in those rare cases. in the exceedingly rare case that presents the potential for grave injustice, a public procedure could serve as a useful safety value. citizens have a right to know what their government is doing in their name. everyone understands the need for secrecy in some cases. the public's right to know public business is not absolute. in addition, taxpayers do have legitimate privacy rights in settling their tax obligations, although the legitimate rights of public corporations to privacy are frequently overstated. those privacy rights obviously are not absolute. they end when the taxpayer challenges the determination of the government in an independent forum. that is the universal rule for domestic courts, and that rule is fundamental to the legitimacy of the decisions reached by those courts. the rationale for that rule is even stronger when the independent adjudication is undertaken by an international body, due to the greater problems that such a body is likely to have in achieving legitimacy. defenders of secrecy are likely to argue that secrecy is a normal feature of an arbitration procedure. it is certainly true that most domestic arbitration proceedings are secret. the analogy to domestic arbitrations, however, is inappropriate.2" domestic arbitrations are typically between private parties, the costs of the arbitration are privately financed, and the issues being resolved are private disputes. in sharp contrast, the oecd is proposing an international body that would be charged with the responsibility of deciding the amount of tax due to sovereign states. that dispute is a public dispute, the costs of resolving it are charged to the public, and the parties to that dispute (the governments) are public bodies accountable to their citizens. those who find force in the analogy between the oecd's proposal and private arbitration might consider the factors typically considered in deciding whether private arbitration is an appropriate mechanism for resolving a particular dispute. i list below the factors that specialists in dispute resolution 20. see william w. park, "income tax treaty arbitration," 10 george mason law rev. 803, 823 (2002) ("without exception, all major institutional rules for international commercial arbitration (icc, lcia, aaa international, uncitral, icsid and geneva chamber of commerce) require arbitrators to state the grounds for their decision unless the parties explicitly opt out of a reasoned award... .on balance, tax arbitration probably should require arbitrators to explain themselves. while this will make their job harder, and in practice mean exposure to a greater degree of judicial scrutiny, the end product will be a better decision.") (hereinafter "park"). [vol. 7:9 comments on the oecd proposal typically would take into account in deciding whether to recommend private arbitration.2 1. neither party to the dispute has an interest in a public resolution of the dispute that would have value as a precedent in resolving similar disputes. 2. arbitration would reduce the risk for one or both parties of an unpredictable and catastrophic result. 3. the case in arbitration would be adjudicated by people better able to handle difficult technical matters. 4. one or both parties needs to be able to control case-scheduling issues and would be able to do so more effectively in the arbitration proceeding. 5. a complete and final resolution of the dispute can be achieved in arbitration and cannot be achieved otherwise within a reasonable time. 6. one or both parties wishes to limit discovery in the case. 7. the costs of arbitration are lower than the costs of the alternatives. i if all or most of these factors are present, then arbitration is likely to be appropriate, whereas if many of the factors are not present, arbitration is inappropriate. i think it fair to say that all or most of these factors are not present for the international arbitration proceedings contemplated in the oecd proposal. in many cases, the two countries would welcome a public precedent that interpreted the provision of a tax treaty. the oecd proposes that the arbitration decision would not even affect the resolution of an identical issue with the identical taxpayer in a subsequent year.22 the parties to an oecd-type arbitration are not seeking to avoid risk, such as the risk of a high damage judgment in a tort case indeed, the oecd's arbitration procedure is more likely to present special risks. although the arbitrators are likely to be competent technically, so also are the likely adjudicators in any alternative proceeding. case scheduling is likely to be more difficult in arbitration, given the tight deadlines and the likely scheduling problems of busy arbitrators. the oecd does make some effort to provide 21. see jay folberg et al, resolving disputes: theory, practice, and law, aspen (2005) at 460-461 (drawing on guidelines for arbitration prepared by the cpr institute for dispute resolution). 22. see oecd proposal, supra note 1, 57. 2006] florida tax review finality to an arbitration result, by requiring the taxpayer to agree to forgo domestic appeals. the oecd procedures, however, clearly anticipate that many arbitrations would not give finality. indeed, it would appear that only a small part of a taxpayer's tax liability might be at issue in the arbitration, and no requirement is provided for limiting counterclaims or collateral defenses. limiting discovery, which is often an issue in the context of u.s. private litigation, is unlikely to be a significant reason for seeking international arbitration in a tax case. finally, the costs of an oecd-type arbitration almost certainly would be significant in any transfer-pricing case. high costs are almost guaranteed as a result of the oecd proposal to allow the taxpayer to participate actively in the proceedings. iv. additional flaws in the oecd proposal the total lack of transparency in the oecd's proposed procedure is sufficient to justify strong opposition to it. even if the secrecy problem is addressed and fully rectified, however, the proposal is still far from acceptable. fortunately, most of the remaining flaws are more easily corrected. a. potential bias ofarbitrators one serious flaw, easily corrected, is the failure to provide measures designed to guarantee the impartiality of the arbitration. for example, the arbitrators are not required to disclose possible conflicts of interest, or appearances of such conflicts, nor are they required to refrain from engaging in remunerated activities on behalf of the taxpayer after the conclusion of the arbitration. each side is expected to name one arbitrator, typically from its own tax office. neutrality is not expected from that arbitrator. the proposed commentary states that the third arbitrator should "act in total neutrality and independence."23 it provides no mechanisms, however, for ensuring such a result or for providing redress if that result is not obtained. indeed, the rules proposed by the oecd would not prevent the oecd or the parties from appointing tax counsel for the taxpayer to serve as the "neutral" arbitrator. although such a result is unlikely in the extreme, the absence of even minimal anti-conflict rules would undermine public confidence in the system. in private arbitration, conflict issues are generally managed by requiring full disclosure by a potential arbitrator of all real or apparent conflicts.24 the basic idea is that the parties have elected to arbitrate and have 23. oecd proposal, supra note 1, 70. 24. the seminal case in the us requiring disclosure of all apparent conflicts of interest is commonwealth coatings corp. v. cont'l casualty co., 393 u.s. 145 (1968). [vol 7:9 comments on the oecd proposal full autonomy to decide by contract how they wish to proceed. as long as they receive the relevant information, they are free to act as they wish. they may decide, for example, to run some extra risk of having a biased arbitrator in order to obtain the services of an arbitrator knowledgeable about their business. full disclosure of conflicts is certainly a minimum for an international tax arbitration. the oecd, nevertheless, does not mandate any such disclosure. full disclosure, even if mandated, would not be sufficient. the arbitrators in the oecd proposal are expected to do the public's business, not the private business of the non-party taxpayer. the public interest needs to be protected by imposing strict conflict rules, buttressed by enforcement measures designed to give them bite. in particular, it is important that the arbitrators have no significant prior financial dealings with the taxpayer and that they agree not to have any such dealings for a significant period after the arbitration is concluded. to minimize potential conflicts of interest and the appearance of such conflicts, it may be best to exclude tax advisors working for major law firms or accounting firms from serving as the neutral arbitrator. taxpayers undoubtedly would prefer a representative from the private sector to serve as the deciding arbitrator. private-sector arbitrators, however, are unsuitable in many cases because they or their partners and associates are unlikely to be able to avoid all potential conflicts of interest. in addition, many potential arbitrators from the private sector are likely to view the taxpayer as the real party to the dispute and may seek a solution that focuses too heavily on the concerns of the taxpayer and too lightly on the concerns of the actual parties. in principle, the parties could select as the neutral arbitrator a person who is not expert on international tax matters but is experienced in running an arbitration proceeding. it is unlikely, however, that most governments would be willing to trust a complex international tax case to a professional arbitrator, whatever the merits of doing so might be. if the parties conclude that expertise in international tax is required, they probably should pick as the neutral arbitrator a tax official or an academic specialist from some third country. b. participation by non-party taxpayers another serious flaw in the oecd proposal is the provision allowing the taxpayer to submit a brief and to participate, with the permission of the arbitrator, in the actual proceedings. non-parties to an arbitration proceeding should be treated as non-parties. this provision again suggests that the multinational companies are using the oecd as a wedge to obtain a secret and quasi-judicial hearing of their tax dispute outside the control of the tax departments of the taxing states. this backdoor creation of a special forum is both unwarranted and highly dangerous. the only valid goal of the oecd's arbitration procedure is to force the parties to the treaty to resolve their dispute 2 006] florida tax review on how the treaty should be applied in the case before them. they do not need a non-party to direct them how to do so. and no country should be asked to run the risk that its court system will be bypassed in favor of some secret international forum. if the non-party taxpayer is allowed to participate in the arbitration proceeding, its legal staff may end up dominating that proceeding in many cases, simply due to the resources the taxpayer will be able to bring to bear on the matter.z5 it may be precisely for that reason that the multinational corporations are pressuring the oecd to accede to their demand to be treated functionally as a party to the litigation. the informality and collegiality that ought to prevail in such a hearing would be lost. the proper rule should be that the non-party taxpayer is treated as an observer. if third party observers are permitted to present briefs or participate in the proceedings, the same rights should be extended to the taxpayer. otherwise, the taxpayer should be allowed to participate only through its correspondence with the competent authority of its country of residence. c. unrealistic time limits under the oecd proposal, a case is sent to arbitration if the competent authorities do not resolve it themselves within two years, and the arbitrators are required to decide the case before them within six months.26 if the arbitrators do not decide the case within the 6-month time limit, the parties may extend the time limit for another six months or replace the arbitrators.27 these time limits are realistic in some cases but are unrealistic for complex transfer-pricing cases. the interest of the oecd in imposing tight time limits for a decision by the arbitrators is understandable. in this one respect, the oecd has followed the wto model. the arbitrators in a wto panel hearing, however, are facing a substantially different situation than the one that the arbitrators in an oecd arbitration would face. the goal of the wto arbitrators is to judge the conduct of the parties. they can put pressure on the parties to cooperate fully and can sanction them in various ways for non-performance of their obligations. the oecd arbitrators, however, are asked to judge the conduct of the non-party taxpayer. in some simple cases, the taxpayer can be expected to give full 25. for a close-to-home example, the oecd might ponder what happened with its e-commerce initiative when it allowed the private sector to assume a major organizational role. to the outside world, it appeared that the private sector took over the effective management of that project, even to the point of getting material inserted into the commentary that would be helpful to multinational companies in avoiding the cfc rules of the united states. 26. see oecd proposal, supra note 1, 93. 27. oecd proposal, supra note 1, 93. [vol. 7:9 comments on the oecd proposal cooperation; and, in cases of recalcitrance, the arbitrator may have the ability to impose sanctions, perhaps by making evidentiary presumptions against the taxpayer. in complex transfer-pricing cases, however, the oecd arbitrators will be heavily dependent on the taxpayer for providing relevant information and will be hamstrung if that information is not provided in timely and usable form.28 the oecd proposal anticipates the problem by providing for a stay of the time clock for any delays caused by the taxpayer. that solution is inadequate because multinational corporations are fully prepared to provide a few hundred cartons of records on request. what the arbitrators need is usable information. that means they need full access to the electronic books and records of the taxpayer and its affiliates, plus access to the software used by the taxpayer in manipulating those books. they need all of the reconciliation data showing the relationship of taxable income to income on their financial statements. the oecd proposal, however, gives no guidance on the data that a taxpayer is expected to produce or the form in which it must be produced. although i favor speedy resolution of disputes, i do not favor strict deadlines that provide procedural benefits to taxpayers. most tax administrators are anxious to resolve cases expeditiously. they fail to achieve that goal in some cases for a variety of good reasons, including a heavy workload, taxpayer recalcitrance, and the general complexity of the issues under review. those problems are not even addressed by the imposition of strict time deadlines. in a complex transfer-pricing case, the matter should not go to arbitration until the factual record has been established and stipulated to by the parties and the taxpayer. otherwise, the arbitrators are required to determine the facts a process that takes many years for tax officials to accomplish. an arbitration board cannot be expected to do that type of work in six months. with the short deadline contemplated by the oecd, all that the arbitrators can be expected to do is pull some compromise number out of the air. d. lack of procedural rules governing arbitration an arbitration proceeding, to function smoothly, needs to have rules of engagement. in private arbitrations, the parties frequently incorporate by reference the detailed rules developed by various arbitration groups, such as the american arbitration association, the international chamber of commerce, the london court of international arbitration, the cpr institute for dispute 28. in the glaxo case, discussed supra note 10, the company had turned over 5 million pages of internal documents to the irs by 2002. glenn r. simpson, "glaxo in major battle with irs over taxes on years ofu.s. sales," wall street journal, june 11, 2002, page 1. 2006] florida tax review resolution, and the judicial arbitration and mediation services. the oecd notes that the arbitrators in an international tax dispute might incorporate such rules, mentioning by name the icc. its general rule, however, is that the arbitrators are to develop their own procedural rules on a case-by-case basis. leaving to the arbitrators the job of developing ad hoc rules for each arbitration proceeding is a decidedly bad idea in my view. i support a full grant of authority to the arbitrators to set their own rules. any other approach might compromise the finality of the decision of the arbitrators. but the arbitrators should not be left without detailed guidance in selecting the rules of engagement. in the typical case, the arbitrators are likely to be tax professionals, not professional arbitrators. having them formulate their own rules of procedure as they go along will severely compromise their ability to meet their strict time deadlines. the experience of private arbitration in the united states clearly shows that inexperienced arbitrators should not be devising procedural rules on the fly. they should adopt an approved set of rules developed by professionals, which they can then adapt as circumstances warrant. e. some additional criticisms the oecd proposal is long and complex, and this brief report does not do itjustice. i have emphasized the features of the proposal i find objectionable or unworkable and have largely ignored the features that deserve praise. my purpose is not to give an overall evaluation of the proposal but to point out areas that i believe need fixing or, in the case of the secrecy rules, a fundamental change in direction. in closing, i offer the following additional brief criticisms. 1. reimbursement for wasted expenses. i understand the rationale for requiring the parties to foot the bill for the arbitration proceedings. it is inconsistent with that rationale, however, to treat the taxpayer as if it were also a party. in any event, the rationale is inapplicable when the taxpayer, after instigating the arbitration procedure, takes advantage of domestic law to challenge the decision of the arbitrators in the domestic courts. in such an event, the taxpayer has wasted the time and resources of the two governments and should be required to reimburse them for the full cost of the arbitration.29 29. for a similar suggestion, see ault, supra note 5 at 147 (2005) ("it might also be possible to stipulate that the taxpayer would have to bear the costs of the arbitration procedure if he subsequently refused to be bound by the procedure which [vol. 7:9 comments on the oecd proposal the recoverable costs should include a reasonable allowance for the time of the tax officials involved in preparing their government's case. 2. respect for tax officials. the negative tone directed at tax officials in the oecd report is palpable. portions of the report sound like they were drafted by the international chamber of commerce. for example, in paragraph 9, the report suggests that tax officials have "no incentive" to settle disputes in the absence of the threat of binding arbitration.30 that claim is obviously wrong and demeaning. tax officials have very strong incentives to settle disputes and achieve fair results, and they do so, according to the oecd, except in rare cases. 3. government avoidance of mutual assistance procedure. the claim of the oecd that the existence of an arbitration procedure will encourage governments to use the competent-authority mechanism3' is almost certainly wrong in most cases. the oecd arbitration procedure is one-sided, secretive, expensive for the governments, and an intrusion on national sovereignty. most governments will want to avoid arbitration. the oecd believes that this aversion to arbitration will lead to settlement in the rare cases not already being settled. that speculation may be well-founded.32 but the aversion to arbitration also is likely to cause many governments to nip the threat of arbitration in the bud by simply declining to engage in the mutual agreement procedure.33 many governments are already cautious in the use of that procedure. i would anticipate that many governments offered him a solution to double taxation"). 30. oecd proposal, supra note 1, 9. 31. see oecd proposal, supra note 1, 11. 32. professor park makes a similar prediction. see park, supra note 20 at 804 ("like dr. johnson's proverbial hanging, the prospect of arbitration would serve to focus the minds of the administrative authorities to find a sensible solution, for fear of seeing the matter taken out oftheir hands altogether for decision by a neutral tribunal."). 33. article 6(2) of the eu arbitration convention permits a party to avoid invoking the competent-authority procedure in the first instance unless "the complaint appears to it to be well-founded." article 25(2) of the oecd model tax convention imposes an obligation on a party to invoke the competent-authority mechanism only "if the objection [of the taxpayer] appears to it to be justified." oecd model tax convention, supra note 2, art. 25, 2. 20061 florida tax review will find an added reason for caution if they face the risk of mandatory arbitration. 4. lack of reciprocity. arbitration is usually a reciprocal arrangement. the oecd proposal lacks that feature. the taxpayer, and the taxpayer alone, can initiate arbitration. i would not give that authority to the taxpayer the power to invoke arbitration should be reserved for the parties. i understand the oecd's motive for the asymmetrical rule. it wants to give the taxpayer a club to force tax officials to resolve its issue. that rule, nevertheless, is foreign to the structure of arbitration. in private arbitration, the usual rule is that arbitration is by consent of the parties. some courts do mandate arbitration, but then the results of the arbitration typically are not binding on the parties. at a minimum, if the taxpayer is given the right to invoke arbitration, then the parties should have the same right. the one-sided feature of the oecd proposal is not tenable. 5. selection of neutrals. the oecd proposed to make itself the agency for appointing arbitrators when the parties fail to do so. in my view, that "mission creep" on the part of the oecd is unwise. the oecd has no particular competence for accomplishing thatjob. more importantly, it does not have the necessary credibility, with many governments or with many taxpayers. it is a highly political organization, by design. that characterization is not meant as criticism -just descriptive of its history and purpose. i concede that the oecd is a better choice than some of the alternatives likely to be suggested by the international business community. still, i would anticipate that a small country entering into an arbitration with a country that has a dominant political position in the oecd would not believe that the appearances of neutrality were being observed if the oecd picked the deciding arbitrator. 6. legal status of commentary. i would respectfully suggest that the oecd might consult with experts on international law before assuming that the oecd commentary, as periodically amended, would be viewed as highly relevant in interpreting a tax treaty under the vienna convention on the law of [vol. 7:9 comments on the oecd proposal treaties.34 the longstanding position of the oecd is that the commentary, as amended, should be viewed as part of the context of the treaty in interpreting a treaty based on the oecd model tax convention, even with respect to the changes in the commentary occurring after the treaty came into force. this so-called ambulatory view of treaty interpretation is sound policy; unfortunately, it is not supported by some commentators and some domestic courts. the arbitrators need to reach their decision based on the actual status of the commentary under local law, not on the basis of the oecd's preferred treatment of the commentary under local law. 7. taxpayer treated as party. the oecd recognizes that the parties to a dispute under the mutual agreement procedure are the contracting states, not the taxpayer that invoked the procedure. it then asserts that "when the process moves to arbitration, the person who presented the case [the taxpayer] is more of a direct participant."35 if the oecd is simply being descriptive of the procedure it envisions, i agree. that de facto treatment of the taxpayer as a participant is one of the many flaws in the proposal. if the point of the assertion, however, is that the move to arbitration justifies the treatment of the taxpayer as a participant, i strongly disagree. the taxpayer simply is not a party to the dispute and should not be treated as a de facto party. 8. language of arbitration. the oecd suggests that an arbitration proceeding might be conducted in multiple languages. experience in private arbitration shows that the disadvantages of that approach are significant. i understand the motive for that proposal governments naturally want to have a proceeding conducted in the language of their country. it is not a problem, aside from cost, to provide for translation. but every effort should be made to get the parties to agree on one official language for an arbitration. 9. premature termination ofarbitration. assuming that the most basic flaw in the oecd proposal its total secrecy is 34. see oced proposal, supra note 1, 89. 35. oecd proposal, supra note 1, 76. 2006] florida tax review corrected, then the oecd ought to rethink its proposal for allowing the parties to terminate an arbitration in mid-stream. the argument made is that, because the parties allegedly control the arbitration, they should be allowed to end it at will if they can agree on a settlement.3 6 that argument has some merit; the parties should be allowed to reach a settlement whenever they wish to do it. it would be bad policy, nevertheless, to allow termination of the proceedings without requiring publication of the resolution of the case. once a proceeding has been initiated, it is a public activity, requiring some minimum public disclosure. v. conclusion for the reasons given above, i do not favor the oecd proposal for mandatory arbitration of international tax disputes and probably would not favor it even if the many flaws in that proposal were corrected. if some form of mandatory arbitration is unavoidable, however, i would fix the various problems discussed above. in addition, i would redesign the oecd proposal as follows: 1. only double taxation cases. i would limit mandatory arbitration to cases involving international double taxation and would exempt from mandatory arbitration all cases involving international double non-taxation.37 given the high costs of the program, including the costs of reduced sovereignty, i see no good reason for mandating arbitration when the end result would be to increase international tax avoidance.3" 2. finality required. i would limit the cases of mandatory arbitration to those cases that can be settled with finality by the arbitrators. finality is one of the hallmark features of arbitration. if the domestic law of one of the parties or the particular circumstances of the taxpayer prevent finality, then 36. see oecd proposal, supra note 1, 98. actually, the parties do not have control of the arbitration under the current oecd proposal; on the contrary, arbitration is triggered by an election of the taxpayer. 37. this is the position taken in the eu arbitration convention. 38. defenders of mandatory arbitration invariably point to the public benefit from a reduction in double taxation as the primary justification for their position. see, e.g., park, supra note 20 at 863. double non-taxation is harmful to the public interest by distorting trade flows and reducing government revenues inappropriately. [vol. 7:9 comments on the oecd proposal i would not allow the taxpayer (or a government) to invoke the procedure. to achieve finality, the arbitrators need to be able to determine (1) the amount of tax the taxpayer must pay and (2) the government that should be allowed to collect that tax. 3. certainty of collection. i would require the taxpayer, as a condition for invoking the arbitration procedure, to provide a surety for the higher of the taxes assessed by the parties. that is, the surety should be enough to guarantee payment of the maximum tax that would be due if double taxation is eliminated and the party claiming the higher tax prevails. 4. transparency. finally, as noted numerous times in this report, i would require that the arbitrators prepare a full report that sets forth the controlling facts and explains in appropriate detail the legal basis for their decision. most importantly, this report should be made public, redacted only to protect the confidentiality of trade secrets. as the oecd has recognized in other contexts, transparency is a condition for legitimacy. an adjudicative system that lacks legitimacy is simply unacceptable in a democratic society. i do not suggest that a revised arbitration proposal embodying the above suggestions would be ideal. i do suggest that it would be a significant improvement over the proposal under discussion by the oecd. i recognize that my proposed system would be less appealing than the oecd proposal to the international business community. but as edmund burke famously noted, "to tax and to please, no more than to love and to be wise, is not given to men." 2006] * professor of law, university of houston law center. ** clarence j. teselle professor of law, university of florida fredric g. levin college of law. 81 florida tax review volume 6 2003 special issue recent developments in federal income taxation: the year 2002 ira b. shepard* martin j. mcmahon, jr.** accounting .............................................................................................. 83 a. accounting methods .......................................................... 83 b. inventories ......................................................................... 87 c. year of receipt or deduction ............................................ 87 d. installment method ............................................................ 90 ii. business income and deductions ........................................... 90 a. income ............................................................................... 90 b. deductible expenses versus capitalization ....................... 91 c. reasonable compensation ................................................ 94 d. miscellaneous expenses .................................................... 94 e. depreciation and amortization ......................................... 98 f. credits ............................................................................. 100 g. natural resources deductions & credits ....................... 101 h. loss transactions, bad debts and nols ........................ 102 i. at-risk and passive activity losses ................................ 104 iii. investment gain ...................................................................... 106 a. capital gain and loss .................................................... 106 b. section 121 ...................................................................... 108 c. section 1031 .................................................................... 111 d. section 1033 .................................................................... 112 e. section 1041 .................................................................... 113 iv. compensation issues .............................................................. 116 a. fringe benefits ................................................................ 116 b. qualified deferred compensation plans ........................ 119 c. nonqualified deferred compensation, section 83, and stock options ......................................... 121 d. individual retirement accounts ...................................... 123 v. personal income and deductions ....................................... 124 a. miscellaneous income ..................................................... 124 b. profit-seeking individual deductions ............................. 125 c. hobby losses and § 280a home office and vacation homes ............................................................................. 127 d. deductions and credits for personal expenses .............. 128 e. education: helping pay college tuition (or is it helping colleges increase tuition?) .................................. 128 vi. corporations ........................................................................... 129 a. entity and formation ...................................................... 129 b. distributions and redemptions ....................................... 130 c. liquidations .................................................................... 131 d. s corporations ................................................................ 131 e. affiliated corporations ................................................... 133 822003] recent developments in federal income taxation f. reorganizations and corporate divisions ...................... 139 g. personal holding companies and accumulated earnings tax ................................................................... 144 h. miscellaneous corporate issues ..................................... 145 vii. partn ersh ips ............................................................................ 145 a. formation and taxable years ......................................... 145 b. allocations of distributive share partnership debt, and outside basis ............................................................ 146 c. distributions and transactions between the partnership and partners ................................................ 147 d. sales of partnership interests, liquidations and merges ...................................................................... 147 e. inside basis adjustments ................................................. 147 f. partnership audit rules .................................................. 147 viii. tax shelters ............................................................................ 148 a. tax shelter cases ............................................................ 148 b. identified “tax avoidance transactions” ......................... 153 c. disclosure and settlement ............................................... 156 ix. exempt organizations and charitable giving ............... 159 a. exempt organizations .................................................... 159 b. charitable giving ........................................................... 161 x. tax procedure ......................................................................... 162 a. penalties and prosecutions ............................................. 162 b. discovery: summonses and foia ................................... 164 c. litigation costs ............................................................... 165 d. statutory notice ............................................................... 166 e. statue of limitations ....................................................... 167 f. liens and collections ...................................................... 168 g. innocent spouse .............................................................. 172 h. miscellaneous .................................................................. 177 xi. w itholding and excise taxes .............................................. 182 a. employment taxes .......................................................... 182 b. self-employment .............................................................. 183 c. excise taxes .................................................................... 183 xii. tax legislation ....................................................................... 183 a. enacted ........................................................................... 183 b. pending ........................................................................... 184 2003] recent developments in federal income taxation 83 1. this outline is based on prior current developments outlines presented by the authors at numerous continuing legal education conferences over the past year. among the conferences at which one or both of the authors presented current developments based on this outline during the year 2002 are the following: aba tax section midyear meeting, american institute on federal taxation, american petroleum institute, denver tax institute, houston bar association tax section, university of montana tax conference, university of north carolina tax institute, south carolina bar association tax section, southern federal tax institute, university of texas tax conference, state bar of texas tax section, tax executives institute, tennessee tax institute, texas society of cpas (austin chapter) institute, tulane t ax institute, university of virginia conference on federal taxation, wednesday tax forum (houston), william & m ary tax conference. this current developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the year 2002.1 most treasury regulations, however, are so complex that they cannot be discussed in detail; only the basic topic and fundamental principles are highlighted. amendments to the internal revenue code generally are not discussed except to the extent that they have either led to administrative rulings and regulations or have affected previously issued rulings and regulations otherwise covered by the outline. the outline focuses primarily on topics of broad general interest – ¾ income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, but generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. i. accounting a. accounting methods 1. proposed regulations on adopting and changing taxable years. reg-106917-99, changes in accounting periods, 66 f.r. 31850 (6/13/01). the treasury department has published proposed amendments to regulations under §§ 441, 442, 706, and 1378 regarding the requirement to obtain the approval of the commissioner to adopt, change, or retain an annual accounting period. proposed regs. §§ 1.441-1 through 1.441-4 generally are substantively the same as temp. regs. §§ 1.441-1t through 1.441-4t, including the general rules for the period for computing tax, numerous definitions, and the requirement that partnerships, s corporations, and pscs generally must demonstrate a business purpose and obtain approval to adopt or retain a taxable year other than their required taxable year, but the proposed regulations are reorganized. ! proposed reg. § 1.441-1(c) provides that a taxable year is adopted by filing the first federal income tax return using that taxable year. filing an application for an ein, filing an extension, or making estimated tax payments, indicating a particular taxable year would not constitute an adoption of that year. [rev. rul. 57-589, 1957-2 c.b. 298, and rev. rul. 69-563, 1969-2 c.b. 104, holding that the filing of an extension and estimated tax payments establishes a taxable year, will be superseded.] ! the proposed regulations under § 442 continue to require that the taxpayer demonstrate a business purpose for 84 florida tax review [vol.6:si changing taxable years. the proposed regulations use the term “business purpose” rather than the “substantial business purpose” of the temporary regulations, but, according to the preamble, the treasury department does not intend the change in the language to change the standard. under prop. reg. § 1.442-1(b), form 1128 would have to be filed by the 15th day of the third [rather than second] month of the first effective [the short] year. the automatic approval provisions have been deleted in favor of the standards of rev. proc. 2000-11, 2000-1 c.b. 309, superseded by rev. proc. 2002-37, 2002-22 i.r.b. 1030 (6/3/02), infra. ! proposed reg. § 1.706-1 reflects the 1986 act required taxable year rules and the least aggregate deferral standard. generally speaking, the substantive rules incorporate temp. reg. § 1.706-1t, but the proposed regulations elaborate the standards for determining a partner’s interests in profits and capital for purposes of applying those tests—income interests are determined with respect to taxable income, not book income, and capital interests are determined with respect to a hypothetical liquidation. procedural rules for requesting a year other than a required year have been removed in favor of prop. reg. § 1.442-1 procedures. ! proposed reg. § 1.1378-1 would not implement any substantive changes, but procedural rules for requesting a year other than a required year have been removed in favor of prop. reg. § 1.442-1 procedures. a. regulations are final, w ith minor changes. t.d. 8996, changes in accounting methods, 67 f.r. 35009 (5/17/02). the treasury department has finalized the proposed regulations [in reg-106917-99, 66 f.r. 31850] with a number of technical and clarifying changes. the treasury department specifically rejected abandoning the general requirement of strict book conformity to adopt a year other than a required or ownership year. the final regulations remove from the proposed regulations specific time and manner requirements for filing applications; instead these are published in rev. procs. 2002-37 through 2002-39, discussed immediately below, to permit more flexibility. modifications were made with respect to the 52-53-week taxable year and for closely held reits. the final regulations are effective 5/17/02. b. the irs prom ulgates comprehensive guidance on the adoption, change, and retention of accounting periods. (1) autom atic approval for corporations. rev. proc. 2002-37, 2002-22 i.r.b. 1030 (6/3/02), modified by notice 2002-72, 2002-46 i.r.b. 843 (11/18/02). this revenue procedure provides the exclusive procedures for most corporations to obtain automatic approval to adopt a taxable year. under the revenue procedure a corporation can receive automatic approval of a year based on the 25 percent of gross receipts natural business year standard notwithstanding holding an interest in a pass-through entity. an automatic change is not available (1) if the corporation’s year is under examination or in litigation, or (2) if the corporation has changed its annual accounting period within 48 months prior to the last month of the requested taxable year (unless the change is to a required taxable year, to or from a 52-53week year ending with the same calendar month, to comply with regs. §§ 1.1502-75(d)(3)(v) or 1.1502-76(a)(1), or if the purpose of the change is to file consolidated financial statements with a new owner of a majority shareholder that has changed its year). the lists of ineligible corporations have been expanded. no audit protection is offered under the revenue procedure. rev. proc. 2000-11, 2000-1 c.b. 309, is superseded. 2003] recent developments in federal income taxation 85 (2) expanded automatic approval of natural business year taxable years for pass-through entities and pscs. rev. proc. 2002-38, 2002-22 i.r.b. 1037 (6/3/02), modified by notice 2002-72, 2002-46 i.r.b. 843 (11/18/02). this revenue procedure [which finalizes notice 2001-35, 2001-1 c.b. 1314] provides the exclusive procedures for most partnerships, s corporations, and personal service corporations to obtain automatic approval to adopt a taxable year other than their statutorily required or permitted taxable year. rev. proc. 87-32, 1987-2 c.b. 396, is modified and superseded. there are quite a few significant changes from the earlier procedures. a partnership, s corporation, or psc may change automatically to a natural business year that satisfies the 25 percent gross receipts test, regardless of whether such year results in more deferral of income than its present taxable year. greater flexibility is available to adopt or change from a 52-53-week year. a partnership that would be required to change its taxable year because of a minor percentage change in ownership may retain its current taxable year for one year, subject to certain circumstances. interests of certain tax-exempt entities are disregarded for purposes of determining the ownership taxable year of an s corporation, unless the s corporation is wholly owned by such tax-exempt entities. the due date for form 1128 is the due date of the taxpayer’s return. automatic changes are not available (1) if the entity’s year is under examination or in litigation, or (2) for a change to, or retention of, a natural business year if the entity has changed its annual accounting period within 48 months prior to the last month of the requested taxable year (unless the change is to a required taxable year, to or from a 52-53-week year ending with the same calendar month, or to comply with regs. §§ 1.1502-75(d)(3)(v) or 1.1502-76(a)(1)). if a taxpayer complies with the revenue procedure, however, audit protection for prior years generally is provided. (3) but sometimes you still have to ask, “mr. comm ish, may i.” rev. proc. 2002-39, 2002-22 i.r.b. 1046 (6/3/02), modified by notice 2002-72, 2002-46 i.r.b. 843 (11/18/02). this revenue procedure [which finalizes notice 2001-34, 2001-1 c.b. 1302] provides the exclusive procedures for everyone to establish a business purpose to obtain non-automatic approval to adopt a taxable year other than their statutorily required or permitted taxable year. rev. proc. 85-16, 1985-1 c.b. 517, and rev. proc. 74-33, 1974-2 c.b. 489, are superseded. a business purpose can be established either by a natural business year or by “facts and circumstances,” but the revenue procedure cautions that permission will be granted under the facts and circumstances standard “only in rare and unusual circumstances.” the “natural business year” test in this revenue procedure is significantly more flexible than the natural business year for automatic approval under rev. proc. 2002-38. the “natural business year” can be based on the “annual business cycle” or “seasonal business” tests ending “soon after” [with a one month safe harbor] the “peak” season. alternatively, the natural business year can be established [except by tiered entities] to end with the 2-month period for each of the prior 3 years with the highest percentage of gross receipts equaling or exceeding 25 percent. administrative and business convenience reasons described in rev. rul. 87-57, 1987-2 c.b. 117, will not justify a taxable year; nor will hiring patterns, compensation periods, years based on annual model changes or price lists, competitors’ years, or related entities’ years. a taxpayer other than a partnership, s corporation, or psc [i.e., an individual] that does not establish a business purpose for the requested annual accounting period can be deemed to have established a business purpose if it provides a nontax reason for the requested annual accounting period and agrees to specified additional terms, conditions, and adjustments intended to neutralize the tax effects of any resulting substantial distortion of income. for this purpose, nontax reasons for 86 florida tax review [vol.6:si 2. see wilkinson-beane, inc. v. commissioner, 420 f.2d 352 (1st cir. 1970) (funeral home required to use accrual method because of its business of selling caskets, not merely providing funeral services). the requested annual accounting period may include administrative and convenience business reasons that are insufficient to satisfy the business purpose requirement for a partnership, s corporation, or psc to adopt a taxable year other than its required taxable year. “[a]n individual taxpayer that is not a sole proprietor will be able to establish a nontax reason for a fiscal year only in rare and unusual circumstances.” compliance provides audit protection for prior years. (4) and to top it off , the irs explains its reasons for changes. announcement 2002-53, 2002-22 i.r.b. 1063 (6/3/02). in this announcement, the irs explains the reasons for the various changes in approval procedures in rev. procs. 2002-37, 2002-38, and 2002-39. c. notice 2002-75, 2002-47 i.r.b. 884 (11/25/02). this notice is a proposed revenue procedure that would provide exclusive rules for individuals filing tax returns on a fiscal year to obtain automatic approval to change to a calendar year. it would supersede rev. proc. 66-50, 1966-2 c.b. 1260. d. the small-dollar limit for use of the cash method goes up to $10 million of gross receipts, but with significant exceptions. rev. proc. 2002-28, 2002-18 i.r.b. 815 (5/6/02). this revenue procedure provides guidance under which a qualifying small business with gross receipts of $10 million or less may obtain automatic consent to change to the cash receipts and disbursements method of accounting. it expands notice 2001-76, 2001-2 c.b. 613, to provide that taxpayers whose principal business is the providing of services [including the providing of property incident to those services] are eligible for the cash method, as are taxpayers whose principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications. ! ineligible businesses include ones that derive the largest percentage of gross receipts from any of the following activities: (a) mining activities within the meaning of naics codes 211 and 212; (b) manufacturing within the meaning of naics codes 31-33; (c) wholesale trade within the meaning of naics code 42; (d) retail trade within the meaning of naics codes 44-45; and (e) information industries within the meaning of naics codes 5111 and 5122. for naics codes see http://www.census.gov/epcd/naics/naicscod.txt. ! eligible businesses include those that perform services such as janitorial, medical, veterinary, photo developing, and repairs (including auto repair), as well as restaurants, bars, hotels, and [ironically2] funeral homes. (2) kinder and gentler accounting m ethod change procedures. a. rev. proc. 2002-9, 2002-3 i.r.b. 327 (1/22/02). this revenue procedure provides revised rules for automatic consent to changes in accounting methods. it was amplified and clarified by rev. proc. 2002-54, 2002-35 i.r.b. 432 (9/3/02). 2003] recent developments in federal income taxation 87 b. rev. proc. 2002-18, 2002-13 i.r.b. 678 (4/1/02). this revenue procedure provides revised rules for changes in accounting methods imposed by the irs. c. really kind taxpayer-favorable § 481 adjustments. rev. proc. 2002-19, 2002-13 i.r.b. 696 (4/1/02). this revenue procedure modifies rev. proc. 97-27, 1997-1 c.b. 680, and rev. proc. 2002-9, 2002-3 i.r.b. 327 (1/22/02). it revises the revised rules for obtaining the irs’s consent to changes in accounting methods. the most significant changes to rev. proc. 97–27 and rev. proc. 2002–9 are: (1) allowing a taxpayer to change its method of accounting prospectively, without audit protection, when the method to be changed is an issue pending for a taxable year under examination or an issue under consideration by either an appeals office or a federal court; and (2) taking negative, i.e., taxpayer-favorable, § 481(a) adjustments into account entirely in the year of change. this revenue procedure was amplified and clarified by rev. proc. 2002-54, 2002-35 i.r.b. 432 (9/3/02). d. and the irs explains itself. announcement 2002-37, 2002-13 i.r.b. 703 (4/1/02). this announcement explains the significant issues raised by the changes in rev. proc. 97-27, rev. proc. 2002-9, and rev. proc. 2002-18. e. and the irs clarifies the application of the one-year adjustment period to pending and recently approved applications. rev. proc. 2002-54, 2002-35 i.r.b. 432 (9/3/02), clarifying and modifying rev. proc. 2002-19, 2002-13 i.r.b. 696 (4/1/02). this revenue procedure makes the change from the 4-year to the one-year adjustment period [for negative adjustments under § 481(a)] available to those applications pending on 3/14/02 with respect to years ending before 12/31/01 to defer the year of change to the first year ending on or after 12/31/01, and allows similar relief for those with approved applications who elect to defer the year of change on or before 12/13/02. b. inventories there were no significant developments in this topic in 2002. c. year of receipt or deduction 1. the money w as sim ultaneously constructively received and constructively paid out for an offsetting deduction. gale v. commissioner, t.c. memo. 2002-54 (2/27/02). the taxpayer’s lawyer received the proceeds from settling a lawsuit, but the proceeds were held in the attorney’s escrow account pending resolution of a fee dispute between the taxpayer and the attorney, with respect to the lawsuit and other matters. judge beghe held that the full amount of the proceeds were constructively received by the cash method taxpayer in the year they were paid over by the defendant to the taxpayer’s lawyer, but a deduction was allowed under § 461(f), except to the extent that the fees, if paid, would not have been deductible. 2. tax court again finds reg. § 1.267(a)-3 valid, this time based upon the chevron doctrine. square d company v. commissioner, 118 t.c. 299 (3/27/02) (reviewed, 10-6). the tax court (judge gale) adheres to its holding in tate & lyle, inc. v. commissioner, 103 t.c. 656 (1994), rev’d. and remanded, 87 f.3d 99 (3d cir. 1996), that reg. § 1.267(a)-3 is a valid exercise of the regulatory authority granted in § 267(a)(3) and that a u.s. corporation 88 florida tax review [vol.6:si 3. chevron u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984). see also bankers life & cas. co. v. united states, 142 f.3d 973 (7th cir. 1998) (chevron doctrine applies to tax regulations, whether legislative or interpretive). wholly owned by a foreign corporation cannot deduct interest accrued until the interest is actually paid even though the interest would have been exempt from taxes under §§ 881 and 1442 under the applicable treaty. “we now hold that the regulation is valid as a permissible construction of the statutory language that authorizes it. to the extent our opinion in tate & lyle i is inconsistent, we will no longer follow it.” ! tate & lyle i was decided on the matching principle. the tax court majority here relies on chevron,3 which holds that where congressional intent is not clear, the question is whether the regulation is based on a permissible construction of the statute. in view of the refinements of the chevron doctrine in brown & williamson, we believe our opinion in tate & lyle i may have given insufficient attention to fitting all parts of section 267(a) into “an harmonious whole”. if, as we held in tate & lyle i, section 267(a)(3) authorizes only regulations that address mismatches resulting from the payee’s method of accounting, then it would appear that section 267(a)(3) is redundant in relation to section 267(a)(2), as the court of appeals for the third circuit reasoned. that is because section 267(a)(2) would already reach, and implicitly authorize regulations covering, payments owed to a related foreign person with a (u.s.) method of accounting for such payments. . . . a close examination of the legislative history reveals that congress intended the secretary’s authority under section 267(a)(3) to encompass imposition of the cash method on the payor where the foreign payee does not have a u.s. method of accounting with respect to the amounts owed. section 267(a)(3) was added to the code because congress felt “the application of * * * [section 267(a)(2)] is unclear when the related payee is a foreign person that does not, for many code purposes, include in gross income foreign source income that is not effectively connected with a u.s. trade or business.” h. rept. 99-426, at 939 (1985), 1986-3 c.b. (vol. 2) 1, 939; s. rept. 99-313, at 959 (1986), 1986-3 c.b. (vol. 3) 1, 959. in this passage, congress expressed its uncertainty as to the application of section 267(a)(2) in a situation where the foreign person has foreign source, non-effectively connected income that need not, for many internal revenue code purposes, be included in u.s. gross income. a characteristic of the foregoing type of income is that the foreign recipient lacks a u.s. method of accounting for it if the income need not be included in u.s. gross income. . . . respondent’s interpretation of the regulatory authority granted in section 267(a)(3) is reasonable in light of the legislative history and therefore is entitled to deference under chevron u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 2003] recent developments in federal income taxation 89 (1984). as a permissible construction, the regulation is ipso facto not manifestly contrary to the statute. 3. they may be losers on the diamond, but not in the tax court. tampa bay devil rays, ltd. v. commissioner, t.c. memo. 2002-248 (9/30/02). the tampa bay devil rays collected advanced season ticket payments for the 1998 baseball season, their first “major league” season, in 1995 and 1996. in those years the devil rays were conducting minor league baseball activities—many sports fans think the devil rays still are conducting only minor league baseball activities—and deducted the expenses, but did not include the advance season ticket receipts. judge swift rejected the commissioner’s argument that under schlude v. commissioner, 372 u.s. 128 (1963), the devil rays were required to include the prepayments, and applied artnell co. v. commissioner, t.c. memo. 1970-85, on remand from 400 f.2d 981 (7th cir. 1968), because, since the receipts would have had to be refunded if the devil rays did not play the season, the facts of the case fit within the narrow artnell exception to the schlude principle. 4. “hello, i’m from the irs, and i’m here to help you.” – and this time it really is true. rev. proc. 71-21 deferral of prepaid income rules loosened. notice 2002-79, 2002-50 i.r.b. 964 (12/16/02). this notice is a proposed revenue procedure to modify and supersede rev. proc. 71-21, 1971-2 c.b. 549. the proposed revenue procedure would expand the availab ility of deferred reporting of advance receipts that are not accrued for financial accounting. first, certain income from other than services would be eligible: (1) sales of goods not covered by reg. § 1.451-5(b)(1)(ii); (2) rents for the use of property in connection with the provision of services, e.g., hotel rooms, recreational facilities, cable converter boxes; (3) royalties for intellectual property; (4) warranties of services or items in the three preceding categories; (5) subscriptions not subject to § 455; and (6) memberships not subject to § 456. second, payments would be eligible even if performance might extend beyond the next succeeding year, although deferral could not extend beyond the next succeeding year. the revenue procedure will not apply to rents generally, insurance premiums, or payments with respect to financial instruments. however, the notice states that the treasury department will propose amendments to reg. § 1.61-8(b) to permit deferral of prepaid rents under the principles of the proposed revenue procedure. 5. no deferral for advance rental receipts. reg-151043-02, rents and royalties, 67 f.r. 77450 (12/18/02). the treasury department has published a proposed amendment to reg. § 1.61-8(b) that expressly requires current inclusion of advance rent receipts, regardless of the period covered or the taxpayers method of accounting, except as otherwise provided in § 467 or in other published guidance. 6. another taxpayer friendly accounting method ruling. rev. rul. 2003-3, 2003-2 i.r.b. 252 (1/13/03). a state or local income or franchise tax refund resulting from nol carrybacks is includible by an accrual method taxpayer in the earlier of the year in which the taxpayer receives payment or notice that the refund claim has been approved. rev. rul. 65-190, 1965-2 c.b. 150, and rev. rul. 69-372, 1969-2 c.b. 104, which held that the refund is accrued in the year of the loss, are revoked. the irs reasoned that review and approval of the refund claims by state authorities is not merely ministerial, but substantive. [this follows the holding in doyle, dane, bernbach, inc. v. commissioner, 79 t.c. 101 (1982), nonacq ., 1988-2 c.b. 1., acq., 2003-2 i.r.b. 251 (1/1/3/03)]. automatic change of accounting method is available. 90 florida tax review [vol.6:si 7. this year or next year? only the irs know s, and now they are telling us. rev. rul. 2003-10, 2003-3 i.r.b. 288 (1/21/03). this ruling addresses the accrual under the all events test of § 451 of income from goods sold when an accrual method taxpayer’s customer disputes its liability under certain circumstances: (1) if the taxpayer “overbills a customer due to a clerical mistake in an invoice and the customer discovers the error and, in the following taxable year, disputes its liability for the overbilled amount, then the taxpayer accrues gross income in the taxable year of sale for the correct amount;” (2) a taxpayer “does not accrue gross income in the taxable year of sale if, during the taxable year of sale, the customer disputes its liability to the taxpayer because the taxpayer shipped incorrect goods;” (3) a taxpayer “accrues gross income in the taxable year of sale if the taxpayer ships excess quantities of goods [and in the next year] the customer agrees to pay for the excess quantities of goods.” ! the irs has requested comments on the application of § 451 to a situation in which a taxpayer ships defective products to a customer that discovers the defect in the next taxable year and disputes its liability: (1) does the taxpayer have a fixed right to income under § 451 in the taxable year of sale? (compare hallmark cards, inc. v. commissioner, 90 t.c. 26 (1988), with celluloid co. v. commissioner, 9 b.t.a. 989 (1927), acq., vii-1 c.b. 6); (2) does the taxable year concept require the taxpayer to accrue income in the taxable year of sale because the dispute did not arise until the next taxable year? d. installment method 1. beware of farmers hauling hay in their jaguar convertibles. thom v. united states, 283 f.3d 939, 2002-1 u.s.t.c. ¶50,293, 89 a.f.t.r.2d 2002-1384 (8th cir. 3/19/02). the taxpayer manufactured and sold farm equipment. it reported credit sales of center pivot irrigation systems to farmers under the installment method of § 453, claiming that the § 453(l)(2)(a) exception to the general prohibition on use of the installment method by dealers for “any property used or produced in the trade or business of farming” applied. the court of appeals (in a 2-1 decision by judge magill) held that § 453(l)(2)(a) applies only to property that has been used in farming by the seller; it does not apply to sales of farm equipment by a non-farmer equipment dealer to a farmer that is “to be used” by the farmer. there is no special exception for single purpose equipment, like center pivot irrigation systems, that are used only in farming. the dissent, rather than focusing on congressional intent and the parallelism between “produced” and “used,” discusses concepts such as “past participles,” “subordinate clauses,” and missing “relative pronouns” and verbs, which it inserted, and raised the specter of a farmer selling his jaguar convertible on the installment method after using it once to haul hay. [we wonder whether the dissenting judge ever sold one of his cars on the used car market. we also wonder how many farmers own jaguars, let alone use them to haul hay!] ii. business income and deductions a. income there were no significant developments in this topic in 2002. 2003] recent developments in federal income taxation 91 4. indo pco v. commissioner, 503 u.s. 79 (1992). b. deductible expenses versus capitalization indopco4 aftermath: “deductions are exceptions to the norm of capitalization.” (blackmun, j.) 1. kudos from taxpayers; pans from professors. advanced notice of proposed rulemaking (“anprm ”), reg-125638-01, guidance regarding deduction and capitalization of expenditures, 67 f.r. 3461 (1/24/02). this anprm describes rules and standards the treasury department and the irs plan to propose under § 263(a) [and not under §§ 195, 263(g), 263(h), or 263a] to provide a framework for addressing capitalization issues with respect to expenditures incurred in acquiring, creating, or enhancing intangible assets. safe harbors and simplifying assumptions are proposed, including a “one-year rule” under which expenditures relating to short lived intangibles need not be capitalized and “de minimis rules” under which certain types of expenditures under a specified dollar amount are not required to be capitalized. ! specifically, (1) loan portfolios would have to be capitalized; (2) amounts paid for § 197 intangibles would have to be capitalized; (3) no capitalization required under the 12-month rule; (4) prepaid items beyond 12 months would have to be capitalized; (5) market entry payments would have to be capitalized but not costs to obtain iso 9000 certification; (6) amounts paid for government licenses that are valid indefinitely would have to be capitalized; (7) amounts paid to modify contractual rights would have to be capitalized, but not those paid where the parties do not enter into a new or renegotiated agreement; (8) amounts paid by a lessor to terminate a lease would have to be capitalized over the remaining period of the lease; (9) transaction costs would have to be capitalized, but this rule would not require capitalization of employee compensation, fixed overhead costs, or costs that do not exceed a specified dollar amount such as $5,000. ! note that these proposed rules accept the courts of appeals decisions in wells fargo & co. v. commissioner, 224 f.3d 874 (8th cir. 2000), and pnc bancorp v. commissioner, 212 f.3d 822 (3d cir. 2000), and turn a cold shoulder on the commissioner’s victory in lychuk v. commissioner, 116 t.c. 374 (2001). these proposed regulations also reject the tax court’s decision in favor of the irs in u.s. freightways corp. v. commissioner, 113 t.c. 329 (1999), vacated and remanded , 270 f.3d 1137 (7th cir. 2001). a. meanwhile, nothing – except for the 12-month rule. a memo from larry r. langdon and joseph g. kehoe, irs division commissioners, to the lmsb and sb/se employees, dated 2/26/02, contains “meanwhile” instructions pending adoption of the above anprm noting that the positions therein are “not service position,” but does note that “it is likely that treasury and this service will ultimately adopt [a 12-month] rule in regulations.” 2002 tnt 40-1 (2/28/02). b. the chief counsel speaks. chief counsel notice cc2002-021 (3/15/02). this notice announces a change in the service’s litigating position regarding capitalization under § 263(a) of transaction costs related to the acquisition, creation, or enhancement of intangible assets or benefits, i.e., the service will not assert that certain employee compensation, fixed overhead, or de minimis transaction costs must be capitalized, because it is an inefficient 92 florida tax review [vol.6:si use of resources to litigate these issues while in the process of proposing regulations that may ultimately allow a current deduction for such costs. c. lmsb and sb/se follow their attorney’s advice. langdon & kehoe reverse their 2/26/02 memo to lmsb and sb/se employees on 4/26/02, by reason of chief counsel notice cc-2002-021. 2002 tnt 90-8 (5/9/02). the memo notes that the requirements respecting the adoption and change of accounting methods pursuant to § 446(e) continue to be applicable, i.e., that a taxpayer may not change its method of accounting on an original tax return without first obtaining consent, nor may it change its method by filing an amended return. 2. treasury department abandons the future benefits test of indopco – long live the separate and distinct asset test. or, do the proposed regulations go beyond the separate and distinct asset test and interpret indopco in a more efficient way? reg-125638-01, guidance regarding deduction and capitalization of expenditures, 67 f.r. 77701 (12/19/02). the treasury department has published the proposed indopco regulations [prop. reg. § 1.263(a)-4] that will deal comprehensively with the capitalization of expenditures that relate to intangible assets and “future benefits.” they are intended to provide bright-line rules to make the standards based approach to capitalization articulated by the supreme court in indopco more administrable. a. capitalization is an exception to the norm of deductibility. under the proposed regulations, only expenditures incurred to (1) acquire, create, or enhance an intangible asset, (2) facilitate the acquisition, creation, or enhancement of an intangible asset, (3) “facilitate . . . a restructuring or reorganization of a business entity or a transaction involving the acquisition of capital, including a stock issuance, borrowing, or recapitalization,” or (4) which are otherwise identified by the irs in prospectively effective published guidance, must be capitalized. the term “separate and distinct intangible asset” is limited to “a property interest of ascertainable and measurable value in money’s worth that is subject to protection under applicable state or federal law and the possession and control of which is intrinsically capable of being sold, transferred, or pledged (ignoring any restrictions imposed on assignability).” the only category of expenses not related to a separate and distinct asset subject to capitalization under the proposed regulations is costs to “facilitate . . . a restructuring or reorganization of a business entity or a transaction involving the acquisition of capital, including a stock issuance, borrowing, or recapitalization.” this category includes only fact patterns analogous to the narrow fact pattern in indopco and a number of cases involving similar issues that followed indopco. transaction costs incurred by a corporation to defend against a hostile takeover are not required to be capitalized, because they do not facilitate an acquisition. however, expenses incurred to recapitalize or to thwart a hostile acquisition by merging with a white knight must be capitalized. ! the proposed regulations provide two very important exceptions to the rule requiring capitalization of transaction costs. first, under a “simplifying convention” that is in fact a major substantive rule, the regulations provide that compensation paid to employees and the employer’s associated overhead are never capitalized. this provision rejects the tax court decisions to the contrary and follows the two recent court of appeals decisions reversing the tax court [norwest corp. v. commissioner, 112 t.c. 89 (1999), rev’d sub nom., wells fargo & co. v. commissioner, 224 f.3d 874 (8th cir. 2000); pnc bancorp, 2003] recent developments in federal income taxation 93 inc. v. commissioner, 110 t.c. 349 (1998), rev’d, 212 f.3d 822 (3d cir. 2000); lychuk v. commissioner, 116 t.c. 374 (2001)], and adopts a rule for dealing with intangible assets that is very different from the treatment of transaction costs with respect to tangible assets, which must always be capitalized under either or both of §§ 263(a) or 263a. second , the propose d regulations provide an exception that permits de minimis transaction costs—defined as costs that do not exceed $5,000 per transaction (not per payee)—to be currently deducted. because this rule is coupled with an elective average cost pooling method, the de minimis rule is subject to substantial manipulation and can result in current deductions for very significant transaction costs. ! the preamble explains that the irs and the treasury department might, in the future, identify expenditures that are not listed in the regulations, but for which capitalization is nonetheless appropriate. capitalization of non-listed expenditures will be required, however, only if (and after) they have been identified in published guidance. unless an expenditure relating to an intangible asset is listed in the regulations or in such subsequently published guidance, capitalization will not be required and a current deduction will be allowed. thus, under the proposed regulations, capitalization thus will become an exception to the norm of deducting expenditures. b. the “whether and which” test shall too pass. the proposed regulations abandon the “whether and which” standard in rev. rul. 99-23, 1999-1 c.b. 998, for determining the line between expenditures subject to § 195 and those that are inherently capital as costs of the acquisition of the business itself. instead, under a “bright-line rule,” expenses incurred in the process of pursuing the acquisition of a trade or business (whether the acquisition is structured as an acquisition of stock or of assets and whether the taxpayer is the acquirer or the target in the acquisition) must be capitalized only if they are “inherently facilitative” of the acquisition or if they relate to activities performed after the earlier of the date a letter of intent (or similar communication) is issued or, if the taxpayer is a corporation, the date the board of directors approves the acquisition proposal. the proposed regulations specifically identify expenditures that are “inherently facilitative,” such as amounts relating to determining the value of the target, drafting transactional documents, or conveying property between the parties. under this bright-line rule, expenditures that do not facilitate the acquisition are capitalized as costs of the business, and instead are subject to § 195. c. depreciation on intangibles with unascertainable useful lives. the proposed regulations would permit amortization of the basis of intangibles that do not have readily ascertainable useful lives and for which a specific amortization or depreciation period is not specified in the code or regulations, and for which amortization or depreciation is not proscribed. [prop. reg. § 1.167(a)-3(b).] unless the irs provides a different amortization period by published guidance, the “safe-harbor” amortization period is 15 years, using a straight-line method with no salvage value. thus, for example, an amount paid to obtain a trade association membership of indefinite duration would be amortizable over 15 years. the amortization rule does not apply to intangible assets acquired from another party or to self-created financial interests, but these intangibles may be amortizable under § 197 or under other provisions of the code or regulations. intangibles that have readily ascertainable useful lives are amortized over those lives. capitalized costs of a corporate restructuring, reorganization, or acquisition of equity capital are not amortizable. 94 florida tax review [vol.6:si d. the 12-month rule for prepaid expenses. the proposed regulations require that prepaid expenses be capitalized; but an expenditure to create or enhance intangible rights or benefits that do not extend for more than 12 months after the expenditure is incurred is not required to be capitalized. prepaid expenses covering a period of more than 12 months would continue to be capitalized in full and deducted ratably over the period benefited. when determining the duration of a right, renewal periods must be taken into account if the facts and circumstances indicate a reasonable expectancy of renewal. for accrual method taxpayers, however, the scope of the ability to deduct prepayments under the “12-month rule” in the proposed regulations is limited by the economic performance requirement of § 461(h), which under the proposed regulations trumps the “12-month rule.” 3. impact fees m ust be capitalized. rev. rul. 2002-9, 2002-10 i.r.b. 614 (3/11/02). impact fees are one-time charges that are imposed by a state or local government against new or expanded real estate developments to finance specific offsite capital improvements for general public use necessitated by the development. these fees are refundable if the new development ultimately is not constructed. these impact fees are capitalized costs allocable to the building under §§ 263(a) and 263a. the ruling also contains provisions for changing accounting methods to comply with its provisions. 4. you don’t have to capitalize and depreciate business assets if you can prove average use of less than one year. prudential overall supply v. commissioner, t.c. memo. 2002-103 (4/23/02). the taxpayer was an industrial uniform rental/laundry business that derived most of its income from services related to the uniforms it rented to customers. the rental uniforms were emblazoned with customers’ logos and fitted to specific customers’ employees. the taxpayer consistently deducted the cost of the uniforms [for both tax and financial accounting purposes], but the commissioner, under § 446(b), sought to change the taxpayer’s accounting method to capitalization and depreciation. judge cohen found that the taxpayer had proven that the average useful service life of the garments was less than one year, even though the physical life of the garments exceeded one year, and allowed the taxpayer to continue to expense the garments. 5. you don’t have to create value to have to capitalize an expenditure. winter v. commissioner, t.c. memo. 2002-173 (7/22/02). the tax court (judge ruwe) required capitalization of legal fees incurred by the buyer of a hotel in a suit against the seller for damages based upon alleged misrepresentations that caused buyer to pay an inflated price. “[t]he test for capitalization does not hinge on the amount of value added to property but looks at the nature of the expense itself.” c. reasonable compensation there were no significant developments in this topic in 2002. d. miscellaneous expenses 1. the employer’s deduction was more than the includible compensation and it was legal! sutherland lumber-southwest, inc. v. commissioner, 114 t.c. 197 (3/28/00), aff’d per curiam, 255 f.3d 495, 2001-2 u.s.t.c. ¶50,503, 88 a.f.t.r.2d 2001-5026 (8th cir. 7/3/01). pursuant to temp. reg. § 1.162-25t, an employer-corporation that provided private nonbusiness flights on a company owned airplane to employees was permitted 2003] recent developments in federal income taxation 95 to deduct the cost of providing the flights because the fair market value of the flights was included in the employees’ reported compensation under reg. § 1.61-21(b). accordingly, pursuant to § 274(e)(2), the limitations of § 274 did not apply even though the airplane otherwise could be considered to be an entertainment facility. furthermore, the employer’s deduction was not limited to the lesser amount includable by the employees under special fringe benefit valuation rules [reg. § 1.61-21(g)]. a. a.o.d. 2002-02, 2002-6 i.r.b. 459 (2/11/02). the commissioner acquiesced in sutherland lumber. 2. the irs never seem s able to catch up with the movements in the price of gasoline, and more tinkering is in store for 2003. rev. proc. 2002-61, 2002-39 i.r.b. 616 (9/30/02), superseding rev. proc. 2001-54, 20012 c.b. 530. the optional standard mileage rate for business use of automobiles will decrease on 1/1/03 from 36.5 cents per mile to 36 cents per mile; the mileage rate for medical and moving will decrease from 13 cents per mile to 12 cents per mile; and the mileage rate for giving services to a charitable organization will remain at 14 cents per mile. 3. a taxpayer who seeks the safe harbor of a revenue procedure can’t complain about the anchorage. beech trucking co., inc. v. commissioner, 118 t.c. 428 (5/23/02). the taxpayer trucking company “leased” its truck drivers from another [related] company (ats). in addition to paying for the drivers’ services on a cents per mile basis and paying other expenses, beech paid a “per diem” of 6.5 cents per mile. beech deducted the full amount of the payments, but the commissioner disallowed 50 percent of the per diem under § 274(n). the commissioner conceded that the per diem met the deemed substantiation requirements of § 6.05 of rev. proc. 96-28, 1996-1 c.b. 686, [which was crucial to allowing any deduction because the taxpayer did not otherwise prove that the per diem, which was for meals and incidental expenses, not for lodging, was less than the federal m&ie rate]. the per diem was treated under rev. proc. 96-28 as being solely for meals and incidentals because it was computed on the same basis as compensation [cents per mile]. the tax court (judge thorton) rejected the taxpayer’s argument that because it leased the drivers from ats, § 274(n) did not apply to its payment to ats. on the facts [which were sparse due to the taxpayer’s failure to introduce evidence], the drivers were the taxpayer’s common law employees because it controlled their activities and had final control over who was hired and who was fired. thus, under rev. proc. 96-28 and § 274(n), only 50 percent of the per diem was deductible. the provisions in rev. proc. 96-28, treating the per diem as being solely for meals and incidentals because it was computed on the same basis as compensation, were not in conflict with reg. § 1.62-2(d)(3)(ii), and the revenue procedure was not otherwise invalid. finally, since the taxpayer was relying on rev. proc. 96-28 for deemed substantiation, in the absence of any evidence of actual substantiation, it would not be heard to challenge the conditions in the revenue procedure. 4. a deeply divided tax court overrules the substantive decision in redlark, but the interpretative issue regarding the weight of the bluebook remains opaque. robinson v. commissioner, 119 t.c. 44 (9/5/02) (appealable to the fifth circuit, but not appealed). temporary reg. § 1.163–9t(b)(2)(i)(a) treats interest on any noncorporate income tax underpayment as nondeductible personal interest, even if the underlying tax liability relates to a trade or business. in redlark v. commissioner, 106 t.c. 31 (1996), rev’d, 141 f.3d 936 (9th cir. 1998), the tax court held that the 96 florida tax review [vol.6:si regulations were invalid to the extent they classified as nondeductible personal interest, any interest paid with respect to an income tax underpayment arising from an unincorporated business. in a reviewed opinion (6-4-5) by judge chabot, the tax court overruled its prior opinion in redlark and upheld the validity of the regulations as applied to an underpayment attributable to the taxpayer’s law practice. ! the plurality reasoned that the words “properly allocable” in § 163(h)(2)(a), which excludes trade or business interest from the definition of nondeductible personal interest, were not intended to incorporate the pre-1986 case law upon which the tax court had relied in redlark: “in redlark . . . we did not deal with the fact that both the enacted tra 1986 language (‘in connection with’) and the enacted tamra 1988 language (‘properly allocable to’) were different from the ‘in carrying on’ and ‘attributable to’ language interpreted in the pre-tra 1986 opinions.” section 163(h) itself is silent or ambiguous with respect to the question, and the regulations represent a permissible construction of § 163(h)(2)(a). the plurality noted that the five courts of appeals that have addressed the validity of the regulations all had upheld them. see allen v. united states, 173 f.3d 533 (4th cir. 1999); mcdonnell v. united states, 180 f.3d 721 (6th cir. 1999); kikalos v. commissioner, 190 f.3d 791 (7th cir. 1999); miller v. united states, 65 f.3d 687 (8th cir. 1995); redlark, supra. unlike in its earlier redlark opinion, the tax court plurality accorded some weight to the 1986 bluebook. ! judge thornton (along with judges gerber and gale) (quoting redlark) concurred in the result but cautioned that: “where there is no corroboration in the actual legislative history, we shall not hesitate to disregard the general explanation [of the blue book] as far as congressional intent is concerned. * * * given the clear thrust of the conference committee report, the general explanation [of the blue book] is without foundation and must fall by the wayside. to conclude otherwise would elevate it to a status and accord it a deference to which it simply is not entitled.” other opinions of this court echo the notion that we require some direct corroboration of congressional intentions before we defer to blue book expressions thereof. ! chief judge wells (joined by judges swift, colvin, laro, and vasquez) dissented: the meaning of section 163(h)(2)(a) can be discerned from a plain reading of the language of that section. moreover, prior case law defined the required nexus between an interest expense on a deficiency and a trade or business, and congress did not indicate any intent to overturn these cases. also, the majority placed undue emphasis and reliance on the blue book in validating section 1.163-9t(b)(2)(i)(a), temporary income tax regs., 52 fed.reg. 48407 (dec. 22, 1987) in contravention of precedent. ! judge vasquez’s dissent (joined by judges wells, swift, colvin, and laro) emphasized that because the regulations in question were temporary regulations promulgated without either a specific delegation of authority or notice and comment, under united states v. mead corp ., 533 u.s. 218 (2001), the regulations were not entitled to deference under the standard of chevron u.s.a. inc. v. natural res. def. council, inc., 467 u.s. 2003] recent developments in federal income taxation 97 837 (1984). he would accord “‘the agency’s interpretation . . . respect proportional to its ‘power to persuade’” pursuant to skidmore v. swift & co., 323 u.s. 134 (1944). the dissent concluded that the plurality erred in relying on courts of appeals’ decisions upholding the regulations because those decisions were pre-mead cases. 5. only half the cost of mint juleps & country ham with beaten biscuits is deductible. church ill downs v. commissioner, 307 f.3d 423, 2002-2 u.s.t.c. ¶50,691, 90 a.f.t.r.2d 2002-6615 (6th cir. 10/8/02), aff’g 115 t.c. 279 (9/26/00). the sixth circuit (judge siler) upheld the tax court’s decision (judge laro) that § 274(n) limited to 50 percent of the cost, churchill downs’ deduction for the expenses of entertainment [the kentucky derby sport of kings gala, press receptions, hospitality tents, winners parties, etc.] in connection with the kentucky derby, the breeders’ cup, and other major horse races. although churchill downs was in the “entertainment business,” the expenses for the functions were not part of its entertainment product, which was horse racing. nor were the costs deductible as entertainment available to the public [§ 274(n)(2), (e)(7) exception] or sold to customers [§ 274(n)(2), (e)(8) exception] because the functions were by invitation only and not open to the public. the court of appeals reasoned that the expenses were “entertainment” under reg. § 1.274-2(b)(1)(ii) because: [t]he purpose of the galas and dinners was not to make churchill downs' product directly available to its customers or to provide them with specific information about it, but rather to create an aura of glamor in connection with the upcoming races and generally to arouse public interest in them. in this regard, the dinners, brunches, and receptions at issue most closely resemble the example [in reg. § 1.274-2(b)(2)(ii)] of a fashion show held for the wives of appliance retailers, and are best characterized not as a product introduction event used to conduct the taxpayer's business, but as pure advertising or public relations expenses. ! the court of appeals then rejected the taxpayer’s argument that its business was “entertainment” generally: although churchill downs argues, as any business that depends on advertising may, that it made money as a result of these publicity events, this does not change their nature as something distinct from what was actually sold. the commissioner puts it succinctly: “taxpayers were in the horse racing business, not the business of throwing parties.” accordingly, it is inappropriate to characterize these non-race events as churchill downs’ “product.” 6. a serially issued captive insurance company instruction manual. a. subsidiary insurance company. rev. rul. 2002-89, 2002-52 i.r.b. 984 (12/30/02). this ruling promulgates a safe harbor and a rocky shoal for deducting insurance premiums to licensed domestic captive insurance subsidiaries. in a situation in which 90 percent of the insurance subsidiary’s premiums, on both a gross and net basis, are derived from its parent, the irs concludes that there is no “risk shifting and risk distribution,” and thus no “insurance” or deductible insurance premiums. on the other hand, 98 florida tax review [vol.6:si in a situation in which less that 50 percent of the insurance subsidiary’s premiums, on both a gross and net basis, are derived from its parent and the remainder are derived from unrelated insureds, and all transactions between the related taxpayer and insurance company meet an arm’s length standard, the irs concludes that there is “risk shifting and risk distribution,” and thus there is “insurance” and deductible insurance premiums. b. sibling insurance company. rev. rul. 2002-90, 200252 i.r.b. 985 (12/30/02). this ruling blesses the deduction of insurance premiums paid to a sibling licensed domestic insurance company, even though it insures no risks outside the group, where all parties conduct themselves in a manner consistent with insurance arrangements between unrelated parties. the ruling postulates 12 operating subsidiaries, each of which represents between 5 and 15 percent of the risks insured by the insurance company member. the ruling follows humana inc. v. commissioner, 881 f.2d 247 (6th cir. 1989), and kiddie industries, inc. v. united states, 40 fed. cl. 42 (1997), and distinguishes malone & hyde, inc. v. commissioner, 62 f.3d 835 (6th cir. 1995). c. group captive. rev. rul. 2002-91, 2002-52 i.r.b. 991 (12/30/02). a small group of unrelated businesses involved in a highly concentrated industry facing significant liability hazards, and required by law to maintain adequate liability insurance coverage, formed “group captive” insurance coverage that provided insurance only to its owner— its only activity. the group captive was adequately capitalized, operated separately from its owners, none of which owned more than 15 percent or had more than 15 percent of the vote. no owner’s individual risk insured by the group captive exceeded 15 percent of the total insured risk insured. premiums were actuarially determined using recognized actuarial techniques, and were based, in part, on commercial rates, and claims were investigated before payment. there was a real possibility that an insured owner would sustain losses in excess of the premiums paid, and no insured owner would be reimbursed for excess premiums paid. on these facts, the irs ruled that the contracts issued by the group captive to its owners were insurance and the premiums were deductible under § 162. the group captive was taxed as an insurance company. e. depreciation & amortization 1. the job creation and w orker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21 (3/9/02), provides for additional first-year depreciation of 30 percent for certain property that was acquired after 9/10/01 and placed in service before 1/1/06. qualifying property consists of: (1) § 168 property with a recovery period of 20 years or less; (2) computer software other than computer software covered by § 197; (3) water utility property; and (4) leasehold improvement property. for passenger automobiles, the § 280f(a)(1)(a)(i) limitation is to be increased by $4,600. this provision also applies to improvements to used property. ! depreciation claimed pursuant to this provision may be used for amt purposes even though the 200 percent declining balance depreciation tables are used for the basis remaining after the additional first-year depreciation is taken. a. rev. proc. 2002-33, 2002-20 i.r.b. 963 (5/20/02). this revenue procedure provides procedures for claiming the additional 30 percent first-year depreciation provided by § 168(k) [and § 1400l(b)]. it also explains how a taxpayer may elect not to deduct the additional first-year depreciation for qualified property. 2003] recent developments in federal income taxation 99 2. proposed guidance on the now statutory “nonstatutory” depreciation method. reg-103823-99, guidance on cost recovery under the income forecast method, 67 f.r. 38025 (5/31/02). the treasury department has published detailed proposed regulations under § 167(g) [added in 1996] to govern depreciation under the income forecast method. the proposed regulations allow mid-recovery period recomputations where conditions necessitate it, e.g., where the facts indicate that the original income forecast was erroneous. “catch-up” depreciation is allowed in a year that basis [determined under § 263a] is redetermined; contingent amounts are not added to basis until the § 461(h) economic performance test. unlike under other § 167 depreciation methods, but like under macrs depreciation, salvage value is not subtracted from basis before computing depreciation. income forecasts must be revised annually for accuracy. income forecast depreciation is generally elected property-by-property, with very limited grouping available. the § 461(g)(2) look-back interest rules do not apply if the basis of the property is $100,000 or less in the year the look-back would occur. in addition, the look-back rule is not applied if forecasted income (and, if applicable, revised forecasted income) for each prior year is more than 90 percent and less than 110 percent of revised total forecasted income for the recomputation year. the proposed regulations will be effective upon finalization. 3. replacing short-lived critical components inside a long-lived shell is a capital expense. smith v. commissioner, 300 f.3d 1023, 2002-2 u.s.t.c. ¶50,583, 90 a.f.t.r.2d 2002-5747 (9th cir. 8/12/02), aff’g vanalco, inc. v. commissioner, t.c. memo 1999-265 (8/6/99). the taxpayer operated an aluminum smelting plant that had 640 reduction cells [each 22 feet long, 76 inches wide, and 36 inches high]. a cell shell had a life of over 50 years and its lining had a life of approximately three years. the cost of relining a cell was 22.21 percent of the cost of a completely rehabilitated cell and was, aside from the superstructure, “by far the most expensive part of the cell to replace.” during each of the 2 years in issue, the taxpayer replaced the lin ings of approximately 200 cells at a cost of over $4 million each year, which it deducted as a repair expense. the court of appeals affirmed the tax court’s holding that the expenses were capital. after first finding that the tax court’s holding that each cell—rather than all of them together— was a separate property was not clearly erroneous, the court then rejected the taxpayer’s argument that the tax court had misapplied plainfield-union water co. v. comm issioner, 39 t.c. 333 (1962) nonacq ., 1964-2 c.b. 8. in order to determine whether the repair was merely incidental, “the significance of the part under repair to the operation of the property [was] a critical inquiry.” because each cell completely lost functionality as result of the deterioration of the lining, the relining process was “integral to ‘putting’ the cell back into its original functional state ...[and] restoring it from a state of functional exhaustion to full functional operation.” the court concluded that “the lining is a critical component of the cell and its replacement is tantamount to reconstituting the cell itself.” because the relining process effectively rebuilt the cell, it conferred a new life expectancy on the cell. 4. does this case permit the cost of a new roof on a rental house to be deducted? is a tax court summary opinion meaningful in any sense? campbell v. commissioner, t.c. summary opinion 2002-117 (9/6/02) (nonprecedential pursuant to § 7463(b)). special trial judge pajak held the $8,000 expenditure for roofing work done on taxpayer’s rental house was a deductible repair expense, and did not need to be capitalized. “the contractors removed the existing top layers of the roof and recovered it with fiberglass sheets and hot asphalt. they made no structural changes to the roof. . . . there 100 florida tax review [vol.6:si 5. section 41(d)(1) includes the requirement that the research must be for “the purpose of discovering information” using a “process of experimentation.” was no replacement or substitution of the roof. petitioner's only purpose in having the work done to the roof was to prevent the leakage and keep [the taxpayer’s] rental house in operating condition and not to prolong the life of the property, increase its value, or make it adaptable to another use.” f. credits 1. the amt can bite even those who don’t owe it. allen v. commissioner, 118 t.c. 1 (1/04/02). section 38(c)(1) provides that the general business credit may not exceed the taxpayer’s net income tax minus the greater of (1) amt or (2) 25 percent of taxable income in excess of $25,000. this generally prevents the credit from offsetting amt. this case involved a taxpayer who was not subject to amt for the year in question, but whose tentative minimum tax would have exceeded the credit if, because the taxpayer claimed the § 51 targeted jobs credit [now the work opportunity credit], § 280c were applied in calculating amti to deny a deduction for the amount of the credit [before limitation by § 38(c)]. the tax court (judge laro) held that in computing amti and tentative amt for purposes of § 38(c), any reduction in the amount of deductions required by § 280c by virtue of a credit having been claimed with respect to the otherwise deductible expenditures, must be taken into account even though the taxpayer was not liable for the amt in that year. judge laro rejected the taxpayer’s argument (which was accepted by the commissioner) that the amt was a “‘separate and independent tax system that operates in parallel with the rt [regular tax] system and requires separate calculations.’” he found no support in the committee reports for treating amti as anything other than regular taxable income as modified by § 55(b)(2), and rejected any inference to the contrary in the 1986 act bluebook on the grounds that the bluebook was “not part of the statute’s legislative history,” [noting that this is especially true with respect to the 1986 act bluebook, which was prepared by the staff of the succeeding congress]. ! judge laro noted that if he had accepted the argument that the amt was a separate and independent tax system that operates in parallel with regular tax system, he would have been inclined to hold for the taxpayer. ! this case has implications beyond the work opportunity credit because the same statutory structures apply to the welfare to work credit, the orphan drug credit, and the increased research activities credit. 2. the court closed the barn door after the treasury department let the horse out. tax and accounting software corp. v. united states, 301 f.3d 1254, 2002-2 u.s.t.c. ¶50,623, 90 a.f.t.r.2d 2002-6107 (10th cir. 8/30/02). the tenth circuit (judge lucero) reversed the district court’s grant of summary judgment to the taxpayer [and remanded the case], holding that the § 41 research credit is limited to research to “discover” new technological information that is applied toward the development of a product,5 but which is separate from the product. to meet this test, the research must expand existing knowledge. however, the process of experimentation can include research in which the taxpayer tries already-known methods to achieve a result that it is not yet known but can be reached by such methods. on the other hand, the credit is allowable only where the feasibility of the end result is 2003] recent developments in federal income taxation 101 uncertain at the time the research is undertaken. on the facts, the taxpayer could not meet these standards. ! note that the proposed regulations, reg-112991-01, credit for increasing research activities, 66 f.r. 66362 (12/26/01), impose less stringent requirements than were applied in this case, particularly with respect to the “new knowledge” requirement. g. natural resources deductions & credits 1. to “produce” or to “transport” gas, that is the question. saginaw bay pipeline co. v. united states, 124 f. supp. 2d 465, 2001-2 u.s.t.c. ¶50,642, 88 a.f.t.r.2d 2001-6019 (e.d. mich. 8/23/01). natural gas gathering systems are used to transport gas [class 46.0]—not in production [asset class 13.2]—and thus are depreciable over 15 years rather than 7 years. the district court described duke energy natural gas corp. v. commissioner, 172 f.3d 1255 (10th cir. 1999), as “wrongly decided.” a. non-producer must use 15-year recovery period. clajon gas co., l.p. v. commissioner, 119 t.c. 197 (10/25/02) (reviewed, 105). the tax court, in a decision by judge halpern, upheld the government’s notices of final partnership administrative adjustments in determining that the recovery period for gathering pipeline systems owned and operated by a nonproducer were transportation property with a 15-year recovery period, and not natural gas production property with a 7-year recovery period. the tax court adhered to its decision in duke energy natural gas corp. v. commissioner, 109 t.c. 416 (1997), rev’d, 172 f.3d 1255 (10th cir. 1999), and refused to follow the tenth circuit’s reversal. the majority held that clajon’s use of the pipeline system was relevant, and inasmuch as clajon was not a producer, the pipeline system could not have been part of the production system. ! judge wells’ dissent was based upon the tenth circuit’s plain language analysis in duke energy of rev. proc. 87-56, 1987-2 c.b. 674, which only requires that the assets be “used” by natural gas producers to qualify for 7-year depreciation. the tax court majority requires that the asset be both owned and used by a natural gas producer. judge wells notes that the tax court held in rauenhorst v. commissioner, 119 t.c. 157 (10/7/02), that “the commissioner may not choose to litigate against an official position the commissioner has published without first revising or revoking that position.” ! judge foley’s dissent was based upon similar grounds, that the asset meets the regulatory requirement even though clajon was not a producer. 2. no depletion of materials excavated from someone else’s construction site. goodfellow v. commissioner, t.c. memo. 2002-128 (5/28/02). taxpayer was not entitled to depletion deductions on materials it excavated from construction sites pursuant to contracts with the general contractor because it did not have an economic interest in the materials in place. pursuant to these contracts, the taxpayer was permitted to remove excavated materials that the general contractors deemed to be unusable, crushed these materials with equipment located at the taxpayer’s quarry and sold them as crushed rock. the taxpayer made no investment in the rock and had no interest in it in the ground, because whether the rock was “usable,” and would be retained by the general contractor, or “unusable,” was decided by the general contractor after excavation. (the taxpayer was entitled to depletion deductions on materials it extracted from its own quarry.) 102 florida tax review [vol.6:si 3. enhanced oil recovery cost credit amount is alive and well for 2002. notice 2002-53, 2002-30 i.r.b. 187 (7/29/02). the § 43 credit for domestic “enhanced oil recovery costs” equals 15 percent of qualified costs for the taxable year. the credit is subject to phase-out for any taxable year in which the reference price of crude oil (determined under § 29(d)(2)(c)) for the prior year exceeds $28, adjusted for inflation. the credit is wholly phased-out if the reference price of oil equals or exceeds $34, adjusted for inflation. for taxable years beginning in 2002, the enhanced oil recovery credit is determined without regard to the phase-out for crude oil price increases. 4. percentage depletion rate on marginal oil or gas that is production is not enhanced for 2002. notice 2002-54, 2002-30 i.r.b. 189 (7/29/02). percentage depletion [15%] remains available to independent producers and royalty owners under § 613a(c). section 613a(c)(6) increases the percentage depletion rate on oil or gas that is “marginal production,” by one percentage point, to a maximum rate of 25 percent, for each dollar by which the “reference price” for crude oil—generally speaking, average wellhead price per barrel for domestic crude oil—for the preceding calendar year falls below $20. the applicable percentage for purposes of determining percentage depletion for oil and gas produced from marginal properties for 2002 is 15 percent. h. loss transactions, bad debts and nols 1. play ball with me! “substance over form” is a different doctrine from “econom ic substance,” but the taxpayer still loses. rogers v. united states, 281 f.3d 1108, 2002-1 u.s.t.c. ¶50,240, 89 a.f.t.r.2d 20021115 (10th cir. 2/22/02), aff’g 58 f. supp. 2d 1235 (d. kan. 6/10/99). the court of appeals (judge henry) affirmed the district court’s decision applying the substance over form doctrine to recharacterize a purported nonrecourse loan and foreclosure as a sale. kaufman and fogelman each owned 50 percent of the stock of the kansas city royals s corporation. when fogelman encountered financial difficulties, on july 31, 1990, kaufman lent the corporation $34 million, which the corporation re-lent to fogelman on a nonrecourse basis, secured by his stock in the corporation and due january 3, 1991. simultaneously, fogelman granted the corporation an option to purchase his stock (and an option to purchase kaufman’s stock on which fogelman had an option). the option price on fogelman’s stock was the amount due on the note. the royals immediately exercised the option to purchase fogelman’s stock, with the closing deferred to january 4, 1991. in the fall of 1990, j.p. morgan & co. conducted an attempted auction sale of the entire royals franchise at a minimum of $80 million. there were no bidders and j.p. morgan opined that fogelman’s 50 percent interest was of only “nominal value.” on january 3, 1991, fogelman transferred his stock to the corporation in lieu of foreclosure. the royals treated the collateral as having no value and, as an s corporation, passed a § 166 bad debt loss through to kaufman. in the course of holding that the loan was not bona fide and that the transaction was in substance a purchase and sale of the stock rather than a loan, judge henry explained that the substance over form doctrine is different from the “economic substance” doctrine that may be applied in tax shelter-type cases. he rejected the taxpayer’s argument that the two were the same and the proper application was limited to tax shelter cases. 2. nols from the grave. lassiter v. commissioner, t.c. memo. 2002-25 (1/25/02). the husband taxpayer, who had nols, was in chapter 11 bankruptcy in 1994 when he died [at which time his nols had been transferred to the bankruptcy estate pursuant to § 1398(i)]. pursuant to fed. r. bankr. p. 2003] recent developments in federal income taxation 103 1016, the bankruptcy proceeding was continued and concluded later in 1994 as if the husband had not died. his nols that survived the bankruptcy were deducted on a joint return for 1994. judge laro held that under §§ 172(b)(1) and 1398(i), the husband’s nols were properly deductible on the joint return. section 1398(i) provides that the “debtor” succeeds to the bankruptcy estate’s nols; the “debtor” was the husband, even if he was not alive when the estate terminated, and he was entitled to use them on his final tax return. 3. “the northern lights have seen strange sights.” kappus v. commissioner, t.c. memo. 2002-36 (2/8/02). the amt § 59(a)(2) limitation to 90 percent of amti of a nol incurred by a canadian resident/u.s. citizen taxpayer did not violate the us-canada tax treaty elimination of “double taxation.” section 59(a)(2) was in “harmony” with the treaty and thus the lastin-time rule did not apply to invoke a treaty override. 4. the job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21 (3/9/02), adds § 170(b)(1)(h) to extend the nol carryback period from 2 years to 5 years for nols in years ending in 2001 and 2002. the 90 percent limit on nol carryovers for amt purposes is temporarily suspended for these years. a. am ended returns should have been filed by 10/31/02. rev. proc. 2002-40, 2002-23 i.r.b. 1096 (6/10/02). this revenue procedure provides procedures that taxpayers with nols incurred in 2001 or 2002 must follow to apply or elect out of the special 5-year carryback period enacted in the job creation and worker assistance act of 2002. qualifying taxpayers who filed returns for the 2001 or 2002 tax years without taking advantage of the 5-year nol carryback, whether by using the 2-year carryback period, not claiming a carryback, or electing under § 172(b)(3) to forgo the nol carryback period, will have until 10/31/02 to file amended returns in which they may use the 5-year carryback period (including, if appropriate, the revocation of the § 172(b)(3) election). see also reg-122564-02, carryback of consolidated net operating losses to separate returns years, 67 f.r. 38039 (5/31/02), and t.d. 8997, carryback of consolidated net operating losses to separate returns years, 67 f.r. 38000 (5/31/02) (corrected, 67 f .r. 45310 (7/9/02)), for similar relief available to acquiring consolidated groups, which permits them to waive the preacquisition portion for the 5-year nol carryback period for losses attributable to acquired members. 5. no bad debt deduction allowed w here the default is caused by the creditor’s own actions to further other business goals. pepsiamericas, inc. v. united states, 52 fed. cl. 41, 2002-1 u.s.t.c. ¶50,326, 89 a.f.t.r.2d 2002-1524 (3/20/02). the taxpayer had established an esop, to which it had lent substantial sums to purchase shares of its stock. to further a planned corporate reorganization involving a spin-off of its key subsidiary—taxpayer was a holding company—it terminated the esop. as a result, the esop was unable to repay the entire debt. immediately prior to its termination, the esop was insolvent under the balance sheet test, but was not equitably insolvent. the court of federal claims (judge futey) upheld the irs’s disallowance of the taxpayer’s claimed bad debt deduction. first, the court held that immediately before its termination, the esop should have been considered to be a solvent debtor, because had it been continued, it would have been able to continue to make payments on the note. second, the court treated the voluntary termination of the esop in furtherance of the reorganization plan as the release of a solvent 104 florida tax review [vol.6:si debtor from liability to further other business purposes of the creditor. citing american felt co. v. burnet, 58 f.2d 530 (d.c. cir. 1932), the court held that no bad debt deduction is allowed under the circumstances. i. at-risk and passive activity losses 1. the statute was self-executing; the taxpayer doesn’t have to wait for regulations on self-charged management fees. hillman v. commissioner, 114 t.c. 103 (2/29/00). the taxpayer’s s corporation performed management services for real estate partnerships in which the taxpayer directly or indirectly was a partner. the taxpayer received pass-through nonpassive income from the s corporation and pass-through passive deductions from the partnerships. based on § 469(l)(2) and its legislative history, under circumstances analogous to those in prop. reg. § 1.469-7, permitting the offsetting of “self-charged” interest incurred in lending transactions, the taxpayer offset passive management fee deductions against the corresponding nonpassive management fee income. section 469(1)(2) provides that the irs “shall” promulgate regulations “which provide that certain items of gross income will not be taken into account in determining income or loss from any activity (and the treatment of expenses allocable to such income).” prop. reg. § 1.469-7 permits offsetting of “self-charged” interest incurred in lending transactions, but the irs did not issue any regulation for self-charged items other than interest. under the proposed regulations, a taxpayer who was both the payor and recipient of interest was allowed, to some extent, to offset passive interest deductions against nonpassive interest income. the commissioner argued that the taxpayer could not offset the deductions and income because the irs had not issued regulations for self-charged items other than interest and had thereby limited the offset. the tax court (judge gerber) held that the substantive set-off rule was self-executing and the taxpayer was entitled to offset the passive management deductions against the nonpassive management income. such self-charged treatment was congressionally intended not only for interest, but also for other appropriate items, and the commissioner did not argue that there was any distinction of substance between interest and management fees within the self-charged regime. the taxable years involved were 1993 and 1994. a. well, now , not for this taxpayer and not in the fourth circuit. what “plain meaning” giveth in gitlitz, it taketh away in hillman . reversed, hillman v. i.r.s., 250 f.3d 228, 2001-1 u.s.t.c. ¶50,354, 87 a.f.t.r.2d 2001-1731 (4th cir. 4/17/01), rehearing en banc denied, 263 f.3d 338, 88 a.f.t.r.2d 2001-5292 (7/30/01). the court of appeals (judge hamilton) reversed the tax court, finding that “nothing in the plain language of irc § 469 suggests that an exception to irc § 469(a)’s general prohibition against a taxpayer’s deducting passive activity losses from nonpassive activity gains exists where, as in the present case, the taxpayer essentially paid a management fee to himself.” the court reasoned that hillman’s argument for ignoring the plain language of the statute could prevail only if one of “two extremely narrow exceptions to the plain meaning rule” applied: (1) “when literal application of the statutory language at issue produces an outcome that is demonstrably at odds with clearly expressed congressional intent to the contrary,” or (2) “when literal application of the statutory language at issue ‘results in an outcome that can truly be characterized as absurd, i.e., that is so gross as to shock the general moral or common sense.’” (quoting sigmon coal co. v. apfel, 226 f.3d 291, 304 (4th cir. 2000)). in the eyes of the court, neither of those situations was present. 2003] recent developments in federal income taxation 105 b. on remand, hillman v. commissioner, 118 t.c. 323 (4/9/02). judge gerber, in denying the taxpayer relief from § 469 by reason of the fourth circuit’s decision, stated: unfortunately, petitioners have been snared by the reach of section 469 in, what appears to be, most inequitable circumstances. as we discussed in our prior opinion, section 469 was designed to limit the use of losses generated by passive activities to offset unrelated income generated by nonpassive activities. although section 469 was designed to stop these practices, congress recognized that it would be inappropriate to treat certain transactions between related taxpayers as giving rise to passive expense and nonpassive income. the secretary was charged with issuing regulations to implement section 469. commentary contained in the legislative history suggests that self-charged items should be provided for in the regulations. in 1991, regulations were proposed that provided for self-charged interest. although more than 15 years have passed since the enactment of section 469 and 10 years have passed since the self-charged regulation for interest was proposed, no action has been taken to relieve inequity that may be suffered with respect to self-charged items other than interest. although we find petitioners’ plight lamentable, the court of appeals for the fourth circuit has held that the courts are incapable of providing relief in this situation. c. “so there, m r. hillman!” t.d. 9013, limitations on passive activity losses and credits--treatment of self-charged items of income and expense, 67 f.r. 54087 (8/21/02). the final regulations under § 469 on self-charged items of income and expense decline to extend self-charged treatment to items beyond interest because congress in 1993 provided relief in § 469(c)(7) to real estate professionals. (section 469(c)(7) is applicable to years beginning after 12/31/93.) the preamble states: noting that congress authorized the secretary to identify other situations in which self-charged treatment is appropriate, several commentators suggested that self-charged treatment be extended to other transactions involving rental real estate activities, such as the payment of management fees and salaries. after publication of the proposed regulations, congress considered the impact of section 469 on rental real estate transactions and enacted specific relief in section 469(c)(7) for certain real estate professionals for taxable years beginning after 1993. there was no indication in the legislative history of section 469(c)(7) that congress considered additional relief for real estate transactions necessary or desirable. moreover, there is less justification for the complexity of a self-charged rule in this area after the enactment of section 469(c)(7) because that change substantially reduced the number of real estate transactions that 106 florida tax review [vol.6:si 6. accord fransen v. united states, 191 f.3d 599 (5 th cir. 1999); sidell v. commissioner, 225 f.3d 103 (1st cir. 2000); schwalbach v. commissioner, 111 t.c. 215 (1998). would benefit from a self-charged rule. accordingly, the regulations do not extend the self-charged treatment to other transactions involving rental real estate. 2. the irs consistently wins on this issue. krukowski v. commissioner, 279 f.3d 547, 2002-1 u.s.t.c. ¶50,219, 89 a.f.t.r.2d 2002827 (7th cir. 2/5/02), aff’g 114 t.c. 366 (5/22/00). mr. and mrs. krukowski owned an interest in a building that they leased to krukowski & costello, a law firm organized as a “c” corporation of which mr. krukowski was the sole shareholder and from which he received all of his earned income. the krukowskis treated the rental income as passive activity income, against which they deducted passive activity losses. the commissioner applied reg. § 1.4692(f)(6) to recharacterize the rental income as active income and disallowed the passive activity losses. the seventh circuit affirmed the tax court’s decision upholding the validity of reg. § 1.469-2(f)(6) and temp. reg. § 1.469-5t(f)(3), which provide that participation by one spouse shall be treated as participation by the other spouse in the activity during the taxable year. accordingly, the rental income was recharacterized as active and the passive activity losses were disallowed.6 3. shucks, it doesn’t work! deemed sale election will not constitute a disposition for purposes of § 469(g)(1)(a). notice 2002-29, 2002-17 i.r.b. 797 (4/29/02). this notice explains the effect under § 469 of a deemed sale of property on january 1, 2001, pursuant to an election under § 311(e) of the taxpayer relief act of 1997, pub. l. no. 105-34, 111 stat. 788 (8/5/97) (tra 97). a question had arisen whether electing a deemed sale of property under § 311(e) of the tra 97 is treated as a disposition of that property under § 469(g)(1)(a). in a technical correction to § 311(e), § 414(a)(2) of the job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21 (3/9/02), clarifies that a mark-to-market election is not a disposition for purposes of § 469(g)(1)(a). thus, the gain included in gross income by reason of a mark-to-market election may be passive activity gross income that can be offset by passive activity deductions, but the election does not otherwise affect the determination of the passive activity loss that is disallowed under § 469. iii. investment gain a. capital gain and loss 1. the 18% rate and a tax-free step-up? no way! rev. rul. 2001-57, 2001-2 c.b. 488. an individual who elects under § 311(e) of the taxpayer relief act of 1997, pub. l. no. 105-34, 111 stat. 788 (8/5/97), to treat his principal residence as being both sold and reacquired for an amount equal to fmv on 1/1/01— in order to secure the 18% capital gains rate for assets acquired on or after that date and held for 5 years thereafter—may not exclude from gross income any of the gain recognized from the deemed sale. this result was enacted statutorily in § 414(a)(1) of the job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21 (3/9/02). 2003] recent developments in federal income taxation 107 7. footnote 5 states: petitioner mistakenly relies on cases in which this court, in narrowly applying the general definition of “capital asset,” has “construed a. notice 2002-58, 2002-35 i.r.b. 432 (9/3/02). this notice provides instructions on how a noncorporate taxpayer may make the election under § 311(e) of the taxpayer relief act of 1997 to treat assets held on 1/1/01 as being sold and reacquired on that date, in order to reduce the § 1(h) rates for capital gain from 20 percent to 18 percent for assets held for more than 5 years thereafter. this election was to have been made by filing an amended return within 6 months of the due date of the original return, excluding extensions. 2. you have to transfer some other business asset before you can sell goodwill. baker v. commissioner, 118 t.c. 452 (5/29/02). the taxpayer was a state farm insurance agent who sold policies exclusively for state farm as an independent contractor, operated his own agency, developed clients, hired employees, and paid expenses. upon retirement, the taxpayer returned to state farm all of its property, but transferred no identifiable assets of his own, and he received a “termination payment.” the insurance policies he had written were assigned to a successor agent. (the customer list belonged to the insurance company.) the tax court (judge panuthos) denied the taxpayer capital gain treatment with respect to the termination payment. he transferred no assets that he owned; the telephone number and at-will employment relationships were not assets. he could not transfer goodwill because he transferred nothing to which goodwill could attach. the entire termination payment was ordinary income without regard to the portion of it allocable to a covenant not to compete. 3. the irs has got you coming and going. year-end straddle coverage of short sales results in gains in earlier year and losses in later year. rev. rul. 2002-44, 2002-28 i.r.b. 84 (7/15/02). if stock to close an existing short position, e.g., from a short sale, is purchased with a trade date in one year and a settlement date the following year, e.g., a december 31 trade date and a january 5 settlement date, pursuant to § 1259, any gain realized with respect to the short position— because the stock has fallen in value— is recognized in the year of the trade date on which the stock to cover is acquired, not the later year the short sale is closed. but if the short sale is closed at a loss—because the stock has risen in value—§ 1259 does not apply and, pursuant to reg. § 1.1233-1(a)(1) and rev. rul. 93-84, 1993-2 c.b. 225, the loss is realized in the year of the closing. 4. arkansas best didn’t ring the death knell for all judicial exceptions to the statutory definition of “capital asset.” davis v. commissioner, 119 t.c. 1 (7/3/02). the taxpayer won the california lottery and received the right to 20 annual payments of $679,000 each. subsequently, the taxpayer sold a portion of his right to 11 of the 14 remaining payments for approximately $1,040,000 and reported the gain as long-term capital gain. judge chiechi rejected the taxpayer’s argument that the supreme court’s decision in arkansas best corp. v. commissioner, 485 u.s. 212 (1998), overruled the line of cases that would have precluded characterizing the future lottery payments as a capital asset (hort v. commissioner, 313 u.s. 28 (1941); commissioner v. p.g. lake, inc., 356 u.s. 260 (1958); commissioner v. gillette motor transp., inc., 364 u.s. 130 (1960); and united states v. midland-ross corp., 381 u.s. 54 (1965)), citing footnote 5 of the arkansas best opinion.7 in holding that the 108 florida tax review [vol.6:si ‘capital asset’ to exclude property representing income items or accretions to the value of a capital asset themselves properly attributable to income,” even though these items are property in the broad sense of the word. midland-ross. see, e.g., gillette motor (“capital asset” does not include compensation awarded taxpayer that represented fair rental value of its facilities); p. g. lake (“capital asset” does not include proceeds from sale of oil payment rights); hort (“capital asset” does not include payment to lessor for cancellation of unexpired portion of a lease). this line of cases, based on the premise that § 1221 “property” does not include claims or rights to ordinary income, has no application in the present context. petitioner sold capital stock, not a claim to ordinary income. [citations omitted]. taxpayer realized ordinary income, not capital gain, on the sale, the tax court specifically held that the “right to receive future annual lottery payments does not constitute a capital asset within the meaning of section 1221,” without placing much, if any, emphasis on the temporal division. [compare mcallister v. commissioner, 157 f.2d 235 (2d cir. 1946), cert. denied, 330 u.s. 826 (1947).]. in this regard, footnote 9 of the davis opinion states: it is well established that the purpose for capital-gains treatment is to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year. * * * [commissioner v. gillette motor transp., inc., 364 u.s. 130, 134, 80 s. ct. 1497, 4 l. ed. 2d 1617 (1960) (citing burnet v. harmel, 287 u.s. 103, 106, 53 s. ct. 74, 77 l. ed. 199 (1932)).]. a. united states v. maginnis, 2002-1 u.s.t.c. ¶50,494, 89 a.f.t.r.2d 3028 (d. or. 5/28/02). summary judgment was entered in the government’s favor, holding that gain recognized on the assignment of lottery winnings to a third party for a lump-sum cash payment was ordinary income, not capital gain. 5. “putting” lipstick on the telltale collar. rev. rul. 2002-66, 2002-45 i.r.b. 812 (11/12/02). if the grantor of a qualified covered call option holds a put option on the same underlying equity, the presence of the purchased put causes the stock and the qualified covered call option to constitute part of a larger straddle within the meaning of § 1092(c)(4)(a). in such event, under § 1092(a), the amount of losses that may be recognized is limited to the amount by which the losses exceed the unrecognized gain in any offsetting positions in that straddle. b. section 121 1. a man’s (wom an’s) home is his (her) tax-free castle. t.d. 9030, exclusion of gain from sale or exchange of a principal residence, 67 f.r. 78358 (12/24/02) [proposed in reg-105235-99, exclusion of gain from sale or exchange of a principal residence, 65 f.r. 60136 (10/10/00)]. the treasury department has promulgated final regulations [regs. §§ 1.121-1 through 1.121-4] dealing with the § 121 exclusion of up to $250,000 ($500,000 for joint returns) of gain on the sale of the taxpayer’s principal residence if the 2003] recent developments in federal income taxation 109 taxpayer owned and used the property as his principal residence for at least 2 years of the preceding 5-year period. ! the final regulations follow the proposed regulations in providing that whether a property qualifies as the taxpayer’s principal residence depends upon all the facts and circumstances. if the property is used a majority of the time during the year it will ordinarily be considered the taxpayer's principal residence. the final regulations add a nonexclusive list of factors that are relevant in identifying a property as a taxpayer’s principal residence. the treasury department declined to follow comments suggesting that the 2-year use requirement should not require actual occupancy or that the regulations provide a safe harbor definition of short temporary absences that would not affect the 2-year use requirement. ! the final regulations extend the § 121 exclusion to the sale of vacant land containing the dwelling unit, which is owned and used as part of the taxpayer’s principal residence, if (1) the dwelling unit is sold within 2 years before or after the sale of the vacant land, (2) the land is adjacent to the dwelling unit, and (3) the sale of the vacant land otherwise satisfies the requirements of § 121. the dollar ceiling on the exclusion applies to the combined sales of the vacant land and dwelling unit. separate sales of the dwelling unit and adjacent vacant land do not violate the § 121(b)(3) restriction allowing only one sale or exchange every 2 years, but both are taken into account in applying § 121(b)(3) to the sale or exchange of any other principal residence. ! the proposed regulations provided that if a residence was used partially for residential purposes and partially for business purposes, only that part of the gain allocable to the residential portion would be excludable under § 121. because the treasury department decided that § 121(d)(6) [excluding from the § 121 exclusion gain attributable to prior depreciation after 5/6/97] addresses the mixed use question, the final regulations do not require an allocation if both the residential and non-residential portions of the property are within the same dwelling unit. however, allocation is required if the non-residential portion is separate from the dwelling unit, and § 121 does not apply with respect to the gain on the nonresidential portion. basis and the amount realized are allocated between the business and residential portions of the property using the same method the taxpayer used to allocate the basis for purposes of depreciation. the term dwelling unit has the same meaning as in § 280a(f)(1), but does not include appurtenant structures. ! the final regulations provide that if a residence is held by a trust, a taxpayer is treated as the owner and the seller of the residence during the period that the taxpayer is treated as the owner of the trust, or portion of the trust, that includes the residence under §§ 671 through 679. a similar rule applies to disregarded entities. ! the final regulations clarify that each unmarried taxpayer who jointly owns a principal residence is eligible to exclude from gross income up to $250,000 of gain attributable to that taxpayer’s interest in the property. ! the final regulations permit a taxpayer to exclude gain from the sale of partial interests (other than interests remaining after the sale or exchange of a remainder interest) in a principal residence if the interest sold includes an interest in the dwelling unit. however, the maximum exclusion amount of $250,000 ($500,000 for joint returns) applies to the combined sales of partial interests. for purposes of the one sale every 2 years rule, each sale or exchange of a partial interest is disregarded with respect to other sales or exchanges of partial interests in the same principal residence, but is taken into account with respect to any other principal residence. 110 florida tax review [vol.6:si ! the final regulations provide that a taxpayer may make or revoke an election under § 121(d)(8) [to apply the exclusion to a sale of a remainder interest] or § 121(f) [not to apply the exclusion to a sale] at any time before the expiration of the period for filing an amended return. ! the final regulations provide that the bankruptcy estate of an individual in a chapter 7 or 11 bankruptcy case may use the individual’s § 121 exclusion if the individual satisfies the requirements of § 121. although this provision is effective 12/24/02 [the date of publication of the regulations], the irs will not challenge a position taken prior to the effective date. ! the irs will not challenge a taxpayer’s position that a sale before the effective date of the regulations qualifies for the § 121 exclusion if the taxpayer has made a reasonable, good faith effort to comply. taxpayers may elect to apply the final regulations for any year for which the statute of limitations has not expired. a. reduced exclusion ceiling on too many castle sales. t.d. 9031, reduced maximum exclusion of gain from sale or exchange of principal residence, 67 f.r. 78367 (12/24/02). under § 121, a reduced maximum exclusion applies to a taxpayer who sells a principal residence owned and used for less than 2 years or who has excluded gain on the sale or exchange of a principal residence within the preceding 2 years, if the primary reason for the sale is a change in place of employment, health, or unforeseen circumstances. temporary reg. § 1.121-3t provides a list of suggestive factors that may be relevant in determining the taxpayer’s primary reason. no single fact or particular combination of facts is determinative. for each of the three grounds for claiming a reduced maximum exclusion, the temporary regulations provide a general definition and one or more safe harbors. ! the primary reason for a sale is deemed to be a change in place of employment if the new place of employment is at least 50 miles farther from the residence sold than was the former place of employment (or if the individual was unemployed, the distance between the new place of employment and the residence sold or exchanged is at least 50 miles). ! a sale is due to health if the primary reason for the sale is (1) to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury, or (2) to obtain or provide medical or personal care for disease, illness, or injury. a sale or exchange that is merely beneficial to general health or well-being is not a sale or exchange due to health. health is defined as the health of a “qualified person,” with a broad definition of qualified person permitting a sale to provide care for family members of the taxpayer. ! the safe harbor for sales due to unforeseen circumstances includes the involuntary conversion of the residence, a natural or man-made disaster or act of war or terrorism resulting in a casualty to the residence, death, the cessation of employment as a result of which the individual is eligible for unemployment compensation, a change in employment or self-employment status that results in the taxpayer's inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household, divorce or legal separation under a decree of divorce or separate maintenance, and multiple births resulting from the same pregnancy. a taxpayer who does not qualify for a safe harbor may satisfy a facts and circumstances test. 2003] recent developments in federal income taxation 111 8. the conditions under which the irs will consider issuing a ruling that an undivided fractional interest in rental real property is not an interest in a business entity, i.e., a partnership interest, are limited. the conditions are: (1) the co-owners must hold title as tenants in common under local law; (2) the number of co-owners must be limited to no more than 35 persons; (3) co-owners must act and hold themselves out as co-owners and not as partners; (4) co-owners may enter into limited co-ownership agreements that run with the land including, for example, a co-ownership agreement providing cross rights of first refusal at fair market value; (5) co-owners must retain the right to manage the property and any sale, lease, blanket encumbrance, hiring of a manager or management contract must be unanimously approved, but as to other matters the owners may agree to be bound by a majority vote; (6) each co-owner must have the right to transfer, partition, or encumber his undivided interest; (7) if the property is sold, net sales proceeds must be distributed to the co-owners; (8) all revenues must be shared and expenses borne in proportion to the co-owners’ undivided interests in the property; (9) all co-owners must share in any blanket indebtedness encumbering the property in proportion to their undivided interests in the property; (10) the co-owners may issue call options on their undivided interests at their fair market value, with fair market value of the undivided interest being the fair market value of the property as a whole multiplied by the co-owner’s fractional interest; (11) the co-owners’ activities, including the activities of their agents, must be limited to those customarily performed in connection with the repair and maintenance of rental property; (12) management and brokerage agreements with respect to the property must be subject to renewal no less often than annually; (13) all leases on the property must be bona fide; (14) any lender with respect to the property of the undivided interests must be unrelated to all owners, lessees, managers, and sponsors of the syndication; and (15) any payments for acquisition of the interest must reflect the fair market value of the co-ownership interest (or services rendered) and may not depend on the profits derived from the property by any person. c. section 1031 1. the erosion of the glass-steagall act changes the face of like-kind exchanges. reg-107175-00, definition of disqualified person, 66 f.r. 3924 (1/17/01). proposed amendments to reg. § 1.1031(k)-1(k)(4) would generally provide that a bank, which is a member of a controlled group that includes an investment banking or brokerage firm as a member, will not be a disqualified person [with respect to deferred like-kind exchanges through an intermediary] merely because the investment banking or brokerage firm has provided services to an exchange customer within a 2-year period ending on the date of the transfer of the relinquished property by that customer. the proposed regulations are applicable to transfers of property made by a taxpayer on or after 1/17/01. a. now final. t.d. 8982, definition of disqualified person, 67 f.r. 4907 (2/1/02). the final regulations amend reg. § 1.1031(k)-1 and are applicable to transfers of property made on or after 1/17/01. 2. ruling guidelines for ufis in real estate are very taxpayerfriendly. rev. proc. 2002-22, 2002-14 i.r.b. 733 (4/8/02), superseding rev. proc. 2000-46, 2002-2 c.b. 438. the service has announced the conditions under which it will consider a request for a ruling that an undivided fractional interest in rental real property is not an interest in a business entity. section 6 of the revenue procedure imposes 15 conditions8 for obtaining a ruling, with a facts-and-circumstances alternative where all 15 conditions are not satisfied. 112 florida tax review [vol.6:si under § 1.761-1(a) and §§ 301.7701-1 through 301.7701-3, a federal tax partnership does not include mere co-ownership of property where the owners’ activities are limited to keeping the property maintained, in repair, rented or leased. . . . where the parties to a venture join together capital or services with the intent of conducting a business or enterprise and of sharing the profits and losses from the venture, a partnership (or other business entity) is created. furthermore, where the economic benefits to the individual participants are not derivative of their co-ownership, but rather come from their joint relationship toward a common goal, the co-ownership arrangement will be characterized as a partnership (or other business entity) for federal tax purposes. [citations omitted]. 3. the nonrecognition canteen turned out to be dry. wiechens v. united states, 228 f. supp. 2d 1080, 2002-2 u.s.t.c. ¶50,708, 90 a.f.t.r.2d 2002-6705 (d. ariz. 9/16/02). the taxpayer [through a partnership] exchanged colorado river water rights, which under state law were real property, for a fee simple interest in land. the water rights were for a limited quantity of water for a duration of 50 years. on summary judgment, the court (judge mcnamee) held that the exchange did not qualify for nonrecognition under § 1031 because the water rights and a fee simple interest in land were not “like-kind,” even under the broad standard of reg. § 1.1031(a)-1(b). the court rejected the taxpayer’s argument that the 50-year water rights were analogous to the 30-year lease that qualified as like-kind with a fee simple in real estate under reg. § 1.1031(a)-1(c). because the water rights were not perpetual, they were not like-kind with a fee simple based on rev. rul. 55-749, 1955-2 c.b. 295 (dealing with perpetual water rights). 4. nonrecognition denied – caught by a targeted anti-abuse rule. rev. rul. 2002-83, 2002-49 i.r.b. 927 (12/9/02). individual a owned highly appreciated real property held for investment (property 1) and individual b, who was related to individual a within the meaning in § 267(b), owned real property (property 2), which was not appreciated. in a multiparty like-kind exchange, a and b each transferred their properties to a qualified intermediary. c, an unrelated purchaser of property 1, transferred cash to the qualified intermediary, who transferred property 1 to c and the cash to b. (property 2 was transferred to a.). the irs ruled that pursuant to § 1031(f), a taxpayer who transfers relinquished property to a qualified intermediary in exchange for replacement property formerly owned by a related party is not entitled to nonrecognition treatment under § 1031(a) if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property. based on the legislative history [h.r. rep. no. 101-247, at 1340 (1989)], the irs reasoned that the purpose of § 1031(f) is to deny nonrecognition treatment for transactions in which related parties make likekind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. accordingly, the irs applied § 1031(f)(4) because the multi-party exchange was “part of a transaction (or a series of transactions) structured to avoid the purposes of § 1031(f)(1).” d. section 1033 1. fire, wind, and pestilence bring tax benefits. willamette industries, inc. v. commissioner, 118 t.c. 126 (2/12/02). taxpayer was forced to harvest some of its trees before maturity by reason of various casualties 2003] recent developments in federal income taxation 113 [wind, ice storm, wildfires, insect damage], and it processed those trees into its usual products. taxpayer sought to defer, under § 1033 [presumably because the cost of qualified replacement property exceeded the value of the downed timber, but the opinion does not describe the replacement property], the portion of its gain on the sale of the resulting inventory equal to the excess of the value of the trees over basis immediately after the casualty and before salvaging and processing. the tax court (judge gerber) held that the deferral was permitted under the holding and reasoning of rev. rul. 80-175, 1980-2 c.b. 230 [in which timber downed by a hurricane was sold for cash without any further processing]. he reasoned that in both the ruling and the instant case, the taxpayers were “prematurely forced to salvage (sell or use) the damaged trees,” and stressed that rev. rul. 80-175 rejected imposing a requirement that the conversion must be directly into cash without a voluntary sale. judge gerber stated that the possibility that the partial damage to the trees might have been “relatively small or resulted in a nominal amount of reduction in gain is not a reason to deny relief.” he further stated that if taxpayer’s “salvage efforts were more successful than [those of] other taxpayers[,] that is not a reason for denial of relief.” e. section 1041 1. is it property or is it income? yankwich v. commissioner, t.c. memo. 2002-37 (2/8/02). pursuant to the taxpayer’s divorce, her husband was obligated to remit to her amounts equal to the interest and principal payments he received from a third party on a promissory note owned by him. [the facts indicated that the note was actually owned by the husband’s controlled corporation, but the parties and the court analyzed the issues as if the husband owned the note.] because there was no transfer of beneficial ownership in the note itself to the taxpayer-wife, § 453b(g) did not apply to treat the note as transferred to the wife in a § 1041 transaction, and thus she did not take a carryover basis in the note. the payments received from the husband were excludable by the wife under § 1041 to the extent they represented principal on the underlying note; to the extent the payments represented interest on the underlying note, § 1041 did not apply. in essence, the court treated the husband as having transferred to the wife a note with a principal amount, interest rate, and payment schedule identical to the underlying note. 2. a sensible ruling that favors § 1041 over the assignment of income theory on the transfer of vested stock options and vested nonqualified deferred compensation incident to divorce. rev. rul. 2002-22, 2002-19 i.r.b. 849 (5/13/02). this ruling held that: (1) a taxpayer who transfers interests in nonstatutory stock options and nonqualified deferred compensation to the taxpayer's former spouse incident to divorce is not required to include an amount in gross income upon the transfer, and (2) the former spouse, and not the taxpayer, is required to include an amount in gross income when the former spouse exercises the stock options or when the deferred compensation is paid or made available to the former spouse. ! the ruling stated, similarly, applying the assignment of income doctrine in divorce cases to tax the transferor spouse when the transferee spouse ultimately receives income from the property transferred in the divorce would frustrate the purpose of § 1041 with respect to divorcing spouses. that tax treatment would impose substantial burdens on marital property settlements 114 florida tax review [vol.6:si involving such property and thwart the purpose of allowing divorcing spouses to sever their ownership interests in property with as little tax intrusion as possible. further, there is no indication that congress intended § 1041 to alter the principle established in the pre-1041 cases such as meisner [v. united states, 133 f.3d 654 (8th cir. 1998)] that the application of the assignment of income doctrine generally is inappropriate in the context of divorce. ! the ruling also cited hempt bros., inc. v. united states, 490 f.2d 1172 (3d cir. 1974), by way of analogizing § 1041 to § 351. this ruling does not apply to transfers of property between spouses other than in connection with divorce. this ruling also does not apply to transfers of nonstatutory stock options, unfunded deferred compensation rights, or other future income rights to the extent such options or rights are unvested at the time of transfer or to the extent that the transferor's rights to such income are subject to substantial contingencies at the time of the transfer. see kochansky v. commissioner, 92 f.3d 957 (9th cir. 1996). [emphasis added]. ! this ruling clarified that rev. rul. 87112, 1987-2 c.b. 207, which held that § 1041 did not apply to accrued interest on transferred u.s. savings bonds that were subsequently cashed in, was based on § 454 rather than on assignment of income principles. ! query: will the non-employee spouse be required to follow this ruling? perhaps. the divorce decree or separation agreement should address this issue, preferably by providing for indemnification of the employee spouse. a. notice 2002-31, 2002-19 i.r.b. 908 (5/13/02). this notice proposes that fica/futa taxes on the exercise of stock options and the distribution of deferred compensation be imposed as if the income was that of the employee-spouse. 3. a welcome regulation is made final! subchapter c principles govern which spouse will be taxed on stock redemptions incident to a divorce – at least unless the spouses mutually elect otherwise. t.d. 9035, constructive transfers and transfers of property to a third party on behalf of a spouse, 68 f.r. 1534 (1/13/03). because of the inconsistent standards applied by the courts in dealing with redemptions of stock incident to a divorce, in reg-107151-00, constructive transfers and transfers of property to a third party on behalf of a spouse, 66 f.r. 40659 (8/3/01), the treasury department proposed regulations [prop. reg. § 1.1041-2] to provide greater certainty in determining which spouse will be taxed on stock redemptions occurring during marriage or incident to divorce. regulation § 1.1041-2 has been finalized and temp. reg. § 1.1041-1t(c), q&a-9, no longer controls redemptions of stock incident to a divorce. regulation § 1.1041-2 applies only where the nonredeemed spouse owns stock of the redeeming corporation either immediately before or immediately after the stock redemption. if a corporation redeems stock of one spouse, and that redemption is treated as a constructive distribution to the other spouse, under subchapter c principles—the primary and unconditional obligation standard [wall v. united states, 164 f.2d 462 (4th cir. 1947); sullivan v. united states, 363 f.2d 724 (8th cir. 1966)]—the 2003] recent developments in federal income taxation 115 9. ninth circuit applies § 1041 to exclude gain on wife’s stock redemption. arnes v. united states, 981 f.2d 456 (9th cir. 1992). the ninth circuit (judge hall) held that the divorce-settlement redemption of taxpayer’s stock (in a mcdonald’s franchise corporation she owned equally with her former husband) qualified for exemption under § 1041. the former husband was held to have been relieved of an obligation by the corporate redemption, and under temp. reg. § 1.1041-1t, q&a 9, the wife’s stock was treated as having been transferred to her former husband, and then redeemed from him by the corporation in a non-§ 1041 transaction. the cash received by the wife from the corporation was treated as paid to her by the corporation on behalf of her former husband. see temp. reg. § 1.1041-1t, a-2, example (3). but the tax court holds § 1041 does not apply to tax her husband on the redemption, so neither is taxed. arnes v. commissioner, 102 t.c. 522 (1994) (reviewed, 7 judges dissenting). the tax court, relying on rev. rul. 69-608, 1969-2 c.b. 42, held that the redemption of the wife’s stock [in the corporation owned 50-50 by husband and wife] was not a constrictive dividend to husband because he did not have a primary and unconditional obligation to purchase the wife’s stock. t he dissents were on the grounds that the ninth circuit has passed on the legal issue, citing golsen v. commissioner, 54 t.c. 742 (1970) aff’d, 455 f.2d 985 (10th cir. 1971), and on the untenable result that neither stockholder will incur tax consequences as a result of the $450,000 stock redemption. the tax court disagrees again with the ninth circuit’s decision in the arnes case, and judge beghe has the correct answer. blatt v. commissioner, 102 t.c. 77 (1994) (reviewed, 3 judges dissenting). the tax court held that the wife’s redemption (pursuant to a divorce decree) of all her stock in a corporation she owned entirely with her husband was not governed by § 1041 and , therefore, was taxable to her. the tax court refused to follow the temp. reg. § 1.1041-1t, q&a 9, theory that the redemption was a transfer to the corporation on behalf of her husband, as held in arnes v. united states, 981 f.2d 456, (9th cir. 1992), which the court refused to follow. judge beghe’s concurring opinion stated that the proper interpretation of that regulation should be that no redemption should be considered to be “on behalf of” the remaining spouse unless it discharges that spouse’s primary and unconditional obligation to purchase the redeemed stock, as set forth in the examples of rev. rul. 69-608, 1969-2 c.b. 42. redemption is treated as a distribution to the spouse who continues as a shareholder. section 1041 applies to the deemed transfer of the stock by the redeemed spouse to the continuing shareholder spouse. section 1041 does not apply to the deemed transfer of stock from the nontransferor spouse to the redeeming corporation. any property actually received by the redeemed spouse from the corporation is treated as flowing through the continuing shareholderspouse, and § 1041 applies to that transfer. in all other cases, the form of the stock redemption will be respected; the redeemed spouse will be taxed on the redemption and the continuing spouse has no tax consequences. the preamble to the proposed regulations specifically state: [i]f the rules of the proposed regulations had applied in the arnes case,9 because the husband did not have a primary and unconditional obligation to purchase the wife’s stock, the redemption would have been taxed in accordance with its form with the result that the wife would have incurred the tax consequences of the redemption. ! a special rule applies if an effective divorce or separation instrument, or a written agreement between the spouses [executed before the due dates of their returns], requires the spouses to file their 116 florida tax review [vol.6:si federal income tax returns in a consistent manner that treats the stock as being redeemed from the continuing shareholder spouse rather than from the spouse from whom it was actually redeemed. in such a case, spouses and former spouses will treat a redemption that otherwise would be taxed according to its form as a redemption from the continuing shareholder spouse involving (1) a deemed § 1041 transfer of the stock by the redeemed spouse to the continuing shareholder spouse, and (2) a deemed § 1041 transfer by the continuing shareholder spouse to the redeemed spouse of the redemption proceeds. ! the final regulations add a provision dealing with situations in which the redemption results in a constructive dividend distribution to the nontransferor spouse under subchapter c principles, but the spouses nevertheless would like to agree that the redemption will be treated as a redemption distribution to the transferor spouse. regulation § 1.1041-2(c) allows the spouses to agree in the divorce or separation instrument, or other valid written agreement, that the redemption will be taxable to the transferor spouse notwithstanding that the redemption might otherwise result in a constructive dividend distribution to the nontransferor spouse. example 2 in § 1.1041-2(d) illustrates the application of this special rule. ! under the final regulations, the spouses can elect one of the special rule by expressly providing, in a divorce or separation instrument or other valid written agreement, that expressly supersedes any other instrument or agreement concerning the purchase, sale, redemption, or other disposition of the stock that is the subject of the redemption, their mutual intent regarding which spouse should receive redemption treatment. ! these regulations are applicable to redemptions of stock on or after january 13, 2003 that are pursuant to instruments in effect after january 13, 2003. these regulations are also applicable to redemptions before january 13, 2003 or that are pursuant to instruments in effect before january 13, 2003 if the spouses or former spouses execute a written agreement on or after august 3, 2001, that satisfies the requirements of § 1.1041-2(c)(1) or (2). iv. c ompensation issues a. fringe benefits 1. fundamental changes in the treatment of split-dollar life insurance. notice 2001-10, 2001-1 c.b. 459. this notice provides interim guidance on split-dollar life insurance contracts. it notes that the p.s. 58 rates no longer reflect the current fair market value of insurance protection. the notice requires that employer payments be consistently treated as (1) interestfree loans under § 7872, (2) investments by the employer in the contract, or (3) payments of compensation. the service had long rejected interest-free loan treatment of the employer investment in the cash value of split dollar life insurance, but the enactment of § 7872 in 1984 enables interest-free loan treatment to be used as a valid model. the alternative is to have the true cost of insurance protection reflected in the employee’s income; insurance companies will be required to provide rates at which comparable term policies will be available to the general public (instead of the low-ball rates that had been provided in the past). this notice revokes rev. rul. 55-747, 1995-2 c.b. 228, and provides that, after 2001, p.s. 58 rates may not be used. a. irs revokes notice 2001-10 and will for future arrangements require taxation under one of two mutually exclusive regimes. notice 2002-8, 2002-4 i.r.b. 398 (1/28/02), revoking notice 2001-10, 2003] recent developments in federal income taxation 117 2001-1 c.b. 459. when the treasury department and the irs publish proposed regulations providing comprehensive guidance regarding the tax treatment of split-dollar life insurance arrangements, the regulations will provide the following in employment-related arrangements: ! if the employer is formally designated as owner of the life insurance contract, then the employer will be treated as providing current life insurance protection and other economic benefits to the employee. a transfer of the life insurance contract to the employee would be taxed under § 83, but an employer would not be treated as having made a transfer of the cash surrender value for purposes of § 83 “solely because the interest or other earnings credited to the cash surrender value of the contract cause the cash surrender value to exceed the portion thereof payable to the employer.” this has the effect of leaving that issue unresolved, and would change the position in notice 2001-10 that the employee would be taxed under § 83 on the transfer of a beneficial interest in the cash surrender value. ! if the employee is formally designated as owner, the premiums paid by the employer would be treated as a series of loans by the employer to the employee—if the employee is required to repay the employer out of insurance proceeds or otherwise. the loans are subject to taxation under the §§ 1271-1275 oid provisions and the § 7872 compensationrelated below-market loan provision. if the employee is not required to repay the employer, then the premiums paid would be treated as compensation income to the employee when paid. ! the above rules will be effective for arrangements entered into after the date of publication of final regulations. p.s. 58 rates may be used for provisions valuing current life insurance protection entered into before 1/28/02 and for arrangements entered into before the date of publication of the final regulations. b. notice 2002-8 is carried into proposed regulations. reg-164754-01, split-dollar life insurance arrangements, 67 f.r. 45414 (7/9/02). these proposed regulations provide guidance on income, employment and gift taxation of split-dollar life insurance arrangements and carry out the concepts of notice 2002-8. these proposed regulations will be effective for split-dollar life insurance arrangements entered after the date of publication of final regulations in the federal register. c. crackdown on split-dollar life insurance arrangements that are designed to understate the value of benefits for income or gift tax purposes. notice 2002-59, 2002-36 i.r.b. 481 (9/9/02). the irs held that neither the premium rates in table 2001 nor the insurer’s lower published premium rates may be relied on to value the insured’s current life insurance protection for the “purpose of establishing the value of policy benefits to which another party may be entitled.” under reverse split-dollar arrangements, one party with a right to current life insurance protection may use various techniques to confer policy benefits, other than current life insurance protection, on another party, but using such techniques to understate the value of other policy benefits “distorts the income, employment, or gift tax consequences of the arrangement.” ! according to tax notes today, 2002 tnt 161-4 (8/20/02), this notice was issued after treasury department officials read a 7/28/02 story in the new york times, which stated that jonathan blattmachr had developed this technique based upon a 1996 private letter ruling [identified as ltr 9636033]. 118 florida tax review [vol.6:si 2. employers may structure cafeteria plans to force-feed insurance and make cash the optional choice. rev. rul. 2002-27, 2002-20 i.r.b. 925 (5/20/02). a § 125 cafeteria plan may provide for automatic enrollment in employee-only group health insurance coverage with a commensurate salary reduction, subject to an opt-out provision whereby the employee may decline the health insurance and receive full salary. such a plan may also include family insurance coverage as a non-automatic option. the plan also may prohibit an employee from electing out of employee-only health insurance unless he proves that he has other medical insurance. ! the ruling contains a model amendment that a sponsor may use if it permits an employee to elect cash in lieu of group health coverage only if the employee is able to certify that he or she has other health coverage. 3. pass the cafeteria tray. rev. rul. 2002-32, 2002-23 i.r.b. 1069 (6/10/02). following an asset purchase and sale of a portion of a seller’s business, the seller’s transferred employees who had elected to participate in uninsured health care expense flexible spending arrangements under the seller’s may continue to exclude salary reduction amounts and medical reimbursements plan from gross income under either the seller’s plan, for a limited period of time, as agreed upon, or under the buyer’s § 125 cafeteria plan, at the same level of coverage without interruption, after becoming employees of the buyer. 4. health reimbursement arrangem ents. a. excludable “health reimbursement arrangements” with carryovers of unused amounts. notice 2002-45, 2002-28 i.r.b. 93 (7/15/02). this notice describes the tax treatment of employer-provided medical care expense reimbursements under a “health reimbursement arrangement” (hra). an hra is a plan that: (1) “is paid for solely by the employer and not provided pursuant to salary reduction election or otherwise under a § 125 cafeteria plan;” (2) the only benefit from which is reimbursement to employees [or certain former employees] for medical expenses incurred by the employee, and the employee’s spouse and dependents; and (3) “provides reimbursements up to a maximum dollar amount for a coverage period and any unused portion of the maximum dollar amount at the end of a coverage period is carried forward to increase the maximum reimbursement amount in subsequent coverage periods.” an hra that meets these conditions is an employerprovided accident or health plan, and coverage and reimbursements are excluded from the employee's gross income under §§ 105 and 106. an hra may allow a participant to carry forward unused reimbursement allowances to later coverage periods because the requirements for flexible spending arrangements (fsas) under § 125 are generally not applicable to hras. to retain exemption from the § 125 fsa requirements, the hra must be solely employer-funded and cannot be directly or indirectly paid for pursuant to a salary reduction election. b. and here’s a qualifying hra. rev. rul. 2002-41, 2002-28 i.r.b. 75 (7/15/02). sections 105 and 106 apply to exclude employer financed medical expense reimbursements, not dependent on salary reduction, available to cover deductibles for employees and retired employees, and their spouses and dependents, under medical insurance provided pursuant to a § 125 cafeteria plan, even though amounts unused in earlier years carry-over and are available in future years [which is not permitted under a § 125 salary reduction plan]. 2003] recent developments in federal income taxation 119 5. well, duh! rev. rul. 2002-58, 2002-38 i.r.b. 541 (9/23/02). amounts reimbursed under a self-insured medical expense reimbursement plan for medical expenses incurred by an employee prior to the establishment of the plan are not excludable from the employee’s gross income under §105(b). 6. it’s not a reimbursed medical expense if the employee is paid in any event and the amount is retrospectively characterized if and when medical expenses are incurred. rev. rul. 2002-80, 2002-49 i.r.b. 925 (12/9/02). an employer provided employees medical insurance under a salary reduction program, but paid employees approximately the same amount as they would have received if there had been no salary reduction. the amount equal to the salary reduction was labeled “advance reimbursement” of the uninsured medical expenses. to the extent an employee submitted claims for uninsured medical expenses during the year, the employer characterized the “advance reimbursement” as excludable income under § 105(b), and did not withhold income tax or treat the amount as wages for fica; excess amounts were treated as compensation includible in the employee’s gross income. the irs ruled that no part of the “advance reimbursements” qualified for exclusion under § 105(b). 7. another tax court loss for an airline pilot. tuka v. commissioner, 120 t.c. no. 1 (1/6/03). the taxpayer claimed that disability payments, based on age, years of service, and salary, received from an employer-sponsored plan were tax-exempt under § 104(a)(3). judge ruwe held that the exclusion of disability benefits under § 104(a)(3) is available only if the contributions to the accident and health plan were includible in the employee’s gross income. even if the plan had been funded by wage savings to the employer resulting from collective bargaining with the union it would not have been an employee contribution plan. 8. am ounts received from employer may be excluded as § 139 qualified disaster relief; amounts received from a state agency are excluded as gifts. rev. rul. 2003-12, 2003-3 i.r.b. 283 (1/21/03). amounts received by an individual from an employer to reimburse the individual for necessary medical, temporary housing, or transportation expenses incurred as a result of a flood are not excludable as a gift under § 102, but are excluded from gross income as qualified disaster relief under § 139 if the flood was a presidentially declared disaster. similar amounts received from a state agency are excludable under the administrative general welfare exclusion, and similar amounts received from a charity are excluded under § 102. b. qualified deferred compensation plans 1. rev. proc. 2002-21, 2002-19 i.r.b. 911 (5/13/02). this revenue procedure describes the steps that may be taken to ensure the qualified status of defined contribution retirement plans maintained by employee leasing organizations (also called professional employer organizations or peos) for the benefit of “worksite employees,” where there may be uncertainty as to whether the employer is the peo or the client organization. the peo retirement plan may either be converted into a “multiple employer plan” or be terminated by various dates in 2003. 2. reg-105885-99, compensation deferred under eligible deferred compensation plans, 67 f.r. 30826 (5/8/02). the treasury department has promulgated proposed regulations [prop. regs. §§ 1.457-1 through 1.457-12] to provide guidance on compensation of employees of state and local governments and tax-exempt entities deferred under § 457(d). the 120 florida tax review [vol.6:si proposed regulations reflect the changes made to § 457 by the tax reform act of 1986, the small business job protection act of 1996, pub. l. no. 104-188, 110 stat. 1755 (8/20/96), the taxpayer relief act of 1997, pub. l. no. 105-34, 111 stat. 788 (8/5/97), the economic growth and tax relief reconciliation act of 2001, pub. l. no. 107-16, 115 stat. 28 (6/7/01), the job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21 (3/9/02), and other legislation. 3. they’re taking all the fun out of calculating minimum required distributions from plans and iras. reg-130477-00 and reg130481-00, required distributions from retirement plans, 66 f.r. 3928 (1/17/01). proposed regulations under § 401(a)(9), etc., substantially simplify the calculation of minimum required distributions from qualified plans, iras, and other related retirement savings vehicles. the changes in the proposed regulations are based on the concept of a uniform lifetime distribution period. the regulations provide a single table that any recipient can use to calculate his or her yearly mrd amount by plugging in his or her age and the prior year-end balance of his or her retirement account or ira. the table eliminates the need to elect recalculation of life expectancy, determine a designated beneficiary by the required beginning date, or satisfy a separate incidental death benefit rule. the proposed regulations will result in reducing mrds for the vast majority of employees and ira holders. although m rds will be calculated without regard to the beneficiary’s age, the regulations will continue to permit a longer payout period if the beneficiary is a spouse more than 10 years younger than the employee. payments after the death of the employee or participant may be made over the life expectancy of the beneficiary designated by the close of the year following the participant’s death. a. regulations are final. t.d. 8987, required distributions from retirement p lans, 67 f.r. 18988 (4/17/02). the final regulations retain the simplifications to the minimum distribution rules for separate accounts provided in the 2001 proposed regulations, including the calculation of the mrd during the individual's lifetime using a uniform table (which has been changed in the final regulations to reflect updated mortality calculations). the final regulations change the date for determining the designated beneficiary to september 30 of the year following the year of the employee's death (to permit sufficient time to calculate the mrd before the end of the year). the temporary regulations provide a number of changes to the annuity rules in the proposed regulations, which merely reflected the 1987 proposed regulations. the final regulations are effective for 2003 and following calendar years. for determining minimum distributions for the year 2002, taxpayers may rely on the final regulations, the 2001 proposed regulations, or the 1987 proposed regulations. b. just “snap on” these m odel plan amendments to comply with the new mrd regulations. rev. proc. 2002-29, 2002-24 i.r.b. 1176 (6/17/02). this revenue procedure provides model plan amendments for plans to comply with the final and temporary regulations under the § 401(a)(9) minimum distribution rules. generally, plans must be amended by the end of the first year beginning on or after 1/1/03. 4. epcrs updated. rev, proc. 2002-47, 2002-29 i.r.b. 133 (7/22/02). according to the revenue procedure: this revenue procedure updates the comprehensive system of correction programs for sponsors of retirement plans that are 2003] recent developments in federal income taxation 121 intended to satisfy the requirements of § 401(a), § 403(a), § 403(b), or § 408(k) . . . but that have not met these requirements for a period of time. this system, the employee plans compliance resolution system (“epcrs”), permits plan sponsors to correct these failures and thereby continue to provide their employees with retirement benefits on a taxfavored basis. the components of epcrs are the selfcorrection program (“scp”), the voluntary correction program (“vcp”), and the audit closing agreement program (“audit cap”). ! the revenue procedure goes on to state that “[s]ponsors and other administrators of eligible plans should be encouraged to establish administrative practices and procedures that ensure that these plans are operated properly in accordance with the applicable requirements of the code.” 5. cash balance plan proposed regulations provide a green light for adoptions of cash balance plans favoring younger employees, including permission to require quasi-geriatrics to spin their [retirement accrual] wheels during “wear-away” periods. reg-209500-86 and reg164464-02, reductions of accruals and allocations because of the attainment of any age; application of nondiscrimination cross-testing rules to cash balance plans, 67 f.r. 76123 (12/11/02). these proposed regulations provide guidance on age discrimination requirements under §§ 411(b)(1)(h) and 411(b)(2), including the allocation of these requirements to cash balance pension plans. ! a cash balance plan is a defined benefit plan under which an employee has a hypothetical individual account that provides a benefit upon retirement based upon pay credits and interest credits—a concept that closely resembles a defined contribution plan. section 411(b)(1)(h) provides that a defined benefit plan fails to comply with the age discrimination rules of § 411(b) if benefit accrual is ceased or reduced on the attainment of any age, and § 411(b)(2) provides that a defined contribution plan similarly fails to comply unless the rate at which amounts are allocated to an employee’s account is not similarly ceased or reduced because of age. ! a cash balance qualifies, inter alia, only if “the participant accrues the right to future interest credits (without regard to future service) at a reasonable rate of interest that does not decrease because of the attainment of any age.” ! the rules for conversion of traditional defined benefit plans to cash balance plans require that either (1) the converted plan defines the benefit as the sum of the benefits under the traditional defined benefit plan and the cash balance account, or (2) the converted plan must establish each participant’s opening account balance as an amount not less than the actuarial present value of the participant’s prior accrued benefit. the second alternative would permit a “wear-away” period during which the participant will not accrue net benefits for some period after the conversion. c. nonqualified deferred compensation, section 83, and stock options 1. although the exercise of a statutory stock option does not result in taxable income, it does result in wages for fica / futa purposes – but not until 2003. reg-142686-01, application of the federal insurance contributions act, federal unemployment tax act, and collection of income tax at source to statutory stock options, 66 f.r. 57023 (11/14/01), issued as 122 florida tax review [vol.6:si provided in notice 2001-14, 2001-1 c.b. 516. proposed regs. §§ 31.3121(a)1(k), 31.3306(b)-1(l), and 31.3401(a)-1(b)(9) would provide that the holder of a statutory stock option [§ 422 iso or § 423 espp] receives wages for fica and futa purposes upon exercise of the option, but no withholding is required because no gross income has been received. the amount of the wages received is the excess of the fair market value of the stock over the amount paid. the irs will develop “rules of administrative convenience” permitting employers to deem the wages to have been paid on a specific date or over a specific period of time. a. notice 2001-73, 2001-2 c.b. 549.the irs announced and requested comments on proposed “rules of administrative convenience” permitting employers to deem the wages to have been paid on a specific date for fica and futa purposes. fica and futa wages could be treated as paid on a pay period, quarterly, semiannually, annually, or on another basis. b. notice 2001-72, 2001-2 c.b. 548.the irs announced and requested comments on proposed rules regarding the employer’s income tax withholding and reporting obligations on the sale by an employee of stock received pursuant to the exercise of a statutory stock option. the employer is not required to withhold, but is required to report if the amount is at least $600, unless the employer has made reasonable efforts to determine if reporting is necessary and has been unable to do so. c. irs extends m oratorium on assessment of employment taxes on stock options for two more years. notice 2002-47, 2002-28 i.r.b. 97 (7/15/02). pending the completion of its review and the issuance of further guidance, the irs will not assess fica or futa taxes (nor will it seek federal income tax withholding) upon the exercise of a statutory stock option or disposition of stock acquired by an employee pursuant to the exercise of a statutory stock option. the notice further provides that it is contemplated that any final guidance that would apply employment taxes to statutory stock options will not apply to exercises of statutory stock options that occur before january 1 of the year that follows the second anniversary of the publication of the final guidance. 2. falling into black-(sc)holes again: valuing stock options for golden parachute purposes. rev. proc. 2002-13, 2002-8 i.r.b. 549 (2/25/02), modified by rev. proc. 2002-45, 2002-27 i.r.b. 40 (7/8/02). this revenue procedure provides guidance for valuing stock options, including a blackscholes safe harbor for valuing “nonpublicly traded compensatory stock option[s] for stock that, on the valuation date, is publicly traded on an established securities market” for purposes of the §§ 280g and 4999 golden parachute rules. ! see also rev. rul. 98-21, 1998-1 c.b. 975, for the valuation of stock options for gift tax purposes. 3. the employee-coo’s behaviour vis-à-vis the shareholders was as unripe as the refund claim . robinson v. united states, 52 fed. cl. 725, 2002-2 u.s.t.c. ¶50,524, 90 a.f.t.r.2d. 2002-5003 (6/24/02). the court of federal claims followed venture funding, ltd. v. commissioner, 110 t.c. 236 (1998), aff’d per curiam, 198 f.3d 248 (6th cir. 1999), cert. denied, 530 u.s. 1205 (2000), to hold that § 83(h) allows a deduction for the value of a compensatory transfer of restricted stock to an employee only when the amount of the discount is actually “included” by the employee, not when the amount is 2003] recent developments in federal income taxation 123 “includable” but not reported as income by the employee. since the employee was appealing from an unfavorable audit with respect to the income item attributable to the year of the transfer [in which the employee-coo had made a § 83(b) election and reported the bargain element as zero, giving notice to himself as a representative of the corporation, even though the taxpayers owned all of the remaining stock of the s corporation—an overwhelming majority], the fact of inclusion was not yet established and the refund claim was not ripe. the taxpayers claimed that the employee received restricted stock worth $28 million for $2 million and the employee made the § 83(b) zero election without advising them or anyone else at the corporation at the time; taxpayers did not find out about the § 83(b) election until negotiating the coo’s termination three years later (when they sent the coo an amended form w -2). ! query: should taxpayers have dealt with this possibility by contract at the time the stock was transferred to the employee? d. individual retirem ent accounts 1. retroactive taxes are ok. kitt v. united states, 277 f.3d 1330, 2002-1 u.s.t.c. ¶50,167, 89 a.f.t.r.2d 2002-497 (fed. cir. 1/10/02), upheld and modified on rehearing, 288 f.3d 1355, 2002-2 u.s.t.c. ¶50,466, 89 a.f.t.r.2d 2002-2212 (fed. cir. 5/1/02). the retroactive amendment of § 408 on july 22, 1998, providing that distributions from roth iras made within 5 years of a rollover that are allocable to the funds rolled-over are subject to the ten percent additional tax under § 72(t), was not unconstitutional because congress was correcting a mistake in the 1997 taxpayer relief act. the court followed united states v. carlton, 512 u.s. 26 (1994). the 10 percent additional tax applied to the 44-year old taxpayer’s premature march 6, 1998 withdrawal from a roth ira into which his regular ira had been rolled-over. 2. he was just a conduit for his ira. ancira v. commissioner, 119 t.c. 135 (9/24/02). the taxpayer had a self-directed ira and asked the custodian to purchase common stock of a corporation that was not publicly traded. although the investment was not prohibited, the custodian, as a matter of policy, refused to purchase the stock because it was not publicly traded. the taxpayer’s desires were accommodated by the custodian issuing a check drawn on the ira account to the issuing corporation, which was sent to the taxpayer, who forwarded it to the corporation. to effectuate the transaction, the custodian required the taxpayer to complete a “distribution request form,” which stated that “(use of this form will result in a distribution reportable to the irs [internal revenue service] on form 1099-r [distributions from pensions, annuities, retirement or profit-sharing plans, iras, insurance contracts, etc.]).” the corporation issued the stock in the name of the taxpayer’s ira. the taxpayer received the stock and delivered it to the custodian. the tax court rejected the commissioner’s argument that this had been a distribution from the ira to the taxpayer. the taxpayer was a conduit. the court distinguished lemishow v. commissioner, 110 t.c. 110 (1998), because in ancira , the taxpayer did not receive cash, and the ira, not the taxpayer, at all times was the owner of the shares even though the ira might not have been in physical possession of the stock certificate. 3. bear market relief for pre-geriatrics. rev. rul. 2002-62, 2002-42 i.r.b. 710 (10/21/02). the irs will allow a one-time change, without penalty, in ira and retirement plan periodic payment schedules for an individual receiving fixed ira or retirement plan payments. this ruling modifies the provisions of q&a-12 in notice 89-25, 1989-1 c.b. 662. this will 124 florida tax review [vol.6:si help a taxpayer who suffers an unexpected drop in the value of his or her retirement savings, who will be able to reduce the amount of those fixed periodic payments without becoming subject to the § 72(t) penalty on withdrawals before reaching the age of 59½. v. personal income and deductions a. miscellaneous income 1. making the [tax] world safer for frequent flyers. announcement 2002-18, 2002-10 i.r.b. 621 (3/11/02). as a matter of administrative policy, the service has announced that “[c]onsistent with prior practice, the irs will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel,” and that any future guidance on the taxability of these benefits will be applied prospectively. ! the safe harbor is inapplicable to benefits that are converted to cash, to compensation paid in the form of benefits, or where these benefits “are used for tax avoidance purposes.” 2. the clergy housing allowance clarification act of 2002, pub. l. no. 107-181, 116 stat. 583 (5/20/02), amends § 107(2) to limit the amount “ministers of the gospel” may exclude from gross income as housing allowances to “the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities.” the legislation applies to tax years beginning after 12/31/01 and “to any taxable year beginning before january 1, 2002, for which the taxpayer – (a) on a return filed before april 17, 2002, limited the exclusion under [§ 107] as provided in [this legislation], or (b) filed a return after april 16, 2002.” a. warren v. commissioner, 114 t.c. 343 (5/16/00) (reviewed 14-3). if a parsonage allowance is paid to a minister, under § 107(2) it is excludable up to the amount of eligible expenses actually paid out of the allowance, even though the amount of the allowance exceeds the “fair rental value” of the parsonage, which can occur when the allowance covers mortgage payments in full, as well as real estate taxes, maintenance, utilities, and furnishings for a home owned by the minister. the tax court rejected the commissioner’s argument that the exclusion under § 107(2) was limited to the $58,000 rental value of the minister’s home where between $76,000 and $80,000 of total compensation of the $77,000 to $99,000 designated as an annual parsonage allowance over 3 taxable years was expended on qualifying expenditures. the excess of the designated allowance over actual housing expenditures was taxable. b. in warren v. commissioner, 282 f.3d 1119, 2003-1 u.s.t.c. ¶50,206 (9th cir. 3/5/02), in a 2-1 decision, the ninth circuit ordered briefing on the constitutionality of § 107(2). judge reinhardt, for the majority, also appointed professor erwin chemerinsky of the university of southern california law school to serve as amicus curiae. ! judge tallman, in his dissent, stated: because the constitutional issue was not raised in the tax court, nor briefed or argued by the parties on appeal, and because it is unnecessarily and improvidently raised by my colleagues sua sponte, i respectfully dissent from the order 2003] recent developments in federal income taxation 125 directing supplemental and court-appointed amicus briefing. this case can easily be decided without reaching the constitutionality of the statutory exclusion. ! the appointed amicus’s report concluded that § 107(2) was unconstitutional under the establishment clause [pursuant to texas monthly, inc. v. bullock, 489 u.s. 1 (1989)], because it accorded clergy a benefit not given to others. the amicus has moved to intervene as a plaintiff in the case, despite a stipulation of dismissal agreed to by the irs and the taxpayer. c. it’s over. warren v. commissioner, 302 f.3d 1012, 90 a.f.t.r.2d 2002-6058 (9th cir. 8/26/02). the appeal was dismissed by stipulation. 3. the court will not “explore the quality of a marriage,” when a husband “visits” his wife. mcadams v. commissioner, 118 t.c. 373 (5/15/02). section 86 includes a portion of social security receipts if the sum of “modified adjusted gross income” plus one half of the social security benefits exceeds the § 86(c) “base amount,” which is $25,000, except for (1) married couples filing a joint return, whose base amount is $32,000, and (2) married persons who file separate returns but live together, whose base amount is zero. the taxpayer, who filed a married filing separately return, spent most of the year away from his wife’s residence. however, he did “visit” his wife’s house for more than 30 days, but stayed in a separate bedroom. refusing to “explore the quality of a marriage,” and looking at case law under § 66(a) by analogy, judge vasquez held that the taxpayer did not “live apart” from his wife. his base amount was zero, which resulted in inclusion of a large portion of the social security receipts. b. profit-seeking individual deductions 1. the alternative minimum tax (“amt”) trap for attorneys’ fees on large recoveries. a. cases decided in past years by the first, fourth, seventh, eighth, ninth, tenth and federal circuits sprang the amt trap. attorney’s fees incurred by an individual in a nonbusiness profit-seeking transaction are [§ 212] miscellaneous itemized deductions [§ 67] and may not be deducted for amt purposes. to avoid this result, taxpayers in a number of cases in recent years have argued the portion of a taxable damage award retained by the taxpayer-plaintiff’s attorney as a contingent fee is excluded from the taxpayer-plaintiff’s income and treated as income earned directly by the attorney. the tax court and most courts of appeals have reached conflicting results on this question. generally, the tax court holds that attorney’s fee awards paid directly to a plaintiff’s attorney [or the portion of a damage award that is the attorney’s contingent fee that is so paid] are nevertheless includable in the litigant’s gross income, and that the taxpayer then may claim a deduction, subject to any applicable limitations, including disallowance of the deduction for amt purposes if it is a § 212 deduction. bagley v. commissioner, 105 t.c. 396 (1995), aff’d, 121 f.3d 393 (8th cir. 1997). accord baylin v. united states, 43 f.3d. 1451 (fed. cir. 1995), aff’g 30 fed. cl. 248 (1993); alexander v. irs, 72 f.3d 938 (1st cir. 1995), aff’g t.c. memo 1995-51; coady v. commissioner, 213 f.3d 1187 (9th cir. 2000), aff’g t.c. memo. 1998-29; benci-woodward v. commissioner, 219 f.3d 941 (9th cir. 2000), aff’g t.c. memo. 1998-395, cert. denied, 531 u.s. 1112 (2001); kenseth v. commissioner, 259 f.3d 881, 2001-2 126 florida tax review [vol.6:si 10. under bonner v. city of prichard, alabama, 661 f.2d 1206 (11th cir. 1981), fifth circuit decisions, rendered before the eleventh circuit was created, are binding precedent in the eleventh circuit. u.s.t.c. ¶50,570, 88 a.f.t.r.2d 2001-5378 (7th cir. 8/7/01), aff’g 114 t.c. 399 (5/24/00) (reviewed, 8-5); young v. commissioner, 240 f.3d 369, 2001-1 u.s.t.c. ¶50,244, 87 a.f.t.r.2d 2001-889 (4th cir. 2/16/01), aff’g, 113 t.c. 152 (8/20/99); hukkanen-campbell v. commissioner, 274 f.3d 1312, 2002-1 u.s.t.c. ¶50,351, 88 a.f.t.r.2d 2001-7283 (10th cir. 12/19/01), aff’g t.c. memo. 2000-180 (6/12/01), cert. denied, 535 u.s. 1056 (5/13/02). b. but the fifth and sixth circuits see things differently. (1) in cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959), the fifth circuit held that attorney’s fees paid directly to a plaintiff’s attorney are not includable by the litigant. the court of appeals reasoned that under the alabama attorney’s lien law, the ownership of the portion of the award representing attorney’s fees vested in the attorney ab initio . subsequently, in srivastava v. commissioner, 220 f.3d 353 (5th cir. 2000) (21), rev’g t.c. memo. 1998-362, a majority decision of a fifth circuit panel held that cotnam applied to attorneys’ fees under texas law because there is no difference in the “economic reality facing the taxpayer-plaintiff” between alabama and texas attorney’s liens and any distinction between them does not affect the analysis required by the anticipatory assignment of income doctrine. a dissent by judge dennis distinguished cotnam on the ground that alabama law gives the holders of attorney’s liens greater power than does texas law. (2) estate of clarks v. united states, 202 f.3d 854, 2000-1 u.s.t.c. ¶50,158, 85 a.f.t.r.2d 2000-405 (6th cir. 1/13/00). the sixth circuit held that the taxpayer was not required to include the portion of the taxable interest attached to a damage award excluded under § 104(a)(2) that was paid directly to the taxpayer’s attorney. the court discussed the particularities of the attorney’s fee statutory lien law in cotnam, found the michigan attorney’s fees common law lien law to be similar to the alabama law involved in cotnam, and stated that it was following cotnam. but the court also provided a broader explanation for its decision, concluding that the opinions representing the weight of authority, e.g., baylin v. united states, 43 f.3d 1451 (fed. cir. 1995), inappropriately relied on the assignment of income doctrine cases, e.g., lucas v. earl, 281 u.s. 111 (1930) and helvering v. horst, 311 u.s. 112 (1940), which, while relevant in family transactions, were not relevant in an arm’s length transaction. (3) in the eleventh circuit (as derived from presplit fifth circuit precedents10), under the golsen rule, attorney’s fees are not included in the income of an alabama taxpayer who received a large punitive damages award. davis v. commissioner, 210 f.3d 1346, 2000-1 u.s.t.c. ¶50,431, 85 a.f.t.r.2d 2000-1567 (4/27/00) (per curiam), aff’g t.c. memo. 1998-248 (7/7/98). the eleventh circuit panel held that with respect to alabama taxpayers, it was bound by cotnam. c. an attempt to escape the amt trap fails: the expense of suing your former employer might be “attributable” to the trade or business of being an employee, but it’s not “incurred by the employee in connection with the perform ance of services as an employee of the 2003] recent developments in federal income taxation 127 employer.” biehl v. commissioner, 118 t.c. 467 (5/30/02). the taxpayer successfully sued his former employer for wrongful termination and, in addition to damages, pursuant to his employment contract, the employer was required to pay his attorney’s fees. the taxpayer [who lived in the ninth circuit, which has already ruled that successful plaintiff’s cannot exclude attorney’s fees, see, e.g., sinyard v. commissioner, 268 f.3d 756 (9th cir. 2001)] attempted to avoid the amt trap on miscellaneous itemized deductions by arguing that the attorney’s fees were employer reimbursement of a § 162 employee business expense excludable under an accountable plan pursuant to § 62(c) and reg. § 1.62-2(c) and (d). judge beghe held that that even though the expenses were § 162 employee business expenses because they were “attributable” to his trade or business of being an employee, the expenses did not meet the requirement of reg. § 1.62-2(d) that the expenses be “paid or incurred by the employee in connection with the performance of services as an employee of the employer.” this latter requirement is met only if the expenses were incurred on the employer’s behalf, which clearly was not true in this case. furthermore, it cannot be met if the expenses are incurred after the employment relationship has been terminated, which happened in this case. 2. schoolteachers should keep receipts. the job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21 (3/9/02), provides for an above-the-line § 162 deduction of up to $250 for k-12 schoolteachers’ purchase of books, supplies, equipment, etc., used in the classroom. the deduction is effective for taxable years beginning after 12/31/01. 3. auditing the auditors. reynolds v. commissioner, 296 f.3d 607, 2002-2 ustc ¶50,525, 90 a.f.t.r.2d 2002-5294 (7th cir. 7/18/02), aff’g t.c. memo. 2000-20 (1/19/00). the taxpayer was an irs revenue agent who was a licensed attorney and to whom the irs had granted permission to practice law part-time during off-duty hours. in connection with an irs investigation about whether he conducted his law practice during irs working hours, the taxpayer incurred substantial legal fees, which he deducted on schedule c as expenses of his law practice, and which resulted in the law practice operating at a substantial loss for the years in question. the court upheld the irs determination that the legal fees were employee business expenses, deducible only as itemized deductions, which were subject to § 67. the origin of the legal fees was an effort to preserve the taxpayer’s irs employment, not to further his independent law practice. c. hobby losses and § 280a home office and vacation homes 1. dancing at the rascal fair. bush v. commissioner, t.c. memo. 2002-33 (2/4/02), aff’d, 51 fed. appx. 422, 2002-2 u.s.t.c. ¶50,797, 90 a.f.t.r.2d 2002-7500 (4th cir. 11/27/02). the taxpayer’s sole proprietorship talent agency, the only client of which was his teenage stepdaughter who was enrolled as full-time student studying ballet in a school for arts, was not a business conducted for profit. expenses for school supplies, pointe shoes, clothing, and dance tuition were inherently personal under § 262 and completely nondeductible. expenses that otherwise would be business expenses were deductible under § 183 to the extent they did not exceed the talent agency’s income from the activity (reduced by any expenses allowable without regard to profit motive). 128 florida tax review [vol.6:si 11. this was originally written before the recent spate of lawsuits against fast food restaurants. d. deductions and credits for personal expenses 1. you don’t have to rush to establish your msa. the deadline for establishing a medical savings account has been extended to 2002. section 62(a)(16) was added by the consolidated appropriations act, 2001c, pub. l. no. 106-554, 114 stat. 2763 (12/21/00), to allow a deduction for contributions to a msa by a taxpayer who does not itemize deductions. see announcement 2001-99, 2001-2 c.b. 40. a. the job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21 (3/9/02), extended the msa deadline through 2003. 2. the irs just might be listening to the ama: obesity is a disease and weight loss program costs are deductible medical expenses. rev. rul. 2002-19, 2002-16 i.r.b. 778 (4/22/02). uncompensated expenses paid by individuals for participation in a weight-loss program [meetings where they develop a diet plan, receive diet menus and literature, and discuss problems encountered in dieting] as treatment for a specific disease or diseases, including obesity and hypertension (even if the taxpayer is not obese) diagnosed by a physician are deductible as medical expenses under § 213 if they have been directed by a physician to lose weight as treatment. the cost of purchasing diet food items, however, is not deductible. rev. rul. 79-151, 1979-1 c.b.116, and rev. rul. 55-261, 1955-1 c.b. 307, are distinguished. ! those trial lawyers who missed out on the big tobacco settlement are looking at manufacturers of fattening foods.11 3. how a dead client may incur attorney’s fees. berry v. commissioner, 2002-1 u.s.t.c. ¶50,453, 89 a.f.t.r.2d 2832 (10th cir. 6/6/02) (nonprecedential order). a former husband’s payment of his former wife’s attorney’s fees in the divorce was not deductible alimony under § 71(b)(1)(d) because [under oklahoma law] he would have been obligated to pay those fees after her death. 4. spell it out in the divorce instrument, don’t rely on state law to fill in the gaps. lovejoy v. commissioner, 293 f.3d 1208, 2002-2 u.s.t.c. ¶50,473, 89 a.f.t.r.2d 2002-2989 (10th cir. 6/18/02), aff’g t.c. memo. 1999273 (8/12/99). an unallocated family support allowance that does not terminate upon the payee’s death (under either the terms of the agreement or state law) cannot qualify as alimony by reason of § 71(b)(1)(d). in this case, neither the divorce instrument nor state law provided that a temporary unallocated family support allowance pendente lite terminated upon the wife’s death. even though her death would have abated the divorce, state law [colorado] provided that child support orders were not terminated by the custodial spouse’s death. state law was at best unclear, and because the taxpayer had the burden, the payments were not deductible by the husband and not includable by the wife. e. education: helping pay college tuition (or is it helping colleges increase tuition?) 1. notice 2001-55, 2001-2 c.b. 299. this notice provides guidance to qualified tuition programs described in § 529 and participants in § 2003] recent developments in federal income taxation 129 529 programs regarding the restriction on investment direction described in § 529(b)(5), and sets forth a special rule under which a program may permit investments in a § 529 account to be changed annually and upon a change in the designated beneficiary of the account. 2. notice 2001-81, 2001-2 c.b. 617. this notice provides guidance regarding record keeping, reporting, and other requirements applicable to § 529 qualified tuition programs in light of the 2001 act amendments. 3. t.d. 8992, information reporting for payments of interest on qualified education loans; magnetic media filing requirements for information returns, 67 f.r. 20901 (4/29/02). the service has promulgated final and temporary regulations relating to the information reporting requirements under § 6050s for payments of interest on qualified education loans. 4. reg-161424-01 and reg-105316-98, information reporting for qualified tuition and related expenses; magnetic media filing requirements for information returns, 67 f.r. 20923 (4/29/02). proposed regulations have been issued relating to the information reporting requirements under § 6050s for qualified tuition and related expenses to assist taxpayers and the irs in determining any of educational tax credits allowable under § 25a (as well as any other tax benefits allowable for higher education expenses). 5. is there any hope that the educational credit rules ever will be understandable to anyone in the income range eligible to use them – like the earned income tax credit rules? t.d. 9034, education tax credit, 67 f.r. 78687 (12/26/02). the treasury department has promulgated final regulations regarding the hope scholarship credit and the lifetime learning credit under § 25a. vi. c orporations a. entity and formation 1. relief for late initial classification elections. rev. proc. 200259, 2002-39 i.r.b. 615 (9/30/02), modifying and superseding rev. proc. 200215, 2002-6 i.r.b. 490 (2/11/02). this revenue procedure provides guidance for seeking relief from a late filed initial classification election under the § 7701 check-the-box regulations by a newly formed entity. relief is available only if form 8832 was not filed, the due date for the return for the desired classification has not passed, and the entity shows reasonable cause. 2. the “emerging equitable interpretation of § 357(c)” argument wasn’t a winner. seggerman farms, inc. v. commissioner, 308 f.3d 803, 2002-2 u.s.t.c. ¶50,728, 90 a.f.t.r.2d 2002-6981 (7th cir. 10/24/02), aff’g t.c. memo. 2001-99 (4/25/01). shareholders who transferred a family farm to a corporation in a § 351 transaction were required under § 357(c) to recognize gain on the transfer to the extent the liabilities to which the transferred property was subject exceeded the adjusted basis of the property. the shareholders argued that because they had personally guaranteed the debt, they were not relieved of their obligations on the transferred property, and thus, no gain should be recognized on the transfer. the court (judge bauer) held that § 357(c) requires gain recognition even if the transferor remains liable as a guarantor. judge bauer rejected the taxpayers’ argument that under “‘the emerging equitable interpretation of § 357(c)’” their guarantees should be treated in the same manner as the shareholders’ promissory notes to the corporations in lessinger v. commissioner, 872 f.2d 519 (2d cir. 1989), and 130 florida tax review [vol.6:si peracchi v. commissioner, 143 f.3d 487 (9th cir. 1998), because the guarantee, standing alone, does not constitute an “economic outlay.” ! although the case arose prior to the 1999 amendments to § 357(c) and (d), the tax court noted in its opinion that the result would not be different under the current statute. b. distributions and redemptions 1. rogers v. united states, 281 f.3d 1108, 2002-1 u.s.t.c. ¶50,240, 89 a.f.t.r.2d 2002-1115 (10th cir. 2/22/02), aff’g 58 f. supp. 2d 1235, 2000-1 u.s.t.c. ¶50,237, 85 a.f.t.r.2d 2000-946 (d. kan. 6/10/99). a purported loan by the kansas city royals baseball team s corporation was a stock redemption, so related expenses were nondeductible under § 162(k). see also ii.h., supra . 2. didn’t judge swift ever see the godfather? capital video corporation v. commissioner, t.c. memo 2002-40 (2/11/02). capital video corporation paid “tribute” to richichi, a capo in the gambino crime family. in connection with these payments, guarino, the sole shareholder of capital video, was indicted, inter alia, for conspiracy to obstruct the irs in collecting richichi’s taxes. capital video paid guarino’s attorney’s fees to defend the criminal charges. judge swift held that the payment of guarino’s attorney’s fees was not deductible by capital video because the payments were disguised shareholder distributions. there is no evidence herein that indicates that richichi would not have provided the protection to capital video if guarino had not participated in the conspiracy relating to richichi’s taxes and if capital video had not paid guarino’s legal fees. . . . apart from whether the tribute payments made by capital video to richichi were made to protect the business of capital video, petitioners have not established that guarino’s participation in the conspiracy to avoid richichi’s income taxes and capital video’s payment of the legal fees in dispute had a sufficient business relationship with the protection or promotion of capital video’s business. 3. after the taxpayer’s crack dealer customers found that he kept books, his tax problems were probably the least of his worries. zhadanov v. commissioner, t.c. memo. 2002-104 (4/25/02). zhadanov’s wholly owned corporation was found to have fraudulently underreported nearly $750,000 of income from its business of manufacturing plastic bottles for sale to crack cocaine dealers. among the badges of fraud were that the cash receipts were not deposited in the corporation’s bank account, but were diverted to a safe in the sole shareholder’s home. nevertheless, judge marvel found that the diversion of possession of the cash to the sole shareholder was not a constructive dividend because, although he had physical control of the cash, he never used any of it for personal purposes, and it was still in the safe when it was seized by dea agents. that none of the diverted cash was used for personal purposes was supported by the taxpayer’s cash receipts journal—a second set of books, (the real books?)—that accounted for the cash. 4. basis can live long after the stock is “redeem ed.” who’d a thunk it? reg-150313-01, redemptions taxable as dividends, 67 f.r. 64331 2003] recent developments in federal income taxation 131 (10/18/02). the irs has proposed replacing the “proper adjustment” to the basis of remaining stock rule of reg. § 1.302-2(c), which takes into account the unused basis of redeemed stock when the redemption is treated as a § 301 distribution. proposed reg. § 1.302-5 would provide that the redeemed shareholder [who is taxed under § 301] would retain the basis of the redeemed stock as a basis item separate from any remaining shares, whether or not the shareholder continues to actually own the stock of the redeeming corporation, and take it into account as a loss deduction at some future date. the loss subsequently can be claimed under either the “final inclusion date” rule or the “accelerated loss inclusion date” rule. the “final inclusion date” is the date on which the redeemed shareholder would qualify under § 302(b)(1), (2) or (3) if the facts on that date had been the facts immediately after the redemption, or alternatively, when an individual shareholder dies or a corporate shareholder is liquidated in a transaction to which § 331 applies. the “accelerated loss inclusion date” rule allows the redeemed shareholder to claim a loss attributable to the unutilized basis when the shareholder subsequently recognizes a gain on stock of the redeeming corporation, but the loss may be claimed only to the extent of the gain recognized. because the loss attributable to the basis of the redeemed stock is treated as recognized on the redemption date, the attributes (e.g., character and source) of the loss are fixed on the redemption date, even if such loss is not taken into account until after the redemption date. these rules apply to § 304(a)(1) transactions taxed under § 301 by treating the unutilized basis in the redeemed corporation stock as basis in the stock of the acquiring corporation. special rules apply to partnerships in consolidated returns [prop. reg. § 1.1502-19(b)(5)] and to foreign corporations. these rules do not apply to redemptions of § 306 stock, but they do generally apply even in the case of a corporation wholly owned by a single shareholder, whether a corporation or an individual. ! these regulations are a reaction, in part, to basis shifting transactions, such as that described in notice 2001-45, 2001-2 c.b. 129 [the so-called bank of america transaction]. ! it has been noted that if nuclear disaster ever overcomes the earth, only the cockroach and basis would survive. c. liquidations there were no significant developments in this topic in 2002. d. s corporations 1. the technical result in gitlitz sleeps the big sleep, but the method of statutory analysis might have everlasting life. the job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21 (3/9/02), reverses the result of gitlitz v. commissioner, 531 u.s. 206 (2001), by amending § 108(d)(7)(a) to provide that excluded cancellation of indebtedness income of s corporations is not to result in an adjustment to the basis of the stock in the hands of shareholders. the statutory rule is applicable to discharges of indebtedness after 10/11/01 (but not to discharges of indebtedness before 3/1/02 pursuant to a plan of reorganization filed with the bankruptcy court on or before 10/11/01). 2. esbt regulations are now final. t.d. 8994, electing small business trusts, 67 f.r. 34388 (5/14/02). the treasury department has promulgated final regulations regarding the qualification and treatment of electing small business trusts (esbts) which reflect amendments in the small business job protection act of 1996, pub. l. no. 104-188, 110 stat. 1755 132 florida tax review [vol.6:si (8/20/96), the taxpayer relief act of 1997, pub. l. no. 105-34, 111 stat. 788 (8/5/97), and § 316 of the community renewal tax relief act of 2000, pub. l. no. 106-554 (12/15/00). regulation § 1.641(c)-1 and the amendments to reg. § 1.1361-1 implement § 1361(f), permitting esbts to be permitted s corporation shareholders. under the final regulations, temporary waivers of powers of appointment do not eliminate a beneficiary, but a permanent release will be effective. “negligible” future interests are disregarded. if a grantor trust makes an esbt election, the trust consists of a grantor portion and a non-s portion, subject to normal rules, and an s portion, subject to § 641(c). when a trust consists of an s-portion and a non-s portion, the source of distributions controls their taxation to beneficiaries. a qsst may convert to an esbt; an esbt can convert to a qsst if it qualifies. the final regulations [reg. § 1.4444] provide that an esbt, or a trust described in § 401(a) or a § 501(c)(3) entity that is tax-exempt under § 501(a), is not treated as a deferral entity for purposes of temp. reg. § 1.444–2t. 3. what happens when subchapter s and subchapter k collide? a. in the tax court, the aggregate theory of partnership taxation was applied. coggin automotive corp. v. commissioner, 115 t.c. 349 (10/18/00). taxpayer originally was a holding company that had a number of controlled subsidiaries engaged in the retail sale of motor vehicles. the subsidiaries maintained their inventories under the lifo method and all of the corporations filed a consolidated return. in 1993, the taxpayer restructured to make an s election. six new s corporations were formed to become the general partners in six limited partnerships. each subsidiary contributed its dealership assets to a limited partnership in exchange for a limited partnership interest, following which the subsidiaries were liquidated and the taxpayer became the limited partner in each. the commissioner asserted that the taxpayer’s conversion to an s corporation triggered the inclusion of the affiliated group’s pre-s-election lifo reserves (approximately $5 million) under § 1363(d). the commissioner argued alternatively (1) that the restructuring should be disregarded because it had no purpose independent of tax consequences, and (2) that under the aggregate approach to partnerships, a pro rata share of the pre-s-election lifo reserves (approximately $4.8 million) was attributable to the taxpayer as a partner. the tax court (judge jacobs) rejected the commissioner’s first argument, holding that the restructuring was a genuine multiple-party transaction with economic substance, compelled by business realities and imbued with tax-independent considerations. but judge jacobs accepted the commissioner’s second argument, holding that application of the aggregate approach [rather than the entity approach] to partnership taxation furthered the purpose of § 1363(d). thus, the taxpayer was treated as owning a pro rata share of the partnerships’ inventories and as a result of its election it was required to include $4.8 million of lifo recapture. ! in reaching its decision regarding subchapter k, the tax court followed casel v. commissioner, 79 t.c. 424 (1982) (applying the aggregate approach to apply § 267 to disallow losses between related parties); holiday village shopping center v. united states, 773 f.2d 276 (fed. cir. 1985) (applying the aggregate approach for purposes of determining depreciation recapture when a corporation distributed a partnership interest to its shareholders); and unger v. commissioner, 936 f.2d 1316 (d.c. cir. 1991), in determining permanent establishment. it distinguished as inapposite the entity approach applied in p.d.b. sports, ltd. v. commissioner, 109 t.c. 423, (1997) (applying the entity approach for purposes of applying § 2003] recent developments in federal income taxation 133 1056); madison gas & elec. co. v. commissioner, 72 t.c. 521 (1979), aff’d, 633 f.2d 512 (7th cir. 1980) (applying the entity approach in determining whether expenditures are deductible under § 162 or nondeductible start-up expenditures); and the eighth circuit’s decision in brown group. inc. & subs. v. commissioner, 77 f.3d 217 (8th cir.1996), vacating 104 t.c. 105 (1995) (concluding that the entity approach, rather than the aggregate approach, should be used in characterizing income (subpart f income) earned by a partnership). the differences, the court found, were based on the determination of the relevant congressional intent in enacting the non-subchapter k provision involved in each case. b. but the eleventh circuit sees things differently, and reverses the tax court. “plain language” requires application of the entity theory. coggin automotive corp. v. commissioner, 292 f.3d 1326, 2002-1 u.s.t.c. ¶50,448, 89 a.f.t.r.2d 2002-2826 (11th cir. 6/6/02). expressly applying the gitlitz “plain language” principle, the eleventh circuit (judge hill) reversed the tax court. the court held that § 1363(d) lifo recapture is triggered only if the corporation electing s status itself directly owned the lifo inventory. since the result turned on “plain language” rather than the purpose of the statutory pattern, judge hill was spared the need to write a lengthy opinion. 4. daisy-chain loans don’t represent an economic outlay. oren v. commissioner, t.c. memo. 2002-172 (7/19/02). the taxpayer was the controlling shareholder of three s corporations, one of which (dart) passed through substantial income, and the others of which (highway leasing and highway sales) passed through losses in excess of the taxpayers basis [due to depreciation on leveraged depreciable equipment]. the taxpayer sought to utilize the losses by creating basis in highway leasing and highway sales through a series of circular loan transactions: the taxpayer borrowed money from dart, which he lent to highway leasing and highway sales on terms identical to the terms of the loans from dart to the taxpayer, following which highway leasing and highway sales lent the funds to dart. judge ruwe held that the loans had no economic substance and that oren had not made any “economic outlay.” thus, except to the extent of $200,000 lent from his own personal assets, oren did not acquire basis in the promissory notes from highway leasing and highway sales against which the losses could be deducted. furthermore, the circular loan arrangement was a “loss limiting arrangement” under § 465(b)(1) because there was no “realistic possibility of loss” by oren; the facts did not indicate that the circular chain of payment could be broken. judge ruwe rejected the possibility that the chain of payment might be broken by a tort judgment against one of the corporations in excess of its large insurance coverage. e. affiliated corporations. 1. the federal circuit doesn’t appear to buy into the single entity theory of consolidated returns. regulation § 1.1502-20, which prohibited recognition of loss in the transactions involving, inter alia , “duplicated losses,” was held to be “manifestly contrary to the statute.” rite aid corp. v. united states, 255 f.3d 1357, 2001-2 u.s.t.c. ¶50,516, 88 a.f.t.r.2d 2001-5058 (fed. cir. 7/6/01), rev’g 46 fed. cl. 500, 2000-1 u.s.t.c. ¶50,429, 85 a.f.t.r.2d 2000-1439 (4/21/00). rite aid sold a subsidiary (encore) and realized a taxable loss of $33 million and an “economic loss” of $22 million, which it claimed should be deductible. regulation § 1.1502-20, subject to certain exceptions, disallows any loss realized by a 134 florida tax review [vol.6:si member of a consolidated group upon the disposition of the stock of a subsidiary. under reg. § 1.1502-20, the amount of loss that is disallowed is limited to the sum of (1) income or gain resulting from “extraordinary gains dispositions,” which are defined as dispositions of capital assets, depreciable property used in the trade or business, certain bulk asset dispositions, and discharge of indebtedness income, (2) positive investment adjustments (other than those attributable to extraordinary gain dispositions), and (3) “duplicated loss,” which is the aggregate of the subsidiary’s asset bases and loss carryovers over the value of the subsidiary’s assets. any losses in excess of these amounts are deductible. regulation § 1.1502-20 is designed to prevent “duplicated losses”—the deduction by both the parent and subsidiary of the same economic loss. the court of federal claims upheld the validity of reg. § 1.1502-20 and because encore’s built-in loss of $28 million [as calculated by rite-aid] exceeded rite-aids’ economic loss, no loss deduction was allowed. the court pointed out that rite aid could have avoided reg. § 1.1502-20 by finding a buyer who would agree to a § 338(h)(10) election. ! the federal circuit (judge mayer) reversed, declaring the “duplicated loss factor” in reg. § 1.1502-20 invalid because it disallows a loss that is otherwise allowed by § 165 and is “manifestly contrary to the statute.” because “[r]ealization of the loss [on the stock sale] does not stem from the filing of a consolidated return, . . . the denial of the deduction imposes a tax on income that would otherwise not be taxed,” something that § 1502 does not authorize the treasury department to do. the federal circuit summarily rejected the government’s argument that reg. § 1.1502-20 is necessary to prevent a double deduction, stating that the subsidiary’s future deductions were not created by the consolidated return rules because the same duplication occurs outside the consolidated return context, and congress has addressed the problem by the enactment of §§ 382 and 383. judge mayer concluded “the duplicated loss factor distorts rather than reflects the tax liability of consolidated groups and contravenes congress’ otherwise uniform treatment of limiting deductions from the subsidiary’s losses.” a. at first the irs decided to keep on f ighting. in chief counsel notice cc-2001-042 (8/21/01), the service has advised chief counsel attorneys that it does not agree with the federal circuit decision in rite aid and that it has filed a petition for rehearing en banc with the federal circuit. b. but six months later, the irs caved and announced that it will change the regulations instead. notice 2002-11, 2002-7 i.r.b. 526 (2/19/02). the notice reads: in rite aid, the federal circuit held that the duplicated loss component of § 1.1502-20 of the income tax regulations, which disallows certain losses on sales of stock of a member of a consolidated group, was an invalid exercise of regulatory authority. the internal revenue service believes that the court’s analysis and holding were incorrect. nevertheless, the service has decided that the interests of sound tax administration will not be served by continuing to litigate the validity of the loss duplication factor of § 1.150220. moreover, because of the interrelationship in the operation of all of the loss disallowance factors, the service has decided that new rules governing loss disallowance on sales of stock of a member of a consolidated group should be implemented. 2003] recent developments in federal income taxation 135 accordingly, the service intends to promulgate interim regulations that, prospectively from the date of their issuance, will require consolidated groups to determine the allowable loss on a sale or disposition of subsidiary stock under an amended § 1.337(d)-2 instead of under § 1.1502-20. for transactions (including those for which a return has been filed) completed before the date of issuance of interim regulations, or for which there is a binding contract before that date, groups will be allowed certain choices with respect to a disposition of subsidiary stock, including a choice to apply § 1.337(d)-2 as amended. the service and treasury are undertaking a broader study of the regulatory provisions necessary to implement § 337(d) of the internal revenue code in the context of affiliated groups filing consolidated returns and will request comments in conjunction with the issuance of the interim regulations. it is the service’s position that the rite aid opinion implicates only the loss duplication aspect of the loss disallowance regulation and that the authority to prescribe consolidated return regulations conferred on the secretary is limited only by the requirement that the secretary, in his discretion, has determined such rules necessary clearly to reflect consolidated tax liability. c. notice 2002-18, 2002-12 i.r.b. 644 (3/25/02). the service announced that it and the treasury department intend to issue regulations that will prevent a consolidated group from obtaining a tax benefit from both the utilization of a loss from the disposition of stock (or another asset that reflects the basis of stock) and the utilization of a loss or deduction with respect to another asset that reflects the same economic loss. for example, where a member of a group contributes built-in loss assets to another member of the group in exchange for stock of such member in a transaction in which the basis of such stock is determined, directly or indirectly, in whole or in part, by reference to the basis of such assets and the transferor member sells such stock without causing the deconsolidation of the transferee, the group may benefit from the built-in loss in the contributed assets more than once. it is expected that the regulations will defer or otherwise limit utilization of the loss on the stock in such transactions and other transactions that facilitate the group's utilization of a single loss more than once. d. the new regulations are here. t.d. 8984, loss limitation rules, 67 f.r. 11034 (3/12/02), and reg-102740-02, loss limitation rules, 67 f.r. 11070 (3/12/02). the irs has published final, temporary and proposed regulations under §§ 337(d) and 1502. new temp. reg. § 1.337(d)-2t governs the amount of loss allowed. the regulations disallow deductions for any losses on the sale of the stock of a subsidiary by a member of a consolidated group except to the extent that the taxpayer can prove that the loss is not attributable to the recognition of built-in gain on the disposition of any asset, including stock and securities. gain recognized on the disposition of any asset is “built-in gain” to the extent that the gain is 136 florida tax review [vol.6:si attributable to any excess of value over basis that is reflected in the basis of the stock. thus, the new rule focuses only on losses attributable to basis adjustments to the subsidiary’s stock attributable to gains recognized by the subsidiary. the new regulations also require that on deconsolidation of a subsidiary, the basis of stock of the subsidiary held by members of a consolidated group must be reduced to an amount not exceeding the stock’s value, except to the extent that the taxpayer can show that the required basis reduction is not attributable to recognition of built-in gain. the new rules do not deal with the duplicated losses formerly disallowed by reg. § 1.150220(c)(1)(iii). the new regulations are applicable to dispositions after 3/6/02. for dispositions prior to 3/7/02 (or pursuant to a binding contract entered into prior to 3/7/02) the taxpayer may elect to apply reg. § 1.1502-20. ! at the october 18 meeting in los angeles of the american bar association section of taxation affiliated and related corporations committee, jeffrey h. paravano, senior adviser to the assistant secretary for tax policy, stated that these regulations would govern future transactions similar to the one in which bank of america corp. dropped some problem loans into a wholly owned subsidiary, strategic solutions inc., along with the bank employees whose job it was to work out those loans. the subsidiary had no assets unrelated to the loans, and [assuming a business purpose] the transaction would be governed by § 351. if so, then the bank would have a basis in the subsidiary shares equal to its basis in the loans, and the subsidiary would have the same basis in the transferred loans. because the fair market value of the loans is less than the original amount lent, the subsidiary shares and the subsidiary's assets would have built-in losses. the aim of such transactions appears to be for the bank to sell some subsidiary shares and to recognize a loss, and then use the subsidiary's losses on the loans themselves, as they occur, on the bank's consolidated return. paravano stated that a taxpayer should be able to use the same economic loss only once, based upon charles ilfeld co. v. hernandez, 292 u.s. 62 (1934), in which the supreme court disallowed a loss on the shares of a subsidiary that was being liquidated, on the grounds that permitting the loss would allow the group to use the subsidiary's operating losses twice. 2002 tnt 205-4 (10/22/02). e. a glitch is fixed – in the taxpayer’s favor. t.d. 8998, loss limitation rules, 67 f.r. 37998 (5/31/02), and reg-102305-02, loss limitation rules, 67 f.r. 38040 (5/31/02). new temp. reg. § 1.337(d)2t(a)(4) provides a netting rule [similar to that in former reg. § 1.150220(a)(4)], pursuant to which gain and loss may be netted with respect to the disposition of stock of a subsidiary, to the extent that, as a consequence of the same plan or arrangement, gain is taken into account by members with respect to stock of the same subsidiary having the same material terms. new temp. reg. § 1.337(d)2t(b)(4) provides a similar netting rule for basis reductions on deconsolidations of subsidiary stock. the temporary regulations are also issued as proposed regulations. f. and here are more of the new regulations. reg131478-02, guidance under section 1502; suspension of losses on certain stock dispositions, 67 f.r. 65060 (10/23/02). temporary reg. § 1.337(d)-2t (3/7/02), which generally allows a loss on the disposition of subsidiary member stock only to the extent that a taxpayer can establish that the stock loss is not attributable to the recognition of built-in gain, does not disallow stock loss that reflects loss carryforwards, deferred deductions, or built-in asset losses of the subsidiary member. proposed reg. § 1.1502-35 expands the principles in temp. reg. § 1.337(d)-2t and notice 2002-18, 2002-12 i.r.b. 644 (3/25/02), to limit the ability of a consolidated group to obtain more than one tax benefit from a 2003] recent developments in federal income taxation 137 single economic loss. the proposed regulations provide three principal rules: (1) a basis redetermination rule, (2) a loss suspension rule, and a (3) basis reduction rule. the proposed regulations also include anti-avoidance rules to address transactions designed to avoid the application of the basis redetermination and loss suspension rules. ! the basis adjustment rule applies where a group absorbs a subsidiary’s inside loss followed by the recognition of a loss on the sale of the stock of the subsidiary by another member of the group. the basis adjustment rule operates differently depending on whether the subsidiary remains a member of the group. if the subsidiary remains a member of the group, immediately before the sale of the stock, the basis of all of the stock of the subsidiary (of all classes) owned by the group is reallocated, first to all of the shares of preferred stock, up to their value, and then among all of the shares common stock in proportion to their value. if the subsidiary is no longer a member of the group immediately after the disposition, the basis redetermination rule requires a reallocation to the subsidiary stock retained by the group from the subsidiary stock that was sold in an amount equal to the lesser of (1) the loss inherent in the stock sold, or (2) the subsidiary member’s items of deduction and loss that were taken into account in computing the adjustment to the basis of any share of stock of the subsidiary member, other than the shares disposed of, during the time the subsidiary was a member of the group. [only items of deduction and loss attributable to formerly unrecognized or unabsorbed items reflected in the basis of the subsidiary member stock sold are taken into account; but there is a presumption that all items of deduction and loss included in the computation of prior investment adjustments to the basis of members’ shares of the subsidiary should be taken into account]. the amount by which the basis in the shares of subsidiary stock sold is reduced is reallocated first to the basis of all preferred shares of the subsidiary held by members of the group, up to their fair market value, and then to all common shares of stock of the subsidiary held by members of the group immediately after the disposition in a manner that, to the greatest extent possible, causes the ratio of the basis to the value of each such share to be the same. [the basis redetermination rule does not apply if the group disposes of all its stock of the subsidiary within a single taxable year or is allowed a worthless stock deduction with respect to the subsidiary’s stock. if a second tax benefit has been derived from an economic loss, the second tax benefit will be recaptured in the taxable year in which it was obtained.] ! the loss suspension rule, which is applied after the reallocation rule, effectively disallows a loss on the stock if the economic loss giving rise to that loss is later reflected on the group’s return. if a member of the group recognizes a loss on the disposition of stock of a member and the subsidiary remains a group member, the selling member’s loss is suspended to the extent of the “duplicated loss.” the “duplicated loss” is the excess of (1) the sum of the aggregate basis of the subsidiary’s assets (excluding stock in other subsidiary members of the group), the subsidiary’s losses that are carried to its first taxable year after the disposition, and the subsidiary’s deductions that have been recognized but deferred under another provision, over (2) the sum of the value of stock of the subsidiary member and the subsidiary’s liabilities that have been taken into account for tax purposes. the definition of “duplicated loss” is substantially identical to that in former reg. § 1.1502-20 [except that securities of other members of the group are not excluded from the computation of the subsidiary's aggregate asset basis]. the suspended loss is thereafter reduced [i.e., disallowed] when the subsidiary’s deductions and losses are absorbed in determining the group’s consolidated taxable income. there is 138 florida tax review [vol.6:si a rebuttable presumption that all deductions and losses are attributable to the loss that gave rise to a suspended stock loss. any suspended stock loss remaining at the time the subsidiary member leaves the group generally will be allowed. ! the basis reduction rule operates if a member disposes of subsidiary stock and thereafter ceases to exist [the subsidiary “is not a member of the group and does not have a separate return year”]. in this case, the basis of the subsidiary’s stock is reduced to the extent of the consolidated net operating loss and net capital loss carry-forwards attributable to such subsidiary member, as though they were absorbed immediately prior to the disposition. this rule applies in the case of liquidations of an insolvent subsidiary or in the case of worthless stock losses. ! the regulations [except the anti-abuse rules] are proposed to be effective for transactions on or after 3/7/02 if the return was not due before 10/23/02. 2. deferred intercompany transaction timing rules are a method of accounting. reg-125161-01, conforming amendments to section 446, 66 f.r. 56262 (11/7/01). these proposed regulations would conform reg. § 1.446-1(c)(2)(iii) to reg. § 1.1502-13(a)(3), promulgated in 1995, which provided that the deferred intercompany transaction rules are a method of accounting. members of the consolidated group are required to apply this method in addition to their usual methods of accounting. ! in general motors corp. v. commissioner, 112 t.c. 270 (1999), the tax court held that the timing rule of former [pre-1995] reg. § 1.1502-13(b)(2) was not a method of accounting for purposes of § 446(e). the proposed regulations confirm the irs’s position that the timing rules of current reg. § 1.1502-13 are a method of accounting. a. finalized. t.d. 9025, intercompany transactions: conforming amendments to section 446, 67 f.r. 76985 (12/16/02). the proposed regulations were adopted without change, and are effective 11/7/01. 3. corporate remarriage ok if you talk sweetly to the irs! rev. proc. 2002-32, 2002-20 i.r.b. 959 (5/20/02). this revenue procedure permits qualifying corporations to obtain a waiver of the § 1504(a)(3)(4) bar from joining in a consolidated return with a group of which it had ceased to be a member within the preceding 60 months. 4. t.d. 9002, agent for consolidated group, 67 f.r. 43538 (6/28/02). regulations §§ 1.1502-77 and 1.1502-78 [proposed in reg-10380599, agent for consolidated group, 65 f.r. 57755 (9/26/00)] clarify and supplement the rules concerning the agent for a consolidated group and the designation of a new agent for the group. the final regulations are substantially the same as the proposed regulations, with clarifying changes. under the regulations, the common parent remains the agent as long as it continues to exist as a corporation, even if it ceases to be the common parent. the common parent is also the agent for any corporation improperly included in the consolidated return. the regulations continue the current rule that if the common parent ceases to exist it may designate another member of the group as its successor agent. if no such designation is made, the irs may designate the successor agent, except in cases where the parent has a single domestic successor, where that successor becomes the agent by default. the prior rule permitting the remaining members to designate the successor agent will be removed. the regulations deal with the interlake corp. v. commissioner, 112 t.c. 103 (1999), problem by providing that a refund resulting from a carryback of a nol under 2003] recent developments in federal income taxation 139 12. for a more complete discussion of these proposed regulations, see shepard, ira b. and martin j. m cmahon, jr., recent development in federal income taxation: the year 2001, 5 fla. tax. rev. 627, 714-17 (2002). § 172 should be paid to the common parent or agent for the carryback year. the revised regulations generally are effective with respect to taxable years beginning on or after 6/28/02. f. reorganizations and corporate divisions 1. the wrath of general utilities repeal rewritten. reg107566-00, guidance under section 355(e); recognition of gain on certain distributions of stock or securities in connection with an acquisition, 66 f.r. 66 (1/2/01). the treasury department revised prop. reg. § 1.355-7 and withdrew proposed regulations (reg-116733-98, 66 f.r. 76 (1/21/01)) issued in reg-116733-98, 64 f.r. 46155 (8/24/99). the proposed regulations provided that whether a distribution and an acquisition are part of a plan is determined based on all the facts and circumstances. they included a nonexclusive lists of facts and circumstances to be considered in making the determination and six safe harbors.12 a. and apparently the governm ent thinks it did a better job on the regulations the second – or is this the third? – time around. t.d. 8960, guidance under section 355(e); recognition of gain on certain distributions of stock or securities in connection with an acquisition, 66 f.r. 40590 (8/3/01). the treasury department has promulgated temporary regulations identical to the proposed regulations, except that the temporary regulations reserve § 1.355-7(e)(6) (suspending the running of any time period during which there is a substantial diminution of risk of loss under the principles of § 355(d)(6)(b)) and example 7 of the proposed regulations (interpreting the term “similar acquisition” in the context of a situation involving multiple acquisitions). b. the third (fourth?) time’s the charm. t.d. 8988, guidance under section 355(e); recognition of gain on certain distributions of stock or securities in connection with an acquisition, 67 f.r. 20632 (4/26/02), and reg-163892-01, guidance under section 355(e); recognition of gain on certain distributions of stock or securities in connection with an acquisition, 67 f.r. 20711 (4/26/02). these temporary and proposed regulations amend temp. reg. § 1.355-7t and identical prop. reg. § 1.355-7, and set forth new guidelines in the anti-morris trust regulations. the 2002 temporary and proposed regulations disregard the presumption of § 355(e)(2)(b) and provide that “whether a distribution and an acquisition are part of a plan is determined based on all the facts and circumstances.” however, temp. reg. § 1.355-7t(b)(2) provides a “super-safe harbor” for an acquisition not involving a public offering that occurs within 2 years following the date of a distribution—the distribution and acquisition “will be treated as part of a plan only if there was an agreement, understanding, arrangement, or substantial negotiations regarding the acquisition or a similar acquisition at some time during the 2-year period ending on the date of the distribution.” [emphasis added]. under the facts and circumstances test, the existence of an agreement, understanding, arrangement, or substantial negotiations during the 2-year period tends to show that the distribution and acquisition are part of a plan, but such an understanding, etc., is merely a factor among the facts and circumstances to 140 florida tax review [vol.6:si be evaluated. if an acquisition precedes the distribution, discussions regarding a distribution with the acquirer by either the controlled or distributing corporation within the 2-year period preceding the acquisition indicate the existence of a plan. the absence of discussions regarding a distribution during the 2-year period preceding the acquisition indicates that the acquisition and distribution were not part of a plan. discussions with an investment banker during the 2-year period preceding an acquisition by public offering are a factor indicating the existence of a plan. a corporate business purpose [as defined in reg. § 1.355-2(b)], other than a business purpose to facilitate the acquisition, is a factor indicating the absence of a plan. that the distribution would have occurred at approximately the same time and in similar form regardless of the acquisition indicates the absence of a plan. a distribution and an acquisition are not part of a plan if they are described in one of the following seven safe harbors: (1) an acquisition occurs more than 6 months after a distribution, there was no agreement, understanding, arrangement, or substantial negotiations regarding the acquisition from one year before the distribution to 6 months after the distribution, and the distribution was motivated in whole, or in substantial part, by a corporate business purpose other than to facilitate an acquisition. (2) an acquisition occurs more than 6 months after a distribution and there was no agreement, understanding, arrangement, or substantial negotiations regarding the acquisition from one year before the distribution to 6 months after the distribution, the distribution was not motivated by a business purpose to facilitate an acquisition of either the distributing or controlled corporations, and no more than 25 percent of the stock of the corporation whose stock was acquired in the acquisition was either acquired or the subject of an agreement, understanding, arrangement, or substantial negotiations during a period from one year before the distribution to 6 months following the distribution. (3) an acquisition occurs after the distribution and there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition at the time of the distribution or within one year thereafter. this provision eliminates the statutory 2-year post-distribution presumption and replaces it with a one-year safe harbor. (4) a distribution occurs more than 2 years after an acquisition and there was no agreement, understanding, arrangement, or substantial negotiations concerning the distribution at the time of the acquisition or within 6 months thereafter. (5)an acquisition of stock of the distributing or controlled corporation listed on an established market occurs as a result of transfers between shareholders of distributing or controlled corporations who are not controlling shareholders [5 percent shareholders who participate in management] or 10 percent shareholders. this safe harbor does not apply if the transferor or transferee of the stock is controlled by the acquired corporation, is a member of a controlled group that includes the acquired corporation, or is an underwriter with respect to the acquisition. (6) an acquisition of stock by an employee, director, or independent contractor [other than controlling shareholders] in connection with the performance of services. (7) an acquisition by a qualified pension or retirement plan. 2. post-spin-off stock options and restricted stock taxation determined with reference to the policy of § 1032. rev. rul. 2002-1, 2002-2 i.r.b. 268 (1/14/02). this ruling answers several questions with respect to transactions involving restricted stock and stock options held by employees of both corporations following a § 355 spin-off of a controlled corporation (c) by a distributing corporation (d). the distributions of c stock and warrants were 2003] recent developments in federal income taxation 141 13. lewis carroll, through the looking glass, the complete work s of lew is car ro ll 196 (1966). in an amount and on terms designed to exactly preserve the employees’ prespin-off economic rights. first, the ruling holds that d does not recognize any gain or loss when restrictions lapse on c stock that was received by d employees in the spin-off with respect to their restricted d stock. likewise, d does not recognize gain or loss as a result of the exercise by d employees of options on c stock that were received in the spin-off with respect to options on d stock that they held. second, c does not recognize gain or loss when restrictions lapse on d stock held by c employees that was received before the spin-off. likewise, c does not recognize gain or loss as a result of the exercise by c employees of options on d stock that were received in the spin-off with respect to options on d stock that they held before the sp in-off. third , d is entitled to deductions for amounts includible in d employees’ income as a result of the lapse of restrictions on d and c stock and the exercise of options to acquire d and c stock, and c is entitled to deductions for amounts includible in c employees’ income as a result of the lapse of restrictions on d and c stock and the exercise of options to acquire d and c stock. 3. just a simple earnings bailout scheme. south tulsa pathology laboratory, inc. v. commissioner, 118 t.c. 84 (1/28/02). the tax court (judge marvel) held that a pre-§ 355(e) pro rata spin-off followed by a prearranged sale of the controlled corporation’s stock was a “device” precluding tax-free treatment under § 355. there was no business purpose for the distribution of the controlled business to the shareholders prior to its sale even if there was a business purpose for the sale. that the distributing corporation’s earnings and profits were only $253,000, compared with the $5,530,000 sale price, did not negate that the transaction was a device to bail out earnings and profits because the earnings and profits that were being bailed out were the profits from the sale of the controlled corporation’s business. the distributing corporation’s recognized gain was computed with reference to the selling price of the stock—not the appraised fair market value of the assets transferred by the distributing corporation to the controlled corporation—because the contemporaneous arm’s length sales price was the best evidence of the fair market value of the stock. pope & talbot, inc. v. commissioner, 104 t.c. 574 (1995), aff’d, 162 f.3d 1236 (9th cir. 1999) (holding that for purposes of § 311(b) a corporation that transferred land to a limited partnership and then distributed the limited partnership units was treated as distributing the land), was distinguished as involving a question of identifying the distributed asset; in the instant case the distributed asset clearly was the stock of the controlled corporation. 4. “when i[rs] use a word . . . it means just what i[rs] choose it to mean.”13 rev. rul. 2002-49, 2002-32 i.r.b. 288 (8/12/02). this revenue ruling deals with whether the 5-year active conduct of a trade or business requirement of § 355(b) is satisfied when, during the 5-year period prior to a transaction that otherwise meets the requirements of § 355, a corporation holding a membership interest in a member-managed limited liability company purchases the remaining interests in that limited liability company, contributes a portion of the business to a newly formed controlled subsidiary, and then distributes the stock of the controlled subsidiary to its shareholders. ! in situation 1, d corporation’s sole asset was 20 percent of the llc, which operated numerous rental properties and its officers actively participated in the management of the llc, along with the 142 florida tax review [vol.6:si officers of another 20 percent owner (none of the other owners participated in management). after 2 years, d purchased the other 80 percent of the interests and the llc became a disregarded entity. on the first day of year 6, the llc distributed 40 percent of the rental properties to d, which contributed the properties to c in exchange for all of c’s stock, following which c was spun-off to d’s shareholders. the irs applied rev. rul. 92-17, 1992-1 c.b. 142, to find d was engaged in the active conduct of the leasing business [within the meaning of § 355(b)] for the first 2 years. notwithstanding rev. rul. 99-6, 1999-1 c.b. 432 (holding that the sale and purchase of all of the remaining interests in an llc is treated as the distribution of assets to the selling members and the purchase of assets by the continuing members), the purchase of the 80 percent interest in the llc within 5 years did not violate § 355(b)(2)(c), even though gain or loss was recognized in the transaction, because the transaction was not the acquisition of a new or different business under reg. § 1.355-3(b)(3)(ii). ! situation 2 is the same as situation 1, except that d obtained the 20 percent interest in the llc on the first day of year 2, in exchange for appreciated securities in a § 721 transaction, before the spin-off in year 6. this situation does not qualify because d is treated as having acquired the llc’s business in a transaction in which gain or loss was recognized within the 5-year pre-distribution period [§ 355(b)(2)(c)]. although no gain or loss was recognized [§ 721(a)] on d’s acquisition of the llc interest in year 2, if d had directly acquired the llc’s business in exchange for the property d contributed to the llc, the exchange would have been a transaction in which gain or loss was recognized. for purposes of § 355(b), therefore, d is treated as acquiring the llc’s business in year 2 in a transaction in which gain or loss was recognized. huh! 5. pooling on the financials, taxable purchase on the tax return. is something strange here or are we just naive? novacare, inc. v. united states, 52 fed. cl. 165, 2002-1 u.s.t.c. ¶50,389, 89 a.f.t.r.2d 20021553 (3/25/02). taxpayer acquired rsc [in a triangular merger] solely in exchange for approximately 6 million shares of its stock on august 9, 1991. by december 31, 1992, the former rsc shareholders had disposed of roughly 87 percent of the novacare stock received. when taxpayer sold its rsc subsidiary in 1995, it reported gain using a purchase price basis, treating the 1991 acquisition as a taxable purchase because of a lack of continuity of interest under the regulations as then in effect, as interpreted by mcdonald’s restaurants of illinois, inc. v. commissioner, 688 f.2d 520 (7th cir. 1982). [of course, in the spirit of enron, worldcom, xerox, and who knows who else, novacare treated the acquisition as a pooling for financial accounting.] the commissioner argued that penrod v. commissioner, 88 t.c. 1415 (1987), should control to treat the 1991 acquisition as a reorganization with a transferred basis. the court (judge horn) denied cross motions for summary judgment, holding that a genuine issue of fact existed as to whether the rsc shareholders intended, at the time of the reorganization on august 9, 1991, to dispose of the novacare stock received in the reorganization or to hold it. ! t he court n oted th at for reorganizations occurring after 1/28/98, under reg. § 1.368-1(e), postreorganization dispositions are irrelevant with respect to continuity of interest, but gave no weight to the promulgation of the regulation to solve the mcdonald's/penrod problem. 6. “expessio unis est exclusio alterius”? nope, not the way the irs thinks. rev. rul. 2002-85, 2002-52 i.r.b. 986 (12/30/02). an acquiring corporation’s transfer of the target corporation’s assets to a subsidiary controlled by the acquiring corporation as part of a plan of reorganization will 2003] recent developments in federal income taxation 143 not disqualify a transaction that otherwise qualifies as a § 368(a)(1)(d) reorganization— i.e., the original transferee acquires substantially all of the target’s assets, the cosi and cobe requirements are met, and the remote continuity principle of groman v. commissioner, 302 u.s. 654 (1937), and helvering v. bashford, 302 u.s. 454 (1938), does not apply—and which would not have qualified as a type (c) reorganization [due to excessive boot]. the irs reasoned, as it did in rev. rul. 2001-24, 2001-1 c.b. 1290, that § 368(a)(2)(c) is permissive and not restrictive; thus the lack of a reference to § 368(a)(1)(d) in § 368(a)(2)(c) does not indicate that such a transfer following a transaction that otherwise qualifies as a reorganization under § 368(a)(1)(d) will prevent the transaction from qualifying. in addition, the irs treated the parenthetical exception in § 368(a)(2)(a), dealing with the overlap of (c) and (d) reorganizations—“other than for purposes of [§ 368(a)(2)(c)]”—as “in the same spirit as § 368(a)(2)(c), i.e., to resolve doubts about the qualification of transactions as reorganizations, and . . . not [to] indicate that the transfer of assets to a controlled subsidiary necessarily prevents a transaction from qualifying as a reorganization under § 368(a)(1)(d).” 7. merging tax somethings into tax nothings is ok! t.d. 9038, statutory mergers and consolidations, 68 f.r. 3384 (1/24/03), and reg126485-01, statutory mergers and consolidations, 68 f.r . 3477 (1/24/03). in reg-126485-01, statutory mergers and consolidations, 66 f.r. 57400 (11/15/01), the treasury department withdrew the proposed regulations [reg106186-98, certain corporate reorganizations involving disregarded entities, 65 fr 31115 (5/16/00)], which would have provided that neither the merger of a disregarded entity into a corporation nor the merger of a target corporation into a disregarded entity was a statutory merger qualifying as a reorganization under § 368(a)(1)(a), and proposed more liberal regulations [prop. reg. § 1.368-2(b)(1)]. under the 2001 proposed regulations, a merger of a corporation into a disregarded entity that is wholly owned by another corporation could qualify as a type (a) merger. the treasury department has now promulgated the 2001 proposed regulations, with some modifications, as temp. reg. § 1.1368-2t(b) and simultaneously published new identical proposed regulations. ! the main point of the regulations is that the merger of a target corporation into an llc wholly owned by another corporation (thereby rendering the llc a disregarded entity) can qualify as a type (a) reorganization [and under more complex structures as a triangular reorganization, that the merger of a corporation into a q-sub [also a disregarded entity] can qualify as a type (a) reorganization, and that a merger into a qualified reit subsidiary can qualify as a type (a) reorganization. ! nevertheless, the new regulations introduce significant definitional jargon. the term “disregarded entity” means a business entity (as defined in reg. § 301.7701-2(a)) that is disregarded as an entity separate from its owner for federal tax purposes, including single member corporate-owned llcs, qualified reit subsidiaries, and q-subs. “combining entity” means a corporation (as defined in reg. § 301.7701-2(b)) that is not a disregarded entity. “combining unit” means a combining entity and all disregarded entities, if any, the assets of which are treated as owned by such combining entity for federal tax purposes. under the proposed regulations, a statutory merger or consolidation under § 368(a)(1)(a) must be effected pursuant to the laws of the united states, a state, or the district of columbia. [foreign statutory mergers still do not qualify, but the domestic statute no longer needs to be a “corporate” law.] all of the following events must occur simultaneously: (1) all of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of each member of one or more combining units (each a transferor 144 florida tax review [vol.6:si unit) become the assets and liabilities of one or more members of one other combining unit (the transferee unit); and (2) the combining entity of each transferor unit ceases its separate legal existence [although its formal existence can continue under state law for certain limited purposes that are not inconsistent with the “all of the assets” requirement.]. the examples provide all of the details of the rules: divisive mergers [see rev. rul. 2000-5, 2000-1 c.b. 436] cannot qualify (ex. 1); forward triangular mergers (into a disregarded entity owned by a subsidiary) are allowed (ex. 2 & 4); the merger of a target s corporation that owns a q-sub into a disregarded entity owned by a c corporation qualifies as to both the target s corporation and its q-sub (ex. 3); the owner of the disregarded entity must be a corporation (ex. 5); mergers of disregarded entities into corporations do not qualify (ex. 6); none of the consideration received by the target shareholders may be interests in the disregarded entity (ex. 7); and the target can be tailored by selling assets and distributing proceeds, as long as all of the remaining assets are transferred to the disregarded entity in the merger (ex. 8). ! these regulations became effective on 1/24/03. g. personal holding companies and accumulated earnings tax 1. “accrued” tax liabilities are different from tax liabilities “imposed.” metro leasing & development corp. v. commissioner, 119 t.c. 8 (7/17/02) (reviewed). in an earlier proceeding [t.c. memo. 2001-119], the tax court held that the taxpayer was liable for the accumulated earnings tax under §§ 531-537. in this supplemental opinion, the tax court, in a reviewed opinion by judge gerber, rejected the taxpayer’s arguments that the amount of the unreasonably accumulated earnings should be adjusted under §§ 535(b)(1) and 535(b)(6)(a) in three respects. ! first, the court held that no adjustment for unpaid “accrued” taxes should be made with respect to taxes that would become due in future years with respect to a closed transaction that was being reported on the § 453 installment method. since the gain to be recognized in future years had not been included in the accumulated income, it was not appropriate to reduce the accumulated income by the taxes attributable to that gain. ! second, no adjustment should be made with respect to any tax deficiency, including the accumulated earnings tax, that the taxpayer continued to contest. since the taxpayer continued to contest an underlying deficiency, even though payment had been tendered, no adjustment was allowed. the tax court specifically declined to follow j.h. rutter rex manufacturing co. v. commissioner, 853 f.2d 1275 (5th cir. 1988), rev’g t.c. memo 1987-296, in which the fifth circuit held to the contrary. the tax court found no basis for treating a taxpayer who pays the contested deficiency differently from the taxpayer who does not pay the contested deficiency. ! third, the court held that the decrease in the downward adjustment for capital gains under § 535(b)(6)(a) should be the taxes “attributable,” i.e. “imposed” under the statute, to those capital gains and is not limited to the combined income tax liability on capital gains and ordinary income or loss shown on the taxpayer’s return. the adjustment also takes into account the taxes due after the determination of a deficiency. accordingly, because the taxpayer’s tax liability exceeded $100,000 after the determination of the deficiency, the taxpayer, who reported $35,884 of net capital gain, but only $17,825 of taxable income due to net operating losses, reduced the negative adjustment by $15,738 of taxes “attributable” to the capital gain, not merely the $2,674 of taxes shown as due on the return. the court 2003] recent developments in federal income taxation 145 14. zenz v. quinlivan, 213 f.2d 914 (6th cir. 1954). found no conflict between its second and third holdings because a tax is “imposed” if it has been paid and is being contested, even though it is not “accrued” under those circumstances. h. miscellaneous corporate issues 1. could they have obtained a better result if their advisor had read zenz14 before structuring the deal? or would § 311(b) have taken a big tax bite? steel v. commissioner, t.c. memo. 2002-113 (5/6/02). the taxpayer was a partner in a partnership that owned the stock of a corporation. at the time of the sale of the stock of the corporation, the corporation had a claim pending for lost profits under a business interruption insurance policy. as permitted by the purchase and sale contract, the claim was assigned to the partnership, but nothing in the purchase and sale agreement indicated that the pricing was in any way related to the assignment. subsequently, the partnership received cash in settlement of the claim, which the partners reported as additional capital gain on the sale of the stock. judge ruwe upheld the commissioner’s determination that the receipt of the insurance claim proceeds was unrelated to the sale of the stock. that the assignment would not have occurred “but for” the stock sale, was not enough to integrate them. since there was no sale or exchange on receipt of the proceeds, the amount realized was ordinary income. 2. telling the irs about your corporate/shareholder transactions. t.d. 9022, information reporting relating to taxable stock transactions, 67 f.r. 69468 (11/18/02). temporary reg. § 1.6043-4t imposes information reporting requirements [form 8806] on corporations that have undergone a change in control or a substantial change in capital structure, e.g., a recapitalization, redemption, merger, transfer of substantially all its assets, or an (f) reorganization. however, transactions in which the amount of cash and the fair market value of property (including stock) provided to the shareholders is less than $100,000,000 are exempt, as are transactions within an affiliated group. vii. partn ersh ips a. form ation and taxable years 1. no more “inappropriate” increases or decreases in the adjusted basis of a corporate partner’s interest in a partnership. t.d. 8986, determination of basis of partner’s interest; special rules, 67 f.r. 15112 (3/29/02). the treasury department has finalized reg. § 1.705-2 [proposed in reg-106702-00, determination of basis of partner’s interest; special rules, 66 f.r. 315 (1/3/01)] which is intended to prevent what the irs has determined to be “inappropriate” increases or decreases in the adjusted basis of a corporate partner’s interest in a partnership [consistent with notice 99-57,1999-2 c.b. 692] resulting from the partnership’s disposition of the corporate partner’s stock [under the general principles of rev. rul. 99-57, 1999-2 c.b. 678], when: (1) a corporation acquires an interest in a partnership that holds stock in the corporation, (2) the partnership does not have a § 754 election in effect for the year in which the corporation acquires the interest, and (3) the partnership later sells or exchanges the stock. the increase or decrease in the corporation’s adjusted basis in its partnership interest resulting from the sale or exchange of the stock equals the amount of gain or loss that the corporate partner would 146 florida tax review [vol.6:si have recognized (absent the application of § 1032) if, for the tax year in which the corporation acquired the interest, a § 754 election had been in effect. the final regulations require appropriate adjustments to the basis of tiered partnerships to prevent evasion of their purpose where a corporation acquires an indirect interest in its own stock though a chain of partnerships and gain or loss from the sale of stock is subsequently allocated to the corporation. the regulation is effective retroactively to gain or loss allocated on sales or exchanges of stock occurring after 12/6/99. a. proposed amendments before the ink is dry. reg167648-01, amendments to rules for determination of basis of partner’s interest; special rules, 67 f.r. 15132 (3/29/02). the treasury department has proposed amendments to reg. § 1.705-2, which was finalized on the same day the proposed amendments were published, “to address remaining issues that [were] considered during the development of the final regulations.” the proposed amendments would extend the rules of reg. § 1.705-2 to situations in which a corporation owns a direct or indirect interest in a partnership that owns stock in that corporation, the partnership distributes money or other property to another partner and that partner recognizes gain on the distribution during a year in which the partnership does not have a § 754 election in effect, and the partnership subsequently sells or exchanges the stock. the proposed amendments also clarify that “stock” of a corporate partner includes any position with respect to stock of a corporate partner. the proposed amendments would be effective retroactively to gain or loss allocated on sales or exchanges of stock occurring after 3/29/02. 2. husbands and wives are co-owners of a disregarded entity or partners [their choice], if the business is community property; if the business is not community property, then they are partners. rev. proc. 2002-69, 2002-45 i.r.b. 831 (11/12/02). this revenue procedure deals with the classification of business entities (other than corporations), i.e., partnerships and llcs, that are wholly owned by a husband and wife as community property. if the husband and wife treat the entity as a disregarded entity for federal tax purposes, the irs will accept the position that the entity is a disregarded entity for federal tax purposes. on the other hand, if the entity, and the husband and wife, treat the entity as a partnership for federal tax purposes and file appropriate partnership returns, the irs will accept the position that the entity is a partnership for federal tax purposes. a change in reporting position will be treated for federal tax purposes as a conversion of the entity. ! nothing in the revenue procedure allows husbands and wives who wholly own an llc or partnership in a common law property state to avoid entity characterization. b. allocations of distributive share, partnership debt, and outside basis 1. the gestalt theory of partnership allocations. estate of ballantyne v. commissioner, t.c. memo. 2002-160 (6/24/02). the decedent taxpayer and his brother for many years operated a partnership that engaged in an oil and gas business, run by the decedent, and a farming business, run by the decedent’s brother. the partnership was an oral partnership, and the brothers consistently reported as equal partners, even though the decedent consistently withdrew the profits from the oil and gas business and the decedent’s brother consistently withdrew the profits from the farming business. after the decedent’s death, the estate took the position that all of the income from the farming activity was reportable as the decedent’s brother’s distributive share. because the partnership did not maintain capital accounts, the allocation lacked 2003] recent developments in federal income taxation 147 economic substance, and the partners’ interests in the partnership were determined under the facts and circumstances test of reg. § 1.704-1(b)(3). based on the evidence, the estate could not overcome the presumption that the partners were equal partners. there was no record of capital contributions, the amount of profits of each activity varied from year to year, as did withdrawals, but the partners’ economic interests and interests in cash flow could not be determined because the partnership books and records were inadequate. however, the “facts”—mostly the witnesses’ “beliefs” that the brothers were 50/50 partners—indicated that they were to share liquidating distributions equally. that factor, combined with the brothers long-time consistent reporting as equal partners and the absence of any evidence that the brothers’ reporting position involved tax avoidance, was sufficient to convince judge ruwe that they were equal partners. c. distributions and transactions between the partnership and partners there were no significant developments in this topic in 2002. d. sales of partnership interests, liquidations and m ergers there were no significant developments in this topic in 2002. e. inside basis adjustments there were no significant developments in this topic in 2002. f. partnership audit rules 1. are conflicts worse than criminality? madison recycling associates v. commissioner, 295 f.3d 280, 2002-2 u.s.t.c. ¶50,515, 90 a.f.t.r.2d 2002-5132 (2d cir. 7/9/02). the ninth circuit held that a consent to extend the statute of limitations executed by an otherwise properly designated agent of the tmp was not invalid merely because the tmp was under criminal tax investigation at the time the consent was signed. because the tmp was unaware of the criminal investigation at the time the consent was signed, he had no conflict of interest. on that basis the court distinguished its holding in transpac drilling venture 1982-12 v. commissioner, 147 f.3d 221 (2d cir. 1998). 2. partnerships shouldn’t bother applying for § 7841(c) interest redeterminations. asa investerings partnership v. commissioner, 118 t.c. 423 (5/22/02). the decision in the tax shelter case, asa investerings partnership v. commissioner, t.c. memo. 1998-305, aff’d, 201 f.3d 505 (d.c. cir. 2000), cert. denied, 531 u.s. 871 (2000), was entered pursuant to a partnership level proceeding filed in the tax court under § 6226(a), rather than § 6215(a). accordingly, the substantive proceeding was not a redetermination of a deficiency, and judge ruwe held that the tax court lacked jurisdiction under § 7481(c) to review the commissioner’s determination of interest, even though all of the other conditions for § 7481(c) review had been met. a petition for redetermination of the deficiency under § 6215(a) is an express statutory prerequisite for § 7481(c) review of an interest determination. 3. gustin v. commissioner, t.c. memo. 2002-64 (3/7/02). a deficiency notice disallowing a portion of a partner’s distributive share of losses from a tefra partnership under § 704(d), on the ground that the losses exceeded the partner’s basis in his partnership interest, was valid even though 148 florida tax review [vol.6:si there had been no fpaa and partnership-level proceeding. a partner’s basis in the partnership is not a partnership item. viii. tax shelters a. tax shelter cases 1. tax shelter benefits from § 453 contingent sale partnership tax shelter not allowed because the tax shelter is a sham and “serves no economic purpose other than tax savings.” merrill lynch’s persistence overcomes initial doubts of tax department. acm partnership v. commissioner, t.c. memo. 1997-115 (3/5/97), aff’d in part, rev’d in part, 157 f.3d 231, 98-2 u.s.t.c. ¶50,790, 82 a.f.t.r.2d 98-6682 (3d cir. 10/13/98) (21), cert. denied, 526 u.s. 1017 (3/2/99). judge laro found a § 453 contingent sale partnership tax shelter to be a prearranged sham, “tax-driven and devoid of economic purpose,” and “serv[ing] no economic purpose other than tax savings,” following goldstein v. commissioner, 364 f.2d 734 (2d cir. 1966), cert. denied, 385 u.s. 1005 (1967). under the scheme to shelter colgate’s $105 million 1988 capital gain, a partnership was formed in 1989; its three partners were affiliates of (a) a foreign bank (about 90%), (b) colgate (about 9%), and (c) merrill lynch (about 1%). a bank note was purchased by the partnership and immediately sold for a large immediate payment and much smaller future contingent payments. under the contingent payment sale provisions of the temporary regulations [§ 15a.453-1(c)] the partnership’s basis was to be allocated ratably over the several years in which contingent payments could be made, resulting in a large 1989 installment sale gain to the partnership. the lion’s share of that installment sale gain was allocated to the foreign bank (which was not taxable on u.s. source capital gain), followed by the redemption of the foreign bank’s partnership interest. this left colgate as the 90 percent partner. in 1991, the installment sale obligation was sold by the partnership, triggering about $100 million of capital losses, which colgate attempted to use to shelter its 1988 capital gain. ! the third circuit affirmed the tax court’s application of the “economic substance” doctrine, which eliminated the capital gains and losses attributable to acm’s application of the ratable basis recovery rule of the contingent installment sale provisions. the third circuit held, however, that out-of-pocket amounts were deductible. 2. judge foley finds another merrill lynch § 453 partnership plan does not work because, under the facts, there was no partnership. asa investerings partnership v. commissioner, t.c. memo. 1998-305 (8/20/98). in another merrill lynch § 453 partnership plan to create capital losses to shelter earlier capital gains, alliedsignal lost when judge foley held that the parties to the partnership agreement did not join together for a common purpose of investing in interest-bearing instruments, and they did not share profits and losses. a. affirmed, asa investerings partnership v. commissioner, 201 f.3d 505, 2000-1 u.s.t.c. ¶50,185, 85 a.f.t.r.2d 2000675 (d.c. cir. 2/1/00), cert. denied, 531 u.s. 871 (10/2/00). the d.c. circuit’s opinion noted that it disagreed with the tax court’s statements that persons with “divergent business goals” are precluded from having the requisite intent to form a partnership; however, this view was not essential to the tax court’s conclusion that the parties did not intend to join together as partners to conduct business activities for a purpose other than tax avoidance. the court held that there was a single business purpose rule. 2003] recent developments in federal income taxation 149 3. saba partnership v. commissioner, t.c. memo. 1999-359 (10/27/99). brunswick’s (the taxpayer’s) transactions, which were identical to acm’s, were found to lack economic substance. judge nims held that the transactions lacked nontax business purposes and that congress did not intend to favor such transactions “regardless of their economic substance.” he held that fees paid for the organization of the partnership were deductible subject to the limitations of § 709(b) [60-month amortization], but that the fees paid with respect to the sham transactions were not deductible. a. d.c. circuit remands saba for reconsideration in light of its opinion in asa investerings. saba partnership v. commissioner, 273 f.3d 1135, 2002-1 u.s.t.c. ¶50,145, 88 a.f.t.r.2d 2001-7318 (d.c. cir. 12/21/01), remanding for reconsideration in light of asa investerings, t.c. memo. 1999-359 (10/27/99), on remand to t.c. memo. 2003-31 (2/11/03). the court felt this case was indistinguishable from asa investerings, which was decided on a sham partnership theory, as opposed to judge nims’s decision in the tax court, which was grounded on a sham transaction theory. the court of appeals refused to simply affirm the tax court’s decision on the alternative ground that the partnerships were shams. even the government conceded that the sham transaction and sham partnership approaches yield different results; the adjustments under the sham transaction theory would be different from those under the sham partnership theory [although the government apparently conceded at oral argument that under either approach, brunswick could deduct actual losses from the transactions]. the government argued that the court of appeals should apply asa investerings to hold that the partnerships were shams, and remand the case to the tax court for the limited purpose of determining the amount of any necessary adjustments. but the court of appeals accepted the taxpayer’s argument that the “question of whether ‘an entity should be regarded as a partnership for federal tax purposes is inherently factual,’” and remanded to allow the taxpayer to address the question to the trial court, even though it doubted that the tax court’s “findings are inadequate because of ‘significant differences’” alleged by the taxpayer “between the actions of brunswick in this case and those of [the taxpayer] in asa.” indeed, the court of appeals opinion said: “as far as we can tell, the only difference between this case and asa is that brunswick and abn did not meet in bermuda.” in remanding, judge tatel foreshadowed what he expected to be the result on remand: in any case, asa makes clear that “the absence of a nontax business purpose is fatal” to the argument that the commissioner should respect an entity for federal tax purposes. here , the tax court specifically found “overwhelming evidence in the record that saba and otrabanda were organized solely to generate tax benefits for brunswick.” arguably, this broader finding subsumes any factual differences that might exist between this case and asa. [citations omitted]. . . . although the present record might strongly suggest that saba and otrabanda were sham partnerships organized for the sole purpose of generating paper tax losses for brunswick, fairness dictates that we ought not affirm on this ground. in particular, in presenting its case in the tax court, brunswick may have acted on the mistaken belief that the supreme court’s decision in moline properties, inc. v. commissioner, 319 u.s. 436, 87 l. ed. 1499, 63 s. ct. 1132 (1943), established a two-part test 150 florida tax review [vol.6:si under which saba and otrabanda must be respected simply because they engaged in some business activity, an interpretation that asa squarely rejected. ! note the effect of this opinion on the boca investerings case, below. 4. same arrangem ent as earlier failed shelters, different trial court judge – it’s a business deal, not a shelter. boca investerings partnership v. united states, 167 f. supp. 2d 298, 2001-2 u.s.t.c. ¶50,690, 88 a.f.t.r.2d 2001-6252 (d. d.c. 10/5/01). american home products [now wyeth] entered into a merrill lynch marketed tax shelter virtually identical to those in acm partnership v. commissioner, 157 f.3d 231 (3d cir. 1998), aff’g t.c. memo. 1997-115, cert. denied, 526 u.s. 1017 (1999), asa investerings partnership v. commissioner, 201 f.3d 505 (d.c. cir. 2000), aff’g t.c. memo. 1998-305, and saba partnership v. commissioner, t.c. memo. 1999-359, judgment vacated by 273 f.3d 1135 (d.c. cir. 2001), on remand to t.c. memo. 2003-31. the losses from the transaction sheltered the gain on the sale of a corporate subsidiary. judge friedman held that a valid partnership existed and that the losses were allowable because he found that the taxpayer had both a business purpose and an objective profit potential in entering into the transaction. a. reversed: asa investerings is followed. boca investerings partnership v. united states, 314 f.3d 625, 2003-1 u.s.t.c. ¶50,181, 91 a.f.t.r.2d 2003-444 (d.c. cir. 1/10/03). the d.c. circuit held that the district court “erred as a matter of law when it did not properly apply the holding of asa investerings, requiring that a legitimate non-tax business necessity exist for the creation of the otherwise sham entity inserted into the partnership for tax avoidance reasons in order to meet the intent test of commissioner v. culbertson, 337 u.s. 733 (1949), as applied to this type of partnership transaction.” judge sentelle quoted asa to make clear that “the absence of a nontax business purpose” is fatal to an argument that the commissioner should respect an entity for federal tax purposes. 5. lease-strip transaction by pseudo-black box intermediary fails in the tax court. nicole rose corp. v. commissioner, 117 t.c. 328 (12/28/01), aff’d, 320 f.3d 282, 2003-1 u.s.t.c. ¶50,137, 90 a.f.t.r.2d 20027702 (2d cir. 12/13/02). the taxpayer corporation’s stock was sold to an intermediary [which then merged downstream], following which its assets were sold to the prearranged ultimate purchaser. to offset the gains realized on the asset sale, the taxpayer acquired by a § 351 transaction interests in certain equipment leaseback transactions [secured by trusts that resulted in a circular cash flow] that had no foreseeable value, which it immediately transferred to a dutch bank, the sole consideration for which was assumption of taxpayer’s obligations [of which there were in reality none]. taxpayer claimed a $22 million ordinary business expense deduction as a result of the transfer of the leaseback interests. the deduction was denied because the transactions lacked business purpose and economic substance under “any version” of the tests. judge swift held that the transaction lacked business purpose and economic substance even as measured against the eleventh circuit’s broad articulation of the test in ups of america, inc. v. commissioner, 254 f.3d 1014 (11th cir. 2001), that “a transaction has a ‘business purpose,’ when we are talking about a going concern . . . , as long as it figures in a bona fide, profit-seeking business.” 6. the tax court ham mers another shelter, and in the process tells us the “purpose” of the legislative plan. andantech l.l.c. v. 2003] recent developments in federal income taxation 151 commissioner, t.c. memo. 2002-97 (4/9/02). norwest, through its equipment leasing subsidiary, engaged in a complex [seven powerpoint slides worth] purchase and leaseback tax shelter transaction involving 40 ibm mainframe computers already under lease to end-users. the promoter [comdisco] sold the computers for cash and notes to an llc owned by two nonresident aliens, which leased them back to the promoter, who retained all responsibilities to the end-users; the llc sold the stream of rental payments to be received for net present value, thereby accelerating income realization, and applied the proceeds to the balance due on the note. less than three months later, one of the nonresident aliens [indirectly] transferred his 2 percent llc interest to a trust established by promoter, and norwest, through a subsidiary, acquired the remaining 98 percent interest in the llc [thereby closing the taxable year in which the income had been realized] for an amount roughly equal to one-half of one percent of the approximately $122 million basis of the computers. norwest subsequently reported its distributive share of depreciation deductions, but was allocated no income. after three years, the computers were reconveyed to the promoter, pursuant to an “early termination option,” which the court found the “economics of the transaction . . . mandate[d],” and the llc was liquidated. ! judge jacobs struck down the shelter. he concluded that neither the original llc with the foreign partners, nor the subsequent llc of which norwest’s subsidiary was a member, was a valid partnership to be recognized for federal tax purposes; in neither case did the purported partners intend to join together as partners for the purpose of carrying on a business, i.e., they did not join together to share in the profits or losses from an equipment leasing activity. alternatively, judge jacobs would have disregarded the participation of the foreign llc members in the transactions under the step transaction doctrine [applying either the end result or mutual interdependence test]. furthermore, the llc’s sale-leaseback transaction with the promoter “was a sham because it (a) was not a true multiple-party transaction, (b) lacked economic substance, (c) was not compelled or encouraged by business realities, and (d) was shaped solely by tax-avoidance features.” as far as norwest and its subsidiary were concerned, the transaction was not respected because it lacked both business purpose and economic substance. the llc, and norwest’s subsidiary, had no reasonable possibility of making an economic profit, but the tax benefits were more than sufficient to cover any potential losses. the norwest subsidiary never acquired the benefits and burdens of ownership of the depreciable equipment, and thus was not entitled to depreciation deductions. in addition, the llc’s debts were not bona fide and no interest deductions were allowable. ! finally, judge jacobs concluded by looking back to early supreme court jurisprudence: in higgins v. smith, 308 u.s. [473] at 476-477 [1940], the supreme court stated: there is no illusion about the payment of a tax exaction. each tax, according to a legislative plan, raises funds to carry on government. the purpose here is to tax earnings and profits less expenses and losses. if one or the other factor in any calculation is unreal, it distorts the liability of the particular taxpayer to the detriment or advantage of the entire taxpaying group. 152 florida tax review [vol.6:si the sale-leaseback transaction was designed by comdisco to create just such a distortion. it is axiomatic that taxpayers may structure transactions to take advantage of tax benefits. but “after a certain point, * * *, the transaction ceases to have any economic substance and becomes no more than a sale of tax profits.” hines v. united states, 912 f.2d 736, 741 (4th cir.1990). here, the evidence in the record clearly indicates that the investment scheme devised and orchestrated by comdisco “reached the point where the tax tail began to wag the dog.” id. 7. a tax shelter that doesn’t work in the tax court. the limited, inc. v. commissioner, 113 t.c. 169 (9/7/99). this tax shelter involved the exclusion from the income of a foreign corporation of the amount of a related bank’s certificates of deposits. judge halpern held that the cds were § 956 assets and were not excludible as “deposits with persons carrying on the banking business.” a. does work in the sixth circuit: another taxpayer victory on appeal. the limited, inc. v. commissioner, 286 f.3d 324, 2002-1 u.s.t.c. ¶50,353, 89 a.f.t.r.2d 2002-1924 (6th cir. 4/11/02). cds purchased by a foreign subsidiary of taxpayer from a taxpayer subsidiary in the banking business were not investments in u.s. property for purposes of § 956, but were “deposits with persons carrying on the banking business.” there is no related party prohibition in the portion of § 956 applicable to this transaction. 8. third circuit comes down hard on coli, with lots of language the governm ent will love. internal revenue service v. cm holdings, inc. (in re cm holdings inc.), 301 f.3d 96, 2002-2 u.s.t.c. ¶50,596, 90 a.f.t.r2d 2002-5850 (3d cir. 8/16/02), aff’g 254 b.r. 578, 2000-2 u.s.t.c. ¶50,791, 86 a.f.t.r.2d 2000-6470 (d. del. 10/16/00). in cmi’s bankruptcy, the irs filed proofs of claim for taxes based on the disallowance of interest deductions that cmi claimed for its coli plan (involving policies on 1,400 employees). ! the district court held no interest deduction was allowable under § 163(a) because the entire transaction was a “sham in substance” that lacked subjective business purpose. apart from tax savings from the interest deduction, cmi could not reasonably expect a positive cash flow from the coli plan in any year and could not expect to benefit from the inside cash value build-up [which continuously remained at zero throughout the plan] or profit from the death benefits on covered employees. interest deductions were disallowed, and § 6662 substantial understatement penalties were imposed because the transaction lacked economic substance. the transaction was entered into without a reasonable expectation of profit—in the absence of the interest deductions—over the life of the 40-year transaction from either the inside build-up or mortality components of the plan. ! the third circuit court of appeals (judge ambro) affirmed on the ground that the “coli policies lacked economic substance and therefore were economic shams.” [the court did not reach the issue of whether the transactions were factual shams.] the court dismissed out of hand the need to examine the “intersection of . . . statutory details.” [p]ursuant to gregory v. helvering, 293 u.s. 465, 55 s.ct. 266, 79 l.ed. 596 (1935), and knetsch v. united states, 364 u.s. 361, 81 s.ct. 132, 5 l.ed.2d 128 (1960), courts have looked beyond taxpayers’ formal compliance with the code 2003] recent developments in federal income taxation 153 and analyzed the fundamental substance of transactions. economic substance is a prerequisite to the application of any code provision allowing deductions. . . . it is the government’s trump card; even if a transaction complies precisely with all requirements for obtaining a deduction, if it lacks economic substance it “simply is not recognized for federal taxation purposes, for better or for worse.” [citations omitted]. in holding for the government, the court rejected the taxpayer’s argument that [based on gregory, knetsch, acm partnership and other cases] the application of the economic shams doctrine properly hinges on the “‘fleeting and inconsequential’ nature” of the transaction under scrutiny. rather, the court concluded that “[d]uration alone cannot sanctify a transaction that lacks economic substance. the appropriate examination is of the net financial effect to the taxpayer, be it short or long term. the point of our analysis in acm partnership is that the transactions ‘offset one another with no net effect on acm's financial position.’” in any event, the court found the coli transactions bore “striking similarities” to knetsch. the court further rejected the argument that for analytical purposes the pre-tax profit should have been “grossed-up” by the anticipated tax benefits because, [t]he point of the analysis is to remove from consideration the challenged tax deduction, and evaluate the transaction on its merits, to see if it makes sense economically or is mere tax arbitrage. courts use “pre-tax” as shorthand for this, but they do not imply that the court must imagine a world without taxes, and evaluate the transaction accordingly. instead they focus on the abuse of the deductions claimed: “[w]here a transaction has no substance other than to create deductions, the transaction is disregarded for tax purposes.” [citation omitted] choosing a tax-favored investment vehicle is fine, but engaging in an empty transaction that shuffles payments for the sole purpose of generating a deduction is not. ! finally, the court rejected the taxpayer’s argument that because “the transaction had objective non-tax economic effects . . . the court must not look further,” and that the district court improperly applied a subjective analysis. rather, the court of appeals read gregory to permit an inquiry into motive. “if congress intends to encourage an activity, and to use taxpayers’ desire to avoid taxes as a means to do it, then a subjective motive of tax avoidance is permissible. but to engage in an activity solely for the purpose of avoiding taxes where that is not the statute's goal is to conduct an economic sham.” because the court found that nothing in statute indicated that congress intended to encourage leveraged coli investments, the inquiry into motive was proper. in this regard, it was significant that “the plan was marketed as a tax-driven investment.” because the coli “plan had no net effect on camelot’s economic position, . . . it fails the objective prong of economic sham analysis.” because there was “no legitimate business purpose behind the plan, . . . it fails the subjective prong as well.” penalties were also upheld. b. identified “tax avoidance transactions.” 1. some of these are still being peddled to your clients. notice 2001-51, 2001-2 c.b. 190, superseding notice 2000-15, 2000-1 c.b. 826. the irs has identified sixteen listed transactions for purposes of temp. regs. §§ 154 florida tax review [vol.6:si 1.6011-4t(b)(2) and 301.6111-2t(b)(2). the listed transactions include: (1) rev. rul. 90-105, 1990-2 c.b. 69, transactions (deductions for contributions to certain pension plans attributable to future year’s compensation); (2) notice 9534, 1995-1 c.b. 309, certain trust arrangements (purported multiple employer welfare benefit funds); (3) notice 95-53, 1995-2 c.b. 334, “lease strips”; (4) notice 98-5, 1998-1 c.b. 334, transactions in which the expected economic profit is insubstantial in comparison to the value of the expected ftcs; (5) asa investerings-type and acm-type transactions; (6) prop. reg. § 1.643(a)-8 transactions involving distributions from charitable remainder trusts; (7) rev. rul. 99-14, 1999-1 c.b. 835, lease-in/lease-out [lilo] transactions); (8) notice 99-59, 1999-2 c.b. 761, transactions involving the distribution of encumbered property in which taxpayers claim tax losses for capital outlays that they have in fact recovered; (9) reg. § 1.7701(1)-3 fast-pay arrangements; (10) rev. rul. 2000-12, 2000-1 c.b. 744, certain transactions involving the acquisition of two debt instruments the values of which are expected to change significantly at about the same time in opposite directions; (11) notice 2000-44, 2000-2 c.b. 255, transactions generating losses resulting from artificially inflating the basis of partnership interests; (12) notice 2000-60, 2000-2 c.b. 568, transactions involving the purchase of a parent corporation's stock by a subsidiary, a subsequent transfer of the purchased parent stock from the subsidiary to the parent's employees, and the eventual liquidation or sale of the subsidiary; (13) notice 2000-61, 2000-2 c.b. 659, transactions purporting to apply § 935 to guamanian trusts; (14) notice 2001-16, 2001-1 c.b. 730, intermediary sales transactions; (15) notice 2001-17, 2001-1 c.b. 730, contingent liability § 351 transfer transactions; and (16) notice 2001-45, 2001-2 c.b. 129 (certain redemptions of stock in transactions not subject to u.s. tax in which the basis of the redeemed stock purports to shift to a u.s. taxpayer. 2. loan assumption agreement used to claim an inflated basis in assets. notice 2002-21, 2002-14 i.r.b. 730 (3/18/02). this notice adds to the list of “listed transactions” one where the taxpayer uses a loan assumption agreement to claim an inflated basis in assets acquired from a tax-indifferent party, and thus generate a loss equal to the excess of the stated principal amount of the loan over the fair market value of the acquired assets. the tax-indifferent party borrows money on a long-term basis and uses the proceeds to purchase assets, which serve as collateral for the loan. a portion of the assets are transferred to the taxpayer, who becomes a co-obligor on the loan; the fair market value of the assets transferred equals the present value of the loan’s principal payment at maturity. taxpayer then disposes of the assets for their fair market value, and claims a loss for federal income tax purposes. 3. accrual over the term of the notional principal contract of the noncontingent component of the nonperiodic payment to be received at the end of the term is required. rev. rul. 2002-30, 2002-21 i.r.b. 971 (5/28/02). when a notional principal contract provides for payment comprised of noncontingent and contingent components, the appropriate method for the inclusion into income or deduction of the noncontingent component of the nonperiodic payment is over the term of the npc. interest must also be accounted for in a manner consistent with regs. §§ 1.446-3(f)(2) (ii) or (iii), and 1.446-3(g)(4). ! taxpayer agrees to make quarterly payments to counterparty based on the 3-month libor multiplied by a notional principal amount of $100 million. in return, at the end of 18 months, the counterparty will pay taxpayer 6 percent per year multiplied by a notional principal amount of $92 million [or, $8,280,000], and, in addition, the counterparty will either pay taxpayer $8 million times the percentage increase 2003] recent developments in federal income taxation 155 in the stock index, or taxpayer will pay the counterparty $8 million times the percentage decrease in the stock index. the ruling holds that, to offset the taxpayer’s deductible quarterly payments, the taxpayer must ratably accrue over the 18-month term the $8,280,000 that taxpayer will receive from the counterparty at the end of the term. a. an arrangement similar to that of rev. rul. 2002-30 is identified as a listed tax shelter. notice 2002-35, 2002-21 i.r.b. 992 (5/28/02). the transaction in this notice involves the use of a notional principal contract to claim current deductions for periodic payments made by a taxpayer, while disregarding the accrual of a right to receive offsetting payments in the future. under the npc, taxpayer is required to make periodic payments to a counterparty at regular intervals of one year or less based on a fixed or floating rate index. in return, the counterparty is required to make a single payment at the end of the term of the npc that consists of a noncontingent component and a contingent component. the noncontingent component, which is relatively large in comparison to the contingent component, may be based upon a fixed or floating interest rate; the contingent component may reflect changes in the value of a stock index or currency. ! this transaction may be entered into without any initial cash investment by the taxpayer. the counterparty may lend the money to the taxpayer, who pays it back in installments as purportedly deductible payments. the taxpayer may engage in other transactions, such as interest rate collars, for purposes of limiting risk with respect to the npc transaction. ! taxpayer seeks to deduct the ratable daily portion of each periodic payment to which that portion relates, but taxpayer does not accrue income with respect to the nonperiodic payment until the year the payment is received. ! the proper treatment of the payments is that the nonperiodic payment to be received by the taxpayer at the end of the term of the npc must be accrued ratably over the term of the npc, as set forth in rev. rul. 2002-30. ! transactions that are the same as, or substantially similar to, the transaction described are identified as “listed transactions” for purposes of temp. regs. §§ 1.6011-4t(b)(2) and 301.60112t(b)(2). 4. the noncontingent bond method applies to a convertible debt instrument that also provides for one or more contingent cash payments. rev. rul. 2002-31, 2002-22 i.r.b. 1023 (6/3/02). the noncontingent bond method described in reg. § 1.1275-4(b) applies to a debt instrument that is convertible into stock of the issuer and that also provides for one or more contingent cash payments. the comparable yield is to be determined as that yield at which the issuer would issue a fixed rate nonconvertible debt instrument, which is to be used to determine the accruals of interest on the instrument. a. but not an arrangement similar to rev. rul. 200231. these arrangements are merely the subject of an invitation for taxpayer comments. notice 2002-36, 2002-22 i.r.b. 1029 (6/3/02). the service and the treasury department ask for comments on the treatment of contingent convertible debt instruments. 5. rev. rul. 2002-69, 2002-44 i.r.b. 760 (11/4/02), modifying and superseding rev. rul 99-14, 1999-1 c.b. 385. a taxpayer may not 156 florida tax review [vol.6:si currently deduct rent under § 162 or interest paid or incurred under § 163 in connection with a lease-in/lease-out transaction (lilo). 6. another listed tax shelter – this time an individual tax shelter. notice 2002-65, 2002-41 i.r.b. 690 (10/15/02). this notice adds to the list of “listed transactions” a tax shelter involving a straddle entered into by an s corporation or partnership, with one or more transitory shareholders or partners. the entity closes the gain leg, and passes through the gain, redeems some shareholders or partners, with the redeemed members claiming losses, closes the books for allocating gain or loss, and then closes the loss leg of the straddle, which is passed through to the remaining shareholders or partners. 7. notice 2002-70, 2002-44 i.r.b. 765 (11/4/02). the irs announces its attack on producer-owned reinsurance arrangements. these arrangements are used to shift income from taxpayers—typically serviceproviders, automobile dealers, lenders or retailers that offer service contracts in connection with the products or services being sold—to related companies which purport to be insurance companies subject to little or no u.s. federal income tax. the irs intends to apply § 482 or § 845 [allocation of income with respect to tax-avoidance motivated reinsurance transactions] to allocate income from the purported insurance company back to the taxpayer, as well as to assert that the purported insurance company is not an insurance company and possibly disregard the insurance and reinsurance arrangements as shams. 8. rev. rul. 2002-71, 2002-44 i.r.b. 763 (11/4/02). a taxpayer should take into account gain or loss on the termination of a notional principal contract that hedges a portion of the term of a debt instrument issued by the taxpayer over the period to which the hedge relates. this is because of the matching requirement of reg. § 1.446-4(b), which requires that this be done in order to clearly reflect income. c. disclosure and settlement 1. t.d. 9000, modification of tax shelter rules iii, 67 f.r. 41324 (6/18/02), and reg-110311-92 and reg-110311-98, modification of tax shelter rules iii, 67 f.r. 41362 (6/18/02). these temporary and proposed regulations modify the disclosure, registration and list maintenance rules under §§ 6011(a), 6111(d), and 6112 with respect to tax shelters. ! the new regulations extend the requirement to disclose listed and other reportable transactions under temp. reg. § 1.6011-4t to individuals, trusts, partnerships, and s corporations that participate, directly or indirectly, in listed transactions. further, they clarify indirect participation in a reportable transaction. a taxpayer indirectly participates in a reportable transaction if the taxpayer knows or has reason to know that the tax benefits claimed from the transaction are derived from a reportable transaction. ! the irs notes that some taxpayers and promoters have applied the “substantially similar” standard in temp. regs. §§ 1.6011-4t and 301.6111-2t in an overly narrow manner to avoid disclosure, and the regulations clarify that the term “substantially similar” includes any transaction that is expected to obtain the same or similar types of tax benefits and that is either factually similar or based on the same or similar tax strategy. further, the term “substantially similar” must be broadly construed in favor of disclosure. 2003] recent developments in federal income taxation 157 2. t.d. 9017, tax shelter disclosure statements, 67 f.r. 64799 (10/22/02), and reg-103735-00, reg-154117-02, reg-154116-02, reg154115-02, reg-154429-02, reg-154423-02, reg-154426-02, and reg110311-98, tax shelter disclosure statements, 67 f.r. 64840 (10/22/02). the irs has promulgated temporary and proposed regulations to provide additional guidance needed to comply with the § 6011(a) disclosure rules. the regulations cover transactions pertaining to tax shelters involving income, estate, gift, employment, or exempt organizations excise taxes. it revises the categories of transactions that must be disclosed on returns: (1) listed transactions; (2) confidential transactions; (3) transactions with contractual protection; (4) loss transactions above stated thresholds; (5) transactions with a significant book-tax difference; and (6) transactions involving a less-than-45-day holding period that result in a tax credit exceeding $250,000. these temporary regulations are effective 1/1/03. a. t.d. 9018, requirement to maintain a list of investors in potentially abusive tax shelters, 67 f.r. 64807 (10/22/02), and reg103736-00, requirement to maintain a list of investors in potentially abusive tax shelters, 67 f.r. 64842 (10/22/02). the irs has promulgated conforming temporary and proposed regulations, which modify the list maintenance requirements under § 6112. 3. irs announces a tax shelter disclosure initiative through 4/23/02 for penalty waivers. announcement 2002-2, 2002-2 i.r.b. 304 (1/14/02). the initiative would result in waiver of any of the § 6662 accuracyrelated penalties if disclosure is made before the earlier of 4/23/02 or the date an issue about the disclosed item is raised during an examination. the disclosure statement must contain, inter alia (1) “the material facts of the item;” (2) “the taxpayer’s tax treatment of the item;” (3) “[t]he taxable years affected by the item;” (5) the names and addresses of the promoters, solicitors, and recommenders of the item and (if known) the parties who advised the promoter, solicitor or recommender; and (6) an agreement to provide [if requested] all transactional documents, internal memoranda, and materials that provide a legal analysis of the item. ! exceptions exist for transactions that: (1) did not in fact occur; (2) involved fraudulent concealment of the amount or source of any item of gross income; (3) involved concealment of an interest over a foreign financial account; (4) involved the concealment of a distribution from, a transfer of assets to, or that taxpayer was a grantor of a foreign trust; or (5) involved the treatment of personal, household, or living expenses as deductible trade or business expenses. a. a memo from larry r. langdon, irs division commissioner, to lmsb employees, 2001 tnt 247-8 (12/20/01), provides guidelines for applying the about-to-be-issued announcement 2002-2, 2002-2 i.r.b. 304 (1/14/02). the irs will not assert that a disclosure made under the tax shelter initiative constitutes a waiver of the attorney-client privilege. b. according to a june 11, 2002 irs “tax talk today” webcast, the irs stated that the tax shelter initiative resulted in 1,633 disclosures from 1,180 taxpayers. the disclosures covered 1,506 tax returns and involved more than $30 billion in claimed losses or deductions. closed initiative continues to reap disclosures, by sheryl stratton, tax analysts tax notes today, 6/11/02, 2002 tnt 113-5. 158 florida tax review [vol.6:si c. irs news release ir-2002-99 (9/16/02). the irs announced that, as of the end of august 2002, the irs office of tax shelter analysis has “recorded 1,664 disclosures from 1,206 taxpayers who disclosed their questionable transactions.” d. in a 6/27/02 news release, 2002 tnt 125-1 (6/28/02), the irs announced that it cut a deal with pricewaterhousecoopers (pwc) to resolve tax shelter registration and list maintenance issues. . . . the irs news release, which is similar to one issued last august regarding merrill lynch, says that without admitting or denying liability, pwc has agreed to make a ‘substantial payment’ to the irs to resolve issues in connection with advice rendered to clients dating back to 1995. under the agreement, pwc will provide to the irs certain client information in response to summonses. it will also work with the irs to develop processes to ensure ongoing compliance with the shelter registration and investor list maintenance requirements, according to the release. e. warm-up the photocopier for those tax accrual workpapers. announcement 2002-63, 2002-27 i.r.b. 72 (7/8/02). in auditing returns filed after 7/1/02 that claim any tax benefits from a “listed transaction,” the irs may request tax accrual workpapers. see notice 2001-51, 2001-2 c.b. 190. listed transactions will be determined “at the time of the request.” neither the attorney-client privilege nor the § 7525 tax practitioner privilege protects the confidentiality of the workpapers. f. no third-party identification without associate chief counsel review . chief counsel notice cc-2002-028 (7/19/02). this notice sets forth the requirements for the review of privilege logs or similar documents that identify third parties, and for the coordination of the disclosure of these documents with the associate chief counsel (procedure & administration). 4. irs news release ir-2002-105 (10/4/02). the irs announced it will for a limited time offer settlements to taxpayers involved in three types of tax shelters. a. rev. proc. 2002-67, 2002-43 i.r.b. 733 (10/28/00). procedures to settle cases involving contingent liability transactions (§ 351 contingent liability tax shelters), similar to the ones described in notice 200117, 2001-1 c.b. 730, are provided. b. announcement 2002-97, 2002-43 i.r.b. 757 (10/28/02). this announcement provides procedures to settle cases involving the § 302/318 basis shifting tax shelter transactions that are the same or similar to those described in notice 2001-45, 2001-2 c.b. 129. notification to the irs must be made on or before 12/3/02. c. announcement 2002-96, 2002-43 i.r.b. 756 (10/28/02). this announcement terminates the appeals settlement initiative to settle corporate-owned life insurance (coli) transaction tax shelters, subject to a 45-day window within which taxpayers will be permitted to enter into the “current settlement arrangement.” 2003] recent developments in federal income taxation 159 5. “the irs and treasury believe that taxpayers have improperly relied on opinions or advice issued by tax advisors to establish reasonable cause and good faith as a basis for avoiding the accuracyrelated penalty.” reg-126016-01, establishing defenses to the imposition of the accuracy-related penalty, 67 f.r. 79894 (12/31/02). the treasury department has published proposed amendments to the regulations under §§ 6662 and 6664 [regs. §§ 1.6662-3 and 1.6664-4] to limit the available defenses to an accuracy-related penalty when a taxpayer (1) fails to disclose a reportable transaction or (2) fails to disclose that it has taken a position on a return based upon a regulation being invalid. under the proposed amendments, a taxpayer who takes a position that a regulation is invalid cannot rely on an opinion or advice to satisfy the reasonable cause and good faith exception under § 6664(c) with respect to that position unless the position was disclosed on a return (including disclosing the position that the regulation in question is invalid). a taxpayer who engages in a reportable transaction [see temp. reg. § 1.6011-4t] cannot rely on an opin ion or advice to satisfy the reasonable cause and good faith exception under § 6664(c) with respect to the transaction unless the transaction was disclosed pursuant to the § 6011 regulations. finally, a taxpayer who engages in a reportable transaction cannot rely on the realistic possibility standard under § 6662 to avoid the accuracy-related penalty for negligence or disregard of rules or regulations if the position regarding the reportable transaction is contrary to a revenue ruling or notice. when finalized, the amendments will apply to returns filed after 12/30/02, with respect to transactions entered into after 12/31/02. ! but be careful about over-reliance on effective dates. the preamble states: the irs, however, cautions taxpayers and tax practitioners that it will rigorously apply the existing facts and circumstances standard under § 1.6664-4(c) regarding a taxpayer’s reasonable reliance in good faith on advice from a tax professional, as well as the other provisions of the regulations under sections 6662 and 6664, including § 1.6664-4(c) relating to special rules for the substantial understatement penalty attributable to tax shelter items of a corporation. in addition to the modifications contained in these proposed regulations, and regardless of when a transaction was entered into, the irs, in appropriate circumstances, may consider a taxpayer's failure to disclose a reportable transaction or failure to disclose a position that a regulation is invalid as a factor in determining whether the taxpayer has satisfied the reasonable cause and good faith exception under section 6664(c) to the accuracy-related penalty. ix. exempt organizations and charitable giving a. exempt organizations 1. intermediate sanctions regulations are out; break out the supply of 1099s. t.d. 8920, excise taxes on excess benefit transactions, 66 f.r. 2144 (1/10/01), and reg-246256-96, excise taxes on excess benefit transactions, 66 f.r. 2173 (1/10/01). the irs has promulgated proposed and temporary regulations under § 4958, which permit the irs to impose excise taxes against disqualified persons who participate in excess benefit transactions with § 501(c)(3) and § 501(c)(4) organizations. these rules reflect the spirit under which § 4958 was enacted, which was to tax “excess” benefits provided 160 florida tax review [vol.6:si by charities to insiders (including board members); these “excess” benefits also include benefits provided to insiders that are not reported as compensation. a. regulations made final. t.d. 8978, excise taxes on excess benefit transactions, 67 f.r. 3076 (1/23/02). the treasury department has promulgated final regulations relating to the excise taxes on excess benefits transactions under § 4958. 2. notice 2001-78, 2001-2 c.b. 576. this notice provides interim guidance to charities regarding payments made by reason of the death, injury or wounding of an individual incurred as a result of the september 11, 2001 terrorist attacks. the service will treat such payments made by a charity to individuals and their families as related to the charity’s exempt purpose provided that the payments are made in good faith using objective standards. the notice is effective until the earlier of final legislation or 12/31/02. a. the victims of terrorism tax relief act, pub. l. no. 107-134, 115 stat. 2427 (1/23/02), clarifies that payments made by charities are for an exempt purpose even if made without demonstration of financial need if made in good faith under an objective formula consistently applied. 3. joint venture did not result in loss of tax exemption for charity hospital despite its failure to meet the criteria of revenue ruling 98-15. st. david’s health care system v. united states, 2002-1 u.s.t.c. ¶50,452, 89 a.f.t.r.2d 2002-2998 (w.d. tex. 6/7/02). summary judgment was granted to a community-owned, not-for-profit hospital on its tax-exempt status. the hospital’s entering into a limited partnership with hca, inc. [a forprofit health care company], in which it had general and limited partnership interests of 45.9 percent and in which the for-profit partner was the managing partner, did not result in the forfeiture of the hospital’s § 501(c)(3) exemption. the court held that the community benefit standard did not absolutely require a community board, and that st. david’s satisfied this standard even though it appointed only half the board members where the chairman’s seat was reserved for a st. david’s appointee. there was language in the partnership agreement requiring all the partnership’s hospitals to operate in accordance with the community benefit standard outlined in rev. rul. 69-545, 1969-2 c.b. 117, and st. david’s could unilaterally dissolve the partnership if they fail to do so. ! query: will rev. rul. 98-15, 1998-1 c.b. 718, which provides an example of an acceptable joint venture in which the nonprofit partner has numerical control of the board, still be considered valid? see also, redlands surgical services v. commissioner, 113 t.c. 47 (1999), aff’d per curiam, 242 f.3d 904 (9th cir. 2001). a. st. david’s health care system v. united states, 20022 u.s.t.c. ¶50,745, 90 a.f.t.r.2d 2002-5415 (w.d. tex. 7/9/02). the district court ordered the united states to pay $951,000 in litigation costs under § 7430 to st. david’s. judge nowlin held that the novelty of the issues did not necessarily mean that any position that the government took was reasonable, concluding: finally, the united states argues that, since this case involved novel issues, it is more likely that its position was substantially justified. while it is true that some of the specific issues had a hint of novelty to them, that does not mean that any position taken on those issues is reasonable. to the extent that there 2003] recent developments in federal income taxation 161 were novel issues in this case, settled law clearly applied and disposed of those issues. 4. public law 107-276, 116 stat. 1929 (11/2/02), amends § 527 to eliminate the notification and return requirements for state and local party committees and candidate committees. the law exempts a state or local political organization from having to file contribution and expenditure reports with the treasury department if it already files those reports with its state, so long as the state makes the report public. the bill also requires the treasury department to post § 527 reports on the internet and make them searchable and downloadable. b. charitable giving 1. is the cost of religious instruction in day schools deductible? field service advice, 1997 wl 333313757, 1997 fsa lexis 153 (7/11/97). tuition payments to jewish day schools were held not deductible as charitable contributions to the extent that their children’s education consisted of religious instruction [55 percent]. the service followed hernandez v. commissioner, 490 u.s. 680 (1989) (substantial benefit received in return for payments), and no mention was made of the 1993 church of scientology settlement nor of § 170(f)(8). in the 1993 closing agreement, the irs agreed “not to contest the deductibility of church of scientology fixed donations in connection with qualified religious services.” a. taxpayers should have sued irs officials like the scientologists did. sklar v. commissioner, t.c. memo. 2000-118 (4/5/00). the tax court, in an opinion by special trial judge nameroff, relied on hernandez and found that the church of scientology settlement was irrelevant because the “auditing” involved there was “not identical [to the general, including religious, education involved in the case at hand] in their organization, structure or purpose.” b. affirmed . sklar v. commissioner, 279 f.3d 697, 20021 u.s.t.c. ¶50,210, 89 a.f.t.r.2d 2002-808 (9th cir. 1/29/02), opinion amended and superseded by 282 f.3d 610, 89 a.f.t.r.2d 2002-808 (2/27/02). the ninth circuit affirmed the tax court in an opinion by judge reinhardt, with a concurrence by judge silverman. the majority opinion explored the apparent conflict between the hernandez case and the settlement with the church of scientology and concluded that (1) the irs improperly refused to disclose the terms of its scientology closing agreement, (2) the closing agreement unconstitutionally discriminated among religions, but that (3) the sklars were not entitled to relief because there was no “administrative inconsistency” in the treatment of their tuition payments and the payments to the church of scientology because taxpayers failed to show that their payments for tuition were “dual payments” in that they exceeded the tuition charged by other private schools (citing united states v. american bar endowment, 477 u.s. 105 (1986)). ! judge silverman’s concurrence was based upon the conclusion that the proper course of action is a lawsuit to stop the preferential policy towards the church of scientology, “not to require the irs to let others claim the improper deduction, too.” 2. price guesstimates aren’t market quotations. todd v. commissioner, 118 t.c. 334 (4/19/02). the fair market value, rather than the basis, is the deduction for a contribution of appreciated stock to a private foundation under § 170(e)(5) only if actual market quotations are readily 162 florida tax review [vol.6:si available. judge halpern held that an estimate of price by the broker who executed trades in the stock, which sporadically traded over the counter but for which market quotations were not readily available, did not qualify as a market quotation. the stock did not meet the standard for market quotations under reg. § 1.170a-13(c)(xi)(a), and the deduction was limited to the taxpayer’s basis in the stock. 3. the high cost of knowingly inaccurate substantiation of claimed charitable contributions. addis v. commissioner, 118 t.c. 528 (6/10/02). the taxpayers entered into a charitable split-dollar life insurance scheme with the national heritage foundation, a § 501(c)(3) organization [prior to the enactment of § 170(f)(10), which would impose a 100 percent excise tax on charitable split-dollar life insurance payments]. the addises paid approximately $36,000 to nhf in both 1997 and 1998 and claimed charitable contribution deductions for the payments. nhf used the amounts as premiums on a charitable split-dollar life insurance policy on mrs. addis’s life. nhf was entitled to 56 percent of the death benefit and the taxpayers’ family trust was entitled to the remainder. nhf was not required to pay the premiums, but the addises reasonably expected it to do so. nhf provided the taxpayers with receipts for their payments which stated that nhf did not provide any goods or services to them in return for the payments. taxpayers claimed charitable contribution deductions for the entire amount of their payments to nhf. judge colvin upheld the commissioner’s disallowance of any charitable contribution deduction. the taxpayers did not meet the substantiation requirements of § 170(f)(8) and reg. § 1.170a-13(f)(7) because nhf failed to make a good faith estimate of the value of the benefits provided to the taxpayers through their family trust’s share of the death benefits. regs. §§ 1.170-1(h)(4)(ii) and 1.17013(f)(6) were interpreted to deny completely a charitable contribution deduction under the circumstances. 4. do you have kelly’s blue book on your desk? rev. rul. 2002-67, 2002-47 i.r.b. 873 (11/25/02). the irs has ruled that an automobile donated to a charity may be valued by reference to an established used car pricing guide if, and only if, the guide lists the sales price for a car that is the same make, model, and year, sold in the same area, and in the same condition as the donated car. the ruling also provides that the substantiation requirements of § 170(f)(8) can be met through an authorized [for-profit] agent of the charity who solicits donations on the charity’s behalf, in this case an entity that solicited and accepted the donations of used cars, sold the cars, and remitted the proceeds to the charity. x. tax procedure a. penalties and prosecutions 1. plead it’s wrong or be ready to pay. swain v. commissioner, 118 t.c. 358 (5/3/02). section 7491(c) provides that the commissioner bears the burden of production with respect to penalties in all cases. the taxpayer, in her petition to the tax court, failed to assign error to the commissioner’s determination that § 6662 accuracy related penalties were due. judge halpern held that pursuant to tax court rule 34(b)(4), the taxpayer conceded the penalties issue, and that notwithstanding § 7491(c), the commissioner was not required to produce any evidence that the penalty was appropriate. the penalty was upheld. 2003] recent developments in federal income taxation 163 2. these guys better hope that the umwa rank and file doesn’t read tax advance sheets. lyon v. united states, 2002-2 u.s.t.c. ¶50,511, 90 a.f.t.r.2d 2002-5069 (w.d. va. 6/4/02). the president and sole shareholder of a corporation was held not a responsible party for purposes of the § 6672 penalty because he was merely a “front-man,” holding title to stock on behalf of and taking orders from the true parties in interest who owned and managed the unionized corporation anonymously to evade union contract limitations [because they owned and managed other nonunionized companies]. 3. deguerin v. united states, 214 f. supp. 2d 726, 2002-2 u.s.t.c. ¶50,606, 90 a.f.t.r.2d 2002-5866 (s.d. tex. 8/5/02). summary judgment was denied to both parties in this action relating to penalties under § 6721(e), which provides for enhanced penalties of between $25,000 and $100,000 for intentional disregard of the obligation to include the names of the payors of cash exceeding $10,000 on forms 8300 pursuant to the requirements of § 6050i and the regulations thereunder. plaintiff’s attorneys contended that the names of the payors on 19 forms 8300 filed during the year were privileged under the attorney-client privilege. judge lake held that if that were so, penalties would not be imposed. plaintiffs are to be given the opportunity at trial to demonstrate factually that the names of the payors were privileged. 4. if you abuse the bankruptcy process to delay your tax court case, you might acquire a new debt – a f ine for criminal contem pt. williams v. commissioner, 119 t.c. no. 17 (12/12/02). after filing a tax court petition, the taxpayer repeatedly filed and withdrew bankruptcy petitions to invoke the automatic stay rule [11 u.s.c. § 362(a)(8)], to delay proceeding in the tax court, and on one occasion he filed a forged bankruptcy petition with the tax court. in addition to imposing a $25,000 penalty under § 6673 for delay, judge gerber imposed a $5,000 criminal contempt sanction. 5. this false w-2 resulted in a felony rather than a misdemeanor. united states v. gambone, 314 f.3d 163, 2003-1 u.s.t.c. ¶50,162, 91 a.f.t.r.2d 2003-330 (3d cir. 1/3/03). an employer who files fraudulent w-2s for the purpose of evading employment taxes and income tax withholding, and who encourages employees to file fraudulent returns consistent with the w-2s, can be convicted of a felony under § 7206(2). the exclusivity of § 7204, which makes filing a false or fraudulent w-2 a misdemeanor in lieu of any other crime is limited to instances in which the only action taken is “merely furnish[ing] false w -2s.” conduct involving the furnishing of false w-2s, but not limited to filing false w-2s, such as encouraging employees to file false returns, can be prosecuted under § 7206(2). 6. irs announces an am nesty for offshore credit-card abusers who clear up their tax liabilities by april 15, 2003. irs news release ir2003-5, 2003 tnt 10-11 (1/14/03). an offshore voluntary compliance initiative provides that “eligible taxpayers,” who used offshore payment cards or other offshore financial arrangements to hide their income, may avoid civil fraud and information return penalties [but not failure to pay tax or accuracyrelated penalties] if they come forward and pay up by 4/15/03 and provide full details on those who promoted or solicited the offshore scheme. promoters and solicitors are not eligible. the information release contains the following example: for example, a taxpayer who understated his income to avoid $ 100,000 in taxes in 1999 would wind up paying $ 149,319 to 164 florida tax review [vol.6:si the government. this includes the tax liability plus $ 29,319 in interest and an additional accuracy-related penalty of $ 20,000. a. rev. proc. 2003-11, 2003-4 i.r.b. 311 (1/27/03). this revenue procedure contains detailed procedures for the offshore voluntary compliance initiative, including as an exhibit the “specific matters closing agreement” to be executed by the taxpayer. b. discovery: summonses and foia 1. hambarian v. commissioner, 118 t.c. 565 (6/13/02). in the course of a state criminal proceeding arising from the same transactions that gave rise to the tax court deficiency proceeding, the taxpayer’s criminal defense lawyer selected 100,000 pages of documents from a much larger amount in the possession of the prosecuting attorney and converted the documents into computer searchable media. in the tax court proceeding, the irs sought production of the documents and computer searchable media, but the taxpayer resisted on the grounds that the criminal defense lawyer's selection of the particular documents reflected his mental impressions and was therefore protected work product. judge gerber held that since over 100,000 pages of otherwise discoverable documents were involved, it was highly unlikely that the attorney's mental impressions would be discernable and the mere selection of particular documents by the taxpayer’s lawyer did not automatically transmute the documents into work product. because the taxpayer failed to otherwise demonstrate how disclosure of the selected documents would reveal the defense attorney's mental impressions of the case, the requested documents and computerized electronic media were not protected by the work product doctrine. 2. the “i relied on advice of counsel, but i w on’t let him tell you what we discussed” defense to tax fraud doesn’t cut it. johnston v. commissioner, 119 t.c. 27 (8/8/02). in a deficiency proceeding in which the commissioner sought to enforce assessment of civil tax fraud penalties, the taxpayer asserted the affirmative defense of reliance on “qualified experts” in preparing the tax returns in question. the commissioner moved for an order in advance of trial denying the taxpayer the right to assert the attorney-client privilege to prevent his former attorney from testifying about or producing notes made by the lawyer regarding a particular meeting between the taxpayer and another person regarding the transactions giving rise to the asserted deficiency and penalties. the commissioner argued that the taxpayer had waived the privilege by claiming reliance on counsel’s advice to avoid the penalties. the tax court (judge nims) first held that the question of whether the attorneyclient privilege had been waived was one of federal law, not state law. next, the court held that there was a 3-part test (quoting chevron corp. v. pennzoil co., 974 f.2d 1156, 1162-63 (9th cir. 1992)) for finding an implied waiver: “(1) assertion of the privilege was a result of some affirmative act, such as filing suit, by the asserting party; (2) through this affirmative act, the asserting party put the protected information at issue by making it relevant to the case; and (3) application of the privilege would have denied the opposing party access to information vital to his defense.” with respect to the first prong, on the various pleadings, the court rejected the taxpayer’s argument that his defense of reliance on “qualified experts” referred to an accountant, not his lawyer; and the court found that the affirmative defense referred to his former lawyer, who had provided him tax advice during the years in question. the second prong of the test was easily satisfied: “‘to the extent that [the taxpayer] claims that its tax position is reasonable because it was based on advice of counsel, [the taxpayer] puts at issue the tax advice it received.’” finally, because the commissioner 2003] recent developments in federal income taxation 165 bears the burden of proving fraud [§ 7454(a)], the third prong was met: “to ‘defend’ against this defense [of reliance on counsel], respondent must show that such reliance either was unreasonable or did not in fact occur. respondent can do so only through knowledge of what tax advice mr. johnston received, and such would include communications from [his lawyer].” having invoked reliance on experts, the taxpayer could not selectively withhold communications from particular experts who provided tax advice, while allowing disclosure of communications from other experts. 3. does the crime/fraud exception to the attorney client privilege defeat privilege claim? united states v. bdo seidman, 225 f. supp. 2d 918, 2002-2 u.s.t.c. ¶50,763, 90 a.f.t.r.2d 2002-6810 (n.d. ill. 10/10/02). documents for which an accounting firm claimed the § 7525 privilege were ordered to be produced for the magistrate’s in camera review. in his opinion, judge shadur noted, one last point has occurred to this court—something that has not been addressed by either of the parties. suppose that some of the documents for which bdo claims privilege could otherwise fit within the standards governing the attorney-client privilege (and hence the equivalent statutory accountant-client privilege), but that they relate to the types of “abusive tax shelters” that have triggered the congressional enactment at issue here. in that event, would the utilization of such an “abusive tax shelters” by a taxpayer to whom bdo has given advice as to its use create the potential of criminal as well as civil liability on the taxpayer's part? and if so, would that trigger the application of the crime-fraud exception to the privilege? 4. are you practicing law or practicing tax when you write that opinion letter? united states v. kpmg llp, 237 f. supp. 2d 35, 2003-1 u.s.t.c. ¶50,174, 91 a.f.t.r.2d 2003-317 (d. d.c. 12/20/02). the irs served administrative summonses on kpmg in connection with the investigation of kpmg’s promotion and participation in tax shelters and sought judicial enforcement when it determined that kpmg had not complied. citing united states v. lawless, 709 f.2d 485 (7th cir. 1983), for the principle that the attorney-client privilege does not extend to communications between a taxpayer and his attorney simply for the purpose of preparing a tax return, chief judge hogan held that the § 7525 privilege does not extend to communications between a taxpayer and tax practitioner simply for the purpose of preparing a tax return. in what might turn out to be a far-reaching decision, he went a step further and held that tax opinions regarding the consequences of a transaction are rendered for the purpose of preparing a return and thus are not subject to the attorney-client privilege. c. litigation costs 1. how not to represent a client. carpentier v. commissioner, t.c. memo. 2002-43 (2/12/02). judge gerber imposed a $15,000 penalty on the taxpayer, who was represented by counsel, under § 6673(a) for a 5-year delay marked by “incorrigible,” “spurious attacks on the authority and/or integrity” of irs counsel and tax court judges, as well as for failure to comply with requests for stipulations. 166 florida tax review [vol.6:si 2. the high price of zealous foot-dragging in representing a client. johnson v. commissioner, 289 f.3d 452, 2002-1 u.s.t.c. ¶50,402, 89 a.f.t.r.2d 2002-2338 (7th cir. 5/3/02), aff’g 116 t.c. 111 (2/27/01). in a case involving defense of a sham trust arrangement, the tax court (judge cohen) imposed sanctions and costs under § 6673 in the amount of $8,587.50 of irs counsel expenses [at $150 per hour] and $807.06 of expenses against taxpayer’s counsel [joe alfred izen, jr.]. izen was described, with citations to prior cases, as “having a long history of involvement with sham trusts” for multiplying the proceedings “unreasonably and vexatiously” by “pursu[ing] claims that have been rejected so frequently that they are ‘entirely without colorable pretext or basis and are taken for reasons of harassment or delay or for other improper purposes’” (quoting the nis family trust v. commissioner, 115 t.c. 523, 548 (2000)) and by “chronic failure to comply with discovery orders.” ! the court of appeals for the seventh circuit (judge posner) upheld the imposition of the government’s costs on izen. judge posner found that for costs to be imposed on the taxpayer’s attorney under § 6673, the attorney must have acted in “bad faith,” and that “‘reckless’ or ‘extremely negligent’ conduct” satisfies that standard. “izen’s repeated flouting of discovery orders even after being threatened with sanctions and promising to comply established his bad faith all by itself.” the tax court properly took into account izen’s behavior in prior cases. “[d]ogged good faith persistence in bad conduct becomes sanctionable once an attorney learns or should have learned that it is sanctionable.” 3. frivolous argum ents are painful to lawyers’ pocketbooks. takaba v. commissioner, 119 t.c. no. 18 (12/16/02). judge halpern sua sponte awarded the government excess attorneys costs of $10,500, payable by taxpayer’s counsel, under § 6673(a)(2), where counsel continued to press a frivolous “§ 861 argument” [that only income earned from possessions, corporations, or the federal government is subject to tax] originally advanced by the taxpayer acting pro se. d. statutory notice 1. an optional statutory provision? rochelle v. commissioner, 116 t.c. 356 (5/24/01). section 3463(a) of the irs restructuring and reform act of 1998, pub. l. no. 105-206, 112 stat. 685 (7/22/98) (an uncodified provision) states that the irs “shall include on each notice of deficiency . . . the date determined by [the irs] as the last day on which the taxpayer may file a petition in the tax court.” the taxpayer received an otherwise valid deficiency notice that omitted the last date for filing a tax court petition and filed his petition 56 days late. in a reviewed opinion (10-6) by judge vasquez, the tax court held that the deficiency notice nevertheless was valid and dismissed the taxpayer’s untimely petition. the court held that § 6213(a) [providing that a petition filed by the date indicated on the deficiency notice as the last date is timely] does not result in unlimited time to file a petition if no due date is specified. the taxpayer was not confused, misled, or prejudiced by the notice or the absence of a specified petition filing date. ! judge chabot (joined by judges gale and marvel) dissented, basically on the grounds that “shall” means “shall” and “each” means “each” and that failure to do what the irs is directed to do must have consequences, specifically, rendering the deficiency notice invalid. judge swift would have found the notice valid but would have allowed a “reasonable extension” of time to file as the consequence of noncompliance with § 3463(a) of the 1998 act and would have found the petition timely. judges foley and 2003] recent developments in federal income taxation 167 colvin would have found that the deficiency notice was valid, but that there was no outside date for filing a petition. a. affirmed by the usually taxpayer-friendly fifth circuit. rochelle v. commissioner, 293 f.3d 740, 2002-1 u.s.t.c. ¶50,447, 89 a.f.t.r.2d 2002-2787 (5th cir. 6/4/02). the fifth circuit affirmed the tax court in a one paragraph per curiam opinion endorsing judge vasquez’s majority opinion. the panel obviously did not find the issue as controversial as did the tax court. 2. the irs relies on postal service form s. clough v. commissioner, 119 t.c. no. 10 (10/18/02). the taxpayer’s petition was dismissed as untimely. where the existence of the notice of deficiency is not disputed, postal service form 3877, acceptance of registered, insured, c.o.d., and certified mail, or its equivalent—a certified mail list—is direct documentary evidence of the date and fact of mailing. exact compliance raises a presumption of official regularity in the commissioner’s favor. e. statute of limitations 1. just where on the return do you find “gross income”? harlan v. commissioner, 116 t.c. 31 (1/17/01). this case involved the calculation of gross income for purposes of determining whether the 6-year statute of limitations in § 6501(e)(1)(a) applied. the tax court (judge chabot), in a matter of first impression, held that pursuant to § 702(c) the gross income of a partner in a partnership (the upper tier partnership) that holds an interest in another partnership (the lower tier partnership) includes the upper tier partnership’s distributive share of the gross income of the lower tier partnership and not merely the gross income of the upper tier partnership. a. a.o.d. 2002-03 (1/19/02), 2002-7 i.r.b. 496 (3/14/02). the commissioner acquiesced in harlan. 2. a “not so simple” application of the refund statute of limitations. wertz v. united states, 51 fed. cl. 443, 2002-1 u.s.t.c. ¶50,192, 89 a.f.t.r.2d 2002-491 (1/9/02). the taxpayer failed to file a tax return, but filed an informal refund claim [for withheld taxes] more than 2 years after the return’s due date but less than 3 years after the due date; he filed a tax return claiming the refund more than 3 years after the due date. the court held that the claim was untimely under § 6511. the late-filed tax return did not relate back in time to the date of an untimely informal claim, so as to permit the 3-year look-back rule of § 6511(b)(2)(a) to permit a refund otherwise barred by the 2year look-back rule of § 6511(a). 3. maybe the irs should have accepted the check for taxes and let the interest and penalty go. hoffman v. commissioner, 119 t.c. 140 (9/24/02). the taxpayers were partners in two partnerships in which they did not materially participate. they filed a timely return for 1990 based on information returns from the partnerships. in 1998, after the 3-year statute of limitations had expired, and 2 days before the 6-year statute of limitations expired, they filed an amended return reporting additional income from the partnership and paid the additional tax. the commissioner proceeded to assess penalties and interest in addition to the tax. in a § 6330 due process hearing, the taxpayers raised the statute of limitations as a bar on lien and levy, and sought a refund of the tax paid, but the commissioner determined that the 6-year statute of limitations applied. the tax court (judge laro) applied the special definition of gross 168 florida tax review [vol.6:si income of a trade or business in § 6501(e)(1)(a)(i), which provides that for a trade or business “gross income” includes the total of the amounts received or accrued from the sale of goods or services before diminution by the cost of those sales or services. judge laro saw no reason to limit the previously established application of this principle to partnerships to cases in which the partners had materially participated. thus, because the commissioner failed to introduce any evidence regarding the partnerships’ gross income, the “gross income stated in the return” was determined by reference to the partnerships’ information returns, and the 6-year period of limitations was inapplicable and, therefore, the assessment was untimely. 4. even the governm ent said the taxpayer was right. omohundro v. united states, 300 f.3d 1065, 2002-2 u.s.t.c. ¶ 50,590, 90 a.f.t.r.2d 2002-5860 (9th cir. 8/19/02). the ninth circuit followed rev. rul. 76-511, 1976-2 c.b. 428, holding that under § 6511(a) a refund claim is timely if it is filed within 3 years from the date the income tax return was filed, regardless of when the return is filed, and overruled its prior decision to the contrary in miller v. united states, 38 f.3d 473 (9th cir. 1974). [note, however, that the amount of the refund continues to be limited by the 3-year look-back rule in § 6511(b)(2).] 5. the eighth circuit rejects a 30-year-old revenue ruling. kaffenberger v. united states, 314 f.3d 944, 2003-1 u.s.t.c. ¶50,164, 91 a.f.t.r.2d 2003-374 (8th cir. 1/3/03). section 6532(a) allows the irs to agree to an extension of time [beyond the normal 2-year period of limitations] for filing a refund suit. in rev. rul. 71-57, 1971-1 c.b. 405, the irs ruled that such an agreement was valid only if the agreement was executed before the statutory time expired. the court of appeals held that rev. rul. 71-57 misconstrues § 6532(a)(2), and that an agreement to extend the statute of limitations executed by the irs after it had expired was valid. the court reasoned that § 6501, the provision limiting the period for the irs to assess taxes, allows the period to be extended “by subsequent agreements in writing made before the expiration of the period previously agreed upon,” but that § 6532(a)(2) contains no such language; and the inference, therefore, is that the agreement need not be entered into before the period expires because “to do so renders the above quoted portion of § 6501 ‘insignificant, if not wholly superfluous.’” 6. brosi v. commissioner, 120 t.c. no. 2 (1/13/03). tolling of the statute of limitations under § 6511(h) is not available to a taxpayer who serves as a “care-giver” to a relative; it applies only in the case of a serious mental or physical disability of the individual taxpayer seeking relief. f. liens and collections 1. due process. downing v. commissioner, 118 t.c. 22 (1/7/02). the tax court has jurisdiction under § 6330(d) to review the commissioner’s determination to levy to satisfy an addition to tax under § 6651(a)(2) for failure to pay the tax shown as due on the return. making an inadequate offer in compromise along with the tax return was not reasonable cause for failure to pay. 2. t.d. 8979, notice and opportunity for hearing upon filing of notice of lien, 67 f.r. 2558 (1/18/02), and t.d. 8980, notice and opportunity for hearing before levy, 67 f.r. 2549 (1/18/02). the irs has promulgated final regulations on the right to a collection due process hearing following a lien 2003] recent developments in federal income taxation 169 filing under § 6320 and on the right to a similar hearing before levy under § 6330. 3. have due process hearings become the playground of frivolity? nestor v. commissioner, 118 t.c. 162 (2/19/02) (8-6-2). judge colvin, writing for the majority, held the taxpayer [who was described in a concurring opinion as a “flagrant tax protestor”] was not improperly precluded from challenging his underlying tax liability—on the grounds that the deficiency notices he received were invalid because they were not prepared or issued by the secretary and because the director of the service center who prepared and issued them did not give petitioner a copy of the delegation order—in a § 6330 hearing. section 6330(c)(2)(b) barred the taxpayer from contesting the liability at the hearing because he [concededly] received the deficiency notices. the court further held that § 6203 (second sentence), which requires that a copy of the record of assessment be delivered upon demand, did not entitle the taxpayer to receive or be shown all of the documentation relating to the assessment at the hearing, and the taxpayer was not prejudiced by the fact that he received copies of the forms 4340 after the § 6330 hearing. the taxpayer’s other arguments were “frivolous.” ! judge swift’s concurring opinion noted that the majority opinion should not be construed to permit the commissioner to withhold computerized transcripts of account or form 4340. in response to judge foley’s dissent, infra, he would have held that “tax protester issues[] need not be considered by appeals officers in collection hearings under section 6330(b) and that tax protester issues may and should be summarily dismissed by the courts.” !judge halpern’s concurring opinion focused on the “rule of prejudicial error”—that in reviewing an administrative action, the court should disregard procedural errors, even statutorily required prerequisites, unless the complaining party was prejudiced by the error. any errors of the appeals officer in the conduct of the hearing were harmless errors. ! judge beghe’s concurrence stated that it should be standard practice for the appeals officer to provide the taxpayer a form 4340 at or before the due process hearing, but in this case the failure was harmless error. ! judge laro (joined by judges vasquez and gale) concurred in the result, but was of the opinion that § 6330(c)(1) requires the appeals officer to verify that all statutory, regulatory, and administrative requirements for assessment and collection have been met, and that providing form 4340 alone is not always sufficient, although on the facts of this case it was. ! judge foley’s dissenting opinion concluded that the failure to have a record of assessment at the hearing or to provide the taxpayer with form 4340 at the hearing constituted a failure to comply with the requirement of § 6330(c)(1) that the appeals officer verify compliance with applicable laws and regulations. he would have afforded the taxpayer a new hearing. 4. a major pronouncement by the supreme court: the existence of “property rights” now is a matter of federal, not state, law. united states v. craft, 535 u.s. 274, 2002-1 u.s.t.c. ¶50,361, 89 a.f.t.r.2d 2002-2005 (4/17/02). mrs. craft’s husband owed delinquent income taxes, but mrs. craft did not. the irs filed a tax lien against property held by them as tenants by the entirety. under state [michigan] law, the spouses had no individual right to sever or convey their interests in the property and the husband’s creditors could not levy on the property. subsequently, mr. craft 170 florida tax review [vol.6:si quitclaimed the property to mrs. craft. when she sold the property, the irs released the lien on the condition that one-half of the proceeds be escrowed, following which mrs. craft brought a quiet title action seeking the escrowed proceeds. the sixth circuit held for m rs. craft, but the supreme court, in an opinion by justice o'connor, held (6-3) that the husband, as a tenant by the entirety, possessed “property” or “rights to property” to which a federal tax lien could attach. “[w]e look initially to state law to determine what rights the taxpayer has in the property the government seeks to reach, then to federal law to determine whether the taxpayer’s statedelineated rights qualify as ‘property’ or ‘rights to property’ within the compass of the federal tax lien legislation.” drye v. united states, 528 u.s. 49, 58, 120 s.ct. 474, 145 l.ed.2d 466 (1999). a common idiom describes property as a “bundle of sticks”--a collection of individual rights which, in certain combinations, constitute property. . . . state law determines only which sticks are in a person’s bundle. whether those sticks qualify as “property” for purposes of the federal tax lien statute is a question of federal law. in looking to state law, we must be careful to consider the substance of the rights state law provides, not merely the labels the state gives these rights or the conclusions it draws from them. such state law labels are irrelevant to the federal question of which bundles of rights constitute property that may be attached by a federal tax lien. the bundle of rights consisting of the taxpayer-spouse’s rights of survivorship, to use the property, to exclude third parties from it, to receive one-half of the income from the property and one-half of the proceeds from its sale (with the consent of his wife), and to bar his wife from selling it, constituted “property” or “rights to property” for purposes of the federal tax lien statute. “[i]f the conclusion were otherwise, the entireties property would belong to no one for the purposes of § 6321.” the court noted that “[e]xcluding property from a federal tax lien simply because the taxpayer does not have the power to unilaterally alienate it would, moreover, exempt a rather large amount of what is commonly thought of as property.” it pointed out that in united sates v. rodgers, 461 u.s. 677 (1983), it had already held that property that could not be unilaterally alienated [texas homestead], nevertheless, could be subject to a federal tax lien. ! note that in the rodgers case, the supreme court upheld not just the validity of the lien, but the power of the district court to order a forced sale of the entire property, subject to an equitable accounting for the value of the nontaxpayer spouse’s interest. ! justices scalia, thomas and stevens dissented. they would have respected the state law characterization of mrs. craft’s rights to the property to which a creditor’s lien could attach. 5. a rare opportunity to run away from tax court jurisdiction once it’s established. wagner v. commissioner, 118 t.c. 330 (4/15/02). the tax court held that a taxpayer may voluntarily withdraw his appeal of the appeals officer’s decision in a § 6320 pre-lien due process hearing. estate of ming v. commissioner, 62 t.c. 519 (1974), holding that 2003] recent developments in federal income taxation 171 taxpayer may not voluntarily withdraw without prejudice a petition in a deficiency case, was distinguished. in a deficiency case, § 7459(d) treats an order dismissing the petition for any reason other than lack of jurisdiction as sustaining the deficiency; but § 7459(d) does not apply to the review of § 6320 [or § 6330] hearings. 6. it can be expensive to seek judicial review of a § 6320/6330 due process hearing primarily for purposes of delay. roberts v. commissioner, 118 t.c. 365 (5/3/02). in reviewing the appeals officer’s decision in a §§ 6320/6330 due process hearing that collection of a tax shown on the return but not paid was warranted, judge chiechi held that a computergenerated record of assessment on form racs 006 complied with the requirements of reg. § 301.6203-1; a signed assessment certificate, form 23c, was not required. a $10,000 penalty under § 6673(a)(1) was imposed on the taxpayer for petitioning for review of the § 6320/6330 due process hearing primarily for purposes of delay. 7. the supreme court appears to be infatuated with tax procedure cases: equitable tolling keeps the claim for taxes alive through successive bankruptcy proceedings. young v. united states, 535 u.s. 43, 2002-1 u.s.t.c. ¶50,257, 89 a.f.t.r.2d 2002-1258 (3/4/02). under § 507(a)(8)(a)(i) of the bankruptcy code, claims for taxes for which a return was due within 3 years before an individual taxpayer files a bankruptcy petition are not dischargeable. the taxpayers had not paid the taxes shown on a return due and filed within 3 years prior to filing the chapter 13 bankruptcy petition in 1996. in march 1997, the taxpayers filed a chapter 7 petition, and their chapter 13 petition was dismissed; they were subsequently discharged of their debts. when the irs sought payment of the taxes, the taxpayers claimed that the taxes were discharged because they were due more than 3 years before their chapter 7 filing. the court, in an opinion by justice scalia, held that the look-back period is subject to equitable tolling. because the chapter 13 petition resulted in an automatic stay that prevented the irs from collecting the unpaid taxes, when the chapter 7 petition was filed, the 3-year look-back period excluded time during which their chapter 13 petition was pending. thus, the tax debt was not discharged. tolling was appropriate regardless of whether the chapter 13 petition was filed in good faith or solely to run down the look-back period. 8. behling v. commissioner, 118 t.c. 572 (6/17/02). if a taxpayer’s consideration of the underlying liability in a collection due process hearing is barred by § 6330(c)(2)(b) [because the taxpayer received a deficiency notice], the tax court will not review the underlying liability, even though the irs appeals officer reconsidered it and addressed it in the notice of determination. 9. you’ll soon have to pay the irs for the privilege of proving that you can’t pay the irs. reg-103777-02, user fees for processing offers to compromise, 67 f.r. 67573 (11/06/02). the proposed regulations [31 c.f.r. § 300.3] would impose a $150.00 user fee for processing offers in compromise [pursuant to the independent offices appropriations act, 31 u.s.c. § 9701]. the proposed user fee would not apply to offers based on doubt as to liability, offers made by low income taxpayers, offers accepted to promote effective tax administration, and offers accepted based on doubt as to collectibility where there has been a determination that, although an amount greater than the amount offered could be collected, collection of more than the amount offered would create economic hardship within the meaning of reg. § 301.6343-1. 172 florida tax review [vol.6:si 10. “decision letter,” “determination letter.” what’s the difference? craig v. commissioner, 119 t.c. 252 (11/14/02). after the irs sent the taxpayer a final notice of intent to levy, the taxpayer filed a timely request for a § 6330 hearing. the taxpayer was accorded an “equivalent hearing” [under reg.§. 301.6330-1(i)], at which the taxpayer was erroneously told that he was not entitled to a hearing, and after which a decision letter upholding the levy was issued, stating that the taxpayer was not entitled to judicial review of the decision because the request for a hearing was untimely. the taxpayer appealed and judge laro held that the tax court had jurisdiction to review the irs’s decision even though the irs never issued the taxpayer a notice of determination with respect to a § 6330 hearing. the commissioner conceded that the taxpayer was entitled to and should have been given a hearing, and judge laro accepted the commissioner’s argument that the tax court had jurisdiction on the grounds that the taxpayer had received an “equivalent hearing” and a decision letter. since there was a timely request for a hearing, an equivalent hearing, and decision letter, “the ‘decision’ reflected in the decision letter issued to petitioner is a ‘determination’ for purposes of section 6630(d)(1).” the court proceeded to grant summary judgment for the commissioner, rejecting the taxpayer’s tax protestor arguments and imposing a $2,500 § 6673(a)(1) penalty. 11. t.d. 9027, levy restrictions during installment agreements, 67 f.r. 77416 (12/18/02). the treasury department has promulgated regulations [reg. § 301.6331-4] under § 6331(k) relating to restrictions on levy during the period that an installment agreement is proposed or in effect. 12. due process in jeopardy assessments and levies. dorn v. commissioner, 119 t.c. no. 22 (12/30/02). section 6330(f) denies taxpayers the right to a pre-levy hearing in the case of jeopardy assessments, but § 6330(b) accords the taxpayer a right to an administrative due process hearing within a reasonable time after the levy. judge colvin held that under § 6330(d), the taxpayer is entitled to tax court review of an administrative decision in a § 6330(b) hearing that finds a jeopardy levy was proper. g. innocent spouse 1. when the legislative history is ambiguous, read the statute. tax court majority holds that the test for knowledge under the § 6015(c)(3)(c) separate liability election is the same as that under former § 6013(e)(1)(c), which is that knowledge of an item of omitted income is sufficient to deny relief even if the spouse has no reason to believe that the way the item was reported on the return was correct. cheshire v. commissioner, 115 t.c. 183 (8/30/00) (reviewed, 11-4). a spouse who has actual knowledge of the transaction giving rise to omitted income has “reason to know” of the understatement and is not entitled to innocent spouse relief under § 6015(b). the taxpayer’s proposed standard based on a prudent taxpayer being expected to know of the understatement was rejected as providing too broad of an escape hatch from liability. more importantly, the tax court (judge jacobs) held that for the spouse to be denied apportioned liability relief, § 6015(c)(3)(c) does not require actual knowledge of whether the entry on the return is or is not correct. the applicable knowledge standard under § 6015(c)(3)(c) is “an actual and clear awareness (as opposed to reason to know) of the existence of an item which gives rise to the deficiency (or portion thereof).” thus, because when the spouse seeking apportioned liability in cheshire signed the joint return, she was aware of the amount, the source, and the date of receipt of a retirement distribution received by her then husband, she 2003] recent developments in federal income taxation 173 was denied apportioned liability, even though at that time she misunderstood how much of the retirement distribution was properly taxable and thus did not know that the amount of income was understated. the court declined to follow a statement in h. conf. rept. 105-599, at 253 (1998) that “if the irs proves that the electing spouse had actual knowledge that an item on a return is incorrect, the election will not apply to the extent any deficiency is attributable to such item.” the court did, however, find that the commissioner abused his discretion in failing to grant equitable relief from penalties under § 6015(f), even though the failure to grant equitable relief on the underlying deficiency was not an abuse of discretion. the taxpayer relied on her husband’s description of the tax consequences of the transaction and his representations that he had been advised by a cpa and had no reason to doubt him. ! judge jacobs writing for the majority held that the wife was properly denied innocent spouse treatment under § 6015(c)(3)(c) where she had knowledge that her husband had received a distribution from his retirement plan. the wife was told by her husband that their accountant had advised him that amounts used to pay off the mortgage could be excluded from income the same way that the portion of the distribution that was “rolled over” was treated. the majority held that the wife does not need to have knowledge of the tax consequences of the item or that the entry on the return is incorrect. the court relied on former § 6013 cases, such as wiksell v. commissioner, t.c. memo. 1999-32, aff’d by order, 215 f.3d 1335 (9th cir. 2000), and bokum v. commissioner, 94 t.c. 126 (1990), aff’d, 992 f.2d 1132 (11th cir. 1993), to the effect that knowledge of the legal consequences of an item may be presumed if the spouse has knowledge of the item. ! the dissenting opinions (judges parr, colvin, marvel, and gale), based on the legislative history, would limit denial of relief under § 6015(c)(3)(c) to cases in which the spouse actually knew of the understatement of the item. judge colvin’s dissent is based upon the conclusion that § 6015(c) was enacted to make clear that the spouse must have had “actual knowledge that the treatment of the item on the tax return was incorrect” in order to be denied innocent spouse treatment. a. affirmed by “plain meaning” interpretation. cheshire v. commissioner, 282 f.3d 326, 2002-1 u.s.t.c. ¶50,222, 89 a.f.t.r.2d 2002-900 (5th cir. 2/8/02). on appeal, mrs. cheshire argued that the case was an erroneous deduction case to which the knowledge-of-theincorrect-deduction standard was applicable; the irs argued that the case was an omitted income case and that the knowledge-of-the-transaction test was applicable. the court of appeals (judge king) held that mrs. cheshire “knew or had reason to know” of the understatement under both the omitted income standard and the price v. commissioner, 887 f.2d 959 (9th cir. 1989), erroneous deduction standard. thus, § 6015(b)(1)(c) barred innocent spouse relief. section 6015(c) apportioned liability relief was denied because “the term ‘item’ . . . refers to an actual item of income, deduction, or credit, rather than the incorrect reporting of such an item.” mrs. cheshire’s argument that § 6015(c)(3)(c) precludes relief only if the spouse has knowledge of incorrect tax reporting was inconsistent with the general rule that “ignorance of the tax laws is not a defense to a tax deficiency.” the court declined to interpret the legislative history as compelling a different result for two reasons: first, when interpreting a statute, this court “must presume that a legislature says in a statute what it means and means in a statute what it says there.” unless the text of a statute is ambiguous on its face, this court adheres to that statute's plain 174 florida tax review [vol.6:si meaning. . . . section 6015(c)(3)(c) is not facially ambiguous. [citations omitted]. second, the legislative history of § 6015(c)(3)(c) is ambiguous. some portions of the history appear to support the commissioner's position. other parts of the history, however, suggest that the § 6015(c)(3)(c) exception is intended to cover spouses with knowledge of the transaction giving rise to the deficiency in addition to spouses with knowledge that the tax return is incorrect. w e decline to allow inconclusive legislative history to affect our interpretation of the plain meaning of § 6015(c)(3)(c). [citations omitted]. the court of appeals noted that subsequent to deciding cheshire, in king v. commissioner, 116 t.c. 198 (2001), the tax court interpreted the applicable knowledge standard in erroneous deduction cases to be “actual knowledge of the factual circumstances which made the item unallowable as a deduction.” even under this standard, however, the court of appeals concluded that mrs. cheshire was not entitled to relief because her “actual and clear awareness” of mr. cheshire's retirement distribution satisfied the § 6015(c)(3)(c) knowledge standard for omitted income cases. 2. they’re literally dying to try to get § 6015(c) relief. estate of jonson v. commissioner, 118 t.c. 106 (2/8/02). in an innocent spouse case involving tax shelter deductions that was appealable to the tenth circuit, the tax court applied the ninth circuit’s liberal standard from price v. commissioner, 887 f.2d 959 (9th cir. 1989), requiring only that a spouse seeking relief “establish that she did not know and had no reason to know that the deduction would give rise to a substantial understatement, on the basis of a favorable citation to price in an unpublished tenth circuit opinion. however, the tax court denied § 6015(b) relief because the spouse was well educated, active in her husband’s financial affairs, had full knowledge of the facts of the investment, and benefited from the understatement. the deceased wife’s personal representative [her husband] made a § 6015(c) apportioned liability election more than 12 months after her death [and the commissioner did not challenge the representative’s procedural right to make the election], but § 6015(c) relief was denied. the personal representative “stepped into the shoes” of the deceased spouse, and she did not qualify for § 6015(c) relief because at the time of her death she and her husband were not divorced or separated and were members of the same household. although h. rept. no. 105-559 at page 252, n.16 states that a taxpayer is no longer married if he or she is widowed, congress did not intend § 6015(c) to apply to the estate of a spouse who was “happily married” at the time of death. equitable relief under § 6015(f) also was denied. 3. no “plain language” limitation of the tax court’s jurisdiction in this case. ewing v. commissioner, 118 t.c. 494 (5/31/02). the taxpayer and her husband filed a joint return but did not pay all of the tax shown on the return. subsequently, before the irs asserted any deficiency, the taxpayer requested equitable relief from joint and several liability under § 6015(f). the irs denied relief and mailed a notice of determination that was not mailed to the taxpayer’s last known address, but was actually received by the 88th day after it was mailed. the taxpayer’s petition for review was postmarked 92 days after the mailing of the notice, and was received and filed 7 days later. the commissioner moved to dismiss on the ground that the petition was not timely filed. the tax court sua sponte raised the issue of whether it had 2003] recent developments in federal income taxation 175 jurisdiction under § 6015(e) to review the irs’s denial of § 6015(f) relief where no deficiency had been asserted. [section 6015(e), granting the tax court jurisdiction to review denials of § 6015 relief, as amended by the consolidated appropriations act of 2001, begins, “in the case of an individual against whom a deficiency has been asserted and who elects to have subsection (b) or (c) apply.”] in a reviewed opinion by judge ruwe, the majority (9-4) held that the tax court has jurisdiction to review a denial of § 6015(f) relief in a stand alone petition where the taxpayer is seeking relief from liability of tax shown on the return, without a deficiency having been asserted. the court further held that the petition was timely because it was filed more than 6 months after the date she submitted her request for relief [see. § 6015(e)(1)(a)], the irs failed to mail the notice of determination to taxpayer’s last known address, and the misaddressed notice prejudiced the taxpayer’s ability to file her petition within 90 days after the mailing of the notice. the court concluded that: [t]he language “against whom a deficiency has been asserted” was inserted into section 6015(e) . . . to prevent taxpayers from submitting premature requests to the commissioner for relief from potential deficiencies before the commissioner had asserted that additional taxes were owed. . . . congress was concerned with the proper timing of a request for relief for underreported tax and intended that taxpayers not be allowed to submit a request to the commissioner regarding underreported tax until after the issue was raised by the irs. there is nothing in the legislative history indicating that the amendment of section 6015(e) . . . was intended to eliminate our jurisdiction regarding claims for equitable relief under section 6015(f) over which we previously had jurisdiction. the stated purpose for inserting the language “against whom a deficiency has been asserted” into section 6015(e) was to clarify the proper time for a taxpayer to submit a request to the commissioner for relief under section 6015 regarding underreported taxes. we conclude that the amendment of section 6015(e) does not preclude our jurisdiction to review the denial of equitable relief under section 6015(f) where a deficiency has not been asserted. in the instant case, petitioner filed a claim for relief from joint and several liability for an amount of tax correctly shown on the return but not paid with the return. because respondent has not challenged the tax reported on the return, no deficiency has been asserted. in this situation, petitioner may be entitled to relief under section 6015(f) because subsection (f) applies where “it is inequitable to hold the individual liable for any unpaid tax or any deficiency.” [citations omitted]. ! judge laro’s dissent argued that the tax court lacked jurisdiction to review the denial of § 6015 relief in the absence of a deficiency, because he considered § 6015(e)(1) to be a “clear statutory mandate from congress” limiting the tax court’s jurisdiction to review denials of § 6015 relief to deficiency cases. 4. it’s not “inequitable” to collect taxes from widows on their husband’s unreported incom e. mitchell v. commissioner, 292 f.3d 800, 2002-2 u.s.t.c. ¶50,475, 89 a.f.t.r.2d 2002-2961 (d.c. cir. 6/14/02). in a case involving receipt of an unrolled-over lump-sum distribution from the taxpayer’s late husband’s pension plan that was not reported on the [final] joint 176 florida tax review [vol.6:si return, the court of appeals held the denial of any § 6015 relief. the wife knew of the receipt and disposition of the distribution and thus had the requisite “knowledge” even if she did not know of the tax consequences of the transactions. a spouse who has actual knowledge of the transaction giving rise to omitted income has “reason to know” of the understatement—“ignorance of tax law is not a defense to liability.” the taxpayer’s proposed standard, based on whether a prudent taxpayer would be expected to know of the understatement, was rejected; the court expressly refused to apply the more relaxed standard applied to erroneous deduction cases under price v. commissioner, 887 f.2d 959 (9th cir. 1989). section 6015(c) apportioned liability relief was denied on the same grounds. in denying relief under § 6015(f), the court rejected the appeal that it would be inequitable to hold her liable due to her bereavement: “the loss of her spouse is not only not the sort of circumstance that makes it inequitable to collect tax, it is a normal condition of many of the taxpayers covered by the provisions of the innocent spouse rule.” 5. proposed § 6015 regulations. reg-106446-98, relief from joint and several liability, 66 f.r. 3888 (1/17/01). the treasury department has published proposed regulations under § 6015 to reflect changes in the law made by the irs restructuring and reform act of 1998, pub. l. no. 105-206, 112 stat. 685 (7/22/98), where § 6013(e) was replaced with § 6015. they clarify that case law interpreting the language under former § 6013(e) will be used to interpret that same language under § 6015. also, “knowledge or reason to know” of an understatement exists only when either the requesting spouse actually knew of the erroneous item giving rise to the understatement, or a reasonable person in similar circumstances would have known of the item. knowledge of an item under the proposed regulations would be knowledge of the receipt or expenditure. the proposed regulations would further amend reg. § 1.6013-4 to clarify that if a spouse asserts and establishes that he or she signed a joint return under duress, then the return is not a joint return, and he or she is not jointly and severally liable. relief must be requested within 2 years from the first collection activity, but not before the taxpayer receives a notification of an audit or notice that there might be outstanding liability. finally, the proposed regulations would provide that the nonrequesting spouse must be given notice that the requesting spouse has filed a claim for relief and be given an opportunity to participate in the proceedings. at the request of one spouse, the irs would omit from shared documents information that would reasonably identify that spouse’s location. a. now final. t.d. 9003, relief from joint and several liability, 67 f.r. 47278 (7/18/02). the final regulations adopt a knowledge standard for § 6015(b) relief that is consistent with that of former § 6013(e). the regulations clarify that the receipt of property traceable to items omitted by the nonrequesting spouse must be beyond normal support before they are considered a significant benefit. ! with respect to the “knowledge” standard applicable to erroneous deductions, the final regulations provide that “knowledge of the item means knowledge of the facts that made the item not allowable as a deduction” [following king v. commissioner, 116 t.c. 198 (2001)]. the final regulations also negate application of the actual knowledge limitation on relief in certain cases involving domestic abuse without specific duress. 6. proposed § 66 regulations for m arried individuals in community property states who do not file joint returns. reg-115054-01, treatment of community income for certain individuals not filing joint 2003] recent developments in federal income taxation 177 returns, 67 f.r. 2841 (1/22/02). the irs has published proposed regulations under § 66, relating to the treatment of married individuals in community property states who do not file joint income tax returns. the proposed regulations deal primarily with issues under § 66(c) [relief from community property rules]. 7. innocent spouse relief applies only to joint returns. raymond v. commissioner, 119 t.c. 191 (10/22/02). the filing of a joint return is a statutory prerequisite for relief under § 6015(b) and (c), but the statute is silent as to § 6015(f) relief. the tax court (judge vasquez) held that a taxpayer who did not file a joint return is not entitled to relief under the equitable relief provisions of § 6015(f) because the conference report states that relief is to be granted where “it is inequitable to hold an individual liable for all or part of any unpaid tax or deficiency arising from a joint return.” relief was unavailable to the taxpayer, who claimed that the income reported on her “married filing separately return” was not hers and that she had not filled it out, but had signed a blank return. 8. did a procedural detail slip through the statutory cracks? maier v. commissioner, 119 t.c. 267 (11/20/02). when one spouse requests innocent spouse relief from the irs, § 6015(h)(2) assures the other spouse a right to participate in the process [although it does not guarantee a personal appearance]. if a requesting spouse seeks tax court review of a denial of innocent spouse relief in a proceeding to which the other spouse is not already a party, § 6015(e)(4) provides the nonrequesting spouse the right to intervene. but if the irs administratively grants the requesting spouse innocent spouse relief, according to the tax court [judge panuthos], the nonrequesting spouse has no independent right to petition the tax court to review the administrative grant of relief to the requesting spouse. h. miscellaneous 1. the victims of terrorism tax relief act of 2001, pub. l. 107-134, 115 stat. 2427 (1/23/02), provides tax relief for those who died or were injured in the terrorist attacks on 9/11/01, the oklahoma city bombing in 1995, and bioterrorism attacks involving anthrax on or after 9/11/01 and before 1/1/02. ! the act waives income taxes for the year of death and the prior year and provides a minimum benefit of $10,000 to each victim. it shields the first $8.5 million in assets from federal estate tax and provides tax-free treatment of death benefits paid by an employer. ! it clarifies that payments made by charities are for an exempt purpose, even if made without demonstration of financial need, if made in good faith under an objective formula consistently applied. ! it imposes a 40 percent excise tax on persons who acquire structured settlements for a lump sum unless the transaction is approved by a court as being in the victim’s best interest. ! it exempts from gross income disaster relief payments received from airlines and certain other “qualified payments” received by individuals in a “qualified disaster.” ! it also clarifies that the secretary has the authority to disregard for up to one year some code provisions by reason of presidentially declared disaster or terrorist or military actions. 178 florida tax review [vol.6:si ! it also broadens § 6103 to permit the treasury department to share return information with federal law enforcement and intelligence agencies engaged in terrorist investigations. 2. notice 2002-60, 2002-36 i.r.b. 482 (9/9/02). this notice provides relief under the § 121(c) reduced maximum exclusion of gain provision for taxpayers who have not owned and used their principal residence for 2 years prior to sale or exchange, but were affected by the 9/11/01 terrorist attacks. 3. can you believe it? the taxpayer complained that the irs didn’t hound her enough for payment! smith v. commissioner, t.c. memo. 2002-1 (1/02/02). judge thornton refused to abate interest on the taxpayer’s deficiency even though the taxpayer offered the novel argument that the reason that she did not pay the deficiency in a timely manner was that the irs failed to “hound her enough.” 4. the commissioner gets a second bite at the apple. hambrick v. commissioner, 118 t.c. 348 (4/22/02). the commissioner had filed uncontested proofs of claim for nondischargable income tax liabilities in the taxpayer’s chapter 11 bankruptcy reorganization; the bankruptcy court confirmed the plan of reorganization without deciding the merits of the tax liabilities. subsequently, the commissioner issued deficiency notices for additional tax liabilities. judge gerber held that res judicata did not apply because the merits of the claim were not litigated in the bankruptcy court. collateral estoppel did not apply because the deficiency was a different issue. the commissioner was not estopped from determining the additional deficiencies. 5. the taxpayer gets a mulligan on premature filing of a refund suit. tobin v. troutman, 89 a.f.t.r.2d 2002-2271, 2002-1 u.s.t.c. ¶50,392 (w.d. ky. 4/19/02). the taxpayer filed a refund suit contemporaneously with the filing of an administrative claim for refund. the irs rejected her claim within 6 months, and the taxpayer filed “a pleading styled ‘first amended and supplemental complaint,’” which the court characterized as a motion under fed. r. civ. p. 15(d), less than 2 weeks later. the government moved to dismiss the taxpayer refund suit on the grounds that under § 7422(a) it had been filed prematurely. the court held that the filing of the amended complaint after the irs denied the administrative claim satisfactorily remedied the original failure to exhaust administrative remedies. 6. foreign postmarks now determine date of filing. rev. rul. 2002-23, 2002-18 i.r.b. 811 (5/6/02). the service will accept as timely filed any document required or permitted to be filed with the service, based upon a timely mailing as evidenced by an official postmark in a foreign country, as well as by timely delivery to a designated international delivery service. 7. the “duty of consistency” makes you stick to your story even when you don’t want to. blonien v. commissioner, 118 t.c. 541 (6/12/02). a former finley kumble partner claimed, in an “affected items” petition following a partnership level proceeding, that he was not a partner to whom a distributive share of the partnership’s cod income passed through. judge beghe held that partnership status is a partnership proceeding level issue when it affects the other partners’ distributive shares. furthermore, the duty of consistency barred the taxpayer from arguing that he was merely an employee, not a partner, of finley kumble in the year the partnership realized cod 2003] recent developments in federal income taxation 179 income, when in prior closed years in which he had received cash draws from the partnership in excess of his reported distributive share of partnership income, he had reported the excess as a reduction in the basis of his partnership interest, rather than as employee compensation. finally, for the year in question, he had failed to file form 8082 notifying the commissioner that he was taking a position inconsistent with the schedule k-1. 8. the kinder and quicker office of chief counsel. rev. proc. 2002-30, 2002-24 i.r.b. 1184 (6/17/02), superseded by rev. proc. 2003-2, 2003-1 i.r.b. 76 (1/6/03). the irs announced a pilot program for a “streamlined” process for issuing technical advice memoranda, dubbed teams. the team pilot program is limited to issues under the jurisdiction of the income tax & accounting branch of the irs chief counsel’s office. 9. let’s mediate, not litigate. rev. proc. 2002-44, 2002-26 i.r.b. 10 (7/1/02). the irs has formally established the voluntary non-binding appeals mediation procedures. the revenue procedure significantly expands the availability of mediation. there is no dollar amount of controversy floor, and legal issues are subject to mediation, as are unsuccessful attempts to enter into closing agreements. a. or should we arbitrate? announcement. 2002-60, 2002-26 i.r.b. 28 (7/1/02).the pilot arbitration program in rev. proc. 2000-4, 2000-1 c.b. 115, has been modified and extended though 6/30/03. 10. reg-126024-01, reporting of gross proceeds payments to attorneys, 67 f.r. 35064 (5/17/02). the irs and the treasury department amended and re-proposed regulations under §§ 6041 and 6045(f), which, inter alia , eliminates the delivery rule [check delivered to non-payee attorney does not constitute making a payment to him], rejects the suggestion that the § 6041 “payor” definition be used for § 6045(f) purposes because under the § 6041 “middleman” rules neither the tort claim defendant nor the insurer are required to report the payment to the attorney, rejects the suggestion that no report is required under § 6045(f) if any other person is required to report the payment under §§ 6041 or 6051, and adopts a $600 reporting threshold. 11. miller v. commissioner, 310 f.3d 640, 2002-2 u.s.t.c. ¶50,759, 90 a.f.t.r.2d 2002-7159 (9th cir. 11/8/02). regulation § 301.64042(a)(1) properly restricts the irs’s authority to abate interest on income, estate, gift, generation skipping, and certain excise taxes. the abatement of interest provisions do not apply to employment taxes. 12. non-tax shelter amendments to circular 230 are final. t.d. 9011, regulations governing practice before the internal revenue service, 67 f.r. 48760 (7/26/02). the final regulations amend and make final the non-tax shelter provisions of reg-111835-99, regulations governing practice before the internal revenue service, 66 f.r. 3276 (1/12/01). the tax shelter provisions in the proposed regulations were not part of these final regulations. among the changes are: ! under § 10.20, a practitioner’s duty to provide information regarding the identity of persons having possession or control of requested documents is “limited only to making reasonable inquiry of the practitioner’s client.” ! under § 10.21, the duty to advise as to the consequences of a failure to take corrective action is limited only to the 180 florida tax review [vol.6:si consequences “provided under the code and regulations of such noncompliance, error, or omission.” ! under § 10.22(b), the standard for due diligence with respect to reliance on the work product of another person will be based on “common sense and experience,” and the standard with respect to the engagement of an outside specialist “will be more focused on the reasonable care taken in the engagement of the specialist.” ! under § 10.28, the requirement to return a client’s records upon request, regardless of a fee dispute, is restricted to those records necessary for compliance with federal tax obligations. ! under § 10.29, the conflict of interest rules are in close conformance with the recently revised aba model rule 1.7 (which requires written consent). ! under § 10.30, solicitation rules follow relevant state bar rules, and also “expand" the prohibition of deceptive and other improper solicitation practices to cover private, as well as public, solicitations.” 13. t.d. 9014, furnishing identifying number of income tax return preparer, 67 f.r. 52862 (8/14/02). the irs has made final as reg. § 1.6109-2, earlier proposed and temporary regulations, which provide for alternative identification numbers for tax preparers to use on returns and refund claims in lieu of social security numbers. procedures under the temporary regulations [the filing of form w -7p, application for preparer tax identification number] had been in place since 1999. 14. marsh & mclennan companies, inc. v. united states, 302 f.3d 1369, 2002-2 u.s.t.c. ¶50,625, 90 a.f.t.r.2d 2002-6216 (fed. cir. 9/6/02), aff’g 50 fed. cl. 140 (8/6/01), petition for cert. filed 12/12/02. the federal circuit held that interest on an overpayment for an earlier year runs only to the due date of the return for the later year against which the overpayment is credited. 15. what do you say about this, wilson? notice 2002-62, 200239 i.r.b. 574 (9/30/02). this notice modifies and supersedes notice 2001-62, 2001-2 c.b. 307, and provides an updated list of approved private delivery services that under § 7502 qualify for the timely mailed/timely filed rule. certain specified airborne express, dhl worldwide express, federal express, and ups services are approved. services not specifically listed, even if offered by an approved service provider, do not qualify. 16 published guidance will be followed by the courts. rauenhorst v. commissioner, 119 t.c. 157 (10/7/02). taxpayers transferred warrants to four charities, which the charities sold shortly thereafter. at the time of the transfer, the taxpayers knew of the contemplated acquisition of the corporation. judge ruwe held that the taxpayers were not subject to tax on the charities’ sale of warrants, under the anticipatory assignment of income doctrine, because rev. rul. 78-197, 1978-1 c.b. 83, holds that the anticipatory assignment of income doctrine is inapplicable to donated property where the charitable donees are not legally obligated, nor can they be compelled, to sell the contributed property. a. chief counsel reminds irs lawyers. chief counsel notice cc-2002-043 (10/17/02). the irs reminds chief counsel attorneys of the requirement to follow published guidance in papers filed in the tax court or in defense or suit letters sent to the department of justice. 2003] recent developments in federal income taxation 181 17. t.d. 9023, taxpayer identification number rule where taxpayer claims treaty rate and is entitled to an unexpected payment, 67 f.r. 70310 (11/22/02). the treasury department has promulgated regulations [regs. §§ 1.1441-6(g) and 301.6109-1] governing withholding agents obtaining individual tins on an expedited basis when foreign individuals who claim reduced withholding rates under a treaty receive an unexpected payment from the withholding agent and do not have a tin. 18. t.d.e 9028, third party contacts, 67 f.r. 77419 (12/18/02). the treasury department has promulgated final regulations under § 7602(c) [requiring reasonable advance notice to the taxpayer] regarding third party contacts made by the irs in audits and collections. the final regulations generally follow the proposed regulations [reg-104906-99, third party contrats, 66 f.r. 77 (1/2/01)]. 19. just how detailed a finding on the burden of proof issue does the eighth circuit want the tax court to make? griffin v. commissioner, 315 f.3d 1017, 2003-1 u.s.t.c. ¶50,186, 91 a.f.t.r.2d 2003486 (8th cir. 1/14/03), rev’g t.c. memo. 2002-6 (1/8/02). reversing the tax court, the eighth circuit, in a per curiam opinion, held that the taxpayer had introduced credible evidence that payments of real estate taxes on property owned by an s corporation in which he was a shareholder were made in his capacity as a proprietor of a business, not in his capacity as a shareholder. (if the payments had been made in his capacity as a proprietor they could have been deductible.) the court accepted the commissioner’s definition of “credible evidence”—“‘the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted (without regard to the judicial presumption of irs correctness)’”—and found this standard satisfied by the testimony of the taxpayer and his accountant. the commissioner had cross-examined the taxpayer’s witnesses, but had not introduced any evidence. the case was remanded to the tax court for further proceedings to determine if the commissioner met the burden of proof, even though the tax court opinion, in a footnote, stated that its decision would have been the same if the commissioner had borne the burden of proof. perhaps tipping its hand that it wanted the taxpayer to win, the court of appeals admonished the tax court that “[i]f the same conclusion is reached by the tax court without a new hearing, an explanation is warranted as to how the existing record justifies the conclusion that the commissioner has met his burden of proof.” ! according to the tax court, the taxpayers did not contend that the real property taxes in question were imposed upon them, that they owned the real property against which the taxes were assessed, or that they owned any equitable or beneficial interest in the real property that might entitle them to a deduction under section 164. . . . the only evidence regarding the nature of [taxpayers’] business activities consists of [one taxpayer’s] summary and uncorroborated testimony. he testified, with little elaboration, that he has been a building contractor and land developer for about 30 years, during which time he has developed about one project a year. on cross-examination, he testified that his construction and real-estate development businesses are not separate businesses, but are ‘all tied together. they’re all – any 182 florida tax review [vol.6:si business i have is – if i – if they are – oftentimes i incorporate, because of the liability aspect. they are subchapter s if they are.’. . . [t]here is no credible evidence that the tax payments were made with respect to such activities. to the contrary, [taxpayer’s] accountant testified that the tax payments were reported on schedule e because they were attributable to [his] s corporations. . . . [taxpayers] failed to introduce credible evidence to establish that [taxpayer’s] failure to make the tax payments would have caused direct and proximate adverse consequences to any businesses conducted in [taxpayers’] individual capacities. [one taxpayer] testified that he made the tax payments ‘in order to preserve my integrity and my standing with the bank, and my good name, my goodwill.’ there is no evidence to indicate, however, to what extent [the taxpayer’s] failure to make the tax payments would have resulted in any damage to his reputation or creditworthiness. [taxpayers] have introduced no credible evidence to show that petitioner made the tax payments to protect the reputation of any business operation conducted in [their] individual capacities. on the basis of [taxpayer’s] testimony, we are unable to conclude that the tax payments would have represented ordinary expenses to advance any business carried on in [taxpayers’] individual capacities, as opposed to capital outlays to establish or purchase goodwill or business standing.” xi. w ithholding and excise taxes a. em ployment taxes 1. the supreme court reverses the seventh circuit and upholds the irs. united states v. fior d’italia, inc., 536 u.s. 238, 2002-2 u.s.t.c. ¶50,459, 89 a.f.t.r.2d 2002-2883 (6/17/02) (6-3). the court held that the irs has broad power under § 6201(a) to determine the method it uses to make assessments, and that its use of the “aggregate estimation method” to determine the total amount of tip income upon which to base an assessment of fica taxes on an employer is reasonable in light of the employer’s stipulation of the accuracy of the calculation. the method used was an amount based upon a percentage of total restaurant checks (extrapolated from the percentage of tips on restaurant checks paid with credit cards) minus the tip income reported by each employee to the restaurant owner. ! justice breyer, writing for the majority, held that an employee-by-employee determination was unnecessary. he further held that certain features of an aggregate estimate—that it includes tips that should not count in calculating fica tax [e.g., tips amounting less than $20 per month] or that a calculation based on credit slips can overstate the aggregate amount [e.g., cash-paying customers tend to leave a lower percentage tip]—do not show that the method is so unreasonable as to violate the law. the employer is free to present evidence that an assessment is inaccurate in a particular case. ! justice souter (joined by justices scalia and thomas) in his dissent notes that the statute and regulations expressly excuse employers from the obligation to keep tips information on an 2003] recent developments in federal income taxation 183 employee-by-employee basis beyond the tip amounts actually reported by each employee. 2. tax planner loses on same scam as his client, with his client’s case decided a year earlier cited as authority. joseph m. grey public accountant, p.c. v. commissioner, 119 t.c. 121 (9/16/02). the taxpayer was an s corporation with a single shareholder, who was the only individual who provided any services on behalf of the corporation. all of the taxpayercorporation’s income was earned by virtue of services provided to third parties by the shareholder. the corporation paid the sole shareholder some fees as an “independent contractor,” but no salary, and he reported all of the taxpayer’s remaining income under § 1366; the income was distributed to him [subject to §1368]. the corporation paid no employment taxes. judge halpern applied veterinary surgical consultants p.c. v. commissioner, 117 t.c. 141 (10/15/01) [which judge halpern noted involved a client of the taxpayer to which the taxpayer had suggested the same arrangement be used to avoid employment taxes], to hold that the shareholder was an employee of the corporation and upheld the recharacterization of the amounts paid to him as salary. under § 3121(d)(1), the shareholder, as its president, was a statutory employee of the corporation and performed all of his services as such. section 530 relief was not available because (1) the corporation had no reasonable basis for not treating the shareholder as an employee, and (2) relief under § 530 was not available with respect to statutory employees. accordingly the wage tax deficiency was upheld. 3. fishy entertainment expenses were disguised wages. townsend industries, inc. v. united states, 2002-2 u.s.t.c. ¶50,697, 90 a.f.t.r.2d 2002-6588 (s.d. iowa 8/21/02), vacated, 90 a.f.t.r.2d 2002-7089 (s.d. iowa 9/30/02). employer-paid fishing trips for employees, provided in conjunction with the employer’s annual sales meeting, were “wages” subject to employment tax. the fishing trips were additional compensation, not “entertainment expenses,” meeting either the “directly related” or “associated with” tests of § 274; nor were the fishing trips excludable fringe benefits under § 132. b. self-employment there were no significant developments in this topic in 2002. c. excise taxes there were no significant developments in this topic in 2002. xii. tax legislation a. enacted 1. the victims of terrorism tax relief act of 2001, pub. l. no. 107-134, 115 stat. 2427 (1/23/02), was signed by president bush on 1/23/02. the act provides tax relief for those who died or were injured in the terrorist attacks on 9/11/01, the oklahoma city bombing in 1995, and bioterrorism involving anthrax on or after 9/11/01 and before 1/1/02. see x.h., supra . 2. the job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21, was signed by president bush on 3/9/02. 184 florida tax review [vol.6:si 3. the clergy housing allowance clarification act of 2002, pub. l. no. 107-181, 116 stat. 583, was signed by president bush on 5/20/02. see v.a., supra . 4. the sarbanes-oxley act, pub. l. no. 107-204, 116 stat. 745, formerly known as the public company accounting reform and investor protection act of 2002, was signed by president bush on 7/30/02. one provision in the act is a “sense of the senate” that corporate federal income tax returns be signed by the ceo. see also § 307 for lawyer whistleblowing requirements. 5. public law 107-276, 116 stat. 1929, which amends § 527 to eliminate the notification and return requirements for state and local party committees and candidate committees, was signed by president bush on 11/2/02. b. pending 1. president bush’s “jobs and growth proposal” tax plan includes (1) elimination of shareholder tax on dividends that were taxed at the corporate level, (2) acceleration of 2001 tax rate cuts, marriage penalty elimination, and increase in the child credit, and (3) increasing the amounts that can be invested in certain retirement plans and modifications of the retirement plan rules. page 1 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 page 16 page 17 page 18 page 19 page 20 page 21 page 22 page 23 page 24 page 25 page 26 page 27 page 28 page 29 page 30 page 31 page 32 page 33 page 34 page 35 page 36 page 37 page 38 page 39 page 40 page 41 page 42 page 43 page 44 page 45 page 46 page 47 page 48 page 49 page 50 page 51 page 52 page 53 page 54 page 55 page 56 page 57 page 58 page 59 page 60 page 61 page 62 page 63 page 64 page 65 page 66 page 67 page 68 page 69 page 70 page 71 page 72 page 73 page 74 page 75 page 76 page 77 page 78 page 79 page 80 page 81 page 82 page 83 page 84 page 85 page 86 page 87 page 88 page 89 page 90 page 91 page 92 page 93 page 94 page 95 page 96 page 97 page 98 page 99 page 100 page 101 page 102 page 103 page 104 page 105 page 106 page 107 page 108 _hlt35706002 c:\1-working\25940 florida tax rev 8-special 2008\first 4 pages.wpd recent developments in federal income taxation: the year 2007 martin j. mcmahon, jr.* ira b. shepard** daniel l. simmons*** i. accounting ................................................................................718 a. accounting methods ................................................................718 b. inventories ................................................................................718 c. installment method ...................................................................718 d. year of inclusion or deduction ................................................718 ii. business income and deductions .........................................722 a. income ......................................................................................722 b. deductible expenses versus capitalization ..............................723 c. reasonable compensation ........................................................725 d. miscellaneous deductions .......................................................727 e. depreciation & amortization ...................................................735 f. credits .......................................................................................737 g. natural resources deductions & credits ................................738 h. loss transactions, bad debts and nols ................................741 i. at-risk and passive activity losses .........................................741 iii. investment gain .......................................................................743 a. capital gain and loss ..............................................................743 b. interest ......................................................................................746 c. section 121 ................................................................................746 d. section 1031 .............................................................................746 e. section 1033 .............................................................................748 f. section 1035 ..............................................................................749 iv. compensation issues ...............................................................749 a. fringe benefits .........................................................................749 b. qualified deferred compensation plans ..................................750 c. nonqualified deferred compensation, section 83, and stock options .........................................................................753 d. individual retirement accounts ...............................................759 v. personal income and deductions .......................................760 a. rates .........................................................................................760 b. miscellaneous income ..............................................................760 c. profit-seeking individual deductions ......................................767 d. hobby losses and § 280a home office and vacation homes ............................................................................770 e. deductions and credits for personal expenses ........................771 f. divorce tax issues .................................................................... 779 g. education ..................................................................................782 * clarence teselle professor of law, university of florida college of law. ** professor of law, university of houston law center. *** professor of law, university of californiadavis. 716 florida tax review [vol. 8:si vi. corporations ............................................................................782 a. entity and formation ................................................................782 b. distributions and redemptions ................................................782 c. liquidations .............................................................................. 783 d. s corporations ..........................................................................784 e. reorganizations ........................................................................788 f. corporate divisions ..................................................................792 g. miscellaneous corporate issues ...............................................795 h. affiliated corporations and consolidated returns ..................798 vii. partnerships .............................................................................802 a. formation and taxable years ..................................................802 b. allocations of distributive share, partnership debt, and outside basis ..........................................................................803 c. distributions and transactions between the partnership and partners ...................................................................................805 d. sales of partnership interests, liquidations and mergers ........805 e. inside basis adjustments ..........................................................806 f. partnership audit rules ............................................................806 g. miscellaneous ...........................................................................811 viii. tax shelters .............................................................................816 a. tax shelter cases ..................................................................... 816 b. identified “tax avoidance transactions.” ...................................821 c. disclosure and settlement ........................................................824 d. tax shelter penalties, etc. .......................................................828 ix. exempt organizations and charitable giving ..............829 a. exempt organizations ..............................................................829 b. charitable giving .....................................................................832 x. tax procedure ..........................................................................834 a. interest, penalties and prosecutions .........................................834 b. discovery: summonses and foia ...........................................843 c. litigation costs ........................................................................851 d. statutory notice of deficiency .................................................852 e. statute of limitations ...............................................................852 f. liens and collections ................................................................855 g. innocent spouse .......................................................................862 h. miscellaneous ...........................................................................865 xi. withholding and excise taxes ............................................876 a. employment taxes ...................................................................876 b. excise taxes .............................................................................879 xii. tax legislation .......................................................................880 a. enacted .....................................................................................880 2008] recent developments in federal income taxation 717 recent developments in federal income taxation: the year 2007 by martin j. mcmahon, jr. ira b. shepard daniel l. simmons this recent developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during 2007 — and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide dan and marty the opportunity to mock our elected representatives. the outline focuses primarily on topics of broad general interest (to the three of us, at least) – income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. any mistakes in this outline are marty’s responsibility; any political bias or offensive language is ira’s; and any useful information is dan’s. 718 florida tax review [vol. 8:si i. accounting a. accounting methods 1. the method of determining “fair market value” under § 475 falls within the definition of “method of accounting” for § 446(b)’s requirement that the taxpayer’s method of accounting must clearly reflect income. in re heilig meyers co., 232 f.app’x 240 (4th cir. 5/9/07). the determination of the fair market value of accounts receivable under the mark-to-market rules of § 475 is an accounting method subject to § 446(b)’s clear reflection of income requirement. the court relied heavily on jpmorgan chase & co. v. commissioner, 458 f.3d 564 (7th cir. 8/9/06), which held that the valuation of interest swaps, which also were subject to the § 475 mark-to-market rules, was an accounting method, in rejecting the taxpayer’s argument that “the dispute was ‘a valuation case,’ as opposed to a method of accounting case.” 2. notice 2007-88, 2007-46 i.r.b. 993 (11/13/07). this notice requests comments regarding a proposal to change the process by which taxpayers obtain the consent of the commissioner to change a method of accounting. it describes the automatic and nonautomatic consent processes, and suggests they be replaced with a system under which a taxpayer requests “standard consent,” “specific consent,” or “letter ruling consent” and describes these processes. b. inventories there were no significant developments regarding this topic during 2007. c. installment method there were no significant developments regarding this topic during 2007. d. year of inclusion or deduction 1. the irs just says ‘no” to the recurring item exception. rev. rul. 2007-3, 2007-4 i.r.b. 350 (1/22/07). under the recurring-item exception to the economic performance rule in § 461(h)(3), taxpayers can accrue deductions no sooner than the year in which the all events test is satisfied. the irs concluded that liabilities were not “established” under the all-events test in the year in which two contracts were executed. in the first situation, the contract, executed in year 1, did not 2008] recent developments in federal income taxation 719 require the performance of services and payment until year 2. in the second situation, the contract, executed in year 1, did not provide insurance coverage or payment for that coverage until year 2. the irs concluded that, in both cases, the mere execution of the contract, “without more,” did not establish the taxpayer’s liability. thus, the recurring-item exception could not apply. 2. deducting payroll taxes in a year before the compensation is deducted. rev. rul. 2007-12, 2007-11 i.r.b. 685 (3/12/07). section 404 does not control the year of deduction of an employer’s liability for payroll taxes, even if the payroll tax liability relates to deferred compensation subject to the rules of § 404. section 404 does not affect the timing of the accrual of payroll tax liability under § 461; if the allevents test and the recurring item exception in § 461 and reg. § 1.4615(b)(1) are otherwise met, an accrual method taxpayer may deduct payroll tax liability in year 1, even though the compensation to which the liability relates is deferred compensation that is deductible under § 404 in year 2. this ruling modifies rev. rul. 96-51, 1996-2 c.b. 36, which concluded that, under the all-events test, an accrual method employer may deduct in year 1 its otherwise deductible payroll taxes imposed on year-end wages properly accrued in year 1 but paid in year 2, provided the employer satisfies the requirements of the recurring item exception in reg. § 1.461-5. 3. rev. rul. 2007-32, 2007-21 i.r.b. 1278 (5/21/07). an accrual method bank is required to take interest into income with respect to loans that are declared by federal banking rules to be a “non-accrual loan” for which the bank is required to treat interest payments as a return of principal. where the bank uses the conformity method of accounting under reg. § 1.166-2(d), uncollected accrued interest is treated as worthless for § 166 purposes in the year that the amount is charged off for regulatory financial accounting purposes. a. rev. proc. 2007-33, 2007-21 i.r.b. 1289 (5/21/07). this revenue procedure describes procedures for automatic consent to a change of accounting method that uses a prescribed safe-harbor to determine for each tax year the amount of uncollected accrued interest that is expected to have a reasonable expectancy of repayment using a recovery percentage for the bank. 4. the saga of whether advance trade discounts are currently includible in gross income. 720 florida tax review [vol. 8:si a. yes, says the tax court. karns prime & fancy food, ltd. v. commissioner, t.c. memo. 2005-233 (10/5/05). a $1.5 million advance received by the taxpayer-retailer from a supplier that was evidenced by a promissory note with the proper indicia of debt nevertheless was not a true debt. because the parties concurrently entered into a supply agreement pursuant to which the debt would be forgiven if the taxpayer purchased the quantity of product required under the supply agreement over its term, there was no unconditional obligation to repay the advance. the amounts under the note were due only if the supply agreement was materially breached by the taxpayer. b. the ninth circuit disagrees. westpac pacific food v. commissioner, 451 f.3d 970 (9th cir. 6/21/06), rev’g t.c. memo. 2001-175 (7/16/01). “cash advance trade discounts” received by a retailer from a manufacturer in exchange for volume purchase commitments, subject to pro rata repayment if the volume commitments were not met, were not includable in gross income when received because these amounts were adjustments to the cost of goods sold and the cash advances were includible in income by virtue of taxpayer’s inventory accounting system. c. and the irs caves. rev. proc. 2007-53, 2007-30 i.r.b. 233 (7/23/07). the irs will follow westpac pacific food v. commissioner and allow accrual method taxpayers who receive advance trade discounts to adopt the “advance trade discount” method of accounting as a change of accounting method. taxpayers who report advance trade discounts as reductions in the price of inventory for financial purposes may do so for tax reporting purposes. taxpayers who lack applicable financial statements must reduce the cost of the specific items of inventory to which the discount relates. d. but the third circuit disagrees with the ninth circuit and affirms the tax court decision in karns. did the irs cave too soon in issuing rev proc 2007-53? karns prime & fancy food, ltd v. commissioner, 494 f.3d 404 (3d cir. 7/20/07). the third circuit affirmed the tax court decision in karns and specifically rejected the reasoning and ninth circuit’s holding in westpac foods. the court (judge sloviter) reasoned that the key question is whether, at the time of receipt of the funds, the recipient was unconditionally obligated to make repayment. under the logic of commissioner v. indianapolis power & light co., 493 u.s. 203 (1990), a receipt is not a loan if the taxpayer controls whether it will be entitled to retain the payment. because karns alone controlled whether it would meet the contractual requirements, the receipt was analogous to an advance payment includable in gross income. although 2008] recent developments in federal income taxation 721 judge sloviter acknowledged that the facts in westpac pacific foods differed somewhat, he concluded that in westpac the ninth circuit had completely ignored the significance of indianapolis power. the third circuit treated payments under a supply agreement as advance payments includible in income because the taxpayer was free to keep the money as long as it fulfilled its part of the bargain. the taxpayer thus had complete dominion and control over the money. the court rejected the taxpayer’s assertion that the advance was a loan because the taxpayer, by performing under the agreement, was in a position to control whether it was obligated to repay. • judge ambro caustically entitled a section of his concurring opinion “the ninth circuit tax shelter, or how to make money by buying things.” the concurring opinion noted that the third circuit’s position has always been that income may be considered to be a loan only when there is an unconditional repayment obligation; it characterized the ninth circuit as the “first and only” court of appeals to conclude that trade discounts paid by the supplier to a taxpayer to offset the taxpayer’s required minimum purchases are loans rather than advance payments. • judge brody dissented on the ground that the agreements between the supplier and karns did not assure that karns could keep the funds, because the supplier retained “immense latitude” to cancel the agreement before karns had met its purchase obligations, a factual conclusion with which the majority disagreed. • in light of rev. proc. 2007-53, in which irs indicated that it will generally follow westpac pacific foods, the third circuit’s decision appears to be of little importance with respect to the specific issue of whether advance trade discounts must be taken into gross income when received, but it nevertheless is an important general precedent regarding the determination of whether other receipts are a loan versus an income item. 5. not all accruals are created equal. the charles schwab corp. v. commissioner, 495 f.3d 1115 (9th cir. 8/2/07). schwab was required to pay a yearly california franchise tax. for the years in question, california calculated a corporation’s franchise tax liability based upon the corporation’s income from the preceding year – the so-called “income” year. schwab used the accrual method of accounting; under § 461(a) it deducted expenses for the year in which they accrued. under california law, schwab’s state franchise tax liability accrued on the last day of the year in which schwab earned the income forming the basis for the tax assessment (december 31 of the “income” or “measuring” year). however, § 461(d)(1) provides, that a taxpayer’s accrual date for federal tax purposes may be no earlier than it would have been under state law as it existed at the end of 1960. under pre-1961 california law, the franchise tax did not accrue 722 florida tax review [vol. 8:si until the first day of the year following the income year (january 1 of the “taxable” year). california amended its franchise tax in 1972. under pre1972 law, a corporation that stopped doing business did not pay any franchise tax on the income earned during its final year of operation. the court of appeals affirmed the tax court, 122 t.c. 191, 203 (2004), holding that § 461(d)(1) required schwab to determine the timing of its franchise tax accruals pursuant to pre-1961 law. as a result, schwab’s liability accrued on january 1 of the taxable year rather than december 31 of the preceding income year, meaning schwab was entitled to deduct on its 1989-1992 federal tax returns its franchise tax obligations based upon its 1988-1991 income. 6. who needs constructive receipt when you have actual receipt? burns v. commissioner t.c. memo. 2007-271 (9/12/07). the taxpayer was owed over $145,000 as the last installment of an award under a whistleblower statute. a private investigator, who had assisted the taxpayer in the investigation that led to the award, obtained a judgment against the taxpayer for failure to pay him pursuant to their contract. to avoid execution of the private investigator’s judgment lien on the funds, the taxpayer filed a voluntary petition in bankruptcy, and the funds were paid over to the bankruptcy trustee by the taxpayer’s debtor. judge carluzzo held that the funds were actually received by the taxpayer in the year they were paid over to the bankruptcy trustee. no reference to the constructive receipt doctrine was necessary. the funds were actually received because the taxpayer’s voluntary action resulted in the payment to the bankruptcy trustee. ii. business income and deductions a. income 1. settlement funds beneficially owned by a governmental entity are tax-exempt. tax increase prevention and reconciliation act of 2005 § 201(a) added code §§ 468b(g)(2) and (3), which provide that certain settlement funds established before 2011 pursuant to consent decrees in order to resolve claims under the comprehensive environmental response, compensation, and liability act of 1980 (cercla) are treated as beneficially owned by a state or federal governmental entity, and are thus exempt from tax under § 468b(g)(1). a. these provisions were made permanent by the tax relief and health care act of 2006 § 409. 2008] recent developments in federal income taxation 723 2. here’s how the irs’s vigorishly reconstructed a bookie’s income from 4 days of records that we bet he wishes he hadn’t kept. paterson v. commissioner, t.c. memo. 2007-109 (4/30/07). the tax court (judge kroupa) upheld the irs’s complex reconstruction of an illegal bookmaker’s income based on records for 4 days of betting seized in a police raid. the method applied consisted of five computational steps: (1) adding 10 percent vigorish to the bets listed on the sheet that did not carry vigorish and adding all bets together to find the gross wagers; (2) dividing total gross wagers by 4 days of betting to obtain the average daily bet; (3) using the call records for the taxpayer’s cellular phones to determine the number of days people called the taxpayer to place bets; (4) multiplying the average daily bet by the number of days people placed bets for each year to arrive at the gross wagers for each year; and (5) multiplying the gross wagers for the year by 4.54 percent, which represented the profit percentage a bookmaker would make if his or her books were balanced. 3. notice 2007-63, 2007-33 i.r.b. 353 (8/13/07). this notice deals with the tax treatment of “market gain” associated with the repayment of commodity credit corporation (ccc) loans under the nonrecourse marketing assistance loan program authorized under the farm security and rural investment act of 2002, pub. l. no. 107-171, 116 stat. 134 (2002). a taxpayer that has made an election under § 77 to take the loan into income accounts for market gain for the year in which a ccc loan is repaid by making an adjustment to the basis of the commodity that secures the loan. a taxpayer that has not made an election under § 77 reports market gain as income for the year in which a ccc loan is repaid. b. deductible expenses versus capitalization 1. big loser in 1996 olympics: corporate president paid $5 million to indemnify his corporation, lost his job, and got no deduction either. tigrett v. united states, 96 a.f.t.r.2d 2005-5649 (w.d. tenn. 8/3/05), as amended, 96 a.f.t.r.2d 2005-6431 (9/2/05). the $5 million paid to a corporation by its president/minority shareholder in satisfaction of his contractual obligation to indemnify the corporation against losses from a specific venture (the house of blues venue in centennial park in atlanta during the 1996 olympics) that he advocated the corporation to undertake constituted a capital contribution – not a business expense – because taxpayer had no possibility of personal business profit from the specific venture by the corporation. a. affirmed, 213 f.app’x 440 (6th cir. 1/12/07). taxpayer failed to prove that the contribution to capital was an ordinary business expense or a business loss. 724 florida tax review [vol. 8:si 2. simplifying complexity. t.d. 9318, guidance regarding the simplified service cost method and the simplified production method, 72 f.r. 14675 (3/29/07). the treasury has promulgated final regulations under the uniform capitalization rules of 263a with respect to the simplified service cost method and simplified production method of capitalizing mixed service costs (costs that benefit production activities and other activities) and production costs that were not capitalized under the taxpayer’s method of accounting before the effective date of § 263a. the rules are applicable to eligible property that consists of self-constructed assets produced by the taxpayer on a routine and repetitive basis in the regular course of the taxpayer’s trade or business. the regulations provide that property is produced on a routine and repetitive basis if numerous substantially identical units of tangible personal property are produced within a tax year using standardized designs and assembly line techniques and the recovery period for the assets is not longer than 3 years. 3. the cost of double-wides just went up. load, inc. v. commissioner, t.c. memo. 2007-51 (3/6/07). costs attributable to placement of model manufactured homes on leased retail sales lots for sale by local independent sellers are includible in inventory under § 263a. the costs are not on-site storage costs under reg. § 1.263a-1(e)(3)(iii)(i) because transfers to independent re-sellers prevented taxpayer from being considered as selling exclusively to retail customers. 4. the irs adopts an uncharacteristic position by requiring deduction instead of capitalization. ilm 200721015 (1/16/07). in this legal memorandum the irs has determined under reg. § 1.2661(b)(1)(iv) that a flat fee paid to a stockbroker for investment services is not a carrying charge. the legal memorandum arrived at this result by virtue of the following reasoning: fees for consulting and advisory services are better viewed as currently deductible investment expenses. consulting and advisory fees are not carrying charges because they are incurred independent of a taxpayer’s acquiring property and because they are not a necessary expense of holding property. stated differently, consulting and advisory fees are not closely analogous to common carrying costs, such as insurance, storage, and transportation. (citation omitted). • this prevents taxpayers from capitalizing § 212 expenditures, the deduction of which would produce no tax benefit as a 2008] recent developments in federal income taxation 725 result of either the § 67 limitation on miscellaneous itemized deductions or the disallowance of such deductions under the amt. 5. environmental remediation may or may not be deductible depending upon the facts. kerr-mcgee corp. v. united states, 77 fed. cl. 309 (6/29/07). the court of federal claims denied summary judgment to the taxpayer on a claim for refund based on deductions for environmental remediation of the site of an oil refinery and uranium processing operation. kerr-mcgee purchased the site, which had continuously operated as an oil refinery since 1915, in 1956, sold it in 1972, and reacquired portions in 1984 and 1987. the court (judge sweeney) held that environmental remediation costs are deductible if the taxpayer caused the contamination and incurred expenses to return the property to the condition it was in before the contamination, regardless of whether the taxpayer continuously owned the property. expenses are required to be capitalized if the remediation allowed the taxpayer to put the property to a new or better use, whether or not the taxpayer caused the contamination, or if the remediation is part of a plan of renovation, rehabilitation, or improvement. ultimately the court determined that the record before it presented factual determinations necessary to reach a judgment. the court specifically noted, however, that it was “not prepared, based on the record before it, to find that kerr-mcgee can deduct remediation expenses for contamination that occurred from 1915 to 1956. in order to make such a ruling, the court would need evidence that contamination on the ... site prior to 1956 can be attributed to kerr-mcgee.” 6. tarter v. commissioner, t.c. memo. 2007-320 (10/25/07). the taxpayer was denied deductions for his employee benefits and payroll taxes, outside services, equipment rental, and depreciation for his business of pouring concrete foundations and flatwork for residential projects because he failed to meet the burden of countering the irs claim that these items had been included in cost of goods sold by the taxpayer. accuracy-related penalties were sustained. c. reasonable compensation 1. group affected by limitations on executive compensation is redefined. notice 2007-49, 2007-25 i.r.b. 1429 (6/18/07). section 162(m) limits deductible compensation paid to covered employees to $1,000,000 (plus performance bonuses). this notice responds to revisions of regulations by the sec defining covered employees, which the irs says will now include the principal executive officer and compensation paid to employees that is required to be reported to shareholders under the 726 florida tax review [vol. 8:si securities exchange act of 1934 by virtue of being among the three highest paid officers of the corporation during the taxable year other than the principal executive officer or the principal financial officer. 2. healthy $2 million and $1 million annual compensation to the ceo and sole owner of the taxpayer corporation is reasonable given the ceo’s skill at developing and marketing skin care products, tanning lotions, diet aids, sports performance products, nutritional supplements, health food products, and indoor tanning salons. vitamin village, inc. v. commissioner, t.c. memo. 2007-272 (9/12/07). in a case appealable to the ninth circuit, the tax court (judge haines) substantially rejected the irs’s arguments that the taxpayer paid its sole shareholder (daniel reeves) unreasonable compensation. judge haines allowed taxpayer to deduct compensation in the form of bonuses in the amounts of $2,000,000 (out of $2,278,000 paid) in one year and of the entire $1,012,000 paid in another year. the tax court applied the five factor test of the ninth circuit from elliotts, inc. v. commissioner, 716 f.2d 1241 (9th cir. 1983): (1) the employee’s role in the company; (2) comparison with other companies; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) internal consistency in compensation. • the shareholder functioned as the corporate president, secretary, and treasurer. in the prior 13 years, reeves’ compensation had never exceeded $310,000 and in 11 of those years was $47,000 or less. the court found that reeves, who was the taxpayer’s sole executive officer and manager, was the driving force behind its success. “his vision and hard work resulted in ... a shareholders return on equity of 93 percent and 25 percent in the respective fiscal years at issue,” and reeves had been underpaid in prior years. • the tax court also allowed deductions for $1.1 million of advertising expenses for promoting suntan products paid to the taxpayer’s sister corporation, wholly owned by reeves, but disallowed depreciation deductions on a newly constructed houseboat and floating garage on the willamette river adjacent to reeves’s residence, which were sold in 2002 to mr. reeves wife’s company in reeves’s bankruptcy. a. reeves v. commissioner, t.c. memo. 2007-273 (9/12/07). the tax court held that amounts expended by the corporation for construction of the houseboat and floating garage did not 2008] recent developments in federal income taxation 727 result in a constructive dividend to reeves, noting that the corporation was reimbursed from the proceeds of reeve’s bankruptcy sale. b. but salary paid by a related support organization proves to be too much. universal marketing, inc. v. commissioner, t.c. memo. 2007-305 (10/9/07). an additional $509,000 paid to reeves was too much for judge haines on top of the compensation paid by vitamin village. applying the elliotts, inc. factors, the tax court found that the taxpayer failed to establish that the amount of time spent on the affairs of the corporation whose sole source of receipts was its sister corporation, vitamin village, justified the salary. d. miscellaneous deductions 1. the irs never seems able to catch up with movements in the price of gasoline. rev. proc. 2006-49, 2006-47 i.r.b. 936 (11/20/06). the optional standard mileage rate for business use of automobiles for 2007 is 48.5 cents per business mile. the optional standard mileage rate for medical and moving expenses is 20 cents per mile. the statutory rate for charitable mileage under § 170(i) remains at 14 cents per mile. a. the irs keeps chasing increases in the price of gasoline. or, is the groundhog sending out mixed signals? rev. proc. 2007-70, 2007-50 i.r.b. 1162 (12/10/07), superseding rev. proc. 2006-49, 2006-47 i.r.b. 936. the optional standard mileage rate for business use of automobiles for 2008 increases to 50.5 cents per business mile. the depreciation component of the mileage rate is 21 cents. the optional standard mileage rate for medical and moving expenses goes down to 19 cents per mile. the statutory rate for charitable mileage under § 170(i) remains at 14 cents per mile. 2. oh, the joy of legitimately deducting large capital expenditures (except for suvs)! the small business and work opportunity tax act of 2007 amended § 179 to increase the amount deductible under § 179 to $125,000 for tax years beginning after 2006 and before 1/1/11. the phase-out threshold was increased to $500,000. both amounts are indexed for inflation after 2007, using 2006 as a base year. the 2007 act also extends the inclusion of off-the-shelf computer software as § 179 property for one year, until 1/1/11, and likewise extends the increased deductible amount (up to an additional $100,000), and the increased phaseout ($600,000) for gulf opportunity zone property until 1/1/11. 728 florida tax review [vol. 8:si 3. wouldn’t it just have been easier to cut rates in october 2004? no. was it because that’s what the french-looking vietnam war veteran was proposing? no, it was a replacement for the fsc/eti export subsidies. section 102 of the jobs act of 2004 added new code § 199, which provides a magical 9 percent deduction of a percentage of taxable income attributable to domestic manufacturing activities. a. partnership that extracts minerals is a qualified in-kind partnership. rev. rul. 2007-30, 2007-21 i.r.b. 1277 (5/21/07). under reg. § 1.199-9(i)(1) and temp. reg. § 1.199-3t(i)(7)(i), each partner of a qualifying in-kind partnership is treated as having manufactured, produced, grown, or extracted property that is manufactured, produced, grown, or extracted by the partnership that is distributed to the partner. the irs ruled that the extraction and processing of minerals (as defined in reg. § 1.611-1(d)(5)) is an activity qualifying a partnership under these provisions. thus, a partnership engaged solely in the extraction and processing of minerals within the united states will be a qualifying partnership as of the effective date of § 199. b. rev. proc. 2007-34, 2007-23 i.r.b. 1345 (6/4/07). this revenue procedure provides procedures that allow certain large partnerships and widely held subchapter s corporations to calculate, at the entity level, qualified production activities income and w-2 wages for purposes of the § 199 domestic production deduction. c. rev. proc. 2007-35, 2007-23 i.r.b. 1349 (6/4/07). this revenue procedure provides statistical sampling methodologies for various allocations between domestic and non-domestic production activities. 4. irs rules on accountable plans. rev. rul. 200656, 2006-46 i.r.b. 874 (11/13/06). if employers pay expense allowances in excess of the amount that may be deemed substantiated without requiring actual substantiation of all the expenses or repayment of the excess amount, and the expense allowance arrangement has no mechanism or process to determine when an allowance exceeds the amount that may be deemed substantiated, then the failure of the arrangement to treat the excess allowances as wages for employment tax purposes causes all payment made under the arrangement to be treated as made under a nonaccountable plan. this rule is not effective for taxable periods ending on or before 12/31/06 in the absence of intentional noncompliance. 2008] recent developments in federal income taxation 729 • the facts of this ruling involve reimbursement of long-haul truck drivers for meal and incidental expenses on a “cents-per-mile driven” basis that regularly exceeds $52 per day – the amount determined by § 4.04 of rev. proc. 2005-67, 2005-2 c.b. 729. 5. the tax relief and health care act of 2006 § 108 extends the § 62(a)(2)(d) above-the-line $250 deduction for k-12 teacher classroom expenses to 2006 and 2007. 6. the tax relief and health care act of 2006 § 109 extends the expensing of brownfields remediation costs under § 198 to 2006 and 2007. it also provides that sites contaminated by petroleum products will be eligible for the deduction. 7. deductions go up in smoke. distributing california legal medical marijuana is illegal drug trafficking. californians helping to alleviate medical problems, inc. v. commissioner, 128 t.c. 173 (5/15/07). taxpayer is a california public benefit corporation engaged in the business of providing care services to its members with a secondary purpose to provide medical marijuana to members pursuant to the california compassionate use act of 1996 and to instruct those individuals on how to use medical marijuana to benefit their health. section 280e disallows deductions in a trade or business of trafficking in controlled substances within the meaning of schedules i or ii of the controlled substances act, which includes marijuana. the tax court (judge laro) held that supplying medical marijuana to taxpayer’s members is trafficking in a controlled substance, and disallowed all deductions with respect to distributing the marijuana. however, the court also found that the taxpayer’s care-giving activities for terminally ill patients were a separate trade or business from its medical marijuana delivery. expenses allocable to the caregiving activity remained deductible as ordinary and necessary business expenses. the court allocated expenses between the two businesses on the basis of the number of employees and the portion of the taxpayer’s facilities devoted to each. • the commissioner conceded that § 280e did not operate to deny the cost of goods sold to the taxpayer. that concession was based on case law predating the enactment of the last sentence of § 263a(a)(2). see, e.g., franklin v. commissioner, t.c. memo. 1993-184 (1993). the last sentence of § 263a(a)(2) states: “any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.” this provision was intended to preclude taking into account as inventory costs items that could not be deducted as business expenses if they did not relate to 730 florida tax review [vol. 8:si inventory, e.g., fines and penalties, bribes, etc. a straightforward reading of § 280e and the last sentence of § 263a(a)(2), taken together, would deny any recovery of cost of goods sold for illegal drug dealers. the concession appears to have been erroneous. 8. proposed regulations outline rules for deducting entertainment use of business aircraft. reg-147171-05, deductions for entertainment use of business aircraft, 72 f.r. 33169 (6/15/07). the treasury has proposed new detailed regulations, prop. reg. § 1.274-9, regarding deductions for entertainment use of business aircraft. in sutherland lumber-southwest, inc. v. commissioner, 255 f.3d 495 (8th cir. 2001), the court allowed a deduction under the exception of § 274(e)(2) that exceeded the amount included in income by the employee for personal use of the company aircraft (the corporation was an s corporation so the deduction passed through to the employee/owner and more than offset the amount included in income). the american jobs creation act of 2004 enacted § 274(e)(2)(b), reversing the result in sutherland lumber-southwest to limit the deduction for expenses attributable to personal use to the amount included in income by the employee, but the provision only applies to personal use by officers, directors, and more-than-10 percent owners. the proposed regulations identify the persons subject to the limitations of § 274(e)(2)(b), including related parties under §§ 267(b) and 707(b), provide rules for the allocation of expenses between entertainment and other uses (including an option to allocate expenses on a flight-by-flight basis rather than using the occupied seat per mile basis or hour formula), rules for allocating expenses for travel that involves both business and entertainment (the entertainment portion is the excess of total expenses over the business portion), among other things. 9. revisiting what is insurance? this fund for clean-up costs is not a deductible insurance premium. rev. rul. 2007-47, 2007-30 i.r.b. 127 (7/23/07). a domestic corporation that engages in a business practice that is “inherently harmful to people and property” acquired an insurance policy for future clean-up costs. while the exact cost of the future clean-up was unknown, there was no uncertainty that the cost will be incurred. the corporation estimated that the present value of the future cost is $150x. the corporation acquired an insurance policy with a premium of $150x that would reimburse future clean-up costs up to $300x. the ruling concludes that the arrangement is not insurance because of the absence of any risk that the corporation will be required to incur the cleanup costs. the arrangement is described as a prefunding of the corporation’s future costs. the corporation is not allowed a deduction for the insurance premium. in addition, the insurance company is not allowed to account for 2008] recent developments in federal income taxation 731 the arrangement as an insurance contract, meaning that the premium is taken into income without any offset for discounted unpaid losses under § 832(b)(5). • note sears, roebuck & co. v. commissioner, 972 f.2d 858 (7th cir. 1992), in which judge easterbrook stated: what is “insurance” for tax purposes? the code lacks a definition. le gierse mentions the combination of risk shifting and risk distribution, but it is a blunder to treat a phrase in an opinion as if it were statutory language. zenith radio corp. v. united states, 437 u.s. 443, 460-62,, 98 s. ct. 2441, 2450-51 (1978), 57 l. ed. 2d 337. cf. united states v. consumer life insurance co., 430 u.s. 725, 740-41, 97 s. ct. 1440, 1448-49, 52 l. ed. 2d 4 (1977). the court was not writing a definition for all seasons and had no reason to, as the holding of le gierse is only that paying the “underwriter” more than it promises to return in the event of a casualty is not insurance by any standard. … corporations accordingly do not insure to protect their wealth and future income, as natural persons do, or to provide income replacement or a substitute for bequests to their heirs (which is why natural persons buy life insurance). investors can “insure” against large risks in one line of business more cheaply than do corporations, without the moral hazard and adverse selection and loading costs: they diversify their portfolios of stock. instead corporations insure to spread the costs of casualties over time. bad experience concentrated in a single year, which might cause bankruptcy (and its associated transactions costs), can be paid for over several years. see generally david mayers & clifford w. smith, jr., on the corporate demand for insurance, 55 j. bus. 281 (1982). much insurance sold to corporations is experience-rated. an insurer sets a price based on that firm’s recent and predicted losses, plus a loading and administrative charge. sometimes the policy is retrospectively rated, meaning that the final price is set after the casualties have occurred. retrospective policies have minimum and maximum premiums, so the buyer does not bear all of the risk, but the upper and lower bounds are set so that almost all of the time the insured firm pays the full costs of the losses it generates. both experience rating and 732 florida tax review [vol. 8:si retrospective rating attempt to charge the firm the full cost of its own risks over the long run, a run as short as one year with retrospective rating. the client buys some time-shifting (very little in the case of retrospective rating) and a good deal of administration. insurers are experts at evaluating losses, settling with (or litigating against) injured persons, and so on. a corporation thus buys loss-evaluation and lossadministration services, at which insurers have a comparative advantage, more than it buys loss distribution. if retrospectively rated policies, called “insurance” by both issuers and regulators, are insurance for tax purposes--and the commissioner’s lawyer conceded for purposes of this case that they are--then it is impossible to see how risk shifting can be a sine qua non of “insurance.” 10. professional gamblers can have net operating losses. tschetschot v. commissioner, t.c. memo. 2007-38 (2/20/07). a professional tournament poker player’s net gambling losses are limited by § 165(d). however, the irs conceded that deduction of non-wagering expenses was not limited by § 165(d). 11. blue cross/blue shield wins again on the fresh start basis of cancelled health insurance contracts. highmark, inc. v. united states, 78 fed. cl. 146 (8/22/07). following trigon ins. co. v. united states, 215 f. supp. 2d 687, 701, 706 (e.d. va. 2002) and capital blue cross v. commissioner, 122 t.c. 224, 237–38 (2004), rev’d on other grounds, 431 f.3d 117 (3d cir. 2005), the court of federal claims granted partial summary judgment in favor of the successor to blue cross/blue shield on refund claims of $21 million plus interest. when blue cross and blue shield were transformed into taxable entities by the tax reform act of 1986, congress included a provision that “for purposes of determining gain or loss, the adjusted basis of any assert held on” january 1, 1987, will be its fair market value. the taxpayer claims that assets include terminated and cancelled contracts in existence on that date. the court rejected the government’s assertion that “assets” did not include the insurance contracts issued by blue cross/blue shield, and that losses included only losses realized on a sale or exchange of assets, not termination of contracts. the court held that the plain language of the statute applies to allow the claimed losses. the court also rejected the government’s argument that the amended returns claiming the losses represented a change in accounting method. 12. the interest deduction for a bank with taxexempt interest income is limited. psb holdings, inc. v. commissioner, 2008] recent developments in federal income taxation 733 129 t.c. 131 (11/1/07). peoples bank and peoples investment company were wholly owned members of a consolidated group filing consolidated returns whose widely held parent company is psb holdings. the bank and the investment company held tax-exempt securities. some of the investment company’s tax-exempt securities were purchased by the bank and transferred to the investment company as contributions to capital. other taxexempt securities were purchased directly by investment company. only bank claimed deductions for interest expense. • section 265(a)(2) disallows deductions for interest on indebtedness incurred to purchase or carry tax-exempt obligations. in the case of a bank, § 265(b), adopting a fungibility approach, provides that interest subject to the § 265(a)(2) limitation is the portion of the amount of interest that bears the same ratio to total interest as “the taxpayer’s average adjusted bases ... of tax exempt obligations,” bears to the average adjusted bases of all of the taxpayer’s assets. while § 265(a)(2) under this formula disallows 100 percent of a bank’s interest attributable to tax-exempt obligations, § 291(e), enacted prior to § 265(b), disallows 20 percent of a bank’s interest attributable to tax-exempt obligations, determined under the same formula as § 265(b)(2). see § 291(e)(1)(b)(ii). section 291(e) applies to interest expense attributable to tax-exempt obligations acquired before august 8, 1986, the date § 265(b) was enacted. however, the 20 percent reduction of §291(e) (rather than the 100 percent reduction of § 265(a)(2)) continues to apply to tax-exempt obligations of small issuers. all of the taxpayer’s exemptobligations were qualified small issues. • the irs argued that for purposes of determining bank’s interest deduction under the allocation formulas of §§ 265(b)(2) and 291(e)(1)(b), the numerator of the allocation formula should include tax-exempt obligations held by investment company because bank included the basis of its investment company stock in the denominator. focusing on the “text” of the allocation formula, the tax court concluded that the numerator included only tax-exempt obligations held by the taxpayer, here, the bank alone. (bank itself included in the numerator tax-exempt obligations purchased by bank and transferred to investment company.) the tax court rejected the contrary holding of rev. rul. 90-44, 1990-1 c.b. 54, stating that a revenue ruling, while representing an interpretation based on experience and informed judgment, is not entitled to the same deference as regulations under chevron u.s.a., inc. v. natural res. def. council, inc., 467 u.s. 837 (1984). 13. the third circuit cans alcoa’s claim of right doctrine benefits. alcoa, inc. v. united states, 509 f.3d 173 (3d cir. 11/28/07). alcoa’s production of aluminum products produces substantial waste. under heightened environmental clean-up standards enacted in the comprehensive environmental response, compensation, and liability act 734 florida tax review [vol. 8:si of 1980 (cercla), and others, alcoa was forced to incur substantial environmental remediation expense to clean up several of its manufacturing sites. alcoa deducted these expenses in 1993 then filed a $12 million claim for refund in the district court. alcoa cleverly argued that its 1993 expenses should have been included in its cost of goods sold in manufacturing operations for the years 1940-1987. its reduced cost of goods sold for those years generated excess income, received under a claim of right, which it was forced to return in the form of the deductible environmental remediation expenses incurred in 1993. alcoa then claimed under § 1341 that, rather than taking the deduction in 1993 for the expense, that it was entitled to a return of the taxes paid in 1940-1987 on its increased gross income resulting from the under-inclusion of disposal costs in its cost of goods sold. the third circuit concluded that alcoa’s obligation to return gross income in the form of increased remediation expenses “did not arise from the same circumstances, terms, and conditions as the initial failure to spend additional funds on environmental clean-up. rather, the obligations were created by new circumstances, terms, and conditions, namely, by an intervening change in environmental legislation.” thus, there is no nexus between the income asserted to have been received under a claim of right, and the expenditure claimed as a refund of that income. the court ultimately concluded that the § 1341 benefits are not available “because alcoa’s expenditure of funds in 1993 was not the restoration of particular moneys to the rightful owner and did not arise from the same circumstances, terms, and conditions as alcoa’s original acquisition of the income.” 14. a sole proprietor can create deductible medical plans by hiring a spouse. frahm v. commissioner, t.c. memo. 2007-351 (11/27/07). a taxpayer farmer (who reported farming income on schedule f) claimed deductions under § 162(a) (ordinary and necessary business expense) for health insurance premiums on plans for his sole employee, his spouse. the employee health plans and medical reimbursement plans included coverage for the employee’s spouse, the sole-proprietor. for the years at issue, deductions under § 162(l) for health insurance premiums paid by a sole-proprietor were limited. the tax court held that all premiums paid by the taxpayer for the employee health benefit plans that covered the employee’s spouse were deductible. a. but you have to follow proper form to create the employee benefit. eyler v. commissioner, t.c. memo. 2007350 (11/27/07). the taxpayer operated a tiling business that had one fulltime employee, the taxpayer’s spouse. judge cheichi rejected the taxpayer’s claim that the taxpayer’s health insurance policy under which the taxpayer 2008] recent developments in federal income taxation 735 was the primary beneficiary was part of an unwritten benefit’s plan established for the taxpayer’s sole employee. the court noted the lack of any credible evidence that the health insurance premiums paid directly by the taxpayer were a contribution to a health benefit plan for the taxpayer’s employee. the taxpayer was allowed by the irs to deduct the insurance premiums under § 162(l) up to the applicable percentage allowed for 2003, which was 60 percent. b. the irs disagrees with its web site and affirms deductibility of medical plan premiums for an s corporation shareholder. notice 2008-1, 2008-2 i.r.b. 251 (1/14/08). contrary to advice posted in the irs web site last year, the irs has indicated that a two percent shareholder-employee of a subchapter s corporation is entitled to deduct under § 162(l) accident and health insurance premiums paid or reimbursed by the s corporation. this is an above-the-line deduction. following rev. rul. 91-26, 1991-1 c.b. 184, an s corporation is treated as maintaining a medical care coverage plan if the corporation makes premium payments on behalf of a two percent shareholder-employee (and the employee’s spouse and dependents), or the two percent shareholderemployee pays the premiums and on furnishing proof of payment is reimbursed by the s corporation. the notice adds that in order for the employee to deduct the premiums under § 162(l), the s corporation must report premiums paid as wages to the employee on a form w-2 for the year of payment, and the employee must report the premiums as gross income. e. depreciation & amortization 1. the tax relief and health care act of 2006 § 113 extended the § 168(e)(3)(e) 15-year depreciation periods for leasehold improvements and for restaurant improvements to 2006 and 2007. 2. using the tax code for subsidies where direct action has failed: first-year depreciation recovery for specified gulf opportunity zone extension property. notice 2007-36, 2007-17 i.r.b. 1000 (4/23/07). this notice provides guidance with respect to the 50 percent original first year deprecation deduction provided under § 1400n(d). a 50 percent first year depreciation allowance is provided for property placed in service in the so-called go zone. the tax relief and health care act of 2006 § 120, adding code § 1400n(d)(6), extends the place in service date for go zone extension property to 12/31/10. go zone extension property is property the substantial use of which is on one or more portions of the go zone (listed in the notice) and which is either nonresidential real property or residential rental property, or personal property that is used in such real 736 florida tax review [vol. 8:si property and is installed within 90 days of the date the building is placed in service. otherwise, property eligible for the 50 percent first year depreciation must have been placed in service by 12/31/07, or 12/31/08 for qualified nonresidential real property and residential rental property. the notice also explains the requirement that original use of the property must commence with the taxpayer. 3. wine grape trellises don’t make good fences, but they are in the same class. trentadue v. commissioner, 128 t.c. 91 (4/3/07). the tax court held that wine grape trellises (in one of our favorite wine areas) are ten year class life property under rev. proc 87-56, 1987-2 c.b. 674, as agricultural equipment in class 01.1, which includes machinery and equipment, grain bins, and fences, but no other land improvements. the court analogized the trellises to fences “with the major difference being that one is intended to keep things in or out and the other to support grape growing equipment or train grapevines.” the taxpayer’s irrigation system and wells, however, were found to constitute land improvements with a 20 year class life in class 00.3. the court noted that components of the taxpayers’ drip irrigation system are buried in the ground and that a substantial portion of it will remain buried until the vines are removed. applying the six factor test from whitco industries, inc. v. commissioner, 65 t.c. 664 (1975), the court focused to some degree on the fact that the trellises, but not the irrigation pipes (and especially not the well), were movable and in fact were moved on occasion. 4. rotable spare parts are depreciable property. rev. proc. 2007-48, 2007-29 i.r.b. 110 (7/16/07). after losing the issue in the courts and announcing in rev. rul. 2003-37, 2003-1 c.b. 717, that rotable spare parts maintained by a manufacturer for the purpose of repairing customers’ equipment (mostly computers) are depreciable assets rather than inventory, the irs has announced a safe-harbor method of accounting with automatic consent to treat rotable spare parts as depreciable. the revenue procedure applies to a taxpayer that repairs customer-owned equipment under warranty or maintenance agreements for no charge or for a maintenance fee and which has a depreciable interest in a pool of spare parts that are exchanged for defective parts in the customers’ equipment. the taxpayer is required to capitalize the cost of the parts and depreciate the assets in the asset class specified in the revenue procedure. the safe-harbor is available only if the taxpayer’s gross sales of rotable spare parts do not exceed 10 percent of the taxpayer’s gross revenues from its maintenance operations. 2008] recent developments in federal income taxation 737 f. credits 1. the tax relief and health care act of 2006 § 104 extended the § 41 research credit through 2007 and creates an additional alternative simplified credit for 2007. a. more time to make research credit elections for 2006 years. the tax relief and health care act of 2006 § 123 extends the time for making research credit elections for taxable years ending after 2005 to the later of 4/15/07 or such time as specified by the treasury. a similar rule shall apply to other elections under expired provisions. 2. the 2007 act, § 8211(a) extends the § 51 work opportunity credit to wages paid before august 31, 2011. • “high risk youths”1 are redesignated as “designated community residents.” youths include otherwise qualifying individuals between ages 18 and 40 on the hiring date. the credit is extended to employment of individuals with a work plan under the social security act “ticket to work plan,” and qualified veterans who are certified as meeting the local food stamp requirement. 3. this telephone booth does not shelter income. sita v. commissioner, t.c. memo. 2007-363 (12/10/07). this is another alpha telcom telephone equipment investment shelter where the taxpayer claimed depreciation deductions and disabled access credits under § 44 on the purchase of seven pay phones for $5,000 each. see arevalo v. commissioner, 469 f.3d 436 (5th cir. 2006). the taxpayer was provided with legal title to pay phones under an equipment purchase agreement that described telephone equipment but did not identify the pay phones subject to the purchase or their locations. the agreement included a service agreement under which alpha telcom selected the pay phone locations, installed and serviced the phones, and collected the revenue. alpha telcom filed for bankruptcy in the year the taxpayer’s purchased the phone equipment and was the subject of a civil action by the sec for selling unregistered securities. judge haines denied the taxpayer’s claim for disabled access credits because the taxpayers failed to demonstrate that they maintained an eligible small business that operated a place of public accommodation or were a common carrier of voice transmission services. the court also denied depreciation deductions because the taxpayers did not obtain the benefits and burdens of ownership with respect to the pay phones. 1. pronounced “utes” by people from new york city. 738 florida tax review [vol. 8:si g. natural resources deductions & credits 1. energy efficient commercial buildings; “greening-up” an existing building. section 179d, added to the code by the energy tax incentives act of 2005, provides a deduction for the cost of “energy efficient commercial building property” placed in service during 2006 or 2007. qualified property must be installed in a building within the united states as part of: (1) the interior lighting systems; (2) the heating, cooling, ventilation, and hot water systems; or (3) the building envelope, and must be certified as being installed pursuant to a plan designed to reduce the building’s total annual energy and power costs by at least 50 percent in comparison to a hypothetical reference building. the deduction may not exceed $1.80 per square foot of the property. the statute directs the treasury department, in consultation with the department of energy, to promulgate regulations setting forth methods of calculating and verifying energy and power costs. in the case of an expenditure made by a public entity (such as a public school), the statute directs the treasury department to promulgate regulations allocating the deduction to the designer of the property in lieu of the owner. • if a building does not satisfy the overall 50 percent reduction standard, a partial deduction (limited to $0.60 per square foot) is allowed for system-specific energy efficient property, if a specific system (i.e., (1) interior lighting, (2) heating, cooling, ventilation and hot water, or (3) building envelope) satisfies system-specific targets to be established by regulation (with the statute providing an interim target, in the case of lighting system retrofits). a. the tax relief and health care act of 2006 § 204 extends the § 179d deduction for energy efficient commercial buildings to 2008. 2. energy efficient home credit. section 45l, added to the code by the energy tax incentives act of 2005, provides a credit, in the amount of either $2,000 or $1,000, to an eligible contractor (including the producer of a manufactured home) who constructs and sells an energy efficient home to a person who will use the home as a residence. to qualify for the $2,000 credit, the home must be certified (in accordance with guidance to be prescribed by the treasury department) as having a level of annual heating and cooling energy consumption at least 50 percent below the level of a comparable hypothetical reference dwelling unit, with at least onefifth of the energy savings attributable to the building envelope. the $1,000 credit, which applies only to manufactured homes, requires at least a 30 2008] recent developments in federal income taxation 739 percent reduction in energy consumption, of which at least one-third must be attributable to the building envelope. manufactured homes are also eligible for the $2,000 credit if they satisfy the usual requirements for that credit. the credit is available only with respect to homes, the construction of which is substantially completed after 2005, and which are purchased during 2006 or 2007. the credit is part of the general business credit. • the credit is effective for homes substantially completed after 8/08/05 and sold after 12/31/05 but before 1/01/08. a. procedures for getting the home certified. notice 2006-27, 2006-11 i.r.b. 626 (2/21/06), updated by announcement 2006-88, 2006-46 i.r.b. 910 (10/30/06). the irs has published procedures that an eligible contractor may follow to certify that a dwelling unit, other than a manufactured home, is an energy efficient home that satisfies the requirements of § 45l(c)(1). certification must be performed by resnet or an equivalent energy rating network. resnet’s website is located at http://www.natresnet.org. b. notice 2006-28, 2006-11 i.r.b. 628. this notice contains procedures that an eligible contractor may follow to certify that a dwelling unit that is a manufactured home satisfies the requirements of §§ 45l(c)(2) and (3). c. the tax relief and health care act of 2006 § 205 extends the code § 45l credit for new energy efficient homes through 2008. 3. credit for residential energy efficient property, e.g., solar panels. section 25d, added to the code by the energy tax incentives act of 2005, provides a nonrefundable credit for certain expenditures on residential energy efficient property. qualifying property is of three types: photovoltaic property (which uses solar energy to generate electricity), solar water heating property, and fuel cell property (which converts a fuel into electricity using electrochemical means). the property must be installed in a dwelling unit located in the united states and used by the taxpayer as a residence (principal residence, in the case of fuel cell property). expenditures allocable to a swimming pool or hot tub are not eligible for the credit. the credit equals 30 percent of qualifying expenditures, subject to annual ceilings (on the credit amounts, not on credit-eligible expenditures) of $2,000 for photovoltaic property, $2,000 for solar water heating property, and $500 per half-kilowatt of capacity of fuel 740 florida tax review [vol. 8:si cell property. the credit originally was available only for property placed in service in 2006 or 2007. a. the tax relief and health care act of 2006 § 206 extends the code § 25d credit for residential energy efficient property placed in service in 2008. 4. credit for biodiesel and renewable diesel used as fuel. section 40a, added to the code by the american jobs creation act of 2004, and amended by the energy tax incentives act of 2005, provides a nonrefundable credit of 50 cents per gallon of biodiesel mixed with regular diesel in the production of a qualified biodiesel mixture, 50 cents per gallon of straight biodiesel used in the taxpayer’s trade or business or sold at retail, a $1 per gallon credit for agri-biodiesel, and a $1 per gallon credit for renewable diesel, which is diesel fuel derived from biomass using a thermal depolymerization process. a. renewable diesel defined. notice 2007-37, 2007-17 i.r.b. 1002 (4/23/07). this revenue ruling clarifies that depolymerization is defined broadly to include processes that use heat and pressure with or without the presence of catalysts, and otherwise defines renewable diesel. 5. the tax relief and health care act of 2006 § 118 extends the code § 613a(c)(6)(h) temporary suspension of the 100 percent of taxable income limit on percentage depletion for oil and natural gas produced from marginal properties to taxable years beginning in 2006 and 2007. 6. guidance issued for the § 30c alternative fuel vehicle refueling property credit. notice 2007-43, 2007-22 i.r.b. 1318 (5/29/07). pending issuance of regulations, this notice provides definitions of qualified alternative fuel vehicle (qafv) refueling property, dual use property, alternative fuel, qualifying biodiesel mixture, and rules for computing the credit. the credit is 30 percent of the cost of depreciable property placed in service as a qafv refueling property, up to $30,000 per property, or $1,000 for other property. proposed technical corrections would limit the credit to a single $30,000 or $1,000 amount. 7. notice 2007-64, 2007-34 i.r.b. 385 (8/20/07). the § 43 enhanced oil recovery credit for taxable years beginning in the 2007 calendar year is phased out completely, because the reference price for the 2006 calendar year ($59.68) exceeds $28 multiplied by the inflation adjustment factor for the 2006 calendar year ($39.82) by $19.86. 2008] recent developments in federal income taxation 741 8. notice 2007-65, 2007-34 i.r.b. 386, (8/20/07). the applicable percentage under § 613a to be used in determining percentage depletion for marginal oil and gas properties for the 2007 calendar year is 15 percent. h. loss transactions, bad debts, and nols 1. heads the government wins, tails the taxpayer loses. bilthouse v. united states, 100 a.f.t.r.2d 2007-6191 (n.d. ill. 9/28/07). the taxpayer was a shareholder in an s corporation engaged in the construction of public works that sustained substantial losses. in 1995 the corporation was insolvent and, as found by the court, the corporation had zero liquidation value. also in 1995, the corporation was unable to obtain construction bonds required for public works projects. the taxpayer had substantial passive activity losses from the s corporation. the taxpayer asserted that cancellation of indebtedness income realized by the insolvent s corporation in 1997 increased the taxpayer’s stock basis and that the stock became worthless in 1997, thereby allowing the taxpayer to treat the worthlessness as a disposition, permitting deduction of the passive activity losses. without addressing whether the corporation had cancellation of indebtedness income in 1997, the court concluded that the taxpayer failed to meet his burden of proving that the stock was not worthless in 1995, when the corporation became insolvent, had zero liquidation value, and could no longer perform work, rather than in 1997 when a lawsuit against the city of jacksonville was terminated without recovery. the court noted that the mere hope of a recovery from the lawsuit did not preclude a finding of worthlessness in the earlier year. i. at-risk and passive activity losses 1. the ninth circuit upholds self-rental regulations to the taxpayer’s disadvantage: following decisions in the first, fifth, and seventh circuits, the ninth circuit rejected the taxpayers’ arguments that the regulation is arbitrary and capricious in its application to c corporations. beecher v. commissioner, 481 f.3d 717 (9th cir. 3/23/07). the taxpayers worked full time for two wholly owned c corporations that rented office space from the taxpayers. the taxpayers also owned other rental properties. they reported net income from the leases of the office space to their corporations and losses from the other rental properties that exceed the net income from the office rental. the taxpayers treated all of the rental activities as passive under § 469 and offset their rental income from the offices with the losses. the irs determined that the income from the office leases was non-passive income under the “self742 florida tax review [vol. 8:si rental” rule in reg. § 1.469-2(f)(6) (applying to rentals to an activity in which the taxpayer materially participates). applying the chevron (chevron u.s.a., inc. v. natural resources defense council, inc., 467 u.s. 837 (1984)) standard, requiring that because “there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation,” the court must afford the commissioner’s interpretation “controlling weight unless . . . [it is] arbitrary, capricious, or manifestly contrary to the statute,” the court of appeals upheld the validity of the regulation. furthermore the court rejected the taxpayer’s argument that congress’s delegation of authority to issue the self-rental rule under § 469(l) was unconstitutional, following krukowski v. commissioner, 279 f.3d 547, 552 (7th cir. 2002), which held the same. finally, the court rejected the taxpayers’ argument that the self-rental rule applies only to “abusive tax shelters” and does not apply to bona fide business transactions. “the relevant statutory distinction under section 469 is not between taxpayers who contrive to limit their tax liability and those who do not. …rather, the distinction between passive and non-passive activities is that in the case of passive activities, the ‘taxpayer does not materially participate’ in the business. ... this question hinges on the extent to which the taxpayer is involved in the affairs of both sides of a given transaction, not the taxpayer’s motivation for structuring the transaction in a particular manner.” 2. due process does not protect this tax attorney’s real estate investments from the passive activity loss rules. ziegler v. commissioner, t.c. memo. 2007-166 (6/27/07). the tax court rejected stephen ziegler’s argument that application of the passive activity loss rules to investment real estate purchased in 1984, two years before the effective date of § 469, was a retroactive application of the law constituting a taking under the due process clause of the fifth amendment. the court observed that tax legislation is not a promise and that the taxpayer has no vested right in the internal revenue code. 3. seeing through entity boundaries, an equipment leasing llc is treated as part of the same economic unit as a radiological services limited partnership. candelaria v. united states, 518 f. supp. 2d 852 (w.d. tex. 10/05/07). under reg. § 1.469-4(c)(2), activities that constitute an appropriate economic unit may be treated as a single activity under the facts and circumstances. reg. § 1.469-4(d) provides that a rental activity may not be grouped with a trade or business unless either the rental activity or the trade or business is insubstantial in relation to the other. the taxpayer was a principal in an llc formed to lease imaging equipment to a related limited partnership that provided radiological services. the ownership of the two entities was not identical, but the owners of the llc 2008] recent developments in federal income taxation 743 owned identical interests in the general partner of the limited partnership. the gross receipts of the leasing llc, which only leased equipment to the limited partnership, were between three and eleven percent (depending on the taxpayer’s or the irs’ position) of the combined gross receipts of the two entities. the district court granted summary judgment to the taxpayer holding that the two entities constituted a single economic unit under the regulation’s facts and circumstances test, and that the activities of the leasing llc were insubstantial next to the trade or business income of the limited partnership. the taxpayer was permitted to treat losses from the leasing company as active business losses. iii. investment gain a. capital gain and loss 1. consigning mcallister to the dustbin of history. prebola v. commissioner, 482 f.3d 610 (2d cir. 3/27/07) (per curiam). the taxpayer sold all of her rights to future lottery payments. the court followed watkins v. commissioner, 447 f.3d 1269 (10th cir. 2006), to hold that the sales proceeds were ordinary income under the “substitute-for-ordinaryincome” principle. this decision is significant because is was handed down by the second circuit, the court that decided mcallister v. commissioner, 157 f.2d 235 (2d cir. 1946), holding that a taxpayer could treat as a capital gain the lump-sum payment she received when she sold her entire rights to future payments from a life estate in a trust. the court stated: “we recognize that there are contexts in which the substitute-for-ordinary-income doctrine does not or should not apply. ... but whatever the doctrine’s outer limits, this case falls squarely within them ... .” the court further noted that mcallister was decided before the supreme court decided commissioner v. p. g. lake, inc., 356 u.s. 260 (1958), which held that capital gains treatment was not applicable where “[t]he substance of what was assigned was the right to receive future income” and the “substance of what was received was the present value of income which the recipient would otherwise obtain in the future.” 2. capital gain treatment for sales of self-created musical works. tipra § 204 added new § 1221(b)(3) to permit taxpayers to elect to treat the sale or exchange of self-created musical compositions or copyrights in musical works sold or exchanged after 12/31/06 and before 1/1/11 as the sale or exchange of a capital asset. this capital asset treatment is to be inapplicable for § 170(e) purposes, so the amount of the charitable deduction of such assets continues to be reduced by the amount of appreciation inherent in such assets. 744 florida tax review [vol. 8:si a. section 1221(b)(3) was made permanent by the tax relief and health care act of 2006 § 412. 3. proposed regulations would treat taxpayers who exchange property for an annuity as if they had sold the property. reg 141901-05, exchanges of property for an annuity, 71 f.r. 61441 (10/18/06). the treasury has published proposed regulations (prop. reg. §§ 1.72-6(e)(1), 1.1001-1(j)) that would provide a single set of rules for the taxation of an exchange of property for an annuity contract. essentially, the proposed rules would treat the transaction as if the property was sold for cash equal to the value of the annuity contract (as determined under § 7520) and the proceeds were used to buy an annuity contract; however, taxpayers may continue to structure transactions as § 453(b) installment sales. these proposed regulations would not change existing reg. § 1.1011-2 for charitable gift annuities, but would change prior law on exchanges of appreciated property for private annuities to the extent it permitted open transaction treatment or ratable recognition as the annuities were paid. the effective date is 10/18/06, with a delayed effective date of 4/18/07 for nonabusive transactions. • these proposed regulations would bring the current treatment of exchanges of appreciated property for private annuities into line with the tax treatment of exchanges for commercial annuities. before these regulations are applicable, the law generally postponed tax on the exchange based on the assumption that the value of a private annuity contract could not be determined for federal income tax purposes. • note that under rev. rul. 85-13, 1985-1 c.b. 184, a transfer of assets to a grantor trust is not a recognition event. 4. distributorship agreement is a capital asset if you’ve invested in it. rev. rul. 2007-37, 2007-24 i.r.b. 1390 (6/11/07). the cancellation of a distributor agreement between a manufacturer and a distributor is treated as a sale or exchange of property that results in capital gain (or § 1231 gain) if the distributor has made a substantial capital investment in the distributorship and the investment is reflected in physical assets. the ruling refers to automobile distributorships that receive payment from the manufacturer for cancellation of the agreement when the manufacturer decides to no longer produce the car. amounts received in cancellation of certain distributor agreements are treated as capital gain by § 1241, which provides deemed “sale or exchange” treatment for cancellation of a lease or distributorship, but does not itself provide capital asset status. gain from the disposition of a distributorship agreement that was subject to amortization under § 197 is treated as § 1231 gain. the ruling 2008] recent developments in federal income taxation 745 also concludes that gain attributable to amortization of the acquisition costs of a distributorship agreement under § 1253 (25 year amortization prior to the effective date of § 197) will also be treated as property subject to the depreciation allowance of § 167 thereby producing § 1231 gain. section 1231 gain on cancellation of the distributorship is subject to recapture under § 1245. 5. gain is recognized on an exchange even if the taxpayer didn’t yet have what she got and she might not have gotten to keep it. united states v. culp, 99 a.f.t.r.2d 2007-618 (m.d. tenn. 12/29/06). the government was granted summary judgment in an erroneous refund suit. the taxpayer exchanged her partnership interest in ernst & young for stock of a corporation acquiring e&y’s consulting business, in a transaction that was not a statutory nonrecognition event; however, the stock was held in escrow to enforce a forfeiture provision if the seller-taxpayer failed to perform certain services as an employee of the acquiring corporation. the court held that the open transaction doctrine was not applicable. if a taxpayer exchanges one property for a different property, the gain realized on the exchange must be recognized in the year the exchange occurs, even though the property received in the exchange is forfeitable if contractual provisions or representations in the contract for exchange are not subsequently satisfied, and even though the property received in the exchange is held in escrow to assure enforcement of the forfeitability provisions. 6. the ever-expanding deemed sale or exchange concept limits ordinary loss deductions. reg-101001-05, abandonment of stock and other securities, 72 f.r. 41468 (7/30/07). prop. reg. § 1.1655(i) would provide that a security that has been abandoned is treated as a wholly worthless security. to abandon a security, a taxpayer must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for it. thus, if the abandoned security (other than a security in an affiliated corporation subject to § 165(g)(3)) is a capital asset, the resulting loss is a capital loss incurred on the last day of the taxable year. all the facts and circumstances determine whether the transaction is properly characterized as an abandonment or other type of transaction, such as an actual sale or exchange, contribution to capital, dividend, or gift. these proposed regulations will be effective after the date of publication of final regulations. 7. the same brokerage account can’t be both a trader’s account and an investor’s account. arberg v. commissioner, t.c. memo. 2007-244 (8/27/07). the duty of consistency prevented the taxpayers 746 florida tax review [vol. 8:si from treating losses incurred on stock traded in a brokerage account as ordinary losses incurred by the husband as a securities trader when gains from the same account in a prior closed year had been reported as capital gains on the wife’s separate return in a prior year. b. interest 1. interest-free loans to continuing care facilities may be without limit through 2010. tipra § 209 added new § 7872(h), which removes the $100,000 dollar cap for excepting interest-free loans to continuing care facilities from the imputed interest rules for years through 2010. it also reduces the minimum age of qualifying lenders from 65 to 62. a. this provision was made permanent by the tax relief and health care act of 2006 § 425. c. section 121 1. more tax breaks for exiting home ownership. the mortgage forgiveness debt relief act of 2007 amended § 121 to extend the $500,000 ceiling for excludable gain on the sale of a principal residence to a sale by an unmarried surviving spouse, if the sale occurs not later than two years after the death of the deceased spouse, and the surviving spouse and the deceased spouse would have qualified for the $500,000 ceiling immediately before the death of the deceased spouse. for all taxpayers other than married couples filing joint returns and qualifying surviving spouses, the ceiling on excludable gain remains $250,000. d. section 1031 1. regulations explain depreciation for macrs property acquired in a §1031 exchange of macrs property, or acquired in replacement of involuntarily converted macrs property to which §1033 applies. a. temporary regulations. t.d. 9115, reg106590-00 and reg-138499-02, depreciation of macrs property that is acquired in a like-kind exchange or as a result of an involuntary conversion, 69 f.r. 9529 (3/1/04). the treasury published final, temporary, and proposed regulations dealing with depreciation of property acquired in a § 1031 like-kind exchange or as § 1033 replacement property and withdrew prop. reg. §§ 1.168(a)-1 and 1.168(b)-1 (which were in the july 2003 proposed regulations). under these temporary and proposed regulations, to the extent the taxpayer’s basis in the acquired macrs property does not 2008] recent developments in federal income taxation 747 exceed the taxpayer’s adjusted basis in the exchanged or involuntarily converted macrs property, the acquired property is depreciated over the remaining recovery period of, and using the same depreciation method and convention as that of, the exchanged or involuntarily converted property if the useful life of the replacement property is the same or shorter than the relinquished property. any additional basis in the acquired property is treated as newly purchased macrs property. (this is the same method as provided for acrs property in prop. reg. § 1.168-5(f) (1984).) if the replacement property has a longer useful life, depreciation is computed as if the replacement property had originally been placed in service when the relinquished property was placed in service by the acquiring taxpayer. any excess basis is treated as property placed in service in the year the acquiring taxpayer places it in service. there are specific rules for deferred exchanges and reverse exchanges, as well as for automobiles. as announced in notice 2000-4, 2000-3 i.r.b. 313, these rules are effective for acquired macrs property placed in service on or after january 3, 2000, in a like-kind exchange of macrs property under § 1031, or as a result of an involuntary conversion of macrs property under § 1033. for property acquired before january 3, 2000, taxpayers who treated the entire basis as new macrs property may continue to do so, or may change accounting methods to conform. b. final regulations. t.d. 9314, depreciation of macrs property that is acquired in a like-kind exchange or as a result of an involuntary conversion, 72 f.r. 9245 (3/1/07). the proposed regulations have been adopted, with the addition of some clarifying language and examples provided in response to comments. the rules for macrs property exchanged in §§ 1031 and 1033 transactions are in reg. § 1.168(i)6. 2. have you heard about how you can do § 1031 like-kind exchanges of vacation homes? don’t drink that kool-aid!2 moore v. commissioner, t.c. memo. 2007-134 (5/30/07). the taxpayer exchanged land with a mobile home, which the taxpayer used as a vacation residence, for another vacation property, and claimed the transaction qualified for nonrecognition under § 1031 because both vacation properties were acquired and held with the expectation that they would appreciate and thus were “investment” property. the court (judge halpern) held that the exchange did not qualify. the mere expectation that property will appreciate does not establish investment intent if the taxpayer uses the property as a 2. more correctly, grape flavor-aid. 748 florida tax review [vol. 8:si residence. there was no evidence that taxpayer made either property available for rent or held either property primarily for sale at a profit. a. and renting it out for a few weeks just before the exchange does not work. the irs provides a safe-harbor for vacation home swappers. rev. proc. 2008-16, 2008-10 i.r.b. 547 (3/10/08). this revenue procedure provides safe-harbor guidance regarding whether a residential property that the taxpayer held or intends to hold for mixed uses, e.g., personal vacation use and rental/investment purposes qualifies as property held for productive use in a trade or business or for investment under § 1031. under the revenue procedure, the relinquished property qualifies if: (1) the property was owned by the taxpayer for at least 24 months immediately before the exchange, and (2) within that period, in each of the two 12-month periods immediately preceding the exchange, (a) the taxpayer rented the property to another person or persons at a fair rental for 14 days or more, and (b) the taxpayer’s personal use of the property did not exceed the greater of 14 days or 10 percent of the number of days during each 12-month period that the dwelling unit was rented at a fair rental. (for this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day)). the replacement property qualifies if (1) the property is owned by the taxpayer for at least 24 months immediately after the exchange, and within that period, in each of the two 12-month periods immediately after the exchange (a) the taxpayer rents the property to another person or persons at a fair rental for 14 days or more, and (b) the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10 percent of the number of days during each 12-month period that the property is rented at a fair rental. (for this purpose, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.) personal use of a dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes under § 280a(d)(2) (taking into account § 280a(d)(3) but not § 280a(d)(4)). e. section 1033 there were no significant developments regarding this topic during 2007. 2008] recent developments in federal income taxation 749 f. section 1035 1. a check in hand leaves the § 1035 tax-free exchange of annuities behind the bush. rev. rul. 2007-24, 2007-21 i.r.b. 1282 (5/21/07). section 1035 provides for nonrecognition of gain or loss on the exchange of an annuity contract for another annuity contract. applying a rule similar to the rule of § 1031 barring the receipt and control of cash in a like-kind exchange, the irs has ruled that the taxpayer’s receipt of a check from an insurance company issuing one annuity, which the taxpayer endorsed over to another insurance company for a replacement annuity, is not entitled to nonrecognition under § 1035. the transaction was not an exchange of the annuity contracts. the taxpayer was required to recognize gross income under § 72. the ruling seems to contradict the holding in greene v. commissioner, 85 t.c. 1024 (1985), which allowed nonrecognition treatment under § 1035 where, without a binding obligation, the taxpayer received a check from one annuity contract that she endorsed in the purchase of a new annuity contract. the annuities in rev. rul. 2007-24 were not in qualified plans. in greene the funds were moved between qualifying § 403(b) plans, but the rollover rules of § 403(b)(8) were not applicable in greene. iv. compensation issues a. fringe benefits 1. guidance on health savings accounts. notice 2004-2, 2004-1 c.b. 269 (1/12/04). the irs has issued guidance in q&a form on health savings accounts under new § 223 (added by § 1201 of the medicare prescription drug, improvement, and modernization act of 2003). this guidance provides basic information about hsas. this new provision offers health spending accounts without the “use it or lose it” requirement of health fsas. a. the tax relief and health care act of 2006 § 302 adds new code § 106(e) to permit one-time transfers to health savings accounts from health flexible spending arrangements and health reimbursement arrangements. b. the tax relief and health care act of 2006 § 303 amends code § 223(b)(2) to repeal the annual deductible limitation on hsa contributions and allow monthly contributions of $2,250 for individuals and $4,500 per family, adjusted for inflation, $2,700 ($5,454 family) even if the deductible is less that those amounts. for 2007, the 750 florida tax review [vol. 8:si inflation adjusted amount was $2,850 for individuals and $5,650 per family. rev. proc. 2006-53, 2006-48 i.r.b. 996, § 3.24. c. the tax relief and health care act of 2006 § 306 adds new code § 4980g(d) to provide for an exception to the current requirement that employer contributions to hsas be “comparable” for all employees by allowing employers to provide additional contributions to lower-paid workers. d. the tax relief and health care act of 2006 § 307 adds new code § 408(d)(9) to permit one-time distributions from iras to fund hsas. this would allow those who cannot afford to fully fund an hsa with direct contributions to move ira money to a more taxadvantaged position. 2. rev. rul. 2007-17, 2007-13 i.r.b. 805 (3/26/07). this ruling updates mileage rates for employer-provided non-commercial aircraft for the first half of 2007. 3. t.d. 9349, section 125 – cafeteria plans, 72 f.r. 41891 (8/1/07). the irs has removed temporary regulations on benefits that may be offered under a § 125 cafeteria plan because these temporary regulations – published more than two decades ago – have been rendered obsolete by subsequent proposed regulations and other § 125 guidance. a. reg-142695-05, employee benefits – cafeteria plans, 72 f.r. 43937 (8/6/07). new cafeteria plan regulations under § 125 are proposed, including: general rules on qualified and nonqualified benefits in cafeteria plans (new prop. reg. § 1.125-1); general rules on elections (new prop. reg. § 1.125-2); general rules on flexible spending arrangements (new prop. reg. § 1.125-5); general rules on substantiation of expenses for qualified benefits (new prop. reg. § 1.125-6); and nondiscrimination rules (new prop. reg. § 1.125-7). the new proposed regulations, prop. reg. §§ 1.125-1, 1.125-2, 1.125-5, 1.125-6 and § 1.125-7, consolidate and restate prop. reg. § 1.125-1 (1984, 1997, 2000), § 1.125-2 (1989, 1997, 2000) and § 1.125-2t (1986). b. qualified deferred compensation plans 1. beginning in 2008, 401(k) plans may contain an automatic contribution feature. pension protection act § 902 adds new code § 401(k)(13) to permit qualified automatic enrollment in 401(k) plans, under which an employee is enrolled to make elective contributions unless 2008] recent developments in federal income taxation 751 he or she affirmatively elects otherwise. this provision is effective for plan years beginning after 12/31/07. • note that employer matching costs should be expected to increase because participation can be expected to increase. a. polly want a qaca? reg-133300-07, automatic contribution arrangements, 72 f.r. 63144 (11/8/07). proposed regulations relating to automatic contribution arrangements. these proposed regulations would amend reg. § 1.401(k)-3 to provide a new design-based safe-harbor for a qualified automatic contribution arrangements (“qaca”) under § 401(k)(13). 2. congress – in reaction to enron – requires that 401(k) participants get what peter lynch calls “di-worse-ification” rights with respect to employer securities. pension protection act § 901 adds new code § 401(a)(35) to provide diversification rights with respect to publicly traded employer securities held by a defined contribution plan. this paragraph is effective with respect to plan years beginning after 12/31/06. a. notice 2006-107, 2006-51 i.r.b. 1114 (12/18/06). this notice provides transitional guidance regarding § 401(a)(35), together with a model notice, to plan participants concerning employer securities. 3. district court finds that ibm cash balance plan violates erisa – but case is reversed after congress passes the pension protection act of 2006. cooper v. ibm personal pension plan, 274 f. supp. 2d 1010 (s.d. ill. 7/31/03). the court held that the plan violated erisa §§ 204(b)(1)(g) (reduction of accrued benefit solely on increases in age or service) and 204(b)(1)(h) (rate of benefit accrual decreases once a certain age is attained). a. seventh circuit reverses ibm case, but only after congress acts to legalize cash balance plans. cooper v. ibm personal pension plan, 457 f.3d 636 (7th cir. 8/7/06), rehearing denied, 2006 u.s. app. lexis 23227 (7th cir. 9/1/06), cert. denied, 127 s. ct. 1143 (1/16/07), rev’g 274 f. supp. 2d 1010 (s.d. ill. 7/31/03). the seventh circuit (judge easterbrook) analyzed the situation by comparing erisa § 204(b)(1)(h) (the anti-age discrimination provision applicable to defined benefit plans) with erisa § 204(b)(2)(a) (the anti-age discrimination provision applicable to defined contribution plans). judge easterbrook made the point that “benefit accrual” in § 204(b)(1)(h) does not have the same 752 florida tax review [vol. 8:si meaning as “accrued benefit,” which is defined in erisa § 3(23)(a) as an amount “expressed in the form of an annual benefit commencing at normal retirement age.” • judge easterbrook ascribed to the district court a conclusion that cash balance plans discriminate on account of age based on an example comparing the benefit received by a 30-year-old who leaves ibm at age 50 with the benefit received by a 45-year-old who retires at age 65, and stated that the district court based its conclusion of discrimination on the fact that the difference in accrued benefit at age 65 – attributable to 15 additional years of compound interest – is not counterbalanced by the fact that older workers generally draw higher salaries. he rejected this interpretation of the statute that “treats the time value of money as age discrimination.” • judge easterbrook reinforced this conclusion by noting it is identical to the view of the treasury department expressed in the december 2002 proposed regulations which concluded that the proper question to ask is, “if this employee were younger, would the hypothetical balance have grown more this year?” b. the world is now safe for cash balance plans. pension protection act § 701 amends erisa §§ 203, 204 and 205, code §§ 411 and 417, and adea § 4(i)(2) to provide that cash balance plans do not per se violate the prohibition on age discrimination. c. or is it? in re citigroup pension plan erisa litigation, 470 f. supp. 2d 323 (s.d. n.y. 12/12/06). the court (judge scheindlin) disagreed with the seventh circuit’s cooper decision and found that cash balance plans violate the prohibition on age discrimination. d. it is! register v. pnc financial services group, inc., 477 f.3d 56 (3d cir. 1/30/07). the third circuit followed cooper, and noted that only a few district courts in the second circuit have held otherwise. e. and, further, it is! wheeler v. pension value plan for employees of the boeing co., 99 a.f.t.r.2d 2007-1557 (s.d. ill. 3/13/07). this decision followed cooper with respect to mcdonnell douglas employees moved to the boeing cash balance plan. also, rejects the employees’ assertion that the plan is backloaded because swings in interest rates on 30 year treasury securities are “likely” to cause interest credits allocated to plan participants’ cash balance accounts at a rate more than one-third higher (under the 133-1/3% test) than the rate of accrual of the benefits in early years. the court pointed to reg. § 1.411(b) 2008] recent developments in federal income taxation 753 1(b)(2)(ii)(d) that provides that relevant factors used to compute plan benefits are treated as remaining constant. f. the irs opens the door for cash balance plans. notice 2007-6, 2007-3 i.r.b. 272 (1/16/07). the irs announced that it is beginning to process a determination letter and examine cases in which an application for a determination letter or a plan under examination involves an amendment to change a traditional defined benefit plan into a cash balance plan. this notice also provides transitional guidance on the requirements of code §§ 411(a)(13) and 411(b)(5), which were added by § 701(b) of the pension protection act. 4. t.d. 9319, limitations on benefits and contributions under qualified plans, 72 f.r. 16878 (4/5/07). the treasury has updated regulations last issued in 1981 addressing contribution and benefits limits with respect to qualified plans under § 415. among other things, the final regulations incorporate statutory changes to the § 415 limitations subsequent to 1981, including the 2001 act (egtrra). 5. final regulations are issued regarding distributions from roth accounts in 401(k) and 403(b) qualified plans. t.d. 9324, designated roth accounts under section 402a, 72 f.r. 21103 (4/30/07). these final regulations provide guidance on the taxation of distributions of amounts designated in § 401(k) plans and § 403(b) plans as roth type contributions, requiring separate accounting. exclusion from income or permissible rollover to a roth type ira depends on whether the distribution is a qualified distribution determined under the regulations. 6. t.d. 9340, revised regulations concerning section 403(b) tax-sheltered annuity contracts, 72 f.r. 41128 (7/26/07). the irs has published final regulations providing a comprehensive revision of the current regulations on § 403(b) tax-sheltered annuity contracts of public schools and § 501(c)(3) tax-exempt organizations. these regulations generally apply for taxable years beginning after 12/31/08. 7. notice 2007-94, 2007-51 i.r.b. 1179 (12/17/07). this notice publishes the 2007 cumulative list of changes in plan qualification requirements. c. nonqualified deferred compensation, section 83, and stock options 1. section 409a added a new layer of rules for nonqualified deferred compensation. section 885 of the jobs act of 2004 754 florida tax review [vol. 8:si added new § 409a, which modifies the taxation of nonqualified deferred compensation plans for amounts deferred after 2004. section 409a has changed the tax law governing nonqualified deferred compensation by making it more difficult to successfully avoid current inclusion in gross income of unfunded deferred compensation. nevertheless, § 409a has not completely supplanted prior law. the fundamental principles of prior law continue in force but have been modified in certain respects. a. section 409a guidance provides transition rules and excludes stock appreciation rights from the purview of that section. notice 2005-1, 2005-1 c.b. 274 (1/10/05), modified by notice 2006-100, 2006-51 i.r.b. 1109 (12/18/06). these notices provide guidance in q&a form with respect to the application of § 409a. b. proposed regulations incorporate much of the guidance in notice 2005-1. reg-158080-04, application of section 409a to nonqualified deferred compensation plans, 70 f.r. 57930 (10/4/05). these proposed regulations incorporate much of the guidance provided in notice 2005-1, as well as “substantial additional guidance.” they identify the plans and arrangements covered by § 409a and describe the requirements for deferral elections and the permissible timing for deferred compensation payments. they also extend the deadline for “documentary compliance” to 12/31/06, but 1/1/05 remains as the effective date for statutory compliance (although there are transition rules applicable for 2005). c. interim guidance on withholding and reporting requirements for 2005 and 2006. notice 2006-100, 2006-51 i.r.b. 1109 (12/18/06). this notice provides interim guidance to employers on their wage withholding requirements for calendar years 2005 and 2006 with respect to compensation and amounts includible in gross income under § 409a, as well as guidance to service providers on their income tax reporting and payment requirements for amounts includible in gross income under § 409a for those years. d. final regulations. t.d. 9321, application of section 409a to nonqualified deferred compensation plans, 72 f.r. 19234 (4/17/07). final regulations have been adopted that generally follow the format and structure of the proposed regulations with a number of clarifications and additions in response to comments. e. transition relief extended for nqdc under § 409a. notice 2006-79, 2006-43 i.r.b. 763 (10/23/06). although the irs expects that the proposed regulations will become final by the end of 2008] recent developments in federal income taxation 755 2006, the proposed effective date of 1/1/07 for the final § 409a regulations is extended to 1/1/08. additional transition relief is provided through 12/31/07. f. and is sort-of extended for one more year through the end of 2008. notice 2007-78, 2007-41 i.r.b. 780 (10/9/07). this notice provides some 2008 transition relief and additional guidance on the application to § 409a to nonqualified deferred compensation plans. g. now, transition relief is really extended through the end of 2008. notice 2007-86, 2007-46 i.r.b. 990 (11/13/07), revoking and superseding notice 2007-78. this notice extends to 12/31/08 the transition relief that was scheduled to expire on 12/31/07, as provided in notice 2006-79. h. more guidance. notice 2007-89, 2007-46 i.r.b. 998 (11/13/07). this notice provides interim guidance to employers regarding reporting and wage withholding requirements for calendar year 2007 with respect to deferrals of compensation and amounts includible in gross income under § 409a. it also provides interim rules on calculating amounts includible in gross income under § 409a. notice 2005-1 was modified; notice 2006-100 was not affected by this notice. i. section 409a as applied to split-dollar life insurance contracts. notice 2007-34, 2007-17 i.r.b. 996 (4/23/07). this notice provides guidance regarding the application of § 409a to split-dollar life insurance contracts. split-dollar life insurance arrangements (other than arrangements that provide only death benefits to the service provider) are deferred compensation arrangements subject to § 409a. a split-dollar life insurance arrangement entered into before september 17, 2003, is not subject to § 409a unless the arrangement has been materially modified. this notice also provides guidance with respect to which modifications to comply with § 409a will not be treated as material modifications for purposes of the transition rule. • section 409a is not applicable to earnings on § 409a grandfathered benefits, which include any increase in the policy cash value attributable to continued services, compensation earned, or premium payments, or other contributions made on or after january 1, 2005. the portion of benefits attributable to grandfathered arrangements can be determined by any reasonable method, but the notice describes a proportional method as reasonable. • a split-dollar insurance plan provides deferred compensation for purposes of § 409a if the arrangement provides a 756 florida tax review [vol. 8:si service provider with economic benefits in the current year (access to policy cash value or any other economic benefit) payable to the service provider in a later taxable year. • split-dollar insurance arrangements that are treated as loans (the policy is owned by the service provider with premiums from a non-owner) generally will not give rise to deferred compensation subject to § 409a. 2. remember when “inappropriate dating” was just a reference to wayne hays and elizabeth ray, gary hart and donna rice, bill clinton and monica lewinsky, gary condit and chandra levy, rudy giuliani and cristyne lategano, newt gingrich and callista bisek, or barney frank and steve gobie? backdated stock options give rise to tax problems, but “innocent employees” may have their § 409a taxes paid by their employer. announcement 2007-18, 20079 i.r.b. 625 (2/26/07). this announcement institutes a compliance resolution program that permits employers to pay the additional § 409a taxes due to the exercise in 2006 of discounted stock options and stock appreciation rights for employees who are not corporate insiders. this is because the backdated stock options and stock appreciation rights were “in the money” when issued, and are, therefore, not excluded from § 409a by the regulations thereunder. of course, these employer payments will be additional wages in the year in which they are made. • this program offers only administrative convenience, and does not result in any benefit to the taxpayers involved. 3. did you know that § 409a will apply for the 2008-2009 school year to teachers who elect to receive their salaries over a 12-month period instead of being paid only during the nine-month school year? irs (or, should it be congress), give us a break! ir-2007142 (8/7/07). school districts that offer annualization elections to teachers may have to make some changes in their procedures in the future, but the irs announced that the new deferred compensation rules will not be applied to annualization elections for school years beginning before 1/1/08. • this results from an anti-enron provision in the 2004 act. 4. stock options are not exercised when the service recipient provides nonrecourse financing because such exercise is merely the continuation of the option, but they are exercised when a third-party lender provides financing on a nonrecourse basis. palahnuk v. united states, 475 f.3d 1380 (fed. cir. 2/12/07), aff’g 70 fed. cl. 87 (2/28/06). taxpayers exercised nonqualified stock options in 2000 using 2008] recent developments in federal income taxation 757 funds obtained through borrowing on a margin account with a third party lender (oppenheimer) with the loan secured by the purchased stock. they contended that the transfer took place in 2001 when they paid off the margin loan used to purchase the stock. the purchase of employer’s stock pursuant to a nonstatutory stock option using funds obtained through borrowing on a margin account with a third-party lender constituted a completed transfer for purposes of § 83; the arrangement was not in substance a continuing option under reg. §§ 1.83-3(a)(2) and 1.83-1(a)(7), ex. (2), because the benefits of ownership and risk of decline in value had been transferred to taxpayers. • the federal circuit (judge mayer) held that a transfer occurs when the employer corporation is paid for the stock, whether the transfer was funded with the buyer’s own cash or from a broker’s margin loan, and there was no evidence that taxpayer’s rights to the stock could have been revoked by the corporation. a. ninth circuit tells taxpayer, “that’s tough.” united states v. tuff, 469 f.3d 1249 (9th cir. 12/4/06), aff’g 359 f. supp. 2d 1129 (w.d. wash. 2/4/05). in this case, compensatory stock was transferred and vested for purposes of § 83 when the option was exercised with funds provided as margin debt by a third-party brokerage firm. these stock purchases do not qualify for the reg. § 1.83-3(a)(2) exception for treating a stock option exercised with a nonrecourse note as in substance the grant of an option. b. racine v. commissioner, 493 f.3d 777 (7th cir. 7/3/07). the seventh circuit reached the same result. there is some discrepancy between the court of appeals opinion, which describes the taxpayer as personally liable for a loan from the brokerage house to exercise the option, and the tax court’s (t.c. memo. 2006-162) description of the loan as nonrecourse. 5. it’s hard to believe this case, but read it and wonder. kimberlin v. commissioner, 128 t.c. 163 (5/8/07). in a mostly factual determination, the tax court (judge foley) held that stock warrants issued to a venture capital firm under a settlement and release agreement executed following a dispute regarding termination of services for a private placement offering were not received for past, present, or future services and therefore not subject to § 83.3 the court determined that the warrants had an ascertainable value in the year of the grant and were, therefore, includable in income in that year rather than in the year of exercise when the value was substantially higher. finally, the warrants were treated as dividend income to 3. but note john milton’s, “they also serve who only stand and wait.” 758 florida tax review [vol. 8:si the taxpayer as a distribution from the taxpayer’s venture capital corporation. 6. tax treatment of vested stock that becomes subject to a substantial risk of forfeiture is explained. rev. rul. 2007-49, 2007-31 i.r.b. 237 (7/30/07). when in the course of corporate affairs employee stock that is vested becomes subject to a risk of forfeiture, and, therefore, non-vested, the transaction may or may not constitute a taxable event. • in situation 1, the taxpayer holding vested stock makes an additional investment in the corporation for stock and agrees that all of the stock will be subject to a substantial risk of forfeiture. since the vested stock is already owned by the taxpayer under § 83, there is no transfer caused by the imposition of restrictions on the stock. • in situation 2, the taxpayer receives substantially non-vested stock for vested stock in a tax-free reorganization. the substantially non-vested shares are treated as being received in exchange for services subject to § 83. the fair market value of the vested shares is treated as the amount paid for the non-vested shares, resulting in zero recognition if the amount paid is greater than the value of the non-vested shares. • in situation 3, the taxpayer exchanges vested stock for substantially non-vested stock in a taxable merger. the transaction is treated as an exchange under § 1001. 7. more amt pain. merlo v. commissioner, 492 f.3d 618 (5th cir. 7/17/07). the taxpayer exercised an incentive stock option and purchased $1,075,289 worth of stock for only $9,225. the employer’s insider trading policy prevented employees from trading the company’s stock during certain blackout periods, but employees could exercise a stock option during a blackout period. the taxpayer had exercised the stock option during a blackout period. less than a year later, the stock was worthless. the tax court (judge haines), t.c. memo. 2005-178, held that the restrictions on the taxpayer’s ability to sell the stock during the blackout period was not a substantial risk of forfeiture under § 83, and that the spread was includable in alternative minimum taxable income pursuant to § 56(b)(3). judge haines later held, 126 t.c. 205 (4/25/06), that the limitations on capital losses under §§ 1211 and 1212 apply for purposes of calculating alternative minimum taxable income. thus, the capital loss realized in 2001 upon worthlessness of the stock acquired pursuant to the exercise of incentive stock options did not create an amt nol that could be carried back to reduce amti in 2000, the year of exercise. the fifth circuit (judge king) affirmed on both issues. first, judge king held that “[t]he blackout period 2008] recent developments in federal income taxation 759 within the insider trading policy is insufficient to create a substantial risk of forfeiture because the remedy for non-compliance does not include forfeiture of the shares.” second, she rejected the taxpayer’s argument that § 56(d)(2)(a)(i) creates an exception to the § 172(d) rule that capital losses are taken into account in an nol only to the extent of capital gains, reasoning that the starting point for the amt nol is the nol under § 172(c) and (d). none of the modifications made pursuant to § 56(d)(2)(a) override the § 172 limitations. 8. the difference between the adjusted amt basis and the regular tax basis of stock received through the exercise of an iso is not a tax adjustment taken into account in the calculation of an amt nol in the year the stock is sold. marcus v. commissioner, 129 t.c. 24 (8/15/07). in a series of transactions between 1998 and 2000, the taxpayer exercised incentive stock options (isos) to acquire 40,362 shares of his employer’s stock. in 2001, he sold 30,297 shares, which had a regular tax basis equal to the $127,920 exercise price, for $1,688,875. the taxpayer’s amt basis in the shares was $4,472,288 – the exercise price increased by the amount included in alternative minimum taxable income (amti) under § 56(b)(3) resulting from the exercise of the isos. judge haines rejected the taxpayer’s argument that the difference between the adjusted amt basis and the regular tax basis of the shares sold created an amt nol under § 56(d) that could be carried back to 2000. the taxpayer’s argument was based on the rules in § 56(d)(1)(b)(i) and (2)(a) providing that the amt nol is determined by taking into account adjustments to taxable income under §§ 56 and 58 (and preference items under § 57). judge haines reasoned that the only adjustment under § 56(b)(3) was made in the year the option was exercised; there was no basis adjustment to take into account in the year of the sale exercise. he explained that basis recovery through depreciation deductions is not analogous to the recovery of basis upon the sale of stock, because stock is a nondepreciable capital asset. when stock is sold at a loss, the capital loss limitations in §§ 1211, 1212, and 172(d)(2) are applicable for amt purposes as well as for the regular tax. d. individual retirement accounts there were no significant developments regarding this topic during 2007. 760 florida tax review [vol. 8:si v. personal income and deductions a. rates 1. tipra § 510 amends § 1(g)(2)(a) to increase the age below which the kiddie tax is applicable from 14 to 18, effective for years beginning after 2005. a. the 2007 act further tightens the kiddie tax, but only from 2008 forward. the 2007 act, § 8241(a), extends application of the § 1(g) kiddie tax to “children” over the age of 18 and under 24 who are full-time students if their earned income does not exceed the amount of their support. the amendment is effective for tax years beginning after 5/25/07. • for at least one of us, this is getting personal. • for another one of us, this is exactly what he suggested in a 1981 law review article – five years before the kiddie tax was enacted. b. miscellaneous income 1. who threw the overalls in mrs. murphy’s chowder? compensation for a personal injury that relates to something that could have been enjoyed tax-free is not income under the sixteenth amendment. murphy v. irs, 460 f.3d 79 (d.c. cir. 8/22/06), vacated, 99 a.f.t.r.2d 2007-396 (12/22/06). taxpayer received environmental whistleblower damages of $70,000 from the new york national air guard in 2000. the damages were awarded “for mental pain and anguish” and “for injury to professional reputation.” the court rejected taxpayer’s argument that her award was for “bruxism” which she argued was a physical injury or physical sickness. however, the court (judge ginsburg) held that § 104(a)(2), as amended in 1996 to exclude non-physical personal injuries from the exemption, was unconstitutional because “compensation for a nonphysical personal injury is not income under the sixteenth amendment if, as here, it is unrelated to lost wages or earnings.” judge ginsburg’s rationale was based upon the consideration that the award of compensatory damages was a substitute for a “normally untaxed” personal quality, good or asset, citing o’gilvie v. united states, 519 u.s. 79 (1996) (punitive damages were taxable pre-1996 act because they were not a substitute for a normally untaxed benefit), and raytheon prod. corp. v. commissioner, 144 f.2d 110 (1st cir. 1944) (“in lieu of what were the damages awarded?”). judge ginsburg looked to the commonly understood meaning of the term 2008] recent developments in federal income taxation 761 “incomes” at the time of the adoption of the sixteenth amendment, and found that the term did not include damages for nonphysical personal injuries that were unrelated to lost wages or earning capacity. • the government moved for rehearing en banc. in response, the panel vacated its opinion. before the opinion was vacated, it temporarily threw the treatment of compensatory damages for nonphysical personal injuries into a state of chaos. the court found that “the damages were awarded to make murphy emotionally and reputationally ‘whole’ and not to compensate her for lost wages or taxable earnings of any kind. the emotional well-being and good reputation she enjoyed before they were diminished by her former employer were not taxable as income.” from this starting point, the court reasoned that because the damages were received in “‘in lieu of’ something ‘normally untaxed’ ... her compensation is not income under the sixteenth amendment; it is neither a ‘gain’ nor an ‘accession[ ] to wealth.’” the court found further support for its holding by looking to what it determined to have been “the commonly understood meaning of the term [income] which must have been in the minds of the people when they adopted the sixteenth amendment.” the court concluded that “the framers of the sixteenth amendment would not have understood compensation for a personal injury — including a nonphysical injury — to be income.” this conclusion was based largely on two 1918 rulings, one by the attorney general (31 op. att’y gen. 304 (1918)) and one by the treasury department (t.d. 2747, 20 treas. dec. int. rev. 457 (1918)), both of which predated the enactment of the statutory predecessor of § 104(a)(2), which concluded that payments received as compensation for personal injuries (without specifying the nature of the injury) were “‘capital’ as distinguished from ‘income’” (in the attorney general’s opinion) and “doubtful whether ... required to be included in gross income” (in the treasury department ruling). the court considered its conclusion to be bolstered by a 1922 ruling of the bureau of internal revenue (sol. op. 132, i-1 c.b. 92 (alienation of affection; defamation of personal character)) that damages received for a nonphysical tort were income, noting that the ruling “regarded such compensation not merely as excludable under the irc, but more fundamentally as not being income at all.” • the court’s reasoning in the opinion is tenuous, at best, and it is unlikely that any other courts will follow this opinion. there are two salient weaknesses, among others, in the court’s reasoning. first, it is very difficult to see any connection between the 1918 administrative pronouncements and the intent of those who adopted the sixteenth amendment five years earlier. second, the court ignored that in 1921, after the enactment of the statutory predecessor of § 104(a)(2), but before the 1922 ruling cited by the court, the bureau of internal revenue changed its position and ruled that damages for nonphysical personal injuries 762 florida tax review [vol. 8:si were includable in gross income because they not specifically excluded by the statute (sol. mem. 957, 1 c.b. 65 (1919) (libel); sol. mem. 1384, 2 c.b. 71 (1920) (alienation of affection)). in 1922 the bureau reversed its position solely because of the holding in eisner v. macomber, 252 u.s. 189 (1920), which at that time was read to limit the constitutional meaning of “income” to “gain derived form capital, from labor, or from both combined.” this narrow crabbed view of the constitutional meaning of income has long since been discredited by subsequent supreme court cases, allowing virtually all accessions to financial wealth from any source, and in any form, to be includable in gross income under the statute. after eisner v. macomber was shorn of its vitality, the irs again took the position that in many cases damages for nonphysical personal injuries were includable in gross income, but prior to 1996 the courts generally held such damages were excluded under the statutory provisions of § 104(a)(2) and its predecessors, not because the damages were not “income” within the meaning of the sixteenth amendment. • in other words, the reasoning of the court of appeals for the district of columbia in murphy was grounded in the supreme court’s view of the constitutional meaning of “income” under the sixteenth amendment in 1920. congress, on the other hand, enacted the 1996 statutory amendments taxing all damages for nonphysical personal injury in light of subsequent supreme court’s jurisprudence regarding the constitutional meaning of “income” under the sixteenth amendment that effectively relegated the narrow eisner v. macomber view to the dustbin of constitutional law history. depending on the court’s opinion following rehearing, the flawed reasoning of the original decision in murphy similarly should be relegated to the dustbin of judicial history. a. compensation for a non-physical personal injury is income under the sixteenth amendment, and in any event the tax is an indirect tax. by the way, forget about filing those protective claims for refund. murphy v. irs, 493 f.3d 170 (d.c. cir. 7/3/07). judge ginsburg had a change of heart on rehearing. the court ultimately concluded (1) that murphy’s award was not received on account of physical injuries, (2) that gross income under § 61 includes an award for non-physical injuries such as murphy’s, and (3) that even if the damages are not income, the tax on damages is not a direct tax subject to apportionment. 2. congress serves up some alka-seltzer to those caught by the amt in the dot-com bubble. the tax relief and health care act of 2006 § 402 added new code § 53(e) to make the amt credits for prior years’ amt liability into a refundable credit (as opposed to a credit limited to the difference between the regular tax liability and the tentative amt liability for the year). a taxpayer who has unused amt credits – 2008] recent developments in federal income taxation 763 including those arising from incentive stock option grants – will be allowed to claim a refundable credit in the amount of the greater of (1) 20 percent of his long-term unused amt credits, or (2) the lesser of (a) $5,000 or (b) the amount of the taxpayer’s long-term unused minimum credit for the year. this latter amount is the portion attributable to tax years before the third tax year immediately preceding the tax year in question. the relief phases out for higher income taxpayers in the same manner as the phase-out of personal exemptions when agi exceeds $150,000. these provisions are effective only for years 2007-2012. 3. the vietnam war era returns—religious objections to paying for the military don’t avoid taxes. jenkins v. commissioner, 483 f.3d 90 (2d cir. 3/6/07). the second circuit affirmed a tax court judgment rejecting the taxpayer’s claims that he had the right under the first and ninth amendments to the constitution to withhold a portion of federal taxes on the basis of religious objections to military spending. the court also affirmed a $5,000 penalty for frivolous arguments. 4. there’s no transition rule in § 104(a)(2). polone v. commissioner, 505 f.3d 966 (9th cir. 10/11/07), aff’g t.c. memo. 2003339. the application of the 1996 amendments to § 104(a)(2) (which denied exclusion for damages received on account of non-physical personal injuries for payments received after 8/20/96) to post-8/20/96 payments received on account of a settlement agreement finalized in may 1996, was not a retroactive application of a newly enacted tax statute. the ninth circuit (judge thomas) held that three of four installment payments from settlement of a defamation suit by the taxpayer talent agent before the effective date of the physical injury amendment of § 104(a)(2) were includible in income. the plain language of the statute applies to damages received after august 20, 1996, unless the parties contracted prior to september 13, 1995. the taxpayer settled his claims for $4 million in may 1996 and received four payments of $1 million each after the effective date of the amendments. the court also rejected the taxpayer’s constitutional claims that application of the statute to payments received after the effective date of the settlement was an impermissible retroactive application of the statute in violation of the taxpayer’s due process rights under the fifth amendment. • judge thomas stated, “‘[a] statute does not operate ‘retrospectively’ merely because it is applied in a case arising from conduct antedating the statute’s enactment,’” quoting landgraf v. usi film products, 511 u.s. 244 (1994). 5. a joint account is not a completed gift that transfers gain from stock sale. estate of freedman v. commissioner, t.c. 764 florida tax review [vol. 8:si memo. 2007-61 (3/19/07). taxpayer deposited stock, which she received from her sale of an internet casino to a corporation, in a joint brokerage account, naming her son as the other joint owner. the tax court held that under the relevant state (texas) law ownership of a joint account is proportional to contributions. since the evidence demonstrated that the account was established with contributions from the taxpayer, her estate was taxable on 100 percent of the gain from the sale of the stock in the joint account. 6. form controls over asserted substance: family transactions produce income and an accuracy-related penalty where the burden of producing “strong proof” was not met. o’malley v. commissioner, t.c. memo. 2007-79 (4/3/07). the taxpayer, patrick o’malley, purchased a 48.5 acre parcel in anne arundel county, maryland. the parcel was subject to subdivision into lots held by family members for a minimum of five years. three lots had houses, one of which was occupied by the taxpayer. because he needed funds to meet various financial obligations, the taxpayer transferred two lots to brothers kevin and edward. kevin borrowed $254,400 from a bank, transferred the proceeds to the taxpayer, and gave the taxpayer a second deed of trust note for $47,000. the written documentation described the transaction as a sale. subsequently the taxpayer issued a $54,400 check to kevin with a notation indicating “loan repayment.” the taxpayer also forgave the $47,000 second loan. he did not report this arrangement as a sale and claimed that the “venture” was a financing arrangement. the tax court rejected the taxpayer’s arguments, indicating that “strong proof” is required where the taxpayer asserts that a transaction, in form a sale of property, is not a sale for tax purposes. the tax court also rejected the taxpayer’s somewhat novel argument that the return of $54,400 to kevin was a purchase price reduction under § 108(e)(5), because there was no indebtedness from the taxpayer to kevin that was reduced. the taxpayer was also found liable for the § 6662(a) accuracyrelated penalty because of the substantial understatement of income attributable to the sale to kevin. • in a second transaction the taxpayer conveyed a second parcel to brother edward under an oral agreement that the transaction was a sale. edward borrowed $180,000 from a bank secured by the property and transferred the proceeds to the taxpayer. the balance of the property’s fair market value was reflected as a loan to edward by the taxpayer on which no payments were required. the taxpayer made all payments on the loan and paid the real property taxes. edward was to retransfer the property to the taxpayer at the end of five years. the tax court concluded, with respect to this transaction, that the taxpayer satisfied his burden of showing by strong proof that this transaction was not a sale. 2008] recent developments in federal income taxation 765 7. some tax exemptions are found in federal statutes outside of the internal revenue code. wallace v. commissioner, 128 t.c. 132 (4/16/07). payments of $16,393 received by a veteran under a compensated work therapy program administered by the department of veterans affairs were excluded from gross income even though the taxpayer was required to perform work as part of a veterans’ construction team as part of the program. 38 u.s.c. § 5301(a) exempts from taxation benefits payments to the beneficiary of veterans’ benefits. see also i.r.c. § 140(a)(3). broadly construing the exemption, the tax court rejected the commissioner’s argument that amounts received under the work therapy program were includible in gross income because of the work requirement. a. and the irs now agrees. rev. rul. 200769, 2007-49 i.r.b. 1083 (12/3/07). payments made by the u.s. department of veterans affairs under the compensated work therapy program described in 38 u.s.c. § 1718 are exempt from income tax as veterans’ benefits pursuant to 38 u.s.c. § 5301(a)(1), which provides that payments of benefits due or to become due under any law administered by the va made to, or on account of, a beneficiary are tax-exempt. 8. forgiven accrued but unpaid interest on a consumer loan is cod income. hahn v. commissioner, t.c. memo. 200775 (4/2/07). the tax court (judge wells) held that the black letter law remains that discharge of indebtedness income can be realized under the kirby lumber co. “freeing of assets” rationale even though the debtor did not receive any cash or other property when he incurred the liability. when a creditor writes off accrued but unpaid interest owed by a cash method debtor, discharge of indebtedness income is realized, unless the interest would have been deductible if it had been paid and thus excludable under § 108(e)(2), because “[t]he right to use money represents a valuable property interest.” taxpayer’s motion for summary judgment was denied because whether the interest expenses incurred in a horse breeding activity was deductible as a trade or business expense was a question of fact on which a trial was necessary. 9. selling your life insurance policy to yourself is not a transfer for value. rev. rul. 2007-13, 2007-11 i.r.b. 684 (3/12/07). a grantor who under the grantor trust rules is treated as the owner of a trust that owns a life insurance contract on the grantor’s life is treated as the owner of the contract for purposes of the transfer for value limitations of § 101(a)(2). relying upon rev. rul. 85-13, 1985-1 c.b. 184, the irs ruled that the transfer of a life insurance contract between two grantor trusts that are treated as wholly owned by the same grantor is not a transfer for value 766 florida tax review [vol. 8:si within the meaning of § 101(a)(2). the transfer of a life insurance contract to a grantor trust that is treated as wholly owned by the insured is a transfer to the insured within the meaning of § 101(a)(2)(b) and is thus excepted from the transfer for value limitations under § 101(a)(2). 10. antarctica is not a foreign country. income earned in “outer space” is not excluded foreign source compensation. kunze v. commissioner, t.c. memo. 2007-179 (7/5/07). on summary judgment the tax court denied claims of 150 individuals that wages earned for services performed in antarctica are not excluded from income under § 911 as income earned in foreign country. the court held that activity in antarctica is deemed space or ocean activity relying on arnett v. commissioner, 126 t.c. 89 (2006), aff’d, 473 f.3d 790 (7th cir. 2007). 11. you have to prove physical injury, not just allege it. gibson v. commissioner, t.c. memo. 2007-224 (8/13/07). the taxpayer received a damage award pursuant to a consent decree entered in a class action lawsuit that provided payments for violation of civil rights, emotional distress, physical injuries, and physical sickness. judge vasquez held that no portion of the damage award was received on account of personal physical injury or physical sickness, because the taxpayer failed to prove to the tax court that the defendant in the class action lawsuit caused his alleged personal physical injury or physical sickness. 12. no exclusion for punitive damages in a wrongful death deep in the heart of texas, even though there is an exclusion where the stars fell on alabama.4 benavides v. united states, 497 f.3d 526 (5th cir. 8/17/07). punitive damages received in a wrongful death suit under texas law were not excludable under § 104(c), because texas law provides for both compensatory and punitive damages in wrongful death suits. 13. all social security benefits are taxed the same way, regardless of why you collect them. green v. commissioner, t.c. memo. 2007-217 (8/7/07). the exclusion under § 104(a)(1) (dealing with worker’s compensation) does not apply to social security disability benefits, the tax treatment of which are determined under § 86. social security disability benefits are taxed in the same manner as social security old-age 4. the difference is that § 104(c) is directed at only alabama where the sole remedy for wrongful death is denoted “punitive damages.” ala. code §§ 6-5-391, 65-410 and 6-11-20. the reference to falling stars is to an 1833 leonid meteor shower, commemorated a century later by a jazz song. 2008] recent developments in federal income taxation 767 benefits, because the social security act provides for disability benefits for an injury regardless of whether the injury occurred in the course of employment. 14. congress provides tax relief for sub-prime mortgage borrowers. the mortgage forgiveness debt relief act of 2007 added new § 108(a)(1)(e), which excludes from gross income the discharge of “qualified principal residence indebtedness” (qpri) that takes place on or after 1/1/07 and before 1/1/10. the provision is, of course, a legislative response to the subprime mortgage loan crisis. qpri is defined as acquisition indebtedness, a loan on a taxpayer’s principal residence, as defined in § 163(h)(3)(b), except that for purposes of § 108(a)(1)(e) the ceilings are $2,000,000 (for married couples filing joint returns) and $1,000,000 (for other taxpayers). qpri does not include (1) indebtedness on a home that is not the taxpayer’s principal residence, or (2) home equity indebtedness. the exclusion is not available if the discharge is not on account of either (1) a decline in the value of the home or (2) the financial condition of the taxpayer. the taxpayer’s basis in the principal residence must be reduced by the amount excluded under § 108(a)(1)(e). if only a portion of the cancelled debt is qpri, the exclusion applies only to the extent the amount discharged exceeds the non-qpri portion of the loan. if a taxpayer qualifies for both the qpri exclusion and the insolvency exclusion of § 108(a)(1)(b), the qpri exclusion applies unless the taxpayer elects the application of the insolvency exclusion. c. profit-seeking individual deductions 1. this one can bite a lawyer/fiduciary who is employed by his own psc if you’re not careful. chaplin v. commissioner, t.c. memo. 2007-58 (3/12/07). judge haines held that the expenses of a professional fiduciary who was employed by a corporation in which he was a shareholder, but which was not itself authorized to serve a fiduciary and conducted business by having its employees serve as named fiduciaries, were employee business expenses. the taxpayer was subject to the control of the corporation in the exercise of his fiduciary powers and the manner in which he conducted business. the opinion provides extensive discussion of the factors that indicate an employment relationship exists. 2. employer reimbursement frozen? ask anyway. contreras v. commissioner, t.c. memo. 2007-63 (3/19/07). taxpayer’s employer, federal express, froze travel reimbursement but allowed employees to obtain reimbursement with approval of a company vicepresident. the court held that employee business expenses are deductible 768 florida tax review [vol. 8:si only to the extent that the taxpayer could not be reimbursed by the employer. taxpayer’s deduction for unreimbursed employee travel was denied where taxpayer did not try to obtain approval. in addition, taxpayer’s offer of credit card statements, ticket stubs, and conclusory testimony was inadequate to substantiate the expenditures. 3. even a former irs auditor can’t get the substantiation correct and ends up footing the bill. karason v. commissioner, t.c. memo. 2007-103 (4/26/07). taxpayer had worked for the irs as an industry specialist in the fields of healthcare, horse operations, farming operations, and as a large case manager in the san francisco office. the tax court denied § 179 deductions and depreciation on medical equipment that the taxpayer claimed to have purchased from his brother’s incorporated podiatry practice and leased back in the taxpayer’s trade or business of medical equipment leasing. the taxpayer’s oral purchase and leaseback arrangement with his brother was substantiated only by their oral testimony at trial, which failed to satisfy the requirements of reg. § 1.1795(a) that the taxpayer maintain records which specifically identify each item of § 179 property, demonstrate how the property was acquired, and when the property was placed in service. the taxpayer was also denied loss deductions from a family investment partnership for failure to substantiate the taxpayer’s partnership basis. in addition, given his experience as an irs employee, the taxpayer was found liable for the 20 percent accuracy-related penalty under § 6662(a). 4. lodging not away from home for the benefit of the employer may still be deductible. the irs comes to the rescue of beloved tax-free company retreats. notice 2007-47, 2007-24 i.r.b. 1393 (6/11/07). reg. § 1.262-1(b)(5) provides that the costs of a taxpayer’s lodging not incurred in traveling away from home are personal expenses and are not deductible unless they qualify as deductible expenses under § 217 (moving expenses). treasury has apparently concluded that some employerprovided lodging while not away from home should be an excludable working condition fringe benefit when provided for the convenience of the employer. thus, the notice indicates that treasury expects to amend reg. § 1.262-1(b)(5) to add that employee expenses for lodging not incurred in traveling away from home are personal expenses, unless they qualify as deductible expenses under § 162 or § 217. the notice indicates that pending the issuance of additional guidance, reg. § 1.262-1(b)(5) will not be applied to limit deduction of employee expenses for lodging that an employer provides or requires the employee to obtain under the following conditions: (1) the lodging is on a temporary basis; (2) the lodging is necessary for the employee to participate in or be available for a bona fide business meeting or 2008] recent developments in federal income taxation 769 function of the employer; and (3) the expenses are otherwise deductible by the employee, or would be deductible if paid by the employee, under § 162(a). this position affects the exclusion of employer-provided working condition fringe benefits under reg. § 1.132-5(a), which requires that to be excluded from income a working condition fringe benefit must be an expenditure that is deductible under §§ 162 or 167. 5. bumped airline employees are not traveling away from home at a new work location. stockwell v. commissioner, t.c. memo. 2007-149 (6/13/07). taxpayer was a mechanic for northwest airlines, who was laid off at his work location in minneapolis. he exercised seniority rights to bump others at different locations, and was himself bumped in turn. he worked in milwaukee and detroit for indefinite periods. because of the indefinite nature of the employment at the alternative locations, the taxpayer was not allowed to deduct living expenses as temporarily away from home. the court allowed the taxpayer’s deduction for uniform cleaning expenses based on estimates, but disallowed deductions for internet services, depreciation on tools, and cell phone expenses. • the tax court has reached the same result in additional cases with the same issues: wasik v. commissioner, t.c. memo. 2007-148 (6/13/07); bogue v. commissioner, t.c. memo. 2007-150 (6/14/07); farran v. commissioner, t.c. memo. 2007-151 (6/14/07); wilbert v. commissioner, t.c. memo. 2007-152 (6/14/07); and riley v. commissioner, t.c. memo. 2007-153 (6/14/07). 6. this salesman is an employee. colvin v. commissioner, t.c. memo. 2007-157 (6/19/07). taxpayer, a computer hardware salesman, was denied schedule c deductions because he was a common law employee. the taxpayer signed an employment agreement and was subject to control of the employer even though the taxpayer set his own hours and sales territory, worked primarily from home, was not required to utilize the employer’s support staff, nor attend routine meetings. the court noted that the employer had the right to control the taxpayer, whether or not exercised. 7. if you are trying to be in a trade or business for tax purposes, it does not help that you are collecting unemployment. cameron v. commissioner, t.c. memo. 2007-260 (8/30/07). the tax court (judge laro) upheld the irs’s determination that the taxpayer was not a trader in stock and securities, and disallowed deductions under § 162, relegating them instead to § 212. in 2002, the taxpayer’s activity consisted of 46 purchases and 14 sales. in 2003, he completed 109 purchases and 103 sales. during the years at issue, petitioner did not trade 5 days a week. of 770 florida tax review [vol. 8:si the years at issue, he traded on more than 10 days in a given month only twice. that the taxpayer was collecting unemployment compensation during 2003 further undermined his argument that he was engaged in a trade or business during that year. d. hobby losses and § 280a home office and vacation homes 1. after divorce, do what you love, love what you do, and they can be integrated into a single for-profit business. topping v. commissioner, t.c. memo. 2007-92 (4/17/07). after her divorce, the taxpayer formed a profitable business designing homes and barns for the wealthy florida horse set. the taxpayer was an accomplished equestrian who made contacts with potential clients while she competed in events at the jockey club, described as an elite private club. she convinced the tax court (judge goeke) that her riding activities were an integral part of her design business, even though she reported her design and horse activities on separate schedules c.5 thus, her horse-related expenditures were fully deductible as a profit seeking activity. • because the scope of an activity is a factual issue, the presentation of the taxpayer’s case can make all of the difference. for example, in this case the tax court held that the taxpayer’s money-losing equestrian activities were an integral part of her profitable business designing homes and barns, even though she reported her equestrian and design activities on separate schedule cs, because she used the equestrian activities to make contacts with potential “extraordinarily wealthy” clients while she competed in events at an elite private equestrian club. the court found that the taxpayer did not advertise her interior design business through advertising media, because “the ethos of the jockey club and its members perceive that kind of generic advertising of a personal service business as tacky or gauche,” and she instead “relie[d] on her exposure and reputation as both a rider and owner, and also her popularity among the members of the jockey club.” furthermore, she “use[d] her general knowledge of horses and specifically her knowledge of the idiosyncrasies of each of her client’s horses to evolve her barn designs.” 2. a horse lover who mucks stalls must be in it for profit rather than fun. rozzano v. commissioner, t.c. memo. 2007-177 5. marty would change the penultimate sentence to read, “the citizen’s ingenious counsel convinced the tax court that her riding activities were an integral part of her design business, even though she reported her design and horse activities on separate schedule cs.” this is because taxpayer’s attorney makes a practice of never referring to a client as a “taxpayer,” but only as a “citizen.” 2008] recent developments in federal income taxation 771 (7/3/07). the taxpayer took a position as a corporate ceo that required a move to chicago. he then converted his ohio farm into a horse boarding facility. the farm had 27 stalls and an indoor arena. the taxpayer used his business skills to develop computer-based spreadsheets and accounting systems for the activity. he spent weekends doing the heavy work of the farm such as mowing, mucking, and mending. in 1999 the taxpayer determined that, due to events beyond his control, the farm would continue to produce losses. the property was offered for sale in 2001 and sold in 2003. the tax court concluded that the taxpayer’s careful accounting systems and general business practices justified treating the activity as engaged in for profit, notwithstanding the taxpayer’s testimony that he realized in 1999 that the activity would not be profitable. the taxpayer maintained the operation in order to facilitate a sale of the property. 3. this taxpayer, a nurse and doctor’s wife, was not able to treat her direct marketing activities as engaged in for profit. smith v. commissioner, t.c. memo. 2007-154 (6/14/07). while working as a registered nurse, the taxpayer, who was a physician’s wife, engaged in numerous direct marketing enterprises in which she sold vitamins, energy supplements, marketing opportunities on the internet, and for a company called renaissance the tax people, inc, she sold “tax relief systems” that were designed to generate federal tax deductions. the court noted however, that most of her activity involved recruiting additional downline distributors. all of these activities produced approximately $160,000 of losses over a four year period. the tax court concluded that the taxpayer did not operate in a business-like manner because of the absence of any indicia of analysis of the market, the potential for profit, or plan to alter the business to make it successful. the business plan provided by the taxpayer was largely prepackaged by the company for which she was selling. the court observed that the records presented by the taxpayer were more indicative of someone preparing for an irs examination rather than someone seeking a profit. the tax court declined to impose an accuracy related penalty on the ground that the taxpayer reasonably relied on her accountant’s advice that the deductions were permissible. e. deductions and credits for personal expenses 1. when will trust investment advisory fees get up off the § 67 floor? rudkin testamentary trust v. commissioner, 124 t.c. 304 (6/27/05) (reviewed, 18-0), aff’d, 467 f.3d 149 (2d cir. 10/18/06) (2-0), aff’d sub nom. knight v. commissioner, 128 s. ct. 782 (1/16/08). 772 florida tax review [vol. 8:si a. no. the tax court (judge wherry) held that amounts paid for investment management advice by trusts set up by a family involved in the founding of the pepperidge farm food products company (which was sold to campbell soup company in the 1960s) are not subject to the § 67(e) exception to the § 67(a) floor of 2 percent of agi (which limits the deductibility of employee business expenses and miscellaneous itemized deductions to amounts exceeding that floor). in reaching this result, the court determined that these expenses did not qualify for the exception in § 67(e)(1), under which costs paid or incurred in connection with the administration of a trust that wouldn’t have been incurred if the property weren’t held in the trust are allowed as deductions in arriving at adjusted gross income. the tax court explained that the statutory text of § 67(e)(1) creates an exception allowing for deduction of trust expenditures without regard to the 2 percent floor where two requirements are satisfied: (1) the costs are paid or incurred in connection with administration of the trust and (2) the costs would not have been incurred if the property were not held in trust. • the tax court previously held that a trust’s investment advice costs were subject to the 2 percent floor. o’neill trust v. commissioner, 98 t.c. 227 (1992). however, the sixth circuit reversed the tax court and held that investment counseling fees paid by the trust to aid the trustees in discharging their fiduciary duty to the trust beneficiaries were not subject to the 2 percent floor under the § 67(e)(1) exception. (994 f.2d 302 (6th cir. 1993)). subsequently, the sixth circuit approach was rejected by the irs (nonacq, 1994-2 c.b. 1); the federal circuit (mellon bank, n.a. v. united states, 265 f.3d 1275 (fed. cir. 2001)); and the fourth circuit (scott v. united states, 328 f.3d 132 (4th cir. 2003)). in reaching their decisions, the federal and fourth circuits emphasized the importance of not interpreting the statute so as to render superfluous any portion of it. they said that if courts were to hold that a trust’s investmentadvice fees were fully deductible, the second requirement of § 67(e)(1) would have been rendered meaningless. • the sixth circuit’s rationale was stated as follows: the tax court reasoned that “[i]ndividual investors routinely incur costs for investment advice as an integral part of their investment activities.” nevertheless, they are not required to consult advisors and suffer no penalties or potential liability if they act negligently for themselves. therefore, fiduciaries uniquely occupy a position of trust for others and have an obligation to the beneficiaries to exercise 2008] recent developments in federal income taxation 773 proper skill and care with the assets of the trust. (994 f.2d at 304) b. the second circuit affirms and gives a third interpretation of “an unambiguous statute.” 467 f.3d 149 (2d cir. 10/18/06) (2-0). judge sotomayor held that § 67(e) was unambiguous and permitted a full deduction only for those types of trust expenses that an individual could not possibly incur. c. the treasury tried to preempt the supreme court with proposed regulations. reg-128224-06, section 67 limitations on estates or trusts, 72 f.r. 41243 (7/27/07). prop. reg. § 1.674 would provide that costs incurred by estates or non-grantor trusts that are unique to an estate or trust are not subject to the 2 percent floor of § 67. under prop. reg. § 1.67-4(b), a cost is unique to an estate or trust if an individual could not have incurred that cost in connection with property not held in an estate or trust. any miscellaneous itemized deductions that do not meet this standard are subject to the 2 percent floor. prop. reg. § 1.67-4(c) prevents circumvention of the limitation by “bundling” investment advisory fees and trustees’ fees into a single fee. if an estate or non-grantor trust pays a single fee that includes both costs that are unique to estates and trusts and costs that are not, the fee must be allocated between the two types of costs. the regulations provide a non-exclusive list of services for which the cost is either exempt from or subject to the 2 percent floor. the regulations will apply to payments made after the date final regulations are published in federal register. • under the reasoning of national cable & telecommunications ass’n v. brand x internet services, 545 u.s. 967 (2005), a court’s interpretation of a statute trumps an agency’s subsequent regulation “under the doctrine of stare decisis only if the prior court holding ‘determined a statute’s clear meaning.’ ... [a] court’s prior interpretation of a statute ... overrides an agency’s interpretation only if the relevant court decision held the statute unambiguous.” otherwise the validity of the regulation is determined under chevron u.s.a. inc. v. natural resources defense council, inc., 467 u.s. 837 (1984). d. the supreme court issued the writ of certiorari to resolve the conflict between the second and sixth circuits, but decided to follow the federal and fourth circuits. the supreme court affirmed sub nom. knight v. commissioner, 128 s. ct. 782 (1/16/08) (9-0). the court affirmed the second circuit in an opinion written by chief justice roberts but rejected the second circuit test in favor of the test of 774 florida tax review [vol. 8:si whether individuals commonly employ investment advisors set forth in mellon bank and scott. e. meanwhile, bundled fiduciary fees may be deducted in full. notice 2008-32, 2008-11 i.r.b. 593 (2/27/08). this notice provides interim guidance on the treatment of investment advisory costs subject to the 2 percent floor of § 67 that are bundled as part of a single fiduciary fee for years beginning before 1/1/08. it provides that the taxpayer may deduct the full amount of the bundled fiduciary fee without regard to the 2 percent floor. 2. who does the kid belong to? notice 2006-86, 2006-41 i.r.b. 680 (9/20/06). this notice provides interim guidance to clarify the rule under § 152(c)(4) (as amended by the working families tax relief act of 2004) for determining which taxpayer may claim a qualifying child when two or more taxpayers claim the same child. the tiebreaking rule is to apply to the following provisions as a group: (1) head of household filing status, (2) the § 21 child and dependent care credit, (3) the § 24 child tax credit, (4) the § 32 earned income credit, (5) the § 129 exclusion for dependent care assistance, and (6) the § 151 dependency deduction. 3. the tax relief and health care act of 2006 § 101 extends the above-the-line deduction for higher education expenses under code § 222 to 2006 and 2007. 4. the tax relief and health care act of 2006 § 102 extends the code § 164(b)(5) election to deduct state and local general sales taxes (instead of state income taxes) to 2006 and 2007. 5. the tax relief and health care act of 2006 § 302 adds new code § 106(e) to permit one-time transfers to health savings accounts from health flexible spending arrangements and health reimbursement arrangements. 6. the tax relief and health care act of 2006 § 302 adds new code § 4980g(d) to provide for an exception to the current requirement that employer contributions to hsas be “comparable” for all employees by allowing employers to provide additional contributions to lower-paid workers. 7. the tax relief and health care act of 2006 § 303 amends code § 223(b)(2) to repeal the annual deductible limitation on hsa contributions and allow monthly contributions of $2,250 for 2008] recent developments in federal income taxation 775 individuals and $4,500 per family, adjusted for inflation, even if the deductible is less that those amounts. for 2007, the inflation adjusted amount was $2,850 for individuals and $5,650 per family. rev. proc. 200653, 2006-48 i.r.b. 996, § 3.24. 8. the tax relief and health care act of 2006 § 307 adds new code § 408(d)(9) to permit a once-in-a-lifetime tax-free transfer from an ira to fund the taxpayer’s hsa deductible contribution amount. this would allow those who cannot afford to fully fund an hsa with direct contributions to move ira money to a more tax-advantaged position. 9. congress encourages sub-prime mortgage lending. the tax relief and health care act of 2006 added new code § 163(h)(3)(e), providing an itemized deduction for the cost of mortgage insurance on a qualified personal residence. the deduction is phased-out ratably by 10 percent for each $1,000 by which the taxpayer’s agi exceeds $100,000. thus, the deduction is unavailable for a taxpayer with an agi in excess of $110,000. as originally enacted, the provision was effective for amounts paid or accrued (and applicable to the period) after 12/31/06 and before 1/1/08 for mortgage contracts issued after 12/31/06. a. and congress extends a provision encouraging sub-prime mortgage borrowing. the mortgage forgiveness debt relief act of 2007 extended the 12/31/07 termination date for § 163(h)(3)(e) to 12/31/10. 10. jailed murderess qualifies for the earned income credit. rowe v. commissioner, 128 t.c. 13 (2/22/07) (reviewed, 5-5-6-1).6 taxpayer and her two young children lived together in 2002 until her arrest on june 5; she continued to support her children after her arrest until july 2. she was confined in jail for the rest of the year. the taxpayer was entitled to the earned income credit because her absence due to being held in jail after her arrest – she was convicted of murder in 2003 and sentenced to life imprisonment – does not prevent her from qualifying for the eic. there was a whole lot of fuss as to (1) whether reg. § 1.2-2(c)(1), which required that it be reasonable to assume she would return to her home after the temporary absence, would apply, or (2) whether hein v. commissioner, 28 t.c. 826 (1957), acq., and rev. rul. 66-28, 1966-1 c.b. 31, which required only the 6. five judges joined in judge kroupa’s principal opinion, five judges joined concurring opinions by judges gale and goeke, six judges joined judge halpern’s dissent, and judge chiechi did not participate. 776 florida tax review [vol. 8:si absence of intent on the part of the taxpayer to change her place of abode, would apply. • judge halpern’s dissent forcefully rejected the applicability of hein and rev. rul. 66-28 on the grounds that the tax court should not lightly assume that the commissioner has, sub silentio, amended reg. § 1.2-2(c)(1). 11. finding every last dollar of deductible medical expenses in continuing care retirement community fees. finzer v. united states, 99 a.f.t.r.2d 2007-1577 (n.d. ill. 3/7/07). the court held that the fact that a continuing care retirement community residency agreement specified that the monthly fee included medical services does not necessarily mean that the entrance fee did not also include medical services. that the entrance fee can be refunded under certain circumstances and may be used to cover a portion of the monthly fees if the taxpayer is unable to pay also does not necessarily affect whether a portion of the entrance fee is allocable to medical care. whether the entrance fee also includes medical services is a question of fact. the government was denied summary judgment. a. well, then again, not every last dollar. finzer v. united states, 496 f. supp. 2d 954 (n.d. ill. 7/20/07). after trial, the court ruled against the taxpayers. the taxpayers filed an amended return claiming a refund on the grounds that 41 percent of the $723,800 entrance fee for the continuing care retirement community was for medical expenses, not the 18 percent claimed on the original return. the court rejected the claim on several grounds. first, there was undisputed testimony that the ccrc residents paid different entrance fees based on the size of the residential unit they selected, and that the taxpayers would have received the same access to medical care if they had selected a smaller unit that required an entrance fee of only $275,000. thus the portion of the entrance fee over $275,000 related solely to housing and had no relationship to medical costs. the court noted that assuming arguendo that 41 percent of $275,000 properly could be deducted as a medical expense, the taxpayers’ deduction would be $112,750, which is less than the $136,798 they claimed on their original return. second, the taxpayers failed to prove that any portion of the entrance fee was properly attributable to medical expenses. the residency agreement stated that the proceeds of the entrance fees are not used to provide services to the residents, and the unrebutted testimony of the ccrc’s executives was that the monthly fees were the sole source of payment for medical expenses incurred by residents. finally, the “entrance fee,” which was represented by a promissory note from the ccrc to the taxpayers the obligation on which was reduced by 2 percent per year of 2008] recent developments in federal income taxation 777 residency, but which was otherwise refundable if the taxpayers left the ccrc, was held to be a loan, not a payment. 12. it might take a village to raise kids, but not all the costs of village people are eligible for the dependent care credit. t.d. 9354, expenses for household and dependent care services necessary for gainful employment, 72 f.r. 45338 (8/14/07). the treasury has promulgated final regulations, reg. §§ 1.21-1 through 1.21-4, regarding the § 21 credit for expenses for household and dependent care services to reflect statutory amendments since 1984 and to renumber the regulations under § 21, rather than under § 44a (which previously was the code section prior to 1984). • reg. §§ 1.21-1(a)(1), (b)(1), and (g) reflect the changes in the working families tax act of 2004 that incorporate the uniform definition of child. for taxable years beginning after december 31, 2004, a qualifying individual is: (1) a dependent (who is a qualifying child within the meaning of § 152) who has not attained age 13; (2) a dependent (as defined in § 152, without regard to subsections (b)(1), (b)(2), and (d)(1)(b)) who is physically or mentally incapable of self-care and who has the same principal place of abode as the taxpayer for more than one-half of the taxable year; or (3) the taxpayer’s spouse who is physically or mentally incapable of self-care and who has the same principal place of abode as the taxpayer for more than one-half of the taxable year. • the requirements of § 21 and the regulations are applied at the time the services are performed, regardless of when the expenses are paid. reg. § 1.21-1(a)(4). the status of an individual as a qualifying individual is determined on a daily basis, reg. § 1.21-1(b)(3), only expenses before a disqualifying event, such as a child turning 13, may be taken into account. a taxpayer must allocate the cost of care on a daily basis if expenses are paid for a period during only part of which the taxpayer is employed or in active search of gainful employment. reg. § 1.21-1(c)(2). a safe-harbor treats an absence of no more than two consecutive calendar weeks as a short, temporary absence from work. reg. § 1.21-1(c)(2)(ii). thus, for example, costs of a day care center that charges by the month and does not refund amounts attributable to days a child is absent, qualify in full if the child is absent for no more than two consecutive weeks for a family vacation. reg. § 1.21-1(c)(3), ex. (4). • employment-related expenses must be for the care of a qualifying individual and may not be for other services such as education. expenses for a child in nursery school, pre-school, or similar programs for children below the kindergarten level are for the care of a qualifying individual and may be employment-related expenses. expenses for a child in kindergarten or a higher grade are not for care and therefore, are not 778 florida tax review [vol. 8:si employment-related expenses. however, expenses for beforeor after-school care of a child in kindergarten or a higher grade may be for care. reg. § 1.211(d)(5). • the full amount paid for a day camp or similar program may be for the care of a qualifying individual although the camp specializes in a particular activity, such as soccer or computers. for administrative convenience, no allocation is required in this situation between the cost of care and amounts paid for learning a specialized skill. expenses for summer school and tutoring programs are not creditable. reg. § 1.21-1(d)(7). • the cost of overnight camp is not an employment-related expense. reg. § 1.21-1(d)(6). but the cost of overnight care (other than overnight camp) can be an employment-related expense for a taxpayer who works at night. • boarding school expenses must be allocated between expenses for the care of a qualifying individual and expenses for other goods or services, unless the other goods or services are incidental to and inseparably a part of the care. reg. § 1.21-1(d)(2), (12), ex. 2. • if a domestic employee cares for qualifying children and also performs other services for the taxpayer, an allocation is required unless the expense for the other purpose is minimal or insignificant or if an expense is partly attributable to the care of a qualifying individual and partly to household services. reg. § 1.21-1(d)(1) (3), (12), ex. 3. • the additional cost of providing room and board for a caregiver over usual household expenses (including an increase in utilities, such as electric, water, and gas) may be an employmentrelated expense. reg. § 1.21-1(d)(10) and (11). • the regulations apply to taxable years ending after 8/14/07. 13. making the world safe from the amt, one year at a time. the tax increase prevention act of 2007 provided another oneyear “patch” for the amt. the 2007 exemption amounts are $44,350 for unmarried taxpayers and $66,250 for married taxpayers filing joint returns, and $33,125 for married taxpayers filing separately. the act also extended to 2007 the special rule in §26(a)(2) allowing the otherwise nonrefundable personal credits to offset the amt (after taking into account the foreign tax credit). 14. you don’t have to be sick to incur deductible medical expenses. rev. rul. 2007-72, 2007-50 i.r.b. 1154 (12/10/07). the 2008] recent developments in federal income taxation 779 irs has ruled that following expenses are deductible medical expenses under § 213: (1) amounts paid for an annual physical examination for diagnosis, even though the taxpayer is not experiencing any symptoms of illness; (2) amounts paid for a full-body scan for diagnosis, and which serves no non-medical function, even though the taxpayer is not experiencing symptoms of illness and has not obtained a physician’s recommendation before undergoing the procedure; and (3) amounts paid for an over-the counter pregnancy test kit, even though its purpose is to test the healthy functioning of the body rather than to detect disease. f. divorce tax issues 1. proposed regulations would identify which divorced or separated parent can claim the dependency exemption. reg-149856-03, dependent child of divorced or separated parents or parents who live apart, 72 f.r. 24192 (5/2/07). prop. reg. § 1.152-4 interprets § 152(e), as amended by the 2005 act (goza), to provide that a child of parents who are divorced, separated, or living apart may be claimed as a qualifying child of the non-custodial parent if the child receives over one-half of his/her support from the parents, the child is in the custody of one or both parents during the calendar year, and the custodial parent signs a written declaration that the custodial parent will not claim the exemption (which must be attached to the non-custodial parent’s return), or a pre-1985 instrument allocates the exemption and the non-custodial parent contributes at least $600 for the support of the child during the year. • under the proposed regulations: (1) the custodial parent is the parent with whom the child spends the greatest number of nights during the taxable year. a child who is temporarily away is treated as spending the night with the parent with whom the child would have resided. if another person is entitled to custody for a night, then the child is treated as spending the night with neither parent. (2) the proposed regulations incorporate the rules of temp. reg. § 1.152-4t regarding the required written declaration and they provide that the declaration must contain an unconditional statement that the custodial parent will not claim the exemption for the specified year or years, and a declaration is not unconditional if it conditions the custodial parent’s release of the right to claim to the exemption on the noncustodial parent meeting a support obligation. (3) the custodial parent may revoke a revocation by providing written notice to the non-custodial parent specifying the years of the revocation. a revocation will be effective in the first calendar year after the year in which the revoking parent provides notice to the other parent. (4) never-married parents who live apart are entitled to agree by written declaration to transfer the exemption to the non-custodial parent (following king v. commissioner, 121 t.c. 245 (2003)). 780 florida tax review [vol. 8:si a. and don’t forget to attach the form. chamberlain v. commissioner, t.c. memo. 2007-178 (7/5/07). a noncustodial parent failed to attach to his 2003 return the form 8332, or its equivalent, signed by the custodial parent releasing her claim to the dependency exemption. the tax court held that, notwithstanding submission at trial of a letter from the custodial parent releasing claims to the dependency exemption, it could not retroactively cure the taxpayer’s failure to attach the required statement to his return for the year at issue. 2. voluntary alimony is still “alimony,” as long as you have a court order. webb v. commissioner, t.c. summ. op. 2007-91 (6/4/07). in a very persuasive nonprecedential summary opinion, the tax court (special trial judge armen) held that payments made pursuant to a court order that specified that the payments were not mandatory, but that the payments, if made, were to be deductible by the payor and includable by the payee, qualified as alimony. the court reasoned that although prior to the 1984 revisions to § 71 there was a requirement that payments be pursuant to a legal enforceable obligation to be considered to be alimony, that requirement was eliminated by the 1984 amendments. the court further observed that although the pre-1984 “legal obligation requirement” was still reflected in a provision of the regulations (reg. § 1.71-1(b)(2)(i)) that has been amended since 1984, a temporary regulation (temp. reg. § 1.711t(a), q&a-3) interpreting the 1984 amendments “makes very clear that ‘the [requirement] that alimony or separate maintenance payments be … made in discharge of a legal obligation … [has] been eliminated.’” • this holding should be reflected in some precedential form because it could be useful for planning purposes. 3. equality yes, but not alimony. sarchett v. commissioner. t.c. memo. 2007-180 (7/9/07). fixed payments denominated as “equalization payments” in a settlement agreement, the stated purpose of which was to equalize the division of the parties community property and debts, were not treated as alimony, because the obligation did not terminate at death, but rather payments were required until a fixed amount had been paid. judge cohen refused to consider the taxpayer’s argument that his obligation would terminate on death under state law. she concluded that there was no evidence that the payments constituted alimony, and, therefore, there was no need to resort to state law. 4. who says the 1984 act made it easier to sort out alimony from property settlements? the husband’s marginal tax rate became enormous because he continued working past the date he was eligible for retirement. commissioner v. dunkin, 500 f.3d 1065 (9th cir. 2008] recent developments in federal income taxation 781 8/31/07), rev’g 124 t.c. 180 (3/31/05). the divorced taxpayer reached eligibility for retirement, and had he retired, his former spouse would have been entitled to receive one-half of his pension. because he continued working and delayed receipt of his pension benefits, under community property law he was required to pay his former wife an amount equal to onehalf of the pension benefits that he had earned during the marriage. the tax court held that poe v. seaborn rather than lucas v. earl controlled, and thus he was entitled to exclude from gross income the amounts paid to his former wife. on appeal, the ninth circuit court of appeals reversed the tax court’s decision, and held that poe v. seaborn was not controlling. the payments were made out of post-divorce wages and were not an actual distribution of community property from the pension plan. because under california law, the wages paid to the former spouse were not community property, lucas v. earl was the controlling precedent. thus, the payments made to the former spouse by the taxpayer were not excludable from his income. • nor were the payments deductible as alimony under § 71. the taxpayer was required to make payments for as long as he was employed by the employer that provided the pension plan, even if his former wife died before his retirement. because the taxpayer’s liability did not terminate upon the payee’s death, the payments were not “alimony” within the meaning of § 71. • query whether a qualified domestic relations order (qdro) might have alleviated taxpayer’s distress? 5. labeling a payment in the divorce instrument as part of the division of marital property does not preclude the payment from being alimony. proctor v. commissioner, 129 t.c. 92 (10/10/07). pursuant to a divorce decree, upon his subsequent retirement from the navy, the taxpayer was required to pay his former wife 25 percent of his disposable retirement pay pursuant to the uniformed services former spouses’ protection act (usfspa), 10 u.s.c. § 1408. when taxpayer failed to comply, pursuant to further proceedings, he was ordered to pay his former wife $5,313 relating to her share of his retirement pay by the end of 2002. the irs argued that the payment of a share of taxpayer’s retirement pay was a division of marital property and did not qualify as alimony. judge foley held that the payments in discharge of the obligation were alimony, because (1) the divorce instrument did not designate the payment as a payment that was not includible in gross income and not allowable as a deduction, and (2) under usfspa the payments were to terminate upon the death of either party. judge foley rejected the irs’s argument that the payment was not alimony because the divorce decree referred to the payments as part of a division of the marital property. “the classification of a payment as part of 782 florida tax review [vol. 8:si the division of marital property does not, however, preclude the payment from being alimony.” 6. amarasinghe v. commissioner, t.c. memo. 2007333 (11/6/07). provisions in a divorce instrument requiring the husband to withdraw funds from his pension trust to pay alimony and child support were not a qdro because the instrument did not give the husband’s former wife any direct interest in the pension trust. rather, the order directed the husband to “cash out” a particular amount and pay it over his former wife. hawkins v. commissioner, 86 f.3d 982 (10th cir. 1996), was distinguished. alternatively, the purported qdro did not qualify because an order cannot be a qdro unless it is delivered to the pension trustee (karem v. commissioner, 100 t.c. 521 (1993)), which the instrument in this case was not. accordingly, husband was required to include the full distribution in gross income and was allowed to deduct the portion paid over to the former wife as alimony, and the wife was required to include only the portion of the payment that was alimony. g. education 1. up, up and away? no, the deduction goes down in flames. thompson v. commissioner, t.c. memo. 2007-174 (7/03/07). judge haines held that an aeronautical engineer could not deduct flight school expenses leading to a commercial pilot’s license, even though the taxpayer did not thereafter become a commercial pilot. even though commercial pilot training improved his engineering skills, the education qualified him for a new trade or business as a pilot. under reg. § 1.1625(b)(3)(ii) ex. (2), educational expenses incurred to qualify for a new trade or business are nondeductible even if the individual does not engage in the new activity. the mere capacity to engage in a new trade or business is sufficient to disqualify the expenses for the deduction. vi. corporations a. entity and formation there were no significant developments regarding this topic during 2007. b. distributions and redemptions 1. redemption that reduces shareholder’s interest by 0.22 percent is essentially equivalent to a dividend. conopco, inc. v. 2008] recent developments in federal income taxation 783 united states, 100 a.f.t.r.2d 2007-5296 (d. n.j. 7/18/07). conopco routinely redeemed shares of its voting preferred stock from its esop trust to fund distributions to employees. it claimed a deduction under § 404(k)(1) for the amount of the redemption proceeds on the grounds that the payments were deductible “applicable dividends,” because each redemption was so minor that it did not constitute a meaningful reduction under § 302(b)(1). the largest single redemption was 4,746 shares of approximately 2 million shares owned by the trust. that redemption reduced the trust’s proportionate interest in conopco from 2.7884 percent to 2.7809 percent. the court (judge greenaway) first held that the redemption was a dividend because it did not qualify under § 302(b)(1). the reduction in voting, dividend, and liquidation rights represented a reduction of only 7.5 thousandths of 1 percent. the court rejected the government’s argument that rev. rul. 76-385, 1976-2 c.b. 92, supported redemption treatment. that ruling held that a redemption that reduced a shareholder’s interest in a public corporation from 0.0001118 percent of 28 million shares to 0.0001081 percent, which was only a 3.7 millionths of 1 percent reduction, was sufficiently meaningful to warrant sale or exchange treatment under § 302. the court reasoned that in addition to the percentage decrease in the shareholder’s stock, the percentage decrease in the corporation’s outstanding stock also was relevant. while the number of shares redeemed in rev. rul. 76-385 was minuscule compared to the corporation’s 28 million shares, it constituted a 3.3 percent reduction in the shareholder’s already “minimal” holding of about approximately 31.304 shares (0.0001118 percent of 28 million equals 31.304 shares). in contrast, the 4,746-share redemption reduced the trust’s approximately 2 million-share holding by only 0.22 percent, a far less meaningful reduction as far as the trust was concerned. because the 4,746-share redemption did not meaningfully reduce the trust’s proportionate interest in conopco, none of the hundreds of other, smaller redemptions did so either. therefore, conopco’s distributions in redemption of stock from the trust were “essentially equivalent to a dividend,” and accordingly, they were dividends for purposes of the § 404(k)(1) deduction. however, the court went on to hold that because the distributions were made “in connection with the reacquisition of its stock,” the deduction was disallowed under § 162(k)(1). c. liquidations there were no significant developments regarding this topic during 2007. 784 florida tax review [vol. 8:si d. s corporations 1. t.d. 9302, prohibited allocations of securities in an s corporation, 71 f.r. 76134 (12/20/06). these final regulations provide guidance concerning requirements under § 409(p) for esops holding stock of s corporations. they provide that if there is a prohibited allocation during a nonallocation year, the esop fails to satisfy the § 4975(e)(7) requirement and is no longer an esop; as a result of this, the plan also would fail to satisfy the § 401(a) qualification rules and the s corporation would face a § 4979a excise tax. 2. alpert v. united states, 481 f.3d 404 (6th cir. 3/23/07). the circuit court upheld a summary judgment denying taxpayer’s attempt to claim discharge of indebtedness income, which would increase basis of subchapter s stock and thereby allow suspended losses barred by § 1366(d) under a bankruptcy case that was “substantially complete.” notwithstanding a receiver’s report that indicates that the bankrupt s corporation’s assets were insufficient to pay the debts, the court required an identifiable event that fixes the loss with certainty in order to trigger discharge of indebtedness income. the court required that the bankruptcy proceeding be completed to constitute the requisite identifiable event. 3. proposed regulations restrict the use of open account debt to increase basis and deduct losses. reg-144859-04, section 1367 regarding open account debt, 72 f.r. 18417 (4/12/07). prop. reg. § 1.1367-2(a), (c)(2), (d), & (e), ex. (6), would limit open account debt from an s corporation to a shareholder to debt not evidenced by written instruments for which the principal amount of aggregate advances, net of repayments, does not exceed $10,000 at the close of any day during the s corporation’s taxable year. the proposed regulations would reverse the result in brooks v. commissioner, t.c. memo. 2005-204 (8/25/05), which allowed an s corporation shareholder to borrow money from a bank, advance the funds to the shareholder’s s corporation which increased basis and allowed loss deductions, receive payment of the debt in the subsequent taxable year, repay the bank, then at the end of the year again borrow funds to avoid gain on release from the low basis debt and deduct further losses. thus the taxpayer was able to create endless deferral of gain. the preamble to the proposed regulations indicates that the purpose of the open account debt provisions is administrative simplicity. whenever advances not evidenced by written instruments exceed $10,000, the indebtedness will be treated as a separate indebtedness for which payments and advances are separately determined for purposes of basis and gain recognition on repayment. 2008] recent developments in federal income taxation 785 4. a bad day for the owner of new day. meeks v. united states, 99 a.f.t.r.2d 2007-2493 (w.d. la. 4/2/07). the taxpayer was the sole shareholder of an s corporation (new day) that had converted from a c corporation within the 10 preceding years. he timely filed his 1999 tax return, which included gain on the sale of certain assets of new day, on april 15, 2000. subsequently, the irs audited new day and asserted a deficiency for built-in gains tax under § 1374. on december 29, 2003, new day and the irs settled by agreeing that new day owed $713,780.00 of built-in gains tax for the 1999 taxable year. on january 12, 2004, less than one month after the new day settlement, but more than 3 years after the taxpayer filed his individual return for 1999, the taxpayer filed an amended return reflecting a $735,194.00 reduction in personal taxable income due to the built-in gain tax paid by new day (§ 1366(f)(2)) seeking a refund of $151,236. the irs denied the refund claim as untimely. the court sustained the government’s position and held that the doctrine of equitable recoupment was not applicable to provide an independent basis for jurisdiction. the court is not unsympathetic to the arguably inequitable and harsh result in this case. however, in the field of taxation, statutes of limitation sometimes enure to the benefit of the government, and at other times they work to the taxpayer’s advantage. ... the instant plaintiffs are also not entirely free from fault. the internal revenue code contains provisions for extending the limitations period upon mutual agreement of the parties. see, 26 u.s.c. §§ 6501(c)(4) & 6511(c), yet there is no indication that the taxpayers here availed themselves of that opportunity during the pendency of the proceedings against new day. 5. esbt allowed to deduct acquisition indebtedness from its share of s corporation income. for tax years beginning after 12/31/06, the 2007 act, § 8236(a), amends code § 641(c)(2) to allow an electing small business trust (a permitted s corporation shareholder) to deduct interest paid on debt incurred to acquire the s corporation stock against its share of s corporation taxable income. an esbt is taxable at the top corporate rate on its share of s corporation income. thus, the interest deduction offsets income at the highest rate. 6. qsub stock sale treated as an asset sale. the 2007 act, § 8234(a), amends code § 1361(b)(3)(c)(ii), to provide that failure to meet the 100 percent ownership requirement to qualify an s corporation subsidiary as a qsub because of a stock sale will cause the stock sale to be treated as a sale of qsub assets in proportion to the stock sale. the deemed 786 florida tax review [vol. 8:si asset sale is followed by a deemed § 351 transfer of assets and assumption of liabilities by the former qsub. the legislative history states that where the s corporation sells 21 percent of the stock, it will be treated as selling 21 percent of the qsub assets. section 351 will apply to the transaction (even though there is a loss of control), so gain is limited to 21 percent. 7. s corporation passive investment income no longer includes gains on sales of stocks and securities. the 2007 act, § 8231(a), amends code § 1362(d)(3)(c) to exclude gain from the sale of stock or securities from the definition of passive investment income of an s corporation with earnings and profits for purposes of the § 1375 tax and termination of s status under § 1362(d)(3). the § 1375 tax is imposed on an s corporation with earnings and profits if it has passive investment income in excess of 25 percent of gross receipts. section 1362(d)(3) will cause termination of the s election if that situation occurs for three consecutive taxable years. 8. pre-1983 s corporation earnings and profits disappear. the 2007 act, § 8235, provides that a corporation that was not an s corporation for its first taxable year beginning after 12/31/96, may reduce accumulated earnings and profits by an amount equal to the portion of any e&p accumulated in pre-1983 s corporation years. the small business job protection act of 1996 had already eliminated pre-1983 s corporation e&p for a corporation that was an s corporation for its first taxable year beginning after 12/31/96. 9. a little help for s corporation banks. the 2007 act, § 8233, allows banks that elect s corporation status to account for § 481 adjustments incurred because of a change in the reserve method for bad debts in the first taxable year for which the s election is in effect. section 8232(a) of the 2007 act amends code § 1361(f)(2)(a) to provide that restricted stock held by an individual in order to serve as a bank director will not be treated as a second class of stock. distributions on such stock are includible in income by the holder and deductible by the s corporation. 10. new additional simplified (and free) method to request relief for late s corporation elections. rev. proc. 2007-62, 200741 i.r.b. 786 (10/9/07). this revenue procedure supplements rev. proc. 2003-43, 2003-1 c.b. 998, and rev. proc. 2004-48, 2004-2 c.b. 172, and provides an additional simplified method for certain eligible entities to request relief for late s corporation elections and late entity classification elections. the procedures are in lieu of the letter ruling process ordinarily used to obtain relief for a late s corporation election and a late corporate 2008] recent developments in federal income taxation 787 classification election filed pursuant to § 1362(b)(5), regs. §§ 301.9100-1 and 301.9100-3. thus, user fees do not apply to corrective actions under this revenue procedure. 11. proposed regulations implementing the evereasing standards for qualifying as an s. reg-143326-05, s corporation guidance under ajca of 2004 and goza of 2005, 72 f.r. 55132 (9/28/07). the treasury has published proposed amendments to various regulations under subchapter s, including, among others, prop. regs. §§ 1.1361-1(e) (number of shareholders); 1.1361-1(h) (special rules relating to trusts eligible to be shareholders); 1.1361-1(m) (esbts); 1.1361-4 (inadvertent terminations and inadvertently invalid elections); and 1.1366-2 (limitations on deduction of passed-though losses). • the entire state of arkansas counts as one shareholder. section 403(b) of goza amended § 1361(c)(1)(b)(iii) to apply the test for qualifying members of a family with a common ancestor not more than six generations removed to the latest of (1) the date the s election is made, (2) the earliest date an individual who is a “member of the family” holds stock in the s corporation, or (3) october 22, 2004. prop. reg. § 1.13611(e)(3) clarifies that the “six generation” test is applied only at the date specified in § 1361(c)(1)(b)(iii) and thereafter has no continuing significance in limiting the number of generations of a family that may hold stock and be treated as a single shareholder. • section 234 of ajca amended § 1361(e)(2) to provide that in determining an esbt’s potential current beneficiaries (pcbs), powers of appointment are disregarded if not exercised by the end of that period. also, the period during which an esbt may safely dispose of s corporation stock after an ineligible shareholder becomes a pcb was increased from 60 days to one year. prop. reg. § 1.1361-1(m)(2)(vi) reflects these changes. all members of a class of unnamed charities permitted to receive distributions under a discretionary distribution power held by a fiduciary that is not a power of appointment, will be considered, collectively, to be a single pcb for purposes of determining the number of permissible shareholders, unless the power is actually exercised, in which case each charity that actually receives distributions will also be a pcb. a power to add beneficiaries, whether or not charitable, to a class of current permissible beneficiaries is generally a power of appointment and thus will be disregarded to the extent it is not exercised. fiduciary powers to spray trust distributions to a class of current beneficiaries or possible current beneficiaries are not “powers of appointment,” and thus every member of the class remains a pcb, whether or not receiving a distribution. • proposed amendments to reg. § 1.13624 implement 1996 amendments to § 1362(f), which provide relief for 788 florida tax review [vol. 8:si corporations with inadvertently invalid s corporation elections (in addition to the relief previously available for inadvertent terminations of valid s corporation elections). section 238 of ajca amended § 1362(f) to provide that qsubs are eligible for relief for an inadvertent invalid qsub election or termination under the same standards applied to an inadvertent invalid s corporation election or termination. the proposed regulations would make conforming changes to reg. § 1.1362-4. • section 235 of ajca amended § 1366(d)(2) to provide that if the stock of an s corporation is transferred between spouses or incident to divorce under § 1041(a), any loss or deduction with respect to the transferred stock that could not be taken into account by the transferring shareholder in the year of the transfer because of the basis limitation in § 1366(d)(1) is treated as incurred by the corporation in the succeeding taxable year with regard to the transferee. proposed amendments to reg. § 1.1366-2(a)(5) would implement this exception to the general rule of nontransferability of losses and deductions. losses and deductions carried over to the year of transfer that are not used by the transferor spouse in that year will be prorated between the transferor spouse and the transferee spouse based on their stock ownership at the beginning of the succeeding taxable year. e. reorganizations 1. all cash (d) reorganizations are now in the regulations. t.d. 9303, corporate reorganizations; distributions under sections 368(a)(1)(d) and 354(b)(1)(b), 71 f.r. 75879 (12/19/06). the treasury has promulgated temporary regulations that provide guidance regarding the qualification of certain transactions as reorganizations described in § 368(a)(1)(d) where no stock and/or securities of the acquiring corporation is issued and distributed in the transaction. this is because under the circumstances of ownership by the same persons in the same proportions, the issuance of stock is a “meaningless gesture.” temp. reg. § 1.368-2t provides that the distribution requirement under §§ 368(a)(1)(d) and 354(b)(1)(b) is deemed to have been satisfied despite the fact that no stock and/or securities are actually issued in a transaction otherwise described in § 368(a)(1)(d) if the same person or persons own, directly or indirectly, all of the stock of the transferor and transferee corporations in identical proportions. to a limited extent, the attribution rules in § 318 are invoked to determine whether the same person or persons own, directly or indirectly, all of the stock of the transferor and transferee. an individual and all members of his family that have a relationship described in § 318(a)(1) are treated as one individual; and stock owned by a corporation is attributed proportionally to the corporation’s shareholder without regard to the 50 percent limitation in § 318(a)(2)(c). 2008] recent developments in federal income taxation 789 • ownership in absolutely identical proportions is not required. a de minimis variation in shareholder identity or proportionality of ownership in the transferor and transferee corporations is disregarded. the regulations give as an example of a de minimis variation a situation in which a, b, and c each own, respectively, 34%, 33%, and 33% of the transferor’s stock and a, b, c, and d each own, respectively, 33%, 33%, 33%, and 1% of the transferee’s stock. stock described in § 1504(a)(4) – nonvoting limited preferred stock (that is not convertible) – is disregarded for purposes of determining whether the same person or persons own all of the stock of the transferor and transferee corporations in identical proportions. • when a transaction qualifies as a § 368(a)(1)(d) reorganization under the regulations, a nominal share of stock of the transferee corporation will be deemed to have been issued in addition to the actual consideration. that nominal share of stock is deemed to have been distributed by the transferor corporation to its shareholders and, in appropriate circumstances, further transferred to the extent necessary to reflect the actual ownership of the transferor and transferee corporations. • reg-125632-06, corporate reorganizations; distributions under sections 368(a)(1)(d) and 354(b)(1)(b), 71 f.r. 75898 (12/19/06). identical proposed regulations have been published by cross-reference. a. guidance is amended to eliminate an unintended glitch. t.d. 9313, corporate reorganizations; additional guidance on distributions under sections 368(a)(1)(d) and 354(b)(1)(b), 72 f.r. 9262 (3/1/07). under previous guidance, there may have been the unintended consequence of causing related party triangular c reorganizations to be treated as d reorganizations, with the voting stock of the corporation in control of the acquiring corporation being treated as boot; they also may cause forward subsidiary mergers to be disqualified by the deemed issuance of a nominal share of stock of the acquiring corporation (not permitted under § 368(a)(2)(d)(i)). consequently, these transactions are excepted under the amended regulations. • reg-157834-06, corporate reorganizations; additional guidance on distributions under sections 368(a)(1)(d) and 354(b)(1)(b), 72 f.r. 9284 (3/1/07). proposed regulations were published by cross-reference. 2. section 357(c)(1) does not apply to acquisitive reorganizations because the transferor corporation no longer exists and cannot be enriched by the assumption of its liabilities. rev. rul. 2007-8, 2007-7 i.r.b. 469 (2/12/07). section 357(c)(1) does not apply to transactions that qualify as reorganizations described in §§ 368(a)(1)(a), 790 florida tax review [vol. 8:si (c), (d) (provided the requirements of § 354(b)(1) are satisfied), or (g) (provided the requirements of § 354(b)(1) are satisfied) and to which § 351 applies. rev. rul. 75-161, 1975-1 c.b. 114, and rev. rul. 76-188, 1976-1 c.b. 99, are obsolete. rev. rul. 78-330, 1978-2 c.b. 147, is modified to the extent it holds that § 357(c)(1) is applicable to a transaction that qualifies as a reorganization described in § 368(a)(1)(a) or (d) (that satisfies the requirements of § 354(b)(1)). 3. when to measure the value of consideration to determine whether continuity of interest exists: it is the business day before the day on which the binding contract is entered into. continuity of interest regulations revised. t.d. 9316, corporate reorganizations; guidance on the measurement of continuity of interest, 72 f.r. 12974 (3/20/07). this treasury decision promulgates temporary and proposed regulations, temp. reg. § 1.368-1t(e)(2), amending the 2005 continuity of interest regulations, reg. § 1.368-1(e). under the 2005 regulations, the value of consideration received in a reorganization for purposes of determining whether shareholders received a sufficient proprietary interest in the acquiring corporation was to be determined as of the last business day before the contract is binding. the temporary regulations apply the signing date value only where the contract provides for a fixed consideration. the definition of fixed consideration is modified to provide that consideration is fixed where the contract specifies the number of shares of the issuing corporation to be exchanged for all or each proprietary interest in the target corporation. definitions referring to the percentage of proprietary interests are deleted. the temporary regulations treat transactions that allow for shareholder elections as providing for fixed consideration regardless of whether the agreement specifies a maximum amount of money or a minimum amount of stock of the issuing corporation. (in any event the shareholders are subject to the economic fortunes of the issuing corporation as of the signing date.) the rule that modifications of the contract that increase the number of shares to be issued does not change the signing date is broadened to also state that a modification that decreases the amount of cash or other property to be issued also does not change the signing date. the temporary regulations also tighten the contingent consideration rules by providing that a contract will not be treated as providing a fixed consideration if provisions for contingent consideration prevent the target shareholders from being subject to the economic benefits and burdens of ownership of the issuing corporation as of the signing date. finally, the temporary regulations provide that the signing date value must be adjusted to take into account the effect of any anti-dilution clause adjustments to reflect changes in the issuing corporation capital structure. 2008] recent developments in federal income taxation 791 4. making post-reorganization intra-group restructurings even easier. t.d. 9361, corporate reorganizations; transfers of assets or stock following a reorganization, 72 f.r. 60552 (10/25/07), making final reg-130863-04, corporate reorganizations; transfers of assets or stock following a reorganization, 69 f.r. 51209 (8/18/04). the treasury has finalized regulations dealing with (1) the continuity of business enterprise requirement (reg. § 1.368-1(d)) and (2) the definition of a “party to a reorganization” requirement (reg. § 1.368-2(f)) to liberalize the rules regarding permissible post-acquisition restructurings of acquiring corporations in a controlled group of corporations. in addition to post acquisition drops of assets to lower-tier subsidiaries, certain post-acquisition distributions by an acquisition subsidiary that is member of the acquiring corporation’s group to a corporation that controls the acquiring corporation of either the target corporation’s stock (following a § 368(a)(1)(b) or § 368(a)(2)(e) reorganization) or assets (following a § 368(a)(1)(a), § 368(a)(1)(c), or § 368(a)(2)(e) reorganization), and certain cross chain transfers, subsequent to the acquisition, do not disqualify the acquisition from reorganization treatment, even though there is no statutory provision expressly providing that such distributions do not affect the validity of reorganization treatment, provided that the distribution would not result in the distributing corporation being treated as liquidated for income tax purposes. the regulations thus permit the acquiring corporation to significantly rearrange ownership of the target corporation’s assets or stock, as the case may be, among the members of its qualified group (based on § 368(c) control) without disqualifying the reorganization. furthermore, the final regulations (reg. § 1.368-1(d)(4)(ii)), unlike the proposed regulations, permit qualified group members to aggregate their direct stock ownership of a corporation, in a manner similar to aggregation under § 1504(a), in determining whether they have the requisite § 368(c) control of such corporation (provided that the issuing corporation has § 368(c) control in at least one other corporation). 5. proposed amendments to regulations governing the marriage of accounting methods in tax-free reorganizations. reg151884-03, update and revision of sections 1.381(c)(4)-1 and 1.381(c)(5)1, 72 f.r. 64545-02 (11/16/07). the treasury department has published proposed amendments to reg. §§ 1.381(c)(4)-1 and 1.381(c)(5)-1, dealing with the carryover of tax attributes, including accounting and inventory methods, in corporate reorganizations and tax-free § 332 liquidations. generally, following a § 381(a) transaction, the accounting method or combination of methods used by the parties to the transaction would continue to be used. if the businesses of the parties to a § 381(a) transaction are combined by the surviving party and different methods have been used, 792 florida tax review [vol. 8:si then the principal and special method (including the inventory method) rules would apply. however, when the prior accounting methods cannot be continued after the transaction, reg. § 1.381(c)(4)-1 would identify the accounting method to be used after the transaction; reg. §1.381(c)(5)-1 would provide similar rules regarding inventory accounting methods. “[t]he current regulations are inconsistent in the treatment of adjustments for inventory methods and for other accounting methods, and that there is confusion regarding the appropriate procedure for making accounting method changes required by section 381.” the proposed amendments generally would continue many of the provisions of the existing regulations regarding the accounting method or combination of methods to be used by the corporation that acquires the assets of another corporation in a § 381(a) transaction, but are designed to eliminate confusion and uncertainty and to provide simplicity and uniformity. unlike the current regulations, the proposed regulations have a default rule to determine the principal method if there is no principal method. f. corporate divisions 1. tipra § 202 amended code § 355(b) to simplify the active trade or business test by looking at all corporations in the distributing corporation’s and the distributed subsidiary’s affiliated groups to determine if the active trade or business test is satisfied. a. the tax relief and health care act of 2006, § 410, made the tipra modification to § 355(b) permanent. b. proposed regulations to carry out the amendment are anything but simple. reg-123365-03, guidance regarding the active trade or business requirement under section 355(b), 72 f.r. 26012 (5/8/07). for purposes of determining whether the active business requirement of § 355(b)(1) has been met, prop. reg. § 1.355-3(b) would treat all of the members of a separate affiliated group (sag) as a single corporation. thus, the subsidiaries of the common parent of a sag are treated as divisions of the common parent for purposes of determining whether either the distributing or controlled sag is engaged in a qualified trade or business. • a corporation’s sag is the affiliated group that would be determined under § 1504(a) if the corporation were the common parent (and § 1504(b) did not apply). thus, the separate affiliated group of the distributing corporation (dsag)7 is the affiliated group consisting of the distributing corporation and all of its affiliated corporations. 7. this acronym has no relationship to cooper’s droop syndrome. 2008] recent developments in federal income taxation 793 the separate affiliated group of a controlled corporation (csag) is determined in a similar manner, but by treating the controlled corporation as the common parent. accordingly, prior to a distribution, the dsag includes csag members if the ownership requirements are met. prop. reg. § 1.3553(b)(1)(iii). • the sag rule is applied for purposes of determining whether a corporation has conducted a trade or business throughout the requisite five-year period preceding the distribution and whether the distributing and controlled corporations are actively conducting a trade or business following distribution. these proposed regulations will affect the application of the active business requirement in a number of respects. • first, if ownership requirements are met, members of the distributing corporation sag and the controlled corporation sag will be treated as belonging to a single sag during the pre-distribution period, which facilitates identifying the appropriate trades or businesses regardless of how the assets are distributed among the sag members. prop. reg. § 1.355-3(b)(3)(i). • second, the sag rule applies for purposes of determining whether there has been a taxable acquisition of the trade or business within the five years preceding the distribution under § 355(b)(2)(c) or (d). because, the subsidiaries of the common parent of a sag are treated as divisions of the common parent, a stock acquisition of a corporation that becomes a member of a sag is treated as an asset acquisition (which affects the application of § 355(b)(2)(d) regarding acquisition of control of a corporation conducting an active business). prop. reg. § 1.3553(b)(1)(ii). • third, prop. reg. § 1.355-3(b)(4)(iii) would permit certain taxable acquisitions of the assets of a trade or business by the distributing corporation without violating the restrictions of § 355(b)(2)(c) and (d), which are interpreted as preventing the use of the assets of distributing to acquire a trade or business in lieu of dividend distributions. the proposed regulations disregard a taxable acquisition by the controlled sag from the distributing sag, disregard the use of cash to pay off fractional shares, and to a limited extent, disregard taxable acquisitions from members of the same sag. however, the proposed regulations do not disregard the recognition of gain or loss in transactions between affiliated corporations unless the affiliates are members of the same sag. (analogous to current regulations, taxable acquisitions to expand an existing business within a sag are disregarded. prop. reg. § 1.355-3(b)(3)(ii)). • fourth, application of § 355(b)(2)(d)(i) (control acquired by any distributee corporation) would be limited to situations designed to avoid the impact of the repeal of the general utilities doctrine. 794 florida tax review [vol. 8:si thus, the proposed regulations allow a taxable acquisition by a distributee corporation of control of distributing in a transaction where the basis of the acquired distributing stock is determined in whole or by reference to the transferor’s basis. prop. reg. § 1.355-3(b)(4)(iii)(c). • fifth, the proposed regulations interpret §§ 355(b)(2)(c) and (d) to have the common purpose of preventing the direct or indirect acquisition of the trade or business (to be relied on a distribution to which § 355 would otherwise apply) by a corporation in exchange for assets other than its stock. thus, if (1) a dsag member or controlled acquires the trade or business solely for distributing stock, (2) distributing acquires control of controlled solely for distributing stock, or (3) controlled acquires the trade or business from distributing solely in exchange for stock of controlled, in a transaction in which no gain or loss was recognized, §§ 355(b)(2)(c) and (d) are satisfied. however, if the trade or business is acquired in exchange for assets of distributing (other than stock of a corporation in control of distributing used in a reorganization) §§ 355(b)(2)(c) and (d) are not satisfied. under this rule, for example, an acquisition by a controlled corporation (while controlled by the distributing corporation) from an unrelated party in exchange for controlled stock has the effect of an indirect acquisition by distributing in exchange for distributing’s assets. such an acquisition violates the purpose of § 355(b)(2)(c), and will be treated as one in which gain or loss is recognized. prop. reg. § 1.355-3(b)(4)(ii). c. transition relief from § 355 sag regulations. notice 2007-60, 2007-35 i.r.b. 466 (8/27/07). this notice provides transition relief to taxpayers applying §§ 355(b)(2)(c) and 355(b)(2)(d) and reg. § 1.355-3(b)(4)(iii) to certain transactions that would be adversely affected by the changes to the active business requirement for § 355 tax-free divisions in these provisions. • first, reg. § 1.355-3(b)(4)(iii) provides an exception to the general no gain or loss rule in § 355(b)(2)(c) and (d) by disregarding an acquisition of a trade or business by one member of an affiliated group from another member of the group. (although reg. § 1.3553(b)(4)(iii) is facially applicable to distributions on or before 12/15/87, the irs has applied it administratively to distributions occurring after that date). the preamble to the proposed sag regulations questioned whether reg. § 1.3553(b)(4)(iii) appropriately reflects § 355(b) as amended in 2006. this notice announced that consistent with past administrative practice, the irs will not challenge the application of the rule in reg. § 1.355-3(b)(4)(iii) to distributions effected on or before the date of publication in the federal register of temporary or final regulations modifying that rule. • second, the proposed regulations would treat a stock acquisition that results in the acquired corporation becoming a 2008] recent developments in federal income taxation 795 subsidiary member of the acquiring corporation’s sag as an asset acquisition for purposes of § 355(b). as a result, acquisitions of stock of the controlled corporation that result in the controlled corporation becoming a member of the distributing corporation’s sag are treated as asset acquisitions subject to § 355(b)(2)(c) regardless of whether the distributing corporation already controlled the controlled corporation. such an acquisition could violate § 355(b)(2)(c) notwithstanding the fact that it would not violate § 355(b)(2)(d) because there was no acquisition of control. this notice provides that the irs will not challenge the distributing corporation’s (or its sag’s) acquisition of additional stock of the controlled corporation as a violation of § 355(b)(2)(c) with respect to the controlled corporation in the case of distributions effected on or before the date the temporary or final regulations are published, provided that the transaction satisfies the requirements of § 355(b)(2)(d) as in effect before the enactment of § 355(b)(3). 2. rev. rul. 2007-42, 2007-28 i.r.b. 44 (6/21/07). a distributing corporation that owns a 33-1/3 percent interest in an llc, which is engaged in owning and managing office buildings, is engaged in the active conduct of a trade or business. however, a 20 percent ownership interest in an llc is not sufficient to enable the corporate llc member to treat the llc’s activities as the active conduct of a trade or business by the corporation. g. miscellaneous corporate issues 1. tax court holds that you do not have to be a cpa to practice “accounting.” rainbow tax service, inc. v. commissioner, 128 t.c. 42 (3/8/07). tax return preparation and bookkeeping services by a corporation that is neither a public accounting firm nor the performer of services that require its employees to hold cpa licenses is nevertheless a “qualified personal service corporation” as defined under § 448(d)(2) because it performs “accounting services.” therefore, its income is taxed at the flat 35 percent rate under § 11(b)(2), not at the graduated rates claimed by taxpayer. the tax court (judge swift) noted the distinction between “public accounting” and “accounting,” and noted that tax return preparation and bookkeeping services are services in the field of accounting. • note that veterinarians are considered to perform services in the field of “health.” rev. rul. 91-30, 1991-1 c.b. 61. a. and yet another 35 percent rate psc. w.w. eure, m.d., inc. v. commissioner, t.c. memo. 2007-124 (5/17/07). a 796 florida tax review [vol. 8:si corporation that was wholly owned by a radiation oncologist/surgeon and which operated a radiation therapy medical practice was a professional service business subject to the 35 percent tax rate under § 11(b)(2), because 95 percent or more of its employee’s time was spent providing healthcare directly to patients or performing ancillary services. 2. taking from the big and contributing to the small does not produce excluded contributions to capital. united states v. coastal utilities, inc., 483 f.supp.2d 1232 (s.d. ga. 3/28/07). summary judgment was granted to the government denying a utility’s refund claim based on its assertion that payments received from the universal service administration company and the state of georgia access funds were contributions to capital excluded from gross income under § 118. the payments were part of state and federally mandated programs funded by fees collected from telecommunications carriers based on revenues. payments are made to carriers with high cost obligations to provide universal access to telephone services. based on undisputed facts, and following an in-depth analysis of the relevant authorities distinguishing non-shareholder contributions to capital from gross income, the district court concluded that the purpose of the payments was to supplement income. the court focused on the mechanisms used to calculate the amount of universal support, which, although largely related to investment expenditures, took into account operation, maintenance, administrative, and other expenses that were unrelated to capital investment. a. the irs concludes the same by ruling. rev. rul. 2007-31, 2007-21 i.r.b. 1275 (5/21/07). the irs ruled that universal service support payments received are not a non-shareholder contribution to capital under § 118(a). b. and the eleventh circuit agrees too. coastal utilities is affirmed. united states v. coastal utilities, 514 f.3d 1184 (11th cir. 1/23/2008). the eleventh circuit adopted in full the district court’s order. 3. debt treated as equity results in a constructive dividend. hubert enterprises, inc. v. commissioner, 230 f.app’x 526 (6th cir. 4/27/07). hubert enterprises, a closely held family corporation, advanced funds to an llc owned by family members, which in turn was the 97 percent general partner in a real estate development partnership. the partnership had difficulty acquiring financing for its development project. the $2.4 million note had no fixed maturity date, was a demand note, was not secured, and called for interest payable at the applicable federal rate. the 2008] recent developments in federal income taxation 797 borrower made only one payment of interest on the note. the sixth circuit affirmed the tax court holding denying the taxpayer’s claimed bad debt deduction under § 166 for the worthless note. the court affirmed the tax court’s conclusion that the note was equity under the factors specified in the sixth circuit’s opinion in roth steel tube co. v. commissioner, 800 f.2d 625 (6th cir. 1986). further, the sixth circuit also affirmed the tax court holding that the corporation was not entitled to deduct the amount advanced to the llc as a loss of capital because the advance represented a constructive dividend conferring an economic benefit on its shareholders (the owners of the llc). the corporation retained no ownership interest in the llc. 4. tightening the belt (noose?) on § 382 limitations. t.d. 9330, built-in gains and losses under section 382(h), 72 f.r. 32792 (6/14/07). temp. reg. § 1.382-7t(a) provides that prepaid income received before a change date that is attributable to services performed after the change date is not recognized built-in gain for purposes of computing the § 382 limitations on nol carryovers following an ownership change. the term prepaid income means any amount received prior to the change date that is attributable to performance occurring on or after the change date. examples to which the temporary regulation applies include, but are not limited to, income received prior to the change date that is deferred under § 455, reg. § 1.451–5, or rev. proc. 2004–34 (or any successor revenue procedure). according to the preamble: the irs and treasury department believe that prepaid income is distinguishable from the income items described in the committee report examples. in each of the committee report examples, the item of income is attributable to the pre-change period because that is the period in which performance occurred and expenses were incurred to earn the income. by contrast, prepaid income is attributable to the post-change period because that is the period in which performance occurred and expenses were incurred to earn the income. therefore, because prepaid income is attributable to the post-change period rather than the prechange period ... such prepaid income should not be treated as [recognized built-in gain] under section 382(h). • identical regulations have been published in proposed form. reg–144540–06, built-in gains and losses under section 382(h), 72 f.r. 32828 (6/14/07). 798 florida tax review [vol. 8:si 5. corporate estimated tax regulations. t.d. 9347, corporate estimated tax, 72 f.r. 44338 (8/7/07). the treasury has promulgated final regulations regarding corporate estimated tax payments to reflect numerous statutory changes since 1984. reg. §§ 1.6425-2; 1.6425-3; 1.6655-1; 1.6655-2; 1.6655-3; 1.6655-4; 1.6655-5; 1.6655-6; 1.6655-7. the regulations address a variety of annualization issues, e.g., items that are generally incurred once or infrequently during tax year are not annualized, allow taxpayers to make reasonable allocations of certain items, the adjusted seasonal installment method, “large corporation” status, short taxable years, accounting method changes, and additions to tax. these regulations apply to taxable years beginning after 9/6/07. h. affiliated corporations and consolidated returns 1. what hath rite-aid wrought? reg-157711-02, proposed rules, unified rule for loss on subsidiary stock, 72 f.r. 2964 (1/23/07). proposed regulations would completely replace the current basis adjustment and loss suspension rules in reg. §§ 1.337(d)-2 and 1.1502-35. prop. reg. § 1.1502-36 would provide “unified rules for loss on subsidiary stock” transferred by a member of an affiliated group filing a consolidated return. a transfer of stock includes any event in which (1) gain or loss would be recognized (apart from the rules in the proposed regulations), (2) the holder of a share and the subsidiary cease to be members of the same group, (3) a nonmember acquires an outstanding share from a member, or (4) the share is treated as worthless. the purpose of these rules is twofold, to prevent the consolidated return provisions from creating non-economic losses on the sale of subsidiary stock and to prevent members of the affiliated group filing the consolidate return from claiming more than one tax benefit from a single economic loss. under the proposed regulations, any transfer of a loss share (defined as a share of stock of an affiliate having a basis in excess of fair market value) requires the application in sequence of three basis rules. • first, a basis redetermination rule, under prop. reg. § 1.1502-36(b) is applied to deal with tax losses attributable to investment adjustment account allocations among different shares of stock under reg. § 1.1502-32 that result in disproportionate reflection of gain or loss in shares. second, if any share is a loss share after application of the basis redetermination rule, a basis reduction rule is applied under prop. reg. § 1.1502-36(c) to deal with loss duplication attributable to investment adjustment account adjustments, but this reduction does not exceed the share’s “disconformity amount.” third, if any duplicated losses remain after application of the basis reduction rule, under prop. reg. § 1.1502-36(d) an attribute reduction rule is applied to the corporation the stock of which was 2008] recent developments in federal income taxation 799 sold to prevent the duplication of a loss recognized on the transfer or preserved in the basis of the stock. if a chain of subsidiaries is transferred (rather than a single subsidiary) the order in which the rules are applied is modified. in this case, the basis redetermination rule and basis reduction rule are applied sequentially working down the chain, and the attribute reduction rule is then applied starting with the lowest tier subsidiary and working up the chain. • the basis redetermination rule. under the basis redetermination rule in prop. reg. § 1.1502-36(b), investment adjustments (exclusive of distributions) that were previously applied to members’ bases in subsidiary stock are reallocated in a manner that, to the greatest extent possible, first eliminates loss on preferred shares and then eliminates basis disparity on all shares. this rule affects both positive and negative adjustments, and thus addresses both noneconomic and duplicated losses. first, positive investment adjustments (up to the amount of the loss) are eliminated from the bases of transferred loss shares. second, to the extent of any remaining loss on the transferred shares, negative investment adjustments are removed from shares that are not transferred loss shares and are applied to reduce the loss on transferred loss shares. third, the positive adjustments removed from the transferred loss shares are allocated to increase basis of other shares only after the negative adjustments have been reallocated. note that this rules does not affect the aggregate basis of the shares, and thus has no impact, and thus does not apply, if all of the shares of a subsidiary are sold; it is important only when some, but not all, shares are sold. a number of special limitations on basis reallocation also must be considered in various specific circumstances. • the basis reduction rule. if, after applying the basis redetermination rule in step one, any transferred share is a loss share (even if the share only became a loss share as a result of the application of the basis redetermination rule), the basis of that share is subject to reduction. the basis reduction rule in prop. reg. § 1.1502-36(c) eliminates noneconomic losses that arise from the operation of the investment adjustment account rules. under this rule, the basis of each transferred loss share is reduced (but not below its value) by the lesser of (1) the share’s disconformity amount, or (2) the share’s net positive adjustment. • the “disconformity amount” with respect to a subsidiary’s share is the excess of its basis over the share’s allocable portion of the subsidiary’s inside tax attributes (determined at the time of the transfer). every share within a single class of stock has an identical allocable portion. between shares of different classes of stock, allocable portions are determined by taking into account the economic arrangements represented by the terms of the stock. “net inside attributes” is the sum of the subsidiary’s loss carryovers, deferred deductions, cash, and asset basis, minus 800 florida tax review [vol. 8:si the subsidiary’s liabilities. the disconformity amount identifies the net amount of unrealized appreciation reflected in the basis of the share. • a share’s net positive adjustment is computed as the greater of (1) zero, or (2) the sum of all investment adjustments (excluding distributions) applied to the basis of the transferred loss share, including investment adjustments attributable to prior basis reallocations under the basis reallocation rule. the net positive adjustment identifies the extent to which a share’s basis has been increased by the investment adjustment provisions for items of income, gain, deduction, and loss (whether taxable or not) that have been taken into account by the group. special rules apply when the subsidiary, the stock of which is transferred itself, holds stock of a lower-tier subsidiary. • the attribute reduction rule. if any transferred share remains a loss share after application of the basis reallocation and basis reduction rules, the loss on the transferred share is allowed. however, in this instance, the subsidiary’s tax attributes (including the consolidated attributes, e.g., loss carryovers, attributable to the subsidiary) are reduced pursuant to prop. reg. § 1.1502-36(c). the attribute reduction rule addresses the duplication of loss by members of consolidated groups, and is designed to prevent the group from recognizing more than one tax loss with respect to a single economic loss, regardless of whether the group disposes of the subsidiary stock before or after the subsidiary recognizes the loss with respect to its assets or operations. • under the attribute reduction rule, the subsidiary’s attributes are reduced by the “attribute reduction amount,” which equals the lesser of (1) the net stock loss, or (2) the aggregate inside loss. the “attribute reduction amount” reflects the total amount of unrecognized loss that is reflected in both the basis of the subsidiary stock and the subsidiary’s attributes. “net stock loss” is the amount by which the sum of the bases (after application of the basis reduction rule) of all of the shares in the subsidiary transferred by members of the group in the same transaction exceeds the value of those shares. the subsidiary’s “aggregate inside loss” is the excess of its net inside attributes over the value of all of the shares in the subsidiary. (net inside attributes generally has the same meaning as in the basis reduction rule, subject to special rules for lower-tier subsidiaries.) • the attribute reduction amount is first applied to reduce or eliminate items that represent actual realized losses, such as operating loss carryovers, capital loss carryovers, and deferred deductions. any excess attribute reduction amount is then applied to reduce the basis of any publicly traded property (other than lower-tier subsidiary stock, which is subject to special rules) held by the subsidiary. last, any remaining attribute reduction amount is applied to proportionately reduce the basis in assets, other than publicly traded property and cash and equivalents neither of which can 2008] recent developments in federal income taxation 801 reflect loss). if the attribute reduction amount exceeds all of the attributes available for reduction, that excess amount generally has no effect. if, however, cash or other liquid assets are held to fund payment of a liability that has not yet been deducted but will be deductible in the future, e.g., a liability the deduction for which is subject to the economic performance rules of § 451(h), loss could be duplicated later, when the liability is taken into account. to prevent such loss duplication, the excess attribute reduction amount will be held in suspense and applied to prevent the deduction or capitalization of later payments with respect to the liability. additional special rules apply to prevent excessive reduction of attributes when the subsidiary itself holds stock of a lower-tier subsidiary. • finally, if the subsidiary ceases to be a member of the consolidated group as a result of the transfer, the common parent of the group can elect to reduce stock basis (thereby reducing an otherwise allowable loss on the sale of the stock), reattribute attributes, or apply some combination of basis reduction and attribute reattribution alter the otherwise required attribute reduction. • worthlessness. the proposed regulations would not remove reg. § 1.502-80(c), dealing with worthlessness of subsidiary stock. 2. t.d. 9341, treatment of excess loss accounts, 72 f.r. 39313 (7/18/07). two final consolidated return regulations have been promulgated. • reg. § 1.1502-19(d) (replacing temp. reg. § 1.1502-19t(d)) provides that, if a member of a consolidated group acquires new shares of a subsidiary that would have an excess loss account and the member owns one or more other shares of the same class of subsidiary stock, the basis of the other shares is allocated to the new shares to eliminate or to equalize any excess loss account that would otherwise be attributable to the new shares. • reg. § 1.1502-80(c) (replacing temp. reg. § 1.1502-80t(c)) provides that subsidiary stock is not treated as worthless before the earlier of (1) the time that the subsidiary ceases to be a member of the group, or (2) the time that the stock of the subsidiary is worthless within the meaning of treas. reg. § 1.1502-19(c)(1)(iii). under reg. § 1.1502-19(c)(1)(iii) a share of subsidiary stock is treated as worthless when the subsidiary disposes of substantially all of its assets, and the deferral of any worthless securities deduction until that time implements single-entity principles, or certain debt cancellations occur. 3. are “new and more precise mechanics” a synonym for “ever-more complicated”? reg-107592-00, consolidated 802 florida tax review [vol. 8:si returns; intercompany obligations, 72 f.r. 55139 (9/28/07). the irs has proposed amendments to reg. § 1.1502-13(g) with respect to the treatment of obligations between members of a consolidated group. reg. § 1.150213(g) applies to three types of transactions: (1) transactions in which an obligation between a group member and a nonmember becomes an intercompany obligation, for example, the purchase by a consolidated group member of another member’s debt from a nonmember creditor or the acquisition by a consolidated group member of stock of a nonmember creditor or debtor (inbound transactions); (2) transactions in which an intercompany obligation ceases to be an intercompany obligation, for example, the sale by a creditor member of another member’s debt to a nonmember or the deconsolidation of either the debtor or creditor member (outbound transactions); and (3) transactions in which an intercompany obligation is assigned or extinguished within the consolidated group (intragroup transactions). the proposed regulations “adopt new and more precise mechanics” for the application of the deemed satisfaction-reissuance model to intragroup and outbound transactions. the following sequence of events is deemed to occur immediately before, and independently of, the actual transaction: (1) the debtor is deemed to satisfy the obligation for a cash amount equal to the obligation’s fair market value, and (2) the debtor is deemed to immediately reissue the obligation to the original creditor for that same cash amount. the parties are then treated as engaging in the actual transaction but with the new obligation. with respect to inbound transactions, the irs and the treasury department have concluded that the mechanics of the deemed satisfaction-reissuance model and its application produce appropriate results and, therefore, no change has been proposed. vii. partnerships a. formation and taxable years 1. the 2007 act, § 8215(a) added code § 761(f), which provides that a husband and wife who operate a qualified joint venture may elect not to treat the joint venture as a partnership. a qualified joint venture is one conducted by a husband and wife both of whom are material participants and who file a joint return. each spouse is required to report the spouse’s share of income and expense items on a separate schedule c. each spouse is individually assessed self-employment tax. i.r.c. § 1402(a)(17), as amended by the 2007 act. note that rev. proc 2002-69, 2002-2 c.b. 831, permitted a husband and wife to treat a wholly owned llc held as community property as a disregarded entity. 2008] recent developments in federal income taxation 803 2. lmsb-04-1007-069, 2007 tnt 202-16 (10/18/07), reaffirming lmsb-04-1106-016 (10/28/06). the § 118 exclusion from income for nonshareholder contributions to the capital of a corporation does not apply to partnerships. the directive contains the following admonition, “this directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.” b. allocations of distributive share, partnership debt, and outside basis 1. partnership deductions are in the proof, and that was lacking when taxpayer fired employees during chinese new year. chong v. commissioner, t.c. memo. 2007-12 (1/17/07). yung chong, a full-time federal express driver, formed a partnership with his brother, lok chong, an australian citizen. at first the partnership successfully exported chicken parts from the united states to china, but when suppliers began exporting directly the chicken parts business dried up so the chong brothers began exporting australian dairy products, western beef, and mexican food to china. when they discovered that some of their chinese employees were competing with them by importing yogurt from france, the chong brothers made the mistake of firing employees during the chinese new year, a cultural taboo. in retaliation the fired employees ransacked the business, destroying business records in the process. the tax court found that a partnership existed between yung cong and lok chong, but disallowed the taxpayer’s claimed $40,000 of partnership loss because the taxpayer was unable to substantiate the loss with adequate records, nor was the taxpayer able to reconstruct the claimed losses, due in large part to his brother’s informal record keeping. in addition, the taxpayer was unable to establish his basis in his partnership interest for purposes of § 704(d). • note that this case has a moral: don’t fire employees during the chinese new year lest bad things happen to your tax benefits. 2. burke v. commissioner, 485 f.3d 171 (1st cir. 5/4/07). the first circuit affirmed a summary judgment in the tax court, burke v. commissioner, t.c. memo. 2005-297 (12/27/05), holding that a partner is taxable on the partner’s distributive share of partnership income notwithstanding the fact that the partnership income is held in an escrow, and is not available for distribution, pending resolution of a dispute between the two individual partners. partners must report their share of partnership earnings in the year the partnership receives them, regardless of when or whether the partners actually receive them. 804 florida tax review [vol. 8:si it is well settled that partners’ distributions are taxed in the year the partnership receives its earnings, regardless of whether the partners actually receive their share of partnership earnings: “few principles of partnership taxation are more firmly established than that no matter the reason for nondistribution each partner must pay taxes on his distributive share.” … reg. § 1.702-1 (providing that a partner must separately account for his distributive share of partnership income “whether or not distributed”). consistent with this long-standing principle, courts have uniformly held that partners must currently recognize in their individual incomes their proportionate shares of partnership income, even if the partnership income was not actually distributed to them for any reason, including disputes, consensual arrangements, ignorance, concealment, or force of law. (citations omitted). 3. rev. proc. 2007-59, 2007-40 i.r.b. 745 (10/1/07). this revenue procedure grants permission to a “qualified partnership” to aggregate built-in gains and losses from “qualified financial assets” for purposes of making reverse allocations of recognized gains and losses under § 704(c) principles. a management or investment partnership is permitted by reg. § 1.704-3(e)(3) to aggregate built-in gains and losses from qualified financial assets, rather than follow the normal property-by-property approach required by regulations. the automatic permission to aggregate built-in gains and losses is granted to a qualified partnership, which is a partnership that allocates gains and losses in proportion to the partners’ capital accounts, which reasonably expects to revalue its assets at least four times a year, holds publicly traded property of at least 90 percent of its noncash assets, has at least 10 unrelated partners, and will make at least 200 trades of financial assets during the year. 4. irs publishes a safe-harbor for allocation of alternative energy tax credits. rev. proc. 2007-65, 2007-45 i.r.b. 967 (11/5/07). section 45 provides a 1.5 cent credit for each kilowatt of energy from qualified energy sources. partnership allocations of tax credits that do not adjust partners’ capital accounts can not have substantial economic effect. reg. §§ 1.704-1(b)(5), ex. (11) and 1.704-1(b)(4)(ii) provide that credits are allocated in proportion to the allocation of expenditures or receipts related to the credit. the revenue procedure indicates that the irs will respect allocations of § 45 wind energy production credits under the principles of reg. § 1.704-4(b)(4)(ii) if certain conditions are satisfied: (1) the developer must have a minimum one percent interest in the partnership 2008] recent developments in federal income taxation 805 and the investors must each have a minimum five percent interest in each partnership material item, (2) the investor must maintain a minimum investment throughout the project equal to 20 percent of fixed capital contributions that is not protected from loss, (3) 75 percent of the investor’s capital contribution must be fixed and determinable, (4) the developer or related parties may not have a right to purchase project property for less than fair market value, and (5) the company cannot have a fixed right to cause any party to purchase project property (except electricity). a. announcement 2007-112, 2007-50 i.r.b. 1175 (12/10/07). rev. proc. 2007-65 was revised to clarify that the requirements that must be met to qualify for the safe-harbor are neither intended to provide substantive rules nor to be used as audit guidelines. c. distributions and transactions between the partnership and partners 1. a distribution of appreciated property to a partner is a nonrecognition event, but a § 707(c) payment to a partner of appreciated property is a festival of taxation. rev. rul. 2007-40, 200725 i.r.b. 1426 (6/18/07). the irs has ruled that the transfer of appreciated property by a partnership to a partner in satisfaction of a guaranteed payment owed to the partner is a sale or exchange of the property by the partnership and not a distribution under § 731. thus the partnership is required to recognize gain on the transfer. the ruling does not deal with whether the partnership is entitled to deduct the value of the property or whether it must capitalize that amount, as the case may be. d. sales of partnership interests, liquidations and mergers 1. proposed regulations track built-in gain following an assets-over partnership merger. reg-143397-05, partner’s distributive share, 72 f.r. 46932 (8/22/07). these proposed regulations adopt the approach of rev. rul. 2004-43, 2004-1 c.b. 842, revoked by rev. rul. 2005-10, 2005-1 c.b. 492. see also notice 2005-15, 2005-1 c.b. 527. in an assets-over partnership merger, the merged partnership is treated as transferring its assets to the continuing partnership in exchange for an interest in the continuing partnership, which is then distributed to the partners of the merged partnership in liquidation of the merged partnership. the continuing partnership is the partnership whose members hold more than 50 percent interests in the resulting partnership. section 704(c)(1)(b) requires recognition of gain or loss by the contributing partner on the distribution of property contributed to a partnership within seven years of 806 florida tax review [vol. 8:si the date of contribution. the recognized gain is the amount of built-in gain or loss existing at the time of contribution that would be required by § 704(c)(1)(a) to be allocated to the contributing partner on a sale of the property for fair market value. section 737 requires recognition of gain on a distribution to a partner who contributed built-in gain property within seven years of a contribution of built-in gain property. under the proposed regulations, following an assets-over merger, with respect to the initial precontribution gain of contributed property, the seven year period continues to run from the date of the initial contribution. in addition, the proposed regulations provide that in the assets-over merger, built-in gain with respect to built-in gain property transferred by the merged partnership to the continuing partnership is subject to the recognition rules of §§ 704(c)(1)(b) and 737 beginning on the date of the merger. the proposed regulations also provide that a merger of two partnerships whose ownership interests in profits and capital are identical will not trigger a new counting period under the seven year rules. (this appears to be a technical error, because under reg. § 1.708-1(c)(1), neither of the merged partnerships is the continuing partnership; both original partnerships have terminated and the resulting partnership is a new partnership. expect this to be changed in the final regulations). the proposed regulations do not address built-in losses, which are the subject of another regulations project. the proposed regulations are applicable to distributions after january 19, 2005. • the proposed regulations follow the holding of rev. rul. 2004-43, 2004-1 c.b. 842 (5/3/04), which was revoked by rev. rul. 2005-10, 2005-1 c.b. 492, after commentators asserted that the ruling was inconsistent with existing regulations. notice 2005-15, 2005-1 c.b. 527, indicated that the irs would promulgate regulations adopting the position of rev. rul. 2004-13, applicable to distributions after 1/19/05. e. inside basis adjustments there were no significant developments regarding this topic during 2007. f. partnership audit rules 1. is this the period that never seems to end? ad global fund, llc v. united states, 67 fed. cl. 657 (9/16/05), motion to certify appeal granted, 68 fed. cl. 663 (11/8/05), aff’d, 481 f.3d 1351 (fed. cir. 3/2/07). the court held that § 6629(a) does not provide an independent statute of limitations for assessing partnership items; instead, it creates a minimum period that may extend the regular § 6501 statute of limitations for assessing tax with respect to partnership items. therefore, the issuance of a 2008] recent developments in federal income taxation 807 final partnership administrative adjustment (fpaa) more than three years after the partnership return is filed, but less than three years after the partners filed their returns, suspends the period of limitations under § 6501(a) for the partners. 2. closed year partnership items from son of boss tax shelter can be reassessed to determine an open year’s tax liability. j & j fernandez ventures, l.p. v. united states, 99 a.f.t.r.2d 2007-2661 (fed. cl. 4/3/07). the government is not barred from recalculating items in a closed year in order to determine the basis of stock sold in an open year. the taxpayers’ 2000-2003 tax liability for gain on the sale of stock was determined from basis adjustments claimed to result from son of boss transactions in 1999, a closed year. • the court follows the holding of ad global fund, llc v. united states to hold that § 6229 creates a minimum period for assessing taxes attributable to partnership items that may extend the § 6501 3-year statute of limitations. • the § 6501(a) limitation prohibits assessment of taxes for closed years, but it does not bar the use of information from closed years. re-assessing basis determinations from closed years is not an assessment of taxes. • under barenholtz v. united states, 784 f.2d 375, 380-381 (fed.cir. 1986), the government may recompute taxable income in a closed year in order to determine tax liability in an open year. the court in fernandez held that the barenholtz principle applies in the tefra context. 3. the tax court follows. g-5 investment partnership v. commissioner, 128 t.c. 186 (5/30/07). the tax court (judge haines) held that § 6229(a) establishes the minimum period for the assessment of tax attributable to partnership items notwithstanding the period provided in § 6501. section 6229 can extend the § 6501 period of limitations with respect to the tax attributable to a partnership item. thus, §§ 6229(a) and 6501 “provide alternative periods within which to assess tax with respect to partnership items, with the later expiring period governing in a particular case.” • under the facts of the case, the partnership filed its 2000 return on october 4, 2001. the partners reported capital loss carryovers attributable to the partnership 2000 tax year on their tax returns for 2002-2004. on april 12, 2006, the irs issued an fpaa notice to the partnership for 2000, more than three years after the partnership return for 2000 was filed. however, the notice was within three years of the dates the partners filed their individual returns for the years 2002-2004. the irs could 808 florida tax review [vol. 8:si assess deficiencies against the partners attributable to the partnership’s 2000 items for the partners’ open 2002-2004 years. 4. and extended by jenkens & gilchrist’s response to the irs summons in son of boss transactions. kligfeld holdings v. commissioner, 128 t.c. 192 (5/30/07). an fpaa that was issued after § 6229(a) barred adjustments to partnership items, but before § 6501 barred assessment of tax against the partner, permitted assessment of deficiencies against the partner in the open year. the § 6501 statute of limitations was tolled under § 7609(e)(2) for the period during which jenkens & gilchrist provided information in response to the irs summons for customers’ names in the son of boss shelter. 5. a criminal fraud investigation of the tax matters partner helped another partner. in re martinez, 366 b.r. 604 (bankr. e.d. la. 4/13/07). a consent to extend the statute of limitations for partnership level audit executed by tax matters partner was invalid with respect to the taxpayer-partner, because the tax matters partner was under criminal investigation with respect to the partnership and thus had a disabling conflict of interest with the other partners of which the irs was aware. 6. river city ranches #1 ltd. v. commissioner, t.c. memo. 2007-171 (7/2/07). on remand from the ninth circuit, 401 f.3d 1136 (9th cir. 2005), the tax court held that an asserted conflict of interest between the tax matters partner and the other partners did not invalidate waiver of the statute of limitations by the tax matters partner. in addition, the tax court found that the six-year statute of limitations for fraud was applicable and that the sheep breeding partnerships at issue were sham partnerships lacking economic substance, which justified increased interest penalties under § 6621(c). 7. a closing agreement is not necessary for a settlement agreement prerequisite to starting the statute of limitations running. gingerich v. united states, 77 fed. cl. 231 (6/22/07), on remand from 82 f.app’x 35 (fed. cir. 2003). in a partnership level audit, pursuant to § 6229(f)(1) the irs has one year to assess a deficiency against the partners with respect to items that pursuant to § 6231(b)(1)(c) became nonpartnership items as a result of a settlement agreement. in this case, while the partnership issue was before the tax court, the irs district counsel and the partners’ lawyers reached a settlement, which was reduced to a writing signed by the partners (the “acceptance forms”), but not by any representative of the irs, which was delivered to the irs, but which did not exactly follow the precise wording of the irs’s settlement offer. both the 2008] recent developments in federal income taxation 809 irs and the taxpayer’s lawyers expected that closing agreements would be signed expeditiously, but there was a delay. in the refund suit, the court of federal claims (judge lettow) held that settlement agreement had been reached when the partners had signed and delivered the “acceptance forms” to the irs, not on the later date on which the closing agreements had been signed. accordingly, the deficiency, which was assessed more than one year after the acceptance forms, but within one year from the closing agreements, was not timely. 8. fear penalties determined in a tefra audit. fears v. commissioner, 129 t.c. 8 (8/2/07). section 6221 provides that the applicability of any penalty, including an accuracy-related penalty that relates to an adjustment of a partnership item must be determined at the partnership level if the tefra partnership audit rules apply. accordingly, the tax court (judge foley) held that it lacked jurisdiction to consider an asserted partner-level defense relating to § 6662 penalties determined in the partnership level proceeding. 9. “the [subchapter b] deficiency procedures no longer apply to the assessment of any partnership-item penalty determined at the partnership level, regardless of whether further partner-level determinations are required.” so, is the irs supposed to assess penalties before the deficiency is determined? domulewicz v. commissioner, 129 t.c. 11 (8/8/07). in a son of boss transaction, the taxpayer claimed a $5,858,801 capital loss. the loss was created by a series of transactions in which the taxpayer entered into a short sale of u.s. treasury notes and contributed the proceeds and the related obligation to a partnership (dip). after dip satisfied the obligation and received from its partners contributions of publicly traded stock purchased for a relatively nominal amount, the partners transferred their interests in dip to dii, an s corporation of which they were shareholders. dip then liquidated and distributed the stock to dii, following which dii sold the stock and passed through to the taxpayer a capital loss of $29,306,024 resulting from the claimed high basis of the stock. following a tefra audit that recomputed the partnership’s basis in the stock as zero (rather than the claimed $30,447,106), when no petition was filed as to the fpaa, the irs did not assess any tax or accuracy-related penalty relating to dii’s sale of the stock, but instead issued an affected items notice of deficiency to the taxpayer. the taxpayer filed a tax court petition and moved to dismiss this case for lack of jurisdiction, asserting that the normal deficiency procedures did not apply to the disallowance of the pass-through loss or the determination of the accuracy-related penalties. the tax court (judge laro) held that under § 6230(a)(2)(a)(i), the deficiency procedures were applicable to the 810 florida tax review [vol. 8:si disallowance of the loss because partner-level factual determinations were necessary to determine deficiency. among other things that had to be determined were dii’s basis in its partnership interests at the time of the liquidating distribution, whether the stock that was sold by dii was the same stock distributed by dip, the portion of the stock actually sold, the holding period for the stock, and the character of any gain or loss. “the fact that these partner-level determinations, once made, may not have changed respondent’s partnership determinations as to dip is of no concern. neither the code nor the regulations thereunder require that partner-level determinations actually result in a substantive change to a determination made at the partnership level.” • however, the irs’s determination of the accuracy-related penalties was not subject to the deficiency procedures by virtue of the parenthetical text added to § 6230(a)(2)(a)(i) by the taxpayer relief act of 1997, pub. l. 105-34, § 1238(b)(2), 111 stat. 1026 — “(other than penalties, additions to tax, and additional amounts that relate to adjustments to partnership items).” judge laro finished his opinion with the following observation: we note in closing that we are not unmindful that a plain reading of section 6230(a)(2)(a)(i) ... may sometimes permit (as it apparently does here) the commissioner to assess a partnership-item penalty before the deficiency to which the penalty relates is adjudicated. we doubt that the drafters of the statute and the regulations, in excluding partnership item penalties from the deficiency procedures, contemplated a situation like this where the deficiency underlying the partnership-item penalty is incorporated in an affected items notice and itself made subject to review under the deficiency procedures before it can be assessed. all the same, we apply the statute as written in accordance with its plain reading and leave to the legislators the job of rewriting the statute, should they decide to do so, to take into account the situation at hand. 10. son of boss tax court petition dismissed, because all items in the deficiency notice are tefra partnership audit items and that proceeding was still pending. nussdorf v. commissioner, 129 t.c. 30 (8/16/07). the irs issued an fpaa on 9/26/05 for 1999 and 2000 to evergreen trading, llc with respect to offsetting currency options, and on the same date issued notices of deficiency to the individuals to whom evergreen’s losses flowed. taxpayers contested the fpaa in the court of federal claims and filed petitions in the tax court with respect to the 2008] recent developments in federal income taxation 811 individual notices of deficiency. the tax court (judge chiechi) denied the taxpayer’s motion to dismiss and granted the irs’s motion to dismiss the taxpayer’s petition. the deficiency notices related only to partnership items, and the court did not have subject matter jurisdiction over any of the items, because it was not a partnership proceeding under § 6226. • after the tax court petition had been filed, the taxpayer’s pass-thru entity that was a partner, but not the tax matters partner, filed a complaint in the court of claims alleging errors in the fpaa and that suit was still pending. judge chiechi concluded that all of the following items were partnership items: (1) the character of the transfer in which the partnership received property from each partner, e.g., whether it was a contribution or a loan; (2) whether any such property should be aggregated with other property received from partner; and (3) and the basis to the partnership of any property contributed to it by partner, including necessary preliminary determinations, such as the partner’s basis in the contributed property. she held that the basis of the property transferred to evergreen is a partnership item under § 6231(a) and it is to be determined in the partnership proceeding. 11. murphy v. commissioner, 129 t.c. 82 (9/26/07). the taxpayer was the sole beneficiary of a trust that was partner in a son of boss partnership. the irs sent a notice of a final partnership administrative adjustment (fpaa) to the taxpayer, rather than to the trust, for the purpose of meeting the notice requirement of § 6223(a). pursuant to § 6223(c)(3) and reg. § 301.6223(c)-1t(f), mailing the fpaa to the taxpayer as an “indirect partner” met the notice requirement of § 6223(a). 12. epsolon limited v. united states, 78 fed. cl. 738 (10/10/07). the fpaa issued in a son of boss case was timely because the issuance of a summons to sidley austin brown & wood seeking the identities of individual investors suspended the running of the statute of limitations. g. miscellaneous 1. the sixth circuit upholds the existing check-thebox rules, and further holds that subsequent proposed regulations making the llc liable for employment taxes may be disregarded. ironically, the rule in the proposed regulations calls for employment taxation at the entity level. littriello v. united states, 484 f.3d 372 (6th cir. 4/13/07). the sixth circuit held that provisions in reg. § 301.77013(b)(1)(ii) treating a sole-owner llc as a disregarded entity are a valid exercise of treasury’s authority to issue interpretative regulations. the 812 florida tax review [vol. 8:si taxpayer was the sole owner of several llcs and claimed that the llcs, not the taxpayer, were individually liable for unpaid employment taxes. affirming the district court, the sixth circuit held that the taxpayer was individually liable for the employment taxes. after the notice of appeal had been filed in the case, the internal revenue service published proposed regulations that would treat single-owner disregarded entities as separate entities for employment tax purposes. see prop. reg. § 301.7701-2(c)(2)(iv), reg-114371-05, disregarded entities; employment and excise taxes, 70 f.r. 60475 (10/18/05). the sixth circuit opined that an agency is entitled to consider alternative interpretations of a statute in proposing regulations before settling its view (citing commodity futures trading commission v. schor, 478 u.s. 833 (1986)). the court stated that the proposed regulations do not undermine the district court’s determination that the current regulations are reasonable and valid. a. the second circuit reaches the same result for the same reasons. mcnamee v. department of the treasury, 488 f.3d 100 (2d cir. 5/23/07). judge kearse ruled that the owner of a single member llc was personally liable for the employment tax liabilities of his llc that was properly formed under state law because he did not elect to have the llc treated as a corporation. judge kearse stated: in light of the emergence of limited liability companies and their hybrid nature, and the continuing silence of the code on the proper tax treatment of such companies in the decade since the present regulations became effective, we cannot conclude that the above treasury regulations, providing a flexible response to a novel business form, are arbitrary, capricious, or unreasonable. • the court’s summary of the interaction of the various supreme court decisions with respect to the weight to be accorded treasury regulations promulgated under the “express” general delegation in § 7805 “to adopt regulations to fill in gaps in the code” is especially worthy of note with respect to all cases in which a regulation might be challenged. in reviewing a challenge to an agency regulation interpreting a federal statute that the agency is charged with administering, the first duty of the courts is to determine “whether the statute’s plain terms ‘directly addres[s] the precise question at issue.’” national cable & telecommunications ass’n v. brand x internet services, 545 u.s. 967, 986 ... (2005) (“ national cable ”) (quoting 2008] recent developments in federal income taxation 813 chevron u.s.a. inc. v. natural resources defense council, inc., 467 u.s. 837, 843 ... (1984)). “if the statute is ambiguous on the point, we defer ... to the agency’s interpretation so long as the construction is ‘a reasonable policy choice for the agency to make.’” national cable, 545 u.s. at 986 (quoting chevron, 467 u.s. at 845). as stated in chevron itself, [f]irst, always, is the question whether congress has directly spoken to the precise question at issue. if the intent of congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of congress. if, however, the court determines congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency’s answer is based on a permissible construction of the statute. (467 u.s. at 842-43) “if congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation [, and s]uch legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute.” [chevron ] at 843-44… . see also united states v. mead corp., 533 u.s. 218, 226-27 ... (2001) (“administrative implementation of a particular statutory provision qualifies for chevron deference when it appears that congress delegated authority to the agency generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the exercise of that authority”). b. but the treasury issues final regulations disagreeing with its own victories. t.d. 9356, disregarded entities; employment and excise taxes, 72 f.r. 45891 (8/16/07). these final regulations promulgate reg. §§ 1.34-1, 1.1361-4 and 301.7701-2, which treat disregarded entities as separate corporations for purposes of employment taxes. the regulations apply to disregarded single owner 814 florida tax review [vol. 8:si entities and to qualified subchapter s corporations. the irs rejected comments that the regulations will complicate reporting requirements for disregarded entities whose owners assumed responsibility for excise taxes claiming that the regulations will avoid administrative inconvenience for the irs in assessing employment taxes. the final regulations are effective 8/16/07. however, there is a more complex deferral arrangement: the employment tax provisions of these regulations apply to wages paid on or after january 1, 2009. the notice of proposed rulemaking provided that these regulations would become effective with respect to wages paid on january 1 following the year of publication of these final regulations in the federal register, which would have been january 1, 2008. however, in order to ensure that taxpayers have sufficient time to make any necessary changes to their systems in response to these regulations, the irs and the treasury department have determined that it is appropriate to delay the effective date of these regulations until january 1, 2009. the irs and the treasury department believe that the considerations that support a january 1, 2009, effective date for the employment tax provisions do not apply to the excise tax provisions. thus, the excise tax provisions of these regulations apply to liabilities imposed and actions required or permitted in periods beginning on or after january 1, 2008. for periods beginning before that date, the irs will treat payments made by a disregarded entity, or other actions taken by a disregarded entity, with respect to the excise taxes affected by these regulations as having been made or taken by the sole owner of that entity. thus, for such periods, the owner of a disregarded entity will be treated as satisfying the owner’s obligations with respect to the excise taxes affected by these regulations, provided that those obligations are satisfied either (1) by the owner itself or (2) by the disregarded entity on behalf of the owner. 2. treasury promulgates final regulations on qualified small business stock held by partnerships. t.d. 9353, section 1045 application to partnerships, 72 f.r. 45346 (8/14/07). under § 1045 an individual holder of qualified small business stock (qsb stock), who has held the stock for more than 6 months, can defer recognition of gain on the sale if the individual acquires replacement qsb stock within 60 days. the 2008] recent developments in federal income taxation 815 proposed regulations allowed a partner in a partnership to elect to defer gain on sales of qsb stock by a partnership that acquired replacement stock within the 60 day period. the proposed regulations did not treat a sale of an interest in a partnership that holds qsb stock as a sale of the qsb stock subject to § 1045. however, the final regulations (reg. § 1.1045-1) provide that gain on sale of qsb stock may be deferred if the partner holds an interest in another partnership that acquires qsb stock during the statutory period the final regulations require basis adjustments under the principles of § 743(b) with respect to replacement qsb stock when a partner elects to defer gain under § 1045. the electing partner’s basis in the partnership interest is also reduced by deferred gain. the final regulations also require an electing partner to recognize deferred gain if replacement qsb stock is distributed to another partner. an election under § 1045 may be made by the partnership affecting all partners. if a partnership elects to defer gain under § 1045, an individual partner is permitted to opt out of the election. an individual partner is also permitted to elect to defer gain on sale of qsb stock if the partnership does not make the election. 3. purchase of fancy life insurance products in the guise of an employee benefit plan fails to produce claimed deductions. v.r. deangelis m.d.p.c. v. commissioner, t.c. memo. 2007-360 (12/5/07). the taxpayer doctors each owned a subchapter s corporation that was a partner in a partnership through which they practiced medicine. each individual doctor was an employee of the doctor’s s corporation. the s corporations made contributions to the partnership which in turn contributed to the severance trust executive program multiple employer supplemental benefit plan and trust (step), a plan promoted to wealthy professionals as a qualified welfare benefits fund that was part of a 10 or more employer plan under § 419a(f)(6). the plan purchased cash-laden whole life insurance policies on behalf of each doctor. judge laro described the case as “arising from a plan designed aggressively to bolster the sale of insurance products through a claim of permissible tax savings.” the court disallowed deductions as ordinary business expenses for contributions to the “welfare benefit plan” finding that “the facts of these cases establish that the plan was nothing more than a subterfuge through which the participating doctors, through vrd/rtd, used surplus cash of the pcs to purchase cash-laden whole life insurance policies primarily for the benefit of the participating doctors personally.” the court rejected the irs’s additional assertion that contributions by the s corporations were included in the doctors’ gross income, finding instead that the contributions represented distributions to the doctors as shareholders of their respective s corporations. 816 florida tax review [vol. 8:si viii. tax shelters a. tax shelter cases 1. district court upholds blips tax shelter on taxpayer’s partial summary judgment motion. klamath strategic investment fund, llc v. united states, 440 f. supp. 2d 608 (e.d. tex. 7/20/06). the court (judge ward) held that the premium portion of the loans received from the bank in connection with the funding of the instruments contributed to the partnership was a contingent obligation, and not a fixed and determined liability for purposes of § 752. the transaction was entered into prior to the release of notice 2000-44, 2000-2 c.b. 255, which related to son of boss transactions. judge ward held that a regulation to the contrary, reg. § 1.752-6 (see t.d. 9062), was not effective retroactively, and was therefore invalid as applied to these transactions. judge ward held that there was clear authority existing at the time of the transaction that the premium portion of the loan did not reduce taxpayer’s basis in the partnership. a. fighting duplication and acceleration of losses through partnerships before june 24, 2003. t.d. 9062, assumption of partner liabilities, 68 f.r. 37414 (6/24/03). temp. reg. § 1.752-6t provides rules, similar to the rules applicable to corporations in § 358(h), to prevent the duplication and acceleration of loss through the assumption by a partnership of a liability of a partner in a nonrecognition transaction. under the temporary regulations, if a partnership assumes a liability, as defined in § 358(h)(3), of a partner (other than a liability to which § 752(a) and (b) apply) in a § 721 transaction, after application of §§ 752(a) and (b), the partner’s basis in the partnership is reduced (but not below the adjusted value of such interest) by the amount of the liability. for this purpose, the term “liability” includes any fixed or contingent obligation to make payment, without regard to whether the obligation is otherwise taken into account for federal tax purposes. reduction of a partner’s basis generally is not required if: (1) the trade or business with which the liability is associated is transferred to the partnership, or (2) substantially all of the assets with which the liability is associated are contributed to the partnership. however, the exception for contributions of substantially all of the assets does not apply to a transaction described in notice 2000-44, 2000-2 c.b. 255 (or a substantially similar transaction). • the temporary regulations purport to be effective for transactions occurring after 10/18/99 and before 6/24/03. 2008] recent developments in federal income taxation 817 b. klamath on the merits: it does not work because it lacks economic substance, but no penalties. the authorities discussed in the holland & hart and olson lemons opinions provide “substantial authority.” klamath strategic investment fund, llc v. united states, 472 f. supp. 2d 885 (e.d. tex. 1/31/07), on appeal to the fifth circuit (9/19/07). the transactions lacked economic substance because the loans would not be used to provide leverage for foreign currency transactions, but no penalties were applicable because taxpayers passed on a 1999 investment and they thought they were investing in foreign currencies and the tax opinions they received that relied on relevant authorities set forth in the court’s earlier opinion provided “substantial authority” for the taxpayers’ treatment of their basis in their partnerships. c. on government motions, judge ward refuses to vacate partial summary judgment decision on the retroactivity of the regulations under § 752, and he permits the deduction of operational expenses, despite his earlier finding that the transactions lacked economic substance, because the taxpayer had profit motives. klamath strategic investment fund, llc v. united states, 99 a.f.t.r.2d 2007-2001 (e.d. tex. 4/3/07). first, judge ward held that even though the loans lacked economic substance, they still existed, and thus the partial summary judgment on the non-retroactivity of the regulations under § 752 was not premised on invalid factual assumptions. second, he held that the existence of profit motive for deduction of operational expenses was based on the purposes of nix and patterson – and not on the motives of presidio, the managing partner of the partnership. 2. this decision might have a “colming” effect on the irs. colm producer, inc. v. united states, 460 f. supp. 2d 713 (n.d. tex. 10/16/06). the court (judge godbey) upheld the disallowance of a loss of about $102.7 million on the sale of a limited partnership interest in december 1999. the partnership interest was funded by the ettman family trust with $2 million plus the contribution of the $102.5 million proceeds of the short sale of $100 million (face value) of u.s. treasury notes subject to the obligation to replace the borrowed t-notes. the partnership interest was then sold to an unrelated third party for $1.8 million. held, the obligation to replace the borrowed t-notes (on the closing of the short sale) should have been treated as a liability under § 752. judge godbey held that – although contingent liabilities were not included as liabilities under § 752 – the obligation to close the short sale was a “liability” based upon his reading of the black’s law dictionary definition (“the quality or state of being legally obligated or accountable” or, “a financial or pecuniary obligation”). he 818 florida tax review [vol. 8:si reinforced his conclusion by citing rev. rul. 95-26, 1995-1 c.b. 131, and salina partnership lp v. commissioner, t.c. memo. 2000-352. 3. hi-lili, hi-lili, lilo! district court grants summary judgment to the government in a lilo transaction. bb&t corp. v. united states, 99 a.f.t.r.2d 2007-376 (m.d. n.c. 1/4/07). taxpayer, a financial services corporation, leased equipment from a wood pulp manufacturer (a head lease) and re-leased it back to the wood pulp manufacturer in a “lease-in-lease-out” (lilo) transaction and claimed substantial rent and other deductions. the court held that the form of the transaction should not be respected for tax purposes because taxpayer did not acquire a current leasehold interest in the equipment and incurred no risk of loss. the reciprocal offsetting obligations were disregarded because, in substance, the taxpayer acquired only a future interest in the right to use and possess the equipment – and acquired that interest only if the ownersublessee did not exercise its option to buy-out taxpayer’s interest in the head lease. the transaction did not substantially affect the wood pulp manufacturer’s rights to use and possess the property. 4. there is partnership liability in a short sale: another shelter falls on summary judgment for the irs, with penalties, and a fpaa to one is as good as an fpaa to the other. this case differs from klamath because the transaction was entered into following the 8/11/00 release of notice 2000-44 (which made it a listed transaction). cemco investors, llc v. united states, 99 a.f.t.r.2d 2007-1882 (n.d. ill. 3/27/07). in this tax shelter scheme, cemco investment trust (cit), a grantor trust, entered into two foreign exchange digital option transactions on december 4, 2000, with deutsche bank. cit simultaneously purchased a $3.6 million digital foreign currency option (the long position) and sold a digital foreign currency option for $3.564 million (the short position). on the following day, cit assigned the options to cemco investment partners (cip), a general partnership. a few days later, cip purchased €55,947 for $50,000. cip then entered into a termination agreement with respect to both of the option contracts. on december 21, cip was liquidated with a transfer of the €55,947 and $45,847 to cit. the transfer occurred by moving assets from cip’s account at deutsche bank to cit’s account. on december 26, cit transferred the euros to cemco, llc. on december 29, cemco sold the majority of the euros for $51,324 (a non-functional currency treated as property). cemco and cip consisted of two partners, steven kaplan and forest chartered holdings, ltd. forest was a shell company to orchestrate the transactions. forest’s sole shareholder and president, paul daugerdas, was the trustee of cit. kaplan and forest were the cit beneficiaries. 2008] recent developments in federal income taxation 819 • cemco claimed a $3.563 million loss on the sale of the euros. cip claimed a $3.6 million basis in the long currency position, and that the contingent obligation of the short position is not treated as a liability for § 752 purposes, which would otherwise have reduced basis on termination of the contracts. (see helmer v. commissioner, t.c. memo. 1975160). cemco asserted that while cip had a total tax basis of $3.6 million, its only assets were the euros and cash in its possession. thus, the basis of the euros distributed in liquidation would be $3.6 million less the $45,847 cash, producing a loss on the sale of euros. the tax court held that notice 2000-44, 2000-2 c.b. 255, which was issued on 9/5/00 (predating the transaction), and reg. § 1.752-1(a)(4)(ii), issued in june 2003, established that the contingent obligation represented by the short sale would be treated as a liability to prevent the creation of artificial basis in transactions designed to create artificial tax losses by overstating basis. thus, cemco’s losses are disallowed. • cemco’s major claim was that that the fpaa should have been issued to cip, which was the partnership that executed the transactions and thereby generated the basis figure with respect to property distributed to cemco. agreeing with the government, the district court held that, although the basis of the euros was a partnership item of cip, cemco was also required to correctly determine the basis of the euros contributed to it and could not merely carry over the basis as determined by either cit or cip. thus, the fpaa issued to cemco was not premised on cip’s errors. • the summary judgment also affirmed imposition of the § 6662(a) accuracy related penalty, increased to 40 percent under § 6662(e) for a gross valuation misstatement. 5. there’s red ketchup all over. six million dollars of financial profit and a $124 million tax loss. a redemption is treated as a dividend disregarded for lack of business purpose. h.j. heinz co. v. united states, 76 fed. cl. 570 (5/25/07). heinz credit company (hcc, a delaware lending subsidiary formed to minimize state taxes on intercompany loans) purchased on the open market 3,500,000 shares of its parent’s (h.j. heinz) stock with cash acquired from commercial lenders. h.j. heinz redeemed 3,325,000 of these shares giving hhc a subordinated zero coupon convertible note. h.j. heinz and hhc treated the transaction as a dividend from h.j. heinz to hcc under §§ 301 and 302(d). hcc thus asserted that its basis in the full 3,500,000 shares shifted to its remaining 175,000 h.j. heinz shares. thereafter, hhc sold the 175,000 shares to an unrelated party claiming a $124 million capital loss, which was reported on the h.j. heinz consolidated return. at the end of three years, hhc converted the note into h.j. heinz stock. between the times it acquired the note and the conversion date, the price of h.j. heinz stock increased from about $39 820 florida tax review [vol. 8:si to $83 per share. the court of federal claims (judge allegra) found that hcc possessed the benefits and burdens of ownership of the h.j. heinz stock and that its transfer of the stock to h.j. heinz met the definition of a redemption under § 317(b). nonetheless, the court concluded that the transaction was a sham because the only purpose of the transaction was to produce a capital loss to wipe out capital gains realized on another transaction, and the transaction had no business purpose. the court also applied the step transaction doctrine to disregard the hcc purchase and redemption of shares. the court concluded: a heinz promotion from the late 1950s and early 1960s touted its tomato ketchup by stating “it’s red magic time!” but no amount of magic, red or otherwise, can hide the meat of the transactions in question, the connective tissues and gristle of which have been revealed by the multitined substance-over-form doctrine. sans sa sauce, it becomes plain that plaintiffs’ transaction simply was not “the thing which the statute intended.” gregory, 293 u.s. at 469. 6. interest is suspended under § 6404(g) because of the absence of fraud. sala v. united states, 99 a.f.t.r.2d 2007-2551 (d. colo. 5/1/07). if an individual files a timely return (including extensions) and the irs has not sent the taxpayer a notice of additional liability (e.g., a math error notice of deficiency), including an explanation of the basis for the liability, within one year following the later of (1) the due date of the return (without regard to extension), or (2) the date on which the taxpayer filed the return, § 6404(g)(1) suspends the accrual of interest for the period beginning one year after the due date (or filing, if applicable) of the return. interest resumes running twenty-one days after the irs sends a notice to the taxpayer. section 6404(g) does not apply at all if an underpayment is due to fraud. in this case, the district court held that the fraud exception to § 6404(g) does not apply to a deficiency from a tax shelter transaction (“baby boss”) that lacked economic substance, unless the government shows that the taxpayer engaged in some act of concealment or misrepresentation. even though the taxpayer entered into the transaction knowing that it was a listed transaction (notice 2000-44), and knowing that it would not be registered with the irs in order to conceal his participation, because taxpayer relied on a “more likely than not opinion” by r.j. ruble that the tax results of the transaction would be upheld, the taxpayer acted in good faith and the government could not prove that the taxpayer had fraudulent intent. summary judgment was entered for the taxpayer. 2008] recent developments in federal income taxation 821 a. was it a “qualified amended return”? sala v. united states, 99 a.f.t.r.2d 2007-1709 (d. colo. 5/30/07). on plaintiff’s motion for partial summary judgment, judge babcock held that the amended 2000 return filed by sala on 11/18/03 was possibly not a “qualified amended return” because the date that the irs notified kpmg that it was under a § 6700 examination was 10/17/03. the resolution of this issue depends upon the scope of the § 6700 examination at the time the amended return was filed, and an issue of fact exists that would preclude summary judgment. the court refused to stay the case pending the availability of testimony from sala’s kpmg accountant, tracie henderson, and from r.j. ruble, both of whom indicated they would invoke their fifth amendment rights, because the delay would be substantial and would prejudice sala. b. sala v. united states, 100 a.f.t.r.2d 20075097 (d. colo. 7/3/07). judge babcock reiterated his holding that there is an issue of fact as to whether the 11/18/03 amended return was a qualified amended return. 7. the court of federal claims follows coltec on the economic substance issue. jade trading llc v. united states, 80 fed. cl. 11 (12/21/07). the court of federal claims (judge williams) held that, although they literally complied with the code, digital options spread transactions lacked economic substance. she relied upon coltec industries, inc. v. united states, 454 f.3d 1340 (fed. cir. 2006), to reach that conclusion. judge williams stated, in sum, this transaction’s fictional loss, inability to realize a profit, lack of investment character, meaningless inclusion in a partnership, and disproportionate tax advantage as compared to the amount invested and potential return, compel a conclusion that the spread transaction objectively lacked economic substance. • the 20 percent and 40 percent penalties were applied although the § 6664 reasonable cause exception issue was postponed to possible partner-level proceedings. b. identified “tax avoidance transactions.” 1. loss importation transactions are listed tax avoidance transactions. notice 2007-57, 2007-29 i.r.b. 87 (7/16/07). listed transactions include loss importation by a subchapter s corporation that acquires a foreign entity classified as a corporation. the foreign entity 822 florida tax review [vol. 8:si engages in offsetting positions in foreign currency. after the gain is recognized, the foreign entity elects to be treated as a disregarded entity preserving the loss side of the transactions for the s corporation. 2. disclosure and list maintenance regulations. t.d. 9295, ajca modifications to the section 6011, 6111, and 6112 regulations, 71 f.r. 64458 (11/2/06). these final and temporary regulations are part of a package of four regulations and proposed regulations that modify the rules for disclosing reportable transactions and list maintenance requirements following the enactment of the jobs act of 2004. a. “transactions of interest” reg-10303805, ajca modifications to the section 6011 regulations, 71 f.r. 64488 (11/2/06). these proposed regulations modify the rules on the disclosure of reportable transactions. they also eliminate the special rule for lease transactions, making those transactions subject to the same disclosure rules as other transactions. these proposed regulations would create a new category, “transaction of interest,” as a reportable transaction category. (1) the regulations are now final. t.d. 9350, ajca modifications to the section 6011 regulations, 72 f.r. 43146 (8/3/07). this treasury decision adopts the proposed regulations as treas. reg. § 1.6111-4, without change. b. reg-103039-05, ajca modifications to the section 6111 regulations, 71 f.r. 64496 (11/2/06). these proposed regulations provide rules for the disclosure of reportable transactions under § 6111 by material advisors. (1) the regulations are now final. t.d. 9351, ajca modifications to the section 6111 regulations, 72 f.r. 43157 (8/3/07). this treasury decision adopts the proposed regulations as treas. reg. § 301.6111-3. c. reg-103043-05, ajca modifications to the section 6112 regulations, 71 f.r. 64501 (11/2/06). these proposed regulations would provide rules for material advisors who must prepare and maintain investor lists under § 6112. the list must identify each person who was advised with respect to any reportable transaction. the proposed regulations would also require the material advisor to include the names of other material advisors to the transaction and any designation agreement to which the material advisor is a party. they also clarify that the list must 2008] recent developments in federal income taxation 823 include an itemized statement of information, a detailed description of the transaction, and copies of documents related to the transaction. (1) the regulations are now final. t.d. 9352, ajca modifications to the section 6112 regulations, 72 f.r. 43154 (8/3/07). this treasury decision adopts the proposed regulations as treas. reg. § 301.6112-1. 3. now the irs doesn’t want to be “toi-ed” with. notice 2007-72, 2007-36 i.r.b. 544 (9/4/07). the transaction described as a “transaction of interest” is one in which a taxpayer purchases the successor member interest in an llc holding real estate from his advisor (who continues to own the membership interests in the llc for a term of years). the taxpayer then transfers the successor member interest more than one year after he acquired it to a charity, and claims a deduction significantly higher than the amount paid by the taxpayer. the irs designated this and similar transactions as “transactions of interest” for purposes of reg. § 1.6011-4(b)(6) and §§ 6111 and 6112. a. notice 2007-73, 2007-36 i.r.b. 545 (9/4/07). in this notice, the irs expressed concern over transactions involving turning grantor status on and off in a short time period for the purpose of allowing the grantor to claim a tax loss greater than any actual economic loss sustained or to avoid inappropriately the recognition of gain, and designated such transactions as “transactions of interest.” • in ir-2007-143 (8/14/07), treasury and irs explained that it believes “transactions of interest” have the potential for abuse, but that they lack sufficient information to determine whether the transactions should be identified specifically as tax avoidance transactions. treasury and the irs further explained that they may take one or more future actions, including designating the transactions as listed transactions, or providing a new category of reportable transaction. • speaking to the tax executives institute on 10/23/07, 2007 tnt 206-2, chief counsel donald korb’s explanation of the significance of the classification “transaction of interest” was reported as follows: korb said the creation of the new transactions of interest designation is the direct result of the penalties congress added for listed transactions in the american jobs creation act of 2004. 824 florida tax review [vol. 8:si “they piled on,” he said. “so once the penalties become so draconian, it really takes away from us the ability to use this tool. it’s that simple.” korb said the irs has only listed two new transactions since he joined the agency because it has to be so careful when listing brings with it so many penalty implications. he called transactions of interest the new “junior listed transaction.” c. disclosure and settlement 1. first was merrill lynch. ir-2001-74, (8/29/01). the irs announced that merrill lynch agreed to settle a penalty case that the irs had brought against it for promotion of the contingent installment sale shelter involved in acm partnership v. commissioner, 157 f.3d 231 (3d cir. 1998), and other cases. the amount of the penalty settlement was described as “substantial.” a. the big four settle with the irs on tax shelters. deloitte cooperated with the irs and settled for a de minimis penalty, which was decided upon after the irs settled with the other three large accounting firms. b. the pwc deal. ir-2002-82 (6/27/02). the irs announced in a news release that it cut a deal with pricewaterhousecoopers (pwc) “to resolve issues relating to tax shelter registration and list maintenance under the internal revenue code.” the irs news release, which is similar to one issued last august regarding merrill lynch, says that without admitting or denying liability, pwc has agreed to make a ‘substantial payment’ to the irs to resolve issues in connection with advice rendered to clients dating back to 1995. under the agreement, pwc will provide to the irs certain client information in response to summonses. it will also work with the irs to develop processes to ensure ongoing compliance with the shelter registration and investor list maintenance requirements, according to the release. c. the ey deal. ir-2003-84 (7/2/03). the irs announced that it settled ernst & young’s potential liability under the tax shelter registration and list maintenance penalty provisions for a nondeductible payment of $15 million. see 2003 tnt 128-1. 2. the kpmg deal: the price of settling goes up dramatically. ir-2005-83 (8/29/05). the irs and the justice department 2008] recent developments in federal income taxation 825 announced that kpmg llp has admitted to criminal wrongdoing and agreed to pay $456 million in fines, restitution, and penalties as part of an agreement to defer prosecution of the firm. nineteen individuals, chiefly former kpmg partners including the former deputy chairman of the firm (jeffrey stein), as well as a new york lawyer (r.j. ruble) were indicted in the southern district of new york in relation to the “multi-billion dollar criminal tax fraud conspiracy;” several of those indicted were partners in kpmg’s washington national tax group. a. judge kaplan refuses to find prosecutorial misconduct in the deferred prosecution agreement. united states v. stein, 428 f. supp. 2d 138 (s.d.n.y. 4/4/06). judge kaplan denied a motion to dismiss based upon alleged prosecutorial misconduct by reason of the alleged manipulation of kpmg in the deferred prosecution agreement. this dpa required the firm “upon pain of corporate death, [to] espouse a government-approved version of [the] facts.” judge kaplan based his decision on the ethical provision applicable to all attorneys that prohibits them from coercing witnesses to give false testimony. he further held that nothing in the dpa pressures individual kpmg employees to testify in any particular way, but that the dpa merely requires the firm to disavow any assertion by an affiliated individual that is inconsistent with the dpa’s statement of facts. b. in its post-enron war against white collar crime, the justice department’s notion that what is fair against organized crime is also fair against white collar crime receives a (temporary?) setback. judge kaplan finds prosecutorial misconduct in the use of the thompson memorandum to prevent kpmg from continuing its customary practice of paying attorney’s fees for individuals caught up in controversy by reason of their affiliation with the firm. united states v. stein, 435 f. supp. 2d 330 (s.d.n.y. 6/26/06), as amended, 7/14/06. the court held that the justice department’s thompson memorandum policy (continued from the holder memorandum) of basing a determination of whether a firm is “cooperating” with the government on its refusal (unless compelled by law) to advance legal fees for affiliated individuals unless they in turn fully cooperated with the government, as it was applied by the prosecutors in this case, was an unconstitutional interference with defendants’ ability to use resources that – absent the government’s misconduct – would be otherwise available to them for payment of attorneys’ fees. the resources in question were funds that would have customarily been received by these defendants from kpmg to pay their attorneys. 826 florida tax review [vol. 8:si • judge kaplan suggested that the constitutional violation could be rendered harmless if the defendants could successfully force kpmg to pay their legal expenses, and sua sponte instructed the clerk of the district court to open a civil docket number for an expected contract claim by the defendants against kpmg for payment of their defense costs. judge kaplan stated that the court would “entertain the claims pursuant to its ancillary jurisdiction over this case.” the defendants subsequently filed the anticipated complaints against kpmg. • judge kaplan subsequently refused to eliminate from his opinion a statement that prosecutors in the case were “economical with the truth.” he also refused to eliminate from his opinion the names of the prosecutors involved. 2006 tnt 130-10. • the thompson memorandum was replaced on 12/12/06 by the mcnulty memorandum which requires threats to prosecute entities “unless” they do something (e.g., waive attorney client privilege) or “if” they do something (e.g., advance legal fees) to emanate from a higher level of the justice department. c. judge kaplan indefinitely postpones the federal criminal trial against 16 former kpmg employees, an outside investment adviser, and a lawyer. united states v. stein, 461 f. supp. 2d 201 (s.d.n.y. 11/13/06). judge kaplan reaffirmed his earlier holding that ancillary jurisdiction existed over the contractual fee dispute between the defendants and kpmg. he rejected kpmg’s argument that the defendant’s claims were foreclosed by written agreements, and found that enforcement of any applicable arbitration clause would be contrary to public policy, because it might interfere with the ability to ensure a speedy trial, could lead to a dismissal of meritorious criminal charges, would endanger the defendants’ rights to a fair trial, and might impose unnecessary costs on taxpayers if the defendants became indigent. judge kaplan cited fears that defendants may be unable to pay their lawyers in further postponing the trial, which was scheduled to begin in january 2007. d. a trial becomes less likely. stein v. kpmg, llp, 486 f.3d 753 (2d cir. 5/23/07). the second circuit vacated the district court orders in united states v. stein to the extent that they found jurisdiction over the complaint against kpmg and dismissed the defendants’ complaint against kpmg. the prejudice to kpmg in having these claims resolved in a proceeding ancillary to a criminal prosecution in the southern district of new york is clear. at stake are garden variety state law claims, albeit for large sums. kpmg 2008] recent developments in federal income taxation 827 believed that contractual disputes between it and the appellees would be resolved by arbitration. instead, kpmg is faced with a federal trial of more than a dozen individuals’ multi-million dollar “implied-in-fact” contract claims. moreover, because such a proceeding is governed by no express statutory authority, the district court has indicated its intention to apply to this expedited undertaking an ad hoc mix of the criminal and civil rules of procedure determined on the fly, as it were. ... first, “the interrelationship of the factual issues underlying the finding of constitutional violations and the asserted contract claims is marginal. ... second, while the ancillary proceeding is a major undertaking, its contribution to the efficient conclusion of the criminal proceeding is entirely speculative. ... third, even if there were constitutional violations and even if kmpg is contractually obligated to advance [defendants’] attorneys’ fees and costs, creating an ancillary proceeding to enforce that obligation was not the proper remedy. ... finally, on the present record, a proceeding ancillary to a criminal prosecution was not necessary either to avoid perceived deficiencies in ordinary civil contract actions to enforce the alleged advancement contracts or to remove some barrier to the [defendant’s] bringing of such actions. e. indictment against 13 kpmg defendants dismissed because the government interfered with their sixth amendment right to secure counsel which would have been available to them absent government interference. united states v. stein, 495 f. supp. 2d 390 (s.d.n.y. 7/16/07). judge kaplan dismissed the indictment as to 13 of the 16 defendants who had been affiliated with kpmg at the time of their alleged conduct because the u.s. attorney’s office interfered with their ability to receive payment of their attorneys’ fees from kpmg. the government announced its intention to appeal the dismissal of the 13 defendants, and judge kaplan indicated his intention to proceed with the trial of the remaining five defendants in october 2007. 828 florida tax review [vol. 8:si 3. taps for jenkens & gilchrist. the justice department announced it would defer the prosecution of the jenkens & gilchrist law firm and that the firm would shut down on 3/31/07 and also be liable for a $76 million promoter penalty on account of the tax shelter practice of paul daugerdas in its chicago office. 2007 tnt 62-2, 3/30/07. 4. pops goes the cobra; the irs flips off sidley austin. ir-2007-103 (5/23/07). the irs announced that sidley austin llp reached a settlement in which it agreed to pay $39.4 million in penalties for promotion of abusive tax shelters and failure to comply with tax shelter registration requirements. the firm issued tax shelter opinions marketing boss, cobra, blips, coins, flip, opis, and pops. 5. these “value ideas” did produce extraordinary results for e&y tax partners, but not the results they expected. united states v. coplan. two current and two former partners of ernst & young – all members of its viper8 group – were indicted on 5/30/07 in the southern district of new york for crimes relating to tax shelters promoted by e&y. the shelters included cds (“contingent deferred swap”); cobra (“currency options bring reward alternatives”); cds add-on; and pico (“personal investment corporation”). 2007 tnt 105-1. a. more defendants. 2008 tnt 35-23 (2/21/2008). the indictment was expanded to add david l. smith, private capital management, and charles bolton to the list of alleged coconspirators. smith is alleged to have introduced the cds strategy to e&y and to have licensed the cds transactions to bolton and a group of bolton companies who implemented the transactions. d. tax shelter penalties, etc. 1. tax-exempt organizations will be subject to tax shelter penalties. tipra § 516(a) adds new § 4965 to impose an excise tax on tax-exempt entities entering into prohibited tax shelter transactions. the tax will be 35 percent of the greater of (a) the entity’s net income or (b) 75 percent of the proceeds received by the entity that are attributable to the transaction. 8. value ideas produce extraordinary results. 2008] recent developments in federal income taxation 829 a. tipra § 516(b) also amends § 6033(a) to provide disclosure requirements and amends § 6652(c) to provide penalties for nondisclosure. b. tipra § 516(b) also adds new code § 6011(g), which requires a taxable party to a prohibited tax shelter transaction to provide a disclosure statement to any tax-exempt entity which is also a party to the transaction, indicating that the transaction is a prohibited tax shelter transaction. a failure to make a disclosure required under § 6011(g) is subject to penalty under § 6707a, the penalty amounts being equal to those imposed for other violations of § 6011 that are penalized by § 6707a. c. and now the regulations. t.d. 9334, requirement of return and time for filing, 72 f.r. 36871 (7/6/07). proposed and temporary regulations require the filing of form 4720, “return of certain excise taxes under chapters 41 and 42 of the internal revenue code,” by exempt entities and entity managers who are liable for the § 4965 excise tax on certain tax-exempt entities and entity managers who are parties to tax shelter transactions. the return is due on the 15th day of the 5th month following the end of the entity’s accounting period. managers of retirement plan entities who are subject to the excise tax are required to file form 5330, “return of excise taxes related to employee benefit plans.” 2. rev. proc. 2007-21, 2007-9 i.r.b. 613 (2/26/07). this revenue procedure provides procedures for requesting rescission of a § 6707a penalty and a nonexclusive list of factors that weigh in favor and against granting rescission. rescission must be requested in writing within 30 days after the irs sends notice and demand for payment, or, if the penalty (not including interest) has been paid in full prior to notice and demand, within 30 days from the date of payment. ix. exempt organizations and charitable giving a. exempt organizations 1. pension protection act §§ 1231-1235 amended code §§ 170, 508, 2055, 2522, 4943, 4958, and 6033, and added code §§ 4966 and 4967 to provide new rules and greater accountability for donor advised funds and sponsoring organizations (e.g., community foundations), which are defined in these provisions. the new provisions also provide new requirements for supporting organizations, which are excluded from private foundation status under code § 509(a)(3); private foundation grants to type 830 florida tax review [vol. 8:si iii supporting organizations that are not functionally integrated supporting organizations are not “qualifying distributions” and may give rise to excise taxes. a. announcement 2006-93, 2006-48 i.r.b. 1017 (11/27/06). this announcement provides procedures that § 501(c)(3) tax-exempt supporting organizations, described in § 509(a)(3), may use to request a change in their public charity classification in light of the effect of the pension protection act. these changes would permit middle-aged geriatrics to use new code § 408(d)(8) to make tax-free distributions from their iras (owned by individuals over 70½ years of age) up to $100,000 directly to charities that are publicly supported under § 509(a)(1) and (2), but not § 509(a)(3). b. notice 2006-109, 2006-51 i.r.b. 1121 (12/18/06). this notice provides interim guidance regarding the application of requirements in the pension protection act with regard to the criteria for private foundations considering distributions to supporting organizations that can be used to determine whether the supporting organization is a type i, type ii, or functionally-integrated type iii supporting organization. the notice also provides for relief for payments that were made pursuant to an agreement that was binding on the organization on the 8/17/06 date of enactment – even though the amended statute became effective for transactions occurring after 7/25/06. 2. this is a real sleeper! all tax-exempt organizations will be required to file annual electronic notices. pension protection act § 1223 adds new code § 6033(i) to require electronic filing of an annual informational notice by all exempt organizations not currently required to file (specifically, organizations with gross receipts under $25,000 and churches) on pain of losing tax-exempt status. this provision is effective for years beginning in 2007. a. calendar year organizations must do this by may 15, 2008. ir-2008-25 (2/25/08). tax-exempt organizations not required to file forms 990 or 990-ez are required to file form 990-n, “electronic notice (e-postcard) for tax-exempt organizations not required to file form 990or 990-ez” for tax years beginning in 2007. section 6033(i) provides that organizations that do not file form 990-n for three consecutive years will lose their tax-exempt status. 3. charitable remainder trusts no longer lose exempt status with one dollar of unrelated business taxable income. the tax relief and health care act of 2006 § 424 amends code § 664(c) to 2008] recent developments in federal income taxation 831 replace the rule that removes the tax exemption of a charitable remainder trust for any year in which the trust has any unrelated business taxable income. instead, there will be a 100 percent excise tax on the ubti of a charitable remainder trust. 4. let there be light on charities’ ubit. organizations exempt from tax under § 501(a) are required by § 6104(d) to make certain returns and other materials available for public inspection. section 6104(d)(1)(a)(ii), added by the pension protection act of 2006, requires public disclosure of returns filed relating to the unrelated business income tax of § 511, form 990-t. a. the irs issues guidance regarding public inspection of unrelated business income tax returns. notice 2007-45, 2007-22 i.r.b. 1320 (5/29/07). this notice provides interim guidance under § 6104(d)(1)(a)(ii). all organizations exempt under § 501(a) and described in § 501(c)(3) are now required to make available for public inspection a copy of their form 990-t filed with the irs. the notice specifically points out that churches and state schools and universities that are not otherwise required to disclose returns, are required to disclose form 990-t where they are subject to tax under § 511. there is an exception for form 990-t filed solely to claim a refund of the telephone excise tax. the notice indicates that treasury will propose regulations under § 6104(d) to comply with § 6104(d)(1)(a)(ii). 5. crso v. commissioner, 128 t.c. 153 (4/30/07). taxpayer was denied tax exemption as a feeder organization because under § 502 its holding of debt financed commercial real estate subject to a triple net lease is the conduct of a trade or business rather than the receipt of rental income excluded from unrelated business taxable income under § 512(b)(3). rental income from the properties is not excluded from ubit under § 512(b)(3) because the rental income is derived from debt financed property subject to the exception of § 512(b)(4). 6. charities jump into the 2008 presidential race at their peril. rev. rul. 2007-41, 2007-25 i.r.b. 1421 (6/18/07). while a § 501(c)(3) exempt charity can conduct educational activities regarding political campaigns, a § 501(c)(3) organization may not participate or intervene directly or indirectly in a political campaign for or against a candidate for elected office. this ruling contains 21 situations providing guidance to locate the line between political education and campaigning. the ruling indicates that while officials of organizations are not constrained to speak for themselves, leaders of exempt organizations cannot make 832 florida tax review [vol. 8:si partisan comments in official organization publications or at official functions of the organization. 7. just like the seventeen-year cicada. rev. proc. 2007-52, 2007-30 i.r.b. 222 (7/23/07), superseding rev. proc. 90-27, 19901 c.b. 514. the irs published an update of procedures for requesting recognition of tax-exempt status. 8. reg-155929-06; payout requirements for type iii supporting organizations that are not functionally integrated, 72 f.r. 42335 (8/2/07). this document provides advance notice of rules that the treasury department and the irs anticipate proposing in a notice of proposed rulemaking regarding the payout requirements for type iii supporting organizations that are not functionally integrated, the criteria for determining whether a type iii supporting organization is functionally integrated, the modified requirements for type iii supporting organizations that are organized as trusts, and the requirements regarding the type of information a type iii supporting organization must provide to its supported organization(s) to demonstrate that it is responsive to its supported organization(s). b. charitable giving 1. being a tree-hugger is good for your tax health. glass v. commissioner, 471 f.3d 698 (6th cir. 12/21/06), aff’g 124 t.c. 258 (5/25/05), the tax court held that the contribution of a perpetual conservation easement that restricted development of certain portions of the taxpayers’ lakefront residential lot, but which did not otherwise affect the taxpayers’ use or enjoyment of the property, was a qualified conservation contribution under § 170(h) because it protected a relatively natural habitat of specifically identified wildlife, including bald eagles, and plants. • the sixth circuit held that the easements prohibited any activity or use of the encumbered property that would undermine their stated conservation purpose, and the reserved rights were carefully limited so as to ensure that the identified plant and wildlife habitats on the encumbered property continued to be protected. 2. the pension protection act makes the following changes to rules governing charitable contributions: a. those $20 bills placed in the collection plate each week will no longer be deductible without a receipt. pension protection act § 1217 adds new code § 170(f)(17) to deny deductions for 2008] recent developments in federal income taxation 833 monetary gifts unless the donor has a bank record or a receipt showing the name of the donee organization, the date of the contribution, and the amount of the contribution. this provision is effective in 2007. (1) notice 2006-110, 2006-51 i.r.b. 1127 (12/18/06). a contribution made by payroll deduction can be substantiated by: (1) a pay stub, form w-2, or other document furnished by the employer that sets forth the amount withheld during a taxable year by the employer for the purpose of payment to a donee organization, together with (2) a pledge card or other document prepared by or at the direction of the donee organization that shows the name of the donee organization. b. pension protection act § 1219 adds new code §§ 170(f)(11)(e) and 6695a and amends code §§ 6662, 6664 and 6696 to provide more oversight of appraisers, as well as impose stricter penalties on both appraisers and taxpayers. (1) notice 2006-96, 2006-46 i.r.b. 902 (11/13/06). this notice provides transitional guidance relating to the new definitions of “qualified appraisal” and “qualified appraiser” in §§ 170(f)(11)(e) and 6695a regarding substantial or gross valuation misstatements, as added by § 1219 of the pension protection act of 2006. c. section 170(b)(1)(e), enacted in the pension protection act, expands the limitations for contributions of qualified conservation easements. (1) greener got better. questions answered regarding contributions of conservation easements. notice 2007-50, 2007-25 i.r.b. 1430 (6/18/07). normally the value of contributions of capital gain property is limited to 30 percent of the taxpayer’s adjusted gross income. after 2005 and before 2008, charitable contribution deductions of the value of contributed qualified conservation easements are available to the extent of the excess of 50 percent of adjusted gross income over otherwise allowable charitable contribution deductions. the excess contribution may be carried forward fifteen years. with respect to qualified farmers, the contribution limit is 100 percent of agi. the notice explains the application of these limitations. 3. charitable contributions for donated clothing were reduced from the claimed $49,000 to $9,000 because she overestimated the value of the gently-worn designer clothing she contributed. stamoulis v. commissioner, t.c. summ. op. 2007-38 (3/8/07). a goldman sachs investment banker with an agi under $115,000 834 florida tax review [vol. 8:si claimed a $55,764 charitable contribution deduction on her 2002 federal income tax return. the tax court (special trial judge carluzzo) reduced the amount claimed for contributions of designer clothing from $49,000 to $9,000 but did not impose the negligence penalty for her overstatement of the fair market values of the donated property, because the determination of the fair market value of personal items is “less than an exact science.” • in relation to the values claimed by bill clinton for his used underwear, ms. stamoulis was conservative. compare the size of the deduction monica might have received had she donated her blue dress with white polka dots. 4. one of timothy mcveigh’s lawyers loses again, but the consequences are not as severe this time. jones v. commissioner, 129 t.c. 1466 (11/1/07). sherrel jones, one of timothy mcveigh’s lawyers in the criminal proceeding stemming from the oklahoma city federal building bombing, donated to the university of texas copies of documents received by him from the government in the course of his representation of timothy mcveigh and claimed a charitable contribution deduction for the appraised value. judge cohen upheld the irs’s disallowance of any deduction on the ground that under the relevant state law (oklahoma), the materials were not attorney work product and not being attorney work product, the client, not the lawyer, was the owner of the materials in the case file. because the taxpayer “was not the legal owner of the materials, he was not legally capable of divesting himself of the burdens and benefits of ownership or effecting a valid gift of the materials.” alternatively, even if the material in the file was attorney work product, by virtue of § 1221(a)(3) it was an ordinary income asset, and thus under § 170(e)(1)(a) the deduction was limited to basis, which was zero. x. tax procedure a. interest, penalties and prosecutions 1. “too good to be true?” common frivolous positions that can result in frivolous return penalties, § 6662 penalties, or civil fraud penalties. rev. rul. 2007-19, 2007-14 i.r.b. 843 (4/2/07) (claiming that wages are not taxable income); rev. rul. 2007-20, 2007-14 i.r.b. 863 (4/2/07) (claiming that complying with the internal revenue laws is voluntary and that taxpayers are not legally required to file federal tax returns or pay federal tax because the filing of a tax return or the payment of tax is a matter of choice); rev. rul. 2007-21, 2007-14 i.r.b 865 (4/2/07) (claiming that before the irs may collect overdue taxes, it must provide taxpayer with a summary record of assessment made on a form 23c, 2008] recent developments in federal income taxation 835 assessment certificate-summary record of assessments, or on another particular form); rev. rul. 2007-22, 2007-14 i.r.b 866 (4/2/07) (claims by taxpayers that they are not subject to federal income tax, or that their income is excluded from taxation, because either (1) they claim to have rejected or renounced united states citizenship and are citizens exclusively of a state (sometimes characterized as a “natural-born citizen” of a “sovereign state”), or (2) they are not persons as identified by the internal revenue code). a. notice 2007-30, 2007-14 i.r.b. 883 (4/2/07) (updating list of frivolous return positions). 2. what is a qualified amended return, and what can it do for the taxpayer submitting it? t.d. 9309, qualified amended returns, 72 f.r. 902 (1/9/07). reg. § 1.6664-2(c) provides that the amount reported on a “qualified amended return” will be treated as an amount shown as tax on the taxpayer’s return for purposes of determining whether there is an underpayment of tax subject to an accuracy-related penalty. generally speaking, a return is not a “qualified amended return” if it is filed (1) after the irs has served a john doe summons on a third-party with respect to the taxpayer’s tax liability; (2) for a taxpayer who has claimed tax benefits from undisclosed listed transactions, after the irs requests information related to the transaction that is required to be included on a list under § 6112 from any person who made a tax statement to or for the benefit of the taxpayer, or any person who gave material aid, assistance, or advice to the taxpayer; or (3) after the date on which published guidance is issued announcing a settlement initiative for a listed transaction in which penalties, in whole or in part, are compromised or waived. 3. the tax relief and health care act of 2006 § 407 modifies the code § 6702 penalty for frivolous tax submissions by increasing the amount of the penalty from $500 to $5,000 and by applying it to all taxpayers and to all types of federal taxes. the submissions to which the provision applies are requests for a collection due process hearing, installment agreements, offers-in-compromise, and taxpayer assistance orders. the provision permits the irs to disregard such requests, and to impose a penalty of up to $5,000 for such requests, unless the taxpayer withdraws the request after being given an opportunity to do so. 4. the continuing troubles of marion barry. united states v. barry, 477 f. supp. 2d 146 (d. d.c. 3/12/07). a magistrate denied the government’s motion to revoke the probation of marion barry on the grounds that mr. barry failed to file federal and district of columbia tax returns while on probation pursuant to a plea agreement to two counts of 836 florida tax review [vol. 8:si failure to file returns. the magistrate ruled that under the rules of the court, the court would entertain a motion to revoke probation only on the request of the probation office, which was not involved in the proceeding. mr. barry also represented through counsel that the returns had been filed. a. but the district court chief judge disagrees. he reverses and remands, so go to jail--maybe. united states v. barry, 99 a.f.t.r.2d 2007-2484 (d. d.c. 4/26/07). notwithstanding that the “long standing practice” of the court is to schedule probation revocation hearings only on motion of the probation office, chief judge hogan ruled that neither the federal rules of criminal procedure nor the local criminal rules indicate who is empowered to move for probation revocation proceedings. he reversed the magistrate’s dismissal of the revocation motion and remanded the case for a decision on the merits. 5. death and taxes are a certainty. abusive shelter penalties survive the death of the promoter! reiserer v. united states, 479 f.3d 1160 (9th cir. 3/20/07). a tax shelter promoter and his law firm promoted an abusive tax arrangement known as offshore employee leasing. the promoter died after the irs had issued a summons to the promoter’s and law firm’s bank as part of an investigation into whether penalties should be imposed on the promoter. the ninth circuit held that liability for a § 6700 penalty for promoting abusive tax shelters and for a § 6701 penalty for aiding and abetting the understatement of tax liability would survive the death of the attorney against whom the penalties are sought to be imposed because those penalties are civil, not criminal. on another issue, the attorney-client privilege did not protect the identity of clients of the attorney under investigation for promoting abusive tax shelters and aiding and abetting understatement of tax liability because revealing the clients’ identities would not disclose communications between the attorney and clients. in addition, a subpoena on a bank to produce all checks deposited and drawn on the attorney’s trust account was enforced. the tax shelters involved were offshore employee leasing arrangements. 6. criminal conviction reversed and remanded: the trial court should have let the defendant testify about consulting tax experts. united states v. moran, 493 f.3d 1002 (9th cir. 7/6/07), amending and superseding 482 f.3d 1101 (9th cir. 4/2/07). pamela and james moran were convicted, among other things, of conspiracy to defraud the united states, as well as aiding and assisting — don’t you love legal redundancies? — in the preparation and filing of false federal income tax returns. the morans were the “executive education officers” who trained the sales force of anderson’s ark and associates. the company offered several forms of 2008] recent developments in federal income taxation 837 tax reduction plans that generally involved shifting funds through costa rica entities and not paying taxes. the trial court sustained the government’s hearsay objection to mrs. moran’s testimony regarding advice she had received from a cpa and testimony regarding legal opinions she received about the tax program. the testimony was offered not for the truth of what was told to mrs. moran, but as evidence of her good faith reliance on the advice of experts as a defense against the willfulness of her actions, and was, therefore, not hearsay. the ninth circuit concluded that the error was not harmless error. the court rejected defendants’ claims that the trial court erred in allowing expert testimony that the marketed transactions were shams, by giving an improper pinkerton instruction to the jury, i.e., each member of a conspiracy may be convicted of a crime committed by another member, and by admitting computer records of a co-conspirator as statements. 7. a unanimous supreme court resolves another pressing tax issue because the circuits disagreed over who has authority to abate interest. hinck v. united states, 127 s. ct. 2011 (5/21/07). section 6404(e)(1) permits the commissioner to abate interest on a deficiency attributable to unreasonable error by the irs. section 6404(h) provides that the tax court has jurisdiction to determine whether failure to abate interest was an abuse of discretion. (relief is not available to taxpayers whose net worth exceeds $2 million or who own a business worth in excess of $7 million. § 7430(c)(4)(a)(ii).) the supreme court held that § 6404(h) grants exclusive jurisdiction over interest abatement to the tax court. the district courts and court of federal claims do not have jurisdiction to review interest abatement claims under their general jurisdiction over refund claims. the decision affirms the federal circuit’s holding in the case, which conflicted with the fifth circuit’s opinion in beall v. united states, 336 f.3d 419 (2003). 8. the standard for preparer penalties is broadened to include preparers of all tax returns, and is heightened from “realistic possibility of success” to “more likely than not.” the 2007 act, § 8246, amends code §§ 6694 and 7701 to expand the applicability of the § 6694 return preparer penalties from “income tax return preparers” to all tax return preparers. it also heightens the standards of conduct to avoid the imposition of the return preparer penalty for undisclosed positions with a requirement that there be a reasonable belief that the tax treatment of the position was “more likely than not” the proper treatment. for disclosed positions, the standard is increased from “nonfrivolous” to “reasonable basis.” penalty amounts are increased from $250 to the greater of $1,000 or 50 percent of the income to be derived by the 838 florida tax review [vol. 8:si preparer under § 6694(a), and from $1,000 to the greater of $5,000 or 50 percent of the income to be derived by the preparer under § 6694(b). these changes are effective for tax returns prepared after 5/25/07. a. but practitioners will be given a pass under the new rules for the rest of 2007. ir-2007-115 and notice 2007-54, 2007-27 i.r.b. 12 (7/2/07). this notice provides transitional relief for all returns, amended returns and refund claims due on or before 12/31/07, to estimated tax returns due on or before 1/15/08, and to employment and excise tax returns due on or before 1/31/08. the transitional relief is that the standards set forth under previous law and current regulations will be applied in determining whether the irs will impose penalties under § 6694(a), but the transitional relief is not available for penalties under § 6694(b), which applies to return preparers who exhibit “willful or reckless conduct.” b. placeholder proposed circular 230 regulations. reg-138637-07, regulations governing practice before the internal revenue service, 72 f.r. 54621 (9/26/07). the treasury department has published proposed amendments to the circular 230 standards of practice, § 10.34, to conform with the § 6694 provisions in the 2007 act. deborah butler, irs associate chief counsel (procedure and administration), has stated that the proposed regulation contains merely “placeholder language,” and that the government will first get out § 6694 guidance before considering whether the historical linkage between § 6694 and circular 230 remains appropriate. c. three subsequent notices released on 12/31/07 clarified notice 2007-54. (1) notice 2008-11, 2008-3 i.r.b. 279 (1/22/08). this notice provides that advice given before 1/1/08 by nonsigning preparers will be governed by standards under former § 6694. (2) notice 2008-12, 2008-3 i.r.b. 280 (1/22/08). this notice specifies which returns require a preparer signature and which returns do not. (3) a notice temporarily relaxes the requirements on practitioners, but it is puzzling in places and is not a free pass. notice 2008-13, 2008-3 i.r.b. 282 (1/22/08). this notice provides interim guidance on the application of the tax return preparer penalties as amended by the 2007 act. these amendments did not modify the exception to liability under § 6694 that is applicable when it is shown, 2008] recent developments in federal income taxation 839 considering all the facts and circumstances, that the tax return preparer has acted in good faith and there is reasonable cause for the understatement. • the notice provides that a tax return preparer is considered reasonably to believe that the tax treatment of an item is more likely than not the proper tax treatment (without taking into account the possibility that the tax return will not be audited, that an issue will not be raised on audit, or that an issue will be settled) if the tax return preparer analyzes the pertinent facts and authorities in the manner described in reg. § 1.6662-4(d)(3)(ii) and, in reliance upon that analysis, reasonably concludes in good faith that there is a greater than 50 percent likelihood that the tax treatment of the item will be upheld if challenged by the irs. • it further provides that a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, as provided in reg. § 1.6694-1(e). in addition, a tax return preparer may rely in good faith and without verification upon information furnished by another advisor, tax return preparer, or other third party. a tax return preparer will be found to have acted in good faith when the tax return preparer relied on the advice of a third party who is not in the same firm as the tax return preparer and who the tax return preparer had reason to believe was competent to render the advice. • a signing tax return preparer shall be deemed to meet the requirements of § 6694 with respect to a position for which there is a reasonable basis but for which the tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on the merits, if the tax return preparer meets any of the following requirements: 1. the position is disclosed in accordance with § 1.6662-4(f) (which permits disclosure on a properly completed and filed form 8275, disclosure statement, or form 8275-r, regulation disclosure statement, as appropriate, or on the tax return in accordance with the annual revenue procedure described in § 1.6662-4(f)(2)); 2. if the position would not meet the standard for the taxpayer to avoid a penalty under section 6662(d)(2)(b) without disclosure, the tax return preparer provides the taxpayer with the prepared tax return that includes the disclosure in accordance with § 1.6662-4(f); 3. if the position would otherwise meet the requirement for nondisclosure under section 6662(d)(2)(b)(i), the tax return preparer advises the taxpayer of the difference between the 840 florida tax review [vol. 8:si penalty standards applicable to the taxpayer under section 6662 and the penalty standards applicable to the tax return preparer under section 6694, and contemporaneously documents in the tax return preparer’s files that this advice was provided; or 4. if section 6662(d)(2)(b) does not apply because the position may be described in section 6662(d)(2)(c), the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer under section 6662(d)(2)(c) and the difference, if any, between these standards and the standards under section 6694, and contemporaneously documents in the tax return preparer’s files that this advice was provided. • a nonsigning tax return preparer shall be deemed to meet the requirements of § 6694 with respect to a position for which there is a reasonable basis but for which the nonsigning tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on the merits, if the advice to the taxpayer includes a statement informing the taxpayer of any opportunity to avoid penalties under § 6662 that could apply to the position as a result of disclosure, if relevant, and of the requirements for disclosure • one of the examples has raised a good bit of interest. example 10. a corporate taxpayer hires accountant j to prepare its tax return. accountant j encounters an issue regarding various small asset expenditures. accountant j researches the issue and concludes that there is a reasonable basis for a particular treatment of the issue. accountant j cannot, however, reach a reasonable belief whether the position would more likely than not be sustained on the merits because it was impossible to make a precise quantification regarding whether the position would more likely than not be sustained on the merits. the position is not disclosed on the tax return. accountant j signs the tax return as the tax return preparer. the irs later disagrees with this position taken on the tax return. accountant j is not subject to a penalty under section 6694. • anita soucy, spokesperson for the treasury office of tax policy explained at a new york state bar association meeting that example 10 should not be relied on because it is a sympathetic 2008] recent developments in federal income taxation 841 case with mitigating circumstances. deborah butler echoed that statement at the same meeting, saying: “the rules aren’t in the examples,” and “don’t overdiagnose the examples. they’re not going to be there in a year.” 2008 tnt 24-8. • it is important to note that the regulations expected to be finalized in 2008 may be substantially different from the rules described in this notice, and in some cases more stringent. 9. a new penalty is imposed upon refund claims made without a “reasonable basis.” the 2007 act, § 8247(a), adds new code § 6676 to impose a penalty of 20 percent of the “excessive amount” on the person making an erroneous claim for refund or credit unless it is shown that “the claim for such excessive amount has a reasonable basis.” the penalty does not apply to claims relating to the § 32 earned income credit. the penalty applies to claims made after the 5/25/07 effective date of the 2007 act. 10. in this case, the result of any amount multiplied by zero is greater than 400 percent of zero. mcdonough v. commissioner, t.c. memo. 2007-101 (4/25/07). if the taxpayer claims cost recovery allowances with respect to property to which he never received the benefits and burdens of ownership or with respect to property that never existed, the correct basis is zero. pursuant to reg. § 1.6662-5(g), the basis claimed on his return is considered to be 400 percent or more of the correct amount, and the enhanced accuracy related penalty (40 percent of the tax deficiency) for gross valuation misstatements under § 6662(h) applies. 11. when valuation storms became threatening, the estate sought an anchorage “in a remote location.” should it be penalized for doing so? estate of thompson v. commissioner, 499 f.3d 129 (2d cir. 8/23/07), vacating and remanding t.c. memo. 2004-174. at her death in 1998, decedent owned about 20 percent of a closely held company that produced business-to-business industrial and manufacturing directories and publications. however, the advent of the internet caused the profitability of the business to decline sharply from 2000 to barely breakeven in 2002. the irs valued decedent’s interest in the company at $32 million, the estate valued it at $1.75 million, and the tax court (judge swift) valued it at $13.5 million. however, even though the claimed valuation was less than 150 percent of the value determined by the tax court, it declined to impose the § 6662(a) substantial undervaluation penalty of 40 percent of the underpayment because the valuation “was particularly difficult and unique” and the court’s own valuation was “closer to the estate’s valuation than to [the commissioner’s] valuation.” 842 florida tax review [vol. 8:si • the second circuit held that this did not constitute a sufficient finding to support a determination that the § 6664(c) reasonable cause and good faith exception to the penalty applied. chief judge jacobs questioned the estate’s decision to hire a lawyer and accountant to perform the appraisal from the “remote location” of anchorage, alaska in order to achieve a more favorable valuation from the irs office in alaska than would be available from the irs office in new york. the lawyer was experienced but conflicted because he was also appointed to act as administrator of the estate to handle the anticipated irs audit, and the accountant who helped the lawyer with the appraisal “belong[ed] to no professional organizations or associations relating to his appraisal or valuation work.” 12. you do the crime, you do time! one year in a half-way house, five years probation, and a $10,000 fine is too lenient. united states v. taylor, 499 f.3d 94 (1st cir. 8/17/07). in an opinion by judge torruella, the first circuit vacated a tax return preparer’s sentence of one year in a half-way house, five years probation and a $10,000 fine as unreasonably lenient, and remanded the case for resentencing. the tax return preparer, who was a full time school teacher and part time return preparer, was convicted on sixteen counts of aiding and abetting the filing of false returns, resulting from false claims of charitable contributions in amounts ranging from $9,000 to $16,000, about which he advised his clients to lie to irs agents. the court noted, that the “offense ... is a serious crime ... at it’s heart, it is theft, specifically theft of money to which the public is entitled,” and that “the tax fraud committed here was not part of an indigent’s effort to avoid personal tax liability, but rather, the supplemental business of a moderately successful man who misled his clients.” a. then again, maybe you don’t have to do time for a tax crime. taylor v. united states, 128 s. ct. 878 (1/7/2008). the supreme court vacated the judgment and remanded the case to the first circuit court of appeals for further consideration in light of gall v. united states, 128 s. ct. 586 (2007), which held that there is no rule that requires “extraordinary” circumstances to justify sentence outside guidelines range. 13. déjà vu. united states v. carlson, 498 f.3d 761 (8th cir. 8/20/07). a non-prison sentence for a conviction (pursuant to a guilty plea) under § 7202 for willful failure to pay over trust fund taxes was vacated as too unreasonably lenient under the sentencing guidelines. the case was remanded for resentencing. 2008] recent developments in federal income taxation 843 14. is it a ménage à trois?. united states v. tomko, 498 f.3d 157 (3d cir. 8/20/07). a sentence of one year of home confinement, “the very mansion built through the fraudulent tax evasion scheme at issue,” a $250,000 fine, three years probation, and 250 hours of community service for evading taxes of $228,557, was vacated as unreasonably lenient. the case was remanded for resentencing. a. but the court has second thoughts about jailing tax cheats. rehearing granted and opinion vacated, 513 f.3d 360 (3d cir. 1/17/08). 15. even if yaweh might oppose war and taxes that fund it, it’s still criminal tax fraud to fail to render unto caesar. united states v. mckee, 506 f.3d 225 (3d cir. 10/29/07). the third circuit (ironically, judge mckee) upheld the conviction under § 7201 for tax evasion by two partners who failed to withhold and pay over income taxes and employment taxes with respect to employees, who like the partners, were members of the reformed israel of yaweh (riy), a small religious sect that opposes payment of taxes based upon the members’ religious opposition to war and the taxes that fund it. one partner (donato) and his wife (inge donato), who was the partnership’s bookkeeper, signed the fraudulent forms 941, and one or both partners distributed the “untaxed” paychecks to employees who were riy members and “taxed” paychecks to employees who were not riy members. when providing the partnership’s payroll records to accountants for preparation of forms 941, inge donato omitted payroll information for the employees who were members of riy. for purposes of § 7201, the overt acts of the donatos on behalf of the partnership were imputed to mckee because he shared the obligation of filing and paying employment taxes on behalf of the partnership. furthermore, “even if [the defendants’] failure to accurately report the total wages subject to employment taxes was motivated by their desire to respect their employees’ religious convictions, that ‘innocent’ motive does not exempt defendants from their obligation to deduct federal taxes and accurately report the wages subject to that tax, particularly since the cornerstone of the tax system is voluntary self-reporting.” b. discovery: summonses and foia 1. honi soit qui mal y pense. united states v. bdo seidman, llp, 95 a.f.t.r.2d 2005-1725 (n.d. ill. 3/30/05). the district court ruled that only one of 267 documents withheld from irs scrutiny by 844 florida tax review [vol. 8:si the intervenors was not protected by privilege or work product, or both.9 in ruling that the crime-fraud exception did not apply, judge holderman found that neither the existence of cookie-cutter tax opinions nor the irs listing of substantially similar transactions as abusive tax shelters was determinative because “the tax code and underlying regulations is [sic] full of complexities and uncertainties.” he further stated that “just because one of bdo’s consulting agreements has been found to have [been] fraudulent does not mean that all consulting agreements entered into by bdo were fraudulent.” • judge holderman found the test for the § 7525(b) tax shelter exception to be the same as for the crime-fraud exception. • footnote 2 of the opinion sets forth the categories of information contained in the privilege log. inasmuch as the adequacy of another privilege log in this litigation was questioned, the categories in this privilege log might be a useful guide. a. the attorney-client privilege does not attach to communications relating to planning to commit tax fraud. 95 a.f.t.r.2d 2005-2835 (n.d. ill. 5/17/05). subsequently, judge holderman found that there was a prima facie case for the remaining document examined in camera not being privileged by reason of the crime-fraud exception, and the intervenors failed to present sufficient explanation to rebut that presumption. the document involved an investment in distressed debt with the sole motive of obtaining a loss for tax purposes. • the government had argued that “document a-40 is not part of legitimate year-end tax planning, but instead is part of the overall abusive sham tax shelter transaction perpetrated by bdo and invested in by intervenor cullio and others.” • judge holderman refused to quash the summons seeking production of document a-40, which he held related to an “abusive sham tax shelter investment,” because the irs made a prima facie case that the crime-fraud exception to the attorney-client privilege applied and taxpayer failed to provide a satisfactory explanation of why the document should not be disclosed under the crime-fraud exception; there were eight indicators of potential fraud: (1) the marketing of pre-packaged transactions by bdo; (2) the communication by the taxpayer to bdo with the purpose of engaging in a pre-arranged transaction developed by bdo or a third party with the sole purpose of reducing taxable income; (3) bdo and/or the taxpayer attempting to conceal the true nature of the transaction; (4) actual or constructive knowledge by bdo that the taxpayers lacked a legitimate business purpose for entering into the transaction; (5) vaguely worded 9. the unprotected document was an e-mail sent by a bdo employee. 2008] recent developments in federal income taxation 845 consulting agreements; (6) failure by bdo to provide services under the consulting agreement despite receipt of payment; (7) mention of a particular tax shelter that had been identified by the irs as a “listed transaction;” and (8) use of boiler-plate documents. b. on appeal of judge holderman’s decisions to the seventh circuit, judge ripple did not make waves but simply decided in favor of the government. he affirmed in part and vacated and remanded in part. united states v. bdo seidman, llp, 492 f.3d 806 (7th cir. 7/2/07). the seventh circuit (judge ripple) affirmed that document a-40 was unprotected by privilege because it fell within the fraudcrime exception. judge ripple rejected the irs’s position that the party asserting the § 7525 privilege must establish that the communication was not made in connection with the promotion of a tax shelter, and has held that the opponent of the irs bears the burden of establishing that the communication falls within the § 7525(b) exception. • he vacated the decision that 266 documents fell within a valid claim of privilege and remanded with respect to these documents so that the irs could have the opportunity to show that the § 7525(b) tax shelter exception to the tax practitioner privilege applied. 2. if the valuation is fraudulent, the crime-fraud exception to the attorney-client privilege will sting! shahinian v. tankian, 242 f.r.d. 255 (s.d.n.y. 5/7/07). in a civil suit involving an estate regarding the ownership, transfer by gift or sale, and valuation of paintings by an artist, the court (judge castel) applied the crime-fraud exception to the attorney-client privilege to allow discovery of communications between the legatees and executors of two estates (and a friend of the legatees / executors) and weil, gotshal & manges, the law firm for the estates. the exception applied because the communications related to the fraudulent valuation and omission of art works on income tax and estate tax returns, and other statements made to the irs. the record contained a relevant estate tax return, written statements made to the irs in the course of an audit of that return, relevant income tax returns, and applications for extensions of time to pay certain taxes, as well as excerpts from the depositions of several witnesses and “documentary evidence demonstrating material variances between the statements made to the irs and the actual facts.” the court concluded that “comparing the estate and income tax returns and other communications with the irs with the information collaterally developed in discovery ... cast significant doubt on the truthfulness of the statements made to the irs, and the circumstances are sufficient to support the conclusion that communications ... were intended to facilitate the crime or fraud.” 846 florida tax review [vol. 8:si 3. warm up the photocopier for those tax accrual workpapers. announcement 2002-63, 2002-27 i.r.b. 72 (7/8/02). in auditing returns filed after 7/1/02 that claim any tax benefits from a “listed transaction,” see notice 2001-51, 2001-34 i.r.b. 190, the irs may request tax accrual workpapers. listed transactions will be determined “at the time of the request.” neither the attorney-client privilege nor the § 7525 tax practitioner privilege protects the confidentiality of the workpapers. a. specific procedures regarding requests for tax accrual workpapers. chief counsel notice cc-2003-012 (4/9/03). this notice provides procedures to be used regarding requests for tax accrual and other financial audit workpapers. b. the definition of “tax accrual workpapers” is clarified. chief counsel notice cc-2004-010 (1/22/04), supplementing cc-2003-012. the general definition is as follows: tax accrual workpapers are those audit workpapers, whether prepared by the taxpayer or by an independent accountant, relating to the tax reserve for current, deferred and potential or contingent tax liabilities, however classified or reported on audited financial statements, and to footnotes disclosing those tax liabilities on audited financial statements. they reflect an estimate of a company’s tax liabilities and may also be referred to as the tax pool analysis, tax liability contingency analysis, tax cushion analysis, or tax contingency reserve analysis. • documents created prior to or outside of the consideration of whether reserves should be created are not within the definition of tax accrual workpapers nor are workpapers reconciling book and tax income, but they both “likely fall within the scope of the general idrs issued at the beginning of an examination and should be produced … even though no request for the tax accrual workpapers has been made.” c. the government seeks summons enforcement for textron’s tax accrual workpapers. united states v. textron, inc., 2006 tnt 84-19 (d. r.i. 4/28/06). in its supporting brief, 2006 tnt 84-4, the government argued that all tax accrual workpapers should be disclosed because textron engaged in several listed transactions, specifically, six separate sale-in, lease-out (“silo”) transactions in 2001, which were designated as listed transactions in notice 2005-13, 2005-9 i.r.b. 630. 2008] recent developments in federal income taxation 847 • united states v. arthur young & co., 465 u.s. 805 (1984), which held that tax accrual workpapers to be available to the government because they were relevant to a legitimate irs inquiry, is strongly supportive of the government’s position. taxpayer may rely upon the work product doctrine for protection because the tax accrual workpapers clearly are not covered by the attorney-client privilege. d. the work product doctrine works in the sixth circuit. united states v. roxworthy (yum! brands, inc.), 457 f.3d 590 (6th cir. 8/10/06). in response to an irs informal document request, yum claimed that seven documents were protected by the work product doctrine. it turned over five of the documents under a limitation of waiver agreement but refused to turn over the remaining two documents, which were memoranda both dated 3/29/00 prepared by kpmg that analyzed the tax consequences of stock transfers made in connection with the creation of a captive insurance company, which involved a loss of $112 million for tax purposes, but not book purposes. on summons enforcement (against yum’s vice president, tax] the magistrate and district court ordered the documents produced, but the sixth circuit (judge cole) held that the two memoranda were protected work product because they were prepared in anticipation of litigation and included “possible arguments that the irs could mount against yum’s chosen tax treatment of the transactions and possible counterarguments.” • the court stated: [i]n united states v. adlman, 68 f.3d 1495, 1496 (2d cir. 1995) (adlman i), an accounting firm prepared documents evaluating the tax consequences and likely irs challenges to a company’s proposed reorganization in which the company would claim a capital loss of $ 290 million. the second circuit held that the district court erred in concluding that the prospect of litigation was too remote for work-product privilege to apply, observing that “[i]n many instances, the expected litigation is quite concrete, notwithstanding that the events giving rise to it have not yet occurred.” id. at 1501. the court remanded the matter for the district court to apply the proper standard. • the standard test to be used to establish whether documents were prepared “in anticipation of litigation” is the question of whether the “documents can be said to have been created because of the prospect of litigation” (the “because of” test) – as opposed to whether they would have been prepared in substantially the same form in the absence of prospective litigation. in applying the test, the court is to ask: “(1) whether a 848 florida tax review [vol. 8:si document was created because of a party’s subjective anticipation of litigation, as contrasted with an ordinary business purpose, and (2) whether that subjective anticipation of litigation was objectively reasonable.” • the court noted that the reason for the requesting party to seek such documents is usually to see the “[tax professionals’] assessment of the [transaction’s] legal vulnerabilities in order to make sure it does not miss anything in crafting its legal case,” which it noted was precisely the type of discovery protected by the work product doctrine. • the court rejected the irs argument that the memoranda were not prepared in anticipation of litigation, but “were more likely prepared to assist yum in the preparation of its taxes and the avoidance of understatement penalties if the irs disagreed with yum’s tax treatment. . . .” • the court finally held that the fact that the memoranda bore an attorney-client privilege designation, not a work product designation, should not alone settle the inquiry as to whether they were prepared in anticipation of litigation. (1) aod 2007-04 (10/1/07). the irs announced its nonacquiescence in united states v. roxworthy, 457 f.3d 590 (6th cir. 2006). the irs took the position that a document prepared in anticipation of its annual audit by a cpa firm is not “prepared in anticipation of litigation,” and that, a fortiorari, tax opinion letters prepared by kpmg to provide advice “with respect to the tax implications of forming a captive insurance company” prior to the formation of that company and provided by yum! brands to its cpa during its annual audit were not protected by the work product doctrine. the irs further announced that it will challenge “unjustified assertions of the work product doctrine (and other privileges) in all appropriate cases, including those that would be appealable to the sixth circuit.” e. district court finds tax accrual workpapers protected by the “work product privilege” and denies the irs petition for summons enforcement. united states v. textron inc., 507 f. supp. 2d 138 (d. r.i. 8/28/07). textron engaged in six silo transactions in 2001 before these became listed transactions in 2005. under irs procedures, engaging in more than one listed transaction means that the irs will request the entire tax accrual workpapers file. textron produced documents with respect to the silo transactions but refused to turn over its entire workpaper file. judge torres held that the tax accrual workpapers were prepared “because of” anticipated litigation with the irs. he refused to follow contrary authority from the fifth circuit in united states v. the el paso company, 682 f.2d 530 (1982), which used the more stringent primary 2008] recent developments in federal income taxation 849 purpose test for determining whether documents are prepared “in anticipation of litigation.” he also held that work product protection was not lost when the tax accrual workpapers were provided to ernst & young for its audit of the company because the aicpa code § 301 on confidential client information made it very unlikely that the accounting firm would provide them to the irs. 4. the government also has privileges. deseret management corp. v. united states, 76 fed. cl. 88 (3/29/07). after the court’s in camera review, taxpayer’s motion to discover certain documents was denied on the basis of the attorney-client privilege applicable to communication among justice department lawyers, irs lawyers, and irs employees. also, documents prepared in anticipation of litigation were protected from disclosure as work product. a. work product privilege applies to irs chief counsel’s work too! ratke v. commissioner, 129 t.c. 45 (9/05/07). after the taxpayer substantially prevailed of the merits of an asserted deficiency, the taxpayer sought attorney’s fees. in the attorney’s fees proceeding, the taxpayer sought discovery of a memorandum sent by the irs chief counsel’s trial counsel to the national office at the time the commissioner’s answer was filed in the case, and an unredacted version of the responding memorandum sent a few months later by irs chief counsel’s national office were protected by the work product doctrine from discovery by taxpayer’s counsel. a redacted version of the latter memorandum, which contained fact-based work product, but not opinion based work product, had been provided to taxpayer’s counsel. the tax court (judge chabot) held that the memoranda were protected from discovery under the opinion work product doctrine. the irs’s reference, in its brief in opposition to the taxpayer’s motion for attorney’s fees, to a pretrial exchange of memoranda between the irs trial counsel and the irs national office, did waive the work product privilege, because the reference in the brief was in the course of reciting the sequence of events leading to disclosure of redacted versions of memoranda, and was not testimonial in nature, i.e. it was not intended to show that irs’s position in case was substantially justified. neither of the memoranda, both of which were examined in camera, contained information sufficiently important to outweigh the privacy and other concerns underlying the work product doctrine. the redacted version of the response memorandum and the irs’s summary of the unredacted version, which was provided to the taxpayer, together provided a fair representation of the legal strategies and opinions in the unredacted version memorandum. because the taxpayer was given a fair representation of the unredacted legal strategies and opinions, and the 850 florida tax review [vol. 8:si redacted portions would not impact the outcome of the motion for attorney’s fees, the taxpayer did not have a compelling need to discover the opinion work product. 5. snider v. united states, 468 f.3d 500 (8th cir. 11/8/06). the court held that a cid agent’s disclosures to third-party witnesses that included taxpayers’ identities and a statement that the taxpayers were the subjects of grand jury investigation, were unauthorized disclosures under § 6103, and that the disclosures were neither necessary nor the result of good faith interpretation of § 6013 under § 7431. each disclosure of each item of information to each person who heard disclosure counted as an “act” in calculating the $1,000 per act. a. aod 2007-03 (7/23/07). the irs has nonacquiesced in snider v. united states. the irs considers it necessary to disclose the name of the taxpayer being investigated to efficiently interview third-party witnesses. the irs will continue to litigate the position that neither the number of return items nor the number of people witnessing disclosure is a “legally significant factor.” 6. tax analysts continues successfully to be “respectfully disagreeable” with the irs on disclosure issues. tax analysts v. internal revenue service, 495 f.3d 676 (d.c. cir. 7/24/07). the court (judge henderson) affirmed a district court order, 416 f. supp. 2d 119 (d. d.c. 2/27/06), granting summary judgment for tax analysts in its suit under § 6110 seeking disclosure of e-mails from lawyers in the irs chief counsel’s office to field personnel containing legal advice. the request dealt with “all written legal advice documents, whether or not styled cca, prepared by national office components of occ for the field, and which have been withheld from public disclosure on the ground that such written advice ‘can be rendered in less than two hours,’ or that such documents ‘can be prepared in less than two hours.’” judge henderson held that e-mails clearly fell under the § 6110(i)(1)(a) definition of chief counsel advice (cca), as “written advice or instruction, under whatever name or designation, prepared by any national office component of the office of chief counsel ... issued to field or service center employees of the service or regional or district employees of the office of chief counsel [which] conveys ... any legal interpretation of a revenue provision.” she rejected the irs’s arguments that “informal advice” or advice rendered in a short timeframe was exempt from disclosure: “it requires no particular form or formality. nor does it distinguish between advice a lawyer renders in less than two hours and advice that takes longer than two hours to prepare.” 2008] recent developments in federal income taxation 851 7. the work product privilege claim didn’t work, but the § 7525 privilege claim did. valero energy corp. v. united states, 100 a.f.t.r.2d 2007-6473 (n.d. ill. 8/23/07). valero sought to quash summonses issued by the irs to valero’s tax advisor, arthur andersen, relating to certain branch transactions, foreign currency transactions, dual consolidated losses, overall foreign losses, and hedge positions in connection with fluctuation risks. the court (judge kennelly) rejected valero’s claim that the documents were protected by the work product doctrine. he found that the documents were “best categorized as having been prepared during the ordinary course of business, with the possibility of future litigation being secondary at most.” he concluded that “valero confuse[d] the possibility of litigation with the requirement that to be protected, a document must have been prepared because of anticipated litigation. the fact that valero hired arthur andersen with an eye toward the complex nature of the transaction, and the possibility that the irs might investigate, does not support a contention that arthur andersen prepared its materials because valero or andersen anticipated actual litigation.” under seventh circuit precedent, the work product doctrine applies only when “the document can fairly be said to have been prepared or obtained because of the prospect of litigation.” logan v. commercial union ins. co., 96 f.3d 971, 976–77 (7th cir. 1996) (emphasis in original). however, the documents were protected under the § 7525 tax practitioner’s privilege as “confidential tax advice.” even though it had the effect of avoiding federal income taxes, the tax shelter exception in § 7525(b) did not apply for two reasons. first, as the taxpayer asserted, “the transactions in question did not involve the promotion of tax shelters”; nothing in the record indicated that arthur andersen had anything to do with “promotion” of participation in a tax shelter. second, the tax shelter exception only applies to a transaction in which tax avoidance is a “significant purpose,” and not where tax avoidance is merely “one of the purposes of the transaction.” nothing in the record indicated the purpose of the transactions. (under seventh circuit precedent, united states v. bdo seidman, llp, 492 f.3d 806 (7th cir. 6/2/07), “the burden rests on the opponent of the privilege to prove preliminary facts that would support a finding that the claimed privilege falls within an exception.”) c. litigation costs 1. the russians are coming! the russians are coming! pacific fisheries, inc. v. united states, 484 f.3d 1103 (9th cir. 4/17/07). the government’s position was not “not substantially justified” where in taxpayer’s suit to quash a subpoena, the irs withdrew the 852 florida tax review [vol. 8:si subpoena, which it had issued at the behest of the russian government, before an answer was due. attorney’s fees were not awarded to the taxpayer. 2. this fees assessment was against taxpayer’s lawyer because he knew the case had no merit. davis v. commissioner, t.c. memo. 2007-201 (7/24/07). the tax court (judge halpern) imposed a $25,800 sanction under § 6673(a)(2) on taxpayers’ lawyer for excess attorney’s fees the irs incurred as result of his “abuse of the judicial process” by “unreasonable and vexatious multiplication” of taxpayer’s cdp proceedings, including signing pleadings and other papers knowing taxpayer’s claims to be meritless. a. different taxpayer, same lawyer, same merits and arguments, same judge, substantially similar result. gillespie v. commissioner, t.c. memo. 2007-202 (7/24/07). this time the lawyer’s sanction was only $12,798. only a $5,000 sanction was imposed on the taxpayer himself. d. statutory notice of deficiency there were no significant developments regarding this topic during 2007. e. statute of limitations 1. the taxpayer’s conduct was not fraudulent, but maybe he wasn’t an innocent babe in the woods either. the return was fraudulent even though the taxpayer did not know it. allen v. commissioner, 128 t.c. 37 (3/5/07). judge kroupa held that the statute of limitations for a fraudulent return is extended under § 6501(c)(1), even though it was solely the return preparer, rather than the taxpayer, who had the intent to evade tax. the taxpayer was a truck driver who filed timely returns for the years at issue. he gave his form w-2, 401(k) statement, mortgage interest statement, and other relevant documents to his return preparer (goosby) who prepared the returns and filed them. as prepared by goosby, the returns claimed false and fraudulent itemized deductions for charitable contributions, meals and entertainment, and pager and computer expenses, as well as various other expenses. the taxpayer received complete copies of the returns for the years at issue after they had been filed, but he did not file any amended tax returns. judge kroupa reasoned as follows: we do not find it unduly burdensome for taxpayers to review their returns for items that are obviously false or incorrect. it is every taxpayer’s obligation. petitioner cannot 2008] recent developments in federal income taxation 853 hide behind an agent’s fraudulent preparation of his returns and escape paying tax if the government is unable to investigate fully the fraud within the limitations period. • she further noted that the irs was seeking to collect only the deficiency (and interest) from the taxpayer. 2. deposit or payment affects limitation on suit for refund. huskins v. united states, 75 fed. cl. 659 (3/16/07). the taxpayer estate’s tax counsel submitted a payment of $165,000 to the irs that was described in counsel’s cover letter as a “payment” of estate taxes. more than three years later the estate filed a return showing zero tax due and requested a refund of the prior payment. the government claimed that refund was barred by the three year limitation period of § 6511. the court concluded that the payment was an “undesignated remittance” treated as a deposit under rev. proc. 84-58, 1984-2 c.b. 501, and therefore refundable. 3. this is indeed a taxing opinion. electrolux holdings, inc. v. united states, 491 f.3d 1327 (fed. cir. 6/20/07). in what the court describes as a “taxing case” the federal circuit interpreted § 6511(d)(2)(a), which provides that the 3-year statute of limitations to claim a refund for a year to which a capital loss carryback is allowed is determined from the year in which the loss providing the carryback was recognized rather than the carryback year. the taxpayer incurred a consolidated loss in 1994 that was ultimately allowed when the loss disallowance rules of reg. § 1.1502-20 were declared invalid in rite-aid corp. v. united states, 255 f.3d 1357 (fed. cir. 2001). the taxpayer had agreed with the irs to an extension of the statute of limitations for its 1994 year to 12/31/99. the irs allowed the taxpayer’s claim for refund for its 1994 year, a refund for its 1993 year to which part of the l994 loss was carried back, and refunds for 1996, 1997, and 1998, which were open years when the taxpayer filed its claim for refund on 12/31/99. however, the federal circuit agreed with the commissioner and the federal claims court that § 6511(d)(2)(a) did not permit the taxpayer to claim a refund for 1995. the court rejected the taxpayer’s argument that § 6511(d)(2)(a) applied to its 1995 year because the amount of the loss carryforward to that year could not be determined until the loss was carried back to 1993. the court held that the taxpayer’s 1995 overpayment was not due to the 1993 carryback and was thus not attributable to the capital loss carryback. • cutting to the chase, the essential holding of the case is that § 6511(d)(2)(a) extends the period of limitations for carrying back a loss, but not for carrying forward such loss, where the amount of the allowable loss is finally determined in a year later than it was incurred, 854 florida tax review [vol. 8:si not all of the loss is absorbed in carryback years, and the carryforward year is closed. 4. overstating basis is not the same as gross income. bakersfield energy partners, lp v. commissioner, 128 t.c. 207 (6/14/07). overstated basis resulted in an understatement of § 1231 gain. looking to precedent under the statutory predecessor of § 6501(e) in the 1939 code (colony, inc. v. commissioner, 357 u.s. 28 (1958)), from which the 6-year statute of limitations in § 6229(c)(2) is derived and to which it is analogous, the tax court concluded that this understated gain was not an omission of “gross income” that would invoke the 6-year statute of limitations under § 6229(c)(2) applicable to partnership audits. a. and the court of federal claims agrees. grapevine imports, ltd v. united states, 77 fed. cl. 505 (7/17/07). in a tefra partnership tax shelter case, the court of federal claims (judge allegra) held that the § 6501(e) 6-year statute of limitations does not apply to basis overstatements under colony, inc. v. commissioner, 357 u.s. 28 (1958). section 6501(e), rather than § 6229(c)(2) as in bakersfield energy partners, lp, because in earlier proceedings in the instant case, 71 fed. cl. 324 (2006), the court had held that § 6229 did not create an independent statute of limitations, but instead only provides a minimum period for assessment for partnership items that could extend the § 6501 statute of limitations, and because the fpaa was sent within this 6-year statute of limitations under § 6229(d) the statute of limitations with respect to the partners was suspended. • however, citing barenholtz v. united states, 784 f.2d 375 (fed. cir. 1986), the court rejected the taxpayer’s argument that because the statute of limitations on 1999 had run, the irs was barred from adjusting the amount of the nol carryover from 1999 to 2000, which remained an open year. b. but a district court in florida disagrees. brandon ridge partners v. united states, 100 a.f.t.r.2d 2007-5347 (m.d. fla. 7/30/07). the court refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) 6-year statute of limitations does apply to basis overstatements. the court reasoned that as a result of subsequent amendments to the relevant code sections, the application of colony, inc. v. commissioner, 357 u.s. 28 (1958) is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or services. (“in the case of a trade or business, the term ‘gross income’ means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) 2008] recent developments in federal income taxation 855 prior to diminution by the cost of such sales or services.”]. the court reasoned that to conclude otherwise would render § 6501(e)(1)(a)(i) superfluous. because the transaction at issue was the partnership’s sale of stock, which was not a business sale of goods or services, the gross receipts test did not apply. on the facts, the partners and partnership returns (and statements attached thereto), taken together “failed to adequately apprise the irs of the true amount of gain on the sale of the ... stock.” thus, the partnership did not show that the extended limitations period was inapplicable. c. and this time the court of federal claims agrees with the district court in florida and disagrees with its own prior opinion (by a different judge) in grapevine imports. salman ranch ltd. v. united states, 79 fed. cl. 189 (11/9/07), amended, 100 a.f.t.r.2d 2007-6893 (12/6/07). the court (judge miller) refused to follow bakersfield energy partners and grapevine imports and held that the § 6501(e) 6-year statute of limitations does apply to basis overstatements. judge miller reasoned that an understatement of “gain” is an omission of gross income, and that omission can result from a basis overstatement as well as from an understatement of the amount realized. like the brandon ridge partners court, judge miller concluded that the application of colony, inc. v. commissioner, 357 u.s. 28 (1958), is limited to situations described in § 6501(e)(1)(a)(i), which applies to trade or business sales of goods or services. (“in the case of a trade or business, the term “gross income” means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services.”). because the transaction at issue was the partnership’s sale of a ranch, which was not a business sale of goods or services, the gross receipts test did not apply. on the facts, the partners’ and partnership returns failed to adequately apprise the irs of the amount of gain (in a variant of the son of boss tax shelter). accordingly, the partnership did not show that the extended limitations period was inapplicable. the amended order certified and interlocutory appeal and stayed the case pending further court order, because of the split of opinion between salman ranch, on the one hand, and bakersfield energy partners and brandon ridge partners, on the other hand. f. liens and collections 1. pension protection act § 855 amends code § 6330(d) to provide that all appeals of collection due process determinations are to be made to the tax court. the provision is effective 856 florida tax review [vol. 8:si for determinations made more than 60 days after the 8/17/06 date of enactment. a. cc-2007-001 (10/13/06). 2006 tnt 201-7. the irs has provided guidance regarding the amendment to § 6330(d) providing the tax court with exclusive jurisdiction over review of all cdp determinations issued on or after 10/17/06. 2. t.d. 9290, miscellaneous changes to collection due process procedures relating to notice and opportunity for hearing upon filing of notice of federal tax lien, 71 f.r. 60835 (10/17/06). these final regulations amend the regulations relating to a taxpayer’s right to a hearing under § 6320 after the filing of a notice of federal tax lien (nftl). they make certain clarifying changes in the way collection due process hearings are held and specify the period during which a taxpayer may request an equivalent hearing. the final regulations affect taxpayers against whose property or right to property the irs files a nftl. these regulations are effective 11/16/06. a. t.d. 9291, miscellaneous changes to collection due process procedures relating to notice and opportunity for hearing prior to levy, 71 f.r. 60827 (10/17/06). these final regulations amend reg. § 301.6330-1, relating to a taxpayer’s right to a hearing before or, in limited cases, after levy under § 6330. they make certain clarifying changes in the way cdp hearings are held and specify the period during which a taxpayer may request an equivalent hearing. the final regulations affect taxpayers against whose property or rights to property the irs intends to levy. these regulations are applicable to requests for cdp hearings after 11/16/06. 3. sometimes small is big. schwartz v. commissioner, 128 t.c. 6 (2/14/07). judge ruwe held that a small case proceeding was not available to review a § 6330 collection due process determination regarding the collection of $153,721 of unpaid tax attributable to seven taxable years, even though the unpaid tax attributable anyone taxable year did not exceed $37,315. in contrast to the annual $50,000 jurisdictional limit for a small case proceeding in deficiency cases, pursuant to § 7463(f)(2), the jurisdictional limit on small case procedures with respect to tax court review of a § 6330 due process hearing regarding collection of unpaid taxes is $50,000 in the aggregate for all of the years to which the determination relates, regardless of the number of years involved. 4. it’s not the government’s fault it doesn’t know your address. bullard v. united states, 486 f. supp. 2d 512 (d. md. 2008] recent developments in federal income taxation 857 2/26/07). notice to the taxpayer of his right to a collection due process hearing, addressed to the taxpayer at the address shown on his last filed return, was returned to the irs as undeliverable. the irs’s responsibility is to serve notice on the taxpayer at the taxpayer’s last known address. the onus is on the taxpayer to notify the irs of any change of address. 5. hansen v. commissioner, t.c. memo. 2007-56 (3/8/07). another investor in a hoyt tax shelter partnership was found to be able to pay more than is offered in compromise. as the court notes, this is just one of a long line of similar cases brought by investors in hoyt partnerships involving levies to collect taxes attributable to participation in the partnerships. 6. united states v. ryals, 480 f.3d 1101 (11th cir. 3/12/07). the § 6331(k)(1) prohibition on making a levy while an offer in compromise is pending does not extend to a continuous levy on the taxpayer’s wages that was in place before the offer in compromise was submitted. 7. deutsch v. commissioner, 478 f.3d 450 (2d cir. 3/2/07). even though taxpayer was never sent a deficiency notice, he had an opportunity to dispute the deficiency because the taxpayer’s representative, who had a power of attorney, had signed a form 4549 “income tax examination changes,” consenting to assessment and waiving the right to contest the liability in the tax court. 8. your accountant is in the hospital with cancer, tough luck. file on time or pay the penalty. and, you only get one bite at the abatement apple. lewis v. commissioner, 128 t.c. 48 (3/28/07). the taxpayer, a plumber, filed his 2002 tax return in january 2004, a little late because, the taxpayer claimed, his accountant who had the taxpayer’s documents was hospitalized with stomach cancer. the taxpayer sought to abate the interest and late filing fees on appeal to the irs, which was denied by the appeals officer. subsequently the taxpayer received a notice of intent to levy, which prompted the taxpayer to request a collection due process hearing. under § 6330(c)(4), a person cannot raise an issue in a collection review proceeding that has been considered at a previous administrative or judicial review. reg. § 301.6330-1(e)(3), q&a-e2, provides that where the taxpayer has a conference with the appeals office the amount of the underlying tax liability cannot be challenged in a collection review proceeding or in the tax court. the tax court upheld the regulation as valid, and determined that because the taxpayer had an opportunity to dispute the underlying tax liability in the prior procedure, there in the 858 florida tax review [vol. 8:si appeals office, he was precluded from raising the issue in the collection action. 9. it has to hurt a little more. smith v. commissioner, t.c. memo. 2007-73 (3/29/07). the commissioner did not abuse his discretion by refusing to accept the taxpayer’s offer of $11,552 to compromise an estimated $265,000 tax liability attributable to a hoyt tax shelter. the appeals officer determined that the taxpayer had the financial wherewithal to pay a higher amount. the taxpayer’s claims of having been defrauded, potential financial hardship, and potential future medical claims were not persuasive. 10. the justices of the supreme court can agree on important tax issues. ec term of years trust v. united states, 127 s. ct. 1763 (4/30/07). a unanimous supreme court (justice souter) held that § 7426(a) is the exclusive remedy for third party wrongful levy claims. a third party who files a claim after the 9-month limitations period has expired is not entitled to pursue a refund action under § 1346(a)(1). the irs collected over $3 million from trusts established by elmer and dorothy cullers representing tax liabilities against the cullerses for tax deductions claimed in the 1980s. almost a year from the date amounts were paid pursuant to the levies, the trusts filed a district court action under § 7426(a) claiming wrongful levies. the district court dismissed the action because it was filed after the 9-month limitation period of § 6532(c)(1) had expired. the trusts then filed a claim for refund with the irs, which was denied, followed by a suit for refund in the district court. the district court, affirmed by the fifth circuit, held that an action under § 7426(a) was the sole remedy available to the trusts, and dismissed the action. the ninth circuit had reached a contrary result in wwsm investors v. united states, 64 f.3d 456 (1995). the supreme court granted certiorari to resolve the conflict. the court concluded that the precisely drawn provisions of § 7426(a)(1) preempt the more general refund provision of § 1346(a)(1). • the court distinguished united states v. williams, 514 u.s. 527 (1995), which held that a property owner who paid taxes of another to remove a lien could recover the payment through a refund suit, as involving a lien that was not subject to challenge under § 7426(a)(1), not a levy, and limited the holding of williams to cases in which, wholly apart from statute of limitations issues, no remedy other than a refund suit under § 1346(a)(1) is open to the plaintiff. with the post-williams enactment of §§ 6325(b)(4) and 7426(a)(4), providing exclusive remedies to remove a lien in a williams-type situation, there is little left of the williams doctrine. 2008] recent developments in federal income taxation 859 11. t.d. 9344, change to office to which notices of nonjudicial sale and requests for return of wrongfully levied property must be sent, 72 f.r. 39737 (7/20/07). reg. § 301.7425-3t provides revised procedures to obtain discharge of a junior federal tax lien by a nonjudicial sale pursuant to § 7425(b) by providing proper notice to the irs. 12. the irs can’t whipsaw a taxpayer out of the right to contest liability in a cdp hearing if no statutory notice was issued. however, “no harm, no foul” so irs wins. perkins v. commissioner, 129 t.c. 58 (9/13/07). on his tax return, the taxpayer claimed ordinary losses from “day trading” stock. the irs disallowed the losses in excess of $3,000 (as allowed by § 1211) as a math adjustment pursuant to § 6213(b)(1), and assessed the increased taxes without issuing a deficiency notice. after expiration of the § 6213(b)(2) period to request abatement, the taxpayer appealed the adjustment. while consideration by appeals was pending, the irs issued a notice of intent to levy, and the taxpayer timely requested a cdp hearing pursuant to § 6330(a)(3)(b). before a cdp hearing was scheduled, appeals responded to the taxpayer’s appeal of the adjustment by denying it. at the cdp hearing, the taxpayer was not allowed to challenge the underlying tax liability, on the grounds that the previous submission to appeals constituted a prior opportunity to dispute the liability under § 6330(c)(2)(b). upon review, the tax court (judge gale) held that the taxpayer did not have an “opportunity to dispute” his underlying tax liability within the meaning of § 6330(c)(2)(b), and the taxpayer was entitled to challenge the underlying tax liability in the tax court. an “appeals conference opportunity…[is] not a prior opportunity where, as in this case, the requested conference opportunity is not resolved by appeals until after the taxpayer has requested, but not received, a section 6330 hearing,” because otherwise the irs “could cut off judicial review in these circumstances by the simple expedient of processing the appeals consideration of the liability outside section 6330 before offering the section 6330 hearing.” on the merits, however, the taxpayer was found not to be eligible for ordinary loss treatment under § 475(f), because he never even attempted an election, so the § 1211(b) limitation applied. 13. even a properly addressed deficiency notice does not necessarily preclude challenging the deficiency at a cdp hearing. kuykendall v. commissioner, 129 t.c. 77 (9/25/07). the taxpayer had moved and did not receive a deficiency notice sent to his last known address until only 12 days remained in the 90-day period within which to petition the tax court. the taxpayer did not file a tax court petition in response to the deficiency notice, which was based on inadequately documented claimed business expenses. after receiving notice of intent to levy, the taxpayer 860 florida tax review [vol. 8:si requested a cdp hearing and attempted to provide documentation to support the claimed deductions. when the taxpayer was denied the opportunity to contest the deficiency at a cdp hearing, the taxpayer petitioned the tax court for review. judge haines held that the taxpayer was not afforded adequate time to file a petition, and accordingly was not barred from contesting the underlying tax liability at a cdp hearing. 14. the tax court’s jurisdiction under § 6330(d) to review cdp determinations is more limited that its jurisdiction under § 6213(a) to review deficiency determinations. giamelli v. commissioner, 129 t.c. 107 (10/30/07) (reviewed opinion, 9-2-8). the majority of the tax court, in an opinion by judge goeke, held that the tax court’s jurisdiction under § 6330(d) to review cdp determinations is more limited than its jurisdiction under § 6213(a) to review deficiency determinations. in contrast to deficiency cases, where “taxpayers may raise any issue regarding their tax liability for the period in question regardless of their prior communication of such issues to the commissioner” because the tax court’s “role in such cases is for a redetermination of [a] deficiency” and “to determine the amount of [an] overpayment,” §§ 6213(a), 6512(b), review in appeals from cdp determinations is limited to issues that “have been raised properly when the appeals officer made her determination.” applying this rule, the majority applied an earlier version of reg. § 301.6330-1(f)(2), q&a-f3 to preclude taxpayer from challenging on appeal to the tax court a previously self-assessed liability that was not properly contested in the administrative hearing before the appeals division. • judge swift’s dissenting opinion (joined by four other judges) raised three arguments against the majority opinion. first, he argued that § 6330(d)(1)(a) confers on the tax court “‘de novo’ review over the ‘matter’ ... (namely, the underlying tax liability),” and not merely the irs’s determination. “although titled ‘judicial review of determination’ the statutory language in subparagraph (a) that grants our jurisdiction uses the word ‘matter,’ not ‘determination.’” second, he reasoned that by its reading of reg. § 301.6320-1(f)(2), q&a-f3, the majority opinion effectively adopted a jurisdictional restriction that did not harmonize with “the plain language of the statute, its origins, and its purpose.” third, he argued that magana v. commissioner, 118 t.c. 488 (2002), “prudently left open the possibility that we might consider issues not raised at appeals because unusual situations may arise where it would make little sense not to consider such issues.” • judge vasquez separately dissented on the grounds that “[t]he legislative history establishes that in section 6330 cases congress intended there to be a trial de novo in the tax court, that we can 2008] recent developments in federal income taxation 861 receive evidence beyond the administrative record, and we may consider issues not raised at the section 6330 hearing.” • judge marvel, in a dissent joined by four judges (some of whom also joined in judge swift’s dissent), argued that because the taxpayer before the court was the estate of the taxpayer, and the estate did not come into existence until after the decedent taxpayer’s death following the cdp hearing, that the estate should not be foreclosed from raising issues on appeal not raised by the decedent in the administrative cdp hearing. 15. “abrupt” issuance of cdp determination letter is evidence of abuse of discretion. blosser v. commissioner, t.c. memo. 2007-323 (10/29/07). the tax court (judge goeke) held that the irs abused its discretion by failing to consider issues regarding changed financial circumstances that might support consideration of collection alternatives raised by the taxpayer during a cdp hearing. in light of lack of transcript, the “abbreviated” nature of the entry in the appeals officer’s log regarding the telephonic hearing, and the “abrupt decision” by the settlement officer, the tax court was “forced to make ... inferences” that “the settlement officer indicates she did not consider the issues petitioner raised during the hearing as required by section 6330(c)(3)(b) before deciding to issue the notice of determination.” 16. nuanced differences in the statutory subsections result in different periods for suspending the statute of limitations on collections. severo v. commissioner, 129 t.c. 160 (11/15/07). section 6503(h) suspends the running of the period of limitations on collection from the date of the taxpayer’s bankruptcy petition was filed to the date six months after the bankruptcy court issues a discharge order. the more limited suspension of the period of limitations in § 6503(b), which applies to judicial proceedings generally when the taxpayer’s assets are under control of a court, does not apply in bankruptcy situations. 17. the tax court tries to minimize game-playing by the baltics in nevada’s answer to monte carlo on the mediterranean. baltic v. commissioner, 129 t.c. 178 (12/27/07). the tax court (judge holmes) held on summary judgment that taxpayers who received a notice of deficiency but did not file a tax court petition could not challenge their underlying tax liability by making an offer-in-compromise based on doubt as to liability (“oic-datl”) and asking for audit reconsideration because that is a challenge to the “underlying tax liability” that is precluded by § 6330(c)(2)(b) (“the person may also raise at the hearing challenges to the existence or amount of the underlying tax liability 862 florida tax review [vol. 8:si for any tax period if the person did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability”). judge holmes held that the settlement officer who conducted the cdp hearing did not abuse her discretion when she referred the oic-datl and audit reconsideration request to the proper offices in the irs, postponed collection by levy until the irs had considered the oic-datl, but sustained the lien in order to give the irs priority over other creditors. • the taxpayers were residents of ohio when they filed their petition, their lawyer is from bellaire, texas, and they chose las vegas, nevada as their place of trial. g. innocent spouse 1. sometimes it really is just too darn late to raise an innocent spouse claim. united states v. boynton, 99 a.f.t.r.2d 2007920 (s.d. cal. 2/1/07). a claim for innocent spouse relief cannot be raised in a suit by the government to reduce to judgment a tax assessment. 2. innocent even though she knew the taxes weren’t being paid. farmer v. commissioner, t.c. memo. 2007-74 (3/29/07). the irs abused its discretion in denying innocent spouse relief to petitioner even though she worked in the ex-husband’s business and was aware that taxes reflected on the joint return that she signed were not being paid. factors favoring the petitioner included the fact that she was divorced from her exhusband when she sought relief, the petitioner received no significant benefit from the money derived in the husband’s business, the petitioner would suffer significant hardship even though she had remarried (her liabilities would prevent the petitioner from paying basic living expenses from her own resources), even though the petitioner knew the taxes were not being paid, the ex-husband had complete control over the business receipts and the petitioner had no direct access, and the tax underpayment was attributable to the ex-husband, not the petitioner. 3. the bankruptcy petition of an ex-spouse does not bar the tax court from considering whether the other spouse is innocent. kovitch v. commissioner, 128 t.c. 108 (4/4/07). the petitioner filed for relief from joint liability for a deficiency arising out of the 2002 tax year. she and her husband divorced after 2002. the ex-husband filed a petition to intervene in the action to eliminate the petitioner’s joint liability. shortly after filing the petition to intervene, the ex-husband filed for bankruptcy. the tax court held that the automatic stay of 11 u.s.c. § 362(a), which operates to bar “actions against or concerning the debtor or 2008] recent developments in federal income taxation 863 property of the debtor,” does not preclude consideration of the other spouse’s petition for innocent spouse relief. the innocent spouse petition does not affect the ex-husband’s joint and several tax liability. the tax court recognized, however, that granting innocent spouse relief could have a financial impact on the ex-husband. 4. the irs and the spouse agree that she’s innocent, but the abusive ex complains. wilson v. commissioner, t.c. memo. 2007-127 (5/21/07). the petitioner and the irs agreed that innocent spouse relief should be granted even though she was involved in her husband’s business. the petitioner provided designs that were etched into engraved stones sold to customers. intervenor husband maintained all of the business records and handled all of the money, although petitioner had signature authority over the business checking accounts. the tax court (judge haines) found that the intervenor maintained control of the business, that the intervenor was abusive, and demanded to have absolute authority over all financial aspects of the marriage and the business. the petitioner was not allowed to review business records or tax returns. the intervenor conceded that deficiencies arising from disallowed business expenses and increased employment taxes were attributable to him. the court concluded that innocent spouse relief was appropriate even if the petitioner had actual knowledge because of the abuse present in her relationship with intervenor. 5. small case status is determined differently for stand-alone innocent spouse petitions than it is for deficiency cases. petrane v. commissioner, 129 t.c. 1 (7/24/07). judge ruwe held that for purposes of qualifying a § 6015(e) petition for review of the irs’s denial of innocent spouse relief as a small case under § 7463, the $50,000 threshold is determined by including the total amount of taxes, interest, and penalties (including accrued but unassessed interest and penalties) for all years as of the date the petition was filed. when the petition was filed, the amount for which the taxpayer sought relief did not exceed $50,000 for any single year, but the total of the amounts for all years did exceed $50,000. because the total amount of relief the taxpayer sought for the years in issue exceeded $50,000, she was not eligible to proceed as a small case. a. schwartz v. commissioner, 128 t.c. 6 (2/14/07). judge ruwe reached a similar conclusion in this case, which held that a small case proceeding was not available to review a § 6330 collection due process determination regarding the collection of more than $50,000 of unpaid tax attributable to multiple taxable years, no one of which had more than $50,000 in controversy. 864 florida tax review [vol. 8:si 6. a trusting, but skeptical, wife earns innocent spouse relief from her husband’s hoyt hell. juell v. commissioner, t.c. memo. 2007-219 (8/8/07). the tax court (judge swift) held that the taxpayer was entitled to complete innocent spouse relief under § 6015(b), not merely apportioned relief under § 6015(c), with respect to a deficiency attributable to her husband’s investment in a hoyt cattle tax shelter. the taxpayer (1) was not involved in the preparation of the joint returns, (2) her husband told her, and she believed that because they were married they had to file joint tax returns, (3) her husband told her that because he was involved in the hoyt partnerships, she was required to sign the documents attached to the returns relating to the hoyt partnerships, relying on her husband, she signed the returns and attached materials, despite having not read them, because she felt she did not know enough to understand them. the taxpayer objected to signing the tax returns and asked her husband to get out of the hoyt partnership investments. she reluctantly signed the tax returns only after her husband reassured her that tax professionals had prepared them and that she was required to sign. the taxpayer’s standard of living remained constant, there were no lavish expenditures that benefited her, and she did not receive any benefit from the tax refunds and the tax reductions based on the hoyt partnerships. 7. it’s what you know when you sign the original return, not when you sign the amended return, that determines what you know. billings v commissioner, t.c. memo. 2007-234 (8/16/07). judge holmes held that the irs abused its discretion in denying equitable relief to the petitioner with respect to taxes on his spouse’s embezzlement income. the petitioner had no knowledge of the embezzlement income at the time the original joint return was filed, but knew of it, and knew the taxes would not be paid, when on the advice of an attorney, he and his wife filed an amended return reporting the embezzlement income. knowledge of income at the time the amended return was filed was not a negative factor because petitioner could have been accorded relief under § 6015(b) if, instead of an amended return having been filed, the irs had audited the original return and asserted a deficiency. petitioner received no benefit from the embezzlement income. the sole factor against granting relief – that petitioner would not suffer economic hardship – standing alone was not a sufficient ground for denying relief. 8. even a dead not-so-innocent spouse has standing to intervene, because “the internal revenue code makes sure that taxes survive even death.” fain v. commissioner, 129 t.c. 89 (10/2/07). suzanne fain petitioned the tax court when the commissioner refused to grant her innocent spouse relief from an unpaid tax liability. “her case was 2008] recent developments in federal income taxation 865 already on a trial calendar when commissioner’s counsel realized that the irs had not notified her husband of his right to intervene. that turned out to be impossible – he was dead.” judge holmes held that the nonrequesting spouse’s right to intervene in proceedings on request for innocent spouse relief survives death; executors and administrators should be afforded an opportunity to intervene to oppose relief. “the survival of a decedent’s tax liability means that as a practical matter his heirs or beneficiaries may be affected by the outcome of an innocent-spouse case. the opportunity to intervene is an opportunity to protect those interests, because granting innocent-spouse relief will make the estate of the nonrequesting spouse the only source of payment for any unpaid tax the deceased has left behind.” when neither the irs “nor the requesting spouse has any idea whether there is an estate and whether it has a personal representative ... it is appropriate ... to file an order requiring both parties to furnish the tax court, insofar as ascertainable and to the best of their abilities, the names and addresses of the heirs at law of the decedent, under the law of the jurisdiction wherein the decedent was a resident when his death occurred and for the court to then notify the heirs.” 9. the statute might not have correctly articulated the statutory cross reference, but the tax court got the drift of congressional intent anyway. adkison v. commissioner, 129 t.c. 97 (10/16/07). the tax court does not have jurisdiction to review a claim for apportioned liability relief under § 6015(c) when the tax liability in question relates to partnership income and the deficiency notice on which the jurisdiction was asserted to be based is invalid because the partnership items are subject to determination in a tefra partnership level proceeding that has not yet been resolved. section 6230(a)(3)(a), which still refers to former § 6013(e), the statutory predecessor of § 6015, evidences congressional intent that the spouse of a partner can initiate a claim for innocent spouse relief with respect to a deficiency attributable to an adjustment of a partnership item only after the irs issues a notice of computational adjustment following the completion of the partnership-level proceeding. judge cohen concluded that congress simply overlooked the need to correct the cross references in § 6230 when it replaced § 6013(e) with § 6015. h. miscellaneous 1. tax court grants taxpayer’s motion for leave to file a motion to vacate an order dismissing his case for lack of jurisdiction, and holds that the motion should be deemed filed on the date it was mailed, rather than on the date it was received. stewart v. commissioner, 127 t.c. 109 (10/3/06) (reviewed, 18-0). the tax court 866 florida tax review [vol. 8:si (judge ruwe) determined that the timely-mailing/timely-filing provisions of § 7502 would apply to a motion for leave to file a motion to vacate an order of dismissal for lack of jurisdiction, so the tax court’s earlier decision would not become final after the 90-day period for appeal had elapsed under § 7481(a). the tax court will no longer follow its decision in manchester group v. commissioner, t.c. memo. 1994-604, rev’d, 113 f.3d 1087 (9th cir. 1997). 2. i’m from the irs and i’m here to help you comply with fin 48. the irs announced on 10/17/06 an lmsb initiative to help taxpayers resolve on an expedited basis their issues with financial accounting standards board interpretation no. 48 (fin 48), “accounting for uncertainty in income taxes – an interpretation of fasb statement 109.” 2006 tnt 201-17. requests for fin 48 resolution must be submitted at least 45 days before the end of taxpayer’s fiscal year; the expedited procedure is not recommended for fiscal years ending after 3/31/07. 3. t.d. 9300, guidance necessary to facilitate business electronic filing, 71 f.r. 71040 (12/8/06). the treasury has promulgated final regulations on eliminating regulatory impediments to businesses filing electronic returns. 4. individuals who follow lauren bacall’s instructions will be entitled to between 15 and 30 percent of the collected proceeds resulting from their information. the tax relief and health care act of 2006 § 406 amends code § 7623 to reform the reward program for individuals who provide information regarding violations involving an individual whose gross income exceeds $200,000 for the relevant year if the tax, penalties, interest, and additional amounts in dispute exceed $2 million. generally, the provision establishes a whistleblower reward floor of 15 percent and a cap of 30 percent of the collected proceeds (including penalties, interest, additions to tax, and additional amounts) if the irs moves forward with an administrative or judicial action based on information brought to the irs’s attention by an individual. under certain specified circumstances, the provision permits awards of lesser amounts. the provision allows an above-the-line deduction for attorneys’ fees and costs paid by, or on behalf of, the individual in connection with any award for providing information regarding violations of the tax laws. a. notice 2008-4, 2008-2 i.r.b. 253 (1/14/08). this notice provides guidance on how to file whistleblower claims on irs form 211. one example of the grounds for not processing claims is “(2) claims submitted by an individual who is required by federal law or 2008] recent developments in federal income taxation 867 regulation to disclose the information, or by an individual who is precluded by federal law or regulation from making the disclosure.” 5. burton kanter got in trouble again, and this time it followed him to the grave. investment research associates, ltd. v. commissioner, t.c. memo. 1999-407 (12/15/99). burton kanter was held liable for the §6653 fraud penalty by reason of his being “the architect who planned and executed the elaborate scheme with respect to … kickback income payments . . . .” a. and the tax court’s procedures are vindicated and taxpayer ballard loses on appeal on the fraud issue in the eleventh circuit. ballard v. commissioner, 321 f.3d 1037 (11th cir. 2/13/03), aff’g t.c. memo. 1999-407. the eleventh circuit affirmed the tax court decision and rejected the taxpayers’ argument that changes allegedly made to the original draft opinion from the special trial judge by judge dawson before he adopted it were improper. b. and the tax court’s procedures are vindicated and taxpayer kanter’s estate10 loses on appeal on the fraud issue in the eleventh circuit. estate of kanter v. commissioner, 337 f.3d 833 (7th cir. 7/24/03) (per curiam) (2-1), aff’g in part and rev’g in part t.c. memo. 1999-407. the court found that the nondisclosure of the special trial judge’s original report was proper, following the eleventh circuit’s ballard opinion. it affirmed the tax court’s findings on the issues of deficiencies, fraud, and penalties, but reversed as to other findings. c. and the tax court’s procedures are vindicated but taxpayer lisle’s estate wins on appeal on the fraud issue in the fifth circuit. estate of lisle v. commissioner, 341 f.3d 364 (5th cir. 7/30/03), aff’g in part and rev’g in part t.c. memo. 1999-407. the fifth circuit (judge higginbotham) followed the eleventh and seventh circuits decisions upholding the nondisclosure of the special trial judge’s original report by the tax court. d. justice ginsburg to tax court judges: “you article i judges don’t understand your own rules, so let me tell you what you meant when you adopted them in 1983.” ballard v. commissioner, 544 u.s. 40 (3/7/05) (7-2), reversing and remanding 337 f.3d 833 (7th cir. 7/24/03) and 321 f.3d 1037 (11th cir. 2/13/03). justice ginsburg held that the tax court may not exclude from the record on appeal 10. burton kanter died on october 31, 2001. 868 florida tax review [vol. 8:si nor conceal from the taxpayers the original draft reports of special trial judges under tax court rule 183(b) or under any statutory authority. • chief justice rehnquist’s dissenting opinion, joined in by justice thomas, states that the “tax court’s compliance with its own rules is a matter on which we should defer to the interpretation of that court.” e. the eleventh circuit orders that the special trial judge’s report be added to the record. ballard v. commissioner, 2005-1 u.s.t.c. ¶ 50,393 (11th cir. 5/17/05). f. tax court changes its rules. (9/20/05). the tax court adopted amendments to tax court rules 182 and 183, relating to special trial judges’ reports in cases other than small tax cases. the special trial judge’s recommended findings of fact and conclusions of law are to be served on the parties, who may file written objections and responses. after the case is assigned to a regular judge, any changes made shall be reflected in the record and “[d]ue regard shall be given to the circumstance that the special trial judge had the opportunity to evaluate the credibility of witnesses, and the finding of fact recommended by the special trial judge shall be presumed to be correct.” g. the eleventh circuit remands the case to the tax court – after reinstating the special trial judge’s report. ballard v. commissioner, 429 f.3d 1026 (11th cir. 11/2/05) (per curiam). the case was remanded to the tax court with the following instructions: (1) the “collaborative report and opinion” is ordered stricken; (2) the original report of the special trial judge is ordered reinstated; (3) the tax court chief judge is instructed to assign this case to a previously-uninvolved regular tax court judge; and (4) the tax court shall proceed to review this matter in accordance with the supreme court’s dictates and with its newly-revised rules 182 and 183, giving “due regard” to the credibility determinations of the special trial judge and presuming correct fact findings of the trial judge. h. estate of lisle v. commissioner, 431 f.3d 439 (5th cir. 11/22/05) (per curiam). the case was remanded to the tax court with orders to: (1) strike the “collaborative report” that formed the basis of the tax court’s ultimate decision; (2) reinstate judge couvillion’s original report; (3) refer this case to a regular tax court judge who had no involvement in the preparation of the aforementioned “collaborative report” and who shall give “due regard” to the credibility determinations of judge couvillion, presuming that his fact findings are correct unless manifestly unreasonable (in dealing with the remaining issues of tax deficiency); and 2008] recent developments in federal income taxation 869 (4) adhere strictly hereafter to the amended tax court rule in finalizing tax court opinions. i. on remand, in a 458-page opinion judge haines of the tax court pours out kanter and ballard. estate of kanter v. commissioner, t.c. memo. 2007-21 (2/1/07). the tax court (judge haines) found that certain of the special trial judge’s findings of fact were “manifestly unreasonable” because they were “internally inconsistent or so implausible that a reasonable fact finder would not believe [the recommended finding]” or they were “directly contradicted by documentary or objective evidence.” judge haines therefore found that the kanter-related entities were shams, that “kanter, ballard, and lisle participated in a complex, well-disguised scheme to share kickback payments earned jointly by kanter, ballard, and lisle,” and that they earned income during the years at issue which they failed to report. • judge haines found that – based upon factors such as (1) failure to report substantial amounts of income, (2) concealment of the true nature of the income and the identity of the earners of the income, (3) use of sham, conduit, and nominee entities, (4) reporting kanter’s and ballard’s income on iras (and another entity’s) tax returns, (5) commingling of kanter’s and ballard’s income with funds belonging to others, (6) phony loans, (7) false and misleading documents, and (8) failure to cooperate during the examination process by engaging in a “strategy of obfuscation and delay” – the commissioner demonstrated by “clear and convincing evidence” that kanter and ballard filed false and fraudulent tax returns for each of the years at issue. • judge haines held that the tax court is “obliged to review the recommended findings of fact and credibility determinations set forth in the stj report under a ‘manifestly unreasonable’ standard of review, and ... may reject such findings of fact and credibility determinations only if, after reviewing the record in its entirety, [it] conclude[s] that the recommended finding of fact or testimony (1) is internally inconsistent or so implausible that a reasonable fact finder would not believe it, or (2) is not credible because it is directly contradicted by documentary or objective evidence.” furthermore, judge haines held that a special trial judge’s credibility determinations may be rejected under the “manifestly unreasonable” standard of review without rehearing the disputed testimony. • judge haines further found that the appropriate standard for determining whether the assignment of income doctrine should be applied had been appropriately articulated in united states v. newell, 239 f.3d 917, 919-920, as follows: 870 florida tax review [vol. 8:si to shift the tax liability, the assignor [taxpayer] must relinquish his control over the activity that generates the income; the income must be the fruit of the contract or the property itself, and not of his ongoing income-producing activity. ... this means, in the case of a contract, that in order to shift the tax liability to the assignee the assignor either must assign the duty to perform along with the right to be paid or must have completed performance before he assigned the contract; otherwise it is he, not the contract, or the assignee, that is producing the contractual income — it is his income, and he is just shifting it to someone else in order to avoid paying income tax on it. 6. tax return information gets out if you sue the irs’s towing company. bowers v. j&m discount towing, llc, 99 a.f.t.r.2d 2007-1607 (d. n. mex. 2/28/07) the district court denied the taxpayer’s motion to seal confidential tax records submitted by the irs in support of its motion to dismiss the case against the irs and a towing company retained by the irs to tow the taxpayer’s automobile to enforce a levy for delinquent taxes. 7. be careful about who you invite into your house. united states v. yang, 478 f.3d 832 (7th cir. 3/7/07). mr. yang called the eau claire police to investigate a burglary in his home. in the course of the investigation, and with mr. yang’s permission, the police took some spiral bound notebooks to examine for fingerprints. unfortunately for mr. yang, who was also being investigated by the irs for tax fraud, the notebooks contained financial information regarding the operation of restaurants by mr. yang and his brother. the police, who were aware of the tax fraud proceedings, notified the irs, which subpoenaed the notebooks as evidence in the criminal tax fraud proceeding. the court denied mr. yang’s motion to suppress the notebooks as evidence on fourth amendment grounds pointing out that the notebooks had been voluntarily given to the police thus ending any expectation of privacy. 8. it’s ok for the government to assist identity theft in lien notices. glass v. united states, 480 f. supp. 2d 162 (d. colo. 3/27/07). taxpayer’s pro se complaint for damages for disclosure of taxpayer identification information, including her social security number, in notices of tax liens filed with a county recorder. first, the taxpayer’s action filed under § 7431 (private right of action if a government employee discloses return information in violation of § 6103) should have been filed under § 7433 (private right of action against the united states if a 2008] recent developments in federal income taxation 871 government employee in connection with the collection of any tax knowingly or negligently violates a provision of title 26 or the regulations), which is the exclusive remedy for unauthorized disclosure. in addition, the court held that disclosure of the taxpayer’s personal information was permissible under § 6103 as necessary to locate assets in which the taxpayer has an interest, notwithstanding exposure to identity theft. 9. pick your attorney carefully. united states v. simcho, 99 a.f.t.r.2d 2007-2044 (n.d. cal. 4/11/07). judge patel granted the government’s motion to dismiss the defendant’s counsel, joe izen, in a prosecution for preparing false tax returns for others and filing false tax returns. the defendant’s attorney had been a speaker at seminars conducted by the defendant to promote allegedly abusive tax avoidance trust schemes. memoranda of witness interviews submitted by the government indicated that izen was a featured speaker at seminars, that he was represented as a “big shot tax attorney from texas who dealt with the irs all the time,” and that he “lectured about how trusts were legal and bragged about how he always won cases against the irs.” reliance on izen’s advice would be a significant element of the defense. judge patel concluded that izen’s conflict-of-interest and his presence as an unsworn witness disqualified his representing the defendant. the court pointed out that an attorney acts as an unsworn witness, creating jury confusion, “when his relationship to his client results in his having first-hand knowledge of the events presented at trial.” 10. when they called, should he have said, “i gave at the office”? commissioner of internal revenue mark everson announced his resignation to become head of the american red cross. 2007 tnt 76-1 (4/19/07). in his message to irs employees, he said, “together, we have rebalanced the organization, bringing to life the equation: service + enforcement = compliance.” a. and kevin brown should have said the same thing. internal revenue service acting commissioner announced his resignation as of september to become chief operating officer of the american red cross. 2007 tnt 145-24 (7/26/07). b. now, we can all look forward to seeing the irs getting stiffed. brown’s successor as acting commissioner will be deputy commissioner for operations support linda stiff, who will assume the position of deputy commissioner for services and enforcement and, on brown’s departure, acting commissioner. 2007 tnt 146-2 (7/30/07). in the press release announcing her appointment, her background was given as 872 florida tax review [vol. 8:si follows: “as deputy commissioner for operations support, stiff has overseen development of policy for irs personnel services, technology and security. she has also been responsible for the accounting of tax revenues collected by the irs.” c. wasn’t anyone at the irs good enough for everson? it appears that everson was really “giving at the office.” mark everson resigned his red cross presidency on november 27, 2007 because the red cross board learned that he “engaged in a personal relationship with a subordinate employee.” d. now, it’s time for the irs to loosen up and shukel with the “shul-man.” president bush nominated douglas h. shulman, vice chairman of the financial industry regulatory authority (formerly known as the national association of securities dealers) on 11/21/07 to be commissioner of internal revenue. 11. proposed circular 230 changes that do not relate to tax shelters are nevertheless controversial, what with new restrictions on the use of contingent fees, monetary penalties for practitioners and their firms, and public hearings before aljs. reg-122380-02, regulations governing practice before the internal revenue service, 71 f.r. 6421 (2/8/06). proposed regulations issued based upon consideration of comments received in response to questions posed in an advance notice of proposed rulemaking (anprm) at 67 f.r. 77724 (12/19/02), as well as amendments made to 31 u.s.c. § 330 by the american jobs creation act of 2004. changes include: (1) changing references to the office of the director of practice to the office of professional responsibility; (2) adding to the definition of “practice before the [irs]” in § 10.2(d) “rendering written advice with respect to any entity, transaction plan or arrangement, or other plan or arrangement having a potential for tax avoidance or evasion;” (3) revoking the authorization of an unenrolled return preparer to represent a taxpayer during an examination of a return that he or she prepared; (4) eliminating the ability of a practitioner to charge a contingent fee for services rendered in connection with the preparation or filing of an amended tax return or claim for refund or credit, although contingent fees are permissible for services rendered in connection with the irs’s examination of, or challenge to, an amended return or claim for refund or credit filed prior to the taxpayer receiving notice of the examination of, or challenge to the original tax return, § 10.27; (5) adding to the standards applicable with respect to tax return positions in § 10.34, the requirement that a practitioner may not advise a client to submit “a document, affidavit or other paper … to the [irs]” if (a) its purpose is to delay or impede the administration of the federal tax laws, (b) it is frivolous or groundless, or (c) it contains or omits 2008] recent developments in federal income taxation 873 information in a manner that demonstrates an intentional disregard of a rule or regulation; (6) adding to the sanctions in § 10.50 the authority to impose a monetary penalty on the practitioner who engages in conduct subject to sanction, as well as the authority to impose a monetary penalty on the “employer, firm or other entity” of a practitioner acting on its behalf provided that the employer, firm or entity knew of reasonable should have known of such conduct; and (7) modifying the definition of disreputable conduct in § 10.51 to include willful failure to sign a tax return the practitioner prepared or unauthorized disclosure of returns or return information. • the most controversial proposed change is a provision in § 10.72(d) that all hearings, reports, evidence, and decisions in a disciplinary proceeding be available for public inspection, with protection of the identities of any third-party taxpayers contained in returns and return information for use in the hearing. a. monetary penalties guidance. notice 2007-39, 2007-20 i.r.b. 1243 (5/14/07). this notice provides guidance with respect to monetary penalties under § 10.52 of circular 230. the examples indicate that the irs office of professional responsibility will interpret this provision broadly to encourage compliance with circular 230. b. final regulations. t.d. 9359, regulations governing practice before the internal revenue service, 72 f.r. 54540 (9/26/07). final regulations, effective 9/26/07, adopted the february 2006 proposed regulations, with changes. • as to whether rendering of written tax advice constitutes practice before the irs, the final regulations hold that it does, but that the attorney or cpa is not required to file a form 2848 power of attorney before doing so. • the contingent fee rules were modified to permit a practitioner to charge a contingent fee for services related to filing an amended return or claim provided that the amended return or claim was filed within 120 days of taxpayer notification of an examination. also permitted are contingent fees for interest and penalty reviews, as well as for services rendered in connection with a judicial proceeding. these changes apply to fee arrangements entered into after 3/26/08. • as to disclosure of a disciplinary decision by an administrative law judge, this disclosure is to be delayed until after the decision becomes final. 12. fleetboston financial corp. v. united states, 483 f.3d 1345 (fed. cir. 4/19/07) the federal circuit interpreted rev. rul. 88874 florida tax review [vol. 8:si 98, 1988-2 c.b. 356, and rev. rul. 99-40, 1999-2 c.b. 441, to provide for interest to be charged where overpayments for a year with respect to which a deficiency subsequently was assessed were credited to the following year’s estimated taxes even though the amount credited was not needed to meet the taxpayer’s estimated tax obligations but was treated as a payment of the following year’s estimated tax by operation of reg. § 301.6402-3(a)(5). the court concluded that the result was not inconsistent with avon products, inc. v. united states, 588 f.2d 342 (2d cir. 1978). 13. t.d. 9327, disclosure of returns and return information in connection with written contracts or agreements for the acquisition of property or services for tax administration purposes, 72 f.r. 30974 (6/5/07). the treasury has promulgated final regulations, reg. § 301.6103(n)-1, regarding disclosure of confidential tax return information by federal and state tax agencies to independent contractors under agreements for goods or services. disclosure is limited to that which is necessary for performance of the contract. in addition, the final regulations provide that a contractor receiving return information becomes liable for penalties for unauthorized redisclosure. 14. timely filing goes postal worker. blake v. commissioner, t.c. memo. 2007-184 (7/12/07). the taxpayer’s tax court petition that bore uncancelled stamps and did not bear a postmark was received outside the 90-day period for timely filing. judge chiechi nevertheless held that the petition was timely filed based on the taxpayer’s attorney’s unrefuted credible testimony that when he found the local post office closed on last day of the 90-day period, he gave a stamped envelope containing the petition to a postal worker who was parked nearby and was assured by the postal worker that the envelope would be postmarked that day. 15. these attorneys missed a procedural step to protect their own fees. set-off sidesteps a possible trumping lien and lienor must file an administrative refund claim before suing to recover. dunn & black v. united states, 492 f.3d 1084 (9th cir. 7/11/07). the government set off unpaid taxes against the full amount due to a plaintiff, under a court of claims judgment relating to a government contract with plaintiff, notwithstanding the plaintiff’s attorney’s lien for fees with respect to the judgment award. the court held that the law firm lacked standing to sue for recovery of the fees because it failed to comply with the § 7422(a) requirement that an administrative refund claim must have been filed. 2008] recent developments in federal income taxation 875 16. these regulations were accompanied by two published rulings. t.d. 9355, clarification to section 6411 regulations, 72 f.r. 48933 (8/27/07) and reg-118886-06, clarification to section 6411 regulations, 72 f.r. 48952 (8/27/07). final, temporary, and proposed regulations § 1.6411-3t(d), that allow the irs to reduce tentative adjustments with unassessed liabilities in some circumstances. a. don’t count on getting any refunds after the irs has issued a 90-day letter for any other tax year. this would apply even if you are contesting the deficiency in the tax court. rev. rul. 2007-51, 2007-37 i.r.b. 573 (9/10/07). section 6402(a) permits the irs to credit an overpayment against an unassessed tax liability if it has determined tax liability in a deficiency notice sent to the taxpayer pursuant to § 6212. similarly, § 6411(b) permits the irs to credit a decrease in tax resulting from a tentative nol carryback adjustment against an unassessed tax liability if, within the 90-day period, it has determined the tax liability in a deficiency notice sent to the taxpayer. • this ruling holds that § 6402(a) allows the irs to credit an overpayment in one year against unassessed internal revenue tax liabilities determined in a notice of deficiency. there is a similar rule for tentative carryback adjustments. this appears to be based upon the principle of lewis v. reynolds, 284 u.s. 281 (1932), which held that taxpayers were not entitled to a refund unless they had overpaid their taxes, although the case was not cited. b. and it is even easier not to get a refund if you’re bankrupt. rev. rul. 2007-52, 2007-37 i.r.b. 575 (9/10/07). pursuant to § 6402(a) the irs may credit an overpayment against unassessed tax liabilities that have not been identified in a deficiency notice sent to the taxpayer, when the liabilities are identified in a proof of claim filed in a bankruptcy case. pursuant to § 6411(b), the irs may credit a decrease in tax resulting from a tentative nol carryback adjustment against unassessed tax liabilities that have not been identified in a deficiency notice when the liabilities are identified in a proof of claim filed in a bankruptcy case. 17. unlike in a deficiency case, you can’t diet your way down to small case status by conceding some of the tax in a cdp appeal to the tax court. leahy v. commissioner, 129 t.c. 71 (9/17/07). the $50,000 “unpaid tax” limit for invoking the § 7463 small tax case procedures in an appeal of a § 6330 cdp determination includes interest accrued to the date of the irs notice of determination. even though the taxpayer disputed only $41,097.54 of liability, an amount below the $50,000 threshold, the case was held not to be eligible for small case status. 876 florida tax review [vol. 8:si xi. withholding and excise taxes a. employment taxes 1. wisdom from the mount. medical residents may be students for fica taxes. united states v. mount sinai, 486 f.3d 1248 (11th cir. 5/18/07). section 3121(b)(10) provides that employment taxes are not payable with respect to services performed in the employ of a college or university by a student who is enrolled and regularly attending classes. the government argued that legislative history with respect to the repeal of an exemption for medical interns in 1965 (former § 3121(b)(13)) established as a matter of law that medical residents are subject to employment taxes. the eleventh circuit concluded that § 3121(b)(10) is unambiguous in its application to students and that the statute requires a factual determination whether the hospital is a “school, college, or university” and whether the residents are “students.” a. and the same holds for residents at the mayo clinic. mayo foundation for medical education v. united states, 503 f. supp. 2d 1164 (d. minn. 8/3/07). the district court held in 2003 that stipends paid to medical residents in the mayo clinic were qualified for the student exclusion from fica taxation, and that the mayo is a school, college, or university for purposes of the exclusion. united states v. mayo found. for med. educ. & research, 282 f. supp. 2d 997 (d. minn. 2003). the treasury responded with reg. § 31.3121(b)(10)-2(c), (d), which limits the definition of a school, college, or university to entitles whose “primary function is the presentation of formal instruction.” the regulation also limits the definition of student to provide that only services provided as incident to pursuing a course of study and that a person whose work schedule is 40 hours or more per week is a full-time employee rather than a student. in granting a $1.6 million refund claim on summary judgment, the district court determined that the regulation is invalid as inconsistent with the plain meaning of a statute that the court finds is unambiguous and held that stipends paid to medical residents are subject to the student exclusion. 2. jordan v. united states, 490 f.3d 677 (8th cir. 6/21/07). meals, lodging, and transportation expenses paid by an air cargo carrier to a pilot for travel from his home in minnesota to the location of his work assignment in alaska (gateway expenses) are wages subject to withholding for fica taxes. employment taxes do not apply to amounts excluded from income by § 132 as statutory fringe benefits. the court rejected the taxpayer’s argument that the gateway expenses were a working condition fringe. the gateway expenses would not have been deductible 2008] recent developments in federal income taxation 877 under § 162 as expenses for travel away from home, and, therefore, do not qualify as a working condition fringe benefit. 3. without a contract, you’re not your psc’s employee. arnold v. commissioner, t.c. memo. 2007-168 (6/27/07). the husband and wife taxpayers were, respectively, a realtor and an accountant, and each of them owned 100 percent of the stock of an s corporation as a “vehicle” for their respective businesses. they reported all of the income from their respective businesses as income of the corporations, which passed though to them under § 1366, but were not paid any salaries or other compensation and paid no wage taxes. however, there were no contracts between the taxpayers and their respective corporations recognizing the right of the corporations to control their performance of services. the court (judge vasquez) held that all of the income of each taxpayer was earned personally, and not by their respective corporations, and upheld deficiencies for self-employment taxes. judge vasquez noted that: “a corporation earns the income if: (a) the service provider is an employee of a corporation which has the right to direct or control that employee in some meaningful sense; and (b) there exists a contract or similar arrangement between the corporation and the person or entity using the services which recognizes the corporation’s right to direct or control the work of the service provider.” 4. t.d. 9337, withholding exemptions, 72 f.r. 38478 (7/13/07). this treasury decision finalizes reg. § 31.3402(f)(2)-1 providing that employers are not required to submit employee form w-4s that claim excessive exemptions, or no withholding, unless the employee receives notice from the irs requiring submission of an employee’s form w-4. the regulations provide procedures for the irs to issue the notice to employers. 5. colorado mufflers unlimited, inc. v. commissioner, t.c. memo. 2007-222 (8/13/07). full time workers in the taxpayer’s muffler shop are treated as employees where the taxpayer exercised control over the manner in which work was performed, provided tools and other facilities, paid the workers on a weekly basis, retained the right to discharge the workers, and the workers believed they were in an employment relationship. the court denied relief under § 530 of the revenue act of 1978 because it had treated workers as employees in previous years. the taxpayer was fined for advancing frivolous positions. 6. hold ‘em – then withhold the winnings. rev. proc. 2007-57, 2007-36 i.r.b. 547 (9/4/07). sponsors of poker tournaments, including casinos, are required to withhold tax from winnings in excess of $5,000 under § 3402(q). winnings include the proceeds of a wager, which 878 florida tax review [vol. 8:si the irs says are determined by reducing the amount received by the amount of the wager. the lucky winner is required to provide the payer a statement on form w-25 or 5754 with identifying information. the withholding rate is the third highest rate of § 1(c), 31 percent. the revenue procedure is applicable to payments made on or after march 4, 2008. 7. fica taxes and penalties hit the university of chicago’s retirement payments. university of chicago v. united states, 100 a.f.t.r.2d 2007-6261 (n.d. ill. 8/21/07). the university of chicago required employees to make payments into a § 403(b) plan and referred to the employee contributions as being withheld from salaries. employees were required to sign a “salary reduction agreement.” the university also contributed to the plan on behalf of employees. section 3121(a)(5)(d) excludes from wages subject to employment taxes any payment under a § 403(b) annuity contract, “other than a payment for the purchase of such contract which is made by reason of a salary reduction agreement.” the university argued that this language is ambiguous and should not be interpreted to apply to every agreement that reduces an employee’s current compensation. granting summary judgment for the government, the court concluded that the “statute’s language is not at all ambiguous, and covers just the set of facts that are present in this case.” the employees’ wages are subject to fica withholding. in addition, the court found that the university’s failure to make the deposits was not due to reasonable cause. the university asserted under the “divisible tax doctrine” that its payment of a portion of the tax in order to bring the refund action absolved it of the penalty. the court indicated that “it is one thing to say that a taxpayer need not pay the total tax in order to gain entry to the courthouse, and quite another to say that the taxpayer may escape the penalty for failure to timely pay the tax by filing a lawsuit.” 8. this one hurts. early retirement bonuses for tenured professors are wages subject to employment tax withholding. university of pittsburgh v. united states, 507 f.3d 165 (3d cir. 11/02/07). in a 2-1 decision, reversing the district court, the third circuit held that payments to early retirees to induce retirement are wages subject to fica withholding rather than non-wage payments for relinquishment of contract rights to tenure. the third circuit follows appoloni v. united states, 450 f.3d 185 (6th cir. 2006), and joins the sixth circuit in rejecting the holding of north dakota state univ. v. united states, 255 f.3d 599 (8th cir. 2001). 9. employment tax wage base for 2008. notice 2007-92, 2007-47 i.r.b. 1036 (11/19/07). the oasdi contribution and benefit base for remuneration paid in 2008 is $102,000. the minimum 2008] recent developments in federal income taxation 879 amount that a domestic worker must earn to trigger employment tax liability for 2008 is $1,600. 10. section 403(b) salary reduction agreements defined. t.d. 9367, payments made by reason of a salary reduction agreement, 72 f.r. 64939 (11/14/07). treasury has finalized regulations, § 31.3121(a)(5)-2, defining contributions to § 403(b) plans under a salary reduction agreement that are subject to employment taxes. employer contributions to a § 403(b) plan that are not made pursuant to a salary reduction agreement are not subject to employment taxes. a salary reduction agreement exists if the employee elects to reduce compensation pursuant to a cash or deferred election, the employee elects to reduce compensation under a one-time irrevocable election made at or before the time of initial eligibility to participate in the plan, or the employee agrees as a condition of employment (whether imposed by statute or otherwise) to make a contribution that reduces compensation. 11. bennett v. commissioner, t.c. memo. 2007-355 (12/3/07). self-employment income earned as a minister is subject to selfemployment tax unless under § 1402(e)(3) the individual files a letter or form 4361 certifying that the individual is conscientiously or on religious principles opposed to the acceptance of public insurance. judge swift rejected the taxpayer-pastor’s claim for exemption in the absence of evidence that the taxpayer had filed the requisite certification. the irs search of its files in the ministerial unit failed to discover a form filed by the taxpayer. the taxpayer was unable to produce documentary evidence of the filing, and the taxpayer had in fact paid employment taxes in some years subsequent to the taxpayer’s claim of having filed the certificate in 1980. b. excise taxes 1. ir-2007-16 (1/25/07). the irs said that early findings show some individual taxpayers have requested apparently improperly large amounts for the special telephone tax refund, such as requesting a refund on the entire amount of their phone bills, or making requests for thousands of dollars indicating they had phone bills in excess of $100,000 – an amount exceeding their income. the irs also noted that some tax preparers are helping their clients file apparently improper requests. 2. this taxpayer’s $54.84 telephone excise tax refund claim challenges the irs under the administrative procedure act. in re long-distance telephone service federal excise tax refund litigation, 501 f. supp. 2d 34 (d. d.c. 8/10/07). the district court denied 880 florida tax review [vol. 8:si the irs’s motion to dismiss the taxpayer’s claim under the administrative procedure act (apa) that the refund procedure of notice 2006-50, 2006-1 c.b. 1141, is arbitrary and unlawfully restricts the taxpayer’s refund claim and potential class action suit by requiring refund claims to comply with the documentation requirements of the notice or accept a safe-harbor amount. the district court held that (1) the taxpayer has standing to raise the claim because of the taxpayer’s alleged financial loss under the approach of the notice, (2) the agency action issuing the notice is not protected from apa review as an exercise of discretionary authority by the irs, (3) the notice is a final agency action subject to review under the apa, and (4) the taxpayer is not required to exhaust administrative remedies by following the refund procedure of the notice in order to avoid the sovereign immunity of the irs. xii. tax legislation a. enacted 1. the tax relief and health care act of 2006, pub. l. 109-432, was signed by president bush on 12/20/06. 2. the small business and work opportunity tax act of 2007 (the “2007 act”), which is contained in the u.s. troop readiness, veterans’ care, katrina recovery, and iraq accountability appropriations act, pub. l. 110-28, was signed by president bush on 5/25/07. this legislation also increased the minimum wage. 3. the mortgage forgiveness debt relief act of 2007, p.l. 110-142, was signed by president bush on 12/20/07. 4. a “blue christmas” package is enacted on december 26th, or is it a christmas package for the blue states? the tax increase prevention act of 2007, p.l. 110-166, i.e., the one-year amt patch, was signed by president bush on 12/26/07. 5. the tax technical corrections act of 2007, p.l. 110-172, passed both houses of congress by unanimous consent on 12/19/07 and was signed by president bush on 12/29/07. it alters the definition of the alternative minimum tax refundable credit amount as provided in the tax relief and health care act of 2006; changes certain rules in the pension protection act (ppa) of 2006 for tax-free distributions from individual retirement accounts to charities; and modifies the § 355 special rule for the active business requirement as added by the tax increase prevention and 2008] recent developments in federal income taxation 881 reconciliation act of 2005. it also deals with § 470 silo transactions for investment partnerships. florida tax review volume 4 1999 number 3 taxation of private business firms: imagining a future without subchapter k lawrence lokken" l introduction ................................ 250 i. the problem. ................................ 253 i. partnership allocations ........................ 255 a. a dollar is not necessarily a dollar ........... 255 b. a dollar is a dollar, not gross income or deduction ............................. 259 c. alternatives; allocations in proportion to capital ... 265 iv. contributions and distributions ................. 269 v. a radical solution ............................. 270 a. subchapter k ............................ 272 b. subchapter s ............................ 272 1. eligibility ......................... 272 2. fixed payment instruments ............. 275 3. contributions ....................... 276 4. distributions ....................... 276 5. allocations of income, loss, and credit .... 278 6. loss limitation; liabilities in basis ....... 279 7. effects of elections and terminations ...... 280 8. application of subchapter c ............ 281 c. subchapter c ............................ 282 vl conclusion .................................. 285 * lawrence lokken is hugh f. culverhouse eminent scholar in taxation and professor of law, university of florida. the author thanks all of those who have read and commented on earlier drafts of this article, including richard cohen, terence cuff, mark gergen, calvin johnson, martin mcmahon, and george yin, some of whom object vigorously to virtually everything said in the article. 249 florida tax review i. introduction subchapter k is a mess. its history began with the simple idea that a partnership should be treated for income tax purposes as a conduit, obligated to report its income to the irs and to allocate this income among its partners but not subject to tax itself.' even when subchapter k was enacted in 1954, congress recognized that the implementation of this simple ideal would not necessarily be simple. under the 1954 legislation, each partner's distributive share of each item of income, deduction, or credit was usually determined by the partnership agreement, as it might be modified at anytime before the due date of the partnership's return, but if the agreement for the allocation of any item was infected with a principal purpose to avoid tax, the item had to be allocated in the proportions that the partners shared overall taxable income.2 although property could generally be contributed to or distributed from a partnership without causing the partnership or any partner to recognize gain,3 a distribution was treated as a taxable sale, at least in part, if it altered the partner's proportionate interests in unrealized receivables or substantially appreciated inventory.4 subchapter k has been amended repeatedly since 1954. over the last 25 years, nearly every substantial revenue act has contained significant changes to subchapter k. although these amendments responded to a variety of emerging problems and issues, one theme underlies a large majority of them: the flexibility of the original conduit model facilitated devices to shift income, deductions, and other tax attributes from partner to partner and from property to property in ways that congress found unacceptable. the original conception of subchapter k-flexibility with some limitations-has thus become encrusted with more and more limitations. 5 this congressional activity has been mirrored and magnified in the development of regulations under subchapter k. in 1976, congress amended the rule on allocations of income, deductions, and credits to deny effect to any allocation agreement that "does not have substantial economic effect."6 the treasury responded with regulations interpreting the quoted words that 1. see h.r. rep. no. 1337, 83d cong., 2d sess. 65 (1954) (subchapter k intended to provide "simplicity, flexibility, and equity as between the partners."). 2. see irc §§ 704(a), (b), 761(c) (before amendment in 1976). 3. see irc §§ 721,731. 4. see irc § 751(b). 5. see jeffrey l. kwall, taxing private enterprise in the new millennium, 51 tax law. 229, 237 (1998) ("since the early 1980s, a seemingly endless series of legislative fixes have endeavored to forestall tax avoidance at the cost of dramatically complicating subchapter k."). 6. tax reform act of 1976, pub. l. no. 94-455, § 213(d), 90 stat. 1520, 1548 (1976). [vol 4:3 taxation of private business firms are prodigiously, even frighteningly complex, and these regulations have required repeated supplementation and amendment, most of which increased their complexity. in 1984, congress restricted partners' flexibility in allocating income and deductions from property contributed by partners to the partnership these restrictions were tightened by statutory amendments in 1989 and 1997 and spawned gargantuan regulations, which have also required several amendments.9 the treasury has found it necessary to issue detailed regulations under many other provisions of subchapter k, either as enacted in 1954 or as added or amended since 1954, in order to mark the bounds of just what partners can and cannot do with respect to a broad range of partnership transactions. one of the more striking, and for many the most troubling, of the accumulations of complexity is an anti-abuse rule, adopted by regulation in 1994, which allows the irs to "recast" a transaction for federal tax purposes if "a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter k."'0 this recasting is possible, even if the transaction "fall[s] within the literal words of a particular statutory or regulatory provision."" although the anti-abuse regulation is not complex in the sense of requiring taxpayers to fathom lengthy and dense recitations of rules and exceptions to the rule, its indefiniteness probably causes it to be more complex in application than the most tangled web of verbiage.' the cumulative result of all of this legislative and administrative activity is a system of such complexity that full compliance is only theoretically possible.'3 if partners' contributions are only in cash, partnership distributions consist solely of cash, and each partner has the same 7. regs. §§ 1.704-1 (as amended by t.d. 8099, 1986-2 c.b. 84; t.d. 8237, 1989-1 c.b. 180; t.d. 8385, 1992-1 c.b. 199; t.d. 8500, 1994-1 c.b. 183; t.d. 8585, 1995-1 c.b. 120; t.d. 8717, 1997-24 i.r.b. 5), 1.704-2 (1992) (allocations attributable to nonrecourse liabilities). 8. see irc § 704(c) (before amendment in 1989, 1997). 9. regs. §§ 1.704-3 (as amended by t.d. 8585, 1995-1 c.b. 120; t.d. 8717. 199724 i.r.b. 5; t.d. 8730, 1997-38 i.r.b. 16), 1.704-4 (as amended by t.d. 8717, 1997-24 i.rb. 5). 10. regs. § 1.701-2(b). 11. id. 12. see kwall, supra note 5, at 238 ("anti-abuse regulations have created unpredictability that exacerbates the complexity"). 13. see curtis j. berger, w(h)ither partnership taxation? 47 tax l. rev. 105, 108 (1991) ("in order to keep tax planners from wholly abusing the partnership's privileged status, while not denying them all remaining flexibility, congress and treasury (fashioned) a statutory and regulatory apparatus which [is] one of the most inaccessible and burdensome features of the entire tax system."). 19991 florida tax review proportionate interest in every item of income and deduction, only a few relatively simple provisions of subchapter k apply, and the partnership's accounting is likely to agree with the tax rules, even if the statutes and regulations are never consulted. however, if any one of these conditions is not met, at least one of the highly complicated subgroups of partnership tax rules applies, and, unless the partnership receives and follows tax advice of the highest sophistication, the tax rules are likely violated. in a large number, perhaps a large majority, of such situations, the costs of such advice are prohibitive, given the partnership's size. moreover, many tax practitioners believe that very few irs auditors of partnership returns understand enough of subchapter k to challenge partnership accounting for items subject to the more complicated aspects of subchapter k and that the few auditors with deep understanding of subchapter k are assigned to very large transactions where their skills will likely produce the greatest revenue yield for the government. this perception diminishes taxpayers' incentives to try their best to comply in any but the largest of transactions. a large number of partnerships thus seem to be governed by what might be called an "intuitive subchapter k." taxpayers and tax advisers who want to comply account for partnership transactions in ways that are consistent with their conceptions of the basic aims of subchapter k; others account as adventurously as they believe the irs is likely to tolerate. irs auditors challenge partnership accounting only if it seems to be seriously out of whack. no one has the ability, resources, and incentive to figure out exactly what the rules require. if the portrait i have painted of subchapter k is accurate, radical reform is, in my opinion, required. americans have traditionally prided themselves as being a society of laws. laws that cannot feasibly be understood and obeyed are the equivalent of no law at all. if laws are enforced only in situations involving very large dollar amounts, ordinary transactions are left in a lawless penumbra. professor yin proposes a solution-a simplified conduit regime for simple private business firms (spbfs) that elect this regime. it is a creative and useful proposal that deserves careful study. my purpose is to use that proposal as a starting point for a more comprehensive examination of the conduit treatment of business entities. professor yin does an excellent job of describing the problems with conduit treatment generally and subchapter k in particular. 4 his proposal provides a means by which a discrete group of entities could avoid these 14. george k. yin, the future taxation of private business finns, 4 fla. tax rev. 141 (1999). [vol. 4.3 taxation of private business firms problems, but it does not solve the problems for entities that either do not qualify for or do not elect spbf treatment. he urges that a separate effort be made to rationalize subchapter k for these other entities, but he rejects any radical shift away from the basic pass-through model for partnerships not eligible for the simplified conduit regime.'" my purpose is to examine the path he rejects-to imagine a world largely without subchapter k. il the problem although there seems to be broad agreement that complexity in subchapter k is a major problem, less attention has been given to the causes of this complexity. is the complexity primarily a result of bungling by congress and the treasury? or, is the complexity an inevitable consequence of the conduit ideal when it is utilized in a business and investment culture where tax minimization is seen as a major aspect of profit maximization and where tax authorities believe that ferreting out abuse is a major aspect of their responsibilities? if the former is the case, all that is needed is a redrafting of the code and regulations. if the latter is the case, alternatives to subchapter k should be considered. although congress and the treasury are not free from blame, the subchapter k mess derives, in my opinion, principally from the ideal, not the execution of the ideal. it is conventional wisdom that subchapter k has, from its inception in 1954, consisted of an amalgam of aggregate concepts (viewing the partnership as only an aggregation of the separate interests of the partners) and entity concepts (viewing the partnership as an entity separate from its owners). the approach of allocating partnership income among the returns of the partners, rather than taxing the partnership on the income, is an aggregate concept, but even the implementation of that approach has strong entity aspects. assume x owns an apartment building and y owns an airplane; they agree that (1) x will claim depreciation deductions for both the building and the airplane, (2) gain on the eventual sales of both items will be reported by x to the extent of the aggregate of the depreciation deductions, and (3) x will make a payment to y in the event the price received on sale of the airplane falls short of the property's value when the agreement is made. this agreement is ineffective because depreciation deductions may only be taken by the owner of property, the owner must report all gain on the property's sale, and these items may not be transferred by contract to a taxpayer other than the owner. this principle is so fundamental that returns filed by x and y consistently with their agreement would be vulnerable to a charge of fraud. 15. id. 19991 florida tax review however, if x and y contribute the building and airplane to the xy partnership and incorporate their agreement into the partnership agreement, the agreement can be given full effect for tax purposes. after the contributions, the income from the contributed property will be income of an entity (the partnership), and subchapter k gives effect to an allocation of the entity's income among the owners, so long as the allocation has substantial economic effect. the partnership entity thus has a tax consequence not achievable by other means of aggregating the interests of x and y. similarly, although the rules generally allowing property to be contributed to or distributed from a partnership without recognition of gain or loss have an aggregate flavor, they also reflect an entity conception of the partnership. for example, if x swaps an undivided one half interest in her building for an undivided one half interest in y's airplane, x and y both recognize gain on the exchange. however, if x and y contribute the building and airplane to the xy partnership, neither recognizes gain or loss, even though the effect of the transaction is that x exchanges 100% direct ownership of the building for 50% indirect ownership of the building and the airplane. similarly, if a partnership purchases land and, several years later, distributes the land to one of its partners in liquidation of the partner's interest, generally, gain or loss is not recognized by the partnership or any of the partners as a result of the distribution, even though the distribution exchanges the distributee's indirect interest in the bundle of partnership assets for direct ownership of one of these assets. these exchanges are apparently allowed tax-free because congress conceived of the partnership as a business and investment entity whose economic usefulness would be diminished by the taxation of gains realized when property enters or leaves the entity. the entity aspects of subchapter k are the source of the great flexibility of the partnership for tax purposes. by treating a partnership as an entity separate from its partners and a partnership interest as an interest in an entity, not a collection of proportionate interests in partnership assets, the law allows partners to share partnership income, deductions, and property in ways that practically suit their business or investment goals, without unwanted tax consequences springing out of shifts in their claims to partnership property. however, the very same flexibility is also the source of subchapter k's burgeoning complexity because it permits the partners to shift income, deductions, and other tax attributes among the partners in ways that minimize tax obligations with little or no economic cost. in this writer's opinion, because subchapter k's flexibility and susceptibility to abuse derive from the same source, the balances struck in the statutory scheme are inherently unstable. uses of the partnership rules that the treasury finds to be abusive will continue to push the law further into complexity, and this complexity will makes compliance less and less feasible for more and more partnerships. [vol, 4:3 taxation of private business finns m. partnership allocations section 704(b) denies tax effect to an agreement on the allocation of partnership income, deduction, or credit unless the agreement has "substantial economic effect." the regulations under section 704(b) enforce this rule by requiring that all allocations be reflected in capital accounts and that the capital accounts ultimately determine the partners' entitlements.' 6 under section 704(c)(1)(a), partnership items attributable to property contributed to the partnership by a partner must be allocated "so as to take account of the variation between" the property's basis and fair market value when contributed. despite their unworkable complexity, sections 704(b) and (c) and the regulations under those provisions are not effective in weeding out allocations that distort partners' income. the premise of the substantial economic effect test, as worked out in the regulations, is that an allocation of income or deduction to a partner has substantial economic effect if it increases or decreases the partner's ultimate entitlements from the partnership by the amount allocated. however, when allocating items, such as depreciation, which are outside of the partnership's cash flow stream, ascertaining the extent to which the allocation affects a partner's ultimate entitlement is, at best, speculative. the substantial economic effect test thus does not meaningfully restrict tax-motivated shifting when it is applied to tax allowances that with respect to which there are no corresponding economic costs. also, even if an allocated item is true income or loss of the partnership, an allocation of the item does not necessarily reflect true income or loss of the partner because the allocation rules do not explicitly take into account the time value of money. a. a dollar is not necessarily a dollar deductions and other tax allowances are often not associated with real economic losses. for example, depreciation deductions are allowed whether or not the depreciable property declines in value. when depreciation exceeds any decline in the property's value, the excess is, at least for the time being, a deduction without cost. an allocation of such a deduction among partners necessarily lacks any true economic consequences, at least in the short run. where there are special allocations of depreciation with provision for gain chargeback, the regulations indulge in various presumptions in order to reconcile the substantial economic effect requirement with this reality. for example, depreciable property held by a partnership is deemed to decline in 16. see regs. § 1.704-1(b)(2). 19991 florida tax review value by the amounts allowed as depreciation, regardless of the property's actual value.' 7 thus, if depreciation on partnership property is allocated to one partner and appropriately reflected in partnership capital accounts, the allocation is deemed to have substantial economic effect, even if the property's value does not decline and the depreciation charge is likely to be recouped through future revenues from the property (e.g., gain on its eventual sale allocated to the partner to whom the depreciation was allocated). arguably, partnership allocations of tax items without economic effect should not be a policy concern. these items can artificially reduce tax, regardless of who owns the property or carries on the activity from which the items arise. because the potential for tax reduction is most attractive to investors who can make best use of the tax allowances, the property or activity tends to be owned by these investors. this being so, perhaps policy makers should not be concerned about which taxpayer claims the item. moreover, the kinds of shifts achievable by partnership allocations can be obtained outside the partnership context by the use of debt financing. assume property worth $851 will produce net revenues (before depreciation) of $100 annually for 20 years, at the end of which time the property will be worthless. the property's yield is 10% (the discount rate at which 20 annual payments of $100 each have a present value of $851). economic income from the property is $85 for the first year (10% of $851), economic depreciation for the first year is $15 ($100 of net revenues less $85 of income), economic income for the second year is $84 (10% of the excess of $851 over $15), and so forth. but, assume that, due to generous depreciation allowances (straight line depreciation), taxable income from the property is projected to be $57 annually (before financing costs) throughout the 20-year period. x purchases the property for $851, paying $713 of the price with a 20-year, 8% loan from l. for the first year, the deduction for interest on the loan is $57 (8% of $713), which equals the taxable income before interest costs. for that year, x thus has economic income of $28 ($85 less $57) and taxable income of zero. of the two persons having an investment in the property, l (the lender) reports the $57 of taxable income from the property, and x (the title holder) enjoys the $28 of economic income that is not taxed. the results would be the same if l and x instead formed a partnership to hold the property, with l being allocated partnership taxable income each year equal to 8% of its capital account and x being allocated the remaining income and with the partnership's annual cash flow being distributable in the 17. see regs. § 1.704-1(b)(2)(iii)(c) (in determining substantiality of allocation's economic effect, fair market value of partnership property is presumed to equal adjusted basis, and "adjustments to the adjusted tax basis [are] presumed to be matched by corresponding changes in such property's fair market value."). [vol 4.3 taxation of private business firms proportions $73 to l and $27 to x. the comparisons are worked out more fully in example 1. example 1 x owns property worth $851 generating annual net revenue of $100 net depreciation net income year revenue economic tax economic tax difference 1 $100 $15 $43 $85 $57 $28 2 100 16 43 84 57 27 3 100 18 43 82 57 25 4 100 20 43 80 57 23 5 100 22 43 78 57 21 10 100 39 43 61 57 4 16 100 62 43 38 57 (19) 17 100 68 43 32 57 (25) 18 100 75 43 25 57 (32) 19 100 83 43 17 57 (40) 20 100 91 43 9 57 (48) x finances property with 8% $713 loan net depreciation net income year revenue interest economic tax economic tax difference 1 $100 $57 $15 $43 $28 -0$28 2 100 56 16 43 28 1 27 3 100 54 18 43 28 3 25 4 100 53 20 43 27 4 23 5 100 51 22 43 27 6 21 10 100 41 39 43 20 16 4 16 100 23 62 43 15 34 (19) 17 100 19 68 43 13 38 (25) 18 100 15 75 43 10 42 (32) 19 100 10 83 43 7 47 (40) 20 100 5 91 43 4 52 (48) 19991 florida tax review x and l are partners partnership income tax allocations year economic tax l x 1 $85 $57 $57 -02 84 57 56 1 3 82 57 54 3 4 80 57 53 4 5 78 57 51 6 10 61 57 41 16 16 38 57 23 34 17 32 57 19 38 18 25 57 15 42 19 17 57 10 47 20 9 57 5 52 to be sure, there are important financial differences between a lender's interest and a partnership interest. however, the point of the example is that, when taxable income diverges from economic income, the benefit or detriment of the divergence can be allocated between a lender and an equity investor in the same way in which the subchapter k rules allow it to be allocated among partners. nevertheless, partnership allocations have unique features that allow tax benefits to be shifted from partner to partner in ways not possible in other contexts. for example, partnership allocations may be altered from year to year. under sections 704(a) and 761(c), each item of partnership income, deduction, and credit is usually allocated among the partners as provided in the partnership agreement, as it may be amended at any time before the partnership's return is due. no partner recognizes gain or loss as a result of an amendment of the partnership agreement, even if the amendment substantially changes the nature of each partner's interest. the allocation of tax benefits from multiparty investments organized in other ways generally flows from the structure in which the investment is originally cast, and a change in this allocation may cause each participant to be taxed as though she had exchanged one interest in the underlying property for another. 8 for example, if x purchases the property in example 1, financing the purchase with a loan from l, x and l cannot trade places without recognizing gain or loss, but if they organize the xl partnership to acquire and hold the property, 18. for example, a substantial modification of a debt instrument is treated as an exchange, often taxable, of one debt instrument for another. see regs. § 1.1001-3. [vol 4:3 taxation of private business firns the allocation of the tax benefits of ownership can be altered year-by-year so long as the substantial economic effect test is met. the partnership allocation mechanism also is more flexible in not confining the sorting to broad categories, such as debt and equity. this allows partners to fashion their arrangements to direct each tax benefit in the way that best minimizes their tax liabilities. b. a dollar is a dollar, not gross income or deduction partnership allocations that have substantial economic effect do not necessarily reflect the partners' economic income. for example, tax laws sometimes attach characterizations to income or deduction items that have important tax consequences but do not have economic consequences. apart from taxes, partners are concerned only about the number of dollars allocated to them, but a partner's tax liabilities can be importantly affected by whether a particular allocation consists, for example, of capital gains or ordinary income or, in the case of a capital gains allocation, whether the allocated item is longor short-term gain. under the regulations, capital gains can validly be allocated to one partner and ordinary income to another if there is a strong likelihood that the dollar amounts of the partnership allocations will be affected by the sorting method prescribed by the partnership agreement, even if the economic effects of the allocation may be neutralized by the tax effects of the ordinary income/capital gains characterizations.' 9 partnership allocations can also alter the timing of partners' income in ways not achievable in other contexts and sometimes in ways that contradict the policies that apply in other contexts. this point is developed in several examples below. example 2a. x purchases for $685 the right to all interest on a $1,000, 8% 15-year bond, and y purchases for $315 the right to the principal payment at maturity. under section 1286, x and y must each accrue interest income annually at 8% on their unrecovered investments. for the first year, the accruals are $55 for x and $25 for y; for the second, they are $53 for x (8% of excess of $685 over capital recovery of $25 for year 1) and $27 for y. over the bond's 15-year term, x has interest income of $515, and y has interest income of $685. 19. see regs. § 1.704-1(b)(5) ex. 7(iii). but see regs. § 1.704-1(b)(2)(iii)(a), under which, after factoring in the after-tax consequences, the allocation may be found to be not substantial. 1999] florida tax review example 2a x and y strip a $1,000, 8%, 15-year bond x cash flow income $80 $55 80 53 80 51 80 48 80 45 80 43 80 40 80 37 80 33 80 30 80 26 80 21 80 16 80 11 80 6 y cash flow income -0$25 -027 -029 -032 -035 -037 -040 -043 -047 -050 -054 -059 -064 -069 $1,000 74 example 2b. x and y instead form a partnership to acquire and manage a portfolio of debt instruments. x and y contribute $685 and $315, respectively, to the partnership. partnership income (expected to be $80 annually) is allocated 99% to x and 1% to y, this income is distributable annually in the same proportions, and on liquidation, which the partnership agreement requires to occur 15 years after the partnership is organized, partnership assets (expected to be worth $1,000) are distributable 1% to x and 99% to y. year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 [vol 4:3 taxation of private business firms example 2b xy investment partnership x distribution income $79.2 $79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 79.2 10 ($675) y distribution income $0.8 $0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 $990 $675 the allocation agreement, by assigning almost all of the interest income to x, contradicts the principle of section 1286-that interest income should accrue at a constant rate to all persons owning segments of a stream of payments represented by a debt instrument. the income allocations are also not permissible under section 704(b). allocations have substantial economic effect only if they are reflected in capital accounts and, among other things, each partner is entitled to distribution of the balance of the partner's capital account.2' since x and y receive income allocations equal to the distributions to them, their capital accounts remain unchanged at $685 and $315 throughout the partnership's existence, and the distribution on liquidation can be made in accordance with the agreement ($10 to x and $990 to 1) only by ignoring the capital accounts. instead of the allocations prescribed in the partnership agreement, the xy partnership's income must be allocated according to the underlying economic arrangement between the partners with reference to the partnership's income items." example 2b illustrates how the substantial economic effect test, by requiring that allocations be reflected in capital accounts and that the capital 20. see regs. §§ 1.704-1(b)(2)(ii)(b), (iv). 21. see regs. § 1.704-1(b)(3)(i). year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 liquidation 19991 florida tax review accounts determine the partners' financial entitlements, imposes significant restraint on the extent to which partnership allocations can be used to upset timing requirements that apply to other investment structures. however, as shown by subsequent examples, the capital account rules do allow significant departures from those timing requirements. example 2c. the xy partnership agreement instead requires partnership taxable income for each year to be allocated in proportion to the partners' capital accounts at the beginning of the year. the income is distributable annually 99% to x and 1% to y, as in example 2b, but the liquidating distribution is in proportion to the partners' capital accounts. since the results are fully consistent with those prescribed by section 1286 for example 2a, it is appropriate that the allocations be considered to have substantial economic effect. example 2c xy investment partnership year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 liquidation x distribution income $79.2 $55 79.2 53 79.2 51 79.2 48 79.2 45 79.2 43 79.2 40 79.2 37 79.2 33 79.2 30 79.2 26 79.2 21 79.2 16 79.2 11 79.2 6 10 -0y distribution income $0.8 $25 0.8 27 0.8 29 0.8 32 0.8 35 0.8 37 0.8 40 0.8 43 0.8 47 0.8 50 0.8 54 0.8 59 0.8 64 0.8 69 0.8 74 $990 -0example 2d. under the xy agreement, (1) partnership taxable income is allocated 80% to x and 20% to y for the first seven years of the partnership's 15-year term and solely to y during the last eight years, (2) annual net income is distributable 99% to x and 1% to y (as in example 2c), and (3) the liquidating distributions will equal the partners' capital accounts. the financial results are nearly the same as in examples 2b and 2c. for x, yearly excesses of distributions over income allocations reduce her capital [vol 4:3 taxation of private business finns account from $685 to $9, and y's capital account increases from $315 to $991 through yearly excesses of income allocations over distributions. example 2d xy investment partnership year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 liquidation x distribution income $79.2 $64 79.2 64 79.2 64 79.2 64 79.2 64 79.2 64 79.2 64 79.2 64 79.2 -079.2 -079.2 -079.2 -079.2 -079.2 -079.2 -09 -0y distribution income $0.8 $16 0.8 16 0.8 16 0.8 16 0.8 16 0.8 16 0.8 16 0.8 16 0.8 80 0.8 80 0.8 80 0.8 80 0.8 80 0.8 80 0.8 80 $991 -0as compared with example 2c, xys income is accelerated and rs income is deferred. under the regulations, an allocation lacks substantial economic effect if it is possible that the allocation may be offset by a subsequent allocation and, when the allocation is agreed upon, "there is a strong likelihood" that (1) the ultimate effects on the partners' capital accounts "will not differ substantially from" the capital account increases and decreases that would occur if the partnership agreement provided for neither the original nor the offsetting allocation and (2) the original and offsetting allocations will reduce the partners' "total tax liability."' the initially greater allocations to x are ultimately offset by smaller allocations near the end of the partnership's life, and the opposite happens for y. by the end of the partnership's 15-year life, the offsets will be complete and the capital accounts will be virtually identical to those in example 2c. however, notwithstanding the possibility of offset, an allocation is deemed to substantially affect ultimate entitlements if "there is a strong 22. regs. § 1.704-1(b)(2)(iii)(c). 1999] florida tax review likelihood" that any offsetting allocation will occur more than five years after the initial allocation.' in example 2d, if offsetting allocations are determined by comparing them with example 2c, the allocations for the first four years have substantial economic effect because the offsets occur more than five years later. although the offsets to the allocations for the fifth year through the eighth year occur in part within five years and thus are probably invalidated by the transitory allocation rule, the regulations allow a significant temporal shifting between x and y. arguably, the results in example 2d are not inappropriate because they follow from the sharp distinction drawn in present law between debt and equity. although congress and the treasury have labored over the years to tax returns from debt instruments on an accrual basis, equity investors are offered many opportunities to defer tax on investment returns. for example, y might purchase land with a timber stand expected to be cut in 10 years, or she might purchase and hold for 10 years stock of a corporation whose policy is to reinvest all earnings in expansion of its businesses. arguably, because being a partner is an equity investment, y should also be allowed to defer tax on investment returns through a partnership investment. however, the partnership situation is unique. wealth accruing to the owner of a stand of trees is not taxed until the trees are cut, regardless of who the owner is. when a corporation retains all of its earnings, it is taxed on these earnings, even though the shareholders are not. if the corporation accrues untaxed wealth (e.g., by building goodwill or developing valuable intellectual property), it escapes tax through principles that apply regardless of who the owner is. in contrast, partnership allocations can be structured to defer tax by shifting currently taxable income to other participants. y's tax deferral in example 2d results from the structure in which the investment is held, not from the type of property comprising the investment. as shown by example 2d, partnership allocations can be used to alter timing mechanisms carefully crafted by congress. although example 2 deals with debt securities, the point made is not limited to partnerships whose principal assets are debt instruments. the example is intended to demonstrate how, even when tax rules applicable to the underlying assets are economically realistic (as is generally so for debt instruments), partnership allocations can be used to divorce tax consequences from economic consequences. in a partnership with other types of assets (e.g., a leasing partnership), partnership allocations may exhibit both the effects demonstrated in example 1 (shifting of tax preferences from partner to 23. see id. offsets are "determined on a first-in, first-out basis." id. regs. § 1.7041(b)(2)(iii)(c)(2). [vol 4:3 taxation of private business firms partner) and those shown in example 2 (shifting of economic income from partner to partner). c. alternatives; allocations in proportion to capital in this writer's opinion, the flaws in the present allocation rules are not merely flaws in the execution of the simple idea of conduit taxation that underlies subchapter k. rather, the flaws expose a fundamental problem with conduit taxation: when an entity's owners share income in complex ways, there is often no feasible means of determining at the end of each year how the entity's income or loss for the year is economically shared by the owners. the owners commonly conceive of their sharing arrangements as they will apply over a period of several years. annual allocations of income and loss, as the tax laws require, may therefore be wholly artificial. any effort to match these allocations with the owners' long-run expectation is bound to be complicated, artificial, or both.24 for example, the problems discussed above might be addressed by amending section 704(b) to require that each item of partnership income, deduction, and credit be allocated in proportion to the partners' interests in partnership capital. in example 2, this approach would require that allocations be made as in variation 2c, which is fully consistent with the principle of section 1286. one objection to this approach is that, in many situations, it would put partners in a tighter straitjacket than investors making similar investments in other contexts. for instance, in the partnership variation of example 1, where x and l invest $138 and $713, respectively, in a real estate partnership, a requirement that allocations be in proportion to income would require that taxable income for the first year be allocated 83.8% ($713/$851) to l and 16.2% to x, even though the partnership allocation agreement (to l to the extent of 8% of its capital account, remainder to x) is consistent with the results of a debt-financed investment outside the partnership context. also, this approach would be awkward as applied to partnerships in which some partners contribute services and other partners contribute money or other property. assume x and y form a partnership to develop and market experimental electronic devices.' x contributes $2,500 in cash and agrees 24. see kwall, supra note 5, at 243-44. subchapter k permits allocations that are not proportionate to owners' interests and allows allocation proportions to change from year to year. see id. at 243. the resulting "burden fall[ingl on the tax law to identify the economic relations of the owners ... inevitably is quite complicated and creates potential for abuse." id. trying to "perfect[] such a system is probably futile because the abuse potential may ultimately be impossible to eliminate." id. at 244. 25. see regs. § 1.704-1(b)(5), ex. 3. 19991 florida tax review to work full-time in the partnership's business; y contributes $100,000 in cash and is not expected to participate actively in the business. under the partnership agreement, deductions for research and development costs are allocated to y, and partnership income and loss, exclusive of these costs, is allocated 99% to y and 1% to x until the income allocations to y have fully recouped the r&d and loss allocations to y; thereafter, x and y will share partnership income and loss equally. a proportionate-to-capital approach would require that all items of gross income and deduction be allocated in the proportions $2,500 to $100,000, approximately 2% to x and 98% to y. the results are not radically different from the partners' agreement on the allocation of r&d costs and start-up losses, but x is prevented from sharing more than minimally in partnership taxable income after these costs and losses have been made up. assume the xy partnership expends all of the capital contributions in research and development during year 1, but thereafter has taxable income of $102,500 annually. the allocations for year 2 restore the partners' capital accounts to $2,500 and $100,000, more or less consistently with the partners' agreement. however, for year 3 and later years, partnership income is split $2,500 to x and $100,000 to y, even though the partners have agreed to share this income equally. if the partnership makes significant distributions of income allocated under the partnership agreement, x's capital account will quickly go into deficit, thereby ending all allocations of taxable income to x. over time, y would be taxed on huge amounts that are distributable to x under the partnership agreement. the problem in this case is that x's principal contribution to the partnership, her services, is not recognized in the allocations. arguably, this problem could be overcome by treating profit shares based on contributions of services much as guaranteed payments are treated under present law-that is, by taxing services partners on their profit shares and allowing these shares as deductions in computing the partnership taxable income to be allocated in proportion to capital. however, as the example illustrates, this approach is not very satisfactory if a services partner also contributes capital and the partnership agreement does not segregate profit shares for, respectively, the services and the capital contributions. if x's 50% share of profits were treated as a guaranteed payment, the remaining 50% of partnership profits would be shared 25 of 1,025 by x and 1,000 of 1,025 by y, yielding results close to those of the partnership agreement only because x's capital contribution is very small in relation to ys. this approach would also do a relatively poor job of reflecting the partners' interests where the partners do not share investment risks in proportion to capital contributions, as developed below in example 3. example 3. the xy partnership purchases undeveloped land for $10,000. y invests in the partnership primarily for the opportunity to share in [vol 4:3 taxation of private business firms appreciation in the property's value, while x is primarily interested in the more certain, but relatively small return that will be earned by leasing the land for agricultural use (expected to be $80 annually). x contributes $1,000 to the partnership, and y contributes $9,000. partnership profits and losses from rental of the land are allocable 99% to x and 1% to y, and profits and losses on the land's sale, which may not occur sooner than 10 years after the partnership's organization, are allocable 1% to x and 99% to y. all allocations are to be recorded in the partners' capital accounts, profits are to be distributed as realized in the proportions allocated to the partners, and the partnership is to be liquidated immediately after the land's sale by distributing to each partner the balance in her capital account. if the partnership sells the land on the first day of the eleventh year for $15,000, recognizing gain of $5,000, the results are as given in example 3a. example 3a xy land partnership allocations under regulations x y year income distrib. cap. act. income distrib. cap. act. 1 $79.2 $79.2 $1,000 0.8 0.8 $9,000 2 79.2 79.2 1,000 0.8 0.8 9,000 3 79.2 79.2 1,000 0.8 0.8 9,000 4 79.2 79.2 1,000 0.8 0.8 9,000 5 79.2 79.2 1,000 0.8 0.8 9,000 6 79.2 79.2 1,000 0.8 0.8 9,000 7 79.2 79.2 1,000 0.8 0.8 9,000 8 79.2 79.2 1,000 0.8 0.8 9,000 9 79.2 79.2 1,000 0.8 0.8 9,000 10 79.2 79.2 1,000 0.8 0.8 9,000 11 50 1,050 -04,950 13,950 -0if the capital accounts are maintained as the regulations require, the allocations in example 3 have substantial economic effect because each partner will receive distribution of each dollar of income allocated to her and will experience a reduction in the distribution on liquidation for each dollar of loss allocated to her. if partnership allocations were required to be proportional to capital, all profits and losses would be allocated 10% to x and 90% to y. for example, if the partnership has net rental income of $80 annually for 10 years and then sells the land for $15,000, the allocations of each year's rental profits would be as in example 3b. 19991 florida tax review example 3b xy land partnership allocations in proportion to capital x y year income distrib. cap. act. income distrib. cap. act. 1 $8.0 $79.2 $928.8 $72.0 0.8 $9,071.2 2 7.4 79.2 857.0 72.8 0.8 9,143.0 3 6.9 79.2 784.7 73.1 0.8 9,215.3 4 6.3 79.2 711.8 73.7 0.8 9,288.2 5 5.7 79.2 638.3 74.3 0.8 9,361.7 6 5.1 79.2 564.2 74.9 0.8 9,435.8 7 4.5 79.2 489.5 75.5 0.8 9,510.5 8 3.9 79.2 414.2 76.1 0.8 9,585.8 9 3.3 79.2 338.3 76.7 0.8 9,661.7 10 2.7 79.2 261.8 77.3 0.8 9,738.2 11 130.9 1,050 (657.3) 4,869.1 13,950 657.3 presumably, x would recognize gain on liquidation equal to the negative balance in her capital account after the liquidating distribution, and y would recognize an equal loss. however, this gain and loss are merely corrections to the cumulative errors that the proportional-to-capital rule would create by allocating partnership income differently from the basis on which the partners agreed to share it. moreover, as example 3b shows, the rule would make the tax allocations much more complicated than they are if the partnership agreement is followed, as it is in example 3a. although the rule is simple to state, it thus exacerbates a principal problem of the present subchapter k: complexity. in this particular case, the regulations provide a more realistic treatment. x invests $1,000, essentially for rights to three items: $79.2 annually for 10 years; the return of the $1,000 at the end of that period; and 1% of any gain or loss on the property's sale. since the latter right is too contingent to warrant any recognition of gain or loss on it before the sale, it is reasonable to tax x on the annual payments and reckon up any gain or loss at the end. the regulations so provide. however, any generalization that might be made from this case is likely to be contradicted by the results in similar cases. example 3 shows the inadequacy of a rule requiring allocations in proportion to capital. it does not prove the adequacy of the substantial economic effect test of section 704(b) and the regulations thereunder. the fundamental objection to a requirement of allocations in proportion to capital is that it often causes income clearly belonging to one partner to be taxed to another partner. when the partners' contributions [vol. 4:3 taxation of private business firms include services as well as financial capital and when partners agree to share different income streams differently, allocations in proportion to capital may not correspond to the partners' economic income from their partnership investments. this objection should be recognized by those protective of the fisc as well as by taxpayer advocates. any tax rule that departs from economic reality is a double-edged sword. for taxpayers who overlook the rule in their planning, the rule can defeat reasonable expectations about the tax consequences of their investments. for taxpayers who fully understand the rule's operation, it is a useful tool for manipulation. iv. contributions and distributions generally, property can be contributed to and distributed from a partnership without recognition of gain or loss by the contributing or distributee partner or by the partnership. in a wholly unrestricted form (as generally existed when subchapter k was enacted in 1954), this approach allows gains and losses inherent in property other than money to be shifted freely to one or more partners. appreciation or depreciation in property owned by one partner can, by contribution to the partnership, be made potential gain or loss to be shared in the partnership collective, and appreciation or depreciation in partnership property can, by distribution, be made potential gain or loss of one partner, the distributee. over the last 25 years, congress has steadily restricted these shifting opportunities. section 704(c)(1)(a)-under which gain or loss on a partnership's sale of property contributed to the partnership is, to the extent of appreciation or depreciation accrued at the time of contribution, allocated solely to the contributing partner-was initially elective, but in 1984 it became mandatory. 6 as originally enacted, the mandatory version of section 704(c)(1)(a) was circumvented if contributed property was distributed to a partner other than the contributing partner or if the contributing partner received a liquidating distribution of property other than the contributed property before gain or loss was recognized on the contributed property. the distribution loophole was closed in 1989, and the prerecognition-exit loophole was closed in 1992.27 the history of section 704(c)(1)(a) has been repeated in several other contexts involving partnership distributions. congress perceives loopholes and legislates to close them, but the legislation and the often lengthy regulations needed to implement the legislation expose other shifting opportunities, 26. see act effective march 31, 1984, §71(a), pub. l no. 98-369, 26 u.s.c. 704. 27. see irc §§ 704(c)(1)(b), 737. 1999] florida tax review requiring further legislation and regulations to close down these possibilities. as with partnership allocations, the accumulated complexity is difficult to comply with, even by taxpayers wanting to comply, and provides cover for even modestly clever efforts to evade the rules. most of these shifting opportunities could be foreclosed by requiring partners to recognize gain or loss on all contributions to partnerships and by requiring partnerships to recognize gain or loss on all distributions. a gain recognition rule could be easily understood by taxpayers, and although it would require valuation of all contributed and distributed property, it surely would be less difficult to administer than the present rules. requiring recognition on all contributions might be seen as erecting an unwise impediment to business formations. it has traditionally been possible to organize a business entity tax-free whether the entity is a corporation, partnership, or other form of organization. under section 351, a transfer of property to a corporation in exchange for stock is a nonrecognition transaction for the transferor only if the transferor (together with others making contemporaneous transfers) holds at least 80% of the corporation's stock immediately after the transaction. section 721 is more liberal, allowing nonrecognition on a transfer to a partnership in exchange for a partnership interest, regardless of the transferor's proportionate interest. given its long history and role in facilitating business formations, the principle of tax-free formation should not be abandoned for partnerships, at least so long as it continues to reign in the corporate context. however, under sections 311 and 336, a corporation distributing property to its shareholders must recognize gain (and sometimes loss) as though it had sold the property to the distributees. this principle applies to s corporations, as well as c corporations, establishing a history of gain recognition on distributions by pass-through entities. congress and the treasury have repeatedly found it necessary to add layers of complexity to stop abuses involving partnership distributions. requiring recognition on distribution is probably less disruptive of legitimate business operations than would be recognition on contribution. recognition on distribution would obviate the need for much complexity and be a more effective guard against manipulation than the present patchwork of permissiveness and complex limitation. v. a radical solution subchapter k suffers from two fundamental flaws: it is so complicated that many partnerships cannot reasonably be expected to comply with its rules, and even when these complex rules are fully obeyed, the tax results do not necessarily reflect the economic realities of the partners' investments. [vol 4:3 taxation of private business firms the most pervasive and consequential of these problems is probably complexity. it could be addressed by returning to a regime much closer to the subchapter k of 1954. for example, the complexity of the allocation regulations could be alleviated by a much simpler statement of the capital account procedures. the primary goal in this simplified restatement would be to ensure that allocations have economic effect, and the substantiality of the allocations' economic effects would be considered only to the extent that substantiality constraints can be simply stated and easily applied. the rules on shifting tax consequences and transitory allocations would probably disappear. however, this approach would aggravate misallocation problems, and for more than 20 years, successive congresses have found unacceptable the potentials for abuse arising from unrestrained flexibility. turning back the clock seems not to be a viable option. the problems of complexity and misallocation under present law could be resolved with a radically different model of pass-through taxation. under this model, subchapters k., s, and c would persist, more or less as under present law, but the allocation of business and investment firms between these regimes would be changed. in light of two signal events in the history of entity classification-widespread adoption of limited liability company (llc) laws and the treasury's promulgation of the check-the-box regulations-it no longer makes sense to classify entities for income tax purposes with reference to their state-law characterizations or characteristics. whether a business entity is organized as a partnership, limited liability company, corporation, or in some other form should not affect federal tax liabilities. instead, income tax classifications should depend on factors peculiarly relevant to the income tax laws. the model proposed here retains subchapters k, s, and c, but it significantly readjusts the sorting of entities between the three categories, and it also makes changes in the rules applicable to entities within each category. subchapter k would be closed to all firms other than service firms. nonservice firms could only qualify for one conduit regime, a revised subchapter s that would encompass partnerships and limited liability companies, as well as corporations, exhibiting the simple ownership structure historically required of s corporations. subchapter c would also be broadened to include all business entities, regardless of form of organization, other than those subject to the revised subchapters k and s. however, subchapter c entities would be divided into two groups, those having at least one publiclytraded equity interest and those having no such interest. the former group would continue to be subject to the classical, double-tax regime now applicable to all c corporations. the latter group-private, nonconduit entities-would be taxed at the highest individual rate of tax on taxable income computed without any deduction for interest expense. the holders of 19991 florida tax review equity interests and debt instruments issued by private, nonconduit entities would not be taxed on distributions (including interest), except that a complete or partial liquidation of an equity interest or retirement of debt would be treated as a sale of the retired interest. in the ensuing discussion of this model, frequent reference is made to a very similar model recently proposed by professor jeffrey l. kwall.28 a. subchapter k under the proposed model, the highly flexible pass-through regime embodied in subchapter k would only be available for services firms with two or more owners for which capital is not a material income-producing factor.29 the significant misallocation possibilities, and nearly all of the complexity that has arisen to limit these possibilities, relate to income from capital. for services firms with relatively little capital, the objective of section 704(b)-that the partners taxed on partnership income should actually receive it in the end-can only be attained through the basics of the capital account mechanisms of the present regulations. so long as these mechanisms operate, no significant distortions can result from allowing partners the right to adjust allocations annually, as late as the due date of the partnership's return. an entity for which capital is not a material income-producing factor would be subject to subchapter k regardless of how it was organized. however, the entity would not be allowed to elect to be subject to subchapter s if it meets the eligibility requirements discussed below, and it could also elect to be a c entity.3" b. subchapter s 1. eligibility.-subchapter s would be revised to apply to any business entity for which capital is a material income-producing factor, regardless of the entity's form of organization, if (1) the entity has only one class of equity interests, (2) none of these interests is publicly traded, (3) 28. kwall, supra note 5. 29. the issue of whether capital is a material income-producing factor in a business existed for several decades under § 911 (partial exclusion of earned income from foreign sources). irc § 911(d)(2)(b). over the years, the concept has also been used in a few other contexts. for a discussion of the case law on the issue, see michael asimow, section 1348: the death of mickey mouse? 58 cal. l. rev. 801, 836-42 (1970). a services firm with only one owner would be disregarded for tax purposes, regardless of its form of organization. see infra note 32 and accompanying text. 30. for the appropriateness of allowing these elections, see yin, supra note 14; see also infra text accompanying note 40. [vol 4:3 taxation of private business firms equity interests are held by more than one person and not more than 100 persons, and (4) the entity does not elect to be a c entity. the one class requirement would be met only if each equity interest entitles its owner to the same proportion of every item of the entity's gross income, deductions, and credits for all years of the entity's existence, except that this proportion would have to change to reflect appropriately the issuance of additional ownership interests, capital contributions, and partial and complete retirements of equity interests. an entity with only one equity-interest holder would be disregarded for u.s. income tax purposes, essentially treated as a sole proprietorship.' several classes of shareholders ineligible under the present subchapter s could be s equity holders under this model. other business entities could be equity holders whether their tax regimes are subchapter c, k, or s. for example, a c entity with publicly traded equity interests could hold an equity interest in an s entity. trusts and estates could also hold s equity interests. professor kwall's simple conduit regime would be closed to an entity having a foreign person among its equity owners.33 his reason for this condition is persuasive. since tax cannot feasibly be collected from foreign persons not directly engaged in business in the united states, tax on their u.s. incomes is usually collected by withholding.' professor kwall worries that a withholding tax collected from the entity could complicate administration of the one class requirement.35 if the entity does not distribute its income currently but is required to pay withholding taxes on the income shares of foreign owners, the proportionate interests of foreign and domestic owners are not fully equivalent since no similar cash disbursement is made on behalf of the domestic owners.36 31. in one situation, a qualifying entity should be an s entity only if it affirmatively elects to be such. if an entity initially does not qualify to be an s entity (because it has more than one class of equity interests, publicly traded equity interests, or more than 100 equity owners) but later qualifies (e.g., by redemptions that eliminate a second class of interests or publicly traded interests or reduce the number of interest holders to 100 or fewer), the entity should not be an s entity unless it so elects. 32. under present law, a one-owner limited liability company electing conduit treatment is so classified as a "tax nothing," but a corporation with one shareholder can be an s corporation. temp. regs. § 301.7701-3(a). consistent with the general goal in this model to avoid distinctions dependent on form of organization, either the tax-nothing approach or the s approach should apply to all entities. the tax-nothing approach is chosen because it is probably simpler and less susceptible to manipulation. 33. see kwall, supra note 5, at 252-53. 34. see irc §§ 1441, 1442 (withholding tax from foreign persons' nonbusiness incomes), 1446 (withholding tax from foreign partners' distributive shares of partnership taxable income effectively connected with u.s. business). 35. see kwall, supra note 5, at 252-53. 36. id. 1999] florida tax review however, the effect of professor kwall's limitation is that conduit taxation would be wholly unavailable to an entity if just one of its owners were foreign, even if this person's proportionate interest were only a fraction of 1%. presently, a corporation with a foreign shareholder cannot be an s corporation," but subchapter k applies to a partnership, regardless of foreign ownership. denying all possibility of conduit taxation to all entities with foreign ownership seems extreme. perhaps, a more reasonable limitation is to allow an entity with a foreign owner to be an s entity only if the documents defining the owners' rights require withholding taxes paid on behalf of any owner to be accounted for as loans, repayable with interest from distributions to the owner if not previously repaid. to limit manipulation, the interest rate for any year might be required to be not less than the short-term applicable federal rate (afr) for the first month of the year and not more than twice that rate. under the model proposed here, conduit treatment would not be available to an entity with more than 100 equity holders, even if none of the entity's equity interests is publicly traded."8 the principal reason for this limitation is administrative: coordinating entity-level determinations of income with owner-level reporting of these items gets more complicated, and as the number of owners increases, the possibilities of coordination errors grow. in recently creating an elective simplified flow-through mechanism for partnerships with 100 or more partners, congress recognized that "relatively small, passive interests in large partnerships [are i]n many respects ... indistinguishable from.., corporate stock."39 professor yin argues that an entity qualifying for conduit treatment should not be allowed to elect against this treatment because, whenever conduit treatment would tax the owners on their economic shares of entity income at their personal tax rates, the election could be made to substitute a wrong rate for the right rate.n0 this position makes sense in the context of his model, which treats all private business firms as conduits. however, under the model proposed here firms would not be precluded from opting c status. since conduit taxation is open only to firms meeting restrictive conditions, a firm not wanting conduit taxation could effectively elect c status by failing one of the conditions in a way that does not substantially alter the owners' interests (e.g., by issuing a small preferred equity interest). moreover, because 37. see irc § 1361(b)(1)(c). 38. under present law, a corporation with more than 75 shareholders may not be an s corporation. see irc § 1361(b)(1)(a). 39. staff of joint comm. on tax'n, 105th cong., general explanation of tax legislation enacted in 1997 354 (comm. print 1997). 40. see yin, supra note 14, at 149-50. [vol. 4:3 taxation of private business firms private c entities are taxed at the highest individual rate, an election of c status would not often have the effect of reducing tax obligations. 2. fixed payment instruments.-the proposed model would allow an s entity to designate as debt any type of instrument if the financial rights of the holder included only (1) annual or more frequent periodic payments in a fixed dollar amount and (2) a distribution on retirement of the instrument in a specified dollar amount.4 an instrument meeting these requirements would be subject to all of the rules for debt instruments, both as to the entity and to the holder of the instrument, whether the instrument is called a debt instrument, preferred stock, or a partnership interest, or bears some other label. an interest designated as debt would not be considered a second class of equity interests, and holders of these interests would not be counted against the 100-equity-holders ceiling. the designation would have to be made when the instrument is issued, and a revocation of the designation would be treated as a payment of the original instrument and the issuance of another. professor kwall would also allow a conduit entity to issue debt-like preferred instruments, but he apparently would not require that the annual return be paid immediately and would treat a preferred interest as either debt or equity, depending on how it is structured (e.g., as debt if it takes that form or as equity if it is or resembles preferred stock).4 however, treating such instruments as equity could raise complex allocation issues, particularly if the annual return is not paid currently. for example, if cumulative preferred stock is treated as equity, what allocation should be made to the shareholder for a particular year if entity taxable income for the year is less than the preferred dividend? if the entity has adequate taxable income, but most of it is longterm capital gain, should the allocation to the preferred shareholder be ordinary income or capital gain? if the dividend is not paid for a particular year and cumulates to the following year, should the allocation to the holder for the year be the amount of the dividend, some lesser figure representing the present value of the eventual distribution, or zero? the proposal made here is that a preferred instrument should violate the second class of equity rule unless it exhibits the principal tax characteristics of debt-fixed payment obligations; the annual return on such a debt-like instrument should be treated as interest, deductible by the entity and taxable as ordinary income to the holder, whether it is paid or not and regardless of the amount or character of the entity's income. 41. the requirement that the annual payment be a fixed dollar amount should be considered met if the payment is expressed as a percentage of the amount payable on retirement. 42. see kwall, supra note 5, at 246-48. 1999] florida tax review 3. contributions.-under present law, gain or loss is rarely recognized on a transfer of property to a partnership in exchange for a partnership interest, and nonrecognition is allowed on a transfer of property to a corporation (including an s corporation) in exchange for stock if the transferor or transferors own at least 80% of the corporation's stock immediately after the transfers.43 the tradition of nonrecognition on property transfers incident to entity organization is long and firmly established, and probably for good reason. requiring gain or loss to be recognized on such a transfer is seen as placing an undue burden on taxpayers' ability to organize and reorganize their business affairs." nonrecognition on transfers to conduit entities raises at least one obvious problem: gain or loss accrued to the contributing owner before the property's contribution may be shifted, at least in part, to other owners of the entity when the entity sells or uses the property. this shifting opportunity could be eliminated by requiring the contributing owner to recognize gain or loss as though the property were sold to the entity at its fair market value. however, the nonrecognition tradition is probably so firmly based in history and business convenience that it cannot feasibly be reversed. therefore, under the proposed model, no gain or loss would be recognized by a person contributing property to an s entity in exchange for an equity interest in the entity or by the entity on receiving the property.45 the possibility of restricting this nonrecognition rule to limit shifting opportunities is discussed further below.46 historically, the law has not allowed nonrecognition on transfers of property in exchange for debt instruments. therefore, if property is contributed to an s entity in exchange for an instrument issued by the entity that the entity designates as debt, the contributor should be treated as selling the property, and the entity as purchasing it, for a price equal to the instrument's principal amount. 4. distributions.-presently, when a partnership distributes property other than money to a partner, gain or loss is generally not recognized by either the partnership or the partner.47 an s corporation, in contrast, 43. see irc §§ 351(a), 721. 44. see kwall, supra note 5, at 254. 45. professor kwall would also allow nonrecognition on property transfers to an entity upon its organization, but gain or loss would be recognized on a subsequent transfer to the entity unless the transferor's interest in the entity was at least 80%. see kwall, supra note 5, at 254-58. 46. see infra text accompanying notes 54-56. 47. see irc § 731(a), (b). [vol 4:3 taxation of private business firms recognizes gain on a distribution to a shareholder as though the property were sold to the shareholder at its fair market value." even in its original formulation of subchapter k, congress acknowledged that the partnership rules on distributions, if not limited, would leave too much opportunity for partners to shift gains and losses between them. under section 751(b), enacted in 1954, a partnership distribution is treated as a constructive sale of property between the distributee and the partnership to the extent that the distribution changes the partner's proportionate interests in various types of property that would generate ordinary income on sale. since most property distributions shift gain or loss inherent in the distributed property from the partners, collectively, to the distributee individually, congress essentially decided that this distortion was acceptable so long as it does not relate to the designated ordinary income assets. on several subsequent occasions, congress has identified other contexts in which shifting of potential income, deduction, gain or loss by distributions was no longer tolerable. 9 the resulting patchwork is one of the principal repositories of unworkable complexity in the present subchapter k. under the proposed model, an s entity would generally recognize gain or loss on any distribution of property to an owner, computed and characterized as though the property were sold to the distributee at fair market value."0 this rule would usually eliminate the possibility of a distribution shifting potential income, gain, or loss to other owners. however, it would sometimes allow an entity's owners to cause gain or loss to be recognized without substantially changing the beneficial ownership of the distributed property. arguably, loss recognition should therefore be restricted.] 5 48. see irc §§ 311(b), 336. 49. see irc § 704(c)(l)(b) (partner who contributed property to partnership recognizes gain or loss accrued at time of contribution if property is distributed to another partner within seven years after contribution), enacted in 1989; § 707(a)(2)(b) (distribution, coupled with distributee's transfer of property to partnership, treated as sale or exchange if that is substance of transactions), enacted in 1984; § 731(c) (marketable securities treated as money for purposes of rule requiring distributee partner to recognize gain to extent money received exceeds basis of partnership interest), enacted in 1993; § 737 (distributee taxed on gain inherent in property contributed by distributee during preceding seven years unless distribution is of contributed property), enacted in 1993. 50. professor kwall would provide nonrecognition on a distribution in liquidation of the entity if the owners continued the business in another form. see kwall, supra note 5, at 260. this exception is not included in the model proposed here because, as discussed below, a change in form of organization is not treated as a distribution unless the new organizational form is not an s entity. 51. compare irc §§ 267(a)(1), 707(b)(1). 1999] florida tax review 5. allocations of income, loss, and credit.-since the proposed model would restrict an s entity to having only one class of equity interests, the allocation of the entity's gross income, deductions, and credits among the owners should usually be relatively simple. each owner would be allocated a constant percentage of each such item. this simple allocation scheme, like that of the present subchapter s, makes no provision for a significant group of problems alluded to earlier. when an s entity receives appreciated or depreciated property as a capital contribution from one of its owners, the gain or loss accrued in the property at the time of contribution is, when realized by the entity, allocated ratably to all of the owners. similarly, when an s entity owning appreciated or depreciated property issues an additional equity interest, gain or loss accrued before the issuance of this interest is, when subsequently realized by the entity, allocated in proportionate part to the holder of the new interest. conversely, if an s entity redeems an equity interest, the redeemed owner's share of appreciation or depreciation in property of the entity not distributed in the redemption is allocated to the remaining owners when the entity ultimately recognizes it. property contributions and issuances and redemptions of equity interests are therefore vehicles by which gain or loss accrued to one person or group of persons may be shifted to another person or group of persons. the partnership rules presently require that gain or loss inherent in contributed property at the time of contribution be allocated to the contributing partner when it is realized by the partnership.52 when a partnership issues new partnership interests, it may, but need not, revalue partnership assets and restate the partnership books to ensure that accrued gains and losses will, on realization, be allocated to the partners in proportion to their interests when the gain or loss accrued.53 the rules provide no procedure by which a departing partner may be taxed on the partner's share of accrued gains and losses on undistributed property. as professor kwall notes, the shifting potential of the s rules has not been considered problematic.' however, the proposed model would expand the categories of entities eligible to utilize subchapter s (e.g., to include entities with corporate owners), and subchapter s would be attractive to much broader classes of investors (e.g., because of the rules on liabilities discussed below). although the proposed one-class-of-entity-interests requirement might lessen the problem of gain and loss shifts, this problem might not be greatly different under the proposed subchapter s than it was under subchapter k 52. see irc § 704(c). 53. see regs. § 1.704-1(b)(2)(iv)(f), (g). 54. see kwall, supra note 5, at 258. [vol 4:3 taxation of private business firms immediately before congress, in 1984, adopted the present partnership rules on contributed property." the model proposed here nevertheless follows the present subchapter s on this point. the partnership rules on contributed property are complex and not wholly effective.56 they are also arbitrary in that they closely regulate one type of shifting of gain and loss, while leaving analogous shifting opportunities subject either to an elective rule or to no rule at all. although the s approach opens opportunities for manipulation, particularly under the more broadly available subchapter s in the proposed model, the burdensome complications of the partnership limitations are not justified by what they accomplish. 6. loss limitation; liabilities in basis.-under both subchapter k and subchapter s, an equity owner can deduct entity losses only to the extent of the basis of the owner's interest.y however, the adjusted basis of a partnership interest includes the partner's share of partnership liabilities," but an s corporation's liabilities have no effect on the shareholders' bases for their stock. the partnership rules greatly facilitate partners' deductions for artificial losses generated by partnership investments. the s example better serves the goal of simplicity. the partnership rules are complex, particularly as applied to liabilities for which some partners have personal liability and some do not. generally, a partner's share of a liability is the portion of the liability for which the partner or a related person "bears the economic risk of loss,"59 but if no partner bears this risk, the liability is allocated among the partners according to a three-tier formula.' all obligations among the partners, as well as to third persons, are taken into account in determining whether partners have personal liability and, if so, the proportions in which they bear the economic risk of the liability.6' none of these determinations are required for s corporations. 55. deficit reduction act of 1984, pub. l. no. 98-369, § 71(a), 98 stat. 494, 589 (1984). 56. see regs. § 1.704-3. the complexity and ineffectiveness both derive in significant part from the regulations' "ceiling rule," which applies when, among other things, property appreciates before it is contributed to the partnership and then depreciates in the partnership's hands or vice versa. see laura cunningham, use and abuse of section 704(c), 3 fla. tax rev. 93 (1996). 57. see irc §§ 704(d)(1); 1366(d). a partner can deduct losses only to the extent of the basis of the partnership interest, but an s shareholder can deduct losses to the extent of the sum of the bases of the shareholder's stock and corporate debt held by the shareholder. 58. see irc § 752. 59. regs. § 1.752-2(a). 60. see regs. § 1.752-3(a). 61. regs. § 1.752-2(a). 1999] florida tax review the facial simplicity of the s approach is undercut by frequent disputes between the irs and s shareholders over whether corporate borrowings from third persons should be considered, in substance, to be borrowings by the shareholders, followed by capital contributions or loans by the shareholders to the corporation.62 whether a corporate liability is reflected in a shareholder's basis often depends more on the form of the transactions than on the substance of the parties' rights and interests, particularly if the shareholder guarantees the liability. a more fundamental problem with the s approach, particularly if it is used in the only conduit regime available to most business entities, is that it draws a sharp distinction between proprietorships and multiowner enterprises and between co-ownership of property and ownership through an entity. the partnership liability rules are essentially an extension of the crane doctrine, which includes in a taxpayer's cost basis for property any portion of the cost that the taxpayer paid with borrowed money, by assuming a liability, or by taking the property subject to a debt.63 to deny liability flowthrough in the only generally available conduit regime for business entities probably gives the entity too much significance. however, the factual determinations required by the partnership rules are complicated. under crane, a liability may be included in a property owner's cost whether or not the owner has personal liability.' 4 this rule has the advantage of avoiding the often difficult and sometimes economically meaningless question of whether a liability is with or without recourse. in an entity context, an equity owner personally liable for an entity debt has a better claim to basis for the obligation than an owner without personal liability, but administration of this distinction adds too much complexity in relation to the fairness benefits obtained from the distinction. each equity owner's proportionate share of each liability of the entity should be the same as the owner's proportionate share of entity income and loss, and the holder's personal liability on the indebtedness, or lack thereof, should be ignored. 7. effects of elections and terminations.-presently, a c corporation's election to be an s corporation does not interrupt the corporation's existence for tax purposes or trigger recognition of gain or loss in the corporation's assets. however, a conversion of a partnership into an s corporation or of a corporation into a partnership is treated as a liquidation 62. compare selfe v. united states, 778 f.2d 769 (11th cir. 1985) (corporate borrowing, guaranteed by s shareholder found to be, in substance, loan to shareholder followed by shareholder loan to corporation), with estate of leavitt v. commissioner, 875 f.2d 420 (4th cir. 1989) (contra). 63. crane v. commissioner, 331 u.s. 1 (1947). 64. id. [vol 4.3 taxation of private business firms of the old entity and a transfer to the new entity.0 the provisions of subchapter s dealing with former c corporations are among the most complex of the rules applicable to s corporations.' under the proposed model, a c entity becoming an s entity or an s entity electing to be a c entity would be treated as making a liquidating distribution of all of its assets, subject to its liabilities, to its equity owners as of the close of business on the day preceding the effective date of the election or termination, and the equity owners would be treated as contributing the assets, subject to the liabilities, to the s or c entity before the start of business on the following day. gain or loss would be recognized on the constructive liquidation as though the corporation had sold its assets to the equity owners. 8. application of subchapter c.-presently, all provisions of subchapter c apply to s corporations, excepting those that are either expressly made inapplicable or are "inconsistent with" subchapter s.67 because the proposed model brings partnerships, limited liability companies, and other unincorporated business entities into the s regime, it is not appropriate that subchapter c have any application to s entities. one consequence of the present incorporation of subchapter c into subchapter s is that an s corporation can be a corporate party to a reorganization, whereas a partnership cannot. for example, if an s corporation's assets are acquired by another corporation in exchange for voting stock of the latter and the s corporation distributes the stock in complete liquidation, the transaction is a tax-free reorganization (a c reorganization), and neither the target corporation nor its shareholders recognize gain or loss.68 in contrast, if a partnership's assets are acquired for stock in a corporation, the partnership's exchange of its assets for the stock is usually a taxable transaction. in the remodeled subchapter s, the corporate reorganization rules would apply only to c entities, but a greatly simplified set of reorganization rules should be constructed for s entities. if an s entity's form of organization is changed (e.g., a partnership is incorporated), but the 65. see rev. rul. 84-111, 1984-2, c.b. 88 (regarding incorporation of a partnership), prop. regs. § 301.7701-3(g)(1)(i), (ii) (elective changes in classification from partnership to association and from association to partnership). 66. see irc §§ 1368(c) (distributions from earnings and profits accumulated before corporation elected under subchapter s); 1374 (gains inherent in corporate property at time of s election subject to corporate tax if recognized by corporation within first 10 years of election); 1375 (passive investment income of former c corporation subject to corporate tax to extent this income exceeds 25% of corporate gross receipts). 67. irc § 1371(a). 68. see irc §§ 354(a), 361, 368(a)(1)(c). 19991 florida tax review proportionate interests of the owners are unchanged, the new entity should be treated as a continuation of the old entity. if the assets of two s entities are combined into one entity, neither entity nor its equity owners should recognize gain or loss if the consideration received by the owners consists solely of equity interests in the surviving entity. a division of one s entity into two or more s entities should also be a nonrecognition transaction if none of the equity owners receives anything but equity interests in the surviving entities. if a transaction would be within either of the foregoing rules, except that one or more equity owners receives consideration other than equity interests in a surviving entity, the owners receiving nonqualifying consideration should be taxed as though they had sold their prior interests at fair market value, but the remaining participants in the transaction should not recognize gain or loss. in contrast, an acquisition of an s entity by a c entity, or vice versa, would be treated as a complete liquidation of the acquired entity, followed by a transfer of its assets to the acquiring entity. c. subchapter c under the proposed model, all business entities not covered by subchapter k or s would be subject to subchapter c. except for entities qualifying for s status and not electing c status, this category would include all entities with publicly traded interests (essentially as under present law) and any entity with two or more owners whose capital is a material factor in the production of its income. form of organization would not be a factor in determining whether subchapter c applies to an entity. the reasons for this radical restructuring of the tax classification of business entities do not require that the double tax regime presently visited on c entities should apply to entities newly reclassified into subchapter c. for example, although a complex partnership cannot reasonably be treated as a conduit for income tax purposes, the complexities of the partners' sharing arrangements provide no reason for taxing the partnership's income both to the partnership as earned and to the partners when distributed. it is proposed that such a partnership be classified as a c entity only because the futility of any effort to allocate its income realistically among the partners requires that tax on the income be imposed at the entity level, not the partner level. on the other hand, a reshuffling of the tax classification of private business entities is not necessarily the appropriate occasion for an abandonment of the classical, double tax regime for publicly held entities. under present law, this regime generally applies to entities with publicly [vol 4:3 taxation of private business firms traded interests, regardless of form of organization. 69 this situation should continue until congress undertakes the separable task of reexamining its commitment to the regime. however, given the artificiality of distinguishing for tax purposes between partnerships, corporations, and business entities organized in other ways, a single level of tax, not a double tax, should apply to all nonpublic business firms. it is therefore proposed that 1. any c entity having at least one class of publicly traded equity interest and the holders of its equity interests should continue to be subject the double tax regime, and debt issued by the entity would remain subject to the present rules for debt. 2. all other c entities should be taxed at a flat rate equal to the highest marginal rate for individuals (presently, 39.6%). 3. nonpublic c entities should be allowed no deduction for interest expense, but consistent with the single-tax objective of this model, interest, dividends, and other distributions from other nonpublic c entities should be excluded from gross income. 4. holders of equity and debt instruments issued by nonpublic c entities should be exempted from tax on interest, dividends, and other distributions from the entities. the system proposed for nonpublic c entities is essentially the comprehensive business income tax (cbit) suggested by the treasury in 1992 for all c entities.70 according to the treasury, "cbit would equate the treatment of debt and equity, would tax corporate and noncorporate businesses alike, and would significantly reduce the tax distortions between retained and distributed earnings."'" the cbit is not, of course, a simple, perfect solution to the problem of double taxation.72 for example, it is not obvious how gains and losses on 69. see irc § 7704 (partnership treated as corporation for federal tax purposes if partnership interests are traded on established securities market or readily tradable on secondary market). 70. see u.s. dep't of the treasury, integration of the individual and corporate tax systems: taxing business income once, 39-60 (1992) [hereinafter treasury studyl. 71. id. at 39. 72. another problem addressed by the treasury study is that the cbit, without some modification, would allow equity owners to enjoy indirectly the benefits of all tax preferences available to the entity, whereas, under present law, shareholders of c corporations are usually taxed when corporate income protected by tax preferences is distributed as dividends. the treasury proposed to preserve the status quo on this issue by imposing an 19991 florida tax review sales of equity interests should be treated under a cbit. to the extent that the enhanced value of an equity interest derives from undistributed income of the entity, an entity-level tax has effectively already been paid on the equity holder's gain, and a tax on the gain would therefore violate the goal of taxing the entity's income only once. on the other hand, to the extent that the enhanced value derives from unrealized gains in the entity's assets, an exemption of the owner's gain from tax would allow the owner to cash out his or her share of the unrealized gains without tax. although the gains may subsequently be taxed to the entity when it sells the assets, the law has not historically allowed the taxation of gain to be delayed beyond the time when the beneficial owner receives cash for it. the treasury proposed to solve this problem by taxing gains on sales of equity interests, and allowing deductions for losses, as under present law, but adopting a dividend reinvestment plan (drip) procedure that would allow entities to treat parts or all of their earnings as having been distributed and reinvested by the equity owners.73 the drip procedure would have the effect of increasing the tax bases of equity interests by the amounts deemed distributed. as professor yin points out, the drip procedure is not problem-free in this model. 74 many nonpublic c entities are so classified in the model because their owners have adopted complex schemes for sharing profits and losses. for them, the imposition of entity-level tax is justified by the fact that conduit taxation, based on allocations of entity income among the owners, would be artificial and susceptible to manipulation. a drip procedure could be implemented only by making such an artificial allocation. the potential for manipulation could be reduced by allowing a drip election for a particular year to apply only to income for that year, thus precluding entities from allocating earnings for several years only after it is clear how the additional compensatory corporate tax on distributions of preference income. see treasury study, supra note 70, at 43-45. see id. at 45-48 (proposing to treat foreign income insulated from u.s. tax by foreign tax credit as corporate preference income). the compensatory tax would be complex, and it probably is not needed in this model. although the treasury proposed the cbit for all business entities (excepting only those with annual gross receipts less than $100,000), the present proposal uses the cbit only for private business entities, nearly all of which are or could be organized as partnerships or other entities presently eligible to be taxed as partnerships. since partners have always had the benefit of tax preferences available to the partnership, a cbit without the compensatory preference tax would not significantly broaden the enjoyment of tax preferences. 73. see treasury study, supra note 70, at 81-88. 74. see yin, supra note 14, at text accompanying notes 74-76. [vol. 4:3 taxation of private business firms allocation would advantage the owners.75 however, the arbitrariness and manipulation potential of the required allocations cannot be denied. alternatively, the equity holder's gain could be exempted from tax, but the entity could be required to recognize gain or loss as though all of its assets were sold at fair market value if, at any time, one or more persons owned a proportion of the equity interests that was more than a specified amount (e.g., 50%) higher than the smallest proportionate interest of these persons during a specified period of time (e.g., the preceding three years). 6 this approach suffers from at least two faults: execution of it would be complex, and it would have the effect of taxing the shares of corporate gain allocable to the interests of equity holders who do not sell their interests. in sum, the capital gains problem has no easy solution. on balance, the best solution seems to be to require the entity to recognize gain when a major portion of the equity interests have been sold. this approach concentrates tax calculations in the entity and thus is more consistent with the thrust of the cb1t to tax entity income only at the entity level. vi. conclusion subchapter k has a terminal illness. for several decades, aggressive tax planners have used partnerships as a vehicle for shifting income and loss arbitrarily between partners, and congress and the treasury have found it necessary to respond to these uses of the partnership by adopting progressively more complicated restrictions on the fairly simple conduit regime found in the original enactment of subchapter k. the result is a system of unworkable complexity that still does not adequately guard against manipulative shifting of income and loss. the problem is not that congress and the treasury have done a poor job of making the law. the problem is that conduit taxation is not feasible for firms with complex arrangements for sharing firm income and loss. congress and the treasury, in trying to develop a conduit regime acceptably free of abuse potential, have been attempting the impossible. before the patient expires, congress should radically reshuffle the respective jurisdictions of subchapters k, s, and c. form of organization should no longer play any role in an entity's tax classification. subchapter k should only remain available to service entities for which capital is not a 75. it would not be desirable to require the entity to adopt procedures ensuring that the earnings allocated to a particular interest would ultimately be distributed to the holder of that interest because this would return to the accounting now required by the substantial economic effect test. 76. see irc §§ 338, 384; see also yin, supra note 14, at text accompanying note 1999] 286 florida tax review [vol 4:3 material income-producing factor. the more restrictive conduit regime of subchapter s should be opened to all private business fins with simple capital structures and should be revised to incorporate as much of the flexibility of subchapter k as is possible without making it unreasonably susceptible to abuse. all firms with more complex ownership structures should be subject to subchapter c, but the incomes of private business firms within subchapter c should only be taxed once. the taxable income of a private c entity should be determined without deduction for interest expense, and returns received by the entity's owners and creditors (e.g., dividends and interest) should be exempt from tax. florida tax review volume 4 1999 number 2 the constitutionality of taxing compensatory damages for mental distress when there was no accompanying physical injury douglas a. kahn* since 1919, statutory tax law has excluded from gross income compensatory damages received on account of a personal injury or sickness.' the current version of that exclusion is set forth in section 104(a)(2) of the internal revenue code of 1986.2 the construction of that exclusion, both by the courts and by the commissioner, underwent significant alterations over the 80-year period that the provision has existed. the statute itself was amended several times, most recently in 1996. it is the 1996 amendment * paul g. kauper professor of law, university of michigan. 1. the first statutory provision was adopted in 1919 as part of the revenue act of 1918. pub. l. no. 65-254, § 213(b)(6), 40 stat. 1057, 1066 (1919). there was an issue for some years as to whether the exclusion also applied to punitive damages received in connection with a personal injury. that issue was laid to rest by a 1996 statutory amendment so that irc § 104(a)(2) explicitly states that it does not apply to punitive damages (with one minor exception for certain wrongful death damages). see irc § 104(c). also, even prior to the amendment's taking effect, the supreme court held that the irc § 104(a)(2) exclusion does not apply to punitive damages. o'gilvie v. united states, 519 u.s. 79 (1996). 2. the current reading of the relevant portions of irc § 104(a) is as follows: except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any taxable prior year, gross income does not include(2) the amount of any damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness; ... (f)or purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. the preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care... attributable to emotional distress. 3. the history of the various interpretations of that provision are set forth in douglas a. kahn, taxation of damages after schleier-where are we and where do we go from here?, 15 quinnipiac l. rev. 305-09 (1995); and douglas a. kahn, compensatory and punitive damages for a personal injury: to tax or not to tax?, 2 fla. tax rev. 327, 330-39 (1995). 4. section 1605(b) of the small business job protection act of 1996, pub. l. no. 104-188, § 1605(b) (1996). the constitutionality of taxing compensatory damages that has raised a constitutional issue concerning the validity of a portion of the statute.5 as a consequence of the 1996 amendment, damages received for a personal injury will not be excluded from gross income unless the victim suffered a physical injury.6 for this purpose, the emotional distress that a victim suffers because of a tortious act does not constitute a physical injury." the house report to the 1996 amendment states that "emotional distress includes physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress."' consequently, damages received for the emotional and mental distress suffered because of defamatory statements or because of discriminatory acts are excludible only to the extent that the victim incurred medical expenses thereby. defamation and discriminatory acts do not cause physical injuries. however, if a victim who suffers a physical injury from a tortious act, also suffers emotional distress, the house report to the 1996 amendment states that damages received for the emotional distress will be excluded from gross income by section 104(a)(2). 9 thus, even if a victim has physical repercussions from a tort causing emotional distress, the damages (other than an amount equal to medical expenses) are not excluded from gross income; but if the victim suffers emotional distress as a consequence of physical injuries received from a tort, the damages received for the emotional distress are excludible. the statutory distinction made between damages received for emotional distress that accompanies a physical injury and those that do not has raised a constitutional issue in the minds of some commentators.') those persons who question the constitutionality of section 104(a)(2) are sometimes referred to herein as "the detractors." the thesis of this commentary is that, contrary to the contention of the detractors, the different treatment that congress ordered in section 104(a)(2), depending upon whether the tortious act caused a physical injury, is constitutional and valid. before presenting the author's reasons, it is useful to describe the argument for the contrary view. the rationale for that view was ably set forth 5. see, f. patrick hubbard, making people whole again: the constitutionality of taxing compensatory tort damages for mental distress, 49 fla. l. rev. 725 (1997). 6. irc § 104(a)(2). 7. irc § 104(a) (penultimate sentence). however, to the extent that the victim incurred medical expenses as a consequence of the emotional distress, the damages received up to the amount of those medical expenses will be excluded from gross income. irc § 104(a) (last sentence). 8. h. rep. no. 104-586, n.24 at 144 (1996). 9. id. 10. see hubbard, supra note 5. 1999] florida tax review by professor hubbard in his 1997 article on this topic,' and the following exposition of the arguments for unconstitutionality is drawn from that article. two of the premises on which the thesis that the statute is unconstitutional rests are very questionable. one premise is that congress cannot tax as income an item that does not fall within the meaning of "income" as that term is used in the sixteenth amendment. support for this premise can be found in the supreme court's 1920 decision of eisner v. macomber,2 in which the court held that a tax on a receipt that is not "income" within the meaning of the sixteenth amendment, is a tax on the taxpayer's capital, and thus constitutes a direct tax that is not apportioned among the states according to population and so is unconstitutional as violative of the requirement of article i, section 9, clause 4 of the constitution prohibiting congress from imposing a direct tax unless in proportion to the population of the states. 3 the macomber decision itself rests on two 1895 decisions of the supreme court in pollock v. farmers' loan & trust co.,14 holding, in a pre-sixteenth amendment case, that a direct tax on property is unconstitutional. macomber holds that a tax that is not authorized by the sixteenth amendment will be invalid if it constitutes a direct tax.' 5 another premise of the attack on the validity of section 104(a)(2) is that a receipt must constitute a "gain" to the taxpayer to qualify as income within the meaning of the sixteenth amendment. this contention also rests on the holding of the supreme court in the macomber case. from those two premises, the argument is made that compensatory damages for emotional distress do not represent a gain, but merely restore the injured party to some sort of equivalence to the condition that the party had before being injured. accordingly, it is argued that the tax on such damages is on an item that does not constitute income within the scope of the sixteenth amendment; and so the tax is unconstitutional as a direct tax not apportioned among the states by population. there are other issues to this topic that need to be addressed, but the validity of the two premises described above should be considered first. even if the sixteenth amendment had not been adopted, there is reason to believe that a contemporary supreme court would sustain the validity of an income tax. by the time that the sixteenth amendment was adopted in 1913, there was reason to question whether the 5-4 divided opinion of the second pollock decision would be sustained by the then current court. for example, in 1909, 11. id. 12. 252 u.s. 189 (1920). 13. id. 14. 157 u.s. 429 (1895), reh'g granted, 158 u.s. 601 (1895). 15. eisner v. macomber, 252 u.s. at 189. [vol 4:2 the constitutionality of taxing compensatory damages congress passed an income tax on corporate income.'6 in a 1911 case, which predated the adoption of the sixteenth amendment, the tax on corporate income was upheld as valid by the supreme court in flint v. stone tracy co.,17 on the ground that it was a tax on the privilege of doing business and so was not a direct tax. the deference that a contemporary court would give to the unapportioned direct tax issue is at least subject to considerable doubt.18 moreover, the contemporary vitality of the constitutional holdings of the court in macomber is very much in doubt. macomber held that a dividend of a corporation's common stock on shares of its outstanding common stock was not income within the sixteenth amendment, and that the statutory provision taxing that stock dividend was invalid as unconstitutional. 9 macomber stands for the view that realization (i.e., severance of income from capital) is a constitutional requisite to having "income" for purposes of the sixteenth amendment. while, as a matter of congressional tax policy, realization is generally required as a condition to imposing an income tax, that requirement is not considered to be constitutionally mandated. to the contrary, in certain circumstances, the tax law imposes a tax on income that has not been "severed" from capital and thus has not been "realized" as that requirement was viewed by the supreme court in its macomber decision. let us simply note two income tax provisions that would be invalid if the limitations adopted in macomber were respected. a united states shareholder of a "controlled foreign corporation" must include in income for united states income tax purposes his pro rata share of the so-called subpart f income of that corporation even though that income was accumulated and retained by the corporation (i.e., it was not realized by the shareholder).2' similarly, a creditor must include as interest income a portion of the original issue discount of a debt instrument that the creditor holds even though the creditor has not received payment of that interest.' these, and other such provisions, have not been challenged and are universally believed to be valid.' 16. 36 stat. 11, 112-17 (1709). the corporate tax statute was adopted as § 38 of the payne-aldrich tarrif act of august 5, 1909. 17. 220 u.s. 107 (1911). 18. see calvin h. johnson, apportionment of direct taxes: the foul-up in the core of the constitution, 7 win. & mary bill of rights jour. 1 (1998). 19. eisner v. macomber, 252 u.s. at 189. 20. id. 21. irc § 951(a). 22. irc § 1272(a). 23. see also, regs. § 1.305-3(e). ex. 7 for an illustration of the extent to which current tax law contravenes the macomber decision. 19991 florida tax review in addition to the questions concerning the necessity of realization, there is also reason to question whether the view of "gain" adopted in macomber is applicable today. in that case, the supreme court defined income as "the gain derived from capital, from labor, or from both combined."'24 that definition limited the application of the income tax in certain circumstances where it appeared unwarranted to do so. the definition was finally laid to rest by the supreme court itself in commissioner v. glenshaw glass co.,25 in which the court stated that the "definition" adopted in macomber "was not meant to provide a touchstone to all future gross income questions."' moreover, the court's reference to "gain" in macomber had less to do with gain than with realization. the "gain" that the stock dividend represented in macomber was the income earned by the corporation. contrary to the court's view, it does not matter whether the shareholder owned her stock at the time that the corporation earned that income. if that were true, it would be unconstitutional to tax a shareholder on the receipt of cash dividends derived from corporate earnings obtained before the shareholder acquired his stock. while the two premises discussed above are open to serious doubt, they do not pose the most interesting issues concerning the validity of section 104(a)(2). in the interest of discussing those other issues, let us assume arguendo that the two premises mentioned above are valid. insofar as the realization of gain is concerned, compensation received for an involuntary conversion of property is treated the same as is a voluntary sale of the damaged property.27 when a taxpayer receives damages for an injury to taxpayer's property (nonhuman capital), the amount received that replaces the capital that the taxpayer is deemed to have invested in the property (i.e., its basis) is merely a substitution for the investment that the taxpayer lost because of the injury, and so is not taxable. if the amount received is greater than the amount of the taxpayer's investment (that is, greater than his basis), the taxpayer will realize income to the extent of any such surplus.' whether that income will be taxed to the taxpayer depends upon whether some nonrecognition provision, such as section 1033, prevents it. nonrecognition provisions are provided by congress when congress deems there to be good policy reasons for not taking realized income or loss into account at that point in time-i.e., they are deferral provisions that postpone the tax consequence of a transaction to a later date when it is deemed more 24. eisner v. macomber, 252 u.s. at 207 (citations omitted). 25. 348 u.s. 426 (1955). 26. id. at431. 27. see, e.g., raytheon production corp. v. commissioner, 144 f.2d 110 (1st cir. 1944). 28. id. [vol. 4:2 the constitutionality of taxing compensatory damnages appropriate to take it into account. the relevant nonrecognition provision in the instant circumstance is section 1033. section 1033 provides nonrecognition of gain from an involuntary conversion to the extent that the taxpayer reinvests the proceeds of that conversion into property that is similar or related in service or use to the damaged or destroyed property. one question is whether the same realization of income treatment should be accorded to compensation received for an injury to human capital. since an individual has no basis in his personal attributes (such as his limbs, eyes, mental well-being, or personal reputation), should the compensation received for damage to those personal attributes be treated as gain because there is no basis (i.e. dollar investment) that is replaced by them? those who question the validity of the current version of section 104(a)(2) maintain that basis should not be the device for measuring gain when the "property" damaged is human capital (i.e., some personal attribute of a human being).' even if basis is an appropriate standard for determining the taxation of damages for certain types of human capital, those who question the constitutionality of the current provision maintain that basis has no place in measuring gain when the injury is to a person's mental and emotional wellbeing.30 they maintain that an individual's right to the psychic security of being protected from invasions of his mental or emotional well-being is part of that person's birthright, part of his personhood, and is not something that can be traded in the market or exploited commercially.' in any event, regardless of whether basis is an inappropriate standard for measuring gain for statutory construction purposes, it is contended that it is constitutionality impermissible to use that standard to determine whether there is income within the meaning of the sixteen amendment. the constitutional attack on section 104(a)(2) proceeds along these lines. an individual who suffers mental distress from a wrongful act that also caused a physical injury is in the same position regarding the invasion of his psychic and mental well-being as is an individual who suffers mental distress from a wrongful act that did not also cause a physical injury. the taxation of compensatory payments received by the latter is therefore unequal treatment to the exclusion of compensatory damages received by the former for the very same type of injury. one ground for objecting to that inequality of treatment might invoke the equal protection clause of the constitution, but that is not a promising contention since the courts have generally refused to apply equal protection to income tax provisions unless there was 29. see hubbard, supra note 5, at 761-66. 30. id. 31. id. 19991 florida tax review discrimination against some protected group.32 rather than rely on an the equal protection clause, the attack on the validity of the statute focuses on the interpretation of the word "income" in the sixteenth amendment. the contention is made that it would be unjust to construe the word "income" in that amendment in such manner that it would permit the tax law to provide disparate treatment to persons receiving damages for injury to their personhood. 3 in both cases, where the victim suffered a physical injury and where he did not, the money that is received by a victim is merely an effort to restore that person to the status that he held before the injury took place. the gist of the opposition to section 104(a)(2)'s requirement of a physical injury is not merely that basis has no role in measuring gain when money is received for an individual's psychic security; rather it is that such receipts lie totally outside the tax law because of their noncommercial nature. the reason for concluding that basis has no role is that the transaction is not subject to taxation since the receipt is not within the scope of the term "income" as used in the sixteenth amendment. while the tax law generally taxes money received for anything in which the taxpayer has no monetary investment, unless it is excluded by a congressional act, the detractors of section 104(a)(2) maintain that that principle is inapplicable to money received to compensate for a taxpayer's psychic security because of the noncommercial nature of human capital. the detractors make a case for not taxing compensation received for damages to certain types of human capital. it is not a compelling case, but it is a respectable position. however, the case made is primarily one of values to be considered in adopting legislation. it goes to tax policy issues that are the subject of congressional legislation and judicial interpretation of statutes. for the moment, at least, congress has given greater weight to other considerations that led it to tax such compensatory payments. while the author concurs with the congressional decision on that issue, there is no need in this piece to go into the competing considerations. one difficulty with the detractors' thesis is that they would constitutionalize a value judgment that would better be left to the more flexible solutions that congress and the internal revenue service can provide. for many years, the supreme court has not sought to impose constitutional constraints on congress's selection among various values. the tax laws do not treat all people in seemingly similar circumstances equally. one problem with demanding equal treatment is that circumstances are not identical. the addition or deletion of certain factors can invoke competing values or can 32. the reasons why equal protection arguments have generally not fared well in the income tax area is discussed later in the text. 33. see hubbard, supra note 5. [vol. 4:2 the constitutionality of taxing compensarory damages create a more compelling case for raising one set of values over the competing ones that previously led to a different treatment. in other words, persons taxed differently may have dissimilarities of circumstance as well as similarity. by focusing on the similarities to the exclusion of the dissimilarities, there can appear to be unequal tax treatment. the weighing of those considerations is best left to congress where changes can be made when it is deemed appropriate. for example, the inequality on which the detractors focus is the disparity of tax treatment of mental stress damages when the victim suffered a physical injury and when he did not. but there are competing values in the physical injury case that are not present or entitled to the same weight when no physical injury occurs. the rationale for excluding any compensatory damages for personal injuries has been discussed in many articles, including several written by the author.34 without recapitulating all that has been said on that subject, consider the following three items that the author considers to be the most likely reasons for that exclusion. two of the items are applicable in both physical and nonphysical injury cases. those are: (1) that the victim's loss is of a personal attribute which is not customarily bought and sold commercially, and (2) that the victim's loss has forced the victim into a monetary replacement of the personal attribute that was lost or damaged, and that there is no substitute property in which the damages can be invested to prevent recognition of the victim's taxable gain. for many persons, neither of those considerations, taken alone, would be sufficient to provide a tax exclusion. but when a third item is added, the combination of all three of these items convinced congress to provide an exclusion. the third item is the distastefulness of taxing someone on compensation aimed at making him whole for a physical loss of a serious nature, and the resulting lessening of the extent to which a taxpayer is returned by the damage recovery to the status held before the injury was incurred. the third item applies especially strongly when a victim suffers a serious physical injury. it is not that there is a lack of sympathy for the plight of those who suffered only nonphysical injuries, but typically they will not be regarded with the same degree of pity as will the victim who lost a limb or was paralyzed. while individuals can disagree about the sympathy extended to victims of nonphysical injuries, the determination of the amount of weight to be given to the third item in those differing circumstances is the kind of policy judgment that congress routinely makes and that congress ought to make. why then did congress exclude from income damages received for nonphysical injuries when a physical injury is also present? the author's 34. see, e.g., kahn, supra note 3. 1999] florida tax review reading of the statute, especially in light of the principle established by the supreme court in commissioner v. schleier,35 is that only those compensatory damages that arise as a consequence of the physical injury (as contrasted to arising from the act that caused the physical injury) are excluded. all such damages are excluded except for medical expense reimbursement where the medical expenses had previously been deducted by the victim. the latter exception is an example of a competing value leading to a different result. the principle that a double allowance should not be given for the same item36 overrode the other considerations and led congress to tax such recoveries. the decision to exclude all such compensatory damages for a physical injury is far-reaching. for example, the portion of the compensatory award that represents lost wages (past and potential future wages) is excluded from income even though the wages would have been taxed if actually received. thus, the substitute for a taxable item is nevertheless excluded from tax. why is that so? two reasons seem the most likely candidates. first, the award is not actually a substitute for the lost wages. there is great difficulty at arriving at the correct amount of monetary award that approximates the personal loss that a victim has suffered. understandably, triers of fact latch on to any demonstrable monetary loss as clear indicators of part of the victim's personal loss, since dollar figures are readily available for those items. thus, the breakdown of the award into several items is merely an indication of the items that influenced the determination of the overall monetary figure awarded to the victim. the victim receives an award for a specified amount to represent his loss of a limb etc., and lost wages are merely an identifiable number that can be used in placing a dollar figure on the personal loss that the victim suffered. second, in jury cases, the damage awards are typically given as a lump sum and are not subdivided into separate parts for each element of the award (other than the separation of items of a noncompensatory nature, such as distinguishing punitive and compensatory damages). congress may have wished to avoid the administrative difficulty of having to determine how much of each such awards was attributable to lost wages. reducing the administrative difficulties of tax determinations is a value of importance to the tax system. considerations of the two types mentioned above and of other factors that have been raised would not necessarily convince everyone that damages traceable to lost profits should be excluded from income; but that decision rests on a weighing of competing values, which also requires the decision 35. 515 u.s. 323 (1995). 36. see, e.g., regs. § 1.161-1. [vol 4:2 the constitutionality of taxing compensatory damages maker to decide the nature of the underlying circumstances; and the resolution of those issues is properly left to the political body. note that none of those considerations was deemed strong enough to prevent congress from distinguishing that part of an award that provides reimbursement of previously deducted medical expenses and subjecting that part of the award to taxation. the apparent explanation is that the competing principle of not permitting double allowances overrode the other considerations. the author would not like to defend the wisdom of that distinction, which in part is inconsistent with one of the rationales suggested for the treatment of compensation for lost wages-namely, that the amount of lost wages is merely an indicator of the proper monetary figure to represent the taxpayer's personal loss. but congress's judgments, in tax as well as in many other matters, are not always wise. nonetheless, wisdom lies in leaving those judgments to congress where there is flexibility for change. the administrative complexity of determining whether taxpayers who are taxed differently do or do not occupy the same status is especially difficult in the tax area where so many differences of treatment exist. the line that congress drew rests on the existence of a physical injury. not all physical injuries arouse a high level of sympathy. the taxation of an award to a victim of a mildly sprained ankle or a bruise would not appear especially rapacious. on the other hand, some nonphysical injuries can arouse great sympathy. the line was drawn at physical injuries, even though it is not a perfect indicator of when high levels of sympathy exist, because it provides a bright line test that generally separates the two groups accurately. it is not a perfect line, but administrative feasibility is an important value that is the source of many such differences of treatment in the tax laws. the proper resort to bright line distinctions is another reason that the courts should not seek to impose equality of treatment on the tax law. if the detractors' thesis were adopted by the supreme court it could lead to undesirable tax consequences in a variety of other circumstances. the case for unconstitutionality of taxing compensatory damages for nonphysical injuries rests on the proposition that human capital is of such a personal, noncommercial nature that a monetary substitution for it should lie outside the scope of the income tax law, and so the absence of basis is not relevant to the determination of whether it is income for constitutional purposes. the case does not rest on considerations of involuntariness of conversion or of relative degrees of sympathy since those have nothing to do with the question of whether the receipt of such damages is not income under the sixteenth amendment. even the issue of inequality of treatment is not the basis of the detractors' case since its assigned role is to influence the court to make a determination that money received for a personal attribute is not subject to the tax law. consider some of the likely consequences of accepting that proposition. 19991 florida tax review if the tax law does not apply to money received for a victim's personal attributes because of the highly personal and noncommercial nature of those attributes, it would seem to have no application when an individual voluntarily accepts payment for the future invasion of those attributes. consider the following hypothetical example. an author and publishing firm inform a that the author has written a book in which an experience of a's is recounted that will humiliate a and subject him to scorn. a is not a public figure, and so the publisher fears that this work may make it vulnerable to an action for invasion of a's privacy. the publisher pays a $100,000 for a's release of all claims a may have because of the publication of the book. the detractors' proposed principle would seem to apply here to prevent taxation of the $100,000, since a has effectively sold part of his right to be secure in his privacy, and (under the detractors' view) basis plays no role in determining whether the receipt was a gain for sixteenth amendment purposes. for statutory purposes, the voluntary commercialization of personal attributes has always been taxed even though compensation received for damage to such attributes would have been excluded,37 and that seems the proper treatment. the taxpayer has chosen to place part of his personhood in the commercial market, and payments received thereby should be taxed. it is possible to distinguish a's situation from that of the compensatory damage award, but that distinction is more difficult to make in a constitutional setting than in a statutory one. the great difficulty in weighing and evaluating additional factors that exist in the huge number of circumstances in which the tax law provides differential treatment may be one of the constraints on subjecting differences in tax law treatment to equal protection claims. the same considerations would likely induce the courts to refrain from giving great weight to the alleged inequality of treatment in determining whether the sixteenth amendment is applicable. in short, the court should refrain from resorting to equality concepts in construing the word "income" in the sixteenth amendment. in regard to the weight to be accorded inequality in constitutional interpretation, professor hubbard (in his article on this topic) relies heavily on the framework for constitutional construction that he attributes to ronald dworkin.38 while the views of dworkin are worthy of respect and consideration, they are not part of the constitution. reframing a statement of justice holmes in his dissent in lochner v. new york, the constitution does not enact dworkin's theory of construction any more than it does herbert spencer's social statics.39 in any event, whether or not, as a general rule of 37. see, e.g., green v. commissioner, 74 t.c. 1229, 1233 (1980). 38. see hubbard, supra note 5. 39. 198 u.s. 45, 74-5 (1905) (holmes j., dissenting). [vol 4:2 t9] constitutionalily of taring compensatory damages construction, the obtaining of equal treatment should be taken into account as a factor influencing the construction of the constitution, that approach, for reasons discussed above, should not apply to a construction of the sixteenth amendment. as justice holmes said in his dissent in the macomber " case, "the known purpose of this [sixteenth] amendment was to get rid of nice questions as to what might be direct taxes."4' it would be unwise to reverse more than 70 years of subsequent judicial refrain from applying the direct tax limitation issue. not all of the judgments that congress made with respect to compensatory damages for physical injuries can be justified on any sensible ground. it its difficult to fathom what reason might exist for the exclusion of the interest element in awards paid out in installments over a number of years. 42 the tax law has many such distinctions. some may be the product of political considerations or of compromises with legislators who are seeking an even more undesirable treatment. those consequences should be acceptable in the tax law, at least constitutionally acceptable, as part of the price paid for having taxes determined by the political process. the same considerations that led congress to incorporate compensation for lost wages in its exclusion of all compensatory damages for physical injuries applies equally to its decision to exclude the part of the award that is attributable to nonphysical injuries that arose from a physical injury. the victim who suffered no physical injury is denied an exclusion because his plight is not deemed to be as sympathetic as that of a physically injured victim. as stated above, the taxation of damage awards for persons without physical injuries does not raise the same level of sympathy (and therefore the taxation of such victims does not raise the same level of distaste) as applies to victims of serious physical injuries. in this respect, the status of nonphysically injured victims is not the same as that of physically injured victims. so the question of the inequality of differences in tax treatment rests on a rejection of the congressional assumption of differences in levels of sympathy and on a determination that such differences do not warrant disparate tax treatment. these are the kinds of judgments that congress should make, and they should not be made permanent by constitutionalizing them. 40. see eisner v. macomber, 252 u.s. 189 (1920). 41. id. at 220. 42. irc § 104(a)(2). 1999] 1 florida tax review volume 6 2003 number 1 the export clause erik m. jensen i. the export clause and the founding . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 ii. ibm and u.s. shoe: the modern supreme court and the export clause . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 a. ibm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 1. the purpose and scope of the export clause . . . . . . . 18 2. eighteenth century legislation as an indication of original understanding . . . . . . . . . . . . . . . . . . . . . . . . . 21 3. the 1915 precedent: thames & mersey . . . . . . . . . . . 25 4. why care about ibm? . . . . . . . . . . . . . . . . . . . . . . . . 33 b. u.s. shoe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 1. the harbor maintenance tax . . . . . . . . . . . . . . . . . . . 35 2. taxes versus other governmental levies . . . . . . . . . . 37 3. the significance of u.s. shoe . . . . . . . . . . . . . . . . . . . 42 iii. interpretational issues after ibm and u.s. shoe: new life for old cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 a. taxes versus other charges . . . . . . . . . . . . . . . . . . . . . . . . . . 43 1. is anything other than a user fee permitted? . . . . . 44 2. kelly and amzel’s criticisms of u.s. shoe . . . . . . . . . 44 a. can the commerce clause trump the export clause? . . . . . . . . . . . . . . . . . . . . . . . . . . 45 b. does the export clause forbid all charges affecting exports? . . . . . . . . . . . . . . . . . 46 b. the required relationship between a tax or duty and “articles exported” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 1. taxes of general application . . . . . . . . . . . . . . . . . . . 51 a. generally applicable income tax . . . . . . . . . 51 b. generally applicable excise on pre-export goods or services . . . . . . . . . . . . . . . . . 52 c. taxes on exportation disguised as taxes of general application . . . . . . . . . . . . . . . . 54 2. taxes on goods and services related to exportation . 56 a. the slam-dunk cases: taxes on surrogates for exported goods . . . . . . . . . . . . . . . . . . . 56 b. taxes on integrally related services . . . . . . . 57 3. when has a taxed good entered the stream of exportation? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 2 florida tax review [vol.6:1 a. pre-export goods . . . . . . . . . . . . . . . . . . . . . . 60 b. in the stream of exportation . . . . . . . . . . . . . . 63 c. at the (wide?) margin: spalding . . . . . . . . . . 64 4. interpreting the export clause: “liberal protection” 66 c. is the export clause really unique? . . . . . . . . . . . . . . . . . . . . 68 1. what’s a levy “on” exports? . . . . . . . . . . . . . . . . . . . 68 2. what’s a tax? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 3. review of tax statutes generally . . . . . . . . . . . . . . . . 72 iv. conclusion: the export clause today . . . . . . . . . . . . . . . . . . . . . . . . 73 2003] the export clause 3 1. u.s. const. art. i, § 9, cl. 5. 2. see infra part i. 3. see leading cases: export clause, 110 harv. l. rev. 196, 196 (1996) (“not every word of the constitution has proven a wellspring of jurisprudence.”). 4. 517 u.s. 843, 863 (1996). 5. 523 u.s. 360, 370 (1998). 6. compare 1 laurence h. tribe, american constitutional law § 5-7, at 842 (3d ed., 2000) (describing export clause as “[t]he more important of these limits in article i, § 9 is that imposed by the export clause”), with laurence h. tribe, american constitutional law § 5-9, at 318 n.1 (2d ed., 1988) (relegating export clause to mention in footnote); see also claire r. kelly & daniela amzel, does the commerce clause eclipse the export clause?: making sense of united states v. united states shoe corp., 84 minn. l. rev. 129 (1999). but see 1 boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts 1-14 (3d ed., 1999) (giving one paragraph in a five-volume treatise on taxation to the export clause). 7. the taxing power is defined broadly: “the congress shall have power to lay and collect taxes, duties, imposts and excises.” u.s. const. art. i, § 8, cl. 1. but the taxing power is subject to limitations – the uniformity rule for duties, imposts, and excises, u.s. const. art. i, § 8, c l. 1; the apportionment rule for d irect taxes, u.s. const. art. i, § 2, cl. 3; u.s. const., art. i, § 9, cl. 4; and the export clause, u.s. const., art. i, § 9, cl. 5. 8. see erik m. jensen, the taxing power, the sixteenth amendment, and the meaning of “incomes,” 33 ariz. st. l.j. 1057, 1058-62 (2001) (discussing conventional understanding of taxing power) [hereinafter jensen, taxing power]; see also erik m. jensen, the apportionment of “direct taxes”: are consumption taxes constitutional?, 97 colum. l. rev. 2334, 2345-50 (1997) [hereinafter jensen, apportionment]; erik m. jensen, taxation and the constitution: how to read the direct tax clauses, 15 j.l. & pol. 687 (1999) [hereinafter jensen, taxation and the constitution]. as hard as it is to imagine today, the export clause – which provides that “[n]o tax or duty shall be laid on articles exported from any state”1 – was an essential part of the constitution. without the protection the export clause provided to exporting states, particularly in the south, the constitutional convention would have imploded.2 times change, however, and, by midtwentieth century, the export clause had become invisible to all but the nerdiest of constitutional scholars. it had become, at best, a historical curiosity. now the export clause is making a comeback. largely ignored for over seventy years, at least in important litigation,3 the clause was the subject of supreme court decisions in 1996, united states v. international business machines corp.,4 and in 1998, united states v. united states shoe corp.,5 both of which struck down levies on constitutional grounds. those decisions made, or should have made, people take notice: the export clause matters.6 the congressional taxing power is often described as plenary,7 and few think the constitution limits that power in any significant way.8 but the export clause, included in the article i, section 9 list of what congress may not do, is an apparently straightforward restriction on the taxing power. yes, there can be 4 florida tax review [vol.6:1 9. the meaning of “export” wasn’t obvious to all in the republic’s early years, when many states maintained a sense of independence. see, e.g., act of july 6, 1797, ch. 11, § 1, 1 stat. 527, 528 (imposing tax on, among other things, “any note or bill of lading for any goods or merchandise to be exported, if from one district to another district of the united states, not being in the same state, ten cents; if to be exported to any foreign port or place, twenty-five cents”) (emphasis added). but it’s now clear the reference is “only to exportation to foreign countries,” united states v. hvoslef, 237 u.s. 1, 13 (1915), not to transfers across state lines. similarly, the term “imports” in the import-export clause [u.s. const. art. i, § 10, cl. 2; see infra note 95] means goods from foreign nations, not goods from other states. see woodruff v. parham, 75 u.s. 123 (1868). 10. 5 u.s. (1 cranch) 137 (1803). 11. id. at 179. 12. id. 13. see infra notes 31-48 and accompanying text. questions about application: what’s a “tax or duty”? what’s an “article exported”? what does it mean to say a tax is laid “on” an article? nevertheless, interpretational difficulties shouldn’t obscure the core principle: it’s not within the power of congress to lay a tax or duty on exported articles.9 that principle isn’t meaningless, as chief justice john marshall recognized in marbury v. madison.10 marshall used the export clause as an example in defense of the proposition that, “[i]n some cases . . ., the constitution must be looked into by judges”11 – in defense, that is, of the idea that judicial review is inherent in the constitutional structure: it is declared that “no tax or duty shall be laid on articles exported from any state.” suppose a duty on the export of cotton, of tobacco, or of flour; and a suit instituted to recover it. ought judgment to be rendered in such a case? ought the judges to close their eyes on the constitution, and only see the law?12 justice marshall obviously thought those questions were no-brainers. and if the judiciary is going to keep its eyes open, as the marbury court concluded it must, congress shouldn’t even try to impose such a prohibited duty. so there’s something to the export clause, but a skeptic might still question the value of reexamining the clause in 2003. to be sure, the duties hypothesized by justice marshall were important concerns in the late eighteenth century, when the southern states were worried that, without a prohibition on export duties, the new national government might try to cripple the southern economies.13 but that was then and this is now. perhaps the south continues to feel itself under siege, but, if so, it’s not because of export taxation. and even if we think the tax treatment of cotton, tobacco, and flour 2003] the export clause 5 14. there’s no reason to think that marshall’s understanding of the export clause was really so limited. his slam-dunk hypotheticals were used to support the idea of judicial review, not to provide a full explication of the export clause. he certainly had a broader understanding of the export clause later in his career. see brown v. maryland, 25 u.s. (12 w heat.) 419 (1827); infra notes 254-256 and accompanying text. 15. see infra part iii. 16. see, e.g., printz v. united states, 521 u.s. 898 (1997) (tenth amendment); seminole tribe v. florida, 517 u.s. 44 (1996) (eleventh amendment); united states v. lopez, 514 u.s. 549 (1995) (commerce clause); new york v. united states, 505 u.s. 144 (1992) (tenth amendment). 17. as i’ll discuss later, the court said its analysis in both cases should be limited to the export clause, but it’s not clear why that should be so. see infra notes 129-132 and 197-199 and accompanying text; part iii.c. is of paramount national importance, what’s there to talk about? the analysis of justice marshall’s hypotheticals is no more difficult now than it was at the time of the founding. of course congress can’t tax such products if they’re in the process of being exported. end of discussion. all of which might make the export clause seem intellectually trivial, but (surprise!) this article suggests that’s not the case. ibm and u.s. shoe reflected a far broader understanding of the clause’s scope than justice marshall’s hypotheticals would suggest,14 and the cases effectively revived a body of case law developed in the late nineteenth and early twentieth centuries under the export clause.15 furthermore, if those cases are taken seriously – and they have to be, as the court twice within a short period invalidated congressional exercises of the taxing power – ibm and u.s. shoe may evidence renewed judicial interest in national taxation. in many other areas, the supreme court has been showing less deference to congress than had been true for decades,16 and that may be happening with taxation as well. if so, that’s a momentous change.17 this much can be said for certain: the export clause is a historically important constitutional provision that modern courts are obligated to interpret in a way that ensures its continuing vitality. that means, too, that congress should legislate with a better sense of the export clause than it has shown recently. to explicate the export clause, the article begins by describing the founders’ understanding of the clause: although not everyone at the constitutional convention was happy with limitations on the national government’s power to tax exports, the export clause was intended to be a complete prohibition of export taxation, and the prohibition was intended to have real bite. application of the clause to situations that go beyond justice marshall’s hypotheticals isn’t at all straightforward, however, and part ii discusses ibm and u.s. shoe, which illustrate the inherent difficulties of the export clause and the supreme court’s not always happy treatment of those 6 florida tax review [vol.6:1 18. the national government was limited to requisitioning funds from the states, without any enforcement mechanism, a procedure that worked poorly. see erik m. jensen & jonathan l. entin, commandeering, the tenth amendment, and the federal requisition power: new york v. united states revisited, 15 const. comment. 355 (1998). 19. see jensen, taxing power, supra note 8, at 1068-69. 20. james madison, notes on the constitutional convention (june 18, 1787), reprinted in 1 the records of the federal convention of 1787, at 286 (max farrand ed., rev. ed. 1937) [hereinafter farrand]. difficulties. part iii considers a number of interpretational issues under the export clause, derived from the pre-1924 cases that were effectively revived by the court’s decisions in ibm and u.s. shoe. finally, part iv discusses the role of the export clause today. i. the export clause and the founding treating the export clause as a serious limitation on the national taxing power is perfectly consistent with original understanding. the clause wasn’t an afterthought at the constitutional convention. indeed, it’s no overstatement to suggest that, without the clause, the delegates in philadelphia would have been unable to agree on the formation of a new national government. whether to permit the national government to tax exports occupied a surprising amount of time and effort at the constitutional convention. because the articles of confederation hadn’t permitted the “national” government even to levy import duties,18 any power given to the government to impose and enforce taxes was going to represent a quantum leap in national authority. it was generally agreed that the government should be able to tax imports – many founders thought that would be the nation’s primary source of revenue in ordinary times19 – but the debates about other forms of taxation, including taxes on exports, were often contentious. to many federalists, exports were an appropriate subject of taxation. the nation needed revenue, and exports were one obvious, readily available source of funds. as reported in madison’s notes, alexander hamilton argued early at the constitutional convention, “whence then is the national revenue to be drawn? from commerce, even [from] exports which notwithstanding the common opinion are fit objects of moderate taxation, [from] excise, &c &c. these tho’ not equal, are less unequal than quotas.”20 and taxes on exports were thought to be relatively easy to administer, something stressed even by some anti-federalists worried about how intrusive other forms of taxation could be. brutus, for example, thought a tax on exports and imports “should be 2003] the export clause 7 21. essays of brutus vii, n.y. j. (jan. 3, 1788), reprin ted in 2 the complete anti-federalist 400, 404 (herbert j. storing ed., 1981). brutus didn’t understand why limits on export taxation were in the constitution: “i cannot perceive the reason of the restriction. it appears to me evident, that a tax on articles exported, would be as nearly equal as any that we can expect to lay, and it certainly would be collected with more ease and less expence than any direct tax.” id. at 405. 22. the views of madison and washington weren’t enough, however, to carry the virginia delegation, which voted against the power to tax exports. see infra text accompanying note 63. 23. 2 farrand, supra note 20, at 307 (aug. 16, 1787). 24. 2 id. at 306 (aug. 16, 1787). “morris considered such a proviso [restricting export taxation] as inadmissible any where. it was so radically objectionable, that it might cost the whole system the support of some members.” 2 id. 25. see infra text accompanying note 63. 26. 2 farrand, supra note 20, at 306 (aug. 16, 1787). raised by simple laws, with few officers, with certainty and expedition, and with the least interferences with the internal police of the states.”21 three of the most significant participants at the constitutional convention, gouverneur morris (representing pennsylvania), james wilson (also pennsylvania), and james madison (of virginia), spoke in favor of a national power to tax exports, as did many others, and the largely silent, but influential, george washington supported such a power.22 morris thought the power to tax exports was essential: “taxes on exports are a necessary source of revenue. for a long time the people of america will not have money to pay direct taxes. seize and sell their effects and you push them into revolts.”23 although most founders focused on taxing imports as the easiest way to fund the new government, morris emphasized “that it would not in some cases be equitable to tax imports without taxing exports; and that taxes on exports would be often the most easy and proper of the two.”24 his state, virginia, wound up opposing export taxation, as did all of the southern states,25 but madison agreed with morris, arguing both in favor of a national power to tax exports and against state power to do so: 1. the power of taxing exports is proper in itself, and as the states cannot with propriety exercise it separately, it ought to be vested in them collectively. 2. it might with particular advantage be exercised with regard to articles in which america was not rivalled in foreign markets, as tobo. &c. . . [t]he price would be thereby raised in america, and consequently the taxes be paid by the european consumer. 3. it would be unjust to the states whose produce was exported by their neighbours, to leave it subject to be taxed by the latter.26 8 florida tax review [vol.6:1 27. 2 id. at 307. t his argument was common. see, e.g. statement of john dickenson of delaware (aug. 21 , 1787), 2 id . at 361 . (“the power of taxing exports may be inconvenient at present; but it must be of dangerous consequence to prohibit it with respect to all articles and for ever. he thought it would be better to except particular articles from the power.”); statement of thomas fitzsimmons of pennsylvania (aug. 21, 1787), 2 id. at 362 (noting he “would be agst. a tax on exports to be laid immediately; but was for giving a power of laying the tax when a proper time may call for it – this would certainly be the case when america should become a manufacturing country.”); statement of james madison (aug. 21, 1787), 2 id. at 361. (“as we ought to be governed by national and permanent views, it is a sufficient argument for giving ye power over exports that a tax, tho’ it may not be expedient at present, may be so hereafter.”) (footnote omitted). 28. 2 id. at 307 (aug. 16, 1787). 29. 2 id. at 362 (aug. 21, 1787). 30. 2 id. 31. 2 id. at 306 (aug. 16, 1787); see also 2 id. at 360 (aug. 21, 1787) (“mr. butler was strenuously opposed to a power over exports; as unjust and alarming to the staple states.”). 32. see james iredell, answers to mr. mason’s objections to the new constitution, recommended by the late convention (1788), reprin ted in pamphlets on the constitution of the united states 333, 367 (paul leicester ford ed., da capo press 1968) (1888) [hereinafter ford] (“congress itself are prohibited from laying duties on exports, because by that means those states which have a great deal of produce to export would be taxed much more heavily than those which had little or nothing for exportation.”). and, emphasized madison, the united states needed to have available the power to tax exports in the future, even if it didn’t do so now: “we are not providing for the present moment only.”27 wilson, too, “was decidedly agst prohibiting general taxes on exports.”28 echoing madison, he noted that granting the power didn’t mean it would always be used: “[t]he power had been attacked by reasoning which could only have held good in case the genl govt. had been compelled, instead of authorized, to lay duties on exports.”29 but the power needed to be available: “to deny [it] is to take from the common govt. half the regulation of trade.”30 taxing exports was nevertheless a touchy subject. the strongest support for prohibition came from southern delegates, who feared that a tax on exports could be used to the south’s detriment. in the late eighteenth century, it was the south that was the primary exporter of goods, largely textiles, tobacco, and related products. the southern states were, george mason of virginia proudly said, the “staple states.”31 a general tax on exports would therefore hit the south hardest,32 and, even if that weren’t so, many of the 2003] the export clause 9 33. however, it wasn’t only southern delegates worried about export taxation’s potential for destroying the union through targeted duties. elbridge gerry of massachusetts, who became an anti-federalist, “thought the legislature could not be trusted with such a power. it might ruin the country. it might be exercised partially, raising one and depressing another part of it.” 2 farrand, supra note , at 307 (aug. 16, 1787); see also 2 id. at 362 (aug. 21, 1787) (noting gerry’s fear that “power over exports . . . might be made use of to compel the states to comply with the will of the genl government, and to grant it any new powers which might be demanded”); cf. 2 joseph story, commentaries on the constitution of the united sta tes § 1011, at 469-70 (da capo press 1970) (1833): the obvious object of these provisions is, to prevent any possibility of applying the power to lay taxes, or regulate commerce, injuriously to the interests of any one state, so as to favour or aid another. if congress were allowed to lay a duty on exports from any one state it might unreasonably injure, or even destroy, the staple productions, or common articles of that state. the inequality of such a tax would be extreme. in some of the states, the whole of their means result from agricultural exports. in others, a great portion is derived from other sources; from external fisheries; from freights; and from the profits of commerce in its largest extent. the burthen of such a tax would, of course, be very unequally distributed. the power is, therefore, wholly taken away to intermeddle with the subject of exports. justice story’s reference to “these provisions” was to the export clause and the provisions following it in article i, section 9, generally preventing congress from favoring one port over another, or requiring vessels bound to or from one state from being subject to regulation or taxation in another state. 34. 2 farrand, supra note 20, at 362-63 (aug. 21, 1787). southern delegates were afraid northern states would gang up against the south to enact targeted duties.33 mason put the concern this way: “[a] majority when interested will oppress the minority”. . . . if we compare the states in this point of view the 8 northern states have an interest different from the five southn. states, – and have in one branch of the legislature 36 votes agst 29. and in the other, in the proportion of 8 agst 5. the southern states had therefore good ground for their suspicions. the case of exports was not the same with that of imports. the latter were the same throughout the states: the former very different.34 a related argument, with a more neutral ring, was that taxing exports would punish industrious behavior. the states producing the most for exportation, whether they were in the north or the south, would obviously be 10 florida tax review [vol.6:1 35. james mchenry, before the maryland house of delegates, made the following argument: that no duties shall be laid on exports or tonage, on vessells bound from one state to another is the effect of that attention to general equality that governed the deliberations of [the] convention. hence unproductive states cannot draw a revenue from productive states into the public treasury, nor unproductive states be hampered in their manufactures to the emolument of others. 3 farrand, supra note 20, at 149 (nov. 29, 1787). 36. see, e .g., 2 id. at 359-60 (aug. 21, 1787) (statement of oliver ellsworth of connecticut) (arguing that export tax “will discourage industry, as taxes on imports discourage luxury”). founders sensitive to economic forces noted other unhappy effects as well. john francis mercer of maryland worried that taxes on exports would “encourag[e] the raising of articles not meant for exportation.” 2 id. at 307 (aug. 16, 1787). 37. 2 id. at 305. mason’s concern that the south might be picked on went far beyond this point. despite prevailing on the prohibition of export taxation, he opposed the constitution. see the objections of the hon. george mason, to the proposed fœderal constitution. addressed to the citizens of virginia, reprin ted in ford, supra note 32, at 327, 331 (“by requiring only a majority to make all commercial and navigation laws, the five southern states (whose produce and circumstances are totally different from those of the eight northern and eastern states) will be ruined”). 38. 2 farrand, supra note 20, at 359-60 (aug. 21, 1787). justice story explained the practicalities: “upon the whole, the wisdom and sound policy of this restriction cannot admit of reasonable doubt; not so much that the powers of the general government were likely to be abused, as that the constitutional prohibition would allay jealousies, and confirm confidence.” 2 story, supra note 33, § 1012, at 471. burdened most by export taxation,35 and it would be crazy for the nation to create a disincentive to productivity.36 finally, southern opponents of export taxation argued, quite reasonably, that northerners in 1787 might see southern exportation as a source of immediate revenue, but the respective interests of the sections could shift over time: you northerners make it possible to tax exports now, thinking that it’s the south that will pay, and you could be sorry. your section of the country may be hit later. george mason “hoped the northn. states did not mean to deny the southern this security [of prohibiting taxes on exports]. it would hereafter be as desirable to the former when the latter should become the most populous.”37 the argument that, in the long run, the north might suffer helped stiffen the resistance of a few northern delegates already worried that, as oliver ellsworth of connecticut put it, “the taxing of exports would engender incurable jealousies.”38 none of those concerns was frivolous, and something else was at stake as well. although some of the arguments against export taxation were phrased 2003] the export clause 11 39. i’ve argued that another limitation on the taxing power, the apportionment rule for direct taxes, wasn’t pro-slavery and therefore shouldn’t be treated as irredeemably tainted. see jensen, taxation and the constitution, supra note 8, at 702-06; jensen, apportionment, supra note 8, at 2358. because of this argument, i was outrageously accused of being indifferent to the “legacy of racism.” see bruce ackerman, taxation and the constitution, 99 colum. l. rev. 1, 30 n.112 (1999). if one is looking for constitutional provisions to trash because of slavery, the export clause strikes me as a much better candidate than the apportionment rule. 40. see u.s. const. art. i, § 2, cl. 3; u.s. const. art. i, § 9, cl. 4. 41. 1 farrand, supra note 20, at 592 (july 12, 1787). 42. 1 id. 43. 1 id. (footnote omitted). as a good southerner, pinckney of course wanted slaves counted in full for this purpose. see 1 id. at 580 (july 11, 1787) (“genl. pinckney insisted that blacks be included in the rule of representation, equally with the whites”) (footnote omitted). in sectionally neutral terms, it was clearly the south that was most concerned about export taxation. a critical issue to the south was the effect of taxes on the “peculiar institution”: duties directed at agricultural exports could be used to strike indirectly at slavery. if southern agriculture were seriously harmed by excessive taxation, slavery itself could be in jeopardy. taxing exports would have been an emotional subject in any event, but with the slavery connection it became a potentially convention-busting issue.39 when apportioning taxation among the states on the basis of population was first seriously addressed at the constitutional convention, on july 12, 1787, gouverneur morris suggested that apportionment ought to be limited to direct taxation (as is now the case):40 “notwithstanding what had been said to the contrary he was persuaded that the imports & consumption were pretty nearly equal throughout the union,”41 and apportionment was therefore unnecessary to make sure taxes on items of consumption didn’t result in sectional abuse. accordingly, he said, “[w]ith regard to indirect taxes on exports & imports & on consumption, the rule would be inapplicable.”42 general charles cotesworth pinckney of south carolina agreed that it made sense to limit apportionment to direct taxation, but part of what morris had said scared him: he was alarmed at what was said yesterday, concerning the negroes [how slaves should be counted in determining a state’s representation in the house of representatives].43 he was now again alarmed at what had been thrown out concerning the taxing of exports. s. carola. has in one year exported to the amount of £600,000 sterling all which was the fruit of the labor of her blacks. will she be represented in proportion to this amount? she will not. neither ought she 12 florida tax review [vol.6:1 44. 1 id. at 592 (july 12, 1787). 45. 2 id. at 95 (july 23, 1787). 46. see also 2 id. at 374 (statement of pierce butler of south carolina) (aug. 22, 1787) (“mr. butler declared that he never would agree to the power of taxing exports.”). 47. see letter from james mad ison to thomas jefferson (oct. 24, 1787), reprinted in 10 the papers of james madison 214 (robert a. rutland et al. eds., 1977): some contended for an unlimited power over trade including exports as well as imports, and over slaves as well as other imports; some for such a power, provided the concurrence of two thirds of both houses were required; some for such a qualification of the power, with an exemption of exports and slaves, others for an exemption of exports only. the result is seen in the constitution. s. caro lina & georgia were inflexible on the point of the slaves. 48. 2 farrand, supra note 20, at 129, 168-69. 49. 2 id. at 307 (aug. 16, 1787). then to be subject to a tax on it. he hoped a clause would be inserted in the system restraining the legislature from a taxing exports.44 a couple of weeks later, general pinckney emphasized how important the connection between slavery and exportation was. he “reminded the convention that if the committee [of detail] should fail to insert some security to the southern states agst. an emancipation of slaves, and taxes on exports, he shd. be bound by duty to his state to vote agst. their report.”45 this was no idle threat.46 what was at stake in the debates on export taxation was whether the thirteen colonies would be able to agree on a constitution at all: south carolina and georgia in particular were unwilling to compromise.47 that’s why the draft prepared by the committee of detail provided the security pinckney demanded: “no tax or duty shall be laid by the legislature, on articles exported from any state.”48 gouverneur morris wasn’t convinced that there was anything especially dangerous in the power to tax exports. skeptics could find something to worry about with any power granted to the new national government: “however the legislative power may be formed, it will if disposed be able to ruin the country.”49 but, in morris’s view, such doomsday concerns shouldn’t shut down the process of creating a constitution. of course, the delegates should do what they could to minimize risks, but, unless the national government was to be powerless — unless, that is, there was going to be no nation — the risks couldn’t be eliminated. morris thought “local considerations 2003] the export clause 13 50. 2 id. at 360 (aug. 21, 1787). morris was responding to hugh williamson of north carolina, who had said, “tho’ n – c. has been taxed by virga by a duty on 12,000 hhs of her tobo. exported thro’ virga yet he would never agree to this power. should it take place, it would destroy the last hope of an adoption of the plan.” 2 id. 51. if no tax can be laid on exports, an embargo cannot be laid, though in time of war such a measure may be of critical importance – tobacco, lumber, and live-stock are three objects belonging to different states, of which great advantage might be maed [sic] by a power to tax exports – to these may be added ginseng and m asts for ships by which a tax might be thrown on other nations. . . . the state of the country also, will change, and render duties on exports, as skins, beaver & other peculiar raw materials, politic in the view of encouraging american manufactures. 2 id. morris’s hyperbole – if we can’t tax exports, we can’t impose an embargo – wasn’t generally accepted . madison also used the need to be able to impose embargos to justify export taxation, but “m r. elseworth [o liver ellsworth of connecticut] did not conceive an embargo by the congress interdicted by this section [prohibiting export taxation].” 2 id. at 361 (aug. 21, 1787). in addition,“mr. mchenry [of maryland] conceived that power to be included in the power of war.” 2 id. at 362 (aug. 21, 1787). 52. 2 id. at 361 (aug. 21, 1787). 53. 2 id. at 306-07 (aug. 16, 1787). ought not to impede the general interest,”50 and he saw that happening with a short-sighted focus on exports.51 to try to soften the resistance of his fellow southerners, madison played down the importance of sectional effects on export taxation, taking a number of not entirely consistent positions. at one point, he argued that the feared negative effects on the south were overblown: as to the fear of disproportionate burdens on the more exporting states, it might be remarked that it was agreed on all hands that the revenue wd. principally be drawn from trade, and as only a given revenue would be needed, it was not material whether all should be drawn wholly from imports – or half from those, and half from exports – the imports and exports must be pretty nearly equal in every state – and relatively the same among the different states.52 at another time he suggested that there might be a case for the south’s initially bearing a disproportionate part of the burden: “the southn. states being most in danger and most needing naval protection, could the less complain if the burden should be somewhat heaviest on them.”53 and he tried to turn george mason’s your-turn-will-come argument, used to scare northern delegates about 14 florida tax review [vol.6:1 54. see supra note 37 and accompanying text. 55. 2 farrand, supra note 20, at 307 (aug. 16, 1787). 56. 2 id. at 308 (aug. 16, 1787); see also 2 id. at 363 (aug. 21, 1787). mr clymer of pennsylvania remarked that every state might reason with regard to its particular productions, in the same manner as the southern states. the middle states may apprehend an oppression of their wheat flour, provisions, &c. and with more reason, as these articles were exposed to a competition in foreign markets not incident to tobo. rice &c – t hey may apprehend also combinations agst. them between the eastern & southern states as much as the latter can apprehend them between the eastern & middle . . . . 57. 2 id. at 361 (aug. 21, 1787). 58. 2 id. at 308 (aug. 16, 1787). 59. 2 id. at 363 (aug. 21, 1787). what export taxation could eventually bring to their part of the country,54 into something that might placate the south: “time will equalize the situation of the states in this matter.”55 but, even if they’d been internally consistent, assurances of this sort could go only so far. whatever morris and madison thought, the parade of horribles was marching through the constitutional convention. the fears were real, whether or not well-founded, and piecemeal solutions were unlikely to work. trying to craft a provision that would have protected against sectional taxation or that would have carved out specified categories of exported products from the taxing power could have tied up the constitutional convention for weeks, with no guarantee of success: “to examine and compare the states in relation to imports and exports will be opening a boundless field,” said roger sherman of connecticut.56 to end the bickering, sherman argued, “it is best to prohibit the national legislature in all cases. the states will never give up all power over trade. an enumeration of particular articles would be difficult invidious and improper.”57 the alternative to prohibiting export taxation – particularly with the slavery subtext in the debates – was no constitution at all: “a power to tax exports would shipwreck the whole.”58 further evidence that the prohibition was intended to be total can be found in the unsuccessful attempts to amend the draft export clause, to preserve some role for national taxation of exports. for example, george clymer of pennsylvania thought export taxation should be permitted as long as it was being done for regulation of trade, but not otherwise. he therefore recommended “inserting after the word ‘duty’ [in the draft language of the export clause] the words ‘for the purpose of revenue,’”59 thus precluding export taxation that had as its only purpose raising revenue. i don’t see how such a purpose-based test could be applied in practice, and clymer’s motion 2003] the export clause 15 60. that’s the lesson the supreme court drew from this experience. see fairbank v. united states, 181 u.s. 283, 292-93 (1901); infra note 83. 61. 2 farrand, supra note 20, at 363 (aug. 21, 1787). the madison motion followed a suggestion by john langdon of new hampshire that if it’s “feared that the northern states will oppress the trade of the southn[,] [t]his may be guarded agst by requiring the concurrence of 2/3 or 3/4 of the legislature in such cases.” 2 id. at 359 (aug. 21, 1787). 62. 2 id. at 363 (aug. 21, 1787). 63. 2 id. at 363-64. 64. 2 id. at 374 (aug. 22, 1787). 65. but see supra note 21 and accompanying text (noting brutus’s support for export taxation). was rejected, suggesting that the founders considered a tax’s purpose to be irrelevant under the export clause.60 a more significant effort at amendment was an attempt, in late august of 1787, to add a supermajority requirement, which, it was hoped, would protect sectional interests in the ordinary course, but would make it possible for the national government to tax exports in extraordinary circumstances. madison moved, with a second by james wilson, “to require 2/3 of each house to tax exports – as a lesser evil than a total prohibition.”61 but, as madison put it, “ it passed in the negative.”62 five states voted “yes” (new hampshire, massachusetts, new jersey, pennsylvania, and delaware) and six voted “no” (connecticut, maryland, virginia, north carolina, south carolina, and georgia). virginia’s vote reflected a division in the delegation: george washington joined madison in the affirmative, but mason, edmund randolph, and john blair voted no. after that, the total prohibition passed 7-4 (with massachusetts joining the six “no” votes on the madison resolution),63 and a later attempt by gouverneur morris and others to recommit the issue, with the hope that “the clauses relating to taxes on exports & to a navigation act . . . may form a bargain among the northern & southern states,”64 also failed. during the ratification period, there was relatively little public discussion of the merits of the export clause, and that shouldn’t be surprising. anti-federalists concerned about the national taxing power had no reason to criticize a provision that was a limitation on that power. the export clause might not have gone far enough for most anti-federalists, but it wasn’t a negative.65 for supporters of the constitution, criticizing the export clause would have been counterproductive. although people like governeur morris, james wilson, and james madison favored a national power to tax exports, a constitution with an export clause was better than no constitution at all. besides, since it was necessary for political reasons to stress limits on the national taxing power – any serious, public suggestion that the power was boundless would have been fatal to ratification – the export clause was likely to be praised even by those who wished it weren’t there. 16 florida tax review [vol.6:1 66. see supra note 12 and accompanying text. 67. when i use the term “direct” or “directly” in this context, i don’t intend to raise the specter of direct taxation, which is subject to its own special rules (generally requiring apportionment among the states on the basis of respective populations). u.s. const. art. i, § 2; u.s. const. art. i, § 9, cl. 4; see generally jensen, apportionment, supra note 8 . instead i refer to taxes that are levied on the goods themselves, rather than on, say, associated insurance or on bills of lading attached to the goods. 68. oh sure, there must be a postmodernist out there who could find fatal ambiguity on this point, but i’m not aware of anyone’s trying to do that . . . yet. 69. that’s not entirely true. there was brief discussion about whether the export clause would prohibit an embargo , suggesting that at least some delegates thought the scope of the export clause was very broad. see supra note 51. 70. the dissenters in united states v. international business machines corp . came close to taking that position, with justice kennedy emphasizing that “specific taxes on exported goods were the only taxes mentioned . . . at the constitutional convention.” 517 u.s. 843, 873 (1996); see infra note 92; note 90 (accepting only grudgingly a broader conception of the export clause). 71. for most readers, this turns the usual assumption on its head – i.e., that congress can impose a tax unless there is a clearly applicable limitation. but the anything-goes-unless-specifically-prohibited perspective ignores the founders’ legitimate fears of concentrated power. the constitution made possible many forms of national taxation that hadn’t been available under the articles of confederation – in that respect it was a pro-tax document – but the taxing power was still to be constrained. i’ve argued elsewhere that the way to interpret taxing provisions in the constitution, if one cares about being consistent with original understanding, is to require strict conformity with ii. ibm and u.s. shoe: the modern supreme court and the export clause to this point, i’ve argued that, at the time of the nation’s founding, proponents and detractors agreed that the export clause was a serious limitation on congressional power; indeed, that’s why the clause was such a controversial subject. the delegates to the constitutional convention discussed taxes and duties that might be levied directly on exports – like those hypothesized by justice marshall in marbury66 – and concluded, to the dismay of some, that a complete prohibition on such taxation was necessary.67 the founders clearly intended to prohibit a levy that takes the form “one cent per pound of flour exported.” on that point, everyone agrees.68 and, because the delegates discussed only the easy cases,69 it’s possible to see the export clause as doing nothing more than that.70 but things can’t be that simple. we know the clause was meant to have real effect, and limiting its application to the most straightforward cases (thereby making it easy for congress to draft around the limitation) would gut the export clause. if the purposes of the clause are to be effectuated, it has to have greater scope than the founding debates intimated.71 2003] the export clause 17 the rules. if there’s doubt about constitutionality, it should be resolved against the statute. see jensen, apportionment, supra note 8, at 2414-19; infra parts iii.b.4 & iv. 72. see infra part iii.b. 73. the last case heard was a. g. spalding & bros. v. edwards, 262 u.s. 66 (1923). see infra notes 314-24 and accompanying text. 74. coherence would require that export clause jurisprudence not only make sense on its own terms, but also that the understanding of the export clause fit with the import-export clause and the commerce clause. but since relatively few cases have required courts to try to square the various clauses, the jurisprudence of each clause has gone off in its own direction. as a result, it’s become more and more difficult to fit the pieces together. see infra part iii.c.1. 75. see, e .g., ackerman, supra note 39, at 3 (“[t]here are no significant limits on the national governments’s taxing, spending, and regulatory powers where the economy is concerned–other than the requirement that government compensate owners if their property is taken for public purposes.”). 76. 517 u.s. 843 (1996). 77. 523 u.s. 360 (1998). over the years, the judiciary struggled to give content to the export clause, to ensure that the purposes of the export clause were carried out. the supreme court evaluated quite a few levies under the export clause between 1876 and 1923, rejecting several,72 and then the court seemed to give up. from 1923 until 1996 it heard no export clause cases.73 perhaps the court found the cases too boring (they often are); perhaps the court despaired of developing any coherent understanding of the export clause (a good reason for despondency);74 or perhaps the court simply decided, as have most academic commentators, that taxation is an area in which congress can do what it wants.75 whatever the reasons for the judicial work stoppage, it ended with u.s. v. international business machines corp.76 and united states v. united states shoe corp.,77 decided in 1996 and 1998, respectively. these cases didn’t involve sexy topics – a tax on premiums paid to foreign insurers (ibm) and a tax levied to fund harbor maintenance (u.s. shoe) – and they didn’t make the front pages. as is often true, however, cases that don’t lend themselves to cocktail chitchat may turn out to be the most important. for decades the supreme court had left congress to determine the limits of its own power in taxation. but in both ibm and u.s. shoe, the court invoked the constitution to reject the application of tax statutes. if nothing else, the cases demonstrate that the export clause can’t be as simple as the marshall hypotheticals suggest and that the judiciary once again has a role to play in evaluating the legitimacy of internal revenue code provisions. a. ibm even though, in 1996, the supreme court was looking at the export clause for the first time since 1923, the court managed to dodge almost all the 18 florida tax review [vol.6:1 78. 517 u.s. 843 (1996). 79. 237 u.s. 19 (1915). 80. ibm, 517 u.s. at 845. 81. justices kennedy and ginsburg dissented; justice stevens didn’t participate. id. at 844. 82. id. at 861; see also id . at 852 (noting that “text . . . expressly prohibits congress from laying any tax or duty on exports”); id. at 859-60 (“while the original impetus may have had a narrow focus, the remedial provision that ultimately became the export clause does not . . . .”); 2 farrand, supra note 20, at 220 (quoting rufus king of massachusetts to the effect that “[i]n two great points the hands of the legislature were important interpretational issues in u.s. v. ibm.78 for those who think the court should be providing detailed guidance about the meaning of constitutional provisions, ibm was an exercise in frustration, as i’ll demonstrate below. frustrating though it was, the case does force us to confront some basic issues in interpreting the export clause. in the following pages, i’ll use ibm as a basis for discussing the nature and purpose of the export clause, the significance of early revenue acts in interpreting the export clause, and the coherence of the 1915 precedent, thames & mersey marine insurance co. v. united states,79 on which the ibm court relied. although the court followed thames & mersey in a mindless way, i’ll argue that the old case actually had some merit and that ibm therefore came to a defensible result. 1. the purpose and scope of the export clause – in ibm, the court struck down what justice thomas called, in the opening paragraph of his opinion for the court, a “generally applicable, nondiscriminatory federal tax on goods in export transit.”80 with the case characterized in that way by six justices,81 ibm reinforced the principle that the export clause is an absolute prohibition: a tax or duty can be forbidden by the export clause even if congress doesn’t single out exports, or a subset of exports, for discriminatory treatment. relying on one of the export clause’s original purposes, to prevent taxation directed at the southern states, the government had argued that the tax was constitutional precisely because it didn’t discriminate against exports. by its terms, however, the export clause has broader sweep, as the court explained: the government’s policy argument – that the framers intended the export clause to narrowly alleviate the fear of northern repression through taxation of southern exports by prohibiting only discriminatory taxes – cannot be squared with the broad language of the export clause. the better reading, that adopted by our earlier cases, is that the framers sought to alleviate their concerns by completely denying to congress the power to tax exports at all.82 2003] the export clause 19 absolutely tied. [t]he importation of slaves could not be prohibited – exports could not be taxed.”) (aug. 8, 1787). 83. in fairbank v. united states, the court wrote, “the requirement of the constitution is that exports should be free from any governmental burden. the language is ‘no tax or duty.’” 181 u.s. 283, 290 (1901). “[t]he purpose of the restriction is that exportation – all exportation – shall be free from national burden.” id. at 292. the court gave as evidence the constitutional convention’s rejection of a motion that the “power of taxing exports . . . should be restrained to regulations of trade, <by inserting after the word ‘duty’ the words> ‘for the purpose of revenue.’” 2 farrand, supra note 20, at 363 (aug. 21, 1787) (citation omitted); see supra notes 59-60 and accompanying text. the inference is that the founders in tended to prohibit taxing exports regardless of the purpose behind a tax. fairbank, 181 u.s. at 292. the levy at issue in fairbank did discriminate against exports, but in other cases the court used the export clause to strike down nondiscriminatory taxes. see, e.g., a. g. spalding & bros. v. edwards, 262 u.s. 66, 68-69 (1923); thames & mersey marine ins. co. v. united states, 237 u.s. 19, 26-27 (1915); united states v. hvoslef, 237 u.s. 1, 13-16 (1915). 84. the government had argued that developments in interpreting the importexport clause, see infra note 95, had invalidated the old authority on the discrimination issue. the court responded in two ways. first, it seemed altogether to reject the relevance of import-export clause jurisprudence to this analysis. the “textual command” of the export clause is absolute, without a hint that lack of discrimination matters. see infra notes 128-132 and accompanying text. in the alternative, however, justice thomas also suggested that the government had failed to convince the court that a state’s nondiscriminatory levy on exports would be acceptable under the importexport clause. see infra note 132. 85. irc § 4371(1). the tax applies to premiums paid to insurers not subject to u.s. income taxation. see irc § 4372 (defining “foreign insurer”). the first codification of american revenue statutes, the internal revenue code of 1939, had provided for taxation of premiums on some limited categories of insurance issued by foreign insurers, including insurance of “property within the united states . . . against peril by sea or on inland waters,” revenue act of 1939, § 1804, 53 stat. 1, 197 -98, which applied both to premiums on export insurance (“peril by sea”) and premiums on inland transfers. in 1942, the stamp tax was extended to apply to “insurance policies of all kinds” issued by such insurers. h.r. rep. no. 77-2333, at 61 (1942); see revenue act of 1942, pub. l. no. 77-753, § 502, 56 stat. 798, 955-56 that is, it was because of the fear of discrimination that a prohibition on all export taxation was deemed necessary in the constitution, and that’s the way earlier cases had interpreted the export clause.83 so far, so good.84 the rest of justice thomas’s statement of the case, however, assumed the conclusion. he characterized the tax as being “on goods in export transport,” which, if true, clearly brought the export clause into play. but whether the tax was really on exported articles should have been a key issue, not a given. in form, the tax was an excise on premiums paid to certain foreign insurers (four cents per dollar of premium),85 not a tax laid directly on 20 florida tax review [vol.6:1 (amending code section 1804). the change was intended partly to raise revenue for the war and partly to “eliminate an unwarranted competitive advantage” for foreign insurers. h.r. rep. no. 77-2333, supra, at 61. so far as i can tell, the enactment of the 1939 code and the amendment in 1942 were made without any consideration of export clause problems. 86. as the dissent noted, “the statute does not discriminate against exports. indeed, it does not even mention them.” ibm, 517 u.s. at 864 (kennedy, j., dissenting). 87. when ibm shipped products to a foreign subsidiary, the sub often placed insurance on the shipment with a foreign insurer. id. at 845. 88. see id. at 863-64 (kennedy, j., dissenting) (“in so reformulating the question, the court makes the assumption that [the] insurance tax is a tax on export goods, thereby adopting the premise . . . that i had thought we were to address.”). 89. see supra text accompanying note 12. 90. the ibm dissenters seemed to accept this point: the protections of the export clause must extend , perhaps, somewhat beyond specific taxes on goods, for “[i]f it meant no more than that, the obstructions to exportation which it was the purpose to prevent could readily be set up by legislation nominally conforming to the constitutional restriction but in effect overriding it.” ibm, 517 u.s. at 879 (kennedy, j., dissenting) (emphasis added) (quoting united states v. hvoslef, 237 u.s. 1, 13 (1915)). with “must” and “perhaps” juxtaposed in that way, however, the acceptance was grudging at best. see also infra note 92 (noting kennedy’s emphasis on “specific taxes” in founding debates). 91. see infra notes 96-97, 106, and 259-70 and accompanying text (describing taxes on bills of lading imposed in 1797, 1862, and 1898). 92. in arguing for a limited role for the export clause, justice kennedy correctly noted that “specific taxes on exported goods were the only taxes mentioned in the debate at the constitutional convention,” ibm, 517 u.s. at 873 (kennedy, j. dissenting), but the founding generation wasn’t oblivious to substance-over-form exported articles.86 ibm challenged the levy as it applied to insurance on exports,87 but it’s not obvious that the export clause has anything to do with such a levy. simply calling the insurance tax a duty “on goods in export transport,” as justice thomas did, seemed to leave nothing for the court to decide.88 it had been clear for over a century that a tax can implicate the export clause even if not levied on exported articles as straightforwardly as the duties hypothesized in marbury v. madison.89 if the export clause prohibited nothing but taxes imposed directly on goods, it would be easy to circumvent. instead of taxing an exported article, for example, congress might impose a tax on the paperwork attached to the article.90 (congress tried to do just that several times in the nation’s history.91) the founders didn’t discuss such possibilities in their deliberations on the export clause, but it’s hard to imagine they would have been indifferent to obvious attempts to sidestep constitutional rules.92 2003] the export clause 21 matters. chief justice marshall, in brown v. maryland, 25 u.s. (12 wheat.) 419, 445 (1827), raised a substance-over-form hypothetical involving the export clause – a hypo that he thought had a clear answer. see infra notes 254-56 and accompanying text. on the other hand, congress in 1797 enacted a stamp tax that appears to have been, at least in part, an attempt to circumvent the export clause. the 1797 stamp tax was valid only if the export clause was understood in the most formalistic way possible, to apply only to “specific taxes on exported goods.” see infra part ii.a.2. 93. for what it’s worth, congress didn’t seem to have bad motives in enacting the modern version of the tax on insurance premiums. see supra note 85. but it also didn’t go out of its way to address the constitutional problems raised in an earlier supreme court decision. see infra note 119. 94. ibm, 517 u.s. at 864 (kennedy, j., dissenting). 95. no state shall, without the consent of the congress, lay any imposts or duties on imports or exports, except what may be absolutely necessary for executing its inspection laws: and the net produce of all duties and imposts, laid by any state on imports or exports, shall be for the use of the treasury of the united states; and all such laws shall be subject to the revision and controul of the congress. u.s. const. art. i, § 10, cl. 2. the critical question in a case like ibm therefore ought to be how close a connection between tax and exported good is needed before there’s an export clause problem. at one level everything’s connected to everything else, of course – we hear that proposition often in popular discourse – but that principle shouldn’t convert every levy into a constitutional issue. the ibm court could have concluded that the tax on insurance premiums was a tax on an ancillary service, insurance, rather than on the exported articles – not close enough, that is, to bring the export clause into play.93 and dissenting justices kennedy and ginsburg thought that was how the case should have been decided. because the tax on premiums “taxes a service distinct from the goods and is not a proxy for taxing the goods,” kennedy wrote, “it does not fall within the prohibition of the export clause.”94 2. eighteenth century legislation as an indication of original understanding – the test enunciated by the dissenters – looking to whether the tax reached “a service distinct from the goods and [was] not a proxy for taxing the goods” – was derived from late twentieth-century cases interpreting the import-export clause (which, among other things, limits state taxation of exports95). i’ll turn to the merits of that position in a moment, but i first want to consider, and reject, the proposition that early congressional practice proves the constitutional validity of a tax on export insurance. 22 florida tax review [vol.6:1 96. act of july 6, 1797, ch. 11, § 1, 1 stat. 527, 527. 97. the tax rate had been changed by the act of feb. 28, 1799 , ch. 17, 1 stat. 622, and repeal came with the act of apr. 6, 1802, ch. 19, 2 stat. 148. henry carter adams, taxation in the united states 1789-1816, at 57 (1884) (“[u]pon the accession of jefferson to the p residency, it was endeavored to change radically the financial policy of the united states. . . . [i]n 1802 , all internal and direct taxes were abolished . . . .”). a similar levy was enacted during the civil war. see act of july 1, 1862, ch. 119, 12 stat. 432, continued by act of june 30, 1864, ch. 173, 13 stat. 223, 291, repealed by act of june 6, 1872, ch. 315, 17 stat. 230, 256. see randolph e. paul, taxation in the united states 6 (1954). 98. 181 u.s. 283 (1901); see infra notes 258-66 and accompanying text. 99. ibm, 517 u.s. at 875 (kennedy, j., dissenting) (citing knowlton v. moore, 178 u.s. 41, 56 (1900) finding support in 1797 act, which included a legacy tax, for congressional power to enact unapportioned estate tax); ludecke v. watkins, 335 u.s. 160, 171 (1948) (“the [alien enemy act of 1798] is almost as old as the constitution, and it would savor of doctrinaire audacity now to find the statute offensive to some emanation of the bill of rights.”). in ibm, dissenting justices kennedy and ginsburg pointed to an early revenue act, enacted by the fifth congress, in support of just that proposition. congress in 1797 approved “an act laying duties on stamped vellum, parchment and paper,” titled to suggest that duties were being laid on legal documents, like bills of lading, rather than on goods. the 1797 act included a stamp duty on any policy of insurance or instrument in nature thereof, whereby any ships, vessels or goods going from one district to another in the united states, or from the united states to any foreign port or place, shall be insured, to wit, if going from one district to another in the united states, twenty-five cents; if going from the united states to any foreign port or place, when the sum for which insurance is made shall not exceed five hundred dollars, twenty-five cents; and when the sum insured shall exceed five hundred dollars, one dollar.96 with that statutory language, it’s clear the fifth congress knew the duty had export implications. the 1797 act stayed on the books for five years, and, when it was repealed under the presidency of thomas jefferson, it was because of a policy shift, not because of any perceived constitutional problems.97 justices kennedy and ginsburg thought, as had four dissenters in fairbank v. united states,98 decided in 1901, that the 1797 statute should be given controlling weight in determining the original understanding of the export clause: “we have always been reluctant to say a statute of this early origin offends the constitution, absent clear inconsistency.”99 and kennedy and ginsburg rejected the idea that the fifth congress had been trying 2003] the export clause 23 100. id. at 876 (kennedy, j. dissenting) (citing act of mar. 3, 1791, ch. 15 , § 51, 1 stat. 199, 210-11 (tax on distilled spirits); act of june 5, 1794, ch. 51 , § 14, 1 stat. 384, 387 (tax on snuff and refined sugar)). section 51 of the 1791 act, for example, provided that if any of the said spirits [otherwise subject to the levy]. . . . shall, after the last day of june next, be exported from the united states to any foreign port or place, there shall be an allowance to the exporter or exporters thereof, by way of drawback, equal to the duties thereupon, according to the rates in each case by this act imposed. act of mar. 3, 1791, supra, § 51, 1 stat. at 210; see a lso act of june 5, 1794, supra, § 14, 1 stat. at 387 (providing similar drawback). refunding duties paid on exported spirits, including spirits not earmarked for exportation at the time of distillation, was more generous than the modern understanding requires. see infra part iii.b.1.b (discussing court’s conclusion that pre-export taxation of ultimately exported goods is permissible). 101. ibm, 517 u.s. at 876 (kennedy, j. dissenting). to circumvent the export clause. the early congresses were scrupulous in honoring the export clause by making specific exemptions for exports in laws imposing general taxes on goods. their refusal to grant exporters similar exemptions from insurance taxes indicates that those taxes were not viewed as equivalent to taxes on goods.100 in the kennedy-ginsburg view, when a founding congress acted with noble motives in enacting a statute that wasn’t clearly inconsistent with the export clause, we should assume that constitutional requirements, as originally understood, had been satisfied. therefore, kennedy and ginsburg concluded, “[t]axes on insurance do not offend the export clause.”101 using the 1797 act as a definitive statement of original intent has its problems. for one thing, some understandings implicit in the act were discarded long ago, and properly so. it should be no surprise to legal scholars that congress, even in 1797, wasn’t always careful in drafting. unless we’re going to revive a few suspect ideas – for example, that the term “export” 24 florida tax review [vol.6:1 102. see supra note 9 (quoting 1797 act language including in category of “goods . . . exported [those transported] from one district to another district of the united states, not being in the same state”). the founders weren’t always clear on this point because the states had a much stronger sense of independence in the postrevolutionary period than we recognize today. but implicit in almost all the founding debates was the assumption that “exports” referred only to transfers to foreign nations, and, in any event, that’s clearly the law today. see united states v. hvoslef, 237 u.s. 1, 13 (1915). 103. we’re talking about the fifth congress, after all. even if early congresses are entitled to deference in constitutional matters, the fifth is presumably entitled to less than the first or second. 104. interpretations of the early supreme court, made up of federalist justices trying to prop up a federalist government, shouldn’t be taken at face value in determining original understanding. see jensen, taxing power, supra note 8, at 1078 n.115. the same principle applies here: we need to be careful in attributing constitutional principles to political actors who, in time-dishonored fashion, may have been trying to push the limits of their power. cf. lee v. weisman, 505 u.s. 577, 616 n.3 (1992) (souter, j., concurring) (rejecting idea that public acts of founding generation in support of religion are controlling in interpreting establishment clause: the acts “prove only that public officials, no matter when they serve, can turn a blind eye to constitutional principle”). 105. see act of july 6, 1798, ch. 66 , 1 stat. 577 (“an act respecting alien enemies”); act of july 14, 1798, ch. 74, 1 stat. 596 (“an act in addition to the act, entitled ‘an act for the punishment of certain crimes against the united states’”). 106. the 1797 act reached “[a]ny note or bill of lading, for any goods or merchandise to be exported, if from one district to another district of the united states, not being in the same state, ten cents; if to be exported to any foreign port or place, twenty-five cents.” act of july 6, 1797, ch. 10, § 1, 1 stat. 527, 528. includes goods that merely cross state lines102 – we can’t defer totally to the fifth congress. and the ibm dissenters were too generous in their praise for that congress. federalists in power didn’t always act in ways consistent with constitutional language, particularly not by 1797,103 with washington gone, federalism on the wane, and political nastiness at a high level.104 this was, we should remember, the same congress that enacted the alien and sedition acts, which aren’t often used as appropriate indicators of constitutional meaning.105 the 1797 act itself included at least one provision that calls the highmindedness of congress into question – a tax on bills of lading for “goods to be exported to any foreign port or place” imposed at a rate higher than that applicable to domestic bills of lading.106 yes, the late eighteenth century was a more formalistic time than today, and maybe the tax on bills of lading wasn’t as blatant a violation of the export clause as a tax imposed directly on exported goods would have been. but obviously congress legislated with the clause in mind – otherwise why not simply tax the goods? – and it’s hard to see this part 2003] the export clause 25 107. in united states v. fairbank, 181 u.s. 283 (1901), a divided court invalidated a statute similar to the 1797 act in its application to, and discrimination against, exports, see act of june 13, 1898, ch. 448, § 6, 30 stat. 448, holding in effect that there was “clear inconsistency” between the export clause and the act: “when the meaning and scope of a constitutional provision are clear, it cannot be overthrown by legislative action, although several times repeated and never before challenged.” fairbank, 181 u.s. at 311; see infra notes 258-266 and accompanying text. in ibm, justice kennedy noted in the dissent that it was possible to accept fairbank’s conclusion that a tax on bills of lading was a proxy for taxing the goods, while still approving a tax on insurance premiums: the tax here , unlike the stamp duty in fairbank, does not discriminate against exports; it taxes a service distinct from the act of exporting; and it has the clear regulatory purpose of eliminating a perceived competitive advantage of foreign insurers. viewed in this light, the conclusion of the fifth congress that the export clause did not bar any tax on export insurance should have great weight in assessing the constitutionality of § 4371, and fairbank is not to the contrary. ibm, 517 u.s. at 876-77 (kennedy j., dissenting). the first quoted sentence makes sense: if we were starting from scratch, those distinctions might justify different treatment for a tax on insurance and a tax on bills of lading. but the 1797 act as a whole hardly supports kennedy’s general proposition that we ought to defer to the fifth congress because that body was sensitive to constitutional restraints. 108. in addition to the tax on bills of lading, the 1797 act contained another provision, a tax on charter parties, the constitutionality of which was called into doubt by later litigation. see act of july 6, 1797, ch. 10, § 1, 1 stat. 527, 528 (imposing tax of one dollar on “any charter-party”); united states v. hvoslef, 237 u.s. 1 (1915) (striking down 1898 tax on charter parties); infra notes 271-281 and accompanying text (describing hvoslef). of the 1797 act as anything other than a transparent attempt to circumvent the limitations of the export clause.107 what participants in the early governments did is relevant in discerning original understanding, of course, and i don’t mean to suggest otherwise. but the ibm majority’s unwillingness to defer to the fifth congress on matters of constitutional interpretation was eminently justifiable. for many reasons, we should resist using the 1797 act as a definitive indication of constitutional meaning.108 3. the 1915 precedent: thames & mersey – however imperfect the fifth congress’s constitutional expertise may have been, or however indifferent that congress may have been to constitutional limitations, justices kennedy and ginsburg’s position in ibm ultimately didn’t depend on unqualified acceptance of the 1797 act. the constitutional status of a tax that reached 26 florida tax review [vol.6:1 109. one might argue, however, that, given the strong feelings against export taxation evidenced in those debates, see supra part i, any doubt about the legitimacy of a tax with ties to exportation ought to be resolved against the tax. see infra parts iii.b. 4.d. and iv. 110. ibm , 517 u.s. at 864 (kennedy, j., dissenting). 111. i emphasize the “might,” however, because i also think it possible that a court could have concluded that the insurance premiums were a proxy for the exported goods. see infra notes 135, 137-144, and 148 and accompanying text. 112. see infra notes 135, 137-144, and 148 and accompanying text. 113. 237 u.s. 19 (1915). 114. see act of june 13 , 1898, ch. 448, 30 stat. 448, 461 (imposing tax on, among other things, marine, inland, and fire insurance policies “upon property . . . whether against peril by sea or on inland waters,” measured by “the amount of premium charged, one-half of one cent on each dollar or fractional part thereof”). 115. thames & mersey, 237 u.s. at 25. 116. id. at 26. 117. id. export insurance wasn’t an issue with a clearly right answer derivable from constitutional text, structure, or original understanding; this sort of issue simply hadn’t come up in founding debates.109 as a result, justices kennedy and ginsburg’s conclusion that the tax on insurance premiums violated the export clause because it reached “a service distinct from the goods and [was] not a proxy for taxing the goods”110 was a plausible interpretation of the clause. if the ibm court had been writing on a clean slate, the dissenters might have carried the day.111 but ibm wasn’t a case of first impression, and taxpayer ibm had precedent on its side – precedent that, as i’ll demonstrate below, had something to be said for it.112 in 1915, in thames & mersey marine insurance co. v. united states,113 the court used the export clause to invalidate an 1898 federal stamp tax on policies insuring against marine risks insofar as the policies related to export shipments. (the tax, part of a comprehensive scheme to raise funds for the spanish-american war, applied to insurance “upon property . . . whether against peril by sea or on inland waters,” and was measured by the “amount of premium charged.”114) the thames & mersey court said the critical question was whether “the tax upon such policies [is] so directly and closely related to the ‘process of exporting’ that the tax is in substance a tax upon the exportation.”115 determining substance depended on “the actual course of trade,”116 and, because it couldn’t “be doubted that insurance during the voyage is by virtue of the demands of commerce an integral part of the exportation,”117 the court held that the tax on insurance was forbidden by the export clause. the parties in ibm agreed there was no fundamental difference between the tax in thames & mersey and the tax in ibm, and that’s probably 2003] the export clause 27 118. the tracing problem (which premiums related to exportation?) was easier on the facts of thames & mersey than on the facts of ibm: when the shipper had a cargo of goods ready for export, ‘designated and set apart from all other goods for shipment on a particular ship,’ he filled up certain blank forms of declaration (furnished to him by the company) in accordance with the facts of each case and delivered the declaration to the company at or about the time of the sailing of the vessel with the cargo on board. in many cases the declaration was not delivered until the vessel had sailed. upon receiving each of the declarations, the company entered the amount and rate of the premium and delivered to the shipper a certificate of insurance by which the goods described were insured for the voyage and upon the vessel specified. id. at 22-23. accordingly, the court was “not called upon to deal with transactions which merely anticipate exportation, of [sic] with goods that are not in the course of being actually exported.” id. at 25. ibm was harder, and, even then, justice kennedy complained that “[n]ot every case will fit the simple model here: a policy written for a single shipment; coverage beginning only with a common carrier picking up the goods from the warehouse or manufacturing plant.” ibm, 517 u.s. at 871 (kennedy, j., dissenting). he saw enforcement nightmares: “it would appear . . . that if a company has an open policy from a foreign insurer covering the domestic leg of the journey for all shipments, the [internal revenue service] must untangle what portion of the insurance covered goods that had commenced the process of exportation, and then prorate the tax.” id. one answer to kennedy is that the service doesn’t have to untangle anything. taxpayers must make out a case for exemption. 119. the connection between the 1898 statute and the current internal revenue code isn’t direct. the modern statute is intended to protect the income tax system, by taxing premiums paid to foreign insurers that aren’t subject to u.s. taxation, see supra note 85 and accompanying text, and there was no income tax, personal or corporate, in effect in 1898. but the reference to “against peril by sea or on inland waters” in the 1898 act was identical to the phrase used in irc of 1939 § 1804, the predecessor of current irc § 4371. see supra notes 85 and 114 and accompanying text. thus, despite the 1915 decision in thames & mersey, congress retained statutory language that d irectly implicated the export clause. the change to more neutral language was part of a 1942 effort to broaden the application of the tax to “insurance policies of all kinds.” see supra note 85 and accompanying text. right.118 (in fact, the modern tax on premiums paid to foreign insurers is traceable to the earlier statute. the language today is more neutral than it used to be – making no reference to exports or anything smacking of exports – but the language change wasn’t a response to constitutional difficulties.119) as justice thomas put it, “a tax on policies insuring exports is not, precisely speaking, the same as a tax on exports, but thames & mersey held that they 28 florida tax review [vol.6:1 120. ibm, 517 u.s. at 854. 121. furthermore, as the ibm dissenters noted, the thames & mersey court hadn’t been briefed on, and therefore hadn’t considered, the relevance of the 1797 statute. id. at 877 (kennedy, j., dissenting); supra part ii.a.2. it would have been possible, therefore, for the court in 1996 to have concluded that the court in 1915 had, through no fault of its own, misinterpreted original understanding. 122. cf. ackerman, supra note 39, at 3 (“under the constitutional regime inaugurated by the new deal, there are no significant limits on the national governments’s taxing, spending, and regulatory powers where the economy is concerned – other than the requirement that government compensate owners if their property is taken for public purposes.”). 123. the power had expanded to such a point that it was considered noteworthy in academia when the modern court held that congress’s power under the commerce clause wasn’t limitless. see united states v. lopez, 514 u.s. 549 (1995). 124. the ibm dissenters’ position, that the tax on insurance premiums “taxes a service distinct from the goods and is not a proxy for taxing the goods,” and, as a result, “does not fall within the prohibition of the export clause,” ibm, 517 u.s. at 863 (kennedy, j., dissenting) derived, in part, from michelin tire corp. v. wages, 423 u.s. 276 (1976), and dep’t of revenue of wash. v. ass’n of wash. stevedoring cos., 435 u.s. 734 (1978), two import-export clause cases. 125. see ibm, 517 u.s. at 850. because thames & mersey hadn’t been explicitly overruled, the lower courts in ibm felt bound to follow the case. see ibm, 31 fed. cl. 500, 506-07 (1994), aff’d, 59 f.3d 1234, 1238-39 (fed. cir. 1995). 126. see ibm, 517 u.s. at 856 (“thames & mersey has been controlling precedent for over 80 years, and the government does not, indeed could not, argue that the rule established there is ‘unworkable.’ . . . [t]here is simply no evidence that thames & mersey has caused or will cause uncertainty in commercial export transactions.”). but see leading cases, supra note 3, at 201-05 (questioning reliance on stare decisis in this case). were functionally the same under the export clause.”120 if thames & mersey remained good law, therefore, the result in ibm was foreordained. it wasn’t clear that thames & mersey still had vitality, however, and that’s why there was a serious issue crying for resolution in ibm. a lot had changed doctrinally since 1915.121 courts had become much more willing to let congress unilaterally define what can be taxed;122 the national power over commerce had expanded exponentially;123 and cases under the import-export clause seemed to have contracted the judicial understanding of what constitutes a tax on exports.124 with a lot of favorable authority on its side, the government asked to have thames & mersey overruled.125 that’s what ibm was – or should have been – about. indeed, it’s difficult to see why the court agreed to hear ibm unless it was going to reconsider thames & mersey. nevertheless, that didn’t happen. in one chunk of his opinion for the court, justice thomas discussed stare decisis, rather than the merits of thames & mersey, concluding that ibm wasn’t a case in which rejecting precedent – precedent that had established a “workable” rule – was appropriate.126 moreover, to the dissenters’ dismay, thomas said the government hadn’t even argued that a tax on services ought to 2003] the export clause 29 127. justice thomas wrote that one may question the finding in thames & mersey that the tax was essentially a tax upon the exportation itself. . . . [t]he marine insurance policies in thames & mersey arguably “had a value apart from the value of the goods.” . . . nevertheless, the government apparently has chosen not to challenge that aspect of thames & mersey in this case. ibm, 517 u.s. at 854 (quoting dep’t of revenue of wash. v. ass’n of wash. stevedoring cos., 435 u.s. 734, 756 n.21 (1978)). it would have been inappropriate, he wrote, to examine the issue “without the benefit of the parties’ briefing,” id., and that point was tied to the value of precedent: “the principles that animate our policy of stare decisis caution against overruling a longstanding precedent on a theory not argued by the parties . . . .” id. at 856. the dissenters, however, said the government had made no such concession. see id. at 866 (kennedy, j., dissenting). 128. in dissent, justice kennedy stressed that “the thames & mersey court relied in part on the theory that insurance is no t commerce,” id. at 877 (kennedy, j., dissenting), an understanding abandoned long ago. and kennedy noted the court had approved a state gross-receipts tax on a steam railroad, even as applied to the railroad’s handling of exports and imports from its marine terminal . . . . the tax “was not on the goods but on the handling of them at the port,” . . . and “when the tax is on activities connected with the export or import the range of immunity cannot be so wide.” id. at 878 (quoting canton r.r. co. v. rogan, 340 u.s. 511, 514-15 (1951)); see also michelin tire corp. v. wages, 423 u.s. 276 (1976); dep’t of revenue of wash. v. ass’n of wash. stevedoring cos., 435 u.s. 734 (1978) (holding state taxation on services, when not measured by value of goods, acceptable under import-export clause). 129. see ibm, 517 u.s. at 851 (“our decades-long struggle over the meaning of the nontextual negative command of the dormant commerce clause does not lead to the conclusion that our interpretation of the textual command of the export clause is equally fluid.”). be treated as distinct from a tax on exported articles, and the court therefore wouldn’t consider that obviously critical issue.127 finally, the court rejected the government’s argument that developments after 1915 in interpreting the commerce clause and the import-export clause were relevant to the export clause.128 those other provisions contain nothing like the clear “textual command” of the export clause,129 said the court, and it therefore discarded the long-time understanding that the export clause and the import-export 30 florida tax review [vol.6:1 130. we are . . . hesitant to adopt the import-export clause’s policy-based analysis without some indication that the export clause was intended to alleviate the same “evils” to which the import-export clause was directed . unlike the import-export clause, which was intended to pro tect federal supremacy in international commerce, to preserve federal revenue from import duties and imposts, and to prevent coastal states with ports from taking unfair advantage of inland states, . . . the export clause serves none of those goals. indeed, textually, the export clause does quite the opposite. it specifically prohibits congress from regulating international commerce through export taxes, disallows any attempt to raise federal revenue from exports, and has no direct effect on the way the states treat imports and exports. id. at 859. 131. brown v. maryland, 25 u.s. (12 wheat.) 419, 445 (1827). 132. see ibm, 517 u.s. at 857 (“we have good reason to hesitate before adopting the analysis of our recent import-export clause cases into our export clause jurisprudence. . . . [m]eaningful textual differences exist [between the two clauses] and should not be overlooked.”) . the court didn’t summarily reject the relevance of all import-export clause cases in this context. justice thomas suggested that importexport clause jurisprudence precludes state-imposed, “nondiscriminatory taxes on imports and exports in transit,” id. at 861 – or a t least that the government hadn’t convinced him otherwise – just as the export clause precludes such taxes. the court nonetheless refused to use import-export cases as aids in determining what constitutes a tax or duty on exported articles. see infra part iii.c (discussing whether export clause is really unique). 133. ibm, 517 u.s. at 863. 134. justice kennedy complained: “it mystifies me that in a constitutional case, where our decision is not subject to congressional revision, the court here accepts the government’s purported concession of the meaning of the export clause without any clause should be read as a package, with mutually reinforcing goals.130 john marshall had written, in 1827, that “[t]here is some diversity in language [between the clauses], but none is perceivable in the act which is prohibited.”131 the ibm court thought it knew better, however, apparently concluding that the export clause is sui generis.132 after all this bobbing and weaving, none of which directly concerned the merits of thames & mersey, the court concluded that “[r]eexamination of the question whether a particular assessment on an activity or service is so closely connected to the goods as to amount to a tax on the goods themselves must await another day.”133 as a result, the key issue in the case, perhaps the only issue, wasn’t addressed – a peculiar way for the court to handle its first export clause case in decades.134 2003] the export clause 31 independent examination of the question, and then invokes the export clause to strike down a statute.” id. at 870 (kennedy, j., dissenting). 135. see supra text accompanying note 12. once we get beyond the idea that the only cases to which the export clause might apply are marbury-like hypotheticals — and no one thinks the export clause is so limited, see supra note 90 — attempts to define a bright-line rule are doomed. and they might be doomed anyway. even with a tax on the exportation of flour, say, it’s still necessary to determine the point at which a tax attaches to flour that might, or might not, be headed for exportation. no bright-line rule can control that determination. see infra part iii.b.3. 136. see supra text accompanying note 94. 137. see supra notes 85 and 114 and accompanying text. 138. ibm, 517 u.s. at 879-80 (kennedy, j., dissenting) (“premiums, i.e., the price of insurance, depend on risk of loss and value of the goods is only one component factor of risk.”). 139. assume a ships one $100 widget and b ships two $100 widgets on the same vessel. the three widgets are stored in precisely the same circumstances, and the likelihood of loss is therefore the same. ignoring any volume discounts, or any other reason for treating a or b specially, one would expect b’s insurance bill to be twice a’s. since the same analysis could also apply under the import-export clause, the court could have decided ibm in favor of the taxpayer without also concluding, as it did, that import-export clause cases are irrelevant in interpreting the export clause. in dep’t of revenue of wash. v. ass’n of wash. stevedoring cos., 435 u.s. 734 (1978), the court held that a state tax was permissible because it didn’t “relate[] to the value of the goods, and therefore . . . . [wasn’t] taxation upon the goods themselves.” id. at 757. insurance premiums do relate to the value of goods, and a tax on premiums could therefore be characterized as a tax on the insured goods – under either clause. thames & mersey wasn’t necessarily wrongly decided, and the result in ibm therefore wasn’t necessarily wrong either. evaluating whether a levy is really on exports can’t be as easy as chief justice marshall’s examples in marbury might have suggested.135 furthermore, had the court reached the merits of thames & mersey in ibm, it might have concluded that the tax on premiums was in fact a “proxy for taxing the goods,” to borrow a phrase from the dissenters,136 and therefore invalid. in fact, thames & mersey made some sense. i can imagine at least two ways in which the court might have concluded that the taxes in ibm and thames & mersey were “prox[ies] for taxing the goods,” and that thames & mersey therefore had been rightly decided. first, in both cases, the taxes were measured by the amount of insurance premiums paid,137 a figure that correlates with the value of exported cargo. insurance rates reflect other factors as well, of course – as the dissenters emphasized138 – but, all other things being equal, the higher the value of cargo, the higher the cost of insurance, and therefore the higher any tax on premiums.139 if, as one commentator sympathetic to the kennedy-ginsburg dissent has suggested, the question should have been 32 florida tax review [vol.6:1 140. leading cases, supra note 3, at 200-01 (“if the court had reached this issue in ibm, it might have adopted justice kennedy’s sensible approach, which focused on whether the cost of the export service taxed correlates tightly with the value of the exported goods.”). 141. see id. 142. dissenting justices kennedy and ginsburg seemed to assume that, if the tax weren’t measured by the value of the goods, it shouldn’t be treated as falling on “exported articles,” see, e.g., ibm, 517 u.s. at 879-80 (kennedy, j., dissenting), but the export clause doesn’t speak in those terms. 143. thames & mersey, 237 u.s. at 26. 144. if there is a “tight correlation,” the tax ought to be treated as falling on exported articles. but failing to satisfy a tight-correlation test shouldn’t lead to any particular result under the export clause. 145. see infra part iii.b.2.b. 146. although the government in ibm relied heavily on the argument that lack of discrimination matters under the export clause, the older cases and the language of “whether the cost of the export service taxed correlate[d] tightly with the value of the exported goods,”140 the court might have answered that question “yes.” so the court could have taken the dissenters’ test on its own terms, and concluded that the tax on insurance premiums failed the test. (the assumption of the ibm dissenters, and of the commentator, was that the “proxy” test would automatically have led to upholding the tax,141 but that’s not necessarily true.) and there’s another way the ibm court could have reconfirmed the result of thames & mersey. the “tight correlation” idea is an accurate restatement of the dissenters’ position in ibm, but it isn’t a test mandated by the export clause. nothing in the export clause requires that, for a tax or duty to be prohibited, it be tied to the value of exported articles.142 a one cent per shipment tax on exports is as impermissible under the export clause as is a one percent tax measured by the value of the exported goods. had it reached the merits in ibm, the court might simply have concluded, as it had in thames & mersey, that “insurance during the voyage is by virtue of the demands of commerce an integral part of the exportation,”143 and, as a result, that a tax on insurance premiums is a proxy for taxing the goods – regardless of the relationship between amount of tax and value of goods and regardless of the correlation between the cost of the insurance and the value of the goods.144 a tax on a service that is “integrally related” to exportation might very well be treated as on exported articles.145 if the ibm court had reexamined the foundation of thames & mersey, it could have found the case structurally sound, under either of the above rationales, or, following justices kennedy and ginsburg, it could have issued a condemnation order. it did neither. by deferring the key issue, the court provided no guidance about how disputes should be analyzed, other than emphasizing that discrimination is irrelevant – something we knew already146 2003] the export clause 33 the clause itself pointed in the opposite direction. see supra notes 82-83 and accompanying text. 147. the import-export clause applies to “imposts or duties,” and the export clause to “tax[es] or dut[ies],” but the assumption had been that the process of determining whether a levy is on “exports” or “articles exported” is the same under the two clauses. see supra note 131 (quoting chief justice marshall); infra part iii.c.1. 148. it’s possible, however, that cutting the tie between the two clauses does simplify matters, in the following way. the court may have decided that the cases under the two clauses had developed in irreconcilable ways. they should have been consistent, at least for purposes of determining whether a levy is on exports, as john marshall suggested, see supra note 131, but the import-export clause cases had become so permissive that the rules developed there simply don’t work with the “clear textual command” of the export clause. see infra part iii.c.1. ignoring those cases may therefore make the export clause stronger — and simpler. 149. is congress supposed to try again with a tax on insurance premiums, leading eventually to resolution of the issue now left for “another day”? or, facing this uncertainty, does congress give up on the issue, thereby insuring that “another day” never comes? 150. the way ibm was decided suggests that many justices wound up wishing they hadn’t granted the petition for writ of certiorari in the first place, maybe because they hadn’t realized how intractable (or boring) the case would be. once the petition was granted, however, the court was locked in. dismissing the petition as improvidently granted was a possibility, but one the court uses sparingly. adhering to precedent was a way to resolve the d ispute, while ducking broader issues. 151. see supra note 125. – and suggesting that the export clause occupies a world of its own, a conclusion that, by shrinking the universe of arguably relevant authority, may not simplify matters. if import-export clause jurisprudence can’t be used to help determine whether a levy is on exports under the export clause – as had been done since at least 1827147 – the only authority under the export clause is a body of cases predating 1924.148 thames & mersey was thus left standing, but plastered with “enter at your own risk” signs. all that we know for sure after ibm is that taxes on export insurance are forbidden today, but maybe they won’t be forbidden tomorrow. it’s as if the court had said, perhaps the rules have changed, but we’re not going to tell you for sure until later. deferring consideration of the key issue for “another day,” after having revived interest in the export clause simply by taking the case, wasn’t helpful to anybody, including congress, which must legislate in the shadow of ibm.149 4. why care about ibm? – ibm wasn’t one of the high points in the history of the supreme court. the case was an exercise in judicial evasion,150 and substantively the court seemed to do little more than leave in place a 1915 precedent, thames & mersey, on which lower courts had relied.151 in form, by 34 florida tax review [vol.6:1 152. several cases in the 1920s, including eisner v. macomber, 252 u.s. 189 (1920), rejected provisions of the personal income tax on the ground that the taxed items weren’t “income” within the meaning of the sixteenth amendment. as recently as 1934, the supreme court took limits on the taxing power for granted. see helvering v. independent life ins. co., 292 u.s. 371, 378 (1934) (“if the statute lays taxes on the part of the building occupied by the owner or upon the rental value of that space , it cannot be sustained, for that would be to lay a direct tax requiring apportionment.”); jensen, taxing power, supra note 8, at 1133-46. after 1934, however, no federal tax was rejected on constitutional grounds until ibm. the pervasive view in the academic world is that, apart from due-process limitations unlikely ever to come into play (congress couldn’t tax members of different races differently, for example), congress can tax what it wants when it wants. cf., e.g., ackerman, supra note 39, at 3. 153. wrote justice kennedy: the majority cites no case in which we have declared a federal statute unconstitutional by disregarding an unargued theory that would save the statute . . . . we should at least consider a construction of the export clause that would render it inapplicable . . ., rather than assuming the issue away and reaching the unnecessary judgment that a coordinate branch violated the constitution. ibm, 517 u.s. at 869 (kennedy, j., dissenting); see also id. at 868 (“to give congress the respect it is owed, we must decide whether the statute is in fact unconstitutional as applied, not make the borderline call that the government’s litigation position bars us from reaching a question . . . .”). blessing an old case, albeit in a backhanded way, the court merely preserved the status quo. not so. the mere fact that the court agreed to hear ibm suggests that it sees a continuing role for the export clause – why spend precious judicial time otherwise? – and that, by itself, was a significant development. in addition, the court used the constitution to repudiate the application of a tax statute, something that hadn’t happened in decades,152 and, in taking that step, the court showed little deference to congress, as the dissenters complained.153 rather than presuming that the application of the tax was constitutional, and looking for ways to interpret the statute in a constitutionally acceptable way, the court left in place a 1915 case that did neither of those things. it would have been noteworthy if the court had struck down the application of a tax after carefully reviewing the substance of the dispute; it’s astonishing that the court did so in this summary fashion. when the court adhered to rules of taxation developed in the second decade of the twentieth century, it wasn’t preserving the status quo. the astonishing effect of ibm is that, in avoiding the merits, the court effectively revived a tradition of judicial scrutiny of taxing statutes that nearly all commentators assumed had disappeared forever. by agreeing to hear ibm and 2003] the export clause 35 154. there were pressures to act. when u.s. shoe was being argued, 4000 cases with the same issue had been stayed in the court of international trade, and over 100 in the court of federal claims. see united states v. united states shoe corp., 523 u.s. 360, 365 n.2 (1998) (citing brief for united states at 4). 155. which should happen once reader’s digest picks up this article. 156. 523 u.s. 360 (1998). 157. irc § 4461(a). “port use” means “the loading of commercial cargo on, or . . . the unloading of commercial cargo from, a commercial vessel at a port.” irc § 4462(a)(2). 158. irc § 4462(a)(3)(a). for these purposes, “cargo” includes “passengers transported for compensation or hire.” id. in carnival cruise lines, inc. v. united states, 200 f.3d 1361 (fed. cir. 2000), and princess cruises, inc. v. united states, 201 f.3d 1352 (fed. cir. 2000), the federal circuit reversed the court of international trade, concluding in both cases that the hmt was valid ly applied to cruise ship passengers. see k eith e. ranta, note, the harbor maintenance tax and the constitutionality of taxing cruise passengers as commercial cargo under the export clause: carnival cruise lines, inc. v. united states, 54 tax law. 211 (2001); see generally sara lundell, note, princess cruises, inc. v. united states: will the love then refusing to substantively reexamine thames & mersey, the court effectively transferred to the late twentieth century the doctrines of an earlier era, when courts were much more skeptical about the taxing power. and there’s another important point about ibm. although the court fumbled the analysis, it came to a defensible result. constitutional limitations on the taxing power should be taken seriously in 2003, just as they were in 1915. b. u.s. shoe considering how badly it handled ibm, the supreme court should probably have decided to leave the export clause alone for another seventy years. but that wasn’t to be. two years later, the court revisited the export clause and again got the right result (or arguably the right result) – this time after full consideration of the issues – rejecting the application of a federal tax in the export context.154 no longer could there be any doubt about the court’s signal: the export clause should be seen as a limitation on congressional power. if export clause jurisprudence were a matter of public interest,155 cries of “judicial activism” would have been heard across the land. 1. the harbor maintenance tax – in u.s. shoe,156 the court considered whether the harbor maintenance tax (the “hmt”), as it applied to exports, was an invalid tax or duty on exported articles. in general, the hmt is an excise imposed on any “port use” in an amount now equal to 0.125% of the value of the “commercial cargo” involved.157 “commercial cargo” is “any cargo transported on a commercial vessel,” including exported goods.158 36 florida tax review [vol.6:1 boat finally sink the harbor maintenance tax?, 8 m inn. j. global trade 325 (1999). the federal circuit gave great weight to regulations interpreting the hmt, but the most straightforward justification for the results is that the founders wouldn’t have considered a passenger (with the possible exception of a slave) to be an “article” under the export clause, and modern usage of the term also doesn’t suggest that it includes people. 159. see supra note 83 and accompanying text. 160. u.s. shoe, 523 u.s. at 363. the proceeds are deposited in a fund from which congress can appropriate amounts for harbor maintenance and development projects. see irc § 9505(a). 161. see pace v. burgess, 92 u.s. 372, 375-76 (1876); infra notes 188-193 and accompanying text. 162. the hm t was enacted as part of the water resources development act of 1986, pub. l. no. 99-662, §§ 1401-03, 100 stat. 4082, 4266-70. see u.s. shoe, 523 u.s. at 363. 163. the hm t was also to be administered and enforced “as if [it] were a customs duty.” irc § 4462(f)(1), (2). 164. see penn mut. indem. co. v. commissioner, 277 f.2d 16, 20 (3d cir. 1960) (“it is not necessary to uphold the validity of [a] tax . . . that the tax itself bear an accurate label.”). 165. congress really wasn’t paying attention. reports on the hmt used the terms “tax” and “fee” without precision, and without sensitivity to constitutional concerns. see, e.g., s. rep. no. 99-126, at 112 (1986) (“national uniform fee”); h.r. rep. no. 99-228, at 1 and 7 (1986) (“port user charges” and “port use charge”); h.r. conf. rep. no. 99-1013, at 228-29 (1986) (describing house version as imposing “port use tax” and “excise tax on the use of a u.s. harbor” and senate version as imposing “charge (in the internal revenue code) . . . on the use”); id. at 230 (describing conference agreement as imposing “port use tax or charge” or “excise tax in the internal revenue code”). one reason congress ignored the export clause may be that the discussion focused on the hmt’s application to imports, which the national government can tax. see, e.g., s. rep. no. 99-126, at 133 (1986) (additional views of sen. mitchell). but if since there was no question that the hmt did apply to exported articles, and since the court had reiterated in ibm that lack of discrimination against exports doesn’t matter for these purposes,159 the government was left to argue that the hmt wasn’t a “tax or duty” at all. it was, the government said, a fee for use of the ports – “a charge designed as compensation for government-supplied services, facilities, or benefits”160 – and the government pointed to authority going back to 1876 in support of the proposition that a user fee isn’t forbidden by the export clause.161 apparently oblivious to export clause concerns in enacting the hmt in 1986,162 congress called the hmt a “tax,” and placed it in the internal revenue code.163 as embarrassing as that designation may have been – congress seemed to be asking for an export clause challenge – that wasn’t the real constitutional problem.164 congressional acts aren’t invalid simply because congress acts in ignorance, paying no attention to constitutional dictates.165 2003] the export clause 37 congress had been sensitive to effects on international commerce, it should have been concerned about possible export clause violations. 166. u.s. shoe, 523 u.s. at 363. the court of international trade had come to the same conclusion: “the tax is assessed ad valorem directly upon the value of the cargo itself, not upon any services rendered for the cargo . . . . congress could not have imposed the tax any closer to exportation, or more immediate to the articles exported .” u.s. shoe, 907 f. supp. 408, 418 (ct. int’l trade 1995), aff’d, 114 f.3d 1564 (fed. cir. 1997). 167. u.s. shoe, 523 u.s. at 370. 168. for example, in pace v. burgess, 92 u.s. 372 (1876), in upholding a charge as a user fee, the court said that, [t]he rule by which [the amounts] are estimated may be an arbitrary one; but an arbitrary rule may be more convenient and less onerous than any other which can be adopted. . . . [h]aving due regard to that latitude of discretion which the legislature is entitled to exercise in the selection of the means for attaining a constitutional object, we cannot say that the charge imposed is excessive, or that it amounts to an infringement of the constitutional provision referred to. id. at 375-76. what was crucial in u.s. shoe was the substance of the charge. did the payor receive something specific in return for its payment, as part of a valuefor-value transaction similar to that which might occur in a commercial context? or were the benefits to the payor, if discernible at all, merely the more generalized ones that every taxpayer gets from paying his, her, or its share of the costs of civilization? the hmt failed constitutionally, held the unanimous court, because the measure of the charge, the value of the cargo, wasn’t “a fair approximation of services, facilities, or benefits furnished to the exporters.”166 if the hmt wasn’t part of a value-for-value transaction, it had to be a tax, not a fee. and insofar as the tax applied to exported articles, it was invalid under the export clause. 2. taxes versus other governmental levies – reasonable people can disagree about how close the relationship should be between amount charged and the value of a specific benefit received for a charge to be treated as a user fee rather than a tax. to be a fee, said the u.s. shoe court, the hmt had to “fairly match the exporters’ use of port services and facilities,”167 but that formulation necessarily leaves wiggle room. the benefits provided by governments are often of a sort not readily available in the marketplace, making determination of a “fair match” problematic. recognizing this difficulty, the court hasn’t required absolute equivalence (whatever that would mean) between value and charge for a charge to be treated as a fee.168 ultimately, and inevitably, characterization is going to depend on the facts and circumstances. 38 florida tax review [vol.6:1 169. id. at 376. 170. the customs service, by form letter, had stated that “the hm t is a statutorily mandated fee assessment on port users, not an unconstitutional tax on exports,” u.s. shoe, 523 u.s . at 364, but that self-serving designation obviously couldn’t be controlling. 171. see supra note 165. 172. 92 u.s. 372 (1876). 173. u.s. shoe, 523 u.s. at 370 (quoting pace, 92 u.s. at 376). 174. congress in enacting the hmt hadn’t tried to disguise the levy as a user fee. furthermore, the “guard against” language came from a case, pace, in which the levy at issue was held to be a permissible user fee, not a disguised tax. 92 u.s. at 376. pace was therefore also not a case of congressional overreaching. see infra notes 188193 and accompanying text. 175. quoted in ellin rosenthal & pat jones, year in review, 46 tax notes 16, 16 (1990) (quoting office of management and budget director-designate). darman was interpreting the first president bush’s “no new taxes” pledge, and his statement came to stand for the wrong-headed proposition that any governmental exaction is a “tax.” 176. this distinction is recognized statutorily. for example, many state “taxes” are deductible in computing federal taxable income, see irc § 164 , but fees for benefits aren’t taxes for this purpose. see, e.g., rev. rul. 77-29, 1977-1 c.b. 44 (“taxes are not payments for some special privilege granted or service rendered . . . .”); rev. rul. 61152, 1961-2 c.b. 42 (to same effect). and many foreign taxes are either creditab le or deductible in computing taxable income, see irc §§ 901–903, but a payment to a foreign country for a specific economic benefit isn’t a tax for this purpose. see regs. § as the court put it in 1876, “[t]he sense and reason of the thing will generally determine the character of every case that can arise.”169 but that’s not to say that anything goes, that a charge is a fee just because congress characterizes it that way. congress hadn’t done that with the hmt anyway – it was the department of justice lawyers defending the hmt who argued that the hmt wasn’t a tax170 – so u.s. shoe wasn’t a case of congressional duplicity. (ignorance perhaps, but not duplicity.171) the court nevertheless saw the case as an opportunity to send congress a message, picking up language from pace v. burgess,172 decided over 100 years earlier: “[i]f we are ‘to guard against . . . the imposition of a [tax] under the pretext of fixing a fee,’ . . . we must hold that the hmt violates the export clause as applied to exports.”173 that message was gratuitous – it had nothing to do with the actual dispute in u.s. shoe174 – but it contained a core of good sense. despite the tendency in popular discourse to treat all governmental exactions as indistinguishable – richard darman’s statement that if a charge “looks like a duck, walks like a duck, and quacks like a duck, it’s a duck” is an example of this phenomenon175 – all charges aren’t identical. there’s a legally significant difference between the quack of a fee – a charge to get into a park, for example – and the quack of a more abstract levy, a tax.176 2003] the export clause 39 1.901-2(a)(2)(i) (“[a] foreign levy is not pursuant to a foreign country’s authority to levy taxes, and thus is not a tax, to the extent a person subject to the levy receives (or will receive). . . a specific economic benefit . . . from the foreign county in exchange for payment pursuant to the levy.”). 177. u.s. const. art. i, § 8, cl. 1. 178. id. 179. u.s. const. art. i, § 9, cl. 5. 180. u.s. const. art. i, § 9, cl. 1. 181. u.s. const. art. i, § 10, cl. 2. 182. u.s. const. art. i, § 2, cl. 3; u.s. const. art. i, § 9, cl. 4. 183. for example, when the language of the general taxing power (“taxes, duties, imposts and excises,” u.s. const. art. i, § 8, cl. 1) was discussed at the convention, luther martin “asked what was meant by the committee of detail (in the expression) ‘duties’ and ‘imposts.’ if the meaning were the same, the former was unnecessary; if different, the matter ought to be made clear.” 2 farrand, supra note 20, at 305 (aug. 16, 1787). james w ilson responded, “[d]uties are applicable to many objects to which the word imposts does not relate. the latter are appropriated to commerce; the former extend to a variety of objects, as stamp duties &c.” id. 184. i’ve argued elsewhere that the term “taxes” in article i, section 8, was an umbrella term that encompassed the “duties, imposts, and excises” subject to the uniformity rule as well as the direct taxes subject to the apportionment requirement. see jensen, apportionment, supra note 8, at 2393-97; see also jensen, taxation and the constitution, supra note 8, at 694-99. 185. one exception: the court in ibm gave as one of the reasons that the import-export clause can’t be used to interpret the export clause the “meaningful textual differences” between the two clauses, including the difference between “tax or duty” and “imposts or duties.” ibm, 517 u.s. at 857. i agree that the term “tax” is broader than “impost,” see supra note 184, and the prohibition under the export clause should be broader than under the import-export clause. see ibm, 517 u.s. at 857 (recognizing “that the import-export clause is ‘not written in terms of a broad prohibition of every “tax,”’ and that impost and duty are narrower terms than tax”) to be sure, that distinction doesn’t jump out from the founding debates or the language of the constitution. the founders’ terminology for governmental exactions was so varied that a search for certainty in characterizing levies is doomed: “taxes, duties, imposts and excises” in article i, section 8;177 “duties, imposts, and excises” in the uniformity clause;178 “tax or duty” in the export clause179 and in the clause limiting a levy on the “migration or importation” of slaves to “ten dollars for each person”;180 “imposts or duties” in the import-export clause;181 and “tax” or “taxes” in the direct-tax clauses.182 most of these provisions have a core of good sense, but it’s doubtful that each term standing alone had a precisely understood meaning. there’s overlap among the terms183 – “imposts,” “duties,” and “excises” are “taxes,” for example, at least for some purposes184 – and cases generally haven’t turned on fine distinctions among the terms, even when they might exist.185 40 florida tax review [vol.6:1 (quoting michelin t ire corp. v. w ages, 423 u .s. 276, 290-93 (1976)); id. at 857-58 (noting “that the term ‘impost or duty’ [in the import-export clause] is not self-defining and does not necessarily encompass all taxes’ and . . . ‘the central holding of michelin [is] that the absolute ban is only of ‘imposts or duties’ and not of all taxes’”) (quoting dep’t of revenue of wash. v. ass’n of wash. stevedoring cos., 435 u.s. 734, 759 (1978)). but it should also be true that a state levy on exports that fails import-export clause requirements would be prohibited to the national government under the export clause. see infra part iii.c.1. 186. the import-export clause does include a passage that creates some interpretational difficulty: it permits a state to lay imposts or duties without congressional consent if do ing so is “absolutely necessary for executing its inspection laws.” u.s. const. art. i, § 10, cl. 2. it’s been said that “[t]he inspection fees which may properly be imposed under this c lause are in no sense a duty on imports or exports, but are a compensation for services.” thomas m. cooley, the law of taxation (4th ed., clark a. nichols ed., 1924). but if the fees are user fees, why mention them at all, because they wouldn’t have been precluded anyway? 187. the founders’ silence doesn’t mean congress has no power to impose fees in cases in which specific economic benefits are received by payors (assuming, of course, that congress has the power to provide the goods or services in the first place). such fees may be necessary to prevent unwarranted subsidies to the beneficiaries of the goods or services. but see kelly & amzel, supra note 6 (arguing that u.s. shoe court improperly let commerce power trump export clause); infra part iii.a.2 (discussing kelly & amzel article). 188. 92 u.s. 372 (1876). nevertheless, none of these terms works in context if understood to include garden-variety governmental charges for services or other benefits. how, for example, can congress apportion a fee for services among the states on the basis of population, as it would have to if the fee were a direct “tax”? should the export clause or the import-export clause really be interpreted to preclude the appropriate governmental body from charging those who use ports and harbors?186 and if a federal charge is imposed for use of a particular port, what would it mean to require that the charge be “uniform” throughout the united states? surely the constitution can’t require that the same fee be charged for services provided in every u.s. port, regardless of the value (or the cost) of the services. one of the reasons the fee-tax distinction doesn’t appear in the founding debates is that the founders, when discussing provisions dealing with taxation, simply weren’t talking about charges for specific benefits.187 the distinction between a fee and a tax also has support in older supreme court cases construing the export clause. for example, the stamp tax upheld in pace v. burgess,188 decided in 1876 (a case on which the court relied in u.s. shoe), was determined to have been “compensation given for services 2003] the export clause 41 189. id. at 375. in ibm, justice thomas did at one point cite pace for the proposition “that pre-export products are not ‘articles exported,’” ibm, 517 u.s. at 846, as if that had been the reason for upholding the charge at issue in the case. and the court had provided this alternative justification for the result in pace when it reexamined the same stamp-tax statute in turpin v. burgess, 117 u.s. 504 (1886). see infra notes 290-300 and accompanying text. but thomas quickly switched gears and got the pace rationale right: “when a tobacco manufacturer challenged the stamp charge, we upheld the charge on the basis that the stamps were designed to prevent fraud in the export exemption from the excise tax and did not, therefore, represent a tax on exports.” ibm, 517 u.s. at 847 (emphasis added). although turp in did supply an alternative rationale to justify the result in pace, it’s absolutely clear from the short pace opinion that the court concluded, under the circumstances, that the stamp levy was not a “tax or duty.” see infra notes 224-228 and accompanying text. 190. act of july 20, 1868, ch. 186, § 74, 15 stat. 125, 157-58. 191. pace, 92 u.s. at 375 (quoted in u.s. shoe, 523 u.s. at 369). 192. ultimately the question depends on correlation: pace establishes that . . . the connection between a service the government renders and the compensation it receives for that service must be closer than is present here. unlike the stamp charge in pace,the hmt is determined entirely on an ad valorem basis. the value of export cargo, however, does not correlate reliably with the federal harbor services used or usable by the exporter. u.s. shoe, 523 u.s. at 369 (emphasis added). properly rendered” and hence not a tax or duty.189 congress had enacted an excise tax on tobacco, generally thirty-two cents per pound, but with an exemption for tobacco intended for exportation. exported tobacco was instead required to have a twenty-five cent stamp affixed to each package, regardless of the package’s size or value.190 the taxpayers in pace argued that the charge for the stamp on exported tobacco was itself a forbidden tax or duty on exports, but the court characterized the charge as, in effect, a user fee. unlike the tax in u.s. shoe, the charge “bore no proportion whatever to the quantity or value of the package on which [the stamp] was affixed.”191 ad valorem levies like the hmt thus shouldn’t be characterized as user fees for these purposes: if a harbor usage fee is going to be measured by value, it should be the value of the benefit provided (presumably determined by the amount or manner of harbor use), not the value of the goods being shipped.192 furthermore, the stamps in pace had a paymentfor-services flavor: they were intended to prevent fraud, and the proceeds from the stamps were used to fund the administrative mechanism necessary to police the excise tax. in short, said the court, “a stamp may be used, and, in the case before us, we think it is used, for quite a different purpose. . . [than] a tax or 42 florida tax review [vol.6:1 193. pace, 92 u.s. at 376 (emphasis added). 194. see infra part iii.c.2 (discussing fees for patent applications). 195. 92 u.s. 372 (1876). 196. see supra part ii.a.3. 197. see, e.g., united states v. sperry corp., 493 u.s. 52, 62 (1989) (holding that 1½ % ad valorem fee on awards certified by iran-u.s. claims tribunal was user fee, not so excessive as to violate t akings clause); m assachusetts v. united states, 435 u.s. 444, 463-70 (1978) (holding flat federal registration fee on civil aircraft was user fee that could be applied to state-owned aircraft despite state’s immunity from federal taxation); evansville-vanderburgh airport auth. dist. v. delta airlines, inc., 405 u.s. 707, 717-21 (1972) (holding flat charge for each passenger enplaning, levied for maintenance of state’s airport facilities, not in violation of dormant commerce clause). in sperry corp., the court said it had “never held that the amount of a user fee must be precisely calibrated to the use that a party makes of government services. . . . all that we have required is that the user fee be a ‘fair approximation of the cost of benefits supplied.’” sperry corp., 493 u.s. at 60 (quoting massachusetts , 435 u.s. at 463 n.19). 198. u.s. shoe, 523 u.s. at 368. duty: indeed, it is used for the very contrary purpose, – that of securing exemption from a tax or duty.”193 the distinction between a user fee and a tax may be important in other ways as well,194 but, at a minimum, it’s a distinction inherent in the structure of the export clause. 3. the significance of u.s. shoe – on the importance of the distinction between tax and fee in interpreting the export clause, the u.s. shoe court thus got it right: not all governmental charges that affect exportation are limited by the export clause. as it did with ibm, the court applied old precedent to a modern controversy: what the court said about the export clause in 1876, in pace v. burgess,195 has continuing significance today. furthermore, in u.s. shoe, the court left no doubt that the old precedent was the law now and in the future. the court blessed pace in a way that it wouldn’t bless thames & mersey in ibm.196 all of that’s important, but even more important is the confirmation that what the court had done in ibm – striking down a taxing statute on constitutional grounds – wasn’t an accident. congressional enactments in taxation are no longer automatically immune from judicial scrutiny. as was true in ibm, however, the court emphasized the uniqueness of the export clause. in other contexts, the government argued, the court had characterized some flat and ad valorem levies as user fees, even though the charges bore no necessary, or even arguable, relationship to the value of benefits received.197 but, wrote justice ginsburg, those cases didn’t matter; they “involved constitutional provisions other than the export clause, . . . and thus do not govern here.”198 “ibm plainly stated,” wrote ginsburg, “that the export clause’s simple, direct, unqualified prohibition on any taxes or duties 2003] the export clause 43 199. id. 200. see infra part iii.c. 201. u.s. const. art. i, § 9, cl. 5 (emphasis added). distinguishes it from other constitutional limitations on governmental taxing authority.”199 i’ll return to the question of whether the export clause’s “simple, direct, unqualified prohibition” really makes it unique later in the article.200 iii. interpretational issues after ibm and u.s. shoe: new life for old cases at first glance, as i’ve noted, the court didn’t seem to do anything striking in either ibm or u.s. shoe. it pointedly avoided reevaluating a 1915 case in ibm, and then relied on an 1876 precedent in u.s. shoe. if the court had heard the disputes in 1916, the results would presumably have been the same as they were in the late 1990s. it’s as if woodrow wilson were still in the white house . . . old news. but it’s because of the time warp that the results in the two cases were striking. resuscitating old doctrines isn’t old news. ibm and u.s. shoe made it clear that the export clause is alive and well, and, while that wouldn’t have been noteworthy in 1916, it certainly was in 1996 and 1998. moreover, by leaving a 1915 precedent in place, and by explicitly relying on an 1876 decision, the court in effect told us to start retrieving a lot of other old export clause cases that, as far as many students of taxation were concerned, had been transferred to the intellectual equivalent of offsite storage. in this part of the article, i discuss the state of export clause jurisprudence, which, after ibm and u.s. shoe, in many respects still means the state of pre-1924 export clause jurisprudence. first, i consider whether any issues remain in distinguishing taxes and duties from other levies, and i criticize the argument, made by two scholars, that we shouldn’t even be trying to make such a distinction. second, i extract principles from cases that have tried to determine in some difficult, and some not so difficult, situations when a tax or duty that has an arguable effect on exportation ought to be treated as falling on exported articles. finally, i question the court’s assertion, in both ibm and u.s. shoe, that the export clause is unique – that the clause neither illuminates, nor is illuminated by, other constitutional provisions. a. taxes versus other charges unless the terms “tax” and “duty” subsume all conceivable exactions, the export clause doesn’t seem to apply to everything: “no tax or duty shall be laid on articles exported from any state.”201 and, as i argued above, the court in u.s. shoe did a respectable job of distinguishing between taxes or 44 florida tax review [vol.6:1 202. see supra part ii.b. 203. see supra notes 177-185 and accompanying text. 204. since the supreme court hasn’t blessed any other sort of levy, lower courts would obviously feel reluctant to strike out on their own. 205. legislators, too, should probably treat user fees as the only permissible levies on exports. 206. see, e .g., ackerman, supra note 39, at 3; see also supra note 122 and accompanying text. duties, on the one hand, and user fees, on the other, in the process of concluding that the export clause isn’t an absolute prohibition of all governmental charges on exports.202 1. is anything other than a user fee permitted? – one question the court didn’t answer in u.s. shoe – it didn’t have to – is whether user fees are the only permissible charges on exportation or whether congress has the power to enact still other types of levies without running afoul of the export clause. the export clause effectively divides the universe of levies into taxes and duties – which can’t fall on exported articles – and everything else. does the “everything else” include any charge that isn’t a user fee (and that also isn’t a tax or duty)? given the founders’ bewildering variety of terms for governmental exactions,203 the classification scheme inherent in the export clause might be even more complex than u.s. shoe suggests. who knows? i certainly don’t. but i’m skeptical that this will turn into a real litigation issue, at least in the near future. no court has yet uncovered a permissible charge on exports that isn’t a user fee, and i doubt that future courts will want to search for such a linguistically possible, but perhaps mythical, concept.204 if my skepticism is justified, the key distinction under the export clause will remain the one outlined in u.s. shoe: taxes or duties versus user fees.205 and that’s an important distinction. to conclude, as the court did in u.s. shoe, that congress may impose value-for-value charges affecting exportation without being constrained by the export clause isn’t a trivial result – even if that’s all that congress can do in the export context. 2. kelly and amzel’s criticisms of u.s. shoe – the typical academic commentator thinks that the taxing power is, and should be, unconstrained, except by political forces, and that provisions like the export clause are nothing but irritants. for those who believe that congress’s taxing power is plenary, the export clause gets in the way, and that’s not a good thing.206 although their numbers are small, a few other scholars think that the court in u.s. shoe left congress with too much flexibility. in an interesting 1999 article, claire kelly and daniela amzel were highly critical of the case, arguing that, although the court came to the right result, it got a key part of the 2003] the export clause 45 207. kelly & amzel, supra note 6. 208. id. at 161; see u.s . const. art i, § 8, cl. 3 (noting congressional power “[t]o regulate commerce with foreign nations, and among the several states, and with the indian tribes”). 209. kelly & amzel, supra note 6, at 198. 210. see generally supra part i. 211. it is, of course, also a specific limitation on the congressional power to impose taxes. analysis wrong.207 under the export clause, they concluded, congress may not impose any charge, including a user fee, that falls on exported articles. kelly and amzel’s big point was that, by endorsing a “mythical user fee exception,” the court allowed the commerce clause potentially to trump the export clause in a way not intended by the founders.208 because the court determined that the hmt was really a tax, that didn’t happen in u.s. shoe, but it could have. if the court had decided that the hmt was a user fee, it would have upheld the hmt – a result that, in kelly and amzel’s view, would have been inconsistent with the dictates of the export clause. in effect, kelly and amzel concluded that the court had made things too complicated: since any governmental charge on exports is forbidden, they said, the court should simply have asked whether the hmt was imposed on “articles exported” – whether, that is, it was “an exaction which: (1) arises during the process of exportation; and (2) is calculated based upon the export or the process of exportation.”209 if it was – and about that there could have been little doubt – it should have been prohibited by the export clause. kelly and amzel were half right, as i’ll now demonstrate. congress ought not to be able to rely on the commerce clause to circumvent the limitation of the export clause, but the user fee “exception,” rather than being a creation of the commerce clause, is implicit in the export clause itself. a. can the commerce clause trump the export clause? kelly and amzel were right that a tax or duty on exported articles is forbidden, regardless of whether the levy might otherwise have been within congress’s power to regulate commerce. if the export clause were simply another factor to throw on the scales – weighing the commerce power against effects on exportation – the export clause wouldn’t have been so controversial at the constitutional convention. but the founding discussions about the clause make clear that what was at stake was whether congress could tax exports at all.210 the export clause is a specific prohibition within the otherwise generally expansive congressional power to regulate commerce.211 it’s true that, in practice, this point may not be nearly as significant as it was in 1787. congress can often avoid export clause issues by relying directly on its regulatory powers under the commerce clause (powers that have 46 florida tax review [vol.6:1 212. if the export clause wouldn’t forbid such a levy, it would have to be because a court might characterize a measure intended to raise little or no revenue as something other than a “tax or duty.” cf. veazie bank v. fenno, 75 u.s. (8 w all.) 533, 549 (1869) (upholding tax on state bank notes, although purpose of tax was to drive notes out of existence). in veazie bank, the government had power to regulate the currency, so that the “tax” at issue might have been valid even if not characterized as a tax. id. 213. in appropriate circumstances, the power to embargo would presumably be implicit in the power to declare war. see supra note 51 (noting conclusion of some founders that war power encompassed power to embargo goods). but see id. (discussing whether forbidding export taxation would have precluded embargo on exports). 214. a serious problem for the kelly-amzel thesis is that the court didn’t even hint it was relying on the commerce clause. kelly and amzel instead saw intellectual osmosis at work, referring to the “conceptual genealogy of the user fee concept,” and stating that, “although the court nominally rejected direct commerce c lause precedent, it still utilized it by employing the mode of thinking created in the commerce clause jurisprudence.” kelly & amzel, supra note 6, at 142. that strikes me as an insubstantial foundation on which to build a case that the commerce clause controlled in u.s. shoe. expanded exponentially over the last two centuries). for example, suppose congress wishes to prohibit exports of a particular good. a confiscatory tax on the export of the good could have a prohibitory effect, but such a tax would face export clause scrutiny.212 in contrast, if congress has the power under the commerce clause (or some other constitutional provision) directly to forbid exportation of the good, no export clause issue would be raised.213 a prohibitory tax and direct prohibition may have the same substantive effect, but form matters: a congressional attempt to use the taxing power to achieve a goal otherwise permitted by the commerce clause would be precluded by the export clause. at a minimum, the export clause cuts down on the options available to congress to affect exportation. b. does the export clause forbid all charges affecting exports? i agree with kelly and amzel that the commerce clause can’t trump the export clause when taxation is involved, but i disagree with them about what happened, and what should have happened, in u.s. shoe. and i disagree that the user fee exception blessed in that case, derived as it was from nineteenth-century cases and constitutional text, was “mythical.” u.s. shoe wasn’t a triumph of the commerce clause over the export clause – the court didn’t speak in those terms214 – but a case in which the court properly struggled to determine what levies are prohibited by the export clause. kelly and amzel argued that “[i]nvestigation into the framers’ intent with respect to the export clause reinforces that the text is the best reflection 2003] the export clause 47 215. id. at 182 (footnote omitted). 216. kelly and amzel argued that the term “tax or duty” shouldn’t be interpreted standing alone, that it instead “should be identified as inseparable from the modifier ‘laid on articles exported.’” id . at 132 . reading the export clause in this way seemed to give primacy to the second phrase, but i’m not sure why that should be so. i’ll concede that the two phrases should be read together — a levy isn’t precluded unless it is both a tax or duty and a levy on articles exported — but that still doesn’t mean that all exactions falling on exports are necessarily included in the prohibited category. 217. see supra notes 186-187 and accompanying text. 218. see supra notes 177-185 and accompanying text. 219. “tax” is an umbrella term that encompasses some, if not all, of the other terms used to refer to governmental levies. see supra note 184. b ut that doesn’t mean it necessarily includes payments for goods or services. kelly and amzel insisted that, “[a]lthough the specific characterization of a governmental exaction as a fee rather than a tax . . . did not exist at the constitutional convention, a modification of the general prohibition which would have allowed for the imposition of fees was raised and rejected at that time.” kelly & amzel, supra note 6, at 183 (citing james m adison, notes of debates in the federal convention of 1787, at 499-503 (adrienne koch ed ., 1987)). i’ve read the cited pages; the inference drawn by kelly and amzel isn’t one i would draw. 220. kelly and amzel stated that the court in ibm had “recognized that the phrase ‘taxes or duties’ relates to all exactions that in any way burden exports.” kelly & amzel, supra note 6, at 180 (citing ibm, 517 u.s. at 847-48). i don’t think the court said any such thing on the cited pages – it certainly didn’t say so straightforwardly – which may explain why kelly and amzel used a “see” signal to introduce the citation. (the court did quote the majority opinion in fairbank to the effect that “[t]he requirement of the constitution is that exports should be free from any governmental burden. the language is ‘no tax or duty.’” ibm, 517 u.s. at 848 (quoting fairbank, 181 u.s. at 290). but the fairbank language is hyperbole. obviously the constitution doesn’t forbid the national government from imposing any burden on exportation; it simply forbids imposing a tax or duty.) 221. 92 u.s. 372, 376 (1876); see supra notes 188-193 and accompanying text. of their intent,”215 and i agree. what follows from the text, however, is that if a charge isn’t a “tax or duty,” the export clause isn’t implicated.216 treating fees for goods or services as something other than taxes may not be mandated by constitutional text, but it’s perfectly consistent with that text. as i argued earlier, the provisions of the constitution creating the taxing power, and those imposing limitations on that power, simply don’t work if interpreted to apply to fees for goods or services.217 and the use of the terms “tax” and “duty,” when so many other configurations of terms had been used in provisions controlling governmental levies,218 suggests that the founders didn’t intend for all conceivable levies to be subject to the export clause.219 that’s what the supreme court had been saying for a long time.220 the judicial conclusion that what we now call a user fee isn’t a tax or duty dates from 1876 in the export clause context, and the court in pace v. burgess221 purported to be interpreting constitutional text. other nineteenth-century cases 48 florida tax review [vol.6:1 222. for example, in packet co. v. st. louis, 100 u.s. 423 (1879), the supreme court held that a municipal corporation could “charg[e] and collect[] from those using its wharves and facilities, such reasonable fees as will fairly remunerate it for the use of its property.” id. at 427. w hen a governmental entity is merely receiving “just compensation,” id. at 428 (discussing cannon v. new orleans, 87 u.s. (20 wall.) 577 (1874), and packet co. v. keokuk, 95 u.s. 80 (1877)), the charge doesn’t violate the import-export clause’s prohibition on states’ levying “imposts or duties on imports or exports” without congressional consent. u.s. const. art. i, § 10, cl. 2; supra note 95. 223. kelly & amzel, supra note 6, at 161. 224. see infra part iii.b. 225. see, e.g., ibm, 517 u.s. at 846 (citing pace for proposition that “preexport products are not ‘articles exported’”). but see supra note 189 (noting that justice thomas, at another point, gave as pace’s rationale that levy wasn’t a “tax,” ibm, 517 u.s. at 847). in turp in v. burgess, 117 u.s. 504 (1886) (discussed in supra note 189 and infra notes 290-300 and accompanying text), a case interpreting the same statute at issue in pace, the court concluded the levy wasn’t on articles in the stream of exportation and therefore was valid even if it were a tax. but the court explicitly didn’t repudiate pace: “the reasons for that decision were given at length in the report of that case, and we see no occasion to modify the views then expressed.” turp in, 117 u.s. at 505. and it treated the levy as a “tax” only for the sake of argument, to provide a basis for the alternative rationale: “in the present case, the tax (if it was a tax) was laid upon the goods before they had left the factory. t hey were not in course of exportation; they might never be exported . . . .” id. at 507 (emphasis added). (for what it’s worth, i question this alternative characterization. see infra notes 302-307 and accompanying text.) explicating other constitutional provisions similarly distinguished user fees from the governmental exactions specifically referred to in the constitution.222 to diminish the precedential value of pace, kelly and amzel reinterpreted the decision, suggesting that it wasn’t based on the taxes-fees distinction. instead, they suggested, the court in pace found that the tax fell outside of the export clause’s prohibition not because it was not a “revenue raising exaction” under the taxing power or fell into some mythical user fee exception under the export clause, but because the exaction was not laid upon articles exported and bore no relationship to those articles.223 if that’s what pace stands for, it’s consistent with principles applied in other cases – by its terms, the export clause doesn’t apply to a levy that’s not on articles exported224 – and it’s consistent with the way kelly and amzel argued that export clause cases should be approached. this isn’t convincing. perhaps pace could have been decided using an alternative rationale – some later cases said that might have happened225 – but 2003] the export clause 49 226. pace, 92 u.s. at 376 (emphasis added). 227. but see kelly & amzel, supra note 6, at 163 (“the ruling in pace did not find a type of exaction outside the scope of ‘tax’ . . . .”). 228. i understand it’s common practice among law professors to examine a line of cases in order to identify a unifying theme, even if the courts decid ing the cases didn’t articulate any such theme. (the practice has been most closely identified with the lawand-economics movement, but it’s not exclusive to that movement.) if the goal is to identify a rationale that can guide courts in the future, fine. a scholar might argue that results in a line of cases are consistent with, say, economic efficiency, although the courts didn’t discuss efficiency in their op inions, and that future courts ought to apply an efficiency rationale explicitly. there’s nothing wrong with looking for better reasons to justify desirable results. but if the argument is that courts were intentionally or subliminally applying a particular rationale while nothing like that was expressed in the opinions, the project rewrites history. cf., e.g., richard a. posner, economic analysis of law 251-55 (4 th ed., 1992) (describing “implicit economic logic of the common law”). it’s one thing to say that pace could have been decided with a different rationale. (the court said that in turpin v. burgess, 117 u.s. 504 (1886); see supra note 225.) it’s quite another to say that pace stands for something other than what was articulated by the court in 1876. see also supra note 214 and accompanying text (questioning kelly and amzel’s proposition that u.s. shoe was based on commerce clause even though court stated no such rationale). that’s not what the court did. i find it impossible to read the short pace opinion and see it as standing for anything other than the distinction between a tax or duty and a user fee. indeed, the court ended its opinion with the statement that “[t]he court being of the opinion that the charge for the stamps . . . was not a tax or duty within the meaning of the [export] clause . . ., it is unnecessary to examine the other questions that were discussed in the argument of the cause.”226 not much reason for doubt there.227 if cases are authoritative (or not), it’s because of the reasoning actually included in the opinions, not because of might-have-beens.228 on its face, pace stands for the exemption of user fees from the prohibition of the export clause. the exemption is quite real, not mythical, and, since the exemption is also consistent with constitutional text, there was no reason for the u.s. shoe court to reject the traditional understanding of pace. to implement the export clause, a court must determine what is a tax or duty and what isn’t. the result in pace, like the result in u.s. shoe, fits the text of the clause perfectly well. b. the required relationship between a tax or duty and “articles exported” some charges may not be taxes or duties and therefore may not be precluded by the export clause. in addition, not all taxes or duties that have an arguable effect on exportation, or on exporters, are prohibited by the export 50 florida tax review [vol.6:1 229. see supra text accompanying note 12. 230. it’s unfair to conclude from marshall’s examples in marbury that he had no idea that the export clause might apply to other sorts of levies. the point of the examples was that some cases are so clear that judicial review is inherent in the constitutional system, and it would have muddied m arshall’s rhetorical waters to throw in more difficult characterization issues. i suspect marshall had a sophisticated sense of substance-versus-form in 1803. he certainly had it by the time of brown v. maryland, 25 u.s. (12 w heat.) 419, 425 (1827). see infra notes 254-256 and accompanying text. 231. see supra part i. 232. ibm, 517 u.s. at 846. 233. see supra part ii.a. clause. in this section, i discuss some of the general principles, derived from the old cases, affecting when a tax or duty is treated as falling on articles exported. as i’ve noted, when the founders considered the propriety of taxing exports, they didn’t focus on the sorts of issues that have become relevant today – such as whether a tax that affected the export market but that wasn’t imposed directly on exported goods was subject to the export clause. i could find no reference in founding debates to questions about how close the relationship between a tax and the act of exporting would need to be before the tax was prohibited. and one can tell from chief justice marshall’s discussion of the export clause in marbury, quoted above,229 that one very bright person, for a particular rhetorical purpose, focused on easy cases in explicating the scope of the export clause.230 but the founders were smart men, and we shouldn’t infer from their failure to discuss all issues at mind-numbing length that the export clause should be limited to taxes and duties imposed directly on exported articles. such an interpretation would have made the clause a dead letter and, although many founders didn’t favor the export clause, they understood that it was supposed to have real effect. indeed, that’s why many opposed it.231 on the other hand, it also makes no sense to try to find export clause issues in every levy that can be tangentially tied, by an imaginative lawyer, to exportation. there need to be some principles, even if they can’t be converted into bright-line rules, to distinguish taxes or duties that are levied “on” exported articles from those that aren’t. in 1996, in ibm, the court said that its “cases have broadly exempted from federal taxation not only export goods, but also services and activities closely related to the export process. at the same time, we have attempted to limit the term ‘articles exported’ to permit federal taxation of pre-export goods and services.”232 i’ve criticized ibm at some length,233 but i have to admit that’s a pretty good description of the state of export clause jurisprudence. the following discussion is divided into four parts. first, i explicate the proposition that a tax of general application isn’t limited by the export clause. 2003] the export clause 51 234. 247 u.s. 165 (1918). 235. act of oct. 3, 1913, ch. 16, § ii, 38 stat. 166, 172. the court said that the sixteenth amendment was irrelevant to its analysis, in that the amendment didn’t extend the taxing power to new sources. w. e. peck & co., 247 u.s. at 172-73. in any event, corporate income taxes had previously been held to be excise taxes not subject to the apportionment requirement for direct taxes. see generally flint v. stone tracy co., 220 u.s. 107 (1911); brushaber v. union pac. r.r., 240 u.s. 1 (1916). 236. w. e. peck & co., 247 u.s. at 174-75. one can infer that a tax imposed only on exportation income or on the income of exporters would therefore not be permitted. see infra part iii.b.1.c. second, i discuss the cases standing for the principle that some levies, although nominally not imposed on exported goods, are so closely tied to such goods that exempting the levies from the export clause would effectively eviscerate the clause. third, i discuss when a good is treated as entering the stream of exportation – the point in time after which congress may no longer impose a tax or duty on the good. finally, i suggest a principle, derived from a 1923 supreme court case, that should be applied in doubtful situations to determine whether a levy falls on exported articles – and, more generally, to resolve all issues affecting the scope of the export clause. 1. taxes of general application – the cases are clear that a tax of general application doesn’t violate the export clause, as long as the tax’s connection with exportation is sufficiently attenuated. at a minimum, this category includes a generally applicable income tax and a generally applicable excise on pre-export goods or services. a. generally applicable income tax a tax that reaches the income of an exporter in exactly the same way it reaches the income of any other taxpayer is consistent with the export clause. in w. e. peck & co. v. lowe,234 decided in 1918, the court held that an exporter could be subject to a corporate income tax, which applied to the “entire net income arising or accruing from all sources during the preceding calendar year.”235 as imposed, the income tax had no particular connection to exportation: “it is not laid on income from exportation because of its source, or in a discriminative way, but just as it is laid on other income. . . . [w]hat is taxed – the net income – is as far removed from exportation as are articles intended for export before the exportation begins.”236 to make the point another way: liability under the corporate income tax wasn’t attributable to exportation per se, but to the success of the enterprise (measured by net income). and the fact and level of the tax would have been exactly the same if none of the income had derived from exportation. 52 florida tax review [vol.6:1 237. see supra notes 82-83 and accompanying text. 238. see jensen, the taxing power, supra note 8, at 1079 n.117 (noting that england adopted income tax only in 1799). 239. national taxes on real property, for example, were intended to be possible under the constitution, as long as the apportionment rule for direct taxes was satisfied. see jensen, apportionment, supra note 8, at 2353-54. there was no discussion at the constitutional convention suggesting that the export clause might limit such taxes as they applied to the real estate of exporters. (of course, i have to admit that there were almost no discussions about how the export clause might limit any levy except one imposed directly on exported articles. see supra part i.) 240. see supra text accompanying note 236. i admit that’s not a totally satisfactory explanation as to why a generally applicable income tax shouldn’t be constrained by the export clause. we know that a tax on exported articles doesn’t become acceptable just because it’s imposed in a nondiscriminatory way,237 and a tax that reaches the income of a successful exporter burdens the exporter in a very real sense: he has fewer dollars after taxes than would otherwise be the case. but at some point, the connection with exportation isn’t close enough to implicate the export clause; ultimately a qualitative judgment is required. one reason a generally applicable income tax should be constitutionally acceptable is that it doesn’t necessarily apply to someone engaged in exporting. for someone who isn’t successful – someone, that is, with no net income – the income tax doesn’t come into play at all, an indication of how tenuous the connection is between a tax on income and the process of exportation. the connection is there, but it’s not strong enough. of course we can’t say for sure what the founders would have thought about income taxes. there was no well-developed conception of an income tax in 1787,238 and, for that matter, there was no conception at all of corporations. nevertheless, we can say this much: if a generally applicable income tax were treated as falling on exported goods – and were, as a result, considered unconstitutional insofar as it applied to the export income of a taxpayer – then any tax that reaches someone involved in exportation, however tangentially, could have constitutional problems. and that result would give the export clause too much effect.239 the export clause was intended to be a real limitation within its sphere, but not to be the primary check on the taxing power. b. generally applicable excise on pre-export goods or services the reference in w. e. peck to “articles intended for export before the exportation begins”240 picked up on a line of cases, discussed in more detail 2003] the export clause 53 241. see infra part iii.b.3. 242. for this purpose, “manufacture” ought to be understood broadly, and not be limited to industrial goods. for example, an excise on agricultural products imposed while the goods are still on the farm should be treated in the same way as goods taxed while still at the factory. however, how these principles ought to apply to federal taxation of e-commerce – particularly to downloadable materials that aren’t manufactured or shipped at all in traditional ways – is just beginning to be explored. see travis mcdade, federal taxation of e-commerce? the constitution says ‘no,’ 98 tax notes 1903, 1906 (2003). 243. ibm, 517 u.s. at 846. “services” wouldn’t be covered by the export clause in any event, unless the services are integrally related to, or are surrogates for, “articles exported.” see supra part iii.b.2. 244. it may be that the founders wouldn’t have been happy with such an interpretation. the first congress did provide, in 1791, for refunds of excises that were collected on distilled spirits that were later exported, and subsequent congresses followed suit. see supra note 100. i’m skeptical that the actions of early congresses ought to be given controlling weight in constitutional interpretation, but, if there’s a case for doing so at all, the actions of the first congress presumably are as authoritative as you can get. cf. supra note 103 (discussing lesser deference to be given to fifth congress). nevertheless, one shouldn’t infer from any particular enactment that congress was exercising the full measure of its power. (congress can always decide to do less than what is constitutionally permitted.) rather than evidencing the limits of congressional power, the refund provisions may simply have reflected caution. why invite disputes about the legitimacy of a levy (and therefore about the legitimacy of congress itself) when it was possible to eliminate any arguable export clause claim(and therefore any arguable claim of congressional overreaching) by providing a refund mechanism? 245. 117 u.s. 504, 507 (1886). 246. see coe v. errol, 116 u.s. 517, 527 (1886) (“goods do not cease to be part of the general mass of property in the state, subject, as such, . . . to taxation in the below,241 that tried to determine the point at which goods ought to be treated as “articles exported.” if, for example, a tax is imposed once a good is on a ship ready to head overseas, there’s no question: the tax is on “articles exported,” within the meaning of the export clause. at the other extreme, a tax imposed at the time of manufacture is generally acceptable, even if it’s known that some of the goods will eventually be exported and even if, in fact, the tax winds up falling both on the goods that are exported and those that aren’t.242 this was what justice thomas, in ibm, referred to as “federal taxation of pre-export goods and services,”243 permissible under the modern understanding of the export clause.244 the “pre-export goods” exemption from the export clause was first articulated in an 1886 supreme court case, turpin v. burgess,245 which relied, in part, on a contemporaneous case interpreting the import-export clause.246 54 florida tax review [vol.6:1 usual way, until they have been shipped, or entered with a common carrier for transportation to another state, or have been started upon such transportation”). 247. 192 u.s. 418 (1904). 248. id. at 427. 249. see infra part iii.b.3.a. 250. about which, more later. see infra part iii.b.4. the court explained the rationale for the exemption, in 1904, in cornell v. coyne:247 the true construction of the constitutional provision is that no burden by way of tax or duty can be cast upon the exportation of articles, and does not mean that articles exported are relieved from the prior ordinary burdens of taxation which rest upon all property similarly situated. the exemption attaches to the export and not to the article before its exportation.248 at the time of manufacture a good isn’t yet an “exported article,” and congress may therefore impose an excise on the manufacture of widgets without violating the export clause.249 as with the generally applicable income tax, there’s a connection with exportation at an abstract level: under the supreme court’s understanding, a good that is ultimately exported may, despite the export clause, be subject to taxation. but if a tax or duty is to be prohibited, the export clause requires a closer, more concrete relationship between levy and exported good than results from the mere possibility of future exportation. the line between permissible and impermissible levies may not be bright – not again! i hear you say250 – but it’s a boundary that must be policed as best we can. in any event, the difficult cases that inevitably arise at the margin shouldn’t hide the basic principle at work here: if a tax is imposed at the time of manufacture and isn’t directed at exportation per se, there should be no problems under the export clause. c. taxes on exportation disguised as taxes of general application none of this is to say, however, that an income tax or an excise on manufactured goods is automatically safe under the export clause. if a tax is targeted at exports, it ought to fail the export clause regardless of its other characteristics. for example, if an excise on manufacturing applied only to goods that were to be exported, even though in form it might appear to be a 2003] the export clause 55 251. for example, suppose a tax is imposed, in a facia lly neutral way, on a category of goods that is manufactured solely, or primarily, for exportation. a bit later i discuss whether a tax is valid if it’s imposed while goods remain at the place of manufacture but some of the goods have already been designated for exportation. see infra notes 302-307 and accompanying text (discussing uncertainty remaining after turpin v. burgess). 252. i question whether a tax that reaches only a small part of the nation’s income-earners would constitute a “tax on incomes” within the meaning of the sixteenth amendment, and would therefore be exempt from the apportionment requirement that otherwise applies to direct taxes. see jensen, apportionment, supra note 8, at 2410-11. for present purposes, however, i’ll put that question aside. 253. presumably the same result should apply if the tax fell disproportionately on exporters for other reasons—for example, if exporters were denied business deductions that were available to other taxpayers. 254. 25 u.s. (12 wheat.) 419 (1827 ). brown was an import-export clause case, and the discussion of the occupational tax under the export clause is technically dictum, but marshall thought the export clause and the import-export clause should be interpreted consistently. see supra note 131 and accompanying text. 255. see supra note 12 and accompanying text. 256. brown, 25 u.s. (12 wheat.) at 445. justice story also took for granted that such an occupational tax would be invalid: “the prohibition extends no t only to exports, but to the exporter. congress can no more rightfully tax the one, than the other.” story, supra note 33, § 1012, at 471. i’m not sure, but i think both marshall and story were concerned about a tax on the person in his capacity as exporter or importer, and that they wouldn’t have thought a tax was unconstitutional simply because it wound up reaching someone who was an exporter. neither jurist would necessarily have been bothered by neutral, pre-exportation tax, it should be invalid.251 an excise would also be flawed if the rate applicable to exported goods were higher than for other articles. as is generally true in american tax law, substance ought to control in characterizing a levy under the export clause. similarly, if a tax applied to the income of exporters only, and not to that of other business persons252 – or if income from exportation were taxed at a higher rate than other income – a court should see the tax as burdening exportation and hence as falling on “articles exported.”253 such a tax would be like a levy hypothesized in 1827 by chief justice marshall, in brown v. maryland.254 marshall’s examples of export taxation in marbury were ridiculously simple, and therefore noncontroversial,255 but, in brown, marshall showed a sophisticated sense of substance-over-form in discussing a hypothetical occupational tax that would fall only on exporters: “would government be permitted to shield itself from the just censure to which this attempt to evade the prohibitions of the constitution would expose it, by saying that [the occupational tax on exporters] was a tax on the person, not on the article, and that the legislature had a right to tax occupations?”256 the tie between the tax 56 florida tax review [vol.6:1 the result in w. e. peck & co. v. lowe, 247 u.s. 165 (1918), finding no export clause problem with a corporate income tax. see supra notes 234-236 and accompanying text; see also 1 bittker & lokken, supra note 6 , 360 , at 1-14 (noting that sixteenth amendment, permitting unapportioned tax on income “from whatever source derived ,” was irrelevant to export clause question). 257. see act of july 6, 1797, ch. 11, § 1, 1 stat. 527; supra part ii.a.2 (discussing 1797 act). 258. 181 u.s. 283 (1901). 259. act of june 13, 1898, ch. 448, 30 stat. 448, 459. 260. id., 30 stat. at 459. 261. see part ii.a.3. and still another in united states v. hvoslef, 237 u.s. 1 (1915). see infra notes 271-281 and accompanying text. and any particular exported good might be minimal with such an occupational tax, but the link between the tax and exportation would be so strong that the tax should fall. 2. taxes on goods and services related to exportation – justice marshall’s dictum in brown was an early indication that courts ought to apply substance-over-form principles to determine whether a tax or duty is on articles exported. as i’ve just argued, one case in which such principles must apply, unless the export clause is to be a nullity, is when congress imposes a tax on an unquestioned surrogate for “articles exported.” but it’s also appropriate to see some services, what i’ll call “integrally related services,” as so closely intertwined with exported goods that a tax on the services ought to be treated as a tax on the goods. a. the slam-dunk cases: taxes on surrogates for exported goods to my mind, there’s little doubt that the export clause should prevent congress from imposing taxes on clear surrogates for exported goods, such as bills of lading. nevertheless, congress did just that several times, beginning in 1797,257 and the legitimacy of such a tax wasn’t tested until 1901, in fairbank v. united states.258 the court in fairbank evaluated the constitutional legitimacy of a stamp tax, imposed at a rate of ten cents, that applied to, among other things, “[b]ills of lading . . . for any goods, merchandise, or effects, to be exported from a port or place in the united states to any foreign port or place.”259 (bills of lading for domestic shipping were subject to only a one cent tax.260) the provision was part of the same 1898 act to raise funds for the spanishamerican war that created another export clause issue in thames & mersey.261 the amount of the tax wasn’t measured by the value of the goods shipped, but nothing in the export clause limits its scope to taxes or duties 2003] the export clause 57 262. see supra notes 141-144 and 148 and accompanying text (discussing how ibm court could have approved the 1915 result in thames v. mersey). 263. fairbank, 181 u.s. at 294. 264. chief justice roger taney had made a similar point in almy v. california , 65 u.s. (24 how.) 169 (1860), a case interpreting the import-export clause: [a] tax or duty on a bill of lading, although differing in form from a duty on the article shipped is in substance the same thing; for a bill of lading, or some written instrument of the same import, is necessarily always associated with every shipment of articles of commerce from the ports of one country to those of another. id. at 174. the california duty at issue in almy was on bills of lading associated with the transfer of gold and silver out of california, and the legislative purpose was c learly to tax the transfer of the gold and silver itself. “the duty is imposed only upon bills of lading of gold and silver, and not upon articles of any other descrip tion. . . . if it was intended merely as a stamp duty on a particular description of paper, the bill of lading of any other cargo is in the same form . . . .” id. at 174-75. 265. fairbank, 181 u.s. at 315 (harlan, j., dissenting). 266. see supra part ii.a.2. measured by value.262 the court looked to the tax’s effect – “a stamp duty on a bill of lading is in effect a duty on the article transported”263 – and came to the obvious conclusion: congress couldn’t burden exports through a tax on exported articles, and that’s exactly what it had done here, albeit surreptitiously.264 fairbank was nevertheless a controversial case, with four dissenters accepting the government’s argument that the tax was really on the bills of lading, which weren’t “articles exported.” adopting an incredibly formalistic position, justice harlan wrote that “stamp duties were imposed specifically for and in respect of the vellum, parchment or paper upon which was written or printed a bill of lading for goods or merchandise to be exported to foreign countries.”265 as i discussed earlier, the dissenters relied in part on the fact that a similar levy had been imposed in 1797, inferring that the founding generation thought such a tax was consistent with the constitution.266 but because this interpretation would have left the export clause with almost no effect, contrary to the understanding at the constitutional convention, fairbank had to be decided the way it was. b. taxes on integrally related services fairbank was (or should have been) easy. in other cases, the court had to consider levies that weren’t as closely tied to particular goods as was a tax on bills of lading. in two cases in particular, the court decided, in effect, that if a tax reaches a service that is critical to exportation, so that one can’t 58 florida tax review [vol.6:1 267. see supra part ii.a.3. 268. thames & mersey, 237 u.s. at 26. 269. id. at 25. 270. see supra part ii.a.3. as i argued above, the ibm court could have concluded not only that it wouldn’t overrule thames & mersey, but also that the earlier case was rightly decided. see supra notes 135, 137-144, and 148 and accompanying text. 271. 237 u.s. 1 (1915). 272. act of june 13, 1898, ch. 448, § 6 , 30 stat. 448, 451, 460. section 6 of the act specified that a tax be imposed on the “things mentioned and described in schedule a,” and schedule a included “charter party,” defined as a [c]ontract or agreement for the charter of any ship, or vessel, or steamer, or any letter, memorandum, or other writing between the captain, master, or owner, or person acting as agent of any ship, or vessel, or steamer, and any other person or persons, for or relating to the charter of such ship, or vessel, or steamer, or any renewal or transfer thereof. 30 stat. at 460; see hvoslef, 237 u.s. at 16. 273. see act of july 6, 1797, ch. 448, § 1, 1 stat. 527 (imposing one-dollar tax on “any charter-party”). as the ibm dissenters noted, the 1797 act wasn’t briefed to the court in hvoslef or thames & mersey. see ibm, 517 u.s. at 877 (kennedy, j., dissenting); supra note 121. 274. for vessels of three hundred tons or less, the tax was three dollars. for vessels of more than three hundred, but not more than six hundred, tons, the tax was five dollars. for vessels over six hundred tons, the tax was ten dollars. 30 stat. at 460. 275. see supra notes 142-143 and accompanying text. realistically untangle the service from the goods, the export clause ought to forbid the tax. i’d call this the “integrally related” test. one example is thames & mersey, the 1915 case relied on by the court in ibm.267 exporting valuable goods without insurance is almost inconceivable, making insurance “an integral part of the exportation.”268 as a result, a tax on insurance premiums was “so directly and closely related to the ‘process of exporting’ that the tax is in substance a tax upon the exportation”269 – a conclusion validated, in a backhanded way, in ibm.270 a similar analysis was applied in united states v. hvoslef,271 a companion case to thames & mersey. like thames & mersey, hvoslef involved yet another tax imposed under the 1898 act as it applied to certain “charter parties” – generally contracts for the lease of vessels – for carrying cargo from the united states to foreign ports,272 and it involved yet another levy with ties to the 1797 act, which also included a tax on charter parties.273 the amount of tax was based on the tonnage of the vessel, not on the value of the cargo carried,274 but nothing in the export clause limits its application to taxes or duties tied to the value of exported articles.275 instead of 2003] the export clause 59 276. perhaps i therefore should have discussed hvoslef together with fairbank, rather than with thames & mersey. ultimately, i think it doesn’t matter. 277. hvoslef, 237 u.s. at 17. 278. see supra notes 82-83 and accompanying text. 279. hvoslef, 237 u.s. at 13. 280. 25 u.s. (12 wheat.) 419, 441 (1827); see supra notes 254-256 and accompanying text. brown involved state power under the import-export clause, and marshall emphasized that the export clause should be interpreted so as not to defeat its purposes: but, while we admit that sound principles of construction ought to restrain all courts from carrying the words of the prohibition beyond the object the constitution is intended to secure; that there must be a point of time when the prohibition ceases, and the power of the state to tax commences; we cannot admit that this point of time is the instant that the articles enter the country. it is, we think, obvious, that this construction would defeat the prohibition. imposing a tax directly on exported goods, congress had slapped a levy on the ships carrying the goods, or, perhaps more precisely, on the paperwork associated with arranging for the ships.276 it’s difficult to imagine anything more “integrally related” to exportation: “the charters were for the exportation; . . . they serve no other purpose. a tax on these charter parties was in substance a tax on the exportation; and a tax on the exportation is a tax on the exports.”277 the tax didn’t discriminate – the levy applied to all charter parties, whether or not the ships went to other countries – but the export clause is an absolute prohibition.278 at bottom, the court concluded that it was necessary to reject the tax on charter parties if the export clause was to be protected: this prohibition . . . is designed to give immunity from taxation to property that is in the actual course of such exportation . . . . this constitutional freedom, however, plainly involves more than mere exemption from taxes or duties which are laid specifically upon the goods themselves. if it meant no more than that, the obstructions to exportation which it was the purpose to prevent could readily be set up by legislation nominally conforming to the constitutional restriction but in effect overriding it.279 not surprisingly, the court referred approvingly to chief justice marshall’s substance-over-form dictum in brown.280 if there was any question at all in hvoslef about the substance of the tax on charter parties, it arose when only part of a vessel’s cargo was destined for exportation. even then, however, the court decided that the export clause 60 florida tax review [vol.6:1 281. hvoslef, 237 u.s. at 17. 282. see supra part iii.b.1.b. 283. ibm, 517 u.s. at 846 ; see supra note 243 and accompanying text. 284. ibm, 517 u.s. at 848 (citing pace v. burgess, 92 u.s. 372 (1976); turpin v. burgess, 117 u.s. 504 (1886); and cornell v. coyne, 192 u.s. 418 (1904)). applied: “whether the contract of carriage covers a small lot, or a partial cargo, or an entire cargo . . . can make no constitutional difference.”281 since the tax was based on the vessel’s tonnage, rather than being tied to the value or weight of the cargo, that result was hardly surprising. a tax on a vessel carrying goods for export, or on the arrangements for the vessel, was in substance a tax on the cargo, including the exported articles. 3. when has a taxed good entered the stream of exportation? – fairbank, thames & mersey, and hvoslef considered whether taxes that didn’t fall directly on goods nevertheless ought to be treated as reaching articles exported. at a minimum, that should be true when the tax falls on a clear surrogate for the goods or when the “integrally related” test is satisfied. in still other cases, the court had to decide whether a tax that was unquestionably on goods ought to be treated as falling on exported goods. that is the subject of the next portion of this article. i consider the treatment of, in order, pre-export goods (a subject i’ve already introduced282), goods that are unquestionably in the process of exportation, and goods that fall between the two polar cases. a. pre-export goods despite the export clause, congress may impose a generally applicable tax on goods, or on the manufacture of goods, even if some of the goods wind up being exported, as long as the tax attaches before the goods have entered a stream of commerce that is heading toward exportation. that’s what the ibm court called “federal taxation of pre-export goods and services,”283 or a “nondiscriminatory pre-exportation assessment.”284 for example, an excise that applies at the time of manufacture to all widgets, whether they’ll be exported or not, is constitutionally permissible. suppose identical widgets a and b are manufactured simultaneously in massachusetts. it turns out that a is headed for mississippi and b for england, but it could just as well have been the other way around. as long as the tax applies before the fungible widgets leave the factory, the tax isn’t foreclosed by the export clause; it isn’t a tax on articles exported. and the principle is broader than that. suppose widgets are, in general, manufactured for use both inside and outside the united states, but a particular manufacturer produces widgets only for exportation. an excise applied to those 2003] the export clause 61 285. 192 u.s. 418 (1904). 286. act of june 6, 1896, ch. 337, § 9, 29 stat. 253 . “filled cheese” was “[a]ll substances made of milk or skimmed milk, with the admixture of butter, animal oils or fats, vegetable or any other oils, or compounds foreign to such milk, and made in imitation or semblance of cheese.” id., § 2, at 253. yum. 287. the act also subjected imported filled cheese to a substantial duty. id., § 11, at 255. congress was trying to encourage the domestic cheese industry. cornell, 192 u.s. at 427. 288. cornell, 192 u.s. at 427 . because the import-export clause generally precludes states from imposing duties on exports, a contrary result might have led to the conclusion that a state “government was bound to refund all prior taxes imposed on articles exported. a farmer may raise cattle with the purpose of exportation, and in fact export them. can it be that he is entitled to a return of all property taxes which have been cast upon those cattle?” id. the question was, of course, rhetorical. 289. id. 290. 117 u.s. 504 (1886). 291. 92 u.s. 372 (1876). 292. see supra notes 188-192 and accompanying text. 293. see act of july 20, 1868, ch. 186, § 74, 15 stat. 125, 157. 294. see act of aug. 8, 1882, ch. 473, 22 stat. 372. to-be-exported widgets would be permissible so long as it applied to all manufacturers of the widgets – those who export everything they produce, those who don’t export at all, and those who export only some of their product. this principle is illustrated by cornell v. coyne,285 decided in 1904, in which the court, over two dissents, held that a one cent per pound manufacturing tax on filled cheese could be imposed on all such ersatz cheese,286 including stuff to be exported.287 the tax had nothing specifically to do with exporting: “subjecting filled cheese manufactured for the purpose of export is casting no tax or duty on articles exported, but is only a tax or duty on the manufacturing of articles in order to prepare them for export.”288 just because they’re exported later, articles aren’t “relieved from the prior ordinary burdens of taxation which rest upon all property similarly situated. the exemption attaches to the export and not to the article before its exportation.”289 the result in cornell followed the stated rationale of turpin v. burgess,290 decided in 1886. in turpin, the court reaffirmed the result in pace v. burgess291 – the 1876 case that first analyzed user fees under the export clause292 – but also added an alternative justification for pace’s result. the statute in turpin was precisely the same one involved in pace: it imposed a stamp levy on tobacco marked for export at a lower rate than would otherwise have applied.293 turpin was decided just ten years after pace, and it appears that the court decided to hear the new case only because, in the meantime, congress had repealed the levy.294 maybe, it was argued, the repeal showed that congress had conceded the stamp charge’s constitutional problems. 62 florida tax review [vol.6:1 295. the repeal wasn’t “a concession by congress that the charge for the stamp was an export tax,” said the court, turpin, 117 u.s. at 505, or, even if the repeal were interpreted that way, “it would only be the opinion of one congress opposed to that of another.”id. at 506. 296. maybe the court felt that, if it provided enough reasons for valid ity, people would decide that it was pointless to keep asking the court to deal with boring export clause issues. 297. turpin, 117 u.s. at 507. 298. id. 299. see supra note 225. 300. turp in, 117 u.s. at 507. 301. id. 302. see supra notes 188-193 and accompanying text. 303. act of july 20, 1868, ch. 186, § 74, 15 stat. 125, 157. the court didn’t buy the concession argument,295 however, and that might have ended the dispute. once it decided that repeal didn’t affect how the statute should be interpreted, the court could simply have reaffirmed its analysis in pace. for reasons that aren’t clear, however, it didn’t do that. instead, without repudiating the reasoning in pace, the court added a new justification for the result.296 the stamp tax, it said, wasn’t imposed “by reason or because of [the goods’] exportation or intended exportation, or whilst they are being exported.”297 “[a] general tax, laid on all property alike, and not levied on goods in course of exportation, nor because of their intended exportation, is not within the constitutional prohibition.”298 even if pace’s stated rationale didn’t hold up – and the court specifically refused to say any such thing299 – the result would have been exactly the same. the levy was valid: “in the present case, the tax (if it was a tax) was laid upon the goods before they had left the factory. they were not in course of exportation; they might never be exported; whether they would be or not would depend altogether on the will of the manufacturer.”300 it’s possible to get a pretty good sense of what the court meant about pre-export levies in both turpin and cornell, but the court left a troubling loose end in turpin. one of the striking things about the court’s opinion is that it didn’t connect with the facts. whatever the merits of permitting a “general tax, laid on all property alike, and not levied . . . because of [the good’s] intended exportation,”301 that wasn’t the situation in the case. the levy at issue in both turpin and pace did single out goods to be exported.302 the charge for tobacco was generally thirty-two cents per pound, but exported tobacco was instead required to have only a twenty-five cent stamp affixed to each package.303 with such a differential rate structure, the total amount a producer owed uncle sam couldn’t be determined until the producer had decided which tobacco was to be exported, and which wasn’t. 2003] the export clause 63 304. turpin, 117 u.s. at 507. 305. fairbank, the first strong judicial statement that lack of discrimination against exports is irrelevant, wasn’t decided until 1901, fifteen years after turp in. see supra note 83. 306. let me reemphasize, however, that the result of turp in would have been unchanged, even if the levy had been treated as targeting exports, so long as the levy was a user fee, as the court had concluded in pace v. burgess, 92 u.s. 372 (1876). see supra notes 188-193 and accompanying text. 307. see ibm, 517 u.s. at 848. 308. see supra notes 223-228 and accompanying text. does turpin therefore mean that, despite the export clause, a tax directed at exported goods can be levied on goods that have been set aside for exportation, as long as the goods are still at the factory? the language of the opinion – not levied . . . because of [the good’s] intended exportation304 – suggests the answer to that question is “no,” but the result of the case is otherwise. to be sure, the charge for the stamp affixed to exported tobacco in pace and turpin was lower, indeed much lower, than would otherwise have been the case; exported goods therefore weren’t being singled out for discriminatorily unfavorable treatment. but lack of discrimination isn’t supposed to matter under the export clause: a tax on exports doesn’t become acceptable simply because exported goods are relatively well treated. since the cases discussing the irrelevance of discrimination came after turpin, however, maybe the turpin result depended on an understanding of the export clause that was repudiated in fairbank and other cases.305 i’m not sure, but it seems to me that a tax that applies specifically because articles have been designated for exportation shouldn’t be treated as on “pre-export goods” – wherever the goods are located when the tax attaches and whether the tax on goods to be exported is less than, equal to, or greater than any tax on other goods.306 as meritorious as turpin’s rationale may have been in the abstract, it shouldn’t have applied to the facts of turpin. that said, however, turpin is cited these days for the proposition that a “nondiscriminatory pre-exportation assessment” is permissible. (the court characterized turpin that way in ibm.307) if turpin is really an example of such an assessment, then a tax that falls on goods set aside for exportation is valid, as long as the goods haven’t “left the factory,” and, presumably, as long as the tax rate for exported goods is no higher than for other goods. b. in the stream of exportation as turpin and coyne concluded (and as revisionists interpret pace as concluding308), congress may tax goods at the pre-export stage without violating the export clause. at the other extreme, once articles have entered the 64 florida tax review [vol.6:1 309. as i suggested above, there may be some doubt about a tax that is directed at goods set aside for exportation, before they’ve left the factory, see supra notes 302307 and accompanying text, but that treats the exported goods no less favorably than goods that aren’t exported. 310. but see supra notes 302-307 and accompanying text. 311. by “overseas,” i mean to include canada and mexico as well as the countries that are, by any definition, overseas. 312. see supra text accompanying note 12. 313. obviously the more narrowly the export clause is understood, the smaller the universe of characterization issues. but even in the clause’s most narrowly understood form – and no one, i think, believes that the export clause applies to less than justice marshall’s hypotheticals – it’s necessary to determine whether the taxed (or potentially taxed) cotton, tobacco, or flour is actually being exported. 314. 262 u.s. 66 (1923). 315. war revenue act, ch. 63, § 600(f), 40 stat. 300, 316 (1917). stream of commerce that leads inexorably to exportation, congress may not impose a tax on the articles. that’s what the export clause is all about. for example, an excise applied only to widgets that have been set aside for exportation would, i think, be invalid.309 an even clearer case: if the widget is already on a ship bound for england at the time the tax attaches, no one would doubt that the tax violates the export clause insofar as it applies to the exported goods, even if all shipped widgets – those going to other countries and those staying within the u.s. – are subject to the tax. c. at the (wide?) margin: spalding except in the polar cases, where a good is still at the manufacturing stage310 or is already on a vessel headed overseas,311 determining whether a good is an “article exported” isn’t easy. even if a purportedly bright-line rule were adopted that would confine the export clause to cases like those in justice marshall’s marbury hypotheticals312 – a tax laid directly on flour, say – there can still be questions about whether, or when, the flour is being exported. if congress is going to tax goods, or surrogates for goods, or services integrally related to goods, there’s no way to eliminate characterization questions of that sort.313 a. g. spalding & brothers v. edwards,314 decided in 1923, the court’s last export clause case before ibm, illustrates the difficult line-drawing that is inevitable. at issue was the constitutionality of a wartime tax imposed on “baseball bats, . . . balls of all kinds . . . sold by the manufacturer, producer, or importer,”315 as that tax applied to baseball equipment that would ultimately wind up in venezuela. a venezuelan purchaser enlisted the efforts of a commission merchant to acquire equipment on its behalf and have the equipment shipped. the commission merchant did just that, arranging for 2003] the export clause 65 316. 117 u.s. 504 (1886); see supra notes 290-300 and accompanying text. 317. 192 u.s. 418 (1904); see supra notes 285-288 and accompanying text. 318. spalding, 262 u.s. at 69. 319. id. at 69. 320. id. 321. id. at 68. 322. id. at 70; see supra notes 285-288 and accompanying text (discussing cornell). 323. spalding, 262 u.s. at 69. spalding to deliver the goods to a carrier, at which point title passed. spalding was paid by the commission merchant and the merchant was paid later by the ultimate purchaser. if the equipment had still been “in process of manufacture” at the time the tax attached, the tax would have been valid, under the authority of turpin316 and cornell.317 in contrast, justice holmes wrote for the court, “no one would doubt that [the bats and other equipment] were exempt after they had been loaded upon the vessel for venezuela and the bill of lading issued.”318 the problem was that the spalding facts fell between those two extremes. the tax liability was not on the manufacture, but it also wasn’t on goods loaded for overseas shipment. the court had to decide which of the two polar cases the facts were closer to, and justice holmes concluded, with a decided lack of certainty, “it seems to us that the facts recited are closer to the latter than to the former side, and that the export had begun.”319 manufacture alone wouldn’t have been treated as a “step in exportation,”320 but this tax was on the sale of the equipment – which by itself gets us closer to the export stage. moreover, although baseball bats manufactured in the u.s. weren’t ordinarily headed overseas, in this case, as holmes put it, “[t]he transaction from start to finish was understood and intended by [spalding and the commission merchant] to be for the purpose of exporting the goods to [the venezuelan buyer].”321 if all of that weren’t enough, “[t]he overt act of delivering the goods to the carrier marks the point of distinction between this case and cornell v. coyne [the filled-cheese case].”322 some might see arbitrariness in this line-drawing, and justice holmes admitted as much: “[w]e have to fix a point at which, in view of the purpose of the constitution, the export must be said to begin. as elsewhere in the law there will be other points very near to it on the other side, so that if the necessity of fixing one definitely is not remembered any determination may seem arbitrary.”323 even hard cases need to be decided, but the harder the case, the easier it is to conclude that the case should have been decided differently. spalding wasn’t clear-cut, but that doesn’t mean the result was arbitrary. justice holmes prescribed a way to decide difficult export clause cases. his reference to the “overt act of delivering the goods to the carrier” was coupled with a principle which justified treating that event as critical: to have 66 florida tax review [vol.6:1 324. id. at 70 (emphasis added). 325. see, e.g., ackerman, supra note 39, at 3. 326. see supra part ii. 327. a term that may be redundant. 328. see generally supra part i. 329. see jensen, apportionment, supra note 8, at 2414-19. the export clause come into play “at any later point would fail to give to exports the liberal protection that hitherto they have received; of which an example may be seen in thames & mersey. . . .”324 as i’ll now discuss, the idea that exported articles should be provided “liberal protection” against the national taxing power is a useful principle to resolve export clause issues generally. 4. interpreting the export clause: “liberal protection” – i’ve been considering the necessary relationship, if the export clause is to apply, between a tax or duty and exported articles. the cases advance some reasonably consistent principles on this point, but, if congress is aggressive in enacting taxes that have export implications, courts will inevitably face tough judgment calls. for that matter, congress also faces uncertainty in evaluating the likelihood that a proposed tax could face a legitimate export clause challenge. because modern commentators generally see congress’s power to enact taxes as plenary,325 they are unlikely to take this uncertainty seriously. one who sees few, if any, limitations on the taxing power is likely to resolve any doubt about constitutionality in favor of a challenged (or a proposed) tax. and resolving doubt in favor of constitutionality means, as a practical matter, that modernists are unlikely to raise any doubts about constitutionality to begin with. but the export clause can’t just be brushed aside. when the supreme court decides two cases under the export clause within a two-year period,326 and strikes down congressional enactments both times, the export clause has a great deal more legitimacy than if it were being promoted only by some crazy law professor.327 ibm and u.s. shoe weren’t aberrations. (one case might have been characterized that way; two in two years can’t be.) the founders intended the export clause to be a real restriction on what congress can do,328 and it should be interpreted in a way that ensures it has real effect. moreover, that’s the way other constitutional restrictions on the taxing power used to be interpreted,329 until modern conceptions of congressional plenary power gained currency, and that’s the way justice holmes concluded that the export clause should be applied in spalding. with the export clause, we’re no longer in the plenary-power era: courts after ibm and u.s. shoe have an obligation to police the export clause. the bottom line in spalding was this: if there’s doubt about whether a tax falls on exported articles – if there’s uncertainty as to where, on the 2003] the export clause 67 330. see supra note 118. 331. there can also be difficulty in determining whether an exaction is a tax or duty, and that issue too should be resolved, when it arises, through application of a “liberal protection” standard. and it may be the case that downloaded electronic materials, which at no point enter the transport stage – at least not in a traditional way – ought to be immune from federal taxation because of the export clause, or so it has been argued. see mcdade, supra note 242, at 1906. 332. i don’t mean to suggest that every levy is in danger. the cases that have dealt with taxes of general app lication, for example, and those dealing with pre-export goods and services will protect many levies from serious constitutional challenge. continuum between manufacture and overseas transport, a particular tax attaches to goods – the doubt should be resolved in a way that protects the principles of the export clause. that’s the liberal protection that justice holmes was talking about. a common argument today is that it’s too onerous to tell whether a levy has suspect effects. the difficulty of determining whether a tax or duty ought to be treated as falling on exported articles isn’t imaginary, and therefore, the argument goes, the constitutional limitation shouldn’t be applied – except, perhaps, in the most straightforward, noncontroversial situations. life’s just too short to worry about this sort of thing. that was one of justice kennedy’s points in his ibm dissent. he suggested that it was going to be a real chore, in most cases, to determine how a tax on insurance premiums relates to exportation, and therefore courts shouldn’t even have to try. if that reluctance leaves the export clause applying to nothing but marbury-like hypotheticals, and therefore leaves congress with a basically unconstrained power to burden exportation, so be it.330 that can’t be the right interpretational principle. the idea that constitutional limitations ought to be applied only when they’re easy to apply gives away the store. the older cases, of which spalding is one, suggest another, reasonable way a limitation might be applied: if there’s doubt about whether a particular levy attaches closer to the manufacturing stage or the transport stage, the doubt should be resolved against the levy.331 to give “liberal protection” to the export clause is, in effect, to create a default rule, and the default position is that a tax isn’t valid unless its legitimacy can be demonstrated.332 providing liberal protection to exported articles isn’t merely a matter of courts getting it right in interpreting the export clause. for a legislator contemplating a proposed piece of tax legislation, a similar rule should apply: if there’s doubt about whether the export clause would forbid a proposed tax, that doubt should be resolved against the proposal. if courts are going to defer to congress’s implicit determination that enactments are constitutional – and that’s still likely to happen, despite ibm and u.s. shoe – then congress should 68 florida tax review [vol.6:1 333. see infra notes 129-132 and 197-199 and accompanying text. 334. see supra note 95 (quoting import-export clause). 335. u.s. shoe, 523 u.s. at 368. 336. id. 337. u.s. const. art. i, § 10 , cl. 2. the language of the export clause forbids “imposts or duties on imports or exports,” but presumably the term “imposts” is limited to imports, so that “duties” is left for exports. legislate with a good sense of what the constitution, including the export clause, requires. c. is the export clause really unique? in both ibm and u.s. shoe, the supreme court discussed the export clause as if it were unique.333 the court rejected the importation of principles from other constitutional provisions into its analysis of the export clause, and it suggested, as well, that export clause principles should be confined to the analysis of that provision. among other things, the court specifically rejected the application of jurisprudence developed under the import-export clause – the provision restricting states’ power to tax exports334 – to disputes arising under the export clause. in the strongest statement of this interpretational posture, justice ginsburg wrote, in u.s. shoe, “ibm plainly states that the export clause’s simple, direct, unqualified prohibition on any taxes or duties distinguishes it from other constitutional limitations on governmental taxing authority.”335 and, if that weren’t clear enough, she rejected the idea that authority “involv[ing] constitutional provisions other than the export clause [should] govern” in an export clause dispute.”336 i’ll concede that the export clause speaks in a direct and relatively unqualified way, but i’m unconvinced that the export clause is unique in that regard. of course, if by fiat the court creates an impenetrable barrier around the export clause, that’s just the way it’s going to be, at least for awhile. but it will be difficult for the court to maintain that position in an intellectually coherent way. in the following discussion, i’ll suggest three respects in which the export clause should not be treated as sui generis. 1. what’s a levy “on” exports? – the language of the export clause is strong, but treating it as if it occupies its own legal universe, particularly in determining whether a levy falls on exported goods, is a marked break with tradition. for decades the assumption had been that the import-export clause, restricting state authority, and the export clause, restricting national authority, ought to be interpreted in tandem. the export clause forbids a national “tax or duty” on “articles exported”; the import-export clause generally forbids state “duties” on “exports” without congressional consent.337 in 1827, in a passage i quoted earlier, chief justice john marshall wrote that “[t]here is some 2003] the export clause 69 338. brown v. maryland, 25 u.s. (12 wheat.) 419, 445 (1827). 339. see supra note 184. 340. see supra note 185. 341. however, the relatively permissive import-export clause cases haven’t relied so much on the distinction between “tax or duty” and “duty” as on a relatively permissive understanding of what constitutes a levy “on” exports. 342. ibm, 517 u.s. at 851. 343. u.s. shoe, 523 u.s. at 368. but see infra part iii.c.3 (questioning whether export clause is really more “unqualified” than other restrictions on taxing power). 344. the purposes of the two clauses are also different: the export clause is a restriction on national power, and the import-export clause is a statement of national supremacy. see supra note 130 (quoting ibm). diversity in language [between the import-export and the export clauses], but none is perceivable in the act which is prohibited.”338 the term “tax or duty” is broader than “duty,”339 obviously, so that the prohibition under the export clause might very well be broader than under the import-export clause,340 as the court concluded in ibm and u.s. shoe.341 moreover, the export clause contains a direct “textual command”342 and it’s sort of an “unqualified prohibition.”343 that’s not as clearly true with the import-export clause.344 the export clause is therefore arguably the stronger restriction. nevertheless, it should also be true that the sort of state levy on exports that fails import-export clause requirements would be prohibited to the national government under the export clause. that is, at a minimum – even if we can’t find any other connections between the two clauses – it should be possible to glean from import-export clause jurisprudence some of the state levies that, if imposed by the national government, would fail the export clause because they fall on exported articles. i can think of no good reason for having two different bodies of law on what is, at bottom, a single issue: when a levy is treated as falling on exported goods. john marshall also thought there was no good reason for such a situation and, on confusing questions, i’m inclined to side with john marshall. for that matter, the post-marshall supreme court said the same thing, repeatedly, when it was hearing export clause cases on a regular basis. it wasn’t until 1996 and the decision in ibm that the court said the two provisions might reasonably be interpreted in different ways. how could it have happened that the supreme court, after not hearing an export clause case in over seventy years, suddenly rejected the timehonored understanding that the export clause and the import-export clause have a core of common meaning? i have a couple of theories. one is straightforward: some of the justices who favored treating the export clause as if it were sui generis might have been uncomfortable with questioning the national taxing power. overturning 70 florida tax review [vol.6:1 345. see supra notes 198-200 and accompanying text. 346. she jo ined justice kennedy’s dissent. 347. dep’t of revenue of wash. v. association of wash. stevedoring cos., 435 u.s. 734, 757 (1978). as i’ve noted, nothing in the export clause limits the prohibition to taxes measured by the value of the taxed goods. see, e.g., supra 142 and accompanying text. 348. the government argued in ibm that a tax failed the export clause only if it discriminated against exports, and it cited developments in import-export clause jurisprudence in support of that proposition. see supra note 84. however, justice thomas’s opinion for the court suggested that import-export clause cases hadn’t held that a nondiscriminatory levy was permissible. see ibm, 517 u.s. at 86 1; supra note 132. 349. because the import-export clause and the export clause are directed at different sovereigns, cases generally don’t require analyzing both provisions, so it’s not surprising that no one was paying attention to the relationship between the two. a revenue statute was unusual enough in the late twentieth century; doing so twice in two years was extraordinary. justice ginsburg’s opinion in u.s. shoe, which stressed the unique nature of the export clause,345 was written by someone who had already shown her distaste for an expansive interpretation of the clause in ibm.346 cabining the export clause, as her opinion for the court in u.s. shoe did, may have been a form of damage control. a second, more elaborate theory is probably closer to the truth. in the years between 1923 and 1996, the court was deciding cases under the importexport clause and ignoring the export clause. the import-export clause became increasingly permissive as the court, for whatever combination of reasons (boredom?), became less and less willing to see state prerogatives limited by the export clause. for one thing, even though the export clause doesn’t say so, the court had stated that, if a tax didn’t “relate[] to the value of the goods, [it wasn’t] taxation upon the goods themselves.”347 and the court had hinted, without resolving the question directly, that a state levy was invalid under the import-export clause only if it discriminated against imports or exports.348 at the same time, because the court was hearing no export clause cases, no one was paying attention to the fact that the rules being applied under the import-export clause were becoming far removed from what had been traditionally understood to apply under the export clause.349 that result shouldn’t be surprising. start with two bodies of law that are governed by a common core of principles, but then focus judicial effort on only one of the bodies of law. at the end of the day, and certainly at the end of seventy years, the original principles may have been stretched out of shape in the active area of the law. notwithstanding stare decisis, courts do make changes in doctrine over time, and the cumulative effect of several decades worth of incremental changes can be dramatic. 2003] the export clause 71 350. it’s worth noting that justice thomas, in his opinion for the court in ibm, hinted that the import-export clause cases might not be as permissive as they’ve generally been interpreted to be. for example, contrary to conventional wisdom, he suggested that a state duty needn’t discriminate against imports or exports to be subject to that export clause. see supra note 132. maybe the reconciliation of the two clauses has already begun. 351. but see bush v. gore, 531 u.s. 98 (2000) (concluding that equal protection analysis in case should be limited to particular facts – i.e., that a single provision can have different meanings in different contexts). 352. maybe the understanding of what constitutes a “user fee” should be extended to non-tax provisions as well, see supra note 197 (citing user fee cases arising under other provisions), but at least there should be conformity among the various taxing clauses. only in 1996, when the court revisited the export clause after a long hiatus, did it become apparent that the two lines of cases were no longer compatible. if, in the interests of conformity, the court in 1996 had applied modern import-export clause jurisprudence, there would have been little left of the clause. applying permissive rules to the interpretation of a export clause that, by its terms, isn’t at all permissive simply wouldn’t have worked. to preserve a significant role for the export clause, the court had to break the historical connection between the two clauses, or so i hypothesize. under the circumstances, breaking the connection between the two clauses made sense, but chief justice marshall was still right that the clauses should be interpreted consistently. if conformity is to be reachieved, however, the court will need to reexamine the principles it developed under the importexport clause. when it does that, it shouldn’t resist making use of export clause jurisprudence.350 2. what’s a tax? – it’s not automatically the case that the term “tax” and its variants have to mean the same thing throughout the constitution, but i would use conformity in meaning as a starting point and abandon it only if absolutely necessary.351 variation in the meaning of terms in a single legal document, even (especially?) a constitution, is something we ought to resist, not to endorse. export clause cases should therefore provide useful guidance on what distinguishes a tax from other governmental exactions. at a minimum, i see no reason why the understanding that a user fee isn’t a “tax or duty” under the export clause, reaffirmed by the supreme court in u.s. shoe, shouldn’t be extended to the interpretation of other taxing provisions in the constitution.352 as i’ve argued, those provisions don’t work if interpreted to include user fees, and we don’t need a full explication of what, if anything, distinguishes a “tax” 72 florida tax review [vol.6:1 353. see supra notes 177-185 and accompanying text. 354. how much is too much will be a question of fact, to be resolved in the particular case, but assume that we can agree that, at some point, a levy is too great to be a user fee. 355. see supra note 152. 356. see supra notes 345-346 and accompanying text. 357. u.s. shoe, 523 u.s. at 368. 358. ibm, 517 u.s. at 851. from the multitude of other terms used in the constitution to distinguish between a “tax” and a “user fee.”353 this is a distinction that matters. for example, suppose congress delegates to an administrative agency the power to set the fees for services provided by the agency – such as fees for processing patent applications. and suppose the administrative agency sets a charge that greatly exceeds any amount that can reasonably be viewed as a fee.354 at least the amount of the excess (and maybe the whole charge) might be recharacterized as a “tax” – the learning in u.s. shoe as to what is, and what isn’t, a “tax” should be relevant to that determination – and, if so, there should be questions about the authority of an administrative agency to impose the tax. regardless of how broad the federal taxing power is, congress ought not to be able to delegate that power to an administrative agency. 3. review of tax statutes generally – perhaps the biggest question that arises from the court’s efforts to cabin export clause jurisprudence is this: is the court’s willingness to review taxing statutes, and to direct other courts to do the same, limited to the export clause? and if the answer to that question is “yes,” we should wonder why that should be so. in ibm and u.s. shoe, the court struck down taxing statutes on constitutional grounds, something that hadn’t happened since the 1920s.355 as i’ve suggested, treating the export clause as unique may well have been intended, by at least some justices, to leave the remainder of the congressional taxing power generally unconstrained by judicial review.356 but why should the court interpret the export clause expansively and other limitations on the taxing power narrowly? justice ginsburg in u.s. shoe pointed to the export clause’s being an “unqualified prohibition” as one reason for treating the export clause as different from other tax provisions in the constitution,357 and, in ibm, justice thomas noted the clear “textual command” of the export clause as a distinguishing factor.358 but the export clause isn’t fundamentally different, in either respect, from other limitations on the national taxing power. the export clause is “unqualified” in a way – when it applies, it’s a command without reservations – but the export clause applies only to levies on “articles exported,” a fairly significant qualification. in any event, compare 2003] the export clause 73 359. see u .s. const. art. i, § 2, cl. 3; u.s. const., art. i, § 9, cl. 4. income taxes were exempted from the apportionment requirement by the sixteenth amendment. u.s. const. amend. xvi. 360. see u.s. const. art. i, § 8, cl. 1. this has been interpreted to require only geographical uniformity: “if a particular item is subject to tax, it must be taxed at the same rate throughout the united states. . . .” boris i. bittker, constitutional limits on the taxing power of the federal government, 41 tax law. 3, 10 (1987); see knowlton v. moore, 178 u.s. 41, 83-106 (1900). the export clause to, say, the direct-tax apportionment clauses, which absolutely prohibit direct taxes that haven’t been apportioned on the basis of respective state populations,359 or the uniformity clause, which absolutely prohibits duties, imposts, and excises that aren’t uniform.360 in fact, the form of the direct-tax apportionment clause in article i, section 9 is identical to the form used for the export clause: “no capitation, or other direct, tax shall be laid” versus “no tax or duty shall be laid.” if the export clause contains a clear “textual command,” so, too, does that direct-tax clause. if congress were to enact an unapportioned direct tax – a national real-estate tax would be the clearest case – or a duty on imports that wasn’t uniform, a court should be just as willing to reject the levy as the supreme court was in ibm and u.s. shoe. perhaps one can infer from the language in both ibm and u.s. shoe that the court is unlikely to be as vigorous in enforcing other limitations on the taxing power as it was with the export clause, and i can understand the reluctance to get involved. maybe the export clause is so peculiar that we should draw no grand conclusions about the supreme court’s willingness to hold taxing statutes, outside the export context, to constitutional requirements. maybe, but i don’t see why. iv. conclusion: the export clause today the export clause was understood, at the time of the founding, to be a critical limitation on the national taxing power, and supreme court cases interpreting the clause gave it great scope. but until ibm and u.s. shoe came along in the 1990s, the cases that treated the export clause seriously were from a period, before 1924, in which the court was generally skeptical of the national taxing power. one might have expected modern developments to have reoriented the understanding of the export clause, just as modern developments have led to the widespread understanding that the national taxing power is largely unconstrained by the constitution. with the export clause, however, that didn’t happen. neither ibm nor u.s. shoe rejected the old doctrines. quite the contrary: both cases applied interpretational principles derived from decades-old cases. the export clause was revived as a limitation on the national taxing power, and the old cases interpreting the export clause were revived as sources of guidance. 74 florida tax review [vol.6:1 361. 262 u.s. 66 (1923); see supra notes 314-324 and accompanying text. 362. spalding, 262 u.s. at 70. 363. see lawrence zelenak, radical tax reform, the constitution, and the conscientious legislator, 99 colum. l. rev. 833 (1999). 364. i’m not entirely convinced . see jensen, taxing power, supra note 8, at 1154-58. 365. deference to congress may be appropriate when the question is whether a taking is for a “public purpose” or whether a statute serves the “general welfare .” those constitutional phrases were once thought to be judicially enforceable, but it’s now conceded to be up to congress to define “public purpose” and “general welfare.” see jensen, taxing power, supra note 8, at 1059, 1090-91. in contrast, questions that arise under the export clause – wha t’s a tax? when’s a good an “exported article”? – lend themselves to judicial resolution, as more than a century of jurisprudence indicates. one point of guidance that hasn’t received the notice it deserves comes from justice holmes’s 1923 opinion in spalding,361 striking down a tax as it applied to exportation of baseball equipment. the dispute was a difficult one, with case law providing no definitive means of resolution. justice holmes concluded, however, that, in a doubtful situation, exports should be provided “liberal protection” to ensure that constitutional values would be protected.362 i interpret this idea as meaning that, when the status of a taxing statute is in doubt, the export clause applies. giving “liberal protection” for exports is a rule of interpretation for the judiciary, but it’s also a useful guide for congress, which should tread lightly when imposing taxes with effects on exportation. congress should legislate with more sensitivity to constitutional limitations in taxation than has been the case for several decades. professor zelenak has argued that “conscientious legislators” effectively define what constitutes income subject to the modern income tax, and legislators shouldn’t have to worry whether every conceivable variation in income tax policy might cause the tax as a whole not to be a “tax on incomes” within the meaning of the sixteenth amendment.363 deference to legislative determinations is inevitable, zelenak argued, in the income tax context. whatever the merits of professor zelenak’s position for the income tax,364 it shouldn’t be extended to other levies. there’s no reason to defer to the “constitutional” determinations of a legislative body that pointedly doesn’t evaluate the constitutionality of its enactments. if we’re to defer to legislators’ views, we should, at a minimum, insist that legislators make a good faith effort to resolve constitutional issues in the drafting process.365 a congress that enacts something called a “tax” which will obviously affect exportation, and does so 2003] the export clause 75 366. indeed, it’s because we might think of deferring to congress’s characterization of the hmt as a “tax” that the constitutional issue becomes so apparent. see supra notes 162-165 and accompanying text. 367. see supra notes 39-48 and accompanying text. without consideration of constitutional issues – exactly what happened with the harbor maintenance tax – isn’t made up of conscientious legislators.366 of course one might argue that this is much ado about nothing; maybe it’s time for the export clause simply to disappear from the constitution. the fears of sectional strife that gave rise to the clause are weaker in 2003 than they were in 1787, but, even if that weren’t true, it’s doubtful that without the export clause we’d see strife reflected in discriminatory taxation of exports. and the clause has its embarrassing history. although i think something like the export clause would have wound up in the constitution anyway, the clause did have an unfortunate connection with slavery.367 besides, the export clause is a peculiarly limited protection against abuse of the national taxing power: when it applies, it has great effect, but it applies only within a narrow area. as sources of revenue largely unknown to the founders have come to dominate the national taxing system – the income tax in particular – a limitation on the national power to tax exports may seem to be an anomaly. nevertheless, there are at least three reasons to care about the export clause. first, like it or not, the clause is in the constitution, and it’s not going to disappear in the near future. second, the supreme court in ibm and u.s. shoe took the clause seriously, which means that we have to, too. finally, and most important, the court showed in those two cases that it’s now willing, at least occasionally, to evaluate the constitutional merits of a federal revenue statute. if the export clause isn’t unique in its fundamentals, and i’ve argued that it isn’t, the long-time assumption that the judiciary will keep its collective hands off the national revenue system may no longer be justified. page 1 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 page 16 page 17 page 18 page 19 page 20 page 21 page 22 page 23 page 24 page 25 page 26 page 27 page 28 page 29 page 30 page 31 page 32 page 33 page 34 page 35 page 36 page 37 page 38 page 39 page 40 page 41 page 42 page 43 page 44 page 45 page 46 page 47 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volume 20 2017 number 6 iii editor-in-chief charlene luke professor of law university of florida associate editors university of florida yariv brauner hugh culverhouse eminent scholar karen burke richard b. stephens eminent scholar dennis a. calfee professor of law patricia e. dilley professor emeritus michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law martin j. mcmahon, jr. james j. freeland eminent scholar adam smith visiting assistant professor lee-ford tritt professor of law samuel c. ullman adjunct professor of law steven j. willis professor of law board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university– bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate student editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell kathleen duggan pfahlert executive assistant jessica e. joseph uf law 2017 fl tax review 20-6 r2.pdf 3 5/4/2017 2:18:33 pm florida tax review volume 20 2017 number 6 iv information for contributors the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law. the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the florida tax review prefers electronic submissions sent via expresso (https://www.bepress.com/products /expresso/); articles may also be e-mailed to ftr@law.ufl.edu as a microsoft word document. if a hard copy submission is necessary, please mail your article to editor-in-chief, florida tax review, university of 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citations to regulations are to treasury regulations promulgated under the internal revenue code of 1986, as amended, unless otherwise indicated. uf law 2017 fl tax review 20-6 r2.pdf 5 5/4/2017 2:18:33 pm uf law 2017 fl tax review 20-6 r2.pdf 6 5/4/2017 2:18:33 pm login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 5 2001 number 2 contingencies and the estate tax wendy c. gerzog* l introduction ...................................... 50 ii. a review of contingencies and estate tax code sections ........................................... 53 a. section 2033: the mathematical rule ............... 53 b. section 2034 and the inclusion of marital expectancies 59 c. section 2036 and the dominant role ofabuse prevention .................................... 59 1. an overview ............................ 60 2. contingent retained life estates and section 2036: overkill or justified policy decision? ........ 64 d. section 2037: an express de minimis rule .......... 71 1. background of section 2037 ................ 71 2. the five percent rule .................... 77 e. section 2038: powers vested at decedent's death ..... 79 f. section 2039 and its relationship to sections 2036 and 2037 ......................................... 83 g. section 2040: a statute with artificial rules of inclusion ..................................... 88 h. section 2041: parallels to sections 2033 and 2036-2038 ................................. 91 1. background and introduction to section 2041.. 91 2. contingencies and section 2041 ............. 97 i. section 2042: a de minimis rule for certain remote contingencies ................................. 99 m. proposed solution ................................ 103 a. contingencies and decedent's control ............. 103 b. problems with de minimis rules ................. 105 c. why categorizing transfers as essentially testamentary or inter vivos does not solve the problems ofdecedentcreated contingencies .......................... 105 * professor, university of baltimore school of law; b.a., clark university 1968; m.a., assumption college 1971; j.d., university of akron 1976; ll.m., george washington university 1979. i would like to thank robb longman and susan mason, my research assistants, as well as barbara jones, my secretary, for all of their help. florida tax review i. introduction contingencies... may assume an infinite variety of shapes and forms to suit the needs of the transferor. a stated contingency may represent a strong probability, and perhaps even a practical certainty, that the property will shortly return to the transferor. on the other hand, the possibility of regaining the property may be so remote as to be essentially nonexistent.' as one federal court reiterated, "the basic purpose of the estate tax 'is to bring within the gross estate of the transferor that which he gave upon a contingency terminable at his death." 2 contingencies3 indicate probabilities. if a decedent dies owning a lottery ticket, the value of that ticket is included in his gross estate. in this instance, the decedent owns the property and it is just the nature of the property itself that involves a contingency related to its value. because the lottery has not yet occurred, the value of that ticket would be its cost, reflecting the unlikelihood that decedent, like any other lottery ticket owner, is holding a "winning" ticket.4 if decedent can possess other types of property that depend on the happening of an event that has not occurred at his death, should that unvested property be included in his gross estate, although similarly discounted to reflect that probability? on the other hand, what if decedent's death extinguishes the possibility that he will ever own the property? in that instance, should the testamentary nature of the transfer and abuse potential require an artificial rule of inclusion at full value? in that context, to what extent should the fact that the contingency is donor created affect inclusion and valuation 1. u.s. treas. dept., federal estate and gift taxes: a proposal for integration and for correlation with the income tax 31 (1947) [1947 treas. proposal]. 2. looney v. united states, 569 f.supp. 1569, 1571 (m.d.ga. 1983), citing broderick v. keefe, 112 f.2d 293, 296 (1st cir. 1940). 3. as used in this article, contingent interests include all types of property interests that are subject to the risk of non-possession. they, therefore, include vested interests subject to defeasance. the restatement of property has noted the confusion of terminology in this context. see restatement of property § 157 (1937) ("the term 'contingent remainder' has been used too frequently in a loose manner to designate any remainder involving an uncertainty."). i apologize if i am inappropriately adding to this ignorance. 4. this treatment may be contrasted to a lottery winner's winnings that are included in his estate, although not necessarily at the payments' actuarial value as the right to future payments may be subject to restrictions. see estate of shackleford v. united states, 98-2 u.s. tax case (cch) 60.320, at 86, 531-32, 82 a.f.t.r. 2d (p-h) 98-5538, 98-5543-44 (e.d. cal. 1998) (holding on motion for summary judgment that if the decedent's estate could demonstrate that the value of decedents right to future lottery installment payments would be almost forty percent lower than the regulations' approach by taking into account restrictions on marketability, then a departure from the regulations' annuity tables would be warranted.) cf. estate of gribauskas v. commissioner, 116 t.c. no. 12 (2001). [vol 5:2 contingencies and the estate tax rules? overall, should there be any de minimis rule to deal with remote contingencies? currently, the treatment of contingent interests for estate tax purposes s varies depending on what code section is applicable. consequently, there are instances when contingent interests are included in decedent's gross estate at different values. that is, some are included at the full fair market value of the property;6 some are included at a value discounted to reflect probabilities;7 and some are excluded altogether.' inclusion with valuation adjustments, i.e., a purely mathematical rule, provides the most even treatment of contingencies. with such a rule, the remoteness or minimal value of a contingency is reflected in the general rule of discounting for unlikely contingencies so that there is no need for a de minimis exception to avoid what might be considered the harsh result of alternative full date-of-death value inclusion rule. essentially, all valuation inherently involves approximation; contingencies complicate the mathematics of valuation and possibly increase reliance on expert appraisals9 but do not change any of the fundamental rules of valuation. even that added difficulty is alleviated or eliminated by focusing on burden of proof. part of the difficulty inherent in formulating a consistent treatment of contingent property interests is a feeling that a too attenuated or too unlikely contingency should be disregarded. at common law, contingencies were indeed "disregarded" or "destroyed" because they resembled "mere 'possibilities"' '0 or expectancies. they were considered potential interests and were not 5. in the gift tax area, a transfer of a contingent interest in property is taxable. see dickman v. commissioner, 465 u.s. 330, 335 (1984), ("the court has also noted that the language of the gift tax statute 'is broad enough to include property, however conceptual or contingent'... .") citing smith v. shaughnessy, 318, u.s. 176,180 (1943). yet, courts have held that gifts of contingent interests that are difficult to value either will not be taxable transfers or will be theoretically taxed but given a zero value. this article is concerned only with the estate tax inclusion sections; however, contingencies related to the gift tax or to estate tax deductions will likely be the subject of another article. 6. see infra parts ii. c, ii. g. and accompanying discussion. 7. see infra part ii. a. and accompanying discussion. 8. see infra part ii. d. and accompanying discussion. 9. expert appraisal is already required, under the regulations, for certain property. see, regs. § 20.2031-6(b) (requiring professional appraisals with respect to household and personal effects, such as "jewelry, furs, silverware, paintings, etchings, engravings, antiques, books, statuary, vases, oriental rugs, coin or stamp collections" valued at more than $3,000). 10. restatement of property, § 162 (1936). "contingent remainders and executory interests are clearly no longer thought of as mere possibilities of receiving an interest in the future. rather, they are thought of as present interests in which the right to possession is postponed and uncertain." lawrence w. waggoner, et al., family property law: cases and materials on wills, trusts, and future interests 957 (2d ed. 1997). the doctrine ofdestructability of contingent remainders, although originating from the need for continuous seisin, also encouraged the alienability of land. see jesse dukeminier & james e. krier, property 295 (3d ed. 1993). 2001] . florida tax review alienable during the decedent's lifetime; they were descendible and devisable only if they survived the decedent's death." in a sense, de minimis contingent interests are only notches a little further along that continuum, greater than mere expectancies, but not much more so. extending this perspective, a rule involving more likely probabilities, such as a "more-likely-than-not" rule, 2 could also be imposed to subject to estate taxation only those property transfers that will probably vest and to ignore contingencies with a probability of 50% or less. 3 alternatively, creating a uniform rule might well require an examination of how the issue of control, which is central to transfer taxes, applies to contingencies. where contingencies are the product of the donor, or essentially the donor, 4 perhaps contingencies should be ignored or interpreted against the interests of the donor.'5 after all, the donor initially controls whether or not to insert a contingency and, even at that time, can decide whether or not to impose it after evaluating the probabilities of the interest returning to him. in a way, contingencies within decedent's control are not real contingencies. since the donor controls whether or not to qualify an interest with a contingency, the risk factor is, to a great extent, undermined. an argument can be made that contingencies created by decedent have a potential for abuse that warrants no discounting to reflect risk. thus, in constructing a rule about contingencies, one may want to distinguish between those contingencies within the decedent's control and those not within his control. more specifically, arule might need to distinguish between those contingencies initially within the decedent's control (regardless of whether he creates a 11. thus, interests extinguished by the condition of decedent's death are not descendible or devisable. id. at 296. dukeninier & krier, supra note 10, at 296. 12. the treasury department proposed the adoption of a more-likely-than-not rule to determine the taxability of reversions as either completed gifts or as testamentary transfers. u.s. dept. of the treasury, 2 tax reform for fairness, simplicity, and economic growth: the treasury department report to the president, reprinted in 52 fed. tax. (p-h) § 3, 59,476 (1984) [hereinafter 1984 treasury reform]. where it was more probable that the property would revert to the transferor, the transfer was an incomplete gift and subject to estate taxation; by contrast, where it was more probable that the property would not revert to the donor, there would be a gift taxed at the property's full value (without reduction for the reversion). id. at 378-80. the likelihood of a reversion would be determined by reference to actuarial determinations of estimates of the donor's (and other relevant individuals') life expectancy. id. at 380. subsequent transfers of any reverted property would reflect and be offset by applicable previous transfer tax. id. 13. a greater than 50% (a more-likely-than-not) rule has the appeal of simplicity; however, such a rule might create additional complexity by encouraging the creation of and combination of such contingencies in trust instruments. moreover, such a rule creates too great an exception to the general rules of inclusion without supplying a cogent rationale to except them. 14. the prohibition may be extended to certain related individuals and entities. 15. this may be characterized as "the rule in robinette" despite some courts' misreading of that case. see infra note 137. ['vol. 5:2 contingencies and the estate tax contingency that he cannot control) and those over which he has never had any control. indeed, in the instance of donor-created contingencies, an artificial rule of full inclusion more successfully prevents tax avoidance. thus, where there exists a great potential for donor manipulation, an artificially constructed rule, with its simplicity and clarity, could apply to ignore all uncertainty and to include the full value of the property in decedent's gross estate. ii. a review of contingencies and estate tax code sections16 a. section 2033: the mathematical rule section 2033 of the internal revenue code,17 a section that remains essentially the same as its predecessor sections,18 includes all property interests that decedent owned at death. property included in decedent's estate under section 2033 is valued according to the rules in section 2031.19 in determining fair market value, "[a]ll relevant facts and elements of value as of the applicable valuation date shall be considered in every case."'2 where a contingent interest 16. this article contains a discussion of the estate tax inclusion under §§ 2033-2034, 2036-2042 and omits any discussion of estate tax § 2035 that includes certain completed gifts in decedent's estate as testamentary transfers. because of§ 2035(a)(2), releases within three years of death of interests that had they been retained at decedent's death would have caused inclusion in decedent's estate under §§ 2036-2038 and 2042 are included in the estate. irc § 2035(a). in this way, deathbed transfers of a "taxable string" or retained interest or power will not avoid estate taxation, and the property will be valued as of decedent's death. likewise, insurance proceeds, that greatly exceed the lifetime value of an insurance policy, are taxed in decedent's estate at that higher value. irc § 2042. section 2035(b) includes the value of the gift tax paid with respect to all taxable gifts made within three years of decedent's death, but § 2035(a) excludes most completed gifts made after 1976. irc § 2035. since § 2035 relates to other estate tax sections, the article addresses them individually, under their specific code sections, rendering an additional review unnecessary. id. 17. section 2033 provides: "the value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death." irc § 2033. 18. this statute was originally enacted in the revenueact of 1916. pub. l. no. 64-271, § 200, 39 stat. 756, 777. initially, § 2033 was codified as § 811(a), in the 1939 code. see internal revenue act of 1954, pub. l. no. 83-591, 68a stat. 1 app. at 931 [hereinafter 1954 code] (comparing provisions in the 1939 code with complimentary provisions in the 1954 code); s. rep.1622, 83d cong., 2d sess. 468 [hereinafter 1954 s.rep.] (noting that § 2033 in the 1954 code corresponded to § 811(a) in the 1939 code). for a briefperiod, the statute excluded real property outside the united states. 1954 code, supra, § 2033, 68a stat. at 381. the exception was deleted effective for decedents dying after october 16, 1962. see revenue act of 1962, pub. l. no. 87-834, § 18, 76 stat. 960, 1052. 19. the regulations under § 2031 indicate that valuation under each estate tax code section (from §§ 2031-2044) should reflect the property's fair market value. "the fair market value is the price at which the propertywould change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." regs. § 20.2031-1(b). 20. id. 20011 florida tax review terminates at decedent's death, like with vested terminating interests, nothing is included under section 2033.21 as the regulations explain, section 2033's inclusion of all of decedent's surviving property interests means "all property, whether real or personal, tangible or intangible, and wherever situated, beneficially owned by the decedent at the time of his death., 22 the irs has maintained that the phrase includes any beneficial interests in a trust that decedent owns at death even though created under another's revocable trust as long as that interest is "descendible, devisable, and alienable" under local law.23 therefore, while the value of an interest that is subject to alteration and complete divestment would reflect those contingencies, the irs has ruled that: [t]he mere presence of these possibilities does not warrant the assignment of a merely nominal value to such a defeasible interest in any case where there is still a reasonable probability that the estate will actually acquire possession of at least some substantial portion of the property in question.24 similarly, the court in hill's estate held includable a decedent's reversionary interest that was contingent on the trustee's determination that some part of the trust corpus was not needed for trust administration on the death of either the decedent's wife or the decedent's daughter.25 although the court explained that "[t]he amount of corpus returnable to the decedent's estate under these provisions of the trust is somewhat speculative and admits of no accurate determination, . . . we cannot doubt that the right had value at the date of the settlor's death., 26 whether contingent or vested, inclusion of an interest under section 2033 depends on whether the interest is transferable under local law. although most states allow for the alienation of contingent interests,27 in a minority of states, only vested interests are includable in the decedent's estate. for example, in a case involving the grandchild exception to the 1986 generationskipping transfer tax legislation, the court needed to determine whether the 21. see, e.g., rev. rul. 75-145, 1975-1 c.b. 298. while interests extinguished at death are not included in decedent's estate, those extinguished by will are includable. see, e.g., regs. § 20.2033-1(b). ("notes or other claims held by the decedent are likewise included even though they are cancelled by the decedent's will."). promissory notes extinguished by decedent's death will be included in decedent's estate unless they were calculated as part of the bargained for consideration given for the notes. estate of moss v. commissioner, 74 t.c. 1239 (1980), acq. in result in part, 1981-2 c.b. 2. 22. regs. § 20.2033-1(a). 23. see rev. rul. 67-370, 1967-2 c.b. 324. 24. id. 25. in re hill's estate v. commissioner, 193 f.2d 724 (2d cir. 1952), acq., 195 1-1 c.b. 1. 26. hill's estate, 193 f.2d at 728. 27. see, restatement of property, § 162 (1936). [vol 5:2 contingencies and the estate tax assets of the trust would be in the grandchild's estate should he die before the trust's termination. in focusing its examination on section 2033, the court stated: "generally, if interests are contingent, they are not includable in the decedent's gross estate, whereas, if the interests are vested, then they are includable in the gross estate under section 2033."28 because of michigan's preference for early vesting, the court found that the interest in question would have vested in the grandchild and thus fell within the statutory language.29 sometimes, under state law a contingent interest does not make the owner a beneficial owner. since the statute and regulations require that decedent "beneficially" own the property for section 2033 to apply,30 in those instances, property over which decedent has a contingent interest will not be included under that section. for example, although the court in arrington v. united states3" held for the government, the issue was still whether the interest was vested or contingent, the answer to which question determined beneficial ownership and, consequently, estate taxation.3 2 specifically enumerated in the regulations under section 2033 are claims decedent held at his death, whether or not cancelled by his will.13 likewise, the irs has maintained that possible claims from potential wrongful death actions that relate to the decedent's pain and suffering are includable in decedent's gross estate.34 property subject to section 2033 includes the right to future property and as such includes contingent fees 35 28. comerica bank v. united states, 93 f.3d 225, 228 (6th cir. 1996). 29. id. at 229. 30. see regs. § 20.2033-1(a). 31. 34 fed. cl. 144 (1995), aff'd, 108 f.3d 1393 (fed. cir. 1997). 32. arrington, 34 fed. cl. at 147-48. 33. regs. § 20.2033-1(b). 34. rev. rul. 75-127, 1975-1 c.b. 296 (finding that damages under any state with a "survival" type wrongful death statute with no recovery for pain and suffering are not includable in decedent's estate but also ruling that damages for the decedent's pain and suffering were includable); rev. rul. 69-8, 1969-1 c.b. 219 (ruling damages for pain and suffering under the federal death on the high seas act are includable in decedent's estate). rights that emerge after decedent's death are not includable in decedent's estate under § 2033. see connecticut bank & trust co. v. united states, 465 f. 2d 760, 763 (2d cir. 1972). 35. see estate of curryv. commissioner, 74 t.c. 540,545-47 (1980) acq., 1981-2 c.b. 1; rev. rul. 55-123, 1955-1 c.b. 443. but see estate of nemerov v. commissioner, 15 t.c. memo. (cch) 855, t.c. memo. (p-h-) 56,164, at 56-696 (1956) (holding that where attorney's fees were undeterminable at decedent's death and where no quantum meruit claim could have been sustained at that time, nothing was includable in decedent's estate although the decedent had performed some work on the cases, because no right ofrecoveryhad accrued at decedent's death). 200] and the like.36 in estate of curry,37 the court held that decedent's interest in contingent fees associated with thirteen pending cases before the indian claims commission was includable, rej ecting the taxpayer' s argument that "contingent fees are not includable in the gross estate because there is no compensable interest as of the date of death."38 moreover, the court "rej ect[ed] petitioner's contention that because the claims here involved had not been reduced to judgment, they were too remote and speculative to be valued."39 along those same lines, the board of tax appeals held that executor's fees earned by decedent before his death, although not at the time reviewed by the probate court and thus not accrued for income tax purposes, were nonetheless includable in decedent's estate as choses in action.4" similarly, in simmons41 the court rejected the estate's argument that the decedent's income tax refund claim had a zero value at decedent's death. indeed, even if, as the estate claimed, decedent did not know about the claim,42 the court reversed and remanded the district court's decision "because there was no rational basis for the jury's finding that the claim for an income tax refund was valueless on the date of the decedent's death."43 recently, in estate of smith,4 the court held that the decedent's right to section 1341 relief was an asset of her estate and rejected the estate's argument that because repayment to exxon pursuant to a settlement agreement achieved over a year after the decedent's death was a pre-condition to section 1341 relief, decedent's right to that benefit did not exist at her death.45 while 36. a promise to return property to the estate where the estate had insufficient assets to satisfy its tax liability was held to be property includable under § 2033. welch v. hall, 134 f.2d 366 (1st cir. 1943); first victoria nat'l bank v. united states, 620 f.2d 1096, 1107 (5th cir. 1980). 37. 74 t.c. 540 (1980). 38. estate of curry, 74 t.c. at 545. in valuing these interests, the court considered the extent to which the claims had been pursued, decedent's success at similar actions, and the probability of success in these cases as determined at decedent's date of death. the court rejected the government's argument that the claims be valued at the amount ultimately recovered by the estate. 39. id. at 547. 40. estate of mcglue v. commissioner, 41 b.t.a. 1199 (1940). the court included these fees at the value equal to one-half (he was co-executor) of the amount claimed as a deduction for executor's fees on that decedent's estate tax return. 41. united states v. simmons, 346 f.2d 213 (5th cir. 1965), rev'g and remanding 12 a.f.t.r.2d (ria) 6291, 63-2 u.s.t.c (cch) 12176 (s.d. ga. 1963). 42. see also bank of california v. commissioner, 133 f.2d 428, 432 (9th cir. 1943) (holding that an income tax refund claim, not yet made at decedent's death, was nevertheless an includable property interest in decedent's estate). 43. simmons, 346 f.2d at 215. 44. estate of smith v. commissioner, 108 t.c. 412 (1997), rev'd and remanded (on the issue of valuation of that interest), 198 f.3d 515 (5th cir. 1999), nonacq., 2000-19 i.r.b. 962. 45. estate of smith, 108 t.c. at 426. florida tax review [vol. 5:2 contingencies and the estate tax the fifth circuit reversed the tax court on a different issue,46 both courts agreed that the section 1341 claim was an asset of decedent's estate includable under section 2033.47 in addition, estate of smith held that fair market value includes potential tax benefits. in the instant case, the tax event that was looming on the horizon at the date of death is the converse of the one in eisenberg: rather than a potential future tax detriment, as was the case in eisenberg, here there was a potential future tax benefit to the estate, which would ripen in the event that it were to repay to exxon, in whole or in part.4" thus, the court cited to49 and analogized its decision to the recent trend of some courts to'allow a discount for built-in capital gains.50 if a contingent liability can affect valuation, the court reasoned, a contingent benefit must also be included in decedent's estate. according to the regulations, valuation of present and future interests in property, such as life estates of third parties or remainder interests owned by the decedent, is made by reference to the actuarial tables."' those tables calculate the present value of partial interests in property by estimating the relevant individual's life expectancy as well as by assuming a constant interest 46. the circuit court reversed the tax court's adoption of post-death facts to value an uncertain claim that ultimately gave rise to an amount refundable under § 1341 in a claim filed subsequent to decedent's death. estate of smith, 198 f.3d at 527-28. 47. id. at 527 ("we agree with the commissioner and the tax court that the contingent right to future income tax relief under section 1341, based on pre-death events, is a factor that must be taken into account in connection with the estate and that the contingent nature of the benefit merely affects its date-of-death value."). 48. id. at 528-529. 49. id. (citing to the second circuit's decision ineisenbergv. commissioner, 155 f.3d 50 (2d cir. 1998)). 50. see, e.g., davis v. commissioner, 110 t.c. 530 (1998) (the court allowed the reduction for built-in capital gains in valuing stock, although no sale was anticipated, because since 1986, if there were such a sale, the tax could not be avoided); eisenberg v. commissioner, 155 f.3d 50 (2d cir. 1998), rev'g, 74 t.c. memo. (cch) 1046, t.c. memo. (ria) 97,483 (1997) (in a gift tax case involving the value of stock, the second circuit allowed a discount for the amount of taxable gain that could have resulted had there been a sale of the building that was the main asset of the company. this discount was allowed despite the fact that there was no intention to sell the building or liquidate the company. the tax court had denied the reduction "where the evidence failed to establish a liquidation or sale of the corporation or its assets is likely to occur, reasoning the tax liability is purely speculative." t.c.m. at 1048.); estate of jameson v. commissioner, 77 t.c. memo. (cch) 1383, t.c. memo. (ria) 99,043 (in valuing stock, the court took into account the company's built-in capital gains and a small marketability discount.). cf. armstrong v. united states, 85 a.f.t.r.2d (ria) 1320 (w.d. va. 2000), wherein, in the gift tax area, the court refused to reduce the value of stock by an illusory assumption ofgift tax liability by the donee. 51. see regs. § 20.2031-7. 2001] florida tax review rate equal to the current market rate. deviation from the tables may only occur in very limited circumstances, such as when the taxpayer is suffering from a terminal disease. 2 thus, these types of interests are dependent on the probability that the individual's actual life duration will match the average person's. they also incorporate a continuous interest rate over that duration that is not likely to reflect actual rates since that rate is not likely to remain the same over that period. further, the government has acknowledged the difficulty posed by valuing contingent interests that are not subject to ordinary rules of actuarial valuation and has stated that the general rules of valuation as expressed in the regulations should apply. 3 thus, for example, to value a remainder interest that is subject to being reduced by additional children either born or adopted by his fifty-three year old mother, ... the actuarial value of the decedent's remainder interest ascertained by the formula set forth in section 20.2031-[7t(d)] of the regulations, should be the starting point. consideration should then be given to all known facts and circumstances that might tend to decrease such value, with due regard for (1) the certainty that a woman who has reached the age of 53 years will not bear children is far greater than that which attends most other human affairs and (2) the unlikelihood that a woman of that age will adopt a child.54 section 2033 includes property that inherently involves risks and difficulty in valuation. in first victoria national bank v. united states,55 the court held the transfer of a rice production history was includable under section 2033 since it was comparable to goodwill that "has value only because it carries the expectancy of receiving future assets of more concrete value."56 likewise, an author's name that could be devised was includable and valued with respect to contracts decedent had entered into before her death, subject to discounting to reflect the uncertainty of the value of the name continued on ghostwritten novels of the same genre subsequent to her death. 7 in estate of andrews,58 while the estate had omitted the decedent's name as an asset of the estate on the estate tax return,59 the court underlined the importance of her name as contributing to the success of the first post-death, ghostwritten, novel.6" thus, 52. see regs. § 20.7520-3(b). 53. see regs. § 20.2031-1(a); rev. rul. 76-472, 1976-2 c.b. 264. 54. rev. rul. 76-472, 1976-2 c.b. 264. 55. 620 f.2d 1096 (5th cir. 1980). 56. first victoria nat'l bank, 620 f.2d at 1106. 57. the court substantially discounted the contract amount by the risk associated with an inability to produce a novel agreeable to the publisher. see estate of andrews v. commissioner, 850 f.supp. 1279, 1291 (e.d. va. 1994). 58. id. at 1279. 59. id. a decedent's name is an unusual property interest. see state ex re elvis presley international memorial foundation v. crowell, 733 s.w.2d 89 (1987). 60. estate ofandrews, at 1286. [vol. 5:2 contingencies and the estate tax while valuation was subject to contingencies, the asset, although unusual, was clearly includable under section 2033, but discounted to reflect uncertainty of the success of the novels written by others under decedent's name after her death. essentially, all "property," as used in the section 2033 includes contingent interests, including all choses in action,61 although valuation may reflect substantial discounts due to the property's contingent nature and although valuation may be problematic and inexact.62 that is, except where contingent interests are excluded because they are not beneficially owned by the decedent under state law, property interests subject to section 2033 are included at a value that reflects the uncertainty of the contingency attached to or inherent in the property interest. b. section 2034 and the inclusion of marital expectancies section 2034 requires that the value of the surviving spouse's dower, curtesy, or statutory share interest be included in the decedent's estate.63 these interests that belong to another onlybelongto them, contingently, at decedent's death or, potentially earlier, in the case of divorce. from 1918,' they were specifically included in decedent's estate as long as, under local law, decedent was not prohibited from ever acquiring an interest in such property. most of the cases brought under section 2034 involve issues of adequacy of consideration for a spouse's relinquishing these interests" and the corresponding deductibility of a claim under section 2053.66 marital property interests that are included in decedent's estate under section 2034 are included in basically the same way that property is included under section 2033. c. section 2036 and the dominant role ofabuse prevention 61. estate of curry, at 545. 62. id. at 546-547 ("however, the contingent nature of the contract right must bear on the factual question of valuation. it cannot, as a matter of law, preclude the inclusion of the interest in the decedent's gross estate or command that the value be fixed at zero .... valuation for estate tax purposes frequently involves difficult and somewhat imprecise calculations."). 63. irc § 2034. 64. revenue act of 1918, pub. l. no. 65-254, § 402(b), 40 stat. 1057, 1097 (1918). 65. see, e.g., empire trust co. v. commissioner, 94 f.2d 307 (1938); estate ofbyram v. commissioner, 9 t.c. 1 (1947). most involve adequacy ofconsideration under § 2043. section 2043(b) specifically denies that relinquishment of these rights are "consideration 'in money or money's worth,"' except for the purposes of a § 2053 debt of the estate to the extent that the transfer satisfies § 2516(1). irc § 2043(b). 66. see, e.g., estate of herrmann v. commissioner, 85 f.3d 1032 (2d cir. 1996). 20011 1. an overview.-under section 2036,67 if a decedent makes an inter vivos transfer of property but retains for himself during his lifetime either a life interest in that property or a power to control the lifetime "possession or enjoyment" of that property, the full date of death value of that property will be included in his estate.68 historically, state inheritance taxes incorporatedthephrase "possession or enjoyment" of property69 and most understood that such transfers were essentially testamentary dispositions.7" these arrangements have often been described as "will substitutes."7 67. section 2036(a) provides: the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom. the relevant regulations define the phrase "right... to designate the person or persons who shall possess or enjoy the transferred property or the income therefrom" to include, a reserved power to designate the person or persons to receive the income from the transferred property, or to possess or enjoy non-income-producing property, during the decedent's life or during any other period described in paragraph (a) of this section. with respect to such a power it is immaterial ... (iii) whether the exercise of the power was subject to a contingency beyond the decedent's control which did not occur before his death (e.g. the death of another person during the decedent's lifetime)." regs. § 20.236-1(b)(3)(iii). 68. irc § 2036. 69. see commissioner v. estate of church, 335 u.s. 632, 637-638 (1949) ("the 'possession or enjoyment' provision appearing in section 811 (c) seems to have originated in a pennsylvania inheritance tax law in 1826 .... most of the states have included the pennsylvaniaoriginated 'possession or enjoyment' clause in death tax statutes, and with what appears to be complete unanimity, they have up to this day... substantially agreed with this 1884 pennsylvania supreme court interpretation.") 70. see united states v. estate of grace, 395 u.s. 316, 320 (1969) ("the general purpose of the statute was to include in a decedent's gross estate transfers that are essentially testamentary i.e., transfers which leave the transferor a significant interest in or a control over the property transferred during his lifetime."); commissioner v. estate of church, 335 u.s. at 639, 646 (1949) (citing their decision in helvering v. hallock, 309 u.s. 106 (1940), the court stated: "testamentary dispositions of an inter vivos nature cannot escape the force of this section by hiding behind legal niceties contained in devices and forms created by conveyancers."); estate of gilman v. commissioner, 65 t.c. 296, aft'd, 547 f. 2d 32 (2d cir. 1976); estate of deobald v. u.s., 444 f.supp. 374, 382 (e.d. la.1978). 71. see, e.g., hallock, 308 u.s. 106, 114 (1940). florida tax review [vol 5:2 contingencies and the estate tax congress has repeatedly reacted to the potential for abuse inherent in section 2036.72 in enacting its predecessor, congress quickly reacted to three supreme court cases73 allowing a decedent to avoid estate taxes where he retained a lifelong right to enjoy property.74 that statute, with substantially the same language as the current one, was enacted to prevent tax avoidance.75 in 1976, congress reacted to the decision in united states v. byrum,76 and enacted 72. in its repudiation of its earlier decision in may v. heiner, 281 u.s. 238 (1930), that emphasized a rule based on legal title, the court, inestate of church, 335 u.s. at 641-642, stated: "the effect of the court's interpretation of this estate tax section was to permit a person to relieve his estate from the tax by conveying its legal title to trustees whom he selected, with an agreement that they manage the estate during his life, pay to him all income and profits from the property during his life, and deliver it to his chosen beneficiaries at death. preparation of papers to defeat an estate tax thus became an easy chore .... and by this simple method one could, despite the 'possession or enjoyment' clause, retain and enjoy all the fiaits of his property during life and direct its distribution at death, free from taxes that others less skilled in tax technique would have to pay." some commentators, however, have minimied the potential for abuse, particularly when compared to the complexities inherent in retaining code §§ 2036-2038. see, e.g., joseph isenbergh, simplifying retained life interests, revocable transfers, and the marital deduction, 51 u. chi. l. rev. 1, 13-15 (1984). 73. the three per curiam decisions are burnet v. northern trust co., 283 u.s. 782 (1931); morsman v. burnet, 283 u.s. 783 (1931); mccormick v. bumet, 283 u.s. 784 (1931). 74. see, estate of church, 335 u.s. at 639-640 ("bothhouses of congress unanimously passed and the president signed the requested resolution that same day." 335 u.s. at 640); united states v. byrum, 408 u.s. 125, 160, 165 (1972) (j. white, dissenting). 75. see commissioner v. estate of church, 335 u.s. at 639-640 (acting secretary of the treasury ogden mills stated that without congressional action to reverse the three supreme court opinions the resulting loss to the treasury would be "in excess of one-third of the revenue derived from the federal estate tax, with anticipated refunds in excess of $25,000,000."); united states v. byrum, 408 u.s. at 159-160 (j. white, dissenting). the dialogue between the following congressmen underscores this intent: "mr. hawley. mr. speaker and gentlemen, the supreme court yesterday handed down a decision to the effect that if a person creates a trust of his property and provides that, during his lifetime, he shall enjoy the benefits of it, and when it is distributed after his death it goes to his heirs-the supreme court held that it goes to his heirs free of any estate tax .... mr. schafer of wisconsin. this is a bill to tax the rich man. i shall not object mr. sabath. reserving the right to object, all the resolution purports to do is to place a tax on these trusts that have been in vogue for the last few years for the purpose of evading the inheritance tax on the part of some of these rich estates? mr. hawley. it provides that hereafter no such method shall be used to evade the tax. mr. sabath. that is good legislation. 74 cong. rec. 7198, cited in united states v. byrum, 408 u.s. at 160 (j. white, dissenting). 76. 408 u.s. 125 (1972). 2001u section 2036(b)77 for the same policy of preventing abuse.78 because of the increaseduse of valuation freezes in estate planning,79 congress enacted section 77. the tax reform act of 1976, pub. l. no. 95-600, § 702(i)(1), adding § 2036(b), effective for transfers after june 22, 1976, states: (b) voting rights(1) in general-for purposes of subsection (a)(1), the retention of the right to vote (directly or indirectly) shares of stock of a controlled corporation shall be considered to be a retention of the enjoyment of the transferred property. (2) controlled corporation-for purposes of paragraph (1), a corporation shall be treated as a controlled corporation if, at any time after the transfer f the property and during the 3-year period ending on the date of the decedent's death, the decedent owned (with the application of section 318), or had the right (either alone or in conjunction with any person) to vote stock possessing at least 20 percent of the total combined voting power of all classes of stock. (3) coordination with section 2035-for purposes of applying section 2035 with respect to paragraph (1), the relinquishment or cessation of voting rights shall be treated as a transfer of property made by the decedent. 78. cited in the house committee report as the "reasons for chang[ing]" the law subsequent to the byrum decision, was the belief"that voting rights are so significant with respect to corporate stock that the retention of voting rights by a donor should be treated as the retention of the enjoyment of the stock for estate tax purposes. your committee believes that this treatment is necessary to prevent the avoidance of the estate and gift taxes." h. rep. no. 94-1380, 94th cong., 2d sess. 64 (1976); joint comm. on taxation, general explanation ofthe tax reform act of 1976, 589 (1976). the committee report cited to an article that suggested that the value of their retained voting control would not be subject to any transfer tax under byrum. id. at 64, n.3. 79. an estate freeze in the context of a grantor retained income interest trust or equivalent is a technique by which the donor freezes the value of the transferred remainder interest, which generally has a greater appreciation potential, while reducing the value of the gift by the retained interest that is actuarially calculated at the date of the gift but in fact has a much lower value. see staff ofjoint comm. on taxation, 101st cong., 2d sess., federal transfer tax consequences of estate freezes (jcs-13-90) 16-19 (comm. print 1990). ("estate freezes raise three basic transfer tax concerns. first, because frozen interests are inherently difficult to value, they can be used as a means of undervaluing gifts. second, such interests entail the creation of rights that, if not exercised in an arm's-length manner, may subsequently be used to transfer wealth free of transfer tax. third, 'frozen' interests may be used to retain substantial ownership of the entire property while nominally transferring an interest in the property to another person." id. at 16. "further, undervaluation may result from the use of treasury tables valuing annuities, life estates, terms for years, remainders and reversions. those tables are based on assumptions regarding rates of return and life expectancy that are seldom accurate in a particular case, and therefore, may be the subject of adverse selection. because the taxpayer decides what property to give and when to give it, use of tables, in the aggregate, more often results in undervaluation than in overvaluation." id. at 18.). the treasury has defined circumstances under which the tables may not be used. see regs. § 25.2702-3(b)(2) and (3). (excluding high payout annuities which exhaust the fund before the term expires; a grantor retained income trust (grit) wherein the transferor's retained interest is comprised of unproductive or underproductive assets; transfers with retained interests based on persons with a terminal illness, which is defined as an incurable illness or deteriorating condition expected result in their death within a year (although a contrary presumption arises if the person actually survives at least 18 months)). florida tax review [vol. 5:2 contingencies and the estate tax 203 6(c). 80 although this subsection of the statute was subsequently repealed,81 its repeal was simultaneous with the enactment of chapter 1482 which contains the gift tax special valuation rules.83 thus, with respect to transfers with a life time retained income or enjoyment, section 2702 not only emphasizes that, without a "qualified interest," such a transfer with a retained income interest will be subject to the gift tax at the full value of the property, ignoring the retained interest, 4 but also by retaining section 2036()(1), congress also 80. see omnibus budget reconciliation act of 1987, pub. l. no. 100-203, § 10402(a) (amending irc § 2036), applicable to decedents dying after 1987, but only with respect to transfers subsequent to december 17, 1987. section 2036(c) applied to grits (grantor retained income trusts) with the exception of trusts where the retained term was ten years or less, where the donor did not serve as a trustee, and where the income interest was determined solely by reference to the trust's income. irc § 2036(c)(6). see h.r no. 100-1104 (vol.2), at 74, n. 1. this exception did not apply where the grantor had a contingent reversion or certain powers of appointment. see notice 89-99, 1989-2 c.b. 422. 81. see omnibus budget reconciliation act of 1990, pub. l. no. 101-508, § 11601, 104 stat. 1388. the omnibus budget reconciliation act of 1990, added code §§ 2701-2704 as part of the amendment to subtitle b which added chapter 14, with code § 2702 effective for transfers after oct. 8, 1990, except as provided in § 11602(e)(1)(b); § 11601 repealed irc § 2036(c). some retained income transfers are not subject to these rules such as incomplete gifts and transfers to a personal residence trust. see irc § 2702(a)(3). 82. chapter 14 was added by the omnibus budget reconciliation act of 1990, pub. l. no. 101-508, § 11602(a). technical miscellaneous revenue act of 1988, pub. l. no. 100647, 102 stat. 3342 (codified in relevant part at irc § 7520), further increased the accuracy of the tables' use. 83. see irc §§ 2701-2704. section 2702 expressly deals with gifts with retained life interests, the subject of§ 2036, so that without a "qualified interest" as defined in § 2702(b), the transferor is seen as making a gift of the full value of the underlying property, unreduced by the value ofthe donor's retained life interest. the provision applies where either the transferor or any "applicable family member" retains an interest in the trust. an "applicable family member" is defined as the transferor, his spouse, either of their lineal descendants or their spouses. see irc §§ 2702(a)(1), 2701(e)(2); regs. § 25.2701-1(d)(2). these family members include the transferor's spouse, either his or his wife's ancestors or lineal descendants or their spouses, and any of the transferor's siblings or their spouse. irc §§ 2704(c)(2) & 2702(e); regs. § 25.27022(a)(1). section 2702 gives a zero value to interests retained by the transferor or applicable family member that are not "qualified interests." irc § 2702(a)(2)(a). however, § 2702(a)(2)(b) allows a reduction of any retained interest that is a qualified interest as defined by § 2702(b), i.e., an interest which is in the form of a qualified annuity, a qualified unitrust interest, or a qualified remainder interest. that interest is then valued under the rules of§ 7520. see regs. §§ 25.27023(b),(c), & (d). note that § 2702(c)(3)(a) defines a "term interest" as including "a life interest in property" so that retained, non-qualified, income interests for life are taxed in full at the transfer of the remainder interest and the full fair market value of the property is subject to estate tax at the transferor's death. the regulations prqvide a reduction in "aggregate taxable gifts" for gift tax purposes, or "adjusted taxable gifts" for estate tax purposes, where a term interest that was valued at zero under § 2702 was subsequently transferred. see regs. § 25.2702-6. 84. the legislative history states: ... the committee [was] concerned about the undervaluation of gifts valued pursuant to treasury tables. based on average rates of return and life expectancy, those tables are seldom accurate in a particular case, and 200o1 florida tax review subjects the transfer to estate tax at the property's full date-of-death value, with appropriate offsets.8" 2. contingent retained life estates and section 2036: overkill or justified policy decision?-under section 2036, where the decedent has at any time transferred property and has retained a contingent life interest in that property, the full date of death value of the property, less the value of any remaining life interest currently enjoyed by another at decedent's death,86 is included in decedent's gross estate.87 moreover, where decedent transferred therefore, may be the subject of adverse selection. because the taxpayer decides what property to give, when to give it, and often controls the return on the property, use of treasury tables undervalues the transferred interests in the aggregate, more often than not. therefore, the committee determines that the valuation problems inherent in trusts and term interests in property are best addressed by valuing retained interests at zero unless they take an easily valued form--as an annuity or unitrust interest. by doing so, the bill draws upon ... rules valuing split interests in property for purposes of the charitable deduction. report on omnibus budget reconciliation act of 1990, s. 3209, 101st cong. (1990), 136 cong. rec. s15,629, s15,681. 85. because of§ 2001 (b) and the regulations under § 2702, the property is not subject to transfer tax twice; rather, the effect of this provision is to include any post-gift appreciation in the decedent's estate. see regs. § 25.2702-6. particularly after the enactment of§ 2702, courts and commentators have urged that the issue of what constitutes "adequate and full consideration" under § 2036 in the sale of a remainder interest in property wherein the decedent has retained a life estate is no longer an area with abuse potential and that this language in the statute should be interpreted without regard to the value of what would have been included in decedent's estate had there been a gift of the remainder interest. see estate ofd'ambrosio v. commissioner, 101 f.3d309 (3d cir. 1996) cert. denied, 520 u.s. 1230 (1997); wheeler v. united states, 116 f.3d 749 (5th cir. 1997); estate of magnin v. commissioner, 184 f.3d 1074 (9th cir. 1999); ronald h. jensen, estate and gift tax effects of selling a remainder: have d'ambrosio, wheeler and magnin changed the rules? 4 fla. tax rev. 537 (1999) (prof. jensen urges that the decisions in these cases be applied to nonspousal election situations). these cases and commentators have rejected the decision in gradow v. united states, 11 cl. ct. 808 (1987), aff'd, 897 f.2d 516 (fed. cir. 1990). this author, however, believes that gradow was correctly decided. see wendy c. gerzog, why gradow is still correct, 89 tax notes 551 (oct. 23, 2000). 86. what is subtracted from the fair market value of the property is the actuarially determined value of the remaining life interest not dependent upon surviving the decedent and currently enjoyed by another at decedent's death. regs. § 20.2036-1(a). some have questioned the fairness of this valuation rule's disregard of multiple contingent life estates since the regulation allows a reduction only for the one life estate currently enjoyed at the decedent's death regardless of the existence of more than one contingent life interest that precedes decedent's and therefore not dependent on surviving him. see regis w. campfield, martin b. dickinson, william j. tumier, taxation of estates, gifts and trusts 343-344 (1999). 87. irc § 2036(a)(1). with respect to property transferred after 1987, unless decedent specifically directs otherwise, his estate may recover the tax attributable to inclusion of property under § 2036 from the transferees of the property. see technical and miscellaneous revenue act of 1988, pub. l. no. 100-647, § 3031 (f)(1), 102 stat. 3342 (codified at irc § 2207b). see also [vol. 5:2 contingencies and the estate tax propertybut retained, during his life, a contingent power to designate who shall enjoy the income or current use of the property, the entire date of death value of the property is included in his estate. 8 the regulations specifically state that "it is immaterial ...whether the exercise of the power was subject to a contingencybeyondthe decedent's controlwhich didnot occurbefore his death (e.g. the death of another person during the decedent's lifetime). ' 9 originally, when a decedent transferred property during his life and retained a life estate subsequent to another's life estate (a contingent life estate), where the decedent did not survive the life tenant, the property was not included in decedent's gross estate.9" it was only in 1932, when congress amended the predecessor to section 2036 to include the phrase "for any period not ascertainable without reference to his death,"91 that this language was taxpayer relief act of 1997, pub. l. no. 105-34, § 1302(b), 111 stat. 788 (amending irc § 2207(a) to require a specific contrary direction of decedent to nullify application of the estate's right to recovery). 88. irc § 2036(a)(2). see estate of field v. united states, 143 f.supp 520, 525 (s.d.n.y. 1956), rev'd, on other grounds, sub nom, hollanderv. united states, 248 f.2d 247 (2d cir. 1957) ('thus, though the donor, according to the letter ofthe trust instrument, had the power to alter or revoke the interests of his children, the exercise of that power was ineffective unless and until the birth of issue. that might be thought to sterilize it as a generating source of taxation but it fell precisely into the words of article 20(b)(3) of the regulations which provided that a powerwould be considered to have existed on the date of a decedent's death although its exercise 'was restricted to a particular time or the happening of a particular event which had not arrived or occurred at decedent's death."') estate of field, 143 f.supp. at 525. on appeal, the second circuit found that a 1951 amendment to the 1939 code provided retroactive relief for decedent's dying between march 18, 1937 and february 11, 1939. hollander, 248 f.2d at 250. 89. regs. § 20.2036-1(b)(3)(iii). 90. see may v. heiner, 281 u.s. 238 (1930) (interpreting § 302(c) of the 1926 act to find that the decedent's reservation of a contingent life estate after one she had given her husband did not cause the trust to be includable in her estate). while retained life estates would subject the property to estate tax inclusion, a retained contingent life estate could not do so because the decedent's "death did not effect the transfer of the possession and enjoyment of the property and income to the daughters from and after that time, but, having occurred during the lifetime of the daughters, it foreclosed the possibility of her acquiring a reversionary interest in this half of the property." nichols v. bradley, 27 f.2d 47, 48 (1st cir. 1928). that is, since she did not survive her daughters, "no reversionary interest ever arose in her favor." id. 91. in the 71 pub. res. 131, 46 stat. 1516 (1931), congress amended § 302(c) to include the time frame for "any period not ending before his death." this section was again amended the next year to include the phrase "for any period which does not in fact end before his death" as well as the phrase "for any period not ascertainable without reference to his death." see revenue act of 1932, § 803(a), pub. l. no. 72-154,47 stat. 279. this language was interpreted as specifically including contingent life estates. see commissionerv. nathan's estate, 159 f.2d 546 (7th cir. 1947); marks v. higgins, 213 f.2d 884 (2d cir. 1954); estate of hohensee v. commissioner, 25 t.c. 1258 (1956). the legislative historyre-enacting thisphrase is clear: "the expression 'not ascertainable without reference to his death' as used in section 811(c)(1)(b)... includes the right to receive the income from transferred property after the death of another person who in fact survived the transferor ..." h. rep. (conf.) no. 1412, 81st cong., 1st sess. (1949) (affirming § 81 1(c)'s applicability to transfers subsequent to june 7, 1932), reprinted in 20011 florida tax review intended to change the scope of the code section to include such contingent retained interests.92 because this code section examines facts as they exist at the time of the transfer and not at the time of the donor's death,93 "[it is irrelevant that the grantor in fact died before her husband [the primary life tenant], since, under the statute, the tax status of the transferred property is determined by the character of the transfer, and not by subsequent events."94 for a brief time after the 1932 legislation, however, even the government took the position that retaining a contingent life estate that never vested at decedent's death would not cause the property to be included in decedent's 1949-2 c.b. 295-301. 92. according to the current regulations, both this type of factual situation and a contingent retained life estate are examples of the meaning of the phrase "not ascertainable without reference to his death" as used in § 2036. see regs. §§ 20.2036-1(b)(1)(i) and (ii). the tax court, in estate of hohensee, explained the effect of the 1932 act amendment: "as of the date of the transfer it was impossible to tell how much decedent would get without knowing when he would die-in other words, a time not ascertainable without reference to his death. this retained interest, in fact, yielded him less than it might have because of the circumstance that he predeceased his wife. but in prospect, when the trust was created, any contingency merely contributed to the question of valuation. the value of the transfer for estate tax purposes is determined by reducing the value of the transferred property by the amount of the outstanding income interest in the wife. [citations omitted]." estate of hohensee, 25 t.c. 1258, 1261. [citation omitted]. see estate of hubbard v. commissioner, 250 f.2d 492, 496 (5th cir. 1957) (because the transfer was made before the effective date of the 1932 amendment, the donor's right to income after the death of the current life beneficiary who survived the donor did not require the property to be included in the donor/decedent's gross estate.) but see estate of curie v. commissioner 4 t.c. 1175 (1945), nonacq., 1945 c.b. 8 (holding that the transfer of additional stock to the trust, which was created in 1928, after the passage of the revenue act of 1932 was subject to that act. the tax court also held that a right to income in excess of$12,000 during his wife's life as well as a contingent right to all of the income if the decedent had survived his wife, did not subject the trust to inclusion in decedent's estate. the court considered the phrase " for a period not ascertainable without reference to his death" inapplicable since this phrase was only intended to apply where "decedent actually came into enjoyment of the income, not for his life, but for a period, in the determination of which the date of his death was a necessary element, for example, where the grantor is to receive the income annually but with the provision that none of the income between the last annual payment and his death is to be received by him or his estate." 4 t.c. at 1184). 93. see estate offarrel v.united states, 213 ct. cl. 622, 627, 553 f.2d 637, 640 (1977) (explaining the difference between §§ 2036 and 2038: "but under the language of 2036(a) there is no compelling reason why the moment of death has to be exclusively important. unlike section 2038, this provision seems to look forward from the time of transfer to the date of the transfer's death, and can be said to concentrate on the significant rights with respect to the transferred property the transferor retains, not at every moment during that period, but whenever the specified contingency happens to arise during that period so long as the contingency can still occur at the end of the period."). 94. commissioner v. estate of arents, 297 f.2d 894, 896 (2d cir. 1962). [vyol 5:2 contingencies and the estate tax estate95 and there was much confusion in the courts and congress about what to do with cases that involved issues concerning that legislation.96 indeed, there have been occasional instances where courts have been uncomfortable with the lack of a de minimis baseline of inclusion with respect to retained contingent interests and they have engrafted their own exceptions to section 2036. specifically, there is an example of ignoring remote contingencies under section 2036(a)(1) in the tax court's decision in pardee v. commissioner97 when the court was calculating the amount includable in the decedent's gross estate. in determining the amount of the trust needed to satisfy decedent's obligation to support his two minor children, the court looked only to the fixed monthly amount of decedent's legal obligation. although the court acknowledged that decedent might have the legal obligation to pay a greater monthly amount while a child was at school or camp, it stated that "this contingency never occurred, and we do not believe the remote possibility should affect the computation."" likewise, the court characterized the decedent's power to use additional trust funds should a court modify the support award as being "dependent upon a contingency beyond the decedent's control which did not in fact occur... ."" this decision to ignore the value of contingent rights made the calculations easier, but reflects some willingness to apply a de minimis exception to what is generally seen as a broadly applied and inclusive code section. in united states v. byrum,' likewise, the majority of the supreme court rejected the government's argument that by retaining voting control of the stock that decedent had transferred to his children, decedent had retained the power to liquidate or merge. instead, the court held that such a power was "a speculative and contingent benefit which may or may not be realized."'' in this instance, the broader right (voting) was vested, but a potential beneficial result of exercising decedent's right was cast as "speculative and contingent." 95. see e.t. 5, 1934-2 c.b. 369, rev'd in t.d. 4729, 1937-1 c.b. 284. see rev. rul 67-97, 1967-1 c.b. 380, declaring the 1934 ruling obsolete. in 1937 and in 1938, the secretary of the treasury issued two regulations to clarify its change in position. see t.d. 4729, 1937-1 c.b. 284; t.d. 4868, 1938-2 c.b. 356. 96. see supranotes 88,91-92. inrev.rul. 72-611,1972-2 c.b. 526, the irs ruledthat the transfer of a contingent interest with a retained right to receive income from that property was a transfer within section 2036 where that contingent interest became vested before his death. that is, the contingent remainder interest vested indefeasibly before the donor's death because he did in fact survive "a," the pre-condition to vesting. 97. 49 t.c. 140 (1967), acq., 1973-2 c.b. 3. 98. id. at 150, n.12. 99. id. at 150. actually, one child did attend summer camp for one season for twice the amount of monthly child support (i.e., the $500 payment to the camp exceeded decedent's $250 monthly support for that child). see id. at 142. 100. united states v. byrum, 408 u.s. at 125 (1972). 101. id. at 150. 2001] however, the characterization as "speculative or contingent" suggests that, unlike the right to appoint oneself a trustee as in estate of farrel, 2 a vote for liquidation or merger is "too unlikely to occur." alternatively, this characterization implies that liquidation (or merger) is too extraordinary or "too great a price to pay" to exercise that right as in estate of smead. '03 essentially, in byrum, the court held that voting control meant control over many corporate decisions, and that decedent's exercise of that control was not discretionary but subject to fiduciary constraints." 4 similarly, some courts have held that, with respect to any retained income rights accompanying a transfer of community property from one spouse to another as her separate property, the donor spouse has not retained sufficient rights over the income from that property under state law to include the property in his gross estate." 5 specifically, one court described the essence of the community property interest in income that the donor spouse possesses in the other spouse's separate property as "an inchoate standing to complain that the other spouse made an excessive or capricious gift to a third party, or to demand an accounting on dissolution of the marriage or partition, alleging the income was used to improve the other spouse's separate property" ' 6 that does not rise to the level of a right to income under section 2036. rather, the donor spouse's interest was "a mere expectanc[y]"' 7 since the other spouse could have disposed of the property or converted it to non-income producing property, destroying the interest.' thus, while the lower court0 9 determined that the right to the income in such a circumstance "was not illusory, but an enforceable right sufficient to require inclusion""' of the property under 102. see infra notes 120-125 and accompanying discussion. 103. estate of smeadv. commissioner, 78 t.c. 43 (1982). see infra notes 274-281 and accompanying text. 104. indeed, it is this latter reasoning (limitation of right because of fiduciary duty) that is the basis for the tax court's decision in estate of wall v. commissioner, 101 t.c. 300 (1993), wherein the decedent had retained the power to remove the sole corporate trustee and replace it with another corporate trustee independent from the grantor. see also rev. rul. 95-58, 1995-2 c.b. 191 (the irs ruled that it would accept the decision in wall as well as in estate of vak v. commissioner, 973 f.2d 1409 (8th cir. 1992) as long as the substitute trustee was neither the grantor nor a trustee "related or subordinate to the decedent (within the meaning of section 672(c))." rev. rul. 95-58, 1995-2 c.b. at 191. 105. see, e.g., estate of wyly v. commissioner, 610 f.2d 1282 (5th cir. 1980) (construing texas community property law); estate ofdeobald v. united states, 444 f.supp. 374 (e.d. la. 1978). 106. wyly, 610 f.2d at 1290. 107. id. at 1291. 108. id. at 1292. 109. estate ofcastleberry v. commissioner, 68 t.c. 682 (1977), nonacq., 1978-2 c.b. 3, rev'd sub nor estate ofwyly v. commissioner, 610 f.2d 1282 (5th cir. 1980). 110. estate of castleberry, 68 t.c. at 690. florida tax review [vol. 5:2 contingencies and the estate tax section 2036, the fifth circuit, in estate of wyly v. commissioner,"' reversed and held that community prop erty interest in the income from separate property "is so limited, contingent, and expectant""' 2 that it is not encompassed within the phrase "right to income" as used in that statute. however, it was the fear of abuse 13 and loss of revenue that motivated congress quickly to overturn case law and enact the predecessor statute to section 2036."' it is that fear of abuse that has resulted in the inclusion of the full value of the property, less the value of the currently held term or life estate, to be included in decedent's estate even when it is very unlikely that decedent will ever receive his contingent retained life interest. in this vein, courts have explained that a threshold, minimal value of that interest is unnecessary so long as the interest is not "illusory." in commissioner v. estate of church,n 5 the estate had argued that it was extremely improbable that the decedent would have survived all of his siblings and their ten children; "the happening of such a contingency was so remote, the money value of such a reversionary interest was so infinitesimal" to subject the property to estate taxes." 6 yet, the supreme court in church held that subjecting such a retained interest to estate tax was necessary to prevent tax avoidance."17 in commissioner v. nathan's estate,"8 the decedent's retained contingent interest depended on his surviving his sister, which he did not in fact do. however, the court did not consider that the contingent aspect of that interest was significant: "we cannot lessen the effect or the meaning of the words because the settlor's interest was less certain or the enjoyment of the estate reserved more remote. we feel we must give the words used their fair, 111. wyly, 610 f.2d 1282 (5th cir.1980). 112. id. at 1294. 113. id. at 1290, ("thepurpose of thisprovision is to prevent circumvention of federal estate tax by use of inter vivos schemes which do not significantly alter lifetime beneficial enjoyment ofpropertysupposedlytransferredbya decedent."); estate of shafer v. commissioner, 749 f.2d 1216 (6th cir. 1984) ("[this] section was enacted to prevent the circumvention of the federal estate law by various inter vivos schemes."). 114. revenue act of 1939 § 811 (c), pub. l. no. 76-1, 53 stat. 121 (codified at irc § 811), read: under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death (i) the possession or enjoyment of; or the right to the income from, the property, or (ii) the right, either alone or in conjunction with anyperson, to designate thepersons who shall possess or enjoy the property or the income therefrom .... section 2036 "corresponds to section 81 l(c)(1)(b) ofthe 1939 code, as amended. no substantive change has been made." 1954 s. rep., supra note 18, at 469. 115. 335 u.s. 632 (1949). 116. id. at 636. 117. id. at 645, 650. 118. 159 f. 2d 546 (7th cir. 1947). 2001u florida tax review rightful meaning and we can not make them depend on the size or nature of the settlor's reservation appearing in his transfer." '119 likewise, with respect to retained contingent powers, in estate of farrel v. united states, 20 the taxpayer had argued that the language in the regulations should only apply "where the contingency relates to the 'exercise' of an already existing power, and conversely, to be inapplicable where the power only springs into existence when a trustee vacancy occurs."'21 the court refused, however, to give a narrow reading to the regulation and found that decedent's legally enforceable right to make herself trustee if a vacancy occurred was a "significant, though contingent, power to choose those who shall have possession or enjoyment.', 22 the court emphasized that this right was "foreseeable when the trust was created-that it was a real right, neither insignificant nor illusory...,,123 the right was exercised twice over "eight years and, if she had lived, may well have had more."' 24 thus, the likelihood of its being used was borne out and the probability of its future use, if calculated at her death but without regard to that fact, was great. 125 the regulations under section 2036 allow the estate to subtract the value of the remaining outstanding life estate currently being enjoyed by another at decedent's estate because the interest is not dependent upon surviving the decedent and, hence, is not testamentary. 26 some commentators have argued that all interests, whether currently enjoyed or not, that are not dependent upon surviving the decedent should reduce the value of the property included under section 203 6.127 yet, to the extent that the decedent has assured himself that should he outlive the life tenant(s), he will continue to enjoy the property or the income from income-producing property for the rest of his life, he is intending to make a testamentary transfer of the entire property. although he does not actually transfer the entire property at his death, that result is merely fortuitous because he had the bad luck to die before his primary life beneficiary. from the time of its enactment to the present day, the fear of abuse has been a major motivating factor for this code section. because a transfer with even a contingent retained income interest or power is essentially a testamentary transfer, the full value of the property that is really being transferred at the decedent's death should be included in his gross estate. 119. id. at 549. 120. 553 f.2d 637 (ci. ct. 1977). 121. id. at 641. 122. id. at 642. 123. 213 ct. ci. at 631; 553 f.2d at 642-643. id. at 642-43. 124. id. at 643. 125. estate of farell, 553 f.2d at 643. 126. see supra note 86 and accompanying text. 127. id. [vol 5:2 contingencies and the estate tax moreover, while this section may apparently dictate a harsh result, the contingency is donor-created so that its remoteness orunlikelihoodis controlled entirely by the decedent. by not retaining any kind of life interest in the transferred property, the transfer would have been truly an inter vivos one, not subject to estate tax. d. section 2037: an express de minimis rule 1. background of section 2037.-section 2037 includes the value of property in decedent's estate128 where decedent had made an inter vivos transfer 129 in which he has retained a statutorily defined "not insignificant" reversionary interest13° and wherein the beneficiary cannot enjoy the property except by surviving the decedent. 31 128. only the interest(s) dependent upon surviving the decedent are includable in decedent's estate. see reg. §§ 20.2037-1(d) & (e), ex. (3). estate oftarverv. commissioner, 255 f.2d 913, 918 (4th cir. 1958). 129. a transfer forthepurposes of§ 2037 may existwith respectto a death benefit paid to an employee's spousebythe act ofdecedent/employee's employment contract. see, e.g., estate offried v. commissioner, 445 f.2d 979, 983-984 (2d cir. 1971); rev. rul. 78-15, 1978-1 c.b. 289. 130. a reversionary interest is "not insignificant" where its value exceeds 5% of the value of the property. the reversionary interest is valued by comparing the value of that interest with the value of the property itself; undiminished by any interest(s) not dependent on surviving the decedent. see regs. § 20.2037-1(c)(4). 131. section 2037(a) provides: (a) general rule-the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time after september 7, 1916, made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, if(1) possession or enjoyment of the property can, through ownership of such interest, be obtained only by surviving the decedent, and (2) the decedent has retained a reversionary interest in the property (but in the case of a transfer made before october 8, 1949, only if such reversionary interest arose by the express terms of the instrument of transfer), and the value of such reversionary interest immediately before the death of the decedent exceeds 5 percent of the value of such property. id. see also regs. § 20.2037-1(a). 20011 thus, section 2037 has a survivorship test, 3 2 requires a retained reversion, 33 132. the survivorship test requires that obtaining the enjoyment and ownership of the property could only have been achieved through surviving the decedent. see, e.g., estate of thacher v. commissioner, 20 t.c. 474 (1953)(wherein decedent's wife whose interest was defeasible on her divorce or separation only acquired her interest "absolute and unconditional" on decedent's death). if there is another way by which the beneficiary could have acquired and enjoyed the property, the survivorship requirement will not be met and the property will not be included in decedent's estate under this code section. to qualify as an alternative means of acquiring the property, i.e. to be an "other event" under the regulations, the means must be real and not illusory. see regs. §§ 20.2037-1(b), 20.2037-1(e), ex. (1), (5) & (6). see also commissioner v. marshall's estate, 203 f.2d 534, 539-40 (3d cir. 1953) (wherein the court held that the possibilities of the beneficiaries' enjoying the property through either a change in pennsylvania's intestate laws, divorce, or willful neglect, non-provision, or desertion within one year of her death, "taken together" were not "so remote as to be 'unreal."'), smith v. united states, 158 f.supp. 344, 349 (d. colo. 1957) (where the beneficiary could have obtained enjoyment of the property not only by surviving the decedent, but also by decedent's wife's exercise of a withdrawal power.). with the technical changes act of 1949, pub. l. no. 81-378, § 7,63 stat. 891 (1949), the predecessor to § 2037 applied to alternative contingencies. see § 81 1(c)(3)(b), 1939 irc. this "alternative contingencies" provision was eliminated from § 2037, as enacted in the 1954 code. 133. irc § 2037(a)(1). see regs. § 20.2037-1(c), -1(e) ex. (2). while § 2037 requires a retained reversionary interest, the predecessor § 81 l(c)(1)(c), of the 1939 code for transfers after october 7, 1949, but before the new provision enacted in the 1954 code, had no such requirement. during those years, § 811 (c) read: (3) transfers taking effect at death-transfers after october 7, 1949-an interest in property transferred by the decedent after october 7, 1949, shall be included in his gross estate under paragraph (1)(c)(whether or not the decedent retained any right or interest in the property transferred) if and only if(a) possession or enjoyment of the property can, through ownership of such interest, be obtained only by surviving the decedent; or (b) under alternative contingencies provided by the terms of the transfer, possession or enjoyment of the property can, through ownership of such interest, be obtained only by surviving the earlier to occur of(i) the decedent's death or (ii) some other event; and such other event did not in fact occur during the decedent's life .... [emphasis added] see technical changes act of 1949, supra note 132, at § 7(a). when the current version of this section was adopted in the 1954 code, the pre-october 8, 1949, version requiring that decedent retained a reversionary interest in the transferred property was re-instituted in order to provide relief from the application of estate of spiegel v. commissioner, 335 u.s. 701 (1949). congress later viewed taxing property when decedent had relinquished all interest in the property as "unduly harsh to subject the property to estate tax merely because the ultimate taker of the property is determined at the time of the decedent's death." 1954 s. rep., supra note 18, at 123; 1954 h. rep., supra note 18, at 90. the reversionary interest requirement of the statute is broadly construed and does not depend on strict property law definitions. the st. louis union trust cases (helvering v. st. louis union trust co., 296 u.s. 39 (1935); becker v. st. louis union trust co., 296 u.s. 48 (1935) were overtumedbyhelveringv. hallock, 309 u.s. 106 (1940), which repudiated formal property law distinctions. for transfers made between the dates of these decisions, regs. § 20.2037-1(g), (providing relief for taxpayers who relied on the earlier case law). florida tax review [vol 5:2 contingencies and the estate tax and excepts those reversionary interests with a minimal value as determined just before decedent's death.134 the requirement of a reversionary interest includes a possibility either that the transferred property be returned to him or his estate, or that it be subject to his power of disposition.135 valuation of the reversionary interest is determined by recognized actuarial principles, including use of the annuity tables. 36 where reversionary interests are difficult to value,'37 the general rules under section 2031 apply.138 in determining the five 134. the 1954 code revision of the predecessor of§ 2037 adopted the 5% rule: "in the future property previously transferred by a decedent will be includable in his estate only ifhe still had (either expressly orby operation of law) immediately before his death a reversionary interest in the property exceeding 5 percent of its value, that is, if he, prior to his death, had 1 chance in 20 that the property would be returned to him." 1954 s. rep., supra note 18, at 123; 1954 h. rep., supra note 18, at 90. 135. irc § 2037(b)(1) & (2). prior to the enactment of§ 2037 in the 1954 code, the supreme court had held that its predecessor section applied to contingent retained powers as well as interests. see fidelity-philadelphia trust co. v. rothensies, 324 u.s. 108 (1945). 136. "the value of a reversionary interest immediately before the death of the decedent shall be determined (without regard to the fact of the decedent's death) by usual methods of valuation, including the use of tables of mortality and actuarial principles, under regulations prescribed by the secretary." irc § 2036(b). see § 20.2037-1(c)(3). estate ofbogley v. united states, 514 f.2d 1027, 1039-40 (1975). see generally, rev. rul. 76-178, 1976-1 c.b. 273 (the probability of a male 88-years old surviving his female counterpart was calculated by using a special factor supplied by the irs. because the reversionary interest exceeded the 5% threshold, the property was included in decedent's estate. the value of the property reduced by the value ofthe life estate not dependent on surviving the decedent is the value included in decedent's gross estate.) estate of roy v. commissioner, 54 t.c. 1317, 1322-1323 (1970). stating that: decedent's actual health immediately before death is not to be considered in determining the value of his reversionary interest for the purposes of the 5% rule; otherwise, only in cases of accident or unexpected death would section 2037 apply. 137. where the reversion is dependent upon more unusual situations, such as several measuring lives, the executor may request a factor from the irs; in addition, the irs publication 1457, "actuarial values, book aleph" may also provide assistance in valuing "more unusual situations." regs. § 20.2031-7t(d)(4). while the actuarial tables maybe used to compute successive life estates, it is difficult to value reversionary interests dependent on events, particularly where the event involves a voluntary act. see robinette v. helvering, 318 u.s. 184 (1943) (wherein a gift was valued without reduction for the donor's retained reversionary interest because that interest, dependent not only on the donor's survivorship but also on the death of his daughter without issue attaining age 21, was unascertainable. "actuarial science may have made great strides in appraising the value of that which seems to be unappraisable, but we have no reason to believe from this record that even the actuarial art could do more than guess at the value here in question." id. at 189.) the effect of the holding in robinette was to deny the donor the benefit of a smaller gift, i.e. reduced by the value of the donor's retained interest which could not be valued due to the contingencies imposed by the donor. unfortunately, however, the holding of this case has sometimes been applied summarily to § 2037 cases with the result that reversions that cannot be valued have been assigned a value of zero and thus allowed to escape taxation under the 5% rule. see, e.g., commissioner v. cardeza's estate, 173 f.2d 19 (3d cir. 1949) (holding that, the death of decedent's son without issue was considered too speculative to value); estate of cardeza v. 2001] percent rule, the courts will not aggregate interests or powers to satisfy this requirement. 3 9 also, where the reversionary interest applies to only a portion of the corpus, only that part will be subject to estate tax. 4' congress wanted to united states, 52 a.f.t.r. 1911 (e.d. pa. 1957), aft'd, 261 f.2d 423 (3d cir. 1958) (relating to the same estate as the 1949 case). in this case, the court stated that the issue was "whether it can be established that a woman 85 years old has a less than 5% chance of surviving a man of 64 married to a woman of 59 and also any child or children whom he may have in the future." id. the court found that the value was unascertainable and thus had a zero value. estate of graham v. commissioner, 46 t.c. 415, 426-427 (1966), the court observed, "decedent's power to dispose of the trust assets immediately before his death was contingent upon survival of the decedent and his wife for 6 years by the decedent's daughters, and the voluntary act of those daughters, or the survivor of them, of terminating the trust." id. at 426. while the contingency of survival may be calculated, the court said it would be a "mere guess" to quantify such a voluntary act. id.). but see in re hill's estate v. commissioner, 193 f.2d 724 (2d cir. 1952) (wherein the court refused to attempt to value a complicated set of factors). "the amount... is somewhat speculative and admits ofno accurate determination, but we cannot doubt that the right had value at the date of the settlor's death." id. at 728. the court found the contingency too remote. this was conditional upon the complete failure of the daughter's issue. actuarially it is most unlikely that the estate will receive anything under this provision. at the settlor's death there was alive an infant granddaughter who might marry and have children before the trust terminated. also, the daughter aged 35 survived; she was married and the prospect that she might have additional children was not improbable. id. although the court cited to both cardeza's estate and to robinette, and stated that it had no ascertainable value, the court actually attempted to "guess" at its value. if a donor-created contingency cannot be calculated, however, perhaps a more reasonable approach would be to ignore this donor-created contingency and to rely on the survivorship contingency to determine whether or not the de minimis requirement of § 2037 would be met. with respect to interests that are difficult to value, the irs has followed the 1954 committee reports: "where it is apparent from the facts that property could have reverted to the decedent under contingencies that were not remote, the reversionary interest is not to be necessarily regarded as having no value merely because the value thereof cannot be measured precisely." 1954 s. rep., supra note 18, at 469; 1954 h. rep., supra note 18, at a314. moreover, with respect to the contingency of a failure of issue, the regulations state that the general rules under § 20.2031-1, are applicable where it cannot be shown that a woman is incapable of having issue. see regs. § 20.2037-1(c)(3). see also rev. rul. 61-88, 1961-1 c.b. 417. but see h. rep. no. 1412, supra note 91, at 297 (stating that "the rule of robinette v. helvering, under which a reversionary interest not having an ascertainable value under recognized valuation principles is considered to have a value of zero, is to apply."). 138. see regs. § 20.2037-1(c)(3). 139. see, e.g., estate of klauber v. commissioner, 34 t.c. 968 (1960) "respondent would have us regard each of these elements as 'strings' attached to corpus and somehow add them (in spite ofbasic differences) in order to determine that the requisite 5 per centum of section 811 (c)(2) had been exceeded." id. at 976. this refusal to aggregate reversionary interests to determine whether they meet the 5% rule contrasts with the third circuit's approach to defining an "unreal" alternative contingency. but see commissioner v. marshall's estate, 203 f.2d 534, 540 (3d cir. 1953). 140. estate of klauber, 34 t.c. at 975-6. florida tax review [vol. 5:2 contingencies and the estate tax tax these transfers because, like under section 2036, transfers under section 2037 are considered will substitutes.141 section 2037 applies only to contingent reversions that never vest. if they did vest, section 2033 or 2038142 would include the value of the property in decedent's gross estate. 143 section 2037 applies only to retained reversionary interests in the property, but not to retained reversionary interests that only comprise rights to the property's income.144 essentially, section 2037 is instructive as a testing ground for different theories regarding contingencies. the section only covers contingent interests that are destroyed by decedent's death and thus never vest; moreover, it is a section that congress has, historically, both broadened and then restricted in its application. it parallels section 2036 in that the testamentary nature of the transfer is emphasized; moreover, because it is property once owned by decedent and it is decedent who creates the contingencies and thus determines the conditions under which the prop erty will return to him, in defining its reach, congress has considered the inherent possibility of abuse. the spiegel decision, and the initial congressional approval of that decision, focused on the possibility of tax avoidance, and established the statute's breadth. in the wake of that decision, no actual reversion was required to characterize a transfer taking effect at decedent's death as a testamentary transfer that would cause inclusion of that property in decedent's estate.14 1 in spiegel, the court stated: the question is not how much is the value of a reservation, but whether after a trust transfer, considered by congress to be a potentially dangerous tax evasion transaction, some present or contingent right or interest in the property still remains in the settlor so that full and complete title, possession or enjoyment does not absolutely pass to the beneficiaries until at or after the settlor's death.'46 141. estate of allen v. united states, 558 f.2d 14, 19 (ct.ci. 1977) ("the background of § 2037 demonstrates that one of the purposes of the statute is to tax transfers with a reversionary interest contingent on survivorship when they are used as testamentary substitutes.'. 142. section 2038 would apply to retained powers decedent actually held at his death. see discussion infra part ii. e and accompanying notes. 143. it is possible for both §§ 2033 and 2037 to apply, but it would require an unlikely scenario. it would require a secondary life estate in a third person following the life of the decedent with a vested reversion in the decedent. 144. see regs. § 20.2037-1(c)(2). 145. see supra note 133. 146. estate of spiegelv. commissioner, 335 u.s. 701,707 (1949). congress restricted the retroactive application of spiegel by imposing a 5% de minimis requirement for transfers before october 8, 1949 (as well as by requiring that the reversion be expressed in the transfer instrument). see the technical changes act of 1949, § 7, supra note 132. in 1954, congress extended the de minimis rule to all transfers when it enacted § 2037. between october 8, 1949 200ou florida tax review indeed, the definition of a "reversionary interest" under section 2037 adopts, like sections 2036147 and 2038,' a broad interpretation of the powers decedent needs to retain in order to cause inclusion under that statute. that is, even the power to withdraw principal for the benefit of another is encompassed within that definition.'49 where the taxpayer had argued that the powers were too meager for inclusion, the court distinguished the limited inclusion of remote reversions from limited powers over the property. 5 ' "the clear rationale of these cases is that the decedent is taxable wherever his death is the only event which will guarantee the ultimate beneficiaries that they will take and that the remainder will not be vested in the decedent or someone to be designated by him "'151 by contrast, the 1954 repudiation of much of an expanded application of section 2037 re-focused on a solution that differentiated between likely and very unlikely returns of the transferred property. in the 1954 version of this statute, a reversion was required for inclusion in decedent's estate and very unlikely reversions, that is, those with less than a five percent chance of returning to the decedent, were exempt from estate tax.152 even the survivorship test, in some sense, appears to have a "remote contingency" or similar threshold. the survivorship test is intended to underline the testamentary nature of the transfer that is subject to inclusion under section 2037. that test is not met if a beneficiary can enjoy the property by an alternate means than by surviving the decedent; 53 however, if that alternative contingency is "unreal," that alternative condition will be ignored so that the beneficiary will be deemed only able to enjoy the property through survivorship. 15 4 and 1954, there was no requirement that decedent retain a reversionary interest for the application of the predecessor to § 2037. 147. see struthers v. kelm, 218 f.2d 810 (8th cir. 1955) (power to control the timing of the beneficiaries enjoyment was a retained power under § 2036.). 148. see lober v. united states, 346 u.s. 335 (1953) (power to accelerate enjoyment of the trust property was caused inclusion under § 2038). 149. see estate of klauber v. commissioner, 34 t.c. 968 (1960) (trustee's power to pay $4,000 a year to decedent's wife for decedent's life was held includable under the predecessor to § 2037. the trustee's powers were attributable to decedent because the court held that the decedent could control the removal and appointment of any trustee). but see united states v. byrum, 408 u.s. 125 (1972); estate of wall v. commissioner, 101 t.c. 300 (1993) discussing the attribution of powers of a trustee where decedent retained the power to remove the trustee and appoint one amenable to his wishes with respect to § 2036). 150. see estate of klauber, 34 t.c. at 974. 151. id. 152. see supra note 134 and accompanying text. 153. see § 20.2037-1(b). see also supra note 132. 154. in commissioner v. marshall's estate, 203 f.2d 534 (3d cir. 1953), the court aggregated the alternative contingencies and found that, "the possible contingencies taken together under which beneficiaries could have taken the interest without surviving marshall [vol 5:2 contingencies and the estate tax 2. the five percent rule.-congress established the five percent rule of section 2037 in the 1954 code, because it considered it "unduly harsh" to include property in decedent's gross estate where he had relinquished practically all of his fights in the property.155 on the other hand, congress considered reversions "under contingencies that were not remote" sufficient interests for inclusions.156 the five percent rule requires that before his death, decedent "had 1 chance in 20 that the property would return to him."'57 the main argument for adopting a de minimis rule is that the decedent has barely retained any likelihood that the interest will return to him and that his beneficiaries will need to survive him to receive the property so that the transfer is only minimally testamentary in character. that argument is a seductive one, easily understood and apparently objective by its use of numbers. the remoteness of it is obvious from the fact that... the possible reverter to the settlor was conceivable only if all three of the children of the settlor were to die before he did and were to die without descendants of their own. disregarding the possibility of descendants of his children, the record shows an actuarial computation of the likelihood that the settlor would survive all three of his children of only about 1 /2 chances out cannot be regarded as so remote as to be unreal." id. at 540. in that case, the beneficiaries could have taken their one-third interests: (1) by a change in the intestate laws of pennsylvania, mitigating or eliminating the surviving spouse's share; (2) under the present intestate laws if marshall had divorced his wife or she had divorced him; (3) if marshall either willfully neglected or refused to provide for mrs. marshall for one year previous to her death, or ifhe willfully and maliciously had deserted her for that period. see id. at 539. the tax court opinion emphasized the lack of the decedent's intention to create a reversionary interest dependent on survivorship, stating that "the language relied upon by the commissioner is the usual provision inserted by lawyers as a catch-all." 16 t.c. 918,922 (1951). the transfer at issue was a pre-october 8, 1949, transfer so that to fall within the predecessor statute of § 2037, the reversion had to exist by the express terms of the instrument and not, as § 2037 allows alternatively, by operation of law. see irc § 2037(a)(2). the regulation itself provides an example of an "unreal" event, i.e., substituting survivorship with a stated term of years requirement that equals or exceeds the decedent's life expectancy. that is, if the alternative contingency is a 70-year old decedent's surviving a 20-year term, that alternative contingency will be denominated "unreal." regs. § 20.2037-1(e), ex. (5). 155. see supra note 133. 156. see supra note 136. (congress wanted the reversionary interest in § 2037 to be "valued by recognized valuation principles and without regard to the fact of the decedent's death. where it is apparent from the facts that property could have reverted to the decedent under contingencies that were not remote, the reversionary interest is not to be necessarily regarded as having no value merely because the value thereof cannot be measured precisely." id.) 157. see supra note 134. 2001] florida tax review of 100. on the basis of such a chance of realization, the computation gave a value of about $4,000 to a trust corpus of $1,000,000. to tax the settlor's estate more than $450,000, as is here proposed, because of the existence of this $4,000 worth of a possible reverter is not the kind of taxation that a court can readily imagine that congress meant to impose.158 indeed, in spiegel, the value of the right to receive $1, for someone the settlor's age, at the time the trust was executed, at the death of the last of the three primary beneficiaries was $0.00390. that figure couldbe adjusted to reflect the birth of the settlor's three grandchildren who also qualified as trust beneficiaries so as to reduce the value of the reverter from $4,000 to $70.159 congress enacted the five percent de minimis rule as a reaction to the numbers in spiegel160 although another rationale given for the five percent rule was "to bring certainty to the law.' 61 perhaps another rationale for the de minimis rule was that it softened the contemporaneous expansion of section 2037 to include unintentional reversions. 62 that is, at the same time the de minimis rule was enacted, section 2037 began to apply to implied reversions, created by operation of law, and often due to drafting errors. 163 thus, the de minimis rule may be said to correct those "mistakes" and, in this respect, it could also be viewed as reflecting the transferor's intent that the transfer was not intended to be testamentary.164 to the extent that section 2037 includes reversions implied by operation of law, it differs from section 2036 and may justify the exception; yet, the de minimis exception applies to intentional reversions as well wherein the transfers are, indeed, testamentary in character. moreover, if one quantified the powers encompassed by the definition of a reversionary interest within section 2037, limited powers such as those restricted to altering when the beneficiaries' would enjoy their vested interests might be considered "remote." yet, here, no numbers were submitted to congress to create such a sympathetic exception. in the same manner, valuing the decedent's reversion based on his actual life expectancy rather than on the 158. estate of spiegel, 335 u.s. at 727 (j.burton, dissenting) (applying the computations of the tax court). 159. see id. at 733-734 (j. burton, dissenting). 160. s. rep. 831, 81st cong., 1st sess. 8-9 (1949). 161. estate of roy v. commissioner, 54 t.c. 1317, 1322 (1970). 162. see the technical changes act of 1949, pub. l. no. 378, § 7, 63 stat. 891 (1949); irc § 2037(a)(2). 163. see boris i.bittker, elias clark, and grayson m.p. mccouch, federal estate and gift taxation 345 (7th ed. 1996). 164. indeed, that was the actual suggestion of j. burton in his dissent in spiegel. "on the other hand, this element of remoteness provides a thoroughly reasonable consideration which may be combined with other evidence to determine the presence or absence of the factual intent on the part of the settlor which is discussed in the fifth and final proposal." estate of spiegel, 335 u.s. at 727. [vol 5:2 contingencies and the estate tax mortality tables has an appeal similar to the argument using numbers to show how little the reversion is worth, but that argument is one that the courts and congress have uniformly rejected. "admittedly such a position has appeal and ignites a sympathetic reaction under the facts here present [footnote omitted]. however, we must be mindful of the old adage that 'hard cases make bad law." 65 likewise, by subjectively quantifying these contingent powers and by identifying those donors who are most likely to exercise their limited powers, one might eliminate some property from estate taxation by extending the de minimis rule in this way.'66 yet, again, no such facts and circumstances exception appears in the statute. by contrast, remoteness created by the transferor makes the focus on numbers less relevant and the apparent harshness or unfairness, less real. by redirecting the focus to the transferor, i.e., the one who created the reversionary interest with those remote contingencies, since he's writing the rules, the likelihood of the event's occurring is not necessarily the best test to determine the application of the estate tax to these transfers. retention of a remote reversionary interest maybe likened to an insurance policy that doesn't cost the donor anything under the current de minimis rule; without subjecting any property to estate tax if he should die as expected before the primary life beneficiary, he is assured that in the unlikely event that he does survive the life beneficiary, he will retain the ability to re-assess who will ultimately receive the property. e. section 2038: powers vested at decedent's death section 2038 includes property that decedent transferred but with respect to which he has retained at his death a power to affect its enjoyment. 167 165. estate of roy v. commissioner, 54 t.c. 1317, 1322 (1970). 166. no one would seriously argue that focusing on the subjective intent of the donor/decedent is a workable test, particularly in the estate tax area. thus, it is good that courts have consistently ignored this factor. see, e.g., estate of graham v. commissioner, 46 t.c. 415 (1966). "for the purposes of section 2037, the fact that decedent expressly declined to exercise the power is irrelevant." id. at 426. 167. irc § 2038(a)(1) provides: the value of the gross estate shall include the value of all property.(1) transfers after june 22, 1936-to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power (in whatever capacity exercisable) by the decedent alone orby the decedent in conjunction with any otherperson (without regard to when or from what source the decedent acquired such power), to alter, amend, revoke, or terminate, or where any such power is relinquished during the 3-yearperiod ending on the date of the decedent's death." when the statute applies, only the value of the interest subject to decedent's retained power is 200o1 florida tax review as the regulations specify, where decedent's power is subject to a contingency beyond his control, section 2038 does not apply. 6' according to the court in estate of farrel,"69 "section 2038 looks at the problem from the decedent's death what he can and cannot do at that specific moment' 7 and contingencies, not within decedent's control, compromise the decedent's ability to exercise a power at death.' thus, because section 2038 only looks at powers held by decedent at his death, this section applies only to powers vested, actually or effectively, at that time. contingent retained powers are, for the most part, covered by sections 2036 or 2037, including the value of such property in decedent's estate. section 2038 provides, however, that a power will be deemed to exist at the decedent's death included in decedent's estate. regs. § 20.2038-1(a). 168. see regs. § 20.2038-1(b). "however, section 2038 is not applicable to a power the exercise of which was subject to a contingency beyond the decedent's control which did not occur before his death (e.g., the death of another person during the decedent's life). see irc § 2036(a)(2) for the inclusion of property in the decedent's gross estate on account of such a power."; see also, jennings v. smith, 161 f.2d 74 (2d cir. 1947) (wherein since the contingencies of illness or financial distress had not occurred before decedent's death, the court held that decedent did not have the power at his death to change the enjoyment of the beneficiaries' property and so the predecessor to § 2038, i.e. irc § 811 (d) of the 1939 code, did not cause the value of that property to be included in decedent's estate; see, e.g., estate of yawkey v. commissioner, 12 t.c. 1164 (1949) (where at decedent's death, none of the beneficiaries was 30 years old, the pre-condition to decedent's having the power to transfer principal to them after age 30 had not occurred so that the property was not included in decedent's estate under the predecessor to § 2038). where the condition precedent to donor's power to revoke is an act within his control, he has made an incomplete gift. see rev. rul. 54-537, 1954-2 c.b. 316. 169. 553 f.2d 637 (1977). 170. see id. 171. indeed, the essence of§ 2038 is that decedent's power "to alter, amend, revoke, or terminate" makes the beneficiaries' interests at least in some way contingent interests until decedent's death. that is, it may be more accurately described as a vested interest subject to defeasance, but such property law distinctions do not control federal estate taxation. see, e.g., helvering v. hallock, 309 u.s. 106 (1940), repudiating such formalities in the context of the predecessor of § 2037. see generally, supra note 133. even where decedent has retained a power limited to determining the timing of the beneficiaries' receipt of property and where he cannot benefit himself directly from the exercise ofhis power, their interest is to that extent uncertain and under decedent's control. see estate of lober v. united states, 346 u.s. 335 (1953); regs. § 20.2038-1(a). since a § 2038 power can be held by decedent "in whatever capacity exercisable," where decedent has the legal power to replace a trustee, the trustee's powers are attributable to him. see regs. § 20.2038-1(a)(3). therefore, decedent maypossess athis death a power over the property's enjoyment by virtue of broad discretion given to a trustee. moreover, incompetence that does not permanently disqualify a decedent from being trustee may nonetheless cause inclusion under § 2038. see round v. commissioner, 332 f.2d 590 (1st cir. 1964). certain transfers wherein, during a continuous period beginning on or before september 30, 1947, through august 16, 1954, decedent was mentally disabled are exempt from § 2038. see regs. § 20.2038-1(f). [vol. 5:2 contingencies and the estate tax even though the exercise of the power is subject to a precedent giving of notice or even though the alteration, amendment, revocation, or termination takes effect only on the expiration of a stated period after the exercise of the power, whether or not on or before the date of the decedent's death notice has been given or the power has been exercised. 72 congress engrafted this exception, or clarification, because it considered decedent to have "to all intents and purposes practical, if not technical, ownership... although notice may be required as a condition precedent... ."" perhaps, however, this addition was unnecessary. that is, the contingency of notice-giving is an act within the decedent's control. moreover, the effective date after the exercise is not really a pre-condition to decedent's possessing a power at his death unless the statute is interpreted as requiring decedent to have a presently effective as well as presently exercisable power at his death. aveto power, if contingent," will avoid inclusion under section 2038, but courts have interpreted a non-contingent veto power as another articulation of ajoint power 175 so as to cause inclusion of the property subject to decedent's veto power in his estate. in this regard, "... it is irrelevant whether the decedent's participation initiates the termination, or, as here, is inthe nature of a consent after others have set the machinery in motion, it being sufficient under the statute merely that she act 'in conjunction with' the others."'76 thus, to distinguish a veto power as a power that is formally effective after a precondition (i.e. the agreement of the other trustees to exercise the power) from anyjoint decision in which the order of concurrence is unknown and irrelevant, is either to say that congress intended this particular type of contingency to be within a natural reading of the statutory language "by the decedent in conjunction with any other person" or to allow an exception for a contingent power that is analogous to the exemption of powers with delayed effective dates found in section 2038(b). any such contingency, however, must be distinguished from a truly contingent veto power, such as the one found in 172. irc § 2038(b). the value of decedent's interest, however, is discounted to reflect this delayed effective date. see regs. § 20.2038-1(b). 173. h. rep. no. 704, 73d cong., 2d sess. (1934), reprinted in 1939-1 c.b. (part 2), at 581. 174. see, e.g., estate ofkaschv. commissioner, 30 t.c. 102 (1958), acq., 1958-2 c.b. 6. 175. see, e.g., estate ofgrossman v. commissioner, 27 t.c. 707 (1957). for transfers after the revenue act of 1924 (june 2, 1924, 4:olp.m est), joint powers fall within § 2038; for transfers before that time, a decedent's joint power held in conjunction with someone with an adverse interest to its exercise would not fall under the predecessor to § 2038. see §§ 20.20381 (a) & (d). section 2038 does not, however, applywhere his power requires the consent ofall the beneficiaries if his power doesn't increase their rights under local law. see regs. § 20.20381(a)(2). 176. grossman v. commissioner, 27 t.c. at 709. 2001] florida tax review estate of kasch, wherein the court rejected the government's emphasis on the form of the decedent's retained power and stated that "[h]is only power was a contingent one to give his written consent to an invasion of the corpus in case his wife or any child or grandchild suffered a period of illness or other incapacity for which other funds were insufficient."'77 in that case, decedent's joint power was itself subject to a contingency beyond his control and thus the property was not includable under section 2038. that is, if a power is subject to an ascertainable standard, there is insufficient control to subject the transfer to estate tax.17 8 moreover, where the decedent has a presently exercisable power to affect contingent interests of the beneficiaries, the courts have distinguished between a contingent power and a power over a contingent interest, resulting in the value of the contingent interest's being included in his estate.'7 9 interestingly, the court in estate of want,180 rejected the taxpayer's argument that the value of the contingent remainder was unascertainable or de minimis, so that nothing should be included in his estate.' 8 ' even if a power is subject to a contingency within the decedent's control, however, section 2038 might not apply where the pre-condition is one that has other significant ramifications.'82 for example, where a trust provides 177. estate of kasch v. commissioner, 30 t.c. at 102, 107 (1958). 178. see, e.g., united states v. powell, 307 f.2d 21 (10th cir. 1962) (wherein a power to withdraw funds for the beneficiary's "happiness" was construed as an ascertainable standard similar to "welfare" and "comfort," exempting it from decedent's estate; the court distinguished merchants national bank of boston v. commissioner, 320 u.s. 256 (1943), interpreting "happiness" as a broader term than these other standards); estate of frew v. commissioner, 8 t.c. 1240 (1947) (wherein a power to withdraw principal for the beneficiaries support and maintenance was held subject to a contingency and not includable under the predecessor to § 2038. moreover, the contingent "spendthrift" powers depended solely on the beneficiary's voluntary act and therefore were not includable under this section. see id. at 1244-1245.). 179. see, e.g., estate of want v. commissioner, 29 t.c. 1223 (1958) (the contingent beneficiaries interests were dependent upon the death ofdecedent's only child without issue prior to age 30 and upon the death ofdecedent's wife); estate of graham v. commissioner, 46 t.c. 415 (1966) while the court held that the decedent had retained a power to alter, amend or revoke a contingent remainder interest the court also found that the value of that interest was unascertainable and, therefore, zero. id. at 431. although the court framed the issue in this manner, the question of who becomes ones heirs is perhaps a question more collateral to that decision and, in this case, subject to a pre-condition and thus really a contingent power. 180. estate of want v. commissioner, 29 t.c. 1223 (1958). 181. see id. at 1242-1243. in want, the court stated that "valuation should consider only the simplest of the contingencies, i.e., that jacqueline should die during decedent's life before attaining age 30 years, the value of the contingent interest, if any, would be considerably less than the full value of the trust corpus." id. however, the court asked the parties to file computations under the tax court's rule 50 to determine the value of that interest. 182. see estate of tully v. united states, 528 f.2d at 1401, 1405-1406 (1976) ("... to conclude that a motive for such action would be the death benefit plan itself is not only speculative but ridiculous.... in reality, a man might divorce his wife, but to assume that he would fight through an entire divorce process merely to alter employee death benefits approaches the [vol 5:2 contingencies and the estate tax that after-born or adopted children will become additional beneficiaries, ".... the act of bearing or adopting children is an act of independent significance, the incidental and collateral consequence of which is to add the child as beneficiary to the trust."'83 similarly, the claims court in estate of tully"8 4 rejected the government's argument that decedent had a power of revocation or termination because he could have changed his compensation contract, terminated his employment, or divorced his wife. "the possibility of divorce in the instant situation is so de minimis and so speculative rather than demonstrative, real, apparent and evident that it cannot rise to the level of a section 2038(a)(1) 'power."" 85 in so doing, the court was adding a type of de minimis test for a power's inclusion under section 2038. if, mathematically, one were to concretize this analysis, one might say that where "x" percent of the volitional pre-condition is attributable to voluntary acts unconnected with a reasonable person's decision to activate his retained power, the power will be exempt from section 2038. it is clear that section 2038 was not intended to apply to contingent powers. the rationale given for this limitation is that the focus is on what decedent owns at his death. if pre-conditions exist to his actually having such powers, the power is said not to exist at his death. yet, another way of interpreting the statute and the phrase what the decedent holds "at his death" is to say that he actually holds a contingent power at his death, one that has value. admittedly, this interpretation of the statute is contrary to current regulations and case law precedent, but it is also another way of looking at the asset decedent owns at his death. that is, during his lifetime, decedent transferred property with respect to which, at his death, he has retained something of value. the only difference between this interpretation and the conventional one is a difference in the value of that retained power; it is not really a distinction between a power in existence at his death and one that is not. by means of traditional analysis, moreover, the regulations and case law engraft a de minimis exception to section 2038. f. section 2039 and its relationship to sections 2036 and 203 7 absurd."); see also rev. rul. 80-255, 1980-2 c.b. 272. 183. rev. rul. 80-255, 1980-2 c.b. 272. 184. see supra note 182 and accompanying text. 185.estate oftully, 528 f.2d at 1406. (stating that "[w]hile it maybe argued that tully kept a certain de minimis association with the death benefit plan, such association never rose to the dignity of a power to 'alter, amend, revoke or terminate' the transfer." id.). 2001u florida tax review section 2039, enacted in the 1954 code as a clarification of the treatment of joint and survivorship annuities in an employment context,186 includes in decedent's estate the value of"an annuity or other payment" issued under some kind of employment agreement'87 that a beneficiary is entitled to receive if he survives the decedent and that the decedent had a right to enjoy during his lifetime or before his death.'88 the statute combines a kind of survivorship requirement somewhat similar to section 2037189 with the time 186. see 1954 h. rep., supra note 18, at 90-9 land at a3 14-a315. the report stated that "[i]t is not clear under existing law whether an annuity of that type purchased by the decedent's employer, or an annuity to which both the decedent and his employer made contributions is includable in the decedent's gross estate" and that "[t]his section is new and does not correspond to any specific provisions of existing law." id. at 90. the report also gave examples of contracts to which section 2039 is applicable. see id. at a314-a315; h. rep. no. 2543, 83d cong., 2d sess. 74 (1954). the statute was intended to tax employee death benefits. see e.g., estate of barr v. commissioner, 40 t.c. 227, 234-235 (1063); estate of schelberg v. commissioner, 70 t.c. 690, 698 (1978), rev'd, 612 f.2d 25 (2d cir. 1979); bahen's estate v. united states, 305 f.2d 827, 835 (1962) (congress wanted to tax "a large share of employer-contributed payments to an employee's survivors."). id. 187. decedent's rights under different employee plans will be considered together to determine the applicability of § 2039. "the scope of section 2039(a) and (b) cannot be limited by indirection." regs. § 20.2039-1(b)(ii) ex. (6). see also looney v. united states, 569 f.supp. 1569 (m.d. ga. 1983) (combining the company's disability plan with its survivor benefits plan). 188. section 2039 provides: (a) general.-the gross estate shall include the value of an annuity or other payment receivable by any beneficiary by reason of surviving the decedent under any form of contract or agreement entered into after march 3, 1931 (other than as insurance under policies on the life of the decedent), if, under such contract or agreement, an annuity or other payment was payable to the decedent, or the decedent possessed the right to receive such annuity or payment, either alone or in conjunction with another for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death. congress had created exceptions for benefits relating to qualified plans (originally designated as irc § 2039(c)) and ira's (§ 2036(e)), which were enacted by the tax reform act of 1976. see h. rep. no. 94-1380, 94th cong., 2d sess. 68-70), and for annuities resulting from community property laws (replacing the above as § 2039(c)), but the exceptions have been repealed. see 100 cong. rec. 3436 (march 17, 1954) (statement of mr. bymes); 1954 s. rep., supra note 18, at 123-124 (the exception for certain qualified plans to the house bill). pub. l. no. 98-369, § 525(a) (i.e., the deficit reduction act of 1984), repealed the special provisions of §§ 2039(c)(g) for qualified plans) and pub. l. no. 99-514, § 1852(e)(1)(a) (i.e., the tax reform act of 1986), repealed the special provision relating to annuities created by community property laws. section 2039 is not an exclusive section and other statutes may apply; however, § 2039 does not include insurance on decedent's life. 1954 s. rep., supra note 18, at 470 ("this section does not, however, apply to insurance under policies on the life of the decedent to which § 2042 is applicable."). 189. see regs. § 20.2039.1(b)(2) ex. (5), (wherein, according to the company's plan, the employee would receive 2 at age 60, his retirement, and his named beneficiary would receive the other 2 at his death; but if the employee died before age 60, the beneficiary would receive all of the annuity. according to the example, if the employee died before age 60, all would be included under § 2039). [vol. 5:2 contingencies and the estate tax frames and lifetime rights parallel to section 2036.19 the amount includable is proportionate to the amount of the decedent's (or employer's) contributions.19 however, when the beneficiary's benefits are forfeitable on the happening of certain events, those contingencies affect the value of the payments received and thus reduce what is included in decedent's estate. 92 the regulations define the terms "other payment" and "agreement' 93 very broadly 94 and the survivorship requirement allows for alternative contingencies. 195 under the regulations, "[t]he payments may be equal or unequal, conditional or unconditional, periodic or sporadic."' 96 further, [t]he decedent 'possessed the right to receive' an annuity or other payment if, immediately before his death, the decedent had an enforceable right to receive payments at some time in the future, whether or not, at the time of his death, he had a present right to receive payments. in connection with the preceding sentence, the decedent will be regarded as having had 'an enforceable right to receive payments at some time in the future' so long as he had complied with his obligations under the contract or agreement up to the time of his death.'97 although the beneficiary must survive the decedent for section 2039 to apply, if, for example, the decedent must also die before a certain age for the beneficiary to receive payments under the employer's plan, the additional required contingency will not take the transfer out of section 2039; by contrast, under similar facts, the survivorship requirement of section 2037 would not apply. 190. the time frames in § 2039 copy verbatim the time frames in § 2036. "for the meaning of the phrase 'or his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death', see section 2036 and 20.2036-1." regs. § 20.2039-1(b)(ii). significantly, the application of § 2039 relates to an agreement or contract entered into after march 3, 1931, the date of the joint resolution enacting the predecessor to § 2036. see supra notes 73-75. 191. irc § 2039(b). see also regs. § 20.2039-1(c). 192. see regs. § 20.2039-1(b)(2) ex.(2). 193. "the term 'contract or agreement' includes any arrangement, understanding or plan, or any combination of arrangements, understandings, or plans arising by reason of the decedent's employment." id. § 20.2039-1(b)(1)(ii). even where the employer is under no legal obligation to pay benefits, "[i]fl however, it canbe established that the employer has consistently paid an annuity under such circumstances, the annuity will be considered as having been paid under a 'contract or agreement."' regs. § 20.2039-1(b)(2), ex. (4). 194. however, the contract or agreement must arise from decedent's employment and not frombenefits receivableby statute. see, e.g., rev. rul. 81-182, 1981-2 c.b. 179 ("the value of monthly benefits payable to decedent's spouse under section 402(e) of title 42 of the united states code (the social security act) is not includable in the decedent's gross estate.") 195. see supra note 189. 196. regs. § 20.2039-1(b)(1)(ii). 197. id. 2001] courts have held two, divergent, interpretations of the definition of "other payment." on the one hand, the claims court' 9 and tax court'99 have held that this term includes decedent's right to disability payments despite the fact that he died without ever having received any payments. those courts determined that because his rights were nonforfeitable, decedent had, at his death, the right to receive disability payments that were includable in his estate under section 2039. according to the court in estate ofbahen, a "decedent's interest in future benefits, even if contingent, is sufficient. 2 10 moreover, the court cited to legislative history of the statute that indicated that congress wanted this statute interpreted along the lines of section 2036201 and considered the remoteness of the contingency irrelevant. 12 on the other hand, the second circuit in estate of schelberg v. commissioner0 3 agreed with the estate's argument that the decedent's rights were "too contingent to meet the condition of section 2039(a) '' 2 ' and interpreted the term "other payment" as excepting certain remote contingencies: even more plainly congress was not thinking of disability payments that an employee would have had only a remote chance of ever collecting had he lived. not only are the disability payments in this case extremely hypothetical, they are also far from the 'annuity or other payment' contemplated by congress. courts have, consistent with basic principles of statutory construction, recognized that 'annuity or other payment' does not mean 'annuity or other payment,' but that 198. estate ofbahen v. united states, 305 f.2d 827 (1962). see also looney v. united states, 569 f.supp. 1569 (m.d. ga. 1983). 199. estate of schelberg v commissioner, 70 t.c. 690 (1978), rev'd, 612 f.2d 25 (2d cir. 1978). ("upon the happening of a contingency over which neither he nor ibm had any controlnamely his becoming permanently and totally disabled at least 52 weeks before reaching the normal retirement age of 65 decedent would have become entitled to the payments under the disability plan.") 200. estate of bahen v. united states, 305 f.2d 827, 831 (1962). according to the court, "the right they possessed may have been contingent but it was not at the whim of the employer." id. at 83 1. 201. see 1954h. rep., supranote 18, ata314-316; 1954 s. rep., supranote 18, at470 ("the rules applicable under section 2036 in determining whether the annuity or similar payment was payable to the decedent, or whether he possessed the right thereto, for his life or such periods shall be applicable under this section."); estate of bahen, 305 f.2d at 832. 202. "we are not inclined to believe that, with potential disability payments of the type involved here, it makes any difference under section 2039 how probable it is that the decedent would, if he had lived, have obtained the benefits. but we point out that, if mr. bahen had survived his heart attack on november 11, 1955, it is not far-fetched to believe that he might have become totally disabled before reaching retirement age." id. at 832, n. 11. 203.612 f.2d 25 (2d cir. 1979). see also estate of van wye v. united states, 686 f.2d 425 (6th cir. 1982). 204. estate of schelberg, 612 f.2d at 29. florida tax review [vol 5:2 contingencies and the estate tax the phrase is qualitatively limited by the context in which it appears. 205 the court proceeded to distinguish estate ofbahen as being on that side of the line, as more like post-retirement benefits; it stated that the facts in estate of schelberg showed benefits more like sick pay, a substitute for wages that had been held not to constitute "other payment."2 6 while the court outlined this issue in terms of whether the disability payments were more like wages than a retirement survivor annuity, the court also framed the issue around whether remote contingencies are covered by section 2039 and, in this context, the second circuit held that they are not. by contrast, based on estate ofbahen, the seventh circuit inestate of wadewitz v. commissioner2 7 held that section 203 9 "includes aright to possess in the future even if such right is contingent upon the happening of an event as long as the contingency is not within the control or discretion of another."2 8 the court emphasized that the decedent's rights to contract payments were solely within his control. that is, the company had no discretion about paying decedent or his named beneficiaries; only the decedent had control over his decision to retire and to avoid certain competitive acts specified in the contract. 09 if the company had had that discretion, the court noted, then the decedent would not have possessed a right, "but a mere expectancy."2 "0 while the legislative history of section 2039 would suggest otherwise,2 " this statute is read differently from section 2036 with respect to 205. id. at 32-33. 206. see, e.g., estate offusz v. commissioner, 46 t.c. 214,217 (1966) acq. in result, 1967-2 c.b. 2 ("obviously, current compensation 'payable to the decedent' cannot also be 'receivable by any beneficiary."); looney v. united states, 569 f.supp. 1569, 1574 (m.d. ga. 1983) (characterizing payments under ibm's disability plan as "post-employment" benefits, the court distinguished those from the company's sickness and accident plan, wherein "it is assumed that at some point in the near future he will be able to return to active employment.") 207. 339 f.2d 980 (7th cir. 1964). 208. id. at 983. the tax court had held only that § 2039 requires the right to receive future payments and not that decedent began to enjoy his interest during his lifetime. estate of wadewitz v. commissioner, 39 t.c. 925, 939 (1963), aff'd, 339 f.2d 980. 209. see also silberman v. united states, 333 f.supp. 1120, 1127 (w.d. pa. 1971) (citing both wadewitz and bahen and holding that where the contract did not require significant services, but only advice and consultation, for decedent to qualify for payments, they contemplated retirement and, thus, § 2039 applied.). but see kramer v. united states, 406 f.2d 1363 (1969) (wherein the court held that because the facts had been filly stipulated and because the court could not read into the facts whether or not decedent's agreement to serve as an advisor and counselor was an employment or a retirement agreement. this was despite the fact that the decedent would be paid the same amount even if he became incapacitated and that his widow would receive a continuation of these benefits after decedent's death). 210. estate of wadewitz, 339 f.2d at 983. 211. see supra notes 190, 201. 2001] florida tax review contingent payments. while the government has stopped litigating this issue212 and has acceded to the second circuit's decision in estate of schelberg,23 it has done so without any formal ruling. with the government's acceptance of schelberg, however, decedent's right to receive an "annuity or other payment" means decedent's right to an annuity or other payment, except one that the decedent is unlikely to receive, engrafting a defacto, de minimis exception to this statute. g. section 2040: a statute with artificial rules of inclusion for non-spousal property, section 2040 enunciates two rules:214 212. although the government's official position, as stated in a.o.d. 1981-14, indicated that they would "continue to litigate this issue in other circuits," they have apparently changed their minds. see richard holz, properly structured death benefit plans can avoid estate and gift tax consequences, 15 est. planning 100, 101 (1988) ("despite its victory in looney, the service decided not to contest the results reached by the sixth circuit in van wye and the second circuit in schelberg. accordingly, in an unreported development, a consent judgment was subsequently entered in favor oflooney's estate. the service's concession appears to resolve in favor of the taxpayer the issue of whether contingent, future benefits under a disability plan must be combined with death benefits in applying section 2039."); john r. cummins, tumey p. bery and martin s. weinberg, using the service's new handbook for estate tax examiners, 68 j. tax'n 276, 282, n.28 (1988). in looney v. united states, 569 f.supp. 1569, 1574-1575 (m.d. ga. 1983), the court found that the decedent, after five years in service with ibm, had an enforceable right to receive the disability benefits; the court rejected the taxpayer's reliance on schelberg despite the same facts and agreed with bahen. 213. 612 f.2d 25 (2d cir. 1978). 214. section 2040(a) provides: (a) general rule.-the value of the gross estate shall include the value of all property to the extent of the interest therein held as joint tenants with right of survivorship by the decedent and any other person, or as tenants by the entirety by the decedent and spouse, or deposited, with any person carrying on the banking business, in their joint names and payable to either or the survivor, except such part thereof as may be shown to have originally belonged to such other person and never to have been received or acquired by the latter from the decedent for less than an adequate and full consideration in money or money's worth: provided, that where such property or any part thereof, or part of the consideration with which such property was acquired, is shown to have been at any time acquired by such other person from the decedent for less than an adequate and full consideration in money or money's worth, there shall be excepted only such part of the value of such property as is proportionate to the consideration furnished by such other person: provided further, that where any property has been acquired by gift, bequest, devise, or inheritance, as a tenancy by the entirety by the decedent and spouse, then to the extent of one-half of the value thereof, or, where so acquired by the decedent and any other person as joint tenants with right of survivorship and their interests are not otherwise specified or fixed by law, then to the extent of the value of a fractional part to be determined by dividing the value of the property by the number ofjoint tenants with right of survivorship. for examples of the percentage of consideration rule, see regs. § 20.2040-1(c), ex. (1)-(6). for examples of the fractional interest rule, see regs. § 20.2040-1(c), ex. (7) and (8). [vol 5:2 contingencies and the estate tax (1) for purchased property, the full value of the property is included in the decedent's estate minus amounts shown to be provided by the contributions215 of the otherjoint tenant(s); and (2) for gifts or inheritedjointly-ownedproperty, the decedent's fractional share is included in his estate. the essential feature of ajoint tenancy is the condition or contingency of survivorship; 2"6 a joint tenant only owns the entire property outright if he survives the otherj oint tenant(s). in other words, aj oint tenancy may be viewed as the equivalent of a life estate with a contingent remainder, contingent on surviving the other joint tenant.21 '7 however, section 2040 covers only that contingency inherent in the property law concept of a joint tenancy with the right of survivorship or a tenancy by the entireties; because of the nature of the property interest, no other contingency can be explicitly imposed on the creation of a joint tenancy. decedent's interest disappears at his death and, immediately, the other joint tenant owns the property outright. if, however, there were conditions imposed in order for the joint tenant to take, the contingencies would effect a severance of the joint tenancy, and thereby create a tenancy in common.1 8 if, for example, the right to possess jointly held property is subject not only to the contingency of survivorship, but also to the condition that the surviving joint tenant did not murder the decedent,219 the joint tenancy is 215. with respect to appreciated property given as a gift by one of the joint tenants to another, the entire value of the property will be seen as the donor's, assuming he had purchased it, despite that the value of the property appreciated while in the hands of the donee; however, if the donee sold the appreciated property, the amount of gain, but not the original cost, will constitute consideration from that donee/joint tenant. see estate of goldsborough v. commissioner, 70 t.c. 1077 (1978), rev. rul. 79-372, 1979-2 c.b. 330; regs, § 20.2040-1(c), ex. (4). likewise, income from income-producingproperty under the above set of facts is treated like gain from the property. see regs. § 20.2040-1(c), ex. (5). for contribution adjustments due to subsequent unequal contributions towards improvements, see estate of peters v. commissioner, 386 f.2d 404 (4th cir. 1967). 216. see united states v. jacobs, 306 u.s. 363, 370 (1939). 217. see estate of sullivan v. commissioner, 175 f.2d 657 (9th cir. 1949). 218. in jurisdictions that recognize a tenancy by the entirety, state law does not allow creditors to reachthis type ofpropertyinterest. see, e.g., sawadav. endo, 561 p.2d 1291 (hawaii 1977); central nat'l bank of cleveland v. fitzwilliam, 465 n.e.2d 408 (1984). 219. according to the restatement, if a donee criminally causes the donor's death, he is precluded from benefiting under a will or will substitute. see restatement (second) property; donative transfers § 34.8, statutory note 11 (1992) (citing state statutes providing that the murderer cannot receive the victim's one-half interest; the death severs the interest and the survivingjoint tenant becomes a tenant in common with decedent's heirs). moreover, most states have enacted laws that reflect the public policy of prohibiting a murderer from materially benefiting from homicide. see, e.g., ga. code ann. § 53-4-6 (2000); d.c. code ann. § 19-320 (2000); cal. prob. code § 250 (deering ann. 2000); ala. code § 43-8-253 (2000). see also estate of grund v. grand, 648 n.e.2d 1182 (ind. ct. app. 1995). likewise, the federal governmentmay seizepropertyused or acquired fromtrafficking in illegal drugs; however, where property is held in a tenancy by the entireties, the criminal spouse's survivorship right may be 2001u florida tax review severed and decedent receives only his one-half interest as a tenant in common with the other half passing to the victim's estate.22 under such a situation, the irs has ruled that section 2040 is inapplicable and section 2033 would apply to the decedent's interest that did not terminate at death.22 ' likewise, in the instance of simultaneous death, the joint tenancy is treated as a tenancy in common. 222 for property owned solely by husband and wife jointly with the right of survivorship, the rule is that one-half of the fair market value of the property is included in the decedent's estate.223 congress created, and changed, the rule under section 2040(b) to simplify the administration of the general rule of this section where, as between married individuals, there were particular problems with tracing issues.224 moreover, within a spousal context, because of the forfeited. see 21 u.s.c. § 881. some courts impose a constructive trust even where there is a conflicting statute. see estate of karas, 485 a.2d 1083 (n.j. app. div. 1984). see also restatement (second) property; (donative transfers) § 34.8, statutory note 6 (1992)(citing caselaw wherein courts have imposed a constructive trust.) 220. see unif. probate code § 2-803(c)(2). 221. rev. rul. 78-166, 1978-1 c.b. 283. 222. see unif. simultaneous death act § 3. 223. irc § 2040 provides: (b) certain joint interests of husband and wife(1) interests of spouse excluded from gross estate-notwithstanding subsection (a), in the case of any qualified joint interest, the value included in the gross estate with respect to such interest by reason of this section is one-half of the value of such qualified joint interest. (2) qualified joint interest defined-for purposes of paragraph (1), the term "qualifiedjoint interest" means any interest in property held by the decedent and the decedent's spouse as(a) tenants by the entirety, or (b) joint tenants with right of survivorship, but only if the decedent and the spouse of the decedent are the only joint tenants. section 2040(b), to deal with spousaljoint tenancies, was originally added by the tax reform act of 1976, effective for joint tenancies created after december 31, 1976. see pub. l. no. 94-455, §§ 2002(c)(1), 2002(d)(3). the revenue act of 1978 added §§ 2040(d) and 2040(e) to allowpre1977 joint tenancies to qualify under the new 50% inclusion rule and § 2040(c) to make spousal services qualify as consideration forjointly held farm or trade or business property in which both spouses materially participate. see pub. l. no. 95-600, §§ 511 (a), 702(k)(2). congress enacted the current version of§ 2040(b) in the economic recovery tax act of 1981, when congress at the same time repealed subsections (c) through (e). see pub. l. no. 97-34, §§ 403(c)(1), 403(c)(3)(a). 224. see s. rep. no. 97-144, 97th cong., ist sess. 127 (1981) [hereinafter 1981 s. rep.] ("[t]he committee believes that the taxation ofjointly held property between spouses is complicated unnecessarily. often such assets are purchased with joint funds making it difficult to trace individual contributions .... accordingly, the committee believes it appropriate to adopt an easily administered rule under which each spouse would be considered to own one-half of jointly held property regardless of which spouse furnished the consideration for the property."). the rule also acknowledged the services furnished by the widow as contributions to the acquisition ofjointly held property. see h. rep. no. 94-1380, 94th cong., 2d sess. 20 (1976). [vol 5:2 contingencies and the estate tax unlimited marital deduction, such a rule would not affect the estate's tax liability although it could have an impact on the surviving spouse's income tax liability when she sold the property.225 section 2040 provides artificial constructs as rules of inclusion for jointly held property.226 because they are artificial, typical valuation rules such as minority discounts or control premiums that are reflective of real market phenomena do not apply.227 in this way, this section parallels sections 203 6 and 2037 that do not follow a mathematical rule of inclusion. h. section 2041: parallels to sections 2033 and 2036-2038 1. background and introduction to section 2041.-section 2041"2 is most comparable to section 2033,229 the section that includes in decedent's gross estate property owned by decedent at his death. but, because the supreme court in helvering v. safe deposit & trust co. of baltimore3. declined to 225. "in light of the unlimited marital deduction adopted by the committee bill, the taxation ofjointly held property between spouses is only relevant for determining the basis of property to the survivor (under sec. 1014) and the qualification for certain provisions (such as current use valuation under sec. 2032a, deferred payment of estate taxes [under sec. 6166] and for income taxation of redemptions to pay death taxes and administration expenses under sec. 303)." 1981 s. rep., supra note 224, at 127. 226. these rules do not apply to community property or to property held as tenants in common. see 1981 s. rep., supra note 224, at 126. 227. estate ofyoung v. commissioner, 110 t.c. 297,316 (1998) ("as a result of this artificial inclusion, we conclude that section 2040 is not concerned with quantifying the value of the fractional interest held by the decedent (as would be the case under section 2033." the court thus denied the application of a fractional interest discount and a lack of marketability discount to the property included under section 2040."). 228. section 2514 is the gift tax equivalent to § 2041 and concerns the inter vivos transfers resulting from an exercise of a general power of appointment. for example, if a holder of a general power of appointment that allows him to withdraw $20,000 from a trust releases that power this year, that declaration that he will not take the money results in the remainderman's being $20,000 richer. thus, he is making a gift of that amount and is thereby subject to gift taxes. 229. "general powers of appointment should continue to be subjected to gift or estate tax. such powers are too much like outright ownership to be treated differently." k. jay holdsworth, et. al., report on transfer tax restructuring, 41 tax law. 395, 412 (1988) [hereinafter report on transfer tax restructuring]. 230. 316 u.s. 56 (1942). in safe deposit & trust co. of baltimore, the decedent was the income beneficiary and held a testamentary power of appointment in three trusts created by others. in addition, in one of the three trusts, he was to have received the corpus at age 28. see id. at 58). the government had argued that his ownership rights in these trusts were essentially fee simple ownership interests, but the estate argued that they were not equivalents as the restrictions on alienation and income use were significant; further, because the decedent died before he reached 21, he could not make a will to transfer the property at his death. see id. while agreeing "that the realities of the taxpayer's economic interest, rather than the niceties of the conveyancer's art, should determine the power to tax," the court did not reach its decision based on an analysis ofthe equivalence ofdecedent's rights and ownership, but on congressional intent. id. at 59, n.1. "we find it unnecessary to decide between these conflicting contentions on the 20011 florida tax review extend the purview of section 2033 to include unexercised testamentary powers of appointment, section 2041 deals specifically with powers of appointment in situations where decedent never first owned the property outright.231 section 2041 basically views a donee general power of appointment, which is defined as a power to appoint the property either to decedent, decedent's creditors, decedent's estate, or the creditors of decedent's estate,232 as an equivalent of decedent's ownership of that property.233 economic equivalence of the decedent's rights and complete ownership. for even if we assume with the government that the restrictions upon the decedent's use and enjoyment of the trust properties maybe dismissed as negligible and that he had the capacity to exercise a testamentary power of appointment, the question still remains: did the decedent have 'at the time of his death' such an 'interest' as congress intended to be included in a decedent's gross estate under §302 (a) of the revenue act of 1926? it is not contended that the benefits during life which the trusts provided for the decedent, terminating as they did at his death, made the trust properties part of his gross estate under the statute. and viewing §302 (a) in its background of legislative, judicial, and administrative history, we cannot reach the conclusion that the words 'interest ... of the decedent at the time of his death' were intended by congress to include property subject to a general testamentary power of appointment unexercised by the decedent." id. at 58-59 (footnote omitted.) the court proceeded to review case law under the predecessor section contained in the revenue act of 1916, wherein the court had held that exercised and, by logical extension, that unexercised general powers of appointment were outside decedent's interests contained in that statute. likewise, the same provision was reenacted in the revenue acts of 1921 and 1924 and so the court considered that when the then current provision was enacted, the same language should be interpreted the same way so as not to include unexercised powers of appointment. further, the regulations subsequent to the 1926 legislation did not indicate a new treatment for these interests. id. at 59. 231. other sections deal with property once owned by decedent but transferred to another while retaining powers over the property. see, e.g., §§ 2036 and 2038. 232. see irc § 2041(b)(1). 233. in part to reconcile the code sections dealing with transfers of property owned outright with retained powers and/or interests, as well as what congress considered the differences between outright ownership and owning a generalpower of appointment under § 2041 or at least concessions congress made to certain perceived differences employed as typical estate planning modes of the time, congress made some exceptions to the definition of a general power of appointment. see 1984 treasury reform, supra note 12, at 384 ("the purpose of this [term 'general power of appointment'] is to include in a decedent's estate property with respect to which the decedent possessed virtually the same control as if the property were owned outright. thus, a power will not be classified as a general power of appointment if it can be exercised only in conjunction with the creator of the power or in conjunction with a person having a 'substantial interest' in the property that would be adversely affected by the exercise of the power of appointment. moreover, a power will not be classified as a general power of appointment if the ability to exercise the power is limited by an 'ascertainable standard' relating to the support, health, education, or maintenance of the holder.") see also irc §§ 2036-2038. the treasury department, however, argued that the exceptions have actually contributed to the disparity in treatment between ownership andpowers of appointment and should therefore be eliminated. see id. at 384-385. if the power to withdraw the $20,000 is held jointly with the creator of the power, for example, congress didn't want the property that would be includable in the creator's estate under §§ 2036 and/or 2038 also to be included in the donee's, holder of the power of appointment's, [vol. 5:2 contingencies and the estate tax when a general power of appointment is a power to appoint property estate in the event that the donee predeceased the creator. see § 2041(b)(1)(c)(i); see also sen. rep. no. 382, 82d cong., 1st sess. 5 (1951), reprinted in 1951 u.s.c. cong. & ad. serv. 1530, 1533 [hereinafter 1951 s. rep.] ("since in this case the property would be includable in the gross estate of the creator of the power.") [hereinafter 1951 s. rep.]. note that for a power created on or before october 21, 1942, no jointpowers are considered as owned by the decedent, since they are excepted from the general power of appointment definition. see § 2041(b)(1)(b). if the property had beenjointly owned in fee simple, § 2040 would have produced that same result as this exception since the creator, having provided all of the consideration, would have had the full value included in his gross estate while the donee joint owner, under that same rule, would have had none of the property included. see supra note 214. in addition, congress imposed an exception to § 2041 wherein the donee holder of the power held the power together with someone having a substantial interest in the property that is similar to the exception present in the gift tax regulations as well as those in the grantor trust rules. see §§ 672(a), 674(a), 677(a), 2041(b)(1)(c)(ii). see also regs. § 25.2511-2(e). ("a donor is considered as himself having a power if it is exercisable by him in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property or the income therefrom.") thus, the donor does not have the power if it is held in conjunction with someone having a substantial adverse interest. likewise, a power of appointment is not taxable in decedent's estate where the holder of the power may only exercise that power with someone holding such substantial adverse interest in the exercise of the power. see id. § 672(a) defines an "adverse party." distinctions focusing on whether the grantor holds ajoint power with an adverse or nonadverse party are central to determining the incidence of taxation under §§ 674-677. "principles developed under the income and gift taxes will be applicable in determining whether an interest is substantial and the amount ofproperty in which the adversity exists." 1951 s. rep., supra, at 1534. in these instances, the theory is that an adverse party's own interests would produce a natural conflict with the decedent's exercise of his power, that is, the holder ofthe power is going to have so much inherent difficulty from his lack of freedom in these situations, that it's hard to say that he really owns the property. section 2040 does not have such a parallel provision; however, the ability to exercise the rights and powers of ownership cannot be blocked by ajoint tenant in the same way as ajoint power can function. if decedent jointly owned property outright with anyone who had a substantial adverse interest to the exercise of any power, independent of that joint tenant, he would have a unilateral right to partition, resulting in his owning his proportionate share of the property as a tenant in common. by contrast, where a donee held a power of appointment jointly with someone with an adverse interest to his exercising that power, the decedent would not have free access to even one-half of the property. finally, if the holder of a power of appointment has a power limited by an "ascertainable standard relating to the health, education, support, or maintenance of the decedent," § 2041 exempts that power from inclusion in the holder's estate. here, like in the judge-made exceptions found in §§ 2036 and 2038, decedent's control is seen as limited by the courts and thus is not an equivalent to ownership. see § 2041(b)(1)(a). "if'the holder of a power is legally accountable for its exercise or nonexercise, the power is not deemed to be a general power." 1951 s. rep., supra, at 1534; leopold v. united states, 510 f.2d 617 (9th cir. 1975); old colony trust co. v. united states, 423 f.2d 601 (1st cir. 1970). critics have suggested that where decedent's power is limited to those four, he is not very limited at all, and indeed "owns" the property, but the statute retains that exception. see, e.g., erwin n. griswold, powers of appointment and the federal estate tax, 52 harv. l. rev. 929 (1939); richard w. harris, ascertainable standard restrictions on trust powers under the estate, gift, and income tax, 50 tax law. 489, n. 118 (1997) ("lilt is difficult to understand why property subject to such a power of invasion should not be included in the powerholder's gross estate."). 20011 florida tax review to the decedent, a donee power of appointment is essentially the equivalent of a fee simple interest. after all, if decedent can withdraw $20,000 from a trust, he owns the $20,000. the act of withdrawal is the only condition required for him to own the property outright and that condition is one wholly within his control. it may be considered a contingency as it is a condition precedent to possession, but it is not a condition precedent to ownership whose essential feature is control. likewise, a power to appoint property to one's creditors is essentially like ownership of a fee interest. that is, if the trustee can withdraw the $20,000 to pay for debts incurred by decedent, decedent owns the property. although decedent must first incur a debt before such a power of appointment may be exercised, this type of general power of appointment mostly just adds indirection to the transfer. the conditions precedent or contingencies are, like with the power to appoint property to oneself, within the control of the holder of the power. a testamentary power of appointment is less of an equivalent to a fee interest since the property cannot be withdrawn from the trust during the decedent's lifetime. however, one of the primary indicia of ownership is the ability to transfer property at one's death. while decedent's death may be seen as a condition precedent for such a power, since death is one of the two inescapables, it is not as much a contingency as a timing factor. a testamentary power to appoint property to one's creditors is a combination of indirection and delayed payments, but despite any discount accorded for the time value of money, the holder's control indicates ownership roughly equivalent to a fee interest. one could spend money fairly freely during one's lifetime and then appoint one's trust property to one's creditors at death. because section 2041 is an equivalent to ownership, there is another aspect of the statute that parallels sections 2035 through 2038. in those latter sections, decedent initially owned the property outright, but then transferred some aspects of the property while retaining others.234 section 2041 includes property 35 in decedent's gross estate where decedent exercised or released2 36 his power of appointment during his lifetime but retained some aspects of the property that would parallel sections 2035 through 2038. for example, if decedent released his power to withdraw $20,000 so that he made a gift to the 234. see discussion infra parts ii. c-e for an explanation of those code sections in more detail. 235. see regs. § 20.2041-3(d)(3)-(5) (illustrating the rules and calculations for computing the proportion of the value of the property includable in decedent's estate.) 236. for powers created on or before october 21, 1942, there are separate rules requiring that decedent had exercised his power either by will or during his lifetime in such a way that would parallel §§ 2035-2038 in order for § 2041 to require inclusion of the property in decedent's gross estate. that is, merely holding that power at death or a total release of a power will not constitute a prohibitive exercise for these grandfathered powers. [vol. 5:2 contingencies and the estate tax remainderman of that amount, but if he also continued to collect the income from that amount as income beneficiary of the trust, he is seen as owning $20,000 and then transferring $20,000 while retaining the income from $20,000. if he had indeed initially owned the $20,000 rather than having had a general power of appointment over the $20,000, he would have had the $20,000 (or the date of death value of that property) included in his gross estate under section 2036(a)(1). however, having stated the parallel between 2041 transfers with retained interests or powers to sections 2035 through 2038, there is also a de minimis, freebie, aspect to the lifetime transfer with retained interest/powerpart of section 2041 which distinguishes section 2041 general powers of appointment from these other sections. section 2514(e) excepts from gift taxation, and correspondingly 2041(b)(2) provides with respect to estate taxation, that a lapse (not exercising or releasing the power, i.e. doing nothing) will not be considered a release such as to cause the property to be included in decedent's gross estate to the extent that the value of the property subject to the general power of appointment did not exceed the greater of $5,000 or five percent of the aggregate value of the property subject to the power. that is, in each year that the decedent, during his lifetime, allowed his power over the statutorily de minimis amount of property to lapse, he could continue to receive the income from that amount and not have any property included in his estate under the part of section 2041 that parallels sections 2035-2038.237 at the time of this rule's enactment, it was unclear how popular this device would become. it is too early to know just what use will be made of the provisions which exempt the first $5,000 or 5% of atrust fund over which a power lapses during the lifetime of the donee. prior to the 1942 act it was quite common for a testator in his will to give a noncumulative power of invasion of principal in a small amount each year to his widow or children, and it is quite likely that this practice will be revived. in other cases, testators will be content to give a power to a disinterested trustee to pay principal to income beneficiaries, since a power in which trustee alone would not involve liability for tax.238 237. note, however, that in the year of decedent's death, since there is no "lapse," the de minimis rule does not come into play and whatever value of the property over which decedent held that $5,000 or 5% power is included in decedent's estate under the part of § 2041 that states that inclusion is required for general donee powers that decedent holds at his death. 238. george craven, powers of appointment act of 1951, 65 harv. l. rev. 55, 78 (195 1) [hereinafter craven]. 2001] florida tax review today, few trusts lack this "benefit," '239 particularly since the crummey2 4 ° case and, indeed, an estate planner might be deemed incompetent for ignoring its use in minimizing a wealthy taxpayer's transfer taxes.241 the de minimis section relating to lapses was added in 1951242 when sections 2514 and 2041 retroactively replaced243 the powers of appointment statute amended in 1942.244 apparently, congress decided to codify the common practice of allowing the beneficiary the availability of small sums of money from a trust as long as he didn't actually withdraw the funds at the end of each year on the grounds that some income beneficiaries were "unsophisticated" and needed such a fallback provision.245 whether this was a policy choice or apolitical expediency, historically, there has been ambivalence 239. estate planners often limit the time for exercising the $5,000 or 5% power to ensure that it is likely to "lapse" and not be exercised. if the power is exercised under this situation, inclusion in decedent's gross estate is determined under regs. § 20.2041-3(d)(3)-(5). 240. see crummey v. commissioner, 397 f.2d 82 (9th cir. 1968). 241. the popularity of the combination was and is rampant. see, e.g., report on transfer tax restructuring, supra note 229, at 412 ("this 'five-and-five' exception and the resulting crummey problem discussed above may be routinely exploited by some sophisticated taxpayers."). 242. powers of appointment act of 1951, pub. l. no. 82-58, 65 stat. 91 (1951), reprinted in 1951-2 c. b. 343. 243. the powers of appointment act of 1951 retroactively applied to powers of appointment created since 1942 as well as retaining the pre-1942 act provision with respect to powers created before october 21, 1942. see 1951 s. rep., supra note 233, at 1530, 1532. 244. the revenue act of 1942, pub. l. no. 77-753, 56 stat. 798 (1942). the revenue act of 1942 was enacted in response to the supreme court's decision in safe deposit and trust co. of baltimore, wherein the court refused to expand the purview of § 2033 to include unexercised general powers of appointment. see helvering v. safe deposit & trust co. of baltimore, 316 u.s. 56 (1942). with respect to a general power of appointment created preoctober 21, 1942, only exercised powers were included in the holder's gross estate. that is, lapsed or released powers were not subject to transfer tax. indeed, when congress enacted the powers of appointment act of 1951, there were advocates of extending this pre-1942 rule so that the only powers that would be subject to estate taxation would be those connected with property that had previously been allowed the marital deduction. see preliminary digest of suggestions for internal revenue revision submitted to the joint committee on internal revenue taxation, prepared by the staff of the joint comm. on internal revenue taxation, april 21, 1953, p. 10 8 . 245. see 1951 s. rep., supra note 233, at 1535 ("since the problem of the termination or lapse of powers of appointment during life arises primarily in the case of dispositions of moderate-sized properties where the donor is afraid the income will be insufficient for the income beneficiary and therefore gives the income beneficiary a noncumulative invasion power, it is believed that the exemption provided in the committee amendment ($5,000 or 5 percent of the principal) will be adequate to cover the usual cases without being subject to possible abuse.") see also craven, supra note 238 at 77. in addition, "the bar association representatives, on the other hand, pointed out... donees in small communities or with general powers over small funds, who did not have access to competent legal advice, either might not learn of the existence or nature of their powers or might not be properly advised of steps which could be taken to reduce their estate tax liability." craven, supra note 238, at 63. [vol. 5:2 contingencies and the estate tax about its retention.246 indeed, it is hard to find a cogent policy reason for its retention; section 2033, the section's clearest parallel, does not contain such a similar exception. rather, the unified credit exempts small estates froni transfer taxation247 and protecting wealthy beneficiaries from their own lack of financial sophistication is either no longer necessary248 or too paternalistic. moreover, ironically, while the main purpose of the 1951 actwas "to make the lawsimple and definite enough to be understood and applied by the average lawyer," '249 the $5,000 or five percent power exception has produced some of the more complex calculations for estate tax inclusions where the decedent's lapsed powers exceed that threshold.250 2. contingencies and section 2041.-what if decedent holds at his death a power to appoint property only if certain conditions are first met? does he have a general power of appointment? is the property subject to such a power valued to take into account the contingency? under the law in effect prior to the powers of appointment act of 1951, the answer to this question was unclear.251 under the current regulations, while notice giving or a delayed effect will not prevent property subject to a general power of appointment from 246. it appears to have been a compromise between the position of the house and the treasury department. see 1951 s. rep., supra note 233, at 1535 ("the house bill provided that the failure to exercise a future power which lapses during the life of the holder of the power shall not be deemed an exercise or release of the power. an amendment by your committee modifies this latter provision so as to exempt from estate and gift tax only limited amounts of property subjectto lapsed powers."). in 1951, the treasurydepartment did not want to havethis exception as it considered it an area of potential tax abuse and so it opposed the house bill to consider a lapse as not an exercise or release. see craven, supra note 238, at 76-77. in its 1984 proposals, the treasury department changed its position. it proposed that § 2041 "be replaced by a rule treating an individual as the owner of property for transfer tax purposes where the individual possesses a nonlapsing right or power to vest the property or trust corpus in himself or herself. for purposes of this rule, a power or right would be treated as nonlapsing if it did not, by its terms, expire prior to the death of the powerholder. see 1984 treasury reform, supra note 12, at 385. by contrast, the aba in 1951 urged its enactment and then in 1988 began to seek its repeal. see report on transfer tax restructuring, supra note 229, at 412 ('there isno conceptual justification for that exception."). one commentator has suggested that the $5,000 or 5% power exception is "simply an obvious example of the propensity of congress to draft transfer tax statutes that exclude from taxation the most common forms of wealth transmission and tax only the unusual ones." see amy morris hess, the federal taxation of nongeneral powers of appointment, 52 tenn. l. rev. 395, 429 (1985). 247. see irc § 2010. 248. many people, both the sophisticated and unsophisticated, use financial planners, have mutual investments, and receive investment advice today. ironically, the exception has been criticized as exacerbating a trap for the unwary. "the treatment of the power-holder as the grantor of the affected portions of the trust for income tax purposes creates an area of noncompliance for unsophisticated taxpayers." report on transfer tax restructuring, supra note 229, at 413. 249. see 1951 s. rep., supra note 233, at 1531. 250. see id. at 1536; see also regs. § 20.2041-3(d)(3)-(5). 251. see craven, supra note 238, at 67-68. 2001] florida tax review inclusion in decedent's gross estate, a power whose exercise is dependent on an event or contingency "which did not in fact take place or occur during [decedent's lifetime] is not a power in existence" at decedent's death.252 thus, contingencies such as surviving to a specific age or surviving certain persons prevent property subject to powers of appointment from being treated as property owned by decedent.253 under section 2041, the court looks to what power decedent had available to him at his death whether or not the exercise of the power could take place at that moment. the seventh circuit in estate ofkurz v. commissioner254 underlined that position when it held that a sequence of withdrawal rights would not prevent a power under section 2041 from being "exercisable. 255 in that case, the decedent had a donee power of appointment wherein she could consume five percent of the family trust if the marital trust was exhausted. the taxpayer argued that there was no general power of appointment because, in order for the decedent to have such a power under section 2041, the event must have occurred by the time of decedent's death; otherwise, the decedent's interest had not ripened and was merely a type of expectancy. the government, on the other hand, adopted the position that unless the contingency attached to decedent's power of appointment was one beyond his control, the property subject to the power was includable in decedent's gross estate. the court found little of a real contingency in this case and held that "section 2041 is designed to include in the taxable estate all assets that the decedent possessed or effectively controlled. if only a lever must be pulled to dispense money, then the power is exercisable., 256 according to the court, "the regulation does not permit the beneficiary of multiple trusts to exclude all but the first from the estate by the expedient of arranging the trusts in a sequence. no matter how long the sequence, the beneficiary exercises economic dominion over all funds that can be withdrawn at any given moment. "257 the tax court in estate ofkurz v. commissioner258 did not look at the contingency as a timing or sequence issue but as a substantive pre-condition to the decedent's exercise of her power.25 9 when the court approached the 252. regs. § 20.2041-3(b). 253. see id. 254. 68 f.3d 1027 (7th cir. 1995). 255. see id. at 1028. 256. id. at 1029. 257. id. at 1030. 258. 101 t.c. 44 (1993), aff'd, 68 f.3d 1027 (7th cir. 1995). 259. the tax court in kurz refused to apply the regulations under § 2041 that parallel § 2038 and are more limited in application with regard to contingent powers than § 2036. explaining their inapplicability, the court described how the government failed to amend its regulation under § 2041 at the time it amended the regulation under § 2038 and stated that "[t] here is no indication that the omission was inadvertent." id. at 57. the court emphasized the difference between the two sections in that, with respect to § 2038, decedent once owned the [vol 5:2 contingencies and the estate tax contingency this way, it engrafted an additional requirement for a contingency to except decedent's power of appointment from inclusion in his estate under section 2041. the court stated that the contingency or event had to have some significant non-tax consequences independent of the decedent's ability to exercise the power and could not be "illusory."260 where that type of precondition was absent, the contingency would not prevent the decedent from having "practical ownership."261 the court gave some examples of such non-tax purpose as having children or obtaining a divorce.262 the treatment of contingent powers of appointment under section 2041 is, like other aspects of section 2041, replete with favored treatment. that is, although this section generally parallels sections wherein decedent had owned the property that he literally only had a power to appoint to himself, his creditors, his estate or his estate's creditors, section 2041, like its concomitant gift tax section 2514, grants tax benefits to lapsed powers. similarly, section 2041, through the regulations, excepts contingent powers of appointment from taxation while property contingently owned by the decedent is subject to estate tax under section 2033. moreover, the tax court has indicated that it is willing to further exempt powers of appointment subject to a contingency within the decedent's control, as long as that contingency is not illusionary and not taxmotivated. i. section 2042: a de minimis rule for certain remote contingencies section 2042 includes property in decedent's gross estate where either the estate is the recipient of the proceeds263 or the decedent owned at his death, or within three years of his death,2" any of the "incidents of ownership," exercisable alone or with anyone else, in an insurance policy on his life.265 property outright and, while transferring some of the property to another, decided to retain a power to regain ownership or a prohibitive indicia of ownership, but that with respect to § 2041, the decedent never owned the property and was only the recipient of a general power of appointment. see id. at 57-58. 260. see id. at 60. indeed, the court defined as illusory those conditions lacking a nontax independent consequence. perhaps, the court adopted the language of the regulations under § 2037. regs. § 20.2037-1(b) explains that the condition of survivorship necessary for inclusion of decedent's reversion under § 2037 would not be found where a beneficiary could obtain the property "either by surviving the decedent or through the occurrence of some other event.... however, if a consideration of the terms and circumstances of the transfer as a whole indicates that the 'other event' is unreal and if the death of the decedent does, in fact, occur before the 'other event', the beneficiary will be considered able to possess or enjoy the property only by surviving the decedent." regs. § 20.2037-1(b). 261. kurz v. commissioner 101 t.c. at 60. 262. see id. 263. see irc § 2042(1). 264. see irc § 2035(a)(2). 265. see irc § 2042(2). 20011 florida tax review incidents of ownership are defined broadly in the regulations to include the economic benefits of the policy266 and include such powers as the ability to change the policy's beneficiary or to obtain a loan against its cash surrender value.267 when decedent is found to hold any of the incidents of ownership in insurance on his own life, the entire proceeds are includable in his gross estate.268 except with respect to reversionary interests, there is nothing in section 2042 that indicates whether or not contingent rights are incidents of ownership.2 69 added by the 1954 code, which attached a similar limitation to the application of section 2037,270 a reversionary interest which is valued at more than five percent of the policy's value just before decedent's death is an incident of ownership and that interest is defined as "a possibility that the policy, or the proceeds of the policy, may return to the decedent or his estate, or may be subject to a power of disposition by him." unlike section 2033 that discounts all contingent interests to reflect their uncertainty, because section 2042 includes the full value of the insurance proceeds in decedent's estate, the only discounting of contingencies under section 2042 operates with the de minimis rule regarding reversionary interests. thus, if it is very unlikely that decedent will regain any incidents of ownership, the statute excepts such ownership from inclusion. however, if it is fairly probable that decedent will re-possess the incidents of ownership, the full, undiscounted, value of the proceeds is includable in his estate. in estate of smith v. commissioner,27' the tax court held that the decedent's right to prevent the cancellation of a life insurance policy on his life by purchasing the policy for its cash surrender value if his employer, whom he did not control, chose to stop paying premiums was not an incident of ownership under section 2042 since it was contingent upon an event that never occurred and over which the decedent had no control.272 likewise, in estate of 266. regs. § 20.2042-1(c)(2). 267. id. 268. regs. § 20.2042-1(a)(3). 269. irc § 2042 includes reversionary interests that the decedent may have retained and treats them like § 2037, imposing a de minimis requirement before requiring inclusion. that is, "... . the term "incident of ownership" includes a reversionary interest (whether arising by the express terms of the policy or other instrument or by operation of law) only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent." the statute states that the value of a reversionary interest shall be determined by applying the traditional methods of valuation. irc § 2042(2). 270. h.r. rep. no. 83-1337, at a316-a317 (1954) ("to place life insurance policies in an analogous position to other property, however, it is necessary to make the 5-percent reversionary interest rule, applicable to other property, also applicable to life insurance."). section 2042 replaced § 811(g) of the 1939 code. 271. 73 t.c. 307 (1979), acq. in result in part, 1981-2 c.b. 2. 272. id. at 309. [vol 5:2 contingencies and the estate tax beauregard v. commissioner,27 the tax court held that decedent lacked incidents of ownership under section 2042 because, under a settlement agreement and local court order, decedent had no right to change the beneficiaries of an insurance policy on his life even though had he survived the children's age of majority or on the happening of certain events, he might repossess that right. finally, in estate of smead v. commissioner,274 the tax court held that a decedent's right to convert a group policy into an individual one on the termination of his employment was not an incident of ownership since it was an event which, although literally within the taxpayer's control, would be unlikely to occur in order to exercise that right. essentially in each of these three cases, decedent held a contingent right to the incidents of ownership in the policy on his life. if these interests were covered by section 2033, they would be included in decedent's estate, although discounted to reflect the unlikelihood of these events occurring. under section 2042, however, the threshold question is whether decedent held any of the incidents of ownership at his death and, if so, the entire proceeds are includable as long as, if it is a reversionary interest, its value exceeds the five percent minimum value. the statute does not suggest that other contingencies should follow a similar de minimis rule and courts have not explicitly fashioned their holdings to parallel that principle. thus, in theory, the statute could be read to say that if decedent held any contingent right in a life insurance policy on his life, the full value of the proceeds of that policy should be included in his estate. however, perhaps because there is no discounting or de minimis rule, courts have been reluctant to hold that attenuated contingencies not within the control of decedent cause inclusion of the entire proceeds in his estate.275 respectively in smith, beauregard, and smead, the tax court was loath to include as an incident of ownership the right to purchase a policy if decedent's employer, whom he did not control, decided to stop paying premiums; the right to change beneficiaries if the decedent survived his 273. 74 t.c. 603 (1980), acq., 1981-2 c.b. 1. 274. 78 t.c. 43 (1982), acq,. rev.rul. 84-130, 1984-2 c.b. 194. 275. likewise, courts were hesitant to hold that a decedent's power to choose a settlement option was an incident of ownership. see estate ofconnellyv. united states, 551 f.2d 545 (3d cir. 1977); hunter v. united states, 624 f.2d 833 (8th cir. 1980). but see estate of lumpkin v. commissioner, 474 f.2d 1092 (5th cir. 1973). one commentator has suggested that the plain language of the statute requires inclusion of "even a fractional interest held by decedent." sharon l.r. miller, 'incidents of ownership' as applied to a right held by a decedent to select an optional mode of settlement, 33 case w. res. 51, 52 (1982). however, with respect to contingent rights or powers, it is not clear whether there is even that "minimal degree of power associated with an 'incident' of ownership" requiring inclusion in decedent's gross estate. see id. at 70. 200] children's majority;276 and the right to convert to an individual policy on termination of employment. one way of viewing these decisions is to say that the court was informally or implicitly applying the probabilities inherent in the five percent rule; that is, there was less than a one in twenty chance that the contingency would occur. because the contingency was an event unlikely to occur, requiring inclusion of the full value of the proceeds, perhaps, seemed "unduly harsh. 277 another way of viewing these decisions is that the court considered the property interests subject to contingencies over which decedent lacked control as insufficiently owned by decedent. in smith, the court stated, "at his death, smith could neither have initiated changes in the two policies nor consented to them; the company alone maintained full control over the policies. 2 7 in smead, the court reviewed the earlier decisions and stated that "in both smith and beauregard, the insured's purported rights in the policy were entirely too contingent or remote to constitute incidents of ownership possessed by the decedent at the time of his death." '279 here, the court stated that while the decedent had more control since he could voluntarily quit his employment, "where the only way the insured can surrender or cancel a policy is by quitting hisjob, that is not considered to be an incident of ownership."2 the court then extended this logic to a conversion privilege that arose only at the termination of decedent's employment. "we conclude that the conversion privilege that decedent could exercise or control only by quitting his job was entirely too contingent and too remote to be considered an incident of ownership possessed by the decedent at the time of his death.""28 in beauregard, the court looked at what decedent owned at his death, chose to ignore rights the decedent could have regained if he had outlived his children's majority, and thus implicitly rejected that contingent rights can be owned at decedent's death. "on this basis, whatever beauregard could have done with the policy had he lived until his two children had attained age 2 1, became self-supporting, or left the custody of their mother is of no significance; the relevant inquiry is, what incidents of ownership, if any, did beauregard possess at the time of death?' 2 2 in each of these insurance cases, decedent owned a valuable economic right. in smith and in smead, decedent would never have to pass a test of his insurability; even if he developed a terminal illness at the time the contingency 276. in beauregard, the court analogized the right to change beneficiaries after the court order and settlement agreement were no longer valid to a reversionary interest under § 2037 and said that in this case the value was below that de minimis threshold. 74 t.c. at 611-13. 277. see supra notes 155-166 and accompanying text. 278. estate of smith v. commissioner, 73 t.c. at 311. 279. estate of smead v. commissioner, 78 t.c. at 49. 280. see id. at 51. 281. see id. at 52. 282. beauregard v. commissioner, 74 t.c. at 610. florida tax review [vol 5:2 contingencies and the estate tax occurred, he had a right to have his insurance continue. in beauregard, the decedent would regain the policy once his children were 21 years old, married, became self-supporting, or left the custody of their mother when all restrictions imposed by the court order and settlement agreement would have been removed. however, in each of these cases, decedent's contingent rights were imposed by others (i.e., either his employer whom he did not control or a court) and were never under his control. in this respect, there is no real potential for abuse in such circumstances. therefore, the most appropriate estate tax treatment for these contingent interests that decedent holds at his death is to include their value, properly discounted to reflect their contingent nature. rather than have a de minimis rule, congress should treat remote contingencies in this circumstance like remote contingencies in section 2033. m. proposed solution a. contingencies and decedent's control two rules should be established to deal with contingent interests and contingent powers. these rules should underline the decedent's initial control in imposing the contingency. the first rule should be applied to non-decedent created contingencies: contingencies should be taken into account so that the value included in decedent's estate approximates the property's economic value, properly discounted to reflect the uncertainty of the contingency. the second rule should be applied to decedent-created contingencies; it should be a harsher, artificialrule of valuation and inclusion, designed to discourage more complex contrivances and avoidance techniques. thus, if section 2033 applies, the estate will continue to include contingent interests at their value as of decedent's date of death, with approximations based on probabilities at that time. by contrast, where sections 2036283 or 2037 apply, the estate should include the full date of death value of the property over which decedent has retained any interest or power.284 including the full date of death value of the 283. unlike under current law, there should be no reduction for any outstanding life estate, even one currentlybeing enjoyed at the decedent's death. while, on the one hand, that life estate is not dependent upon surviving the decedent, full inclusion would promote simplicity. in addition such treatment would be consistent with the grantor trust provisions that treat a grantor who has retained a reversionary interest as the owner of the income for income tax purposes. 284. where an interest is subject to a contingency that was created by another and not under decedent's control, only the value of that contingent interest should be included in decedent's estate. thus, where § 2041 applies to donee general powers of appointment held by decedent at his death, since that part of the statute parallels § 2033, property included under that aspect of § 2041 should be valued like property included under § 2033, reflecting the actual economic value of the property over which the taxpayer has such a power. by contrast, with respect to the part of§ 2041 thatparallels transfers with retained interests orpowers, these § 2041 interests should be artificially valued, as under §§ 2036 and 2037. likewise, with respect to 20011 florida tax review property in decedent's estate in these instances will encourage simpler lifetime transfers. with respect to decedent-inserted non-tax motivated contingencies such as reversions at the decedent's divorce or failure of issue, currently, the reversion would not satisfy the "survivorship test" of section 2037,285 and the property would not be included under that statute. likewise, under section 2036, the focus is on what income interest decedent retains for his life, for a period not ascertainable without reference to his death, or for a period that does not end before his death so that non-testamentary contingencies are generally irrelevant to that analysis. 86 yet, decedent has controlled the initial imposition of the contingency and the contingent reversion that he holds at his death has value. because this interest does not expire until decedent's death, moreover, it is in a very real sense testamentary. to the extent that he has not, until his death, "let go" of the property he once owned outright, a full date of death inclusion would discourage such partial transfers. 87 on the other hand, with respect to non-decedent created or controlled non-tax contingencies, all interests should be valued to approximate the risk. for example, a remainder interest subject to inclusion under 2033 would be valued as it currently is, discounted to reflect the probability of the contingency's occurring.2 where an employee insurance policy may be converted to an individual policy if and when he leaves his employment,289 the contingency was not decedent created and should reduce the value of what is property included under §§ 2039 and 2042, where the contingency is decedent created and/or controlled, the full date of death value of the property should be included in decedent's estate. with respect to contingencies that were not imposed or controlled by the decedent, a mathematical rule should be applied to include value of these interests discounted to reflect their unlikelihood. with respect to property included under §§ 2034 and 2040, sections that otherwise resemble § 2033, but whose property interests are inherently contingent, the current rules of inclusion should continue to apply. 285. see supra note 132 and accompanying text. 286. where a court could alter decedent's support obligation so that it was unclear what part of the trust could produce the income "retained" by the decedent, because decedent had created a trust wherein income would satisfy his support obligation, even under current law, the court should have included the full value of the trust in decedent's estate rather than approximate what additional amounts of income could be applied because of the possibility of a court's increasing decedent's support obligation that could be satisfied from trust income. see supra notes 97-99, and accompanying discussion. 287. concededly, the imposition of the contingency is not a consequence of an attempt for tax avoidance. thus, with these non-tax motivated contingencies, it would be preferable to the current tax treatment to at least adopt a mathematical rule that would include the value of decedent's contingent reversion immediately before his death. 288. see supra notes 24, 54, and 62, and accompanying discussion. 289. see supra notes 272, 278-281, and accompanying discussion. [vol. 5:2 contingencies and the estate tax included in decedent's estate.29 that is, the value of that contingent conversion right should be viewed as an asset of the estate and valued under the mathematical rule.291 b. problems with de minimis rules while de minimis rules have appeal in that remote retained powers or interests are ignored, the element of decedent control over these contingencies is also ignored. moreover, they create inequitable treatment with other property interests included in decedent's estate. that is, estate assets with relatively small value that are owned outright are included in decedent's estate under section 2033 and various other estate tax provisions. therefore, it is unclear why, when a decedent owns property with a large value and chooses to transfer most but not all of it, he is rewarded by the application of a de minimis rule that exempts the value of his retained interest from inclusion in his estate. if the reason for the de minimis rule is that otherwise the full value of the property is included in decedent's estate, the issue maybe whether the rule itself is unduly harsh. thus, either the rule itself should be changed for every transfer, or the decedent should not be allowed to retain any power or interest and escape its application. since an attorney drafts the trust or advises the transfer, an unduly harsh result can be avoided by a professional's advice; if the decedent insists on including a retained interest or power, the rule is not "unduly harsh." if the potential for abuse has effected a rule that requires inclusion of the full value of the property at decedent's death, where decedent has imposed a contingency on a retained interest or power, there is no reason for a de minimis rule. indeed, in the instance of decedent created contingencies, de minimis exceptions should be rejected as they undermine the rationale for, and create more complexity with respect to, a policy driven, artificial rule of inclusion. c. why categorizing transfers as essentially testamentary or inter vivos does not solve the problems ofdecedent-created contingencies 290. theoretically, decedent's employment choice was affected by the existence ofthis employer-created benefit, so that one might assert that the decedent had ultimate control of the decision to possess this benefit at his death. but, that argument is too tenuous and far-fetched, even for this author. on the otherhand, one might argue that at least until all non-vested employer created benefits are included in decedent's gross estate, this contingent life insurance benefit should also be excluded. see, e.g., estate of barr v. commissioner, 40 t.c. 227 (1963); estate of tully v. united states, 528 f.2d 1401 (ct. cl. 1976). however, this author believes all such benefits should be included in decedent's gross estate and supports such general change as has been proposed by the a.b.a. tax section. see report on transfer tax restructuring, supra note 229, at 411. 291. this contingent reversion right was created by a third party unlike the donorcreated non-tax contingent interest that was property originally owned outright by the decedent. 2001u florida tax review an early attempt to deal with contingent reversionary interests and powers focused on whether or not the transfer is essentially testamentary. 292 the government proposed that where any beneficiary could possess or enjoy the property during the transferor's lifetime, the transfer should be treated as a completed gift and not taxed in decedent's estate. if no one could enjoy the property during the transferor's lifetime, the full date of death value of the property would be included in the decedent's estate without considering the value of the reversionary interest or a reduction for another's outstanding life estate.293 this test, and this distinction, is similar to the one embodied in the survivorship test of section 2037.294 unlike section 2037, however, there was no de minimis exception and no adjustment for the currently enjoyed life estate not dependent upon surviving the decedent. "in this manner there is but one taxable event and difficult problems of valuing 'slippery and elusive' interests are avoided." '295 according to the 1947 treasury proposal, where an essentially inter vivos transfer reverts to the transferor, it will cause the property potentially to be subject to a second transfer tax that "will tend to discourage such devices. 29 6 with respect to contingent reversionary powers, as opposed to contingent reversionary interests, over the property, however, where the transferor has a contingent power to appoint the property if he survives the life beneficiary, because this transfer does not have the same potential for the imposition of a second transfer tax, the proposal treats as testamentary all 292. applying some of these ideas to create an artificial rule of inclusion for contingent retained interests and powers, the rule first characterizes a transfer as essentially testamentary or not; if denominated testamentary, the full date of death value would be included in decedent's estate. "essentially testamentary" might constitute all but minimally valued or remote reversions ofboth income or principal, expanding the de minimis exception of § 2037 that currently applies only to remote reversions of the property itself. alternatively, such a proposal might broaden the current 5% requirement of§ 2037 to exclude any reversion that is not "mostly" testamentary in character, enlarging the current § 2037 exception to any reversionary interest valued at more than one-half of the property. on the other hand, instead of a survivorship test, like in § 2037, that requires that a beneficiary can receive the property only by surviving the decedent, the survivorship requirement could be met by a lower threshold, where survivorship is a predominant or likely (as opposed to the only) contingency for the reversion. 293. 1947 treas. proposal, supra note 1, at 23-24. in describing the gift tax consequences of such a transfer, the government proposal suggested that these were obvious and settled by supreme court case law: either the value of the property less the value of the contingent reversionary interest was subject to gift tax or the full value of the property would be taxed where "the reversionary interest cannot be valued according to recognized actuarial methods of computation (robinette v. helvering, 318 u.s. 184 (1943))." 1947 treas. proposal, supra note 1, at 22-23. 294. see supra note 132. an example of an essentially inter vivos transfer is a reversionary interest contingent upon absence ofthe transferor's issue. see 1947 treas. proposal, supra note 1, at 23. 295. id. 296. id. at 24. [vol. 5:2 contingencies and the estate tax contingent reversionary powers to change the beneficial enjoyment of the property. 297 subsequent reform attempts, moreover, have expanded the de minimis exception to section 2037 and have urged an "easy to complete" rule (a completed gift) where it is "more likely than not" that the reversionary interest will not return to the donor so that it is taxed as a completed gift at its full value; by contrast, where it is more probable that the reversionary interest will indeed vest in the donor, a "hard to complete rule" (an incomplete gift subject to estate tax at the decedent's death) will be applied and it will be an incomplete transfer.298 297. id. at 24-25. retained powers to alter the timing of the beneficial enjoyment of property were not to be subject to estate taxation. this proposal contrasts to § 2036(a)(2) that includes suchretained powers in decedent's estate. see struthers v. kem, 218 f.2d 810 (8th cir. 1955). 298. see 1984 treasury reform, supra note 12, at 380. some reform measures have advocated easy-to-complete rules and have emphasized simplicity. for example, professor isenbergh proposed that the complicated estate tax sections, such as §§ 2036-2038, be repealed as long as the gift taxes paid on these inter vivos transfers are themselves subjected to transfer tax. that is, the rule of § 2035(b) would be extended to apply to all gifts, rather than merely those gifts made within three years of decedent's death. (section 2035(c) was re-numbered, without substantive changes, § 2035(b) by the tax reform act of 1997, pub. l. no. 105-34, § 1310(a), applicable to decedent's dying after august 5, 1997.) isenbergh, supra note 72, at 8-9. with respect to his proposal to eliminate § 2036, professor isenbergh noted the problem of taxpayer abuse: "this potential abuse is simply an aspect of the ubiquitous and largely irreducible problem of valuation of lifetime transfers, an area where taxpayers often have the upper hand." id. at 16. with respect to these problems, he suggested an estate tax reporting requirement of gifts of remainder interests with the irs making proper adjustments "entail[ing] no greater administrative difficulties than the present system. .. ." id. professor isenbergh proposed the repeal of § 2038 byrequiring thatrevocable transfers be treated as irrevocable and taxed on their creation. id. at 17-18. since the grantor controls valuation, any uncertainties should be interpreted against his interest. other commentators have advocated the adoption of "hard-to-complete" rules in the instance of retained interest transfers to avoid double taxation and on the basis that these transfers are essentially testamentary. currently, these transfers are often subject to both gift tax and estate tax; a "hard-to-complete" rule would subject them only to estate tax. see, e.g. a.l.i., federal estate and gift taxation 43 (1969); 1984 treasury reform, supra note 12, at 378-79 (compare proposedrule regarding retained beneficial interests to § 25.2511-1(e), irc § 2702); charles l.b. lowndes, common sense correlation of the estate and gift taxes, 17 u. fla. l. rev. 507, 518 (1965); harry l. gutman, a comment on the aba tax section task force report on transfer tax restructuring, 41 tax law. 653, 676 (1988) (advocating a hard-to-complete rule where the estate and gift tax bases are uniform and where the donor can no longer affect the enjoyment of the property); see generally, josephm. dodge, redoing the estate and gift taxes along easy-tovalue lines, 43 tax l. rev. 241 (1988) (professor dodge emphasized the appropriateness of "hard-to-complete" rules to tax, at the decedent's death, inter vivos transfers that are essentially testamentary. he proposed that gifts not be valued based "on estimates of, or speculation about, future events and by analyzing relevant events as they actually occur. hindsight, in other words, should be used whenever possible. for example, the ultimate transfer tax effect of inter vivos transfers with retained interests should be suspended until the retained interest expires or the transferor dies, whichever occurs first. similarly, certain inter vivos transactions that attempt to 2001] florida tax review however, categorizing a transfer as essentially testamentary or as essentially inter vivos depending upon the contingency itself ignores the issue of control and its concomitant potential for abuse. thus, fashioning rules for determining where on a continuum of lifetime or testamentary transfers a particular decedent-created contingency falls may increase complexity without substantial equitable gains. additionally, analyzing the transfer after the imposition of a decedent-created contingency misdirects the focus from control to the result of the decedent's exercise of his control. the primary emphasis should be placed on the imposition of the contingency in the first place and on who controls that decision. with rules of full inclusion for partial transfers of property, moreover, congress would be underlining its policy of encouraging simple, completed transfers of property. fix low transfer tax values should be held open until death. id. at 244). [vol. 5:2 florida tax review volume 9 2010 number 10 875 ghosts of 1932: the lost history of estate and gift taxation by jeffrey a. cooper introduction ......................................................................................... 878 i. the early history of estate and gift taxes ............................ 881 a. 1797 to 1916 ............................................................................. 881 b. 1917 to 1926 .............................................................................. 882 c. 1927 to 1932 .............................................................................. 884 ii. politics of 1932 ................................................................................. 885 a. the background ......................................................................... 885 1. economic disparity ...................................................... 885 2. the politics of crisis ..................................................... 886 3. rejection of borrowing ................................................. 889 b. the architect ............................................................................. 890 c. the result .................................................................................. 893 iii. choices of 1932 ................................................................................ 896 a. broadening the base .................................................................. 896 1. the choice .................................................................... 896 2. the impact .................................................................... 897 3. the lesson .................................................................... 905  associate professor of law, quinnipiac university school of law. a.b., harvard college; j.d., yale law school; ll.m. (taxation), new york university school of law. i appreciate the thoughtful comments provided by workshop participants at quinnipiac university school of law and the 2009 annual meeting of the law & society association. i am also grateful to erika tyler, kevin casini and katherine dale for research assistance, jacque roethler and the staff of the university of iowa libraries for facilitating access to congressman ramseyer’s private papers and archival material, and dean brad saxton for his financial support of this work. 876 florida tax review [vol.9:10 b. squeezing the states ................................................................ 905 1. the choice .................................................................... 905 2. the impact .................................................................... 907 3. the lesson .................................................................... 909 c. the gift tax loophole ............................................................... 910 1. the choice .................................................................... 910 2. the impact .................................................................... 913 3. the lesson .................................................................... 914 conclusion .............................................................................................. 916 2010] ghosts of 1932 877 abstract in 1932, the united states confronted a bleak economic landscape. amid the financial carnage caused by the 1929 stock market crash and the ensuing great depression, economic activity had ground to a halt, tax revenues had plunged, and the nation’s debt had soared. the declining government revenues and soaring debt threatened both the viability of american industry and the stability of the nation’s credit rating. congress took bold action that year, enacting a massive tax bill (“the revenue act of 1932”) designed to balance the federal budget without further stifling economic growth. as has been true through nearly a century of tax legislation, congress included estate and gift taxes as a component of the revenue act of 1932. the architects of the 1932 estate and gift tax provisions made a number of crucial legislative choices that fateful year, implicating issues of tax policy that remain as relevant today as they were some eighty years ago. yet, histories of american taxation typically devote frustratingly little analysis to the specific estate and gift tax provisions included in the revenue act of 1932. as a result, despite their continued relevance, the details of key decisions, and the motivations of those who made them, effectively have been lost to history. in this paper, i seek to reclaim this lost history of estate and gift taxation. while the ensuing analysis certainly will enable us to more fully appreciate the events of 1932 and evaluate the actions congress took in that fateful year, my inquiry is not of mere historical interest. rather, the choices made in 1932 have helped shape the fundamental structure of u.s. estate and gift taxation for nearly eight decades, including our modern estate and gift tax code. accordingly, understanding the events of 1932 can help us to understand why our estate and gift taxes operate the way they do as well as help inform future debate about the optimal structure of our wealth transfer tax system. 878 florida tax review [vol.9:10 introduction in 1932, the united states confronted a bleak economic landscape. amid the financial carnage caused by the 1929 stock market crash 1 and the ensuing great depression, 2 economic activity had ground to a halt, 3 tax revenues had plunged, 4 and the nation’s debt had soared. 5 the declining government revenues and soaring debt threatened both the viability of american industry 6 and the stability of the nation’s credit rating. 7 1. in 1929, the u. s. stock market crashed, beginning a multi-year decline that would result in the market losing 86.2% of its value. floyd norris, stocks surge, ending streak of six weeks with losses, n.y. times, oct. 12, 2002, at c1, available at 2002 wlnr 4048795. for a history of the market decline and its aftermath, see john kenneth galbraith, the great crash 1929 (houghton mifflin co. 1997) (1955). 2. during much of the 1930’s, the american economy endured “the most devastating economic collapse in modern history,” a contraction so severe and so prolonged that it has come to be known simply as the great depression. t. h. watkins, the great depression: america in the 1930’s 23 (1993). 3. between 1929 and 1932, the u.s. economy “went into a fatal tailspin” as some 5,000 banks and 50,000 other businesses went bankrupt, unemployment rates soared from 3% to 25% and manufacturing activity declined by more than 50%. don nardo, introduction to the great depression 3, 13 (don nardo ed., 2000). the economic carnage was felt even more profoundly in major american industries. for example, by 1933, domestic automobile production had declined by 80%, while u.s. steel mills were operating at a mere 12% of capacity. william k. klingaman, 1929: the year of the great crash 337 (1989). 4. in senate hearings, treasury secretary mills projected that tax revenues would decline by nearly 44% from $4.18 billion in fiscal 1930 to $2.38 billion in 1932. an act to provide revenue, equalize taxation and for other purposes: hearing on h. r. 10236, before the s. comm. on finance, 72nd cong. 2 (1932) [hereinafter 1932 senate hearings] (statement of ogden l. mills, sec’y of the treasury of the united states). mills characterized the situation as a “collapse in our revenue system.” id. at 2. 5. although the federal government enjoyed a budget surplus in fiscal 1930, the national budget deficit for fiscal 1931 ultimately exceeded $900 million—an amount 400% larger than treasury secretary andrew mellon had forecast at midyear. harris gaylord warren, herbert hoover and the great depression 160 (1959). the deficits for 1932 and 1933 were projected to be even worse, and were expected to add an additional $3.2 billion to the nation’s debt. id. at 159. 6. id. at 159 (“the government could not borrow much more without destroying confidence, denuding commerce and industry of their resources, extending unemployment, and demoralizing agriculture.”). 7. see 1932 senate hearings, supra note 4, at 48 (statement of ogden l. mills, sec’y of the treasury of the united states) (warning senators that if they allowed the national debt to grow any further, the result would be “a rapid and precipitous decline in the value of all government securities . . . .”). 2010] ghosts of 1932 879 congress took bold action that year, enacting a massive tax bill 8 (“the revenue act of 1932”) designed to balance the federal budget without further stifling economic growth. by securing additional revenue through a combination of increased tax rates and exploitation of new forms of tax revenue, congress sought to bring the united states out of the great depression with both its economy and its credit rating intact. 9 as has been true through nearly a century of tax legislation, 10 congress included estate and gift taxes as a component of the revenue act of 1932. yet, histories of american taxation typically devote frustratingly little analysis to these specific estate and gift tax provisions. leading authorities cast these provisions as simple and straightforward ones: estate tax rates were increased as a means of generating additional revenue and preserving the nation’s credit rating, 11 while a gift tax was enacted to prevent wealthy taxpayers from circumventing the estate tax by making intervivos gifts. 12 these sources also note the prevailing populist sentiment underlying these changes, as congress took aim at the nation’s increasingly dramatic concentrations of family wealth. 13 the standard analysis typically ends there. 8. revenue act of 1932, ch. 209, 47 stat. 169 (1932). 9. although “practically all whom [president] hoover listened to or read agreed that an increase in taxes was needed” to help balance the budget, martin l. fausold, the presidency of herbert c. hoover 159 (1985), the decision to raise taxes was, and remains, controversial. for a sampling of contemporaneous opinions, see sidney ratner, american taxation: its history as a social force in democracy 447 (1942). for citations to numerous sources indicating that the u.s economy began a dramatic rebound in mid-1932, see herbert hoover, the memoirs of herbert hoover: the great depression 1929-1941 164-166 (1952). for a modern critique, see jim powell, fdr’s folly: how roosevelt and his new deal prolonged the great depression 49 (2003) (contending that the revenue act of 1932 resulted in further contraction of the u.s economy, exacerbating unemployment by stifling consumer spending and discouraging business investment). see also infra part ii.a.3 (discussing congress’s decision to attempt to balance the federal budget for 1933). 10. as discussed more fully infra part i, the modern estate tax was enacted in 1916 and has been a fixture in the internal revenue code ever since, while gift taxes were imposed from 1924 through 1926 and again from 1932 until the present day. 11. see, e.g., ratner, supra note 9, at 447 (stating that the act “attempted to balance the federal budget and uphold the national credit . . . .”); randolph e. paul, taxation in the united states 157 (1954) (estate and gift taxes were proposed to raise substantial revenue). 12. ratner, supra note 9, at 449 (noting that gift tax proponents “regarded the gift tax as necessary to prevent wholesale avoidance of the federal estate tax . . . .”). for additional authority on this point, see infra notes 153 to 154 and accompanying text. 13. ratner, supra note 9, at 449-50 (indicating that proponents of the act intended to “prevent the concentration of the national wealth in the hands of a few 880 florida tax review [vol.9:10 this prevailing characterization, while accurate, is woefully incomplete. congress did indeed expand gift and estate taxation in 1932 with the goal of both raising revenue and curtailing concentration of wealth. however, a deeper analysis reveals a far more interesting story. in crafting the estate and gift tax provisions of the revenue act of 1932, congress made a number of crucial legislative choices, implicating issues of tax policy that remain as relevant today as they were some eighty years ago. 14 yet, despite their continued relevance, the details of significant legislative choices, and the motivations of those who made them, effectively have been lost to history. in this paper, i seek to reclaim this lost history of estate and gift taxation. while the ensuing analysis certainly will enable us to more fully appreciate the events of 1932 and evaluate the actions congress took in that fateful year, my inquiry is not of mere historical interest. rather, the choices made in 1932 have helped shape the fundamental structure of u.s. estate and gift taxation for nearly eight decades, including our modern estate and gift tax code. accordingly, understanding the events of 1932 can help us to understand why our estate and gift taxes operate the way they do as well as help inform future debate about the optimal structure of our wealth transfer tax system. 15 this paper is organized in three major parts. in part i, i provide a brief summary of estate and gift taxation through the early 20th century, culminating with an analysis of the core estate and gift tax provisions of the revenue act of 1932. in part ii, i detail the events of 1932, both exploring the motivation of key proponents of estate taxation, most notably iowa congressman c. william ramseyer, 16 and analyzing the tax legislation they created. in part iii, i discuss three significant policy decisions that helped shape the 1932 act, evaluating both the historical impact and the continued relevance of these crucial policy choices. through this analysis, i seek to shed a new light on a key era in the history of american estate and gift taxation, analyzing long-forgotten actions of long-forgotten actors and gleaning distinctly modern lessons from these ghosts of 1932. families,” and “lighten the tax burden of the masses”); paul, supra note 11, at 157 (estate and gift taxes prevented undue concentration of wealth). 14. attributing these crucial decisions to “congress” as a whole may overstate the actual involvement of most members of the legislature. as discussed infra part ii.c, the estate and gift tax provisions of the revenue act of 1932 were produced by a limited group of draftsmen and given relatively superficial consideration by many members of congress. 15. for purposes of this article, the term “wealth transfer taxes” refers to the federal estate and gift taxes. 16. for a more detailed discussion of ramseyer, his background and his vision for u.s. estate taxation, see infra part ii.b. 2010] ghosts of 1932 881 i. the early history of estate and gift taxes in this part i, i briefly review the history of federal estate and gift taxation prior to 1932. 17 a. 1797 to 1916 federal estate taxes scarcely existed during the eighteenth and nineteenth centuries. 18 on just three brief occasions did congress resort to estate taxation as a means of collecting revenue: from 1797 to 1802, 19 from 1862 to 1872, 20 and again from 1898 to 1902. 21 congress proposed and implemented all three of these taxes as emergency measures to raise revenue in times of war or threat of war. 22 consistent with that rationale, congress 17. for a more comprehensive legislative history of history of federal estate and gift taxation, see louis eisenstein, the rise and decline of the estate tax, 11 tax l. rev. 223 (1956) (detailing the history of federal death taxes); see also staff of j. comm. on taxation, 107th cong., description and analysis of present law and proposals relating to federal estate and gift taxation 10-18 (comm. print 2001) (jcx-14-01) [hereinafter description and analysis] (providing a legislative history of federal estate taxes from 1797 to 2001). 18. sacrificing accuracy in the name of readability, i use the term “federal estate taxes” to refer generically to federal taxes collected upon the occasion of a taxpayer’s death, without regard to the method of computation and payment of such taxes. although such distinctions are not relevant for purposes of this article, many of the taxes generically referred to herein as “estate taxes” technically should be classified as “inheritance taxes,” “transfer taxes,” or simply “death taxes.” 19. an act laying duties on stamped vellum, parchment, and paper, ch. 11, 1 stat. 527 (1797), repealed by an act to repeal the internal taxes, § 1, 2 stat. 148, 148 (1802). 20. an act to provide internal revenue to support the government and to pay interest on the public debt, § 110, 12 stat. 432, 483 (1862), modified by an act to provide wages and means for the support of the government, and for other purposes, § 1, 13 stat. 218, 218 (1864) and by an act to provide internal revenue to support of the government, to pay interest on the public debt, and for other purposes, § 126, 13 stat. 223, 285-91 (1864), repealed in part by an act to reduce internal taxes, and for other purposes, § 1, 16 stat. 256, 256 (1870), and repealed in full by an act to reduce duties on imports, and to reduce internal taxes, and for other purposes, § 36, 17 stat. 230, 256 (1872). 21. an act to provide ways and means to meet war expenditures, and for other purposes, § 29, 30 stat. 448, 464-65 (1898), repealed by an act to repeal war-revenue taxation, and for other purposes, pub. l. no. 57-67, ch. 500, 32 stat. 96, 96 (1902). 22. description and analysis, supra note 17, at 10-11 (indicating that the first three federal estate taxes were used to finance a naval buildup in response to strained u.s.-french relations, the u.s. civil war, and the spanish-american war). 882 florida tax review [vol.9:10 repealed each of these taxes once the associated military exigency had passed. 23 in 1916, congress again turned to estate taxes to fund another looming military conflict, enacting a new estate tax just prior to u.s. entry into world war i. 24 however, the fourth act in the nation’s story of federal estate taxation did not end as had the prior three. rather, even after the war had ended and the fiscal demands of wartime had been replaced by budget surpluses, 25 the federal estate tax remained in place, as it has ever since. the 1916 estate tax thus was fundamentally different than prior taxes. nominally a wartime measure, it ultimately embodied loftier ambitions. it became a core element of the nation’s increasingly progressive tax system, an agent of social change embracing the ideals of theodore roosevelt 26 and andrew carnegie 27 and designed to help reverse the inequitable division of wealth resulting from the gilded age. 28 b. 1917 to 1926 the first few years in the history of the modern u.s. estate tax were relatively uneventful ones. in 1917, to meet pressing wartime revenue needs, 23. id. 24. an act to increase the revenue, and for other purposes, pub. l. no. 64-271, § 1, 39 stat. 756, 756-57 (1916). 25. paul, supra note 11, at 132. 26. in his 1906 state of the union address, roosevelt, the 26th president of the united states, urged congress to enact a national estate tax. theodore roosevelt, president of the united states, 6th annual message to congress (dec. 3, 1906), (available at http://www.presidency.ucsb.edu/ws/index.php?pid=29547). in an oftquoted phrase, roosevelt argued that “[t]he man of great wealth owes a peculiar obligation to the state, because he derives special advantages from the mere existence of government.” id. for more on roosevelt’s life, see generally nathan miller, theodore roosevelt: a life (1992). 27. a prominent american industrialist and generous philanthropist, carnegie contended that estate taxation was “the wisest” of all possible forms of taxation. andrew carnegie, wealth, north american review, june 1889, reprinted in the andrew carnegie reader, at 129, 136 (joseph frazier wall ed., 1992). carnegie’s pronouncements on the subject of estate taxation have become a mainstay of american political discourse. see infra note 55 and accompanying text. for more on carnegie’s life, see generally david nasaw, andrew carnegie (2006). 28. see william h. gates, sr. & chuck collins, wealth and our commonwealth: why america should tax accumulated fortunes 41 (2002) (“early in the twentieth century, gilded age corruption and inequality, powerful and popular social movements, and growing moral misgivings within the wealthy elite all converged on america’s political stage. out of that convergence came america’s first lasting estate tax.”). 2010] ghosts of 1932 883 congress increased estate tax rates. 29 the following year, congress responded to the war’s end by modestly reducing those rates. 30 this relative stability would be short-lived. the 1920’s brought a major battle over the future of estate taxation, with opposing factions alternatively advocating for the tax’s immediate elimination or its dramatic expansion. in 1924, those advocating expansion carried the day, as legislation altered the tax in three major ways. first, it increased marginal tax rates, raising the top rate from 25% to 40%. 31 second, it introduced a new gift tax, designed in significant part to prevent taxpayers from evading the estate tax by making intervivos gifts. 32 third, it created a new estate tax credit for state death taxes paid, a change which effectively reserved 25% of estate tax revenues for the states. 33 just two years later, the tide of estate taxation shifted again as opponents of the estate tax, led by treasury secretary andrew mellon, 34 reorganized after their 1924 defeat and coordinated a “propaganda campaign of considerable magnitude” against the estate tax. 35 while these vocal opponents didn’t succeed in convincing congress to enact a full repeal, they achieved considerable traction towards their goal. legislation enacted in 1926 restored the pre-1924 tax regime in three major ways: reducing the top marginal rate from 40% to 20%, 36 increasing each taxpayer’s lifetime exemption from estate tax from $50,000 to $100,000, 37 and repealing the 1924 gift tax. 38 in addition, the 1926 legislation also fundamentally altered the relationship between federal and state estate taxes by increasing the maximum state death tax credit from 25% to 80% of the federal tax otherwise due. 39 the end result of these legislative changes was an estate tax that impacted significantly fewer taxpayers and generated dramatically lower federal revenues. for secretary mellon, it was “one of the happiest days of his life.” 40 29. description and analysis, supra note 17, at 11. 30. id. at 12. 31. revenue act of 1924 § 301(a). 32. id. §§ 319-324. 33. id. § 301(b). 34. secretary mellon was not exactly a neutral observer on issues of taxation. in 1924, he had paid $1,900,000 in annual income taxes, the fourth highest amount paid by any american that year. w. elliot brownlee, federal taxation in america: a short history 73 n. 13 (2d ed. 2004). 35. paul, supra note 11, at 138. 36. revenue act of 1926 § 301(a). 37. id. § 303(a)(4). 38. id. § 1200. 39. id. § 301(b). 40. paul, supra note 11, at 139. 884 florida tax review [vol.9:10 c. 1927 to 1932 during this period, the federal estate tax remained largely static. the most dramatic changes occurred on the state level, as those jurisdictions began to fully comprehend the potential impact of the state death tax credit and altered their state death tax regimes to maximize this new revenue source. 41 by the early 1930’s it thus might have seemed that the modern estate tax had achieved stability. that impression would be short-lived. in 1932, congress set u.s. estate taxation down yet another new path by increasing estate tax rates across-the-board, 42 restoring the 45% top marginal rate, 43 lowering the exemption from $100,000 to $50,000 44 and reenacting the federal gift tax. 45 at the same time, seeking to ensure that the federal government, and not the states, would capture all of the incremental revenue generated from these changes, congress froze the state death tax credit at its prior, 1926, level. 46 the result was a federal estate tax regime more robust than any in prior american history and capable of generating far greater federal revenues than ever before. as discussed later in this article, 47 in designing the estate and gift tax provisions of the revenue act of 1932, congress made several questionable legislative choices and introduced considerable inefficiencies into the transfer tax regime. those poor decisions were in considerable part a response to forces that transcended well beyond issues of estate and gift taxation. congress debated the revenue act of 1932 during a very unique time in history, and powerful political and social forces impacted legislators’ viewpoints and ultimately shaped their legislative choices. thus, before turning in greater detail to a critical analysis of the choices made in 1932, it is necessary to explore the relevant political backdrop. that exploration follows in part ii. 41. i have analyzed these state developments at length in an earlier article. jeffrey a. cooper, interstate competition and state death taxes: a modern crisis in historical perspective, 33 pepp. l. rev. 835, 859-61 (2006). 42. revenue act of 1932 § 401(b). 43. id. 44. id. § 401(c). 45. id. § 501 et seq. 46. id. § 402(a). 47. see infra part iii. 2010] ghosts of 1932 885 ii. politics of 1932 a. the background 1. economic disparity the decade of the roaring 1920s had resulted in a markedly unequal distribution of american wealth. between 1921 and 1928, the number of americans with annual incomes over $1,000,000 increased from 21 to 511, while the number earning between $500,000 and $1,000,000 annually increased from 63 to 983. 48 then the bubble burst. as the nation spiraled towards economic depression, a populist backlash developed against the wealthiest americans, their excessive lifestyles and speculative investments being blamed for much of the economic carnage that followed. proponents of increased taxation thus urged that the revenue act of 1932 should be designed not merely to raise revenue but should also “have for its purpose the redistribution of a part of these tremendously large private fortunes.” 49 the populist rhetoric advocated imposing significant estate taxes on these great fortunes, in tones that grew increasingly scathing. as one congressman contended: “after allowing the big boys to play with their money during their lifetime and after allowing them the pleasure and pride of piling up dollar on dollar, while living, a generous estate tax should be levied on their death.” 50 characterizing wealthy americans as the “tax dodgers of the higher brackets,” 51 proponents of the 1932 estate tax saw in america’s great fortunes “a menace to the security and continuation of american institutions.” 52 48. 75th cong. rec. 6159 (1932) (statement of rep. rankin). 49. 75th cong. rec. 5906 (1932) (statement of rep. swing). 50. id. 51. 75th cong. rec. 5889 (1932) (statement of rep. laguardia). 52. 75th cong. rec. 5897 (1932) (statement of rep. swing). the concept of concentrated wealth as a “menace” to american society became a common rallyingcry in the congress. see, e.g., 75th cong. rec. 6257 (1932) (statement of rep. davis) (“the greatest menace to america to-day is the vast accumulation of wealth into the hands of a few and the tremendous power which they wield….”); 75th cong. rec. 6476 (1932) (statement of rep. simmons) (“the greatest menace this country faces is the accumulation of great wealth in the hands of a few individuals.”). while the concentration of american wealth may well have been highly undesirable, those congressman who considered it the “greatest menace” to america in 1932 perhaps should have paid greater attention to international affairs. see warren, supra note 5, at 161 (discussing hitler’s rise to power in germany and increased military tensions between china and japan). 886 florida tax review [vol.9:10 even the more moderate voices on the issue conceded that amid the growing economic crisis, taxing the wealthy was simply a lesser evil than seeking to raise revenue from poorer americans struggling to survive in the great depression. as one congressman concluded: “i do not want to ‘soak’ anybody, but it would be better to soak the rich than to starve the poor.” 53 another stressed the same concept even more pointedly, contending that taxing decedent’s estates was preferable to “taxing the school boy’s lunch basket and widow’s bowl of soup.” 54 yielding to this growing public sentiment, and paying requisite homage to the populist writings of andrew carnegie, 55 the congress of 1932 set out to erode america’s most significant family fortunes. 2. the politics of crisis while debating the revenue act of 1932, congress was operating in a highly-charged political climate. as the nation spiraled deeper into depression and closer towards upcoming elections, members of congress missed no opportunity to extract maximum political value from the daunting challenges facing the nation, while an anxious administration urged the legislature to produce less political rhetoric and more decisive action. the resulting environment made for great political theatre but was not necessarily conducive to reflective deliberation. 56 compounding these woes was the fact that congress expended much of its legislative time and energy debating an unsuccessful proposal to enact a comprehensive national sales tax rather than 53. 75th cong. rec. 6258 (1932) (statement of rep. davis). 54. 75th cong. rec. 6171 (1932) (statement of rep. cannon). 55. albert atwood, a staff writer for the saturday evening post, once observed how proponents of increased taxation seemingly always invoked andrew carnegie in support of their efforts. national tax association, inheritance and estate taxes, proceedings of preliminary conference and of the sixth session of the seventeenth national tax conference 106 (1925) (asking rhetorically: “did any of you ever read a speech in congress . . . in fulsome favor of higher death duties, that did not begin and generally end by quoting andrew carnegie in their favor?”). members of the seventy-second congress lived up to atwood’s expectations. see, e.g., 75th cong. rec. 5842 (1932) (statement of rep. selvig) (calling carnegie “an intelligent, enthusiastic, and persistent advocate of estate and inheritance taxes”); 75th cong. rec. 5896 (1932) (statement of rep. ramseyer) (quoting from carnegie’s writings); 75th cong. rec. 6257 (1932) (statement of rep. davis) (calling carnegie “a real patriot” and quoting from his writings). 56. see paul, supra note 11, at 155 (characterizing the tenor of debate in the house as “bickering” and indicating that house “leaders deplored the lack of a proper frame of mind for legislation”). for further discussion of this issue, see infra note 61 and accompanying text. 2010] ghosts of 1932 887 carefully considering key details of the income and estate tax legislation they ultimately enacted. congress had responded aggressively to the economic challenges presented by world war i. although prosperity had followed the war, the tide of fortune had quickly turned again as the nation entered the great depression. by 1932, significant budgetary surpluses had morphed into major shortfalls, and the united states confronted the largest budget deficit of any country on earth. 57 the prevailing sentiment in congress was that the resulting economic challenges were as great as the military ones faced during the (first) world war. stoking the passions of an election year, congress presented itself to be once again leading a nation at war, this time waging “a war against ruin, starvation and despair” rather than confronting a military foe. 58 amid this backdrop, the administration pressured congress to act with haste. this sense of urgency was reflected in treasury secretary mills’s growing frustration with congress for failing to enact tax legislation more rapidly. mills lambasted congress for the slow pace of legislation, arguing that in a time of war congress “would pass an emergency revenue bill in less than a week; and this emergency is greater than war.” 59 president hoover shared mills’s frustration and repeatedly accused congressional leaders of dragging out the tax debate for political ends. 60 resisting the administration’s repeated calls for more urgent legislation, congress did hold hearings and extensively debated major elements of the tax act. however, much of that debate concerned the merits 57. 75th cong. rec. 5892 (1932) (statement of rep. watson). 58. 75th cong. rec. 5900 (1932) (statement of rep. huddleston). see also 75th cong. rec. 5905 (1932) (statement of rep. swing) (“[w]e are to-day confronted with a crisis equal to that of the world war; a crisis that has caused the american people more suffering, more in loss of property than the world war.”); 75th cong. rec. 5841 (1932) (statement of rep. selvig) (“the present emergency equals in intensity that of our war-time period . . . .”). president hoover employed similar rhetoric. herbert hoover, special message to congress on the economic recovery program (jan. 4, 1932), available at http://www.presidency.ucsb.edu/ws/index.php? pid=23021 (“combating a depression is indeed like a great war . . . .”). 59. 1932 senate hearings, supra note 4, supplement no. 4 at 5. (statement of ogden l. mills, sec’y of the treasury of the united states). 60. in his memoirs, hoover dismissed the congressional debates as largely political posturing, designed to defer an economic recovery until after the 1932 elections. hoover, supra note 9, at 138-41, 159-60. hoover repeatedly expressed these concerns to congress, ultimately telling the senate that their actions would determine “whether democracy has the capacity to act speedily enough to save itself in an emergency.” paul, supra note 11, at 159, 161. the senate passed the revenue act of 1932 that same day. id. 888 florida tax review [vol.9:10 of two conflicting approaches to tax policy: institution of a national sales tax versus expansion of the existing progressive income and estate tax regime. many key congressional leaders focused their time and energies on this overarching policy debate, joining in “an avalanche of wild gestures and screaming hysterical speeches” 61 rather than deliberating the more mundane nuts and bolts of the proposed income and estate tax legislation. in the end, the deteriorating economic climate and the timeconsuming and divisive sales tax debate minimized the potential for detailed deliberation of key provisions of the revenue act of 1932. 62 as one observer concluded: “the law as passed was the work of the committees and their draftsmen, not the work of the whole of congress. there is no evidence that even important details of the bill received the studied attention of congress.” 63 61. 75th cong. rec. 6367 (1932) (statement of rep. cross). congressman cross urged his colleagues “to calm themselves, wipe the froth from their lips, and let reason get back on its throne.” id. other members of congress offered similar advice. for example, on mar. 19, 1932, just days before the revenue act passed the house, acting ways & means committee chairman crisp opined as follows: “i do not believe the house is in a proper frame of mind to legislate to-day. i think it would do us all good to have an opportunity to cool off and to think.” 75th cong. rec. 6512 (1932) (statement of rep. crisp). congressman rainey, a member of the ways & means committee, concurred. rainey lambasted his fellow congressmen: “this is a crucial hour in the history of this republic, and there are many of you who do not seem to me to realize it. . . . this house, i realize, at the present time is a runaway house. you are adopting measures here without proper consideration . . . .” 75th cong. rec. 6512 (1932) (statement of rep. rainey). see also house cheers outcome, n.y. times, mar. 25, 1932, at 1 (contending the legislative process had been “reduced to chaos”). 62. for example, congressman ramseyer initially was allotted just twenty minutes to explain his detailed proposal for revision of estate tax rate brackets and contrast it with two counterproposals. 75th cong. rec. 6671 (1932). ramseyer spouted a variety of statistics and drew numerous graphs on a blackboard he had brought into the house chamber for the occasion. id. after ramseyer’s presentation, congressman johnson contended that “not five men can stand up here now and say what the various proposals really are, as indicated on the blackboard,” an assertion which drew laughter and applause. 75th cong. rec. 6674-75 (1932) (statement of rep. johnson). apparently, congressman johnson was correct. although the house voted in favor of the ramseyer amendment that same day, many members later conceded that they were confused about what exactly which tax rates they had approved. sales levy foes boost estate tax: amendment bearing 45 per cent rate forced upon house, the salt lake tribune, mar. 23, 1932, at 1. 63. c. lowell harriss, legislative history of federal gift taxation, 18 taxes 531, 538 (1940). although harriss was referring specifically to the gift tax provisions of the act, his observation is equally applicable to the act’s other provisions. see paul, supra note 11, at 156 (indicating that the house adopted many 2010] ghosts of 1932 889 3. rejection of borrowing a final crucial aspect of the legislative climate of 1932 was the extent to which certain legislative options were summarily rejected. most noteworthy among these was the possibility of borrowing, rather than taxing, to fund the government’s fiscal shortfall. members of congress were unified in the belief that a balanced budget was an essential step towards recovery. speaker of the house garner repeatedly advocated that theory, urging his colleagues that “the worst taxes you could possibly levy would be better than no taxes at all” and predicting that congress’s failure to enact tax legislation “would result in the insolvency of every single american bank within two months time.” 64 when garner implored any member of the house who didn’t wish to balance the budget to stand up to be recognized, not a single congressman stood. 65 across the capitol, members of the senate committee on finance unanimously agreed that the budget had to be balanced without additional borrowing. 66 excess debt had devastated the economies of other nations, and the congress simply would not follow a similar course. 67 even within the executive branch, the notion of balancing the budget quickly came to be seen as politically inevitable. secretary mills feared that there were no buyers willing to purchase additional u.s government debt. 68 president hoover agreed. even though hoover initially advocated that the budget be balanced through a combination of tax increases and additional government borrowing, he also warned that the national government would soon “reach the utmost safe limit of its borrowing capacity.” 69 ultimately, he concluded that that nation had reached that limit and that further borrowing would lead to higher interest rates and undermine the value of the dollar. 70 provisions of the revenue act of 1932 “without mature consideration.”). see also supra note 61. 64. paul, supra note 11, at 155. 65. id. 66. s. comm. on finance, report on revenue bill of 1932, s. rep. no. 72665, at 1 (1932) [hereinafter senate report]. 67. indeed, one member of congress went so far as to suggest that it would be “criminally negligent” not to balance the budget. 75th cong. rec. 5906 (1932) (statement of rep. andrew). 68. see 1932 senate hearings, supra note 4, at 49 (statement of ogden l. mills, sec’y of the treasury of the united states) (warning the senate that if they failed to balance the budget “no one will buy your securities.”). 69. president herbert hoover, president of the united states, annual message to the congress on the state of the union (dec. 8, 1931), available at http://www.presidency.ucsb.edu/ws/index.php?pid=22933. 70. brownlee, supra note 34, at 82. see also robert s. mcelvaine, the great depression: america 1929-1941 86 (“although there are indications that in 890 florida tax review [vol.9:10 ultimately, thus, the administration and the congress agreed that the revenues needed to confront the great depression would come from taxation, not government borrowing. although some legislators continued to advocate for more borrowing as a stop-gap measure, 71 their voices largely fell upon deaf ears. for a clear majority in congress, the idea of relying on borrowing, instead of taxation, to finance the nation’s economic recovery had become simply “unthinkable.” 72 b. the architect in 1932, iowa congressman c. william ramseyer was serving his ninth term in congress. 73 it would be his last. 74 ramseyer is hardly a household name, and legal scholarship provides almost no analysis of his private hoover said he believed moderate deficits might be as necessary in depressions as in wars, he concluded that this position was politically untenable.”). hoover should not be overly-criticized for adopting “what was then conventional thinking about budgets.” steven r. weisman, the great tax wars 352 (2002). in fact, during the 1932 campaign, hoover’s eventual successor, franklin d. roosevelt, pledged to balance the budget. brownlee, supra note 34, at 85. the philosophy of ‘deficit spending’ as a means of stimulating growth, the approach advocated by economist john maynard keynes and ultimately adopted by roosevelt, would not achieve widespread acceptance until the latter part of the 1930s. weisman, supra, at 353. keynesian economics has remained in vogue ever since, such that “[n]o modern american president would repeat the fiscal mistake of 1932, in which the federal government tried to balance its budget in the face of a severe recession.” paul krugman, fifty herbert hoovers, n.y. times, dec. 29, 2008, at a25, available at 2008 wlnr 24868372. president obama certainly has not done so. jeff zeleny and edmund l. andrews, obama warns of prospect for trillion-dollar deficits, n.y. times, jan. 7, 2009, at a1, available at 2009 wlnr 288234 (quoting obama’s prediction that governmental efforts to reverse the current economic crisis would lead to “trillion-dollar deficits for years to come.”) 71. see, e.g., 75th cong. rec. 6248 (1932) (statement of rep. gilchrist) (suggesting that congress borrow on a short-term basis in anticipation of estate tax revenues); 75th cong. rec. 6033 (1932) (statement of rep. parsons) (suggesting that congress borrow an additional $600 million on a short-term basis); 75th cong. rec. 6367 (1932) (statement of rep. cross) (“[a]n unbalanced budget now and then is not an unmixed evil.”). 72. 75th cong. rec. 5807 (1932) (statement of rep. crowther). 73. christian william ramseyer, in biographical directory of the united states congress, available at http://bioguide.congress.gov/scripts/biodisplay.pl? index=r000031. 74. id. in january 1933, president roosevelt appointed ramseyer as a judge of the united states customs court. roosevelt to have record patronage, n.y. times, jan. 3, 1933, at 10. previously ramseyer had been under consideration as a possible supreme court nominee to replace the retiring oliver wendell holmes. twenty are mentioned for supreme court, n.y. times, jan. 16, 1932, at 17. 2010] ghosts of 1932 891 legislative career. by way of illustration, the entire universe of law review articles in westlaw reveals just five mentions of his name. 75 the same westlaw database suggests that muppet kermit the frog has received more than six times the scholarly attention accorded to ramseyer, 76 while the trials and tribulations of singer britney spears have earned her more than 300 scholarly references. 77 while lacking the iconic celebrity status accorded to others, ramseyer achieved something that neither a frog nor a pop singer ever has: he single-handedly designed many of the estate and gift tax provisions included in the revenue act of 1932. 78 the exemption, tax brackets, and rate tables were all included in the “ramseyer amendment,” which the congressman from iowa successfully offered as an alternative to the estate tax provisions proposed by the house ways & means committee. this achievement was a fitting capstone to ramseyer’s career as one of congress’s experts on matters of estate and gift tax. 79 ramseyer had been a vocal proponent of increased estate taxation as early as 1921, seeing in america’s growing wealth “a large and inexhaustible reservoir” of potential tax revenue 80 and contending that the federal government had “hardly scratched the surface of the possibilities of the estate tax as a revenue getter.” 81 by more aggressively tapping that revenue source, ramseyer 75. search of westlaw “jlr” database performed on aug. 10, 2009 located 5 documents. 76. search of westlaw “jlr” database performed on aug. 10, 2009 located 31 documents. kermit the frog is one of the best known of the “muppets,” a series of large puppets created by jim henson and featured on the children’s television show “sesame street” for the past four decades. kermit’s popularity in law reviews is attributable in part to his frequent performance of a song entitled “it’s not easy being green,” a phrase often-repeated in law review articles dealing with environmental law matters. 77. search of westlaw “jlr” database performed on aug. 10, 2009 located 309 documents. 78. while ramseyer deserves full responsibility for designing many of the 1932 estate and gift tax provisions, he did not personally design the rate table adopted in 1932. the rate table itself was produced by l. h. parker, chief of staff of the joint committee on taxation, who designed it in response to ramseyer’s request that parker design an estate tax rate table that would generate $500,000,000 of tax annually with a $50,000 exemption. revenue revision, 1932: hearings before the h. comm. on ways and means, 72nd cong. 433 (1932) [hereinafter 1932 house hearings]. 79. ratner, supra note 9, at 449 (calling ramseyer the “veteran champion of the estate and gift taxes”). 80. hearings on internal-revenue revision before the h. comm. on ways and means, 67th cong. 200 (1921) [hereinafter 1921 house hearings] (statement of rep. ramseyer). 81. 75th cong. rec. 5896 (1932) (statement of rep. ramseyer). 892 florida tax review [vol.9:10 argued, congress would be able to lessen other “burdensome taxes now weighing so heavily on the backs of the people.” 82 while he cited andrew carnegie as the inspiration for his support of inheritance taxation, 83 ramseyer often broke with carnegie and many other social progressives on key questions. for example, ramseyer opposed an unlimited charitable deduction for transfers made at death. 84 while nontaxable charitable transfers indeed would have a redistributive effect, ramseyer considered them undesirable insofar as they deprived the government of its share of the decedent’s wealth. 85 for ramseyer, unlike many other progressives, estate taxation was first and foremost a means of revenue generation rather than a tool of social policy. in 1924, ramseyer again advocated for increased estate taxation, unleashing a barrage of statistics upon his fellow congressman and urging that rates of u.s. estate taxation be modeled after great britain’s. 86 this time, ramseyer’s pleas found a sympathetic audience, and congress enacted his proposal. 87 but the political tide soon turned against ramseyer. first, in 1926, congress reversed many of the estate and gift tax provisions enacted in 1924, while expansion of the state death tax credit undercut the effectiveness of the estate tax as a tool for generating federal revenue. 88 then, in 1929, considerable annual budget surpluses led congress to further reduce a variety of tax rates. ramseyer was the sole member of the house ways and means committee to dissent from these tax cuts, 89 prophetically contending that the projected budget surpluses could prove ephemeral, in which case the tax cut 82. 1921 house hearings, supra note 80, at 200. 83. id. at 201 (“i got my first ideas about the inheritance tax from andrew carnegie . . . .”). 84. id. 85. id. 86. revenue revision, 1924: hearings before the h. comm. on ways and means, 68th cong. 248-256 (1924) [hereinafter 1924 house hearings] (statement of rep. ramseyer). according to ramseyer’s figures, in 1922 the british estate tax produced 50% more revenue than the u.s. estate tax, even though u.s. national wealth was three to five times that of great britain. id. at 258 (statement of rep. ramseyer). by 1932, the gulf had widened further, with annual british estate tax revenue now more than doubling u.s. estate tax revenue. 1932 house hearings, supra note 78, at 427 (statement of rep. ramseyer). 87. house increases inheritance taxes, starting at $100,000, n.y. times, feb. 26, 1924, at 1. 88. see supra notes 34 to 40 and accompanying text. ramseyer’s personal views regarding these developments were thinly-veiled. indeed, referring to the 1925 and 1926 efforts to repeal the estate tax, ramseyer sounded more like a worried parent than an experienced statesman, lamenting how “we almost lost the estate tax.” 75th cong. rec. 5895 (1932) (statement of rep. ramseyer). 89. tax reduction speeded in house, n.y. times, dec. 5, 1929, at 5. 2010] ghosts of 1932 893 would produce a budget deficit. 90 ramseyer called it an act of “political cowardice” to appease the electorate by reducing taxes when the money would be more prudently spent to retire governmental debts. 91 as the 1930’s began, ramseyer shared the view of those who considered the nation’s unequal distribution of wealth a cause for “apprehension and alarm.” 92 yet, his primary motivation for continuing to advocate increased estate taxation remained a desire to generate revenue. as a result, when the nation’s economic fortunes turned sour, the ensuing need for revenue provided ramseyer with what would be his final opportunity to tout increased estate taxation as a solution to the nation’s fiscal ills. the events of 1932 thus brought ramseyer to the moment he had waited nearly two decades for. in the end, he would make the most of it. c. the result as the u.s. economy continued to spiral downward in 1932, congress enacted a tax bill designed to provide the revenue needed to balance the federal budget. 93 a significant component of this legislation was the package of estate and gift tax provisions introduced by a congressman from iowa, and which bore his name. for proponents of increased wealth transfer taxation, the economic carnage of 1932 had provided an opportunistic moment to enact legislative changes they had long desired. the ramseyer amendment had become law. 94 90. id. 91. tax cut passed by house, 282 to 17, n.y. times, dec. 6, 1929, at 1, 2. history would validate ramseyer’s concerns. see supra note 57 and accompanying text. 92. 1932 house hearings, supra note 78, at 428 (statement of rep. ramseyer). 93. the act in its entirety was projected to generate just over $1.2 billion in additional revenue. final vote is 327-64, n.y. times, apr. 2, 1932, at 1. 94. the ramseyer amendment was one of three competing proposals for estate tax reform. the other two proposals were the original revenue bill as reported by the committee on ways and means and an amendment unsuccessfully offered by congressman lewis of maryland. lewis’s alternative featured a lower top rate than did the ramseyer amendment (40% vs. 45%), yet reached that top rate at a net estate value of just $500,000, far lower than the $10,000,000 needed to reach the top bracket under the ramseyer amendment. as a result, lewis’s plan would have raised considerably more revenue than ramseyer’s proposal. for a detailed comparison of the lewis and ramseyer proposals, including debates on their relative merits, see 75th cong. rec. 6661-81 (1932). it is worth noting that ramseyer’s primary objection to lewis’s proposal was not that the tax rates were too high but merely that lewis’s proposal attempted to achieve too dramatic a change in estate tax rates too quickly. 75th cong. rec. 6671 (1932). ramseyer contended that the key to achieving a lasting long-term increase in the estate tax was to “develop it 894 florida tax review [vol.9:10 the very inclusion of estate tax reform in the revenue act of 1932 was noteworthy given the overarching purpose of that act as a short-term, emergency, revenue measure. this short-term orientation was made explicit, for example, in the fact that the manufacturers excise taxes included in the act were enacted solely for limited periods of time and were designed to automatically expire with the passage of time. 95 however, while proponents sought to characterize increased estate taxation as a similarly temporary revenue measure, the estate tax provisions of the revenue act of 1932 included no expiration date. the report of the committee on ways and means suggests that such was not an innocent omission but rather the product of a legislative sleight of hand. the report contends that the committee envisioned that the estate tax be viewed solely as “an emergency measure” 96 and expressed the committee’s “hope” 97 that the tax be revisited once economic conditions improved. however, in the same paragraph, the committee acknowledged that they consciously did not make the estate tax expire by its own terms, as they did in the case of the proposed special excise taxes. 98 while the report attempts to finesse the issue, congress’ deeds here spoke louder than its words. the decision to require further legislative action to repeal the supposed “temporary” estate tax suggests that the tax might not have been intended as temporary at all. 99 the inclusion of a potentially permanent estate tax increase in an emergency revenue act is even more surprising when one considers the estate tax’s long collection cycle. not only must a taxpayer die in order to generate estate tax revenue, a process presumably beyond the control of the united states congress, but estate taxes are not due until months after such death occurs. 100 as a result, of all the forms of taxation that congress could gradually.” id. “if you go to excess now,” he warned congressman lewis, “you get a reaction later.” id. 95. the manufacturers excise tax under § 605 of the act was to be effective during the two-year period from jun. 21, 1932 to jul. 1, 1934, at which time it would expire by its own terms. due to subsequent legislation, the tax actually remained in place until 1936. see revenue act of 1936 § 809 (repealing the tax effective jun. 23, 1936). 96. h. comm. on ways & means, report on revenue act of 1932, h.r. rep. no. 72-708, at 8 (1932) [hereinafter house report]. 97. id. at 8. 98. id. 99. indeed, ramseyer envisioned the estate tax as anything but temporary. rather, he hoped that congress would gradually continue to increase estate tax rates in future years. see supra note 94. 100. at the time, estate taxes were due 12 months after a taxpayers’ death. revenue act of 1926 § 305(a); revenue act of 1932 § 403. the commissioner of internal revenue could grant an estate an extension of time to pay the tax, in which 2010] ghosts of 1932 895 impose, estate taxes would be among the most inefficient sources of emergency revenue. 101 certainly, some raised this concern. for example, one trade association transmitted a detailed analysis of the entire revenue act which argued that estate taxes should have “no part” in an emergency revenue bill. 102 yet, congressional leaders paid mere lip service to such concerns. ways and means committee chairman crisp, for example, freely admitted that the estate tax could not provide short-term revenue. yet he still contended that all of the taxes on wealth would be temporary ones. “i, for one, will be glad when [economic conditions improve] . . . so that these burdensome taxes can be lowered. but for 1933 how are we going to get the revenue needed?” 103 the estate tax, with its long collection cycle, simply did not provide an answer to crisp’s question. estate tax increases imposed upon those dying in the latter half of 1932 would not impact federal revenues until early 1934. yet, while chairman crisp didn’t dispute that fact, 104 he also didn’t allow that fact to interfere with his argument. 105 in the end, such merely technical concerns about the estate tax’s collection cycle yielded to politics and passions. during legislative votes, the climate in the house chamber assumed the spirit of a bullfight, with raucous legislators whistling, stomping their feet and shouting “soak the rich.” 106 with respect to the crucial ramseyer amendment, many members of case interest would not begin to accrue until 18 months after death. revenue act of 1926 § 305(c). under current law, the deadline for payment of estate tax is 9 months after death. irc § 6075(a) (2008). 101. secretary treasury mellon had emphasized this point to the house of representatives. 1932 house hearings, supra note 78, at 7 (1932) (statement of andrew w. mellon, sec’y of the treasury of the united states) (indicating that estate taxes have a “longer period” from imposition to collection than other forms of taxation). 102. 1932 senate hearings, supra note 4, at 198 (letter of channing e. sweitzer, managing director of the national retail dry goods association). 103. 75th cong. rec. 5691 (1932) (statement of rep. crisp). 104. id. (“[t]he estate tax will bring in a colossal sum of money to the people of the united states, but it will not do this for the year 1933 . . . .”). 105. while i contend that crisp was simply lost in his own political rhetoric, the estate tax actually did have the potential to indirectly generate significant short-term revenues. as discussed infra part iii.c, congress enacted a gift tax as a companion to the estate tax and offered taxpayers significant financial incentives to make intervivos gifts rather than retaining assets until death. as a consequence, the estate tax ultimately did bolster short term revenues—not through direct estate tax receipts but by the estate tax’s mere existence incentivizing taxpayers to make intervivos transfers subject to gift taxation. 106. robert s. mcelvaine, the great depression: america 1929-1941 87 (1984). 896 florida tax review [vol.9:10 congress didn’t even bother to vote. 107 while some members were out of town during the vote adopting the ramseyer amendment, others reportedly “stayed in their offices answering correspondence,” or simply didn’t bother to cast a vote on the measure. 108 whether opponents of the ramseyer amendment were demoralized or simply uninterested is not particularly clear. either way, the result was the same—a supposedly temporary tax bill included a massive, permanent, increase in a tax that wouldn’t be collected until years in the future. iii. choices of 1932 in the end, ramseyer and his followers got exactly what they had long hoped for: a more robust estate tax with a broader base, and a comprehensive gift tax. however, we may rightly ask whether the choices congress made regarding the structure of the 1932 estate and gift taxes were the correct ones. i contend that some were not. indeed, three crucial estate and gift tax provisions contained in the revenue act of 1932 were particularly unwise. while these legislative provisions may have helped congress address a pressing revenue need, or at least appeared to, they offended far more important principles of tax policy. they thus took our national wealth transfer tax regime in a wrong direction from which we have yet to turn back. in this part, i explore these three crucial choices, seeking to both objectively measure and normatively evaluate their impact. a. broadening the base 1. the choice given its dual mission of raising revenue and curtailing concentration of wealth, it is no surprise that the congress of 1932 sought to increase estate tax rates. however, the structure of those rate increases raises significant questions. the revenue act of 1932 didn’t impact solely those “bloated fortunes” that provided the most obvious target for those seeking to raise revenue and redistribute wealth. instead, the act aggressively sought to broaden the base of the estate tax, actually imposing the most dramatic changes in estate tax rates upon those in the lowest estate tax brackets. the revenue act of 1932 accomplished this base-broadening through two means. first, it replaced the previous rate table with ramseyer’s 107. maximum rate 45 per cent, n.y. times, mar. 23, 1932, at 1. 108. id. 2010] ghosts of 1932 897 new version—featuring increased tax rates and narrowed tax brackets. 109 second, the act lowered the lifetime exemption from estate tax from $100,000 per taxpayer to $50,000 per taxpayer. 110 this change not only exposed thousands of previously nontaxable estates to estate taxation but also produced a ripple effect, as all estates above that level were subject to estate taxation on a larger proportion of their assets. taken together, these changes resulted in extremely significant estate tax increases for the most modest taxable estates. while the top rate saw the largest nominal increase, more than doubling from 20% to 45%, lower rates actually increased by a far higher relative percentage. for example, the marginal rate imposed upon a $150,000 net estate increased from 2% to 9%, a more than four-fold increase. yet, given the structure of the tax and the distribution of the nation’s wealth, the significant financial (and administrative) burdens congress imposed on these relatively modest estates did little to raise significant federal revenue. indeed, the most significant effects of these efforts to broaden the base of the estate tax were the increased burdens and compliance costs imposed on relatively modest estates. 2. the impact as noted, the revenue act of 1932 had a dramatic impact on all estates—significantly increasing the total estate tax due from the wealthiest decedents but also significantly impacting the smallest taxable estates. table 1 provides a comprehensive view of the results, illustrating the changing estate tax burden confronted by representative estates of various sizes. 109. under the 1926 revenue act, the first $50,000 of a decedent’s net estate was subject to tax at a 1% rate. revenue act of 1926 § 301(a). a 2% rate applied to the next $100,000 of assets and a 3% rate to the $100,000 after that. id. under the revenue act of 1932, the five lowest tax brackets were only $10,000 wide, thus moving an estate much more quickly up the marginal rate scale. revenue act of 1932 § 401(b). four decades later, professor bittker decried the continuing existence of these “nervous twitches” of the rate table and advocated their replacement with far broader brackets. boris bittker, federal estate tax reform: exemptions and rates, 57 american bar association journal 236, 240 (1971). the post-2001 iteration of the estate tax comports to bittker’s design, at least insofar as it has fewer, broader, brackets. see irc § 2001 (2008). 110. revenue act of 1932 § 401(c). 898 florida tax review [vol.9:10 table 1: change in transfer tax burden on representative estates: 1926 rates vs. 1932 rates gross estate (in $) 50,000 100,000 150,000 200,000 500,000 1 million 5 million 10 million 1926 estate tax (in $) 0 0 500 1,500 12,500 41,500 489,500 1,334,500 1932 estate tax (in $) 0 1,500 5,000 9,500 42,500 117,500 1,149,500 3,094,500 % change 0 infinite 900% 533% 240% 183% 135% 132% table 1 reveals much about the true effect of the revenue act of 1932. certainly, in real terms, the largest estates bore the largest brunt of the tax increases. an estate valued at $10,000,000 would have owed $1,334,500 in federal estate taxes prior to the 1932 act and $3,094,500 thereafter—a massive increase of $1,760,000. at the margin thereafter, the increase in top rate from 20% to 45% would have increased the estate tax due by $250,000 per $1,000,000 of estate value, another significant increase in nominal terms. thus, at the top end of the wealth spectrum, the revenue act of 1932 surely brought significant nominal increases in estate tax rates. however, the revenue act of 1932 didn’t merely target the nation’s wealthiest. when viewed in relative terms, the impact on smaller estates was far more pronounced than that on larger estates. for example, in the case of a $150,000 net estate, the tax increased by a full order of magnitude, from $500 before the revenue act of 1932 to $5,000 thereafter. as noted above, two factors combined to create this altered tax landscape reflected in table 1. the first, ramseyer’s new rate table, provides little fodder for detailed mathematical analysis. one might rightly criticize the narrowness of the 1932 tax brackets 111 or suggest other relatively modest revisions to the rate table used. beyond such criticism, the altered rate table largely does what it professed to do—mechanically and dispassionately increase taxes across-the-board for all taxable estates. the second factor leading to the results reflected in table 1 provides a basis for far more interesting analysis. this factor was the decision to lower the lifetime exemption from estate tax from $100,000 to $50,000. ramseyer offered little justification for the $50,000 exemption beyond the 111. indeed, professor bittker did just that. see supra note 109. 2010] ghosts of 1932 899 unsubstantiated assertion that it was necessary to raise sufficient revenues. 112 however, my analysis reveals his assertion to be a false one. in actuality, the change generated relatively little additional revenue, while significantly increasing compliance and administrative burdens imposed on thousands of smaller estates. the reduced exemption thus produced far more paperwork than it did revenue. what is most striking about this aspect of the 1932 legislation was the fact that its relative futility should have been apparent to everyone at the time, including its proponents, had they fully studied the issue. history suggests that proponents of the reduced estate tax exemption never actually calculated the projected fiscal impact of the change. during congressional debates, ramseyer freely admitted that he hadn’t done so. 113 however, using data provided by congressman ramseyer himself during 1932 congressional debates, 114 it is possible to reconstruct the projected fiscal impact of the reduced estate tax exemption. that analysis follows in table 2, which calculates the incremental annual revenue resulting from the reduced exemption. 112. 75th cong. rec. 5896 (1932) (statement of rep. ramseyer) (suggesting that the lower exemption would help “make the rates productive”). interestingly, this same unsubstantiated assertion, that a reduced exemption would materially increase tax collections, is found in a 1931 letter to ramseyer from former chairman of the ways and means committee william green. letter from william r. green, judge, u. s. court of claims, to c. william ramseyer (apr. 14, 1931) (original located in the university of iowa libraries; copy on file with author). in this letter, green urged ramseyer to propose a $50,000 estate tax exemption, a change he indicated would “largely increase the receipts from the inheritance (sic) tax.” id. at 2. green estimated that this reduced exemption and a new gift tax could together generate an additional $40 million in annual revenue, but urged ramseyer to ask treasury officials to provide a more detailed revenue estimate. id. at 3. ramseyer, however, did not take this suggestion. see infra note 113. 113. 75th cong. rec. 6673 (1932) (statement of rep. ramseyer) (confirming that ramseyer did not ask the treasury to analyze the revenue impact of the ramseyer amendment). indeed, the record suggests that ramseyer’s sole source of technical advice regarding the estate tax was l. h. parker, chief of staff of the joint committee on taxation. as discussed supra note 78, while parker designed the 1932 rate table and opined as to its revenue impact, it was ramseyer who mandated that the tax feature a $50,000 exemption. there is no evidence that parker independently modeled the revenue impact of that exemption. 114. 1932 house hearings, supra note 78, at 434. the data was provided to congressman ramseyer by l. h. parker, chief of staff of the joint committee on taxation. as discussed supra note 78, parker designed the 1932 rate table at ramseyer’s request. 900 florida tax review [vol.9:10 table 2: change in annual estate tax collections resulting from reduced estate tax exemption 115 estate size number per year federal tax due with $50,000 exemption federal tax due with $100,000 exemption incremental revenue per estate total annual incremental revenue $70,000 7,500 $300 $0 $300 $2,250,000 $120,000 1,835 $2,740 $140 $2,600 $4,771,000 $170,000 850 $6,080 $2,180 $3,900 $3,315,000 $240,000 975 $10,940 $6,440 $4,500 $4,387,500 $380,000 755 $22,140 $16,640 $5,500 $4,152,500 $700,000 658 $51,500 $44,000 $7,500 $4,935,000 $1,200,000 205 $109,300 $99,800 $9,500 $1,947,500 $1,700,000 108 $174,500 $164,000 $10,500 $1,134,000 $2,200,000 64 $245,700 $234,200 $11,500 $736,000 $2,700,000 37 $322,900 $310,400 $12,500 $462,500 $3,200,000 14 $406,100 $392,600 $13,500 $189,000 $3,700,000 16 $495,300 $480,800 $14,500 $232,000 $4,400,000 23 $630,100 $614,600 $15,500 $356,500 $5,400,000 12 $849,700 $832,200 $17,500 $210,000 $6,400,000 8 $1,084,300 $1,065,800 $18,500 $148,000 $7,400,000 7 $1,330,900 $1,311,400 $19,500 $136,500 $8,400,000 5 $1,589,500 $1,569,000 $20,500 $102,500 $9,400,000 2 $1,860,100 $1,838,600 $21,500 $43,000 $10,400,000 15 $2,142,700 $2,120,200 $22,500 $337,500 totals: 13,089 $29,846,000 as revealed by table 2, using ramseyer’s own data, reducing the exemption from $100,000 to $50,000 could be expected to yield less than $30 million in incremental revenue—increasing projected federal estate tax receipts by a mere 5%. 116 certainly, for a country facing a billion dollar 115. for purposes of this table, the “federal estate tax due” is computed net of the state death tax credit based on the assumption that applicable state estate taxes exactly equaled the available state death tax credit. 116. ramseyer estimated that the 1932 estate tax provisions ultimately would yield $500 million to $600 million annually. 75th cong. rec. 5896-97 (1932) (statement of rep. ramseyer). ramseyer contended that his figures had been vetted 2010] ghosts of 1932 901 deficit, every $30 million of revenue helped. however, that $30 million annual revenue gain would impose significant administrative costs—adding to the tax rolls approximately 7,500 annual estate tax returns and thus more than doubling the annual number of estate tax returns required to be prepared and filed by taxpayers and processed by the government. on average, these 7,500 marginal annual estate tax returns necessitated by the reduced exemption would generate a paltry $300 in tax revenue each, a figure which hardly seems worth the administrative and compliance costs imposed on both these taxpayers and the government. 117 in the aggregate, these 7,500 estates would generate more than 55% of the annual estate tax returns filed but would provide less than 1% of the total annual estate tax revenue. although the lowered exemption would produce a ripple effect of modestly increasing total tax collections from all larger estates, the combined aggregate increase still amounted to a mere 5% of projected annual estate tax revenues. 118 certainly, the congress of 1932 was in a desperate quest for revenue. however, the decision to reduce the estate tax exemption produced compliance costs which congress never fully considered and which simply outweighed the benefits of additional tax revenue. 119 retaining the by “experts.” 75th cong. rec. 6673 (1932) (statement of rep. ramseyer). however, as discussed supra note 113, ramseyer did not count any treasury officials among these “experts.” to the contrary, treasury secretary mills vocally disputed ramseyer’s projections, contending that they were based on data from before the stock market crash and thus reflected “grossly inflated values.” sales tax backers gird for test vote; both sides hopeful, n.y. times, mar. 24, 1925, at 1. 117. of course, many of these estates would have owed state succession or estate taxes even if exempt from the federal estate tax. 118. estate tax returns filed in 1924, when the exemption also had been $50,000, had shown a similar pattern. in a year in which just under 13,800 estate tax returns were filed, filings from 9,500 estates valued at $50,000 or less after deductions (nearly 70% of the total filings) generated just 3% of total estate tax revenues. simeon e. leland, the future of the estate tax, 4 nat’l. income tax mag. 9, 11 (1926). conversely, the 48 largest estates produced more than half of the annual estate tax revenue, with the five largest estates producing 20% of total estate tax revenues. id. those five largest estates thus produced more than six times the revenue provided by the smallest 9,500. id. 119. congress took a similar approach to the question of income taxes, by reducing the personal exemption from income tax by $500. revenue act of 1932 § 25(c). chairman crisp defended the change as a matter of fairness, reporting that the ways and means committee had concluded that it “was not right or fair” to assess additional taxes on wealthy americans without imposing additional burdens on the less wealthy. 75th cong. rec. 5690 (1932) (statement of rep. crisp). he also defended the change as essential for increasing tax revenues, projecting that the lowered exemptions would increase tax receipts by $39,000,000. id. however, he conceded the administrative burdens resulting from the lowered exemptions. some 902 florida tax review [vol.9:10 exemption at $100,000 would have reduced the number of annual estate tax returns by 55% while retaining some 95% of the tax’s revenues. that’s the choice congress should have made. 3. the lesson congress’s choice to significantly increase estate taxation on the smallest taxable estates provides a variety of lessons. as an initial matter, it indicates the importance of detailed critical analysis of tax legislation, relying on mathematical modeling rather that unsubstantiated assertions. the modern tax legislative process has sought to remedy that shortcoming. 120 however, the most crucial lesson retains far more current applicability. specifically, in 2010 as in 1932, the vast majority of estate tax revenues will be generated by the largest taxable estates. as a result, in the modern world as in 1932, attempts to broaden the base of estate taxation through modest reductions in the estate tax exemption will produce dramatically greater compliance burdens but bear little fiscal fruit. for much of the past decade it seemed as if congress had learned this lesson. as a result of the increased federal exemption, annual taxable estate tax return filings declined by more than 50% between 1998 and 2006. 121 the families that dropped from the estate tax roles as a result needed to focus less of their time, energies, and money on estate planning. 122 yet, federal estate tax revenues remained largely unchanged. 123 2,900,000 additional annual income tax returns would be filed as a result. id. of these, 1,200,000 would generate no revenue, while the other 1,700,000 would generate “negligible” taxes. id. borrowing a phrase from professor graetz, one might rightly characterize these additional filings as three million unnecessary returns. see michael j. graetz, 100 million unnecessary returns: a simple, fair, and competitive tax plan for the united states 104 (2008) (proposing elimination of all income taxes for americans earning under $100,000 per year, thus eliminating 100 million annual federal income tax returns). 120. for example, the joint committee on taxation now plays a far more expanded role in the analysis of tax legislation than it did in 1932. see generally, staff of joint comm. on taxation, 109th cong., background information relating to the joint committee on taxation (comm. print 2005) (jcx-2-05) (providing an overview of the role played by the joint committee on taxation in the analysis of proposed tax legislation). 121. nonna a. noto, estate and gift tax revenues: past and projected in 2008, congressional research service report rl34418, at 7 (2008) (reporting a decline in annual taxable returns from 47,475 in 1998 to 22,798 in 2006). 122. wealthy americans devote a substantial amount of time, money, and energy to planning for the disposition of their estates and minimizing the impact of wealth transfer taxes. for an overview of some of these planning techniques, including a discussion of their costs, see richard schmalbeck, avoiding federal wealth transfer taxes, in rethinking estate and gift taxation 113, 121-58 (william 2010] ghosts of 1932 903 the congress of 2010 has yet to show similar wisdom. barring further legislation, the estate tax exemption will revert to $1,000,000 in 2011, 124 a level which will dramatically expand estate planning and compliance burdens on relatively modest estates 125 yet generate relatively modest tax revenues from these estates. if members of the congress of 2010 have read their history, or this article, they will enact a permanent estate tax exemption at or around the $3,500,000 level. state governments face a similar decision. traditionally, most state estate tax regimes mirrored the federal system and featured the same exemption. 126 however, in the last decade, efforts to maximize estate tax revenue have led many state legislatures to ‘decouple’ from the federal estate tax regime and reduce state estate tax exemptions below the federal level. 127 such changes create significant estate planning complications for taxpayers, who must plan for two independent taxing regimes, as well as state taxing authorities, who must attempt to administer these independent state tax systems. 128 yet, these lowered exemptions generate only modest incremental tax revenues. accordingly, state governments would be well served to rethink this approach. g. gale, james r. hines jr. & joel slemrod eds.) (2001). for an attempt to quantify the administrative and compliance burdens associated with wealth transfer taxes, see william g. gale & joel b. slemrod, life and death questions about the estate and gift tax, 53 nat’l tax j. 889, 902-05 (2000). 123. noto, supra note 121, at 7 (reporting a modest increase in total estate taxes paid from $20.3 billion in 1998 to $24.7 billion in 2006). 124. irc § 2010(c) (2008); p.l. 107-16 § 901(a)-(b) (2001). 125. some may disagree with my characterization of estates of $1,000,000 to $3,500,000 as “relatively modest.” by way of comparison, however, the 400 wealthiest americans (the so-called “forbes 400”) have a combined net worth exceeding $1.2 trillion, available at http://www.forbes.com/2009/09/30/forbes-400gates-buffett-wealth-rich-list-09_land.html (last visited jan. 20, 2010). accordingly, in the grand scheme of potentially taxable american wealth, an estate of under $3,500,000 is properly characterized as relatively modest. 126. prior to 2001, the vast majority of state estate taxes were designed to coordinate with the federal estate tax and structured to maximize an available federal credit for state death taxes paid up to a specified limit (“the state death tax credit”). jeffrey a. cooper, john r. ivimey & donna d. vincenti, state estate taxes after egtrra: a long day’s journey into night, 17 quinnipiac prob. l. j. 317, 318 (2004). as discussed infra note 152, congress repealed the state death tax credit in 2001, leading many state governments to completely redesign their state estate tax regimes. 127. joel michael, state estate, inheritance and gift taxes five years after egtrra, state tax notes, dec. 25, 2006, at 871, 873-78. as noted supra note 126, this phenomenon was a direct response to congressional repeal of the state death tax credit in 2001. 128. cooper, ivimey & vincenti, supra note 126, at 332-36. 904 florida tax review [vol.9:10 consider the example of connecticut, where the state estate tax exemption historically had been $2,000,000. 129 recent data from that state shows that more than 57% of taxable estate tax returns reported taxable estates of $2,000,000 to $4,000,000. 130 yet these returns generated less than 15% of the state’s estate tax revenue. 131 vermont’s estate tax features a $675,000 exemption. 132 however, in one recent year estates of $5,000,000 or less generated nearly 90% of vermont’s estate tax filings but only 20% of the tax revenue. 133 similarly, estates of $5,000,000 or less generate more than 90% of the taxable estate tax returns filed each year in new york state yet produce just 30% of the state’s estate tax revenue. 134 if these states were to increase their state estate tax exemptions, perhaps to a level as high as $5,000,000, they would free countless taxpayers from the planning, administrative and compliance burdens associated with state estate taxes while preserving the vast majority of current estate tax revenues. the first lesson of 1932 thus remains true today. the vast majority of estate tax revenue comes from the largest estates, and thus the revenuegeneration potential of the estate tax, is almost entirely a product of the rate 129. conn. gen. stat. § 12-391(g)(1) (2009). effective jan. 1, 2010, the connecticut estate tax exemption increased from $2,000,000 to $3,500,000. conn. gen. stat. § 12-391(g)(2) (2009). between 2005 and 2009, connecticut’s estate tax features a rather unique feature—a ‘cliff’ in the rate table whereby estates below $2,000,000 paid no estate tax while estates above $2,000,000 were taxed on the entire estate, including the first $2,000,000 of assets. id. this extremely controversial feature of the tax system actually offered a considerable efficiency advantage by freeing many modest estates from the administrative burdens caused by a lower exemption yet maximizing the revenue collected from larger estates. 130. connecticut department of revenue services & connecticut office of policy and management, estate tax study, 13 (2008) (data for fiscal year 2006-07), available at http://www.ct.gov/drs/lib/drs/research/estatetaxstudy/estatetaxstudyfinal report.pdf. 131. id. 132. vt. stat. ann. tit. 32, § 7442(a) (2009) (incorporating the $675,000 federal exemption in effect on jan. 1, 2001). 133. sara teachout, joint fiscal office, vermont estate tax brief 7 (2001) (partial data for fiscal year 2001), available at www.leg.state.vt.us/jfo/reports/estate tax brief 12-2001.pdf. in 2001, the largest 5 vermont estates produced 75% of the state estate tax revenue. id. in 2009, a single vermont estate paid $13 million in vermont estate taxes, nearly single-handedly balancing the state’s budget. state gets $13 million windfall inheritance, rutland herald.com, jun. 9, 2009, available at http://www.rutlandherald.com/article/20090609/thisjustin/906099995. 134. new york state department of taxation and finance, office of tax policy analysis, new york state estate tax sfy 2000-01: analysis of tax returns 9 (2001) (data for fiscal year 2000-01), available at http://www.tax.state.ny.us/pdf/stats/stat_estate/new_york_state_estate_tax_sfy_2000 _01.pdf. 2010] ghosts of 1932 905 structure applied to these estates. within reasonable limits, the size of the exemption will have significant administrative implications but produce relatively little revenue effect. the notion that a broader tax base will materially increase estate tax collections is as inaccurate in 2010 as it was in 1932. b. squeezing the states 1. the choice the 1926 estate tax had included a “state death tax credit” mechanism, which provided a dollar-for-dollar reduction in federal estate taxes for state estate taxes paid. the limit of the credit was an exceedingly generous one—up to 80% of the federal estate tax otherwise payable. assuming the applicable state government imposed an estate tax sufficient to maximize the potential of this credit, as most eventually did, 135 the result of the state death tax credit was to effectively redirect 80% of estate tax revenues to the state governments. 136 congressional leaders of 1926 envisioned that the 80% state death tax credit would achieve two policy ends. first, since the credit would fully offset the cost of most taxpayers’ state estate tax payments, it largely equalized the total federal and state estate taxes paid by domiciliaries of states that imposed state estate taxes and states that did not. the credit thus eliminated any political advantage to be gained by states such as florida that declined to impose state estate taxation as a means of luring wealthy elderly residents into the state. 137 second, the state death tax credit appeased state leaders who contended that estate taxes were a well-established traditional source of state revenue with which the federal government should not interfere. 138 although the fiscal crisis of the great depression impacted both federal and state governments, the congress of 1932 simply didn’t feel like sharing the fiscal fruits of increased taxation. accordingly, they designed the 1932 estate tax as a ‘supertax,’ which would supplement, rather than replace, the 1926 variant of that tax. a crucial consequence of this design was the fact 135. cooper, supra note 41, at 860-61. 136. under the 1924 act, the credit had been 25% rather than 80%. revenue act of 1924 § 301(b). 137. cooper, supra note 41, at 852-57. 138. id. at 857-58. accord paul, supra note 11, at 139 (concluding that the state death tax credit “mitigated the alleged invasion of an area reserved to the states.”) indeed, thirty-two governors had petitioned for the federal government to completely abandon estate taxation, contending that the field of estate taxation belonged to the states. 32 governors ask congress to ban inheritance tax, n.y. times, oct. 24, 1925, at 1. 906 florida tax review [vol.9:10 that the state death tax credit mechanism was deliberately frozen at its 1926 level. 139 while from a taxpayer’s standpoint the difference might be of little consequence, the structure had a crucial impact on federal tax receipts. all of the additional tax imposed by the 1932 act would pass entirely to the federal government. in making this choice, congress effectively ignored both the economic plight of the states and its own legislative history. whereas the congress of 1926 had disavowed any notion to tap estate taxation as a major source of federal revenue, the congress of 1932 set out to do just that. 140 this evolving federal attitude towards state estate taxes was typified by the changing personal viewpoints of secretary of the treasury ogden mills. as a member of the house ways and means committee in 1926, thencongressman mills had argued that the estate tax “belonged to the states” as a well-established, and much needed, source of state revenue. 141 indeed, congressman mills had advocated outright abolition of federal estate taxes in order to enable state governments to tap the full potential of the revenue source. 142 however, by 1932, his viewpoint had changed significantly. secretary mills opined that the existing state death tax credit had preserved sufficient revenue for the states, indeed more than they would ever had been able to collect without the credit. 143 accordingly, mills contended, the federal government was free to appropriate for itself any additional available estate tax revenue. 144 over the span of six short years, mills simply abandoned his prior belief that the realm of estate taxation “belonged to the states.” 145 congress did the same. 139. revenue act of 1932 § 402(a). 140. in one of the period’s great ironies, proponents of the 1926 state death tax credit envisioned that the mechanism would remain in place for six years, at the end of which time congress would repeal the federal estate tax and abandon the field of estate taxation to the states. cooper, supra note 41, at 857. that six year period ended in the fateful year of 1932. rather than abandoning the field of estate taxation, congress chose to further invade it. 141. paul, supra note 11, at 157. 142. nathaniel seefurth, proceedings of the inheritance tax conference, 3 nat’l income tax mag. 99, 99 (1925). 143. paul, supra note 11, at 157. 144. id. mills’ predecessor, andrew mellon, agreed that sharing the additional estate tax revenues with the states would be an “undesirable result” that should be avoided by structuring the additional estate tax as a ‘supertax’ exempt from the state death tax credit mechanism. 1932 house hearings, supra note 78, at 7. 145. mills’s change of position was even more troubling given that he was fully aware of the desperate fiscal plight of many states and the problematic overreliance of state treasuries on real property taxes as a primary source of revenue. indeed, mills himself had implored congress to endeavor to find ways to help states raise revenue to redress the “crushing burden” of these real property taxes. 1932 house hearings, supra note 78, at 43. 2010] ghosts of 1932 907 2. the impact by freezing the state death tax credit at its 1926 level, congress was able to extract dramatically greater revenue from estate taxes than ever before. although the federal treasury could expect to keep just 20 cents of every dollar of gross estate tax imposed under the 1926 estate tax, it would retain every penny of additional ‘supertax’ imposed under the revenue act of 1932. by aggressively capturing all of this incremental revenue, congress fundamentally altered the relationship between federal and state estate taxes. whereas estate taxes under the 1926 statute had been designed primarily to facilitate state revenue, the revenue act of 1932 was designed to fill federal, not state, coffers. as a result, while the state death tax credit once potentially offset up to 80% of federal estate taxes, that figure fell dramatically after 1932. table 3 reveals the full results, illustrating for estates of various sizes the percentage of estate tax revenues effectively reserved to the states by the state death tax credit. table 3: state share of total estate tax revenue 146 gross estate (in $) 50,000 100,000 150,000 200,000 500,000 1 million 5 million 10 million 1926 state share 0% 0% 80% 80% 80% 80% 80% 80% 1932 state share 0% 0% 8% 13% 24% 28% 34% 34% table 3 reveals a significant weakening of the state death tax credit regime. whereas the 1926 iteration of the state death tax credit operated to reserve 80% of available estate tax revenue to the states, the congress of 1932 completely scuttled that regime. in the case of the largest estates, the post-1932 state death tax credit would serve to offset just 34% of the total estate tax payable. in the case of smaller estates, the effect was even more dramatic. a mere 8% of the tax imposed on a $150,000 estate would pass to the states via the state death tax credit mechanism. it is crucial to note that the congress of 1932 didn’t directly cut state estate tax receipts. they merely froze the credit at its existing rates. accordingly, congressman ramseyer could say quite correctly that while he 146. this table assumes that applicable state estate taxes exactly equaled the available state death tax credit. 908 florida tax review [vol.9:10 had personally opposed enactment of the state death tax credit, 147 his 1932 amendment would “not disturb that provision.” 148 while factually correct, the statement is misleading. providing states no assistance in an era of declining asset values and preserving for the federal government the full fruits of the incremental rate increases certainly undercut the spirit, if not the letter, of the 1926 state death tax credit. 149 while state estate tax revenue didn’t decline in absolute terms as a result, 150 congress nevertheless had effectively muscled the state governments out of any incremental estate tax revenue. by using the frozen state death tax credit as a means of capturing a larger proportion of estate tax dollars, congress was able to mask the true magnitude of the 1932 estate tax increases. only when the nominal rate changes are adjusted to reflect the frozen state death tax credit are the federal estate tax increases of 1932 revealed for what they truly were. table 4 illustrates the true changes in federal estate tax collections resulting from the revenue act of 1932. 147. ramseyer preferred an alternate regime, by which the federal government would collect all estate tax revenues but remit 50% of those revenues back to the states. revenue revision, 1925: hearings before the h. comm. on ways and means, 69th cong. 402 (1925) [hereinafter 1925 house hearings] (statement of rep. ramseyer). ramseyer did not formally propose his alternative, yielding instead to the alternative state death tax provisions which had already garnered a majority of support in the house of representatives. id. despite his objection to the structure of the state death tax credit, ramseyer maintained that he had always favored “some kind of equitable division [of estate tax revenue] with the states . . . .” id. at 403. 148. 75th cong. rec. 5897 (1932) (statement of rep. ramseyer). 149. one new york congressman forcefully argued that freezing the state death tax credit at its 1926 level offended “the doctrine of state rights” by “preventing the states from raising revenue in a field which we used to believe belonged exclusively to the states.” 75th cong. rec. 6682 (1932) (statement of rep. o’connor). he reminded his colleagues: “the states also have to raise money to conduct their governments.” id. the acting chairman of the ways committee offered a very telling response: “i recognize there is some force in the statement of the gentleman from new york, but the object of this bill is to provide revenue for the federal government . . . .” 75th cong. rec. 6682 (1932) (statement of rep. crisp). in other words, 1932 was not a time for debating the niceties of states’ rights. it was a time for generating federal revenue. the chairman was not alone in that view. see 75th cong. rec. 6338 (1932) (statement of rep. stafford) (“we must view this question [of the state death tax credit] primarily from a national standpoint. leave it to the states to get their amount of inheritance taxes . . . .”). 150. while state revenue did not decline as a direct result of this change, declining asset values during the great depression did result in reduced state estate tax collections. 2010] ghosts of 1932 909 table 4: net federal estate tax revenue 151 gross estate (in $) 50,000 100,000 150,000 200,000 500,000 1 million 5 million 10 million 1926 estate tax (in $) 0 0 100 300 2,500 8,300 97,900 266,900 1932 estate tax (in $) 0 1,500 4,600 8,300 32,500 84,300 757,900 2,026,900 % change 0 infinite 4500% 2667% 1200% 916% 674% 659% table 4 reveals a startling picture. an estate valued at $10,000,000 would have generated $266,900 in federal estate taxes prior to the 1932 act and $2,026,900 thereafter—a massive 659% increase. for smaller estates, the impact was even greater, with the net federal estate tax collected from many estates increasing by an order of magnitude, or more. as seen throughout this analysis, the smallest estates once again were the most impacted by this change. as a result of the revenue act of 1932, the federal government could expect to extract 2667% more revenue from a $200,000 estate and 4500% more revenue from a $150,000 estate than under prior law. state governments saw no such increase in revenue. after just six years, the era of federal-state cooperation on the issue of state death taxes had come to an end. 3. the lesson the revenue act of 1932 marks a stunning reversal in the federal government’s attitude towards state estate tax regimes. just six short years after congress conceded estate taxes to be a traditional source of state revenue, the federal government assumed primacy in the field, marginalizing the revenue impact of the state death tax credit and reserving for itself the lion’s share of estate tax revenues. congress has never relinquished this role. despite enacting subsequent estate tax rate increases, congress never increased the state death tax credit, refusing to share estate tax revenues beyond the level allowed by the 1926 state death tax credit. then in 2001, congress dealt the states an 151. this table assumes that applicable state estate taxes exactly equaled the available state death tax credit. 910 florida tax review [vol.9:10 even greater fiscal blow—repealing the state death tax credit in its entirety and replacing it with a mere deduction. 152 although the congress of 1932 cannot be charged with all of those subsequent developments, the fact remains that they consciously chose to abandon state governments in the name of federal estate tax revenue needs. to the extent the congress of 2001 placed an unfair burden upon state governments by repealing the state death tax credit, they were not the first to undermine the original intent of the state death tax credit. rather, the congress of 1932 had been the first to do so. future congresses now must decide whether the federal government will ever again honor a promise made in 1926, ignored in 1932 and completely broken in 2001. as a first step towards doing so, congress should restore the state death tax credit to its pre-2001 level and enable estate taxes to once again become a viable source of state revenue. yet, the history of 1932 shows that such would be merely a first step. a true resolution requires a much more fundamental re-evaluation of the proper division of estate tax revenues between the federal and state governments and the optimal means of facilitating that division. c. the gift tax loophole 1. the choice the congress of 1932 made a final crucial choice when voting to reinstitute a federal gift tax. however, far more noteworthy than the decision to enact this gift tax was the manner in which congress structured that tax. congressional leaders of 1932 portrayed the gift tax as a mere companion to the estate and income taxes, designed solely to prevent 152. see generally cooper, ivimey & vincenti, supra note 126, at 320 (discussing the repeal of the state death tax credit). the current deduction for state death taxes, found in i.r.c. § 2058, is less valuable to taxpayers than the prior credit. specifically, unlike a credit, a deduction does not fully offset the impact of a state death tax. as a result, state governments seeking to impose a state estate tax no longer have a ‘free’ source of revenue by virtue of the state death tax credit. state death taxes have become far less politically viable as a result, leading a significant number of states to abandon this traditional source of state revenue. michael, supra note 127, at 880. note that under current law, the state death tax credit is scheduled to return on jan. 1, 2011. p.l. 107-16 § 901(a)-(b) (2001). for much of the past decade, commentators contended that congress would enact some form of permanent estate tax legislation before then. see william g. gale & samara r. potter, an economic evaluation of the economic growth and tax relief reconciliation act of 2001, 55 nat’l tax j. 133 (2002) (“virtually no one believes the bill will sunset as written.”). time, however, is running short. 2010] ghosts of 1932 911 taxpayers from avoiding these taxes by making lifetime gifts. 153 modern scholarship so routinely reiterates this accepted legislative history that it has become accepted as truth. 154 however, the structure of the gift tax reflects a very different intent—a stealth legislative agenda which has been effectively lost to history. notwithstanding assertions to the contrary, the architects of the 1932 gift tax did not intend to deter lifetime gifts by imposing a gift tax. to the contrary, they sought to incentivize such gifts. the congressional logic regarding gift taxation was clear. congress needed to balance the coming year’s budget. despite their calculated pronouncements to the contrary, 155 key congressmen understood that estate taxes provide a uniquely slow form of tax revenue. as a threshold matter, a taxpayer had to die in order to trigger imposition of estate taxation. 156 furthermore, the tax payable by virtue of that death would not be payable 153. both the house committee on ways and means and the senate committee on finance characterized the gift tax solely as a means of preventing avoidance of income and estate taxes. house report, supra note 96, at 8 (indicating that gift tax was needed “[t]o assist in the collection of the income and estate taxes, and prevent their avoidance through the splitting up of estates during the lifetime of a taxpayer . . . .”); senate report, supra note 66, at 11 (“as a protection to both estate and income taxes, a gift tax is imposed.”). chairman crisp reiterated this stated purpose in floor debates. 75th cong. rec. 5691 (1932) (statement of rep. crisp) (“the estate tax, without a mother [gift] tax to protect it, might easily be evaded . . . .”) 154. see, e.g., boris i. bittker, elias clark & grayson m.p. mccouch, federal estate & gift taxation 10 (9th ed. 2005) (gift tax was enacted “[t]o block th[e] route by which assets may be transmitted from one generation to another without payment of estate or inheritance tax . . . .”); elias clark, louis lusky, arthur w murphy, mark l. ascher & grayson m.p. mccouch, cases and materials on gratuitous transfers: wills, intestate succession, trusts, gifts, future interests, and estate and gift taxation 851 (5th ed. 2007) (“to prevent easy avoidance of the estate tax by means of lifetime gifts, congress enacted the federal gift tax in 1932.”) (emphasis removed); mitchell w. ganz & jay a. soled, reforming the gift tax and making it enforceable, 87 b.u. l. rev. 759, 761 (2007) (“unlike other taxes, the gift tax does not serve an independent function. rather, congress designed it to protect the integrity of the estate tax and income tax.”) (internal citation omitted); william g. gale & joel slemrod, overview, in rethinking estate and gift taxation 1, 15 (william g. gale, james r. hines jr. & joel slemrod eds. 2001) (gift tax was enacted “[i]n an effort to stem tax avoidance . . . .”); jeffrey n. pennell, wealth transfer planning and drafting 18-1 (2005) (“the federal gift tax buttresses the estate tax.”); stephanie j. willbanks, federal taxation of wealth transfers: cases and problems 5 (2d. ed. 2008) (“congress recognized the possibilities of tax avoidance through inter vivos gifts and adopted a gift tax . . . .”). 155. see supra note 153. 156. as chairman crisp colorfully indicated, “you cannot get blood out of a turnip … and you cannot get a tax from an inheritance or as an estate tax until a man dies.” 75th cong. rec. 5691 (1932) (statement of rep. crisp). 912 florida tax review [vol.9:10 until a full 18 months thereafter. 157 that was simply too long to solve congress’s pressing revenue problems. as one member of the committee on ways and means bluntly put it: “it takes a period of 18 months under existing law before you can get settlements of these estates, and we need money now.” 158 the gift tax provided a far more timely solution. rather than being due 18 months after a taxpayer’s death, gift taxes were payable no later than march 15 of the year following a gift. 159 as a result, if wealthy taxpayers could be induced to make large gifts in 1932, the treasury would receive the resulting tax revenue before the spring of 1933. this more rapid collection cycle made gift taxes a far better source of emergency revenue than estate taxes could ever be. congress faced one problem, however, in the fact that gift tax liability results from a taxpayer’s voluntary act. accordingly, as congressman ramseyer warned his colleagues, high gift tax rates will discourage taxpayers from making gifts. 160 as a result, the congress of 1932 consciously designed the gift tax to induce gift-giving, by setting gift tax rates significantly below the estate tax rates imposed upon a similarly-sized transfer. 161 congress adopted this structure “with the expressed hope that it would persuade owners of large estates to makes gifts to their heirs as soon as possible.” 162 congress fully realized that this approach would provide wealthy taxpayers with a significant opportunity to reduce their overall tax burden but were willing to do so as a means of generating immediate federal revenue. 163 157. the tax technically was due 12 months after death, although an estate could request a six-month interest-free extension of time to pay the tax. see supra note 100. 158. 75th cong. rec. 6352 (1932) (statement of rep. hill) (emphasis added). 159. revenue act of 1932 § 509(a). under current law, the general due date is now april 15 rather than march 15. irc § 6075(b)(1) (2008). 160. 75th cong. rec. 5896 (1932) (statement of rep. ramseyer) (“you can get gift tax rates so high that people will not make any gifts, and, therefore, such high rates would not yield any revenue.”). 161. the structure of the gift tax provided an additional benefit to taxpayers, insofar as the gift tax is computed on a tax exclusive basis (the money used to pay gift tax is not subjected to gift tax) while the estate tax is computed on a tax inclusive basis (estate tax is imposed on that portion of a decedent’s estate tax that will be used to pay taxes). for a more detailed discussion of this distinction, see regis w. campfield, martin b. dickinson & william j. turnier, taxation of estates, gifts & trusts 12, 29 (22nd ed. 2002). 162. 75th cong. rec. 5903 (1932) (statement of rep. canfield). 163. id. (noting that taxpayers who elected to pay gift tax will “lower their estate tax and increase the income to the treasury while it is most needed.”). 2010] ghosts of 1932 913 in effect congress told wealthy taxpayers, you can pay us now or you can pay us later. but, they added one key proviso: if you pay us now, you’ll pay far less. the gift tax thus wasn’t designed to prevent estate tax avoidance. rather, it was carefully designed to encourage such avoidance. 164 2. the impact in order to encourage significant gifts, congress needed for taxpayers to perceive paying immediate gift tax as preferable to paying future estate tax. the most obvious way congress achieved this goal was by enacting a separate rate table for gifts, pegging the rates of tax on gifts 25% lower than the equivalent estate tax rates. 165 however, that was not the only advantage the new gift tax offered wealthy taxpayers. in addition to these separate rate tables, the revenue act of 1932 also provided a separate $50,000 gift tax exemption, use of which did not reduce the taxpayer’s equivalent exemption from estate tax. 166 also, gift tax was computed more favorably than the estate tax insofar as gift tax was assessed solely on the net amount received by a beneficiary, whereas estate tax was imposed on the decedent’s entire estate, including the funds ultimately used to pay taxes. 167 for the wealthiest americans, these favorable aspects of the gift tax regimes truly added up. for example, consider the possibilities confronting a multi-millionaire taxpayer seeking to avoid the top 45% estate tax marginal rate. if this taxpayer made a single lifetime gift of $10,000,000, she would owe less than $2,300,000 of gift tax. she would have reduced her future 164. throughout this section, i have suggested that members of congress were somewhat duplicitous about the gift tax – casting the tax as a mere companion to the estate and income taxes while truly seeing it as a crucial tool for generating short-term revenue. i do not wish to suggest that every member of congress was involved in some grand conspiracy to mischaracterize the gift tax. indeed, to the extent such a conspiracy existed, most legislators were likely victims rather than conspirators. included among these many victims may have been nearly all of the members of the senate who voted to enact the gift tax. in the senate, senator smoot reported the bill as one designed solely to prevent evasion of the estate tax rather than generate any material revenue. 75th cong. rec. 10081 (1932) (statement of sen. smoot) (indicating that the “full purpose” of the gift tax was to prevent evasion of estate taxes and not to generate any significant revenue). the senate did not engage in any debate on the subject. c. lowell harriss, legislative history of federal gift taxation, 18 taxes 531, 536 (1940). 165. revenue act of 1932 § 502. 166. revenue act of 1932 § 505(a)(1). 167. put more technically, the gift tax was computed on a tax-exclusive basis whereas the estate tax was computed on a tax-inclusive basis. this distinction persists until the present day. see supra note 161. 914 florida tax review [vol.9:10 estate by $12,300,000 168 but paid only $2,300,000 in tax, an effective rate of 18.7% that 18.7% tax rate not only compared favorably with the 45% top marginal estate tax rate, but was actually lower than the 20% top estate tax rate in effect under the 1926 act. 169 by providing congress with gift tax revenue right now rather than estate tax revenue in the future, this hypothetical taxpayer would have enjoyed a transfer tax reduction of nearly 60% on her $10 million gift. at the margin thereafter, her effective tax rate on gifts would have been 25%, a massive discount to the 45% top estate tax rate. the federal government thus would have sacrificed significant future estate tax revenues in order to capture revenue when it was most needed. however, such is not the end of the analysis. indeed, once again a seemingly simple story from 1932 is not the accurate one. the twist in the tale arises from the fact that there was no gift tax counterpart to the state death tax credit. revenue from the gift tax, like the ‘supertax’ estate tax, thus inured entirely to the federal government. 170 taking into account this factor, the 25% top marginal federal gift tax rate nearly equaled the 29% top net federal estate tax rate after application of the state death tax credit. taxpayers who elected to pay gift tax rather than estate tax would receive a significant benefit, but that benefit effectively came at the expense of state governments rather than the federal treasury. characterized for decades as a simple means of preventing tax evasion, the gift tax actually has a far different history. its structure was designed to incentivize, rather than impede, gift giving. it was intended to siphon off future federal estate tax revenues rather than protect those revenues. although solely a federal tax, it dealt yet another stealth revenue blow to ailing state governments. such is the lost history of the 1932 gift tax. 3. the lesson in their desire to capture immediate revenue, members of the congress of 1932 found a simple legislative solution: they offered taxpayers significant long-term tax savings in exchange for short-term revenue. in common parlance, the congress of 1932 simply accelerated future revenues. 168. consisting of $10,000,000 gifted to the recipient plus $2,300,000 paid in gift tax. 169. revenue act of 1926 § 301(a). 170. congress seemingly was so concerned with this issue that it modified the state death tax credit to have it operate after the credit for gift taxes paid. revenue act of 1932 § 802(a). as a result, once a taxpayer had made a gift of property, the property would not be included in computation of the state death tax credit even if that gift subsequently was included in the taxpayer’s estate. see senate report, supra note 66, at 49 (1932) (confirming this interpretation). 2010] ghosts of 1932 915 however, to the extent legislators offered taxpayers a discount for paying gift taxes today rather than estate taxes tomorrow, they ultimately reduced total transfer tax revenues. those most able to accept congress’s offer were the wealthiest americans. taxpayers uncertain about their own financial futures will not make significant intervivos gifts, while those awash in cash and devoid of worries will do so most freely. the 1932 gift tax thus would be most exploited by the wealthy and the well-advised. 171 the congress of 1932 would receive the resulting revenue. future generations, and future congresses, would pay the price. the congress of 1932 faced extraordinary times. however, its solution of offering disproportionate benefits to those who provide accelerated revenue has become an all too common theme in modern tax policy. some examples are subtle, structural, ones. for example, while congress has largely “unified” the estate and gift taxes since 1932, the gift tax still offers taxpayers a more favorable tax-exclusive regime. 172 other examples are far more dramatic. for example beginning january 1, 2010, taxpayers can convert their traditional ira retirement plans to roth iras regardless of income limits. 173 while taxpayers making such conversions must pay income tax on the assets converted, the roth iras will thereafter grow on a tax-free basis, potentially for generations. 174 to the extent 171. indeed the wealthiest americans were the intended beneficiaries of this tax-saving opportunity. with respect to the wealthiest americans, congress wanted to provide a special “invitation to the holders of these enormous estates to dissipate them . . . before death.” 75th cong. rec. 5691 (1932) (statement of rep. crisp). 172. see supra note 161. 173. tax increase prevention and reconciliation act of 2005, pub. l. no. 109-222 § 512, 120 stat. 345, 365-66, amending irc § 408a(c)(3) effective january 1, 2010. while “traditional” iras and “roth” iras are both types of qualified retirement accounts, they differ in several material respects. for purposes of this article, the major distinction is the different income tax treatment accorded to these accounts. specifically, as a general rule, contributions to a traditional ira account are deductable from the participant’s gross income during the year of contribution while all future distributions from the account will be subject to income tax as ordinary income. the roth ira offers the exact opposite regime, with no deduction available for contributions to the account but no income tax imposed on future distributions. for a more detailed discussion of these and other distinctions, see ray d. madoff, cornelia r. tenney & martin a. hall, practical guide to estate planning § 13.04[b] (2010 ed.). 174. unless the taxpayer elects otherwise, she must recognize half of the income resulting from the roth conversion on her 2011 individual income tax return and half on her 2012 return. tax increase prevention and reconciliation act of 2005, pub. l. no. 109-222 § 512, 120 stat. 345, 365-66, amending irc § 408a(d)(3)(a) effective jan. 1, 2010. for more on the potential tax-savings 916 florida tax review [vol.9:10 taxpayers elect to convert their plans, these conversions will enrich the treasury for few fleeting years but will reduce annual income tax revenues for a century thereafter. 175 the result is a tax code rife with intentional loopholes waiting for those savvy enough to find them and wealthy enough to exploit them. while economists might debate the long-term economic impact of such provisions, the fact remains that congress typically seems unconcerned with such analysis. 176 rather, congress routinely solves its own fiscal problems by creating new ones. the only difference is that the new problems will belong to a different set of politicians. conclusion the events of 1932 brought a perfect storm to the u.s. wealth transfer tax regime. as an unprecedented financial emergency confronted the country, congressional leaders mired in debate over a proposal to enact a national sales tax. for a group of politicians led by congressman william ramseyer, the ensuing political chaos provided the moment they had long been waiting for—an unprecedented opportunity to reinvent the federal wealth transfer tax system. histories of american taxation have typically devoted far too little attention to the specific estate and gift tax provisions contained within the revenue act of 1932 and to the legislative choices made that fateful year. indeed, the history of 1932 has become largely a lost one—depriving modern scholars of the opportunity to reconsider the legislative choices made in 1932 and to appreciate their continued relevance to current tax policy. in this article, i have attempted to reclaim this lost history. looking back at the events of 1932, i have demonstrated both the fiscal impact and the policy significance of choices made in that fateful year. the choices of 1932 have helped shape the fundamental structure of u.s. estate and gift taxation for nearly eight decades. as a result, understanding these choices is hardly of mere historical interest. rather, as our nation confronts new economic challenges in a new century, a deeper understanding of the events opportunities resulting from a roth ira conversion, see richard s. franklin & lester b. law, the roth ira – what a great deal, 72 fla. b.j. 51 (mar. 1998). 175. the federal budgetary process encourages this short-sighted result. see karen c. burke & grayson m.p. mccouch, lipstick, light beer and backloaded savings accounts, 25 va. tax rev. 1101, 1108-09 (2006) (“[t]he budget rules generally require that congress take account of the cash-flow effects of tax expenditures only over a five-year budget window. this timing gimmick permitted roth ira proponents to minimize the short-term budget costs and avoid taking the inevitable long-term revenue shortfalls into account.”) (internal citation omitted). 176. id. at 1108-16. 2010] ghosts of 1932 917 of 1932 can inform crucial policy debates regarding our modern estate and gift tax code. the congresses of 2010 and beyond have vital decisions to make regarding the future of federal wealth transfer tax policy. they must decide the optimal exemption and rate structure for our modern estate and gift tax regime. they must revisit the interplay between federal and state estate taxes and determine the ultimate fate of the state death tax credit. they must reconsider the relationship between u.s. estate taxation and gift taxation as part of a larger reevaluation of short-term and long-term revenue priorities. this legislative agenda is an ambitious one. but, modern politicians are hardly the first to face all of these crucial policy choices. they thus have much to learn from a study of the long-forgotten decisions embodied in the revenue act of 1932 and the motivations of the men who made them. in short, they have much to learn from the ghosts of 1932. florida tax review volume 4 1999 number 2 international comity and the foreign tax credit: crediting nonconforming taxes glenn e. coven* i. introduction ................................. 84 ii. a note on the significance of the question ....... 87 m. the contours of the foreign tax credit .......... 89 iv. a hypothetical case ........................... 91 v. the nature of an income tax: the squinting eye of the beholder .......................... 92 a. the fonnative years ........................ 94 b. the united states conception .................. 96 c. oil royalties and the reversal of policy ......... 100 d. evaluating the attack on abuses ............... 103 vi. separate levies and predominant characters ..... 105 a. divisibility .............................. 107 b. confonnity .............................. 114 vii. "in lieu of" taxes .............................. 116 viii. multiple, related taxes ........................ 123 ix. conclusion .................................. 127 * mills e. godwin professor of law, the college of william & mary school of law. florida tax review i. introduction the combination of expanding international trade and climbing corporate income tax rates in the early part of this century required nations to evolve methods for reducing the level of international double taxation. while most countries came to rely upon a variety of techniques,' two general approaches emerged to the taxation of the income of residents derived from foreign economic activity.2 some countries adopted a territorial based system in which foreign source income is normally exempted from domestic tax.3 that system generally leaves the taxation of foreign income to the government within whose territory the activity occurs and thus avoids double taxation entirely. other countries, including the united states, chose to impose their tax on the world-wide income of their individual citizens and residents and domestic corporations.4 that approach necessitated the development of specific mechanisms to reduce double taxation when the country within whose borders the income had been derived also imposed a tax on that income.5 the prevailing solution to this source of double taxation is for the residence country to allow its taxpayers to credit taxes paid to foreign jurisdictions against their domestic income tax liability. the extent to which such a foreign tax credit effectively relieves double taxation, however, depends in part upon the adequacy of the description of the foreign taxes that may be credited against the domestic tax liability. if the description is overinclusive, allowing too broad a range of foreign taxes to be credited, the foreign income will be taxed too lightly. conversely, if the description is under-inclusive, double taxation will not be fully relieved and the foreign source income will be taxed more heavily than domestic income. the united states foreign tax credit is both overand under-inclusive and thus incorrectly taxes foreign source income in a wide range of circumstances. the most serious deficiency in the existing credit, however, 1. the bilateral income tax treaty, the function of which is to reduce the level of taxation by the source country, is one common example. sometimes source countries unilaterally exempt items of income from tax, see, e.g., irc § 871 (h) (interest), or a residence country that nominally taxes world-wide income may in fact exempt some foreign source income from tax, see, e.g., irc § 911. 2. see adrian ogley, principles of international tax: a multinational perspective 22-25 (1993). 3. france, the netherlands and some latin american countries are notable among these. some countries, germany in particular, exempt foreign source income by treaty. 4. see michael j. mcintyre, the international income tax rules of the united states § 4/al (1989). 5. for the history of u.s. policy in this regard, see generally michael j. graetz & michael m. o'hear, the "original intent" of u.s. international taxation, 46 duke l.j. 1021 (1997). [vol. 4:2 international comity and the foreign tax credit is the failure to allow the crediting of taxes collected by foreign governments pursuant to provisions that might fairly be described as integral to a general income tax but which do not conform to a conception of income taxation as developed by the united states. that flaw in the international income tax rules of the united states is harmful to both united states based multinational business and to foreign governments seeking to fashion innovative but nonconforming taxing statutes. the need to clarify and revise the scope of the credit is long overdue.6 a definitive description of the foreign taxes that ought to be eligible for the foreign tax credit has proven to be surprisingly elusive. during the first third of a century following the adoption of the credit in 1918, congress twice sought to fine tune its coverage but neither effort was particularly successful.7 following the collapse of the second attempt, the undertaking was abandoned-more for lack of a solution than satisfaction with existing law. in her highly respected study of the credit, elisabeth owens concluded that "the chief determinative factor in deciding whether a tax qualifies for the credit should be whether or not the tax is shifted or passed on by the person paying the tax"9 but she was forced to admit that the practical application of that test would be difficult, at best. professor owens argued, however, that her shifting test required that a relatively narrow scope be extended to the credit, and she was highly critical of both the extension of the credit to taxes "in lieu of' income taxes and the further extension proposed in 1954 to the "principal tax" of a foreign country. that philosophy, if not the shifting test itself, proved influential. while the impropriety of crediting taxes that have been shifted to others cannot be doubted, the fundamental flaw in the shifting test emerged in the succeeding decades. since even the corporate income tax is likely shifted at least in material part, tax incidence analysis provides little basis for discriminating among foreign taxes and in fact suggests that no tax should be creditable.10 6. for examples of previous workings calling for reform, see joseph isenbergh, the foreign tax credit royalties, subsidies, and creditable taxes, 39 tax. l rev. 227 (1984); stanley l. ruby, note, characterization of an income tax for the purpose of the foreign tax credit, 14 vand. l. rev. 1469 (1961). 7. see infra text accompanying notes 98-101. 8. the conceptual confusion of the times is marvelously summarized in an article by then professor stanley surrey. stanley s. surrey, current issues in the taxation of corporate foreign investment, 56 colum. l. rev. 815, 819-22 (1956). 9. elisabeth a. owens, the foreign tax credit: a study of the credit for foreign taxes under united states income tax law 83 (1961). 10. see, e.g., karen n. moore, the foreign tax credit for foreign taxes paid in lieu of income taxes: an evaluation of the rationale and a reform proposal, 7 am. j. tax pol'y 207, 224 (1988). 1999] florida tax review the absence of a generally accepted conception of creditable taxes is partly attributable to an unduly rigid approach to the concept of "double taxation." the point of the foreign tax credit is to mitigate the burden of international double taxation when a residence country insists on taxing the worldwide income of its residents in order to promote a version of capital export neutrality. that burden is broader than the mere imposition of two taxes upon a single tax base. what should be credited are foreign taxes incurred by the taxpayer by virtue of activities abroad that are in addition to, rather than in replacement of, the u.s. taxes that are imposed on the taxpayer's foreign source income. given the numerous taxes that are and are not imposed by the united states and by the various foreign jurisdictions, it may well be impossible to reduce that elemental concept of additional tax burden to a workable definition of a creditable tax. nevertheless, this perspective on the credit at the very least suggests that a relatively broad scope should be given to the concept of creditable taxes, broader, in fact, than existing u.s. law. this article does not attempt to reduce that or any other conception of a creditable tax to administrable language. rather, it seeks a far more modest but, hopefully, more attainable goal. within the confines of the existing sections 901 and 903 credits, there exists a great range of possible interpretations of what constitutes a creditable tax. at many, seemingly unrelated, points, u.s. administrative rules and practices have over the years evolved towards the adoption of indefensibly narrow interpretations of what kinds of foreign taxes are eligible for the credit. those interpretations have narrowed the scope of the foreign tax credit without statutory authority for doing so and perhaps in conflict with the congressional design for the credit. this article identifies several of those interpretations, seeks to establish their irrationality, and calls for their revision in a manner that will better execute the spirit and purpose of the foreign tax credit. one of the more engrossing aspects of the excessive narrowness of the existing credit is the history of its evolution. surprisingly, perhaps, in the formative years of the credit, the courts and, to a large extent, the tax collector did a fairly good job of defining the foreign taxes for which a credit might be claimed under u.s. law. after nearly a half-century of reasonably satisfactory experience, however, taxpayer abuses prodded the internal revenue service into an overly restrictive reaction that evolved into current law. thus, as is true elsewhere in the taxing system," the deterioration in 11. the massive complexity of the partnership rules of the code resulted from the same phenomenon and developed during the same period of time. subject to numerous conditions, § 901 authorizes a credit for taxes of foreign countries and of possessions of the united states. section 903 allows a credit for a tax paid in lieu of a tax on income, war profits, or excess profits otherwise generally imposed by a foreign country or united states possession. [vol 4:2 international comity and the foreign tax credit the quality of the foreign tax credit is largely attributable to the inability of the tax collector to stem taxpayer abuse with measured and appropriate responses. this article examines the workings and derivation of four specific and related features of the foreign tax credit: (1) the rules defining "the tax" for which a credit may be claimed; (2) the rules governing the extent to which the use of proxies for computed income destroys the classification of a tax as an "income" tax; (3) the rules limiting the ability to credit alternative or minimum taxes imposed in connection with an income tax; and (4) the rules governing the extent to which such nonconforming provisions of foreign law may be treated as a creditable tax "in lieu" of an income tax. the conclusions suggested by this examination are that the united states foreign tax credit is in fact unduly narrow and that this scope is unnecessary to accomplish any legitimate objective of the credit. accordingly, the scope of the credit should be expanded, largely by restoring the regulatory rules that prevailed prior to the aggressive reinterpretations that occurred in the 1970s. 2 ii. a note on the significance of the question in the following pages, the attempt will be made to demonstrate that the scope of the existing foreign tax credit is simply wrong. the results produced in practice do not reflect the most rational construction of the credit and do not further the policies of the credit as well as would alternative constructions. however, the inadequacies of the foreign tax credit have the capacity to do harm beyond the mere miscalculation of the tax liabilities of a subset of taxpayers. to the extent that an overly restrictive interpretation of the credit results in the inability to credit taxes that functionally duplicate in the international arena the effect of the internal revenue code domestically, international double taxation is not relieved for the american businesses subject to the foreign tax. that means two things. all else being equal, the foreign business opportunity will be rendered less attractive than a domestic opportunity and international trade will be discouraged by the artificial barrier created by domestic tax law. 3 second, relative to its competitors in other countries which more effectively eliminate international double taxation, the u.s. business will be disadvantaged. thus, should it pursue the foreign 12. a broader inquiry would be whether limiting the credit to income taxes is appropriate. while that question deserves consideration, the task is not undertaken here. 13. see generally joint comm. on tax'n, factors affecting the international competitiveness of the united states 232-64 (comm. print 1991); s. van weeghel. the improper use of tax treaties 16 (kluwer, 1998). 1999] florida tax review opportunity, it will not find itself competing on a level field and will be less likely to survive the foreign competition. 4 a further, and perhaps more compelling, reason to rethink the scope of the foreign tax credit lies in its effect on foreign governments. foreign governments clearly understand the discouraging effect of double taxation. if a significant tax that a foreign government proposes to levy will not be creditable in a second jurisdiction which pursues a policy of world-wide taxation of its domestic corporations, then that tax will quite reasonably be assumed to discourage inbound investment from that second country. if, in addition, the second country is an important source of investment for the foreign government, that government will find itself under substantial, probably overwhelming, pressure to revise its otherwise preferred approach to broad based taxation. there are at least two undesirable consequences of this pressure on foreign governments to conform the boundaries of their income tax laws to the u.s. conception of income taxation. first is the potential damage to our relationships with our trading partners. of course, not all foreign taxes will ever be, or should be, eligible for the credit. however, an excessive and unreasonable narrowness in the description of the taxes that are creditable in the united states works an unnecessary oppression on our neighboring countries without producing any countervailing benefit to the united states. there is no gain from such an approach to international relations. moreover, to the extent that other countries do conform their taxing systems to the admittedly creditable, innovation and experimentation in public finance will be discouraged. the current level of antagonism within the united states to our own income tax law has led to repeated calls for "major tax reform." yet, one of the obstacles to truly major reform is the lack of international experience with other forms of taxation other than value added taxation. just as the states may function as laboratories for public policy development within our federal system, the several countries of the world have and should be able to continue to serve as testing grounds for new approaches to taxation. the pressure to conform their system to our definition 14. despite the negative effect of an unduly narrow credit, the existing scope of the foreign tax credit has not in recent years been as controversial as might have been expected. there are perhaps two reasons for business' acquiescence. the failure of prior efforts to correct the scope of the credit has taught that the solution is elusive while attempts to achieve it can be counterproductive. second, the combination of the relatively low rates of u.s. taxation of business and particular features of the computation of the overall limitation on the amount of foreign taxes that may be credited against u.s. income tax liabilities have left many u.s. businesses with more foreign tax credits than they can use. in the face of such excess credits, making the credit more inclusive naturally falls low on the list of tax reform priorities. [vol. 4:2 international conity and the foreign tar credit of income taxation may severely retard such experimentation, and that is our loss as well as theirs. these concerns are not merely theoretical. charles mclure and george zodrow have reported that in 1994 bolivia seriously considered adopting a flat tax which would have provided a working model for the consumption tax advocates in the united states. however, "the irs's decision that the hybrid cash flow tax would not be creditable prevented bolivia from introducing a tax that had clear economic and administrative benefits for that country."15 while the experiences of other countries have not been documented like the bolivian experience, the pressures that forced bolivia to adopted a conventional income tax exist for all countries that are dependant upon investment from the united states. iii. the contours of the foreign tax credit in order to appreciate the importance of crediting foreign taxes and to understand how that result can be blocked under current law, it will be useful to rehearse the operation of the credit in broad outline. for the sake of this discussion, assume that the u.s. tax rate is 35% while the foreign rate is only 25% and that the only income in question is $1000 of net income derived from a single foreign jurisdiction. as one basis for comparison, notice that if the united states, the residence jurisdiction in our example, applied a territorial based taxing system, the final tax paid by the taxpayer on this income would be $250, 25% of the net income, and there would be no need to coordinate the foreign and domestic taxes. the foreign tax would be, quite simply, the final tax. the united states, of course, does tax foreign source income and extends a remedial foreign tax credit. first, however, assume that the foreign tax is found to be noncreditable. under this assumption, the foreign tax would at least be deductible for u.s. tax purposes so that u.s. taxable income would be less than foreign income by the amount of the tax. the final world-wide tax imposed upon this taxpayer would be computed as follows: net income for foreign purposes $1000 foreign tax at 25% 250 net income for u.s. purposes 750 u. s. tax at 35% 262.50 total taxes paid 512.50 overall effective tax rate 51.25% 15. charles e. mclure, jr. & george zodrow, creditability concerns doom bolivian flat tax, 12 tax notes int'l 825, 829 (mar. 11, 1996). 19991 florida tax review the ability to deduct the foreign tax of course provided some benefit to the taxpayer. had the tax not been even deductible, the united states tax would have been $350 and the overall effective rate of tax would have been a crushing 60%. still, the deduction has not provided a great deal of benefit. the foreign source income will obviously be subject to a far higher rate of tax than the 35% that the taxpayer would incur on purely domestic income. if the foreign tax is held to be creditable, the world-wide tax computation would be as follows: net income for foreign purposes $1000 foreign tax at 25% 250 net income for u.s. purposes 1000 u. s. tentative tax at 35% 350 foreign tax credit (250) final u.s. tax 100 total taxes paid 350 overall effective tax rate 35% this difference between the effect of crediting the foreign tax and the effect of a mere deduction is dramatic and amply explains the significance, not only to the taxpayer, but also to both the foreign and united states governments, of the characterization of the foreign tax as creditable or not. familiarity with one added aspect of the credit will prove useful. this time, assume instead that the foreign rate of tax is 45%, higher than the u.s. rate, and that the taxpayer derives income of $1000 from u.s. sources as well as $1,000 from foreign sources. the computation of the credit would be as follows: net income for foreign purposes $1000 foreign tax at 45% 450 net income for u.s. purposes 2000 u. s. tentative tax at 35% 700 foreign tax credit (450) at this point it can be seen that, if the entire foreign tax of $450 is credited against the u.s. tax of $700, the credit will not only offset the u.s. tax on the foreign income but will also offset a portion of the u.s. tax on the u.s. source income. that result, while consistent with the goal of eliminating international double taxation, is nonetheless unacceptable. foreign governments could use high rates of tax to simply drain the u.s. treasury. accordingly, except for three innocent years following the introduction of the credit, the amount of foreign taxes that may be credited in any given year has been subject to some form of limitation that generally prevented a credit for more than the u.s. tax on the foreign income. thus, under the present [vol 4:2 international comity and the foreign tax credit workings of section 904, the amount of the credit that could be claimed currently would be limited to $350. to continue: credit after limitation (350) final u.s. tax 350 total taxes paid 800 overall effective tax rate 40% in addition, the taxpayer has an unused credit of $100 which may be carried forward and applied in a future year, subject to the overall ceiling of section 904. the taxpayer, in the practitioner's jargon, is in an "excess credit position." iv. a hypothetical case the narrow scope of the foreign tax credit can better be understood through illustration. that illustration can be provided by applying the specific rules of the credit that are of interest here to the taxing statutes of a hypothetical foreign jurisdiction. the example is based upon provisions of various european and latin american tax laws currently in force. the hypothetical jurisdiction imposes a tax at the national level which is called an income tax. unlike the u.s. internal revenue code, however, the law does not purport to tax "all income from whatever source derived" but rather taxes income from specific sources. nevertheless, most sources of income are subject to tax. receipts from specified sources are reported on one of six "schedules" along with the deductions related to those receipts. all net receipts shown on the five schedules applicable to residents of the foreign jurisdiction are subject to the same fiat rate of tax. 6 income from farming is reported on schedule 2. however, farmers who own less than a specified acreage do not report their receipts from the sale of their production and expenditures associated therewith on that schedule. rather, the taxable amount reported by such persons on schedule 2 is the amount determined by multiplying a statutorily prescribed rate and the assessed value of the property. that assessment varies depending upon the precise use to which the property is placed and is revised at infrequent intervals. 7 the resulting taxable amount is quite small-almost undoubtedly 16. compare, for example, the tax system of the united kingdom. see william b. barker, a comparative approach to income tax law in the united kingdom and the united states, 46 cath. u. l. rev. 7 (1966). 17. compare the inclusion of cadastral income in the base of the income tax of many countries. cadastral income may be described as a form of imputed income, typically from real property, based upon a valuation of the property that may or may not reflect actual market value. see, e.g., vanja mihajlova, republic of macedonia's tax system examined, 10 tax notes int'l 287, 287 (jan. 23, 1995). 1999] florida tax review less that the actual net income from the farm determined in accord with united states tax concepts. income from active business operations is reported on schedule 3. under article 12 of the income tax law, all incorporated businesses must compute a nominal yield on their business assets. that yield is determined by multiplying 5% times the fair market value of the tangible and most of the intangible assets of the business, determined annually. if this so-called nominal yield is greater than the amount of net income otherwise reported on schedule 3, then the nominal yield is to be reported instead of actual income."1 in addition, the jurisdiction has imposed an emergency recovery tax at the rate of 2% on all agricultural and industrial businesses. the tax is quite simple in design, in imposed on net profits, and, standing alone, would constitute a creditable tax under section 901. as will be developed in the following pages, there should not be any question but that the tax paid on the amounts reported on schedule 2 as income from farming should, from the perspective of sound income tax policy, be creditable against the u.s. income tax liability of the farmer/taxpayer. moreover, there should not be much question but that minimum tax liability reportable on schedule 3 should also be creditable. in either case, a u.s. citizen or resident subject to both u.s. tax and the foreign country tax will be subject to exactly the kind of double taxation that the foreign tax credit was created to relieve. the fact that the foreign country uses a proxy for certain categories of income does not in the least alter the essential nature of the foreign tax as a tax on income nor does it in any respect eliminate the prospect of double taxation. indeed, it would be overbearing and oppressive for the united states to force the foreign country to choose between abandoning a desired modification of its income tax and causing potential investors from the united states to be deterred by the prospect of uncreditable taxes. if we conclude that the tax cannot be credited under existing united states law, then something is wrong with the scope of the credit under u.s. law. v. the nature of an income tax: the squinting eye of the beholder before it can be said that a payment made pursuant to a provision of a foreign tax is creditable, many issues must be resolved favorably. first, the payment must be a "tax."' 9 that obvious and seemingly innocuous requirement turns out to be one of the major, albeit unnecessary, reasons for the 18. compare the business assets taxes used in latin america. see infra note 104 and accompanying text. 19. see regs. § 1.901-2(a)(1)(i). [vol 4:2 international comity and the foreign tar credit narrow scope of the credit. second, the "predominant character" of the tax must be that of an "income tax" in the "u.s. sense."' we will return to the required character and sense. the central issue is whether the foreign tax, standing alone, constitutes an income tax. as the economies of the world shifted from basically agrarian to basically industrial, income taxation emerged as the most popular mechanism for funding governments. 2' the taxation of income, however, requires resolving large numbers of definitional and interpretative issues. that in turn requires the involvement of relatively large numbers of highly educated tax specialists both within and without government. in short, income taxation is expensive both for governments and taxpayers. in addition, relative to other tax bases, income is hard to identify and easy to conceal. as a result, the costs of collecting the tax due, once it has been defined, are high. even without the desire to conceal, compliance with the relatively complex rules of income taxation can be difficult, particularly for a population of limited literacy and virtually no exposure to accounting conventions. all of these costs of income taxation become more pronounced for countries whose economies are relatively less developed. the administrative difficulties are magnified when the taxpayer is a multinational business whose financial dealings span national boundaries. in response to these costs and obstacles, countries, particularly developing countries, that have determined to adopt income taxation have also determined to adopt features and provisions that compromise the theoretical rigor of their taxing system but provide more than adequate compensation in the form of simplified administration and easier, more reliable collection. relative to taxation in the united states, the use of such proxies or approximating devices appear more significant than they are in fact. the united states' tax system is distinguished by the acceptance of numbing complexity in the pursuit of extremely refined and precise consequences. much of the rest of the world is content to achieve the more balanced approach to taxation that characterized the u.s. system prior to 1969. in the hypothetical example, that compromise is contained in the treatment of the relatively low income farm population. income from near sufficiency level farming is presumed or estimated pursuant to a formula that is not directly related to actual cash flow. the question is whether such an approximation of income can be viewed as a feature of income taxation. in neither theory nor practice is there likely to be a clear and simple answer to that question. if a country were to rely exclusively upon proxies for 20. regs. § 1.901-2(a)(1)(ii). 21. see ken messere, tax policy in oecd countries 46-50 (ibfd publications 1993). 1999] florida tax review income in the design of its taxing statute, the result would not be an income tax. if taxable income for all taxpayers were deemed to equal the number of windows in the taxpayer's principal residence or place of business multiplied by $10, the tax would be a tax on windows, not income. however, if some applications of a tax generally imposed on actual net income employed proxies for that computation in some contexts, the fundamental nature of the overall tax would not be altered. indeed, such compromises would find strong parallels within the u.s. system. for example, one compromise within the u.s. system is that appreciation in the value of property is taxed only on a sale or other disposition; not when it occurs.22 that doctrine of realization is a quite substantial compromise with an ideal system of income taxation which would tax such accretions to wealth as they occur. 3 the proxy tax imposed on low income farmers in the illustrative example would not, standing alone, constitute an income tax for purposes of the credit. under the regulations, an income tax is a tax that is "likely to reach net gain in the normal circumstances in which it applies."'24 were that the sole content of the test for income taxation, it might well be possible to demonstrate that the tax on farming would meet the test. however, the regulations continue to preclude that result by specially defining the phrase "likely to reach net gain" as meaning the tax meets three specific tests.25 the tax must be imposed upon realized income, it must be imposed upon gross receipts and it must allow the deduction of significant expenses. thus, in order to be "likely to reach net gain," the tax must be imposed on a base consisting of realized gross receipts reduced by the significant items of deduction granted by u.s. tax law. while each of these three requirements is softened by elaboration and exception, the tax on farming would fail most, if not all, of the specific requirements. the harshness of that result is surprising and, as argued above, inappropriate. the reason that u.s. law has gravitated to this position is just as surprising and provides a basis for beginning to rethink the existing regulations. a. the fontnative years the effect of the use of proxies or income-approximating devices appears to have been the first question raised in connection with the new foreign tax credit. in the post-world war i era, many americans lived and 22. eisner v. macomber, 252 u.s. 189 (1920). 23. ironically, one of the features of u.s. law against which foreign taxes are measured is the doctrine of realization. the foreign taxes that have failed that test are sometimes closer to an ideal system of income taxation than is the u.s. system. see, e.g., f.w. woolworth co. v. united states, 91 f.2d 973 (2d cir. 1937), cert. denied 302 u.s. 768 (1938). 24. regs. § 1.901-2(a)(3)(i). 25. regs. § 1.901-2(b). [vol. 4:2 9]ternational conity and the foreign tax credit worked in france, and herbert ide keen was one of them. under french tax law, the taxable income of resident aliens was subject to a minimum tax computation: taxable income was the greater of actual income or seven times the rental value of the taxpayer's french residences. (it might be speculated that the french authorities expected that aliens typically would devote about 14% of their salary to rent.) under this provision, mr. keen was determined to have taxable income for french purposes of $4,784. in fact, that amount was substantially less than his actual compensation for his services in france of $10,915, all of which was reported as income in the united states.26 the commissioner had taken the position in prior published rulings that this french tax was not an income tax but rather was a property tax and that payments pursuant to the tax were not creditable.' the board of tax appeals without hesitation rejected the commissioner's characterization of the tax as a property tax and held instead that it was an income tax and creditable against the taxpayer's u.s. tax liability. the board noted that the fact that the income was determined differently from the computation of income for u.s. purposes did not alter the nature of the tax which, the board concluded was "a tax upon his income in 1923."' the commissioner almost immediately acquiesced in the result.29 the broad and flexible view of income taxation held by the board of tax appeals in keen quickly became generally accepted by the tax collector. in particular, the narrow holding of that case, that the amount paid pursuant to a provision embedded in a general income tax law which estimates net income through the use of an approximating formula is a creditable tax, remained good law for nearly half a century. thus, for example, in 1950 the service ruled that a dominican republic tax,30 which contained a rebuttable presumption that the net income of nonresident transportation companies was equal to 6% of gross receipts, was an income tax.? similarly, in 1967 the service considered the application of the guatemalan income tax to foreign insurance companies.' article 15 of the law provided that in the case of reinsurance arrangements with foreign companies, in taxing the assignees of the insurance contracts it would be 26. keen v. commissioner, 15 b.t.a. 1243 (1929). no issue was made of the fact that this larger amount might properly have been reportable in france. possibly france in 1923 made no effort to identify income of americans in excess of the computed minimum. 27. o.d. 1093, 5 c.b. 194 (1921); s.m. 3155, 4-1 c.b. 45 (1925). 28. keen v. commissioner, 15 b.t.a. at 1246. 29. 8-2 c.b. 27 (1929). 30. i.t. 3997, 1950-1 c.b. 63. 31. see also rev. ru. 272, 1953-2 c.b. 56 (treating a haitian tax quite similar to the french tax involved in keen as an income tax); rev. rul. 59-192, 1959-1 c.b. 191. 32. rev. rul. 67-329, 1967-2 c.b. 257. 1999] florida tax review "assumed by right the taxable income of these companies is equivalent to 10% (ten percent) of the amount of the premiums assigned." the commissioner concluded that the tax imposed by the overall law was "essentially a tax on net income" and the fact that the law required that income of some taxpayers be computed "in a different manner from that used for taxpayers generally does not change the nature of the tax imposed." thus, "the tax on income as determined by the formula described in article 15 is an income tax within the meaning of section 901 of the code." although it was not evident from their highly abbreviated texts, this doctrine also underlies the rulings that the "taxes" imposed upon united states oil companies by various foreign countries were income taxes.33 these rulings would prove to be the undoing of the doctrine. this acceptance of nonconforming elements in foreign tax systems by the board is also evident in the first cases to arise that involved the realization of income in a manner then unknown to u.s. law. 4 the burk brothers bought goat skins through an office in calcutta and imported them to philadelphia where they manufactured the skins into leather which they then sold. under the united states rules governing the source of income, all of the income from the sales in the united states of goods purchased abroad would be attributed to the united states. however, under the source rules applied by the income tax laws of british india, a portion of the actual overall profits derived by burk brothers was allocable to the calcutta office and subjected to (a relatively small) tax. while the issue was not made entirely clear, the income was apparently deemed to arise upon the export of the skins and prior to their actual sale in the united states. the commissioner sought to deny a credit for the indian tax on the ground that the tax was an excise tax, not an income tax. the board, while recognizing that the united states did not treat the transfer of inventory between a branch and the home office as an income generating event, nevertheless founds that it was "perfectly clear" that the tax paid was a creditable income tax.35 b. the united states conception while the decision in keen established a flexible approach to the use of proxies for income, language in the opinion contained the seeds of a very 33. e.g., rev. rul. 55-296, 1955-1 c.b. 386; rev. rul. 68-552, 1968-2 c.b. 306. 34. e.g., burk brothers v. commissioner, 20 b.t.a. 657 (1930). 35. the favorable decision unfortunately availed the burks nothing. since under u.s. law they did not have any foreign source income, under the recently enacted overall limitation on the credit, their credit ceiling was zero. five years later, however, a second trader in indian goatskins who did have foreign source income was able to credit the indian tax under the authority of burk brothers. briskey co. v. commissioner, 29 b.t.a. 987 (1934), aff'd, 78 f.2d 816 (3d cir. 1935). [vol. 4:2 international comity and the foreign tax credit different rule. while it seems clear that the board believed that the french approach to estimating the income of resident aliens was compatible with the fundamental notions of income taxation embodied in the tax laws of the united states, in arriving at that conclusion the board remarked that this tax was upon "what the french government determines to be income." it seems extremely unlikely that this was so. rather, it seems rather obvious that an amount computed by multiplying apartment rental times seven would not be regarded as income by any government, french, american or otherwise. to the contrary, the computed amount was quite plainly intended as a proxy for income, as a "rough justice" but easy to administer method of estimating the net income of resident aliens, which the french chose to use but the united states did not. this issue in keen was not whether the french were foolish enough to think that an expenditure was income, but rather whether the use of a proxy for certain limited categories of income was incompatible with the characterization of the broader tax as an income tax. nevertheless, in the early cases construing the credit, there was some confusion on the point. shortly after its decision in keen the board heard a case involving the creditability of a cuban municipal tax law. the only issue was whether a tax on the profits from the operation of the taxpayer's "gas and electric light" plants was an income tax or a tax on the privilege of doing business. the commissioner relied upon an expert on cuban law who was able to persuade the board that the tax in question was a privilege tax that was merely measured by profits and which therefore was not creditable. 6 the taxpayer thereupon filed a motion for rehearing which was granted. at the new evidentiary hearing, nine experts on cuban law, five on one side and four on the other, testified. these proceedings produced a different result. the earlier opinion was vacated and a decision rendered in favor the creditability of the tax. 37 while the board placed substantial stress on the cuban understanding of the cuban law, it does not appear that the board thought that the cuban characterization was controlling. the board observed approvingly that: the respondent has also said that determination of whether a given foreign tax is thus 'a tax on income' is to be made from an examination of the foreign tax law itself, without regard to any title or classification given to it by the foreign government: i.t. 2620 .... 36. havana electric railway, light & power co. v. commissioner, 29 b.t.a. 1151 (1934), rev'd on rehearing, 34 b.t.a. 782 (1936). 37. havana electric railway, light & power co. v. commissioner, 34 b.t.a. 782 (1936), rev'g, 29 b.t.a. 1151 (1934). 1999] florida tax review the board undertook that examination and concluded that the tax in question was imposed upon net profits and thus constituted a creditable income tax. without doubt, however, the proceedings and opinion of the board devoted far more attention to that cuban classification than to an examination of the law itself and that disproportionate emphasis might have been misleading. two years later the supreme court first addressed the foreign tax credit in biddle v. helvering.38 biddle involved the tax system of the united kingdom in which the corporate and shareholder taxes were largely integrated in a way entirely alien to u.s. tax law. the issue presented was simply whether the corporation or the shareholders should be regarded at the payor of the tax.39 although there was no question but that the tax involved was an income tax within anyone's conception, in the course of its opinion the court quite generally noted that united states law should govern the determination of whether a tax was an income tax within the meaning of the united states tax laws. that statement by the court could not have been intended or regarded by others as a change in the application of the credit. the commissioner had always regarded the definition an income tax to be determined by u.s. law. for example, in i.t. 2620,40 issued five years before and relied upon by the board in havana electric, the commissioner stated that "it must be shown that the tax imposed by the foreign law is a tax on income, according to the united states concept. . . ." nevertheless, subsequent authorities would treat the dicta in biddle as establishing a new rule inconsistent with then existing caselaw4 while there may have been some confusion on the point in the very early years of the income tax, there was never a very serious question but that the dicta in biddle was a correct statement of how the foreign tax credit was to be applied. labels and classification created by foreign governments cannot be allowed to control u.s. income tax consequences absent a clear congressional intention to that effect. the vastly more important question, however, was what exactly was meant by the reference to a united states conception of income. in its most provincial sense, that phrase could be intended to mean the financial receipts, and only the receipts, subject to tax in fact under the internal revenue code. on the other hand, there is a 38. biddle v. helvering, 302 u.s. 573 (1938). 39. mostly because of its discomfort with the british system, the court held that the shareholder was not entitled to a credit for the tax withheld by the corporation on the distribution of dividends. that unsatisfactory result persisted for exactly eight years when it was overruled by the treaty with the united kingdom. 40. i.t. 2620, 11-1 c.b. 44 (1932). 41. commissioner v. american metal co., 221 f.2d 134, 140 (2d cir. 1955). the unexplained remark to that effect in this opinion would be relied upon heavily by chief counsel in seeking to change prior law. see infra note 45. [vol 4:2 international comity and the foreign tax credit generalized concept of income taxation which is shared by students of taxation in germany and england-and in the united states. no single enacted national law embodies the fully developed concept of income shared by these scholars, nor could it, for the details of the concept are subject to continual debate. nevertheless, each of these countries and countless others have a law that falls squarely within that general conception of an income tax. in this sense, the united states conception of an income tax is the same as the german conception of an income tax although the two countries have enacted very different versions of that conception. during the period beginning with the enactment of the foreign tax credit and extending into the early 1970s, the board of tax appeals and the service personnel clearly viewed the concept of income referred to in biddle and later authorities as a broad concept, not at all limited to enacted provisions of the code.42 indeed, there is no indication that the service personnel regarded biddle as reflecting any material change in the law at all. most rulings during this period refer to the requirement that a tax be an income tax with the u.s. conception. the only change in this recitation occasioned by the decision in biddle was the citation to that case. as a result, in the postbiddle era the service continued to treat keen-type taxes that employed proxies or presumption or estimates as income taxes and creditable. thus, in 1953, for example, a full 16 years after the decision in biddle, the service ruled that a haitian tax quite similar to the tax considered in keen "falls within the united states concept of an income tax.' 3 that was so although taxable income was computed in a manner entirely unknown to u.s. law. biddle was compatible with keen because the conception of income referred to by the supreme court was not a narrow, provincial conception but rather was a broad, generalized conception of income. thus, to be creditable, a foreign tax did not need to conform to u.s. law in all details. rather, the tax need only be a tax "on income in its fundamental sense as meaning gain or profit." accordingly, a foreign tax might well be an income tax even though it was imposed on amounts that were not in fact subject to tax under u.s. law. by the end of the 1960s, therefore, it was well established that the use of various devises to estimate net income, such as presumption, estimates and formulae, within the context of a broader income tax act did not detract from the creditability of the tax. the firmness of that position is underscored 42. and see philip r. west, foreign law in u.s. international taxation: the search for standards, 3 fla. tax rev. 147, 154-56 (1996). 43. rev. rul. 272, 1953-2 c.b. 56. see also rev. rul. 67-329, 1967-2 c.b. 257 (guatemala). 44. i.t. 2620, 11-1 c.b. 44, 46 (1932). 1999] florida tax review by a memorandum issued by chief counsel45 in 197 1.46 the taxpayer, which otherwise was subject to the general income tax imposed by jamaica, had entered into an agreement with that government that its taxable income would be determined by assuming a profit from its mining operations that was geared to the selling price of processed ore. it then sought a ruling with respect to the creditability of the tax paid and the rulings division was prepared to rule that payments under the agreement were indeed creditable as a tax, but only as a tax in lieu of an income tax under section 903. chief counsel concluded that the tax was an income tax and creditable under section 901. the agreement merely provides for an alternative method of computing the net income that is subject to the general income tax and the use of that formula does not alter the nature of the tax. c. oil royalties and the reversal of policy at the same time, however, chief counsel's office was becoming concerned that some foreign governments, presumably in collusion with u.s. taxpayers, were using formula-generated computations of net income to achieve improper results.47 as a result of transfer pricing audits under section 482 of the international operations of major oil companies, the service had developed an understanding of the pricing policies of those companies and of their financial relationships with the host governments. the service apparently concluded that payments to the host governments that should have been characterized as royalties and thus deducted were being disguised as creditable taxes, thus producing a vastly greater reduction in u.s. tax liability. the problem arose when a u.s. business was engaged in extracting minerals, often oil, in a foreign country under whose laws the mineral belonged to the government. under those conditions, the taxpayers might properly be required to pay an income tax based upon their net income from activities in the foreign jurisdiction and might properly be required to pay a royalty which traditionally would be based upon the quantity of minerals extracted or their gross selling price or value. by using a formula price geared to the value of the mineral extracted, such as the formula approved in general counsel memorandum 34567, colluding taxpayers and 45. in the following pages, reference is made to chief counsel's office, as distinguished from the irs in general. that office houses the legal advisor to the irs and lies within the service but the office is highly independent. in fact, chief counsel reports to the general counsel of the treasury department, not to the commissioner. see george guttman, should irs chief counsel report to the commissioner?, 79 tax notes 1542 (june 22, 1998). for that reason, memorandum issued by chief counsel are entitled general counsel memorandum. 46. gen. couns. mem. 34,567 (july 28, 1971). 47. see tech. adv. mem. 98-21-003 (feb. 9, 1998) (observing that the final regulations under § 901 had resolved that issue). [vol 4:2 international comity and the foreign tar credit foreign governments might combine both payments into a single payment that would be treated as a creditable tax. in the middle east that formula price took the form of a "posted price." by agreement between the producer and the host government, all sales of crude oil must be made at the posted price which was not related to, and in fact was far greater than, the market value of the crude. as a result of this device, the governments using the technique would obtain revenue geared to the quantity of production rather than the profitability of the producer while the producer would pass the burden of the payment along to the united states treasury through the mechanism of the foreign tax credit. this problem of disguised royalties was indeed a real problem and one requiring redress by the service. however, when the service first studied the issue, it concluded that disallowing a credit for these payments would be "extremely difficult to maintain in court" in light of the existing precedents. 48 in particular, general counsel memorandum 33348 concluded that the line of cases and rulings following keen, which the memorandum characterized as "comput[ing] net income by means of arbitrary percentages or other fixed factors in an apparent attempt to avoid uncertainty as to the amount of tax due" [emphasis in original], were indistinguishable. over the next decade, however, the attitude of the chief counsel's office, if not of the service generally, towards the crediting of these payments hardened and that office determined to aggressively reshape those precedents to its own liking in order to provide a firmer foundation for attacking the crediting of what appeared to be oil royalties. accordingly, chief counsel initiated a wide ranging attack which included a frontal assault on keen and its progeny. that attack is developed in a series of general counsel memoranda prepared during the mid-1970s49, the conclusions of which were embodied in several subsequently issued revenue rulings.50 the scope of the attack emerges from general counsel memorandum 36540,51 which involved indonesia. the taxpayer had entered into an agreement with an agency of the government which, among other matters, required that the taxpayer's income for purposes of the corporate income tax be computed under a formula that was geared to the value of the oil produced. under the operation of this 48. gen. couns. mem. 33,348 (ocl 7, 1966). 49. the differences in the tone of gen. couns. mem. 33,348 issued in 1966 and the several gcms issued in the 1970s is strildng. the earlier document is a careful. impartial legal analysis with only a touch of strategic manipulation in the area of "in lieu of" taxes. see text at notes 94-95. the later documents are briefs-and aggressive briefs at that. 50. in particular, rev. ruls. 76-215, 1976-1 c.b. 194; 78-61, 1978-1 c.b. 221; 7862, 1978-1 c.b. 226; 78-63, 1978-1 c.b. 228; each of which was declared obsolete following the adoption of the 1983 regulations. rev. rul. 84-172, 1984-2 c.b. 315. 51. gen. couns. mem. 36,540 (jan. 5, 1976). see rev. rul. 76-215, supm note 50. 19991 florida tax review highly complex agreement, an increase in the selling price of the oil produced a disproportionately large increase in the computed amount of taxable income and thus in the amount treated as a tax. in addition, the payment of this amount was to be discharged from the share of production allocated to the agency. the memorandum concludes, first, that the amounts paid under the agreement are royalties, not taxes, and thus are not creditable. that conclusion, which seemed generally correct, was sufficient to dispose of the ruling request before the service. however, the memorandum continued to conclude that even if a part of the allocation of production to the government agency did constitute the payment of a tax, that the tax would still not be creditable because the portion of the allocation of production that constitutes a tax cannot be severed from the portion that constitutes a royalty. thirdly, if that were not enough, the memorandum further asserted that even if the portion of the allocation that constitutes a royalty could be severed, it would still not be creditable because the tax did not constitute a tax on income. referring to the base of the tax as "fictitious income," the memorandum argues that if the tax base includes "substantial amounts of fictitious income," it does not fall "predominantly on net gain in the american sense" and thus is not a tax on income. this third alternative basis for denying the credit represented an abrupt reversal of the position that the service has held for nearly 50 years. 52 the reason for that reversal of policy apparently is to be found in the conclusion reached 10 years before that the denial of the credit for the payments by the oil producers would be inconsistent with the line of authority flowing from keen. if that were so, the oil royalties could not be attacked without first undermining the precedential value of that line of authority. that undermining was developed in general counsel memorandum 3655253 which nominally addressed the issue of whether the ontario mining tax act constituted an income tax. the ontario tax was imposed on the net profit from mining and generally resembled an income tax. however, to deal with the problem of an 52. it is evident from gen. couns. mem. 37,263 (sept. 21, 1977), that the service believed that its reversal of position received support from the decision of the court of claims in the bank of america case. that case involved a gross income tax which the trial commissioner had held to fall within the u.s. conception of an income tax because at the time it was commonly believed that the sixteenth amendment allowed a tax on gross income and that deductions were a matter of legislative grace. while this decision was reversed by the full court, the court made clear that its decision was not intended to bar a credit for a gross income tax used as a proxy for a net income tax, such as was involved in santa eulalia mining co. v. commissioner, 2 t.c. 241 (1943). 53. gen. couns. mem. 36,552 (jan. 19, 1976). [vol 4:2 international comity and the foreign tar credit integrated miner-manufacturer that sold processed minerals rather than ore, the tax provided that profit included the market value of the output at the mine head. the ontario tax thus presented a second type of nonconformity which had troubled the administration of the foreign tax credit from the very beginning: whether a tax that employed notions of deemed dispositions resulting in taxable gain at an earlier stage of the manufacturing process than in the united states was nevertheless an income tax.' the ontario tax did not raise the issue, first presented in keen, of the creditability of a tax that relied upon the use of a proxy for computed income. however, for no reason relevant to the issue before it, general counsel memorandum 36552 brought the early case within the scope of its analysis. keen was said to have imposed a tax on "unrealized rental income" which, of course, did not conform to the united states standard of an income tax. thus, the service concluded, the case was inconsistent with the later decision of the supreme court in biddle which required such conformity. chief counsel's office thus suggested to their colleagues in the rulings division that the long-outstanding acquiescence in keen be withdrawn and that the series of rulings relying on the doctrine of that case be revoked.5 d. evaluating the attack on abuses these 1970' era gcms make it clear that the service disowned the more flexible approach to the concept of income taxation begun, in the 1920s with the decisions in keen and burk and extending into the decade of the 1970s, solely in order to strengthen its litigating position with respect to the oil royalties. two observations can be drawn from that conclusion. first, the broad revision of prior law sought by chief counsel and embodied in the new ruling policy was entirely unnecessary. the fundamental defect in the oil payments was that the payments, at least in substantial measure, were not taxes, and that defect was recognized at the time. that issue, of course, was 54. see burk brothers v. commissioner, supra note 34. 55. including rev. rul. 272, 1953-2 c.b. 56 (haitian tax similar to the french); rev.rul, 59-192, 1959-1 c.b. 191, and rev.rul. 56-658, 1956-2 c.b. 501 (cuban tax using deemed disposition); and lt. 3997, 1950-1 c.b. 63, (dominican republic tax on estimated income). a similar approach was taken to the decision in burk brothers and the line of authority that it represents. in burk brothers the taxpayers had been subject to taxation in india on the appreciation in the value of exported goatskins, a tax that may have been due at the time of export rather than the later time of the sale of the skins in the united states. characterizing the tax as "triggered by a purchase" and "without reference to the amount of income, if any, actually realized during the year," general counsel memorandum 36,552 argued that the tax could not be credited and that position was subsequently published in rev. rul. 78-62, supra note 50. 19991 florida tax review completely unrelated to the issue presented in such cases as keen and burk of whether an admitted tax was an income tax. it does not appear from the written record exactly why the personnel in the office of chief counsel went from the assertion in 1971 that formula computations of income constituted a form of income taxation to the scattergun attack on the crediting of such taxes five years later. however, it is clear that the american oil companies, working in conjunction with the governments of friendly nations, had devised a scheme for passing more of the burden of the payments to the foreign governments on to the u.s. treasury than was permissible, and it is also clear chief counsel was determined to stop that abuse. in that light, the revision of the scope of the foreign tax credit was a simple casualty of the seemingly endless warfare between aggressive taxpayers and a beleaguered internal revenue service. second, it also appears that these revisions of the credit were misguided as well as unnecessary. during the long history of the foreign tax credit a variety of approaches to the definition of the base of an income tax had been discovered throughout the world. in numerous rulings and court decisions, these various provisions had been treated as constituent elements of general income taxes. those decisions achieved a reasonable and appropriate accommodation with our neighboring countries by accepting differences in the rigor with which the tax base may be defined in an income tax. this tolerance for atypical and nonconforming features of a broad based tax allowed countries to fashion the system of taxation that worked best for them without preventing the creditability of their taxes and thereby jeopardizing needed investment from the united states. moreover, that flexible approach to the definition of an income tax furthered the purposes of the foreign tax credit by reducing instances of international double taxation. laying aside technical definitional issues, there is no real commonsense doubt but that the credited taxes had been imposed by the foreign government in replacement for the individual or corporate income tax that would have been imposed by the united states had the economic activity occurred within the united states. this plainly desirable flexibility of the pre-1970s credit was attacked by the service, and ultimately discarded in the 1983 regulations, because the service doubted its ability to persuade a court that payments to the oil producing countries were royalties, not taxes. that unfortunate tactical decision should now be reversed. recall the hypothetical tax on farming discussed above. prior to the mid-1970s there would have been little doubt but that the tax would be treated as part of an income tax within the u.s. conception and thus creditable. after the issuance of revenue ruling 78-62, the substitution of a nonacquiescence in keen, and the issuance of the 1983 regulations, the contrary result surely would be reached. clearly, the tax would not, standing alone, be treated as an income tax. on the other hand, the tax might still be [vol 4:2 international conity and the foreign tar credit creditable under current law if it could be regarded as an inseparable part of a law that concededly was an income tax. vi. separate levies and predominant characters the service came to embrace the creditability of taxes containing proxies and estimating devices presumably because it recognized that in these instances, the foreign governments were seeking to impose a tax on the same specific items of income or gain that the united states sought to tax. the mechanics and procedures might be alien to the u.s. experience, but the result was the same. since that result would produce the very double taxation that the foreign tax credit was enacted to reduce, granting the credit quickly came to be viewed as appropriate. at the same time, the service has always been far more reluctant to allow a credit for a foreign tax that is imposed upon specific items of income that the united states has determined not to tax. that reluctance has been reflected in a variety of doctrines that impose further, and unnecessary, limits on the creditability of foreign taxes. while the broad view of what can be treated as income taxation which prevailed until the 1970s is preferable as a matter of tax policy, that approach does raise two additional definitional issues of concern here. first, by hypothesis, the tax for which credit is sought contains elements that are not used in the income tax laws of the united states and that might not, standing alone, constitute the taxation of income. at some point, under the most flexible approach to crediting, the non-income tax elements of the law in question will so alter the character of that law that it can no longer be treated as a creditable income tax. to identify that point some test will be required to determine when a tax that contains nonconforming elements will nevertheless be treated as an income tax. second, it is necessary to consider the scope of the tax in issue. clearly, before the creditability of a tax can be tested, its boundaries must be defined; its divisibility must be determined. however, this divisibility issue interacts with the conformity issue in important ways. if the scope of the tax to be tested is broadly defined to treat all loosely related elements of the tax law as a single indivisible tax, that would seem to suggest that more foreign taxes will be credited than under a narrower approach to divisibility. certainly that will be true if the conformity test is also a liberal one. if the inclusion of a significant non-income tax provision within a single indivisible law will not cause the overall law to be treated as a noncreditable tax, then a broad approach to the scope of the laws to be tested will result in an expansive approach to crediting. on the other hand, if a strict approach to conformity is taken, one requiring the foreign law to closely resemble u.s. income tax law before crediting is allowed, then a broad approach to divisibility actually would 1999] florida tax review result in substantially fewer foreign taxes becoming eligible for the credit. in fact, such an approach would deny the credit to a wide range of taxes that were without question imposed upon net income, but had become contaminated by the inclusion of nonconforming elements within the scope of the law. obviously, such an approach, in failing to minimize international double taxation, would be objectionable both as a matter of policy and as a matter of international comity. while it would reduce the volume of nonconforming taxes that were credited, it would accomplish that at the expense of barring credits for a greater number of conforming provisions. accordingly, were the service to seek to reduce the number of payments to governments that were eligible for the credit, applying a strict conformity rule to a broad approach to divisibility would seem undesirable. other things being equal, the more narrowly the scope of the tax to be tested is defined, the smaller will be the number of foreign taxes eligible for the credit. moreover, under a narrow definition of scope, the approach taken to conformity becomes of little significance. if the tax is divided into fragments, those conforming to u.s. tax law will be credited and those not conforming will not be credited. thus, divisibility alone will control eligibility for the credit.5 6 in terms of the hypothetical example, if the entire law is a single indivisible tax and a moderately liberal approach is taken to conformity, the tax on farmers will be creditable as a part of a broader income tax. under a strict approach to conformity, however, none of the taxes paid under any provision of the law would be creditable. under a narrow approach to divisibility, the tax on farmers will not be creditable while the taxes paid on other schedules would remain creditable, regardless of the approach taken to conformity. the key decision, therefore, concerns divisibility, not conformity. a broad approach to defining the scope of the tax to be tested will in practice require the use of a relaxed approach to the required degree of conformity. the resulting test will allow for relatively liberal crediting for foreign taxes. one the other hand, an approach to scope that requires fragmenting foreign tax systems renders the conformity issues insignificant and results in the crediting of significantly fewer taxes. 56. in theory, at least, a narrow approach to divisibility, combined with a strict approach to conformity, could result in greater foreign tax credits than would a broad approach to divisibility coupled with notions of strict conformity. under the narrower approach to scope, credits would not be denied for taxes that were essentially income taxes but that had been tainted by nonconforming elements. however, that advantage of a narrow definitional approach is somewhat illusory; the combination of a broad definition with a rigid approach to conformity is not viable in practice. [vol. 4:2 international comity and the foreign tax credit a. divisibility the existing regulations, at least as they are understood by the service, take an extraordinarily narrow approach to divisibility.' in general, a foreign tax enactment is to be divided into the smallest components possible for the purpose of testing whether the provision constitutes an income tax in the u.s. sense of that term. that extreme narrowness, however, does not appear from the vague and relatively brief standard for divisibility set forth in the regulations. that text provides little beyond the bare concept that levies are separate taxes if they are imposed upon bases that are "different in kind, and not merely in degree.""8 greater insights, however, can be gleaned from examples contained in the regulations. initially, the notion of bases that are different in kind is illustrated by reference to the code itself. the tax on corporations imposed by section 11 is said to be separate from the penalty tax imposed by section 541 on the adjusted taxable incomes9 of personal holding companies and from the now repealed tax of former section 1491 on the appreciation (computed under normal income tax rules) in property transferred to foreign business entities.6° significantly, each of those taxes is functionally interrelated and employs a common computation of gain. in a more telling example, the regulations describe a hypothetical foreign law that requires that income from different types of activities, such as mining and providing technical services, be computed separately, although presumably pursuant to common accounting rules, and imposes different rates of tax on each activity. the tax on each activity constitutes a separate levy unless net losses from one activities can be applied in reduction of the tax imposed on the other activities. 61 two aspects of these regulations operate to produce a high level of fragmentation. first, without expressly so stating, the regulations effectively create a powerful presumption in favor of the finding of multiple levies. taxes that are manifestly complementary and conceptually coordinated, but which are imposed by different paragraphs, or even different clauses of the same paragraph, will be treated as separate levies unless it can be shown that, because of some netting of expenses or cross crediting of losses, the tax attributable to distinct activities cannot be identified. 57. regs. § 1.901-2(d). 58. regs. § 1.901-2(d)(1). 59. the tax is imposed on "undistributed personal holding company income" which is taxable income as normally computed subject to the handful of adjustments listed in irc § 545. 60. regs. § 1.901-2(d)(1). 61. regs. § 1.901-2(d)(3), ex. 3 & 4. 19991 florida tax review second, the regulatory test for separateness is purely mechanical. no weight is to be given to the purpose or function of a taxing provision within its own legal environment or to the interaction of the provision with other aspects of a nation's taxing system. the examples contained in the regulations plainly indicate that a tax will be fragmented if it is mechanically possible to trace a portion of the total tax liability to distinct elements of the taxpayer's income. the issue thus turns on the mechanic detail of the taxing statute. it may even be the case that, notwithstanding that income from different sources is combined and subject to a progressive rate of tax, the result will still be treated as a series of separate taxes if a netting of income and loss is not permissible.62 this mechanical approach seems to derive from a somewhat confused, result-oriented opinion in lanman & kemp-barclay & co. of colombia v. commissioner,63 a case discussed in some detail below. returning again to our illustrative example, even though the tax on farming may not, standing alone, constitute an income tax, the tax is plainly a integral component of an income tax that is designed to approximate the effect of an income tax on a narrow segment of the economy. hence, it ought to be eligible for the credit. however, under the existing regulations, it seems clear that income reported on each schedule would be regarded as a separate levy and tested individually for conformity to income taxation.64 in that event, the tested tax will be creditable only if it meets the test for conformity to u.s. notions of income taxation. that test of the "predominant character" of the tax will be considered further below. here it is sufficient to note that the tax on low acreage farmers, considered separately, would surely fail that test. as discussed above, under a narrow approach to divisibility, the test for conformity is of little importance. nonconforming taxes, like the tax on farming, will generally not be eligible for the credit. the approach of the service to the divisibility issue is undeniably harsh. it is also surprising in that it is counterintuitive and sharply at variance with the normal use of language by either nonspecialists or tax technicians. under the regulations, single, integrated taxing statutes are treated as comprised of numerous "separate levies," each imposed on a segment of a nation's economic activity and separately creditable. this peculiar approach 62. while at one time the service treated income subject to a progressive rate of tax as subject to a single levy, that rule has been omitted from the current regulations. see gen. couns. mem. 32,859 (june 15, 1964) (explaining rev. rul. 64-260, 1964-2 c.b. 187) and gen. couns. mem. 36,441 (sept. 26, 1975). 63. lanman v. commissioner, 26 t.c. 582 (1956). 64. that result might be altered if the income from farming were combined with the income on other schedules and subject to a progressive rate of tax on the aggregate as would occur in the united states. however, because the regulations are oddly silent on the point, even that result is not certain. [vol. 4:2 international comity and the foreign tax credit did not flow naturally from the language or purpose of the credit but rather was designed to limit the creditability of nonconforming elements in foreign taxing systems. the reasons for the adoption of this approach again are illuminating and are to be found in the historical evolution of the provision. the early cases did not address either of these issues, at least not expressly. however, it is fairly clear that the courts in such cases as keen and burk were influenced by the fact that they were examining a single feature of a broader tax that fit squarely within the general understanding of an income tax. the decisions, while devoid of reasoning, are consistent with a broad approach to divisibility and, of course, reflect a liberal approach to conformity. the service, however, with no more analysis, seems to have initially sought a narrow scope to the laws to be tested in order to limit creditability. thus, for example, in an early ruling on a mexican tax which enumerated in separate clauses the business activities subject to tax, each clause was treated as a distinct tax to be separately tested for creditability.' in 1936, however, in hubbard v. united states, the commissioner succeeded in persuading the court of claims that, if an item of income that was taxed by a foreign government were not in fact subject to taxation by the united states, no credit could be claimed for the portion of the foreign tax attributable to that item because that item of income was not in fact subject to double taxation.' in the years following that victory, the commissioner began to take a broader view of the scope of the foreign tax that is to be tested for creditability, relying on hubbard to limit the crediting of nonconforming foreign taxes. by the early 1950s the commissioner had arrived at a reasonably balanced approach to the divisibility issue. thus, a 1952 ruling considered the creditability of a cuban tax on the receipt of a stock dividend, a receipt that would not have been taxable in the united states.67 the ruling concluded that, since the provision was "part of the over-all cuban tax law" which had previously been ruled to be a creditable income tax, "the fact that some of the items taxed are nonincome items is not material" because the tax is "indivisible."8 the courts soon concluded, however, that the decision in hubbard lacked support in the statute and was erroneous as a matter of policy.' by 1952 it had become clear that the victory in hubbard would no longer be 65. i.t. 2620, 11-1 c.b. 44 (1932). 66. hubbard v. united states, 17 f. supp. 93, 96, 84 cl ci. 205 (c. cl. 1936). 67. i.t. 4074, 1952-1 c.b. 87. 68. id. at 87-88. see also rev. rul. 272, 1953-2 c.b. 56, 57, which took a similar approach to the unity of an income tax law, and rev. rul. 67-329, 1967-2 c.b. 257. 69. helvering v. nell, 139 f.2d. 865, 871 (4th cir. 1944). 19991 florida tax review followed7" and in 195471 the commissioner conceded the loss, thus terminating that brief chapter in the interpretation of the credit. however, the service almost immediately responded to the loss of the hubbard rule by returning to a narrow approach to divisibility. that about-face is dramatically illustrated by the inconsistent treatment of cuban taxes. in 1953 the service had considered the creditability of the taxes imposed by two paragraphs of a cuban law which imposed taxes in addition to the generally applicable income tax.72 article 14 of the law levied a flat tax on the value of the capital of every company and plainly was not an income tax. article 15 imposed a tax on profits in excess of 10% of the value of the capital taxed under the first tax. although an excess profits tax is a creditable tax, the service concluded that neither tax was creditable. while the ruling was notably devoid of reasoning, the service evidently concluded that the taxes were indeed indivisible but that, in this case, the resulting levy did not conform to the u.s. conception of an income or excess profits tax. in revenue ruling 56-51" the service re-examined that conclusion. explaining that the earlier ruling was based on the assumption that the two taxes were "interrelated and interdependent," on reflection the service concluded that the mere fact that the second tax employed the valuation made for the first tax did not cause the taxes to be so integrated that they must be treated as a single tax. considered separately, the second tax was an excess profits tax and creditable. the service cautioned, however, that if the tax had been a single tax imposed on both items, the creditability of the tax would be an all or nothing proposition determined by the "predominant character" of the unified tax.74 this brief summary of the wavering history of the service's approach to divisibility serves to underscore the role that the doctrine has played under the credit. divisibility has never been used as a value-neutral step in the definition of a creditable tax. indeed, as currently employed it does not even reflect an intrinsic quality of the foreign tax law to be tested. rather, divisibility turns out to be a result-oriented doctrine, a malleable concept used to control the scope of the foreign taxes that are eligible for the credit. the 70. in brace v. commissioner, 11 t.c. memo (cch) 906-07 (1952), the court referred to the commissioner's argument as an "attempt to revive an extinct question." 71. rev. rul. 54-15, 1954-1 c.b. 129. 72. rev. rul. 31, 1953-1 c.b. 225. 73. rev. rul. 56-51, 1956-1 c.b. 320. 74. in rev. rul. 64-260, 1964-2 c.b. 187, the irs considered a tax system that added gross compensation income to notional income from property and subjected the result to a single rate that apparently was progressive. the service ruled that the tax was unified, that its predominant character determined creditability and that as a whole it did not fall within the u.s. concept of an income tax. here a broad approach to the tax law was taken but for the purpose of denying the credit. [vol 4:2 9nternational comit and the foreign tar credit narrow approach of current law is not at all necessary to the interpretation of the credits; other approaches have been employed in the past. rather, as in other features of the current credit, divisibility is simply one of the devices used to prevent the creditability of nonconforming elements in foreign tax systems. the service has particularly sought to use a narrow approach to divisibility to bar the crediting of foreign taxes that are imposed on amounts that are not subject to tax under u.s. practice. that regulatory approach, however, is defective for the very reasons that the courts rejected the service's alternative approach in hubbard." under the overall limitation on the ability to claim a foreign tax credit, a taxpayer may not claim a credit for an amount of foreign tax in excess of the u.s. tax on the taxpayer's foreign source income determined under u.s. standards. that is, while the united states and the foreign jurisdiction might not choose to tax exactly the same items at exactly the same time, the taxpayer would not be able to claim a full credit for the foreign tax paid unless the aggregate amount of income subject to tax in the foreign country equaled the aggregate amount of foreign source income determined under u.s. law. in view of this limitation on the credit, the further limitation imposed under hubbard was redundant and thus inappropriate. the effect of these limitations can best be seen by example. assume that the taxpayer derives two items of income from foreign sources: a $100 stock dividend that is taxed by the foreign government but is not taxed by the united states (item a) and other income of $100 which is not taxed by the foreign government but is taxed by the united states (item b). the taxpayer also derives $100 of u.s. source income (item c). the foreign tax rate is 45% while the u.s. rate is 35%. the tax would be computed as follows: net income for foreign purposes (item a) $100 foreign tax at 45% 45 net income for u.s. purposes (items b & c) 200 u. s. tentative tax at 35% 70 the section 904 limitation on the crediting of the foreign tax would limit the credit to the fraction of the tentative u.s. tax of $70 equal to the foreign source income computed under u.s. concepts of $100 (i.e., item b) over the taxpayer's world wide income computed under u.s. concepts of $200. thus, the limitation is $35 and that is the maximum amount that may be credited currently. thus: foreign tax credit (35) final u.s. tax 35 75. see dexter v. commissioner, 47 b.t.a. 285 (1942). 19991 florida tax review while the taxpayer will have a credit that may be carried over and used in future years of $10, that future use remains subject to the same overall limitation. whether this taxpayer has been subject to international double taxation that ought to be relieved by the foreign tax credit will depend upon one's perspective. viewed narrowly, as the service has continually sought to do, the stock dividend has not been subject to double taxation since the united states did not tax it. similarly, the other income has not been subject to double taxation since the foreign government did not tax it. however, viewed more broadly, the taxpayer's foreign source income as a whole has been subject to tax in both jurisdictions. more particularly, this taxpayer, which did have foreign source income computed under united states concepts, did pay a foreign income tax. in that broader sense, which the courts have generally adopted, the taxpayer has been subject to double taxation that should be relieved by the foreign tax credit. the judicial rejection of hubbard was entirely consistent with the broad approach to crediting reflected in the keen line of authority. creditability is not a matter of comparing taxes imposed on specific items of income. rather, the entire income tax imposed upon the taxpayer's entire taxable income from foreign sources was creditable subject only to the overall limitation imposed by the predecessor to section 904. that broader approach to crediting seems plainly preferable from the perspective of sound tax policy. in the foregoing example, a taxpayer that pursued a business opportunity in the foreign jurisdiction rather than in the united states would be subject to an income tax that functionally replaced the tax that would have been imposed under our code. the fact that the taxpayer's income has been defined somewhat differently under foreign law than it would have been in the united states seems quite irrelevant to the potential double taxation. if the credit is denied, the essential purpose of the credit is not being served. the existing approach to divisibility, however, reflects an effort to deny that credit. the effect of that approach readily can be seen if the assumption is added that the foreign tax on the stock dividend is regarded as a separate levy from the tax on the other income. standing alone, the tax on the stock dividend would not constitute an income tax in the u.s. sense under the regulations, and thus the $45 tax paid to the foreign government would not be creditable at all. as a result, the taxpayer would be subject to full double taxation. this use of extreme divisibility is designed to achieve the same result that had been rejected on the merits as a part of the judicial rejection of hubbard. this narrow approach to divisibility is furthered by employing a mechanical, rather than a functional, approach to the definition of a separate levy. that approach seems to have originated in the 1956 tax court decision [vol. 4:2 international comity and the foreign tar credit in lanman.76 in that case, which is the first case in which a court gave serious consideration to the issue of whether taxes were separate or unitary, the service successfully used its newly narrowed approach to divisibility to limit the crediting of a foreign tax. colombia, which had a creditable income tax of long standing, enacted a patrimony tax for the purpose of increasing the progressivity of the overall tax structure and fine-tuning its distributional impact. the patrimony tax was imposed on the net worth of the taxpayer's assets, other than assets exempt from the tax, and thus resembled a property tax. however, under colombian jurisprudence, the tax was regarded as a tax on imputed income, or the potential return from unproductive or under-productive assets. the tax court accepted the assertion that the patrimony tax was designed as a supplement to the income tax to reach the otherwise untaxed benefit that the wealthy classes derived from the use of property. citing revenue ruling 5651, the taxpayer then argned that the colombia tax system imposed a single tax which was predominantly an income tax and thus creditable. the court quite properly concluded that the fact that the government of colombia may have regarded the patrimony tax as integrally related to the income tax did not control the determination of whether the tax was creditable. that rejection of the foreign characterization of these taxes as interlocking, however, did not establish the converse: the mere rejection of the significance of the colombian government's view did not establish that the two taxes were not related. nevertheless, the court did not proceed to consider whether, from the perspective of the united states, the conceded purpose and effect of the patrimony tax was relevant to the question of whether the tax was an inseparable component of a broader income tax. rather, the court ignored that issue altogether and proceeded to an examination of the mechanical details of the computation of the tax. since the computation of the patrimony tax could be accomplished without reference to the computation of the income tax, the taxes could be separated and thus were divisible for purposes of the credit.' although the approach was refined and developed over the years, the basic approach of lanman was adopted by the service. three years following 76. lawnan, 26 t.c. 582 (1956). 77. lanman is one of those difficult cases that are correctly decided for all the wrong reasons. the treatment of the patrimony tax as part of the income tax by the colombian authorities was suspect. that position had been adopted to avoid the consequences of an agreement by the government not to impose any taxes but income taxes on certain investors who were not involved in the tax case. more importantly, the patrimony tax did not appear to be correctly designed if it were to function as a supplemental tax on imputed income. the tax apparently was imposed even though the property in question was put to productive use and the income thereby generated subject to the income tax. 19991 florida tax reviewv lanman the service applied a similarly aggressive approach to carving up the german trade tax for the purpose of disallowing a credit for a minor but nonconforming portion of the tax.78 divisibility was based upon the mechanical, computational details of the law rather than by any analysis of the purpose or function or effect of the law. thus form, and relatively unimportant form at that, came to prevail over substance. the consequence of this approach was sharply to limit the scope of creditable taxes. b. conformity once the boundaries of a tax have been established, it must be determined whether the tax so defined is an income tax and thus creditable. that determination requires the application of a standard for prescribing just how closely the foreign tax must resemble the united states conception of an income tax in order to be creditable. the early authorities tended to ignore the need for a standard or at least the need to articulate the standard applied. in a vague manner, both rulings79 and cases8" seemed to apply an i'llknow-it-when-i-see-it test to the existence of an income tax containing nonconforming elements. later authorities seemed to recognize the need for such a test and articulated the degree of conformity required using words such as "essential" and "substantial."'" it is not clear, however, that those authorities were intending to enunciate a considered test for the degree of conforming or were simply employing somewhat randomly selected language. by the late 1950s, however, the practice within the service had become settled. consistently with the relatively liberal approach taken to what constituted income taxation, "the service has taken the position that when a unified tax is imposed by a foreign country its predominant character will determine whether the tax is an income tax .... ,,s that test continued to be applied internally by the service into the mid-1970s. thus, in a pair of general counsel memoranda issued in 1975,83 the service recited that the foreign tax will be creditable if it is "predominantly an income tax in the american sense-i.e. is imposed on a tax base consisting predominately of realized net gain." 78. rev. rul. 59-208, 1959-1 c.b. 192, modified on a different issue in rev. rul. 63-268, 1963-2 c.b. 290. 79. e.g., i.t. 4074, 1952-1 c.b. 87. 80. e.g., keasbey & mattison co. v. rothensies, 133 f.2d 894 (3d cir. 1943). 81. commissioner v. american metal co., 221 f.2d 134, 140 (2d cir. 1955). 82. gen. couns. mem. 32,859 (june 15, 1964), citing rev. rul. 56-51, 1956-1 c.b. 320. see also gen. couns. mem. 33,348 (oct. 7, 1966). 83. gen. couns. mem. 36,304 (june 10, 1975) and gen. couns. mem. 36,441 (sept. 26, 1975). [vol 4:2 international comity and the foreign tax credit as the office of chief counsel was beginning to explore its options for challenging the creditability of the payments made to foreign government by the oil producers, one of the legal obstacles identified was the predominant character test. in the 1966 memorandum concluding that the state of the law did not support denying credits for those payments, it was observed that under that test, "it would be hard to say" that the typical tax on oil producers would not qualify as an income tax.' predictably, therefore, in formulating the service's multi-faceted attack a decade later, the predominant character test was identified as one of the aspects of prior law that required change. thus, the most aggressive of the general counsel memoranda8 noted the lack of uniform usage in the courts and asserted that the use of the term predominant character by the service thus "creates ambiguity." accordingly, in the future the service should discuss creditability in terms of "substantial equivalence."' while the point is not belabored in the memorandum, it is plain that its author believed that the new test would materially reduce the likelihood that foreign taxes containing nonconforming elements would be treated as creditable income taxes. unfortunately for this semantic attack on crediting, in the very next year, the tax court, in a strong opinion by judge raum, clearly adopted the long-standing predominant character test.y partly in response to that opinion, the existing regulations, adopted in 1983, abandon the effort to revise the verbalization of the test for conformity and expressly provide that a foreign tax will be treated as an income tax if the "predominant character of that tax is that of an income tax in the u.s. sense."' however, that retreat may not be as complete as first might appear. indeed, the regulations may not reflect a retreat at all. under prior law, a tax law would be treated as meeting the predominant character test if the u.s. tax court generally recognized the law as an income tax notwithstanding that it contained significant nonconforming elements.89 during the 60-year period prior to the mid-1970s, regardless of whether specific reference is made to a predominant character test, a substantial number of foreign taxes that did not closely conform to u.s. law were nonetheless found to be creditable. by contrast, under the current regulations, the concept of "predominant character" is not defined. however, 84. gen. couns. mem. 33,348 (oct. 7, 1966). 85. gen. courts. mem. 37,263 (sept. 21, 1977) which formed part of the basis for rev. rul. 78-63, 1978-1 c.b. 228. 86. the rulings issued on the basis of these gcms did precisely that. see, e.g., rev. rul. 78-61, 1978-1 c.b. 221, 223. 87. schering corp. v. commissioner, 69 t.c. 579 (1978). 88. regs. § 1.901-2(a)(l)(ii). 89. sclering corp., 69 t.c. 579. see also rev. rul. 56-51, 1956-1 c.b. 320. 1999] florida tax review the regulations do provide that the predominant character of the tax will not be that of an income tax in the u.s. sense unless the tax is found to be "likely" to reach net gain in the normal circumstance in which it applies.9° that in turn will be the case if the tax, "judged on the basis of its predominant character, satisfies each of the realization, gross receipts, and net income requirements." because a foreign tax must be found to meet each of these relatively narrow and specific tests in order to be creditable, the degree to which a foreign tax may vary from the u.s. income tax has narrowed substantially-notwithstanding the nominal retention of the predominant character test.91 in fact, in the years following the promulgation of the present regulations, it is difficult to pinpoint a single case or ruling that holds a tax to be creditable under the predominant character tolerance that would not have been creditable if strict conformity to u.s. tax law had been required. quite plainly, the predominant character test does not mean the same thing today that it meant in the 1950s and '60s. indeed, it is not clear that the test has any real meaning today at all. because of the narrow approach to divisibility, the degree of conformity and the predominant character test are not as important in practice as might have been supposed. nevertheless, to the extent that the test matters to particular taxes and taxpayers, this test as well has become quite narrow in application. as in the case of the service's approach to estimation and approximation devices, this narrow approach was not a result of a considered approach to the reduction of international double taxation but rather was a byproduct of a wide-ranging, and generally unnecessary, attack on the crediting of oil royalties. vii. "in lieu of" taxes if a tax, standing alone, does not constitute an income tax under u.s. concepts and does not constitute a part of a broader tax which is an income tax under those concepts, then the tax cannot be credited under section 901. however, all may not be lost. even if a tax is not an income tax, it may nevertheless be credited against the tentative u.s. tax under section 903 if the tax is imposed "in lieu of' an income tax. in the hypothetical example, the scope of the "in lieu of' tax becomes important in two distinct ways. first, as has been discovered, the tax on low income farmers may not be creditable under section 901. while that result 90. regs. § 1.901-2(a)(3). 91. see texasgulf inc. v. commissioner, 107 t.c. 51 (1996). judge colvin noted that "the task of deciding whether the predominant character of the omt is that of an income tax in the u.s. sense is simplified because the terms and clauses in the regulations just described tie the 'predominant character' inquiry to several specific tests." 107 t.c. at 63. [vol 4:2 international comity and the foreign tax credit may be objectionable, it will not be very important if the tax can nevertheless be credited under section 903. that result should be expected since the proxy tax imposed by schedule 2 is plainly imposed in place of the income tax that otherwise would be payable. but, is the tax imposed "in lieu of" an income tax? second, under schedule 3 all businesses are subject to a minimum tax that is computed on a base that starts with asset values. some businesses will pay that tax instead of the income tax. again, the minimum tax is plainly imposed in place of the income tax, but will it qualify as an "in lieu of" tax? under the existing regulations to section 903, most of the restrictive qualifications that rendered the "in lieu of" provisions illusory prior to 1984 have been eliminated.92 the only remaining test of note is the seemingly reasonable requirement that the "in lieu of' tax is "imposed in substitution for, and not in addition to, an income tax or a series of income taxes otherwise generally imposed."93 that requirement includes at least two features. the foreign jurisdiction must impose an income tax on a broad segment of its taxpayers. and the income of the taxpayer from the activity subject to the tax for which the section 903 credit is sought cannot be subject to any income tax in that jurisdiction. neither of the taxes in the illustration would meet these tests and thus neither could be credited under section 903 even though both are quite obviously imposed as substitutes for the "otherwise generally imposed" income tax. the example does not raise the issue of the lack of a generally imposed income tax although that aspect of the regulation is treated briefly below. however, as is relatively common, the tax in question is imposed in place of one income tax to which the taxpayer is subject but does not replace all income taxes to which the taxpayer is subject because a temporary income tax supplements the regular income tax. as a result, assuming that second tax applies to low income farmers, as the service interprets its regulations, the tax in question would be imposed "in addition to" the emergency tax, which is an income tax, and thus would not be creditable as long as the emergency tax remained in effect.94 92. for a description of the prior regulations, see owens, the foreign tax credit, supra note 9, at 70-72. 93. regs. § 1.903-1(b)(1). 94. if the income tax were the only tax imposed by the foreign jurisdiction, the tax on low income farmers might qualify for the § 903 credit although that is not free from all doubt. taxpayers engaged in both farming and other taxable activities will be subject to both the regular income tax and the proxy tax on farm income. that possibility raises the question of whether the proxy tax is not in substitution for the income tax but is imposed in addition to that tax-in which event it would not be creditable under the quoted portion of the regulation. if farming is an activity separate from all others, however, such that the farming activity can be said to be exempt from the income tax, then the proxy tax on farming will be treated as imposed in substitution for the income tax on farming and thus will be creditable. 19991 florida tax review in a general sense, the substitution requirement derives from the arguments presented to congress in support of the enactment of the "in lieu of' provision. the senate committee report, for example, recites as one reason for the need for the liberalizing provision the possibility that a foreign government would impose a non-income tax in place of an income tax on a class of taxpayers.95 however, general counsel memorandum 33348 discloses a narrower reason. the memorandum observes that following the adoption of the "in lieu of' credit, the service sought some test for distinguishing between the royalties and non-income taxes which were not creditable, and the non-income taxes which had just become creditable notwithstanding that they were imposed on a base consisting of gross receipts or total sales. 96 "the answer seems to lie in whether the in lieu of tax was a substitute for an income tax which would otherwise apply" [emphasis in original]. without a doubt, some manner of substitution requirement is needed to properly define the scope of the "in lieu of' credit. as long as the basic section 901 credit is limited to foreign income taxes, the scope of the section 903 credit cannot be broader than taxes that take the place of a creditable income tax. however, the technical narrowness of the existing rule is not necessary to that purpose and has improperly barred tax credit relief. as seen in connection with other aspects of the credit, the "in lieu of' credit is susceptible to a wide range of interpretation. the simple language of the provision, however, suggests a broad construction: a foreign tax should be creditable if it is imposed by a foreign government to generate revenue that otherwise could have been generated by an income tax. when that fundamental character of a foreign tax is present, added technical limitations that would deny the credit should be highly suspect. such a broad construction of the provision would make section 903 widely applicable. the regulations, however, continue to apply a relatively narrow construction that sharply limits the availability of the credit. the issue here, as before, is whether a broad or narrow construction best serves the purposes that the credit was enacted to serve. the history of the provision suggests, although it does not prove, that congress at least intended a relatively broad construction.97 here that result seems likely. thus, were the income tax the only tax imposed, the tax on farning would be creditable, the correct result. 95. s. rep. no. 1631, 77th cong., 2d sess., 131 (1942). 96. gen. couns. mem. 33,348 (oct. 7, 1966). 97. there is some contemporaneous support for this view. see the well-known remarks of the chair of the senate finance committee recounted in elisabeth a. owens, the foreign tax credit, supra note 9, at 71 n.148. [vol 4:2 international comity and the foreign tar credit the excessively narrow scope of the foreign tax credit has become a matter of concern to congress on two separate occasions. the first reexamination, which occurred in 1942, resulted in an expansion of the availability of the credit while the second, in 1954 did not. while both the service and the courts had been fairly liberal in treating nonconforming taxes as income taxes, the number of less favorable authorities began to accumulate in the years following the decision in biddle.9" of particular concern were the taxes based upon some version of gross, rather than net, income that many countries imposed on corporations engaged in certain industries such as mining, banking and shipping. accordingly, industry proposed that the credit be extended to include foreign taxes imposed "on gross income or on some other basis" when the levy was "in substitution" for a creditable net income tax.99 in response, congress included in the revenue act of 1942 the predecessor of section 903 allowing a credit for taxes imposed "in lieu of' income taxes. while opinions differed on the cause,"m there is no dispute but that few taxes were found to qualify under the new provision and the regulations initially issued thereunder. writing nearly 20 years after the adoption of the "in lieu of' provision, elisabeth owens reported that the service had ruled favorably under this section on only five foreign taxes. the second attempt to expand the scope of the credit occurred in connection with the 1954 recodification of the income tax law. responding in part to the criticism of the restrictive application of the 1942 legislation, the treasury proposed that the credit be made available for the "principal" tax to which the taxpayer was subject in a foreign country. that proposal failed to pass when it became clear that an unintended consequence of the legislation would have been to reduce the number of foreign taxes that could be credited.'' in the wake of this failure to achieve a broader credit, attention turned to other matters and the fundamental scope of the credit has not been addressed by congress since 1954. while statutory interpretation arguments based upon the yellowing pages of legislative history are inherently weak, the record at least shows a congress seeking to expand, not narrow, the availability of the credit. expansiveness, however, has never been an attribute of section 903. 98. e.g., keasbey & mattison co. v. rothensies, 133 f.2d 894 (3rd cir., cert. denied, 320 u.s. 739 (1943). 99. revenue act of 1942: hearings before the committee on finance on h.r. 7378. 77th cong., 2d sess. 217 (1942) (memorandum of mitchell b. carroll). 100. the principal early commentator on the credit, elisabeth owens, argued that while senator george of the finance committee had placed the blame on overly restrictive regulations, in fact the limited effect of the amendment was attributable to the language adopted by the senate. see owens, the foreign tax credit, supra note 9, at 71-72 & n.148. 101. see stanley s. surrey, current issues in the taxation of corporate foreign investment, 56 colum. l. rev. 815, 820 (1956). 19991 florida tax review the narrowness of the existing regulations appears from the two features of the substitution requirement noted above. first, in order for there to be an "in lieu of' tax, the foreign jurisdiction must have a generally applicable income tax of which the tax in question is "in lieu." that means that for a tax to be creditable under this provision, the foreign country first must have adopted an income tax which remains applicable to a significant sector of the taxpaying public. it must then have exempted all or an identifiable segment of the income of a class of taxpayers from that income tax and have imposed a different form of taxation in place of that income tax on those taxpayers. in fact, the service has taken the position that a replacement tax cannot be an "in lieu of' tax unless all taxpayers subject to the replacement tax are exempt from the income tax on a category of income; the mere fact that this taxpayer is exempt is not sufficien! 1°2 in practice, this somewhat convoluted requirement largely limits the usefulness of the "in lieu of' credit to those special industries, such as mining and finance, that tend to be subject to special tax regimes and are not subject to the general income tax. 03 the requirement plainly would prevent the crediting of a foreign tax if, as some countries have done and other considered, the countries repealed its income tax, or its corporate income tax, and enacted one or another version of a consumption or cash flow tax such as those sometimes proposed for adoption in the united states in place of its former income tax." similarly, some countries, for reasons unique to their experience, have appended features to what otherwise would clearly constitute an income tax that prevent the tax from qualifying as an income tax in the u.s. sense. for example, the initial russian income tax limited the deduction of wages paid in excess of a fixed level in an attempt to retard wage inflation. the resulting tax may not have constituted an income tax for crediting purposes and clearly did not constitute an "in lieu of' tax because there was no other income tax. 5 those results are manifestly wrong as a 102. priv. ltr. rul. 97-13-001 (apr. 26, 1996). 103. see bank of america nat'l t. & s. ass'n v. united states, 459 f.2d 513, 523 (1972); rev. rul. 78-61, 1978-1 c.b. 221. section 903 is also used today as the basis for crediting withholding taxes based on the gross amount of a payment. prior to the adoption of the 1983 regulations, however, such withholding taxes were creditable as income taxes because they conformed to the withholding taxes that the united states imposed. 104. see, e.g., belize abolishes corporate income tax, i tax notes int'l 152 (july 20, 1998) (reporting that belize had replaced its corporate income tax with an undescribed form of business tax); jorge martinez-vazquez & l.f. jameson boex, croatia adopts tax system to market economy, 13 tax notes int'l 839 (sept. 9, 1996) (reporting that croatia had adopted a consumption tax on individuals). 105. see william p. streng, russian federation tax legislation impacting russia based oil & gas operations: endless (?) transition, 15 hous. j. int'l l. 553, 570-71 (1993). [vol 4:2 international comity and the foreign tar credit matter of sound income tax policy. more importantly, they fall far short of the relief needed to appropriately relieve instances of clear international double taxation. the second restrictive feature of the regulations is in the requirement that the tax be in lieu of all income taxes imposed in the jurisdiction on the segment of the income of the taxpayer with respect to which the section 903 credit is claimed. it is not at all uncommon for a jurisdiction to impose more than one general income tax. sometimes multiple taxes are imposed at the national level, as in our example, and sometimes, as in the united states, subnational governments impose taxes that parallel the tax imposed by the national government. generally the tax proposed for crediting under section 903 is imposed in place of less than all of the income taxes imposed in the jurisdiction. when that occurs, the tax can never be credited as an "in lieu of" tax. this somewhat shocking result is illustrated by the real world result in allstate insurance company v. united states.106 that case raised the question of whether the canadian tax on insurance premiums received by a casualty insurance company could be credited under section 903. several courts had previously found that very tax to be an "in lieu of" tax, but those decisions had involved life insurance companies. under canadian law, life insurance companies are not subject to the canadian income tax but casualty insurance companies are. thus, the court held that the tax on premiums, while creditable by life insurance companies, was not creditable by this taxpayer because the tax was imposed, not in substitution for the income tax, but in addition to the income tax. had the taxpayer in allstate been subject to two income taxes, both would have been creditable. moreover, if the tax on premiums had been imposed in place of both of those income taxes, the tax on premiums would have been creditable as an "in lieu of' tax. however, because the tax on premiums only replaced one of the income taxes, it could not be credited-an utterly bizarre result. an equally inappropriate consequence of the substitution requirement occurs in connection with the imposition of alternative taxes, a point further developed in the following section and illustrated in the example by the alternative tax imposed under article 12. as under our own code, taxpayers in the hypothetical jurisdiction are required to pay an alternative tax if the amount of the tax exceeds the amount of the regular income tax. however, under the typical alternative tax, taxpayers remains subject to the regular income tax. when the alternative tax, rather than the income tax, is paid, the payment should without question be creditable under section 903 as the 106. 419 f.2d 409 (1969). 19991 florida tax review payment is plainly in lieu of the payment of the income tax. however, because the taxpayer remains subject to the income tax (although none is paid), the regulations treat the alternative tax as imposed in addition to the income tax and thus not at all creditable. this surprising result is clearly required by the regulations when the minimum tax is smaller than the regular income tax so that some regular tax must be paid. in the example provided in the regulations, the taxpayer has an alternative tax liability of 30x and an income tax liability of 100x against which the 30x may be credited. the conclusion reached is that the 30x may not be credited under section 903 because it is imposed "in addition to, and not in substitution for, the generally imposed income tax.""w that result is less clear under the regulations if the minimum tax exceeds the income tax so that only a minimum tax must be paid. in that event, it may be argued that the minimum tax is in complete substitution for the regular income tax and thus is creditable. however, the service is evidently of the view that even if no amount of income tax is payable, a taxpayer remains subject to the income tax and thus a minimum tax can never be treated as an "in lieu of' tax. 03 while that result seems particularly harsh, it may nevertheless be required to avoid an even more absurd result. plainly, if the minimum tax is one dollar less than the regular tax, none of it may be credited. to allow the crediting of the entire tax if it is one dollar more than the regular tax would be hopelessly irrational. this feature of the section 903 regulations is particularly objectionable when viewed in connection with the regulations to section 901. the result in allstate occurs because the "in lieu of' tax must be in substitution for all income taxes to avoid being characterized as imposed in addition to an income tax. put differently, for the purpose of section 903, income taxes are not treated as separate taxes, each of which may be replaced by a non-income tax that is a creditable "in lieu of' tax. rather, all income taxes are treated as a single tax which must be entirely replaced by the "in lieu of' tax for that tax to be creditable. that aggregation of what in fact are separate taxes occurs under the regulations for the purpose of reducing the number of foreign taxes that can qualify under section 903. as has been observed, under section 901, the regulations and the service's practice require extreme fragmentation of what in common understanding would be treated as a single taxing provision-again for the purpose of limiting the number of foreign taxes that may be credited. the only unifying theme to these sharply inconsistent jurisprudential approaches is that both improperly restrict the scope of the foreign tax credit. 107. regs. § 1.903-1(b)(3), ex. 5. 108. see rev. rul. 91-45, 1991-2 c.b. 336 (mexican business assets tax). [vol 4:2 international comig and the foreign tar credit the fundamental difficulty with the section 903 credit may lie in section 901. as long as the basic foreign tax credit is limited to income taxes, the supplemental credit must be limited to taxes that in some fashion substitute for the taxes otherwise creditable under the basic provision. otherwise, the "in lieu of' credit would engulf the basic credit and that, at least, was not intended and would not be a sensible approach to defining creditable taxes. given that limitation, it would be as difficult to draft, in definitive form, the reach of the "in lieu of' credit'0 however, as has already been developed in other contexts, the absence of a wholesale revision of the definition of creditable taxes does not justify the retention of the irrationalities of existing law. at the very least, taxes that replace less than all income taxes and taxes that reinforce income taxes, as do the alternative taxes, ought to be creditable under existing law. while the minimum tax may not be creditable as an "in lieu of' tax under section 903, the taxpayer still has one argument in its favor. if the payment of the minimum tax can be viewed as the payment of the regular income tax, then that payment should be creditable under section 901. viii. multiple, related taxes it is not at all uncommon in complex tax systems for a single payment to discharge two tax liabilities. in fact, the u.s. foreign tax credit is one example: the payment of the foreign tax discharges the taxpayer's liability for the u.s. income tax. one of the more frequent reasons for adopting such a system lies in the inherent difficulty of administering an income tax and the relative ease with which income can be concealed from understaffed tax collectors. in response to that reality, many government have sought more objective measures of income to use as a means of verifying or challenging reported actual income. such measures can take a variety of forms, but the most natural approach to is enact an alternative minimum tax. in effect, the taxpayer's income tax base is not allowed to fall below the more objectively determined alternative. the french tax involved in keen was just such a minimum tax. the tax was imposed on an amount computed by reference to rent paid, unless actual income were greater, in which event the tax was imposed upon actual income. currently, many latin american countries have enacted one or another version of a "business assets tax" which consists of a very low rate of tax imposed upon the value of a business' assets."' the ultimate tax 109. revisiting the 1954 principal tax proposal, this time as a substitute for § 903 rather than § 901, however, might be a good place to begin. 110. see peter d. byrne, the business assets tax in latin america-the end of the beginning or the beginning of the end?, 15 tax notes int'l 941 (sept. 22, 1997). 19991 florida tax review payable is the greater of the income tax or the assets tax. the evident premise of such a tax is that over time for any business to survive it must obtain some reasonable return on its invested capital. if the business is consistently reporting income below that return, it may be inferred that income is being concealed or improperly diverted to another jurisdiction. thus, if 10% is a reasonable minimum rate of return in the economy and the prevailing rate of tax is 30%, the business ought to pay a tax at least equal to 3% of the value of the capital of the business. a 2% assets tax accordingly would function as an appropriate minimum tax that would limit the taxpayer's opportunities to evade the regular income tax-and would do so at a minimum administrative cost. these minimum taxes are not separate property taxes. there are integral to the income tax system and are inseparable from that system."' the assets taxes do not result in a tax liability unless the income tax payable falls to suspicious levels. they are fairly clever devices that promote the efficient collection of the income tax and discourage the development of underground economies. plainly the role of the united states should be to encourage the invention and use of such techniques. if the amounts paid under the kinds of minimum taxes seen in keen and in use in latin america are not eligible for the foreign tax credit, the scope of the credit is defective. minimum taxes of the business asset tax variety can assume a variety of forms, the selection of which is very largely arbitrary. thus, the law might provide that taxpayers are liable for the assets tax but that the liability is discharged by payments of the income tax. conversely, the law might provide that taxpayers are liable for the income tax but that the liability for that tax is discharged by payments of the assets tax. perhaps the easiest formulation is to say that the taxpayer is liable for the greater of the tax imposed by the income tax or the assets tax. from the perspective of sound income tax policy, and even of simple good sense, it should not matter which of these formulations a country adopts. to the extent that the full amount paid under the combination of foreign income and business assets taxes is not creditable, international double taxation is not relieved. unfortunately, such taxes do not fare very well under the credit. because the business assets tax is an approximation technique designed to define net income, it would be most appropriate to treat it as an income tax. as has been seen, however, like the tax in keen, it would not be so treated today.1 2 if the tax, standing alone, is not an income tax, it would 111. see peter d. byrne, the business asset tax in latin america-no credit where it is due, 9 tax notes int'l 533 (aug. 15, 1994). 112. see also robert f. hudson, jr. & gregg d. lemein, u.s. tax planning for u.s. companies doing business in latin america, 27 u. miami inter-am. l. rev. 233, 26163 (1995). [vol 4:2 international comity and the foreign tax credit be appropriate to treat it as an inseparable part of a larger income tax and creditable for that reason. as has been seen, under the narrow approach to divisible taxes, it would not be so treated. if the tax is not creditable as an income tax, since it is imposed in place of the income tax, it would be appropriate to treat it as an "in lieu of' tax. however, the tax is imposed in addition to the income tax and thus, as has been seen, it would not be treated as creditable under section 903. if the business assets tax is not creditable, at least the income tax remains creditable and the assets tax is a mere prepayment of that income tax. thus, for that reason the payment should be creditable under the basic section 901 credit. amazingly, perhaps even that may not be so. the regulations to section 901 provide that if a taxpayer's liability for one tax is reduced by payments of a second tax, then it is the second tax that is deemed to be paid and not the first."3 only to the extent that the amounts paid pursuant to the second tax exceed the amount of the liability for that second tax is the payment treated as a payment of the first tax. assume, therefore, that a foreign government wished to draft its law to provide that all taxpayers are liable for both the income tax and the assets tax but that payments of the assets tax, which were due on january 15', would discharge the liability for the income tax for the prior year which was due on march 15'h. if the taxpayer's liability for the assets tax equals or exceeds its liability for the income tax, then no amount of the income tax and no amount of the assets tax may be credited against its u.s. income tax liability. here the assets tax is the "second" tax and thus is the one deemed paid. under the regulations, no amount of the income tax is treated as paid-a result that is simply foolish. but, it gets worse-much worse. the same paragraph of the regulations also provides that if the taxpayer's liability is the greater of its liability under the income tax or its liability under the assets tax, then the entire amount paid is treated as paid pursuant to the tax that imposes the greater liability. thus, for example, if the taxpayer's liability for the income tax is 1000u (i.e., units of the foreign currency) and its liability for the assets tax is 999u, then the entire 1000u may be credited against the u.s. income tax. however, if its liability for the assets tax were 1001u, then no amount may be credited! that result is unacceptably irrational. to some extent, of course, these results can be avoided by the foreign countries that draft business assets or other minimum tax provisions. by casting their income tax as the second tax, payments of that tax will be 113. regs. § 1.901-2(e)(4)(i). 1999] florida tax review creditable." 4 however, neighboring jurisdictions should not be required to alter the structure of their internal fiscal legislation to accommodate the pointless irrationalities of u.s. tax law. in this context, at least, it is the united states that should amend its law to respond to the needs and desires of its neighbors, not the reverse. as in the case of the crediting of proxies for net income, the history of how u.s. law assumed such an unsatisfactory form provides encouragement for the prospects of reform. here, however, the story is short. prior to the adoption of the 1983 regulations, the consequence of multiple levies apparently had been considered in only one case, queen insurance company v. commissioner."5 under a canadian tax provision, the amounts paid under a tax, which was assumed to be not an income tax, reduced the taxpayer's liability under the general income tax. the board of tax appeals quite sensibly treated the payment of the first tax as a payment of the income tax and thus creditable. the second circuit, in a per curiam opinion that placed controlling stress on the technical language of the canadian statute, held that the taxpayer had paid the first tax, not the income tax, and that the payment was not creditable." 6 in the preamble to the final revision of the regulations under section 901, the treasury characterized the regulations as adopting the rule of queen insurance, acknowledged the criticism of the result reached by that case, but determined to retain that rule which "respect(s) foreign law in determining which levy or levies are paid.""..7 neither of those bases for the regulations are persuasive. the decision in queen insurance is of little significance. the service routinely declines to follow far stronger judicial authority than a single per curiam reversal. the reference to foreign law is hard to even take seriously. as discussed in the early portions of this article, the treasury has gone to some lengths to establish the proposition that the characterization of a taxing statute as an income tax under foreign law is of no significance to its characterization for the purposes of the foreign tax credit; rather, u.s. concepts apply. for the treasury to reverse that approach in this portion of the same regulations and to defer here to foreign law rings of disingenuousness. moreover, the better view would seem to be that it does not matter which tax is deemed to be paid. if the payment of the alternative 114. revenue ruling 91-45 was designed to explain to our latin american neighbors how they should draft their assets taxes to avoid the loss of credits. 1991-2 c.b. 336. 115. 40 b.t.a. 484 (1939). 116. see helvering v. queen ins. co., 115 f.2d 341 (2d cir. 1940), cert. denied 312 u.s. 706 (1941). 117. t.d. 7918, 1983-2 c.b. 113, 115. [vol 4:2 international comity and the foreign tax credit tax discharges the liability for the income tax, then both are paid and to the extent of the liability for the income tax, the payment ought to be creditable. why the treasury adopted such a harsh position on multiple taxes does not emerge with any clarity from the historical record. perhaps that conclusion is sufficient. if there was no persuasive reason for the adoption of the rule, and the rule is not sensible, the conclusion that the rule can and should be changed is hard to escape. however, oil royalties may well have played a part in this aspect of the credit, as well. in some countries, the payments made by the oil producers could be deducted from their liability for the general income tax in a manner similar to the current business assets taxes 1 18 ix. conclusion the discussion over the preceding pages has sought to demonstrate two things. in the most fundamental respects, the scope of the u.s. foreign tax credit is far too narrow. in order to properly ameliorate the consequences of international double taxation, many more foreign taxes payments should be creditable against the u.s. income tax on foreign source income. second, there is no substantial justification for the existing contours of the credit, and thus there is no rational impediment of importance to the reformation of the credit. the more appropriate scope of the credit that initially prevailed was discarded largely as a by-product of an overly enthusiastic attack on the abusive crediting of royalties-a problem that today has been resolved satisfactorily by others means. the scope of the section 901 definition of a creditable tax has never been addressed by congress except when it sought to expand the scope of the credit by the addition of the predecessor to section 903. the narrowing that occurred in the 1970s occurred entirely through a revision of the regulations. given that history, the expansion of the credit does not require congressional intervention. the treasury is entitled to reconsider its 1983 regulations and to return to the broader approach to crediting that it then abandoned. it should do so. 118. see priv. ltr. rul. 86-11-001 (nov. 20, 1985); priv. ltr. rul. 68-07-081230a (july 8, 1968). 1999] florida tax review volume 10 2009 number i understanding the oecd model tax convention: the lesson of history by john f. avery jones, cbe* i. introduction ..................................................... 3 a. direct taxation ........................ ........... 5 b. indirect taxation. .................................. 5 c. standardization of concepts ............ 5.........5 d. inequalities in taxation on grounds ofnationality.................. 5 ii. the lessons of history in relation to some definitions in the model ............ 6.............. ........................ 6 a. the definitions of "person" and "company ... .......... 6 b. the definition ofdividend .......................... 11 c. the definition of interest. ................. .......... 14 d. residence.................................. ..... 16 e. the expressions used in the residence tie-breaker for individuals.......................8.... ............ 18 f. place of effective management in the residence tie-breaker for companies............... .................. ..... 21 g. article 1 ........................................... 23 h. permanent establishment............. ............. 24 1. the list ofitems that permanent establishments includes especially........................... 24 2. the exclusion for a stock of goods ...... ......... 25 3. how the taisei problem arose....... ................... 26 4. the priority rule now in article 7(7) ......................... 27 5. conclusion on the definitions .................. 28 iii. non-discrimination ........................................ 28 a. the nationality non-discrimination provision . ........... 28 b. non-discrimination was intended to be dealt with in a multilateral treaty..........................30 c. in the same circumstances...................... 32 * judge of the upper tribunal (tax and chancery chamber). 1 2 florida tax review [vol. 10:1 d. other or more burdensome taxation or requirements connected therewith ............................. 33 e. public bodies and charities ........................ 34 f. the permanent establishment non-discrimination provision.. 36 g. enterprise ..................................... 37 h. not less favourably levied........................39 i. the ownership non-discrimination provision . ........... 40 j the deduction non-discrimination provision . ............ 48 k. taxes ofevery kind and description ............. ..... 48 l. conclusion on non-discrimination ................... 48 understanding the oecd model tax convention i. introduction an important recent development in international taxation is the publication of the oeec (the forerunner of the oecd when it was a purely european organization, although representatives from the united states and canada were also present at the discussions on tax treaties) archives on the development of tax treaties in a website http://www.taxtreatieshistory.org/ organized by the institute for austrian and international tax law, vienna, ibfd, universith cattolica del sacro cuore, piacenza, italy, ifa canadian branch and the canadian tax foundation. while this may sound like a rarefied topic, the oeec period from 1956 to 1961 is the story of the making of the current oecd model. previously there was a gap in the published sources after the end of the league of nations mexico and london models of 1943 and 1946,1 which suffered from the wartime domination by the south americans of the mexico model, and the europeans doing what they could in the london model to reverse some of the worst excesses. by the time of the oeec it was accepted that this was not the way of the future. after the london model there was previously a complete gap in the history until the publication of the 1963 oecd draft, which is essentially the oecd model as we have it today. true there have been many changes in the meantime, particularly to the commentary, but when compared to the whole edifice these are merely tinkering. the 1963 oecd draft seemed to have arrived from nowhere and one wondered how this arose. now, with the 1. the un fiscal commission was dissolved in 1954 without having published anything further. 2. the secretary-general's note of nov. 12, 1954 to the council of the oeec said: the i.c.c. resolution refers to the model agreement produced by the league of nations in 1946, which is known as the 'london draft,' but his particular text has not been accepted by all member and associated countries, and it seems probable that some at least of them would wish to raise fundamental objection to any attempt to make it a standard form of bilateral double taxation convention. in these circumstances, it is not easy to see how the oeec could intervene to obtain a more rapid conclusion of bilateral agreements than that which is now taking place, nor, in particular, does it seem likely that agreement could be reached in the council that the 'london draft' should be the standard form of bilateral convention between member and associated countries, since the draft itself is not, as it stands at present, fully acceptable to every member. if an approach of this kind were to be adopted by the oeec, therefore, it would be necessary for the organization to set up an expert body charged with the duty of attempting to produce a more acceptable draft. c(54)294 (nov. 12, 1954) 18. 2009] 3 florida tax review publication of the oeec archives, we know. it was the work of (ultimately) 15 working parties (plus another dealing with estate taxes) of the fiscal committee each comprising delegates from two countries3 working on a separate article of the model and reporting to the other countries at regular meetings of the fiscal committee.4 the results were most impressive and one can trace how the articles developed. the minutes are available as transcribed versions in english and french together with a pdf file of the original minutes so that, for example, alterations can be seen. a few of the current problems can be traced to the technique of working on each article separately with, for example, the definitions article being started late and not being published in any of the fiscal committee's four reports. in that respect the league of nations method of working was superior.5 for example, the other income article, which is effectively the general rule that had come first in the original league of nations drafts,6 appears at the end because working party 14 started much later. i believe that we still have a mutual agreement provision in the tie-breaker for individuals because that article was drafted before the mutual agreement article. in addition some of the less obvious overlaps were not considered. the fiscal committee was set up by the council of the oeec as a result of urging initially by the international chamber of commerce8 and then by the dutch delegation. the terms of reference were worked out by an ad hoc committee of experts on taxation under the chairmanship of van den temple, the director general of fiscal affairs in the netherlands.9 the 3. working party 10 on dependent and independent employment had a single delegate from sweden, id. at 14. before the publication of the minutes it used to be a game to deduce which countries might have been on a particular working party. my co-authors and i once wrote: "we surmise that this part of the commentary was originally drafted by a german (or dutch or swiss) author and approved by the fiscal committee without realizing that permanent agent was a term of art." ("agents as permanent establishments under the oecd model tax convention" [1993] btr 341 at fn 226). it transpires that the members of working party i on permanent establishment were from germany and the uk, confirming our surmise. 4. this met, for example, in 1957 on jan. 23-25, jun. 5-7, oct. 1-7 and nov. 25-27. 5. this point is made in residence of companies under tax treaties and ec law, ed g maisto, ibfd, 2009 by r vann in chapter 7 at p. 228 in fn.41. 6. 1927 draft articlel0, the first article relating to personal taxes; 1928 draft 1(a) articlel0, (the same as for the 1927 draft), draft 1(b) articlel. 7. there was joint meeting of working parties 8 (royalties), 11 (interest), 12 (dividends) and 15 (avoidance of double taxation), for which there is a document prepared for the meeting, but unfortunately no minutes seem to be available. 8. see supra note 2. 9. c(56)1 (jan. 13, 1956). the dutch, swiss and german delegations submitted memoranda, see report c(56)49. 4 [vol 10: 1 understanding the oecd model tax convention fiscal committee was given the ambitious project of dealing with all the followinglo in the period from march 1956 to july 1958 when it would be determined whether the fiscal committee should be continued." a. direct taxation the committee should submit concrete proposals as to which taxes on income, capital, estates and inheritances should be included in double taxation agreements, and which methods should apply in such agreement especially as regards apportionment between commercial profits, taxation or investment income, royalties and similar payments. b. indirect taxation the committee should make concrete proposals concerning the means of avoiding double taxation on transactions subject to turnover taxes in several member countries and of avoiding double taxation on turnover tax on services.12 c. standardization of concepts the committee should submit concrete proposals as regards the means or standardization of the most important concepts to be found in double taxation agreements. d. inequalities in taxation on grounds of nationality the committee should make concrete proposals concerning the means of removal of such inequalities.13 the fiscal committee made an interim report in 195714 and a further report in 195815 by which time it had prepared draft articles and commentary 10. note by the secretary-general, fc(56) 1 (may 16, 1956). 11. c(56)49 (final) (mar. 19, 1956). 12. the swiss delegation were pressing for a multilateral convention on indirect tax, see their notes c(54)331 (dec. 16, 1954) (in french only); and c(55)88 (apr. 19, 1955). this was supported by the netherlands and germany as well, see c(55)307 (dec. 9, 1955). 13. this had been identified as a topic by the ad-hoc group of experts, see c(56)49 (feb. 24, 1956). 14. c(57)145 (jul. 3,1957). by that time the following working parties were in operation: (1) permanent establishment (germany, the uk); (2) fiscal domicile (denmark, luxembourg); (3) listing of taxes (italy, switzerland); (4) discrimination (netherlands, france);(5) shipping and air transport (sweden, belgium). more were then created: (6) inland waterways (france, germany); (7) 2009] 5 florida tax review on the definition of taxes, permanent establishment, fiscal domicile, and nondiscrimination, which became a recommendation of the council to be adopted in treaties, which was published.16 this was a very considerable achievement in such a short period. further reports followed in july 1959,17 august 196018 and august 1961.19 with minor changes the articles included in these reports plus six further articles20 were joined together to become the oecd draft of 1963. i shall in the paper explore the origins of some of the more obscure (at least in english) terms used in the definitions in the model to see whether the history now available sheds any light on their intended meaning. in addition i shall look more generally at the development of one article, the non-discrimination article, in the light of item d of the terms of reference of the fiscal committee as it seems surprising today that nationality discrimination should feature so prominently as one of the topics. ii. the lessons of history in relation to some definitions in the model a. the definitions of "person" and "company" the definitions of "person" and "company" are crucial to the application of a treaty based on the model. they originated from oeec working party 14 on definitions (the members of which were from austria and sweden) which started late in the development of the articles, being formed in september 1958 and first reporting on march 3, 1959 by which time the oeec had already published its first report, and work on the apportionment of profit (uk, netherlands); (8) royalties (germany, luxembourg); (9) immovable property (italy, austria); and (10) dependent and independent services (sweden). by the end, there were also working parties (11) interest (france, belgium); (12) dividends (germany, italy, switzerland); (13) capital (switzerland); (14) territorial scope, definitions, mutual agreement, exchange of information, diplomatic privileges, entry into force (austria, sweden); and (15) avoidance of double taxation (denmark, ireland). no.17 dealt with inheritance taxes. 15. c(58)118 (may 28, 1958). 16. c(58)118(final) (jul. 15, 1958), published as the fiscal committee's first report in september 1958. 17. covering shipping and air transport, dependent and independent personal services, immovable property, and capital. 18. covering allocation of profits to a permanent establishment, other income, personal scope, and territorial extension. 19. covering dividends, interest, royalties, avoidance of double taxation and mutual agreement procedure. 20. the articles on general definitions, capital gains, exchange of information, diplomatic and consular officials, entry into force, and termination. 6 [vol. 10:1 understanding the oecd model tax convention dividends article, for which the definition of company was critical, had been going on since march 1958. indeed all four oeec reports were published without the definitions article. the working party identified the following three borderline cases of non-corporate bodies of persons: a) bodies of persons, which are not treated as taxable units under the taxation laws of any of the contracting states concerned; b) bodies of persons, which are treated as taxable units under the taxation laws of any of the contracting states and which further are treated by such laws in the same way as legal persons; c) bodies of persons which are treated as taxable units under the taxation laws of any of the contracting states, but are not treated in the same way as legal persons (the taxable treatment of which resembles that of an individual, as for instance happens to be the case with certain partnerships where the austrian and the german gewerbesteuer is concerned).2' the conclusion they drew was that the definition of "person" should be as broad as possible, particularly in view of the agency permanent establishment provision: "where a person.. .is acting on behalf of an enterprise," otherwise a transparent partnership acting as an agent would not be included as a permanent establishment if it were not a person.22 in relation to other references to person in the model they said: the term "person" is however mainly used within the rules for the allocation of taxation rights and also in the rules for fiscal domicile. used in this way, the term necessarily has to include all bodies of persons, which might under the taxation laws of any of the contracting states be treated as a taxable unit.23 since a "person" must also be a "resident" for the allocation of taxing rights to be relevant, it was unnecessary to have a wide definition of person for this purpose, but a wide definition did no harm either and was necessary for the agency permanent establishment provision. their original 21. fc/wp14(61) 2 (sept. 18, 1961), 15. 22. id. at 7. they considered an alternative of excluding partnerships and replacing the word "person" by "agent" in the agency permanent establishment provision. in fact, this reference started life as agent and employee, after which it was changed to person to make clear that it was the type of authority that mattered, not the nature of the function, see fcim(57) 3 (nov. 5, 1957). 23. ibid. 8. 2009] 7 florida tax review definition was: "the term 'person' comprises an individual and anybody of persons, corporate or not corporate."24 this is very similar to the final one adopted by the fiscal committee2 5 that was in the oecd 1963 draft: "the term 'person' comprises26 an individual, a company and any other body of persons." the difference is essentially only a drafting change since "company" deals with corporate bodies of persons, leaving non-corporate ones to be covered by "any other body of person." the definition of "company" was required mainly for the dividend article for which there was no need to include categories (a) and (c) above although the working party recognized that problems could arise if a body was treated as a body corporate in only one of the states, the now-familiar problem of partnerships. the definition therefore had to catch real bodies, corporate and non-corporate bodies, in category (b) above. their definition was: the term 'company' includes anybody corporate and any entity which is treated as a body corporate for tax purposes.2 7 there was no suggestion that a real body corporate would be anything other than taxable,28 which has since led to difficulties now that this is no longer the case, even apart from the check-the-box regulations. for example, a recent case in the uk concerned a uk unlimited company with a single shareholder which to the us was a disregarded entity and to the uk was a company taxed as such. from the point of view of each country the treaty entitled the other to tax, giving a source in the other country, and so apparently both had to give relief.29 a better definition today would delete the reference to body corporate and be restricted to entities taxed in the same way as the generality of bodies corporate. on the problem of different categorization of an entity treated as a body corporate in each country, the working party concluded that no provision was required: an individual [who] decides to participate in a partnership, which is treated as a body corporate in a certain state, did 24. this was first included in fciwpl4(59) 1 (mar. 3, 1959) and was repeated in subsequent reports. the customary definition in early uk treaties was almost identical: the term 'person' includes anybody of persons, corporate or not corporate. 25. fc/m(62) 1 (feb. 19, 1962). 26. "comprises" became "includes" in the 1977 model. the french remained comprend in both. 27. as in the previous footnote, the definition is the same as uk-germany (1955) except that this said means rather than includes. 28. "in all the states, companies are taxed on their profits." fc/wp12(60) i (jan. 8, 1960). 29. bayfine uk products v. hmrc [2009] stc (scd) 43. 8 [vol. 10:1 understanding the oecd model tax convention initially not mind the fact that the so received corporate income will be liable to tax twice, on the one hand as income of the body corporate and, when distributed, as income of the shareholder. it does not seem necessary to avoid such double taxing which is purposely levied by one of the contracting states by international agreements for the sole reason that other contracting states do not take the same view in the treatment of like income."3 o in saying this, either they assumed that the residence state, which treated the entity as transparent, would follow the source state's categorization of the income as a dividend, in which case they were way ahead of their time, or they did not consider that the residence state might also tax the partner's share of the undistributed income of the partnership, perhaps because they were thinking in terms of an exemption system.32 unsurprisingly, they did not get to the bottom of the problems of partnerships and tax treaties. they did, however, make some progress, as can be seen in an explanation given to the fiscal committee when discussing the definition of "person" and "company:" this might be an incentive for a resident of a third state to establish a partnership in one of the contracting states with a permanent establishment in the other state, in order to enjoy the advantages of the convention. furthermore, a resident of a third state might evade taxation in a contracting state if the activity in which he engaged through a partnership set up in the other contracting state was not considered to be an activity of a permanent establishment within the meaning of the convention, but was considered as such under the law of the former contracting state. the working party considered that there would be fewer disadvantages in including partnerships in the definition of 'persons' than in including them in the definition of 'companies.' 30. fc/wpl4(61) 2 (sept. 18, 1961), at i 11; and fc/wp14(62) 1 (jan. 8, 1962). 31. the commentary first included a provision to this effect (article 23 comm t 32. 1) in the 2000 update. 32. in a tax credit system the right answer would seem to be for the residence state to give credit for both the withholding tax on the dividend and the share of the underlying tax paid by the entity as a corporation, which i believe is the position in canada where a us partnership is taxed in the us as a corporation. 2009] 9 florida tax review another example of serious thinking about partnerships is that in the fiscal committee the austrian delegate suggested that a transparent partnership with two partners resident in different states should be treated as two separate enterprises for the definition of enterprise of a contracting state. this was included by the working party in their commentary: 6. the laws of some member states do not treat a partnership as a taxable unit and, consequently, a partnership as such cannot be regarded as "a resident of a contracting state" under article iii on fiscal domicile; where such a member state is concerned, it could be maintained that an enterprise carried on by a partnership is not strictly "an enterprise carried on by a resident of a contracting state." in such a case, it may assist towards a clarification of the meaning of the term "an enterprise of a contracting state" if each participation in a partnership is looked upon as a separate enterprise, the test being whether the partner holding the participation is a resident of the one or the other contracting state or of a third state. the member states concerned may consider adopting this line of interpretation in bilateral relations. a final example is the following: [the uk delegate] felt that a state should be able to tax royalties arising in that state and paid to a resident of that state even if he was a member of a partnership which had its effective management in the other state and was taxable in that other state in accordance with the laws currently in force. 33. fc/m(62) 1 (feb.16, 1962). 34. fc/wp14(62) 2 (feb. 28, 1962). this became the commentary to the term enterprise in article 3 of the oecd 1963 draft. the definitions article was not included in the four oeec reports. a similar point is now made in more detail in article 3 comm 5 and article 4 comm 8.2. the uk court of appeal in padmore v. irc [1989] stc 493 (discussed in fn. 36) decided that the partnership, not the partner, was the enterprise in circumstances in which the partnership was taxable in jersey although the total tax was the same as if it had been transparent. the partnership also had a residence. there is evidence in relation to a guernsey partnership that the uk revenue thought that there was no enterprise of a contracting state where not all the partners were resident in that state, public record office document ir40/11917 (although the document relates to switzerland there are some papers relating to guernsey). 10 [vol. 10:1 understanding the oecd model tax convention this situation is found as example 16 in the oecd partnerships report3 and now in paragraph 6.1 of the commentary to article 1. later in the same minutes it was reported that: the delegate for the united kingdom thought it necessary to include some overriding provision indicating that nothing in the convention prevented a state from taxing dividends, interest and royalties arising in that state and paid to one of its residents, or compelled it to give credit for taxes on such income which had been paid in another state. unfortunately his good advice was never taken (which shows the wisdom of the us in including the saving clause in treaties), which eventually led to the padmore case3 6 in the uk in which a uk resident partner in a jersey partnership successfully claimed exemption for his share of the partnership profits on the ground that the partnership, as a treaty person taxable in jersey, did not have a permanent establishment in the uk and its profits (and therefore the partner's share of them) were accordingly exempt from uk tax. the law was changed to prevent this. again this is now considered in examples 16 and 17 of the oecd partnerships report, in the latter of which only a minority of states agreed with the uk delegate's point about not giving credit. b. the definition ofdividenc7 this definition, which depends on the definition of "company," was developed by working party 12 (comprising members from germany, italy and switzerland) and went through some interesting changes. it started as: the term 'dividends' means income from shares in companies limited by shares and limited partnerships with share capital, 'jouissance' shares, mining shares, 'jouissance' bonds, 'founders' shares, debentures participating in profits, and other corporate profit sharing rights represented by paper securities, as well as income 35. the application of the oecd model tax convention to partnerships, oecd, 1999. 36. see supra note 34. 37. my co-authors and i have discussed this in more detail in "the definitions of dividends and interest in the oecd model: something lost in translation?" in course of press in the world tax journal and the british tax review. 2009] 11 florida tax review from shares in co-operative societies and limited liability partnerships [socidtis a responsabilitg limitie]. the working party stated that their definition corresponded to the definition found in a number of treaties. they set out the definitions (of income from movable capital, as they then were; separate dividend and interest articles were only just beginning to be used) contained in four swiss treaties that in french 3 9 used the same expression adopted by the working party (et autres parts sociales sousforme de papiers-valeurs) and two italian treaties" that used a closely-related expression not referring to paper securities: et d'autres parts sociales analogues, meaning analogous participations in a company. it is relevant that none of the treaties referred to by the working party was in english. this is what my co-authors and i wrote about the origin of the english "other corporate rights," which fully justifies the "something lost in translation?" in the title of the article:41 the english version of the working party's minutes is therefore probably the work of the oeec translator of the minutes (or possibly was taken from a collection of treaties translated by the oeec) who translated the same french expression (et autres parts sociales sous forme de papiersvaleurs) in each of the swiss treaties into english in the following different ways: "or other membership shares in the form of securities;" "or other company shares in the form of securities;" "or other interests in the form of securities issued by bodies corporate;" "or other interests in the form of securities;" and translated the slightly different, but common, french wording in the two italian treaties (et d'autres parts sociales analogues) as "and like participations in companies" and (importantly to the later history) "and all other similar corporate profit sharing rights" respectively.42 therefore the wording "other corporate profit sharing rights represented by paper securities" in the working party's 38. fc/wpl2(58) 1 (nov. 28, 1958). this was before working party 14 developed the definition of company, the first draft of which is fc/wp14(59) 1 (mar. 3, 1959). 39. switzerland-sweden (1948), switzerland-netherlands (1951), switzerland-austria (1953), switzerland-france (1953) (all being in the definition of income from moveable capital). 40. italy-sweden (1956), and italy-france (1958) et de toutes autres parts sociales analogues of which the italian was ogni altra quota sociale analoga. 41. see supra note 37. 42. the order of these english translations corresponds to the order of the treaties in fn. 39 and 40. [vol. 10:112 understanding the oecd model tax convention english version of their definition of dividends was not only a translation of the different french wording of the two italian treaties rather than the french contained in the swiss treaties that was adopted by the working party, but was also possibly the english that was farthest away from the french of all the translator's versions. if this is a translation of the minutes by the oeec translator rather than a collection of treaties translated at different times by different people, it is remarkable that he or she managed to create so many english variations from essentially the same french in the same document, although it may be said that there is no possible exact english translation. the fiscal committee moved income from debentures participating in profits to the definition of interest.43 the reference only in english to limited partnerships with share capital was also deleted. at the same time "shares participating in profits" was added, and later changed to rights participating in profits." the definition originally specifically included the french sarl (oddly translated as limited liability partnership) which does not have shares (actions) but parts, meaning something more like a partnership interest which are not necessarily "paper securities." i believe the us llc is similar in this respect, although i understand it is allowed to have shares if the other country requires this. next "income from parts de socidtis as the national laws treated as dividends or was taxed as such" (revenus de parts de socidtis que les idgislations nationales considbrent comme des dividendes ou qui sont taxds comme tels) was added,45 and in consequence the specific reference to the sarl was dropped.46 the existing "other corporate profit sharing rights represented by paper securities" and the new addition were combined into "income from other corporate profit-sharing rights which are subject to tax on income from shares according to the fiscal laws of the state of which the company paying the dividends is a resident" (les revenus d'autres parts sociales qui sont imposis comme les revenus d'actions, d'apr~s la idgislation fiscale de l'etat dont la socidtd distributrice est un risident).47 43. fc/m(60) 3 (may 28, 1960). 44. fc/m(61) 2 (meeting of mar. 5-10, 1962) presumably because "shares" was not a correct translation of parts beneficiaries. 45. the last words also mirror the second part of the definition of company "any entity that is treated as a body corporate for tax purposes" that wp 14 had by then developed since the treatment of the company and its distributions are likely to correspond. 46. the current commentary (article 10 comm t 26) still explains: "the laws of many of the states put participations in a socidtd a responsabilit limitie (limited liability company) on the same footing as shares." 47. fc/wpl2(60) 3 (aug. 1960). 2009] 13 florida tax review finally, "profit-sharing" was dropped in english, having no equivalent in french. thus we ended up with a definition in english that has caused problems ever since.4 8 fortunately in common law countries most companies have shares and the income from them is covered by the opening phrase, but the rest of the definition has to cater for the us llc (or limited or general partnershi or trust) electing to be treated as a corporation for us tax purposes. most of the definitional problems, such as the width of "other corporate rights" are problems of civil law countries, although it is noticeable that the us sensibly avoids using the expression in the us model and its treaties, and the uk has started to do the same.50 an interesting feature is that moving income from debentures participating profits to the definition of interest occurred at the same meeting as the addition of income from corporate rights taxed as income from shares. it seems difficult to argue, as the oecd has since done,s1 that the latter covers income from excessive debt in thin capitalization cases. this is an example where the history is useful to understand the present. c. the definition of interest a different working party, 11, developed the definition of interest. their first version was: for the purpose of this article, the term 'interest' means interest on and all other income (including prizes and redemption premiums) from government securities, bonds or debentures, whether or not secured by mortgage and whether or not carrying a right to participate in profits, debt-claims of every kind, notes of indebtedness, deposits, cash guarantees and other capital assets which can be assimilated to debtclaims or to loans.52 48. see, for example, the oecd report on thin capitalization (nov. 26, 1986). 49. the only item in the uk is the company limited by guarantee but it is very unusual for this to make distributions. 50. the uk normally leaves it in but adds a reference to anything treated as a distribution in domestic law, thus also effectively avoiding the problem. in three recent treaties, uk-japan (2006), uk-libya (2008), uk-moldova (2007), the uk has followed the us practice of using the oecd definition but without the reference to corporate tights instead of adding a reference to distributions. this seems to be a change of policy. 51. article 10 comm 25. 52. fc/wp11(59) 1 (jan. 15, 1959). [vol. 10:114 2009] understanding the oecd model tax convention 15 interestingly this was before debentures participating in profits were taken out of the definition of dividend so for a time they were in both definitions, an example of the consequences of different working parties working simultaneously. the fiscal committee asked the working party to try to simplify the definition.53 this, working party 11 were reluctant to do, saying that the definition corresponded to domestic law in many countries and was found in treaties, citing france-switzerland (1953), but they suggested the following: the term 'interest' employed in this article means income from government securities, bonds or debentures, whether or not secured by mortgage and whether of not carrying a right to participate in profits, and debt-claims of every kind, as well as all other income assimilated by the taxation law to income from money lent.54 the inclusion of a reference to domestic law corresponded in that respect with the definition of dividend. this version found favour with the fiscal committee. the working party's commentary explained: in any case, the article does not give a complete and exhaustive list of the various kinds of interest. such a list might not be fully in harmony with the various states' laws, which may differ among themselves in their interpretation of the concept of interest. it therefore seems preferable to include in a general formula all income which is assimilated by those laws to remuneration on money lent. this applies in particular to interest derived from cash deposits and security lodged in money.56 much later, the oecd 1977 model deleted the reference to domestic law, thus returning to the oeec's original concept, saying in the commentary to article 11: 19. moreover, the definition of interest in the first sentence of paragraph 3 is, in principle, exhaustive. it has seemed preferable not to include a subsidiary reference to domestic laws in the text; this is justified by the following considerations: 53. fc/m(60) 3 (may 28, 1960). 54. fc/wp 11(60) 2 (oct. 20, 1960). 55. fc/m(61) 1 (feb. 17, 1961). 56. fc/wp 1(62) 1 (apr. 10, 1961). florida tax review a) the definition covers practically all the kinds of income which are regarded as interest in the various domestic laws; b) the formula employed offers greater security from the legal point of view and ensures that conventions would be unaffected by future changes in any country's domestic laws; c) in the model convention references to domestic laws should as far as possible be avoided. it nevertheless remains understood that in a bilateral convention two contracting states may widen the formula employed so as to include in it any income which is taxed as interest under either of their domestic laws but which is not covered by the definition and in these circumstances may find it preferable to make reference to their domestic laws. thus we came to have the odd present position that the definition of dividend contains a reference to domestic law while the definition of interest does not, which makes it virtually impossible to avoid any overlap. even where both definitions refer to domestic law, which several countries still do in the definition of interest, overlaps are still possible, where, for example, something that is interest within the general wording of the definition of interest is taxed as a dividend, or something that is a dividend within the general wording of the definition of dividend is taxed as interest. d. residence richard vann has explained in detail the origin of article 4(1) and in particular the expression "liable to tax."57 in summary, working party 2 started from the basis that the treaty applied to persons who were fully liable to tax in one of the states, necessarily under domestic law (i.e. the forerunner of article 159), to which they added some tie-breaker provisions 60 switzerland, although not on the working party, but who were, as always extremely active,' submitted a draft that has considerable similarities to the form of the present article, including "...fully liable to taxation under the internal law, by reason of his or its domicile, head office of residence or by 57. see supra note 5, at 224 onwards. 58. comprising delegates from denmark and luxembourg. 59. see the heading article i below. 60. fc/wp2(57) 1 (may, 27 1957). 61. see below on their involvement with the tie-breaker for individuals, and the non-discrimination article. 16 [vol. 10:1 understanding the oecd model tax convention reason of any other similar criterion." the fiscal committed did not like the concept of "full liability," and working party 2 came back with this proposal: at any rate the word "full" would presumably have to be dropped. this would mean that in the subsequent articles of the convention the brief expression: "the state in which he is fully liable to taxation" could not be used, but it would be necessary to say: "the state in which he is liable to taxation by reason of domicile, residence, etc...." for terminological reasons it would be desirable if "a shorthand expression" could be used in all cases where the state of "domicile" is mentioned.... consequently the working party has fixed upon the term "resident," which is used in conventions concluded by the united kingdom and by the united states of america. that was the origin of the term "resident" in the model. the fiscal committee completed the drafting: for the purposes of this convention, the expression "resident" of a state means any person who, under the national law of that state, is liable to taxation therein by reason of his domicile, residence, place of management or any other similar criterion. working party 2 did not view the significance of dual residence in the same way as we do today. their minutes include the following: the typical cases of conflict are these: (a) between two (or more) domiciles; (b) between domicile and source. in both cases the conflict arises because, under their internal legislation, one or more states claim that the person concerned has his domicile in their territories. primarily, the states always apply their own law in so far as it does not conflict with the provisions of a convention. if it does, the provisions of the convention must be applied. the working party has pointed out that in the case of a conflict between two domiciles it is not sufficient to refer to the concept of domicile adopted in the internal laws of the state concerned. it is precisely because both states apply their internal laws to the person concerned that the double taxation arises. in these cases special provisions must be established in the 62. fc/wp2(57) 3 (nov. 5, 1957). 63. fc/m(58) 1 (jan. 6, 1958). 2009] 17 florida tax review convention to determine which of the two concepts of domicile is to be given preference.... in other cases the working party's view was that it seemed sufficient to refer to the concept of domicile adopted in the internal laws. the working party will revert to this question in paragraph 9 in connection with the discussion of the question of giving a definition of 'domicile.' [the definition was: the term 'resident' of a state means any person who, under the national laws of that state, is subject to tax in that state as a resident.]6 the working party was intending to give a single meaning of the term "resident" where the taxing right depends on residence only. they did not regard the tie-breaker as having any relevance to source-residence issues as we do now. as the residence article was one of the first set of articles to be completed, along with permanent establishment, taxes covered and nondiscrimination, the relationship with other articles was never explored. this is an example where the method of having separate working parties dealing with different articles at different times was unsatisfactory. e. the expressions used in the residence tie-breaker for individuals dual residence for individuals goes through a series of tie-breakers: permanent home available to him, centre of vital interests, habitual abode, nationality and finally settling it by mutual agreement. only the first of these is clear. the second tie-breaker is interesting because of its development. oeec working party 2 originally proposed "the state with which his personal relations are closest (centre of vital interests)." 65 they had considered whether it should be (1) the stronger economic relations, or (2) the stronger economic and personal relations, or (3) the stronger personal 64. fc/wp2(57) 3 (nov. 5, 1957). the fiscal committee seems to have been content with this: fc/m(57) 2 (jul. 3, 1957). 65. see john f. avery jones et al "the origins of concepts and expressions used in the oecd model and their adoption by states" [2006] btr 695, 718 (for the following earlier use in domestic law). centre of economic (but not personal) interests is one of the tests for residence in france (law of dec. 29, 1976 (law no.76-1234)), and centre of personal interests is used in case law in belgium (mitchell b carroll, taxation of foreign and national enterprises (league of nations, geneva, vol. 2 (1933) at 49. r. zondervan, les impdts sur les revenus et l'extranditd, (ets. pauwels, brussels, 1967), at 92); netherlands practice used to take into account both factors as one of its tests for residence: "the place where his activities (profit-seeking and other) and recreation are centered" mitchell b carroll, supra, vol. 2 at 340. an early treaty use is germany-sweden (1928) referring to the taxpayer's interests being centered in one place, and also germany-sweden (1928), france-sweden (1936) where the state in which the taxpayer's interests are centered is the first test for resolving dual residence, followed by nationality. 18 [vol 10:1 understanding the oecd model tax convention relations." they decided against (1) and it looked as if they had chosen (3) by adopting this reference to personal relations only. the fiscal committee, which seems to have adopted its now familiar preference for changing the commentary rather than the article even while the article was being drafted, said that the commentary should state that personal relations covered both family and economic connections.67 the working party did this and its commentary was: "this term [personal relations] being understood as the centre of vital interests and covering both family and economic relations."68 the fiscal committee then rightly changed the wording of the article to "personal and economic relations,"69 and the commentary became: "the state with which his personal and economic relations are closest, this being understood as the centre of vital interests."70 the third tie-breaker (habitual abode) is the most puzzling in english. the working party started by quoting the netherlands-switzerland treaty (1951), the original languages of which are dutch and french, and so the english is a translation: ... in the place where he regularly resides (oi elle sdjourne de fagon durable).7' for the purposes of this provision a person shall be deemed to be regularly resident in the place in which he resides in such manner as to indicate that he does not intend to remain in the place only temporarily. (une personne sdjourne de fagon durable, au sens de cette disposition, la oil elle riside d'une manidre qui permet de conclure qu'elle a l'intention de ne pas demeurer en cet endroit de fagon passagre seulement.)7 2 66. fc/wp2(56) 1 (oct. 2, 1956), at 4. 67. fc/m (58) 1 (jan. 6, 1958), at 3. 68. fc/wp2(58) 1 (jan.10, 1958), at 5. 69. fc/m (58) 2 (mar. 29, 1958), at 5. 70. fc (58) 2 (1st revision) part ii annex c (feb. 13, 1958), at 18. 71. the ibfd unofficial english translation says "permanently resides." 72. fciwp2(56) 1 annex a (oct. 2, 1956), at 9. an early similar use is hungary-sweden (1936) in which treaty residence is defined as the place where the taxpayer has his permanent home, or if there is no permanent home in either state the place where they permanently reside, defined as "residence in any given place in the said state in circumstances which warrant the presumption that such residence is not intended to be temporary only." some italian treaties from the 1920s use similar expressions, including the treaties with austria (1922), hungary (1925) (which includes the explanatory sentence), germany (1925), croatia (1941): see avery jones et al "the origins of concepts and expressions used in the oecd model and their adoption by states" [2006] btr 695 718-19. 2009] 19 florida tax review at the next meeting the working party considered a written observation by the swiss delegation which put forward the same wording in french as this treaty. this time it came out quite differently in english in the minutes; which must be a translation by the working party, or an oecd translator: "the place in which he has his continuing abode."7 3 that is not an expression one would ever use in english and it is much less clear than the previous english version "regularly resides," although this did not matter in view of the explanatory sentence that followed: "a person has his continuing abode in the state in which he resides in such a manner as to warrant the conclusion that he does not intend to live in that state merely temporarily" (une personne sdjoume de fagon durable, au sens de cette disposition, dans i'etat oia elle riside d'une manibre qui permet de conclure qu'elle a l'intention de ne pas y demeurer de fagon passagbre seulement). the working party, however, adopted a different wording: "the country in which he principally resides (oi il a sa risidence principale)"74 and at the same time they dropped the explanatory sentence, no doubt because they thought it unnecessary to such a concept. their next version returned more closely to the swiss proposal, with the same english translation of a slightly different french expression: "the state in which he has his continuing abode (l'etat sur le territoire duquel elle sdjourne d'une faqon continue)."75 unfortunately the explanatory sentence, which would have been useful assuming that the new french expression had a similar meaning to the previous one, was not reintroduced. the working party's final thought was a variation on this: "the state in which he has a habitual abode" (elle sdjourne d'unefagon habituelle).7 6 one can see that unfortunately the same unclear english version (continuing abode) of the swiss proposal, compared to the better english translation of the netherlands-swiss treaty (regularly resides) was carried over as a translation of a different french wording elle sdjourne d'une faqon continue (instead of elle sdjourne de fagon durable) and then changed slightly to habitual abode with a corresponding change in the french (elle sdjourne d'une fagon habituelle). the reason why we still have the incomprehensible "a habitual abode" today is therefore the combination of a bad translation of a completely different french expression, probably made by the working party whose first language was not english, and the decision 73. fc/wp2(57) 2 annex 1 (sep. 19, 1957), at 4; annex 2 at 9. the original language of these minutes is english and french which suggests that the translation is by the working party. 74. fc/wp2(57) 2 annex 3 (sep.19, 1957) at 11. 75.1 fc/wp2(57) 3 (nov. 5, 1957), at 2; and tdf/fc/27 (nov. 26, 1957). the original language of the minutes is english. 76. fc/wp2(58) 1 (jan. 10, 1958), at 2. the original language of the minutes is english. 20 [vol 10:1 understanding the oecd model tax convention to drop the sentence which would have explained its meaning. incidentally sdjourne is also currently used in the model in the 183 day test in aticle 15(2)(c): le bindficiaire sdjourne dans l'autre tat pendant une piriode ou des piriodes n'excidant pas au total 183 jours durant toute piriode de douze mois .... ("the recipient is present in the other state for a period or periods not exceeding in aggregate 183 days in any twelve month period..."). perhaps an habitual abode really means "is habitually present," which would be much clearer. a further, and unconnected, language problem is that in the german version of treaties the expression gewohnlicher aufenthalt is used as the equivalent to habitual abode, which has been in domestic law since 1934n7 indicating six months' presence. in german this tends to be interpreted in the same way as domestic law78 even though there is no support in the commentary for the use of any fixed period. f. place of effective management in the residence tie-breaker for companies in early oeec drafts the tie-breaker was not the current "place of effective management" but the uk (and common law) domestic law residence test of "place of management and control" that had consistently been used in early uk treaties.7 9 the reason for the inclusion of this definition in these treaties was not that it was considered to be a good tiebreaker but to prevent the possibility of an alternative domestic law from applying based on the then wrong understanding of the decision in swedish 77. a similar term "habitual and permanent abode" was in use from 1919. 78. prof klaus vogel said: "i have not yet met a german judge who, in this situation, would be prepared to accept an interpretation which differs from german domestic law." bulletin for international taxation vol.57, no.5, p. 186. (2003). 79. uk treaties with: us (1945) (as to uk companies only), canada (1946), southern rhodesia (1946), south africa (1946), new zealand (1947) with a variation, palestine (1947), netherlands (1948, extended to netherlands antilles 1957), sweden (1949) with a variation, denmark (1950) (this was varied in 1969 to add after stating that a company was resident in denmark if it was managed and controlled in denmark "and it is resident in denmark for the purposes of danish tax"), ceylon (1950), france (1950), norway (1951), greece (1953) referring to domiciled or resident in greece, germany (1954), and in about 44 arrangements with colonial territories. in uk treaties with france (1945 and 1950) and belgium (1953) this is used as the definition of fiscal domicile in those countries (which is equated to residence). uniquely, it was not included in uk-australia (1946) which had a different statutory definition of residence. the dates in brackets refer to the date of signature which may differ from the date of the statutory instrument giving effect to the treaty. 2009] 21 florida tax review central railways v. thompson80 that a company could be uk resident also because it was incorporated in the uk and did some business there. because of the uncertainties in the meaning of the expression management and control, this was coupled with a mutual agreement provision similar to that still applying to the tie-breaker for individuals (the mutual agreement article had not then been drafted1 ).82 the commentary explained: "as the question will hardly be of practical importance, it has been found reasonable and natural to reserve such cases for agreement between the interested parties." the change to the current place of effective management was made to harmonize the test with that in the shipping article, which in turn had been taken from that article in some (but by no means all) existing treaties.84 at the same time as this change was made, the mutual agreement provision was dropped on the basis that "it will hardly ever be required."8 it seems strange today that anyone thought that the new expression was that clear in its 86meaning. the history seems to show that the meaning of place of effective management was never clear. the unfortunate feature of it is that the expression is sufficiently close to practically every country's domestic law that they all consider that it means the same as their domestic law expression. the u.s. is wise not to use the expression in treaties. 80. [1925] 1 ac 495. 81. the first draft of the mutual agreement article is in fc/wp14(59) 1 (mar. 3, 1959); the final report of working party 2 on residence was in fc/wp 2(58)1 (jan. 10, 1958). 82. article 4(2)(d) of the oecd model. 83. fc/wp2(57) 1 (may 27, 1957). 84. it was used in belgium-sweden (1953), and belgium and sweden were the members of working party 5 on shipping, and so its adoption by the working party may not be a coincidence. 85. fc/wp2(57) 3 (nov. 5, 1957). 86. i have explored this in more detail in john f. avery jones, 2008 oecd model: place of effective management what one can learn from the history 63 bulletin for international taxation p. 183. (2009) 87. see, e.g., residence of companies under tax treaties and ec law, supra note 5, ch. 9 by j. sasseville at p. 297-9 where at least six countries see similarities with their domestic law. the same was seen in the discussion of the topic at the 2004 ifa congress in vienna in which panelists from three states each argued that place of effective management had the same meaning as their domestic law term with different results. see john f. avery jones, "place of effective management as a residence tie-breaker," bulletin for international fiscal documentation 1 (2005), at 20. the last thing one wants of a tie-breaker is for both states to think that it is the same as their domestic law. 22 [vol. 10:1 understanding the oecd model tax convention g. article 1 closely related to the definition of residence is article 1 of the model which in its current form says: "this convention shall apply to persons who are residents of one or both of the contracting states." this is puzzling because the point of the tie-breakers is that a person can never be resident in both states for the purposes of the treaty. from the context, even though the definition of resident is not subject to the context otherwise requiring as are the article 3 definitions, it must mean that the person is resident in domestic law in one or both states. the problem cannot be explained by the way the oeec worked in dealing with each article separately because article 1, which was drafted by working party 14, came after working party 2 on residence had finished their definition. 8 the explanation seems to be that, as already mentioned, originally working party 2 proposed the equivalent of article 1 as part of their definition of residence but were told by the fiscal committee to concentrate on the definition itself rather than its field of application.8 9 that article said "this agreement shall apply in every case where a person is fully liable to taxation in one of the member countries."" (this is an indication that the model was then proposed for a multilateral treaty, as we shall see below.91) in the context this article clearly meant fully liable to tax under domestic law. the draft went on to define in which member country the right to tax belonged by virtue of the tie-breakers for individuals, companies or other bodies corporate, and also estates of deceased persons. neither part originally used the expression resident, although by the time working party 2 had finished it did. it seems that when working party 14 drafted article 1 they were aware of this previous draft and followed the sense of it. their draft read: "the present convention applies to individuals and legal persons who are residents of the contracting state a or of contracting state b or of both states [under the provisions of article....]" the draft had become bilateral by then, although a later draft retained a multilateral alternative. 92 it is strange that the working party should say "individuals and legal persons" when in the same draft they proposed definitions of "person" and "company" in a draft of the whole of 88. the first draft of article 1 is in fciwp14(59) 1 (mar. 3, 1959); the final report of working party 2 on residence was in fc/wp2(58) 1 (jan. 10, 1958). 89. they also proposed a definition of "person" which the fiscal committee did not want either: fc/m(57) 2 (jul. 3, 1957). 90. fc/wp2(57) 1 (may 27, 1957). 91. see the heading non-discrimination was intended to be dealt with in a multilateral treaty. 92. fc/wp14(60) 1 (jan. 19, 1960). 2009] 23 florida tax review what is now article 3; they corrected this is their next draft.93 it is even stranger that they suggested as a possibility by the passage in square brackets that the definition in the residence article should apply when its purpose was to prevent residence in both states; this was also dropped in the next draft.94 was the reason connected with the dual residence provision not being intended to be applicable to residence-source provisions? 95 the proposed commentary does not help explain this as it merely states that older treaties applied to citizens but residence was a preferable connection. h. permanent establishment 1. the list of items that permanent establishment includes especially the original definition of "permanent establishment" proposed by working party 1,96 the members of which were from germany and the uk, was little different in outline from today, no doubt because of the long history of the use of such a definition in actual treaties.9 7 no guidance was given on why there is a list of items (place of management, branch, office etc) that the term "includes especially." is it clear that, for example, an office available for a short time only which is not a permanent establishment by virtue of the general definition is not deemed to be one by virtue of office being included in the list in paragraph 2? the original commentary," as it still does today, 99 describes the list as prima facie examples, or in another place in the original commentary as examples that can be regarded a priori as constituting a permanent establishment, which convey that the list is of items that constitute a permanent establishment at first sight but might not do so when looked into fully. the working party explained that the list was one to which all member states would agree with a minimum of discussion, and which closely followed the list in the inclusive definition in the london and mexico drafts. a place of management was added as it was not necessarily an office, as the commentary still explains; "head office" and "professional 93. see supra note 92. 94. id. 95. see supra note 64. 96. this was the first article to be finalized. it was complete by oct. 2, 1957, see tdf/fc/125. 97. in the league of nations london and mexico drafts the list of items that the term "includes especially" was part of an inclusive definition: "includes head offices, branches" etc ending with "and other fixed places of business having a productive character." the oeec moved the last item to the beginning as the general principle and at the same time kept the list. 98. fc/wpl(56) 1 (sep. 17, 1956). 99. oecd article 5 comm 1 12. 24 [vol. 10:1 understanding the oecd model tax convention premises," which were in the london and mexico drafts, were dropped as unnecessary, being covered by place of management, and office respectively; "installations" was dropped as being meaningless; and "plantations" was dropped because agriculture was not trading income in all states. a "warehouse" was originally included in the list but was deleted because of the potential conflict with the stock of goods exception ("the maintenance of a stock of merchandise, whether in a warehouse or not, merely for convenience of delivery") with the result that the only example left was that of warehouse for letting facilities for storage to third parties, which was covered by the general wording." in short, unfortunately little can be gained from the history to explain the reason for including the list as well as the general principle; the working party accepted the concept from the mexico and london drafts. 2. the exclusion for a stock of goods an agent or employee was originally deemed to constitute a permanent establishment of the principal if (as an alternative to having power to contract) he "habitually maintains in the first-mentioned territory a stock of goods or merchandise belonging to the enterprises from which he regularly delivers goods or merchandise on its behalf."'o' at the same time "the maintenance of a stock of merchandise, whether in a warehouse or not, merely for convenience of delivery" was excluded from constituting a permanent establishment except where the agency provision applied.102 when the working party changed the requirement for the agent to have and habitually exercise a "general authority" to conclude contracts to merely having "authority" to negotiate or conclude contracts, the reference to the agent habitually maintaining a stock of goods was deleted. 0 3 storage (originally) and then display and storage, which were originally in a separate exclusion, were added to the delivery exception, thus creating the current storage, display or delivery; and "merely for the convenience of delivery" 100. the fiscal committee had asked the working party to consider this in fc/m(57) 1 (feb. 8, 1957), and the swiss delegate proposed the change (tdf/fc/l 1 (jan. 24, 1957) which was discussed in fc/m(57)3 (nov. 5, 1957); see the explanation in tdf/fc/24 (oct. 2, 1957). 101. fc/wp1 (56) 1 (sep. 17, 1956), at 4. the uk delegate said he was unable to accept this and said it would make a formal reservation if it were approved, fc/m(57)1 (feb. 8, 1957), correction to the minutes in fc/m(57) 2 (jul. 3, 1957). this is mysterious since this provision was contained in all uk treaties of the time, and enabling legislation dating from 1930 gave power to enter into agency treaties to exempt agency profits from tax except where this applied (or the agent had was power to contract). 102. fc/wp1(56) 1 appendix 1, at 3. (sep. 17, 1956). 103 fc/wpl(57) 2 at 12. (aug. 29, 1957). 2009] 25 florida tax review became "for the purpose of [display or] delivery, and then solely for the purpose of [storage, display or] delivery.'o4 one can deduce some points from this history. when the agency permanent establishment caused by the agent habitually maintaining a stock of goods was deleted, it seems that the enterprise, through its agent, could make deliveries without there being a permanent establishment so long as the agent did not make the sale. it therefore seems that the delivery exception originally applied to deliveries of goods that were sold from abroad. the combination of storage, display and delivery would have originally have been excluded from being a permanent establishment because storage and delivery were originally in separate paragraphs and the other items were added to both paragraphs. the or in storage, display or delivery is unlikely to have been intended to exclude such combinations. 3. how the taisei'05 problem arose working party 1's original commentary to the permanent establishment article contained the following: 10. agents who may be deemed to be permanent establishment must be strictly limited to those who are dependent, both from the legal and economic points of view, upon the enterprise for which they carry on business dealings (report of the fiscal committee of the league of nations, 1928, page 12). the passage referred to in the cross-reference was about independent agents which defined this as "absolute independence, both from the legal and economic point of view." applying this to dependent agents logically requires one to change the and to or, so that a dependent agent is one who is either legally or economically dependent. that passage remained in the commentary in the 1963 draft. the 1977 commentary reverted to defining independent agent by requiring both legal and economic independence. the court in taisei was absolutely right to use the 1977 commentary to correct the error in the 1963 commentary: generally, we would have reservations about interpreting a convention, ratified in 1971, on the basis of a commentary, adopted in 1977, that contradicts the literal language of the 104. fc/wpl(s7) 2 (aug. 29, 1957) and fc/wpl(57) 3 (nov. 12, 1957) respectively. 105. taisei fire and marine ins. co., ltd. v. commissioner, 104 t.c. 535 (1995). 105.0 fc/wp1 (56) 1, at 9. (sep. 17, 1956). 26 [vol 10: 1 understanding the oecd model tax convention commentary in effect at the time of ratification. however, in light of the extensive analysis by the previously cited commentators and the confirmation of such analysis by our own research, we are persuaded that the criteria in the later commentary reflects the original intention of the commentary to the 1963 model and that the 1963 model should be interpreted as having a disjunctive ("or") meaning. 4. the priority rule now in article 7(7) although not a definition, the current priority rule in article 7(7) that "where profits include items of income which are dealt with separately in other articles of this convention, then the provisions of those articles shall not be affected by the provisions of this article" started life as a proposed definition of profits by working party 14 which said: the term 'profits' as used in articles xv and xvi includes income derived from the direct exercise of business as well as income from the letting of the business to others and income from the alienation of the business, but does not include income from the operation of ships or aircraft in international traffic or from the operation of boats engaged in inland waterways transport or income in respect of independent and dependent personal services or income from immovable property, nor does the term include income in the form of dividends, interest, rents or royalties;10 the working party debated whether profits arose on the letting of the whole or part of the enterprise. in the fiscal committee some expressed views that a definition of profits was not necessary and others that a priority rule was required, for example for banks receiving interest as part of their profits. they said that profits arising on the alienation of the enterprise should be considered in connection with capital gains.107 letting of a permanent establishment gave rise to different views: that it was possible that the permanent establishment ceased to exist when let, and that this was a management arrangement rather than a letting.108 in the end the definition of profits was dropped in favour of a priority rule that originally referred to seven other articles having priority and eventually ended with the current reference to items of income dealt with by other articles generally. 106. fc/wpl4(61) 1, at 1 (jan. 9, 1961) 107. the capital gains article was not included in the oeec reports but first appeared in the oecd 1963 draft. 108. fc/m(61) 5, (sep. 29, 1961). 2009] 27 florida tax review presumably because the focus started by being in relation to profits a more general consideration of priority between other articles did not take place, and the existence of separate working parties working independently on different articles made this unlikely. 5. conclusion on the definitions there is some interesting material here explaining how we arrived at where we are, even though in some respects this is an accident caused by how the oeec working parties carried out their separate tasks, or even of translation (as with corporate rights, and habitual abode). as a result of the history we have a better understanding of what these definitions were intended to cover, such as the intended width of the definition of "person," why all bodies corporate were assumed to be taxable, and the purpose of the stock of goods exception to a permanent establishment. the oeec method of working explains a lot, such as why the main priority rule between articles relates only to profits, why article 1 seems to ignore article 4, and why article 4 has its own mutual agreement provision for individuals but not companies. there were some early thoughts about the treaty problems of partnership. and it is good to have confirmation that the meaning of place of effective management was never clear. iii. non-discrimination a. the nationality non-discrimination provision as mentioned above, one of the oeec fiscal committee's terms of reference'09 was: d inequalities in taxation on grounds of nationality the committee should make concrete proposals concerning the means of removal of such inequalities. clearly, nationality discrimination was assumed to be a major issue by the ad hoc group of experts who wrote the terms of reference of the fiscal committee. in spite of this, working party 4, comprising members from france and the netherlands, who were charged with developing the nondiscrimination article, did not find widespread nationality discrimination. indeed the nationality non-discrimination provision was originally intended to deal first with minor differences in personal allowances that existed in france, united kingdom,"l0 ireland, and the netherlands. secondly, 109. fc (56) (may, 26, 1956), at 2. for the others, see supra note 13. 110. this was not abolished until 2009. 28 [vol 10:1 understanding the oecd model tax convention reference was made to the application of the remittance basis in the uk and ireland to non-ordinarily resident british/irish subjects, which was (correctly) described as not very important."' thirdly, the following further miscellaneous examples of nationality discrimination were mentioned: the netherlands exercises discrimination in not allowing foreign nationals domiciled in its territory to avail themselves of the internal measures for double taxation relief unless they maintain their domicile in the netherlands for at least 3 years or unless the state whose nationality they possess extends reciprocal treatment, while netherlands nationals who have their fiscal domicile in the netherlands may claim such relief without exception. in ireland special exemptions or relief are given to companies registered, managed and controlled in ireland, so far as concerns profits arising to them from certain mining business. finally, in sweden, foreign corporate bodies are subject to a tax on capital invested in sweden, while swedish companies and certain other swedish corporate bodies are not. the swedish reply states that in principle this does not result in any difference in the tax assessment.1 12 it therefore seems that by 1957 examples of nationality discrimination in taxation in europe were found only on the fringes. perhaps nationality discrimination has been more important earlier. the drafting of the oeec nationality provision generally, including the definition of nationality, was acknowledged to derive from uk treaties of the early 1950s." 3 111. this continued in the uk until 2005 when it was abolished as part of the tax law rewrite in ittoia 2005 s.831(4), see explanatory notes to the bill change 132. since a non-domiciled person was also entitled to the remittance basis the only discrimination was against uk domiciled foreigners, who were probably few in number. 112. fc/wp4(57) 1, at 2 (jan. 11, 1957). 113. fc/wp4(57) 1 (jan. 11, 1957). see uk treaties with: denmark (1950), france (1950), norway (1951), finland (1951), greece (1953), belgium (1953), switzerland (1954), germany (1954), and austria (1956). the definition of nationality of legal persons etc is the same as us-uk (1945) but the nationality nondiscrimination provision is different in that treaty, being restricted to nationals of one state who are resident in the other state. 2009] 29 florida tax review b. non-discrimination was intended to be dealt with in a multilateral treaty interestingly, the non-discrimination article was originally planned as a multilateral treaty between oeec countries,1 4 then only european countries, and so it was planned as a forerunner of the far-wider current ec rule. that a multilateral treaty was planned can be seen from the original oeec working party 4 definition of national: the term 'nationals' means: (a) all individuals possessing the nationality of a member country of the oeec; (b) all legal persons, partnerships and associations deriving their status as such from the law in force in any member country of the oeec."' in relation to paragraph (b) the commentary explained: by declaring that all legal persons, partnership and associations deriving their status as such from the law in force in a contracting state are considered to be nationals for the purposes of paragraph 1 of the article, the provision disposes of a difficulty which often arises in determining the nationality of companies. in defining the nationality of companies, certain states have regard less to the law which governs the company than to the origin of the capital with which the company was formed or the nationality of the 114. the international chamber of commerce had put forward this possibility. see c(54)294. (nov. 12, 1954). by apr. 19, 1955 the swiss delegation had accepted that a multilateral treaty on direct tax was not the way forward, although they favoured it for indirect tax. on the former they said: "however, because of the growing complexity of national taxation laws, and of the legal, financial and technical difficulties which make efforts to avoid double taxation problems increasingly arduous, it has not up to now seemed possible to envisage the conclusion of multilateral conventions in regard to such taxes, and switzerland has therefore given its preference to the conclusion of bilateral conventions, that having seemed to be the most suitable procedure." see c(55)88, at 2. the option of a multilateral convention on discrimination and possibly shipping profits was still being considered in 1957: fc/m(57) 3 (nov. 5, 1957). 115. fc/wp4 (57) 1 (jan. 11, 1057), at 4. the french version of (b) was << toutes les personnes morales, toutes les socidtis et associations constitudes conformgment b la idgislation en vigueur dans un etat-membre de l'o.e.ce. > 30 [vol. 10:1 understanding the oecd model tax convention individuals or legal persons controlling it. no ambiguity need be apprehended, therefore.' 16 in other words, for legal persons etc, nationality in the model was equated to governing law, whatever domestic law on nationality might be. if the above definition had been retained in a bilateral treaty it would have prevented country a from discriminating against nationals of any oeec country but the oeec states other than state b with which it was contracting would have made no commitment not to discriminate against state a's nationals. when the article became bilateral the definition was therefore restricted to nationals of a contracting state, as it had been in the original uk early treaties. another indicator of an intended multilateral convention is the stateless persons provision which makes more sense in a multilateral context because such a person has no obvious connection with either state in a bilateral treaty. the original form was: (4) stateless persons shall not be subjected in the territory of any member country to any taxation or any requirement connected therewith, with respect to taxes on income, on capital and on estates and inheritances, which is other, higher or more burdensome than the taxation and connected requirements to which the nationals of that country are or may be subjected. the immediate cause of a stateless persons' non-discrimination provision was a convention of september 28, 1954 to improve the conditions of stateless persons'" 7 under article 29 of which stateless persons were to be given the treatment accorded to nationals. both working party 4 and the fiscal committee said that this provision was appropriate only to a multilateral convention," 8 but they retained it when the non-discrimination article became bilateral without any explanation for their change of mind. the current model restricts this provision to stateless persons resident in a contracting party (unlike the nationality provision that extends to nationals who are not resident in either state) and provides that they shall not be subjected in either contracting state to other or more burdensome taxation 116. fc (58)2 (1st revision) part ii (apr. 19, 1958), at 26. similar wording is still contained in the commentary at article 3 comm 9. 117. this was signed by belgium, denmark, germany, italy, the netherlands, norway, sweden, switzerland, the united kingdom, and france: fc/wp4(57) 1 (jan. 11, 1957). 118. fc/wp4(57) 3 (sep. 13, 1957) and commentary at fc/wp4(58)1 (feb. 19, 1958); fc/m(57) 1 (11 jan. 11, 1957), at 4; fc/m(57) 3 (nov. 5, 1957). 2009] 31 florida tax review (or connected requirements) compared to nationals of the state concerned. something on the lines of the original wording is now contained in the commentary as a possible alternative." 9 during the debates on whether to have a multilateral convention on discrimination there was no great enthusiasm in the fiscal committee for a multilateral treaty. although the delegate from germany thought it would have favourable psychological effects, the uk delegate said that "a multilateral convention on a question which did not give rise to serious difficulties in practice would give the impression of an academic study."l20 the italian delegate also thought such a multilateral convention would be limited in scope. this is further evidence that nationality discrimination at least was not a serious concern by this time. the debate on whether to have a multilateral treaty generally was still continuing at the time of the oecd 1963 draft, the introduction to which left open the possibility of certain groups of countries entering into a multilateral treaty "until it proves possible, after further studies, to conclude a multilateral convention among all member countries of the oecd."l2 1 i believe that this was the last statement made by the oecd raising the possibility of a model multilateral treaty. c. in the same circumstances originally there was no reference to the same circumstances in the nationality non-discrimination provision on the basis that this is inherent in the concept of discrimination. it was not included in the early uk treaties that were the source of the drafting of the oeec provision, but it had been added in the uk-switzerland treaty (1954) because during the negotiations for that treaty switzerland had queried whether they were required to treat a uk national resident in the uk in the same way as a swiss national resident in switzerland. 12 2 the uk suggested the addition of "in the like circumstances" in both the nationality and the ownership non-discrimination provisions. the belgian and swiss delegates to the oeec proposed "in identical/similar circumstances." working party 4 was of the opinion that such an addition was unnecessary but agreed to the addition of "in the like circumstances."l2 3 it is not clear why "identical circumstances" was not adopted because the comparator, being hypothetical, can always be in 119. article 24 comm 30. 120. fc/m(57) 3 (nov. 5, 1957), at 9. 121. introduction t 2. 122. uk national archives, public record office file ir40/11451 at 283j. the nationality provision was the same as the current model's but without these words. 123. fciwp4(57) 2, at 2 (may 10, 1957). 32 [vol. 10:1 understanding the oecd model tax convention identical circumstances (unless there is nobody in identical circumstances,124 in which case the comparison cannot be made and there can be no discrimination). unfortunately, use of the like (later, same) circumstances led to the commentary's odd statement: "the expression 'in the same circumstances' refers to taxpayers (individuals, legal persons, partnerships and associations) placed, from the point of view of the application of the ordinary taxation law and regulations, in substantially similar circumstances both in law and in fact."l 25 the reference to similar circumstances in law is strange; clearly the discriminatory legal provision must be excluded from the circumstances in law. d. other or more burdensome taxation or requirements connected therewith the current "other or more burdensome" was originally "other, higher or more burdensome" in the early uk treaties that were the source of the drafting of the oeec nationality provision.126 one suspects that this was intended to cover, respectively, a different tax, a higher rate of the same tax, and more burdensome connected requirements, the belgian delegation proposed more burdensome only, and working party 4 countered with "taxation which is other than the taxation"l27 imposed on its own nationals, on the basis that this would also cover higher taxation.128 in the end they compromised on "other or more burdensome" which had in fact been first used in the us-uk treaty of 1945; this makes the reference to "higher" taxation unnecessary. this expression was explained by working party 4 in an interpretative comment to mean that tax may not be in another form (no different tax, no different mode of computing the taxable amount, no different rate, etc.) and that the formalities connected with 124. for example, a non-resident national if nationality is the test for residence, as is common for corporations. 125. article 24 comm $ 7. apart from defining same to mean substantially similar, which is unnecessary, the reference to similar circumstances in law is strange as the law will be the cause of the discrimination. 126. the league of nations london and mexico drafts used "higher or other" taxes in what was then a residence non-discrimination provision. early us treaties contained other variations: u.s.-canada (1942) "more burdensome;" u.s.france (1939) "higher;" u.s.-sweden (1939) "higher or other." 127. connected requirements are not mentioned but presumably were intended to be covered. 128. fc/wp4(57) 2 (may 10, 1957), at 2. 2009] 33 florida tax review the taxation (returns, payment, prescribed times, etc.) may not be more onerous.12 9 the uk privy council later (and without having the benefit of this history) came to the same conclusion in woodend rubber co. v. commissioner of inland revenue: 130 to speak in this context of 'other' taxation must ... at least include some income tax other than the income tax to which resident [in a non-discrimination provision based on residence, rather than nationality] companies are subjected. the ceylon (as it then was) tax in question was a branch profits tax measured by reference to (rather than charged on) the remittances to the head office made out of the permanent establishment state, amounting to one-third of the remittances up to a maximum of one-third of taxable income. resident companies, on the other hand, paid an additional tax equal to one-third of the dividends paid, which was deductible from the dividends. this was in form an additional tax on the profits of the company, rather than a withholding tax on the dividends. since resident companies did not pay tax on remittances abroad, the tax on nonresident companies was an "other" tax, which was prohibited by the residence (in that treaty) non-discrimination provision, even though the charge to tax was all part of income tax. the tax was actually less burdensome since tax on the non-resident company was a maximum of one-third of taxable income when the remittances exceeded one-third of taxable income, while the additional tax on a resident company was one-third of the dividends paid out of the profits, whatever their amount. e. public bodies and charities originally the commentary's statements that public bodies are not included was contained in the draft article: (3) the provisions of paragraph 1 of this article shall not have the effect of requiring a member country of the oeec which accords special [taxation] privileges to public bodies or services, or to private institutions not for profit whose 129. fciwp4(57) 3 (sep. 13, 1957) at 5. 130 [1971] a.c. 321, 332f. [vol 10:134 understanding the oecd model tax convention activities are performed exclusively in the religious, charitable, artistic or scientific field or in any other field of cultural life, or for social or national defense purposes, to extend the same privileges to the like bodies of another member country.131 the fiscal committee deleted itl 32 in favour of including a comment, and working party 4 added the following to the commentary: "from this point of view such [public] bodies and services can never be in comparable circumstances to those of the public bodies and services of another state; their position in relation to the state to which they belong is a unique one." and in relation to private charities working party 4 said: "such institution[s] likewise have a unique position in relation to the state to which they belong, since the taxation privileges are accorded them not because they derive their status from the law of that state (although this might be one of the conditions prescribed for the granting of the privileges), but rather because their activities are performed for purposes of public benefit which are specific to that state. example: state a gives exemption from tax on estates of deceased persons in respect of legacies to charitable institutions which derive their status as such from its law and whose activities are performed in its territory. paragraph (1) does not imply that state a must give exemption in respect of legacies received by a charitable institution whose activities are performed in the territory of state b. but state a will be bound to give the exemption to a charitable institution which derives its status as such from the law of state b but whose activities are performed in the territory of state a (although, of course, any other conditions to which the exemption may be subject e.g. the condition of being established in state a must be satisfied). 133 131. fc/wp4(57) 2 (may 10, 1957), at 10. 132. fc/m(57) 1 (jan. 11, 1957) at 4. 133. fc/wp4(57) 3 (sep. 13, 1957), at 9-10. note the distinction made between governing law and place of establishment, also made in the ownership nondiscrimination provision below. 2009] 35 florida tax review it seems that these statements were intended to be restricted to activities of the state and charities for the benefit of the state concerned, whereas many charities formed in a state benefit persons outside the state, and so it is difficult to see why discrimination against such charities governed by the law of the treaty partner state should not be prevented. f. the permanent establishment non-discrimination provision in spite of the initial focus on nationality discrimination, the permanent establishment provision seems to have been regarded as the most relevant provision in practice. it was described as being "of great importance for the development of commercial and industrial activity across the frontiers."' 34 the type of discrimination identified was explained as follows: the replies to the questionnaire show that, in a number of member countries of the oeec, non-domiciled persons (individuals and corporate bodies) are in several respects subjected to different treatment from that applied to domiciled persons. the working party will confine itself to giving a few examples of this. it is the case that one state allows persons domiciled in its territory to deduct, in computing their profits, all expenditure incurred in carrying on a business, whereas non-domiciled persons, for the purpose of computing profits from business carried on in its territory, may take into account no more than the expenditure laid out in its own territory, so that expenditure incurred out of its territory for the purposes of the same business is unallowed.135 moreover, there are some states which give non-domiciled persons no relief for losses incurred in carrying on a business situated in their territory while they give different treatment to persons domiciled in its territory. finally, it was found that some legislations prescribe a notional method of computing the taxable profits of foreign transport businesses. 36 134. fc/wp4(57) 2 (may 10, 1957), at 6. i believe that the state referred to is belgium. 135. this was also the reason for what is now article 7(3). 136. fc/wp4(57) 1 (jan. 11, 1957), at 6. 36 [vol 10:1 understanding the oecd model tax convention it is clear that in practice discrimination against permanent establishments were far more widespread that discrimination against nationals. the delegate for switzerland suggested drafting the permanent establishment provision in terms of nationality rather than a residence, making the comparison with an enterprise engaged in the like business and possessing the nationality of that other contracting party.'37 working party 4 rightly disagreed saying that it had nothing to do with nationality.' but this debate is the reason for the commentary still saying what seems to be obvious: strictly speaking, the type of discrimination which this paragraph is designed to end is discrimination based not on nationality, but on the actual situs of an enterprise.13 9 g. enterprise the term enterprise is used in the legal, and consequently the tax, systems of civil law countries, and is a term derived from economics. the model today uses the word in several different senses. in french, enterprise can mean either the person or the activity depending on the context: this accounts for the use of both meanings in the english version of the model which makes it difficult to understand as this is not normal english usage.1 the us model avoids this problem by referring in article 7 to the "business profits of an enterprise," where "enterprise" refers to the taxpayer. there are other difficulties with the english in the definition of permanent establishment in article 5: "... a fixed place of business through which the business of an enterprise is wholly or partly carried on." the french version of "...une installation fixe d'affaires par l'intermidiaire de laquelle une entreprise exerce tout ou partie de son activitd" (meaning, a fixed place of business through which the enterprise carries on all or part of its activities), is much clearer than the english. article 7, the business profits article, read with the definition of "enterprise of a contracting state" is also clearer in french: "les bindfices [d'une entreprise exploitle par un risident d'un etat contractant] ne sont imposables que dans cet etat, a moins que l'entreprise 137. fc/m(57) 3 (nov. 5, 1957), at 7. 138. fc/wp4(57) 4 (7 nov. 7, 1957), at 2. 139. article 24 comm 1 33, originally fc/wp4(57) 3 (sep. 13, 1957) at 11 in an interpretative note that "nationality plays no part in this type of discrimination;" original version of the commentary at fc/wp4(58) 1 (19 feb. 19, 1958) at 7. 140. see k. van raad, "the term 'enterprise' in the model double taxation conventions-seventy years of confusion" in essays in international taxation, festschrift for sidney i roberts (kluwer, deventer, 1993) at 317; intertax, 1994/11 p. 491. he lists examples of the model using enterprise in the sense of the person, and in the sense of the business, and those that could mean either. 2009] 37 florida tax review n'exerce son activit6 dans l'autre etat contractant par l'intermidiaire d'un itablissement stable qui y est situd" (meaning, the profits of an enterprise [carried on by a resident of a contracting state] shall be taxable only in that state unless the enterprise carries on its activities in the other state through a permanent establishment), compared to the english "...unless the enterprise carries on business in the other state...."41 one can see the seeds of the problem in the discussions on the permanent establishment non-discrimination provision. the draft was originally in terms of an operator (entrepreneur): profits which an operator [in the original french version les entrepreneurs] domicile[d] or established in a member country of the oeec through a permanent establishment situated therein shall not be less favourably computed by the latter member country than similar profits obtained by an 142 operator established or domiciled in its own territory. the fiscal committee instructed working party 4 to consider whether the word "entrepreneur" (operator) should not be replaced by the word "entreprise" (enterprise).143 they failed to take the hint as it seemed to them that the choice between these two terms should depend on the terminology used in the convention in which the provision in question will be inserted. they proposed that the word "entrepreneur" should be maintained for the time being, and observed that it very frequently happens that it is not the enterprise itself that is taxed but the individual who operates it. the advantage of the word 'entrepreneur' was that it applies both to individuals and to legal persons and taxpayers assimilated thereto.1" the fiscal committee also wanted the provision to apply to all taxes to which a permanent establishment might be subjected, which resulted in dropping the reference to profits. 14 5 the working party's final version, which still used entrepreneur in english, was: (4) the taxation levied by any contracting party on permanent establishments situated in the territory of that contracting party and owned by an entrepreneur domiciled or established in the territory of any other contracting party 141. see also "does 'enterprise' in the oecd model mean 'business'?" (2006) 60 bulletin for international taxation no.12 p. 476 (oecd/ifa seminar 2006). 142. fc/wp4(57) 1 (jan.11, 1957) at 7. 143. fc/m(57) 2 (jul. 3, 1957), at 4. 144. fc/wp4(57) 3 (sep.13, 1957), at 12. 145. fc/m(57) 2 (jul. 3, 1957), at 4. 38 [vol. 10:1 understanding the oecd model tax convention shall not be less favourable than that levied on an entrepreneur domiciled or established in its own territory and carrying on the same activities. the original draft of the commentary stated: finally, with regard to the use of the word 'entrepreneur' in the first paragraph of paragraph 4, the question was raised whether it would not be better to use the word 'enterprise' instead. the word 'entrepreneur' has been adopted become it has the merit of designating both. 14 6 the fiscal committee, as might have been expected from their earlier comment, came to the opposite conclusion and changed entrepreneur to enterprise: finally, with regard to the use of the word 'enterprise' in the first sub-paragraph of paragraph 4, the question was raised whether it would not be better to use the word 'entrepreneur' instead which had the merit of designating both individuals and legal persons and of thus being applicable where it is not the enterprise itself that is taxed but the individual carrying on the enterprise. the word 'enterprise' was finally selected, it being understood that the choice between the two terms might depend on the terminology used in the convention in which the provision is to appear.147 enterprise fits perfectly well in the permanent establishment nondiscrimination provision; it is the other references in the model that are the problem in english. h. not less favourably levied a swiss proposal would have harmonized the wording of taxation which is other, higher or more burdensome with the nationality provision. 148 working party 4 thought that this would have greater repercussions on member countries' law and preferred a more restricted version that enabled different methods of taxation of a permanent establishment. the working party was also asked to mention in the official comments that to tax, for reasons of practical convenience, non-domiciled 146. fc/wp4(58) 1 (feb.19, 1958) at 8. 147. fc(58) 2 (1st revision) part ii (apr. 19, 1958), 1 17 at 27. 148. fc/wp4 (57) 2 (may 10, 1957), at 6. 2009] 39 florida tax review persons differently from domiciled persons does not constitute discrimination so long as this does not result in more burdensome taxation on the non-domiciled persons than on the others. the working party considers that the words 'shall not be less favourably assessed' give the right to apply such different taxation. but the states should limit their claims in this respect, by endeavouring not to resort to different taxation unless it is in keeping, not only with their own conceptions, but also with generally accepted standards. 149 the different wording of the permanent establishment provision is therefore deliberate. i. the ownership non-discrimination provision the ownership provision was originally proposed to working party 4 by the swiss delegation.'50 such a provision had been contained in its treaty with the uk (1954) and it had been in general use by the uk from the early 1950s in its treaties with countries outside its dominions and colonies, although this is not mentioned in the working party's minutes.' 5' the usual form of the ownership provision in these uk treaties was: the income, profits and capital of an enterprise of one of the territories, the capital of which is wholly or partly owned or controlled, directly or indirectly, by a resident or residents of the other territory, shall not be subjected in the firstmentioned territory to any taxation which is other, higher or more burdensome than the taxation to which other 149. fc/wp4(57) 3 (sep. 13, 1957), at 12. 150. fc/wp4(57) 2 (may 10, 1957), at 7. 151. see uk treaties with: denmark (1950), france (1950), norway (1951), finland (1951), greece (1953), belgium (1953) (which stated that the provision was not to affect a specific treaty provision that profits distributed by a belgian company to its uk 90% holding company were to be taxed at the lower rate on undistributed profits), switzerland (1954), germany (1954), and austria (1956) (ending "...other enterprises of the first-mentioned territory similarly carried on are or may be subjected"); it was not included in us (1946), netherlands (1948), or sweden (1949). the working party acknowledged the origin of the wording of the nationality provision and the definition of nationality as "based on a provision which is to be found in the conventions for the avoidance of double taxation concluded between the united kingdom and most of the countries represented in the committee." non-discrimination articles were not included at that time in treaties with the dominions or colonies presumably because nationality discrimination was not relevant. 40 [vol. 10:1 understanding the oecd model tax convention enterprises of that first-mentioned territory are or may be subjected in respect of the like income, profits and capital.15 2 the swiss proposal was accepted by working party 4 on the basis that it was unlikely ever to apply: it would appear that the discrimination arises only very rarely in the member countries of the oeec. the working party therefore considers that the member countries will find it easy to accept the proposed provision. nevertheless, such a provision will be of the fullest importance in relations with countries which see no objection in applying such discrimination. accordingly, the working party considers that it should insert this provision in its draft article subject to slight modifications.* *[footnote to the original] indeed it is not easy to see how the swiss delegation's proposal can have any real significance. the proposal mainly concerns companies under foreign control, as is made clear in the delegation's commentary. however, although it is true that the company's nationality is sometimes determined by reference to the country of origin of the capital invested in it and of the individuals controlling it, the effect of the article proposed by the working party is that in determining a company's nationality one must look to the law governing companies. hence, one of two things: assuming that a company established in state a is controlled by persons domiciled in another state b, then either it will derive its status as a company from the law of the latter state and possess in consequence that latter state's nationality, in which case, it should not, by virtue of the equivalent treatment clause, be subjected to treatment different from that which will be applied to a company possessing the nationality of state a; or it will possess the nationality of state a, in which case it is inconceivable that it could be subjected to discriminatory treatment as compared with other companies of state a on the ground that it is controlled by persons domiciled in state b, when, even if it derives its status from the law of state b, it ought in virtue of the equivalent treatment clause to receive the treatment ordinarily applied in state a. having defined nationality in terms of governing law for the purpose of the nationality non-discrimination provision, the working party's argument was that for a company incorporated in state a and owned by 152. only uk-switzerland (1954) added "in similar circumstances" after the last "subjected." in all these uk treaties (except with belgium) the nondiscrimination article applied to all taxes but the opening words effectively restrict the application of the ownership provision to taxes on income, profits and capital. 2009] 41 florida tax review residents of state b there were two possibilities: (1) if the company is regarded as governed by the law of state b on account of being controlled by residents of that state, as the state of origin of the capital, 53 it will already be protected by the nationality non-discrimination provision' 54 (for which nationality is equated to governing law;15 5) or (2) if it is governed by the law of state a on account of its being incorporated in that state, it is highly unlikely that state a would discriminate against it by treating two companies governed by its law differently, particularly when, under the nationality nondiscrimination provision, it must not treat a company governed by its law better than one governed by state b's law. in other words, whichever system of defining governing law of a company applied, there was protection against discriminating against it, however, unlikely discrimination might be in the latter case. the swiss delegation's original draft, which is the same as the ukswitzerland treaty (1954) with some minor drafting changes, was: the income, profits and capital of an enterprise of one of the states, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more persons domiciled in the other state, shall not be subjected in the first-mentioned state to any taxation which is other, higher or more burdensome than the taxation to which other 153. civil law states ask why should legal relations between members of a company, or as between them and the company, or involving third parties, be determined by a state b court based on the corporate law of state a where the members of the company (and particularly where also the assets) are in state b? in the most fundamental sense, their premise is that incorporation is a legal fiction that provides the members with certain privileges, including in certain cases protection from liability, so they would ask why should those members be able to choose privileges under a foreign law (meaning foreign not just as one that is other than that of state b but one that has little if any connection with the members (and, possibly, the assets)) that are superior to the privileges that state b law has decided to accord? common law states look only to the country of incorporation for the governing law, perhaps because traditionally they have not had large minimum capital requirements and so there was no incentive to incorporate a company elsewhere to reduce this. 154. nationality non-discrimination provisions existed in the mexico and london models: "a taxpayer having his fiscal domicile in one of the contracting states shall not be subject in the other contracting state, in respect of income he derives from that state, to higher or other taxes than the taxes applicable in respect of the same income to a taxpayer having his fiscal domicile in the latter state, or having the nationality of that state." this is wider than the present article 24(1), applying to residence as well as nationality, although the residence part may have been intended as a permanent establishment non-discrimination provision, which it later became. 155. see supra note 116. 42 [vol 10: 1 understanding the oecd model tax convention similarl56 enterprises of that first-mentioned state in the like circumstances are or may be subjected in respect of the like income, profits and capital.'57 working party 4's first draft, which as already mentioned, was intended to be a multilateral convention on non-discrimination, was: the income, profits and capital of an enterprise established in a member country of the oeec, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more persons domiciled in some other member country, shall not be subjected in the first-mentioned country to any taxation which is other, higher or more burdensome than the taxation to which other similar enterprises in the like circumstances establishment in that first-mentioned country are or may be subjected in respect or the like income, profits and capital. 158 although the deletion of this provision was proposed by italy in the fiscal committee159 working party 4 apparently took no notice and their subsequent draft for a bilateral treaty was: an enterprise established in the territory of one of the contracting parties, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more 156. this word was not in the uk-switzerland treaty (1954) and has remained in the model. 157. rc/wp4 2 (may 20, 1957), at 8. in french: <<les revenus, bnefices et capitaux d'une entreprise de l'un des deux etats, dont le capital est en totalitd ou en partie, directement ou indirectement ditenu ou contr6kl par une ou plus leurs personnes domicilides dans i'autre etat, ne doivent etre soumis dans le premier etat 6 aucune imposition autre, plus levie ou plus lourde que celle i laquelle sont ou pourront tre soumises, pour de semblables revenus, bdnefices et capitaux, d'autres entreprises analogues de ce premier etat se trouvant dans une situation semblable.) 158. fc/wp4(57) 2, at 10. (may 10, 1957). in french: << les revenus, binefices et capitaux d'une entreprise 9tablie dans un des etats-membres de l'o.e. c.e., dont le capital est en totalitg ou en partie, directement ou indirectement, ditenu ou contrd6l par une ou plusieurs personnes domicilides dans quelque autre etat-membre de l'o.e.c.e., ne doivent etre soumis dans le premier etat 6 aucune imposition autre, plus glevie ou plus lourde que celle a laquelle sont ou pourront 6tre soumises, pour des revenus, bdnefices et capitaux analogues, d'autres entreprises semblables 9tablies dans ce premier etat et se trouvant dans la mme situation. )) 159. fc/m(57) 2 (jul. 3, 1957), at 4. 2009] 43 florida tax review persons domiciled in the territory of another contracting party, shall not be subjected in the territory of the first mentioned contracting party to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which (other)16o similar enterprises in the like circumstances established in the territory of the first-mentioned contracting party are or may be subjected.' 6 ' the modifications were that the provision was no longer limited to income, profits or capital, 16 2 and the reference to "higher" taxation was deleted, as it had been in the nationality provision. the drafts compared two companies established in state a-one with local control and the other with state b control. the provision prevented discrimination against the one with state b control whichever was their governing law (and therefore nationality in the model). it was therefore more like an extension of the nationality nondiscrimination provision to prevent discrimination purely on account of 160. the reason for "other" being in brackets is found in the french version: <<une entreprise 9tablie dans le territoire d'une des parties contractantes, dont le capital est en totalitg ou en partie, directement ou indirectement, ditenu ou contrdk par une ou plusieurs personnes domicilides dans le territoire d'une autre partie contractante, ne sera soumise dans le territoire de la premidre partie contractante 6 aucune imposition ou obligation y relative, qui serait autre ou plus lourde que celle 6 laquelle sont ou pourront etre assujetties [the next word d'autres was crossed out and changed to les] entreprises semblables itablies dans le territoire de la premidre partie contractante et se trouvant dans la meme situation.)) 161. fc/wp4(57) 3 (sep. 13, 1957), at 3. this was adopted by the fiscal committee with minor drafting changes in fc/m(58) 2 (mar. 29, 1958), at 5: the opening words became "enterprises established" (les entreprises tablies), with a consequential plural ne seront soumises in the french, and the reference to "other" (les autres enterprises) was retained. 162. uk-switzerland (1954) and the other uk treaties (except with belgium) applied to all taxes but limited the ownership provision to income, profits or capital, presumably on the basis that it would not apply to other types of taxes (although there could be such taxes that were not within the treaty, such as local taxes). the swiss proposal that the non-discrimination article should apply to all taxes, see the heading taxes of every kind and description below was made at the same time and so they had deliberately limited this provision to taxes on income, profits and capital. it is interesting that the oecd model estate tax treaty has a non-discrimination rule applying to all taxes but only the equivalent of 1 and 2 of the oecd model on income and capital. its commentary says "it was decided not to include $$ 4 to 6 [now 3 to 5 after 1992 renumbering] of article 24 of the 1977 income tax model since the provisions of those paragraphs relate, more or less exclusively, to taxes on income and capital and are not appropriate in the concept of this model." 44 [vol. 10:1 understanding the oecd model tax convention foreign ownership where this did not give rise to different nationality, as defined to mean governing law.163 it seeks to treat in the same way discrimination based on the governing law (nationality) of the company and that based on the residence of the shareholders.' 6 the following example was given of the type of circumstance covered by the ownership provision: example: state a subjects companies established in its territory to special profits tax if the majority of the shares in them are owned by persons not domiciled in it. the result is that a company established in the territory of state a, all the shares in which are owned by persons domiciled in that state, is not subject to the special tax, while another company which is also established in the territory of state a, but all the shares in which are owned by persons not domiciled in that state, has to pay the tax. the purpose of paragraph (5) is to prohibit such difference in treatment of taxpayers who are equal to one another from all points of view. as a result of paragraph (5), therefore, state a will no longer be able to subject the last-mentioned company to the special tax.165 the reference to enterprises established in a state was later changed by the fiscal committee to "enterprises of a contracting state," defined to mean resident of the contracting state concerned.'6 6 this was not intended to be a change of substance because it had previously been assumed that a company established in a state was a resident of that state, as can be seen from the commentary's reference to ensuring "equal treatment for taxpayers 163. it is interesting that the scope of the ownership provision corresponds exactly to the nationality provision by covering taxation that is other or more burdensome, and connected requirements that are other or more burdensome than those suffered by the object of comparison. by contrast the permanent establishment provision applies only to taxation that is less favourably levied. 164. it is interesting that canada splits the issues and treats them differently. canada generally grants non-discrimination protection to foreign nationals (along the lines of 24(1)), and to non-residents in respect of their canadian pes (along the lines of 24(3)), but reserves the right to discriminate against canadian companies that have foreign ownership or control by making the comparison with third country controlled companies in the ownership provision (a most-favoured nation test). 165. fc/wp4(57) 3 (sep. 13, 1957), at 13. it is not known whether there was an actual example of this at the time. canada does this today. 166. fc(58) 2(1st revision) part i (apr. 19, 1958), at 24. 2009] 45 florida tax review residing in the same state." that was not true of the uk and many other common law countries in which residence was not connected to incorporation until later.16 7 the ownership provision now compared two resident companies, whatever the governing law of the companies, one controlled by residents of the other state and the other with domestic control. the words "in the like circumstances," 68 near the end of the draft, which were included only in the uk treaty with switzerland (1954) out of the 1950s uk treaties containing an ownership provision,' 69 were subsequently deleted in the working party's final report for the following reasons: "first, they might lead to misunderstanding; secondly, they add nothing to the meaning of the provision, the purpose of which is to subject enterprises situated in a given state and under foreign control to the same treatment as similar enterprises likewise established in the same state." 70 logically, the words should have been deleted from the nationality provision for the same reason, but they still remain there. the early uk treaties did not say other similar enterprises, but just "other enterprises." the fiscal committee's minutes stated: "it was agreed that the expression 'other similar enterprises established in the territory of that first-mentioned contracting party' referred to enterprises not under foreign control." 71 this was implicit in the working party's original proposal, but unfortunately this statement was never included in the commentary (and nor was the provision redrafted accordingly). if it had been, it would have avoided the disagreements that have subsequently developed about the meaning of this phrase. for example, the uk revenue's long-standing interpretation 7 2 and their original argument in nec semiconductors ltd. and other test claimants v. ircl7 3 was that the comparison 167. one by one the common law countries adopted incorporation as an additional test for residence (australia 1930, canada 1961, south africa 1962 (at the same time replacing the common law test by place of effective management), uk 1988). management and control still applies to companies not incorporated in the state. 168. fciwp4(57) 4, at 5. (nov. 7, 1957). originally the nationality provision did not refer to the same circumstances either (fc/wp4(57) 1 (jan. 11, 1957)) on the basis that it was implied but "in the like circumstances" was added at the suggestion of the belgian and swiss delegates (fc/wp4(57) 2 (may 10, 1957)). 169. see supra note 152. 170. fc/wp4(58) 1 (feb. 19, 1958) at 4. 171 fc/m(58) 2 (mar. 29, 1958), at 5. 172. see [1978] btr 198. although in a memorandum to the select committee on statutory instruments (oct. 25, 1994, hc 20-xi) the revenue gave an example where the comparison was with a company owned by residents of the same state. 173. [2007] stc 1265. the case is also known as boake allen, ltd. v. irc, [2007] 1 w.l.r. 1386. 46 [vol. 10:1 understanding the oecd model tax convention should be with an enterprise owned by third-state residents. it was, however, accepted by all the uk courts' 74 that the comparison is with domestic-owned enterprises. the oecd discussion draft of may 3, 2007 considered that this interpretation was clear and that there was no need to change the commentary. 17 5 the history shows that the discussion draft was correct on this point. does similar add anything? it is not a substitute for the deleted reference to "in the same circumstances" as they were both contained in the original swiss proposal. it is suggested not, because sameness is inherent in the concept of discrimination. indeed it is unfortunate that the word "similar" was used. all the other references in the article are to same: "same circumstances" in article 24(1)176 and (2), "same activities" in article 24(3), and as a later addition, "same conditions" in article 24(4). the oecd discussion draft, in a passage that is not repeated in the 2008 update, raised an argument that the ownership provision had no relevance to domestic grouping provisions. it argued that "similar enterprises" referred to the company concerned as a separate enterprise only, so that transactions with other members of the group should be ignored since in respect of such transactions similarity could not be achieved between subsidiaries with domestic and non-resident parent companies: 11. these questions [relating to groups of companies] are linked to the meaning of the term "similar enterprises" in paragraph 5. contrary to paragraph 1, paragraph 5 does not explicitly require that the enterprises must be in the same circumstances. however, the term "similar enterprises" might imply that they should be comparable and that this is not always the case. the term "similar enterprises" might suggest that paragraph 5 is dealing with companies as separate entities only and that as far as transactions between the subsidiary and the parent are concerned, the subsidiary of a domestic parent might not be a similar enterprise. also, the question has been raised whether or not an enterprise is 174. park j in the high court lists four possible interpretations: uk subsidiaries of (i) other parent companies in the treaty-partner state (which he described as the most correct grammatical reading but obviously not intended); (ii) third-state parent companies (which was the revenue's contention; the amendment that canada makes in its treaties is to this effect: see note 164); (iii) uk parent companies (which he accepted as being the correct interpretation); (iv) that there are no similar enterprises, [2004] stc 489 at [27]. 175. oecd discussion draft 188. 176. but supra note 125 for the commentary's interpretation of the same circumstances to mean substantially similar circumstances. 2009] 47 florida tax review "similar" if the foreign parent company is not necessarily subject to national taxes on a worldwide basis. the history shows that this passage is extremely doubtful. first, nothing can be deduced from the absence of a reference to same circumstances, which was deleted as being unnecessary. secondly, there is nothing to suggest that similar has anything to do with looking at the company as a separate enterprise. thirdly, treating the subsidiary of a domestic enterprise as a similar enterprise as a comparator to the actual subsidiary of a foreign enterprise is the whole purpose of the ownership provision. lastly, having said that the provision deals with the subsidiary as a separate enterprise, why is the taxability of the parent company relevant at all? j. the deduction non-discrimination provision there are no discussions in the oeec about this provision, which was only added to the model in 1977. k. taxes of every kind and description it was the swiss delegation that proposed the inclusion of this paragraph, which on the face of it is rather dangerous; uk treaties, for example, do not include it, and indeed the provision under which treaties are given effect in domestic law does not enable them to do so. working party 4 approved the proposal in principle and the fiscal committee minutes do not record any disagreement.'m l. conclusion on non-discrimination while it is interesting to see how the non-discrimination article evolved, it is sad that nobody stopped to ask what the article was trying to achieve, which would have been helpful to those coming after in trying to construe it. the oeec set out to deal with discrimination on grounds of nationality as one of their four major topics, but found little. they included a nationality provision for good measure largely because this was found in 19th century non-tax treaties, such as consular or establishment conventions, and treaties of friendship or commerce, as the commentary still explains. a stateless persons' provision was designed solely for inclusion in a multilateral treaty on tax discrimination to mirror a then-recent multilateral non-tax law european convention, and it was retained without any explanation in a model for bilateral treaties. the important topic turned out to 177. fc/wp4(57) 2 (may 10, 1957), at 1. 48 [vol. 10:1 understanding the oecd model tax convention be discrimination against permanent establishments, the prevention of which they identified as being "of great importance for the development of commercial and industrial activity across the frontiers." but even that was drafted in a more restrictive form than the nationality provision, not covering "other" taxation, since to do so "would have greater repercussions on member countries' law and [the working party] preferred a more restricted version that enabled different methods of taxation of a permanent establishment." discrimination on grounds of foreign ownership was included essentially as a back-up to the nationality provision for those states who took a different view of nationality, as defined to mean the governing law. it was adopted because "it would appear that the discrimination arises only very rarely in the member countries of the oeec. the working party therefore considers that the member countries will find it easy to accept the proposed provision." the history of the ownership provision is relevant to the current debate about the effect on provisions relating to groups of companies. there was therefore no overview of the policy of a nondiscrimination article and because of the method of working parties operating independently there was no thought given to how it related to the rest of the model, such as the suggestion which has been made later that its purpose was that double taxation relief would be given only for nondiscriminatory taxes. that is why the non-discrimination article is, as mary bennett has said, "a concept in search of a principle."s 178. non-discrimination in international tax law: a concept in search of a principle (2005) republished in mason, ed., the tillinghast lecture 1996-2005 (new york, 2007, nyu school of law) p. 411. 2009] 49 florida tax review volume 8 2007 number 7 practical aspects of implementing formulary apportionment in the european union by joann martens weiner i. fundamental company tax reform in the european union 630 a. why a common company tax system for the european union? .................................... 632 b. pressures for company tax reform ................... 633 1. european court of justice ..................... 633 2. enlargement and globalization ............... 637 c. why formulary appointment in the eu? ............... 640 1. transfer pricing ............................ 641 2. advantages of formulary apportionment ........ 642 i. the ccctb working group ............................. 643 a. the basic contours of formulary apportionment in the european union ..................................... 645 1. the taxable connection ...................... 645 2. the taxable group .......................... 646 b. the apportionment formula ......................... 647 c. international aspects of formulary apportionment ....... 649 1. territorial vs worldwide taxation............... 651 2. water's edge limitation to the eu consolidated tax base .................................... 654 iii. economic impacts of formulary apportionment in the european union ........................................... 656 a. potential impact of formulary apportionment on individual m ember states ....................................... 656 1. us. multinational operations in europe ......... 656 2. financial accounts from a european company ... 656 3. possible revenue effects ..................... 659 b. theoretical and analysis ofeu formulary apportionment . 661 iv. conclusion ............................................ 667 practical aspects of implementing formulary apportionment in the european union by joann martens weiner' i. fundamental company tax reform in the european union the european commission is fast approaching its self-imposed deadline to present a legislative measure introducing a consolidated common corporate tax base and formulary apportionment within the european union in 2008. this deadline represents the culmination of work that began when the commission released a study in 2001 advocating that the european union adopt a new method of taxing eu multinational companies that would eliminate the tax obstacles to cross-border investment that undermine the international competitiveness of eu multinationals.2 the commission has concluded that the european union would not be able to function as a true internal market as long as its multinational enterprises had to contend with up to 27 different sets of company tax rules one set of rules for each of the 27 member states. eu business groups generally support the commission's efforts, noting that a common eu level company tax system would reduce the complexity and uncertainty surrounding corporate taxation in the eu. for example, the trade group business europe (formerly unice) has indicated that a common consolidated eu corporate tax base is the only way to eliminate the tax obstacles to cross-border business integration in the european union. eu multinationals could become more competitive and expend fewer 1. joann martens weiner is an adjunct professor of economics at the george washington university and is also the author of company tax reform in the european union. guidance from the united states and canada on implementing formulary apportionment in the eu, (new york: springer science + business media, 2006). the author presented this paper at the 2007 international tax symposium held at the university of florida levin college of law graduate tax program. i would like to thank prof. lawrence lokken for inviting me to this conference and to the participants in the seminar, especially paul mcdaniel and yariv brauner, for helpful comments. i extend a special thanks to michael durst for his detailed comments on the draft paper. any errors are my own. 2. see european commission, towards an internal market without tax obstacles, com (2001) 582 final. for an update on the project, see european commission, communication on further progress during 2006 and next steps toward a proposal on the common consolidated corporate tax base (ccctb), com (2007) final, may 2, 2007, available at http://ec.europa.eu/taxationcustoms/resources/ documents/common/whatsnew/ccctben.pdf. florida tax review [vol. 8:7 2007] practical aspects of implementing formulary apportionment 631 resources in complying with member states tax rules if they could use one set of tax rules to calculate their eu-wide profits. after analyzing many options, the commission settled on the strategy of allowing eu mne's to use a common consolidated corporate tax base (ccctb) to calculate their eu level profits and to use formulary apportionment (fa) to distribute a share of the consolidated eu tax base to each member states according to the location of their business activity. member states will continue to apply their own tax rates to their share of the eu tax base. the eu ccctb with fa will be optional so that eu multinational companies may continue to use national tax systems. this article addresses some practical aspects involved in implementing formulary apportionment in the european union. it first describes the basic landscape for company tax reform in the eu and identifies pressures coming from the european court of justice on member states to reform their company tax systems. it also describes the work being conducted by the ccctb working group at the european commission. second, it draws on experience from the u.s. states and canadian provinces to set forth the basic contours of a formulary apportionment system in the eu. it also deals with certain international issues, including technical aspects that arise when the scope of the system is limited to the boundaries of the eu. the u.s. state experience can be very helpful in this analysis, especially concerning the scope of the tax base and the definition of the formula. all u.s. states now allow multinational companies to limit application of their formulary apportionment system to the geographical boundaries of the u.s. (known as the water's edge). in moving away from worldwide taxation with formulary apportionment, the states have resolved many of the issues that the eu commission faces as it heads into the final stages of its project. third, the paper evaluates some of the pioneering research in this area on the economic effects of fa on investment and business location decisions. these papers evaluate particular aspects that deal with introducing a formulary method for taxing multinational companies in the eu. this paper does not evaluate the merits of formulary apportionment versus the arm's length system of taxation since the subject has been treated at length elsewhere.' it proceeds on the assumption that the political and economic 3.the list of papers in this area is wide-ranging. see reuven avi-yonah, the rise and fall of arm's length: a study in the evolution of u.s. international taxation, 15 va. tax rev. 89 (1995), revised and updated version available at http://law.bepress.con/umichlwps/olin/art73 (last visited nov. 20, 2007); eric coffill and prentiss willson, federal formulary apportionment as an alternative to arm's length pricing: from the frying pan to the fire?, 4 st. tax notes 1232 (1993); stanley langbein, the unitary method and the myth of arm's length, 30 tax notes 625 (1986); jerome hellerstein, federal income taxation of multinationals: replacement of separate accounting with formulary apportionment, 5 st. tax notes 407 (1993); conditions in the european union make formulary apportionment the best way to tax the income of multinational corporations in the european union.4 the political context is a key uncertainty surrounding the final contours of a possible ccctb with fa. although it has new methods, such as enhanced cooperation, to achieve its goals, the commission still faces tremendous barriers to reaching its goals. it must achieve a proper balance between preserving the sovereign rights of the individual member states and promoting the best interests of the european union as a whole. overcoming the political obstacles may prove more difficult than overcoming the economic obstacles; nevertheless, an analysis of the political negotiations and compromises necessary to achieve eu company tax reform are beyond the scope of this paper. a. why a common company tax system for the european union? the european union is now composed of 27 member states that have jointly decided to work together to "lay the foundations of an ever closer union among the peoples of europe."5 in making this commitment, these sovereign nations have undertaken a monumental task to create a common market together, united by a desire to expand economic growth and employment and to enhance the global competitiveness of the european union. the attractiveness of the european union as an economic and political union is evident its membership has more than quadrupled since its founding in 1957 by six european countries, belgium, the netherlands, luxembourg, france, germany, and italy. as the eu celebrates its 50th anniversary in 2007, it can recognize many achievements, especially the lack of any military conflict among the member states over this period, a peace that stands in sharp contrast joann martens weiner, using the experience in the u.s. states to evaluate issues in implementing formula apportionment at the international level, ota paper 83, office of tax analysis, u.s. dep't of the treas. (apr., 1999). for an international view, see organization for economic cooperation and development (oecd), transfer pricing guidelines for multinational enterprises and tax administrations (1995) [herinafter guidelines]. 4. for a detailed analysis, see joann martens weiner, formulary apportionment and group taxation in the european union: insights from the united states and canada, (european commission, taxation and customs union, working paperno. 8,2005) available at http://ec.europa.eu/taxationcustoms/taxation/gen info/ economicanalysis/tax_papers/indexen.htm (follow 'taxation paper no 8" hyperlink). 5. see treaty of rome pmbl., mar. 25, 1957,298 u.n.t.s. 11 (establishing the european economic community). the european economic community (eec) is now known as the european union while the treaty, which since 2002 is the consolidated version of the treaty establishing the european community, is known as the european community, or ec, treaty. for details on the treaty, see ruth mason, primer on direct taxation in the european union (2005). florida tax review [vol 8:7 2007] practical aspects of implementing formulary apportionment 633 to the two world wars fought largely in europe during the fifty years before the european community existed. the eu also shows tremendous achievements in the economic arena. the member states have eliminated internal tariffs, many have adopted the euro as the common currency, all have adopted generally common consumption tax rules, and they are working together to create a single market among the member states. despite these achievements, the eu has made only minor progress in eliminating the direct tax obstacles that eu multinationals encounter when expanding into another eu member states. the most important achievements occurred in 1990 with the parent-subsidiary directive,6 the mergers directive,7 and the arbitration convention the commission, however, has not been able to bring about a common eu company tax system. the existence of a different company tax system in each member states is a key source of the barriers to cross-border business expansion. it is the variation in tax rules, not the variation in tax rates, that creates the cross-border tax obstacles in the european union. complying with different rules in each member states imposes high compliance costs and creates a barrier to cross-border economic activity. b. pressures for company tax reform the eu member states are not moving with complete independence toward company tax reform. the main pressures to make their national tax systems compatible with the internal market come from two sources: in specific, from the european court of justice and the tax competition from the dozen newer member states and, in general, from globalization. 1. the european court of justice in more than a hundred cases dealing with direct taxation, the european court of justice has routinely found that numerous long-standing international tax rules in the member states were inconsistent with a single market. these decisions began with the 1986 avoir fiscal case concerning the french dividend imputation system and continue through cases concerning relief from double taxation of dividends, thin capitalization rules, controlled foreign 6. council directive 90/443 (eec). 7. council directive 90/435 (eec). 8. see the convention on the elimination of double taxation in connection with the adjustment of profits of associated enterprises, council directive 90/436 (eec). florida tax review corporation rules, exit taxes, and limits on cross-border loss deductions, among others.9 table 1 lists selected ecj cases in the direct tax area. table 1 selected european court of justice direct tax cases year case name issue 1986 c-270/83 2000 c-35/98 2000 c-141/99 2001 c-397/98 c-410/98 2002 c-324/00 2003 c-168/01 2004 c-315/02 2004 c-9/02 2004 c-319/02 2005 c-446/03 2006 c196/04 2006 2007 2007 2007 c170/05 c-292/04 c-231/05 c-34704 2007 c-157/05 2007 c-492/04 commission v. france (avoir fiscal) verkooijen amid metallgesellschaft. hoechst lankhorst-hohorst bosal holding bv lenz hughes de lasteyrie du saillant manninen marks & spencer cadbury schweppes denkavit meilicke oy aa rewe zentralfinanz holbck lasertec imputation tax credit dividend exemption cross border losses taxation of group income; advance corporation tax thin capitalization participation exemption; parentisubsidiary directive inbound foreign dividends exit tax cross-border dividend imputation credit group relief; cross-border loss compensation anti-deferral and controlled foreign corporation regimes dividend withholding tax tax credits for dividends group contributions write-downs on foreign participations third country dividend payments thin capitalization and noneu countries source: european commission broadly speaking, the ecj has such a strong influence on eu company tax rules because it takes a different view of company tax policy than do the individual member states. the ecj's goal is to create a seamless "internal union" where companies are able to invest in any member states within the european union without facing discriminatory taxation when they do so. 9. for a discussion of these cases, see michael j. graetz and alvin c. warren, jr., income tax discrimination and the political and economic integration of europe, 115 yale l.j. 1186 (2006). [viol. 8:7 2007] practical aspects of implementing formulary apportionment 635 the member states, however, often enact policies that protect their national tax bases, sometimes in a discriminatory fashion. as o'shea has commented, "what is 'tax avoidance' from one member state's perspective is simply an exercise of the freedoms from another state's point of view."'" in striving to create a seamless internal union, the ecj has repeatedly struck down member states tax measures that, to varying degrees, favor domestic companies or domestic investment over foreign companies or foreign investment. the ecj has found numerous national tax provisions that violate the fundamental freedoms the freedom of movement for goods, persons, services, and capital, and the freedom of establishment guaranteed in the eu treaty. it was not until the marks and spencer case in 2005," however, that the court seemed to accept that although certain features of national tax systems might not be entirely consistent with the internal market, they could, nevertheless, be acceptable for other reasons, such as maintaining the internal consistency of the tax system and preventing tax avoidance. the ecj walks a fine line between accepting member states tax policies that pursue national interests while also insisting that member states apply policies consistent with the single market. marks andspencer addressed the united kingdom's system of group relief and cross-border loss compensation. the uk government argued that since it had not taxed the foreign subsidiaries' profits when earned, it was not obligated to allow marks and spencer to offset the losses of those foreign subsidiaries when incurred. however, marks and spencer claimed that since uk law allowed it to offset losses from its uk subsidiaries against its uk profits, then uk law should also allow it to offset losses from its french, german, and belgian subsidiaries against its uk profits. the company argued that the uk government's failure to extend the domestic group relief scheme to foreign operations in the eu was a prohibited discrimination against freedom of establishment. in december 2005, the ecj ruled that the united kingdom was not required to extend its cross-border loss offsetting system broadly throughout the european union. in this particular case, however, because the company had no other possibility to offset its losses the court required the uk to extend the group taxation scheme to marks and spencer's foreign subsidiaries. thus, the ecj stopped short of requiring the uk to extend its group relief system throughout the eu. 10. see tom o'shea, the uk's cfc rules and the freedom of establishment: cadbury schweppes plc and its ifsc subsidiaries tax avoidance or tax mitigation? 2007/1 ec tax review 13 (2007) available at www.law.qmul.ac.uk/people/academic/ docs/cadburyschweppes ec tax review_2007_issuel.pdf. 11. case c-446/03, marks and spencer plc v. david halsey, 2005 e.c.r. i10837, 2005 ecj celex lexis 734. cadbury schweppes12 concerned the united kingdom's controlled foreign corporation legislation and the general question of whether member states may apply their anti-abuse rules broadly or whether they must limit them to so-called "artificial arrangements."13 the general purpose of controlled foreign corporation (cfc) legislation, which exists in the uk and in several other eu member states as well as in the united states, is to prevent abusive tax avoidance. in the united kingdom, subject to some exceptions, the cfc legislation applies where the host country taxes the subsidiary's profits at a much lower rate than they would be taxed in the united kingdom. under uk law, uk companies are taxed on their worldwide income, but income of their foreign subsidiaries is subject to uk tax only when the income is distributed to the uk parent. however, subject to certain exceptions, if the foreign subsidiary is subject to a rate of taxation that is less than three-fourths of the uk tax that would be paid on the foreign subsidiary's profits computed under uk rules, the cfc rules apply and the uk taxes currently such profits at the uk rate with a tax credit offered for foreign income taxes paid. in the relevant years, cadbury schweppes' subsidiaries in dublin were subject to a 10% rate of tax under ireland's international financial services centre regime while the subsidiaries would have been subject to a 30% rate of tax had they been located in the united kingdom. 4 this case attracted interest from several eu member states, including belgium, cyprus, denmark, finland, france, germany, ireland, italy, portugal, spain, sweden and the united kingdom. belgium and cyprus were the only eu member states that supported cadbury schweppes in its position that the uk could not broadly apply its anti-abuse rules. the european commission also expressed interest, arguing that cross-border investment should not be viewed as having an abusive motive if that investment has an economic substance. the court ruled that the uk's cfc legislation has a legitimate public purpose to prevent tax avoidance; nevertheless, it is valid only when the establishment of the foreign subsidiary is wholly artificial. merely incorporating the subsidiary in a low-tax area is not sufficient for the action to be invalid. to be invalid, the foreign subsidiaries must lack economic substance. the court ruled that eu member states have the right to counteract tax avoidance, but they must limit application of the rules to cases where tax avoidance is the sole purpose. under this reasoning, general anti-abuse rules may violate the ec treaty's freedom of establishment principle. however, as long as the subsidiaries provide genuine and actual services to the parent company, the fact that the parent company may reduce its overall tax burden by locating its operations in a low-tax area does not violate the freedom of establishment guaranteed by the ec treaty. 12. case c196/04, cadbury schweppes plc and cadbury schweppes overseas ltd. v. comm'rs of inland rev., 2006 e.c.r. 1-07995, 2006 ecj celex lexis 445. 13. id. at 51. 14. see id. at 14. although the european commission had sanctioned the special tax regime as legitimate state aid, in compliance with the eu code of conduct, ireland has phased out this legislation. florida tax review [vol. 8:7 2007] practical aspects of implementing formulary apportionment 637 after a series of rulings in favor of companies, in 2007 the ecj finally issued a broad ruling in favor of a member states. in oy aa, 5 finland allowed group relief for transfers among finnish-resident companies, but not for transfers between a finnish resident company and a non-finnish resident in the eu. thus, a finnish company could obtain a tax deduction for its taxable profits transferred to its loss-making finnish companies but not for profits transferred to its lossmaking uk-resident parent company. in oyaa the ecj found that although finland's group contribution regime discriminated on the basis of residence, and thus violated freedom of establishment, the court justified the measure as a legitimate attempt to prevent the use of purely artificial arrangements designed solely to transfer group income to companies resident in low tax member states. the court reasoned that the finnish measure struck an appropriate balance between the need to prevent tax avoidance and the need to raise revenue. without this restriction, the ecj reasoned, member states would be subject to the risk that companies would create "wholly artificial arrangements" to shift income to companies located in the member states with the lowest rate of tax. to attempt to coordinate these anti-abuse rules following these ecj decisions, the european commission adopted a communication in december 2007 that encourages member states to review their anti-abuse rules for the purposes of exploring possible coordinated action against abuse (see ip/07/1878). in the commission's view, because the member states' existing anti-abuse rules often do not take into account the goals of the eu as a whole, the ecj frequently finds that these rules violate the eu treaty. rather than abandon anti-abuse rules, however, the commission favors developing coordinated measures that balance the needs to prevent abuse with the desire to eliminate the barriers to cross-border activity in the european union. 2. enlargement and globalization eu enlargement and economic globalization are putting additional pressures on the tax systems in the member states. the twelve newer member states that have joined the eu since 2004, many of which only recently adopted a corporate income tax, tend to tax corporate income at a lower rate than do the older member states. table 2 shows the eu statutory corporate tax rates in 2007. these rates range froml 0% in bulgaria and cyprus to nearly 40% in germany (germany reduced its rate to just below 30% effective january 2008).most eu member states have reduced their statutory tax rates in recent years. the average rate in the eu 15 member states has fallen by roughly ten percentage points over the past decade. the rate declines in the newer member states are even more dramatic, with the average rate falling by nearly 15 percentage points over this period. moreover, many of the newer member states have relatively low statutory rates. the newest 15. case c-231/05, oy aa, 2006 e.c.r. 1-7605, 2006 ecj celex lexis 1049. florida tax review member states, bulgaria and romania, tax corporate income at 10% and 16%, respectively. chart 1 shows the statutory tax rates in the eu 27 member states for 2007. chart 2 shows the development in these tax rates and the variation in rates since 1995. these data show the dramatic declines in the top statutory tax rates over the past decade. (the eu-15 are the older member states and the eu12 are the newer member states.) the chart also shows that the variation in statutory tax rates has not changed significantly during this period. table 2 corporate income tax rates in the european union member states, selected years eu-15 member states 1995 2000 2004 2005 2006 2007 austria 34% 34% 34% 25% 25% 25% belgium 40.2 40.2 34 34 34 34 denmark 34 32 30 30 28 28 finland 25 29 29 26 26 26 france 36.7 37.8 35.4 35 34.4 34.4 germany 56.8 51.6 38.3 38.7 38.7 38.7 greece 40 40 35 35 29 25 ireland 40 24 12.5 12.5 12.5 12.5 italy 52.2 41.3 37.3 37.3 37.3 37.3 luxembourg 40.9 37.5 30.4 30.4 29.6 29.6 netherlands 35 35 34.5 31.5 29.6 25.5 portugal 39.6 35.2 27.5 27.5 27.5 27.5 spain 35 35 35 35 35 32.5 sweden 28 28 28 28 28 28 united kingdom 33 30 30 30 30 30 eu-12 member states 1995 2000 2004 2005 2006 2007 bulgaria 40% 32.5% 20% 15% 15% 10% czech republic 41 31 28 26 24 24 cyprus 25 29 15 10 10 10 estonia 26 26 26 24 23 22 hungary 19.6 19.6 17.6 17.5 17.5 18.6 latvia 25 25 15 15 15 15 lithuania 29 29 24 15 15 15 malta 35 35 35 35 35 35 poland 40 30 19 19 19 15 slovakia 40 29 19 19 19 19 slovenia 25 25 25 25 25 23 romania 38 25 25 16 16 16 average eu-15 38.0% 35.4% 31.4% 30.1% 29.6% 28.9% average eu-12 32.0 27.6 21.6 19.7 19.8 18.8 average eu-27 35.3 31.9 27.1 25.5 25.3 24.4 source: commission services. commission of the european communities, eurostat, taxation trends in the european union. data for the eu member states and norway, 2007 edition. [vol 8:7 2007] practical aspects of implementing formulary apportionment chart 1. eu-27 adjusted top corporate tax rate, member states and eu averages, 2007 45 40 3. 32 34 a 3 20 22 1.05a 25 2 20 w6u8 18.8 o to' 1516t 15 12.1 10 it q0 chart 2. eu27 adjusted top corporate tax rates, 1995 to 2007 so1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2008 2005 2007 1 eu 7 aver.ge eu 27 plus one std 0ev eu 27 minu me s5 dev i florida tax review c. formulary apportionment in the eu these pressures to undertake company tax reform in the eu do not necessarily lead to formulary apportionment. thus, one question that arises is why the commission is now pursuing formulary apportionment rather than pursuing the traditional methods it has favored in the past? the history of company tax reform efforts in the eu helps understand the change in direction. these earlier efforts, in one form or another, all relied on the traditional methods that essentially centered on deciding which "national" tax system was the "best" national tax system for the european union. these methods include partial imputation, classical, and split-rate, among others. despite many attempts, the member states never agreed on which method is the "best" method and, thus, never moved beyond the initial stages of implementing eu company tax reform. 16 in 2001, the european commission decided to take a new direction and examine modem concepts for taxing international income. the european commission broke from tradition when it proposed a new strategy for taxing multinational companies in the european union. in so doing, the commission recognized that the 21st century economy bears little resemblance to the economy that existed at the turn of the 20th century. a century ago, since there were few cross-border transactions for member states to be concerned about when designing their tax policies, companies generally created a physical presence when conducting business in other countries. thus, basing a tax system along geographical borders for separate companies doing business in the country seemed entirely reasonable. by 2001, cross-border transactions dominated multinational investment in the european union and companies could conduct their cross-border business among their related affiliates without necessarily establishing a physical presence in the foreign country. geographic boundaries became increasingly irrelevant for determining where a multinational company earned its income. in light of this blurring of geographic boundaries, it became evident that the european union should consider "borderless" approaches to taxing multinational enterprises. rather than requiring each multinational corporate group to attempt to calculate its profits "as if" they had been earned by independent entities operating at arm's length within national borders, the commission suggested allowing each multinational company to calculate its eu profits as if the internal borders were not relevant to how they organized their operations. thus, 16. the european commission began issuing company tax reform proposals shortly after the creation of the common market, starting with the 1962 neumark committee and continuing to the 1992 ruding report. its only formal proposal occurred in 1975 when the commission proposed a common partial imputation system, which it withdrew in 1990. for detail see supra note 2. [vol. 8:7 2007] practical aspects of implementing formulary apportionment 641 the commission proposed developing an eu level common consolidated corporate tax base and then using a common formula to distribute the eu tax base to the individual member states for taxation at local rate.17 in another break from tradition, the european commission is not proposing that the eu system replace the tax system in each member states. it has taken an innovative approach of allowing multinational enterprises the option to adopt the eu level tax rules or to continue to use the national rules. 1. transfer pricing formulary apportionment does not require calculating transfer prices for controlled transactions. thus, it avoids many of the complexities of the transfer pricing system. the transfer pricing regime that is a fundamental part of the separate entity accounting method has several weaknesses. under international tax practices, multinational corporations determine the income earned in each country according to the separate accounting with arm's length pricing method.'" companies price internal controlled transactions according to the prices that companies operating independently would have used. in theory, national tax authorities have the ability to verify that the amount of income that the multinational attributes to its country is the correct amount, as determined under the transfer pricing rules. in practice, tax payers and tax authorities often disagree about those amounts. since the transfer price determines where income is allocated, the tax authorities have a strong interest in ensuring that companies establish the proper transfer prices. if the competent authorities can not reach agreement on the amount of income attributed to each country, the company may suffer unrelieved double taxation. the amounts in dispute can be substantial a recent transfer pricing dispute involving glaxosmithkline and the u.s. tax authorities involved more than $13 billion in transfer pricing adjustments. asserting that glaxo 17. using a formula to distribute profits acrossjurisdictions is generally known as formulary apportionment. using a system of internal transfer prices to distribute these profits is generally known as 'separate entity accounting with arm's length pricing. the separate entity accounting system is also often known as separate accounting and the arm's length method is also known as the arm's length standard or the arm's length principle. the definition of the taxable group is also often referred to as a consolidated group or as a unitary group, depending on the context. unless the context requires otherwise, for simplicity and consistency, this article uses the terms formulary apportionment and consolidated group. 18. for the united states, these rules are contained in § 482 of the internal revenue code and are expanded upon the regulations. "a controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm's length result)." reg. § 1.482-1 (b)(1). florida tax review improperly shifted profits to its uk parent company, the irs reallocated a substantial amount of the company's income to the united states. glaxo had requested relief from the u.s. and u.k. competent authorities, but the bilateral negotiations failed when the british tax authorities supported the company's view that it did not owe any additional taxes to the u.s. glaxo reached a settlement with the irs in september 2006. 2. advantages offormulary apportionment its advocates argue that formulary apportionment better reflects the economic reality of multinational (or, more generally, multijurisdictional) firms' corporate structure than the separate entity system does. 9 consolidated taxation with formulary apportionment does not require firms to draw artificial boundaries among the various, integrated parts of the corporation and then to price the transactions occurring between the members "as if' they operated at arm's length. by contrast, the separate entity system with arm's length pricing rests solidly on the view that an integrated company is able to find prices that independent entities operating at arm's length would use to price comparable internal transactions among dependent entities. increasingly in the global economy, however, no independent transactions exist for the transfer of unique items, such as intangibles or services. walter hellerstein summarized this point: "a key reason to employ formulary apportionment, whether to a single corporation or to a group of commonly controlled corporations, is because they are engaged in integrated cross-border economic activity that cannot readily be treated on an arm's length/separate-geographic accounting basis."20 as the economic integration in the european union has deepened, so has support for formulary apportionment.2 weiner (1994) conducted an early analysis of the impact of formulary apportionment on investment in the european community.22 drawing from their experience in state corporate income taxation, charles mclure and walter hellerstein have argued in favor 19. for an analysis of this issue, see jinyan li, international taxation in the age of electronic commerce: a comparative study (2003). 20. see walter hellerstein, international income allocation in the twenty-first century: the case for formulary apportionment, 12 int'l transfer pricing j. 103 (2005). 21. see joann martens weiner, company tax reform in the european union. guidance from the united states and canada on implementing formulary apportionment in the eu, new york, springer, (2006). 22. see joann martens weiner, company taxation for the european community. how sub-national tax variation affects business investment in the united states and canada (1994) (unpublished ph.d. dissertation, harvard university) (on file with author). [vol. 8:7 2007] practical aspects of implementing formulary apportionment 643 of introducing formulary apportionment in the european union. other authors, including marcel gdrard, peter sorensen, and christoph spengel support formulary apportionment in the eu. 23 although it has definitely not endorsed global formulary apportionment, the oecd recognizes that the economic integration in the eu has caused the european commission and many member states to "rethink" their views of formulary apportionment.24 the oecd member countries have adopted profit-based methods that resemble formulary apportionment methods.25 i. the ccctb working group with the approval of european union economics and finance ministers, the european commission established a common consolidated corporate tax base (ccctb) working group in 2004 to evaluate the technical details involved in moving to a common eu tax base. since its first meeting in 2004. the commission's ccctb working group and the various subgroups have met more than a dozen times to focus on the technical details of the common consolidated corporate tax base with formulary apportionment. 26 the 23. see walter hellerstein and charles e. mclure, jr., the european commission's report on company income taxation: what the eu can learn form the experience of the u.s. states, 11 int'l tax and public fin. 199 (2004); walter hellerstein and charles e. mclure, jr., lost in translation: contextual considerations in evaluating the relevance of u.s. experience for the european commission's company taxation proposals, 58 bull. int'l fiscal documentation 86 (mar. 2004); charles e. mclure, jr., corporate tax harmonization for the single market; what the european union is thinking, business economics oct. 2004, at 28, marcel g6rard, multijurisdictional firms and governments' strategies under alternative tax designs, (cesifo,working paper no. 1527, 2005) available at http://www.cesifogroup.de/doccidl/cesifo l_wp 1527.pdf, peter birch sorensen, company tax reform in the european union, 11 int'l tax and public fin. 91 (2004); christoph spengel, presentation at the international tax conference, berlin: concept and necessity of a common tax base an academic introduction (may 15, 2007). 24. see organization for economic cooperation and development, are the current treaty rules for taxing business profits appropriate for e-commerce?, public discussion draft (nov. 26, 2003), available at http://www.oecd.org/dataoecd /2/38/20655083.pdf. 25. see robert e. culbertson, a rose by any other name: smelling the flowers at the oecd's (last) resort, 10 tax notes int'l 370, 376 (1995); guidelines, supra note 3. 26. see joann m. weiner, approaching a common consolidated corporate tax base in the european union, 46 tax notes int'l 647 (2007) (summarizing the status of the eu's project and listing key eu documents from the ccctb working group). commission still has a great deal of work ahead, but it is convinced that it will release a legislative proposal in 2008. from the start of the project, the commission has made it clear that member states will retain the ability to apply their national tax rates to their share of the eu tax base. the commission also has decided to use formulary apportionment to distribute the eu tax base to the member states. although not all member states agree, the commission believes that the eu tax base should be consolidated from the start rather than proceeding in a two-step process that first introduces a common tax base and then introduces consolidation. the commission recently noted that "it would be counterproductive to pursue at this stage a common tax base without consolidation and apportionment."2 7 to maintain business support for its program, eu businesses have repeatedly stressed that they must have the option of using the new ccctb or of remaining under their national tax systems. the commission would impose restrictions on the option, requiring, for example, that the taxpayer remain with its choice for a specified period. member states would be required to make the ccctb available to multinational companies that chose to use it. in response to concerns over the optional aspect of the ccctb, the commission has noted that if a member states wished to make the ccctb mandatory, then it could decide to eliminate its national tax rules. the commission has emphasized that the ccctb should be limited to the european union's territorial boundaries, i.e., to the eu's water's edge (euwe). this decision is primarily a practical one, as the technical difficulties in gaining worldwide agreement to use ccctb with formulary apportionment on a global basis seem insurmountable at this time. the basic contours of the eu commission's work on the ccctb with formulary apportionment resemble the apportionment systems used in the u.s. states and the canadian provinces. however, the sharply different political structure in the european union, where each member states remains a fully independent nation, will inevitably lead the final proposal to differ significantly from the apportionment systems used in these north american federations. 27. see summary record of the meeting of the common consolidated corporate tax base working group, ccctb\wp\055\en at 2 (jun. 28,2007), available at http://ec.europa.eu/taxationcustoms/resources/documents-/taxation/ companytax/common-tax-base/ccctbwp055_summaryen.pdf. florida tax review [vol 8:7 2007] practical aspects of implementing formulary apportionment 645 a. the basic contours of formulary apportionment in the european union this section summarizes the basic contours of a formulary apportionment system in the european union. these main issues encompass the taxable connection, the definition of the taxable group, the formula and the factors, and international issues, including the treatment of foreign source income and the interaction with third countries.28 1. the taxable connection before an entity may be subject to tax in a jurisdiction, it must have a minimum "connection" with that jurisdiction. the permanent establishment concept, which originated in the mid-19th century, is a long-standing test for determining whether an entity has a sufficient connection with ajurisdiction to fall under its taxing powers. all of the european union's bilateral tax treaties and the oecd model convention on income taxation include a permanent establishment article. the usefulness of the permanent establishment notion as a criterion for being subject to tax, however, is questionable. the u.s. states, for example, have adopted a variety of tests for determining whether a non-resident corporation without a permanent physical presence in the state nevertheless has a sufficient economic presence to make it liable to the state's corporate income tax. the inappropriateness of basing taxation solely on a physical presence appears most starkly in the u.s. states where economic and geographic borders have long ago disappeared and common rules apply in each state. in the u.s., many out-of-state holding companies have asserted that the lack of a physical connection in a state removes their obligation to pay tax on the intangible income derived from the use of intangible property in that state.29 one of the earliest cases to address the intangible income issue arose in 1993 and involved geoffrey, inc., the delaware holding company for the toys r us retail stores.30 geoffrey licensed the use of its trademark to its various retail stores in the states in exchange for royalty payments. in this case, since the trademark was geoffrey's only presence in south carolina, geoffrey claimed that it was not 28. for additional analysis, see weiner, supra note 26. 29. physical presence is necessary for states to collect sales and use taxes on out-of-state sellers in certain circumstances. see quill corp. v. north dakota, 504 u.s. 298 (1992). 30. see geoffrey, inc. v. s.c. tax comm'n, 437 s.e.2d 13 (s.c. 1993). geoffrey is a delaware corporation. since delaware exempts income of a delaware holding company from state corporate income tax, geoffrey pays no delaware corporate income tax on the royalty income it receives from its operating companies. florida tax review liable for state taxation when its operating company used its intangible property in the state. the south carolina state court disagreed and ruled that use of geoffrey's intangible property in the state created a constitutionally sufficient connection with the state. the court noted that it was the customers who created geoffrey's income, not the licensing agreement. although the company lost in south carolina, geoffrey has continued to assert in other states that the use of intangible property does not create a taxable connection. in a similar case in 2007, geoffrey's operating company toys r us massachusetts, inc. used the trademark solely in the state and paid royalties to the holding company. as in south carolina, geoffrey had no employees or physical property in massachusetts so that its only presence in the state occurred through its intangible property, and geoffrey again claimed that its intangible property did not create a substantial nexus with the state.3 however, the massachusetts tax board disagreed, claiming that substantial nexus encompasses more than a physical presence. the massachusetts appellate tax board ruled that geoffrey was liable for state income tax on an apportioned share of the more than $33 million in royalty income that it generated from its retail toy stores in massachusetts.32 although intangible property does not have a physical location, a nonresident company that receives substantial amounts of income from the use of that intangible property in the state does reap an economic gain from the state. the massachusetts tax board found that "geoffrey purposefully sought to reap economic benefits from the massachusetts retail marketplace by licensing its assets for use in massachusetts" and that the facts introduced at trial "supported a finding of substantial nexus."33 several state courts have ruled that a "significant economic presence" better indicates substantial nexus than physical presence."' 2. the taxable group given the prevalence of low-tax jurisdictions around the world, the type of structure that geoffrey and other intangible property holding companies 31. geoffrey, inc, v. comm'r of revenue, findings of fact and report 2007690, 693 (mass. atb, 2007). 32. id. at 713. 33. id. at 701. 34. see, e.g., lanco, inc., v. dir., div. of taxation, 879 a.2d 1234, 1237 (n.j. super. ct. app. div. 2005), cert. denied, 127 s.ct. 2974 (2007); kmart props., inc., v. taxation and rev. dept., 131 p.3d 27, 32 (n.m. ct. app. 2001); aandf trademark, inc. v. tolson, 605 s.e.2d 187, 195 (n.c. ct. app. 2004); tax comm'r of state v. mbna america bank, na, 640 s.e.2d 226 (w. va. 2006), cert. denied, 127 s.ct. 2997 (2007). [vol. 8:7 2007] practical aspects of implementing formulary apportionment 647 use to minimize their state corporate income tax liability is likely to pose a significant challenge to the european union. as long as companies are able to establish separate holding companies in tax favored locations outside of the european union, they may be able to structure their operations so that the eu affiliate is able to deduct its royalty expenses on royalties paid to the holding company while the holding company pays little or no tax on the royalty income. several solutions exist. for entities located entirely within the eu, requiring that companies consolidate their operations addresses this type of income shifting. by including both the payor and the payee of the royalty in the taxable entity, mandatory consolidation eliminates this tax minimization strategy. for entities located both inside and outside the european union, antiavoidance measures can address income shifting. for example, montana combats against income shifting outside of the water's edge group by including certain foreign operations located in so-called "tax haven" countries within the ''water's edge." by including these entities within the water's edge consolidated group, the corporation eliminates income and expenses associated with these operations as intracompany transactions. since their "location" has no impact on overall income, the company has a reduced incentive to shift income. a difficulty with the tax haven approach, however, arises in determining whether a jurisdiction is a tax haven. the oecd created a list of tax havens in 2000 as part of its project on harmful tax practices, but that list may no longer be up to date. b. the apportionment formula ideally, the apportionment formula would assign income to locations where a company earns its income. since the initial practices derived from the taxation of the transcontinental railroad based on the miles of track located in the state, states used the location of the company's tangible property to determine the location of the company's income. over time, states modified their apportionment formulae to take into account additional factors, such as payroll and gross receipts, so that the distribution of income would more accurately represent the factors that generated the income than did a single factor property formula. in recent years, many states have moved toward a super-weighted sales factor formula, and a handful of states have adopted a formula that apportions income based solely on the location of sales. one difficulty in defining the apportionment formula arises because there is no single "correct" apportionment formula. some authors suggest that the formula should balance the supply and the demand sides and thus recommend a double-weighted sales formula, where property and payroll are weighted one-fourth each and sales are weighted by one-half. other authors suggest that states should adopt a formula that does not affect the investment florida tax review location decision and, thus, recommend using a formula based solely on the location of sales measured on a destination basis. the variety in state apportionment formulae arises, in part, from the lack of constraints on how states may determine the formula. the u.s. supreme court has allowed the states relatively free rein in this area and the trend toward a super-weighted sales factor can be traced back to a decision in 1978 validating iowa's destination-based sales-only formula. the u.s. congress has never mandated a particular formula. as of 2007, a double-weighted sales formula is the most common state apportionment formula. table 3 shows the state formulae as of january 1,2007. table 3 state apportionment of corporate income alabama * alaska * arizona * (2) arkansas * california * colorado * connecticut delaware florida georgia (3) hawaii * idaho * illinois * indiana (3) iowa kansas * kentucky * louisiana maine * maryland massachusetts michigan minnesota (3) mississippi missouri * montana 3 factor 3 factor 60% sales, 20% property & payroll double wtd. sales double wtd. sales 3 factor/sales & property & payroll double wtd. sales/sales 3 factor double wtd. sales 90% sales, 5% property & payroll 3 factor double wtd. sales sales 60% sales, 20% property & payroll sales 3 factor sales double wtd. sales double wtd. sales double wtd. sales/sales double wtd. sales/sales 92.5% sales, 3.75% property 78% sales,l 1% property & payroll accounting/3 factor 3 factor/sales 3 factor nebraska sales nevada no state income tax new hampshire double wtd. sales new jersey (1) double wtd. sales new mexico * double wtd. sales new york (3) 80% sales, 10% property north carolina * double wtd. sales north dakota * 3 factor ohio * 60% sales, 20% property & payroll oklahoma 3 factor oregon * sales pennsylvania * triple wtd. sales rhode island double wtd sales south carolina (4)double wtd. sales/sales south dakota no state income tax tennessee * double wtd. sales texas sales utah * 3 factor/double wtd. sales vermont double wtd. sales virginia double wtd. sales washington no state income tax west virginia * double wtd. sales wisconsin * (3) 80% sales, 10% & payroll wyoming no state income tax dist of colutmbia13 factor note: the formulas listed are for general manufacturing businesses. some industries have special formula different than those reported.* state has adopted substantial portions of the uditpa. (1) a 3-factor formula is used for corporations not subject to the corporation business franchise tax. (2) for tax years beginning in 2008, formula changes to 70% sales and 15% property and payroll. (3) state is phasing in a single sales factor. weightings will change each year until 100% sales factor in 2008 for georgia, new york and wisconsin, 2011 in indiana, and 2013 in minnesota. (4) taxpayers are allowed only 20% of the reduced taxes from a single sales factor (40% in 2008). source: compiled by federation of tax administrators from various sources. see www.taxadmin.org. [vol. 8:7 2007] practical aspects of implementing formulary apportionment 649 the european commission has examined many ways to define the formula to share the common consolidated tax base among the member states. these options include one based on macroeconomic variables, such as aggregate national value added, or on microeconomic variables, such as the firm's value added, or on traditional formulary apportionment using labor, capital and sales." the business europe task force on the ccctb has identified four elements as important for the ccctb to succeed. the tax base must be consolidated from the start, transfer pricing problems should be removed, the sharing mechanism should be based on a formulary apportionment approach, and the formula should be uniform and identical for all member states.36 the business group favors the formulary apportionment method using a predetermined formula based on factors (e.g., payroll, assets, or sales) deemed to have generated the group income. the group notes that in no circumstances, however, should the fa approach include a "distribution factor" that is based on the perceived origin of a specific income (or loss) as this would re-introduce transfer pricing problems."37 after initial discussions by the commission's working group on the tax base sharing mechanism, it decided to put aside the macro and value added distribution mechanisms and to focus on traditional formulary apportionment methods.3 ' according to the commission's summary, experts showed no support for a sales factor measured on a destination basis. one expert objected to using a destination-based sales factor because it would assign too much income to the consuming state and would duplicate the revenue raised by the value added tax. an origin-based sales factor may create tax planning opportunities. c. international aspects of formulary apportionment work on the international aspects of the ccctb began with establishing its territorial limits. from the start, the commission has indicated that the territorial scope of the ccctb will be limited to the eu water's edge 35. see ana agfindez-garcia (2006), the delineation and apportionment of an eu consolidated tax base for multi-jurisdictional corporate income taxation: a review of issues and options, taxation paper no. 9, directorate-general taxation and customs union. 36. see krister anderson, businesseurope task force, comments on document ccctb\wp\047: common consolidated corporate tax base working group: sharing mechanism," mar. 8, 2007. 37. id. 38. see the ccctb working documents an overview of the main issues that emerged during the discussion on the mechanism for sharing the ccctb, ccctb\wp\052\doc\en, feb. 27, 2007 and the mechanism for sharing the ccctb, ccctb\wp\047\doc\en, nov. 17, 2006. (euwe). it has not yet established what income will be considered to be earned within the euwe or which companies or permanent establishments will be covered by the ccctb.39 the commission distinguishes between tax residents and tax nonresidents. a tax resident is an eu company that earns income outside its country. a tax non-resident is a company from outside the eu that earns income in the eu. non-eu member states are referred to as third countries. the territorial scope of the ccctb is important to establish for purposes of allocating taxing rights when there is consolidation and apportionment of income to the member states. in terms of the scope of the ccctb rules, the commission has raised the issue of whether the ccctb rules should apply to all tax residents and include their activities outside the euwe and any activity of tax non-residents regardless of the territory. the commission's concern about this approach is that it "may lead to a situation where the ccctb rules are applied on activities of companies performed almost exclusively outside of the ccctb jurisdictions (e.g., the dutch parent with u.s. and japanese subsidiaries and permanent establishments in korea, china, and kuwait), which may be a bit of an overambitious plan."4 in evaluating the commission's presentation, the working group agreed that the foreign income of non-residents should not be covered by the ccctb. thus, the arm's length principle will continue to apply for transactions between related parties in the ccctb and in non-eu countries. the ccctb should include business income earned by a permanent establishment in the ccctb jurisdiction. the subgroup also acknowledged the complications of integrating the arms length method with the ccctb's formulary method.4 it noted, in particular, that the international community has largely viewed the arm's length principle as the only acceptable method of allocating profits to permanent establishments. other allocation methods, such as apportionment of total profits, may be acceptable if their use has been customary in a contracting state. the commission suggested that in the short term the member states establish how major third countries would react to the use of a method different 39. to simplify the presentation, the commission's initial work also assumes that all multinational enterprises and all member states participate in the ccctb. 40.cccbt working group, international aspects in the ccctb, ccctb\wp\0 1 9\aoc\en, nov. 18, 2005. 41. to remain open to alternative "allocation mechanisms" the commission's early documents did not state that the ccctb would be allocated to the ms using the mechanism of formulary apportionment. the commission notes that "the current method of allocation is to separately account on a single entity basis and apply arm's length pricing" and that "in the ccctb a different mechanism would be used for the allocation of the tax base to participating ms." for a more detailed discussion, see weiner, supra note 26. florida tax review [vol. 8:7 2007] practical aspects of implementing formulary apportionment 651 from the arm's length principle for allocating profits to permanent establishments. if such countries viewed the new method as compatible with the treaty, the treaties would not require immediate renegotiation. 1. territorial vs. worldwide taxation the commission also must decide whether the ccctb should treat foreign source income (i.e., income earned outside of the euwe) under the worldwide method or the territorial method.42 if the commission chooses the worldwide method, then it must choose to provide relief from double taxation either via exemption or by offering a foreign tax credit." the eu can turn to the member states for guidance on how to tax international income. two member states, denmark and france, operate a territorial system, although the numerous restrictions on exempt income mean that the systems are not pure territorial systems. the other member states operate a worldwide system, with the exemption system being the most common approach to avoid double taxation in these member states." some 42. there is some ambiguity in the literature over the difference between a territorial and an exemption system. technically speaking, a territorial system applies the tax solely on a source basis. any foreign-source income is not subject to tax. territorial systems do not distinguish between residents and non-residents but, instead, look solely to the source of income. by contrast, many countries tax on a worldwide basis and avoid double taxation either through exemption or by offering a foreign tax credit. countries that apply an exemption system may decide to tax their residents on their worldwide income but offer an exemption for certain types of foreign-source income. no industrialized economies apply a pure territorial system. in practice, since many countries that apply worldwide taxation with a foreign tax credit allow deferral of active income from tax, the two methods are very similar, with one of the biggest differences arising in the treatment of dividend repatriations. for additional details, see hugh j. ault, "u.s. exemption/territorial system vs. credit-based system," tax notes int'l, nov. 24, 2003. for additional discussion, see j. clifton fleming, jr., robert j. peroni, and stephen e. shay, fairness in international taxation: the ability-to-pay case for taxing worldwide income, 5 fla. tax rev. 299 (2001). 43. in 2005, the u.s. president's advisory panel suggested a simplified income tax plan that proposed moving to a territorial system. see report of the president's advisory panel on federal tax reform, simple, fair and pro-growth: proposals to fix america's tax system (nov. 2005). 44. for a comparison of the dividend exemptions in canada, germany, and the netherlands with the panel's proposal, see peter merrill, oren penn, hans-martin eckstein, david grosman, and martijn van kessel, "restructuring foreign-sourceincome taxation: u.s. territorial tax proposals and the international experience," tax notes 799, may 15, 2006, pp. florida tax review member states provide exemption only by treaty while others apply the same rules whether a bilateral treaty is in place or not.45 [vol. 8:7 table 4 corporate taxation of residents and double-tax relief systems for dividends received in eu member states, 2003 taxation of method of member states tax residents double tax relief austria worldwide exemption belgium worldwide exemption (to 95%) bulgaria worldwide indirect credit direct credit if no treaty cyprus worldwide exemption czech republic worldwide indirect credit deduction if no treaty denmark territoriality exemption estonia worldwide indirect credit finland worldwide exemption direct credit if no treaty france territoriality exemption (to 95%) germany worldwide exemption (to 95%) greece worldwide indirect credit hungary worldwide exemption ireland worldwide indirect credit italy worldwide exemption (up to 60%) latvia worldwide exemption lithuania worldwide exemption luxembourg worldwide exemption malta worldwide indirect credit netherlands worldwide exemption poland worldwide indirect credit direct credit portugal worldwide direct credit romania worldwide indirect credit slovakia worldwide indirect credit no relief if no treaty slovenia worldwide exemption spain worldwide exemption indirect credit no treaty sweden worldwide exemption united kingdom worldwide indirect credit source: huizinga, laeven, and nicodeme (2006). 45. see harry huizinga, luc laeven, and gaetan nicodeme, capial structure and international debt shifting, centre for economic policy research, oct. 2006. the european court of justice is considering whether applying different taxation of foreign dividends between treaty and non-treaty countries is compatible with the ec treaty. 2007] practical aspects of implementing formulary apportionment 653 when applying the system when several underlying national tax systems are involved, exemption offers advantages in terms of simplicity as it does not require keeping track of the different tax rates or applying the various double-tax relief provisions offered via tax treaties. moreover, since the eu will be designing an exemption system from scratch, it could avoid many of the transition issues that hinder movements toward territorial taxation in other countries. given the variation in tax rates among the eu member states, operating a credit system might become quite complicated. a system of worldwide taxation with deferral for active foreign income closely resembles the system of exemption with current taxation of foreign passive income. the main difference in the two systems lies in how they treat foreign-source income repatriations. a worldwide system defers residence taxation of foreign income while the territorial/exemption system provides permanent exemption. thus, the territorial system reduces the incentive for multinational enterprises either to re-invest continually their profits in foreign jurisdictions or to engage in tax planning strategies to find ways to repatriate the income in tax-advantaged forms.46 renegotiating the bilateral income tax treaty network to accommodate the new eu tax method would be a formidable task. creating identical bilateral treaties among the 27 eu member states and between the u.s. and the 27 member states would require 368 identical treaties. to accommodate the new common rules in the eu member states, the eu may wish to negotiate a multilateral tax treaty with non-eu countries. a common tax treaty between the eu and third countries would help bring about common approaches to elimination of double tax and prevention of tax evasion/avoidance.47 despite its advantages, moving to a territorial or a worldwide system with exemption system introduces its own difficulties. exempting foreignsource income from home taxation places additional pressure on anti-abuse rules designed to prevent inappropriate income shifting to tax-favored locations. in addition, since active foreign income is permanently exempt from tax under a territorial system rather than just benefiting from deferral, transfer pricing becomes very important under a territorial system. to address these pressures, systems that exempt foreign-source income provide the exemption only to active foreign income and subject passive foreign income to current taxation. 46. for an analysis of some of these issues, see lawrence lokken, territorial taxation: why some u.s. multinationals may be less than enthusiastic about the idea (and some ideas they really dislike), 59 smu rev. 751 (2006). lokken's basic point is that u.s. multinational companies are able to obtain greater tax savings under the current system than under an exemption system. 47. the european business initiative on taxation (ebit) encourages work on a european model treaty in the oecd framework. see eurpean business initiative on taxation, ebit contribution to the commission on the ccctb, nov. 2006. if income earned outside of the water's edge is exempt from tax, then the expenses associated with that exempt income should also be treated as outside of the water's edge and thus non-deductible. it would be necessary to create reasonable rules so that domestic expenses incurred to generate exempt foreign income would not be deductible against domestic income. if the home country exempts foreign source dividends from tax, then to avoid allowing a tax deduction for exempt income, expenses incurred in earning the income should be allocated to that income. companies should not be allowed to deduct the interest expense on debt used to finance investments in operations outside of the water's edge. 2. water's edge limitation to the eu consolidated tax base the commission's plan to limit the ccctb to the water's edge boundaries of the eu raise two key issues. first, which entities will be included in the water's edge group? second, what income will be included within the water's edge? the practices in the u.s. states that limit their corporate income tax to the water's edge provide several approaches to these questions. in general, states that allow water's edge taxation include only the income and apportionment factors of members included in the water's edge in the tax calculation. california gives corporations the option to elect to compute income attributable to california sources on the basis of a "water's edge combined report." making this election allows the corporation to exclude foreign affiliates from the combined report. foreign corporations are included in the combined report only to the extent of their u.s.-source income and apportionment factors. the election, which is binding for seven years, does not change the unitary concept, but only limits the unitary entities included in the combined report.48 california provides a list of criteria for determining whether an entity should be included in the combined report. if the entity meets any one of the criteria and is unitary, then it must be included in the combined report. the california water's edge group generally includes: 1. any corporation, regardless of where it is incorporated, if the average of its property, payroll, and sales factors in the united states is 20% or more; 2. any controlled foreign corporation (cfc) as defined in irc section 957 that has subpart f income as defined in irc section 952; 3. any other corporation with less than 20% of its property, payroll, or 48. see cal. rev. and tax. code § 25110. see also state of california, franchise tax board, 2001 guidelines for corporations filing a combined report, ftb pub. 1061. florida tax review [vol. 8:7 2007] practical aspects of implementing formulary apportionment 655 sales in the u.s. but only to the extent of their u.s. located income and factors. u.s. located income includes both of the following: (a) income that is effectively connected income (eci) with a u.s. trade or business, or is treated as effectively connected under provisions of the internal revenue code. (b) u.s. source income that is business income as described under the state tax code. california includes the income of cfcs that have subpart f income according to the ratio of the entity's subpart f income for the year to its current year earnings and profits (e&p). if current year e&p is zero or less, none of the income and factors of the entity is included in the combined report. like other states, california includes so-called 80/20 corporations within the water's edge only to the extent of their u.s. located income and factors. california includes income that is effectively connected income (eci) with a u.s. trade or business and does not provide the immunity of federal income tax treaties concerning this income. california also includes u.s. source income that the state considers business income regardless of whether the federal government considers that income to be eci. california does not allow deductions for expenses that are allocable to income that is not included in the tax base. interest expense attributable to foreign investment equals the amount of interest expense that is specifically assigned to foreign investment plus the amount of unassigned interest expense that is allocated to foreign investment. unassigned interest expense is allocated by formula. in new hampshire, a water's edge combined group is a group of business organizations operating as a unitary business, except for overseas business organizations, which are those with 80% or more of their average payroll and property assignable to a jurisdiction outside the fifty states and the district of columbia. generally, an overseas business organization is not included in the water's edge group if the group can certify that transactions conducted between the overseas business and members of a water's edge group are similar to transactions conducted between other businesses owned by the overseas business and any other member of the water's edge group and if the overseas business agrees to report any adjustments made by the irs regarding transactions between related business organizations that bear on the comparability of transactions between the members."' in illinois, an entity is excluded from the unitary group if its business activity outside the united states equals 80% or more of its total business activity." the vermont corporate income tax is a water's edge unitary tax because an "affiliated group" excludes overseas business organizations. an "overseas business organization" means an organization that ordinarily has 80% 49. n.h. rev. stat. ann. § 77-a: 1 xv, xix (2007). 50. ill. comp. stat. 15/1501(a)(27) (2007). or more of its payroll and property outside the fifty states and the district of columbia.5 iii. economic impacts of formulary apportionment in the european union a. potential impact offormulary apportionment on individual member states the eu member states are keenly interested in how their revenues might be affected in moving to formulary apportionment, and the eu commission is keen to provide this information. absent any tax data and a concrete proposal, it is impossible to make an accurate prediction. however, it is possible to construct some potential outcomes. 1. u.s. multinational operations in europe the distribution of the operations of the affiliates of u.s. multinational corporations in europe provides one illustration.52 considering a purely static analysis, countries that have a greater share of net income than of operations in a location under the current system would report lower net income to that location under apportionment than under separate accounting, and vice versa. u.s. multinational activity is relatively low in the new member states. poland, the largest of the new member states, has an average of just 1.2% of u.s. affiliate activity. the newer member states tend to have a relatively larger share of employees than of compensation, thus suggesting their interest in using number of employees as an apportionment factor instead of employee compensation. 2. financial accounts from a european company financial accounts data present another view of how income may be distributed under formulary apportionment. to see the possible distributional effects within the eu, consider the merck group, which is headquartered in germany and has 171 companies in 52 countries and 61 production sites in 28 countries. its annual report provides details for selected countries, including germany and france, as well as for regions, such as europe, asia, and north america. table 5 uses these accounts to show a rough idea of the geographic distribution of the company's group activity. 51. vt. stat. ann. 32 § 5811(18)(c); vt. stat. ann. 32 § 5811(22) and vt. stat. ann. 32 § 5811(24). 52. detailed data are not available for the distribution of the operations of eu multinational companies across the eu twenty-seven member states. florida tax review [vol 8:7 2007] practical aspects of implementing formulary apportionment 657 table 5 illustration of apportionment using merck company data 2006 2005 2004 2003 2002 2001 germany shares of europe external sales 20.9% 22.4% 20.9% 23.1% 22.9% 26.5% operating assets 68.5 51.0 64.2 54.1 52.1 52.9 number of employees 57.5 56.7 56.4 51.1 44.0 51.3 average 49.0% 43.3% 47.2% 42.8% 39.7% 43.6% ebit in germany (6 million) by financial statements e676 e222 e317 6 (38) e (41) e67 by apportionment 476 268 237 97 108 293 france shares of europe external sales 33.6 31.6 29.9 27.1 26.6 27.1 operating assets 11.6 17.6 18.9 18.7 20.0 19.1 number of employees 15.7 16.5 18.0 19.9 17.4 20.8 average 20.3 21.9 22.3% 21.9% 21.4% 22.3% ebit in france (6 million) by financial statements c149 e138 €152 101 151 c490 by apportionment 197 136 112 50 58 150 note: the figures used are proxies for the property, payroll, and sales factors used in the typical apportionment formula. the actual apportionment factors are likely to be different from the factors obtained from the financial reports. source: merck annual reports, various years if european income were distributed to germany on the basis of the average of the shares of external sales, operating assets, and number of employees, germany would receive around 40% of the company's european income. because the company is headquartered in germany, it has a relatively large share of its assets located there. by contrast, merck's assets, sales, and employees are distributed relatively more equally in france than in germany. france would receive about 20% of european income, regardless of which factors are used to apportion income. table 5 also shows how earnings before interest and taxes might be distributed using an apportionment formula. for example, merck reported a financial loss in its german operations for 2003 and 2002, although the company reported positive profits throughout europe during those years. under apportionment, some of those european profits would be apportioned to germany each year. the chart below illustrates this situation. it compares merck's earnings before interest and taxes and its income under formulary apportionment in germany and france over several years. this chart shows that the distribution of income varies significantly depending on the method of income allocation. it also shows that as long as the company is profitable overall, the formula will apportion each country some of the overall tax base. this feature of apportionment leads countries to compete for the tax base and preserves tax competition. tvbrdk goaw cc namd fmr w d e n3w appmdored h ca., gmmrn mrd frum mom eur1 i meran nnci l ogernan: aportknae ifrench: fincw ifrend:apwtmrnent i the firm-specific data from the german company merck and the aggregate u.s. multinational data from the u.s. bureau of economic analysis also show that income attributed to each country, and therefore tax revenues, are more stable under apportionment than under the current system. thus, a system of apportionment addresses the issue that reducing compliance costs is not the most important objective for a large eu multinational company.53 obtaining stability and certainty may be important in terms of shareholder 53. paul morton, challenges for a listed multinational enterprise doing business in europe, ec tax review, 2006/3 (2006). florida tax review [vol. 8:7 2007] practical aspects of lmplementing formulary apportionment 659 value. in this respect, formulary apportionment seems to have an advantage over the current system. 3. possible revenue effects devereux and loretz examined how formulary apportionment might affect corporate tax revenues in the eu member states.54 using a comprehensive database containing five years of eu multinational company data provided by orbis from 2000 to 2004, the authors calculated pre-tax profit from the tax payments reported in the unconsolidated financial accounts and used this figure as the measure of taxable profits. total profits are fixed, but companies may consolidate losses within the group. this amount is then distributed to the individual member states and taxed at the national tax rate, which they assume is fixed. assuming no changes in behavior, the authors find that an optional ccctb with fa would cause eu corporate tax revenues to decline very slightly.the distributional effects would not be even. some countries would benefit in terms of revenue while others would be worse off under the new scheme. in discussing the revenue impacts, however, it is important to note that a formula that maximizes revenue may also discourage the location of business operations in that location. the u.s. state experience suggests that countries prefer a formula that creates fewer distortions to investment to a formula that increases revenue. more generally, countries receive less income under apportionment than under separate accounting if their apportionment factors are "highly productive," that is, if the ratio of income to the apportionment factor is greater than one. countries that are a common location for headquarter companies, which do not have much economic activity relative to the income generated, also would likely receive less income under mandatory apportionment than under the current system. as long as the system is optional, groups that would see a significant amount of income apportioned to high-tax countries germany, italy, and denmark might decide to opt out of the system. in this case, the high-tax countries do not gain the benefit of having the eu tax base distributed to them but remain with the low tax revenue reaped under the current system. many newer member states, such as lithuania, latvia, hungary, the slovak republic and estonia would gain from the new system. since these countries are among the lowest tax countries in the eu, as long as the companies remain free to choose whether to adopt the ccctb or not, it seems likely that revenue would rise in these countries relative to the higher tax countries as companies choose to adopt a system that assigns relatively more 54. see michael p. devereux and simon loretz, the effects of eu formula apportionment on corporate tax revenues, oct. 15, 2007. florida tax review income to these locations. the netherlands would benefit under a voluntary system but lose under a mandatory system since most multinationals with operations, mainly headquarters, in the netherlands are assumed not to participate when the system is optional. other studies find that the revenue distribution may be less sanguine than expected. for example, fuest, hemmelgarn, and ramb created an eu tax base from the deutsche bundesbank's foreign direct investment data and corporate balance sheet data for german multinational enterprises." using this database, the authors find that german tax revenues fall by 20% under formulary apportionment relative to the current situation. although this result stands in contrast to loretz and devereux, who find that german tax revenues rise slightly under apportionment, it is not surprising since the two studies use different data and cover different time periods. many participants in the working group have taken a pragmatic view towards revenue estimates. many note that "there may be winners and losers in the first years of application of the new system" but that all member states would benefit in the long run from the positive economic consequences brought about by introducing a tax system that is appropriate for the internal market. making revenue estimates for a plan that has not yet been proposed using data that do not exist is very difficult. fennell explored the devereux and loretz results for ireland and found that data issues may limit the usefulness of the results." for example, many multinational corporations doing business in ireland are not included in the database, the data include some very large loss making groups (which are described as "negative" tax payments), and many operations in ireland are subsidiaries of foreign headquartered companies. in addition, the ccctb system would not necessarily shift profits of u.s. groups outside of ireland. based on these limitations, fennell suggests that any conclusions regarding how a country might fare under the commission's tax proposal should be "treated with caution" until the commission presents a proposal that can be tested with actual company data. another set of researchers developed a general equilibrium model to analyze the impact of introducing fa in the eu. van der horst, bettendorf, and rojas-romagosa show that the fact that the proposal will be optional and that tax rates will not be harmonized offset the benefits of adopting a ccctb.57 55. see clemens fuest, thomas hemmelgarn, and fred ramb (2007), how would formula apportionment in the eu affect the distribution and size of the corporate tax base? an analysis based on german multinationals. international tax and public finance, oct. 2007. 56. see david fennell, are businesses covering all the common consolidated corporate tax bases? ernst and young tax newsletter, aug. 2007. 57. see albert van der horst, leon bettendorf, and hugh rojas-romagosa, will corporate tax consolidation improve efficiency in the eu?, cpb netherlands bureau for economic policy analysis, mar. 2007. [vol. 8:7 2007] practical aspects of implementing formulary apportionment 661 however, in terms of tax competition, if the formula includes a capital factor, formulary apportionment increases tax competition relative to separate accounting since countries are more likely to reduce their tax rates to attract investment than to attract paper profits as under separate accounting. the authors also analyze the impacts on individual countries. in contrast to the results discussed above, ireland, for example, is worse off under the ccctb since multinational enterprises can no longer manipulate transfer prices to shift income into the country. more generally, the impact of moving to ccctb with formulary apportionment depends on the country's industrial composition, the tax base, and the formula. these wide differences in outcomes suggest the wisdom of approaching "revenue estimates" with a good deal of caution. depending on the time period, the database, and the treatment of losses, for example, a country may find that estimates show it benefits greatly, not at all, or is not affected by a move to apportionment. b. theoretical analysis ofeu formulary apportionment since the european commission released its report in 2001, european researchers have taken an active interest in how formulary apportionment might affect investment and employment decisions and the level of tax revenues in the member states. unlike in the u.s. states, where data are readily available, there are no data on the distribution of tax revenues and operations by individual member states, so that european research is limited to undertaking a theoretical examination of potential results under fa.58 much of this research builds on the initial theoretical work of mclure, who demonstrated how a tax applied via a formula alters the incidence of that tax relative to a tax levied on profits directly.59 in particular, mclure showed that basing a tax on, say, the location of capital transforms the profits tax into a peculiar type of capital tax. the incidence effects that arise under apportionment are similar to the incidence effects that arise from excise taxes levied directly on the factors included in the apportionment formula. a simple equation demonstrates how this transformation occurs. state profits are a function of total profits, the weight applied to each factor, and the share of each factor located in that state. the equation below shows the general case where each state may set the weight on the apportionment factor (including setting the weight to zero). 58. see joann martens weiner, company tax reform in the european union, ch. 7 for further analysis of the empirical and theoretical studies. new york, springer (2006). 59. see charles e. mclure, jr, the elusive incidence of the corporate income tax: the state case, 9 public finance quarterly, 395. a firm's total net federal profits, h, are distributed to each individual state, i, as shown below: (1) ii = [aik(ki/k) + ail(l'il) + ais(s/s)] i[ where hi is post-apportionment state profits, k,, li, and si are the company's property, payroll, and sales, respectively, in state i and k, l, and s are total property, payroll, and sales, respectively, over all states; and g k ail and ais, are the weights applied to the property, payroll, and sales shares in each state, where the sum of the weights on the factors is one, i.e., aik + a l+ ais= 1. (technically speaking, the sum of the weights must be less than or equal to one.) the parameters without subscripts stand for the total values for capital, payroll, sales, and profits across all locations. the tax liability in any state is the product of the local tax rate, ti,, and the post-apportionment profits, as shown below (2) ti ti,.fi st i [laik(k/k) + ail(l./l) + ais (s/s)] h1 where tj is tax revenue in state i and ti is the statutory tax rate in state i.60 the state corporate income tax may be represented as three separate taxes, each of which is levied as a share of the statutory rate on each factor in the formula. thus, the property-related portion of the profits tax tk may be represented as: (3) ti, = ti [aik(kik)] ii if the apportionment formula weights the property factor by one-third, i.e., aik = 1/3, then the tax rate applied to state property is levied at one-third the statutory weight, i.e., ti ai if the statutory tax rate is 9% and the state weights the property factor by one-third, then the rate applied to the state property share falls to 3%. representing the tax in this manner illustrates the incentive to 60. the definitions of total profits and the factor totals depend on how the taxable group is defined. for example, compared with water's edge consolidation, if the group includes worldwide operations, the factor shares will decrease so that a smaller share of total income will be apportioned to the state; however, the amount of total profits will generally increase when the composition of the group expands geographically. total profits will decrease under worldwide consolidation if the company has losses in its foreign operations. the fact that worldwide consolidation (combination) can reduce a company's tax liability explains why many companies choose worldwide combination in the states that make this option available. for an illustration, see supra note 58 at ch. 6. florida tax review [vol 8:7 2007] practical aspects of implementing formulary apportionment 663 eliminate the property factor from the formula, since this move reduces to zero the tax applied to property located in the state. the tax rate applied to in-state capital is the product of the state tax rate, the weight levied to the capital share, and the share of capital located in the state. thus, if a state applies a profits tax of 20% but applies a weight of one-half to the capital factor, then the tax rate applied to the share of capital in the state falls from 20% to 10%. a multistate firm's overall tax rate is the sum of the average tax rates applied to each factor included in the formula. a firm can reduce its tax burden by locating its apportionment factors in relatively low tax areas. apportionment has a second impact that affects the cross-state tax rate differential between states that participate in the formulary system and those that do not participate. this effect is particularly important in the case of the european union, which is planning to limit the formulary system to the territorial borders. due to the averaging effect, apportionment causes the tax rate in relatively low tax areas to rise relative to the rates in jurisdictions that do not participate in the apportionment system and causes the tax rate in relatively high tax rate areas to fall relative to the rates in jurisdictions that do not participate in the apportionment system. therefore, under apportionment, multistate firms in low-tax areas have a relatively greater incentive than do multistate firms in high-tax areas to shift their physical operations outside of the formulary area. gordon and wilson showed that fa creates an incentive for crossborder mergers because firms doing business in a high-tax state can reduce their overall tax burden by merging with a company doing business in a low-tax state." their analysis also shows that if the formula includes destination-based sales, then fa encourages companies to produce in a state and sell out of the state. the states put these theoretical results into practice by moving away from a property and payroll based formula to one that increases the weight on the sales factor. recent research that focuses on the eu's plan to move to fa modifies this model to incorporate additional issues, such as income shifting, that alter some of the traditional conclusions of fa. for example, sorensen finds that tax rates may be too high under fa compared with sa if countries do not take the negative impacts of fa into account when setting their tax rates.62 nielsen, 61. see roger gordon and john d. wilson, an examination of multijurisdictional corporate income taxation under formula apportionment, 54 econometrica 6, 1357 (1986). 62. peter b. sorensen, company tax reform in the european union, 11 j. of int'l tax pub. fin. 91 (2004); soren bo nielsen, pascalis raimondos-moller, and guttorm schjelderup, tax spillovers under separate accounting and formula apportionment 1-7 economic policy research union, copenhagen business school (2004). raimondos-moller, and schjelderup showed that countries will tend to keep their tax rates low if they face the threat of tax base flight. under separate accounting this threat is stronger the weaker is transfer pricing enforcement. under formulary apportionment the threat is stronger the greater are pure profits. if multinational firms can shift profits at a relatively low cost, say because transfer pricing enforcement is weak in the current system, then the attractiveness of formulary apportionment in terms of preventing tax base flight rises relative to separate accounting. however, if transfer pricing is costly, say because the tax authorities impose penalties for transfer pricing abuse, then profit shifting becomes more costly under separate accounting and that method becomes more attractive in preventing tax base flight relative to formulary apportionment. by contrast, if pure profits are relatively large, then companies have an incentive to shift the location of their investment under formulary apportionment and countries face pressures to keep their tax rates low. combining these effects shows that if countries increase the cost of shifting income and if companies have high pure profits, then formulary apportionment increases tax competition relative to separate accounting. assuming that countries agree to use the same formula, pethig and wagener examine how tax competition varies under different formulae. tax competition will generally be stronger the more sensitive factor shares are to tax rate differences. since labor is assumed to be the least mobile factor, at least in the short run, tax competition is likely to be lower under this formula than under formulae that include property and sales factors. the tax base is also an important element to consider. kolmar and wagener find that although the amount of tax competition is independent of the tax base under separate accounting, the tax base and the formula simultaneously affect tax competition under apportionment.63 mintz and weiner consider the efficiency aspects of the commission's specific proposals. as long as tax rates continue to differ across member states, economic inefficiencies arise under formulary apportionment. it is not clear whether the inefficiencies introduced through formulary apportionment (e.g., distortions through the factors) are empirically more important compared to the inefficiencies that are removed (e.g., the differences in tax bases.).' gerard and gdrard and weiner examine a situation of formulary apportionment and cross-border loss offsetting in a model with uncertainty. the 63. rudiger pethig and andreas wagener, profit tax competition formula apportionment (ilpf conference, prague (2004), available at http://www2.unisiegen.de/dept/fb05/vwliv/papers/current/106-03.pdf; martin kolmar and andreas wagener, the role of the tax base in tax competition with formula apportionment 1, (university of vienna, working paper, 2004), available at http://homepage.univie.ac.at/andreas.wagener/papers/kolmar-wagener.pdf. 64. jack mintz and joann weiner, exploring formula allocation for the european union, 10 int'l tax and pub. fin. 695, 701 (2003). florida tax review [vol 8:7 2007] practical aspects of implementing formulary apportionment 665 uncertainty arises because companies may have losses in one jurisdiction and profits in anotherjurisdiction. if the eu introduces cross-border loss offsetting, a multinational company will be able to offset profits in one jurisdiction with losses from another jurisdiction and member states revenue may fall as it absorbs losses from otherjurisdictions. formulary apportionment, however, has the benefit of partially insuring governments against these negative impacts. as long as the firm is profitable overall, member states will receive some income under formulary apportionment. governments are, therefore, eager to attract foreign investment since formulary apportionment acts as a type of insurance against a bad outcome, so they continue to set competitive income tax rates.65 the data reported earlier for merck illustrate this "insurance" situation. in the case where the company reported losses in one country under separate accounting, the company, nevertheless, still had positive amounts of the factors in each country. thus, the country's tax revenues (and, the company's tax payments) are more stable under fa than sa. much of the research on formulary apportionment focuses on how it affects business decisions in cases where all countries participate in the system. a recent study by gdrard may alter some of the conclusions concerning fa in the eu. in particular, gdrard suggests that the gains from tax reform are not clear unless all eu countries adopt the system using a formula with factors that are not easily moved, and the system is mandatory, and the eu adopts a credit system rather than an exemption system.66 riedel and runkel identify another interesting impact of eu formulary apportionment under a water's edge limitation. they extend the research to the case where two countries apply formulary apportionment within an economic union (i.e., the european union) and a third country exists outside of the union where transactions occur under separate accounting. 67 if a country within the formulary area increases its national tax rate, the multinational enterprise's total tax rate within the system will rise, thus increasing the difference between the average tax rate within the formulary area and the rate outside the area. this rate differential creates an incentive for investment to flow out of the apportionment area, causing a negative externality 65. marcel gerard and joann weiner, cross-border loss offset and formulary apportionment: how do they affect multijurisdictional firm investment spending and interjurisdictional tax competition? (cesifo working paper no. 1004 (2003); marcel g6rard, multijurisdictional firms and governments' strategies under alternative tax designs, (cesifo, working paper no. 1527, 2005), available at http://www.cesifogroup.de/pls/guestci/download/cesifo%20working%2opapers%202005/cesifo%2 oworking%2opapers%2oaugust%202oo5/cesifo i_wp 1 527.pdf. 66. marcel gerard, reforming the taxation of multijurisdictional enterprises in europe, 53 cesifo econ. studies, 329 (2007). 67. nadine riedel and marco runkel, company tax reform with a water's edge, 91 j. of pub. econ., 1533 (2007). florida tax review within the formulary area and, perhaps, leading to an inefficiently high level of taxation. however, as the authors point out, the initial "profit shifting" incentives are not the same under apportionment as under separate accounting. in particular, the incentive to shift profits is weaker under formulary apportionment than under separate accounting so that, on balance, the union is better off under apportionment than under separate accounting. consolidation within the union largely eliminates profit shifting abilities in the formulary apportionment area. however, profit shifting incentives still exist between the union and the rest of the world and between the participating and the non-participating countries. multinationals with headquarters (hq) located outside of the union and subsidiaries located in two different union countries face different incentives from those faced by operations located solely within the apportionment area. the non-union headquarters company has an incentive to shift income to or from either subsidiary. however, the hq company in the union will tend to shift investment to the subsidiary located in the low-tax rate country. subsidiaries located in the union face new transfer pricing incentives when formulary apportionment replaces separate accounting. to see how this happens, assume that the non-union country is a tax haven so that its tax rate is lower than the statutory rates in the two union countries. in this scenario, although the lower tax country in the union has a greater incentive to shift income to the tax haven, the higher tax country has a lesser incentive to shift income to the tax haven. on balance, the shift to formulary apportionment reduces the amount of total profit shifting outside of the union. this outcome occurs because the effective tax rate under formulary apportionment is "biased" toward the low tax rate so that the effective tax rate is lower than the unweighted average of the two rates. in simple terms, moving from sa to fa increases the incentive for companies in low-tax countries to shift income to "tax haven" countries outside of the fa area. the opposite incentive arises in the high-tax country the incentive to shift profits to the tax haven is lower under fa than under sa. since these incentives are offsetting, the impact on total profit shifting depends on whether the increased shifting from the low tax fa country is smaller than the reduced shifting from the high tax fa country. in the simplest case where a change in the tax rate differential between the fa area and the tax haven leads to a proportional change in transfer pricing and profit shifting, then the reduced profit shifting from the high tax fa country outweighs the increased profit shifting from the low tax fa country. as the authors explain, the only case where total profit shifting out of the fa area increases from the shift from sa is when the tax rates in the union countries are relatively close to one another. in this case, however, the initial [vol 8:7 2007] practical aspects of implementing formulary apportionment 667 incentive to shift profits is relatively small so that income shifting is not a major problem. in cases where the non-union country tax rate is above the union rate under fa, there is increased profit shifting into the union. since the tax rates in the major non-eu industrialized countries are well above the eu average, this effect may become quite strong. thus, the eu could become an attractive location for investment coming in from non-eu countries. iv. conclusion the growing economic integration in the european union has led the european commission to suggest that the eu member states re-consider how they tax multinational enterprises. specifically, the eu commission would like to give multinational enterprises the opportunity to calculate a common consolidated corporate tax base at the eu level and use a common formula to distribute the single tax base to the member states for taxation at local rates. using a formula to distribute income to the member states does not eliminate member states tax sovereignty. to the contrary, the local tax rate remains a highly effective fiscal tool even within a system with a common formula and common tax base. as long as the member states are able to set their own tax rates, they will be able to remain competitive in the drive to stimulate new investment and employment. the european commission has set forth an ambitious schedule for 2008. to achieve its goal of making a legislative proposal, it must define taxable income, the consolidated group, the apportionment formula, and the definition of the eu's territorial boundaries. whether the commission can achieve this goal or not is uncertain. the member states may not have the political will to create a common consolidated tax base with formulary apportionment in the european union. whether the commission should aim for this goal is not in question. despite some technical and political difficulties, a common consolidated corporate tax base with formulary apportionment appears to be the best way to tax multinational companies in the european union. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 19 2016 number 4 article conservation easements and the valuation conundrum nancy a. mclaughlin 225 i florida tax review volume 19 2016 number 4 the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states and $145.00 per volume 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the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: "articles," "commentaries," and "book reviews." the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions,. it does have a preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations 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indicated. v * associate professor of law, chapman university school of law. b.a., university of california, santa barbara; m.b.a., san diego state university; j.d ., university of california, davis; ll.m. (taxation), new york university school of law. the author gratefully acknowledges chapman university school of law for a generous research grant and recognizes her affiliation with the george l. argyros school of business and economics. this article is dedicated to countless disaster victims and tireless relief workers around the globe who persevere despite immeasurable losses. 953 florida tax review volume 6 2005 number 10 anatomy of a disaster under the internal revenue code francine j. lipman* i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 955 ii. anatomy of a disaster: sources of relief . . . . . . . . . . . . . . . 961 a. introduction: southern california wildfires of 2003 . . . . . . . 961 b. federal emergency management agency (fema): response and recovery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 962 1. the registration and information gathering process . . . . . . . . . . . . . . . . . . . . . . . . . . . 963 2. federal assistance to individuals and households . . 964 c. insurance coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 971 d. relief from charitable and other non-profit organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 973 e. gifts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 975 iii. tax consequenc es of relief and tax relief provisions . 975 a. exclusions from gross income . . . . . . . . . . . . . . . . . . . . . . . . 976 1. disaster loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 977 2. gifts: irc section 102 . . . . . . . . . . . . . . . . . . . . . . . . 978 3. disaster relief payments: irc section 139 . . . . . . . 980 4. insurance payments for excess living expenses: irc section 123 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 983 5. application to the bell family, hypothetical disaster victims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 985 b. casualty gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 988 1. recognition of casualty gains . . . . . . . . . . . . . . . . . 989 2. nonrecognition of casualty gains . . . . . . . . . . . . . . 990 3. application to the bell family, hypothetical disaster victims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 997 c. casualty losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1002 1. personal casualty losses . . . . . . . . . . . . . . . . . . . . 1005 2. business or investment casualty losses . . . . . . . . . 1007 3. presidentially declared disaster losses . . . . . . . . . 1009 4. application to the bell family, hypothetical disaster victims . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1010 954 florida tax review [vol.6:10 d. net operating loss deduction . . . . . . . . . . . . . . . . . . . . . . . 1012 1. application to the bell family, hypothetical disaster victims . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1013 e. deductibility of interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1014 1. interest expense on sba disaster loans . . . . . . . . . 1014 2. interest expense on existing home mortgage debt 1016 3. application to the bell family, hypothetical disaster victims . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1018 f. tax administration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1019 1. extension of tax filing and payment deadlines . . 1019 2. abatement of interest and penalties . . . . . . . . . . . . 1020 3. restoring records and moving forward . . . . . . . . 1020 4. application to the bell family hypothetical disaster victims . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1021 iv. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1022 2005] anatomy of a disaster 955 1. see jane clifford, san diego county firestorms aftermath: building a future, first in occasional series, the san diego union-trib., dec. 28, 2003, at e1, e4 (describing the narrow escape from the firestorm of 2003 by the bellante family and their devastating loss of everything, but their lives). 2. id. 3. see id., at e4 (waking their eleven and thirteen year-old daughters they hustled into their truck and drove down the dirt road to escape the firestorm). 4. see id. (facing a wall of flames they made a quick, impossible turn to retreat, but soon the lack of oxygen stalled the truck’s engine and they had to abandon the flaming vehicle). 5. see id. (surmising that the small area that saved their lives must have been cleared of trees and brush for a trailer). 6. see id. (acknowledging that “[w]e were going to live together, or die together,”). 7. see id. (recounting how the firestorm melted the skin off lori bellante’s arm and then raged around them for four endless hours). 8. see janine zuniga, san diego county firestorms aftermath: eight lives lost in small community near barona, neighbors killed trying to evacuate homes, others barely escaped, the san diego union-trib., nov. 2, 2003, at a10 (describing the tragic loss of eight of the bellante’s neighbors in the firestorm they barely escaped). anatomy of a disaster under the internal revenue code francine j. lipman i. introduction it might have been the howl of whipping winds; or the crackle, snap, pop of sizzling cinders; or the stench of smoke that woke them into the nightmare of 3:00 a.m. on october 26, 2003.1 they awoke on wildcat canyon road surrounded by their woods and the cleveland national forest engulfed in a firestorm.2 lonnie and lori bellante and their teenage daughters, melanie and lindi, raced from their third-generation homestead to the family ford to escape threatening flames.3 the heat, registering hundreds of degrees, melted the truck’s tires and set it ablaze.4 the family surrounded by hundreds of burning trees somehow found a small clearing.5 huddled together, they buried their sweaty faces and burned bodies in the dirt and waited.6 for four incessant hours, the wildfire that consumed everything but their lives, raged around them.7 finally, the bellante family stumbled to their feet, shocked and exhausted they began to grasp the horror that surrounded them. even though they lost everything, the bellantes are reminded daily by the absence of eight neighbors how lucky they are to have survived this disaster.8 956 florida tax review [vol.6:10 9. see federal emergency management agency, fema brochure, availab le at http://www.fema.gov/pdf/library/thisisfema.pdf (last visited feb. 17, 2005) (noting that “disasters can strike at any time, any where . . . they can be an act of nature or an act of terrorism. they can strike suddenly, or build over days and weeks before bringing catastrophe. no matter how they come, disasters put millions of americans in danger every year, and destroy billions of dollars worth of property.); international federation of red cross and red crescent societies, world disasters report 2002, 10, 37, 171-72, 187 (table 1) (reporting that over the past thirty years the number of people impacted by disasters has increased dramatically; in 2001, 170 million people worldwide (11.2 million in the americas) were affected by disasters – below the decade’s average of 200 million but significantly greater than the 74 million average during the 1970s). 10. over the last decade, earthquakes have been the most expensive of all disasters, with a worldwide price tag of $238 billion in damages ($39.6 b illion in the americas), without including any effect on the economy. world disaster report 2002, supra note 9 , at 172 , 192 (table 8). during 2001, earthquakes affected 19 million people, more than any other year of the decade. id. at 172, 191 (table 7). on january 17, 1994, a killer earthquake rocked northridge, california and cost $17.3 b illion in insured losses. this disaster was the third most costly catastrophe in the united states and the world. see insurance information institute, facts and statistics: catastrophes, the ten most costly world insurance losses, at http://www.iii.org/media/facts/ statsbyissue/catastrophes (last visited june 30, 2004). earthquakes account for approximately 9.8% of inflation-adjusted u.s. catastrophic losses. id. 11. “floods cause more destruction in the u.s. than any other disaster.” fema brochure, supra note 9 (commenting that flood damage is not covered by regular homeowners or renters insurance, but that fema’s offers federally backed flood insurance coverage to residents in more than 19,000 communities). floods have cost the world almost $192 billion ($36.4 billion in the americas) over the last decade and have caused the broadest impact on people’s lives accounting for almost two-thirds of people affected by disasters worldwide. world disaster report 2002, supra note 9, at 172 (figure 8.2), 196 (table 12). the number of floods and windstorms is 64% of all natural disasters and 35% of all disasters. id. at 189 (table 5). in 2000 and 2001, there were more than 150 floods worldwide. id. 12. drought/famine have cost the world more than $32.5 billion ($3.5 billion in the americas) over the last decade and affected over 86 million people worldwide in 2001. id. at 172, 191 (table7), 196 (table 12). over the last decade, drought/famine was pervasive affecting 82% of all disaster victims in africa; 48% in oceania; and 35% in the americas. id. at 172, 195 (table 11). 13. forest/scrub fires have cost the world more than $25 billion ($3.6 billion in the americas) worldwide. id. at 196 (table 12). “america’s fire death rate is one of the highest per cap ita in the industrialized world . fire kills more than 4,000 and injures more than 23,000 people each year. . . . direct property losses due to fire exceed $8.5 billion a year.” fema brochure, supra note 9; see also insurance information institute, facts and statistics: catastrophes: catastrophic wildland fires in the united states at http://www.iii.org/media/facts/statsbyissue/catastrophes (last visited june 30, 2003). “fires have been growing bigger and badder. . . . [e]xploding out of forest tinderboxes, megafires are lethal, fast-moving and spread to more than 100,000 acres.” micah morrison, danger: flames ahead!, parade, june 27, 2004, at 5 (describing the increased threat of fire to property and life). 14. tornadoes account for more than 32% of the inflation-adjusted catastrophic losses in the united sta tes. insurance information institute, facts and statistics: catastrophes, at http://www.iii.org/media/facts/statsbyissue/catastrophes (last visited june 30, 2004) (charting catastrophic losses and ranking the ten most costly tornadoes in the united states). 15. all tropical cyclones (including hurricanes and tropical storms) account for 28% of all inflation-adjusted catastrophic losses in the united states. see insurance information institute, facts and statistics: catastrophes: inflation-adjusted u.s. catastrophe losses by category, at http://www.iii.org/media/facts/statsbyissue/ each year disasters affect millions of innocent victims like the bellantes.9 earthquakes,10 floods,11 drought,12 fires,13 tornadoes,14 cyclones,15 2005] anatomy of a disaster 957 catastrophes (last visited june 30, 2004) (charting inflation-adjusted catastrophic losses in the united states). 16. see id.; insurance information institute, facts and statistics: catastrophes: the ten most costly hurricanes in the united states, available at www.iii.org/media/ facts/statsbyissue/catastrophes (last visited june 30, 2004) (listing hurricane andrew on august 23, 1992, which cost $20.9 billion, as the most costly hurricane in the united states and the second most costly insured loss in the world); chris isidore, charley c o uld pack do l la r punch , cnnm oney , a t h t tp : / /money .c n n .c o m / 2004/08/13/news/economy/hurricane_charley/index.htm (last visited aug. 17, 2004) (estimating that hurricane charley which hit southwest florida on friday, august 13, 2004, will be one of the most expensive storm in u.s. history with insured losses in the $10 billion range); tom herman, ask dow jones, the san diego union-trib., aug. 22, 2004, at h7 (reporting that the insurance information institute estimates that insurers are likely to deliver $7.4 billion to people whose homes, businesses and property were damaged by hurricane charley); ivan’s stormy trek floods southeast, cnn.com, at h t t p : / / w w w . c n n . c o m / 2 0 0 4 / w e a t h e r / 0 9 / 1 6 / hurricane.ivan/index.html (last visited feb. 12, 2005) (recounting that in september, 2004, hurricane ivan, caused estimated insured losses from about $4 billion to $10 billion); eqecat estimates o f insured losses from hurricane frances, at http://www.eqecat.com/documents/eqeca+sunday/9.5.04.pdf (last visited sept. 21, 2004) (estimating that insured losses in september 2004 from hurricane frances in florida and nearby states could range from $3 billion to $6 b illion, but that the total loss estimate is likely to exceed $10 billion). 17. terrorism accounted for 12.4% of the aggregate inflation-adjusted catastrophic losses in the united states. insurance information institute, facts and statistics: catastrophes: inflation-adjusted u.s. catastrophe losses by category, at http://www.iii.org/media/facts/statsbyissue/catastrophes (last visited june 30, 2004). 18. see world disasters report 2002, supra note, at 173, 185 (table 4) (noting that the total amount of estimated damages inflicted by disasters during 2001 was $24.4 billion – the decade’s lowest and well below the annual average of $69 billion). each week, direct costs of disasters worldwide “amount to well over a billion dollars.” id. at 37. earthquakes, floods and windstorms have proven to be very expensive disasters. id. at 173; see also national climatic data center, billion dollar u.s. weather disasters 1980-2003 (feb. 3, 2004) at http://www.ncdc.noaa.gov/oa/reports/billionz.html (last visited june 16, 2003) (reporting that the u.s. has suffered 58 weather-related disasters over the past 24 years in which overall damage was equal to or greater than $1billion and totaled nearly $350 billion); see also insurance information institute, facts and statistics: catastrophes: the ten most costly world insurance losses, at http://www.iii.org/media/facts/statsbyissue/catastrophes (last visited june 30, 2004) (setting forth the ten most catastrophic losses in the world including september 11, 2001, costing $21 billion in insured losses, hurricane andrew, costing $20.9 billion, and the northridge earthquake, costing $17 .3 billion as the top three most costly disasters). the federal emergency management agency (fem a) has listings of the federally declared disasters, emergency declarations and fire management assistance declarations beginning in 1953 through 2003 on its informative website. federal emergency m a n a g e m e n t a g e n c y 2 0 0 3 f e d e r a l d i s a s t e r s d e c l a r a t i o n s , a t http://www.fema.gov/news/disasters.fema?year=2003 (last visited june 4, 2003). over this period, there were 1,504 major disasters declared with an average annual number of major disaster declarations of thirty. in 2003, fem a reported fifty-six federally declared disasters ranging from a winter storm in alaska to flooding in florida to a tornado in new york and a hurricane in texas. see federal emergency management a g e n c y : d i s a s t e r f e d e r a l r e g i s t e r n o t i c e s , a t http://www.fema.gov/news/disasters.fema?year=2003 (last visited june 5, 2004). in addition, there were forty-six fire management assistance declarations and nineteen emergency declarations including the loss of the space shuttle, columbia, on february 1 and the power outages in michigan, new jersey and ohio on september 23. id. hurricanes16 and terrorism17 account for billions of dollars of direct damage annually.18 the terrorist attacks on september 11, 2001 resulted in unparalleled, 958 florida tax review [vol.6:10 19. see federal emergency m anagement agency, a nation remembers, a nation recovers, responding to september 11 , 2001, one year later (sept. 2002); u.s. small business administration, business assistance guide, for the september 11th tragedy in the greater new york area; insurance information institute, facts and statistics: catastrophes: september 11, 2001 world trade center losses, at http://www.iii.org/media/facts/statsbyissue/catastrophes (last visited june 30, 2004) (recounting the catastrophic disaster on september 11, 2001, and enumerating the estimated total insured loss to be about $40 billion with property damage alone at $20.3 billion). 20. “hazards are an unavoidable part of life. each day, every one of us faces some degree of personal risk from hazards of one kind or another. the hazards we face are very diverse. t hey arise from our society (for example, conflict, terrorism, civil strife) and technology (industrial and transport accidents), as well as from the natural environment (such as floods, windstorms, droughts, earthquakes) and from threats to public health.” world disaster report 2002, supra note 9, at 9. 21. see id. at 171, 185 (table 1) (determining that the total number of disasters worldwide in 2001 was 712 (127 in the americas), which was lower than the 759 disasters worldwide in 2000 (144 in the americas), but was the second highest total of the decade with increases in weather-related disasters); fema, supra note 9 (stating that it is a myth to believe that a disaster will never happen to me and that every state in the u.s. is at risk for man-made disasters and for some natural disaster). 22. insurance information institute, facts and statistics: catastrophes: insured l o s s e s f o r u . s . c a t a s t r o p h e s 1 9 9 4 2 0 0 3 , a t http://www.iii.org/media/facts/statsbyissue/catastrophes/content.print (last visited july 3, 2004) (setting forth the number and dollar amounts of catastrophic insured losses from 1994 through 2003). 23. see for example world disaster report 2002, supra note 9, at 34 (natural disasters pose “undoubtedly massive” threats to human society); jeanette steele, san diego county firestorms aftermath: sadness, frustration, despair creep in for victims, experts say those feelings are normal, the san diego union-trib., feb. 15, 2004, at b1 (recounting that fire victims facing the herculean task of restarting their lives may feel so depressed that they find it difficult to get out of bed in the morning or erupt in angry outbursts); san diego county firestorms aftermath: information you can use, the san diego union-trib., nov. 2, 2003, at a13 (describing a multitude of information for victims of the fires ranging from how to receive mail to avoiding fire-related scams); michael burge, community solutions: san diego county firestorms aftermath: neighbors answer the call to mobilize moe than 100 for valley center fire recovery, the san diego union-trib., dec. 14 , 2003, at a1 (describing five community outreach efforts to assist in myriad of fire victims needs from housing to clean-up to transportation to emotional support); jane clifford, san diego firestorms aftermath: building a future, one in an occasional series, brown family, taking stock the san diego union-trib. , feb. 7, 2004, at e1 (explaining the tedious task of applying for insurance reimbursements including listing all household items up to and including toothpicks); jeanette steele, san diego county firestorms aftermath: insurance shortfall, the san diego union-trib., mar. 21, 2004, at b1 (describing that because of significant insurance shortfalls many fire victims will need second mortgages or drain their savings accounts to rebuild); jeanette steele, san diego county firestorms aftermath: owner fears for quality of life, ranch, the san diego union-trib. , mar. catastrophic physical damage and loss.19 while disasters can be earth shattering, they are commonplace, striking average citizens20 worldwide almost twice a day.21 in the united states, catastrophic disasters causing at least $25 million in direct damages occur almost twice a month.22 the challenges faced by victims of disasters are pervasive and overwhelming.23 one of the many challenges is trying to comprehend and 2005] anatomy of a disaster 959 21, 2004, at b4 (describing the challenges of inadequate insurance coverage); jeanette steele, san diego county firestorms aftermath: agent told scripps ranch man he had enough home insurance, the san diego union-trib., mar. 21, 2004, at b4 (describing $223,362 shortfall to rebuild home that victim believed was adequately insured); nancy mccarthy, attorneys and judges w ere victims, too, california bar journal, dec. 2003 , at 1, 14 (explaining the devastation fire victims experienced to their homes and businesses including how a “fireproof” box where important documents were stored melted); anne krueger, san diego county firestorms aftermath: san diego county fair exhibit an act of healing for fire victims, the san diego union-trib., june 20, 2004, at b6 (quoting caitlin finch, a student who lost her family home in the wildfires, “infinity is the number of times a day i feel like screaming. the number of times i have to fight back tears. the number of people who want to help and do, but then stroll back to the comfort of their somewhere. they don’t truly know how it feels to be nowhere. and sometimes i wish i were them.”). 24. see for example dept. of the treasury, internal revenue service, 2003 disaster losses kit for individuals, pub. 2194, at www.irs.gov (last visited june 17, 2004) (explaining in almost 100 pages tax relief for individual disaster victims). a similar kit exists for businesses. see dept. of the treasury, internal revenue service, 2003 disaster losses kit for businesses, pub. 2194b, at www.irs.gov (last visited june 17, 2004) (explaining tax disaster relief for business victims). experts in taxation note that the delay in getting adequate disaster relief legislation enacted is indicative “of the complexity and cost of the tax issues involved.” annette nellen, disaster relief provisions: changes to § 1033 and the problems that remain, 22 j. real est. tax’n 158, 158; see tom herman, ask dow jones, the san diego union-trib., aug. 22, 2004, at h7 (commenting that while taxes are probably “the furthest thing from their minds” hurricane charley disaster victims in florida may benefit from a fresh look at available tax breaks). 25. in addition to federal income tax issues disaster victims may face state and local income and property tax issues. many states incorporate federal income tax provisions including income tax disaster relief into their state statutes. therefore, the coverage of federal disaster tax relief should be very informative for understanding similar state provisions. in addition, to income tax many states assess annual property taxes, which are ad valorem taxes based upon the value of the property. when a disaster damages or destroys property, many states have procedures for having the assessed value reduced, thereby reducing the owner’s property taxes. see annette nellen, disaster relief provisions: changes to § 1033 and the problems that remain, 22 j . real est. tax’n 158, 166-67 (1995). in addition, states may have limited provisions allowing replacement property to retain the same assessed value as the destroyed property despite the replacement property’s higher fair market value on the date of the replacement. id.; see cal. rev. & tax code § 69 , 69.3 (2003). disaster victims and their advisors should explore and maximize any state and local disaster relief tax provisions. t his article will address only federal income tax matters. 26. the southern california wildfires provide an excellent framework for this analysis for several reasons. first, fire is a common disaster. according to the national interagency fire center, “an average of 97,000 wildfires have burned nearly 5 million acres annually each year in the past decade.” see m ichael d. brown, under secretary emergency preparedness and response, the california fires coordination group a manage the tax consequences of a disaster.24 this article describes the assortment of disaster relief and the federal income tax issues experienced by disaster victims.25 as a framework for this analysis, the article will illustrate the various tax issues for a hypothetical family named the bells, who like the bellantes, lost everything in the 2003 southern california wildfires.26 part ii describes the 960 florida tax review [vol.6:10 report to the secretary of homeland security (feb. 13, 2004), at www.fema.gov/txt/library/draft_cfcg_report_0204.txt at 5 (last visited june 17, 2004) [hereinafter california fires report] (setting forth wildfire activity in the united states from 1994-2003). moreover, wildfires are a continuing threat to wildland-urban communities. id. at 5, 9 (stating that wildfires are a significant risk to more than 7 .2 million california homes and that more than 190 million acres of federal forest and rangelands, an area twice the size of california, are at risk for catastrophic wildfires); see micah m orrison, danger: flames ahead!, parade (june 27, 2004) at 4-5 (stating that the dangers of catastrophic wildfires are growing across american and that they appear to be the wave of the future citing a thirteen-fold increase in catastrophic fires over the last two decades); dar a. roberts, the fire storm of 2003, 34 coast lines 38 (winter 2004) (discussing the continuing threat of wildfires in southern california). second, the timing of these fires is appropriate because they are close enough in time to allow us to apply current law while still providing the opportunity to review post-disaster statistics and analysis. the california fires coordination group has issued its extensive report on the fires providing qualitative and quantitative information on the relief provided during t h i s h i s t o r i c d i s a s t e r . c a l i f o r n i a f i r e s r e p o r t , a t www.fema.gov/txt/library/draft_cfcg_report_0204.txt at 50. third, the 2003 california wildfires were among the largest fires in american history involving a unique level of coordination and magnitude of response. id. at 50; insurance information institute, facts and statistics: catastrophes, at www.iii.org/media/facts/statsbyissue/catastrophes (last visited june 30, 2004) (listing the california 2003 wildfires as the e ighth most costly catastrophe in the united states). fourth, the documentation and analysis of the california wildfires is extensive and comprehensively reported on february 13, 2004 by the washington d.c.-based california fires coordination group headed by the under secretary for emergency preparedness and response in the recently repositioned federal emergency management agency now part of the department of homeland security. id. fifth, the southern california wildfires are similar to many other d isasters, including terrorism, that without discretion destroy personal and business use property and leave taxpayers homeless and stripped of all belongings and subject to a variety of different tax provisions. many types of disaster relief for individuals and households including grants and loans from government agencies, reimbursements from private insurance providers, assistance from charitable and other non-profit organizations and gifts from family, friends and strangers. part iii discusses the tax consequences of these relief payments and various other tax provisions that provide relief for unreimbursed losses and reinvested gains. the tax provisions presented include the tax treatment of reimbursements for additional living expenses and lost income and disaster loans. in addition, the article presents the tax relief available for gains realized as a result of the disaster and tax benefits for casualty and net operating losses. next, the article describes the tax consequences of interest expense resulting from disaster relief loans and from existing loans on property that has been damaged or destroyed by the disaster. finally, the article imparts several administrative provisions that assist disaster relief victims with tax filing and payment deadlines and the challenges of restoring current and historic tax records. part iv provides a summary and conclusion for the article. 2005] anatomy of a disaster 961 27. the cedar fire was the largest, costliest and most destructive of the california 2003 wildfires. california fires report, supra note 26, at 15. this fire, which began in the early hours of october 26 , 2003, grew to 115,000 acres within two days, and by the time it was contained on november 5, 2003, had scorched 273,246 acres, destroyed 2,200 homes and 22 businesses and caused 113 injuries and 14 deaths. id. 28. see clifford, supra note 1, at e1 (describing the bellante family’s narrow escape from death in the cedar fire). 29. id. (lori bellante spent twelve days at ucsd’s burn center for the severe burns on her arm). 30. see california fires report, supra note 26, at 18-21 (describ ing the chronology of the federal response to the 2003 california wildfires). 31. see id. at 4, 21 (detailing the historic losses of the 2003 california wildfires); insurance information institute, facts and statistics: catastrophes, at www.iii.org/media/facts/statsbyissue/catastrophes (last visited june 30, 2004) (listing the california 2003 wildfires as the eighth most costly catastrophe in the united states and the second most costly wildfire in the united states since 1970). 32. see california fires report, supra note 26, at 12, 21; dar a. roberts, the fire storm of 2003, 34 coast lines 38 (winter 2004) (professing about the tragic, but not surprising losses from the 2003 southern california wildfires). 33. id. (reporting the costs of the fire including fire fighting costs estimated at hundreds of millions of dollars). see also california fires report, supra note 26, at 21 (estimating insured losses between $1.7 $3.5 billion). 34. id. at 4, 17-21 (elaborating the recovery efforts set in motion on october 27, 2003 when p resident george w. bush, within hours of california governor gray davis’s request, declared the california wildfires a major disaster). section 401 of the stafford act requires that “all requests for a declaration by the president that a major disaster exists shall be made by the governor of the affected state.” see 42 u.s.c. § 5170; 44 c.f.r. § 206.36(a). the governor’s request is made through the regional fema/epr office after a preliminary damage assessment. depart. of homeland ii. anatomy of a disaster: sources of relief a. introduction: southern california wildfires of 2003 eventually, the wildfire, named the cedar fire, raced away from the bellantes’ scorched property in its relentless pursuit of fuel.27 the bellantes, traumatized and weary, reunited with a neighbor who drove them to nearby stelzer park.28 in the safety of the neighborhood park, paramedics attended to their burns and the long, torturous healing process began.29 by the close of this life-altering day, october 26, 2003, eleven people had died, 500 homes were destroyed, and 30,000 more homes and thousands more people were being threatened from wildfires jeopardizing more than 200,000 acres.30 the southern california wildfires in late october through early november of 2003 rank among the largest disasters in california’s history and the costliest fires in american history.31 in all, california suffered more than 750,000 scorched acres, over 15,000 damaged structures including 3,631 destroyed homes and many businesses, 217 injured people and 24 deaths.32 structural losses have been estimated between one and four billion dollars.33 in response to california governor gray davis’ request president george w. bush declared the california wildfires a major disaster on october 27, 2003 setting in motion an array of federal programs to assist individuals, like the bellantes, in their recovery efforts.34 962 florida tax review [vol.6:10 security, emergency preparedness and response directorate, a guide to the disaster declaration process and federal disaster assistance. the governor must execute the state’s emergency response plan as part of the request for federal assistance. id . fema brochure, supra note (detailing the federal disaster declaration process). 35. fema was an independent government agency until it became part of the new department of homeland security in march 2003, fema, fem a history, at www.fema.gov/about/history.shtm (last visited june 22,2004) (tracing detailed history of fema beginning in 1803 until its current multi-faceted operation). 36. the stafford act gives the president the authority to direct “any federal agency, with or without reimbursement, to utilize its authorities and [its] resources . . . in support of state and local assistance efforts.” 42 u.s.c. § 5170a(1) (2004). additionally, the president has the authority to coordinate all disaster relief assistance and provide or direct any federal agencies to provide certain assistance essential to meeting immediate threats to life and property resulting from a major disaster. 42 u.s.c. § 5170a, b; see also sandra leon & sandy lubin, fema: federal disaster relief, 17 gpsolo 26, 27 (july/aug. 2000) (describing the fema’s charge for disaster relief); david g. tucker & alfred o. bragg, iii, florida’s law of storms: emergency management, local government, and the police power, 30 stetson l. rev. 837, 861-65 (winter 2001) (describing fema and the various powers and responsibilities it has under the stafford act). 37. pub. l. no. 93-288, 88 stat. 143, (as amended, at 42 u.s.c. §§ 5121-5195 (1994)) the stafford act. congress amended the stafford act, and president clinton signed those amendments into law on october 30, 2000. disaster mitigation act of 2000, pub. l. no. 106-390 , 114 stat. 1552 (2000). 38. 44 c.f.r. § 206 .35-208 (2004); see california fires report, supra note 26, at 8 (describing the declaration process in the case of the 2003 california wildfires). 39. 42 u.s.c. § 5170; 44 c.f.r. § 206.36(a); see tucker & b ragg, supra note 36, at 862-63 (describing the process the stafford act and regulations provide for the president’s declaration of a major disaster including one regulation § 206.48(a)(1) that suggests that the threshold amount of damage the state must meet or exceed for a residential declaration is one do llar per person in the state’s population); leon & lubin, supra note 36, at 28 (setting forth the disaster or emergency declaration process). 40. 42 u .s.c. § 5174 (2004); see tucker & bragg, supra note 36, at 864-65 (describing the scope of the federal government’s assistance available in a presidentially declared major disaster); leon & lubin, supra note 36, at 28-29 (enumerating the recovery process and disaster aid programs for individuals and others). 41. 42 u.s.c. § 5170a; see tucker & bragg, supra note 36, at 863-64 (describing the federal government’s response to a presidentially declared major disaster); leon & lubin, supra note 36, at 27 (describing fema’s role as coordinator b. federal emergency management agency (fema): response and recovery the department of homeland security’s fema35 is charged with, among other responsibilities, delivering aid to victims of major disasters declared by the president.36 in 1988, congress enacted the robert t. stafford disaster relief and emergency assistance act37 to provide support for state and local governments and their citizens when disasters overwhelm them and their resources.38 the stafford act, as amended, establishes a process for requesting and obtaining a major disaster declaration by the president,39 defines the type and scope of assistance available from the federal government and sets the conditions for obtaining assistance.40 fema, now part of the emergency preparedness and response directorate of the department of homeland security, is also charged with coordinating the federal government’s response with state, local, and tribal governments and private and faith-based voluntary organizations.41 2005] anatomy of a disaster 963 of federal assistance); california fires report, supra note 26, at 18-19 (explaining fema’s federal response plan as a signed agreement among twenty-seven federal departments and agencies, including the american red cross, as “the mechanism for coordinating joint delivery of federal assistance and resources to augment efforts of state and local governments overwhelmed by a major disaster or emergency through a series of agency-tasked emergency support functions”). 42. leon & lubin, supra note 36, at 28. 43. id. 44. id. 45. id.; california fires report, supra note 26, at 28 (recounting the delivery of aid in the california wildfires of 2003, which stretched over 1,100 square miles and touched diverse and numerous communities). 46. “only disaster victims who are u .s. citizens, non-citizen nationals (those born in an outlying u.s. possession, such as american samoa), and qualified aliens are eligible to receive federal public benefits (i.e., grants and loans) from fema. this requirement does not apply to short-term, non-cash, in-kind emergency relief such as search and rescue, emergency medical care, emergency shelter, crisis counseling, and legal services.” leon & lubin, supra note 36, at 28. 47. 44 c.f.r. § 206.112 (2204) (setting forth sixty-day standard period of registration, which may be extended and that late registrations with appropriate filings will be accepted for an additional sixty day period); see fema california, recovery times 1 at www.fema.gov/txt/rt/rt1498_sandiego.txt (dec. 20, 2003) (encouraging disaster victims from the 2003 california wildfires to “[a]pply now to protect your ability to get help” and do not wait for insurance settlements before registering for assistance to cover uninsured or underinsured losses). 48. dept. of homeland security, emergency preparedness and response directorate, office of legis. affairs, a guide to the disaster declaration process and federal disaster assistance (mar. 2003), at www.fema.gov/rrr/dec_guid.shtm (last visited june 26, 2004) (setting forth the process and toll-free telephone registration number as 1-800-621-fem a (or ty y 1-800-462-7585 for the hearing or speech impaired)); fema: the disaster assistance process for individuals, at www.fema.gov/about/process (last visited june 26, 2004) (setting forth general information about the registration process); fema california, recovery times 1 (nov. 10, 2003) at www.fema.gov/txt/rt/rt1498.txt [hereafter recovery times (nov. 10, 2003] (urging residents and business owners in disaster declared counties register with fema from 8 a.m. to 6 p.m. seven days a week, until further notice). 1. the registration and information gathering process immediately after the president declares a major disaster, fema employees travel to the disaster site “to set up a field office to coordinate the recovery effort.”42 “fema also opens recovery centers in or near the community affected by the disaster.”43 disaster victims visit the centers to obtain information about the recovery process.44 in addition, fema’s national teleregistration centers are activated and toll free numbers are broadcast to allow affected residents and business owners to register for assistance and receive referrals to other aid providers.45 every qualifying disaster victim46 must register for assistance within a limited period of time47 to establish eligibility for relief.48 fema’s specially trained employees register disaster victims with information provided over the telephone including the applicant’s name, date of birth, social security number, home address, mailing address, telephone number, insurance information and 964 florida tax review [vol.6:10 49. leon & lubin, supra note 36, at 28; see also recovery times 1 (nov. 10, 2003) supra note 48, at 2 (describing the disaster assistance registration process and related information). 50. sean holton and jeff kunerth, getting federal help, orlando sentinel trib., feb. 25, 1988, at a12 (describing the federal assistance available for victims of tornadoes hitting central florida). 51. recovery times 1 (nov. 10, 2003) supra note 48, at 2; leon & lubin, supra note 36, at 28; fema, about fema, the disaster assistance process for individuals, available at www.fema.gov/about/process (last visited june 26, 2004). 52. california fires report, supra note 26, at 28 (describing the details of the process and the aid delivered to fire victims); see also vickie chachere, hundreds of good samaritans help florida hurricane victims, the san diego union-trib., aug. 22, 2004, at a-3 (reporting that fema had registered 77,000 households only one week after hurricane charley hit florida). 53. california fies report, supra note 26, at 28 explaining the vastness of the disaster area. 54. id. at 20, 26 (describing the activation of the federal response plan as a result of the president’s major disaster declaration). 55. id. at 28 (detailing the delivery of aid to the victims of the fire). the five counties declared a major disaster by the president included los angeles, riverside, san bernadino, san diego and ventura. id. at 12-16. 56. id. 57. leon & lubin, supra note 36, at 28-30 (setting forth disaster relief assistance availab le to individuals and state and local governments). this article will not discuss fema disaster relief provided to governmental agencies, because governmental agencies are not subject to tax and, therefore , there are generally no tax consequences of their receipt of relief. family gross income.49 the application process takes approximately 15-20 minutes.50 applications with housing damage are referred to inspectors who schedule onsite visits to inspect the damaged property, verify ownership and occupancy and file a report with fema for consideration of assistance.51 when the registration period for the california wildfires of 2003 closed on january 9, 2004, fema had received 38,296 applications for assistance.52 because the declared disaster area stretched over 1,100 square miles,53 the disaster field office was established in pasadena with satellite operating facilities in san bernardino and san diego.54 fema staff worked with the california governor’s office of emergency services and local authorities to set up as many as sixteen local area recovery centers in community centers and other convenient locations throughout the five-county disaster area.55 these centers provided approximately 18,989 disaster victims with the opportunity to gather critical information and advice from representatives from federal relief organizations (such as fema, small business administration, the internal revenue service (irs or service) and the united states department of agriculture), private insurance providers and local volunteer agencies.56 through these resources individuals and households received disaster assistance.57 2. federal assistance to individuals and households federal assistance for individuals and households includes financial aid for damage to residences, businesses, and personal property and necessary 2005] anatomy of a disaster 965 58. id.; 44 c.f.r. § 206.11(h). 59. leon & lubin, supra note 36, at 28. 60. recovery times 1 (nov. 10, 2003), supra note 48, at 3 (describing assistance available to disaster victims of the 2003 california wildfires). 61. see fema, individual assistance programs, available at www.fema.gov/rrr/inassist.shtm (last visited june 26, 2004); recovery times (nov. 10, 2003), supra note 48, at 2, 5 (setting forth answers to faqs about disaster assistance and describing the availability of sba loans); california fires report, supra note 26, at 53 (noting that eighty percent of the disaster relief in the california wildfires was from sba in the form of low-interest loans); david w. sar, helping hands: aid for natural disaster homeless vs. aid for “ordinary homeless,” 7 stan. l. & pol’y rev 129, 132 (winter 1995-96) (describing the benefits of sba loans in the disaster relief process); see also 15 u.s.c.a. § 636(b) (2004); 13 c.f.r. § 123 (2004), et seq. 62. see 13 c.f.r. § 123.3 (2004). 63. see jeffrey a. unger, valuation of real estate losses arising from natural disasters: opportunities for coordination with fema disaster loss verification, 25 j. real est. tax’n 52, 58 (fall 1997). 64. 13 c.f.r. § 123.101. 65. see 15 u.s.c. § 636(b); 13 c.f.r. § 123.61; recovery times 1 (nov. 10, 2003), supra note 48, at 3 (detailing homeowner disaster loans). “disasters are the only times the sba may provide low-interest loans to homeowners, as well as small business owners.” leon & lubin, supra note 36, at 29; see also fema, recovery times 3 (dec.30, 2003) (answering faqs on sba loans including that the sba can refinance an existing mortgage to include necessary funding for disaster repairs not covered by insurance). the sba will increase the amount of any loan by up to twenty percent to protect from or mitigate damage from future similar disasters. 13 c.f.r. § § 123.7, 123.105(a)(4), 123.107 (2004). in addition to the costs of restoration and mitigation, sba loans may cover personal expenses and professional fees. see unger, surpa note 63, at 71. however, the sba is prohibited from lending funds that represent compensation for the disaster victim’s labor. 13 c.f.r. § 123.9(a) (2004). expenses and serious needs that are not covered by insurance.58 only registered individuals and businesses that are located in an area declared a disaster by the president qualify for federal assistance.59 this assistance is comprised of several components including low-interest loans, cash grants, and in-kind assistance.60 a. small business administration (sba) disaster loans most of the federal assistance for individual disaster victims is in the form of low-interest, federally subsidized loans for expenses not covered by state or local programs, or private insurance.61 any owner of damaged real property located in a presidentially declared disaster area is eligible to apply for a loan to repair uninsured damage.62 the government wants to encourage disaster victims to rebuild.63 therefore, government loans are not generally available to buyers of disaster property.64 small business administration (sba) low-interest disaster loans of up to $200,000 are available to homeowners for real estate repairs, and additional loans of up to $40,000 are available to tenants and homeowners to replace personal property losses and other costs.65 966 florida tax review [vol.6:10 66. see 15 u.s.c. § 636(b); 13 c.f.r. § 123.61; recovery times 1 (nov. 10, 2003) supra note 48 , at 3 (detailing business disaster loans). 67. id.; california fires report, supra note 26, at 53 (describing this program as the physical damage loan program addressing physical damage to real estate and personal property including inventory); dept. of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process a n d f e d e r a l d i s a s t e r a s s i st a n c e 2 ( u p d a t e d m a r . 2 0 0 3 ) , a t www.fema.gov/rrr/dec_guid.shtm (describing the assistance available for individuals). 68. id.; recovery times 1 (nov. 10, 2003) supra note 48 at 3, 5 (detailing the types of business disaster loans); california fires report, supra note 26, at 53 (describing this program as the economic injury disaster loan program assisting in meeting basic operating expenses with working capital loans for disaster related business downturns). 69. leon & lubin, supra note 36, at 29 (describing the coordination of the sba loan application process with the fema registration process to minimize duplication of services). 70. id. 71. 13 c.f.r. § 123.100(b) (2004). 72. see unger, supra note 63, at 55. 73. leon & lubin, supra note 36, at 29. 74. unger, supra note 63, at 68. 75. 13 c.f.r. § 123.9(a). 76. id. 77. 13 c.f.r. § 123.9(b). the sba also provides disaster loan assistance to businesses.66 businesses of any size in the disaster-declared and surrounding areas may borrow up to $1.5 million to repair or replace real estate, machinery and equipment, inventory and other business assets.67 small businesses may also qualify for working capital loans of up to $1.5 million to assist them with their cash flow needs through the disaster recovery period.68 the sba works closely with fema to obtain the information it needs from disaster victims for its loan applications.69 after registering with fema, a disaster sba loan application is delivered to certain victims to gather more information about the applicant.70 after a disaster victim completes her loan application, an sba loss verifier inspects the property to document the damage.71 the sba details the amount necessary to repair various components of the damaged property in a loss verification report.72 while the loan approval process may take several weeks, the sba processes these applications with special procedures and designated staff on an expedited basis.73 sba personnel work closely with disaster victims during the entire rebuilding process, “which includes reviewing the completed application, performing financial analysis to determine creditworthiness, disbursing funds, and verifying the progress of repairs.”74 if approved, the loan agreement between the sba and disaster victim will designate specific categories for use of the loan proceeds.75 the sba will only disburse disaster loan funds as the disaster victim submits her evidence of the designated repairs and the disbursed funds must be used for such designated purpose within sixty days.76 if the disaster victim deviates her use of the loan proceeds from the specific categories without amending the loan agreement the disaster victim will be in default of the loan agreement and subject to civil penalties of up to fifty percent of the disbursed loan proceeds and potential criminal penalties.77 individuals 2005] anatomy of a disaster 967 78. id.; see sar, supra note 61, at 132 (describing disaster relief provided by the sba through low-interest loans); recovery times 1 (nov. 10, 2003), supra note 48, at 2 (answering the question “what happens if i cannot afford a loan?”). in addition, the department of housing and urban development can provide increased limits for and a foreclosure moratorium on federal housing administration (fha)-insured loans. see california fires report, supra note 26, at 30 (describing a ninety day foreclosure moratorium on and increased limits of fha-insured loans for disaster-affected properties). in addition, fannie mae, the nation’s largest source of financing for home mortgages, has provided disaster relief to its borrowers. see colleen haggerty, fannie mae announces mortgage relief for wildfire victims in southern california (oct. 27, 2003) at www.faniemae.com/newsreleases/cases/203/2812.shtm. the disaster relief may include temporary suspension or reduction of mortgage payments or even term modification. id. 79. california fires report, supra note 26, at 31, 34, 53 (recounting how 100 sba representatives were on site staffing information desks and attending public meetings to assist victims, while an additional 100 support staff were responding to the disaster in sacramento). 80. id .; fema, six months later: more than $317 million approved for southern california wildfire recovery (may 7, 2004) (setting forth the amount of sba loans as reaching almost $170 million six months after the deadly southern california wildfires). 81. california fires report, supra note 26, at 31-32 (se tting forth tab le depicting the combined fem a/sba aid). 82. 44 c.f.r. § 206.119 (2004) (requiring that applicant must apply to the sba for relief and be declined or demonstrate that sba assistance does not satisfy necessary expenses or serious needs arising out of the major disaster). 83. 42 u.s.c. § 5174(e) (2004) (setting forth parameters of financial assistance for other needs); 44 c.f.r. § 206.119 (describing the types of assistance availab le including clothing, schoolbooks, public transportation costs); leon & lubin, supra note 36, at 4; dept. of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process and federal disaster assistance (updated march 2003) at www.fema.gov/rrr/dec_guid.shtm. and businesses that do not qualify for these loans may qualify for alternative assistance.78 after the ashes settled from the 2003 southern california wildfires, fema had referred over 14,000 applicants to sba (out of 38,296 registrants) resulting in 1,245 homeowner and nearly 200 business sba loans totaling $161,713,800.79 experts estimate that the final sba disaster loan amount will range from $175-200 million.80 sba loans represents the single largest source of federal disaster assistance “accounting for over 80 percent of non-insurance recovery resources” provided to these disaster victims.81 b. individuals and household program (ihp) individuals who do not qualify for an adequate sba loan82 and have suffered losses not covered by insurance may receive cash grants for necessary expenses and serious needs including medical, dental, funeral, personal property, transportation, moving and storage and other government approved expenses.83 this relief is provided by fema’s ihp-other needs assistance 968 florida tax review [vol.6:10 84. 42 u.s.c. § 5174(g)(2) (describing the cost sharing between the federal and state governments); 44 c.f.r. § 206.110(i)(2); leon & lubin, supra note 36, at 4. 85. dept. of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process and federal disaster assistance (updated march 2003) at www.fema.gov/rrr/dec_guid.shtm. 86. 42 u .s.c. § 5174(a), (b) (setting forth when the president may provide housing assistance to disaster victims). a major disaster victim does not have to have applied for or have received a loan from the sba to receive temporary housing, repair, replacement or permanent housing construction assistance. 42 u.s.c. § 5174(a)(2); (c)(2)(b). however, this assistance will not be provided if adequate insurance coverage is available. dept. of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process and federal disaster assistance (updated march 2003) at www.fema.gov/rrr/dec_guid.shtm. 87. 42 u.s.c. § 5174(c)(1) (setting forth the type of temporary housing assistance available); 44 c.f.r. § 206 .117(b)(1) (detailing the aid to be made available to disaster victims); see also sar, supra note 61, at 131-32 (explaining the temporary housing assistance available during recent disasters). 88. 42 u.s.c. § 5174(c)(2) (setting forth the type of disaster residence repair assistance the president may provide); 44 c.f.r. § 206.117(b)(2), (c) (detailing the type of repair assistance available up to $5,000 (as adjusted annually for inflation)); california fires report, supra note 26, at 30 (describing the repair assistance provided to victims of the california wildfires). 89. 42 u.s.c. § 5174(c)(3), (4) (setting forth the type of replacement and permanent housing construction financial assistance the president may provide to major disaster victims); 44 c.f.r. § 206 .117(b)(3), (4) (describing the unique conditions under which this limited assistance ($10,000 adjusted for inflation for home replacement) is available); california fires report, supra note 26, at 30-31; leon & lubin, supra note 36, at 28 -29; fem a, ind ividua l assistance programs, available at www.fema.gov/rrr/inassist.shtm (last visited oct. 31, 2004). 90. leon & lubin, supra note 36, at 28 (describing the registration and recovery process); sar, supra note 61, at 131 (reporting that after the 1994 san fernando earthquake fem a rushed housing assistance checks to uninsured victims of disasters in los angeles for two months of housing for renters ($2,200) and three months of housing for homeowners ($3,300)); holton & kunerth, supra note 50, at a12 (describing that federal assistance payments for central florida tornado victims should be available approximately one week after an on-site inspection). (ona) program and is funded seventy-five percent by fema and twenty-five percent by the relevant state.84 the ihp – housing assistance (ha) is intended to assure that people whose homes are damaged by a major disaster have a safe place to live.85 when a major disaster is declared this program provides financial and in-kind assistance to people in the declared area whose property has been damaged or destroyed and whose losses are not covered by insurance.86 housing assistance includes financial or direct assistance for temporary housing (e.g., reimbursements for expenses related to hotels, motels or rental or temporary housing units when rental properties are not available) for up to eighteen months;87 up to $5,100 for uninsured home repairs to return owner-occupied primary residences to a safe and sanitary living or functioning condition;88 and under rare circumstances funds for home replacement and permanent housing construction.89 once approved, fema delivers housing assistance checks to disaster victims within seven to ten days of an onsite inspection.90 2005] anatomy of a disaster 969 91. 42 u .s.c. § 5174(h) (setting forth the maximum amount of federal assistance for individuals and households at $25,000 as adjusted annually for inflation); 44 c.f.r. § 206.110(b) (same); fema, individual assistance programs, available at www.fema.gov/rrr/inassist.shtm (last visited oct. 31, 2004); fema, six months later: more than $317 million approved for southern california wildfire recovery (may 7, 2004) at www.fema.gov/news/newsrelease.fema?id=12175 (last visited oct. 31, 2004) (noting that $25,600 is the maximum for fema benefits). 92. california fires report, supra note 26, at 30. 93. id. 94. id. at 31. 95. id. 96. 42 u .s.c. § 5177(a) (setting forth authorization for the president to provide weekly unemployment compensation to disaster victims that would not otherwise be eligible); dept. of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process and federal disaster assistance (updated oct. 22, 2004) at www.fema.gov/rrr/dec_guid .shtm (last visited oct. 31, 2004); fem a, recovery times 5 (nov. 10, 2003) (educating victims about federal unemployment benefits for individuals who lost their job due to a presidentially declared disaster). 97. 42 u.s.c. § 5177(a) (setting forth twenty-six week limitation); dept. of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process and federal disaster assistance (updated march 2003) at www.fema.gov/rrr/dec_guid.shtm (last visited nov. 4, 2004). 98. id.; see 42 u.s.c. § 5177(a) (directing the president to provide such assistance through agreements with states with adequate systems to administer such assistance). 99. california fires report, supra note 26, at 31. 100. 42 u.s.c. § 5179 (providing for federal disaster relief in the form of food stamps). aggregate benefits provided by fema under the ihp are limited to $25,000 (indexed for inflation this benefit was increased to $25,600 in 2003) per individual or household.91 in the 2003 california wildfires, fema provided over $32 million under these programs to disaster victims.92 as of february 10, 2004, fema had issued 3,740 ha checks totaling approximately $8 million and 9,585 ona checks aggregating approximately $24 million.93 in addition, ninety families had been placed in temporary manufacturing housing while awaiting the repair of their damaged homes.94 in addition to the immediate and sudden loss of housing and personal property, disasters disrupt the livelihoods of many, causing loss of employment and income as disasters force the closure of businesses.95 c. disaster unemployment assistance (dua) the dua program provides weekly unemployment benefits to individuals who are unemployed because of a presidentially declared disaster and not covered by other unemployment compensation programs.96 the benefits begin with the date of unemployment and can extend up to twenty-six weeks after the date of the president’s declaration of the major disaster.97 qualifying individuals must register with their state employment services office.98 as of january 26, 2004, fema approved 504 dua claims totaling $203,240 of unemployment benefits for victims of the 2003 california wildfires.99 in addition to unemployment cash benefits, the government may provide desperate disaster victims with in-kind benefits through its food stamp programs.100 970 florida tax review [vol.6:10 101. 42 u .s.c. § 5179(a) (seeting forth authorization). 102. california fires report, supra note 26, at 29. 103. id. 104. see 42 u.s.c. § 5182 (setting forth authorization for the assurance of adequate legal services for low-income households); dept. of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process and federal disaster assistance 2 (updated march 2003). 105. id. 42 u.s.c. § 5182; dent of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process and federal disaster assistance 3 (updated march 2003) (advising that cases that will produce a fee are turned over to local lawyer referral services); nancy mccarthy, when disaster strikes, lawyers help out: hundreds offer their time and advice – free, california bar journal, dec. 2003, at 1, 18 (recounting how one after another disaster victims were assisted by hundreds of volunteer lawyers activated through the aba’s young lawyer division). 106. see 42 u.s.c. § 5183 (setting forth authoriza tion for the president to provide professional counseling services to victims of major disasters to relieve mental health problems). 107. dept. of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process and federal disaster assistance 1 (updated march 2003); fema, recovery times 5 (nov. 10, 2003) at www.fema.gov/pdf/rt/rt1448.pdf (educating victims about disaster-related stress). d. emergency food stamp program the president is authorized to cause the united states department of agriculture (usda) to distribute food stamps for low-income major disaster victims that are unable to purchase adequate amounts of nutritious food.101 the usda’s food and nutrition service administers an authorized emergency food stamp program, which provides expedited food stamp assistance to eligible applicants during a major disaster.102 in the 2003 california wildfires, over 2,600 households received $853,939 in emergency food stamp assistance.103 in addition, to emergency housing assistance, housing, wage, and food assistance the federal government provides much needed legal and crisis counseling to disaster victims. e. legal services fema, through an agreement with the american bar association’s young lawyers division, provides free legal assistance to low-income individuals who are unable to secure adequate legal services as a result of a major disaster.104 the legal assistance typically includes assistance with insurance claims; replacement of important legal documents destroyed by the disaster; and counseling on landlord/tenant matters.105 f. crisis counseling assistance and training program (ccp) the ccp, authorized under the stafford act,106 provides supplemental funding to states for short-term crisis counseling services for presidentially declared disaster victims.107 the program helps states respond immediately and for up to nine months for victims with mental health needs through screening, 2005] anatomy of a disaster 971 108. dept. of homeland security, emergency preparedness and response directorate, a guide to the disaster declaration process and federa l disaster assistance 5-6 (updated march 2003). 109. id.; fem a, individual assistance programs, available at www.fema.gov/rrr/inassist.shtm (last visited oct. 31, 2004) (describing how to access confidential crisis counseling through fema’s toll free helpline number and disaster recovery centers). 110. california fires report, supra note 26, at 31. 111. see internal revenue service, casualties, disasters, and thefts, pub. 547, at 5 (stating that the most common type of casualty reimbursement is an insurance payment); see also insurance information institute, facts and statistics: catastrophes, availab le at www.iii.org/media/facts/statsbyissue/catastrophes (last visited nov. 4, 2004) (setting forth major u.s. catastrophes and the magnitude of the insured losses); w orld disasters report 2002, supra note 9, at 30 (noting that in developed countries insurance markets for natural hazards are well-established). 112. see insurance information institute, facts and statistics: homeowners insurance, available at www.iii.org/media/facts/statsbyissue/homeowners/content.print (last visited nov. 4, 2004) (stating that in 2001, 88% of all homeowners had insurance coverage); see also insurance information institute, publications: settling insurance claims 13, available at www.iii.org (noting that “[a]s a condition of granting a mortgage, lenders usually require that they are named in the homeowners policy and that they are a party to any insurance payments related to the structure”). 113. see id . (noting that in 2001, 48% of renters had insurance coverage for their personal property); insurance information network of california, consumer issues: insurance for your house and personal possessions item 10, available at www.iinc.org/cons_issues/home/insurance.html (noting that homeowners insurance policies typically include insurance coverage for the contents of one’s home, which is generally 50% of the amount of insurance on the dwelling, but may be as high as 75%). diagnosis, counseling and community outreach and education.108 crisis counselors are often available at disaster recovery centers to help disaster victims immediately in managing their grief, stress or other mental health problems caused by or aggravated by the disaster or its aftermath.109 fema approved $844,025 for state and local mental health agencies for the ccp in the 2003 california wildfires.110 c. insurance coverage by far the most significant source of relief from the economic costs of a disaster in the united states is insurance.111 because real property is often acquired with debt and most lenders require insurance coverage to protect their secured interest, many real property owners have insurance coverage.112 in addition to real property coverage, many automobile owners, tenants, home and business owners have insurance coverage for their personal property.113 additional insurance coverage includes reimbursements for additional living 972 florida tax review [vol.6:10 114. see insurance information institute, publications: settling insurance claims 7, available at www.iii.org (describing additional living expense coverage as typically including extra food costs, increased housing costs, telephone or utility installation costs in a temporary residence, and extra transportation costs to and from work or school). 115. see insurance information network of california, news & issues: iinc answers questions raised by wildfires: homeowners coverage, available at www.iinc.org/news/home/brushfire_advisory2_2003.html (last visited oct. 31, 2004) (answering the question of whether rental income is covered under a homeowners insurance policy by commenting that the policy covers the fair rental value of premises less any expenses that do not continue). 116. see insurance information network of california, consumer issues: c a t a s t r o p h e p l a n n i n g f o r b u s i n e s s e s , a v a i l a b l e a t www.iinc.org/cons_issues/business/catastrophe.html (last visited oct. 31, 2004) (noting that businesses should make sure they have enough coverage for the indirect costs of a disaster including business disruption coverage, extra-expense insurance, as well as coverage for repairs and rebuilding). 117. see dave dasgupta, insurance services office, inc., insurers to pay california policyholders $2 .04 b illion for w ildfire losses, estimates iso’s property c l a i m s e r v i c e s u n i t ( n o v . 1 7 , 2 0 0 3 ) a t www.iso.com/press_releases/2003/11_17_03.html (stating that insurers expect more than 19,000 claims from homeowners, businesses and vehicle owners from the wildfires); dean calbreath, no satisfaction, the san diego union-trib., may 16, 2004, at h1 (noting that by december 31, 2003 11,841 residential fire claims had been received by insurance carriers). 118. see california fires report, supra note 26, at 50, 54 (documenting the $483 million of federal assistance provided in the 2003 california wildfires). 119. see insurance information institute, facts and sta tistics: catastrophes, available at www.iii.org/media/facts/statsbyissue/catastrophes (last visited nov. 4, 2004) (listing the california 2003 wildfires as the eighth most costly catastrophe in the united states). 120. see jeannette steele, san diego county firestorms aftermath: insurance shortfall burned-out homeowners grapple with big disparity between the estimates for rebuilding and the payouts, the san diego union-trib., mar. 21, 2004, at b1, b5 (reporting that of southern california wildfires victims “[a]t least half of the homeowners are underinsured” and nationwide “64 percent of u.s. homes were undervalued by an average of 27 percent on homeowners insurance policies”); jeanette steele, san diego county firestorms aftermath: owner fears for quality of life, ranch, the san diego union-trib., mar. 21, 2004, at b4 (describing the challenges of inadequate insurance coverage); jeanette steele, san diego county firestorms aftermath: agent told scripps ranch man he had enough home insurance, the san diego union-trib., mar. 21, 2004, at b4 (describing $223,362 shortfall to rebuild home that victim believed was adequately insured). expenses114 and lost rental115 and business income116 resulting from a covered loss. in the 2003 california wildfires, the insured losses are estimated to reach more than $2 billion117 or more than four times the aggregate amount of federal aid.118 while these insured losses are catastrophic,119 most of the fire victims who lost their homes were notably underinsured.120 nevertheless, the $2.04 billion of cash payouts from insurance companies to approximately 2005] anatomy of a disaster 973 121. see dave dasgupta, insurance services office, inc., insurers to pay california policyholders $2.04 billion for wildfire losses, estimates iso’s property claim services unit (nov. 17, 2003) (stating that insurers expect more than 19,000 claims from homeowners, businesses and vehicle owners from the wildfires); dean calbreath, no satisfaction, the san diego union-trib., may 16, 2004, at h1 (noting that by december 31, 2003 11,841 residential fire claims had been received by insurance carriers). 122. california fires report, supra note 26, at 39 (summarizing the impact of voluntary agencies in the 2003 california wildfires). 123. id. at 40-42. 124. id. at 40. 125. id. 126. id. 127. id.; see jeanette steele, faithful volunteers, the san diego union-trib., june 20, 2004, at b1, b6 (describing how the faith-based mennonite disaster service, christian aid ministries and christian reform w orld relief committee of grand rapids, michigan are coordinating hundreds of volunteers with the san diego firestorm community recovery team to assist fire victims with free labor for home rebuilding). 128. see california fires report, supra note 26, at 41(noting that after the american red cross closed shelters it operated several service centers for assistance 19,000 southern california fire victims will be the most significant source of disaster relief.121 d. relief from charitable and other non-profit organization while insurance companies are the greatest source of economic relief from a disaster, private and faith-based non-profit organizations “are among the first to arrive and the last to leave communities touched by disasters.”122 voluntary organizations such as the american red cross, lutheran disaster response, mennonite disaster services, christian aid ministries, “create a coalition of caring that provides essential services to vulnerable populations such as low-income families, the elderly, and area residents.”123 “fema works with private and faith-based voluntary organizations by providing training and donations management support, as needed, and as a facilitator to assist voluntary agencies in forming long-term recovery committees (ltrcs)” with state and local governments.124 when state and local governments are alerted about a disaster, they contact the american red cross, state and local chapters of volunteer agencies active in disasters, and church world services (an interfaith group that contacts faith-based disaster aid groups) to assess, plan and coordinate their responses for the emerging needs of the disaster community.125 “[v]oluntary organizations open and operate shelters, provide feeding services,” and staff local area and disaster recovery centers to provide information to disaster victims.126 moreover, private and faith-based organizations assist local authorities and disaster victims throughout the recovery process, which may take as long as five years.127 as the california wildfires raged, approximately 10,871 people found shelter in 41 evacuation centers opened by the american red cross, local churches and other volunteer organizations.128 more than 10,000 american red 974 florida tax review [vol.6:10 of disaster victim and expects total costs for its organization for the california wildfire assistance to approach $10 million). 129. id.; see also vickie chachere, hundreds of good samaritans help florida hurricane victims, the san diego union-trib., aug. 22, 2004, at a-3 (reporting one week after hurricane charley hit florida that the red cross had been preparing 125,000 meals a day and had housed 2,200 families in shelters). 130. see the san diego union-trib., dec. 14, 2003, at a1, a16-17 (describing five community volunteer groups and their efforts to help their neighbors through the wildfires and its aftermath. 131.id. at 42. 132. jeanette steele, faithful volunteers, the san diego union-trib., june 20, 2004, at b1, b6 (describing how the faith-based mennonite disaster service, christian aid ministries and christian reform w orld relief committee of grand rapids, michigan are coordinating hundreds of volunteers with the san diego firestorm community recovery team to assist fire victims with free labor for home rebuilding). 133. see also vickie chachere, hundreds of good samaritans help florida hurricane victims, the san diego union-trib., aug. 22, 2004, at a-3 (commenting that it is “the unofficial aid stations that have become a life-line for many people” in the aftermath of hurricane charley in florida and recounting how neighbors near and as far as california helped the disaster victims with basic needs such as water, ice, bread and peanut butter. 134. see for example elizabeth fitzsimons, julian volunteers took matters in their own hands, the san diego union-trib., dec. 14, 2003, at a17 (quoting one neighbor who stated that “people’s lives have been changed forever); michael burge, community solutions: san diego county firestorms aftermath, neighors answer the call two m obilize more than 100 for valley center fire recovery, the san diego union-trib., dec. 14, 2003, at a1, a16 (describing how neighbors repaved a burned street and chopped down a tree to minimize the heartache for a father who lost his 16year old daughter in a car accident escaping from the fire); jeannette steele, assistance in scripps ranch came quickly, efficiently, the san diego union-trib., dec. 14, 2003, at a17 (selecting the name project phoenix for their disaster relief group). cross workers from around the country joined together with other volunteers to serve 374,000 meals and snacks through 49 fixed and 32 mobile feeding centers, deliver 6,057 comfort kits as well as provide childcare, health services and crisis counseling to thousands of overwhelmed victims.129 after the wildfires were under control on november 10, 2003, the american red cross closed all of the shelters and began to assist victims with the long process of recovery.130 the american baptist men, apostolic christian church, southern baptists, united methodists committee on relief, and other volunteer groups worked with the government to establish clean-up procedures and assist in debris removal operations.131 the mennonite disaster service, christian aid ministries and christian reform world relief committee continue to assist in the southern california 2003 wildfire reconstruction effort by providing free labor to desperate fire victims with inadequate resources to rebuild.132 in addition, to national and faith-based volunteer assistance, communities joined together to provide relief for their disaster-victim neighbors.133 numerous community volunteer groups were formed immediately after the fires to help themselves and their neighbors cope with and recover from a disaster that changed their lives forever.134 these community groups provided organized in-kind assistance including carpooling, temporary housing, repairs, clothing, running errands, debris removal, landslide control and 2005] anatomy of a disaster 975 135. see jeannette steele, assistance in scripps ranch came quickly, efficiently, the san diego union-trib., dec. 14, 2003, at a17; michael burge, poway residents go to bat for devastated neighbors, the san diego union-trib., dec. 14, 2003, at a16; anne krueger, crest volunteer group came together w ithin a week, the san diego union-trib., dec. 14, 2003, at a16; michael burge, two mobilize more than 100 for valley center fire recovery, the san diego union-trib., dec. 14, 2003, at a1, a16 (quoting one neighbor who state that while they are not fema or the red cross they are filling the gaps for their neighbors); elizabeth fitzsimons, julian volunteers took m atters in their own hands, the san diego union-trib., dec. 14, 2003, at a17. 136. the bells are a hypothetical couple that like the real life couple, the bellante family, lost all of their material assets in the southern california wildfires of 2003, includ ing their home, business and all of their business and residential personal property. the bells’ story is fictitious, but based upon the real life hardship faced by millions of disaster victims every year. any resemblance to actual persons is entirely coincidental. 137. see leslie berestein, tax relief for homeowners complicated, but available, the san-diego union-trib., feb. 20, 2004, at c1, c5 (describing that while complex the tax laws may provide relief for disaster victims); john eckhouse, tax considerations for east bay fire victims, the san francisco chronicle, dec. 9, 1991, at b2 (reporting that determining the tax consequences of the fire may be more daunting than rebuilding). 138. irc §§ 1 et. seq. 139. california fires report, supra note 26, at 28 (describing the details of the process and the sixteen local recovery centers that delivered assistance to fire victims). rebuilding.135 in addition, to organized assistance, disaster victims may receive assistance spontaneously through gifts. e. gifts when disaster strikes relatives, neighbors and strangers make informal direct gifts of cash and in-kind services and personal property including shelter, food, clothing and other basic necessities to disaster victims.136 these gifts are usually given with love and affection and without any application, registration or restrictions. out of the ashes from many different sources relief came pouring in to the victims of the california wildfires. soon after the ashes settled, disaster victims were faced daily with issues and decisions to begin their life-restoration process. a process that may last years and that undoubtedly will be heaving with challenges. sorting through the tax consequences of the relief received and understanding the many tax relief provisions are some of the overwhelming hurdles facing disaster victims.137 iii. tax consequenc es of relief and tax relief provisions after receiving medical treatment, the bells,138 like the bellantes, joined their fellow disaster victims exhausted, frightened and traumatized at one of the many emerging shelters.139 at the shelter, the bells were able to rest, 976 florida tax review [vol.6:10 140. see id. at 41 (describing and depicting relief facilities and resources provided by private and faith-based volunteer groups including counseling and comfort packages). 141. see id. at 8. 142. see leon & lubin, supra note 36, at 28. 143. see discussion regarding fema temporary housing assistance supra. 144. id. 145. id. 146. see fema california, recovery times 2 (nov. 10, 2003) (describing how to file an insurance claim); insurance information institute, how to settle an insurance claim 2, at www.iii.org/media/publications (last visited nov. 4, 2004) (detailing the insurance claims process and advising victims to contact their insurance company as soon as possible because of deadlines). 147. see california fires report, supra note 26, at 28 (describing that representatives from numerous agencies, including the irs, were staffing centers to provide victims with “one-stop recovery shops”). 148. see tom herman, ask dow jones, the san diego union-trib., aug. 22, 2004, at h-7 (taking a brief look at disaster tax relief on behalf of disaster victims from hurricane charley occurring on august 13, 2004). 149. irc § 61(a)(3). eat and receive basic necessities including crisis counseling.140 because president george w. bush declared the california wildfires a major disaster, the bells could register with fema by telephone for assistance.141 within a few days, an inspector would schedule an appointment to perform an onsite inspection.142 within a week to ten days after the inspection, the bells would receive an sba loan application and a check for any uninsured temporary housing and home repair needs.143 if the bells did not qualify for an sba loan to cover any uninsured or underinsured necessary and serious personal expenses, they would receive a cash grant to cover these expenses.144 the aggregate amount of federal assistance under these programs available in 2003 was $25,600. in addition, if mr. or mrs. bell became unemployed as a result of the disaster, either or both of them could apply for up to twenty-six weeks of unemployment assistance not otherwise available.145 moreover, the bells would contact their insurance providers and begin the claim process for the insured damage to their home, car, personal belongings and rental and business losses.146 as the bells emerge from the shock of the wildfires and their catastrophic losses, they may visit one of the many disaster recovery centers to receive legal counseling including tax advice.147 while the tax consequences of a disaster may not be among the most immediate issues facing a disaster victim, disaster tax issues are critical components of the recovery process.148 this part will describe these tax consequences for the millions of annual disaster victims like frank and jennifer bell. a. exclusions from gross income under the internal revenue code of 1986, as amended (the “code”),149 all amounts included in gross income generally increase federal taxable income 2005] anatomy of a disaster 977 150. irc § 63(b); see also james edward maule, gross income: overview and conceptual aspects, 501-2nd tax management a-1, a-4 (providing an overview of the concept o f gross income and its relationship to taxable income and federal income tax liability). “federal income tax liability is determined as a percentage of taxable income, which is derived from gross income.” id. at a-4 (citations omitted). 151. irc § 61(a) (setting forth a nonexclusive list of relatively commonplace examples of gross income); see also maule, supra note, at a-1 (describing the expansive scope of gross income). 152. see irc §§ 101 through 139 (setting forth exclusions from gross income). 153. see comm’r v. glenshaw glass co., 348 u.s. 426, 431 (1920) (defining gross income as “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion”). 154. see j. sneed, the configurations of gross income 14 (1967) (income occurs when there is a gain and gross income is income that is between gross receipts and taxable income). 155. see james edward maule, gross income: overview and conceptual aspects, 501-2nd tax management a-8 (citing r. haig, the federal income tax (1920) and h. simons, personal income t axation (1938)). 156. see dilks v. comm’r, 15 b.t .a. 1294 (1929); stayton, jr. v comm’r, 32 b.t.a. 940 (1935). 157. see irc §§ 101 through 139a. 158. see irc §§ 61(a), 71 through 90. 159. see fem a, individual assistance programs, available at www.fema.gov/rrr/inassist.shtm (last visited nov. 4, 2004); fema, recovery times 2, 5 (nov. 10, 2003) (setting forth answers to faqs about disaster assistance and describing the availability of sba loans); california fires report, supra note 26, at 53 (noting that eighty percent of the disaster relief in the california wildfires was from sba in the form of low-interest loans). and, correspondingly, a taxpayer’s federal income tax liability.150 gross income is very broadly defined and includes all income from whatever source derived unless specifically excluded under the code.151 accordingly, all items of income received by an individual, including disaster victims, must be included in gross income unless specifically excluded.152 fortunately for disaster victims, the code excludes certain types of disaster relief from gross income. 1. disaster loans gross income generally includes any accession to wealth.153 an accession to wealth occurs if a taxpayer gains economically from a transaction.154 under the haig-simons definition of income, income for a specific period equals the sum of the taxpayer’s increase in wealth plus any amount consumed for the period.155 loan proceeds that must someday be paid back to the lender do not constitute an accession to wealth.156 a taxpayer’s wealth does not increase because while she has an increase in her assets as a result of her receipt of loan proceeds she also has a corresponding increase in her liabilities as a result of her obligation to the lender. thereby, while loan proceeds are not statutorily excluded from gross income,157 loan proceeds are not income and thereby are excluded from the code’s broad definition of gross income.158 most federal assistance for individual disaster victims is in the form of low interest, federally subsidized loans.159 fortunately, loan proceeds received 978 florida tax review [vol.6:10 160. see james j. freeland, daniel j. lathrope, et al., fundamentals of federal income taxation 62-63 (14th ed. 2004) 161. irc § 63. 162. see irc § 7872 (imputing interest income for borrowers with belowmarket interest rate loans). 163. irc § 7872(a)(1). 164. irc § 7872(e)(2) (defining forgone interest). 165. prop . regs. § 1.7872-5t(b)(5). 166. see for example vickie chachere, hundreds of good samaritans help florida hurricane victims, the san diego union-trib., aug. 22, 2004, at a-3. 167. irc § 102(a). 168. see commissioner v. duberstein, 363 u.s. 278, 285 (1960). 169. id. at 285-86 (stating that whether or not a transfer is a gift requires an inquiry into the transferor’s intention in making the payment). 170. see runy0n v. comm’r, t.c. memo 1984-623 (holding that payments were gifts because the transferors expected nothing in return); veterans of foreign w ars, dept. of mich. v. commissioner, 89 t.c. 7, 42 (1987) (holding that payments in excess of fair market value were a gift because purchasers intended to provide the organization with more than the selling price as a gift). 171. irc §102(c) (describing that transfers from employers may not be excluded from gross income unless the transfer qualifies as a de minimis fringe benefit under irc § 74(c) or an employee achievement award under irc § 132(c)); but see by a disaster victim are not included in her gross income160 and as a result is not included in her taxable income.161 therefore, a disaster victim’s receipt and repayment of loan proceeds will not have any direct tax consequences. in addition to the tax consequences of the receipt of the loan proceeds, the preferential rates and terms granted for disaster victims could themselves generate gross income.162 under the code, certain borrowers enjoying belowmarket interest rate loans must recognize as gross income any forgone interest expense.163 this provision could cause disaster victims to have to recognize as taxable income the amount of interest she is not paying because her belowmarket interest rate is below a minimum specified interest rate.164 fortunately for disaster victims any loans “subsidized by the federal, state (including district of columbia), or municipal government (or any agency or instrumentality thereof), and which are made available under a program of general application to the public” are exempt from the requirement to include imputed interest in gross income.165 in addition, other forms of disaster relief such as gifts are excluded from gross income under the code. 2. gifts: irc section 102 when disasters hit family members, friends, strangers and charities may make direct payments to disaster victims to help them get back on their feet.166 fortunately, for these disaster victims gross income does not include the value of property, including cash, acquired by gift.167 neither the code nor the treasury regulations provide taxpayers with a definition of gift, but the supreme court has described one essential element of a gift as “detached and disinterested generosity, . . . out of affection, respect, admiration, charity or like impulses.”168 the transferor must intend that the transfer is a gift169 without any strings or expectation for any returned consideration.170 accordingly, the gift exclusion does not include any amount transferred by or for an employer to, or for the benefit of, an employee.171 2005] anatomy of a disaster 979 priv. ltr. rul. 2003-07-084 (finding that hardship payments made to employees from public charity were excludible gifts because corporate-employer did not control the charity or its process for selecting recipients for relief). 172. rev. rul. 2003-12, 2003-3 i.r.b. 283; see comm’r v. duberstein, 363 u.s. 278, 285 (1960). 173. see kavoosi v. comm’r, t.c. memo 1986-190 (holding that payments made to friend were excludable gifts because of his personal affection for his friend’s parents); mesinger v. commissioner, t.c. memo 1972-229 (holding that payments to writer were made out of personal affection and not because of an expected benefit). 174. rev. rul. 2003-12, 2003-3 i.r.b. 283. 175. rev. rul. 2003-12, “the internal revenue service has concluded that payments made by governmental units under legislatively provided social benefits programs for the promotion of general welfare (i.e., based on need) is not includ ible in the gross income of the recipients of the payments. . . .” id.; see rev. rul. 98-19, 199815 i.r.b. 5 (permitting exclusion of relocation payments authorized and funded by the government); rev. rul. 76-144, 1976-1 c.b. 17 (concluding that grants received under the disaster relief act of 1974 by individuals unable to meet necessary expenses or serious needs as a result of a disaster are in the interest of general welfare and not includible in the recipients’ gross income); rev. rul. 82-106, 1982-1 c.b. 16 (providing that payments by non-governmental entities cannot be considered payments for the general welfare and therefore may not qualify for exclusion from gross income under the general welfare exclusion); chief couns. adv. 200114044 (finding that payments from fema for living expenses to uninsured or underinsured victims of presidentially declared disasters are excluded from gross income under the “general welfare” exception of code § 61); chief couns. adv. 200114045 (same); chief couns. adv. 200114046 (determining that fema payments for flood insurance premiums and claim preparation expenses are excluded from gross income); priv. ltr. rul. 199918053 (finding that state government assistance payments for food and other necessities for disaster victims who could not afford to pay for necessities were excluded from gross income); chief couns. adv. 200017040 (finding that payments made pursuant to state disaster relief program to assist individuals purchasing comparable housing outside of flood plain were excluded from gross income). however, transfers made by charities and private parties to disaster victims without any expectation of returned consideration will qualify for this exclusion from gross income. “[a] payment made by a charity to an individual that responds to the individual’s needs, and does not proceed from any moral or legal duty, is motivated by detached and disinterested generosity.”172 taxpayers that receive cash or real or personal property interests from any transferor out of love and affection can exclude them from gross income.173 governmental relief in response to a disaster generally does not constitute a gift because the government does not have the requisite donative intent because it is obligated to provide disaster relief.174 accordingly, these payments are not excludible from gross income under the gift exclusion. alternatively, disaster relief payments “made by governmental units under legislatively provided social benefit programs for the promotion of the general welfare (i.e., based on need)” are not includible in gross income under the “general welfare exclusion.”175 more recently, congress incorporated this longstanding general exclusion into a specific exclusion under the code. the new provision excludes from gross income all disaster relief provided by 980 florida tax review [vol.6:10 176. irc § 139(b)(1), (2) and (4); see also rev. rul. 2003-12, 2003-1 c.b. 283 (demonstrating that while certain disaster relief payments from employers to employees are accessions to wealth that cannot be excluded as a gift or under the “general welfare exception,” they can be excluded under code § 139). 177. pub. l. no., 107-134, § 111, 115 stat. 2427 (2002), (setting forth new code § 139 effective for taxable years ending on or after september 11, 2001). 178. irc §§ 139(a), 61(a), 63 (setting forth an exclusion from gross income and in turn taxable income any amount received as a “qualified disaster relief payment”). 179. see irc § 139(c), (e) (setting forth definition of qualified disaster). 180. irc § 139(b)(1). 181. see maule, supra note 150, at a-199. 182. irc §139(b)(2). 183. staff of the joint comm. on taxation, technical explanation of the “victims of terrorism tax relief act of 2001,” as passed by the house and the senate on dec. 20, 2001, 16 (comm. print 2001). 184. irc § 139(b)(4). also included in the definition of “qualified disaster relief payment” is any payment to or for the benefit of an individual “by a person engaged in the furnishing or sale of transportation as a common carrier by reason of the death or personal physical injuries incurred as a result of a qualified disaster.” irc § 139(b)(3). 185. see maule, supra note 150, at a-200. government and certain disaster relief provided by any transferor, including certain transfers from employers to employees.176 3. disaster relief payments: irc section 139 in response to the tragic events of september 11th, congress enacted the victims of terrorism tax relief act of 2001,177 which among other things, provides under code section 139 that gross income does not include any amount received by an individual as a “qualified disaster relief payment.”178 the definition of a “qualified disaster relief payment” is very comprehensive with narrow and well-reasoned exceptions.179 specifically, a qualified disaster relief payment includes “any amount paid to, or for the benefit of an individual to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster.”180 notably, this definition is an expansion of the general welfare exclusion because it includes relief payments received by or for a disaster victim from any source, including employers.181 specifically included in the definition of “qualified disaster relief payment” are payments from any source “to reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or repair or replacement of its contents to the extent that the need for such repair, rehabilitation, or replacement is attributable to a qualified disaster.”182 a rented residence can qualify for this exclusion.183 in addition, a “qualified disaster relief payment” includes any amount paid to or for the benefit of a disaster victim from “a federal, state, or local government, or agency or instrumentality thereof, in connection with a qualified disaster in order to promote the general welfare.”184 disaster victims are not required to keep records of actual expenses incurred, provided that the payments received can be expected to reasonably approximate the costs suffered as a result of the disaster.185 2005] anatomy of a disaster 981 186. irc § 139(b) (flush language). 187. see rev. rul. 74-74, 1974-1 c.b . 18 (denying exclusion from gross income for medical expense reimbursements received); chief couns. adv. 200016019 (commenting that state grants for the repair of flood-damaged homes would be included in gross income to the extent that losses were deducted); see also notice 2001-42, 2001 c.b. 70. i.r .b. (warning victims of the cerro grande fire that payments that reimburse them for medical expenses must reduce any deduction to be taken for medical expenses). 188. irc § 139(e). 189. see irc § 85 (providing that unemployment compensation is specifically included in gross income). 190. if the payments are for the loss of the use of business property versus lost profits, then the payments may qualify as proceeds from an involuntary conversion eligible for deferral of recognition under irc § 1033. see rev. rul. 86-12, 1986-1 c.b. 290 (discussing distinction between profit loss and loss of use and occupancy in the context of insurance proceeds); regs. § 1.1033(a)-2(c)(8) (providing that proceeds for lost profits do not qualify as involuntary conversion proceeds and, therefore, must be included in ordinary income); see a lso bruce n. edwards, involuntary conversions, 568 tax mgmt. (bna) a-56 through a-57 (discussing the tax treatment of insurance proceeds from a business interruption insurance policy). 191. see maule, supra note 150, at a-200; chief couns. adv. 200013030 (2000), (finding that state relief payments made to farmers, growers’ associations, and fisherman that suffered business losses caused by a hurricane were not excluded from gross income because the payments were made to replace lost profits). because the exclusion applies to reimbursements that are not attributable to wages, compensation or self-employment earnings, payments qualifying for exclusion from gross income are also excluded from self-employment and employment taxes. irc § 139(d). compensation for lost profits must be recognized in the tax year received or accruable, which may not correspond to the actual period of loss. see cappel house furnishings co. v. united states, 244 f.2d 525 (6th cir. 1957). 192. for this purpose, terroristic or military action is defined in § 692(c)(2) and means “any terroristic activity which a preponderance of the evidence indicates was directed against the united states or any of its allies, and any military action involving the armed forces of the united states and resulting from violence or aggression against the united states or any of its allies (or threat thereof). for purposes of the preceding sentence, the term military action does not include training exercises.” irc § 692(c)(2). 193. for this purpose, a presidentially declared d isaster is defined in §1033(h)(3) and “means any disaster which, with respect to the area in which the property is located, resulted in a subsequent determination by the president that such not surprisingly, tax-free treatment is denied for a double reimbursement or any payment of an expense that has already been reimbursed by insurance or otherwise.186 similarly, to the extent any payment is for expenses for which a taxpayer has enjoyed a tax deduction in a previous taxable year, the payment may not be excluded from gross income under the tax benefit doctrine.187 also not surprisingly, the exclusion does not apply to individuals who the attorney general identifies as a participant or conspirator, or any representative of the foregoing, in a terroristic action.188 finally, any payments received replacing lost income, such as unemployment compensation189 or lost business profits190 must be included in gross income in the tax year received.191 a “qualified disaster” for this purpose is defined very broadly and includes “a disaster which results from a terroristic or military action,”192 “a presidentially declared disaster,”193 “a disaster which results from an accident 982 florida tax review [vol.6:10 area warrants assistance by the federal government under the disaster relief and emergency assistance act.” irc § 1033(h)(3). 194. irc § 139(c) (defining what is a “qualified disaster”). 195. irc § 139(c)(4). 196. “the internal revenue service has concluded that payments made by governmental units under legislatively provided social benefits programs for the promotion of general welfare (i.e., based on need) is not includible in the gross income of the recipients of the payments.” rev. rul. 2003-12, 2003-1 c.b. 283; see rev. rul. 98-19, 1998-1 c.b. 840 (permitting exclusion of relocation payments authorized and funded by the government); rev. rul. 76-144, 1976-1 c.b. 17 (concluding that grants received under the disaster relief act of 1974 by individuals unable to meet necessary expenses or serious needs as a result of a disaster are in the interest of general welfare and not includible in the recipients’ gross income); rev. rul. 82-106, 1982-1 c.b. 16 (providing that payments by non-governmental entities cannot be considered payments for the general welfare and therefore may not qualify for exclusion from gross income under the general welfare exclusion); chief couns. adv. 200114044 (2001) (finding that payments from fema for living expenses to uninsured or underinsured victims of presidentially declared disasters are excluded from gross income under the “general welfare” exception of code § 61); chief couns. adv. 200114045 (2001) (same); chief couns. adv. 200114046 (2001) (determining that fema payments for flood insurance premiums and claim preparation expenses are excluded from gross income); chief couns. adv. 199918053 (1999) (finding that state government assistance payments for food and other necessities for disaster victims who could not afford to pay for necessities were excluded from gross income); chief couns. adv. 200017040 (2000) (finding that payments made pursuant to state disaster relief program to assist individuals purchasing comparable housing outside of flood plain were excluded from gross income). 197. see rev. rul. 2003-12, 2003-1 c.b. 283. moreover, as a result of the enactment of code § 139 and the joint committee on taxation staff’s comment that disaster victims will not have to account for their actual expenses as long as the payments can be reasonably expected to be commensurate with the expenses to be incurred, the internal revenue service has stated that the same standard will apply for disaster relief under the general welfare exclusion. id. 198. id. (ruling that grants to employees from their employers’ program to pay or reimburse certain reasonable and necessary medical, temporary housing, or transportation expenses resulting from a flood are not included in gross income under involving a common carrier, or from any other event, which is determined by the secretary to be of a catastrophic nature.”194 in addition, with respect to amounts received from the government, its agency or instrumentality, any disaster that is determined by the governmental authority to warrant assistance.195 accordingly, this expansive definition should exclude from a disaster victim’s gross income any payments received from a governmental authority that is not attributable to lost wages or profits. prior to congress’ enactment of these specific gross income exclusions under code section 139, disaster relief payments made by governmental units under legislatively provided social benefit programs for the promotion of the general welfare (i.e., based on need) were not includible in the gross income under the “general welfare exclusion.”196 while code section 139 does not replace the “general welfare exclusion,” it appears to embody all government payments made for disaster relief under the exclusion as well as providing exclusion for nongovernmental payments for certain types of disaster relief.197 code section 139 is an expanded, yet explicit statutory version of the “general welfare exclusion” of disaster relief payments from gross income.198 2005] anatomy of a disaster 983 code § 139 but not the “general welfare exclusion”). prior to enactment of irc § 139, there was no statutory exclusion for disaster relief payments and taxpayers had to rely on interpretations of the “general welfare” exception to gross income. see sources cited supra note 157; see also rev. rul. 57-102, 1957-1 c.b. 26 (setting forth that amounts received from a government’s general welfare fund are excluded from gross income). in addition to providing for a specific statutory exception for general welfare payments, code § 139 provides for exclusion from gross income of certain payments from common carrier businesses for death or personal injuries. irc § 139(b)(3), (4). 199. irc § 139(b) (flush language) (providing that payments are excluded from gross income to the extent not compensated by insurance). 200. see irc § 123 (setting forth exclusion from gross income for insurance payments received for certain additional living expenses incurred due to a disaster). 201. irc § 123(a). prior to congress’ enactment of code § 123 in 1969, insurance reimbursements for additional living expenses incurred because of the destruction of a taxpayer’s residence due to a casualty were included in a taxpayer’s gross income, taxable income and, therefore, subject to income tax. see mccabe v. comm’r, 54 t .c. 1745 (1970) (holding that the mccabe’s gross income included insurance proceeds they received due to the loss of occupancy of their principal residence due to a kitchen fire); millsap v. comm’r, 46 t .c. 751 (1966), acq., 1967-1 c.b. 2, aff’d, 387 f.2d 420 (6th cir. 1968); cornelius v. comm’r, 56 t .c. 976, acq ., 1977-2 c.b. 1, rev. rul. 59-360, 1959-2 c.b. 75, declared obsolete by rev. rul. 72619, 1972-2 c.b. 650. 202. irc § 123(a). 203. see regs. § 1.123-1(a)(3). 204. regs. § 1.123-1(c). 205. id. while code section 139 is very broad in its coverage of disaster relief payments that are excluded from gross income, it specifically does not include payments received from insurance providers.199 many disaster victims who have insurance coverage will not receive government assistance because their insurance providers will reimburse their covered disaster related expenses. fortunately for these disaster victims, the code provides an exclusion from gross income for certain payments received from insurance providers.200 4. insurance payments for excess living expenses: irc section 123 code section 123 generally provides that gross income does not include insurance payments received for excess living expenses incurred because a taxpayer cannot occupy her principal residence as a result of damage or destruction from a casualty.201 the loss of use or occupancy must result from a fire, storm or other casualty or the government’s denial of access to the property because of the threat or occurrence of a casualty.202 insurance reimbursements for excess living expenses incurred because of a condemnation not related to a casualty are not excluded from gross income under this narrowly drafted exclusion.203 in addition, the reimbursements must be for loss of use or occupancy of property that is the disaster victim’s principal residence, which includes a house or apartment that is leased or owned outright.204 whether or not the property is the taxpayer’s principal residence is a facts and circumstances analysis of the taxpayer’s living arrangements.205 this analysis is critical because insurance reimbursements attributable to increased expenses for the 984 florida tax review [vol.6:10 206. see regs. § 1.123-1(a)(3). 207. see regs. § 1.123-1(a)(4)(i). 208. see regs. § 1.123-1(a)(4)(ii), -1(a)(4)(iii). 209. irc § 123(a), (b); regs. § 1.123-1(a)(2). 210. regs. § 1.123-1(b)(1), -1(a)(2). 211. regs. § 1 .123-1(a)(2). if the loss of use or occupancy results in a decrease in normal household expenses during the loss period, then such amount is not considered to have been incurred to the extent of the decrease for purposes of determining the excess expenses incurred. regs. § 1.123-1(b)(3), -1(b)(4) (setting forth example where bus fares decreases by $20 because temporary housing is closer to work so the normal bus fare is equal to this decrease in expense or $20). 212. regs. § 1.123-1(b). 213. see regs. § 1.123-1(b)(2), -1(b)(4). 214. see regs. § 1 .123-1(b)(4) (example (1)); see also maule, supra note 150, at a-190 (setting forth application of the statute to hypothetical situation). 215. internal revenue service, casualties, disasters, and thefts, pub. 547, at 5 (2004) (describing and providing an example of the timing of recognition of excess insurance reimbursements in gross income). loss of use of any nonresidential portion or whole property are not excluded from gross income.206 moreover, the exclusion only applies to amounts that are specifically identified by the insurance company as being paid exclusively for excess residential living expenses.207 any unallocated lump-sum insurance payment must be allocated among the various insurance claims, including additional living expenses, but must be limited to the contractual amount of coverage.208 the exclusion from gross income only applies to reimbursements for increased living expenses resulting from the disaster for the taxpayer and members of her household for the period of loss of use or occupancy.209 the period of loss of use or occupancy is limited to “the period of repair or replacement of the damaged principal residence or denial of access by governmental authority.”210 excludible increased living expenses must be reasonable and necessary actual household expenses incurred to maintain the taxpayer’s and her household’s customary standard of living that are in excess of normal household expenses.211 generally, excludable actual living expenses include the cost for renting suitable temporary housing, meals at restaurants, which customarily would have been prepared in the residence, and other extraordinary utilities, transportation, and other expenses.212 a number of expenses specifically do not qualify for exclusion under code section 123. for example, insurance reimbursements for any normal, that is, not excess living expenses including mortgage payments on a damaged residence cannot be excluded from gross income.213 the reasoning is that mortgage payments are contractual obligations that have “no causal relationship to the occurrence of the casualty” and cannot be included in the analysis as either normal or excess expenses.214 a disaster victim must include insurance reimbursements for normal living expenses in gross income in the later of the tax year the disaster victim regains use of her residence, or the tax year of its receipt.215 while this does not provide exclusion of these reimbursements from gross income, it may provide for a deferral of the recognition of the income. the limitations for excludible insurance reimbursements from gross income are strict, but in practice they may have little application. homeowner’s 2005] anatomy of a disaster 985 216. see insurance information network of california, iinc answers q u e s t i o n s r a i s e d b y w i l d f i r e s , a t www.iinc.org/news/home/brushfire_advisory2_2003.html (last visited july 6, 2004) (answering the question regarding coverage for extra expenses incurred when a home is severely damaged and uninhabitable). 217. see id. (describing that homeowners insurance includes typically includes reimbursement for damage to real and personal property and “the fair rental value of premises less any expenses that do not continue while it is not fit to live in”). 218. see maule, supra note 150, at a-189. 219. id. while reimbursements for lost income must be included in gross income, under certain circumstances farmers may defer recognition of the income until the taxable year after receipt. irc § 451(d), (e) (providing that farmers may defer recognition of insurance proceeds for crop damage or sale proceeds from livestock sold on account of drought until the year after receipt if she can establish that the proceeds would not have arisen if not for the damage or drought). 220 . see irc § 1033. 221. id. insurance coverage generally only reimburses a homeowner for additional living expenses, which is defined consistently with the exclusion provision.216 accordingly, most insurance reimbursements received for additional living expenses incurred as a result of a disaster will be excluded from gross income. in comparison, homeowner’s insurance coverage typically does include insurance coverage for lost rental income and reimbursements for damage to, real or personal property.217 in addition, business insurance coverage usually provides relief for lost business profits and damage to real and personal property. insurance reimbursements for lost rental and business income and damage to real or personal property are not excluded from gross income under this provision.218 while disaster victims must include any lost rental and business income in gross income,219 under certain situations the code provides that any gain resulting from insurance reimbursements for damage to or destruction of real or personal property may be deferred and not included in gross income for the current tax year.220 the applicable provision of the code provides that under certain circumstances a disaster victim may defer recognition of any gain resulting from the involuntary conversion of property into cash (e.g., insurance proceeds).221 before the article presents the relief provided under the code for gain realized as a result of a disaster, the foregoing provisions will be applied to the bells, our hypothetical disaster victims. 5. application to the bell family, hypothetical disaster victims as the bells and their surviving neighbors begin to emerge from the nightmare of the california wildfires, the bells almost daily contemplate the magnitude of their losses; the assistance they have received during the first few months of their recovery and the insurance proceeds they hope and anticipate are forthcoming. the bells lost everything, but their lives. the staggering extent of their losses include their family home and business, wildcat canyon laundromat, and all contents, including all clothing (except the jeans and sweatshirts each threw on as they ran for their lives), household goods, furniture, and their business machinery and equipment and all their personal and business records. 986 florida tax review [vol.6:10 222. see san diego county firestorms aftermath: information you can use, the san diego union-trib., nov. 2, 2003, at a13 (warning residents in unincorporated areas not to remove any debris from fire-damaged properties until assessment teams document losses); see also fema, recovery times, at 6 (nov. 10, 2003) at www.fema.gov/pdf/rt/rt1498.pdf (providing safety tips for debris clean-up process). 223. see jeannette steele, after the fires: insurance shortfall, the san diego union-trib., mar. 21, 2004, at b1, b5 (reporting that of southern california wildfires victims “[a]t least half of the insured homeowners are underinsured” and nationwide “64 percent of u.s. homes were undervalued by an average of 27% on homeowners insurance policies”); jeanette steele, after the fires: owner fears for quality of life, ranch, the san diego union-trib. , mar. 21, 2004, at b4 (describing the challenges of inadequate insurance coverage); jeanette steele, agent told scripps ranch man he had enough home insurance, the san diego union-trib., mar. 21, 2004, at b4 (describing $223,362 shortfall to rebuild home that victim believed was adequately insured). immediately after the fire destroyed their home, the bells sought shelter in an american red cross facility receiving basic necessities, including food, beds, hygiene kits, clothing and crisis counseling. from the shelter, the bells were able to register with fema and contact their insurance company to begin their claim process. soon after these contacts, site inspectors visited the rubble that was once their home and business. after inspectors combed the property, with the assistance of their community association the bells began to clear the debris from their property.222 soon after initiating the disaster relief process, the bells discovered that they, like many of their neighbors, were underinsured.223 their insurance company provided them with immediate funds to cover their additional living expenses, which under their policy was limited to $2,500. the bells have receipts to document that their excess living expenses for the loss period are well in excess of this amount and are likely to exceed $30,000. fema has provided them with a cash grant of $15,000 to cover some of the cost of their uninsured temporary housing; $5,100 for uninsured home repairs (maximum available) and another $5,500 to cover uninsured medical expenses incurred to treat jennifer bell’s burns. because the bells received the maximum dollar amount of assistance, or $25,600, that fema could provide in 2003, they must look to other sources for immediate disaster relief. fortunately, they also received food stamps from the usda’s emergency food stamp program. jennifer bell’s mother sent them a check for $1,000 with her love and affection to help get them through this horrible time. while many of the victims of the fire lost their homes, the bells also lost their primary source of income when their family-owned and operated business, wildcat canyon laundromat, was also burned to the ground. the bells were self-employed, so they do not qualify for unemployment compensation under california law. however, because of president george w. bush’s declaration of the wildfires as a major disaster and their immediate loss of employment due to the disaster, they qualify for up to 26 weeks of unemployment compensation. the bells are working with their insurance company on the claims for their auto, home and its contents, and all of their business assets. volunteer lawyers from the young lawyer’s division of the american bar association have been assisting them with the claims process by answering many questions 2005] anatomy of a disaster 987 224. see irc § 85(a) (setting forth general rule that gross income includes unemployment compensation). about the timing of the process; the extent of their coverage and because they have determined they are underinsured other potential sources of disaster relief. the bells, like most of their neighbors, will not receive sufficient insurance proceeds to rebuild, so they have applied for low-interest sba business and residential loans. while the bells have not yet received any payment from their insurance company for their damaged residential and business real and personal property, they have received payments for lost rental income and business income. in addition, to owning and operating wildcat canyon laundromat, the bells had rented a portion of their residential property to supplement their monthly income. the bell’s homeowner’s insurance policy covers the fair rental value of their rental property less any expenses that will not continue while the property is uninhabitable. the bell’s business interruption insurance coverage will compensate them for lost business profits during the period of time their business must be closed, subject to certain specific time limitations. the insurance company has issued initial checks to them to compensate them for their lost business and rental income. more than one month after the fires, the bells spend long days and nights trying to manage their disaster relief. the bells are overwhelmed with the consequences of the southern california wildfires. as disaster relief begins to trickle in, they must add one more critical task to their endless “to do” list: determine the tax consequences of their disaster relief. a. disaster relief assistance excluded from gross income all of the disaster relief assistance received by the bells from fema, the young lawyers division of the aba (legal advice provided by fema through its agreement with the aba), the crisis counseling assistance and training program, and the usda’s emergency food stamp program is excluded from their gross income under the general welfare exclusion. the food stamps from the usda and $25,600 received from fema are also excluded from gross income under code section 139(b)(1)(personal living expenses) and (b)(2)(personal residence repair). the $1,500 received from their insurance company is excluded from gross income under code section 123(a). the shelter, food, clothing, counseling, and comfort kits received from the american red cross, the debris removal services from their community association and the $1,000 from jennifer’s mother are gifts excluded from gross income under code section 102. finally, the proceeds from sba disaster loans that the bells anticipate receiving will not be included in gross income because it will not result in any accession of wealth. b. disaster relief assistance included in gross income the weekly unemployment compensation the bells will be receiving over the next 26 weeks will be included in their gross income in the tax year in which the payments are received.224 in addition, the insurance compensation the bells receive for their lost rental income and lost business profits will be 988 florida tax review [vol.6:10 225. see internal revenue service, notice 2001-42, 2001-14 i.r.b. (answering frequently asked questions asked by victims of the cerro grande fire in new mexico) 226. see generally irc § 165(c)(3). 227. a realization event or “dealing in property” occurs if the taxpayer’s relationship with the property is changed in a manner that significantly reduces or terminates her property interest. see eisner v. macomber, 252 u.s. 189 (1920) (setting forth principle of realization); irc §§ 165(h)(2)(b), 1001. 228. in general, amount realized is the economic benefit received by the taxpayer as a result of her dealing in the property. regs. § 1.1001-1(a). amount realized includes cash and the fair market value of property received as well as the amount of debt relief and any other benefits enjoyed. irc § 1001(b). 229. a taxpayer’s adjusted basis in property is her investment in the property (generally cost), irc §§ 1011, 1012, adjusted for improvements, depreciation, and other statutorily required adjustments. irc § 1016. 230. for this purpose, amount realized includes any amount paid on behalf of the disaster victim directly to a mortgagee, including any amount paid with respect to nonrecourse debt. regs. § 1.1033(a)-2(c)(11). 231. see irc § 1001(a) 232. id. 233. see irc§ 1001(c). included in their gross income. because the bells operate their business, wildcat canyon laundromat, as a sole-proprietorship, the reimbursement for lost business income is self-employment income, subject to self-employment taxes.225 as the bells try to prepare for the tax consequences of their disaster relief assistance to date, the most significant relief payments and tax issues will arise when they receive their anticipated insurance proceeds and must plan for the resulting casualty losses or gains. b. casualty gains when insured property is destroyed or damaged in a disaster, the disaster victim will receive insurance proceeds to compensate her for the loss. under the code, gross income includes “gains derived from dealings in property.”226 the receipt of insurance proceeds with respect to destroyed or severely damaged property is treated as a “dealing in property,” or “a realization event.”227 a realization event will result in a gain or loss depending upon the relationship of the amount realized228 to the taxpayer’s adjusted basis in the property damaged or destroyed.229 if the amount realized by the insured230 exceeds her adjusted basis in the property, the taxpayer has realized a gain equal to the excess.231 alternatively, if the amount received by the insured is less than her adjusted basis in the property, the taxpayer has realized a loss.232 generally, any gain or loss realized from a transaction must be recognized and included in gross income unless a nonrecognition provision applies.233 2005] anatomy of a disaster 989 234. see irc §§ 61(a)(3), 63. 235. capital assets are defined in the code, by a negative inference or enumerated what types of property are not capital assets. irc § 1221(a) (setting forth items that are not capital assets including inventory, depreciable property, copyright, account and notes receivables, and supplies). accordingly, capital assets include a taxpayer’s home, car, jewelry and other personal assets. see id. 236. see irc § 1222 (defining short-term and long-term capital gains). under certain circumstances, gain recognized from the sale or exchange of a capital asset held for more than one year may be recharacterized as ordinary income. see irc §§ 1245 (recapturing generally as ordinary income all depreciation taken on personal property), 1250 (recapturing generally as ordinary income accelerated depreciation on real property), 1231(c) (recapturing generally as ordinary income long-term capital gains to the extent of ordinary losses enjoyed by the taxpayer in the prior five years). 237. irc § 165(h)(3)(a), (b) (defining personal casualty gains and personal casualty losses). 238. irc § 165(h)(2)(b). 239. irc § 1222 (defining net capital gains as the excess of long-term capital gains over net short-term capital losses). 240. see irc § 1(h) (setting forth maximum tax rates for net capital gains). 241. see irc § 1222(3) (defining long-term capital gain). 242. see irc § 1222(1) (defining short-term capital gain). 243. see irc §§ 1222 (setting forth statutory requirement of offset of capital losses against capital gains); 1212 (describing capital loss carryforwards); 1211 (describing limits on current year recognition of capital losses). 244. irc § 1222(11) (defining “net capital gain”). 245. irc § 1(h). however, long-term capital gain tax rates for gains on the disposition of collectibles (e.g., antiques, coins, stamps, etc.) are subject to tax at a maximum tax rate of 28% and long-term capital gains due to depreciation taken on real property is subject to tax at a maximum tax rate of 25%. id. 1. recognition of casualty gains any net gain realized and recognized must be included in gross income.234 if the property damaged is a capital asset,235 the gain recognized generally will be characterized as a capital gain.236 moreover, if a taxpayer’s casualty gains exceed her casualty losses on property that is used personally (and not in a trade or business or held for investment),237 then her casualty gains and losses will be characterized as capital gains and losses, respectively.238 under the code, certain capital gains239 receive favorable tax treatment.240 capital gains recognized from the disposition of property that had been held by the taxpayer for more than one year are characterized as long-term capital gains.241 alternatively, capital gains recognized from the disposition of property that had been held for one year or less are characterized as short-term capital gains.242 long-term and short-term capital gains must be offset by any current year (or carried-forward) long-term and short-term capital losses, respectively, to derive any net long-term and net short-term capital gains or losses.243 net long-term capital gains in excess of net short-term capital losses, are designated “net capital gains.”244 net capital gains are subject generally to very favorable tax rates, which currently do not exceed fifteen percent.245 990 florida tax review [vol.6:10 246. see irc §§ 64 (defining ordinary income), 1(a)-(d) (setting forth a maximum tax rate of 35%). 247. see irc § 1033(a)(2). 248. for this purpose, “involuntary conversion” includes destruction, in whole or in part, theft, seizure or requisition or condemnation or threat or imminence thereof. irc § 1033(a). property that is voluntarily sold may qualify for nonrecognition treatment if it is sold because of threat of condemnation or if the property is part of an “economic unit” with the converted property. id .; rev. rul. 59-361, 1959-2 c.b. 183; rev. rul. 96-32, 1996-1 c.b. 177 (ruling that sale of residential lot after destruction of residence); priv. ltr. rul. 9334007 (ruling that sale of land adjacent to house destroyed by tornado qualified for nonrecognition treatment under code § 1033); priv. ltr. rul. 9143056 (ruling that sale of lot underlying building destroyed by fire qualified for nonrecognition treatment); but see rev. rul. 78-377, 1978-2 c.b. 208 (disallowing nonrecognition treatment for voluntary sale because sale was not forced upon the taxpayer); rev. rul. 80-175, 1980-2 c.b. 230 (same). 249. see irc § 1033(a)(2)(a), (b). 250. irc § 1033(b)(2). if an electing property owner reinvests an amount in excess of her disaster relief proceeds (including loans) in qualifying property, she will increase her basis in the replacement property by any excess and decrease her basis by the gain realized but not recognized. regs. § 1.1033(a)-2(c)(12). 251. see irc § 1001 (setting forth the computation for determining gain or loss and the general rule that any gain realized must be recognized). if the property subsequently decreases in value gain may not be realized or recognized but any loss realized will be reduced. when the property’s basis is determined by reference to a property received in exchange, including replacement property received in exchange for converted property, the holding period of the replacement property includes the holding period of the converted property. irc § 1223(1)(a). t his may allow a subsequent sale of the rep lacem ent pro perty to qualify for long-term capital gain treatment even though the replacement property itself had been held for less than one year. 2. nonrecognition of casualty gains while the tax rates for net capital gains are more favorable than the tax rates for other income, that is, ordinary income,246 the recognition of a casualty gain will cost an innocent disaster victim precious dollars at a time when money is needed, often desperately, for replacement, repair and other unexpected expenses. fortunately, disaster victims can elect under certain circumstances to defer recognition of all or part of their casualty gains.247 the code provides nonrecognition of gain when property is involuntarily converted248 into cash and within a limited time period the taxpayer purchases qualified replacement property.249 this nonrecognition provision under the code can provide welcome relief for many disaster victims who often plan to purchase replacement property irrespective of the tax consequences. if all requirements are satisfied, this tax provision eliminates the unexpected current tax liability resulting inadvertently from a disaster. however, the tax liability for the gain realized is only deferred, because the tax basis in the replacement property is reduced by any gain not currently recognized.250 the gain realized is deferred through the basis reduction and potentially recognized upon any subsequent sale or other realization event.251 if a disaster victim does not reinvest all of her insurance proceeds received in 2005] anatomy of a disaster 991 252. irc § 1033(a)((2)(a). 253 . see rev. rul. 68-642, 1968-2 c.b. 337; rev. rul. 68-362, 1968-2 c.b. 334; ruud v. comm’r, 28 t.c. memo (cch) 1284, (p-h) ¶ 69 ,252 (1969); priv. ltr. rul. 8021126 (feb. 29, 1980). 254. see irc §§ 1001, 61(a)(3), 63. 255. see irc § 1033. 256. irc § 1033(a)(2)(a). however, if property is involuntarily converted directly into qualifying replacement property, then nonrecognition of gain is mandatory. irc § 1033(a)(1). 257. regs. § 1.1033(a)-2(c)(2). 258. regs. § 1.1033(a)-2(c)(2). this information may be included on an amended tax return. see priv. ltr. rul. 8424026 (mar. 12, 1984). 259. regs. § 1.1033(a)-2(c)(2). 260. see irc § 1033(a)(2)(c). however, if replacement property is purchased before the beginning of the last tax year casualty gain is realized, any conversion-related deficiency may be assessed through the close of the statute of limitations for the latest tax year. irc § 1033(a)(2)(d). this situation could occur if insurance proceeds are being contested and the insured replaces the property before the final settlement is received. qualifying property within the requisite time period, she will have to recognize gain equal to any shortfall.252 notably, a disaster victim does not have to reinvest specifically her cash proceeds, she may acquire the replacement property with debt and use some or all of her cash proceeds for other purposes and qualify for nonrecognition treatment.253 in many cases, disaster victims desiring to rebuild their lives by replacing their damaged property will satisfy the nonrecognition requirements inadvertently. however, if the specific requirements are not satisfied the disaster victim would have to recognize her gain, albeit at potentially favorable tax rates.254 a disaster victim who is unaware of these requirements could reinvest all of her insurance proceeds in property that does not qualify for nonrecognition treatment or property that does qualify, but after the close of the reinvestment period and owe tax dollars that she has spent. because this nonrecognition provision has a number of detailed requirements255 disaster victims should carefully plan the reinvestment of their insurance proceeds to ensure they receive the desired treatment. a. taxpayer must make a valid election for nonrecognition treatment nonrecognition treatment under this provision is elective.256 a disaster victim makes the election by excluding all or some of her casualty gain from her annual federal income tax return.257 the regulations also require taxpayers to provide details regarding the gain realized including any information about the acquisition of replacement property, including the cost, description and date of acquisition.258 however even if a taxpayer fails to include any information about her casualty gain from her return, the government will deem that she has made a nonrecognition election.259 taxpayers who make this election have also agreed to extend the statute of limitations for assessment of conversion-related deficiencies for up to three years after the taxpayer affirmatively notifies the government that she has or has not made a qualifying replacement for each tax year in which she realized any casualty gain.260 taxpayers are thereby 992 florida tax review [vol.6:10 261. regs. § 1.1033(a)-2(c)(2); see tech. adv. mem. 78-09-006 (1978) (interpreting the situations in which the election may be altered or revoked). 262. regs. § 1.1033(a)-2(c)(2). 263. see p riv. ltr. rul. 9548005 (ruling that in addition to interest on the tax deficiency, late filing penalties were applicable). 264. regs. § 1.1033(a)-(2)(c)(2). 265. see santucci v. comm’r, 32 t.c. memo (cch) 840, t.c. memo (p-h) ¶ 73,178 (1973), (holding that an amended return election must be made before the close of the replacement period). 266. see edwards, supra note 190, at a-18 (citing rev. rul. 63-127, 1963-2 c.b. 333, for the proposition that the refund claim must be filed within the statutory period for refund claims and not within the replacement period and recommending that cautious taxpayers file their refund claim within both time periods). 267. see irc §§ 6072 (describing annual due date for individual income tax returns), 6081 (describing extensions for the due dates for filing tax returns); regs. § 1.6081-4 (setting forth the details for an automatic extension of time for filing individual income tax returns). 268. regs. § 1.1033(a)-(2)(c)(2). motivated to keep the government informed about their replacements to start the running of the extended statute of limitations. taxpayers who make this election may revoke or change it if sufficient qualifying replacement property is not acquired within the replacement period.261 if the disaster victim fails to satisfy the replacement requirements, she must amend the return for the tax year in which the casualty gain was realized and include her casualty gain in her gross income.262 any applicable income taxes, interest, and penalties will be due and payable with the amended return.263 if a disaster victim files her tax return inadvertently or intentionally reporting her casualty gain and later decides she would like to defer its recognition, she may file an amended returning excluding the gain and making the nonrecognition election.264 the taxpayer must file an amended return election before the expiration of the replacement period.265 if the taxpayer timely satisfies the requirements for nonrecognition, she will receive a refund of any overpayment of taxes paid with respect to the original return.266 fortunately, disaster victims have the luxury of time to determine whether or not they want to elect not to recognize their casualty gains. individuals must file their annual federal income tax returns no later than april 15th of the following tax year, or as late as august 15th with an automatic extension and as late as october 15th with an additional discretionary extension.267 moreover, even if a disaster victim cannot make her decision by these dates, an election may be made on an amended return as long as it is within the several year replacement period.268 however, this alternative would require that the taxpayer pay her tax liability upfront and later request a refund. finally, the disaster victim can make the nonrecognition election and if she later decides not to reinvest all or some of her insurance proceeds she, will owe the government applicable income taxes, interest, and penalties with her amended tax return. to achieve the most efficient result, disaster victims should carefully analyze the foregoing alternatives before they file their tax return for the tax year in which their casualty gain was realized. 2005] anatomy of a disaster 993 269. see irc § 1033(a) (describing the threshold requirement that property must have been compulsorily or involuntarily converted to qualify for nonrecognition treatment as a result of its destruction, theft, seizure, requisition or condemnation). 270. see irc § 1033(a)(2)(a) (setting forth the requirement that if property is involuntarily converted into cash it must be reinvested in qualifying property). 271. irc § 1033(a)(2)(a). in addition, to purchasing ualified replacement property outright, a disaster victim may purchase a controlling interest (or greater) in a corporation that owns property that qualifies as similar in service or use property. id. for this purpose, a controlling interest is defined as 80% of the total combined voting power of all voting classes of stock, and 80% of the total number of shares of all other classes of stock. irc § 1033(a)(2)(e)(i). 272. see rev. rul. 64-237, 1964-2 c.b. 319; rev. rul. 76-319, 1976-2 c.b. 242 (ruling that billiard facilities were not similar in use to bowling alley); rev. rul. 8370, 1983-1 c.b. 189; priv. ltr. rul. 8820055; priv. ltr. rul. 9723032; priv. ltr. rul. 200109005; johnson v. comm’r, 43 t.c. 736 (1965), acq., 1965-2 c.b. 5; maloof v. comm’r, 65 t.c. 263 (1975); davis regulator co. v. commissioner, 36 b.t.a. 437 (1937), acq., 1937-2 c.b. 7; woodall v. comm’r, 964 f.2d 361 (5th cir. 1992). 273. see edwards, supra note 190, at a-25. 274. id. 275. see rev. rul. 56-347, 1956-2 c.b. 517; edwards, supra note 190, at a-25 (noting that the property does not have to be exactly identical or the same). 276. see internal revenue service, casualties, disasters, and thefts, pub. 547 at 9 (2003). 277. see rev. rul. 76-319, 1976-2 c.b. 242. 278. see rev. rul. 71-575, 1971-2 c.b. 61. b. replacement property must be similar or related in service or use to the converted property if a disaster victim makes a nonrecognition election for all or part of her qualifying casualty gains269 she must use all or a portion of her disaster proceeds to purchase qualified replacement property.270 qualified replacement property is defined as property that is “similar or related in service or use” to the converted property.271 while neither the code nor the treasury regulations define what is “similar or related in service or use” property, the phrase has been the subject of significant litigation and administrative rulings.272 the test for satisfaction of this requirement turns on whether the destroyed property was used by the owner or held as an investment.273 i. owner used the converted property if the owner used the converted property, then the applicable inquiry is a “functional/end use test.”274 the replacement property must have closely similar physical characteristics and end uses to the converted property.275 the replacement property must function in the same manner as the converted property.276 the government strictly enforces this test and has denied nonrecognition treatment for an owner-user in the case of the replacement of a bowling alley with a billiard hall277 and the replacement of a farm truck with a farm tractor.278 994 florida tax review [vol.6:10 279. rev. rul. 64-237, 1964-2 c.b. 319. see liant record, inc. v. comm’r, 303 f.2d 326 (2d cir. 1962); clifton inv. co. v. united states, 312 f.2d 719 (6th cir. 1963), cert. denied, 373 u.s. 921 (1964); loco realty co. v. united states, 306 f.2d 207 (8th cir. 1962); pohn v. comm’r, 309 f.2d 427 (7th cir. 1962); johnson v. comm’r, 43 t.c. 736 (1965), acq. 1965-2 c.b. 5. 280. see priv. ltr. rul. 8820055; priv. ltr. rul. 9723032. 281. see liant record, inc., 303 f.2d at 329. 282. rev. rul. 71-41, 1971-1 c.b . 223 (allowing taxpayer to satisfy requirements for replacement property by constructing leased gas station on property already owned). 283. priv. ltr. rul. 9326042 (determining whether an apartment building is similar to destroyed warehouse). 284. irc § 1033(h)(3) (defining presidentially decla red d isaster for this purpose as “any disaster which, with respect to the area n which the property is located, resulted in a subsequent determination by the president that such area warrants assistance by the federal government under the disaster relief and emergency assistance act”). 285. irc § 1033(h)(2). 286. id. 287. see tech. adv. mem. 2001-11-056 (advising that while replacement property is broadly interpreted it does not include property held for investment). ii. owner invested in the converted property if the owner is an investor in the property and leases the converted property to the end user, then the applicable inquiry is whether the relationship of the owner to the original property is the similar to the relationship of the owner to the replacement property.279 the fact that the disaster victim was the lessor of both the converted and replacement properties is not enough.280 qualifying replacement property will include a lease that is similar to the converted property with respect to the nature and extent of the owner’s management activities with respect to the property; the quantity and quality of the services required by the owner under the lease; and the nature of the property’s business risk to the owner.281 the government has allowed nonrecognition treatment for taxpayer/investors who replaced land and a leased warehouse with a leased gas station282 as well as the replacement of a leased industrial warehouse with a residential apartment development.283 iii. property was damaged or destroyed in a presidentially declared disaster if the property was converted in a presidentially declared disaster284 and it was held for investment or used in a trade or business, then more liberal replacement property rules apply.285 under these circumstances, qualifying replacement property is any tangible property used in any trade or business.286 this provision will allow a disaster victim of a presidentially declared disaster to qualify for nonrecognition of gain by replacing her destroyed investment or trade or business property with any type of tangible business property in any trade or business, including an existing business.287 this exception to the general rule affords disaster victims with a broad array of reinvestment options. 2005] anatomy of a disaster 995 288. see irc § 1033(h)(4) (defining principal residence for this purpose as the same meaning as used in code § 121 , excep t that the taxpayer is not required to own the property). 289. irc § 1033(h)(1)(a)(i); rev. rul. 95-22, 1995-1 c.b. 145. 290. id. 291. irc § 1033(h)(1)(a)(ii). 292. irc § 1033(a)(2)(a) (stating that replacement property must be purchased); regs. § 1.1033(a)-2(c)(4). taxpayers may acquire replacement property by constructing it as long as it is paid for and completed by the close of the replacement period. see rev. rul. 56-543, 1956-2 c.b . 294. if an individual taxpayer’s aggregate realized gain exceeds $100,000 for all converted gain property, then nonrecognition treatment is not available for replacement property purchased from a related party. irc § 1033(i)(2)(c). corporate taxpayers and certain partnerships with corporate partners are denied nonrecognition treatment for replacement properties acquired from related parties under any circumstance. irc §1033(i)(2)(a), (b). for purposes of this analysis, related parties are defined in code §§ 267(b) (including, without limitation, brothers, sisters, spouse, ancestors and lineal descendants, an individual and a more than 50% owned-corporation) or 707(b)(1) (including, without limitation, an individual and a more than 50% owned partnership). irc § 1033(i)(3). 293. irc § 1033(a)(2)(b). 294. irc § 1001(a) (setting forth the calculation for determining gain). 295. irc § 1033(h)(1)(b). 296. see for example mike freeman, jennifer davies and roger m. showley, end in sight: rebuilding may be long process for homeowners, the san diego uniontrib., nov. 2, 2003, at a-1, a-11 (noting that because of the overwhelming loss of in addition, if the property was converted in a presidentially declared disaster and it was the taxpayer’s principal residence288 or any of its contents, the code does not require reinvestment of insurance proceeds received for any personal property contents that were not specifically scheduled insured items.289 therefore, a presidentially declared disaster victim can use insurance proceeds from the destroyed unscheduled contents of her home for any purpose and not have to recognize any gain realized with respect such property.290 moreover, insurance proceeds received for personal property that is scheduled for insurance purposes may be pooled with the proceeds received for the residence itself and reinvested in property that is similar or related in service or use property to the residence (or its contents).291 this flexibility affords disaster victims with different tax-favored options for replacing their home and contents. c. replacement property must be purchased within the applicable time period to qualify for nonrecognition of gain realized, the replacement property must be purchased292 no later than two years after the close of the first taxable year in which any conversion gain is realized.293 gain is realized as soon as proceeds exceed the taxpayer’s basis in her property.294 a more liberal four-year replacement period applies for the involuntary conversion of a principal residence resulting from a presidentially declared disaster.295 while these time periods may at first impression seem generous, the replacement process can be very time consuming and due to circumstances outside of the control of the taxpayer take many years.296 fortunately, the code provides that 996 florida tax review [vol.6:10 homes san diego county would be embarking upon its biggest rebuilding effort in history and that it would be a long (12 to 18 months of planning and construction) and challenging process for residents and the ill-equipped construction industry); ron harris, lack of workers may delay fire rebuilding, los angeles times, nov. 9, 2003, at real estate (commenting that even if homeowners can find a builder it could be weeks before some areas are safe due to intense heat leaving roads unstable due to oil boiled out of the pavement); roger m. showley, rebuild? a series of hurdles ahead, the san diego union-trib., nov. 2, 2003, at h8 (reporting that rebuilding a home isn’t what it used to be). 297. irc § 1033(a)(2)(b )(ii). the application for extension should be addressed to the district director for the internal revenue district in which the return was filed for the first taxable year in which gain from the conversion was realized. regs. § 1.1033(a)-2(c)(3). 298. id.; rev. rul. 60-69, 1960-1 c.b. 294 (indicating that extension requests are generally not granted until the end of the replacement period). 299. id.; regs. § 1.1033(a)-2(c)(3). 300. see rev. rul. 56-300, 1956-1 c.b. 624. 301. see edwards, supra note 190, at a-38 through a-39 (presenting examples of reasonable causes that the government has accepted and rejected including the rejection of scarcity and high values of replacement property or shortage of condemnation proceeds and accepting death (but not inexperience) and miscalculations by tax advisor). 302. id. 303. see irc § 121(d)(5) (setting forth provision providing for the exclusion of gain from the sale of a principal residence and treating an involuntary conversion as a sale or exchange for this provision); regs. § 1.121-4(d)(1). the taxpayer may apply to the government for a discretionary extension of the replacement period.297 an application for an extension of the replacement period should be made before the replacement period expires.298 however, the irs usually does not grant them until very near the end of the period.299 under certain circumstances, the irs may extend the replacement period even if the request is filed after the close of the replacement period.300 extensions of the replacement period are only granted if there is reasonable cause for the failure to make timely replacement and, if applicable, reasonable cause for the late filing of the extension request.301 the irs usually grants extensions for periods of one year or less when the taxpayer has demonstrated that she has made diligent and timely efforts to find replacement property.302 disaster victims are well advised to keep a written journal and any relevant newspaper or magazine articles documenting their efforts to obtain qualifying replacement property and any specific challenges during the process. this journal, together with any supporting independent evidence, should provide a ready source of information for an extension request if it should become necessary near the end of the relevant replacement period. d. conversion of principal residence if the property destroyed is the taxpayer’s principal residence, taxpayers may elect to exclude some or all of the gain realized under an alternative provision of the code.303 code section 121 is an elective provision that permits taxpayers who have owned and lived in their principal residence 2005] anatomy of a disaster 997 304. see irc § 121(a), (b) (applying this exclusion provision generally to only one sale or exchange every two years). 305. see irc § 121. 306. see for example irc §§ 1031(d) (carryover basis in like-kind exchange); 1033(b) (cost basis reduced by gain realized but not recognized); 1091(d) (carryover basis increased by new investment and decreased by cash withdrawn); 1032(b) (carryover basis). 307. see irc § 121(d)(5)(b); internal revenue service, casualties disasters, and thefts, pub. 547, at 10. 308. id. 309. irc § 121(d)(5)(b). 310. id. 311. id. 312. irc § 121(d)(5)(c); regs. § 1.121-4(d)(3). for at least two of the last five years to exclude $250,000 ($500,000 for married filing joint taxpayers) of gain realized from gross income.304 this provision provides for the complete exclusion rather than mere deferral of gain realized and does not require any reinvestment of sale proceeds.305 this tax provision is unique because the tax benefit comes at no cost or basis reduction in the replacement property.306 disaster victims may elect to use this gain exclusion provision in lieu of or in addition to electing to defer any excess gain under the involuntary conversion provision.307 disaster victims with casualty gains on their principal residences in excess of $250,000 ($500,000 for married filing jointly) may want to use both provisions to exclude from gross income the maximum allowable (e.g., $250,000 for unmarried or married filing separately taxpayers) and defer any excess gain under the nonrecognition involuntary conversion provisions.308 this strategy will allow disaster victims to benefit to the extent allowable from the generous principal residence gain exclusion provision and to the extent of any additional gain, the casualty gain deferral provisions. technically, the code requires taxpayers to reduce the amount realized from the involuntary conversion by the amount of any gain excluded.309 taxpayers desiring to defer all gain realized in excess of the allowable exclusion amount will have to reinvest in qualified replacement property within the replacement period.310 the amount that must be reinvested is the total amount of insurance proceeds received reduced by the amount of excluded gain.311 if a taxpayer elects to reinvest in qualified replacement property, the taxpayer’s ownership and use of the destroyed residence is attributed to the replacement residence for purposes of excluding gain on a subsequent sale of the replacement residence.312 3. application to the bell family, hypothetical disaster victims after submitting detailed lists, photographs, and engaging in weeks of intense negotiations, the bell family received insurance proceeds for their business and residential assets. the initial insurance checks came in late december, just after the less than festive holiday season. the insurance checks were separately allocated between the bell’s business and residence and their personal and real property losses. 998 florida tax review [vol.6:10 313. see irc §§ 179, 167, 168 (setting forth provisions for immediate expensing and depreciation of trade or business property, respectfully). 314. see irc §§ 1012 (setting forth definition of adjusted basis), 1011 (setting forth definitions of cost basis), 1016 (setting forth adjustments to basis to derive adjusted basis). 315. fifty thousand dollars (amount realized) less $0 (adjusted basis of equipment) = $50,000 gain realized. see irc § 1001(a). 316. the building would have been depreciated on a straightline basis over a 39-year recovery period. see irc § 168(b)(3), (c) (setting forth the depreciation method and recovery period for nonresidential real property); 225,000/39 = $5,769 per year/12 = $480.76 per month for almost 42 months or almost 3.5 years = $20,000 of depreciation reducing the basis to 205,000. see irc §§ 1012, 1016 (setting forth how depreciation reduces basis to derive adjusted basis). 317. one hundred fifty thousand dollars (amount realized) less $205,000 (adjusted basis of building) = $55,000 loss realized. see irc § 1001(a). 318. see irc § 1011. 319. one hundred fifty thousand dollars (amount realized) less $70,000 (adjusted basis) = $80,000 gain. 320. thirty thousand dollars (amount realized) less $40,000 (adjusted basis) = ($10,000) loss; $5,000 (amount realized) less $4,000 (adjusted basis) = $1,000 gain. 321. see irc § 1033(h)(2). the bells received $50,000 for their business equipment, which was comprised primarily of commercial washers and dryers. because these items had been held for several years, the bell had fully depreciated them,313 so their adjusted basis in the equipment had been reduced to zero.314 therefore, the bells realized a $50,000 gain on the involuntary conversion of the equipment.315 in addition, the bells received insurance proceeds of $150,000 for their destroyed business structure. the bells had acquired their business property several years ago for $350,000, $125,000 of which was allocated to the land and the balance of $225,000 was allocated to the structure. the building had been depreciated and had a basis on the date of its destruction of $205,000.316 accordingly, the bells have realized a $55,000 casualty loss on their business structure.317 the bells have also received insurance reimbursements for their residence and the contents of their residence. the insurance proceeds will be $150,000 for their home and $35,000 for lost contents, including $5,000 for specifically scheduled jewelry. the bells had acquired their home approximately fifteen years ago for $100,000, which was allocated $30,000 to land and $70,000 to the structure. the bells had a cost basis318 in their lost contents including furniture, fixtures, clothing and household appliances of approximately $44,000, including $4,000 basis in their jewelry. accordingly, the bells have an $80,000 gain on their residence319 and a $10,000 personal casualty loss on their residential contents and a $1,000 personal casualty gain on their scheduled property.320 the bells’ casualty gains result from a disaster declared a major disaster by president george w. bush. accordingly, more favorable rules apply if they want to qualify for tax-deferred treatment of their gains. for example, the bells may qualify for tax-deferred treatment if they reinvest their business insurance proceeds from the involuntary conversion of their laundromat assets in any tangible trade or business property.321 this treatment is much more generous than the much narrower reinvestment requirement for trade or 2005] anatomy of a disaster 999 322. see irc § 1033(a)(2)(a). 323. see irc § 1033(h)(2). 324. see irc §§ 1033(a)(2)(a); 1245(a) (describing recapture of depreciation taken as ordinary income). 325. forty-five thousand ollars (cost basis) – $45,000 (gain realized, but not recognized) = $0 basis in replacement property. see irc § 1033(b)(2) (describing the basis computation). 326. see irc § 1(a) (setting forth marginal income tax rates for married individuals filing joint returns). 327. thirty-five percent marginal income tax rate x $50,000 ordinary income = $17,500. 328. see irc § 1033(a)(2)(a). 329. see irc § 1033(b)(2). 330. fifty thousand dollars cost less $50,000 gain realized, but not recognized = zero. 331. see irc § 1033(a)(2)(b). 332. see irc § 1033(a)(2)(a). 333. see irc § 1033(a)(2)(c). business or investment property destroyed in a non-presidentially declared disaster. under the later, more narrow case, property must be reinvested in “similar or related in service or use” property.322 under such circumstances, to avoid recognition of their business casualty gain the bells would have to reinvest their insurance proceeds in commercial washers and dryers. however, because the property was destroyed in a presidentially declared disaster, the bells might avoid recognition by reinvesting all $50,000 of their insurance proceeds from their destroyed washers and dryers in any tangible trade or business property.323 if the bells decide to reinvest less than $50,000 in trade or business tangible property, they will have to recognize any reinvestment shortfall as ordinary income in 2003.324 for example, if the bells reinvest only $45,000 in qualifying property, they will have to recognize $5,000 of ordinary income and their basis in their new business property will be zero.325 in 2003, the highest marginal ordinary income tax rate was thirty-five percent.326 if the bells decide not to reinvest any insurance proceeds in qualifying replacement property, their maximum federal income tax cost would be $17,500.327 the bells do not have to use their cash insurance proceeds but may finance all or some of their reacquisition as long as they purchase qualifying replacement property within the replacement period.328 the bells basis in their new property will be their cost reduced by any gain realized but not recognized.329 accordingly, if the bells purchase $50,000 of trade or business replacement property, their basis in the new property will be zero.330 any reinvestment of the bells business insurance proceeds must occur no later than december 31, 2005 to avoid recognition.331 the bells will have to elect nonrecognition treatment on their 2003 income tax return by filing a statement detailing the involuntary conversion and their reinvestment plans.332 this election will extend the bells’ statue of limitations with respect to any deficiency related to this casualty gain to three years from the date the bells notify the government of their reinvestment or failure to reinvest in qualifying replacement property.333 1000 florida tax review [vol.6:10 334. see irc § 121 (setting for the rules for exclusion of gain for sales or exchanges of principal residences). 335. irc § 121(b)(2)(a). 336. irc § 121(d)(5) (describing the coordination rules for exclusion and deferral of gain realized on the involuntary conversion of a principal residence). 337. see irc § 121(d)(5)(b). 338. four hundred thousand dollars cost basis less $100,000 (gain realized ($600,000 – $500,000 = $100,000), but not recognized) = $300,000. 339. see irc § 1033(h)(1)(b) (setting forth the four year replacement period). 340. irc § 1033(h)(1)(a)(ii) (providing that insurance proceeds for scheduled property may pooled with insurance proceeds for the residence for reinvestment in a new residence). 341. see irc § 1033(a)(2)(a). 342. the bells had an adjusted basis of $45,000 in their destroyed contents and received $35,000 insurance proceeds. the casualty gain on the involuntary conversion of the bell’s principal residence may be excluded under the residential gain exclusion provisions.334 under this provision the bell’s may exclude up to $500,000 of gain irrespective of any reinvestment in qualifying property.335 if the bells casualty gain exceeded $500,000, they could defer recognition of any excess gain by reinvesting in a new principal residence.336 for example, if the bells’ gain were $600,000 and they had received $800,000 of insurance proceeds, the bells would have to reinvest at least $300,000, or the amount of the insurance proceeds reduced by the excluded gain, in a new residence to defer recognition of the $100,000 of gain in excess of the excluded gain of $500,000.337 the bells’ basis in their new home would be its purchase price, including debt, less any gain realized (reduced by gain excluded under the principal residence provisions) but not recognized. if the bells reinvested $275,000 in a new principal residence, the home’s basis would be $250,000338 and $575,000 gain realized would be excluded ($500,000) or deferred ($75,000) and $25,000 longterm capital gain ($300,000 less 275,000) would be recognized at a preferable maximum tax rate of fifteen percent. any reinvestment to defer gain under the involuntary conversion rules would have to be completed no later than december 31, 2007.339 the $1,000 gain on the bells’ jewelry, scheduled residential contents, may be deferred if the $5,000 insurance proceeds are reinvested in “similar or related in service or use property” expanded for this purpose to include the residential structure in addition to the destroyed jewelry.340 therefore, if the bells reinvest their $5,000 of insurance proceeds in replacement jewelry or with other funds in their new residence, they will not have to recognize any of their $1,000 casualty gain. any shortfall of reinvestment will give rise to casualty gain equal to the amount of the shortfall (limited to the amount of gain realized).341 the bells suffered a personal casualty loss on the involuntary conversion of their residential contents because the insurance proceeds they received were less than the cost of the unscheduled and scheduled contents.342 if the insurance proceeds had exceeded the cost of their contents (resulting in a realized gain), they could have excluded from recognition any gain on 2005] anatomy of a disaster 1001 343. irc § 1033(h)(1)(a)(i) (providing an exclusion of gain realized for insured, nonscheduled personal property). 344. fifty thousand dollars of gain realized and recognized as ordinary income subject to a maximum tax rate of 35%. 345. property that is voluntarily sold may qualify for nonrecognition treatment if it is sold because the property is part of an “economic unit” with the converted property. id.; rev. rul. 59-361, 1959-2 c.b. 183; rev. rul. 96-32, 1996-1 c.b. 177 (ruling that sale of residential lot after destruction of residence qualified for nonrecognition treatment); priv. ltr. rul. 9334007 (ruling that sale of land adjacent to house destroyed by tornado qualified for nonrecognition treatment under code § 1033); priv. ltr. rul. 9143056 (ruling that sale of lot underlying building destroyed by fire qualified for nonrecognition treatment); but see rev. rul. 78-377, 1978-2 c.b. 208 (disallowing nonrecognition treatment for voluntary sale because sale was not forced upon the taxpayer); rev. rul. 80-175, 1980-2 c.b. 230 (same). 346. see irc § 1031 (setting forth the gain deferral provisions for like-kind exchange). 347. see irc § 121. unscheduled residential contents because the gain resulted from a presidentially declared disaster.343 the bells project a budget of $335,000 to rebuild and re-equip their business and $450,000 to rebuild their home and acquire basic furnishings. their total insurance proceeds are $385,000. the bells need a minimum of $785,000 to reestablish their pre-fire lives and, therefore, have a $400,000 shortfall. the bells have applied for sba loans and have been notified that they qualify for a $100,000 residential loan and a $150,000 business loan. as a result, the bells need an additional $150,000 to reestablish the basic components of their pre-disaster lives. alternatively, the bells could decide not to rebuild their lost laundromat. if they decide not to rebuild, they could use the insurance proceeds from the loss of their equipment and business structure for the reconstruction of their residence. the bells would owe up to $17,500344 of federal income tax as a result of not reinvesting in qualifying replacement property, but they would have enough cash to re-establish their home by accepting most or the entire $100,000 sba residential loan. as part of this plan, the bells may decide to sell the land underlying their laundromat. if they sell this land, they will have to recognize any gain or loss realized and will not receive favorable treatment unless they can demonstrate that the entire property was one economic unit effectively destroyed in the disaster.345 alternatively, the bells could exchange the former laundromat land for other real property. the code provides deferral of gain recognition if real property held for investment or in a trade or business is exchanged for other real property to be held in a trade or business or for investment purposes.346 under this alternative, the bells should be able to exchange their former laundromat property for another business or investment property without recognizing any gain. however, the bells may lack the cash resources or emotional energy to begin a new business in a new location. another option would be for the bells to sell their residential property, buy a less expensive home, and use the excess funds to rebuild their business. any gain from the sale of the residential property should be excluded under the exclusion provision for gains on the sale of a principal residence.347 any gain 1002 florida tax review [vol.6:10 348. see irc § 1033(h)(1)(b); rev. rul. 96-32, 1996-1 c.b. 177 (ruling that sale of residential lot qualified for nonrecognition treatment even though it was not involuntarily converted as long as the sale occurs within the statutory replacement period). 349. one hundred eighty-five thousand dollars residence and contents insurance proceeds + $480,000 net sale proceeds (after $50,000 estimated selling costs) = $665,000 $200,000 home mortgage = $465,000. 350. see internal revenue service, casualties, disasters, and t hefts, pub. 547, at 13-14; mccoy, supra note 356, at a-93 through a-94; irc § 172(a), (b)(1)(f) (describing three-year carryback period for any casualty losses incurred by ind ividuals and farmers and small businesses and farmers with presidentially declared disasters). alternatively, the carryback period for net operating losses is two years. irc § 172(b)(1)(a)(i). 351. see rev. rul. 59-398, 1959-2 c.b. 76; millsap v. commissioner, 46 t.c. 751 (1966), acq., 1967-1 c.b. 2, aff’d, 387 f.2d 420 (8th cir. 1968). unfortunately, this means that the bells will not receive any tax benefit for their uninsured and on the land and property in excess of $500,000 could be deferred under the involuntary conversion provisions if a new residence is acquired no later than december 31, 2007.348 the bells could use excess residential sale proceeds to supplement their insurance and loan proceeds to rebuild their business and its contents and perhaps even provide some working capital. for example, if the bells sold their residential lot for $530,000, they would realize a $500,000 gain on its sale in addition to the $80,000 gain on the involuntary conversion of their residential structure. the bells would have to pay in full their $200,000 home mortgage. as a result, their net proceeds from their residential property, including contents, would be approximately $465,000.349 the $465,000 of net proceeds on their residence could be used together with their business insurance proceeds of $200,000 to acquire a new, less expensive home and business. in addition, the bells could retain some of this $665,000 cash for other purposes such as working capital for their business and use debt including any approved sba loans to re-establish their home and business. to avoid recognition of any casualty gain realized, the bells would have to purchase a residence for at least $155,000 (insurance proceeds with respect to their residence and scheduled jewelry) and business property costing at least $50,000. this minimal amount of reinvestment to avoid gain recognition by the code is likely significantly less than the marketplace will demand. the bells have many different options for minimizing the tax costs of their casualty gains and re-establishing their home and business. unfortunately, the bells may have to incur more debt, so they must carefully analyze their future cash flow to ensure that they can support any increased level of indebtedness. the bells should consult competent professionals to assist them in their tax and financial analyses. the bells will also want to ensure that they maximize any tax benefits from their realized casualty losses. c. casualty losses disaster victims may realize casualty losses in addition to or in lieu of realizing casualty gains.350 casualty losses must be attributable to a loss of property and do not include any unreimbursed additional living expenses resulting from a casualty.351 under the code, casualty losses generally arise 2005] anatomy of a disaster 1003 uncompensated additional living expenses resulting from the fire. the bells estimated that these costs were in excess of $10,000. 352. see regs. § 1.165-7(b)(1) (setting forth rule for determining the amount of the loss for a qualifying casualty loss). 353. id. the exception to this rule is if the property was used in a trade or business or held for the production of income and it is totally destroyed by the casualty. regs. § 1.165-7(b)(1)(ii). 354. this result may not be true if a taxpayer inherited the property and received a stepped-up basis in the property, which represents appreciation in the property that has never been subject to income tax. see irc § 1014(a). 355. see for example jeannette steele, after the fires: insurance shortfall, the san diego union-trib., mar. 21, 2004, at b1, b5 (describing that because of significant insurance shortfalls many fire victims will need second mortgages or drain their savings accounts to rebuild); jeanette steele, after the fires: owner fears for quality of life, ranch, the san diego union-trib., mar. 21, 2004, at b4 (describing the challenges of inadequate insurance coverage); jeanette steele, agent told scripps ranch man he had enough home insurance, the san diego union-trib., mar. 21, 2004, at b4 (describing $223,362 shortfall to rebuild home that victim believed was adequately insured). 356. see john c. mccoy, esq., loss deductions, 527-2d tax m anagement portfolio (explaining that a taxpayer cannot claim a loss on income that has not been recognized for tax purposes). 357. see irc § 1001(a). 358. see irc§ 165(c)(1), (2). 359. irc § 165(c). 360. irc § 165(c)(3). 361. internal revenue service, casualties, disasters, and thefts, pub. 547, at 2 (defining “sudden” as swift, not gradual or progressive; “unexpected” as ord inarily unanticipated and unintended; and “unusual” as not a day-to-day occurrence and not typically engaged in). when disaster relief received for damaged or destroyed property is less than the taxpayer’s adjusted basis in her property.352 in most cases, the loss may not exceed the taxpayer’s decrease in the value.353 accordingly, the loss is limited to the taxpayer’s actual investment in the property and no deduction is allowed for a loss in unrealized appreciation in the property.354 in cases where property values have appreciated greatly and insurance coverage is inadequate,355 the decline in the property’s value will exceed the insurance proceeds, giving rise to a nondeductible loss in unrealized appreciation.356 because the insurance proceeds exceed the taxpayer’s adjusted basis in her property, the taxpayer has realized a casualty gain and not a casualty loss.357 a disaster victim may be agonizing over her significant economic loss without realizing that under the code she has a taxable gain. fortunately, as demonstrated above, the disaster victim may qualify for nonrecognition of her realized casualty gain. even if a taxpayer has suffered a tax loss, recognition under the code is limited. the code generally only permits individual taxpayers deductions for losses incurred in a trade or business or a transaction entered into for profit.358 personal losses are generally not deductible.359 the one exception to this general rule is that if the loss arises from fire, storm, shipwreck, or other casualty or theft, the loss is allowable.360 for this purpose, a “casualty” is defined by the government as “the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.”361 1004 florida tax review [vol.6:10 362. major disasters are defined as a natural catastrophe including a hurricane, tornado, storm, flood, and drought. 42 u .s.c. § 5122(1). for purposes of code § 165(c)(3), drought may or may not qualify as a casualty due to its progressive rather than sudden, unexpected nature. rev. rul. 77-490, 1977-2 c.b. 64. 363. an emergency is broadly defined as “any occasion or instance” requiring federal assistance. 42 u.s.c. § 5122(2). 364. see m ccoy, supra note 356, a-69 (commenting that as a practical matter the irs will likely agree with the president for determining whether an event is a casualty). 365. regs. § 1.165-7(a)(2)(i) (stating that the loss is limited to actual damage resulting from the casualty and not due to a decrease in value due to general market decline resulting from the casualty); see rev. rul. 66-242, 1966-2 c.b. 56 (ruling that loss does not include general economic decline of the property resulting from buyer resistance due to the casualty); see also caan v. united states, 99-1 u.s.t.c. ¶ 50,349 (c.d. cal. 1999) (denying casualty loss deduction for decline in value due to buyer resistance attributable to the close proximity of the property to the residence of o.j. simpson during his double murder trial). 366. see regs. § 1.165-7(b)(1). the “bluebook” value (but not the trade-in value) of an automobile as adjusted for mileage and condition may provide evidence as its pre-casualty value. internal revenue service, casualties, disasters and thefts, pub. 547, at 4. for an excellent analysis of the myriad of caselaw covering the success and failure of taxpayers’ attempts to prove their casualty loss through a wide range of appraisals, see mccoy, supra note 356, at a-86 through a-88. 367. regs. § 1.165-7(a)(2)(i). the appraisal may not include any general market decline due to the casualty. id. any costs (e.g., appraisals and photographs) incurred to determine the casualty loss are deductible as expenses related to tax preparation deductible as miscellaneous itemized deductions, which are in the aggregate only deductible as itemized deductions to the extent they exceed two percent of adjusted gross income. see irc § 67(a); internal revenue service, casualties, disasters, and thefts, pub. 547, at 4. 368. id.; irc § 165(i)(4). 369. regs. § 1.165-7(a)(2)(ii). 370. see internal revenue service, casualties, disasters and thefts, pub. 547, at 4; rev. rul. 71-161, 1971-1 c.b. 76 (noting that the cost of debris removal must be included in computing casualty loss); mccoy, supra note 356, at a-83. major disasters362 and emergencies363 declared by the president under the disaster relief and emergency assistance act will qualify as a casualty for purposes of this tax relief.364 taxpayers also have the burden of proving that the damage or destruction to property was the direct result of the “casualty.”365 in addition, a taxpayer has the burden of proving the amount of her casualty loss.366 the government advises that the best evidence of the decrease in value includes competent appraisals of the fair market value of the property immediately before and after the casualty.367 if a taxpayer’s casualty loss is from a presidentially declared disaster appraisals, she may use any appraisals obtained for federal loans.368 alternatively, a disaster victim may use the cost to repair the property to its original condition as evidence of the decrease in value as long as the repair is only necessary to bring the value of the property to its pre-casualty level.369 the cost of removing debris and other clean-up work should be including in calculating the decrease in the property’s value by including it in repair costs or in appraised values.370 disaster relief reimbursements actually received or reasonably anticipated with respect to the damaged property reduce the amount of the 2005] anatomy of a disaster 1005 371. irc § 165(a); see internal revenue service, casualties, disasters and thefts, pub. 547, at 4. 372. id.; regs. § 1.165-1(d)(2)(i); tech. adv. m em. 2001-11-056 (feb. 15, 2001) (finding that losses were not deductible because disaster victim had reasonable prospect of a recovery); spak v. comm’r, 76 t.c. 464 (1981), acq., 1981-2 c.b. 2. 373. id. 374. see jeffrey v. comm’r, 12 t.c. memo 534 (1953) (holding that legal fees to obtain insurance recovery offset insurance proceeds eventually received); but see tarsey v. comm’r, 56 t.c. memo 553 (1971) (holding that legal fees incurred for unsuccessful pursuit of recovery for personal casualty loss were not deductible). 375. see internal revenue service, casualties, disasters, and thefts, pub. 547, at 5-6 (describing the tax consequences of receiving reimbursements greater or less than the amount anticipated after the year of the disaster). 376. id.; see irc § 111. 377. irc § 165(h) (describing the different tax treatment for personal casualty losses as compared to business or investment casualty losses). 378 irc § 165, (h)(3) (describing personal casualty losses resulting from personal-use property, which is property that is not used in a trade or business or held for investment). 379. regs. § 1.165-7(b)(1). 380. irc § 165(a); regs. § 1.165-1(c)(4). 381. irc § 165(h)(3)(e). a claim does not have to be filed if the loss is less than the amount of the insurance policy deductible because the loss is not insured. see internal revenue service, casualties, disasters, and thefts, pub. 547, at 7. casualty loss.371 for this purpose, all insurance proceeds, federal and state reimbursements, charitable or employer received or reasonably anticipated reimbursements specifically for restoration, repair or rehabilitation of the damaged or lost property reduce the amount of the casualty loss.372 unrestricted gifts or loans or reimbursements for living expenses are not treated as recoveries for purposes of this analysis.373 legal, accounting and other expenses incurred to obtain property reimbursements offset the amount of any recovery.374 if anticipated reimbursements are no longer receivable in full or in part, the disaster victim may deduct any resulting loss in the tax year of this discovery.375 if actual reimbursements are greater than anticipated, then the excess reimbursement will have to be included in gross income to the extent of any tax benefits previously enjoyed by the taxpayer.376 the amount of realized loss that is deductible depends upon whether the property is used personally, in a trade or business, or held for investment.377 1. personal casualty losses personal-use property is defined as any property that is not used in a trade or business or held for investment.378 the amount of casualty loss for personal-use property is the lesser of (1) the decrease in the fair market value of the property immediately before and after the casualty; or (2) the adjusted basis in the property.379 as noted above, the taxpayer must reduce this amount by any insurance proceeds or other reimbursements received or recoverable, including any salvage value.380 taxpayers with damage to personal-use property must file a timely insurance claim for any damaged insured property or the loss will be denied.381 1006 florida tax review [vol.6:10 382. for this purpose, husband and wife are treated as one taxpayer. irc § 165(h)(4)(b); regs. § 1.165-7(b)(4)(iii). however, if the married couple file separately and the property is jointly owned each taxpayer must reduce her ½ of the casualty loss by $100. see internal revenue service, casualties, disasters, and thefts, pub. 547, at 7. 383. irc § 165(h)(1). for this purpose, the government liberally construes the scope of each casualty and will aggregate events that are closely related in origin (e.g., damage from wind, hail and water from the same storm to a home, automobile, and rental property will be treated as a single casualty). see h.r. rep. no. 88-749, 1st. sess. (1963) at 1472; internal revenue service, casualties, disasters, and thefts, pub. 547, at 6-7. 384. this analysis only includes casualty gains that are not deferred or excluded under code §§ 1033 or 121, but are recognized. see mccoy, supra note 356, at a-80. 385. irc § 165(h)(2)(a). for this purpose, adjusted gross income does not include any recognized personal casualty gains. irc § 165(h)(4)(a). 386. irc § 163(h)(3) (setting forth requirements for deduction of home mortgage interest). 387. irc § 164(a) (setting forth the general rule that state taxes are deductible). 388. irc § 165(h)(4). adjusted gross income is defined as gross income reduced by certain expenses including trade or business and rental expenses, alimony, certain retirement savings, moving expenses, interest on education loans, higher education expenses, and eligible educator out of pocket expenses. irc § 62. 389. irc § 68 (setting forth overall limit on itemized deductions). 390. irc § 63 (describing the computation to derive taxable income); § 1(describing the tax imposed on taxable income). 391. irc § 63(c) (describing the basic standard deduction, which amounts vary based upon filing status and are indexed for inflation). 392. irc § 63(d) (defining itemized deductions). 393. irc § 63(a), (b) (stating that taxable income is derived by reducing gross income by the greater of itemized deductions or the standard deductions). 394. see internal revenue service, statistics of income, individual complete report 2001, pub . 1304, table a, mar. 2004 (setting forth that from 1997-2001 approximately 84 to 85 million taxpayer claimed the standard deduction and approximately 36 to 44 million taxpayers elected to itemize their deductions). each taxpayer382 must further reduce her personal casualty losses by $100 for each casualty.383 all personal casualty losses must then be offset against all recognized personal casualty gains.384 if personal casualty losses exceed personal casualty gains, such excess is further reduced by ten percent of a taxpayer’s adjusted gross income.385 the balance of any personal casualty loss is allowed with other deductions such as home mortgage interest386 and state taxes387 as an itemized deduction.388 a taxpayer’s aggregate itemized deductions, less an overall cutback for high-income taxpayers,389 reduce her adjusted gross income to derive her taxable income and her resulting tax liability.390 however, if a taxpayer’s applicable standard deduction391 exceeds her itemized deductions,392 she will reduce her adjusted gross income by her standard deduction in lieu of her itemized deductions and derive no tax benefit from her casualty loss.393 historically, approximately sixty-five to seventy percent of all taxpayers claim the standard deduction rather than itemize their deductions.394 because of the significant reduction of personal casualty losses to derive the deductible amount, generally only significant personal casualty 2005] anatomy of a disaster 1007 395. see internal revenue service, statistics of income, individual complete report 2001, pub. 1304, table 2.1, mar. 2004 (setting forth that just 97,424 out of 130 million taxpayers claimed personal casualty loss deductions as an itemized deduction in 2001 and 23,434 of whom were taxpayers with no income tax liability); see also tom herman, ask dow jones, the san diego union-trib., aug. 29, 2004, at h6 (noting that many disaster victims effectively receive little or no tax benefit from their personal casualty losses). the internal revenue service provides taxpayers with an excellent workbook for calculating their casualty losses for personal-use property. internal revenue service, casualty, disaster, and theft loss workbook, pub. 584. the workbook contains eighteen schedules for potentially lost household items that will facilitate greatly a disaster victims accounting of her loss. id. at 4-22. 396. see annette nellen, disaster relief provisions: changes to § 1033 and the problems that remain, 22 j. real est. tax’n 158, 167-68 (1995) (suggesting that disaster victims keep their adjusted gross income low by avoiding sales of investment property at a gain and taxable retirement distributions and deferring income, if possible). 397. id. at 168-69. 398. id. 399. id. (suggesting that replacement of withdrawn retirement funds within a specified period of time could avoid income inclusion and penalties). 400. id. at 167 (reporting that the reduction of casualty losses by ten percent of adjusted gross income prevents many taxpayers from obtaining any tax benefit from their personal casualty loss). 401. inventory loss in a casualty is generally no t deductible as a casualty loss, but rather is automatically reflected in cost of goods sold under code § 471. see regs. § 1.165-1(c)(4). 402. the internal revenue service provides taxpayers with an excellent workbook for calculating their casualty losses for business and investment property. losses ultimately generate any tax benefit.395 disaster victims with net personal casualty losses should consider tax planning to minimize adjusted gross income for the tax year they claim the loss.396 unfortunately, desperate disaster victims suffering from inadequate cash flow and resources to rebuild their lives might consider selling investments or withdrawing funds from any available source, including tax-deferred retirement funds.397 these actions are inconsistent with the tax-planning goal of reducing adjusted gross income for a casualty loss year. the withdrawal of retirement funds may increase adjusted gross income, reducing the allowable amount of the casualty loss. moreover, early withdrawals could subject disaster victims to penalties costing precious dollars at a critical time.398 with proper planning, disaster victims might be able to time and structure income recognition and withdrawals to minimize tax costs and maximize tax benefits.399 proper planning is critical to salvage any tax relief from personal casualty losses.400 nevertheless, in many cases, because of the ten percent of adjusted gross income floor, personal casualty losses will not provide any tax benefit. 2. business or investment casualty losses alternatively, casualty losses with respect to trade or business401 or investment property ultimately provide more generous tax benefits than personal casualty losses because they are treated more favorably under the code.402 first, allowable casualty losses are not reduced by $100 per casualty 1008 florida tax review [vol.6:10 internal revenue service, business casualty, disaster, and theft loss workbook, pub. 584b. 403. irc § 165(h)(1), (h)(2) (stating that these reductions are for personal-use property only). 404. regs. § 1.165-7(b)(1). 405. see irc § 1231(a)(4)(c). 406. irc § 67(a), (b)(3) (stating that casualty losses that are itemized deductions that are not due to property held for investment or for personal use is a miscellaneous itemized deduction and is only deduction to the extent the amount exceeds 2% of her adjusted gross income). w hile this reduces the benefit of this deduction, the reduction is significantly less than the ten percen t of adjusted gross reduction for personal casualty losses. 407. regs. § 1.165-7(b)(2)(i), (b)(3), ex. 2 (demonstrating that the loss determination is made on an item-by-item basis). 408. regs. § 1.165-7(b)(2)(ii). 409. see mccoy, supra note 356, at a-76-77 (commenting that the single, identifiable property rule has resulted in taxpayer litigation). 410. these loss limitations are set forth in code § 469 and are called the passive loss limitations. 411. irc § 469(c). 412. see regs. § 1.469-2(d)(2)(xi). or ten percent of adjusted gross income.403 second, if trade or business or investment property is completely destroyed, the casualty loss is the adjusted basis irrespective of the amount of the decline in value.404 third, if casualty losses exceed casualty gains, the net loss is a deduction for adjusted gross income and not an itemized deduction.405 however, if the disaster victim used the property in her capacity as an employee, the casualty loss attributable to the property is characterized as a miscellaneous itemized deduction, which will be deductible only to the extent total miscellaneous itemized deductions exceed two percent of the taxpayer’s adjusted gross income.406 because of the foregoing differences, casualty loss deductions for business or investment property may provide a greater tax benefit than personal casualty losses. a final difference between the tax treatment of business and personal casualty losses may not be favorable. a taxpayer must determine business casualty losses for each identifiable piece of property.407 alternatively, real property and improvements not held for business or investment purposes are treated as an integral part of one property for purposes of determining the amount of a casualty loss.408 this difference is most notable in the context of investment real estate, where the difference between characterizing the property as residence versus rental property may cause the item by item casualty loss calculation to result in a smaller overall casualty loss.409 taxpayers with operating losses on investment real estate may be subject to passive loss limitations if they do not materially participate in the trade or business.410 personal casualty losses are not subject to these limitations because they arise from personal versus trade or business or rental activities.411 notably, the government has provided that casualty losses incurred in a trade or business or rental activity are not subject to the passive loss limitations.412 2005] anatomy of a disaster 1009 413. see jeffrey a. unger, valuation of real estate losses arising from natural disasters: opportunities for coordination with fema disaster loss verification, 25 j . real est. tax’n 52, 63 (1997) (explaining that the passive loss limitations do not apply to casualty losses). 414. irc § 165(a); regs. § 1.165-7(a)(1). 415. irc § 165(i). this election appears to include losses sustained for damaged inventory. see internal revenue service, casualties, disasters, and thefts, pub. 547 , at 12 (describing the app lication of presidentially declared loss provisions for inventories). 416. irc § 165(i)(2); regs. § 1.165-11(d). 417. irc § 165(i)(3); regs. § 1.165-11(c). 418. regs. § 1.165-11(e). 419. id. 420. id. 421. internal revenue service, casualties, disasters, and thefts, pub. 547, at 12. this relief highlights the importance of the threshold characterization of a business loss as a casualty versus operating loss.413 while business and investment casualty losses generally are treated more favorably than personal casualty losses, if the casualty occurs in a presidentially declared major disaster, the treatment could be beneficial for certain disaster victims. accordingly, the following provisions for the timing of recognition of casualty losses should be reviewed and included in tax planning for victims of presidentially declared disasters. 3. presidentially declared disaster losses a. timing of loss recognition generally, taxpayers must deduct casualty losses in the tax year suffered.414 however, if the casualty losses were incurred in a presidentially declared disaster and the disaster victim elects, the casualty loss may be deducted in the immediately preceding tax year.415 disaster victims may want to make this election to accelerate their receipt of any available refund of tax. if made, the entire casualty loss is treated for all purposes as if it occurred in the prior tax year.416 nevertheless, the amount of the casualty loss must be determined on the basis of all the facts existing as of the date the taxpayer claims the loss, including any reimbursements received or reasonably receivable.417 the disaster victim makes the election for prior year tax treatment by filing the prior year return, if not already filed, or if filed, an amended return or a refund claim.418 the filing should specify the date or dates of the disaster and the location (city, town, county, and state) of the damaged property.419 the disaster victim must make the election by the later of (1) the due date (without extensions) for filing the income tax return for the tax year in which the disaster occurred; or (2) the due date (with extensions) for filing the tax return for the preceding tax year.420 for most calendar year individual taxpayers, this will be april 15th of the tax year following the disaster.421 the irs has granted 1010 florida tax review [vol.6:10 422. see p riv. ltr. rul. 9603023 (oct. 20, 1995) (granting extension to taxpayers who missed deadline by relying on tax professionals inaccurate advice); priv. ltr. rul. 9603024 (oct. 20, 1995) (same); priv. ltr. rul. 9218022 (jan. 27, 1992) (granting extension where announcement designating disaster area occurred after the deadline); priv. ltr. rul. 9145009 (july 31, 1981) (granting extension where amount of loss could not be determined by deadline). 423. regs. § 1.165-11(e). 424. irc § 165(k). 425. irc § 165(k)(1); internal revenue service, casualties, disasters, and thefts, pub. 547, at 12. 426. irc § 165(k). 427. business casualty losses for property that is completely destroyed is measured as the ad justed basis in the property (here, $205,000) reduced by the insurance proceeds (here, $150,000) or $55,000. 428. personal casualty losses are measured as the lesser of the decrease in fair market value (here, approximately $50,000) (the fair market value of the residential contents before the disaster was approximately $50,000 and the fair market value of the property after the fire was $0)) or the adjusted basis (here, approximately $45,000) and further reduced by the insurance proceeds or $35,000. therefore, the bells personal casualty loss was $45,000 less $35,000 or $10,000. 429. see irc § 165(h)(2), (3). 430. see irc § 165(h)(1), (2)(a). extensions to taxpayers with compelling reasons for missing the deadline.422 a taxpayer can revoke this election at any time within ninety days of making it if she returns any refund (or credit) received within the later of the end of the revocation period or thirty days of her receipt of the refund.423 in addition to accelerating loss recognition, casualty losses for victims of presidentially declared disasters under certain circumstances are more inclusive. b. deduction for casualty loss expenses victims of presidentially declared disasters that have been ordered to demolish or relocate their principal residence because the government has rendered it unsafe may recognize any resulting loss as a personal casualty loss.424 the government must execute this order within 120 days of the president’s declaration of the area as a major disaster.425 a taxpayer may elect to deduct this personal casualty loss in the prior tax year.426 4. application to the bell family, hypothetical disaster victims unfortunately, the bells have suffered a $55,000 business casualty loss on their laundromat structure427 and a $10,000 personal casualty loss428 on their residential contents. personal casualty losses must first be offset against any recognized personal casualty gains.429 assuming that the bells acquire a new residence, they will not recognize any personal casualty gains. therefore, the bells will have a net personal casualty loss of $10,000, which must be further reduced by $100 and ten percent of the bells adjusted gross income in 2003.430 any remaining personal casualty loss will be allowable as an itemized deduction. assuming the bell family has a very low or negative adjusted gross income in 2003 because of uninsured business losses due to the fire, their net personal casualty loss itemized deduction would be no more than $9,900. 2005] anatomy of a disaster 1011 431. see irc § 1231(a)(4)(c). 432. see irc § 165(i). 433. see irc § 165(h)(a)(ii) (describing the reduction of personal casualty losses of ten percent of the taxpayer’s adjusted gross income). 434. the code treats the casualty as having occurred in the preceding tax year, but the loss is measured including all reimbursements anticipated as of the date the taxpayer claims the loss. irc § 165(i)(2), (3) (providing that the loss is determined as if the casualty causing the loss occurred in the immediate preceding tax year, but that the amount of the loss is determined by including all facts available on the date the loss is claimed). 435. see tom herman, ask dow jones, the san diego union-trib., aug. 22, 2004, at h7 (noting that disaster victims may be able to adjust their withholding or estimated tax payments for the balance of the tax year to accelerate the tax benefits of their losses). because the california wildfires occurred so late in the tax year, the b ells may only be able to reduce their 4th quarter estimate due on jan. 15, 2004. 436. see irc § 172 (setting forth the net operating loss deduction). in addition, the bells suffered a $55,000 business casualty loss. this business casualty loss would first be offset against any recognized business casualty gains.431 if the bells reinvest the insurance proceeds received for their business equipment, they will not have any recognized business casualty gains. if they decide not to purchase any replacement property, their $55,000 business casualty loss would offset their $50,000 recognized business casualty gain resulting in a $5,000 net business casualty loss. assuming they reinvest in qualifying trade or business replacement property, the bells have a $55,000 business casualty loss that will provide a business tax deduction, reducing their 2003 adjusted gross income. these casualty losses were incurred in a presidentially declared disaster, so the bells may elect to recognize their deductions in the preceding tax year or 2002.432 this election could provide the bells with an accelerated tax benefit. however, upon review of their 2002 tax return timely filed on april 15, 2003, the bells discover that their 2002 adjusted gross income was $155,000. accordingly, if they elect to recognize their casualty losses in 2002, they will receive a $55,000 business casualty loss, but will lose their entire personal casualty loss. the bells would lose any tax benefit from their personal casualty loss because it would be reduced by $10,000 or ten percent of their revised adjusted gross income for 2002 of $100,000, that is, $155,000 less $55,000.433 because the election to accelerate the tax losses to the preceding tax year treats all losses resulting from the casualty as 2002 losses, the bells cannot elect to accelerate their business casualty losses and not their personal casualty losses.434 accordingly, the bells determine that the election is not beneficial because while they would have accelerated their tax benefits from their business casualty loss, they will lose any tax benefits from their personal casualty loss. the bells must wait until they file their 2003 tax return in 2004 to receive any available tax benefits.435 the bells worry that because the fire forced them to close their business in november and december of 2003, they will have business operating losses and therefore may not receive any tax benefit from their casualty losses. fortunately, the code provides relief for taxpayers with businesses that operate at a loss especially when those losses result from a disaster.436 1012 florida tax review [vol.6:10 437. irc § 163(a). 438. irc § 172(b)(1)(a)(ii); regs. § 1.172-6 (setting forth the ordering rule that the loss must be carried forward to the first tax year following the loss year). 439. irc § 172(b)(3). 440. irc § 441(a) (setting forth the annual determination of taxable income). 441. see james j. freeland, et al., fundamentals of federal income taxation (foundation press 13th ed.) at 586, 672-674 (describing the integrity of the taxable year and one exception to its rule the net operating loss deduction); see also burnet v. sanford & brooks co., 282 u .s. 359, 51 s. ct. 150 (1931). 442. irc § 172(a), (d). 443. irc § 172(d)(4)(c). 444. see for example smith v. comm,r, 48 t.c. memo (cch) 135 (1984). 445. see irc § 172(b)(1)(a)(i). 446. paul r. mcdaniel, martin j . mcmahon, j r., et al., federal income taxation: cases and materials 888 n.7 (found. press 5th ed. 2004) (describing the alternative quick refund process). 447. id. d. net operating loss deduction if a disaster victim’s casualty losses exceed her net income for any tax year, she may be eligible to carry back excess losses as an offset against taxable income for each of three prior tax years.437 any losses remaining after the threeyear carryback may be carried forward for up to twenty tax years.438 a taxpayer may elect to waive the entire carryback period with respect to her net operating loss and only carry her losses forward.439 this option may provide a greater tax benefit for taxpayers whose marginal tax rates will be higher in future as compared to past tax years. a net operating loss deduction for all casualty losses is unusual for a couple of reasons. first, taxable income is computed for each tax year440 and deductions from one tax year may not be offset against another tax year without specific statutory authority.441 fortunately, one such allowable deduction is the “net operating loss deduction,” which generally includes only trade or business deductions exceeding gross income.442 notably, the code provides that for this purpose, personal casualty losses will be treated as trade or business deductions.443 under the provisions for deduction of a net operating loss, a disaster victim suffering casualty losses in excess of her gross income may enjoy an otherwise lost tax benefit.444 if casualty losses in excess of other income could not be offset against taxable income for another tax year, the taxpayer would not enjoy any tax benefit for these excess losses. most net operating loss deductions may only be carried back two tax years.445 the opportunity to carry back the net operating loss to the three prior tax years could generate a tax refund immediately. disaster victims with net operating losses must file an amended tax return for the carryback tax year or apply for a quick refund under the code.446 the code provides a “quick refund” process by allowing a taxpayer with a net operating loss to apply for a tentative adjustment of their tax liability for earlier tax years.447 the code provides that the government shall examine the 2005] anatomy of a disaster 1013 448. see irc § 6411(b) (describing the ninety-day period as the later of ninety days after (1) the filing of the application or (2) the last day of the month in which the due date for the tax return (including any granted extensions) falls for filing the return giving rise to the net operating loss). 449. mcdaniel, mcmahon, jr., et al., supra note 446, at 888 n.7. 450. the internal revenue service provides taxpayers with an illustrative publication describing the application of net operating losses at its website, www.irs.gov (last visited july 12, 2004). see internal revenue service, net operating losses (nols) for individuals, estates, and trusts, pub. 536. 451. see irc § 172(b)(1)(f)(i), (ii). 452. even if the bells are somehow able to file their 2003 federal income tax return and their application for a tentative carryback and refund adjustment before apr. 15, 2004, the government has ninety days from apr. 30, 2004 or through july 29, 2004 (that is, within the later of ninety-days after the last day of the month in which the due date for the tax return (including any granted extensions) generating the net operating loss falls or the filing of the application) to provide a refund. see irc § 6411(b). application and issue any refund within a ninety-day period.448 however, the government’s initial examination is provisional and may be adjusted at a later date under the normal audit procedures.449 this provision provides quick tax relief in the form of a refund of tax dollars previously paid for victims of significant casualty losses, like the bells.450 1. application to the bell family, hypothetical disaster victims undoubtedly, 2003 was a difficult year for the bells. the financial burden of losing a home and business even with insurance coverage can be devastating. the fire turned the bells’ profitable business into ashes. the bells business income ceased at 3:00 a.m. on october 26, 2003. while they had some insurance coverage of their lost business income, the bells expect that the wildcat canyon laundromat will generate an operating loss in 2003. in addition to their business operating loss, the bells have a $55,000 business casualty loss deduction that will increase their business loss. if the bells business loss combined with their personal casualty loss of approximately $9,900 exceeds their other business and net nonbusiness income they will have a net operating loss in 2003. under the code, the bells can carry back their 2003 net operating loss deduction to offset any taxable income first in 2000, second in 2001 and finally in 2002.451 this carryback could generate tax refunds of prior year taxes paid for the bells freeing up much needed cash by mid-year 2004.452 any net operating losses that are not used in 2000, 2001 and 2002 can be carried forward to 2004 through 2023 to offset future taxable income. because the bell family has adequate taxable income in 2000, they will be able to generate a refund of taxes from their net operating loss carryback shortly after they file their 2003 tax return as soon as practicable in 2004. while this is not quite as fast as compared to how quickly they would have received their refund if they had amended their 2002 tax returns, the delay should not be significant because the fire occurred so close to the end of the 2003 tax year. the bells may be motivated by a potentially large cash refund to file their 2003 tax return as early as possible in 2004. 1014 florida tax review [vol.6:10 453. see internal revenue service, casualties, disaster, and thefts, pub. 547, at introduction. 454. irc § 163(h). 455. temp. regs. § 1.163-8t. 456. id.; irc § 163(h). 457. see rev. rul. 96-32, 1996-1 c.b. 177 (addressing the question of deductibility of home mortgage interest on two residences destroyed by a tornado and an earthquake). 458. irc § 163(h)(2)(a) (noting that the trade or business may not be in one’s capacity as an employee). 459. irc §§ 163(h)(2)(c) (including as deductible interest any interest taken into account in computing income or loss from a passive activity), 469(c)(2) (stating that all rental activities are passive activities). 460. see irc §§ 62(a)(1); 63(d). before they file their 2003 tax return, the bells will have to understand all of the tax consequences of the wildfires. the bells are wondering about one of their most significant pre-fire tax deductions, the deduction for interest paid on their home mortgage. the bells are struggling to continue to make payments on their home mortgage, but wonder about the deductibility of the interest paid now that their home is a pile of ashes. e. deductibility of interest expense under the code, certain interest expense paid or accrued within the tax year is deductible from gross income.453 personal interest, other than trade or business and rental activity interest, investment interest and qualified residence interest, is generally not deductible.454 therefore, whether or not interest is deductible depends upon tracing a taxpayer’s loan proceeds to the designated use.455 if loan proceeds can be traced to a use that falls into one of a few specific categories, then the taxpayer may deduct the interest.456 when property has been destroyed and it can no longer be used for its original purpose, what is the character of the interest paid on mortgages securing the property?457 many disaster victims, like the bells must address this issue as they struggle through the rebuilding process. before this article addresses this question, the article will discuss the deductibility of interest on sba disaster loans. 1. interest expense on sba disaster loans a. business loans sba disaster loans may be made for a variety of purposes. if the loan proceeds are used in the disaster victim’s business to rebuild or replenish lost trade or business real or personal property assets including inventory, the disaster victim will be able to deduct the interest on the loan as a trade or business expense.458 if the disaster victim uses loan proceeds for rebuilding or repurchasing her real and personal property used in a rental activity, the interest paid on the loan will be deductible.459 this interest is a deduction for adjusted gross income and not an itemized deduction.460 if the taxpayer’s expenses from her trade or business or rental activity exceed her income from the activity, her 2005] anatomy of a disaster 1015 461. see irc § 469 (setting forth limitations for losses in trades or businesses in which the taxpayer does not materially participate and rental activities). 462. see irc § 172 (setting forth net operating loss provisions). 463. irc § 163(h). 464. irc § 163(h)(2). 465. irc § 163(h)(3). 466. irc § 163(h)(3)(a), (3)(b), (4)(a). 467. irc § 163(h)(3)(b). 468. irc § 163(h)(3)(c). 469. rev. rul. 67-297, 1967-2 c.b. 87. 470. irc § 461(g)(2). 471. irc § 62(d), (c), (b). 472. irc § 68 (providing for a cutback of itemized deduction for certain highincome taxpayers). 473. irc § 63(a). losses may be limited under certain circumstances.461 however, if these losses exceed her other income, she may be able to offset this loss as a net operating deduction against taxable income from prior or subsequent tax years.462 b. personal loans interest paid on loans used for nonbusiness or personal purposes is not generally deductible.463 if the sba loan proceeds are traced to pay personal expenses including replacement of clothing, furniture and other household items and expenses, the interest is not deductible.464 in contrast, an sba loan to repair or rebuild a disaster victim’s residence should generate deductible qualified residence interest.465 qualified residence interest is interest paid during the taxable year on up to $1,000,000 ($500,000 for married persons filing separately) of indebtedness secured by the taxpayer’s principal residence and one other residence.466 the proceeds from the debt must have been used to acquire, construct or substantially improve the secured property.467 in addition, up to $100,000 ($50,000 for married persons filing separately) of additional indebtedness secured by the residence qualifies even if the loan proceeds are used for purposes other than acquisition, construction or substantial improvements of the property.468 thereby, home equity loans can be used for personal expenses converting otherwise nondeductible interest into deductible interest. loan fees charged by lenders for services other than the use of money are not deductible.469 however, if the fees are expressed as a percentage of the loan amount, are for the use or forbearance of the money (e.g., points) and are attributable to a loan to acquire or improve the taxpayer’s principal residence, a taxpayer may deduct them in the year paid as qualified residence interest.470 qualified residence interest is an itemized deduction.471 if a taxpayer’s aggregate itemized deductions, after any applicable reduction,472 are greater than her standard deduction she will reduce her adjusted gross income by her allowable itemized deductions to derive her taxable income.473 however, if the standard deduction exceeds allowable itemized deductions then a taxpayer will derive no tax benefit from her qualified residence interest. the foregoing discussion addresses the deductibility of interest on a disaster victim’s new 1016 florida tax review [vol.6:10 474. see rev. rul. 96-32, 1996-1 c.b. 177 (addressing the question of deductibility of home mortgage interest on two residences destroyed by a tornado and an earthquake). 475. see id. (describing this hypo thetical, but reality-based fact pattern for the government’s analysis and ruling). 476. id. 477. id. 478. id. 479. see rev. rul. 96-32, 1996-1 c.b. 177. 480. id. 481. temp. regs. § 1.163-10t(p)(5) (setting forth example of the limitation of this qualifying period). 482. id. 483. rev. rul. 96-32, 1996-1 c.b. 177. loans. however, when a taxpayer owns property that has been destroyed and it can no longer be used for its original purpose, what is the character of the interest paid on mortgages that were secured by the destroyed property.474 2. interest expense on existing home mortgage debt the government answered this question using the following two hypothetical, but painfully realistic scenarios. assume an earthquake declared a major disaster by the president destroys ariel’s principal residence.475 because of a severe shortage of equipment, materials and labor due to the widespread destruction, ariel was not able to even begin reconstruction of her destroyed home for eighteen months.476 sixteen months later, ariel was able to reoccupy her home as her principal residence.477 during the reconstruction process, ariel lived offsite in a rental.478 similarly, zoe’s home is destroyed by a tornado, a presidentially declared disaster.479 two years later, zoe decides not to rebuild, but rather sells her now vacant lot and buys a new home.480 during the two-year period before her reinvestment, zoe lived in a rental property. ariel and zoe are faced with many tax issues, including whether or not they could deduct the interest paid on their existing home mortgages during the period of time they no longer resided in their property. under a strict definition of principal residence the properties no longer qualify as the taxpayers’ principal residences. the temporary treasury regulations underlying code section 163 do provide that a taxpayer may treat a residence under construction as a qualified residence for a period up to twenty-four months, but only if the residence becomes the taxpayer’s qualified residence when it is ready for occupancy.481 this provision provides relief during a two-year construction period, before occupancy of the property by the taxpayer as a residence.482 however, it does not provide relief for the period before construction or for taxpayers, like zoe, who decide they do not want to rebuild. fortunately, the government has ruled that in ariel’s and zoe’s case, the interest paid on their existing home mortgages would continue to qualify as deductible residence interest.483 in both cases, the government determined that the reoccupation or reinvestment occurred within a “reasonable period of time” and, therefore, the property would continue to be treated as a qualified 2005] anatomy of a disaster 1017 484. id. 485. id. 486. id. 487. id. 488. temp. regs. § 1.163-10t(p)(5) (setting forth example of the limitation of this qualifying period). 489. taxpayers may request a private letter ruling from the government holding that the interest on the indebtedness will be deductible for the pre-occupation period. 490. while this amount of time might seem more than reasonable for a taxpayer to act with respect to damaged property, the rebuilding process for homeowners in a major disaster can be long and herculean. see mike freeman, jennifer davies and roger m. showley, end in sight: rebuilding may be long process for homeowners, the san diego union-trib., nov. 2, 2003 , at a-1, a-11 (noting that because of the overwhelming loss of homes san diego county would be embarking upon its biggest rebuilding effort in history and that it would be a long (12 to 18 months of planning and construction) and challenging process for residents and the ill-equipped construction industry); ron harris, lack of w orkers m ay delay fire rebuilding, los angeles t imes, nov. 9, 2003, at real estate (commenting that even if homeowners can find a builder it could be weeks before some areas are safe due to intense heat leaving roads unstable due to oil boiled out of the pavement); roger m. showley, rebuild? a series of hurdles ahead, the san diego union-trib ., nov. 2, 2003, at h8 (reporting that rebuilding a home isn’t what it used to be); fire notes: reconstruction fair to be held saturday, the san diego union-trib., mar. 21, 2004, at b5 (noting that a reconstruction fair would be held bringing together contractors, architects and other construction professionals with fire victims who are beginning to rebuild their homes five months after the fires). 491. see for example jeanette steele, owners are paid over policy limits, the san diego union-trib., aug. 29, 2004, at b2, b5 (quoting extended battle of southern california wildfire victims and insurance companies and quoting california commissioner of insurance john garamendi advising disaster victims to “[f]ight fiercely and never give up”). residence during the period.484 the government also clarified that the same treatment would apply if the property were the taxpayer’s second residence or if the destruction had been caused by a disaster not declared to be a major disaster by the president.485 accordingly, any disaster victim may deduct interest paid on her mortgage that is secured by her principal or second residence during a reasonable period of time between its destruction and reconstruction or sale.486 disaster victims should note that the construction period stated in the government’s example was only sixteen months.487 the temporary treasury regulations authorize a twenty-four month construction period.488 if a taxpayer’s construction period exceeds twenty-four months, she will want to obtain written documentation explaining the reasons for the extended delays and might want to obtain a ruling from the government on the deductibility of her related interest expense.489 additionally, the government’s two-year pre-sale and eighteen month pre-construction periods set forth in the revenue ruling should be used as guidance for a reasonable period of time before a taxpayer acts with respect to her damaged property.490 taxpayers will want to document in writing the efforts they make to replace their lost home and describe the myriad of issues and roadblocks faced during these periods. when disaster hits, local newspapers and magazines often document the challenges of the rebuilding process.491 1018 florida tax review [vol.6:10 492. see jane clifford, caught in the middle, the san diego union-trib., aug. 28, 2004, at e1 (recounting the bellante family’s struggle to rebuild their home on wildcat canyon road). 493. see rev. rul. 96-32, 1996-25 i.r.b. 5. 494. id.; temp. regs. § 1.163-10t(p)(5). 495. see irc § 1033(h)(1)(b) (setting forth four-year replacement period for the replacement of a principal residence by the victim of a presidentially declared disaster). 496. see id. 497. see irc §§ 163(h)(3) (providing for the deductibility of interest on qualified acquisition or home equity indebtedness); 461(g)(2) (providing for deductibility of points paid on a taxpayer’s principal residence). these independent sources should provide convincing, supporting evidence for delays that may otherwise seem unreasonable.492 3. application to the bell family, hypothetical disaster victims in accordance with the government’s ruling, the bells should be able to deduct the interest paid on their home mortgage after their home was destroyed for a “reasonable period of time” pre-sale or pre-construction.493 however, the bells will have to demonstrate that this interim period, that is, the period of time their former residential lot is owned by them and vacant, is reasonable. the government’s guidance for what is reasonable provides for a two-year pre-sale, eighteen-month pre-construction and sixteenand twentyfour-month construction periods.494 if the bells use the entire four-year replacement period authorized under the code for residential property destroyed by a presidentially declared disaster area, or through december 31, 2007,495 to replace their home their interim period may exceed the government’s guidance. notably, the guidance was issued after the code was amended to extend the replacement period for principal residences destroyed in a presidentially declared disaster from two to four years.496 accordingly, the bells should make sure they are able to document that their pre-sale, pre-construction and any construction periods are reasonable under the facts and circumstances facing them. if delays persist, they may consider asking the government for a favorable ruling that their interest on their former home is deductible. in addition to deducting interest paid on the bells’ existing home mortgage, when the bells incur additional debt to reconstruct or acquire a new residence including any sba loans, the bells should be able to deduct as an itemized deduction any interest paid, including points, on qualified residence interest.497 if the bells use sba or other loan proceeds to pay living or other personal expenses, they will not be able to deduct any interest paid during the tax year on these loans. the bells should consider using any equity in their new principal residence up to $100,000 to secure the indebtedness and have it qualify as home equity indebtedness. if the bells are able to structure their debt to qualify as home equity indebtedness, any interest paid with respect to such debt should be deductible. in addition to incurring debt to acquire or construct a new residence, the bells will likely have to incur debt to rebuild their business. the debt may include sba business loans and other debt to acquire real and personal business 2005] anatomy of a disaster 1019 498. see irc §§ 163(a); 162(a). 499. jane clifford, caught in the middle, the san diego union-trib., aug. 28, 2004, at e1 (recounting the bellante family’s struggle to rebuild their home on wildcat canyon road between the cleveland national forest and the barona indian reservation). 500. id.; see also tom herman, ask dow jones, the san diego union t rib., aug. 22, 2004, at h-7 (quoting the irs commissioner, mark w. everson, providing tax relief for florida disaster victims of hurricane charley by extending the tax filing and payment deadlines until oct. 15, 2004 and abating interest and any late-filing or latepayment penalties). 501. irc § 7508a(a)(1). 502. irc §§ 7508a; 1033(h)(3). taxpayers that are affected by a terroristic or military action (as defined in § 692(c)(2)) are also for these extensions. irc § 7508a(a). 503. see internal revenue service, casualties, disasters and thefts, pub. 547, at 13. 504. id. the irs has suggested that relief workers that are assisting disaster victims may themselves qualify for relief under this provision. id. 505. irc §§ 7508a(a)(1); 7508(a)(1). property or to provide working capital to support the bells’ new business endeavor. any interest paid on these loans will be deductible as a trade or business deduction for adjusted gross income in the tax year paid.498 if the business interest paid creates or increases a net operating loss, the resulting net operating deduction may be carried back two years and forward twenty years to offset taxable income and generate a tax refund of precious dollars. f. tax administration disaster victims face numerous challenges as they rebuild their lives. one of the many overwhelming challenges is reconstructing destroyed records. unfortunately, fema and the sba require that disaster victims must have filed all required federal tax return to qualify for disaster loans and grants.499 fortunately, the government works with disaster victims to rebuild their lives by quickly issuing or reissuing tax refunds, extending tax filing and payment deadlines, waiving interest and penalties, offering free tax preparation assistance and providing free copies of previously filed tax returns and other tax documents.500 1. extension of tax filing and payment deadlines under the code, the government may extend certain tax filing and payment deadlines for a period of up to one year for disaster victims.501 taxpayers that are victims of presidentially declared disasters502 because their principal residences, principal places of business or record-keeping facilities are located in the designated area are candidates to benefit from these extensions.503 in addition, the government can add any other party that it determines is affected by the designated disaster.504 the extension includes taxpayers’ filing of any return, refund claim or tax court petition or the payment of any income, employment, estate, excise, or gift taxes.505 moreover, the government may extend any deadline for required or permitted actions with respect to pension or employee benefit plans that are 1020 florida tax review [vol.6:10 506. irc § 7508(b). 507. id.; regs. § 301.7508a-1. 508. irc § 7508a(a)(2). 509. irc §§ 7508a(b); 7508(b); 6611(b)(3), (e) (providing that interest on overpayments canno t be disregarded and that tax filings that are timely made under any extension with overpayments shall receive interest on any such overpayment from the date of the overpayment even if the refund is paid within forty-five days after the return is filed). 510. see internal revenue service, form 4506, request for copy of tax return, at www.irs.gov (last visited july 12, 2004). 511. see internal revenue service, form 4506-t, request for transcript of tax return, at www.irs.gov (last visited july 12, 2004) 512. see supra notes 510 and 511. 496. id. affected by a declared disaster or the government’s extension of another matter under this provision.506 similarly, the government is permitted to extend its own deadlines for making assessments, taking collection action, and bringing suit.507 2. abatement of interest and penalties while the extension of filing and payment deadlines for up to one year could give disaster victims time to replace necessary documents and marshal their information and assistance, if interest and penalties on unpaid taxes continued to accrue theses costs might undermine any benefit of the extension forcing disaster victims to ignore the extensions and act to stop the accrual of interest and penalties. fortunately, the code provides that the government may also abate the amount of any interest, penalty or additional amount, or addition to the tax with respect to any tax liability for any designated period of extension for up to one year.508 while the government may extend its own deadlines for deficiency tax assessments, tax collection or filing suits, it may not abate any interest due to disaster victims on their tax overpayments.509 3. restoring records and moving forward reconstructing tax records is a necessary task for disaster victims. disaster victims who used a paid preparer to file their current and prior year income tax returns should be able to get copies of their prior year tax filings directly from their preparer.510 in addition, disaster victims could request copies of information tax returns such as forms w-2 and 1099 directly from the payer.511 alternatively, taxpayers can request copies or transcripts of tax forms filed during the current calendar year and the three prior calendar years, including information tax returns, by filing form 4506 or form 4506-twith the irs.512 the service should deliver any requested tax return transcripts, which include most line items from the original tax return, within seven to ten workdays of receipt of the request, and any requested copies of tax forms, including w-2 information, within sixty calendar days.513 moreover, taxpayers can visit, write or call an irs office to request tax account information or 2005] anatomy of a disaster 1021 514. id. 515. notice 126, irs grants tax relief for victims of california wildfires, ir2003-126 (oct. 28, 2003). 516. id. 517. id. 518. id. 519. id. 520. see irc 6801 (setting forth provisions for extensions). forms 1099, which will include any changes made by the taxpayer or the irs to original tax returns.514 4. application to the bell family, hypothetical disaster victims on october 28, 2003, the irs announced that it would extend the deadline for victims of the southern california wildfires for filing any tax returns, performing any time-sensitive actions and paying any income tax due from october 21 through december 29, 2003 until december 29, 2003.515 the service agreed to abate any applicable interest, late payment and filing penalties arising from this extension.516 in addition, the irs agreed to consider abating penalties from october 21 through november 7 for affected taxpayers making late federal employment and excise tax deposits no later than november 7, 2003.517 disaster victims, like the bells, could also request copies of previously filed tax returns for free and on an expedited basis.518 to qualify for this relief, disaster victims were advised to put “ca wildfires” in red ink at the top of their tax returns, requests and payments.519 the bells should not have had any tax returns or tax payments due during the deadline extension period. therefore, the government’s extension likely did not provide any relief for them. the bells’ 2003 tax return and tax liability were due on their original due date of april 15, 2004. accordingly, the bells must try somehow to marshal the information necessary to determine their 2003 tax liability. as with any taxpayer, the bells could extend the filing of their 2003 federal income tax return automatically until august 15, 2004 and with an acceptable reason until october 15, 2004.520 the bells will want to rebuild their personal tax records as soon as possible. to this end, the bells should request copies of prior year tax returns from their accountant. if they did not use an accountant for prior year tax returns or their accountant does not have adequate historical records, the bells should contact the government as soon as possible for free and fast copies of their prior year tax returns. in addition, the bells will have to contact their banks, suppliers and other institutions to recreate their personal and business records for 2003 and the preceding years. the rebuilding of the bells’ records is critical for them to determine their 2003 tax liability and prepare and file their tax returns in a timely manner. moreover, as this article demonstrates, the bells will have to engage in significant tax planning as they proceed to reestablish their lives. tax planning requires sound data usually obtained from thick current and historical business and personal tax and accounting files. victims of a disaster may find 1022 florida tax review [vol.6:10 521. id. 522. see id. at e1, e7 (reporting that lori bellante still has an unsettling fear of loss). 523. see id. at e7 (remembering the bellantes’ eight neighbors who did not escape the inferno). 524. id. 525. clifford, supra note 521, at e7. 526. id 527. id. (commenting that no one told the bellantes that if three or more insurance companies refused coverage, they could seek coverage from the state). as a result of the number of uninsured hardship cases emerging from the wildfires, community groups are providing forums to educate themselves about coverage options. see fire notes: ramona, plans for workshop on insurance told the san d iego uniontrib., aug. 29, 2004, at b4 (advertising workshop for people who are having trouble finding or keeping homeowner’s insurance). 528. clifford, supra note 521, at e-7 (noting that habitat for humanity is concerned about the project because of insurance coverage and the lack of an easement to access their property through the barona indian reservation). 529. id. 530. id. 531. many states incorporate federal income tax provisions including income tax disaster relief into their state statutes. therefore, the coverage of federal disaster tax relief should be very informative for understanding similar state provisions. in addition to income tax, many states assess annual property taxes, which are ad valorem taxes based upon the value of the property. w hen a d isaster damages or destroys property, many states have procedures for having the assessed value reduced, thereby reducing the themselves with no information or records. therefore, recreating information is a critical step to allow the tax planning process to begin. iv. conclusion more than one year after surviving their worst nightmare, the bellante family remains homeless. the bellantes lost everything in the cedar fire.521 after experiencing regular emotional turmoil, they now know some of those things will never be replaced.522 yet the bellantes still have their most precious assets; they have each other and their beloved family homestead.523 the bellantes have returned to their land and have set a 6-by-13-foot trailer where their seventy-two year old home once proudly stood.524 trying to focus on the future, they are hoping someday to build a new home, but the bellantes had no insurance.525 the bellantes were told again and again that their property was uninsurable because it was too far from a fire station.526 no one mentioned that they could have sought california-provided homeowner’s insurance.527 rising above the rubble, the bellantes are working with habitat for humanity to build a new fully-insured home, but there are complications that may douse this dream.528 ever optimistic, “[t]he pioneer spirit that drove the first generation of bellantes west 72 years ago still is very much alive in this family.”529 the bellantes focus on the little joys each day brings.530 fortunately, for the bellantes and millions of other disaster survivors, life does go on. this article demonstrates the complexity, depth and breadth of disaster relief under the code. disaster victims must also face state and local income and property tax consequences not addressed in this article.531 understanding 2005] anatomy of a disaster 1023 owner’s property taxes. see annette nellen, disaster relief provisions: changes to § 1033 and the problems that remain, 22 j. real est. tax’n 158, 166-67 (1995). states may have limited provisions allowing replacement property to retain the same assessed value as the destroyed property despite the replacement property’s higher fair market value on the date of the replacement. id; see cal. rev. & tax code § 69, 69.3. disaster victims and their advisors should explore and maximize any state and local disaster relief tax provisions. roger m. showley, rebuild? a series of hurdles ahead, the san diego union-trib., nov. 2, 2003, at h8 (advising fire victims to contact property tax assessors immediately after damage to their homes to have their property taxes reduced and possibly deferred). 532. jeanette steele, after the fires: sadness, frustration, despair creep in for victims, san diego union-trib., feb. 15, 2004, at b1 (reporting that melody morse, a mother of three, who was uninsured, has not received any fema grant money, and who relied on credit cards to replace basic furniture, picks up the newspaper every morning looking for fresh leads for disaster victim assistance). 533. when president george w. bush visited fire victims in early november, he commented “america has got some wonderful citizenry who just refuse to be defeated.” bush visits fire victims, the orange county register, nov. 5, 2003, at a1 (quoting the president while he walked through the devastation of the 2003 southern california wildfires). and planning for the tax consequences of a disaster are critical pieces of the rebuilding process. regrettably, disaster victims are often stripped of basic resources and must focus daily on the restoration of shelter, food, clothing and mental health.532 this article should serve as some relief for courageous disaster victims533 facing federal income tax issues that might otherwise seem insurmountable. unfortunately, the tax consequences of disaster relief and tax disaster relief provisions under the code are complex and lack transparency. this article should also serve as a framework for analysis of these provisions and provide a foundation for devising relief from the federal disaster relief provisions themselves. page 1 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 page 16 page 17 page 18 page 19 page 20 page 21 page 22 page 23 page 24 page 25 page 26 page 27 page 28 page 29 page 30 page 31 page 32 page 33 page 34 page 35 page 36 page 37 page 38 page 39 page 40 page 41 page 42 page 43 page 44 page 45 page 46 page 47 page 48 page 49 page 50 page 51 page 52 page 53 page 54 page 55 page 56 page 57 page 58 page 59 page 60 page 61 page 62 page 63 page 64 page 65 page 66 page 67 page 68 page 69 page 70 page 71 page 72 page 73 page 74 page 75 *associate director, tax program, and senior lecturer, northwestern university school of law. **professor of law and director, tax program, northwestern university school of law. the authors would like to thank allison christians, charlotte crane, andrea monroe, and adam rosenzweig for reviewing earlier drafts of this article. 339 florida tax review volume 7 2006 number 6 the lazarus effect: a commentary on in-kind guaranteed payments by david l. cameron* philip f. postlewaite** when he had said this, he cried with a loud voice, “lazarus, come out!” the dead man came out, his hands and feet bound with strips of cloth, and his face wrapped in a cloth. jesus said to them, “unbind him, and let him go.” – john 11:43-44 i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 ii. section 707(c) – twisting slowly in the wind . . . . . . . . . . . . . 345 iii. non-liquidating guaranteed payments made in-kind . . . . . 351 a. central thesis of kahn and cuenin’s article . . . . . . . . . . . . . . 351 b. the non-partnership setting .. . . . . . . . . . . . . . . . . . . . . . . . . . . 356 c. non-recognition of gain or loss by the partnership . . . . . . . . 359 d. basis of property received as a guaranteed payment . . . . . . . 373 e. effect on outside basis of guaranteed payments . . . . . . . . . . . 380 f. kahn and cuenin’s erroneous application of the modified aggregate approach . . . . . . . . . . . . . . . . . . . . . . . . . . 381 g. the application of section 707(a)(2) .. . . . . . . . . . . . . . . . . . . . 393 iv. liquidating distributions .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395 a. application of section 736 to liquidating distributions . . . . . 397 b. in-kind guaranteed payments under section 736(a) . . . . . . . . 399 v. conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407 340 florida tax review [v0l.7:6 1. irc § 707. all references herein are to the internal revenue code of 1986, as amended. 2. philip f. postlewaite & david l. cameron, “twisting slowly in the wind: guaranteed payments after the tax reform act of 1984,” 40 tax law. 649 (1987). i. introduction section 707 of the internal revenue code contains a number of provisions that control the tax implications of transactions involving a partnership and its partners. in particular, section 707(a) provides that a1 transaction between a partnership and a partner, in which the partner is not acting in his capacity as a partner, is to be treated as a transaction with a third party. alternatively, section 707(c) provides that a transaction between a partnership and a partner, in which the partner is acting in his capacity as a partner, is also to be treated as a transaction with a third party but only for certain limited purposes and only if the payment to the partner is not determined with regard to the income of the partnership. payments satisfying the requirements of section 707(c) are referred to as guaranteed payments. almost 20 years ago, in response to various congressional enactments and amendments, we authored a eulogy proposing the repeal of section 707(c). although we may have been somewhat premature in laying2 to rest the concept of guaranteed payments as no longer possessing purpose or use in subchapter k, at a minimum we viewed section 707(c) as “twisting slowly in the wind.” like many tax academics who offer their modest contributions to society at large and hope that somewhere in the tax-making machinery their constructive suggestions will be seized upon to effectuate meaningful change, we hoped that our proposed repeal of section 707(c) would actually find its way into the tax law. regularly, albeit privately, we lamented the continuation of section 707(c), wondering why our call for its repeal had not been fully embraced by those charged with the effectuation of meaningful tax policy. we were particularly hopeful and watchful for such a change when many in both the academic and political communities were actively 2006] the lazarus effect 341 3. see, e.g., staff of the joint comm. on tax’n, “study of the overall state of the federal tax system and recommendations for simplification, pursuant to § 8022(3)(b) of the internal revenue code of 1986” (jcs-3-01, apr. 2001); samuel a. donaldson, “the easy case against tax simplification,” 22 va. tax rev. 645 (2003); samuel diamon, “simplification of the internal revenue code,” 95 tax notes 575 (2002); pamela olson, “thoughts on the impact of tax complexity on small businesses,” 88 tax notes 1531 (2000); joseph a. snoe, “tax simplification and fairness: four proposals for fundamental tax reform,” 60 albany l. rev. 61 (1996); pamela j. pecarich & siobhan c. rausch, “tax simplification versus the legislative process,” 133 trusts & estates 24 (mar. 1994); michael a. andrews, “tax simplification,” 47 smu l. rev. 37 (1993); edward j. mccaffery, “the holy grail of tax simplification,” 1990 wisc. l. rev. 1267; charles e. mclure jr., “the budget process and tax simplification/complication,” 45 tax l. rev. 25 (1989). 4. staff of the joint comm. on tax’n, “options to improve tax compliance and reform tax expenditures” 170-73 (jcs-02-05, jan. 27, 2005). the text of the report was in excess of 400 pages and offered over 65 proposals through which to improve the tax law. see also staff of the joint comm. on tax’n, “review of selected entity classification and partnership tax issues,” 45-47 (jcs-6-97, apr. 8, 1997) (proposing to modify the treatment of guaranteed payments and noting prior recommendations, including ours, for the repeal of § 707(c)). 5. “several commentators have questioned the continued viability of a concept of guaranteed payments separate from the concept of payments treated as made to a partner in a non-partner capacity.” staff of the joint comm. on tax’n, “options to improve tax compliance and reform tax expenditures,” supra note 4, at 172, n.401 (citing, inter alia, p. postlewaite and d. cameron, “twisting slowly in the wind: guaranteed payments after the tax reform act of 1984,” 40 tax law. 649 (1986)). later, the report stated: several commentators have advocated an approach like that of the proposal, stating that the ‘better approach would be to eliminate ' 707(c) totally and provide that any payment to a partner, not determined with regard to partnership income, constitutes a § 707(a) payment.’” id. (citing p. postlewaite & j. pennell, “jct’s partnership tax proposals – ‘houston, we have a problem’,” 76 tax notes 527 (1997)). calling for simplification of the code. the repeal of a code provision is, by3 definition, the ultimate act of simplification. against this backdrop of anticipation, one can easily imagine our excitement when, in january of 2005, the joint committee on taxation proposed the repeal of section 707(c) in response to a congressional request for a periodic report from the committee recommending improvements to the tax law. not only might the reform we advocated 20 years earlier finally4 see the light of day, but the narrative accompanying the proposal and explaining the reasons for the repeal of section 707(c) discussed and cited with approval our earlier article.5 we quickly characterized ourselves as visionaries, men ahead of their time, who fortunately had lived sufficiently long to see the fruits of their labor actively embraced by the tax-making machinery. however, while celebrating this public (foot)note of recognition, we uncovered a recently 342 florida tax review [v0l.7:6 6. douglas a. kahn & faith cuenin, “guaranteed payments made in kind by a partnership,” 6 fla. tax rev. 405 (2004). 7. john 11:1-44 (new revised standard). it has become quite fashionable in the tax academy to invoke biblical references in scholarly articles. see, e.g., martin j. mcmahon, jr., “the matthew effect and federal taxation,” xlv b.c. l. rev. 993 (2004) (referring to the “matthew effect” as based on the verse from matthew 25:29 (“for to all those who have, more will be given, and they will have an abundance; but from those who have nothing, even what they have will be taken away.” (new revised standard)), which is synonymous with the colloquialism “the rich get richer and the poor get poorer,” and decrying the failure of the federal tax system to address the matthew effect); deborah h. schenk, “the luke effect and federal taxation: a commentary on mcmahon’s the matthew effect and federal taxation,” xlv b.c. l. rev. 1129 (2004) (referring to the “luke effect” as based on the verses from luke 18:22-25 (“how hard it is for those who have wealth to enter the kingdom of god! indeed, it is easier for a camel to go through the eye of a needle than for someone who is rich to enter the kingdom of god.” (new revised standard)), which may be paraphrased as “the rich love their money and will not give it up easily,” and concluding that significantly greater progressivity of tax rates will not effectively reduce the matthew effect). any trend in the use of biblical references in the tax literature may reflect the influence of professor susan pace hamill, whose work directly relies upon the biblical text of both the new and old testaments in assessing the appropriateness of certain tax policies. see susan pace hamill, “an evaluation of federal tax policy based on judeo-christian ethics,” 25 va. tax rev. 671-764 (2006); susan pace hamill, “an argument for tax reform based on judeo-christian ethics,” 54 ala. l. rev. 1 (2002). see also adam chodorow, “tax reform: what would god do?,” 108 tax notes 1167 (2005) (noting that an income tax may be more consistent with biblical text than a consumption tax). 8. the character of lazarus referred to herein is not to be confused with the lazarus appearing in the story of a rich man and a beggar named lazarus, in which the rich man finds himself cast into hell following his death while lazarus is carried by angels to be with abraham. luke 16:19-31 (new revised standard). seeing lazarus on the other side of the chasm, the rich man asks abraham to “have mercy on me, and send lazarus to dip the tip of his finger in water and cool my tongue; for i am in agony in these flames.” abraham reminds the rich man that because he received good things during his lifetime while lazarus received only evil things, lazarus is comforted after death. the rich man then asks that lazarus be sent to warn his five brothers so that they will not suffer like him after death. abraham responds that, if the brothers have not published article in this journal by douglas kahn and faith cuenin regarding the treatment of in-kind guaranteed payments. because of the article’s6 provocative and thorough analysis, we feared that kahn and cuenin’s efforts might be viewed as breathing new life into section 707(c), not dissimilar from the return of lazarus from the dead. lazarus was a biblical figure appearing in the gospel of john, which, like the gospels of matthew, mark, and luke, can be found in the new testament. lazarus, who was brought back from the dead by christ,7 presages the most important event of the new testament, the resurrection of christ following his crucifixion. thus, the character of lazarus now serves8 2006] the lazarus effect 343 heeded the warnings of moses and the prophets, they would not repent even if warned by someone who is raised from the dead, alluding to christ and his resurrection. although the biblical tale of the rich man and lazarus is obviously ripe for application to the tax law, we leave any direct analogies to a future commentator. 9. see, e.g., davis bunn, the lazarus trap (2005); rashid darden, lazarus (2005); joanna brooks, america lazarus: religion and the rise of african-american and native american literatures (2003); david sherman & dan cragg, lazarus rising (2003); carl marcum, cue lazarus (2001); john bayer, the lazarus project (1999); robert mawson, the lazarus child (1998); jo bannister, the lazarus hotel (1997); the lazarus man (directed by johnny e. jensen, 1996); robert pensak, raising lazarus (1994); the x-files: lazarus (directed by david nutter, 1994); samuel brassfield, the lazarus generation: how to raise the spiritually dead (1993); robert richardson, the lazarus tree (1992); morris west, lazarus (1990); franklin w. dixon, the lazarus plot (1987); sting, “the lazarus heart,” in nothing like the sun (1987); frank herbert & bill ransom, the lazarus effect (1983); john lutz, lazarus man (1979); andre malraux, lazarus (1977); sylvia plath, “lady lazarus,” in the collected poems (1962); and leonid andreyev, lazarus (1918). 10. regretfully, our position on this issue places us in the role of the chief priests who, following lazarus’ return from the dead, planned the death not only of jesus but of lazarus as well, “since it was on account of him that many of the jews were deserting and were believing in jesus.” john 12:10-11 (new revised standard). 11. arthur b. willis, john s. pennell, & philip f. postlewaite, partnership taxation (6th ed. 2002). 12. see kahn & cuenin, supra note 6, at 407. in both high and popular culture as the emblem for any person or idea that once dead, or thought dead, is miraculously returned to life.9 the fact that our recommendation concerning the repeal of section 707(c) has belatedly received the support it deserves by definition ensures that we will oppose any interpretation of section 707(c) that may delay its interment. an acceptance of kahn and cuenin’s thesis concerning section 707(c) would also undercut our previously articulated position that no meaningful distinction exists between the operation of sections 707(a) and 707(c). over and above the potential damage to our crusade for the repeal of section 707(c) that may result if kahn and cuenin’s thesis is left unchallenged, we believe that their conclusions regarding the application of section 707(c) are, by themselves, incompatible with sound tax policy.10 however, this commentary is compelled by more than our goal of ensuring that section 707(c) and the concept of guaranteed payments soon become a distant and fading recollection of the tax bar. it is also driven by the confusion caused by the discussion, or the limitations of the discussion, of guaranteed payments in our treatise on partnership taxation. kahn and11 cuenin detected both a lack of clarity and, at times, a lack of coverage on this topic, an observation that has been most instructive. consequently, we12 344 florida tax review [v0l.7:6 13. authors of treatises regularly fear the discovery of inaccurate or incomplete coverage of the topics they address. as one of us is about to begin a rolling revision of the sixth edition of partnership taxation, kahn and cuenin’s provocative article has alerted him to a need to clarify his views on the tax treatment of in-kind guaranteed payments. thus, the thoughts herein will soon find their way into the seventh edition of partnership taxation to be completed in 2009. 14. see infra text accompanying notes 21-40. will utilize this commentary as an initial forum in which to eliminate this defect.13 in their article, kahn and cuenin conclude that the transfer of property by a partnership to a partner as a guaranteed payment does not result in gain or loss recognition by the partnership. this surprising result conflicts with the generally held interpretation of section 707(c) as adopting the entity theory of partnerships with respect to guaranteed payments. although their conclusion in this regard is consistent with the aggregate theory of partnerships, they also conclude that the recipient partner takes a fair market value basis in the transferred property rather than a carryover basis from the partnership. curiously, this conclusion is consistent with the entity theory of partnerships rather than the aggregate theory of partnerships. finally, they conclude that the recipient partner’s basis in his partnership interest is reduced by the partner’s share of the deduction generated by the guaranteed payment but is not otherwise affected by the transfer of the property. this conclusion is also consistent with the entity theory of partnerships rather than the aggregate theory of partnerships. thus, their analysis results in an odd combination of both the aggregate and entity theories of partnerships in connection with the tax treatment of a single transaction, in this case a transaction involving an in-kind guaranteed payment. our analysis will demonstrate that a consistent application of the entity theory of partnerships best implements the policy objectives of subchapter k with respect to the treatment of in-kind guaranteed payments. as a result, our ultimate conclusions differ from kahn and cuenin’s only with respect to the question of gain or loss recognition by the transferring partnership. however, in reaching this conclusion, we undertake a more searching analysis of the statutory language, legislative history, and judicial interpretation of section 707 as well as a more careful application of the governing law to a number of hypothetical situations that kahn and cuenin posed in their article. this commentary proceeds as follows. part ii provides a summary of the history and evolution of section 707 that we detailed in our previous article. in particular, we reiterate the fact that the enactment of section14 707(a)(2) in 1984 fundamentally changed the interpretation of section 707 and effectively repealed section 707(c). part iii then considers the question of in-kind guaranteed payments, focusing first on kahn and cuenin’s central 2006] the lazarus effect 345 15. see infra text accompanying notes 41-68. 16. see infra text accompanying notes 69-110. 17. see infra text accompanying notes 111-31. 18. see infra text accompanying notes 132-37. this portion of the article is followed by a detailed examination of kahn and cuenin’s incomplete analysis that resulted in their questionable conclusion that a partnership should not recognize gain or loss on the transfer of an in-kind guaranteed payment. see infra text accompanying notes 138-55. 19. see infra text accompanying notes 156-62. 20. see infra text accompanying notes 163-91. 21. irc § 707(a). thesis and then considering the three questions that in-kind guaranteed15 payments explicitly raise: (1) the recognition of gain or loss by the transferring partnership, (2) the basis of the transferred property in the16 hands of the recipient partner, and (3) the effect of the transfer on the17 recipient partner’s basis in his partnership interest. although we18 acknowledge that, in the absence of section 707(a)(2), our conclusions are not entirely free from doubt, we believe that the better interpretation of section 707(c) requires that a partnership recognize gain or loss on the transfer of property in satisfaction of a guaranteed payment. after bringing the changes wrought by section 707(a)(2) into the analysis, any lingering doubt in this regard vanishes. finally, we consider the treatment of in-kind19 transfers in the liquidation setting that are referred to as guaranteed payments under section 736 and again conclude that the proper interpretation of subchapter k requires that the partnership recognize gain or loss in connection with any such transfers.20 ii. section 707(c) – twisting slowly in the wind in 1954, congress enacted sections 707(a) and 707(c). while both provisions ensured third-party treatment for payments between a partnership and its partners, congress intended that some differences, as reflected in the statutory language, would exist between the tax treatment of transfers under the two subsections. as originally enacted, section 707(a) provided as follows: if a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.21 346 florida tax review [v0l.7:6 22. irc ' 707(c). as discussed below, for clarity purposes, congress subsequently added a requirement to ensure that payments under § 707(c) were subject to the capitalization rules of § 263 as well. 23. although § 707(c) makes no explicit reference to the capacity in which the partner is acting, the legislative history and the regulations indicate that § 707(a) is the controlling provision for transactions in which the partner is acting in the capacity of a non-partner, leaving § 707(c) to govern transactions in which the partner is acting in the capacity of a partner and the payments are determined without regard to the income of the partnership. postlewaite & cameron, supra note 2, at 676-77. 24. for a more expansive discussion of this issue, see postlewaite & cameron, supra note 2, at 665-66. notwithstanding a similar focus, section 707(c) was somewhat more narrow in its statutory command as its breadth was circumscribed by the following language: to the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61(a) (relating to gross income) and for purposes of section 162(a) (relating to trade or business expenses). 22 based on the language of these provisions, section 707(a) governed payments to a partner for activities not connected to those required by his partner status, while section 707(c) controlled if the activities were connected to his partner status. the mutual exclusivity of the two subsections ensures23 that a payment can not simultaneously fall into both categories. given the differing statutory language and the explanations of each type of payment in the legislative history, differences in the tax treatment of payments under sections 707(a) and 707(c) initially existed. however, over the ensuing 30 years, congress eroded the most significant differences between the two subsections. the first such change occurred with respect to the capitalization requirements applicable to payments under sections 707(a) and 707(c).24 following the enactment of section 707, it was generally accepted that section 707(a) payments were subject to the capitalization rules of section 263. however, the limited reference in section 707(c) to sections 61(a) and 162(a) emboldened some practitioners to suggest that guaranteed payments were not subject to the capitalization requirements of the code. once this issue was identified, the service and the courts did not hesitate to expand the number of sections beyond those to which guaranteed payments are 2006] the lazarus effect 347 25. cagle v. comm’r, 63 t.c. 86 (1974), aff’d, 539 f.2d 409 (5th cir. 1976); rev. rul. 75-214, 1975-1 c.b. 185. the courts also confronted the question of whether the reference to § 61(a) in § 707(c) incorporated other provisions of the code pertaining to exclusions from gross income as well. in carey v. united states, 427 f.2d 763 (ct. cl. 1970), the court concluded that guaranteed payments in the form of salary received by a partner for services performed abroad were excludable from the partner’s gross income under § 911. the court reasoned that § 707(c)’s reference to § 61(a) included the phrase “[e]xcept as otherwise provided in this subtitle.” the court rejected the argument that the guaranteed payments represented a portion of the partner’s distributive share of partnership income for purposes of § 911. see miller v. comm’r, 52 t.c. 752 (1969), acq. (interpreting § 707(c) in the same manner as as the court in carey). similarly, in armstrong v. phinney, 394 f.2d 661 (5th cir. 1968), the court stated that, if the benefits involved in that case were found to be guaranteed payments, they would be excludable from the gross income of the recipient partner under § 119 as a result of § 707(c)’s reference to § 61(a). but see rev. rul. 91-26, 1991-1 c.b. 184 (accident and health insurance premiums paid by a partnership on behalf of its partners are includable in the partners’ gross incomes because the premiums are treated as a distributive share of partnership income under § 707(c)); g.c.m. 34173 (arguing that a partner cannot be treated as an employee of the partnership even if the partner is treated as “one who is not a partner” under § 707(a) or “one who is not a member of the partnership” under § 707(c)). accord rev. rul. 69-184, 1969-1 c.b. 256 (bona fide members of a partnership are not employees of the partnership for purposes of fica, futa, and income tax withholding). 26. tax reform act of 1976, pub. l. no. 94-455, § 213(b)(3), 90 stat. 1520, 1547 (1976). following this amendment, § 707(c) read as follows: to the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses). interestingly, the original house bill regarding this amendment made it applicable to all taxable years to which the 1954 code applied on the rationale that the provision merely declared and clarified existing law. h.r. 10612, 94th cong. § 210(e) (1975); h.r. rep. no. 94-658, at 122 (1975), reprinted in 1976 u.s.c.c.a.n. 2897, 3017. 27. irc § 706(a); regs. § 1.707-1(c). for a more expansive discussion of this issue, see postlewaite & cameron, supra note 2, at 668-73. explicitly subject under the language of section 707(c). congress25 subsequently put the capitalization question to rest with an amendment specifically subjecting guaranteed payments to the rules of section 263.26 regarding timing issues, section 706(a) and the regulations for guaranteed payments mandated a matching of income inclusion by the recipient of the guaranteed payment with the deductibility of the payment to the partnership. if the partnership were on a different accounting method27 348 florida tax review [v0l.7:6 28. irc §§ 267(a)(2) and 267(e). section 267(e) specifically excludes guaranteed payments from the requirements of § 267(a)(2). irc § 267(e)(4). section 267(e) was enacted as part of the tax reform act of 1984, pub. l. no. 98-369, § 174(a)(2), 98 stat. 494, 705-06 (1984). 29. matching in the timing of the income inclusion by the partner and the expense deduction by the partnership is not required under § 267(a)(2) in connection with a transaction under § 707(a) if the partnership is on the cash method and the payee is on the accrual method, the services are rendered in year 1, and the payment is not made until year 2. such a situation is not considered abusive because the income, and not the deduction, is accelerated as a result of the accounting methods of the parties involved. 30. in 2001, the joint committee on taxation recommended conformity of the timing rules applicable to guaranteed payments and to transactions between a partnership and a partner not acting in the capacity of a partner. 2 joint comm. on tax’n, “study of the overall state of the federal tax system and recommendations for simplification, pursuant to § 8022(3)(b) of the internal revenue code of 1986,” 291-94 (jcs-3-01, apr. 2001). the joint committee recommended that the timing of the income inclusion by the partner be based on the partnership’s time of deduction. the joint committee also considered the repeal of § 707(c) but refused to recommend such a proposal on the grounds that it would create complexity by eliminating the existing certainty surrounding the treatment of guaranteed payments and because such a proposal was unnecessarily broad in curing the inconsistent timing rules applicable to payments under §§ 707(a) and 707(c). than the partner (accrual versus cash or vice versa), the accounting method of the partnership controlled the year of the income inclusion to the partner. thus, a cash method partner could experience an acceleration of income without receipt of payment if the partnership were an accrual method partnership and the partner was on the cash method of accounting. however, section 707(a) payments were not subject to such matching. a partnership on the accrual method of accounting could deduct the payment before its payment and inclusion by a service-performing, cash-method partner. again such differences and their exploitation precipitated a congressional response which subjected most section 707(a) payments to the matching requirements of section 267, which further minimized the distinctions between sections 707(a) and 707(c). although28 the timing of payments under section 707(a) was controlled by the accounting method of the recipient partner while the timing of payments under section 707(c) was controlled by the accounting method of the partnership, a matching of income inclusion by the partner and expense deduction by the partnership generally resulted. thus, much of the29 difference in the tax treatment between the two types of payments was rapidly eroding.30 in 1984, congress dealt the final blow to what little remained of the vitality and independence of section 707(c) through its enactment of section 2006] the lazarus effect 349 31. tax reform act of 1984, pub. l. no. 98-369, § 73(a), 98 stat. 494, 591 (1984). 32. for a more expansive discussion of this issue, see postlewaite & cameron, supra note 2, at 676-94. 33. see, e.g., pratt v. comm’r, 64 t.c. 203 (1975), aff’d in part and rev’d in part, 550 f.2d 1023 (5th cir. 1977); rev. rul. 81-300, 1981-2 c.b. 143; rev. rul. 81-301, 1981-2 c.b. 144. 34. 1981-2 c.b. 143. 35. in this regard, revenue ruling 81-300 rejected the position of the tax court in pratt v. comm’r, 64 t.c. 203 (1975), aff’d in part and rev’d in part, 550 f.2d 1023 (5th cir. 1977), concluding that payments determined with respect to gross rentals of the partnership were determined with regard to the income of the partnership and, thus, excluded from treatment under § 707(c). 36. s. rep. no. 98-169, at 227 (1984). see also staff of the joint comm. on tax’n, general explanation of h.r. 4170, 227-28 (1984). in issuing regulations under § 707(a)(2) following its enactment in 1984, the service did not address the treatment of services but reserved regulation § 1.707-2 for future coverage of the issue. 707(a)(2). the legislative history behind the enactment suggested that the31 capacity distinction between sections 707(a) and 707(c) warranted a new focus on entrepreneurial risk, as to both fact and amount of payment, from the perspective of the recipient partner.32 historically, capacity was determined by focusing on the nature of the services rendered by the partner in relation to the activities of the partnership. for example, in revenue ruling 81-300, the general partners33 34 of a limited partnership contributed time and effort through the rendition of managerial activities on behalf of the partnership in return for a fee equal to 5% of the gross rentals of the partnership. the service reasoned that, because the partners rendered the managerial activities in their capacity as partners, section 707(a) was inapplicable to the transaction. in addition, the service concluded that a fee dependent on the gross rentals of the partnership was “determined without regard to the income of the partnership.” thus, the35 service treated the fee as a guaranteed payment under section 707(c). as part of the tax reform act of 1984, congress enacted section 707(a)(2) which requires third-party treatment for any partner who renders services or transfers property to a partnership and who thereafter receives a related direct or indirect allocation of partnership income and a distribution of partnership property if such transfers are “properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership.” in making this determination, the legislative history focused on the entrepreneurial risk to which the partner is exposed with respect to the amount of any related distribution and whether the distribution will, in fact, be made.36 as part of its discussion of section 707(a)(2)(a) in the legislative history, congress referenced revenue ruling 81-300 and stated that the transaction described therein should be governed by section 707(a), rather 350 florida tax review [v0l.7:6 37. s. rep. no. 98-169, at 230 (1984). see also staff of the joint comm. on tax’n, general explanation of h.r. 4170, 230-31 (1984). 38. most casebook authors and other academic commentators have not rushed to acknowledge that the enactment of § 707(a)(2) dramatically affected the capacity analysis applicable to guaranteed payments. instead, they largely limit any discussion of § 707(a)(2) to the issue of distinguishing payments under § 707(a)(1) from a partner’s distributive share of partnership income and a distribution of partnership property and continue to cite the law as it existed prior to 1984, including the pratt decision, when considering the capacity question in the context of guaranteed payments. see, e.g., stephen a. lind, stephen schwartz, daniel j. lathrope & joshua d. rosenberg, fundamentals of partnership taxation: cases and materials 222-42 (7th ed., 2005); glenn c. coven, robert j. peroni & richard c. pugh, taxation of business enterprises: cases and materials 973-90 (2d ed., 2002); laura e. cunningham & noel b. cunningham, the logic of subchapter k: a conceptual guide to the taxation of partnerships 120-21 (2d ed., 2000); jerold a. friedland, understanding partnership and llc taxation § 7.02 (2000). but see alan gunn & james r. repetti, partnership income taxation 124-25 (4th ed., 2005) (acknowledging the difficulty of applying the capacity analysis under § 707(a)(2) to the problem of distinguishing a guaranteed payment from a § 707(a) payment); karen c. burke, federal income taxation of partners and partnerships 234-35 and 243 (3d ed., 2005) (acknowledging the capacity analysis introduced by § 707(a)(2) and noting that “[s]ince § 707(c) payments are by definition fixed, all such payments might plausibly be treated as § 707(a) payments”). see also 4 boris i. bittker & lawrence lokken, federal taxation of income, estates & gifts ¶ 89.1.3 (3d ed., 2003) (noting that the distinction drawn in the pratt decision between activities within and without the scope of the partnership to resolve the capacity question was effectively eliminated by the enactment of § 707(a)(2)(a)). 39. nevertheless, the regulations under § 707 do recognize a continuing role for guaranteed payments following the enactment of § 707(a)(2). thereunder, a payment for the use of capital that is characterized by the parties as a guaranteed payment and is reasonable (as defined therein) is presumed to be a guaranteed payment for capital and not part of a sale of property for purposes of § 707(a)(2)(b). regs. § 1.707-4(a)(1). the regulations make no mention of the revised capacity analysis introduced by § 707(a)(2) to determine if such payments properly fall within § 707(c) as subject to the entrepreneurial risks of the partnership and, thus, paid to the partner in his capacity as than section 707(c). the only apparent explanation for this statement is that37 the new concept of capacity reflected in section 707(a)(2) focusing on economic risk should apply in the context of section 707(c) as well. 38 with this dramatic alteration in the determination of capacity, the distinction between a section 707(a) payment and a section 707(c) payment virtually disappeared because most transactions designed to compensate a partner/service-provider or partner/capital-provider lack risk as to both the fact and the amount of payment. consequently, most, if not all, payments previously falling under section 707(c) now fall under section 707(a). it is a rare setting in which a payment could meet the textual requirements of section 707(c) and yet possess entrepreneurial risk as to the fact and the amount of payment. as described above, this change was not all that39 2006] the lazarus effect 351 a partner. nevertheless, the regulations apply a facts and circumstances inquiry to determine if the payment should properly be treated as part of a sale of property. compare regs. § 1.707-4(a)(4), example (1) (in which a payment is treated as a guaranteed payment for capital) and example (2) (in which the presumption that a payment is a guaranteed payment for capital is rebutted). although this portion of the regulations is seemingly inconsistent with the proper application of the capacity analysis following the enactment of § 707(a)(2), such payments do not raise the complications associated with in-kind guaranteed payments that are at issue herein because they are expressly limited to transfers of money. regs. § 1.707-4(a)(1)(ii). thus, their treatment under § 707(c), rather than § 707(a), is virtually meaningless. 40. postlewaite & cameron, supra note 2, at 694-96. 41. kahn & cuenin, supra note 6, at 408-10. kahn and cuenin also provide the reader with a review of the tax treatment for both the partnership and the recipient partner of liquidating and non-liquidating distributions of partnership property. id. at 411-14. remarkable because the distinctions between the two subsections had been previously eroded. given these developments, we, almost 20 years ago, called into question the continuation of section 707(c). the erosion of any distinctions40 between the subsections as a result of legislative changes by congress between 1954 and 1984 had effectively eliminated any differences in the tax treatment for payments classified as payments under section 707(a) and those classified as guaranteed payments under section 707(c). furthermore, the revised capacity analysis introduced through the enactment of section 707(a)(2) made section 707(c) inapplicable to the typical types of payments that it previously covered. section 707(c) had been effectively repealed and all that remained was statutory surplusage prone to produce confusion and complexity. accordingly, we advocated that the slow death of the concept of guaranteed payments be hastened by the outright repeal of section 707(c). iii. non-liquidating guaranteed payments made in-kind a. central thesis of kahn and cuenin’s article kahn and cuenin begin their article with a brief introduction to the purpose and operation of section 707(c) and the concept of guaranteed payments. kahn and cuenin embrace the historical emphasis, no longer41 controlling in light of the subsequent legislative enactments previously described, on an evaluation of the capacity in which a partner is acting in order to distinguish between payments under sections 707(a) and 707(c). thus, their discussion fails to incorporate the profound developments introduced by the tax reform act of 1984 that resulted from a congressional reinterpretation of the capacity test. as a result, they overlook the central role played by section 707(a)(2) to the questions they consider. 352 florida tax review [v0l.7:6 42. kahn & cuenin, supra note 6, at 406-07. they also cite leading treatises in the field of partnership taxation as supporting this conclusion. id. (citing 2 willis, pennell & postlewaite, supra note 11, at ¶ 15.06 and 1 william s. mckee,william f. nelson & robert l. whitmire, federal taxation of partnerships and partners ¶ 13.03[5] (3d ed., 1997). see also rev. rul. 91-26, 1991-1 c.b. 184 (treating accident and health insurance premiums paid by a partnership on behalf of its partners as a guaranteed payment and referring to guaranteed payments under § 707(c) as “[a]mounts paid in cash or in-kind by a partnership”). given kahn and cuenin’s subsequently articulated desire to implement the statutory language of § 707(c) as closely as possible, it is curious that they do not explore the distinct difference in the statutory language between § 707(c)’s explicit reference to “payments” to a partner and § 707(a)’s more general reference to “transactions” between a partner and a partnership. this difference in language, as well as the acknowledged congressional failure apparently to consider in-kind guaranteed payments when enacting § 707 in 1954, may well suggest that § 707(c) was never intended to apply to in-kind transfers of partnership property. see armstrong v. phinney, 394 f.2d 661 (5th cir. 1968) (questioning whether in-kind meals and lodging received by a partner could constitute “payments” for purposes of § 707(c)). thus, through close attention to the statutory language and through the adoption of reasonable assumptions regarding congressional intent, the problems encountered in considering the application of § 707(c) to in-kind transfers could easily be avoided. 43. kahn & cuenin, supra note 6, at 407 and 417-18. 44. kahn & cuenin, supra note 6, at 410 and 423-24. this latter type of guaranteed payment is illustrated through an example contained in the regulations. regs. § 1.707-1, example (2). under this example, partner c provides services to the partnership and is entitled to receive 30% of partnership income, before taking into account any guaranteed payments, but not less than $10,000. if the partnership’s income is $60,000, c will receive a distributive share of partnership income of $18,000 and no guaranteed payment. however, if the partnership’s income is only $20,000, c will receive a distributive share of partnership income of only $6,000. because c is entitled to receive not less than $10,000, the difference, $4,000, is a guaranteed payment. kahn and cuenin’s attention to this type of guaranteed payment is curious for three reasons. first, it is not clear how frequently payments are structured in this manner. thus, their importance in determining the proper interpretation of § 707(c) may be overstated. second, the regulations apparently fail to follow the legislative history while acknowledging that guaranteed payments are traditionally made in cash, kahn and cuenin conclude, given the absence of a statutory or regulatory prohibition, that such payments can be made in-kind as well.42 kahn and cuenin briefly acknowledge the infrequency with which such payments are made, a recognition which by itself might dictate an interpretation of the statutory and regulatory framework in such a way as to minimize aberrational results. they then move their focus from the typical43 type of guaranteed payment (a payment fixed in amount) to address an infrequent, atypical type of guaranteed payment (a payment structured as a percentage of partnership income with a minimum dollar amount) and the tax issues which present themselves in such a case.44 2006] the lazarus effect 353 with respect to such payments. both the house and senate reports regarding § 707 state that “[a] partner who is guaranteed a minimum annual amount for his services shall be treated as receiving a salary in that amount.” h.r. rep. no. 83-1337, at a227 (1954), reprinted in 1954 u.s.c.c.a.n. 4017, 4367; s. rep. no. 83-1622, at 387 (1954), reprinted in 1954 u.s.c.c.a.n. 4621, 5029. we raised this issue in our earlier article and proposed that the entire minimum amount be considered as a payment to a third party regardless of the partner’s share of partnership income. see postlewaite & cameron, supra note 2, at 700-02. but see rev. rul. 66-95, 1966-1 c.b. 169 (prohibiting a partnership from treating the entire minimum amount of a guaranteed payment structured as a percentage of partnership income, but not less than a specified dollar amount, as deductible under § 707(c)). third, a payment in this form is not “determined without regard to the income of the partnership” as required by the explicit language of § 707(c). see martin b. cowan, “compensating the general partner: the pratt case,” 56 taxes 10 (1978). as described above, the amount of the guaranteed payment depends entirely on the income of the partnership. some of the potential problems regarding guaranteed payments structured in this manner were noted immediately following the enactment of § 707(c). see j. paul jackson, mark h. johnson, stanley s. surrey, carolyn k. tenen & william c. warren, “the internal revenue code of 1954: partnerships,” 54 colum. l. rev. 1183, 1203 (1954). see also rev. rul. 69-180, 1969-1 c.b. 183 (detailing the treatment of this type of guaranteed payment when the partnership has both ordinary income and capital gain). 45. kahn & cuenin, supra note 6, at 406. 46. kahn & cuenin, supra note 6, at 422-27. 47. kahn & cuenin, supra note 6, at 407. 48. kahn & cuenin, supra note 6, at 428-36. 49. kahn & cuenin, supra note 6, at 419-22. kahn and cuenin assert that the “unresolved question” is whether in-kind guaranteed payments made by the partnership “will cause the partnership that made the payment to recognize gain or loss if the property is appreciated or depreciated.” with respect to this question, they conclude45 that the partnership should recognize neither gain nor loss on the transfer of an in-kind guaranteed payment, treating such a payment instead as a distribution of partnership property. 46 thereafter, kahn and cuenin focus on two related but “unresolved questions . . . (1) how is a partner’s basis in property that was received as a guaranteed payment to be determined, and (2) . . . what effect does the payment have on the partner’s outside basis in his partnership interest.”47 referencing the lack of coverage and clarity in the treatment of the issue in the leading works on partnership taxation, kahn and cuenin conclude, in the first of their deviations from the statutory language of subchapter k, that the service provider/partner receives a fair market value basis in the transferred property. furthermore, and in another deviation from the statutory language48 of subchapter k, they conclude that a partner’s basis in his partnership interest is not directly affected by the payment. they do note that an49 indirect impact on the recipient’s partnership interest occurs because the 354 florida tax review [v0l.7:6 50. irc § 707(c) (emphasis added). kahn & cuenin, supra note 6, at 409-10 and 415-19. 51. kahn & cuenin, supra note 6, at 415 (stating that “[t]he ‘but only for the purposes of’ language of the statute strongly suggests that for all other purposes the payment is treated as a distribution to a partner”). 52. kahn & cuenin, supra note 6, at 418. 53. 52 t.c. 752 (1969). payment is deductible to the partnership and the partner’s share of the deduction filters its way through to the partner in the determination of his distributive share of partnership income. to reach their conclusions regarding the tax implications of in-kind guaranteed payments, kahn and cuenin rely heavily on the precise language of section 707(c), which requires that guaranteed payments be treated as made to a third party “but only for the purposes of section 61 . . . and, subject to section 263, for purposes of section 162(a) . . . .” for any purpose other50 than those specified in the statute, kahn and cuenin assert that the payment is to be treated as a distribution by the partnership subject to the controlling provisions of subchapter k. however, on a number of subsequent51 occasions, kahn and cuenin recognize a policy need to deviate from the confines of the statutory language. as a result, they do not advocate a literal application of the language of section 707(c) but suggest that it creates a “presumption” that a payment will be treated as a partnership distribution other than for the purposes of sections 61(a), 162(a), and 263. thus, “there52 is a burden on those who would seek to expand the entity treatment to demonstrate that there is a compelling reason to do so.” they claim to have satisfied this burden when they deviate from the strictures of the legislative language, as for example, when they conclude that the recipient partner takes a fair market value basis in the property received. nevertheless, they implicitly fail to satisfy this burden when they conclude that a partnership recognizes neither gain nor loss on the transfer of an in-kind guaranteed payment despite the unusual tax treatment when property is transferred in return for the rendition of services. this willingness to selectively apply the statutory language of section 707(c) for different aspects of the same transaction calls into question the persuasiveness of their advocacy. their analysis also appears to be in conflict with the tax court’s approach to the statutory language of section 707(c). in miller v. comm’r,53 the court concluded that guaranteed payments in the form of salary received by a partner for services performed abroad were excludable from the partner’s gross income under section 911. the court reasoned that section 707(c)’s reference to section 61(a) included the phrase “[e]xcept as otherwise provided in this subtitle” and that section 911 provided otherwise. the court also reasoned that the legislative history to section 707 indicated that “the general approach of the section is to apply the entity theory to the dealings 2006] the lazarus effect 355 54. id. at 761. 55. id. (quoting h.r. rep. no. 83-2543, at 59 (1954) (conf. rep.), reprinted in 1954 u.s.c.c.a.n 5280, 5319-20. 56. id. at 762. between partners and the partnership,” relying on the following statement54 from the legislative history: no inference is intended, however, that a partnership is to be considered as a separate entity for the purpose of applying other provisions of the internal revenue laws if the concept of the partnership as a collection of individuals is more appropriate for such provisions.55 the court found no reason why, for purposes of section 911, the entity theory should not be applied as consistent with the policy goals of both sections 707(c) and 911. thus, the court appeared to create a presumption that the entity, not the aggregate, theory should prevail under section 707(c) unless the aggregate theory was more appropriate in a particular context. the tax court also addressed the implications of the “but only for the purposes of” language under setion 707(c) and concluded that it was intended to achieve only a very narrow purpose regarding the timing of guaranteed payments. this conclusion does not ignore the effect of the “but only” words. these words were added to section 707(c) by the senate which at the same time also amended section 706 to provide that guaranteed payments received by a partner are to be included in his income for his taxable year in which the partnership’s taxable year ends. in connection with section 707(c), the senate committee report indicates that the reason for the change was to provide that guaranteed payments are to be included in income at the same time as a partner’s distributive share – not at the time when compensation would ordinarily be included in income. this is the only example in the legislative history of the need for the “but only” words. 56 thus, the tax court did not view the “but only for the purposes of” language as creating any presumption regarding the interpretation of section 707(c). in summary, kahn and cuenin conclude that an in-kind guaranteed payment results in ordinary income for the recipient partner equal to the fair market value of the property received, a basis for the property in the hands of the recipient partner equal to the property’s fair market value, and no direct 356 florida tax review [v0l.7:6 57. kahn & cuenin, supra note 6, at 414-15. interestingly, kahn and cuenin suggest that a sole proprietor recognizes gain or loss because “the employer is satisfying a debt with appreciated or depreciated property, and so there is an exchange of the property for the debt.” id. at 414. subsequently, they claim that the issue for determination is whether an in-kind guaranteed payment should “be treated as if it were made by an employer (a separate entity) to an employee.” id. at 415. by moving the issue to whether an employer-employee relationship exists, they ignore the more important component of their formulation – whether there was an exchange of property for debt. basis adjustment to the recipient partner’s partnership interest. while the partnership receives a deduction on the transfer, they assert that it is immune from gain or loss recognition. according to kahn and cuenin, these results are dictated by a combination of the statutory language of section 707(c), the provisions of subchapter k applicable to partnership distributions, and general tax policy principles. b. the non-partnership setting interestingly, the conclusions reached by kahn and cuenin conflict with the results derived in an identical transaction in the context of an individual/sole proprietorship. although considered by kahn and cuenin only in passing, the sole proprietorship paradigm involving an employer57 satisfying an obligation for services rendered by his employee through the transfer of property rather than cash not only is instructive regarding the proper tax treatment of guaranteed payments, but also serves as a baseline against which any conclusions regarding the tax treatment of guaranteed payments can be compared. significantly, the identical questions are confronted – income issues to the employee, including the amount of income and its character, the basis of any property received by the employee, the recognition of income or loss by the employer through the transfer of property to satisfy an obligation for services rendered, and the deduction by the employer for the expenditure incurred. in the sole proprietor paradigm, encountered in the first four weeks of virtually every basic tax course, the tax landscape is fairly well defined with regard to the tax issues confronted by both the employer and the employee. the typical hypothetical involves the following: assume that a full-time employee, e, has rendered services during the past month in return for his employer’s promise to pay him $10,000 per month. at the end of the month, e’s employer, r, offers to pay him in-kind through the transfer of property previously purchased for $8,000. e and r agree that the value of the property is $10,000, and e is willing to accept the property in satisfaction of his claim for payment for the services rendered. what are the tax consequences to the parties? 2006] the lazarus effect 357 58. irc § 61(a)(1); regs. § 1.61-2(d). 59. irc § 1012; regs. §§ 1.61-2(d)(2) and 1.1012-1(a). 60. irc §§ 162(a)(1) and 212; regs. §§ 1.162-1(a), 1.162-7, and 1.212-1. 61. irc §§ 61(a)(3) (referring to gains from dealings in property), 1001(a) (specifying the determination of gain realized), and 1001(c) (requiring the recognition of realized gain unless a non-recognition provision is applicable). see also regs. §§ 1.61-6, 1.1001-1(a), and 1.1002-1. 62. kahn & cuenin, supra note 6, at 414-15. 63. irc §§ 1221 and 1231. notwithstanding the usual confusion that ensues in the classroom, ultimately the professor leads the class to see, understand, and conclude that e has ordinary income in the amount of $10,000 from compensation for services rendered under section 61 of the code. since his receipt was in-58 kind, rather than in cash, the tax law accords him a basis in the property in order that, upon a future sale, a proper determination of gain or loss can be made. the tax law quite properly and logically accords e a basis equal to59 the amount of income reported on the transfer. thus, e receives the property with a basis equal to its fair market value of $10,000. after addressing the tax consequences to e, the class turns its attention to the other side of the transaction. most students instantly advocate a deduction for r, assuming of course that the activity in which e rendered his services is one that is either a trade or business or an activity for the production of income, in the amount of $10,000. (it is usually left to the60 professor to caution that, before finalizing such a conclusion, a determination needs to be made as to whether such a payment, in cash or in-kind, requires capitalization under section 263.) the final component in addressing the totality of the tax issues presented, often left to the professor to forcefully advocate, is the determination of whether gain or loss results from r’s satisfaction of an obligation by transferring property with a fair market value that differs from r’s basis in that property. students soon realize that r61 should be treated as if he transferred cash to e in the amount of the obligation and subsequently transferred the property to e in return for the cash deemed paid. thus, in this example, r takes a $10,000 current62 deduction, combined with the realization and recognition of $2,000 of gain, the character of which will depend on the type of property transferred in the hands of r. 63 most would neither question nor object to the conclusions reached in this example involving a sole proprietor. nevertheless, kahn and cuenin advance the bold proposition that the movement of a virtually identical transaction into the poorly understood and frequently complex world of partnership taxation can upset our understanding of these fundamental tax principles. while acknowledging that the tax treatment involving an in-kind guaranteed payment generally follows the sole proprietor paradigm, kahn and cuenin conclude that for purposes of gain or loss recognition by the 358 florida tax review [v0l.7:6 64. see kahn & cuenin, supra note 6, at 417. 65. kahn & cuenin, supra note 6, at 417. kahn and cuenin cite § 751 as another example of a section of subchapter k that applies both the entity and aggregate approach. 66. kahn & cuenin, supra note 6, at 417. kahn and cuenin cite the legislative history in support of their assertion that congress intended to adopt this flexible approach to transactions between a partnership and its partners. id. at n.48 (citing h.r. rep. no. 83-2543, at 59 (1954) reprinted in 1954 u.s.c.c.a.n. 5280, 5319-20). 67. kahn & cuenin, supra note 6, at 417-18. 68. kahn & cuenin, supra note 6, at 418. transferring partnership, the transfer constitutes a distribution of partnership property otherwise subject to the property distribution scheme of subchapter k. accordingly, the partnership recognizes neither gain nor loss on the satisfaction of its obligation through the transfer of an in-kind guaranteed payment. as a general matter, one would expect a heavy burden of proof on those advocating any tax treatment that is so obviously contradictory with the basic principles of taxation. in responding to our asserted analogy between the sole proprietor and partnership situations, kahn and cuenin would likely claim that the involvement of a partner rendering services to a partnership rather than a third-party employee complicates any attempt to apply the sole proprietor paradigm and raises the slippery questions of whether the partnership should be conceptualized as an entity separate from its partners or as simply an aggregate of its individual partners. indeed, kahn and cuenin decline to64 take sides on this question, recognizing that congress refused to exclusively adopt either an entity or aggregate approach to the taxation of partnerships in enacting subchapter k. moreover, they assert that individual sections of subchapter k, including section 707(c), reflect this “dual approach.” as65 stated in their article, “[section 707(c)] treats the partnership as an entity to the extent that it requires the partner to recognize ordinary income and grants the partnership a deduction; and it applies aggregate or conduit treatment to the extent that the payment is treated as a partnership distribution.”66 nevertheless, kahn and cuenin acknowledge that congress likely did not consider the tax consequences of in-kind guaranteed payments. we67 agree with them that any legislative intent regarding this question “will have to be extrapolated from the meager history that is available and from the assumption that congress would wish the statute to be construed in a manner that arrived at results that conform to the broad policies that underlie subchapter k.” however, we believe that the proper interpretation of68 section 707(c) is derived from a comprehensive understanding of the history of section 707(c) and an appreciation of the fact that subchapter k’s nonrecognition provisions are an exception from baseline principles, illustrated in the sole proprietor paradigm, requiring the recognition of realized gain or loss resulting from any and all property transactions. 2006] the lazarus effect 359 69. kahn and cuenin suggest that the statutory reference to § 61 contained in § 707(c) was only to ensure ordinary income treatment by the recipient partner. kahn & cuenin, supra note 6, at 422. they do note, however, that an argument could be made that the reference to § 61(a) incorporates § 61(a)(3) applicable to “gains derived from dealings in property” which could require gain recognition by the partnership in connection with an in-kind guaranteed payment. id. (citing 1 mckee, nelson & whitmire, supra note 42, at ¶ 13.03[5], n.174). they reject this argument because § 61(a) does not refer to losses, and, under such an argument, a partnership making an in-kind guaranteed payment would not be allowed to realize a loss if property with a basis greater than its fair market value were transferred as a guaranteed payment. the argument that § 707(c)’s reference to § 61(a) incorporates § 61(a)(3) is probably erroneous because it is inconsistent with the statutory evolution of § 707(c) in any event. as originally passed by the house, § 707(c) applied only to partnership payments for the rendition of services by a partner, and the language referred specifically to § 61(a)(1)’s inclusion of compensation for services in gross income. h.r. 8300, 83d cong. § 707(c) (1954). the more general reference to § 61(a) was made by the senate, presumably when it expanded § 707(c) to apply to payments for the use of capital. s. rep. no. 83-1622, at 387 (1954), reprinted in 1954 u.s.c.c.a.n. 4621, 5029. the reference to § 61(a)(1) in the original bill strongly suggests that the reference to § 61(a) was intended to apply only to the treatment of a guaranteed payment by the recipient partner and not to the transferring partnership. an appreciation of the statutory evolution of § 707(c) and its intended reference to § 61(a)(1) and, presumably, § 61(a)(4) with respect to payments for the use of capital also avoids any possible confusion that the intended reference is to § 61(a)(13) – a partner’s distributive share of partnership gross income – and any possible implications that such a reference might generate. see g.c.m. 34173. nevertheless, the courts have not adopted such a limited c. non-recognition of gain or loss by the partnership as previously described, kahn and cuenin part company with the sole proprietor paradigm with respect to the partnership’s recognition of gain or loss on the transfer of an in-kind guaranteed payment. as a result, the resolution of this question is central to their analysis. the mere comparison of the partnership setting with the sole proprietor paradigm without more would seemingly mandate an affirmative response to the question. nothing from the standpoint of general tax policy principles appears to distinguish the two situations and, thus, from a policy perspective, there would appear to be no compelling rationale for treating the virtually identical situations differently. nevertheless, kahn and cuenin resolve this question in the negative, based on two related rationales – the statutory language of section 707(c) and the policies underlying subchapter k. according to kahn and cuenin, the statutory language of section 707(c) imposing third-party treatment in connection with guaranteed payments is applicable “only for the purposes of sections 61(a) . . . 263 . . . [and] 162(a).” as a result, kahn and cuenin69 360 florida tax review [v0l.7:6 view of the statutory language of § 707(c) and have interpreted it as incorporating all of § 61(a). see supra note 25. kahn and cuenin are probably incorrect that the reference to § 61(a) was only to ensure ordinary income treatment by the recipient partner. the problem that existed prior to the enactment of § 707(c) was that a salary payment to a partner in excess of the partnership’s income was treated as derived from the partners’ capital. thus, a portion of such a payment was a return of capital for the recipient partner, which was excluded from gross income. see lloyd v. comm’r, 15 b.t.a. 82 (1929); estate of tilton, 8 b.t.a. 914 (1927); g.c.m. 6582, viii-2 c.b. 200 (1929). the reference to § 61(a) was probably intended to ensure that the entire payment was included in the recipient partner’s gross income and was not intended to characterize for tax purposes the nature of the income received. see infra note 149. 70. while kahn and cuenin do not explicitly explore this aspect of the history of § 707(c) as part of their interpretative methodology, it is noteworthy that earlier “strict constructionists” concluded that the limiting language of § 707(c), as originally enacted, precluded the application of the capitalization rules. see supra text accompanying notes 24-26. nevertheless, the courts held to the contrary, and congress subsequently amended § 707(c) to resolve any lingering uncertainty. although the frequency of transactions involving guaranteed payments that should be capitalized probably exceeds that of transactions involving in-kind guaranteed payments, the judicial approach in addressing the capitalization issue suggests that the resolution of the question of in-kind guaranteed payments in a manner consistent with third-party treatment should not easily be dismissed. 71. kahn & cuenin, supra note 6, at 415 (emphasis added.) 72. irc § 706(a); regs. §§ 1.706-1(a) and 1.707-1(c). kahn & cuenin, supra note 6, at 415, n.42. kahn & cuenin also note that the timing rules applicable to related persons in certain circumstances under § 267(a)(2) do not apply to guaranteed payments under § 267(e)(4). id. acknowledge that third party treatment is mandated with respect to the compensatory aspects of the transaction, i.e., income inclusion on the part of the recipient partner under section 61(a) and the availability of the corresponding deduction on the part of the transferring partnership under sections 162 and 263.70 kahn and cuenin then assert that the “language of the statute strongly suggests that for all other purposes the payment is treated as a distribution to a partner.” thus, they maintain that the default treatment of a71 guaranteed payment is that of a distribution of partnership property. to support this assertion, they point to the code and regulations which use the partnership’s accounting method for determining the timing of the recipient partner’s income inclusion of the guaranteed payment. they observe that72 the rule applicable to the timing of the recipient partner’s inclusion of a guaranteed payment is the same as the rule applicable to a partner’s distributive share of partnership income. for kahn and cuenin, this similarity of treatment between the timing rules governing guaranteed payments and those governing a partner’s distributive share of partnership 2006] the lazarus effect 361 73. irc § 706(a); regs. §§ 1.706-1(a) and 1.707-1(c). regulation § 1.707-1(c) specifically states that “a partner must include such payments as ordinary income for his taxable year within or with which ends the partnership taxable year in which the partnership deducted such payments as paid or accrued under its method of accounting.” see gaines v. comm’r, t.c. memo. 1982-731, 45 t.c.m. (cch) 363 (noting the equivalent treatment of the partner’s distributive share of partnership income and stating that “any unfairness in taxing a partner on guaranteed payments that he neither receives nor benefits from results from the conduit theory of partnerships, and is a consequence of the taxpayer’s choice to do business in the partnership form”). although § 707(c) refers to a “payment,” the timing of a guaranteed payment by an accrual-method partnership to a cash-method partner is unrelated to the time of actual payment. the potential inconsistency between the use of the word “payment” in § 707(c) and the timing rule under § 706(a) was noted immediately following the enactment of subchapter k. see j. paul jackson,et al., supra note 44, at 1203. 74. such a view would be consistent with the conceptualization of guaranteed payments prior to the 1954 enactment of subchapter k. see kahn & cuenin, supra note 6, at 409. for a more extensive discussion of the treatment of guaranteed payments prior to the enactment of subchapter k, see postlewaite & cameron, supra note 2, at 651-53. kahn and cuenin acknowledge that congress viewed the pre-1954 treatment of such payments as “unrealistic and unnecessarily complicated.” kahn & cuenin, supra note 6, at 409 (citing h.r. rep. no. 83-1337, at 68 (1954), reprinted in 1954 u.s.c.c.a.n. 4017, 4094). nevertheless, they insist congress intended to retain this earlier conceptualization rather than treat guaranteed payments as payments to a third party for all purposes. although they may be correct with regard to congress’s original intent (see infra note 149), the courts have not interpreted § 707(c) in this manner. income is interpreted as evidence of congressional intent to treat a guaranteed payment as a distribution of partnership property. however, the similarity of rules regarding the timing of income resulting from guaranteed payments and distributive shares of partnership income are largely irrelevant to any connection between guaranteed payments and distributions of partnership property. a partner includes his distributive share of partnership income in gross income whether or not he receives a distribution of partnership property from the partnership during the year. similarly, a cash-method partner includes a guaranteed payment in gross income whether or not he receives property, either in cash or in-kind, from an accrual-method partnership during the year in satisfaction of that guaranteed payment. nevertheless, this observation implies little, if73 anything, about the treatment of a guaranteed payment as a distribution of partnership property. the similarity of guaranteed payments and distributive shares of partnership income becomes relevant to a conclusion that guaranteed payments should be treated in a manner similar to distributions of partnership property only if a guaranteed payment is conceptualized as a special allocation of partnership income and a simultaneous (or subsequent distribution) of partnership property. kahn and cuenin are supported in this74 362 florida tax review [v0l.7:6 75. regs. § 1.707-1(c). interestingly, the statement in the regulations that “guaranteed payments are regarded as a partner’s distributive share of ordinary income” is seemingly inconsistent with statements included in the legislative history. both the house and senate reports regarding § 707 state that “[t]he amount of such payment shall be included in the partner’s gross income, and shall not be considered a distributive share of partnership income.” h.r. rep. no. 83-1337, at a227 (1954), reprinted in 1954 u.s.c.c.a.n. 4017, 4367; s. rep. no. 83-1622, at 387 (1954), reprinted in 1954 u.s.c.c.a.n. 4621, 5029. 76. regs. § 1.707-1(c). kahn & cuenin, supra note 6, at 415. in addition, the regulations dictate that a guaranteed payment cannot qualify for the sick pay exclusion under prior law at § 105(d) and that a partner who receives a guaranteed payment is not regarded as an employee for purposes of employee withholding and deferred compensation. 77. kahn and cuenin note that no similar limitations exist under § 707(a), thereby suggesting that the limiting language of § 707(c) was intended to have some significance. however, the question is not whether a difference exists between §§ 707(a) and 707(c), but whether the statutory and non-statutory exclusions can be reconciled with the treatment of guaranteed payments as distributions of partnership property. 78. regs. § 1.704-1(b)(2)(iv)(o). kahn & cuenin, supra note 6, at 418. while the regulations under § 704 dictate the treatment of guaranteed payments for capital account purposes, their guidance is meager at best. regulation § 1.704-1(b)(2)(iv)(o), which addresses guaranteed payments, provides nothing more than an instruction consistent with a conceptualization of guaranteed payments as transfers in cash. under this regulation, the recipient partner’s capital account is adjusted only by his share of the partnership’s “deduction, loss, or other downward capital account adjustment endeavor by the regulatory statement that, with certain exceptions, “guaranteed payments are regarded as a partner’s distributive share of ordinary income.”75 however, kahn and cuenin must confront the fact that the explicit statutory limitations contained in the language of section 707(c) are not exclusive. for example, the regulations provide that guaranteed payments do not constitute an interest in partnership profits for purposes of sections 706(b)(3), 707(b), and 708(b). these provisions are each concerned with76 determining the extent of a partner’s interest in a partnership and exclude guaranteed payments from that determination. however, if guaranteed payments are properly viewed as a special allocation of partnership income and a subsequent distribution of partnership property, the opposite conclusion would appear to ensue. because guaranteed payments are typically structured as predictable distributions of fixed amounts, it is surprising they are excluded from the determination of a partner’s interest in a partnership.77 significantly, kahn and cuenin also cite the fact that guaranteed payments are not treated as allocations of partnership income and distributions of partnership property for purposes of maintaining the partners’ capital accounts under the regulations to section 704. under these78 2006] the lazarus effect 363 resulting from such payment.” the focus of the language on a “deduction, loss, or other downward adjustment” most likely reflects the drafters desire for thoroughness and to ensure a proper adjustment should the payment constitute a capital expenditure. the reference to “loss” is puzzling, although possibly explained in an overall loss, rather than net income, situation for the partnership. significantly, the regulation does not reference the term “gain.” thus, it seems logical to conclude that the regulations gave no consideration to in-kind guaranteed payments. 79. regs. § 1.704-1(b)(2)(iv)(b). 80. kahn & cuenin, supra note 6, at 417. 81. kahn & cuenin, supra note 6, at 418. 82. kahn & cuenin, supra note 6, at 418. regulations, a partner’s capital account is only adjusted by the partner’s distributive share of any deduction resulting from a guaranteed payment. this provision, at a minimum, suggests that a guaranteed payment is conceptualized for purposes of maintaining capital accounts as a payment to a third party. if, as kahn and cuenin propose, a guaranteed payment should be treated as an allocation of partnership income and a distribution of partnership property, additional adjustments would be required. thus, the79 exceptions to the regulatory statement that “guaranteed payments are regarded as a partner’s distributive share of ordinary income” appear to effectively swallow the general rule. as a result of these non-statutory exceptions to the treatment of guaranteed payments as distributions of partnership property, kahn and cuenin are forced to shift the focus of their analysis from the statutory language of section 707(c) to a policy-based approach in order to suggest that the classic aggregate/entity dichotomy supports the treatment of a guaranteed payment as a distribution of partnership property. kahn and80 cuenin’s earlier reliance on the statutory language of section 707(c) is transformed into a pragmatic approach in which congress in enacting subchapter k refused to “slavishly adhere to consistency” in choosing between an entity or aggregate approach. thus, the literal text is no longer controlling. instead, kahn and cuenin acknowledge that the principles of sound tax policy should control the question presented. presumably, a symmetry between sole proprietorships and partnerships should become compelling under such an analysis. however, as part of their pragmatic approach to resolving the section 707(c) problem, kahn and cuenin contend that “the statutory limitation creates a presumption that, for purposes other than those three code sections, the payment will be treated as a partnership distribution . . . .” this81 presumption imposes “a burden on those who would seek to expand the entity treatment to demonstrate that there is a compelling reason to do so.”82 for kahn and cuenin, a compelling reason is apparently a conflict with either the policies of subchapter k or the avoidance of any potential tax 364 florida tax review [v0l.7:6 83. kahn & cuenin, supra note 6, at 418. curiously, kahn and cuenin make no effort to determine the compelling reason that the regulations depart from the statutory language for purposes of §§ 704(b), 706(b)(3), 707(b), and 708(b). see supra text accompanying notes 76-77. such an inquiry might shed some light on the government’s view of any such compelling reason standard. 84. irc § 731(b). kahn & cuenin, supra note 6, at 418-19 and 427. 85. kahn & cuenin, supra note 6, at 422. 86. kahn & cuenin, supra note 6, at 422. 87. see infra text accompanying notes 138-55. 88. kahn & cuenin, supra note 6, at 423. 89. the type of guaranteed payment at issue is one in which the partner receives a percentage of partnership income, but not less than a specified dollar amount. for example, assume that partner c provides services to the partnership and is entitled to receive 30% of partnership income, before taking into account any guaranteed payments, but not less than $10,000. regs. § 1.707-1(c), example (2). if the partnership’s income is $60,000, c will receive a distributive share of partnership income of $18,000 and no guaranteed payment. however, if the partnership’s income is only $20,000, c will receive a distributive share of partnership income of only liability. because they fail to find any such compelling reason, they83 conclude that the statutory limitations of section 707(c) control. as a result, a guaranteed payment should be treated in the same manner as a distribution of partnership property in which the partnership recognizes neither gain nor loss on an in-kind transfer.84 not only do kahn and cuenin not find a compelling reason to treat guaranteed payments as payments to a third party, they suggest that the treatment of guaranteed payments as distributions of partnership property better effectuates the policy objectives of subchapter k. this conclusion is85 based on the policy of subchapter k to defer the recognition of gain or loss in connection with property transfers between partners and partnerships “to the extent that deferral is feasible and [any transfer] does not create an opportunity for significant tax evasion.” kahn and cuenin clearly86 demonstrate that deferral of gain or loss by the partnership is feasible, but, as described below, they fail to adequately consider the opportunities for tax87 evasion that their proposal entails. additionally, kahn and cuenin assert that recognition of gain or loss on the transfer of an asset in satisfaction of its obligation to a service provider “would cause a greater amount of complexity than that which congress sought to remove by adopting the guaranteed payment provision.” to document the potential complexity resulting from a88 requirement that the partnership recognize gain or loss, they resort to an atypical type of payment, one in which the payment is, in part, a guaranteed payment and, in part, a distribution of partnership property, thereby requiring an apportionment of the inside basis of the transferred property between the guaranteed payment portion of the transfer and the distribution portion.89 2006] the lazarus effect 365 $6,000. because c is entitled to receive not less than $10,000, the difference, $4,000, is a guaranteed payment. kahn and cuenin protest that, if gain or loss had to be recognized by the partnership with respect to an in-kind guaranteed payment, the transfer of property in satisfaction of the guaranteed payment in such a situation would require that the inside basis of the transferred property be apportioned between the part of the transaction treated as a partnership distribution and the part of the transaction treated as a guaranteed payment. kahn & cuenin, supra note 6, at 423. but this assumes that the partnership transfers property worth $10,000 to the partner, equal to both the partner’s distributive share of partnership income and the partner’s guaranteed payment. if property worth only $4,000, the amount of the guaranteed payment, is distributed, no such apportionment would be necessary. 90. see, e.g., irc § 1011(b) (requiring the allocation of basis in a part sale/part gift to a charitable organization in order to determine the amount of gain from the sale portion of the transfer); irc § 1060 (requiring the allocation of basis among the assets of a going business when acquired for a lump sum); regs. § 1.61-6(a) (requiring the equitable apportionment of basis among the several parts of a larger parcel of property when one or more of those parts are sold); regs. § 1.167(a)-5 (requiring the allocation of basis between depreciable and non-depreciable property acquired for a lump sum “as for example, buildings and land”); rev. rul. 53-286, 1953-2 c.b. 20 (requiring the allocation of basis between the personal and business use of property in determining gain or loss on sale); sharp v. united states, 199 f. supp. 743 (d. del. 1961), aff’d, 303 f.2d 783 (3d cir. 1962) (same). 91. kahn and cuenin go on to complain that further complication ensues in such a situation because the amount of the guaranteed payment depends on the dollar amount of the partner’s distributive share of partnership profits. kahn & cuenin, supra note 6, at 423-24. they apparently believe that the gain or loss resulting from the distribution of partnership property in satisfaction of the guaranteed payment will require the recomputation of the amount of the guaranteed payment. even if correct, their concern in this regard is overstated. more importantly, any such complications are easily avoided. their concern that any gain or loss resulting from the distribution of partnership property in satisfaction of the guaranteed payment will require the recomputation of the amount of the guaranteed payment is overstated because in many, if not most, instances the partnership will not distribute property in satisfaction of a guaranteed payment until the taxable year following that in which the services are actually rendered. this is because the partnership’s income, and thus the amount of the guaranteed payment, cannot be determined until after the end of the taxable year. for a cash-method partnership, the transfer of the property in the following taxable year means that both the deduction of the guaranteed payment and the recognition of any gain or loss resulting from the transfer would be deferred to that year. although an accrual-method partnership would be allowed a deduction for the guaranteed payment however, any necessary allocation of basis to ensure proper results would hardly be unique to section 707(c). it is present elsewhere in the code and, in itself, has not been found debilitating to the administration of the tax law.90 one should not be surprised that an added layer of difficulty is encountered in such an atypical setting.91 366 florida tax review [v0l.7:6 in the taxable year in which the services are actually rendered, the recognition of any gain or loss resulting from the transfer would be deferred to the following taxable year when the transfer is made. thus, in both cases, any gain or loss resulting from the transfer is not relevant to the determination of the amount of the guaranteed payment in the taxable year in which the services are rendered. nevertheless, kahn and cuenin’s concern could arise for either an accrual-method partnership or a cash-method partnership that transfers property in satisfaction of the guaranteed payment in the year the services are actually rendered despite the fact that the amount of the guaranteed payment is unknown at the time of the transfer. in such a situation, the amount of the gain or loss resulting from the transfer could be relevant to the determination of the amount of the guaranteed payment itself. however, the complexities encountered in this situation are easily avoided. the basic equation to determine the amount of a guaranteed payment when structured as a percentage of partnership income subject to a minimum amount is: gp = ma (pi * ds) equation 1 where pi > 0 and ma > pi * ds and gp = guaranteed payment; ma = the guaranteed minimum dollar amount; pi = partnership income before taking into account any guaranteed payment; and ds = the partner’s distributive share of partnership income. using the facts of the regulatory example described in note 89, supra, in which the partner is entitled to a distributive share of partnership income of 30% but not less than $10,000 and the partnership has income of only $20,000, the partner would receive a distributive share of partnership income of $6,000 and a guaranteed payment of $4,000. regs. § 1.707-1, example (2). admittedly, the determination of the amount of the guaranteed payment is made significantly more complicated through the inclusion of any gain or loss recognized by the partnership as a result of the transfer of partnership property in satisfaction of the guaranteed payment. kahn and cuenin are correct that the inclusion of this recognized gain or loss will affect the amount of the partnership’s income which will affect the amount of the guaranteed payment which will, in turn, affect the amount of the recognized gain or loss which will affect the amount of the partnership’s income, and so on in a pyramiding fashion. they recognize that this problem “can be solved through the use of an algebraic formula” but caution that concerns regarding the administrability of the tax laws favor the avoidance of such a formula. kahn & cuenin, supra note 6, at 424. see old colony trust co. v. comm’r, 279 u.s. 716 (1929) (recognizing that an algebraic formula could be used to determine the appropriate amount of tax when an employer pays the income taxes of an employee which generates additional income to the employee, which, in turn, results in additional income taxes to be paid by the employer, thereby generating additional income to the employee, and so on). 2006] the lazarus effect 367 assuming that the fair market value of the property to be transferred is equal to the amount of the guaranteed payment, the algebraic formula necessary to determine the amount of the guaranteed payment in such a situation is: gp = [ma (pi * ds)] / [1 + (1 x) * ds] equation 2 where pi > 0 and ma > pi * ds and gp = guaranteed payment; ma = the guaranteed minimum dollar amount; pi = partnership income before taking into account any guaranteed payment; ds = the partner’s distributive share of partnership income; and x = is the ratio of the basis of the property to be transferred to its fair market value. using the facts of the example previously described and assuming that the partnership wishes to satisfy the guaranteed payment through the transfer of an interest in property with a fair market value of $25,000 and a basis of $15,000 (in which case x would equal 0.6 ($15,000 divided by $25,000)), the guaranteed payment would be only $3,571 rather than $4,000, partnership income would be $21,429, and the partner’s distributive share of partnership income would be $6,429. in this case, the partnership would transfer to the recipient partner a 14.28% interest in the property with a value of $3,571 and a basis of $2,143. fortunately, all of the computational complications previously described can be easily avoided in the same manner that they are avoided in connection with the deduction of guaranteed payments in the determination of partnership income. in the example from the regulations, the facts provide that partnership income is determined ‘before taking into account any guaranteed payments.’ regs. § 1.707-1, example (2). thus, the deduction generated by the guaranteed payment is not considered for purposes of determining the amount of partnership income. in the absence of such a provision, the guaranteed payment would be deductible by the partnership in the determination of partnership income which would affect the amount of the guaranteed payment which would, in turn, affect the amount of the partnership’s income, and so on. the algebraic formula that would have to be applied to properly account for the deduction of any guaranteed payment in this situation is: gp = [ma (pi * ds)] / (1 ds) equation 3 where pi > 0 and ma > pi * ds and gp = guaranteed payment; ma = the guaranteed minimum dollar amount; pi = partnership income before taking into account any guaranteed payment; and ds = the partner’s distributive share of partnership income. 368 florida tax review [v0l.7:6 using the facts of the regulatory example described in note 89, supra, and assuming that partnership income is determined only after taking into account any guaranteed payment, the guaranteed payment would be $5,714, partnership income would be $14,286, and the partner’s distributive share of partnership income would be $4,486. if the complications that the deduction of any guaranteed payment would create can be avoided simply by providing that partnership income for purposes of calculating any guaranteed payment is determined “before taking into account any guaranteed payments,” such words could also easily be interpreted to avoid the complications of a requirement that the determination of any guaranteed payment take into account any gain or loss recognized on the transfer of partnership property in satisfaction of the guaranteed payment. in a footnote, kahn and cuenin acknowledge that “[t]he gain or loss from making the guaranteed payment would be excludable, for example, if the partnership provision that the partner is to receive a percentage of partnership income ‘computed before taking into guaranteed payments into account’ is construed to exclude a gain or loss recognized on the constructive sale of the distributed property as well as the deduction allowed for making that payment.” id. at n.61. significantly, however, they fail to suggest any reason why such a similar interpretation would somehow be improper. furthermore, if the words “before taking into account any guaranteed payments” apply to avoid the complications resulting from the deduction of a guaranteed payment, they should apply to any gain or loss on the transfer of property in satisfaction of a guaranteed payment when, unlike the deduction generated by a guaranteed payment for an accrual-method partnership, the transfer might not even occur in the partnership’s current taxable year. thus, no need to recompute the partnership’s income would actually arise. 92. kahn & cuenin, supra note 6, at 424-25. 93. kahn & cuenin, supra note 6, at 425. kahn and cuenin recognize that a similar burden arises under § 751, which requires gain or loss recognition in connection with certain distributions of partnership property. they conclude, however, that congress viewed this added administrative burden as justified in order to prevent the kahn and cuenin suggest that the complexity incurred by requiring the partnership to recognize gain or loss on the transfer of partnership property in satisfaction of a guaranteed payment is exacerbated if the partnership has an election in effect under section 754. after providing an92 example of the basis adjustments under section 743(b) resulting from an election under section 754, they assert that the administrative burden of complying with such a requirement could become significant. [i]f the partnership must recognize gain or loss on the guaranteed payment portion of the distributed property, not only will the inside basis of each asset that was distributed have to be apportioned between the guaranteed payment portion and the partnership distribution portion, but there would have to be a separate calculation and apportionment made for every partner’s share. especially when there are a sizeable number of partners, all of whom have special shares of inside basis, that could become burdensome.93 2006] the lazarus effect 369 potential shifting of characterization of income among partners. properly framed, the question then becomes whether the absence of a requirement for gain or loss recognition by the partnership presents a similar opportunity for abuse. see infra text accompanying notes 127-31. 94. kahn & cuenin, supra note 6, at 425, n.63. 95. kahn & cuenin, supra note 6, at 426-27. 96. see supra text accompanying notes 81-84. 97. kahn & cuenin, supra note 6, at 426 and 430-31. 98. kahn & cuenin, supra note 6, at 426, 433, n.77. in addition, the timing of any preserved gain is deferred of course, although this result occurs any time that a transfer of property is treated as a distribution of partnership property. id. at 433. kahn and cuenin fail to appreciate that their approach gives rise to yet another form of abuse, a partnership deduction in excess of any amounts previously included in the income of the partners. see infra text accompanying notes 128-30. however, in a footnote, kahn and cuenin acknowledge that the partnership will have to apportion the inside basis of the transferred assets between the guaranteed payment and the distribution portions of the transaction in order to determine the proper basis of the property in the hands of the recipient partner regardless of whether the partnership is required to recognize gain or loss. thus, the only additional administrative burden in94 requiring the recognition of gain or loss with respect to the property transferred to satisfy the guaranteed payment arises in determining each partner’s share of that gain or loss. the real question is whether this added level of complexity is appropriately attributable to a requirement to recognize gain or loss with respect to the in-kind guaranteed payment or simply one of a number of additional burdens that result from a partnership’s decision to make a section 754 election. only at this point in their analysis do kahn and cuenin finally address the real issue at hand: whether the treatment of a guaranteed payment as a distribution of partnership property entails any opportunity for abuse and whether a requirement that the partnership recognize gain or loss on the transfer of partnership property in satisfaction of a guaranteed payment might avoid such abuse. in other words, this inquiry attempts to determine if a95 compelling reason exists to rebut the presumption that a guaranteed payment will be treated as a distribution of partnership property under the statutory language of section 707(c). interestingly, kahn and cuenin acknowledge96 that the potential for abuse exists under their proposal if the partnership transfers appreciated property that would otherwise generate ordinary income if sold by the partnership to the recipient partner in satisfaction of a guaranteed payment. because the partnership level gain in the transferred property is preserved in the outside basis of the partners’ partnership interests under the approach advanced by kahn and cuenin, the potential exists that97 the preserved gain might be converted into capital gain on the sale of a partner’s interest.98 370 florida tax review [v0l.7:6 the treatment of an in-kind guaranteed payment as a distribution of partnership property also raises the curious result that, under § 735, the transfer of any unrealized receivables or inventory items as described in § 751(c) and 751(d), respectively, will give rise to ordinary income or loss on disposition (albeit only if disposed of within five years in the case of inventory items) by the recipient partner despite the fact that, under kahn and cuenin’s approach, he receives a fair market value basis in the property. see 2 willis, pennell & postlewaite, supra note 11, at ¶ 13.04. such a result seems inappropriate if the property is properly characterized as a capital asset in the hands of the partner since the characterization rules of § 735 are intended to prevent the conversion of ordinary income at the partnership level into capital gain at the partner level, principally with respect to pre-distribution gain. in addition, § 735 again demonstrates the extent to which congress is willing to impose restrictions on transactions that can result in the conversion of ordinary income into capital gain as a result of distributions of partnership property. 99. kahn & cuenin, supra note 6, at 426. 100. kahn & cuenin, supra note 6, at 426. 101. curiously, kahn and cuenin do not grapple with the question whether § 751 would actually apply to a transfer of property in satisfaction of a guaranteed payment, relying solely on a regulation suggesting that payments for services are immune from the application of § 751. kahn & cuenin, supra note 6, at 411-12 (citing although recognizing the potential for abuse, kahn and cuenin state that the possibility of such abuse “is not of sufficient significance to warrant both abandoning the principle of non-recognition that plays such a prominent role in subchapter k and embracing the administrative complexity that recognition will engender.” in addition, they state: 99 the choice available for the construction of the currently applicable provision is either to deny nonrecognition entirely to guaranteed payments or to accept the potential for shifting of characterization as a relatively minor cost of the benefit of having nonrecognition so that ordinary transactions of this nature are not deterred. the latter course seems far more desirable given the strong sentiment in subchapter k to allow nonrecognition so as to prevent the tax law from unnecessarily influencing legitimate business transactions.100 however, their position in this regard appears flawed for a number of reasons as discussed below. furthermore, they are not explicit in describing why the policy of non-recognition under subchapter k weighs more heavily on the decision-making scale than the concern over the potential for tax abuse. their only possible response in this regard would be based on a failure to rebut the implicit presumption that they earlier asserted exists under section 707(c). kahn and cuenin do acknowledge that congress enacted section 751 to prevent a similar type of potential abuse. they point out that the101 2006] the lazarus effect 371 regs. § 1.751-1(b)(1)(ii)). however, if a guaranteed payment is properly conceptualized as a distribution of partnership property, § 751 would be applicable if the transfer resulted in a disproportionate distribution of the partners’ rights to ordinary income assets. see 2 willis, pennell & postlewaite, supra note 11, at ¶ 14.02. alternatively, if the transfer of property in satisfaction of a guaranteed payment results in the recognition of gain or loss on the transfer by the partnership, § 751 is not implicated and the complexities to which kahn and cuenin allude can be avoided. 102. kahn & cuenin, supra note 6, at 426. kahn and cuenin cite only the 1986 statement of one commentator before a subcommittee of the house ways and means committee as evidence of the “severe criticism” surrounding § 751. id. at 426, n.64. 103. kahn & cuenin, supra note 6, at 426. they also state that a provision requiring the recognition of gain in connection with a guaranteed payment to the extent of any appreciation that would be taxed as ordinary income if sold could only be adopted through legislative amendment. id. at n.64. although the necessity for legislative action is probably correct if we were advocating such an approach, the third-party treatment that we propose, requiring the recognition of gain or loss by the transferring partnership regardless of its character, would not require legislative amendment. instead, it would require only the application of basic principles of the existing tax law as reflected in the sole proprietor paradigm. 104. kahn & cuenin, supra note 6, at 418, 426. see also supra text accompanying note 85. 105. kahn & cuenin, supra note 6, at 427. complexity engendered by section 751 has been the subject of “severe criticism” and that an interpretation of section 707(c) as requiring third-party treatment would also entail an element of complexity. as a result, they102 caution against an interpretation of section 707(c) that would introduce a “complex and cumbersome structure that [would prove] very difficult to administer.”103 however, the existence of section 751 cuts against their argument in this regard since it indicates a high degree of congressional tolerance for complexity to combat potential abuse. presumably, we should be more concerned about interpreting the code in a manner that will best effectuate the policies of subchapter k and basic tax principles than in avoiding104 “severe criticism.” given the doubts described above concerning the extent of any significant additional complexity that a gain or loss recognition requirement would entail, the balance may well fall in favor of preventing the potential for tax abuse. kahn and cuenin cite as illustrative of an asserted congressional preference for non-realization, even at the expense of potential conversion of ordinary income into capital gain, the basis adjustment rules under sections 108(b)(2)(e) and 1017 in connection with discharge of indebtedness income under section 108(a)(1)(b). they assert that these provisions create the105 possibility that a taxpayer may convert deferred discharge of indebtedness income that would otherwise be taxable as ordinary income into capital gain 372 florida tax review [v0l.7:6 106. they assert that such a result could occur because the regulations under § 1017 provide ordering rules under which the basis of property that would produce capital gain (or § 1231 gain) can be reduced to account for the discharge of indebtedness income excluded from gross income under § 108. regs. § 1.1017-1(a). 107. kahn & cuenin, supra note 6, at 427. 108. section 1017(d) requires that any property whose basis is reduced under § 1017 and that is not § 1245 or § 1250 property will be treated as § 1245 property and that a reduction under § 1017 is to be treated as a depreciation deduction. irc § 1017(d)(1). with respect to § 1250 property, the determination of what would have been the depreciation adjustments under the straight line method are made as if no basis reduction had been made under § 1017. irc § 1017(d)(2). “the effect of this rule is that if the property was actually depreciated on a straight line basis, there is additional depreciation, subject to recapture, equal to the § 1017 reduction.” boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts ch. 51.3.2, n.19 (3d ed., 2000). thus, any gain attributable to a basis reduction under § 1017 will be recaptured as ordinary income under any circumstances. 109. several commentators have reached a similar conclusion, albeit for a variety of reasons. mckee, nelson & whitmire, supra note 42, at ¶ 13.03[5]; sheldon i. banoff, “guaranteed payments for the use of capital: schizophrenia in subchapter k,” 70 taxes 820, 836-37 (1992). one commentator has noted that an in-kind guaranteed payment can be conceptualized as a cash payment in satisfaction of the guaranteed payment followed by a sale of the transferred property in a taxable transaction in exchange for the cash. id. at 836, n.122. in such a situation, the partnership would recognize gain or loss on the transfer. this is, of course, precisely the type of transaction that congress intended to be treated as a transaction with a third party under § 707(a)(2)(a). see infra text accompanying notes 156-62. to be recognized at a later date. at a minimum, they suggest that these106 provisions “indicate that congress is willing to allow ordinary income to be converted into capital gain in order to implement a system of nonrecognition.” however, kahn and cuenin appear to have overlooked the107 fact that section 1017(d) specifically requires that any gain resulting from a basis reduction under sections 108 and 1017 be recaptured as ordinary income. thus, sections 108 and 1017 may better serve to illustrate a108 congressional tolerance of non-recognition only when the shifting of the character of any gain can be avoided. to us, it would appear easier, more logical, and “better attuned” to congressional concerns regarding tax policy to conclude that under section 707(c) the transfer of partnership property in satisfaction of a guaranteed payment requires gain or loss recognition by the partnership rather than treatment as a distribution of partnership property. although there may be109 some additional administrative complexity as a result, this approach equates guaranteed payments with payments to a third party, payments with which most taxpayers are intimately familiar. even kahn and cuenin acknowledge that, under section 707(c), the references to sections 61(a), 162(a), and 263 are not exclusive: “entity treatment is applied in a few other circumstances, 2006] the lazarus effect 373 110. kahn & cuenin, supra note 6, at 427. 111. kahn & cuenin, supra note 6, at 428-36. 112. see supra text accompanying notes 47-48. 113. curiously, kahn and cuenin begin this section of their article with the observation that “the basis of the property received is important not only for its own sake, but also because that determination could influence the decision whether the partnership should recognize gain.” kahn & cuenin, supra note 6, at 428. unfortunately, their failure to revisit the implications of this observation means that they do not fully explore the opportunities for tax avoidance that their proposal entails. see infra text accompanying notes 129-30. 114. irc § 732(a)(1). the basis of the property received in a distribution by the partnership is limited to the partner’s basis in his partnership interest. irc § 732(a)(2). but only where it was needed to prevent results that would contravene basic tax principles.” as illustrated by the paradigm of the sole proprietor,110 compensatory in-kind transfers of property result in income to the recipient and (typically) a deductible expense to the payor, as well as the recognition of gain or loss by the payor with respect to the property transferred. clearly, the tax results in the sole proprietor paradigm are illustrative of “basic tax principles” under the code. the proposed non-recognition of gain or loss on the transfer of partnership property in satisfaction of a guaranteed payment, as advocated by kahn and cuenin, conflicts with these basic principles. d. basis of property received as a guaranteed payment having concluded that there is no gain or loss recognition to the partnership on the transfer of partnership property in satisfaction of a guaranteed payment, kahn and cuenin address the determination of the basis of the property received in the hands of the recipient partner. as previously111 described, they conclude that the recipient partner takes a fair market value basis in the property received. because the result of their approach is112 consistent with that under the sole proprietor paradigm, we can find no fault with their conclusion. their analysis, however, is another matter.113 because section 707(c) makes no reference to specific provisions of the code that would require third-party treatment in connection with the basis issue, the presumption employed by kahn and cuenin requires that the transferred property be treated as a distribution of partnership property generally resulting in a carryover basis for the property in the partner’s hands. to avoid this result and provide the property with a fair market114 value basis, kahn and cuenin attempt to identify a compelling reason for such a conclusion in order to rebut this presumption. they claim to have accomplished this objective through a capital account analysis demonstrating that a carryover basis for the transferred property would improperly account 374 florida tax review [v0l.7:6 115. kahn & cuenin, supra note 6, at 428-32. as described below, this analysis appears flawed. see infra text accompanying notes 138-49. 116. kahn & cuenin, supra note 6, at 432. 117. kahn & cuenin, supra note 6, at 433. 118. kahn & cuenin, supra note 6, at 433. 119. kahn & cuenin, supra note 6, at 433. see supra text accompanying notes 95-108. 120. kahn & cuenin, supra note 6, at 428-29. for the amount of income that the recipient partner would ultimately recognize on the subsequent disposition of his partnership interest.115 kahn and cuenin acknowledge that their approach, which does not require the recognition of gain or loss by the partnership and allows the recipient partner to receive a fair market value basis in the transferred property, preserves the appropriate amount of gain or loss as does a third-party approach in which gain or loss is recognized by the partnership and the transferred property takes a fair market value basis in the hands of the recipient partner. they claim the only difference between their116 proposal and the sole proprietor paradigm is the timing of the recognition of this gain or loss and the potential character of the gain or loss. under their proposal, the gain or loss attributable to the transferred property will not be recognized when the transfer is made but only at some later time when the partners dispose of their partnership interests. in addition, and as117 previously described, gain that would otherwise be taxable as ordinary income can be converted into capital gain if the property transferred would have generated ordinary income if sold by the partnership.118 despite these differences, kahn and cuenin revert to their previous discussion that promoting the policy goal of subchapter k to allow for the non-recognition of gain or loss on distributions of partnership property is more important than the “minor cost” associated with the conversion of ordinary income into capital gain. however, in dismissing this type of119 potential for abuse, they overlook another significant problem that their proposal entails. unlike typical distributions of partnership property, in which the unrecognized gain or loss is preserved in the property itself, the unrecognized gain or loss in the transferred property under their proposal is transferred to the partners’ partnership interests. in addition, because the transferred property receives a fair market value basis in the hands of the recipient partner, that partner can subsequently deal with the property free of any tax implications. these two facts, by themselves, create opportunities for abuse. this problem can be illustrated through the examples developed by kahn and cuenin. they describe a situation in which p, a general partnership, has three equal partners, a, b, and c. in year 1, p has neither120 2006] the lazarus effect 375 121. in their description of the facts of the example, kahn and cuenin state that the book value of each asset equals its fair market value. in addition, they focus on the partners’ capital accounts and assert that, because the book value of each asset equals its fair market value, the appreciation of each asset has already been included in the partners’ capital accounts. kahn and cuenin may have made the assumption that the book value of each asset equals its fair market value to simplify the explication of their analysis. in reality, this would be a most unusual situation because capital accounts are not adjusted except as authorized under the § 704 regulations. kahn and cuenin state only that “[u]nder certain specified circumstances, the book value of the partnership’s assets and the partners’ capital accounts can be written up or down to reflect a revaluation of the partnership’s assets.” kahn & cuenin, supra note 6, at 428, n.68 (citing regs. § 1.704-1(b)(2)(iv)(f)). while this general statement is correct, the difficulty is that a revaluation of all assets is not permitted under the circumstances that they are addressing, a distribution of partnership property. in such a situation, only the book value of the distributed asset would be written up or down to its current value. regs. § 1.704-1(b)(2)(iv)(f)(5)(ii). a further difficulty arises because of their unique interpretation that the transfer of the asset is not a distribution for purposes of determining the property’s basis. thus, it is far from clear that any book up would be available for any asset under their interpretation. confusingly, later in the article, they apply their analytical framework to a situation in which the book and fair market values of the distributed property differ and demonstrate that their approach is unaffected. kahn & cuenin, supra note 6, at 433-35. because the use of the partners’ capital accounts is unnecessary to the actual analysis, we have modified kahn and cuenin’s examples and refer only to the bases and fair market values of the partners’ partnership interests instead of referring to their capital accounts. net income nor net loss. in addition, the partnership has no liabilities. the121 bases and fair market values of the partnership’s assets and the partners’ partnership interests are as provided in figure 1. each partner has $10,000 of gain inherent in his partnership interest ($30,000 fair market value minus each partner’s $20,000 outside basis). figure 1 partnership’s assets and partners’ partnership interests prior to the guaranteed payment assets partnership interests ab fmv ab fmv cash $35,000 $35,000 a $20,000 $30,000 land 1 $10,000 $25,000 b $20,000 $30,000 land 2 $15,000 $30,000 c $20,000 $30,000 total $60,000 $90,000 total $60,000 $90,000 on december 31, year 1, p transfers land 2 to a as a guaranteed payment. under kahn and cuenin’s proposal, a has ordinary income of $30,000 and takes a basis in land 2 equal to its fair market value, $30,000. 376 florida tax review [v0l.7:6 122. see irc § 705(a)(2); regs. § 1.705-1(a)(3). 123. although each partner continues to have $10,000 of gain inherent in his partnership interest, the distribution of partnership property that would have resulted in ordinary income to the partnership if sold will result in the conversion of what would have been ordinary income into capital gain on the sale of the partnership interest. see supra text accompanying notes 95-108. 124. see kahn & cuenin, supra note 6, at 432. 125. see irc § 705(a); regs. § 1.705-1(a). 126. the character of this gain would be based on the type of property transferred to a in satisfaction of the guaranteed payment. thus, this approach would not result in a potential shift of the character of gain realized by the partners on the disposition of their partnership interests as compared with the approach proposed by kahn and cuenin. see supra note 123. in addition, p is allowed a deduction of $30,000. the deduction reduces each partner’s outside basis by $10,000. as a result, the bases and fair market122 values of the partnership’s assets and the partners’ partnership interests are as provided in figure 2. as can be seen, each partner continues to have $10,000 of gain inherent in his partnership interest ($20,000 fair market value minus $10,000 outside basis).123 figure 2 partnership’s assets and partners’ partnership interests under kahn and cuenin’s approach assets partnership interests ab fmv ab fmv cash $35,000 $35,000 a $10,000 $20,000 land 1 $10,000 $25,000 b $10,000 $20,000 total $45,000 $60,000 c $10,000 $20,000 total $30,000 $60,000 if the guaranteed payment is treated as a payment to a third party, the results are different. as under the kahn and cuenin proposal, a has124 ordinary income of $30,000 and takes a basis in land 2 equal to its fair market value, $30,000. however, p recognizes $15,000 of gain on the transfer and is allowed a deduction of $30,000. each partner is allocated a net deduction of $5,000 because the recognized gain increases each partner’s outside basis by $5,000 while the deduction reduces each partner’s outside basis by $10,000. as a result, the bases and fair market values of the125 partnership’s assets and the partners’ partnership interests are as provided in figure 3. as can be seen, each partner has only $5,000 of gain inherent in his partnership interest ($20,000 fair market value minus $15,000 outside basis). this reflects the fact that each partner has already accounted for $5,000 of gain attributable to the property transferred to partner a. as compared to126 2006] the lazarus effect 377 127. kahn and cuenin acknowledge the fact that “[i]deally, a partner’s share of the net unrealized appreciation of properties held by the partnership should be the same as the appreciation of the partner’s interest in the partnership . . . .” but note that this situation will not always exist as a result of §§ 734(a) and 743(a). kahn & cuenin, supra note 6, at 430. unfortunately, the adoption of kahn and cuenin’s approach will create yet another situation in which the tax results will diverge from the ideal. kahn and cuenin will have difficulty in claiming that the imbalance between the partners’ aggregate outside bases and the aggregate inside bases of the partnership’s assets could be cured through an adjustment to the bases of the partnership’s assets under § 734 if the partnership files a timely election under § 754. this is because an adjustment under § 734 is available only if the distributee partner recognizes gain or loss under § 731(a)(1) or § 731(a)(2) as a result of the distribution or the basis of the distributed property in the hands of the recipient partner differs from that of the property in the hands of the partnership as a result of the application of the basis limitations under § 732(a)(2) or § 732(b). irc § 734(b). because the recipient partner does not recognize gain or loss on the distribution of an in-kind guaranteed payment under § 731(a)(1) or § 731(a)(2) and takes a fair market value basis in the transferred property unaffected by the basis limitations of § 732(a)(2) or § 732(b), a basis adjustment under § 734(b) is unavailable under kahn and cuenin’s approach. the results under kahn and cuenin’s proposal, the third-party approach prevents both the deferral of income and the potential shift in the character of the gain from ordinary income to capital gain if the property transferred is a non-capital asset. figure 3 partnership’s assets and partners’ partnership interests under an entity approach assets partnership interests ab fmv ab fmv cash $35,000 $35,000 a $15,000 $20,000 land 1 $10,000 $25,000 b $15,000 $20,000 total $45,000 $60,000 c $15,000 $20,000 total $45,000 $60,000 in addition, and as shown in figure 2, kahn and cuenin’s approach leads to a discrepancy between the partners’ aggregate outside bases ($30,000) and the aggregate inside bases of p’s assets ($45,000). in their127 article, they acknowledge this fact but ignore its true significance. prior to the making of the guaranteed payment, there was $30,000 appreciation in both p’s inside assets and in the partners’ partnership interests. the appreciation in the partners’ partnership interests was unchanged by the payment, but $15,000 of p’s inside appreciation in land 2 378 florida tax review [v0l.7:6 128. kahn & cuenin, supra note 6, at 432. no similar discrepancy results under the third-party approach because the partners’ aggregate outside bases ($45,000) is equal to the aggregate inside bases of p’s assets ($45,000). thus, the gain inherent in the partners’ partnership interests is fully reflected in the partnership’s assets. transactions involving these assets will cause the partners to recognize neither excess or inadequate gain or loss. 129. see mckee, nelson & whitmire, supra note 42, at ¶ 13.03[5] (noting that “[i]nherent in the allowance of a market value deduction is the realization of gain or loss by the transferor of the property”). see also martin j. mcmahon, jr., “recognition of gain by a partnership issuing an equity interest for services,” 109 tax notes 1161 (2005) (describing the opportunity for tax arbitrage when a partnership is permitted a deduction equal to the value of any appreciated property transferred in return for the rendition of services without the concomitant recognition of gain). we recognize that the service has recently issued a proposed regulation providing that no gain or loss is recognized by a partnership on the transfer or substantial vesting of a compensatory partnership interest despite the fact that the transfer is treated as a guaranteed payment and the partnership is entitled to a deduction in connection therewith. prop. regs. § 1.721-1(b)(2). nevertheless, the proper treatment of compensatory partnership interests (assuming that no gain or loss recognition by the was removed from p and exists only as it continues to be reflected in the partners’ appreciation in their partnership interests. the total potential amount of gain to be recognized was not changed. there was $30,000 of potential gain before the payment was made, and the same amount afterwards.128 as a result, transactions involving the partnership’s assets will not fully account for the gain inherent in the partners’ partnership interests. for example, the partnership could sell land 1, resulting in p’s recognition of $15,000 of gain and causing each of the partners to report a distributive share of partnership income of $5,000. despite having liquidated the partnership’s assets, each of the partners will still have $5,000 of gain inherent in their partnership interests. the partners will only recognize this gain if the partnership is itself liquidated or the partners sell their partnership interests. although kahn and cuenin’s approach preserves the proper amount of gain in the partners’ partnership interests, this discrepancy creates the opportunity for abuse through the manipulation of basis. for example, under their proposal, a, b, and c have each obtained a $10,000 deduction, $5,000 of which is attributable to appreciation in value that, although preserved in the partners’ partnership interests, will not be subject to tax until the disposition of those interests. in effect, the partnership can use appreciated property to create deductions equal to the value of the transferred appreciated property without the partners suffering the burden of the corresponding gain recognition until some indefinite time in the future. deductions are typically not allowed on the transfer of appreciated property unless the taxpayer has previously taken the value supporting the deduction into income. thus,129 2006] the lazarus effect 379 partnership on the transfer of such an interest is the proper treatment) may be distinguishable from the proper treatment of the more typical situation involving guaranteed payments paid in return for the rendition of services since no actual transfer of partnership property occurs in the context of compensatory partnership interests. 130. kahn and cuenin end this portion of their article with an example in which the outside basis of the partner receiving the guaranteed payment is not equal to the partner’s share of the partnership’s aggregate inside bases of the partnership’s assets because the partner acquired the interest through either purchase or inheritance. kahn & cuenin, supra note 6, at 435-36. they proceed to demonstrate how, under their proposal, the transfer of appreciated partnership property to the partner in satisfaction of a guaranteed payment will allow the partner to avoid gain recognition on any subsequent sale of the property as well as any subsequent sale of his partnership interest. in the absence of a § 754 election, the partner would have been required to recognize his share of partnership gain had the property been sold by the partnership to a third-party. of course, the partner could have avoided any such gain if a § 754 election had been in effect. at the same time, the proper amount of gain for the remaining partners is unaffected. kahn and cuenin appear to be making the argument that their proposal has the benefit of avoiding gain recognition for such a partner when the partnership has not made a § 754 election and that third-party treatment of a guaranteed payment would not provide such a benefit. kahn & cuenin, supra note 6, at 439 (stating that “the deferral system that applies to the guaranteed payment is one that would actually cure a glitch in subchapter k in some circumstances, and so can be said to further tax policy rather than to hinder it” (footnote omitted)). however, their proposal has no effect in connection with any other assets held by the partnership so that, unless the partnership expects to transfer all of its property to the partner in satisfaction of a guaranteed payment obligation, the problems faced by the partner in the absence of a § 754 election cannot be avoided. instead of viewing this as a benefit of their proposal, it simply illustrates why a § 754 election is often of value to a partner acquiring a partnership interest by purchase or inheritance. it would seem to be of only minor significance that a particular approach to a question of statutory interpretation should be preferred to another approach when, under certain circumstances, the first approach alleviates in part kahn and cuenin’s proposal creates unacceptable tax shelter opportunities. in addition, a now has an asset, land 2, that can be disposed of without recognition of gain. kahn and cuenin may maintain, as they do with the potential abuse resulting from the conversion of ordinary income into capital gain, that this concern is simply a “minor cost” that must be tolerated to effectuate the policy of non-recognition on distributions of partnership property under subchapter k that they otherwise find compelling. however, a typical distribution of partnership property does not entail the creation of deductions that can be used to shelter other income nor does it result in a fair market value basis in the distributed property that allows the recipient partner to dispose of the property without tax implications. these distinctions seem, to us, to be sufficiently compelling to require third-party treatment in connection with all aspects of a guaranteed payment.130 380 florida tax review [v0l.7:6 a problem that the second approach does not when an election, freely available to all taxpayers regardless of which approach is adopted, may be made to fully resolve the precise problem at hand. 131. kahn & cuenin, supra note 6, at 428. 132. kahn & cuenin, supra note 6, at 419-22. actually, kahn and cuenin address this question before addressing the questions of the recognition of gain or loss by the partnership and the basis of the transferred property in the hands of the recipient partner. unlike the answers to the latter two questions, the answer to the question of the effect of an in-kind guaranteed payment on the recipient partner’s basis in his partnership interest appears not to raise issues that might have caused kahn and cuenin to reassess their conclusions regarding gain or loss by the partnership and the basis of the transferred property. see supra text accompanying notes 69-131. 133. irc § 733; regs. § 1.731-1. 134. see irc § 705(a)(2); regs. § 1.705-1(a)(3). kahn and cuenin note that the effect on the partner’s outside basis would be identical to the effect of the distribution on the partner’s capital account. kahn & cuenin, supra note 6, at 419 (citing regs. § 1.704-1(b)(2)(iv)(o)). at the beginning of the section addressing the basis determination for the property received in the hands of the recipient partner, kahn and cuenin observed that “the basis of the property received is important not only for its own sake, but also because that determination could influence the decision whether the partnership should recognize gain.” for the reasons131 articulated in this section of our article, as well as those in the previous section, we believe that gain or loss recognition by the partnership is a necessary consequence of in-kind guaranteed payments. e. effect on outside basis of guaranteed payments finally, kahn and cuenin address the effect of an in-kind guaranteed payment on the recipient partner’s basis in his partnership interest.132 because section 707(c) makes no reference to specific provisions of the code that would require third-party treatment in connection with this basis issue, the presumption employed by kahn and cuenin would require that the transferred property be treated as a distribution of partnership property generally, thus resulting in a reduction of the partner’s partnership interest in an amount equal to the basis of the transferred property. to avoid this133 result and conclude that no basis reduction results from the guaranteed payment (other than the partner’s share of the deduction associated with the guaranteed payment as provided under the regulations to section 705),134 kahn and cuenin attempt to identify a compelling reason for such a conclusion to rebut this presumption. as with the question involving the basis of the transferred property in the hands of the recipient partner, they claim to have accomplished this objective through a capital account analysis in which treating the transfer as a distribution of partnership property with a reduction in the basis of the recipient partner’s partnership interest equal to 2006] the lazarus effect 381 135. kahn & cuenin, supra note 6, at 419-22. but see infra text accompanying notes 138-55. 136. kahn & cuenin, supra note 6, at 421-22. 137. see supra text accompanying notes 67-68. the basis of the property in the hands of the partnership improperly accounts for the amount of income that the recipient partner should appropriately recognize.135 kahn and cuenin begin their analysis by examining a guaranteed payment paid in cash to reach their conclusion that no direct basis reduction is appropriate. they then extend the same treatment to in-kind payments without any further discussion. the important aspect of this analysis is that136 the same result is far more directly achieved through the application of the basic tax principles reflected in the sole proprietor paradigm. the question then becomes whether congress would have endorsed this more complicated analysis if, as kahn and cuenin acknowledge, it had paid any attention to in-kind guaranteed payments when drafting subchapter k. the complexity137 of the analysis (as well as the potential for abuse as described in the previous sections of this article) leaves us with significant doubts that it would. f. kahn and cuenin’s erroneous application of the modified aggregate approach before considering the implications of the enactment of section 707(a)(2) to the treatment of guaranteed payments under section 707(c), kahn and cuenin’s overall analysis must be revisited. as described above, they claim that (1) the partnership recognizes neither gain nor loss on the transfer of an in-kind guaranteed payment, (2) the basis of the transferred partnership property in the hands of the recipient partner is equal to its fair market value, and (3) the only adjustment in the recipient partner’s basis in his partnership interest resulting from a guaranteed payment is the partner’s share of the deduction generated by the guaranteed payment. to reach their first conclusion, they treat a guaranteed payment as a distribution of partnership property based on the limitations contained in the language of section 707(c). they depart from the language of section 707(c) to reach their second and third conclusions and claim to have compelling reasons to do so, largely because they assert that the appropriate results are otherwise impossible to achieve. however, consistent treatment of a guaranteed payment as both an allocation of partnership income and a distribution of partnership property will produce the appropriate results, albeit results different from those obtained by kahn and cuenin, who fail to follow through with their analysis based on the statutory language of section 707(c). if a guaranteed payment is treated as an allocation of partnership income followed by a distribution of partnership property, kahn and 382 florida tax review [v0l.7:6 138. see supra text accompanying notes 120-23. cuenin’s first conclusion that the partnership realizes neither gain nor loss on the transfer of an in-kind guaranteed payment is correct. however, their second and third conclusions do not follow from the first. instead, the basis of the transferred partnership property in the hands of the recipient partner should be a carryover basis from the partnership, consistent with the general rule applicable to distributions of partnership property, and the adjustments to the recipient partner’s outside basis similarly should follow the rules applicable to all allocations of partnership income and distributions of partnership property. kahn and cuenin’s analysis with respect to their second and third conclusions is based on a consideration of the economics of the transaction. to demonstrate the proper application of kahn and cuenin’s preferred interpretation of section 707(c), let us return to the example contained in their article and described above. p, a general partnership, has three equal138 partners, a, b, and c. in year 1, p has neither a net income nor a net loss. in addition, the partnership has no liabilities. the bases and fair market values of the partnership’s assets and the partners’ partnership interests are as provided in figure 1. (for convenience, figures 1 and 2 are reproduced below.) figure 1 partnership’s assets and partners’ partnership interests prior to the guaranteed payment assets partnership interests ab fmv ab fmv cash $35,000 $35,000 a $20,000 $30,000 land 1 $10,000 $25,000 b $20,000 $30,000 land 2 $15,000 $30,000 c $20,000 $30,000 total $60,000 $90,000 total $60,000 $90,000 on december 31, year 1, p transfers land 2 to a as a guaranteed payment. under kahn and cuenin’s proposal, a has ordinary income of $30,000 and takes a basis in land 2 equal to its fair market value, $30,000. in addition, p is allowed a deduction of $30,000. the deduction reduces each partner’s outside basis by $10,000. as a result, the bases and fair market values of the partnership’s assets and the partners’ partnership interests are as provided in figure 2. 2006] the lazarus effect 383 139. kahn & cuenin, supra note 6, at 432. 140. the modified aggregate approach described herein is intended to describe the treatment of a guaranteed payment under § 707(c) as originally enacted. it is an alternative to the pure aggregate approach that the courts generally applied in determining the tax treatment of partner salaries prior to the enactment of § 707(c). for further discussion of the pure aggregate approach and the modified aggregate approach, see infra note 149. kahn and cuenin’s approach is not reflective of either the pure aggregate approach or the modified aggregate approach. as described previously, kahn and cuenin’s approach is a strange hybrid, combining aspects of the modified aggregate approach and the entity approach. figure 2 partnership’s assets and partners’ partnership interests under kahn and cuenin’s approach assets partnership interests ab fmv ab fmv cash $35,000 $35,000 a $10,000 $20,000 land 1 $10,000 $25,000 b $10,000 $20,000 total $45,000 $60,000 c $10,000 $20,000 total $30,000 $60,000 according to their analysis, the amount of appreciation in each partner’s partnership interest, $10,000, is the same before the transfer ($30,000 fair market value minus $20,000 outside basis) as after the transfer ($20,000 fair market value minus $10,000 outside basis). if the basis of the transferred property in the hands of the recipient partner, a, is equal to its fair market value, a’s potential gain on the sale of both land 2 ($0) and his partnership interest ($10,000) will be the appropriate amount, $10,000. alternatively, if the basis of land 2 is $15,000, its basis in the hands of the partnership, they claim that a’s potential gain on the sale of both land 2 ($15,000) and his partnership interest ($10,000) will be $25,000. “clearly, a gain of $25,000 would be excessive.”139 but had kahn and cuenin adjusted the recipient partner’s basis in his partnership interest by treating the guaranteed payment as a distributive share of partnership income followed by a distribution of partnership property as they claim the explicit language of section 707(c) requires, a gain of $25,000 would not have arisen. we will refer to the treatment of a guaranteed payment in this manner as the “modified aggregate approach.” to140 appreciate all of the adjustments that must be made, the bases of the partners’ partnership interests must be considered at two points in time: (1) immediately following the determination of the guaranteed payment but prior to its payment and (2) immediately following the transfer of partnership 384 florida tax review [v0l.7:6 141. such an approach is consistent with the regulations under § 707(c) which recognize that an accrual-method partnership can make a guaranteed payment without making an actual transfer of money or property. regs. § 1.707-1(c) (second sentence). see gaines v. comm’r, t.c.memo. 1982-731, 45 t.c.m. (cch) 363 (noting that the absence of any actual payment does not affect the status of a transaction as a guaranteed payment under § 707(c)); pratt v. comm’r, 64 t.c. 203 (1975), aff’d in part, rev’d in part, 550 f.2d 1023 (5th cir. 1977). as a result, a guaranteed payment can be bifurcated into the two steps referred to in the text although the statutory language speaks only in terms of a single payment. 142. see irc § 705(a)(2); regs. § 1.705-1(a)(3). 143. see irc § 705(a)(1); regs.§§ 1.705-1(a)(2). see gaines v. comm’r, t.c. memo. 1982-731, 45 t.c.m. (cch) 363, n.17 (“as part of a partner’s distributive share of profit and loss, the guaranteed payments included in his income increase the partner’s basis in his partnership interest. sec. 705(a)(1) and (2).”). cf. rev. rul. 9126, 1991-1 c.b. 184 (accident and health insurance premiums paid by a partnership on behalf of its partners are includable in the partners’ gross incomes because the premiums are treated as a distributive share of partnership income under § 707(c)). 144. the existence of an unpaid guaranteed payment could be conceptualized in two ways. under the first approach (adopted in the text), the unpaid guaranteed payment could be reflected in the capital account of the service partner as simply a special allocation of partnership income. the partner’s capital account would be increased by the amount of the guaranteed payment/special allocation and then reduced by the fair market value of the partnership property distributed in satisfaction of the guaranteed payment. regs. §§ 1.704-1(b)(2)(iv)(b) and 1.704-1(b)(2)(iv)(e)(1). of course, the partner’s capital account would also be reduced by the partner’s share of the property in satisfaction of the guaranteed payment. this two-step analysis141 is appropriate regardless of the method of accounting adopted by the partnership. however, its application is more clearly illustrated by considering an in-kind guaranteed payment in the context of an accrual-method partnership and a cash-method partner in which the transfer of property in satisfaction of the guaranteed payment does not occur until the year following that in which the services giving rise to the guaranteed payment are rendered. assume that in year 1, a is entitled to a guaranteed payment of $30,000 for services rendered to an accrual-method partnership, but no transfer of partnership property occurs until year 2. for year 1, a has ordinary income of $30,000, and p is allowed a deduction of $30,000. the deduction reduces each partner’s outside basis by $10,000. in addition,142 treating the guaranteed payment as a distributive share of partnership income creates a $30,000 increase in a’s outside basis. as a result, the bases and143 fair market values of the partnership’s assets and the partners’ partnership interests are as provided in figure 2a. as can be seen, each partner continues to have $10,000 of gain inherent in his partnership interest ($50,000 fair market value minus $40,000 outside basis for a and $20,000 fair market value minus $10,000 outside basis for b and c).144 2006] the lazarus effect 385 deduction attributed to the guaranteed payment. regs. §§ 1.704-1(b)(2)(iv)(b). if the fair market value of the property distributed in satisfaction of the guaranteed payment exactly equals the amount of the guaranteed payment, the net effect on the partner’s capital account is a reduction equal to the partner’s share of the deduction attributed to the guaranteed payment. this is exactly the result dictated by the regulations in connection with guaranteed payments that are presumably paid in cash. regs. § 1.7041(b)(2)(iv)(o). see supra note 78. under the second approach, the unpaid guaranteed payment could be viewed as creating an obligation on the part of the partnership and a claim by the service partner against the assets of the partnership that must be satisfied before any liquidating distributions may be made to the partners based on the balances of their capital accounts. the partner’s claim would thus be analogous to that of a third party in a comparable situation. presumably, the obligation of an accrual-method partnership would create a liability for purposes of § 752 that would be allocable to the partners and result in an increase in the bases of their partnership interests. regs. § 1.752-1(a)(4)(i)(b). the $20,000 basis of each partner’s partnership interest (see figure 1) would be reduced by that partner’s share of the deduction attributable to the guaranteed payment and increased by that partner’s share of the resulting liability. in such a situation, the bases and fair market values of the partnership’s assets and the partners’ partnership interests would be as provided below. if, prior to the transfer of cash or property by the partnership in satisfaction of the guaranteed payment, one of the partner’s sold his partnership interest, that partner would have $10,000 of gain equal to the difference between the amount realized of $30,000 ($20,000 fair market value plus $10,000 relief of liability) and the $20,000 basis of his partnership interest. partnership’s assets/liabilities and partners’ partnership interests under the modified aggregate approach assets/liabilities partnership interests ab fmv ab fmv cash $35,000 $35,000 a $20,000 $20,000 land 1 $10,000 $25,000 b $20,000 $20,000 land 2 $15,000 $30,000 c $20,000 $20,000 total $60,000 $90,000 total $60,000 $60,000 liability ($30,000) net $60,000 although an unpaid guaranteed payment is conceptualized differently under the two approaches described above, the tax treatment of the guaranteed payment is not affected. the code and regulations are ambiguous on which conceptualization is preferred. however, to the extent that the regulations under §§ 704 and 752 would treat the guaranteed payment in a manner similar to a payment involving a third party, they serve as support for our argument that entity treatment of the guaranteed payment is more appropriate than the approach proposed by kahn and cuenin. we now turn our attention to the implications of the transfer of partnership property in satisfaction of the guaranteed payment. to do so, we first consider the implications of a $30,000 cash payment, rather than an 386 florida tax review [v0l.7:6 145. see irc § 733; regs. § 1.733-1. in-kind transfer of partnership property, in satisfaction of the guaranteed payment. if the guaranteed payment is treated as a distribution of partnership property, a’s outside basis will be reduced by $30,000. as a result, the145 bases and fair market values of the partnership’s assets and the partners’ partnership interests are as provided in figure 2b. as can be seen, each partner continues to have $10,000 of gain inherent in his partnership interest ($20,000 fair market value minus $10,000 outside basis). thus, the proper amount of income has been preserved for each partner. figure 2a partnership’s assets and partners’ partnership interests under the modified aggregate approach assets partnership interests ab fmv ab fmv cash $35,000 $35,000 a $40,000 $50,000 land 1 $10,000 $25,000 b $10,000 $20,000 land 2 $15,000 $30,000 c $10,000 $20,000 total $60,000 $90,000 total $60,000 $90,000 figure 2b partnership’s assets and partners’ partnership interests under the modified aggregate approach (cash payment) assets partnership interests ab fmv ab fmv cash $ 5,000 $ 5,000 a $10,000 $20,000 land 1 $10,000 $25,000 b $10,000 $20,000 land 2 $15,000 $30,000 c $10,000 $20,000 total $30,000 $60,000 total $30,000 $60,000 importantly, figure 2b is virtually identical to figure 2 except in two respects. first, the types of the partnership’s assets after the transfer are different because p distributed cash instead of land 2 to a to satisfy the guaranteed payment. second, and far more significant, there is no discrepancy between the partners’ aggregate outside bases ($30,000) and the aggregate inside bases of p’s assets ($30,000). as a result, transactions involving the partnership’s assets will fully account for the gain inherent in the partners’ partnership interests. for example, if p liquidates the 2006] the lazarus effect 387 146. see mckee, nelson & whitmire, supra note 42, at ¶ 13.03[5]; sheldon i. banoff, supra note 109, at 836. 147. see irc § 733; regs. § 1.733-1. 148. see irc § 732(a)(1); regs. § 1.732-1(a). partnership’s assets and realizes $30,000 of gain, this gain will account for all of the gain inherent in the partners’ partnership interests. now consider the implications if p satisfies the guaranteed payment by transferring land 2, property with a fair market value of $30,000, and the transfer is treated as a distribution of partnership property. a’s outside146 basis will be reduced by $15,000, the basis of land 2 in p’s hands. in147 addition, a will take a carryover basis of $15,000 in land 2. as a result,148 the bases and fair market values of the partnership’s assets and the partners’ partnership interests are as provided in figure 2c. figure 2c partnership’s assets and partners’ partnership interests under the modified aggregate approach (in-kind payment) assets partnership interests ab fmv ab fmv cash $35,000 $35,000 a $25,000 $20,000 land 1 $10,000 $25,000 b $10,000 $20,000 total $45,000 $60,000 c $10,000 $20,000 total $45,000 $60,000 like figure 2b, figure 2c is virtually identical to figure 2 except in two respects. first, like the results shown in figure 2b, there is no discrepancy between the partners’ aggregate outside bases ($45,000) and the aggregate inside bases of p’s assets ($45,000). as a result, transactions involving the partnership’s assets will again fully account for the gain inherent in the partners’ partnership interests. second, a’s outside basis is $25,000 rather than $10,000, which will result in a $5,000 loss if sold for $20,000. this basis and the resulting loss is appropriate, however, because a holds land 2 with a basis of $15,000 and a fair market value of $30,000. a’s potential gain on the sale of both land 2 ($15,000) and his partnership interest (a $5,000 loss) will be $10,000. b and c continue to have $10,000 of gain inherent in their partnership interests ($20,000 fair market value minus $10,000 outside basis). thus, each partner’s potential gain of $10,000 before the payment was determined remains the same following the transfer of the partnership property in satisfaction of the guaranteed payment. the benefit of treating the guaranteed payment consistently as a distributive share of partnership income and a distribution of partnership 388 florida tax review [v0l.7:6 149. the modified aggregate approach is, in our view, the approach most likely intended by congress when it originally enacted § 707(c). prior to the enactment of the 1954 code, salaries paid to partners were viewed as simply a special allocation of partnership income and a distribution of partnership property in the form of cash. this view prevailed because, under a pure aggregate theory of partnerships, a partner was considered as incapable of being an employee of the partnership. pauli v. comm’r, 11 b.t.a. 784 (1928) (concluding that an agreement between the partners to pay salaries only served as a basis for dividing partnership profits); estate of tilton, 8 b.t.a. 914 (1927) (“in effect any allowances drawn by a partner from partnership assets are payments which he makes to himself and no man can be his own employer or employee.”). but see wegener v. comm’r, 119 f.2d 49 (5th cir. 1941) (employing the entity theory of partnerships to require that a partner rendering services to a partnership include the full amount of compensation in income without reduction for any alleged self-paid portion thereof); sverdup v. comm’r, 14 t.c. 859 (1950) (compensation for services not considered as a distributive share of partnership income and, thus, excludable from gross income under § 116 of the 1939 code); toy v. comm’r, bta memo. 1442 (1942) (concluding that a partner was taxable on commissions he paid the partnership on acquisition of partnership property; partner’s share of commissions not a reduction in purchase price). the application of the pure aggregate theory can be illustrated through the following example. assume that a and b are members of the ab partnership in which a holds a 25% interest and b holds a 75% interest. in addition to a distributive share of partnership income, a is entitled to receive a salary of $30,000 each year. if the partnership income is $100,000 before taking into account a’s salary, a will receive a $47,500 distributive share of partnership income, made up of a $30,000 special allocation of partnership income equal to the specified salary plus $17,500, a’s distributive share of the partnership income ($70,000 after taking into account the special allocation times 25%). b will receive a $52,500 distributive share of partnership income ($70,000 after taking into account the special allocation times 75%). a’s distributive share of partnership income is the same as a salary of $30,000 plus a’s distributive share of the partnership income after treating the salary as a deductible expense. the same is true for b as well. problems with the pure aggregate theory arise, however, when partnership income is less than the salary payment in a particular year. under service rulings and judicial decisions prior to the enactment of the 1954 code, a partner’s salary in such a situation was considered to be comprised of the recipient partner’s distributive share of partnership income plus a return of capital shared between the two partners. lloyd v. comm’r, 15 b.t.a. 82 (1929), acq.; estate of tilton, 8 b.t.a. 914 (1927); rev. rul. 55-30, 1955-1 c.b. 430; g.c.m. 6582, viii-2 c.b. 200 (1929); g.c.m. 2467, viii-2 c.b. 188 (1928). see stout v. comm’r, 31 t.c. 1199 (1959), aff’d in part and remanded property is that, as compared to kahn and cuenin’s proposal, there is no necessity to depart from the language of section 707(c). in addition, the treatment of the guaranteed payment follows the general rules applicable to allocations of partnership income and distributions of partnership property. no special rules are necessary to properly determine either the basis of the transferred property in the hands of the recipient partner or the basis of the recipient partner’s partnership interest. 149 2006] the lazarus effect 389 sub nom., rogers v. comm’r, 281 f.2d 233 (4th cir. 1960) (applying pre-‘54 law). see also benjamin v. hoey, 139 f.2d 945 (1944) (partner not taxable on share of commissions paid to a partnership by the partner). the recipient partner’s share of his own return of capital was not taxable while the portion contributed by the other partners was treated as income to the recipient partner and a deduction for the other partners. the complications resulting from application of the aggregate theory in such a situation can be illustrated using the facts of the prior example. if the partnership income was only $20,000 in a particular year, a’s salary of $30,000 was considered to be comprised of all of the partnership income plus a return of capital shared between the two partners. a’s distributive share of partnership income would be $20,000 (the amount of the partnership’s income less than the salary amount). the $10,000 of salary in excess of a’s distributive share was considered as funded in the amount of $2,500 ($10,000 times 25%) from a’s contributed capital and $7,500 ($10,000 times 75%) from b’s contributed capital. thus, a had income of $27,500 ($20,000 distributive share of partnership income plus $7,500 of capital from b). a’s $2,500 return of capital was not taxable. b had a deduction of $7,500 (b’s share of capital transferred to a). of course, the calculations become more complicated if multiple partners receive a salary in such a situation. see lloyd v. comm’r, 15 b.t.a. 82 (1929). the complicated calculations described in the preceding paragraph could be vastly simplified by treating the salary as a deductible expense of the partnership. thus, if the partnership’s income were only $20,000 before accounting for the partner’s salary and partner a was entitled to a salary of $30,000, the partnership could be treated as having a loss of $10,000 ($20,000 partnership income $30,000 partner a’s salary), allocated $2,500 ($10,000 partnership loss times 25%) to a and $7,500 ($50,000 partnership loss times 75%) to b. thus, a would have net income of $27,500 ($30,000 from the salary paid $2,500 distributive share of partnership loss), and b would have loss of $7,500 ($10,000 partnership loss times 75%), the same results produced above. recognizing the equivalence in result between these two methods, congress probably only intended that § 707(c) incorporate the less complicated approach rather than the more complicated approach applicable under prior law. (we have referred to the more complicated approach applicable under prior law as the “pure aggregate approach” and to the less complicated approach as the “modified aggregate approach.”) this interpretation would explain the “but only” language of § 707(c) under which the entire amount of the partner’s salary is included in the partner’s gross income under § 61(a) (with no portion treated as a return of capital) and the partnership is allowed a corresponding deduction under § 162 (which had not been permitted under the pure aggregate approach). this interpretation would also explain the statements in the legislative history to the effect that the pre-1954 treatment of transactions between partners and partnerships was “unrealistic and unnecessarily complicated.” h.r. rep. no. 83-1337, at 68 (1954), reprinted in 1954 u.s.c.c.a.n. 4017, 4094. see arthur b. willis, handbook of partnership taxation § 11.05 (1st ed., 1957) (“the senate committee on finance suggests that one significant effect is to clarify the tax status of the situation where the guaranteed compensation paid to a partner exceeds partnership net income, computed before deducting compensation to the partners.” (footnote omitted)). unfortunately, the modified aggregate approach cannot be characterized as solely a simplified version of the pure aggregate approach because it does not reach the same results as the pure aggregate approach when the partnership has capital gain or tax 390 florida tax review [v0l.7:6 exempt income rather than, or in addition to, ordinary income. under the modified aggregate approach, no portion of the partner’s salary is treated as capital gain or tax exempt income although it would be under the pure aggregate approach. commentators at the time noted this inconsistency. id. at § 11.05, n.21; j. paul jackson, et al., supra note 44, at 1202. indeed, one group of commentators criticized § 707(c) as “inequitable in that it may deprive a partner of the tax benefits of capital gains or tax exempt interest.” id. at 1204. in addition, the two approaches are not the same if, under the modified aggregate approach, the partnership is required to capitalize the salary payment as if the payment had been made to a third-party when a distribution of partnership income under the pure aggregate approach would not be capitalized. curiously, a desire to keep the results under the modified aggregate approach as consistent as possible with the results under the pure aggregate approach may explain why § 263 was not included in § 707(c), along with §§ 61(a) and 162(a), as originally enacted. in suggesting that congress originally intended to implement the modified aggregate approach under § 707(c), we acknowledge the conflict thus created with our argument in this commentary that the entity theory should be applied to in-kind guaranteed payments. although the treatment of partner salaries by both a partner and the partnership under the modified aggregate approach is consistent with certain aspects of the entity theory, the modified aggregate approach was not viewed as the adoption of the entity theory but as only a restatement of the aggregate theory in simplified form. see willis, handbook of partnership taxation, supra at § 11.05 at 131 (“when it’ s all sifted down, the net effect of considering guaranteed compensation paid to a partner as made to one who is not a partner is quite innocuous and marks little change from prior law.”). see also j. paul jackson, mark h. johnson, stanley s. surrey & william c. warren, “a proposed revision of the federal income tax treatment of partnerships and partners – american law institute draft,” 9 tax l. rev. 109, 138-39, 177 (1954) (advocating the adoption of the entity theory in connection with transactions between partners and partnerships but only when the partner is not acting in his capacity as a partner). because § 707(c) represented a continuation of the aggregate approach, albeit in modified form, the aggregate theory should have continued to serve as the model for all other purposes including, presumably, in-kind guaranteed payments, at least until the enactment of § 707(a)(2)(a) in 1984. nevertheless, almost immediately following the enactment of subchapter k, § 707(c) was seen as incorporating the entity theory for most, if not all, purposes. see cagle v. comm’r, 63 t.c. 86 (1974) (requiring the capitalization of guaranteed payments prior to the amendments of § 707(c) in 1976 and referring to the “employment of the entity theory of partnerships in this facet of partnership taxation”), aff’d, 539 f.2d 409 (5th cir. 1976); rev. rul. 81-300, 1981-2 c.b. 143 (“[u]nder § 707(c), the partnership is considered an unrelated entity for purposes of §§ 61 and 162 . . .” ); j. paul jackson, et al., supra note 44, at 1201-02 (“the new law applies the entity concept not only to a partner’s transactions with his partnership when he is not acting in his capacity as a partner, but also to guaranteed annual payments of salary and interest.”). our ultimate conclusion that the entity theory should be applied in connection with in-kind guaranteed payments does not rely on this judicial and administrative “gloss,” however, but on the legislative enactment of § 707(a)(2)(a). see infra text accompanying notes 156-62. 2006] the lazarus effect 391 150. this concern has been noted by others. 1 mckee, nelson & whitmire, supra note 42, at ¶ 13.03[5]. of course, the results under kahn and cuenin’s proposal, the modified aggregate approach developed above, and the entity approach that we advocate differ with respect to both the timing and potentially the character of any resulting income, gain, deduction, or loss. the results are summarized below. kahn and cuenin’s approach year 1 tax implications for a $30,000 guaranteed payment – ordinary income ($10,000) deduction future tax implications for a $10,000 gain inherent in partnership interest $ 0 no gain or loss in land 2 modified aggregate approach year 1 tax implications for a $30,000 guaranteed payment – ordinary income ($10,000) deduction future tax implications for a ($ 5,000) loss inherent in partnership interest $15,000 gain inherent in land 2 entity approach year 1 tax implications for a $30,000 guaranteed payment – ordinary income ($10,000) deduction $ 5,000 share of gain on transfer of land 2 future tax implications for a $ 5,000 gain inherent in partnership interest the modified aggregate approach produces some potentially troubling results. first, the recipient partner receives a carryover basis in the transferred property despite the fact that she was taxed on the full fair market value of the property. as a result, she would realize additional income on a subsequent disposition of the property. however, this objection becomes150 questionable if the partner is viewed as taxed on the full fair market value of the services rendered and not on the full fair market value of the property ultimately transferred. in other words, the partner (as a provider of services) should be viewed as the recipient of cash from the partnership in return for the services rendered, which the partner (as a partner) immediately reconveys 392 florida tax review [v0l.7:6 151. we acknowledge that this response raises the difficulty of how a partner performing such services is acting, not as a partner, but as a third-party provider of services if § 707(c) applies only when the partner is acting in the capacity of a partner. that difficulty, however, is a result of the legislative shift in the definition of capacity under § 707(a)(2)(a) without a full appreciation of its implications for guaranteed payments under § 707(c). 152. such an interpretation is not consistent with the capacity analysis of § 707(a)(2)(a), however, which views the rendition of services, the allocation of partnership income, and the distribution of partnership property in such a situation as all parts of a related transaction to be treated as a transaction between the partnership and a non-partner under § 707(a)(1). this inconsistency illustrates the irreconcilability of §§ 707(a)(2)(a) and 707(c) and the reason why we called for the repeal of § 707(c) in our earlier article. postlewaite & cameron, supra note 2, at 694-96. 153. see supra text accompanying notes 129-30. 154. one is reminded of jacob rabkin and mark johnson’s admonition, “[i]f it were a matter of redrafting the partnership tax law, perhaps as good a case can be made for one theory as the other. one of them, however, must be consistently applied.” jacob rabkin & mark h. johnson, “the partnership under the federal tax law,” 55 harv. l. rev. 909, 949 (1942), quoted in mark p. gergen, “the story of subchapter k” in business tax stories 221 (steven a. bank & kirk j. stark eds., 2005). to the partnership as a contribution of capital. the subsequent distribution151 of property in satisfaction of the guaranteed payment is viewed as separate and independent of the previous rendition of services. the partner is treated as acting as a third party with respect to the rendition of services and as a partner with respect to the distribution of property. such an approach is consistent with the statutory language of section 707(c). 152 the modified aggregate approach also raises the same problem as kahn and cuenin’s approach because the partnership is permitted a deduction equal to the full fair market value of the property transferred (or the services rendered if one prefers). in effect, the partnership can use153 appreciated property to create deductions equal to the value of the appreciated property involved without the partners suffering the burden of the corresponding gain recognition until some indefinite time in the future. thus, the modified aggregate approach creates the same opportunities for tax shelter abuses that are created by kahn and cuenin’s approach. despite the potential objections to each approach, the issue now is a choice between, not two, but three differing interpretations of section 707(c). which is the proper approach? we believe that kahn and cuenin’s proposal is the least acceptable. it is least consistent with the statutory language and combines both entity and aggregate concepts in a manner that creates opportunities for abuse as previously described. alternatively, both the154 modified aggregate approach and the entity approach can be supported by various aspects of the statutory language, the legislative history, and the regulations surrounding section 707(c), as well as statements contained in 2006] the lazarus effect 393 155. one commentator acknowledges that the modified aggregate approach produces the proper amount of income over the life of the partnership for the partners (as do the other two methods) but results in timing differences. mckee, nelson & whitmire, supra note 42, at ¶ 13.03[5]. nevertheless, they reject this approach as inconsistent with the language of § 707(c) and open to uncertainty and complexity when applied in conjunction with other sections of subchapter k. 156. we apologize to the readers who have followed our discussion up to this point but who are only interested in the final answer to the legal question regarding the proper treatment of in-kind transfers to partners for the rendition of services, transfers that are typically, albeit improperly, referred to as guaranteed payments (assuming that the term “guaranteed payments” is reserved solely for payments falling within § 707(c)). 157. postlewaite & cameron, supra note 2. 158. see supra text accompanying notes 31-39. judicial decisions both before and after 1954. fortunately, there is no155 reason to debate the question regarding the application of the modified aggregate approach or the entity approach because congress resolved any controversy through the enactment of section 707(a)(2) in 1984. g. the application of section 707(a)(2)156 although we believe that the foregoing discussion more than adequately demonstrates the superiority of treating in-kind guaranteed payments as transfers to a third-party for all purposes, as opposed to the approach advocated by kahn and cuenin that treats in-kind guaranteed payments as a distribution of partnership property for some purposes and as a payment to a third-party for other purposes, this debate is largely, if not completely, academic. congress addressed and resolved this issue through the enactment of section 707(a)(2) as part of the tax reform act of 1984. as a result of the enactment of section 707(a)(2), congress effectively repealed section 707(c) and decided that the types of guaranteed payments that kahn and cuenin describe in their article should be treated as payments to a third party under section 707(a). the enactment of section 707(a)(2) was the motivation for our earlier article. our conclusion that congress effectively157 repealed section 707(c) is applicable to both cash and in-kind guaranteed payments. congress effectively repealed section 707(c) through its redefinition of the concept of capacity under section 707(a). as previously described,158 section 707(a)(2) requires third-party treatment for any partner who renders services or transfers property to a partnership and who thereafter receives a related direct or indirect allocation and distribution if such transfers are “properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the 394 florida tax review [v0l.7:6 159. in the context of guaranteed payments, the “related allocation” for purposes of § 707(a)(2) is the allocation of income attributable to the guaranteed payment and the “related distribution” is the cash or property transferred by the partnership in satisfaction of the guaranteed payment. this conceptualization of guaranteed payments as an allocation and distribution of partnership income is consistent with the modified aggregate approach described above. 160. s. rep. no. 98-169, at 227 (1984); regs. §§ 1.707-3, 1.707-4, 1.707-5, and 1.707-6. see also staff of the joint comm. on tax’n, general explanation of h.r. 4170, 227-28 (1984). 161. the congressional reversal of the conclusion in revenue ruling 81-300, 1981-2 c.b. 143, that fees for managerial services based on the gross rentals of the partnership should be treated as payments under § 707(a), rather than § 707(c), illustrates the dramatic effect of the enactment of § 707(a)(2). s. rep. no. 98-169, at 230 (1984). see also staff of the joint comm. on tax’n, general explanation of h.r. 4170, 230-31 (1984). 162. see postlewaite & cameron, supra note 2, at 691-93. of course, if the transfer is expressly dependent on the income of the partnership, the transfer will not fall within § 707(c) because it would not be “determined without regard to the income of the partnership” and, thus, would be excluded from § 707(c). conversely, if not dependent on the income of the partnership, the transfer would not be subject to the entrepreneurial risks of the partnership and, thus, would be included under § 707(a). as a consequence, little, if anything, continues to fall within § 707(c). as we cautioned in our earlier article, § 707(c) has been effectively repealed. partnership.” in making this determination, the legislative history and159 subsequent regulations focus on the entrepreneurial risk to which the partner is exposed in connection with the amount of any related distribution and whether the distribution will, in fact, be made. this new definition of160 capacity represented a dramatic shift from the earlier definition that examined the connection between the types of services performed by the partner and the activities in which the partnership was engaged. under this revised definition of capacity, virtually all transfers from a partnership to a partner for the rendition of services, whether in cash or in-kind, will receive third-party treatment under section 707(a) unless the transfer, with respect to both the fact and the amount of payment, is subject to the entrepreneurial risk of the partnership. as we stated in our earlier161 article, it is difficult to envision a transfer for the rendition of services by a partner that, unless expressly dependent on the current or future income of the partnership, could somehow be subject to the entrepreneurial risk of the partnership. certainly, the types of transfers discussed by kahn and162 cuenin in their article would not be subject to the entrepreneurial risk of the partnership and, thus, would be treated under section 707(a) as a payment to a third party. accordingly, there is no need to engage in the complicated analysis advocated by kahn and cuenin. because kahn and cuenin did not consider the dramatic change in the concept of capacity introduced by the enactment of section 707(a)(2), 2006] the lazarus effect 395 163. kahn & cuenin, supra note 6, at 436-38. 164. philip f. postlewaite & adam h. rosenzweig, “anachronisms in subchapter k of the internal revenue code: is it time to part with § 736?,” 100 northwestern l. rev. 379 (2005). see also walter d. schwidetzky, “hyperlexis and the loophole,” 49 okla. l. rev. 403 (1996); john a. lynch, jr., “taxation of the disposition of partnership interests: time to repeal irc § 736,” 65 neb.l. rev. 450 (1986); philip f. postlewaite, thomas e. dutton & kurt r. magette, “a critique of the ali’s federal income tax project – subchapter k: proposals on the taxation of partners,” 75 geo. l. j. 423 (1986). 165. kahn & cuenin, supra note 6, at 436. they erroneously assumed that section 707(c) remains alive and well. this was the precise concern that we addressed almost 20 years ago, and the reason why we have expectantly waited for some official recognition that section 707(c) represented only a trap for the unwary. iv. liquidating distributions in the concluding section of their analysis, kahn and cuenin consider the implications of in-kind guaranteed payments in the context of liquidating distributions under section 736. section 736 is a complicated163 and confusing aspect of subchapter k with a questionable policy basis when enacted in 1954 that has been significantly undermined since that time as a result of amendments to both subchapter k and the code more generally. because of the problems inherent in section 736, one of us has called for its repeal in a separate article. consequently, the difficulties that arise in164 considering the implications of in-kind guaranteed payments under section 707(c) are only compounded in the context of section 736. essentially, kahn and cuenin incorporate their conclusions with respect to guaranteed payments under section 707(c) into section 736 without significant additional analysis. they simply assert that a partnership recognizes no gain or loss on the transfer of partnership property to a partner in liquidation of that partner’s partnership interest and that the partner takes a fair market value basis in the property received regardless of whether the payment falls within section 736(a) or section 736(b). however, kahn and165 cuenin apparently ignore the fact that the context of transfers under section 736 is significantly different from that of section 707(c). most importantly, transfers under section 736 are not part of a reciprocal relationship between the partner and the partnership involving the rendition of services or the use of capital. this difference, by itself, influences the analysis of the proper treatment of such transfers. although section 736 explicitly refers to guaranteed payments under section 707(c), this reference may not incorporate all of the particular details of such payments as discussed above for the purposes of liquidating distributions. 396 florida tax review [v0l.7:6 166. see also postlewaite & cameron, supra note 2, at 707-08 (describing how guaranteed payments structured as a percentage of partnership income subject to a minimum amount may not be determined in the same manner under § 736(a) as under § 707(c)). 167. cagle, 63 t.c. at 95 (1974) (footnote omitted). 168. s. rep. no. 94-938, 94, n.7 (1976), reprinted in 1976 u.s.c.c.a.n. 3439, 3530, n.7. see regs. § 1.707-1(c) (specifically stating that the reference to § 263 contained in § 707(c) “does not affect the deductibility to the partnership of a payment described in § 736(a)(2) to a retiring partner or to a deceased partner’s successor in interest”). an example of the differences that exist between the treatment of guaranteed payments under section 707(c) and those under section 736 is the requirement that guaranteed payments under section 707(c) are subject to the capitalization requirements of section 263. prior to the amendment of166 section 707(c) in 1976 explicitly subjecting guaranteed payments to the capitalization requirements of section 263, the tax court reached the same conclusion but cautioned that its decision for purposes of section 707(c) might not apply for purposes of section 736. in deciding that the section 707(c) payment herein must run the gauntlet of section 162(a) in order to be deductible, we expressly reserve determination of a similar question under section 736(a)(2) and think that no inference should be drawn from the decision in the instant case. see sec. 1.736-1(a)(4), income tax regs. 167 thus, the tax court recognized that the different policy justifications for sections 707 and 736 may require different approaches to the treatment of guaranteed payments under each section. the court’s perceptiveness in this regard was prescient of congressional intent when congress amended section 707(c) to clarify that the capitalization requirements of section 263 applied to guaranteed payments. congress specifically directed in the legislative history that the amendment to section 707(c) “is not intended to adversely affect the deductibility to the partnership of a payment described in section 736(a)(2) to a retiring partner.” consequently, the history of the168 relationship between sections 707 and 736 suggests that caution should be exercised when assuming that all aspects of section 707(c) apply in the context of section 736(a)(2) payments treated as guaranteed payments. we conclude that the treatment of in-kind guaranteed payments under section 736, a provision with a narrow statutory focus and legislative purpose, is not identical to that under section 707(c). instead, the reference to guaranteed payments under section 736 was intended only to resolve questions regarding the characterization of income by the recipient partner and the deductibility of such transfers by the partnership. section 736 does 2006] the lazarus effect 397 169. irc §§ 736(a) and 736(b)(1). see kahn & cuenin, supra note 6, at 437. 170. irc § 736(b)(3). as originally enacted in 1954, § 736(b) permitted the treatment of payments for unrealized receivables and unspecified goodwill as payments under § 736(a) regardless of the type of partnership or partner involved. congress enacted the restrictions currently imposed under § 736(b)(3) in 1993. see 2 willis, pennell & postlewaite, supra note 11, at ¶¶ 15.02 and 15.03. 171. irc § 736(b)(2). 172. irc § 736(a). 173. irc § 736(a)(1). 174. irc § 736(a)(2). in our earlier article proposing the repeal of § 707(c), we suggested that payments in excess of those in exchange for the withdrawing partner’s interest in partnership property under § 736(b) and determined without regard to partnership income be treated as a payment under § 707(a)(1) as made to a partner other not address the question of whether the partnership must recognize gain or loss on the transfer of partnership property in satisfaction of a guaranteed payment. the answer to that question depends on an independent analysis of the implications of guaranteed payments in the specific context of liquidating distributions. a. application of section 736 to liquidating distributions section 736 applies to distributions in liquidation of a partner’s interest in a partnership. as kahn and cuenin explain, section 736 divides such distributions into two categories: section 736(b) applies to distributions in exchange for the partner’s interest in partnership property while section 736(a) applies to all other distributions. importantly, section 736(b) does169 not apply to unrealized receivables held by the partnership or to goodwill of the partnership provided that (1) capital is not a material income-producing factor for the partnership and (2) the retiring or deceased partner was a general partner in the partnership. in other words, distributions in170 exchange for a partner’s interest in unrealized receivables and goodwill are not treated under section 736(b) if the distribution is in liquidation of a general partner’s interest in a service partnership. the exclusion from section 736(b) for distributions with respect to partnership goodwill is subject to the additional requirement that the partnership agreement must not otherwise provide for payments with respect to goodwill.171 distributions that are not treated as made in exchange for the partner’s interest in partnership property are treated under section 736(a) either as a distributive share of partnership income or as a guaranteed payment. such distributions constitute a distributive share of partnership172 income if the amount of the distribution is determined with regard to partnership income. alternatively, such distributions are treated as a173 guaranteed payment described in section 707(c) if the amount of the distribution is determined without regard to partnership income.174 398 florida tax review [v0l.7:6 than in his capacity as a member of the partnership. postlewaite & cameron, supra note 2, at 705-09. such an approach is consistent with the revised capacity analysis introduced by § 707(a)(2) that considers the risk as to the fact and the amount of the payment in determining the capacity in which a partner is acting. payments in liquidation of a partner’s interest in a partnership that are determined without regard to partnership income bear no risk with respect to the amount of the payment and presumably bear risk similar to that of a payment to a third-party with respect to the fact of payment. the need to treat liquidating payments under § 736(a)(2) as guaranteed payments in order to specify the characterization and timing of such payments could be easily provided by § 707(a)(1). 175. as stated in the legislative history: the amounts paid for the capital interest of the withdrawing partner are treated in the same manner as a distribution. the remaining partners, of course, are allowed no deductions for such payments. essentially, these payments represent a purchase by the remaining partners of the withdrawing partner’s capital interest in the partnership. h.r. rep. no. 83-1337, at 72 (1954), reprinted in 1954 u.s.c.c.a.n. 4017, 40948. see s. rep. no. 83-1622, at 97 (1954), reprinted in 1954 u.s.c.c.a.n. 4621, 4730. 176. part of the rationale for treating such distributions as ordinary income to the withdrawing partner combined with a current deduction to the remaining partners was the view that such distributions were in the nature of deferred compensation upon the partner’s retirement for services previously rendered. the legislative history for § 736 specifically anticipated a retirement payout function for § 736. the legislative history states: where a retiring partner receives a lump sum or fixed payments determined without regard to the income of the partnership, the portion of such payments attributable to the capital interest of the retiring partner is to be treated as the purchase of a capital interest by the remaining partners. the balance, however, will be treated like a salary paid by the partnership. it will constitute ordinary income to the recipient and a deduction to the partnership. . . . this distinction between distributions under sections 736(a) and 736(b) means that different tax results arise depending on the category in which the distribution falls. distributions under section 736(b) are effectively treated as an acquisition by the remaining partners of the withdrawing partner’s interest in the partnership property. to the extent that gain is175 recognized on the distribution, the withdrawing partner typically receives capital gain treatment, and the remaining partners are not permitted a deduction in connection with the distribution. on the other hand, distributions under section 736(a) typically result in ordinary income to the withdrawing partner and a reduction in the remaining partners’ share of partnership income. 176 2006] the lazarus effect 399 thus, to the extent that payments to a retiring partner or deceased partner’s successor are not in exchange for a capital interest, they are treated as deductions to the remaining partners and as income to the withdrawing partner or his successor irrespective of over how long a period they may be paid. . . . s. rep. no. 83-1622, at 98 (1954), reprinted in 1954 u.s.c.c.a.n. 4621, 4731. 177. of course, this result was even more egregious prior to the enactment of § 197 in 1993 when all other taxpayers were prohibited from amortizing goodwill under § 167. interestingly, even if the distribution falls under § 736(b) because the goodwill is specified in the partnership agreement, the remaining partners may be permitted to amortize the withdrawing partner’s share of the partnership goodwill under § 197. if the partnership makes a § 754 election and the anti-churning rules do not apply, the remaining partners may amortize the goodwill payments over a 15-year period under § 197(f)(9)(e). 178. kahn & cuenin, supra note 6, at 436. as a result, kahn and cuenin note that the issues and disputes involving in-kind guaranteed payments are most likely to arise in the context of liquidating distributions. id. at 37. the most disturbing aspect of section 736 lies in the fact that service partnerships may treat distributions in exchange for a general partner’s interest in the goodwill of the partnership as a distribution under section 736(a) rather than section 736(b). although such distributions will effectively be taxed as ordinary income to the withdrawing partner, they will give rise to an immediate deduction to the partnership. consequently, partners in service partnerships are effectively able to currently deduct payments for the purchase of goodwill from a withdrawing partner while all other taxpayers confront a unified regime under section 197 that requires the amortization of acquired goodwill over a 15-year period.177 b. in-kind guaranteed payments under section 736(a) kahn and cuenin begin their consideration of in-kind guaranteed payments under section 736(a) by suggesting that, although such payments are unusual in the section 707(c) context because payments are typically made in cash, in-kind guaranteed payments will “occur far more frequently” in the liquidation context under section 736. we question whether this178 assertion is accurate. liquidating distributions arise in two distinct situations: the liquidation of the partnership as a whole, in which the enterprise terminates, and the liquidation of a single partner, in which the partnership continues its partnership operations. when terminated, the partnership will liquidate either by selling the assets and distributing the sales proceeds or by distributing the assets in-kind. if the partnership liquidates by selling its assets, the issue of in-kind payments under section 736(a) will not arise because only cash is distributed. alternatively, if the partnership liquidates by distributing its 400 florida tax review [v0l.7:6 179. kahn & cuenin, supra note 6, at 438. the omnipresence of § 1245 depreciation recapture, an unrealized receivable for purposes of § 751(b), given the availability of expensing and rapid amortization and depreciation under §§ 168, 179, and 197 suggests that kahn and cuenin’s assertion may be exaggerated. 180. as one of us has cautioned elsewhere, in-kind distributions under § 736 involve numerous problems that can be avoided through the use of cash distributions. “if any generalizations can be made, it is that fewer problems exist if property (other assets in-kind, the partnership will likely distribute the assets on a pro rata basis to the members of the partnership in accordance with their economic interests in the partnership. in this situation as well, the issue of in-kind guaranteed payments will not arise because none of the partners will receive payments, in cash or in-kind, for their interests in unrealized receivables or partnership goodwill, which is necessary in order to implicate section 736(a). instead, they will simply receive their individual share of the partnership’s assets. thus, no portion of the transaction would be subject to section 736(a). the only setting in which section 736(a) might be implicated in a complete liquidation of a partnership would occur in a non-pro rata distribution of the partnership’s assets. importantly, non-pro rata distributions of the partnership’s assets in a complete liquidation would have to run the gauntlet of section 751(b), notwithstanding kahn and cuenin’s assertion that “section 751(b) is rarely invoked” in the context of liquidating distributions. nevertheless, in this very limited circumstance, the issue of179 in-kind distributions under section 736(a) may arise. similar considerations attend the liquidation of a partner’s partnership interest by an ongoing partnership. kahn and cuenin assert that “it is common for the liquidation of a partner to include a premium,” in which case the premium may well constitute a guaranteed payment under section 736(a)(2). however, since most such payments would presumably be made in cash, the issue of in-kind guaranteed payments under section 736 would not arise. cash payments presumably occur in the vast majority of situations involving liquidating distributions to a single withdrawing partner because the partnership presumably needs its assets in order to continue conducting business. in addition, distributions of the withdrawing partner’s pro rata share of his assets would not implicate section 736(a)(2) as discussed above. non-pro rata distributions could be subject to section 736(a)(2) but would first have to work their way through the potential application of section 751(b). thus, contrary to kahn and cuenin’s assertion, it appears that in-kind guaranteed payments may not be as frequently encountered in the liquidation context as they suggest. this observation strongly cautions against any conclusion that in-kind guaranteed payments under section 736 warrant special consideration and a possible deviation from fundamental principles of sound tax policy.180 2006] the lazarus effect 401 than money) is not distributed as a § 736(a) payment. in actual practice, the business realities of the situation may dictate the easier approach because many of the assets will be essential to the partnership’s continuing business operation and are unlikely to be distributed.” 2 willis, pennell & postlewaite, supra note 11, at ¶ 15.06[4]. 181. irc § 736(a). 182. see supra text accompanying notes 31-39 and 156-62. 183. kahn & cuenin, supra note 6, at 417. indeed, one group of early commentators on the implications of subchapter k noted that “§ 736(a) apparently applies only to cash payments.” j. paul jackson, et al., supra note 44, at 1225, n.81. the regulations under § 736 as originally proposed provided that payments under § 736(a) be made in cash. prop. regs. § 1.736-1(a)(2), available in notice of proposed rulemaking, 20 fed. regs. 5,871 (1955) (providing that “[a] distribution of property does not qualify as a payment under § 736. payments under § 736 must be in money . . . .”). however, the final regulations removed this requirement. 184. presumably, congress believed that distributions under § 736(a) were made to the withdrawing partner in his capacity as a member (albeit a former member) of the partnership. the fact that congress changed the capacity analysis under § 707 from a focus on the activities of the partner giving rise to the allocation and distribution turning to the question of the proper treatment of in-kind guaranteed payments under section 736, if and when they do arise, an in-depth analysis like that provided above in the context of in-kind guaranteed payments under section 707(c) is required. the first aspect of this analysis requires a consideration of the language of section 736(a)(2) itself. in referring to guaranteed payments, section 736(a) states that “payments made in liquidation of the interest of a retired or deceased partner shall . . . be considered . . . as a guaranteed payment described in section 707(c) if the amount thereof is determined without regard to the income of the partnership.” this language appears to treat distributions that fall within181 section 736(a)(2) as guaranteed payments without regard to the issues previously discussed concerning the application of section 707(c) when a payment is made to a partner deemed to be acting in the capacity of a partner. apparently, no consideration is to be given to the issue of risk as182 to the fact or the amount of the payment that is required for purposes of section 707(c) as a result of the enactment of section 707(a)(2). however, we do not believe that the capacity analysis of section 707(a)(2) should be ignored in the context of section 736(a), particularly when considering the treatment of in-kind guaranteed payments. although kahn and cuenin do not reiterate the point that congress probably gave little, if any, thought to in-kind guaranteed payments under section 707(c), we suggest that congress gave even less thought (if that is possible) to in-kind guaranteed payments in the context of section 736.183 consequently, in attempting to divine “congressional intent” regarding the proper treatment of in-kind guaranteed payments under section 736, we should not disregard subsequent legislative developments under section 707. assuming that a “guaranteed payment” under section 736(a)(2) is184 402 florida tax review [v0l.7:6 to the entrepreneurial risk surrounding the allocation and distribution should be a factor in determining the proper application of § 736(a). 185. see supra text accompany notes 120-29 and 138-49. unfortunately, kahn and cuenin provide no such analysis in this portion of their article. 186. see supra text accompanying notes 120-23. the only modifications to facilitate the analysis of § 736 are an increase in the fair market value of land 1 from $25,000 to $35,000 and a reduction in the fair market value of land 2 from $30,000 to $20,000. 187. irc §§ 736(b)(1) and 731(a)(1). limited as to risk, such a payment should presumably be treated as a payment to a third party, requiring the recognition of gain or loss to the transferor partnership. an in-depth analysis to determine the proper treatment of in-kind guaranteed payments under section 736 next requires a consideration of hypothetical situations and an examination of the bases and fair market values of the partnership’s assets and the partners’ partnership interests following the approach described above. to do so, let us again return to185 the example posed by kahn and cuenin earlier in their article and described above, but this time with certain modifications to facilitate the analysis of section 736. p, a general partnership, has three equal partners, a, b, and c.186 in year 1, p has neither net income nor net loss. in addition, the partnership has no liabilities. the bases and fair market values of the partnership’s assets and the partners’ partnership interests are as provided in figure 1. figure 1 partnership’s assets and partners’ partnership interests prior to the liquidating distribution assets partnership interests ab fmv ab fmv cash $35,000 $35,000 a $20,000 $30,000 land 1 $10,000 $35,000 b $20,000 $30,000 land 2 $15,000 $20,000 c $20,000 $30,000 total $60,000 $90,000 total $60,000 $90,000 in this situation, assume that on december 31, year 1, p transfers $35,000 to a in liquidation of a’s partnership interest, $5,000 of which is attributable to unspecified goodwill. section 736 requires that the $35,000 distribution be divided between that portion made in exchange for a’s interest in partnership property under section 736(b) and that portion paid for unspecified goodwill of the partnership under section 736(a). consequently, $30,000 of the $35,000 distribution would result in capital gain to a of $10,000 ($30,000 minus a’s basis in his partnership interest of $20,000).187 section 736(a)(2) would apply to the remaining $5,000 distribution, which 2006] the lazarus effect 403 188. irc § 734(b)(1)(a). a basis adjustment under § 734 is allocated among the partnership’s assets in accordance with the rules under § 755. the regulations under § 755 provide that a basis adjustment resulting from gain recognized by a withdrawing partner under §§ 736(b)(1) and 731(a)(1) is allocated only to capital gain property. regs. § 1.755-1(c)(1)(ii). the adjustment is then allocated among the capital gain properties in proportion to their respective amounts of unrealized appreciation but only to the extent of each property’s unrealized appreciation. regs. § 1.755-1(c)(2)(i). assuming that land 1 and land 2 in the example are capital assets, the $10,000 basis adjustment under § 734 would be allocated $8,333 to land 1 ($10,000 basis adjustment times ($25,000 appreciation in land 1/$30,000 total appreciation in lands 1 and 2) and $1,667 to land 2 ($10,000 basis adjustment times ($5,000 appreciation in land 2/$30,000 total appreciation in lands 1 and 2). see 2 willis, pennell & postlewaite, supra note 11, at ¶ 13.05[8]. would be treated as a guaranteed payment under section 707(c) resulting in ordinary income of $5,000 to a. the distribution would result in $15,000 of gain for a, $10,000 of capital gain and $5,000 of ordinary income. the guaranteed payment would also generate a $5,000 deduction for the partnership. the $5,000 deduction would reduce the remaining partners’ bases in their partnership interests by $2,500. following the liquidating distribution, the bases and fair market values of the partnership’s assets and the partners’ partnership interests would be as provided in figure 2a. figure 2a partnership’s assets and partners’ partnership interests following the liquidating distribution assets partnership interests ab fmv ab fmv land 1 $10,000 $35,000 b $17,500 $27,500 land 2 $15,000 $20,000 c $17,500 $27,500 total $25,000 $55,000 total $35,000 $55,000 importantly, the $10,000 of gain previously inherent in each partner’s partnership interest has been preserved, but, as can be seen, the liquidating distribution has generated a mismatch between the aggregate inside bases of the partnership’s assets and the aggregate outside bases of the partners’ partnership interests. if p files a timely election under section 754, the partnership will be permitted to adjust the basis of land 1 and land 2 by $10,000, the amount of gain recognized by a that was attributable to that portion of the distribution made in exchange for a’s interest in partnership property under section 736(b). this adjustment would re-establish an188 equivalence between the aggregate inside bases of the partnership’s assets and the aggregate outside bases of the partners’ partnership interests as shown in figure 2b. 404 florida tax review [v0l.7:6 189. irc § 732(b). figure 2b partnership’s assets and partners’ partnership interests following the liquidating distribution and section 734 adjustment assets partnership interests ab fmv ab fmv land 1 $18,333 $35,000 b $17,500 $27,500 land 2 $16,667 $20,000 c $17,500 $27,500 total $35,000 $55,000 total $35,000 $55,000 instead of a $35,000 cash distribution to a in liquidation of his partnership interest, assume that p transfers land 1 to a in liquidation of a’s partnership interest. section 736 again requires that the $35,000 distribution be divided between that portion made in exchange for a’s interest in partnership property under section 736(b) and that portion paid for unspecified goodwill of the partnership under section 736(a). consequently, land 1 would have to be bifurcated between the section 736(a) and the section 736(b) portions of the transaction. a would receive 6/7ths of land 1 (hereinafter referred to as “land 1a”) with a fair market value of $30,000 in exchange for his interest in partnership property and would take a basis in land 1a of $20,000, his basis in his partnership interest. if a subsequently189 disposes of this portion of land 1a for $30,000, a will realize and recognize $10,000 of gain. section 736(a)(2) would apply to the remaining 1/7th portion of land 1 (hereinafter referred to as “land 1b”). land 1b would be treated as a guaranteed payment under section 707(c), resulting in ordinary income of $5,000 to a. in this case, a would have income of $5,000 as a result of the guaranteed payment and $10,000 of gain preserved in land 1a. because this gain equals that in the prior example involving a $35,000 distribution of cash, we would expect that a takes a basis in land 1b equal to its fair market value of $5,000 so that no further gain or loss would be realized and recognized on a subsequent disposition of land 1b for $5,000. a fair market basis in land 1b is consistent with both kahn and cuenin’s proposed treatment of guaranteed payments as well as an entity approach to guaranteed payments. like a cash distribution, the guaranteed payment would also generate a $5,000 deduction for the partnership. the $5,000 deduction would reduce both of the remaining partners’ bases in their partnership interests by $2,500. the interesting question, however, is the effect on the partnership of the $5,000 guaranteed payment in addition to the $5,000 deduction. under kahn and cuenin’s proposal, p would not recognize gain on the transfer. 2006] the lazarus effect 405 190. irc § 734(b)(2)(b). this basis adjustment would be solely allocable to land 2. irc § 755; regs. §§ 1.755-1(c)(1)(i) and 1.755-1(c)(2)(ii). following the liquidating distribution, the bases and fair market values of the partnership’s assets and the partners’ partnership interests are as provided in figure 3a. figure 3a partnership’s assets and partners’ partnership interests following the liquidating distribution assets partnership interests ab fmv ab fmv cash $35,000 $35,000 b $17,500 $27,500 land 2 $15,000 $20,000 c $17,500 $27,500 total $50,000 $55,000 total $35,000 $55,000 as in the prior example, the $10,000 of gain previously inherent in each partner’s partnership interest has been preserved, but, as can be seen, the liquidating distribution has generated a mismatch between the aggregate inside bases of the partnership’s assets and the aggregate outside bases of the partners’ partnership interests. if p filed a timely election under section 754, the partnership would be permitted to reduce the basis of land 2 by $11,429, the difference between the adjusted basis of land 1a in the hands of the partnership (6/7th of the $10,000 basis or $8,571) and the adjusted basis of land 1a in the hands of a ($20,000). unfortunately, this adjustment alone190 would not be sufficient to re-establish an equivalence between the aggregate inside bases of the partnership’s assets and the aggregate outside bases of the partners’ partnership interests as shown in figure 3b. figure 3b partnership’s assets and partners’ partnership interests following the liquidating distribution and section 734 adjustment assets partnership interests ab fmv ab fmv cash $35,000 $35,000 b $17,500 $27,500 land 2 $ 3,571 $20,000 c $17,500 $27,500 total $38,571 $55,000 total $35,000 $55,000 assume, however, that the partnership is required to recognize gain in connection with the transfer of land 1b in satisfaction of the guaranteed payment. in this case, the amount of gain would be $3,571 ($5,000 fair 406 florida tax review [v0l.7:6 191. irc § 734(b)(2)(b). this basis adjustment would be solely allocable to land 2. irc § 755; regs. §§ 1.755-1(c)(1)(i) and 1.755-1(c)(2)(ii). market value of land 1b minus its basis of $1,429 (i.e., 1/7th of $10,000)). the gain would be divided equally between b and c (i.e., $1,785.50) and would result in an increase in the bases of their partnership interests. consequently, the bases of the remaining partners’ partnership interests would be adjusted for the deduction generated by the guaranteed payment and for the gain recognized. consequently, the bases and fair market values of the partnership’s assets and the partners’ partnership interests would be as shown in figure 4a. figure 4a partnership’s assets and partners’ partnership interests following the liquidating distribution assets partnership interests ab fmv ab fmv cash $35,000 $35,000 b $19,285.50 $27,500 land 2 $15,000 $20,000 c $19,285.50 $27,500 total $50,000 $55,000 total $38,571.00 $55,000 in this case, the proper amount of gain has been preserved in the partner’s partnership interests, $8,214.50 ($27,500 fair market value minus $19,285.50 adjusted basis), which, with the $1,785.50 of gain recognized by each partner on the transfer of land 1b, results in a total gain of $10,000. this is the same amount that existed for each partner prior to the liquidating distribution. unfortunately, the liquidating distribution again results in a mismatch between the aggregate inside bases of the partnership’s assets and the aggregate outside bases of the partners’ partnership interests. however, if p filed a timely election under section 754 in this situation, the partnership would be permitted to reduce the basis of land 2 by $11,429, the difference between the adjusted basis of land 1a in the hands of the partnership (6/7th of the $10,000 basis or $8,571) and the adjusted basis of land 1a in the hands of a ($20,000). with such an adjustment, an equivalence between191 the aggregate inside bases of the partnership’s assets and the aggregate outside bases of the partners’ partnership interests would be restored as shown in figure 4b. 2006] the lazarus effect 407 192. referring to subchapter k, the legislative history to the 1954 code provided that “[i]n general, the proposed statutory treatment retains the existing scheme of regarding the partnership as merely an income-reporting, and not a taxable, entity.” h.r. rep. no. 83-1337, at 65 (1954)), reprinted in 1954 u.s.c.c.a.n. 4017, 4091; s. rep. no. 83-1622, at 89 (1954), reprinted in 1954 u.s.c.c.a.n. 4621, 4722. in addition, the house conference committee report stated: both the house provisions and the senate amendment provide for the use of the “entity” approach in the treatment of the transactions between a partner and a partnership which are described above. no inference is intended, however, that a partnership is to be considered as a separate entity for the purpose of applying other provisions of the internal revenue laws if the concept of the partnership as a collection of individuals is more appropriate for such provisions. h.r. rep. no. 83-2543, at 59 (1954), reprinted in 1954 u.s.c.c.a.n 5280, 5319-20. see rev. rul. 89-85, 1989-2 c.b. 218 (stating that “subchapter k of the code is a blend of the ‘aggregate’ and ‘entity’ treatment for partners and partnerships”). figure 4b partnership’s assets and partners’ partnership interests following the liquidating distribution and section 734 adjustment assets partnership interests ab fmv ab fmv cash $35,000 $35,000 b $19,285.50 $27,500 land 2 $ 3,571 $20,000 c $19,285.50 $27,500 total $38,571 $55,000 total $38,571.00 $55,000 this analysis demonstrates that, if the adjustment under section 734 is to achieve its objective of re-establishing an equivalence between the aggregate inside bases of the partnership’s assets and the aggregate outside bases of the partners’ partnership interests, it can only do so if the transfer of an in-kind guaranteed payment under section 736(a)(2) results in gain or loss recognition by the transferor partnership. thus, a strong argument can be made that the policy goals and structure of subchapter k are best implemented if the partnership is required to recognize gain or loss on the transfer of an in-kind guaranteed payment under section 736(a)(2). v. conclusion in enacting subchapter k, congress specifically noted that it was not adopting either the aggregate or the entity theory of partnerships but was combining the two theories and using one or the other depending on the circumstances involved. unfortunately, it is not always obvious which of192 408 florida tax review [v0l.7:6 193. kahn & cuenin, supra note, 6, at 417. these two theories congress intended to apply in a particular context. the difficulties are acutely presented when considering transactions between a partner and a partnership. kahn and cuenin have engaged in a valiant attempt to probe the difficulties of discerning the proper tax treatment of in-kind guaranteed payments. they conclude that the transfer of property by a partnership to a partner as a guaranteed payment does not result in gain or loss recognition by the partnership. they also conclude that the recipient partner takes a fair market value basis in the transferred property and that the recipient partner’s basis in his partnership interest is reduced by the partner’s share of the deduction generated by the guaranteed payment but is not otherwise affected by the transfer of the property. their first conclusion is consistent with the aggregate theory of partnerships, while their second and third conclusions are consistent with the entity theory of partnerships. their analysis thus results in an odd combination of both the aggregate and entity theories to explain the tax treatment of a single transaction, which they claim is reflective of the congressional refusal to adopt one theory to the exclusion of the other.193 we reject kahn and cuenin’s first conclusion and disagree with portions of their subsequent analysis. although they address the question presented through an examination of the statutory language and policy objectives of section 707(c), problems involving the application of subchapter k, or any section therein, cannot be resolved through a narrow focus on the language and application of one section or subsection but must rest on a consideration of how each section and subsection fits within the overall statutory framework. in addition, that framework has evolved over time through legislative, administrative, and judicial action in response to problems and difficulties that have arisen in its application. rather than resorting to the original congressional intent underlying one section of subchapter k for guidance, a consideration of the congressional intent underlying other subsequently enacted sections may require a modification of what might otherwise have been the applicable law. kahn and cuenin appear to have neglected to follow their initial reliance on the language of section 707(c) that guaranteed payments should be treated as payments to “one who is not a member of the partnership but only for the purposes of section 61(a) . . . and . . . section 162(a).” their reading of the statutory language led them to the conclusion that the transfer of property by a partnership to a partner as a guaranteed payment does not result in gain or loss recognition by the partnership, treating the transfer instead as a distribution of partnership property. they then deviated from the statutory language and concluded that the recipient partner takes a fair market value basis in the transferred property and that the recipient partner’s basis in his partnership interest is reduced only by the partner’s share of the 2006] the lazarus effect 409 194. see text accompanying notes 140-49. 195. staff of the joint comm. on tax’n, “options to improve tax compliance and reform tax expenditures,” supra note 4, at 170-73. deduction generated by the guaranteed payment, results contrary to the treatment of the transfer as a distribution of partnership property. they do so because they believe that a different result will not properly account for the income attributable to the recipient partner as a result of the basis adjustment that would otherwise be required. as we have demonstrated above, however, kahn and cuenin failed to consider all of the basis adjustments that a transfer of property in satisfaction of a guaranteed payment would trigger. under the modified194 aggregate approach, which we believe is reflective of the original congressional intent regarding the treatment of guaranteed payments, the consistent treatment of a guaranteed payment as an allocation of partnership income and a distribution of partnership property, with all of the associated basis adjustments required under subchapter k, would indeed preserve the proper amount of income for the recipient partner. the complex analysis and combined application of aggregate and entity theories of partnerships proposed by kahn and cuenin appears unnecessary to the resolution of the questions that they raise. kahn and cuenin also overlook the impact that the enactment of section 707(a)(2)(a) made on the question of the capacity in which the partner is acting for purposes of section 707. twenty years ago, we asserted that section 707(a)(2)(a) had effectively repealed section 707(c) because the economic risk analysis that it employed in determining the capacity in which a partner is acting is fundamentally inconsistent with the former capacity analysis upon which guaranteed payments under section 707(c) could be distinguished from payments under section 707(a)(1). as a result, virtually all payments that had previously been categorized as guaranteed payments are instead properly categorized as payments under section 707(a)(1), for which the entity approach is indisputably applicable. with respect to in-kind “guaranteed payments,” the entity approach requires that the partnership recognize gain or loss on the transfer, the recipient partner take a fair market value basis in the transferred property, and the recipient partner’s basis in his partnership interest be reduced only by the partner’s share of the deduction generated by the payment. the congressional failure to recognize the effective repeal of section 707(c) and erase its language from subchapter k creates a source of confusion and complexity, a trap for the unwary. fortunately, the staff of the joint committee on taxation has finally recognized that a small step in the name of tax reform and simplification can be taken by explicitly repealing section 707(c). the fact that the staff’s195 recommendation has taken 20 years since we first proposed the explicit repeal of section 707(c) demonstrates how difficult it is to “kill” a subsection 410 florida tax review [v0l.7:6 196. unfortunately, the actual repeal of § 707(c) will require somewhat more than one sentence of statutory language as some conforming amendments and modifications of those provisions currently referring to guaranteed payments or § 707(c) will also be necessary. see irc §§ 168(h)(6)(g), 267(e)(4), 514(c)(9)(e)(ii)(ii), 706(a), 736(a)(2), 736(b)(1), 1402(a)(13), 2701(c)(1)(b)(iii), and 7519(d)(5). of the code (much less an entire section), even a subsection whose only effect is the promotion of needless confusion and complexity. the committee staff should draft the required language (one sentence should be all that is necessary) and urge the committees of congress to act on its recommendation before someone breathes new life into a provision whose time and usefulness has clearly passed.196 florida tax review volume 19 2016 number 3 articles the intersection of eu state aid and u.s. deferral: a spectacle of fireworks, smoke and mirrors romero j.s. tavares bret n. bogenschneider marta pankiv cost sharing agreements & the arm's length standard: a matter of statutory interpretation? sienna c. white 121 191 i florida tax review volume 19 2016 number 3 the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states, plus sales tax where applicable and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117634, gainesville, florida 32611-7627. requests for back issues 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jasper l. cummings, jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university graduate editors grayson mccouch professor of law adam smith visiting assistant professor samuel c. ullman adjunct professor of law stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina kerry a. ryan st. louis university laura michael hughes m. blair james young hei jo michael schwartz mark westenberger executive assistant keyosha r. monroe iii alisa french paul hankin john hodnette florida tax review volume 19 2016 number 3 information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: "articles," "commentaries," and "book reviews." the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manual. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. iv florida tax review volume 19 2016 number 3 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. v i florida tax review volume 7 2006 number 7 agency activism as a new way of life: administrative modification of the internal revenue code through limited issue focused examinations by w. edward afield * i. introduction. ..................................................................................... 457 ii. the irs’s recent budgetary problems preventing effective enforcement. ...................................................... 459 iii. the lmsb’s solution to a lack of resources: limited issue focused examination (life). ............................ 461 a. general overview of life....................................................... 461 b. differences between traditional limited scope examinations and life. ........................................................... 466 c. issue selection and the materiality thresholds. ....................... 468 1. issue selection. ............................................................. 468 2. materiality thresholds. ................................................ 470 iv. is life a legitimate use of the irs’s audit authority or an illegitimate secret law?. ........................... 472 a. life is an inappropriate use of the irs's statutory audit authority.................................................................................... 472 b. the irs’s unwillingness to disclose certain aspects of life raises a presumption that the irs is exceeding its audit authority through life.............................................................. 477 * harvard college, a.b.; columbia law school, j.d.; university of florida levin college of law, ll.m. i would like to express my gratitude to professor david richardson for his invaluable comments and advice throughout the writing of this paper. all errors, of course, are my responsibility alone. 455 456 florida tax review vol.7:7 v. even if life is legitimate, is it good policy?. ........................ 483 a. public arguments supporting life. ........................................ 483 b. public arguments attacking life. ........................................... 486 1. life sacrifices thoroughness and enables taxpayer manipulation. ................................................................. 486 2. life hurts the rule of law. .......................................... 491 3. life violates the irs’s duty to treat taxpayers consistently. ................................................................... 493 4. life is premised on a faulty assumption regarding taxpayer honesty......................................................... 494 vi. conclusion. ...................................................................................... 497 2006] agency activism as a new way of life 457 i. introduction the irs has begun to get more aggressive. contrary to what one might expect, however, this new stance has greatly benefitted taxpayers. due to a lack of proper funding, the agency has found itself in an impossible situation when it comes to enforcing the tax laws. this problem is not new, however, as the irs has historically never had enough resources to provide for completely effective administration of the tax laws. it knows full well that it cannot audit taxpayers quickly and thoroughly with the resources it currently has. although the problem is a familiar one, what the irs has recently been doing about it is cause for concern. in the name of increasing efficiency and better utilizing limited resources, the irs has begun to adopt audit policies that overly favor taxpayers and greatly hinder the irs’s ability to perform thorough audits. highlighting this trend is a relatively new audit technique used by the large to mid-size business division (lmsb), which “serves corporations, subchapter s corporations, and partnerships with assets greater than $10 million.”1 when faced with the conflict between currency and thoroughness, the lmsb has chosen to focus primarily on improving audit currency. the lmsb2 believes that improved currency will have several positive effects: a. taxpayer records will become more easily accessible and available on current years; b. taxpayer personnel familiar with transactions selected for examination will still be available; c. there will be the ability to eliminate issues from future examinations by using resolution tools; d. there will be the ability to enter into pre-filing actions for future returns; and e. there will be the improved employee and customer satisfaction.3 the lmsb has considered several techniques to improve audit currency, such as limited scope audits, skip-cycle examinations, multi-year examinations, 1. large to mid-size business division homepage, at http://www.irs.gov/ business/article/0,,id=103401,00.html. 2. see i.r.m. 4.45.7.2 (2004). 3. i.r.m. 4.45.7.2(1) (2004). 458 florida tax review vol.7:7 lmsb sweeps, and accelerated examination plans. one of the lmsb’s more4 imaginative initiatives for improving audit currency is the audit technique known as the limited issue focused examination (life) process. under life,5 the lmsb has attempted to involve taxpayers in the audit process by sharing responsibility for timely completion of the audit and has attempted to streamline the audit by reducing the scope of issues examined and applying materiality thresholds to limit scope expansion.6 although the lmsb has had success improving audit currency through the use of life, it is paying too high a price for this result. by instituting life, the lmsb has exceeded the audit authority congressionally granted to the irs. furthermore, the irs is doing so without full disclosure to the public of how life is implemented. in other words, the irs is in effect legislating without any political accountability. in addition, although the lmsb believes that it will not be sacrificing much in the way of quality, this claim does not hold up, especially when one considers the potential for taxpayer abuse of the program. the fact that corporate america views tax departments as profit centers almost assures that lmsb “customers” will be able to exploit the lack of audit thoroughness to engage in questionable if not outright fraudulent activity. life also greatly undermines the rule of law because the program misuses discretion and arbitrarily treats similarly situated taxpayers unequally. this paper will examine life and whether the lmsb has given up too much in the name of improving audit currency in a world of insufficient enforcement resources. part ii will discuss some of the recent budget and enforcement problems that the irs has been having. part iii will examine life and explain the program’s specifics. part iv will analyze whether the irs has exceeded its authority in implementing life. part iv will also address the irs’s unwillingness to explain fully critical aspects of life to the public. part v will explore whether or not life, even if legitimate, is good public policy. finally, part vi concludes that the irs is indeed sacrificing too much for improving audit currency through life. by implementing life, it has both changed the historical relationship between taxpayers and the tax collector, and it has done so in a manner that it must know that neither congress nor the public would sanction. 4. i.r.m. 4.45.7.2(4) (2004). 5. i.r.m. 4.45.7.2(5) (2004). 6. i.r.m. 4.45.7.2(5) (2004). 2006] agency activism as a new way of life 459 ii.the irs’s recent budgetary problems prevent effective enforcement during at least one of the years from 2001-2003, eighty-two of the nation’s largest corporations did not pay federal income taxes. while there are7 several causes for such an astounding number, the irs’s failing ability to8 conduct effective audits of a large number of corporate taxpayers is certainly one of them. in recent years there has been a marked decline in corporate audit activity. 9 only about a third of very large businesses are audited every year, down from more than half as recently as 1995. audit rates for businesses with assets of between $10 million and $250 million, . . . plunged to 10% to 15% in 2001 from 20% to 30% in the early 1990s. 10 as one commentator has observed: tax experts agree that corporate tax avoidance has become a serious problem. corporate tax receipts – already in a long, steady decline – fell to $132 billion in the fiscal year that ended sept. 30, [2003] the lowest since 1993, even before adjusting for inflation. expressed as a percentage of total tax receipts or as a share of the economy, corporate tax receipts this year will 7. kurt ritterpusch, [ctj tallies corporate tax boon under bush; 82 corporations have had a tax-free year,] 184 bna daily tax rep. g-8, g-8 (sept. 23, 2004). the rebate checks that were owed to these eighty-two corporations actually totaled $12.6 billion. 8. factors like a slower economy, an increasingly complex set of tax structures, ease of s corporation formation, and the proliferation of stock options have also contributed to the recent decline in corporate taxation. irs: speeding corporate tax a u d i t s , g l a s s j a c o b s o n ’ s e . p e r s p e c t i v e , a t http://www.glassjacobson.com/index.php3?page=270 (jan. 2004) (hereinafter glass jacobson). 9. albert b. crenshaw, irs putting life on line in bid to improve corporate audits, chi. trib., jan. 6, 2003, at 10. 10. id. 460 florida tax review vol.7:7 be at their second-lowest level since the great depression. only 1983’s receipts were lower.11 “with corporate tax receipts at record lows, irs commissioner mark w. everson recently declared that corporate audits, which now take an average of 38 months, should be completed in less than half that time.” the irs’s hope12 is that improved audit efficiency will increase audit risk and thereby present a more constant audit threat to the corporate taxpayer that will in turn lead to greater compliance. this push for increased efficiency has been the driving13 force behind recent irs internal procedures.14 the irs has been relying on an increased budget to accomplish its goals of improving audit times while maintaining quality. to support its15 argument for increased funding, however, the irs has been trying to show that it was doing as much as it could with its resources. commissioner everson has stated “that improving the agency’s efficiency gave him more ammunition when it came time for him to plead his case to congress for a funding boost. in the meantime, . . . greater efficiency has enabled the agency to cope when it doesn’t 11. glass jacobson, supra note 8 (brackets added). 12. id. 13. id. as will be discussed in more detail in section v, infra, however, there is legitimate concern that steps taken to increase audit efficiency may lead to a greater potential for tax fraud. id. 14. allen kenney, [official says irs audit process still needs work,] 105 tax notes 27 (oct. 4, 2004): on a larger scale, [deputy irs commissioner for services and enforcement mark e.] matthews said in his conference speech that irs commissioner mark everson’s mantra that “time matters” has reached all corners of the agency, pushing his charges to “ruthlessly prioritize” their use of resources. “nobody feels in the irs that they are not under the gun in terms of thinking about how they function and what kind of efficiencies they can bring,” matthews said. “it’s not a message that we don’t seek excellence – it’s about making right decisions about resources and about risk.” id. (brackets added). 15. id. at 28. even without such funding increase, however, the irs still planned on moving ahead towards “pursuing its goals of increased enforcement and improved service.” id. 2006] agency activism as a new way of life 461 get the money it asks for.” everson’s funding fears have turned into reality,16 and the irs will thus have to hope that it can continue to increase efficiency without additional resources in order to make up for funding shortfalls.17 however, funding problems are nothing new to the irs. hoping to compensate for these problems through increasing efficiency is a laudable goal. taking this stance to the point at which efficiency increases are being achieved by giving away the entire farm, however, and subverting the rule of law, is not justifiable. nevertheless, this is what the lmsb is doing with life. iii.the lmsb’s solution to a lack of resources: limited issue focused examination (life) a. general overview of life because the irs did not expect to receive additional resources for enforcement, the lmsb implemented life on december 4, 2002. the irs’s18 press release summarizes life’s basic structure: this initiative will involve a formal agreement, a memorandum of understanding (mou), between the irs and 16. allen kenney, everson strong on enforcement despite bleak irs funding outlook, 105 tax notes 503, 503 (oct. 25, 2004). 17. see allen kenney, everson evaluates state of irs, pledges strong agenda for 2005, 106 tax notes 40 (jan. 3, 2005). president bush had requested a 5% irs budget increase in 2005 (which comes out to about $490 million). id. at 41. while everson wanted a “10% increase of $134 million over the previous year’s budget from the requested $300 million increase set aside for enforcement:” congress, however, appeared to have other plans. when all the politicking was said and done, the irs was left with $10.3 billion in the fiscal 2005 omnibus appropriations bill, a nominal increase of $134 million over the previous year’s budget and $356 million less than bush requested. id.; see also stephen joyce, everson letter says irs will forfeit billions, lack auditors unless fy2005 request is met, 189 bna daily tax rep. g-8 (sept. 30, 2004) for a discussion of everson’s concerns over how funding problems could drastically reduce the amount of the revenue that the irs was able to collect. 18. irs news release ir-2002-133 (dec. 4, 2002); irs life training video, received pursuant to foia request. 462 florida tax review vol.7:7 taxpayer to govern key aspects of the examination. the mou will contain dollar-limit thresholds, established on a case-bycase basis, below which the irs will agree not to raise issues and the taxpayer will agree not to file claims. this will create, with the taxpayer’s assistance, an atmosphere where the examination process is less difficult, less time-consuming, less expensive and less contentious for all involved.19 in addition, an initial risk analysis will significantly restrict the number of issues to be examined, resulting in situations in which only a small number of issues are examined while the irs in effect concedes all others prior to examination.20 according to the life training manual, after identifying as many as fifty issues “warranting examination,” the auditor might work only the top few that are “most material to the transaction as a whole” thereby conceding almost all of the other issues warranting examination: for example, if you had identified 50 areas warranting examination in your risk analysis, use of the life process might result in raising the bar to perhaps the 10 or 15 of the most significant issues. if you had classified your issues as priority a, b and c for your traditional audit plan, life might result in only the “a” issues being examined. depending upon the circumstances of your examination, life might involve working only the top few “a” issues. you will use the principles of risk analysis to isolate those issues that are most material to the tax return as a whole. 21 also, under life, the auditor has the authority to waive certain steps considered so important in traditional examinations that they are normally mandatory. life resulted from the irs establishing “best practices” for scope22 19. irs news release ir-2002-133 (dec. 4, 2002). see also lmsb life training manual, at 26-7, 32 received pursuant to foia request (may not be cited as official authority) (hereinafter life training manual); i.r.m. 4.51.3 (2004). 20. life training manual, supra note 19, at 32. 21. life training manual, supra note 19, at 32 (emphasis in original). “however, life does not impact the depth to which issues are examined.” i.r.m. 4.51.3.3.6(9) (2004). 22. i.r.m. 4.51.3.3.6(4) (2004). the steps that may be waived are: a. the mandatory income probe; b. minimum inventory checks; 2006] agency activism as a new way of life 463 limitation from its former practice of informally agreeing with certain corporate taxpayers to limit audit scope. the lmsb did not develop these best practices23 solely based on internal feedback; it also relied on the input from the private sector.24 the lmsb has established guidelines for determining when a life audit is appropriate. these guidelines provide a mechanism to allow the lmsb to maximize its resources while not applying the taxpayer friendly life limitations to taxpayers whose behavior does not indicate that a limited audit c. mandatory compliance checks (the requirement to verify filing of and reviewing payroll, excise, and pension returns, verify filing information returns and forms 8300, cash transaction reports.); id. 23. jennifer corbett dooren, tax facts: irs to streamline corporate audits, dow jones newswires, at http://www.salestax.org/news/thisweeksnews_12-6-02.html. 24. the life training manual describes how the lmsb consulted with private interest groups in developing the “best practices:” after securing information on best practices from within lmsb, we contacted outside stakeholder groups including the tax executives institute (tei), the american bar association (aba), and the american institute of certified public accountants (aicpa). in seeking their input, we crafted nine questions covering specific problem areas of the examination process. we also invited them to share examination success stories and best practices they believed to be important. surprisingly, many of the key elements in their “success stories” mirrored those expressed by the examination teams, including increased communication and participation in the planning process. life training manual, supra note 19, at 3. because of the role that these groups were permitted to play in designing life, taxpayers’ enthusiasm for life, as discussed in section v.a, infra, is unsurprising. 464 florida tax review vol.7:7 would be appropriate. despite these guidelines, the lmsb believes that the25 application of life should be considered in every audit.26 25. i.r.m. 4.51.3.2.1(1) (2004) provides the following factors as supporting the use of a life audit: a. the risk analysis identifies a limited number of material items (no specific number since this will vary based on the facts and circumstances); b. prior experience indicates the taxpayer is both capable and willing to meet the commitments required in the mou; c. workload demands exceed resources available and require scope limitations; d. special project cases where the primary issue is identified; e. out-of-cycle returns when there is an issue requiring examination for tax administration purposes; f. there is no prior examination history of the taxpayer, but the interaction to date indicates the taxpayer is both capable and willing to meet the commitments required in the mou, or g. improved currency is a primary concern and the taxpayer is reasonably compliant, even if there have been issues in the past. see also life training manual, supra note 19, at 5-6 for a more specific breakdown of the factors supporting a life audit, in which the lmsb establishes separate criteria depending on whether the audit is an industry case or a coordinated industry case. irm 4.51.3.2.1(2) (2004) lists the factors that, either individually or together, could make a life audit inappropriate: a. a history of substantial noncompliance, such as aggressive positions or the use of marketed tax products; b. a history of failing to consistently meet agreed upon information document request (idr) response times (including completeness); c. average idr response times that will most likely impede an efficient examination; d. a tax shelter transaction that was not properly disclosed as required by any notice, revenue procedure, revenue ruling or treasury regulations; e. a large number of material issues which render scope limitation unreasonable; f. an indication of fraud on the part of the taxpayer, or g. the taxpayer is unable or unwilling to meet the commitments required in the mou. see also, life training manual, supra note 19, at 5-6. 26. i.r.m. 4.51.3.2.1(1) (2004). 2006] agency activism as a new way of life 465 larry langdon, the lmsb commissioner when life was announced, emphasized that life was meant to be used for cooperative taxpayers. driving27 life, however, was a desire to reduce audit times and maximize the use of limited resources. in an interview about life, langdon stated that:28 as is true of our corporate taxpayers and their practitioners, the irs realizes that we also have limited resources. there are only about 6,000 employees in lmsb to deal with 150,000 taxpayers with assets exceeding $10 million. because our current audit process only allows us to deal with a small number of our mid-sized taxpayers, we need to revise these audit procedures to properly increase our audit coverage. the life program and our other initiatives will allow lmsb auditors to do this.29 27. see, e.g., irs news release ir-2002-133 (dec. 4, 2002). as a result of reducing the audit times of compliant taxpayers, the irs hopes through life to be able to focus on issues often found in non-compliant taxpayers like tax shelters. terry carter, the irs wants to save you time and money . . . seriously: bigger businesses with good records get to determine audit issues in advance, 2 no. 2 a.b.a. j. e-rep. 6, (jan. 17, 2003). furthermore, the irs hopes that life will allow it to focus on more mid-size businesses by reducing audit times of large corporations. id. 28. carter, supra note 27. langdon indicated that the irs was auditing returns that were five years old, and that he was hoping to reduce that number to three years. id. in fact, langdon stated that one of his reasons for leaving the private sector, where he had been a hewlett-packard vice president and a former president of the tax executives institute, was to change the lmsb’s audit process to result in less documentation and increased coverage. see biography of larry langdon, at http://www.mayerbrown.com/lawyers; interview with l a r r y l a n g d o n o n f r o n t l i n e , n o v . 5 , 2 0 0 3 , a t http://www.pbs.org/wgbh/pages/frontline/shows/tax/interviews/langdon.html. 29. larry r. langdon, 81 taxes 279 (mar. 1, 2003). the irs training manual providing instruction on how to administer life echoes this need for increased efficiency: “with finite resources, lmsb can only [streamline the process]. . . by reducing the resources we devote to some of our traditional examination areas.” life training manual, supra note 19, at 1 (brackets added); see also life training manual, supra note 19 at ii. see also, irm 4.45.7.2(1) (2004). increased efficiency will allow it to focus more on its highest enforcement priorities, which include “[a]busive tax avoidance transactions, . . . executive compensation, offshore tax avoidance transactions, flow-through entities, special purpose entities, and financial vs. tax reporting discrepancies.” lmsb compliance priorities, at http://www.irs.gov/businesses/article/0,,id=121348,00.html. 466 florida tax review vol.7:7 langdon summarized the problem that these figures present to the irs: that means there are about 148,000 that are not covered as extensively as we’d like.” “we haven’t decreed a number, but we hope that at least a quarter of new case starts use . . . [life] principles, and we will be pleased if it’s more than that. then, we’ll have resources to be able to touch more taxpayers, for lack of a better term, and focus on what’s material.30 b. differences between traditional limited scope examinations and life although any audit procedure is inherently discretionary in terms of the examination’s scope, life is distinguishable from other audit procedures in several critical respects. while some auditors prior to the implementation of life may have been limiting examined issues to post-life levels, through life the lmsb is attempting to get all their “agents to leave their comfort zone and to take some risks in the process,” by greatly reducing the number of issues examined. the lmsb is asking taxpayers to do the same thing by agreeing to31 leave certain claims off the table and to “share in the responsibility for timely completion of the examination.” more specifically, the lmsb established six32 factors that distinguish life from traditional full scope audits: a. the examination plan is more issue-driven than resource driven; b. the scope of the examination is limited based on materiality concepts; c. some mandatory compliance checks and mandatory steps may be waived; d. once the scope is set, it is not necessary to comment on other luq [large, unusual, and questionable] items; 30. carter, supra note 27. (brackets added). 31. life consolidated frequently asked questions, aug. 1, 2003, at 4, received pursuant to foia request (hereinafter life consolidated faq). in providing an example to its auditors, the lmsb stated that “maybe you will only be able to focus on category a (will work) issues when in the past you focused on category a and b (would like to work) issues. in some cases, you might even limit the scope to only some of the ‘a’ issues.” id. 32. id. 2006] agency activism as a new way of life 467 e. once the scope is set, managerial approval is required to expand it, and f. life requires the taxpayer to commit to actions specified in the life mou.33 one of the factors, issue limitation, is nothing new as the irs has for some time used traditional limited scope examinations. traditional limited34 scope examinations, however, provide much more discretion in issue expansion than life does. as a result, the lmsb believed that these traditional limited35 scope examination procedures were not consistently being applied to lmsb audits, and the lmsb implemented life, in part, to establish more consistency with these limited audits. the lmsb listed three primary factors of traditional36 limited scope audits that distinguish them from life audits: a. the examiner may only waive gross income and inventory checks; b. the limited scope examination can involve only one or two issues, and c. there are only a few instances or circumstances where the traditional, limited scope examination is appropriate, such as whipsaw issues and other related returns.37 thus, through life, the lmsb hopes to provide more uniformity as well as a broader application of limited scope examinations, which is consistent with the irs’s stated goal of maximizing the use of its decreasing resources. 33. i.r.m. 4.51.3.1.2(2) (2004) (brackets added). 34. see i.r.m. 4.10.2.6.1 (1999) et seq. for a description of the traditional limited scope examinations. 35. see i.r.m. 4.10.2.6.1.2(1) (1999) which states at the outset that “[e]xpanding the scope of the examination is based on the examiner’s judgment;” see also i.r.m. 4.10.2.6.1(3) (1999), which also establishes that “[e]xaminers are expected to continually exercise judgment throughout the examination process to expand or contract the scope as needed.” this discretion is very different from a life examination, in which the established materiality thresholds greatly restrict the examiner’s discretion to expand the audit’s scope. see section iii.c, infra, for a more detailed discussion of how the initial risk analysis and subsequent materiality thresholds impact an examiner’s ability to expand a life audit. 36. life training manual, supra note 19, at 4-5. 37. i.r.m. 4.51.3.1.2(3) (2004); see also life frequently asked questions, at 1, received pursuant to foia request (hereinafter first life faq). 468 florida tax review vol.7:7 despite the irs’s attempts to create more uniformity and consistency, life’s very nature will result in inconsistent taxpayer treatment, as discussed in section v.b.3 further. this inconsistency results from life’s overly discretionary methods of issue selection and determining materiality thresholds. c. issue selection and the materiality thresholds while life consists of many procedural intricacies, at its heart are two questions: (1) how are issues selected and (2) how are the materiality thresholds determined. this section will explore what little guidance there is for how the lmsb makes these determinations. at the conception of life, the initial plan was to use materiality thresholds to govern issue selection and scope expansion. after getting38 feedback from the field, however, the lmsb changed this procedure to remove the consideration of any materiality thresholds in issue selection. as will be39 discussed further, although specific thresholds are not used in issue selection, materiality concepts still play a pivotal role in the determination of the examination’s initial scope. what resulted is a process consisting of two independent steps. the first step consists of performing a risk analysis, without40 regard to any dollar thresholds, to determine which issues will be examined.41 the second step involves setting the materiality thresholds for scope expansion by either the irs or the taxpayer. “the thresholds may be the lowest dollar42 value selected in the life exam plan or another amount based on the examiner’s professional judgment.” to understand how the lmsb makes its43 issue and threshold selections, analyzing these two steps separately is helpful. 1. issue selection – initially, “[t]he examiner will perform a risk analysis in the same manner as in a traditional, full scope examination.” in this44 38. interim review produces changes to the life process, at http://www.irs.gov/businesses/article/0,,id=103618,00.html (hereinafter interim review); life consolidated faq, supra note 31, at 7. 39. life consolidated faq, supra note 31, at 7. 40. id.; i.r.m. 4.51.3.3.6(1) (2004). 41. interim review, supra note 38; life consolidated faq, supra note 31, at 7; i.r.m. 4.51.3.3.6(1) (2004). 42. interim review, supra note 38; life consolidated faq, supra note 31, at 7-8; i.r.m. 4.51.3.3.6(1) (2004). 43. life consolidated faq, supra note 31, at 8. 44. i.r.m. 4.51.3.3.3(1) (2004). this provision refers the reader to i.r.m. 4.10.2.4.1 (1999) and i.r.m. 4.45.7.2 (2004) for a discussion of risk analysis. 2006] agency activism as a new way of life 469 risk analysis, auditors are expected “to effectively manage their workload by prioritizing the issues so that the issues with higher audit potential are examined over those with lower potential. issues with little or no audit potential should not be selected for examination.” the most important issues are generally the45 large, unusual, and questionable (luq) items. materiality issues are46 commonly used to identify these luq items. thus, although specific47 materiality thresholds are not being used to govern issue selection, materiality48 does come into play at the issue selection step. in fact, according to the internal revenue manual, materiality considerations are the most important ones in limiting an audit’s scope.49 several factors come into play in determining materiality. the first and most basic is the dollar amount of an item – the higher an item’s dollar amount, the more likely it is to have a significant affect on tax liability and thus be 45. irm 4.10.2.4.1(1) (1999). the lmsb has attempted to come up with a few examples of factors that might be used to conduct an effective risk analysis: the outcome of issues from prior years (was it agreed, unagreed, or how was the issue ultimately resolved?) is the issue a “must work” item such as a coordinated issue or tax shelter? is the issue an emerging issue? is the item one with a high probability of error? (some accounts are inherently more prone to errors than others) consideration of the resources needed to address the item estimated time to complete the examination of an item materiality life training manual, supra note 19, at 8-9. note also that it is unclear from the internal revenue manual whether “high audit potential” means items in which the irs is likely to prevail or items that will result in a high adjustment of tax liability. 46. i.r.m. 4.10.2.4.1 & 4.10.2.6 (1999); life training manual, supra note 19, at 8-9. while the auditor is generally expected to examine all luq items, an exception to this general rule is made when the scope of an examination is to be limited. id. 47. life training manual, supra note 19, at 8-9. 48. “materiality is an accounting concept which does not exist, for the most part, in tax law. materiality is both a qualitative and quantitative concept used in identifying those items most relevant and consequential in determining the correct tax liability.” i.r.m. 4.51.3.3.4(1) (2004). 49. i.r.m. 4.51.3.3.4(3) (2004). 470 florida tax review vol.7:7 material. a second critical materiality question is, in the case of two equal50 dollar amount items, which item will have the more permanent effect on tax liability (thus becoming more material)? timing also plays a key role in51 materiality, and timing adjustments that affect a larger deferral/acceleration period are considered to be the more material timing adjustments. more52 qualitative factors, such as “significant transactions involving a tax haven entity,” or even the absence of an item, can also be factored into a materiality analysis, even if quantitative numbers cannot be attached to them.53 2. materiality thresholds – after the risk analysis has been performed and the issues have been selected, the auditor must establish the materiality thresholds that will determine whether the irs or the taxpayer will be54 permitted to add any other item discovered during the audit to the agreed audit 50. i.r.m. 4.51.3.3.5(1) (2004). note that “[c]ertain transactions or events may be of such a nature that it is difficult to associate a dollar amount for materiality without significant audit work. the fact that there is no specific dollar amount associated with an issue should not exclude it from consideration under life.” i.r.m. 4.51.3.3.5(7) (2004). also note that high dollar amount might not always be indicative of an item that would have a material effect on tax liability. for example, if an item had a very high dollar amount but a very low profit margin, it might not involve a significant amount of taxable income. 51. i.r.m. 4.51.3.3.5(2) (2004). 52. i.r.m. 4.51.3.3.5(3) (2004). changes in accounting should be considered in regards to certain timing issues. i.r.m. 4.51.3.3.5(4) (2004). in addition, even an issue that might not be material from a timing perspective could be material if it involves a large enough amount. i.r.m. 4.51.3.3.5(5) (2004). 53. i.r.m. 4.51.3.3.5(7) & (9) (2004). examples of other qualitative factors include: a. a taxpayer who has experienced a number of mergers and acquisitions during the cycle; b. non-deductible personal expenses or shareholder distributions; [and] c. employment tax compliance i.r.m. 4.51.3.3.5(7) (2004). 54. the plural “thresholds” is used because one materiality threshold does not necessarily apply to all items. for example, in the irs’s instructions for completing the mou, the irs states that a different threshold could be established for each item. see instructions for completing the m ou, revised aug. 1 , 2003, at http://www.irs.gov/pub/irs-utl/mou_8_1_03.pdf. 2006] agency activism as a new way of life 471 scope. the lmsb implemented the concept of materiality thresholds to55 combat “scope creep,” which many lmsb field teams said often contributed to prolonged audits. the auditor must state these thresholds as a specific dollar56 amount, which “may be based on the lowest dollar value for each type of issue included in the life plan or another amount based on the examiner’s professional judgment.” these thresholds can apply to issues as well as to57 “any tax return line item, tax attribute, or a combination of any of the above.”58 the scope can be expanded to include certain high priority issues, however, regardless of whether or not they fall within the materiality thresholds. these59 high priority issues are: “tax shelters, coordinated issues, fraudulent items, items contrary to public policy, worker classification issues, executive compensation, and lmsb field directive issues.” these thresholds do not have to be the60 same for the entire audit period, and it is conceivable that the auditor might have to establish different materiality thresholds for different taxable years. 61 if the auditor does plan on expanding the audit’s scope, he must obtain managerial approval. this approval is required regardless of whether the62 expansion satisfies the materiality thresholds. this is because the lmsb has63 decided that for scope expansion there should be virtually no professional discretion allowed to the audit team. even if scope expansion is possible, a64 manager may decide not to expand the audit’s scope if other perceived resource considerations indicate that the scope should not be expanded.65 as can be seen, life both dramatically limits the number of issues that will be audited and, in effect, concedes many other issues even when the auditor has established that they warrant examination. this institutionalized, severe 55. note, however, that if an item is selected for audit, the materiality thresholds will not affect the depth to which that item is audited. i.r.m. 4.51.3.4.5(7) (2004). 56. life training manual, supra note 19, at 20. 57. i.r.m. 4.51.3.4.5(2) (2004). 58. i.r.m. 4.51.3.4.5(4) (2004). 59. i.r.m. 4.51.3.4.5(8) (2004). 60. i.r.m. 4.51.3.4.5(8); i.r.m. 4.51.3.4.5(11) (2004). note also that certain “obvious computational/mathematical or accounting errors/omissions” can be corrected without regard to materiality thresholds. i.r.m. 4.51.3.4.5(9) (2004). the lmsb can also expand the scope without regards to the materiality thresholds if the taxpayer has not followed a “stated accounting policy or practice.” i.r.m. 4.51.3.4.5(10) (2004). 61. first life faq, supra note 37, at 7. 62. i.r.m. 4.51.3.4.5(12) (2004). 63. life training manual, supra note 19, at 20. 64. id. 65. id. 472 florida tax review vol.7:7 audit constraint is hardly conducive either to assuring compliance by the taxpayers under audit or to instilling in those not under audit the proper respect for the system. life is not just a new technical way of auditing; it represents a radically different approach in the philosophy and goals of auditing. one is left to ask whether the irs can enact such an entirely different approach without prior congressional approval and oversight. iv. is life a legitimate use of the irs’s audit authority or an illegitimate secret law? a. life is an inappropriate use of the irs’s statutory audit authority. in analyzing life’s implications, the first issue that must be addressed is whether the irs even has the authority to conduct a life audit. generally, the irs derives its authority to conduct an audit from irc section 7602(a). this code section’s language is critical in determining exactly what the irs is authorized to do. specifically, the code states, in relevant part: a. authority to summon, etc. – for the purpose of ascertaining the correctness of any return, . . . determining the liability of any person for any internal revenue tax . . . or collecting any such liability, the secretary is authorized – (1) to examine any books, papers, records, or other data which may be relevant or material to such inquiry66 the code on its face limits the irs to examining only documents that are “relevant and material” to “ascertaining the correctness of any return.” congress has not required the irs to examine every taxpayer for every item for every year nor has it explicitly outlawed any examination that did not result in “ascertaining the correctness of any return.” congress emphasizes this point further by preventing any “unnecessary examinations or investigations” as well as providing a general limitation of one examination per taxable year. 67 life, however, is an illegitimate expansion of the irs’s audit authority. life, by definition, cannot lead to “ascertaining the correctness of any return.” in life, the irs is not just limiting the scope of its examination to the items 66. irc § 7602(a). the irs’s general authority to issue regulations is found in irc § 7805. 67. irc § 7605(b). 2006] agency activism as a new way of life 473 that are relevant to “ascertaining the correctness of any return.” by limiting the scope of an audit and establishing a materiality threshold below which items are ignored, it is intentionally ignoring information that may very well be highly relevant in “ascertaining the correctness” of a corporate taxpayer’s return. indeed, the irs admits that life would result in the examination of only a few of potentially fifty issues that warranted examination. such an68 acknowledgment inherently recognizes that life cannot ascertain “the correctness of any return” because both the irs and the taxpayer are intentionally leaving issues worthy of audit off the table. the irs’s stated justification for the vast reduction in the number of issues examined as well as the strict restriction on issue expansion is only one of improved efficiency rather than one of better “ascertaining the correctness of any return.” thus, life does not fall within the irs’s congressional authority to examine all information that is relevant to “ascertaining the correctness of any return.” the code gives no grant of authority to the irs to avoid relevant information intentionally in the name of efficiency. the irs, however, has inappropriately given itself authority to conduct life through the regulations under irc section 7602. in treasury regulation section 301.7602-1(a), the irs slightly but significantly changed the statutory language that grants its audit authority. rather than stating that the irs is “authorized” to examine the information described in the statute, the regulation states that the irs “may” examine this information. by making this language much more permissive, the69 irs has given itself authority to choose not to examine materials that may very well be relevant to “ascertaining the correctness of any return.” surely congress did not intend to authorize the irs to intentionally ignore relevant tax liability. such an authorization would give the irs an enormous amount of power to decide arbitrarily to audit relevant information in one taxpayer and ignore the same relevant information in another taxpayer. if congress truly did intend this result, it would have made this intention plain. furthermore, congress certainly knows how to state directly that it is willing to allow the use of thresholds similar to those used in life. for example, irc section 6051(a)(13) requires an employer to furnish to its employees who participate in nonqualified deferred compensation plans a written statement showing “the total amount of deferrals for the year.” the flush language to irc section 6051(a), however, states that “the secretary may (by regulation) establish a minimum amount of deferrals below which” such statement is not required. in this example, congress has specifically authorized 68. see example from life training manual discussed in section iii.a, supra. 69. regs. § 301.7602-1(a). 474 florida tax review vol.7:7 the irs to employ the use of a threshold. in the unlikely event that congress wanted to allow the irs to establish thresholds below which errors in computing tax liability could be ignored, it is perfectly capable of granting treasury this authority. if congress felt that, having established a reporting rule, it also had to establish an exception to the rule, one can imagine that, having authorized the irs to audit taxpayer returns to determine their correctness, it would certainly reserve the right to establish an exception to the rule, particularly an exception that in effect eviscerated the rule. in addition to knowing about how to authorize treasury’s use of thresholds, congress also knows how to provide a broad grant of authority clearly permitting the establishment of thresholds through the regulations. in a recent notice, the irs has requested comments on the potential use of thresholds for reporting of taxable acquisitions under irc sections 6043(c) and 6045. these code sections state explicitly that the filing of information under70 these sections shall only occur to the extent that the secretary requires it. thus,71 for these code sections, the secretary has regulatory authority to establish thresholds for the reporting requirement. this could be why the irs actually felt confident promulgating regulations for establishing thresholds under these taxable acquisition code sections as opposed to establishing the thresholds without promulgating regulations. had congress desired to provide similar authority to the irs in the context of life, it could have easily done so. its failure to do so does not give the irs the right to circumvent the regulatory process by initiating the program administratively. the irs’s justification for establishing life through questionable legal authority is that it needs to compensate for the fact that it does not have the resources to follow congress’ authorization to examine information to ascertain the correctness of a taxpayer’s return. gregg polsky has argued that the treasury department has increasingly been trying to achieve positive policy results even if they contradict direct legal authority. polsky argues that72 treasury has three options if it perceives a difficulty in tax administration: “(1) propose legislation to congress to fix the problem, (2) promulgate regulations that fix the problem in a taxpayer-adverse manner, or (3) promulgate regulations that fix the problem in a taxpayer-friendly manner.” polsky73 70. irs notice 2005-7, 2005-3 i.r.b. 340. 71. irc §§ 6043(c); 6045(a). 72. gregg d. polsky, can treasury overrule the supreme court?, 84 b.u. l. rev. 185 (2004) (arguing that the check-the-box regulations contradict established supreme court authority in morrissey v. comm’r, 296 u.s. 344 (1935)). 73. id. at 188-9. 2006] agency activism as a new way of life 475 correctly argues that a congressional solution is the only valid one, but “[t]he treasury, however, has recently shown a tendency to choose option number (3) (fix the problem in taxpayer-friendly manner).” polsky’s argument resonates74 regarding life. life is extraordinarily taxpayer-friendly because of the restrictions on issue selection and audit expansion. treasury is apparently75 trying to solve the problem of its insufficient resources by creating a program that is unlikely to trigger any taxpayer complaint. 76 the irs is aware of these arguments against life. in fact, the irs directly contemplated whether it had congressional authority for life early on when it was developing its internal guidelines for life. in response to the argument that life directly conflicts with provisions of the code that 74. id. at 189. 75. the irs would likely argue that the application of materiality thresholds to taxpayers’ claims as discussed in section iii.a, supra, counteracts any overly taxpayer-friendly effects. this aspect of life likely does little to lessen life’s protaxpayer effects. in the audit context, it is the irs that is much more likely to want to raise additional issues. taxpayers, especially profit-minded corporations with sophisticated tax advisers, have most likely already taken all of the deductions that they believe are even remotely available and have excluded all items that might remotely be argued not to be income. 76. see note 24 for a discussion of the private interest groups that lmsb consulted with in designing life. such consultation is akin to the farmer consulting with the fox on appropriate ways to guard the hen house, and thus the taxpayer-friendly nature of life is easy to understand. in addition to the fact that taxpayers would likely not complain about the program, the irs knows that taxpayers will be unable to challenge life, even if the program is invalid. gregg polsky argues a similar idea with regards to the check the box regulations: a more cynical explanation is that the treasury was aware of the regulations' invalidity yet issued them anyway because it severely discounted the likelihood of any judicial challenge. under this view, the treasury intentionally promulgated invalid regulations but determined that the regulations were insulated from a challenge due the very restrictive taxpayer standing doctrine discussed below. if, however, the treasury had this troubling view, it was short-sighted because, although a taxpayer with standing to challenge the regulations might be hard to find, it is inevitable that such taxpayers exist. polsky, supra note 72, at 238-9. 476 florida tax review vol.7:7 specifically treated how taxpayers should handle certain items, the irs stated in an early version of an internal frequently-asked-questions document: “it is the irs’ obligation to efficiently utilize its resources. we do not think that congress would dispute comparing potential benefits from examining an area to the resources required to perform the examination.” merely stating this, however,77 does not make it so. the irs is basically assuming congressional support for its actions rather than directly asking congress for authority to implement life. the irs is, thus, justifying taking on a legislative function based solely on its questionable assertion that congress would approve. such action is legally inappropriate even if one believes that the irs is adopting life as a good way to deal with the very real problem of diminishing enforcement resources. in78 77. first life faq, supra note 37, at 10. the full question and answer reads: based on information presented to me, it is my impression that if the taxpayer had expensed an item that has normally been capitalized over a 3-year life, i would not propose an adjustment. is this correct? if i am correct, isn’t this in direct conflict with the irc and the intent of congress? in most cases, a timing issue such as the one described in your question would not result in a material impact on the returns as a whole. there may be instances where the size of a short-term timing item would cause it to be material, in which case the item would be selected for examination. in addition, agents cannot ignore requirements involving a change in accounting method. it is the irs’ obligation to efficiently utilize its resources. we do not think that congress would dispute comparing potential benefits from examining an area to the resources required to perform the examination. yes, you have found the issue without having to perform much examination work. however, the compliance impact of spreading the deferral over the three years may not be material enough to support the time spent. 78. see polsky, supra note 72, at 187 (arguing that invalidity of the check-thebox regulations was not eliminated by the fact that they represented sound tax policy). a recent example involving the irs’s desire to assist victims of the 2004 hurricane season also illustrates this point. in response to the devastating property losses in alabama, florida, and ohio, the irs issued several notices in which owners of property that qualified for the low-income housing credit could provide temporary housing to individuals displaced by the hurricanes. notice 2004-74, 2004-48 i.r.b. 875; notice 2004-75, 2004-48 i.r.b. 876; notice 2004-76, 2004-48 i.r.b. 878. the property owners 2006] agency activism as a new way of life 477 fact, the irs has sensed the weakness of its justification, as the question about whether life exceeds the irs’s congressional authority is conspicuously absent from the final version of the frequently-asked-questions document.79 b. the irs’s unwillingness to disclose certain aspects of life raises a presumption that the irs is exceeding its audit authority through life. by acting on its own and without affording the public any opportunity to be heard, the irs has in effect created a secret law applicable to a limited group of taxpayers. the irs has compounded the problem by its unwillingness to disclose certain key components of life to the public. as can be seen from the discussion of issue selection and materiality thresholds discussed earlier, the irs has provided general guidelines as to how these processes are accomplished. the irs, however, has not provided any clear indication of (i) the amounts of the materiality thresholds it is establishing, (ii) how it establishes these thresholds, or (iii) how it will determine which issues to examine and which to ignore. in fact, in a speech on february 1, 2001, larry langdon stated that he was “frankly surprised at how large” the materiality thresholds being used were, but he refused to say what these thresholds were. rather, the irs80 has chosen to cloak these specifics behind general statements that each taxpayer’s differences make it impossible to come up with any specific, meaningful guidelines for determining materiality thresholds. even finding the guidelines is not easy. apart from what was available in the internal revenue manual, most of the information discussed in this article was obtained through a document request to the irs under the freedom of information act (foia). that request asked for all irs documents, including81 could provide this temporary housing regardless of income, without fear of losing their low-income housing credit under irc § 42 (2004). id. no one could doubt the benefits of helping those displaced by hurricanes. nevertheless, this action provides yet another example of the irs changing a section of the code without congressional authority. it is for the legislative, not the administrative, branch to change the law and to decide whether the government should be helping hurricane victims through the tax code. 79. see life consolidated faq, supra note 31. 80. larry langdon, (feb. 1, 2001), aba-177 irs’s new toolbox to resolve tax disputes: pre-filing technical guidance and other initiatives. 81. 5 u.s.c.a. § 552 (west 2004). the foia request to the irs, submitted on november 1, 2004, requested the following documents: 1. all memoranda of understanding (“mous”) entered into between the irs and taxpayers pursuant to the limited issue focused 478 florida tax review vol.7:7 mous, that might shed light on how the irs conducts issue selection and materiality threshold determinations under life. while the irs produced a variety of documents, it refused to provide copies of completed mous. these documents would provide data on the specific materiality thresholds that the irs used for corporate taxpayers from july 1, 2003 to december 31, 2003. in refusing to produce the mous, the irs stated in its response: examination (“life”) program in the large and medium sized business (“lmsb”) division from july 1, 2003 through december 31, 2003. 2. all documents prepared or used by the irs to determine the scope and the materiality thresholds for mous, as these concepts are described in sections 4.51.3.3 and 4.51.3.4 of the internal revenue manual. for your convenience, a copy of these sections of the internal revenue manual is attached. this request includes, but is not limited to, a request for any general guidance, policies, or procedures that the irs has prepared or used to determine the scope and materiality thresholds in the life program as a whole as well as the specific documents relating to scope and materiality thresholds established in the mous provided pursuant to request no. 1. 3. all documents prepared or used by the irs to determine which taxpayers will be offered to have their audits conducted under the life program. this request includes, but is not limited to, a request for any general guidance, policies, or procedures that the irs has prepared or used to determine which taxpayers generally are offered to have their audits conducted under the life program as well as the specific documents relating to how the taxpayers who entered into the mous provided pursuant to request no. 1 were determined to be eligible to have their audits conducted under the life program. 4. all training materials prepared or used by the irs to train its personnel to administer audits under the life program, including, but not limited to, training materials prepared or used by the irs to train its personnel to determine selection of taxpayers for participation in the life program and/or to establish the scope and/or materiality thresholds in the life program (described in requests 2 and 3). letter from walter edward afield to maureen sapero, foia disclosure manager, (nov. 1, 2004). 2006] agency activism as a new way of life 479 all documents are being released to you in their entirety with the exception of the deleted information that is being withheld in accordance with subsection 5 u.s.c. (b)(3) and (b)(6) of the freedom of information act. the statute for the (b)(3) exemption is 26 u.sc. 6103. the documents contain taxpayer identifiers and information that would constitute a clearly unwarranted invasion of personal privacy. life memoranda are part of a taxpayers examination file and therefore, “return information” which is not releasable in accordance with subsection 5 u.s.c. (b)(3) of the freedom of information act. however, we have enclosed a copy of the life mou template for your information.82 in withholding the mous, the irs is preventing the public from having any significant knowledge about which specific return items will meet the criteria for audit under life and what amounts of potential tax liability will be ignored under the materiality thresholds. under case law discussed further in this section, whether the irs has the authority to withhold this information in the face of a foia request depends on whether a court would consider the information to be useful in allowing taxpayers to circumvent audits or would consider disclosure of the information as serving a positive public purpose. under foia and irc section 6103 (which prohibits the disclosure of return information), the irs would likely argue that the withheld information is analogous to discriminant function scores (difs), an investigatory technique that the irs uses internally to select tax returns for an audit. courts have83 routinely held it permissible for the irs to withhold these dif scores under 5 u.s.c. section 552 and irc section 6103 because “[r]elease of this84 information could compromise the integrity of the irs and its regulatory function by allowing individuals to manipulate their dif scores and possibly 82. letter from maureen sapero, manager hq disclosure office to walter edward afield (jan. 28, 2005) (hereinafter response). 83. see buckner v. irs, 25 f.supp.2d 893, 898 (n.d. ind. 1998). 84. foia contains a list of exceptions in 5 u.s.c. § 552(b) (2004). specifically, 5 u.s.c. § 552(b)(3) protects documents that are exempt under another statute from disclosure. irc § 6103 is one such statute, as this section of the internal revenue code protects taxpayer return information from disclosure. for a full discussion, see the cases cited in note 85. 480 florida tax review vol.7:7 avoid a well-deserved audit.” courts have extended this reasoning outside of85 the dif score context and have applied it to other internal irs practices and procedures that taxpayers could use to avoid audit selection. furthermore,86 under irc section 6103, the irs can legitimately withhold information that constitutes taxpayer “return information.” courts have even held that redaction of certain portions of a document containing “return information” (such as redacting a taxpayer’s name or tax identification number) will not necessarily allow the irs to disclose the redacted document.87 these cases do present strong arguments for the irs to withhold the mous. the irs would likely argue that the mous contain corporate taxpayer information that is protected and that even redaction of the corporate taxpayer identities would not remove this protection. in addition, the irs would likely argue that disclosure of mous containing a list of the issues selected for examination, as well as the materiality thresholds used, would allow taxpayers to manipulate their returns to avoid detection of certain items that should be subject to audit. 88 authority does exist, however, that could be used to support disclosure of mous, or at least a statistical compilation of what issues are audited and 85. buckner, 25 f.supp.2d at 898 (citations omitted); e.g., gillin v. irs, 980 f.2d 819, 822 (1st cir. 1992); long v. irs, 891 f.2d 222, 224 (9th cir. 1989); pully v. irs, 939 f.supp. 429, 438 (e.d. va. 1996); lamb v. irs, 871 f.supp. 301, 304 (e.d. mich. 1994). 86. see e.g., united states v. imbrunone, 379 f.supp. 256 (e.d. mich. 1974) (protecting from disclosure numerous documents relating to irs investigatory techniques and selection of taxpayers for audit); flamingo fishing corp. v. united states, 22 cl. ct. 625, 630 (1991) (protecting disclosure of “the irs’s past practices in determining through specific audits over an 8to 10-year period that crew members of a scalloper were subject to income taxes because the normal size of the crew was not fewer than 10.”). 87. see e.g., long, 891 f.2d at 223-24; church of scientology of texas v. irs, 816 f.supp. 1138, 1150 (w.d. tex. 1993) (citing church of scientology of california v. irs, 484 u.s. 9, 19 (1987)). these cases hold that, while mere redaction is not sufficient to allow disclosure, if the information was compiled into some sort of statistical data analysis, it could be produced. 88. note that the irs has not, as of the writing of this paper, raised this argument in response to the author’s foia request. see response, supra note 82. were this issue to actually be litigated, however, this argument could potentially be available to the irs. note, however, that this argument is based on taxpayers’ inherent desire to buck the system, while life is premised on taxpayers’ honesty. see infra section v. the irs appears to have a flexible view of taxpayers’ ethics.. 2006] agency activism as a new way of life 481 what materiality thresholds are used. should the irs ever prepare a statistical89 compilation of the materiality thresholds and issues selected in a series of mous, as discussed earlier, the irs would probably not be able to rely on its privacy argument to prevent disclosure. thus, the irs would likely have to rely on the argument that disclosure of such a compilation would allow taxpayers to avoid being audited. an older case out of the sixth circuit presents a potential solution to this argument. in hawkes v. irs, the court stated that certain irs guidelines90 relating to audit selection should be produced. one of the documents made available to the public was section 6.051 of the return classifier’s handbook, which listed “the average ratio of officers’ salaries to gross income in various types of businesses.” the irs argued against disclosure “presumably on the91 ground that knowledge of the table’s specific ratios would encourage corporations not to report salaries in excess of the averages, with the hope of avoiding an audit concerning the reasonableness of their deductions for officers’ salaries.” holding that the information should be available to the public, the92 court stated: information which merely enables an individual to conform his actions to an agency’s understanding of the law applied by that agency does not impede law enforcement and is not excluded from compulsory disclosure . . . . far from impeding the goals of law enforcement, in fact, the disclosure of information clarifying an agency's substantive or procedural law serves the very goals of enforcement by encouraging knowledgeable and voluntary compliance with the law. . . . disclosure . . . would give the public a rough notion of what salaries may be unreasonable for corporate deduction purposes, in the view of the enforcing agency – the irs. the sole effect of disclosure of this information would not be easier evasion of the tax laws. rather, companies taking unreasonable deductions would be encouraged to reduce their officers' salaries to within the ranges specified . . . , and companies wishing substantially to exceed the average range would be on 89. see supra note 87. 90. 507 f.2d 481 (6th cir. 1974). 91. id. at 484 (quoting return classifier’s handbook § 6.051). 92. id. 482 florida tax review vol.7:7 notice that proof of the reasonableness of the higher salary deductions would probably be required by an irs auditor.93 the hawkes rationale could be applied to support production of the mous. hawkes could be applied on a broader scale to stand for the proposition that disclosure should occur if there is a significant public interest favoring disclosure and minimal to zero risk of abuse. cases analyzing foia’s provision protecting internal agency records from disclosure further support this view.94 applying this rationale, a taxpayer arguing for irs disclosure could make the argument that the materiality thresholds and selected issues will not help taxpayers circumvent selection for audit because a taxpayer has already been selected for audit when life is employed. granted, knowing the issues that are selected and knowing the materiality thresholds could still allow a taxpayer to keep items from being included in a life examination. however, if the irs is correct in its assertion that taxpayer differences prevent application of uniform materiality thresholds to all taxpayers, then the taxpayers will not95 be able to avoid audit by knowledge of the thresholds that have been applied to other taxpayers because the thresholds will not be the same. furthermore, the irs is essentially creating a secret law in which material relevant to an audit is intentionally ignored for certain taxpayers without any type of congressional approval, oversight, or opportunity for the public to be heard. all of the guidelines that the irs has created to determine issues and materiality thresholds under life basically boil down to the irs providing general guidance to its personnel and stating that actual determinations have to be made under the auditor’s discretion on a case-by-case basis. therefore, if examples of what these issues or thresholds are remain secret, the irs will have succeeded in fundamentally changing the law relating to taxpayer audits without the public’s knowledge. such secrecy creates a political accountability problem and inherently compromises life’s integrity. full disclosure is the only solution to these problems so that the people and their elected representatives can know what new law the irs has created without 93. id. (citations omitted). 94. church of scientology, 816 f.supp. at 1148-49 (citations omitted) (discussing “exemption 2” of foia found in 5 u.s.c. § 552(b)(2), which protects internal agency records, and stating that “[r]ecords are exempt under exemption 2 if they are internal records that (1) relate to trivial agency matters of which the public does not have a legitimate interest or (2) if disclosure would risk circumvention of an agency regulation.”). 95. see infra section v.b.3. 2006] agency activism as a new way of life 483 authorization and can make their own decisions about whether this program is sound policy. therefore, while the irs might be able to withhold individual mous based on privacy concerns, it should disclose any statistical compilation of mou data it has because of this high public interest and the fact that taxpayers cannot avoid audit selection with this knowledge. although96 encouraging greater disclosure is important, this analysis naturally leads to a broader question of whether life is in fact good public policy, regardless of any legitimacy concerns that exist. v. even if life is legitimate, is it good policy? a. public arguments supporting life the irs has taken an aggressive approach in claiming life’s advantages. commissioner mark everson has stated publicly that he believes that decreasing audit times will lead to more revenue because corporations will realize that they will be more likely to be audited because the irs will be able to perform more, though less comprehensive, audits. everson expressed97 96. note that whether the irs possesses any such statistical compilations is unclear. it did not produce any as responsive to the foia request nor did it acknowledge whether they exist or, if they exist, whether it viewed them as part of the protected “return information” it withheld. see response, supra note 82. the irs’s refusal to produce all of the requested documents is consistent with a recent culture of secrecy that has pervaded the irs. see federal lawsuit filed today against irs is part of broad effort to provide information about agency’s audit activities to the public, apr. 14, 2005, at http://trac.syr.edu/foia/ (last visited jun. 6, 2005) [hereinafter federal lawsuit]; see also dangers posed by irs secrecy, at http://trac.syr.edu/tracirs/latest/current/include/side_1.html (last visited jun. 6, 2005). susan b. long, a co-director of transactional records access clearinghouse (trac) and one of the plaintiffs currently suing the irs for its refusal to comply with a trac foia request, argues: “because a fair, effective and open tax system is so important to the nation, the irs’s new wave of secrecy about its operations is deeply disturbing and if left uncorrected could well undermine public confidence along with taxpayer compliance.” federal lawsuit supra note 96. id. her co-director and co-plaintiff in the action against the irs, david burnham, adds: “from my research, it appears the irs is reverting to its habits in the 1950s and 1960s, when secrecy was the norm and the problems of corruption and political abuse were later uncovered by the congress.” id. a copy of trac’s complaint in long v. irs, no. 05-0756 (d.d.c. apr. 14, 2005) can be found at http://trac.syr.edu/foia/complaint.pdf. id. 97. jonathan weisman, irs speeds corporate tax audits; fast-track method may miss fraud, the wash. post, dec. 29, 2003, at a01. 484 florida tax review vol.7:7 disgust with the fact that because of the historically slow pace of audits, the irs could not be a key figure in discovering the wave of the 1990s corporate scandals. everson hoped that life would help combat the “atrocious” statistic98 that a mid-size company usually faces one audit every twenty years. former99 irs commissioner charles rossotti agreed that the historical audit pace was in dire need of improvement to increase the overall amount of collected revenue: “‘does it make sense spending literally five or six years auditing routine matters that won’t produce much when there are people out there promoting billiondollar shelters in the open market?’”100 recent data seems to support the irs’s claim that life is increasing audit currency. the current commissioner of the lmsb, deborah nolan, has stated that “[t]he overall [audit] currency rate has increased from 37% in 2003 to 47% in 2004. . . .” although nolan did not single out life as the cause of101 this improvement, “[s]he attributed much of that success to the issue management tools the lmsb has developed to reduce its aging inventory of cases.” 102 life’s benefits are more evident when one compares the audit rates of lmsb taxpayers with the audit rates of small businesses: the overall audit rate for [corporations with $10 million or more]. . . rose almost 40% from a record low of 7,125 in 2003 to 9,500 in 2004. the service also increased its examination coverage of the country’s largest corporations, those with assets of at least $250 million, from 30% in 2003 to 40% in 2004. 103 this increase in audit rate for lmsb taxpayers contrasts with the decrease in audit rate for small businesses (which do not qualify for life by virtue of not being covered by the lmsb) which “fell from 0.58% in 2003 to 0.32% in 2004 – a 45% drop.” how much of this increase in lmsb audits is104 98. id. 99. id. 100. id. 101. kenneth a. gary, enforcement remains priority for lmsb, nolan says, 105 tax notes 504, 504-5 (oct. 25, 2004). 102. id. 103. allen kenney, everson evaluates state of irs, pledges strong agenda for 2005, 106 tax notes 40, 40-1 (jan. 3, 2005). 104. id. at 41. 2006] agency activism as a new way of life 485 directly attributable to life, however, is unclear as trac has credited the numbers to an increase in correspondence audits over “face-to-face” audits.105 unsurprisingly, life has received high praise from the taxpayers that are eligible for the program. an irs survey of lmsb audited taxpayers whose cases the lmsb closed between october 2002 and september 2003 revealed that taxpayers were very satisfied with life. in addition, deputy lmsb106 commissioner bruce ungar has pointed out that life’s popularity has increased from 2002 to 2004. 107 tax executives institute (“tei”), whose members are almost entirely assigned to the lmsb, has been a strong advocate of life:108 105. id.: one study, published following the irs’s release of the 2003 enforcement data, noted that most of the ballyhooed boosts in audit coverage were attributable to the agency’s growing use of correspondence audits. . . . trac called correspondence audits, which are conducted through the mail, “comparatively superficial” to audits conducted in person. id. indeed, a recent audit conducted by the inspector general for tax administration’s office stated that “[a]s of september 2004, approximately 4.2% of the examinations initiated for large businesses involved the life process.” memorandum from pamela j. gardiner, deputy inspector general for audit, for commissioner, large and mid-size business division (feb. 18, 2005), in the limited issue focused examination process has merit, but its use an productivity are concerns, ref. no.: 2005-30-029 (feb. 2 0 0 5 ) , a t h t t p : / / w w w . u s t r e a s . g o v / t i g t a / a u d i t r e p o r t s / 2 0 0 5 r e p o r t s / 200530029fr.pdf (hereinafter life audit memo). of course, even if correspondence audits played a significant role, they represent a similar audit policy to life – namely to sacrifice thoroughness in the name of efficiency. 106. alison bennett, taxpayer satisfaction with larger audits relatively high, but tied to time, irs finds, 154 bna daily tax report g-2, g-2 (aug. 11, 2004). 107. kurt ritterpusch, ungar details programs to accelerate lmsb audits, adaptation to new tax law, 213 bna daily tax report g-9, g-9 (nov. 4, 2004). 108. statement of timothy j. mccormally, executive director, tax executives institute, inc., testimony before the subcommittee on oversight of the house c o m m i t t e e o n w a y s a n d m e a n s , ( m a r . 3 0 , 2 0 0 4 ) , a t http://waysandmeans.house.gov/hearings.asp?formmode=view&id=1318. 486 florida tax review vol.7:7 an informal survey of tei members recently confirmed that lmsb’s life initiative – which focuses on materiality of issues and risk analysis of issues to be audited – is streamlining the examination process. we understand that lmsb’s interim review of life validates this conclusion, and accordingly strongly recommend that future initiatives be designed to complement and supplement these programs, not replace or supplant them. 109 the fact that both the irs and the taxpayers have such a positive opinion of life could be viewed optimistically as rare agreement by the government and the taxpayers that a government program can fairly tax citizens while improving government efficiency. pessimistically, and more realistically, such agreement could signal that one of the sides is not correctly perceiving the program’s consequences. one must ask the question: if faster audit times really result in fair collection of revenue as well as an increased frequency of audits, why would such a program excite taxpayers? the answer to this question must be found in some of the criticisms that have been leveled against life. b. public arguments attacking life while the irs and lmsb taxpayers have gone to great lengths to tout life’s advantages, the program has several problems that take the petals off the rose. contrary to the irs’s belief, life inappropriately sacrifices audit quality for reduced audit time. that sacrifice can directly lead to taxpayer manipulation. second, life’s inappropriate use of discretion irreparably damages the rule of law. in addition, life violates the irs’s duty to treat taxpayers consistently. finally, life is premised on a faulty assumption that there are morally good corporate taxpayers and that the irs can identify them. 1. life sacrifices thoroughness and enables taxpayer manipulation – although the irs’s top officials have been touting life’s successes, voices from irs auditors have raised several concerns regarding life. these auditors state that life provides a much too rigid audit formula that results in a vastly increased potential for fraudulent taxpayer activity to go undetected. one110 auditor quoted in the washington post summarized this complaint: 109. id. 110. weisman, supra note 97; glass jacobson, supra note 8, at 1-2. 2006] agency activism as a new way of life 487 “there used to be a point of no return, where when you found something wrong, you were there, and you were going to stay there,” said one corporate tax auditor, who spoke only on condition of anonymity out of fear of being fired. “there was no way they were going to get you out, and you had the power of the irs behind you. “now, even if you find the adjustment, find actual fraud, management is still throwing you out of the building,” the auditor said.111 in addition, some irs officials have complained “that accounting firms and corporate tax offices are too plugged in to what the irs is focusing on. . . . focusing on particular issues simply changes the behavior of tax cheats.” 112 even life’s creators are questioning its current use. larry langdon believes that commissioner everson’s focus on using life as a sword to cut down audit times so drastically is a misuse of the program. langdon stated113 that he originally intended life to be used on around 25% of lmsb audits, which would decrease the time of those audits but would not affect the overall time of lmsb audits. according to langdon, to achieve everson’s goals, the114 lmsb would have to use life on nearly 75% of its audits, defeating langdon’s original goal only to use life on taxpayers with a good track record of compliance. 115 b. john williams jr., the former irs chief counsel, echoed langdon’s concerns about the overuse of life. williams stated that “[b]y declaring that audits should take 15 to 18 months, everson is virtually guaranteeing that irs auditors will miss tax dodges, fail to explore suspicious transactions, or even walk away from audits that are on the verge of finding wrongdoing.”116 111. weisman, supra note 97. 112. id. 113. id. 114. id. 115. id. 116. id. these misses and failures could have profound economic effects: [t]he statistics show life cases are generating less additional recommended taxes than other large business examinations, which could impact tax revenues. [o]ur analysis indicates [if the irs allocated] 5% of the available examinations [of large businesses to the life process] over the next 5 years, the amount of recommended 488 florida tax review vol.7:7 indeed, because of the irs’s new policy of secrecy, it is impossible for the public to determine if life is playing a significant role in achieving everson’s efficiency goals, especially in light of a recent inspector general for tax administration audit indicating a more limited use of life. in its quest117 to demonstrate increased audit rates, the irs may be hiding something. to know for sure whether life is the cause of the efficiency increase is currently not possible because the irs has been withholding some of the information necessary to attribute the reported increase to life. the transactional records access clearinghouse (trac) has gathered data indicating that: while the overall audit rate for corporations has continued to decline, the fy 2004 rates for the larger corporate returns with assets of $10 million or more increased for the first time in many years. still the fy 2004 rates for these are only a fraction of what they were a decade ago.118 trac, however, indicated that it was having difficulty explaining this recent increase in lmsb audit rates because of the irs’s refusal to provide trac with all of the information it needed to conduct an informed analysis: the reality behind this very recent increase in the audits of larger corporations is not clear, partly because the irs currently is withholding essential data. because the irs has refused to make public supporting details to back up commissioner everson’s official statements or to provide other material about a wide range of other irs enforcement activities, fully documenting what the agency is doing, and not doing, has become more and more difficult. the agency's additional taxes could drop an average of $349 million a year ($1.7 billion over 5 years). life audit memo, supra note 105, at 6, 7. one shudders to estimate what the impact if langdon’s goal of 25% use of life were implemented, much less if life were used in 75% of the audits, the number langdon anticipated would be necessary to achieve everson’s goals. see section v.b.1. 117. life audit memo, supra note 105. 118. corporate audit rates – wide disparities found in different industries, at http://www.trac.syr.edu/tracirs/latest/current/ (last visited jun.6, 2005). 2006] agency activism as a new way of life 489 current closed-door policy reverses information practices that have been generally followed for the last three decades. 119 such limited disclosure combined with the irs’s refusal to disclose all of the documents in this author’s foia request supports the conclusion that the irs is creating a secret law through life without any accountability.120 some insight can be obtained by a trac analysis performed on data from the first half of 2004. “the group said irs data showed a 10% decline in the time spent on examinations of moderately sized corporations in the first half of fy 2004, while time spent on audits of the largest companies dropped by 33%, trac said.” trac believed that such a decline in thoroughness of the121 audits of large corporations could have greatly contributed to the fact that the irs concluded that substantially less additional taxes discovered through corporate audits were due in the first half of 2004 than in 2003. trac122 concluded that the lmsb “has tried to hold the line on audit coverage by allowing the time allocated for each audit to slip.” thus, this data contradicts123 the irs’s claim that it can decrease audit times while maintaining audit thoroughness. the irs has summarily dismissed many of these complaints against the program with little acknowledgment of their possible merit. the internal revenue manual states succinctly that “[t]he establishment of a materiality threshold(s) will not impact the examiner’s responsibility to verify the proper computation of tax liability.” the internal revenue manual, however, does124 not say how an auditor can ascertain the correctness of any return while ignoring all but a few items that warrant audit. other irs officials have offered a better answer to the negative comments. they have argued that “their analytical techniques, along with their knowledge of the company’s history, will prevent taxpayers from using the life process to divert attention from scams and abuses.” this statement is,125 119. id. see section iv.b, supra, for a more detailed discussion of the information that the irs has withheld regarding life. 120. see supra section iv.b. 121. alison bennett, trac says pace of corporate audits headed toward new low in fiscal 2004, 211 bna daily tax report g-2, g-3 (nov. 2, 2004). note that the irs has criticized trac’s arguments because the irs does not believe that accurate conclusions can be derived from data that only reflects six months. id. 122. id. 123. id. 124. i.r.m. 4.51.3.4.5(5) (2004). 125. crenshaw, supra note 9. 490 florida tax review vol.7:7 of course, tacit recognition of the fact that life offers taxpayers new opportunities to cheat. in the first place, life requires one to ignore all but a few issues that warrant audit. life is premised on the fact that many items that warrant audit will be intentionally ignored. furthermore, how can the auditors have a strong knowledge of a company’s history if it has been audited only once in twenty years? deborah nolan has also relied on the life audit procedures as an inherent obstacle to abuse of life because these procedures “allow auditors to follow trails off audit plans if solid evidence indicates problems.” 126 one of the more telling statements that the irs has made regarding these complaints occurs in an internal, frequently-asked-questions document that the irs prepared regarding life. in response to the question of whether it would be possible for the auditor to “determine the issues that will have substantial noncompliance without getting into the books and records of the taxpayer,” the entire answer was as follows: the life process may change the way you conduct your examination. after conducting your full risk analysis, life involves increased communication and interaction with the taxpayer as well as materiality considerations in setting/narrowing your initial scope. inherent in the process is examining issues with the greatest compliance risk in a shorter timeframe due to increased involvement of the taxpayer. once you have identified an account or a transaction, you should be communicating with the taxpayer, having them explain the transaction to you, rather than issuing a series of idrs. the examination techniques that you use to determine that the taxpayer has reasonably complied with the law do not change. 127 this double-speak makes it clear that the irs understands the problem, has no answer, and has determined to ignore its implications. by merely stating that the audit process will change, the irs has managed to answer the question without answering it at all. nothing in the above statement actually addresses the concern over whether the shortened audit process could have drastic thoroughness ramifications. 126 weisman, supra note 97. also see section iii.c.2, supra, for a discussion of how an audit can be expanded without regard to materiality thresholds if the auditor discovers certain types of abuse. 127. first life faq, supra note 37, at 3 (emphasis in original). 2006] agency activism as a new way of life 491 the irs is not convincingly addressing the merits of these arguments against life. the irs’s attitude seems to be “trust us, we can handle it.” merely stating that the complaints are without substance is not an answer to them. the irs needs to be much more persuasive in explaining how it is effectively handling the concerns over life leading to a lack of thoroughness and potential taxpayer abuse. imagining how the irs can do this, however, is difficult because it defies logic to argue that limiting the issues to be addressed and utilizing materiality thresholds to curb audit scope expansion will not compromise the thoroughness of those audits. 2. life hurts the rule of law – although life involves very little discretion once the issues are selected and the materiality thresholds are set, the decision of whether or not to use life as well as the issue selection and threshold determination are highly discretionary. larry langdon recognized this when he instituted life, and he stated in an internal memorandum in the life training manual: i recognize that the life process is not appropriate for all examinations. i also realize that there will be instances when we have agreed to conduct a life examination but circumstances require that it be terminated. i will be relying on your judgment to determine when the use of this process should be employed, as well as when the process should be terminated. 128 this discretion over which taxpayers should be eligible for life, as well as the discretion in issue selection and materiality threshold determination, present significant problems if one assumes that the tax system should favor rule of law values. edward morse has argued that “[r]ule-based constraint is likely to enhance efficiency in tax administration and protect taxpayer rights to a greater degree than a discretionary approach to justice.” although discretion cannot129 be completely removed from the tax system, it must be contained to preserve the rule of law. too much discretion in a rule-based system is problematic130 128. memorandum from larry langdon to lmsb employees (oct. 21, 2002), reprinted in life training manual, supra note 19, at ii. 129. edward a. morse, reflections on the rule of law and “clear reflection of income:” what constrains discretion?, 8 cornell j.l & pub. pol’y 445, 451 (1999). 130. id. at 448. 492 florida tax review vol.7:7 because it creates distrust in a decisionmaker’s ability to apply rules consistently and fairly. in addition, “[d]iscretion also threatens the internal morality of law131 by undermining the notice and publicity requirement of rules.” life132 exemplifies these destructive characteristics of an audit system that has too much uncontrolled discretion. an audit is inherently discretionary. it is properly up to treasury to determine which taxpayers and what issues should be audited consistent with ascertaining a tax return’s correctness. while such discretion might injure the rule of law, it does not destroy it entirely. life, however, greatly and inappropriately expands this discretion. in life, the lmsb has created an audit program that it will apply to taxpayers on a discretionary basis. in addition, the program’s authorization of an auditor to select only a few of many identified issues for audit provides the irs with the discretion to intentionally ignore information relevant to ascertaining the correctness of a return. thus, with this system, the discretion that the irs has solely on the basis of its own authority now directly conflicts with the irs’s legislatively granted authority to examine relevant information (and not to ignore it intentionally) to ascertain the correctness of a return. the problems133 with such discretion are compounded by the fact that the irs is not enacting life through the promulgation of regulations. as morse points out: deference to agency interpretations embodied in prospectively applicable regulations does not present a significant threat to rule of law values. changing the locus of rulemaking from the legislative to the executive branch may implicate other concerns, but regulations with rule-like characteristics provide taxpayers with notice of their obligations and facilitate planning. moreover, they facilitate consistent treatment of taxpayers by announcing the official agency position to those who must enforce those rules.134 not only does life signify an increase in the irs’s discretion with questionable legislative support, it does so without treasury adopting the program through specific regulations that could lessen its damage to the rule of 131. id. 132. id. 133. see section iv, supra, for a more complete discussion of whether or not the irs has the authority to conduct life. 134. morse, supra note 129, at 485-86 (citations omitted). 2006] agency activism as a new way of life 493 law. furthermore, it has determined to keep secret two critical elements of the135 program – the issues it is selecting and the manner in which materiality thresholds are determined. thus, life effectively gives auditors discretion136 to secretly change the law as it applies to a particular taxpayer. 3. life violates the irs’s duty to treat taxpayers consistently – another problem with life is that it violates the government’s duty to treat taxpayers consistently. while there is some debate as to the extent of the duty137 of consistency, the general rule appears to be, unless there is a rational basis138 to treat taxpayers differently, they should be treated similarly. even a139 publication by the tax executives institute, an organization that enthusiastically supports life, stated that there could be a potential duty of consistency problem because “[o]ne examiner may establish more stringent materiality limits and audit more items than another examiner who is more liberal with the threshold.”140 in response to this concern, the irs believes it can treat taxpayers consistently regarding the use of materiality thresholds without establishing any specific guidelines. in establishing its materiality guidelines both for issue and threshold selection, the irs has stated that producing specific guidelines for 135. the only apparent regulatory authority is the permissive language in regs. § 301.7602-1(a) discussed earlier in section iv. this general regulatory language is not specific enough to satisfy the uncertainty that threatens the rule of law. 136. see supra section iv.b. 137. this problem is ironic considering that the irs’s press release announcing life stated: “life is an effort by lmsb to institutionalize best practices and provide consistency in the treatment of taxpayers.” irs news release ir-2002-133 (dec. 4, 2002). 138. see molly moses, uphill battle predicted for glaxo on apa discrimination claim, 94 bna daily tax report j-1, j-3 (may 17, 2004) (comparing recent cases indicating a duty of consistency with those that indicate that the irs is not required to treat current taxpayers consistently with prior erroneous treatment). 139. sherwin-williams co. v. u.s., 403 f.3d 793, 797 (6th cir. 2005) (citing oshkosh truck corp. v. u.s., 123 f.3d 1477, 1481 (fed. cir. 1997)). 140. james a. dougherty & rona m. faust, irs instills new “life’ into its audits -limited issue focused examinations, tax executive, (jan.-feb. 2003), at http://www.findarticles.com/p/articles/mi_m6552/is_1_55/ai_98416259. of course, perhaps because of tei’s enthusiasm over the program, the authors tempered their concern by mentioning several mitigating factors: “the first is that the examiner should seek input in determining the thresholds from irs specialists and the taxpayer. furthermore, if the taxpayer disagrees with the materiality level, the taxpayer should ask to speak to the team manager.” id. 494 florida tax review vol.7:7 determining materiality is impossible. nevertheless, the irs has stated it can141 provide equal treatment to taxpayers by applying a consistent process in determining materiality. despite this emphasis on consistency, the irs states142 that an auditor’s discretion is essential in determining materiality. in fact,143 when compiling its initial frequently asked questions about life, the lmsb responded to the question of whether or not it was attempting to create blanket materiality thresholds for all taxpayers as follows: absolutely not! no two taxpayers are identical. the differences in location, size, business practices, industries, etc., make it impossible and impractical to set one standard. for this reason, provided [sic] examples to demonstrate different ways to establish materiality and encourage agents to use professional judgment in conjunction with a methodology that they believe is appropriate.144 what the irs perhaps does not realize in its response, however, is that the use of materiality thresholds will, by definition, result in the inherent inconsistent treatment of taxpayers. the fact that taxpayers are not identical does not mean that they cannot be treated relatively equally. the more discretion that is given in an audit process, however, the more unlikely it is for this consistent treatment to occur. thus, life’s discretionary side creates as many problems as its overly rigid aspects, indicating that life does not integrate necessary discretion properly into the audit process. furthermore, the irs’s response does nothing to address the fact that taxpayers outside of the lmsb’s jurisdiction are not even eligible to participate in life. if life is so beneficial and does not result in the problems already discussed, what rational basis could there be for not applying it to all audits? 141. i.r.m. 4.51.3.3.4(2) (2004). 142. see, e.g., i.r.m. 4.51.3.3.4(2) (2004); life training manual, supra note 19, at 8-9; first life faq, supra note 37, at 7, 9; life consolidated faq, supra note 31, at 8. 143. i.r.m. 4.51.3.3.5(10) (2004); life training manual, supra note 19, at 1012, 18. 144. first life faq, supra note 37, at 9-10 (emphasis in original). the internal revenue manual echoes this statement: “a threshold(s) set for one period or taxpayer should not be automatically extended to either another taxpayer or another period for the same taxpayer. a separate risk analysis must be performed for each examination.” i.r.m. 4.51.3.4.5(6) (2004). 2006] agency activism as a new way of life 495 4. life is premised on a faulty assumption regarding taxpayer honesty – if the rule of law suffers in the tax system, “citizens lose faith in the fairness of the tax system and are less inclined to honor it.” richard lavoie145 argues that today “[t]he rule of law is flagging as the system struggles with its own mind-numbing complexity and revelations that many profitable corporations and wealthy individuals pay little or no tax.” as a result, while146 taxpayers in the 1970s considered the tax system to be fair, today, after the increase of corporate tax shelter activity in the 1990s, most taxpayers believe that the system is unfair.147 lavoie argues that this failure of the rule of law has contributed to the modern taxpayer rarely taking moral or ethical considerations into account when deciding the taxpayer’s level of compliance with the tax laws. the148 government should not expect taxpayers to rely on their own internal sense of right and wrong as they consider their tax liability. rather, the government149 should understand that taxpayers’ behavior will be much more heavily influenced by issues such as the taxpayer’s determination of the likelihood of being caught and punished. 150 for corporations, this failure of morality in tax planning is even starker than for individuals. according to lavoie, for the corporate tax planner “[e]thical considerations about the moral appropriateness of playing games with the tax system generally do not enter the calculus.” maximizing profits to151 shareholders is much more likely to drive corporate executives making tax 145. richard lavoie, subverting the rule of law: the judiciary’s role in fostering unethical behavior, 75 u. colo. l. rev. 115, 176-77 (2004). 146. id. at 181. 147. id. at 181. 148. id. lavoie points out that: for some the very concept that ethical considerations could impinge on tax planning may seem absurd. after all, the appropriateness of tax planning has long been accepted. additionally, certain provisions of the internal revenue code (the “code”) were adopted with the express goal of harnessing tax planning as a means of modifying taxpayer behavior. however, while tax planning is permissible, tax evasion is not. the gray area between the two falls under the domain of tax ethics. id. at 175-76 (citations omitted). 149. id. at 121-22. 150. id. at 121-22. 151. id. at 186. 496 florida tax review vol.7:7 compliance decisions, especially if the corporations are publicly traded. such profitability would necessarily include minimizing the corporation’s tax liability. this mindset has enormous implications for life. as discussed in section v.b.1, when life was created, the lmsb intended that it should only be used for a small number of lmsb taxpayers that had good compliance histories and were therefore trustworthy. life, however, appears to be based on a faulty premise. assuming that any corporate152 taxpayer can be trusted to pay its fair share is risky because of the non-ethically based motives that drive taxpayer decisions today. just because a corporation has a good past track record does not mean that the government can trust that corporation not to take advantage of the life system. the more realistic presumption is that if corporate taxpayers determine either through observation or conversations amongst themselves that there are ways to manipulate the lack of thoroughness inherent in the life system without being caught, they will do so. for example, if corporations determine that the irs tends to look at similar issues across the board or tends to set similar materiality thresholds, it will not be difficult for those corporations to manipulate their transactions to take advantage of this knowledge. despite the government’s contention that different materiality thresholds will be used for each taxpayer, its reticence in disclosing any hard data about what materiality thresholds are being used strongly suggests that a discernible pattern applicable to a number of taxpayers exists. although the government technically states that it can terminate the life audit if there is an indication of fraud, there is only a slim chance of the government even detecting this fraud because of the restrictions on looking outside specific issues. 152. at least one other division of the irs recognizes the faultiness of this premise. martha sullivan, the director of the irs exempt organizations division, in describing her division’s recent initiatives, stated: “‘it’s important to understand that a balanced enforcement program has to have some across-the-board coverage. if you don’t, then the good taxpayers will start to become bad because they will start to think we’re not looking.’” stephen joyce, irs shifting enforcement actions regarding taxexempt groups to crack down on abuses, 98 bna daily tax report g-12, g-12 (may 23, 2005). the irs is not the only taxing entity that is operating from this faulty premise. france has recently unveiled a plan to reform corporate audit procedures and improve taxpayer response time. lawrence j. speer, france unveils blueprint for simplifying return filing, new corporate audit limits, 213 bna daily tax report g-2 (nov. 4, 2004). in commenting on the new plan, the french finance minister nicolas sarkozy stated that “[o]ur idea is that taxpayers are honest, and that only a slight minority are committing fraud.” id. at g-2. 2006] agency activism as a new way of life 497 this potential for taxpayer abuse of life undermines life’s goal of relying upon increased audit coverage to lead to greater corporate compliance and in increased revenue. life will likely result in decreased, rather than increased, corporate compliance as taxpayers manipulate their participation in the program to their benefit. as a result, any increase in revenue obtained by increasing the audit rate will be more than offset by the decreased revenue resulting from the taxpayer abuse. vi. conclusion although having insufficient resources is not a new problem for the irs, the agency is getting much more aggressive in its solutions to this problem through a new policy of administrative activism. the expanded use of life reflects the irs’s clear vision to make the most of its very limited resources by reducing audit times to perform as many audits as possible. this vision is also evident in the fact that timesaving techniques are beginning to spread to other irs divisions. the irs cannot solve this problem by unilaterally153 153. for example, the irs is launching a pilot program in 2006 in which virtually real-time audits will be used to detect abuse trends and provide better advice to taxpayers. john herzfeld, irs to launch pilot project to speed audits, guidance process, official says, 188 bna daily tax report g-1 (sept. 29, 2004). furthermore, the irs has experimented with establishing artificial cutoff points on certain audit times: “though auditors may prefer to hold out to complete the “perfect audit,” [deputy irs commissioner for services and enforcement mark e.] matthews said, ‘the return on investment for that last 50% or 70% of effort may not be that great.’” id. at g-1. in addition, the lmsb is instituting other timesaving policies of its own to improve audit currency. see kenneth a. gary, irs evaluating comments on enhancing audit currency, 104 tax notes 887, 887 (aug. 30, 2004); glass jacobson, supra note 8, at 34. in fact, the only sign that use of life might be diminishing comes in the form of it being potentially replaced by a “currency initiative” announced in 2004 that takes an even more aggressive stance to emphasizing audit speed. molly moses, practitioners say hurried audits under currency initiative leading to incomplete analyses in large, complex transfer pricing cases, 64 bna daily tax report j-1, j-1 (apr. 5, 2005): we found, for example, the progress of implementing the life process was hindered by a new initiative, the currency and cycle time improvement initiative (currency initiative), that overlapped with the implementation of the life process and was more aggressive in holding examiners accountable for closing examinations. as a result, examiners gave the currency initiative a 498 florida tax review vol.7:7 implementing procedures that possibly exceed its congressionally granted audit authority. to do so would greatly damage the rule of law that is essential to the tax system. in addition, while life is reducing audit times, it is doing so at too great a price. life has allowed too much discretion where none should exist and limited discretion where more should be used. the very nature of the system creates enormous problems due to a drastic decline in audit thoroughness. as a result, the lmsb is giving corporate taxpayers an opportunity to take advantage of life to hide fraudulent activity. even if life were just applied to “good” taxpayers as it was originally intended, such taxpayers, especially at the large corporate level, probably do not exist. despite the irs’s efforts to prevent taxpayers from discovering detailed information regarding how issue selection and materiality threshold determination are established, corporate taxpayers will eventually learn from sharing information with each other whether there is a discernible pattern that could aid in predicting how the irs determines these issues. compounding these problems is the fact that the irs’s lack of full disclosure regarding the program basically allows the agency to create a secret law without any meaningful political accountability. the solution is a simple one. the irs needs to go to congress. either congress needs to increase the amount of resources going to the irs so that the lmsb is not forced to disregard information that could be highly relevant in determining tax liability or congress needs to give the irs direct authority to use techniques like life. while congressional approval of life would not remove its problems, at least it would indicate that the people, through their elected representatives, had consented to the trade-offs that accompany life. congressional approval of life is unlikely, however, because such approval would lead to a negative reaction from the public and the media because of its favorable treatment of large corporate taxpayers. thus, increased resources154 higher priority than the life process, which had the effect of reducing the number of life cases. id. (quoting from a feb. 18, 2004 treasury inspector general for tax administration report). 154. of course, direct congressional disapproval of life could be equally as unlikely because congress might not want to be seen as opposing a program that is so popular with corporate america. this would not be the only example of congress doing nothing while the irs gives too much to corporations. for example, the senate finance committee recently investigated the irs’s advance pricing agreement program (“apa”), “wherein the irs cuts transfer pricing deals with large corporate taxpayers.” lee a. sheppard, draft senate finance apa 2006] agency activism as a new way of life 499 for irs enforcement is the only solution that makes practical sense. without either of these solutions, however, the irs has greatly overstepped its function. a society that values the rule of law cannot tolerate this result, even if done with the best of intentions, because these intentions can pave the road to a place where we dare not go. report shows incompetent irs, 2005 tax notes today 119-21, (june 22, 2005). the apa is somewhat similar to life in the sense that both programs involve an advance agreement between the taxpayer and the irs. “an apa is a binding contract between the irs and a taxpayer by which the irs agrees not to seek a transfer pricing adjustment under irc § 482 for a covered transaction if the taxpayer files its tax return for a covered year consistent with the agreed transfer pricing method.” advance pricing a g r e e m e n t p r o g r a m , a t http://www.irs.gov/businesses/corporations/article/0,,id=96277,00.html. the investigation resulted in a draft report that “points out . . . that the program is badly managed, and the irs is giving away the store.” sheppard, supra note 154. according to the draft report, rarely are taxpayers actually kicked out of the apa, and some taxpayers are not paying tax because of transfer pricing. id. furthermore, there was considerable movement of apa officials into the private sector, which resulted in “some back scratching.” id. although the specific revenue loss under the apa is unknown, it is predicted “to be massive.” id. “yet the report was widely expected to be a whitewash, since senators on both sides of the aisle like the apa program because business likes it. the court of appeals for aggrieved business is not about to kill a program that business is happy with.” id. a. public arguments supporting life florida tax review volume 20 2017 number 5 i articles the fallacious objections to the tax treatment of carried interest douglas a. kahn jeffrey h. kahn considering "citizenship taxation": in defense of fatca young ran (christine) kim uf law 2017 fl tax review 20-5 kahn-kim r2.pdf 1 5/13/17 11:01 am florida tax review volume 20 2017 number 5 ii information for subscribers the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. for volume 20, the subscription rate is $125.00 in the united states and $145.00 elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. for volume 20, subscriptions and changes of address should be sent to florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. beginning with volume 21, the florida tax review will be published by the university of florida press on behalf of the graduate tax program of the university of florida levin college of law. for subscription information and queries relating to volume 21 and subsequent volumes, please contact the johns hopkins university press, p.o. box 19966, baltimore, md 21211; phone 1-800-548-1784; jrnlcirc@press.jhu.edu. all correspondence of a business nature, including advertising, should be addressed to the university of florida press, 15 nw 15th st., gainesville, fl 32603; phone 352-392-1351; http://upress.ufl.edu. copyright © 2017 by the university of florida uf law 2017 fl tax review 20-5 kahn-kim r2.pdf 2 5/13/17 11:01 am florida tax review volume 20 2017 number 5 iii editor-in-chief charlene luke professor of law university of florida associate editors university of florida yariv brauner hugh culverhouse eminent scholar karen burke richard b. stephens eminent scholar dennis a. calfee professor of law patricia e. dilley professor emeritus michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law martin j. mcmahon, jr. james j. freeland eminent scholar adam smith visiting assistant professor lee-ford tritt professor of law samuel c. ullman adjunct professor of law steven j. willis professor of law board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university– bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate student editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell kathleen duggan pfahlert executive assistant jessica e. joseph uf law 2017 fl tax review 20-5 kahn-kim r2.pdf 3 5/13/17 11:01 am florida tax review volume 20 2017 number 5 iv information for contributors the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law. the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the florida tax review prefers electronic submissions sent via expresso (https://www.bepress.com/products /expresso/); articles may also be e-mailed to ftr@law.ufl.edu as a microsoft word document. if a hard copy submission is necessary, please mail your article to editor-in-chief, florida tax review, university of florida levin college of law, 309 village drive, gainesville, fl 32611. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. all citations should follow the bluebook uniform system of citation (20th ed.); some modifications will, however, be made by our editors to conform to the florida tax review style manual. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the florida tax review. uf law 2017 fl tax review 20-5 kahn-kim r2.pdf 4 5/13/17 11:01 am florida tax review volume 20 2017 number 5 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations promulgated under the internal revenue code of 1986, as amended, unless otherwise indicated. uf law 2017 fl tax review 20-5 kahn-kim r2.pdf 5 5/13/17 11:01 am uf law 2017 fl tax review 20-5 kahn-kim r2.pdf 6 5/13/17 11:01 am microsoft word knoepfle 1st 5 pages-use.doc florida tax review volume 9 2009 number 4 the pension protection act of 2006: a misguided attack on donor-advised funds and supporting organizations by terry w. knoepfle∗ i. introduction…………………………………………………….223 ii. background …………………………………………………….223 a. supporting organizations……………………………………….224 b. sponsoring organizations and donor-advised funds …………227 iii. intermediate sanctions prior to the 2006 amendments ……………………………………………….228 a. enactment…………………………………………………………228 b. irs enforcement of irc section 4958 prior to the 2006 amendments………………………………………………….231 c. final regulations under irc section 4958 .............................. 232 d. new final regulations………………………………………….237 e. donor-advised funds ………………………………………….238 iv. the irs’s stepped-up enforcement of irc section 4958 ……………………………….……………………239 a. irs confusion ……………………………………………………239 b. the irs gets aggressive: stepped-up enforcement and the carracci case ………………………………………………240 v. the pension protection act of 2006 targets donor-advised funds and supporting organizations ….243 a. ppa’s amendments to the intermediate sanctions provisions …244 b. ppa’s provision imposing excise taxes on more than incidental benefits…………………………………………….246 c. ppa’s provision imposing taxes on sponsoring organizations for taxable distributions and distributions to certain supporting organizations……………………………………………246 ∗ terry w. knoepfle, j.d., cpa; associate professor of business law, north dakota state university college of business. this author gratefully acknowledges his mother, mary, late father, lyle, and late grandparents william and albina hunter, for their invaluable guidance and encouragement over the years. the author also thanks north dakota state university and its college of business for providing research support. 222 florida tax review [vol. 9:4 d. differences between irc section 4966 and section 4967 ……………………………………….……………..247 e. study of donor-advised funds and supporting organizations ……………………………………………………..247 vi. jct and irs guidance on the 2006 amendments ............. 250 a. jct report on amendments to irc section 4958: impact on donor-advised funds ……………………………………………250 b. excise tax on more than incidental benefits to disqualified persons ……………………………………………….251 c. jct report on amendments impacting supporting organizations …………………………………………252 d. irs guidance ............................................................................. 253 vii. the case against the attack on donor-advised funds and supporting organizations ………………………………256 a. bad tax policy………………………………………………….256 1. targeting donor-advised funds and supporting organizations to raise revenue or close the tax gap is unsound policy ................................................................. 256 2. there is no rationale to treat donor-advised funds and supporting organizations more harshly than other exempt organizations……………………………….258 3. the irs had the tools needed to resolve issues of excess benefits prior to the ppa’s amendments ……….259 4. facts and circumstances test is meaningless and unworkable in these situations, and the impact on smaller exempt organizations is disproportionate…….260 b. bad public policy: ppa amendments dissuade donors from establishing donor-advised funds and being actively involved in the charitable issues that matter most to them ………..262 viii. conclusion ……………………………………………………….263 2009] the pension protection act of 2006 223 i. introduction in 2006, with the passage of the pension protection act (ppa),1 congress provided the tools for the internal revenue service (irs) to launch a full-scale attack on tax-exempt, charitable organizations, particularly sponsoring organizations of donor-advised funds, donor-advised funds, and supporting organizations, as well as their donors and advisors. in fact, the irs already had every tool it needed to monitor, regulate, and sanction donor-advised funds and supporting organizations. the legislation was primarily enacted as a message to the irs to go after donor-advised funds and supporting organizations. as an incentive, congress passed draconian penalty excise taxes that apply only to donor-advised funds and supporting organizations, and not to other public charitable organizations. the impact of this legislation has been to dissuade donors from creating donor-advised funds and, as a result, to negatively impact the ability of public charities to provide the types of assistance and support that communities across the united states have relied on for decades. the ppa’s amendments impacting sponsoring organizations, donoradvised funds, and supporting organizations has added incomprehensible complexity to the code that flies directly in the face of recommendations from the treasury department. moreover, these amendments open the door to the types of irs abuses discussed in this article. tragically, the economic costs to these charitable organizations will result in less revenue being expended for vital community needs. this article will (1) introduce the ppa’s amendments that have negatively impacted donor-advised funds and supporting organizations, (2) explain the events that led up to the misguided enactment of these amendments, particularly with regard to intermediate sanctions and the “incidental benefit” provisions, (3) analyze the impact that these amendments have had and will have on exempt organizations, including donors, officers, employees, and advisors to donor-advised funds and supporting organizations, and (4) explain why congress’ and the irs’s attack on donor-advised funds and supporting organizations is both bad tax and public policy. ii. background charitable organizations described in irc section 501(c)(3) are classified under irc section 509 as either public charities or private foundations, depending on their exempt purposes, the sources of their financial support, or their manner of operation.2 a contribution to a public charity allows a taxpayer 1. pension protection act of 2006 (pub. l. 109-280). 2. see generally irs notice 2007-21. 224 florida tax review [vol. 9:4 to take a higher charitable deduction than a contribution to a private foundation.3 supporting organizations are classified as irc section 501(c)(3) charitable organizations.4 donor-advised funds often are established and maintained by public charities through sponsoring organizations that are also classified as irc section 501(c)(3) charitable organizations.5 a 501(c)(3) or (4) organization is not operated exclusively to further a tax-exempt purpose if its net earnings inure to the benefit of a private shareholder or individual.6 in addition, such an organization is not organized and operated exclusively to further an exempt purpose if it is operated for the benefit of private interests.7 the private inurement rule addresses the issue of benefits to an organization’s insiders. the private benefit rule prohibits an exempt organization from providing benefits (other than incidental benefits) to any person, whether or not that person is an insider. (of course, benefits may be provided to the class of persons that fall within the scope of the organization’s exempt purpose). a. supporting organizations in general, supporting organizations are tax-exempt organizations that provide support to another 501(c)(3) organization that is not a private foundation. to qualify as a supporting organization, an organization must: (1) be organized and operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of, one or more “publicly supported organizations;”8 or (2) be operated, supervised, or controlled by, or in connection with, one or more publicly supported organizations;9 and (3) not be controlled directly or indirectly by one or more disqualified persons (as defined in 4946) other than foundation managers and one or more publicly supported organizations.10 by qualifying as a supporting organization under 509(a)(3), a nonexempt charitable organization can avoid being classified as a “private foundation,” which is subject to much stricter regulation. supporting organizations are public charities that fulfill their exempt purposes by supporting one or more other exempt organizations. the primary feature of a supporting 3. id. 4. supporting organizations that meet the requirements of 501(c)(3) are classified as public charities. see irc § 509(a)(3). 5. see generally irs notice 2007-21. 6. irc § 501(c)(3); treas. reg. § 1.501(c)(3)-1(d)(2)(ii). 7. treas. reg. § 1.501(c)(3)-1(d)(1)(ii). 8. irc § 509(a)(3)(a). 9. irc § 509(a)(3)(b). 10. irc § 509(a)(3)(c). 2009] the pension protection act of 2006 225 organization is its very close bonds to the organization(s) it supports. the code recognizes three different types of supporting organizations.11 11. the code provides that certain supporting organizations (generally, organizations that support another 501(c)(3) organization that is not a private foundation) are classified as public charities rather than private foundations. irc § 509(a)(3). to qualify as a supporting organization, the organization must meet all of the following tests: (1) it must be organized and at all times operated exclusively for the benefit of, or to perform the functions of, or to carry on the purposes of, one or more “publicly supported organizations” (as described in irc § 509(a)(1) or (2)) (the “organizational and operational tests”). irc § 509(a)(3)(a); (2) it must be operated, supervised, or controlled by, or in connection with, one or more publicly supported organizations (the “relationship test”). irc § 509(a)(3)(b); and (3) it must not be controlled directly or indirectly by one or more disqualified persons other than foundation managers and other than one or more publicly supported organizations (the “lack of outside control test”). irc § 509(a)(3)(c). the joint committee on taxation, technical explanation of h.r. 4 (aug. 3, 2006) explained: to satisfy the relationship test, a supporting organization must hold one of three statutorily described close relationships with the supported organization. the organization must be: (1) operated, supervised, or controlled by a publicly supported organization (commonly referred to as a “type i” supporting organization); (2) supervised or controlled in connection with a publicly supported organization (“type ii” supporting organizations); or (3) operated in connection with a publicly supported organization (“type iii” supporting organizations). see treas. reg. § 1.509(a)-4(f)(2). in the case of a “type i” supporting organization, one or more supported organizations must exercise a substantial degree of direction over the policies, programs, and activities of the supporting organization. treas. reg. § 1.509(a)-4(g)(1)(i). the relationship between the type i supporting organization and the supported organization is comparable to that of a parent and subsidiary. this type of relationship may be established by the fact that a majority of the directors, officers or trustees of the supporting organization are appointed or elected by the governing body, officers, or the membership of one or more supported organizations. id. “type ii” supporting organizations are supervised or controlled in connection with one or more publicly supported organizations. instead of a parent-subsidiary relationship, the relationship between a type ii supporting organization and its supported organization is more like a brother-sister relationship. to satisfy the relationship requirement, generally there must be a 226 florida tax review [vol. 9:4 common supervision or control by the persons supervising or controlling both the supporting organization and the publicly supported organizations. treas. reg. § 1.509(a)-4(h)(1). an organization is usually not considered to be “supervised or controlled in connection with” a publicly supported organization merely because the supporting organization makes payments to the publicly supported organization, even if the obligation to make the payments is enforceable under state law. treas. reg. § 1.509(a)-4(h)(2). “type iii” supporting organizations are “operated in connection with” one or more publicly supported organizations. to satisfy the “operate din connection with” test, treasury regulations require that the supporting organization be responsive to, and significantly involved in the operations of, the publicly supported organization. this relationship is considered to exist where the supporting organization meets two tests: (1) the “responsiveness test,” and (2) the “integral part test.” treas. reg. § 1.509(a)-4(i)(1). in general, the responsiveness teat requires type iii supporting organizations be responsive to the needs and demands or the publicly supported organization. the integral part test requires a type iii supporting organization to maintain significant involvement in the operations of one or more publicly supported organizations, and that the publicly supported organizations also dependent upon the supporting organization for the type of support that it provides. the treasury regulations provide two alternative methods for satisfying the integral part test: (1) establish that the activities engaged in for, or on behalf of, the publicly supported organization are activities to perform the functions of, or carry out the purposes of, the supported organizations; and establish that these activities, but for the involvement of the supporting organization, normally would be engaged in by the publicly supported organizations themselves. treas. reg. § 1.509(a) 4(i)(3)(ii) (emphasis added). organizations that satisfy this “but for” test are referred to as “functionally integrated” type iii supporting organizations. (2) establish that the supporting organization pays substantially all of its income to, or for the use of, one or more publicly supported organizations; establish that the amount of support received by one or more of the publicly supported organizations is sufficient to insure the attentiveness of the organization(s) to the operations of the supporting organization (known as the “attentiveness requirement”); and establish that a significant amount of the total support of the supporting organization goes to those publicly supported organizations that meet the attentiveness requirement. treas. reg. § 1.509(a)-4(i)(3)(iii). the irs has defined the term “substantially all” of a supporting organization’s 2009] the pension protection act of 2006 227 b. sponsoring organizations and donor-advised funds some charitable organizations (sponsoring organizations/sponsoring charities) establish one or more donor-advised funds to which donors may contribute and provide nonbinding advice with regard to distributions in the funds or investment decisions of the fund. these sponsoring organizations, however, must have both control and legal ownership of the assets following the donor’s contribution for that contribution to qualify for the charitable deduction.12 similarly, if the sponsoring organization permits the donor to have too much control over the amounts contributed, the donation may not qualify for the charitable deduction.13 donors often contribute to donor-advised funds because they can give a large contribution in a single year, receive a full charitable deduction at that time, and not have the contribution distributed for charitable purposes until later years. donor-advised funds usually require donations of at least $100,000, but some accept smaller donations. in addition, donors often have their name attached to the fund, much like a private foundation. a contribution to a donor-advised fund is deductible as an outright gift to charity. the maximum itemized deduction for cash contributions (50% of the taxpayer’s adjusted gross income) is allowed if the contribution is to an entity such as a church; publicly supported charitable, religious, educational, scientific, or literary organization; private operating foundation; or irc section 509(a)(3) supporting organization (with some limitations).14 special rules apply to the gifting of capital gain property.15 income to mean 85% or more. rev. rul. 76-208, 1976-1 c.b. 161. joint committee on taxation, technical explanation of h.r. 4. congress and the irs have been particularly concerned about the opportunity for abuses with type iii supporting organizations because their relationship to the publicly supported organization is the most tenuous among the three types of supporting organizations. this is the reason that a type iii supporting organization must meet both the responsiveness and integral part test. see generally cch’s tax exempt advisor no. 379, practitioners discuss irs focus on exempt organizations, provide solutions (feb. 13, 2006). 12. see generally joint committee on taxation, supra note 11. 13. id. 14. irc § 170(b)(1)(a). 15. generally, gifts of securities and real estate held longer than one year are deductible at their full present fair market value, with no tax on appreciation. irc § 170(e). gifts of long-term capital gain property are deductible up to 30% of adjusted gross income with a five-year carry-over for the excess. irc § 170(b)(1)(c)(i). special provisions apply so that donors may elect to raise the ceiling. see generally irc § 170(b)(1)(c)(3), (e)(1)(b). 228 florida tax review [vol. 9:4 iii. intermediate sanctions prior to the 2006 amendments a. enactment the taxpayer bill of rights of 1996 added section 4958 to the irc.16 irc section 4958 applies to acts of self-dealing between tax-exempt organizations and disqualified persons. it is patterned after irc section 4941, which applies to acts of self-dealing between private foundations and disqualified persons. irc section 4958 applies to organizations that are exempt from federal income taxes under irc sections 501(c)(3) and 501(c)(4).17 the committee on ways and means submitted a house report on the 1996 taxpayer bill of rights that discussed the provisions of irc section 4958.18 the committee explained that prior to the taxpayer bill of rights, there was no provision for the “imposition of penalty excise taxes in cases where a 501(c)(3) public charity or a 501(c)(4) social welfare organization engages in a transaction that results in private inurement.”19 the only provision with penalty excise taxes was related to private foundations and was codified in irc section 4941.20 as a result, the only sanction that could be imposed against a public charity was revocation of the organization’s tax-exempt status.21 the committee indicated that the reasons for enacting intermediate sanction provisions were “to ensure that the advantages of tax-exempt status ultimately benefit the community and not private individuals.”22 it noted that the legislation would provide for intermediate sanctions to be imposed when nonprofit organizations engaged in transactions with insiders that would result in private inurement.23 section 4958 imposes penalty excise taxes, known as intermediate sanctions, in cases in which organizations that are exempt under sections 501(c)(3) and 501(c)(4) engage in excess benefit transactions with a disqualified person.24 an “excess benefit transaction” subject to tax under irc section 4958 is: (1) any transaction in which an economic benefit is provided by a section 501(c)(3) organization (except for a private foundation) or a section 501(c)(4) organization directly or 16. pub. law no. 104-168, § 1311(a), 110 stat. 1452, 1475 (1996). 17. irc § 4958(c). 18. h.r. rep. no. 104-506, at 1 (1996), reprinted in 1996 u.s.c.c.a.n. 1143, 1143. 19. id. at 54. 20. id. 21. id. 22. id. at 55. 23. id. 24. irc § 4958(a). 2009] the pension protection act of 2006 229 indirectly to, or for the use of, any disqualified person if the value of the economic benefit exceeds the value of the consideration (including the performance of services) received for providing the benefit;25 or (2) any transaction, to the extent provided in the treasury regulations, in which the amount of any economic benefit to, or for the use of, any disqualified person is based on the exempt organization’s income in a transaction that violates the private inurement prohibition under irc sections 501(c)(3) and 501(c)(4).26 25. irc § 4958(c)(1); treas. reg. § 53.4958-1(b). see also irs notice 96-46, 1996-2 c.b. 212 (sept. 23, 1996). 26 h.r. rep. no. 104-506 (1996). the private inurement prohibition on charities goes back to the tariff act of 1909. tariff act of 1909, ch. 6 § 38, 36 stat. 112. in 1919 the statute was amended to specify that a charitable organization’s “net earnings” could not inure to the benefit of any private shareholder or individual. the taxpayer bill of rights 2 of 1996 (public law 104-168) extended the private inurement prohibition to 501(c)(3) organizations to 501(c)(4) organizations. essentially, the private inurement prohibition provides that an organization is eligible for tax-exempt status only if no part of its net earnings inures to the benefit of any private shareholder or individual. h.r. rep. no. 104-506 (1996). treas. reg. § 53.4948-4(a)(1) discusses excess benefit transactions. it provides that “the rules of this section apply to all transactions with disqualified persons, regardless of whether the amount of the benefit provided is determined, in whole or in part, by the revenues of one or more activities of the organization.” generally, private inurement refers to benefits to insiders, such as officers and directors, through the use or distribution of the organization’s funds. see treas. reg. § 1.501(c)(3)-1(c)(2). the irs has focused on four primary issues in enforcing the prohibition against private inurement: (1) that the organization does not pay more than “reasonable compensation” for services rendered (treas. reg. § 1.162-7(b)(3)); (2) that the organization does not pay excessive rent for the use of property; (3) that the organization does make loans that do not conform to the prevailing interest rate or do not meet normal criteria for security or other guarantees (see., e.g., orange county agric. soc’y v. comm’r, 893 f.2d 529 (2d cir. 1990) (interest free loans to organization insiders constitutes private inurement); and (4) whether a donor retains an interest in a donated asset. the case of ginsberg v. commissioner, 46 t.c. 47 (1966), is considered the benchmark case addressing public versus private benefit (inurement). in that case, an exempt organization was formed to dredge a navigable waterway that fronted its members’ private properties. the waterway was rarely used by the public and the dredging appreciated the value of the members’ properties. evidence was submitted that the organization’s members contributed funds to the organization in accordance with the value of the member’s property. the court held that the organization’s purpose was substantially a nonexempt purpose and that the public benefit was incidental. but see, irs rev. rul. 70-186, 1970-1 c.b. 128 (exempt organization that improved a lake 230 florida tax review [vol. 9:4 a “disqualified person” is any person who was, at any time during the five-year period ending on the date of the excess benefit transaction, in a position to exercise substantial influence over the affairs of the organization.27 disqualified persons also include family members and certain entities in which at least 35% of the control or beneficial interests are held by a disqualified person.28 as enacted in 1996, irc section 4958 imposed three taxes (intermediate sanctions): (1) a “first-tier” penalty excise tax equal to 10% of the excess benefit amount is paid by any organization manager29 who knowingly participates in an excess benefit transaction;30 (2) a “first-tier” penalty excise tax equal to 25% of the excess benefit amount is paid by any disqualified person who engages in an excess benefit transaction;31 and (3) a “second-tier” penalty excise tax equal to 200% of the excess benefit amount is paid by any disqualified person if the excess benefit transaction is not corrected within the taxable period.32 there is no “second-tier” penalty imposed on organization managers. in 1997, irc section 4962(b) was amended and cross-referenced to irc section 4958. the practical effect of this amendment was to make it clear that the irs had the authority to abate the first-tier excise taxes if it was established that the excess benefit transaction was due to reasonable cause and not willful neglect and the transaction was corrected within the specified time period. the irs has the discretion to impose intermediate sanctions instead of, or in addition to, revocation of an organization’s tax-exempt status. extensively used by the public for public recreational purposes was primarily a public benefit even though the adjoining landowners (who were primarily but not solely contributors to the exempt organization) also received a benefit; the benefit was held to be incidental to the general public’s primary benefit). 27. irc § 4958(f)(1)(a). 28. irc § 4958(f)(1)(b), (c). 29. an organization manager is an “officer, director, trustee, or any individual having powers and responsibilities similar to those of an officer, director, or trustee. irc § 4958(f)(2). see also irs notice 96-46, 1996-2 c.b. 212 (sept. 23, 1996). 30. irc § 4958 (a)(2). with respect to this third tax, any one excess benefit transaction could not result in an amount exceeding $10,000. the 2006 amendments raised this amount to $20,000. 31. irc § 4958 (a)(1). 32. irc § 4958 (b). 2009] the pension protection act of 2006 231 b. irs enforcement of irc section 4958 prior to the 2006 amendments when irc section 4958 was first passed, it was touted as applying only to major transgressions and not to “foot faults.” since then it has morphed into a generally applicable rule used not only for conflict of interest violations but also for paperwork and judgment infractions.33 after irc section 4958’s intermediate sanctions provisions were enacted, the irs needed to implement a plan to enforce these penalty excise tax provisions. from 1996 through 2002, the irs released a series of memoranda regarding irc section 4958, which basically stated and restated that it was unable to provide real guidance on intermediate sanctions. in october 1996, the irs initiated a temporary procedure for handling all cases involving intermediate sanctions or irc section 501(c)(4) inurement.34 instead of providing guidance to the irs field offices, the memorandum noted that there were no regulations covering these issues, even though the statutory changes made under irc section 4958 were retroactive to september 14, 1995.35 the irs noted that without regulations, field offices were “unable to assert positions with respect to issues arising under the new provisions, either during examinations of exempt organizations, or in subsequent negotiations with taxpayers to close examinations.”36 in an attempt to ensure some level of national uniformity in the resolution of these cases, the irs directed the field offices to contact the assistant chief, project branch 1, before asserting any position with respect to intermediate sanctions and private inurement and exempt organizations.37 nearly two years later, the irs released a memorandum restating the october 1996 memorandum and noting that proposed regulations under irc section 4958 had still not been issued.38 33. excise tax on excess benefit transactions: introduction (cch-exp, federal-exempt ¶ 4994e.01 (quoting barnaby zall, weinberg & jacobs, llp, rockville, md.). 34. irs mem. (oct. 30, 1996). 35. id. 36. id. 37. id. the assistant chief would then inform the irs agent what information should be included in the request. id. 38. the irs noted in irs mem. (jun. 25, 1998) that the issuance of regulations was a “priority item for 1998.” however, in the meantime irs field offices were instructed to continue contacting the assistant chief with all questions concerning intermediate sanctions. all examinations in which irc § 4958 was an issue were required to be submitted for technical advice, including all cases in which a tax under irc § 4958 was proposed, as well as any cases considered for a closing agreement in which an irc § 4958 excess benefit transaction or inurement issue was an issue to be 232 florida tax review [vol. 9:4 on august 24, 1998, the irs released proposed regulations under irc section 4958 that failed to provide any real guidance to irs field offices.39 the proposed regulations made it clear that the irs could seek intermediate sanctions and the revocation of an organization’s tax-exempt status.40 four months later, the irs acknowledged “widespread interest within the exempt organization community regarding excess benefit audits.”41 the irs made public three internal memoranda requiring field staff to coordinate with the irs national office examinations that might involve intermediate sanctions, private inurement, and qualification of exempt status.42 on april 13, 1999, the irs again released a memorandum restating that field staff must contact the irs national office about any examinations that might involve intermediate sanctions, private inurement, and qualification of exempt status.43 c. final regulations under irc section 4958 in 2001, the treasury department and the irs issued temporary regulations under irc section 4958. the preamble to the temporary regulations resolved in the closing agreement. it was also stated that separate technical advice was necessary for persons with interests inconsistent with the exempt organization or the interests of other persons that participated in the excess benefit transaction. id. 39. irs notice of proposed rulemaking, reg-246256-96. the proposed regulations stated that “[t]he excise taxes imposed by § 4958 do not affect the substantive statutory standards for tax exemption under § 501(c)(3) or (4).” the preamble to the 1998 proposed regulations stated that the irs will “exercise its administrative discretion in enforcing the requirements of §§ 4958, 501(c)(3), and 501(c)(4). four factors were listed that the irs would consider in “determining whether an applicable tax-exempt organization described in § 501(c)(3) continues to be described in § 501(c)(3) in cases in which § 4958 excise taxes are also imposed: (1) whether the organization has been involved in repeated excess benefit transactions; (2) the size and scope of the excess benefit transactions; (3) whether, after concluding that it has been a party to an excess benefit transaction, the organization has implemented safeguards to prevent future recurrences; and (4) whether there was compliance with other applicable laws. 63 fed. reg. 41,488-489. 40. id. 41. irs exempt orgs. mem. (dec. 23, 1998). 42. id. 43. irs announcement of release of exempt orgs. mem. (apr. 13, 1999). three days later the irs released another memorandum restating that separate technical advice was necessary for persons with interests inconsistent with the exempt organization, or the interests of other persons that participated in the excess benefit transaction. exempt orgs. mem. (apr. 16, 1999). 2009] the pension protection act of 2006 233 stated that the irs intended to publish guidance regarding the factors it will consider “as it gains more experience in administering section 4958.”44 the final regulations relating to excise taxes on excess benefit transactions under irc section 4958 became effective on january 23, 2002.45 the regulations focus on 44. irs notice of proposed rulemaking (reg-111257-05), 70 fr53599-01, 2005-2 c.b. 759 (sept. 9, 2005) (emphasis added). 45. t.d. 8978, 2002-1 c.b. 500 (corrected mar. 19, 2002). the 2002 irc § 4958 final regulations included the following provisions: treas. reg. § 53.4958-1(e)(1) provides that except as otherwise provided, an excess benefit transaction occurs on the date on which the disqualified person receives the economic benefit for federal income tax purposes. treas. reg. § 53.4958-1(e)(2) provides that in the case of rights to future compensation, including benefits under a nonqualified deferred compensation plan, the excess benefit transaction occurs on the date the right to future compensation is not subject to a substantial risk of forfeiture. however, where a disqualified person elects under § 83(b) of the code to include deferred compensation in gross income in a taxable year, any excess benefit transaction with respect to this deferred compensation occurs in that year. treas. reg. § 53.4958-1(f)(1) provides that § 4958 of the code applies to transactions occurring on or after september 14, 1995. however, under treas. reg. § 53.4958-1(f)(2), § 4958 does not apply to any transaction occurring pursuant to a written contract that was binding on september 13, 1995, and at all times thereafter before the transaction occurs. but if a binding written contract is materially changed, it is treated as a new contract entered into as of the date the material change is effective. the regulations state: “a material change includes an extension or renewal of the contract ..., or a more than incidental change to any payment under the contract.” the extension or renewal of a contract that results from the contracting person unilaterally exercising an option expressly granted by the contract is not a material change. treas. reg. § 53.4958-3(a)(1) defines a disqualified person, with respect to any transaction, as any person who was in a position to exercise substantial influence over the affairs of an applicable tax-exempt organization at any time during the five-year period ending on the date of the transaction. treas. reg. § 53.4958-3(b)(1) provides that a person is a disqualified person with respect to any transaction with an applicable tax-exempt organization if the person is a member of the family of a person who is a disqualified person with respect to any transaction with the same organization. a person’s family includes the person’s spouse. treas. reg. § 53.4958-3(c) provides that voting members of the governing body, presidents, chief executive officers, or chief operating officers are persons who are in a position to exercise substantial influence over the affairs of the organization. treas. reg. § 53.4958-4(a)(1) of the regulations provides that to determine whether an excess benefit transaction has occurred, all consideration and benefits exchanged between a disqualified person and the applicable tax-exempt organization and all entities it controls are taken into account. treas. reg. § 53.4958-4(a)(3)(ii)(a) provides that the term "fixed payment" means an amount of cash or other property specified in the contract, or determined by a fixed formula specified in the contract, which is to be paid or transferred in exchange for the provision of specified services or property. a fixed formula may incorporate an 234 florida tax review [vol. 9:4 excise taxes imposed on excess benefit transactions and disqualified persons included: (1) contemporaneous substantiation requirements regarding benefits to a disqualified person as compensation for services; (2) an explanation of what constitutes disregarded economic benefits in situations where benefits were provided on equal terms to a disqualified person as well as to other donors; (3) a definition of “knowing” participation of an organization manager in an excess benefit transaction; and (4) requirements for organizations receiving correction amount that depends upon future specified events or contingencies, provided that no person exercises discretion when calculating the amount of a payment or deciding whether to make a payment (such as a bonus). treas. reg. § 53.4958-4(a)(3)(v) provides that if the parties make a material change to a contract, it is treated as a new contract as of the date the material change is effective. treas. reg. § 53.4958-4(b)(1)(ii)(a) that the value of services is the amount that would ordinarily be paid for like services by like enterprises under like circumstances (i.e., reasonable compensation). the standards under § 162 of the code apply in determining the reasonableness of compensation, taking into account the aggregate benefits provided to a person and the rate at which any deferred compensation accrues. treas. reg. § 53.4958-4(b)(1)(ii)(b) provides that the compensation for purposes of determining reasonableness under § 4958 includes all economic benefits provided by the organization in exchange for the performance of services, except for economic benefits that are disregarded for purposes of 4958 under treas. reg. § 53.4958-4(a)(4). treas. reg. § 53.4958-4(b)(2) provides that the facts and circumstances to be taken into consideration in determining the reasonableness of a fixed payment are those existing on the date the parties enter into the contract pursuant to which the payment is made. treas. reg. § 53.4958-6(a) provides that payments under a compensation arrangement are presumed to be reasonable if all of the requirements in treas. reg. § 53.4958-6(c) are satisfied, as follows: 1. the compensation arrangement is approved in advance by an authorized body of the organization or an entity it controls, composed entirely of individuals who do not have a conflict of interest as to the compensation arrangement or property transfer; 2. prior to making its determination, the authorized body obtained and relied upon appropriate data as to comparability; and 3. the authorized body adequately documented the basis for its determination concurrently with making that determination. treas. reg. § 53.4958-6(e) provides that the fact that a transaction between an organization and a disqualified person is not subject to the rebuttable presumption of reasonableness does not create any inference that the transaction is an excess benefit transaction. see priv. ltr. rul. 200244028 (jun. 21, 2002). note that these final regulations remain virtually unchanged, except for technical corrections, but do not reflect the 2006 amendments to irc § 4958. 2009] the pension protection act of 2006 235 amounts due to excess benefit transaction involving a property transfer by an exempt organization to a disqualified person.46 the final regulations provided specific rules for determining the fair market value of economic benefits under irc section 4958. in addition, the final regulations allowed exempt organizations a rebuttable presumption that a transaction was not an excess benefit transaction.47 the final regulations also contained numerous examples covering when a person was a disqualified person (although these examples did not include when an excess transaction would occur).48 examples illustrating when economic benefits were provided indirectly did focus on excess benefits.49 the 46. id. 47. treas. reg. § 53.4958-6 provides that payments under a compensation arrangement are presumed to be reasonable and a transfer of property is presumed to be at fair market value if three conditions are met: (1) the compensation arrangement or terms of the property transfer are approved in advance by an authorized body or committee of the organization composed entirely of individuals who do not have a conflict of interest with respect to the proposed transactions; (2) the authorized body obtained and relied upon appropriate data as to comparability prior to making the determination; and (3) the authorized body adequately documented the basis for its determination concurrently with making the determination. if all of these conditions were met, the irs could only rebut the presumption if it developed sufficient contrary evidence to rebut the probative value of the comparability data that the authorized body relied on. treas. reg. § 53.4958-6(b). 48. id. 49. treas. reg. § 53.4958-4(a)(2)(iv) provides the following four examples: example 1. k is an applicable tax-exempt organization for purposes of § 4958. l is a wholly-owned taxable subsidiary of k. j is employed by k, and is a disqualified person with respect to k. k pays j an annual salary of $12m, and reports that amount as compensation during calendar year 2001. although j only performed services for k for nine months of 2001, j performed equivalent services for l during the remaining three months of 2001. taking into account all of the economic benefits k provided to j, and all of the services j performed for k and l, $12m does not exceed the fair market value of the services j performed for k and l during 2001. therefore, under these facts, k does not provide an excess benefit to j directly or indirectly. example 2. f is an applicable tax-exempt organization for purposes of § 4958. d is an entity controlled by f within the meaning of paragraph (a)(2)(ii)(b) of this section. t is the chief executive officer (ceo) of f. as ceo, t is responsible for overseeing the activities of f. t’s duties as ceo make him a disqualified person with respect to f. t’s compensation package with f represents the maximum reasonable compensation for t’s services as ceo. thus, any additional economic benefits that f provides to t without t providing additional consideration constitute an excess benefit. d contracts with t to provide enumerated consulting services to d. however, the contract does not require t to perform any additional services for d that t is not already 236 florida tax review [vol. 9:4 examples, however, primarily addressed the issue of compensation. similarly, examples illustrating the rules governing fixed payments made pursuant to an initial contract focused primarily on compensation and the initial contract exception.50 other examples illustrated the timing of determining the reasonableness of compensation or a fixed payment51 and the contemporaneous substantiation requirement.52 the final examples addressed the data necessary to create a rebuttable presumption of reasonableness (again, these examples focused on compensation)53 and the requirements for correction.54 the examples in the final regulations created an impression that the irs was primarily interested in situations where a disqualified person received obligated to perform as f’s chief executive officer. therefore, any payment to t pursuant to the consulting contract with d represents an indirect excess benefit that f provides through a controlled entity, even if f, d, or t treats the additional payment to t as compensation. example 3. p is an applicable tax-exempt organization for purposes of section 4958. s is a taxable entity controlled by p within the meaning of paragraph (a)(2)(ii)(b) of this section. v is the chief executive officer of s, for which s pays v $w in salary and benefits. v also serves as a voting member of p’s governing body. consequently, v is a disqualified person with respect to p. p provides v with $x representing compensation for the services v provides p as a member of its governing body. although $x represents reasonable compensation for the services v provides directly to p as a member of its governing body, the total compensation of $w + $x exceeds reasonable compensation for the services v provides to p and s collectively. therefore, the portion of total compensation that exceeds reasonable compensation is an excess benefit provided to v. example 4. g is an applicable tax-exempt organization for § 4958 purposes. f is a disqualified person who was last employed by g in a position of substantial influence three years ago. h is an entity engaged in scientific research and is unrelated to either f or g. g makes a grant to h to fund a research position. h subsequently advertises for qualified candidates for the research position. f is among several highly qualified candidates who apply for the research position. h hires f. there was no evidence of an oral or written agreement or understanding with g that h will use g’s grant to provide economic benefits to or for the use of f. although g provided economic benefits to h, and in connection with the receipt of such benefits, h will provide economic benefits to or for the use of f, h acted with a significant business purpose or exempt purpose of its own. under these facts, g did not provide an economic benefit to f indirectly through the use of an intermediary. 50. treas. reg. § 53.4958-4(a)(3)(vi). treas. reg. § 53.4958-4(a)(3)(i) provides that “§ 4958 does not apply to any fixed payment made to a person pursuant to an initial contract,” unless the “person fails to perform substantially the person’s obligations under the initial contract during that year.” treas. reg. § 53.49584(a)(3)(iv). 51. treas. reg. § 53.4958-4(b)(2)(iii). 52. treas. reg. § 53.4958-4(c)(4). 53. treas. reg. § 53.4958-6(a)(3)(iv). 54. treas. reg. § 53.4958-7(f). 2009] the pension protection act of 2006 237 excessive compensation or payments above the fair market value for services or other consideration provided to the exempt organization. these regulations left many issues unanswered, but they did not seem overly biased in favor of the irs because of the rebuttable presumption regulations that created a quasi-safe harbor for exempt organizations. d. new final regulations the treasury department and the irs issued new final regulations clarifying the requirements for tax exemption under irc section 501(c)(3) and how these requirements relate to the imposition of excise taxes on excess benefit transactions under irc section 4958.55 the final regulations primarily reaffirmed that a private benefit may involve noneconomic as well as economic benefits, be inconsistent with exempt status if the benefit is substantial instead of merely incidental to the exempt organization’s purpose, and be a private benefit even if the transaction is at fair market value.56 the examples make it clear that the irs considers itself to have an independent basis to revoke an exempt organizations status even if the private benefit does not involve an economic benefit or raise the issue of the fair market value of a transaction.57 55. t.d. 9390, i.r.b. 855 (mar. 27, 2008) (corrected apr. 28, 2008). 56. id. 57. id. example 3. (i) o conducts educational programs for the benefit of the general public. since its formation, o has employed its founder, c, as its chief executive officer. beginning in year 5 of o’s operations and continuing to the present, c caused o to divert significant portions of o’s funds to pay c’s personal expenses. the diversions by c significantly reduced the funds available to conduct o’s ongoing educational programs. the board of trustees never authorized c to cause o to pay c’s personal expenses from o’s funds. certain members of the board were aware that o was paying c’s personal expenses. however, the board did not terminate c’s employment and did not take any action to seek repayment from c or to prevent c from continuing to divert o’s funds to pay c’s personal expenses. c claimed that o’s payments of c’s personal expenses represented loans from o to c. however, no contemporaneous loan documentation exists, and c never made any payments of principal or interest. (ii) the diversions of o’s funds to pay c’s personal expenses constitute excess benefit transactions between an applicable tax-exempt organization and a disqualified person under § 4958. therefore, these transactions are subject to the applicable excise taxes provided in that section. in addition, these transactions violate the proscription against inurement under § 501(c)(3) and ¶ (c)(2) of this section. (iii) the application of the factors in paragraph (f)(2)(ii) of this section to these facts is as follows. o has engaged in regular and ongoing activities that further exempt purposes both before and after the excess benefit transactions occurred. however, the size and scope of the excess benefit transactions engaged in by o beginning in year 5, collectively, are significant in relation to the size and scope of o’s activities that further exempt purposes. moreover, o has been involved in multiple excess benefit 238 florida tax review [vol. 9:4 the new final regulations stress that an exempt organization that implements safeguards that are reasonably calculated to prevent excess benefit transactions will have those safeguards treated as a factor in favor of its continuing to receive exempt status. this will be the case even if the organization implements these safeguards in direct response to an excess benefit transaction, such as contesting the existence of an excess benefit transaction at issue, or as a general governance policy.58 two commentators had suggested that the final regulations clarify the relationship between the determination of an organization’s exempt status and the determination of the existence of an excess benefit transaction. the suggestion that the irs not take action to remove an organization’s exempt status on excess benefit transaction grounds while the irs’s determination of the existence of an excess benefit transaction was being contested in court was rejected. in their response, the treasury department and the irs stated that “the determination of an organization’s exempt status and the determination of the existence of an excess benefit transaction are separate determinations, involving distinct parties, different legal elements, and separate processes, even though they may relate to the same facts.”59 this author is troubled by the fact that the irs has both weapons to use simultaneously against an exempt organization. it is conceivable that an exempt organization will be bullied into paying excess benefit transaction penalty taxes, even if the organization has a solid case that no excess benefit transactions took place, in order to keep its exempt status. e. donor-advised funds at the american bar association (aba) section of taxation’s 1999 mid-year meeting (january 15, 1999), “government officials overseeing taxexempt organizations” told the aba that donor-advised funds had come under scrutiny in 1998, “when officials became aware of charitable arrangements that seemed to blur the line between public charities and private foundations.”60 the preamble to the temporary regulations noted that the irs and treasury department considered adopting a special rule with respect to donor transactions. o has not implemented any safeguards that are reasonably calculated to prevent future diversions. the excess benefit transactions have not been corrected, nor has o made good faith efforts to seek correction from c, the disqualified person who benefited from the excess benefit transactions. based on the application of the factors to these facts, o is no longer described in § 501(c)(3) effective in year 5. treas. reg. § 1.501(c )(3)-1(f)(2)(iv). 58. t.d. 9390, i.r.b. 855 (mar. 27, 2008) (corrected apr. 28, 2008). 59. id. 60. government officials warn of 1999 scrutiny for donor-advised funds, insurance schemes, the bureau of national affairs, no. 11 (jan. 19, 1999). 2009] the pension protection act of 2006 239 advised funds, and sought comments on potential issues raised by applying the fair market value standard under irc section 4958 to distributions from donoradvised funds to (or for the use of) a donor or advisor.61 several comments were received on this issue and “[m]ost of the comments objected to treating a donor or advisor to this type of fund as a disqualified person based solely on influence over a donor-advised fund.”62 other commentators stated that “the existing factors contained in the temporary regulations were adequate to find disqualified person status in appropriate circumstances.”63 the irs and the treasury department stated that in response to these comments, “the final regulations do not adopt a special rule regarding any donor or advisor to a donor-advised fund. thus, the general rules of section 53.4958-3 will apply to determine if a donor or advisor is a disqualified person.”64 iv. the irs’s stepped-up enforcement of irc section 4958 a. irs confusion the irs’s enforcement of irc section 4958 prior to 2004 does not appear to have been particularly aggressive. this is true in part because the irs was unable to develop guidance for taxpayers or irs field representatives and, in part, because field representatives were required to submit all issues that might involve intermediate sanctions, private inurement, and qualification of exempt status to the irs national office.65 the irs’s private rulings from 1997 through 2004 do not indicate an aggressive stance in enforcing irc section 4958. in fact, the bulk of these irc section 4958 rulings focused on whether an individual was a disqualified person and the traditional question of whether the organization’s transactions resulted in private inurement to a disqualified person.66 generally, when the irs found that an excess benefit transaction had or had not occurred, it reached an obvious conclusion. for example, an annual monetary award presented by a public charity was not an excess benefit transaction because disqualified persons were excluded from eligibility.67 a person who was the most senior officer of an exempt organization who was responsible for the day-to-day operations, served on the board, and had substantial influence over the organization was a 61. t.d. 8978, 2002-1 c.b. 500. 62. id. 63. id. 64. id. 65. see supra notes 31-33 and accompanying text. 66. see supra notes 4, 5 and accompanying text. 67. priv. ltr. rul. 98-02-045 (oct. 16, 1997). 240 florida tax review [vol. 9:4 disqualified person under irc section 4958.68 a taxpayer who was a disqualified person and organization manager received excess benefits from salary, severance, undocumented loans, automobile valuations, property rents, and insurance payments.69 in a series of private letter rulings, the irs found that the excess benefit transaction proscriptions were violated in situations involving churches and disqualified individuals, usually when the situations were particularly egregious.70 b. the irs gets aggressive: stepped-up enforcement and the carracci case in late july 2004, the irs began its tax exempt compensation enforcement project. this project was designed to identify excess benefit transactions in terms of excessive compensation and benefits to exempt organization officers and “other insiders.”71 the irs announced that it was contacting nearly 2,000 charities and foundations in an effort to identify and halt abuses by exempt organizations.72 the project’s focus included the compensation of “specific officers and various kinds of insider transactions, such as loans and the sale, exchange or leasing of property to officers and others.”73 in addition, the irs also focused on how exempt organizations answered 68. priv. ltr. rul. 2002-44-028 (jun. 21, 2002). the irs cited the applicable 2002 regulations in great detail in making its determinations. see supra notes 39-49 and accompanying text. 69. t.a.m. 200243057 (jul. 2, 2002). 70. see e.g., irs priv. ltr. rul. 2004-35-018 (may 5, 2004), irs priv. ltr. rul. 2004-35-019 (may 5, 2004), irs priv. ltr. rul. 2004-35-020 (may 5, 2004), irs priv. ltr. rul. 2004-35-021 (may 5, 2004), irs priv. ltr. rul. 2004-35-022 (may 5, 2004) (the founder of a church and his wife, son and son-in-law engaged in excess benefit transactions by (1) using the church truck for private business, (2) use of church credit cards for private purchases, (3) gasoline purchases, (4) private use of cell phone paid for by church, (5) unsubstantiated expenses paid by the church to the son, (6) expenses for the founder’s personal residence, including a security system, landscaping, satellite television, telephone service and unsubstantiated expenses, (7) meals, and (8) use of church provided computer. but see irs priv. ltr. rul. 2004-21-010 (feb. 24, 2004) (shared use of office space, employees and office equipment did not result in excess benefit transaction). 71. irs news release ir-2004-106 (aug. 10, 2004). 72. id. irs commissioner mark w. everson stated that “the irs has an obligation to investigate questionable compensation practices and put a stop to the abuses we find. we won’t let the misbehavior of a few organizations damage the credibility of the vast majority of law-abiding charities and foundations.” id. 73. id. 2009] the pension protection act of 2006 241 questions on their form 990 “about excess benefit transactions – and other compensation information.”74 it appeared that the irs was taking a reasonable position in enforcing irc section 4958 and attempting to learn more about exempt organizations, their practices, and the degree to which excess benefit transactions were a serious issue. while the irs’s public proclamations regarding excess benefit transactions seemed reasonable, the irs adopted an aggressive enforcement approach that was shocking in its unreasonableness. the first major case that interpreted irc section 4958 was caracci v. commissioner.75 the court of appeals for the 5th circuit ruled that the tax court had erred as a matter of law when it affirmed the irs’s determination that excess benefit transaction excise taxes were warranted on a group of home health agencies. the agencies had transferred assets resulting from conversion of the exempt organization to a nonexempt organization. the court of appeals held further that the tax court erred in its valuation of the assets and liabilities transferred and made clearly erroneous findings of fact when applying the valuation method. from the record, it was obvious that the plaintiff-appellants did not receive an excess benefit from the transfer and were not liable for the excise taxes. in caracci, the irs had issued deficiency notices requiring the taxpayers, three privately held home healthcare agencies and the family that owned and operated them, to pay over $250 million in excise taxes under irc section 4958.76 the irs based this amount on its internal valuation of the assets and liabilities transferred when the agencies converted to nonexempt status. the irs found that the taxpayers received a net excess benefit of $18.5 million.77 during the two-year audit and almost two years of litigation, the irs maintained that the deficiency notices and underlying valuations were correct.78 at trial before the tax court, the irs finally conceded that the deficiency notices were “excessive and erroneous.”79 the tax court also recognized that the irs’s deficiency notices were wrong and that the irs’s valuation expert – whose data was the only evidential support that the irs presented for imposing excise taxes – also had made significant errors in analysis.80 even so, the tax court affirmed the irs’s decision to impose excise taxes, finding that the fair market value of the assets transferred to the nonexempt organizations exceeded the value of the liabilities and debts assumed by over $5 million.81 74. id. 75. 456 f.3d 444 (5th cir. 2006), rev’g 118 t.c. 379. 76. id. at 447. 77. id. 78. id. 79. id. 80. id. 81. id. 242 florida tax review [vol. 9:4 the irs’s position on appeal was that the deficiency notices were erroneous and the tax court had made a $1.78-million error in its valuation analysis.82 but the irs insisted that the tax court was correct in finding that the taxpayers received an excess net benefit of over $5 million in the conversion to nonexempt status and thus owed $69,702,390 in excise taxes under irc section 4958(a) and (b).83 in the first paragraph of its analysis of the case, the appellate court stated that “there are so many legal and factual errors – many of which the commissioner acknowledges – infecting this case from the outset that reversal must result.”84 for purposes of this article, what is most telling are the tactics the irs employed and its motivation for employing these tactics in order to impose excess benefit excise taxes against the taxpayers. among the tactics and motivations: (1) the issued deficiency notices were based on a “brief, intermediate internal analysis, which “stated on its face that it was intermediate and that a final economic study had to be performed.”85 (2) the irs ignored the disclaimer that a final economic study had to be performed and issued the deficiency based notices asserting excise tax penalties and retroactively revoking the exempt status of the organizations.86 (3) internal irs documents revealed that the irs issued the notices on the basis of the intermediate internal analysis rather than a final economic study because the irs wanted to prevent the taxpayers from correcting these “prohibited transactions” and, thereby, reduce the amount of the intermediate sanction penalties.87 (4) “even more disturbing,” said the appellate court, was that the trial record revealed that despite the “tentative and incomplete nature of the analysis used as the basis for the deficiency notices, the [irs] commissioner defended the correctness of those notices for several years into this litigation” and finally conceded that the notices overstated the irs’s tax claim when the trial began before the tax court.88 82. id. 83. id. 84. id. at 456. 85. id. at 457. 86. id. 87. id. 88. id. 2009] the pension protection act of 2006 243 (5) the irs also relied on the intermediate internal analysis because it was worried about the statute of limitations, which the irs blamed on the taxpayers.89 in its strongest condemnation of the irs’s tactics, the appellate court stated: this court has recognized that when, as here, the commissioner persists in taking a position in litigation that is so incongruous as to call his motivation into question, …[i]t can only be seen as one aimed at achieving maximum revenue at any cost, …seeking to gain leverage against the taxpayer in the hope of garnering a split-the-difference settlement – or, failing that, then a compromise judgment – somewhere between the value returned by the taxpayer…and the unsupported excess value eventually proposed by the commissioner.90 the appellate court reversed the tax court’s decision instead of remanding the case because it found clearly from the record that the irs could not meet its burden of proof in this matter.91 v. the pension protection act of 2006 targets donor-advised funds and supporting organizations on august 17, 2006, president bush signed the ppa. the ppa made significant changes to the code, impacting donor-advised funds (and the sponsoring organizations set up to hold the funds) and supporting organizations. while the changes to the intermediate sanctions provisions in irc section 4958 were the most oppressive of these changes, the ppa also added irc section 4967, which imposes an excise tax on donors, advisors, or related persons (but not investment advisors) who advise a sponsoring organization to make a distribution from a donor-advised fund that results in that person receiving, directly or indirectly, more than an incidental benefit. in addition, the ppa added irc section 4966, which imposes a 20% tax on a sponsoring organization for taxable distributions and a five-percent tax on any fund manager who knowingly makes such a distribution (with a limit of a $10,000 tax imposed on management). 89. id. an irs employee stated in an affidavit that the irs asked the taxpayers to extend the limitations period and informed the taxpayers that without their agreement to extend the limitations period, the irs would proceed based on the best information it had at that point. 90. id. at 457 (citing dunn, 301 f.3d at 339, 349 (5th cir. 2002), rev’g and rem’g 79 tcm 1337, cch dec. 53,713 (m)). 91. id. at 462. 244 florida tax review [vol. 9:4 the irs may not impose penalties under both irc sections 4958 and 4967. no additional taxes will be imposed on any distribution if a tax has already been imposed with respect to the distribution under the excess benefit rules of irc section 4958. a. ppa’s amendments to the intermediate sanctions provisions the ppa made three significant changes to irc section 4958 (intermediate sanctions): (1) for transactions after july 25, 2006, the definition of “excess benefit” and “excess benefit transaction” was broadened as those terms relate to irc section 509(a)(3) supporting organizations. for transactions after august 17, 2006, the definition of a “disqualified person” was expanded.92 (2) for transactions after august 17, 2006, the definition of “disqualified person” for the purpose of excess benefit transaction taxes was extended to include donors, donor advisors, and 92. a “disqualified person” (in regards to a supporting organization) is any person who (1) was in a position to exercise substantial influence over the affairs of the organization at any time during the five-year period preceding the transaction in question, (2) was a member of the family of such an individual, or (3) was a 35% controlled entity. irc § 4958(f)(i)(i). an “excess benefit transaction (in regards to supporting organizations) includes any grant, loan, compensation or similar payment made by a supporting organization to a substantial contributor, family member of a substantial contributor or a 35% controlled entity.” irc § 4958(c)(3)(a). any loan that a supporting organization makes to a disqualified person (excluding organizations described in irc § 509(a)(1), (2), and (4)) also is an excess benefit transaction. id. an “excess benefit” is the amount of the grants, loans or similar payments. irc § 4958 (c)(3)(a). a “substantial contributor” is a person who contributed or bequeathed in excess of $5,000 to the supporting organization if the aggregate contributions constitute in excess of two percent of the total contributions and bequests received by the supporting organization in the tax year in which the funds were received. if the contributions are from a trust, the contributions from the trust and the creator of the trust are aggregated. organizations described in irc § 509(a)(1), (2), and (4) are not considered substantial contributors under this provision. irc § 4958(c)(3)(c). a 35% entity is (1) a corporation in which a substantial contributor to a supporting organization or a family member (as defined in irc § 4958(f)(4)) if such an individual owns more than 35% of the total combined voting power; (2) a partnership in which such a person owns more than 35% of the profits and interests; or (3) a trust or estate in which such persons own more than 35% of the beneficial interest. irc § 4958(c)(3)(b). 2009] the pension protection act of 2006 245 investment advisors to donor-advised funds (and family members). these persons are automatically treated as disqualified persons with respect to the excess benefit transaction rules of irc section 4958.93 (3) for transactions after august 17, 2006, the dollar limitation on the penalty of managers of public charities and social welfare organizations who participate in excess benefit transactions was doubled from $10,000 to $20,000.94. although the term “donor-advised fund” has been commonly used for years, it was not until the ppa that it was finally defined. a “donor-advised fund” is a fund or account: (1) that is separately identified by reference to contributions of a donor or donors; (2) that is owned and controlled by a sponsoring organization; and (3) with respect to which a donor (or any person appointed or designated by the donor (a “donor advisor”) has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of the amounts held in the fund or account by reason of the donor’s status as a donor.95 a “sponsoring organization” is an organization that: (1) is described in irc section 170(c) (describing organizations to which charitable contributions can be made) and without regard to 93. an “investment advisor” in terms of any supporting organization is any person (other than an employee of the sponsoring organization) that is compensated by the sponsoring organization for managing the investment of, or providing investment advice with respect to, assets maintained in the donor-advised funds owned by the sponsoring organization. irc § 4958(f)(8). distributions from a donor-advised fund to a person who, with respect to that fund, is a donor, donor advisor, or a related person (though not an investment advisor) automatically will be treated as an excess benefit transaction under irc § 4958, with the entire amount paid to the disqualified person being deemed the amount of the excess benefit. irc § 4958(c)(2). any amount repaid as a result of correcting an excess benefit transaction will not be held in or credited to any donor-advised fund. irc § 4958(f)(6). 94. irc § 4958(d)(2). 95. irc § 4966(d)(2). all three prongs of the definition must be met for a fund or account to be treated as a donor-advised fund. joint committee on taxation, supra note 11. 246 florida tax review [vol. 9:4 any requirement that the organization be organized in the united states;96 (2) is not a private foundation under irc section 509(a); and (3) maintains one or more donor-advised funds.97 b. ppa’s provision imposing excise taxes on more than incidental benefits the ppa added irc section 4967, which imposes two excises taxes impacting sponsoring organizations and its donors, donor advisors, and related persons. the taxes imposed are: (1) 125% of the amount of the benefit on the person who advised the distribution and received a benefit as a result of the distribution;98 and (2) 10% of the benefit on the agreement of any fund manager to make a distribution, knowing that the distribution would confer an improper benefit, unless the agreement is not willful and is due to reasonable cause. the tax imposed on fund managers is limited to $10,000.99 c. ppa’s provision imposing taxes on sponsoring organizations for taxable distributions and distributions to certain supporting organizations the ppa added irc section 4966, which imposes a 20% tax on a sponsoring organization for taxable distributions to any natural person or to any other person if the distribution is for any purpose other than the charitable, or other purposes specified in irc section 170(c)(2)(b), or the sponsoring organization does not exercise expenditure responsibility as provided in irc section 4945(h).100 a 5% tax is imposed on the agreement of any fund manager 96. irc § 170(c)(2)(a). a government entity described in irc § 170(c)(1) is not, by definition, a sponsoring organization. joint committee on taxation, supra note 11. 97. irc § 4966(d)(1). 98. irc § 4967(a)(1). 99. irc § 4967(a)(2). 100. irc § 4966(c). the expenditure responsibility rule generally requires “that an organization exert all reasonable efforts and establish adequate procedures” to ensure that the distributions from the organization are spent solely for purposes for which they are made, to obtain full and complete reports from the distribute on how the funds are spent, and to make full, detailed reports regarding the expenditures to the irs. a taxable distribution does not include a distribution to: (1) an organization described in irc § 170(b)(1)(a) (other than a disqualified supporting organization; (2) the sponsoring 2009] the pension protection act of 2006 247 to make a distribution if the fund manager knows it is a taxable distribution (limited to $10,000).101 in addition, grants from donor-advised funds to non-functionally integrated type iii supporting organizations are potentially taxable transactions, as well as grants to type i, type ii, and type iii (functionally integrated) supporting organizations. this is the case only if the donor or any person designated by the donor controls a supported organization of the organization, or the irs determines that a distribution to such organization is inappropriate.102 d. differences between irc section 4966 and section 4967 irc section 4967 addresses the issue of donors and donor advisors receiving more than an incidental benefit when a sponsoring organization makes a distribution from a donor-advised fund. irc section 4966 generally addresses any distributions from a donor-advised fund that is made for a noncharitable purpose or to a supporting organization in certain situations, even though the supporting organization meets the public charity criteria of irc section 509(a)(3). e. study of donor-advised funds and supporting organizations in addition to these changes, the ppa of 2006 also directed the treasury department to undertake a study of the organization and operation of donoradvised funds and supporting organizations, and to report its findings within one year of august 17, 2006. when this article was written, the study was not yet released. the purpose of the study was to monitor the effectiveness of the new rules governing the activities of these organizations and how the issues affecting them are addressed.103 organization of the donor-advised fund; or (3) to another donor-advised fund. see joint committee on taxation, supra note 11. 101. irc § 4966(b)(1). 102. irc § 4966(d)(4). 103. specifically, the study was designed to determine whether: (1) the deductions allowed for the income, gift, or estate taxes for charitable contributions to sponsoring organizations of donor-advised funds or to “supporting organizations” described in irc § 509(a)(3) are appropriate in consideration of the use of the contributed assets or the use of the assets of such organizations; (2) donor-advised funds should be required to distribute for charitable purposes a specified amount in order to ensure that the sponsoring organization is operating 248 florida tax review [vol. 9:4 the ppa also contained many other provisions that impacted sponsoring organizations and donor-advised funds104 and supporting organizations.105 consistent with the purpose or functions constituting the basis for its exemption; (3) the retention by donors to organizations of rights or privileges is consistent with the treatment of such transfers as completed gifts qualify for the deduction for income, gift, or estate taxes, and (4) the three issues raised above are also issues with respect to other forms of charities or charitable donations. pension protection act of 2006 § 1226(a). it is this author’s opinion that the purpose of this study was to provide a basis for enacting even more burdensome federal laws on exempt organizations, especially donor-advised funds and supporting organizations. 104. in addition to the changes that are the subject of this article, the ppa amendments to the irc impacted donor-advised funds and sponsoring organizations in other ways: (1) for tax years after august 17, 2006, the tax on excess business holdings that previously applied only to private foundations also apply to donor-advised funds. irc § 4943(3). (2) limitations were imposed on the income tax deductibility of contributions to donor-advised funds. contributions to sponsoring organizations for the maintenance of a donor-advised fund is not deductible if the sponsoring organization is a veteran’s organization or lodge, fraternal society, or a cemetery company. except for cemetery companies, these deductions are also denied for federal estate and gift taxes. see irc §§ 170(f)(18), 2055(e)(5), 2522(c)(5). no deduction is allowed for contributions to a non-functionally integrated type iii supporting organization. irc § 4943(f)(5)(b). (3) sponsoring organizations are required to include: (a) the total number of donor-advised funds owned by the organization; (b) the aggregate value of assets held in these funds at the end of each tax year; and (c) the aggregate contribution to and grants from the funds during the tax year. irc § 6033(k). (4) donors must obtain a contemporaneous written acknowledgement from the sponsoring organization that provides that the sponsoring organization has exclusive legal control of the assets contributed. this statement is required for each contribution to a donor-advised fund. see irc §§ 170(f)(18)(b), 2055(e)(5)(b), 2522(c)(5)(b). 105. the ppa added complex new rules that apply to supporting organizations. after august 17, 2006, type iii supporting organizations must provide each supported organization with any information that the irs may deem necessary to verify that the supporting organization “remains responsive to the needs and demands of the supported organization.” irc § 509(f)(1)(a). in addition: 2009] the pension protection act of 2006 249 (1) type iii supporting organizations may not be operated in connection with any supported organization that is not organized in the united states. there is a transition rule that delayed the effective date of this provision for three years if the supporting organization was already operated in connection with non-u.s. supported organizations. irc § 509(f)(1)(b)(ii). (2) if a type i or type iii supporting organization supports an organization that is controlled by a donor (with some exceptions), the supporting organization is treated as a private foundation instead of a public charity for purposes of the relationship test. (see supra note 11). these supporting organizations will fail the relationship test if they accept gifts or donations from: (a) any person (other than irc § 509(a)(1), (2), or (4) organizations) who controls, directly or indirectly, either alone or together with persons listed in the next two provisions (b) and (c), the gover ning body of a supported organization; (b) any family member described in (a) above; or (c) a 35% controlled entity as described in irc § 509(f)(2)(b). (3) the treasury department was directed to create new regulations governing the payout requirements of non-functionally integrated type iii supporting organizations. these regulations were to require type iii supporting organizations to make significant distributions of a percentage of income or assets to supported organizations. pension protection act of 2006 § 1241(d). (4) with certain exceptions, the tax on excess business holdings was expanded to apply to type iii supporting organizations that are not functionally integrated. type ii supporting organizations are also impacted by the excess business holdings provisions if they accept gifts or donations from a person (other than a public charity, but not a supporting organization) with direct or indirect control over the governing body of an organization supported by the supporting organization, a member of the person’s family, or a 35% controlled entity. irc § 4943(f). (5) the definition of a “qualifying distribution” was modified so that payments made by a non-operating private foundation to a supporting organization do not constitute a qualifying distribution. the definition of a “taxable expenditure” was changed to provide that any amounts that private foundations paid to supporting organizations would be treated as a taxable expenditure unless the private foundation exercises expenditure responsibility. as a result, no payments to type iii supporting organizations that are not functionally integrated count as a qualifying distribution. irc § 4942(g)(4)(a)(i). no payments made to type i or ii supporting organizations, or to organizations that are supervised or controlled in connection with type i or ii organizations, or to functionally integrated type iii supporting 250 florida tax review [vol. 9:4 vi. jct and irs guidance on the 2006 amendments the joint committee on taxation (jct) provided tax practitioners with its analysis of the ppa’s amendments impacting supporting organizations, donor-advised funds, and sponsoring organizations. a. jct report on amendments to irc section 4958: impact on donor-advised funds the jct report addressed four key changes impacting donor-advised funds: (1) automatic excess benefit transactions; (2) disqualified persons; (3) taxable distributions;106 and (4) more than incidental benefit.107 however, it was the jct’s example of the incidental benefit provision that drew the most attention from tax practitioners.108 barely mentioned in the jct report was the fact that congress, in enacting the amendments to irc section 4958, had opted to treat donors, donor advisors, and investment advisors to donor-advised funds much more harshly than from the generally applicable rule. the generally applicable rule provides that an excess benefit is the “amount by which the value of the economic benefit provided exceeds the value of the consideration received.”109 instead, the entire amount of the payment is treated as the amount of the excess benefit, even if the donor-advised fund received valuable consideration from the donor, donor advisor, or other disqualified person.110 considerations, count as qualifying distributions if: (a) a disqualified person of the private foundation controls, directly or indirectly, either the organization or a supported organization; or (b) such a distribution is declared inappropriate by regulations issued by the irs. irc § 4945(d)(4)(a). (6) supporting organizations are subject to new tax return requirements that must include information concerning the organizations it supports, whether it meets the definitional requirements of irc § 509(a)(3)(b), and a certification that it is not directly or indirectly controlled by one or more disqualified persons. irc §§ 6033(a)(3)(b) and 6033(l). 106. a 20% tax is imposed sponsoring organizations of donor-advised funds for taxable distributions under irc § 4966(a), and an additional tax is imposed on a fund manager who knowingly agrees to make a taxable distribution (up to a limit of $10,000). 107. see supra notes 4, 5 and accompanying text. 108. see supra note 103 and accompanying text. 109. joint committee on taxation, supra note 11, n.524. 110. id. 2009] the pension protection act of 2006 251 b. excise tax on more than incidental benefits to disqualified persons if disqualified persons111 provide advice to a donor-advised fund that results in any disqualified person receiving more than an incidental benefit, an excise tax of 125% of the benefit is imposed on that person.112 of primary concern to practitioners was the very low threshold that the jct set in its example of an “incidental benefit” from a distribution made from a donor-advised fund. the jct report stated: in general, under the provision, there is more than an incidental benefit if, as a result of a distribution from a donor advised fund, a donor, donor advisor, or related person with respect to such fund receives a benefit that would have reduced (or eliminated) a charitable contribution deduction if the benefit was received as a part of the contribution to the sponsoring organization. if, for example, a donor advises that a distribution from the donor’s donor advised fund be made to the girl scouts of america, and the donor’s daughter is a member of the local unit of the girl scouts of america, the indirect benefit the donor receives as a result of such contribution is considered incidental under the provisions, as it generally would not have been reduced or eliminated the donor’s deduction if it had been received as part of a contribution by the donor to the sponsoring organization.113 whether the jct example will define when an incidental benefit becomes an excess benefit remains to be seen. however, by setting such a low threshold, sponsoring organizations and donors, donor-advisors, and related persons must be very cautious. the following hypothetical examples illustrate this point: • example 1: the donor advises that the distribution from the donoradvised fund be made to a special girl scout fund that will pay for girl scouts across the country to travel to the girl scouts international jamboree in japan, and the donor’s daughter is among a group of 2,000 girl scouts that will have their expenses paid. 111. disqualified persons are the persons described in irc § 4958(f)(7). 112. irc § 4967. if an excess benefit excise tax is assessed under irc § 4958, then an irc § 4967 tax is not imposed. see supra notes 97, 98 and accompanying text. 113. joint committee on taxation, supra note 11, n.528 and accompanying text. 252 florida tax review [vol. 9:4 • example 2: same facts as in example 1, but the fund is set up to pay the expenses of girl scouts in the local community, so that 15 girls have their expenses paid. • example 3: same facts as in example 2, but the fund is set up to pay the expenses of the girl scouts in the local community who cannot afford to travel to the jamboree. a decision was made that either all of the 15 girls would be able to go or that none of them would go. as a result of the distribution from the donor-advised fund, the donor (mother) and her daughter are able to go to the jamboree at their own expense, while the donation allows other girls, who could not afford to go, to attend. but for the distribution from mother’s donor-advised fund, the donor and her daughter would not have been able to attend. • example 4: the donor (mother) is the leader of her daughter’s girl scout troop and also works part-time for the girl scouts of america, and receives $20,000 compensation for her services. she advises the donor-advised fund to make a distribution to her city’s girl scout chapter. the distribution funds the local girl scout chapter, which, in part, pays her salary and also provides funds to her to use as the leader of her daughter’s scout troop. in which of these examples does an incidental benefit become an excess benefit? there are no clear guidelines. this author maintains that there will never be clear guidelines because there are so many possible variations on just this single example provided in the jct’s report. the irs relies on a “facts and circumstances test” to determine when excess (or more than incidental) benefits occur. without meaning to seem glib, this author sees this rule as a “onecookie/two-cookie rule.” taking one cookie may be only an incidental benefit whereas taking two cookies may result in an excess benefit, subjecting the taxpayer to intermediate sanctions under irc section 4958. what happens when a taxpayer takes 1.25 or 1.5 or 1.67 cookies? without clearer guidelines, the only possible result will be serious inconsistencies in enforcement and significant confusion for sponsoring organizations and donor-advised funds. c. jct report on amendments impacting supporting organizations as previously stated, barely mentioned in the jct report was that congress, in enacting the amendments to irc section 4958, opted to treat supporting organizations much more harshly than other exempt organizations. irc section 4958 provides that if a supporting organization is involved in an excess benefit transaction, the entire amount of the payment is treated as the amount of the excess benefit. the general rule is that the amount by which the value of the economic benefit provided exceeds the value of the consideration 2009] the pension protection act of 2006 253 received is the amount of the excess benefit that is subject to the penalty excise tax.114 d. irs guidance substantive irs guidance for donor-advised funds and supporting organizations regarding the ppa’s amendments is in the process of being developed. however, the irs has issued two notices that have provided some technical guidance. notice 2006-109 explained that sponsoring organizations of donoradvised funds may determine the type i or type ii status of a supporting organization by (1) obtaining a written statement, signed by an authorized representative of the supporting organization, that describes the relationship between the supporting organization and its supported public charities; and (2) reviewing and retaining copies of the supporting organization’s current governing documents establishing the type i or type ii relationship. for distributions to type iii supporting organizations, the irs suggested that sponsoring organizations of donor-advised funds obtain more detailed information to substantiate the relationship required for a type iii supporting organization to meet the requirements for being “functionally integrated” (meeting the “but for” test).115 the primary problem confronting the irs was the fact that sponsoring organizations (some of which managed hundreds of donor-advised funds) were being asked to play detective and draw the fine line between integrated and nonintegrated type iii supporting organizations. in notice 2006-109 the irs stated that until the treasury department and irs could issue regulations defining a “functionally integrated type iii supporting organization,” a grantor may rely on the standards set forth in the notice116 to determine whether the grantee is a 114. joint committee on taxation, supra note 11, n.569. 115. treas. reg. § 1.509(a)-4(l)(3)(ii). 116. irs notice 2006-109: section 3, .01, a. to establish that a grantee is a type i or a type ii supporting organization, a grantor, acting in good faith, may rely on a written representation signed by an officer, director or trustee of the grantee that the grantee is a type i or type ii supporting organization, provided that: i. the representation describes how the grantee’s officers, directors, or trustees are selected, and references any provisions in governing documents that establish a type i (operated, supervised, or controlled by) or a type ii (supervised or controlled in connection with) relationship (as applicable) between the grantee and its supported organization(s); and 254 florida tax review [vol. 9:4 ii. the grantor collects and reviews copies of governing documents of the grantee (and, if relevant, of the supported organization(s)). b. to establish that a grantee is a functionally integrated type iii supporting organization a grantor, acting in good faith, may rely on a written representation signed by an officer, director or trustee of the grantee that the grantee is a functionally integrated type iii supporting organization, provided that: i. the grantee’s representation identifies the one or more supported organizations with which the grantee is functionally integrated; ii. the grantor collects and reviews copies of governing documents of the grantee (and, if relevant, of the supported organization(s)), and any other documents that set forth the relationship of the grantee to its supported organizations, if such relationship is not reflected in the governing documents; and iii. the grantor collects and reviews a written representation signed by an officer, director or trustee of each of the supported organizations with which the grantee represents that it is functionally integrated describing the activities of the grantee and confirming, consistent with § 3.02 of this notice, that but for the involvement of the grantee engaging in activities to perform the functions of, or to carry out the purposes of, the supported organization, the supported organization would normally be engaged in those activities itself. as an alternative to relying on a written representation from a grantee and specified documents as described in a or b above, a grantor may rely on a reasoned written opinion of counsel of either the grantor or the grantee concluding that the grantee is a type i, type ii, or functionally integrated type iii supporting organization. a private foundation considering a grant to a type i, type ii, or functionally integrated type iii supporting organization may need to obtain a list of the grantee’s supported organizations from the grantee to determine whether any of the supported organizations is controlled by disqualified persons of the private foundation. see § 3.02, below, for the definition of control that may be used. if such control exists, the grant may not be a qualifying distribution and the foundation may be required to exercise expenditure responsibility with respect to the grant. similarly, a sponsoring organization considering a grant from a donor-advised fund to a type i, type ii, or functionally integrated type iii supporting organization may need to obtain a list of the grantee’s supported organizations from the grantee to determine whether any of the supported organizations is controlled by the fund’s donor or donor advisor (and any related parties). see § 3.02, below, for the definition of control that may be used. if such control exists, the sponsoring organization will be required to exercise expenditure responsibility. section 3, .02 the service and the treasury department intend to issue regulations regarding the meaning of “control” under §§ 4942(g)(4)(a) and 2009] the pension protection act of 2006 255 public charity and to determine the grantee’s public charity classification under irc section 509(a)(1), (2), or (3). perhaps recognizing this heavy burden being placed on sponsoring organizations, the irs provided in the notice that sponsoring organizations, “acting in good faith,” may rely on information from the irs business master file (bmf) or the grantee’s current irs letter recognizing the grantee’s tax-exempt status. in every situation, the sponsoring organization is required to verify that the grantee is listed in publication 78, cumulative lists of organizations described in section 170(c) of the code of 1986, or obtain a copy of the current irs letter recognizing the grantee as exempt from federal income tax. the irs also provided transitional relief and filing procedures for certain charitable trusts that fail the responsiveness test for type iii supporting organizations.117 4966(d)(4)(a) and the definition of a “functionally integrated type iii supporting organization” under § 4943(f)(5)(b). until those regulations are issued, a grantor may rely on the standards described below for purposes of §§ 4942, 4945 and 4966 (as applicable). although regulations may adopt different standards from those referenced below, those regulations will apply to grants made by private foundations and sponsoring organizations no sooner than the date that the regulations are proposed. the standards set forth below will apply with respect to any grants made prior to that date. in determining whether a disqualified person with respect to a private foundation controls a supporting organization or one of its supported organizations, the control standards established in treas. reg. § 53.4942(a)-3(a)(3) will apply. under these standards, an organization is controlled by one or more disqualified persons with respect to a foundation if any such persons may, by aggregating their votes or positions of authority, require the supporting or supported organization to make an expenditure, or prevent the supporting organization or the supported organization from making an expenditure, regardless of the method by which the control is exercised or exercisable. similarly, in determining whether a donor or donor advisor or a person related to a donor or donor advisor (as described in § 4967(d) and 4958(f)(7)) of any donoradvised fund controls a supported organization of the grantee, the control standards established in treas. reg. § 53.4942(a)-3(a)(3) will apply. under these standards, a supported organization is controlled by one or more donor or donor advisors (and any related parties) of any donor-advised fund if any such persons may, by aggregating their votes or positions of authority, require a supported organization to make an expenditure, or prevent a supported organization from making an expenditure, regardless of the method by which the control is exercised or exercisable. also, solely for purposes of a representation or opinion of counsel on which a grantor may rely, an organization will be considered a functionally integrated type iii supporting organization if it would meet the test set forth in treas. reg. § 1.509(a)4(i)(3)(ii). 117. irs notice 2008-6, 2008-3 i.r.b. 275. 256 florida tax review [vol. 9:4 vii. the case against the attack on donor-advised funds and supporting organizations there are many reasons that the congressional and irs attack on donoradvised funds and supporting organizations is misguided. the ppa’s amendments relating to donor-advised funds and supporting organizations are terrible tax policy and even worse public policy. donor-advised funds and supporting organizations are an essential component of continuing communitybased charitable work. the history of both donor-advised funds and supporting organizations makes it obvious that these charitable giving vehicles are among the most efficient and cost-effective ways to ensure that charitable gifts are actually used for the intended charitable purpose. with little more than anecdotal evidence of serious abuses, congress has hindered the ability of charitable organizations to continuously fund successful and on-going charitable projects and threatened the existence of essential community charities. a. bad tax policy 1. targeting donor-advised funds and supporting organizations to raise revenue or close the tax gap is unsound policy tax rate reductions on businesses and individuals coupled with a ballooning deficit have resulted in congress seeking other ways to raise revenue. the ppa increased penalty taxes in a number of areas, including those on tax preparers who fail to comply with a number of complex new tax laws adopted in the ppa. the provisions relating to donor-advised funds and supporting organizations increased the penalty excise taxes significantly and added confusing new provisions to the code, especially relating to supporting organizations and, in particular, type iii integrated and non-integrated supporting organizations.118 118. one might have expected there to be an outcry from sponsoring organizations of donor-advised funds and supporting organizations regarding these provisions. there was opposition to these amendments but not to a great degree. this is best explained by the fact that the original provisions in the senate bill were even more oppressive. for example, in the senate bill, excise taxes on more-than-incidental benefits would have applied to the entire distribution, not just the benefit. thus, if a donor advised that a grant of $1,000,000 be awarded to a university, and the university gave the donor football tickets worth $1,000, the donor could be subjected to a 25% excise tax on the whole $1,000,000, resulting in a $250,000 penalty that is entirely out of proportion to the $1,000 benefit. 2009] the pension protection act of 2006 257 congress enacted these burdensome changes and now expects the irs to aggressively implement their enforcement as a means of “closing the tax gap.”119 in theory, increased penalties and stricter regulation of donor-advised funds and supporting organizations should result in greater tax revenues; however, this is not necessarily the case. the treasury department’s office of tax policy has studied the issue of reducing the tax gap and provided “an aggressive strategy” and specific recommendations to congress,120 which congress has ignored. in setting its strategy, the treasury noted three primary characteristics of the tax gap: (1) over 70% of the gross tax gap is attributable to the individual income tax; (2) over 80% of the gross tax gap is caused by underreporting of tax, with roughly half of this amount attributable to underreporting of net business income by individuals; and (3) noncompliance is highest among taxpayers whose income is not subject to third-party information reporting or withholding requirements.121 treasury stressed that reforming and simplifying the tax law would reduce the opportunity for tax evasion “and make it easier for the irs to administer the tax laws.”122 the treasury department stated that: the complexity of the tax law also contributed to the tax gap because limited irs resources are increasingly committed to administering a wide array of targeted tax provisions created to meet social policy goals. these targeted provisions, which themselves are growing increasingly complicated, divert irs resources from basic compliance efforts.123 see aba tax section, letter questioning need for some charitable incentives in senate tax reconciliation bill (s. 2020) (feb. 6, 2006). 119. the “tax gap” refers to the difference between what the irs actually collects and what taxpayers should be paying in taxes. 120. u.s. department of the treasury, office of tax policy, a comprehensive strategy for reducing the tax gap (sept. 26, 2006). 121. id. at 5. 122. id. at 3 (emphasis added). 123. id. at 15 (emphasis added). on aug. 3, 2007, an irs investigator told the house ways and means committee that charitable organizations were responsible for nearly $1 billion in unpaid federal payroll taxes in 2006. cch, treasury delivers tax gap plan to baucus (aug. 3, 2007). this is an area in which the irs should be able to 258 florida tax review [vol. 9:4 although treasury was not referring to any specific tax provisions, it could not have described the enactment of the new irc provisions related to donor-advised funds and supporting organizations more accurately. nowhere are the new tax provisions more complex and confusing than in the ppa’s creation of the new categories of functionally integrated and non-functionally integrated type iii supporting organizations and the new restrictions directed at type iii supporting organizations that are not functionally integrated.124 finally, in its report, treasury noted that penalties were useful in deterring noncompliance with the code, but if penalties are set too high, examiners may be “unable or unwilling to assert them, particularly when they believe the taxpayers may have made inadvertent errors.”125 2. there is no rationale to treat donor-advised funds and supporting organizations more harshly than other exempt organizations the ppa’s establishment of a new type of automatic excess benefit transactions between a charity and disqualified persons applies exclusively to donor-advised funds and supporting organizations.126 the tax section of the american bar association (aba) responded critically to congress’ enactment of these provisions.127 from the time these provisions were enacted, this author has failed to find any possible rationale for such harsh treatment exclusively directed at donor-advised funds and supporting organizations. similarly, the aba could find no explanation for these changes to the automatic excess benefit transactions amendments. the aba stated: it is not clear why supporting organizations and donor-advised funds should be subject to a more stringent rule [than private foundations or other exempt charitable organizations]. implicit achieve greater compliance without expending an inordinate amount of resources. see also infra note 128 and accompanying text. 124. these new provisions are a source of significant complexity and have resulted in significant confusion. the statutory definitions are ambiguous … we encourage the oversight committee to reconsider these rules. if congress decides to retain these rules, the oversight committee should monitor how the treasury department carries out it broad regulatory authority to ensure that these provisions do in fact address the reported abuses that led to their enactment. aba tax section, letter to congressional leaders on pension protection act of 2006 provisions affecting exempt organizations (aug. 8, 2007). 125. id. at 9. 126. irc § 4958(c)(2), (3). 127. see supra note 123. 2009] the pension protection act of 2006 259 in this change must be the view that payments of compensation or expense reimbursements to disqualified persons by supporting organizations or donor advised funds are more likely to result in abuse than similar payments by private foundations. however, we are not aware of any substantial evidence to that effect.128 the aba also complained that the ppa provisions result in nonfunctionally integrated type iii supporting organizations being treated more harshly than private foundations. the code provides that a grant from one private foundation to another private foundation may qualify as a qualifying distribution that counts against the minimum distribution requirements under the “out of corpus” rules of irc section 4942(g)(3). there is no flexibility for this treatment of grants by private foundations to non-functionally integrated type iii supporting organizations.129 3. the irs had the tools needed to resolve issues of excess benefits prior to the ppa’s amendments the irs has always had the ability to prevent charitable organizations from permitting the private inurement of private shareholders or individuals (insiders) and conferring excessive benefits upon any person, other than a member of the charitable class, whether or not an insider.130 as the new york community trust stated: the law governing charitable contribution deductions (section 170 of the code and the accompanying treasury regulations, court case and so forth) quite clearly provides that a gift to a charity that provides impermissible private benefits to the donor or another private individual is not tax-deductible. to create special rules and regulations for contributions to donor-advised funds that are part of a functioning public charity 128. id. (emphasis added). the aba also stressed that the ppa amendments to the excess benefit transaction provisions reversed the priorities of irc § 4941 [the selfdealing provisions that apply to private foundations] by prohibiting the payment of compensation but allowing sales and leases. “congress previously had determined in enacting § 4941 that sales and leases were more susceptible to abuse than compensation for services, but the ppa takes a contradictory approach.” the aba added that the “rules under § 4941 already were subject to much criticism for their complexity, and by prohibiting the payment of all compensation by supporting organizations and donoradvised funds the ppa effectively creates more traps for the unwary.” 129. id. 130. see supra note 6 and accompanying text. 260 florida tax review [vol. 9:4 does not add anything material to existing law. the need is for best practices and oversight by sponsoring organizations and donors and for enforcement by the irs: new and redundancy special rules will only create a maze of foot faults.131 4. facts and circumstances test is meaningless and unworkable in these situations, and the impact on smaller exempt organizations is disproportionate as explained earlier, the ppa’s amendments impacting sponsoring organizations, donor-advised funds, and supporting organizations have added a host of new complexities to the provisions governing the operation of these organizations. the irs made repeated attempts to explain the operation of the intermediate sanctions provisions before finally releasing final regulations after six years. the irs is still grappling with this issue and continues to try to formulate understandable guidance. complex tax provisions often require the irs to adopt a “fact and circumstances” test to determine whether a charitable organization has violated provisions regarding private inurement or private benefit, more-than-incidental benefits, and self-dealing provisions. now, the irs and charitable organizations will have to perform complicated, time-consuming work to determine such things as whether an organization is a type iii supporting organization, whether a donor or some other person is a disqualified person, whether the transaction was intentional or unintentional, and the value of the benefit. this will be no easy task. applying the facts and circumstances test to these issues will inevitably lead to disparate results in similar circumstances. the potential for the irs to target certain types of organizations is also an issue. the facts and circumstances test is really no test at all. in united cancer council, inc. v. commissioner of internal revenue,132 the irs objected to a small charity that had hired an outside fundraising organization to raise money for the organization. the contract was an arm’s-length transaction and the irs never claimed that any of the funds paid to the fundraising organization found its way into the “pockets of any members of the charity’s board.”133 nor did the irs contend “that any members of the board were owners, managers, or employees of the fund-raising organization.” nor did the irs claim that the fund-raising organization had any direct or indirect involvement in the creation of the 131. statement of new york community trust to the house ways and means committee (jul. 24, 2007). 132. 165 f.3d 1173 (7th cir. 1999). 133. id. at 1175. 2009] the pension protection act of 2006 261 charitable organization or the organization’s goals.134 instead, the irs contended that the contract was so disadvantageous to the charitable organization that the “charity must be deemed to have surrendered control of its operations and earnings” to the fund-raising organization.135 in the court’s opinion in united cancer council, judge posner seemed incredulous that these were the irs’s assertions. he explained that the private inurement provisions had long been understood to refer to insiders of the charitable organization.136 he explained: the [inurement] provision is designed to prevent the siphoning of charitable receipts to insiders of the charity, not to empower the irs to monitor the terms of arm’s length contracts made by charitable organizations with the firms that supply them with essential inputs, whether premises, paper, computers, legal advice or fundraising services.137 the court rejected the irs’s decision to revoke the charitable status of the organization on these grounds. judge posner’s description of the “facts and circumstances” test in these situations was pointed and accurate: we were not reassured when the government’s lawyer, in response to a question from the bench as to what standard he was advocating to guide decision in this area, said that it was the “facts and circumstances” of each case. that is no standard at all, and it makes the tax status of charitable organizations and their donors a matter of the whim of the irs.138 the ppa’s amendments will result in organizations either opting for a “better-safe-than-sorry” approach that will make them much less effective at attracting charitable-minded people to set up a donor-advised fund, or force these organizations to waste vital resources in an attempt to comply with these confusing tax laws. currently, supporting organizations have been able to distribute 98-99% of their funds because they were not handcuffed with burdensome over-regulation, as are private foundations. the result is that distributions will likely sink to the 60-80% level of private foundations. an often-overlooked consequence of the ppa’s amendments to the donor-advised fund provisions is the fact that elimination of all distributions 134. id. 135. id. 136. id. at 1176. 137. id. 138. id. at 1179. 262 florida tax review [vol. 9:4 from donor-advised funds to individuals and to for-profit companies that do not conduct charitable activities eliminates the ability of these funds to pay vendor expenses incurred during fundraising events. this particularly impacts smaller donor-advised funds and will serve to discourage donors from raising additional money for these funds.139 b. bad public policy: ppa amendments dissuade donors from establishing donor-advised funds and being actively involved in the charitable issues that matter most to them community foundations first developed donor-advised funds to encourage donors to invest in the present and future needs of their community. these funds allow permanent charitable organizations to consolidate many grants from different types of funds to support community endeavors in order to provide for the future well-being of their communities.140 donor-advised funds offer many advantages to both community foundations and to donors as compared to private foundations or individual contributions to exempt organizations. first, there is no question that some organizations that have exempt tax status are scams. the overhead costs result in a miniscule use of funds for the intended charitable purpose. donors must expend much time and energy to ascertain the legitimacy and efficiency of the thousands of charitable organizations seeking their support. it is likely that many well-intentioned donors give contributions to organizations that have no intention of using the donations as the donor expects. this unfortunate result is highly unlikely when contributions are made to donor-advised funds. sponsoring organizations of donor-advised funds play a crucial role in ensuring that a donor’s funds are actually used for the intended charitable purpose, instead of leaving donors to simply guess which charitable organizations they can entrust with their direct gift. donor-advised funds educate donors about priorities important to the community and serve to create a broad base of support for charitable endeavors that support the community.141 donoradvised funds “engage and educate donors” and build lasting endowments to benefit the community.142 community foundations also serve to insure that all 139. see, e.g., north virginia community foundation comments on irs notice 2007-21 on donor-advised funds, supporting organizations (mar. 30, 2007). 140. see generally supra note 123. 141. see, e.g., bna, ujc opposes overregulation of donor-advised funds, cites advantages of organization type (apr. 13, 2007). the united jewish communities represents 155 jewish service organizations and claims to be the nation’s largest holder of donor-advised funds. id. 142. north virginia community foundation comments on irs notice 2007-21 on donor-advised funds, supporting organizations (mar. 30, 2007). 2009] the pension protection act of 2006 263 grants from donor-advised funds go to bona fide nonprofits in good legal standing.143 second, “98-99% of every dollar that flows into a donor advised fund is available for grant making to nonprofits in the community.”144 this is in stark contrast to the percentage that most private foundations are able to grant for charitable purposes.145 “most private foundations only manage to grant out between 60%-80% of the input dollars.”146 third, supporting organizations provide the expertise to ensure that a donor’s funds are disbursed to organizations that meet the requirements for exemption under the code. moreover, the expertise of fund managers coupled with the involvement of donors serves as a double-check that funds are being used wisely. it seems obvious that an informed donor working with fund managers that do not want to risk the credibility or the exemption status of their sponsoring organization are more likely to make charitable contributions to organizations that are fiscally responsible and committed to their charitable purpose.147 “in addition to providing guidance on the selection of grantees, the sponsoring organization provides an extra layer of oversight and necessary administration that is otherwise difficult for individual donors or unstaffed family foundations to manage.148 finally, the ppa’s amendments have created a situation in which donors are discouraged from being actively involved in the charitable issues that most matter to them. viii. conclusion the ppa’s amendments have threatened the ability of sponsoring organizations, donor-advised funds, and supporting organizations to perform their vital charitable services and provide essential resources to communities across the country. at the same time, these amendments have forced the irs to focus on an area that will not result in much additional tax revenue and an area in which the irs has shown a tendency to act abusively. the ppa’s amendments are terrible tax policy – and even worse public policy. 143. id. “by virtue of the collaboration between donors and community organizations through donor advised funds, donors have ready access to information about community needs and the nonprofits meeting those needs.” this often results in donors making sound recommendations that meet community needs. id. 144. id. 145. id. 146. id. 147. see generally journal of accountancy, more restrictions may await this popular way to give (jan. 2008) (online issues, www.aicpa.org/pubs/jofa/jan2008/ donor_advised_funds.htm). 148. supra note 130. florida tax review volume 2 1995 number 7 at the conclusion of the fall 1994 semester, professor james j. (jack) freeland retired from his position as distinguished service professor at the university of florida college of law. professor freeland is a graduate of this law school and served as a member of its tax faculty for more than 35 years. the florida tax review is pleased to honor professor freeland on his retirement. four of his former colleagues, dean jeffrey e. lewis of the university of florida college of law, professor guy b. maxfield of new york university school of law, m. carr ferguson, esq., of the law firm of davis, polk & wardwell, new york, and professor stephen a. lind of the university of florida and the university of california, hastings college of the law, reflect below on their long associations with professor freeland. -~ hthis issue of the florida tax review is dedicated to james j. freeland florida tax review jack freeland's tenure as a member of the faculty at the university of florida began in 1957. by every measure, jack has distinguished himself as a scholar and a teacher. he has brought great distinction to his alma mater. thousands of students over the years have had the benefit of his tutelage in the classroom. jack is a charismatic and challenging teacher. his scholarship has provided guidance to lawyers and law students for decades. jack's retirement was a great loss to the law school, but his contributions will be long lasting. and jack has been a good friend to so many of us over the years. thank you, jack. jeffrey e. lewis what is an institution? webster's ninth new collegiate dictionary states: "also: something or someone firmly associated with a place or thing." james j. ("jack" or "jj") certainly fits the definition. he is firmly associated, and has been for 37 years, with the law school at the university of florida; and the thing that he has been firmly associated with is tax law. although jack has made the decision to retire, he cannot cease being an institution. institutions take on a life of their own, and as years pass, they seem to grow in stature, complexity, intensity, and fame. as long ago as 1962, when i first was introduced to the institution that was jack freeland, he was already a formidable structure. over the past 33 years, each time i have seen him, he has grown even more impressively. jack's foundation, however, began well before 1962. perhaps it was at sewanee military academy that jack started on the road to becoming an institution. he spent about two years in the united states navy-doing, what else-but as a corpsman, helping others. after completing his military duty, jack spent five years at duke university. he received his bachelor's degree in 1950 and finished his first year of law school at duke. upon being advised that if he wanted to practice law in florida, he should attend the university of florida law school, jack transferred and received his juris doctor degree in 1954. the next three years were spent practicing tax law with dowling & culverhouse in miami. it was in 1957 that jack began his life-long loveteaching and writing about taxes. from the time he began as a neophyte teacher to his last class some 37 years later, jack was recognized as a superb teacher. indeed, many of his former students who continued their education at new york university (which jack affectionately called the "mother church") said that it was jack who instilled in them the desire to pursue the world of tax for their professional lives. it was not only as a teacher that jack developed his reputation. during his time at florida (with side jaunts to new york, arizona, and holland), jack wrote or was the co-author of 13 books and 20 articles! the [vol 2:7 dedication: james j. freeland breath of topics covered by jack ranges from the intricacies of corporate tax to the effect of distributions in kind by an estate or trust. (it was on this last topic that jack's observations led to an amendment of the statute.) during this period, jack also was an administrator. in 1974, he, along with dick stephens, founded the graduate tax program at the university of florida college of law, which confers the ll.m. (in taxation) degree. for some five years, jack served as director of the program and was responsible for faculty recruitment, student placement, fund raising, and all the other things that administrators do to fill up their time. with delight, jack was able to return in 1982 to full-time writing and teaching. this short biographical statement does not do justice to a man who became an institution. for those of us who have been privileged to share a glass of pop at four in the morning discussing life in all of its fullness with jack, he will always seem larger than life itself. while he may be retired, he will never be retiring. guy b. maxfield jack's arrival at new york university in the fall of 1962 made an immediate and vivid impression on his new colleagues and students. most of the denizens of greenwich village and vanderbilt hall were yankees of one stripe or another, and jack struck our northern eyes as a dashing, if somewhat rumpled, confederate cavalry officer. his softened vowels fell charmingly on our ears, and his speech was laced with surprising turns of phrase, metaphors, and shimmering verbal pictures-the match of e.e. cummings or any other village denizen and far beyond the grayer, linear phrasing of his new tax colleagues. what we could learn of his background only fed the stories that sprang up in his footsteps through washington square and vanderbilt hall. fascinating vignettes of his childhood, adventures in and out of military school, duke, the university of florida, and of his early days as a lawyer working with two of the most colorful and unlikely law partners in florida quickly endeared him to all of us. jack's imagery of piloting an old buick just under the speed of sound, up and down the state, driven by the competing demands of his two hughs-dowling and culverhouse-was particularly memorable to me, since, at about the same time jack must have been driving and sleeping in that car, hugh dowling and i, after trying a case against each other in birmingham, had discussed joining in practice. as i heard jack's stories, i felt a sense of relief that we had not met until years later, in another stage of our lives. he brought to new york not just the heady perfume of north florida life and his beautiful, delightful family, but, as well, the swagger, uninhibited humor, and individualism that sprang from his roots-and a pride in his work 19951 florida tax review that drove him to the top. all of this he brought into his classrooms. the nyu graduate tax program, founded 14 years earlier by the legendary jerry wallace, demanded the best of its students and its teachers alike. intensive preparation for class was taken for granted. so was gifted teaching. jack exceeded all expectations. in a faculty of great teachers, jack's classes were sought out and over-enrolled. it was no wonder. he would plow the rockiest, thinnest tax soil and grow not brambles but rich, colorful fruit. he taught always through socratic dialogues based on assigned problems, a technique that in his classes, led to understanding rather than deeper mysteries. an example springs to mind from a subject we both, perhaps perversely, loved to teach and write about: income taxation of estates and trusts. a few years before jack's arrival, an nyu student working through a complex problem of distributable net income was asked "what's your dni?" he responded miserably, "professor, i don't know my dni from my ass." such defeats were not permitted in jack's class. before tackling this same problem a few years later, jack turned dni into a "rainbow of assorted flavors of income" (an unforgettable, mixed metaphor, typical of jack's humor and genius) and, through baby steps, gave even the slower students a sense of having mastered the basic concepts. then he would grab the chalk, whirl around to the board, shirttail dangerously near liberation, and commence his questions, cocking his ear quizzically, issuing a warning "huh?" to an errant answer and, in the end, leaving the whole class convinced that determining fiduciary and beneficiary taxable income is a delicious piece of cake. from my office next to his, i remember the stream of students, animated discussions and bursts of laughter coming from his room. jack and his wife and children missed home. jack tried living in the village, they tried a new jersey suburb. he tried commuting in the car of a colleague who drove with such suicidal abandon that jack's low-flying days down the florida highways paled in memory to a sedate creep. he loved his classes, his many new friends, and the resources of nyu, but finally decided to go home to gainesville. when he left, it was as if the pied piper had ended his concert. we missed him very much. i have been fortunate to remain in touch with him through our collaborations in writing and speaking. he was and is a new adventure every time i am in his company. may his rainbow follow him wherever he goes! m. carr ferguson when i first learned that jack freeland was planning to retire, i was shocked. i doubt that i was alone in thinking that jack would be carried feet first out of the university of florida college of law. i'm glad that i'm not [vol 2:7 dedication: james j. freeland writing an obituary for jack, but that instead i'm writing some words of thanks to him on his retirement. as a colleague, a co-author, and in many ways a student of jack's, there is much to thank him for. first, thanks for his pioneering work on and dedication to the ll.m. program in taxation at the university of florida. jack and dick stephens overcame what were almost insurmountable obstacles in creating an advanced tax law program. it is safe to say the program would not now exist, if it were not for their joint perseverance. indeed, it was during jack's five years as director of the program that it grew from a young upstart to one of the highest ranked programs in the country. thanks, too, for including me to work with him and dick stephens on an income tax casebook that, during its 23 year life span, has sold in excess of two hundred thousand copies. the book had its origins in teaching materials developed by jack and dick. many of the cases and problems found in those materials are still in the casebook because they have endured as effective teaching aids. the aspect of jack's career for which he deserves the most thanks, however, is one that i have only vicariously experienced. although i've learned a lot from jack, i've never taken a law school course from him. but that doesn't mean that i am unaware of his teaching style and ability. my introduction to jack came not from a personal meeting, but when i filled his teaching slot when he was visiting another law school. when i began teaching an advanced tax course, students in the class began using a vocabulary that sounded like a foreign language to me. i soon discovered "jj's tax language"-a series of terms he used in teaching that were humorous, clever, memorable, and just down-right effective in teaching tax law. terms such as the "the gotcha" for the concept of recapture and "the hotchpot" for sorting out tax consequences under section 1231, and "the section 67 haircut" are a few in a long list. i am sorry that i never took the opportunity to take one of his courses-but as another colleague said year's ago---"one can't do that because one would end up only imitating him, and no one could be as good as the real thing." so, jack, on behalf of the thousands of students that you have taught over the years for whom a course from j.j. was truly a rewarding and memorable experience-thank you. i hope that he enjoys his retirement years. part of that enjoyment should come from the well deserved pride he can take in the significant contributions he has made to the tax law, our graduate tax program, and his many students. stephen a. lind 19951 florida tax review volume 4 1999 number 6 an overview concerning certain recent changes for foreign compensatory trusts: 402(b) trusts, grantor trusts and "rabbi" trusts steven iv. rabitz" . introduction ........................ ii. structural considerations ............ a. treatment of grantor trusts .......... 1. generally ................. 2. u.s. taxation of foreign grantors b. section 402(b) "secular" trusts ....... c. situs of the trust .................. 1. prior law ................. 2. recent changes in law ....... 3. reporting requirements ....... m. "inbound" grantor trust rules ........ a. prior law ...................... b. statutory and regulatory changes to section 672(f) .................... ....... 431 ....... 433 ....... 433 ....... 433 ....... 435 ....... 436 ....... 441 ....... 441 ....... 442 ....... 446 ....... 447 ....... 447 ....... 448 c. turning foreign section 402(b) trusts into grantor trusts: the "overfiaided" tests ......... 452 1. requirements for foreign section 402(b) non-grantor trust treatment ........... 452 2. the "exception" to the general rule: section 402(b) overfimded "grantor" trusts ............................ 453 a. controlled foreign corporations ... 454 b. passive foreign investment companies ................... 454 c. foreign partnerships ........... 456 3. policy considerations ................. 456 d. fractional amount computation ............... 462 e. grantor "secular" trusts ................... 466 * associate, cleary, gottlieb, steen & hamilton, new york. new york. b.a. 1992, brandeis university; j.d. 1995, ll.m. (taxation) 1998, new york university school of law. © steven w. rabitz. all rights reserved. 430 florida tax review [vol 4:6 1. the "fundamentally inconsistent" standard revisited ................... 466 2. proposed regulations ................. 469 f. summary ............................... 473 iv. outbound grantor trust rules ................ 474 a. the scope of section 679 .................... 474 b. legislative changes to section 679 occasioned by the small business job protection act ......... 476 c. proposed regulations ...................... 477 v. conclusion .................................. 480 recent changes for foreign compensatorv tnsts i. introduction foreign companies and their u.s. subsidiaries employing u.s. persons have devised a wide range of executive and other deferred compensatory arrangements in order to be an incentive to their workforce. because of matters relating to administrative ease, or in some cases, certain foreign legal or accounting issues, these incentive awards are often contributed to trusts by foreign employers or foreign parents of u.s. employers, and most notably foreign trusts described in section 7701 (a)(3 1). under the code, special rules govern the u.s. federal income taxation of trusts. in particular, under sections 671 through 679, a grantor of a trust who retains certain powers over or interest in the trusts is treated as the "owner" of the trust, with the result that all of the trust's income is taxable to the owner. certain special vehicles, so-called "rabbi trusts," whose assets are subject to the claims of creditors of the employer, are also subject to these rules. additionally, under section 402(b), certain compensatory trust arrangements result in a separate level of tax on the trust entity, along with the additional result that participants are often taxed on their vested interest in the trust. in 1996, the small business job protection act' amended portions of sections 672 and 679, among others, and in september of 1996, and again in june of 1997, the internal revenue service (the service) issued proposed regulations which dramatically affect the foreign trust deferred and incentive compensatory world. in february 1999, and again in august 1999, the service issued certain final regulations affecting foreign trusts. the cumulative effects of the statutory and regulatory changes are broad, involving changes in the treatment of both "inbound" and "outbound" compensatory trust arrangements. first, the changes alter the definition of "foreign trust." because special rules have traditionally applied to foreign trusts (and because the recent statutory and regulatory changes now impose additional special rules on foreign trusts) the classification of such entities forms an important first analytical step in examining many cross-border deferred or incentive compensatory arrangements. as described below, these statutory changes offer some much needed clarity on the demarcation between domestic and foreign trusts-an area which has often been riddled with ambiguity. second, some of the changes put forth are designed to preclude certain perceived abuses of foreign deferred compensation plans as tax shelters. unchecked, these abuses might permit u.s. entities to protect income 1. small business job protection act of 1996, pub. l. no. 104-188, 110 slat. 1755 (1996). 1999] florida tax review in offshore trusts. prompted by concerns that u.s. persons were not paying their fair share on income attributable to foreign trusts, certain foreign affiliates of u.s. entities may now be treated as grantors on the overfunded portion of certain foreign compensatory trusts, and thus may be subject to u.s. federal income tax on the items of income produced by the trust, regardless of whether the trust would otherwise be so treated under subpart e of subchapter j. in particular, these rules are designed to curb abuses by plans maintained by u.s. sponsors as well as by: (a) controlled foreign corporations, (b) certain passive foreign investment companies and (c) certain foreign partnerships. these rules, in particular, are potentially expansive in scope because arrangements of purely foreign entities which employ mostly foreign persons may now be subject to u.s. taxation even though the only united states nexus is through their affiliation with a u.s. entity. accordingly, some practitioners have queried whether such a jurisdictional extension of u.s. taxing authority is appropriate. equally notable from the policy standpoint is these proposed regulations' impact on the dividing line between "secular" section 402(b) arrangements and grantor trusts. insofar as the rules apply to certain overfunded secular trusts, the service appears to be departing from its established policy of treating section 402(b) "secular" trust arrangements as "fundamentally inconsistent" from grantor trusts-a distinction with potentially multiple consequences, as discussed below. moreover, while the proposed changes affect many overfunded foreign arrangements, they leave open some issues as to how and when these foreign arrangements may be viewed as "overfunded." the rules of determining when a trust is overfunded, as described below, not only invoke practical concerns in measuring a trust's funding status, but also potentially raise several accounting translation issues between u.s. and foreign procedures and standards. third, the proposed changes alter the treatment of certain "outbound" compensatory trust arrangements (i.e., foreign trusts with a u.s. employer and u.s. beneficiaries). section 679, as amended, now clarifies that u.s. grantors of "outbound" foreign trusts with u.s. beneficiaries will not be treated as owners of the trusts under that provision if the arrangement is considered to be covered by section 402(b). however, in spite of this statutory change, as described below, certain recently issued proposed regulations indicate that portions of "outbound" section 402(b) trusts will be subject to the grantor trust rules as a result of the application of the overfunding rules described above. these developments raise interesting questions as to the cumulative interpretation of these recent changes as well as to the underlying rationale of the proposed regulations and the recent changes in law. finally, the proposed regulations prompt certain basic questions about the treatment of deferred compensatory grantor trusts. the proposed changes raise the possibility that deferred compensatory arrangements that do not [vol. 4:6 recent changes for foreign compensatory tnsts qualify as rabbi trusts will never be treated as grantor trusts even if they would otherwise so qualify under sections 671 through 677. this is a potentially broad assertion and is especially important for those compensatory arrangements that fail to meet the requirements of revenue procedure 9264--the service's safe harbor for favorable rabbi (grantor) trust treatment. thus, both as a matter of practice and policy, these changes appear not only to redefine the boundaries between section 402(b) trusts and grantor trusts but also thus effect the line between section 402(b) arrangements and rabbi trusts themselves. consequently, this article seeks to describe some of the salient practical and policy issues confronting the foreign deferred compensatory trust world in light of the recent changes to the code and the more recently issued proposed regulations. part ii first outlines some of the basic u.s. federal income tax considerations involved in trust-structured foreign deferred compensatory arrangements. part ii describes the conditions necessary for grantor trust treatment as well as the tax consequences associated with section 402(b) secular trust arrangements. part ii further discusses the recent changes in law refining the boundary between domestic and foreign trusts. part [h highlights "inbound" foreign grantor trusts, and discusses the recent proposed changes to section 672, and the potential consequences to foreign compensatory arrangements occasioned by the "overfunding" rules discussed above. part iii also examines changes with respect to the apparent demarcation between section 402(b) trusts and grantor trusts and further explores several potentially key consequences for rabbi trusts. finally, part in examines "outbound" foreign grantor trusts including the recent effects of the changes in law on those arrangements. e. structural considerations a. treatment of grantor trusts 1. generally.-section 671 provides that if the grantor of a trust retains any of the rights of beneficial ownership enumerated in sections 673 through 677 with respect to property held in the trust, the grantor will be treated as the "owner" of the trust corpus and the trust will be "ignored" for certain u.s. federal income tax purposes. accordingly, the grantor is taxed on all items of income of the trust, reduced by any ordinary and necessary deductions. the powers enumerated in sections 673 through 677 that will cause a grantor to be treated as the owner of the trust property are: 19991 florida tax review (i) a reversionary interest in the principal or income of the trust, if that interest exceeds 5% of the value of the trust;2 (ii) a power to control who is to receive beneficial enjoyment of the income or principal of trust;3 (iii) certain administrative powers; e.g., powers to borrow from the trust, power to control investment decisions of the trust, and power to reacquire trust corpus by substituting property of equivalent value;4 (iv) power to revoke the trust and regain title to trust property;5 and (v) power to distribute trust's income to grantor.6 grantor trusts are a familiar component of the executive compensation landscape. beginning in the early 1980s, and prior to further guidance issued by the service in 1992, certain irrevocable deferred compensation arrangements that permit creditors of the employer access to the assets of the arrangement in the event of the employer's insolvency (so called "rabbi" trusts)7 relied on certain of the powers contained in the grantor trust rules to achieve grantor trust tax treatment.8 in particular, compensatory arrangements relied upon ensuring that the arrangement comported with the substance of regulations section 1.677(a)-i(d), which provides that a trust will be treated as a grantor trust if the income of the trust is, or at the discretion of the grantor may be "applied in discharge of a legal obligation of the grantor." 9 these early rabbi trust rulings also required that the arrangement in fact be subject to the claims of creditors of the employer; a fact dependent in part on federal and state law.10 additionally, the service in these early rulings indicated that because the assets of the employer were made available to creditors of the employer in the event of bankruptcy, the transfer of assets would not be a "transfer" of property to the trust within the meaning of regulations section 1.83-3." 2. irc § 673. 3. irc § 674. 4. irc § 675. 5. irc § 676. 6. irc § 677. 7. see rev. proc. 92-64, 1992-2 c.b. 422. 8. see, e.g., priv. ltr. ruls. 92-06-019 (nov. 8, 1991), 92-04-046 (oct. 30, 1991), 91-51-010 (sept. 18, 1991), 88-44-020 (aug. 5, 1988), and 88-34-042 (may 27, 1988). 9. regs. § 1.677(a)-l(d). 10. priv. ltr. ruls. 91-50-043 (sept. 17, 1991), 89-51-025 (sept. 22, 1989), and 8730-041 (apr. 28, 1987). 11. see sources cited supra note 8. [vol 4:6 recent changes for foreign compensatoty trusts in 1992, the service released revenue procedure 92-64 which was intended to provide a safe harbor for rabbi trust arrangements. assuming a trust complies with the revenue procedure's guidelines, the arrangement is assured of grantor trust treatment under the code. as in the prior private letter rulings described above, revenue procedure 92-64 requires that the assets of the trust be available to creditors of the employer in the event of insolvency as a condition for favorable treatment under the safe harbor. the revenue procedure also states that the service will issue rulings regarding unfunded deferred compensation trusts that do not conform to the requirements contained in the revenue procedure "only in rare and unusual circumstances,"' 2 thus leaving open the question of whether deferred compensatory arrangements might otherwise qualify as grantor trusts under the code outside the scope of the revenue procedure.' 3 2. u.s. taxation of foreign grantors.-assuming an arrangement qualifies for grantor trust treatment, a grantor of a trust, including a grantor of a compensatory rabbi trusts, is treated as the "owner" of the underlying trust assets. under the grantor trust rules of subpart e of subchapter j, as "owner" of the trust, the grantor is subject to u.s. federal income tax on all items of income from the trust. where the grantor is a foreign person, taxation of the foreign grantor comports with the general scheme of taxation of non-u.s. persons. nonresident aliens and foreign corporations are taxed by sections 871(b) and 882(a) at graduated rates on taxable income "effectively connected with the conduct of a trade or business within the united states." neither the code nor the regulations fully define the term "trade or business" and thus the inquiry is often fact specific. 4 similar principles apply in the case in which the foreign grantor can make use of an income tax treaty with the u.s., in which case the crucial inquiry is whether, under the provisions of the treaty, the foreign grantor is deemed to have a "permanent establishment" in the u.s. and whether the profits derived are "attributable" to this permanent establishment. in the event income of a foreign person is not effectively connected with a u.s. trade or business (or attributable to a u.s. permanent establishment) such income is exempt from u.s. taxation unless it is from u.s. sources and falls within certain classes of income that 12. see source cited supra note 7, at 423. 13. see priv. ltr. rul. 92-35-006 (dec. 4, 1991), which conferred rabbi trust treatment under the theory of § 675(4) where the grantor could, at any time, substitute assets held by the trust for other assets of equal fair market value. the ruling was later partially revoked. see priv. ltr. rul. 96-09-010 (nov. 20, 1995). 14. a discussion of whether a particular activity or series of activities rises to the level of a "trade or business" is beyond the scope of this article. 1999] florida tax review are "fixed or determinable annual or periodical" (fdap).5 these instruments typically include annuities, interest payments on debt obligations and dividends on stock which are issued by or are the obligations of u.s. persons. consequently, if a foreign grantor of a compensatory trust is not engaged in a u.s. trade or business, its u.s. tax exposure from the income produced by the assets of the trust is limited to the trust's u.s. source fdap income. assuming that the foreign grantor trust holds only foreign source property, income on the assets of the trust would escape taxation at the trust level and the grantor level. for example, if the foreign trust held only stock of a foreign parent, no tax would inure to the foreign parent grantor. 6 pursuant to section 404(a)(5), the contributions made to a grantor trust may be deducted at the time the employee is taxed on the contributions. generally, in the case of rabbi trusts, this is at distribution. additionally, the earnings of the trust may also be deducted by the employer at the time the employee is taxed on the earnings of the trust's contributions. again, this is most generally when there is a "completed transfer" of the contributed property for purposes of section 83 and there is considered to be constructive receipt for purposes of section 451. b. section 402(b) "secular" trusts section 404a of the code applies to any electing u.s. taxpayer with foreign operations that maintains certain deferred compensation plans abroad for the benefit of nonresident alien individuals. generally speaking, section 404a permits a deduction for contributions to a foreign branch's plan or arrangement in the year paid, even if the conditions of section 404 (which apply to qualified plans) are not met, and permits in certain cases, reductions in earnings and profits for a foreign subsidiary of a u.s. company. section 404a, which has had a textured history since its enactment in 1980, involves a highly complex set of rules, most of which are beyond the scope of this article. what is most important is the fact that section 404a arrangements, for various reasons, impose significant constraints in order to realize the benefits of the election. first, as a condition for electing section 404a treatment for a funded arrangement, 90% or more of the amounts taken into account for any taxable year under the plan must be attributable to services performed by nonresident aliens whose compensation is not subject to u.s. federal income tax. second, 15. irc §§ 871(a)(1)(a). 16. this article does not discuss the implication of certain proposed regulations issued under § 1032 associated with the relief of certain u.s. federal income tax issues in the affiliated group environment regarding the so-called zero-basis issue. [vol 4:6 recent changes for foreign compensatory tnsts deductions are subject to similar limits imposed by the rules applicable to u.s. tax qualified retirement plans. third, deductions are permitted only if the trust (or the equivalent of a trust) "meets the requirements of section 401(a)(2)."' 7 in many jurisdictions, the concept of a trust does not exist. creating functional equivalents to a trust can sometimes be problematic under foreign law, since meeting the tests required by proposed regulations issued under section 404a for determining whether an arrangement is a functional equivalent of a trust often turns on foreign legal interpretations not necessarily suited to the task. moreover, the use of such arrangements may often result in adverse tax consequences to participants under foreign law. equally problematic, even in jurisdictions which are home to trusts, is the "exclusive benefit" rule of section 401(a)(2) which mandates that no assets of the trust may be used other than for the "exclusive benefit" of the employee beneficiary. proposed regulations issued under section 404a indicate that trusts which lend its assets back to the employer would not satisfy this requirement; nor will a reversion of plan assets to the benefit of the employer before the satisfaction of plan liabilities. additionally, the proposed regulations indicate that one factor in satisfying the exclusive benefit rule is whether the trust has been engaged in any "prohibited transaction" under section 4975(c)(1). a legal regime that is unique to u.s. tax and pension law, these "prohibited transaction" rules are enormously complicated and can easily be violated by a foreign trust. in addition to being unfamiliar with the prohibited transaction regime, most foreign jurisdictions are unfamiliar with even the more general "exclusive benefit" concepts. indeed, certain conditions which attach to this "exclusive benefit" rule may conflict with the rules in many foreign jurisdictions, for example the united kingdom. consequently, many foreign deferred compensatory arrangements may have difficulty satisfying the conditions of section 404a. a foreign deferred compensation arrangement which does not or cannot rely on a section 404a election may be governed by section 402(b). section 402(b), however, applies both to domestic and foreign arrangements, including plans of foreign companies that benefit u.s. persons, plans of u.s. subsidiaries of foreign companies as well as those plans of a u.s. company's foreign operations. in effect, pursuant to sections 402(b)(1) and 83, employer contributions to a secular trust are taxed to the employee at the first time the employee's rights therein are transferable or nonforfeitable, and the tax is on the value of his interest at that time. to the extent that amounts vest only some time after the related contribution is made, the employee's inclusion in income is the value of his interest when that vesting event occurs. upon distribution, benefits are generally taxed in accordance with section 402(b)(2), 17. irc § 404a(b)(5)(a). 19991 florida tax review which provides for taxation under the provisions of section 72."8 because the trust is treated as a separate entity and is, thus, taxed on earnings during the period of deferral pursuant to section 402(b)(3), under sections 402(b)(2) and 402(b)(3), earnings on employer contributions are taxed to the employee when distributed, even though they were previously taxed to the trust as a separate entity. thus, section 402(b) arrangements are regimes of double taxation because investment income is first taxed to the trust, and after reduction by that first tax on the trust, is secondarily taxable to the employee upon distribution. in this regard, a grantor trust is often the preferred vehicle in deferred compensatory arrangements since, as described above, the income of the grantor trust is not separately taxable to the trust, and the employer receives a deduction when the benefits are distributed in an amount equal to the value of the distribution at that future time. highly compensated employees within the meaning of section 414(q) are treated more severely. specifically, these employees are taxed each year on the excess of their vested accrued benefit over the "investment in the contract." 19 this means that highly compensated employees are currently taxed on unrealized appreciation and on amounts otherwise not subject to tax, such as tax-exempt bonds. section 404 provides that the employer is entitled to a deduction of an amount equal to the employer's contribution in the taxable year in which an amount attributable to the contribution is includable in the income of the beneficiary of the foreign trust. additional requirements are imposed under section 404(a)(5) regarding the employer's deduction. that provision requires that separate accounts for each individual participant must be maintained under the "secular" trust arrangement in order to provide the employer a deduction for its contributions. pursuant to section 404(a)(5), the contributions may be deducted by the employer at the time the employee is taxed on the contribution. however, only the amount of the original contribution is deductible, not the value of the employee's interest at that time. pursuant to section 402(b)(3), the trust (not the employer) is taxable as a separate entity (rather than as a grantor trust of the employer) and thus the employer receives no deduction for the earnings of the trust. in line with the statutory provision, regulations section 1.404(a)-12(b)(1) further provides that an employer's 18. section 72 provides general rules with respect to the treatment of annuities and certain proceeds of endowment and life insurance contracts, and further details that the employee's exclusion for these purposes is limited to the "investment in the contract." irc § 72(c). for purposes of determining a participant's "investment in the contract," amounts previously taxed to the recipient under § 402(b) are classified as "premiums or other consideration paid for the contract," and thus are excludable from taxation. see, e.g., priv. ltr. rul. 92-12-024 (dec. 20, 1991). 19. irc § 402(b)(4)(a). [vol. 4:6 recent changes for foreign compensatory trusts deduction for contributions to a nonexempt employee's trust is restricted to the amount of the contribution and excludes any income received by the trust with respect to such contributed amounts. the boundaries of section 402(b) arrangements have to some remained uncertain. one might think that section 402(b) itself might provide insights, but that section reads in relevant part: (1) contributions. contributions to an employees' trust made by an employer during a taxable year of the employer which ends with or within a taxable year of the trust for which the trust is not exempt from tax under section 501(a) shall be included in the gross income of the employee in accordance with section 83 (relating to property transferred in connection with performance of services), except that the value of the employee's interest in the trust shall be substituted for the fair market value of the property for purposes of applying such section. (2) distributions. the amount actually distributed or made available to any distributee by any trust described in paragraph (1) shall be taxable to the distributee, in the taxable year in which so distributed or made available, under section 72 (relating to annuities), except that distributions of income of such trust before the annuity starting date (as defined in section 72(c)(4)) shall be included in the gross income of the employee without regard to section 72(e)(5) (relating to amounts not received as annuities).? a facial reading of the statute does not define, describe or illuminate the scope of section 402(b). for example, is it intended to apply to all compensatory arrangements? is it intended to apply solely to "failed" qualified plans? are rabbi trusts covered by the language? do these rules somehow "trump" the grantor trust rules? the statute and the legislative history do not themselves give many clues. section 402(b) originally was thought to apply to retirement plans or arrangements which, for one reason or another, failed to satisfy one of the statutory or regulatory discrimination tests to obtain tax qualified status.2' this reading appears to comport with the specific reference to "highly compensated" employees under section 402(b), since that term has particular 20. irc § 402(b). 21. see irc §§ 410(b), 401(a)(4). 19991 florida tax review meaning in the context of the qualified plan rules. however, the service has apparently taken a somewhat expanded view, invoking section 402(b) not only in retirement arrangements which intend to qualify under section 401(a), but which nonetheless fall one of the tests for qualification, but also to other nonretirement deferred or incentive compensation arrangements which are not intended to implicate the nondiscrimination requirements of the code. additionally, in what has been an important policy statement in compensatory arrangements, the service has taken the position in a number of private letter rulings that the rules of sections 402(b) and 404(a)(5) preclude a section 402(b) arrangement from being treated as owned by the employer under the grantor trust rules described above.22 under section 404(a)(5), an employer's deduction for contributions to a section 402(b) arrangement over the life of the trust arrangement is limited to the amount of the employer's contribution to the trust, and can never include trust income. application of the grantor trust rules by which the employer would be treated as grantor/owner of the trust would compel that employer to include income of the trust even though section 404(a)(5) bars the employer from ever deducting the trust's income. furthermore, if the employer were to be treated as the grantor of a section 402(b) arrangement, the fact that the timing under section 404(a)(5) of the employer's deduction of the amount of the contributions matches the timing of the employee's inclusion in income would result in the employer deducting contribution amounts while the employer would still be considered to be the owner of the underlying assets for u.s. federal income tax purposes. accordingly, the service has taken the position that: these tax consequences of a section 402(b) employees' trust funding deferred compensation are fundamentally inconsistent with treatment of the employer as the owner of the trust under subpart e. therefore, the provisions of subpart e cannot apply to treat the employer as the owner of any portion of a section 402(b) employees' trust funding deferred compensation. [emphasis supplied]' while highlighting certain inconsistencies between the two regimes, as discussed in part ill.e, the service's position is not necessarily the only possible outcome concerning the interaction of section 402(b) arrangements and grantor trusts. in any event, however, establishing that section 402(b) trusts are "fundamentally inconsistent" with the grantor trust rules, however 22. see, e.g., priv. ltr. ruls. 92-12-024 (dec. 20, 1991); 92-12-019 (dec. 20, 1991); 92-07-010 (nov. 12, 1991); 92-06-009 (nov. 11, 1991). see also priv. ltr. rul. 93-02-017 (oct. 18, 1992). 23. see id. [vol 4:6 recent changes for foreign compensatory trtsts expansive, does not necessarily demarcate the limits of section 402(b) vis-izvis the grantor trust landscape. accordingly, because the boundaries which define the section 402(b) set have not been entirely clear, the service's position in these "fundamentally inconsistent" rulings has staked out only a portion of the scope of section 402(b)'s application. c. situs of the trust 1. prior law.-as described above, the treatment of a person as a resident or nonresident in part determines which regime of taxation in the u.s. the person is subject to. the code and the regulations also identify specific tax regimes for u.s. and foreign persons that are trusts. prior to the recent statutory and regulatory changes in law, section 7701(a)(31) defined a foreign trust as "the income of which, from sources without the united states which is not effectively connected with the conduct of a trade or business within the united states, is not includable in gross income under subtitle a."'24 while one can surmise under this definition that a foreign trust was akin to a nonresident alien individual, the language of the statute, taken by itself, left no bright line guidance. in interpreting this definition, cases and rulings focused on several factors, including looking to the country under whose laws the trust was created, the situs of the trust's corpus as well as the situs of the trust's administration, the nationality and residence of the trustee, and the nationality and residence of the grantor and beneficiaries. it is conceivable that the factors all pointed to one conclusion in a given case. however, where certain factors might have pointed towards a foreign jurisdictional nexus, and others pointed to domestic relationships, the conclusion was less certain, especially since no single factor is determinative under this test of nonresident alien status of the trust: the internal revenue code does not specify what characteristics must exist before a trust is treated as being comparable to a nonresident alien individual. however, internal revenue service rulings and court cases indicate that this status depends on various factors, such as the residence of the trustee, the location of the trust assets, the country under whose laws the trust is created, the nationality of the grantor and the nationality of the beneficiaries. if an examination of these factors indicates that the trust has 24. section 7701(a)(31), prior to the amendments effected by the small business job protection acl 19991 florida tax review sufficient foreign contacts, it is deemed comparable to a nonresident alien individual and thus a foreign trust.2 courts therefore, were forced to rely on a variety of facts and circumstances to conclude whether a trust was considered a domestic or a foreign entity. 26 accordingly, because matters were often so fact specific, certain trust arrangements faced considerable uncertainty in their classification for u.s. tax purposes. 2. recent changes in law.-as a result of changes made by the small business job protection act of 1996, a trust will be considered to be a u.s. entity only if it meets the definition of a domestic trust contained in section 7701(a)(30)(e). section 7701(a)(30)(e) provides that a trust is considered to be a domestic trust if (i) a court within the united states is able to exercise primary supervision over the trust's administration and (ii) one or more united states fiduciaries have the ability to control all of the trust's substantial decisions. section 7701(a)(31)(b) states that a "foreign trust" is any other trust not described in section 7701(a)(30)(e). the taxpayer relief act of 1997 changed the reference to fiduciaries in clause (ii) above, to "persons." while the statute itself does not directly define what a united states person is for purposes of this rule, the definition contained in section 7701(a)(30) makes most sense.27 under that provision, a u.s. person is a citizen or resident of the united states, a corporation, partnership or other entity created or organized in or under the laws of the united states or any political subdivision of the united states, an estate the income of which is subject to u.s. federal income taxation regardless of its source or any domestic trust described above, in section 7701(a)(30)(e). in 1997, the service issued proposed regulations clarifying when a court may be deemed to exercise primary supervision over the trust's administration for purposes of section 7701(a)(30)(e). in february 1999, the 25. s. rep. no. 94-938, at 215 (1976), reprinted in 1976 u.s.c.c.a.n. 3439, 3645; h.r. rep. no. 94-658, at 206 (1975), reprinted in 1976 u.s.c.c.a.n. 2897, 3101. see also staff of the joint committee on taxation, 94th cong., 2d sess., general explanation of the tax reform act of 1976, p. 218 (1976). 26. see b. w. jones trust v. commissioner, 46 b.t.a. 531 (1942), aff'd, 132 f.2d 914 (4th cir. 1943); maximov v. united states, 373 u.s. 49 (1963); rev. rul. 60-181, 1960-1 c.b. 257, modifying i.t. 1885, 23 c.b. 11-2; rev. rul. 73-521, 1973-2 c.b. 209, superseding o.d. 743, 1920 c.b. 203; rev. rul. 70-242, 1970-1 c.b. 89. 27. the legislative history to § 7701 makes this somewhat clear. see h.r. rep. no. 94-658, supra note 25, at 209, reprinted in 1976 u.s.c.c.a.n. at 3103; s. rep. no. 94-938, supra note 25, at 218, reprinted in 1976 u.s.c.c.a.n. at 3648. see also, prop. regs. § 301.7701-7(d)(1)(i). [vol 4:6 recent changes for foreign compensatory trusts service released final regulations, which are applicable to trusts for tax years ending after february 2, 1999.' the final regulations mirror the statutory changes by providing that a trust is a united states person if (i) a court within the united states is able to "exercise primary supervision over the administration of the trust"; and (2) one or more united states persons have the "authority to control all substantial decisions of the trust." 9 for these purposes, the term "court" means any federal, state or local court, while the term united states includes the states and the district of columbia.' the term "primary supervision" means that a court has or would have the authority over substantially all of the administrative issues associated with the trust.3' "[is able to exercise" means that a court has or would have the authority under applicable law to render orders or judgments resolving issues concerning the administration of the trust.32 "[a]dministration of the trust" means the carrying out of the duties imposed on a fiduciary by the terms of the trust instrument and applicable law, including maintaining the books and 28. see regs. § 301.7701-7. the final regulations are also applicable to those trusts whose trustees elected to apply §§ 7701(a)(30) and 7701(a)(31) of the code for taxable years ending after august 20, 1996. the taxpayer relief act of 1997 gave the treasury department authority to establish a transitional relief rule pursuant to which certain trusts in existence prior to august 20, 1996, could elect to continue to be classified as a domestic trust under the rules in effect prior to the small business job protection act. this relief has been granted provided that the trustee (1) filed an irs form 1041 and (2) had a reasonable basis that the trust was a domestic entity. this relief does not apply, however, to grantor trusts unless they were partially owned. regs. § 301.7701-7(f). trusts created after august 19, 1996, and before april 3, 1999, if satisfying the "control test" under the proposed regulations but not satisfying the "control test" under the final regulations (discussed in greater detail below in the text), may be modified by december 31, 1999, in order to meet the final regulations' control test. if this modification is completed by december 31, 1999, the trust will be treated as satisfying the control test of the final regulations for taxable years beginning after august 20, 1996, (and for taxable years thereafter if an election under the small business job protection act is made). regs. § 301.7701-7(e)(2). in the final regulations, the service explicitly refused to grant additional grandfather treatment for pre-existing foreign trusts. one commentator had expressed concern that some trusts believed to be foreign trusts may in fact have been domestic trusts under prior law. if such trusts qualify as foreign trusts under new law, they will be considered to have changed their classification from domestic to foreign trusts on january 1, 1997, and may be subject to tax for a deemed transfer to a foreign trust under § 1491 (in effect prior to repeal in 1997), and subject to penalties for failure to report the transfer under § 6677. when the situs of the trust changes from domestic to foreign, the trust is treated as having made an "outbound" transfer of its assets on the date of the election, with the possibility of an excise tax under § 1491. 29. regs. § 301.7701-7(a)(i), (ii). 30. regs. § 301.7701-7(c)(3)(i), (ii). 31. regs. § 301.7701-7(c)(3)(iv). 32. regs. § 301.7701-7(c)(3)(iii). 19991 florida tax review records of the trust, filing tax returns, defending the trust from suits by creditors and determining the amount and timing of distributions.33 regulations section 301.7701-7(c)(1) provides a safe harbor in that a trust satisfies the "court test" above if (1) the trust instrument does not direct that the trust be administered outside the united states, (2) the trust is in fact administered exclusively in the united states and (3) the trust is not subject to an automatic migration provision. with respect to (1), above, an example in the final regulations provides that if a trust is in fact administered exclusively in the united states, it is not necessary that the trust instrument actually direct that the trust be administered in the united states. additionally, with respect to (3), above, the proposed regulations had made clear that a court within the united states would not be considered to have primary supervision over the administration of the trust if the trust instrument provided that a united states court's attempts to assert jurisdiction or otherwise supervise the trust directly or indirectly would cause the trust to migrate from the united states. the final regulations have clarified that this "automatic" migration provision does not apply, however, if the trust instrument provides that the trust will migrate from the united states only in the case of foreign invasion of the united states or widespread confiscation or nationalization of property in the united states.34 the proposed regulations had provided a more general safe harbor. under that safe harbor, a trust was a domestic trust if, pursuant to the terms of the trust instrument, the trust had only united states fiduciaries which administered the trust exclusively in the united states and the trust was not subject to automatic migration provisions. in response to comments that underscored the proposed regulations' potential bias in favor of foreign trust treatment, the preamble to the final regulations clarified the service's desire that this safe harbor should not be limited to trusts with only united states fiduciaries. additionally, since the safe harbor was meant to address the complexities of whether a court of a particular state would assert primary supervision over the administration of a trust if the trust had never appeared before a court, the safe harbor in the final regulations is provided only in the context of the court test. a trust that satisfies this safe harbor, therefore, would still need to comply with the "control test." in addition to this "court test" safe harbor, the regulations also provide four examples, which are not intended to be exclusive, under which a court will be deemed to exercise primary supervision over the 33. regs. § 301.7701-7(c)(3)(v). 34. regs. § 301.7701-7(c)(4)(ii). commentators had argued that an automatic migration clause should not cause a trust to be treated as a foreign trust if migration was triggered only by events that are not particular to a given trust arrangement, such as a foreign invasion. [vol 4:6 recent changes for foreign compensatory tnhsts administration of the trust: the trust is registered in a united states court pursuant to a state statute that has provisions substantially similar to the uniform probate code, the trust is a testamentary trust and all fiduciaries have been qualified as trustees by a united states court, the trust is an inter vivos trust and the fiduciaries or beneficiaries take steps with a court within the united states that cause the administration of the trust to be subject to the primary supervision of the court, or a united states court and a foreign court are both able to exercise primary supervision over the administration of the trust. the final regulations also speak to when the "control" branch of the statutory test will be deemed to be satisfied. "control" for these purposes means having the power, by vote, or otherwise to make all of the substantial decisions of the trust, with no other person having the power to veto those substantial decisions.35 "substantial decisions" for these purposes refers to those decisions that persons are authorized or required to make under the terms of the trust instrument and applicable law which are not purely ministerial. 36 for example, substantial decisions include, but are not limited to, (1) whether and when to distribute income or corpus, (2) the amount of any distributions, (3) the selection of a beneficiary, (4) whether to terminate the trust, (5) whether a receipt is allocable to income or principal, (6) whether to arbitrate, compromise or abandon claims of the trust, (7) whether to remove add or replace a trustee, (8) whether to sue on behalf of the trust or defend suits against the trust, or (9) whether to appoint a successor trustee. the final regulations also clarify that if a united states person hires an investment advisor for the trust, the investment decisions made by the advisor will be considered "substantial decisions" controlled by the united states person if the united states person can terminate the investment advisor's power to make investment decisions at will.37 the proposed regulations had provided that substantial decisions did not include decisions exercisable by a grantor or a beneficiary (unless the beneficiary or grantor is acting as a fiduciary), that affected solely the portion of the trust in which the beneficiary has an interest.' the proposed regulations had provided the rule because the code, prior to amendment by the taxpayer relief act of 1997, stipulated that united states fiduciaries must control all substantial decisions of a domestic trust. the proposed regulations, therefore, ignored decision making powers held by nonfiduciaries. the taxpayer relief act of 1997, however, substituted "persons" for "fiduciaries" in the control test. in light of the change in the statute, 35. regs. § 301.7701-7(d)(1)(iii). 36. regs. § 301.7701-7(d)(1)(ii). 37. regs. § 301.7701-7(d)(1)(ii)(j). 38. prop. regs. § 301.7701-7(e)(1)(ii)(b). 19991 florida tax review commentators pointed out that there was no statutory basis for ignoring the powers held by grantors and beneficiaries for purposes of the "control" test. accordingly, the final regulations change the rule contained in the proposed regulations and, for purposes of the control test, count all powers held by grantors and powers held by beneficiaries including those that affect solely the portion of the trust in which the beneficiary has an interest. thus, all persons with any power over substantial decisions of the trust whether acting in a fiduciary capacity or not must be counted for purposes of the control test. the final regulations also provide that a trust is deemed to satisfy the control test if united states persons control all substantial decisions by a majority vote. under the proposed regulations, excluding grantors (and beneficiaries) from the control test would have allowed certain individual retirement accounts (iras) and other tax exempt trusts to continue to be treated as domestic trusts (and thus maintain their tax exempt status), even if the grantor or beneficiary were a foreign person. because the treasury department and the service view the taxpayer relief act changes to the definition of a foreign trust as not affecting the tax exempt status of iras and other trusts where their tax-exempt status depends on their being classified as u.s. trusts, the final regulations provide a special rule pursuant to which these trusts will satisfy the control test as long as united states fiduciaries control all of the substantial decisions of the trust made by trust fiduciaries. this special rule reaches the same general result as was provided under the proposed regulations.39 the final regulations make clear that united states persons are not considered to control all substantial decisions of the trust if an attempt by any governmental agency or creditor to collect information from or assert a claim against the trust would cause one or more substantial decisions of the trust to no longer be controlled by united states persons. there may still continue to be some residual uncertainty over the treatment of trusts under these new tests. however, these changes in law generally help to create some greater sense of clarity in the evaluative process and also remove much of the facts and circumstances nature that pervaded the law prior to the revisions. 3. reporting requirements.-the recent statutory and regulatory changes have produced additional consequences concerning trust classification in the form of reporting requirements. although a detailed discussion of these 39. an additional rule permits 12 months to correct an inadvertent change in fiduciary that might cause a change in residency for the trust. this is an extension of the 6month period provided by the proposed regulation. regs. § 301.7701-7(d)(2). [vol 4:6 recent changes for foreign compensatory tnsts rules and the intricacies of their recent development is beyond the scope of this article, several points are briefly worth mentioning. first, under section 6048(c), as amended by the small business job protection act, any u.s. person receiving distributions from a foreign trust must file a return with the service identifying the trust, distributions received from the trust and other information prescribed by the treasury department. in addition, amended section 6048(a) requires that the creation of a foreign trust by a u.s. person and transfers of money or property other than for fair market value (either directly or indirectly) to a foreign trust (excluding, however, in either case, section 402(b) arrangements) by a u.s. person be reported. moreover, u.s. persons who are treated as grantors over a foreign trust are charged with the responsibility of filing appropriate returns for the trust and with furnishing certain information to each u.s. grantor and beneficiary who receives a distribution from the trust. under section 6048(b), unless the trustee of a foreign trust owned by a u.s. grantor designates a u.s. agent for service of process upon the trustee, the amount of income taxable to the u.s. grantor with respect to the trust may be determined by the service, subject only to judicial review under an "arbitrary and capricious" standard. under section 6677, a u.s. person receiving a distribution from a foreign trust who fails to file the appropriate reports with the service may be subject to a 35% penalty on the gross amount of the distribution. similarly, a 35% penalty may be imposed on the gross amount of the value of the property transferred to the foreign trust, if the applicable reporting requirements are not satisfied. a 5% penalty is imposed with respect to the trust's year end assets deemed to be owned by a u.s. grantor if the trustee fails to file an appropriate return on behalf of a foreign trust. these violations may also be subject to additional penalties including $10,000 for each uncorrected 30 day period following the 90 day period after which a notice of noncompliance is issued by the service. i. "qnbound" grantor trust rules a. prior law under prior law, a grantor of a trust generally was treated as the owner of any portion of the trust over which he retained any of the powers or interests described in sections 673 through 677, without regard to whether the grantor was a foreign or u.s. person. a special rule contained in prior section 672(f) generally provided that if a u.s. beneficiary of a trust created by a foreign person transferred property to the foreign person by gift, the u.s. beneficiary was treated as the grantor of the trust to the extent of the transfer. under these prior rules, taxpayers could utilize the grantor trust rules to cause a foreign person to be viewed as the owner of the trust. the trusts 19991 florida tax review would then earn income which could be allocated to the foreign owner. a distribution of income from the trust to the u.s. beneficiary was treated as a gift to the beneficiary and was not subject to u.s. federal income tax.4" thus, if the income of the trust was not taxable to the foreign grantor under section 871 and was also not taxable to either the grantor or the trust by the grantor's home jurisdiction, the income of the trust was never subject to taxation. b. statutory and regulatory changes to section 6720r the small business job protection act amended code section 672(t) to ensure that u.s. persons who benefit from offshore trusts created by foreign persons pay an appropriate amount of u.s. federal income tax. generally, the grantor trust rules now treat a person as the owner of a trust only to the extent the application of the grantor trust rules result, directly or indirectly, in an amount being currently taken into account in computing the income of a u.s. citizen or resident. in other words, to the extent that the grantor trust rules would result in income being taken into account by foreign persons, section 672(f) now prevents the grantor trust rules from applying. section 672(f) now provides: (f) subpart not to result in foreign ownership. (1) in general. notwithstanding any other provision of this subpart, this subpart shall apply only to the extent such application results in an amount (if any) being currently taken into account (directly or through 1 or more entities) under this chapter in computing the income of a citizen or resident of the united states or a domestic corporation. (2) exceptions. (a) certain revocable and irrevocable trusts. paragraph (1) shall not apply to any portion of a trust if (i) the power to revest absolutely in the grantor title to the trust property to which such portion is attributable is exercisable solely by the grantor without the approval or consent of any other person or with the consent 40. see rev. rul. 69-70; 1969-1 c.b. 182. [vol 4:6 recent changes for foreign compensatory trusts of a related or subordinate party who is subservient to the grantor, or (ii) the only amounts distributable from such portion (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor. (b) compensatory trusts. except as provided in regulations, paragraph (1) shall not apply to any portion of a trust distributions from which are taxable as compensation for services rendered. (3) special rules. except as otherwise provided in regulations prescribed by the secretary (a) a controlled foreign corporation (as defined in section 957) shall be treated as a domestic corporation for purposes of paragraph (1), and (b) paragraph (1) shall not apply for purposes of applying section 1297.4' on june 5, 1997, the service issued proposed regulations under section 672(f). on august 5, 1999, the service then released final regulations under section 672(f). the final regulations are effective for taxable years of a trust beginning after august 10, 1999. the proposed regulations42 described a two step analysis for implementing this principle. first, the grantor trust rules were applied to determine the "worldwide amountv43 (i.e., the worldwide amount of trust income of all beneficiaries of the trust) and the "u.s. amount" (i.e., the amount of trust income being currently taken into account under the same rules by u.s. taxpayers). 44 then the trust was treated as partially or wholly owned by a foreign person based on an annual 41. irc § 672(f). 42. prop. regs. § 1.672(0-1. 43. the proposed regulations define the "worldwide amount" as the net amount of income, gains, deductions and losses that would be taken into account for the current taxable year under the basic grantor trust rules in computing worldwide taxable income of any person. regardless of whether they are or are not a u.s. person. 44. the "u.s. amount" is defined as the net amount of income, gains, deductions and losses that would be taken into account for the current year under the basic grantor trust rules in computing the taxable income of a u.s. taxpayer. the u.s. amount also includes such amounts as interest from tax-exempt obligations which are ordinarily excluded from gross income. 19991 florida tax review year-end comparison of the worldwide amount and the u.s. amount. if the worldwide amount and the u.s. amount were the same, the basic grantor trust rules would continue to apply without the limitation of section 672(f). if the worldwide amount was greater than the u.s. amount, the proposed regulations under section 672(f) prevented the basic grantor trust rules from treating a person as the owner of that portion of the trust attributable to the excess of the worldwide income. in essence, to the extent that the basic grantor trust rules resulted in income being created which was not currently taxed to a u.s. taxpayer, the proposed rules would not apply to cause a foreign person to be viewed as the owner of the trust. under the proposed section 672 rules, and in particular, proposed regulations section 1.672(f)-2(a), a controlled foreign corporation (cfc) that created and funded a foreign trust was treated as a domestic corporation only to the extent that, if the basic grantor trust rules were applied, income earned by the trust would be subpart f income to the trust for the taxable year to which the income relates and would be currently taken into account in computing the gross income of a u.s. citizen or resident or a domestic corporation. the proposed regulations made clear, therefore, that the cfc would not be treated as a domestic corporation for these purposes to the extent the income of the trust would not be considered subpart f income, or to the extent it would be considered subpart f income but would not currently increase a u.s. person's adjusted gross income. the proposed regulations also contained similar provisions for passive foreign investment companies (pfics) and foreign personal holding companies. the proposed regulations in this regard also made it clear that for purposes of determining whether or not a given foreign entity is a pfic, the grantor trust rules were to be applied as if section 672(f) had not come into effect. as a result, applying the proposed rules under section 672(f), a foreign corporation would not be able to avoid pfic status merely by transferring its passive assets to a trust that would otherwise have been treated as a non-grantor trust. commentators had suggested that the two step analysis comparing the "worldwide amount" and the "u.s. amount" was unnecessarily complex. in response to these concerns, the final regulations now provide that the grantor trust rules of sections 671 through 677 and 679 other than section 672() must be applied first to determine whether, under these rules, a foreign person would be treated as owner of the trust. if under this analysis, a foreign person would be treated as an owner, the foreign person will be treated as a grantor only if the person is a cfc, pfic or a foreign personal holding company. the final regulations, therefore, abandon the proposed regulations' condition that a cfc may only be treated as a domestic entity, and thus a grantor, to the extent that the trust income was subpart f income currently taken into account in computing the gross income of a u.s. person. consequently, a cfc, pfic or foreign personal holding company will now generally be [vol 4:6 recent changes for foreign compensatory tnsts treated as a grantor of a trust if it would be so treated under sections 673 through 677 and 679, regardless of the application of section 672(f). while these recent statutory and regulatory changes are generally intended to apply to all trusts with foreign grantors, section 672(f)(2)(b) also provides that the special rules of section 672(f)(1) do not apply to certain revocable trusts as well as to "any portion of a trust distributions from which are taxable as compensation for services rendered." section 672(f)(2)(b)'s literal language, however, is ambiguous. indeed, there was some debate among practitioners as to whether the statutory exception applied merely to rabbi trusts, or, jointly or alternatively, section 402(b) arrangements particularly given the service's position in prior rulings that grantor trusts and section 402(b) trusts are "fundamentally inconsistent" and, thus, should be taxed in different ways. because of the statutory language that appears to concentrate on the fact that the compensation is taxable upon "distribution," it would seem that rabbi trusts should be included within the statutory definition. however, it is unclear whether section 402(b) arrangements were also intended to be included. even though a beneficiary of a section 402(b) arrangement is taxed when his rights in the trust property become transferable, there are also provisions for tax upon the distribution of that property in accordance with section 72. while the small business job protection act did not itself address the question, the proposed regulations issued in 1997, and the final regulations provide greater clarity. the proposed regulations (and their preamble) made clear, and the final regulations now make clear that both rabbi trust arrangements with foreign grantors and most secular trusts with foreign grantors are included within the statutory exception. in particular, proposed regulations section 1.672(f)-3(c)(2) defined a "compensatory trust" for purposes of section 672(f) not only as "[a] nonexempt employees' trust described in section 402(b) (see sections 1.671-1(g) and (h))" but also as "[a] trust that would be a nonexempt employees' trust described in section 402(b) but for the fact that the trust's assets are not set aside from the claims of creditors of the actual or deemed transferor" under section 1.83-3(e). the service has clarified in the final regulations that such excluded compensatory arrangements include those plans that are created on behalf of self-employed individuals. consequently, final regulations section 1.672(f)-3(c) provides that the general rules of section 672(f) do not apply to (1) a nonexempt employees' trust described in section 402(b), including a trust created on behalf of a self-employed individual; and (2) a trust, including a trust created on behalf of a self-employed individual, that would be a nonexempt employees' trust described in section 402(b) but for the fact that the trust's assets are not set aside from the claims of creditors of the actual or deemed transferor within the meaning of section 1.83-3. consequently, under the final regulatory provision, foreign compensatory trusts are not generally subject to 19991 florida tax review section 672(f), and thus, ignoring any other provision of the regulations, foreign grantors will continue to be taxed as "owners" of the trust consistent with sections 671 through 677. in the case of foreign rabbi trusts, therefore, because the grantor presumably retains a power described under section 677, the foreign owner would be subject to tax on all items of income of the trust, depending again, for u.s. tax purposes, on the activity of the foreign owner and the source of the income. it is noteworthy, however, that the proposed regulations and the preamble to both the proposed and final regulations specifically make reference to proposed regulations sections 1.671 -1 (g) & (h) in the context of section 402(b) arrangements. these provisions are discussed in greater detail below. c. turning foreign section 402(b) trusts into grantor trusts: the "overfunded" tests 1. requirements for foreign section 402(b) non-grantor trust treatment.-under proposed regulations issued under section 671 on september 27, 1996, certain foreign secular section 402(b) trusts are subject to additional rules. assuming these proposed regulations are enacted in their currently proposed form, they will be effective with respect to taxable years ending after september 27, 1996. proposed regulations section 1.671-1(h) states in relevant part: [e]xcept as provided under section 679 or as provided under this paragraph (h)(1), an employer is not treated as an owner of any portion of a foreign employee's trust (as defined in paragraph (h)(2) of this section) regardless of whether the employer has a power or interest described in sections 673 through 677 over any portion of the trust. proposed regulations section 1.671-1(h)(2) defines a "foreign employees' trust" for these purposes as a nonexempt employees' trust described in section 402(b) that is part of a deferred compensation plan and that is a foreign trust within the meaning of section 7701(a)(3 1). thus, at first glance, the proposed regulations generally restate the service's long-standing position that section 402(b) deferred compensatory arrangements are "fundamentally inconsistent" with the grantor trust rules. this seemingly simplistic synopsis, however, may require additional elaboration. in particular, in order to secure such treatment, the proposed regulations require meeting five conditions. first, the arrangement must be a trust. most deferred compensation arrangements that intend to make use of trusts actually meet the formal requirements of using a trust. pursuant to regulations section 301.7701-4, however, certain arrangements that do not vest trustees with the responsibility [vol 4:6 recent changes for foreign compensatory trists of protecting the trust's property on behalf of designated beneficiaries and which are more in the nature of associations or for-profit joint enterprises will not be considered trusts. accordingly, such arrangements would not be considered to qualify under the proposed regulations. nor, however, would they be likely to qualify as grantor trusts under subpart e of subchapter j of the code. second, the arrangement must constitute a foreign trust. as discussed above, the new regulations clarify the classification of a trust either as domestic or foreign. a trust will be considered to be a u.s. entity only if it does not meet the definition of a domestic trust contained in section 7701(a)(30)(e). section 7701(a)(30)(e) treats a trust as domestic if (1) a court within the united states is able to exercise primary supervision over the trust's administration and (2) one or more united states persons have the ability to control all of the trust's substantial decisions. this definition is discussed in greater detail in part ii.c.2. third, the trust must be part of a "deferred compensation plan." trusts that are not considered deferred compensatory arrangements would technically not meet this definition. presumably, this would exclude arrangements involving deferred benefits under section 404(b)(2). the proposed regulation does not provide further elaboration of the meaning of "deferred compensation." fourth, the trust must be a trust described in section 402(b). while this generally means that contributions to the trust must be considered to be transfers of property to participants within the meaning of regulations section 1.83-3(e), as discussed above, the boundaries of section 402(b) remain unclear. finally, the fifth condition for non-grantor trust status is that the arrangement must not fall within any alternative treatment described in either section 679 or any other provision of proposed regulations section 1.6711(h). it is this "exception" to the general rule that deserves greater discussion immediately below. 2. the "exception" to the general rule: section 402(b) overfinded "grantor" trusts.-as discussed above, in keeping with the "fundamentally inconsistent" standard, the general rule of proposed regulations section 1.671-1(h) is that no section 402(b) foreign trust is treated as a grantor trust. however, this general rule is subject to any alternative treatment in either section 679 or proposed regulations section 1.671-1(h). despite the broadly stated general rule, under proposed regulations section 1.671-i(h)(2) and (h)(3), grantor trust status is imposed on certain section 402(b) arrangements involving cfcs and certain u.s.-related foreign partnerships with respect to a specified overfunded "fractional interest" of the trust as well as certain other 19991 florida tax review non-u.s. employers intending to avoid the pfic rules.45 this imputation of income is also applicable to section 404a arrangements. the potential policy considerations associated with each such entity is now briefly described below. the discussion of overfunded "fractional interests" then follows. a. controlled foreign corporations.-under the proposed regulations, cfcs that maintain deferred compensation arrangements funded through a foreign employees' trust are subject to the "fractional interest" rules described below. a cfc is a foreign corporation 50% or more of whose stock is owned by u.s. shareholders, each of which owning at least 10% of such stock.46 generally, certain u.s. shareholders of cfcs are currently taxed pro rata on their share of the cfc's subpart f income and income described in section 956. subpart f income generally includes dividends, interest, income equivalent to interest, rents, royalties and annuities. the service was apparently concerned that the cfc might be able to transfer subpart f income to a funded foreign employees' trust, since, without giving effect to rules like the ones contained in the proposed regulations, the income could escape taxation under subpart f and under the other grantor trust rules. for example, the cfc could transfer subpart f-type items to a foreign employees' trust that is already sufficiently funded in order to protect its u.s. shareholders from the pro rata taxation that would otherwise be imposed. b. passive foreign investment companies.-under general u.s. tax principles, the anti-deferral regimes in sections 1291 through 1297 impose accelerated taxation on the income of certain foreign entities. the proposed regulations also apply the fractional amount anti-abuse rules for these non-cfc employer entities. the proposed regulations, however, make clear that these rules only apply in the case of pfics where one of the principal motives of transferring assets to the trust is to avoid application of the pfic rules.4 7 under proposed regulations section 1.1297-4, whether a principal purpose for the transfer is to reduce or eliminate tax under section 1291 or 1293 or is to avoid classification as a pfic is determined on the basis of all the facts and circumstances, including whether the amount of assets held by the trust is reasonably related to the plan's anticipated liabilities, taking into account any local law and practice relating to proper funding levels.48 45. the explanation of provisions section of the proposed regulations implementing § 672(f) states that § 402(b) trusts will be treated as grantor trusts "only to the extent provided in proposed regulations § 1.671-1(g) and § 1.671-1(h)." 62 fed. reg. 30785, 30788 (1997). 46. irc §§ 957(a), 951(b). 47. prop. regs. § 1.1297-4(a)(1). 48. prop. regs. § 1.1297-4(a)(2). [vol. 4:6 recent changes for foreign compensatory trusts in general, a u.s. person that owns stock in a foreign company pays no income tax on the income earned by that company. however, in the case of pfics, sections 1291 through 1297 provide that a u.s. person who is a direct or indirect shareholder of a pfic is subject to a special tax regime upon either disposition of the pfic's stock or the receipt of certain distributions. the pfic rules were added by congress in 1986 with the specific intention of targeting foreign mutual funds that avoided other antideferral rules through dispersal of, and limitations on, stock ownership by u.s. persons. congress accordingly defined a "pfic" as a foreign corporation where (1) 75% or more of its gross income for the taxable year is passive income, or (2) at least 50% of the value of its assets produce passive income or are held for that purpose. "passive income" is generally defined as dividends, interest, income equivalent to interest, rents, royalties, and annuities. if a foreign corporation is a pfic, an interest charge is generally imposed on distributions from the pfic to a u.s. person or upon a disposition of the pfic's stock by a u.s. person regardless of that person's level of ownership. the interest charge is imposed on the distributed earnings that had the benefit of u.s. tax deferral. while a u.s. shareholder can avoid the charge by causing the entity to elect "qualified electing fund" status to include his pro rata share of includable pfic income in the year in which the pfic earns it, or, in certain cases by electing to "mark to market" the shares it owns in the pfic,49 the service has expressed the concern that the pfic may transfer passive income-producing assets to a foreign employees' trust, thereby either (1) divesting itself of a sufficient quantity of passive income to cease qualifying as a pfic, or (2) minimizing the income a u.s. shareholder would need to declare where the u.s. shareholder made the previously-described income inclusion election. if the principal purpose of an asset transfer is to avoid classification as a pfic or to reduce or eliminate taxation under sections 1291 or 1293, the grantor trust rules will apply to the fixed dollar amount in the trust that is equal to the fair market value of the property transferred to avoid such classification or to reduce or eliminate such taxes. 49. irc § 1296. a u.s. shareholder of a pfic may make a mark-to-market election with respect to the stock of the pfic if such stock is regularly traded either on a national securities exchange registered with the securities and exchange commission, the national market system established under § i ia of the securities exchange act of 1934 or an exchange or market that the service determines has rules sufficient to ensure that the market price represents a sound valuation. under the election, any excess of the fair market value of the pfic stock measured at the close of the tax year over the shareholder's adjusted basis in the pfic stock is included in the income of the shareholder and, under certain circumstances, any excess of basis over fair market value is allowed as a deduction. see irc § 1296. 19991 florida tax review c. foreign partnerships.-in addition to plans maintained by cfcs and plans maintained by pfics, the proposed regulations stipulate that plans maintained by certain u.s.-related foreign partnership employers are also subject to the fractional amount rules. for these purposes, a u.s.-related foreign partnership is a foreign partnership in which a u.s. person or a cfc owns a partnership interest either directly or indirectly through one or more partnerships. under subchapter k, a u.s. partner must include on his tax return his distributive share of the partnership's gain, loss, deduction or credit, whether the partnership is foreign or domestic." thus, a u.s. partner of a foreign partnership is subject to tax on its distributive share of the foreign partnership's gain, loss, deduction or credit. the service has apparently been concerned that a foreign partnership could overfund a foreign employees' trust it maintains while retaining control over the excess assets. to the extent the foreign partnership is not viewed as the trust grantor, it would not have to include in its taxable income the items attributable to the excess assets, thereby precluding u.s. taxation of those amounts with respect to any related u.s. partners. in this respect, the preamble to the proposed regulations state: if the grantor trust rules do not apply to any portion of a foreign employees' trust, a foreign partnership could fund a foreign employees' trust in excess of the amount needed to meet its obligations ... and yet retain control over the excess amount. as a result, the foreign partnership would not have to include items in taxable income attributable to the excess amount, and consequently the u.s. partner or cfc would not have to include those items in its income.5 3. policy considerations.-as stated above, the underlying policy reason, apparently, for the exceptions in proposed regulations section 1.671-1 is the service's broader concern that an employer will purposely overfund foreign employees' trusts (1) in the case of certain foreign partnerships, in order to avoid its distributive share of certain income (2) in the case of cfcs, in order to navigate past the anti-deferral rules of subpart f and (3) in the case of certain other passive investment entities, in order to bypass the rules applicable to pfics. generally speaking, to the extent an employer/grantor (or its u.s. affiliate) is no longer to be taxed under sections 671 through 679 as the grantor with respect to the income on the assets of foreign employees' 50. provided the entity is treated as a partnership for u.s. federal income tax purposes under § 7701(a)(2). 51. 61 fed. reg. 50778, 50780 (1996). [vol 4:6 recent changes for foreign compensatory trists trusts, it potentially can defer tax on income simply by overfunding such a trust located in a jurisdiction with a lower or no tax. at some point, the sheltered income could be repatriated without adverse tax consequences. at the outset, it is interesting to note that the imposition of grantor trust treatment in these cases appears to mark a departure from the service's "fundamentally inconsistent" position. in this respect, it is interesting that the preamble released with these proposed regulations restates the established position, at least in the domestic context, without regard to the exceptions that are apparently being made to the general rule: the rule in the proposed regulations is consistent with the holdings of a number of private letter rulings with respect to nonexempt employee's trusts and with the service's treatment of trusts that no longer qualify as exempt under 501(a) (because they are no longer described in section 401(a)) as separate taxable trusts rather than as grantor trusts.52 having asserted that the proposed regulations in fact are consistent with this "fundamentally inconsistent" standard the preamble then later curiously states: under these proposed regulations, the grantor trust rules of subpart e do not apply to a foreign employees' trust with respect to a foreign employer other than a cfc or a u.s.-related foreign partnership, except for cases in which assets are transferred to a foreign employees' trust with a principal purpose of avoiding the pfic rules.53 apparently, some within the service advocated limiting the scope of the firewall between section 402(b) and grantor trusts to purely domestic situations5 4 however, the statement in the preamble quoted above does not appear to indicate the recognition of any such internal tension, if indeed it exists. a broader point can be raised, however, when one considers the fact that section 671 itself does not apply to grantors unless they are otherwise treated as owners under the other grantor trust rules. regulations section 1.671-1(a) makes this point by stating that sections 673 through 677 define 52. id. at 50781 (citation omitted); see also priv. ltr. ruls. 92-12-024 (dec. 20, 1991); 92-07-010 (nov. 12, 1991); 92-06-009 (nov. 11, 1991). 53. 61 fed. reg. 50778, 50781 (1996) (emphasis added). 54. see william l. sollee, overfunded portion of foreign employees' trust treated as grantor trust, 86 j. tax'n 134, n.5 (1997). 19991 florida tax review the circumstances under which income of a trust is taxed to a grantor. other than sections 679 and 672(f), no other grantor trust provision explicitly provides for foreign grantor trust compensatory arrangements. moreover, as described in part iv, section 679 does not apply to foreign section 402(b) arrangements. additionally, section 672(f)(2)(b), (and regulations section 1.672(f)-3(c)), as described above, appears to suggest that the grantor trust rules of section 671 through 677 continue to apply to foreign compensatory arrangements notwithstanding the general anti-foreign grantor rule now contained in section 672(f). thus, for example, the exception for compensatory trusts in section 672(f) should permit foreign grantors of rabbi trusts to be treated as owners, since, presumably, per revenue procedure 9264, they retain a power under section 677. however, the service appears to have been motivated in the section 672(f) context more by the earlier released proposed regulations section 1.671-1 than any other statutory provision when it noted "[tihe irs and treasury contemplate that the [i.e., section 402(b) trusts] nonexempt employees' trusts ... will be treated as grantor trusts only to the extent provided in proposed regulations § 1.671-1(g) and § 1.6711(h). 55 potentially noteworthy also is the fact that the beginning of the preamble to proposed regulations section 1.671-1 appears to suggest that existing confusion from proposed regulations issued under section 404a was the underlying rationale for promulgation of proposed regulations section 1.671-1; the beginning of the preamble makes no reference of a need to clarify sections 673 through 677. that confusion resulted from certain 1993 proposed regulations which some commentators viewed as implying that grantor trust status is automatically accorded to foreign deferred compensatory trusts that do not or cannot elect section 404a status. such a conclusion, if true, might not only implicate the "fundamentally inconsistent" standard but would, on a more practical level, result in a loss of reduction in earnings and profits for contributions and an increase in earnings resulting from the trust assets. while the proposed regulations and their preamble may serve to clarify that arrangements which fail to qualify as section 404a arrangements do not necessarily implicate the grantor trust rules, some have questioned whether any application of the grantor trust rules to section 404a arrangements (i.e., the overfunding rules) is appropriate. in any event, if the need to clarify existing uncertainty under section 404a is the primary motive behind the issuance of the proposed regulations, an argument could be made that applying the grantor trust rules to overfunded portions of compensatory arrangements may be in conflict with existing statutory law. 55. 62 fed. reg. 30785, 30788 (1997). [vol 4:6 recent changes for foreign compensatory trusts however, there may be evidence to the contrary in that the language of the proposed regulations may be meant to impose grantor status in such overfunded contexts only where the cfc, pfic or foreign partnership otherwise maintains a power described in sections 673 through 677. indeed, the preamble suggests "[s]uch an employer is treated as the owner of a portion of a foreign employees' trust under these proposed regulations only if the employer retains a grantor trust power or interest over a foreign employees' trust and has a specified 'fractional interest' in the trust."' moreover, proposed regulations section 1.1297-4 in the pfic anti-abuse context states: if the foreign employer has a power or interest described in sections 673 through 677 over the trust, then the grantor trust rules of subpart e ... will apply... to a fixed dollar amount in the trust that is equal to the fair market value of the property that is transferred for the purpose of avoiding classification as a passive foreign investment company." this language, however, is not directly incorporated in the cfc and foreign partnership overfunding provisions of proposed regulations section 1.6711(h). additionally, proposed regulations section 1.671-1(h)(8), examples 1 and 2, appear to conclude grantor trust status on a cfc by virtue of the existence of a "relevant amount," without any mention of the existence of any other grantor power under sections 673 through 677. without referring to the pfic anti-abuse provisions, the preamble to those proposed regulations also later suggests "[tihe proposed regulations provide subpart e rules for foreign employees' trusts of cfcs ... [and] foreign partnerships ... that apply for all federal income tax purposes."" as a practical matter, the exceptions to the general rule contained in proposed regulations section 1.671-1(h) are potentially expansive in their scope because arrangements of purely foreign entities which employ mostly foreign persons may now be subject to u.s. taxation even though the only nexus that the foreign entities have with the united states is through their affiliation with a u.s. entity. because this affiliation may have nothing to do with the scope of an employee's services or the locale in which they are performed for the foreign entity, this overfunding exception may be possibly regarded as overreaching. some commentators have raised particular issues that the proposed regulations unfairly extend the reach of the u.s. taxing 56. 61 fed. reg. 50778, 50781 (1996) (emphasis added). 57. prop. regs. § 1.1297-4(a)(1) (emphasis added). 58. 61 fed. reg. 50778, 50781 (1996) (emphasis added). 1999] florida tax review authority,59 in particular because the proposed regulations may unreasonably apply to plans that mostly cover nonresident alien employees. these foreign arrangements, for example, may be established, maintained and administered in a foreign jurisdiction. moreover, funds for the plans may be invested solely or predominantly in the foreign jurisdiction. in most cases, the arrangement is invariably the subject of foreign regulation, and is thus usually subjected to foreign tax. in the face of such involved foreign regulation, one wonders whether u.s. taxation is appropriate where the trust's only connection with the u.s. may exist solely because a u.s. entity may be deemed to have an interest in the foreign employer that maintains the plan. in addition, the proposed changes may in certain circumstances impose additional administrative and transactional costs, particularly by requiring that the foreign entity incorporate u.s. tax and financial accounting regimes with respect to calculating the overfunded "fractional amount" of the arrangement. such computational requirements may be viewed as particularly intrusive especially where the arrangement is otherwise required to be subject to tax and accounting reporting under the host country's norms. thus even though the trust may exist solely for the exclusive benefit of participants, and overfunding may result from foreign legal requirements, the proposed regulations may have the unintended effect of putting u.s. businesses at a competitive disadvantage vis-ii-vis foreign competitors with no u.s. operations. however, while some may make the case that these rules are overly burdensome, one could argue that if the income had been earned directly by the foreign entity (i.e., the cfc, pfic or foreign partnership) it would have been taxed to the u.s. owner and that, therefore, the promulgation of these foreign grantor trust rule changes merely comport with that broad policy. from that vantage point, the service's efforts may not be viewed as greatly expanding the u.s. tax authority's jurisdiction. additionally, the statutory changes to section 672(f) also appear to confirm a more widespread antiabuse approach which has been adopted by the service. for example, that cfcs are now generally treated as u.s. persons for purposes of applying the grantor trust rules appears to be consistent with the service's proposed regulations under section 671. during the january 15, 1997, hearing on the proposed regulations, government representatives asserted a particular concern that certain 59. james r. murray, public comments on proposed regulations sections 1.671(g) & (h), 97 tnt 39-19 (feb. 27, 1997) (lexis, fedtax library, tnt file); paul t. shultz, public comments on proposed regulations sections 1.671-1(g) & (h), 97 tnt 4-20 (jan. 7, 1997) (lexis, fedtax library, tnt file); john f. woyke, public comments on proposed regulations sections 1.671-1(g) & (h), 97 tnt 4-21 (jan. 7, 1997) (lexis, fedtax library, tnt file). [vol 4:6 recent changes for foreign compensatory trusts jurisdictions may permit taxpayers to overfund their deferred compensatory arrangements and thus enable the taxpayers to shield income from assets that the trust may hold. some practitioners have raised objections to this fear on the grounds that overfunding of foreign trusts results less from such deliberate "parking" of funds than from legitimate occurrences, such as downsizing or retirement which may cause shifts in the age of the population.' in addition, the excess funds are often used to reduce future contributions. some have also objected to the service's concerns on the theory that it would make little business sense to transfer assets to a trust vehicle that is outside the employer's control.61 others have noted that certain jurisdictions, as a matter of law, directly forbid the reversion of plan assets, or otherwise impose limitations on tax deductions or impose unfavorable tax consequences on such reversions. in situations in which surplus assets may be unavailable for repatriation until plan liabilities have been satisfied, the potential for abuse perceived by the service may be unwarranted. in that context, it may make sense for the regulations to build in some flexibility that would ignore surpluses if the contribution may be otherwise compulsory or if reversions would face adverse consequences under foreign law. it will be interesting to see how the service and the treasury respond to such broader jurisdictional and administrative policy concerns in the final regulations. in this regard, it is important to note that the service has, on at least one occasion, tackled the issue of overfunded trusts in certain foreign situations. in revenue ruling 74-41,62 the service examined the issue of whether investments by a trustee of a qualified trust under sections 401(a) and 501(a) which was maintained by a cfc constituted investments in u.s. property of the earnings of the cfc within the meaning of section 956 of the subpart f rules. the service held in revenue ruling 74-41 that because the trust in the ruling was a qualified trust, the stocks of domestic corporations as well as u.s. issued obligations held in trust should not be viewed as being held by the trustee on behalf of the cfc. the service's conclusion on this, however, rested on the fact that "none of [the cfc's] contributions resulted in an overfunding of the trust (other than through an erroneous actuarial computation), and no amounts of trust income or corpus" were diverted to the cfc.63 revenue ruling 74-41, therefore, appears to leave open the possibility that the foreign cfc could be treated as subject to tax on items of income of the trust if the trust were overfunded. while the revenue ruling would not, 60. see murray, supra note 59, at 1 14. 61. id. 62. 1974-1 c.b. 190. 63. id. at 191. 1999] florida tax review assumably, treat the cfc as a grantor of the particular trust arrangement at issue because the trust involved was qualified under section 401(a) and regulations section 1.641(a)-o provides that the grantor trust rules do not apply to employees' trusts associated with qualified plans, the analytical principle remains the same. accordingly, revenue ruling 74-41 may be viewed in some respects as the precursor of the proposed regulations. it is unclear, however, what the force of revenue ruling 74-41 may be if and when the proposed regulations are adopted in final form. in any event, assuming these "overfunding" rules will be issued as final regulations in their currently proposed form, it is important to examine two other key aspects of the proposed regulations. the discussion that follows below first highlights the mechanics of determining how and when a trust may be viewed as "overfunded" for purposes of the proposed regulations section 1.671-1(h) rules. the discussion which follows in part ii.d explores some of the ambiguities and uncertainties occasioned by these overfunding rules, including certain considerations relating to the harmonization of foreign and u.s. computations of the funding of trusts, along with certain policy and administrative considerations raised by practitioners in the implementation of these rules. finally, part mli.e, discusses the potential impact of proposed regulations section 1.671-1(h) on rabbi trusts and other non-rabbi compensatory trusts, explores the apparent shifts in the service's traditional "fundamentally inconsistent" position, and examines the potential legal and policy considerations associated with foreign compensatory trust arrangements. d. fractional amount computation in order to curtail the potential for the perceived foreign overfunding abuses in the cfc and foreign partnership arena, the proposed regulations now permit the service to impute as income a specified percentage of the trust's assets that represents the surplus. in the pfic context in which the funding of a foreign employees' trust stems from a "principal purpose" to reduce or eliminate taxation under sections 1291 or 1293 or to avoid classification as a pfic, if the foreign owner has a power or interest described in sections 673 through 677 over the trust, then the provisions of subpart e will apply to a fixed dollar amount in the trust that is equal to the fair market value of the property transferred for the purpose of reducing or eliminating taxation under sections 1291 or 1293 or avoiding classification as a pfic. in the cfc and foreign partnership arenas, the proposed regulations generally require that the amount of the foreign employees' trust with respect to which the effected employer is treated as owner is equal to an undivided fractional interest in the trust's assets. it is important to note that aside from the potential application to foreign deferred compensatory [vol 4:6 recent changes for foreign compensatory trusts arrangements under section 404a and section 402(b), these "overfunding" rules would also apply to foreign nonqualified pension arrangements. the "fractional interest" is an undivided fractional interest equal to the "relevant amount" divided by the fair market value of trust assets. more technically, the proposed regulations define the relevant amount for the employer's taxable year as the amount, if any, by which the fair market value of trust assets, plus the fair market value of any assets available to pay plan liabilities that are held in the equivalent of a trust exceed the plan's accrued liability, determined using a projected unit credit funding method that satisfies the requirements of regulations section 1.412(c)(3)-1.( the preamble, however, to the proposed regulations also makes clear that accrued liability "is intended to track the method used for calculating pension costs under statement of financial accounting standards no. 87 (fas 87)."65 under the proposed regulations, for a taxable year of the employer, the fair market value of trust assets, and the fair market value of retirement annuities or other assets held in the trust funding the foreign deferred compensatory arrangement equals the fair market value of those assets on the employer's measurement date and the end of the employer's taxable year. the fair market value of these assets is adjusted to include contributions made between the measurement date and the end of the employer's taxable year. under the proposed regulations, the plan's accrued liability for a taxable year of the employer is computed as of the measurement date for the employer's taxable year using a projected funding method and taking into account only liabilities related to services performed for the employer or predecessor employer. the plan's accrued liability is also reduced (but not below zero) by any liabilities that are provided for under annuity contracts held to satisfy the arrangement's liabilities. for purposes of these rules, a plan's accrued liability must be calculated using an interest rate and other actuarial assumptions that the commissioner determines to be reasonable. the proposed regulations stipulate that it is appropriate in determining this interest rate to look to available information about rates implicit in current prices of annuity contracts, and to look to rates of return on high-quality fixed-income investments currently available and expected to be available during the period prior to the maturity of the arrangement's benefits. in the case of "qualified business units" that compute their income and earnings and profits in dollars pursuant to the dollar approximate separate transaction methods in regulations section 1.98564. 61 fed. reg. 50778, 50782 (1996). this also includes amounts held under annuity contracts that exceed the amount needed to satisfy the liabilities provided for under those contracts. id. 65. id. 1999] florida tax review 3, the employer must use an exchange rate that can be demonstrated to clearly reflect income, based on all relevant facts and circumstances, including appropriate rates of inflation and commercial practices. 66 the regulations do not themselves incorporate fas 87, although, as described above, the preamble makes reference to it. indeed, the service also requested comments concerning the extent to which the proposed regulations are consistent with the procedures under fas 87. because the preamble specifically references regulations section 1.412(c)(3)-1, some commentators have requested that the regulations should more directly incorporate the actuarial assumptions under fas 87 either as a safe harbor or as an alternative to the "reasonable funding methods" prescribed by regulations section 1.412(c)(3)-1, particularly since there are differences in the assumptions used in the two methods. for instance, commentators have noted in particular that, while regulations section 1.412(c)(3)-i might prohibit taking into account changes that may take place in the future, fas 87 focuses on the benefits that are reasonably expected to be paid and are based on projected salary levels.67 for example, in the united kingdom, increases in certain post-retirement cost of living adjustments are apparently mandated by local law-under fas 87, the anticipated increases would be part of the projected benefit obligation, while regulations section 1.412(c)(3)-1 would not permit incorporating these increases. in addition, many foreign companies are already performing valuations in accordance with u.s. generally accepted accounting principles (u.s. gaap). by making fas 87 a safe harbor, employers would have the advantage of avoiding the additional transactional costs of producing two sets of numbers.68 because of differences in legal and other practice and custom across borders, a good argument could be made for a fas 87 safe harbor on the ground that it is more universal and comprehensive, particularly when viewed against an alternative that would require the host jurisdiction to import the technical funding rules prescribed by the code that are generally of lesser applicability. as described above, these overfunding rules would be particularly harsh if the overfunding resulted purely from appreciation in investments over the rate assumed in the funding calculations, or as to other forces over which 66. sections 985 through 989 of the code provide for the treatment of transactions in foreign currencies. transactions are typically accounted for under these provisions in a taxpayer's "functional currency," which is effectively the currency used by a "qualified business unit." a qualified business unit is a trade or business for which separate books are kept. a detailed discussion of these foreign currency translation rules is beyond the scope of this article. see irc §§ 985 through 989. 67. see woyke, supra note 59, at 11 27-28. 68. murray, supra note 59, at 9; cf. woyke, supra note 59, at 29. [vol 4:6 recent changes for foreign compensatory trsts the employer has little or no control. the proposed regulations provide that the "relevant amount" may be reduced to the extent that the taxpayer proves to the commissioner that the funding mechanisms chosen are pursuant to a "reasonable funding method," or to experience that is favorable relative to actuarial assumptions used by the employer that the commissioner determines to be reasonable. thus the proposed regulations already contain at least some degree of flexibility. for these purposes, however, a funding method will be considered reasonable if the amount is contributed to a funding method permitted under section 412 (i.e., the entry age normal funding method) that is consistently used to determine plan contributions. additionally, a funding method is only considered reasonable if the method provides for any initial unfunded liability to be amortized over a period of at least six years, and for any net change in accrued liability resulting from a change in funding method to be amortized over a period of at least six years. if there has been a change to one method from another funding method, an amount is considered contributed to a reasonable funding method only if the prior funding method is also a method that would be permitted under section 412. it is unclear how or under what circumstances a taxpayer may be able to prevail under such a showing. moreover, some commentators have already voiced their opinions that such alternative calculations should not be confined to the methods permissible under section 412, and have suggested the use particularly of fas 87 principles.69 as an alternative, however, some have argued that the funding methods that are adopted by the plan pursuant to the norms adopted by the host jurisdiction should be able to satisfy this requirement since in many such jurisdictions, employers are required to make payments to their plan arrangements on a reasonable basis to protect workers' interests.7 under the "reasonable funding exception," the proposed regulations make clear that a cfc (and apparently, only a cfc) must affirmatively make an election signifying that it is relying on the exception. this has prompted some commentators to take exception on the grounds that the requirement will force companies to make protective elections on irs form 5471, even when no surplus currently exists.7 ' finally, the proposed regulations have a de minimis exception. if the "relevant amount" would not otherwise be greater than the plan's normal cost for the plan year ending with or within the employer's taxable year, then the relevant amount is considered to be zero for purposes of the overfunding rules. as a transition rule, the relevant amount is also reduced (but not below 69. murray, supra note 59, at h 9-10, 12; cf. woyke, supra note 59, at u 27-29. 70. murray, supra note 59, at 12. the proposed regulations concerning pfics appear to acknowledge the use of local law and funding practices to reduce to determine whether there is a principal abuse motive involved. 71. murray, supra note 59, at t 16. 19991 florida tax review zero) by any "preexisting amount" (the relevant amount determined without regard to the de minimis exception, computed as of the measurement date that precedes september 27, 1996) multiplied by the "applicable percentage" (100% for the first tax year ending after the proposed regulations are adopted in final form, and reduced 10 percentage points every year thereafter) for a given year, with an affected employer's overfunding thus being taken into account over a ten year period. additionally, there are special transition rules for corporations that become cfcs and for partnerships that become u.s. related partnerships after september 27, 1996. e. grantor "secular" trusts 1. the "fundamentally inconsistent" standard revisited.-as described in part ii, in interpreting section 402(b), the service traditionally has insisted that section 402(b) arrangements and grantor trusts are "fundamentally inconsistent." in the private letter rulings that articulate the "fundamentally inconsistent" standard, the service held that highly compensated employees were taxed under section 402(b)(2) principles under deferred compensatory arrangements that were not ever intended to meet the tax qualification tests of section 401(a).72 this broad position has made it possible for non-rabbi, nonretirement, incentive compensatory trusts to be taxed under the provisions of section 402(b). it has, however, continued to insulate rabbi grantor trusts from adverse section 402(b) treatment under revenue procedure 92-64. some practitioners, however, have questioned whether a compensatory arrangement could be treated as a grantor trust without being a rabbi trust, notwithstanding the service's expansive view in the "fundamentally inconsistent" private letter rulings. in other words, given the uncertain limits of section 402(b), some practitioners have queried as to whether arrangements which for one reason or another fail the requirements of revenue procedure 92-64 (the safe harbor for rabbi trusts) may nonetheless be accorded grantor trust treatment provided that the employer retains one of the other powers described under the other grantor trust provisions of the code. in the noncompensatory arena, trusts which meet any of the grantor powers described in sections 673 through 677 are generally afforded grantor trust treatment. it has not been clear, therefore, why in the compensatory realm these powers might be trumped, especially where section 402(b) itself gives no such direct indication. even in the original private letter rulings 72. see priv. ltr. ruls. 92-12-024 (mar. 20, 1992); 92-12-019 (mar. 20, 1992); 9207-010 (feb. 14, 1992); 92-06-009 (jan. 7, 1992). [vol 4:6 recent changes for foreign compensatory tnsts which articulate the "fundamentally inconsistent" standard, the service did not cite any direct authority to support the conclusion that any inconsistencies between section 402(b) and subpart e necessarily mean that the grantor trust rules cannot apply. in fact, some within the service have noted that the statutory intersection does not necessarily lead to an obvious result." an alternative position could be taken, for example, that would permit the grantor trust rules to apply where any grantor power exists even if it produces inconsistent tax results relating to contributions and deductions. the inconsistency could be addressed by treating any income earned by the grantor-secular trust as immediately "recontributed" by the employer, thus ensuring that the income and the deduction would offset.74 in any event, especially when viewed against the service's willingness to impose grantor trust status on otherwise "overfunded" section 402(b) arrangements, as discussed above, the strength of the purported analytical boundary between section 402(b) and the grantor trust rules, as pronounced in the earlier private letter rulings, may in fact be in question. in this regard, it is interesting to note that the service in at least one private letter ruling held that a deferred compensation arrangement qualified as a rabbi trust because the employer maintained a power described in sections 673 through 677 other than the power required by revenue procedure 92-64 or the one traditionally relied upon in pre-revenue procedure 92-64 private letter rulings.75 the ruling appears to suggest that an arrangement may be treated as a compensatory grantor trust, as long as an employer maintains one of the powers described in section 673 through 677. consequently, one may conclude that the service's position is that a compensatory arrangement may be treated as a grantor trust without the assistance of revenue procedure 92-64, and without encroaching upon the border established by the "fundamentally inconsistent" position adopted by the service in the 1992 private letter rulings with regard to section 402(b). however, this conclusion is not unassailable. for example, the service appears to have taken a contrary position when it underscored its 73. see, 51 tax notes 1349 (jun. 17, 1991) in which internal revenue service branch chief a. thomas brisendine was queried about whether the grantor trust rules should override § 402(b). brisendine was reported to have observed that there was no good answer to this question, but noted that the irs leaned toward the view that § 402(b) should override the grantor trust rules. 74. deferred compensation arrangements, 385 tax mgmt. 3d (bna). at a-30(6) (apr. 28, 1997). 75. see rev. proc. 92-64, 1992-2 c.b. 422. specifically, as discussed above, rev. proc. 92-64 relies in substance on regs. § 1.677(a)-i(d) by requiring that the assets of the trust be available to creditors of the employer in the event of insolvency. the private letter ruling under discussion relied instead on the grantor's power to substitute trust property under § 675(4). 1999] florida tax review "fundamentally inconsistent" holding in private letter ruling 93-02-017. in that ruling, the service arguably reaffirmed its position that a grantor-secular trust cannot exist. under the facts of that private letter ruling, an employer structured a compensatory trust so as to require the annual distribution of trust earnings to the employer, but then permitted the immediate recontribution of the earnings to the trust as an employer contribution. under section 677(a)(2), a grantor is treated as the owner of any portion of a trust whose income, without the approval or consent of any adverse party is, or in the discretion of the grantor or a nonadverse party (or both), may be held or accumulated for future distributions to the grantor. even though the grantor of the compensatory trust in the ruling maintained this right, the service flatly denied ruling that the employer-grantor be treated as an owner of the trust for purposes of subpart e of subchapter j. furthermore, the 1993 ruling appeared to articulate the steps which will affirmatively result in section 402(b) treatment: under the terms of the plan and the trust agreement, [employer] ... and its affiliates will make irrevocable contributions to the trust for the exclusive purpose of providing benefits under the plan to participating employees and their beneficiaries. the trust's assets are not subject to the claims of [the employer's] ... or its affiliates' creditors, and the trust is not exempt from tax under section 501(a) of the code. accordingly, the rules of section 402(b) govern the taxation to participating employees of employer contributions to the trust.76 additionally, while the service in private letter ruling 98-10-005 approved the use of a "three party" nonqualified deferred compensation arrangement, which it treated as a grantor trust, the service squarely noted that it was not expressing any opinion as to the tax consequences of the arrangement under section 402(b). under this arrangement, a tax exempt entity deferred service fees owed by it to another entity by contributing the fees to a trust over which it maintained a grantor power. the assets of the trust were not reachable by creditors of either the tax exempt entity or the service provider entity. since the grantor was a tax-exempt entity, no tax was ever paid on the trust's earnings, and the trust assets became taxable to the beneficiary entity only when there was no substantial risk of forfeiture and the trust property was paid to the beneficiary entity. the beneficiary entity then used the distributed assets, which it held in its general account, to pay 76. priv. ltr. rul. 93-02-017 (jan. 15, 1993) (emphasis added). [vol 4:6 recent changes for foreign compensatory tnsts deferred compensation obligations owed to its employees. while under the trust in question, it was the employer that was viewed as the beneficiary, and not the contributor, as noted above, the service has broadly construed the application of section 402(b) to funding arrangements involving deferred compensation. thus, especially since the service raised the possible application of section 402(b) in this case, it may be potentially instructive. however, it may be difficult to envision the application of section 402(b) to this particular trust arrangement since the employer never makes any contribution to the trust and the statutory language of section 402(b)(1) requires an employer contribution. 2. proposed regulations the proposed regulations may now speak directly to the ongoing non-rabbi grantor-secular compensatory trust debate discussed above. proposed regulations section 1.671-1(g) in the domestic trust context now states: an employer is not treated as an owner of any portion of a nonexempt employees' trust described in section 402(b) that is part of a deferred compensation plan and that is not a foreign trust within the meaning of section 7701(a)(31), regardless of whether the employer has a power or interest described in sections 673 through 677 over any portion of the trust.' moreover, as described above, proposed regulations section 1.671 -1 (h) in the foreign trust context states: except as provided under section 679 or as provided under this paragraph (h)(1), an employer is not treated as an owner of any portion of a foreign employees' trust (as defined in paragraph (h)(2) of this section), regardless of whether the employer has a power or interest described in sections 673 through 677 over any portion of the trust.78 proposed regulations section 1.671-1(h)(2) defines a "foreign employees' trust" for these purposes as "a nonexempt employees' trust described in 77. prop. regs. § 1.671-1(g)(1) (emphasis added). 78. prop. regs. § 1.671-1(h)(1) (emphasis added). 19991 florida tax review section 402(b) that is part of a deferred compensation plan, and that is a foreign trust within the meaning of section 7701(a)(3 1).'79 read broadly, therefore, the proposed regulations pack some powerful punches. it appears that a literal reading of the proposed regulations indicates that no power in section 673 through 677 retained by the employer will be able to effect grantor trust tax treatment in the compensatory trust environment. second, some practitioners have noted that the proposed regulations read literally could potentially be viewed to apply to rabbi trusts.8" the preamble to proposed regulations section 1.672(f) adds further fuel to the controversy by stating that "[t]he irs and treasury contemplate that the nonexempt employees' trusts listed in category (iii) above [i.e., section 402(b) trusts] will be treated as grantor trusts only to the extent provided in proposed regulations § 1.671-1(g) and § 1.671-1(h) ... ."', as described above, the only means by which a compensatory section 402(b) trust is treated as a grantor trust under proposed regulations sections 1.671l(g) and 1.671-1(h) is in the cfc, pfic and foreign partnership abuse paradigms.82 the final 1.672(f) regulations do not repeat the proposed regulations' preamble, however they do still refer to proposed regulations sections 1.671-1(g) and (h) for proposed rules describing when an employer will be treated as an owner of any portion of a nonexempt employees' trust that is part of a deferred compensation plan. accordingly, the preambles to the proposed and final section 672(f)-i regulations may lend further support for the proposition that a literal reading of the proposed regulations works to dismiss all compensatory trusts from the grantor trust rules, other than with respect to the overfunded portions of certain foreign trusts. at least in the rabbi trust context, this result does not appear to make much sense, unless of course, the service actually desired to treat all compensatory arrangements as section 402(b) arrangements. the preambles to regulations section 1.672(f), and the preamble to proposed regulations section 1.671-1 do not otherwise give any evidence of such a far reaching retreat from revenue procedure 92-64, or an outright abandonment of rabbi trusts. in the absence of explicit authority to the contrary, the better reading is probably that the "described in section 402(b)" language in proposed 79. prop. regs. § 1.671-1(h)(2) (emphasis added). 80. see george strobel ii, public comments on proposed regulations section 1.671-1(g), 97 tnt 54-31 (mar. 20, 1997) (lexis, fedtax library, tnt file); woyke, supra note 59, at 7-9. as described above, the safe harbor of rev. proc. 92-64 relies upon a power or interest described in §§ 673 through 677 which the employer retains over any portion of the trust to accord rabbi-grantor trust treatment-namely, the substance of regs. § 1.677(a)-l(d). 81. 62 fed. reg. 30785, 30788 (1997). 82. see also part iv for one additional important paradigm. [vol 4:6 recent changes for foreign compensatory trusts regulations section 1.671-1(h)(2) above does not include rabbi trusts. in particular, one may refer to proposed regulations section 1.672(f)-3(c)(2) and final regulations section 1.672(f)-3(c) which make a distinction between section 402(b) arrangements and a trust that would be a nonexempt trust described in section 402(b) but for the fact that the trust's assets are not set aside from the claims of creditors of the actual or deemed transferor under regulations section 1.83-3(e). while revenue procedure 92-64 does not explicitly provide that a rabbi trust is not a section 402(b) trust, some additional relief may be gleaned from the language of section 402(b) itself as well as one of the proposed regulations' examples. additionally, as described in part iv, some of the statutory amendments to section 679 may have been effected in order to clarify the distinction between section 402(b) arrangements and rabbi trusts. the proposed regulations section 1.671-1(g)(2) example states: employer x provides nonqualified deferred compensation through plan a to certain of its management employees. employer x has created trust t to fund the benefits under plan a. assets of trust t may not be used for any purpose other than to satisfy benefits provided under plan a until all plan liabilities have been satisfied. trust t is classified as a trust under § 301.7701-4 of this chapter, and is not a foreign trust within the meaning of section 7701(a)(31). under regulations § 1.83-3(e), contributions to trust t are considered transfers of property to participants within the meaning of section 83. on these facts, trust t is a nonexempt employees' trust described in section 402(b) .... 83 the example hints, consistent with both the statutory language of section 402(b) and with the pre-revenue procedure 92-64 rabbi trust rulings, that contributions of property to compensatory trusts that are not considered "transfers" under section 83 will not be treated as section 402(b) trusts. as described above, many of the pre-revenue procedure 92-64 private letter rulings reason that a compensatory trust will be treated as a rabbi trust, and hence a grantor trust per regulations section 1.677(a)-1(d), if the contribution of property to the trust does not result in a "transfer" within the meaning of regulations section 1.83-3(e). no such "transfer" occurs under those rulings because assets of the trust are made available to creditors in the event of employer insolvency. regulations section 1.83-3(e) states: 83. prop. regs. § 1.671-1(g)(2) (emphasis added). 19991 florida tax review for purposes of section 83 and the regulations thereunder, the term "property" includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future. the term also includes a beneficial interest in assets (including money) which are transferred or set aside from the claims of creditors of the transferor....' even with the relevant provisions contained in sections 83 and 402(b) and possible inferences that may be drawn from section 679, it is not wholly evident, however, that the particular example cited in the proposed regulations was intended to address the potential rabbi trust concern. the preamble to proposed regulations sections 1.671-1(g) & (h), however, briefly notes "[i]f under these principles, no assets have been transferred to an employees' trust for federal tax purposes, these proposed regulations do not apply."85 thus, from the preamble and through a more seasoned reading of the broader provisions, rabbi trusts should not be viewed as subject to proposed regulations section 1.671-1, although the service may wish to more directly clarify its position in the body of the final regulations, when issued, to dispel completely any contrary reading. in any event, as discussed above, in greater peril is the treatment of compensatory arrangements that seek grantor trust treatment on a basis other than that of revenue procedure 92-64. because proposed regulations section 1.671-1(h)(1) states that "regardless of whether the employer has a power or interest described in sections 673 through 677 over any portion of the trust," there is now significant doubt under the proposed regulations as to whether a compensatory trust that wishes to secure grantor trust treatment may do so as a result of maintaining a power other than the segregation of assets for the benefit of creditors in the event of insolvency. at least under a formalistic reading of the proposed regulations, a compensatory trust that does not satisfy revenue procedure 92-64 may be unlikely to get a "second bite" at the grantor trust apple even if in the noncompensatory setting, providing the grantor with one of the powers described in sections 671 through 677 would ordinarily result in grantor trust treatment. accordingly, under such a view, any compensatory arrangement making use of a trust which results in a transfer under section 83 may result in section 402(b) treatment. because it may be possible for a trust to receive a transfer of property within the meaning of regulations section 1.83-3(e) while still providing the grantor with one or more of the powers described in 84. regs. § 1.83-3(e) (emphasis added). 85. 61 fed. reg. 50778, 50779 (1996). [vol 4:6 recent changes for foreign compensatory trsis sections 671 through 677, the fate of secular grantor compensatory trusts, other than in the overfunded context, may be in doubt under the proposed regulations. this may be the case, even though, curiously, the preamble to the proposed regulations explicitly recognizes that: [e]ven if there has been a completed transfer of trust assets, the subpart e rules may apply to treat the grantor as the owner of a portion of the trust for federal income tax purposes.86 the expansive "fundamentally inconsistent" position, therefore, may now be significantly elevated from a position articulated through several private letter rulings to that of potentially more universally applicable regulatory authority despite the fact that it may not be clear under a broader statutory analysis whether there may be a conflict with the grantor trust rules.87 while unclear under the larger statutory scope of section 402(b), this outcome is apparently consistent with the reasoning reached in private letter ruling 93-02-017, which held, despite any other grantor power maintained by the sponsor, that no grantor trust status may be concluded where there is a transfer of property under section 83 and where the assets of the trust are not available to the creditors of the employer. it is not certain whether the outcome of the proposed regulations may conflict with private letter ruling 98-10-005, which, as described above, conferred grantor trust status in a three party non-rabbi trust deferred compensatory setting. however, since the "employer" under that arrangement never "contributed" property to the trust, section 402(b) may in fact not be implicated. f. summary while there has historically been and continues to be uncertainty regarding the scope of section 402(b) arrangements, the proposed regulations have codified for the first time, other than through private letter rulings, a more universally applicable statement concerning the apparent relationship between section 402(b) arrangements and rabbi trusts and other purported compensatory grantor trusts. the proposed regulations formally sanction the conclusion that certain nonqualified deferred compensation plans are subject to taxation, a conclusion reached by the service in various previous rulings concerning domestic secular trusts. additionally, the proposed regulations 86. 61 fed. reg. 50778, 50779 (1996) (emphasis added). 87. see discussion supra part ii.e. 1. 19991 florida tax review provide that an employer is not treated as the owner of a foreign employees' trust except to the extent there may be overfunding or abuse. in so doing, the grantor trust rules' application to domestic section 402(b) arrangements is nullified. it is also effectively limited in inbound foreign section 402(b) and section 404a arrangements to the extent necessary to safeguard perceived abuses of foreign deferred compensation plans as tax shelters in which there may be overfunding or other abuses in the cfc, pfic, or foreign partnerships context. reading the literal language of regulations section 1.672(f)-3(c), and the preamble to that provision, along with examples in proposed regulations section 1.671-1, compensatory trusts that do not make their assets available to creditors in the event of bankruptcy may be included in the section 402(b) universe-a potentially broad reaching development that may affect a variety of incentive and deferred compensatory structures. the proposed regulations thus appear to strike a compromise with the service's "fundamentally inconsistent" position in the domestic and foreign contexts. while in the grantor "secular" arrangements, section 402(b) appears to take the more expansive role at the expense of the grantor trust rules, in the "overfunding" anti-abuse environment, the grantor trust rules appear to cause section 402(b) to yield in favor of perceived abuses which apparently dictate even larger policy considerations. iv. outbound grantor trust rules a. the scope of section 679 while section 672 governs "inbound" transactions, section 679 governs outbound trust transactions. section 679(a), as amended by the small business job protection act, states: in general.-a united states person who directly or indirectly transfers property to a foreign trust (other than a trust described in section 6048(a)(3)(b)(ii)) shall be treated as the owner for his taxable year of the portion of such trust attributable to such property if for such year there is a united states beneficiary of any portion of such trust. 88 the requirement in section 679(a)(1) that a u.s. person transfer property to a foreign trust is extremely broad, applying both to direct and indirect transfers of property. moreover, the provision generally has only two exceptions: (1) transfers by reason of the death of the transferor and (2) 88. irc § 679(a)(1). [vol 4:6 recent changes for foreign compensatory trusts transfers that result from a sale or exchange of the property for at least its fair market value.8 9 examples in the committee reports which accompanied the enactment of section 679 underscore the breadth of section 679's application: example: a u.s. person transfers property to a foreign person or entity that transfers the property (or its equivalent) to a foreign trust that has u.s. beneficiaries. the u.s. person is treated as having made a transfer to a foreign trust, unless it can be shown that the foreign person or entity's transfer to the trust was unrelated to the u.s. person's transfer. example: a u.s. person transfers property to a domestic trust or corporation that subsequently transfers the same or equivalent property to a foreign trust. the u.s. person may be treated as having made a transfer of property indirectly to the foreign trust. example: a u.s. person transfers property (or engages in certain deferred sales transactions) with a domestic trust which subsequently becomes a foreign trust. the u.s. person may be treated as having made an indirect transfer to a foreign trust." many u.s. companies may establish foreign compensatory trusts for either u.s. employees working abroad or foreign employees. in addition, in many deferred compensation arrangements, there may be funding, reimbursement or other arrangements between the foreign parent "funding" the arrangement and the u.s. subsidiary whose employees benefit under the plan. for example, it is common for employees of a u.s. subsidiary to be granted stock or stock-related rights tied to the equity of a foreign parent and for the u.s. employer to reimburse the foreign parent---directly or indirectly-for the costs of such compensation. even though neither section 679 nor the accompanying legislative history appear to provide any guidance on the absolute measure of control a u.s. subsidiary would have to maintain over the foreign trust for that u.s. entity to be deemed an indirect transferor to the trust,9' some practitioners have considered the possibility that a subsidiary of the purported foreign grantor may be deemed to be an indirect grantor of the arrangement because of such direct or indirect reimbursements. 89. irc § 679(a)(2). 90. see h.r. rep. no. 94-658, at 209 n.10 (1975), reprinted in 1976 u.s.c.c.a.n. 2897, 3014; s. rep. no. 94-938, pt. 1, at 219 n.8 (1976). reprinted in 1976 tj.s.c.c.a.n. 3439, 3650-51. 91. this article does not address issues prompted by § 482. 19991 florida tax review for purposes of these outbound grantor trust rules, section 679(c) provides that a trust will be treated as having a u.s. beneficiary unless (1) the trust expressly provides that no part of the income or corpus of the trust may be paid or accumulated to or for the benefit of a u.s. person and (2) were the trust to terminate, no part of the income or corpus of the trust could be paid to or for the benefit of a u.s. person. section 679(c)(2) also provides attribution rules pursuant to which an amount is treated as an "amount paid or accumulated to or for the benefit of a united states person" for purposes of clause (1), above, if an amount is paid or accumulated to or for the benefit of a cfc, or a foreign partnership with a u.s. partner. accordingly, given the breadth of section 679's statutory ambit, the possibility of a u.s. subsidiary being viewed as an "indirect" or "deemed" grantor of an outbound foreign trust arrangement was, in some circles, viewed as a real possibility. b. legislative changes to section 679 occasioned by the small business job protection act prior to the small business job protection act, section 679(a) read in relevant part: in general.-a united states person who directly or indirectly transfers property to a foreign trust (other than a trust described in... [sections 404(a)(4) or 404a]) shall be treated as the owner for his taxable year of the portion of such trust attributable to such property if for such year there is a united states beneficiary of any portion of such trust. 2 it was not clear under that definition what precisely section 404(a)(4) or section 404a trust arrangements included. for example, it was unclear whether that definition also was intended to include "secular" trusts described in section 402(b) or "rabbi" trusts, particularly since there had been some question regarding the relationship between grantor trusts and section 404a arrangements and also because the specific reference of section 404a without an accompanying reference to section 402(b) carried a potentially negative inference regarding the latter. although section 404(a)(4) and section 404a trusts are compensatory arrangements, neither a section 402(b) plan nor a rabbi trust technically fit into either one of these in the strict sense. the small business job protection act amended section 679(a) by replacing the reference to sections 404(a)(4) and 404a with a reference to 1995). 92. irc § 679(a) (prior to 1996 amendment, retroactively effective from feb. 6, [val 4:6 recent changes for foreign compensatory trusts trusts described in "section 6048(a)(3)(b)(ii)." section 6048(a)(3)(b)(ii) refers to: deferred compensation [arrangements] and charitable trusts. subparagraph a shall not apply with respect to a trust which is--(i) described in section 402(b), 404(a)(4) or 404a, or (ii) determined by the secretary to be described in section 501(c)(3). 93 these statutory amendments, therefore, make it clear that, along with section 404a arrangements, foreign section 402(b) trusts with u.s. grantors and u.s. beneficiaries are twt subject to grantor trust treatment under section 679; a position which appears in line with the service's "fundamentally inconsistent" standard, and a position which appears to protect rabbi trusts from exclusion under the grantor trust rules.94 c. proposed regulations as described above, a formalistic reading of regulations section 1.672(f)-i, as well as a literal reading of sections 402(b) and 83, appear to imply that rabbi trusts should not be section 402(b) trusts. accordingly, it would make sense that such a literal reading is directly incorporated into the sections 679 and 6048 contexts. indeed, a contrary reading would appear to make little policy sense under section 679 especially since without the application of section 679, rabbi trusts should already be treated as grantor trusts by reason of the fact that their assets are subject to the claims of creditors of the employer. it may not be as clear, however, what the precise interplay is intended between section 679 and grantor "secular" trusts that do not meet the conditions of revenue procedure 92-64 but which otherwise maintain a power described in sections 671 through 677 in favor of the grantor. the source of regulatory uncertainty does not end, however, in determining whether or not for section 679 purposes grantor "secular" trusts may be equated with section 402(b) trusts. as described above in part m, proposed regulations section 1.671-1(h) generally does not treat any section 402(b) compensatory arrangement as a grantor trust. in this vein, proposed regulations section 1.671-1(h) is entirely consistent with the small business 93. irc § 6048(a)(3)(b)(ii). 94. additionally, the small business job protection act amended the code to provide that transfers of property by u.s. persons to a foreign trust with u.s. beneficiaries will not result in the grantor being treated as the owner of the trust if the trust paid fair market value to the transferor for the property transferred. 1999] florida tax review job protection act's revisions to section 679 since that provision now prevents the application of grantor trust status for outbound section 402(b) trusts. however, as noted above in part hi, proposed regulations section 1.671-1(h) contains an important exception. that exception works to impose grantor trust treatment on certain "overfunded" arrangements of certain controlled foreign corporations, foreign partnerships and passive foreign investment companies. proposed regulations section 1.671-1(h), however, contains one additional exception to its general rule of excluding foreign section 402(b) arrangements from the grantor trust rules. that exception, which presumably is intended to stand for the same anti-abuse principles as the other exceptions, applies to u.s. persons and states as follows: if a united states person (as defined in section 7701(a)(30)) maintains a deferred compensation plan that is fiunded through a foreign employees' trust, then, with respect to the u.s. person, the provisions of subpart e apply to the portion of the trust that is the fractional interest that is described in paragraph (h)(3) of this section. 95 again, "[a] foreign employees' trust is a nonexempt employees' trust described in section 402(b) that is part of a deferred compensation plan, and that is a foreign trust within the meaning of section 7701(a)(31). ' '" this exception, then, requires foreign trusts with u.s. grantors to become subject to the grantor trust rules with respect to the "fractional amount." as discussed in part el, proposed regulations section 1.671-1 (h)(3) generally requires that the amount of the foreign employees' trust with respect to which the affected employer is treated as owner be equal to an undivided fractional interest in the trust's assets. the fraction consists of the "relevant amount" (the excess of the fair market value of the trust assets over the accrued liability using a projected unit credit funding method taking into account only liabilities relating to services performed for the employer or a predecessor employer) for the employer's taxable year. this exception, therefore, may appear at odds with the statutory revisions made to section 679. the exception in proposed regulations section 1.671-1 is particularly curious because the preamble does not make particular reference to the case of a u.s. grantor and instead notes only that: 95. prop. regs. § 1.671-1(h)(1)(ii) (emphasis added). 96. prop. regs. § 1.671-1(h)(2) (emphasis added). [vol 4:6 recent changes for foreign compensatory trusts under these proposed regulations, the grantor trust rules of subpart e do not apply to a foreign employees' trust with respect to a foreign employer other titan a cfc or a u.s.-related foreign partnership, except for cases in which assets are transferred to a foreign employees' trust with a principal purpose of avoiding the pfic rules.' because section 679 is the only statutory provision that explicitly applies to foreign grantor trusts (other than section 672(f)), and because congress specifically excluded section 402(b) arrangements from the application of section 679, one could read all of the provisions taken in their entirety to mean that congress did not intend for the grantor trust rules to apply to foreign nonexempt employees' trusts at all. such an interpretation would still appear to remain consistent with the current tax treatment of rabbi trusts since rabbi trusts (not being foreign nonexempt employees' trusts) would otherwise be treated as a grantor trust by virtue of the powers it retains under section 677. similar interpretative concerns may arise with respect to overfunded section 404a arrangements in light of their specific exclusion under section 679. alternatively, read literally, section 679(a) does not itself provide that the u.s. sponsor of a foreign section 402(b) arrangement with u.s. beneficiaries will never be treated as a grantor. instead, one could read section 679 merely as providing one mechanism by which a u.s. sponsor of a nonsection 402(b) arrangement would be treated as an owner under the grantor trust rules. in that case, the authority promulgated by proposed regulations section 1.671-1(h) could work to independently permit overfunded portions of foreign secular trust arrangements with u.s. sponsors to be taxed under the grantor trust rules. under any reading, the proposed regulations do not appear directly in conflict with section 679 concerning u.s. sponsored foreign arrangements which do not benefit u.s. persons since section 679 does not apply to those arrangements. given the service's position that, absent the overfunding rules, grantor compensatory trusts cannot exist without there being a rabbi trust, one might question under the above analysis how section 679 might otherwise have any bite to outbound compensatory arrangements. however, the conclusion that both section 679 and the proposed regulations under section 671 work independently could be consistent with the potential purpose behind the small business job protection act's revisions to section 679 in the compensatory arena, which may have added the reference to section 402(b) merely to clarify that foreign rabbi trusts were not intended to be excluded 97. 61 fed. reg. 50778, 50781 (1996) (emphasis added). 19991 florida tax review from grantor trust treatment-a concern among some practitioners with respect to section 679 prior to the statutory amendments-giving credibility to the conclusion that the statutory changes should not be viewed as a broader statement on the border between the grantor trust rules and section 402(b). under this view, the independent application of the proposed regulations may be seen as bolstering the service's purported policy that section 402(b) arrangements, whether foreign or domestic, should not be treated as grantor trusts except to the extent needed to redress perceived abuses.9" as discussed above, however, such an interpretation does not necessarily address whether the proposed regulations under section 671 themselves provide a permissible grantor power apart from the others prescribed by statute in sections 673 through 677. because of the potential ambiguity and the fact that the preamble to the proposed regulations do not address in great detail the interaction of the proposed regulations and section 679, it will be interesting to note the manner in which the service seeks to provide further clarification. v. conclusion the recent changes to the code and proposed regulations dramatically affect many foreign trust based deferred compensatory arrangements. as discussed above, the changes alter the definition of "foreign trust" by adding some much needed clarity to the boundary between domestic and foreign trusts-an area which has often been filled with ambiguity. additionally, prompted by concerns that u.s. persons were not paying their fair share on income attributable to foreign trusts, certain foreign affiliates of u.s. entities may now be treated as grantors of the overfunded portion of certain foreign compensatory trusts, and thus may be subject to u.s. federal income tax on the items of income produced by the trust, regardless of whether the trusts would otherwise be so treated under subpart e of the code. in particular, these rules are designed to curb abuses by plans maintained by (1) cfcs, (2) certain pfics and (3) certain foreign partnerships. as described above, these rules, in particular, are potentially expansive in their scope because arrangements of purely foreign entities which employ mostly foreign persons may now be subject to u.s. taxation even though the only nexus they have with the united states is through their affiliation with a u.s. entity. equally important is the fact that by subjecting 98. while congress may have added the statutory reference to § 402(b) to clarify that outbound rabbi trusts were not necessarily outside of the grantor trust rules, this "independent application" rationale, however, would appear to make such a clarification unnecessary since, presumably, as stated above, rabbi trusts would independently be treated as grantor trusts, exclusive of § 679, under regs. § 1.677(a)-l(d). [vol. 4:6 recent changes for foreign compensatory trusts these foreign trusts to the grantor trust rules, the service appears to be departing from its long-standing policy of treating section 402(b) "secular" trust arrangements as "fundamentally inconsistent" from grantor trusts. this broad assertion is especially important for those compensatory arrangements which might fail to meet the requirements of revenue procedure 92-64--the service's safe harbor for favorable rabbi (grantor) trust treatment. for determining when an arrangement may be viewed as overfunded these rules not only invoke practical concerns, but also potentially raise accounting translation issues between u.s. and foreign procedures and standards. given the apparent shift in favor of section 402(b) in the case of failed rabbi trusts on the one hand, and the reliance on the grantor trust rules for certain foreign deferred compensatory arrangements on the other hand, it is not clear how consistent the "fundamentally inconsistent" distinction may remain. finally, section 679, as amended, now makes clear that u.s. grantors of "outbound" foreign trusts will not be treated as grantor trusts if the arrangement is considered to be covered by section 402(b) of the code. however, in spite of this statutory change, certain recently issued proposed regulations now indicate that portions of "outbound" trusts will be subject to the grantor trust rules as a result of the application of the overfunding rules described above. these developments raise some interesting questions as to the practical cumulative effects and the intended spirit of the changes to both section 679 and the proposed regulations. accordingly, the foreign trust deferred compensatory world is rife with changes. some of the changes are explainable-driven by policy concerns long felt unaddressed by congress and the service. however, some of these changes may produce unclear results. while the foreign trust arena requires effective policing, the service may wish to think about the interaction of all of the legislative and regulatory changes in order to produce in the final regulations an even clearer picture of the tax treatment in certain ambiguous or uncertain cases. in short, therefore, the host of changes occasioned by the statutory and legislative changes dramatically alter the treatment of foreign trust based compensatory arrangements. however, the changes also in some instances mark changes in policy. how that policy will be best prosecuted in the aggregate within the limitations of each applicable provision remains to be seen. 19991 normative capital equipment expensing and capital formation in a transition tax base 215 capital equipm ent expensing: increm ental tax reform for a transition realization-based incom e tax by charles t. terry i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217 ii. taxing equipment investment in a realization-based income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 a. realization, basis and earnings-financed investment . . . . . 223 b. capital cost recovery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 c. interim findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 iii. tax capital creation and tax capital formation in the u.s. rbit base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 a. loss offsets and the impact of various cost recovery methods on pre-investment tax capital creation . . . . . . . . . 230 b. loss offsets and the impact of various cost recovery methods on post-investment tax capital formation . . . . . . . 234 iv. structural capital creation, formation and recovery issues created by current equipment expensing schemes 236 a. unlimited full offset expensing . . . . . . . . . . . . . . . . . . . . . . . 236 b. limited and/or partial offset expensing . . . . . . . . . . . . . . . . 238 1. under-expensing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238 2. over-expensing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239 v. normative capital creation, equipment expensing and capital formation in a transition income tax base . . . . . . 239 a. defining the problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239 b. developing a basic proposal for normative capital equipment expensing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240 1. the basic proposal . . . . . . . . . . . . . . . . . . . . . . . . . . 240 2. the treatment of excess tax capital creation or equipment investment . . . . . . . . . . . . . . . . . . . . . . . . . . . 241 3. the treatment of excess non-tax capital investment . . . . . . . . . . . . . . . . . . . . . . . . . . . 241 216 florida tax review [vol.7:4 vi. a preliminary look at administering capital equipment expensing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 a. areas of possible administrative simplification . . . . . . . . . . . 243 1. aggregating expensing deduction computations . . . 243 2. simplifying the treatment of asset dispositions . . . . 243 3. treatment under the alternative minimum tax . . . . . 244 b. areas of possible administrative complexity . . . . . . . . . . . . . 244 1. defining the scheduler contours of capital equipment expensing . . . . . . . . . . . . . . . . . . . . . . . . . 244 2. defining the proper treatment of debt financing in relation to capital equipment expensing . . . . . . . 246 vii. normative capital equipment expensing as an agent of capital creation, revenue generation and capital formation in a transition realization-based income tax . . . . . . . . . . . . . 249 a. unlimited capital equipment expensing . . . . . . . . . . . . . . . . 249 b. limited capital equipment expensing . . . . . . . . . . . . . . . . . . 250 c. a deeper analysis of the model . . . . . . . . . . . . . . . . . . . . . . . 252 1. moderately high earnings levels . . . . . . . . . . . . . . . 252 2. low earnings levels . . . . . . . . . . . . . . . . . . . . . . . . . 253 3. very high earnings levels . . . . . . . . . . . . . . . . . . . . 254 viii. summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255 conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257 2006] capital equipment expensing 217 * professor of law, university of illinois college of law. b.a., stanford university; j.d., southwestern university school of law; ll.m. (taxation), new york university school of law. this article could literally not have been written without the extraordinary assistance of student research assistants, ji kim, amina kaal, kurt meyer, and amy tomaszewski. professor deborah schenk graciously provided invaluable comments. any remaining errors are my sole responsibility. 1. charles t. terry, normative cost recovery policy for a realization-based income tax, 5 fla. tax rev. 467, 470-76, 498-510 (2002). the term “realization-based income tax” has begun to acquire wide currency. see e.g., michael j. graetz, 100 million unnecessary returns: a fresh start for the u.s. tax system, 112 yale l.j. 261 (2002); jeff strnad, some macroeconomic interactions with tax base choice, 56 smu l. rev. 171, 172, 185-87 (2003); deborah h. schenk, a positive account of the realization rule, 57 tax l. rev. 355 (spring 2004). 2. that article actually discussed cost recovery theory and policy with respect to “short-lived and completely wasting assets.” terry, supra note 1, at 472. at that time, i did not want to be viewed as specifically discussing the particular characteristics of irc § 179; although it was, and still is, the closest real world manifestation of the issues addressed in that article. this article focuses on “section 179 property,” which is defined in irc § 179(d) as property (a) which is (i) tangible personal property (to which § 168 applies), or (ii) computer software (as defined in § 197(e)(3)(b) which is described in § 197(e)(3)(a)(i), to which § 167 applies, and which is placed in service in a taxable year beginning after 2002 and before 2008, (b) which is § 1245 property (as defined in § 1245(a)(3), and (c) which is acquired by purchase for use in the active conduct of a trade or business. such term shall not include any property described in § 50(b) and shall not include air conditioning or heating units. irc § 179 (2003). however, the focus of this article is on the functional structure of § 179 within the u.s. income tax base as of jan. 1, 2005, and the tax policy implications of that structure, rather than on the specific provisions of irc § 179. capital equipment expensing: incremental tax reform for a transition realization-based income tax by charles t. terry* i. introduction three years ago, i published an article that characterized the u.s. income tax as a specialized variant of a true income tax and dubbed it a “realization-based income tax” (rbit). it analyzed then current cost recovery1 theory and policy with respect to equipment. the earlier article argued that2 normative cost recovery policy for a tax on capital income in a rbit should exhibit two financial features: first, it should provide for the complete financial 218 florida tax review [vol.7:4 3. the term “capital” is difficult to define, and is often defined in terms of what it is not. for example, “. . . generally, a taxpayer’s adjusted basis in property. the term is undefined, yet is of vital importance in that the 16th amendment allows the taxation of income, but implicitly disallows the taxation of capital.” wf&l tax dictionary. in addition to difficulty of definition, the term capital has different meanings depending on the context. generally, the term is used to refer to tangible income producing assets, such as real property and equipment, as well as intangible assets such as intellectual property, in order to distinguish property from services as a general source and type of income. see infra note 5. 4. those three cost recovery approaches were economic cost recovery, accelerated cost recovery and immediate expensing. 5. this article refers to economic, non-debt financing in general as “capital” or “economic capital” and to financing from after-tax or contemporaneously taxed dollars in particular, as “tax capital.” within the context of a rbit base, economic capital can consist of pre-tax or untaxed dollars in whole or in part, while tax capital consists exclusively of after-tax dollars or “nascent after-tax dollars.” these are potential after-tax dollars at any point in time. they are derived from “contemporaneously taxed dollars” (dollars which would be available for investment from current earnings if tax was hypothetically imposed on those earnings immediately before “tax capital” investment could take place). in this article, nascent after-tax dollars are only determined and utilized at the end of a taxpayer’s taxable period. see discussion infra, text accompanying notes 26 and 73. in a general sense, the word nascent means”the state of coming into existence, beginning to form or develop, etc.” oxford english dictionary (2003). 6. see terry, supra note 1, at 510-15, 542. (“in other words, in a state of financial equilibrium, only with expensing does the financial return to capital provided by the federal government’s cost recovery system ‘pay for’ the financial cost of the tax imposed on depreciable asset investments by the same government.”) 7. id. at 530-38. recovery of all capital invested in equipment; and second, it should financially3 measure any realized income produced by the investment in the equipment accurately. the earlier article evaluated three prototypical cost recovery approaches, and concluded that only immediate expensing produced financial4 characteristics consistent with those features of a normative realization-based income tax when applied to equipment purchases financed exclusively with “tax capital.”5 as that analysis demonstrated, only what i now call “capital equipment expensing” (cee) provides complete recovery of tax capital investment financially, and only expensing as a cost recovery method causes6 realized income to be taxed financially in exact proportion to the tax rate across a wide range of contextual financial variables.7 the previous article concluded that a normative rbit can and should allow a given taxpayer’s investment in short-lived depreciable assets (i.e., equipment) to be expensed, but only to the extent such investment is made with 2006] capital equipment expensing 219 8. this condition was imposed on the analysis in the earlier article in order to exclude the economic effects of loss offsets, thus creating a narrow economic context that allowed me to focus exclusively on the financial characteristics of the three archetypical rbit capital cost recovery methods. see terry, supra note 1, at 506-10. 9. in this article, that constraint has been relaxed. since this article focuses on the interaction between expensing as a cost recovery method and capital creation and formation, the existence of loss offsets are taken as a given. instead, this article focuses on the economic creation, utilization, and post-investment formation of after-tax capital within the context of contemporaneously taxed earnings. 10. see discussion of debt-financed equipment investment infra part vi.b.2. 11. this article uses the term “earnings” to refer to income that is produced by a taxpayer’s ongoing trade or business or income producing activities exclusive of any income produced by the particular equipment asset under analysis. this article focuses on “earnings financed” purchases of equipment, and thus the term “invested earnings.” the treatment of debt-financed purchases of equipment is explored briefly in part vi.b.2., infra. this article ultimately defines “appropriate taxation of invested earnings” as subjecting capital expensed equipment investment to roughly the same effective tax rate as other forms of capital investment. see infra note 106. 12. see supra note 5. 13. see h.r. 1388, 109th cong. (2005) (proposing to make permanent the increase from $25,000 to $100,000 in § 179 expensing of depreciable business assets). see also h.r. 364, 109th cong. (2005) (proposing to extend both 50% and 30% bonus depreciation for 2 years, until jan. 1, 2008). and offsets tax capital. therefore, that article only proved that immediate8 expensing produces financially normative capital cost recovery for such investment under those circumstances.9 this article picks up where the other one left off, and asks whether equipment expensing as a rbit cost recovery method for all earningsfinanced equipment purchases can ever be made economically consistent with two additional norms of a realization-based income tax. those seemingly10 contradictory norms are: 1) the appropriate taxation of all invested earnings that are allowed to be expensed, and 2) the contemporaneous existence or11 creation of “tax capital” in an amount equal to whatever amount of current12 earnings are allowed to be expensed. this article pursues this inquiry not only for its own sake but in the hope of furthering a broader purpose. multiple forms of equipment cost recovery and/or expensing now exist under the internal revenue code that arbitrarily apply to different classes of taxpayers, and there is already support to reinstate newly expired partial expensing (50% bonus depreciation) despite its recent expiration. this situation raises important immediate tax policy13 issues involving capital formation, the equitable and efficient taxation of investment in depreciable and non-depreciable assets, tax law complexity, and the impact of these multiple cost recovery techniques and paradigms on revenue collection. 220 florida tax review [vol.7:4 14. recently, in a continuing process of evaluating particular forms of consumption tax, the congressional research service recently listed and described four major types of broad-based consumption taxes with at least some congressional backing: 1) the hall-rabnushka flat tax, 2) a national retail sales tax, 3) a consumed income tax, and 4) a value-added tax. see james m. bickley, flat tax proposals and fundamental tax reform: an overview, congressional research service, march 23, 2005. 15. dustin stamper, gop sweeps elections: is tax reform next?, 2004 tax notes 214-1 (quoting finance committee chair charles e. grassley, r-iowa). four proposals can be mentioned in this “non true consumption tax” category: 1) the gephard proposal to broaden the base and lower tax rates; 2) a dual-rate income tax in which capital income would be taxed at a lower flat rate than other income, which would be taxed at a higher flat rate; 3) a dual-structure tax in which all but the wealthiest income taxpayers would be removed from the income tax and pay a consumption tax, and 4) the recent burgess proposal to let taxpayers elect out of the current tax system and pay an initial flat tax rate of 19%. 16. but, as one of the main architects of the bush ii revolution puts it, “we want to move toward fundamental tax reform incrementally. every piece of getting to fundamental tax reform is more popular than doing it all at once.” id. (quoting grover norquist, president of americans for tax reform). 17. see james m. bickley, crs issues overview of tax reform proposals, 2004 tax notes 196-32. to make matters worse, in 2005, we are beginning to engage in a transition from an income tax base to either some form of a consumption tax14 or, at a minimum, a major attempt to “simplify and restructure the tax code.”15 assuming these efforts may take some time to unfold, there seems to be a16 small window of opportunity to propose a transition method of equipment expensing that can be implemented quickly, that is relatively simple to administer, that can be scaled outward and upward to include all classes of business taxpayers at all levels of taxable income, that is comparatively revenue neutral, and that is a more efficient method of capital cost recovery, and more importantly, capital formation than we have now. my hope is that at least a partial scheme of normative capital creation, equipment expensing, and capital formation for a rbit, although eventually transitory, can provide a temporary but stable transaction platform from which federal tax policy, at least with respect to equipment investment, may be developed principally and deliberately, rather than politically and hastily, over the next few years. ideally, this process could also help to develop a more comprehensive and coherent overall u.s. tax policy during the current decade. my goal is to enable decision makers to either move forward to a consumption tax or backward to a better designed income tax base, without losing17 unnecessary revenue relative to existing law, and without introducing unnecessary and unproductive complexity into the u.s. tax system during this critical period of tax reform transition. 2006] capital equipment expensing 221 18. economic depreciation in theory satisfies this criterion. the vestigial acrs cost recovery method also satisfies this condition under some circumstances. see terry, supra note 1, at 504-06. 19. theoretical instantaneous expensing. see discussion in terry, supra note 1, at 506. 20. full and partial expensing. part ii of this article defines and illuminates the basic underlying structural framework and principles of our traditional u.s. tax base that relate to equipment expensing and other cost recovery schemes. those principles are realization, basis, and capital cost recovery. this part concludes that realization necessitates capitalization, capitalization requires capital recovery, and capital recovery should always and only consist solely of capital available for recovery at the time of investment. because the current cost recovery methods within the u.s. tax base today function as agents of both capital cost recovery and capital creation, part iii of this article explores this broader role. this part shows that u.s. cost recovery methods theoretically can run a range from cost recovery methods that allow invested earnings to be fully taxed, to a cost recovery method18 which figuratively causes invested earnings to be exempt from taxation. not19 surprisingly, those cost recovery methods which produce no loss-offset against invested earnings pay the highest amount of tax and form the least amount of after-tax capital of any cost recovery methods within the u.s. income tax base today. conversely, the cost recovery methods that produce the greatest amounts of loss-offset pay the least amount of tax, and form the greatest20 amount of after-tax capital. part iv of the article explores the structural capital creation, capital formation and capital cost recovery issues created by the current u.s. equipment expensing schemes in effect today. this analysis shows that none of these schemes succeed in limiting expensing deductions to available tax capital, and none succeed in not allowing pre-tax earnings to be offset by expensing deductions. existing equipment expensing methods in the u.s. either deny immediate recovery of invested capital (under-expensing) or allow immediate recovery of untaxed earnings (over-expensing). the technical problem is that, when expensing is limited to dollar amounts or percentages of investment in equipment, both under-expensing and over-expensing can, and most likely, will occur. thus, the underlying tax base structural problem is two-fold. first, tax capital creation is not measured or accounted for under any existing expensing method. second, no current expensing methods are structured to relate expensing deductions to tax capital creation and availability. only when such accounting and matching is structurally assured globally within our subsidiary business income tax base, will any form of equipment expensing properly reflect the normative structure and dynamics of our hybrid, transitory, realization-based income tax. my proposed solution is to carve out a business 222 florida tax review [vol.7:4 income sub-rbit for equipment investment, and apply to it the complementary principles of: 1) tracking tax capital creation, and 2) both allowing and requiring tax capital, and only tax capital, to be recovered taxfree completely and immediately through cee. part v of the article develops a preliminary proposal for implementing normative capital creation, capital equipment expensing, and capital formation within our current transitional rbit base. this proposal describes a way to measure and compare the concurrent tracks of tax capital creation and equipment investment on an annual basis. aggregate equipment investment for a given taxable year is allowed to be expensed to the extent that sufficient tax capital creation has been generated to support the cee deduction during that taxable year. it then describes a way to measure and carry over excess capital creation and investment concurrently, in separate tracks, to succeeding taxable years, so that they may be added to new capital creation and equipment investment that occurs in those succeeding taxable years. annually, investment in equipment would be allowed to be expensed to the extent excess tax capital creation has occurred previous to that taxable year of investment, as well as concurrently during the current taxable year in which that new investment occurs. on the separate concurrent track, equipment investment in a given taxable year that exceeds the amount of tax capital both carried over and created concurrently during that taxable year, would be carried over to succeeding taxable years and tested for immediate expensing deduction, based on the amount of current and cumulative tax capital creation that is available then. part vi of the article offers preliminary observations on how cee can be implemented and administered within our current tax base. it first looks at areas of possible administrative simplification. these include how to aggregate equipment investment; how to compute tax capital formation broadly, but efficiently; and how to simplify record-keeping. it also offers thoughts on how capital equipment expensing can simplify tax accounting, as well as reduce the cost of administration and compliance. cee also offers an opportunity to simplify the complex area of asset dispositions. it should be possible to simplify, if not completely repeal, the provisions that deal with depreciation recapture, as well as gain or loss characterization, at the time of equipment asset dispositions. finally, as a preliminary thought, it might be possible to eliminate the application of the alternative minimum tax to equipment investments that are subject to capital expensing. part vi also briefly discusses two other areas of possible administrative complexity, such as defining the scheduler contours of cee administration, and defining the proper treatment of debt financing of equipment purchases. part vii analyzes the comparative characteristics of cee as a systemic level agent of capital creation, capital formation, and revenue production. it 2006] capital equipment expensing 223 21. realization basically refers to the acquisition of wealth or consumption rather than a mere increase in the value of those items. realized changes of wealth are usually evidenced by a conversion of an asset into money or other property differing materially in kind or extent from the asset itself. see regs. § 1.1001-1(a). 22. imputed income is the consumption of self-produced goods or services, or the use of personally or family owned property. it is generally excluded from the tax base as a matter of administrative convenience. 23. for a brief, thorough and fascinating history of the evolution of “mark-tomarket” tax accounting for commodities and securities dealers in the united states, see book-tax conformity and the corporate tax shelter debate: assessing the proposed § 475 mark-to-market safe harbor, linda m. beale, 24 va.tax.rev. 301, 323-301 (2004) finds that capital equipment expensing would provide the best combination of capital formation and revenue production of any current cost recovery method. in addition, it would produce the same amount of capital formation as full expensing at high earnings levels, but more revenue than full expensing at lower earnings levels. this article concludes that overall, cee can be a tax-sustaining, economic capital-generating engine, which produces more tax capital bang for every revenue dollar lost than any current cost recovery or equipment expensing provision. and, although we have not yet moved to full expensing, it is the best engine for both revenue sustenance and capital formation that we could have for equipment cost recovery during this critical period of tax reform transition today. ii. taxing equipment investment in a realization-based income tax a. realization, basis and earnings-financed investment for purposes of this article, a realization-based income tax (rbit) will be viewed simplistically as an accretion-measured income tax (amit) with a realization requirement superimposed on amit base structural principles. therefore, the rbit base can be represented by the following variation of the haig-simons definition of economic income where r represents the realization requirement. 21 equation 1: formula defining a realization-based income tax rr ri = c + dw although realization may seem like a mere tax base accounting convention, it has substantial structural implications. for example, under traditional u.s. income tax principles, imputed income is not included in the tax base; nor are interim fluctuations in the value of property.22 23 224 florida tax review [vol.7:4 24. “[i]f the taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit. the calculation of the profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a fair market value.”) glen arlen kohl, the identification theory of basis, 40 tax l. rev. 623, 624625 (1984-1985) (quoting h.r. rep. no. 704, 73d cong., 2d sess. 13 (1934), reprinted in 1939-1 c.b. (part 2) 554, 564 (emphasis added)). 25. see c.f.r. § 1.1012-1(a) (2003) (defining the basis of property as its cost, the cost being “the amount paid for such property in cash or other property,” subject to exceptions). but cf. kohl, supra note 25 (opining that basis in terms of cost is a misconception and proposing a new system of classifying transactions according to whether the code defers calculation of any realized gain or loss, a system thought to be more useful for understanding basis than the current system of distinguishing transactions according to whether realized gain or loss must be recognized). the greatest difference between an amit and a rbit for purposes of the analysis undertaken in this article, is the use of tax basis rather than the initial value of an asset as an initial element for measuring net income. in an amit base, assuming a non-bargain purchase, tax base accounting begins with the value of an asset, such as equipment, at acquisition. assuming the purchased equipment has the same value as the amount paid for it, all subsequent increases or decreases in the tax base stem from net changes in the equipment’s value from one taxable period to another. in a rbit base, however, income does not enter the tax base until a realization event such as a sale or exchange occurs, often after several taxable periods have transpired. the baseline for measuring the net amount of income24 to be taxed at that time depends upon the relationship between the amount realized and the initial amount paid for the equipment, as represented by its tax basis. tax basis is widely viewed to be that amount which corresponds to the amount invested in the equipment by the taxpayer at its acquisition.25 however, in one key way, a rbit base is identical to an amit base. a rbit is still an “income” tax rather than a consumption tax. therefore, in a manner similar to amit base treatment, but in contrast to cash-flow income tax (cfit) base treatment, the act of investing earnings does not structurally decrease a rbit base. as a result, as a practical matter, equipment purchases financed from current earnings must ultimately come from after-tax or concurrently-taxed dollars. the overall operation of an rbit base with respect to invested earnings can be illustrated using the following example. example 1 – a rbit base taxpayer who has annual net income of $200,000 purchases equipment costing $100,000. the tax rate is 40%. because a rbit base fully taxes invested earnings, the taxpayer is only able to invest the after-tax dollars that remain after paying (or setting aside) $80,000 in tax. that after-tax dollar investment can never exceed $120,000. in this case the taxpayer 2006] capital equipment expensing 225 26. the formula for nascent tax capital creation can be expressed as cap = e x (1-t), where e represents net earnings, and t represents the tax rate. see definition and discussion of nascent tax capital, supra note 5, and accompanying text. see also, infra note 73 and accompanying text. 27. as a practical matter, the atcoi for the $100,000 investment is really only $40,000. the theoretical definition of after-tax cost of investment (atcoi) is the amount of tax concurrently imposed ($40,000) on the amount invested ($100,000) in order to generate the amount invested in after-tax dollars. 28. “whatever difficulty there may be about a precise and scientific definition of ‘income,’ it imports . . . something entirely distinct from principal or capital either as a subject of taxation or as a measure of the tax; conveying rather the idea of gain or increase. . . . understanding the term in this natural and obvious sense, it cannot be said that a conversion of capital assets invariably produces income. if sold at less than cost, it produces rather loss or outgo. . . . in order to determine whether there has been gain or loss, and the amount of the gain, if any, we must withdraw from the gross proceeds an amount sufficient to restore the capital value that existed at the commencement of the period under consideration.” doyle v. mitchell brothers co., 247 u.s. 179, 185 (1918). pays $80,000 in tax, purchases equipment for $100,000 and retains $20,000 after tax. three characteristics of rbit base capital income taxation are revealed in this example. first, the taxpayer has created $120,000 of nascent tax capital and made it available for investment in equipment, simply by concurrently generating $200,000 of net business pre-tax income during the taxable year. this article terms this process the “tax-capital creation” process.26 second, the taxpayer has formed $20,000 of new tax capital after investing and paying tax on his net post-investment income. this article terms this normative or prototypical taxation of earnings and generation of after-tax dollars for investment as “tax capital formation.” third, a rbit base taxpayer (subject to a 40% tax rate) with $200,000 of current earnings will have to pay up to $80,000 of tax in order to make up to $120,000 of new “tax capital” available to purchase equipment. this article terms this process the after-tax cost of investment (atcoi).27 the notion of “tax capital” used in this article merely puts a name to what is clearly a long-standing and fundamental structural principle of the u.s. realization-based income tax – capital. that the notion of tax capital formation28 dovetails with the realization requirement can be seen in the context of § 226 florida tax review [vol.7:4 29. “the gain from the sale or other disposition of property shall be the excess of the amount realized there from over the adjusted basis provided in § 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.” irc § 1001(a). 30. “gain realized on the sale or exchange of property is included in gross income, unless excluded by law. . . . the specific rules for computing the amount of gain or loss are contained in § 1001 and the regulations thereunder.” regs. § 1.61-6(a). 31. irc § 1001(a) (2000). 32. “the general method of computing such gain or loss is prescribed by § 1001(a) through (d), which contemplates that from the amount realized upon the sale or exchange there shall be withdrawn a sum sufficient to restore the adjusted basis prescribed by § 1011. . . . the amount which remains after the adjusted basis has been restored to the taxpayer constitutes the realized gain.” 26 c.f.r. § 1001-1(a) (2002). 33. see charles terry, supra note 1, at 500. “as an asset (or its successor) moves through the tax system, its tax basis moves along with it as an ongoing measure of the continuing amount of after-tax (or already-taxed) dollars invested in the asset. when a taxable disposition occurs (one in which gain or loss is both realized and recognized), the difference between the original basis (plus or minus any adjustments to that basis allowed for certain intervening events) and the amount realized produces either an increase or a decrease in the taxable income of the taxpayer disposing of the asset at that time.” id. see also kohl, supra note 26, at 631 (stating, “the role of basis as the measure of prospective tax exemption sheds light on the nature of gain and loss realized . . . under § 1001”). 34. see e.g., allied corp. v. u.s., 685 f.2d. 396, 404 (ct. cl. 1982) (citing § 1001(a) in stating “[t]he internal revenue code provides that a taxpayer is entitled to a tax-free recovery of his capital investment”); brea canon oil co. v. comm’r, 29 bta 1134, 1137 (1934) (stating “[i]t is well established that allowances for depreciation are based upon the principle that a taxpayer is entitled to tax-free recovery of his capital investment”). for examples of how the tax-free recovery of capital concept is so basic to the federal income tax law that it has been permitted in situations in the absences of explicit statutory authorization, see clark v. cir, 40 bta 333 (1939) (allowing a taxpayer who was reimbursed by a tax adviser for an error resulting in an overpayment in a prior year to exclude the amount from his gross income); cox v. kramer, 88 f.supp. 835 (d. conn. 1948) (permitting a taxpayer to exclude a grant, even though the legal expenses for which he was reimbursed were deducted when incurred); raytheon prod. corp. v cir, 144 f.2d. 110 (1st cir.), cert denied, 323 us 779 (1944) (recognizing that a taxpayer whose business goodwill is tortiously destroyed by a 1001(a) of the internal revenue code. that provision prescribes the method29 for computing the amount of the “gains derived from dealings in property” that section 61(a)(3) includes in the gross income of all taxpayers. section 1001(a)30 simply states that “[t]he gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain.” the regulations under section 100131 make clear, however, that the “adjusted basis” represents amounts which a taxpayer must be allowed to “recover” tax-free. both commentators and the32 33 courts have suggested that one of the chief rationales for the tax-free recovery34 2006] capital equipment expensing 227 competitor is taxable on damages paid by the wrongdoer only to the extent the recovery exceeds the cost or other basis of the lost goodwill). 35. see e.g., philadelphia park amusement co. v. united states, 126 f.supp. 184 (ct.cl.1954) (holding that where the value of the property given up differs from the value of the property received, the taxpayer’s basis in the property received is its value). 36. see regs. § 1.61-2(d)(1). 37. where an employee makes a bargain purchase from her employer, the regulations prescribe a total basis in the purchased property that consists in part of the amount paid in after-tax dollars and in part the amount of compensation gross income (the excess of the value of the in-kind compensation over its adjusted basis), which is treated as tax capital. see regs. § 1.61-2(d)(2). 38. see e.g., regs. § 1.167(a) – 1. section 167(a) provides that “a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business or of property held by the taxpayer for the production of income shall be allowed as a depreciation deduction.” the accelerated cost recovery system (acrs) and the modified accelerated cost recovery system (macrs) are two different depreciation systems currently in use. acrs was introduced by the economic recovery tax act of 1981 in order to stimulate capital formation and simplify cost recovery. depreciation under acrs is calculated by determining the asset’s basis, and multiplying the unadjusted basis of the asset by the appropriate recovery percentage for the tax year. the cost of acrs property is generally recoverable in 3, 5, 10, 15, 18, or 19 years, with most personal property in the 3-year or 50-year class. macrs was introduced by the tax reform act of 1986 and is a different system of deducting the of amounts paid for property through the operation of section 1001(a) is that this computation allows taxpayers to recover tax-free all previously-taxed dollars that were invested in the property. a similar rationale applies to the notion of what has been called “tax cost” basis in situations involving methods of property acquisition other than purchase. in circumstances where property is acquired through the medium35 of an event that causes gain recognition and results in a “stepped up” cost basis to the person acquiring the property, some or all of the amount credited to the asset’s basis consists of contemporaneously taxed dollars rather than after-tax dollars. for example, if a taxpayer receives equipment worth $100,000 as compensation for services provided to his or her employer, the fair market value of the equipment becomes the taxpayer’s cost basis in the equipment.36 the justification for including $100,000 in the basis of the equipment is that the taxpayer has been taxed once on that amount upon receipt of the equipment, and should not be taxed on that amount again if the asset is later disposed of in a taxable transaction involving section 1001.37 b. capital cost recovery in the case of many assets, the internal revenue code prescribes an alternative manner of recovering basis tax-free prior to an asset’s disposition, and that is through depreciation or cost recovery deductions. specifically,38 228 florida tax review [vol.7:4 cost of tangible depreciable property. to calculate depreciation under macrs, one must use 1) the applicable depreciation method; 2) the applicable recovery period; and 3) the applicable convention. macrs has two depreciation systems: macrs general depreciation system (gds) and macrs alternative depreciation system (ads). using gds, each class of property has an applicable depreciation method, such as the 200% declining-balance method, the 150% declining-balance method, and the straight-line method. the ads system uses straight-line. a half-year or mid-quarter convention applies to personal property, and a mid-month convention applies to real property. in contrast to acrs, under which an annual deduction is generally a constant percentage of unadjusted basis, macrs may require basis adjustments to compute subsequent years’ deductions identifying the class to which the asset belongs and the recovery period and statutory recovery percentages corresponding to the class. acrs was supplementary to a general 10 percent credit for the cost of most tangible personal property and other categories of property; therefore, merely comparing macrs rules to acrs rules does not allow for a meaningful analysis of differences in tax effects. 39. irc § 167(a) (2002). 40. see e.g., fiddlers on the tax: depreciation of antique instruments invites reexamination of broader tax policy, 13 am.j.tax pol’y 87 (1996). “the place of the depreciation allowance in the united states income tax regime has always been somewhat anomalous. in a transaction-based income tax regime that generally does not account for gains or losses until they have been realized, the estimated decrease in an asset’s value resulting from physical deterioration is accounted for even in the absence of any realization event. the depreciation allowance exists, at least in principle, to bring the measure of realization-based taxable income more in line with the economic measure of income, as it would be determined by mark-to-market accounting. nevertheless, the putative decrease in depreciable assets’ value is reflected in taxable income according to accounting conventions that have never traced the assets’ actual; decline in value. in fact, the depreciation allowance has long tended to be accelerated in some degree relative to economic depreciation. it thereby inches the taxation of businesses closer toward a consumption tax, in which the cost of an investment assets is deducted in the year incurred.” id. at 87. 41. the “business income” from which tax-free recovery occurs need not be generated exclusively by the asset itself. section 167(a) states that “there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including obsolescence) of property used in the trade or business or of property held for the production of income.” the theory of cost recovery has been discussed39 extensively elsewhere, but for purposes of this article, it can be viewed as a40 means of recovering the after-tax dollars (or other form of “tax capital”) invested in a depreciable asset tax-free from business income generated at some point over the course of its useful life, rather than exclusively from the amount realized resulting from a disposition of the asset at the time realization occurs.41 throughout most of its history, the u.s. income tax has prescribed systems of “reasonable allowances” that follow certain mathematically uniform 2006] capital equipment expensing 229 42. for example, straight-line depreciation is calculated by dividing the original cost of the asset less salvage value (if any) by the expected useful life of the asset. sumof-the-years’-digits depreciation is calculated by multiplying the depreciable value of the asset (which is original cost less salvage value) by the ratio of the remaining number of years over the sum of the digits (the sum of the digits can be expressed by the formula n(n+1)/2). double-declining balance method of depreciation basically allows deductions equal to 200% of straight line deductions. 43. see regs. § 1.167(a)-1(a). formulae. as regulation 1.167(a)-1 notes, however, “the allowance is that42 amount which should be set aside for the taxable year in accordance with a reasonably consistent plan (not necessarily at a uniform rate), so that the aggregate of the amounts set aside, plus the salvage value, will, at the end of the estimated useful life of the depreciable property, equal the cost or other basis of the property as provided in section 167(g) . . .”(emphasis added). this43 language suggests two things: first, that a cost recovery allowance may take place all in one year in the form of an immediate total capital recovery deduction, and second, that the amount of total cost recovery deductions, in whatever form it takes, should equal the amount of “tax capital” invested in the asset. the open question is whether the structure of a rbit requires that the total restoration of capital investment only occur at the “end of the estimated useful life of the depreciable property?” c. interim findings overall, one can now state three broadly-defined fundamental principles of a realization-based income tax: 1) realization necessitates capitalization, 2) capitalization requires capital recovery, and 3) capital recovery should equal and consist of capital available for recovery. the theory of “capital expensing” espoused by this article is that when “tax capital” is recovered tax-free through expensing deductions, the amount recovered tax-free should equal (but not exceed) the amount of tax capital invested in the asset. conversely, the amount of an asset’s cost that is allowed to be expensed, should not exceed the amount of “tax capital” available to be invested in the asset at the time of the investment. the combination of these principles, as applied to equipment, constitutes what i call “normative capital equipment expensing in a realization-based income tax.” 230 florida tax review [vol.7:4 44. see table 1, terry, supra note 1, 477-80, and accompanying discussion. see esp., 479, note 33. 45. the maximum amount that may be invested from earnings in a tax base is the amount of investment for which the tax burden plus the amount invested equals the total earnings available. in other words earnings equals investment plus tax (e = i + m axt). therefore, maximum investment equals earnings minus tax. (i = e t ). in a consumption tax base, the tax is imposed on consumption which equals earnings minus savings, such as investment. (c = e – i). therefore, the maximum m axamount of investment in a consumption tax base equals total earnings. (i = e). where m axall earnings are invested, no tax is imposed, so (i = e). in an income tax base, however, income equals the sum of consumption plus changes in wealth. (i = c + äw), pursuant to the haig-simons definition. therefore savings, such as investments in equipment, do not reduce the income tax base. therefore, it can be said that investments must be made with after-tax dollars, because investment represents a change in the form of wealth, rather than in the amount of a taxpayer’s wealth. iii. tax capital creation and tax capital formation in the u.s. rbit base a. loss offsets and the impact of various cost recovery methods on pre investment tax capital creation if economic depreciation could be used as a rbit base cost recovery method and applied to the facts in example 1, that cost recovery method would offset no current earnings in the year of investment, and the equipment purchase would be made entirely from pre-investment tax capital. the maximum44 investment of tax capital available for investment with such a “no loss-offset” cost recovery method ($120,000 in the above example) would exactly match the amount of tax capital created after all current earnings were concurrently taxed. in contrast, partial and full-offset expensing cost recovery methods do offset contemporaneous earnings, and this produces two significant and related taxdriven consequences. the first consequence of a cost recovery method that causes a loss offset against contemporaneous earnings is an increase in the amount of preinvestment tax capital that can be created from a given amount of earnings. as a practical matter this means that the maximum amount of nominal investment that can be made from a given amount of current earnings in a rbit base increases as the amount of loss offset created by a given cost recovery method increases. the structure of a given tax base with respect to capital income taxation determines the maximum amount of economic capital that may be invested within that particular tax base, given identical economic contexts. cost45 recovery can take one of many different forms in a rbit base. therefore, which form of cost recovery is applied to a given equipment purchase determines how much economic capital can be invested in equipment from a given amount of 2006] capital equipment expensing 231 46. zero loss-offset cost recovery methods produce no deduction in the year of equipment acquisition which offsets taxable income other than that generated by the equipment investment itself. under conventions adopted in this article, only the economic depreciation and acrs cost recovery methods produce a zero loss-offset in the year of acquisition. see table 2 infra, and accompanying discussion. 47. this article uses the term “partial expensing” to refer to the 50% bonus depreciation deduction which was allowed under irc § 168(k) until jan. 1, 2005, in which a “50% bonus depreciation” deduction was allowed in the year in which some property was placed in service. see supra note 13. 48. for a detailed discussion of the financial principles supporting and illustrating this statement, see terry, supra note 1, at 477 – 80. see also, terry, current earnings. rather than one maximum amount of tax capital that may be invested from current earnings, rbit base cost recovery methods create a spectrum of “maximum tax capital thresholds” within a rbit base. the following table 1 shows the maximum amount of pre-investment tax capital that is possible in a rbit base using three cost recovery methods: zero loss-offset cost recovery methods, partial expensing, and full expensing.46 47 from left to right, the second and third columns of the table show the formula for the tax base, taking into account the effect of each cost recovery method, and the formula for determining the maximum possible economic capital investment, using each cost recovery method. the fourth through sixth columns apply the formulas to investments made from $200,000 of earnings using a 40% tax rate. those columns show the amounts of the earnings, maximum investment, and tax paid for those investments, when subject to each of these three cost recovery methods. the seventh column proves that the formula produces the correct result by showing that the sum of the investment (i) and tax paid (t) equals earnings (e), the necessary source of both payments. table 1: comparison of maximum investment amounts allowed by various rbit cost recovery methods (1) cost recovery (2) tax (3) maximum (4) earnings (5) maximum (6) tax (7) invest + method base investment investment paid tax = earnings 0 offset e e (1 t) 200 120 80 120 + 80 = 200 50% expensing e .5i e (1 t)/1-.5t 200 150 50 150+50 = 200 full expensing e i e (1 t)/ 1-t 200 200 0 200 + 0 =200 as the first row of table 1 shows, when a cost recovery method that produces no loss offset (economic depreciation) is applied to an earningsfinanced equipment purchase, the formula for determining the maximum amount of investment possible from earnings is identical to that for economic maxdepreciation within an amit base: amit i = e x (1 – t). because such a cost recovery method produces no loss offset in the year of investment, the48 232 florida tax review [vol.7:4 leverage-financed tax arbitrage: a structural and accounting analysis, 7 am. j. tax pol’y 109 (1988). 49. irc § 168(k). job and growth tax relief reconciliation act of 2003, pub. l. no. 108-27, 117 stat. 752 (2003). the 50% additional depreciation allowance is applied in much the same way as the 30% allowance granted by congress in 2002. property must qualify as per the 2002 provisions in § 168(k). as long as the property meets the preceding acquisition and placed-in-service dates, any property that fulfilled the requirements for the 30% bonus depreciation deduction qualifies for the 50% additional depreciation. see supra note 13, for expiration date information. 50. regs. § 1.168(k)-1t(d)(2). the remaining adjusted depreciable basis of the qualified property or the 50% bonus depreciation property is then depreciated using the applicable depreciation provisions under the internal revenue code for the qualified property or the 50% bonus depreciation property. the remaining adjusted depreciable basis of the qualified property or the 50% bonus depreciation property that is macrs property is also maximum amount that may be invested equals the amount remaining after earnings have been concurrently taxed. that amount is expressed as e (1 – t). given $200,000 of earnings and a 40% tax rate, for example, $120,000 is the maximum amount remaining after those earnings are taxed and thus is also the maximum amount that may be invested in equipment that is subject to economic cost recovery. when a cost recovery method that does produce a loss offset against earnings is employed (macrs), the increase in the tax base represented by the receipt of earnings is offset to some extent by the immediate reduction in the tax base caused by any loss offset created by the cost recovery method. where full loss offset expensing is allowed, as shown in row 3 of table 1, the after-tax amount available after the tax base increase [e x (1 – t)] minus the after-tax amount available after the tax base decrease [i x (1 – t)] should equal zero if all earnings that are not devoted to tax payments are invested. thus; equation 2: maximum economic capital investment with full expensing e (1 – t) – inv (1 – t) = 0 this equation is solved for i as follows: inv (1 – t) = e (1 – t) inv = e (1 – t)/(1 – t) inv = e thus a rbit base that allows full loss offset expensing may allow a taxpayer to invest all current earnings rather than simply the amount remaining after earnings are taxed. as table 1 shows, all $200,000 of earnings in our example may be invested if full loss offset expensing is available. finally, under the recently expired partial expensing method, only 50% of amounts invested in equipment may be expensed under certain conditions.49 the balance of the cost must be recovered through macrs deductions.50 2006] capital equipment expensing 233 the basis to which the annual depreciation rates in the optional depreciation tables apply (for further guidance, see § 8 of rev. proc. 87-57 (1987-2 c.b. 687) and § 601.601(d)(2)(ii)( b) of this chapter. the depreciation deduction allowable for the remaining adjusted depreciable basis of the qualified property or the 50% bonus depreciation property is affected by a taxable year of less than 12 months. id. see also, regs. § 1.168(k)-1t(e)(2) ex. 2. 51. $200,000 $150,000 = $50,000 which is the exact amount of the tax liability. thus the entire positive cash flow is absorbed by the exact sum of the investment and the tax payment. 52. as table 1 showed in columns 1 (cost recovery method), 5 (maximum investment), and 6 (tax paid), the more loss-offset is created by a cost recovery method, the less tax is paid by a fixed amount of investment subjected to that recovery method. the relevant columns are reproduced below. cost recovery method maximum invest tax paid 0 offset 120 80 50% expensing 150 50 full expensing 200 0 where only 50% partial expensing is allowed, the maximum amount available after the tax base increase [e x (1 – t) minus the after-tax amount available after the tax base decrease [inv x (1 – .5t)] should equal zero if all earnings that are not devoted to tax payments are invested. thus; equation 3: maximum economic capital investment with partial expensing maxe (1 – t) – inv (1 – .5t) = 0 this equation is solved for i as follows: maxinv (1 – .5t) = e (1 – t) maxinv = e (1 – t)/(1 – .5t) as the second row in table 1 shows, when partial expensing is employed, the maximum amount that may be invested from current earnings while allowing the tax on earnings to be paid is $150,000. the partial expensing deduction for that investment equals 50% of that amount or $75,000. taxable income therefore is $125,000 ($200,000 minus $75,000). the tax liability equals 40% of that amount or $50,000. if one subtracts the amount of the equipment purchase ($150,000) and the tax liability ($50,000) from the earnings, the remainder is zero, proving that $150,000 is the maximum amount of expensed investment that may be made under these circumstances.51 as table 1 shows and the previous discussion explains, the greater the amount of loss-offset produced by a recovery method, the greater the amount of economic capital investment can occur. table 1 also shows that the greater the amount of loss-offset and investment created by a cost recovery method, the less tax is paid.52 234 florida tax review [vol.7:4 53. $200,000 of earnings minus $100,000 invested in equipment minus $40,000 in tax paid. 54. see tables 1, 2 and 3 in terry, supra note 1, 478-482. 55. the most significant assumption made in both the previous article and this one is that a certain amount of income is produced by the purchased equipment, both over the equipment’s useful life, and in the year of purchase. in the model used in the first article, the yield rate of the investment equaled the pre-tax discount rate used to determine the financial characteristics of “break-even investments” when subject to a variety of cost recovery methods. in the framework of this model, the income produced by the purchased asset in the year of purchase was more than the first year cost recovery deductions allowed under the economic and acrs cost recovery methods. thus neither of those cost recovery methods created a “loss offset” in the year of purchase. however, macrs created a very small loss offset. since current partial expensing allows a 50% “bonus depreciation” deduction, in addition to normal macrs deductions on the remaining 50% of the purchase price, this article makes the simplifying assumption that the entire partial expensing deduction offsets earnings. b. loss offsets and the impact of various cost recovery methods on post investment tax capital formation the second consequence of a cost recovery method that causes a loss offset in a rbit base is a decrease in the amount of post-investment tax capital that may be formed from a given amount of earnings. full expensing, for example, offsets taxable income dollar-for-dollar and therefore decreases the amount of post-investment tax capital formed when earnings finance equipment purchases. example 2: a taxpayer with $200,000 in earnings that is subject to a 40% tax rate creates $120,000 of tax capital during a taxable year in which she purchases equipment for $100,000 and expenses the cost. that taxpayer’s taxable income is reduced to $100,000 and the $40,000 tax liability is paid. the taxpayer’s after-tax cash flow is $60,000, which constitutes new tax-capital53 formation. each cost recovery technique currently employed in the united states offsets a different amount of invested earnings and therefore has a different economic impact on the tax capital formation process. the following table is derived from my previous article and shows the amount of tax capital that is54 formed under various cost recovery methods when equipment is purchased for $100,000 under certain financial conditions. the tax rate remains at 40% in all55 cases. 2006] capital equipment expensing 235 56. all of the figures are derived from a spreadsheet investment model of a $100,000 investment that is subject to the various cost recovery methods shown. the term “loss offset” occurs when the act of investing creates a deduction or deductions that offset income from sources other than the investment itself during the taxable year in which the investment occurs. under the assumptions used in table 2, acrs and macrs offset non-asset income in subsequent years, but only macrs creates immediate tax savings in the year of investment. for a fuller explanation of the methodology underlying table 2, see terry, normatic cost recovery policy for a realization-based income tax at pages 477-79 in note 1. 57. earnings – loss offset. 58. earnings – investment minus tax paid. 59. earnings – loss offset x (1 t), supra example 1 and accompanying discussion. table 2: comparative amounts of tax capital formed by various rbit cost recovery methods recovery loss tax tax method earnings investment offset t.i. paid atcf formed56 57 58 59 economic 200,000 100,000 0 200,000 80,000 20,000 20,000 acrs 200,000 100,000 0 200,000 80,000 20,000 20,000 macrs 200,000 100,000 1,780 198,220 79,288 20,712 20,712 50% par tial exp 200,000 100,000 50,000 150,000 60,000 40,000 40,000 full expg 200,000 100,000 100,000 100,000 40,000 60,000 60,000 table 2 shows, the amount of post-investment tax capital that can be formed in a rbit base in the year a fixed amount of earnings is invested also depends directly on the cost recovery method employed. for a given amount of investment, economic cost recovery produces the least post-investment tax capital (e.g., $20,000 in table 2), and expensing produces the most (e.g., $60,000 in table 2). these results stem from the fact that economic cost recovery produces no loss offset in the year earnings are invested, while full expensing produces a loss-offset equal to the entire amount invested. partial expensing creates a loss offset that falls in between the extremes of economic cost recovery and full expensing ($50,000), and thus allows the formation of an amount of tax capital that falls in between the amounts created by those recovery methods as well.(e.g., $40,000). overall, there is a direct relationship between the amount of loss offset produced by a given cost recovery method and post-investment tax capital formation: the greater the loss offset a cost recovery method produces, the more tax capital that cost recovery method causes to be formed, after tax, relative to other cost recovery methods. this increase in post-investment tax capital formation is shown by the increased after-tax cash flow and the corresponding decrease in tax paid in table 2. 236 florida tax review [vol.7:4 60. while unlimited full expensing is rarely proposed in congress, a history of proposed legislation shows assorted attempts to increase the taxpayer’s ability to more fully expense equipment, particularly in the realms of small business and agriculture. e.g., h.r. 2264, 103rd cong. (1993) (originally proposing to increase the limitation on expensing certain depreciable business assets for small businesses, but enacted with an increase in the limitation only for enterprise zone business); h.r. 3824, 102nd cong. (1991) (“allow[ing] a business expense deduction for up to $250,000 ([then only] $10,000) of depreciable business assets if property is used as an integral part of manufacturing, production, or extraction”); h.r. 5493, 101st cong. (1990) (“amend[ing] the internal revenue code of 1986 to allow smalland medium-sized manufacturers to expense certain acquisitions of productive equipment”); s. 3042, 98th cong. (1984) (“permit[ting] the taxpayer to take a deduction with respect to expensemethod property in the year it is placed in service equal to the basis of such property”); h.r 3443, 97th cong. (1981) (proposing an amendment to the internal revenue code of 1954, “provid[ing] a capital cost recovery method which combines the investment credit with the depreciation deduction in a first-year allowance”). 61. in 1996 congress passed the small business job protection act, pub. l. no. 104-188, 110 stat. 1755, that which raised the dollar limitation on expensing to $25,000 from $17,500 and provided a year-by-year increase through 2003 to facilitate its implementation. h.r. 3448, 104th cong. (1996). in 2002, congress passed the job creation and worker assistance act of 2002, pub. l. no. 107-147, 116 stat. 21 (2002), act § 101(a) (adding irc § 168(k)). this act provided certain taxpayers with a first-year “bonus depreciation” deduction equal to 30% of the cost of equipment placed in service after september 11, 2001. id. finally, in 2003, congress passed the jobs and growth tax relief reconciliation act of 2003 pub. l. no. 108-27, (2003), 117 stat. 752. act § 201 increased the amount of “bonus depreciation” to 50% of the cost of equipment iv. structural capital creation, formation and recovery issues created by current equipment expensing schemes under current (and/or recent) equipment expensing provisions, the amount of a taxpayer’s expensing deduction bears no necessary relationship to the amount of tax capital created and actually invested in expensed equipment by the taxpayer. this frequently creates one of two tax base structural problems depending upon the specific characteristics of a given equipment purchase: 1) the ability to recover pre-tax earnings tax-free on one hand and 2) the inability to recover invested tax capital tax-free on the other. an examination of the various forms of expensing that are allowed under current or recent law illustrates how each current form of expensing raises one or both of these issues. a. unlimited full offset expensing unlimited full offset expensing is not currently prescribed with respect to equipment purchases under the internal revenue code. however, in recent60 years there has been growing support in congress for increasing the cap on equipment expensing deductions. nonetheless, the structural problems that61 2006] capital equipment expensing 237 purchased in tax years ending after 2003. act § 202 increased the amount of equipment expensing deduction under irc § 179 to $100,000 for taxable years 2003 through 2005. id. § 202. 62. see supra example 2 and accompanying text. 63. if expensing were not available, the taxpayer would have to pay $40,000 in tax on her earnings and would only be able to purchase $60,000 in equipment using pre-investment tax capital. 64. during testimony before the president’s advisory panel on federal tax reform, two experts discussed depreciation rules and capital cost recovery in tax reform. kevin a. hassett, of the american enterprise institute, testified that, because recent studies indicated the economic cost resulting from the differential tax treatment of capital goods is relatively inconsequential, almost all of the benefit from revising depreciation rules would come from the associated reduction of the tax on capital income, if depreciation allowances were expanded in the direction of expensing, and not from an improved allocation of business investment across assets. on the other hand, andrew b. lyon, of pricewaterhousecoopers, llp testified that, if tax depreciation is not neutral, capital will be allocated inefficiently. the cost of an inefficient allocation of capital is fewer goods and services being produced than is otherwise achievable. he further testified that the efficient allocation of capital requires either expensing or tax depreciation that is related to economic depreciation for equityfinanced investments. in comparing the two systems, he pointed out that the difficulty of ascertaining true economic depreciation requires extensive initial study and constant monitoring. expensing, on the other hand, requires fewer factual determinations. would be created by full loss offset expensing can be seen in a microcosm within the confines of recently expanded section 179, a limited equipment expensing provision, under certain circumstances. section 179 currently allows certain taxpayers to expense up to $100,000 of equipment purchases in a taxable year, provided that this amount does not exceed the taxpayer’s trade or business income for the year, and provided that the taxpayer has not purchased more than $400,000 of equipment during that same year. a taxpayer in the 40% bracket who has exactly $100,000 of net income from her trade or business for a year in which she purchases $100,000 of equipment may expense the entire cost of the purchase, thus zeroing out her trade or business income and paying no tax. as shown above,62 the taxpayer recovers the entire cost of the equipment ($100,000) tax-free from untaxed earnings and generates $60,000 of post-investment tax capital. the net cost of the equipment to the taxpayer after tax is only $40,000, because there is a negative 40% effective tax rate on the pre-tax earnings invested in the equipment.63 the economic results produced by unlimited full-offset expensing are based on conscious policy reasons, but this would be consumption, not64 income, taxation structurally and, therefore cannot serve as normative capital creation or equipment expensing for a transition realization-based income tax. 238 florida tax review [vol.7:4 65. over-expensing would occur to the extent investment exceeded the natural capital creation threshold for full expensing. based on $400,000 of earnings, that threshold would be $240,000. any equipment purchase in excess of that amount would begin to offset pre-tax income, instead of nascent pre-investment tax capital, and, therefore, constitute non-normative rbit treatment. 66. see temp. regs. § 1.168(k)-1t(a)(2)(iii). 67. section 179(b)(1), the expensing deduction, is limited to $100,000. however, § 168(k) also allows a 50% bonus depreciation deduction for the remaining uncovered cost of $100,000, thus allowing a total first year deduction of $150,000. 68. $400,000 earnings minus the $150,000 expensing deduction equals taxable income of $250,000 x the 40% tax rate equals $100,000. 69. $400,000 of earnings minus $200,000 (equipment purchase) minus $100,000 (tax paid) equals $100,000. 70. see terry, cost recovery, supra note 1, at 488-494. 71. under the facts of example 3, where $400,000 of earnings were subject to a 40% tax rate. b. limited and/or partial offset expensing 1. under-expensing while section 179 may cause the exemption of untaxed income (“overexpensing”) under some circumstances, it is also likely to deny an expensing65 deduction for actual capital investment (“under-expensing”) in many other circumstances. example 3: a taxpayer who is eligible for section 179 expensing has $400,000 of earnings and purchases $200,000 of equipment. despite the ability to piggyback the section 179 expensing deduction and the section 168(k) 50% bonus depreciation deduction, this taxpayer is only able to generically66 “expense” the first $150,000 of the purchase price and must recover the remaining $50,000 over the life of the investment. assuming the macrs67 deduction for the year of purchase does not produce an additional loss offset, the taxpayer would owe $100,000 in tax, and the taxpayer’s after-tax cash flow68 would also be $100,000. because only $150,000 of the equipment’s cost may69 be expensed, this taxpayer would actually create $240,000 of tax capital and invest $200,000 of it. however, the taxpayer would only recover $150,000 of that tax-capital tax-free in the year of purchase. the remaining tax-capital investment ($50,000) would eventually be completely recovered tax-free economically, but not financially, under section 168 (macrs).70 the treatment of this transaction combines normative capital expensing of the first $150,000 of invested capital, with under-expensing of the second $50,000. normative capital equipment expensing should allow complete and immediate recovery of all invested tax capital when the entire amounts invested (e.g., $200,000), do not exceed the natural tax capital creation threshold for a fully expensed equipment purchase in a rbit base under these circumstances ($240,000). the $200,000 equipment purchase in the current example is below71 2006] capital equipment expensing 239 72. after deducting $100,000 under § 179, he is able to deduct 50% of the remaining basis of $150,000 under § 168(k), which equals another $75,000, for a total first year deduction of $175,000. the capital creation threshold for a fully expensed asset under these circumstances. therefore, the purchase price consists entirely of invested tax capital and, under normative capital creation and equipment expensing principles, a deduction for the full purchase price of the equipment should be allowed. 2. over-expensing section 179 and section 168(k) combined produce under-expensing under the circumstances above, but in different circumstances, they can produce over-expensing. example 4: the same taxpayer as in the previous example has only $250,000 of earnings and purchases the same $200,000 of equipment. due to the ability to piggy-back the section 179 expensing deduction and the section 168(k) 50% bonus deprecation deduction, the taxpayer is able to generically expense the entire first $175,000 of the equipment purchase price. this72 taxpayer has only created $150,000 of tax capital, which she properly recovers tax-free; but she also offsets $25,000 of pre-tax income, which exempts that amount from tax. this transaction combines normative capital expensing of the first $150,000 of created tax capital, with over-expensing of the additional $25,000 of investment that offsets pre-tax income, and thus exempts that amount from tax. when the amounts invested in equipment exceed the natural capital creation threshold for a fully expensed asset under these circumstances, normative cee should allow only the recovery of the invested tax capital ($150,000). v. normative capital creation, equipment expensing and capital formation in a transition income tax base a. defining the problem existing equipment expensing methods in the u.s. can either deny immediate recovery of invested capital, or allow immediate recovery of untaxed earnings. this happens for two basic reasons. when expensing is limited to dollar amounts or percentages of investment in equipment, both underexpensing and over-expensing can occur. to the extent that unlimited expensing is allowed, over-expensing alone will always occur. the tax base structural problem is two-fold. first, tax capital creation is not measured or accounted for under any expensing method. second, current expensing methods are not structured to relate expensing deductions to tax 240 florida tax review [vol.7:4 73. nascent tax capital (cap) equals after-tax earnings [e(1-t)]. 74. in addition to the problems of administration, employing mark-to-market accounting at other intervals would be contrary to normative realization based income tax principles. capital creation and availability. while existing expensing methods are applied to myriads of individual transactions, the measurable economic and financial characteristic of those individual transactions, that could relate expensing deductions to capital creation, vary from taxpayer to taxpayer, and from equipment purchase to equipment purchase. those characteristics include the tax rate of the investor, the taxable income available prior to taking the expensing deduction, and the amount of equipment investment relative to taxable income. as just shown, only when actual investment falls within the variable, but precise parameters that economically determine the amount of tax capital created concurrent with that investment, can expensing deductions be sure to recover all invested tax capital tax-free, and not to recover pre-tax income. only when such accounting and matching is structurally assured can any system of equipment expensing properly reflect the normative structure and dynamics of a realization-based income tax, and its complementary principles of creating tax capital and allowing it, and only it, to be completely recovered tax-free. b. developing a basic proposal for normative capital equipment expensing 1. the basic proposal designing a system of normative capital equipment expensing starts with the notion that nascent tax capital is created concurrently with pre-tax business income or earnings during a given taxable year. nascent tax capital can be defined as the after-tax earnings potentially available at any interim point during a taxable year, and can be represented by the formula in equation 4.73 equation 4: tax capital available from earnings cap = e(1 – t) however, for administrative convenience and simplicity, i propose to measure the amount of tax capital created during a taxable year at the end of a given taxable year, also using equation 4.74 at that time, i basically propose to match the amount of investment in equipment made during the taxable year against the amount of tax capital created and available at the end of the taxable year. more specifically, i propose to aggregate all investment in section 179 property made by a taxpayer during a taxable year, and test the total amount of that investment against the total amount of tax capital created from the taxpayer’s business income during that 2006] capital equipment expensing 241 75. this basic calculation should not be inordinately difficult to administer or comply with, even for small businesses. applying this formula within a progressive rate structure will clearly allow taxpayers who are subject to lower tax rates to deduct a greater percentage of their equipment investment. several administrative and policy issues immediately pop into mind, but development of these issues are beyond the scope of this introductory article. taxable year. the amount of tax capital created and available at the end of the taxable year will also be determined by using equation 4 above.75 to the extent that, the taxpayer’s aggregate investment in section 179 property equals, but does not exceed, the tax capital creation threshold for the taxable year, as defined in equation 4, all of the taxpayer’s equipment investment for the year will be allowed as an immediate deduction under section 179. for example, in example 3, the taxpayer’s net earnings were $400,000, and she purchased $200,000 of equipment. applying equation 4, her tax capital creation threshold was $240,000. thus, she will be allowed to deduct the entire cost of the equipment under normative capital equipment expensing. 2. the treatment of excess tax capital creation or equipment investment returning to example 3, however, one also sees an example of excess capital creation. in example 3, the taxpayer’s net earnings in year 1 were $400,000, and she purchased $200,000 of equipment. again applying equation 4, her tax capital creation threshold was $240,000. thus, she was allowed a deduction for the entire cost of the equipment she purchased, and $40,000 of tax capital was left unused. if, in the following year, our example 3 taxpayer produced the outcome just described in example 4, a question would arise that illustrates the efficacy of carrying over unused tax capital. let us assume that our example 3 taxpayer’s net earnings in year 2 were only $250,000, and yet she purchased $200,000 of new equipment for her business. applying the tax capital creation formula in equation 4, our example 3 taxpayer would now be able to deduct only $150,000 of the cost of the equipment because the amount she invested exceeded the tax capital creation for year 2 by $50,000. however, if the excess tax capital created in year 1 ($40,000) was carried forward to year 2, our taxpayer would be able to expense all but $10,000 of the entire cost of the equipment purchase that took place in year 2 ($190,000). 3. the treatment of excess non-tax capital investment now, our new question becomes how to treat the $10,000 excess nontax capital investment in year 2’s equipment purchase. two options are available at first glance. 242 florida tax review [vol.7:4 76. see discussion supra note 66. 77. taxpayers would possibly have to disaggregate their equipment investments in order to apply macrs rules to different classes and types of assets. 78. see terry, supra note 1, at 487. 79. see testimony of andrew s. lyon, supra note 62. 80. in the current example 4 scenario, there is no excess capital creation carryover from the previous taxable year because the amount of equipment investment in the first year exceeded the tax capital creation threshold for that taxable year. the first alternative is to apply section 168 to the excess investment in equipment, as the irc currently prescribes. existing law under sections 16876 and 1012 does not require cost recovery deductions to consist of tax capital. however, this alternative would likely impose a significant compliance burden on both taxpayers and the government. perhaps more importantly, this77 alternative would cause unpredictable variations in the overall effective tax rate on income produced by equipment treated in this fashion. as my previous article showed, one of the benefits of equipment expensing as a recovery method is to equalize the pre-tax and after-tax rates of return from investments, making investment decisions more accurate and easier to make. this characteristic can potentially make capital expensing, as such,78 the most efficient method of cost recovery available in a rbit base. as a79 result, there seems to be no compelling policy reason for maintaining a conflicting, counterproductive cost recovery method as a default rule, in an attempt to graft the old and the new recovery systems together. furthermore, one of the goals of this proposal is to simplify this area of taxation, rather than to unnecessarily compound its complexity. the second alternative is to carryover the excess non-capital equipment investment in the current year ($10,000) to the following taxable year. it could be combined with new investment for the following year, and tested against the cumulative tax capital creation threshold for the succeeding taxable year. that cumulative capital creation threshold for the carryover year would consist of the sum of that year’s new tax capital creation plus all unused and carried over excess tax capital created during the previous year, if any.80 vi. a preliminary look at administering capital equipment expensing this part vi of the article takes a preliminary and cursory look at how the theory of capital equipment expensing might be applied and administered within our current u.s. income tax base. 2006] capital equipment expensing 243 81. see e.g., joseph m. dodge & jay a. soledad, “inflated tax basis and the quarter-trillion-dollar revenue question,” 106 tax notes 453 (jan. 24, 2005) (asserting that inflated tax basis is a widespread phenomenon with significant revenue loss implications). 82. there would be no unrecovered basis to offset any amounts realized upon whatever type of disposition was involved. equipment that has been capital expensed would have a zero basis throughout its useful life and until its disposition. as a result, only gains could be realized. 83. section 1231 would cause recognition of capital gain in most circumstances. 84. e.g., §§ 351 and 721 would provide for no gain or loss recognition upon contribution of capitalexpensed equipment to corporations or subchapter k entities. subsequent taxable or nontaxable dispositions of those assets by such business entities a. areas of possible administrative simplification 1. aggregating expensing deduction computations as suggested earlier, i propose to aggregate all of a taxpayer’s equipment investment during a given taxable year, and test that amount for immediate expensing against the amount of nascent tax capital created during that same taxable year. aggregating all equipment investment could possibly obviate the need to sub-classify many types of individual assets, to maintain as many asset specific records, and to make asset-by-asset cost recovery calculations on an annual basis. in most cases, tax payers should be able to administer and comply with this approach relatively easily, compared to the existing state of tax administration and compliance. 2. simplifying the treatment of asset dispositions dispositions of individual equipment items at any point after their acquisition would not require identifying or quantifying an adjusted basis for any item, which would always remain at zero. only gains would be realized at81 the time of such dispositions. at that time, it would not be necessary to82 characterize those gains as section 1245 gain, in whole or in part. there would be no previously taken cost recovery deductions that needed to be recaptured. the entire cost of the asset would have been recovered already at the time of its acquisition, and the recovery of the tax capital invested in it would not have offset any pre-tax earnings. currently, section 1231 would still apply, however, resulting in potential capital gain treatment of the gain resulting from any disposition.83 dispositions that utilized non-recognition provisions of the irc could be administered fairly simply as well. once equipment assets have been capitalexpensed, they will have a zero basis, which should make for smooth transfers into and out of business entities under existing law.84 244 florida tax review [vol.7:4 could be treated under existing law with no additional adjustments or computations than already required. 85. boris i. bittker & lawrence lokken, 4 federal taxation of income, estates and gifts, 111-94 (2d ed. warren, gorham &lamont 1992). 86. generally speaking, a schedular tax system is one “under which each category of income is subject to separate taxation, thereby preventing income and losses from offsetting income from other sources.” see richard a. westin, wg&l tax dictionary, (2000) (emphasis omitted). the term has been used to describe the system prescribed by irc § 469 passive activity loss limitation, under which a taxpayer’s income producing activities are divided into three “baskets” – investment income, active trade or business income, and a basket in the middle where a taxpayer’s income arises from trade or business activities in which the taxpayer does not materially participate. losses from a taxpayer’s passive activity basket are not allowed to offset income produced from either of the other two baskets. 87. the current limitations on the amount of expensing deduction ($100,000), and the maximum taxable income of taxpayers eligible to take the deduction ($400,000), are scheduled to expire on dec. 31, 2007. 3. treatment under the alternative minimum tax subject due a deeper analysis in the future, i would presently suggest that capital equipment expensing should not be subject to the amt. generally speaking, for purposes of the amt, depreciation “is computed on a less accelerated basis or over a longer recovery period,” than regular tax depreciation. the underlying rationale for the amt is that many tax85 preferences, such as accelerated depreciation, are more generous to taxpayers than the normative treatment of such items would be handled in a normative income tax base. in 2005, there is little use for the pretense that the u.s. income tax has many, if any, characteristics of a normative income tax left to buttress. i suggest that the normative treatment of investment in equipment under a realization-based income tax is capital equipment expensing as such. therefore, there is no reason to apply the amt to investments subject to cee at all. b. areas of possible administrative complexity 1. defining the scheduler contours of capital equipment expensing at first glance, there appear to be two potential types of issues that could revolve around the possible schedular contours of capital equipment expensing. the first type would be vertical schedularity, and the second type86 would be horizontal schedularity. in this context, a vertical schedularity problem would arise if i proposed to let existing law with respect to equipment expensing under section 179 continue unimpeded indefinitely. this would allow taxpayers with less than87 $400,000 per year of equipment investment to continue applying existing law. i could suggest this because the accounting and record-keeping requirements for 2006] capital equipment expensing 245 88. see e.g., equipment leasing association 2004 survey of industry activity, v (2004) (showing that only the two smallest categories of equipment lease transactions showed growth during 2003 when the deduction limit under § 179 was increased from $25,000 to $100,000). the fairly different new system that i propose will require a period of adjustment, and because the current system may be more generous to this group of taxpayers than the new system that i propose.88 although i tentatively propose to create an element of vertical schedularity within the equipment investment sector of the tax base, i am even less certain about how to respond to the potential problems of horizontal schedularity exhibited in the following two examples. example 5: abc corp. owns one factory, two retail outlets, and a small service center in a moderate sized city. the net taxable income after all deductions (except cost recovery on $200,000 of new equipment purchased for the factory) was $1 million. example 6: xyz corp. owns 10 factories, 200 retail outlets, and a service center in each of the 30 states in which it does business. its net taxable income after all deductions (except depreciation on $20 million of new equipment purchased for its factories, retail outlets and service centers combined) was $100 million. in both examples, equipment may be purchased and used in different locations, different types of businesses, different corporate divisions, or even different taxable entities, all under the ultimate direct or indirect control of one taxpayer. identifying the scope of operation of capital equipment expensing within these two examples can likely begin at the taxpayer level, whoever or whatever that taxpayer may be. abc corp. likely files one tax return, in which equipment investment from different locations and stages of production, distribution, sales and service could all be combined and administered centrally. on the other hand, an enterprise as large and compartmentalized as xyz corp. might present more challenges. xyz could consist of various lateral and/or vertical departments, divisions, or units, including subsidiary entities. defining the scope of operation of capital equipment expensing in this context will clearly require some careful additional work. fortunately, this is only a preliminary proposal, whose usefulness as such today lies largely in identifying issues that need to be addressed later on, rather than attempting to solve every conceivable problem that could arise in administering capital equipment expensing in the future. 246 florida tax review [vol.7:4 89. charles t. terry, leverage-financed tax arbitrage: a structural tax accounting analysis, 7 amer. j. tax pol’y 109-10 (1988). for broader references to discussion of the term, see id, at 110, n.2. the classic kind of tax arbitrage juxtaposes interest deductions against pre-tax income. under cee, debt financing to the extent of the maximum allowed cee deduction would only offset nascent after-tax dollars. the use of debt financing in excess of the allowable cee deduction for possible arbitrage purposes is the issue addressed by this part of the article. 90. under the assumptions used so far in this article, that amount equals the prospective capital creation threshold at the end of the taxable year of the purchase. (e – et) = (200 – [(200x.4]) = 200 80 = 120. 2. defining the proper treatment of debt financing in relation to capital equipment expensing the entire analysis so far has concentrated on the context of earningsfinanced investment. within that context, the analysis has focused specifically on the generation and use of after-tax, equity-financed capital investment. within the year of investment, earnings are being generated and taxed, and nascent tax capital is being created and simultaneously invested in equipment. within such a complex and dynamic milieu, is it not possible that some form of tax arbitrage can be created if the analysis shifts to debt-financed equipment purchases? the term “tax arbitrage” has been used in the tax legal and policy literature to describe transactions in which opposing financial positions taken with respect to one underlying transaction enable one or more parties to the transaction to profit at the expense of the fisc after tax solely because of the income tax or income tax accounting treatment of the transaction.89 indeed, a small amount of tax arbitrage can be created when one is allowed to leverage the purchase of equipment that is subject to capital equipment expensing. a series of simple examples can illustrate the basic phenomenon, as well as the consequences of denying interest deductions as a potential way of dealing with the anticipated “problem” of tax arbitrage. example 7a: savings-financed investment: a taxpayer, who employs capital equipment expensing, expects to have at least $200,000 of net taxable income (prior to computing an equipment expensing deduction) available at the end of the next taxable year. he decides to purchase some important equipment for his business on the first day of the year that costs $120,000, using cash on90 hand. under normative capital equipment expensing, he will be able to deduct the entire cost of the equipment, because his equipment expenditure does not exceed the tax capital creation threshold of $120,000. 2006] capital equipment expensing 247 91. earnings ($200,000) minus cee deduction ($120,000) = taxable income ($80,000). the amount of tax in example 7a ($32,000) equals 40% of that taxable income. the after-tax capital formation amount is the excess of the post-investment net taxable income of $80,000 over the tax payment ($32,000). 92. this is because his taxable income is first reduced to $188,000 by the $12,000 interest deduction before computing the cee deduction, which now only equals 60% of that amount. because the cee deduction equals 60% of net taxable income (exclusive of equipment recovery deductions) ($188,000), reducing taxable income by $12,000 first, must reduce the cee deduction by 60% of that amount ($7,200) ($120,000 minus $112,800 equals $7,200). 93. taxable income = earnings ($200,000) – interest deduction ($12,000) – cee deduction ($120,000) = $75,200. forty percent of that amount equals the amount of tax paid ($30,080). 94. from $200,000 of earnings, he will have to pay $132,000 to repay the loan principal and accrued interest. he will also have to pay $30,080 in tax, leaving him only $37,920 after tax for future investment. his after-tax cash flow cum after-tax capital formation amount is now only 126% of his tax liability, compared to a ratio of 150% for the debt-financed investment in table 7a. 95. tax burden is reduced from $32,000 to $30,080. 96. after tax capital formation reduced from $48,000 to $37,920. if his predictions are correct, he will have to pay $32,000 in tax on $80,000 of taxable income. therefore, he will be able to retain $48,000 after tax for future investment. his after-tax cash flow is 150% of his tax liability.91 allowing a deduction for the interest on indebtedness used to finance capital expensed equipment purchases will alter the economic consequences, but not in a way that produces tax arbitrage. example 7b: interest deduction allowed – alternatively, the taxpayer decides to borrow $120,000 in order to purchase the equipment. he agrees to pay 10% of that amount as interest and to repay the debt at the end of the year. at that time, he will be able to deduct $12,000 as an interest deduction, but only $112,800 as a cee deduction. as a result, he will reduce his net taxable92 income to $75,200 and pay 40% of that amount in tax ($30,080). 93 as a result of using debt financing to buy the equipment, he will retain only $37,920 after tax, compared to the $48,000 he retained by investing his own earnings. by borrowing, he reduces his tax burden by only 6%, but94 95 taxpayer friendly tax arbitrage does not occur because he decreases his after tax capital formation (cash flow) by 21%. based on this rough, preliminary96 analysis, cee does not appear to be an equipment cost recovery regime that will encourage debt financing of equipment investment. in addition, if interest deduction denial were actually implemented, example 7c below suggests that it would likely constitute a counter-productive tax policy decision. example 7c: interest deduction disallowed – if the taxpayer in example 7b is not allowed to deduct the interest on his equipment acquisition indebtedness, the results will almost mimic those of the equity-financed 248 florida tax review [vol.7:4 97. from $200,000 of earnings, he will have to spend $132,000 to repay the loan and interest plus $32,000 in tax liability based on $80,000 of taxable income. 98. in my earlier article, i suggested that tax arbitrage transactions should be analyzed on two levels. the transactional level, as illustrated in example 7 itself, and the systemic level, where one evaluates the impact of a leverage-financing transaction with respect to all of the parties to the transaction, and the combined impact of the transaction on the fisc. of course the simple analysis in this article is incomplete at this time. for example, one can argue that lenders are likely to be subject to a lower effective tax rate than the borrowers in many equipment finance transactions. for an example of such a broader tax arbitrage analysis, see terry, indexed capital assets and tax arbitrage: a preliminary tax accounting policy analysis, 361372, the capital gains controversy: a tax analysts reader (tax analysts, 1992) 45 tax notes 605 )oct. 30, 1989) (describes how to further the tax policy aims implicit in indexing capital assets while preventing tax arbitrage that would otherwise arise from debt-financing such assets). investment in example 7a. his taxable income will again be reduced to $80,000; and he will again have to pay $32,000 in tax. however, he will only be able to retain $36,000 after all his expenditures for the loan repayment, the nondeductible interest, and the tax liability, (compared to $48,000 after-tax for97 the equity-financed investment in example 7a), thus potentially forming $12,000 less tax capital for future reinvestment. in terms of after-tax capital formation, the atcf in example 7c ($36,000) is now only 113% of the amount of tax paid ($32,000). this is less than the ratio for both the equity and the unfettered debt-financed investments. essentially, denying interest deductions for debt-finance of capital expensed equipment purchases serves no purpose other than to further reduce the after tax benefit of the investment to taxpayers, thus reducing the likelihood that such debt-financed investments would occur at all. since it also produces no increase in revenue, denial of interest deductions based on a theory of nonexistent tax arbitrage should be a contra-indicated addition to any potential future cee legislation. finally, on the systemic level, in many cases, the lender in the transaction above will have paid a sufficient amount of tax on the interest income it earned from financing this taxpayer’s equipment acquisition, to justify continuing the status quo with respect to debt financed equipment acquisitions.98 overall, my tentative conclusion is that there is no immediate pressing need to counter the potential minor negative effects of debt financing at this stage of the development of cee theory, at least not with the complete denial of interest deductions for debt-financed equipment investment. before any legislation is introduced, more analysis of this question should be done. 2006] capital equipment expensing 249 99. i have intentionally declined to address the application of capital equipment expensing to the equipment leasing industry, although it is a major source of capital formation and financing for equipment acquisitions in the u.s., as well as a source of job creation. see discussion supra note 88 (discussing the effect of § 179 limits on economic growth in particular sectors). see also discussion infra note 116 (discussing effect of equipment investment on job creation). i intend to address this particular subject further in a subsequent article. 100. this was below the $120,000 tax capital creation threshold. 101. these amounts represent after-tax funds (viz, tax capital) that may be immediately reinvested in subsequent equipment purchases, saved in other forms of investment, or consumed at the taxpayer’s choice. this comparative analysis is designed to illustrate to what extent various cost recovery methods create new tax capital (after tax has been imposed), which may potentially be used for reinvestment. vii. normative capital equipment expensing as an agent of capital creation, revenue generation and capital formation in a transition realization-based income tax if normative cee were introduced into the u.s. income tax base today, how would it compare to existing cost recovery methods with respect to the amount of revenue loss it would potentially create, as well as the amount of after-tax capital formation it would also potentially create to help compensate for such a revenue loss? this section of the article conducts a preliminary99 analysis of these questions on the tax base level. a. unlimited capital equipment expensing this section provides a model to define the quantitative factors which will help answer the question raised by the examples in the introduction to this article. in example 1, the taxpayer had $200,000 of earnings and invested $100,000 in equipment. as a result, he paid $80,000 in tax and formed only100 $20,000 of after-tax tax capital. in order to compare and analyze the effect of the three prevailing cost recovery methods in use today and the most likely “cost recovery method” of the future (full expensing), i have constructed table 3. table 3 compares the effects of a taxpayer with $200,000 of earnings investing $100,000 in equipment under macrs, 50% bonus depreciation, capital equipment expensing, and full or 100% expensing. with respect to each cost recovery method, from left to right, the columns display the values for earnings, investment, taxable income (ti), tax, and after-tax capital formation (atcf).101 table 3: comparative amounts of tax characteristics under 2004 equipment cost recovery methods and full expensing: investment below tax capital creation threshold. 250 florida tax review [vol.7:4 102. taxable income equals earnings minus the entire investment. 103. the table also reveals the fact that the results of 50% bonus depreciation are exactly halfway between the extremes of macrs and full expensing. recovery method earns invest t.i. tax atcf macrs 200 100 200 80 20 50% bonus 200 100 150 60 40 capital expensing 200 100 100 40 60 table 3 illustrates the fact that when macrs is applied, equipment investment does not reduce the tax base as a result of that investment. thus, ti equals earnings, and the tax/atcf ratio is 4:1. on the other end of the spectrum, this table also shows that, by allowing the entire investment to reduce the tax base under full expensing, the amount of tax is cut in half, and the102 atcf is tripled, which produces a tax/atcf ratio of 4:6, which reflects the application of the nominal tax rate.103 this table also shows that because the amount of investment ($100,000) does not exceed the tax capital creation threshold of $120,000, (cee) does not limit full equipment expensing deductions, relative to full expensing. thus, the full amount invested in equipment ($100,000) can be immediately deducted; and all of the tax-generated economic consequences of normative capital equipment expensing are identical to those of full expensing. the tax-generated economic consequences of cee and full expensing are only identical under circumstances such as those portrayed in table 3. part vii.c of this article reveals the disparate economic consequences produced by cee and full expensing under a broader range of economic circumstances. b. limited capital equipment expensing on the other hand, when the amount invested in equipment does exceed the natural tax capital creation threshold, cee will limit capital expensing deductions, and produce economic consequences that differ from both 50% bonus depreciation, as well as unlimited expensing. these statements are supported by table 4, which demonstrates the consequences of applying the four cost recovery methods to a taxpayer, who has only $150,000 of current year earnings, but decides to invest $100,000 in new equipment for his business. table 4: comparative amounts of tax characteristics under 2004 equipment cost recovery methods and full expensing: investment above the tax capital creation threshold recovery earns invest t.i. tax atcf macrs 150 100 150 60 -10 50% bonus 150 100 100 40 10 capital 150 100 60 24 26 full exp 150 100 50 20 30 2006] capital equipment expensing 251 104. applying the formula for tax capital (e x [1-t]) to the facts of the example results in a tax capital threshold equal to 60% ($90,000) of the earnings involved ($150,000). 105. the macrs taxpayer must pay $60,000 in tax, in order to be able to invest a maximum of $90,000 in equipment. 106. of the $50,000 taxable income, 40% ($20,000) is allocated to tax, and the remaining 60% ($30,000) is retained as atcf. in table 4, the tax capital creation threshold is only $90,000 based on the $150,000 of earnings from which the investment was made. this situation104 affects the use of macrs cost recovery because taxpayers cannot invest more than the nascent after-tax dollars available to them without resorting to borrowing or withdrawing from savings. thus, in table 4, an investment subject to macrs cost recovery cannot exceed $90,000.105 under full expensing, however, taxpayers can always choose to invest up to the full amount of their current earnings because their investment reduces their tax base dollar for dollar. under full expensing, there will always be enough earnings left, after investment, to pay 40% of whatever earnings remain as tax. under the scenario displayed in table 4, the full expensing deduction reduces the tax base to $50,000, which results in 40% allocated to tax, and the other 60% allocated to the taxpayer after-tax. this allocation is proportional to the nominal tax rate.106 under 50% bonus depreciation, the taxable income equals the amount of earnings, reduced by half of the amount invested, which equals $100,000. at low earnings levels relative to investment, the amount of the investment plus the tax burden leaves a relatively small amount of after-tax capital for future reinvestment ($10,000). as with macrs, at relatively low earnings levels, tax consumes most of the remaining earnings after investment is made ($40,000). unlike macrs, however, the taxpayer does not have to resort to funding tax payments with savings. under capital equipment expensing, only $90,000 of the $100,000 invested is allowed to be deducted as a cee deduction. this reduces the taxable income to $60,000, which produces $24,000 in tax revenue, plus $26,000 of atcf. cee produces more tax revenue but less atcf than full expensing under these circumstances. but, like full expensing, and unlike macrs and 50% bonus depreciation, cee does not allocate so much of the taxable income to tax payments, that atcf is either severely reduced, or completely eliminated. overall, cee creates the best combination of revenue collection and capital formation of any existing equipment cost recovery scheme today. 252 florida tax review [vol.7:4 c. a deeper analysis of the model 1. moderately high earnings levels table 5 isolates and summarizes the key economic characteristics of the existing and potential methods of taxing earnings-financed investment in equipment portrayed in table 3, in which the taxpayer had $200,000 of earnings and invested $120,000 in equipment. the key economic characteristics are the amount of tax paid and the amount of after-tax cash flow. the amount of after-tax cash flow represents the amount generated for potential subsequent capital investment and is, therefore, characterized as (atcf). table 5: comparative amounts of revenue and after-tax capital formed by various equipment cost recovery methods at moderately high earnings levels 200k earns tax atcf macrs 80 20 50% bonus dep 60 40 full expensing 40 60 cap equip exp 40 60 at moderately “high” earnings levels ($200,000) (significantly above both the $120,000 tax capital creation threshold and the amount invested), when $100,000 investments in equipment are subjected to the four types of cost recovery displayed in table 5, macrs produces the highest amount of tax revenue (80), and the lowest amount of post-investment tax capital formation (20). therefore, this current prevailing cost recovery method is best for revenue generation, but the worst for ongoing tax capital formation. at the other end of the spectrum, full expensing produces the lowest amount of tax revenue (40), and the corresponding highest amount of postinvestment tax capital formation (60). resting halfway between these polar opposites, not surprisingly, 50% bonus depreciation produces the mid-level amount of tax revenue (60), and the mid-level amount of post-investment tax capital formation (40). in terms of revenue generation, bonus depreciation is not as bad for revenue raising as full expensing. in fact, it causes 50% more tax to be paid (60) than full expensing (40). on the other hand, it is clearly not as good for revenue collection as macrs, because the amount of tax generated by bonus depreciation (60) is 25% less than the amount of tax paid under macrs (80). in terms of aftc, bonus depreciation is not as beneficial as full expensing. its atcf amount (40) is only 67% of the atcf produced by full expensing (60). however, in comparison to macrs, the prevailing cost recovery system for most investments in equipment, 50% bonus depreciation 2006] capital equipment expensing 253 107. $40,000 atcf for 50% bonus depreciation, compared to $20,000 for macrs. 108. $60,000 tax paid for bonus depreciation, compared to $80,000 for macrs. 109. the amounts in table 6 are taken from the columns in table 4 labeled tax and atcf. produces 100% more tax capital formation, while at the same time also107 producing 75% as much tax revenue.108 cee provides the best combination of revenue and capital formation among all of the alternatives currently available or likely to be available in the near future. although it produces the least relative amount of revenue tied with full expensing it also produces the greatest amount of atcf tied with full expensing. at moderately high earnings levels, the relative proportions of revenue and capital formation generated by capital expensing and 50% bonus depreciation, respectively, place them on opposite sides of the tax policy direction the country seems to be heading. in table 5, bonus depreciation produces $60,000 of revenue compared to only $40,000 of atcf. in direct contrast, cee produces $40,000 of revenue compared to $60,000 of aftc. many tax policy makers today believe that capital formation is relatively more important than revenue generation. 2. low earnings levels in order to get a better idea of how cee functions when investments occur below the natural capital creation threshold, table 6 presents the same data as that presented in table 5, with the exception of the amount of earnings employed. this time, our taxpayer has only $150,000 of earnings, but still invests $100,000 in equipment. that amount is only $10,000 greater than the109 $90,000 tax capital creation threshold. table 6 reveals the same type of results as those shown in table 5 for the same range of recovery methods. table 6: comparative amounts of revenue and new tax capital formed by various equipment cost recovery methods at relatively low earnings levels 150k earns tax atcf macrs 60 10 50% bonus dep 40 10 full expensing 20 30 cap equip exp 24 26 in table 6, the capital creation threshold limits the cee deduction to only $90 of the $100 invested in the equipment. the result is $60 of taxable income, which in turn creates $24 in tax and $26 of aftc. in comparison to full expensing, cee generates 20% more revenue and only 13% less after tax capital. 254 florida tax review [vol.7:4 110. at this early stage of the development of cee, i acknowledge the need to refine and/or modify the definition of the generic term “taxable income,” to better accommodate the potential policy and administrative constraints that may come into play in the future, if cee is to be further developed. cee also performs well relative to 50% bonus depreciation. while it produces 40% less tax revenue than bonus depreciation, it forms 260% more after-tax capital. again, cee produces the most capital formation bang for every buck of tax revenue lost of any existing or likely future equipment cost recovery scheme. 3. very high earnings levels lastly, i will explore the relative advantages of cee in the context of relatively high earnings in relation to amounts of investment. in this type of environment, the computation of allowable deductions under cee depends on the availability of nascent tax capital, which in the highest bracket of today’s tax rate schedule, can equal 65% of taxable income remaining after all deductions, other than cost recovery for equipment, have been taken. on the other hand,110 deductions for equipment under sections 168(k) and 179 are limited by the amounts of the investments themselves and by arbitrary fixed ceilings, respectively. as a result, they cannot exceed 50% of the amount invested plus $100,000. as a result of the difference in deduction computation, at very high earnings levels, cee deductions will always exceed deductions currently available under sections 168(k) and 179 combined at every level of investment. table 7 compares the amounts of deductions allowed by the combination of sections 168(k) and 179, to the amount of cee deductions allowed for the same amount of investment at various levels of investment between $200,000 and $800,000. table 7: comparative amounts of revenue and tax capital formed by various equipment cost recovery methods at relatively high earnings levels ($1m) deduct 200k investment 400k investment 600k investment 800k investment allow 179/168 cap 179/168 cap 179/168 cap 179/168 cap exp exp exp exp 1 mil 800k 600 650 600k 400 450 400k 350 at even higher levels of earnings, the combination of sections 168(k) and 179 deductions, will max out at a little more than 50% of the amount 2006] capital equipment expensing 255 111. for single individuals with taxable income greater than $319,100, and for corporations with taxable income greater than $18.33million. 112. essentially, cee allows nascent capital investment to be expensed in the same year that nascent tax capital is created, rather than waiting until the succeeding year, in which the after-tax earnings that had been taxed but not invested the year before, were then free to invest, as true tax capital. the maximum amount available to invest in that succeeding taxable year will not exceed the amount allowed to be expensed during the prior year under cee as described in this article. in broad strokes, a rbit with cee can be viewed as a specialized sub-tax base, whose general dynamics, on one hand, can be compared to those of a consumption tax base. rather than the formula for this tax base being e minus i (earnings minus investment), it can be represented as e minus cap i (earnings minus tax capital investment). only the nascent after-tax dollars invested in equipment investment is expensed within this novel and hybrid tax base. in equally broad strokes, cee can also be viewed as a dynamic, repetitive application of the principles of irc § 1001(a), the cornerstone of our rbit. however, in this context, these principles are used to determine the net income derived from equipment investment and income production, on an ongoing basis, rather than only at the termination of the investment by sale or other disposition, in order to determine the gain or loss realized by that particular disposition. it would be interesting to explore a unified theory of cee in the future, because of both the similarities and dissimilarities between income and consumption tax base principles it exhibits. for example, when cfit base and rbit base structural principles and elements are juxtaposed against each other in year 1, through cee, the cfit base expensing treatment is allowed up to the extent that the rbit base cee deduction invested. cee deductions will max out at 65% of net taxable income. for a111 $20 million investment for example, the 168k/179 deduction today will equal $10.1 million, while a cee deduction would equal $13 million. viii. summary this article is based on three fundamental principles of a realizationbased income tax system: 1) realization necessitates capitalization; 2) capitalization requires capital cost recovery; and 3) capital cost recovery should consist entirely and exclusively of already or concurrently invested capital. within the u.s. realization-based income tax base, nascent tax capital creation consists of the generation of nascent tax capital concurrent with the generation of pre-tax earnings during a taxpayer’s taxable year. nascent tax capital is the amount of after-tax capital that would be available if net pre-tax earnings during a taxable year were instantaneously subjected to tax, and the amount of after-tax capital generated was allowed to be immediately invested, and simultaneously expensed. within this hypothetical economic context, these instantaneous events would occur in a manner completely consistent with the three fundamental structural principles of a realization-based income tax described above.112 256 florida tax review [vol.7:4 treatment takes over. the modified cfit treatment accounts for the investment aspect of the transaction. at this point, modified rbit treatment takes over. the amount of taxable income generated from the transaction from this point on is the amount by which an “amount realized” from the remaining untaxed initial earnings exceeds an “adjusted basis,” as represented by the nascent tax capital, which has not yet been recovered through any interim rbit base cost recovery deductions. while an amount equal to the nascent tax capital creation threshold was allowed to be deducted by the cfit base treatment of the investment, no true tax capital was affected by that treatment, in rbit base terms. at that moment, the remaining nascent tax capital still had significance for determining the rbit bas consequences of the year 1 event. thus, the net amount of gross income to be reported under our rbit base, is the excess of the net amount of earnings yet to be realized from the in initial earnings, after reduction for the cfit base treatment (as implemented and limited by the cee deduction. 113. cap = e(1 – t). tax capital equals nascent after-tax earnings. cost recovery, under the current, underlying macrs regime, is financially insufficient to completely restore the amount invested in equipment by taxpayers (capital or not). although, selectively overriding this cost recovery regime, none of the current partial or limited expensing deduction provisions under sections 168(k) and/or 179, bear any relationship to the amounts of tax capital concurrently created and actually invested in expensed equipment by taxpayers. this frequently creates one of two tax base structural problems depending on the specific characteristics of a given equipment purchase: 1) the ability to recover pre-tax earnings tax-free, on one hand, or 2) the inability to recover actual invested tax capital tax-free on the other hand. at this preliminary stage of development, i basically propose matching the amount of investment in equipment made during a taxable year against the amount of tax capital created and available at the end of that taxable year. more specifically, i propose to aggregate all investment in equipment made by a taxpayer during a taxable year, and compare it to the total amount of tax capital created from that taxpayer’s net business income as of the end of that taxable year. the amount of tax capital created and available at the end of a taxable year would be determined by using the simple formula in equation 4.113 to the extent aggregate investment in section 179 property equals, but does not exceed, the tax capital creation threshold for that year at that time, all equipment investment for the year would be allowed as an immediate deduction under section 179. to the extent tax capital is created in excess of equipment investment for that year, it would be carried over to following years, to be matched against the aggregate equipment investment that occurs in those following years. similarly, to the extent aggregate equipment investment in a given year is made in excess of tax capital created during that year, excess nonexpenseable amounts of equipment investment would be carried over to following years to be tested for deductibility against current and any cumulative tax capital created or available in those following years. 2006] capital equipment expensing 257 114. primarily because interest deductions will only be able to offset a small amount of pre-tax earnings, and by doing so, they will reduce both the tax capital creation threshold, as well as allowable expensing deductions. see discussion supra section vi.b.2. 115. see irc § 1(h). 116. see global insight, advisory services group, the economic contribution of the equipment leasing industry to the u.s. economy, (equipment leasing association), mar. 1, 2004 (measuring the contribution of the equipment leasing industry on the u.s. economy, asserting that over the 1997-2002 period, the equipment leasing industry produced between $100 billion $300 billion additional real gdp, $227 billion $229 billion additional real equipment investment, and created between 3 million 5 million jobs; further estimating that the higher level of sustainable jobs attributable to the leasing industry accounts for roughly $375 billion of real personal administering cee would create at least two areas of possible administrative complexity, but it would also create two areas of possible administrative simplicity. aggregating expensing deduction computations into cee would greatly simplify both the administration and compliance aspects of equipment acquisition, utilization and disposition. however, it would be necessary to supply rules to deal with some foreseeable horizontal and vertical aspects of this scheduled aggregation. however, as this article demonstrated, debt-financed tax arbitrage would not necessarily be a serious problem in the context of aggregate cee, indeed, normative cee is likely to discourage,114 rather than encourage, debt financing of equipment investment that is subject to cee, because inflating the amount of investment through debt financing increases the likelihood of creating non-deductible investment in equipment. finally, section vii of this article demonstrated that, compared to all other forms of capital cost recovery for equipment now employed in the u.s., normative cee produces the most tax capital formation bang for every buck of lost tax revenue that it causes. it accomplishes this regardless of the level of a taxpayer’s earnings relative to the amount of a taxpayer’s investment. in addition, it subjects the invested income to a 12.5% effective tax rate, which is similar to the 15% nominal tax rate now imposed on some net capital gain and qualified dividend income.115 conclusion overall, cee is a tax-sustaining, economic capital-generating engine. it produces more tax capital for every dollar of revenue lost than any existing equipment expensing or cost recovery method. and, since we have not moved to full expensing yet, it is the best engine for both revenue sustenance and capital formation that we can have during this transition period of unknown duration today. furthermore, studies have shown that investment in equipment, in particular, is directly related to job creation, which makes this sector of the economy a proven job-creation source. therefore, optimizing capital116 258 florida tax review [vol.7:4 income annually, of which $255 billion in concentrated in the leasing industry and all related supplier industries). see also, j. bradford de long, machinery investment as a key to american growth, in tools for american workers: the role of machinery and equipment in economic growth 1 (american council for capital formation center for policy research, dec. 1992) (concluding that (1) any nation wishing to be among the world’s industrial leaders should shape its tax preferences and industrial policies in order to encourage the installation and use of machinery because policies that increase machinery investment carry benefits that far outweigh costs; (2) american workers are the highest paid workers in the world because of the u.s.’s position as a capitaland machinery-intensive economy; and (3) low us national savings and net machinery investment rates are concerning because low savings leads to low capital stock of machinery and structures with which employees work, and without machinery, the u.s. will lack new technology, leaving workers to fall behind in learning new technologies efficiently). 117. note that both computer hardware and software qualify as § 179 property. see § 179(d)(1)(a). formation and reinvestment on an ongoing tax-sensitive basis through cee should increase investment in equipment, as well as create more jobs associated with those equipment investments.117 cee has tremendous efficacy as a transition sub-tax base structure for an important sector of our economy. how long this specialized sub-tax base would endure is open to question since the federal government is engaged in an ongoing major tax reform process. nonetheless, cee can create a stable transitional platform, from which a wide variety of subsequent tax reform options can be more easily and efficiently pursued in the near or distant future. finally, cee can likely be implemented without the immediate serious administrative and fiscal problems that would likely be caused by other transition platforms. page 1 page 2 page 3 page 4 page 5 page 6 page 7 _toc101861923 _toc104351483 _toc101861924 _toc104351485 page 8 page 9 page 10 page 11 page 12 page 13 _toc101861925 _toc104351486 _toc101861926 _toc104351487 page 14 _ref8368501 page 15 page 16 page 17 _toc101861927 _toc104351488 page 18 page 19 _toc101861928 _toc104351489 page 20 _ref5107095 _ref5107115 _ref5107145 _ref6028085 _toc10195266 _toc101861929 _toc104351490 _hlt4579462 _toc10195267 _toc101861930 _toc104351491 page 21 _ref6647917 page 22 _ref9323860 page 23 page 24 _toc10195268 _toc101861931 _toc104351492 _ref9235580 page 25 _ref4431279 page 26 _hlt4579493 _toc10195275 _toc101861932 _toc104351493 _toc10195276 _toc101861933 _toc104351494 page 27 page 28 _ref7322799 _ref7324551 _toc10195277 _toc101861934 _toc104351495 _toc101861935 _toc104351496 page 29 _toc101861936 _toc104351497 _toc10195279 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this income. this selfassessment system, however, depends on taxpayers ferreting out the provisions of the tax law that apply to them and properly applying those provisions to their factual situations. the immensity and complexity of the tax law and the difficulty of applying even apparently clear legal provisions to complex sets of facts (the most difficult lesson in law school for the typical law student) make this process impossible for many taxpayers. as a result, they turn to tax professionals for assistance in preparing tax returns. these professionals generally fall into one or more of four groups: (1) lawyers licensed to practice law in at least one state or the district of columbia (licensed lawyers); (2) certified public accountants (cpas); (3) those admitted to practice before the irs under the provisions of circular 230;' and (4) "income tax return preparers," as defined in section 7701 (a)(36) * associate dean and professor of law, university of maine school of law. this paper was originally written for the second invitational conference on professionalism in tax practice, which was scheduled to be held in washington in january 1996 under the sponsorship of the american bar association section of taxation, the american college of tax counsel, the american institute of certified public accountants, the national association of enrolled agents, the national association of tax practitioners, the national society of public accountants, and the tax executives institute. the conference was postponed because of the blizzard of 1996. this paper has benefited from comments by frederic g. corneel, colleen a. khoury, david m. richardson, and gwen thayer handelman. copyright © 1996 by michael b. lang. i. the most significant members of this group are enrolled agents, most of whom must take a special examination to qualify to practice before the irs, and lawyers and cpas admitted to practice before the irs. enrolled actuaries are also eligible to practice before the irs, but only in particular areas involving employee benefit plans. treasury dept. circular 230, § 10.3(d)(1) (1994), codified in 31 c.f.r. § 10 (1995) [hereinafter circular 230]. nothing precludes an enrolled actuary from preparing tax returns. the enrolled actuary might then be subject to the same standards as "enrolled agents" with regard to the preparation of tax returns, although it is not clear that circular 230 envisions this possibility. a variety of other persons may practice before the irs in limited circumstances. see circular 230, § 10.7. the author understands that the commissioner's advisory group has under consideration a recommendacommeniary on retun preparer obligations (return preparers).2 professionals in each category are subject to their own set of practice standards. many professionals in the tax field are members of more than one group and thus subject to multiple sets of standards. for example, licensed lawyers or cpas may be subject to their respective state regulatory authorities, circular 230 (because they are admitted to practice before the irs), and the statutory provisions affecting return preparers.' once the taxpayer seeks the help of a professional, several difficulties inevitably mar the return preparation process. first, although the professional should be more skilled at finding the tax law relevant to the taxpayer's situation, the professional's knowledge of the facts underlying the taxpayer's tax situation depends entirely on the information known to and conveyed by the taxpayer. the way in which the professional inquires about the facts may influence how the facts are reported by the taxpayer. hence, the taxpayer's response is a function of the professional's inquiry. furthermore, the taxpayer may deliberately slant the facts in the hope of reducing her tax, or simply fail to report all of the relevant facts because of misunderstanding, misperception, forgetfulness, or the like. these considerations raise the prospect that a return prepared by even the most assiduous professional may be less accurate than what a well-informed, well-intentioned taxpayer might have prepared independently.4 inevitably, the return preparation process also suffers because the taxpayer must pay for the professional's services, a factor that significantly limits the amount of time and effort that the professional can commit to the taxpayer's return. while the taxpayer might be willing to spend his own time establishing exact amounts for various return entries and satisfying substantiation requirements, resort to estimates and less rigorous review of supporting tion to amend circular 230 to require registration of "commercial tax return preparers," who would then be subject to circular 230's standards. 2. the term "income tax return preparer" generally refers to "any person who prepares for compensation, or employs one or more persons to prepare for compensation." any income tax return or claim for an income tax refund. irc § 7701(a)136)ta). the definition contains exceptions for, among others, those who prepare returns or refund claims for their employers (or officers or employees of their employers) or as fiduciaries. irc § 7701(a)(36)(b). 3. the rendering of tax advice in connection with a return may trigger other penalty provisions of the code, even if the advisor is not a return preparer with respect to the return. see, e.g., irc § 6701 (relating to penalties for aiding and abetting understatement of tax liability). 4. there is some empirical evidence that noncompliance is greater on returns prepared by return preparers than on returns prepared by taxpayers themselves. see brian erard, the impact of tax practitioners on tax compliance: a research summary, 90 tnt 237-47 (nov. 21, 1990) (lexis, fedtax library. tnt file). the reason for this difference is not clear. i am grateful to professor gwen thayer handelman for calling this interesting report to my attention. 19961 florida tax review documentation are bound to follow when a professional's time (and fees) are involved. similarly, the legal research and analysis necessary to determine the proper treatment of various items may prove more costly than is justified by the amount at stake for the taxpayer. in theory, the taxpayer and the professional are both interested in preparing an accurate return, but in some cases, the taxpayer's interest in reducing the tax shown on the return conflicts with the professional's responsibility to assure that the return meets some minimum standard. the taxpayer may simply fail to cooperate or may refuse to follow the advice of the professional in the preparation of the return. how professionals respond to such taxpayers can have major consequences for the viability of the selfassessment system. the foregoing issues define the environment in which the practice standards applicable to tax professionals must apply.5 these standards are designed to assure that returns prepared by tax professionals are basically accurate and complete. the standards may also have the salutary effect of offering the scrupulous tax professional shelter against the entreaties of the unscrupulous taxpayer-client. in general, the standards represent an accommodation between the practical concerns discussed above and the need for integrity in the filing of tax returns. given the diverse sources of the standards, it is remarkable how they have evolved so as often to apply similar rules in similar contexts, regardless of the professional status of the practitioner. indeed, despite differences in wording, emphasis, and, in some cases, important substantive results, it is possible to discuss many aspects of these diverse rules as one whole. in addition to facilitating efficient, intelligent discussion of an otherwise unmanageable morass, this approach offers the additional benefit of suggesting how the morass could be transformed into a body of uniform standards. the multiple sets of standards, however, provide little guidance in two major problem areas: (1) the evaluation of facts and the application of the law to the facts, and (2) whether there is an obligation to amend a return subsequently found to be erroneous. in both of these contexts, the role of the taxpayer is preeminent, and the integrity of the return may ultimately be beyond the control of even the most conscientious tax professional. in addition, once the facts and applicable law have been established, there may be choices about how to report some items on the return. the professional should discuss alternative positions that may be taken on the return (and the disclosures that some positions may require) and explain the 5. this paper is not intended to be a comprehensive analysis of the ethical principles and law applicable to the various categories of return preparers. for more extensive discussion of some of the issues discussed here, see bernard wolfman, james p. holden & kenneth l. harris, standards of tax practice (3d ed. 1995). [vol 3:3 conunentary on return preparer obligations risks associated with those positions (including the possibility of a successful challenge by the service, penalties, and other costs, such as legal and accounting fees, of pursuing a dispute with the service). ultimately, however, it is the taxpayer's decision how to report items on the return. similarly, as discussed below, it is ultimately the taxpayer's decision whether to amend an erroneous return. although the taxpayer's greater knowledge of and access to the facts affecting the tax liability has played a major role in the development of the practice standards, the standards also reflect the concerns of those with different stakes in both the tax system and the interests of their clients. thus, the statutory return preparer rules of section 6694 (including the accompanying regulations) and the provisions of circular 230 regarding return preparation by those admitted to practice before the irs (including both general due diligence standards and provisions reflecting the standards of section 6694) all reflect a governmental concern with receiving accurate tax returns. the somewhat lower standards that must be met to avoid the accuracy-related penalties under section 6662 reflect the same concern. to varying degrees, all of these standards limit the aggressive advocate's ability to assist a taxpayer-client in making a nonfrivolous challenge to a government tax position. licensed lawyers on the other hand, have always viewed loyalty to the client, who is to be represented zealously within the bounds of the law, as the base line for ethical analysis. 6 that the taxpayer-client may at some point be represented by the lawyer in an adversarial proceeding involving the client's tax return has long colored the development of ethical standards governing the provision of tax advice by lawyers.7 even the supreme court has drawn a sharp contrast between the lawyer's training as an advocate and the cpa's role in audit and attest functions, where independence from the client is essential.' although the court noted this distinction in the context of the first amendment protection accorded commercial speech in the form of in-person uninvited solicitations of business, the distinction must be borne in mind in understanding the historical underpinnings of both professions' approaches to the ethical standards applicable to return preparation. this is true despite the fact that licensed lawyers and cpas perform essentially the same roles in advising about and preparing tax returns and representing the 6. see model code of professional responsibility. ec 7-1 (1986); see also model rules of professional conduct, rules 1.3, 3.1 and cmts. (1994). 7. see aba comm. on ethics and professional responsibility, formal op. 352 (1985), reprinted in 39 tax law. 631, 632 (1986) ("in many cases a lawyer must realistically anticipate that the filing of the tax return may be the first step in a process that may result in an adversary relationship between the client and the irs"). 8. see edenfield v. fane, 507 u.s. 761 (1993) (invalidating florida's ban on direct. in-person uninvited solicitation of employment by cpas). 19961 florida tax review taxpayers on audit, roles which are also performed by other preparers and enrolled agents. il present standards a return preparer must, above all, prepare the return in conformity with the law. in general, a return preparer should not recommend a return position unless the preparer has a good faith belief that the position has a realistic possibility of being sustained on the merits.9 however, even if the preparer concludes that a return position does not meet this "realistic possibility" standard, the preparer may recommend the position and sign the return if the position is not frivolous and is adequately disclosed on the return.' ° the preparer may also recommend a nonfrivolous position if the preparer advises the client of the opportunity to avoid the accuracy-related penalty by adequate disclosure." in addition, return preparers subject to circular 230 (those admitted to practice before the irs) must satisfy circular 230's due diligence requirements, 2 requirements that are similar to those applied in malpractice litigation against professionals and to professional ethical standards. all of these standards use terms of art, the general application of which is discussed below. in addition, the tension between these practitioner standards and the return-filing standards applicable to taxpayers is a source of considerable difficulty for preparers. iii. realistic possibility standard the realistic possibility standard is expressed similarly in the statements and provisions of the aba, the american institute of certified public accountants (aicpa), circular 230, and the internal revenue code. 9. irc § 6694(a); circular 230, supra note 1, § 10.34(a); tax return positions, statement on responsibilities in tax practice no. 1, § .02 (am. inst. of certified pub. accountants rev. 1991) [hereinafter aicpa statement no. i]; aba formal op. 352, supra note 7. 10. aicpa statement no. 1, supra note 9, § .02; irc § 6694(a); circular 230, supra note 1, § 10.34(a)(1). the ethical principles and opinions applicable to licensed lawyers do not address this point and may even be read as not permitting adequate disclosure of a nonfrivolous position that lacks a realistic possibility of success to allow the lawyer to advance the position on the client's return. the better view, however, seems to be that licensed lawyers may participate in advancing such a return position if the position is adequately disclosed. see wolfman et al., supra note 5, 204.2.4.2. 11. see circular 230, supra note 1, § 10.34(a)(l)(ii); regs. § 1.6694-2(c)(3)(ii)(a). this action appears to be ethical for both licensed lawyers and cpas, although no authority expressly so provides. what the preparer should do if the taxpayer proceeds to take the return position without adequately disclosing it is discussed below. 12. circular 230, supra note 1, § 10.22. [ vol 3:3 coimneniarv on retuni preparer obligations however, these various expressions of the standard have not been interpreted in the same way. indeed, the absence of parallel interpretation seems to be a hallmark of this area. the standard of aba opinion 85-352 has been interpreted to be satisfied by a position "closely approaching" a one-third chance of success,' 3 similar to the one-in-three standard of circular 230. also, section 1.6694-2(b)(1) of the regulations provides: a position is considered to have a realistic possibility of being sustained on its merits if a reasonable and wellinformed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits (realistic possibility standard). 4 in contrast, an interpretation of the aicpa statement on responsibilities in tax practice states that the standard "cannot be expressed in terms of percentage odds."' 5 the aicpa view is more realistic because the probability of a doubtful position being sustained on the merits cannot be determined with any precision. however, it raises an obstacle to any attempt to come up with a uniform interpretation of the realistic possibility standard in its various guises.'6 in any event, the one-in-three standard is probably as good a baseline as any for measuring the viability of a return position under the realistic possibility standard. the likelihood that the return will be audited or that the issue will be detected by the irs may not be considered as part of this calculus. 17 if a return contains a position that fails the one-in-three standard of the regulations and results in an understatement of tax liability and if the 13. report of the special task force on formal opinion 85-352, 39 tax law. 635, 638-39 (1986). 14. regs. § 1.6694-2(b)(1). 15. see realistic possibility standard, statement on responsibilities in tax practice, interpretation no. 1-1, § .05 (am. inst. of certified pub. accountants rev. 1991) [hereinafter aicpa interpretation no. 1-1]. 16. many of the differences between the various forms of the realistic possibility standard are discussed in this commentary. for a more extensive discussion of the variations, see wolfman et al., supra note 5, ch. 2. 17. see regs. § 1.6694-2(b)(1); aicpa statement no. 1. supra note 9, § .03a; aicpa interpretation no. i-i, supra note 15, § .05; report of the special task force on formal opinion 85-352, supra note 13, at 638. however, where a cpa has a good faith belief that more than one possible position meets the realistic possibility standard, the cpa may advise "of the likelihood that each such position might or might not cause the client's tax return to be examined and whether the position would be challenged in an examination." aicpa statement no. 1, supra, § .08. 19961 florida tax review preparer knew (or reasonably should have known) of the position, section 6694(a) imposes a penalty on the preparer unless (1) the position is not frivolous and is disclosed or (2) it is shown that there is reasonable cause for the understatement and the preparer acted in good faith. aicpa statement on responsibilities in tax practice no. 1 and aba opinion 85-352 set forth similar basic realistic possibility standards, in both cases requiring the professional to have a good faith belief that the position has a ("some" in the aba opinion) realistic possibility of being sustained on the merits.' 8 the aicpa statement and the regulations under section 6694 elaborate on the application of their respective formulations of the realistic possibility standard. in both cases, however, most of the elaboration consists of illustrations of how to evaluate and weigh authorities that may be relied upon in determining whether the standard has been met. "cpas may rely on well-reasoned treatises, articles in recognized professional tax publications, and other reference tools and sources of tax analyses commonly used by tax advisors and preparers of returns."' 9 the regulations under section 6694, in contrast, permit consideration of only the kinds of authorities listed in the regulations under section 6662, defining the term "substantial authority" for purposes of the substantial understatement penalty.2" such authorities are generally limited to those that are binding on the irs (such as statutory and regulatory provisions, treaties, and judicial decisions) and a variety of other official documents, such as blue books, congressional committee reports, administrative pronouncements, and official explanations of treaties.2' while this more restrictive list of authorities effectively coordinates the realistic 18. because the aba standard appears as part of a formal ethics opinion, rather than as a rule, its formulation is somewhat different, calling for a good faith belief that the position is warranted in existing law or can be supported by a "good faith argument for an extension, modification or reversal of existing law." aba formal op. 352, supra note 7. good faith is defined as requiring that there be "some realistic possibility of success if the matter is litigated." also, the aba opinion does not spell out exceptions to the realistic possibility standard of the kind provided in § 6694. the aicpa standard requires that the cpa have a "good faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged." this is later explained in language paralleling that of the aba opinion. compare aicpa statement no. 1, supra note 9, §§ .02a and .07. 19. aicpa interpretation no. 1-1, supra note 15, § .07. aba formal op. 352 is not explicit on this point but probably also permits reliance on this broader range of authorities. see wolfman et al., supra note 5, 204.2.2 text accompanying notes 30 and 31. 20. regs. § 1.6694-2(b)(2). circular 230 applies the same overall approach as the regulations. circular 230, supra note 1, § 10.34(a)(4)(i). 21. regs. § 1.6662-4(d)(3)(iii). a limited special provision allows consideration of certain written determinations issued to or naming the taxpayer, such as private rulings, determination letters, and technical advice memorandums, but it is not likely to be of much help in this context. see regs. §§ 1.6662-4(d)(3)(iv), 1.6694-2(b)(4). [vol 3:3 connzentar " on reurn preparer obligations possibility of success preparer standard with the substantial authority standard applicable to taxpayers, it is not at all clear that this tie-in is justified by the code.22 in any event, the wide application of the preparer penalty means that even cpas should keep the regulatory standards in mind in all but the most unusual cases. the difficulty is that weighing authorities to evaluate the likelihood of success of a return position on a fairly well-defined legal issue is neither the typical nor the most difficult problem in assisting a client with the preparation of a return. the preparer must first ascertain the facts from a client who may be ignorant, inarticulate, unable or unwilling to cooperate, or lacking the crucial information. often, the client's ability to substantiate the facts raises questions. once the facts are ascertained, the preparer must determine how the applicable law applies to the facts. these factors must all be weighed in evaluating whether the return position has a realistic possibility of success on the merits, yet the ability to research, evaluate, and weigh various legal authorities is frequently of little help in dealing with them. furthermore, how the preparer deals with a particular client's tax return depends in large part on the economics of the situation and the preparer's judgment about the client. what then can be said about such matters by way of guidance? iv. diligence and care circular 230, the ethical precepts governing cpas and licensed lawyers, and the principles of tort and contract law provide guidance about the degree of skill, care, and diligence a preparer must exercise in preparing a return. circular 230 requires those admitted to practice before the irs to exercise due diligence in preparing, assisting, approving, and filing returns with the irs.23 professionals have similar duties under both tort and contract principles, 24 as well as under professional ethical standards.2-y these standards may at times diverge in practical application, given their varied sources, the parties called upon to apply them (e.g., juries, judges, the irs 22. the report of the special task force on aba formal opinion 352 states that "[o]rdinarily, there would be some realistic possibility of success where the position is supported by 'substantial authority,' as that term is used in [the substantial understatement rules]." 39 tax law. 635, 639 (1986). this statement is consistent with the possibility that a broader range of authorities may be considered because it does not indicate that support by substantial authority is essential to the conclusion that a realistic possibility of success exists. 23. circular 230, supra note 1, § 10.22. 24. see wolfman et al., supra note 5. ch. 6. 25. see, e.g., model rules of professional conduct. rules 1.1 and 1.3 (1994), aicpa code of professional conduct, rule 201 (am. inst. of certified pub. accountants 1988). 19961 florida tax review director of practice, aicpa, and state licensing authorities), and the kinds of penalties or other costs occasioned by their breach. nonetheless, the proper level of practitioner skill, care, and diligence is measured in such terms. clearly, the preparer is not required to guarantee every fact underlying the return or to audit the taxpayer's records.26 this would not be economical or, in some cases, possible. on the other hand, the preparer should make a reasonable effort to obtain all relevant information from the taxpayer. prior years' returns should be reviewed, where appropriate, because they may be helpful in avoiding omissions or duplications of items and may provide a basis for the treatment of similar or related items in the current return.27 in gathering information, the preparer may in good faith rely on information provided by the taxpayer or third parties.28 however, the preparer cannot rely on information that appears either on its face or from other facts known to the preparer to be incorrect, incomplete, or inconsistent. in such cases, the preparer must make whatever further inquiry seems reasonable under the circumstances.29 reasonable efforts should be made to confirm the adequacy of the taxpayer's record-keeping procedures and inquire about the adequacy of substantiation where substantiation of return items is an issue. in most cases, it is probably sufficient if, in response to such an inquiry, the taxpayer represents that adequate records or other kinds of sufficient evidence exist.30 other facts or the nature of the taxpayer's response may, however, indicate that further inquiry is necessary. for example, if a taxpayer residing in a suburban area tells the preparer that all automobile use is business-related and claims to have adequate records to support the claim, the preparer should probably pursue the issue further. also, if the preparer knows that the taxpayer could not substantiate similar deductions when audited for a prior tax year, the preparer may have a duty to explore the matter further, despite the taxpayer's statement that he has sufficient records.3' 26. see regs. § 1.6694-1(e)(1). 27. certain procedural aspects of preparing returns, statement on responsibilities in tax practice no. 3, § .09 (am. inst. of certified pub. accountants rev. 1991). the professional's response to the discovery of errors on prior returns is discussed below. 28. see regs. § 1.6694-i(e)(1); circular 230, supra note 1, § 10.34(a)(3). both of these regulations only mention relying on information provided by the taxpayer. it seems clear that in appropriate circumstances, however, the preparer should be able in good faith to rely on information provided by third parties. 29. regs. § 1.6694-1(e)(1); circular 230, supra note 1, § 10.34(a)(3). 30. regs. § 1.6694-1(e)(1), (2) ex. see rev. rul. 80-266, 1980-2 c.b. 378 (negligence penalty applies to preparer who fails to ask whether taxpayer has sufficient records to satisfy § 274(d) substantiation requirements for travel and entertainment expenses deducted on return and fails to show adequate normal office practices). 31. rev. rul. 80-266, 1980-2 c.b. 378 (indicating such a duty). [vol 3:3 conunentary on return preparer obligations the preparer should make a reasonable effort to obtain from the taxpayer appropriate answers to all questions on the return that apply to the taxpayer. reasonable grounds may exist for the return to omit an answer to a question, such as when the information regarding a relatively insignificant item (in terms of taxable income or loss or in terms of the tax liability shown) is unavailable, when there is genuine uncertainty regarding the meaning of the question, or when the answer is voluminous (although the return should then provide assurance that the information will be supplied upon request).32 v. valuation and estimates often, the exact amount to be entered on a return is uncertain because (1) it is impossible or impracticable to obtain all of the data needed to determine the amount or (2) the amount is not susceptible to exact determination. in the first situation, the use of estimates may be necessary; the taxpayer or the tax professional is often in a position to make an estimate that is reasonable under the circumstances. in the second, generally involving a question of valuation, the tax professional should often defer to someone with appropriate expertise. in both situations, the figure entered on the return should not be presented in a manner that is misleading." for example, if the estimated amount is $5,000, it should not be entered on the return as $5,021.43. the aicpa statement on responsibilities in tax practice no. 4 provides guidance on the use of estimates.-" it discusses the appropriateness of using estimates for transactions involving small expenditures, for cases where accuracy in recording data may be difficult to achieve, and when records are missing or precise information is not available on the return's due date. the statement indicates that although specific disclosure that an estimate has been used is ordinarily not required, disclosure may be necessary 32. the subject of responding to return questions is addressed by aicpa statement of responsibilities in tax practice no. 2, which states that while a cpa is not required to explain the reasonable grounds that justify omitting an answer to an applicable question, "the cpa should consider whether the omission of an answer to a question may cause the return to be deemed incomplete." answers to questions on returns. statement on responsibilities in tax practice no. 2, § .06 (am. inst of certified pub. accountants rev. 1991). this could prove damaging to the client (e.g., by attracting an audit or by tolling the statute of limitations), a factor that must always be weighed and should be discussed with the client. 33. see use of estimates, statement on responsibilities in tax practice no. 4. § .06 (am. inst. of certified pub. accountants rev. 1991) [hereinafter aicpa statement no. 41 (estimate should not be presented so as to convey a "'misleading impression as to the degree of factual accuracy"). 34. aicpa statement no. 4, supra note 33. 19961 florida tax review in unusual circumstances to avoid misleading the service.35 examples of such unusual circumstances include the death or illness of the taxpayer, the failure of the taxpayer to receive a form k-1 from a flow-through entity, pending litigation bearing on the return, or the destruction of relevant records by fire or computer failure. how a preparer should deal with a valuation issue may depend on the value of the property and the potential tax liability involved as well as what legal provision controls. often, particularly when relatively small amounts of property are involved, the preparer should be able to rely on the taxpayer's valuation of property. a brief inquiry to be sure that the taxpayer's valuation is not without foundation should suffice. where the property is more substantial, an appraisal is likely to be necessary, although special factors, such as arm's length bargaining over the property's value, may obviate the need for an appraisal. in some instances, however, an appraisal is required by law.36 also, obtaining a "qualified appraisal" from a "qualified appraiser" may ensure against penalties for overvaluation or undervaluation of property.37 if the taxpayer does not wish to bear the cost of obtaining an appraisal when an appraisal is appropriate, the preparer has a duty to advise the taxpayer of the operative law and the risks involved in not obtaining the appraisal. if an appraisal required to support particular return items is not obtained, a preparer who nonetheless signs the return subjects himself to penalties. the preparer should assure himself that any valuation, whether by an appraiser, the taxpayer, or another person, is responsibly done, makes sense, is wellreasoned, and internally consistent. 8 ordinarily, because of ethical limitations on a lawyer serving as a witness and advocate in the same proceeding, a licensed lawyer who may later represent the taxpayer as an advocate against the irs should refrain from serving as appraiser of the taxpayer's property.39 however, following an appropriate explanation of the lawyer's ethical concerns, the lawyer, if qualified, may serve as appraiser, although the lawyer might later be unable to represent the taxpayer as an advocate with respect to the tax issues 35. id. § .07. 36. see regs. § 1.170a-13(c)(2)(i)(a) (requiring a "qualified appraisal" for a charitable gift of more than $5,000 in the form of property other than money or publicly traded securities). 37. see irc § 6664(c)(2) (allowing the reasonable cause defense to valuation overstatement penalties only if a qualified appraisal is obtained from a qualified appraiser and other requirements are met). 38. see frederic g. comeel, guidelines to tax practice second, 43 tax law. 297, 304 (1990). 39. see model rules of professional conduct, rule 3.7 (1992); model code of professional responsibility, dr 5-101(b), 5-102(a) (1981). [vol 3:3 connentary on retm:t preparer obligations involved. preparers who are not licensed lawyers should consider whether any subsequent representation of the taxpayer before the irs would lessen the credibility or weight of an appraisal provided by the preparer. the preparer should generally discuss this issue with the taxpayer before agreeing to serve as appraiser. vi. failure to meet realistic possibility standard if a preparer realizes that the taxpayer's return position does not satisfy the realistic possibility standard but is nonetheless not frivolous, the preparer can sign the return without incurring a penalty under section 6694 if the position is adequately disclosed.40 a nonsigning preparer may advise a taxpayer to take a nonfrivolous position on the return if the preparer advises the taxpayer of any opportunity to avoid the accuracy-related penalty of section 6662 by adequate disclosure.4 ' the term "frivolous" has been defined, not very helpfully, as "patently improper."42 probably, a position that a person knowledgeable in tax law would conclude had less than a 10% chance of being sustained on the merits is frivolous, but the dividing line between frivolous and nonfrivolous is not clear. the disclosure requirement is the subject of considerable regulatory gloss.4 3 the principal problem with respect to this requirement, however, is its relationship to the return standards applicable to taxpayers. section 6662(a) imposes a penalty on an underpayment of tax that is attributable to negligence, and the regulations provide that a return position is negligent "if it lacks a reasonable basis." 4 taxpayers can therefore generally avoid a negligence penalty with respect to a return position if the return position has a reasonable basis. the reasonable basis standard, while clearly higher than the "not frivolous" standard, is probably lower than the realistic possibility of success standard. it is not entirely clear, however, whether the reasonable basis standard may be satisfied by a position with as low as a 15% chance of success or whether the standard requires satisfaction of a somewhat higher, albeit less than a 33-1/3%, threshold.45 40. irc § 6694(a). 41. regs. § i.6694-2(c)(3)(ii)(a); circular 230, supra note 1. § 10.34(a)t )(ii) (also requiring the preparer to advise the taxpayer of the requirements for adequate disclosure). 42. regs. § 1.6694-2(c)(2); circular 230, supra note 1, § 10.34(a)(4)ii). see aicpa statement no. 1, supra note 9, § .09, ("frivolous" position is one -knowingly advanced in bad faith" that is "patently improper"). 43. regs. § 1.6694-2(c)(3). 44. regs. § 1.6662-3(b)(1). 45. see regs. § 1.6662-3(b)t3)(ii) (stating that reasonable basis standard "significantly higher than" not frivolous standard): wolfman et al., supra note 5. '1 207. 1.1 at 89 (written before the regulation was promulgated and referring principally to authority under prior law). it is possible that the "reasonable basis" standard is not applied in probabilistic 19961 florida tax review if a preparer concludes that a return position does not satisfy the realistic possibility standard but does meet the reasonable basis threshold, the preparer can sign the return without incurring a preparer penalty only if the position is adequately disclosed. the preparer should advise the taxpayer, however, that disclosure is not required to protect the taxpayer against the negligence penalty, particularly since the taxpayer is acting on the advice of a tax professional.46 in this circumstance, the preparer's own legal position is untenable. if the taxpayer chooses not to disclose the position on the return, the preparer must either (1) cease participating in preparing the return and not sign it or (2) sign the return and risk a preparer penalty.47 strangely, the regulatory gloss on adequate disclosure does not discuss this difficult situation. in addition, the reasonable cause, good faith exception to the preparer penalty provision has not been interpreted in the regulations as covering this situation, but has instead been interpreted as focusing on factors relating to the preparer's overall practice and office procedures. 4 ' this bizarre discontinuity in the law should be corrected. if a taxpayer wants to assert a nonfrivolous return position that does not have a reasonable basis, the preparer should advise the taxpayer that the taxpayer is risking imposition of a negligence penalty. if the taxpayer does not want to disclose the position, the preparer must also refuse to sign the return to avoid incurring a preparer penalty. the preparer must also advise the taxpayer of any other penalties that the taxpayer's return position might trigger. for example, in many cases where the negligence penalty is potentially applicable, the substantial understatement penalty may also apply.49 the preparer should advise the taxpayer terms, but instead reflects a mixture of factors, including whether the taxpayer is acting on the advice of a tax professional. 46. as discussed below, disclosure may be required to protect the taxpayer against the substantial understatement penalty. 47. if the preparer withdraws from the preparation of the return, the preparer may want to consider whether he should refund any compensation received for preparing the return. however, in some cases, it may be possible to view the preparation of the return as consisting of several distinct tasks, in which case compensation could clearly be retained to the extent attributable to tasks not connected to the problematic return position. 48. see regs. § 1.6694-2(d), discussing five factors: (1) the nature of the error causing the understatement, (2) the frequency of errors, (3) the materiality of errors, (4) the preparer's normal office practice, and (5) reliance on advice of another preparer. see generally james r. hamill, proper procedures can help to avoid preparer penalties, 55 tax'n acct. 294 (1995). 49. see irc § 6662(a), (b), (d). both penalties, however, cannot be applied to the same portion of an underpayment. regs. § 1.6662-2(c). another possible penalty (although only in lieu of the negligence or substantial understatement penalty) is for disregard of rules and regulations. see irc § 6662(b)(1). adequate disclosure may prevent application of this penalty. see regs. § 1.6662-3(c)(1). [vol 3:3 comnentary on retuns preparer obligations that the latter penalty is inapplicable to the extent an understatement is attributable to the tax treatment of an item for which there is or was substantial authority or for which there is both adequate disclosure and a reasonable basis. since the substantial authority standard is generally believed to be higher than the realistic possibility standard,-"" satisfaction of the former implies satisfaction of the realistic possibility standard. if the realistic possibility standard is not satisfied, adequate disclosure and a reasonable basis are required to avoid this penalty. if the taxpayer nonetheless wants to assert the position on the return and risk a penalty, the preparer can avoid the preparer penalty only by refusing to participate further in preparing, and refusing to sign, the return. in discussing the risks of aggressive return positions with the taxpayer, the preparer should not suggest that the risks are lessened by the improbability of an audit. nonetheless, if asked directly, many practitioners consider it not inappropriate for the preparer to indicate the likelihood of an audit.5 in all cases where a preparer has advised taxpayers about the risks of aggressive return positions, the preparer should, for his own protection, maintain records of the advice.5 2 a licensed lawyer should take care in maintaining such records to preserve the confidentiality of communications 50. see wolfman et al., supra note 5. l 207. 1.1 at 89-90. 51. in the case of a licensed lawyer. once the taxpayer-client has decided to file a return asserting a position that the lawyer is not permitted to recommend, the lawyer, in this author's opinion, is obligated to withdraw from the engagement and hence may not subsequently answer questions about the likelihood of an audit. see infra text accompanying note 59. a vigorous discussion at the january 20, 1996 meeting of the committee on standards of tax practice of the american bar association section of taxation indicated that many tax lawyers do not agree with the author's view. others may agree that responding to such an inquiry is inappropriate, but for different reasons. professor david m. richardson argues, for example, that lawyers do not have enough knowledge about the possibility of an audit to answer such a question. if the client has not yet made a decision about the position to be taken on the return or if the preparer is not a licensed lawyer, the propriety of responding to the client's inquiry about the audit lottery is likely to be even more controversial. full discussion of this issue is beyond the scope of this paper. for two views, see all restatement of the law governing lawyers § 151, draft comments (preliminary draft no. 10, 1994): a gathering of legal scholars to discuss "professional responsibility and the model rules of professional conduct"--panel discussion, 35 u. miami l. rev. 639. 659 (1981) (statement of professor geoffrey hazard, jr.). see also aicpa statement no. 1. supra note 9. § os. allowing a cpa to discuss the "likelihood that each [of two positions meeting the aicpa realistic possibility standard] might or might not cause the client's tax return to be exanined." possibly implying that the likelihood of an audit should not be discussed in other circumstances. 52. cf. regs. § 1.6694-2(c)(3)(ii)(a) (with respect to a nonsigning preparer, disclosure requirement is satisfied with respect to a return position only if the preparer's advice informs the client that the position lacks substantial authority and may therefore subject the client to the substantial understatement penalty unless it is adequately disclosed on the return). 19961 florida tax review with a taxpayer whose relationship with the lawyer is a lawyer-client relationship. 3 when a cpa concludes that a position does not meet the aicpa version of the realistic possibility standard, the cpa may prepare and sign a return including the position if the position is not frivolous and is adequately disclosed on the return. 4 if these requirements are not met, the cpa is apparently not supposed to prepare or sign the return, although the aicpa statement on responsibilities in tax practice no. i does not explicitly so state. in recommending certain tax return positions and signing a return, the cpa should, where relevant, advise the client of potential penalty consequences of the recommended positions and the opportunities, if any, to avoid penalties through disclosure.5 whether and how to disclose is the client's decision.56 the ethical obligations imposed on licensed lawyers who prepare returns are not as clearly defined as one might hope, in part because return preparation may be a small part of the lawyer's representation of the client. if a position on the taxpayer's return does not meet the realistic possibility standard of aba opinion 85-352, the lawyer may generally not prepare the return, regardless of whether the lawyer signs the return or simply forwards it (without his signature) to the taxpayer. 7 this general rule raises two major questions: (1) can a lawyer recommend a nonfrivolous, or perhaps somewhat more promising, return position that does not satisfy the realistic possibility standard without risking professional discipline? (2) if the client insists on asserting a return position that the lawyer is ethically precluded from recommending, must the lawyer withdraw from representing the client? aba opinion 85-352 does not expressly provide a disclosure exception for return positions that do not meet the realistic possibility standard. nonetheless, the leading treatise in this area, after a full canvas of the issue, concludes that lawyers should be permitted to recommend a disclosed nonfrivolous return position.5 8 the authors note both that the adequate disclosure puts the irs on notice of the position (thus preventing 53. see corneel, supra note 38, at 306. 54. aicpa statement no. 1, supra note 9, § .02c. the aicpa, as noted above, takes the rather lenient view that a "frivolous" position is one that is "knowingly advanced in bad faith and is patently improper." id. § .09. 55. id. § .02d. 56. for purposes of the preparer penalty, however, "adequate disclosure" is defined by regs. § 1.6694-2(c)(3). 57. see wolfman et al., supra note 5, t1 207.2.1 at 97 ("inappropriate" for lawyer to prepare return and send it to client with "note attached indicating that the position should not be taken," referring to paul j. sax, ethics in tax practice: current issues, 38 tul. tax inst. ch. 18 (1988)). 58. wolfman et al., supra note 5, 204.2.4.2 at 80-81. [vol 3:3 commentary on retuni preparer obligations the taxpayer from playing the audit lottery with the issue) and that the section 6694(a) penalty on preparers for substandard return positions does not apply to a nonfrivolous position that is adequately disclosed. if a client insists on asserting a return position that a lawyer is not permitted to recommend (such as a nonfrivolous, but substandard position as to which the client refuses to make adequate disclosure), the lawyer must withdraw from "the engagement, at least to the extent that it involves advice as to the position taken on the return. ' 59 this clearly means that the lawyer must withdraw from any involvement in preparing the return. the lawyer could presumably continue to represent the client in other matters, such as a child custody dispute. suppose, however, the return is part of an "engagement" involving a larger transaction. must the lawyer withdraw from the entire "engagement"? notwithstanding the somewhat inflexible language of the aba task force report, this seems to depend on the circumstances. the lawyer should weigh a variety of factors, including the importance of the return position to the overall transaction (for example, whether the transaction's viability depends on the questionable return position or the position is a peripheral matter), the proportion of the lawyer's work on the engagement represented by the return, and the potential harm to the client that the lawyer's withdrawal might occasion. even if the lawyer does withdraw, the lawyer does not appear to be precluded from representing the client subsequently when the return position is raised on audit.' vii. discovery of error on filed return when a return preparer discovers an error in a previously filed return for a year not barred by the statute of limitations, the preparer should advise the taxpayer of the error.6' the preparer should advise the taxpayer that the law does not require the filing of an amended return to correct the error,62 59. report of the special task force report on formal opinion 85-352. supra note 13, at 635, 639. 60. for other thoughts on this subject. see wolfman et al.. supra note 5. 1 204.2.4.1 at 80. 61. circular 230, supra note 1. § 10.21 (those admitted to practice before the service); knowledge of error. return preparation. statement on responsibilities in tax practice no. 6, § .03 (am. inst. of certified pub. accountants rev. 1991) [hereinafter aicpa statement no. 6]. 62. see, e.g., badaracco v. commissioner, 464 us 386. 393 (1984) (-internal revenue code does not explicitly provide either for a taxpayer's filing, or for the commissioner's acceptance, of an amended return"). whether an amended return should be required in at least some situations has been a matter of considerable discussion in the literature. see wolfman et al., supra note 5, t 207.4.4; kenneth l. harris. on requiring the correction of 19961 florida tax review but that if the error has a significant effect on the taxpayer's tax liability, the taxpayer should consider filing an amended return to correct the error.63 correction of the error is the proper ethical action as a citizen taxpayer and is often the most practical action. in explaining this to the taxpayer, the preparer should note why it may be important to correct the return because of future return-filing requirements, the possibility of an audit, or any possible inquiry to the taxpayer's attorney from an independent auditor about the presence of contingent liabilities that should be disclosed on a financial statement. the taxpayer should also be advised of any risk that filing an amended return might lead to the imposition of penalties or charges of fraud or criminal misconduct. 64 if the preparer is not a licensed lawyer, the taxpayer should be advised to consult experienced legal counsel before acting, particularly in situations presenting a risk of criminal charges. such counsel (or the lawyer-preparer) should fully apprise the client of the various options in the face of a potential criminal indictment, including assertion of any applicable constitutional rights.65 when the error is on a return prepared by the preparer, particularly if the error is the preparer's fault, the preparer's interest in having the error corrected may conflict with the taxpayer's interest in not filing an amended return. accordingly, in such cases, the preparer-after explaining this potential conflict-should advise the taxpayer to seek other advice about correcting the error.66 if the preparer was responsible for the error, the preparer should prepare the amended return at no expense to the taxpayer and should pay any interest or penalties that resulted from the error. once the preparer has advised the taxpayer about any error that ought to be corrected by an amended return, any consequences of amending the error under the federal tax law, 42 tax law. 515 (1989); joseph e. ronan, jr., do clients have a duty to file amended tax returns, 33 prac. law., mar. 1987, at 25. a proposal to require the filing of amended returns in some cases, prepared by frederic g. corneel, was recently discussed by the aba section of taxation committee on standards of tax practice. 63. in determining whether the error has a significant effect, the possible effect of the error on both the tax year in question and future tax years should be considered. see aicpa statement no. 6, supra note 61, § .07. 64. see badaracco v. commissioner, supra note 62 (filing an amended return does not start the running of the statute of limitations where the earlier return was fraudulent). 65. see corneel, supra note 38, at 307; aicpa statement no. 6, supra note 61, § .05. 66. corneel, supra note 38, at 307. in most cases, simply advising the taxpayer of the conflict of interest should suffice. the taxpayer should be free to decide not to seek other advice. in some cases, however, the conflict of interest may be such that the client must seek independent advice. although this analysis derives from the conflict of interest rules applicable to licensed lawyers, the practical conclusions should apply with equal force to other preparers. [vol 3:3 comnneniary on retuni preparer obligations return, and any circumstances suggesting that the taxpayer should seek other advice or consult legal counsel, the final decision whether to amend the return is the taxpayer's alone. nonetheless, if the taxpayer chooses not to amend the return, the preparer must consider whether to continue the professional relationship with the taxpayer. each category of professional must make this decision in light of the factual situation at hand and any relevant ethical principles. clearly, the professional should not represent the taxpayer in an audit of the uncorrected return if the taxpayer refuses to have the error disclosed on audit.67 some degree of withdrawal from the relationship with the taxpayer is also likely to be appropriate where the return was prepared by the preparer and contains a "clear and material" error.s if the preparer chooses to continue the professional relationship with a noncorrecting taxpayer, the preparer should take reasonable steps to assure that the error is not repeated or compounded in a return for a subsequent year.' viii. final thoughts a complex web of overlapping rules of law and professional ethics regulates the work of return preparers. some of this complexity reflects the overall complexity of the tax system and the transactional activity to which it applies. some of the complexity occurs because returns are prepared by members of different professions. the fact that preparers, depending on their professional status, are subject to discipline by the director of practice of the internal revenue service, by the aicpa, by state bar and accounting regulatory authorities, under the penalty provisions of the code, and perhaps through malpractice and contract law, is nonetheless not sufficient justification for all of the complexity. the definition of appropriate conduct in preparing returns does not truly vary with the professional status of the preparer, even if the sanction for improper action varies. furthermore, the preparer penalty structure of the code should be more closely coordinated with the taxpayer penalty structure. in light of these considerations, the following reforms should be pursued: 67. see aba formal op. 352, supra note 7, at 633 (referring to model rules of professional conduct, rules 4.1, 8.4(c) (1983). and model code of professional responsibility, dr 1-102(a)(4), 7-102(a)(3) and (5) (1969)); knowledge of error:. administrative proceedings, statement on responsibilities in tax practice no. 7. § .04 (am. inst. of certified pub. accountants rev. 1991). 68. see corneel, supra note 38, at 307 (noting that an attorney may be required to insist that the client seek other counsel if attorney's "own interest is sufficiently disparate from that of the client"). the attorney, however, may not need to withdraw completely. for example, the attorney might choose to discontinue representing the client in tax matters, but continue to handle the client's child custody dispute. 69. aicpa statement no. 6, supra note 61, § .06. 19961 florida tax review 1. the various formulations of the realistic possibility standard should be replaced with one standard. the standard in section 6694 was enacted in part to reflect the professional conduct standards developed by the aicpa and the aba, but the three versions of the standard have not been normalized under one formulation. it is time to undertake this effort.7" in connection with this effort, the aicpa may want to reconsider its definition of a "frivolous" position, and the aba should make clear that a lawyer may ethically recommend an adequately disclosed nonfrivolous position. the aba and the code standards should reflect the nonadversarial nature of return preparation. 2. the regulations under section 6694 should be amended to expand the kinds of authorities that may be considered in evaluating whether the realistic possibility standard is met. presently, the regulations do not seem to reflect the legislative intent to have the statutory standard reflect the professional conduct standards of lawyers and accountants. nor do they reflect the realities of tax practice. the list of authorities that may be considered under aicpa statement on responsibilities in tax practice no. 1 is much more realistic. 3. the preparer penalty rules under section 6694 should be coordinated with the taxpayer penalty provisions to eliminate the present discontinuities. either the taxpayer standards could be stiffened or the preparer standards could be liberalized. 4. serious consideration should be given to requiring the filing of amended returns to correct at least the most material errors. 5. the standards, as reformed, should not attach any significance to the fact that the taxpayer may obtain prepayment judicial review of a return position in the tax court. these reforms would substantially improve the functioning of the return preparer part of the tax-filing system. 70. there are areas of tax practice, however, where the roles of different groups of professionals may justify different regulatory rules. for example, the attorney-client privilege and lawyers' role as advocates may call for special regulatory rules for lawyers engaged in tax practice in some contexts. return preparation, however, does not seem to be such a context. [vol 3:3 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 6 2004 number 5 guaranteed payments made in kind by a partnership douglas a. kahn* faith cuenin** i. introduction ...................................... 406 ii. history and role of irc section 707 ................ 408 i. partner's percentage interest subject to a minimum dollar amount ............................. 410 iv. nonrecognition of gain for partnership distributions and basis of distributed property ................... 411 v. nonliquidating guaranteed payments made in kind . 414 a. effect on outside basis of a guaranteed payment m ade in cash ................................. 419 b. partnership's recognition of gain or loss .......... 422 c. basis of property received as a guaranteed payment . 428 vi. liquidating distributions ........................... 436 v. conclusion ....................................... 438 * paul g. kauper professor of law, university of michigan. b.a. university of north carolina at chapel hill,1955; j.d., with honors, george washington university, 1958. elected to the order of the coif; served as the recent case notes editor for the law review; trial attorney with the appellate section of the tax and civil divisions of the u.s. department of justice, 1958-1962; associate with the washington, d.c. law firm of sachs and jacobs, 1962-1964; joined the law faculty of the university of michigan in 1964; named the paul g. kauper professor at michigan, 1984. professor kahn has published numerous treatises, casebooks, and articles on the subject of taxation. **j.d. (1985), suffolk university, ll.m. (2003), washington university. florida tax review i. introduction if a partnership makes a payment to a partner for services rendered in the latter's capacity as a partner or for the use of capital, to the extent that the payment is determined without regard to partnership income, it is characterized by the internal revenue code as a "guaranteed payment" and is treated differently from other partnership distributions.' in addition, if a partnership makes a payment in liquidation of a retiring or deceased partner's interest in the partnership, part of that payment may be characterized as a guaranteed payment by section 736(a)(2). we will discuss in part vi of this article the circumstances when a liquidating payment is treated as a "guaranteed payment." while section 707(c) and 736(a) refer to a "payment," there is no reason that it must be made in cash, and the leading treatises on partnership taxation agree that guaranteed payments can be made in kind.2 as used in this article, a "liquidating" distribution or payment refers to a partnership distribution or payment made pursuant to the liquidation of a partner's interest in the partnership. all other partnership distributions or payments are sometimes referred to as "operating" distributions or payments. an unresolved question is whether a guaranteed payment of property in kind will cause the partnership that made the payment to recognize gain or loss if the property is appreciated or depreciated. even if the answer to that question were affirmative, and the authors have concluded otherwise, no deduction would be allowed for a loss recognized on a payment to a person owning, directly or indirectly, more than a 50 % interest in the profits or capital 1. irc § 707(c). unless stated otherwise, references herein to "irc" or to the "code" are to the internal revenue code of 1986 as currently amended. 2. 1 william s. mckee, william f. nelson & robert l. whitmire, federal taxation of partnerships and partners 13.0315] (3d ed. 1997), [hereinafter cited as mckee]; arthur b. willis, john s. pennell & philip f. postlewaite, partnership taxation 15.06 (6th ed. 2002) [hereinafter willis. the discussion in the willis treatise pertains to liquidating distributions of property in kind under irc § 736, some of which constitute guaranteed payments, and the treatise expressly concludes that such payments can be made in kind. 2 willis 15.06[1], [4]. however, the willis treatise also states that guaranteed payments are "generally thought to be money payments," and that "[n]othing in the regulations, the case law, interpretive rulings, or the legislative history considers such payments other than in terms of money." 2 id. 15.06[1]. the willis treatise concludes, however, that the statutory language is sufficiently broad to apply to liquidating payments made in property in kind. see also, stephen a. lind, stephen schwartz, daniel j. lathrope & joshua d. rosenberg, fundamentals of partnership taxation 328-329 n. 10, 20 & 21 (6th ed. 2002) [hereinafter lind]. [voi.6:5 guaranteed payments made in kind by a partnership of the partnership.3 in this article, the authors will focus on the question of the partnership's recognition of gain or loss, and will not examine questions of deductibility for a recognized loss. two allied unresolved questions, which are discussed in this article, are: (1) how is a partner's basis in property that was received as a guaranteed payment to be determined, and (2) regardless of whether the guaranteed payment is made in cash or in kind, what effect does the payment have on the partner's outside basis in his partnership interest. the mckee treatise concludes that the proper treatment of guaranteed payments made in kind is that the partnership will recognize gain or loss for the amount of appreciation or depreciation of the property, and that the partner will have a basis in the property equal to its fair market value.4 while the willis treatise does not discuss the question of gain or loss recognition, the treatise does consider the basis question in the context of a guaranteed payment made as part of the liquidation of a partner's interest. the willis treatise concludes that although granting the partner a basis equal to the property's fair market value is the logical and desirable treatment, the statutory authority for that treatment is weak.5 the willis treatise does not resolve that issue. the lind casebook states that the partnership will recognize gain or loss, but does not discuss the basis issue.6 in this article, the authors contend that no gain or loss is recognized, and nevertheless, the partner takes a basis in the distributed property equal to its fair market value. the authors also contend that a guaranteed payment does not affect the partner's outside basis in his partnership interest except to the extent that any deduction allowed to the partnership for making the payment is allocated to the partner as his share of a partnership loss. there is no case, regulation or ruling expressly addressing those issues. one possible explanation for this dearth of authority is that guaranteed payments are rarely made in kind except for liquidating payments, and many of those are made in cash. nevertheless, especially since liquidating distributions are sometimes made with property in kind, the issue is worthy of exploration. the issue may yet be raised by the service. the question of the effect of a guaranteed payment, whether made in cash or in kind, on the partner's outside basis in his partnership interest will arise frequently. before examining the question of gain or loss recognition, it is useful to set forth the history and role of section 707(a) and (c). other code provisions 3. irc § 707(b). in determining a partners percentage interest, constructive ownership rules are applied. irc § 707(b)(3). 4. 1 mckee, supra note 2, 13.03[5]. the mckee treatise also concludes that the partner's outside basis in his partnership interest is affected by the guaranteed payment only to the extent of the partner's share of any deduction allowed to the partnership and the partner's share of the gain or loss that the partnership recognized from the transaction. 1 mckee, supra note 2, 13.03[5], at ex. 13-8. 5. 2 willis, supra note 2, 15.06[4]. 6. lind, supra note 2, 329 n. 21. 20041 florida tax review come into play, especially when considering the basis that a partner will acquire in the distributed property and the effect that the payment will have on the partner's outside basis, but section 707 is at the epicenter of this subject. h. history and role of irc section 707 section 707 was first adopted in 1954 as part of subchapter k of chapter 1 of subtitle a of the internal revenue code of 1954. subchapter k was adopted by congress to bring order to the field of partnership taxation where confusion and inconsistent treatment previously had reigned. the report of the ways and means committee on h.r. 8300, which bill became the internal revenue code of 1954 when adopted, described the status of the pre1954 tax law as follows: the existing tax treatment of partners and partnerships is among the most confused in the entire income tax field. the present statutory provisions are wholly inadequate. the published regulations, rulings, and court decisions are incomplete and frequently contradictory. as a result partners today cannot form, operate, or dissolve a partnership with any assurance as to tax consequences.7 one of the areas addressed in the 1954 code was the treatment of transactions between a partnership and a partner. in section 707(a), congress dealt with those transactions in which the partner was acting in some capacity other than his role as a partner. in section 707(c), congress dealt with payments from a partnership to a partner for services rendered in his partnership capacity (or for the use of capital), but only to the extent that the payment was determined without regard to the income of the partnership. a partnership can hire a partner to perform services and pay the partner a salary, determined without regard to partnership income. if the services were connected to the partner's role as a partner, section 707(c) applies to the payment; but if the services were not pursuant to the partner' s role as a partner, section 707(a) controls. that division still exists and is reflected in the current forms of section 707(a) and (c). prior to the adoption of the 1954 code, a partnership was generally not treated as a separate entity whose transactions with a partner are treated similarly to its transactions with a stranger. section 707(a) changed that; consequently a transaction between a partnership and a partner, other than in the latter's capacity as a member of the partnership, is now treated the same as a 7. h.r. rept. no. 83-1337, pt. 22, at 65 (1954), reprinted in 1954 u.s.c.c.a.n. 4025,4091, [vol6:5 guaranteed payments made in kind by a partnership transaction between the partnership and a stranger, except that there are rules denying a deduction or requiring ordinary income treatment in certain cases involving a sale or exchange.8 a partnership may pay a "salary" to a partner for services performed in the latter's capacity as a partner. the "salary" may be nothing more than an advance on the partner's share of partnership income. or, it can be a payment of a specified amount, after which the profits of the partnership are divided among all of the partners, including the payee, in proportion to their partnership interests. another version of a "salary" is to provide a partner with a percentage interest in partnership profits, but guarantee that the partner's share will not be less than a specified dollar amount. payments made under the first of these alternatives will not constitute a guaranteed payment; payments made under the second alternative will be a guaranteed payment; and the extent to which a payment received under the third alternative constitutes a "guaranteed payment" is discussed in part h of this article. prior to the adoption of the 1954 code, salary payments to a partner for services rendered were merely a basis for dividing the partnership's profits.9 if the salary payments did not exceed partnership profits, the salaries were treated as distributions of those profits and taxed accordingly. to the extent that partnership profits were less than the amount of salary payments, the excess salary was treated as having been made from the partners' capital accounts. salary deemed to have been paid from the service partner's own capital account was not taxable to him, but salary deemed to have been paid to the service partner from the capital account of another partner was taxable to the service partner and deductible by the partner whose capital account was reduced.'l the determination of tax was even more complex when, as a consequence of paying salaries, the partnership had a net loss for the year." congress determined that the pre-1954 treatment was "unrealistic and unnecessarily complicated."'2 congress cured this problem by adopting section 707(c), which treats a guaranteed payment as one made to a person who is not a member of the partnership, "but only for the purposes of section 61 (relating to gross income) 8. irc § 707(a). no loss deduction is allowed for a sale or exchange between a partnership and a partner who owns, after applying certain attribution rules, more than a 50% capital or profits interest in the partnership. irc § 707(b)(1). also, gain recognized on a sale or exchange between a partnership and a more than 50% partner of an asset that is not a capital asset in the hands of the transferee will be treated as ordinary income. irc § 707(b)(2); see irc § 1239. 9. lloyd v. commissioner, 15 b.t.a. 82, 87 (1929). 10, cagle v. commissioner, 63 t.c. 86,93 (1974), aff'd, 539 f.2d 409 (5th cir. 1976). 11. see lloyd, 15 b.t.a. 82 (1929). 12. h.r. reptno. 83-1337, supra note 7, at 68, reprinted in 1954 u.s.c.c.a.n. at 4094. 20041 florida tax review and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses)."'' 3 the "but only for the purposes of' language in the statute was added to the 1954 bill by the senate finance committee and accepted by the house. the clause referring to "section 263" was added in 1976 to clarify that guaranteed payments will have to be capitalized instead of deducted in appropriate circumstances.4 iii. partner's percentage interest subject to a minimum dollar amount if a partnership provides that a service partner is to receive a specified percentage of partnership profits, computed before taking any guaranteed payments into account, but also provides that in no event will the amount distributed to the partner in a taxable year be less than a specified dollar amount, what amount of the distribution to that partner will be a guaranteed payment? that issue is resolved in regulations section 1.707-1(c), ex. 2. the amount that equals the partner's percentage interest in the partnership's profits is treated as a partnership distribution, but the additional amount of the payment above the partner's percentage interest is treated as a guaranteed payment."5 the following illustration is taken from the regulation. partner c, who provides services to the cd partnership in his capacity as a partner, is to receive annually 30% of partnership income as determined before taking into account any guaranteed payments, but no less then $10,000. if the partnership's income for a year is $60,000, then c's distributive share would be $18,000($60,000 x 30%), and there would be no guaranteed payment. in the next year, the partnership's income was only $20,000. c's distributive share of that income is $6,000 ($20,000 x 30%). but c is guaranteed no less than $10,000. the $4,000 difference is a guaranteed payment to c. to recap, $6,000 paid to c is a partnership distribution, and the remaining $4,000 is a guaranteed payment.' 6 13. irc § 707(c) (emphasis added). 14. tax reform act of 1976, pub. l. no. 94-455, 90 stat. 1520 (1976). this amendment codified the result reached by the courts in cagle v. commissioner, 63 t.c. 86 (1974), afftd, 539 f.2d 409 (5th cir. 1976). 15. see rev. rul. 69-180, 1969-1 c.b. 183. 16. see regs. § 1.707-1, ex. 2. [vol.6:5 guaranteed payments made in kind by a partnership iv. nonrecognition of gain for partnership distributions and basis of distributed property the general rule is that neither a partnership nor a partner recognizes gain or loss when property is distributed to a partner either as an operating or as a liquidating distribution.7 there are several exceptions. one exception is that a partner recognizes gain to the extent that the partner receives cash from the partnership in excess of the partner's outside basis (i.e., "outside basis" is the basis that a partner has in his partnership interest). 18 a second exception, in which both the partner and the partnership can recognize a gain or a loss, arises when section 751(b) comes into play. section 751(b) applies when the consequence of a distribution is that the value of the partner's aggregate share of certain ordinary income assets (sometimes referred to as "section 751 assets" or as "hot assets")9 of the partnership, determined immediatelybefore the distribution, is increased or decreased and the value of the partner's aggregate share of other partnership assets is correspondingly decreased or increased.2" when applicable, section 751(b) causes there to be a constructive exchange of assets between the partnership and the partner in which both parties can recognize gain or loss. while there are several other circumstances in which a partner (not necessarily the partner who received the distribution) can recognize a gain because of a distribution in kind,2' it is only in a constructive exchange triggered by section 751 (b) that a distribution can cause the partnership to recognize gain or loss. the section 751(b) constructive exchange arises only under special circumstance and invokes a complex set of tax rules. in the balance of this article, we will deal with distributions that do not trigger section 751 (b), and so we will ignore that provision for the most part. section 751 (b) does not apply 17. irc §§ 73 1(a), (b), 736(b)(1). 18. irc § 731(a)(1). 19. section 751 assets consist of two categories of properties: "unrealized receivables," and "inventory;" and for purposes of irc § 751(b), the aggregate inventory of the partnership must be substantially appreciated for any of its inventory to be included. the terms "unrealized receivables" and "inventory" are specially defined in irc § 75 1(c) and (d), and those special definitions are much broader and inclusive than the ordinary meaning of those terms would imply. some properties may qualify both as unrealized receivables and as inventory; in such cases, even inventory that otherwise would have been excluded because of failing the "substantially appreciated" requirement of § 751(b) will be a section 751 asset. 20. irc §§ 73 1(d), 75 1(b). 21. see irc §§ 704(c), 737. 20041 florida tax review to guaranteed payments,22 and so it bears only minor relevance to the subject of this article. in the case of an operating distribution (i.e., one not in liquidation of a partner's interest and not a guaranteed payment) of property in kind, the partner's basis in the distributed property is the same as the basis that the partnership had in that property immediately before distributing it.23 however, there is a ceiling on the basis that a partner can acquire. a partner's aggregate basis in the properties distributed to him cannot exceed the amount of the outside basis that the partner had in his partnership interest reduced by any money "distributed in the same transaction.,24 the partner's outside basis is reduced by the amount of cash distributed to him and by the amount of basis he obtained in the distributed properties. in other words, the partner's basis in his partnership, interest (his "outside basis") is reduced by cash he received, and then any remaining basis is shifted from the outside basis to each item of distributed property, but only to the extent of the partnership's basis in that property immediately before making the distribution. if more than one property was distributed to a partner, and if the partner's outside basis is insufficient to provide the partner with a basis in all of the properties he received equal to the basis that the partnership had therein, the code provides an ordering method for allocating the permissible basis among those distributed properties.26 a distribution to a partner, regardless of whether an operating or a liquidating distribution, will reduce that partner's capital account by the amount of cash plus the fair market value of property distributed in kind.27 but first, an adjustment will have to be made to the property's book value and to the partners' capital accounts. if the distributed property has a fair market value that is different than its book value in the partnership, then immediately before the distribution takes place, the book value of the property is changed to equal its fair market value, and the increase or decrease in book value is allocated to the partners' capital accounts in proportion to their respective percentage interests in the partnership.28 thus, the book value of distributed property will always equal its fair market value at the time that the distribution takes place, and the partners' capital accounts will reflect the amount of unrealized appreciation or depreciation that the partnership had in that property. 22. see regs. § 1.75 1-1(b)(l)(ii). 23. irc § 732(a)(1). 24. irc § 732(a)(2). 25. irc §§ 705(a)(2), 733. 26. irc § 732(c). 27. see regs. § 1.704-1(b)(2)(iv)(b). the fair market value of the distributed property is reduced by any liabilities to which it is subject and which the partner either assumed or accepted. see regs. § 1.704-1(b)(2)(iv)(c). 28. see regs. § 1.704-1(b)(2)(iv)(e)(1). [vol.6:5 guaranteed payments made in kind by a partnership the core principle of the code's treatment of partnership operating distributions to a partner is to defer recognition of any gain or loss to the extent that it is feasible to do so.29 the amount of the unrealized appreciation or depreciation of the partner's interest in the partnership is left intact, but is divided between his partnership interest and the distributed property. the shifting of part or all of the partner's outside basis in his partnership interest to the distributed property does not alter the net amount of the partner's potential gain or loss, but it transfers part of that potential to the distributed property so that the partnership's inside appreciation or depreciation of that property is taken over by the partner. the treatment of distributions in liquidation of a partner's interest in the partnership is different. distributions to a retiring or deceased partner are divided by section 736 into two categories: (1) payments for the partner's interest in partnership property (section 736(b)), and (2) all other payments (section 736(a)) which are categorized either as guaranteed payments or as distributions of partnership income. we will address the determination and treatment of section 736(a) payments in part vi of this article. at this time, we will focus on liquidating distributions that are attributable to the partner's interest in partnership property and that are controlled by section 736(b). you will recall that the same rules for operating distributions regarding the write-up or write-down of the book value of distributed property to its fair market value and the allocation of the change to the partners' capital accounts apply equally to liquidating distributions.30 a partner will recognize gain to the extent that the amount of cash distributed to the partner exceeds the partner's outside basis in his partnership interest.31 a partner generally will not recognize a gain on receiving a liquidating distribution in kind unless one of the exceptions noted above is applicable.32 the principal exception is where section 751(b) applies to cause a constructive exchange of assets. a partner can recognize a loss on receiving a liquidating distribution, but that can occur only if the partner receives no assets other than cash, unrealized receivables, and inventory, or if there is a constructive exchange under section 751(b).33 a partnership will not recognize any gain or loss except where there is a constructive exchange of assets under 29. for example, to the extent that a partner receives cash in excess of his outside basis, it is not feasible to defer the gain that the partner realized. it would be possible to defer that gain by reducing the partner's basis in some other asset that he owns, but that would entail more of an administrative burden than the benefit of nonrecognition warrants in that situation since there is little reason for nonrecognition when the partner has recouped all of his basis and realized a profit in cash. 30. see supra text accompanying notes 27-28. 31. irc § 731(a)(1). 32. see supra text accompanying notes 17-21. 33. irc § 731(a)(2). 2004] florida tax review section 751(b).34 in examining liquidating distributions, we will deal with circumstances where section 751(b) does not apply, and so we will give only brief attention to that section. a partner's basis in property received in liquidation is determined differently from the determination of basis in operating distributions. since the partner's interest in the partnership is being terminated, there would be no usefulness to leave the partner with any remaining outside basis in his partnership interest. accordingly, the partner takes all of his outside basis, less any cash received in the same transaction, and allocates that to the property he received under section 736(b)." however, the basis allocated to unrealized receivables and inventory cannot exceed the basis that the partnership had in those properties.36 the definition of "unrealized receivables" and "inventory" for this purpose is the same as the definition employed in section 751.37 after allocating outside basis to any unrealized receivables and inventory, any remaining outside basis is allocated to other properties the partner received;38 but if the partner did not receive any other property, the partner is permitted to take a deduction for the remaining outside basis.39 that rule explains why a partner is allowed to deduct a loss for any unallocated outside basis if the only properties the partner receives are cash, unrealized receivables, and inventory. if the partner receives more than one property, the manner in which basis is allocated among the properties is set forth in section 732(c). v. nonliquidating guaranteed payments made in kind if an employer pays an employee's salary by paying the employee with property in kind, the employer will recognize gain or loss to the extent that the property is appreciated or depreciated.4" the reason that gain or loss is recognized in such cases is that the employer is satisfying a debt with appreciated or depreciated property, and so there was an exchange of the property for the debt. putting it differently, the transaction can be viewed as one in which the employer constructively paid the employee cash equal to the value 34. see irc §§ 731 (b), 751 (b). 35. irc § 732(b). 36. irc § 732(c)(l)(a)(i). 37. id. for this purpose, there is no requirement that the inventory be substantially appreciated. you will recall that the definitions of the terms "unrealized receivables" and "inventory" in irc § 751 are broader than the usual definitions of those terms. see supra note 19. 38. irc § 732(c)(l)(b)(i). 39. irc § 731(a)(2). 40. see, e.g., mckee, supra note 2, 13.03[5] (citing cases therein); see also, united states v. davis, 370 u.s. 65 (1962) (applying the same concept in a different context). [vol.6:5 guaranteed payments made in kind by a partnership of the property, and the employee then constructively used that cash to purchase the property. in such circumstances, the employee's basis in the property is equal to its fair market value, i.e., the employee is treated as if he purchased the property for cash in an amount equal to its value. if the employee was not permitted to take a basis equal to value, there would be double taxation when the employee sold the asset if it were appreciated at the time the employee received it. a major issue then is whether, for purposes of gain or loss recognition and for determination of basis, a guaranteed payment made in kind to a partner for services is to be treated as if it were made by an employer (a separate entity) to an employee. as noted above, section 707(c) states that a guaranteed payment is to be treated as having been made to a person who is not a member of the partnership "but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a)(relating to trade or business expenses)."'" in other words, a guaranteed payment constitutes ordinary income to the partner and is deductible by the partnership unless the payment constitutes a capital expenditure. the "but only for the purposes of' language of the statute strongly suggests that for all other purposes the payment is treated as a distribution to a partner. the regulations construing this provision reiterate the statutory language and state that the partner's income from the payment is to be reported in the partner's "taxable year within or with which ends the partnership taxable year in which the partnership deducted" the payment under its method of accounting.42 the regulation further states: guaranteed payments do not constitute an interest in partnership profits for purposes of sections 706(b)(3), 707(b), and 708(b). for the purposes of other provisions of the internal revenue laws, guaranteed payments are regarded as a partner's distributive share of ordinary income. thus, a partner who receives guaranteed payments for a period during which he is absent from work because of personal injuries or sickness is not entitled to exclude such payments from his gross income under section 105(d). similarly, a partner who receives guaranteed payments is not regarded as an employee of the 41. irc § 707(c) (emphasis added). 42. regs. § 1.707-1(c). this timing rule is the same as the one for the timing of a partner's recognition of his distributive share of partnership income or other tax items. irc § 706(a). so, the timing of recognition depends upon the accounting method used by the partnership. note that irc § 267(a)(2), deferring a deduction for accruals of obligations to a related person in certain circumstances, does not apply to guaranteed payments. irc § 267(e)(4). 20041 florida tax review partnership for the purposes of withholding of tax at source, deferred compensation plans, etc. 3 section 707(c) was first adopted as part of the 1954 code. prior to its adoption, guaranteed payments were treated as partnership distributions for all purposes. that treatment caused complexity and led to incongruous results when the guaranteed payments exceeded the partnership's income for that year. as previously noted, the "but only for the purposes of' language in the statute was first included in the provision by the senate finance committee, which explained the reason for its insertion as follows: in the case of guaranteed salary payments your committee followed the house bill but made it clear that such income is to be reported for tax purposes at the end of the partnership year in which it is paid and that this treatment is only provided for purposes of the reporting of the income by the partner and the deducting of the payments by the partnership.4 the language employed in section 707(c) is in sharp contrast to the language of section 707(a) which treats a salary payment made to a partner in a capacity other than his position as a partner as a payment to one who is not a partner; and, unlike the section 707(c) provision, the section 707(a) treatment is not limited to several specified code provisions. contrary to the restrictive language of section 707(c) limiting nonpartner treatment to three code provisions, the regulations describe several other statutory provisions for purposes of which a guaranteed payment is not 43. regs. § 1.707-1(c). in a much criticized decision of the fifth circuit, the court held that a partner who deals with the partnership in a capacity other than that of a partner can be treated as an employee for purposes of other provisions of the internal revenue code, but the decision relates to a irc § 707(a) relationship rather than to a irc § 707(c) relationship. armstrong v. phinney, 394 f.2d 661 (5th cir. 1968). even as to the fifth circuit's holding under § 707(a), the service has stated that the court's decision is in error. general couns. mem. 34,173 (july 25, 1969). that general counsel memorandum further states that irc § 707(c) treats a guaranteed payment to a partner as having been made to an employee only for the very limited purposes of applying the three statutory provisions listed in irc § 707(c). see also, h.r. conf. rep. no. 83-2543, at 59 (1954), reprinted in 1954 u.s.c.c.a.n. 5280, 5319-20. 44. s. rep. no. 83-1622, at 94 (1954), reprinted in 2 internal revenue acts of the united states: the revenue act of 1954 with legislative histories and congressional documents (bernard d. reams, jr. ed., 1982). 45. accordingly, the timing for reporting income and deductions from a § 707(a) salary payment is determined by the accounting method employed by the partner. irc § 267(a)(2), (e)(1). see lind, supra note 2, at 226-227. [vol6:5 guaranteed payments made in kind by a partnership treated as a distribution to a partner.6 the regulation under section 707(c) itself states that a guaranteed payment is not taken into account in determining a partner's percentage interest in partnership profits for purposes of sections 706, 707, and 708, even though those sections are not mentioned in the statute.47 a key question then is to what extent a guaranteed payment under section 707(c) is to be treated as made to one who is not a partner for purposes other than income recognition by the partner and deductibility by the partnership. that question incorporates the age-old conflict of whether a partnership should be treated as a separate entity or merely as a representative of the aggregate of interests of its partners. under an aggregate approach, a partnership is treated as a mere conduit from which its tax items are allocated among its partners. to the extent that section 707(c) treats a guaranteed payment as a partnership distribution, it accords with the aggregate or conduit approach; whereas, to the extent it treats the payment as having been made to a stranger, it adopts a separate entity approach. in adopting subchapter k, congress decided that it is not desirable to treat a partnership exclusively either as an entity or as an aggregate of interests. instead, in subchapter k, a partnership is treated as a separate entity for some purposes and as an aggregate of interests and a conduit for other purposes. rather than slavishly adhering to consistency, congress chose a pragmatic approach which adopted entity treatment when that suited its purpose and aggregate treatment when that did so.48 not only do different sections of the code reflect this flexibility, but even a single section (e.g., section 751) can apply entity and aggregate treatment for different parts of the provision. indeed, as noted above, section 707(c) itself reflects that dual approach. it treats the partnership as an entity to the extent that it requires the partner to recognize ordinary income and grants the partnership a deduction; and it applies aggregate or conduit treatment to the extent that the payment is treated as a partnership distribution. there is no indication that congress gave any thought to the question of the partnership's gain or loss recognition and the partner's basis when it adopted section 707(c). one likely reason for its failure to consider those issues is that congress did not contemplate the possibility that guaranteed payments would be made in kind. operating guaranteed payments typically are not made in kind, and congress likely did not consider the consequence of including guaranteed payments in the characterization of liquidating distributions. to the 46. see infra text accompanying notes 49 and 50. 47. regs. § 1.707-1(c). 48. in the conference report on the internal revenue code of 1954, congress indicated that its decision to apply entity or aggregate treatment depending upon which was more appropriate to the occasion applied also to transactions between a partnership and its partners. h.r. conf. rep. no. 83-2543, supra note 43, at 59, reprinted in 1954 u.s.c.c.a.n. at 5319-20. 20041 florida tax review extent that legislative intent can bear on the resolution of the instant questions, the intent will have to be extrapolated from the meager history that is available and from the assumption that congress would wish the statute to be construed in a manner that arrived at results that conform to the broad policies that underlie subchapter k. it seems clear that the restriction in section 707(c) to treat a guaranteed payment as having been made from a separate entity only for purposes of three code sections cannot be taken at face value. while there are many provisions for whose purposes a guaranteed payment is treated as a partnership distribution (and so not a payment from a separate entity),49 there also are a number of circumstances, not listed in the statute, in which it is treated as a payment from a separate entity. as noted above, the regulations under section 707(c) list several provisions (not listed in the statute) for purposes of which the partnership is given entity treatment in making a guaranteed payment.5" other examples of entity treatment exist. for example, the regulatory rules under section 704, requiring for certain purposes that capital accounts of partners be maintained in a specified manner, state that a guaranteed payment to a partner is not treated as a partnership distribution, and so the payment reduces the partner's capital account only to the extent that a resulting deduction allowed to the partnership is allocated to that partner.5 if the payment were treated as a partnership distribution, which is an aggregate or conduit treatment, the amount of the distribution would reduce the partner's capital account.52 although there are exceptions to the statutory language limiting entity treatment for guaranteed payments to three code sections, the statutory limitation creates a presumption that, for purposes other than those three code sections, the payment will be treated as a partnership distribution; and so there is a burden on those who would seek to expand the entity treatment to demonstrate that there is a compelling reason to do so. one of the reasons, but not the only one, that the authors have concluded that a partnership does not recognize gain or loss on making a guaranteed payment in kind is that there is no compelling reason to depart from the statutory limitation on entity treatment in that case. that is, as we will show later, the non-entity treatment of not recognizing a gain or loss not only does not conflict with any of the policies of subchapter k or provide a means for escaping from potential tax liability, but rather implements one of the prime principles of subchapter k, i.e., the 49. for example, a guaranteed payment is not subject to employment taxes or withholding, and so is treated as a partnership distribution for those purposes. regs. § 1.707-1(c). instead, a guaranteed payment made for services is treated as self-employed income of the partner. irc § 1402(a)(13); regs. § 1.1402(a)-l(b). 50. regs. § 1.707-1(c). see supra text accompanying note 43. 51. regs. § 1.704-1(b)(2)(iv)(o). 52. regs. § 1.704-1(b)(2)(iv)(b). [vol6:5 guaranteed payments made in kind by a partnership principle that in transactions between a partner and a partnership, recognition of gain or loss should be deferred to a later date. nonrecognition of gain does create one relatively minor potential for tax reduction that is discussed in part v.b. in the view of the authors, that potential is not of sufficient significance to warrant departing from the normal subchapter k design for nonrecognition or from the express statutory limitation in section 707(c). a. effect on outside basis of a guaranteed payment made in cash as noted above, not all of the circumstances in which entity treatment is applied to guaranteed payments are set forth in the statute or the regulations. entity treatment should prevail in circumstances where failure to do so would produce unsavory consequences. no statute should be construed in such manner as to lead to results that fly in the face of reason. for example, consider the effect that a guaranteed payment that was made in cash has on the partner's outside basis in his partnership interest. sections 705(a)(2) and 733 require that a partner's outside basis in his partnership interest be reduced (but not below zero) by the amount of cash the partner received as an operating partnership distribution. since neither of those two sections is one of the three code sections that section 707(c) states to be the only provisions for which entity treatment is to be applied, a literal application of section 707(c) and the regulations would require a partner to reduce his outside basis by the amount received. but, that would reach an anomalous result. since the payment constitutes ordinary income to the partner, it would be wrong to reduce the partner's outside basis, the effect of which would be to treat the payment as a return of the partner's capital. accordingly, the authors conclude that a partner's outside basis is not reduced by a guaranteed payment, whether made in cash or in kind, except to the extent of the partner's share of any deduction the partnership obtained from the payment. the effect on outside basis therefore will be identical to the effect that the regulations provide that the payment has on a partner's capital account.53 in the area of partnership taxation, it frequently is the case that an examination of a partnership's financial balance sheet makes a problem more understandable and the correct results become easier to reach. while it is not necessary to examine a balance sheet to see that a partner's outside basis should not be reduced by a guaranteed payment because that is fairly obvious, let us see 53. see supra text accompanying note 51. 20041 florida tax review what a balance sheet displays. throughout this article, the authors will use a "book/tax" type of balance sheet. 54 as of december 30, year one, the p general partnership had three equal partners, x, y, and z. apart from the effect of making the guaranteed payment described below, p had no net income or loss in year one. p's assets consisted of cash, capital asset # 1, and capital asset # 2. p had no liabilities, and the adjusted basis and book values of its assets and of its partners' capital accounts were as follows: assets liabilities and partners' capital a.b. book liabilities none cash $60,000 $60,000 partners' capital ca # 1 $40,000 $60,000 a.b. book ca # 2 $20,000 $60.000 x $40,000 $60,000 total '$120,000 $180,000 y $40,000 $60,000 z $40.000 $60.000 total $120,000 $180,000 on december 30, p made a guaranteed payment of $12,000 cash to x for services performed by x in her capacity as a partner. the payment was ordinary income to x and was deductible by p under section 162 as a business expense. the guaranteed payment to x does not affect x's capital account, which remains unchanged except for any effect that the deduction that p obtained from the payment will have. let us leave open for the moment the effect that the payment will have on x's outside basis of $40,000 in her partnership interest. since, apart from the effect of the deduction for the guaranteed payment, p had no net income or loss for that year, the deduction caused p to have a loss of $12,000 for the year. one-third of that loss ($4,000) is allocated to each partner who can deduct it and whose outside basis and capital account are reduced by that amount.55 consequently, the capital accounts of each of the partners after the payment was made is $56,000 ($60,000 minus each's $4,000 share of the loss). each partner's outside basis would also be reduced by $4,000, 54. a "book/tax" balance sheet is a financial statement that shows the book value and the adjusted basis of the partnership's assets, the amount of the partnership's liabilities, and the adjusted basis and book value of the partners' capital accounts. see lind, supra note 2, at 35, n. 5. 55. irc § 705(a)(2), and regs. § 1.704-1 (b)(2)(iv)(b) (7), 1 (b)(2)(iv)(o). even if p had had net income that year, each partner's share of the deduction would have reduced that partner's outside basis and capital account since it would have reduced the amount by which their basis and capital account otherwise would have been increased by their share of p's income. in this example, we have simplified the facts by making p have a loss, but the operation of the rule would be the same if p had net income. [vol.6:-5 guaranteed payments made in kind by a partnership and so each would have an outside basis of $36,000. the question remaining is what effect the guaranteed payment has on x's outside basis, apart from the effect of her share of the deduction. before the guaranteed payment was made, each partner would have had a gain of $20,000 if he had sold his partnership interest for its book value (i.e., $60,000 book value minus $40,000 outside basis). that is, each partner had unrealized appreciation of $20,000 in his partnership interest. if no adjustment is made to x's outside basis for the guaranteed payment, each partner will continue to have unrealized appreciation of $20,000 (i.e., $56,000 book value minus $36,000 outside basis). this is the correct result since nothing happened other than p's having incurred a loss of $12,000; and since each partner can deduct his share of that loss, there is no reason that the amount of any partner's unrealized appreciation should have changed. while x did recognize $12,000 of ordinary income, her one-third interest in the $60,000 of appreciation in partnership assets was unaltered; and so there should be no change in the amount of gain she will recognize on a sale of her partnership interest. the $12,000 of income that x recognized has no relationship to her share of partnership assets. if, contrary to the authors' view, the guaranteed payment to x were deemed to reduce her outside basis in her partnership interest, x would have an outside basis of only $24,000; and so x would recognize a gain of $32,000 on a sale of her partnership interest for its book value ($56,000 book value minus $24,000 outside basis). the $12,000 that x received from p was included in her ordinary income, and so there is no justification for having that payment increase the amount of gain she would recognize on a sale of her interest. it must be acknowledged that the tax scheme employed by subchapter k will not always yield an optimum result. since congress chose not to apply exclusively either an entity or an aggregate approach, there will be some inconsistencies of treatment. however, the partnership tax provisions should be construed to avoid an obviously improper result when there is no statutory language requiring that result and there is no external reason for imposing it. to require x to reduce her outside basis in her partnership interest by the $12,000 guaranteed payment would be capricious. for the same reasons, a guaranteed payment made in kind will affect the service partner's outside basis only to the extent of the partner's share of the deduction allowed to the partnership under section 162. since the amount of the partnership's deduction is equal to the fair market value of the property, the book value of the property must be changed to equal its fair market value immediately before the payment is made; and the difference between the property's new and old book values must be allocated among the partners' capital accounts according to their percentage interests in the partnership. 20041 florida tax review consequently, the book value of property used to make a guaranteed payment will equal its fair market value at the time the payment takes place.ss b. partnership's recognition of gain or loss as noted above, if a partnership makes a guaranteed payment in kind, and the property is appreciated, the partnership will recognize income if that payment is treated as one made by an entity to an employee;57 but it will not recognize income if the payment is treated as a partnership distribution (i.e., a non-entity treatment).58 the problem is that the guaranteed payment is treated as a payment to an employee for some purposes but not for others. the literal language of section 707(c) would treat the payment as having been made to an employee only for purposes of three code sections, one of which is section 61(a). it could be contended that the statutory reference to section 61(a) incorporates the provision in section 61 (a)(3) that gross income includes "gains derived from dealings with property." while noting that possibility, the mckee treatise rejects it because section 61(a)(3) does not refer to losses, and so reliance on that approach would conflict with the case law treatment of payments in kind to employees where either gain or loss can be recognized.5 9 more importantly, it seems clear that congress referred to section 61 (a) only for the purpose of causing the payment to be treated as ordinary income to the recipient, and congress never gave any thought to the treatment to be accorded payments made in kind. in addition to the suggestion in the language of the statute that a guaranteed payment is to be treated as a partnership distribution for all purposes other than the three mentioned in the statute, there are policy reasons for finding that the partnership does not recognize gain or loss on making a guaranteed payment in kind. one of the prime principles of subchapter k is to defer the recognition of income or loss when property is distributed to a partner to the extent that deferral is feasible and does not create an opportunity for significant tax evasion. presumably, congress chose a deferral system because it removes a tax deterrent to making a partnership distribution that a requirement of immediate recognition would impart and because it conforms to a non-entity 56. since the partnership deducts the fair market value of the property, it is necessary to change its book value and the capital accounts of the partners so that the actual value of the partners' interests in the partnership will be reflected in those capital accounts. the treatment so accorded to guaranteed payments is the same in this respect as the treatment accorded to partnership operating distributions of property. see supra text accompanying notes 27 and 28. 57. see supra text accompanying note 40. 58. see supra text accompanying note 17. 59. mckee, supra note 2 at 113.03(5), n. 174. [vol.6:5 guaranteed payments made in kind by a partnership characterization of a partnership. prior to the adoption of section 707(c), in most circumstances, a salary payment to a partner in his capacity as such was treated as having come from a non-entity and having significance only in being a source for the allocation of partnership income among the partners; but that treatment was subject to arbitrary variations which sometimes were difficult to predict. congress adopted section 707(c) to provide more consistent and predictable rules. it seems highly unlikely that in making that simplifying change, congress would have wished to depart from its normal rule of deferral for the appreciated or depreciated element of distributed property. moreover, as shown below, if the partnership were required to recognize gain or loss, that would cause a greater amount of complexity than that which congress sought to remove by adopting the guaranteed payment provision. consider the circumstance described in part iii of. this article where a partnership provides that a service partner is to receive a percentage of partnership income, computed before taking guaranteed payments into account, but no less than a specified dollar amount. as explained in part iii, if the service partner's percentage of income is less than the specified amount, the difference is a guaranteed payment. what if the payment to the service partner were made with appreciated property? part of the property would then be a partnership distribution, on which the partnership would not recognize income,60 and part would be a guaranteed payment. if the partnership were deemed to recognize gain on making a guaranteed payment, it would have to apportion the partnership's inside basis in the property between the part of the transaction that is a partnership distribution and the part that is a guaranteed payment; and then one portion of the property would not cause income recognition to the partnership and the remaining portion would cause income recognition. it seems highly unlikely that congress would wish income recognition consequences to be split in that manner just because part of the payment is guaranteed. that would make income recognition turn on somewhat artificial distinctions, which would contravene one of the purposes for the adoption of section 707(c), namely, to eliminate the arbitrariness that existed in the pre-1954 code's method of determining the extent to which a salary payment is included in a service partner's income. splitting income recognition between the two parts of a distribution could cause another complication unless excluded by the partnership agreement. the determination of the portion of the distribution that is treated as a guaranteed payment depends upon the dollar amount of the partner's share of partnership profits. an increase in partnership profits will reduce the share of the distribution that constitutes a guaranteed payment. unless the partner's share of profits is to be determined by excluding any gain or loss incurred by the 60. irc § 731(b). 20041 florida tax review partnership as a consequence of making the guaranteed payment," an increase in partnership income because of the gain recognized from making the guaranteed payment would reduce the amount of the guaranteed payment, which in turn would reduce the amount of gain the partnership recognized on the transaction and thereby would increase the amount of the guaranteed payment and thereby increase the gain recognized, and so on. the mutual dependency of the figures for the amount of the partnership's gain and the amount of its guaranteed payment can be solved by use of an algebraic formula; but nevertheless, in the interests of administrative ease, it is desirable to avoid a scheme of recognition that might require that calculation to be made. the complexity of requiring income recognition for guaranteed payments is exacerbated if the partnership has an election under section 754 in effect. if a partnership makes a section 754 election, it triggers the operation of two code provisions: sections 734(b) and (c), and 743(b) and (c). once section 754 is elected, those two code sections continue to apply to the partnership until the election is revoked by the partnership with the permission of the district director.12 a partnership's basis in its assets is sometimes referred to as its "inside basis." section 743(b) operates by providing a different inside basis for some partners' purposes when there has been a transfer of a partnership interest by death or by a sale or exchange. so, when a section 754 election is in effect, it is possible that each partner's share of the gain or loss recognized on a sale of a partnership asset may have to be determined by using a different inside basis for the asset. the operation of section 743(b) is illustrated in the following example. the p partnership has three equal partners, a, b, and c. p has an inside basis of $60,000 in land, which had a value of $210,000. if there had been no section 754 election, each partner's share of p's inside basis would be $20,000; and a sale of land for its value would cause each partner to recognize a $50,000 gain. but, since p had made a valid section 754 election, and since each partner had either purchased his partnership interest from a prior partner or had inherited it on the death of a prior partner, the amount of each partner's share of p's inside basis in land is different. by virtue of section 743(b), p's inside basis for one-third of the land for purposes of a's interest is $40,000; p's inside basis for one-third of the 61. the gain or loss from making the guaranteed payment would be excluded, for example, if the partnership provision that the partner is to receive a percentage of partnership income "computed before taking guaranteed payments into account" is construed to exclude a gain or loss recognized on the constructive sale of the distributed property as well as the deduction allowed for making that payment. 62. regs. § 1.754-1(c). [vol.6:5 guaranteed payments made in kind by a partnership land for purposes of b's interest is $60,000; and p's inside basis for one-third of the land for purposes of c's interest is $70,000. ifp were to sell the land for its value of $210,000, a would have a gain of $30,000 allocated to him (i.e., $70,000 (one-third of the selling price) minus a's $40,000 share of the inside basis); b would have a gain of $10,000 allocated to him, and c would have no gain or loss. in the circumstance where a payment of appreciated property to a service partner is partly a guaranteed payment and partly a partnership distribution, and where the amounts of the partners' share of inside basis in partnership assets differ because a section 754 election is in effect, if the partnership must recognize gain or loss on the guaranteed payment portion of the distributed property, not only will the inside basis of each asset that was distributed have to be apportioned between the guaranteed payment portion and the partnership distribution portion, but there would have to be a separate calculation and apportionment made for every partner's share.63 especially when there are a sizeable number of partners, all of whom have special shares of inside basis, that could be burdensome. in opposition to the point made above, it might be urged that congress accepted a bifurcation of income recognition when it adopted section 75 1(b) to require gain or loss recognition for some properties in certain circumstances involving partnership distributions. but, section 751(b) is an extraordinary provision that was adopted to prevent an abusive use of the partnership tax provisions by shifting the characterization of income among several partners. congress considered that potential abuse to be of such importance that it justified a limited intrusion into its broadly utilized principle of deferring gain or loss when partnership distributions are made. let us look at the one potential abuse that arises from the authors' proposals for nonrecognition treatment and (as discussed in part v.c.) for a basis in the distributed property equal to its fair market value. 63. it is true that, regardless of whether gain is recognized by a partnership on making a guaranteed payment in kind, the partnership's inside basis in each distributed asset will have to be split between the guaranteed and distributed portions in order to determine the basis that the service partner acquired in the property; and the service partner's special share of inside basis under irc § 743(b) would have to be taken into account for that purpose. but, if gain is not recognized by the partnership, there is no need to calculate each of the other partners' share of inside basis. also, as explained in part vi, while a division of basis will be needed if the distribution part of the transaction is an operating distribution, no division will be needed for a liquidating distribution except for a distribution of unrealized receivables and inventory; and unrealized receivables will have a zero basis, which imposes no difficulties of division. 20041 florida tax review the potential abuse is that the character of a deferred gain can be changed by manipulation of the properties distributed as the guaranteed payment. if appreciated ordinary income property is used to make a guaranteed payment, and if, as the authors propose, the basis of that property in the hands of the service partner becomes its fair market value, then the potential ordinary income that the partnership had in that property will have been converted to a potential capital gain in the partners' interests in the partnership. as shown in part v.c., the partnership's unrealized appreciation or depreciation in the distributed property is reflected in the unrealized appreciation or depreciation of the partners' interests, and that is why it is proper for there to be no appreciation or depreciation built in to the distributed property in the hands of the service partner. but, when appreciated property that would have produced ordinary income when sold is used to make a guaranteed payment, that does result in a change of the character of the deferred income. in the view of the authors, that possibility is not of sufficient significance to warrant both abandoning the principle of nonrecognition that plays such a prominent role in subchapter k and embracing the administrative complexity that recognition will engender. while congress did address a similar type of potential abuse when it adopted section 751 (b), that provision has been subjected to severe criticism for its complexity and for having made a mountain out of a mole hill. in adopting that provision, congress was not willing to eliminate all nonrecognition for distributions of property in which section 751(b) was implicated; that would have been too draconic. instead, congress required recognition only to the extent needed to prevent the abuse. the problem is that by focusing only on the abusive element, congress introduced a complex and cumbersome structure that has proven very difficult to administer. given that no similar structure has been adopted for guaranteed payments (and none would appear to be desirable),64 the choice available for the construction of the currently applicable provision is either to deny nonrecognition entirely to guaranteed payments or to accept the potential for shifting of characterization as a relatively minor cost of the benefit of having nonrecognition so that ordinary transactions of this nature are not deterred. the latter course seems far more desirable given the strong sentiment in subchapter k to allow nonrecognition so as to prevent the tax law from unnecessarily influencing legitimate business transactions. 64. the complexity of irc § 751(b) has generated severe criticism and spawned recommendations for its repeal. see lind, supra note 2, at 316, (quoting a statement in 1986 to a subcommittee of the house ways and means committee). a provision requiring recognition of gain on making a guaranteed payment to the extent of the property's appreciation that would be taxed as ordinary income if the property were sold could be adopted only by a legislative amendment, and it is doubtful that such an amendment is desirable given the complexity it would engender. [vol.6:5 guaranteed payments made in kind by a partnership in contrast to the weight that congress accorded, in adopting section 751 (b), to a concern over the possibility of shifting potential ordinary income to a potential capital gain, congress deemed the goal of nonrecognition to be more important when it deferred cancellation of indebtedness income for insolvent taxpayers. under section 108(a)(1)(b), a taxpayer does not recognize income for a cancellation of a debt of the taxpayer to the extent of the taxpayer's insolvency at that time, but the realized income typically is deferred by reducing a favorable tax attribute of the taxpayer's under section 108(b). the income that is realized from a cancellation of a debt is ordinary income. in some instances, under sections 108(b)(2)(e) and 1017, the tax attribute that is reduced to defer the recognition of that ordinary income is the taxpayer's basis in property that the taxpayer owns. treasury regulation section 1.1017-1(a) establishes an order of priority for the taxpayer's properties whose basis is to be reduced; and generally the basis of property that would produce a capital gain (or a comparable section 1231 gain) is reduced first. while that provision is less vulnerable to manipulation by the taxpayer, it does constitute a situation where it is possible for a taxpayer's ordinary income to be converted to a potential capital gain to be recognized at a later date. it does indicate that congress is willing to allow ordinary income to be converted to capital gain in order to implement a system of nonrecognition. the legislative history of section 707(c) demonstrates that congress intended guaranteed payments to continue to be treated as partnership distributions, as they had been treated before section 707(c) was adopted, except that the determination of income to the partner and deductibility for the partnership were simplified and given more consistent treatment. it was only for those limited purposes that a guaranteed payment was to be treated as a payment from a separate entity. entity treatment is applied in a few other circumstances, but only where it was needed to prevent results that would contravene basic tax principles.65 this is in contrast to the treatment congress proscribed for section 707(a) transactions, where congress treated them as having been made between an entity and a third person for all purposes. a rule providing nonrecognition of gain or loss for the property used by the partnership to make a guaranteed payment to a partner is better attuned to the congressional view of those payments. once a partner has received a guaranteed payment in kind, it is necessary to determine the basis that the partner will obtain in that property. let us now turn to the basis issue. 65. for example, as noted above, a guaranteed payment does not reduce a partner's capital account or outside basis because that reduction would leave the partner with a capital account that is less than the value of his actual interest in the partnership and an outside basis that is less than the amount of capital that the partner still has invested in his partnership interest. 20041 florida tax review c. basis of property received as a guaranteed payment. the determination of basis of the property received is important not only for its own sake, but also because that determination could influence the decision whether the partnership should recognize a gain or loss. if a section 707(c) guaranteed payment in kind were treated as an entity payment to a non-partner for the purpose of requiring the partnership to recognize gain or loss, the basis of the property in the hands of the partner would equal its fair market value. the partner's basis would be determined in the same manner as is the basis of property in the hands of an employee who received it as compensation from his employer.66 but, what if, as the authors contend, the partnership does not recognize gain or loss; what is the partner's basis? the authors conclude that the partner nevertheless acquires a basis in the property equal to its fair market value. to see the consequences of the several alternative choices for basis, let us once again examine the problem from the perspective provided by a book/tax balance sheet approach.67 p general partnership has three equal partners: a, b, and c. a is a service partner. in year one, before taking into account the tax consequences of the guaranteed payment that p made to a and which is described below, p had neither a net income nor a net loss. as of december 31, year one, p had $35,000 cash, two capital assets, land 1 and land 2, and no liabilities. the book value of each of p's assets equals its fair market value. the book/tax balance sheet for p shows the following: assets liabilities and partners' capital a.b. book liabilities none cash $35,000 $35,000 partners' capital land 1 $10,000 $25,000 a.b. book land 2 $15,000 $30,000 a $20,000 $30,000 total $60,000 $90,000 b $20,000 $30,000 c $20,000 $30,000 total $60,000 $90,000 note that the book value of the capital account for each partner equals that partner's share of the book value of the partnership. thus, the appreciation in land 1 and land 2 that is reflected in the asset side of the balance sheet has already been included in the partners' capital accounts.68 consequently, a gain 66. see supra text accompanying note 40. 67. see supra note 54. 68. under certain specified circumstances, the book value of partnership assets and of the partners' capital accounts can be written up or down to reflect a revaluation of the partnership's assets. regs. § 1.704-1(b)(2)(iv)(f). [voi.6:5 guaranteed payments made in kind by a partnership recognized by p on the disposition of either of those assets will not cause an increase in the partners' capital account if the gain does not exceed the appreciation already reflected in those accounts.on december 31, year one, p gave land 2 to a as a guaranteed payment which qualified for a deduction for p under section 162. a recognized $30,000 ordinary income, and p was allowed a deduction of $30,000. the payment to a did not reduce his capital account except for his $10,000 share of the $30,000 deduction that p obtained. for reasons explained in part va of this article, the transaction did not reduce a's outside basis in his partnership interest except for the $10,000 reduction caused by a's share of the deduction allowed to p. let us consider what basis a obtained in land 2 if, as the authors contend, p did not recognize a gain on making the payment to a. the limiting language of section 707(c) suggests that a guaranteed payment should be treated as a partnership distribution for purposes of applying statutes other then the three listed in that subsection. however, as we showed in part v.a., despite the language of the statute, a guaranteed payment will not be treated as a partnership distribution in circumstances where that treatment would contravene a fundamental tax principle. no tax principle could be of greater importance or more fundamental than the principle that gain should be measured accurately. as shown below, if the limiting language of section 707(c) were applied to the determination of a service partner's basis in property received as a guaranteed payment, that would greatly exaggerate the amount of gain that the service partner ultimately will recognize. consequently, in the interest of measuring correctly the amount of a taxpayer's gain, the limiting language of section 707(c) should not be controlling. as noted in part iv of this article, the general rule is that when an operating partnership distribution is made in kind, an amount of the partner's outside basis in his partnership interest equal to the basis that the partnership had in that property immediately before the distribution is shifted to the property that the partner received.69 since, as we demonstrated in part v.a. of this article, a guaranteed payment will not change a partner's outside basis (other than a reduction for the partner's share of the partnership's deduction for making the payment), that approach is not available for property received as a guaranteed payment. how then should the partner's basis in such property be determined? there are two principal choices:7 ° either the partner's basis should 69. see supra text accompanying notes 23-26. 70. a third possibility would give the partner a zero basis in the property; but there is no justification for that position. a zero basis would leave the partner with a built-in gain for the property equal to its entire value (i.e., the entire value of the property would constitute appreciation), and that would be justified only if there were a tax reason to imbue the property with a potential gain because a gain that the taxpayer or someone else had realized had not been recognized. the only unrecognized gain here is the gain that the partnership realized, but did not recognize, on making the payment; 20041 florida tax review equal the fair market value of the property, or it should be equal to the basis that the partnership had in that property immediately before giving it to the partner. to make the proper choice, it is necessary to consider the principles that underlie the scheme that the code employs to determine a partner's basis in property received as an ordinary operating partnership distribution. a partner's outside basis reflects the appreciation or depreciation of the partner's interest in the partnership. to the extent that the value of a partner's interest is greater than his basis, the interest is appreciated. ideally, a partner's share of the net unrealized appreciation of properties held by the partnership should be the same as the appreciation of the partner's interest in the partnership; but that will not always be the case because of a glitch in subchapter k which is caused by sections 743(a) and 734(a).71 to cure that glitch, the code provides an election in section 754, which provision is discussed in part v.b. 72 a key aspect of the method that congress employed to determine a partner's basis in property that was received as an operating distribution is that, immediately after receiving the distribution, the net appreciation or depreciation of the distributed property and of the partner's interest in the partnership will equal the amount of appreciation of the partner's interest in the partnership immediately before the distribution was made. the nonrecognition granted to partnership distributions is a deferral provision. the total amount of gain or loss that the partner potentially will recognize should not be altered because of the distribution of partnership property to him. the partner's potential gain or loss is kept intact, but is divided between his partnership interest and the distributed property. when a partner receives property as a guaranteed payment, the partner is taxed on the entire value of that property, and the appreciation or depreciation of his interest in the partnership is unchanged. if the partner were given a basis in the property he received that is less than its value, then the net amount of aggregate appreciation of the partner's property and his partnership interest would be increased (or the net amount of depreciation would be decreased). while granting nonrecognition for the partnership means that the appreciation or depreciation of the property in the partnership's hands is not recognized, that amount of appreciation or depreciation either is reflected in the and so no appreciation in a's hands should exceed the amount of appreciation the property had in the hands of the partnership. 71. for example, unless an election is made under irc § 754, a person buying a partnership interest from a former partner will have as his share of the partnership's inside basis in its assets the same amount that the former partner had even though the new partner paid an amount for that share of the partnership's assets that was greater or less than the former's partner's share of the inside basis for those assets. irc § 743(a). 72. see supra text accompanying note 62. when irc § 754 has not been elected, the code provides limited relief in irc § 732(d), under certain circumstances. [vol6:5 guaranteed payments made in kind by a partnership partners' interests in the partnership (and so potentially will be recognized by the partners at a later date);73 or, if not reflected in the partners' interests, that is because there was no section 754 election in effect and the difference is caused by a glitch in the tax law.74 the reason that this is so is explained later in this part v.c. there is no reason to strain the application of the basis rules to perpetuate a glitch. the reason for choosing fair market value for the partner's basis in the property is illustrated by examining the set of facts set forth above in the context of a book/tax balance sheet. the book/tax balance sheet for p just before p made the guaranteed payment of land 2 to a was: assets liabilities and partners' capital a.b. book liabilities none cash $35,000 $35,000 partners' capital land 1 $10,000 $25,000 a.b. book land 2 $15.000 $30,000 a $20,000 $30,000 total $60,000 $90,000 b $20,000 $30,000 c $20,000 $30.000 total $60,000 $90,000 you will recall that p gave a land 2 as a guaranteed payment, and a recognized $30,000 ordinary income. we will assume that p did not recognize any of the $15,000 gain it realized on that transaction. the book value of each of p's assets equals its fair market value. p received a deduction of $30,000, which is divided equally among the three partners. as a result of that deduction, each partner's capital account and outside basis is reduced by $10,000 (onethird of the deduction). the book/tax balance sheet for p immediately after the payment is as follows. assets liabilities and partners' capital a.b. book liabilities none cash $35,000 $35,000 partners' capital land 1 $10,000 $25,000 a.b. book total $45,000 $60,000 a $10,000 $20,000 b $10,000 $20,000 c $10.000 $20 total $30,000 $60,000 73. if another partner has an appreciated partnership interest that reflects his share of the partnership's appreciation in its inside assets, the appreciation of that partner's partnership interest will continue to reflect his share of the partnership's inside appreciation in the property that was used to make the guaranteed payment. so, the other partner will not escape the recognition of the deferred gain. 74. see supra note 71 and accompanying text (describing the glitch). 20041 florida tax review the $10,000 amount of appreciation of each partner's interest in p is the same after the guaranteed payment was made ($20,000 book value minus each partner's $10,000 outside basis) as it was before that payment was made ($30,000 book value minus each partner's $20,000 outside basis). if, as the authors contend, a's basis in land 2 equals its fair market value of $30,000, then a's potential gain on a sale of both land 2 and his partnership interest will be $10,000. but, if instead a were given a $15,000 basis in land 2 (i.e., an amount equal to p's basis therein), a would have a potential gain of $25,000 on the sale of both land 2 and his partnership interest. clearly, a gain of $25,000 would be excessive. note, however, that the aggregate outside basis of the partners ($30,000) is no longer equal to p's inside basis in its assets ($45,000). prior to the making of the guaranteed payment, there was $30,000 appreciation in both p's inside assets and in the partners' partnership interests. the appreciation in the partners' partnership interests was unchanged by the payment, but $15,000 of p's inside appreciation in land 2 was removed from p and exists only as it continues to be reflected in the partners' appreciation in their partnership interests. the total potential amount of gain to be recognized was not changed. there was $30,000 of potential gain before the payment was made, and the same amount afterwards. as we will see, the payment may change the timing of recognition and the character of the gain in certain circumstances. giving a a basis of $30,000 in land 2 provides a with the same overall amount of gain that he would have had if p had sold land 2 to a stranger and then paid the proceeds to a as a guaranteed payment. in the case of a sale to a stranger, p would recognize a gain of $15,000 of which $5,000 would be apportioned to each partner. each partner's outside basis would be increased by $5,000, but his capital account would not be increased since the appreciation of land 2 was already reflected in that account. the partnership would receive a deduction of $30,000 for making the cash guaranteed payment to a of which $10,000 would be apportioned to each partner. each partner's capital account and outside basis would be reduced by $10,000 for their share of the deduction. each partner had an outside basis of $20,000 before the sale took place; each would add $5,000 for his share of the gain on the sale and deduct $10,000 for his share of the deduction p obtained from making the guaranteed payment. so, after the guaranteed payment was made, each partner would have an outside basis of $15,000 in his partnership interest, which would have a value of $20,000. the net result for a is that a would have recognized $5,000 on p's sale of land 2 and another $5,000 if he subsequently sells his partnership interest for its $20,000 value. thus, a would have the same amount of total income as is the case when land 2 was paid to him as a guaranteed payment and he received a basis equal to its fair market value. similarly, b and c would each continue to have $10,000 of gain b $5,000 recognized on the sale, and another potential $5,000 when they dispose of their partnership interests. [vol.6:5 guaranteed payments made in kind by a partnership while the amount of all of the partners' potential gain is the same whether p used land 2 to make the guaranteed payment or sold land 2 and paid the cash proceeds to a, the timing of recognition is different, and the character of the income could be different in some cases. in the case of the payment of land 2 as a guaranteed payment, neither a nor the other partners will recognize income until they dispose of their partnership interest; whereas each would currently recognize $5,000 of that potential gain if p instead sold land 2. perhaps that difference in the timing of recognition was a factor in the conclusion of the mckee treatise that p should recognize gain or loss on making a guaranteed payment in kind.75 but, congress went to great lengths in subchapter k to prevent the recognition of income on a distribution to a partner to the extent that it is feasible to do so, and instead to defer any gain or loss. only when there was a potential abuse, the prevention of which congress deemed to be so important that it warranted abandoning the normal rule of deferral, did congress impose recognition.76 since the nonrecognition of p's gain does not pose a significant risk of abuse," the position adopted by the authors to adhere to the congressional scheme of deferral is appropriate. in the examples above, the book values of the assets that p held were the same as those assets' fair market values. what would be the consequence if the actual fair market value of the property used to make the guaranteed payment were different than its book value? in that case, immediately before the payment was made, the book value of the property would be changed to equal its fair market value, and the amount of the change would be allocated among the partners' capital accounts in accordance with their percentage interests in the partnership.7" consequently, the book value of the property will always equal its fair market value at the time the payment is made. to illustrate how this scheme operates, let us reexamine the example above after changing the facts so that the actual fair market value of land 2 is $39,000 even though its book value is only $30,000. the book/tax balance sheet, prior to the making of the guaranteed payment, and showing actual values as well as book values, would be: 75. mckee, supra note 2 at 13.0315]. 76. see, e.g., irc § 75 1(b). 77. one possible area of abuse was noted in part v.b. if a partnership were to use appreciated ordinary income property to make a guaranteed payment, then the deferral of the ordinary income on that property by reflecting it in the partners' partnership interests will alter the character of the income from ordinary to capital gain. as stated in part v.b., that possibility should be regarded as a minor cost of obtaining the otherwise wholly desirable goal of nonrecognition. ordinary income conversion likely will occur infrequently and is such a minor element of the picture, it should not be deemed to be of sufficient importance to warrant a distortion of what otherwise is the proper treatment of the transaction. in other words, the tail should not wag the dog. 78. see supra note 56 and accompanying text. 20041 florida tax review assets liabilities and partners' capital a.b. book fmv liabilities none cash $35,000 $35,000 $35,000 partners' capital land 1 $10,000 $25,000 $25,000 a.b. book fmv land 2 $15,000 $3 9000 $39.000 a $20,000 $30,000 $33,000 total $60,000 $90,000 $99,000 b $20,000 $30,000 $33,000 c $20.000 $30.000 $33,000 total $60,000 $90,000 $99,000 p gives land 2 to a as a guaranteed payment. a has $39,000 ordinary income, and p is allowed a deduction of $39,000 for making that payment. onethird of the deduction ($13,000) is allocated to each partner and will reduce each partner's outside basis and capital account. immediately prior to the payment, the book value of land 2 will be increased to $39,000; and one-third of the $9,000 increase in book value ($3,000) will be allocated to each partner's capital account. before taking into account the actual making of the guaranteed payment and the resulting deduction allowed to p, the book/tax balance sheet for p would be: assets liabilities and partners' capital a.b. book fmv liabilities none cash $35,000 $35,000 $35,000 partners' capital land 1 $10,000 $25,000 $25,000 a.b. book fmv land 2 $15.000 $30.000 $39,000 a $20,000 $33,000 $33,000 total $60,000 $99,000 $99,000 b $20,000 $33,000 $33,000 c $20.000 $33.000 $33,000 total $60,000 $99,000 $99,000 the balance sheet shows that each partner has $13,000 of appreciation in their partnership interest. this is the actual amount of their appreciation since the book value of land 2 now equals its actual value. if land 1 also had a different value than its book, that difference will not be reflected in the partners' capital accounts until the item is sold or some event occurs to permit a change of its book value. p now makes the payment of land 2 to a. the $39,000 deduction allowed to p is allocated among the three partners, and each partner reduces his outside basis and his capital account by $13,000 (one-third of the deduction). consequently, each partner has an outside basis of $7,000, and a capital account of $20,000. the $13,000 of appreciation that each partner had in his partnership interest was not changed by the payment of the guaranteed payment. each partner continues to have the same $13,000 potential gain that he had before the payment was made. after the payment, p's balance sheet would be: [vol6:5 guaranteed payments made in kind by a partnership assets liabilities and partners' capital a.b. book liabilities none cash $35,000 $35,000 partners' capital land 1 $10.000 $25.000 a.b. book total $45,000 $60,000 a $7,000 $20,000 b $7,000 $20,000 c $7.000 $20,000 total $21,000 $60,000 if p then sold land 1 for its $25,000 value, each partner would recognize a $5,000 gain and would increase his outside basis by that amount. if a partner then sold his partnership interest for its $20,000 value, he would have a gain of $8,000. the partner's total gain would be $13,000 ($5,000 from p's sale of land 1 and $8,000 from the sale of his partnership interest). let us turn to the situation where a partner's outside basis does not correspond with the partnership's inside basis. one circumstance in which that can occur is when a person purchased a partnership interest from a former partner or inherited a partnership interest.79 in those circumstances, the new partner's outside basis will equal what the partner paid for it or, in the case of an inheritance, will be the basis determined by section 1014. consider again the facts of the p partnership that are discussed above with the changes that: (1) before the guaranteed payment was made, d had purchased a's partnership interest for $30,000, and (2) the guaranteed payment of land 2 was made to d for her services. before the guaranteed payment was made, the book/tax balance sheet for p was as follows. assets liabilities and partners' capital a.b. book liabilities none cash $35,000 $35,000 partners' capital land 1 $10,000 $25,000 a.b. book land 2 $15.000 $30,000 d $30,000 $30,000 total $60,000 $90,000 b $20,000 $30,000 c $20,000 $30.000 total $70,000 $90,000 the disparity between d's $30,000 outside basis and her $20,000 share of p's inside basis would be cured if a section 754 election were in effect, but no election has been made. this is one of the circumstances where a glitch in subchapter k arises. if p were to sell land 2 for its value of $30,000, each partner, including d, would recognize one-third of the $15,000 gain that p had. but, of the $30,000 that d paid for the partnership interest, $10,000 was paid 79. see supra note 71. 20041 florida tax review for her one-third share of land 2; and so d should have no gain when p sold the land. if a section 754 election were in effect, d would not have a gain from p's sale; but no election was made. instead of selling land 2, p gave it to d as a guaranteed payment for services. following the conclusions described above, p will not recognize any gain; and d will take a basis of $30,000 in land 2. d's outside basis will be reduced by her one-third share of p's $30,000 deduction to $20,000, which also is the value of her one-third share of the partnership after land 2 was removed from the partnership's assets. thus, d will have no appreciation either in land 2 or in her partnership interest. that is the proper result since d had no appreciation in her partnership interest before receiving the payment and would have recognized a gain from a sale of the land by p only because of a glitch in the tax law. there is no reason to feel aggrieved when that glitch is avoided by p's having used land 2 to make the guaranteed payment. the nonrecognition of p's gain on giving land 2 to d means that b and c will not recognize income at that time. will each's $5,000 share of p's realized gain ever be recognized? the answer is that their share of the appreciation of p's properties is reflected in the appreciation of their partnership interest, and so the deferred gain will be recognized when they sell their partnership interest. take b's situation for example. b had appreciation of $10,000 in his partnership interest before the guaranteed payment was made ($30,000 book value minus his $20,000 outside basis). p's delivery of land 2 to d as a guaranteed payment does not relieve b of any of his potential gain. b's outside basis of $20,000 is decreased by his $10,000 share of the $30,000 deduction that p obtained from making the guaranteed payment, and b's capital account is reduced by the same amount. b then has an outside basis of $10,000, and the value of his partnership interest (i.e., his capital account) is reduced to $20,000. consequently, b continues to have a potential gain of $10,000. vi. liquidating distributions the same reasons that are described above for providing nonrecognition to the partnership for making operating guaranteed payments in kind and providing the service partner with a basis in the property equal to its fair market value apply equally to guaranteed payments made in kind in conjunction with a liquidating distribution (i.e., a distribution in liquidation of a partner's interest in the partnership). guaranteed payments in kind will occur far more frequently in connection with a liquidation of a partner's partnership interest than in the context of an operating payment. this is especially true when the partnership itself is liquidated so that all of its assets are distributed to its partners. consequently, liquidating distributions are where the issues and disputes are most likely to arise. you will recall that when the property distributed in liquidation, whether under section 736(a) or (b), has a book value that differs from its fair [vol6:5 guaranteed payments made in kind by a partnership market value, the book value will be changed to equal its fair market value; and the difference in values is allocated proportionately among partners' capital accounts.° liquidating distributions are divided by section 736 into two camps, with a subdivision within one of the camps. section 736(b) applies to distributions that are made to a retiring or deceased partner in exchange for the partner's interest in partnership property. distributions in exchange for two classes of partnership property are excluded from section 736(b), but only if the distributee was a general partner and if capital was not a material incomeproducing factor for the partnership. in general then, payments for those two classes of property are excluded from section 736(b) only in the case of a liquidation of a general partner's interest in a service partnership. the two classes of property that are excluded in such cases are: unrealized receivables (as defined in section 751 (c)) and good will unless the partnership agreement provides for a payment for good will. all liquidating payments that do not fall within section 736(b), including payments for the two classes of property mentioned above, are treated by section 736(a) either as a guaranteed payment if determined without regard to partnership income or as a distributive share of partnership income if determined with regard to partnership income. a guaranteed payment will be ordinary income to the partner and deductible by the partnership.8 it is common for the liquidation of a partner's interest to include a premium, that is, a payment in excess of the amount of the indicated value of the partner's share of partnership property. if the amount of the premium is not determined by reference to partnership income, it will be a guaranteed payment. if a partnership distributes more than one item of property to a service partner as a liquidating distribution, and if only part of the distribution is a guaranteed payment, how are the several distributed properties to be assigned between the portion of the distribution that is a guaranteed payment and the portion that is not? the willis treatise addresses that issue and raises three alternative solutions, which we will not discuss. the parties might be able to finesse that issue by expressly agreeing beforehand as to the assignment of the properties. there is a reasonable prospect that the service will accept the parties agreement. in part v.b. of this article, we described the administrative complexity that the imposition of gain recognition on the partnership would cause when a payment is partly a partnership distribution and partly a guaranteed payment, and when a section 754 election is in effect, because of the need to determine each partner's share of the partnership's inside basis for the distributed property 80. see supra text accompanying notes 27, 28, and 30. 81. irc § 707(c). 20041 florida tax review and then apportion it between the two types of payments.2 we noted that even if gain is not recognized, some apportionment of inside basis is required in order to determine the service partner's basis in the distributed property. that latter point is applicable only to a very limited extent in the context of a liquidating distribution. except for unrealized receivables and inventory, a partner's basis in property received under section 736(b) in exchange for his interests in partnership property is determined without regard to the partnership's inside basis in those properties, and so no determination of inside basis need be made for them.83 even as to the two exceptions, the partnership's inside basis in unrealized receivables will be zero, so that property will not cause any computational problems. a significant factor in favor of providing a rule of nonrecognition for a partnership's gain or loss in such cases is the relative simplicity of its administration. it is true that complexity will be reintroduced if section 751(b) applies to the payment for the property portion of the distribution; but section 751(b) is rarely invoked. moreover, there is no virtue to exacerbating the complexity that section 751(b) creates. the administrative ease of providing nonrecognition shows the wisdom of congress in favoring that treatment in subchapter k. v. conclusion the question of whether a partnership should recognize gain or loss on making a guaranteed payment in kind cannot be resolved definitively merely by pointing to a specific statutory or regulatory provision. while the language of section 707(c) strongly points towards nonrecognition, that is not conclusive. the regulations themselves demonstrate that there are circumstances and tax provisions, in addition to the three listed as exclusive in section 707(c), in which entity partnership treatment will be applied to a guaranteed payment. and, there are circumstances not mentioned in the regulations in which that is so. for example, in this article, the authors demonstrate that a guaranteed payment should be treated as having been made from a separate entity for the purpose of determining that the outside basis of a partner in his partnership interest is not reduced by the amount of the payment whether the payment is made in cash or in kind. the most that the authors can claim, and that is what we do claim, is that the weight of considerations favor nonrecognition for the partnership. the 83. irc § 732 (b) and (c). note that since the service partner's basis is property received as a guaranteed payment is not determined by irc § 732 and since the service partner's income from the receipt of the guaranteed payment is not dictated by irc § 73 1, the guaranteed payment will not ncessitate a change of the partnership's inside basis in its assets under irc § 734(b)(1) even if an irc § 754 election is in effect. [vol.6:5 guaranteed payments made in kind by a partnership statutory language of section 707(c) pointing to non-entity treatment for the partnership, other than for the three listed exceptions, while not conclusive, means that entity treatment should be imposed only if it can be demonstrated that non-entity treatment would frustrate a principle of the existing tax law or would create a significant risk that parties could abuse that status. as to the question of whether non-entity treatment, which results in providing nonrecognition for the partnership, conflicts with basic tax policy for partnerships, it seems clearly not to do so. the basic approach of subchapter k is to defer recognition of gain or loss in transactions between a partner and a partnership. moreover, the deferral system that applies to the guaranteed payment is one that actually would cure a glitch in subchapter k in some circumstances,' and so can be said to further tax policy rather than to hinder it. the question of whether nonrecognition lends an opportunity to parties to distort their tax posture is a more difficult one. it does not permit the parties to reduce the amount of income they potentially will recognize. all nonrecognition provisions possess some potential for escaping from tax if, for example, basis is later increased on the death of the person holding the property in which the deferral in imbedded. but, nonrecognition is one of the fundamental principles of the income tax system, and so the possibility of a basis step-up at death has not been deemed of sufficient importance to induce congress to require immediate recognition of gain when there are good reasons for deferral. the relevant potential for abuse here is that the character of a deferred gain can be changed by manipulation of the properties distributed as the guaranteed payment. in the view of the authors, that possibility is not of so great a significance as to warrant both abandoning the principle of nonrecognition that plays such a prominent role in subchapter k and embracing the complexity that requiring recognition would engender. by way of analogy, in the area of the realization of ordinary income from a cancellation of indebtedness, congress has chosen to allow nonrecognition of that income for an insolvent taxpayer even when the deferral of that income will be recognized as a capital gain. the case for providing a partner with a basis in distributed property equal to its fair market value is very strong. if, contrary to the authors' view, the partnership is required to recognize gain or loss, than a fair market value basis obviously is correct. but, even if nonrecognition is allowed, as the authors maintain it should be, the partner's basis in the property should nevertheless be equal to its fair market value. if a different figure were employed for the partner's basis in the property, such as the basis that the partnership had therein, the aggregate amount of gain or loss that the partner will eventually incur will be different than the amount of the deferred gain or loss that the partner had 84. this glitch occurs when a partner's outside basis is out of sync with his share of the partnership's inside basis. see n. 71, supra, and the text thereto. 20041 440 florida tax review [vol.6:5 imbedded in his partnership interest just before receiving the guaranteed payment. since the partner recognized income for the full value of the guaranteed payment, there is no justification for changing the amount of his potential gain or loss. some persons, having decided that the proper basis for property received as a guaranteed payment is its fair market value, might perhaps jump to the conclusion that the partnership must therefore recognize gain or loss so that there need be no deferral built into the basis of that property. but, a basis of fair market value is just as appropriate when the partnership does not recognize its realized gain or loss. the reason that deferral need not be built into the property received as a guaranteed payment even when the partnership,' s gain or loss is unrecognized is that the deferral already is imbedded in the partner's partnership interest, and it will continue to be there after the partner receives the payment. florida tax review volume 2 1996 number 12 text, purpose, capacity and albertson's: a response to professor geier edward a. zelinsky i. introduction in a recent issue of the florida tar review,' professor deborah geier added yet another chapter to the running commentary on the albertson's litigation,2 using that case to demonstrate her theories of statutory purpose and to criticize, in particular, statutory textualism as she conceives of it. professor geier correctly identifies the underlying issues in albertson's-the role of statutory purpose, the differing institutional capacities of the congress and the courts, fidelity to statutory text-but resolves those issues in ways that prompt me to rebuttal. while i commend professor geier for her effort to explicate many important questions about the code and its interpretation, i find myself in strong disagreement with her conclusions. professor geier's basic analysis is unsound and, when applied to albertson's, produces an incorrect result. her arguments for assigning to the courts a proactive role in tax controversies like albertson's are unconvincing, and her mechanical conception of textualism is ultimately unhelpful in exploring the issues in albertson's. * professor of law, benjamin n. cardozo school of law of yeshiva university. i thank several colleagues who reviewed an earlier draft of this article: professors michael herz, james b. lewis, laura cunningham, lawrence cunningham. noel cunningham, and stewart sterk. thanks are also due to my advisors on talmudic issues: rabbi daniel greer, dov ben-daniel greer, and aaron zelinsky. this article is dedicated to the memory of a loving and heroic woman, my mother-inlaw, sara geizhals twersky, who lost her prolonged battle with cancer while this article was being written. 1. deborah a. geier, interpreting tax legislation: the role of purpose, 2 fla. tax rev. 492 (1995). 2. the ninth circuit issued two opinions in albertson's. inc. v. commissioner. the first opinion, allowing an employer to deduct interest accruing on its obligation under a nonqualified deferred compensation agreement, was withdrawn by the court and by vest publishing company, but it is available at 1993 u.s. app. lexis 33985. the second opinion, finding that § 404(a)(5) (delaying an employer's deduction for nonqualified deferred compensation until payment) applies to all amounts under a nonqualified deferred compensation agreement, including interest, is reported at 42 f.3d 537 (9th cir. 1994), cert. denied, 116 s.ct. 51 (1995). florida tax review for the commissioner and the taxpayer, the supreme court's refusal to hear albertson's ends the litigation.3 however, for scholars and others concerned with the questions raised by the controversy, albertson's has entered the pantheon of cases which, because of the fundamental nature of the issues they pose, permanently challenge our understanding of the tax law. ii. professor geier's basic analysis central to professor geier's analysis is the distinction between the "fundamental structure" of the code and those aspects of the code that constitute "[p]ure social policy legislation."4 when courts construe structural provisions of the tax statute, professor geier asserts, nonliteral, purpose-based interpretations are appropriate since the judiciary should protect and be guided by "the structure underlying the internal revenue code and created by the sum of its sections."'5 on the other hand, the courts should adhere more faithfully to statutory text when the text implicates "economic or social policy" since "policy choices in a statute are the province of congress." 6 there are at least three premises here: the courts can, with a reasonable degree of coherence, distinguish structural from nonstructural provisions of the code; structural provisions do not involve congressional policy choices to which courts should properly defer; and courts can reliably glean from tax provisions an underlying purpose that justifies disregard of statutory text. all of these premises are questionable. professor geier's distinction between structural and policy provisions essentially relabels professor stanley surrey's well-known dichotomy between the code's normative aspects and its tax expenditure provisions.7 such relabelling does not eliminate the problem with the distinction: in its stronger form, the distinction is unworkable; in its weaker form, it provides little guidance. the problem is not simply one of borderline issues or close cases. rather, at the core of the distinction, no one has convincingly explained how to distinguish structural/normative provisions from policy/expenditure provisions. consider, for example, the charitable deduction. professor geier suggests that "one can argue" that section 170 "is premised on nontax 3. the petition for certiorari asked the court to review, not only the deferred compensation issue which has provoked such controversy, but also the investment tax credits taken by albertson's and challenged by the irs. 4. geier, supra note 1, at 497. 5. id. at 502. 6. id. 7. see stanley s. surrey & paul r. mcdaniel, tax expenditures 184-96 (1985). [vol 2:12 text, purpose, capacity and albertson's grounds and is therefore outside the fundamental structure of an income tax."' simultaneously, professor geier alludes to professor william andrews' classic defense of the charitable deduction as part of the normative structure of the income tax.9 how, then, is a judge, persuaded that courts construing structural provisions should more freely effectuate underlying purpose, to decide whether section 170 controversies fall within that rule or are to be resolved with greater fidelity to statutory text? professor andrews extends his logic to deductions and exclusions for medical costs and casualty losses, which, he argues, can be understood as normative sections of the code.10 is the geier-guided judge to agree (and thus decide medical expense and casualty loss cases by virtue of underlying structural purpose) or to embrace the contrary consensus in the tax policy community that sections 105, 106, 213, and 165(c)(3) are tax expenditures" (and thus decide cases under these sections with greater respect for the terminology of the statute)? if one accepts the basic premises of professor andrews' analysis, the deduction for state and local taxes is a structural/normative provision insofar as these taxes finance public outlays similar to charitable, medical, and casualty loss disbursements; 2 in contrast, among tax policy commentators, section 164 is more commonly viewed as a tax expenditure. 3 professor douglas kahn argues that accelerated depreciation is structurally correct, notwithstanding that much scholarly opinion holds otherwise.14 on the other hand, any depreciation deduction (including straight line) deviates from the premises of realization-based taxation since 8. geier, supra note 1, at 499 n.21. 9. id. 10. william d. andrews, personal deductions in an ideal income tax. 86 harv. l rev. 309 (1972). 11. see, e.g., congressional research serv., u.s. senate budget comm., tax expenditures: compendium of background material on individual provisions (senate print 103-101), 95 tax notes today 8-35 (jan. 12, 1995) [hereinafter tax expenditures] (analyzing as tax expenditures the exclusion from gross income of employer-provided medical benefits, the exclusion of payments under medical insurance policies, the deduction for medical expenses, and the deduction for personal casualty losses); joint comm. on tax'n. estimates of federal tax expenditures for fiscal years 1995-1999 (jcs-6-94), 94 tax notes today 22123 (nov. 10, 1994) [hereinafter estimates] (estimating the tax expenditure costs of these exclusions and deductions). 12. see edward a. zelinsky, the deductibility of state and local taxes: income measurement, tax expenditures and partial, functional deductibility, 6 am. 1. tax pol'y 9 (1987). 13. see tax expenditures, supra note 11 (analyzing the deduction for state and local taxes as a tax expenditure); estimates, supra note i 1 (estimating the tax expenditure cost of the deduction). 14. douglas a. kahn, accelerated depreciation-tax expenditure or proper allowance for measuring net income? 78 mich. l. rev. 1, 12 (1979). 1996] florida tax review such a deduction presumes decline in value of the taxpayer's property without the confirmation of a realization event. and, professor geier assures us, realization is part of "the fundamental structure [of] the income tax."' 5 in which category-structure or policy--does all of this leave the depreciation deduction? while the basic tax treatment of qualified plans is conventionally characterized as a tax expenditure 6 or, to use professor geier's term, a policy provision, there are strong reasons to conclude that the code's qualified plan rules are consistent with normative tax principles. 7 some scholars respond to these difficulties by eschewing altogether the attempt to identify structural/normative provisions. 8 others jettison the notion of a single set of normative rules and instead suggest a weaker formulation under which more than one set of rules may be structurally acceptable.19 yet others attempt to implement the normative/expenditure distinction in its stronger form by identifying a single set of normatively correct choices in the design of the income tax.20 the upshot is that the structural/policy distinction, which lies at the core of professor geier's analysis, does not provide the courts sufficient guidance for resolving particular tax controversies. even if the courts could workably implement the structural/nonstructural dichotomy, it is wrong to associate the latter kinds of code provisions with congressional policy choices deserving of deference but not the former. provisions that professor geier labels structural represent congressional policy decisions as surely as do those provisions that she classifies as nonstructural. professor geier, for example, identifies the realization requirement as structural.2 ' over the years, congress has enacted measures that impose tax on some forms of unrealized appreciation. 2 under these circumstances, the 15. geier, supra note 1, at 497. 16. see norman p. stein, qualified plans and tax expenditures: a reply to professor zelinsky, 9 am. j. tax pol'y 225 (1991). 17. see edward a. zelinsky, tax policy v. revenue policy: qualified plans, tax expenditures, and the flat, plan level tax, 13 va. tax rev. 591 (1994); edward a. zelinsky, qualified plans and identifying tax expenditures: a rejoinder to professor stein, 9 am. j. tax pol'y 257 (1991) [hereinafter zelinsky, rejoinder]; edward a. zelinsky, the tax treatment of qualified plans: a classic defense of the status quo, 66 n.c. l. rev. 315 (1988). 18. see boris i. bittker, accounting for federal '"tax subsidies" in the national budget, 22 nat'l tax j. 244 (1969). 19. see zelinsky, rejoinder, supra note 17, at 259. 20. see tax expenditures, supra note 11; estimates, supra note 11. 21. geier, supra note 1, at 497. 22. see, e.g., irc §§ 475 (enacted in 1993) (requiring securities dealers to use mark-to-market accounting for securities inventories), 1256 (enacted in 1981) (requiring markto-market accounting for futures contracts and some other derivatives). [vol. 2:12 text, purpose, capaciy and albertson's "structural" rule of realization, where congress has left it intact, reflects a legislative policy choice as deserving of judicial deference as the policy preferences embedded in any nonstructural code provision. professor geier classifies "the distinction between ordinary income and capital gain" as structural.' of course, many others view the treatment of capital gains as a classic tax preference. 4 but, even if the capital gains provisions are properly characterized as structural in nature, it is hard to think of provisions as to which congress, over the years, has implemented its policy-based views more frequently. sometimes congress has made the taxation of capital gains relatively more favorable than the taxation of ordinary income;' at other times, congress has narrowed the gap between capital and ordinary gains.' these repeatedly expressed policy preferences are no less worthy of respect than those embodied in allegedly nonstructural portions of the tax statute. finally, even if the structural/nonstructural distinction were workable and even if structural tax provisions were devoid of congressional policy content, we should be skeptical that judges (and academics) can discover underlying purpose that justifies disregard of statutory text. it is an unexceptional claim that, confronted with statutory ambiguities or unreasonable results, courts can and should turn to secondary sources.' however, professor geier's claim is stronger than this, as was the final position of the ninth circuit in albertson's: even in the absence of ambiguity or absurdity, the courts can articulate underlying statutory purpose better than can the statute itself. when courts and commentators speak this way, they are essentially substituting their own policy preferences for those embodied in the statute and calling that substitution the implementation of underlying purpose. this is neither a new insight nor one limited to the federal tax statute. several generations before congress adopted the modem federal income tax, francis lieber, reflecting on the process of interpreting legal texts, observed: [i]n many cases, it is difficult to discover the motives which may have prompted those who drew up the text; but it is also 23. geier, supra note 1, at 497. 24. surrey & mcdaniel, supra note 7, at 3; tax expenditures, supra note 11 (analyzing as a tax expenditure the maximum 28% rate on long-term capital gains): estimates, supra note 11 (estimating the cost of the capital gains tax expenditure). 25. see, e.g., revenue act of 1978, pub. l. no. 95-600, § 402, 92 stat. 2673. 2867 (increasing capital gain deduction from 50% to 60%). 26. see, e.g., tax reform act of 1986, pub. l no. 99-514, § 301(a). 100 stat. 2085, 2216 (abolishing deduction for capital gains). 27. these ambiguities may reflect, inter alia, failures of draftsmanship, the exigencies of political compromise, evolution over time of the meaning of particular words, or legislative delegation to the courts and administrators of responsibility for developing the law. 19961 florida tax review dangerous to construe upon supposed motives, that is, such as are not ascertainable from the interpretation of the text. everyone is apt to substitute what his motives would have been, or, unconsciously perhaps, to fashion the supposed motives according to his own interests and views of the case; and nothing is a more ready means to bend laws, charters, wills, etc., according to preconceived purposes, than their construction upon supposed motives. to be brief, unless motives are expressed, it is exceedingly difficult to find them out, except by the text itself; they must form, therefore, in most cases, a subject to be found out by the text, not the ground on which we construe it.28 in a somewhat more modem idiom, justice kennedy, chiding his colleagues for ignoring statutory text to implement the perceived spirit of legislation, similarly observed: "the problem with spirits is that they tend to reflect less the views of the world whence they come than the views of those who seek their advice. 29 when professor geier applies her analysis to the albertson's litigation, the limitations of her analysis come into particular focus. the issue in albertson's was whether an accrual-basis employer could, for 1983, deduct accrued but unpaid interest under its nonqualified deferred compensation arrangements or, instead, had to delay the deductibility of such interest under section 404(a)(5) until the employees actually received it. in its second confrontation with this issue, the ninth circuit, with explicit reluctance, held that, although the literal terms of the statute granted albertson's its 1983 deduction for accrued but unpaid interest, those terms were to be disregarded and the deduction denied to implement the underlying purposes of the code's provisions for deferred compensation. 0 professor geier first treats section 404(a)(5), the statute at issue in albertson's, as "structural" without explaining why. she draws an analogy to sections 483 and 1271-1275 for the proposition that time-value-of-money 28. francis lieber, legal and political hermeneutics, or principles of interpretation and construction in law and politics, with remarks on precedents and authorities, 16 cardozo l. rev. 1891, 1975 (1995). lieber also observed that "interpretation may be predestined (interpretatio predestinata), if the interpreter, either consciously or unknown to himself, yet laboring under a strong bias of mind, makes the text subservient to his preconceived views, or some object he desires to arrive at." id. at 1933. 29. public citizen v. united states dept. of justice, 491 u.s. 440, 473 (1989) (kennedy, j., concurring). 30. see albertson's, inc. v. commissioner, 42 f.3d 537 (1994), cert. denied, 116 s.ct. 51 (1995). [vol. 2:12 text, purpose, capacity and albertson's provisions are structural in nature, but she never tells us why these relatively new sections are themselves structural and, thus, an appropriate springboard from which to classify section 404(a)(5) as structural also. moreover, sections 483 and 1271-1275 apply only to property-based income; for those who believe it feasible to categorize certain features of the code as structural, the distinction between property and services would seem to be a prime candidate for such categorization. hence, even if sections 483 and 1271-1275 are conceded to be structural in nature, their "structural value"'" may plausibly be characterized as the importance of time-value-of-money considerations for property-derived income, a characterization that does not support the classification of section 404 as structural since that provision regulates the tax treatment of the opposite structural category, labor-based earnings. having put section 404 into the basket marked "structure," professor geier then slights the explicit policy congress made in that provision for 1983 (the year at issue in albertson's): to restrict the rule of delayed deductibility to the elements of deferred compensation otherwise deductible under section 162 (the deferred compensation itself), but not to delay deductibility for other elements of deferred compensation arrangements, including interest deductible under section 163. ironically, this policy choice emerges with clarity from the kind of legislative history professor geier views as valuable in determining statutory purpose.32 before its amendment in 1986, section 404(a)(5) provided that for nonqualified deferred compensation, amounts otherwise immediately deductible "under section 162" were instead to be deducted on a delayed basis, when taxed to the employees receiving such compensation. in 1986, congress amended section 404(a), effective retroactively to 1984, to provide that all amounts otherwise deductible "under this chapter"r-the income tax as a whole-were henceforth subject to the rule of delayed deductibility. thus, for 1983, the year at issue in albertson's, the controlling version of section 404(a) remained the older version, which explicitly delayed deductibility only of amounts governed by section 162 and not of interest governed by section 163.33 it is possible that, when congress declared its 1986 alteration of section 404(a) to be effective as of 1984, it simply overlooked the possibility of extending the broader, interest-inclusive rule of delayed deductibility to 1983. at least as plausibly, congress chose the 1984 effective date because 31. geier, supra note 1, at 502. 32. id. at 503. 33. these issues are treated more extensively in edward a. zelinsky. the ninth circuit's albertson's decision: right for 1983, wrong for today, 63 tax notes 231 (apr. 11, 1994) and edward a. zelinsky, albertson's: why courts shouldn't override clear statutory language, 66 tax notes 1691 (mar. 13, 1995) [hereinafter zclinsky, language]. 19961 florida tax review taxpayers had, since the enactment of the tax reform act of 1984,' been on notice of congress's desire to alter the rules governing nonqualified deferred compensation. if so, it was appropriate to amend section 404(a) as of the time of that notice. for earlier years, taxpayers had no reason to expect settled law to change retrospectively and were therefore entitled to the tax treatment of the preexisting rule, which limited delayed deductibility to amounts covered by section 162 and not to interest governed by section 163. finally, professor geier, echoing the ninth circuit on its second try at albertson 's,35 discerns an "immediate implementive purpose ... to defer the employer deduction for amounts paid to employees under a nonqualified plan until the employees are taxed on these amounts. 36 she finds this purpose to "create[] ... a matching regime" from "the face of the statute." 37 however, the face of the statute for 1983 indicates something very different and more precise: that amounts otherwise deductible immediately under section 162 were to be deducted on a delayed basis under section 404(a). when professor geier and the ninth circuit purport to find a broader purpose to delay the deductibility of interest governed by section 163, they are merely advancing their own preference for such a rule for 1983 and calling that preference underlying legislative purpose. this substitution of policy for congress is particularly striking since congress made the broader, interestinclusive rule of delayed deductibility effective for the following year. what is defended as the search for statutory purpose is merely the disregard of statutory text. to buttress her position on albertson's, professor geier misdescribes the pro-taxpayer position taken by myself and others. we have, according to professor geier, consulted the dictionary and been told by webster's that the taxpayer should receive a deduction for its accrued but unpaid interest.38 there has been much thoughtful commentary on the albertson's litigation, both pro-taxpayer and pro-treasury. i know of no pro-taxpayer commentator who has defended albertson's 1983 interest deduction along the mechanical, dictionary-based lines suggested by professor geier; i know of no protreasury commentator (until professor geier) who characterized the opposing view in this superficial fashion. 34. see tax reform act of 1984, pub. l. no. 98-369, § 512(a), 98 stat. 494, 862 (amending § 404(b)). 35. professor geier contends that her analysis is fundamentally different from the ninth circuit's. i am skeptical that this is so. both the ninth circuit in its second albertson's opinion and professor geier view a broad matching principle as justifying disregard of old § 404(a)'s explicit limitation to § 162 deductions. 36. geier, supra note 1, at 519. 37. id. at 519. 38. id. at 518. [vol 2:12 text, purpose, capaci., and albertson's the pro-albertson's position is far more serious than professor geier's caricature would indicate: for 1983, the year at issue in albertson's, the statute delayed deductibility only for those deferred compensation items governed by section 162; interest is governed by section 163. congress, however inartfully,3 9 brought interest within the rule of delayed deductibility starting in 1984. there are reasonable policy justifications for the rule embodied in the older, pre-1984 version of section 404. it was not the role of the courts to make the new interest-inclusive rule of delayed deductibility retroactive to 1983 when congress made the new rule retroactive to 1984. when it addresses an issue explicitly, the text of the code is the paramount expression of the tax law. ill. the issue of institutional capacity as professor geier correctly notes, this line of discussion ultimately leads to the question of relative institutional capacities, i.e., the normative roles of the congress and the courts in molding the tax law. in my critique of the ninth circuit's albertson's decision, i pointed to the history of section 404(a)-which congress had already changed before the albertson's litigation began-as indicating the code's great amenability to legislative correction. congress' willingness and ability to remold tax law, i argued, counsels a restrained role for the courts. if the courts' implementation of the code's literal command produces results congress finds unpalatable, congress will change the code.' ° in contrast, professor geier envisions the courts vigorously shaping the tax law in its structural aspects rather than deferentially applying the code as congress enacts it. among the factors professor geier cites to support a proactive role for the courts in tax controversies are the inherent limits of language,4 the "cumbersome" nature of the legislative process,4 the political freedom of congress in passing structural (as opposed to policy) provisions,43 the expanding bulk of the code as congress repeatedly amends it,4 aggressive tax advisors' ability to manipulate an increasingly complicated tax statute,45 and revenue constraints.46 professor geier takes particular aim at my observation that the albertson's saga indicates the code's susceptibility to legislative correction, declaring this approach "far too facile" in a 39. see zelinsky, language, supra note 33, at 1698-99. 40. see id. at 1700. 41. see geier, supra note 1, at 508. 42. id. at 511. 43. see id. at 508-09. 44. id. at 511. 45. id. at 511-12. 46. id. at 511 n.62. 19961 florida tax review world where congress must balance any revenue-losing legislation it adopts with an offsetting revenue gain.47 of course, most of the courts' day-to-day business in tax matters is not as contentious as albertson's, for example, the application of uncontroverted legal principles to particular factual settings, the resolution of statutory ambiguities and conflicts, the filling of gaps in the statutory and administrative framework. cases like albertson's are so valuable precisely because the choices are rarely posed as starkly as the ninth circuit ultimately perceived them: the terminology of the code unequivocally pointing in one direction (immediate deductibility), the court's judgment-couched as underlying statutory purpose-leading to the other (delayed deductibility). it is in these infrequent but important settings that we must decide which institutioncongress or the judiciary-has fundamental responsibility for making the tax law. professor geier's reasons for assigning to the courts the more proactive role are not persuasive. as professor geier notes, language has its limitations;" indeed, legal scholars have in recent years developed an extensive literature exploring these limitations and their implications for the legal system.49 but, these concerns do not help decide the relative strengths of judges and legislators: they use the same language. there is no reason for language in the hands of judges to be more determinant, less problematic than in the hands of legislators. professor geier argues that statutory terminology is "self-executing," while judicial writing is "expository. ' 50 assuming that distinction to be true, it is unclear why it is meaningful: self-executing language may be preferable for purposes of the tax law. important instances of judicial exposition in tax cases reveal the limits of judges' language. for over a generation, the lower courts, scholars, and the tax bar struggled with the meaning of the supreme court's national carbide51 phraseology only to be told by the court that it meant nothing at all.52 no serious student of the legislative process would contest professor geier's assertion that that process is cumbersome. again, however, the relevant inquiry is the relative merits of the courts and the congress. although our system of litigation has many advantages, no one has ever argued that efficiency is one of them. insofar as professor geier suggests that 47. id. at 511 & n.62. 48. id. at 508. 49. see, e.g., a symposium on legal and political hermeneutics, 16 cardozo l. rev. 1879 (1995). 50. geier, supra note 1, at 508. 51. nat'l carbide corp. v. commissioner, 336 u.s. 422 (1949). 52. commissioner v. bollinger, 485 u.s. 340, 349 (1988). [vol 2:12 text, purpose, capacity and albertson's litigation is a less cumbersome means than the legislative process for resolving important questions of tax law, that suggestion reflects an unrealistic view of the judicial system. 3 professor geier also contends that congress can legislate particularly well on structural matters; while "hard decisions must be made" as to policy provisions, congress is less constrained politically as to the code's structural aspects and thus can legislate on them in a qualitatively superior fashion.' this contention will not prove persuasive to the reader unconvinced of the structural/nonstructural distinction and to the reader who views the structural aspects of the code as embodying policy choices and thus also entailing "hard decisions" and political implications. there is, moreover, at least some tension between professor geier's characterization of the legislative process as unwieldy and her assertion that congress legislates with freedom on structural tax matters. even if professor geier is correct in assuming that congress can legislate on structural matters without the pressures and distractions attending nonstructural provisions, that observation suggests that courts should be more (rather than less) respectful of the resulting legislative output, which often uses "the best words that congress could have chosen." given the assumption of superior legislative performance unfettered by political constraints, we should be skeptical that courts can find underlying legislative purpose that congress, relieved from political pressures and thus free to use "the best words" available, failed to express in the statutory text. professor geier bemoans that placing a primary role on congress to protect and upgrade the tax statute will increase the verbiage of an already prolix document. but, by assigning the courts to the vanguard, she would merely shift the verbiage to the judicial reporters. it is hard to see any net gain from this. professor geier correctly notes that aggressive tax advisors can manipulate statutory rules. but, judge-made rules can be exploited too: remember mrs. crane?56 53. the taxpayer in albertson's took its disputed interest deduction for 1983. only when the taxpayer's request for supreme court review was finally denied in 1995, 12 years later, was there a final judicial determination of that deduction's propriety. we can only speculate about the legal costs incurred in this litigation, but, for both albertson's and the government, such costs must have been considerable. 54. geier, supra note 1, at 509. 55. id. 56. for those who don't, in mrs. crane's celebrated litigation before the u.s. supreme court, the court treated nonrecourse debt as equivalent for tax purposes to recourse debt and therefore to be included in the basis of property acquired subject to the debt. this rule (which was pro-fisc in crane) was in subsequent years used by tax shelter developers to create basis and depreciation for investors at no economic risk to them. the lesson is that 19961 florida tax review finally, professor geier argues that i am wrong to characterize the code as highly correctable by legislation. an overly-sanguine view of congress's willingness and ability to repair the tax statute, she suggests, improperly relieves the courts of their responsibility for fixing the tax law. my argument for the amenability of the tax law to legislative change had three components. empirically, by the time the albertson's litigation reached the courts, congress had already remedied the perceived statutory flaw for 1984 and later years. congress had not merely reacted to a judicial decision indicating the need for legislative correction of section 404(a), but had been persuaded of the problem in advance of litigation. second, annual tax legislation has, for better or worse, proven a durable feature of the legislative process, giving congress the yearly opportunity to correct perceived deficiencies in the code. in contrast to the courts' constitutional decisions (where for all practical purposes the courts are the ultimate decisionmakers) and the courts' application of statutes which congress revisits infrequently, the opportunity typically exists for reasonably prompt legislative response to judicial applications of the tax statute. third, the specialized institutions with primary responsibility for tax policy (congress's tax-writing committees and the treasury) are less capturable by interest groups than their nontax counterparts because tax policymakers are subject to multiple, often offsetting pressures, in contrast to bureaucracies and legislative committees with narrower, more homogeneous jurisdictions and constituencies. the more pluralist, competitive nature of tax institutions gives tax policymakers a greater ability to pursue corrective measures than nontax policymakers dependent for political support on more limited ranges of interest groups.57 i qualified my comments with the observation that it is indeed too facile to say that congress can simply overturn judicial decisions.5" a judicial determination affects the legislative process since an interest group that wins in court has the easier task of blocking legislative action to preserve the status quo, while the loser has the harder task of obtaining affirmative legislative relief. nevertheless, on balance, i concluded that the code is very amenable to legislative correction and that this should caution against the courts assuming for themselves the task of repairing the tax law when literal application of the code arguably leads to an incorrect policy result. judge-made rules, not just statutory rules, can be manipulated in unforeseen and unpleasant ways. see crane v. commissioner, 331 u.s. 1 (1947). 57. this idea is developed more extensively in edward a. zelinsky, james madison and public choice at gucci gulch: a procedural defense of tax expenditures and tax institutions, 102 yale l.j. 1165 (1993). 58. zelinsky, language, supra note 33, at 1700. [vol 2:12 text, purpose, capacity and albertson's professor geier replies that congress must find revenue-raising measures to offset those tax changes that hurt the fisc."9 on its face, the rule of revenue-neutrality supports my position since it encourages congress to adopt those repairs to the tax statute that procure additional tax money and thereby liberate congress from that rule. members of congress otherwise indifferent to the requirements of tax policy will, given the mandate that revenue increases balance revenue losses, support corrections to the code generating the funds needed to finance proposals which they advocate. moreover, legislative corrections in the sense professor geier and i are discussing them are typically revenue-raisers. the need for legislative repair is classically perceived when the literal application of the code leads to a pro-taxpayer result that is unacceptable to treasury officials, congress's tax-writers, and the professionals who advise them. the resulting change to the code is typically scored as a revenue-raiser since it reverses a moneylosing judicial decision and is thus particularly attractive to legislators looking to finance their own proposals.' finally, even if the rule of revenue-neutrality on balance reduces congress's ability to correct the code, the tax statute remains quite amenable to legislative repair, given the other, offsetting factors which enhance congress's capacity to mend the code, i.e., the annual nature of tax legislation, the pluralistic character of tax institutions which gives tax policymakers greater independence than is possessed by their nontax counterparts. the suspectibility of the tax statute to legislative repair is particularly pronounced in comparison with judge-made constitutional law (essentially untouchable by congress) and the courts' construction of those statutes revisited by congress infrequently and subject to the jurisdiction of more capturable legislative and executive institutions. in short, if the code is not amenable to congressional correction, no statute is. as this line of analysis makes clear, the amenability of the code to legislative repair is ultimately an empirical question. professor geier counters my prime example--congress's alteration of section 404(a) even before the albertson's litigation began-with efforts to overturn the soliman decision6 and thus liberalize the deductibility of taxpayers' home office expenses. these efforts, professor geier indicates, have been hampered by the requirement that the money lost by repealing soliman be balanced by a countervailing revenue gain.62 the final outcome of the soliman saga remains to be seen; there is strong, bipartisan support for overturning that decision legislative59. geier, supra note 1, at 511 n.62. 60. i infer that professor geier disagrees with these observations. id. at 496. 61. commissioner v. soliman, 506 u.s. 168 (1993). 62. geier, supra note 1, at 511 n.62. 19961 florida tax review ly.63 but even if congress leaves standing the present statutory provisions governing home office deductions, that may in the final analysis reflect the considered judgment that the statute embodies the correct compromise of the contending considerations and that the court properly (and literally) applied the statute to deny dr. soliman a home office deduction. iv. what is textualism? integral to professor geier's analysis is a mechanical conception of textualism. textualism, professor geier tell us, is the process of consulting the dictionary to determine the meaning of particular words and then applying these dictionary-based meanings in a wooden fashion.64 textualism in this formulation is the opposite of the search for purpose and, as professor geier makes clear, is a poor way to resolve albertson's or any other tax controversy. so understood, textualism is indeed an appropriate target for critique. in fact, textualism as defined by professor geier is something of a straw man, a particularly cramped view of a text-centered approach to the code that is both more substantive and more nuanced than professor geier's formulation. 65 that approach starts with the proposition that for a variety of reasons, the modem tax law is quintessentially a statutory matter. taxation ultimately involves political choices that appropriately belong to elected officials-the congress and the president-who act through legislation. while courts are largely limited to deciding particular issues raised in cases litigated after-thefact, congress can statutorily promulgate, prospectively and comprehensively, the many general rules and detailed provisions required of a modern tax system. while the supreme court can definitively resolve only a handful of tax controversies in any year, congress has far greater capacity to provide legislative output for the perceived problems and needs of the tax system. the various courts of appeals can each settle legal issues for only a portion of the nation's taxpayers, while congress legislates nationally and is thus able to make the tax law more predictable and uniform. the executive branch and congress contain both specialized tax policymakers and expert tax staff, while the federal judiciary is largely a body of generalists.66 63. see, e.g., amy s. cohen, administration open to increasing flexibility of home office deduction, 95 tnt 109-5 (june 6, 1995) (lexis, fedtax library, tnt file). 64. geier, supra note 1, at 510, 518. 65. courts do indeed sometimes invoke dictionary definitions in tax cases. see, e.g., dittler bros., inc. v. commissioner, 72 t.c. 896, 915 (1979). the point is that there is more than this to text-based interpretive methodology. 66. the bulk of federal tax cases are initially litigated in the tax court, a specialized body, but appeals of tax court decisions, as well of those of other courts trying tax cases, are to courts of general jurisdiction. [vol 2:12 text, purpose, capaciy and albertson's since the statute as enacted by congress and the president is, for these reasons, the fundamental source of the tax law, those who interpret and apply it should respect the statutory text and should view the text as the primary and initial basis for resolving tax controversies. adjudicators should resort to secondary sources-case law, regulations, administrative authority, notions of tax policy (even when dressed up as unexpressed statutory purpose)-only after the possibilities of statutory-based solutions have been exhausted. courts should not lightly declare the code ambiguous or its literal command unreasonable since any such declaration necessarily displaces the statute adopted by the elected officeholders with ultimate responsibility for the tax law. since the code is a relatively new and continually updated text, it requires less liberal construction than older texts which, by definition, could not have been drafted with an understanding of contemporary conditions and which often use words whose connotations have changed with the passage of time. 67 from this perspective, textualism in tax cases means an initial and primary emphasis on statutory text and a reasonably high threshold to be met before pronouncing the code ambiguous or its literal application absurd. interpreting and applying text in this fashion is not a mechanical, dictionarybased process, but a creative one in which the reader actively engages the text to derive meaning. individual readers bring to this process cultural and there may be benefits to using generalist judges as the adjudicators in tax cases, as well as in other technical areas of law. requiring specialists to explain the issues to generalists can improve and focus the presentation of those issues. specialists sometimes become overly enmeshed in the technicalities of their field and miss or de-emphasize matters more apparent to nonspecialists not so enmeshed. these observations do not detract from my statement in the text: among the reasons we have assigned primary responsibility for the formulation of the tax law to the legislative process is the tax-writing expertise of the congress and the executive branch. 67. for example, the framers of the constitution authorized the congress to maintain "armies" and "a navy" and to regulate these "land and naval forces." u.s. const,, art. i, § 8, cl. 12-14. few would doubt that, pursuant to this authority, congress can constitutionally establish an air force. on the other hand, a statute adopted in 1995 referring to "the army and navy," but not mentioning the air force, should be understood literally, as applying only to the two older branches of the military, because in 1995 congress knew of the air force's existence and, in the context of 1995, the statutory expression "army and navy" means just that. similarly, those who revised § 404(a) in 1986 knew that, before revision. § 404(a) only delayed those deductions for nonqualified deferred compensation that were covered by "section 162." indeed, the cross-reference to § 162 is precisely the terminology they chose to change effective as of 1984. the constitutional authority for an air force has been discussed by several commentators on the legal interpretation of texts. see, e.g., lawrence lessig, fidelity in translation, 71 tex. l. rev. 1165, 1203 (1993). 19961 florida tax review individual assumptions and predilections different from those brought by others. text-centeredness is thus a methodology based on the presumption and desirability of solutions grounded in statutory language, not a guarantee that such solutions can be found or agreed upon universally." important objections can be raised to this text-based approach to the code. professor livingston, for example, argues that legislative history materials emerge contemporaneously from the same network of specialized professionals which develops the statutory language and that elected officials, if they read anything, read those materials, not the proposed statutory language. 69 he is thus inclined to utilize legislative history materials earlier in the interpretive process and to give them greater weight. alternatively, it can plausibly be argued that tax policy norms ought play a more central and earlier role in the interpretive process than my analysis suggests. notions of indeterminacy generate skepticism that statutory language can convey meaning. these are real and important challenges to the approach which requires interpreters of the code to exhaust, initially and extensively, the possibilities of text-based solutions before resorting to other sources and authorities. in contrast, professor geier dismisses text-centered methodology by focusing upon the narrowest and most mechanical formulation of that methodology, thereby attacking an easy target and ignoring the more demanding one. the text-based approach to the code, as i have presented it, challenges another of professor geier's central tenets: the dichotomy between text and purpose. while professor geier treats respect for text and the search for purpose as opposites, such a search is often an important part of the reader's engagement with the text. consider in this respect professor geier's analysis of section 102(a) and the supreme court's duberstein decision.70 professor geier and i agree that the court should have accepted the government's argument that "gift" in the context of section 102(a) refers to transfers in personal and family settings and that gifts cannot occur for tax purposes in employment or other business 68. textualism, according to professor eskridge, comes in both its "boneheaded" version and its "sensible" version. the former, frequently manifested by reliance on dictionary definitions, is the form of textualism criticized by professor geier and a fairly easy target; the latter corresponds more closely to the methodology i propose for the interpretation of the code. see william n. eskridge, jr., fetch some soupmeat, 16 cardozo l. rev. 2209, 2210-14 (1995). 69. michael livingston, congress, the courts, and the code: legislative history and the interpretation of tax statutes, 69 tex. l. rev. 819 (1991). 70. commissioner v. duberstein, 363 u.s. 278 (1960). the statutory provision at issue in duberstein was the 1939 code predecessor of § 170. [vol. 2:12 text, purpose, capacity and albertson's contexts. professor geier reaches this conclusion largely by invoking notions of structure that i find problematic,7 and she characterizes the court's contrary analysis as "a plain-meaning approach to statutory language."' in fact, the duberstein court was not terribly interested in the text of section 102(a), but instead viewed its task as the application of "decisional law" principles previously "spelled out in the opinions of this court"; indeed, the court stated, the duberstein "problem is one which, under the present statutory framework, does not lend itself to any more definitive statement" than that developed in prior case law.' similarly, the separate opinions of justice black74 and justice frankfurter" did not address the language of section 102(a) or the implications of that language for the duberstein decision. in contrast, under a text-centered approach, the court should have grappled with the language of section 102(a), which, in its totality, excludes from gross income "the value of property acquired by gift, bequest, devise, or inheritance." the search for purpose would have been an important part of that inquiry, leading, in my judgment, to the conclusion that section 102(a) removes only family and personal transfers from the ambit of federal income taxation. that professor geier and i reach, from different directions, the same conclusion in duberstein suggests the importance of the rare case like albertson's. different methodologies often lead to the same or similar results. as much legislative history material essentially tracks the statute, those more inclined to resort to such history and those more code-oriented typically come to the same conclusions about particular cases. given the influence in the tax-writing process of the specialists who work for congress and the executive branch and given the widespread acceptance of certain norms in the tax community, those emphasizing tax policy considerations and those stressing statutory text often come to the same result because the statute reflects the policy-based input of those specialists and the norms of the professional community of which they are part. there is plenty of ambiguity in the code, stemming, inter alia, from political compromise, poor draftsmanship, deliberate and implicit delegation to the courts and tax administrators, and the inherent limitations of language. hence, even those aggressively searching for statutory answers to tax questions must often turn to the same secondary sources that others consult earlier in the process. 71. see supra notes 7-19 and accompanying text. 72. geier, supra note 1, at 498. 73. duberstein, supra note 70, at 284. 74. id. at 293-94. 75. id. at 294-98. 19961 florida tax review in contrast, albertson's is the rare and important case where different interpretive methodologies do not overlap, but lead to conflicting conclusions, and thus provides a useful opportunity to explore and contrast those methodologies. i do not dispute that those who would disallow albertson's 1983 deduction for accrued interest can raise serious objections to the textcentered approach that leads me and others to condone that deduction. i do dispute that professor geier's description of dictionary-based textualism is a useful depiction of that text-centered approach. v. conclusion in a talmudic commentary, the rabbis conclude that an egg laid by a chicken on the sabbath cannot be used immediately to balance a broken table because that use would violate the strictures of the sabbath.76 the rabbis, whose jurisprudence was at least as sophisticated as our own, fully understood that their hypothetical was of little practical relevance, but was a device for exploring the assumptions and implications of norms fundamental to their legal system. the albertson's case is a modem tax law equivalent. it is of little practical import whether the taxpayer in albertson's was entitled to a 1983 interest deduction under the version of section 404(a) then in effect. it is of great importance to our understanding of the tax law and the interpretation of the code how the albertson's controversy is ultimately comprehended. professor geier and i agree neither as to result nor underlying analysis. i find that professor geier's basic approach is flawed and that when applied to albertson's, it produces an incorrect outcome. i similarly find unpersuasive professor geier's reasons for assigning to courts a proactive role in cases like albertson's and believe that professor geier improperly characterizes the text-centered approach to the code that underpins my view of albertson 's. professor geier and i, like the rabbis who explored the jurisprudence of a sabbath-hatched egg, do share the belief that colloquies of this sort are fundamental to a better understanding of laws and institutions. i thus welcome her contribution to the academic literature even while disagreeing with it. 76. babylonian talmud, beitzah 3b. [vol 2:12 florida tax review volume 2 1994 number 2 simplification and irc § 415 norman p. steitz i. introduction there has been much talk of late about simplifying subchapter d, the web of rules governing the affairs of tax-qualified pension plans.' among the targets that the simplification advocates have in their sights is section 415 of the code.2 section 415 places limits on contributions to defined contribution * douglas arant professor of law, university of alabama school of law. the author gratefully acknowledges the helpful comments of don grubbs, dan halperin. mary oppenheimer, mary radford, bruce wolk, and members of the aba subcommittee on section 415, despite, in many cases, their disagreement with the author's conclusions. the university of alabama law school foundation generously provided funding for the article. finally, this article is dedicated to don grubbs, who will retire later this year. and whose career and devotion to public service have provided an exemplary model for me and other members of the employee benefits bar. 1. see, e.g., h.r. 2742, 102d cong., 1st sess. (1991); pension access and simplification act of 1991, h.r. 2730, 102d cong., 1st sess. (1991); h.r. 2390, 102d cong., 1st sess. (1991); h.r. 1735, 102d cong., 1st sess. (1991); employee benefits simplification act. s. 2901, 101st cong., 2d sess. (1990); the association of private pension & welfare plans, gridlock: pension law in crisis and the road to simplification 32-34 (1989) [hereinafter gridlock]. 2. simplification of the rules applicable to pension plans may have a range of purposes. these include making plans easier and less costly to administer, and easier for both the plan sponsors and plan participants to understand; easing the irs's burden of monitoring compliance; reducing the opportunities for plan sponsors to evade legislative purpose through plan design; and improving the ability of professionals to predict accurately the consequences of particular rules to particular situations. the meaning of simplification in the tax law has been subject to extensive scholarly reflection and debate. see, e.g.. boris i. bittker, tax reform and tax simplification, 29 u. miami l. rev. 1 (1974); walter j. blum, simplification of the federal income tax law, 10 tax l. rev. 239 (1954); robert b. eichholz, should the federal income tax be simplified?, 48 yale lj. 1200 (1939); james s. eustice, tax complexity and the tax practitioner, 45 tax l. rev. 7 (1989): randolph e. paul. simplification of federal tax laws, 29 cornell l.q. 285 (1944); stanley s. surrey & gerard m. brannon, simplification and equity as goals of tax policy, 9 win. & mary l rev. 915 (1968); laurence n. woodworth, tax simplification and the tax reform act of 1969, 34 law & contemp. probs. 711 (1969). florida tax review plans and on benefits payable from defined benefit plans.' the basic idea justifying section 415 is that an employer should not be able to use the code's qualified plan provisions to bestow tax deferral on deferred compensation in excess of the reasonable retirement needs of its employees.4 the simplification advocates have proposed repeal of section 415 or at least of its most supremely complex part, section 415(e), which sets combined limits for individuals who participate in both defined contribution and defined benefit plans. they argue that section 4980a, which was enacted in 1986 and which imposes a nondeductible excise tax on excessive distributions from pension plans, has rendered section 415 limitations, or at least the section 415(e) limitation, superfluous.5 they also argue that subsection (e) is impervious to any sort of simplification efforts short of outright repeal.6 3. the limit on benefits payable from a defined benefit plan affects the amount of contributions paid to the plan, since the employer's annual contribution is limited to the appropriate annual actuarial cost of the maximum benefit permitted by § 415(b). for an excellent treatment of the technical operation of the § 415 rules, see richard b. stanger et al., tax-qualified retirement plans after tefra: limitations on benefits and contributions and top-heavy plan rules, 41 inst. on fed. tax'n § 37 (1983) [hereinafter tax-qualified retirement plans after tefra]. although congress has since modified § 415, this article remains the most comprehensive treatment of the rules. 4. see infra text accompanying notes 48-54; see also h.r. rep. no. 807, 93d cong., 2d sess. 35 (1974); 2 dep't of the treasury, tax reform for fairness, simplicity, and economic growth: general explanation of the treasury dep't proposals 346, 350 (1984) [hereinafter tax reform]. 5. see memorandum from lee irish to elaine church & roger siske 8 (oct. 25, 1990) (on file with author) [hereinafter irish memo]; see also dianne bennett, plan distributions: a call for some order out of the chaos, in ali-aba fifth pension invitational conference 33, 39-40 (oct. 11-12, 1987) (on file with author). bennett's paper provides an extraordinarily thoughtful approach to the web of rules governing distributions from qualified plans. bennett, in suggesting that a bolstered version of § 4980a replace § 415, noted that the suggestion, even if rejected, might give rise to "consideration... of simplifications to section 415." id. at 40. as is noted later, the proposals to eliminate § 415 are not nearly so serious as the proposals to eliminate subsection (e). the association of private pension & welfare plans ("appwp") has argued that § 415(e) should be eliminated if congress retains the § 4980a tax. gridlock, supra note 1, at 32-34. however, appwp would prefer repeal of § 4980a to repeal of § 415(e). the concept for the § 4980a excise tax came from the department of the treasury. tax reform, supra note 4, at 349-53. the influential proposals led to the tax reform act of 1986. the department had proposed an excise tax as a substitute for § 415(e), which it stated "may be the primary source of complexity in the retirement plan area." id. at 350. congress, although adding the excise tax, retained the § 415(e) limits. 6. the case for elimination of § 415(e) is made articulately in a memorandum prepared by an attorney participating in the american tax policy institute pension roundtable. see irish memo, supra note 5, at 8. the memorandum also suggests that § 415 itself might be eliminated. id. [vol 2:2 simplification and irc § 415 because i agree with the basic idea undergirding section 415 and reject the argument that section 4980a serves adequately as a replacement, i disagree that section 415 is an attractive candidate for repeal. moreover, in my view even a repeal limited to subsection 415(e) would be an error because of the subsection's importance in maintaining section 415's overall integrity. this article explains the basis for these views and also suggests ways of simplifying section 415(e) short of repealing it. the article is divided into three parts. the first part describes the pertinent provisions of section 415. the second part responds to the argument that section 415 should be eliminated rather than simplified; this part explores the policy goals served by section 415 and considers whether section 415 has anything to add to other code sections-primarily section 4980a-that serve similar policy objectives. the third part suggests two approaches that congress might take toward simplification of section 415. i. description of section 415 section 415 includes three limits. one limit (from section 415(b), hereinafter referred to as the "(b) limit" or the "defined benefit limit") restricts the maximum annual retirement benefit an employee can accrue under all defined benefit plans maintained at any time by an employer. the limitation is an annual straight single-life annuity equal to the lesser of $90,000 or 100% of the employee's average compensation over the highest three-year period.7 the dollar figure, however, is indexed to the cost of the american bar association section of taxation has prepared a report advocating several changes to simplify § 415, including repeal of § 415(e). american bar association. section of taxation, possible simplification proposals relating to limitations on benefits and contributions under qualified plans (sept. 23, 1993) (on file at the university of alabama school of law library) [hereinafter aba report]. the author of this article, who was a member of the subcommittee that drafted the report, dissented from the report's recommendation that § 415(e) be deleted. id. at i. 7. irc § 415(b)(1). erisa originally set the dollar limi" at s75,000. but cost-of-living adjustments pushed it up to s136,425 by 1982. i.r.s. information rcl. ir-8"2-18 (1982). congress reduced the limitation to s90,000 in the tax equity and fiscal responsibility act of 1982 ("tefra"), pub. l. no. 97-248, § 235(g)(2). 96 stat. 324, 508 (1982) but generally preserved already-accrued benefits in excess of the reduced limits. § 235(g)(4), 96 stat. at 508-09. see generally tax-qualified retirement plans after tefra. supra note 3, § 37.03[6]. congressional lore, as retold by former tax-writing committee staff members, has it that there had been intense lobbying in 1982 from business interests to leave the dollar limits intact, since the limits were an integral part of erisa, a statute that was then only eight years old. reducing the limits, they argued, would have an adverse effect on plan formation and also would be unfair to the businesses that had continued plan sponsorship since erisa's passage in reliance on the limits being indexed. the lobbying efforts appeared to be successful and a majority of members of the house ways and means committee was ready to vote against 19941 florida tax review living and in 1994 is $118,881.8 the dollar limit is adjusted if the benefit begins earlier or later than social security retirement age, or is paid in a form other than a straight-life annuity.9 in addition, the dollar limit is phased in ratably over ten years of actual plan participation."° the compensation limit is phased in over ten years of service with the employer rather than plan participation. a second limit (under section 415(c), hereinafter referred to as the "(c) limit" or the "defined contribution limit") applies to defined contribution plans. the defined contribution limit provides that the annual additions to an employee's accounts in all defined contribution plans maintained by an employer may not exceed the lesser of $30,000 a year or 25% of the reductions to the dollar limits. before the vote, however, the roll call bell rang and the committee members filed out to the floor of the house, where they participated in a vote to reduce food stamps. the irony of voting to cut food stamps while preserving a $136,425 dollar limit for benefits of the nation's most affluent citizens was apparently too much for a majority of the committee members, who returned to their committee seats and voted to reduce the § 415 limits. 8. i.r.s. information rel. ir-94-3 (jan. 13, 1994). tefra delayed indexation until 1986, with indexation reflecting cost-of-living increases occurring after 1984. tefra, supra note 7, § 235(g)(1), (2), 96 stat. at 508. 9. irc § 415(b)(2)(a)-(d). see tax-qualified retirement plans after tefra, supra note 3, § 37.03 for details on the rules and their operation. 10. irc § 415(b)(5). the § 415(b)(5) phase-in period for the dollar limit formerly was based on years of service with the employer rather than years of participation in the plan. the department of the treasury believed that phasing in the dollar limits based on service permitted a small employer to establish a defined benefit plan close to the time its key employee would retire. because the benefit could be based on past service with the employer, the key employee generally would have service sufficient for "a fully funded benefit [but the plan could] ... avoid providing benefits to non-key employees," who generally would have less past service credit. tax reform, supra note 4, at 351. thus, the department proposed, and congress accepted, a phase-in period for the dollar limit on the basis of years of plan participation rather than service. section 415(b)(5)(d) provides that to the extent provided in regulations, the phase-in period applies to changes in benefit structure. the service initially took the position that the phase-in of the dollar limits would apply to a plan amendment improving benefits. thus, an amendment to a plan could improve benefits by no more than 10% of the dollar limit per year of participation after the plan amendment. i.r.s. notice 89-45, 1989-1 c.b. 684. the service later reconsidered its position in light of the regulations it promulgated under § 401(a)(4), which prohibit discrimination in favor of highly compensated employees. see regs. § 1.401(a)(4)-l(b). in revenue procedure 92-42, the service noted that the legislative history of § 415(b)(5) indicated that congress was not concerned with phasing in benefit improvements that were not primarily for the benefit of highly compensated employees. the service therefore concluded that the § 401(a)(4) nondiscrimination regulations eliminated the need for the phase-in period to apply to "changes in benefit structure," since those regulations prohibit amendments that discriminate in favor of highly compensated employees. rev. proc. 92-42, 1992-1 c.b. 872. [vol 2:2 simplification and irc § 415 employee's compensation." for these purposes, additions include employer contributions, employee contributions, 2 and forfeitures allocated to the employee's account.' 3 the $30,000 limit is indexed to inflation, but the indexing will not commence until the inflation-adjusted defined benefit limit reaches $120,000, which will likely occur in 1995.4 there is an important conceptual distinction between the (b) and (c) limits. the (b) limit restricts the total career benefit an employee can accrue in defined benefit plans maintained by an employer; the (c) limit restricts the annual additions to a defined contribution plan. a third limit (from section 415(e), hereinafter referred to as the "(e) limit" or the "combined limit") applies when employers maintain both a defined contribution plan and a defined benefit plan, whether simultaneously or seriatim. the limit, which is quite complex, is designed to permit an employer who sponsors or has sponsored both types of plans to provide greater benefits to its employees than can be provided by an employer who sponsors only one type of plan. the increased benefits under the combined limit are, however, less than those determined by combining the full limits applicable to each type of plan. the combined limit's complexity reflects the difficulty of combining a career defined benefit limit with an annual defined contribution limit. the combined limit requires the preparation of both a "defined contribution fraction" and a "defined benefit fraction" indicating the percent11. irc § 415(c)(1). erisa originally set the limit at s25,000, with indexation to the cost of living. by 1982, the limit reached $45,475, but congress cut back the limit to $30,000 in 1982. tefra, supra note 7. § 235(a)(2), (g)(1), 96 stat. at 505, 508. the defined contribution limit permits the funding of a larger benefit over an employee's career than does the defined benefit limit. see infra note 52 and accompanying text. the two limits, although far from mathematically equivalent, apparently were regarded in congress as political equivalents. 12. irc § 415(c)(2)(a), (b). one of the minor complexities in § 415 is that the tax reform act of 1986 expanded the definition of included employee contributions. before the act, employee contributions for § 415(c) purposes were limited to the lesser of the amount of the contributions in excess of 6% of compensation or one-half of the contributions. irc § 415(c)(2)(b) (1985). the current version of § 415 includes all employee contributions. thus. in determining employee contributions, a plan administrator has to cope with different sets of rules depending on the year in question. 13. irc § 415(c)(2)(c). 14. the statutory mechanism for indexing the defined contribution limit is § 415(c)(1)(a), which provides that the dollar limit is "s30,000 (or. if greater. 1/4 of the dollar limitation in effect under subsection (b)(l)(a))." the defined benefit dollar limit, in turn. is indexed to the cost of living. irc § 415(d)(1). the original dollar limit for defined benefit plans was set at $90,000. irc § 415(b)(l)(a). the indexation of the defined contribution limit is deferred, however, until the defined benefit limit is adjusted under § 415(d) to s120,000. 1994] florida tax review age of utilization of each type of limit.'" the sum of the two fractions must not exceed one.' 6 this description suggests that there would be no advantage to sponsoring two types of plans. the manner in which the fractions are calculated and the effect of the time value of money on the funding of defined benefit plans, however, permit employers who sponsor two types of plans (either simultaneously or seriatim) to provide greater total benefits than can be provided by employers who sponsor only one type of plan. both the calculation of the combined limit and the implications of the time value of money are discussed below. the numerator of the defined benefit fraction is the amount of the projected annual benefit the employee has accrued under the plan. 7 the denominator of the fraction is the lesser of 1.25 times the dollar limit in effect for the year or 1.4 times the compensation limit applicable to the employee for the year.'8 this means that for an employee who has accrued the maximum defined benefit under the (b) limit, i.e., $118,881 in 1984, the defined benefit fraction is $118,881/(1.25 x 118,881), or 1/1.25, or 0.8. thus, even though the employee has accrued the maximum defined benefit under section 415(b), he or she also may have contributions made to a defined contribution plan so long as the defined contribution fraction does not exceed 0.2. the defined contribution fraction is more complex because rather than reflect a defined benefit as currently calculated, it reflects the cumulative use of the (c) limit over the employee's service for the employer. the numerator is the sum of all applicable additions to the employee's accounts in all defined contribution plans ever maintained by the employer.' 9 the denominator of the fraction is the sum of variables calculated for each year of service.2" the variable for each year is the lesser of 1.25 times the dollar (c) limit or 1.4 times the compensation (c) limit for defined contribution plans in effect for the applicable year.2' 15. irc § 415(e)(l)-(3). 16. irc § 415(e)(1). 17. irc § 415(e)(2)(a). 18. irc § 415(e)(2)(b). 19. irc § 415(e)(3)(a). 20. irc § 415(e)(3)(b). 21. id. a source of needless complexity with respect to § 415(e) is that the definition of compensation under § 415(c)(3) often differs from the definition of compensation actually used by the employer to determine contributions under the plan. some employers find that a quite burdensome part of § 415(e) computations is determining § 415(c)(3) compensation over the employee's career, which might span 40 or more years. records of such compensation may not be in plan records, and w-2 information, when it can be unearthed, is not useful if the plan year is other than the calendar year. [vol 2:2 simplification and irc § 415 to illustrate, consider an employee with two years of service. in the first year, the employee's compensation was $64,285.72, and no additions were made to a defined contribution plan for the employee; in the second year, compensation was $125,000, and $30,000 in additions were allocated to the employee's account. in the first year, the compensation limit-25% of compensation ($16,071.43)-is applicable; in the second year, the dollar limit is applicable. thus, the denominator is ($16,071.43 x 1.4) + (30,000 x 1.25). the numerator of the fraction is 0 + $30,000. the fraction, then, is as follows: 0 + 30.000 (16,071.43 x 1.4) + (30,000 x 1.25) this reduces to 30,000/60,000), or 0.5. if an employee subject to the dollar limits in each year received the maximum additions under the (c) limitation for each year of service, the defined contribution fraction, like the defined benefit fraction for an employee who has accrued the maximum benefit permitted under the (b) limitation, would be 1/1.25, or 0.8. the result of the above calculations is that an employee can completely utilize either the (b) or (c) limit and still have a benefit under plans subject to the other limit. there is one important exception to the above rules: certain plans must substitute a 1 for the 1.25 factor applied to the dollar limit.2the effect of this is that participants subject to the dollar limit may use only a single maximum limit. thus, for example, an employee whose defined benefit equaled the dollar limit could not receive any contributions under a defined contribution plan. the exception applies to two types of "top-heavy plans." a top-heavy plan is essentially a plan in which more than 60% of the total benefits are for key employees. 23 the types of top-heavy plans covered by the exception are plans in which more than 90% of total benefits are for key employees and other top-heavy plans that do not satisfy certain optional minimum benefit requirements.24 22. irc § 416(h). 23. irc § 416(g)(1). 24. irc § 416(h)(2). employers must contribute at least 3% of compensation (or if less, the percentage of compensation contributed for the key employee for whom the percentage is greatest) annually for each non-key employee. irc § 416(h)(2)(a). top-heavy defined benefit plans must provide a retirement annuity equal to at least 2% times years of service (up to 10) times average compensation. irc § 416(c). section 415(e can remain at 1.25, however, only if 4% of compensation is contributed to a defined contribution plan, or 19941 florida tax review the time value of money affects the amount an employer contributes to a defined benefit plan: the longer the period between contribution and benefit distribution, the smaller the contribution to the plan because the contribution will have more time to produce investment return. to illustrate, assume an employer will make a contribution to a pension plan sufficient to pay the employee a $1,000 lump sum benefit when the employee attains age sixty-five. assuming an annual 8% rate of return on investment, the employer would have to contribute a single payment of $46 to fund the benefit for a twenty-five-year-old employee or $681 to fund the benefit for a sixty-year-old employee.25 this simply reflects the fact that the contribution for the twentyfive-year-old will produce investment return for forty years, while the contribution for the sixty-year-old will produce a return for only five years. this has important consequences to small employers who wish to benefit a principal employee while sponsoring only one plan at a time.26 when the employee is young, the employer will sponsor a defined contribution plan, for the $30,000 maximum addition to such plan will exceed the maximum contribution that can be made to fund the maximum defined benefit for such employee. however, a switchover point will be reached, where the defined benefit contribution for the employee will exceed the $30,000 maximum defined contribution addition.2 7 depending on circuma benefit of 3% times years of service times average compensation is provided by a defined benefit plan. irc § 416(h)(2)(a). 25. the contributions in the text do not reflect a discount for preretirement mortality. such a discount would somewhat reduce each of the contributions. the percentage decrease of the contribution on behalf of the younger employee would be slightly greater because actuarialy a 25 year-old is expected to die at an earlier age (82.0) than a 60 year-old (84.2). see regs. § 1.72-9, tbl. v. 26. the costs of defined benefit plans, plus the § 415(e) limits, especially as applicable to certain top-heavy plans, constrain many small employers from adopting defined benefit plans. if the § 415(e) limits were repealed, small employer sponsorship of defined benefit plans almost certainly would increase. 27. see, e.g., stanley n. bergman & david l. reynolds, plan selection-pension and profit-sharing plans, 350 tax mgmt. (bna) 10 (indicating that larger annual contributions can be made to defined benefit plans than to defined contribution plans for employees near retirement age); robert e. madden, tax planning for highly compensated individuals 5.02[2] (1983) ("[ain employer who is contemplating the implementation of a qualified plan may favor a defined benefit pension plan over other options that are available if that employer has older employees it particularly wishes to benefit."); american bar association, senior lawyers division, the lawyers guide to retirement 140 (david a. bridewell ed., 1991) [hereinafter lawyers guide to retirement]. [vol. 2:2 simnplification and irc § 415 stances, this point will generally occur sometime between an employee's early forty's and early fifty's.' for example, assume a fifty-year-old employee, with a defined contribution fraction of 0.4. the defined benefit fraction for the employee is 0.6, which translates into a defined benefit limitation equal to 75% of the defined benefit dollar limitation.29 assume that the limit is $ 12 0 ,0 00o." thus, the plan could provide, and the employer could fund, a $90,000 defined benefit, unless the plan were subject to the more restrictive top-heavy limitations."1 the amount of the annual contribution required to fund this benefit will depend on the actuarial cost method and assumptions employed by the plan's actuary.32 the employer probably will contribute between $35,000 28. the literature does not indicate the age at which a contribution to a defined benefit will exceed the maximum contribution to a defined contribution plan, and indeed, the age will vary depending on a number of factors. see infra text accompanying notes 29-35. the immediately following textual example involves an employee who is age 50. in preparing this article, the author spoke with six pension attorneys, who suggested that the age at which defined benefit plans permit larger contributions than defined contribution plans occurs somewhere between 41 and 51. of course, the actual point at which contributions to a defined benefit plan, with respect to a particular participant may exceed contributions to a defined contribution plan, will depend on the assumptions the plan's actuary makes concerning interest, mortality, assumed retirement age, the history of previous additions to defined contribution plans, and the actuarial method used by the plan to assign benefit costs to each year in which the plan is being funded. see generally i gary i. boren. qualified deferred compensation plans ch. 8 (1993) (discussing the elements of various actuarial methods). 29. a defined benefit fraction with a numerator of .75 and a denominator of 1.25 is .6. 30. the $120,000 dollar limit was selected because indexation of the defined contribution begins when the (b) limit reaches s120,000. see supra note 14. 31. see supra text accompanying notes 23-24. in the example, if the plan were super top-heavy, the defined contribution fraction would have been .5 rather than .4 (i.e., .5/1.25=.4). and the defined benefit fraction also would have been .5. thus, the maximum defined benefit that could be funded would have been $60,000 if the plan had been super top-heavy. 32. see jerome mirza & assocs. v. united states, 882 f.2d 229 (7th cir. 1989). in jerome mirza & associates, the employer's contribution was based on an interest rate assumption of 5% and an actuarial method that allocated costs related to past service entirely to the year of plan adoption. the service successfully argued that the 5% interest rate assumption was unreasonable and that the costs attributable to past years should have been allocated to those years and then amortized over a ten-year period. the court adopted the service's 8% interest rate assumption. the plan itself had invested in government securities that yielded between 11.65% and 15.75%. the court reduced the taxpayer's original deduction of $625,925 to $115,953. id. at 230-31. however, more recently, the service was unable to persuade the tax court that a 5% interest rate or an assumed retirement age of 55 was unreasonable. citrus valley estates, inc. v. commissioner. 99 t.c. 379 (1992): vinson & elkins v. commissioner, 99 t.c. 9 (1992). aff'd. 7 f.3d 1235 (5th cir. 1993); wachtell. lipton, rosen & katz v. commissioner, 64 t.c. memo 1992-392 (cchi) 1992. 19941 florida tax review and $85,000, 33 depending on how aggressive it wishes to be (i.e., how much risk of dispute with the service it wishes to assume). 34 moreover, the amount of the permissible benefit for the employee will increase each year because the employee's defined contribution fraction will decline to reflect the fact that no further contributions are being made to the defined contribution plan. an employer whose sole motive was to maximize tax deferral, however, would sponsor defined contribution and defined benefit plans simultaneously rather than seriatim. simultaneous funding would permit full utilization of the defined contribution fraction and permit earlier funding of 33. the low-end figure assumes retirement at age 65, an interest rate of 8%, and a life expectancy of 85. funding at a level-dollar amount over 15 years would yield a contribution of $36,491.30. the high-end figure assumes a retirement age of 60, a 6% interest rate, and a life expectancy of 90. these assumptions would yield a first year contribution of $86,244.90. the latter assumptions are less conservative than the assumption challenged in jerome mirza & associates, or in the tax court cases cited supra note 32. it should be noted that the size of the contribution depends not only on the plan's actuarial assumptions, but also its actuarial method, which assigns portions of the cost of benefits to each year in which the benefits are funded. see boren, supra note 28, ch. 8. 34. the service has engaged in an audit of small defined benefit pension plans. the american society of pension actuaries has opposed this program vigorously. see, e.g., american society of pension actuaries, irs small plan actuarial audit program (1990); ellin rosenthal & herman ayayo, pbgc told to wait in line; small plan actuarial audit program feud continues, 47 tax notes 1157 (june 4, 1990); ellin rosenthal, irs v. actuaries: the feud continues over small plan audits, 47 tax notes 140 (apr. 9, 1990). the service apparently routinely challenged interest rate assumptions lower than 8% and age-65 minimum retirement ages. see rosenthal, supra, at 140. the positions that the service took in the audit program were rejected by the tax court in a trio of 1992 decisions. see supra note 32. a relatively recent disincentive to some small employers making aggressively large contributions to a defined benefit plan is the excise tax that § 4980 imposes on surplus assets reverting to the employer when an overfunded pension plan terminates. the excise tax is 50%, unless the employer establishes a "qualified replacement plan" or shares the plan surplus with the employees, in which case the tax is reduced to 20%. irc § 4980(d). assume a small business will come to a close when a principal employee reaches retirement age and that the business will then have an overfunded pension plan. when the plan terminates, the residual assets will be taxed at punitive rates under § 4980(d) unless they are partially used to provide additional benefits to employees. the principal employee, however, will not be able to share in the additional benefits if already at the § 415 limits. thus, the employer will either have to pay the tax or give 20% of the surplus to employees other than the principal. this scenario will discourage some small employers from funding their plans aggressively. there may, however, be ways to plan around this problem to some extent; for example, a plan might provide for a lump sum distribution option, with a relatively low interest rate assumption. see irc § 415(b)(2)(e)(i). 35. in effect, a zero is added to the numerator in each year, to reflect a zero contribution, while 1.25 times the (c) dollar limit is added to the numerator. forfeitures added to the employee's account, however, are also treated as additions. irc § 415(c)(2). thus, any forfeitures allocated to an employee's account would increase the numerator. [vol 2:2 simplification and irc § 415 a portion of the same defined benefit that can be funded at a later stage.36 earlier plan funding is less costly than later plan funding because earlier funding enjoys the benefits of the tax-deferred plan funding vehicle for a longer period of time. however, there are reasons why small employers might prefer not sponsoring defined benefit plans while the favored employee is young. the most evident reason is that defined benefit plans are relatively expensive to administer and may not be justified until the sponsor can make substantial contributions on behalf of the favored employee.3 ' additionally, given the relative illiquidity of pension wealth prior to the time an employee retires, not all younger employees wish to maximize contributions to qualified plans." thus, many small employers will sponsor only a defined contribution plan when the favored principal is young and later will switch to only a defined benefit plan. this strategy has an additional benefit to small employers that wish to minimize the cost of providing benefits for employees other than the principal-provided such other employees are younger than the principal during the defined benefit sponsorship. there are three reasons why defined benefit plans can minimize costs attributable to young employees. the first reason is the time value of money's effect on contributions. section 401(a)(4) of the code, which proscribes discrimination in favor of highly compensated employees, generally permits an employer to fund a 36. section 404j), however, does not permit a deduction for a contribution to a defined benefit plan to the extent that the benefit being funded exceeds the benefit permissible under § 415. irc § 4040). this prevents an employer from anticipating inflation-adjusted increases in the § 415 limits for purposes of plan funding. thus, maintaining two plans would permit early funding of only a portion of the complete benefit that ultimately can be funded under a defined benefit plan. 37. defined benefit plans must utilize actuarial services, which can add costs. in addition, many defined benefit plans must pay premiums to pension benefit guarantee corporation ("pbgc") for each participant. there are important exceptions to pbgc coverage. including an exception for professional service employer plans which never have had more than 25 active participants. erisa § 4021(b)(13) (codified at 29 u.s.c. § 1321(b)(13)). finally, because defined benefit plans are considerably more complex than defined contribution plans, associated legal and accounting costs also may be higher. see, e.g., madden. supra note 27, 5.02[2]. 38. section 72(t) imposes a 10% excise tax on most distributions from a qualified plan to a participant younger than age 59.5. irc § 72(t). in addition, the service has long taken the position that a pension plan (as opposed to a profit-sharing plan) may not make distributions to an employee prior to the employee's separation from service, death, or disability. rev. rul. 56-693, 1956-2 c.b. 282. to some extent, this can be mitigated by an employee's access to plan loans, but plan loans are subject to many restrictions and are not available to owner-employees who sponsor keogh plans or to shareholder-employees in subchapter s plans. see generally boren, supra note 28, § 11:18. in addition, loan programs do not work well in defined benefit plans because plan assets are not allocated to individual participants. 19941 florida tax review defined retirement benefit for each employee equal to a uniform percentage of the employee's compensation. 39 the cost of funding this benefit is lower for younger employees than for older employees because the period between contribution and benefit payment is longer. what this means is that the employer will contribute a smaller percentage of pay to fund the benefits of younger employees than for older employees.4" in a garden variety defined contribution plan, however, this will not be the case, for the employer generally will contribute the same percentage of each employee's compensation to the plan. the second reason defined benefit plans are more attractive than defined contribution plans when the goal is to favor older employees is the ability to combine a flat benefit formula with the fractional rule of accrual.42 the fractional rule permits a plan to define a benefit for all employees and have the benefit accrue over the remaining period of an employee's service with the employer. thus, for example, a plan might promise a benefit of 30% of compensation for all employees, to accrue over each employee's period of projected future service. a fifty-five-year-old doctor would (but for antidiscrimination regulations noted below) thus accrue 1/10 of the benefit in a plan with normal retirement age of sixty-five, or a benefit accrual of 3% of compensation, each year, while the twenty-five-year-old nurse would accrue 1/40 of the benefit, or .75% of compensation, each year. when the doctor 39. a defined benefit plan can be integrated with social security, such that the benefit for lower-compensated employees will be a smaller percentage of their compensation than for higher-compensated employees. irc § 401(1). see generally nancy j. altman, rethinking retirement income policies: nondiscrimination, integration, and the quest for worker security, 42 tax l. rev. 433 (1987). 40. this does not, however, mean that the ultimate benefit being paid to the younger employee will be a smaller percentage of pay, but only that the cost to the employer of funding the benefit is less. see supra note 25 and accompanying text for an illustration. assume further that each employee in the example eams $10,000; thus, each of them accrues a benefit equal to 10% of pay. however, the employer would contribute .46% of the younger employee's compensation, compared to 6.81% of the older employee's compensation. see generally lawyers guide to retirement, supra note 27, at 140 (noting that "[blecause the contribution formula considers the number of years remaining to retirement for all participants, a defined benefit plan works best when your employees are somewhat younger than you"). 41. the defined contribution plan, like a defined benefit plan, can be integrated with social security, resulting in larger contributions for employees whose compensation exceeds the plan's integration level. irc § 401(l)(2)(a); see supra note 39. also, an employer, at the cost of added complexity, can sponsor a defined contribution plan that permits contributions that are larger as a percentage of pay for older employees. see regs. § 1.401(a)(4)-8(b)(3) (describing safe harbor nondiscrimination rules for target benefit plans); regs. § 1.401(a)(4)8(b)(1)-(2) (providing rules to cross-test defined contribution plans on the basis of benefits). however, contributions to such plans may run up against the defined contribution limitation of $30,000. irc § 415(c). 42. irc § 411(b)(1)(c). [vol. 2:2 siniplification and irc § 415 retires in ten years, the doctor will have accrued a benefit equal to 30% of compensation while the nurse during this same period of time will have accrued a benefit equal to 71/2% of compensation.13 relatively recent regulations under section 401(a)(4) put limits on this technique but do not eliminate it. 44 the third reason is that a defined benefit can be based in part on past-service credit.45 in many cases, the favored principal will have substantially more past service than other employees. thus, the benefit being funded for the principal can be larger (as a percentage of compensation) than the benefits for employees without equivalent past service credit. newly finalized regulations under section 401(a)(4) limit but do not eliminate an employer's ability to exploit the grant of past-service credits to favor a principal.6 this conflicts with a purpose of the tax subsidy for qualified plans, which is to encourage employers to establish plans that provide benefits to rank-and-file employees that are proportionate (as a percentage of compensation) to the benefits provided to highly compensated employees. 7 43. it is probable that the plan will terminate when the doctor retires. thus, the nurse will not have the opportunity to increase her benefit accruals to 30% of pay. 44. regs. § 1.401(a)(4)-3(b)(2)(iv), (4). the regulations create a safe harbor in which a plan's fractional rule formula will be considered nondiscriminatory, and thus nonviolative of § 401(a)(4), if the denominator of the fraction is at least 25 for each employee. regs. § 1.401(a)(4)-3(b)(4). 45. for example, an employer might adopt a plan on january 1. 1994, providing a benefit equal to 1% of final pay multiplied by years of service. the years of service might include all years that an employee worked for the employer, even those before 1994. section 415(b)(5), however, does place some limit on this, since the defined benefit dollar is phased in over 10 years of plan participation. irc § 415(b)(5). 46. the regulations create a safe harbor generally permitting a plan to award five years of past-service credit. prop. regs. § 1.401(a)(4)-5(a)(3). 47. the subsidy has been justified as an inducement to employers to set up plans by providing substantial tax benefits to upper-income employees who participate. the antidiscrimination rules of § 40 1(a)(4) and coverage rules of § 410 then require that benefits be provided to a substantial percentage of the non-highly compensated portion of the employer's workforce, and § 401(a)(4) requires that the benefits provided to rank-and-file employees be comparable to those provided to highly compensated employees. see generally michael j. graetz, the troubled marriage of retirement security and tax policies, 135 u. pa. l. rev. 851 (1987); bruce wolk, discrimination rules for qualified retirement plans: good intentions confront economic reality. 70 va. l. rev. 419 (1984). both professors graetz and wolk question the effectiveness of the qualified plan rules in directing benefits to rank-and-file employees. taking a more extreme view, professor joseph bankman argues that the nondiscrimination mechanism may harm the welfare of rank-and-file employees. joseph bankman, tax policy and retirement income: are pension plan anti-discrimination provisions desirable?, 55 u. chi. l. rev. 790, 805-14 (1988). 19941 florida tax review iii. the purpose of section 415 and the arguments for its elimination a. purpose of section 415 prior to the enactment of erisa, the code placed no direct limitations on contributions or benefits for individual employees. 48 it was thus possible for an employer to make exceedingly large contributions or to fund exceedingly large benefits for an employee. congress, in enacting erisa, believed that the law's failure to place limits on contributions and benefits represented a shortcoming.49 senator long expressed this view in comments before the senate: [section 415] makes the tax laws regarding pension plans fairer by limiting the amount of the contributions or benefits that can be provided to any individual under such a plan. the fact that present law does not provide such specific limitations has made it possible for extremely large contributions and benefits to be made under qualified plans for some highly paid individuals. while there is, of course, no objection to large retirement benefits in themselves, it is not appropriate to finance extremely large benefits in part at public expense through the use of special tax treatment.50 the purpose of section 415 can be understood as limiting contributions and benefits under qualified plans to levels that are proportionate "to the reasonable needs of individuals for a dignified level of retirement income."' benefits and contributions in excess of these levels are not eligible for the tax deferral available under a qualified plan. one can argue about how well section 415 actually effects this purpose. first, the limits under section 415 are generous, perhaps to a fault. take the case of a twenty-year-old who receives the maximum contributions to a defined contribution plan for forty-five years. if we assume no inflation 48. see tax-qualified retirement plans after tefra, supra note 3, § 37.02. the pre-erisa internal revenue code, however, did include rules prohibiting discrimination in favor of shareholders, officers, and other highly compensated employees. see irc § 401 (a)(4) (1973). in addition, § 162(a) requires that compensation be reasonable. irc § 162(a)(1). this placed an indirect limit on deferred compensation. 49. see tax-qualified retirement plans after tefra, supra note 3, § 37.01. 50. 120 cong. rec. s. 29,946 (1974) (statement of sen. long). 51. h.r. rep. no. 807, 93d cong., 2d sess. 112 (1974), reprinted in 1974 u.s.c.c.a.n. 4670, 4777. [vol. 2:2 simplification and irc § 415 and that the plan realizes an annual rate of return of 4% the employee would accumulate a defined contribution account balance of approximately $3,630,000 by the time the employee reaches age sixty-five. 2 in addition, the employer could fund 25% of the maximum defined benefit permitted under section 415(b).13 it is difficult to regard this level of benefit as no more than reasonable. a second problem with the limits is that they apply on a per-employer basis. thus, an employee who works for more than one employer theoretically can accumulate greater benefits than those just described.-4 notwithstanding these criticisms, section 415 does at least put an outer limit on benefits and contributions. moreover, there probably are not very many young people who are credited with $30,000 in annual additions to defined contribution plans or employees whose changes of employer significantly increase their total benefits because of section 415's separate applicability to each employer." thus, even though section 415 does not work perfectly, it does serve the purpose of placing at least some limits on the amount of tax deferral available to participants in qualified plans. in so doing, section 415 controls the tax expenditures for qualified plans. b. the argument for eliminating section 415 those who argue that we should repeal section 415 generally do not take issue with its basic policy goals.5 6 rather, their argument is that section 415's contribution to these goals does not justify the costs imposed by its intractable complexity.' in the next part of this article, however, it will be shown that section 415 is less impervious to simplification efforts than generally has been acknowledged. the argument that section 415 should be 52. as noted in the text, this benefit figure assumes no inflation and a true rate of return of 4%. assuming an annual inflation rate of 4% (which would increase the (c) limits) and a rate of return on investments of 8%, the employee will accumulate an account balance in excess of $19,500,000 by the time the employee attains age 65. by way of contrast, the present value of a $120,000 retirement annuity at age 65 is approximately $1.6 million. assuming a 4% interest rate and a 20-year-life expectancy. 53. sponsors of certain top-heavy plans, however, would not be able to provide the defined benefit. see supra notes 22-24 and accompanying text. 54. see bruce wolk, the new excise and estate taxes on excess retirement plan distributions and accumulations, 39 u. fla. l. rev. 987, 989 (1987). 55. moreover, an employee who works for two related employers within the meaning of §§ 414(b), (c), (m), (n), or (o), is subject to a single, aggregate § 415 limit. see irc § 415(g). 56. none of the sources cited supra note 5 argue against the basic policy goal of placing limits on the use of tax deferral provided by qualified plans. 57. see sources cited supra note 5. 1994] florida tax review repealed is weakened considerably if it is correct that the section can be simplified in a manner that substantially reduces its administrative costs. this still leaves the question of whether section 415 has anything to add to other sections of the code that also serve the purpose of limiting tax deferral. if section 415 serves little or no purpose, there is no reason to retain even a simplified version of it. proponents of eliminating section 415 argue that the policy goals effected by section 415 can be served adequately by the section 4980a excise tax on excess distributions, which is less complex than the section 415 rules. 8 section 4980a imposes a 15% excise tax on "excess distributions" from qualified plans.59 an excess distribution is the amount of distributions from all qualified plans, individual retirement accounts, and section 403(b) annuities in a given year to the extent that such distributions exceed a threshold amount.6° the threshold amount is currently $150,000, except for taxpayers who elected a grandfather provision.6' example: a is an individual who in a single year receives a $90,000 annual annuity payment from the defined benefit plan of employer x and a $40,000 payment from a defined contribution plan of the same employer. in addition, a receives another $50,000 annuity payment from a defined benefit plan of employer y and also withdraws $30,000 from an individual retirement account. in all, a receives $210,000 in distributions in plans whose distributions are subject to section 4980a in the year in question. the distributions exceed the threshold amount by $60,000. thus, a would pay $9,000 in tax (15% x $60,000) under section 4980a.62 58. see generally sources cited supra note 5. note that even those who argue that § 415 should be repealed do not seem to regard repeal as likely. dianne bennett, who makes the case against § 415 articulately, notes that consideration of her argument might lead to simplification of § 415 even if it does not lead to repeal. bennett, supra note 5, at 40. 59. irc § 4980a(a). for a discussion of the operation of the excise tax and opportunities to plan around it, see dianne bennett et al., taxation of distributions from qualified plans ch. 13 (1991). 60. irc § 4980a(c)(1), (e). 61. irc § 4980a(c)(1), (f). the grandfather provisions are found in § 4980a(f). dianne bennett proposed deleting the grandfather provisions from the code. see bennett, supra note 5, at 39. 62. section 4980a includes special rules reducing the tax in a year in which the employee receives a lump sum distribution. irc § 4980a(c)(4). the provision is elective and may be made only once. irc §§ 4980a(c)(4), 402(d)(4)(b). [vo61 2:2 simplification and irc § 415 an analogous tax provision increases the estate tax of decedents who die with excessive accumulations in plans whose distributions are subject to section 4980a. 63 in a nutshell, then, section 4980a is an additional tax on unreasonably large benefit distributions from qualified plans.' in theory, the section recoups a portion of the tax deferral attributable to the excessive portion of the benefits. the effect of the section should be limiting benefit size, which is, of course, also the effect of section 415. but where section 415 operates directly by limiting what goes into a plan,6 5 section 4980a operates indirectly by imposing a tax on what comes out of the plan. section 415 works as a prophylactic, section 4980a as a corrective. section 4980a, however, would not be an adequate substitute for section 415.66 the primary problem with section 4980a is that it is a flat tax that does not take into account many of the variables that contribute to the extent of the tax deferral an employee will realize from participation in a qualified plan. 67 a 15% tax, for example, will do more than recover the tax savings embedded in assets that have been in the plan for a short time but recover only a small percentage of the tax savings reflected in assets that have been accumulating over an extended time period. example: assume a taxpayer with a 39.6% marginal tax rate and assume that both the taxpayer and the qualified plan will earn a 6%, pre-tax, annual rate of return on investments. the taxpayer is paid $1,000 in taxable compensation in 1991, yielding $604 after tax. the $604 will grow to $1,757 with a pre-tax 6% rate of return after thirty years. assume now that instead of being paid $1,000 in taxable compensation, the taxpayer's employer contributed $1,000 to a qualified plan, which earns a 6% rate of return. the $1,000 will grow to $5,743 in thirty years. if this amount is then distributed to the taxpayer in a lump sum, the taxpayer will retain $2,608 after paying a 39.6% income tax and a 15% section 4980a tax on the distribution. this is approximately 148% of the amount that the taxpayer could have accumulated outside the plan. 63. irc § 4980a(d). 64. tax reform, supra note 4, at 350-53. 65. the (c) limit directly limits what goes into a defined contribution plan; the (b) limit, by providing a maximum benefit, indirectly limits the contributions that are made to a defined benefit plan. 66. see wolk, supra note 54, for an excellent critique of the § 4980a excise tax. 67. id. at 1022-24. 1994] florida tax review the differential between the value of after-tax savings and the qualified plan increases as tax or interest rates increase.68 assuming the applicability of the section 4980a tax, the point at which a contribution to a qualified plan becomes more valuable than immediately taxable compensation is approximately twelve years, given the assumptions about interest and tax rates in the example.69 in other words, given these assumptions and all other things being equal, a taxpayer whose retirement distributions will be subject to the section 4980a excise tax should choose deferred compensation if the deferral period is greater than twelve years.7" thus, section 4980a is not a very effective tax to limit accumulations in qualified plans during much of a taxpayer's career. despite the existence of section 4980a, eliminating section 415 would give some taxpayers a reasonably free hand to decide how much compensation to defer on a tax-advantaged basis." one could argue that section 4980a could be restructured to target more precisely the embedded tax advantage in a qualified plan distribution, or that the section 4980a tax rate could be increased.72 a more precise section 4980a, however, would make section 415 appear a model of simplicity. an excise tax that perfectly compensates for previous tax deferral attributable to "excess distributions" would have to be based on the difference between (1) the plan's pre-tax return on all contributions multiplied by the taxpayer's marginal tax rate at the time of distribution, and (2) a theoretical after-tax rate of return that the taxpayer would have realized had she paid immediate tax on each contribution and invested it in a taxable investment format. such calculations would require that the taxpayer identify the amount 68. id. at 1020-21. the benefit of the qualified plan is enhanced in states with an income tax. 69. the figures were derived on a spreadsheet, which compared the after-tax accumulation of an after-tax payment to the employee in the hypothetical with the after-tax distribution of a contribution to a plan. the figures assume that the entire plan distribution was subject to a 39.6% marginal tax rate, plus the 15% excise tax. an earlier version of this article assumed a 31% marginal tax rate and an 8% return. these assumptions yielded an approximately 10-year break-even point. 70. different assumptions would either lengthen or shorten the period. in addition, there are planning opportunities to reduce the effect of the excise tax. for example, § 4980a(c)(4) provides for special treatment of a lump sum distribution qualifying under § 402(d)(4)(b) and § 4980a(d)(5) for an effective marital deduction for an electing spouse who elects to treat post-mortem payments as a retirement distribution to the spouse. irc § 4980a(c)(4), (d)(5). see bennett, supra note 59, 13.4, .6[7][c][ii]; see also wolk, supra note 54, at 996-97, 1006-10. professor wolk also suggests planning possibilities in community property states. id. at 999-1002. 71. it is possible that some employers ignore the § 415 limits because of their complexity. part of the issue, then, might be which is preferable: § 4980a with compliance or § 415 without? 72. see bennett, supra note 5, at 38-39; irish memo, supra note 5, at 7-8. [vol. 2:2 simplification and irc § 415 contributed to the plan in each year, the plan's rate of return for each year, the taxpayer's marginal tax rate for each year, and the taxpayer's theoretical rate of return on nonqualified plan investments for each year.'" no one could seriously suggest that such an approach is workable. the recordkeeping requirements would be staggering and determining alternate rates of return virtually impossible without resort to across-the-board, rough-justice assumptions. what's worse still, the complexity would be visited at the individual taxpayer level. at least with section 415, the complexity occurs at the plan level, where it is likely to be less bedeviling.74 increasing the section 4980a tax also is an unappealing idea. if the increase is high enough to discourage excessive early accumulations of assets, it will impose a substantial tax penalty on individuals whose pension wealth is attributable either to strong investment performance or late plan contributions." moreover, assuming annual returns on investment of 6% and an employee with a constant 39.6% marginal tax rate, the excise tax would have to be approximately 27.2% to prevent tax deferral advantages for benefits resulting from level contributions over a forty-year career.76 finally, changes in income tax rates would virtually mandate complicated adjustments of the excise tax.77 73. see wolk, supra note 54, at 1020-21. 74. interestingly, the department of the treasury, when it proposed the excise tax as a replacement for § 415(e), argued that complexity at the participant level was preferable to complexity at the plan level because it did not impose an administrative burden on the plan. tax reform, supra note 4, at 352-53. 75. see gridlock, supra note 1, at 33 (noting that the tax "acts as a penalty on investment success"); bennett, supra note 5, at 39 (noting that "the excise tax penalizes good investment experience rather than simply addressing overaccumulation from contributions," but also that even "good investment experience [has] the advantage of tax-free build-up in a plan"). professor wolk, however, notes that the tax acts particularly unfairly in cases of unrealized appreciation. wolk, supra note 54, at 1022. in such cases, the qualified plan offers no tax benefit since unrealized gain is not taxed outside the plan until disposition. id. subjecting what would be unrealized appreciation outside the plan to an excise tax when the appreciated assets are distributed is difficult to defend. 76. the 27.2% tax rate reflects a further assumption: that plan benefits were paid out in a lump sum at retirement age. for benefits paid out as annuities, the tax would have to be still higher to reflect the fact that tax deferral continues while assets are held by the plan. in an earlier draft of this article, which assumed an 8% rate of return and a 31% marginal income tax rate, the excise tax would have needed to increase to 33.3%. if the marginal tax rate were 31% and the rate of return were 6%, the excise tax would need to be 26%. 77. this is so because a change in tax rates would change the size of the tax subsidy, sometimes reducing it, sometimes increasing it. moreover, changes in tax rates could affect people differently. assume a taxpayer accumulated pension wealth while her marginal tax rate was 40%. when the taxpayer retires, congress increases the tax rates such that the taxpayer's marginal tax rate is now 50%. one could argue that the excise tax should be 19941 florida tax review even if section 4980a were substantially increased or amended to precisely, or at least more precisely, target the tax deferral of "excess distributions," elimination of section 415 might still be a source of potential havoc for revenue collection over a transition period, because the revenue loss would occur annually as contributions were made to qualified plans while revenue gains would be delayed until benefits are distributed. (this assumes that current distributions subject to section 4980a are relatively small compared to the contributions that will ultimately result in excess distributions in the future.) moreover, it is possible that the day of revenue payback will never arrive for some taxpayers. change in the tax law is as much a certainty as death and taxes themselves. congress may in the future respond to pressures about the complexity and unfairness of the section 4980a tax by repealing section 4980a. of course, it is also plausible that congress may respond to pressures to raise more revenue by increasing the tax or lowering the taxability threshold. thus, an argument for repeal of section 415 based on the similar policy goals of section 4980a is not persuasive.7" despite this, a repeal of section 415 probably would not result in employees of large employers receiving significantly larger benefits from qualified plans than they receive today. the rules prohibiting discrimination against non-highly compensated employees would be a substantial economic disincentive to providing excessively large benefits for the highly paid because similar levels of benefits would have to be provided for all employees.79 large employers lowered to reflect the fact that the distributions will be taxed at a 50% rate. however, an active employee whose marginal rate jumped from 40% to 50% would now realize greater deferral from qualified plan savings. one could thus also argue that the excise tax should be increased. increasing the rate for some taxpayers, while reducing it for others, would breed complexity. 78. without § 415, the only direct limit on contributions to a defined contribution plan would be the § 404 rule limiting contributions to a profit sharing or stock bonus plan to 15% of compensation and contributions to two or more plans to the greater of 25% of compensation or the minimum contribution to a defined benefit plan required under § 412. see infra note 81 for further discussion of the § 404 limits on deductions. whether § 4980a should be retained as an adjunct to § 415 is a difficult question. professor wolk views the tax as fundamentally flawed. wolk, supra note 54, at 1020-26. the appwp has argued that the tax should be repealed. gridlock, supra note 1, at 32-34. but see bennett, supra note 5 (expressing the view that § 4980a does not present difficult issues). given the fact that § 415 permits wealthy taxpayers to accumulate rather large tax-favored pools of money, one could argue that § 4980a, despite its problems, should be left in the code. 79. see supra note 39 and accompanying text. [vol. 2:2 simplification and irc § 415 normally have too many non-highly compensated employees to make such strategies appealing.'0 repeal of section 415 would, however, provide tax planning opportunities for small businesses seeking to benefit principal employees. a vivid illustration of this is provided by a consideration of a successful self-employed professional with no employees. assume the professional earns $500,000 annually, which will be allocated between current compensation and qualified deferred compensation. under current law, the professional could contribute $30,000 each year to a defined contribution plan. were section 415 repealed, the taxpayer could contribute perhaps $100,000 or more to the plan in 1994, and perhaps could contribute as much compensation as the taxpayer desired, depending on how limitations on deductions are interpreted.8 1 moreover, section 404 places no direct limit on the size of a defined benefit that can be funded with deductible contributions; without section 415, the only limit on such contributions would be the general restriction under section 162 limiting compensation to reasonable amounts. it might be argued that allowing a class of affluent taxpayers to defer large amounts of income is a small price to pay for banishing section 415 from the code. but the revenue costs of effectively unfettering many professionals and small business owners from the limits of section 415 are likely to be high, particularly if income tax rates continue to rise. moreover, to allow even a small group of taxpayers to decide how much tax they should 80. employers currently may provide for benefits in excess of § 415 limitations through nonqualified "excess benefit" plans. the floor debates on erisa indicated an awareness of the difficulty that large employers would have in providing extraordinary benefits through qualified plans. see subcomm. on labor of the senate comm. on labor and pub. welfare. 94th cong.. 2d sess., legislative history of the employee retirement income security act of 1974 1740 (comm. print 1976) (statement of sen. long noting that discrimination rules and threat of shareholder litigation would prevent loading up benefits for executives from qualified pension plans). 81. the sole constraint on this would be the limitations on deductions under § 404. while deductions are limited to 15% of compensation for contributions to a stock bonus or profit-sharing plan, and to the greater of 25% of compensation or the minimum contribution to a defined benefit plan under § 412 if the employer maintains a defined contribution and defined benefit plan, § 44(a)(7), there is no limit on deductions for an employer who maintains only a money-purchase pension plan. of course, one could argue that were § 415 repealed, the 25% limitation should apply (or be legislatively amended to apply) to employers who maintain only money-purchase plans. in addition, § 401(a)(17) would limit the compensation to $150,000 in 1994. if the 25% limit on deductions applied, the taxpayer's contribution would be limited to $37,500 which would be 25% of the s 150.000 of § 401(a)(17) compensation. however, the argument that the 25% limit should apply is difficult to make. for two plans are not involved. moreover, § 404(j), which reduces deductions by the amount that annual additions exceed the § 415 limits, suggests that the § 404 25% limit need not apply to single-plan situations. thus, textual statements seem correct under the current version of § 404. 1994] florida tax review pay in a particular year sends a symbolically appalling message to other taxpayers, which may be unwise for a system dependent on voluntary compliance. there is another potential disadvantage to repeal of section 415: a probable increase in the use of defined benefit plans, which will make it more likely that benefits for non-highly compensated employees will be reduced. we have already seen that defined benefit plans favor older employees, and that as a result some small employers wishing to benefit a particular older employee will switch from a defined contribution plan to a defined benefit plan. this not only maximizes contributions under section 415, but also minimizes the cost of providing benefits for their younger employees. notwithstanding these facts, some such employers do not swap plan types because the size of the permissible benefit for the favored employee under section 415 may not be great enough to warrant the costs and bother of administering a defined benefit plan. such costs, however, might be seen as trivial if section 415 ceased to limit benefits under defined benefit plans. employers currently shunning such plans because of a cost/benefit analysis might well begin adopting such plans. as just noted, adoption of such plans sometimes will result in disproportionately low benefits for non-highly compensated employees, an outcome that is at odds with one of the purposes of the qualified-plan tax subsidy: providing approximately proportional benefits (as a percentage of compensation) for all participants. c. consideration of the arguments for eliminating section 415(e) most of the complexity of section 415 is attributable to section 415(e), which provides the limitation for combinations of defined benefit and defined contribution plans. a case can thus be made that section 415 should be retained but that subsection (e) should be repealed.82 repeal of section 415(e), however, might substantially reduce revenues. an employer would be free both to fund a maximum defined benefit and to make maximum contributions to a defined contribution plan. in all, this would permit some employees to accumulate by retirement age a defined benefit and defined contribution account with an aggregate value of approximately five million dollars, given current tax rates and relatively low interest assumptions.83 the value could be still higher depending on the 82. the department of the treasury initiated the idea of substituting an excise tax on distributions for § 415(e). see tax reform, supra note 4, at 352-53. 83. this assumes a 4% investment return and no inflation (after the dollar limit is adjusted to $120,000). the accumulation in the defined contribution plan would be approximately $3,600,000, and the value of a $120,000 annuity would be approximately $1,600,000, assuming a life expectancy of 20 years at retirement. see supra note 52 and accompanying [ vol 2:2 simplification and irc § 415 investment return in the defined contribution plan and on the actuarial assumptions used to value the defined benefit. a substantial portion of the benefit's value would reflect the value of the tax deferral extended to qualified plans.84 one possible means of reducing the revenue loss that would result from repealing section 415(e) would be a lowering of the (b) and (c) limits for employees of employers who maintain both types of plans. however, this approach, if it were to work, would reintroduce the very complexity it seeks to eliminate, for the lowered limits would have to apply not only to employers who simultaneously sponsor defined benefit and defined contribution plans, but also to employers who sponsor only one type of plan for a number of years and then either switch to, or add, the other type of plan in later years. rules to apply the reduced limits for employers who adopt plans seriatim would look very much like the current section 415(e) limitation. another approach to reducing the revenue loss would be to lower the (b) and (c) limits for all plans, regardless of whether the employer sponsors more than one type of plan. there are serious policy problems with this approach. the reduction in the (b) and (c) limits might have to be substantial in order to control the tax benefits of sponsoring both plan types. but if the reduction were substantial, it would reduce the size of benefits that an employer who sponsored only one type of plan could provide for its employees. employers who wished to provide reasonably high levels of benefits thus would be forced to sponsor both types of plans, saddling some employers who would prefer sponsoring only a defined contribution plan with the added expense and complexity of defined benefit plan sponsorship."s there is a third possible approach for recovering the revenue loss, which merits consideration: reduce the defined contribution limits for younger employees. this might be done with respect only to the dollar limits, or with respect to both the dollar and compensation limits. for example, the dollar limit might be cut in half for employees under the age of thirty, and then gradually rise until the limit reaches its maximum level when an employee text. the amount of the benefit would be considerably higher if we assumed even moderate rates of inflation. however, as banks in advertising individual retirement accounts have learned, stating the benefit in terms of future nominal dollars tends to inflate the value of the tax deferral. the repeal would be valuable especially to participants in those top-heavy plans whose denominator for the dollar limit is i rather than 1.25. see supra text accompanying notes 22-24. 84. the number of employers who might adopt defined benefit plans because of the repeal of § 415(e) is of course a matter of conjecture. the complexity and cost of defined benefit plans would continue to deter at least some employers from sponsoring such plans. 85. under current law, employers who want to maximize benefits must sponsor both types of plans, but high levels of benefits can be provided through either plan format alone. 19941 florida tax review reaches age fifty-five. such an approach might constructively contribute to tax and retirement policy. as already noted, if an employer annually contributes $30,000 to an employee's account in a defined contribution plan beginning at age twenty-one, the total accumulation will be approximately $3,600,000 at age sixty-five, assuming an annual rate of return of 4%. this is an unusually large accumulation, worth approximately twice the present value of the maximum defined benefit at age sixty-five. a large portion of the accumulation is attributable to the tax deferral associated with the earliest contributions. by reducing the early contributions and the concomitant taxdeferred investment growth, the value of career-long participation in the defined contribution plan, would be brought more in line with the value of a maximum defined benefit. arguably this is a desirable result in a world with or without section 415(e). under this approach, the cost of repealing section 415(e) would be born by affluent employees who participate in defined contribution plans while they are young. there are some reasonable objections one might make to this approach. first, the approach goes beyond simplification: it creates a class of people that will pay for repeal of section 415(e) that is broader than the class that would benefit from the repeal.8 6 second, it is by no means clear that the tax savings under this approach would equal the tax costs of repealing section 415(e). third, some employers may stop sponsorship of defined contribution plans if the benefit they can provide to favored young employees is substantially reduced. 7 section 415(e)'s repeal would create problems in addition to revenue loss. a repeal of section 415(e) might encourage more employers to adopt defined benefit plans when the employees it wishes to favor have reached mid-to-late middle age, resulting in diminished contributions on behalf of younger non-highly paid employees. moreover, as we have seen, congress has substantially tightened the section 415(e) limits for certain top-heavy 86. while this is true, note that under current law, a 30-year-old employee who receives an annual $30,000 contribution to a defined contribution plan and obtains a 4% rate of return, will accumulate a defined contribution account in excess of $3 million dollars by age 65. this large benefit also may be supplemented by a benefit from a defined benefit plan. cutting the limits along the lines hypothesized still would produce a very large benefit. 87. this certainly would be true to some extent, but a considerable amount of conjecture would be required to determine to what extent plan sponsorship actually would be affected. many small employers-who are the ones most likely to stop plan sponsorship-have already substituted § 401(k) plans for employer-funded defined contribution plans, despite the maximum employee contributions permissible under such plans. [vol 2:2 simplification and irc § 415 plans.8 repeal of section 415(e) would also repeal the stricter limits on the benefits for key employees in such plans." iv. approaches to simplification of section 415(e) the case for repeal of section 415 loses appeal if the section can be simplifiedwe have already seen that much of the complexity derives from subsection (e). in this part, i will suggest two approaches toward simplification of subsection (e). the approaches stand alone, although they also could be combined. 90 a. lengthening the dollar linit phase-hi under section 415(b)(5), with annual allocation of a section 415(e) percentage the major cause of complexity in section 415(e) is that the (c) limits on additions to defined contribution plans are annual, while the (b) limits on a defined benefit are aimed at limiting a benefit accrued over a participant's career with an employer. section 415(e) attempts to cope with this dissimilarity of limits by forcing the defined contribution fraction into a career mold, reflecting defined contribution utilization for all of an employee's years of service with the employer. it is this fraction that is at the root of the complexity in section 415(e), for it is this fraction that requires a backward look at all previous additions to a participant's account in light of both the dollar and compensation limits; results in annually changing fractions; and results in different fractions for each employee. because there does not appear to be any simple means of equating the (c) limit to a career benefit, simplification of the defined contribution fraction, and thus subsection 415(e), has not seemed possible. a change in focus, however, yields a possibility for simplification. instead of attempting to force the defined contribution fraction to mimic a career benefit, it would be possible to do the reverse, (i.e., equate defined benefit accruals to annual additions). this could be accomplished by extending the current ten-year 88. see supra text accompanying notes 22-24. 89. any proposals to repeal § 415(e) thus should be inapplicable to top-heavy plans, although it should be noted that repeal of the rules applicable to such plans is another target of simplification-minded reformers. see gridlock, supra note 1. at 34. it should be noted that the proposal of the aba tax section to eliminate § 415(e) would apply to all plans, including super top-heavy plans. see aba report, supra note 6. at 12. 90. there are a number of relatively small, and relatively noncontroversial, changes that would simplify § 415. see supra notes 12 & 21. 19941 florida tax review phase-in for the dollar limits, perhaps to thirty-five or so years.9' if this were done, employers could simply allocate a section 415(e) percentage between the defined benefit and defined contribution plans for each year in which an employer maintains two plans. this approach dispenses with the need to recompute annually the defined contribution limitation, the primary source of section 415(e)'s complexity. if the employer does not alter the allocations of the section 415(e) percentage from year to year, the plan would be able to determine an employee's defined benefit limit by multiplying a participant's years of participation by the portion of the overall percentage allocated to the defined benefit limit. even if the employer did choose to vary the allocations, the section would not present a high degree of complexity or significantly increase the amount of recordkeeping for the plan. 92 to illustrate, assume that congress amended subsection (e) to permit a 120% combined limit of the sort suggested. each employer that sponsors both types of plans would allocate the 120% between the separate limits for each plan type. assume an employer allocates 100% of the combined limit to the defined benefit plan and 20% to the defined contribution plan. an employee could receive 20% of the maximum annual additions to the defined contribution plan in a particular year and would also be credited with 1/35 of the defined benefit limitation for that year.93 when the employee retired, his defined benefit limit would be the sum of the annual phase-in credits, multiplied by the adjusted defined benefit dollar limit at the time of benefit payment. thus, an employee with twenty years of credit under such an allocation, could receive a maximum benefit of 20/35, or 57% multiplied by whatever the indexed dollar limit is at retirement. or assume that the employer allocates 40% of a year's allocation to a defined contribution plan and 80% to a defined benefit plan. in such a year, the employer could contribute 40% of the (c) dollar limit to the defined contribution plan. in addition, the employee's dollar limit for the defined benefit would be 80% of 1/35 of the indexed dollar limit at retirement. an employee who had twenty years of service under a plan that maintained such 91. this article suggests the phase-in for the dollar limit only. the alternative limit restricting benefits to 100% of compensation could continue to apply but would not require a phase-in period based on participation. 92. the plan would have to keep track of the employer's allocation of the § 415(e) percentage for each plan year, but the same allocation would apply to all employees. in addition, transition rules would require that one-time transition data be created and retained. 93. appwp has suggested that congress repeal the compensation limit on additions to defined contribution plans because this limitation is unnecessary to control benefits of the highly compensated because of the applicability of the dollar and deduction limitations and can harm lower-paid employees. see gridlock, supra note 1, at 34. [vol 2:2 simplification and irc § 415 an allocation of the section 415(e) percentage would earn 80% of 20/35, or 46% of the dollar limit as indexed through the date of retirement. one policy objection to this approach toward simplification is the limitations it would place on an employer who has not in the past sponsored any retirement plans and now wishes to sponsor a defined benefit plan that will provide a generous benefit for all employees, even those within ten years of retirement. under current law, the employer could provide a benefit equal to 100% of the (b) dollar limit; under the approach suggested here, however, the benefit could not exceed 10/35 of the dollar limit. this does not seem a particularly troubling problem. the employer can still fund a very large benefit for the employee over ten years, just not as large as is permissible under current law. this may not be too steep a price to pay for simplicity. in any event, it would be possible to base the phase-in on years of service rather than participation with respect to any prior year in which the employer had not maintained a qualified plan, which would permit a more accelerated phase-in of the (b) dollar limits.9' a formula could also be devised to award prorated years of past service in cases in which less than the maximum annual additions were made to an employee's defined contribution account. this would add a measure of complexity to things, but at least the complexity would be a one-time occasion and affect only a relatively small number of employers. the restructuring of the defined benefit limitation into annual increments suggested here would bring with it an advantage in addition to simplicity. under current law, the limitations are applied separately for each employer. thus, an employee who changes employment may accumulate 94. section 415(b)(5) currently requires that the dollar limit be phased in over 10 years of participation in the plan. irc § 415(b)(5)(a). the compensation limit, on the other hand, may be phased in over 10 years of service, which means that the phase-in has no effect on most participants in a plan whose benefits are based on past service. the 10-year phase-in of the dollar limit was intended to prevent a small employer from timing the establishment of a defined benefit plan to shortly before retirement of a key employee, who would have enough service to receive a fully funded benefit while other employees might lack sufficient service. after the key employee retires, the employer may decide to terminate the plan. depriving other employees of the opportunity to earn a full benefit. thus, if this article's proposal permitted past-service credit for purposes of the extended phase-in period for the dollar limits, an additional 10-year participation phase-in still would be necessary to prevent employers from timing establishment of defined benefit plans in the manner described. the current phase-in period for the dollar limits applies not only to establishment of a defined benefit plan, but, to the extent provided in regulations, to benefit improvements in existing plans as well. irc § 415(b)(5)(d). the service. however, has decided not to implement this provision because the nondiscrimination regulations substantially eliminated the need for the requirement. rev. proc. 92-42, 1992-1 c.b. 872, §§ 2.02, 3. in any event. there is no reason why an extended 35-year phase-in period should apply to benefit improvements if the proposal suggested here were adopted. 1994] florida tax review substantially larger retirement savings than an employee who remains with one employer for his or her career. because the approach suggested here would be applied separately for each year, the benefits for employees who work for multiple employers would be reduced.95 b. restricting section 415(e) calculations to small employers we have earlier seen that a repeal of section 415(e) would not have a significant effect on the benefits provided by large employers." the reason for this is that the nondiscrimination rules of section 401(a)(4) will generally require that whatever benefits are provided to highly compensated employees (as a percentage of their compensation, with a $150,000 limit on compensation taken into account) 97 are also provided to other employees. as a result, the costs of providing high benefits to non-highly compensated employees would constrain most large employers from providing too high a level of benefits for highly compensated employees. and if these costs did not constrain employers, there would be a measurable gain in the extent to which the tax subsidy is benefiting all employees, a desirable policy goal. if this analysis is correct, one approach to simplification of section 415(e) would be to define a class of employers for whom its application does not generally serve any purpose and then exempt that class from its requirements.98 one possible definition of plans that could be exempted from 95. this article does not propose transition rules to the suggested simplification of the (e) limits. there are many directions transition rules could take, however, depending on how one resolves various policy choices. an outline of one approach would be for the defined benefit dollar limit under prior law to be frozen as of the effective date and to assign a fresh-start dollar limit to each employee. each employee's fresh-start limit would grow annually under the new § 415(e) approach (i.e., a percentage would be added to it each year; the percentage in each year would be the same for each employee) and would be applicable when it exceeded the frozen limit under prior law. the defined contribution fraction could be dispensed with immediately. one possibility for the initial fresh-start limit would be the lesser of (i) the frozen limit and (ii) years of defined benefit plan participation as of the effective date multiplied by 1/35, with reduced amounts for years in which the employee participated in both a defined contribution and a defined benefit plan. another possibility for the fresh-start limit might be (i) years of service multiplied by (ii) the § 415(e) percentage (which as suggested in the text, would be 120%) less the defined contribution fraction as of the effective date (but in no event to be greater than 100%). 96. see supra text accompanying note 79. 97. irc § 401(a)(17). prior to the omnibus budget reconciliation act of 1993, p.l. no. 103-66, the compensation limit was $200,000. 98. indeed, the legislative debate over erisa included early proposals to apply limitations only to "proprietary employees" in relatively small corporations. see s. 1179, 93d cong., 1st sess. § 702 (1973) (bill reported out of senate finance committee applied limits [vol 2:2 simplification and irc § 415 section 415(e) is "top-heavy plans," as defined in section 416(g).9 while determining whether a plan is top-heavy is itself a complex undertaking, plans already are required to make the determination. to further limit complexity, the section 415(e) limitation might be applied only to "key employees" under section 416(i)(1) or "highly compensated employees" under section 414(q).'o while this approach to simplification may be sensible, it does go against the grain of an apparent policy in subchapter d that distinctions between large and small employers generally are inappropriate.'"' nevertheless, the argument that section 415(e) should be eliminated for the class of employers who would not in any event be in a position to load up contributions in excess of what the (e) limits already provided is a strong one; if the contours of such a class can be outlined, administration of such plans would be simplified. v. conclusion section 415, as it currently exists, serves a purpose but its complexity extracts a cost. is the cost too steep a price to pay for the section's contributions? the answer is debatable, but is also beside the point if the section can be simplified. if simplification is possible it should occur, regardless of one's feelings about whether the section in its current form is worth its current costs. in this article i have shown that it is possible to reduce substantially the section's complexity by altering the structure of subsection (e). i have only to plans of "proprietary employees," which were defined as plans in which at least 25% of the benefits were for employees with 2% or more of the corporation's stock and to plans of self-employed persons); see also subcomm. on labor of the senate comm. on labor and pub. welfare, supra note 80, at 1653 (statement of sen. curtis): id. at 1656. 1658-59 (statement of sen. nelson). 99. see irc § 416(a). see also supra notes 23-24 and accompanying text. 100. there is at least one problem with applying § 415(e) to top-heavy plans: how to treat plans that are top-heavy in some years, but not others. for example, assume a defined benefit plan that is not top-heavy and in which all participants have accrued the maximum benefits permissible under § 415(b). assume further that the employer also has made maximum contributions to a defined contribution plan. in a subsequent year, the plan becomes top-heavy. if the § 415(e) limit now applies, the plan will have to reduce accrued benefits. this scenario is certainly not desirable. but neither is it inevitable: § 415(e) could apply only to benefit accruals that take place in years when the plan is top-heavy. 101. it apparently was this concern that caused congress to create limits for all plans rather than only for smaller plans with proprietary employees. subcomm. on labor of the senate comm. on labor and pub. welfare, supra note 80, at 1704 (statement of sen. buckley); id. at 1706-07 (statement of sen. gravel); id. at 1755 (statement by sen. bellmon); id. at 1777-1780 (statement of sen. thurmond). see also supra note 94. 1994] 98 florida tax review [vol 2:2 also suggested that it might be possible to limit the effects of the section's complexity by targeting the section more precisely at employers in a position to exploit the tax planning possibilities its repeal would make possible. either, or both of these suggestions, would simplify the administration of qualified plans. it is true, of course, that outfight repeal of section 415, or section 415(e), would simplify administration of qualified plans even more, but it is also true that outright repeal would result in a loss of revenue at a time when we can ill afford it. moreover, repeal might indirectly reduce the benefits of younger non-highly compensated employees by creating fresh incentives for some small employers to substitute defined benefit plans for defined contribution plans. repeal, then, should be regarded as the remedy of last resort, not the remedy of choice. territorial vs worldwide 283 florida tax review volume 8 2007 number 3 territorial vs worldwide international tax systems: which is better for the u.s.? by paul r. mcdaniel part i ....................................................................................................... 286 part ii ...................................................................................................... 289 a. wwi/ftc system .................................................................... 289 b.teritorial system ....................................................................... 290 part iii .................................................................................................... 291 a. source of income rules ............................................................ 291 b. source (or allocation) of deduction rules .............................. 292 c. outbound transfers of property .............................................. 292 d. transfer pricing ...................................................................... 293 e. tax havens ............................................................................. 294 f. look-thru rules ...................................................................... 294 g. foreign losses ........................................................................ 295 h. tax treaties ............................................................................. 295 i. transition rules ........................................................................ 296 j. conclusion ................................................................................ 296 part iv .................................................................................................... 297 part v ...................................................................................................... 299 part vi .................................................................................................... 301 284 florida tax review [vol. 8:3 * james j. freeland eminent scholar in taxation and professor of law, university of florida levin college of law. this article was presented at the 2006 annual symposium on international taxation held at the university of florida levin college of law graduate tax program. i thank karen reschly and andrew dodl for research assistance. an earlier version of this article was presented before the new york city bar association as the 2006 annual herman goldman memorial lecture. 1. hereinafter “panel report.” this paper generally will not consider the domestic aspects of the two major proposals in the panel report – the simplified income tax plan and the growth and investment tax plan. a helpful discussion by the senior counsel and the senior economist to the panel can be found in jonathan z. ackerman and rosanne altshuler, constrained tax reform: how political and economic constraints affect the formation of tax policy proposals, lix n.t.j. 59 nat’l tax j. 165 (2006). 2. see, e.g., lawrence lokken, territorial taxation: why some u.s. multinationals may be less than enthusiastic about the idea (and some ideas they really dislike), 59 smu l. rev. 753 (2006); j. clifton fleming, jr. & robert j. peroni, exploring the contours of a proposed u.s. exemption (territorial) tax system, 41 tax notes int’l 217 (jan. 16, 2006); michael j. graetz & paul w. oosterhuis, structuring an exemption system for foreign income of u.s. corporations, 54 nat’l tax j. 771 (2001); ernest r. larkins, double tax relief for foreign income: a comparative study of advanced economies, 21 va. tax rev. 233 (2001); ernest s. christian, the international components of tax reform: tax policy that serves the national interest, 14 j. of int’l tax. 48 (2003 [part i]) and 15 j. of int’l tax. 36 (2004 [part 2]); peter merrill, oren penn, hans-martin eckstein, david grosman & martijn van kessel, u. s. territorial tax proposals and the international experience, 42 tax notes int’l 895 (jun. 5, 2006). territorial vs worldwide international tax systems: which is better for the u.s.? by paul r. mcdaniel* the report of the president’s advisory panel on federal tax reform, entitled “simple, fair, and pro-growth: proposals to fix america’s tax system,” was released in november 2005. one of the issues addressed1 in the panel report was whether the u.s. should shift from its current international tax system (taxing the worldwide income of its nationals with a credit for foreign income taxes) to a territorial system (exemption of foreign branch business income and dividends from foreign subsidiaries out of business income). the panel opted for the territorial system. the report devoted only about twelve pages to the subject, but its recommendation has reignited interest in a subject which has recurred with some regularity over the past decade.2 2007 territorial vs worldwide international tax systems 285 3. the approach in this paper in general was taken by the american bar association section of taxation task force on international tax reform, u.s. international tax reform: objectives and overview, 59 tax law. 649 (2006) (hereinafter “aba task force”). the difference is that, because of disagreements among the task force members, neither system was endorsed over the other. in adopting the approach described in the text, i reject competitiveness of u.s. companies as a tax policy criterion, although increased competitiveness by u.s. companies is often cited as a reason for adopting a territorial system. see, e.g., panel report, supra note 2, at 105; staff of joint comm. on taxation, the impact of international tax reform: background and selected issues relating to u.s. international tax rules and the competitiveness of u.s. businesses, 55-56 (comm. print 2006) (discussing the various meanings of the term “competitiveness”) (hereinafter “jct staff competitiveness report”); hearing on the impact of international tax reform on u.s. competitiveness, hearing before the subcommittee on select revenue measures of the house committee on ways and means, 109th cong. (2006) (statement of r. glenn hubbard); david l. brumbaugh, taxes and international competitiveness, crs report to congress, rs 22445 (may 23, 2006). i reject competitiveness as a criterion (1) because it has no substantive tax policy content (it seems largely to be a rhetorical slogan for u.s. multinationals that want tax cuts) and (2) i have found no empirical studies that show u.s. companies are at a competitive disadvantage vis-à-vis their foreign competitors. the world economic forum publishes an annual global competitiveness report, the most recent being for 2006-2007. the report utilizes nine different factors to assess a country’s (not a company’s) competitiveness in global markets. taxation – let alone a given international tax system – is not among the nine factors. the report can be found online at www.weforum.org. mihir a. desai & james r. hines, jr., old rules and new realities: corporate tax policy in a global setting, 57 nat’l tax j. 937 (2004), advanced a new criterion, that of “ownership neutrality.” that concept was sharply critiqued by harry grubert as lacking any “conceptual basis” and as of no use in addressing “any relevant policy issue.” see harry grubert, comment on desai and hines, “old rules and new realities: corporate tax policy in a global setting,” 58 nat’l tax j. 263 (2005). i find the grubert analysis persuasive and will not employ the ownership neutrality concept in this paper. see also the critique of the concept by fleming & peroni, supra note 3, at 235-39. finally, i do not employ the criterion of “international norms,” as was done, for example, by the treasury department in its study of subpart f. see united states department of the treasury office of tax policy, the deferral of income earned through u.s. controlled foreign corporations: a policy study (2000). the problem is that supposed “norms” change. for example, prior to the issuance of the first set of regulations under irc § 482 in 1968, there was no international consensus and hence no norm about the comparable uncontrolled price method to be used in the arm’s length in this paper, i explore whether the proposal of the panel would represent a beneficial tax policy change for the u.s. in so doing, the territoriality recommendation and what i will term a “model” worldwide taxation of income coupled with a foreign tax credit (wwi/ftc) system will be examined from the perspectives of efficiency, equity, and simplicity.3 286 florida tax review [vol. 8:3 pricing methodology. some 25 years later, when the treasury issued proposed regulations, setting forth the largely formulary profit split and comparable profits methods, there was an outcry from many oecd countries that the international norm of arm’s length transfer pricing was being violated by the new rules. 4. panel report, supra note 1, at 240. the panel report closely parallels a report prepared by the staff of the joint committee on taxation, “options to improve tax compliance and reform tax expenditures,” 186-98 (comm. print 2005) (hereinafter jct staff report). this discussion will include references to that study and notes any differences between the panel report and the jcs approach. the jct staff adopts the same two-pronged approach. id. at 189. that report also observed that current subpart f and pfic rules would have to be retained, including retaining the foreign tax credit for such income. id. at 191-92. 5. panel report, supra note 1, at 241. 6. id. the 2004 act changed the mandatory “water’s edge” interest allocation rule to provide certain corporations with an election to adopt a worldwide allocation method beginning in 2009. irc § 864(f). part i of the paper describes the panel’s proposal and the arguments it advanced in favor of the proposed change. part ii sets forth a model by which the panel proposal will be evaluated. part iii compares the simplicity arguments for each of the two international tax regimes. in part iv, the efficiency arguments advanced for each system are considered. part v analyzes the equity issues under each system. part vi sets forth my own conclusions on the issues. part i the panel recommended that the current u.s. international tax regime be replaced with a two-part system: 1. foreign active business income, as well as dividends from foreign subsidiaries out of such income, would be exempt from u.s. income tax. 2. current u.s. income tax would be imposed on passive income and so-called mobile income (including, for example, financial services business income); a foreign tax credit would be allowed against the u.s. tax, with all such income being placed in a single basket.4 the report provides a few of the technical details that would be required to implement the basic rules. thus, allocation of expense rules between u.s. and foreign source income would be required. the report asserts, without explanation, that these rules could be simpler than the current u.s. allocation rules. the panel goes on to recommend that interest5 expense allocation rules like those adopted in the 2004 act be employed.6 2007 territorial vs worldwide international tax systems 287 7. panel report, supra note 1, at 241. the jct staff report makes the same points with respect to expense allocation rules. jct staff report, supra note 4, at 190. 8. panel report, supra note 1, at 240. 9. id. 10. id. presumably, look-thru rules like those contained in irc § 904 would be required. 11. id. at 134. 12. id. 13. id. at 240. the panel also recommended that increased disclosure requirements be adopted for foreign income. id. the jct staff report observed that adoption of an exemption system by the u.s. would require it to renegotiate all of its income tax treaties. jct staff report, supra note 4, at 192. 14. apparently, the panel exemption system would apply to all post-enactment dividends, including those paid out of pre-enactment earnings on which u.s. tax had been deferred. the jct staff report, at 191, proposed a transition rule under which the new exemption system would apply only to qualifying foreign income generated after the effective date of the enacting legislation. present law would continue to apply to preeffective date foreign earnings. general and administrative expenses provided free of charge by one member of a (presumably controlled) group of corporations to another member would be required to be allocated first between u.s. and foreign income and then the expenses allocated to foreign income would have to be allocated between exempt and currently taxable income. research and experimentation7 expenditures, however, would be allocated only between u.s. and foreign mobile income.8 as to the exempt income group, the report stated that gain on the sale of assets generating exempt foreign income likewise would be exempt from u.s. tax, but losses realized on such assets could not be deducted against u.s. income. the panel also noted that special rules would be9 needed for dividends from foreign corporations in which a u.s. company owned between 10 and 50% of the stock. while dividends out of foreign10 active business income would be exempt, royalty and interest payments would be subject to u.s. tax if those payments were deductible in the source country.11 as to other issues, the report noted that transfer pricing rules would become even more important under the proposed exemption system than under current law, and recommended that increased resources be devoted12 to enforcing transfer pricing rules.13 the report contains no recommendations with respect to transition rules that would be required if the panel’s recommendation were adopted.14 the panel offered several reasons for its proposed changes. they will simply be listed here and discussed in succeeding parts of this paper. the reasons included: 288 florida tax review [vol. 8:3 15. panel report at 103. the panel also asserted that u.s. tax on repatriated dividends distorts the repatriation decision. id. at supra note 1, at 133. the jct staff report added that basing u.s. taxation on repatriation makes the u.s. tax on foreign source income substantially elective. it also noted that maintaining deferral indefinitely is the equivalent of exemption of the income so deferred. jct staff report, supra note 4, at 188. 16. panel report, supra note 1, at 104. the panel apparently had in mind tax planning that aims at averaging down overall foreign tax rates to avoid falling into an excess credit position for foreign tax credit purposes. the jct staff report also asserts without any authority that u.s. corporations engage in a greater degree of tax-induced business planning than do corporations in exemption countries. jct staff report, supra note 4, at 189. 17. panel report, supra note 1, at 104. 18. id. at 134. the jct staff report, however, notes that the need to retain subpart f rules, and transfer pricing rules, and to provide transition rules would create significant complexities. jct staff report, supra note 4, at 195. 19. panel report, supra note 1, at 135. the jct staff report, however, warned that there would need to be rules to prevent shifting of income to low-tax jurisdictions. it did observe that disallowance of deductions attributable to exempt foreign income should serve as a brake on incentives to move more activity to low-tax jurisdictions. jct staff report, supra note 4, at 194-95. 1. the availability of deferral of u.s. tax on income earned by a foreign subsidiary creates an incentive to retain those earnings in the subsidiary for as long as possible and distorts other business and investment decisions.15 2. the current system distorts business decisions, treats different u .s. multinational corporations (m ncs) differently, and encourages wasteful tax planning.16 3. changing to an exemption system would make u.s. businesses more competitive in their foreign operations.17 the benefits of changing to an exemption system, according to the panel, include: 1. it would allow u.s. companies to compete abroad more effectively. 2. it would reduce the degree of tax-induced distortions on business decisions. 3. it would produce simplification gains.18 the report also stated, without discussion, that there is no definitive evidence that investment location decisions would be significantly changed from the present situation.19 2007 territorial vs worldwide international tax systems 289 20. see panel report, supra note 1, at 104-105. this same approach was taken in harry grubert & john mutti, taxing international business income: dividend exemption versus the current system (american enterprise institute, 2001); see also, rosanne altschuler & harry grubert, where w ill they go if we go territorial? dividend exemption and the location decisions of u.s. multinational corporations, 54 nat’l tax j. 787 (2001). at various points in the following discussion, i do compare aspects of the proposed exemption system to current law. 21. for extensive discussions of a proposal to end deferral, see robert j. peroni, j. clifton fleming, jr., & stephen e. shay, getting serious about curtailing deferral of u.s. tax on foreign source income, 52 smu l. rev. 455 (1999); j. clifton fleming, jr., robert j. peroni & stephen e. shay, an alternative view of deferral: considering a proposal to curtail, not expand, deferral, 20 tax notes int’l 547 (jan. 31, 2000). senator john kerry has introduced legislation to require current taxation of the income of controlled foreign corporations, coupled with a reduction in the corporate tax rates. the export products not jobs act, s. 3777, 109th cong., 2d sess. (2006). part ii in this part, i will set forth the model i propose to use in assessing whether a worldwide taxation of income with a foreign tax credit system (wwi/ftc) or a territorial system is better for the u.s. and by “better,” i mean which maximizes the welfare of u.s. citizens and residents. in so doing, i reject the approach of the panel and the jct staff in which they compared an ideal (or near ideal) territorial system with the current imperfect wwi/ftc system in effect in the u.s. this approach, it20 seems to me, does a real disservice to policymakers (unless, of course, they have predetermined that they desire the adoption of a territorial system). instead, i believe the appropriate policy comparison is between a (near) ideal wwi/ftc system and a (near) ideal exemption system. only then can policymakers assess each in terms of equity, efficiency, and simplicity. accordingly, this part sets forth a model of a wwi/ftc system and a model of a territorial system. a. wwi/ftc system in very brief form, the following basic elements constitute a (near) ideal wwi/ftc system. 1. all foreign income, whether from business operations or passive investments, would be taxed currently, on an accrual basis, by the u.s. no deferral of tax on foreign source income would be permitted. as a result, u.s. income tax21 290 florida tax review [vol. 8:3 note that this element of the model eliminates the concerns expressed in the panel report, that the current system discourages repatriation of dividends from foreign subsidiaries. panel report, supra note 1, at 133. 22. see aba task force, supra note 3, at 672, for a discussion of a similar proposal. considerations would not affect the decision whether to operate in branch or subsidiary form, a situation that does not currently exist, e.g., the branch form is preferred if foreign losses are expected that can offset u.s. source income whereas if profits are expected, the use of a subsidiary provides the opportunity to defer u.s. tax on those profits. 2. an ftc would be allowed for all foreign income taxes paid by the u.s. taxpayer on its foreign source income. a. the allowable credit would be limited to the u.s. tax on the foreign source income. b. two baskets – active business income and passive investment income – would be retained. c. because worldwide averaging of business income presents too much opportunity for eliminating u.s. tax on foreign source income, a per-country limitation (with two baskets in each country) should be employed.22 d. as discussed in further detail in following parts of this paper, a number of elements of the current u.s. ftc system would continue, e.g., look-through rules and allocation of deduction rules. the implications of these basic elements and additional needed rules are detailed further in subsequent parts of this paper. b. territorial system in very brief terms, the following sets forth the basic elements of a (near) ideal territorial system. 1. the residence country could include foreign source income in its tax base but exempt foreign source business income. exempt income includes both branch income and dividends from foreign subsidiaries paid out of foreign business income. 2. typically, countries adopting such a system do not extend the exemption to foreign investment income. as per the 2007 territorial vs worldwide international tax systems 291 23. see, e.g., panel report, supra note 1, at 132-34; christian, supra note 3, at 40 (territoriality is simplest system “[w]ithout question”); larkins, supra note 3, at 250. 24. the best analysis of why an exemption system is not more simple than a wwi/ftc system is in hugh j. ault, u.s. exemption/territorial system vs. creditbased system, 32 tax notes int’l 725 (nov. 24, 2003). 25. in accord with the text discussion are ault, supra note 24, at 727; merrill et al., supra note 2, at 905; graetz & oosterhuis, supra note 2, at 782. panel report, such income may be taxed currently, with a foreign tax credit allowed. 3. foreign source losses are not permitted to offset domestic source income. implications of the foregoing and the rules necessary to implement a territorial system are discussed in subsequent parts of this paper. part iii supporters of a territorial system frequently assert that such a system is more simple than a wwi/ftc system. typically, little analysis23 accompanies this assertion. and, indeed, there is no basis for such a statement. in fact, virtually all the elements that add up to complexity in a wwi/ftc system are, or should be, present in a territorial system. and, when additional elements of the panel proposal are factored in, the u.s. international tax system would be made more, rather than less, complex. the following discussion identifies the elements that can create complexity, or in any event are necessary, in a model wwi/ftc system. as each rule is identified, its role in a territorial system is considered, including an assessment whether there is greater or less pressure on the rule in one system versus the other.24 a. source of income rules source of income rules play a critical role in the current u.s. international tax system and would continue to do so in a model wwi/ftc system. such rules are equally necessary in a territorial system. since in that system complete exemption is provided for specified foreign source income, there would be greater pressure on the source of income rules than is the case even under present law. under present law, deferral of tax but not complete exemption turns on classifying income as foreign source. a territorial system is no more simple (or complex) when compared to a model wwi/ftc system insofar as source of income rules are concerned.25 292 florida tax review [vol. 8:3 26. in accord with the text discussion are ault, supra note 2, at 728; panel report, supra note 1, at 134; merrill et al., supra note 2, at 905; graetz & oosterhuis, supra note 2, at 782. 27. in accord are ault, supra note 24, at 728; aba task force, supra note 3, at 665-66; graetz & oosterhuis, supra note 2, at 783. b. source (or allocation) of deduction rules under current law, source of deduction rules play a crucial role in the operation of the ftc system. deductions allocated to foreign source income reduce the allowable foreign tax credit (and for a taxpayer in an excess credit position, the allocation is equivalent to denying the deduction altogether). such rules would continue to be necessary in a model wwi/ftc system. but it is also true that such rules play an equally important role in a territorial system. failure to allocate appropriately deductions to foreign source income that is exempt from domestic tax means that the taxpayer would be able to deduct against domestic taxable income items that are costs of producing tax-exempt income (from the perspective of the residence country). this result, of course, would violate a long-accepted principle in u.s. tax policy. for these reasons, as compared to present law, pressure on the source of deduction rules would be at least as great in a territorial system. and, as with the source of income rules, in this respect, a territorial system is no more simple than a model wwi/ftc system or, indeed, even the present rules.26 c. outbound transfers of property currently, irc section 367(a) may impose a toll charge on outbound transfers of property that has appreciated in value while subject to u.s. domestic taxation. exceptions to this rule and exceptions to the exceptions are also to be found. in turn, irc section 367(b) and the regulations thereunder provide rules for the treatment of certain inbound and foreign-toforeign transactions. in a model wwi/ftc system, there would be no need for irc section 367. gain on appreciated property transferred to a cfc would be taxed currently by the u.s. whenever realized. similarly, the concerns of irc section 367(b) would appear to decline significantly. under a territorial system, however, irc section 367(a) would be of greater importance than under current law and would be necessary to protect the u.s. tax base. currently, the irc section 367(a) toll charge is the price27 paid to transfer property into a world of deferral. but under a territorial system the appreciation in value would be completely exempt from u.s. tax if the gain is not taxed at the time of transfer. it thus appears that some of the exceptions in irc section 367(a) that are tolerable in a world of deferral 2007 territorial vs worldwide international tax systems 293 28. ault, supra note 24, at 728, observes that the issues to which the current regulations under irc § 367(b) are directed also would arise in an exemption system. 29. in accord are ault, supra note 24, at 728; panel report, supra note 1, at 134, 240; jct staff competitiveness report, supra note 3, at 30; merrill et al., supra note 3, at 905; graetz & oosterhuis, supra note 2, at 782. would not be acceptable in a world of exemption. the irc section 367(b) rules would need to be examined in a shift to a territorial system to see if it would still be necessary to deal with some of the inbound situations.28 in this set of rules, a territorial system produces more, not less, complexity than does a wwi/ftc system. d. transfer pricing transfer pricing rules play two important roles. first, they seek to assure that each entity in a controlled group is assigned the income that is appropriate to its role in cross-border transactions. second, transfer pricing rules operate to allocate revenues between the governments of the countries that are involved in particular cross-border transactions. as the panel report recognized, a territorial system would place greater pressure on transfer pricing rules than is true under present law.29 again, the reason is that profit that can be isolated in a lowor no-tax country is totally exempt from u.s. tax; in today’s world, deferral of u.s. tax is at stake. the panel also noted that in fact a territorial system would require a much higher degree of enforcement of transfer pricing than is currently the case. by contrast, i argue that a wwi/ftc system could actually reduce the pressure on transfer pricing rules. in general, there would be no benefit from isolating profit in the cayman islands since the u.s. would tax that profit currently and would have to give little or no ftc. the argument needs to be modified if a per-country limitation is adopted. there would be an incentive, for example, to shift profits from a high-tax country in which the taxpayer is in an excess credit position to a low-tax country in which the taxpayer is in an excess limit position. this result could be most easily accomplished by making interest or royalty payments that are deductible in the payer’s country. of course, the high-tax country would have an interest in applying its own transfer pricing rules to such transactions. effective exchange of information procedures would help protect the tax bases of both the u.s. and the high-tax country. 294 florida tax review [vol. 8:3 30. see ault, supra note 24, at 727-28. 31. astonishingly, the panel report contained no mention of the tax haven problem. presumably, under the panel approach even if foreign business income incurred no tax at source, the income would still be exempt from u.s. tax. 32. irc § 904(d)(3), (4). e. tax havens the u.s. seeks to protect its tax base through the application of its transfer pricing rules and the rules of subpart f (requiring current taxation of specified base company income and passive investment income). countries with exemption systems have found that some rule is necessary to deal with efforts by their taxpayers to isolate income in lowor no-tax countries. some countries require that the source country impose a specified minimum rate of tax, others that the income be subject to tax, and still others maintain lists of “good” countries, the income earned in which would qualify for exemption. the point is that shifting to an exemption system does not eliminate the need for subpart f-type rules. as a result, no30 simplification gains from such a change should be expected as compared to the present u.s. approach. on the other hand, such regimes are unnecessary in a wwi/ftc system. all foreign income would be taxed currently by the u.s. even if earned in a lowor no-tax country. thus, purely on simplification grounds, in this area the model wwi/ftc system has the edge over a territorial system.31 f. look-thru rules for purposes of applying the indirect ftc under irc section 902, the u.s. uses look-thru rules to determine the proper basket into which to place dividends received either from a cfc or a so-called 10/50 corporation.32 under the model wwi/ftc system, these look-thru rules would continue to be needed as it includes a two-basket (business income and passive investment income) system on a per-country basis. an exemption system in theory would not require baskets. however, in practice countries with territorial systems typically do not exempt foreign source passive investment income. instead, they tax such income earned by their residents on a worldwide basis and provide a ftc for foreign taxes (typically withholding taxes) paid. the panel report adopts this approach. it would tax so-called “mobile” income on a current basis and allow a ftc for foreign taxes incurred, if any. two observations may be made. first, in effect a two-basket system is retained because it is necessary to distinguish business income from mobile income. second, each basket of income is subject to a different 2007 territorial vs worldwide international tax systems 295 33. irc §§ 367(a)(3)(c), 904(f)(1) . 34. irc § 904(f)(5). 35. see, e.g., article 23 of the 2006 united states model income tax convention. international tax regime, i.e., an exemption system for business income and a worldwide system for mobile income. in contrast, under the model wwi/ftc system, while two baskets are employed, the same international tax system would apply to each basket. the panel report approach inevitably will be more, not less, complex than either the model wwi/ftc system or current law, as it requires the complete implementation of an exemption and an ftc system for each of the two different classes of income. g. foreign losses under present u.s. law, a special set of rules applies to deal with foreign losses incurred by u.s. companies. the rules play two different roles. the first role is to account for the fact that, in the case of operation through a foreign branch, any losses incurred by the branch reduce u.s. taxable income. if the branch subsequently earns a profit, then special rules insure that the u.s. in effect recaptures those previously deducted losses into income. the second set of rules operates within the ftc basket system and 33 mandates how foreign losses in one basket of income are to offset income in other baskets of income. again, the objective is to ensure that foreign losses34 in one basket offset foreign income in other baskets before offsetting u.s. income for ftc purposes. similar foreign loss rules would be necessary in a model wwi/ftc system, although their ftc role would be significantly diminished in a twobasket system. foreign losses must also be dealt with in an exemption system. the basic rule needs to be that, since foreign source business income is exempt from domestic tax, foreign source losses cannot be taken against domestic source income. that is the approach recommended by the panel report. it should be noted, however, that exemption systems are not impervious to deviations from the norm. in a number of exemption countries, foreign losses are allowed as a deduction against domestic source income. such a rule constitutes a tax expenditure or tax subsidy in an exemption system. h. tax treaties all current u.s. bilateral tax treaties guarantee u.s. taxpayers the availability of a foreign tax credit. if the panel proposal were adopted, all35 296 florida tax review [vol. 8:3 36. see jct staff competitiveness report, supra note 3, at 12-13; merrill et al, supra note 2, at 905. it could be argued that a domestic law exemption system would apply to u.s. taxpayers without regard to the treaty in any event so no treaty change is required. however, some u.s. multinationals will pay a higher tax under an exemption system than they do under current law. such taxpayers might assert that they are entitled to a treaty-based ftc. 37. see jct staff report, supra note 3, at 10; graetz & oosterhuis, supra note 2, at 783-84. these treaties would have to be renegotiated, a prescription for complexity and uncertainty for the government and taxpayers alike.36 i. transition rules another element of complexity involved in a change to an exemption system would arise from transition rules from the current system to an exemption system. remarkably, the panel report contains no such rules. apparently, dividends repatriated out of pre-effective date tax-deferred business earnings would be wholly exempt from tax. more realistically, as noted above, the jct staff report did include transition rules to ensure that distributions out of previously untaxed foreign earnings would be subject to tax. presumably, some sort of ordering rule would be required to determine whether a post-effective date dividend was made out of pre-effective date or post-effective date earnings (or some combination thereof), the latter qualifying for exemption. as the jct staff report recognizes, however, the necessity of such a transition rule introduces an additional layer of complexity. if the u.s. were to adopt the model wwi/ftc system, transition rules would also seem to be required. that is, post-effective date income would be taxed currently, but tax on pre-effective date earnings would be taxed only when repatriated. again, additional complexity is introduced by the necessity for transition rules.37 j. conclusion the assertion that an exemption system is less complex than a model wwi/ftc system simply will not stand up to analysis. indeed, it does not even hold true as compared to the current u.s. rules. as noted above, in several important areas, the model wwi/ftc system actually achieves greater simplification than does an exemption system. moreover, the panel approach involving the use of an exemption system for business income and a wwi/ftc system for other income necessarily is inherently more complex than either current law or the model wwi/ftc system proposed here, as taxpayers have to comply with two different systems of taxing foreign income. 2007 territorial vs worldwide international tax systems 297 38. for a discussion of the impact of these rules in the international context, see lawrence lokken, whatever happened to subpart f? u.s. cfc legislation after the check-the-box regulations, 7 fla. tax rev. 186 (2005). see also aba task force, supra note 3, at 668; lokken, supra note 2, at 759-64; paul w. oosterhuis, the evolution of u.s. international tax policy – what would larry say? 42 tax notes int’l 1119, 1124 (jun. 21, 2006). part iv the next issue to be addressed is whether efficiency gains would be realized by changing from the present system to a territorial system or, alternatively, by changing from the present system to a model wwi/ftc system. there may be a number of different ways in which the term efficiency is used. for definitional purposes in this paper, the term shall refer to a tax system that affects as little as possible the nature and location of business and investment activities. there are a number of problems with the current u.s. international tax rules that violate this efficiency criterion. in no particular order, these include, but are not limited to, (1) use of the check-the-box rules for foreign subsidiaries; (2) the ability of a parent company to borrow in the u.s. to 38 fund foreign subsidiaries the tax on whose income is deferred but the interest on the loan is fully deductible against u.s. taxable income; (3) the deferral regime itself; (4) the ability to treat as foreign source 50% of export sales income even though that income is unlikely to be taxed in the importing country; (5) to this observer, at least, insufficient resources devoted to curbing aggressive transfer pricing structures; and (6) the ability to average down foreign taxes by cross-crediting low and high tax country taxes. the result has been very low effective rates of u.s. tax on the foreign income of u.s. companies. two competing notions of neutrality have been employed in assessing international tax systems: capital export neutrality (cen) and capital import (or competitive) neutrality (cin). the former is associated with a foreign tax credit mechanism and the latter with an exemption system. the issue is whether both of these asserted neutralities satisfy the efficiency criterion set forth above. the panel report, following earlier studies, asserts that shifting from the present u.s. system to an exemption system would have little impact in terms of the decisions by u.s. companies to locate in lowor no-tax countries. even if one accepts that view, it does not lead to the conclusion that adopting an exemption system is a desirable policy for the u.s. all these studies tell us is that the u.s. wwi/ftc system is deeply flawed. one can gain perspective on the efficiency issue only if the comparison is made between an exemption system and the model wwi/ftc system outlined earlier in this paper. the model wwi/ftc system generally achieves cen while the exemption system generally would achieve cin. i 298 florida tax review [vol. 8:3 39. see dan r. mastromarco, u.s. international tax reform? define ‘reform’ for me, 43 tax notes int’l 481, 487 (aug. 7, 2006). 40. see aba task force, supra note 3, at 665. 41. see united states department of treasury, supra note 3, at 23. have defined efficiency as including minimization of the tax impact on business location decisions. the model wwi/ftc system comes closer to achieving efficiency than the proposed exemption system. that is, the decision whether to carry on business or invest in the u.s. or another country generally would be unaffected by u.s. income tax rules in the model wwi/ftc system. there would be no incentive to invest or do business in a lowor no-tax country because, regardless of location, the u.s. tax would be imposed. this result would be reinforced by adopting a per country limitation for ftc purposes. there is one deviation from a pure cen approach that is accepted in the model wwi/ftc system proposed here. a completely implemented cen policy would require that the u..s. refund all foreign taxes in excess of the u.s. tax on foreign source income. such a rule, of course, would put u.s. revenues completely at the mercy of foreign countries’ tax rates. neither the u.s. nor any other ftc country will accept or has accepted this result. accordingly, the model wwi/ftc system does accept that the u.s. will limit the allowable ftc to the u.s. tax on foreign source income, albeit imposed on a per country basis to prevent averaging between highand lowor no-tax countries. as compared to the cen model, cin does not satisfy the efficiency criterion as i have defined it. there is an inherent bias in favor of investing or carrying on business in countries with a tax rate lower than that of the residence country. in addition, it is unlikely that an exemption system can achieve its stated goal of insuring that a residence company can do business in another country and face the same tax rate as its local or third country competitors operating in the source country. this failure is due to the fact that an exemption system will “work” only if all countries employ an exemption system and have identical tax rates, conditions obviously not now met or ever likely to be met.39 to a non-economist, it is puzzling why a territorial system would be seen as preferable to a model wwi/ftc system. it seems clear that whereas the model system would not favor locating business or investment abroad at the expense of u.s. workers, an exemption system would create just such an incentive in a world where there are a substantial number of lowand no-tax countries. as a treasury study concluded, cen maximizes global40 (including the u.s.) welfare, whereas cin does not.41 the panel report advances as a reason in support of its territorial recommendation its assertion that the sophisticated (wasteful) tax planning that is carried out under current u.s. rules would be greatly curtailed. the 2007 territorial vs worldwide international tax systems 299 42. for an extensive analysis of fairness issues in the international context, see j. clifton fleming, jr., robert j. peroni, & stephen e. shay, fairness in international taxation: the ability-to-pay case for taxing worldwide income, 5 fla. tax rev. 299 (2001). jct staff went further and asserted that u.s. corporations engage in a greater degree of tax-induced planning than do corporations in exemption countries. these, i assume, are efficiency concerns. unfortunately, neither report provides any basis for these assertions. and, indeed, there is no such basis. the assertion that tax planning is less complex in an exemption country would be astonishing to a dutch tax advisor, for example. tax planning for dutch multinational companies is at least as sophisticated as that carried on in the u.s. on the other hand, my own experience in dealing with tax advisors in japan (an ftc country) is that less emphasis is placed on tax planning. thus, the presence of complex tax planning has nothing to do with whether a country employs a wwi/ftc or a territorial regime. i believe that the degree of sophisticated tax planning is affected far more by what i would term the “tax culture” of a country. in the u.s., that culture includes the general rule that lawyers are to advance the interests of their clients as vigorously as is permitted by law. in addition, in the tax context, this approach is reinforced by the view that no taxpayer is obligated to pay a dollar more in taxes than the law requires. these elements of the u.s. “tax culture” result in legal (and accounting) tax advisors aggressively advancing the tax interests of their clients to produce the lowest tax possible. nothing in this tax culture would change just because the u.s. adopted a territorial system. nor would it change if the u.s. adopted the model wwi/ftc system. sophisticated and complex tax planning, and equally sophisticated legislative and regulatory responses thereto, are here to stay. part v finally, i turn to the question whether an exemption system or the model wwi/ftc system is more equitable. of course, the traditional notions of horizontal and vertical equity apply only to individuals. at the corporate level, as discussed in part iv, the primary concern is efficiency, and that is the level at which most cross border investment and business is carried out. but this does not mean that there are no fairness issues raised by an international tax regime, particularly when coupled with a country’s corporate/shareholder tax regime.42 it is not always appreciated that there is an equity as well as neutrality principle embedded in a wwi/ftc system. the horizontal equity principle can be stated as requiring that a u.s. taxpayer pays the same amount of u.s. and foreign taxes as does a taxpayer realizing the same amount of income solely from a u.s. source. likewise, vertical equity 300 florida tax review [vol. 8:3 43. suppose that u.s. corporation a has 100 of foreign source income on which it pays 30 of tax. u.s. corporation b has 100 of domestic source income on which it pays 35 of tax. corporation b distributes a 65 dividend which, under the panel proposal, is exempt from tax at the shareholder level. corporation a distributes a dividend of 70 and a tax of 24.50 (35% x 70) is imposed at the shareholder level because the dividend is not tax exempt. the shareholder of corporation a has thus borne a total tax of 54.50, leaving only 45.50 in after-tax income, compared to the 65 that the shareholder of corporation b realizes. this result will occur at any time the foreign source income is subject to a positive rate of tax. see also merrill et al., supra note 3, at 907, for a further example of the phenomenon described here. the panel’s integration proposal also raise’s complexity concerns as some type of ordering rules would be required for corporations that have both domestic and foreign income in order to determine the portion of a dividend that is subject to shareholder tax and the portion that is exempt. the panel suggests a pro rata approach. requires that a taxpayer with greater income from u.s. and foreign sources should pay relatively more tax than does a u.s. taxpayer with lower income, whether from u.s. or foreign sources. the equity issue may be more readily seen if a model wwi/ftc system were employed by a country that had a fully integrated shareholder/corporate tax regime. by fully integrated, i mean that all income and tax attributes flow through the corporation and are taken into account only at the shareholder level. (a withholding obligation might be imposed on the corporation.) this would mean that in a model wwi/ftc system all foreign income taxes incurred by a corporation would flow through and be creditable by individual shareholders. in such a system, both horizontal and vertical equity would be satisfied. the panel report did propose an integration system. under its proposal all foreign income would be exempt at the corporate level but domestic income would be taxed. at the shareholder level, dividends paid out of domestic income would be exempt but dividends out of foreign (exempt) income would be fully taxable. this pair of proposals has several perverse effects. i shall describe three. first, depending on the tax rate in the foreign country, an individual u.s. shareholder could well experience a tax reduction on corporate-earned domestic income but a tax increase on dividends paid out of corporate-earned foreign income. indeed, if there is any positive rate imposed on foreign source income, a dividend out of that income will bear a higher tax rate than a dividend paid out of domestic income. thus, the repatriation tax, much decried by exemption proponents,43 is retained; it is imposed at the shareholder level rather than at the corporate level. perversely, only if the foreign income is not subject to any tax would dividends out of foreign and domestic source income bear the same tax. the inherent incentive in a territorial system to earn income in no-tax countries would thus be aggravated. second, the panel proposal replaces the asserted lock-in effect under current law for income earned abroad with a lock-in 2007 territorial vs worldwide international tax systems 301 effect on distributing dividends out of foreign earnings. thus, the only way to avoid the shareholder level repatriation tax is the same as that used to avoid the current corporate-level repatriation tax: do not distribute dividends to a u.s. parent corporation out of business income earned by a foreign subsidiary. third, and following from the first two points, is that the sophisticated tax planning that currently takes place to avoid the corporatelevel repatriation tax will shift to be carried out to avoid the shareholder-level repatriation tax. it is thus clear that, under the panel proposal, both horizontal and vertical equity principles would be violated. shareholders with the same amount of dividend and other income generally would not pay the same amount of tax. nor would there be any guarantee that higher income shareholders would bear a relatively greater tax than lower income counterparts, at least not in the manner specified in irc §1. part vi the panel report missed an opportunity to assist u.s. tax policy makers and the american public by comparing its proposed exemption system only to the current flawed ftc system. in my view, it would have performed its stated mission far better if it had also compared its exemption proposal with a model wwi/ftc system so that taxpayers and tax policymakers could have formed a better judgment as to which direction the u.s. should move in reforming its international tax system. of course, had the panel done so, it might well have concluded, as did this examination of the issues, that a model wwi/ftc system is superior to a territorial system, on simplicity, efficiency, and equity grounds. florida tax review volume 1 october 1992 nuiber i valuing personal consumption: cost versus value and the impact of insurance daniel halperin" "an ideal income tax would perhaps differentiate among individuals according to their talents for using funds in consumption; but ... income taxes must [be based upon] measurable quantities! ... [clonsumption, as an element of income, must be measured ... by outlays for consumption purposes."' i. introduction andy is excited. he has finally been able to get the money together for an expensive new car. after years of making do with a used car or cheaper models he is about to pick up a new $50,000 mercedes sedan. but alas! andy's dream of years of driving comfort are soon shattered. the car is a lemon. it is constantly in the shop for repairs wasting andy's time and eventually costing him several thousand dollars. in the end, it never drives as well as expected. would an ideal tax system, as simons suggests, take some account of andy's misfortune? should we, if we could, somehow determine what the car is really worth and allow andy a deduction for the difference between that amount and his outlay of $50,000? alternatively, should we ideally allow a deduction for the extraordinary cost of repairs, the amount spent * professor of law, georgetown university law center. j.d. harvard. 1961. like many law professors, i have been thinking about the issues raised in this article for a long time. i am grateful to boston university law school for inviting me to a workshop which led to the initial draft of this article. i have benefitted from comments at that workshop, a workshop at georgetown, and from comments received at a 1989 seminar on current research in taxation sponsored by the harvard law school fund for tax research. i also want to thank my colleague stephen cohen as well as professor lawrence lokken with whom i exchanged early drafts of our respective musings on this subject. professor lokken's draft stimulated my thinking on a number of points. i am particularly indebted to my colleague richard diamond for his suggestion which led to one of the central ideas in this article. my research assistants, particularly daniel luchsinger and ajay mehrotra. contributed enormously to this effort. 1. henry c. simons, personal income taxation: the definition of income as a problem of fiscal policy, 119-20 (1938). florida tax review beyond what would normally be expected? is our failure to take account of andy's misfortune a concession to administerability rather than a matter of principle? this article explores the answer to that question as well as whether recoveries, from insurance or otherwise, should be taxable, if such losses are disallowed. there are a number of reasons why there might be a great deal of difference between the amount of enjoyment derived from a consumer purchase and the cost to the individual on the market. consumer surplus, circumstance of use, variation in quality, events subsequent to purchase, and changes in market price may explain the discrepancy between actual enjoyment and cost. consumer surplus is the difference between the amount the buyer is willing to pay and the market price.' the difference occurs because sellers cannot efficiently determine each buyer's willingness to pay, and hence cannot extract that amount in price. thus, it is not possible for a seller, say of wine, to charge each consumer the amount she is willing to pay. for some, an excellent bottle of wine might be worth $50, but if there are not enough such individuals to buy the entire supply, the price will be lower. to simplify, the market price will be the highest price that will move the merchandise on hand. if a person would be willing to pay $50, but she can buy the bottle of wine for its market price of $30, she will be said to have obtained $20 of consumer surplus.3 individuals will also differ in the circumstances under which they will use the product. a bottle of wine enjoyed with a loved one, perhaps on an anniversary or birthday or in the company of superior food, may take on additional value. some purchases will be rarely used, such as an exercise bike purchased at a time when dreams of self-improvement momentarily took control. items which are supposedly alike may differ in actual quality. some automobiles are lemons. there can be differences in taste among wines of the same vintage. if information is available as to the range of quality but not as to the quality of any particular item, one should expect the price to reflect average quality.4 in other circumstances, perhaps due to fraud, all items of 2. paul a. samuelson & william d. nordhaus, economics 733 (14th ed. 1992). 3. inclusion of consumer surplus or other non-monetary satisfactions (watching sunsets) in the tax base, even if feasible, could lead to difficulty in payment of the tax for those for whom such satisfactions represent a large proportion of their income. somehow the impact of the potential tax would have to be taken into account in determining the true amount of the benefit. see daniel i. halperin, business deduction for personal living expenses: a uniform approach to an unsolved problem, 122 u. pa. l. rev. 859, 882-85 (1974). this matter is not pursued in this article. 4. while the price will reflect average quality in the case of new products, that may not be the case for used goods. the literature suggests that because everyone believes used [vol 1:1 valuing personal consunption a particular product will turn out to be worth far less than the price charged. this variation in quality may be reflected by differences in the cost of upkeep or repairs. if the value of consumption is based simply on expenditures, an automobile with a terrible repair record would be found, contrary to common understanding, to produce more enjoyment than one which is trouble free.5 a difference in value may also arise because of events, possibly fortuitous, which take place after the initial purchase. an automobile may be involved in an accident. a bottle of wine can break. a vacation may be ruined by bad weather, an elegant dinner because of the chef's disposition. many arbitrary events can alter the identity between cost and amount of enjoyment. finally, there may be changes in relative market prices. a home or a work of art may increase or decline in value.6 arguably these gains and losses, whether from market fluctuation or otherwise, should be taken into account in an ideal tax system whether or not the asset is actually sold. currently, however, such gains and losses are generally ignored. gains on consumption expenditures are recognized only upon sale or other disposition of the items. while certain medical expenses may be deducted,7 other losses are taken into account only in the event of a "casualty"-a sudden unexpected and unusual event, such as a collision or fire, as opposed cars are "lemons" their price reflects the bottom of expected quality. see george a. akerlof. the market for "lemons": quality uncertainty and the market mechanism. 84 q. j. econ. 488, 489-90 (1970). 5. see zarin v. commissioner, 92 t.c. 1084, 1101 (1989) (tannenwald. j., dissenting), rev'd, 916 f.2d 110 (3d cir. 1990). in an analogous situation. judge tannenwald argued against the proposition "that the more a gambler loses, the greater his pleasure and the larger the increase in his wealth." id. 6. sometimes a product may be sold for more than the purchase price even if the underlying market does not change. thus. if a wine improves with age, its price can be expected to rise as it approaches the ideal time for consumption. for example. a bottle of wine purchased for $30 may be expected to sell 10 years later for s60 even if there is no change in the underlying market value for the wine. this increase in price reflects the fact that an individual who purchases the wine when it is first bottled gives up the opportunity to invest the sum devoted to the wine. if he did not expect a return on this investment, he would wait and purchase the wine when it was ready for drinking. although the difference between s30 and s60 does not reflect current use value, it seems related to imputed income on a consumer durable which is ordinarily not subject to tax. suppose, however, the price of the wine actually increases to s100. a sale of the wine for $100 would produce taxable income of s70, consisting of the imputed return of $30 and an increase in market price of $40. 7. irc § 213(a). 19921 florida tax review to an unusually high cost of repair.8 further, while at one time casualty losses were deductible in full, such losses now can be deducted only to the extent that they are truly extraordinary in that losses for the year exceed 10% of adjusted gross income.9 this article analyzes whether these results are correct as a matter of principle or merely-as simons suggests-a concession to reality?'0 a related question that this article also considers is whether insurance and tort recoveries that compensate for a loss related to a consumption item should be taxable. to illustrate, andy may not be totally out-of-luck. the repairs are likely to be covered by a dealer warranty. in fact, under recently enacted legislation, in some states, he may be entitled to a new car to replace a "lemon."" if andy's car were destroyed by collision or fire, he would probably recover the amount of his loss from either his insurance carrier or the tortfeasor who caused the damage. intuitively, i believe most of us would conclude that such recoveries or benefits from the dealer, a tortfeasor or an insurance carrier should not be taxable to andy. after all he is no better off than those who did not suffer 8. personal losses are deductible only if they "arise from fire, storm, shipwreck, or other casualty, or from theft." irc § 165(c)(3). the internal revenue service has defined the terms "sudden," "unexpected," and "unusual" in the following manner: to be "sudden" the event must be one that is swift and precipitous and not gradual or progressive. to be "unexpected" the event must be one that is ordinarily unanticipated that occurs without the intent of the one who suffers the loss. to be "unusual" the event must be one that is extraordinary and nonrecurring, one that does not commonly occur during the activity in which the taxpayer was engaged when the destruction or damages occurred, and one that does not commonly occur in the ordinary course of day-to-day living of the taxpayer. rev. rul. 72-592, 1972-2 c.b. 101, 101-02. 9. irc § 165(h)(2). 10. "to abandon amounts paid and market prices as measures is to leave one's self stranded in the intellectual desert of subjective values and psychic numeraires." simons, supra note 1, at 119. if one purchases a vacuum cleaner and finds that it will not sweep, this fact must be recognized in the computation of "final income." such a proposition may seem too obvious to question; yet one may apply the same line of argument to purchases of patent cures that cure nothing, informational literature that misinforms, and almost everything sold by false representations. simons, supra note 1, at 120 (citing economics and accountancy 166 (1929)). 11. see e.g., cal. civ. code § 1793.2 (west supp. 1992); fla. stat. ch. 681.10-.i 18 (1991); pa. stat. ann. tit. 73, §§ 1951-1963 (supp. 1992); p.r. laws ann. tit. 10, §§ 20512065 (supp. 1989); va. code ann. §§ 59.1-207.9 to .16 (michie 1992). [vol 1:1 valuing personal consumption a loss. there is statutory support for this result? but insurance recoveries are not always nontaxable, as hal millsap discovered to his chagrin. 3 millsap was not a lucky fellow. his residence was severely damaged by fire and became temporarily unusable. fortunately for millsap, his insurance policy provided him with $2,500 for temporary living expenses, sufficient, he thought, to bear the expense of a motel. but this turned out not to be true, as the internal revenue service succeeded in including the proceeds in millsap's income.' 4 my intuition that most of us would think this unfair turned out to be correct, as congress quickly reacted to overturn this result.' 5 in the future, people whose homes are damaged or destroyed by fire, storm or other casualty will not be subjected to tax on the portion of their insurance recovery for living expenses that exceeds their normal living expenses.' 6 the legislation, however, is limited to the millsap situation-extraordinary living expenses resulting from loss of use of occupancy of a principal residenceand does not cover such cases as car rental to replace a stolen car or even compensation for loss of use of a second residence. can any principle, beyond intuition, explain when and why a recovery from an insurance company or tortfeasor should be nontaxable? can such a principle reconcile non-taxation of such recoveries with the lack of deduction to andy if he is uninsured and personally bears the loss? alternatively, would consistency require that a deduction be allowed to the unreimbursed andys of the world to reflect the difference between their situation and the situation of those who were made whole without being subject to tax? in other words, should the tax system explicitly take account of any differences between expenditures and actual enjoyment of goods and services? 12. a specific exemption applies to amounts received on account of death. irc § 101, personal injury or sickness, irc § 104(a)(3), for living expenses resulting from loss of use or occupancy of a principal residence due to a casualty such as fire or flood. irc § 123, and for an insurance recovery, with respect to property destroyed by casualty, which is reinvested in similar property, irc § 1033. the list of exceptions suggests insurance recoveries could be taxable in the absence of a specific statutory exemption. most people probably believe there should be no taxable income to a tortfeasor when the insurance company pays a victim's claim against her but it is not clear how to reach this result under the present code. boris i. bittker, a comprehensive income tax base? a last word 126 (1968): see charles 0. galvin & boris i. bittker, the income tax: how progressive should it be? 64 (1974). 13. millsap v. commissioner, 387 f.2d 420, 423 (8th cir. 1968). 14. id. 15. irc § 123, titled "amounts received under insurance contracts for certain living expenses." 16. the exclusion is limited to the actual living expenses incurred during the period, in excess of the normal living expenses that would have been incurred during the period. irc § 123(b). 19921 florida tax review initially, it would seem that the answer to these questions requires an understanding of the proper tax base under an income tax system. an examination of the literature, as more fully described in part ii, does not, however, indicate any unanimity of opinion as to the proper role of the actual value of goods and services enjoyed by a taxpayer in determining the applicable tax base. some suggest that consumption is irrelevant-we should care only about income, namely the amount available for consumption. 7 others argue that ideally we should look to actual enjoyment of goods and services-taking into account differences that are both large and measurable.8 since i believe that most significant losses are a result of voluntary behavior or could be avoided through insurance, i tend to prefer the ex ante approach. further, if the ex post perspective were adopted, both equity and efficiency, in terms of incentive to insure, would require the recognition of gains (more than expected enjoyment) in addition to losses. since i believe this is unlikely to occur, i ultimately conclude that regardless of whether in principle one favors an ex ante or ex post approach to measurement, consumption should normally be measured ex ante by the amount expended. as suggested, i reach this result because it can be shown that for administrative reasons an ex ante approach may in many instances be a better second best approximation of actual enjoyment than an attempt to measure such enjoyment is likely to be. finally, i believe that exemption for insurance and other recoveries can generally be reconciled with nondeductibility of losses for those who are not reimbursed. because the degree of comfort one has with these suggestions may well depend upon one's view of the ideal tax base, i begin in part ii with a discussion of the "correct" tax base under an income tax. although i deal with the issue on the assumption that we continue the present income tax base, the question must also be faced under a consumption tax which would generally be measured as income plus or minus the change in savings during 17. simons, supra note 1, at 139; see mark g. kelman, personal deductions revisited: why they fit poorly in an "ideal" income tax and why they fit worse in a far from ideal world, 31 stan. l. rev. 831, 835 (1979). 18. william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309, 313 (1972). according to robert m. haig: modem economic analysis recognizes that fundamentally income is a flow of satisfactions, of intangible psychological experiences.... if one spends his dollar [of income] for something more durable than a dinner-say a book or a pipe-is his true income the book or the pipe, or the series of satisfactions or "usances" arising from reading the book or smoking the pipe? there is no doubt as to the answer.... a man strives for the satisfaction of his wants and desires and not for objects for their own sake. robert m. haig, the concept of income-economic and legal aspects, in readings in the economics of taxation 54, 55 (r. musgrave & c. shoup eds. 1959). nvot. 1:1 valuing personal consmnaption the year.' 9 i then turn in part iii to the implementation of the ex ante and expost alternatives without regard to the possibility of recoveries of loss from insurance, tortfeasors or otherwise. in part iv, i explore the treatment of such recoveries. part v, which concludes with a brief discussion of insurance to protect against loss of income, explores whether insurance raises total utility by providing security and peace of mind. ii. choosing the "proper" tax base i begin by considering whether the reason income is chosen as a tax base can help determine how income should be defined. some view income as the best indicator of ability to pay for the cost of govemmentz) they sometimes assert that the tax rates should be set to extract an equal level of personal sacrifice. 2' by itself "equality of sacrifice" is an ambiguous term. it can either mean that the loss of units of utility demanded of each individual be equal ("equal sacrifice") or that each taxpayer should be required to give up an equal percentage of total utility derived from income ("proportionate sacrifice"). if utility per dollar of expenditure declines as income rises, the latter interpretation would require progressive rates. others have more explicitly focused on the role of the income tax in redistributing society's resources. according to professor alvin c. warren, "an income tax serves to deflect to the government, for the purpose of providing for public goods and for distribution of the remainder, a progressive portion of each citizen's share of the product otherwise allocated to him by transfers and the marketplace."' professor thomas griffith, expressing a similar view, explicitly grounds his proposals upon principles of distributive justice.24 he offers two notions of welfare maximization for consideration: 19. see william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1149 (1974). under the andrews proposal. the tax base would be more or less as it is now decreased by any addition to savings or increased by withdrawal from savings. 20. see generally, joseph bankman & thomas griffith. social welfare and the rate structure: a new look at progressive taxation, 75 cal. l. rev. 1905 (1987). 21. for those who view the payment of taxes as a "coerced contribution to the government ... a confiscation of property," the equality of sacrifice argument assures that the pain associated with taxes is apportioned equitably. walter j. blum & harry kalven. jr., the uneasy case for progressive taxation, 19 u. chi. l. rev. 417, 455 (1952). generally, this argument ignores the government benefits originating from taxation and concentrates on the sacrifices taxes entail. 22. id. at 457. 23. alvin warren, would a consumption tax be fairer than an income tax?. 89 yale l.j. 1081, 1090 (1980). 24. thomas d. griffith. theories of personal deductions in the income tax. 40 hastings lj. 343, 345 (1989). griffith criticizes professors kelman and andrews for not 1992] florida tax review maximizing total societal welfare, utilitarianism, or improving the lot of the least well-off member of society, the rawlsian maximin. 5 griffith's model assumes that the marginal utility from any given expenditure declines as income rises and is the same for all individuals at any income level.26 if the tax is to be assessed so as to cause the minimum reduction of total individual utility, it follows that, except for incentive effects, the tax rate would be 100% at the highest income levels until the requisite revenue was collected.27 in measuring the base, any expenditures that do not provide utility, which in this model would include medical expenses, should be excluded.28 in any event, whether the goal is redistribution, or equal division of sacrifice, for the goal to be accomplished the tax base must correctly measure resources. redistribution requires that we take more from those who enjoy greater resources in order to provide for those who initially have smaller claims. equality of proportional sacrifice also requires that those with more resources should pay more tax. in either case, two individuals with the same resources should pay the same tax. it is not clear, however, what we mean by resources in this regard. as henry simons described it, income is the algebraic sum of consumption29 and accumulation.3' one way of thinking about simons's maxim is to focus on the term income, the right side of the equation being merely descriptive of the only two uses of income. if one takes this view, one might well conclude that how one spends income and the results of such spending are irrelevant.3' income is important not use. professor william d. andrews, on the other hand, focused on the right side of simons's formulation32 and concluded that the ideal tax base explicitly grounding their proposals upon any "coherent normative principle," such as a principle of distributive justice. id. 25. id. utilitarianism seeks to provide the greatest good to the greatest number; thus, it is willing to sacrifice individual desires in the name of maximizing society's total benefit. the rawlsian maxim, with its bottomup perspective, proposes to maximize the utility of the marginal members of society, despite the decrease in society's total benefits. 26. id. at 392-93. 27. id. at 394. 28. id. 29. more precisely, simons defines consumption as "the market value of rights exercised in consumption," which, if taken literally, means that simons would not have taken account of what was actually consumed. simons, supra note 1, at 50. 30. simons defines accumulation as "the change in the value of the store of property rights between the beginning and the end of the period in question." simons, supra note 1, at 50. 31. see kelman, supra note 17, at 835. 32. see andrews, supra note 18, at 313. of course, such an interpretation of simons's maxim makes a "shift toward a more explicitly consumption-oriented tax ... appear [vol 1:1 vahing personal constumption took account of the actual value of goods and services or consumption enjoyed by the taxpayer.33 according to professor andrews, consumption outcomes ought to be taken into account when it is reasonable to do so, such as when there are large differences that are administratively feasible to measure. 34 professor andrews's provocative article has led, in recent years, to a lively debate about the proper role of personal deductions under an income tax.3 1 the arguments raised in this debate, particularly with respect to medical expenses36 and casualty losses, 37 are relevant to the more general question considered herein: should the value of consumption expenditures ideally be based on the market price or on the amount of actual enjoyment to the taxpayer? we now turn to this debate concerning the proper tax base. possible bases include earning capacity, power to consume after taking account of the extent to which earning capacity has been exercised, and ultimate utility or satisfaction perhaps only taking account of involuntary losses of utility. a. alternative standards 1. earning capaciy.-it might be said that ideally an income tax should be based upon earning capacity. this method would best reflect the individual's potential to acquire resources and thus may "best assess the sacrifice a particular taxpayer is making when he is asked to give a certain sum of money to the state., 38 implementation of this concept raises a number of questions. would much less radical than it is commonly assumed to be." andrews, supra note 18, at 317. recognition of the importance of the consumption element lends support to my view that entertainment and other forms of enjoyment derived while engaged in business should ideally be included in the tax base even if the expenditure is wholly justified for business reasons. see halperin, supra note 3, at 862. 33. andrews, supra note 18, at 313. 34. andrews, supra note 18, at 329-330. 35. a variety of personal expenditures are deductible under the present income tax, including medical expenses, irc § 213 and casualty losses, irc § 165(c)(3). 36. see griffith, supra note 24: louis kaplow. the income tax as insurance: the casualty loss and medical expense deductions and the exclusion of medical insurance premiums, 79 cal. l. rev. 1485, 1493-99 (1991); kelman, supra note 17. at 858-79. 37. see kaplow, supra note 36, at 1489-93 for a discussion concerning casualty losses. 38. kelman, supra note 17, at 841. although professor kelman raises the earning capacity argument, he ultimately rejects this standard in favor of a net receipts tax. he believes "that once people deliberately exercise their earning power in the market, the tax system should measure their relative positions as a prelude to redistribution." keiman. supra note 17, at 880. 19921 florida tax review actual earnings in excess of the amount expected from an individual of a particular ability also be taken into account? while individuals who spend their time beachcombing or who leave their money in a mattress would have some income imputed to them, it is more difficult to determine the correct treatment of a taxpayer who tries but is unsuccessful, either in investment or in exploiting the value of her personal services. the assertion that you should have done better and, therefore, we will include more than you actually earned in income is troubling, i think, even under a capacity approach. these questions have not been explored because no one argues that the tax base should actually be based upon capacity. there are two reasons. first, such a tax would violate the simple libertarian principle that the state should not require people to engage in particular activities. for example, if the tax were based on how much a taxpayer could earn, a law school professor might be forced to practice law in order to pay the tax. second, measurement of earning capacity would be too intrusive. presumably, in addition to education level, one would have to measure such attributes as intelligence, judgment and charm.39 2. income or power to consume.-these concerns could lead one to reject earning capacity as a tax base in favor of income or realized power to consume. this approach is responsive to the belief, based on administrative grounds, that the tax base must be measured mostly by money earned in market transactions. it also would be simpler to implement and far less intrusive than efforts to measure either earning capacity or the actual value of consumption. beyond administerability, there is logic to measuring taxable capacity by power to consume. the assertion that equality of such power is all we can hope to achieve is appealing. as kelman puts it, "[o]nce the taxpayer voluntarily takes control of resources, her particular subsequent uses of those resources are irrelevant to tax law., 40 behavior will be most efficient if individuals bear the full burden of their errors. at least in terms of expectancy, the individual will get what he pays for and even outcomes will often be subject to the individual's control. for example, one who does not research thoroughly before purchasing can expect to get less bang for the buck. in addition, variations in outcome could in some circumstances be prevented by adopting less risky behavior or by the purchase of insurance. although i think the issue is a close one, on balance, i find the arguments for the income approach more persuasive than those in favor of the actual enjoyment approach. 3. actual enjoyment.-there is, nevertheless, force to the idea that the disparities we are concerned with are disparities in actual enjoyment of 39. see generally kelman, supra note 17, at 855. 40. kelman, supra note 17, at 835. [vol 1:1 valuing personal consumption real goods and services.4' this may be particularly true if failure to utilize consumption power to the fullest is not the fault of the individual. in many cases, consumers constrained by limited resources cannot adequately prevent losses.4 2 according to professor andrews, while the concept of ability to pay may suggest that taxes should be levied by the receipt of income (which shows such ability, whether or not it is devoted to personal consumption), an ideal personal income tax would apportion tax burdens to a taxpayer's "aggregate personal consumption plus accumulation of real goods and services. ,4 3 "[i]ncome once earned and received is [not] income whatever is done with it."44 andrews's focus on ultimate enjoyment of real goods and services makes sense "if we think part of the purpose of a graduated income tax is relative redistribution ... [since] [wihat we mean to redistribute ... must be shares of real goods and services which persons otherwise would be consuming .... ,4 according to andrews, "[w]e rely on money expenditures to provide a practical measure of the real consumption ... which such spending buys" only because we cannot measure consumption directly.46 but, "if consumption ... of real goods and services is less than ... money income ... in any substantial and ascertainable way, ... that discrepancy should be adjusted for by a deduction from money income." '47 griffith's focus on minimizing sacrifice would also apparently lead to a tax base based on actual enjoyment. griffith appears to agree with andrews that an "unvarnished net income tax base would not ... redistribute to those most in need ... because net income is likely to be a less accurate measure of need than a tax base that takes into account such items as medical expenses and casualty losses...." professor stanley a. koppelman also advocates a more direct linkage 41. andrews, supra note 18, at 326. 42. the poor are more often victimized by limited outlets, insufficient consumer information and exploitative rental policies. cf. kelman. supra note 17. at 860 n.87 (noting that the poor are more likely to make "bad buys"). 43. andrews, supra note 18, at 327. andrews says the tax should be based on consumption of real goods and services because that is what will be ultimately sacrificed to pay the tax. andrews, supra note 18, at 327. many have noted, however, that there would not necessarily have to be an identity between the tax base and the medium of payment. see e.g.. halperin, supra note 3, at 883. 44. andrews, supra note 18, at 325. 45. andrews, supra note 18, at 326. 46. andrews, supra note 18, at 327. 47. andrews, supra note 18. at 325. 48. griffith, supra note 24, at 384. 19921 florida tax review between the tax base and theories of welfare maximization,49 such as rawlsian or utilitarian philosophy.5" under his view, "the consumption component of income involves the exercise of economic consumption power in a manner intended to produce a current personal benefit."'" while voluntary expenditures unrelated to profit-seeking activity should be considered taxable consumption, koppelman agrees that deductions for involuntary expenditures may be justified because the involuntary nature of the transactions may suggest that the taxpayer does not receive personal value equal to the amount of the expenditure.5" there may be no personal benefit because "the expenditure compensates for a psychic, noneconomic loss which necessitated the expenditure." 3 b. choosing the base this discussion suggests that a reasoned argument could be made either for the view that ultimate enjoyment should be taken into account or that we should focus solely on expenditures without regard to how things work out. in all likelihood neither reason nor logic will help us choose between an ex ante or ex post approach to measuring the benefit of consumption expenditures. this dilemma could be avoided, however, if we could conclude either that there is not likely to be a material difference in the results of the two approaches, or that, because of likely imperfections in implementing the ex post perspective, it is unlikely to do a better job of measuring actual consumption than the ex ante method. these questions are discussed in the next section. iii. implementation of ex ante or ex post approach in this part, i explore a number of points which relate to the question of whether a tax system which ignores consumption gains and losses is, nevertheless, likely to give a fairer picture of ultimate satisfaction than one which uses an ex post, direct, measure of such enjoyment. i believe that the ex ante approach may be more accurate for a number of reasons. first, there is no reason to suspect that there would often be large differences between expenditures and enjoyment. in part this is true because what at first glance appears to be a loss may on a closer examination 49. see stanley a. koppelman, personal deductions under an ideal income tax, 43 tax l. rev. 679, 697-704 (1988). 50. id. at 698-700. 51. id. at 705. 52. id. at 709. 53. id. at 710. [vol 1:1 valuing personal consuniption be merely a reflection of a pattern of consumption. in addition, we might expect losses and gains to even out. but it seems likely, as is developed below, that any attempt to measure consumption ex post would not only exclude some losses while allowing others, but more importantly would systematically exclude gains while allowing losses. if this is the case an ex post approach would understate aggregate income and it may well tend to exclude gains achieved by the very persons whose losses would be taken into account. finally measuring consumption ex ante does not preclude taking into account an increase in the market value of housing and other consumer durables. a. ex ante and ex post measures may not differ significantly if there is no reason to suspect that any one individual or class of individuals is likely to experience unusual differences between cost and actual enjoyment, it is at least possible that the purchase price will give a fair indication of overall enjoyment. to pursue this further, let us look at the reasons previously identified as causes for the difference between purchase price and outcome. consumer surplus, which measures the difference between willingness to pay and price, is one reason for the difference between cost and actual enjoyment. i see no reason why consumer surplus would not be somewhat equally distributed, at least among people in the same income class. some suggest that consumer surplus is not "distributed unevenly across classes; thus, it poses no vertical equity problems."' on the other hand, it seems to me that those with large amounts of income would willingly pay much more than market price for such items as ordinary entertainment and travel." this income effect would create larger consumer surplus for each dollar spent by the well-to-do. although changes in market prices and variation in the quality of the particular item among models should be random, choosing wisely among models and avoiding fraud and misrepresentation might not be. one suspects that the less well off or the less well educated are more likely to be victimized by lower quality products as they have less resources with which to research potential purchases and access to fewer sales outletsy still, if the amount of difference between cost and outcome is not 54. mark g. kelman, time preference and tax equity. 35 stan. l rev. 649, 657 n.23 (1983). 55. but see herbert hovenkamp, positivism in law & economics. 78 cal. l rev. 815, 839-40 (1990) (arguing that while the rich may have a greater willingness to pay, that does not necessarily mean they achieve greater utility from a purchase). 56. see kelman, supra note 17, at 860 n.87. 19921 florida tax review likely to be significant among people at a particular income level, it may not be important that there might be large differences between one income level and another. these vertical differences can be handled by varying the rates more than the amount required by the desired degree of progression." suppose a rate of 15% was imposed on lower levels of income and a rate of 28% on higher levels of income on the assumption that the tax base correctly reflected all resources or at least an equal proportion thereof. if it were believed likely that income at the higher level was understated to a greater degree, lowering the 15.0% rate to 14.5% and/or raising the 28.0% rate to 28.5% could ameliorate the vertical inequity. i recognize that it may be naive to believe that rates are chosen solely to achieve a certain distribution. there may be political or efficiency objections to higher rates even if the distribution of resources is less than "ideal." for example, high marginal rates may be said to inhibit investment or work effort. nevertheless, at least in theory, vertical inequities can be eliminated through a rate adjustment without correcting the tax base. b. apparent losses are not always real while we all may commonly experience "the minor frustrations of life," the burdens of serious casualties and illnesses may not be equally distributed even at a particular income level. andrews suggests there would be "large differences in ... [the] magnitude ... [of medical expenses] between people in otherwise similar circumstances."58 this also seems to be the view of professor boris i. bittker who defends the deduction for casualty losses as follows. in a statistical sense, of course, destruction by fire is one of the hazards of home ownership "voluntarily" assumed when the taxpayer chooses to buy a personal residence. but if a dog can distinguish between being kicked and being stumbled over, as holmes asserted, we can properly distinguish between the minor frustrations of life-a cigarette burn in a rug, a dented fender, a quarter lost when fumbling for change to put in a parking meter-and major casualties ("sudden, unexpected, and unusual" events that do not "commonly occur in the ordinary course of day-to-day living").59 57. griffith, supra note 24, at 360-363. 58. andrews, supra note 18, at 336. 59. boris i. bittker, income tax deductions, credits and subsidies for personal expenditures, 16 j.l. & econ. 193, 197 (1973). bittker draws some support for the casualty [ vol 1: 1 valuing personal consumption on the other hand, it may be that what appears to be bad luck would often be a direct result of the consumer's behavior. for example, according to kelman, it is plausible that "most medical needs really arise from voluntary decisions to pursue potentially unhealthful activity '" such as smoking, skiing, or not closeting oneself away from potentially tortious automobile drivers. thus, kelman asserts that many departures from good health result from past decisions that gave the taxpayer untaxed benefits." a deduction for loss of health without inclusion of the gains from such risky activities will mismeasure how relatively well-off two taxpayers are.... recognizing that medical spending may involve discretion before illness manifests itself, it is no longer plausible to say that such spending "restores" the taxpayer to a baseline position enjoyed by those without medical care "needs."' professor koppelman finds, for different reasons, that most currently deducted medical expenditures have a strong voluntary component."l since those claiming the medical deduction are typically insured against involuntary costs, he believes generally their uninsured expenditures are at least in some sense voluntary.64 thus, it cannot be said that medical treatment merely restored the pre-illness condition. clocking more miles, driving faster than average or improper care of an automobile are additional examples of voluntary activities that provide loss deduction from an example which purports to show that you need to reach a peculiar conclusion to justify determining simons's income without regard to a casualty loss. in bittker's example, a taxpayer who earns s50,000, spends s20,000 on necessities, and s30,000 to replace a $20,000 residence destroyed by fire. according to bittker. since increase in net worth is $10,000 (new residence s30,000 compared to old residence s20,000), consumption must be $40,000 which can only come from $20,000 of necessities and $20,000 of old residence literally consumed by fire. bittker, 16 j.l. & econ. 193, at 196. however, it would seem more accurate to measure lifetime consumption from a residence by the purchase price in the year of acquisition. andrews, supra note 19, at 1157-58. under this view, the old residence does not enter into the calculation. there is $50,000 of consumption-$20,000 of necessities and $30,000 from the new residence. 60. kelman, supra note 17, at 869. 61. kelman, supra note 17, at 869. of course, no one is suggesting this is true of all illness. 62. kelman, supra note 17 at 869. 63. koppelman, supra note 49. at 712-13. 64. koppelman, supra note 49, at 712-13. of course this is not true to the extent that a loss of job leads to loss of health insurance, and an individual is unable to secure a policy which will cover pre-existing conditions. it is not clear how many people in this position substantially benefit from the medical expense deduction. in any event the true solution to the problem is continuing insurance coverage, not tax relief. 19921 florida tax review unaccountable benefits. the car may depreciate more than expected, but the owner has also derived more consumption, or increased her leisure time. furthermore, differences in the quality of purchases which result among taxpayers, perhaps even at the same income level, could arise in part because some individuals spend more time on shopping and research, reading consumer reports and the like. in a sense the better outcome merely reflects the fact that the expected value among the more cautious group can be said to be higher than that for those who are more cavalier in their purchases. however, members of the cavalier group, all other things being equal, are able to enjoy more leisure time, which, unlike the cautious group, they presumably value more highly than time spent on research. for example, members of the cautious group, after expending five hours on research, each spend $1,000 on an item and the item averages $1,050 in overall quality. members of the more cavalier group also each spend $1,000 on a similar product, but forgo the research and therefore purchase items that average $1,000 in quality. the cavalier consumers also have five more hours of leisure which they value at more than $50. thus, the cautious consumers' research raised their expectancy for the product that invariably led to a greater outcome. the cavalier consumers knew, in the absence of research, they might not get the best product (for example, they had an expected value of only $1,000) but believed the extra leisure time was worth the difference. in both cases average ex post results did not differ from what was expected ex ante. in short, differences in outcome are merely a reflection of a lifestyle providing additional noneconomic pleasures. persons who choose not to insure when insurance is available will get a greater difference between expectancy and outcome than those who choose to insure. the same can be said for those who make more risky consumption choices. while in these cases there may be a real difference between expectancy and outcome, it seems to me that the concerns which lead one to prefer a tax base which takes account of actual enjoyment, as opposed to mere opportunity to consume, may not extend to those whose losses are in this sense voluntary.65 c. attempts to measure outcomes will be incomplete in this section, i explore the possibility that even if actual losses can 65. this latter point seems even stronger if what is lost is a luxury item rather than a necessity which must be replaced. see koppelman, supra note 49, at 709. we will also see later that allowing the uninsured to deduct losses is likely to be unfair because they will tend to have gains which will be ignored. thus, if uninsured losses could be deducted there would be a disincentive to insure which would lead to inefficient behavior. kaplow, supra note 36, at 1491. [vol 1:1 valuing personal consuimption be identified, an ex ante approach might still come closer to measuring actual enjoyment than an attempt to measure outcomes. first, past experience would indicate we might only take account of selected losses. perhaps more importantly, although it has not been generally understood, many of the transactions that can cause losses can also provide gains to others. since these gains are unlikely to be recognized, taking account of losses could unfairly skew the base. this would be particularly troublesome if it is likely that the people who would tend to have losses are also more likely to have gains. 1. consumption windfalls.-it may be that sometimes people make expenditures that do not increase their consumption. individuals incurring such costs may have a claim to a deduction. if so, however, there are others who enjoy a benefit because they spend less than they expected, to achieve a certain level of enjoyment.' these people should have additional income. to illustrate, i present first the purchase and operation of an automobile, and then turn to medical expenses and casualty losses, which have been the subject of extensive discussion. 67 assume bob purchases a car for $10,000. to determine whether the purchase is worthwhile, bob would take account of the costs of operation, including maintenance and insurance, as well as his initial outlay, and compare the total costs with the benefits of driving. assume that bob expects his costs to average $5,000 a year, but the car needs extensive repairs over its life, so the average annual cost is $6,000.6s annual costs will also be more than expected if the car depreciates more quickly than assumed. it may be said that bob has suffered a loss, not necessarily because he derives less value from the car, but because he will be able to buy fewer other goods and services than expected. on the other hand, assume the cost of operation for carol, who owns a similar car, averages only $4,000 annually. since the benefits from driving have not decreased (if anything, driving a trouble free car is more valuable), carol has an unexpected gain of $1,000. put another way, she has the ability, without any diminution of her enjoyment from driving, to buy an additional $1,000 worth of goods and services as compared to what she could buy if her car had an average repair record. if the tax base is to reflect actual consumption, it should include the $1,000 gain to carol and allow the $1,000 loss to bob. since individuals may take flawless performance for granted and certainly have no incentive to bring it to the attention of the internal revenue service, such gains would be even 66. see daniel shaviro, the man who lost too much: zarin v. commissioner and the measurement of taxable consumption, 45 tax l. rev. 215, 232 (1990). 67. see supra notes 17-18 and 36. 68. the comparison is actual to expected costs, not higher cost of repairs on one make of car compared to another. 19921 florida tax review harder to measure and take into account than losses. medical expenses raise similar concerns. some argue that a deduction for medical expenses, in excess of some percentage of gross income, is justified because such costs do not provide greater than expected consumption.69 like bob, who does not get more than the normal benefit from his car despite the extra expenditure, such individuals are no healthier than average. according to andrews, "[tihe right basis for making interpersonal welfare comparisons ... is that ultimate object, good health, rather than the intermediate good..." medical services, which is not a proxy for good health.7 ° if anything, the relation is apt to go the other way. "as between two people with otherwise similar patterns of personal consumption ..., a greater utilization of medical services by one is likely not to reflect any greater material well-being or taxable capacity, but rather only greater medical need.' while it would be impractical to include good health directly, differences can be partially reflected by allowing a deduction for medical services that will be used more by those in poorer health. this approach "reflect[s] differences in health only as they manifest themselves in financial terms. 72 in other words, the best tax base would be money income plus some amount to take account of varying degrees of health, including disabilities encountered from birth. if the base is purely money income, those with poor health would be overtaxed. since high medical expenses tend to reflect poor health, a deduction for such expenditures would be a proxy for taking account of such poor health directly. professor kelman raises a number of objections to andrews's argument.73 he disagrees with andrews's conclusion that expenditures on medical care are a good proxy for differences in health.74 essentially, kelman believes that people with similar conditions spend different amounts or none at all on health care, reflecting to some extent general consumption desires.75 therefore, a medical expense deduction based on the nature of the injury or illness would provide a better picture of differences in well-being. in other words, if b and c suffer from an illness while a is in perfect health, b and c can both be said to be less well off than a by an identical amount. 69. andrews, supra note 18, at 335-37. 70. andrews, supra note 18, at 335-36. 71. andrews, supra note 18, at 314. 72. andrews, supra note 18, at 336. 73. kelman, supra note 17. 74. andrews, supra note 18, at 336. 75. kelman, supra note 17, at 869-70. [vol 1:1 valuing personal consunption b may choose to treat his illness with heavy medical expenditures while c perhaps does not need to because he has adequate insurance or would just rather console himself by eating and drinking well. if one, nevertheless, concludes that excessive medical expenditures fairly reflect differences in well being which should be taken into account in determining the tax base, it would follow that individuals who are still able to enjoy good health despite expending significantly less than the average are, like carol, able to enjoy unexpected additional amounts of other goods and services. ideally, this would be taken into account if excessive medical costs are to be deducted. again, however, this is unlikely to occur. a similar problem arises with respect to what might be called "casualty gains" 76 which correspond to casualty losses for uninsured persons. returning to bob's $10,000 car, implicitly, the car must have an expected value of at least $10,000 even though there is say a 1% chance it will be totally destroyed in the very near future. a car which is not destroyed must then yield $10,101 of enjoyment.' in other words, $10,000 reflects the average expected value of all cars, not just cars which are neither victims of casualties nor lemons.78 taxpayers who do not have an accident obtain $ 10,101 of automobile value for $10,000. the one driver in one hundred who suffers a casualty has a $10,000 loss. if this loss were allowed, the total consumption of the group would be undervalued unless each person who did not have an accident reported a $101 gain.79 if neither gains nor losses are taken into account the group as a whole would report the correct taxable income. since it would be difficult to explain to taxpayers why a good repair record, excellent health, or avoiding an accident should result in taxable income, the type of gains just discussed will not, and perhaps cannot, be taxed. to the extent that losses and gains could be expected to be incurred by the same persons, as they would if some people systematically underinsure or take greater risks in their purchases, we might expect to more accurately measure individual consumption by outlays than if we tried to take outcomes into account. indeed, the notion of allowing losses for such riskneutral individuals while ignoring the noneconomic gains from such risky activity suggests that consumption is best measured by expenditures rather than outcomes. louis kaplow reaches the same result by a different approach. he 76. kaplow, supra note 36, at 1502. 77. this is assuming there is no consumer surplus. a 99% chance of enjoying $10,101 equals $10,000. 78. it would seem that $10,000 is the expected value to the marginal risk-neutral purchaser. if an individual were risk adverse she might demand an expected value in excess of $10,000 in order to make the purchase. 79. shaviro, supra note 66. at 241. 19921 florida tax review finds that if uninsured losses are deductible, individuals would be driven by the tax law to absorb more risk than desired.80 since the loss deduction provides free partial insurance, a taxpayer who chooses to insure and forego the free partial insurance pays for more than the additional coverage acquired. therefore insurance may be rejected where it would otherwise be chosen. because, all other things being equal, they would prefer to avoid the additional risk, if there is an opportunity to insure, individuals would ex ante uniformly prefer lower tax rates and nondeductibility of losses as long as the rate cut was such as to be neutral, on distributional grounds, compared to expected losses. in these circumstances, loss deductibility accompanied by higher rates would leave everyone worse off. thus, kaplow is able to find deductions for medical expenses and casualty losses undesirable without, he says, going through the type of exercise pursued in this article.8" but it is important to recognize that the loss deduction would cause an undesirable change in behavior precisely because of the disparity between the treatment of uninsured gains, which would not be taxable, and uninsured losses, which would be deductible.82 2. only selected losses will be deducted.-federal income tax law has only taken account of medical deductions and losses due to casualty.83 it is not clear what distinguishes casualty losses as defined in the tax law from other disasters. it may be that the requirement that the loss be "sudden, unexpected and unusual"' 4 is essential to distinguish extraordinary occur80. kaplow, supra note 36, at 1500 n.68 & 1505. 81. kaplow, supra note 36, at 1487. while he does not, at least initially, identify the failure to take account of gains to the uninsured as the culprit, at a later point in the article kaplow, citing a draft of this article, notes the idea that a casualty loss deduction is asymmetric because it does not include in income what he refers to as casualty gain. kaplow, supra note 36, at 1502. 82. if gains were somehow accounted for, deductibility of losses would not cause individuals to under insure. thus, exploration of issues of income measurement helps explain, and thereby reinforces, kaplow's conclusion. 83. losses from bad debt on bona fide loans, not connected with a trade or business, are treated as capital losses. irc § 166(d). it has been suggested that bad debts even from loans to relatives or friends reduce net worth and if repayment was genuinely expected, the loss should be deductible. bittker, supra note 59, at 199. it seems to me, however, that in many circumstances, a potential gift was contemplated. for example, a taxpayer may loan $10,000 to a relative, and while repayment is expected, he believes there is a 20% possibility that default will occur. while it is possible that the interest rate is high enough to compensate for the potential default, and the loan would be made by the taxpayer to a stranger under similar circumstances, it seems more likely that there are personal motivations and the taxpayer may well be willing, perhaps without explicitly thinking about it, to make a gift with an expected value of $2,000. when the "gift" turns out to be $10,000 instead, would there be an argument for an $8,000 loss? if so, is there $2,000 of income if the loan is repaid and the gift becomes costless? 84. see rev. rul. 72-592, supra note 8. [vol 1:1 valuing personal consimption rences from normal wear and tear. according to kelman, however, casualty losses resemble other disappointments with purchased commodities.s" automobiles that are "lemons" may involve as big a loss from expected return as those which suffer a fire.86 professor kelman also finds it hard to distinguish health from other psychic pleasures. he believes that it is not plausible that taxpayers differ in health far more than they do in other forms of well being, such as untreated depression, bad marriage, or a boring job.8 in fact, these other conditions, unlike poor health, are more likely to be inflicted on the poor. therefore, it is not appropriate to take account of decline in health without also comparing other noneconomic attributes. in this connection, this article would be remiss and out of step with much of the recent tax scholarship if it did not refer to zarin v. commissioner.88 as probably every reader of this article well knows, zarin lost over three million dollars gambling with chips furnished him on credit by a casino. when the debt was settled for one-half million dollars, the internal revenue service charged zarin with discharge of indebtedness income for the difference. zarin lost in tax court but eventually won on appeal. of concern to this article is whether zarin has a loss equal to the difference between what he spent and the presumed enjoyment derived from gambling.89 as daniel shaviro has pointed out, given the amount of money and time zarin devoted to gambling (huge sums, twelve to sixteen hours a day, over a period of several months), it is likely that his actual losses coincided with the amount he should have expected to lose." therefore, the only argument for a loss deduction would be that because he was a compulsive gambler, zarin's actual enjoyment was much less than even the expected 85. kelman, supra note 17, at 860 n.87; see boris i. bittker & lawrence lokken. federal taxation of income, estates and gifts 1 34.2 (2d. ed. 1989) (listing of significant losses which have been denied as not attributable to casualties). 86. professor kelman also believes that casualties are more likely to be evenly distributed than "bad buys," which the poor are more likely to make. kelman. supra note 17. at 860 n.87. as discussed above, vertical equity may not be a concern, however. see supra note 57 and accompanying text. 87. kelman supra note 17, at 869. 88. zarin v. commissioner, 92 t.c. 1084 (1989). rev'd. 916 f.2d 110 (3d cir. 1990); see babette b. barton, legal and tax incidents of compulsive behavior. lessons from zarin, 45 tax law. 749, 749-50 nn.4 & 7 (1992) (zarin is "widely celebrated" in law school texts and legal commentaries). 89. perhaps more important is whether zarin has a non-taxable recovery, regardless of whether the loss is recognizable. again, however, this presupposes a loss. but if zarin achieved full value from his gambling there is no loss to be recovered. therefore, the issue remains the same--should zarin's mental state be taken into account in determining the value derived from gambling? 90. shaviro, supra note 66, at 233. 19921 florida tax review cost.9' even if an ex post approach to consumption were to be adopted, it is unlikely that such subjective feelings, as opposed to differences in outcome which could be objectively measured, would be taken into account. 92 this reinforces the conclusion that a tax base which ignored losses could be fairer than one which took account of only some losses, such as casualties and medical expenses. this would be particularly so if losses of all types combined tended to be fairly evenly distributed. d. lost paycheck the previous sections in this part suggest that ex post measurement should be approached with extreme caution, if not actually rejected. still, in limited circumstances, we need not measure consumption by the amount of income earned. some who generally prefer an ex ante measurement would favor a deduction for a taxpayer who suffers the loss of his paycheck on the way to the bank. this income may be viewed as never effectively received or appropriated and, therefore, equivalent to never having been earned in the first place.93 of course, the reasons that cause us not to base income on earning capacity do not apply once income has been earned. the amount earned is measurable, and no one has been forced to work in order to meet his tax liability. still, one who is sympathetic to an ex post result but is concerned about the measurement problem might allow losses to reflect a stolen paycheck, or perhaps misplaced cash in general, even if they ordinarily disregarded losses once consumption took place. in this view, a taxpayer whose paycheck is stolen gets no benefit from the transaction and should be entitled to a deduction.94 putting aside problems of proof as to whether a loss actually 91. cf. shaviro, supra note 66, at 236-39. 92. shaviro, supra note 66, at 225. if one is sympathetic to zarin's cause, as most seem to be, it seems a better course to argue he never purchased more than $500,000 worth of chips because the casino's course of conduct made it impossible to enforce the debt. shaviro, supra note 66, at 244. while such a bargain purchase, if it occurred, would not be treated as income, this description of events may be hard to accord with the facts. barton, supra note 88, at 762-65. however, one way to view the settlement is as a purchase price adjustment, analogous to irc § 108(e)(5). shaviro, supra note 66, at 249. 93. see kelman, supra note 17, at 859 n.87; william andrews, basic federal income taxation 519 (3d ed. 1985). 94. an analogous situation may arise in the case of a taxpayer who erroneously overpays her income taxes. in this case, like the loss of cash, the amount the individual can actually spend on consumption is less than would be expected based on the income earned. in the next section, at note 126, i consider whether taxpayers who recover from an accountant or other person who caused an excessive income tax to be paid can exclude that recovery from income. if the exclusion is allowed, should a taxpayer who is unable to recover be entitled to a deduction to recognize, as in the lost paycheck case, that his income does not fairly reflect [vol 1:1 vahing personal consumption occurred, the amount of the loss, since it is money, can be measured and it is unlikely that the person suffering the loss would have unreported gains of a similar type. nevertheless, it could be that the loss of a paycheck or theft of cash is a result of a life-style choice, just in the way that some see many medical expenses. for example, the taxpayer may lose his paycheck when he stops in a bar on the way home from work. further, allowing this type of loss and not others could be viewed as favoritism toward some taxpayers. e. sale of assets held for personal use despite the general adoption of an ex ante approach to measuring consumption, there is no question that if an automobile or a boat is voluntarily sold in a market transaction, gain, if any, will be taken into account. we need to consider whether it is the sale, which makes such gains measurable, or whether there is some other attribute that distinguishes this case from an absolutely wonderful dinner, perfect weather during vacation, or an extraordinarily exciting baseball game, all of which might be worth more than the price paid. it must be recognized that regardless of how consumption is measured, income would be determined according to how things turned out, rather than by expectancies.95 a lottery ticket purchased for one dollar probably has an expected value of less than fifty cents, but the winner of a forty million dollar jackpot will be taxable on the forty million dollars. in measuring income, ex post results count not ex ante expectations. but if we are to take account of actual outcome with respect to income but only expectancy as to consumption, it is necessary to clearly draw a line between the two activities. this may not be easy.9 many consumption purchases have an investment aspect. the purchase of a residence, an automobile, fine wine, art, or jewelry is in many ways an investment similar his spending power? 95. see michael j. graetz, implementing a progressive consumption tax. 92 harv. l. rev. 1575, 1601 (1979). 96. as simons puts it: consumption, presumably, should be measured in terms of values at the time of consumption; but to ignore changes in value between time of purchase and time of use will ordinarily make very little difference. the difference might be large, of course, where a man purchased choice beverages and allowed them to acquire the quality and distinction of ripe age.... at all events, there is suggested here the difficult question of where to draw the line between acquisition of means and their employment. at what point shall the idea of gain or loss be dropped. one finds no ready answer.... simons, supra note 1, at 119. 19921 florida tax review to the purchase of a stock or bond. with respect to items such as artworks and jewelry, and perhaps a residence as well, a purchaser would often count on appreciation to provide a return on his "investment" in addition to the imputed income from use. whether or not this is the case, with respect to consumer durables it should be explicitly recognized that the true element of consumption is the value of the use of the item and that the purchase is in effect an investment.97 unlike a ball game, dinner or vacation the consumption value of more durable items still exists in the future, and it is possible by sale to switch one's consumption to other items. this is hard or impossible to do for most items of consumption. when appreciation occurs, the ability to shift consumption to another form seems to reflect increased market power to consume and not merely the level of enjoyment from purchases after the fact. therefore, it would be appropriate to take gains on consumer durables into account even if unrealized. as richard a. epstein has noted, it appears to be the realization requirement and not the ex ante approach that keeps this from happening.98 this impact of the realization requirement is particularly troublesome because the result is exemption rather than, as is the usual case, deferral. exemption could extend to even realized gains under present law. because we do not adjust basis for depreciation99 there is gain on sale only if the selling price exceeds the original cost. apart from residences, where gains are most often deferred and eventually forgiven, and art and other collectibles, which generally do not depreciate, appreciation over the original cost with respect to consumer items would be extremely rare. but, if we adjusted basis for depreciation, which we should do whether or not depreciation is deductible, gains upon sale would be more common. apparent gain would reflect not only changes in market price but such variables as better than average quality or lower than average wear."° in the latter case, however, if depreciation were properly measured, there would be no gain to report. for example, assume agnes's automobile costs $10,000, should normally last five years and decline in value at the rate of $2,000 a year. after three years of use agnes sells her car for $5,000 or $1,000 above the depreciated basis of $4,000. the gain could reflect a rise in market value (overall good quality) for automobiles of that vintage, recognition, based on repair record or otherwise, that agnes owns a better 97. joseph a. pechman, the brookings institution, what should be taxed: income or expenditure? 94 (ed., 1980). 98. richard a. epstein, the consumption and loss of personal property under the internal revenue code, 23 stan. l. rev. 454, 457 (1971). 99. irc § 167. 100. see graetz, supra note 95, at 1617. [vol 1:1 valting personal consumption than average car,'0 ' or merely the fact that agnes has driven fewer than average miles. if, however, depreciation in the value of an automobile reflects not only the period of ownership but also the level of use and care, in the last case the adjusted basis of agnes's automobile should not be $4,000 but rather should be $5,000 to indicate that depreciation over the three years of use was less than the $6,000 expected. put another way, agnes did not get 60% of the expected use of the automobile over the three years that she owned it; more than 40% was saved for the future. she had only $5,000 of use and $5,000 of cash from her original $10,000 expenditure, and consequently she had no gain.102 professor epstein recommended allowance for losses as well as taxation of gains on transfers of consumer durables and residences (after properly adjusting basis for depreciation).' whether allowing a loss is appropriate would again seem to depend on the reason why the loss was incurred.,'t in addition to the possibility of a decline in market value for automobiles of that vintage, a loss could reflect the fact that the car had been damaged in an accident or is known to have suffered above average repairs or just is not running as well as it should. all these events could reflect additional consumption on the part of agnes from more than average mileage or from a style of driving or of care for the car (leaving more time for other 101. it is unlikely that the used car market would recognize agnes's better than average car. because fraud often goes undetected in the used car market, consumers cannot differentiate between good and bad cars. thus, the rational consumer assumes that all cars are of average quality, and the seller, without a method of proving the superior quality of his automobile, has little choice but to ask the average price for the car. eventually, better than average cars will not be available in the market, the average quality will decline, and the price which consumers are willing to pay for a car of unknown quality will be reduced. the cycle will repeat itself driving owners of average quality cars out of the market. david m. green. comment, due diligence under rule 415: is the insurance worth the premium?, 38 emory lj. 793, 818 (1989). see generally akerlof, supra note 4. 102. if the reduction in the rate of depreciation is due to diligent care and use, it may be reflected by maintenance expenditures. this is not to suggest that depreciation charged should be directly related to maintenance costs. large repair records could reflect accelerated wear and tear, not prevention of depreciation. in the absence of a method to distinguish between expenditures made to prevent depreciation and those made because of depreciation, there may be no objective measurement other than mileage (which would not be entirely accurate) to adjust depreciation to reflect actual wear. 103. see generally epstein, supra note 98. 104. it has been suggested to me that loss allowance is inappropriate as long as imputed income from use is not taxed. it is not clear that the two are necessarily related. i note that gains and losses on the sale of state and local bonds are taken into account even though interest income is exempt. it seems to be true, however, that if imputed income were taxed, it could reflect an increase in the value of the car or a better than average repair record depending upon how the amount of imputed income was computed. 19921 florida tax review pursuits) which led to excessive deterioration or even a major casualty.'0 5 if the loss occurred because agnes drove greater than the expected number of miles or failed to properly care for the car, allowance of a loss would be clearly unjustified, as would recognition of gain in the converse situation. if the loss was not a result of agnes's behavior, however, recognition might be appropriate. one problem with recognition of such losses would be the adverse selection that would occur from taxpayers selling assets which have declined in value and holding on to those which have increased. in fact, more frequent sales of items of low quality might occur even in the absence of such a tax incentive. even if realization were not required, comfort with loss recognition might depend upon whether we would be able to identify comparable gains because a particular car was better built than average or gratuitously had a better than average repair record.' °6 in sum, even under an ex ante approach, gains on sales of consumer durables are taken into account. it would be appropriate, moreover, to recognize gains even in the absence of realization. in theory, an exception should be provided for gains that are a result of less than average use but it seems difficult to separate such gains from market changes. furthermore, perhaps such gains do not occur often enough to be worth the trouble, if, as is suggested above, the market does not readily distinguish between a particularly good used car and an average one. 1°7 while symmetry might require deduction of losses, particularly if attributable to a market decline, a number of concerns arise. if realization is required, it seems losses would be much more likely to be recognized than gains. again, even though the existence of a declining market could be objectively documented, it seems impossible to separate and disallow "losses" that reflect higher than average consumption in the particular case, and it may be that it is these items which are most likely to be sold. moreover, even where extra consumption is not present, losses, because a particular item has performed below average, are comparable to gains for those whose "costs" are below average. since discovering unrealized gains of this type is difficult, loss recognition would seem likely to systematically understate total income 105. as professor kelman has noted, above average medical expenses can also be the product of lifestyle-smoking, drinking, or engaging in other activities that are inherently dangerous, such as skiing. kelman, supra note 17, at 869. 106. there may be, for example, a number of 3-year old cars worth more than $4,000 (or more than the average market value of that model at that age). even if realization were not required, how would such gains be discovered? on the other hand, cars which suffer a casualty or are otherwise lemons are more likely to be sold. see generally, julie a. vergeront, note, a sour note: a look at the minnesota lemon law, 68 minn. l. rev. 846 (1984). 107. see supra note 101 and accompanying text. [vol. 1:1 valuing personal consunption for society as a whole.' if allowance of losses is unwise, as i believe it is, the question is whether recognition of gains alone, perhaps even if unrealized, produces a better tax base than if both gains and losses are ignored. the above discussion suggests that ignoring gains because we cannot allow losses is better only if those who have gains are also more likely to have losses. there should be some correlation to the extent gains and losses arise from the ownership of particular assets or a penchant for more risky purchases. nevertheless, since the losses involved here do not necessarily arise from failure to insure, matching of gains and losses is somewhat less likely. moreover, as a matter of equity, or at least perceived equity, there seems to be little difference between an investment gain in the stock market and an increased net worth due to appreciation in the housing market. certainly with respect to art, we could not exempt gains merely because a taxpayer designates the item as purchased solely for personal use. since i believe that gains must be included in income and that allowance of losses could be abused, i am forced to grasp for a way to distinguish losses due to a decline in market value of consumer durables and residences from other investment losses." 9 consider that it may not be possible, even in the case of a market decline, to identify the true amount of consumption derived from housing. for example, assume an individual purchases a new residence for $100,000. assume, for ease of exposition, that the property is not expected to depreciate during the first year."' the expected cost, and therefore consumption value of the house, at a 10% interest rate, would be $10,000 a year which is the imputed income from home ownership or the loss of income from withdrawing $100,000 from other investments.' if at the end of the year the residence were sold for $95,000, is the $5,000 decline an investment loss, or can it be considered an additional cost of consumption? assume the owner would have been willing to pay $16,000 per year to live in the house. while the $6,000 premium over expected cost would normally be considered consumer surplus, is it possible to consider at least $5,000 of this amount as an additional cost of consumption when the 108. more precisely, loss recognition would underestimate total value of goods and services. 109. the house has recently passed a provision allowing losses on sale of a principal residence to be carried forward and allowed against future gains. in effect, the purchase price of the new residence would be increased by the disallowed loss on the sale. see, barbara kirchheimer, archer real estate measure called harmless enough to win passage, 56 tax notes 254 (july 20, 1992). 110. i am ignoring inflation and possible incentive depreciation in order to assume that depreciation is intended to reflect actual decline in value. 11l. under current law this imputed income is not subject to tax. 19921 florida tax review surplus in fact does not materialize to that extent?" 2 the converse of this argument could not be used to justify exclusion of gain. for example, suppose the residence sells after one year for $105,000. the owner cannot as easily argue that his true consumption was only $5,000 because if this is the expected value he attached to the residence, he would not normally have purchased it. for him to have done so, he would have had to have believed that the market was wrong. the owner who valued the use of the home above expected cost would have purchased the home in any event. thus, while this point does not have overwhelming force, it offers some justification for asymmetrical treatment of gains and losses which appeals to me on other grounds. f. conclusion in sum, the case for ex post as opposed to ex ante measurement does not seem strong enough to warrant taking on the additional administrative difficulty. there should be little difference in most cases especially if gains on housing and consumer durables are properly accounted for. moreover, much of what appears to be losses actually reflects increased consumption or preference for leisure. further, the theoretical advantage of taking account of actual differences in enjoyment seems to be considerably weakened to the extent that unfavorable outcomes are the result of failure to insure or other voluntary action. finally, particularly because gains are hard to identify, any attempt to measure outcomes may fall shorter of the goal than if the effort were not made. iv. treatment of recoveries the previous part of this paper has considered whether a taxpayer who experiences less than expected enjoyment from an expenditure should be entitled to a tax deduction for this "loss." we turn now to the treatment of those luckier individuals who would have suffered such a decline in enjoyment but for their ability to "recover" from someone else such as the seller of the product, an insurance company or a tortfeasor. at first glance, it may appear to be obvious that such recoveries would be tax-exempt regardless of the approach favored for the treatment of those who cannot recover for their losses. if the tax base were income or power to consume, consumption would be measured ex ante by the amount expended in the purchase of goods or services. outcomes would be irrelevant. 112. some may consider it relevant that the $10,000 of imputed income was not included in income. see supra note 104. a similar argument could be made for not treating the excess of the actual over the expected cost of any consumer purchase as a loss. [vol 1:1 valuing personal consumption under this approach the value of insurance or a dealer warranty could be said to be the price or premium charged, whether or not the taxpayer recovered on the policy. the purchaser who insures has merely acquired a more "reliable," and hence a more expensive product, no different than if she had purchased a better quality model. in short, there is no "recovery." those who prefer a tax base equal to actual consumption would care how matters turned out. but the purchase of insurance or other protection is, ostensibly at least, to protect the consumer's expectancy. unlike the uninsured, the insured experiences no difference between such expectancy and actual enjoyment. for example, if property is damaged or destroyed, insurance will replace it. therefore, there is no reason to tax any recovery. i believe, however, that while this conclusion might be at least generally correct, the explanation is not quite that simple. as we have seen, even under an ex ante approach, the consumer who transfers what might be considered an item of consumption, such as an automobile, will be taxable to the extent that the amount recovered exceeds her basis. proceeds in excess of basis may be taxable whether or not the seller's position is improved. for example, an amount received in return for permission to violate an individual's right to privacy would be taxable even though such an individual could be said to be no better off."3 in the case of an insurance or other recovery, the recovery measured ex post will exceed the cost of the protection which cost might appear to be the taxpayer's basis. ultimately of course, it might seem unfair to include the recovery in income without allowing a deduction for the loss which the recovery reimburses. but this justification for the exclusion of recoveries appears inconsistent with no deduction for uninsured losses. in short, how can we justify similar tax treatment for two individuals who seem to be in different positions in that one recovers for her loss and the other does not? therefore, while tax exemption for insurance or warranty recoveries does seem appropriate under either an ex ante or ex post approach to measuring consumption, such exemption is not easily explained. after considering a number of possible justifications, one can better understand the possible limits of such an exemption. a. basis recovery 1. in general.-even voluntary transfers would not be subjected to tax if the amount received did not exceed the taxpayer's basis. for example, if an automobile which cost $50,000 were sold for $30,000, there would be no tax on the transaction. as we have seen, this treatment is incorrect to the extent that the owner's basis is not reduced to reflect depreciation over the 113. kelman, supra note 17, at 842-43. 19921 florida tax review period of use. if, however, proper depreciation did not exceed $20,000, tax exemption of the proceeds would be appropriate. some have noted a potential discontinuity if basis is taken into account for the purpose of excluding the proceeds of sale, but not for the purpose of allowing a loss. 14 in that connection, we have discussed previously whether a deduction for a loss would be appropriate if an automobile were sold for less than its basis after properly adjusting for depreciation.,"5 however that question is determined, it is inappropriate to tax proceeds which are not in excess of basis. thus, for example, suppose the automobile purchaser immediately changed her mind and was able to sell the new car for the original $50,000 purchase price and buy a boat instead. it would seem to be clearly wrong to include the $50,000 from the sale of the car in income. total consumption remains at $50,000, even though it is shifted from an automobile to another form. as long as the taxpayer receives no more than her basis, consumption does not increase and neither should taxable income. in the case of insurance or seller warranty, however, the very purpose of the transaction is to pay a small, fixed amount up front to protect oneself against the possibility of a very large expenditure later on. while the taxpayer may seem to be no better off when the insurer or seller makes good after a "disaster" occurs than she would have been if all went well, an exclusion may not be explainable on the grounds of basis recovery. the essential nature of insurance is to pay a little for a large amount of protection. 2. is basis essential?-under one view, the fact that the individual is no better off is sufficient without regard to whether there is "technically" enough basis. andrews notes that the exclusion of medical services provided by a charity or by a government welfare program or by a tortfeasor has not been considered to be a tax preference." 6 he suggests this is because "[tihe taxpayer is no better off after the whole transaction than before he incurred his injury and it would be unnatural to view the provision of medical services in isolation from the injury as producing a taxable gain.".... there are difficulties with this approach, however. it is not consistent with the treatment of taxpayers who are taxable on a sale of rights, such as privacy, even though they would not appear to be better off."8 in addition, as andrews notes, it may follow from his premise that a taxpayer who pays for his own treatment should be allowed a medical expense deduction to 114. see, lawrence zelenak, the taxation of indemnity payments: recovery of capital and the contours of gross income, 46 tax l. rev. 381, 389 n.43 (1991). 115. see supra text accompanying notes 98-106. 116. andrews, supra note 18, at 334. 117. andrews, supra note 18, at 334. 118. andrews's view would also suggest that wages would be exempt to the extent leisure is lost. [vol 1:1 valuing personal consumption reflect the fact that he is worse off than either a taxpayer who does not get sick or one who is reimbursed for his costs." 9 while a deduction is allowed for medical expenses in excess of 7.5% of adjusted gross income, as we have seen, losses are generally not allowed. some would avoid these difficulties by asserting that it is only when the transaction is involuntary that it is unfair to tax an individual who ends up no better off. noting that we do tax a person who voluntarily markets his privacy rights, even while we exclude tort recoveries for violation of privacy,12 kelman sees the distinction between voluntary and involuntary action as "a political recognition of a basic human resistance to commoditization."12' according to kelman, the tax system must confirm a person's refusal to treat his privacy as a saleable object)'" it is the involuntariness of the conversion that bars taxability. others are not sure. griffith suggests that once a taxpayer's rights have been violated, imposing a tax on the proceeds does not necessarily add to the injury."2 if the injured party is worse off because he is forced to substitute taxable dollars for an untaxed benefit, perhaps the recovery should have been increased so as to make him whole. further, when the tax law specifically waives current tax on insurance proceeds under section 1033, it conditions the exemption for the amount received in excess of basis on reinvestment in similar property.'24 the presumed need for section 1033 may indicate that in the absence of basis, involuntariness does not necessarily make a recovery nontaxable, or at least that exemption should be conditioned on reinvestment in similar property. 3. does basis exist?-assuming sufficient basis is a prerequisite to exclusion of proceeds, to what extent can it be said that there is adequate basis in the transactions we are considering? if instead of comparing the insurance proceeds to the premium, we could compare the proceeds to the full original cost of the insured purchase, as if the item were sold to the insurer, the recovery, in some instances at least, may be said not to exceed basis. thus, an individual whose car was stolen or totally destroyed would be likely to have a basis in the car at least equal to the amount recovered from insurance or the tortfeasor who caused the damage. something analogous to basis recovery occurs when a taxpayer merely gets her money refunded. consider, for example, a resort which has 119. andrews, supra note 18. at 334. 120. see irc § 104(a)(2). 121. kelman, supra note 17, at 842. kelman rejects the notion that the non-taxability of tort judgments supports the medical expense deduction. 122. kelman, supra note 17, at 843. 123. see griffith, supra note 24. at 381. 124. irc § 1033(a)(2). 19921 florida tax review a policy that reimburses 80% of the cost of the hotel if it rains more than 50% of the time during a week's stay. a refund from the hotel would clearly seem to be nontaxable, even if the refund technically might not amount to a recovery of basis. this approach could possibly extend to "refunds" from a third party. for example, an insurance company might contract to "refund" the cost of a vacation in the event of excessive bad weather. the internal revenue service has accepted the tax free status of tax indemnities from tax counsel who erred in return preparation." after filing a joint return on the advice of their accountant, mr. and mrs. clark later learned that their tax liability would have been almost $20,000 less had they filed separate returns. their accountant admitted his error and reimbursed the clarks for the additional liability. the internal revenue service acquiesced in the non-taxability of such a recovery. 126 125. clark v. commissioner, 40 b.t.a. 333 (1939), acq. 57-1 c.b. 4; rev. rul. 5747, 1957-1 c.b. 23. 126. id. before it recently reversed its position, the internal revenue service also agreed to exemption for tax indemnity payments received from a transferor of assets who guaranteed that the purchaser would be entitled to certain tax treatment. g.c.m. 39697 (jan. 27, 1988) withdrawn, g.c.m. 39857 (aug. 15, 1991). in one case, a contracting party failed to live up to his promise that interest from the package of mortgages transferred would earn a tax credit under irc § 936. priv. let. rul. 8748072 (sept. 3, 1987). in another case, the transferor under a safe-harbor lease had represented that all the property was "qualified lease property" when in fact some of it was not. this led to a denial of an expected investment credit and depreciation deduction. priv. let. rul. 8923052 (mar. 16, 1989). general counsel memorandum 39697 appears to argue that if the taxpayer had paid the lower tax it legitimately expected to pay, it would have been able to retain the excess cash without additional tax. therefore, the same result should follow when the cash is recovered from the contracting party. after first withdrawing the earlier ruling, priv. let. rul. 9014404 (january 5, 1990), the internal revenue service has now reversed its position, priv. let. rul. 9226032 (march 26, 1992) and priv. let. rul. 9226033 (march 26, 1992). the service reasoned that unlike clark, the taxpayers involved in the private rulings had paid the proper tax under the facts as they existed. amounts received from a third party to offset such tax payments are taxable under the principle of old colony trust co. v. commissioner, 279 u.s. 716 (1929). the internal revenue service's action has been criticized. william l. raby, irs change of position may up the cost of tax malpractice, 56 tax notes 195 (july 13, 1992); lewis m. horowitz, excludability of tax indemnification payments threatened by recent change in irs position: plr 9014046, 49 tax notes 799 (nov. 12, 1990). professor zelenak, however, agrees with the service. he points out that if the earlier position had been maintained, a corporation might be able to represent that the interest on its bonds is taxexempt. it could then claim that the additional payments it must make when the representation turns out to be false are non-taxable tax indemnity payments as opposed to taxable interest. zelenak, supra note 114, at 398-99. it may be, however, that the issue is more complex. suppose, if proper advice had been given, adverse tax consequences could have been avoided without changing the [vol. 1:1 valuing personal consniption no matter how far the concept can be expanded, however, basis recovery will not suffice as an explanation whenever an individual pays a small amount for protection against a potentially large future cost. examples would include the value of repairs under a dealer warranty,'a regular airline ticket provided to a traveler unable to make the return flight by charter,1 s and payment by an insurance company of a judgment entered economics of the transaction, or in priv. let. rul. 8748072 (september 3. 1987), other mortgages were available that had not been purchased by taxpayers seeking benefits under irc § 936. 127. the basis in the original part may not be sufficient particularly if depreciation were required. 128. assume a charter flight is available for s 1,000. if the traveler cancels, the ticket price is non-refundable. if she is stranded overseas, and is unable to make the return connection, a regular ticket will cost $800. assume the traveler will value the trip at sl,100. her calculation of whether it makes sense to purchase the charter ticket will be as follows: percent chance expected cost expected value charter both ways 90% $ 900 s 990 charter one way 5% 90 55"" trip canceled 5% 50 0 $ 1,040" s 1,045"" if the expected cost is less than the expected value, the charter flight is a sensible purchase as shown. but the risk-adverse traveler may be unwilling to make the purchase since there is a 10% chance of a substantial loss. even a risk neutral person would find the trip inadvisable if the risk of a separate return increases to 6% which would increase the expected cost to $1,048. she may, however, be able to purchase insurance for, say $90, which will reimburse the cost of the charter flight if she cannot make the trip, or supply a return ticket if she is unable to make the return flight. if the insurance is purchased, the calculus is as follows: expected cost expected value 95% x $1,090 = $1,035.50 95% x $1,100.00 = si,045 5% x $90 = $ 4.50"" $1,040.00 viewed from an ex ante perspective, the insurance is worth no more than $90 and the value of the ticket and the insurance is worth no more than $1,090. what should be the result if the insurance provides reimbursement of $1,000 or if it pays the cost of a return flight. $800? "the expected cost is $1,000 (the cost of the charter) + s40 (the expected cost of the return flight for the "'stranded" traveler) (5% of $800) = $1,040. in other words, the cost is $1,000 for charter whether canceled or not and an additional $800 when there is a separate return, which has a 5% chance of occurring. .. the expected value is 95% of $1,100. assuming a separate return does not indicate a reduction in value of the trip. this may not be true if, for example, the traveler returns early because of illness. 19921 florida tax review against a driver held liable in an accident. the recovery reimburses the insured against a cost that she would otherwise have to incur. but to claim this is merely a refund of that outlay, which in many cases will not actually occur, seems to stretch basis recovery beyond recognizable limits. in fact, this suggestion seems more like an argument for recovery of a loss. in sum, basis recovery cannot explain exclusion of all recoveries. in fact, since the value of the recovery measured ex post clearly exceeds the amount paid for the protection, basis recovery may not in general be a good explanation for exemption for insurance, warranty or tort recoveries. another justification for non-taxation of insurance recoveries would be needed to deal with situations where basis is insufficient. b. there is no recovery the question of whether a recovery is taxable could be avoided if we can determine that there is in fact no recovery by the taxpayer. an individual who insures or obtains a warranty purchases a different product, since she now has a one hundred percent chance of full enjoyment for the price paid. the difference in value of the two items is merely the cost of insurance. the cost to the insurance company or the seller should be irrelevant.'29 for example, an automobile has an expected cost of operation which includes the initial purchase price, the cost of gasoline and repairs, and potential liability to injured parties. one presumably measures this expected cost against the expected value in determining whether to make the purchase. but there is a risk that the actual cost might be greater than expected. insurance (or a seller's warranty) merely guarantees that actual cost of operation will be closer to expected cost. thus, once the premium is paid for insurance or a warranty, the purchaser is out of the picture. her cost of operation is fixed. in a sense, this is just another way of explaining the ex ante approach. value is measured by the cost in a market transaction, here the sum of purchase price and insurance. as described above, however, the ex ante approach does not preclude taking account of gains on consumption items whenever there is further market transaction, for example a sale of a residence which would enable the taxpayer to substitute a different form of consumption. in the situation we are now concerned with, there may be a *** if ticket price is reimbursed when the traveler must cancel, expected cost is $90 (insurance) + $950 (95% of $1,000 cost of ticket). 129. kaplow, supra note 36, at 1500-01 n.68 (citing an earlier draft of this article). professor kaplow compares an insurance company to a lessor that promises to make an asset available regardless of whether a casualty occurs. kaplow, supra note 36, at 1501 n.68. [vol 1:1 valuing personal consumption gain in the sense that the recovery exceeds the cost of the insurance or warranty. nevertheless, while the recovery does provide, in some sense at least, a market transaction, it does not necessarily permit such consumption to vary. in the case of a seller warranty, there is no opportunity to alter the form of consumption. a vacationer who can stay an extra, hopefully less rainy, week at a resort which provides this option when there is excessive rain during the initial week, or a car or television set owner exercising his rights under a product warranty can in no way change the mode of consumption. they are merely enjoying the original purchase, a working car or television set or a week of good weather, at the agreed upon price, which price, because of the seller's warranty, was higher than it otherwise would have been. it is immaterial that the vendor's costs with respect to a particular buyer may exceed the price paid. in the case of payment of liability by an insurance company, one of the costs of operating an automobile, the potential liability to injured parties, has been "purchased" at a fixed price. that price has not changed nor can the money be used for any other purpose. the insurance company pays the injured party directly. the analysis is more strained in the case of a charter flyer, who is stranded in europe because she is unable to make her return flight. her insurance may provide her with cash in lieu of a return ticket. although she receives cash, she is likely to have little discretion in how to use it. in any event, this approach would not explain all situations. if, when it rains, the vacationer gets her money back from the resort rather than an additional week, she clearly has money which could be used for other pursuits, as does the driver who recovers when an automobile is destroyed by a collision. while in these cases there may be said to be basis equal to the amount of the recovery, exemption cannot be explained on the grounds that the consumption choice remains unchangeable. in other situations the original form of consumption cannot be maintained. an individual whose privacy is violated is reimbursed in dollars rather than in restored privacy. in the event of a fire that makes a residence unusable, the insurer provides cash to meet additional expenses incurred as a result of being denied access to the residence. the insured becomes a renter, not a home owner. thus, once again we have an incomplete theory for exemption of recoveries. c. deduction for insurance premiums there may be another way to explain exclusion for certain recoveries. it is arguable that if insurance or warranty proceeds are properly taxable, the premium or cost should be deductible. taking account of neither is simpler, 19921 florida tax review in part, because it alleviates the need for additional insurance to cover the tax liability. 30 it is also revenue neutral if we can assume similar marginal rates would apply to deduction of premiums and taxation of proceeds. the premise is that if the value of insurance must be measured ex post to produce gain to those that recover, the value would have to be similarly measured for those that do not suffer a loss. if the value in the latter case is zero, 131 there would be a loss. if this loss is deductible, the insured, except for the impact of progressive rates, could, at the same net cost, provide additional insurance to cover the tax liability on the recovery. for example, assume an individual could purchase $100 of insurance for $1 to protect against a potential $100 loss. if the proceeds were taxable, at a 28% marginal rate, he would need $138.80 in insurance to have enough left after tax to cover the loss, but this would still only cost $1 if the premium ($1.39) were deductible. the net cost to a person who does not suffer the loss would be $1 whether one adopted the premium ($1.39) deductible and proceeds taxable or the premium ($1.00) nondeductible and the proceeds nontaxable approach. the identity disappears if we take account of the insurance company's expenses, investment income' 32 and profit or loss on the transaction. if, taking these factors into account, the payout exceeds the premiums collected, clearly the revenue suffers if neither the premiums nor the proceeds are taken into account in determining the insureds' taxable income. on the other hand, it is much more likely that, in the long run, premiums will exceed the proceeds in order to cover the insurance company's expenses and provide a profit. when both gains and losses are excluded, this "loading charge" is effectively not deducted by the policy holders. this fact, as well as the effect of a change in tax rates, indicates that there would not necessarily be an identity between the two approaches considered in this section. this makes it necessary to consider further which approach is more appropriate. to the extent progressive rates are intended to reflect greater ability to pay, they would seem to be misapplied to loss recoveries which replace other expenditures. moreover, it would be burdensome if taxpayers had to predict the applicable tax rate in order to determine the adequacy of insurance. professor kaplow has also noted a potential for serious moral hazard 130. kaplow, supra note 36, at 1501. 131. this assumption is questionable. see infra p. 37. 132. the discussion generally assumes insurance against a contingency which will or will not occur instantaneously. if there is a delay, the insurer will invest the premiums and earn investment income. ideally this investment income should be taxed to the insured. see generally daniel i. halperin, interest in disguise: taxing the time value of money, 95 yale l.j. 506 (1986). this matter will not be pursued further in this article. [vol 1:1 valuing personal conslinption if a drop in marginal rates caused a taxpayer to be over-insured. 33 this may suggest that even if it were theoretically more correct to allow a deduction for premiums and impose a tax on recoveries, it could be better to do neither. moreover, the latter approach may in fact be more appropriate. as noted above, exclusion of the proceeds is not equivalent to a deduction for the premiums to the extent that the premiums exceed the proceeds. however, since to the extent of the loading charge the insured pays more than the expected value of the purchase in order to avoid the possibility of a large loss, perhaps the value of insurance to those who do not suffer a loss can be said to be their share of the insurance company's loading charge. this would not be unreasonable even if ex post the risk related premium can be said to be worthless." achieving this result when a deduction for the premium is allowed would entail the additional difficulty of separating out the nondeductible loading charge. for these reasons, exclusion of proceeds and nondeductibility of premiums would seem to be a better choice than inclusion of proceeds and deductibility of premiums, assuming one or the other were theoretically correct. there are, however, reasons why deductibility of premiums might not be generally accepted. as noted below in section d, the insurance premium would reflect the difference between the expected value of the product and the value if the event insured against does not occur. because of the insurance protection, in all circumstances, the insured achieves the value determined as if the insured event did not occur. thus, the total amount spent, the cost of the product plus insurance, equals the value received. treating the insurance premium as a loss, in a sense, ignores the excess of the total value over the price of the product, just as treating insurance proceeds as income ignores the decline between price and actual enjoyment when a loss occurs. in any event, justifying non-taxation of recoveries on the grounds that it compensates for nondeductibility of premiums would not apply to recoveries from a tortfeasor. it could not be argued that if premiums were deductible and proceeds taxable, the parties could adjust by increasing the size of the policy. here any adjustment, such as increasing the recovery to the victim to compensate for taxes, could have real consequences. for these reasons, i do not rely on this argument to justify exclusion for recoveries. 133. kaplow, supra note 36, at 1493-1504 (insurance would exceed the sum of the potential loss and the lower than expected taxes). kaplow defines "moral hazard" as the "tendency of individuals to take less effort to control costs when some or all of their costs are borne by others, such as the insurer." kaplow, supra note 36, at 1494. 134. william vickrey, insurance under the federal income tax. 52 yale li. 554. 557 (1943). 19921 florida tax review d. recovery offset by loss the difficulty of explaining exemption for recoveries could be avoided if we acknowledge that the recovery itself might produce a gain. exemption still could be justified on the grounds that the recovery reimburses the taxpayer for a corresponding nondeductible loss. if the loss were allowed, the two transactions would be offsetting. the loss in some cases would be the original purchase price that failed to produce value. if an automobile suffers a casualty, the recovery on the policy equals the cost of the destroyed automobile. the loss and gain balance out. the amount reimbursed in the event of bad weather on vacation would also equal the original cost which was "lost." in other situations the loss would be the additional amount expended as a result of the injury as opposed to the cost of the item which becomes unusable. for example, consider the charter traveler who purchases a round-trip ticket for $1,000 and cannot use the return flight.'35 the unused portion of the ticket cost $500, while the "value" of the recovery would be the cost of a one-way ticket, say $800. the loss would be $800, the additional "unexpected" expenditure which added no value. in the case of a fire damaged house, if there is to be a deductible loss, it would have to be the additional money spent on the hotel and food over what would have been spent had the fire not occurred. this justification for exemption of recoveries requires an explanation as to why a deduction for losses would be denied to those who choose not to insure. the following is suggested. as noted above, if an uninsured taxpayer does not suffer any loss, the value of the actual outcome exceeds the expected value. unless such gains are accounted for, it would be inappropriate to allow a deduction for uninsured losses. 3 6 symmetrical treatment of winners and losers requires that the uninsured be denied a loss deduction even if it were appropriate to effectively allow a loss to those who are insured. to further explain this argument, return to the previous example where we considered a $10,000 car which has a 1% chance of being a total loss. in these circumstances, the insured taxpayer pays $101 for casualty insurance, representing a $100 premium for the insurance to cover the car and a $1 premium for insurance to cover an insurance policy on the replacement car. if there is an accident resulting in a total loss he collects $10,101 which would enable him to replace the car and purchase a new insurance policy. the $10,000 gain on the insurance recovery offsets the $10,000 casualty loss. if no accident occurs there is, perhaps, neither a gain nor a loss as the owner paid $10,101 to guarantee that she will enjoy the full $10,101 value of the car 135. see supra note 128. 136. see supra notes 76-79 and accompanying text. [vol 1:1 valuing personal consiunption as opposed to paying $10,000 for a 99% chance she will do so. put another way, the $101 gain over the expected value of the car is offset by the $101 cost of the policy. the uninsured driver who suffers a casualty has a $10,000 loss with no offsetting recovery on the policy. the treatment of insureds (exemption of recoveries) suggests that we should allow a deduction for this uninsured loss. but allowing this loss could systematically undervalue consumption of the uninsureds as a group. recall that the ninety-nine uninsured taxpayers who do not have an accident obtain $10,101 worth of value for $10,000. for every uninsured $10,000 loss, there are ninety-nine $101 gains. if neither gains nor losses were taken into account, uninsureds as a whole would report the correct taxable income. further, to the extent people who systematically do not insure could be expected to have equal amounts of gains and losses, they too would report the correct amount of taxable income. moreover, if the benefit to the lucky uninsureds were to go untaxed while losses were deductible, the tax system would systematically favor selfinsurance. a taxpayer who is risk neutral would be indifferent between a 1% chance of a nondeductible $100 loss and a certain outlay of si for insurance. on the other hand, if the loss were deductible and insurance premiums were not, 37 the potential loss would be reduced while the cost of insurance would remain one dollar. this could cause even the risk averse person, who would normally purchase insurance, to self-insure. therefore, it may be logical, on the grounds of both equity and efficiency, to deny a deduction to the uninsured even if we effectively allow a loss for an insured individual by non-taxation of recoveries. while this approach would not explain loss disallowance to an individual who had no opportunity to insure, it should be recognized that insurance-like protection against a difference between expectancy and outcome could be achieved in a variety of forms." individuals can obtain a product warranty, lease from an owner who bears responsibility for losses or repairs, purchase a less destructible model'39 or, in the extreme, forego risky activities altogether. consider, for example, what would have happened to the clarks if they negligently prepared their own return." when they hired an accountant, part of the fee was for the assurance of accuracy or malpractice liability for error. if they had prepared their own return they might have made an error that was not reimbursable. if they did achieve the 137. section 106 of code exempts premiums on medical insurance paid by an employer, effectively allowing a deduction for premiums. 138. kaplow, supra note 36, at 1489-92. 139. with an abundance of consumer information available, it is well known that automobiles manufactured by certain car manufacturers have better records of durability and performance. 140. see supra note 125 and accompanying text. 19921 florida tax review best result, however, they would in some sense have a gain-payment of less taxes than the average self-preparer. if this gain is not taxed, perhaps an unreimbursed loss should not be deductible. in summary, it is possible to explain why those who forego an opportunity to insure should be denied the loss deduction which is effectively allowed by exempting recoveries. since insurance in some form is generally available, general disallowance of unreimbursed losses may be justified. e. summary and conclusion a number of explanations have been offered to reconcile non-taxation of recoveries by way of insurance or otherwise with nondeductibility of losses suffered by the uninsured. these include the application of basis, the existence of an offsetting loss and the argument that there is in fact no "recovery" for the consumer. consistent with my belief that the value of consumption should generally be measured by the costs incurred in a market transaction, i am comfortable with the view that the "recovery" can generally be "ignored" by a taxpayer who is insured, protected by seller warranty, or reimbursed by a tortfeasor. 14' she has originally purchased a different more reliable product and her consumption is measured by the amount paid for that product, which amount includes the cost of insurance. the cost and hence the "value" of potential liability to victims, for example, is determined by the insurance premium rather than the uncertainties of future events. this approach fits most easily with situations in which the recovery is not directly received by the taxpayer or at least must be used in connection with the original activity. in such cases it can be said that, while there may be a market transaction, the taxpayer does not have a new consumption choice. thus, a dealer warranty can be used only to fix the car. payments pursuant to liability insurance go directly to the victim. blue cross will only reimburse actual costs. the traveler stranded by his charter flight ostensibly has more choice if recovery is in cash, but nevertheless must return home. this analysis will not cover all cases, however. the victim of a collision need not replace his auto. vacation insurance payable in cash could be used for other purposes. cash cannot restore violated privacy. basis recovery may explain exemption in some circumstances, but, perhaps because the recovery would exceed the price or premium paid for protection, basis would sometimes be insufficient. some would argue that, regardless of basis, an individual who is no better off as a result of the transaction should not be subject to tax. while this 141. if reimbursed by an employer, the value of that protection should be taxable. contra andrews, supra note 18, at 334 (suggesting employer reimbursement be tax-free). [vol 1:1 valuing personal conswnmption seems too broad, a less drastic version-the idea that all involuntary receipts that leave the taxpayer no better off should be tax-free-has appeal. in assessing this view, it is useful to consider how an individual could be said not to be "better off' if her basis is less than the amount recovered. for example, consider an individual who purchased a residence for $100,000. the property increases in value to $150,000 before being destroyed by fire. while insurance proceeds of $150,000 would leave the taxpayer no better off, it is clear that, in the absence of reinvestment, the amount received in excess of basis, $50,000, would be taxable.' 42 the fire becomes the occasion to recognize the previously unrealized gain. "no better off" in this context must mean, therefore, that even though basis is inadequate, there is no "unrealized gain." how could that occur? two possibilities may be suggested. first, the recovery reimburses the taxpayer against an expense, subsequent to the original purchase, which provides no additional utility. examples include a tort judgment from negligent operation of an automobile, a return flight from europe when the traveler cannot for some reason use the previously booked charter and, perhaps, the cost of a hotel room when fire makes the taxpayer's residence unusable. second, in the absence of injury, the individual had access to a form of tax-free consumption; for example, privacy, use of one's body, or imputed income from use of a residence or one's own services. the first possibility seems easier to deal with. in most of these cases, as noted above, the recovery does not enable the consumer to vary the form of purchase and thus can reasonably be considered irrelevant. even if this is not the case, it seems unfair for a person who is no better off than he would have been had he not been injured or suffered a loss to bear a larger tax burden. thus upon comparison to the uninjured, exemption seems required so as not to tax the injured more heavily. one way to justify exemption is by assuming that for any income there is an offsetting loss. thus, any taxable income from the reimbursement of the cost of a vacation, ruined by bad weather, would be offset by a "loss" for the difference between the original cost of the vacation and the actual benefit derived. this might suggest, however, that the injured party who does not recover should have a deductible loss.' 43 nevertheless, while it might be more appealing to allow a deduction to the unreimbursed individual in order to treat all three situations consistently, we have seen that there are reasons for denying a loss for those who choose not to insure. since insurance in some form is available with respect to most purchases, the denial of deductions for unreimbursed losses does not necessarily determine how "insured" losses should be treated. if this is so, exemption for recoveries can more comfortably be justified by the 142. irc § 1001(a). 143. cf. zelenak, supra note 114, at 388. 19921 florida tax review assumption that there is a corresponding loss which should be allowed to those who are insured. there would be cases, however, where a loss could not be found. for example, to the extent recovery for physical injury, such as loss of a limb, exceeds additional out-of-pocket costs, there would be no additional expenditure for the injured person to deduct as a loss. this analysis suggests that the most difficult cases involve the substitution of money for tax-free benefits such as the use of one's body or the imputed income from home ownership. it is at least difficult, if not impossible to say that there is no change in the original form of consumption; there is clearly no basis to recover and in the case of one's body no offsetting loss. the home ownership issue was considered in millsap v. commissioner145 and mccabe v. commissioner.146 millsap owned his own home and appliances and enjoyed tax-free imputed income 47 from their use and from his own services in cooking, cleaning and doing laundry. the home became temporarily unusable because of fire, and as a consequence millsap's access to such imputed income was interrupted. millsap, however, was covered by insurance that reimbursed the cost of temporary living quarters, as well as the additional expenses of laundry and food. it would appear that the additional costs incurred by millsap after the fire would in effect reflect the loss of the imputed return from his residence and its contents, the absence of his input in cooking and cleaning, which made food and laundry more expensive, and the depreciation on his residence for the period of absence.'48 despite the fact that millsap seemed no better off, the internal revenue service concluded that the recovery was taxable to him. 49 it 144. use of proceeds to rent living quarters could be considered similar enough to home ownership so that there is no change in the original form of consumption. however, money in lieu of privacy is clearly different. 145. 387 f.2d 420 (8th cir. 1968). 146. 54 t.c. 1745 (1970). 147. michael j. graetz, federal income taxation principles and policies, 152-54 (2d ed. 1988). 148. the assumption is that the hotel must charge enough to cover its operating costs for utilities, laundry and meals, depreciation of its assets and a return on its investment. millsap's operating costs in the absence of the fire would be similar except for the value of services. thus, his excess costs cover imputed income from property and services and depreciation. if millsap's residence continues to depreciate despite being unoccupied, he must bear this cost plus his share of the hotel's depreciation expense, which indicates why this cost should be reimbursed even though the amount he normally spends on utilities, for example, need not be. 149. millsap v. commissioner, 46 t.c. 751 (1966), aff'd, 387 f.2d 420 (8th cir. 1968). accord mccabe v. commissioner, 54 t.c. 1745 (1970); arnold v. u.s., 289 f. supp. [vol. 1:1 valuing personal consumption asserted that while the taxpayer could enjoy tax-free imputed income from the use of his residence and his own services, the entire cost of rent, food and laundry must be purchased with after-tax income. moreover, if millsap rented the residence, cash received would be taxable even if used to rent another home. therefore, cash received from an insurance company was taxable because, in a sense, it could be said to be effectively renting the property.' in sum, what millsap was seeking was continued tax-free treatment for an amount equal to the imputed value of the goods and services he enjoyed prior to the fire, even though the fire deprived him of his access to this in-kind income and the insurance company replaced it with cash. the internal revenue service, on the other hand, viewed the tax-free benefits as lost. in mccabe the court recognized the dilemma, but opted for inclusion of insurance proceeds in the absence of basis. it specifically rejected an exclusion put forth on the grounds that the proceeds were in fact a substitute for a nontaxable type income.' i think the tax court got the question exactly right in mccabe, namely, whether one should be taxable when he has been forced against his will to shift the form of consumption from a nontaxable form to a taxable one? this issue also arose in a private letter ruling5 2 in which the internal revenue service dealt with a tenant in a rent controlled building who received $20,000 in exchange for giving up his apartment and all claims against the owner for fraud and for scheming to end rent control by violating rules against seeking non-tenant buyers. the service held the $20,000 to be taxable. if the taxpayer were otherwise able to retain his rights to the apartment, at least temporarily, the $20,000 compensates him for higher rents he will have to pay elsewhere for similar quarters; he is not better off than he would have been if he stayed in his apartment.' 3 the $20,000 payment merely reimburses the extra cost of the more expensive apartment which provides no additional utility. the tenant has, however, exchanged access to an apartment at a below market rent, a form of nontaxable benefit, for cash 206 (e.d. n.y. 1968). but see conner v. u.s., 303 f. supp. 1187 (s.d. tex. 1969. aff'd in part and rev'd in part, 439 f.2d 974 (5th cir. 1971); taylor v. u.s.. 28 aftr 2d 6108 (n.d. ala. 1971). 150. if this analogy is appropriate, millsap should be entitled to a depreciation deduction, which would mean that his taxable income would equal the lost imputed income from property and services. 151. mccabe, 54 t.c. at 1748. 152. priv. let. rul. 8952030 (september 29. 1989). 153. alternatively, the $20,000 might reflect a discount from market being provided to existing tenants who buy these apartments. under this view, the s20.000 is akin to the profit he might have obtained by purchasing the apartment and reselling it as soon as he was free to do so. this would seem to be taxable. 1992] florida tax review which would ordinarily be taxable. if the transaction is voluntary, it would seem clearly taxable, but the answer is more difficult if the tenant was in someway coerced, perhaps by the landlord's fraudulent behavior. it is appealing to permit the substitution to be tax-free when it occurs without the individual exercising any choice. 1"4 cash substituted for a limb or for the pleasure of being pain-free seems to me to be properly nontaxable.155 the millsap case seems harder because while we all enjoy tax-free use of our bodies, renters and homeowners are treated very differently by the tax law.'56 should millsap retain the more favorable homeowner treatment just because his shift to rental status was against his will? 157 proper measurement of income would require that imputed income from home ownership be included in the base. the exclusion must be defended on administrative grounds or more likely because the public would not accept the inclusion. therefore, there is no theoretical way to determine how far to extend exemption for imputed income. if public perception is the key, i would guess insurance recoveries in the millsap circumstances and similar situations, such as to temporarily replace a stolen car, would be exempt as indicated by the prompt enactment of section 123 to overrule millsap. i find this result acceptable while at the same time i applaud the service's conclusion regarding the tenant who lost his rent controlled apartment. the distinction may be that the tenant had a special advantage, access to a rent controlled apartment. while we generally do not tax the value 154. this is similar to kelman's view that the involuntary nature of the transaction is controlling although i found kelman's reasoning unpersuasive. see supra text accompanying note 123. 155. contra griffith, supra note 24 at 374; joseph m. dodge, taxes and torts, 77 cornell l. rev. 143, 182 (1992). the utilitarian approach would justify exclusion of personal injury recoveries only if the impact of personal injury increased the injured recipient's need for income. "if the victim ... has no greater economic need as a result of the injury ... payments should be subject to taxation." griffith, supra note 24, at 374. see also william a. klein, tax effects of nonpayment of child support, 45 tax law rev. 259, 271 (1990). 156. imputed income from home ownership is not taxed while rent is not deductible. regs. § 1.262-1(b)(3). in one sense at least, tax exemption is more easily explainable in millsap on the grounds that the loss incurred from the expenditure on his hotel room (which provided no additional utility) could offset the proceeds. loss of privacy does not necessarily increase one's costs. 157. in an analogous situation, simons justifies present irc § 119, which excludes the value of lodging from income when an employee is required to reside on the business premises for the "convenience of the employer," as providing benefits similar to home ownership to those who, because of the nature of their work, are not free to buy their own home. simons, supra note 1, at 123-24. [vol. 1:1 valuing personal consuiption generated by below-market purchases, there seems to be no reason to continue favorable tax treatment when the special status is lost. millsap, on the other hand, is a member of a much larger group-homeowners. he merely seeks to continue to be treated like all the rest. still, if millsap loses, he is merely treated like all renters. thus, i am less comfortable with taxexemption for millsap than i am with tax exemption for payments for physical injury or loss of privacy.'58 ultimately, the conclusion may reflect intuition rather than logic. it was also suggested above that tax-free treatment for insurance recoveries could be defended on the grounds that premiums should be deductible if recovery is taxable. the validity of this argument, which was previously questioned, will be developed more fully in the next section. v. insurance against loss of income as a final matter, i want to briefly consider whether the discussion thus far leads to any preliminary conclusions concerning taxation of insurance that provides protection against loss of income as opposed to protection of an item of consumption. in the case of an item of consumption, i have argued that generally proceeds from such insurance should not be included in income and the premium should be nondeductible. does this conclusion apply to insurance against loss of income as well? under current law this treatment-nondeductibility of premiums and excludibility of recoveries-is accorded premiums on and proceeds of insurance to protect against loss of income from "personal" risks of illness or death.1 59 on the other hand, premiums on insurance to protect against "business" risks are deductible160 and in that situation the proceeds are included in income. thus, a storekeeper who buys business interruption insurance is taxable on the proceeds, but the premium is deductible. the internal revenue service would also allow a deductible business expense to an employee who sought protection against loss of income caused by a business risk-from on the job injury or unemployment caused by an industry decline.16' but according to the service, the cost of protection against a loss of income from personal causes such as illness or death caused by a non-job related injury or disease would not be deductible. 62 158. replacement of lost earnings, of course, should be taxable. 159. irc §§ 101, 104(a)(3), 262; regs. § 1.262-1(b)(1l. the value of a limited amount of group-term life insurance provided by an employer is excluded from income under irc § 79, which is equivalent to a deduction for the premium and an exclusion of proceeds. 160. irc § 162. 161. g.c.m. 39016 (january 18, 1983). see rev. rul. 81-193, 1981-2 c.b. 52. 162. rev. rul. 81-193, supra note 161. 1992] florida tax review this distinction has little practical importance, since where a deduction is not allowed, the proceeds have been excludible and, as we have seen, the two approaches can produce equivalent results. as described above, 163 as long as brackets are the same, the insured can adjust to the taxability of the benefit by the purchase of additional insurance. if the premium is deductible, the net cost does not increase. disallowance of a deduction for premium payments and treating the proceeds as exempt is merely a simpler way to achieve the same result as a deduction for the premium and taxation of recoveries. in fact, tax-free treatment of mortality gains on life insurance cannot be justified on the grounds that the taxpayer is no better off than she would be if the insured lived (if the insured lived, earnings would be taxable), or that the gain on insurance would be offset by a deduction for lost earnings (failure to earn cannot lead to a deduction). the only viable explanation for the tax-free treatment of mortality gains is that the exemption is balanced by a denial of a deduction for the premium, which would be allowed as a cost incurred for the production of income if life insurance proceeds were taxable.' 64 some, however, who argue that life insurance proceeds should be taxable, view the premiums, not as a deductible cost of producing what should be taxable income, but rather as a nondeductible personal expense to achieve comfort and peace of mind. 65 this discussion suggests two questions for consideration. first, is it possible that the purchase of insurance, which increases utility by reducing risk, should be viewed as enlarging the tax base? second, if the purchase of insurance does not create any additional overall income, 66 is it more appropriate to tax the proceeds and deduct the premium or to exempt the proceeds and treat the premium as nondeductible? turning to the second question, there is, i believe, a distinction between life and disability insurance on the one hand and, for example, collision coverage on the other. as we have seen the purchase of casualty insurance increases the value expected from the automobile-it means full value will be obtained in all circumstances, not just in the absence of a casualty. 167 it seems clear, therefore, that a deduction for the insurance premium would not correctly measure the enjoyment of an individual whose car is undamaged. if the premium is to be deducted, there must be an offsetting amount of income, the difference between the value produced by the 163. see supra text accompanying note 131. 164. robert b. harris, comment, compensation for loss of income and its taxation, 34 nat'l tax j. 135 (1981). 165. william d. popkin, taxing personal insurance: the case of tax audit insurance, 4 va. tax rev. 379, 403 (1985). 166. warren, supra note 23, at 1087. 167. see supra note 129 and accompanying text. [vol 1:1 valuing personal consumption car (outcome) and the purchase price (expected value). life insurance presents a different picture. since in this case the excess of actual over expected income is subject to tax, there may be said to be a double counting of income if the premium is not deducted. assume a taxpayer, who has a 99% chance of surviving through next year, will earn $10,101 if she does. thus, assuming she is risk neutral, the expected value of her future income is $10,000. if $10,101 of life insurance is purchased at a cost of $101, there is now a 100% chance of receiving this expected value-salary or life insurance proceeds of $10,101 less premium of si01. however, if she lives what will be taxed is the actual amount she earns, $10,101, not the expected value. therefore, unless the premium is deductible, the purchase of life insurance would increase her expected income. furthermore, if the insured dies, there is no loss to offset the proceeds. the insurance provides additional value. therefore, in the case of life insurance, deduction of the premium and taxation of proceeds is at least in theory more appropriate than the opposite approach which was suggested for casualty insurance. as noted, however, a deduction for the premium means everyone will be taxed at the expected value. is this the proper income for an insured who lives? is true income just $10,000 since she must pay $101 to assure she will receive the expected income in all circumstances or does such a person actually earn $10,101? we can examine the question by comparing two people who survive. a is uninsured and has $10,101 to spend on food and drink. b is insured and, after paying the premium, has only $10,000 to so spend. should a pay more tax than b, or does b have $101 worth of peace of mind or security? it might appear that b has as much consumption as a. he merely chooses to spend some of his resources on insurance which makes him feel more secure. it therefore seems hard to argue that b, if he lives, has less than a, if he lives. they both have $10,101. if b were to die, however, it seems that the insurance should be valued at $10,101 not its ex ante value of $101. after all, unlike a's family when a dies uninsured, b's heirs can consume at least $10,000 worth of goods and services when b dies insured. if these suggestions are followed the purchase of insurance would increase overall income." if there is no insurance, there would be a total 168. gambling raises a similar issue. suppose c gambles sl on a 100 to i shot (assume no take for the house or the state). in the absence of the bet c has a 100% chance of $1 equaling $1. with the bet c has a 1% chance of 100, which also equals 1. life insurance would be seeking to protect against risk---to change a 99% chance of $100, into a certainty of $99. when one gambles he is moving from certainty to a risky situation. in both cases, however, the expected value of resources does not change. if gambling winnings are taxable while losses are not deductible, taxes nevertheless increase. the justification for this result may be the loser, despite his loss, has si worth of 1992j florida tax review of $1,000,000 for each one hundred people, $10,101 for each of the ninetynine who live and zero for the one who dies. but if everyone is insured, total income would be $1,010,100 ($10,101 not $10,000 for each). insurance, by reducing risk, does increase overall utility but if this argument for nondeductibility of the premium and taxation of proceeds is valid why would it not extend to business interruption insurance as well. in the case of insurance against business risk, by allowing a deduction for premiums we do not include the value of peace of mind in the tax base. perhaps one way to resolve this apparent dilemma is to recognize that a and b are not identical. a is risk neutral. he views a 99% chance at $10,101, and a 1% chance that he will earn nothing, as equivalent to a 100% guarantee of $10,000. therefore, he need not insure. b being risk averse considers the former option less valuable than the latter. to b the expected "value" of the former option is less than $10,000. therefore, when b guarantees that he will receive $10,000, the expected "value" of his income increases, which would not be inconsistent with a higher tax burden. however, what b has achieved through insurance (an expected value of $10,000) is merely what a already has because of his greater tolerance for risk. therefore it is not necessarily clear that b should pay a greater "expected" tax than a. this would occur if all bs were taxable at $10,101,169 while as would only be so taxed if they lived. perhaps we need not worry about discrimination between a and b, if most people are in fact bs. but if that were the case, it might not matter what tax base were chosen for b. apart from equity considerations, taxation of insurance proceeds without a deduction for premiums could be said to create a disincentive to insure. a risk neutral individual would certainly not want to increase her expected tax burden without an increase in the expected value of income. however, in the case of b, the additional security from alleviating the risk could offset the additional tax burden. for example, assume the tax rate is 20%. if b insures, his pre-tax cash income after insurance is $10,000 and his tax liability is $2,020.20 based on $10,101 of income. in all circumstances b or his heirs will have $7,979.80 in cash after tax. if b did not insure, he would have $8,080.80 if he lives (80% of $10,101). the expected value, given the 99% chance of survival, is $8,000, which is greater than the amount available to the insured if the premium is not deductible. however, if b is risk averse, he might not consumption from the excitement of gambling. a consumption value to gambling seems plausible whether or not the same can be said for life insurance. 169. equivalent treatment in the case of casualty insurance would require not only that premiums not be deducted, but that, in addition, an amount equal to the premium be included in income. [vol 1:1 valuing personal consumption consider a 99% chance for $8,080.80 more valuable than $7,979.80. after taking account of risk, he might prefer a lower expectancy. thus, he might still insure. in the end, i believe i would continue to allow insurance proceeds to be tax free as long as the premium is not deductible."'u since the government would not be placing a charge on diminution of risk, this approach would be certain not to hinder a decision to insure. it would also avoid difficult questions about deductibility of what has clearly always seemed to be business expenses-such as expenditures for business interruption insurance. 171 vi. summary this paper has shown that measuring consumption by outlay is generally supportable even if one believes that ideally outcomes should be taken into account, and that non-taxation of recoveries which exceed basis can be reconciled in most cases with nondeductibility of losses for the uninsured. if consumption is measured by outlays, insurance is generally just another outlay, albeit for a different and more expensive product, and any recovery under the policy can in most cases be thought of as merely a means of preventing an increase in the costs of an activity, which activity has not changed. cash which is freely available for other purposes, particularly if it replaces normally tax free benefits presents more difficulty. if outcomes matter then non-taxation of recoveries can be justified by asserting that there should be a deduction either for the premium or for the loss that has been incurred. the latter rationale does not necessarily support 170. it was noted above that exclusion of proceeds combined with non-deductible premiums is not the same as taxability and deduction if the insurance company increases its premium to cover expenses and profit. see supra note 133 and accompanying text. for example, assume in the above case that the premium is s102. if the proceeds are excluded those who live are taxed on s10,101 whether they are insured or not. those who die would not be taxed in either event. insurance does not change the expected tax liability. however, if the proceeds are taxable and the premium of s102 is deductible, the tax base for those who insure, both expected and actual would be reduced to s9,999. it seems better to assume that income does not in fact decline when insurance is purchased. this would be achieved if the loading charge were non-deductible, or more directly by excluding the proceeds and treating the entire premium as non-deductible. 171. in fact, if business insurance is held to be non-deductible, would similar reasoning cast doubt on the deduction for other items like security guards? suppose a business determines that in the absence of a robbery, it will earn s 100,000 per year. there is. however, a 50% chance of a theft, which will reduce its income to s90,000. suppose hiring a security guard for $5,000 will prevent the robbery, so that actual and expected income will be s95,000. could it nevertheless be claimed that taxable income is s100.000? 19921 50 florida tax review [vol. 1:1 deductions for the uninsured. denial of such deductions follows from the failure, which has not generally been recognized, to tax gains when actual costs are less than expected. since gains and losses can be thought to ordinarily balance out, it is best to take neither into account. deduction of premiums on insurance to protect against loss on consumer purchases would, however, not correctly measure income. it can only be justified as a balance to another "error"-taxation of proceeds without recognition of the offsetting loss. the issue of whether premiums on policies which protect against loss of income should be deductible may be more difficult. this article offers only a tentative position in favor of such deductibility, assuming proceeds were to be taxed. thus, the tax system, properly, does not take account of andy's unfortunate experience with his mercedes. on the other hand, if he could recover from the dealer, the amount received should be tax-exempt. * professor of law, seton hall university school of law. b.s., university of illinois; m.s.t., depaul university; j.d., georgetown university law center. earlier versions of this article were presented at the american tax policy institute roundtable, the 2004 critical tax conference at rutgers school of law-newark, seton hall university school of law, the 2005 critical tax conference at seattle university school of law, the tax research network conference 2005 at edinburgh university and the comparative fiscal federalism conference at the university of michigan law school. the author received many useful observations and comments from the participants at these conferences and separately from william nelson, angela carmella, daniel shaviro, bertil wiman, charles mclure, jr., neil buchanan, mark alexander, joseph guttentag, michael mcintyre, mel marquis, lee sheppard, steven shay, michael lang and albert rädler. the author also benefitted greatly from a u.s. fulbright scholar program grant and visiting professorship with dr. wolfgang kessler at the university of freiburg in germany. the author is grateful to the american tax policy institute and the seton hall university school of law dean�s research fellowship program, which provided financial support for this article. the author would also like to thank her research assistants deirdre bussom, carolyn conway, andrew farrelly, wayne jentis, monica kraft, alison lam, victor macam, anneke niemira, aliza sherman and lynn tatum. 47 florida tax review volume 7 2005 number 2 tax discrimination: a comparative analysis of u.s. and eu approaches by tracy a. kaye* 48 florida tax review [vol.7:2 i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 ii. eu vs. u.s. federalism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 a. the legislative branch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 b. the judicial branch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 iii. principles of international and interstate taxation . . . . 75 iv. judicial limitations on tax sovereignty . . . . . . . . . . . . . . . . 77 a. judicial limitations on state tax sovereignty in the united states . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 1. the privileges and immunities clause . . . . . . . . . . . . . 79 2. the equal protection clause . . . . . . . . . . . . . . . . . . . . 84 3. the dormant commerce clause . . . . . . . . . . . . . . . . . 86 b. judicial limitations on member state tax sovereignty in the european union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 1. the free movement of goods . . . . . . . . . . . . . . . . . . . 95 2. the free movement of persons . . . . . . . . . . . . . . . . . . 96 3. the freedom to provide services . . . . . . . . . . . . . . . . 98 4. the free movement of capital . . . . . . . . . . . . . . . . . . 99 5. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 v. comparative case law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 a. corporate taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 1. the u.s. approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 2. the eu approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 3. analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 b. individual taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 1. the u.s. supreme court�s approach . . . . . . . . . . . . . 111 2. the european court of justice�s approach . . . . . . . . 114 3. analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 vi. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 2005] tax discrimination 49 1. on october 29, 2004, leaders from the 25 eu member states officially signed the new european constitution. graham bowley, heads of state sign the european union�s first constitution, n.y. times, october 30, 2004, at a3. the treaty establishing a constitution for europe integrates the treaty establishing the european community and the treaty on the european union and replaces the �co-decision procedure,� among other procedural changes. jacques ziller, the new european constitution 17, 148 (mel marquis trans., 2004); see also treaty establishing a constitution for europe, 2004, o.j. (c 310), at http://europa.eu.int/constitution/en/ lstoc1_en.htm. as of july 2005, 13 member states had ratified the constitution. the constitution, which must be ratified by all 25 member states to enter into effect, was rejected in referendums in france and the netherlands. sarah laitner & george parker, germany steps up pressure to save eu treaty, fin. times, july 12, 2005, at 8. although the ratification process has continued beyond the french and dutch �no� votes, several countries, including the united kingdom, have indefinitely postponed their referendums. id. the lack of a constitution, however, does not greatly affect this article because �from a strictly normative viewpoint it has made little difference that the community was established by a network of treaties rather than by a formal constitution.� eric stein, treaty-based federalism, a.d. 1979: a gloss on covey t. oliver at the hughes academy, 127 u. pa. l. rev. 897, 901 (1979). 2. baldwin v. g.a.f. seelig, inc., 294 u.s. 511, 522 (1935) (citations omitted). see generally, 2 the records of the federal convention of 1787 at 308 (max farrand ed., 1911); 3 id. at 547, 548; the federalist no. 42 (james madison). 3. see 1 paul j. hartman & charles a. trost, federal limitations on state and local taxation § 1:1, at 4 (2d ed. 2003) (�[t]he court has repeated . . . that the power to impose and collect taxes for the support of state government shall not be unduly curtailed.�). 4. see treaty establishing the european economic community, mar. 25, 1957, art. 2, 298 u.n.t.s. 11 [hereinafter eec treaty]. the eec treaty established the european economic community as of january 1, 1958. id. the objective of the eec tax discrimination: a comparative analysis of u.s. and eu approaches i. introduction both the united states of america and the european union were founded in part because of the need for economic unity.1 the united states was formed in 1787 in hopes of a solution to �the mutual jealousies and aggressions of the states, taking form in customs barriers and other economic retaliation.�2 the u.s. constitution, however, establishes the dual sovereignty of the states and the federal government and reserves to the states the power to define their own tax systems.3 more than one hundred and fifty years later, the founding countries of the european economic community strove to establish a common market in 1958.4 the single european act5 incorporated the objective of an internal 50 florida tax review [vol.7:2 treaty was to create a single common market that would increase the volume and gain from trade between the member states. id. the original member states were belgium, france, federal republic of germany, italy, luxembourg, and the netherlands. the united kingdom, ireland, and denmark joined in 1973, greece in 1981, and spain and portugal in 1986. emile noel, working together: the institutions of the european community 5 (1993). austria, sweden, and finland acceded to the eu on january 1, 1995. p.s.r.f. mathijsen, a guide to european union law 21 (8th ed. 2004). the czech republic, cyprus, estonia, hungary, latvia, lithuania, malta, poland, slovakia and slovenia joined on may 1, 2004. roger j. goebel, joining the european union: the accession procedure for the central european and mediterranean states, 1 loy. u. chi. int�l l. rev. 15 (2003-04). 5. single european act, 1987 o.j. (l 169) amending eec treaty, supra note 4 [hereinafter sea]. the then twelve member states signed the single european act in 1986. id. 6. sea, supra note 5, art. 13. the internal market is defined as �an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured . . . . � eec treaty, supra note 4, art. 7a (now art. 14.2). 7. the 1992 amendment of the sea by the treaty of maastricht established the european union and became effective on november 1, 1993. treaty on european union, 1992 o.j. (c 191) 1 [hereinafter teu]. the treaty of amsterdam, effective may 1, 1999, amended and renumbered the eec treaty and the teu. treaty of amsterdam, amending the treaty on european union, the treaties establishing the european communities and certain related acts, 1997 o.j. (c 340) 1. the most recent revisions of the treaty entered into force on february 1, 2003. treaty of nice, amending the treaty on european union, the treaties establishing the european communities and certain related acts, 2001 o.j. (c 80) 1 [hereinafter treaty of nice]. for a detailed analysis of the treaty of nice see roger j. goebel, the european union in transition: the treaty of nice in effect, enlargement in sight, a constitution in doubt, 27 fordham int�l l.j. 455 (2004). 8. eec treaty, supra note 4, art. 3(c) (now art. 3(1)(c)). 9. the freedom of establishment is the freedom of a business established in one member state to establish itself in another member state. see infra notes 331-35 and accompanying text for a discussion of the freedom of establishment. 10. george bermann et al., cases and materials on european community law 451 (2d ed. 2002). see also infra notes 291-98 and accompanying text. �the court refers to the four freedoms as �fundamental principles of community law� whose substance must be interpreted widely and exceptions narrowly.� servaas van thiel, free movement of persons and income tax law: the european court in search of principles 5 n.17 (2002) [hereinafter van thiel, free movement of persons]. market into the founding treaty (known as the eec treaty).6 thus, the european union (eu) also has evolved into a project for economic union.7 to create such an economic union, the eec treaty contemplated the removal of obstacles to the free movement of goods, persons, services, and capital between the member states.8 these treaty provisions are known as the �four freedoms� and, together with the freedom of establishment,9 they constitute the fundamental rules of the european community�s internal market.10 2005] tax discrimination 51 11. van thiel, free movement of persons, supra note 10, at 12. 12. michel de wolf, the power of taxation in the european union and in the united states, 3 ec tax rev. 124 (1995). one exception is that community civil servants pay income tax on their community salaries to the community instead of their member states. mathijsen, supra note 4, at 104. see also council regulation 260/68, 1968 o.j. (l 056) (eec, euratom, ecsc). 13. �the sanctity of the member states� power to levy direct taxes . . . is illustrated by the ec treaty�s almost complete silence on this subject.� jan wouters, the case-law of the european court of justice on direct taxes: variations upon a theme, 1 maastricht j. eur. & comp. l. 179, 180 (1994). 14. van thiel, free movement of persons, supra note 10, at 12. the drafters of the maastricht treaty on european union (teu) made the subsidiarity principle a central tenet of the community�s 1992 constitutional reform. george a. bermann, taking subsidiarity seriously: federalism in the european community and the united states, 94 colum. l. rev. 332, 333-34 (1994). 15. consolidated version of the treaty establishing the european community, art. 5, o.j. (c 325) 33 (2002) [hereinafter ec treaty], incorporating changes made by treaty of nice, supra note 7. the community�s activities are furthermore subject to the principle of proportionality, according to which �[a]ny action by the community shall not go beyond what is necessary to achieve the objectives of this treaty.� id. 16. van thiel, free movement of persons, supra note 10, at 13. see infra notes 108-13 and accompanying text for a discussion of the various ec directives that have been implemented in the direct tax area. just as the u.s. constitution established the dual sovereignty of the states and the federal government, the eec treaty also divided competencies between the member states and the community.11 as a general matter, the treaty provides no legal basis for the imposition of taxes by the community itself.12 the power to tax has been reserved to the member states.13 however, it is understood that the community and the member states share competencies in the income tax area such that both have the right to legislate, although community measures in this respect are subject to the principle of subsidiarity.14 the principle of subsidiarity requires that the community only take action if the objectives cannot be sufficiently achieved by the member states individually and can be better achieved (e.g., due to economies of scale) by the community.15 this criterion, however, can be satisfied where differences in national rules tend to distort the internal market. therefore, the community can exercise its legislative powers to eliminate any income tax obstacles to the intra-community flow of goods, persons, services and capital.16 this article focuses on these two �federalist� systems and their respective approaches to thwarting tax discrimination. like congress, the council of ministers (comprised of representatives of the member states at the ministerial level) has the power to regulate commerce between the 52 florida tax review [vol.7:2 17. james hanlon, european community law 36 (3d ed. 2003). see also infra notes 70-73 and accompanying text. 18. see, e.g., commission of the european communities, report of the committee of independent experts on company taxation (1992). 19. see infra notes 109-13 and accompanying text. 20. servaas van thiel, eu case law on income tax part i 425 (2001). �due to the unanimity requirement it has been difficult in recent years to make progress in a number of areas in which action is urgently required to ensure the proper functioning of the internal market and the unfettered exercise of the treaty freedoms.� communication from the commission on supplementary contribution of the commission to the intergovernmental conference on institutional reforms, qualified majority voting for single market aspects in the taxation and social security fields, com (2000) 114 final at 5 [hereinafter qualified majority voting position paper]. 21. van thiel, supra note 20, at 425-26. 22. servaas van thiel, removal of income tax barriers to market integration in the european union: litigation by the community citizen instead of harmonization by the community legislature, 12 ec tax rev. 4, 4-5 (2003). 23. van thiel, free movement of persons, supra note 10, at 5 n.16. the relevant tax cases referred by their name only are �humblet, commission v. france, daily mail, krantz, biehl, bachmann, commission v. belgium, werner, commerzbank, halliburton, schumacker, wielockx, commission v. luxembourg, svensson, asscher, futura, safir, gilly, ici, terhoeve, royal bank of scotland, baxter, gschwind, st gobain, eurowings, vestergaard, xab-yab, baars, zurstrassen, verkooijen, amid, metallgesellschaft/hoechst.� id. additional cases involving the free movement of persons are: wallentin, de baeck, commission v. federal republic of germany; weigel, mertens, schilling, and de groot. 24. see infra notes 291-98 and accompanying text. member states.17 nevertheless, despite several studies outlining the distortions to the internal market caused by tax differences,18 the scope of ec direct tax legislation is currently very limited when compared to progress made in the value added tax area.19 many commentators blame the �continuous legislative vacuum in the income tax area� on the continued unanimity requirement for tax legislation.20 the european court of justice (ecj) began filling this void by using directly applicable community law to eliminate income tax barriers to the internal market.21 as community law has evolved, the court has gradually expanded its role in the integration process and has begun rigorously to enforce a �constitutionally guaranteed minimum of economic integration in the form of directly applicable private sector rights to equal treatment and free movement.�22 since 1986, more than thirty cases have come before the european court of justice testing the compatibility of various national tax provisions with the ec treaty provisions on free movement of persons.23 taking into account all of the four freedoms,24 there have been approximately 2005] tax discrimination 53 25. see, e.g., 2 materials on international & ec tax law (kees van raad ed., 5th ed. 2005). see generally court cases in the field of, or of particular interest for, direct taxation, at http://europa.eu.int/comm/taxation_customs/resources/documents/ taxation/gen_info/tax_law/legal_proceedings/court_cases_direct_taxation_en.pdf. 26. see cordia scott, europe�s changing view of nondiscrimination may color future tax treaty talks, 33 tax notes int�l 851, 852 (2004); see, e.g., case 81/87, the queen v. h. m. treasury and comm�rs of inland revenue ex parte daily mail and general trust plc, 1988 e.c.r. 5483; case c-204/90, bachmann v. belgium, 1992 e.c.r. i-249; case c-112/91, werner v. finanzamt aachen, 1993 e.c.r. i-429; case c-336/96, gilly v. directeur des services fiscaux du bas-rhin, 1998 e.c.r. i2793; case c-391/97, gschwind v. finanzamt aachen-au$enstadt, 1999 e.c.r. i-5451; case c-403/03, schempp v. finanzamt munchen v, http://europa.eu.int/index_en.htm (select documents tab; follow case law hyperlink; then follow case law since 1997 (curia) hyperlink); case c-376/03, d. v. inspecteur van de belastingdienst, http://europa.eu.int/index_en.htm (select documents tab; follow case law hyperlink; then follow case law since 1997 (curia) hyperlink). 27. taxing judgments, the economist, aug. 28, 2004, at 67. since 2000, the ecj has taken on national tax laws addressing thin capitalization (see, e.g., case c324/00, lankhorst-hohorst gmbh v. finanzamt steinfurt, 2002 e.c.r. i-11779), interest deductibility (see, e.g., case c-168/01, bosal holding bv v. staatssecretaris van financiën, 2003 e.c.r. i-9409), and exit taxes (see, e.g., case c-9/02, de lasteyrie du saillant v. ministère de l�économie, des finances et de l�industrie, 2004 e.c.r. i2409). id. at 67-68. see also lee a. sheppard, dowdy u.k. retailer set to destroy european corporate tax, 35 tax notes int�l 132 (2004). 28. u.s. const. art. i, § 8, cl. 3 [hereinafter commerce clause]. see infra note 187. 29. see congressional power to proscribe certain state taxes, state taxation of nonresidents� pension income: hearings before the subcomm. on economic and commercial law of the house comm. on the judiciary, 103d cong. 99, 100 (1993) (legal memorandum by johnny killian, senior specialist, american constitutional law, cong. res. serv., lib. of cong.) (citing champion v. ames, 188 u.s. 321 (1903)). this memorandum [hereinafter crs memo i] provides a brief but comprehensive discussion of federal preemption in the area of state taxation. see also kathryn moore, state and local taxation: when will congress intervene, 23 j. legis. 171 (1997) (reviewing the one hundred direct tax cases.25 what is fascinating is that in all but about seven of these cases, the ecj has struck down the national tax provision concerned, stating that it violated one of these treaty freedoms.26 �while european union governments do their best to avoid harmonising taxation, the eu�s court of justice is busy doing it for them.�27 although the united states has no such unanimity requirement for its tax legislation, there had been a similar legislative vacuum in the state tax area. congress clearly has the authority to regulate commerce among the states under the commerce clause.28 this authority includes the power to regulate cross-border transactions, even to the extent of prohibiting certain state taxes.29 state tax laws enjoy no immunity from congress�s commerce 54 florida tax review [vol.7:2 legislative history of various bills prohibiting state taxation); charles e. mclure, jr. & walter hellerstein, congressional intervention in state taxation: a normative analysis of three proposals, 31 st. tax notes 721 (2004) (providing an overview of congressional intervention in state tax matters and analyzing congressional proposals regarding internet access taxes, sales tax streamlining, and business activity taxes). 30. crs memo i, supra note 29, at 100. 31. see moore, supra note 29, at 182. one notable exercise of its power occurred in 1959, when congress passed a law preventing states from taxing corporations when the corporation�s only nexus with the state was personal property sales solicitations conducted in the state. see act of sept. 14, 1959, pub. l. no. 86-272, 73 stat. 555-56 (codified as amended at 15 u.s.c. §§ 381-384 (1976)). congress was responding to business concerns that mere solicitation within a state would establish a tax nexus following the supreme court�s decision in northwestern states portland cement co. v. minnesota, 358 u.s. 450 (1959) (holding that net income from interstate operations of a foreign corporation is properly subject to state taxation if apportioned to local activities forming a sufficient nexus with that state). see crs memo i, supra note 29, at 103-04. for more recent activity in congress, see infra part ii. 32. ward v. maryland, 79 u.s. (12 wall.) 418, 430 (1871) (holding that a maryland statute requiring nonresident traders pay a higher licensing fee than resident traders was in violation of the privileges and immunities and commerce clauses). 33. see generally walter hellerstein, state taxation of international business: perspectives on two centuries of constitutional adjudication, 41 tax law. 37 (1987) [hereinafter hellerstein, state taxation]. 34. walter hellerstein, federal limitations on state taxation of interstate commerce, in courts and free markets 431 (terrence sandalow & eric stein eds., 1982) [hereinafter hellerstein, federal limitations]. 35. id. clause powers.30 however, congress historically had used these powers sparingly.31 given this historic reluctance of congress to intervene in state taxation, the united states supreme court has been forced to examine issues similar to those now confronting the european union. in 1871, the court recognized the right of a citizen of one state to �be exempt from any higher taxes or excises than are imposed by the [other] state upon its own citizen.�32 for more than two centuries, there has been a stream of cases involving state taxation of interstate commerce.33 the supreme court has had to interpret �constitutional provisions directed to concerns far broader than taxation alone,�34 thus creating virtually all of the federal restraints that exist on the states� taxing power.35 in this article, i examine whether the ecj has been able to handle tax discrimination more effectively than the u.s. supreme court. i thought this research might prove fertile because the time span of consideration of these issues was so compressed in the european union. it has only been 2005] tax discrimination 55 36. hellerstein, state taxation, supra note 33, at 40. 37. ec treaty, supra note 15, art. 234. 38. id. lower courts and tribunals may also refer such questions to the ecj. the interpretation of article 234 determines which questions must be subject to a preliminary ruling and those questions for which a preliminary ruling by the ecj may be requested by a national court or tribunal. p.j.g. kapteyn & p. verloren van themaat, introduction to the law of the european communities: from maastricht to amsterdam 517 (3d ed. 1998). 39. case 26/62, van gend en loos v. nederlandse administratie der belastingen, 1963 e.c.r. 1, ¶ 10. 40. ec treaty, supra note 15, art. 220: �the court of justice shall ensure that in the interpretation and application of this treaty the law is observed.� id. the commission formulates community policy, makes proposals to the council, and drafts the detailed measures needed for their implementation. trevor c. hartley, the foundations of european community law 16-18 (5th ed. 2003). 41. communication from the commission to the council, the european parliament and the economic and social committee: tax policy in the european union priorities for the years ahead, position paper for the commission, com (2001) 260 final at 23 [hereinafter tax policy in the eu]. in 2005, the commission introduced four times as many cases to the ecj than it had just two years prior. michael aujean, conference at the university of michigan school of law: comparing fiscal federalism: comparing the european court of justice and the u.s. supreme court�s tax jurisprudence (oct. 21-22, 2005) (on file with author). 42. the tax injunction act holds that �the district courts shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under state law where a plain, speedy and efficient remedy may be had in the courts of such state.� 28 u.s.c. § 1341 (2004). by tempering the power of the federal courts over certain state actions, the tax injunction act protects an inherent aspect of state sovereignty, the power to approximately 20 years since the first eu tax case as compared to over 200 years of u.s. jurisprudence.36 unlike the u.s. supreme court, the european court of justice is obligated under the treaty to take every case that is referred to it under article 234 of the ec treaty.37 although eu nationals in general must litigate before their respective domestic courts, the highest courts or tribunals must refer questions regarding the incompatibility of member states� domestic law or tax treaties with the ec treaty to the ecj if such questions arise in the national proceedings.38 the goal is to secure uniform interpretation of the treaty by the national courts and tribunals.39 along with these referrals, the ecj must also hear cases brought by the commission pursuant to its obligation to enforce the treaty.40 the commission has stated that it intends to pursue a more proactive strategy in the field of tax infringements and is more willing to initiate action before the court upon finding incompatible tax provisions.41 in the u.s. judicial system, taxpayers normally have to challenge a state tax in state court.42 the state courts review federal law in the course of 56 florida tax review [vol.7:2 assess and levy state and local taxes. 17 charles alan wright et al., federal practice and procedure § 4237 (2d ed. 1988). 43. r. rotunda & j. nowak, treatise on constitutional law: substance and procedure § 1.6, at 70 (3d ed. 1999). �when reviewing federal laws these courts must follow the rulings of the supreme court and enforce federal laws over inconsistent state acts.� id. 44. id. states are free to interpret their own state�s law or constitution in ways that do not violate the principles of federal law. this includes granting greater rights than the federal constitution provides. id. the supreme court was granted the appellate jurisdiction over state court decisions with respect to federal questions in the judiciary act of 1789. 1 laurence h. tribe, american constitutional law § 3-4, at 255 (3d ed. 2000). 45. robert l. stern et al., supreme court practice § 1.19, at 54 (8th ed. 2002). �[t]he supreme court cannot possibly hear arguments in and decide more than a small proportion of the cases in which parties would like to bring before it. the consequence is that every type of case . . . goes through a preliminary sifting process.� id. only those cases deemed �sufficiently important or meritorious to warrant further review� are granted the writ of certiorari. id. 46. �review on writ of certiorari is not a matter of right, but of judicial discretion. a petition for a writ of certiorari will be granted only for compelling reasons.� sup. ct. r. 10. 47. bob woodward & scott armstrong, the brethren 362 (1979) (stating that justice brennan hated tax cases, and that his normal reaction to a certiorari request in a tax case was: �this is a tax case. deny.�). 48. see infra part ii. 49. see infra part iii. deciding these cases, but are not required to get a ruling from the supreme court prior to issuing a decision.43 a state court must �follow the supreme court�s rulings on the meaning of the constitution of the united states or federal law,�44 but the state court is doing the actual interpreting. after a loss in the state�s highest court, either party has the right to petition the u.s. supreme court to grant certiorari to hear the case.45 however, it is at the supreme court�s discretion as to whether it should hear the case.46 thus, the u.s. supreme court does not proportionally rule on the same amount of tax cases as the ecj because the u.s. supreme court declines to hear many tax cases.47 for all these reasons, i was hopeful that a more coherent theory might have developed in the european union. unfortunately, as described in part iv, the jurisprudence is confused on both sides of the atlantic. in part ii, i provide background for the reader unfamiliar with the european union and outline the eu�s distinctive institutional arrangements.48 in part iii, i set forth the principles of international and interstate taxation that underlie the tax legislation that has been promulgated by the respective member states and the u.s. states.49 2005] tax discrimination 57 50. see infra part iv. 51. ben j.m. terra & peter j. wattel, european tax law 45-46 (3d ed. 2001). 52. peter j. wattel, the ec court�s attempts to reconcile the treaty freedoms with international tax law, 33 c.m. l. rev. 223, 224-26 (1996). 53. see infra notes 394-587 and accompanying text. 54. bermann, supra note 10, at 3. in 1955, the benelux countries proposed a path to political integration through economic integration. id. at 6. robert schuman and jean monnet were the driving forces behind the establishment of the european coal and steel community (ecsc) in 1950. richard mayne & john pinder, federal union: the pioneers: a history of federal union 123-27 (1990). the ecsc�s founding member states, including france, italy, and germany, intended the community to be much more than an economic union. the intention was for a political union to ensure peace on the in part iv, i outline how the supreme court and the european court of justice have struggled with the conflict between these generally accepted tax principles and the effective prevention of discriminatory treatment of foreign source income.50 for example, it has been accepted under international tax law that nonresident taxpayers are in a different situation than resident taxpayers and the taxation of nonresidents can be different than that of resident taxpayers.51 this creates a conflict between these generally accepted tax principles and the effective prevention of discriminatory treatment of foreign source income.52 in part v, i choose the most recent supreme court case that deals with individual tax discrimination and then examine the ecj jurisprudence to determine how the european court of justice would decide the issue.53 although the ecj approach yields much certainty (the national tax provision is generally found to violate the treaty), it does not appear to solve the discrimination problem. because great strides have been made towards an internal market, i believe that the eu would be better served by harmonization at the legislative level. at a minimum, the ecj should, at this point, give more deference to member state tax systems. on the other hand, given the recent u.s. experience with federal intervention in state tax legislation and the current anti-tax rhetoric, the united states is better served by judicial oversight instead of the congressional interference that has restricted the ability of the states to levy necessary taxes. i conclude with a recommendation that the supreme court should give more priority to state tax conflicts and additional restraints should be placed on the ability of congress to tamper with state tax laws. ii. eu vs. u.s. federalism although the european economic community was principally designed for economic purposes, the idea of a political union was in the minds of many of its founders.54 france�s foreign minister robert schuman 58 florida tax review [vol.7:2 continent. id. 55. the schuman declaration 1950-1990. luxembourg: office for official publications of the european communities (1990), citing the schuman declaration of may 9, 1950. schuman proposed: [t]hat franco-german production of coal and steel as a whole be placed under a common high authority, within the framework of an organization open to the participation of the other countries of europe. the pooling of coal and steel production should immediately provide for the setting up of common foundations for economic development as a first step in the federation of europe, and will change the destinies of those regions which have long been devoted to the manufacture of munitions of war, of which they have been the most constant victims. the solidarity in production thus established will make it plain that any war between france and germany becomes not merely unthinkable, but materially impossible. the setting up of this powerful productive unit, open to all countries willing to take part and bound ultimately to provide all the member countries with the basic elements of industrial production on the same terms, will lay a true foundation for their economic unification. europa, the eu at a glance, declaration of 9 may 1950, at http://europa.eu.int/abc/ symbols/9-may/decl_en.htm. 56. eec treaty, supra note 4, at preamble. 57. bermann, supra note 10, at 17. 58. id. at 27. 59. �it was loyalty to one�s country that moved men, whether radical or conservative, and one�s country was the state in which one lived, not the thirteen more or less united states along the atlantic coast.� merrill jensen, the articles of confederation: an interpretation of the social-constitutional history of the american revolution 1774-1781, at 163 (1970). believed that economic unity would be the �leaven from which may grow a wider and deeper community between countries.�55 the preamble to the 1957 treaty establishing the european economic community aspires to the achievement of �an ever closer union among the peoples of europe.�56 the european economic community has evolved from a �common market� to an �internal market� to an �economic and monetary union� to a �european union.�57 it �represents the most ambitious example of deliberate political and economic integration in recent times,� having created a �fully-developed form of federation in a matter of three to four decades.�58 the united states�s form of federalism has also evolved but over the last two hundred years. some have forgotten how powerful the individual states were before the founding of the united states.59 the states printed their 2005] tax discrimination 59 60. jeffrey c. cohen, politics and economic policy in the united states 36 (1997). 61. see ira mickenberg, abusing the exceptions and regulations clause: legislative attempts to divest the supreme court of appellate jurisdiction, 32 am. u. l. rev. 497, 511 (1983). 62. lawrence d. cress, citizens in arms 63 (1982). 63. joseph m. lynch, negotiating the constitution: the earliest debates over original intent 1 (1999) (citing the federalist no. 45, at 308, 313 (james madison)). 64. klaus-dieter borchardt, european integration: the origins and growth of the european union 26 (1995) [hereinafter european integration]. community law either has direct internal effect as law in the member states or requires the member states to implement the legislation domestically. eec treaty, supra note 4, arts. 5, 189 (now arts. 10, 249). 65. case 26/62, van gend en loos v. nederlandse administratie der belastingen, 1963 e.c.r. 1. the doctrines of direct applicability, direct effect, and supremacy not only describe legal relationships, but actually demand member state action. these doctrines �essentially require, respectively, that national institutions recognize community measures as law, effectuate those measures at the request of private parties wherever appropriate, and prefer claims based on community law to those based on member state law whenever a choice must be made.� bermann, supra note 14, at 349. 66. case 26/62, van gend en loos v. nederlandse administratie der belastingen, 1963 e.c.r. 1, ¶ 9. 67. id. ¶ 10. own currency,60 had their own courts,61 and formed their own militia.62 james madison�s basic thesis in the federalist was that �the powers delegated by the proposed constitution to the federal government, are few and defined. those which are to remain in the state governments are numerous and indefinite.�63 admittedly, these individual states did not have the duration of independent history that the member states possessed at the formation of the european economic community. a. the legislative branch the eec treaty established an institutional system that enables the community to enact legislation that is equally binding on all its members.64 after the european court of justice�s landmark decision on direct applicability, it is understood that the treaty grants rights and imposes obligations on individuals, member states, and community institutions.65 �[t]his treaty is more than an agreement which merely creates mutual obligations between the contracting states.�66 instead, �the community constitutes a new legal order of international law for . . . which the states have limited their sovereign rights . . . .�67 community law is comprised of basic legislation, including the treaties and their protocols, and secondary 60 florida tax review [vol.7:2 68. tracy a. kaye, european tax harmonization and the implications for u.s. tax policy, 19 b.c. int�l & comp. l. rev. 109, 122 (1996) [hereinafter kaye, european tax harmonization]. secondary community legislation consists of regulations, directives, decisions, recommendations, and opinions. ec treaty, supra note 15, art. 249. 69. bermann, supra note 10, at 34; hartley, supra note 40, at 41; see also ec treaty, supra note 15, art. 7. most regulations are made by the commission and are binding on all member states without any further action by the individual states. id. (expressly providing that regulations are directly applicable). directives create obligations on the governments of the member states to transpose the provisions adopted by the community into national legislation. directives are binding upon the member states as to the result to be achieved but leave the national authorities free to choose the form and methods of compliance. id. decisions are binding on the specific entities to whom they are addressed. id. see also noel, supra note 4, at 9. recommendations and opinions are not legally binding but are issued by the commission and council to advise on specific topics. ec treaty, supra note 15, art. 249. 70. ec treaty, supra note 15, art. 203; see european integration, supra note 64, at 26; hartley, supra note 40, at 19. 71. bermann, supra note 10, at 35. 72. see bermann, supra note 14, at 395. 73. bermann, supra note 10, at 35-36. �the framers of the ec treaty had entrusted the community�s legislative powers chiefly to a council of ministers in which representatives of the member states could unapologetically express and vote the political interests of the states they represented.� bermann, supra note 14, at 353 (citing ec treaty, supra note 15, art. 146). 74. ec treaty, supra note 15, arts. 213, 214. legislation that is the legislative product of the community institutions.68 the three community institutions most involved in the legislative process are the council of ministers, the commission, and the european parliament.69 the council of ministers is comprised of representatives of the member states, usually the ministers responsible for the subject matter under discussion.70 for example, the member states� finance ministers meet with respect to tax and other economic matters and are known as the economy and finance council (ecofin).71 thus, the council is set up in a manner that should enable it to safeguard the economic interests of the member states because the minister�s acknowledged responsibility is to look after the member state�s interests in the matter before the council.72 in tax matters, the council is the principal lawmaking body of the community, but it can only act on a proposal from the commission.73 the commission consists of members appointed by mutual agreement between member governments for five-year terms.74 these commissioners are required to act in complete independence from their own 2005] tax discrimination 61 75. ec treaty, supra note 15, art. 213; treaty establishing a single council and a single commission of the european communities (merger treaty), apr. 8, 1965, 1967 o.j. (l 152), art. 10(2); bermann, supra note 10, at 44; hartley, supra note 40, at 11-12. see also european integration, supra note 64, at 26. 76. ec treaty, supra note 15, art. 211. in 2002, the commission proposed drafts for 54 directives, 193 regulations and 239 decisions, and in 2003 drafts for 491 legislative proposals and decisions. george bermann, european union law 2 (roger j. goebel ed., 2d ed. supp. 2004) [hereinafter goebel supplement, european union law] (professor goebel�s electronic developments update on file with author). 77. ec treaty, supra note 15, art. 226. 78. ec treaty, supra note 15, arts. 189, 190. the most recent election was held in june 2004. lizette alvarez, �enthusiasm� is not a candidate in elections for european union, n.y. times, june 10, 2004, at a11. 79. eec treaty, supra note 4, art. 137; bermann, supra note 10, at 51. 80. bermann, supra note 10, at 51; ec treaty, supra note 15, art. 192. 81. see klaus-dieter borchardt, the abc of community law 72 (5th ed. 1999) [hereinafter community law]. see also hartley, supra note 40, at 41. 82. ec treaty, supra note 15, art. 250; see also community law, supra note 81, at 72; hartley, supra note 40, at 38. 83. ec treaty, supra note 15, art. 252; see also hartley, supra note 40, at 40. 84. ec treaty, supra note 15, art. 251; see also hartley, supra note 40, at 40. 85. community law, supra note 81, at 81-82; see, e.g., ec treaty, supra note 15, arts. 49, 105(6), 107(5), 214(2). 86. community law, supra note 81, at 82; see also ec treaty, supra note 15, art. 211. 87. community law, supra note 81, at 82; see also ec treaty, supra note 15, art. 202. 88. paul craig & grainne de burca, eu law text, cases and materials 139 (3d ed. 2003). governments and the council, and for the good of the community.75 the commission formulates community policy, makes proposals to the council, and drafts the detailed measures needed for policy implementation. the commission must also ensure that the treaties and community law are respected and applied, and must act on any infringements.76 this includes referring matters to the court of justice, if necessary.77 the european parliament consists of no more than 732 members directly elected in their member states every five years.78 although the eec treaty originally defined the role of the european parliament as advisory and supervisory,79 the legislative role of the parliament has been consistently increasing.80 depending on the subject matter, current legislation is adopted pursuant to one of six different legislative procedures spelled out under the ec treaty.81 the consultation procedure,82 the co-operation procedure,83 the co-decision procedure,84 the approval procedure,85 the simplified procedure,86 and the procedure for implementing measures87 differ principally with respect to the degree of power afforded the parliament.88 62 florida tax review [vol.7:2 89. id. at 144-46. see ec treaty, supra note 15, art. 251. 90. bermann, supra note 10, at 83. 91. directives do not directly amend national law; rather they obligate the governments of the member states to take implementing action to incorporate the directives� provisions into their national legislation. directives are the legislative instruments most commonly used to harmonize the member states� legislation. see bermann, supra note 10, at 253. nearly all of the steps taken to harmonize the tax laws to date have been achieved through the use of directives. see generally kaye, european tax harmonization, supra note 68, at 124. when a member state does not implement the directive into national law, the question arises as to whether the directive has direct effect, i.e., whether it is effective without such enactment. the european court of justice has observed that �a member state which has not adopted the implementing measures required by [a] directive within the prescribed period may not plead, as against individuals, its own failure to perform the obligations which the directive entails.� case 8/81, becker v. finanzamt munster innenstadt, 1982 e.c.r. 53, ¶ 24 (holding that although germany had not yet implemented the sixth vat directive, the directive was directly effective). the test is whether the provisions of the directive are unconditional and sufficiently precise to be relied upon in a conflict with an incompatible national provision. id. ¶ 25. 92. ec treaty, supra note 15, art. 94. 93. ec treaty, supra note 15, art. 257; see also hanlon, supra note 17, at 5657. 94. bermann, supra note 10, at 71-72. articles 198a-198c of the teu established the committee of the regions to provide non-binding advisory opinions on matters having a particular affect on regions of the eu. hanlon, supra note 17, at 57; see also ec treaty, supra note 15, arts. 263-65. 95. ec treaty, supra note 15, art. 250; see also hartley, supra note 40, at 41; bermann, supra note 10, at 83. most community legislation is made pursuant to the co-decision procedure, which emphasizes reaching a text approved by both the parliament and the council.89 however, the consultation procedure applies to taxation.90 under this procedure, the commission delivers a proposal, such as a proposed directive, to the council.91 the european parliament is consulted and publishes an opinion accepting, rejecting, or suggesting amendments to the proposal. the economic and social committee must also be consulted for any legislation that directly affects �the establishment or functioning of the common market.�92 this committee consists of representatives of various economic and social interests such as trade unions, employers� groups, consumer groups and the professions.93 the committee of the regions, composed of representatives of regional and local entities within the member states, may also be consulted.94 the commission may amend the proposal to incorporate any changes and the council then examines and votes upon the proposed directive.95 the treaty provides three different voting formulas: unanimity, 2005] tax discrimination 63 96. craig & de burca, supra note 88, at 153. 97. id. at 154. 98. ec treaty, supra note 15, art. 94 (ex art. 100). article 94 states: the council shall, acting unanimously on a proposal from the commission and after consulting the european parliament and the economic and social committee, issue directives for the approximation of such laws, regulations or administrative provisions of the members states as directly affect the establishment or functioning of the common market. id. it is understood that article 94 of the treaty in the chapter on �approximation of laws� provides a legal basis for direct taxation harmonization measures. van thiel, free movement of persons, supra note 10, at 112. 99. qualified majority voting position paper, supra note 20, at 5, 11. �[i]t remains the commission�s view that a move to qualified majority voting at least for certain tax issues is indispensable.� tax policy in the eu, supra note 41, at 9. 100. see bermann, supra note 10, at 24 (citing teu, supra note 7, art. 48). 101. id. at 31. 102. tax policy in the eu, supra note 41, at 5. 103. charlemagne: the tyranny of the majority, the economist, may 29, 2004, at 55. simple majority, and qualified majority.96 the treaty article under which the legislation is enacted specifies the appropriate voting rule to be used.97 although the eec treaty has been amended on multiple occasions to provide for the adoption of various harmonization measures by only a qualified majority vote of the council, a unanimous vote is still required by the ec treaty for tax legislation.98 in fact, the commission has proposed qualified majority voting for the introduction of minimum requirements in the tax area and the adoption of coordinating provisions to remove direct obstacles to the exercise of the four freedoms but has so far been unsuccessful.99 the european council convened an intergovernmental conference (igc) in nice to discuss, among other issues, extension of qualified majority voting to various legislative areas.100 an igc is a meeting of representatives of each member state for the purpose of negotiating new amendments to the treaties.101 the commission was disappointed in the outcome of the treaty negotiations with respect to decision-making for tax issues at the 2000 igc as no changes were made for tax legislation.102 the draft european union constitution briefly contained a provision that would have moved certain areas of legislation that affect the single market, such as corporate taxes, to majority voting.103 however, this provision did not survive the final negotiations because the united kingdom 64 florida tax review [vol.7:2 104. goebel supplement, european union law, supra note 76, at 445-522. see also chuck gnaedinger, eu convention adopts draft constitution, 31 tax notes int�l 206, 206 (2003) (�[qualified majority voting] for all tax legislation is not included in the draft text because of opposition from the united kingdom and ireland.�). 105. tax policy in the eu, supra note 41, at 22. �since the legal basis will, for the present, remain unanimity it will, after enlargement, be much more difficult to have any new community legislation agreed.� id. at 5. the most recent accession on may 1, 2004 enlarged the eu from 15 to 25 member states. goebel, supra note 4, at 15. 106. for example, article 90 states that member states may not use internal taxes to discriminate against products coming from other member states. ec treaty, supra note 15, art. 90. 107. ec treaty, supra note 15, art. 293. this article was the legal basis for convention 90/436 on the elimination of double taxation in connection with the adjustments of transfers of profits between associated undertakings, july 23, 1990, 1990 o.j. (l 225) 10 [hereinafter arbitration convention]. see infra note 113 and accompanying text. 108. ec treaty, supra note 15, art. 94. 109. council directive 90/435, 1990 o.j. (l 225) 6 (eec) [hereinafter parentsubsidiary directive], amended by council directive 2003/123, 2004 o.j. (l 7) 41 (ec); council directive 90/434, 1990 o.j. (l 225) 1 (eec) [hereinafter mergers directive], amended by council directive 2005/19, 2005 o.j. (l 58) 19 (ec); council directive 2003/49, 2003 o.j. (l 157) 49 (ec) (interest and royalty directive). �unlike vat, direct taxation is at a purely embryonic stage of harmonization.� case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i-225, op. ¶ 19. 110. council directive 2003/48, 2003 o.j. (l 157) 38 (ec) (savings directive). and ireland vetoed it.104 the commission remains committed to a move to qualified majority voting for certain tax issues, pointing out that eu enlargement will only exacerbate the inability to have agreement on any new community tax legislation.105 although the treaty specifically covers indirect taxes,106 article 293 contains the only explicit reference to direct taxes and provides that member states shall enter into negotiations to eliminate double taxation.107 it is understood, however, that article 94 of the treaty, in the chapter on �approximation of laws,� also provides a legal basis for direct taxation harmonization measures. this article authorizes the council, acting unanimously on a proposal from the commission, to issue directives for the approximation of laws that �directly affect the establishment or functioning of the common market.�108 thus, the council has the power to regulate commerce between the member states to the extent consistent with the treaty. unfortunately, the scope of ec direct tax legislation is currently limited to a few corporate tax directives,109 a savings directive,110 and a 2005] tax discrimination 65 111. council directive 77/799, 1977 o.j. (l 336) 15 (eec) (mutual administrative assistance and exchange of information directive), amended by council directive 79/1070, 1979 o.j. (l 331) 8 (eec). 112. council directive 76/308, 1976 o.j. (l 73) 18 (eec) (mutal assistance for the recovery of claims directive), amended by council directive 2001/44, 2001 o.j. (l 175) 17 (ec). see also jan de goede, european integration and tax law, 43 eur. tax�n 203 (2003). 113. arbitration convention, supra note 107, at 10. unlike the parentsubsidiary directive and the mergers directive, the arbitration convention is actually a multilateral treaty. a.p. lier et al., tax and legal aspects of ec harmonization 167 (a.p. lier ed., 1993). when the original arbitration convention expired at the end of 1999, the 1999 protocol was signed by most of the member states to extend its applicability. pietro antonini & maurizio di bernardo, italy ratifies protocol to eu arbitration convention, 34 tax notes int�l 912 (2004). as of november 1, 2004, the arbitration convention re-entered into force, having been ratified by all member states. european commission, eu joint transfer pricing forum: secretariat discussion paper on the re-entry into force of the arbitration convention, august 25, 2004, jtpf/019/2004/en. the arbitration convention will apply retroactively to january 1, 2000, with some limitations. id. 114. see koen lenaerts, constitutionalism and the many faces of federalism, 38 am. j. comp. l. 205 (1990) (�the political reality that decision-making within the american union is organically independent from the states, whereas in the european community the member states themselves play the double role of participants in the community decision-making and of antipodes to the legal order of the community as such.�) id. at 262. 115. vikram amar, indirect effects of direct election: a structural examination of the seventeenth amendment, 49 vand. l. rev. 1347, 1352 (1996). 116. id. at 1349. see generally robert c. byrd, the senate 1789-1989 (1988); c.h. hoebeke, the road to mass democracy, original intent and the seventeenth amendment (1995). mutual assistance directive.111 there is an additional mutual assistance directive that enables tax authorities to assist each other in the collection of tax claims.112 on july 23, 1990, the member states also concluded the arbitration convention to provide for binding arbitration of transfer pricing disputes when the respective tax authorities have been unable to resolve the issues within two years.113 unlike the eu, where the member states play a double role, decision-making in the u.s. congress is currently independent from that of the fifty states.114 originally, the u.s. constitution required that two senators were to be chosen by the legislatures of each respective state because the framers wanted to safeguard the interests of the state governments.115 in 1787, the state legislative election of senators was seen as a �central device for the protection of states� rights and interests.�116 however, in 1913, the states ratified and added the seventeenth amendment to the constitution 66 florida tax review [vol.7:2 117. u.s. const. amend. xvii, cl. 1. �the senate of the united states shall be composed of two senators from each state, elected by the people thereof, for six years; and each senator shall have one vote.� id. proposals to amend the process had been around since the 1820�s. laura e. little, an excursion into the uncharted waters of the seventeenth amendment, 64 temple l. rev. 629, 636 (1991). 118. amar, supra note 115, at 1353. he also cites �(3) the dissatisfaction with deadlocks in state legislatures that delayed the filling of vacant senatorial seats; and (4) the feeling that state legislatures were spending too much time on the �national� matter of senatorial selection, thus leaving local matters unattended.� id. 119. id. at 1349. 120. hellerstein, federal limitations, supra note 34, at 431; see also mclure & hellerstein, supra note 29, at 722 (providing another listing of examples of legislation restricting states� power). 121. see generally moore, supra note 29; 2 hartman & trost, supra note 3, § 14:1, at 575 n.1. for an example of an exception to this rule, see the internet tax freedom act (itfa), which was enacted on october 21, 1998, as part of public law 105-277. the original itfa imposed a three-year moratorium on taxation of internet access. william j. quirk & r. rhett shaver, does congress put federalism at risk when it limits the states� power to tax?, 21 st. tax notes 649, 653-54 (2001). 122. see, e.g., soldiers� and sailors� civil relief amendments of 1942, ch. 581 § 17, 56 stat. 777 (codified at 50 u.s.c. app. § 574 (1942)) (providing that members of the armed forces are subject to tax only in their respective states of residence, and not necessarily in the states in which they are stationed). 123. see, e.g., airport development acceleration act of 1973 § 7(a), pub. l. no. 93-44, 87 stat. 88 (codified in 49 u.s.c. app. § 1513 (1973)) (preempting state and local gross receipts taxes on the sale of commercial air transportation). this law was passed after the supreme court validated airline passenger head taxes in evansvillevanderburgh airport auth. dist. v. delta airlines, inc., 405 u.s. 707 (1972). see also congressional power to proscribe certain state taxes, miscellaneous tax bills � 1991: hearings on s. 90, s. 150, s. 267, s. 284, s. 649 and s. 913 before the subcomm. on calling for the direct election of senators.117 there were a number of reasons for the adoption of the seventeenth amendment and the move to direct elections including: �(1) the perception that bribery and corruption had tainted the state legislatures� choice of senators;� and �(2) the related belief that private interest groups dominated state legislatures to the point where senatorial choices did not adequately represent ordinary citizens.�118 now, however, special interests in washington are overshadowing the needs of the state government. professor vikram amar observes that unfunded federal mandates and federal conscription of the states are a result of removing the state legislatures from the electoral loop.119 generally, congress has refrained from exercising its authority under the u.s. constitution �to enact legislation impinging on state tax power�120 except in the following three categories:121 (1) state taxation of federal employees;122 (2) state taxation of interstate transportation and their employees;123 and (3) state taxation of natural resources.124 however, in the 2005] tax discrimination 67 taxation of the senate comm. on finance, 102d cong. 289, 291 (1991) (legal memorandum by johnny killian, senior specialist, american constitutional law, cong. res. serv., lib. of cong.) [hereinafter crs memo ii]. 124. tax reform act of 1976, pub. l. no. 94-455, 90 stat. 1520 (codified as amended at 15 u.s.c. § 391 (1976)) (forbidding states from imposing taxes on or with respect to the generation or transmission of electricity when such a tax would discriminate against out-of-state manufacturers, producers, wholesalers, retailers and consumers of that electricity). congress�s increased restriction on state taxation was engineered by arizona senators because of a conflict with new mexico and arizona concerning new mexico�s tax on electricity generated within the state. crs memo ii, supra note 123. 125. see multistate tax commission, federalism at risk, app. c. (2003). for two examples of legislation currently pending before congress that would interfere with a state�s ability to tax see the telecommuter tax fairness act of 2005, s. 1097, 109th cong. (2005) (only allowing a state to tax income earned while physically within the state) and the economic development act of 2005, s. 1066, 109th cong. (2005) (in certain circumstances allowing tax incentives that would otherwise be barred by the commerce clause). see generally mclure & hellerstein, supra note 29, for an analysis of three congressional proposals. to avoid such interference, states can coordinate with each other. for example, currently, 42 states and the district of columbia are involved in the creation of a streamlined sales and use tax agreement that went into effect october 1, 2005. this project includes uniform definitions for key items, state level administration and collection of local taxes, and rules designed to make the sourcing of transactions both uniform and simplified. streamlined sales tax governing board, inc., http://www.streamlinedsalestax.org (last visited feb. 21, 2006). as of october, 19 states are deemed in compliance with the agreement as either full or associate members. emily dagostino, streamlining system in place with inception of governing board, 38 st. tax notes 165, 165 (2005). 126. act of jan. 10, 1996, pub. l. no. 104-95, 109 stat. 979 (codified at 4 u.s.c. § 114 (1996)). the law became effective for retirement income payments received after december 31, 1995. see also tracy a. kaye, show me the money: congressional limitations on state tax sovereignty, 35 harv. j. on legis. 149, 167 (1998). 127. the statute protects all distributions from qualified plans, including, but not limited to: individual retirement accounts, simplified employee pensions, annuity plans or contracts, eligible deferred compensation plans, and governmental plans. see douglas l. lindholm et al., state source taxation of retirement benefits � what�s barred, what�s left, 84 j. tax�n 299, 299 (1996). see also brian j. kopp, new federal last decade, there has been an increase in interference with state tax systems.125 the state taxation of pension income act of 1995 (source tax act) is an example of congressional intrusion on state tax sovereignty with respect to the income taxation of individuals.126 the source tax act prohibits states from taxing the retirement income and pension distributions of their former residents (i.e., those individuals who moved from the state where they earned the income).127 the most vociferous proponents of the source tax act were 68 florida tax review [vol.7:2 statute bars states from taxing pension income of nonresidents, 6 j. multistate tax�n 68 (1996). california and fifteen other states were attempting to collect income taxes from their absentee retirees, nonresidents who had earned pensions in their states but were collecting these benefits in different states. quirk & shaver, supra note 121, at 654. 128. state taxation of nonresidents� pension income: hearings on h.r. 371, h.r. 394 and h.r. 744 before the subcomm. on commercial and admin. law of the house comm. on the judiciary, 104th cong. 24, 40 (1995) [hereinafter 1995 pension hearings] (prepared statement of william c. hoffman, president, retirees to eliminate state income source tax (resist)). how can a nation that was formed over the issue of �taxation without representation� allow this to happen? because it was the best kept secret in america! no one was told about this unfair tax that interferes with our right to travel across our country and live where we choose without suffering a financial penalty. it is unthinkable for an individual in the united states of america to be controlled by a taxing agency without recourse. more important, how can our great nation allow senior citizens to be treated in this terrible manner. id. at 41. 129. see h.r. rep. no. 104-389, at 3-4 (1995), reprinted in 1995 u.s.c.c.a.n. 1006 [hereinafter source tax report]. 130. professor james smith testified that the �taxation without representation� argument must focus on the time during which the income was earned, the time when the state provided the taxpayer with ample benefits. see 1995 pension hearings, supra note at 128 (prepared statement of james c. smith, professor of law, georgia university school of law). 131. quirk & shaver, supra note 121, at 654. 132. see source tax report, supra note 129, at 9. the cbo�s estimate of the source tax act clarified that: revenue losses could be higher, however, because of the bill�s impact on the taxation of certain types of deferred compensation. . . . states that offer their residents credit for taxes paid to other states on retirement income would realize an increase in tax revenue. . . . the extent to which one state�s revenue gain would offset another state�s revenue loss depends on whether the taxed nonresident currently lives in a state that offers a tax credit. . . . the net overall cost of the bill to state governments would stem primarily from affected retirees who live in states that do not tax personal income or retirees who had moved to states that do not impose an income tax.128 in their view, nonresidents should not be taxed if they do not currently receive benefits from their tax payments.129 of course benefits were received when the income was earned130 but congress determined that the same income might be �taxed by multiple jurisdictions if the employee had worked in a number of states.�131 congress�s solution was simple, no taxation of the absent retirees by their former states of residence. the congressional budget office estimated the revenue loss to the states at $70 million annually.132 2005] tax discrimination 69 offer such tax credits. many of these nontaxing states tend to be popular retirement destinations. source tax report, supra note 129, at 9-10. note that this cbo estimate is for the bill as reported. the legislation that actually passed would be costlier. see telephone interview with theresa a. gulo, chief, state & local government cost unit, congressional budget office (c.o.) (aug. 12, 1997). 133. act of oct. 21, 1998, 105 p.l. 277, 112 stat. 2681 (1998). 134. see quirk & shaver, supra note 121, at 653. the original itfa imposed a three-year moratorium on taxation of internet access. the moratorium generally prevented: (1) the taxation of internet access, (2) multiple and discriminatory taxes on electronic commerce, and (3) the application of federal excise taxes on internet access. id. 135. donald bruce et al., has internet access taxation affected internet use?, 32 st. tax notes 519, 520 (2004). 136. internet tax nondiscrimination act, h.r. 1522, 107th cong. (1st sess. 2001). 137. act of dec. 3, 2004, 108 p.l. 435, 118 stat. 2615 (2004). [hereinafter itna]. see also emily dagostino, president signs internet tax moratorium extension, 34 st. tax notes 708 (2004). 138. itna, supra note 137. see bruce et. al., supra note 135 (detailing economic study); see also mclure & hellerstein, supra note 29, at 730 (describing the case for exempting internet access by households as weak). 139. cox internet tax moratorium bill signed into law at white house, st. news serv., dec. 6, 2004. the new law allows states that enacted taxes on internet access prior to october 1998, to continue to have such authority, except for wisconsin�s another congressional intrusion on state tax sovereignty has been with respect to taxation of internet access. the internet tax freedom act (itfa) was originally enacted in 1998.133 congress�s exercise of its commerce clause powers in legislating against state and local government interference with interstate commerce on the internet or related services has cost the states billions in foregone revenues.134 the itfa only grandfathered the ten states that were already imposing a tax on internet access at the time of initial passage.135 the act also imposed a three-year moratorium on new or discriminatory state and local taxes on electronic commerce that was extended for two years in november 2001 and expired in 2003.136 on december 3, 2004, the president signed the internet tax nondiscrimination act (itna). this act broadens the definition of internet access and retroactively extends the moratorium through november 2007.137 itna also redefines �tax on internet access� to include any tax on internet access, �regardless of whether such tax is imposed on a provider of internet access or a buyer of internet access and regardless of the terminology used to describe the tax.�138 this broader definition prevents states from taxing dsl, cable, satellite, or wireless internet access.139 the states are asserting that this 70 florida tax review [vol.7:2 tax on the internet. telephone interview with thad bingle, majority counsel, house judiciary committee (dec. 13, 2004). wisconsin�s tax, which was enacted in 1991, will not be grandfathered after nov. 1, 2006. press release, congressman f. james sensenbrenner, jr. sensenbrenner provision eliminates internet taxes for wisconsin (nov. 19, 2004) [hereinafter sensenbrenner release]. 140. karen setze, u.s. house votes to extend moratorium on internet access taxes until 2007, 34 st. tax notes 564, 564 (2004). wisconsin alone collected an estimated $24.3 million in revenue from its internet access tax in 2002. sensenbrenner release, supra note 139. 141. cbo rep. s.150 internet tax nondiscrimination act (sept. 9, 2003). 142. passage of internet tax bill hailed as victory for broadband, telecommunications reporter, dec. 15, 2004. 143. mark c. alexander, campaign finance reform: central meaning and a new approach, 60 wash. & lee l. rev. 767, 811 (2003). 144. id. at 812. 145. i have previously recommended eliminating the $50 million threshold of the unfunded mandates reform act (umra) for legislation that prohibits states from raising revenue. my hope was that this new procedural hurdle would ensure that the states receive heightened protection in the federal legislative process from congressional intrusion on state tax sovereignty. the threat of a recorded vote on whether to impose legislation will cost state and local government billions in lost revenues.140 the congressional budget office estimates that repealing the grandfather clause could cost states at least $80 million to $120 million per year.141 this estimate, however, does not consider the amount of revenue lost to the other states that are unable to currently tax the internet. the itna is the result of fierce lobbying by the telecommunications industry. verizon communications, inc., the u.s. telecom association, and the ctia (former congressman largent�s company) touted the bill as a victory for the industry.142 additionally, senator george allen (r-va), who was the lead sponsor of the bill, represents many internet and technology companies including america online. the recent experience of congressional intervention in state tax sovereignty as demonstrated by the source tax act and the internet tax nondiscrimination act lead me to prefer judicial oversight rather than legislative intervention with respect to the united states when protection from tax discrimination is required. unfortunately, at this point in american history �the few maintain a disproportionate sway over elected representatives . . . .�143 professor alexander goes on to point out that �[t]he will of the people is not done because of the influence of lobbyists, pacs, and others who control large sums of campaign cash.�144 unlike the council of ministers, congress does not represent the states and there is increasing temptation to enact legislation that benefits a select constituency at a revenue cost to the states.145 congress is causing more harm than good in the name of 2005] tax discrimination 71 an unfunded mandate would provide a meaningful deterrent to such legislation. kaye, supra note 126, at 188. 146. see amar, supra note 115, at 1352. 147. the nice treaty amended ec treaty article 221 to create a grand chamber of judges that could customarily be used to avoid the burden of plenary sessions. goebel supplement, european union law, supra note 76, at 32-33. the grand chamber will initially be composed of thirteen judges with eleven usually sitting in a proceeding. id. 148. ec treaty, supra note 15, arts. 221-23. 149. anthony arnull, the european union and its court of justice 7-8 (1999). the opinion of the advocate general outlines relevant facts and legislation, further analyzes the issues raised and relevant case law, and concludes with a recommendation to the judges. while it is difficult to determine the influence of the advocate general on the judgments of the court, most legal scholars believe that the advocate general�s opinion is helpful in the judges� decision-making. id. at 8. avoiding tax discrimination and should exercise the legislative restraint it historically had shown to the taxing powers of the states. direct election of senators has increased their susceptibility to private interest group pressures and has rendered them unable to play their designated role as guardian of the states� rights and interests.146 i am not willing to advocate repeal of the seventeenth amendment, however, i do recommend an additional procedural constraint on congress to ensure less congressional interference with state tax laws. modeling two of the advisory bodies of the european union, i recommend the formation of a committee (like the economic and social committee and the committee of the regions) that must be consulted prior to the passage of any legislation impacting state tax laws. in this case, the committee would be composed of the treasurers of the fifty states. a vote on the tax measure would not be allowed until the committee of treasurers had the opportunity to study the legislation, opine on the consequences to the states and give its recommendations. although this proposal is no guarantee that the state taxation of pension income act of 1995 or the internet tax nondiscrimination act would not have been enacted anyway, a substantive report from the committee of treasurers might have provided cover for those senators and representatives who desired to vote against the legislation. b. the judicial branch the european court of justice is comprised of twenty-five judges,147 each appointed for a renewable six-year term, and is assisted by eight advocates general.148 the advocate general�s role is to �present an independent and impartial opinion after the parties have concluded their submission and before the judges begin their deliberations.�149 the court�s duties are multi-faceted, although its fundamental task is to �ensure that in 72 florida tax review [vol.7:2 150. ec treaty, supra note 15, art. 220. 151. ec treaty, supra note 15, art. 230; see also art. 249. 152. ec treaty, supra note 15, art. 230; see also lier et al., supra note 113, at 19. 153. arnull, supra note 149, at 8. see also laurence r. helfer & anne-marie slaughter, toward a theory of effective supranational adjudication, 107 yale l.j. 273, 326 (1997). �[t]he treaty does not prohibit individual opinions; it is the court itself that has imposed a rule of unanimity.� id. at 326 n.230 (citing rules of procedure of the court of justice, rule 27.5, 1974 o.j. (l 350) 1, reprinted in encyclopedia of european community law at b8108 (1992)). see generally david edward, how the court of justice works, 20 eur. l. rev. 539, 557 (1995) (discussing the advantages and disadvantages of the collegiate approach of the ecj). 154. ec treaty, supra note 15, art. 234. article 234 provides: the court of justice shall have jurisdiction to give preliminary rulings concerning: a. the interpretation of this treaty; b. the validity and interpretation of acts of the institutions of the community and of the ecb; c. the interpretation of the statutes of bodies established by an act of the council, where those statutes so provide. where such a question is raised before any court or tribunal of a member state, that court or tribunal may, if it considers that a decision on the question is necessary to enable it to give judgment, request the court of justice to give a ruling thereon. where any such question is raised in a case pending before a court or tribunal of a member state against whose decisions there is no judicial remedy under national law, that court or tribunal shall bring the matter before the court of justice. id. the interpretation and application of this treaty the law is observed.�150 the court has jurisdiction to examine the validity of all acts adopted by the council and the commission, including regulations, directives, and decisions.151 appeals can be brought on the grounds of: lack of competence; misuse of powers; or infringement of an essential procedural requirement, the treaty of rome, or any rule of law relating to its application.152 �[t]he court gives a single collective judgment signed by all the judges who took part in the deliberations.�153 to ensure the uniform interpretation of community law, the european court of justice will render, at the request of any court or tribunal of a member state, a legally binding preliminary ruling in a case where any question of community law arises.154 these preliminary rulings concern such matters as the interpretation of provisions of the treaties or of acts of the community institutions and the examination of the validity of community legal acts. the court will not formally rule on the merits of the pending case but rather limits the judgment to the interpretation or validity of the relevant 2005] tax discrimination 73 155. lier et al., supra note 113, at 20. 156. stephen weatherill & paul beaumont, ec law 157-58 (1993). since october 31, 1989, the court of first instance (cfi) has resolved disputes between the ec and its employees as well as appeals against an ec institution concerning competition matters (i.e., antitrust and merger control). the treaty of nice has expanded the cfi�s jurisdiction, which is now competent to rule on matters covering a wide range of matters arising under the ec treaty and in connection with the community�s secondary law. see goebel supplement, european union law, supra note 76, at 10. 157. arnull, supra note 149, at 50-51. article 234 does not give the court jurisdiction �to decide upon the validity of a provision of domestic law in relation to the treaty . . . .� id. (citing case 6/64, costa v. enel, 1964 e.c.r. 585, 592-93). �rather the proceedings take the form of a dialogue in which the two courts seek a solution to the case in hand which is in harmony with the requirements of community law.� id. at 51. 158. bermann, supra note 14, at 355. 159. ec treaty, supra note 15, art. 220. article 220 states �[t]he court of justice shall ensure that in the interpretation and application of this treaty the law is observed.� id. 160. tax policy in the eu, supra note 41, at 23. in the direct tax field, progress towards community objectives cannot be left to chance that a taxpayer will bring a case to the ecj. id. for example, in 2004, the commission sent a reasoned opinion, the second stage of infringement proceedings, to germany because of a �discriminatory� tax on school fees paid to non-german schools. press release, european commission, commission requests germany to end discrimination concerning housing grants and tax deductions (jan. 7, 2004), at http://europa.eu.int/rapid/pressreleasesaction.do? reference=ip/04/20. in 2005, the commission referred portugal to the ecj, the final state of infringement proceedings, because of a �discriminatory� tax on capital gains reinvested in another member state. press release, european commission, commission takes portugal to court over discriminatory rules on tax relief for capital gains from home sales (jan. 13, 2005), at http://europa.eu.int/rapid/pressreleasesaction.do? reference=ip/05/36. question of community law.155 other national courts can rely on these article 234 rulings as authoritative interpretations of community law or may resubmit the question to the court for a preliminary ruling in the hope that the court of justice departs from its previous decision.156 thus, unlike the u.s. supreme court, the ecj does not normally rule directly on the validity of member state laws.157 however, it often clearly indicates as a matter of law that a member state�s legislation violates the ec treaty.158 along with referrals under article 234, the ecj must also hear cases brought by the commission pursuant to its obligation to enforce the treaty.159 the commission has stated that it intends to pursue a more proactive strategy in the field of tax infringements and is more willing to initiate action before the court upon finding incompatible tax provisions.160 indeed on february 5, 2003, the commission started infringement proceedings against belgium, france, italy, portugal, and spain with respect to the non-deductibility of 74 florida tax review [vol.7:2 161. jcg, six member states rapped for discrimination against pension funds, eur. rep., feb. 8, 2003, at 2003 wl 10439196. 162. commission on structural alternatives for the federal courts of appeals, final report 73 (dec. 18, 1998), at http://www.library.unt.edu/gpo/csafca/final/ appstruc.pdf. two examples of state tax cases that were denied certiorari are white v. reynolds metals co., 558 so. 2d 373 (ala. 1989), cert denied, gmc v. dep�t of revenue of ala., 496 u.s. 912 (1990) (out-of-state corporation claimed disparate treatment between in-state and out-of-state corporations; court held that the alabama code violated neither the equal protection nor the commerce clauses) and colo. interstate gas co. v. okla. tax comm�n, 774 p.2d 468 (okla. 1989), cert. denied, 493 u.s. 854 (1989) (pipeline companies purchasing gas for sale out-of-state objected to oklahoma�s severance tax on the gas, arguing unsuccessfully that it violated the supremacy, due process and equal protection clauses). 163. see, e.g., case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i-225, ¶ 21; see infra part v(b). 164. see infra part iv(b). 165. see infra part iii. 166. see, e.g., case 270/83, comm�n v. france, 1986 e.c.r. 273 (holding that the failure of french law to extend a tax credit granted to french companies for frenchsource dividends to the permanent establishments of foreign companies constituted a restriction on their freedom of establishment); case c-330/91, the queen v. ex parte commerzbank, 1993 e.c.r. i-4017 (holding that a uk law prohibiting nonresident companies from obtaining interest on tax repayments was incompatible with articles 52 and 58 of the ec treaty); case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i-225 (holding that a german law denying nonresident taxpayers special tax deductions allowed residents for family circumstances was incompatible with article contributions to pension funds resident in other member states.161 all this leads to a far greater proportion of tax cases being heard by the ecj when compared to the u.s. supreme court, which decides very few tax cases.162 the ecj�s judgments in the direct tax area have been increasing in number and the implications of these decisions are far-reaching. it is clear that national income tax regimes must be exercised consistently with the treaty provisions establishing the fundamental freedoms of the community.163 the fundamental freedoms encompass a prohibition of discrimination on the grounds of nationality specifically found in the following articles: article 39 for the free movement of workers, article 43 for the freedom of establishment, article 49 for the freedom of provision of services, and article 56 for the free movement of capital.164 because tax law often distinguishes between resident and nonresident taxpayers and between permanent establishments and subsidiaries, the application of this nondiscrimination principle may result in the incompatibility of national tax provisions with ec law.165 the court of justice has ruled that when such distinctions result in the unequal treatment of individuals or companies from other member states, the tax law must be struck down unless the member state can justify a derogation.166 2005] tax discrimination 75 48 when the nonresident worker receives almost all his income from that member state). see also de wolf, supra note 12, at 127-28. 167. for a more thorough discussion of the difference between residence-based and source-based taxation, see hugh j. ault & brian j. arnold, comparative income taxation: a structural analysis 347-49, 395-97 (2d ed. 2004). see also brian arnold & michael mcintyre, international tax primer 15-26 (2d ed. 2002). �as to residents [a state may], and does, exert its taxing power over their income from all sources, whether within or without the state . . . .� shaffer v. carter, 252 u.s. 37, 57 (1920). 168. see ault & arnold, supra note 167, at 357-60. generally, the amount of creditable foreign income taxes is limited to the amount of home country tax otherwise due on the taxpayer�s foreign source income. id. at 362-65. 169. see id. at 357-60. 170. jerome r. hellerstein & walter hellerstein, state and local taxation, cases and materials 898 (7th ed. 2001). as of april 2005, 41 states had broad-based personal income taxes. see 1 research institute of america, all states tax guide ¶ 228 (2005). see infra notes 403-07 and accompanying text for a discussion of how business income is allocated in the united states. 171. �[i]nternational tax law, and in particular the model double taxation treaty of the organization for economic cooperation and development (oecd), recognizes that in principle the overall taxation of taxpayers, taking account of their personal and family circumstances, is a matter for the state of residence.� case c279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i-225, ¶ 32. 172. michael j. mcintyre & richard d. pomp, state income tax treatment of residents and nonresidents under the privileges and immunities clause, 13 st. tax notes 245, 248 (1997). professor van raad points out that the member states could verify the data required for computing personal deductions and the amount of income derived from sources abroad by using the ec 1977 directive concerning mutual assistance by the competent authorities but acknowledges that the administrative burden would be relatively great. kees van raad, fractional taxation of multi-state iii. principles of international and interstate taxation most national governments as well as most state governments in the united states employ a set of jurisdictional rules based on the principle of residence-based taxation of residents and source-based taxation of nonresidents.167 for example, some eu member states tax residents on their worldwide income but allow them to claim a credit for any foreign taxes paid on their foreign source income in order to prevent double taxation.168 other member states grant an exemption for the foreign source income.169 all of the states that employ broad-based personal income taxes allow a credit for taxes paid by their residents to other states.170 taxpayers� personal and family circumstances are taken into account in the state of residence, because residence-based taxation often taxes taxpayers in accordance with their ability to pay.171 administratively, this is also logical because the state of residence has all the information necessary to assess the taxpayer�s overall ability to pay tax.172 76 florida tax review [vol.7:2 income of eu resident individuals � a proposal, in 27 series on international taxation, liber amicorum sven-olof lodin, 211, 220 (krister andersson et al. eds., 2001). 173. see ault & arnold, supra note 167, at 357-60. however, some member states using an �exemption with progression� approach, apply a tax rate based on worldwide income but only with respect to the includible income. id. at 372-74. 174. shaffer v. carter, 25 u.s. 37, 57 (1920); see also hellerstein & hellerstein, supra note 170, at 368-69. 175. mcintyre & pomp, supra note 172, at 248; see also j.s. phillips & m.h. collins, the general report, lxxa cahiers de droit fiscal international 15, 52-53 (1985). 176. terra & wattel, supra note 51, at 45-46; see also roy rohatgi, basic international taxation 132-33 (2002). 177. wattel, supra note 52, at 224-26. 178. as of april 2005, nine states had no broad-based personal income taxes. see research institute of america, supra note 170, ¶ 228. 179. as of 2004, the top statutory personal income tax rate in the eu is 56%. press release, european commission, taxation in the eu from 1995 to 2002, tbl., (july 1, 2004), at http://europa.eu.int/rapid/ pressreleasesaction.do?reference=stat/04/85. in contrast, most eu member states tax nonresidents on any income derived from sources within the country�s borders (subject to treaty restrictions) but do not attempt to tax nonresidents on income derived from sources outside the country�s borders.173 similarly, a state�s power to tax nonresidents �extends only to their property owned within the state and their business, trade, or profession carried on therein, and the tax is only on such income as is derived from those sources.�174 traditionally, source countries do not allow personal deductions to nonresidents because they are only taxing nonresidents on a portion of their income.175 it has been accepted under international tax principles that nonresident taxpayers are in a different situation than resident taxpayers and thus, the taxation of nonresidents can be different than that of resident taxpayers.176 this creates a conflict between these generally accepted tax principles and the effective prevention of discriminatory treatment of foreign source income.177 as the top statutory personal income tax rates in u.s. states range from zero178 to 11% as compared to the lowest top rate in the eu of 25%,179 it is obvious that the stakes are quite high in the eu. in part iv, i outline how the supreme court and the european court of justice each have struggled with this problem. 2005] tax discrimination 77 180. daniel shaviro, federalism in taxation: the case for greater uniformity 6 (1993). 181. id. (citing the federalist no. 7 (alexander hamilton), no. 42 (james madison)). 182. art. of conf. art. iv. article iv states: the better to secure and perpetuate mutual friendship and intercourse among the people of the different states in this union, the free inhabitants of each of these states, paupers, vagabonds, and fugitives from justice excepted, shall be entitled to all privileges and immunities of free citizens in the several states; and the people of each state shall have free ingress and regress to and from any other state, and shall enjoy therein all the privileges of trade and commerce, subject to the same duties, impositions, and restrictions as the inhabitants thereof respectively, provided that such restrictions shall not extend so far as to prevent the removal of property imported into any state, to any other state, of which the owner is an inhabitant; provided also that no imposition, duties or restrictions shall be laid by any state, on the property of the united states, or either of them. id. 183. see tribe, supra note 44, § 6-36, at 1251 n.4. �article iv, § 2, is a shortened version of the privileges and immunities clause of art. iv of the articles of confederation. persuaded that art. iv, § 2 of the proposed constitution was �formed exactly upon the principles of the 4th article of the present confederation . . . ,� the constitutional convention adopted the privileges and immunities clause with little discussion.� id. (citing 3 the records of the federal convention at 112 (max farrand ed., 1911); 2 id. at 173, 187, 443). the commerce clause and privileges and immunities clause both have their sources in the fourth article of the articles of confederation. baldwin v. fish & game comm�n. of mont., 436 u.s. 371, 379 (1977). 184. the fourteenth amendment to the constitution also contains a privileges and immunities clause which provides that �[n]o state shall make or enforce any law which shall abridge the privileges or immunities of citizens of the united states.� u.s. const. amend. xiv, § 1. the framers of the fourteenth amendment used the article iv clause as a model for the amendment. tribe, supra note 44, § 7-2, at 1299. their iv. judicial limitations on tax sovereignty a. judicial limitations on state tax sovereignty in the united states the �capacity of state and local taxation to burden national markets has long been recognized� in the united states.180 the protectionist tariffs that the states were levying upon each other were �one of the chief motives for the constitutional convention in 1787.�181 the constitution incorporated the fourth of the articles of confederation,182 albeit in a briefer form, and its goal of eradicating state sponsored discrimination against nonresidents.183 in fact, there are three provisions of the u.s. constitution that an individual taxpayer may utilize to challenge an allegedly discriminatory state tax:184 the 78 florida tax review [vol.7:2 intention was to �nationalize individual rights� by incorporating �not only those rights specifically secured by the first eight amendments, but also those declared in the original constitution . . . . � id. at 1301-02. however, five years after the amendment was adopted, the supreme court held in the slaughter house cases, 83 u.s. (16 wall.) 36 (1873) that the provision created no new rights of national citizenship, but merely furnished an additional guarantee of rights, which citizens of the united states already possessed. id. justice miller�s narrow construction of the clause reduced it to �a vain and idle enactment, which accomplished nothing, and most unnecessarily excited congress and the people on its passage.� id. at 96 (field, j., dissenting). it is therefore �viewed by many commentators as a �dead letter for tax purposes.�� 1 richard d. pomp & oliver oldman, state and local taxation 4-2 (4th ed. 2001) (citing paul j. hartman, federal limitations on state and local taxation 162, 165 (1st ed. 1981)). 185. u.s. const. art. iv, § 2, cl. 1 [hereinafter privileges and immunities clause]. see, e.g., toomer v. witsell, 334 u.s. 385 (1948) (striking down a licensing fee on nonresident shrimp boat owners at a rate 100 times greater than resident owners because the state failed to demonstrate a unique link between the state�s conservation interests and the discriminatory fee measures and thus violated the privileges and immunities clause). 186. u.s. const. amend. xiv, § 1 [hereinafter equal protection clause]. the equal protection clause of the fourteenth amendment states �[n]o state shall . . . deny to any person within its jurisdiction the equal protection of the laws.� id. 187. commerce clause, supra note 28. the commerce clause of the united states constitution grants congress the power �to regulate commerce with foreign nations, and among the several states, and with the indian tribes.� id. 188. see bank of augusta v. earle, 38 u.s. (13 pet.) 519, 586 (1839) (holding that the protections of the privileges and immunities clause do not extend to corporations). see also w. & s. life ins. co. v. state bd. of equalization, 451 u.s. 648, 656 (1981) (citing hemphill v. orloff, 277 u.s. 537, 548-50 (1928)) (noting that the privileges and immunities clause does not protect corporations); blake v. mcclung, 172 u.s. 239 (1898); paul v. virginia, 75 u.s. (8 wall.) 168, 177-78 (1868). 189. see, e.g., wheeling steel corp. v. glander, 337 u.s. 562 (1949) (holding ohio�s ad valorem tax against intangible property of foreign corporations, whom the state chose to domesticate, constituted unequal treatment of corporations in violation of the equal protection clause). see infra notes 226-40 and accompanying text. 190. see, e.g., complete auto transit, inc. v. brady, 430 u.s. 274, 278 (1977) (upholding a mississippi tax on the �privilege of doing business� thus unanimously rejecting the rule that this type of state tax is per se unconstitutional). see infra notes 264-83 and accompanying text. privileges and immunities clause of article iv;185 the equal protection clause;186 and the commerce clause.187 the privileges and immunities clause is inapplicable to corporations,188 but they may assert either the equal protection clause189 or the commerce clause.190 2005] tax discrimination 79 191. when analyzing a state�s statutory scheme under this clause, the supreme court has held that the terms �citizen� and �resident� are basically interchangeable. see travis v. yale & towne mfg. co., 252 u.s. 60, 78-79 (1920). the court discussed the terms �citizen� and �resident� stating: [a] general taxing scheme . . . if it discriminates against all nonresidents, has the necessary effect of including in the discrimination those who are citizens of other states; and, if there be no reasonable ground for the diversity of treatment, it abridges the privileges and immunities to which such citizens are entitled. id. at 79. �the court has held that in determining whether a person is a citizen of a state, residency in the state is synonymous with state citizenship.� erwin chemerinsky, constitutional law: principles and policies 446 (2d ed. 2002) (citing united bldg. & constr. trades council v. mayor of camden, 465 u.s. 208, 216 (1984)). 192. privileges and immunities clause, supra note 185. see generally douglas laycock, equal citizens of equal and territorial states: the constitutional foundations of choice of law, 92 colum. l. rev. 249, 261-66 (1992). 193. camden, 465 u.s. at 230 (blackmun, j., dissenting). �citizens of sister states are outsiders, subject to in-group/out-group bias, denied the right to vote, which is the key to power in the political process, and thus dependent on judicial protection.� laycock, supra note 192, at 267. 194. camden, 465 u.s. at 230-31 (blackman, j., dissenting) (citing j. ely, democracy and distrust 83 (1983)). 1. the privileges and immunities clause the u.s. constitution explicitly limits a state�s power to discriminate against residents of the other states through the privileges and immunities clause.191 article iv bans state discrimination against citizens of other states by providing that �[t]he citizens of each state shall be entitled to all privileges and immunities of citizens in the several states.�192 justice blackmun wrote, [t]he [privileges and immunities] clause has been a necessary limitation on state autonomy not simply because of the self-interest of individual states, but because state parochialism is likely to go unchecked by state political processes when those who are disadvantaged are by definition disenfranchised as well.193 the clause remedies this breakdown in the representative process by requiring state residents to bear the same burdens that they choose to place on outsiders �by constitutionally tying the fate of nonresidents to those possessing political power, the framers insured that their interests would be well looked after.�194 80 florida tax review [vol.7:2 195. shaffer v. carter, 252 u.s. 37, 49 (1920). 196. id. at 52-53. 197. id. at 57. 198. id. 199. travis v. yale & towne mfg. co., 252 u.s. 60, 80-81 (1920). 200. id. at 81. 201. see walter hellerstein, some reflections on the state taxation of a nonresident�s personal income, 72 mich. l. rev. 1309, 1342 (1974). in 1920, the supreme court had to decide whether a state had the right to tax any part of a nonresident�s income when an illinois resident challenged oklahoma�s power to tax him on more than a million and a half dollars from his oklahoma oil business holdings.195 as long as the taxes on nonresidents were not �more onerous in effect� than the taxes imposed on similarly situated residents, the court held that oklahoma could tax nonresidents on income earned within the state.196 the appellant claimed a further violation of the privileges and immunities and equal protection clauses because the oklahoma statute denied nonresidents a deduction for losses except those incurred within the state.197 the court held that there was no obligation to allow a deduction for losses elsewhere incurred as the tax on nonresidents was only on income derived from sources within the state.198 the travis case, decided the same day, held that the privileges and immunities clause prohibited the complete denial of personal exemptions to nonresidents even though new york law provided a corresponding credit against new york taxes if they paid resident income taxes in a state that allowed such a credit to new york residents.199 the denial of the exemption was also not justified by the theory that nonresidents have untaxed income derived from sources in their home states or elsewhere . . . corresponding to the amount upon which residents of that state are exempt from taxation . . . [because] the discrimination is not conditioned upon the existence of such untaxed income; and it would be rash to assume that nonresidents taxable in new york under this law, as a class, are receiving additional income from outside sources equivalent to the amount of the exemptions that are accorded to citizens of new york and denied to them.200 unfortunately, the travis case left many unanswered questions regarding the implementation of this rule.201 subsequent courts have had difficulties interpreting both the shaffer and travis decisions, resulting in confused and inconsistent decisions regarding the allowance of exemptions, deductions, and credits to 2005] tax discrimination 81 202. id. see, e.g., goodwin v. state tax comm�r, 146 n.y.s.2d 172 (n.y. app. div. 1955), aff�d, 133 n.e.2d 711 (n.y. 1956), cert. denied, 352 u.s. 805 (1956) (holding as constitutional a new york statute that denied a new jersey resident, who derived all of his income from new york, any deductions such as real estate taxes and mortgage interest paid in connection with his residence in new jersey); berry v. state tax comm�n, 397 p.2d 780 (or. 1964) (holding that a statute that restricted deductions unless connected to income arising from sources within oregon was not a denial of the privileges and immunities of citizenship because the clause did not preclude disparity of treatment when there are independent reasons for it). but see spencer v. s.c. tax comm�n, 316 s.e.2d 386 (s.c. 1985), aff�d, 471 u.s. 82 (1985) (holding that a statute that denied personal deductions to nonresidents violated the privileges and immunities clause); wood v. dep�t of revenue, 749 p.2d 1169 (or. 1988) (holding that an oregon statute that denied a deduction for alimony to nonresidents violated the privileges and immunities clause). see also james michael dailey, case note and comment, the thin line between acceptable disparate tax treatment of nonresidents and unconstitutional discrimination under the article iv privileges and immunities clause: lunding v. new york tax appeals tribunal, 118 s. ct. 766 (1998), 21 hamline l. rev. 563, 580-86 (1998). 203. lunding v. n.y. tax app. trib., 522 u.s. 287 (1998) (holding that new york state�s denial of a tax deduction for alimony payments made by nonresidents while allowing such deduction for residents violated the privileges and immunities clause). see also infra notes 430-59. 204. marcia coyle, justices eye deductibility of alimony: at issue is a state�s power to tax nonresidents differently, nat�l l.j., nov. 17, 1997, at b1. 205. 334 u.s. 385 (1948). 206. tribe, supra note 44, § 6-36, at 1250. 207. id. § 6-37, at 1256. 208. 436 u.s. 371 (1978). 209. id. at 387. see also tribe, supra note 44, § 6-37, at 1257. the dissent, justice brennan joined by justices marshall and white, argued that it is irrelevant whether a given right is deemed fundamental. [t]he time has come to confirm explicitly nonresidents.202 thus, when the lunding case203 presented itself, commentators noted that the �high court�s prior income tax rulings . . . offer no clear standards to apply to constitutional challenges to state taxes and have generally been closely decided.�204 toomer v. witsell205 marks the beginning of our modern understanding of the privileges and immunities clause.206 the supreme court shifted its focus of review from categorizing fundamental rights of citizenship to analyzing the state�s justifications for the discrimination.207 thirty years later, the supreme court muddied the waters with their decision in baldwin v. fish and game commission of montana.208 although the toomer court had invalidated a commercial licensing fee that was 100% greater for nonresidents, the baldwin court upheld an elk-hunting fee that was 25% greater for nonresidents holding that the privileges and immunities clause protects only �basic and essential activities.�209 thus, the baldwin 82 florida tax review [vol.7:2 that which has been implicit in our modern . . . decisions, namely that an inquiry into whether a given right is �fundamental� has no place in our analysis of whether a state�s discrimination against nonresidents . . . violates the clause. rather, our primary concern is the state�s justificaton for its discrimination.� baldwin v. fish & game comm�n of montana, 436 u.s. 371, 402 (1977) (brennan, j., dissenting). see also rotunda & nowak, supra note 43, § 12.7, at 255 (3d ed. 1999). 210. tribe, supra note 44, § 6-37, at 1257. 211. laycock, supra note 192, at 265. 212. gary j. simson, discrimination against nonresidents and the privileges and immunities clause of article iv, 128 u. pa. l. rev. 379 (1979) (citing corfield v. coryell, 6 f. cas. 546, 551 (c.c.e.d. pa. 1823) (no. 3230)). 213. tribe, supra note 44, § 6-37, at 1256. the substantial reason test replaced the reasonableness exception that the supreme court had carved out in the late nineteenth and early twentieth century. id. at 1254 (citing blake v. mcclung, 172 u.s. 239, 256 (1898)). 214. toomer v. witsell, 334 u.s. 385, 396 (1948) (emphasis added). �the state is not without power . . . to restrict the type of equipment used . . . to graduate license fees according to the size of the boats, or even to charge nonresidents a differential which would merely compensate the state for any added enforcement burden . . . .� id. at 398-99 (citations omitted). see, e.g., carlson v. state, 798 p.2d 1269 (alaska 1990) (fee differentials between residents and nonresidents for commercial fishing licenses did not violate the privileges and immunities clause if the differential equalized the financial burden of fisheries management between residents and nonresidents). see also sarah h. davis, carlson v. state and the privileges and immunities clause: the alaska wrinkle in nonresident fishing fee differentials, 21 alaska l. rev. 91 (2004) (discussing carlson�s three trips to the alaska supreme court). court did not feel compelled to apply the �substantial reason test� of toomer.210 this limitation of the privileges and immunities clause to �fundamental� rights is rarely invoked211 and the freedom from discriminatory taxation had previously been named as a fundamental right.212 the toomer case had established the �substantial reason� test when the supreme court decided that the privileges and immunities clause would not preclude nonresident discrimination where there were valid independent reasons for such treatment.213 thus, [l]ike many other constitutional provisions, the privileges and immunities clause is not an absolute. it does bar discrimination against citizens of other states where there is no substantial reason for the discrimination beyond the mere fact that they are citizens of other states. but it does not preclude disparity of treatment in the many situations where there are perfectly valid independent reasons for it.214 2005] tax discrimination 83 215. toomer, 334 u.s. at 398. 216. tribe, supra note 44, § 6-37, at 1256. 217. id. �nothing in the record indicates that nonresidents use larger boats or different fishing methods than residents . . . , or that any substantial amount of the state�s general funds is devoted to shrimp conservation.� toomer, 334 u.s. at 398. 218. tribe, supra note 44, § 6-37, at 1256. 219. 420 u.s. 656 (1975). 220. id. at 657-58. 221. id. at 658. in such a case, the new hampshire tax would be reduced to the amount of the tax that the state of residence would have imposed. id. 222. id. at 658-59. as the court explained: the commuters income tax initially imposes a tax of 4% as well on the income earned by new hampshire residents outside the state. it then exempts such income from the tax, however: (1) if it is taxed by the state from which it is derived; (2) if it is exempted from taxation by the state from which it is derived; or (3) if the state from which it is derived does not tax such income. id. at 658. 223. id. at 665. note, however, that the supreme court has thus far refused to answer whether �telecommuting� is similarly unconstitutional. huckaby v. n.y. state div. of tax app., 829 n.e.2d 276 (n.y. 2005), cert. denied, 126 s. ct. 546 (2005). in huckaby, the high court of new york ruled that a tax on a tennessee resident working for a new york company form his home in tennessee does not violate the constitution. id. at 284. 224. austin, 420 u.s. at 665-66. because south carolina was unable to prove that �non-citizens constitute a peculiar source of the evil at which the statute is aimed,�215 the state�s discriminatory licensing fee was struck down.216 the state also failed to demonstrate a sufficient link between �the legitimate interests served and the discrimination practiced�217 and that less restrictive alternatives were impractical.218 the supreme court applied this test in austin v. new hampshire.219 new hampshire imposed a commuter income tax on nonresidents� �new hampshire-derived income in excess of $2,000.�220 the tax rate was 4% unless the nonresident taxpayer�s state of residence imposed a lesser rate of tax had the income been earned in that state.221 although new hampshire residents were also taxed on their out-of state income, the statute excluded various categories of income such that no resident was actually taxed on his out-of-state income.222 given the �rule of substantial equality of treatment� for resident and nonresident taxpayers, the supreme court found the commuter tax unconstitutional because the tax fell exclusively on the income of nonresidents.223 new hampshire argued that the tax was not more burdensome once the tax credit the commuters received from their state of residence was taken into account.224 the majority replied that �the 84 florida tax review [vol.7:2 225. id. at 668. 226. see bank of augusta v. earle, 38 u.s. (13 pet.) 519, 586 (1839) (holding that the protections of the privileges and immunities clause do not extend to corporations). see also w. & s. life ins. co. v. state bd. of equalization, 451 u.s. 648, 656 (1981) (citing hemphill v. orloff, 277 u.s. 537, 548-50 (1928)) (noting that the privileges and immunities clause does not protect corporations); blake v. mcclung, 172 u.s. 239, 259 (1898) (determining that a corporation may not invoke the protection of the privileges and immunities clause); paul v. virginia, 75 u.s. (8 wall.) 168, 177-78 (1868) (stating that a corporation is not a citizen within the meaning of the privileges and immunities clause). 227. hellerstein, supra note 201, at 1332 n.104. see also shyy, inc. v. borough of glassboro, 393 u.s. 117 (1968) (holding that a state cannot deny a tax exemption to a foreign corporation, allowed to enter that state to do business, that a domestic corporation would receive); wheeling steel corp. v. glander, 337 u.s. 562 (1949) (holding that where a state has permitted a foreign corporation to enter and transact business equal protection must be accorded at least to the extent that their property is entitled to an equally favorable ad valorem tax basis). 228. u.s. const. amend. xiv, § 1. the supreme court ruled that a corporation is a �person� within the meaning of the fourteenth amendment in santa clara county v. south pacific railroad, 118 u.s. 394 (1886). 229. see lehnhausen v. lake shore auto parts co., 410 u.s. 356, 359-60 (1973) (holding that an illinois constitutional amendment authorizing ad valorem taxes on personal property of corporations and similar entities, but not with respect to personal property of individuals, did not violate the equal protection clause because it was not the result of invidious discrimination and was within the state�s discretion to make classifications for tax purposes). see also allied stores of ohio inc. v. bowers, 358 u.s. 522, 526-27 (1959) (holding that an ohio statute imposing an ad valorem tax on property stored by local companies while exempting out-of-state owners of warehouses did not deny domestic corporations the equal protection of the law). 230. nordlinger v. hahn, 505 u.s. 1, 11 (1992) (citing u.s. r.r. ret. bd. v. fritz, 449 u.s. 166, 174, 179 (1980)). constitutionality of one state�s statutes affecting nonresidents [cannot] depend upon the present configuration of the statutes of another state.�225 2. the equal protection clause although the privileges and immunities clause is inapplicable to corporations,226 the equal protection clause, which also forbids states to discriminate against outsiders in favor of locals, has been used to prohibit discrimination against corporations.227 the fourteenth amendment, ratified in 1868, decrees �[n]o state shall . . . deny to any person within its jurisdiction the equal protection of the laws.�228 the clause does not, however, prohibit the states from making reasonable classifications among such persons.229 the statute will be upheld as long as there is a plausible policy reason for the classification,230 plausible legislative facts on which a 2005] tax discrimination 85 231. id. (citing minnesota v. clover leaf creamery co., 449 u.s. 456, 464 (1981)). 232. id. (citing cleburne v. cleburne living ctr., inc., 473 u.s. 432, 446 (1985)). 233. id. at 12-13. the court found california�s property tax scheme to be constitutional even though it created dramatic disparities. id. see also leo p. martinez, the trouble with taxes: fairness, tax policy, and the constitution, 34 hastings const. l. q. 413 (2005). ms. nordlinger, for example, paid approximately the same taxes on a $170,000 home as her neighbor paid on a malibu beach front home worth $2.1 million. nordlinger, 505 u.s. at 6-7. 234. nordlinger, 505 u.s. at 10. 235. matthew j. zinn & steve reed, equal protection and state taxation of interstate business, 41 tax law. 83, 92 (1987). 236. regan v. taxation with representation, 461 u.s. 540, 547 (1983). see also madden v. kentucky, 309 u.s. 83, 88 (1940) (noting that legislatures have the greatest freedom with respect to classifications in the tax area). 237. zinn & reed, supra note 235, at 92. 238. s. r.r. co. v. greene, 216 u.s. 400, 417-18 (1910). rational legislator could rely,231 and �the relationship of the classification to its goal is not so attenuated as to render the distinction arbitrary or irrational.�232 specifically, the court found in nordlinger that california could differentiate between existing landowners and new owners with respect to the property tax. the state�s interest in preserving neighborhoods by allowing existing owners to rely on certain tax rates to discourage constant turnover of land was legitimate.233 �[u]nless a classification warrants some form of heightened review because it jeopardizes exercise of a fundamental right or categorizes on the basis of an inherently suspect characteristic, the equal protection clause requires only that the classification rationally further a legitimate state interest.�234 the supreme court has rarely invalidated state tax laws on the sole basis that they are in violation of the equal protection clause.235 legislatures have been given broad latitude to create classifications and distinctions in tax statutes.236 one exception to this deference exists with respect to interstate business and classifications involving residency, usually taking the form of a �domestic preference tax.�237 in southern railway, the supreme court invalidated an alabama statute that imposed a higher ad valorem property tax on railroads not chartered in the state on the grounds that no legitimate reason was proffered for favoring local companies over nonresidents.238 legitimate state interest did not include a state favoring �its own residents by taxing foreign corporations at a higher rate solely because of their residence 86 florida tax review [vol.7:2 239. metro. life ins. co. v. ward, 470 u.s. 869, 878 (1985) (invalidating alabama statute that taxed out-of-state insurance companies at a higher rate than domestic companies because the state�s purposes were not legitimate to pass the equal protection rational basis test). insurance corporations in particular utilize the equal protection clause because the mccarran-ferguson act exempts insurance corporations from commerce clause restraints. hellerstein & hellerstein, note 171, at 64-65. however, this use of the equal protection clause has been characterized as disingenuous: �this newly unveiled power of the equal protection clause would come as a surprise to the congress that passed the mccarran-ferguson act . . . . in the mccarran-ferguson act, congress expressly sanctioned such economic parochialism in the context of state regulation and taxation of insurance.� ward, 470 u.s. at 900-01 (o�connor, j., dissenting). 240. ward, 470 u.s. at 878. 241. david schmudde, constitutional limitations on state taxation of nonresident citizens, 1999 mich. st. l. rev. 95, 119. see also christopher r. drahozal, preserving the american common market: state and local governments in the united states supreme court, 7 sup. ct. econ. rev. 233 (1999). 242. see mark tushnet, rethinking the dormant commerce clause, 1979 wisc. l. rev. 125, 130-31. 243. id. (quoting h.p. hood & sons v. dumond, 336 u.s. 525, 539 (1949)) (�our system, fostered by the commerce clause, is that every farmer and every craftsman shall be encouraged to produce by the certainty that he will have free access to every market in the nation . . . .�). 244. hellerstein, federal limitations, supra note 34, at 433 n.24. the evolution of the early commerce clause doctrine has been outlined numerous times. see, e.g., justice felix frankfurter, the commerce clause under marshall, taney and waite 1819 (chicago quadrangle books 1968) (1928); f.d.g. ribble, state and national power over commerce (edwin w. patterson ed., columbia j. press, 1937); john b. sholley, the negative implications of the commerce clause, 3 u. chi. l. rev. 556 (1936). . . . .�239 this �constitutes the very sort of parochial discrimination that the equal protection clause was intended to prevent.�240 3. the dormant commerce clause discrimination against sister-state corporations has most often been analyzed using the dormant commerce clause.241 implicitly, the commerce clause prohibits state discrimination of interstate commerce as well as undue burdens on commerce.242 the commerce clause embodies the �principle that our economic unit is the nation . . . .�243 although the principal source of judicial doctrine limiting state taxation of interstate commerce, the court did not espouse this proposition until the late nineteenth century.244 in 1827, justice marshall indicated in dictum that a state tax measure could interfere with interstate commerce and would be treated like state regulatory measures 2005] tax discrimination 87 245. hellerstein, federal limitations, supra note 34, at 434 (quoting brown v. maryland, 25 u.s. (12 wheat.) 419, 448-49 (1827)). justice marshall wrote: [t]he taxing power of the states must have some limits. . . . it cannot interfere with any regulation of commerce. if the states may tax all persons and property found on their territory, what shall restrain them from taxing goods in their transit through the state from one port to another . . . or from taxing the transportation of articles passing from the state itself to another state, for commercial purposes? these cases are all within the sovereign power of taxation, but would obviously derange the measures of congress to regulate commerce, and affect materially the purpose for which it [sic] was given. id. 246. reading r.r. co. v. pennsylvania, 82 u.s. (15 wall.) 232 (1873). two companion cases were decided in 1873 that bore the same name. they were distinguished in the reports as case of the state freight tax and state tax on railway gross receipts, 82 u.s. (15 wall.) 284 (1873). both cases were cited for the proposition that �a state tax on any activity or process of interstate commerce was an invalid �regulation of commerce.�� william b. lockhart, a revolution in state taxation of commerce?, 65 minn. l. rev. 1025, 1027 (1981). 247. hellerstein, federal limitations, supra note 34, at 435. 248. reading r.r. co., 82 u.s. (15 wall.) at 279. 249. see chemerinsky, supra note 191, at 434. �the thrust of the formal rule was that a state may not impose a tax on any activity or process viewed by the court as a part of interstate commerce.� howard o. hunter, federalism and state taxation of multistate enterprises, 32 emory l. j. 89, 95 (1983). 250. lockhart, supra note 246, at 1029. 251. chemerinsky, supra note 191, at 434 (citing freeman v. hewit, 329 u.s. 249 (1946); mcleod v. j.e. dilworth co., 322 u.s. 327 (1944); mills v. portland, 268 u.s. 325 (1925), respectively). found to infringe upon the national commerce power.245 it was not until the case of the state freight tax246 that the supreme court explicitly established �the doctrine that the commerce clause by its own force limits state tax power over interstate commerce.�247 the u.s. supreme court held that a pennsylvania levy on all freight transported in the state was unconstitutional because it was �in effect a regulation of interstate commerce.�248 this rule, that a state may not directly tax interstate commerce, became known as the �formal rule.�249 from its origin in 1873 until 1977, this �formal rule� was one of the primary bases for invalidating state taxes that affected commerce.250 using this rule, the supreme court found unconstitutional state taxes such as a gross receipts tax, a sales tax, and a license tax on interstate sales.251 other grounds for invalidation included discrimination against interstate commerce, the risk of multiple taxation, unfair apportionment, and the absence of due 88 florida tax review [vol.7:2 252. lockhart, supra note 246, at 1029. this article will only focus on discrimination of interstate commerce as the basis for invalidating a state tax. 253. chemerinsky, supra note 191, at 434 (citing u.s. glue co. v. oak creek, 247 u.s. 321 (1918); mcgoldrick v. berwind-white coal min. co., 309 u.s. 33 (1940)). 254. complete auto transit, inc. v. brady, 430 u.s. 274 (1977) (upholding a mississippi tax on the �privilege of doing business� thus unanimously rejecting the rule that this type of state tax is per se unconstitutional). see lockhart, supra note 246, at 1026. 255. chemerinsky, supra note 191, at 435. see infra notes 264-26 and accompanying text. 256. laycock, supra note 192, at 269. see also schmudde, supra note 241, at 119. 257. fulton corp. v. faulkner, 516 u.s. 325, 331 (1996) (quoting or. waste sys., inc. v. dep�t of envtl. quality of or., 511 u.s. 93, 99 (1994)) (holding that the north carolina intangibles tax was unconstitutional because the amount of the tax was inversely proportionate to the corporation�s liability for north carolina income tax). see chemerinsky, supra note 191, at 440. 258. see chem. waste mgmt., inc. v. hunt, 504 u.s. 334, 342-43 (1992) (quoting hughes v. oklahoma, 441 u.s. 322, 337 (1979)) (noting that �facial discrimination invokes the strictest scrutiny of any purported legitimate local purpose . . . .�). 259. boston stock exch. v. state tax comm�n, 429 u.s. 318, 329 (1977) (citing nw. states portland cement co. v. minnesota, 358 u.s. 450 (1959)). see also chemerinsky, supra note 191, at 440. 260. tribe, supra note 44, § 6-16, at 1113. process jurisdiction.252 however, the �formal rule� was severely criticized because taxes found to have only an indirect burden on interstate commerce were upheld even though the distinction was arbitrary and unpredictable.253 in complete auto,254 the supreme court abandoned this historical approach and replaced it with a more functional four-part test that focused on the purpose and effect of the tax to determine whether the commerce clause had been violated.255 modern commerce clause doctrine forbids nearly all discrimination based on economic factors from sister-states.256 discrimination against interstate commerce is �virtually per se invalid�257 or has been subject to the �strictest scrutiny.�258 in boston stock exchange, the supreme court stated: �no state, consistent with the commerce clause, may �impose a tax which discriminates against interstate commerce . . . by providing a direct commercial advantage to local business.��259 professor lawrence h. tribe has said that �[t]he states may still serve as laboratories for democracy, but their fiscal experiments are subject to rigorous judicial scrutiny, designed to smoke out measures that discriminate.�260 2005] tax discrimination 89 261. laurence h. tribe, american constitutional law § 6-15, at 442 (2d ed. 1988). 262. see id. see also edmund w. kitch, regulation and the american common market, in regulation, federalism, and interstate commerce 9, 31 (a. dan tarlock ed., 1981). 263. daniel shaviro, an economic and political look at federalism in taxation, 90 mich. l. rev. 895, 942 (1992) (citing richard briffault and henry monaghan, respectively). 264. 430 u.s. 274 (1977). in a unanimous decision, the supreme court upheld the constitutionality of a mississippi tax on gross revenues for the privilege of doing business in that state. the court stated that the taxpayer �did not allege that its activity which mississippi taxes does not have a sufficient nexus with the state; or that the tax discriminates against interstate commerce; or that the tax is unfairly apportioned; or that it is unrelated to services provided by the state.� id. at 277-78 (citations omitted). see also chemerinsky, supra note 191, at 435. 265. see pomp & oldman, supra note 184, at 1-21. 266. complete auto transit, inc. v. brady, 430 u.s. 274, 279 (1977). 267. tribe, supra note 44, § 6-16, at 1107. however, the supreme court on occasion exercises �an extra dose of judicial sympathy for state taxing power.�261 the court grants greater deference to state and local taxation autonomy than to commerce clause cases involving regulation.262 professor daniel shaviro notes: the supreme court may treat tax cases as meriting greater deference to state and local governments than regulation cases because it regards the power to tax as at the heart of a government�s sovereignty. another explanation is that the court simply lacks confidence in its ability to understand tax cases and resolve them intelligently, and thus prefers to let most challenged taxes stand.263 under the test spelled out in dicta in complete auto,264 a tax on interstate commerce must meet four requirements if seeking to survive constitutionality under the commerce clause:265 1) the tax must be fairly apportioned, 2) the tax must be fairly related to benefits provided to the taxpayer, 3) the tax must not discriminate against interstate commerce, and 4) the activity must be sufficiently connected to the state to justify a tax.266 the third prong of this test, the ban on discrimination against interstate commerce, is the predominant basis upon which the supreme court has struck down state taxes in recent years.267 a tax law is discriminatory if it �tax[es] a transaction or incident more heavily when it crosses state lines than when it occurs entirely within 90 florida tax review [vol.7:2 268. chem. waste mgmt., inc. v. hunt, 504 u.s. 334, 342 (1992) (quoting armco inc. v. hardesty, 467 u.s. 638, 642 (1984)). 269. chemerinsky, supra note 191, at 442. 270. id. (citing 512 u.s. 186 (1994)). 271. id. 272. am. trucking ass�ns, inc. v. scheiner, 483 u.s. 266 (1987). see also walter hellerstein, is �internal consistency� foolish?: reflections on an emerging commerce clause restraint on state taxation, 87 mich. l. rev. 138, 164 (1988) (noting that such flat taxes effectively discriminate against interstate commerce in that they �bear more heavily on the interstate than the intrastate enterprise merely because the former does business across state lines.�). 273. am. trucking ass�ns, inc., 483 u.s. at 284. 274. see generally jon david pheils, defining the scope of the article four privileges and immunities clause, 54 u. cin. l. rev. 883 (1986); david schultz, state taxation of interstate commuters: constitutional doctrine in search of empirical analysis, 16 touro l. rev. 435 (2000). 275. see zinn & reed, supra note 235, at 99-102 (arguing the court applies two different standards in tax cases); george f. carpinello, state protective legislation and nonresident corporations: the privileges and immunities clause as a treaty of nondiscrimination, 73 iowa l. rev. 351, 408 (1988) (arguing that the court refuses to invalidate state protectionist measures under a test greater than rational basis). 276. see generally david f. shores, state taxation of interstate commerce � quiet revolution or much ado about nothing?, 38 tax l. rev. 127, 129 (1982); edward a. zelinsky, restoring politics to the commerce clause: the case for abandoning the dormant commerce clause prohibition on discriminatory taxation, 29 ohio n. u. l. rev. 29 (2002). 277. see hellerstein, state taxation, supra note 33, at 44; see also dailey, supra note 202, at 563. the state.�268 the supreme court will also strike down state taxes that are facially neutral, but have a disproportionate impact on nonresidents.269 for example, in west lynn creamery, inc. v. healy, a massachusetts tax on all milk dealers was held unconstitutional.270 the impact of this tax was identical to that of a discriminatory tax because the revenues from the tax were used to subsidize in-state dairy farmers.271 in american trucking associations, inc., a flat tax on trucks for pennsylvania road use violated the commerce clause because the effect was to impose a higher burden on a multistate company than on an in-state company.272 �if each state imposed flat taxes for the privilege of making commercial entrances into its territory, there is no conceivable doubt that commerce among the states would be deterred.�273 unfortunately, commentators are unanimous in their criticism of privileges and immunities,274 equal protection,275 and commerce clause276 jurisprudence as it relates to constitutional scrutiny of state tax laws.277 in 1977, the supreme court itself observed again that its judicial application of constitutional principles to the multitude of state tax cases �left much room for controversy and confusion and little in the way of precise guides to the 2005] tax discrimination 91 278. boston stock exch. v. state tax comm�n, 429 u.s. 318, 329 (1977) (quoting nw. states portland cement co. v. minn., 358 u.s. 450, 457 (1959)). see also hellerstein, federal limitations, supra note 34, at 441. �supreme court decisions concerning commerce clause limitations on state taxing power have long been characterized by meaningless distinctions, encrusted rules, and a lack of principled analysis.� shores, supra note 276, at 128. 279. as professor stark explains: the �problem� here (if one considers it that) is that the only institutional regulator is the u.s. supreme court, which only periodically hears state tax cases. and when it does hear such cases, it is pulled in too many directions to regulate this field effectively. it wants to prevent states from �overreaching� while also preventing taxpayer abuses while also respecting state [sovereignty] while also not prescribing rules that are too detailed (since the constitution, after all, says congress gets to regulate interstate commerce, not the supreme court). as a result, this whole field has a sort of wild west quality to it. posting of professor kirk stark, stark@law.ucla.edu to taxprof@listserv.uc.edu (june 23, 2002) (on file with author). 280. see laurence h. tribe, american constitutional law § 6-15, at 442 (2d ed. 1988); lockhart, supra note 246, at 1026-27. 281. for a pessimistic analysis of the complete auto decision, see generally shores, supra note 276, at 129 (suggesting that �the court has failed to lay the groundwork for a coherent method of analysis.�). 282. jesse h. choper & tung yin, state taxation and the dormant commerce clause: the object-measure approach, 1998 sup. ct. rev. 193. 283. hunter, supra note 249, at 97. 284. the supreme court has failed to develop a bright line test or guiding interpretation for the privileges and immunities clause but instead applies a narrow analysis on a case-by-case basis. dailey, supra note 202, at 565. see also christopher h. lunding, u.s. supreme court finds new york�s resident-only alimony deduction unconstitutional, 8 j. multistate tax�n 52 (1998); phiels, supra note 274. states in the exercise of their indispensable power of taxation.�278 professor kirk stark has described the whole field as having �a sort of wild west quality to it.�279 although the complete auto decision has generally received favorable comments from scholars,280 there are doubts about the ability of judges to undertake the complex inquiries seemingly compelled by the case.281 some scholars believe that the test is more complicated than necessary �primarily because several of its parts are functionally redundant.�282 there is also the fear that the supreme court will apply the complete auto test as mechanically as it applied the formal rule. 283 with respect to the privileges and immunities clause, the supreme court has consistently refused to develop bright-line rules, preferring instead to analyze each case on an ad hoc factual basis.284 in tracing the evolution of equal protection in cases involving the taxation of nonresident corporations, 92 florida tax review [vol.7:2 285. zinn & reed, supra note 235, at 92. 286. see pomp & oldman, supra note 184, at 2-35. 287. eec treaty, supra note 4, art. 2. 288. eec treaty, supra note 4, art. 3(c) (now art. 3(1)(c)). 289. see paul farmer & richard lyal, ec tax law 310 (1994); see also eileen o�grady, world tax conference comes to london, 26 tax notes int�l 1058 (2002). 290. ec treaty, supra note 15, art. 12. 291. ec treaty, supra note 15, arts. 28, 29. 292. ec treaty, supra note 15, art. 39. 293. ec treaty, supra note 15, art. 49. 294. ec treaty, supra note 15, art. 56. 295. terra & wattel, supra note 51, at 23. the only situations where article 12 has been applied independently are those in which there is no specific prohibition of discrimination in the ec treaty. id. (citing case 305/87, comm�n v. hellenic republic, 1989 e.c.r. 1461; case c-1/93, halliburton services bv v. staatssecretaris van financiën, 1994 e.c.r. i-1137; case c-311/97, royal bank of scotland plc v. elliniko dimosio (greek state), 1999 e.c.r. i-2651). 296. case 26/62, nv algemene transport en expedite onderneming van gend & loos v. nederlandse administratie der belastingen, 1963 e.c.r. 1, ¶ 12. commentators have noted that the court has vacillated between �rigorous and virtually nonexistent review.�285 scholars have also noted that an inherent weakness in equal protection analysis is choosing the proper level of generality to examine.286 b. judicial limitations on member state tax sovereignty in the european union the objective of the treaty of rome was to create a single common market that would increase the volume and gain from trade between the member states.287 to create such a market, the eec treaty contemplated the removal of obstacles to the free movement of goods, persons, services, and capital between the member states.288 primarily, the removal of obstacles to free movement is based on the principle of equal treatment similar to the equal protection clause of the u.s. constitution. this principle is enshrined in the general prohibition of discrimination on the grounds of nationality found in article 12 of the ec treaty.289 article 12 provides: �within the scope of application of this treaty, and without prejudice to any special provisions contained therein, any discrimination on grounds of nationality shall be prohibited.�290 however, because of the �special provisions� governing the free movement of goods,291 workers,292 services,293 and capital,294 article 12 has rarely been applied independently.295 instead, the ecj has interpreted the �four freedoms� as having direct applicability,296 meaning that economic operators can invoke these rights before national courts and challenge the 2005] tax discrimination 93 297. van thiel, supra note 20, at 5; see also terra & wattel, supra note 51, at 30. 298. van thiel, free movement of persons, supra note 10, at 22. professor van thiel concludes that �there is no convincing theoretical or jurisprudence-based argument to support either the strict or the moderate sovereignty exception� for the income tax laws and treaties of the member states. id. he points out that the court has rejected the strict sovereignty exception in its income tax case law either implicitly or explicitly. id. at 23-24. 299. id. at 21. 300. deloitte eu tax group, deloitte & touche, llp, study on analysis of potential competition and discrimination issues relating to a pilot project for an eu tax consolidation scheme for the european company statute (societas europaea) 13 n. 36, at http://europa.eu.int/comm/taxation_customs/resources/documents/report_ deloitte.pdf [hereinafter deloitte eu study]. 301. van thiel, free movement of persons, supra note 10, at 19. 302. the commission may bring an action against a member state for failing to fulfill its obligations under the treaty. ec treaty, supra note 15, art. 226. see also supra notes 41 and 159 and accompanying text. 303. case 18/84, comm�n v. french republic, 1985 e.c.r. i-1339 [hereinafter newspaper publishers case] (holding that a french tax law that denied certain tax benefits to newspaper publishers for publications printed in other member states violated article 30 of the eec treaty). 304. van thiel, free movement of persons, supra note 10, at 20. see also stein, supra note 1, at 901. �from its inception, the court of justice has construed the european economic community treaty in a constitutional mode rather than employing the international law methodology of treaty interpretation.� id. validity of domestic legislation.297 thus, it is now clear that treaty provisions, because they have been adopted by the member states as part of their basic constitutional charter, take precedence over all forms of domestic law, including tax law.298 this distinguishes the ec treaty from international treaties such as nafta and gats, where income taxation has been excluded from their coverage.299 although, in the absence of harmonization, competence for direct taxation falls to the member states, well-established case law holds these treaty provisions applicable in the field of direct taxation.300 member states must apply community law and refrain from applying those provisions of their national law that are incompatible with the ec treaty.301 the commission began challenging member states� tax laws by instituting infringement proceedings pursuant to article 226,302 starting with the newspaper publishers case of 1985.303 it was only a matter of time before private parties decided to test the compatibility of national income tax provisions against their �constitutional rights.�304 the first case regarding the individual income tax concerned a luxembourg law that denied any 94 florida tax review [vol.7:2 305. case c-175/88, biehl v. admin. des contributions du grand-duche de luxembourg, 1990 e.c.r. i-1779, ¶ 5. 306. id. ¶ 3. 307. id. ¶¶ 4-6. 308. id. ¶ 7. the ecj held that the luxembourg law violated article 48 (now art. 39) with respect to the free movement of workers. id. ¶ 19. 309. see, e.g., case c-330/91, the queen v. inland revenue comm�rs, ex parte commerzbank ag, 1993 e.c.r. i-4017. 310. case c-175/88, biehl v. admin. des contributions du grand-duche de luxembourg, 1990 e.c.r. i-1779, ¶ 13 (citing case 152/73, sotgiu v. deutsche bundespost, 1974 e.c.r. 153, ¶ 11). see also armand de mestral & jan winter, mobility rights in the european union and canada, 46 mcgill l. j. 979, 999 (2001) (citing case 15/69, wurttembergische milchverwertung-sudmilch-ag v. ugliola, 1969 e.c.r. 363). 311. case 152/73, sotgiu v. deutsche bundespost, 1974 e.c.r. 153, ¶ 11. 312. paul farmer, the court�s case law on taxation: a castle built on shifting sands?, 12 ec tax rev. 75, 76 (2003). 313. id. see, e.g., case c-237/94, o�flynn v. adjudication officer, 1996 e.c.r. i-2617. 314. �although, as community law stands at present, direct taxation does not as such fall within the purview of the community, the powers retained by the member states must nevertheless be exercised consistently with community law . . . .� case c279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i-225, ¶ 21 (citing case c-246/89, comm�n v. united kingdom, 1991 e.c.r. i-4585, ¶ 12). see also case c80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493, ¶ 16; case repayment of tax to a part-year resident.305 mr. biehl, a german national, resided and worked in the grand duchy of luxembourg until october 1983.306 his employer over withheld income tax, but when mr. biehl filed for a repayment, the tax office denied his request.307 mr. biehl successfully argued that the law was covertly discriminatory because it mainly applied to taxpayers who were not luxembourg nationals.308 settled case law requires equal treatment under the ec treaty and prohibits not only overt discrimination based on nationality,309 but also all covert forms of discrimination that lead to the same result.310 �[c]riteria such as . . . residence of a worker may, according to circumstances, be tantamount, as regards their practical effect, to discrimination on grounds of nationality . . . .�311 covert discrimination is defined broadly enough by the court to include a wide range of restrictive rules such as residence, language and qualification requirements.312 these restrictive rules are considered discriminatory unless they serve a legitimate purpose and are proportionate.313 in its judgments, the court has continually explained that although direct taxation falls within the competence of the member states, they must nonetheless exercise that competence consistently with community law and avoid any discrimination on grounds of nationality.314 2005] tax discrimination 95 c-311/97, royal bank of scotland plc v. elliniko dimosio (greek state), 1999 e.c.r. i-2651, ¶ 19. 315. case c-251/98, baars v. inspecteur der belastingen particulieren/ondernemingen gorinchem, 2000 e.c.r. i-2787, ¶ 30. 316. id. ¶ 31. 317. �the relevant treaty provisions (articles 30 through 37) basically require the member states to refrain from enacting or maintaining unjustifiable trade-impeding restrictions. by attributing direct effect to these provisions, the court enabled � in fact directed � national courts to deny legal effect to member state measures containing such restrictions.� bermann, supra note 14, at 355. 318. newspaper publishers case, supra note 303. 319. ec treaty, supra note 15, arts. 23-27. 320. ec treaty, supra note 15, arts. 28-31. 321. case 8/74, procureur du roi v. dassonville, 1974 e.c.r. 837, ¶ 5. 322. bermann, supra note 14, at 355. 323. newspaper publishers case, supra note 303, ¶ 2. 324. id. ¶ 3. furthermore, the four freedoms also prohibit restrictions in the country of origin. in baars, the netherlands refused to grant the same tax exemption from the wealth tax to residents who manage a company resident in a member state other than the netherlands, while granting that advantage to residents with a substantial holding in a company resident in the netherlands.315 the ecj found that this difference in the treatment of taxpayers was contrary to article 52 (now art. 43) of the treaty.316 1. the free movement of goods the free movement of goods, the most important treaty freedom for achieving a customs union,317 provided the legal basis for one of the earliest tax cases, the newspaper publishers case.318 the free movement of goods articles provide for a total prohibition of customs duties or their equivalent,319 as well as a prohibition of quantitative restrictions on imports and all measures having equivalent effect.320 the second prohibition forbids any trading rules enacted by member states that �are capable of hindering, directly or indirectly, actually or potentially, intra-community trade.�321 this �negation of impermissible restraints on interstate trade of course powerfully echoes the supreme court�s dormant commerce clause jurisprudence.�322 in the newspaper publishers case, french tax law provided for special reserves or deductions for the acquisition of equipment or buildings used in the publication of newspapers devoted to politics.323 however, publishing houses could not benefit from these special tax provisions if the printing was done outside of france.324 the court held that because this tax provision caused french publishing houses to print in france rather than 96 florida tax review [vol.7:2 325. id. ¶ 16. 326. id. ¶¶ 15-16. see infra notes 381-91 and accompanying text regarding justifications. 327. although not explicitly referred to in the u.s. constitution, it is understood that the constitution guarantees a right to travel. united states v. guest, 383 u.s. 745, 757 (1966). justice jackson stated that it �is a privilege of citizenship of the united states, protected from state abridgment, to enter any state of the union, either for temporary sojourn or for the establishment of permanent residence therein . . . .� edwards v. california, 314 u.s. 160, 183 (1941) (jackson, j., concurring). see also a.p. van der mei, freedom of movement for indigents: a comparative analysis of american constitutional law and european community law, 19 ariz. j. int�l & comp. l. 803, 810 (2002). 328. de mestral & winter, supra note 310, at 1003; ec treaty, supra note 15, art. 18. article 18 provides: 1. every citizen of the union shall have the right to move and reside freely within the territory of the member states, subject to the limitations and conditions laid down in this treaty and by the measures adopted to give it effect. 2. if action by the community should prove necessary to attain this objective and this treaty has not provided the necessary powers, the council may adopt provisions with a view to facilitating the exercise of the rights referred to in paragraph 1. the council shall act in accordance with the procedure referred to in article 251. id. 329. van der mei, supra note 327, at 830 n.129; ec treaty, supra note 15, art. 39. article 39 states: �1. freedom of movement for workers shall be secured within the community. 2. such freedom of movement shall entail the abolition of any discrimination based on nationality between workers of the member states as regards employment, remuneration and other conditions of work and employment.� id. abroad, this tax measure obstructed intra-community trade.325 as the french government provided no reasonable justification for the tax provision, it was prohibited for having an equivalent effect to that of a quantitative import restriction.326 2. the free movement of persons although the citizens of the european union do not have a general right of residence across the union comparable to that of u.s. citizens with respect to the states,327 they may move and reside freely within the eu subject to limitations and conditions set forth in article 18 of the ec treaty.328 article 39 protects the free movement of workers.329 as early as 1968, the council laid down the requirement in article 7 of regulation no. 1612/68 that workers who are nationals of a member state are to enjoy, in 2005] tax discrimination 97 330. council regulation 1612/68, art. 7, 1968 o.j. (l 257) 2, ¶¶ 1, 2. article 7 of regulation 1612/68 provides: �1. a worker who is a national of a member state may not, in the territory of another member state, be treated differently from national workers by reason of his nationality . . . ; 2. he shall enjoy the same social and tax advantages as national workers.� id. 331. ec treaty, supra note 15, art. 43. �freedom of establishment shall include the right to take up and pursue activities as self-employed persons and to set up and manage undertakings . . . .� id. 332. deloitte eu study, supra note 300, at 14 n.38. 333. paul farmer, ec law and direct taxation � some thoughts on recent issues, 1 ec tax j. 91, 92-93 (1997) [hereinafter farmer, direct taxation]. 334. the privileges and immunities clause provides no protection for corporations, because corporations are not �citizens.� hellerstein & hellerstein, supra note 170, at 85. see also supra notes 226, 241-67 and accompanying text. 335. ec treaty, supra note 15, art. 48. although individual citizens are not required to live in a member state in order to receive these protections, corporations must have a primary establishment within the eu. deloitte eu study, supra note 300, at 15. 336. see, e.g., case c-141/99, algemene maatschappij voor investering en dienstverlening nv (amid) v. belgische staat, 2000 e.c.r. i-11619; case c-330/91, the queen v. inland revenue commissioners, ex parte commerzbank ag, 1993 e.c.r. i-4017; case c-264/96, imperial chemical industries plc (ici) v. colmer (her majesty�s inspector of taxes), 1998 e.c.r. i-4695. 337. case c-107/94, asscher v. staatssecretaris van financien, 1996 e.c.r. i-3089, ¶ 29 (citing case c-106/91, ramrath v. ministre de la justice, 1992 e.c.r. i3351, ¶ 17) (stating that articles 48 and 52 (now arts. 39 and 48) are based on the same principles with respect to the prohibition of all discrimination on the grounds of nationality). the territory of another member state, the same tax benefits as nationals working in the state.330 this nondiscrimination principle is also embodied in article 43 of the ec treaty that deals with discriminatory restrictions on the free movement of self-employed persons and the freedom of establishment.331 the concept of the right of establishment is very broad and allows a community national to participate in the economic life of another member state.332 the prohibition on restrictions on establishment applies to permanent establishments of foreign enterprises as well as subsidiaries of foreign corporations.333 unlike the u.s. constitution,334 the ec treaty dictates that companies or firms formed in accordance with the laws of a member state and that have their registered office, central administration or principal place of business within the community must be treated in the same way as natural persons who are nationals of member states.335 thus, foreign branches or subsidiaries have brought many direct tax cases before the ecj.336 the same analysis that applies to workers has been used to decide cases involving foreign branches and subsidiaries.337 98 florida tax review [vol.7:2 338. case 270/83, comm�n v. french republic, 1986 e.c.r. 273 (avoir fiscal case). 339. id. ¶¶ 4-6. 340. id. ¶ 10. 341. id. ¶ 22. 342. id. 343. richard lyal, non-discrimination and direct tax in community law, 12 ec tax rev. 68, 69 (2003). 344. ec treaty, supra note 15, art. 49. 345. farmer, direct taxation, supra note 333, at 92-93. 346. deloitte eu study, supra note 300, at 18 n.66. 347. id. at 18 n.65. the ecj has struck down numerous discriminatory tax regimes that affect residents and nonresidents relying on both articles 39 and 43 of the ec treaty. in one of the earliest direct taxation cases to reach the court (known as the avoir fiscal case), the commission instituted infringement proceedings against france pursuant to article 169 (now art. 226).338 france had an imputation system for the taxation of distributed company profits. because french tax law granted imputation credits (avoir fiscal) only to resident shareholders, the french branches of german insurers were denied the credit.339 if the german insurers had invested by locally incorporating subsidiaries in france, these local subsidiaries, as french residents, would have been eligible for avoir fiscal.340 the court held that this was not a legitimate reason to justify denial of the credit to the branches because such a holding would coerce foreign investors into incorporating subsidiaries.341 article 52 (now art. 43) expressly allows foreign investors the right to choose the legal form they deem appropriate for operating in another member state.342 france was discriminating on the grounds of nationality, as it is understood that the location of the registered office of a company is equivalent to its nationality.343 3. the freedom to provide services article 49 provides that �restrictions on freedom to provide services within the community shall be prohibited.�344 this nondiscrimination rule applies to the taxation of the service provider as well as to the taxation of foreign investors.345 furthermore, the ecj has acknowledged that an investor may invoke article 49 when a tax law restricts a nonresident company seeking capital346 as well as a service recipient may invoke article 49 on behalf of a service provider.347 for example, in a dispute between a finnish national and the taxation verification committtee, ms. lindman had won 1,000,000 sek in 2005] tax discrimination 99 348. case c-42/02, lindman v. skatterattelsnamnden, 2003 e.c.r. i-13519, ¶ 7. 349. id. ¶ 8. 350. id. ¶ 5. 351. id. ¶ 9. 352. id. ¶ 12. 353. id. ¶ 21. 354. id. ¶ 27. 355. id. ¶ 23. 356. id. ¶ 26. 357. ec treaty, supra note 15, art. 56(1). note that this article is drafted as a restriction prohibition rather than solely being aimed at discriminatory measures. see kristina stahl, free movement of capital between member states and third countries, 13 ec tax rev. 47, 47 (2004). a swedish lottery.348 the winning amount was taxable income according to the finnish government,349 whereas an exemption would have applied if the lottery had been organized in finland.350 after losing her administrative appeals, ms. lindman finally appealed to the administrative court of the åland islands in finland.351 this finnish court referred the following question to the ecj for a preliminary ruling: �does article 49 ec preclude a member state from applying rules under which winnings from lotteries held in other member states are regarded as taxable income of the winner chargeable to income tax, whereas winnings from lotteries held in the member state in question are exempt from tax?�352 the ecj held the finnish tax law was discriminatory because it was clear that foreign lotteries were treated differently for tax purposes than, and are in a disadvantageous position compared to, finnish lotteries.353 thus, the ecj ruled that article 49 forbids one member state from charging a different tax rate on lotteries conducted in a foreign state because the difference in taxation entails discrimination.354 the finnish government attempted to justify the discriminatory national legislation by citing �overriding reasons in the public interest such as the prevention of wrongdoing and fraud, the reduction of social damage caused by gaming, the financing of activities in the public interest and ensuring legal certainty.�355 the court found that there was no evidence �of a particular causal relationship between such risks and participation by nationals of the member state concerned in lotteries organized in other member states.�356 4. the free movement of capital article 56 provides that �all restrictions on the movement of capital between member states . . . shall be prohibited.�357 article 58 allows member states to apply national tax law provisions that �distinguish between 100 florida tax review [vol.7:2 358. ec treaty, supra note 15, art. 58(1)(a). 359. deloitte eu study, supra note 300, at 16. see also declaration on article 73d of the treaty establishing the european community, annexed to ec treaty, supra note 15, art. 58(1)(a) (art. 73d) (�the conference affirms that the right of member states to apply the relevant provisions of their tax law as referred to in article 73d(1)(d) of this treaty will apply only with respect to the relevant provisions which exist at the end of 1993.�). 360. ec treaty, supra note 15, art. 58(1)(b). 361. ec treaty, supra note 15, art. 58(3). 362. case c-319/02, manninen v. keskusrerolautakunta, 2004 e.c.r. i-7477, ¶ 12. 363. id. ¶¶ 6-8. 364. id. ¶¶ 8-9. 365. id. ¶¶ 10, 13. 366. id. ¶ 15. 367. id. ¶ 16. 368. id. ¶¶ 17-18. taxpayers who are not in the same situation with regard to their place of residence or with regard to the place where their capital is invested.�358 however, this exception applies only to laws that were in force on december 31, 1993.359 member states also are allowed to take measures to prevent the violation of tax laws in particular,360 but not as �a means of arbitrary discrimination or a disguised restriction on the free movement of capital and payments.�361 in manninen, a finnish national held shares of a swedish company quoted on the stockholm stock exchange.362 under finnish tax law, dividends were taxed at the rate of 29%, as were the corporate profits of companies established in finland.363 finnish shareholders of finnish companies were entitled to a tax credit that effectively reduced the income tax on dividends from finnish companies to zero in order to avoid the double taxation of corporate profits.364 mr. manninen was taxed at 29% on the distributions received from the swedish company and was denied use of the tax credit that would have been available had the dividends been received from a finnish company.365 after the central tax commission held that mr. manninen was not entitled to any tax credits with respect to dividends from a swedish company,366 he appealed the decision to the supreme administrative court of finland.367 the national court asked the ecj for a preliminary ruling as to whether articles 56 and 58, with respect to the free movement of capital, preclude a corporate tax credit system that only allows credits for dividends received from domestic companies.368 there is a risk of double taxation of company profits regardless of whether the company distributes the dividend to a shareholder residing in the 2005] tax discrimination 101 369. id. ¶ 35; see also case c-319/02, manninen, 2004 e.c.r. i-7477, op. ¶ 44. 370. case c-319/02, manninen, 2004 e.c.r. i-7477, ¶¶ 22-23 (citing case c35/98, verkooijen, 2000 e.c.r. i-4071, ¶ 35; case c-334/02 comm�n v. france, 2004 e.c.r. i-2229, ¶ 24). 371. id. ¶¶ 48-49, 54. 372. id. ¶ 55. 373. farmer, supra note 312, at 75. 374. �[t]he court has long subjected taxation to other limits and has long treated taxation differently from other kinds of regulation.� tribe, supra note 44, § 6-15, at 1105. see also chemerinsky, supra note 191, at 434 (�[t]he topic of state taxation of interstate commerce requires separate consideration because the court, both historically and currently, has formulated distinct tests for evaluating state taxes that burden interstate commerce.�). 375. �[t]he court of justice has declined to erect a barrier around tax law, and vigorously maintains its insistence that here, as elsewhere, member states must exercise their powers consistently with the fundamental principles of community law.� paul stanley, annotation, case c-107/94, asscher v. staatssecretaris van financiën, 34 c.m.l. rev. 713 (1997). 376. lyal, supra note 343, at 68. 377. id. same member state or to a shareholder in another member state.369 thus, the ecj reasoned that the finnish law effectively deterred residents of finland from investing in foreign companies and constituted an obstacle to the raising of capital in finland for companies established in other member states.370 finding no justification,371 the ecj ultimately ruled that the law amounted to a restriction on the free movement of capital within the meaning of article 56. 372 5. conclusion the european court of justice�s case law on direct taxation is part of a much larger body of case law that has evolved over the last twenty years on nondiscrimination and the fundamental freedoms.373 unlike u.s. constitutional jurisprudence,374 the constitutional analysis in ecj direct tax cases does not differ from other areas of the law.375 a tax disadvantage is just another obstacle that can confront individuals and businesses that seek to exercise the freedoms that are guaranteed by the treaty.376 due to the political sensitivity of taxation, however, �there was initially a tentative approach� that ended around 1993.377 in the beginning, allegations of violations of the free movement of goods were the most prevalent, and thus the case law in this area was the most developed. the case law on goods has gone beyond a strict discrimination-based approach and includes examining nondiscriminatory 102 florida tax review [vol.7:2 378. farmer & lyal, supra note 289, at 310. 379. id. at 310-11, 325-26. 380. see, e.g., eric hinton, european security on the threshold of the 21st century: current development and future challenge: balancing justice, expedience, and legal certainty: the free movement of goods in the european union, 5 willamette j. int�l l. & dispute res. 1, 20-21 (1997) (citing case c-23/89, quietlynn ltd. v. southend bor. council, 1990 e.c.r. i-3059, 3 c.m.l.r. 55 (1990); case 155/80, summary proceedings against oebel, 1982 e.c.r. 1993, 1 c.m.l.r. 390 (1981); case c-169/91, stoke-on-trent city council v. b & q plc., 1992 e.c.r. i-6635, 1 c.m.l.r. 426 (1992); case 145/88, torfaen borough council v. b & q plc., 1989 e.c.r. 3851, 1 c.m.l.r. 337 (1989)). 381. ec treaty, supra note 15, art. 39 (ex art. 48). 382. ec treaty, supra note 15, art. 49 (ex art. 59). 383. ec treaty, supra note 15, art. 56 (ex art. 73b). 384. lyal, supra note 343, at 74. 385. ec treaty, supra note 15, art. 30 (ex art. 36). article 30 also allows restrictions on intra-community trade if justified on the grounds of �public security, protection of health and life of humans, animals or plants; the protection of national treasures possessing artistic, historic or archaeological value; or the protection of industrial and commercial property.� id. discriminatory measures falling within the scope of arts. 39, 49 or 56 may be justified on the grounds of public policy, public security or public health. farmer & lyal, supra note 289, at 310. see also ec treaty, supra note 15, arts. 39(3), 46(1), 58(1)(b). 386. case 120/78, rewe-zentral ag v. bundesmonopolverwaltung für branntwein, 1979 e.c.r. 649 (cassis de dijon case). 387. case c-204/90, hanhs martin bachmann v. belgian, 1992 e.c.r. i-249. see also terra & wattel, supra note 51, at 71-76. professor wattel notes that this is inconsistent with nontax case law where the ecj sometimes allows rule of reason justifications even though the �national measure at issue clearly makes a distinction restrictions on the free movement of goods.378 this broader interpretation has also been followed in cases reviewing violations of the free movement of persons, services and capital.379 the language used by the ecj is often inconsistent, in some cases because the wording of the actual treaty provisions differs.380 note that article 39 speaks in terms of �the abolition of any discrimination�381 whereas articles 49 and 56 prohibit restrictions on the freedom to provide services382 and the movement of capital383 respectively. however, in many cases, while the ecj speaks in terms of restrictions, it in fact applies a nondiscrimination test by focusing on the difference of treatment between the situations.384 the only exemptions from the prohibitions in the free movement of goods articles are justifications such as public morality and public policy that are listed in article 30.385 there are also justifications recognized under the rule of reason developed by the ecj in the cassis de dijon case.386 applying the rule of reason in the tax area, the court has only accepted the need to maintain the integrity of the tax system as such a justification387 and the scope 2005] tax discrimination 103 between residents and non-residents or between the domestic situation and the cross border situation.� peter wattel, red herrings in direct tax cases before the ecj, 31(2) legal issues of economic integration 81, 83 (2004). 388. see, e.g., case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493; case c-484/93, svensson v. ministre du logement, 1995 e.c.r. i-3955; case c-251/98, baars v. inspecteur der belastingen particulieren/ ondernemingen gorinchem, 2000 e.c.r. i-2787; case c-35/98, staatssecretaris van financien v. b.g.m. verkooijen, 2000 e.c.r. i-4071; see also terra & wattel, supra note 51, at 71-76. 389. see, e.g., case c-136/00, danner, 2002 e.c.r. i-8147, ¶ 48. but see case c-250/95, futura participations sa v. administration des contributions, 1997 e.c.r. i-2471, ¶ 31. 390. see, e.g., case c-136/00, danner, 2002 e.c.r. i-8147, ¶ 54; terra & wattel, supra note 51, at 32-33, 77-80. 391. see, e.g., case c-141/99, algemene maatschappij voor investering en dienstverlening nv (amid) v. belgische staat, 2000 e.c.r. i-11619; case c-264/96, imperial chemical industries plc (ici) v. colmer (her majesty�s inspector of taxes), 1998 e.c.r. i-4695. 392. see, e.g., case 270/83, comm�n v. french republic, 1986 e.c.r. 273 (avoir fiscal case). 393. see, e.g., case c-107/94, asscher v. staatsecretaris van financien, 1996 e.c.r. i-3089. 394. see, e.g., case c-330/91, the queen v. inland revenue comm�rs, ex parte commerzbank ag, 1993 e.c.r. i-4017; case c-294/97, eurowings luftverkehrs ag v. finanzamt dortmund-unna, 1999 e.c.r. i-7447. 395. terra & wattel, supra note 51, at 33. 396. paul farmer, european court and corporate tax, 2002 tax j. 9, 11. of this �fiscal cohesion� justification has been limited by the ecj in subsequent cases.388 the court has rejected arguments based on the effectiveness of fiscal supervision,389 the need to prevent the abuse of ec law,390 the loss of tax revenue,391 the absence of tax harmonization,392 the need to compensate for lower rates of tax in another member state,393 and the counterbalancing of disadvantage with other advantages.394 furthermore, even if a justification is accepted, the principle of proportionality must be applied. the tax law must be proportionate in its restrictive effect with respect to the legitimate aim pursued meaning that there is no less restrictive yet equally effective way to attain the same goal.395 this appears to be a more difficult test to meet than the substantial reason test. the case law has evolved such that all four freedoms prohibit discrimination as well as nondiscriminatory restrictions.396 any national law that restricts one of the fundamental freedoms must meet four requirements in order to withstand ecj scrutiny: 1) the law must be applied in a nondiscriminatory manner; 2) the law must be justified and required by the 104 florida tax review [vol.7:2 397. case c-55/94, gebhard v. consiglio dell�ordine degli avvocati e procuratori di milano, 1995 e.c.r. i-4165, ¶ 37. 398. see generally walter hellerstein & charles e. mclure, jr., lost in translation: contextual considerations in evaluating the relevance of u.s. experience for the european commission�s company taxation proposal, 58 bull. int�l fisc. doc. 86 (2004). the individual income tax is also more appropriate to analyze because it is a significantly greater share of the total tax revenue collected by both the u.s. and the eu member states. most countries raise significantly more revenue from the personal income tax than from the corporate income tax. oecd, revenue statistics 1965-2003 103-89 tbls. 42-71 (2005). for example, in 2002 the u.s. received 38% from the personal income tax while only 7% from the corporate tax, while germany, france, the uk and poland received 25%, 17%, 30% and 23%, respectively, from individuals; and 3%, 7%, 8% and 6% respectively, from corporations. id. at 119 tbl. 49, 125 tbl. 50, 158 tbl 63, 175 tbl. 70, 178 tbl. 71 (percentages calculated by author). 399. roberta romano, the genius of american corporate law 6, 8 (1993). delaware has been the leading state for incorporation since the 1920�s, and more corporations listed on national exchanges are incorporated in delaware than in any other state. id. �over 40 percent of the companies listed on the new york stock exchange are incorporated in delaware.� leo herzel & laura d. richman, foreword to r. franklin balotti & jesse a. finkelstein, 1 the delaware law of corporations & business organizations (3d ed. 1998) (citing n.y.s.e. guide (cch) n725-800). �moreover, the vast majority of reincorporating firms move to delaware.� romano, supra, at 6. 400. romano, supra note 399, at 1. �firms choose their state of incorporation, a statutory domicile that is independent of physical presence and that can be changed with shareholder approval.� id. general interest; 3) the law must be appropriate for securing its objective; and 4) the law must not go beyond what is necessary to attain its objective.397 v. comparative case law in this section, i chose the most recent supreme court case that deals with tax discrimination and then examined the ecj jurisprudence to determine how the european court of justice would decide the issue. i selected an individual income tax case because the state corporate tax issues raised in the united states are very different than the issues addressed in the eu.398 generally, there is not the kind of tax discrimination that is found in the eu because a majority of publicly traded corporations are incorporated in delaware or in states other than the states in which they operate.399 thus, any state in the united states attempting to write a corporate income tax law that discriminates against nonresident corporations could find itself affecting corporations headquartered in its own state. in other words, the concept of corporate �residency� (place of incorporation) does not necessarily match the reality of where the corporate entity is �resident.�400 2005] tax discrimination 105 401. 2 pomp & oldman, supra note 184, at 10-1. only nevada, south dakota, washington and wyoming have no corporate income tax. hellerstein & hellerstein, supra note 170, at 413. texas�s franchise tax resembles a net income tax in many ways. id. 402. hellerstein & hellerstein, supra note 170, at 418. congress enacted a corporate tax law as part of the payne-aldrich tariff act of 1909, which marked the beginning of the federal government�s practice of taxing corporate income. boris i. bittker & james a. eustice, federal income taxation of corporations and shareholders 1-3 (7th ed. 2000). 403. see 1 research institute of america, supra note 170, ¶ 221 (2004); hellerstein & hellerstein, supra note 170, at 418. 404. hellerstein & hellerstein, supra note 170, at 418. 405. michael mazerov, the single-sales-factor formula: a boon to economic development or a costly giveaway?, 20 st. tax notes 1775 (2001). most states� corporate income tax laws have substantially incorporated the provisions of the uniform division of income for tax purposes act (uditpa), a model law written by the national conference of commissioners on uniform state laws in 1957. uditpa contains a three-factor formula for apportioning corporate income whereby the share of a corporation�s total profit that a particular state may tax is determined by averaging: 1) the share of the corporation�s total sales that are made to residents of the state (the sales factor); 2) the share of the corporation�s total payroll that is paid to employees working in the state (the payroll factor); and 3) the share of the corporation�s total property that is located in the state (the property factor). id. at 1782. since then, the double-weighted sales variant of this three-factor apportionment formula has been adopted by most states and has become the new de facto standard. id. 406. however, congress may limit a state�s taxing authority. see, e.g., public law 86-272 (preventing states from taxing corporations when the corporation�s only nexus with the state is personal property sales solicitations conducted in the state). act of sept. 14, 1959, pub. l. no. 86-272, 73 stat. 555-56 (codified as amended at 15 a. corporate taxation 1. the u.s. approach forty-five states and the district of columbia have enacted state corporate income taxes401 that broadly conform to the federal corporate income tax.402 every state except arkansas and mississippi determines the state corporate tax liability by beginning with federal taxable income.403 the difficulty for the states then is allocating that tax base among themselves when a multistate business is involved, as each state requires the business to pay tax on just a portion of its profit.404 the tax laws of the majority of the states determine the portion of the corporation�s profit that is subject to tax by using an apportionment formula that refers to the shares of the corporation�s total property, payroll, and sales located in each state.405 although the states have broad leeway in designing division-of-tax base formulas,406 they are subject to the constraints of the due process and 106 florida tax review [vol.7:2 u.s.c. §§ 381-384 (1976)). see 2 pomp & oldman, supra note 184, at 10-26. see generally kaye, supra note 126, at 165; see also charles e. mclure, the tax assignment problem: ruminations on how theory and practice depend on history, 54 nat�l tax j. 339, 341 (2001). 407. see quill corp. v. north dakota, 504 u.s. 298, 305 (1992) (stating that �the [due process and commerce] clauses pose distinct limits on the taxing powers of the states.�). thus, a state may levy a corporate income tax only on the income (or a portion thereof) that has a sufficient nexus with the taxing state. 2 pomp & oldman, supra note 184, at 10-7. see also miller bros. co. v. maryland, 347 u.s. 340, 344-45 (1954) (stating that �due process requires some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax.�). 408. hellerstein & hellerstein, supra note 170, at 419. for a state to impose income tax generated in interstate commerce, there are two requirements: (1) a �minimal connection� between the taxing state and the interstate activities generating the tax and (2) a rational relationship between the income taxed and the activities conducted within the state. see exxon corp. v. wis. dep�t of revenue, 447 u.s. 207, 219 (1980). see also mobil oil corp. v. comm�r of taxes, 445 u.s. 425, 436-37 (1980). a state may tax only income that is fairly attributable to a corporation�s income-producing activities within the state. see container corp. of america v. franchise tax bd., 463 u.s. 159 (1983) (a state may not tax income earned outside its borders when imposing an income tax). see also asarco v. idaho state tax comm�n, 458 u.s. 307, 315 (1982) (stating �a state may not tax value earned outside its borders.�); see also supra notes 264-67 and accompanying text. 409. see, e.g., case c-330/91, the queen v. inland revenue comm�rs, ex parte commerzbank ag, 1993 e.c.r. i-4017 (articles 52 and 58 of the treaty prevent a member state from granting repayment on overpaid tax to companies that are resident for tax purposes in that state while refusing the supplement to companies resident for tax purposes in another member state); imperial chem. indus. plc (ici) v. colmer (her majesty�s inspector of taxes), 1998 e.c.r. i-4695 (article 52 precludes making a particular form of tax relief in a member state contingent on a holding company�s business consisting wholly or mainly in the holding of shares in subsidiaries established in that member state). 410. see, e.g., am. trucking ass�ns, inc. v. scheiner, 483 u.s. 266 (1987) (challenged taxes do not pass the �internal consistency� test under which a state tax must be of a kind that, if applied by every jurisdiction, there would be no impermissible interference with free trade); complete auto transit, inc. v. brady, 430 u.s. 274 (1977) (holding constitutional a mississippi tax imposed for the privilege of doing business within the state because there were no allegations of insufficient nexus, discrimination, commerce clauses407 and may tax no more than their fair share of the property, income, or receipts of the multistate business.408 thus, while eu member states� corporate income tax laws had routinely denied nonresident corporation�s branches various tax benefits that are available to resident corporations,409 the u.s. case law with respect to corporations focuses on issues of state taxation of interstate business. these issues include the risk of multiple taxation, unfair apportionment, and the absence of due process jurisdiction.410 2005] tax discrimination 107 unfair apportionment, or no relation to services provided); okla. tax v. jefferson lines, 514 u.s. 175 (1995) (finding the tax on the full cost of a bus ticket for interstate travel was �fairly apportioned� because it reached only activity within the taxing state, that is, the sale of the service); nw. states portland cement co. v. minnesota, 358 u.s. 450 (1959) (the state�s taxation of a foreign business�s income within the state was not unconstitutional, provided that the tax was properly apportioned to local activities within the states and was not discriminatory). 411. charles e. mclure, jr., corporate tax harmonization for the single market: what the european union is thinking, 39 bus. econ. 28, 29 (2004). many states now use combined reporting methods. hellerstein & hellerstein, supra note 171, at 519. however, 19 states still do not have combined reporting requirements. id. at 583 tbl. 3. 412. mclure, supra note 411, at 29. 413. commission of the european communities, company taxation in the internal market, commission staff working paper (luxembourg: office for official publications of the european communities, 2002). 414. id. at 458-60. 415. walter hellerstein & charles e. mclure, jr., the european commission�s report on company income taxation: what the eu can learn from the experience of the us states, 11 int�l tax & pub. fin. 199, 200 (2004). 416. edward a. zelinsky, restoring politics to the commerce clause: the case for abandoning the dormant commerce clause prohibition on discriminatory taxation, 29 ohio n.u.l. rev. 29, 29 (2002). under his proposal, dormant commerce 2. the eu approach unlike many of the american states, the member states of the eu use separate accounting to compute the income of each member of a corporate group and arms length prices to value the transactions between the members of the group.411 source rules are then used to attribute the income to the �appropriate� member state.412 the commission is exploring the use of a consolidated base with formulary apportionment for european multinationals in lieu of the current system of separate accounting and the arm�s length standard.413 this change is receiving serious consideration because of the complexity of applying 25 member states� national tax systems if the company operates within the entire european union.414 as pointed out by professors hellerstein and mclure, depending on how the eu designs their system, such a change would raise many of the issues currently litigated in the united states.415 in the state corporate tax area in the united states, professor zelinsky has concluded �that the time has come to scrap the dormant commerce clause prohibition on discriminatory taxation. since the judicially-created prohibition has served its historic purpose, to create a single common market of the united states, it can now safely be laid to rest.�416 zelinsky reaches this conclusion because judges and scholars have 108 florida tax review [vol.7:2 clause restraints on state taxation such as the requirement �that taxes be fairly apportioned among the states, that such taxes be levied only by states with a nexus to the taxed activity, and that such taxes be reasonably related to the services the taxpayer receives from the taxing state� would continue. id. 417. id. at 30. 418. id. at 30-31. 419. id. at 30. 420. id. at 31. 421. deloitte eu study, supra note 300, at 23. see also walter hellerstein, state aid control in the american federal system, european competition law annual 1999: selected issues in the field of state aids 577 (c. ehlermann & m. everson eds., 2001). 422. deloitte eu study, supra note 300, at 23 n.105. been unable to distinguish convincingly between state taxes and states� and localities� direct expenditure programs or to identify a principled basis for declaring which taxes are discriminatory and which are not.417 the supreme court�s distinction between discriminatory taxation, which is prohibited under their decisions, and equivalent direct government subsidies, which are generally permitted, is fundamentally incoherent because taxes and subsidies are often similar in design and effect.418 in light of this doctrinal indeterminacy, zelinsky believes that the only options are to abandon the nondiscrimination principle in the context of state taxes or expand the dormant commerce clause to cover state direct subsidy programs.419 because the united states contains a robust network of interstate economic actors with the wherewithal to protect their interests politically, these interstate actors no longer need the protection of this commerce clause doctrine.420 the eu has avoided such inconsistencies by also prohibiting any state aid through a member state�s tax system. the principle of state aid restrictions as set forth in articles 87, 88 and 89 prohibits the member states from granting any advantage that distorts or has the potential to distort competition or trade between the member states.421 although some member states have argued that these provisions are not applicable to tax measures, the european commission as well as the court of first instance have rejected this argument.422 3. analysis the current situation in the eu with respect to member states� national tax systems is reminiscent of the first 100 years of supreme court commerce clause jurisprudence in that the effect of ecj case law is that in certain circumstances cross-border activity can receive more advantageous tax treatment than purely domestic activity. corporate cases in the last five 2005] tax discrimination 109 423. see case c-324/00, lankhorst-hohorst gmbh v. finanzamt steinfurt, 2002 e.c.r. i-11779 (holding that germany�s thin capitalization rules violated the freedom of establishment enshrined in article 43 of the ec treaty). 424. see case c-168/01, bosal holding bv v. staatssecretaris van financiën, 2003 e.c.r. i-9409 (holding that council directive 90/435/eec precludes a national provision that made the deductibility of costs in connection with a parent company�s holdings in a subsidiary established in another member state contingent on the costs being related to profits that are taxable in the parent company�s member state). 425. see case c-315/02, lenz v. finanzlandesdirektion für tirol, 2004 e.c.r. i-7063 (holding that a tax rate difference between foreign capital income and domestic capital income infringed on the free movement of capital, which is prohibited under article 56 of the ec treaty). 426. see case c-319/02, manninen, 2004 e.c.r. i-7477 (holding that a finnish law that taxed individuals at different rates depending on whether the dividend income was received from finnish or non-finnish corporations was incompatible with article 56 of the ec treaty). for a more complete discussion of this case, see supra notes 35866. 427. taxing judgments: corporate tax and the eu court, the economist, august 28, 2004, at 67-68. see also lee a. sheppard, dowdy u.k. retailer set to destroy european corporate tax, 35 tax notes int�l 132 (2004). �so off the wall are some ecj decisions that it is a wonder that european multinationals pay any tax at all.� id. at 132-33. in the recent marks & spencer case, uk legislation preventing the british parent company from using its losses from subsidiaries in other member states was struck down, provided that the parent company had exhausted its opportunity to deduct the losses in the country where the loss occurred. case c-446/03, marks & spencer plc v. david halsey (hm inspector of taxes), ¶ 59, http://europa.eu.int/index_en.htm (select documents tab; follow case law hyperlink; then follow case law since 1997 (curia) hyperlink) (ruling that a group relief tax provision that does not permit a parent company to deduct losses from its foreign subsidiary is incompatible with the ec treaty if those losses cannot be deducted in the country of origin). for the potential impact on a member state�s tax revenue, see clemens fuest et al., the tax revenue implications of marks & spencer for germany, 38 tax notes int�l 763 (2005). germany�s possible tax revenue loss is estimated to be as high as 1.5% of the german gross domestic product. id. at 767. but cf. gerard t.k. meussen, cross-border loss relief in the european union following the advocate general�s opinion in the marks & spencer case, 45 eur. tax�n 282, 284 (2005) (explaining that the ecj does not accept possible tax losses as a public interest exception to a violation of a fundamental freedom). for an analysis of advocate general maduro�s opinion, see michael lang, marks and spencer � more questions than answers: an analysis of the opinion delivered by advocate general maduro, 14 ec tax rev. 95 (2005). years have found the german thin capitalization rules,423 the dutch interest allocation rules,424 the austrian foreign-source investment income tax rules,425 and the finnish corporate tax legislation426 all in violation of ec treaty law.427 european commentators have raised the question of whether the danish controlled foreign corporation (cfc) rules are compatible with ec 110 florida tax review [vol.7:2 428. anders rubinstein & nikolaj bjornholm, news analysis: do the lenz and manninen decisions invalidate danish dividend and cfc taxation?, 36 tax notes int�l 286, 286 (2004). 429. case c-196/04, cadbury schweppes plc v. comm�rs of inland revenue, 2004 o.j. (c 168) 3 (referral to the ecj for a ruling on the issue of whether tax legislation that provides different rates of taxation for companies with subsidiaries in the same and different member states is compatible with the ec treaty). jens schönfeld predicts that the ecj is likely to answer the special commissioner�s question by replying that the uk cfc legislation is incompatible with the ec treaty. jens schönfeld, the cadbury schweppes case: are the days of the united kingdom�s cfc legislation numbered?, 44 eur. tax�n 441, 452 (2004). the united kingdom�s cfc legislation is also being challenged in case c-203/05, vodafone 2 v. her majesty�s revenue and customs. hans van den hurk, et al., eu tax review, 39 tax notes int�l 39, 41 (2005). 430. emilio cencerrado, controlled foreign company and thin capitalization rules are not applicable in spain to entities resident in the european union, 13 ec tax rev. 102, 103 (2004). interestingly, germany responded to the lankhorst judgment by extending their then legislation to lender companies resident in germany as well whereas spain amended their legislation to exempt all residents of the eu unless the territory is classified as a tax haven. id. at 105. 431. luc hinnekens, forum: european court goes for robust tax principles for treaty freedoms. what about reasonable exceptions and balances?, 13 ec tax rev. 65, 66 (2004). 432. see infra part iv. 433. cencerrado, supra note 430, at 107. law428 and the finance and tax tribunal referred a question dealing with the uk�s cfc legislation to the ecj on april 29, 2004.429 european tax scholars are concerned that the pendulum has swung so far in favor of taxpayers as to create a preference for cross-border activity. denying the member states the ability to maintain certain domestic anti-avoidance measures jeopardizes tax justice as well as causing substantial losses in the tax revenue of the member states.430 given the progress made towards the internal market, it is time for a more balanced approach that takes into account the member states� needs to finance their governments. this could be accomplished through a more judicious use of the rule of reason.431 it seems unreasonable that only one justification has ever been accepted by the ecj in direct taxation cases.432 emilio cencerrado suggests reliance on article 4 of the ec treaty, which obligates the member states to avoid excessive public deficits.433 this is accomplished in part through sound tax policies that combat anti-avoidance conduct. unlike in the united states, in the case of the european union, it is the judicial branch�s decisions that are affecting the member states� ability to finance their governments. 2005] tax discrimination 111 434. 522 u.s. 287 (1998). 435. id. at 293. 436. id. at 291-93 (citing n.y. tax law § 631(b)(6) (mckinney 1997), which states that the deduction for alimony �shall not constitute a deduction derived from new york sources.�). 437. id. at 293. 438. brief for petitioners at 4, lunding (no. 96-1462). 439. after the department of taxation and finance denied the deduction, the lundings appealed to the new york division of tax appeals where they were also denied. they then brought an action before the appellate division of the new york supreme court. lunding, 522 u.s. at 293. see also lunding v. tax app. trib., 639 n.y.s.2d 519 (n.y. app. div. 1996), rev�d, lunding v. tax app. trib., 675 n.e.2d 816 (n.y. 1996), rev�d, lunding v. n.y. tax app. trib., 522 u.s. 287 (1998). �the new york division of taxation, the state tax appeals tribune, and the new york court of appeals determined that he was not entitled to the deduction; only the appellate division, third department, found fault with new york�s denial of the alimony deduction.� diann lee smith, new york: denial of alimony deduction for nonresidents unconstitutional, 10 multistate tax analyst 8 (1998). 440. lunding, 522 u.s. at 293. for a critique of this position, see michael j. mcintyre & richard d. pomp, post-marriage income splitting through the deduction for alimony payments: a reply to professor schoettle on lunding v. new york, 13 st. tax notes 1631 (1997). b. individual taxation 1. the u.s. supreme court�s approach the most recently litigated case of individual tax discrimination in the united states is lunding v. new york tax appeals tribunal.434 in this case, a connecticut married couple filed a new york nonresident income tax return and took a pro rata deduction of the alimony paid by the husband to the former spouse in proportion to the percentage of the husband�s business income that was earned in new york (approximately 48%).435 the new york state income tax statute did not allow for such a deduction for nonresidents.436 the deduction was denied and the department of taxation and finance recalculated the couple�s tax liability.437 the recalculated new york state tax liability was 14.8% higher than what a new york resident with the same income and alimony would be required to pay.438 the lundings appealed the assessment through the administrative process and then through the new york state court system.439 the taxpayers asserted that new york�s tax provision violated the privileges and immunities clause because it resulted in a nonresident�s tax liability being greater than if the nonresident was a resident.440 the new york court of appeals upheld the constitutionality of the new york statute�s disparate tax treatment of alimony paid by a nonresident 112 florida tax review [vol.7:2 441. lunding v. tax app. trib., 675 n.e. 2d 816, 821 (n.y. 1996), rev�g, 639 n.y.s.2d 519 (n.y. app. div. 1996). 442. 334 u.s. 385, 396 (1948). 443. 252 u.s. 37 (1920). 444. 252 u.s. 60 (1920). 445. lunding, 675 n.e.2d at 819. 446. id. at 821. 447. id. 448. lunding, 522 u.s. at 289-90. 449. id. at 315. �[a] state may defend its position by demonstrating that �(i) there is a substantial reason for the difference in treatment; and (ii) the discrimination practiced against nonresidents bears a substantial relationship to the state�s objectives.�� id. at 298 (citing supreme court of n.h. v. piper, 470 u.s. 274, 284 (1985)). 450. id. at 297. 451. id. at 299. 452. id. at 296 (citing paul v. virginia, 75 u.s. (8 wall.) 168, 180 (1869)). as fully justified because in effect �the advantage granted residents is offset by the additional burden of being taxed on all sources of income.�441 the �substantial reason test� created in the toomer v. witsell case,442 allows a state�s disparate treatment of nonresidents only when they have a valid independent reason. the new york court of appeals asserted that shaffer v. carter443 and travis v. yale & towne mfg. co.444 �established that limiting taxation of nonresidents to their in-state income was a sufficient justification for similarly limiting their deductions to expenses derived from sources producing that in-state income.�445 thus, the new york court of appeals agreed with new york state�s argument that the nonresident discrimination was justified given that nonresidents were only taxed on in-state income while residents were taxed on worldwide income.446 the court of appeals� finding that alimony payments are �wholly linked to personal activities outside the state� was further justification for the disallowance.447 the supreme court reversed and declared the tax provision unconstitutional in a six to three decision.448 the majority held that the new york tax provision violated the privileges and immunities clause because the state had not presented a substantial justification for the discriminatory treatment of nonresidents.449 although the privileges and immunities clause affords no assurance of precise equality in taxation between residents and nonresidents of a particular state,450 new york failed to assert �a substantial justification for its different treatment of nonresidents, including an explanation of how the discrimination relates to the state�s justification.�451 justice o�connor, writing for the majority, pointed out that the purpose of the privileges and immunities clause is to �strongly . . . constitute the citizens of the united states one people,� by �placing the citizens of each state upon the same footing with the citizens of other states, so far as the advantages resulting from citizenship in those states are concerned.�452 one 2005] tax discrimination 113 453. id. (citing shaffer v. carter, 252 u.s. 37, 56 (1920)); see also toomer v. witsell, 334 u.s. 385, 396 (1948); ward v. maryland, 79 u.s. (12 wall.) 418, 430 (1871). 454. lunding, 522 u.s. at 308. 455. id. 456. travis v. yale & towne mfg. co., 252 u.s. 60, 79-80 (1920). 457. lunding, 522 u.s. at 309. 458. id. at 304-05. 459. id. at 311. 460. id. at 310, 314. �alimony payments also differ from other types of personal deductions, such as mortgage interest and property tax payments, whose situs can be determined based on the location of the underlying property.� id. at 310. 461. id. �and as a personal obligation that generally correlates with a taxpayer�s total income or wealth, alimony bears some relationship to earnings regardless of their source.� id. at 314. 462. id. at 327 (ginsburg, j., dissenting). such advantage is the right of a citizen of any state to �remove to and carry on business in another without being subjected in property or person to taxes more onerous than the citizens of the latter state are subjected to.�453 she noted that there were other provisions within new york�s tax scheme that allowed for a proportionate deduction by nonresidents of personal expenses other than alimony.454 therefore, �[a]lthough the state has considerable freedom to establish and adjust its tax policy respecting nonresidents, the end results must, of course, comply with the federal constitution, and any provision imposing disparate taxation upon nonresidents must be appropriately justified.�455 citing travis,456 the court held that nonresidents must be allowed tax exemptions in parity with residents.457 the court also rejected new york�s second justification that alimony was linked to lunding�s personal life outside the state.458 the court distinguished alimony from valid disallowances such as business losses from out-of-state activities, because alimony is not �geographically fixed in the manner that other expenses, such as business losses, mortgage interest payments, or real estate taxes, might be.�459 the majority argued that alimony, while personal, bore some relationship to lunding�s overall earnings including amounts earned in new york.460 �[a]limony payments reflect an obligation of some duration that is determined in large measure by an individual�s income generally, wherever it is earned.�461 the dissenters, justice ginsburg, chief justice rehnquist, and justice kennedy, disagreed with this contention noting that other factors such as the length of the marriage, the recipient�s earnings, and child custody and support arrangements are more significant influences.462 criticizing the majority�s approach as inconsistent, the dissent argued that the majority�s 114 florida tax review [vol.7:2 463. id. 464. mcintyre & pomp, supra note 172, at 246. 465. see supra notes 336-39 and accompanying text. 466. case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i225. 467. case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493. 468. id. ¶ 2. 469. id. ¶ 10. 470. id. ¶ 3. 471. id. ¶ 4. holding would require states to allow nonresidents every personal deduction allowed to residents.463 2. the european court of justice�s approach thus, lunding raised the following fundamental question: is a state constitutionally required to extend to nonresident taxpayers who are subject to tax only on income arising within that state the same personal deductions and other related allowances that it grants to its residents, who are taxable on their worldwide income?464 the european court of justice has had essentially the same question referred to it by member state national courts since the avoir fiscal case was decided in 1986.465 this section will focus on a line of cases examining this problem as it arises for individual taxpayers with respect to the income tax. although the schumacker case466 was the first in this line of individual income tax cases, i will begin by discussing the wielockx case467 as its fact pattern is more analogous to that of lunding. in wielockx, the european court of justice dealt with a similar issue to that examined in lunding. mr. wielockx, a belgian national resident in belgium, challenged the inspector of taxes of the netherlands concerning the latter�s refusal to allow a deduction for his contributions to a pension reserve.468 mr. wielockx was self-employed and had a physiotherapy practice in the netherlands where he received his entire income. thus, he had to pay income tax in the netherlands.469 the netherlands 1964 law on income tax �defines �national taxpayers� as natural persons resident in the netherlands as opposed to �foreign taxpayers,� natural persons who are not resident in the netherlands but who do receive income there.�470 a voluntary pension-reserve tax scheme was adopted in 1972, allowing self-employed persons �to allocate a proportion of the profits of their business to form a pension reserve . . . .�471 the 1964 law provided that �national taxpayers� (the residents) �are subject to tax on the income arising from their business profits, reduced by amounts 2005] tax discrimination 115 472. id. ¶ 5. �[w]hen the taxpayer reaches the age of sixty-five, the pension reserve is to be liquidated. it is then treated as income and taxed either once on the total capital or when periodic payments are made from that capital.� id. ¶ 6. 473. id. ¶ 7. 474. id. ¶ 13. 475. id. ¶ 14. 476. case c-204/90, bachmann v. belgium, 1992 e.c.r. i-249 (accepting the necessity of preserving the fiscal cohesion of the applicable tax system as a justification for making the deductibility of annuity contributions contingent on their being paid in that state); see also supra note 325. 477. wattel, supra note 52, at 239. 478. case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493, ¶ 16 (citing case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i-225, ¶¶ 21, 26). 479. id. ¶ 17. 480. id. ¶ 19. 481. id. ¶ 20. added to the pension reserve and increased by amounts taken out of it.�472 under the 1964 law, �foreign taxpayers� (the nonresidents) �are taxed solely on their �taxable national income,� namely their total income in the netherlands during a calendar year as reduced by losses.�473 the ecj was asked whether article 52 (now art. 43) prohibits a member state from permitting residents to deduct a pension reserve from their taxable income, while denying such a deduction to community national taxpayers who, �although resident in another member state, receive all or almost all of their income in the first state.�474 is that difference in treatment �justified by the fact that the periodic pension payments subsequently drawn out of a pension reserve by the non-resident taxpayer are not taxed in the state in which he works but in the state of residence . . . ?�475 here the netherlands was invoking the bachmann justification,476 that it is essential to the cohesion of their tax system to maintain tax symmetry between the deductibility of the contributions and the taxability of the subsequent receipts within the same tax jurisdiction.477 while acknowledging that �direct taxation falls within the competence of the member states . . . ,� the court reiterated that member states must �avoid any overt or covert discrimination by reason of nationality.�478 �[d]iscrimination arises through the application of different rules to comparable situations or the application of the same rule to different situations.�479 a difference in treatment between resident and nonresident taxpayers cannot �in itself be categorized as discrimination within the meaning of the treaty.�480 however, a nonresident taxpayer �who receives all or almost all of his income in the state where he works is objectively in the same situation . . .� as a resident of that state who also works there because both are taxed in that state alone.481 therefore, if a nonresident taxpayer is 116 florida tax review [vol.7:2 482. id. ¶ 21. 483. id. 484. id. ¶ 22. 485. case c-204/90, bachmann v. belgium, 1992 e.c.r. i-249. 486. case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493, ¶ 23. the bachmann judgment has been severely criticized for ignoring the bilateral treaty in effect between belgium and germany. wattel, supra note 52, at 240. 487. case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493, ¶ 25. the ecj explained: [t]he effect of double-taxation conventions which, like the one referred to above, follow the oecd model is that the state taxes all pensions received by residents in its territory, whatever the state in which the contributions were paid, but, conversely, waives the right to tax pensions received abroad even if they derive from contributions paid in its territory which it treated as deductible. fiscal cohesion has not therefore been established in relation to one and the same person by a strict correlation between the deductibility of contributions and the taxation of pensions but is shifted to another level, that of the reciprocity of the rules applicable in the contracting states. id. ¶ 24. professor wattel calls this the invention of �macro-cohesion.� wattel, supra note 52, at 238. 488. case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493, ¶ 27. 489. case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i225. not allowed the same tax deductions, his personal situation will not be taken into account in either state.482 �consequently his overall tax burden will be greater and he will be at a disadvantage compared to a resident.�483 the court found that a nonresident taxpayer who �receives all or almost all of his income in the state where he works but who is not entitled to set up a pension reserve qualifying for deductions under the same tax conditions as a resident taxpayer suffers discrimination.�484 the netherlands�s attempt to justify this discrimination based �on the principle of fiscal cohesion laid down in . . .� bachmann485 was dismissed by the court.486 the court held that fiscal cohesion had been achieved by virtue of the bilateral convention concluded with belgium.487 the discriminatory treatment could not be �justified by the fact that the pension payments subsequently drawn out of the pension reserve by the nonresident taxpayer . . .� would be taxed in the state of residence pursuant to the respective member state�s double taxation treaty.488 previously in the schumacker case,489 the ecj had closely examined the distinction drawn in national tax laws between residents and nonresidents when a belgian national challenged the way germany taxed his earnings as 2005] tax discrimination 117 490. see elizabeth keeling, some observations on finanzamt köln-altstadt v. schumacker, 1 ec tax j. 135 (1995-96). 491. case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i225, ¶ 15. 492. id. ¶ 16. 493. id. ¶ 3. 494. id. ¶¶ 4, 5. 495. id. ¶ 7. 496. id. 497. id. 498. id. ¶ 17. 499. id. ¶ 18. 500. id. ¶ 12. 501. see nils mattsson, does the european court of justice understand the policy behind tax benefits based on personal and family circumstances?, 43 eur. tax�n 186 (2003). an employee.490 mr. schumacker earned his income in germany while living in belgium with his wife who did not work outside the home.491 pursuant to a double taxation treaty between belgium and germany, germany was entitled to tax his income.492 under german tax law, different tax regimes are applied to persons depending on their residence.493 residents of germany are subject to tax on all their income (�unlimited taxation�) while individuals with no permanent residence in germany are subject to tax only on the part of their income arising from employment in germany (�limited taxation�).494 to calculate the tax, �employed persons subject to unlimited taxation are divided into several taxation categories . . . .�495 married individuals who are not separated may use the �splitting� tariff provided that both spouses are german residents subject to unlimited taxation.496 the �splitting� tariff was designed to mitigate the progressive nature of the income tax rates by aggregating the spouses� total income, attributing 50% to each spouse and then taxing accordingly.497 mr. schumacker asked the finanzamt to calculate his tax on an equitable basis, by reference to the �splitting� tariff.498 the german tax authority refused to refund the extra taxes deducted from his wages due to his tax classification as an unmarried person.499 under the legislation in force at the time, persons subject to limited taxation came within this category regardless of their family circumstances.500 consequently, they did not qualify for the tax benefit of �splitting� and nonresident married employed persons were treated in the same way as unmarried persons. schumacker appealed his case to the bundesfinanzhof (federal tax court).501 the bundesfinanzhof asked for a preliminary ruling from the ecj with respect to the following questions (as summarized): 118 florida tax review [vol.7:2 502. case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i225, ¶ 19. 503. id. ¶ 24. 504. id. ¶ 21 (citing case c-246/89, comm�n v. united kingdom, 1991 e.c.r. i-4585, ¶ 12). 505. id. ¶ 22. 506. id. ¶ 23 (citing case c-175/88, biehl v. administration des contributions, 1990 e.c.r. i-1779, ¶ 12). 507. id. ¶ 28. the ecj explained: [n]ational rules . . . under which a distinction is drawn on the basis of residence in that non-residents are denied certain benefits which are, conversely, granted to persons residing within national territory, are liable to operate mainly to the detriment of nationals of other 1. does article 48 of the eec treaty restrict the right of germany to levy income tax on a national of another member state? if so: 2. does article 48 allow germany to impose a higher level of income tax on a belgian resident than on an otherwise comparable person resident in germany, if he commences employment in germany without transferring his permanent residence there? 3. does it make any difference if the belgian referred to above derives almost all (that is over 90%) of his income from germany and this income is only taxable in germany, in accordance with the double taxation agreement between germany and belgium? 4. is it contrary to article 48 for germany to exclude nonresidents who derive income from employment in germany from the benefit of annual adjustment procedures that are available to residents?502 after reviewing the german legislation and rationale, the ecj explained that the principle of free movement of persons within the community limits the right of a member state to enforce discriminatory provisions with respect to the taxation of a national of another member state.503 the court stated that although �direct taxation does not as such fall within the purview of the community, the powers retained by the member states must nevertheless be exercised consistently with community law . . . .�504 additionally, �article 48(2) (now art. 39(2)) requires the abolition of any discrimination based on nationality between workers of the member states as regards, inter alia, remuneration.�505 the court stated that �the principle of equal treatment with regard to remuneration would be rendered ineffective if it could be undermined by discriminatory national provisions on income tax.�506 with respect to questions two and three, the court found that where a distinction is drawn on the basis of residence, the rule is likely to operate to the detriment of nationals of other member states.507 indirect discrimination 2005] tax discrimination 119 member states. non-residents are in the majority of cases foreigners. id. 508. id. ¶ 30. 509. id. ¶ 41. 510. id. ¶ 58. 511. id. 512. farmer, supra note 312, at 77. 513. lunding v. n.y. tax app. trib., 522 u.s. 287, 311 (1998) (citing travis v. yale & towne mfg. co., 252 u.s. 60, 80 (1920)). 514. id. at 313 (citing brief for state of ohio et al. 8). thus, �the taxpayer would pay roughly the same total tax in the two states, the only difference being that [the taxpayer�s resident state] would get more and new york less of the revenue.� id. does arise when different rules are applied to comparable situations.508 because schumacker earned a major part of his income in germany and was not entitled to any tax benefits in belgium on account of his family circumstances, he was comparably situated to a resident of germany. thus, the community principle of equal treatment requires that germany consider his personal and family circumstances and grant him the same tax benefits as residents.509 as to the fourth question, article 48 of the treaty (now art. 39) mandates equal treatment at the procedural level for nonresident and resident eu nationals.510 the ecj found that the refusal to grant these nonresidents the benefit of the annual adjustment procedures that were available to residents constituted unjustified discrimination.511 note that in both the schumacker and wielockx cases, the court examines the overall tax situation of the taxpayer (and only that specific taxpayer) and looks at the home state position as well as the host state situation.512 the specific taxpayer analysis is disregarded in the supreme court�s opinion in lunding. instead, the supreme court takes a more global approach: [w]e are not satisfied by the state�s argument that it need not consider the impact of disallowing nonresidents a deduction for alimony paid merely because alimony expenses are personal in nature, particularly in light of the inequities that could result when a nonresident with alimony obligations derives nearly all of her income from new york, a scenario that may be �typical.�513 however, the supreme court rejected an attempt by various states, as amici for respondents, to assert that the effect of new york�s statute was de minimis given that �states imposing an income tax typically provide a deduction or credit to their residents for income taxes paid to other states.�514 this was not the case for mr. lunding, as connecticut imposed no income 120 florida tax review [vol.7:2 515. id. at 314 (citing reply brief for petitioners 4 n.1). 516. id. at 314 (citing austin v. new hampshire, 420 u.s. 656, 668 (1975)); see also travis, 252 u.s. at 81-82. 517. case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i225, ¶ 31; case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493, ¶ 18. 518. case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i225, ¶ 36; case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493, ¶ 20. 519. case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i225, ¶ 36; case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493, ¶ 22. 520. case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i225, ¶ 36; case c-80/94, wielockx v. inspecteur der directe belastingen, 1995 e.c.r. i-2493, ¶ 13. 521. case c-391/97, gschwind v. finanzamt aachen-au$enstadt, 1999 e.c.r. i-5451. 522. id. ¶¶ 2, 9. 523. id. ¶¶ 9, 10. 524. id. ¶ 10. tax on earned income for the year in question.515 finally, the court admonished that �the constitutionality of one state�s statutes affecting nonresidents [cannot] depend upon the present configuration of the statutes of another state.�516 in schumacker and wielockx the taxpayers won their cases because although the situations of residents and of nonresidents are not, as a rule, comparable,517 �the position is different where the nonresident receives no significant income in the state of his residence and obtains the major part of his taxable income from an activity performed in the state of employment . . . . �518 because mr. wielockx derived all of his income in the netherlands and mr. schumacker earned 90% of his income in germany, these member states were not justified in treating them differently than residents with respect to the tax treatment of their personal and family circumstances.519 the question that naturally arose next was what constitutes �the major part� of a taxpayer�s income.520 this question was dealt with in the gschwind case.521 in gschwind, the ecj also interpreted an article 48 (now art. 39) question raised by a dutch national regarding taxes assessed on his income from employment in germany.522 mr. gschwind lived in the netherlands with his wife. in 1991 and 1992, mr. gschwind was employed in germany earning approximately 58% of the couple�s total income while his wife was employed in the netherlands.523 pursuant to the income tax treaty between germany and the netherlands, mr. gschwind paid income tax on his earnings to germany and his wife paid income tax to the netherlands.524 2005] tax discrimination 121 525. id. ¶ 4. 526. id. ¶ 6. germany had amended their income tax law in 1995 in order to take into account the judgment by the ecj in the schumacker case. see supra notes 48493, 495-502 and accompanying text. 527. case c-391/97, gschwind v. finanzamt aachen-au$enstadt, 1999 e.c.r. i-5451, ¶ 11. mr. gschwind did not request personal deductions in germany but rather only sought the splitting benefit. in the tax regime of the netherlands that seeks to avoid double taxation, mr. gschwind lost his basic allowance and all other personal deductions available to residents. peter j. wattel, progressive taxation of nonresidents and intra-ec allocation of personal tax allowances: why schumacker, asscher, gilly, and gschwind do not suffice, 40 eur. tax�n 210, 218 (2000). 528. case c-391/97, gschwind v. finanzamt aachen-au$enstadt, 1999 e.c.r. i-5451, ¶¶ 12, 13. the question referred to the court was: is it contrary to article 48 of the ec treaty for paragraph 1(3), second sentence, in conjunction with paragraph 1a1.2 of the einkomensteuergesetz (german law on income tax) to provide that a netherlands national deriving taxable income from employment in germany without having a permanent residence or usual abode there and his spouse, who is not permanently separated from him and likewise has no permanent residence or usual abode in germany and earns income abroad, are not to be treated as persons subject to unlimited taxation for the purposes of applying paragraph 26(1), first sentence of the einkommensteuergesetz (joint assessment) on the ground that the combined income of the spouses for the calendar year in question does not fall as to at least 90% within the einkommensteuergesetz, or that the income not subject to the einkommensteuergesetz amounts to more than dem 24 000? id. ¶ 13. under the german income tax code, a married couple is able to apply for a joint assessment and use a splitting procedure that results in a lower tax liability.525 however, for the splitting procedure to apply to nonresident couples, 90% of the couple�s total income must be taxable in germany.526 thus, for the 1991 and 1992 tax years, mr. gschwind was treated as if he was single and forced to pay an additional tax liability.527 after mr. gschwind�s objection to his treatment as an unmarried person was dismissed, he appealed to the tax court of cologne, which referred the question to the ecj for a preliminary ruling.528 essentially, the issue was whether article 48 (2) of the treaty precludes the application of a member state�s legislation which grants resident married couples favourable tax treatment . . . , yet makes the same treatment of non-resident married couples subject to the condition that at least 90% of their total income must be subject to tax in that member state or, . . . , 122 florida tax review [vol.7:2 529. id. ¶ 14. 530. id. ¶ 32. 531. id. ¶ 27. 532. id. ¶ 29. 533. case c-403/03, schempp v. finanzamt munchen v, http://europa. eu.int/index_en.htm (select documents tab; follow case law hyperlink; then follow case law since 1997 (curia) hyperlink). 534. id. ¶ 11. 535. id. ¶ 4. 536. id. ¶ 8. 537. id. ¶ 9. that their income from foreign sources not subject to tax in that state must not be above a certain ceiling.529 the ecj concluded that the treatment of the gschwind family by the german tax authority was not discriminatory in violation of article 48 (2) (now art. 39 (2).530 in order for the nonresident couple to be protected under the schumacker doctrine, three elements must be met: (1) the couple earns no significant income in their state of residence, (2) the tax the couple is required to pay in the foreign state is higher than a resident couple would pay, and (3) the couple is similarly situated to the resident couple in that they derive the major part of their taxable income from activity in the state of employment.531 in these circumstances, the state of residence is not in a position to grant tax benefits resulting from the taking into account personal and family circumstances. thus, the state of employment must do so. in the gschwinds� case, the court assumed that the netherlands would take into account the personal and family circumstances of mr. gschwind despite his lack of income in the state because of the 42% of income his wife brought to the couple�s combined income in the resident state.532 because 58% of total income in state of employment is not enough to earn ecj protection, one can conclude that the ecj also would not have found in mr. lunding�s favor. however, evidence that the ecj might protect mr. lunding can be found in the ecj�s judgment in the schempp case.533 the german federal tax court asked for a preliminary ruling from the ecj with respect to whether the non-deductibility of maintenance payments from a german resident taxpayer to his ex-spouse residing in austria constitutes tax discrimination based on articles 12 and 18.534 maintenance payments by a german resident to a divorced spouse are generally deductible by the payer and are also regarded as taxable income to the recipient.535 however, where the ex-spouse resides in another member state, the recipient must prove through production of a certificate issued by the relevant taxing authorities that the maintenance payments will be taxed.536 mr. schempp was unable to produce the certificate because austria does not tax maintenance payments.537 2005] tax discrimination 123 538. id.; see also claudia daiber, multinational tax cases top ecj agenda, 37 tax notes int�l 966, 966-67 (2005). 539. case c-403/03, schempp v. finanzamt munchen v, ¶ 39, http://europa.eu.int/index_en.htm (select documents tab; follow case law hyperlink; then follow case law since 1997 (curia) hyperlink). 540. id. ¶ 47; daiber, supra note 538, at 967. 541. case c-403/03, schempp v. finanzamt munchen v, ¶ 35, http://europa.eu.int/index_en.htm (select documents tab; follow case law hyperlink; then follow case law since 1997 (curia) hyperlink). 542. id. ¶¶ 34, 36, 43. 543. id. ¶ 33. 544. case c-385/00, de groot v. staatssecretaris van financien, 2002 e.c.r. i-11819. 545. id. ¶ 46. 546. id. ¶ 27. schempp argued that he suffered discrimination because, had his former wife been resident in germany, he would have been able to deduct these maintenance payments.538 this would be true even though his spouse would not have actually paid any german income tax, as her income was less than the taxable minimum.539 the ecj found that this german income tax provision is not incompatible with the ec treaty.540 �[t]he payment of maintenance to a recipient resident in germany cannot be compared to the payment of maintenance to a recipient in austria. the recipient is subject in each of those two cases, as regards taxation of the maintenance payments, to a different tax system.�541 thus, articles 12 or 18 do not prohibit the german tax law because the criterion used in the tax law relates solely to the tax treatment of the maintenance payments in the member state of the recipient�s residence and not in any way to the nationality or residence of the payer of the maintenance payments.542 the ecj points out that, if mr. schempp�s former wife moved to the netherlands where maintenance allowances are subject to taxation, mr. schempp would be able to benefit fully from the maintenance payment deduction.543 this is not the case in lunding, where the deduction of alimony was clearly dependent on the residence of the payer. a resident of new york gets the deduction whereas a nonresident does not, regardless of the tax circumstances of the recipient. the de groot case,544 however, demonstrated some problems with the schumacker doctrine. in this case, the ecj had to tackle the question of whether article 48 (now art. 39) precludes a national tax law system that proportionally decreases a resident�s personal tax benefits on account of employment income from other member states.545 mr. de groot was a resident of the netherlands but also earned significant income from germany, france and the united kingdom.546 he paid taxes in these three 124 florida tax review [vol.7:2 547. id. ¶¶ 30-31. 548. id. ¶ 21. 549. id. ¶ 18. 550. id. ¶¶ 29, 36-37. 551. id. ¶ 30. 552. id. ¶ 48. 553. id. ¶ 49. 554. id. 555. id. ¶ 79. 556. id. ¶ 98. as the ecj explained: [t]he mechanisms used to eliminate double taxation or the national tax systems which have the effect of eliminating or alleviating double taxation must permit the taxpayers in the states concerned to be certain that, as the end result, all their personal and family circumstances will be duly taken into account . . . . id. ¶ 101. countries and also paid tax in the netherlands.547 although the netherlands exempted the foreign income pursuant to the respective tax treaties with germany, france and the united kingdom, the foreign income was taken into account for purposes of computing the appropriate progressive rate.548 after calculating tax on total income, a tax relief amount was calculated by multiplying the tax by a proportionality factor (foreign gross income divided by total gross income).549 as a result of this calculation, mr. de groot lost a proportionate share of his tax deduction (more than 60%), which included a proportionate share of his alimony deduction.550 neither germany, france, nor the united kingdom took his alimony deduction into account for purposes of calculating his tax liability in each of these countries.551 mr. de groot observed that the free movement of persons provisions of the ec treaty are intended to preclude any national legislation that would place community citizens at a disadvantage because they engage in crossborder activities.552 he claimed that he was disadvantaged, comparing his tax liability with the tax he would pay the netherlands if he worked exclusively in the netherlands.553 he received a smaller tax deduction because his employment income was earned from several member states.554 the ecj agreed with de groot and reasoned that although �the rules on freedom of movement for workers are intended, in particular, to secure the benefit of national treatment in the host state, they also preclude the state of origin from obstructing the freedom of one of its nationals to accept and pursue employment in another member state . . . .�555 overruling accepted tax principles, the ecj required the state of residence to grant all of the personal allowances regardless of the fact that the tax system of the netherlands exempted foreign income from taxation.556 with respect to the argument that the disadvantage suffered by the taxpayer was compensated for by the lack of a progressive tax rate being applied by the other tax jurisdictions, the ecj 2005] tax discrimination 125 557. id. ¶ 97 (citing with respect to the freedom of establishment, case 270/83, comm�n v. french republic, 1986 e.c.r. 273 (avoir fiscal), ¶ 21; case c-107/94, asscher v. staatssecretaris van financien, 1996 e.c.r. i-3089, ¶ 53; case c-307/97, compagnie de saint-gobain, zweigniederlassung deutschland v. finanzamt aacheninnenstadt 1999 ecr i-6161, ¶ 54; with respect to the freedom to provide services, case c-294/97, eurowings luftverkehrs ag v. finanzamt dortmund-unna, 1999 e.c.r. i7447, ¶ 44; and, with respect to the free movement of capital, case c-35/98, staatssecretaris van financien v. b.g.m. verkooijen, 2000 e.c.r. i-4071, ¶ 61). 558. see christian wimpissinger, gerritse case addresses source taxation as hindrance, 31 tax notes int�l 624, 626 (2003). 559. case c-234/01, gerritse v. finanzamt neukölln-nord, 2003 e.c.r. i5933. 560. id. ¶ 24. 561. id. ¶¶ 9-10. 562. id. ¶ 3. 563. id. ¶¶ 3, 8. 564. id. ¶ 13. 565. id. ¶ 24. found �that detrimental tax treatment contrary to a fundamental freedom cannot be justified by the existence of other tax advantages, even if those advantages exist . . . .�557 however, in a more recent direct tax decision with respect to the free movement of services, the ecj confirmed the generally accepted allocation of the right to tax among residence and source states.558 in gerritse,559 the ecj had to tackle the question of whether article 59 (now art. 49) precludes a national law that taxes gross income when taxing nonresidents, but net income when taxing residents.560 mr. gerritse, a citizen and resident of the netherlands, earned approximately 6,000 dem, or 10% of his income, for performing as a drummer in berlin.561 german income tax law distinguished between residents, who are allowed to deduct business expenses, and nonresidents like gerritse, who are not allowed to deduct such expenses.562 resident taxpayers are taxed on worldwide income at progressive tax rates with a nontaxable threshold of 12,095 dem, whereas nonresident artists are taxed at a flat 25% rate.563 mr. gerritse argued that if he were a german resident, he would not have been required to pay taxes on the amount of income earned in berlin, as that amount was less than the nontaxable threshold.564 the german court referred the matter to the ecj, asking whether the treaty precludes a german tax law that allows no business deductions and a uniform tax rate applied to nonresidents, whereas residents are able to deduct business expenses and are taxed according to a progressive tax table, including a nontaxable threshold amount.565 because gerritse performed services in germany, the main issue 126 florida tax review [vol.7:2 566. id. ¶ 23. 567. id. ¶ 28. 568. id. ¶ 35. 569. id. ¶ 53. 570. id. ¶ 54. 571. id. ¶¶ 54-55. 572. id. ¶ 55. 573. three new tax cases before the ecj, dec. 20, 2004, at http://www.allarts.nl/english/articles/2004 (follow �three new cases ecj . . .� hyperlink) (explaining that the ecj will likely expand on the gerritse decision in the recently referred tax cases of c-290/04 fkp scorpio konzertproduktion, c-345/04 centro equestro de leziria grande lda. and c-386/04 centro di musicologia walter stauffer, and rule that member states cannot tax nonresident artists and sportsmen more heavily than resident artists and sportsmen). before the court concerned the freedom to provide services, rather than the freedom of establishment.566 with respect to the deductibility of the business expenses, the ecj ruled that a tax law permitting only residents to deduct business expenses constitutes indirect discrimination on grounds of nationality, contrary to the principles of articles 59 and 60 (now arts. 49 and 50) of the ec treaty.567 regarding the different rates of taxation, the finanzamt and the finnish government attempted to justify the difference by arguing that the obligation to consider a taxpayer�s personal situation is the responsibility of the state of residence and not the state where the income is generated.568 the ecj ruled that although different rates of taxation for residents and nonresidents constitutes indirect discrimination violating article 60 (now art. 50),569 the flat tax rate (in this case 25%) must be compared to the appropriate tax rate in the progressive rate table.570 in this case, germany�s flat rate was not in violation of treaty provisions because when the tax-free allowance amount was added to his net income (as he had already received the benefit of a taxfree allowance in his state of residence), germany would have applied a rate of tax of 26.5% using the progressive rate table.571 thus, in this case, the 25% flat rate was not in excess of the rate that would have been applied to a resident using the progressive rate table after factoring in the tax-free allowance.572 three cases recently referred to the ecj further question whether or not a member state can tax nonresident artists and sportsmen more heavily than resident artists and sportsmen.573 3. analysis in the area of tax discrimination, both the supreme court and the european court of justice are engaged in a similar enterprise, balancing well-established tax principles against rights provided by a constitution or a 2005] tax discrimination 127 574. tribe, supra note 44, § 6-37, at 1270. 575. id. 576. ec treaty, supra note 15, art. 48 (ex art. 58). 577. case c-55/94, gebhard v. consiglio dell�ordine degli avvocati e procuratori di milano, 1995 e.c.r. i-4165, ¶ 37 (citing case c-19/92, kraus v. land baden-wuerttemberg, 1993 e.c.r. i-1663, ¶ 32). 578. id. �nothing in the record indicates that nonresidents use larger boats or different fishing methods than residents, that the cost of enforcing the laws against them is appreciably greater, or that any substantial amount of the state�s general funds is devoted to shrimp conservation.� toomer v. witsell, 334 u.s. 385, 398 (1948). 579. tribe, supra note 44, § 6-37, at 1256. 580. lunding v. n.y. tax app. trib., 522 u.s. 287, 297 (1998) (citing austin v. new hampshire, 420 u.s. 656, 665 (1975)). treaty. in the american jurisprudence, there appear to be three different tests to be applied depending on which constitutional right is asserted. matters are further unnecessarily complicated by the fact that corporations may not avail themselves of protection under the privileges and immunities clause.574 only individuals may assert this protection; corporations must invoke either the equal protection or the commerce clause.575 in the eu, however, the treaty requires that corporations must be treated like natural persons.576 in addition, the case law has evolved to the extent that there is now a uniform approach that is followed with respect to each of the four freedoms. in 1995, the court summarized this approach in the gebhard case: it follows, however, from the court�s case-law that national measures liable to hinder or make less attractive the exercise of fundamental freedoms guaranteed by the treaty must fulfil four conditions: they must be applied in a nondiscriminatory manner; they must be justified by imperative requirements in the general interest; they must be suitable for securing the attainment of the objective which they pursue; and they must not go beyond what is necessary in order to attain it.577 thus, the ecj is applying a very similar test to the supreme court�s substantial equality test where an individual state must demonstrate a sufficient link between the legitimate interests served and the discrimination practiced578 and that less restrictive alternatives were impractical.579 the supreme court has described this balance as �a rule of substantial equality of treatment� for resident and nonresident taxpayers.580 in the jurisprudence of the ecj, it is settled law that discrimination can arise only through the application of different rules to comparable 128 florida tax review [vol.7:2 581. case c-279/93, finanzamt köln-altstadt v. schumacker, 1995 e.c.r. i225, ¶ 30. 582. see, e.g., id. ¶ 31. 583. id. ¶ 34. 584. hellerstein, supra note 201, at 1332 n.104. see also metro. life ins. co. v. ward, 470 u.s. 869 (1985) (invalidating alabama statute that taxed out-of-state insurance companies at a higher rate than domestic companies because the state�s purposes were not legitimate to pass the equal protection rational basis test); wheeling steel corp. v. glander, 337 u.s. 562 (1949) (holding that where a state has permitted a foreign corporation to enter and transact business equal protection must be accorded at least to the extent that their property is entitled to an equally favorable ad valorem tax basis). 585. see lehnhausen v. lake shore auto parts co., 410 u.s. 356, 359-60 (1973) (holding that an illinois constitutional amendment authorizing ad valorem taxes on personal property of corporations but not with respect to personal property of individuals did not violate the equal protection clause because it was not the result of invidious discrimination and was within the state�s discretion to make classifications for tax purposes); see also allied stores of ohio v. bowers, 358 u.s. 522, 526-27 (1959) (holding that an ohio statute imposing an ad valorem tax on property stored by local companies while exempting out-of-state owners of warehouses did not deny domestic corporations the equal protection of the law). 586. nordlinger v. hahn, 505 u.s. 1, 10 (1992). 587. see united states r.r. ret. bd. v. fritz, 449 u.s. 166, 174, 179 (1980). 588. see minnesota v. clover leaf creamery co., 449 u.s. 456, 464 (1981). 589. nordlinger, 505 u.s. at 11 (citing cleburne v. cleburne living ctr., inc., 473 u.s. 432, 446 (1985)). 590. zinn & reed, supra note 235, at 92. situations or the application of the same rule to different situations.581 the ecj has consistently stated since the schumacker judgment that �[i]n relation to direct taxes, the situations of residents and of nonresidents are not, as a rule, comparable.�582 thus, a member state�s failure to grant certain tax benefits to a nonresident that it grants to a resident is not, as a rule, discriminatory because these two categories of taxpayers are not in a comparable situation.583 this analysis resembles the equal protection rational basis test that is used in tax cases.584 the equal protection clause does not prohibit the states from making reasonable classifications among such persons585 and �requires only that the classification rationally further a legitimate state interest.�586 the statute will be upheld as long as there is a plausible policy reason for the classification,587 plausible legislative facts on which a rational legislator could have relied,588 and �the relationship of the classification to its goal is not so attenuated as to render the distinction arbitrary or irrational.�589 however, unlike the ecj, the supreme court has rarely invalidated state tax laws solely on the basis that they violate the equal protection clause.590 legislatures have been given broad latitude in the classifications and distinctions created 2005] tax discrimination 129 591. regan v. taxation with representation, 461 u.s. 540, 547 (1983). see also madden v. kentucky, 309 u.s. 83, 88 (1940) (noting that legislatures have the greatest freedom with respect to classifications in the tax area). one exception to this deference exists with respect to interstate business and classifications involving residency usually taking the form of a �domestic preference tax.� zinn & reed, supra note 235, at 92. 592. metro. life ins. co. v. ward, 470 u.s. 869, 878 (1985). 593. id. 594. higher tax liabilities that are the result of nondiscriminatory differences in each state�s tax rates do not violate the free movement of workers. see, e.g., case c336/96, gilly v. directeur des services fiscaux du bas-rhin, 1996 e.c.r. i-2793, ¶¶ 30, 47. 595. case c-136/00, danner, 2002 e.c.r. i-8147, op. ¶ 38. by tax statutes.591 but legitimate state interest does not include a state favoring �its own residents by taxing foreign corporations at a higher rate solely because of their residence . . . .�592 this �constitutes the very sort of parochial discrimination that the equal protection clause was intended to prevent.�593 this schumacker test appears to function in the simple cross-border employment situation where the workers are earning substantially all of their income from the host state. however, complications such as a spouse earning income in a different member state, as in gschwind, or a person earning income from multiple member states, as in de groot, could cause an individual to be worse off by engaging in cross-border activity. the question to be addressed is how much protection should be guaranteed by the european union or the united states. does not a cross-border worker knowingly disadvantage herself every time she works in a state with a higher tax rate than her own?594 there has to be a balance struck between the encouragement of an internal market and the compelling needs of the states and member states to raise the revenues necessary for their governance. in the danner case, advocate general jacobs states that the ecj�s primary task in preliminary rulings is not to decide specific cases on the basis of narrowly distinguished facts, or to solve a problem for the national court in the particular case, but to state clearly and coherently for the benefit of everyone in the community what the correct understanding of the law is, and to give rulings of general significance.595 unfortunately, although much guidance has been given to the member states, most of the recent cases are adjudicating very similar issues to those 130 florida tax review [vol.7:2 596. jonathan schwarz, personal taxation under the european court of justice microscope, 58 bull. int�l fisc. doc. 12 546, 550 (2004). 597. since connecticut�s enactment of an individual income tax in 1992, the concern over under taxation is relieved. instead, the question becomes an issue of how the personal income tax should be apportioned between new york and connecticut. after the lunding decision, nonresident payers of alimony will pay less new york tax, which results in a smaller credit against their connecticut taxes. the nonresident recipient of alimony will only pay tax to connecticut, as is the case of a former spouse of a new yorker who now resides in connecticut. thus, the current effect of the lunding decision is to shift tax revenues to connecticut, a decision new york had previously made with respect to the former spouses of new york residents. see mcintyre & pomp, supra note 172, for a defense of the new york taxing scheme for alimony. 598. lunding v. n.y. tax app. trib., 522 u.s. 287, 311 (1998). 599. id. 600. the justices� caseload, at http://www.supremecourtus.gov/about/ justicecaseload.pdf (last visited jan. 16, 2006). that have been previously decided.596 the use of a legislative instrument such as a directive would be more efficient in establishing appropriate tax law. even though the united states does not have a system of preliminary rulings, supreme court opinions serve the same function by providing the state courts with judicial guidance. thus, it follows that the u.s. supreme court should also give rulings of general significance. the lunding majority did not limit their examination to mr. lunding�s particular fact pattern, which was unsympathetic for the tax year in question since connecticut had no income tax at that point and mr. lunding derived only 48% of his income from new york.597 the lunding majority was not satisfied by the state�s argument that it need not consider the impact of disallowing nonresidents a deduction for alimony paid merely because alimony expenses are personal in nature, particularly in light of the inequities that could result when a nonresident with alimony obligations derives nearly all of her income from new york, a scenario that may be �typical� . . . .598 the lunding majority also expressed concern about the nonresident who makes payments to a new york resident and the double taxation that would ensue.599 the supreme court only grants certiorari in about 100 cases of the approximately 7,000 petitions filed per term.600 although the court�s recent 2005] tax discrimination 131 601. quirk & shaver, supra note 121, at 650-51 (citing, e.g., citicorp n. am. inc. v. franchise tax bd., 100 cal. rptr. 2d 509 (cal. ct. app. 2000), cert. denied, 533 u.s. 963 (2001); kalama chem., inc. v. washington, 9 p.3d 236 (wash. app. 2000), cert. denied, 533 u.s. 931 (2001)). 602. see supra note 427 for a discussion of the different approaches member states have taken with respect to the finding of incompatibility of cfc legislation. 603. ec treaty, supra note 15, art. 4. denials of certiorari show a lack of enthusiasm for state tax cases,601 the court�s review is particularly significant in a constitutional challenge to a state tax system in order to send appropriate messages to the state legislatures. unfortunately when state taxpayers turn to congress, the result is that no one pays taxes. vi. conclusion the judgments of the european court of justice have caused some coordination of various individual and corporate tax laws through negative integration. pure tax harmonization has not resulted, in that a finding of incompatibility of a tax law with a treaty provision does not guarantee that all member states will resolve the problem in the same way legislatively.602 arguably, this judicial action was necessary during the infancy stage of the internal market. however, given the progress made towards the internal market, it is time for a more balanced approach that takes into account a member state�s need to finance its government. this could be accomplished through a more judicious use of the rule of reason, on occasion exercising, like the supreme court, an extra dose of judicial sympathy for the member state�s taxing power. alternatively, a european scholar suggests reliance on article 4 of the ec treaty. because this treaty provision obligates the member states to avoid excessive public deficits,603 sound tax policies that combat anti-avoidance conduct would need to be accepted as justifications for infringements of the treaty freedoms. on the legislative side, the council is designed to safeguard the economic interests of the member states. the finance minister�s acknowledged responsibility is to look after the member state�s interests in tax matters before the council. the commission should refocus its energies on formulating community tax policy, making proposals to the council, and drafting the detailed measures needed for their implementation. the commission should continue to push for a move to qualified majority voting for certain tax issues. hopefully, the member states will soften their opposition as they experience the frustration that eu enlargement has only exacerbated the inability to have agreement on any new community tax legislation. at a bare minimum, the commission can issue recommendations, 132 florida tax review [vol.7:2 which although not legally binding, would be persuasive in pushing member states towards more tax coordination. in contrast to my eu recommendation, with respect to the united states, i advocate less congressional involvement. the recent u.s. experience with federal intervention in state tax legislation demonstrates that congress is being too generous with the states� money. unlike the council of ministers, congress does not represent the states and there is increasing temptation to enact legislation that benefits a select constituency at a revenue cost to the states. at present, the united states is better off with increased judicial oversight, because in the name of reducing complexity, the congressional answer seems to be that no one should pay taxes. i conclude with a recommendation that the supreme court should give priority to state tax conflicts and additional restraints should be placed on the ability of congress to tamper with state tax laws. i recommend the creation of a committee of treasurers patterned after the eu�s economic and social committee or the committee of the regions but in this case comprised of the treasurers of the fifty states. this committee of treasurers would have to be consulted with respect to any federal intervention in state tax legislation. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 3 1996 number 6 u.s. income taxation of cross-border pensions cynthia blun" i. introduction ................................ 262 ii. u.s. taxation of deferred compensation in a domestic context .......................... 263 a. swnmary of current tax rules ................ 263 1. unfunded deferred compensation ........ 264 2. qualified retirement plans ............. 265 3. funded nonqualified plans ............. 266 4. individual retirement accounts .......... 269 b. rationale for u.s. tax treatment of qualified retirement plans .......................... 270 c. taxation of pensions in other developed countries ............................... 272 d. new considerations in cross-border context ...... 273 m. source-based taxation by u.s. of deferred compensation paid to nonresident aliens ........ 275 a. background: u.s. taxation of current compensation and investment income of nonresident aliens ...... 275 b. u.s. taxation of deferred compensation received by a nonresident alien ..................... 277 1. unfunded deferred compensation ........ 277 2. qualified pension plan ................ 278 3. funded but nonqualified plans .......... 282 4. employee contributions to retirement arrangements ...................... 283 5. period of u.s. residence and exit tax proposals ......................... 284 c. treaty position ........................... 285 * professor of law, rutgers, the state university of new jersey, school of lawnewark. b.a., 1972, yale college; j.d., 1976, harvard law school. the author wishes to thank thomas st.g. bissell for reading an earlier draft of the manuscript and to thank tracy a. kaye for her helpful comments. florida tax review 1. pension distributions ................. 285 2. pension contributions ................ 300 d. rationale for source-based taxation ............ 303 1. unfunded deferred compensation ........ 303 2. different treatment of funded deferred compensation ...................... 304 e. rationale for treaty relinquishment of source-based jurisdiction over pensions ................... 306 1. eliminating difficulties created by inconsistent source rules .............. 308 2. administrative difficulties of source-based taxation .......................... 308 a. elimination of administrative difficulties by eliminating source-based taxation .......... 308 b. alternative means of easing administrative difficulties ........ 312 3. determination of overall "ability to pay" . . 313 4. reliance on residence-based taxation ..... 315 f. proper scope of source-based exemption ........ 316 g. source-based taxation of contributions to foreign pension plans ...................... 318 iv. residence-based u.s. taxation of deferred compensation paid to u.s. citizens or residents ... 322 a. u.s. citizen who works in foreign country before retirement in the u.s. .................. 322 1. imposition of u.s. tax ................ 322 2. foreign tax credit considerations ....... 327 3. treaty provisions .................... 328 4. possibilities for manipulation of timing differences ........................ 332 5. lack of citizenship jurisdiction in most countries ..................... 334 b. alien performs services outside the u.s. and receives payments of deferred compensation after becoming u.s. resident ................. 335 1. results under the internal revenue code ... 335 2. results under treaties ................ 338 a. treatment by country x ......... 338 b. treatment by united states ....... 339 [vol 3:6 1996] u.s. income taxation of cross-border pensions 261 c. the problems associated with u.s. residence-based taxation of participants in foreign plans ........ 341 d. u.s. residence-based taxation of u.s. multinational employer ............................... 343 e. possible improvements of u.s. residence-based taxation of beneficiaries of foreign plans ........ 349 v. a more comprehensive u.s. treaty policy ........ 352 v1. conclusion .................................. 366 florida tax review i. introduction this article will explore the u.s. income tax rules applied to deferred compensation transactions that cross national borders; it will consider whether the rules that the u.s. has developed, as a source country and as a residence country, constitute both a coherent and administrable approach and one that meshes harmoniously with the laws of other countries. one objective in this context is to avoid erecting barriers to the free movement of employees across borders. others are to avoid creating unwarranted loopholes for employees and to insure that the u.s. obtains its rightful share of tax revenues. this topic is of increasing significance because of the growth in cross-border movements of employees in recent years. there are a number of troubling features of the u.s. rules for taxing cross-border deferred compensation that suggest the need for this exploration. the rules for u.s. source-based taxation are often complex and difficult to administer. in stark contrast to its stringent source-based taxation under the code, the u.s. in its treaties completely surrenders source-based jurisdiction over "pensions." however, no such treaty relief is provided for other forms of deferred compensation; yet the term "pension" has not been defined by the irs in an authoritative form, and the rationale for the special treatment of "pensions" remains unclear. it seems doubtful that u.s. residence-based jurisdiction over "pensions" is exercised effectively, at least when the employer is not affiliated with a u.s. multinational. u.s. tax concepts employed in a domestic context are employed to characterize foreign retirement schemes even though the effects of such characterizations probably were not foreseen when the concepts were developed. the u.s. residence-based rules, even as supplemented by treaty, fail to take into account the manner of taxation by the source-country so as to guard against double taxation or inadvertent tax exemption. part ii of this article is a brief introduction, reviewing the u.s. income taxation of deferred compensation in a domestic context and the rationale for these rules. parts iii and iv will examine the use of these concepts in the development by the u.s. of its rules for cross-border transactions. part iii will first describe the u.s. assertion of source-based jurisdiction over cross-border 1. see richard e. andersen, new oecd model updates employment, selfemployment provisions, 4 j. int'l tax'n 94 (1993). andersen states that "[aiccompanying the globalization of financial capital during recent decades has been a somewhat less publicized, but no less significant, increase in the volume of cross-border movement of human capital, i.e., international transfers of employees in the public and private sector, as well as a heightened degree of global activity by self-employed persons .. " id. [vol 3:6 u.s. income taxation of cross-border pensions deferred compensation transactions. it will then explore the rationale for source-based taxation of deferred compensation and the disadvantages and difficulties associated with such taxation by the u.s., concluding with a discussion of the basis for u.s. treaty policy surrendering source-based taxation of pensions (as most recently expressed in the u.s. treasury department's 1996 model tax convention and technical explanation2). part iv first describes the u.s. assertion of residence-based jurisdiction over crossborder deferred compensation transactions. it will then explore the difficulties associated with u.s. residence-based taxation of deferred compensation and how they are occasioned by the u.s. attempt to apply its own tax concepts to a large variety of foreign retirement schemes. this part will then analyze the potential for "mismatching" of u.s. and foreign tax rules, with resulting underor over-taxation. part v will consider alternatives that might improve the current u.s. rules governing cross-border deferred compensation. these alternatives will include unilateral revisions of the u.s. treatment under the code and refinements of the u.s. treaty policy. i. u.s. taxation of deferred compensation in a domestic context a. summary of current tax rules a wage-earner who receives a current salary and invests it in a savings account is taxed on his salary upon receipt and then taxed on his interest income from the bank as it is earned.3 this treatment is generally consistent with the ideal of a comprehensive income tax, i.e., a definition of income that includes both amounts consumed and amounts devoted to saving. 4 however, there are a number of alternative means for a wage-earner to save for retirement. these generally involve an arrangement with the employer to defer payment of compensation to the employee. the tax 2. see treasury department, united states model income tax convention, sept. 20, 1996, 96 tnt 186-6 (sept. 23, 1996) (lexis, fedtax library. tnt file) (hereinafter 1996 u.s. model]; treasury department technical explanation for united states model income tax convention of sept. 20, 1996, 96 tnt 186-7 (sept. 23. 1996) (lexis, fedtax library, tnt file) [hereinafter 1996 treasury explanation]. 3. cf. andrew dilnot, the taxation of private pensions, in securing employerbased pensions-an international perspective 213, 215 (zvi bodie, ct al, 1996) (noting that a regime in which contributions are taxed, fund earnings are taxed, and payment of retirement benefits is tax-free is "basically that applied to interest-bearing short-term saving in most oecd countries"). 4. see david f. bradford and the u.s. treasury tax policy staff, blueprints for basic tax reform 2 (2d ed. rev. 1984); see also dilnot, supra note 3, at 220. 1996] florida tax review treatment of these alternative arrangements, under the internal revenue code, depends upon whether they are funded (i.e., whether the employee's rights under the plan are of a type to attract current taxation under the cash method of accounting),5 and, if so, whether taxation is nevertheless deferred because the plan is a qualified plan. 1. unfunded6 deferred compensation.-under the cash method of accounting, an employee who receives merely an unsecured promise of his employer to pay deferred compensation generally defers taxation until payment. the tax deferral is unaffected by the employer setting aside assets for purposes of paying the deferred compensation in a so-called "rabbi trust" meeting irs guidelines;8 under these guidelines, the employee's rights must be limited to "mere unsecured contractual rights" against the employer, and the trust assets must be subject to the claims of the employer's general creditors in the event of insolvency. 9 5. see john h. langbein & bruce a. wolk, pension and employee benefit law 180 (2d ed. 1995) (stating that "[tihe basic difference between funded and unfunded plans is that under a funded plan the employee may be taxed on contributions to the plan before the employee actually receives distributions," pursuant to irc § 83 or 402(b)). see also discussion at infra note 6. 6. the term "unfunded" is used in this article to describe nonqualified deferred compensation arrangements that achieve tax deferral for a cash method employee. see langbein & wolk, supra note 5, at 190 (explaining that "[t]he key feature of the rabbi trust" described at infra notes 8-9, "is that the trust assets remain subject to the claims of the employer's creditors in the event of the employer's bankruptcy or insolvency," and "[lt is this feature that makes the trust 'unfunded' for tax purposes, avoiding both constructive receipt and the application of the economic benefit doctrine"). 7. see rev. rul. 60-31, 1960-1 c.b. 174; 2 boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts 60.2.1 (2d ed. 1990 & supp. 1 1996). in addition, see rev. proc. 92-65, 1992-2 c.b. 428 (providing irs guidelines for obtaining a ruling that the doctrine of constructive receipt is inapplicable to an unfunded deferred compensation arrangement). under irs guidelines, an election to defer payment of compensation must (with two specified exceptions) "be made before the beginning of the period of service for which the compensation is payable." id. further, "[tihe plan must provide that a participant's rights to benefit payments under the plan are not subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment, or garnishment by creditors of the participant". id. 8. see rev. proc. 92-64, 1992-2 c.b. 422 (providing a model form for a rabbi trust). following irs guidelines insures that "an employee wili not be in constructive receipt of income or incur an economic benefit solely on account of the adoption or maintenance of the trust." id. § 3. see discussion of "rabbi trusts" in daniel i. halperin, special tax treatment for employer-based retirement programs: is it 'still' viable as a means of increasing retirement income? should it continue? 49 tax l. rev. 1, 26 & nn.82-84 (1993). see also yale d. tauber, funding non-qualified deferred compensation benefits, 1 erisa & benefits l.j. 177, 179, 182-89 (1992). 9. rev. proc. 92-64, 1992-2 c.b. 422, § 5.02, model trust § i(d). [vol. 3:6 u.s. income taxation of cross-border pensions when nonqualified deferred compensation is structured so as to defer the employee's tax until receipt of payment, the employer's deduction is also deferred until that time but includes the entire amount eventually paid to the employee.1° any investment return earned during the period of deferral is taxed currently to the employer (under the grantor trust rules, in the case of a rabbi trust)." this type of deferred compensation results in overall tax savings to the employer and employee only to the extent that the employer's tax rate (applied to the investment return during the period of deferral) is less than the tax rate that would have applied to the investment return earned by the employee and to the extent that the employee's marginal tax rate at the time of pay-out is less than it would be at the time when the compensation was earned. 12 2. qualified retirement plans.-when an employer sets aside funds in a retirement trust for employees that is beyond the reach of the employer's creditors (and thus not a "rabbi trust"), 3 the treatment depends upon whether the trust is "qualified" under the pension provisions of the code. as provided in section 401 of the internal revenue code, a "qualified" pension trust must be "created or organized in the united states," and must be "for the exclusive benefit of ... employees or their beneficiaries."'14 in addition, the trust must satisfy a myriad of other requirements, e.g., it must meet the minimum participation standards of section 410, must not discriminate in contributions or benefits in favor of highly compensated employees, must meet minimum vesting standards of section 411, must comply with the limitations on contributions and benefits set forth in section 415, must prohibit assignment or alienation of benefits, and satisfy minimum funding standards of section 412." if the plan is qualified, the employer's contribution to the plan is currently deductible, up to specified limits. 6 the income of the pension 10. see irc § 404(a)(5); bittker & lokken, supra note 7. 1 60.2.2. 11. see irc §§ 671-679. to meet the irs guidelines for a model "rabbi trust," the trust agreement must provide that it is intended to be a grantor trust of the employer as grantor. rev. proc. 92-64, 1992-2 c.b. 422, § 5.02, model trust § 1(c). 12. see halperin, supra note 8, at 13 & n.45. 23-24, 27; daniel i. halperin, interest in disguise: taxing the "time value of money," 95 yale lj. 506. 520-23 (1986). 13. see supra notes 6, 8-9 and accompanying text. 14. irc § 401(a). 15. id.; see bittker & lokken, supra note 7, u 61.2-61.10. 16. see irc § 404(a)(1). the deduction is "limited to the amount necessary to fund the plan properly under the actuarial method and assumptions used." bittker & lokken, supra note 7, 61.14.1. 19961 florida tax review trust is tax-exempt pursuant to section 501(a). 7 the employee is taxed only when he or she receives distributions from the trust. 8 certain premature distributions (i.e., withdrawals not used for retirement) are subject to a 10% penalty tax.9 in the case of a qualified plan, the investment return accumulates free of any tax.20 this is consistent with the consumption tax model, under which amounts set aside for future consumption should accumulate at a before-tax rate of return.2 1 3. funded nonqualified plans.-until recently, employers have not deliberately sought to establish a funded nonqualified plan,22 and thus the precise tax consequences have gone largely unexamined. recently, however, employers have sought and obtained private rulings regarding the tax consequences of such arrangements. 23 the simplest case is a "defined contribution plan," in which each participant has a separate account; the account reflects contributions as well as trust income, expenses, and gains or 17. see irc § 501(a); bittker & lokken, supra note 7, 61.15. 18. see irc § 402(a); bittker & lokken, supra note 7, 61.13. a further advantage is that "most pensions (but not employee contributions to 401(k) plans) are exempt from payroll taxes." eric m. engen & william g. gale, comprehensive tax reform and the private pension system, 96 tnt 137-82, para. 9 (july 15, 1996) (lexis, fedtax library, tnt file) [hereinafter engen & gale]. 19. see irc § 72(t); infra note 117. in addition, see gene steuerle, tax reform and private pensions, 70 tax notes 1693 (mar. 18, 1996) (explaining that this penalty "might be viewed as an attempt to 'recapture' some of the tax benefits that may have accrued" in light of the fact that "the taxpayer turns out not to have saved for retirement"). he explains that "[t]he government's penalty tax might also be viewed as its attempt to save welfare or transfer payments down the road." id. similarly, the penalty on early withdrawal has been described as "ensur[ing] that the tax break for pensions is only given for retirement saving." engen & gale, supra note 18, para. 39. 20. see halperin, supra note 8, at 13. 21. see dilnot, supra note 3, at 214, 220 (noting that this "treatment confers a posttax rate of return on saving equal to the pre-tax rate of return," and that, under this approach, "both present and future consumption are taxed on the same basis"). 22. for a discussion of the tax treatment of "secular trusts," see deborah walker and sallie olson, maximizing the benefits of deferred compensation plans funded through secular trusts, 77 j. tax'n 90 (1992); stuart m. lewis, secular trusts-irs rulings form new pentateuch, 33 tax mgmt. memo (bna) 301 (1992) (discussing priv. ltr. ruls. 88-41023, 88-43-021, 92-06-009, 92-07-010, 92-12-019, and 92-12-024); halperin, supra note 8, at 24-33; see also washington items: the climate of current thinking on new developments, "tax consequences of distributions from nonexempt trusts unclear," 35 tax mgmt. memo (bna) 268 (1994) (discussing priv. ltr. rul. 94-17-013 (jan. 24, 1994)); internal revenue service, notice of proposed rulemaking, application of grantor trust rules to nonexempt employees' trusts [reg-209826-96], 96 tnt 190-4 (sept. 27, 1996) (lexis, fedtax library, tnt file) [hereinafter 1996 proposed rulemaking]. 23. see, e.g., priv. ltr. rul. 95-02-030 (oct. 13, 1994). [vol. 3:6 u.s. income taxation of cross-border pensions losses, and it serves as the basis for determining the participant's benefits."4 an employer's contribution to this type of plan is currently includible by the employee pursuant to section 402(b)(1)5 and, as a consequence, is currently deductible by the employer under section 404(a)(5), provided that amounts contributed to the plan are nonforfeitable (notwithstanding early termination of employment).2 the trust is treated as a separate taxable entity (rather than as a grantor trust of the employer), and the trust's investment income is taxed under the rate schedule for trusts,27 except to the extent of certain current distributions to beneficiaries.2 the eventual distribution to the employee is taxable to him upon receipt pursuant to section 72, which allows for the amount already taxed at the time of contribution.24. the term "defined contribution plan" is defined in § 414(i). for a further discussion, see bittker & lokken, supra note 7. 61.1.2. 25. under § 402(b)(1), the contributions are included in income in accordance with § 83, except that the value of the employee's interest in the trust is substituted for the property's fair market value in applying § 83. see priv. ltr. rul. 95-02-030 (oct. 13, 1994j. however, an exception to this current inclusion is provided for a non-highly-compensated employee if the sole reason the trust fails to qualify for exemption under § 501(a) is failure to meet the requirements of § 401(a)(26) or § 410(b). see irc § 402(b)(4)(b); see. e.g.. priv. ltr. rul. 92-12-019 (dec. 20, 1991) (ruling (5)). 26. under § 83, the employee's inclusion is in the first year in which his rights are transferrable or are not subject to a substantial risk of forfeiture. see irc §§ 83(a). 402(b)t 1). 27. see priv. lr. rul. 92-12-019 (dec. 20, 1991) (ruling (1)) (stating that "[tihe rules of sections 402(b) and 404(a)(5) of the code preclude a section 402(b) employees' trust from being treated as owned by the employer under subpart e." and ruling that "the tax imposed by section 1(e) of the code will apply to the taxable income of the trust pursuant to section 641"); priv. ltr. rul. 95-02-030 (ocl 13, 1994) (rulings (1) & (2)) (giving a similar ruling); halperin, supra note 8, at 30 & n.94. see also 1996 proposed rulemaking, supra note 22, u 34, 37. under the proposed regulations, "an employer is not treated for federal income tax purposes as an owner of any portion of a nonexempt employees' trust described in section 402(b) that is part of a deferred compensation plan, and that is not a foreign trust within the meaning of section 7701(a)(31)." id. 37. 28. see priv. ltr. rul. 92-12-019 (dec. 20, 1991) (ruling (3)) (ruling that "[flor any taxable year, the trust is entitled to a deduction under section 661(a) for amounts distributed to a participant or a participant's beneficiary ... during that taxable year," with the deduction limited "with respect to each participant's account" to the "amount of distributable net income computed for each account as if each account were a separate trust"); see also priv. ltr. rul. 94-17-013 (jan. 24, 1994) (ruling (3)); priv. ltr. rul. 95-02-030 (oct. 13. 1994) (rulings (4)(5)). a trust's distributable net income ("dn') is its taxable income, determined with modifications described in § 643(a). see irc § 643(a). 29. see irc § 402(b)(2); see, e.g., priv. ltr. rul. 92-12-024 (dec. 20, 1991) (rulings (5) and (6)); priv. ltr. rul. 95-02-030 (oct. 13. 1994) (ruling (8)). because no credit is given for the tax paid by the trust, investment income is double taxed, see halperin. supra note 8. at 29-30 & n.94, except to the extent of the trust's distribution deduction (limited to dni). id. at 32 & n.105. for purposes of determining a participant's "investment in the contract," amounts previously taxed to the recipient under § 402(b) are classified as "premiums or other 19961 florida tax review if the plan deviates from this simple example there are additional complications. if the benefits become nonforfeitable only some time after the contribution is made, then the employee's inclusion is of the value of his interest when that occurs.3" the employer's deduction is delayed to the time of the employee's inclusion but cannot exceed the original contribution.3' no deduction is allowed to the employer at any time unless separate accounts are maintained for the various covered employees.32 thus, no deduction is generally allowed for contributions to a nonqualified "defined benefit plan" because a defined benefit plan does not maintain such accounts.33 a defined benefit plan is a pension plan that provides for definitely determinable benefits, determined, for example, by reference to an employee's years of service or rate of compensation.' moreover, if the employee is a highly compensated employee35 and the trust fails to meet certain requirements of a qualified plan for broad coverage and participation of employees,36 then, according to the irs, the consideration paid for the contract." see priv. ltr. rul. 92-12-024 (dec. 20, 1991) (rulings (10) and (11)). see generally 1996 proposed rulemaking, supra note 22, 23-24 (describing the treatment of the beneficiary and employer in respect of a nonexempt employees' trust). 30. see irc § 402(b)(1) (stating that benefits are includible in accordance with § 83); yale d. tauber, funding non-qualified deferred compensation benefits, i erisa & benefits l.j. 177, 190 (1992); halperin, supra note 8, at 26 n.87; bittker & lokken, supra note 7, 60.3 (supp. 1 1996). 31. see halperin, supra note 8, at 30 & nn.95-96; regs. § 1.404(a)-12(b)(1); priv. ltr. rul. 94-17-013 (jan. 24, 1994); see also priv. ltr. rul. 95-02-030 (oct. 13, 1994). in the case where there is a delay in the employer's deduction because the benefit is forfeitable, the employer is in effect taxed on the "after-tax income of the trust," with the result that this portion of the investment income is double taxed. see halperin, supra note 8, at 30-31 & n.97. 32. irc § 404(a)(5). 33. see irc § 414(j) (defining a "defined benefit plan" as a plan which is not a defined contribution plan); supra note 24 and accompanying text (defining a "defined contribution plan"). but cf. priv. ltr. rul. 92-12-019 (dec. 20, 1991) (ruling that an employer was entitled to deduct contributions to the participants' accounts of a trust that secured the benefits for a nonqualified defined benefit plan and maintained separate accounts). 34. regs. § 1.401-1(b)(1)(i); see bittker & lokken, supra note 7, t 61.1.2 (explaining that regs. § 1.401-1(b)(l)(i) is applicable because a defined benefit plan is a pension plan). an example of a defined benefit plan is "an annual pension equal to two thirds of the employee's average annual compensation during the last five years of employment." id. in this example, the "employees ... are not affected by the earnings actually realized by the trust fund, mortality experience, or employee turnover." id. 35. the term "highly compensated employee" is defined for this purpose in § 414(q). see irc § 402(b)(4)(c). 36. these requirements are contained in irc §§ 410(b) and 401(a)(26), respectively, and are designed "to restrain discrimination in favor of highly compensated employees." see bittker & lokken, supra note 7, 61.3.1. see also id. u 61.3.3-61.3.4 for a detailed description of these requirements. [vol. 3:6 u.s. income taxation of cross-border pensions employee must additionally include his vested accrued benefit "7 (other than his investment in the contract) on an annual basis.38 in that situation, the amount taxable to the employee at the time of eventual distribution is unclear.39 some commentators have argued, however, that this unfavorable treatment of highly compensated employees was intended by congress only for pension plans that originally had, but then lost, qualified status. 0 these unfavorable results4' of a nonqualified funded plan may be avoided to the extent that the arrangement is structured so that the trust is a grantor trust of the employee.42 in that case, the results are the same as for current compensation invested by the employee." 4. individual retirement accounts.-the favorable treatment accorded a qualified pension plan is also available for individual savings of a limited amount contributed to an individual retirement account (ira)." that is an individual who either does not participate in an employer pension plan or whose income falls below certain limits may contribute up to $2,000 37. see irc § 402(b)(4)(a); cf. halperin, supra note 8, at 31 & n.99 (noting that the effect is that the "employee is forced to include as income both the unrealized appreciation and income as it accrues instead of at the time of distribution"). 38. for irs applications of § 402(b)(4)(a). reflecting its view that § 402(b)(4fla) applies to any nonqualified funded plan, see, e.g.. priv. ltr. rul. 95-02-030 (oct 13, 1994) (ruling (6)); priv. ltr. rul. 94-17-013 (jan. 24. 1994) (ruling (5))priv. ltr. rul. 92-12-019 (dec. 20, 1991) (ruling (4)). 39. see washington items, supra note 22 (discussing priv. ltr. rul. 94-17-013 (jan. 24, 1994)). in that ruling, the irs states that "[s]ection 402(b)(4)(a) of the code in its current form does not apply section 402(b)(2) to trigger application of section 72 to distributions to a highly compensated employee from a nonexempt trust to which section 402(bj(4f(a) applies." priv. ltr. rul 94-17-013 (jan. 24, 1994) (ruling (a)). however, the irs notes that this would have been accomplished by a "technical correction contained in h.r. 11, 102d cong., 2d sess. section 6102(j)(1)(a) (1992)" which was passed by both houses of congress "'but never signed into law by the presidenl" id. as a result, the irs does not rule on this issue in priv. ltr. rul. 94-17-013. id.; see also priv. ltr. rul. 95-02-030 (oct. 13, 1994) (ruling (11)). 40. halperin argues "the legislative history... implies that this rule was intended to apply only if the plan had been previously qualified." halperin, supra note 8, at 31 & n.100 (citing s. rep. no. 445, 100th cong., 2d sess. 159-60 (1988) and h.r. rep. no. 795, 100th cong., 2d sess. 152-53 (1988)). this view, however, has not been accepted by the irs. see supra note 38. 41. the portion of a distribution includible in income may also be subject to the 10% penalty tax under § 72(q) if the distribution is premature. see priv. ltr. rul. 92-12-024 (dec. 20, 1991) (ruling (12)). 42. see halperin, supra note 8, at 32 (noting that this can be done by "giv[ing] the employee an option as to whether to receive cash or to contribute to a trust for her benefit"); walker & olson, supra note 22, at 91; priv. ltr. rul. 8843-021 (july 29, 1988). 43. see halperin, supra note 8, at 32. 44. see generally bittker & lokken, supra note 7, 62.3. 19961 florida tax review per year to such an account on a tax deductible basis.45 the ira itself is exempt from tax.' no tax is imposed on the employee until distributions are made from the account.47 b. rationale for u.s. tax treatment of qualified retirement plans48 the tax treatment that the u.s. accords to current compensation invested by an employee in a bank account is in accord with the norm of a comprehensive income tax, with a base including both consumption and savings. 49 as discussed above, the overall tax treatment to the employer and employee of unfunded deferred compensation is comparable except to the extent of variation between the employer and employee's tax rate and any decline in the employee's tax rate at retirement.50 by contrast, the tax treatment that the u.s. accords to qualified pension plans and ira accounts (holding deductible contributions) is in accord with the norm of a cash flow tax, in which the tax base is limited to consumption.5 many commentators view this favorable treatment of qualified pension plans as justifiable under an income tax only as a tax incentive to encourage workers to save for retirement52 so as to reduce the need for 45. see irc § 219(a), (b), (g); bittker & lokken, supra note 7, 62.3.2. 46. see irc § 408(e)(1). 47. see irc § 408(d)(1); bittker & lokken, supra note 7, % 62.3.4. 48. see generally edward a. zelinsky, tax policy v. revenue policy: qualified plans, tax expenditures, and the flat, plan level tax, 13 va. tax rev. 591 (1994) [hereinafter zelinsky, flat, plan level tax]; halperin, supra note 8; general accounting office, tax policy: effects of changing the tax treatment of fringe benefits, reprinted in 92 tnt 76-16 (apr. 7, 1992) (lexis, fedtax library, tnt file) [hereinafter gao report]; norman p. stein, qualified plans and tax expenditures: a reply to professor zelinsky, 9 am. j. tax pol'y 225 (1991) [hereinafter stein]; edward a. zelinsky, qualified plans and identifying tax expenditures: a rejoinder to professor stein, 9 am. j. tax pol'y 257 (1991) [hereinafter zelinsky, rejoinder]; joseph bankman, tax policy and retirement income: are pension plan anti-discrimination provisions desirable, 55 u. chi. l. rev. 790 (1988); edward a. zelinsky, the tax treatment of qualified plans: a classic defense of the status quo, 66 n.c. l. rev. 315 (1988) [hereinafter zelinsky, status quo]; nancy j. altman, the reconciliation of retirement security and tax policies: a response to professor graetz, 136 u. pa. l. rev. 1419 (1988); michael j. graetz, the troubled marriage of retirement security and tax policies, 135 u. pa. l. rev. 851 (1987). 49. see supra notes 3-4 and accompanying text. 50. see supra note 12 and accompanying text. 51. see bradford, supra note 4, at 54, 118; dilnot, supra note 3, at 220. for discussion of the possible effects on pension savings if the current income tax is replaced with a form of consumption tax, see gene steuerle, tax reform and private pensions (pts. 1 & 2), 70 tax notes 1693 (mar. 18, 1996), 70 tax notes 1831 (mar. 25, 1996); engen & gale, supra note 18. 52. see, e.g., gao report, supra note 48, ch. 2 (stating that "congress uses tax preferences to encourage employers to sponsor pension plans and employees to provide savings [vol. 3:6 u.s. income taxation of cross-border pensions government to provide direct support to the elderly. 3 the favorable tax treatment of qualified plans may accomplish this by making such plans attractive to relatively well-compensated employees, while the nondiscrimination rules insure that the pension benefits are not limited to such employees. 4 the minimum vesting and funding requirements and the fiduciary standards applied to qualified plans insure that a participant will in fact receive benefits." the penalty for premature distributions assures that benefits will not be withdrawn before retirement.' some have expressed doubt that these goals are effectively achieved, either because the tax advantage of a qualified plan over a nonqualified plan is not sufficiently large" or because the nondiscrimination requirements are not in fact well-tailored to insuring broad coverage of employees.58 and some have proposed eliminating the tax advantage by imposing a flat tax (designed to approximate the average tax rate of participants in the plan) on the earnings of qualified pension trusts.59 by contrast, professor zelinsky has argued that the current treatment of qualified retirement plans should not be characterized as a "tax expendifor their future retirement"); janet g. stotsky & emil m. sunley, the tax system of the united states, 9 tax notes int'l 1755, 1765 (dec. 5, 1994) (noting that "[tihere are various incentives in the tax code intended to increase retirement savings."). 53. see, e.g., gene steuerle, tax reform and private pensions, 70 tax notes 1693, 1693 (mar. 18, 1996) (noting that the penalty for early pension withdrawals "might also be viewed as [the government's] attempt to save welfare or transfer payments down the road"). 54. the reduction in the overall pre-tax compensation accepted by the wellcompensated employees, as a result of the tax benefits, is used by the employer to partially fund an increase in overall pre-tax compensation for rank-and-file employees, who would not be willing to substitute deferred compensation for current compensation. see halperin, supra note 8, at 13-15. 55. see bittker & lokken, supra note 7, 61.2, 61.5, 61.10, 61.16 (discussing the antidiversion requirements of § 401(a)(2), minimum vesting standards, funding requirements and prohibited transactions). 56. see supra note 19. 57. see halperin, supra note 8, at 6-7, 15-21. professor halperin has suggested the possibility of a harsher treatment of nonqualified plans to preserve the relative attractiveness of qualified plans (with their prospect of greater rank-and-file coverage). id. at 43-44. 58. see bankman, supra note 48, at 805-13, 821-24, 828-30. 59. the tax advantage offered by the qualified pension plan, as compared to current compensation invested by the employee, is the exemption provided for the income of the pension trust. see supra text accompanying note 20. under one proposal, a 15% flat tax would be imposed both on employer contributions and on pension trust earnings; however, no further tax would be imposed on employees receiving pension distributions. see gao report, supra note 48, chapter 2 & n.24; zelinsky, flat, plan level tax, supra note 48, at 591-92 & nn.1-6. zelinsky sharply criticizes this proposal. id. at 591-608. 19961 florida tax review ture." 6 he emphasizes that a pure income tax treatment of a defined benefit pension plan (i.e., attribution of accrued benefits to employees) is impractical due to problems of valuation, liquidity and comprehensibility to the public.6' he argues that the alternative of the flat tax on earnings in a qualified pension trust is not sufficiently accurate (since it would not reflect the individual tax rates of the individuals for whom the benefits are accrued). 62 the favorable treatment of an ira is viewed as an incentive for retirement savings for those who are not provided pension coverage by their employers.63 the fairly small amounts permitted to be contributed and the denial of deductions to higher income individuals covered by an employer plan prevent the ira incentive from undermining the incentive to participate in a qualified employer-sponsored plan.' c. taxation of pensions in other developed countries the scholar andrew dilnot has recently compared the tax regimes applied to pensions in a number of developed countries. 65 "almost all" of the fourteen countries studied "impose upper limits on the level of contribution and/or benefits that can be paid, although typically these limits affect only a small proportion of the workforce. 66 the dominant tax regime was found to be the same as that applied by the u.s. to tax-qualified plans, i.e., exemption from tax at the point of contribution and when earnings are derived, but full taxation on distribution, which is described by dilnot as "exemption, exemption, taxation" or "eet."67 by contrast, new zealand has recently adopted the approach of taxing contributions as well as earnings as 60. see zelinsky, status quo, supra note 48, at 326-34; zelinsky, rejoinder, supra note 48, at 259-71. 61. see zelinsky, status quo, supra note 48, at 334-47. 62. see id. at 358-60; zelinsky, flat, plan level tax, supra note 48, at 602-07. 63. see, e.g., stotsky & sunley, supra note 52, at 1755, 1765. 64. see generally graetz, supra note 48, at 895-96 (noting when the ira deduction was enacted in 1974, it was opposed by "organized labor ... because of fear that such a deduction would deter employers from establishing pension plans for employees"). graetz observes that "the relatively small $2,000 limit ... seems to have been quite significant in reducing the potential threat of iras to employer-provided plans." id. at 896. he concludes that "by limiting availability of iras ... the 1986 legislation should provide some protection for employer-provided pension plans from accelerating encroachment by more individualized retirement savings vehicles." id. at 901. 65. see dilnot, supra note 3, at 213-231. 66. id. at 216. 67. id. at 214, 217 (explaining that the tax treatment of pensions used by "the bulk of [the] countries" is "most like" the regime of "eet"). dilnot explains that this regime is clearly followed by canada, ireland, the netherlands, the u.k., and the u.s., and less clearly so by france, germany, greece, and portugal. id. at 217 tbl. 2. [vol 3:6 u.s. income taxation of cross-border pensions they accrue, described by dilnot as "taxation, taxation, exemption" or 'tre,''6s which is the approach applied in the u.s. to wages invested in ordinary savings accounts; australia has also "moved in a similar direction."'69 sweden and denmark do not tax contributions to pension plans but do tax earnings as they accrue. ° in japan, the earnings of a pension fund are taxed at a low rate and distributions are also taxable." d. new considerations in cross-border context a number of new considerations arise in the context of cross-border employment because of a need to coordinate the treatment of a single employment and retirement arrangement under more than one country's laws.72 there might be complications even if every other country in the world adopted exactly the same tax rules as the u.s.; the fact that they do not causes the complications to multiply. other countries' laws may differ not only in the treatment accorded pension plans in a domestic context but also in the rules applied to deal with cross-border transactions. if cross-border deferred compensation is to attract an overall tax burden similar to that applied in an entirely domestic situation, taxation on the basis of source needs to be coordinated (both in respect of amount and timing) with taxation on the basis of residence. this task is complicated by the fact that there are two potential bases for a claim to impose source-based taxation: (a) the location where the services are performed and (b) the situs of the retirement plan. in addition, since a long time may often elapse between the time that contributions are made to a pension plan and the time of eventual payout, there may also be more than one country with a potential claim to impose residence-based tax. because of the potential number of interested countries, more than one treaty may be applicable to the transaction 68. id. at 215, 217 tbl. 2. 69. id. at 217. 70. see id. at 217 tbl. 2. 71. see id. 72. see generally james p. klein, international benefits planning, u.s. income tax treaties and deferred compensation plans, 14 int'l tax j. 379 (1988); thomas st.g. bissell & alfred giardina, international aspects of u.s. retirement plans, deferred compensation and equity-based compensation plans: an overview. 25 tax mgmt. int'l j. 275 (1996) [hereinafter bissell & giardina]; david w. ellis et al., structuring international transfers of executives, ria tax advisors plan. series i (sept. 1994) [hereinafter ellis & navin]; arthur a. feder, pension planning in the international context, in international tax problems of charities and other private institutions with similar tax treatment, 39th congress of the international fiscal association, 41-56 (1985) [hereinafter feder]; henry ordower. a theorem for compensation deferral: doubling your blessings by taking your rabbi abroad. 47 tax law. 301 (1994); leif muten, international experience of how taxes influence the movement of private capital, 8 tax notes int'l 743 (1994). 19961 florida tax review (at the same or different times). finally, taxation of cross-border pensions (by other than the country where the plan is situated) requires that pension plan administrators be required to provide tax information that may not be relevant under their own country's laws. part ee of this article will focus on the u.s. assertion of source-based jurisdiction over cross-border pension income, i.e., u.s. claims to tax pension income derived by an individual who is not a u.s. citizen or resident. consideration will be given to the following situations,73 depicted in the corresponding rows of table 1, pages 358-59: a nonresident alien performs services in the u.s., and: (1) he earns unfunded deferred compensation; or (2) his employer contributes to a qualified u.s. pension plan;74 or (3) his employer contributes to a nonqualified funded pension plan located in the u.s.; or (4) his employer contributes to a funded pension plan located in a foreign country. alternatively, a nonresident alien performs services in his country of residence, and: (5) his employer contributes to a qualified u.s. pension plan; or (6) his employer contributes to a nonqualified funded pension plan located in the u.s. part iv of this article will focus on the u.s. assertion of residencebased jurisdiction over cross-border deferred compensation, i.e., jurisdiction to tax such income earned by a u.s. citizen or resident. consideration will be given to the following situations, depicted in the corresponding rows in table 2, pages 360-61: a u.s. citizen or resident performs services abroad, and (7) earns unfunded deferred compensation; or (8) his employer contributes to a funded pension plan located in a foreign country.75 73. cf. feder, supra note 72, at 55-56 (describing a number of common situations). 74. see, e.g., priv. ltr. rul. 92-53-049 (oct. 6, 1992). 75. see feder, supra note 72, at 43-48, 51-53 (discussing germany and u.k.). in many cases, however, a u.s. multinational may send a u.s. citizen employee to work in a foreign branch or subsidiary and may continue making contributions on behalf of the employee to a u.s. based pension plan. see, e.g., rev. rul. 79-389, 1979-2 c.b. 281 (employee retired abroad). see also feder, supra, at 48-50. [vol 3:6 u.s. income taxation of cross-border pensions a foreign national performs services abroad, and later becomes a u.s. resident before receiving payments: (9) from an unfunded deferred compensation arrangement; or (10) from a funded pension plan located in a foreign country.76 m. source-based taxation by u.s. of deferred compensation paid to nonresident aliens a. background: u.s. taxation of current compensation and investment income of nonresident aliens a u.s. citizen or an alien classified by u.s. tax law as a "resident" (by virtue of "substantial presence" or immigration status as a permanent resident) is taxed by the u.s. on worldwide income.7 by contrast, u.s. taxation of a nonresident alien extends only to income considered to have a sufficient nexus with the u.s. a nonresident alien is taxed at the usual u.s. individual rates on income considered to be effectively connected with a u.s. trade or business, and at a flat 30% rate on certain categories of u.s.-source income, such as fees, dividends and interest. 78 apart from a fairly narrow exception for short-term commercial travelers to the u.s., compensation for services performed in the u.s. is treated as from u.s. sources and as effectively connected income;' thus, it is taxed to a nonresident alien at usual u.s. rates~o and subject to withholding; such withholding is even required of foreign employers, although compliance is apparently poor."' compensation paid for services performed 76. see, e.g., tech. adv. mem. 89-11-001 (sept. 27, 1988) (pre-retirement distributions to canadian citizen who became u.s. resident alien). 77. see regs. § 1.1-1(b); cf. irc § 2(d) (special rules for nonresident alien individuals). in some cases, an alien classified as a resident under the code will also be classified as a resident m another country. such a conflict may be resolved in a treaty ticbreaker clause. 78. see irc §§ 2(d), 871-874. 79. see irc §§ 861(a)(3) (source rule for compensation), 864(b) (defining "u.s. trade or business"), 864(c) (defining "effectively connected income"); regs. § 1.864-4(c)(6) (effectively connected income involving personal services). for taxable years beginning after december 31, 1975, if the services are performed partly within and partly outside the u.s., the allocation between u.s. and foreign sources is "determined on the basis that most correctly reflects the proper source of income under the facts and circumstances of the particular case." regs. § 1.861-4(b)(1)(i). 80. see rev. rul. 92-106, 1992-2 c.b. 258 (situations 3 and 4); thomas st.g. bisseu, irs rules on international payroll tax issues, 22 tax mgmt. int'l j. 145, 147 (1993). 81. whether or not an alien's employer is a u.s. person or a foreign person, wages paid in respect of services performed in the u.s. (and not qualifying under the exception) are subject to income tax withholding under § 3402(a) and withholding of fica taxes under § 3101(a) and (b). rev. rul. 92-106, supra note 80 (situations 3 and 4). such employers are 19961 florida tax review outside the u.s., whether or not paid by an american employer, is not subject to u.s. tax in the hands of a nonresident alien employee. the exception from u.s. tax for compensation received by a shortterm commercial traveler applies only if (1) the employee is present in the u.s. for no more than 90 days during the year, (2) the compensation does not exceed $3,000, and (3) either the employer is a foreign person not engaged in a u.s. trade or business or, if the employer is a u.s. person, the services are performed for the employer's foreign office.s2 treaties entered into by the u.s.83 commonly expand upon the "business traveler" exemption in the code,84 by eliminating the dollar limitation and extending the permitted period of presence to 183 days. such treaties, however, do not otherwise limit u.s. taxation of compensation for services performed in the u.s. by employees.8 5 subject to fica taxes imposed under § 3111(a) and (b) and futa taxes imposed under § 3301. id. according to thomas st.g. bissell, "it is quite common [however,] for a foreign employer who employs a nra working in the united states not to establish a u.s. payroll system and thus to fail to withhold fica, futa and wage withholding tax." bissell, supra note 80, at 147. this may be because the employee, who has a temporary business visitor visa, "normally cannot obtain a u.s. social security number"; "more commonly" this situation is due to the employer's "concern that the filing of u.s. payroll tax forms may be likely to elicit inquiries from the irs and/or from the relevant state tax authorities as to whether the employer is engaged in trade or business in the united states ... and/or is 'doing business' for state corporate income tax purposes." id. where a nonresident alien is employed by a foreign employer in the u.s., "the irs enforcement of all three payroll taxes ... tends to be quite spotty." id. 82. see irc § 861(a)(3)(a)-(c). 83. such a provision is included in the 1996 u.s. model. see 1996 u.s. model, supra note 2, art. 15; see also u.s. treasury department model income tax treaty, art. 15 (1981), 85 tni 42-33 (april 21, 1990) (lexis, fedtax library, tni file) [hereinafter 1981 u.s. model]. the 1981 u.s. model was withdrawn in july 1992. see treasury announces review of model income tax treaty, july 17, 1992, reprinted in 92 tni 31-29 (july 29, 1992) (lexis, fedtax library, tni file) (announcing withdrawal and undertaking of project for revision). see also organization for economic cooperation and development, comm. on fiscal affairs, model tax convention on income and capital, art. 15 (1992) [hereinafter 1992 oecd model] (requiring that the recipient be present not more than 183 days, the remuneration be paid by or on behalf of a nonresident employer, and the remuneration not be borne by either a permanent establishment or fixed base of the employer in the source state); jacques sassesville, the oecd model tax convention is revised, 4 j. int'l tax'n 129, 13132 (1993) (describing changes in the 183-day rule in the 1992 oecd model); see generally irs publication 901, u.s. tax treaties at 2-10 (revised nov. 1995) (discussing how "residents" of other countries are taxed on personal service income under various treaties). 84. see andersen, supra note 1, at 94. 85. these treaties also generally contain a separate article for compensation for independent services, which provides exemption unless the services are performed in connection with a fixed base in the host country. see 1992 oecd model, supra note 83, art. 14; irs publication 901, supra note 83, at 2-10. [vol 3:6 u.s. income taxation of cross-border pensions if a nonresident alien who performs services in the u.s. during the taxable year also receives investment income, the treatment of the investment income is generally separate from the treatment of the compensation income. 6 dividends and interest from u.s. sources are subject to a flat 30% withholding tax, 7 subject to treaty reductions. however, much interest is exempted by the exception for portfolio interest and the exception for interest on bank deposits.8 a nonresident alien would generally be taxed on capital gains89 only if the individual is present in the u.s. for more than 183 days during the year9" and has a tax home in the u.s.9' b. u.s. taxation of deferred compensation received by a nonresident alien 1. unfunded deferred compensation.-when compensation for services performed in the u.s. is deferred by an employer in an unfunded arrangement, the full amount eventually paid is treated as compensation for services; thus, upon receipt, the full amount is from u.s. sources and is taxed to the nonresident alien as effectively connected income (absent satisfaction of the business traveler exception). 92 prior to the tax reform act of 1986, such compensation paid in a year that the nonresident alien was no longer performing services in the u.s. was treated as not effectively connected with a trade or business.93 however, section 864(c)(6), enacted in the tax 86. see regs. § 1.864-4(c)(6)(i) (u.s.-source income or gain derived from an asset by a nonresident alien who is engaged in a u.s. trade or business, by virtue of performing personal services in the u.s., is not treated as effectively connected "unless there is a direct economic relationship between his holding of the asset ... and his trade or business of performing the personal services"). 87. see irc § 871(a)(l)(a). 88. see irc § 871(h), (i)(2)(a). 89. gains from the disposition of u.s. real property interests by nonresident aliens are, however, taxed and treated as effectively connected income. irc § 897. 90. see irc § 871(a)(2) (taxing u.s.-source capital gains for such taxpayers). 91. income from the sale of personal property is generally u.s.-sourccd only if derived by a u.s. resident. irc § 865(a). a nonresident alien is classified as a u.s. resident only if he or she has a tax home (as defined in § 91 l(d)(3)) in the u.s. irc § 865(g)l). 92. see bissell & giardina. supra note 72, at 280-82 (describing the tax consequences for a nonresident alien receiving distributions from an unfunded retirement plan for executives (referred to as a "serp")). bissell & giardina state that "[ulpon the payment of benefits from the serp upon retirement or the termination of employment, the entire distribution would be treated as compensation and would be sourced in accordance with where the individual worked during the years that the accruals to the plan were made." id. at 281; cf. rev. rul. 78-227, 1978-1 c.b. 242 (ruling that the portion of a foreign service retirement annuity representing payments from a current congressional appropriation is attributable to an employer's contribution and thus treated as foreign source income to the extent allocable to services performed abroad). 93. see irc § 864(c)(1)(b); regs. § 1.864-3(b), ex. 3. 19961 florida tax review reform act of 1986,95 changed this rule by requiring that the categorization of the income as effectively connected be made by reference to the year in which services are performed.96 (this result is depicted at row 1 of table 1, page 358.) by contrast, many foreign countries are said to impose immediate taxation upon vested, but unfunded retirement benefits. 9 2. qualified pension plan.-a different and more complex treatment applies to a funded plan for deferred compensation.9" in the case of a qualified 9 u.s. plan, there are no tax consequences to the employee until 94. section 864(c)(6) provides that: in the case of any income or gain of a nonresident alien... which-(a) is taken into account for any taxable year, but (b) is attributable to... the performance of services ... in any other taxable year, the determination of whether such income or gain is taxable under section 871(b) ... shall be made as if such income or gain were taken into account in such other taxable year and without regard to the requirement that the taxpayer be engaged in a trade or business within the united states during the taxable year referred to in subparagraph (a). for a detailed discussion of § 864(c)(6) and its relationship to treaties, see meenakshi ambardar, comment: the taxation of deferred compensation under i.r.c. 864(c)(6) and income tax treaties: a rose is not always arose [sic], 19 fordham int'l l.j. 736 (1995). 95. pub. l. no. 99-514, § 1242, 100 stat. 2580. the staff of the joint committee explained that "congress believed that foreign persons should not be able to avoid u.s. tax on their income from performance of services in the united states where payment of the income is deferred until a subsequent year in which the individual is not present in the united states." staff of the joint comm. on taxation. 100th cong., 2d sess., general explanation of the tax reform act of 1986, at 1048 (1987). 96. apparently, under § 864(c)(6) "effectively connected" treatment results whether the individual was a nonresident alien or resident alien at the time the u.s. services were performed. see priv. ltr. rul. 89-04-035 (oct. 31, 1988) (dealing with "german citizens working in the united states" who participate in a u.s. company's 401(k) plan and then retire, whereby § 864(c)(6) applies to the distributions in excess of employee contributions, excluding earnings and accretions, "[b]ecause the [e]mployees' income would have been taxed on a net basis at graduated rates in the performance years"). 97. see bissell & giardina, supra note 72, at 281 (noting that some "countries arc often more lax ... if the accrual consists of benefits under an actuarially based defined benefit plan, rather than under a defined contribution or salary reduction plan"). 98. see generally thomas st.g. bissell, u.s. pension plan distributions to nras: plrs 9143067 and 9253049, 23 tax mgmt. int'l j. 77 (1994); charles m. bruce & martin a. culhane, qualified plan distributions to nonresident aliens treated as "effectively connected" income, 18 tax mgmt. int'l j. 335 (1989); barbara n. seymon-hirsch, irpac discussion paper on nonresident alien withholding and pension payment reporting, 95 tni 91-11 (may 22, 1995) (lexis, fedtax library, tni file) [hereinafter irpac paper]. 99. in many cases, an alien individual may work in the u.s. as a resident and become a nonresident only at a later point when pension distributions are being made. see, e.g., rev. rul. 79-388, 1979-2 c.b. 270. for a discussion of reasons why an "inbound executive" would participate in a u.s. qualified plan, see ellis & navin, supra note 72, at 82-83. [vol. 3:6 u.s. income taxation of cross-border pensions the time of a distribution. a distribution is disaggregated into (a) the contribution by the employer, classified as compensation, and (b) the investment return earned on the contributions (of employer or employee), referred to as "earnings and accretions."'" with respect to the former component, contributions in respect of services performed in the u.s. are taxable as effectively connected income'o' (or as u.s. source fixed and determinable income in the case of pre-1986 act contributionst02). assuming that the pension plan is located in the united states,'"3 the earnings and accretions are treated as u.s. source noneffectively connected income,'"4 subject to a flat 30% tax collected by withholding."5 this treatment applies even if the contributions were in respect of services performed outside the u.s. moreover, the fact that the pension trust invests in a form that would have been free of u.s. tax in the hands of a nonresident alien investor is considered irrelevant because the trust is not viewed as a conduit.16 100. see rev. rul. 79-388, 1979-2 c.b. 270. 101. see priv. ltr. rul. 90-41-041 (july 13. 1990) (discussing a distribution made from a § 401(k) plan). the irs ruled that "section 864(c)(6) applie[d] to the portion of each [d]istribution that consists of the participant's deductible contributions and employer's matching contributions to the extent the contributions are attributable to services performed after december 31, 1986 as long as the participant's income would have been treated as effectively connected with the conduct of a u.s. trade or business in the years of performance." priv. ltr. rul. 90-41-041 (july 13, 1990). see also priv. ltr. rul. 89-04-035 (oct. 31. 1988); bruce & culhane, supra note 98, at 335-42; bissell, supra note 98. at 78 (priv. ltr. rul. 89-04-035 "was apparently the first plr in which the irs ruled that § 864(c)(6) would be applied to non-treaty-exempt pension distributions."); t.d. 8288, 1990-1 c.b. 163. 164, explanation of temp. regs. § 1.1441-4(b)(1)(ii) (explaining that § 864(c)(6) applies to pensions, because "[pl]ensions are treated as compensation for services under 31.3401(a)1(a)(2)"). 102. thus, this portion of the payment is subject to taxation under § 871(a)(l)(a) and withholding under § 1441(a). see rev. rul. 79-388, 1979-2 c.b. 270. 103. see irc § 401(a) (defining a qualified trust as being "[a] trust created or organized in the united states"). 104. see rev. rul. 79-388, 1979-2 c.b. 270: see also priv. ltr. rul. 90-41-041 (july 13, 1990) (stating that § 864(c)(6) does not apply to distributions from § 401(k) plan attributable to earnings and accretions of the plan). but cf. bissell & giardina. supra note 72, at 278 (stating that "the rules at the moment are unclear" as to whether "the investment income portion will be subject to tax either at the 30% rate under § 87 1. or as wages taxable under § 1"). 105. see rev. rul. 79-388, 1979-2 c.b. 270; priv. ltr. rul. 89-04-035 (oct. 31, 1988); priv. ltr. rul. 90-41-041 (july 13, 1990); see also rev. rul. 79-389, 1979-2 c-b. 281 (similar analysis in application of § 901 to u.s. citizen retiring abroad); rev. rul. 84-144, 1984-2 c.b. 129 (application of § 901 to distribution from ira established by a qualifying rollover distribution from a qualified u.s. pension plan). 106. see clayton v. united states, 95-2 u.s. tax cas. (cch) 1 50,391, 89.232. 76 a.f.t.r.2d (ria) at 95-5197 (cl. ct. 1995) (endorsing irs policy that "conduit theory of taxation embodied in subchapter j does not apply to distributions from qualified employee 1996] florida tax review rows 2 and 5 of table 1, pages 358-59, depict the case of a nonresident alien participating in a u.s. qualified plan. in each case, tax is imposed only at the time of distribution. in row 2 where services are performed in the u.s., the "compensation" element is taxed as effectively connected income, and the "accretions" element is taxed at a 30% flat rate. in row 5, where the services are performed abroad, only the "accretions" element is taxed by the u.s. this treatment of "earnings and accretions" was approved by the irs in a 1952 pronouncement"° that was later declared obsolete in 1970."' s this approach was again adopted by the irs in a 1979 revenue ruling after objections put forward by the irs chief counsel in a 1975 general counsel memorandum were put aside."° just recently, the u.s. court of federal claims and the court of appeals for the federal circuit confirmed this approach in clayton v. united states,"10 which involved the u.s. tax treatment of canadians who were employed by chrysler's subsidiaries operating in canada and who received distributions on termination of chrysler's employee stock ownership plan taking the form of cash proceeds of sales of chrysler stock. both courts endorsed the irs position that u.s. taxation of earnings and accretions of a u.s. pension trust was intended by congress. 1' plans"), affd, 96-1 u.s. tax cas. (cch) 50,314,77 a.f.t.r.2d (ria) at 96-2484 (fed. cir. 1996). see also priv. ltr. rul. 87-21-006 (jan. 30, 1987) (holding that a distribution from a decedent's ira, consisting of a deposit at a savings bank, made to a nonresident alien beneficiary could not be treated as foreign-source income pursuant to § 861(c)(2) because an ira trust is governed by subchapter d rather than subchapter j). 107. ir-mim. 71, 1952-2 c.b. 170. 108. rev. rul. 70-278, 1970-1 c.b. 281. 109. see rev. rul. 79-388, 1979-2 c.b. 270; gen. couns. mem. 36,344 (july 23, 1975); gen. couns. mem. 38,007 (july 10, 1979). 110. 95-2 u.s. tax cas. (cch) 50,391, 76 a.f.t.r.2d (ria) at 95-5197, aff'd, 96-1 u.s. tax cas. (cch) 50,314, 77 a.f.t.r.2d (ria) at 96-2484 (fed. cir. 1996). 111. the claims court first concluded that the capital gains characterization at the level of the trust did not pass through to the trust beneficiaries because the conduit rules of subchapter j do not apply to employer trusts. the court further held that the treatment of the earnings and accretions component of distributions from qualified plans as u.s.-sourced based on the situs of the trust was a "long-standing [irs] policy" that "congress has repeatedly approved ... by enacting narrow exclusions to the general tax rule." 95-2 u.s. tax cas. (cch) at 89,232. the claims court noted congress's 1960 enactment of § 402(a)(4) (the predecessor of § 402(e)(2)), containing an exception for certain distributions paid by the u.s. government as employer. id. at 89,233. the court further cited congress's enactment in 1966 of § 871(f), providing an exclusion for certain amounts received as an annuity under a qualifying plan if services were performed outside the united states and the broadening of this provision in 1980. id. at 89,234; see 96-1 u.s. tax cas. (cch) 50,391, at 84,152 (approving claims court's analysis). the senate finance committee noted, in approving § 871(0 in 1966, that "[u]nder present law a nonresident alien receiving pension or annuity income from a plan [vol 3:6 u.s. income taxation of cross-border pensions prior to the enactment of section 864(c)(6), the portion of the pension payment attributable to contributions with respect to u.s. services was noneffectively connected income if the pensioner was no longer engaged in the conduct of a u.s. business." 2 however, the irs now takes the position that payments attributable to contributions made with respect to u.s. services in years beginning after december 31, 1986, are treated by reason of section 864(c)(6) as effectively connected income. ' 3 an exception to u.s. source-based taxation of distributions from a u.s. pension trust is contained in section 871 (f) (which is viewed by some as an implicit acknowledgement by congress of the general rule that the 30% u.s. tax applies to the accretion element of a distribution from a u.s. pension trust).' 4 under this provision, first enacted in 1966,' any amount received as an annuity by a nonresident alien from a qualified annuity plan described in section 403(a)(1) or from a qualified trust described in section 401(a) is excluded from gross income if all the alien's services were performed outside the united states and 90% of the employees benefitting located in the united states is subject to u.s. tax (flat 30% or lower treaty rate) on the interest portion of the pension income notwithstanding the fact that the services qualifying the nonresident alien for the pension were entirely rendered outside the united states." s. rep. no. 1707, 89th cong., 2nd sess. (1966), reprinted in 1966-2 c.b. 1059, 1077. by contrast. chief counsel argued that this legislative statement merely reflects ir-mim. 71. which was obsoleted in 1970, and indicates congress's "dissatisfaction with the rule of taxing the interest element at least under the circumstances covered by the section." gen. couns. mem. 36344 (july 23, 1975). see also discussion in gen. couns. mem. 38,007 (july 10. 1979). 112. see rev. rul. 79-388, 1979-2 c.b. 270. 113. see supra notes 93-95 and accompanying texl 114. see supra note 11 and accompanying texl 115. the provision was added to the foreign investors tax act by the senate finance committee. see s. rep. no. 1707, 89th cong., 2d sess. (1966). reprinted in 1966-2 c.b. 1059, 1077. there is no explicit rationale presented for the provision. the report states that "[u]nder present law, a nonresident alien receiving pension or annuity income from a plan located in the u.s. is subject to u.s. tax... on the interest portion of the pension income not withstanding [sic] the fact that the services qualifying the nonresident alien for the pension were entirely rendered outside the united states." id. the report then explains: "your committee has added an amendment to this provision of the bill which would exempt from u.s. tax the type of pension income described above if 90 percent of the persons under the plan were u.s. citizens." id. in the miscellaneous revenue act of 1980, congress expanded this exemption to make "it available to an individual if (i) the recipient's country of residence grants a substantially equivalent [exemption] ... or (2) the recipient's country of residence is a beneficiary developing country under section 502 of the trade act of 1974." s. rep. no. 96-1036, 2d sess. (1980), reprinted in 1980-2 c.b. 723, 724. the committee reasoned "that a pension paid to a nonresident alien should be exempt from withholding where his country of residence has unilaterally... enacted a provision granting the same relief to u.s. citizens and residents." id. at 727. it further explained that "employers should be encouraged to provide pensions for their employees in certain developing countries." id. 19961 florida tax review from the plan are u.s. citizens or residents."l 6 (thus, row 5 of table 1, page 359, notes that where section 871(f) applies, no u.s. tax is imposed.) distributions from a qualified u.s. plan, if otherwise subject to u.s. tax, may also be subject to the penalty tax on premature distributions.. 7 and the 15% excise tax on excess distributions."' 3. funded but nonqualified plans.-if an employer makes contributions to a funded deferred compensation plan in respect of u.s. services performed by a nonresident alien and the plan is not a qualified u.s. plan, then the employee is taxed pursuant to section 402(b)(1) on the value of his interest in the plan once it has vested. this could occur when contributions are made either to a u.s.-based nonqualified plan or to a foreign-based plan, which may be qualified under the foreign country's law, but not under u.s. law." 9 thus, an alien performing services in the u.s. (not satisfying the exemption for short-term business travelers) is currently taxable on vested employer contributions made to a pension plan in his home country. 2 if the plan has a u.s. situs, then the u.s. also has a claim to tax accretions on the contributions, which are classified as u.s. source noneffectively connected income. if the individual is a "highly compensated 116. see irc § 871(f)(1)(a), (b). the latter requirement need not be met if "the recipient's country of residence grants a substantially equivalent" exemption to u.s. citizens and residents. irc § 871(f)(2)(a). for a recent application of this provision, involving interpretation of the phrase "received as an annuity," see priv. ltr. rul. 95-37-028 (june 21, 1995). 117. see, e.g., priv. ltr. rul. 92-53-049 (oct. 6, 1992) (ruling that a distribution from a rollover ira to a nonresident alien was not subject to the 10% additional tax of § 72(t) because the distribution was excluded from u.s. gross income under the "other income" article of the u.s.-u.k. income tax convention). see also priv. ltr. rul. 88-37-009 (june 2, 1988) (ruling that § 72(t) was applicable to earnings and accretions distributed from a 401(k) plan to a nonresident alien to the extent the amounts were includible in gross income). 118. see priv. ltr. rul. 88-37-009 (june 2, 1988) (ruling that the 15% excise tax on certain excess distributions is potentially applicable to a distribution to a nonresident alien from a § 401(k) plan, except to the extent of the investment in the contract as defined in § 72(0). the irs noted that "[t]here is nothing in the statute, the regulations or the legislative history to indicate that nra employees should be exempt from this tax." id. see also priv. ltr. rul. 92-53-049 (oct. 6, 1992) (ruling that a distribution that was excluded from u.s. income tax under the u.s.-u.k. income tax convention was not thereby protected from the excise tax imposed by § 4980a); bissell, supra note 98, at 79. 119. see 1996 proposed rulemaking, supra note 22, 23 (stating that "[t]he rules of section 402(b) apply to a beneficiary of a nonexempt employees' trust regardless of whether the trust is a domestic trust or a foreign trust"); see also infra notes 266-267 and accompanying text. 120. see ellis & navin, supra note 72, at 88; see also bissell & giardina, supra note 72, at 279. [val. 3:6 u.s. income taxation of cross-border pensions individual," then the tax might be imposed as the accretions are earned. 2' otherwise the tax would be imposed by withholding at the time of distribution. when a distribution is made from a funded but nonqualified plan, the income element is determined under section 72 for a nonresident alien recipient (as for a u.s. citizen)." all contributions by the employer are treated as investment in the contract pursuant to section 72 (f.'2-' any amount of the distribution in excess of investment in the contract would apparently be considered to be earnings and accretions and would be classified as u.s. source noneffectively connected income subject to the 30% withholding tax of sections 871 and 1441. these results are depicted in table 1, page 358; row 3 deals with a nonqualified u.s. plan, and row 4 deals with a foreign plan. 4. employee contributions to retirement arrangements.-when a nonresident alien performs services in the u.s., the portion of his compensation that he elects to defer in a 401(k) plan is not currently taxable to him." similarly, an amount contributed by him to an ira account" is eligible to be deducted in computing his effectively connected income (e.g., 121. tax is imposed under § 871(a) on an "amount received." irc § 871(a); cf. central de gas de chihuahua s.a. v. commissioner, 102 t.c. 515 (1994) (discussing § 482 allocation). 122. see irc § 402(b)(2). 123. contributions made in respect of services performed in the u.s. or as a resident alien would already have been taxable to the employee. see irc § 402(b)(1). contributions made in respect of services performed outside the u.s. as a nonresident alien would not have been taxable even if paid directly to the nonresident alien. see irc § 72(f0; ellis & navin. supra note 72, at 88. in the case of a highly compensated employee in a plan not satisfying the nondiscrimination requirements, the investment in the contract would presumably also include the accrued benefits prior to the distribution. see infra notes 322-329 and accompanying text. 124. see irc § 402(e)(3) (providing that "contributions made by an employer on behalf of an employee to a... qualified cash or deferred arrangement" are not treated as made available to the employee even though the employee has an election to receive the amounts in cash); bittker & lokken, supra note 7, 1 61.8.1. 125. section 219(a) allows any individual a deduction of up to $2,000 for the amount of his "qualified retirement contributions." which include cash payments to an individual retirement account. see irc § 219(a), (e). under § 873, a nonresident alien is allowed deductions for purposes of § 871(b) to the extent that such deductions are connected with effectively connected income. see irc § 873(a). it has been suggested that an ira might be an attractive investment for u.k. employees working temporarily in the u.s. see artemis velahos koch, ira contributions by foreign nationals: long-term investments with shortterm returns, 25 tax adviser 141, 142 (1994) [hereinafter koch]; see also bissell. supra note 98, at 77 (noting that aliens "on temporary u.s. assignments [if] excluded from u.s. retirement plans,.. . may often make fully tax-deductible ira contributions even if their income exceeds the limits prescribed in § 219"). 19961 florida tax review from services performed in the u.s.). however, the portion of a nonresident alien's compensation contributed by him (or by the employer on his behalf) to a foreign retirement arrangement is taxed by the u.s. as current compensation (whether or not the foreign retirement arrangement is qualified in the home country or is an employer-based or personal retirement arrangement).' 26 thus, the result is the same as if the employer makes a contribution to a funded foreign retirement plan (as in row 4 of table 1, page 358). 5. period of u.s. residence and exit tax proposals.-a foreign national working in the u.s. for an extended period will often be classified as a resident alien for u.s. tax purposes. the fact of u.s. residence may have little impact on the treatment of his participation in a u.s. qualified'27 plan, however. no tax will be imposed on the employee with respect to such participation prior to distributions being made to him. the entire amount of the distributions from the plan (assuming that the u.s. was the place of employment) would be taxable by the u.s. either on a source basis (if the individual has returned to his home country) or on a residence basis if he has not. see table 1, row 2, page 358. u.s. resident status may have greater significance for a foreign national working in the u.s. if he is participating in a foreign pension plan. see table 1, row 4, page 358. the accretion element in a foreign plan has a foreign source and thus would be taxed by the u.s. only if the alien is a u.s. resident at the time when the accretion is properly subject to u.s. tax.'28 thus, in this situation, a resident alien would generally seek to terminate u.s. resident status before the accretion is subject to tax. it would be possible for the u.s. to counteract such tax planning by imposing u.s. tax on previously untaxed amounts of accrued foreign pension benefits at the time when an alien's long-term residence is terminated. thus, the senate recently approved an "exit tax" on appreciation in the worldwide 126. an ira is defined as "a trust created or organized in the united states for the exclusive benefit of an individual or his beneficiaries." irc § 408(a). in addition, the written instrument creating the trust must meet certain requirements in order for the trust to qualify as an ira. see id. 127. if the individual is performing services in the u.s. and participating in a nonqualified u.s. plan (see table 1, row 3, page 358), temporary u.s. residence also may be irrelevant because the contributions to a u.s. plan and earnings accrued thereon could be taxed either on a source basis or on a residence basis. however, in the absence of residence jurisdiction, taxation of the accretion might be delayed because § 871 requires an "amount received." see supra note 121. 128. the time for taxing the accretion element in a foreign pension plan may be as benefits accrue if the individual is a highly compensated employee. see supra note 38. current taxation might also occur under § 679. see infra notes 272, 277-278 and accompanying text. otherwise, tax would await the time of distribution. [vol. 3:6 u.s. income taxation of cross-border pensions assets of departing long-term residents,' including foreign pension plan interests, at least to the extent their value exceeds $500,000.'"" however, the senate's "exit tax" was replaced in conference with a provision that subjects departing long-term residents (and expatriating citizens) for a period of ten years to expanded u.s. source-based jurisdiction;' 3' and this expanded jurisdiction does not extend to foreign pension assets.13 2 c. treaty position 1. pension distributions.-the treatment of deferred compensation under u.s. treaties depends upon whether a payment is classified as a "pension" under the pension article of the treaty. the preferred u.s. treaty position, embodied in the 1981 u.s. model and most (old and new) u.s. treaties, is to include a pension article providing that pension payments are taxable only in the residence country.'" this same position has now been endorsed by the treasury in the 1996 u.s. 129. see h.r. rep. no. 736, 104th cong., 2nd sess. (1996), partially reprinted in 96 tnt 151-7 (aug. 2, 1996) (lexis, fedtax library, tnt file) [hereinafter h.r. rep. no. 736]. for discussion of "exit taxes" imposed by other countries, see infra notes 334-336 and accompanying text. under the senate amendment, expatriating u.s. citizens and departing long-term u.s. residents "are treated as having sold all of their property at fair market value immediately prior to the [expatriating event]." h.r. rep. no. 736. supra, 1 256. "the net gain, if any, on the deemed sale ... is subject to u.s. tax at such time to the extent it exceeds $600,000 ... " id. the rule "generally applies to all property interests held by the individual [at that time] provided that the gain on such property interest would be includible in the individual's gross income if such property interest were sold for its fair market value on such date." id. 257. for discussion of earlier versions of this proposal, see staff of the joint comm. on tax'n, 104th cong., 1st sess., issues presented by proposals to modify the tax treatment of expatriation (jcs-17-95) (1995), reprinted in 37 highlights & documents 3351 (june 5, 1995) [hereinafter jct report on expatriation]. 130. see h.r. rep. no. 736, supra note 129, 257 (noting that the senate amendment contained an exclusion for "interests in qualified retirement plans and, subject to a limit of $500,000, interests in certain foreign pension plans as prescribed by regulations."). see also jct report on expatriation, supra note 129, at 3367. noting similar exclusion in earlier version. 131. see h.r. rep. no. 736, supra note 129, 1 230-51, 280. the conference report follows the house bill, which "expands and substantially strengthens in several ways the present-law provisions" in §§ 877, 2107, and 2501(a)(3). id. 1 230. these existing provisions are applied to "certain long-term residents of the united states," and are applied in some situations "without inquiry as to... motive." moreover, the conference report "expands the categories of income and gains that are treated as u.s. source." id. 132. for a discussion of the types of income covered in the house bill, see h.r. rep. no. 736, supra note 129, u91 236-42. 133. see, e.g., 1981 u.s. model, supra note 83, art. 18, i. article 15, dealing with dependent personal services, is made "[s]ubject to the provisions of articl[el 18." id. art. 15, 1. 19961 florida tax review model (although with a new limitation on taxation by the residence country)." 4 thus, in rows 2 and 5 of table 1, pages 358-59, where a distribution is received by a nonresident alien from a u.s. qualified plan, this treaty rule would bar imposition of u.s. tax on the distribution.'35 this treaty position is consistent with the 1963, 1977 and 1992 oecd 136 model treaties, 137 although reservations to this aspect of the 134. the 1996 u.s. model provides that "pension distributions... beneficially owned by a resident of a contracting state, whether paid periodically or as a single sum, shall be taxable only in that state, but only to the extent not included in taxable income in the other contracting state prior to the distribution." 1996 u.s. model, supra note 2, art. 18, $ 1; 1996 treasury explanation, supra note 2, 241-46. see infra text accompanying notes 296-301 (discussing the new limitation imposed on the residence country). 135. the savings clause of treaties would, however, generally preserve the u.s. right to tax pension income of a u.s. citizen even if he or she is resident in another country at the time of retirement. see, e.g., 1981 u.s. model, supra note 83, art. 1, u 3, 4(a). this may result in double international taxation of pension income derived by a u.s. citizen resident in another country, even though that country is a u.s. treaty partner. in the recent treaty with france, special provisions are included to avoid such double taxation. convention between the government of the united states of america and the government of the french republic for the avoidance of double taxation on income and prevention of fiscal evasion with respect to taxes on income and capital, aug. 31, 1994, art. 24, 2, reprinted in tax treaties (cch) 3001.04, 27005-13 [hereinafter u.s.-france income tax treaty]. first, in the case of a pension distribution attributable to services performed while the principal place of employment was in the u.s., france agrees to provide an effective exemption from french tax for a u.s. citizen resident in france. id. art. 24, i 2(a)(i), 2(b)(iv). second, the u.s. agrees generally that where u.s. tax is imposed solely on the basis of citizenship, the u.s. will provide credit for french tax imposed on the basis of residence (e.g., on pension income derived by a french resident/u.s. citizen with respect to employment outside the u.s.). id. art. 24, l(b). see treasury department technical explanation of the u.s. france income tax treaty, reprinted in tax treaties (cch) 3058, 27,197-5, discussing art. 24 [hereinafter treasury explanation of u.s.-france treaty]. 136. the model tax treaties prepared under the auspices of the league of nations varied in their approach to the treatment of pensions. draft conventions ia and ic provided that "[p]ublic or private pensions shall be taxable in the state of the debtor of such income." league of nations, report presented by the general meeting of government experts on double taxation and tax evasion, (c.562.m. 178.1928.11) oct. 31, 1928, official journal, jan. 1929, at 205, 208, 215. the commentary states that "[iut appeared both right and practical that all pensions should be made subject to the same rules." id. at 211. it then explains: "in the special case of private pensions, however, the country of the debtor may be taken to be that in which the activity was carried on within the meaning of article 7 [dealing with salaries], or that in which the parties concerned subsequently established their domicile." id. by contrast, in draft convention ib, source taxation is limited to income from immovable property, income from a industrial, commercial or agricultural undertaking, fees of managers, salaries and wages, or public pensions. id. at 213. in the "mexico draft convention" of 1943, the fiscal committee of the league of nations provided that private pensions and life annuities should be taxed exclusively "in the state where the debtor has his fiscal domicile." fiscal committee, league of nations, london and mexico model tax conventions, commentary and text [vol. 3:6 u.s. income taxation of cross-border pensions 1992 oecd model were noted by canada, finland and sweden.' 8 by contrast the 1980 u.n. model includes two alternative provisions, one consistent with the oecd model and the other allowing source-based taxation of a pension payment "made by a resident of that ... state or a permanent establishment situated therein."'39 a u.s. treaty that exempts a pension payment from u.s. tax is viewed as also precluding application of section 72(t) (penalty on premature distributions). however, section 4980a, imposing an excise tax on certain excess distributions from a qualified pension plan, may nevertheless be applicable."t only two major u.s. treaties, those with canada and the netherlands, and a few treaties with less important' 4' trading partners (indonesia,4 ' (c.88m.88.1946.]i.a.) nov. 1946, at 66-67. however, in its 1946 "london draft." the fiscal committee provided for exclusive taxation of such items "in the state where the recipient has his fiscal domicile." id. the commentary explains that the mexico draft's treatment of private pensions is "according to the principle of taxation by origin" and is consistent with the draft's treatment of income from movable capital as taxable only in the country where the capital is invested. id. at 28, 62. the commentary states that, in the london draft. jurisdiction to tax pensions is given to "the country of fiscal domicile of the creditor, as in the case of interest from debts." id. at 28. for further discussion of the history of the "pension" article in treaties, see albert a. ehrenzweig and f.e. koch, income tax treaties, 180 (1949). 137. see 1992 oecd model, supra note 83. art. 18 (entitled "pensions"). article 18 provides that "pensions and other similar remuneration paid to a resident of a contracting state in consideration of past employment shall be taxable only in that state." id. art. 18. this provision was also included in the 1963 and 1977 oecd models. see organization for economic cooperation and development model for the avoidance of double taxation with respect to taxes on income and capital, tax treaties (cch) 1 201. at 10,525-8; model income tax treaties 58 (kees van raad ed.. 1983) (comparing the 1963 and 1977 oecd model treaties). this provision is subject to an exception provided for pensions paid in respect of government service in article 19. id. art. 19, t 2. a pension paid by a contracting state in respect of services to that state is taxable only by that state; however, where the individual is a resident and national of the other state, the other state is given the exclusive right to tax. id. 138. the commentary to the 1992 oecd model notes that "canada reserves its position on [article 18]"; its negotiating position is to "propose that the country in which the pensions arise be given a limited right to tax." commentary on the organization for economic co-operation and development model tax convention on income and capital [ 19921 [hereinafter 1992 oecd commentary], at c(18)-12. finland and sweden. when negotiating conventions, will attempt to "retain the right to tax pensions paid to non-residents, where such pensions are paid in respect of past services rendered mainly within their respective territory." id. 139. u.n. dep't of int'l economics & social affairs, u.n. model double taxation convention between developed and developing countries at 33-34, u.n. dce. st/esa/102, u.n. sales no. e.80.xvi.3 (1980) [hereinafter u.n. model]. the commentary notes that the parties were unable to reach a consensus between the two alternative guidelines. id. at 171-72. 140. see supra notes 117-118 and accompanying text. 141. the u.s.-u.s.s.r. income tax treaty, signed on june 20, 1973, did not contain a pension article. see priv. ltr. rul. 87-21-006 (jan. 30. 1987) (noting that the treaty 19961 florida tax review jamaica, 4 3 the philippines'" and poland'45), depart from the u.s. preferred treaty position on pensions. under the u.s. treaty with canada, sourcebased taxation is permitted (in addition to residence-based taxation) but may not exceed 15% of the gross amount of a periodic pension payment.146 the new treaty with the netherlands 47 provides that in the case of a private does not provide an exemption or lower rate for private pensions). however, the new treaty between the u.s. and the russian federation, signed june 17, 1992, contains a provision (article 17) exempting private pensions from source country tax. see senate foreign relations comm., report on the 1992-u.s.-russia income tax treaty and protocol nov. 18, 1993, reprinted in 31 highlights & documents 3175, 3192, (nov. 29, 1993). 142. the u.s. treaty with indonesia provides that both countries may tax "pensions and other similar remuneration in consideration of past employment derived from sources within one of the contracting states by a resident of the other contracting state." convention between the government of the united states of america and the government of the republic of indonesia for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, july 11, 1988, art. 21, 1. however, the source country's tax is limited to 15% of the gross amount. id. for source rules, see id. art. 7, t 6, art. 21, t 4. the treasury's technical explanation provides that this "rule ... is a concession to indonesia's interest, as a developing country, in preserving source-basis taxation." tax treaties (cch) 4350, at 31,536-37. the recently signed protocol to the treaty does not affect the treatment of pensions. see protocol amending the convention between the government of the united states of america and the government of the republic of indonesia for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, july 24, 1996, reprinted in tax treaties (cch) 4345, 31,523, 31,523-2. 143. the u.s. treaty with jamaica provides that a pension received by a resident of the one state in consideration of "past employment ... performed in the other contracting state while such person was a resident of that other state" may be taxed by the latter as well as the former state. convention between the government of the united states of america and the government of jamaica for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, may 21, 1980, art. 19, 1, t.i.a.s. 10206. see also report of the senate foreign relations committee, tax treaties (cch) 5055, at 33,571. 144. the u.s. treaty with the philippines provides that "pensions and other similar remuneration paid to an individual in consideration of past employment shall be taxable by the contracting state where the service is rendered." convention between the government of the united states of america and the government of the republic of the philippines with respect to taxes on income, oct. 1, 1976, art. 18, 1, t.i.a.s. 10417. 145. the u.s. treaty with poland does not contain a pension article. see convention between the government of the united states of america and the government of the polish people's republic for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, oct. 8, 1974, t.i.a.s. 8486. article 5 provides, in general, for source country taxation. see id. art. 5. 146. convention between the united states of america and canada for the avoidance of double taxation on income, sept. 26, 1980, t.i.a.s. 11087, 27 art. 18, %t 1, 2, [hereinafter u.s.-canada income tax treaty]. the treaty does not seek to define the source of a pension, but simply allows taxation of pensions "in the contracting state in which they arise." id. art. 18, 2. this aspect of the treaty is not changed by the march 1995 protocol. 147. see treasury department technical explanation of the convention between the united states of america and the kingdom of the netherlands for the avoidance of [vol 3:6 u.s. income taxaion of cross-border pensions pension that is not paid in the form of periodic payments, the country where the employment is exercised may tax the payment (with allowance of a credit for residence country tax) provided that the individual was a resident of the source country at any time during the preceding 5-year period; 4 8 this source-based tax does not apply, however, to certain qualified rollovers of the lump sum into a residence country retirement account.'4 9 the contours of the term "pension"'" have not been established double taxation and the prevention of fiscal evasion with respect to taxes on income, signed dec. 18, 1992, and protocol signed oct. 13, 1993. reprinted in 31 highlights & documents 1631, 1653-54, (nov. 2, 1993) [hereinafter treasury explanation of netherlands treaty]; sen. comm. on foreign relations, 103d cong.. ist sess.. exec. rept. 103-19. report on the tax convention with the kingdom of the netherlands (1993). 148. see convention between the united states of america and the kingdom of the netherlands for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, dec. 18, 1992. s. treaty doc. no. 6, 103d cong.. 1st sess. (1992), art. 19, 1-2, art. 25, t 7 [hereinafter u.s.-neth. treaty]; see also treasury explanation of netherlands treaty, supra note 147, at 1631, 1653. article 25 of the convention provides that for purposes of allowing the credit for residence-based tax, the u.s. is to treat the lump sum payment as arising in the netherlands. u.s.-ncth. treaty. supra, art. 25, 1 7. an example of the application of article 19 is provided in priv. ltr. rul. 96-26-055 (apr. 11, 1996), reprinted in 96 tni 128-24 (july 2. 1996) u 6-13 (lexis. fedtax library, tni file). 149. the u.s.-netherlands tax convention exempts from source-country tax "the portion of the.., lump sum.., that is contributed to a pension plan or retirement account under such circumstances that, if the ... lump sum had been received from a payer in the state of the recipient's residence, the imposition of tax on the payment by the state of the recipient's residence would be deferred until the amount of the payment was withdrawn from the pension plan or retirement account to which it was contributed." u.s.-neth. treaty, supra note 148, art. 19, 1 3. see also treasury explanation of netherlands treaty. supra note 147. at 1653 (explaining that, for example. a lump sum payment from a netherlands pension plan that was invested in a u.s. ira would be exempt from netherlands tax. in this case, explains the treasury, "the tax avoidance concerns of the netherlands would not be present."). 150. the commentary to the 1992 oecd model states that article 18 applies to "pensions paid in respect of private employment" as well as "widows' and orphans' pensions and other similar payments such as annuities paid in respect of past employment." 1992 oecd commentary, supra note 138, at c(18)-1. it is further noted that "a common solution" was not reached regarding "amounts paid to an employee on the cessation of his employment." id. these amounts are viewed as "a pension. . .. paid as a lump sum" in some countries. "as the final remuneration for the work performed" by others, and in some cases "as a bonus . .. subjected to a gift tax." id. at c(i 8)-i-(l 8)-2. for a discussion of article 18 of the 1992 oecd convention, see manfred gunkel, the taxation of pensions (article 18). 1992/12, intertax 690. according to gunkel, to come within this article "the pension has to be paid by the former employer himself or by a separate organization, e.g. an employer's pension fund." id. at 691. gunkel explains that article 18 "does not apply to social security pensions [which] are not paid in consideration of past employment" but rather are dealt with under article 21 pertaining to other income. id. (citing klaus vogel on double taxation conventions, commentary, december 1991, article 18, annotation 12 and article 21. annotation 12). 19961 florida tax review very clearly in the treaty language itself or in technical explanations of the treaties. 5 ' private'52 letter rulings have been an important source of law in this area, an approach disconcerting to taxpayers and withholding agents. 53 the treasury department's technical explanation of the 1996 u.s. model provides useful insight into the treasury's current negotiating 151. see, e.g., convention between the government of the united states of america and the government of the united kingdom of great britain and northern ireland for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, dec. 31, 1975, art. 18, 1, t.i.a.s. 9682 [hereinafter u.s.-u.k. treaty] (exempting "any pension in consideration of past employment and any annuity"); technical explanation of the [u.s.-u.k. treaty, supra], tax treaties (cch) $ 10,941, at 44,553-54 (stating that "[t]he term 'pension' includes payments from qualified retirement plans as well as other forms of retirement benefits paid for services rendered, or by way of compensation for injuries or sickness incurred in connection with past employment."); u.s.france income tax treaty, supra note 135, art. 18, $ 1 (exempting "pensions and other similar remuneration, including distributions from pension and other retirement arrangements ... in consideration of past employment, whether paid periodically or in a lump sum"); treasury explanation of the u.s.-france treaty, supra note 135, tax treaties (cch) 3058, at 27,19731 (explaining that the provision "applies to both periodic and lump-sum payments" and to "pension payments in consideration of past employment that are paid to a resident of the other contracting state, whether to the employee or to his or her beneficiary."). 152. for published rulings, see rev. rul. 56-446, 1956-2 c.b. 1065, 1066 (lump sum distribution from u.s. qualified pension plan to canadian resident, paid on death or other separation from service, treated as capital gain under § 402(a)(2), was exempt from u.s. tax under article vi a of u.s.-canada income tax convention, as a pension, or under article viii, as a capital gain), modified by rev. rul. 58-247, 1958-1 c.b. 623, 24 (treaty exemption in latter situation is under article viii, and not article vi a); rev. rul. 58-248, 1958-1 c.b. 621, 622 (similarly, article xii(1) of the u.s.-australia income tax convention, dealing with pensions and annuities, does not apply to such a distribution treated as capital gain under § 402(a)(2)); rev. rul. 71-478, 1971-2 c.b. 490, 490-91 (the term "pension" as used in the u.s.-u.k. income tax convention, article xii, refers to "a stated allowance or stipend paid by an employer in consideration of services rendered, to a retired employee, payment being conditioned on retirement"; thus, bonuses paid in periodic installments as "compensation for services rendered in specific prior years" did not qualify); rev. rul. 72-12, 1972-1 c.b. 440, 441 (under u.s.-sweden income tax convention, article x, the term "private pension" means a pension paid by a private person (in contrast to a government) either directly or through the medium of a trust); rev. rul. 72-460, 1972-2 c.b. 659, 660 (supplemental annuity payments in excess of guaranteed minimum payments under retirement annuity contracts qualify as "pensions" under u.s.-canada income tax treaty, article vi a). 153. see bissell, supra note 98, at 77 (noting that "virtually all of the irs' views [on pension or ira distributions to nonresident aliens] have been expressed in plrs, which may not formally be relied upon by anyone except the taxpayer to whom the ruling was issued"); irpac paper, supra note 98, issue i (recommending that, "for purposes of promoting certainty and uniformity among payors concerning income tax withholding, the service publish guidance, upon which payors may rely, concerning the treatment of nonperiodic pension and annuity payments under foreign tax treaties which exempt 'periodic' payments from taxation."). [vol 3:6 u.s. income taxation of cross-border pensions position regarding the definition of the treaty term "pension"; m but it is not an authoritative interpretation of any particular treaty.!5 ' this 1996 technical explanation is discussed after analysis of the materials interpreting existing treaties. there is no direct guidance as to whether a payment from an unfunded deferred compensation plan may qualify as a pension; overall, the failure of the irs or treasury 56 to refer to "funding" as a requirement leaves the impression that it is not required.'" however, if an unfunded plan is not designed to provide benefits that are dependent on retirement, it seems unlikely that the treaty article will apply. if the pension article is not applicable, the entire amount paid to the employee is viewed as compensation, and treaty benefits, if any, are under the provision dealing with dependent services.' the "183 day" rule of that provision is applied by 154. see 1996 treasury explanation, supra note 2, u 242-245. 155. id. 6 (explaining that "a principal function of the model is to facilitate negotiations by helping the negotiators identify differences between income tax policies in the two countries," and that "[a]nother purpose... is to provide a basic explanation of u.s. treaty policy for all interested parties"). 156. id. 1 243. the treasury states that the term "pension" in the 1996 u.s. model includes "qualified plans under section 401(a), individual retirement plans ... , nondiscriminatory section 457 plans, section 403(a) qualified annuity plans, and section 403(b) plans." id. 1 243. all these examples are funded plans, except that § 457 plans are required to be "unfunded." see irc § 457(b)(6); bittker & lokken, supra note 7, q1 60.2.3. the treasury then states that "competent authorities may agree that distributions from other plans that generally meet similar criteria to those applicable to other plans established under their respective laws also qualify for the benefits of" the treaty. 1996 treasury explanation, supra note 2, t1 243. the treasury then lists a series of criteria for u.s. plans that does not include any requirement of funding. id. see discussion of these criteria at infra notes 181-186. 157. see bissell & giardina, supra note 72. at 282 (stating that payments from an unfunded supplemental executive retirement plan (a "serp") would often qualify as a pension for purposes of u.s. treaties). bissell and giardina consider that a lump sum payment from a serp that complies with the requirements of irs private letter rulings, described infra in notes 166-167 and accompanying text, might also qualify. id. however, they note that "the plrs only deal with distributions from qualified plans. and the irs has apparently never been faced with the question of whether to apply the same rules to unfunded plans such as a serp." id. 158. see priv. ltr. rul. 93-32-038 (may 18, 1993), reprinted in 94 tni 22-17 (feb. 2, 1994) (lexis, fedtax library, tni file), where despite a lack of compliance with the model "rabbi" trust format of rev. proc. 92-64. 1992-2 c.b. 422, the irs ruled that contributions made by a canadian employer to a trust to provide deferred compensation benefits to a u.s. citizen key employee were not includible in the employee's income until amounts are actually distributed or made available to him. the irs further ruled that payments made by the employer to the employee pursuant to the arrangement "shall be treated as dependent personal services income" under article 15 of the u.s.-canada income tax treaty. id. 19961 florida tax review reference to the year in which the services were performed.'59 thus, in row 1 of table 1, page 358, the treaty bars imposition of u.s. tax on unfunded deferred compensation received by a nonresident alien only if the payment qualifies as a "pension" or if the "183 day" rule is met. the irs has not indicated that a funded deferred compensation plan must be tax-qualified for distributions to come under the "pension" article of treaties, and the treasury's september 1996 explanations of the treaties with luxembourg and austria state explicitly that these treaties do not contain such a requirement.' 6° thus, in rows 3 and 6 of table 1, pages 358-59, involving a u.s. nonqualified funded plan, any u.s. tax that would otherwise be imposed on the accretion element at the time of distribution is apparently barred. in addition, even though some treaties define pensions as "periodic payments" made in consideration for services, the irs 16' has recently stated in a series of private letter rulings that "the term 'periodic' is simply descriptive of a pension payment generally, not a restriction on the manner of payment."' 62 the treasury's technical explanation of the u.s.-nether159. see rev. rul. 86-145, 1986-2 c.b. 297, 298 (ruling that in applying article 15 (dealing with dependent personal services) of the u.s.-u.k. income tax convention to compensation earned in the u.s. by a u.k. resident in 1985 but received in 1986, the "183 day" test applies to 1985, the year in which the services were performed); see also 1996 treasury explanation, supra note 2, 212. 160. see treasury department technical explanation of the convention between the government of the united states of america and the grand duchy of luxembourg for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital, 96 tnt 185-13 (sept. 20, 1996), 184 (lexis, fedtax library, tnt file); treasury department technical explanation of the convention between the united states of america and the republic of austria for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, 96 tnt 185-15 (sept. 20, 1996), 234 (lexis, fedtax library, tnt file). see also infra note 178 (discussing the u.s.-canada income tax treaty). 161. under the u.s.-canada income treaty, only "periodic" payments qualify for the 15% reduced tax rate. u.s.-canada income tax treaty, supra note 146, at 21,018. one commentator has noted that revenue canada applies a narrower definition of the term "periodic" under the treaty than does the irs. peat marwick urges renegotiation of tiebreaker rules in u.s.-canada income tax treaties, 90 tni 24-18 (april 30, 1990) (lexis, fedtax library, tni file) [hereinafter kpmg letter]. 162. priv. ltr. rul. 90-41-041 (july 13, 1990), reprinted in 90 tnt 211-92 (oct. 16, 1990) (lexis, fedtax library, tnt file) (interpreting art. i1, 3 of the u.s.-swiss income tax convention, which defines a pension as periodic payments made in consideration for services rendered). the irs ruled that a distribution from a 401(k) plan (whether in a single lump sum or in equal quarterly installments over two years) would be treated as a pension payment, provided that "it meets general united states pension rules," as described infra in the text accompanying note 166. priv. ltr. rul. 90-41-041; see also priv. ltr. rul. 8904-035 (oct. 31, 1988), reprinted in 89 tni 6-5 (feb. 8, 1989) (lexis, fedtax library, tni [vol 3:6 u.s. income taxation of cross-border pensions lands income tax convention, signed in 1992, states that "[i]t is preferred, though not uniform, u.s. treaty policy not to distinguish in treatment between periodic and lump-sum pensions.' 63 the proposed treaty with turkey refers specifically to a pension "whether paid periodically or in a lump-sum."" in recent letter rulings, the irs has instead provided its own quite specific guidelines for defining the term "pension" (at least in the case of a qualified plan). for example, private letter ruling 95-41-043, interpreting the pension article of the u.s.-india tax treaty, 65 states that: file) (applying exemption for pension amounts, under art. ii. t 2 of the u.s.-germany income tax treaty, defined in art. i1, 3 as "periodic payments made in consideration for services rendered"). see discussion in bissell, supra note 98, at 77 (stating that "[the major development in the irs' interpretation of tax treaties has been the irs' willingness to treat a lump-sum distribution from a tax-qualified u.s. retirement benefits plan as exempt from u.s. tax under a tax treaty-although it has not taken a consistent stance on which theory to rely on"). bissell cites priv. ltr. rul. 89-34-025 (interpreting the u.s.-u.k. income tax convention) as well as the rulings listed above. id. at 77-78. he notes that "these rulings mark a clear change from the prior irs position, even if they cannot be officially relied upon." id. at 78. bissell cites, as an example of the irs' former position, gen. couns. mem. 37,899 (mar. 26, 1979), where "the chief counsel's office concluded that a lump-sum distribution from a u.s. plan was fully taxable because it violated the 'periodic payment' requirement in the denmark-u.s. treaty." bissell, supra note 98, at 79 n.4. see also irpac paper, supra note 98, issue 1, (further citing priv. ltr. rul. 89-01-053, interpreting the u.s.-swiss income tax convention, as an example of the new irs position). 163. treasury explanation of netherlands treaty. supra note 147, at 1653. the treasury notes that "[i]t is the policy of the netherlands, however, to preserve by treaty the right of the netherlands to tax any lump-sum pension payment made in consideration of employment in the netherlands." id. 164. proposed agreement between the government of the republic of turkey and the government of the united states of america for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, art. 18. 1 1. reprinted in tax treaties (cch) 10,103, 43,647-63 [hereinafter proposed u.s.-turkey income tax treaty]. however, the recently proposed treaties with austria and luxembourg do not contain this language. see proposed convention between the republic of austria and the united states of america for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, art. 18, reprinted in tax treaties (cch) q 14.017-033 [hereinafter proposed u.s.-austria income tax treaty]; proposed convention between the government of the grand duchy of luxembourg and the united states of america for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital, art. 19, i. reprinted in tax treaties (cch) 5701. 35,02140 [hereinafter proposed u.s.-luxembourg income tax treaty]. 165. article 20(3) of that treaty provides that "[t]he term 'pension' means a periodic payment made in consideration of past services or by way of compensation for injuries received in the course of performance of services." convention between the government of the united states of america and the government of the republic of india for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, sept. 12, 1989, art. 20, t 3, reprinted in tax treaties (cch) t 4203. 31.007-023 (hereinafter u.s.-india income tax treaty]. the explanation of the treaty upon which senate approval was 19961 florida tax review it is the position of the service that distributions from a qualified retirement plan will be treated as pension amounts for treaty purposes provided that: (1) the employee had been employed for 5 years or more prior to the time the benefit is paid, or, if employed for less than 5 years, first employed by the employer (or a related employer) on or after reaching age 60; (2) the benefit is: (a) paid on or after attainment of social security retirement age as defined in section 216(1) of the social security act, (b) paid on account of the employee's death or disability, (c) paid either as part of a series of substantially equal payments over the employee's life expectancy (or over the joint life expectancy of the employee and his or her beneficiary), or paid for the life of the employee (or for the life of the employee and his or her beneficiary), or (d) paid after separation from service after attaining age 55; and (3) all distributions are made after the employee has separated from service with the employer maintaining the plan, except for distributions made on or after the employee attains age 70 and 1/2.166 based stated that the treaty definition of a pension as a periodic payment "excludes a lumpsum pension benefit, which is generally understood to be covered by the corresponding article of the u.s. model treaty." staff of joint comm. on tax'n, 101st cong., 2d sess., explanation of proposed income tax treaty (and proposed protocol) between the united states and the republic of india (jcs-20-90) 59 (joint comm. print 1990). thus, it seems inconsistent for the irs to interpret the pension article of this treaty in a way that could apparently allow for coverage of a lump sum distribution. 166. priv. ltr. rul. 95-41-043 (oct. 13, 1995) (involving application of art. 20, i 1, of the u.s.-india income tax convention to distributions from qualified u.s. retirement plans to a resident of india). the irs found that the requirements quoted in the text accompanying this note were satisfied because "taxpayer was employed by corp x for over five years and the monthly distributions from [the plan] will be paid after taxpayer separated from service with corp x after attaining age 55." id. [vol, 3:6 u.s. income taxation of cross-border pensions the separation from service requirement would be violated if the employee begins work for a related employer within five years.'67 one commentator has questioned "what basis (if any) these tests may have in the code, the regulations, or in non-tax statutory law or regula,,16s h r a tssfrations. the irs has stated that these tests for classification as a pension169 "ensure that the distributions will occur upon retirement after longcontinued and faithful service."'170 in the recent clayton decision, 7 ' the u.s. court of federal claims treated the "pension" article of the u.s.-canada treaty as inapplicable to the u.s.-sourced "accretion" portion of a 1986 distribution on termination of chrysler's employee stock ownership plan paid 167. see priv. ltr. rul. 89-04-035 (oct. 31, 1988) (ruling applying u.s.-germany income tax treaty). this will result in disqualification from the point of rehiring and in retroactive disqualification if the rehiring was intended by the employer at the point of cessation. id. 168. bissell, supra note 98, at 78. in a recent private ruling, the irs noted that requirement (2) described in the text accompanying note 166 is similar to the requirements of § 72(t)(2)(a) of the code. priv. ltr. rul. 96-26-055 (apr. 11, 1996), at 9-10. 169. the irs has addressed the treaty definition of a "pension" most recently in priv. ltr. rul. 96-26-055 (apr. 11, 1996), which interprets the u.s.-netherlands income tax treaty signed in 1992. a provision of that treaty permits the u.s. to tax a lump sum pension distribution in respect of u.s. employment made to a netherlands resident who had been a u.s. resident within the previous five years. id. at 6. the irs determined that this provision applied to a lump sum payment made out of a "pure rollover" ira. which was created from funds distributed upon the termination of a qualified section 401(a) retirement plan and transferred to a spouse pursuant to a qualified domestic relations order. id. at 7-9. in addition, the irs held that the payment did not qualify for exemption as "other income" under the treaty. id. at 10-11. the irs reasoned that "[wihile a pension is not specifically defined under the code, it is considered to be a payment in consideration of services rendered and conditioned on retirement." id. at 7. the irs further explained that "[a] payment from a qualified retirement plan under section 401(a) of the code is a payment in consideration of services and is conditioned upon retirement and is commonly referred to as a pension for u.s. tax purposes." id. 170. priv. ltr. rul. 89-04-035 (oct. 31, 1988) (ruling applying u.s.-germany income tax treaty). as support for its ruling, the irs states: "see rev. rul. 71-478. 1971-2 c.b. 490; staff of joint comm. on tax'n, 99th cong., general explanation of the tax reform act of 1986, 713 (joint comm. print 1987) (explaining congress' intent not to penalize under section 72(t) distributions the timing or character of which reflect a genuine intent to retire); cf. schellfeffer v. u.s., 343 f.2d 936, 941 (ct. cl. 1965) (employee not 'retired' within the intendment of a law increasing federal pensions, if he or she resigns early in his or her career)." see also priv. ltr. rul. 89-34-025 (may 25, 1989) (applying exemption under article 18 of u.s.-u.k. income tax treaty to lump sum distribution; and providing identical explanation). in revenue ruling 71-478, interpreting the term "pension" under article 12 of the predecessor u.s.-u.k. income tax treaty, the irs explained that payment of a pension is "deferred until after retirement in order to induce 'long-continued and faithful service.'" 171. clayton v. united states, 95-2 u.s. tax cas. (cch) '1 50,391, 76 a.f.t.r.2d (ria) 95-5197 (cl. ct. 1995), aff'd, 96-i u.s. tax cas. (cch) 1 50,314 (fed. cir. 1996). 19961 florida tax review to canadians employed by chrysler's canadian subsidiaries. 72 it agreed with irs reasoning that "payment of a pension for purposes of the treaty must be contingent on retirement." '173 the irs apparently views a distribution from an ira as outside the scope of the term "pension" as used in "most treaties."'74 however, distributions from ira's containing solely rollover distributions from qualified plans (and earnings thereon) may in some cases 175 be treated as a pension, 7 6 although application of this rule by withholding agents may 172. the clayton court stated that "[t]he distribution at issue is neither a pension nor an annuity under united states tax law, but a distribution from a stock bonus plan." id. at 89,240, 76 a.f.t.r.2d at 95-5224. 173. priv. ltr. rul. 86-33-081 (may 27, 1986) (cited in clayton, 95-2 u.s. tax cas. at 89,240, 76 a.f.t.r.2d at 95-5224). according to the ruling, the esot plan provided that "distributions ... may be made on the employee's separation from service and are thus not contingent on an employee's age or retirement." priv. ltr. rul. 86-33-081 (may 27, 1986). 174. see irpac paper, supra note 98, (issue (8)) (citing priv. ltr. rul. 92-53-049, priv. ltr. rul. 91-43-067, and priv. ltr. rul. 89-04-036). the irpac paper states that: "it appears that the service may take the position that an ira is not a 'pension' within the meaning of most treaties, unless it is a 'pure' pension rollover ira .... [the service might adopt this position] notwithstanding the fact that such vehicles may be used for retirement savings." id. in the first of the rulings cited above, the irs stated: "generally, an ira is not a pension. however, in certain circumstances a distribution from an ira that consists solely of amounts rolled over from a qualified pension plan and earnings thereon will be treated as a pension distribution for purposes of the pension article in a treaty." priv. ltr. rul. 92-53-049 (oct. 6, 1992). in priv. ltr. rul. 91-43-067 (july 31, 1991), discussed in bissell, supra note 98, at 78, the irs stated that the treatment of "withdrawals from [iras] that do not qualify as a pure rollover ira is currently under study." see also kpmg letter, supra note 161 (stating that the irs interprets the term "pension" in the canadian treaty to refer to "pensions paid by private employers" or the u.s. or canada). kpmg concludes that an ira would not qualify "[s]ince the individual may establish these plans on their own account and receive a distribution from the plan upon demand prior to retirement .... ). id. 175. recently, the irs stated its position that the term "pensions" includes a distribution in compliance with requirement (2), quoted in the text accompanying note 166, that is made from a "pure rollover ira," i.e., an ira that "contain[s] only distributions from qualified retirement plans (plus earnings thereon) that meet the above requirements and are themselves treated as pensions." priv. ltr. rul. 95-41-043 (oct. 13, 1995) (applying pension article of u.s.-india income tax convention to periodic distributions from an ira created by a rollover from two qualified defined contribution plans sponsored by a u.s. employer). see also priv. ltr. rul. 89-04-036 (oct 31, 1988) (pension article of u.s.-italy income tax treaty exempted distributions from an ira, into which lump sum distributions from u.s. qualified retirement plans had been rolled over). in the latter ruling, the irs stated that "amounts otherwise qualifying as pension payments ... which are rolled over into a segregated ira and which qualify as 'rollover contributions' under section 408(d)(3) . . ., will continue to qualify as pension payments under the treaty, including interest earned while in the ira." id. 176. see priv. ltr. rul. 96-26-055 (apr. 11, 1996), where the irs ruled that a lump sum distribution from a "pure rollover" ira that had been transferred to a netherlands resident pursuant to a qualified domestic relations order was pension income and thus taxable under [vol 3:6 u.s. income taxation of cross-border pensions be difficult.'" moreover, the march 17, 1995 protocol to the u.s.-canada income tax treaty expands the coverage of the pension article to include an ira 178 in its explanation of the 1996 u.s. model, the treasury has set forth its current negotiating position regarding the definition of a "pension" (which is not necessarily its interpretation of existing treaties). the text of article 18 of the 1996 u.s. model refers to "pension distributions and other similar remuneration... whether paid periodically or as a lump sum." '79 the treasury's explanation specifies that this provision applies to "qualified plans under section 401, individual retirement plans .... nondiscriminatory section art. 19, 2 of the u.s.-netherlands income tax treaty. see supra note 169. the irs explained that "certain conditions must be met for a distribution from a 'purc-rollovcr' ira to be treated as a pension for purposes of a treaty, in order to ensure that the distribution is made as a retirement benefit." priv. ltr. rul. 96-26-055. "thesc conditions arc similar to those prescribed under section 72(t)(2)(a) ... for avoiding the 10 percent additional tax upon an early withdrawal .. " id. the service reasoned that because the "additional tax does not apply in the case of a distribution to a divorced spouse pursuant to a qdro (by reason of the exception in section 72(t)(2)(c)], such distributions ... are to be treated as retirement benefits in all events." id. the irs will not, it explained, "impose conditions for treaty purposes that are not otherwise required to affect the u.s. tax consequences of the distribution." id. 177. see irpac paper, supra note 98, issue 8. the irpac paper points out that "[tihe original source of funding for an ira is not always clear to a payor of ira distributions, especially where the ira was established pursuant to a rollover or direct transfer from another ira at a different institution." id. accordingly, the paper suggests, "the different withholding rules that apply to iras, based on the original source of such funds, leads [sic] to confusion and undue administrative burdens to the payor." id. bissell recommends that taxpayers "discuss the u.s. tax and treaty rules in advance with the ira fiduciary, so as to anticipate whether the fiduciary will withhold tax." bissell, supra note 98, at 80. 178. revised protocol amending the 1980 tax convention with canada. mar. 17, 1995, art. 9, 11 (replacing art. 18, t1 3 of the u.s.-canada income tax treaty, signed september 26, 1980) reprinted in tax treaties (cch) 1 1946 [hereinafter 1995 revised protocol]. the reference in the 1980 treaty to a "superannuation, pension or retirement plan" was changed to a "superannuation, pension or other retirement arrangement." see id. this change "clarifies that the definition of pensions includes, for example, payments from [an ira or a canadian registered retirement savings plan or registered retirement income fundl." joint comm. on tax'n, explanation of proposed protocol to the income tax treaty between the united states and canada (jcs-15-95), may 23, 1995, (joint comm. print 1995). see also treasury department technical explanation of the protocol amending the convention between the united states of america and canada (june 13, 1995). 95 tnt 115-64 (june 14, 1995) (lexis, fedtax library, tnt file) [hereinafter treasury explanation of revised protocol to u.s.-canada treaty]. the treasury explanation further states: "the term 'pensions' also would include amounts paid by other retirement plans or arrangements, whether or not they are qualified plans under u.s. domestic law; this would include, for example. plans and arrangements described in section 457 or 414(d) of the internal revenue code." id. 179. see 1996 u.s. model, supra note 2, art. 18. 9 1. the treasury states that "'[t~he same result is understood to apply in u.s. treaties that do not make this point explicitly." 1996 treasury explanation, supra note 2, 1 242. 19961 florida tax review 457 plans, section 403(a) qualified annuity plans, and section 403(b) plans." all these examples of included plans are funded plans, except that section 457 plans are required to be "unfunded."'80 the treasury further explains that "competent authorities may agree that distributions from other plans that generally meet similar criteria to those applicable to other plans established under their respective laws also qualify for the benefits of' the treaty. the criteria listed for the u.s. by treasury' are that the plan (a) be "written"; (b) be "nondiscriminatory" in the case of an employer-sponsored plan; 82 (c) contain restrictions on non-retirement use of assets by participants; 183 and "in all cases be subject to tax provisions that discourage participants from using the assets for purposes other than retirement;" and (d) require minimum distributions so that death benefits to survivors are merely incidental."8 it would seem that the second part of criteria (c) would not be met by most plans that are ineligible for tax-qualified treatment under the code. finally treasury in its explanation of the 1996 u.s. model restates the position previously announced in private rulings that "certain distribution requirements" (essentially those set forth in the private rulings)' "must be met before distributions from these plans would fall under" the treaty provision. 86 180. see irc § 457(b)(6); bittker & lokken, supra note 7, 60.2.3. 181. see 1996 treasury explanation, supra note 2, 243. 182. treasury states that "[i]n the case of an employer-maintained plan, the plan must be nondiscriminatory insofar as it (alone or in combination with other comparable plans) must cover a wide range of employees including rank and file employees, and actually provide significant benefits for the entire range of covered employees." id. 183. treasury states that "[i]n the case of an employer-maintained plan the plan must contain provisions that severely limit the employees' ability to use plan assets for purposes other than retirement." id. 184. treasury states that "[tihe plan must provide for payment of a reasonable level of benefits at death, a stated age, or an event related to work status, and otherwise require minimum distributions under rules designed to ensure that any death benefits provided to the participants' survivors are merely incidental to the retirement benefits provided to the participants." id. 243. 185. see supra notes 166-168 and accompanying text. 186. these are that "the employee must have been either employed by the same employer for five years or be at least 62 years old at the time of the distribution"; and "the distribution must be either (a) on account of death or disability, (b) as part of a series of [vol. 3:6 u.s. income taxation of cross-border pensions payments of funded deferred compensation that do not qualify under the "pension" article of a treaty may come under the "other income" article. for example, in its recent decision in clayton, the u.s. court of federal claims agreed with the irs position that the "accretion" element of a 1986 distribution to canadian employees working in canada in termination of chrysler's employee stock ownership plan was subject to article 22 of the u.s.-canada treaty, dealing with "other income."'87 similarly, the irs has ruled that a distribution from a rollover ira made before age 59-1/2 (and thus not classified as a "pension") was to be classified as "other income" under the u.s.-u.k. treaty; as a result the distribution was exempted from u.s. tax. 18 1 this treaty classification may not be available, however, to the extent that distributions are subject to section 864(c)(6) (because they are attributable to deductible contributions made with respect to services performed after 1986)."9 in addition, some treaties, such as the u.s.substantially equal payments over the employee's life expectancy (or over the joint life expectancy of the employee and a beneficiary), or (c) after the employee attained the age of 55"; and finally that "the distribution must be made either after separation from service or on or after attainment of age 65." 1996 treasury explanation, supra note 2, q 244. and the distribution cannot be "solely due to termination of the pension plan." id. 187. clayton, 95-2 u.s. tax cas. (cch) at 89,241, 76 a.f.t.r.2d (ria) at 955226. under art. 22, 1, other income arising in the u.s. can be taxed by the u.s. id. the clayton court held that paragraph two of article 22, providing a maximum rate of 15% for distributions from a trust resident in one country to a resident of the other country, was applicable. id. the taxpayer had unsuccessfully argued that the distribution represented "remuneration" for services rendered outside the u.s., and, therefore, was exempt under article 15 (dependent personal services). id. at 89,239-40. 76 a.f.t.r.2d (ria) at 95-5223-24. this argument was also rejected on appeal. see clayton v. united states, 96-1 u.s. tax cas. (cch) 150,314, 77 a.f.t.r.2d (ria) 96-2484 (fed. cir. 1996). 188. see priv. ltr. rul. 92-53-049 (ocl 6. 1992). the irs further ruled that the second sentence of art. 22,9 11, denying an exemption for income from trusts, was inapplicable to an ira trust. see discussion in bissell, supra note 98, at 79-80. the irs had applied this article of the u.s.-u.k. income tax convention to a distribution from a non-rollover ira annuity in a 1984 private letter ruling. id. (citing priv. ltr. rul. 84-22-069). by contrast, in priv. ltr. rul. 96-26-055 (apr. 11, 1996), the irs treated a lump-sum distribution from a "pure rollover" ira, transferred to a spouse pursuant to a qdro, as "pension income," and thus rejected the taxpayer's argument that the distribution qualified for a treaty exemption as "other income." see supra notes 169 & 176. 189. bissell points out that in priv. ltr. rul. 92-53-049 (oct. 6, 1992). the irs noted that no u.s. services were performed by the employee after august 1984, for which pension contributions were made, and it concluded that § 864(c)(6) does not apply to distributions from the rollover ira. bissell, supra note 98, at 79. bissell states that "[tihere is an implication in these comments that if the individual had worked in the united states after 1986 .... to that extent the article 22 exemption might not have been available." id. (footnote omitted). in that case, bissell concludes, the distributions might have been classified as "the payment of deferred u.s. source compensation under § 864(c)(6) that is subject to u.s. tax under the 'dependent personal services' article of the relevant tax treaty." id. at 80. 1996] florida tax review mexico treaty, do not provide an exemption from source-based taxation for "other income."'" 2. pension contributions.-the basic treaty provision providing for exclusive residence taxation of pensions (just discussed) is applicable only to pension distributions and not to pension contributions. in the 1981 u.s. model and in most u.s. treaties, there is no limitation on source-based taxation of pension contributions. thus, in rows 3 and 4 of table 1, page 358, involving a u.s. nonqualified funded plan and a foreign funded plan, respectively, the 1981 u.s. model does not block the u.s. source-based tax on contributions in respect of u.s. services performed by a nonresident alien. the commentary to the 1992 oecd model treaty does, however, suggest a provision t9 that would ameliorate the treatment of employee contributions to home country pension plans for employees assigned to work abroad. 192 such a provision was added to the treaty between the u.s. and france by a 1984 protocol, 93 and was again included in the revised treaty signed on august 31, 1994. under the 1994 provision, for example, contributions paid by or on behalf of a french citizen who is a u.s. resident to a retirement arrangement established in france and qualifying for tax relief (with respect to contributions) in france is to be treated in the same way by the u.s. as a u.s. retirement arrangement qualifying for tax relief (with respect to contributions) in the u.s. provided that the u.s. competent authority agrees that the french arrangement corresponds to an arrangement qualifying for tax 190. the 1996 u.s. model does provide for exclusive taxation by the residence country of income not dealt with in other articles of the model. 1996 u.s. model, supra note 2, art. 21, 1. 191. under the proposed provision in the 1992 oecd commentary, the host state is to accord the employee relief for contributions made by him to a pension scheme in the home country comparable to that accorded contributions to a pension plan in the host country. to achieve this, the employee must not have been a resident of the host country and must have been contributing to the home country pension scheme before taking up employment in the host country, and the home country scheme must be "accepted by the competent authority" of the host country "as generally corresponding to a pension scheme recognised as such for tax purposes by [the host country]." 1992 oecd commentary, supra note 138, at c(18)4. see also andersen, supra note i, at 95-96; sassesville, supra note 83, at 129, 135 (1993); gunkel, supra note 150, at 690-93. 192. 1992 oecd commentary, supra note 138, at c(18)-2. 193. see protocol to the convention between the united states of america and the french republic with respect to taxes on income and property of july 28, 1967, signed jan. 17, 1984, art. 8, (adding 5 to article 19 of the 1967 treaty), reprinted in tax treaties (cch) 3038, 27,073. [vol. 3:6 u.s. income taxation of cross-border pensions relief in the u.s. 94 a similar provision was also included in article 19 of the u.s.-sweden tax convention, signed on september 1, 1994, and in the proposed treaties with austria and switzerland, signed in 1996.'" the treasury department's technical explanation of the french and swedish provisions suggests that (as in the commentary to the 1992 oecd model196 ) they provide only for deductions of employee contributions, and not an exclusion for employer contributions. 97 194. u.s.-france income tax treaty, supra note 135, ar. 18. 7 2(a), (b)(iii). tax treaties (cch)1 3001.04,27,005-13; see also treasury explanation of the u.s.-france treaty. supra note 135, tax treaties (cch) 1 3058, 27,197-31 (noting that this provision is "based on... the suggested provision set forth in the commentaries to article 19 of the 1992 oecd model"). 195. convention between the government of sweden and the government of the united states of america for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, sept. 1. 1994. an. 19. 1 4. tax treaties (cch) § 8801,41,505-11 [hereinafter u.s.-sweden tax convention]; treasury technical explanation of 1994 u.s.-sweden income tax treaty, tax treaties (cch) 9i 8802a, 41.505-66 [hereinafter treasury explanation of u.s.-sweden treaty]. proposed u.s.-austria income tax treaty. supra note 164, art. 18, 91 5. proposed convention between the united states of america and the swiss confederation for the avoidance of double taxation with respect to taxes on income, signed oct. 2, 1996, art. 28, 91 4. 96 tni 194-41 (oct. 4, 1996) (lexis. fedtax library, tni file). the swedish provision differs from the provision in the french treaty by requiring that "contributions [be] paid by, or on behalf of. such individual to [the home country] arrangement before [the individual becomes] a resident of the [host countryl." u.s.sweden tax convention, supra, art. 19, 1 4(a)(i), tax treaties (cch) 91 8801. 41.505-11. 196. the 1992 oecd commentary states that the proposed provision's reference to "[c]ontributions borne by an individual" is intended to include only an employee's contributions, and that the provision "is silent on the treatment of' an employer's contributions. however, the commentary suggests that "member countries may wish to extend" the provision "to ensure that employers contributions in the context of the employees' tax liability are accorded the same treatment that such contributions to domestic schemes would receive." 1992 oecd commentary, supra note 136, at c(18)-4. c(18)-10. 197. the language of the treaties with sweden and france refers to "contributions paid by, or on behalf of," an individual to a home country plan being "treated in the same way for tax purposes" as contributions to a host country plan. u.s.-france income tax treaty, supra note 135, art. 18, 1 2(a); u.s.-sweden tax convention. supra note 195. art. 19.4(a). but the treasury's technical explanation states that the provision "permits" the employee "to deduct contributions ... that are made by or on his behalf' to certain home country plans "to the same extent that deductions would be permitted" for contributions to a host country plan. treasury explanation of the u.s.-france treaty, supra note 135 (discussing art. 18); see treasury explanation of the u.s.-sweden treaty. supra note 195 (discussing art. 19 (similar language)). but cf. letter of price waterhouse to cynthia beerbower, international tax counsel, dated june 7, 1994, 94 tni 136-20 (july 15. 1994) (lexis, fedtax library. tni file), recommending that a provision like art. 19(5) of 1967 u.s.-france treaty be added to u.s. model treaty [hereinafter pw letter]; and section of taxation, aba, comments on income tax treaty between finland and the united states, dated nov. 1. 1990.90 tn1 48-71, (nov. 28, 1990) (lexis, fedtax library, tni file). recommending inclusion of a provision 19961 florida tax review the treasury has now indicated that its policy is to negotiate for inclusion of such a provision in future treaties in order to "ensure that certain differences between the two contracting states' laws regarding pension contributions and pension plans will not inhibit the flow of personal services between the contracting states."'9 8 the 1996 u.s. model treaty contains a provision of this nature that is in some ways broader in scope than the provisions in the french and swedish treaties. under the provision in the 1996 model,' 99 an individual performing services in the u.s. who has already participated2 "° in a pension plan recognized under the legislation of the other country and generally corresponding to a tax-qualified u.s. pension plan is eligible for three treaty benefits:2"' (1) contributions to the plan are deductible (if made by the employee) or excludable if made by the employer, up to the limits applied by the u.s. to u.s. tax-qualified plans;2" (2) the u.s. may not tax earnings in the plan prior to distribution; and (3) the u.s. may not tax distributions rolled over into a u.s. tax-qualified plan pursuant to u.s. rules.20 3 moreover, the 1996 model's provision also allows the employer in such a case to deduct contributions in computing taxable income in the u.s., subject to the limits that would be applied to a u.s. plan. °4 like art. 19, t 5 of the 1967 u.s.-france treaty [hereinafter aba comments]. price waterhouse suggests that this provision would "ensure that employees do not lose the opportunity to continue sharing in benefit programs and are not unduly burdened with income tax on employer contributions during the period of residency in the country in which the employee is not a citizen." pw letter, supra. the aba tax section suggests that art. 19, 5 of the 1967 french treaty is an example of "a provision for mutual recognition by each contracting state of the qualification of a retirement plan under the other contracting state's rules, both for the purposes of deductions by employers and timing of inclusion by employees." aba comments, supra. 198. 1996 treasury explanation, supra note 2, 251. 199. 1996 u.s. model, supra note 2, art. 18.6. 200. the treasury states that "the individual ... must be a visitor to the host country," in that the provision applies "only if he was contributing to the plan in his home country." 1996 treasury explanation, supra note 2, 257. 201. these benefits are not denied by the savings clause to u.s. residents who are neither u.s. citizens nor permanent residents. 1996 u.s. model, supra note 2, art. 1.5(b). 202. see 1996 treasury explanation, supra note 2, $ 252-254. treasury explains that "the exclusion of employee contributions from the employee's income ... is limited to elective contributions not in excess of the amount specified in section 402(g)." id. 254. the treasury further explains that "the benefits [under art. 18, 6] are limited to the benefits that the host country accords under its law, to the host country plan most similar to the home country plan." id. 258. 203. id. 256. 204. see 1996 u.s. model, supra note 2, art. 18, 6; 1996 treasury explanation, supra note 2, 253-254. the treasury explains that the employer's deduction "is subject to the limitations of sections 415 and 404." id. 254. [vol. 3:6 u.s. income taxation of cross-border pensions d. rationale for source-based taxation 1. unfunded deferred compensation.-it is clearly within international norms for the u.s. to tax current salary paid to a nonresident alien performing services in the u.s. as effectively connected income. the oecd model provides for such source-based taxation of compensation for dependent services, subject to a "short-term business travel" exception (which is incorporated in u.s. treaties, as well as in the internal revenue code in a narrower version). presumably, the host country is viewed as providing valuable benefits to the employee by providing the situs for his employment.' unfunded deferred compensation is viewed by the u.s. as merely a delayed substitute for current compensation in that it comes directly from the employer. thus, the u.s. considers it appropriate to apply the same treatment to eventual payments of unfunded deferred compensation as to current payment of compensation. the enactment of section 864(c)(6) (taxing deferred compensation as effectively connected income) apparently does not conflict with any treaty obligations of the u.s.' presumably, it would be permissible under international norms for the u.s. to adopt a broader concept of constructive receipt or economic benefit that would result in current taxation of the present value of unfunded deferred compensation. 2 7 the generosity of the u.s. in not taxing currently does not seem a valid reason for precluding it from taxing at a later date more convenient to the employee.05 205. see, e.g., david gliksberg, the effect of the statist-political approach to international jurisdiction of the income tax regime-the israeli case. 15 mich. j. int'l l 459, 472 (1994) (proposing that "[llustification for imposing [tax on foreign taxpayers on a territorial basis] is centered on the connection between income and governmental expenditure incurred in creating a working environment to enable the production of that income"). 206. see aba, section of tax'n, issues paper on technical corrections to the tax reform act of 1986 relating to tax treaties at nn.63-66 (july 1, 1988), available in 88 tnt 146-39, (july 15, 1988) (lexis, fedtax library, tnt file) (indicating general agreement that § 864(c)(6) added by the 1986 act is not inconsistent with any treaties). 207. for example, in 1978, the irs published proposed regulations providing that "if a taxpayer ... individually chooses to have payment of some portion of his current compensation... deferred and paid in a later year, the amount will nevertheless be treated as received by the taxpayer in the earlier taxable year." notice of proposed rulemaking, deferral tax treatment of amounts of compensatory payments llr-194-771, 43 fed. reg. 4638 (1978) (irs explanation of proposed regulation). the revenue act of 1978 barred the treasury from implementing this proposal. pub. l. no. 95-600, § 132(a), 92 stat. 2763, 278283 (1978). 208. this argument has been made in the context of state taxation of pensions of nonresidents. see walter hellerstein & james c. smith, state taxation of nonresidents' pension income, 56 tax notes 221, 224 (july 13, 1992) [hereinafter hellerstein]. they argue that the fact that the state as "a matter of legislative grace" accorded deferral when pension 19961 florida tax review 2. different treatment of funded deferred compensation.-a distribution to an employee from a funded pension plan can be conceptualized in the same way as a payment of unfunded deferred compensation, i.e., as a substitute for current compensation. 2' the amount to be received by the employee on a deferred basis should be greater than the amount he would receive on a current basis because the funds can be invested in the interim. thus, under this approach, the full amount of the deferred payment would be classified as compensation. such an approach was advocated by the chief counsel in 1975 with respect to a qualified u.s. pension plan,20 but was eventually rejected by the irs in favor of a "bifurcated" approach. under the bifurcated approach, only the amount contributed by the employer (or by the employee on a taxdeferred basis) to a funded plan is viewed as compensation to be sourced on the basis of the place of performance of services. the "accretions" earned in the retirement trust by investment of the contributions is viewed as a separate element of investment income for the employee, which is sourced to the u.s. if the trust has a u.s. situs. rights were earned should not be used as a basis for "prevent[ing] a state from taxing income earned within its borders." id.; see also jean m. klaiman, note: take the money and run: state source taxation of pension plan distributions to nonresidents, 14 va. tax rev. 645, 664 (winter 1995) [hereinafter klaiman]. nevertheless, the recent federal legislation barring state taxation of pensions paid to nonresidents does appear to apply to unfunded deferred compensation that qualifies as an executive excess benefit plan or is paid in periodic installments for at least 10 years. see pub. l. no. 104-95, 104th cong., 1st sess. § l(a), (1996) (adding 4 u.s.c. § 114); amy hamilton, clinton signs source tax bill, 96 tnt 8-4 (jan. 11, 1996) (lexis, fedtax library, tnt file) [hereinafter hamilton]. 209. gen. couns. mem. 36,344 (july 23, 1975) at *9; gen. couns. mem. 38,007 (july 10, 1979) at *4-5. it was the chief counsel's position that "[e]xemptions in treaties for pensions have always been applied to pensions as a whole." gen. couns. mem. 36,344 at * 11 (july 23, 1975). in addition, chief counsel cited rev. rul. 72-3, 1972-1 c.b. 105, for the proposition that a "pension is a substitute for current compensation." id. as yet further support, chief counsel cited gen. couns. mem. 35,894 (july 11, 1974), "in which a lump sum payment from a qualified employee's profit-sharing plan in excess of the employee's own contributions is [treated as] business income for purposes of computing a net operating loss." id. at *6, *11. counsel also pointed to: h.r. rep. no. 2, 70th cong., 1st sess. 22 (1927) ("to the effect that distributions from a pension trust are taxed as compensation"); and rev. rul. 73-252, 1973-1 c.b. 337 (holding that "supplemental unemployment benefits paid to [a nra] who performed all his services outside the united states from a tax-exempt trust operated by a domestic voluntary employee's association constitutes income from" foreign sources). id. at * 12-13. 210. gen. couns. mem. 36,344, supra note 209. in 1979, chief counsel, although restating the same objections, acquiesced in itc's approach and concurred in the adoption of rev. rul. 79-388. gen. couns. mem. 38,007, supra note 209. see also supra notes 108-111 and accompanying text. [vol 3:6 u.s. income taxation of cross-border pensions international tax counsel criticized the chief counsel's approach of sourcing the entire distribution based upon the place of performance of services as: represent[ing] an unwarranted transmutation of a provision for tax deferral into one which unilaterally concedes primary tax jurisdiction on certain u.s. source income to foreign taxing authorities."' thus, international tax counsel apparently supported bifurcation as a means to strengthen u.s. source-based jurisdiction: i.e., to allow the u.s. to impose tax on the accretion portion of a distribution to a nonresident alien from a u.s. pension plan even if the employee performed all his services outside the u.s. this situation could occur, for example, when the employer is a u.s. multinational. international tax counsel apparently did not believe that an employee should have the advantage of investing in u.s. assets through a tax-exempt u.s. pension trust and at the same time avoid u.s. tax on the distribution of such investment earnings. the statement by international tax counsel may also suggest that a strong assertion of source-based jurisdiction over pensions might be a useful tool in bilateral negotiations for a reciprocal source-country exemption for pensions. these policies are undercut, however, by enactment of section 871 (f) exempting from u.s. tax any amounts received as an annuity from a qualified pension trust by a nonresident alien if all of the services were performed outside the u.s. and at least 90% of the employees benefitting under the plan are u.s. citizens or residents.1 2 it is hard to explain how the ceding of u.s. jurisdiction with respect to "accretions" earned in a u.s. pension trust becomes more or less warranted in principle depending on what percentage of the beneficiaries under the plan are nonresident aliens. overall, it seems advisable for congress to amend the internal revenue code so as to treat the entire amount of a distribution from a u.s. qualified pension plan as compensation (to be sourced to the place where the services were performed). this change would greatly simplify u.s. sourcebased taxation of distributions from u.s. qualified pension plans (when there is no treaty bar to taxation); with this change, it would no longer be necessary to separately identify the "accretions" element of a distribution or to determine whether the requirements of section 871 (f) are met. the sourcebased jurisdiction that the u.s. would thereby surrender has already been 211. gen. couns. mem. 38,007. supra note 209, at *6-7. 212. see supra notes 114-116 and accompanying text. as noted there a further exemption is provided even though the 90% requirement is not met when the recipient's country of residence grants a substantially equivalent exclusion to residents and citizens of the united states. irc § 871(f)(2)(a). 19961 florida tax review largely abandoned as a result of the operation of section 871(f). the simplifying effects of this proposal are depicted in bold print in table 1-a, rows 2 and 5, pages 362-63. whether the irs should continue to apply a bifurcated approach to distributions from a nonqualified funded plan (domestic or foreign) is a harder question. since the u.s. treats contributions to such a plan as taxable compensation (at the point of vesting), pursuant to section 402(b)(1), it is harder to conceptualize the eventual distribution from the trust as merely a substitute for current compensation. in the case of a u.s. secular trust, the bifurcation approach may not add much complexity in that separation of the contributions element from the earnings element may be necessary in any event to determine the proper time for taxing. moreover, in the case of a foreign retirement trust with a nonresident alien beneficiary, the bifurcation rule has the simplifying effect of treating the accretion element as foreign and thus not subject to u.s. tax; this may be a worthwhile concession to the limits of irs enforcement ability. these considerations suggest that bifurcation should be retained in the taxation of a nonresident alien participant in a funded nonqualified retirement plan. 213 e. rationale for treaty relinquishment of source-based jurisdiction over pensions why does the u.s., while making a strong assertion of jurisdiction over deferred compensation (particularly after the 1986 act), simultaneously embrace a treaty policy of complete relinquishment of source-based taxation over pension payments (whether or not made in a lump sum)? somewhat inconsistently, the u.s. does not relinquish by treaty its source-based taxation, on a current basis, of compensation for u.s. services that is contributed (by the employer or employee) to a foreign retirement arrangement or to a nonqualified u.s. funded plan. 213. see table 1-a, rows 3, 4, and 6, page 362-63. but cf. infra part iv.e (proposing a different treatment of foreign defined benefit plans). the irs also applies the bifurcation approach in determining the source of a pension distribution for purposes of computing the foreign tax credit of a u.s. citizen or resident. see supra note 105. if the proposal described in the text to eliminate bifurcation of a distribution from a u.s. qualified plan is implemented for this purpose as well, the aggregate effects are likely to be fairly modest. the only change would be that a u.s. citizen or resident who performed services abroad could treat the entire distribution (and not just the original contribution) from a u.s. qualified plan as having a foreign source. this would simplify the task of the plan trustee, particularly in the case of a defined benefit plan. [vol. 3:6 u.s. income taxation of cross-border pensions the u.s. treaty policy is obviously consistent with international norms, as it is also embodied in the oecd model tax conventions for 1963, 1977 and 1992.214 however, one commentator from the u.k. has argued that the bar to source country taxation of pensions under the oecd model is "outdated, having been designed in an era when there were fewer privately funded pensions and less costly tax-deductible pension reserves.... and the mobility of individuals not so marked."2 5 she notes that "[tihose states, such as the united kingdom and the netherlands, that allow generous deductions to pension reserves, are high-tax, developed nations vith strong welfare systems.,,2 11 the author further notes that this tax break is "justified only in relation to keeping down future welfare costs and substituting a stream of taxable income when employment has ceased. 2 1 7 she believes that "high-earning 'mobiles' will draw their pensions as (technical) residents of havens where the sun shines and the taxes are low; [while] the midto lower-income sector and the poor needing welfare [will] stay behind in hightax countries. 2 8 a main purpose of bilateral tax treaties is to avoid "tax barriers to the free international exchange of goods and services. ' thus, a major goal is avoidance of double taxation of cross-border transactions, which obviously is a discouragement to such transactions. however, this goal is generally achieved to a large extent by a country's internal tax rules giving priority to source-based tax; thus, for example, the u.s. allows a credit for foreign taxes paid in respect of foreign source income, while some other countries provide an exemption for foreign source income.= by contrast, treaties generally operate by reducing or eliminating source-based taxation.2in some cases, however, the internal rules of the two countries may not be effective to avoid double taxation because of inconsistent treatment 214. in fact, this policy seems to have gained acceptance prior to 1963 since official commentary for the three oecd model treaties do not provide any explanation of the rationale for this treatment. for the treatment of pensions in draft model conventions prepared under the auspices of the league of nations, see supra note 136. see also muten, supra note 72, at 750 (noting that "we swedes have learned by experience that this rule is extremely hard to get prospective treaty partner countries to modify"). 215. jill c. pagan, united kingdom: momentum for change in approach to taxation gathers pace, ii tax notes int'l 802, 805 (sept. 18, 1995). 216. id. 217. id. 218. id. at 805-06. 219. american law institute, international aspects of united states income taxation ii, proposals on united states income tax treaties. 1991 a.l.i. fed. income tax project 1 (may 13) [hereinafter all]. 220. see id. at 5-6. 221. see id. at 2. 19961 florida tax review accorded a transaction by two countries, e.g., in their application of source rules.222 moreover, in some cases, source taxation may be considered "burdensome" either in amount or in enforcement, even if "not duplicative."2" thus, a treaty provision may be needed to prevent either "double" or "burdensome" taxation. 1. eliminating difficulties created by inconsistent source rules.-the pension article of the u.s. model treaty eliminates problems of double taxation that are created if more than one country seeks to impose source-based tax on the same pension income. at least three possible sourcing rules could be applied to a distribution from a pension plan:224 as under the code, the distribution could be sourced to the situs of the plan to the extent of the accretion element and to the place of services to the extent of the compensation element; alternatively, the entire amount could be sourced to the situs of the plan (as under the un model) or the entire amount could be sourced to the place of services (as for unfunded deferred compensation). the u.s. model, by providing for taxation of a pension payment exclusively in the residence country, effectively eliminates conflicts between different views of the source of a pension payment.2 5 another way of achieving this goal, however, would be to specify by treaty which sourcing rule should prevail. this suggests that there may be additional reasons for the u.s. treaty policy regarding pensions payments. 2. administrative difficulties of source-based taxation a. elimination of administrative difficulties by eliminating source-based taxation.-the most obvious rationale for u.s. treaty policy 222. see id. at 6-8. 223. see id. at 9. ali offers the example of "source-based withholding taxes on investment income." id. ali notes the further "objective" of "exempt[ing] income entirely at the source in cases in which the contact of the foreign taxpayer with the jurisdiction is relatively weak and the compliance burden on the taxpayer is large by comparison." id. at 10. ali cites as examples "[t]reaty provisions exempting income derived from international shipping and air transport," and the "permanent establishment" limitation on the taxation of business profits. id. 224. see id. at 8 (noting that "[t]wo countries may assert source jurisdiction to tax the same income of a taxpayer that is not a resident of either country," for example, because of the "application of inconsistent source rules"). 225. see reuven s. avi-yonah, the structure of international taxation: a proposal for simplification, 74 tex. l. rev. 1301, 1311 (1996) (arguing that one "pragmatic" reason "for preferring residence over source taxation for individuals" is that "individuals can only be in one place at any given time," whereas "determining the source of income is a highly problematic endeavor, and in most cases, income will have more than one source"). [vol. 3:6 u.s. income taxation of cross-border pensions regarding pensions is the serious administrative difficulties associated with source-based taxation of distributions from u.s. qualified plans. as in the case of unfunded deferred compensation, the withholding agent first must characterize contributions to the plan as made with respect to services performed outside the u.s., services performed within the u.s. before 1987, or services performed within the u.s. after 1986. but also, in contrast to the case of unfunded deferred compensation, the withholding agent for a u.s. qualified plan must allocate each distribution between the amount contributed by the employer (and thus treated as compensation) and the accretion element.' chief counsel noted the special difficulty of this task-' with respect to a defined benefit plan' in that, for such a plan, "the amount of the pension ... does not depend on the amount of earnings."' these 226. see gen. couns. mem. 38,007, supra note 209, at *4 (referring to the "almost overwhelming administrative difficulty (in many cases) in allocating a trust distribution between employer contributions and trust accretions"). 227. the chief counsel also viewed identification of the earnings element of a pension payment as inconsistent with the treatment of the trust as a separate entity. he argued that, because of the trust's separate status, "whatever increment may be paid out loses its character in the hands of the distributee"; thus, for example. the employee cannot claim an exemption under § 103 for municipal bond interest received by the trust or a dividends received exclusion for dividends received by the trust. gen. couns. mem. 36,344. supra note 209, at *10. but see clayton v. united states, 95-2 u.s. tax cas. (cch) 1 50.391, 76 a.f.t.r.2d (ria) 95-5197 (cl. cl 1995). affd, 96-1 u.s. tax cas. (cch) 7 50,314 (fed. cir. 1996). in clayton, the u.s. court of federal claims approved the separate identification of the "increment" in a distribution on termination of an esop. while rejecting the argument that capital gains recognized by the trust could pass through to the beneficiary. id. at 89,23189,232. the court noted that the conduit rules of subchapter j do not apply to employer trusts. id. at 89,232 (citing rev. rul. 72-99, 1972-1 c.b. 115, and rev. rul. 55-61, 1955-1 c.b. 40). 228. a recent report of the irs information reporting program advisory committee states that "it is unclear whether rev. rul. 79-388 is applicable to distributions from defined benefit plans and, if applicable, how its methodology would apply." irpac paper. supra note 98, issue 5. the report adds that "[i]t is unclear, for payments made under a defined benefit plan, how a plan administrator would identify contributions from earnings and, with respect to contributions, distinguish between benefits attributable to services performed both [sic] before or after a specified date for a specific employee." id. the report recommends that "[the service should clarify whether the principles contained in rev. rul. 79-388 apply to pensions paid from defined benefit plans"; and, if they do apply, it should "provide guidance that any reasonable method may be used by payorslplan administrators" for making this determination. id. 229. chief counsel noted further that "in many cases it would be difficult, if not impossible, to determine the amount of earnings that are allocated, or should be treated as allocated, to each employee's account." gen. couns. mem. 36,344. supra note 209, at $9. see also gen. couns. mem. 38,007, supra note 209 (chief counsel acquiesced to the approach taken in rev. rul. 79-388, 1979-2 c.b. 270). in gen. couns. mem. 38,007. chief counsel pointed out that "[a] similar allocation problem was involved in the original lump-sum distribution provisions of section 402," requiring identification of "any part of a lump-sum 19961 florida tax review problems of allocation are compounded when the distribution is made in a series of payments, 23' rather than a lump sum, and have been emphasized23 in a recent report by the information reporting program advisory committee to the irs. 2 the u.s. and oecd model treaty provision for pensions allows these administrative difficulties to be completely sidestepped. because only the state of residence of the recipient may tax a pension payment, there is no need for the plan administrator to make the allocation between compensation and earnings. similar administrative concerns are the most convincing justification for federal legislation enacted in 1996 that bars an individual state of the united states from imposing tax2 1 3 on pension payments made to an distribution which represented employer contributions accrued after 1969." id. at *5. chief counsel confessed that "[i]t was found difficult if not impossible to administer this provision"; thus, in 1974 erisa replaced it with "a relatively simple averaging." id. at *5-6. 230. irpac paper, supra note 98, issue 6 ("it is unclear how the principles contained in rev. rul. 79-388 would apply to pensions, other than lump sum distributions, which are attributable to services performed both within and outside the united states."). 231. the irpac report also criticized "current rules that may require the application of three distinct withholding methodologies to a single pension payment to a nonresident alien" for promoting "undue hardship" and "confusion." id. at issue 3. under the current withholding rules: (1) "[t]hat portion of [a distribution] attributable to pension contributions for u.s. services performed after 1986... is [generally] subject to the 10% withholding requirement under irc section 3405(b) unless [the beneficiary] elects out of withholding in which case 30% withholding under section 1441 would apply"; (2) however, "the 20% withholding requirement under section 3405(c)" would apply mandatorily to any such amount "in excess of the minimum required distribution under section 401(a)(9)"; and (3) "that portion of [a distribution] attributable to contributions for u.s. services performed before 1987 plus all plan earnings would apparently be subject to 30% withholding under section 1441." id. the report notes that payors may have to "issue and process several different types of information returns and... apply different withholding methodologies with respect to the same payee in any one calendar year" because of the payee's ability to "freely elect in or out of irc section 3405 withholding." id. the report recommends that the law be clarified and simplified by a replacement of temp. regs. § 1.1441-4(b)(1)(ii); under the proposed replacement, withholding for effectively connected pension payments made to nonresident aliens from qualified pension plans would be exclusively under § 1441, and never under § 3405. id. the irpac paper's recommendation was adopted in a proposed regulation issued by the treasury in 1996. under this proposed regulation, "payments to a nonresident alien individual from a trust described in section 401(a) are subject to withholding under section 1441 and not under section 3405 or 3406." prop. regs. § 1.1441-4(b)(1)(ii). 232. see irpac paper, supra note 98, at issues 5 and 6. 233. states have generally conformed to federal income tax rules deferring recognition of pension income. see hellerstein, supra note 208, at 221, 222; hamilton, supra note 208; richard reichler, state taxation of executive and employee compensation, 35 tax mgmt. j. 275 (sept. 5, 1994) (lexis, fedtax library, tmjnl file). in the event that the individual enjoying this deferral becomes a resident of another state before retirement, most [vol. 3:6 u.s. income taxation of cross-border pensions individual currently resident in another stateyz-u because the source-based jurisdiction of a state extends to intangibles only if they have a "business situs" in the state, states that sought to tax pension payments paid to nonresidents had to allow exclusion of an amount "reflect[ing] accumulations after the taxpayer's change of residence." 5 thus, the pension trust would states do not seek to tax the pension income, adopting a "de facto policy of tax forgiveness." hellerstein, supra note 208, at 223. reichler notes that "27 states have no explicit statement of policy on this issue," and that "nine states do not impose a personal income tax that would apply to pensions or retirement annuities distributed from qualified plans." reichler, supra, at text accompanying nn.26-27. further, eight states do have an explicit policy of not taxing such income. id. at text accompanying n.28. see also klaiman, supra note 208, at 647 & nn.3-4 (stating that of 13 states with tax codes authorizing such taxation, five indicated in a 1991 survey that they do not enforce the tax; however, some states, particularly california. have sought to tax pension income of former residents); hamilton, supra note 208 ("california has been notably aggressive in pursuing source tax...; kansas, louisiana and oregon also have the statutory right to tax all types of nonresident pension income."): reichler, supra, at nn.29 & 30 and accompanying text (stating that california, idaho and oregon "explicitly do impose such a tax" and that kansas, massachusetts and new york "do so under some circumstances"); klaiman, supra note 208, at 647 & n.4 (stating that only california. new york and vermont "have systems in place to pursue nonresidents" receiving such income). 234. see hamilton, supra note 208 (noting that president clinton signed h.r. 394 on january 10, 1996). for the statutory language, see 95 tnt 252-50 (dec. 28, 1995) (lexis, fedtax library, tnt file). for a description of earlier efforts to pass such legislation, see klaiman, supra note 186, at 659-662. professors walter hellerstein and james charles smith, leading commentators on state taxation issues, label as "ludicrous" the arguments of former senator harry reid of nevada that state taxation of nonresident pensions is taxation "without representation" and without reciprocal benefits. hellerstein, supra note 208, at 223-24. see also letter from carolyn joy lee, chair, tax section, n.y.s.b.a., to rep. sam gibbons (nov. 9, 1995) 95 tnt 227-6 (nov. 21, 1995) (lexis, fedtax library, tnr file) (criticizing as "not ... persuasive" the "[a]rgument that the [federal legislation] is necessary to correct unfair state taxation"). for further description of such arguments by reid and others, see klaiman, supra note 208, at 663-64. however, hellerstein and smith "remain agnostic" as to the desirability of such proposed legislation limiting states' taxation of pension income of nonresidents because of the "serious practical complication[s]" resulting from such taxation. hellerstein, supra note 208, at 230, 226. see also letter of carolyn joy lee, supra (stating that "[t]he complexities of multistate compliance and the risks of multiple taxation may be factors that warrant federal intervention"). ms. lee suggests that "[it also might be fruitful to consider more limited forms of restriction, for example federal rules that allocate deferred income among the states in which an individual has lived or worked." id. 235. hellerstein, supra note 208, at 226. hellerstein and smith note, however, that in 1989 "a new jersey court held a nonresident taxable on the payout from a profit-sharing plan from his former new jersey employer over the objection that new jersey was taxing dividends, interest, and appreciation in the value of a nonresident's intangible assets." id. at n.32 (citing mcdonald v. director, division of tax'n, 10 nj. 556 (1989), modified in part, aff'd in part, 589 a.2d 186 (nj. super. ct. app. div. 1991). hellerstein and smith note that the n.j. legislature provided a statutory exemption in that same year. id. determining the amount that may be taxed becomes particularly complicated when "[a] taxpayer has worked in more than one state prior to retirement or has earned income in a state other than his state 19961 florida tax review have to make a separate determination of that amount.236 b. alternative means of easing administrative difficulties.-recognition of the administrative difficulties of source-based taxation of pension payments does not lead inexorably to the current treaty policy. instead, the u.s. rules for source-based taxation might be revised in order to ease these difficulties. a statutory change in u.s. source-based taxation would have the advantage of completely freeing withholding agents from the administrative difficulties created by the current rules, even where the recipient of a pension payment is not protected by a treaty. for example, as urged by the irs chief counsel in 1975 and as recommended above for qualified u.s. pension plans, pension payments could be sourced entirely to the place where the services were performed to avoid the need to separately identify the "accretions" element. this approach would not preclude the need to identify multiple source countries where services are performed in more than one country; however, this same problem also exists for payments of unfunded deferred compensation that are not classified as "pensions," and is not considered unworkable in that context. a second approach to simplifying source-based taxation would be to treat a pension payment as sourced entirely to the situs of the payor trust. thus, the entire amount distributed by a u.s. pension trust would be classified as from u.s. sources (even if services were performed abroad as in table 1, row 5, page 359); no amount distributed by a foreign pension trust would be classified as from u.s. sources (even if services were performed in the u.s., as in table 1, row 4, page 358). a similar approach is suggested by the u.n. model treaty, which contains two alternative provisions for pensions (one allowing source-based taxation and the other precluding it). in the former provision, source-based taxation is permitted when a pension payment is "made by a resident.., or a permanent establishment situated" within a treaty state. the commentary explains that this approach was directed at avoiding problems in the situation where employees have "performed services consecutively in several different countries." the commentary concluded: of residence." id. at 227. hellerstein & smith note that if a resident of new jersey performs services in pennsylvania and then moves to florida upon retirement, "[logically new jersey has jurisdiction to tax the full amount of the deferred compensation, together with any accumulations thereto up to the date of the taxpayer's relinquishment of new jersey residence." id. however, new jersey's statute would not require filing of a resident return in the year of retirement when the individual is not a n.j. resident. id. 236. cf. supra note 226; letter of carolyn joy lee, supra note 234 (noting that "taxation of deferred income requires the allocation of pension distributions between deferred compensation and deferred investment income, as well as allocation among the states where income was earned or where an individual resided"). [vol 3:6 u.s. income taxation of cross-border pensions [i]t would be very difficult for the head office of a company to allocate each pension among the various countries in which the pensioner had worked during his years of employment. it was generally agreed, therefore, that taxation of pension at source should be construed to mean taxation at the place in which the pension payments originated, not the place in which the services had been performed. " ' if the u.s. were to unilaterally redefine the source of a pension payment as the situs of the pension trust, then consistency would seem to require that it disclaim source-based taxation of contributions to foreign pension plans in respect of u.s. services (see table 1, row 4, page 358). however, for the u.s. to amend the code to relinquish this claim to sourcebased tax would seem to create a huge loophole for nonresident aliens performing services in the u.s. such aliens could avoid u.s. tax permanently by having their employers set up nonqualified pension trusts for them outside the u.s., even though the employees were never subject to a significant home country tax with respect to such plans. 3. determination of overall "ability to pay. "-a third rationale for relinquishment of source-based taxation of pensions by treaty is that "the country of residence [is] probably in a better position than the source country to structure its taxation of pensions to the taxpayer's ability to pay."" s this argument may be based on the concern that source country taxation will lead to hardship. 239 thus, a country taxing on the basis of source may be unable 237. u.n. model, supra note 139, commentary on article 18b, at 172. 238. id. this argument was presented by members from developed companies in connection with drafting of the u.n. model treaty. members from developed countries also argued that "since the amounts involved were generally not substantial, developing countries would not suffer measurably if they agreed to taxation in the country of residence." id. at 172. see also julie roin, rethinking tax treaties in a strategic world with disparate tax systems, 81 va. l. rev. 1753, 1761 (1995). professor roin notes that, in general. "[residencecountry taxation is thought to be preferable because it enables greater inter-taxpayer equity." id. at 1761. she explains that this "argument stems in part from concerns about the implementation of a progressive rate schedule when taxation is split between the country of residence and country of source." id. at 1761 n.27. see also gliksberg, supra note 205. at 473 (noting that "the principle of ability to pay ... examines the income of the taxpayer from every source, including that produced abroad"). 239. cf. the commission of the european communities. commission recommendation of 21 december 1993 on the taxation of certain items of income received by nonresidents in a member state other than that in which they are resident, 94 tni 61-22 (mar. 30, 1994) (lexis, fedtax library. tni file). the commission recommended that when a resident of one member state derives at least 75% of his taxable income in the form of compensation for dependent or independent services (or from industrial or commercial activities) in another member state in which he is not resident, the latter country should not 19961 florida tax review to provide remedial measures designed to insure that an elderly individual's sole source of income is not subjected to excessive tax (e.g., a special rate schedule, standard deduction, or credit for retirees). the residence country's mechanism to avoid double tax (whether a credit system or exemption system) will not serve to remedy excessive tax in the source country.24 on the other hand, such a concern could be addressed by requiring source countries to exempt a generous amount of pension income received by each recipient. for example, the developing countries participating in discussions of the 1980 u.n. model proposed exclusive source-based taxation but with an exemption "for amounts equivalent to the personal exemptions allowable in the source country. ' 24' alternatively, this rationale for the current u.s. treaty policy might be based on the concern that source-based taxation may be inappropriately low. thus, if the pension is the only item of u.s.-source income of a nonresident alien and it is (to the extent of the compensation element) taxed as effectively connected income,242 the applicable u.s. tax rate may be quite low. 243 however, this concern does not seem very serious as long as residence-based tax is not precluded.2" impose any heavier burden of tax than if the individual were a resident. id. at the same time, the residence country "may decide not to grant deductions or other tax reliefs which it normally grants to residents" if such deductions would be duplicative. id. similarly, some countries have entered into bilateral arrangements providing for taxation of frontier workers by the residence country only. 240. see ali, supra note 219, at 9-10. 241. see u.n. model, supra note 139, commentary to article 18b, at 172. 242. ironically, § 864(c)(6) treating deferred compensation as effectively connected income, rather than fixed or determinable income subject to a 30% withholding rate, may have a favorable effect on the treatment of nonresident aliens. 243. thus, it has been suggested that an ira might be an attractive investment for u.k. employees working temporarily in the u.s. because the eventual distribution may not be subject to u.k. tax and the rate of u.s. taxation may be low if this is the only effectively connected income. see koch, supra note 125, at 141-42. koch notes that a nonresident alien would be eligible for a $2,350 personal exemption, and might well be taxed at a 15% rate. id. at 141. see also roin, supra note 238, at 1761 n.27 (noting that "the source country typically treats the income earned by the taxpayer in that country as the taxpayer's only income, and computes the applicable rate starting at the bottom of the rate schedule"). 244. but see avi-yonah, supra note 225, at 1311-12 (arguing that "because most individuals have only one residence jurisdiction and are part of only one society, distributional concerns can be effectively addressed only in the country of residence"). professor avi-yonah points to the "vertical equity problem in taxing an investor with low domestic earnings and high foreign earnings that are not taxed abroad in the same way that a person with only low domestic earnings is taxed." id. at 1312. he notes that "[tihis problem can be resolved if the residence jurisdiction is allowed to tax on a residual basis only foreign source income that is not taxed abroad (or is taxed at lower effective rates) and allows a credit for foreign taxes." id. he concludes, however, that "it is much simpler to address the issue if the residence [vol 3:6 u.s. income taxation of cross-border pensions 4. reliance on residence-based taxation.-each of the arguments for relinquishment of source-based taxation (described above) rests on the implicit assumption that the residence country will in fact impose a tax on a pension payment derived from another country, and that such a tax will be enforceable. otherwise, individuals who earn a pension in one country and retire to another would have the opportunity for achieving complete tax exemption by virtue of a treaty. such complete tax exemption is a concern in the context of state taxation of pensions within the united states. thus, for example, now that california is barred by federal law from imposing its tax on pensions earned in california and paid to former california residents who retire in florida, such pensions will be free of any state income tax (since florida has no income tax).245 a desire to limit such abuses by the wealthy (who are often more mobile) was behind failed proposals to limit the federal legislation to pensions from qualified plans.2 by contrast, in the context of a bilateral treaty relationship, it should be possible for the u.s. and its treaty partner to assure themselves that residence-based taxation at a reasonable rate will in fact be imposed on recipients of pension payments exempted from source-based tax. this assumption is discussed further in part iv of this article, dealing with residence-based taxation. if so, a country such as the u.s. that (unlike a developing country)247 could expect to have a fairly balanced position (as a residence country and a source country) with other developed countries, may see no disadvantage to entering bilateral agreements that entail giving up source-based jurisdiction while preserving residence-based jurisdiction over pensions.2' therefore, even if the u.s. adopts this article's recommenjurisdiction is given the exclusive right to tax all income of its residents." id. professor aviyonah further notes that "taxation based on residence is a useful, though far from perfect, proxy for taxation with representation." id. 245. some predict that the federal legislation could lead to "substantial abuses of the pension system" on the part of wealthy taxpayers with the ability to shift considerable compensation to the form of a pension and to move to a low tax state on retirement. see klaiman, supra note 208, at 667-68. this outflow of wealthy taxpayers could lead states to lower their top marginal rates to be more attractive to such taxpayers. id. at 668. 246. id.; see id. at 660-62 (describing legislative proposals). 247. in the discussions leading to the u.n. model treaty. developing countries "observed that pension flows between some developed and developing countries were not reciprocal and in some cases represented a relatively substantial net outflow for the developing country." u.n. model, supra note 139, commentary to article 18b, at 172. developed countries responded with the argument that "since the amounts involved were generally not substantial, developing countries would not suffer measurably if they agreed to taxation in the country of residence." id. at 172. 248. the recent opinion by the court of justice of the european communities in the wielockx case reflects this view. see case c-80/94, g.h.ej. wielockx v. inspecteur der directe belastingen, 95 tni 216-11 (nov. 8, 1995) (preliminary ruling) (lexis, fedtax 19961 florida tax review dation to simplify the u.s. statutory rules for source-based taxation, there is no great incentive to change the long-standing treaty policy of barring sourcebased taxation of pension payments. f. proper scope of source-based exemption if the treaty exemption from source-based taxation of pensions is to be maintained, then it seems appropriate to delineate more clearly, and in an authoritative manner, the payments to which it applies. as the irs has noted, the term "pension" generally refers to a payment or series of payments that is "contingent on retirement," i.e., a separation from service due to reaching retirement age, death or disability. the irs may reason that the refinements in measurement of ability to pay that are possible in the residence country (but not the source country) are most important for individuals who are no longer in the workforce and may be completely dependent on a pension. a focus on this aspect of "pensions" suggests that lump-sum payments during retirement are at least as deserving of treaty protection as periodic payments (even though periodic payments may present greater administrative difficulties in respect of segregating the "compensation" and "accretion" elements). the "contingent on retirement" criterion might further suggest that the treaty exemption for pension payments should apply to payments from unfunded, as well as funded, arrangements, provided that the payments are contingent on retirement. on the other hand, one might argue that only payments from funded plans should qualify for the treaty exemption because only payments from funded plans present the administrative difficulty of separating the "compensation" element from the "accretions" element. to the extent that this administrative problem is eased by eliminating the distinction under u.s. internal law between the "compensation" and "accretions" element of a pension payment, this argument would have less force. perhaps, most unfunded plans are not "contingent on retirement" in any event; thus, as a practical matter, unfunded deferred compensation (even if not specifically excluded library, tni file); see also kees van raad, ec court of justice decides wielockx case, restricting the scope of bachmann decision, 11 tax notes int'l 779 (sept. 18, 1995) [hereinafter van raad]; jill c. pagan, united kingdom: momentum for change in approach to taxation gathers pace, ii tax notes int'l 802, 803-06 (sept. 18, 1995). in the wielockv case, the court held that the netherlands' refusal to allow a belgium resident working full-time in the netherlands to establish a deductible pension reserve violated the "freedom of establishment" article of the ec treaty. see van raad, supra, at 779-80. the court concluded that allowance of such a deduction by the netherlands would not disrupt the "cohesion" of its tax system, even though the netherlands had relinquished its right to tax distributions from the pension reserve under its treaty with belgium. id. at 780. the court found that overall "cohesion" was achieved through the reciprocity in the obligations under the treaty. id. [vol. 3:6 u.s. income taxation of cross-border pensions from "pension" classification) would generally not qualify for the treaty exemption. the irs should provide guidance in an authoritative form regarding the scope of the term "pension" in treaty provisions being applied to limit the assertion of u.s. tax. the current use of private letter rulings to delineate the term (and even then, only in respect of "qualified plans") creates serious problems for u.s. plan administrators, who face substantial penalties for failure to withhold when required. some of the requirements that the irs has set forth in private letter rulings seem to be appropriate guidelines for determining whether a payment is "contingent on retirement." for example, the irs requirement that payments be made only after the employee has reached social security retirement age, has separated from service after attaining age 55, or has died or become disabled (unless the payments are to be spread over the employee's entire life or life expectancy) may be useful for this purpose. on the other hand, it is not clear why the irs further requires that payments be made "after the employee has been employed for 5 years or more" or alternatively, if the employee was "first employed ... on or after reaching age 60." it seems ironic that the source country would condition giving up its jurisdiction to tax a pension upon the pensioner having a long-term relationship with the employer and thus in many cases a longer relationship with the source country. distributions from an ira are not directly contingent on retirement, even though lump-sum distributions prior to age 59 and 1/2 (and absent death or disability) are subject to penalty. however, the age threshold of 59 and 1/2 assures that a large portion of distributions from iras are in fact made during retirement. in addition, it seems appropriate for a distribution from an ira that is attributable to a rollover from a qualified pension plan to qualify for the pension exemption. creating a different treatment for a distribution from an ira to the extent not attributable to a rollover would create serious administrative difficulties for the ira trustee. certain types of payments that might otherwise be classified as "pensions" might nevertheless be excluded from this category if the task of ensuring adequate residence-based tax is particularly difficult with respect to such payments. for example, the netherlands' policy of preserving sourcebased taxation of lump sum pension payments in its treaties is apparently based upon concern about avoidance of residence-based tax. 49 that the 249. see treasury explanation of netherlands treaty, supra note 147. at 1653. the treaty allows taxation of a lump sum pension payment by the country where services were performed if the employee was resident in that country at any time in the previous five years. see u.s.-neth. treaty, supra note 148, art. 19, t 2. the treasury explains that the u.s. sought to accommodate the netherlands "concern ... that the lump-sum payment might avoid tax 19961 florida tax review netherlands is willing to accept the superiority of the residence country's claim to tax is suggested by the fact that the source-country taxing a lump sum pension payment is required to give a credit for residence-based tax. g. source-based taxation of contributions to foreign pension plans as just discussed, the u.s. is willing to surrender source-based taxation of pension payments from a u.s. qualified pension plan in the context of a bilateral treaty (where residence country taxation and a relatively balanced movement of employees between the two countries is assured). should it be equally willing to give up by treaty its source-based taxation of compensation derived by a nonresident alien from u.s. services and contributed by his employer (or by the employee himself) to a plan qualified in a foreign country that is a u.s. treaty partner? (see table 1, row 4, page 358). in either case, even though services have been performed in the u.s., the combination of such a treaty provision with the applicable provisions of the code would result in complete elimination (rather than merely deferral) of u.s. tax. until recently, a policy of relinquishing source-based tax on contributions to foreign pension plans has had relatively little acceptance among the u.s. and its treaty partners. such a rule is suggested only in the commentary of the 1992 oecd model, and the rule suggested is quite limited in scope. the suggested rule applies only to employee contributions (which do not present the valuation issues of some employer contributions), only to an individual who is a resident but not a national of the country where services are performed, and only where an employee has previously been contributing to the home country pension plan prior to taking up a work assignment in the other country. the court of justice of the european community has ruled that the treaty of rome's provision guaranteeing freedom of movement of workers does not require an ec member country to permit a national of another member country to deduct contributions made to a pension plan entered into in the latter country prior to arrival in the former country." altogether, or be subject to only a low rate of tax, even though the contributions on which the payment is based had been deductible for netherlands tax purposes." treasury explanation of netherlands treaty, supra note 147, at 1653. under the treaty, however, taxation of a lump sum payment by the country where the services were performed is barred when the lump sum payment is contributed to a pension plan or retirement account under circumstances that would have qualified for tax deferral in the residence country if the payor were also resident in that state. see u.s.-neth. treaty, supra note 148, art. 19, 3. the treasury explains that in this case "the tax avoidance concerns of the netherlands would not be present." treasury explanation of netherlands treaty, supra note 147, at 1653. see also supra note 163. 250. in the bachmann case, belgium refused to allow a german national working in belgium to claim a deduction from his belgium income for contributions paid to pension [vol 3:6 u.s. income taxation of cross-border pensions the u.s. has included a rule similar to that in the oecd commentary only in its treaties with sweden and france and in its proposed treaties with austria and switzerland. the french provision applies to an employee who is a u.s. resident but not a u.s. national; but the employee is not required to have previously contributed to the french plan. however, the inclusion of such a provision in the 1996 u.s. model suggests that such a provision may be included in u.s. treaties more frequently in the future. the hesitancy of the u.s., until recently, and the hesitancy of other countries to give up imposition of source-based tax on contributions made to a foreign plan seems odd given the disadvantages that may be involved in imposition of such a tax. first, imposition of a current tax under section 402(b)(1) on contributions to a foreign pension plan in respect of u.s. services involves serious administrative difficulties (particularly if the plan is a defined-benefit plan). if the foreign country where the plan is located does not impose an immediate tax on contributions to this type of plan, then the foreign tax authorities may not require the types of computations that would be required to determine the u.s. tax (i.e., determination of the employee's interest in the trust, and determination of the portion of the services performed in the u.s. before or after 1986). it seems questionable whether the u.s. tax in this situation has been uniformly enforced. further, imposition of a source-based tax on contributions to a foreign pension plan may create burdens for the employee that discourage his acceptance of a work assignment in the u.s. particularly when the country where the plan is situated accords tax-favored treatment to the plan. for example, the u.s. tax on contributions may create liquidity problems that would have been avoided if the employee had instead continued to work in his home country. in addition, double taxation may result because generally treaties have not barred further taxation by the country where the employee resides at the time of distribution. if that country uses a foreign tax credit mechanism, it may not grant credit for a tax paid to a source-country so many years before. finally, source-based tax may not provide as accurate a determination of ability to pay as a residence-based tax. (and other) insurance plans entered into in germany prior to his arrival in belgium. case c204/90, bachmann v. belgian state, 94 tni 50-15 (jan. 28, 1992) (lexis. fedtax library, tni file). the court found that, notwithstanding provisions guaranteeing freedom of movement of workers in the treaty of rome, belgium's position was "justified by the need to ensure the cohesion of [its] tax system." id. 28. that is, the court believed that belgium should not be required to allow a deduction for contributions to a plan the distributions from which would not be subject to belgium tax. id. for a subsequent limitation imposed by the court on the principle of "cohesion," see discussion of the wielockx case. supra note 248. the bachmann case is further discussed in muten, supra note 72. 1996] florida tax review the past reluctance of the u.s. to relinquish source-based tax over pensions in this context can perhaps be attributed to the following factors. because a foreign plan is ordinarily not a qualified plan under the internal revenue code, the appropriate time for the u.s. to impose its tax is when contributions are made (or, if later, when they are vested). even if the plan situs is a country having a treaty with the u.s., the u.s. may not be able to determine at that time whether any country will ultimately impose a residence-based tax on the pension income. at the time of the contributions, the employee may be a resident of the u.s. for tax purposes. the u.s. cannot be sure that the employee will retire in the country of the plan's situs. that country may impose tax only at the time of distributions from the plan and only if the employee is resident at that time (because the underlying services were performed elsewhere). (by way of analogy, when the only nexus of the u.s. with a pension is the situs of the pension trust, the u.s. taxes only the accretions element of a distribution and forgives that tax in many cases under section 871(f)). it is possible that the employee will retire in the cayman islands, or some other country not having a treaty with the u.s. thus, if the u.s. forbears from immediate imposition of source-based tax, it cannot be assured that residence tax will ever be imposed. this concern may perhaps be addressed by the u.s. providing merely a deferral of its source-based tax at the time of the contributions to the foreign plan and only if the situs of the plan is a u.s. treaty partner and provides for deferral with respect to such a plan. under this approach, the u.s. would retain jurisdiction to impose source-based tax on an eventual distribution from the plan if residence jurisdiction is not claimed at that time by a treaty partner of the u.s." 1 the country of the plan situs, as a u.s. treaty partner, would be able to facilitate the u.s. obtaining the necessary information to impose tax at the time of distribution. if the u.s. eventually surrenders its source-based tax because the individual retires as a resident of a treaty partner of the u.s., the u.s. is giving up its tax as part of a reciprocal arrangement. provided that limits on the dollar amounts contributed to the pension plan are similar to those applied by the u.s. for contributions to a u.s. qualified pension plan, some parity in the revenues surrendered is preserved. nevertheless, some may question why the u.s. should allow deferral of u.s. tax for contributions to a foreign pension plan that is not subject to u.s. standards for vesting, funding, rank-and-file participation, and fiduciary behavior. allowing the deduction may be seen as undermining the incentive 251. however, the total amount subject to tax would be reduced in terms of present value unless the u.s. were to treat the entire distribution (including the accretions element) as u.s. source. [vol 3:6 u.s. income taxation of cross-border pensions effect of the tax-favored treatment of u.s. qualified pension plans because the same u.s. tax advantage can be obtained without all the detailed restrictions of a u.s. qualified plan. it is not clear whether this concern is valid, however. the true advantage of a tax-favored pension plan (exemption of the investment return from tax in the country where the plan is located) is not being granted by the u.s. in this situation; in fact, the country in which the plan is situated may not even grant complete exemption from tax for investment income of the plan. moreover, in the case of contributions made directly by the employer, if the u.s. defers the tax on the employee, it would presumably also defer the allowance of a u.s. tax deductione 2 for the employer.2-3 further, the employee's decision to make contributions in respect of u.s. services to a pension plan situated outside the u.s., but in a country that is a u.s. treaty partner, is more likely to be based upon his expected, continuing relationship with that country, than upon avoidance of the requirements of a u.s. qualified plan. this would seem to be especially true where the employee is a national of (or has been a long-term resident of) the country where the plan is situated. moreover, if the employee has already contributed to the foreign plan prior to his u.s. work assignment, there may be significant advantages in continuing with the same plan.' in addition, it seems reasonable for the u.s. to entrust a country with which the employee has had significant ties with the responsibility to assure the adequacy and safety of his retirement arrangements. thus, this innovation in the 1996 u.s. model is to be commended. the u.s. should provide more generally in treaties for the giving up of source-based tax on contributions to pension plans situated in the other treaty country where the other treaty country also provides employee tax deferral with respect to plan contributions. this treaty policy is especially compelling if limited to cases where the employee is a national (or prior resident) of the 252. the restrictions of § 404(a)(5) would apply because the plan would not be a qualified plan for u.s. tax purposes. the more lenient rules of § 404a are inapplicable to "any item to the extent such item is attributable to services... performed in the united states the compensation for which is subject to tax under this chapter." irc § 404a(g)(1)(b). 253. however, if the employee is treated as receiving compensation and then making a deductible contribution to the foreign pension plan, there would be no deferral of the employer's deduction for u.s. tax purposes. 254. it has been suggested that the "right of deduction [be limited] to persons with legitimate reasons for requesting deductions-say, having moved internationally"; in other words, limited to "cases where it is required to safeguard the principle of mobility of labor." see muten, supra note 72, at § viii. bissell & giardina point out that "many u.s. plans exclude foreign nationals who retain [home country pension] coverage"; they explain that "because such groups are relatively small, and/or highly compensated, usually no prohibited 'discrimination' results." bissell & giardina, supra note 72, at 279. 19961 florida tax review treaty country where the plan is situated, and the employee has previously contributed to the plan in that country. iv. residence-based u.s. taxation of deferred compensation paid to u.s. citizens or residents if the u.s. treaty policy of relinquishing source-based taxation of pensions is based upon the assumption that residence-based taxation is preferable and will be asserted by the u.s. and its treaty partner, then further examination is warranted of residence-based taxation. two principal scenarios for u.s.-residence-based tax will be described. in the first, a u.s. citizen performs services in another country in respect of which contributions are made by him or his employer to a foreign retirement arrangement; the individual remains a u.s. citizen (though perhaps resident outside the united states) when distributions are eventually made to him from the foreign retirement arrangement. see table 2, row 8, page 360. in the second scenario, a nonresident alien performs services in a foreign country in respect of which contributions are made to a foreign retirement arrangement; the individual retires in the u.s. and is a u.s. resident at the time of receiving retirement distributions from the foreign plan. see table 2, row 10, page 361. a. u.s. citizen who works in foreign country before retirement in the u.s. 1. imposition of u.s. tax.-unlike almost all other countries, 5 the u.s. taxes its citizens on their worldwide income, regardless of where they may be resident.5 6 however, a u.s. citizen or resident present in a foreign country for an extended time may exclude from income up to $70,000 of foreign earned income annually pursuant to section 911.257 foreign income taxes paid by a u.s. citizen with respect to compensation for services 255. apparently, the only other countries taxing worldwide income on the basis of citizenship are the philippines and eritrea; however, mexico had such a regime prior to 1981. see jct report on expatriation, supra note 129, app. at b-1. 256. see supra note 77. 257. remuneration paid to a u.s. citizen for services rendered abroad to a u.s. or foreign employer are subject to income tax withholding to the extent the remuneration exceeds the allowable § 911 exclusion and is not subject to foreign withholding. rev. rul. 92-106, 1992-2 c.b. 258 (situations 1 and 2). the exemption from withholding for the § 911 exclusion amount is not available to a u.s. resident. id. at 259. if the remuneration is paid by an "american employer," as defined in §§ 3121(h) and 3306(j)(3), it is also subject to fica and futa taxes. id.; see bissell, supra note 80, at 146-47; see also supra note 81 and accompanying text. as explained by bissell, "[iut is believed that the irs does not actively enforce [the requirement that a foreign employer perform u.s. wage withholding] except possibly where the foreign employer is a payroll subsidiary owned by a u.s. company and located in a foreign tax haven." see bissell, supra note 80, at 146. [vol. 3:6 u.s. income taxation of cross-border pensions performed abroad may be creditable against u.s. tax under section 901. however, no credit is allowable with respect to foreign taxes attributable to income excluded by section 911.2's a u.s. citizen working overseas may be able to continue making contributions to a u.s. deferred compensation plan.s9 whereas taxation of contributions to a qualified u.s. pension plan will be deferred for u.s. tax purposes, there may be a current tax in the country where the services are performed.26 in addition, no exemption is available from u.s. tax under section 911 for the eventual distributions"' from the plan because section 911 is inapplicable to deferred compensation ' (although some wish to 258. irc § 911(d)(6); regs. § 1.911-6(c)(1). 259. for example, the worker's employer may be a u.s. corporation with a qualified plan who sends the employee to a foreign branch operation. a u.s. multinational employer may arrange for the employee to be "seconded" to a foreign subsidiary (so that the employee's employment relationship and pension plan coverage remain with the u.s. parent company). see ellis & navin, supra note 72, at 9, 18-24 (discussing this possibility for an "outbound executive"); see also bissell & giardina, supra note 72. at 276-78. 260. see ellis and navin, supra note 72, at 24 ("[t]he local tax rules may provide for taxation when the contribution is made to the plan, allocated to a plan account on the executive's behalf or when the executive vests in the contribution." the "vesting date" is "the most likely date" for "a number of countries (e.g., brazil, germany and spain)." whereas in the u.k. it is "when [the executive] first becomes entitled to receive payment under the plan."). see also bissell & giardina, supra note 72, at 277-78 ("as a general rule, most foreign countries do not attempt to tax employer contributions to an actuarially-based defined benefit pension plan located in an employee's home country. in contrast, most foreign countries do not respect the salary reduction portion of a u.s. § 401(k) plan, and will tax the employee on his own contributions to the plan if they know about it."). 261. similarly, it cannot be argued that the employee has an investment in the contract in the amount of employer contributions that would have been excludable under § 911 if paid directly to the employee. see irc § 72(f); rev. rul. 72-149, 1972-1 c.b. 218. this rule applies only to services performed after 1962. id. 262. section 911 does not apply to: (1) any compensation "received after the close of the taxable year following the taxable year in which the services are performed," (2) any amounts "received as a pension or annuity" and (3) any amounts "included in gross income by reason of § 402(b) (relating to ... nonexempt trusts)." irc § 911 (b)(1 (b)(i). (iii), (iv). these restrictions were added to the code in 1962. see h.r. rep. no. 1447, 87th cong., 2d sess. 54 (1962), reprinted in 1962-3 c.b. 405, 458. congress denied the § 911 exclusion for an amount paid as a pension because "congress thought it discriminatory to allow [an employee who worked abroad] to retire in the united states next to another individual who had worked in the united states for the same employer and who was fully taxable on the contributions made by the employer." gen. couns. mem. 36.345 (july 23, 1975) (citing s. rep. no. 1881, 87th cong., 2d sess. 74-75 (1962). reprinted in 1962-3 c.b. 780-81); see also h.r. rep. no. 1447, 87th cong., 2d sess. 54-55 (1962), reprinted in 1962-3 c.b. 405,458-59. congress denied the § 911 exclusion for deferred compensation (received after the end of the taxable year following the year of performance of the services) because it saw "no reason... to provide [a] special inducement for overseas employment long after the period in which the 19961 florida tax review change this).263 a u.s. citizen working abroad may alternatively2l participate in a foreign deferred compensation plan.265 a foreign retirement plan is almost certain to be a nonqualified plan for u.s. tax purposes.266 as a result, employer contributions to a funded plan are taxed under section 402(b) 267 employment occurred." id. at 55. the committee report further noted that "this will treat deferred compensation under the exclusion the same as qualified pensions." id. 263. legislation introduced by representative bill alexander in 1992 would expand the scope of § 911 to reach deferred compensation income. h.r. 4562, 102d cong., 2d sess. (1992). under the proposal, "[a]mounts received after the close of the taxable year in which the services to which the amounts are attributable are performed shall be excluded ... without regard to the taxable year in which they are received." id. § 2(a) (adding new § 911 (c)(3), and in effect repealing § 911(b)(1)(b)(iv)). further, the current law's denial of a § 911 exclusion for a pension or amount included in income under § 402(b) is in effect reversed; the § 911 exclusion is not denied for "so much of any amounts received as a pension ... as is attributable to personal service rendered outside the united states during the periods for which the taxpayer met" the eligibility requirements; nor is the exclusion denied for "amounts received or otherwise includible in gross income under a foreign pension, annuity, or trust (except to the extent that such amounts are attributable to personal services rendered within the united states .... id. (adding new § 911 (c)(5)(a), (b), and in effect repealing current § 91 1(b)(1)(b)(i) and (iii)). 264. see ellis & navin, supra note 72, at 30-31 for a discussion of "reasons" for participating in foreign deferred compensation plans. 265. assuming that the foreign deferred compensation plan is not a u.s. qualified plan, then an employee's participation in it will not be a barrier to making deductible contributions to an ira. id. at 31 (citing irc § 219(g)(1), (5)). 266. id. they consider it "highly unlikely that a foreign retirement plan would ever satisfy the tax qualification requirements set forth in irc § 401(a)." id. they note that "very few jurisdictions in the world [have] private pension requirements as complicated" as these, and, even though there are "similar schemes" in canada, u.k., and australia, "few rules are the same." id. see also letter from raymond j. wiacek to leonard b. terr, international tax counsel, (aug. 10, 1988), reprinted in 88 tni 38-32 (sept. 21, 1988) (lexis, fedtax library, tni file) [hereinafter wiacek letter to terr] (noting that although canadian pension arrangements may be "analogous to u.s. retirement vehicles" a canadian registered pension plan "does not constitute a 'qualified' plan for u.s. purposes, because canadian requirements are different from those set forth in section 401 of [the] code."). the fact that the pension trust is not organized under u.s. law is not in itself disqualifying if all of the other requirements of § 401(a) are met. see § 402(e)(5), which was repealed and reinstated as § 402(d), by small business job protection act of 1996, pub. l. no. 104-188, § 1401(b)(13), 110 stat. 1755 (effective for tax years after december 31, 1999). 267. see walker & olson, supra note 22, at 98: [section 402(b) will] generate a tax liability for resident aliens accruing benefits in a foreign plan that is funded, whether or not the foreign plan is a tax-preferred vehicle for accumulating retirement savings in the foreign country. to avoid this result, the foreign employer needs to consider delaying the funding of benefits ... or make the benefit that is being funded subject to a substantial risk of forfeiture until the individual is no longer a u.s. resident. [vol. 3:6 u.s. income taxation of cross-border pensions when made, if they are vested; otherwise, the value of the employee's interest at the time of vesting is included ; the amounts so included are not eligible for section 911 exclusion.m9 one might anticipate problems in applying these provisions when separate accounts are not maintained for each employee, for example in a defined benefit plan.270 moreover, if the employee is a "highly compensated employee" and the plan fails to meet certain "participation" or "coverage" requirements of a qualified plan,"' he or she is taxed currently under section 402(b)(4)(a) on the amount of his vested accrued benefit.272 id. walker & olson state that "[w]hile the effect of section 402(b) on aliens most likely was not considered when the statute was enacted, the provisions do not exclude such employees." id. at 95 n.28. they suggest that "[i]n an increasingly global economy, the adverse consequences will be more noticeable." id. see also letter from raymond j. wiacek to peter barnes, associate international tax counsel (jan. 25, 1990). reprinted in 90 tni 8-54 (feb. 21, 1990) (lexis, fedtax library, tni file) [hereinafter wiacek letter to barnes] ("because [canadian] registered plans are not qualified plans under the code, canadian citizens resident in the u.s. and u.s. citizens (wherever resident) who are covered by registered plans are required under section 402(b) to include in their income contributions by their employer... to the extent the employees' benefits under the plan are vested"); kpmg letter, supra note 161 ("section 402(b) will subject a u.s. citizen to u.s. income tax as the individual becomes vested in the benefits of a canadian pension... plan."). 268. see regs. § 1.402(b)-l(a)(l), (b) (when interest that was nonvested becomes vested, the employee must include the value of his interest in the trust at the time of change); ellis & navin, supra note 72, at 31-32. 269. see irc § 91 l(b)(l)(b)(iii) (irc § 911 is inapplicable to amounts included in gross income under § 402(b)); ellis & navin, supra note 72, at 33. 270. see regs. § 1.402(b)-1(b)(2)(ii) (providing that in such a case "the value of an employee's interest in such trust shall be determined in accordance with the formula described in § 1.403(b)-l(d)(4) or any other method utilizing recognized actuarial principles that are consistent with the provisions of the plan.., and the method adopted by the employer for funding the benefits .. "); ellis & navin, supra note 72, at 32; wiacek letter to barnes, supra note 267; wiacek letter to terr, supra note 266. see also infra note 346 for a discussion of wiacek letter to terr. 271. see §§ 402(b)(4)(a), 401(a)(26). 410(b); ellis & navin, supra note 72, at 31 (explaining that most foreign retirement plans will attract the application of § 402(b)(4)(a) for an employee who is a "highly compensated employee" as defined in § 414(q)). they comment that: even if a foreign retirement plan covers the lesser of 50 employees or 40% of all employees (§ 401 (a)(26)), it probably will not cover a percentage of non-highly compensated employees which is at least 70% of the percentage of highly compensated employees covered by the plan (or satisfy alternative coverage requirements), and there are likely to be several other § 401(a) qualification requirements that will not be met. id. 272. in a 1996 amendment to the foreign trust rules, congress made clear that § 679 (dealing with foreign trusts having a u.s. beneficiary) is not applicable to a trust described in § 402(b). see §§ 679(a) and 6048(a)(3)(b)(ii), amended by small business job protection act 19961 florida tax review if a foreign retirement arrangement is unfunded by u.s. standards,273 then u.s. tax is delayed until payment of the deferred compensation.274 see table 2, row 7, page 360. this may be true of a foreign pension plan meeting the foreign country's requirements for an immediate employer deduction.275 although u.s. standards are necessarily applied, the irs recently showed some flexibility in applying its usual ruling guidelines for classifying a deferred compensation arrangement as unfunded in order to take into account the fact that the arrangement had to "comply with canadian tax law as well as united states tax law. 276 of 1996, pub. l. no. 104-188, § 1901(a), 1903(b), 110 stat. 1755, 1904-10 (effective for transfers after feb. 6, 1995). 273. see ellis & navin, supra note 71, at 32 (suggesting that "it may be possible to argue that § 402(b) is inapplicable where the foreign retirement plan is financed through book reserve accruals or other arrangements that do not constitute typical u.s. employee benefit plan trusts"; noting the absence of a definition of "employee's trust" in § 402(b) or the regulations thereunder; suggesting that reference should be made to the definition of a trust in regs. § 301.7701-4, and further noting that "an outbound executive may be taxable with respect to his interest in a foreign retirement plan pursuant to § 83 if it is funded but not otherwise subject to taxation under § 402 or § 403"). 274. see priv. ltr. rul. 93-32-038 (may 18, 1993), where the irs ruled that a deferred compensation agreement and trust established in canada (and modelled according to canada's income tax act as an employee benefit plan trust) by a canadian employer for a u.s. citizen employee did not result in any income for the employee until amounts were actually distributed or otherwise made available to the employee. the irs ruled that there was no transfer of property under § 83, no contribution to an employee's trust under § 402(b), and no inclusion under the economic benefit or constructive receipt doctrine prior to that time. id. see also ellis & navin, supra note 72, at 33 ("[to the extent that a foreign retirement plan is unfunded and participants receive benefits on a 'pay as you go' basis, the outbound executive is not taxable on the foreign retirement benefit until receipt."). 275. see feder, supra note 72, at 43-44 (most german pension plans are unfunded, with "[a]nnual additions to reserves for pension expenses deductible for german income tax purposes under a precise set of actuarial assumptions."). feder further notes that a u.s. executive participating in such a plan does not recognize income for u.s. tax purposes "until payment is actually made" to him. id. at 47. 276. priv. ltr. rul. 93-32-038 (may 18, 1993) (confirming unfunded status for a trust formed by a canadian sports team for the benefit of a u.s. citizen key employee). the irs considered that the formation of the trust in canada and the need to "comply with canadian tax law as well as united states tax law" was a "rare and unusual circumstance" justifying a ruling notwithstanding failure to follow the model format. id. the trust agreement provided that the employee "has the status of a general unsecured creditor," and the "material terms and provisions of the trust ... are enforceable" under canadian law. id. the ruling states as a proviso that "the provision in the trust requiring use of the trust assets to satisfy the claims of general creditors in the event of insolvency is enforceable by the general creditors of the employer under canadian as well as ... provincial law." id. (the trust at issue in that ruling followed the irs's model language but not its model format for a rabbi trust. rev. proc. 92-64, 1992-2 c.b. 422.) [vol 3:6 u.s. income taxation of cross-border pensions when a u.s. citizen or resident working overseas contributes to an individual retirement savings trust organized under foreign law, the consequences are similar to those of participating in a foreign employer-sponsored plan. contributions to such plans are not deductible for u.s. tax purposes. moreover, such plans may be viewed as grantor trusts under section 679 of the code,2" with the result that trust earnings are taxable to the beneficiary pursuant to section 671.278 2. foreign tax credit considerations.-u.s. taxation of deferred compensation of a u.s. citizen who works overseas may be duplicative of the host country's tax. in some cases, the host country will be prevented from imposing source-country taxation by the dependent services article of a treaty (where the "commercial traveler" test is met) or by the pension article of a treaty (if source-based tax would otherwise be imposed at the time of the pension payment). at the same time, the host country may seek to impose a residence-based tax; even if a treaty applies, the treaty tie-breaker rule may classify the individual as a resident of the host country, rather than the u.s.279 under the french or swedish treaties, employee contributions to a u.s. qualified retirement arrangement may be deductible in the host country. 280 as the residence country, the u.s. undertakes to mitigate international double taxation by the allowance of a credit under section 901 for foreign taxes paid with respect to foreign source income." assuming that all services are performed abroad, the entire amount of unfunded deferred compensation is treated as foreign source income (when paid); the entire amount of income arising from contributions to a foreign pension plan or from distributions from the plan would also be foreign source. in the case of a distribution from a u.s. qualified pension plan, only the amount represent277. see wiacek letter to barnes, supra note 267 (concluding that a canadian registered savings plan created as a trust by a u.s. citizen or resident would be subject to § 679); see also wiacek letter to terr, supra note 266. 278. see wiacek letter to barnes, supra note 267 (wiacek notes that if a canadian citizen with a rrsp trust establishes u.s. residence, the application of § 679 would be triggered. under the u.s.-canada income tax treaty, supra note 146. prior to the effective date of the 1995 protocol, the election to defer u.s. tax on the earnings pursuant to art. 29, 5 was not available to a canadian citizen.) wiacek argued that "[n]oncompliance here" is "potentially serious." wiacek letter to terr, supra note 266. on the other hand, "if. before establishing a u.s. residence, the canadian citizen uses his rrsp/rrif assets to purchase an annuity contract ... the u.s. trust taxation rules would never apply." and the purchase price of the contract would be the "investment in the contract" for purposes of § 72. id. 279. see ellis & navin, supra note 72, at 48-49. 280. see supra notes 193-200 and accompanying text. 281. see irc § 901. 1996] florida tax review ing contributions in respect of services abroad is foreign source; the amount representing "accretions" is from u.s. sources.282 however, effective use of the foreign tax credit may be hindered by timing differences under u.s. and foreign tax rules.283 thus, for example, contributions to, or accretions in, a foreign funded pension plan may be eligible for deferral under foreign law;' in that case, u.s. taxation of the employee will precede foreign taxation. in the year that foreign taxation is imposed, the employee may have no foreign source taxable income for purposes of the section 904 credit fraction. a carryback of the credit is permitted only to the two preceding years.285 3. treaty provisions.-the recently negotiated treaties with france and canada provide some relief for such mismatching.286 under canadian tax rules, taxation of the earnings of a canadian registered retirement savings plan is deferred until distribution; however, the failure of such a savings plan to qualify as an ira under section 408(a) results in immediate u.s. taxation of the earnings to a beneficiary who is a u.s. citizen or resident. under article 29, paragraph 5 of the u.s. tax treaty signed with canada in 1980,287 282. see rev. rul. 79-389, 1979-2 c.b. 281 (a distribution to a u.s. citizen from a u.s. pension plan is treated as u.s. source for purposes of § 904 to the extent of "accretions" and contributions made with respect to services performed in the u.s.); rev. rul. 78-227, 1978-1 c.b. 242 (distributions from a foreign service retirement annuity that were attributable to current congressional appropriations were considered to be "employer contributions" and thus sourced for purposes of § 904 on the basis of the place where services were performed.); rev. rul. 84-144, 1984-2 c.b. 129 (amounts withdrawn from an ira established by a rollover from a qualified pension plan were foreign source, for purposes of § 904, only to the extent attributable to employer contributions with respect to wages earned abroad.). see also bissell & giardina, supra note 72, at 277 (noting that § 402(d)(7) creates a separate foreign tax credit basket for a "lump sum distribution from a qualified plan"). 283. see rev. proc. 89-45, 1989-2 c.b. 596 (implementing provision of u.s.canada income tax treaty designed to avoid such a "mismatch"). see also penny mavridis, a cross-border view: election to defer u.s. income tax on earnings of canadian registered savings plan, 24 tax mgmt. int'l j. 382 (1995). 284. see supra notes 66-71 and accompanying text for a discussion of the tax treatment of pensions in other countries. 285. irc § 904(c). section 904(c) also allows carryover to the five succeeding years. 286. see u.s.-france income tax treaty, supra note 135, at 3001.04, 27005-13; u.s.-canada income tax treaty, supra note 146, at t.i.a.s. 11087, 27. 287. see u.s.-canada income tax treaty, supra note 146, art. 29, 5; see also treasury department technical explanation of the convention between the united states of america and canada with respect to taxes on income and on capital, signed at washington, d.c. on sept. 26, 1980, as amended by the protocol signed at ottawa on june 14, 1983 and the protocol signed at washington on mar. 28, 1984, 1986-2 c.b. 295, reprinted in tax treaties (cch) 1950, 21,089 (explaining that the intent is to "resolve conflicts between the canadian and u.s. treatment of individual retirement accounts") [hereinafter treasury [vol 3:6 u.s. income taxation of cross-border pensions the beneficiary of an rrsp can make an election' to defer u.s. tax on the earnings until distribution 9 to the extent the earnings are attributable to contributions made during a period of canadian residency.' the march 17, 1995 protocol to the canadian treaty extends this election to allow deferral of canadian tax by beneficiaries of u.s. retirement plans, and includes any retirement plan exempt from taxation in its residence country and operated exclusively to provide pension, retirement or employee benefits."' similar relief is provided in the u.s. treaty with france.' article 18, paragraph 2(c) provides that payments received by a beneficiary resident in one contracting state in respect of a pension or other retirement arrangement established in and recognized for tax purposes by the other contracting state shall be included in income in the contracting state of the beneficiary's department technical explanation of the u.s.-canada income tax treaty]; klein. supra note 72, at 382. 288. see rev. proc. 89-45, 1989-2 c.b. 596 (establishing procedure under which beneficiary elects deferral); mavridis, supra note 283, at 382-84. 289. the eventual distribution is taxed pursuant to § 72. rev. proc. 8945, 1989-2 c.b. 596. under rev. proc. 89-45, the investment in the contract in the case of a 'person who is a u.s. citizen in all years for which contributions are made to the plan ... is the sum of: (i) [e]mployee contributions from after-tax (that is, after u.s. tax) earnings, and (ii) [elmployer contributions included in the u.s. gross income of the employee. . ." if the person is not a u.s. citizen or a u.s. resident in any years for which contributions are made to the plan, the gross investment in the contract ... is equal to the lesser of (a) the fair market value of the assets in the plan at the time the beneficiary became a u.s. citizen or resident, or (b) the sum of contributions to the plan plus earnings accrued in the plan at the time the beneficiary became a u.s. citizen or resident. id. 290. see protocol amending u.s.-canada income tax treaty, june 14, 1983, art. 13, 4, t.i.a.s. 11087,72 [hereinafter 1983 protocol] (stating that the deferral privilege "shall not apply to income which is reasonable [sic] attributable to contributions made to the plan by the beneficiary while he was not a resident of canada"). but see 1995 revised protocol supra note 178, art. 9, 1 3, and art. 17, 9 2, reprinted in tax treaties [cchj 11946, 21,043-6, 21,043-11 (eliminating the residence requirement). 291. see 1995 revised protocol, supra note 178, art. 9. j 3 (adding new 7 7 to art. 18 of the u.s.-canada income tax treaty) and art. 17, 1 2 (replacing art. 29, 1 5 of the treaty); joint comm. on tax'n, explanation of proposed protocol to the income tax treaty between the united states and canada, supra note 178; treasury explanation of revised protocol to u.s.-canada treaty, supra note 178, 1 1952, 21,091-5 (discussing art. 9 of the protocol); see also notice 96-31, 1996-22 i.r.b. i (may 28, 1996) (specifying that the provisions of the protocol apply to a rrsp or rrjf). 292. u.s.-france income tax treaty, supra note 135, art. 18, j 2(c). a similar provision was added to the 1967 u.s.-france income tax treaty by a protocol signed jan. 17, 1984; the provision originally arose in a "side letter to the 1978 protocol for the purpose of providing french benefits to u.s. citizens resident in france." treasury department technical explanation of u.s.-france income tax treaty, supra note 135, j 3058, 27,197-31. 19961 florida tax review residence "when and to the extent such payments are considered gross income by the other contracting state." thus, for example, if a u.s. citizen came to work in france as a french resident,293 but contributed to a u.s. qualified pension plan, the contribution would be deductible (pursuant to paragraph 2(a) of article 18) for french tax purposes, and france would not tax accrued benefits in the plan until such benefits would be taxed by the u.s.294 the treaty with canada contains a further provision, which is designed to prevent mismatching in the situation where the source country imposes tax earlier than the residence country. under this provision, the residence country must exempt "the amount of any ... pension that would be excluded from taxable income" in the source country if the recipient were resident there.295 thus, if canada as the source country had imposed a 293. staff of the joint comm. on tax'n, explanation of proposed protocol to the tax treaty between the united states and france, jcs 22-84, apr. 26, 1984, reprinted in 87 tni 53-44 [hereinafter staff of the joint comm. on tax'n, explanation of 1984 protocol to the u.s.-france income tax treaty]; report of the senate foreign relations committee on the protocol signed on jan. 17, 1984 to amend the income tax treaty with france (cch) 3053, 27,163 ("[a] u.s. citizen residing in france... may be required to include benefits received from a u.s. retirement plan in income for french tax purposes when distributed since, under u.s. internal law, an employee's benefits from or under a qualified plan ... generally are includible in income when distributed.") [hereinafter senate foreign relations comm. report on the 1984 protocol to u.s.-france income tax treaty]. 294. paragraph 2, subparagraph (c) of art. 18 refers back to "an arrangement referred to in subparagraph (a) that satisfies the requirements of this paragraph.. . ." this may mean that relief is limited to the situation where, as described in subparagraph (a), a national of one country who is working and resident in the other country contributes to a plan in his country of nationality. however, the provision is apparently potentially applicable to the case of a u.s. citizen who contributes to a u.s. plan while his principal place of employment is in the u.s. and later resides in france; this can be inferred from the fact that the provision is made "subject to" art. 24, which provides in such a case for france to grant a credit (in the amount of the french tax otherwise due) with respect to such pension income. u.s.-france income tax treaty, supra note 146, art. 24, 2(b)(iv); see also senate foreign relations comm. report on the 1984 protocol to u.s.-france income tax treaty, supra note 293, 3053, 27,163-64 (stating that if a u.s. citizen residing in france receives benefits from a u.s. retirement plan attributable to services while his principal employment "was in the united states (rather than in france or a third country), then the benefits will not be included in income for french tax purposes because such benefits are exempt from french tax under the treaty's double taxation relief article"). it is not as clear that the provision could be applied to defer u.s. tax for a u.s. citizen who works in france and makes contributions to a french plan, and then resumes residence in the u.s. 295. 1983 protocol, supra note 290, art. 9, i, replacing art. 18, $ 1 of the treaty. as signed on sept. 26, 1980, the provision stated that the "amount of any pension included in income for the purposes of taxation" in the residence country "shall not exceed the amount that would be included" in the source country if the recipient were a resident there. u.s.canada income tax treaty, supra note 146, art. 18, 1. this language apparently left the implication that the residence country would have to grant a "personal allowance" granted by [vol. 3:6 u.s. income taxation of cross-border pensions current tax on contributions or accrued benefits in a pension plan and thereafter granted basis for such amounts, the u.s. could not, as the residence country, impose a tax on such amounts at a later time. a similar provision has been included as a limitation on the residence country in the 1996 u.s. model." article 18, paragraph 1 of this model provides that "pension distributions... shall be taxable only in" the residence state, "but only297 to the extent not included in taxable income in the other contracting state prior to the distribution.""5 the treasury explained that "[t]he exclusive residence-based taxation provided under... [article 18, paragraph 1] is limited to taxation of amounts that were not previously included in taxable income in the other contracting state."' 99 thus, "if a contracting state had imposed tax on the resident with respect to some portion of a pension plan's earnings, subsequent distributions to a resident of the other state would not be taxable in that state to the extent the distributions were attributable to such amounts. '"10° this provision will affect u.s. residence-based taxation of a pension only if u.s. tax is delayed until the time of the pension's distribution. therefore, this provision's impact will be only on (a) distributions from a u.s. qualified plan or an unfunded pension plan, or (b) in the case of the source country. to counter, this language was revised by the protocol of june 14, 1983, art 9, 1. 1983 protocol, supra note 290, art. 9, 9 1. under the revised version. if s5,000 of a $10,000 pension payment arising in the source country "would be excluded from taxable income as a return of capital" in the source country "if the recipient were a resident," then the $5,000 should be exempted by the residence country; at the same time, the fact that the source country "would also grant a personal allowance as a deduction from gross income if the recipient were a resident" would not result in an increase in the amount to be exempted by the residence country. treasury department technical explanation of the u.s.-canada income tax treaty, supra note 287, s 1950, 21,069. see also klein, supra note 72, at 382 (stating that the provision is "believed... to make any basis in the pension created in one country recoverable tax-free in the other country."). 296. 1996 u.s. model, supra note 2. this provision is not exempted from the savings clause. id. art. 1, 91 4; 1996 treasury explanation. supra note 2 1 259. this result is perhaps unintended. 297. 1996 u.s. model, supra note 2, art. 18, $ 1. this language is ambiguous due to the double use of the term "only." the language could be interpreted to mean that the residence country can tax the full amount in all cases, but that its jurisdiction to tax is not exclusive when the other country has previously taxed. however, the treasury's technical explanation does not adopt this interpretation. see infra notes 299-300 and accompanying text. 298. 1996 u.s. model, supra note 2, art. 18, 1. 299. 1996 treasury explanation, supra note 2, 1 246. 300. id. treasury states that "[i]n determining the amount of a distribution that is attributable to previously taxed amounts, the ordering rules of the residence state will be applied." id. in particular, "[t]he united states will treat any amount that has increased the recipient's 'investment in the contract' (as defined in section 72) as having been previously included in taxable income." id. 19961 florida tax review distributions from a funded nonqualified plan (u.s. or foreign), only to the extent benefits have avoided earlier u.s. taxation because the benefits are forfeitable or the individual is not a highly compensated individual. for example, suppose a u.s. citizen, who is resident and performing services in a treaty country, were to participate in a u.s. qualified pension plan and the treaty country were to impose a current tax on contributions and plan earnings (notwithstanding the 1996 model's rules limiting source taxation of home country pensionsa"1); upon retirement, the individual becomes a u.s. resident. under the 1996 u.s. model, the u.s. would be barred from taxing the distribution since that amount was already taxed by the other country.3°2 a further example would be the case of a u.s. citizen who performs services in a treaty country and participates in a pension plan located there, and who is not a highly compensated employee. the u.s. would impose a current tax on nonforfeitable contributions to the plan, but not on plan earnings. assume that the foreign country imposes a current tax on plan earnings and that, prior to the time of distribution, the individual becomes a u.s. resident. in that case, the u.s. would not tax any part of the distribution from the foreign plan. the contributions were previously taxed by the u.s.; and, under the 1996 u.s. model, the u.s. is barred from taxing the earnings because they were previously taxed by the other country. 4. possibilities for manipulation of timing differences.-in an entirely domestic context, deferral of an employee's tax liability with respect to nonforfeitable retirement benefits is conditioned upon compliance with the rules for qualified pension plans (or iras) or upon deferral of the employer's deduction for compensation and treatment of the employer as continued owner of the pension assets. these conditions can be avoided in some cases when a foreign employer creates a hybrid retirement arrangement for a u.s. citizen employee.303 for example, the foreign employer may establish a cayman islands trust to secure the employer's liability to pay deferred compensation to the u.s. citizen employee; the cayman islands trust may be viewed as a grantor trust by the u.s., but as a separate taxpayer by the employer's home country. in that case, the employee is not subject to u.s. tax on the deferred compensation until it is distributed to him. assuming that the employer is not engaged in the conduct of a u.s. trade or business, the employer is 301. see 1996 u.s. model, supra note 2, art. 18, 6; see also supra notes 190-203 and accompanying text. 302. this example and the subsequent example assume an exception to the savings clause. see supra note 296. 303. ordower, supra note 72, at 322-35 (analyzing this type of arrangement and its tax consequences for employer and employee). [vol 3:6 u.s. income taxation of cross-border pensions indifferent to the deferral for u.s. tax purposes of the allowance of a deduction for compensation. nor will the employer be subject to u.s. tax on the investment income derived from the trust assets, provided that the assets are invested outside the u.s. or in bank deposits or bonds yielding portfolio interest.3° at the same time, the home country of the employer may allow the employer an immediate deduction for assets contributed to the trust, and may not seek to impose any tax on the income of the cayman islands trusl 3 5 however, the situations where such benefits are fully available may be fairly limited.3° if the u.s. citizen is employed outside the u.s. (e.g., in the home country of the employer), he may be subject to an immediate foreign tax on the deferred compensation; the employee will subsequently incur the u.s. tax without any possibility of a section 911 exemption and with a risk that the foreign tax credit will be lost because of delay in the inclusion of the foreign source income for u.s. tax purposes.m if the employee performs his services for the foreign employer in the u.s., the employee avoids foreign tax liability. on the other hand, if services are performed by the employee in the u.s. in connection with a u.s. business of the employer, the employer will not be indifferent to the u.s. tax treatment of the trust.3c)' those in the best position to benefit from such a hybrid arrangement may be (a) an offshore investment company employing a u.s. citizen employee to perform services in the u.s. as its investment advisor or broker,3 9 or (b) a foreign employer employing a u.s. citizen employee to temporarily provide business or engineering expertise with respect to nonu.s. activities of the employer.1 the clinton administration's february 1995 proposal 311 to curb 304. id. at 322-26. moreover, the u.s. citizen employee avoids the impact of §§ 551-558, 951, or 1291-1295. id. at 325, 329 & n.157. 305. id. at 323. 306. id. at 328-29. 307. id. at 329-33. 308. id. at 333-35. 309. id. at 329. the employee's performance of services in the u.s. can be arranged in such a way as to avoid "u.s. business" status for the employer. id. (citing § 864(b)). 310. id. 311. treasury explanation of clinton's proposals to "curb foreign tax avoidance": tax responsibilities of americans renouncing u.s. citizenship, 95 tni 26-24 (feb. 8. 1995) (lexis, fedtax library, tni file). the treasury stated concern with "[wlealthy foreign families [who] set up foreign trusts which benefit a u.s. family member." id. the treasury explained that "income generated by foreign trust assets frequently is not taxed in any country;" this occurs because "[mlany foreign jurisdictions do not consider the foreign grantor to be the owner of the trust assets, and trusts are normally established in jurisdictions which do not impose tax on trust income." id. because the u.s. treats the trust assets as owned by the foreign family, the u.s. views the "distribution of trust income to the u.s. beneficiary... 1996] florida tax review abuses involving foreign trusts might have interfered with the desired effects of such an arrangement. under the proposal, the grantor trust rules would not be applied unless the effect would be to require current income inclusion by a u.s. citizen or resident or a domestic corporation.3 2 however, the version finally enacted in 1996 provides an exception for trusts used to pay compensation. 3 5. lack of citizenship jurisdiction in most countries.-as noted, hardly any of the trading partners of the u.s. impose tax on the basis of citizenship.1 4 thus, nationals of other countries who earn deferred compensation while living and working in the u.s. can avoid any risk of current taxation in their country of nationality if they are considered resident in the u.s. for example, canada does not impose its tax on an individual who is a canadian citizen-u.s. resident with respect to employer contributions to, or accrued earnings of, a qualified u.s. pension plan or a canadian registered pension plan because canadian taxation is based on residency." 5 in many cases, deferred compensation payments made to such individuals after reestablishing residence in their country of nationality may also be exempt from tax in such country.316 as a nontaxable gift." id. under the administration's proposal, the "trust income would be taxed" by the u.s. "when distributed to u.s. beneficiaries." id. 312. h.r. rep. no. 981, 104th cong., 1st sess. (1995) (section 204 of the bill amends irc § 672(f)(1) to provide that subpart e (the grantor trust rules) "only apply to the extent such application results in an amount being included in gross income of a citizen or resident of the united states or a domestic corporation."). 313. conference report for small business job protection act of 1996, h.r. rep. no. 3448, 104th cong., 2d sess. (1996) (enacted). under the final version, § 672(f)(2)(b) is amended to state that: "except as provided in regulations, paragraph (1) shall not apply to any portion of a trust distributions from which are taxable as compensation for services rendered." id. § 1904(a)(1). apparently congress concluded that if the trust distributions are subject to u.s. tax as compensation, the type of abuse of concern to treasury was not present. 314. see supra note 255. 315. see letter from raymond j. wiacek to peter barnes, office of int'l tax counsel (oct. 3, 1988), reprinted in 88 tni 43-40 (oct. 26, 1988) (lexis, fedtax library, tni file). see also bissell & giardina, supra note 72, at 282 ("[a] foreign national working in the united states would usually not be subject to foreign tax on current accruals in a u.s.based serp because most foreign countries do not impose personal income tax on their citizens who are resident in another country."). 316. see ellis & navin, supra note 72, at 88 ("many foreign countries (e.g., the u.k.) will exempt deferred compensation payments from tax if they were earned during a period of u.s. residence" although "some foreign countries (e.g., italy and switzerland) may tax these payments."). see also e.a. nicholson & thomas st.g. bissell, tax planning for foreign nationals working in the united states, 1992 intertax 55, 58 (placing belgium, germany and u.k. in the former category and italy, switzerland, and sweden in the second). [vol. 3:6 u.s. income taxation of cross-border pensions b. alien performs services outside the u.s. and receives payments of deferred compensation after becoming u.s. resident 1. results under the internal revenue code.-assume that a citizen of country x spends his working years employed in country x by a country x employer who makes contributions for the employee to a country x qualified pension plan. assume, however, that this individual takes up permanent residence in florida at the time of his retirement and is treated by the u.s. as a resident alien and is no longer classified as a resident by country x tax authorities.1 7 see table 2, row 10, page 361. if the country x tax rules regarding pensions are the same as in the u.s., then country x would defer taxation of amounts contributed to the plan until distributed to the employee. country x tax rules may or may not provide for taxation of the eventual distribution. this would depend upon whether country x seeks to retain jurisdiction to tax items that have accrued to a long-term resident prior to his departure; it also depends upon whether country x asserts a source-based tax over pensions by reason of the location of the services or the situs of the trust. 31 in this situation, even though the u.s. taxes its residents on worldwide income, u.s. taxation of the entire distribution is not assured. if the pension plan in country x is classified by u.s. standards as an unfunded plan (despite the contrary result under country x law),319 then the u.s. will treat distributions from the plan as foreign-source compensation income, taxable in full and ineligible for section 911 relief (because it is deferred). see table 2, row 9, page 361.yt if, however, the u.s. agrees with country x's 317. see, e.g., tech. adv. mem. 89-11-001 (sept. 27, 1988). reprinted in 89 tni 13-42 (mar. 29, 1989) (lexis, fedtax library, tni file) (involving a canadian citizen who receives pre-retirement distributions from a canadian pension plan after becoming a u.s. resident alien). 318. for example, norway imposes its income tax on "[all remuneration (including pension distributions) derived from employment in norway or paid to a manager or member of the board of directors of [a] company resident in norway ... " ict report on expatriation, supra note 129, at b-5. "a business... distributing pension benefits is responsible for withholding taxes on such income regardless of the individual's country of residence," e.g., even if he is a former resident. id. denmark imposes its income tax on "[p]ension distributions received by nonresidents from danish pension plans ... but many tax treaties effectively override this provision of danish law." id. at b-8. 319. see supra note 276 and accompanying text. for example, the plan may be a "rabbi trust," for u.s. tax purposes, but country x may view a plan secured by such a trust as a funded plan. 320. in priv. ltr. rul. 96-28-024 (apr. 16, 1996), the irs ruled that an individual, who becomes a resident alien after performance of services and before payment, is taxable as a resident on the compensation paid, regardless of its source. the results in the ruling were not affected by the relevant treaty because of the applicability of the savings clause. id. 19961 florida tax review characterization of the plan as funded, then the distribution will be viewed as a return of capital at least to the extent of amounts previously contributed to the plan (by employee or employer). see table 2, row 10, page 361. because the foreign plan would in all likelihood be "nonqualified" for u.s. tax purposes, distributions from the plan would be subject to the rules of section 402(b) and thus the rules of section 72.32' for this purpose, investment in the contract takes account not only of employee contributions, but also of contributions made by the employer that either (a) were includible in the employee's gross income for u.s. tax purposes at an earlier time or (b) would not have been so includible if paid directly to the employee at the time of contribution. 22 in the example given, the employer contributions do not meet condition (a) since they were not includible in gross income of the employee for u.s. tax purposes when made; however, the employer contributions do meet condition (b); that is, even if the employer contributions had been paid directly to the employee, they would not be includible because the employee was a nonresident alien receiving compensation for services performed outside the u.s. 323 thus, these contributions are, pursuant to section 72(t), considered part of the investment in the contract (even though not yet taxed in the u.s. or in country x). 32 4 thus, only the portion of the distribution representing "earnings and accretion" is treated as income by the u.s. this income would apparently be foreign source income (as coming from a foreign situs trust) for purposes of determining a foreign tax credit.325 321. see tech. adv. mem. 89-11-001, supra note 317. 322. irc § 72(0. see tech. adv. mem. 89-11-001, supra note 317 (citing rev. rul. 58-236, 1958-1 c.b. 37). 323. see tech. adv. mem. 89-11-001, supra note 317; walker & olson, supra note 22, at 98 (discussing exclusion under irc § 872); rev. rul. 58-236, 1958-1 c.b. 37, 38-39. 324. tech. adv. mem. 89-11-001, supra note 317 (citing rev. rul. 58-236, 1958-1 c.b. 37). see walker & olson, supra note 22, at 98; see also bissell & giardina, supra note 72, at 278-79. walker & olson argue that this analysis is supported by the supreme court's opinions in biddle v. commissioner, 302 u.s. 573 (1938) and united states v. goodyear tire & rubber co., 493 u.s. 132 (1989) (requiring application of u.s. tax principles in applying the foreign tax credit rules). see also kpmg letter, supra note 161 ("[a] canadian citizen resident in the u.s. will be subject to u.s. income tax to the extent vesting [in a canadian pension plan] occurs after the u.s. residence is established."); michael j. canan, qualified retirement and other employee benefit plans § 23.6, at 1094-95 n.3 (practitioner ed. 1995) (noting that the fact that basis is granted for employer contributions made to a foreign pension plan on behalf of a nonresident alien "may open the door for planning opportunities with respect to deferred compensation or retirement income paid while the individual was a nonresident alien."). 325. see supra note 282 and accompanying text. [vol. 3:6 u.s. income taxation of cross-border pensions it has been suggested that the u.s. will in many cases not tax even the "earnings and accretion" portion of the distribution. if the employee is considered under u.s. tax rules to be a "highly compensated employee" and the pension plan does not meet the nondiscrimination rules applied to u.s. qualified plans, then the investment in the contract might include the entire amount of the vested accrued benefits.3" if the individual had been a u.s. citizen or resident throughout his employment, he would have been taxed annually pursuant to section 402(b)(4)(a) on the amount of his vested accrued benefit (other than his investment in the contract); presumably for this purpose, amounts once included under this provision would thereafter be treated as investment in the contract. 327 in support of this result, one might argue by analogy to section 72(f) (which deals only with employer contributions) that investment in the contract should also include amounts that would have been taxed annually to an alien under section 402(b)(4)(a) but for his status at the time as a nonresident and the foreign source of the income.31 more generally, one might argue that under u.s. timing rules, the appropriate time to tax would have been as the vested benefit accrued; thus, as the benefits accrued, basis is created (even though the u.s. was in fact unable to tax because of the individual's nonresident alien status).329 under this theory, the fact that the u.s. did not 326. see walker & olson, supra note 22, at 98 (stating that the biddle. 302 u.s. 573 (1938), and goodyear, 493 u.s. 132 (1989), decisions by the supreme court "and the enactment of section 402(b)(2) arguably enable the noncitizen taxpayer who is an hce participant in a plan that does not satisfy the rules of sections 410(b) or 401(a)(26) to count as investment in the contract any earnings that accrued during a period of nonresidency."). 327. see regs. § 1.402(b)-l(b)(5) ("the basis of any employee's interest in a trust to which this section applies shall be increased by the amount included in his gross income under this section."). see also ellis & navin, supra note 72, at 32. however, this is not clearly a reference to inclusions pursuant to § 402(b)(4)(a), which are not discussed in regs. § 1.402(b)-i). as noted above, the irs is unwilling to rule on the treatment of distributions to a highly compensated employee, in the absence of a technical correction to § 402(b)(4)(a). see supra note 39. 328. see walker & olson, supra note 22, at 98 (suggesting that § 72(f)'s "focu[s] on contributions rather than accrued benefits" is due to the fact that "it was enacted before section 402(b)(2)."). (section 402(b)(2) was relocated at § 402(b)(4)(a), as a result of the unemployment compensation amendments of 1992, pub. l. no. 102-318, § 521(a), 106 stat. 300, 301 (1992)). 329. walker & olson, supra note 22, at 98 n.26 (citing tech. adv. mem. 87-49-008 (aug. 18, 1987)). in that technical advice memorandum, the irs national office ruled on the proper determination of the adjusted basis of a foreign corporation's depreciable property that was placed in service in a foreign country in 1967 but then used in a business in the u.s. beginning in 1975. tech. adv. mem. 87-49-008 (aug. 18, 1987). the national office concluded that the adjusted basis should reflect depreciation allowable under u.s. principles beginning in 1967, even though no u.s. tax return was required to be filed prior to 1975 and the depreciation was attributable to income not subject to u.s. tax. id. see also gen. couns. 19961 florida tax review have jurisdiction (either source or residence-based) to tax at that time should not permit it to tax at a later time when it acquires residence jurisdiction. a similar approach seems to be accepted by the irs in implementing article 29, paragraph 5 of the u.s.-canada treaty, providing for deferral of u.s. tax with respect to certain earnings accrued in a canadian registered retirement savings plan (rrsp).33° the irs has taken the position that when a person becomes a u.s. resident or citizen only after making all contributions to a rrsp, the gross investment in the contract under section 72(c)(1)(a) is "the sum of the contributions to the plan plus earnings accrued in the plan at the time the beneficiary became a u.s. citizen or resident" (or, if lesser, "the fair market value of the assets in the plan at the time the beneficiary became a u.s. citizen or resident").33' 2. results under treaties a. treatment by country x.-if a treaty (following the oecd or u.s. model) were in effect between the u.s. and country x in the above-described situation, country x would surrender its right to assert source-based tax jurisdiction over the pension payments because its national had become a u.s. resident. it is possible, however, that country x would assert a residence-based tax, focusing on the employee's continued citizenship in country x or on his long-term residence in country x, and seek to protect this jurisdiction in its mem. 34,572 (aug. 3, 1971), where the chief counsel concluded that when "a nonresident alien acquires property before becoming a u.s. resident and then sells the property after such date ... the general statutory basis provisions set forth in sections 1001 and 1011 ... are applicable .... general counsel acknowledged "that a strictly 'equitable' approach ... might possibly dictate use of a 'special basis' . . . such as, a basis equal to the fair market value... upon taxpayer's initial entry into the united states .... id. however, it explained that: "the present basis provisions of the code cannot be so interpreted .. " id. in support of this interpretation, chief counsel cited the case of gutwirth v. commissioner, 40 t.c. 666 (1963), acq. in result, 1966-2 c.b., where the tax court had to determine the loss to be claimed for war damage occurring in 1945 to a factory in antwerp that was owned by alien individuals who took up u.s. residence in 1939. the court held that the adjusted basis of the property included the original investment made in 1922 and 1923, increased by "subsequent capital additions" notwithstanding that "these additions were treated as expenses in belgium." id. at 678. the court held that the basis should also reflect downward adjustment for depreciation so as to avoid "discriminat[ing] in favor of resident aliens owning property abroad as against resident taxpayers in identical situations." id. at 679. 330. see supra notes 287-291 and accompanying text. the march 17, 1995 protocol has moved this provision to art. 18, 7 of the treaty. see 1995 revised protocol, supra note 290, art. 9, 3. 331. rev. proc. 89-45, supra note 283 (stating "[t]his amount does not include unrealized appreciation in the plan assets."). see mavridis, supra note 283, at 383-84 n.12. [vol 3:6 u.s. income taxation of cross-border pensions treaty with the u.s. such an approach is taken to some extent by finland, germany, the netherlands, norway, and sweden.332 for example, in finland, a finnish citizen who is also a permanent resident of that country is taxed by finland for three years after departing finland unless he maintains no "essential ties" with finland.33 in addition, a few countries may impose a form of "exit tax" on departing residents. 3 3 in particular, beginning in 1987, denmark imposes an exit tax on departing individuals who have been "resident for at least five of the preceding 10 years," with respect to "certain unrealized capital gains" and "certain pension contributions made in the five years prior to" the departure.335 in addition, since 1995, the netherlands imposes tax on the "fair market value of pension assets" at any time that they are removed from the netherlands, unless "the pension distributions will be taxed in the foreign jurisdiction in which a former resident lives at the time of the distribution. ' 6 b. treatment by united states.-on the other hand, pension articles in most treaties would not impose any limitation on the pension's taxation by the u.s. as the taxpayer's residence country. the lack of treaty impact is suggested in a 1989 technical advice memorandum, in which 332. see jct report on expatriation, supra note 129, at b-2 b-6. for example, "germany imposes a so-called 'extended limited tax liability' on german citizens who emigrate to a tax-haven country or do not assume residence in any country and who maintain substantial economic ties with germany .. " id. at b-3. under this rule, the emigrating citizen is taxed for 10 years "as a german resident on all income that is not treated as foreign source income for german tax purposes." id. however. "tax treaties generally take precedence" over this rule. id. under its treaty with monaco, france treats its citizens residing in monaco as residents for french income tax purposes. id. at b-2. the netherlands in its treaties seeks "to secure the right to tax the sale of substantial interests in netherlands' companies for a period of five years after emigration." id. at b-4. in norway, "[a] former resident may still be considered resident for purposes of the income tax if he keeps a home in norway which is not let out and is unable to prove that he is considered resident for tax purposes in the country in which he is living." id. at b-5. 333. id. at b-2. however, the treaty with the u.s. precludes application of this rule. id. at b-2, n.4. a citizen or resident of sweden cannot shed his resident status if he maintains "essential ties" with sweden; an individual who has been a resident of sweden for at least 10 years is presumed to remain a resident for five years after departing, unless he proves that he has not kept "essential ties." id. at b-6. 334. the staff of the joint committee has identified australia, canada. and denmark as falling in this category. id. at b-7-b-8. the australian exit tax applies to the appreciation in non-australian assets at the time residence is ended. id. at b-7. an individual giving up canadian residence "is deemed to have disposed of all capital gain property at its fair market value .. " id. 335. id. at b-8. 336. id. at b-5. 19961 florida tax review section 402(b) and section 72(t) were applied to a distribution from a canadian pension plan to a canadian citizen who retired in the u.s. there the irs stated that the treaty in effect with canada as of 1983 did not address these issues.337 the current u.s. treaty with canada does, however, provide a limitation on the taxation of pensions by the residence country; i.e., the residence country is required to exempt the amount of any pension that would be excluded from income in the source country if the recipient were resident there.338 the 1996 u.s. model contains a similar provision, barring the residence country from taxing a pension distribution to the extent attributable to amounts previously taxed by the other country.339 but these provisions do not seem relevant to a case where the source country (country x in the example above) has allowed deferral of tax on contributions and accrued benefits until distribution. of possibly greater relevance is article 18, paragraph 2(c) in the u.s.france treaty.' the staff of the joint committee describes this article as "provid[ing] that the timing and extent of taxation of pension benefits is determined under the laws of the source country."' this provision clearly applies to delay imposition of u.s. tax when contributions to a french pension plan are made on behalf of a french citizen working and residing in the u.s.34 2 it is not as clear, however, that this provision would apply if a french citizen working and residing in france and contributing to a french pension plan became a u.s. resident immediately before receiving distributions from the french plan. absent the treaty, the u.s. would never have imposed a tax on the french citizen, assuming that he or she is a "highly compensated employee" and all contributions are nonforfeitable. in that case, the proper time to tax, under u.s. timing rules, is as benefits accrue. because the individual was not a u.s. resident at that time and the income is from 337. tech. adv. mem. 89-11-001, supra note 317. the treaty signed sept. 26, 1980, did not go into force until aug. 16, 1984. 338. see u.s.-canada income tax treaty, supra note 146, art. 18, 1. 339. see 1996 u.s. model, supra note 2, art. § 18, 1, and supra notes 296-302 and accompanying text. 340. see supra notes 292-294 and accompanying text. 341. staff of the joint comm. on tax'n, explanation of proposed income tax treaty between the united states and the french republic, jsc 10-95, 32 (joint comm. print 1995) [hereinafter joint comm. on taxn's explanation of proposed u.s.-france income tax treaty]. 342. see supra text accompanying notes 292-294; staff of the joint committee on taxation, explanation of 1984 protocol to the u.s.-france income tax treaty, supra note 293 (stating that the protocol would "make reciprocal rules similar" to those applied to "americans in france" by the 1978 side note "so that french citizens resident in the united states, as well as u.s. citizens resident in france, can benefit"). [vol 3:6 u.s. income taxation of cross-border pensions french sources, no u.s. tax would be imposed. thus, if the treaty provision were applied to delay the u.s. tax until the time of distribution, when the individual had become a u.s. resident, the effect of the treaty provision would be to impose a u.s. tax that would never have been imposed by the internal revenue code. yet the french treaty (like most others) provides that the treaty "shall not restrict in any manner any ... allowance ... accorded by... the laws of... the united states."4 3 c. the problems associated with u.s. residence-based taxation of participants in foreign plans the u.s. rules for taxing its citizens and residents who participate in foreign pension plans involve application of u.s. tax concepts to such plans to determine if they are "funded" or "unfunded" and "qualified" or "nonqualifled." if the plans are funded but nonqualified, u.s. tax concepts must be applied to determine the amount to be taxed at the time of vesting, whether the employee is a "highly compensated employee," and, if so, the annual amount of accrued benefits. this creates at least four potential problems.3 first, particularly if the employer is a foreign person, not affiliated with a u.s. company, it may be difficult for the employee to obtain information about the foreign plan sufficient to categorize the plan under u.s. tax standards and to determine the amount and timing of any income inclusion. the plan documents may not be in english, and the employer may have no need for local tax purposes to draw the distinctions made under u.s. law.3 5 343. u.s.-france income tax treaty, supra note 135, art. 29, 1 1; see 1996 u.s. model, supra note 2, art. 1, t 2 (referring to the "laws of either contracting state-). see also 1996 treasury explanation, supra note 2 ("[this provision] also means that the convention may not increase the tax burden on a resident of a contracting states (sic] beyond the burden determined under domestic law. thus, a right to tax given by the convention cannot be exercised unless that right also exists under internal law."). the treasury further explains that "a taxpayer's liability to u.s. tax need not be determined under the convention if the code would produce a more favorable result." id. see also ali. supra note 219, at 81. 344. for a similar catalogue of problems in the context of a u.s. citizen or resident participating in a canadian registered pension plan, see wiacek letter to barnes, supra note 267, and wiacek letter to terr, supra note 266. see generally avi-yonah. supra note 225, at 1336 (noting that "even developed countries find it hard to effectively enforce residence-based taxation on the global income of individuals." he further explains that "[slource-based taxation of passive income is much more effective than residence-based taxation because the source country has the information needed to enforce the tax if it wishes to do so."). 345. see wiacek letter to barnes, supra note 267 (making this point with regard to u.s. citizens or residents participating in canadian registered plans). in this letter, wiacek states that "determining the correct amount to include in an individual's income can be extremely difficult, especially in the case of a defined benefit plan. not only can the task be difficult, but canadian employers simply may not perform the calculations necessary to determine the includible amount, imposing a significant burden on individual employees." id. 19961 florida tax review second, whereas in the case of a u.s. plan, employers ordinarily structure deferred compensation arrangements to obtain desired tax results under u.s. tax law for the beneficiaries, such structuring generally would not occur for a pension plan organized in a foreign country with more than a few participants. most of the participants would generally be nonresident aliens of the u.s. who would not be subject to u.s. tax (assuming services are performed abroad). moreover, it might not be possible to conform the plan to u.s. tax requirements and local tax requirements at the same time since the two sets of requirements may be inconsistent. thus, given these factors and the enormous complexity of the requirements for qualification under section 401(a), it is virtually impossible that a foreign plan would meet the u.s. requirements for a qualified pension plan. third, the treatment of funded but nonqualified plans under u.s. law will generally be applicable to foreign pension plans, but such treatment is difficult to administer (even in an all "domestic" context), particularly for defined benefit plans. 46 as zelinsky points out, in arguing that the treatment accorded to qualified plans should be considered the norm, 7 current taxation of accruing pension benefits creates problems of valuation and of liquidity and understandability for the employee." s in a domestic context, difficulties in applying the rules for nonqualified plans may be tolerated since taxpayers have the option of complying with the qualified plan rules. in fact, one commentator suggested that the treatment of nonqualified plans should be "punitive" in order to encourage creation of qualified plans.349 even those who favor increasing the present value of tax imposed on qualified plan benefits have generally proposed doing so, not by extending the current rules for nonqualified plans to all plans, but rather by imposing a new flat tax on pension income. 346. see wiacek letter to terr, supra note 266 (noting the difficulty for canadian defined benefit plans, "where the employer makes a contribution based on the ages, probability of vesting, and salary levels of the employee group as a whole, and the u.s. rules ... require a calculation of the 'annual incremental projected normal retirement benefit' as a proxy for the employer contribution per employee."). 347. see supra notes 60-62 and accompanying text. 348. see wiacek letter to barnes, supra note 267 (noting that "includability in income of amounts contributed to a trust from which the employee cannot withdraw the contributions creates a cash flow problem for the employee when the tax is assessed"); kpmg letter, supra note 161 (noting that a u.s. citizen participating in a canadian pension plan "may be required to make a cash payment of tax based on a vesting of benefits, even though, by operation of canadian income tax law or by virtue of the restrictions of the plan, the individual is not yet entitled to a cash distribution."). 349. see halperin, supra note 8, at 43-44; see also supra note 57 and accompanying text. 350. see supra note 59 and accompanying text. [vol. 3:6 u.s. income taxation of cross-border pensions fourth, because u.s. taxation of its residents or citizens participating in foreign plans does not take account of foreign tax rules, the potential for inconsistency in the timing of taxation under the two countries' rules is great. this may lead to a situation where no tax is imposed by either country, or two taxes are imposed, but at different times, creating problems for application of the u.s. foreign tax credit. for example, many foreign countries allow participants in local pension plans to defer taxation until distribution (as in a u.s. qualified plan); however, since the u.s. will generally classify the foreign pension plan as nonqualified, deferral of u.s. tax will not be available for a u.s. citizen.35' moreover, an alien who retires to the u.s. may avoid taxation in the country where he worked and yet avoid significant u.s.-residence based taxation because the distribution is treated as a return of capital. d. u.s. residence-based taxation of u.s. multinational employer the difficulty of applying u.s. rules for taxing deferred compensation arrangements to foreign plans has been demonstrated very clearly in connection with the u.s. tax treatment of the employer. although congress acted in 1980 to make u.s. rules more easily applicable to foreign plans in this context, the treasury has had difficulty in adopting regulations that would simplify and clarify the rules in this area. a u.s. corporation with a foreign branch may establish a foreign pension plan for local employees, which is structured to satisfy local tax and labor requirements. the u.s. corporation will wish to currently deduct contributions to the plan on its u.s. tax return. prior to 1980, u.s. tax rules were applied without modification to this foreign context; thus assuming that the foreign plan did not meet the requirements of section 401(a),352 a u.s. corporation's deduction was governed by section 404(a)(5), dealing with contributions to nonqualified plans. under that provision, the deduction must 351. see wiacek letter to barnes, supra note 267 ("iflor u.s. citizens working in canada, u.s. income tax liability and foreign tax credits are mismatched twice: frust, upon the inclusion of amounts in income for u.s. tax purposes as contributions are made to the plan when there is no corresponding inclusion in income for canadian tax purposes: and second, upon the full includability in income for canadian tax purposes of distributions from the plan when there is only partial includability for u.s. tax purposes... [due to] ... the basis recovery rules of section 72 .... "). 352. if the u.s. employer were to establish a funded pension plan that complied with all u.s. requirements for a qualified pension plan, except that the trust was foreign, then the u.s. employer could deduct contributions to the pension plan under § 404(a) subject to the same restrictions on overfunding applied to a domestic plan. see irc § 404(a)(4). the beneficiary's treatment would also be the same as for a qualified plan. see supra note 266. 19961 florida tax review await the year of inclusion by the employee353 and is conditioned on maintaining separate accounts for each employee (a condition generally not met by defined benefit plans).3" a similar issue arises when a u.s. corporation's foreign subsidiary creates a local pension plan for local employees. the proper timing of the subsidiary's reduction of earnings and profits to reflect pension contributions will be a factor in applying section 902 and the subpart f rules to the u.s. parent. the irs took the position prior to 1980 that the requirements of section 404 were also applicable in this context.355 in response to the irs position in this context,356 congress in 1980 enacted section 404a357 allowing an electing employer to deduct certain contributions to a "qualified foreign plan." a "qualified foreign plan" is not required to meet all the requirements of section 401(a); rather, it is defined simply as "any written plan of an employer for deferring the receipt of compensation" as to which an employer makes an election, provided that the plan is "for the exclusive benefit of the employer's employees or their beneficiaries," and meets a requirement that 90% of the benefits represent compensation to nonresident aliens that is not taxable by the u.s. 35s pursuant to section 404a, contributions to qualified foreign plans are deductible when paid, either to a trust (or the equivalent of a trust) meeting section 401(a)(2)'s requirement of exclusive benefit to employees, for a retirement annuity, or to a participant or beneficiary; 359 alternatively, "reserve plan" treatment may be elected so that the employer may take into account "the reasonable addition for such year to a reserve for the taxpayer's liability under the plan.' '36 0 the deduction for funded plans is, in the case 353. it is not clear how this rule is applied when the employee is a nonresident alien not subject to u.s. taxation on the contribution. see letter from mark j. ugoretz, infra note 367. 354. see priv. ltr. rul. 79-04-042 (oct. 25, 1978) (applying § 404(a)(5) to defined benefit plans maintained by u.s. subsidiaries for local employees so as to permanently deny a deduction for contributions if separate accounts are not maintained). 355. tech. adv. memo. 78-39-005 (june 21, 1978). the irs ruled that the earnings and profits of an accrual basis german subsidiary could be reduced "only by the amount of payments actually made under its pension plan, and not by the liabilities accrued under its pension plan" in light of the "emphasis of section 404(a)... on actual payment... ." id. the subsidiary was entitled to a current deduction for the accrued liability under german tax law even though the plan was not funded. id. 356. see s. rep. no. 1039, 96th cong., 2d sess. 10-12 (1980) [hereinafter 1980 senate report]. 357. act of dec. 28, 1980, pub. l. no. 96-603, § 2, 94 stat. 3503, 3505 (1980). 358. see irc § 404a(e). 359. id. § 404a(b)(1), (5). 360. id. § 404a(c)(1), (f). some limitations on the determination of the addition to the reserve are set forth in § 404a(c)(1)-(4). [vol 3:6 u.s. income taxation of cross-border pensions of a defined benefit plan, subject to the limits on overfunding in section 404(a)(1) and in the case of a defined contribution plan, subject to the 15% of compensation limit of section 404(a)(3)."6 in any case, the taxpayer's deduction may not exceed, on a cumulative basis, "the aggregate amount allowed as a deduction under the appropriate foreign tax laws."32 the senate finance committee explained its reason for enacting section 404a as follows: the committee believes that the provisions of present law generally applicable to deferred compensation plans are illsuited to plans maintained for the benefit of foreign employees. these plans must frequently comply with provisions of foreign law which are either inconsistent with u.s. law or can be made consistent only through the surrender of major tax benefits under the foreign system ..... it is unnecessary to burden qualification for these tax benefits with many of the provisions intended to protect employees and their beneficiaries applicable to domestic plans. 6' similarly, congressman barber conable, jr., stated that foreign plans for foreign employees should not have to "comply with those u.s. deduction rules that are motivated by u.s. social policy concerns rather than general u.s. tax policy with respect to the appropriate calculation of taxable income for the period."3" perhaps not surprisingly, the diversity of foreign rules regarding pension plans has made it difficult and controversial to apply even the stripped-down requirements of section 404a to foreign pension plans. proposed regulations issued in 1985"6 were withdrawn and replaced by 361. irc § 404a(b)(3). 362. id. § 404a(d). in order that the irs may monitor satisfaction of this requirement, the employer is required to furnish "a statement from the foreign tax authorities specifying the amount of the deduction allowed in computing taxable income under foreign law for such year," a copy of the foreign tax return showing the deduction "as a separate identifiable item," or some other evidence of the amount of the deduction that is viewed as sufficient under regulations. id. § 404a(g)(2). 363. 1980 senate report, supra note 356, at 12. 364. minor tax bills: hearings before the subcommittee on select revenue measures of the committee on ways and means, 96th cong., 2d sess. 143, 162 (1980) (statement of rep. barber conable, jr.). see generally gliksberg, supra note 205. at 472 (noting that "the objects of social policy are, as a rule, local residents or citizens"). gliksberg argues, for example, that "it is substantially right that redistribution of income within society should apply to all the income of the members of that society, because they, and not foreign residents, are the object of the redistribution." id. at 473. 365. see 50 fed. reg. 13,821 (1985) (to be codified at 26 c.f.r. pt. 1) (proposed apr. 8, 1985). 19961 florida tax review new proposed regulations in 1993.3' 6 both sets of regulations have aroused considerable criticism from u.s. multinationals. 67 some have argued that 366. see 58 fed. reg. 27,219 (1993) (to be codified at 26 c.f.r. pt. 1) (proposed may 7, 1993). in september 1996, the irs supplemented these proposed regulations with proposed regulations specifying the limited circumstances in which an employer is treated as owner of a foreign employees' trust. see 1996 proposed rulemaking, supra note 22, 38-54. generally, these circumstances are (a) when the employer is a u.s. employer or a foreign employer that is a cfc and plan funding is excessive, or (b) where a foreign employer transfer assets to the trust "with a principal purpose of avoiding the pfic rules." id. h 35-36, 45-46. 367. for criticism of the 1993 regulations at the public hearing on oct. 5, 1993, see irs' proposed foreign deferred plan rules may be costly, perpetuate "ugly american," bna pensions & benefits daily (oct. 7, 1993) (lexis, bna library, bnapen file); meegan m. reilly, imposing u.s. pension concepts on foreign plans "smacks of ugly-americanism," irs told, 93 tni 194-1 (oct. 7, 1993); unofficial transcript of irs hearing on nonresident pensions, 93 tni 197-10 (oct. 5, 1993) (lexis, fedtax library, tni file). for criticism of the 1985 regulations, see e.g., sam goodley, irs hears unanimous criticism of "all or nothing" election rule in sec. 404a foreign plan regs., 85 tni 33-4 (sept. 25, 1985) (lexis, fedtax library, tni file). for further criticism of the 1993 proposed regulations, see, e.g., comments of thomas a. rowley of william m. mercer, inc. (dec. 4, 1994), reprinted in 95 tni 9-14 (jan. 13, 1995) (lexis, fedtax library, tni file); comments of kevin w. johnson of dow chemical company (aug. 30, 1994), reprinted in 94 tni 182-38 (sept. 15, 1994) (lexis, fedtax library, tni file); draft of comments on proposed regulations under section 404a of the internal revenue code of american bar association, section of taxation (june 23, 1994), reprinted in 94 tni 156-18 (aug. 12, 1994) (lexis, fedtax library, tni file); letter from tom mcmahon of financial executives institute on behalf of committee on employee benefits (apr. 13, 1994), reprinted in 94 tni 81-28 (apr. 27, 1994) (lexis, fedtax library, tni file) [hereinafter letter from tom mcmahon]; comments of tax executives institute, inc. (jan. 6, 1994), reprinted in 94 tni 13-24 (jan. 20, 1994) (lexis, fedtax library, tni file); letter from towers perrin on behalf of a group of companies with foreign pension plans (oct. 5, 1993), reprinted in 93 tni 198-6 (oct. 14, 1993) (lexis, fedtax library, tni tile) [hereinafter letter from towers perrin]; letter from william l. sollee of ivins, phillips & barker (oct. 5, 1993), reprinted in 93 tni 198-4 (oct. 14, 1993) (lexis, fedtax library, tni file); comments of american institute of certified public accountants (oct. 1, 1993), reprinted in 93 tni 199-3 (oct. 13, 1993) (lexis, fedtax library, tni file); letter from lynn d. dudley, on behalf of association of private pension and welfare plans (sept. 30, 1993), reprinted in 93 tni 199-4 (oct. 15, 1993) (lexis, fedtax library, tni file); comments of e.i. du pont de nemours on the proposed regulations under internal revenue code section 404a (sept. 30, 1993), reprinted in 93 tni 198-5 (oct. 14, 1993) (lexis, fedtax library, tni file); letter from mark j. ugoretz on behalf of the erisa industry committee (sept. 24, 1993), reprinted in 93 tni 195-10 (oct. 8, 1993) (lexis, fedtax library, tni file) [hereinafter letter from mark j. ugoretz]; statement of the united states council for international business to the internal revenue service regarding proposed regulations under section 404a of the internal revenue code (sept. 24, 1993), reprinted in 93 tni 193-16 (oct. 6, 1993) (lexis, fedtax library, tni file) [hereinafter statement of the united states council for international business]; letter of joseph w. tierney, jr. on behalf of digital equipment corp. (sept. 23, 1993), reprinted in 93 tni 193-14 (oct. 6, 1993) (lexis, fedtax library, tni file) [hereinafter letter from joseph w. tierney, jr.]; letter [vol. 3:6 u.s. income taxation of cross-border pensions the irs is using section 404a "as the vehicle for exporting u.s. erisa type rules and protections to employees" of qualified foreign plans;' s this, it is contended, will "penalize us based multi-nationals and... also smacks of ugly americanism." '369 thus, for example, critics argue that the requirements for qualification of a fund as a "trust equivalent" under the proposed regulations' 0 "are based on anglo-american trust law," and will lead to "significant confusion because of the different types of funding vehicles utilized throughout the world."371 they argue that "it might be difficult in many countries to create a legally enforceable duty of prudence in the holder of the fund, or to provide absolute priority for creditors," 3 as required by the proposed regulations. some argue that the "strict impossibility of reversion requirement" imposed by the proposed regulations may preclude section 404a qualification even with respect to "trusts established under [such] english-speaking countries as the united kingdom, canada and australia, which follow the common law system and recognize the trust concept.. . ."'3 critics note that in some from marian a. campbell on behalf of exxon corporation (sept. 22, 1993), reprinted in 93 tni 193-15 (oct. 6, 1993) (lexis, fedtax library, tni file); letter from norbert rossier on behalf of international pension consultants (july 1, 1993), reprinted in 93 tni 134-16 (july 14, 1993) (lexis, fedtax library, tni file). 368. letter from joseph w. tierney, jr., supra note 367. 369. unofficial transcript of irs hearing on nonresident pensions, supra note 367 (statement of robert heitzman). barbara felker from the office of associate chief counsel. international, asked mr. heitzman whether his view could be reconciled with the general "requirement of us law ... that earnings and profits be computed under us principles," as exemplified in the goodyear case. id. mr. weitzman replied that "pension law ... involves balancing ... social goals versus revenue goals-and every country strikes its own balance." id. he further explained that "what we're really trying to do. i think, with this law is to prevent manipulation of taxes and not to impose social policy that we in the us seem to have deemed to be correct on foreign jurisdiction." id. 370. see prop. regs. § 1.404a-i(e), imposing four requirements for a fund to be treated as "equivalent of a trust": "(i) the corpus and income [of the fund] is separately identifiable and segregated, through a separate legal entity, from the general assets of the employer, (ii) the corpus and income... is not subject, under the applicable foreign law, to the claims of the employer's creditors prior to the claims of employees... under the plan; (iii) the corpus and income. . ., by law or by contract, cannot at any time prior to the satisfaction of all liabilities with respect to employees under the plan be used for... any purpose other than providing benefits under the plan; (iv) the corpus and income.. . is held by a person who has a legally enforceable duty to operate the fund prudently." 58 fed. reg. 27,219, 27,230 (1993) (to be codified at 26 c.f.r. pt. 1) (proposed may 7, 1993). 371. aba section of tax'n, foreign pension task force subcommittee of the committee on employee benefits, comments on proposed regulations under code section 404a (nov. 2, 1994), reprinted in 94 tni 232-7 (dec. 2, 1994) (lexis, fedtax library, tni file) [hereinafter aba comments]. 372. letter from towers perrn, supra note 367. 373. statement of united states council for international business, supra note 367. 19961 florida tax review countries withdrawals of surplus assets are permitted or even "required" under local law.374 among the important pension vehicles that may not meet the requirements of the proposed regulations are the so-called security contract3 75 under german law and funds covering a number of different 374. withdrawals of surplus assets are said to be "required," in some cases, in the united kingdom and japan and to be permitted in mexico, the netherlands and ontario. see comments of tax executives institute, inc., supra note 367 (mentioning uk and mexico); comments of the dow chemical company, supra note 367 (discussing dow plans in canada and the netherlands); letter from tom mcmahon, supra note 367 (in the uk, "surplus reversion is a commonly utilized method of complying with... [the] requirement" that surplus assets be reduced; also discussing requirement of returning surplus assets in japan); letter from towers perrin, supra note 367, ("the laws of some countries, such as the united kingdom, . . . allow surplus assets to revert to the employer, and in some cases require it."); letter from c. frederick oliphant ili, of miller & chevalier (feb. 6, 1995), reprinted in 95 tnt 36-14 (feb. 23, 1995) (lexis, fedtax library, tnt file) (under qualified canadian pension plans subject to the local law of ontario, the employer may be permitted to withdraw surplus assets even though no settlement has been made of existing pension liabilities). the erisa industry committee stated that "the impossibility-of-reversion requirement is virtually impossible to satisfy in any country except the united states, and in many countries would either be illegal or contrary to accepted business and actuarial practice." letter of mark j. ugoretz, supra note 367. the committee of erisa industry states that "in the united kingdom, plans that do not permit reversions of surplus assets ... are at a serious tax disadvantage" because "[f]unding practices are conservative and, should large surpluses result ... the inland revenue will require them to be eliminated." id. moreover, "[s]ettling the liabilities would generally not be permitted, or be practical in terms of the local insurance market." id. the committee states more generally that "itihe capital markets in foreign countries are often not sufficiently well-developed to annuitize participants' accrued benefits on plan termination, or even reliably to determine the amount that would be necessary to satisfy those benefits." id. see also statement of united states council for international business, supra note 367 ("[m]any countries with advanced legal systems generally thought to be protective of employees permit or even require pension trusts or funds to revert money to the employer ... if the plan is overfunded," including "united kingdom, canada, australia and holland .... [i]t is not clear whether in all these countries an employer can modify the trust instrument to negate this possibility."). 375. in a security contract arrangement, assets funding pension liabilities are transferred to a wholly-owned subsidiary that "pledges its assets to a custodian who then gives a guaranty to the employees." comments of tax executives institute, inc., supra note 367. the proposed regulations decline to approve this arrangement because of uncertainty as to whether the pledged assets are in fact "protected from the claims of an employer's creditors in the event of bankruptcy." preamble to proposed regulations, 58 fed. reg. 27,219, at 27,221 (to be codified at 26 c.f.r. pt. 1) (proposed may 7, 1993). the tax executives institute recommends that the regulations approve such arrangements "perhaps on the basis of an opinion of german counsel that the pension assets are protected from claims of the employer's creditors." comments of tax executives institute, inc., supra note 367. see also letter of mark j. ugoretz, supra note 367 ("[in germany,. . . there exists no [other] legal vehicle... that can prevent a reversion to the employer without also resulting in the current taxation of plan participants."). [vol 3:6 u.s. income taxation of cross-border pensions employers under the laws of france, the netherlands, and sweden. 6 one suggestion offered to the treasury to better accommodate foreign law is to allow a foreign plan to be "qualified" despite gaps in foreign law protections provided that the plan "make[s] certain representations which would have the effect of protecting the integrity of the funded investment vehicle."3" others propose that any detailed attempt to apply u.s. concepts to foreign plans should be abandoned; instead the irs should "publish a list of foreign countries whose laws adequately protect the employees' pension funds," and accept plans "complying with a foreign country's laws and regulations.9 378 the experience with section 404a demonstrates the difficulties of applying u.s. tax rules to foreign pension plans. these difficulties are at least somewhat eased by the fact that the pension plan is created by a u.s. corporation or its foreign subsidiary. by contrast, when the u.s. seeks to tax a u.s. citizen or resident participant in a foreign plan, and the employer has no contact with the u.s., the difficulties of obtaining information about foreign law and the operation of the plan would likely be much greater. e. possible improvements of u.s. residence-based taxation of beneficiaries of foreign plans present law's approach for taxing u.s. participants in foreign pension plans is to apply u.s. pension standards and, consequently, classify virtually all foreign plans as nonqualified; therefore, current taxation of contributions to the plan and accrued earnings (in the case of an hce) is required. as noted, this approach presents serious problems of enforcement, valuation, 376. in these countries, employers "may be required by law or by union agreements. to contribute to a nongovernmental fund covering many different companies under a full or partial cross-subsidies between the various participating companies." unofficial transcript of irs hearing on nonresident pensions, supra note 367 (statement of thomas rowley of william m. mercer, inc.). thus, these plans are not "for the exclusive benefit of the employees of the employer .. " id. 377. aba comments, supra note 371. the representations, relating to trust equivalence, are that "(a) the corpus and income of the fund shall be segregated from the assets of the employer and shall be separately accounted for," (b) generally, "the corpus and income shall not, any time prior to the satisfaction of all liabilities with respect to employees under the plan be used for, or diverted to, any purpose other than providing benefits under the plan"; and "(c) the administrator holding the corpus and income shall agree to operate the fund prudently." id. there would be further contractual undertakings to insure compliance with the exclusive benefit rule, i.e., "there shall be no reversions of assets from the plan to the employer unless-(i) the reversion shall leave in the plan assets having a fair market value equal to 125% of the accrued benefit obligation under the plan ... : and (ii) the reversion is permitted under local law or regulation." id. 378. comments of tax executives institute, inc., supra note 367. 19961 florida tax review liquidity, and mismatching of u.s. and foreign tax (with resulting double or under-taxation). yet there are at least two alternative approaches available: (1) the u.s. might treat all foreign pension plans as qualified plans (or, to the same effect, as unfunded). thus, all taxation of the employee would be deferred until the time of distribution. (2) the u.s. might follow the tax treatment accorded in the place where the plan is situated; that is, if the plan is eligible for deferral of employee tax on contributions, the u.s. would also allow such deferral. thus, it is worth examining the justifications for the present law. the logic behind the present law is that deferral of the employee's tax on deferred compensation should depend upon the quid pro quo that either (a) the arrangement satisfies the requirements of section 401, or (b) the employer's deduction is also deferred (as in the case of an unfunded plan).379 since foreign plans do not satisfy all the detailed requirements of section 401, this quid pro quo is viewed as not being present. requirements for pension plans in other developed countries may be designed to achieve similar goals, but are considered to be insufficiently similar to substitute for the requirements of section 401. if a u.s. citizen or resident can achieve the same u.s. tax results in a foreign plan as in a u.s. qualified plan, the incentive to participate in a qualified plan is undermined. as long as an individual is a u.s. citizen or resident, the u.s. has the responsibility to apply its own standards to pension plans in which the individual participates (in part for his or her own protection).380 the logic of this "quid pro quo" theory is not, however, as compelling in a cross-border context as in a domestic context. first, if the employer is a foreign corporation without u.s. business activities or a u.s. affiliate, the employer will not offer the employee the option of participating in a qualified u.s. pension plan. thus, there is no point in denying deferral to the employee as an incentive to channel his retirement savings to a u.s. qualified plan (unless the intent is to encourage him not to work abroad for a foreign employer). second, in many cases, pension plans organized in a foreign country may meet the objectives behind the requirements of section 401 even if the foreign law does not embody all the requirements of section 401. at the same time, it is not realistic to expect a foreign employer to design a plan that is primarily for employees working outside the u.s. so as to meet the precise requirements of section 401. 379. see supra notes 303-313 and accompanying text. 380. as explained by professor gliksberg, residence-based jurisdiction "focus[es] ... on the connection between the resident and the state, and the taxpayer's general duty to contribute to government expenditure since he or she benefits from the full range of its services, in all spheres of life .... gliksberg, supra note 205, at 473. [vol 3:6 u.s. income taxation of cross-border pensions third, in many cases, deferral of employee taxation by the u.s. may not lead to any overall advantage to the employee. the overall effect will also depend upon foreign law, which is outside the u.s.'s control. foreign law may tax the employee on contributions to the plan when made. the foreign law may impose a tax on the pension trust's investment income (thereby eliminating the advantage of a qualified plan under u.s. law), or the foreign law may defer the employer's deduction. fourth, in a case where an alien's u.s. residence begins only after contributions are made to a foreign pension plan, a deferral of the employee's tax will close an existing loophole rather than opening a new one. in situations where the foreign country defers its tax on the employee and then forgives it if the employee retires abroad, deferral by the u.s. has the effect of insuring that some tax will be imposed on the deferred compensation. on the other hand, it is not clear that either of the two alternative treatments should be adopted by the u.s. by unilateral action. the first alternative (deferral for all foreign pension plans) has the advantage of eliminating the problems of valuation, liquidity, and understandability entailed by current taxation. since the actual distribution to the employee is always the taxable event, the employee is in a position to determine the amount subject to u.s. tax without the assistance of the foreign plan administrator or foreign tax authorities. on the other hand, it would not insure much greater coordination with the foreign law treatment than does the current approach. moreover, especially outside the context of a treaty, the u.s. might be concerned that delaying imposition of tax might make enforcement more difficult. this approach might be viewed as particularly unwarranted in a situation where a u.s. citizen or resident works in a low-tax or tax-haven country, and thus is subject to little or no foreign tax. the second alternative (following the foreign law treatment) would eliminate current taxation with its associated problems in many cases. under this alternative, u.s. tax would be imposed currently only to the extent that the situs of the plan would also tax currently. thus, the plan administrators would be in a position to determine the amount to report as current income for u.s. tax purposes; problems of liquidity and understandability would not be exacerbated by the u.s. treatment. however, this approach would be difficult to administer outside the context of a treaty relationship because it would require characterization of the pension plan under the law of the situs country and would require the cooperation of the plan administrator. these considerations suggest that unilateral change in u.s. law should be relatively limited, and that, in general, the needed improvements should be by treaty. however, there are two changes that the u.s. should adopt unilaterally. first, the u.s. should unilaterally close off opportunities for a foreign national who retires in the u.s. to avoid all tax on distributions from a pension plan in a foreign country; the other country, where the foreign 19961 florida tax review national previously worked and resided, may not assert jurisdiction to tax such distributions. the u.s. can insure that u.s. tax is imposed in such a case by amending section 72 so that an individual's investment in the contract for pension distributions includes only amounts shown to have been already subjected to tax either by the u.s. or by the country where the services were performed or where the pension fund is located. the u.s. should not in its role of residence country provide a tax haven for foreign nationals, regardless of whether the country of nationality has a treaty with the u.s. to ease administrative burdens for the irs, the taxpayer should have the burden of establishing that foreign taxation has previously been imposed. see table 2a, row 10, page 365. second, the u.s. should amend the code to treat all foreign defined benefit plans as unfunded. under this change, a u.s. resident or citizen who participates in a defined benefit plan in a foreign country would be taxable only when actual distributions are made from the plan; the distributions, when made, would be sourced entirely to the place where the services were performed. see table 2-a, row 8, page 364. the u.s. should make this change unilaterally because the current rules applied to foreign defined benefit plans are uncertain in application and too difficult to administer. it seems highly unlikely that a satisfactory level of enforcement is, or could ever be, achieved. if this "unfunded" treatment is considered too alluring an opportunity for u.s. tax planning, then it could be limited to situations where the structure is likely determined by foreign tax or other considerations. for example, this "unfunded" treatment could be reserved for foreign plans for which at least 90% of the benefits accrue to nonresident aliens. this treatment of foreign defined benefit plans as unfunded should also be applicable to nonresident aliens who participate in a foreign defined benefit plan in respect of services performed in the u.s. see table l-a, row 4, page 363. administrative problems of imposing the u.s. source-based tax on a current basis are equally severe in this context. allowing income of a nonresident alien to be deferred to the time of retirement when the individual may have no further connection to the u.s. in itself greatly lessens the likelihood of enforcement. nevertheless, the likely advantage in enforcement from imposing tax while the individual is still conducting activities in the u.s. does not seem sufficient to outweigh the burden of computing current tax with respect to a foreign defined benefit plan. v. a more comprehensive u.s. treaty policy the treaty policy for pensions embodied in most existing u.s. treaties, the 1981 u.s. model and the oecd model, i.e., that pension payments should be taxed exclusively in the residence country, does not resolve all of the complex issues of coordination presented by the taxation of cross-border pensions. [vol 3:6 u.s. income taxation of cross-border pensions the term "pension" as used in existing treaties does not have an authoritative and clear-cut definition; this makes the position of a withholding agent extremely difficult. most existing u.s. treaties address only the treatment of payments from pension plans: they do not address taxation of contributions when made or earnings when accrued in a plan. thus, apparently, the country where services are performed, the country where the plan is located, or the country where the pensioner resides prior to retirement are all authorized to impose tax on pension benefits prior to distribution (even though such taxation may be very difficult to administer). this creates the potential for overlapping taxation at different times. in addition, there is no attempt to assure that residence taxation will in fact be imposed in situations where source-base taxation is foregone. thus, further refinements of the u.s. treaty policy are clearly required. a few treaties entered into by the u.s., i.e., those with canada, france and sweden, as well as the proposed treaty with austria, do contain provisions beyond those contained in the 1981 u.s. model. thus, the french and swedish treaties, as well as the proposed treaties with austria and switzerland, include a variation of the provision of the oecd commentary dealing with contributions to a home country plan. the treaties with canada and france, moreover, provide for some coordination of residence-based tax with the timing rules in the source country. the 1996 u.s. model has commendably embraced this kind of broadening of u.s. treaty policy. the 1996 u.s. model has provided further elaboration of the term "pension" in its technical explanation, has adopted a somewhat expanded variation of the oecd commentary provision dealing with contributions to a home country plan, and has provided for the residence country to relinquish tax on distributions to the extent previously taxed in the source country. these provisions should be adopted more widely and be expanded upon to create a more comprehensive treaty policy for pensions. the following proposal for a new treaty policy attempts to address the concerns described above. under this proposal, (a) a pension plan would be defined as an arrangement created by an individual or his employer to provide a separate fund for his retirement, provided that the country where the fund is located treats the fund as a tax-favored pension arrangement with respect to which employee tax is deferred until distribution, and establishes limits on the amount of tax-favored contributions or benefits. neither the pension article nor the "other income" article would protect any other form of deferred compensation from source-based tax; however, the "dependent services" article would potentially be applicable. (b) no country having a treaty with the country in which the pension plan has its situs would tax amounts contributed to the pension plan 19961 florida tax review (by employee or employer) or earnings accrued in the plan, prior to distribution to the employee (or beneficiary). see table 1-a, row 4, page 363; table 2-a, row 8, page 364. however, the pension plan would be required to report the eventual distribution to tax authorities in the country where the services are performed, the country where the plan is located, and the country in which the employee then resides."' (c) when a pension is distributed in a manner permitted under the laws of the plan's situs (whether by lump sum or periodic payments), any country where the services were performed or where the plan is situated would refrain from taxation if such country has a treaty with the country of the pensioner's then residence. the residence country would be required382 to tax the full amount of the distribution; except that (as in the 1996 u.s. model) the residence country would be barred from taxing amounts previously taxed by a country that is its treaty partner. see table 2-a, row 10, page 365. however, because of paragraph (b) above, the likelihood of previous taxation would be reduced. the proposed policy (if widely adopted in u.s. treaties) would achieve much greater coordination in the taxation of cross-border pensions. for any particular pension, one country's laws would control the timing of the imposition of tax (including the amount to be taxed at any particular time). the country where the plan is located is the most logical choice to serve in this role. this place (unlike the place of residence) ordinarily would not change over time. moreover, this rule assures that the plan administrator would be familiar with the controlling law; thus, he would be in a position to issue information reports at the correct time and showing the correct amount. reliance on the timing rules of the country where the plan is situated 381. see avi-yonah, supra note 225, at 1336-37 (suggesting two ways to make residence-based taxation of passive income more effective: "to enhance the information exchange programs under tax treaties" and "for developed countries to establish a concerted program of withholding taxes at the source of income for the benefit of the residence country."). this withholding tax could be remitted to the residence country if "the investor furnishes documentation showing that the income has been declared in his or her residence country." id. at 1337. 382. if necessary, an explicit exception could be made to the statement in most treaties, e.g., in 1996 u.s. model, art. 1, 2, that the treaty will not restrict a benefit accorded by internal law. see supra note 343. the proposal in text should be viewed as merely providing for a treaty to change the timing of a tax under internal law and not as providing for the treaty to impose a tax that does not exist under internal law. [vol. 3:6 u.s. income taxation of cross-border pensions is already accepted in treaties with france,383 canada,3 and sweden.3 s under this proposal, an employee would not be discouraged from working away from the country of his permanent residence by the prospect of losing favored pension treatment. thus, for example, a u.s. citizen working abroad would not need to be concerned about immediate u.s. taxation if he participated in a foreign qualified plan; nor would he be concerned about immediate foreign taxation if he participated in a u.s. qualified plan. this policy (if adopted widely) would also insure that only one country has jurisdiction to tax pension benefits, i.e., the residence country, determined at the time of the distribution. for example, assume that an employee is a participant in a pension plan, located in a country that allows taxation of contributions to the plan to be deferred. if the country where the plan is located has entered into a treaty with the employee's country of then residence and the country where services are performed, then the treaties would prevent current taxation of contributions to the plan or accruals of earnings in the plan. since the agreed time to tax would be the time of distribution, the country of residence at the time of distribution would have exclusive tax jurisdiction (assuming that it had a treaty with each of those countries having potential source-based jurisdiction). this proposal also seeks to insure that treaties will not have the effect of rendering pension income completely exempt from any significant tax. thus, this proposal requires that the country of residence at the time of distribution may not decline to tax the distribution received by a resident on the grounds that the distribution is merely a return of capital or income previously earned at a time when residence was not established, except to the extent that the pension benefit has already been subject to tax by a country that is a treaty partner of the residence country. in this way, the countries that relinquish source-based taxation can be assured that the pension benefits will not completely escape taxation. if the place of the employee's residence at the time of distribution is not a treaty partner of the source countries, source-based taxation would be preserved. assume that a country x national, residing and working in the u.s., contributes to a country x qualified pension plan and that country x defers employee taxation with respect to a qualified pension plan until the 383. see supra text accompanying note 341 (the staff of the joint committee on taxation describes the french treaty provision as looking to the "source" country to determine the time and extent of taxation). the "source" country for this purpose seems to be the place where the plan is located, i.e., france, where a french national living and working in the u.s. contributes to a french plan. 384. see supra text accompanying note 295. 385. see supra text accompanying note 195. 19961 florida tax review time of distribution. under the treaty between the u.s. and x, the u.s. would defer imposition of tax (whether residence-based or source-based) until the time of distribution (in conformity with country x law). if the employee ultimately received distributions while residing in country x, country x (but not u.s.) tax would be imposed at that time. if, however, the employee retired in the cayman islands, neither the u.s. nor x would be precluded by any treaty from taxing the eventual distribution. the plan administrators would have to insure that the plan provides information about distributions to the u.s. and country x tax authorities. if the country where the plan is located has not entered into income tax treaties (e.g., the cayman islands), the special treaty treatment for pensions described above would be inapplicable. contributions to the pension plan could be taxed as compensation either by the country of the employee's residence and/or by the country where the services were performed (unless taxation by the latter country is precluded under the dependent services article of a treaty between the two countries). similarly, the above-described treaty provisions would not apply if the country where the plan is located does not treat the type of plan as eligible for deferral of employee tax (e.g., a u.s. nonqualified plan), whether or not that country actually has a basis for sourceor residence-based taxation of the employee. in that case, however, treaties would subject the plan to information-reporting requirements. thus, the plan administrator would be required to provide information regarding the amount treated as current income (under the situs country's rules) to the tax authorities in the country where services are performed and the tax authorities in the country of the employee's residence. this proposal may be criticized as surrendering too much of the currently claimed u.s. tax jurisdiction over pensions. in contrast to the 1981 and 1996 u.s. model, this proposal may block u.s. imposition of a current tax on contributions to a foreign plan by an employee resident in the u.s. or performing services in the u.s., even if the foreign plan is not a home country plan in which the employee has previously participated (as required by 1996 u.s. model, article 18 paragraph 6). however, this effect may not be as significant as it first appears. the u.s. would retain the opportunity to tax the eventual distribution from the plan unless the participant's residence at that time is in a foreign country that is a treaty partner. moreover, the savings clause could preserve u.s. taxation at the time of distribution if the participant is a u.s. citizen. this proposal and the proposals for improvement of u.s. residencebased taxation of beneficiaries of foreign pension plans386 are depicted in 386. see supra part iv.e. [vol 3:6 1996] u.s. income taxation of cross-border pensions 357 bold (to contrast with the depiction of current law) in tables 1-a, page 362, and 2-a, page 364. florida tax review table 1" nonresident alien employee: services performed in the u.s. type of plan 1. unfunded deferred compensation 2. u.s. qualified plan 3. u.s. nonqualified funded plan 4. foreign funded plan treatment under code eet.* entire distribution treated as effectively connected income. eet.* at time of distribution, compensation element is taxed as effectively connected income, and accretion is taxed at 30% rate. tet.* contributions taxed as effectively connected income; accretion taxed at 30% on distribution (or on accrual if highly compensated employee). tee.* contributions taxed as effectively connected income. treatment under u.s. models no change (except that distribution is exempt if it qualifies as pension or meets business traveler exemption of dependent services article). eee.* the pension article bars u.s. tax on distribution. tee.* the pension article may bar u.s. taxation of accretion on distribution. no change under 1981 model. under 1996 model, contributions to home country plan may be exempt, if employee already participated in plan. * in the terminology of andrew dilnot, see supra notes 67-71 and accompanying text, a pension tax regime can be described by a three letter acronym, referring to its status as "exempt" (e) or "taxable" (t) at each of three points in time: the time of contribution, the time when earnings are derived in the plan, and the time of distribution. thus, for example, "eet" refers to a tax regime of exemption from tax at time of contribution; exemption when earnings are derived, and full taxation at the time of distribution; "eee" refers to a regime of exemption throughout; 'tb" refers to a regime of taxation at the point of contribution and at the time of distribution. [vol 3:6 1996] u.s. income taxation of cross-border pensions (table 1 continued) nonresident alien employee: services performed outside u.s. type of plan 5. u.s. qualified plan 6. u.s. nonqualified funded plan treatment under code eet.* accretion taxed on distribution, unless exempted by § 871(f). eet.* accretion taxed on distribution (or on accrual, if highly compensated employee). treatment under u.s. models eee.* treaty bars u.s. taxation of distribution. eee.* treaty may bar taxation of accretion on distribution. florida tax review table 2 u.s. citizen or resident at time of distribution: services performed outside u.s. u.s. citizen or resident at all times type of plan 7. unfunded deferred compensation 8. foreign funded plan treatment under code eet.* distribution is taxable as foreign source compensation. tet.* because plan is nonqualified, contributions are taxed; accretion taxed on distribution (or on accrual, if highly compensated employee). treatment under u.s. models no change under 1981 model. under 1996 model, any payment classified as pension is exempt to extent previously taxed by other country. no change under 1981 model. under 1996 model, on distribution u.s. tax is barred to extent of amount previously taxed by other country. [vol 3:6 u.s. income taxation of cross-border pensions (table 2 continued) nonresident alien at time of accrual; resident alien at time of distribution of benefits type of plan 9. unfunded deferred compensation 10. foreign funded plan treatment under code eet.* entire distribution is taxable as foreign source compensation. eee.* distribution is exempt as return of capital, except that accretion element is taxed if not highly compensated employee. treatment under u.s. models no change under 1981 model. under 1996 model, any payment classified as pension is exempt to extent previously taxed by other country. no change under 1981 model. under 1996 model, accretion element not taxed to extent previously taxed by other country. * see footnote to table 1, page 358. 19961 florida tax review table 1-a nonresident alien employee: services performed in the u.s. type of plan 1. unfunded deferred compensation 2. u.s. qualified plan 3. u.s. nonqualified funded plan treatment under code eet.* entire distribution treated as effectively connected income. eet.* at time of distribution, compensation element is taxed as effectively connected income, and accretion is taxed at 30% rate. proposal: entire distribution taxed as effectively connected income. tet.* contributions taxed as effectively connected income; accretion taxed at 30% on distribution (or on accrual if highly compensated employee). treatment under u.s. models no change (except that distribution is exempt if it qualifies as pension or meets business traveler exemption of dependent services article). eee.* the pension article bars u.s. tax on distribution. tee.* the pension article may bar u.s. taxation of accretion on distribution. proposal: treaty inapplicable since situs country does not defer employee taxation. [vol 3:6 u.s. income taxation of cross-border pensions (table 1-a continued) type of plan 4. foreign funded plan treatment under code tee.* contributions taxed as effectively connected income. proposal: in case of defined benefit plan, treatment in row 1 applies, i.e., eet.* treatment under u.s. models no change under 1981 model. under 1996 model, contributions to home country plan may be exempt, if employee already participated in plan. proposal: eef.* us. does not tax at time of contribution if plan's situs provides deferral of taxation for employee. nonresident alien employee: services performed outside u.s. type of plan 5. u.s. qualified plan 6. u.s. nonqualified funded plan treatment under code eet.* accretion taxed on distribution, unless exempted by § 871"(f). proposal: eee.* accretion not taxed. eet.* accretion taxed on distribution (or on accrual, if highly compensated employee). treatment under u.s. models eee.* treaty bars u.s. taxation of distribution. eee.* treaty may bar taxation of accretion on distribution. proposal: treaty inapplicable since situs country does not defer employee taxation. * see footnote to table 1, page 358. 1996] florida tax review table 2-a u.s. citizen or resident at time of distribution' services performed outside the u.s. u.s. citizen or resident at all times type of plan 7. unfunded deferred compensation 8. foreign funded plan treatment under code eet.* distribution is taxable as foreign source compensation. tet.* because plan is nonqualified, contributions are taxed; accretion taxed on distribution (or on accrual, if highly compensated employee). proposal: in case of defined benefit plan, treatment in row 7 avplies. treatment under u.s. models no change under 1981 model. under 1996 model, any payment classified as pension is exempt to extent previously taxed by other country. no change under 1981 model. under 1996 model, on distribution, u.s. tax is barred to extent of amount previously taxed by other country. proposal: eet.* u.s does not tax at time of contribution if plan's situs provides deferral of tax for emplo.e. as in 1996 model, on distribution, u.s. does not tax amount previously taxed by other country. [voi. 3:6 u.s. income taxation of cross-border pensions (table 2-a continued) nonresident alien at time of accrual; resident alien at time of distribution of benefits type of plan 9. unfunded deferred compensation 10. foreign funded plan treatment under code eet.* entire distribution is taxable as foreign source compensation. eee.* distribution is exempt as return of capital, except that accretion element is taxed if not highly compensated employee. proposal: eet.* no basis recovery allowed except for amounts subjected to tax by other country. treatment under u.s. models no change under 1981 model. under 1996 model, any payment classified as pension is exempt to extent previously taxed by other country. no change under 1981 model. under 1996 model, accretion element not taxed to extent previously taxed by other country. proposal: eet.* residence country to tax any amount of distribution not previously subjected to tax by other country. * see footnote to table 1, page 358. 19961 florida tax review v. conclusion the growth in the number of employees who move across national borders makes this an opportune time for the u.s. to examine its tax treatment of deferred compensation paid to such employees. the current u.s. statutory rules governing these transactions together with the u.s. treaty network do not assure a coherent and administrable approach for taxing such compensation. this article proposes three changes that the u.s. should unilaterally make in its statutory treatment of these transactions to meet these concerns. the first change is to simplify the u.s. assertion of source-based jurisdiction over pension distributions from a u.s. qualified plan by eliminating separate identification of the "accretions" element. the second change is to adjust u.s. basis rules to close off existing opportunities for a foreign national to use the u.s. as a tax haven on retirement. the third change is for the u.s. to relinquish its impractical assertion of current taxation of a u.s. resident's contributions to foreign defined benefit plans. more generally, this article recommends that the u.s. should promote a more comprehensive treaty policy dealing with these transactions. if this policy were widely adopted, it would lead to better coordination of the taxation of an employee's deferred compensation by the potentially large number of countries that may assert source-based or residence-based jurisdiction. this would prevent employees from suffering unwarranted double taxation or from seeking out unwarranted tax exemption, and would simultaneously assure that the u.s. and its trading partners receive their rightful share of tax revenues. [vol. 3:6 holo5 _stb final_ 1-15-09 florida tax review volume 9 2008 number 3 161 taxing the business of sports by robert holo jonathan talansky part i – introduction ……………………………...…………………162 part ii – prepaid income ……………………………………………..163 a. taxation of prepaid income – overview ……………………...164 b. advance payments: sponsorship and broadcast agreements ..170 c. advance payments: ticket sales & seat licensing …………..178 d. continuing viability of the “certainty of performance” standard ………………………………………………………….181 part iii sports franchises and player contracts ………...…185 a. taxation of sports intangibles – pre-2004 ……………….......185 b. sports intangibles and the american jobs creation act of 2004……………………………………………………….201 c. measuring the effect of the jobs act on sports franchise values …………………………………………………………….203 d. individual player contracts – collateral tax issues …………207 part iv the home-run ball ……………………………………….209 part v – conclusion …………………………………………………215 © 2008 robert holo & jonathan talansky 162 florida tax review [vol. 9:3 part i introduction * “the rising value of american professional franchises, together with league expansions and more sale transactions, has caused the internal revenue service to take interest.” 1 major professional sports in america, according to several estimates, is a $225 billion industry. while fan interest may wax and wane as athletes and organizations are beset by scandal and, even worse, mediocrity, the enterprise of sports continues to thrive and to occupy a disproportionate share of the public consciousness. sports leagues today are immensely profitable businesses – more interested, perhaps, in the bottom line than the box score. yet, somewhat anomalously, the purveyors of sport claim to be providing a public service – to the fans and to the communities in which they play. sports leagues and franchises routinely assert that they, more so than most private enterprise, are entitled to a sizable share of the public fisc to finance their expansion. state and local governments have responded in unprecedented ways; during the 1990s alone, taxpayers shelled out approximately $11 billion to fund new sports facilities for the owners of major american sports franchises. 2 as the sports industry has come to rely on public funding for its rapid growth, the internal revenue service (“irs,” or “service”) has attempted to ensure that these increasingly complex and profitable businesses are timely and accurately paying their taxes.3 the tax law tirelessly attempts * rob holo is a partner and jonathan talansky is an associate in the tax department of simpson thacher & bartlett llp in new york. this article was first prepared for a presentation at the tax forum on january 7, 2008. the authors would like to thank steven todrys, dickson brown, and aaron cohen for their invaluable assistance. 1. paul l.b. mckenney & eric m. nemeth, tax law: the purchase and sale of a sports team: tax issues and rules, 80 mich. bar j. 54, 54 (june 2001). 2. it is by no means clear that sports franchises generate net economic surplus to their home communities and economies. for an instructive discussion (well beyond the scope of this paper) regarding the extent to which sports owners should be entitled to costly public subsidies (primarily in the form of tax-exempt municipal bond financings), see paul c. weiler, leveling the playing field, 263-77 (harvard university press 2000). see also john r. dorocak, tax advantages of sports franchises: the stadium, tax notes, nov. 13, 2000, at nn. 3-4; andrew zimbalist, baseball and billions, 136-40 (basicbooks 1992). 3. in fact, in 1999, the irs established a sports franchise office and staffed it with specialists in the business and law of sports. see also “market segment specialization program, sports franchises,” (aug. 1, 1999), available in lexis, 2008] taxing the business of sports 163 to keep pace with the sophisticated economic transactions that are now the hallmarks of the business of american sports. this paper will examine selected united states federal income tax issues that arise in sports, with a nearly exclusive emphasis on the franchise (as opposed to the athlete) as taxpayer. while sports owners inevitably grapple with ordinary issues of business taxation, the peculiarities of sports involve a unique set of problems that may require particular scrutiny. part ii of this paper will address issues relating to prepaid income and the timing of income recognition associated with common sports transactions, as well as a 2004 revenue procedure that may offer greater flexibility and tax planning alternatives to sports franchises. part iii examines the singular role of certain intangible assets in the tax profile of sports teams and chronicles the evolving tax treatment of player contracts. in this area, recent legislative and regulatory action stands to affect significantly the valuation of sports franchises and the structuring of their acquisitions. part iv takes a bit of a digression and briefly addresses the well publicized topic of the “record home-run ball.” part ii prepaid income “look, we play the ‘star spangled banner’ before every game. you want us to pay income taxes too?” 4 sponsorship and broadcasting are two of the most important sources of revenue to sports leagues and their teams. (by way of background, the major sports ‘leagues’ are generally operated as tax exempt organizations under section 501(c)(6) of the internal revenue code of 1986, as amended (the “code”)).5 for the most part, individual sports teams enter into advertising agreements with local businesses (or national companies seeking local exposure) for the right to be associated with the franchise and its trademarks. 1999 tnt 225-9 (“mssp”).the mssp is only an internal training manual for irs examiners and has no precedential value, but it is useful in that it reveals the service’s thinking on several key issues. 4. zimbalist, supra note 2, at 35 (quoting bill veeck, the former major league baseball owner known for his innovative ideas (such as team revenue sharing) and equally imaginative quips). 5. unless otherwise noted, all references to the “code” and “sections” are to the internal revenue code of 1986, as amended, and the regulations promulgated thereunder. although § 501(c)(6) only refers to “professional football leagues,” the service has interpreted it to apply to other sports leagues as well. see, e.g., plr 8321094 (1983) (golf). 164 florida tax review [vol. 9:3 television and radio broadcasting exist both on the national and local level, and involve the rights to air broadcasts of games to viewers and listeners.6 as described below, advertising and broadcast agreements often call for large, up-front payments, followed by periodic payments over the duration of the contract. sports franchises regularly attempt to defer the recognition of much of the initial payments and report such income as deferred revenue. because of the sheer magnitude of these items of revenue, even a single year of deferral can create large tax savings. this section will consider the taxation of prepayments in typical sports contracts. it will also briefly address the prepayment doctrine in the context of sports ticket transactions between franchises and individual fans. a summary of the evolution of the legal principles is a helpful starting point. a. taxation of prepaid income overview at the heart of the u.s. federal income tax system is the annual accounting concept. the supreme court, in its landmark decision in burnet v. sanford & brooks,7 established that the essence of any tax system is to produce revenue that is measurable and payable at regular intervals. these goals are not entirely consistent with the principles of financial accounting, which are preoccupied with accurate snapshots of economic wealth. clearly, taxpayers are loath to pay taxes on income that has not been duly matched with related expenses. these “vastly different objectives” of financial and tax accounting have given rise to a great deal of tension in the administration of the federal income tax. as justice blackmun eloquently framed it, “[f]inancial accounting, in short, is hospitable to estimates, probabilities, and 6. sports broadcasting revenue has exploded over the past 25 years. this explosion has been due primarily to the passage of the sports broadcasting act of 1961, codified at 15 u.s.c. § 1291. the act, a monumental result of intense lobbying efforts, grants antitrust immunity to sports leagues and enables them to sell packaged broadcasting rights to national television networks. see united states v. nfl, 116 f.supp. 319 (e.d. pa. 1953) (precursor to the sports broadcasting act); zimbalist, supra note 2, at ch.7; paul c. weiler & gary r. roberts, sports and the law, 684-738 (3rd ed. west 2004). the various sports leagues have benefited immeasurably from this cartel power. one sports economist estimated that within two years of the passage of the act, national football league (“nfl”) and major league baseball (“mlb”) revenues tripled, while the number of broadcast games was cut in half. see infra note 39. 7. 282 u.s. 359, 365-66 (1931). for a helpful discussion, see, e.g., stephen f. gertzman, federal tax accounting, ¶ 12.02 (warren, gorham & lamont 1988). 2008] taxing the business of sports 165 reasonable certainties; the tax law, with its mandate to preserve the revenue, can give no quarter to uncertainty.”8 congress has enacted various code provisions relating to tax accounting in an effort to strike a workable balance between these competing principles. section 446(a) states that taxpayers should generally use their method of financial accounting when computing their taxes. however, the commissioner, under section 446(b), may require that the taxpayer use a tax accounting method that “clearly reflects income.” section 451(a) contains the general rule regarding advance receipts – specifically, “the amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.” regulations section 1.451-1(a) interprets this standard and states that under the accrual method, income is includible “when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.”9 the well known ‘trilogy’ of supreme court cases during the 1950s and 1960s, decided under the statutory predecessor of section 446, established the general rule that advance payments for services may not be deferred by accrual method taxpayers.10 in automobile club of michigan v. commissioner,11 the court required an accrual method taxpayer to include in income advance payments for membership dues which entitled members to 8. thor power tool co. v. comm’r, 439 u.s. 522, 543 (1979) (upholding the commissioner and holding that under the relevant provisions, conformity with generally accepted accounting principles does not create a presumption of proper tax accounting). accord frank lyon co. v. united states, 435 u. s. 561, 577 (1978); comm’r v. idaho power co., 418 u.s. 1 (1974); boise cascade corp. v. united states, 530 f.2d 1367, 1373 (ct. cl. 1976) (“boise cascade”) (tax accounting “starts from the premise of a need for certainty… and focuses on the concept of ability to pay”). 9. the so-called “all events test” is satisfied when (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer, whichever happens earliest. see rev. rul. 84-31, 1984-1 c.b. 127; rev. rul. 80-308, 1980-2 c.b. 162. the origin of the all events test was the supreme court’s decision in united states v. anderson, 269 u.s. 422 (1926). 10. the seminal prepaid income decision prior to the trilogy cases was beacon publishing co. v. commissioner, 218 f.2d 697 (10th cir. 1955), which involved prepaid newspaper subscriptions. the tenth circuit noted that the code permitted an accrual method of accounting, and held that requiring current inclusion of such prepayments “would in most cases result in a distortion of an accrual taxpayer’s true income.” 11. 353 u.s. 180 (1957). 166 florida tax review [vol. 9:3 receive certain services during the following year. deferral of the prepaid dues did not clearly reflect income because pro-rating the recognition of the prepayment was “purely artificial and [bore] no relation to the services which [the taxpayer] may in fact be called to render for the member.”12 therefore, in rejecting the taxpayer’s method of tax accounting, the commissioner was properly exercising his statutory discretion. american automobile association v. united states13 involved facts similar to those in automobile club of michigan. however, the taxpayer in aaa provided an expert witness who testified that the deferral of the prepaid dues was consistent with generally accepted accounting principles. the witness adduced statistical evidence showing that the cost of providing member services correlated with the period of time over which the dues were recognized. the court held that the prepaid dues did not sufficiently relate to the incurrence of ‘fixed’ expenses, and therefore that the taxpayer's method of accounting did not clearly reflect income. the aaa court also pointed to the fact that section 452 (which sanctioned the deferral of prepaid income) was enacted in 1954 in order to provide consistency between financial and tax accounting, but was retroactively repealed in 1955 because of excessive revenue loss.14 in the last of the trilogy cases, schlude v. commissioner,15 the supreme court held that an accrual method dance studio could not defer prepaid dance lesson fees. the taxpayer sought to defer including the tuition until the lessons were actually taken. in ruling against the taxpayer, the court stressed the importance of deferring to the commissioner in tax matters and section 446’s broad grant of discretion. importantly, however, schlude asserted that it was relying upon an “additional ground” deployed by aaa, one that was “also controlling here.”16 specifically, the taxpayer’s method of tax accounting was artificial because the advance payments related to services to be performed only upon each customer’s demand without relation to fixed dates in the future. arguably, the lack of certainty pertaining to the schedule of future services was what gave the commissioner the discretion to reject the deferral method of tax accounting. 12. id. at 189. 13. 367 u.s. 687 (1961) (“aaa”). 14. id. at 695. furthermore, in 1958, § 455 was enacted, allowing accrual method publishers of newspapers, magazines and other periodicals to defer prepaid subscription income until the periodicals are delivered. these congressional enactments and repeals, reasoned the aaa court, suggested that congress was well aware of the problems surrounding prepaid income and that any taxpayer relief would come via explicit statutory codification. 15. 372 u.s. 128 (1963). 16. id. at 135-36. 2008] taxing the business of sports 167 seizing primarily upon the “additional ground” in schlude, several courts have interpreted the trilogy cases to have left a deferral “window” open in appropriate circumstances. in artnell co. v. commissioner,17 for example, the seventh circuit reversed a decision of the tax court which had relied on aaa to uphold the commissioner’s disallowance of the taxpayer’s method of deferral tax accounting. at issue in the case was a baseball owner’s practice of deferring the unearned receipts attributable to game tickets, parking and media rights. instead, these items were reported only as the games to which they were allocated were played. the artnell court stated that “there must be situations where the deferral technique will so clearly reflect income that the court will find an abuse of discretion if the commissioner rejects it.”18 several courts have relied on the trilogy cases to deny income deferral and to express their disapproval of the result in artnell.19 as for the service, its response to artnell was clearly stated in its subsequent action on decision.20 the irs asserted that it would “not follow artnell to the extent the rules for deferral could be deemed to be broader than those contained in rev. proc. 71-21.” as discussed below, rev. proc. 71-2121 was issued on the heels of artnell in order to more firmly establish the principles embraced in the trilogy cases. yet, the ruling offers taxpayers some degree of flexibility and has been viewed by some as a concession on the service’s part given the weight of judicial authority supporting the general rule of non-deferral.22 17. 400 f.2d 981 (7th cir. 1968) (“artnell”). see also morgan guaranty trading co. of n.y. v. united states, 585 f.2d 988 (ct. cl. 1978). 18. id. at 985. 19. see, e.g., hagen adver. displays, inc. v. comm’r, 407 f.2d 1105, 1109 n.7 (6th cir. 1969). see also gertzman, supra note 7, ¶ 4.03 (pointing out the “sound tax policy” embraced by the trilogy cases and suggesting that “it was appropriate for concepts of ability to pay, certainty, and protection of the public treasury to require that the income be recognized on its receipt”). 20. aod 1971 wl 29312 (july 27, 1971). the irs issues actions on decision at its discretion and only with respect to unappealed issues decided adversely to the government in the tax court. such documents do not affirmatively state official irs positions that may be relied upon, but rather provide guidance to irs personnel. 21. 1971-2 c.b. 549. 22. see, e.g., jules silk, advance payments – prepaid income: recent developments; an old problem put to rest, 30 n.y.u. inst. fed. tax. 1651, 1659, 1666 (1972) (noting that, by its issuance of rev. proc. 71-21, the commissioner had “relented” and “decided to forego, in part, the favorable results which he has received in litigation”); jonathan sobeloff, new prepaid income rules: irs reversal of position will aid many taxpayers, 33 j. tax’n. 194 (1970). a survey of post168 florida tax review [vol. 9:3 rev. proc. 71-21 was promulgated pursuant to the commissioner’s authority under section 446 and its stated purpose was to “reconcile the tax and financial accounting treatment” of advance payments for services “without permitting extended deferral.”23 section 3.02 of the revenue procedure states the general principle that “an accrual method taxpayer who, pursuant to an agreement (written or otherwise), receives a payment in one taxable year for services, where all of the services under such agreement are required by the agreement as it exists at the end of the taxable year of receipt to be performed by him before the end of the next succeeding taxable year, may include such payment in gross income as earned through the performance of services.” however, if the taxpayer has not completed performance of all contemplated services by the end of that next succeeding taxable year, “the amount allocable to the services not so performed” must be included in income for that year regardless of when, if ever, such services are actually performed. if, under the agreement, any portion of the services is to be performed after the end of the following year, or, alternatively, if any portion of the services is to be performed at an unspecified future date, the entire amount of income must be reported in the year of receipt.24 thus, rev. proc. 71-21 mandates harsh results for taxpayers whose large service agreements call for payments allocable to services scheduled to be performed more than a year hence. eight years after artnell, the court of claims in boise cascade focused on the “additional ground” relied upon in schlude and rejected the government’s argument that income received for the future performance of services may never be deferred absent an explicit statutory exception.25 although decided in 1976, boise cascade involved tax years 1955 through 1961.26 the taxpayer in boise cascade called expert witnesses to support its schlude cases reveals that an overwhelming majority of taxpayers were unable to overcome the “purely artificial” designation. 23. the issuance of rev. proc. 71-21 was preceded by a report by a presidential task force in september 1970 expressing concern regarding the many instances in which accrual method taxpayers were being required to include prepaid amounts in income. 24. rev. proc. 71-21, § 3.03. section 3.11 adds that the amount of any advance payment included in income cannot be less than the amount that has been reported as income for financial accounting purposes. 25. boise cascade, supra note 8, at 1375. the government emphasized, as had the court in aaa, the congressional enactment in 1958 of § 455. the courts in artnell and boise cascade were unwilling to permit unfettered congressional discretion notwithstanding the proper “reflection of income” under § 446(b). 26. although rev. proc. 71-21 was not applied in boise cascade, the taxpayer invoked it to counter the government’s reliance on a strict nondeferral position based on the trilogy cases. 2008] taxing the business of sports 169 claim that the deferral of advance payments for engineering services clearly reflected income. refusing to read the trilogy as “an unvarying rule of law,” the court underscored the relevance of a fixed and certain schedule of future services and permitted deferral of the advances until the related services were performed. not surprisingly, the service did not take well to boise cascade. in its action on decision, the service took the court to task for applying the ‘certainty of performance’ test and focusing on the alternative ground for decision in schlude. specifically, such analysis “overlooks the primary ground upon which the supreme court relied in refusing income deferral: the ‘long-standing’ principle that ‘accounting systems deferring prepaid income could be rejected by the commissioner’ pursuant to the broad discretion given him by irc section 446.”27 in support of its position, the service cited favorably to rca corp. v. united states,28 which held that the commissioner has a great deal of discretion pursuant to section 446 to reject accounting methods that rely upon “prognostications and assumptions about the future demand for services.”29 ostensibly to further reduce controversy in this “troublesome and confusing area of tax law,”30 the irs in 2004 issued a more comprehensive ruling that softened some of the standards of rev. proc. 71-21 and extended certain carefully circumscribed deferral rights to other situations. indeed, the stated purpose of rev. proc. 2004-3431 (“2004-34”) was to reduce the “considerable controversy” that abounded regarding the scope of rev. proc. 27. aod 1986-014 (feb. 19, 1986) (emphasis in original). 28. 664 f.2d 881, 888 (2nd cir. 1981). 29. aod 1986-014 (feb. 19, 1986). significantly, a number of cases in the tax court decided subsequent to the issuance of rev. proc. 71-21 lend support to the continued vitality of an independent “certainty of performance” criterion. for example, in t.f.h. publications, inc. v. commissioner, 72 t.c. 623, 644 (1979) (“t.f.h.”), the court stated that “it will not follow the rationale of [artnell] unless the facts present a certainty, of performance or fixed dates, such as was presented in artnell.” similarly, in both standard television tube corp. v. commissioner, 64 t.c. 238, 242 (1975) and allied fidelity corp. v. commissioner, 66 t.c. 1068, 1077-78 (1976), the tax court chose to distinguish the facts at bar from those in artnell, as opposed to questioning artnell’s applicability. the continued viability of artnell and the “certainty of performance” doctrine is discussed more fully infra part ii.d. 30. boise cascade, supra note 8, at 1374. 31. 2004-22 i.r.b. 991 (“2004-34”), modifying and superseding rev. proc. 71-21. for a helpful general discussion, see boris i. bittker, martin j. mcmahon & lawrence a. zelenak, federal income taxation of individuals, ¶ 39.03 (warren, gorham & lamont 1995 & supp. 1 2008). section 6.01 of 2004-34 provides that the ruling is effective for taxable years ending on or after may 6, 2004. 170 florida tax review [vol. 9:3 71-21. at its most basic level, 2004-34, which does not apply to cash method taxpayers, did away with the limitation in rev. proc. 71-21 which stated that deferral was only permitted if all the services contemplated by the arrangement were scheduled to be performed by the end of the succeeding taxable year. however, as under the prior ruling, 2004-34 only allows deferral, where permitted, to the next succeeding taxable year.32 section 5.02 of 2004-34 is the operative provision permitting deferral tax accounting for certain advance payments. this method is identified as a proper method of accounting for the purposes of regulations section 1.451-1. the application of the ruling, and its liberalization of the prior standards, will be explored more fully below in the context of sports sponsorship agreements, broadcast agreements, and ticket purchases. b. advance payments: sponsorship and broadcast agreements 1. timing considerations in the mssp,33 the service describes the typical structure of a sports sponsorship agreement and its appropriate tax treatment. team x enters into a sponsorship agreement with local bank y, under which the bank will be the ‘official bank’ of team x and will be entitled to a host of rights, including print and broadcast advertising, stadium signage, atm placement and the right to publicize its affinity with the team.34 the sponsorship 32. an illustration of this difference can be seen in the following example: an advance payment of $100,000 is received in 2007 for services to be performed in 2008 and 2009. under rev. proc. 71-21, the entire advance payment is required to be recognized when received in 2007. however, under 2004-34, assuming certain conditions are satisfied, the taxpayer may defer until 2008 the recognition of that portion of the payment allocable to services scheduled to be performed after 2007. the irs did not provide an explanation under either ruling as to why the deferral privilege was limited to one year. it is likely that one year was a compromise between the competing tax policies of matching income and expenses, on the one hand, and taxing only those who are able to pay, on the other. see generally susan kalinka, proposed revenue procedure may offer more opportunities for deferral for accrual method taxpayers, 81 taxes 5 (2003); bittker, mcmahon & zelenak, supra note 31, ¶ 39.03[4][b]. 33. supra note 3, at 3-4. recall that this internal guidance was promulgated prior to rev. proc. 2004-34. 34. an example of a wide-ranging sports sponsorship agreement is that between the jones soda co., inc. and the seattle seahawks football team, publicly filed (in redacted form) pursuant to the securities exchange act of 1934. jones soda co., current report (form 8-k) (may 23, 2007). under the terms of the agreement, jones is entitled to act as the exclusive beverage of qwest field, to use the team’s trademark in its promotional materials, to have unobstructed signage at the stadium, 2008] taxing the business of sports 171 agreement is a 5-year contract worth approximately $6 million. for obvious reasons, the franchise would like to receive a large portion of the contract price up front, with periodic payments to be made over the course of the agreement.35 upon execution of the contract, bank y pays $4.2 million to team x, representing a $3.75 million ‘exclusivity rights’ fee ($750,000 per year, all paid up front) and a $450,000 sponsorship fee for the first year. each year thereafter, bank y pays team x another $450,000 fee. on these facts, 80% of the $3.75 million rights fee must be analyzed under the rules governing advance payments.36 the service states that under rev. proc. 71-21, it would reject the taxpayer’s attempt to defer any of the $3.75 million payment. this is because the payment is made pursuant to an agreement for the performance of services where a portion of the services is to be performed after the end of the immediately succeeding taxable year. pursuant to section 3.03(a) of rev. proc. 71-21, the entire advance payment must be included in income in the year of receipt. indeed, since most sponsorship agreements have terms stretching over a number of years, the irs position (prior to 2004-34) was that most advance sponsorship payments were ineligible for deferral. under the deferral method of 2004-34, however, the taxpayer on these facts may argue that exactly 20% of the rights fee is earned during each of the five years of the agreement.37 therefore, under section 5.02(3)(b) of that revenue procedure (which requires that advance payments be included in the year of receipt only to the extent earned in that year, with the remaining and to occupy a luxury suite. in exchange, jones is required to pay the seahawks a sponsorship fee each year. this agreement will be referred to throughout this section. 35. front-loaded sponsorship agreements are most common where a team is selling the naming rights to a new stadium and seeks extra capital to finance the project. 36. whether such payment is properly characterized as an advance payment for “services” will be addressed more fully infra part ii.b.2. for purposes of this section, it will be noted that the service has expressed its preference for first addressing timing questions (and thus the applicability of the relevant rulings) so as to avoid the more difficult determination of whether an item of income is for “services” or for some other right. nonetheless, the mssp makes it clear that the service is willing to posit an alternative argument that the rights fee may be a payment in exchange for a property right and thus, under the general principal of § 451, includible in the year of receipt. 37. this would satisfy the requirement in § 5.02(1)(b) of 2004-34 that a taxpayer, in order to qualify for deferral of advance payments, “must be able to determine… the extent to which advance payments are earned… in the taxable year of receipt.” the example also assumes that the taxpayer franchise is not public and does not prepare a financial statement as defined in § 4.06 of 2004-34. 172 florida tax review [vol. 9:3 amount to be included in the following year), the taxpayer may defer the recognition of $3 million of the rights fee until the year following the execution of the agreement. similarly, in the jones soda/seahawks agreement, the sponsorship fees are paid in two installments per year; if the payments are frontloaded, the seahawks may be entitled to defer, until year two, a portion of the sponsorship fee paid in year one, since a portion of the first year fee may be allocable to subsequent years (i.e., they are not “earned” in year one) under the deferral method of 2004-34. as described above, sports franchises benefit from both local and national broadcasting deals. these agreements generally involve sums that were unfathomable at the time the first televised baseball game (an ivy league matchup between columbia and princeton) was aired on may 17, 1939.38 the league-wide broadcasting contracts are shared equally by the teams in the four major american sports leagues, and payments are usually made on a per-season basis.39 franchises may therefore receive payments for broadcasting rights during the tax year preceding the year to which these payments relate. in such cases, the question that arises under the applicable rulings is whether the franchise may postpone inclusion of these (sizeable) amounts until the following year. an example of a typical broadcast agreement is contained in the mssp guide.40 team x is a member of a league that has entered into a national television broadcasting deal with a national sports network. the contract covers the 1994 through 1997 seasons (assuming, for the sake of simplicity, that the seasons do not straddle the calendar year). payments under the contract are to be made quarterly by the network, beginning on october 1, 1993. the franchise, a calendar year taxpayer, receives its $7.5 million share of the first quarterly payment on that date. the service concluded that rev. proc. 71-21 does not even apply to the broadcast revenue of a sports team, since such income is not for personal services but rather for the sale of a property right (for reasons that are explained more fully below). today, this type of arrangement would be governed by 2004-34, which clearly covers more than just service income. 38. zimbalist, supra note 2, at 149. 39. in 2005, mlb signed an 8-year extension with espn for an estimated $2.368 billion for the right to nationally broadcast various games each week. the nfl’s current television contracts with cbs, fox, espn and nbc generate revenue of approximately $3.7 billion annually, which computes to approximately $115 million per year for each of the 32 nfl franchises, which in most cases is a majority of the team’s revenue. see roger noll, the economics of sports leagues, law of professional and amateur sports, at 17.8; bill griffith, baseball, espn renew contract, boston globe, sept. 15, 2005; late season games can be moved to monday nights, available at http://www.espn.com/nfl/news/story?id=1918761. 40. mssp, supra note 3, at 4-3. 2008] taxing the business of sports 173 under section 4.01 of 2004-34, the $7.5 million payment is an advance payment, and the taxpayer may defer its inclusion until tax year 1994. similarly, if the payments were to be made in full annual installments payable on october 1 of each year, the taxpayer would likely be entitled to defer the full amount of the october 1, 1993 payment until 1994, the year in which the games will be played and the broadcasting revenue will be ‘earned’ pursuant to section 5.02(3)(b) of 2004-34. moreover, if the franchise prepared the financial statements described in section 4.06 of 200434, and recognized some fraction of the october 1, 1993 installment payment in revenue for that year, 2004-34 would mandate that the same percentage of such payment be included in taxable income for 1993.41 as far as the broadcast networks are concerned, the irs chief counsel ruled, in cca 200726023 (may 25, 2007), that broadcast companies may not deduct the entire amount of license fees called for under a sports contract in the year the contract is signed. section 461 governs the timing of the networks’ deductions, and regulations section 1.461-1(a)(2) states that under the accrual method, a deduction is permitted only if the liability is fixed or payment is due. furthermore, under section 461(h), economic performance does not occur until the sports league provides the network with the “property” represented by the right to air the game broadcasts. since these agreements usually cover multiple sports seasons, the entire fee liability is not incurred, for the purposes of the accrual method, in the year the contract is entered into. it is the party’s performance, and not the mere execution of the contract, that establishes the fact of the liability. 2. property rights or services? on its terms, rev. proc. 71-21 was limited to prepayments for “services.” under that ruling, the irs’s audit posture called for a threshold determination of whether the prepayment was in exchange for services or some other tangible or intangible property right. specifically, “[s]ince a tax distinction is made for advance payments for services and advance payments for property rights, the nature of the advance payments in question needs to be determined.”42 as in the broadcasting example described above, if a payment was adjudged to be in exchange for a property right of some sort, the taxpayer was precluded from relying upon the special deferral privilege of rev. proc. 71-21 and instead was subjected to the section 451 baseline of current inclusion, where s/he faced a strong presumption of non-deferral. 41. 2004-34, § 5.03, ex. 15. 42. mssp, supra note 3, at 3-6. 174 florida tax review [vol. 9:3 the irs generally permitted taxpayer reliance on rev. proc. 71-21 with respect to the advance payment of sponsorship fees. in the mssp, the service cited t.f.h.,43 a case holding that a taxpayer must include in income the value of property received (in this case, in the form of a reduction in purchase price) in exchange for advertising to be supplied in the future. t.f.h. assumed without much analysis that “advertising is considered a service.” notably, most sports sponsorship agreements provide for an elaborate hybrid of “services” and rights. for example, the jones soda/seahawks agreement purports to grant to the sponsor certain “beverage availability rights” at the stadium, including the right to be the exclusive beverage concession sold at specified sporting events. jones is also entitled to merchandise its products at seahawks football games, and to promote its strategic sponsorship relationship with the team. in addition, the seahawks have granted jones the right to use its team logo and other trademarks on beverage containers. as for billboards and signage, section 3.3 of the agreement provides that “jones is entitled to have permanent signage in the [stadium] for jones beverages” and that “[a]ny changes or modifications to such signage will be paid by jones. jones will specify the advertising message and graphics for its signage. all other aspects of the design, construction, and general appearance of the signage must meet jones’s reasonable specifications.” with respect to the obligations of the team, section 3.5 (“obligations to maintain signage”) states that the seahawks “will install and maintain all materials and lighting used for the signage…and the structures supporting the signage” and “repair any malfunction, damage, or destruction to the signage or supporting structures within a commercially reasonable period. all installation, maintenance and repair will be at [the seahawks’] expense, except that jones will pay the cost of installing any replacement signage used to modify jones’s initial advertising message or graphics.” despite the wide variety of rights granted to jones under the above agreement, the sponsorship fees are not broken out or allocated to different components of the contract. thus, it is not clear how much the sponsor is paying for advertising, merchandising rights, or the exclusivity privilege. the irs does not appear to have sought an allocation of sponsorship fees in its audits of contracts of this type; therefore, to the extent the service characterized prepaid sponsorship fees as advance payments for advertising (and thus, on the authority of t.f.h., for “services”), it appears that 43. id. at 3-3 (quoting t.f.h, supra note 29, at 640). 2008] taxing the business of sports 175 taxpayers were able to benefit from the deferral rules of rev. proc. 71-21 even for prepayments on various non-service items.44 it is somewhat surprising that the service has not questioned whether advertising truly constitutes a “service” for tax purposes. as mentioned above, the tax court in t.f.h. did not provide an explanation for its conclusory determination that advertising revenues were entitled to treatment under the special rules for prepaid services income. similarly, the service in tam 200147032 (november 26, 2001) cited t.f.h. for this proposition without any discussion. clearly, as the jones soda/seahawks agreement demonstrates, the typical sponsorship agreement entered into by sports teams and their sponsors grants various self-styled “rights” to the sponsor. although these contracts are generally in the nature of advertising arrangements, since they also memorialize a sale of such rights, it would not have been unreasonable for the irs to insist on current inclusion of any advance payments for such rights due to the inapplicability of rev. proc. 7121. to be sure, it is difficult to find a clear definition of “services” for purposes of the prepaid income rules. in barnett banks of florida, inc. v. commissioner,45 the tax court held that annual credit card membership fees constituted prepaid income for services under rev. proc. 71-21. specifically, the credit card company provided its customers with data processing services, assisted them with lost or stolen cards, and authorized the issuance of credit. the court rejected the irs’ argument that the annual fees were “for membership in the card plan” and thus analogous to additional interest or a commitment fee.46 in signet banking corp. v. commissioner,47 however, the tax court ruled that the annual credit card fees at issue were not received in exchange for services and that, accordingly, deferral under rev. proc. 71-21 was not available. although the credit card issuer in signet banking did perform a host of card-related services, the court meticulously scrutinized the operative cardholder agreement and concluded that while many services were indeed contemplated by the agreement, the issuer fixed its right to earn the fee when it opened the account and established a credit limit for the holder. in the court’s words, the credit card provider “performed all of the acts that it was required to perform in order to be entitled to the annual membership fee when it issued a credit card to the customer.”48 the federal 44. a review of various agreements reveals that sponsorship and broadcasting rights are often subsumed under one “rights fee.” 45. 106 t.c. 103, 116 (1996). 46. id. at 110. 47 106 t.c. 117 (1996), aff’d 118 f.3d 239 (4th cir. 1997). 48 id. at 126. 176 florida tax review [vol. 9:3 circuit took up the question of “services” under rev. proc. 71-21 in american express co. v. united states,49 but concluded only that the term was ambiguous and therefore that the service’s interpretation of its own revenue procedure should be granted deference. other code and regulatory provisions that refer to personal services, such as sections 448(d)(2) (definition of “qualified personal service corporation”), 269a (definition of “personal service corporation”) and 469(j)(2) (same), section 954(a)(3) (foreign base company services income), sections 861(a)(3) and 862(a)(3) (income sourcing rules), regulations section 1.512(b)-1(c)(5) (for ubti purposes, amounts paid for occupancy do not constitute “rent from real property” where substantial services are rendered to the occupant), and sections 351 and 721 (nonrecognition upon incorporation or formation of a partnership) do not shed sufficient light on whether advertising (at least in the context of sports sponsorships) is properly classified as a “service” (as opposed to a license of a limited property right) for united states federal income tax purposes. the distinction between services and property rights was at least partially eliminated when the service issued 2004-34. in addition to liberalizing the rules regarding the timing of performance, 2004-34 expanded the scope of rev. proc. 71-21 by allowing income deferral for items other than services. given the ambiguity of the term ‘services’ under prior law, this revenue procedure eliminated a prime basis for dispute. section 2.04 of 2004-34 asserts that “taxpayers and the internal revenue service frequently disagree about whether advance payments are, in fact, for ‘services.’” section 4.01 provides that the deferral is available under 2004-34 for payments made in exchange for services as well as various other items of income, including “the use (including by license or lease) of intellectual property.” ‘intellectual property’ is further defined in section 4.03 of 200434 as “copyrights, patents, trademarks, service marks, trade names, and similar intangible property rights (such as franchise rights and arena naming rights).” extending the benefits of deferral to rights in intangible property may have a real effect on sports broadcasting agreements. under such agreements, licensing fees are paid to sports franchises (or sports leagues) in exchange for the rights to broadcast the team’s games over the air. in plr 8331053 (april 29, 1983), a taxpayer attempted to defer the first installment of a payment made pursuant to a television contract. the service disallowed such deferral under rev. proc. 71-21 and stated that “the payments received under the contracts with the networks in the present case are made not in exchange for services but in exchange for the [t]axpayer’s property interest in the publicity of its enterprise.” the service cited a number of cases in 49. 262 f.3d 1376, 1381 (fed. cir. 2001). 2008] taxing the business of sports 177 support of its conclusion, including board of regents of the university of oklahoma v. ncaa,50 which held that “[t]he right to telecast college football games is the property of the institutions participating in the games, and that right may be sold or assigned by those institutions to any entity at their discretion.” usually, broadcast agreements do not contemplate the provision of services on the franchise’s part, but merely grant the network the right to broadcast the action. thus, whereas under prior law any advance payments were treated as a current sale of property rights, subject to a presumption of current inclusion under section 451, under 2004-34 these intangible property rights likely constitute “intellectual property,” and sports leagues and franchises should be entitled to the deferral benefits so long as they meet the other requirements of the ruling. advance credit card fees similar to the ones addressed in the barnett and signet cases, however, are not eligible for deferral treatment under 200434. credit card issuers have had difficulty convincing the irs and the courts that annual fees were paid in exchange for services, as opposed to the mere availability of credit. in this regard, the service has stated that the annual fee “is a fee charged for the acquisition of a property right, the right to the use of money, and not for the performance of services.”51 although section 4.03 of 2004-34 extended deferral benefits to intellectual property and “similar intangible property rights,” section 4.02 of 2004-34 provides that an “advance payment does not include – payments with respect to…credit card agreements.” since 2004-34 effectively broadened the standards set forth in rev. proc. 71-21,52 credit card issuers seeking income deferral can plausibly argue that, to the extent a prepaid credit card fee constitutes service income (contrary to the service’s conclusion in plr 8543004), it is entitled to the more limited deferral of rev. proc. 71-21 despite its being excluded from the scope of 2004-34. 50. 546 f. supp. 1276, 1328 (w.d. okl. 1982). see also uhlaender v. hendrickson, 316 f.supp. 1277 (d. minn. 1970); weiler & roberts, supra note 6, at 434 (noting that copyright law creates a property right in the public broadcasting of sporting events but not in the bare events of a game). see mssp, supra note 3, at 42, 4-3 (disallowing deferral relating to broadcasting contracts on grounds that these payments are in exchange for property rights, not services). 51. plr 8543004 (july 18, 1985). see also rev. rul. 81-160, 1981-1 c.b. 312. 52. section 2.04 of 2004-34 asserts that “the service has determined that it is appropriate to expand the scope of rev. proc. 71-21 to include advance payments for certain non-services.” in light of this statement, one can take the position that 2004-34 does not disallow the deferral of any service income that falls within rev. proc. 71-21. 178 florida tax review [vol. 9:3 c. advance payments: ticket sales & seat licensing sports franchises derive a significant amount of revenue from ticket sales. tickets are often sold as part of singleor multi-season packages, with substantial sums paid up front as deposits or advances. seat licensing involves advance sales of the right to purchase season tickets for a specified period of time. in the case of luxury suites or skyboxes, which are most commonly occupied by corporations and large sponsors, the advances can be quite sizable.53 of course, in the case of prepayments for tickets, as is the case with all prepayments, it must first be determined that the prepaid sum constitutes a taxable advance payment (as opposed to a nontaxable deposit) for the trilogy and related doctrines to apply. that question, which is beyond the scope of this paper, is governed by the “complete dominion” standard as expressed by the supreme court in commissioner v. indianapolis power & light co.54 in general, the distinction between a tax-free deposit and a (generally)taxable advance payment will depend on the precise contractual terms and the use to which the funds are put, since the difference is one of degree rather than kind. payments for seat licenses and (although to a lesser degree) season tickets usually are refundable only if the games are not actually played, which militates against deposit treatment. these types of sports ticket transactions have played a prominent role in the development of the prepaid income doctrine. artnell involved the proceeds of advance ticket sales by the chicago white sox, and the 7th circuit in that case easily distinguished the facts at bar from those in the trilogy cases. specifically, the court pointed out that since baseball games are played on a fixed schedule, “the uncertainty stressed in those decisions is not present here.”55 unlike the dance lessons in schlude or the member services in aaa, the scheduled playing of baseball games can be relied upon with 53. by selling seat licenses, a sports team “receives a substantial additional and accelerated source of income, with no obligation of repayment.” schuyler moore, taxation of the entertainment industry, ¶ 1304 (cch 2008). 54. 493 u.s. 203 (1990). see generally burgess j.w. raby & william l. raby, taxable advance payments vs. deposits and deferrals, 2001 tnt 164-88 (aug. 23, 2001) (advising practitioners to carefully structure escrow arrangements and advances for their clients so as to maximize income deferral). to the extent an arrangement is silent as to refundability, irs guidance suggests that the complete dominion test will be met. see tam 200619023 (feb. 1, 2006) (holding that a prepayment made pursuant to a service contract that did not contain any refund provision was a taxable advance payment since the payor surrendered control of the proceeds once they were paid). 55. artnell, supra note 17, at 984. 2008] taxing the business of sports 179 near certainty (subject to occasional rain-outs or the like). therefore, the court ruled, the deferral of income in such circumstances embodies a near perfect reflection of income.56 the tax court had an opportunity to apply the reasoning of artnell in the 2002 case of tampa bay devil rays, ltd. v. commissioner.57 in devil rays, the taxpayer partnership received payments in 1995 and 1996 for season tickets and luxury suites for games that were to be played in 1998, the inaugural year for the devil rays baseball franchise. for book and tax purposes, these amounts were not reported until the games were played in 1998. after reviewing the trilogy cases and subsequent developments, the court concluded that “the facts before [it] in the instant case fall within the narrow fact pattern of artnell.”58 since all game-related expenses were to be predictably incurred beginning in 1998, deferral of income was proper under section 446. additionally, the advances were refundable in the event the devil rays did not play the 1998 season. in the case of seat licenses, the irs has ruled that deferral is not permitted beyond the date of receipt of the license fee. in cca 200247035 (august 16, 2002), a professional sports franchise sold personal seat licenses to help finance the construction of a new stadium. the licensing fee was paid in three installments to be paid over three years, and entitled the licensees to purchase tickets to all future games to be played at the new stadium. the license agreement provided that “the licensees had only a revocable right of personal privilege and that the licenses did not confer any real property or leasehold interest in any particular stadium seats.” the irs chief counsel, relying on sections 446 and 451, ruled that the taxpayer was required to include in income each installment payment under the contract at the time it became due and payable or was paid, whichever occurred first. one commentator has observed that this ruling was decided correctly and that 56. in the various irs rulings and reported cases, advance payments for sports tickets have been uniformly treated as prepayments for services. see artnell, supra note 17 (assuming without analysis that advance ticket payments are for services to be performed when game is played); silk, supra note 22, at 1662 (characterizing the rendered service as “the playing of the game”). undoubtedly, franchises perform numerous services for ticket-holders, such as parking, concessions and promotions. however, most of a ticket’s value is attributable to the right it vests in the holder to gain admittance into the arena to view the sporting event. since the game is played irrespective of fan attendance, query whether advance ticket payments are perhaps more properly viewed as prepayments for a limited property right, (a license to enter private property for a limited purpose). 57. t.c. memo 2002-248 (“devil rays”). 58. id. at 19. notably, in devil rays the advance payments represented 25% of the total season ticket prices. 180 florida tax review [vol. 9:3 under the prevailing authorities on prepaid service income, deferral of seat license fees would be improper because of the uncertainty regarding if and when the seat license will actually be used.59 the nature of seat licenses, however, raises the question of whether it would be more appropriate to treat such prepayments as option premiums (and therefore subject to the tax accounting applicable to options) instead of items of prepaid income subject to section 451 and the trilogy cases. under section 1234(b), a grantor of an “option in property” does not incur taxable income until the option transaction is completed through lapse, exercise or other disposition.60 this “open transaction” treatment is accorded because the prepayment is eventually applied (if and when the option is exercised) as a credit to the purchase price of the tickets.61 while section 1234(b) on its terms only applies to options in stock, securities, commodities and commodity futures, options on other types of property are probably still entitled to open transaction accounting under presection 1234 case law.62 if the seat license lapses, the team’s gain will generally be ordinary income under the extinguishment doctrine.63 therefore, to the extent a seat license is 59. moore, supra note 53, ¶ 1304 (“if payments for a seat license were not taxable on receipt, it would be difficult to rationalize why any other advance payments would be taxable”). moore points out that another typical seat license arrangement involves the licensee’s purchasing an interest-free bond from the franchise in exchange for which the franchise grants a seat license. these loan proceeds are obviously not taxable to the franchise. yet, under the rules of § 7872, the purchaser is deemed each year to receive imputed interest income from the team and to make a non-deductible payment for the seat license. 60. see rev. rul. 78-182, 1978-1 c.b. 265. 61. see comm’r v. dill co., 294 f.2d 291 (3d cir. 1961) ($50,000 paid for five year extension on a license to use a trademark, which license included an option to purchase, was not currently includible to licensor because it was intended to be a downpayment on the purchase price in the event the licensee exercised the purchase option). a similar payment in a capital transaction was found not to be currently taxable in virginia iron coal & coke co. v. commissioner, 99 f.2d 919 (4th cir. 1938), since at the time the payments were made, it was impossible to know whether the sum would ultimately represent a return of capital or premium on a lapsed option. see also rev. rul. 58-234, 1958-1 c.b. 279. 62. see, e.g., virginia iron coal & coke co., supra note 61. where the call option is exercised, the premium constitutes part of the writer’s amount realized on the sale, and will take the character based on the nature and holding period of the underlying property being sold. rev. rul. 78-182, supra note 60. 63. leh v. comm’r, 260 f.2d 489 (9th cir. 1958); rev. rul. 57-40, 1957-1 c.b. 266. capital treatment would not be available under § 1234a, which grants sale/exchange treatment to the termination or lapse of certain contracts. the provision was expanded by the taxpayer relief act of 1997, pub. l. no. 105-34, § 1003(a), to cover “right[s] or obligation[s]” with respect to all property which would 2008] taxing the business of sports 181 an ‘option’ for tax purposes, a prepayment could conceivably be subject to deferral, character notwithstanding. regrettably for sports franchises, a seat license is likely not an option for tax purposes. firstly, the arrangement does not entitle the holder to purchase seats at a fixed price; instead, he typically must pay the going price at the time of purchase. this militates against option treatment since the presence of a ‘strike price’ is one of the hallmarks of a true option.64 second, since advance payments for tickets themselves have been treated as prepayments for services, payments for the right to purchase a ticket may not constitute an option to buy property, but rather a payment creating an executory obligation to purchase services. the language of section 1234(a) suggests that there must be underlying property in order for a statutory option to exist. consequently, a seat license fee is probably not entitled to deferral, while a true prepayment for specific tickets (as described above) can be deferred under artnell and devil rays. the next part of the paper discusses the broader importance of these cases in the area of income deferral. d. continuing viability of the “certainty of performance” standard the court in devil rays relied on the theory of artnell to permit deferral without even mentioning, much less applying, the strictures of rev. proc. 71-21. the advance payments in that case would have failed the be a capital asset in the hands of the taxpayer. thus, a seat license fee (assuming it were an “option”) could still be entitled to sale treatment (to the team) upon lapse if the license were “with respect to” property (i.e., the ticket), and such ticket would be a capital asset in the team’s hand. however, tickets are clearly not capital assets in the team’s hands under § 1221(a)(1), and thus § 1234a would not apply. consequently, even if a seat license were an option, a lapse would result in ordinary income to the team. 64. the underpinnings of the service’s approach to options taxation can be found in the seminal case of burnet v. logan, 283 u.s. 404 (1931). an option transaction has been described by the service in rev. rul. 58-234, supra note 61: “just as the optionee thereby acquires a right to sell, or buy, certain property at a fixed price during a specified future period or on or before a specified future date, so does the optioner become obligated to accept, or deliver, such property at that price” (emphasis added). the fact that a seat licensee is not taking an economic “position” with respect to the seats makes a seat license unlike a traditional option. see generally stanley i. langbein, federal income taxation of banks & financial institutions, ¶ 4.06 n. 322 (warren, gorham & lamont 2001). admittedly, a seat license may still be similar enough to a “traditional” option to warrant open transaction treatment under general principles. 182 florida tax review [vol. 9:3 applicable requirements since the services to be performed by the team were to take place as many as three years after the payments were made. the tax court nevertheless found artnell to be determinative of the deferral question. sports tickets are perhaps the quintessence of “fixed and definite” services, and these two “ticket cases” lend great support to the proposition that, as a general matter, and notwithstanding the trilogy, service agreements that are drafted with enough precision and specificity may enable taxpayers to defer income recognition over multiple taxable years. while the trilogy involved prepayments for services and appear to represent weighty authority against deferral, it is not unreasonable to read the cases as being limited to their facts. indeed, the nature of the prepaid income rules require factspecific inquiries into whether a particular taxpayer’s method of tax accounting represents a clear reflection of his economic income. the trilogy taxpayers employed methods that were artificial and indeterminate, and statistical showings could not persuade the courts that deferral resulted in a clear reflection of income. arguably, income earned in advance of services that are as fixed and definite as the occurrence of baseball games should not be limited by rev. proc. 71-21 or 2004-34. the above conclusion is borne out by a careful review of post-trilogy court decisions. initially, many cases interpreted the non-deferral principle broadly and categorically.65 however, courts eventually began to focus on the particular circumstances before them, and acknowledged that the supreme court had not established an inflexible rule of law.66 although most of these decisions have articulated a high threshold for artnell treatment, they have consistently intimated that deferral is appropriate on the right set of facts.67 thus, even in light of the 1971 and 2004 irs revenue procedures, taxpayers should still be able to find support in the case law. as one 65. see, e.g., gillis v. united states, 402 f.2d 501, 506 (5th cir. 1968) (“the theory behind the accrual system is not complicated. income items are reported in the year in which the right to receive them becomes fixed even though such items are not immediately receivable. at no time, however, are such items reportable later than the year of actual receipt”). 66. in addition to artnell and boise cascade, see generally t.f.h., supra note 29 and chesapeake financial corp v. commissioner., 78 t.c. 869 (1982) (disallowing deferral of mortgage banker’s commitment fees on the grounds that it “lack[ed] a precise breakdown as to… the time the service was provided”). 67. automated mktg. sys., inc. v. united states, 34 aftr 2d 5427 (n.d. ill. 1974) (allowing deferral of marketing service income for more than two years); handy andy t.v. & appliances, inc. v. comm’r, t.c. memo 1983-713 (stating that deferral may be permitted “based upon contract terms or historical data regarding services performed for the specific payee”); collegiate cap & gown co. v. comm’r, t.c. memo 1978-226 (applying artnell because future performance was fixed). see also cases cited supra note 29. 2008] taxing the business of sports 183 commentator has noted, “depending on the particular facts, pre-trilogy cases may be just as applicable today as both the trilogy and post-trilogy cases.”68 indeed, the service itself in a number of rulings has not given dispositive weight to the taxpayer’s failure to comply with the requirements of rev. proc. 71-21. in tam 200001006 (january 7, 2000), the taxpayer provided various consulting services for its clients, including carrying out market research studies over a specified period of time to study retail consumer trends. fees for these studies were generally received in advance of the performance of the services. with respect to specific types of market studies, the taxpayer argued that although he failed to come under the ambit of rev. proc. 71-21, the boise cascade/artnell line of cases furnished a basis for deferral of income. the service did not reject the argument in principle, but instead distinguished these cases and concluded that the taxpayer’s method of tax accounting did not clearly reflect income under the trilogy and its progeny. in tam 200619023,69 the service addressed a taxpayer’s deferral claim based on artnell and its progeny despite the taxpayer’s clear failure to secure the commissioner’s consent, as required by rev. proc. 71-21. specifically, section 5.01 of rev. proc. 71-21 states that with respect to services performed by related parties, the adoption of the deferral method of accounting under the revenue procedure is to be treated as a change in method of accounting subject to the consent requirements of section 446(e). the taxpayer in the tam received advance payment from a related party (for whom it had contracted to perform services) and utilized the deferral method without procuring consent. nevertheless, the taxpayer cited to artnell and devil rays and argued that its deferral methodology clearly reflected income. the service held that the services provided by the taxpayer were not performed on a fixed schedule. rather, the trucking services at issue were carried out based upon reasonable request, albeit during predetermined time intervals. the ruling is critical not so much for its result but for the fact that the service proceeded to address the artnell claim even after determining that the taxpayer clearly ran afoul of rev. proc. 71-21. sports franchises that enter into lucrative sponsorship agreements that feature sizeable front-loaded payments are well served to draft contracts that are excruciatingly specific about the “services” owed to the sponsor. doing so can serve to support the (accrual method) taxpayer’s position that deferral of inclusion until the time that services are performed is a clear reflection of income. the credit card fee cases demonstrate the significance 68. gertzman, supra note 7, ¶ 4.03[3]. see also moore, supra note 53, at 61 (suggesting that artnell, boise cascade and devil rays may still be good law). 69. see supra note 54. 184 florida tax review [vol. 9:3 of precise drafting in this fact-intensive area of tax law, as courts and the service are likely to insist that the smallest amount of uncertainty or ambiguity precludes the deferral of prepaid income. indeed, “a simple change in the language of the applicable agreement may provide the basis for a deferral.”70 exhibit c to the jones/seahawks agreement discussed above (“signage specifications”) deals with jones’ advertising and signage rights at qwest field. the agreement provides, each agreement year, jones is entitled to the following permanent signage: • one (1) 42’ x 12’ tri-vision panel on the north tower scoreboard. • one (1) in stadium led rotation per seahawks home game. • one (1) 28’ x 4’ backlit interior qwest field event center panel. • one (1) 2’ x 2’ qwest field event center exterior sign. if a prepaid income question were to arise on audit, the seahawks could point to the precise wording of the contract and the ‘fixed and definite’ nature of the advertising services they are called upon to perform under the contract, especially since such services are ultimately linked to the games scheduled to be played by the seahawks. in this case, the deferral of advance payments is perfectly consistent with the “clear reflection of income” standard as developed by the courts. while the prepaid income doctrine is relevant to the ongoing operations of sports teams, there are also numerous tax issues that arise in connection with the acquisition and sale of such franchises. the next part of this paper will address the colorful historical backdrop and legal developments pertaining to one such issue; the amortization of player contracts (and other intangibles). 70. gertzman, supra note 7, ¶ 4.03[3][e]. see also c.l. kelley & a.h. lieberman, how to defer revenue from prepaid service income, 75 taxes 3, (1997). kelley and lieberman draw on the credit card cases discussed above and conclude that the tax court’s analyses in these cases “can be helpful to other taxpayers with service income such as health clubs, cellular phone companies, online service providers and law firms.” 2008] taxing the business of sports 185 part iii sports franchises and player contracts “you go through the sporting news of the last 100 years, and you will find two things are always true. you never have enough pitchers, and nobody ever made money.”71 the acquisition and sale of sports franchises have always piqued the interest of the irs. this fascination is due to the fact that the value of sports teams consists disproportionately of intangible assets, a characteristic that presents tremendous challenges in the areas of allocation and valuation. according to the irs, nearly 90% of the value of a sports franchise is attributable to its intangible assets.72 moreover, buyers are usually wealthy individuals with extensive business interests outside the franchise itself.73 the tax treatment of these intangible assets, which include franchise value, player contracts, and media rights, has substantially affected the market’s valuation of franchises. part iii of this paper will explore the current treatment of “sports intangibles” under the applicable tax laws and will describe the concerns that have fueled congressional and judicial action in this area, one that is rich with tax policy considerations. a. taxation of sports intangibles – pre-2004 although sports teams usually own a small number of tangible assets such as uniforms and equipment,74 their most valuable assets are generally 71. donald fehr, former director, mlb players’ association, quoted in zimbalist, supra note 2, at 47. 72. irs memorandum, examination of sports franchise acquisitions,2003 tnt 221-37 (oct. 24, 2003). this directive is discussed further infra note 137 and accompanying text. 73. see robert f. reilly, sports franchise acquisitions: purchase price allocation procedures, the cpa journal (oct. 2003). 74. even the most valuable sports franchises generally do not own their own stadiums, but instead rely on public financing for such costs. for example, the new york yankees’ new stadium, under construction in the bronx at the time of this writing, is expected to cost $930 million, and the team will receive $866 million from tax-exempt bonds issued by new york city. in january 2009, the yankees requested an additional $370 million in tax-exempt bond financing. richard sandomir, hearing on bonds for new yankees stadium gets testy, n.y. times, jan. 14, 2009. bryan virasami, mets detail stadium financing, newsday, apr. 11, 2006. by brandishing the threat of relocation, teams have been able to negotiate 186 florida tax review [vol. 9:3 the league franchise (and the concomitant right to geographical exclusivity), rights to league-wide revenue streams (especially media and licensing contracts), and player contracts.75 since these assets comprise such a substantial percentage of the sports franchise, the available methods of cost recovery stand to impact overall franchise value. 1. early cases and the franchise value explosion until 1993, with the introduction of section 197 and its 15-year amortization of most intangibles, the amortization of intangible assets was governed exclusively by section 167 and its regulations. regulations section 1.167(a)-3 provides that depreciation deductions are available with respect to intangible assets only if it can be demonstrated that such assets have limited useful lives and ascertainable values, and that no depreciation is allowable with respect to goodwill.76 therefore, taxpayers traditionally sought to allocate large amounts of purchase price to amortizable intangible assets such as player contracts, while the irs would insist on allocating value to intangible assets with indeterminate useful lives such as the franchise itself, or goodwill. under regulations section 1.167(a)-1(b), the estimated useful life of an asset is “the period over which the asset may reasonably be expected to be useful to the taxpayer in his trade or business or in the production of his income.”77 the tax benefit attributable to sports player contracts purchased as part of a franchise acquisition can be traced back to a number of cases from the 1920s and 30s. at the time, typical contracts used in professional baseball, football and basketball provided for one year of service and contained a “reserve” clause granting the team an option to renew the contract for another year. the athlete and the team would typically favorable leases in stadiums built with taxpayer dollars. see supra note 2 and accompanying text. 75. see stephen a. zorn, ‘couldna done it without the players’: depreciation of professional sports player contracts under the internal revenue code, 4 seton hall j. sport l. 337 (1994). 76. see also houston chronicle publishing co. v. united states, 481 f.2d 1240 (5th cir. 1973), cert. den., 414 u.s. 1129 (1974); rev. rul. 74-456, 1974-2 c.b. 65. the disallowance for amortizing goodwill was first introduced in t.d. 4055, vi-2 c.b. 63; reg. 69, art. 163 (revenue act of 1928, reg. 69, art. 163). treas. reg. § 1.167(a)-3 still contains the general rule for intangible assets, but now cross references § 197 for the treatment of goodwill and certain other intangibles acquired after aug. 10, 1993. 77. of course, costs are treated as capital expenditures in the first place only if they are attributable to the acquisition of an asset whose useful life extends substantially beyond the taxable year. treas. reg. § 1.263(a)-2(a). 2008] taxing the business of sports 187 renegotiate the salary prior to the option year; however, if no agreement was reached, the club had a limited right to fix the salary. if negotiations turned acrimonious, the team, of course, could not force the player to play, but could prevent the player from playing for another team in the league.78 the first tax case to address the issue of player contracts in connection with the purchase of an entire team was the 1935 decision in chicago national league ball club.79 in that case, the taxpayer had 78. the reserve clause was a key feature in professional sports contracts from as far back as the late 1800s. the seminal supreme court decision in federal baseball club v. national league, 259 u.s. 200 (1922), held that baseball was an “amusement,” and therefore not subject to the antitrust laws. this ruling ensured that the reserve clause, and the bargaining power it gave to baseball owners, would remain a fixture of the game for many years. however, in 1975, an arbitrator ruled that two pitchers playing under the reserve clause could bargain with other teams, since a sports league could not retain the services of a player indefinitely. the ruling was upheld by the eighth circuit and gave rise to the advent of free agency, changing the course of modern professional sports. 79. b.t.a. memo. 1933-197 (1933), aff’d per curiam, 74 f.2d 1010 (7th cir. 1935) (“chicago national league”). to be sure, owners of sports franchises had litigated the issue of cost recovery on player contracts from as early as the 1920s. however, prior to chicago national league, the question primarily arose with respect to the acquisition of individual player contracts (where it was clear that a specific sum was allocable to a particular contract), as opposed to purchases of franchises that included an aggregate of contracts. indeed, chicago national league also involved deductions with respect to individually acquired player contracts. the first case to address the sale of individual player contracts was dallas athletic ass’n. v. commissioner, 8 b.t.a. 1036 (1927), which held that amounts paid by one minor league baseball team to another for player contract rights were in the nature of capital expenditures and were not ordinary and necessary business expenses. in later cases, however, including chicago national league, the board of tax appeals (the “board”) reversed course and permitted current expensing of the cost of acquiring player contracts. in these later cases, the courts’ holdings were based on highly questionable analyses of the reserve clause. for example, in pittsburgh athletic co. v. commissioner, 27 b.t.a. 1074, 1076 (1933), the board permitted a current deduction even though the contracts were sure to benefit the club for more than a single year, as baseball’s version of the reserve clause gave the team the right to unilaterally set the salary for the renewal year. the third circuit affirmed the board, 72 f.2d 883, 884 (3d cir. 1934), pointing out that “if the player should cease to engage in professional baseball, the option for renewal of his contract would become valueless.” see also helvering v. kansas city american assoc. baseball co., 75 f.2d 600 (8th cir. 1935). notably, pittsburgh athletic co., chicago national league and kansas city american assoc. baseball co. were accepted by the irs in two administrative pronouncements, i.t. 2932, xiv-2 c.b. 61 (1935) and i.t. 4078, 1952-1 c.b. 39. the service eventually realized that the reserve clause did in fact 188 florida tax review [vol. 9:3 purchased a baseball franchise and the thirty or so player contracts that were owned by it at the time. the board clearly accepted in principle an allowance for the depreciation of these contracts; however, due to lack of proof and a failure by the taxpayer to allocate the purchase price between the contracts and the franchise, the board effectively passed on the question of amortization. in rev. rul. 54-441,80 the irs squarely addressed, for the first time, the proper tax treatment of player contracts acquired as part of a larger acquisition. the service held that the cost of a roster of baseball player contracts must be capitalized and recovered over the useful life of such contracts. since the contracts at issue were uniform one-year player contracts with then-standard reserve clauses, the service stated that it would be reasonable to compute their useful lives based on the prior owner’s pattern of exercising the options.81 with respect to the acquisition of individual player contracts, by contrast, rev. rul. 54-441 agreed to full deductibility in the year of purchase, thereby approving of the results in prior board cases. however, the service eventually rejected these cases (along with rev. rul. 54-441) in rev. rul. 67-379,82 where it held, quite sensibly, that all costs of acquiring player contracts must be capitalized and amortized over their useful lives. capitalization was mandated even with respect to the 1-year contracts with reserve clauses, since the effect of the team’s option “is the same as if the player were expressly to bind himself to play only for the club which owns his contract for the entire period of his useful life as a player in organized baseball, subject to annual salary adjustments.” a similar conclusion was reached with respect to professional football contracts in rev. rul. 71-137,83 which likened football’s “option clause” to baseball’s reserve clause and disallowed current deductibility of such costs. in these rulings and cases, the point of contention was current deductibility versus capitalization and amortization. at no point did the irs argue that player contracts were not give teams an upper hand on players and rejected current deductibility for all acquisitions of player contracts (requiring instead depreciation over the useful life of such contracts). see rev. rul. 67-379, infra note 82. 80. 1954-2 c.b. 101. 81. in baseball, unlike football and basketball, when the renewal option was exercised, the renewed contract would itself contain an option to extend. although this feature could have furnished an independent basis for the service to differentiate between the useful lives of baseball player contracts and those in other sports, it never attempted to do so. see leslie s. klinger, professional sports teams: tax factors in buying, owning and selling them, 39 j. tax’n. 276, 277 n.4 (1973). 82. 1967-2 c.b. 127. 83. 1971-1 c.b. 104. 2008] taxing the business of sports 189 depreciable property, which proved to be a boon to the sports franchises that claimed these deductions to the tune of millions in tax savings. because of the ability to amortize the costs of player contracts over a relatively short timeframe, taxpayers involved in the purchase of sports teams began to allocate a substantial portion of acquisition costs to the contracts.84 this phenomenon proved to be a driving force behind the explosive growth of professional sports franchises throughout the 1950s and 1960s. the deduction attributable to purchased player contracts roughly doubled the value of major league sports franchises from 1959 to 1975.85 the favorable tax rules also fueled expansion of the sports leagues themselves. indeed, by 1974, the number of professional sports teams had increased to 114 from just 42 in 1959.86 notably, many franchises continued to report tax losses as cash income and enterprise values continued to rise. according to one commentator, “the purchasers were attracted by the tax shelter aspects of the business rather than by the prospect of operating profits.”87 in the mid 1970s, the courts again began to look seriously at the amortization of player contracts in sports. in laird v. united states,88 the government argued that an allocation of over 90% of a sports franchise’s purchase price to the player contracts was improper. the taxpayer in laird was a shareholder of the s corporation that had purchased the nfl’s atlanta falcons as an expansion franchise in 1966. pursuant to the acquisition documents, the taxpayer paid total consideration of $8.5 million for a “bundle of inextricably related assets” that included participation in the nfl’s lucrative television contract with cbs, a right to participate in an expansion draft and acquire 42 veteran player contracts, and the right to be the sole nfl team within a 75-mile radius.89 on its tax return, the taxpayer reported the cost of the player contracts as $7.7 million (91% of the purchase price), and claimed sizeable depreciation deductions accordingly. the momentous nature of the laird case is evidenced by the fact that the irs held approximately 130 cases in abeyance pending the district 84. zorn, supra note 75, at 345, 351. 85. id. at 351 n. 49. see also steven braun & michael pusey, taxation of professional sports teams, 7 tax adviser 196 (1976) (pointing out that the ability to amortize player contracts (at least as of 1976) is the most significant tax aspect of sports franchise ownership). 86. zorn, supra note 75, at 351 (citing richard a. koch, note, the professional sports team as a tax shelter – a case study: the utah stars, 1974 utah l. rev. 556 (1974)). 87. id. the “tax shelter” nature of the player contract amortization allowance is discussed infra part iii.a.2. 88. 391 f. supp. 656 (n.d. ga. 1975), aff’d 556 f.2d 1224 (5th cir. 1977). 89. id. at 659. 190 florida tax review [vol. 9:3 court’s decision.90 clearly troubled by the zeal with which sports franchises were writing off their intangible assets, the government’s stance was that it would “no longer accept the arbitrary valuations placed on player contracts for depreciation purposes.”91 after hearing expert witnesses describe, in great detail, the proper method of valuating each of the player contracts, the court in laird disallowed the taxpayer’s allocation and concluded that a significant portion of the purchase price was allocable to the present value of the (nonamortizable) league-wide television rights. specifically, in reducing the amortizable basis of the player contracts to $3.03 million, the court ruled that “the allocation of the entire amount of the purchase price to player contracts and nothing to the extraordinarily valuable television rights which also were owned by and acquired from the member teams in the same transaction” did not comport with “the principles of economic reality.”92 the tax treatment of transferred franchises (as opposed to the expansion teams at issue in laird and first northwest) was addressed in selig v. united states93 a case dealing with the 1970 purchase of the seattle pilots, an american league baseball team that was ultimately moved to milwaukee as the brewers. the syndicate of purchasers, led by allan ‘bud’ selig, allocated $10.2 million of the $10.8 million purchase price to the major league and minor league player contracts acquired along with the team.94 the district court heard the testimony of appraisers on both sides and concluded that selig’s appraisers had offered the more convincing valuations. interestingly, the court suggested that the small size of the milwaukee market supported the modest franchise allocation (“the right to play baseball in milwaukee is not worth much; everyone agrees on that”95). the seventh circuit affirmed the district court in selig in what reads more 90. s. barksdale penick, the selig case and amortization of player contracts: baseball continues its winning ways, 6 comm. ent. l. j. 423, 430 (1984). the commissioner testified that these cases involved “millions of dollars in additional taxes.” inquiry into professional sports before the house select committee on professional sports, 94th cong., 270 (2d sess. 1976). 91. weill, depreciation of player contracts – the government is ahead at the half, 53 taxes 581, 584 (1975). 92. laird, supra note 88, at 659, 669. in a similar case, first northwest industries of america, inc. v. commissioner, 70 t.c. 817 (1978), rev’d and remanded on other grounds, 649 f.2d 707 (9th cir. 1981) (“first northwest”), the taxpayer was the purchaser of the seattle supersonics of the national basketball association (“nba”). the tax court reduced a 91% player contract allocation to 28.6%. 93. 565 f. supp. 524 (e.d. wis. 1983). 94. id. at 525. the purchasers allocated only $500,000 to the franchise itself. 95. id. at 535. 2008] taxing the business of sports 191 like a ken burns paean to baseball than a legal opinion.96 (in a strange twist of irony, selig, then (and still) the commissioner of baseball, appointed a panel in 1999 in response to owners’ clamoring about the escalation of player salaries.)97 the selig case has been called the “high water mark of taxpayer success” in allocating purchase price to player contracts.98 indeed, the owners of the pilots were able to write off nearly their entire investment over five years, the approximate “useful life” of a baseball player at the time. the government clearly found the allocation in selig to be abusive and even went so far as to suggest that baseball clubs and their tax lawyers were colluding to establish artificially high contract valuations in a conspiracy to deprive the government of its taxes.99 in response to cases such as selig, congress enacted section 1056 as part of the tax reform act of 1976.100 that provision established a rebuttable presumption that when a sports franchise “is sold or exchanged,” not more than 50% of the purchase price is allocable to player contracts. it also provided that the purchaser’s basis in a player contract cannot exceed the seller’s adjusted basis plus the seller’s recognized gain on the transfer. according to senate testimony, the provision was expected to generate upwards of $5 million per year in additional tax revenue.101 in tam 96. selig v. united states, 740 f.2d 572 (7th cir. 1984). judge bauer opens the opinion with a detailed discussion of the history of baseball and a recounting of momentous events and legendary players. sprinkled throughout are excerpts from “casey at the bat.” the decision famously concludes, “[t]here should be joy somewhere in milwaukee – the district court's judgment is affirmed.” selig, 740 f.2d at 580. 97 william h. baker, symposium: sports law in the 21st century: taxation and professional sports – a look inside the huddle, 9 marq. sports l.j. 287, 287 n.2 (1999). 98. zorn, supra note 75, at 389. 99. one of the appraisers used by the pilots was a close friend and confidante of selig’s, a fact that the court noted but dismissed. it concluded that the appraisal was independent and fair, and supported by generally accepted accounting principles. 100. tax reform act of 1976, pub. l. no. 94-455, § 212(a)(1). section 1056 was ultimately repealed as part of the american jobs creation act of 2004, pub. l. no. 108-357 (the “jobs act”), discussed infra part iii.b. 101. ultimately, § 1056 failed to serve its intended purpose, as sports ownership structures proved too sophisticated given the limited scope of the rule. in the first case to interpret § 1056, the tax court exposed one such flaw. in p.d.b. sports, ltd. v. commissioner, 109 t.c. 423 (1987), the taxpayer purchased a 61% interest in the partnership that owned the nfl’s denver broncos, triggering a deemed termination of the partnership under § 708(b)(1)(b). under the applicable 192 florida tax review [vol. 9:3 9617001 (april 26, 1996), the service clarified that section 1056 applied to the creation of a new expansion franchise and not only the sale of an existing franchise. the 1976 legislation also enacted section 1245(a)(4), which provided for the recapture of previously taken depreciation of player contracts upon the sale or exchange of a sports franchise.102 this rule essentially amalgamated all player contracts for depreciation recapture purposes. in congress’ view, this provision worked hand-in-hand with the basis rule of section 1056. according to the senate report, under section 1056, “a more appropriate allocation will be achieved since, to a substantial extent, the buyer and seller will be adverse parties with respect to the allocation (i.e., to the extent that the amount of gain attributable to player contracts will be fully recaptured as ordinary income, the buyer and seller will be operating at arms length with respect to the allocation).”103 even with the limitation imposed by section 1056, however, the depreciability of player contracts proved to be a boon to some sports owners. the syndicate of investors who purchased the boston red sox in 2002 for $700 million allocated $350 million to player salaries. thus, the first $70 million of red sox operating profits for each of the next five years104 were regulations, the transaction was treated as a deemed distribution of the partnership property to the new and continuing partners followed by a contribution of the property to the ‘new’ partnership, triggering a basis step-up under the partnership basis provisions of §§ 732 and 743. the service contended that § 1056 still applied despite the fact that the contracts were acquired through the transfer of a partnership interest (as opposed to a transfer of the franchise itself). the tax court held that since there was no “sale or exchange” of a sports franchise, the § 1056 limitation did not apply. consequently, the partnership was able to take a fair market value basis in the player contracts (approximately $36 million) irrespective of the gain recognized by the selling partner with respect to the player contracts and despite the fact that the prior partnership had a basis in such contracts equal to $6 million. in light of the fact that many sports teams are operated through partnerships, the failure of congress and treasury to explicitly address the interplay of § 1056 with the self contained basis provisions of subchapter k left a large hole in the statute. see also jasper l. cummings, jr. & robert p. hanson, american jobs creation act of 2004: a selective analysis, ¶ 5.02 (warren gorham & lamont 2005) (arguing that the result in p.d.b. sports essentially made § 1056 elective). 102. tax reform act of 1976, supra note 100, at § 212(b)(1) (effective for player contracts transferred as part of a sale occurring after dec. 31, 1975). this provision was also eventually repealed by the jobs act. 103. s. rep. no. 94-938, 94th cong., 90 (2d sess. 1976), 1976-3 vol. 3 c.b. 128. 104. under the § 1056 regime, the service generally accepted useful lives of between three and six years for baseball contracts. this was based on the 2008] taxing the business of sports 193 essentially tax free. similarly, of the $130 million franchise fee paid by the partnership that acquired the expansion tampa bay devil rays, approximately $75 million was allocated to the 35 players selected by the team in the expansion draft.105 in these cases, even if initial team profits fell short, the excess deductions were able to be used by the owners to offset their other business income.106 2. player contract amortization as tax shelter? several commentators have suggested that the service was not aggressive enough in its early rulings (and the early judicial decisions) regarding player contract amortization and the allocation of purchase price in franchise acquisitions.107 interestingly, the early irs pronouncements, such as rev. ruls. 54-441 and 67-379, were hailed by some as government victories against aggressive sports owners seeking to gain current write-offs for longer term “capital” investments.108 however, later cases demonstrated that these franchises, along with their crafty financial advisors, were able to parlay the new legal standards into tremendous after-tax results. given the deductibility of player salaries and various player development expenses, there were certainly a number of theories on which the government could have argued that the cost of a player contract is recoverable only upon disposition.109 it is possible that the government failed to anticipate the historically accepted measure of the average player’s productive career. see mssp, supra note 3, at 9-1. 105. see devil rays, supra note 57, at 1538. 106. see nathan r. scott, take us back to the ballgame: the laws and policy of professional sports ticket prices, 39 u. mich. j.l. reform 37, 58-59 (2005); klinger, supra note 81, at 277 n.6. 107. see, e.g., zorn, supra note 75 (characterizing the amortization of player contracts as a “tax shelter” and arguing that under pre-2004 law, no deduction should be allowed with respect to player contracts acquired in bulk). see also gerald w. scully, the business of major league baseball 130 (1989); klinger, supra note 81. 108. zorn, supra note 75, at 379. 109. the costs of player development (including the operation of a farm system and the employment of talent scouts) is a deductible expense under § 162. the court in selig, supra note 93, at 528, pointed out that the allowance for player contract amortization, combined with the current deductibility of these development costs “in effect enables the owners to double up on expenses (i.e., tax deductions) during the first five years of operation (i.e., the period of amortization).” see also zorn, supra note 75, at 392-93. 194 florida tax review [vol. 9:3 growth in sports franchise value, and that it consequently abandoned any argument that player contracts should not be amortizable at all. the amortization of player contracts consistently yielded significant benefits to sports owners at least through the 1980s. in fact, such a practice resulted in the “puzzling phenomenon” of skyrocketing franchise values’ coinciding with sustained tax losses.110 as an illustration, in 1974, only five of the 27 professional basketball teams reported a profit.111 in baseball, the pittsburgh pirates experienced steady growth on the field and at the box office between 1986 and 1991. during that period, their payroll more than doubled from $6 million in 1986 to $15.5 million in 1990. yet, large amortization deductions turned the pirates’ operating profits into tax losses.112 stephen zorn argues that the service was not aggressive enough in disputing the courts’ penchant for treating franchise value as a residual similar to goodwill. in too many cases, argues zorn, the court would preoccupy itself with valuing the player contracts and would drastically underestimate the value of the franchise itself. in most cases, the league franchise and the right to operate a sports team in a geographical area are the most economically significant dimensions of sports ownership. in the era of free agency, players may come and go, but fans remain loyal to their home teams.113 another possible shortcoming in the irs’ early litigating position was its failure (at least after laird) to assert the so-called “mass asset” rule to player contracts. the mass asset rule, a judicially created doctrine, denies 110. see weiler & roberts, supra note 6, at 632 (describing victor kiam’s purchase of the new england patriots in 1988 for $85 million. within four years, the patriots had suffered great financial losses both on and off the field. in 1992, however, jim orthwein purchased the team for an estimated $105 million, and after three seasons of continued operating losses, sold the team in 1995 to its current owner, robert kraft, for $160 million). this skepticism is not limited to the ranks of legal scholars such as weiler and zorn. whitey herzog, the former baseball player, coach and manager, referring to the claim by then kansas city royals owner ewing kauffman that his team lost $1.8 million in a [very successful] 1985 season, asserted that “there’s no way – if you draw two million people – that you can lose money. unless you’re trying.” zimbalist, supra note 2 at 72. see also supra notes 86-87 and accompanying text. 111. u.s. news & world report, aug. 12, 1974, at 51. 112. zimbalist, supra note 2, at 69-70. 113. zorn, supra note 75, at 364-65. see also zimbalist, supra note 2, at 35 (“it is obvious that the overwhelming share of the value of a franchise belongs to the monopoly rent that is generated by belonging to major league baseball and the exclusive territorial rights membership confers, not the player contracts”). empirically, it is undeniable that many clubs have loyal fans who fill the seats even where the teams perform poorly. 2008] taxing the business of sports 195 depreciation where acquired intangible assets are an indivisible part of an aggregate intangible that does not deplete over time.114 under the mass asset rule, if the intangibles with a definite life have no value separate and apart from the indefinite assets, amortization will be denied. in laird, while the irs put forth a mass asset argument, it appears to have undermined its own cause by conceding (in the alternative) that the contracts did have separate value.115 the court seized on this concession and rejected the government’s mass asset position, asserting that “the concession of value reveals the flaw in the mass asset theory.”116 from that point forward, the service essentially abandoned the theory completely, choosing instead to engage in valuation disputes (often with little success, as in cases such as selig) with taxpayers and their well prepared experts.117 had the service continued to insist that player contracts have no value at all apart from the franchise, it would have better served its argument that an allowance for depreciation is economically unsound. even in its focus on valuation of the player contracts, the service appears to have lost sight of a fundamental principle of contract valuation. namely, an intangible asset is only as valuable as the income it produces for its owner. when the asset is an executory contract for the performance of services, which includes bilateral obligations, a proper framework for valuation must compare the revenue generated by the player with the compensation called for under the contract. indeed, it is the contract that must be amortized, not the player himself. if a player is “overpaid”, his contract is technically of no value to the franchise (from a purely economic perspective), and any allocation thereto should be denied. based on an earlier mathematical model developed in the mid-1970s, andrew zimbalist estimated the “marginal revenue product” of various baseball players in 1989.118 the findings indicate that players with six or 114. boe v. comm’r, 35 t.c. 720 (1961), aff’d 307 f.2d 339 (9th cir. 1962); first northwest, supra note 92, at 845. note that this rule is far less consequential with the advent of § 197, and various cases have cast great doubt on its continued viability. but the doctrine was very much in play in the early rulings regarding contract amortization. 115. laird, supra note 88, at 1237. 116. id. at 1233. 117. zorn, supra note 75, at 383-38. zorn also argues that the irs did not adequately pursue the argument based on the disallowance of “hobby” losses under § 183. 118. zimbalist, supra note 2, at 90-92. this method of deriving a player’s effect on team revenue, developed by economist gerald scully, is based on rough approximation and assumptions (which are beyond the scope of this paper). for instance, it does not account for the “intangible” qualities that a ballplayer provides 196 florida tax review [vol. 9:3 more years of experience are generally overpaid, while players with fewer than three years of service are generally exploited (i.e., their contracts have positive value for the franchise). it does not appear that the irs used these “net value” principles in the player contract cases.119 doing so could have been effective in fighting the very large allocations that became a chronic irs concern over the years. 3. passage of code section 197 and the sports exception section 197 was enacted in 1993 as part of the revenue reconciliation act120 in order to provide more clarity to an area that was rife with litigation. it provides for straight-line amortization over a period of fifteen years of the basis of certain intangible assets used in a trade or business. section 168, which sets out a comprehensive cost recovery system, applies only to tangible property; intangible assets were historically left to the murky standards of section 167 and its regulations. consequently, prior to 1993, taxpayers and the irs frequently disputed the valuation and useful lives of intangible assets acquired as part of a business. additionally, there were disputes concerning whether an amortizable intangible asset existed in the first place. by enacting section 197, “congress believed that much of the controversy that arises under present law with respect to acquired intangible assets could be eliminated by specifying a single method and period for recovering the cost of most acquired intangible assets and by treating acquired goodwill and going concern value as amortizable intangible assets.”121 under section 197, the cost of an “amortizable section 197 intangible” is amortized on a straight line basis over 180 months, beginning with the month in which the intangible is acquired.122 the statutory recovery period represented a compromise, as the legislative history makes clear that to his teammates and his club. however, scully’s approach involves robust formulas, has been published in reputable peer-reviewed journals, and has been used in arbitration hearings. 119. the “net lease” concept is not unfamiliar to the tax law. for example, for purposes of firpta, the fair market value of a lease is the present value of the difference between the rental payments and the current rental value of the real property. treas. reg. § 1.897-1(o)(3). 120. pub. l. no. 103-66 (1993). 121. h.r. 111, 103rd cong., 760 (1st sess. 1993). 122. the tax reduction and reform act of 2007, h.r. 3970, § 3402 (2007), sponsored by rep. charles rangel (d-ny), contained a proposal to change the amortization period from 15 to 20 years. in light of the value of intangible assets owned by sports teams, such an amendment could disproportionately affect their valuation. the provision has not been enacted into law. 2008] taxing the business of sports 197 the mandated 15-year amortization period would have favorable effects on the tax treatment of certain transferred intangibles but detrimental effects on others, depending on the useful lives of the intangible at issue.123 section 197 applies only to costs that are otherwise required to be capitalized and does not apply to either immediately deductible or permanently nondeductible expenses.124 for example, if a cost is deductible under section 162 but is also incurred to improve goodwill, section 197 will not pre-empt the operation of section 162 by denying a current deduction. at the time section 197 was enacted, taxpayers could amortize intangible assets only if they could establish that the intangible possessed two critical features: that it was distinct from goodwill (for which no depreciation deduction was allowed) and that it was of use in a trade or business for a limited period, the duration of which could be determined with “reasonable accuracy.”125 this standard, specifically the former component, proved difficult for taxpayers to establish. for example, the irs continually argued that most “customer-based” intangibles (such as a subscriber list or an advertiser account) were too bound up with goodwill in order to warrant separate cost recovery. the supreme court, in its seminal decision in newark morning ledger co. v. united states,126 allowed the buyer of a newspaper to depreciate the portion of the purchase price allocable to the intangible asset styled as “paid subscribers.” while acknowledging the great difficulties inherent in the treatment of intangible assets, the court asserted that an asset’s relationship to general business goodwill (or “the expectancy of continued patronage”) is not the sole factor in determining whether depreciation is permitted; rather, the more important inquiry is whether the asset in question can be valued and whether it wastes over a limited useful life.127 although newark morning ledger represented a significant taxpayer 123. see generally ronald e. creamer & emily s. mcmahon, tax planning for transfers of business interests, ¶ 3.03 (warren, gorham & lamont 2003). 124. treas. reg. § 1.197-2(a)(3). see boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts, ¶ 23.4 (warren, gorham & lamont 2003). 125. treas. reg. § 1.167(a)-3. see supra note 76 and accompanying text. 126. 507 u.s. 546 (1993). 127. id. at 555-56 (“because intangible assets do not exhaust or waste away in the same manner as tangible assets, taxpayers must establish that public taste or other socioeconomic forces will cause the intangible asset to be retired from service, and they must estimate a reasonable date by which this event will occur”) (citing bittker & mcmahon, federal income taxation of individuals, ¶ 12.4, 10-12 (1988)). the non-categorical approach taken by the supreme court in newark morning ledger had been tentatively accepted in rev. rul. 74-456, 1974-2 c.b. 65, in which 198 florida tax review [vol. 9:3 victory, it did not establish a rule of thumb or an administrable standard. the strain on judicial resources was sure to remain significant, and this burden compelled congress to enact section 197. congress deliberately excluded sports franchises from the scope of section 197. as originally enacted, section 197(e)(6)128 had provided that any items acquired in connection with the acquisition of a sports franchise were not subject to section 197 amortization. this exclusion had been enacted so that the treatment of sports intangibles would continue as under then-current law.129 consequently, while section 197 effectively ended the protracted disputes regarding purchase price allocations in general, it did not settle the long-standing clashes between sports owners and the service. while it is true that certain sports owners received large tax benefits from player contract allocations, the irs throughout the 1990s became more attuned to the issue and began to question purchase price allocations with greater frequency and fervor. the commissioner’s stated position under pre2004 law was that since sports franchises do not have a determinable useful life, the sports franchise intangible asset is not eligible for amortization under section 167. since player contracts were amortizable under section 167 over a short period, the service was focused on ensuring that buyers and sellers were properly applying the residual allocation method of section 1060 and were complying with the player contract limitation in section 1056.130 where adversity of tax interests between the parties could not be relied upon (such as where the seller had unused net operating losses or capital losses), the irs applied heightened scrutiny to the taxpayers’ allocation. additionally, the irs clearly interpreted section 1056 as establishing only a “presumed upper the irs, contrary to its prior guidance, conceded that in “unusual cases,” where a customer-based intangible such as a subscriber list was distinct from goodwill, depreciation would be permitted. 128. § 197(e)(6), before amendment by jobs act, supra note 100, § 886. 129. see h.r. 213, 103rd cong., 682 (1st sess. 1993) (“the term “section 197 intangible” does not include a franchise to engage in professional baseball, basketball, football, or other professional sport, and any item acquired in connection with such a franchise. consequently, the cost of acquiring a professional sports franchise and related assets (including any goodwill, going concern value, or other § 197 intangibles) is to be allocated among the assets acquired as provided under present law (see, for example, § 1056 of the code) and is to be taken into account under the provisions of present law”). 130. mssp, supra note 3 at 10-5 (“the service has the authority to value the franchise rights to determine the reasonableness of the player contracts valuations”). the mssp also clarifies that the irs would resort to substance over form principles in altering the allocation contractually agreed upon by the parties. 2008] taxing the business of sports 199 limit” on the amount allocable to player contracts, with the precise amount to be allocated based on facts and circumstances of the particular transaction.131 between 1993 and 2004, the service challenged the depreciability of media and broadcasting rights acquired along with sports franchises. for example, in fsa 200142007 (july 3, 2001), the taxpayer was a limited partnership that acquired a professional sports team. in addition to the franchise itself, the taxpayer acquired local television and radio contracts as well as a right to share in the league’s national television broadcast revenues. the taxpayer engaged an accounting firm to valuate these media rights and to demonstrate that they were indeed distinct from goodwill. the irs asserted that the ability to separately identify and value intangible rights was not sufficient to establish depreciability under section 167. the intangible asset must also have a limited useful life. in this case, although the television and radio contracts were not automatically renewable, past practice indicated that the contracts would be renewed, whether with the current network or a new one. since these media rights were a component of the franchise, they did not have a limited useful life. the contractual term of the broadcast agreements was of no moment; since “the life of an asset cannot be limited by the remote, speculative possibility that renewal of a contract might not occur.”132 fsa 200142007 was consistent with several cases that had addressed the amortization of rights to share in sports broadcast agreements. in laird,133 the court held that the acquired television rights were essentially coextensive with the franchise itself and would therefore continue indefinitely. first northwest (basketball)134 and mccarthy v. united states (baseball),135 which characterized these acquired contracts as “links in a perpetual chain of broadcast revenues,” reached similar conclusions. unlike the subscriber lists at issue in newark morning ledger, which would diminish over a predictable period of time, the media rights attendant to a sports franchise are self-regenerating. the acquired asset is not the rights to a particular broadcast contract, but the enduring right to share in any such contracts. this ongoing entitlement ceases only upon the elimination of the franchise as a member of the league.136 131. id. at 10-6. 132. fsa 200142007 (july 3, 2001) (citing richmond television corp. v. united states, 354 f.2d 410, 412 (4th cir. 1965)). 133. see supra note 88 and accompanying text. 134. see supra note 92. 135. 807 f.2d 1306 (6th cir. 1986). 136. see also tam 200244019 (nov. 1, 2002); brian cornell et. al., media rights coincident to sports franchise acquisition are not depreciable, 96 j. tax’n vol. 2 (feb. 2002). 200 florida tax review [vol. 9:3 this treatment of media rights demonstrates the breadth of the sports franchise exception as it existed under section 197(e)(6) as originally enacted. the language of prior section 197(e)(6) carved out from section 197 treatment a “franchise to engage in professional football, basketball, baseball or other professional sport, and any item acquired in connection with such a franchise.” the service interpreted the “in connection with” language broadly, requiring only that there be a nexus between the acquired intangible and the franchise in order for section 197(e)(6) to apply. taxpayers argued, to no avail, that the exception was only applicable to intangibles that were acquired concurrently with a sports franchise, and not to separate rights that existed between the seller and a third party (e.g., a broadcast network).137 because sports teams were exempted from section 197 treatment, the process of structuring franchise acquisitions continued to grow more complex and less certain throughout the 1990s and early 2000s. the strain on irs and taxpayer resources reached something of a crescendo in 2003, when the irs issued a directive to its examiners spelling out certain compliance tools to be deployed in evaluating sports franchise acquisitions. as the allocation between amortizable player contracts and non-amortizable league membership rights was highly disputed in nearly every irs examination, the directive had a stated goal of enabling agents to “resolve acquisition issues…in a more focused and expedited manner.”138 the published “compliance measure” instructed agents not to adjust claimed amortization deductions arising out of a sports franchise acquisition if the present value of such deductions (not including claimed media rights deductions, which are categorically disallowed) did not exceed 60% of the purchase price allocable to all acquired intangibles, using a 5.5% discount rate.139 for example, a taxpayer acquires a sports franchise for $200 million and allocates $20 million to hard assets. of the $180 million allocated to 137. tam 200244019, supra note 136. 138. 2003 tnt 221-37 (oct. 24, 2003). 139. in a simultaneously issued field directive, the service advised agents to expect taxpayers to claim useful lives of between four and five years on the player contracts and to allocate approximately 55% of the franchise purchase price to the contracts. it also described the way in which asset bases are adjusted in the event a taxpayer’s claimed amortization exceeds the 60% threshhold. essentially, when the present value of the scheduled amortization deductions exceeded 60% of the amount allocated to all acquired intangible assets, the basis of the amortizable intangibles is stepped down until 60% is reached, and the reduction in basis is re-allocated pro-rata to acquired nonamortizable intangibles such as franchise or media rights. the basis reallocation procedure contemplated by this field directive is emblematic of the time consuming nature of the disputes that arose prior to 2004 on audit of sports franchise acquisitions, and no doubt contributed to the changes wrought by the jobs act. see 2003 tnt 221-38 at ¶¶ 5, 6, 17 (oct. 24, 2003). 2008] taxing the business of sports 201 intangibles, $38 million is allocated to nonamortizable assets such as future media rights and the league franchise itself. of the $142 million remaining, the taxpayer allocates $15 million to current media rights, $115 million to player contracts and $12 million to various other amortizable assets such as sponsorship agreements and luxury suite contracts. under the compliance measure, the first action taken is to disallow (for purposes of the compliance measure) any amortization relating to the $15 million allocation to media rights, since these rights were not amortizable under well established principles. then, the present value of the future deductions on the $127 million allocated to amortizable intangible assets is computed, based on the useful lives of the assets. the present value is $112,558,000,140 which is 62.31% of the $180 million that was allocated initially to all acquired intangibles. because this number exceeds the 60% threshold, the agent must impose a downward adjustment to the $127 million of amortizable intangibles. since the present value exceeded the threshold by 3.85% (i.e., 2.31 percentage points above 60%), the basis adjustment must be 3.85% of $127 million, or $4,708,233. this amount is subtracted from the amount initially allocated to amortizable intangibles and added as a basis step-up to the amount allocated to the nonamortizable intangibles (each on a pro rata basis).141 b. sports intangibles and the american jobs creation act of 2004 fortunately, the complex standard created by the compliance measure was short lived, as congress determined in 2004 that section 197 treatment is appropriate for all types of businesses and repealed the section 197(e)(6) exception for property acquired after october 22, 2004.142 thus, the 15-year recovery period applicable to section 197 intangibles now extends to professional sports franchises as well as any other intangible assets acquired in connection with the franchise. the house committee report to section 886 of the jobs act states that “the present-law rules for acquisitions of sports franchises do not eliminate the potential for disputes, because they address only player contracts, while a sports franchise acquisition can involve many intangibles other than player contracts . . . [t]he committee further believes that the section 197 rules should apply to all 140. this present value is computed using a discount rate of 5.5% and the following useful lives: player contracts – 3.29 years; season ticket holder list – 21 years; concession agreement – 5.5 years; sponsorship agreements – 2.5 years; luxury suite contracts – 2 years. id. at example 1. 141. id. 142. jobs act, supra note 100, § 886. 202 florida tax review [vol. 9:3 types of businesses regardless of the nature of their assets.”143 this description was an accurate assessment of the uncertain state of the law, as the service and taxpayers continued to expend considerable resources litigating purchase price allocations. even the “present law rules” alluded to by the house committee relating to player contracts were the subject of considerable uncertainty and ambiguity.144 as a result of the 2004 legislation, disputes between the irs and sports owners are sure to dwindle, at least with respect to the allocation of purchase price between the acquired assets. currently, any tangible property acquired along with a sports franchise will be depreciated (as always) under section 168, while intangible assets are now amortizable under the existing standards of section 197. player contracts, sponsorship agreements, luxury suite contracts and various other intangibles (including the franchise itself)145 are now written off ratably over a 15-year period. to conform with the repeal of the section 197 exception, the jobs act also repealed section 1056, on the theory that special basis limitation rules were no longer needed in the absence of strong taxpayer incentive to allocate value away from the nondepreciable franchise to the player contracts. the jobs act also repealed sections 1253(e) and 1245(a)(4) in order to conform with the new treatment of player contracts. section 1253(a) states that where a seller of a franchise, trademark or trade name retains any “significant power, right, or continuing interest” in the franchise, the sale is not treated as the sale or exchange of a capital asset. this provision, enacted in 1969, reflects congressional judgment that where a transferor retains supervisory authority over the transferee’s operation of a franchise, capital treatment is inappropriate.146 prior to its repeal, section 1253(e) stated that section 1253 “shall not apply to the transfer of a franchise to engage in professional football, basketball, baseball or other professional sport.” the jobs act amendment to section 1253 brings sports franchises within the ambit of the rule; thus, where power over a sports franchise is retained in an acquisition, section 1253(a) will deny capital treatment (even assuming the transaction qualifies as a sale or exchange of a capital asset as defined in section 1221). this provision looms large in the area of expansion sports teams. generally, incoming owners pay the existing owners for the 143. h.r. rep. no. 108-548. 144. in its 2001 budget proposal, the treasury noted that § 1056 had failed to serve its intended purpose and that sports franchises could no longer be excluded from § 197. see general explanation of the administration’s fiscal 2001 revenue proposals, pt. 2 (feb. 2, 2000). see also supra note 101. 145. section 197(d)(1)(f). 146. section 1253 also denies capital treatment to a transferor of a franchise where the proceeds include amounts that are contingent upon the productivity or use of the franchise. section 1253(c). 2008] taxing the business of sports 203 right to operate an expansion sports franchise. historically, it was not uncommon for the franchise agreement to provide that the expansion team could not be transferred or assigned without the consent of a majority of the other league franchises. this veto right falls squarely within section 1253(b)(2)(a), which states that “[a] right to disapprove any assignment” of the franchise constitutes a “significant power or interest.” consequently, after the jobs act, any gain realized by the current owners on the sale of the expansion franchise will be ordinary income where the owners retain veto rights. as described above, before its repeal, section 1245(a)(4) contained a special depreciation recapture rule where player contracts were transferred in connection with the acquisition of a sports franchise. that provision required the seller of a team to calculate his “recomputed basis” in the transferred contracts (for the purpose of depreciation recapture) by adding to his adjusted basis in such contracts the greater of 1) the previously unrecaptured depreciation on contracts acquired by the seller at the time the franchise was acquired, and 2) the previously unrecaptured depreciation on contracts involved in the particular sale at hand. this provision had the effect of recapturing the depreciation taken on contracts of players who retired or died while playing for the team. because these players’ contracts were never sold or exchanged, recapture was not otherwise triggered in the absence of a special rule.147 the legislative history of section 1245(a)(4) makes it fairly clear that the special recapture rule does not apply to the transfer of individual player contracts, but only contracts transferred in connection with the sale of an entire franchise.148 even after the repeal of section 1245(a)(4), however, the “standard” recapture rules of section 1245 still apply to player contracts.149 c. measuring the effect of the jobs act on sports franchise values the sports provisions of the jobs act have generated much discussion and debate, due in no small part to their potential impact on franchise values. as a technical matter, the key jobs act amendment is easy to summarize. while under prior law, sports franchises were able to write off 147. baker, supra note 97, at 294. 148. see s. rep. no. 94-938, 94th cong., 90 (2d sess. 1976). 149. treas. reg. § 1.197-2(g)(8) (“an amortizable § 197 intangibles constitute § 1245 property”). as discussed infra part iii.d.1, individually acquired player contracts are not § 197 intangibles. these contracts constitute § 1245 property since they are subject to the allowance for depreciation under § 167. see § 1245(a)(3). 204 florida tax review [vol. 9:3 the values of player contracts over three to five years, after the jobs act, teams could amortize their basis in all intangible assets (including player contracts acquired with the organization) over fifteen years. yet, due to the numerous variables that go into the complex valuation of sports franchises, the legislation’s overall effect was, and remains, unclear. both congress and the sports industry have claimed political victory. the clinton administration’s fiscal 2001 budget proposal contained an extension of the section 197 rules to sports franchises, but the measure remained dormant until it appeared as part of the senate finance committee’s version of the jobs and growth reconciliation tax act of 2003.150 the joint committee on taxation report accompanying the jobs act states that the measure will increase taxes for sports owners by $382 million over ten years.151 a spokesman for the house ways and means committee characterized the bill as a “revenue raiser,”152 and the spokeswoman for thenchairman bill thomas of the senate finance committee posited that the section 197 sports amendment was included in the bill “to bring down the overall cost of the legislation.”153 despite these pronouncements from lawmakers, the sports industry itself, somewhat anomalously, was the key lobbyist in support of the legislation. as far back as 1999, mlb had hired william schweitzer, a washington attorney, to lobby regarding “legislation affecting amortization, depreciation and allocations in regard to franchise purchase prices.”154 in a letter to then-treasury secretary summers on behalf of mlb, schweitzer stated that the league supported a general rule permitting amortization of all intangible assets over a fifteen year period. schweitzer pointed out that although player contracts and various other intangible assets have useful lives significantly less than fifteen years, mlb nevertheless supported a rule that would “provide consistent treatment and minimize disputes regarding acquired intangibles.”155 several commentators have asserted that the legislation will ultimately prove to be a boon to sports owners. some have estimated that the 150. pub. l. no. 108-27 (2003). see martin a. sullivan, sports franchises may win big in eti bill, tax notes, jun. 21, 2004. 151. jcx-69-04, “estimated budget effects of the conference agreement for h.r. 4520, the ‘american jobs creation act of 2004,’ fiscal years 2005 – 2014” (oct. 7, 2004). 152. duff wilson, bill would raise franchise value of sports teams, n.y. times, aug. 2, 2004. 153. analysts: profitable franchises likely to benefit, associated press, aug. 3, 2004, www.espn.com. 154. political lobbyist summaries available at www.sopr.senate.gov. 155. letter from william h. schweitzer to honorable lawrence h. summers, 2000 tnt 213-26 (nov. 2, 2000). 2008] taxing the business of sports 205 change would add 5% to the values of sports teams, and noted commentator robert willens has suggested by way of example that the new york jets, who were sold in 2000 for $635 million, could be worth an additional $55 million under the proposal.156 many other experts in the area of sports ownership agreed that the repeal of section 197(e)(6) would increase the sale value of franchises across the board, particularly nfl franchises, which have been estimated to receive upwards of $77 million per year from national broadcast rights negotiated by their league.157 based on forbes magazine’s 2002 estimates of franchise values, if the jobs act benefits sports teams by adding 5% to their value as a result of the tax savings, the industry as a whole effectively received a $2 billion subsidy. the empirical data regarding franchise values is difficult to interpret, largely because it is based on various assumptions and financial projections. there are also many confounding factors, such as baseball’s revenue sharing and luxury tax systems158 as well as the increased revenues attributable to a new stadium or ballpark. moreover, any value increases attributable to the jobs act amendments would be manifest only in new acquisitions of sports teams, since the legislation was made effective only to property acquired after the date of enactment (october 22, 2004).159 in other words, current owners cannot realize the benefits of the amendments through modified amortization, but only through the (potentially) enhanced purchase price their teams can fetch based on the market’s valuation of the present value of incremental amortization deductions available in the future. forbes’ value 156. duff wilson, supra note 152. according to wilson, willens was “mystified” by the congressional claims regarding the revenue raising nature of the proposal. aaron barman was also quoted as rather categorically stating that “at the end of the day, [there is no doubt the amendment adds to the current value of franchises].” 157. id. 158. for example, the new york yankees, who recently surpassed the $1 billion value mark in the annual forbes report, paid an estimated $70 million in revenue sharing in 2006. forbes franchise values: yankees franchise hits value of $1.2 billion, associated press, apr. 20, 2007, http://findarticles.com/p/articles/mi_qn4188/is_20070420/ai_n19038349. a luxury tax is designed to penalize the teams that spend more than their counterparts. the national football league uses a “hard” salary cap, which is based on a percentage of league revenues. the nba also uses a salary cap that is based on a percentage of league revenues, though its cap is a “soft” cap. the nature of the nba’s “soft” cap is such that teams may exceed the cap in certain instances, such as when re-signing their own free agents. to encourage adherence to the cap, the nba also imposes a luxury tax on teams that exceed the prescribed salary limits. 159. jobs act supra note 100, § 886(c)(1). the legislation also does not affect the treatment of individual player contracts, as discussed below. 206 florida tax review [vol. 9:3 estimates are based on multiples of revenue and are adjusted for new ballparks, but they probably do not capture the somewhat subtle effects of changes to tax write-offs going forward. therefore, the effect of the jobs act on sports valuation will be seen in future sale transactions, as bankers, accountants and lawyers evaluate the actual tax savings (or cost) on a caseby-case basis.160 franchises with the most lucrative national and local broadcasting contracts stand to gain the most from the jobs act amendments, since the primary effect of the new law is to permit depreciation on these heretofore unamortizable intangibles. there are a number of ways to account for the inconsistent pronouncements from the government and the sports industry regarding the repeal of section 197(e)(6). one possibility goes to the underlying difficulty inherent in valuing future cash flows. recall that the irs’ 2003 directive regarding player contract amortization capped the present value of claimed amortization at 60% of the total acquired intangibles, using a 5.5% discount rate. under the new law, all intangibles are amortized over fifteen years; yet, the present value of such write-offs depends in large part on the discount rate used.161 the appropriate rate may depend on the franchise’s creditworthiness, its ownership of hard assets, or its future prospects. since the chosen rate will affect (along with many other factors) current valuation, it is not surprising that different parties (with different perspectives of the market) will take divergent views on an economic proposal. furthermore, the discount rate problem is related to the relevant timeframes used in estimating the revenue impact of a proposal. the government’s 10-year time horizon will obviously bias the short term gains and losses, while the financial models of the sports teams themselves may utilize a longer-term measurement window. government budget windows are also subject to change and can be based on political gamesmanship, while private actors such as sports owners utilize their own financial modeling techniques to assess legislative reforms.162 160 the forbes franchise value estimates show an increase in overall team values in the four major sports between 2003-2007, with major league baseball experiencing a slight decline from 2003-2004. an economic interpretation of these results is well beyond the scope of this paper. a graphical representation is available at http://www.forbes.com/2005/09/28/forbes-sports-index-mlb-nfl-nhlnba_cz_sportsindex.html. 161. see generally sullivan, supra note 150 (“the higher the discount rate, the less attractive will be a change to 15-year amortization”). 162. see e.g., id. in fact, the u.s. office of management and budget has indicated that it will phase out ten-year budget projections since this relatively short horizon obscures the true economic effects of fiscal policies. see http://www.whitehouse.gov/omb/budget/fy2003/bud08.html. for an instructive 2008] taxing the business of sports 207 a second, and more concrete explanation is that the repeal of section 197(e)(6) will simplify the tax reporting positions of sports teams. indeed, section 197 was enacted in order to reduce the level of costly disputes regarding the amortization of intangible assets under section 167.163 as discussed above, the litigation between sports owners and the irs continued well beyond 1993. after 2004, however, the buyer of a sports team need not hire appraisers and accountants to support a specific allocation, a change no doubt resulting in millions of dollars in cost savings throughout the industry. it is fair to assume that on an individual basis, taxpayers value a simpler, less litigious regime more so than the government, which is involved in audit activity regardless. consequently, it is possible that the sports industry internalized these benefits of tax simplification to a greater degree than did the government, leading to disparate conclusions. d. individual player contracts – collateral tax issues sports player contracts are constantly exchanged, acquired and renegotiated even outside the context of franchise acquisitions. since these contracts are highly valuable assets, such market transactions naturally implicate various tax rules aside from section 197. this section will briefly describe the relevant considerations involving individual player contract transactions. 1. purchasers despite the repeal of the section 197(e)(6) exclusion, player contracts that are acquired separately remain exempt from the 15-year amortization period of section 197, as section 197(e)(4)(b) excludes from the definition of a “ section 197 intangible” any right to receive tangible property or services under a contract where such right is not acquired as part of a larger acquisition of a trade or business.164 thus, the cost of separately acquired player contracts remains subject to pre-jobs act law and may be recovered over the useful life of the contract. in the case of an individual player contract, the amortizable basis will generally be the signing bonus paid to the player, which is a capitalized expense (and is not currently discussion on budget “games,” see elizabeth garrett, comment: accounting for the federal budget and its reform, 41 harv. j. on legis. 187 (2004). 163. see supra notes 117 and 121 and accompanying text. 164. see also treas. reg. §1.197-2(c)(6), -2(c)(13). this exception applies even where the right would otherwise be amortizable under § 197. 208 florida tax review [vol. 9:3 deductible) under section 263 and the regulations thereunder.165 in plr 9303002 (oct. 5, 1992), the service ruled that a baseball team may begin amortizing a player’s signing bonus as soon as the contract is signed. the theory of the ruling was that a signing bonus establishes a “service liability,” whose economic performance occurs (under the principles of section 461 and regulations section 1.446-1(c)(1)(ii)(a)) upon the player’s signing of the contract.166 since the useful lives of player contracts are still relatively short (typically 3-6 years), the ability to amortize acquisition costs still provides a significant tax benefit to the sports team. in the era of free agency, the government no longer has in its arsenal an argument that contracts have no definite useful life, as players are clearly free to negotiate with other clubs when they attain free agency. additionally, outside of team purchases, there is no issue of valuation or allocation, as acquisition costs for individual contracts will be delineated clearly. 2. player trades generally, player trades constitute like-kind exchanges under section 1031, and gain will be recognized in such transactions only to the extent of “boot.”167 consequently, the team’s basis in the acquired contract will be the carried over basis in the contract exchanged, decreased by the boot received and increased by any recognized gain.168 moreover, if the acquired contract has a shorter useful life than the contract traded away, amortization is taken over the shorter useful life. frequently, player trades involve future draft picks. it has been the irs’ position that a team does not have an ascertainable tax basis in future draft picks given up in a trade. of course, the franchise that acquires a draft 165, professional athletes may not terminate their contracts at will and do not have the right to go play for a competitor. therefore, signing bonuses represent amounts paid by the teams to receive services and must be capitalized. see treas. reg. § 1.263(a)-4(d)(6)(i),(iv),(vii) ex. 8. signing bonuses were first popularized in the 1960s and today they are a staple of sports contract negotiations. in 2004 peyton manning inked a deal with the indianapolis colts worth approximately $100 million, including a record $34.5 million signing bonus. alex rodriguez’s $275 million contract included a $10 million signing bonus. 166. signing bonuses were also the subject of a significant tax development in 2004. in rev. rul. 2004-109, 2004-50 i.r.b. 958, the service held that signing bonuses constitute wages for federal employment (fica and futa) and income tax withholding purposes. this ruling represented a significant reversal in irs policy on an issue that was watched closely by sports teams. 167. rev. rul. 67-380, 1967-2 c.b. 291. 168. section 1031(d). 2008] taxing the business of sports 209 pick may obtain a basis therein under the principles of section 1031. if and when the draft pick is exercised and a player is drafted, the basis in the pick will be capitalized into the basis of that player’s contract.169 in the mssp guide, the service identifies as an “emerging issue” the question of whether future draft picks and existing player contracts constitute like kind property for the purposes of section 1031. treas. reg. section 1.1031(a)-2(c) states that while intangible personal property is categorically eligible for like-kind treatment, whether an exchange actually involves like-kind property will depend on the nature of the underlying rights and property. on the one hand, the rights underlying both future draft picks and actual contracts are the services of a professional athlete. however, a team has a separate basis in player contracts while the right to future draft picks is an inseparable component of the franchise intangible asset, a difference that tends towards non like-kind treatment.170 3. sellers where an individual contract is sold, the portion of the gain that exceeds recaptured depreciation can receive capital gains treatment under section 1231.171 specifically, if the gains resulting from the sale of player contracts (which will generally constitute depreciable property used in a trade or business, as required by section 1231) exceed the losses from the sale of such property, both gains and losses are treated as long term capital gains and losses. in plr 9617001 (dec. 19, 1995), the service ruled that where a sports franchise cuts a player, an ordinary loss is allowed under section 165 in an amount equal to the team’s adjusted basis in the contract. part iv the home-run ball “sometimes pieces of the tax code can be as hard to understand as the infield fly rule. all i know is that the fan who gives back the home run ball deserves a round of applause, not a big tax bill.”172 169. mssp, supra note 3, at 12-2, 12-3. 170. id. at 12-7. 171. rev. rul. 67-380, supra note 167. see also rev. rul. 71-123, 1971-1 c.b. 227 (applying the reasoning of rev. rul. 67-380 to the gain recognized by established football franchises upon their sale of individual player contracts to an expansion team. the ruling also held that the gain in excess of that which was allocable to the contracts constituted gain from the sale of the “franchise property right,” and was a sale of a capital asset by the old teams to the new team). 172. press release, irs commissioner charles rossotti, sept. 8, 1998. 210 florida tax review [vol. 9:3 it would appear that the intersection of tax and sports cannot be adequately addressed without at least a brief nod to the perplexing question of the record-breaking home run ball. this issue, however esoteric and theoretical, has captured the attention of the mainstream media and numerous commentators. in fact, in a 2005 speech to the tax section of the new york state bar association (delivered, appropriately, on the grounds of the national baseball hall of fame in cooperstown, n.y.), irs chief counsel donald korb characterized mark mcgwire’s then-record 62nd home run ball as “the most significant tax event in the history of baseball.”173 mark mcgwire’s home run ball, which was clubbed at busch stadium in st. louis on september 8, 1998, was actually not caught by a fan. a cardinals groundskeeper retrieved the ball and returned it to mcgwire. however, an irs representative had touched off a firestorm a few days earlier by stating on the record that a fan who caught such a ball, and subsequently returned it to mcgwire, would be subject to a gift tax. as korb described in his speech, the service soon retracted its position, but not before congressional lawmakers attempted “to make an income and transfer tax repeal issue out of baseball’s home run race.” matt murphy became a household name when he emerged from a at&t park scrum with barry bonds’ record-breaking 756th career home run on august 7, 2007. the next month, murphy sold the ball at auction to new york fashion designer marc ecko for $752,467.20,174 giving new life to the tax debate. to be clear, the fan who catches the ball and immediately returns it is not subject to federal income tax. this conclusion is based on rev. rul. 57-374,175 which states, in its entirety, that “[w]here an individual refuses to accept an all-expense paid vacation trip he won as a prize in a contest, the fair market value of the trip is not includible in his gross income for federal income tax purposes.” the bill that was impulsively introduced in the house the day after mcgwire’s home run came to the same conclusion.176 the more 173. lest this be taken as a negative reflection on the authors’ choice of topic, korb ranked the selig case and the issue of player contract allocation as the third and fourth most significant events, respectively. 174. press release, scp auctions, barry bonds record breaking 756 home run ball sold for $752,467.20 (sept. 15, 2007), www.scpauctions.com/html/auctions/bonds/results/bondspostsale.html. 175. 1957-2 c.b. 69. at least two commentators have pointed out that this principle is not necessarily consistent with the doctrine of constructive receipt as embodied in treas. reg. § 1.451-2(a), which states that income is constructively received by a taxpayer at the time it is made available to him “although not actually reduced to a taxpayer's possession.” lawrence a. zelenak & martin mcmahon, jr., taxing baseballs and other found property, tax notes, aug. 30, 1999. 176. see h.r. 4522, 105th cong. (2d sess. 1998). 2008] taxing the business of sports 211 interesting tax question arises where the fan holds the ball as a keepsake or for ultimate sale. clearly, catching a record breaking artifact represents an accession to wealth under section 61. in commissioner v. glenshaw glass company,177 the supreme court recognized that congress, in defining gross income, intended to exert the full measure of its taxing power and to tax all gains without limitation as to their source.178 the gross income regulations generally embody this principle. treas. reg. section 1.61-14(a) states that “treasure trove, to the extent of its value in united states currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession.” the treasure trove regulation has been applied on extremely rare occasions by the courts and the service in the context of found property or windfalls. in one case, a taxpayer found cash in an old piano several years after purchasing it at an auction. the court held that the currency was taxable in the year of discovery rather than when the piano was purchased.179 the tax court has stated in dictum that the treasure trove regulation is properly applied to a person who finds a sweepstakes ticket, even where the ticket turns out to be a loser later in the same day.180 in plr 6205104610a (may 10, 1962) the irs suggested that the treasure trove rule is applicable to items found by individuals who are in the “business” of searching for valuables in sunken ships. in the context of unsolicited merchandise, the service has ruled that a reviewer of books was taxable on the value of unsolicited books sent to him by a publisher.181 the irs retreated from this position in a subsequent ruling where it stated that the taxpayer would be taxed on the value of the books only where he donated them to charity and claimed a deduction for 177. 348 u.s. 426 (1955) (“glenshaw glass”). 178. prior to glenshaw glass, the prevailing gross income standard was stated in the supreme court’s decision in eisner v. macomber, 252 u.s. 189, 207 (1920) where the court defined income as “the gain derived from capital, from labor, or from both combined.” under that standard, an argument could be made that a “pure” windfall, resulting from neither a capital investment nor labor, was not income. zelenak & mcmahon, supra note 175, at n. 21. however, the court in glenshaw glass clearly asserted that “congress applied no limitations as to the source of taxable receipts,” thereby taking much of the appeal out of the foregoing arguments. id. at 429. 179. cesarini v. united states, 296 f. supp. 3 (n.d. ohio 1969), aff'd per curiam, 428 f.2d 812 (6th cir. 1970). 180. collins v. comm’r, t.c. memo. 1992-478. 181. rev. rul. 70-330, 1970-1 c.b. 14. 212 florida tax review [vol. 9:3 their value.182 apparently, the theory of the ruling is that the recipient has not truly reduced the property to his possession until he has committed an act consistent with dominion and ownership. although based on broad notions of gross income under section 61, the unsolicited merchandise rulings are probably not a helpful framework for analyzing the home-run ball, since dominion is clearly demonstrated by the mere act of retaining the ball. a home run ball is also not perfectly analogous to a prize or award, which are generally taxable under section 74. although the provision contains exceptions to the general rule,183 the courts have refused to interpret these exceptions as applying to an award based on professional sports performance.184 a home run ball caught by a spectator is probably not a prize or award in the first place, so section 74 and its exceptions are likely inapposite. two commentators, lawrence zelenak and robert mcmahon, jr., have argued that the fan who catches the home run ball should not be taxed (until sale) since the treasure trove regulation is of questionable validity, primarily because the service has adopted an unofficial practice of not taxing found property.185 specifically, in dealing with commercial fishermen and big game hunters, the irs has not invoked the treasure trove rule to argue for immediate inclusion of fish or game, but has imposed a tax at the time of sale.186 with respect to miners, treas. reg. section 1.61-3(a) states that gross income is generally defined as “total gross sales, less the cost of goods sold.” this provision appears to embody an assumption that miners are not taxable upon their extraction of the minerals from the ground, but only upon sale. as a normative manner, zelenak and mcmahon posit that “found” property is analogous to self-created property such as a work of art, and should be treated as non-taxable imputed income.187 taxpayers who grow 182. rev. rul. 70-498, 1970-2 c.b. 6. 183. section 74(b). 184. see, e.g., hornung v. comm’r, 47 t.c. 428 (1967). in that case, the most valuable player of a professional football game received a corvette from a prominent sports magazine in recognition of the achievement. the court held that the award was not covered by the exceptions to the taxability of prizes under § 74(b), and that it was not a gift under § 102. see also wills v. comm’r, 411 f.2d 537 (9th cir. 1969) (player taxed on receipt of a belt in recognition of baseball accomplishments since sports award is not in recognition of religious, charitable, scientific, educational, artistic, literary or civic achievement). 185. see zelenak & mcmahon, supra note 175. 186. id. 187. h.r. rep. no. 413, 91st cong., at 149 (1st sess. 1969) (discussing the exception of self created property from the definition of capital asset in section 1221(3) and stating that “it is appropriate to treat the income arising from the sale of such property as ordinary income.”) the implication is that the value of the property 2008] taxing the business of sports 213 crops for self-consumption or hunt game for food are not taxed unless and until such items are sold.188 similarly, services rendered for one’s own family in the home do not give rise to taxable services income. clearly, in all these cases the taxpayers have experienced an accession to wealth. however, the policy of the tax law is to forgo taxation.189 these commentators argue that found property (other than cash) should be treated in the same way as self created property and thus excluded from gross income (like imputed income) until the time it is disposed of. clearly, zelenak’s and mcmahon’s argument is open to ample criticism. first and foremost, the treasure trove regulation has the force of law notwithstanding the service’s failure to assert it in various contexts. furthermore, a windfall in the form of found property is arguably very different from self created property in that the latter entails an investment of capital and services, while the former rings of “something for nothing.” catching a $1 million baseball is an unmistakable accession to wealth, and the notion of “imputed income” is not needed to reach that conclusion.190 one may argue that catching a home run ball does not entail “finding” anything, and the legal definition of “treasure trove” is “valuables (usu. gold or silver) found hidden in the ground or other private place, the owner of which is unknown.”191 in addition to resembling a mere sophism, this argument overlooks the fact that an in-kind windfall can still constitute residual gross income under section 61 even if it is not a “treasure trove.” specifically, treas. reg. section 1.61-1(a) states that “gross income includes income realized in any form.” in this way, the treasure trove regulation can be understood as a limiting rule; namely, that with respect to a unique subset upon creation is not taxable to the artist/creator. zelenak & mcmahon, supra note 174, at n.62. 188. see, e.g., morris v. comm’r, 9 b.t.a. 1273, 1277-78 (1928) (farmer not taxable on the value of crops produced and personally consumed). 189. for a general discussion of imputed income, see haskell and kauffman, taxation of imputed income, 17 nat’l. tax. j. 232 (1964). broadly stated, imputed income is economic gain that is hypothetical because it results from non-market behavior. 190. for a comprehensive criticism of the zelenak & mcmahon theory of imputed income, see joseph m. dodge, accessions to wealth, realization of gross income, and dominion and control: applying the ‘claim of right’ doctrine to found objects, including record-setting baseballs, 4 fla. tax. rev. 685 (2000) (arguing that the treasure trove regulation is a perfectly valid rule regarding the taxability of in-kind windfalls and that catching a record home run is a taxable event so long as the ball is not disclaimed by the taxpayer within a reasonably short period of time). 191. black’s law dictionary (8th ed. 2004). 214 florida tax review [vol. 9:3 of receipts (“treasure trove”), gross income includes only those items that are “reduced to undisputed possession.”192 although the home run ball may be difficult to value at the time it is caught, this should not affect whether a taxable event has occurred. recordsetting home runs are now preceded by frenzied anticipation and excessive media coverage. experts customarily opine on the expected price tag and potential buyers sound off on how much they are willing to pay. in this way, to the extent there is a “valuation” issue at all, it is far less salient than in the case of one who truly “finds” a singular item with no established market. more fundamentally, difficulty of valuation is not generally treated as a prerequisite to income realization in the tax law, with a few possible exceptions.193 recall that an option premium is not taxable upon receipt,194 but the rationale for such treatment is not difficulty of valuation, but the more central question of whether there is income at all with respect to the underlying property. perhaps catching the home run ball is tantamount to a “commercial bargain purchase,” that is, the acquisition of property at a cost (equal to the money spent on the ticket) that is less than the value. the property is therefore “purchased” with a considerable amount of built-in, unrealized appreciation, and in the absence of a separate ground for treating the bargain as income to the purchaser (for example, where the parties share an employer/employee or corporation/shareholder relationship), tax is deferred until sale or disposition.195 under this approach, catching the ball is the 192. see dodge, supra note 190, at 689-90, where this argument is put forth in a more articulate and comprehensive manner. 193. arguably, the treatment of compensatory stock option grants under § 83 runs counter to the argument that the tax law does not postpone income realization due to difficulties in valuation. significantly, however, the issue of valuation in the compensatory option context is usually tied up with forfeiture risk, and contingencies that could completely negate the value of the options. moreover, catching the home run ball is comparable to the exercise of the option (whereby the underlying property is obtained), as opposed to the granting of the option, and by all accounts the exercise of a compensatory option is taxable under sections 83(a) and (b) irrespective of difficulties in valuation. see treas. reg. § 1.83-7(a); section 83(e)(3). finally, § 83 is a specific statutory exception to general rules of income recognition, and in the noncompensation setting, general gross income principles should apply. see dodge, supra note 190, at 725. 194. see supra note 61. the same reasoning applies to financial instruments such as prepaid forward contracts, which are generally thought not to produce income tax consequences until they are settled, on the theory that the transaction relates to the underlying property and is “open” until the property is physically delivered (or the contract is cash settled). 195. see, e.g., pellar v. comm’r, 25 t.c. 299 (1955); palmer v. comm’r, 302 u.s. 63, 68 (1937). 2008] taxing the business of sports 215 consummation of a capital investment, analogous to exercising an option on property. the problem with this argument is that the nexus between the ball and the purchase of the ticket is attenuated. stated otherwise, the cost is not “purposefully incurred in an activity or venture to obtain valuable property.”196 rather, the ticket’s cost is wholly attributable to the entertainment value of the game, with no accompanying “investment” in the chance to catch the ball (which is simply an in-kind windfall to the extent it occurs). while a fan’s motivation for purchasing a ticket may very well be for the chance to catch a record baseball, the likelihood of such an occurrence is sufficiently remote so as to preclude the characterization of the transaction as a “purchase.” in sum, once one accepts that “income” is not synonymous with “cash,” and that our tax law recognizes in-kind wealth accretion, there is no principled reason to conclude that the home run ball produces only “hypothetical” economic gain or that it simply embodies some type of bargain capital investment. the better view is that under current law the catch is a taxable event, subject to the administrative grace (and the good sense) of the irs. part v conclusion in describing what he refers to as the “sports factor,” schuyler moore observes that “a recurrent theme throughout taxation of the sports industry is that congress, the courts, and the service are astounding in their favoritism of the industry, which may be attributable to the reverence and awe that team sports are accorded in american culture.”197 andrew zimbalist describes judge bauer, who wrote the opinion for the seventh circuit in selig, as “confused and addled by his love for baseball.”198 to the extent the sports industry has been accorded special treatment over the years, the 2004 legislation appears to represent a shift in such a trend. while sports are still a diversion, at the professional level it is a business enterprise with its own 196. dodge, supra note 190, at 695. by way of example, dodge posits that a personal consumption cost, such as a vacation to belize, should not be treated as an “investment” in valuable property (such as gold coins) that the traveler fortuitously finds in belize. of course, the purposive nature of the expenditure is a factual question, and theoretically a fan could have incurred the expense 197. moore, supra note 53, ¶ 1301. 198. andrew zimbalist, in the best interests of baseball? the revolutionary reign of bud selig (2006), at 131. in a similar vein, the district court in selig asserted that “baseball is good for americans (who can argue with this).” selig, supra note 96, at 528. 216 florida tax review [vol. 9:3 legislative agenda and special interests. the topics addressed above hopefully provide an insightful perspective on the way tax policy impacts the economics of sports in ways not always obvious to the everyday fan. microsoft word first 5 pages-new.doc florida tax review volume 9 2009 number 5 469 international corporate income tax reform: issues and proposals by jane g. gravelle∗ i. the current international tax system ..................................... 471 ii. economic issues and the allocation of production............. 474 iii. tax avoidance and evasion .......................................................... 483 iv. proposals for revision.................................................................. 487 a. specific provisions to address tax avoidance and tax havens .... 488 b. moving to a territorial tax .......................................................... 491 c. moving toward worldwide taxation ........................................... 492 d. revisions in the u.s. corporate tax ............................................. 494 v. conclusion ......................................................................................... 496 ∗ jane g. gravelle is currently a senior specialist in economic policy in the government and finance division of crs, specializing in the economics of taxation, particularly the effects of tax policies on economic growth and resource allocation. recent papers have addressed fiscal stimulus, tax rebates, consumption taxes, dynamic revenue estimating, investment subsidies, capital gains taxes, individual retirement accounts, estate and gift taxes, family tax issues, charitable contributions, and corporate taxation. in addition to her work at crs she is the author of numerous articles in books and professional journals, including recent papers on the tax burdens across families and tax reform proposals. she is the author of a book, the economic effects of taxing capital income, and co-editor of the encyclopedia of taxation and tax policy and also the editor of the tax expenditure compendium published every two years by the senate budget committee. she holds a b.a. and an m.a. in political science from the university of georgia and a ph.d. in economics from george washington university and is the past president of the national tax association and received the nta’s public service award in 2007. (the views in this paper do not reflect the views of the congressional research service or the library of congress.) 470 florida tax review [vol. 9:5 while details have changed from time to time, the basic treatment of foreign source income in the united states tax code has remained essentially the same as that in 1918, when the foreign tax credit was introduced.1 all worldwide income is currently taxed, with a credit for foreign taxes paid, but income of subsidiaries incorporated in foreign jurisdictions is not considered part of that worldwide income until it is repatriated. as a result of a revision in 1962, certain passive income of foreign subsidiaries is subject to current taxation under subpart f of the internal revenue code. this system produces a number of economic distortions as well as opportunities for tax avoidance. those continuing issues, along with the increasing integration of the global economy, have led to proposals for reform. these proposals fall roughly into four categories: narrow proposals aimed at tax avoidance concerns, proposals to move the system towards a pure territorial (or source-based) system, proposals to move the system in the opposite direction towards a current world-wide tax system, or proposals to retain the current system but lower the corporate tax rate with revenue offsets. in evaluating these proposed tax changes, two issues, which are related but nevertheless not identical, should be considered. the first is the real effects of current law and of a revision on economic activity. when investment responds to tax differentials, it affects the allocation of capital which in turn has implications for efficiency and income distribution (the extent to which the tax burden falls on capital versus labor incomes). in a closed economy with a fixed capital stock, the burden of the corporate tax falls on capital income in general.2 if the u.s. corporate tax does not apply in the foreign jurisdiction, capital can flow abroad with the result that some of the burden on the tax falls on labor (depending on the mobility of capital).3 thus, the international tax system has implications for the overall welfare of the united states, and the world, and for the division of that welfare between those with primarily labor income, who tend to have lower incomes, and those with primarily capital income, who tend to have higher incomes. 1. see william p. mcclure and herman b. bouma, “the taxation of foreign income from 1909 to 1989: how a tilted playing field developed,” tax notes, jun. 19, 1989, pp. 13701390 for a discussion of the evolution of the tax system. 2. this outcome is the standard result of the widely accepted harberger model. see arnold c. harberger, “the incidence of the corporate income tax,” journal of political economy 70 (jun. 1962): 215-240. 3. see gravelle, jane g. and kent a. smetters (2006), ‘does the open economy assumption really mean that labor bears the burden of a capital income tax?’ advances in economic policy and analysis 6 (1): 1-42. 2009] international corporate tax reform 471 the second issue is revenue. the revenue base can be affected by international capital flows. in addition, without changing economic activity, revenues are affected if firms move the location of their profits. this shift in profits can occur through either avoidance or evasion. i define avoidance as reducing taxes legally, but often in ways not intended by policy-makers; evasion is an illegal activity. evasion may be more of an issue with individuals and smaller firms rather than large multinationals;4 however, the line between the two is often blurred. tax avoidance, at least, may be facilitated or limited by the fundamental tax regime. ideally, a tax system that moves closer to neutrality and economic efficiency as well as limiting the scope for avoidance would be preferable. when the two conflict, it is important to know which might be more serious. for example, if real capital flows are viewed as relatively immobile, and artificial shifting of profits relatively costless, a reform that focuses on avoidance might be preferable to one that focuses on efficiency. to begin our analysis we first review the major features of the current tax regime and the basic tax reform alternatives. the following sections evaluate the effects on real economic activities and on avoidance issues. the final section concludes with an evaluation of alternatives. i. the current international tax system there are two alternative, conceptually “pure,” principles on which countries could base their tax: residence and territory. under a residence system, a country taxes its own residents (or domestically chartered “resident” corporations) on their worldwide income, regardless of its geographic source. under a territorial or source-based system, a country taxes only income that is earned within its own borders. in practice, no country uses a pure residence-based tax; historically, virtually all countries tax income foreign investors earn within their borders, although they may grant tax holidays in some cases as an inducement to investment. some countries, however, do have an exclusively territorial or source-based tax.5 most territorial systems have some anti-abuse provisions for 4. this view was expressed by larry langdon, former irs commissioner of the large and mid-sized business division in an interview on frontline (pbs), feb. 19, 2003, after several corporate scandals and the passage of sarbanes oxley. interview is posted at: http://www.pbs.org/wgbh/pages/frontline/shows/tax/interviews/langdon.html 5. president bush’s advisory panel on tax reform published a list of countries that use a territorial system either by statute or treaty. the territorial countries are: australia, austria, belgium, canada, denmark, finland, france, germany, greece, hungary, iceland, italy, luxembourg, netherlands, norway, portugal, slovak republic, spain, sweden, switzerland, and turkey. the following countries tax foreign-source income at some point and rely on foreign tax credits to relieve double taxation: czech republic, iceland, japan, korea, mexico, new zealand, poland, the united kingdom, 472 florida tax review [vol. 9:5 taxing mobile income, similar to the u.s. subpart f rules discussed below. the united states uses a system that taxes both income of foreign firms earned within its borders as well as the worldwide income of its u.s.-chartered firms.6 despite these nominal “residence” features, however, u.s. taxes do not apply to the foreign income of u.s.-owned corporations chartered abroad. as a result, a u.s. firm can indefinitely defer u.s. tax on its foreign income if it conducts its foreign operations through a foreign-chartered subsidiary corporation; u.s. taxes do not apply as long as the foreign subsidiary’s income is reinvested overseas. with some exceptions, u.s. taxes apply only when the income is remitted to the u.s.-resident parent as dividends or other intra-firm payments such as interest and royalties. the deferral feature reduces the effective u.s. tax burden on foreign income and imparts an element of territoriality to the system. it also results in a dichotomous structure for taxing overseas business income: deferral in the case of foreign-subsidiary income and current taxation in the case of branches of u.s. chartered corporations. the bulk of active business investment by u.s. firms is through foreign-chartered subsidiaries.7 certain passive income is subject to current tax even if not repatriated under anti-abuse rules; this income is commonly referred to as subpart f (for the provision of the internal revenue code imposing the rules). only stockholders owning at least 10% of subsidiary stock and only subsidiaries that are at least 50% owned by 10% u.s. stockholders are subject to subpart f. countries that have territorial tax systems generally also have some type of anti-abuse provision to protect their tax base. along with deferral, another basic feature of the u.s. system is the foreign tax credit. while the united states taxes worldwide income on either a current or deferred basis, it also allows credits for foreign taxes paid on a dollar-for-dollar basis against u.s. taxes otherwise owed.8 this treatment avoids the doubletaxation that would otherwise apply and concedes the first right of taxation to the country of source. in effect, the united states gives the foreign host country the first opportunity to tax the income, and collects only what tax is left (up to its own rate) after the foreign host country collects its share. and the united states. president’s advisory panel on federal tax reform, simple, fair, and pro-growth: proposals to fix america’s tax system (washington, nov. 2005), p. 243. 6. a more detailed description of the tax system can be found in joint committee on taxation, economic efficiency and structural analyses of alternative u.s. tax policies for foreign direct investment, jcx-55-08, june 25, 2008. 7. according to irs data for 2004, before-tax earnings and profits of controlled foreign corporations were $362 billion; branch income was $97 billion. the data are posted on the irs website, at [http://www.irs.gov/taxstats/bustaxstats/article/0,,id= 96282,00.html]. 8. u.s. parent firms are permitted to claim foreign tax credits for foreign taxes paid by their foreign-chartered subsidiaries. such “indirect” credits can be claimed by the parent when the foreign-source income is remitted as dividends. 2009] international corporate tax reform 473 when the foreign tax is higher than the u.s. tax, the credit is limited to the u.s. tax that would be due on the foreign income. the purpose of the limit is to protect the u.s. domestic tax base: without it, foreign countries could impose very high taxes without discouraging inbound u.s. investment, because the cost of the higher taxes would be shifted to the u.s. treasury. with the limitation, if foreign taxes exceed the u.s. tax that would be due, the excess foreign taxes cannot be credited. foreign tax credits that exceed this limitation are termed “excess credits.” currently, foreign tax credits are allowed on what is sometimes termed an “overall” basis, so that income and tax credits from all countries are combined. this treatment allows for “cross-crediting,” where credits paid in excess of u.s. tax in one country may be used to offset u.s. tax in a country where the foreign tax is lower than the u.s. tax. to prevent abuse, tax credits are divided into “baskets” which separate passive income easily shifted to low-tax countries. currently, there are two baskets, one for active income and one for passive income. about half of foreign-source active business income is earned by firms with overall excess credits.9 an alternative to the overall limit is the per country limit. with an effective per country limit, cross-crediting, at least across countries, would no longer occur. in the past, the u.s. has had a percountry limit as either a requirement or option from 1932 to 1976, including a period when the less generous of the two limits applied, as discussed by mcclure and bouma.10 they note, however, that when the per-country limit applied, companies could still cross-credit by setting up a holding company since income was sourced to the holding company rather than the original country of origin. a per country limit can also have an advantage, because it prevents countries with losses from reducing aggregate foreign source income for purposes of the limit. the debate leading up to the repeal, however, suggests that the motivation for adopting the overall limit was to move closer to an effective territorial system. tax deferral results in heightened importance for the system=s rules for dividing income between related firms; the more income a firm can assign, for tax purposes, to a foreign subsidiary in a low-tax country, the lower its overall tax burden. there are several methods for doing so, such as altering the prices for inter-company sales (transfer pricing), transferring the ownership of intangibles to low-tax jurisdictions and using contract manufacturing to produce goods in the country of destination, relying more heavily on debt in high-tax jurisdictions than in low-tax ones. more recently, attention has been focused on the use of ahybrid@ entities, where the entity is recognized as a corporation in one jurisdiction but not in another. the development of these hybrid entities arises 9. based on tabulations by harry grubert presented at the james a. baker ii institute for public policy conference on tax reform, apr. 27-28, 2006. 10. see william p. mcclure and herman b. bouma, “the taxation of foreign income from 1909 to 1989: how a tilted playing field developed,” tax notes, jun. 19, 1989, pp. 13701390. the discussion of foreign tax credit limits is based on their paper. 474 florida tax review [vol. 9:5 from “check-the-box” rules that were adopted to simplify the issues of whether a firm is to be taxed as a corporation or partnership, but they have been exploited in an unexpected direction internationally and permit, in many cases, the circumvention of subpart f. according to sicular, a temporary provision enacted in 2006 (section 954(c)(6)) formalizes the “check-the-box” rules, although this provision expires at the end of 2009.11 in sum, the united states taxes its resident corporations on their worldwide income, but permits indefinite deferral of active business income earned through foreign subsidiaries. where u.s. taxes apply, foreign tax credits alleviate double taxation but are limited to offsetting u.s. tax on foreign income. subpart f is designed to deny deferral to what is generally passive income but may be circumvented. the overall outcome of this system is that very little u.s. tax is paid on foreign source income. in a 1995 study, grubert and mutti found the u.s. tax is only about 3% using bea data, and the gao in a 2008 study found a rate of 4% using the new schedule m-3 reconciliation form.12 ii. economic issues and the allocation of production the debate over international tax issues has been confused because of the reference to the term “international competitiveness,” which does not have a clear economic meaning. in economic analysis, it is not countries that are competitive, it is companies that are. a company generally thinks of itself as competitive if it can produce at the same cost as, or a lower cost than, other firms. but a country=s firms cannot be competitive in all areas. indeed, even if firms in a country are more productive than firms in all other countries in every respect, a country would still tend to produce those goods in which its relative advantage is greatest. the other countries need to produce goods with their resources as well. this notion is called comparative advantage, and it is an important concept in economic theory.13 the issue, therefore, is not how to compete in general but how to use limited resources in the best way. 11. see david r. sicular, “the new look-through rule: w(h)ither subpart f?” tax notes, apr. 23, 2007, pp. 349-378. the provision originally expired at the end of 2008, but was extended an additional year by the emergency economic stabilization act of 2008, p.l. 110-343. 12. harry grubert and john mutti, “taxing multinationals in a world with portfolio flows and r&d: is capital export neutrality obsolete?” international tax and public finance, vol. 2 (nov. 1995): 439-57. government accountability office, u.s. multinational corporations: effective tax rates are correlated with where income is reported, gao-08-950, aug. 2008. 13. comparative advantage is not a technical or unfamiliar concept; it is a common, everyday occurrence. a lawyer may be able to do his or her paralegal employee=s work more efficiently, but that activity is not the best use of his or her time. a lawyer has an absolute advantage in both law practice and paralegal work, but a comparative advantage in practicing law. 2009] international corporate tax reform 475 economic analysis does sometimes discuss the competition of countries for capital, an issue that relates to inbound investment, not the outbound investment that the international competitiveness argument is frequently applied to. this issue is discussed below in the consideration of optimal taxation. economists tend to discuss tax policies in terms of efficiency and optimality. consider efficiency first. if a tax system is to be designed to be efficient, then, barring the need to correct for externalities and other market imperfections, it should also be neutral. a capital income tax should not alter the allocation of capital, so that the share of a fixed capital stock should be the same as it would be in the absence of tax. this efficiency can be achieved under many types of rules if all countries have the same tax rate, but only under one regime if tax rates differ. that regime is referred to as capital export neutrality, and it means that investments owned by the citizens of any one country will face the same tax rate regardless of the location. investors will still be earning the same return after tax in each jurisdiction, and will have no incentive to shift the location of investment. given competitive markets, this rule will maximize worldwide output, that is, be optimal from the standpoint of overall worldwide welfare. note that there is no need to have equal tax rates in a particular location, a condition that is often identified with “competitiveness.” it is also referred to as capital import neutrality. if the pre-tax rate of return is 10% and one country imposes a 50% tax rate and another imposes a 25% tax rate, investors resident in the first country will earn a 10% return before tax and a 5% return after tax on their domestic investments and on any foreign investments. residents of the second country will earn the same pretax return but their after-tax return will be 7.5% in both jurisdictions, or in any other jurisdiction. this difference in aftertax return does not interfere with the ability of each country=s firms to compete in any jurisdiction since they are still earning the same pre-tax return and the price of the products produced is driven by pre-tax, not post-tax, return; that is, cost includes the required return after tax to the investor and the tax. while no country imposes a pure residence-based tax, such a system could also be obtained with worldwide taxation and unlimited foreign tax credits as long as investment abroad is direct (made by corporations) as it typically was in the past. even if foreign tax credits are limited, the world wide system, without deferral, and perhaps with an effective per-country foreign tax credit limit, might be a fairly good approximation of a neutral system, especially when tax rates tend to be in similar ranges. only investments in countries with higher tax rates would be affected, as those investments would be discouraged relative to other investments. another perspective about tax policy of a particular country is that of optimality b what u.s. tax policy maximizes the welfare of u.s. citizens. this policy for outbound investment is to equate the return earned to the u.s. in 476 florida tax review [vol. 9:5 foreign investments to that earned domestically,14 a rule sometimes referred to as national neutrality. (this policy only holds when the actions of the investing country cannot affect the return earned abroad.) since foreign taxes are not received by u.s. citizens either privately or for their use in funding public goods, the optimal prescription is to allow only a deduction, not a credit, for foreign taxes. as investors equate their after-tax returns, they will also equate returns before foreign taxes to domestic returns. the tax rate should be even higher for a large country which can influence with its on outbound capital the rate of return in the rest of the world. optimal taxation of returns on inbound investment is not necessarily related to the tax rate on domestic investment. it depends on how responsive that investment is to taxes: if it is very responsive, tax rates should be lower and if it is not very responsive tax rates should be higher.15 if the country of origin imposes a tax with a credit, then the tax rate should be at least as high as that rate. indeed, that is a reason that worldwide developed country tax regimes with a foreign tax credit may be helpful to developing countries in establishing a needed tax base: a foreign firm=s income can be taxed by the host country without actually increasing the firm=s tax burden, and if the country has a limited domestic tax base, it would be desirable to impose a corporate tax. in general, this concept of optimizing a single country=s welfare has not been a very important philosophy in the united states, perhaps because of fear of retaliation, perhaps because of the notion that the u.s. should be a good citizen of the world rather than adopting a “beggar thy neighbor” policy. the analysis of optimality does, however, suggest that the flaw in a practical world-wide system with a foreign tax credit limit, if it tended toward imperfection with respect to high-tax countries, would simply move towards an optimal tax system.16 14. this optimal rule is derived from the maximization of domestic income, f(k)+r(1-tf)k, where k is outbound investment, r is the foreign pre-tax return, and tf is the foreign tax rate. the result, differentiating with respect to k and setting the result equal to zero is that the pre-tax return in the domestic economy equals the return after foreign tax in the foreign jurisdiction. this outcome would be different if the outbound investment could affect the pre-tax return in the foreign jurisdiction: in this case, the tax rate should be higher to discourage outbound investment and increase the pre-tax return earned in the foreign jurisdiction. 15. using a demand elasticity, the optimal tax is 1/(1+e) where e is the elasticity of inbound investment with respect to the after-tax return. maximizing f(k) -r(1-t)k with respect to t, and recognizing that r and k are functions of t, and r is the marginal product of capital yields this result. when inbound capital is very elastic, the tax rate is close to zero while as it becomes very inelastic, the tax rate rises towards 100%. 16. note that in almost all of the discussion about international tax issues, little attention has been directed toward the effects of risk. in a standard analysis of risk, if taxes are proportional and full loss offset is allowed, and if the riskless rate is zero, there is no burden of the tax at all and the investor can restore the original risk and variance by expanding the share of risky assets. indeed, a high tax rate can be beneficial as it shifts risk and return to the government, which is able to spread risk more efficiently 2009] international corporate tax reform 477 in neither the efficient nor the optimal system is there a justification for territorial, or source-based taxes. a territorial system does not achieve efficiency because after-tax returns are initially higher in low-tax countries. in the example above, and supposing a third 0% tax country were added, all companies would earn a 5% return in the 50% tax rate country, a 7.5% return in the 25% tax rate country, and a 10% return in the 0% country. this discrepancy would cause capital to flow out of the high-tax (50%) jurisdiction and into the 0% low-tax jurisdiction (with the effect on the 25% jurisdiction unclear). capital would be mis-allocated and production would be inefficient. despite the term applied to such a system, capital import neutrality, there is no neutrality in this system, but rather a distortion in the allocation of capital. why then, in light of these observations, is there much support for a territorial system? virtually every country (and every one with a sophisticated tax system) either has such a system, or has a close approximation to it through a deferral and credit system that leads to little tax collected on foreign income. the simplest explanation is that the original rules were formulated based on legal concepts of what income was appropriate to tax, and that inertia, the political influence of multinational corporations and the simplifications of a territorial tax (if abuses are not vigorously monitored) led to the system common around the world today. indeed even today, there is pressure to move to a territorial tax.17 kleinbard discusses three reasons that are advanced for moving to a territorial system: to improve international competitiveness, to encourage repatriation, and to simplify.18 the first reason, as demonstrated above, is the result of a (perhaps willful in some cases) misunderstanding of the basics of economics. the second reason is possibly a legitimate reason, but the disincentive to repatriate could also be eliminated by moving in the opposite direction, ending deferral, which appears more consistent with both economic efficiency and optimality. kleinbard disagrees particularly with the argument that tax administration and compliance would be simplified, as there are increased (especially across generations). since corporate taxes tend to be proportional, risk premiums are large relative to risky returns, and there is scope for offsetting losses (through diversification and loss carrybacks and carryforwards) an argument can be made that the burden of the tax is limited and that the main effect of the tax is to reallocate risk. see roger h. gordon, (1985), >taxation of corporate capital income: tax revenues versus tax distortions,= quarterly journal of economics 100 (feb. 1985): 1-27. in an international context, incorporating risk still suggests capital export neutrality in order to allocate private risk efficiently. 17. for example, the president=s advisory panel proposed moving to a territorial tax. president=s advisory panel on federal tax reform, simple, fair, and pro-growth: proposals to fix america=s tax system (washington, nov. 2005). 18. edward d. kleinbard, athrow territorial tax from the train,@ tax notes, feb. 5, 2007, pp. 547-564. 478 florida tax review [vol. 9:5 pressures (as discussed below) to shift income under a territorial system. a similar position is taken by paul mcdaniel.19 one argument that might be made and might appear persuasive is that the u.s. cannot achieve efficiency in isolation. suppose, in the example above, that the 25% tax rate (low-tax) country taxes on a source basis and the 50% (hightax) country on a current basis with a foreign tax credit. more of the 25% tax rate country=s investment would flow to the 0% tax rate country than would the hightax country=s investment. there would be a higher relative concentration of the high-tax country=s investment domestically than in the case of a residence-based tax or even with both countries with limited foreign tax credits. however, there is no reason to see this system as undermining the welfare of the high-tax country. investments at home are still earning higher domestic returns (including the taxes collected) than investments abroad. and the effect on worldwide efficiency cannot be worse than the case with both countries having a territorial tax (at the extreme, with perfect substitutability of capital, all the investment in the 0% tax rate country will be owned by the 25% country and the allocation of capital the same as if both countries had a territorial tax). another argument which has been used inappropriately is the argument that savings is responsive to the rate of return and therefore lowering the tax on outbound investment would not displace domestic investment because it is new savings. aside from considerable uncertainty as to whether lowering tax rates increases or decreases savings,20 this argument suffers from a fundamental fallacy: the assumption that the domestic tax rate is not reduced to allow for a revenue neutral change. that is, if the revenue from an increase in the tax rate on outbound investment is used to decrease the overall tax rate, there is no overall change in the savings incentive.21 but are there any other economic reasons? for most of the history of the tax system there seem to be none. however, the growth in portfolio investments (investments by u.s. individuals of stock in foreign companies) has given rise to new arguments for source-based taxation and a new concept of neutrality. the term capital ownership neutrality (con) is closely associated with desai and hines, professors, respectively, of business at harvard and economics at the university of michigan.22 the term itself, however, appears to have been coined 19. paul r. mcdaniel, “territorial vs. worldwide international tax systems: which is better for the u.s.?” florida tax review, vol. 8, no. 3, 2007. 20. because of income and substitution effects, the theoretical outcome is not clear. in dynamic life cycle models, the result depends on what type of tax substitutions for lower capital income taxes. see, for example, alan j. auerbach and laurence j. kotlikoff, dynamic fiscal policy, new york, cambridge university press, (1987) where the capital stock changes negligibly with a substitution of a wage tax. 21. for a review of this argument, see donald j. rousslang, “deferral and the optimal taxation of international investment income,” national tax journal, vol. 53, (sep. 2000): 589-600. 22. mihir desai and james hines, evaluating international tax reform, national 2009] international corporate tax reform 479 by michael devereux,23 a british economist. the underlying justification for the new standard=s development, the growth of portfolio investment, was also discussed independently about the same time in a paper by frisch.24 essentially, capital ownership neutrality is the same as capital import neutrality in that, under certain very restrictive assumptions, it is achieved by source-based taxation, and some of the earlier discussions viewed it as a resurrection of capital import neutrality.25 the issue of ownership neutrality developed because international investment markets changed. at the time the previous notions of neutral international tax systems were first developed b generally, the early 1960s b virtually all u.s. investment abroad was carried out through foreign direct investment by u.s. firms.26 u.s. portfolio investors held almost no stock in foreign firms. in 1976, portfolio holdings of stock were only 4% of the total of direct investment and portfolio holdings; in 2007, it was 61%. until the mid1980s, the share of foreign stocks in u.s. residents= stock portfolios was less than 1%,27 and thus it was reasonable to assume, as in the discussion above, that there was no substitution across the nationality of firms, but rather only across locations b that is, u.s. investors could not substitute investment abroad through foreign firms for investment in u.s. firms with foreign operations. to make the argument that capital ownership neutrality (and therefore source-based taxation) should be the guiding principle for an efficient and neutral tax system, three requirements are needed. first, firms are assumed not to substitute operations in one location for those in another b capital is completely immobile across locations. second, firms must differ in their productivity b that is, some firms are more efficient than others b and there must be substitution across portfolios that results in firms being shut out of lines-of-business that they could run more efficiently. third, there must be no mechanisms available to tax journal, vol. 56, (sep. 2003): 487-502. 23. michael p. devereux, “capital export neutrality, capital import neutrality, capital ownership neutrality, and all that,” unpublished paper, jun. 11, 1990. 24. daniel j. frisch, “the economics of international tax policy: some old and new approaches,” tax notes, apr. 30, 1990, pp. 581-591. 25. frisch, in “the economics of international tax policy: some old and new approaches,” states, “in short, a major element of the cin view would seem to possess a grain of truth,” (p. 590) referring to the capital import neutrality framework. devereux, in “capital export neutrality, capital import neutrality, capital ownership neutrality, and all that,” indicated that he originally attempted to redefine capital import neutrality to cover the capital ownership neutrality concept. 26. the concepts were first developed by peggy musgrave. see, for example, her united states taxation of foreign investment income: issues and arguments (cambridge ma: harvard law school, 1969), pp. 108-121. 27. jane g. gravelle, reform of international taxation: alternatives, congressional research service report rl34115, library of congress, washington, d.c. 2008. 480 florida tax review [vol. 9:5 obtain the benefits of productive efficiency b short of owning the productive capital assets. for example, relatively inefficient firms cannot rent efficient technologies or hire efficient managers away from efficient firms. if only the first requirement is met (immobility across locations), any system of taxing investment abroad would be neutral because the particular distortion b allocation of investment across locations b is simply assumed away. it does not matter if overseas operations are taxed higher or lower than domestic investment, because investment has no reason to move. residence taxation would be efficient as well as source-based taxation, because the national affiliation of firms would not matter to productivity (although residence taxation would not be optimal for the high-tax country which would have no revenues).28 if the two remaining assumptions also apply b productivity differs and no mechanisms exist to boost efficiency b residence-based taxation is inefficient while source-based taxation produces efficiency. with residence-based taxation, the after-tax return of the high-tax country=s productive firms in the above example, would still not be enough to sell shares of stock in some cases. for example, in the earlier two-country illustration, if the pre-tax return were 12%, the after tax return of 6% in the high-tax country would not be enough for these firms to operate given the return of at least 7.5% for investments of corporations of the low-tax country with a pre-tax return of 10%. if the only way to realize the higher return is to own the capital, the higher pre-tax yields of these more efficient firms would not be realized. with source-based taxation, the efficient firms in each country would operate and displace the less efficient ones. in the more realistic tax systems where countries also tax capital income in their own location, the high-tax country=s especially productive firms would still operate in their own country. that is, by taxing income within its borders, a hightax country that is attempting to practice capital export neutrality with a worldwide tax still faces neutral ground in its home country. thus, any distortion arising in practice from the current system would involve foreign firms and the solution of exempting foreign-source income from tax is the solution consistent with capital ownership neutrality. consider each of the restrictions in turn. the first is the assumption that capital is immobile across locations; yet, there is a large body of evidence that suggests that the location of capital does respond to taxes, although the response is not large, and the empirical estimates vary across studies.29 so, at best, it 28. this optimality issue has also been addressed with the notion of national ownership neutrality, which indicates that it is both efficient and optimal to have sourcebased taxation. 29. this literature is reviewed in organization for economic development and cooperation (oecd), tax effects on foreign direct investment: recent evidence and policy analysis, oecd tax policy studies, no. 17, 2007. the mean of all elasticities (p.12) is 0.75, although the elasticity estimates vary considerably and are statistically significant only about half the time. this elasticity is quite small, although the elasticities appear to be rising over time. 2009] international corporate tax reform 481 would be a question of picking which type of distortion is worse. as long as capital is mobile across jurisdictions, “capital ownership neutrality” is not neutral. at most, the model shows that there is no way to achieve neutrality with a corporate tax and that one is in a second-best world. the second restriction requires a high, perhaps perfect, degree of substitution in portfolios of different types of stocks that would lead to the exclusion of stock of high-tax countries. the fact that the portfolio share has grown does not, in itself, provide evidence of a significant elasticity; rather, it may reflect a variety of technical and institutional changes that make holding foreign stocks more feasible. (the shares can also fluctuate with stock market values). there is considerable evidence to suggest that such perfect substitution is not the case. if it were, investors around the world would tend to hold shares of different country=s firm=s stocks in proportions reflecting their share of total worldwide value. it has long been known, however, that there is a significant home bias in the holding of both portfolio and direct assets, and this bias continues to hold. at the end of 2007, worldwide stock values were $60.8 trillion while the u.s. accounted for $19.9 trillion, or about a third of the total, using u.s. located stock exchange values as a proxy for the domestic equity share.30 according to bea, holdings of foreign portfolio stock investments (investments with ownership of less than 10% of the firm) by u.s. residents were $5.2 trillion, while portfolio holdings of u.s. stock by foreign investors was u.s. $2.8 trillion.31 thus u.s. residents had 23% of their stock portfolios in foreign investment.32 however, if there were no home bias they would be expected to hold two thirds in foreign stocks, or $15.4 trillion, about three times as much. similarly, the remainder of the u.s. stocks, $12.6 trillion, should be held by foreign investors, almost six times the amount actually held. moreover, the portfolio shares are consistent with the notion that the holdings that do exist are not so much due to tax differences but to a general desire to diversify assets across countries to reduce cyclical risk. two-thirds of investment is in other countries with similar tax rates. at the end of 2005, the two largest shares were for the u.k. (16%) and japan (15%). while the u.k., with a 30% corporate rate, has a lower statutory rate than the u.s. (39% including state taxes), japan has a rate of 41%. the next two largest claimants with 7% and 6% have rates of 35%.33 there are significant shares in two tax 30. world federation of exchanges: [http://www.world-exchanges.org/wfe/ /home.asp?menu=436&document=4822]. 31. [http://www.bea.gov/international/index.htm#iip]. 32. this ratio is based on the share of foreign portfolios of $5.2 trillion of total portfolios which is the u.s. equity value of $19.9 trillion minus the amount held by foreigners of $2.4 trillion plus the $5.2 trillion of foreign portfolios. 33. data are from tax rates cited in congressional budget office, corporate tax rates: international comparisons, nov. 2005, and portfolio share data are from u.s. department of treasury report on u.s. portfolio holdings of foreign securities. 482 florida tax review [vol. 9:5 havens, bermuda (5%) and the cayman islands (3%). according to the department of treasury, however, the bermuda investments are largely former u.s. firms that have moved their location to avoid u.s. tax (a phenomenon called inversion, which was subsequently addressed with legislative restrictions), and the cayman islands investments are in offshore financial centers (again likely a tax avoidance issue rather than direct production issue).34 unlike studies of foreign direct investment, which are numerous, the empirical estimates of portfolio substitution are just beginning and should be treated with caution. those to date have found varying effects, which suggest far from perfect substitutability.35 an imperfect portfolio substitution elasticity also suggests that the phenomenon of eliminating efficient firms is less likely to happen. firms that are especially productive and efficient will earn higher returns than other firms in similar circumstances of nationality and location, and they would be expected to be retained in both domestic and foreign investors= portfolios. any firms whose size is contracted by portfolio shifts due to tax rates are more likely to be the marginal firms that have a normal level of productivity. finally, this model assumes that there are no other ways to enjoy the additional productivity of more efficient firms. in effect, the model begins with the assumption of productive advantages without defining in formal terms b so that the effects can be modeled b the source of the productivity. for example, if the greater productivity of the firm is due to the employment of managers with greater skills, then that productivity arises at a cost, and these management skills embodied in the individuals resident in a given country should be free to move to their highest use, and allocated efficiently. since they add a surplus value, they would not be driven out of the market, and worldwide efficiency requires a capital export neutrality approach to labor resources as well as capital. if the asset is uniquely tied to the firm b such as a value through a trademark, intangible r&d, or even a management set-up b the model does not allow for the fact that ownership of the productive assets and ownership of the intangible asset can, in most cases, be separated. trademarks and patents can be franchised and sold. or, if the intangible cannot be separately sold (for example, 34. u.s. department of treasury, report on u.s. portfolio holdings of foreign securities. 35. mehir desai and dhammika dharmapala, “taxes, institutions and foreign diversification opportunities,” working paper, oct. 2007, find elasticities between 0.8 and 2.1 depending on specification, examining response across time to corporate tax rates, although one specification was only marginally significant. the same authors find an elasticity of 1.6 comparing non-treaty countries to treaty countries eligible for dividend and capital gains relief after 2003, in “taxes, dividends and international portfolio choice.” an earlier paper by roger gordon and joosung jun, “taxes and the form of ownership of foreign corporate equity,” in alberto giovanni, r. glenn hubbard and joel slemrod, eds., studies in international taxation, chicago: university of chicago press, 1993 did not find an effect. 2009] international corporate tax reform 483 if the r&d could be easily copied and thus is not patented but kept secret), there are ways for the firm to operate without ownership of the capital assets, such as factories, machinery, and equipment, that give rise to normal products. these assets could be leased by the firm with the intangible asset. moreover, if the asset is not closely tied to management, the firm could arrange for contract manufacturing, a technique commonly used to shift profits. these techniques may be less than perfect if there are principal-agent costs,36 but this effect is of questionable importance. in light of the many ways in which the efficiency costs of capital ownership non-neutrality are unlikely to be significant compared to location distortions, it seems questionable to use meeting this standard of neutrality to evaluate tax reform changes and questionable to see source-based taxation as an efficient international tax regime. iii. tax avoidance and evasion a second issue involves the collection of revenues which may be undermined by avoidance and evasion. (this paper does not deal with individual evasion issues such as secret bank accounts.) the line between avoidance and evasion is blurred. by avoidance we mean structuring transactions in a way that is, or appears to be, legal but which distorts the allocation of profits and reduces company taxes without changing the fundamental economic activities. evasion is generally viewed as an illegal activity. both of these are different from the real economic effects of reallocating capital and production in response to tax differentials, which have consequences for revenue. basic techniques include intercompany pricing for goods and services (charging high prices for sales from low-tax to high-tax operations and low prices in the other direction), increasing debt shares in high-tax jurisdictions, and transferring valuable intangibles to affiliates in low-tax jurisdictions for understated royalties. transfer pricing issues are discussed in detail by a 2007 treasury study.37 subpart f rules were intended to capture some of these effects, such as payments between subsidiaries of interest and royalties, but there are ways to avoid these effects. recent check-the-box rules which allow firms to elect to be considered non-corporate have led to hybrid firms and have made avoidance of these taxes much easier. tax code changes in 2006 put this treatment, which was introduced by regulation, into the law, albeit on a 36. principal-agent costs occur when the objectives of the two parties are not identical. for example, the contract manufacturer (the agent) may want to increase the scale of the operation rather than maximizing profits for the firm authorizing the manufacturing (the principal). 37. u.s. department of treasury, earnings strippings, transfer pricing, and u.s. income tax treaties, nov. 2007. 484 florida tax review [vol. 9:5 temporary basis.38 with this mechanism, for example, loans from an affiliate in a tax haven to an affiliate in a high-tax country can generate interest deductions in the high-tax country, but not lead to taxation under subpart f for the interest income paid to the tax haven because, from the point of view of the u.s. tax authorities, the two affiliates are one company. similarly, once an intangible has been transferred to a lowtax jurisdiction, earnings can be allocated to that jurisdiction by arranging for contract manufacturing in the (high-tax) country of actual production and sale. if most of the profit from production is due to the intangible, that income will be allocated to the jurisdiction which owns the intangible. this income is considered active income and thus not captured by subpart f.39 as indicated above, whether these activities constitute avoidance or evasion is not always clear. a firm that deliberately sets its prices knowing that they are not arms length, given the requirement of such pricing, might be deemed to be engaging in evasion rather than avoidance, while a firm that structures transactions using check-the-box and the recently enacted tax revision appears to be engaged in avoidance. one difference between the two is that the remedies for addressing avoidance may be more directly addressed with changes in the law and regulations, while addressing tax evasion may require expenditures on tax enforcement. companies also can avoid subpart f and other u.s. allocation rules by inversions, or shifting headquarters to other countries, which places the firm=s foreign operations outside the reach of u.s. tax law. inversions also facilitate earnings stripping (reducing the u.s. income tax base through leveraging). in 2004, restrictions on this activity were enacted and those, along with publicity, may have stemmed this activity. but inversion, along with the possibility of international mergers with the foreign firm becoming the parent, remain potential ways of shifting organizational form to avoid taxes without altering real activity. there is ample evidence that income shifting is occurring, although the degree of the shifting is not as easily known. grubert and altshuler, for example, point out that profits of controlled foreign corporations in manufacturing relative to sales in ireland, a low-tax country, are three times the group mean.40 gao showed that low-tax countries such as bermuda, ireland, the uk caribbean, 38. see david r. sicular, “the new look-through rule: w(h)ither subpart f?” tax notes, apr. 23, 2007, pp. 349-378 for a discussion of the evolution of this provision. 39. for a discussion of tax planning techniques see organization for economic development and cooperation (oecd), tax effects on foreign direct investment: recent evidence and policy analysis, oecd tax policy studies, nov. 17, 2007, chapter 5. 40. harry grubert and rosanne altshuler, “corporate taxes in a world economy: reforming the taxation of cross-bordern income,” in john w. diamond and george zodrow, eds., fundamental tax reform: issues, choices and implications, cambridge, mit press, 2008. 2009] international corporate tax reform 485 singapore, and switzerland had a higher share of pretax profits of u.s. multinationals than they did of value added, sales, physical assets, compensation, or employees.41 martin sullivan has been reporting on the discrepancies in pretax return on assets across tax havens for many years. for example, in 2004, he reports a return on assets for 1998 averaged 8.4% for u.s. manufacturing subsidiaries, but the returns were 23.8% in ireland, 17.9% in switzerland, and 16.6% in the cayman islands, three well-known tax havens.42 he has also documented the growth of profits in tax havens.43 more recently, he reported that of the ten countries that accounted for the most foreign multinational profits, the five countries with the highest manufacturing returns for 2004 (the netherlands, bermuda, ireland, switzerland, and china) all had tax rates below 12% while the five countries with lower returns (canada, japan, mexico, australia, and the united kingdom) had tax rates in excess of 23%.44 gravelle points out that the earnings of multinationals in the cayman islands is larger than the cayman islands gdp.45 a number of econometric studies of this issue have also been reported in the economics literature,46 and the recent study by the joint committee on taxation reviews the literature.47 the magnitude of these effects on revenues is, however, uncertain. the joint committee on taxation, which prepares official revenue estimates projects the revenue gain from ending deferral to be about $6 billion a year,48 a figure that should capture both the income retained abroad and not taxed and income artificially shifted abroad because of lower tax rates. altshuler and grubert project a higher number: they estimate for 2002 that the corporate tax could be cut to 28% if deferral were ended, and based on corporate revenue in that year the gain is about $11 billion.49 that year was at a low point because of the 41. government accountability office, u.s. multinational corporations: effective tax rates are correlated with where income is reported, gao-08-950, aug. 2008. 42. martin sullivan, u.s. citizens hide hundreds of billions in the caymans, tax notes, may 24, 2004, p. 960. 43. martin sullivan, “data show dramatic shift of profits to tax havens,” tax notes. sept. 14, 2004, pp. 1190-1200; “latest irs data show jump in tax haven profits, tax notes, oct. 11, 2004, pp. 151-153. 44. martin sullivan, “extraordinary profitability in low-tax countries,” tax notes, august 25, 2008, pp. 724-727. 45. jane g. gravelle, reform of international taxation: alternatives, crs report rl34115, washington, d.c. library of congress, 2008. 46. for a review, see james r. hines, jr., “lessons from behavioral responses to international taxation,” national tax journal, vol. 52 (jun. 1999): 305-322. 47. joint committee on taxation, economic efficiency and structural analyses of alternative u.s. tax policies for foreign direct investment, jcx-55-08, jun. 25, 2008 48. joint committee on taxation, estimates of federal tax expenditures for 2007-2011, sep., 24, 2007, p. 24. 49. harry grubert and rosanne altshuler, “corporate taxes in the world economy, in fundamental tax reform: issues, choices, and implications@ ed. john w. diamond and george r. zodrow, cambridge, mit press, 2008. 486 florida tax review [vol. 9:5 recession; if the share remained the same, the gain would be around $13 billion for 2004 and $26 billion for 2007. martin sullivan estimates that, based on differences in pre-tax returns, $75 billion in profits is artificially shifted abroad.50 if all of that income were subject to u.s. tax, it would result in a gain of $26 billion for 2004. he acknowledges that there are many difficulties in determining the revenue gain. some of this income might already be taxed under subpart f, some might be absorbed by excess foreign tax credits, and the effective tax rate may be lower than the statutory rate. sullivan concludes that an estimate of between $10 billion and $20 billion is appropriate. altshuler and grubert suggest that sullivan=s methodology may involve some double counting; however, their own analysis finds that multinationals saved $7 billion more between 1997 and 2002 due to check-the-box rules.51 some of this gain may have been at the cost of high-tax host countries rather than the united states, however. sullivan subsequently presents an estimate of a $17 billion dollar revenue cost.52 christian and schultz, using rate of return on assets data from tax returns, estimated $87 billion was shifted in 2001, which, at a 35% tax rate, would imply a revenue loss of about $30 billion.53 pak and zdanowicz estimated that lost revenue due to transfer pricing alone was $53 billion in 2001.54 kimberly clausing, using regression techniques on cross country data, which estimated profits reported as a function of tax rates, estimated that revenues of over $60 billion are lost for 2004 by applying a 35% tax rate to an estimated $180 billion in corporate profits shifted out of the united states.55 she estimates that the profit shifting effects are twice as large as the effects from shifts in actual economic activity. this methodological approach differs from those above, which involve direct 50. “shifting profits offshore costs u.s. treasury $10 billion or more,” tax notes, sept. 27, 2004, pp. 1477-1481. 51. rosanne altshuler and harry grubert, “governments and multinational corporations in the race to the bottom,” tax notes international, feb. 2006, pp. 459474. 52. martin sullivan, “u.s. multinationals shifting profits out of the united states,” tax notes, mar. 10, 2008, pp. 1078-1082. 53. charles w. christian and thomas d. schultz, roa-based estimates of income shifting by multinational corporations, irs research bulletin, 2005 [http://www.irs.gov/pub/irs-soi/05christian.pdf]. 54. simon j. pak and john s. zdanowicz, u.s. trade with the world, an estimate of 2001 lost u.s. federal income tax revenues due to over-invoiced imports and under-invoiced exports. oct. 31, 2002. 55. multinational firm tax avoidance and u.s. government revenue, kimberly clausing, working paper, mar. 2008. her method involved estimating the profit differentials as a function of tax rate differentials over the period 1982-2004 and then applying that coefficient to current earnings. 2009] international corporate tax reform 487 calculations based on returns or prices, and is subject to the econometric limitations with cross country panel regressions.56 note, as suggested above, that the consequences of tax planning techniques on u.s. corporate tax revenue are unclear. consider, for example, the check-thebox provision, with a subsidiary in a high-tax host country and a subsidiary in a tax haven. the tax haven subsidiary loans money to the host country with a deduction for interest in that country, but no taxation of interest by the united states. if inter-company payments were subject to subpart f through a retraction of check-the-box, companies might pay the subpart f tax, increasing u.s. revenues. they might, instead, no longer make loans, increasing the host country revenues. in other cases, as well, restrictions on methods of transferring income may benefit foreign high-tax jurisdictions in part. issues relating to evasion in general in tax havens have been addressed by some international agencies including the oecd and the european union, which has sought to expand the exchange of information and limit harmful tax practices.57 the scope of the original oecd proposal was, some argue, undermined by the withdrawal of support by the u.s. in 2001, although it may not have been very effective in any case, since the exchange of information is on a request basis, requiring the requesting country to be able to identify the tax evader in advance58 the european union initiative which requires automatic information sharing or automatic withholding might be more effective but does not include the united states.59 as noted above, the evasion of this type is more likely to be associated with individuals rather than large multinational corporations, but developing automatic information exchange would be helpful in achieving greater tax compliance for business as well as individuals. iv. proposals for revision there is general agreement that the current system could be worse than either a purer residence or a purer territorial system. it is effectively a territorial system, in that taxes imposed on measured foreign source income are negligible and it may also shelter domestic income from tax. by allowing deferral, companies can elect when to repatriate to match taxes with excess credits, allow deductions of parent company overhead such as interest while not taxing income, and allow foreign losses to offset domestic income. as indicated in the previous discussion, many of the subpart f taxes on passive income may be avoided by 56. these approaches often find it difficult to account for country-specific effects. 57. see tax justice network, tax us if you can, sep. 2005, pp. 39-42, for a brief discussion of some of these efforts. 58. for a discussion see martin a. sullivan, “lessons from the last war on tax havens,” tax notes, jul. 30, 2007, pp. 327-337. 59. ibid. 488 florida tax review [vol. 9:5 provisions such as check-the-box, and passive income in the aggregate, as the result of changes made in 2004, is eligible for cross-crediting. in this section we discuss proposals for revision that can be revenue neutral (by altering the corporate tax rate) and that maintain a capital income tax, thus avoiding concerns regarding distributional effects of more fundamental tax reforms.60 the proposals discussed below fall into four main categories. the first category is narrow changes in the international tax regime that largely address international tax avoidance. the second is a proposal to move to an explicit territorial regime for active business while limiting some of the benefits associated with the current regime. the third is a proposal to move in an opposite direction, by eliminating deferral and possibly taking other measures to enforce more of a residence-based tax system. the final is some reforms in the domestic corporate tax that may alleviate some of the problems with the international tax regime. all of these changes at least claim to raise revenues or be revenue neutral, permitting the corporate tax rate to remain fixed or to fall. a. specific provisions to address tax avoidance and tax havens in this section, a series of targeted proposals that largely address tax avoidance are discussed. some of these provisions would, however, be quite sweeping, such as those affecting tax havens or those disallowing parent company cost deductions for deferred income. note that this list is not exhaustive, as there are numerous narrow technical changes in the law and regulations that might reduce tax avoidance; this list focuses on broader proposals. reverse check-the-box for foreign subsidiaries b one change that would reduce profit shifting is to disallow the application of check-the-box rules for multinationals, which would require revising the regulatory rules and repealing the legislative provision for look-through adopted in 2006. as noted earlier, this change may not necessarily raise much revenue for the united states, if the response is to shift income to high-tax host countries rather than to pay subpart f taxes. such a change would not, therefore, be in pursuance of national optimality to the extent that it increases revenues of high-tax countries, but it would reduce 60. thus, this section does not discuss the advisory panel=s proposal to move to a consumption tax base by allowing expensing of investment. note, also, that one problem with this approach is, while it would introduce investment neutrality, it is not clear that it would deal with profit shifting unless the tax were on a destination basis (so that tax on cash flows would hinge on the place of sale rather than the place of production). current international rules do not allow rebates of direct taxes. there are also many challenges, largely relating to distribution and transition, because such a tax, although it appears to be a tax on capital, no longer functions that way. see jane g. gravelle, the advisory panel=s tax reform proposals, congressional research service report rl33545, washington, d.c., library of congress, 2007. 2009] international corporate tax reform 489 those circumstances where profits are not taxed anywhere, which, after all, was the original point of subpart f. indeed, one can make the case that this checkthe-box regulation as applied to multinational firms may have effectively undone, through regulation, much of the legislated subpart f provisions. formula apportionment b one proposal that would directly address profit shifting behavior is a formula apportionment, such as is typically applied by the states and the canadian provinces. the states typically allocate income based on a formula that includes assets, payroll, and sales, while the canadian provinces use payroll and sales. the proposal for formula apportionment has been the subject of a lengthy study by clausing and avi-yonah,61 who propose a formula based on sales, which is the least responsive of the factors. charles mclure discusses a similar proposal being considered in the european union.62 clausing and avi-yonah suggest a significant revenue gain for the u.s. treasury is likely in such a system, on the order of $50 billion per year, in part because the fraction of worldwide income in the united states is smaller than the fraction of worldwide sales. this revenue gain may be larger than the gain from repealing deferral, discussed below, because there would be less scope for the use of foreign tax credits to offset u.s. taxes on foreign source income. there are a number of reservations about formula apportionment. theoretically, using a formula based on assets would more closely allocate income to its origin, but it is very difficult to value intangible assets or determine their location, and intangibles could be easily manipulated. one could base part of the formula on tangible assets instead, but, again, for a company where the largest asset is an intangible one, there would be considerable incentive to locate these assets (as well as employment) in a low-tax country that facilitates manufacturing activity (such as ireland or singapore). basing the formula largely or solely on sales would reduce or avoid these problems but would convert the tax in part to a sales tax. using other factors changes the nature of the tax and its incidence. adopting such a formula unilaterally may be problematic and lead to double taxation (although if the european union countries could also agree to such a formula, the problems would be much lessened). yet, given the powerful evidence on profit shifting, such costs may be worth the benefits. sourcing royalty income to the country of development b under current law, when foreign subsidiaries pay royalties to the u.s., they are considered foreign source income and eligible for foreign tax credits, which, under overall credit limits, are often available. harry grubert has suggested that such income 61. kimberly a. clausing and reuven s. avi-yonah, reforming corporate taxation in a global economy: a proposal to adopt formulary apportionment, brookings institution: the hamilton project, discussion paper 2007-2008, jun. 2007. 62. charles e. mclure, “harmonizing corporate income taxes in the european community: rationale and implications,” in tax policy and the economy, ed. james m. poterba, forthcoming 2008. 490 florida tax review [vol. 9:5 be considered domestic source and not eligible for the foreign tax credit.63 or as an alternative, he suggests a separate foreign tax credit basket be allowed, which would reduce cross crediting. his motivations are less for dealing with tax avoidance issues and directed toward neutrality in the locational choice of where to exploit an intangible. extending subpart f to tax haven countries: treating tax haven firms as u.s. firms b the clinton administration proposed to apply current taxation to tax haven countries, and it spelled out this approach as one of its three options in its 2000 study of subpart f.64 it is obvious that little or no real activity is taking place in tax haven countries, and that, rather, the allocation of income is simply a blatant tax avoidance mechanism. this treatment could also be extended to branch income of tax havens under check-the-box rules or applied simultaneously with eliminating check-the-box. a tax haven could be defined with reference to the tax rate (as proposed by treasury) and perhaps other factors (such as bank secrecy and lack of information sharing.) this tax haven income could also be segregated (either by country, or as a group) into a separate foreign tax credit basket so it could not be shielded from tax by excess foreign tax credits, or denied any foreign tax credit. such an approach has also been proposed by senator levin. a related approach, proposed by senators dorgan and levin (s. 396, 100th congress) would treat any firm not engaged in an active business in any tax haven as a u.s. firm, similarly making them ineligible for deferral or foreign tax credits. disallowing interest and other overhead expense deductions for deferred income b a 2007 tax reform proposal by chairman rangel of the ways and means committee (h.r.3970) proposed to disallow the deduction of parent company costs (the most important of which is interest) to the extent that profits of foreign subsidiaries are repatriated.65 this proposal would also allocate foreign tax credits based on the share of total deferred income repatriated. the proposal was estimated by the joint committee on taxation to raise $106 billion over ten years. the revenue raised by this proposal suggests that deferred income may have been effectively subsidized to the extent that borrowing in the u.s. and the attendent interest deductions allowed deductions of effective costs without inclusion of income. the restriction also reduces the disincentive to repatriate income. 63. harry grubert, tax credits, source rules, trade and electronic commerce: behavioral margins and the design of international tax systems, cesif0 working paper 1366, dec. 2004. 64. u.s. treasury department, office of tax policy, the deferral of income earned through u.s. controlled foreign corporations, dec. 2000. 65. this proposal is discussed in jane g. gravelle, the tax reduction and reform act of 2007: an overview, congressional research service report rl34249, washington, d.c., library of congress, 2007. 2009] international corporate tax reform 491 b. moving to a territorial tax several researchers have proposed a territorial tax system with cost allocation rules and current taxation of passive income.66 this proposal was also advanced by the president=s advisory panel on tax reform and the joint committee on taxation in 2005; the joint committee on taxation also recently discussed such an approach along with the alternative of a full-inclusion system.67 the analyses of these proposals by harry grubert indicated that the plan would raise revenue compared to the current system, estimated at $10 billion,68 presumably due to the restriction on deductions such as interest and the taxation of royalties. (the rangel proposal, discussed above, imposes the deduction restriction while leaving deferral in place). by moving to an explicit exemption, this provision encourages capital and investment to move abroad, a provision that is consistent with neither worldwide efficiency or national optimization. at the same time, the current system is, more or less, a territorial one and an explicit territorial approach eliminates the disincentive to repatriate. studies of the response to the repatriation holiday (which temporarily allowed a lower tax on repatriations) showed a significant response, suggesting this distortion is important.69 thus, in economic efficiency terms, it might be an improvement over current law. it is less clear (since the change is projected to raise revenues, whether it reduces the incentive for foreign portfolio investments (since the returns to corporations reflect on taxes on real activity and taxes avoided through profit shifting). 66. this proposal was originally advanced by harry grubert and john mutti, taxing international business income: dividend exemption versus the current system, washington, d.c. aei press, 2001. it is further discussed, along with a full inclusion approach, by harry grubert and rosanne altshuler, acorporate taxes in the world economy,@ in fundamental tax reform: issues, choices, and implications, ed. john w. diamond and george r. zodrow cambridge, mit press, 2008. 67. president=s advisory panel on federal tax reform (2005), simple, fair, and pro-growth: proposals to fix america=s tax system (washington, dc: u.s. government printing office); joint committee on taxation, options to improve tax compliance and reform tax expenditures, jcs-02-05, jan. 27, 2005; joint committee on taxation, economic efficiency and structural analyses of alternative u.s. tax policies for foreign investment, jcx-55-08, jun. 26, 2008.. 68. harry grubert, “enacting dividend exemption and tax revenue,” national tax journal, vol. 54, dec. 2001, pp. 811-827. 69. see joann m. weiner, “measuring the effects of the dividend repatriation holiday,” tax notes, nov. 26, 2007, pp. 853-854 reporting on a presentation at the national tax association meetings in nov. 2007 by melissa redmiles of the irs and roy clemmons and michael r. kinney, “an analysis of the tax holiday for repatriation under the jobs act,” tax notes, aug. 25, 2007, pp. 759-768. 492 florida tax review [vol. 9:5 a number of criticisms and problems with the territorial tax have been identified.70 the main reservation with an explicit territorial approach is that it increases the pressure to shift profits into active business enterprises in low-tax jurisdictions. the increased pressures on transfer pricing, including shifting of intangibles and the income from those intangibles into low-tax jurisdictions, were cited by the joint committee on taxation and others as a problem with a territorial approach. this problem is probably worse than it was when this territorial proposal was first discussed in 1995 (with check-the-box, which was introduced in 1997). in other words, the anti-abuse system in a territorial tax system may not work very well, and may work less effectively than it did in the past and less effectively than it does under the current system. one option discussed by the joint committee on taxation was to require income to be subject to a certain level of foreign tax before it could become exempt, an approach used by some other countries. various observers have also pointed out a number of reservations and controversial details that would have to be addressed in moving to a territorial tax. for example, there may be pressure to exempt royalties, there is the issue of whether to include mobile income related to active income in the tax base, and there is the issue of the incompatibility of this regime with the 2006 provision that facilitates the activities carried out by hybrid corporations. there is also considerable uncertainty about whether such a territorial tax, often justified as a simpler approach to international taxation, would achieve that purpose given the need to retain anti-abuse provisions and allocate expenses. c. moving toward worldwide taxation this section discusses several proposals that might move the united states towards the economically efficient residence based, or worldwide tax system. the centerpiece of such a proposal would be to end deferral entirely and tax foreign income currently. several variations of an inclusive system have been proposed, which vary in the extent they would apply to minority owned subsidiaries and the extent to which foreign losses would be offset against u.s. income.71 as noted above, altshuler and grubert projected a higher number: 70. see joint committee on taxation, economic efficiency and structural analyses of alternative u.s. tax policies for foreign investment, jcx-55-08, jun. 26, 2008; edward kleinbard, “throw territorial taxation from the train,” tax notes, feb. 5, 2007, pp. 547-564; j. clifton fleming, jr. and robert j. peroni, “exploring the contours of a proposed u.s. exemption (territorial) tax system,” tax notes, dec. 19, 2005, pp. 1557-1577. 71. see the discussion in j. clifton fleming, jr., robert j. peroni, and stephen e. shay, “deferral: consider ending it instead of expanding it,” tax notes, feb. 7, 2000; harry grubert and rosanne altshuler, “corporate taxes in the world economy,” in fundamental tax reform: issues, choices, and implications, ed. john w. diamond and george r. zodrow cambridge, mit press, 2008; joint committee on taxation, 2009] international corporate tax reform 493 they estimate for 2002 that the corporate tax could be cut to 28% if deferral were ended, and based on corporate revenue in that year the gain is about $11 billion.72 that year was at a low point because of the recession; if the share remained the same, the gain would be around $13 billion for 2004 and $26 billion for 2007. the effectiveness of a worldwide taxation system in achieving capital export neutrality from the point of view of the united states depends on whether firms have excess credits. without excess credits, which would be less common to the extent that the u.s. tends to be at the higher end of the tax rate scale, there is no benefit to investing in a low-tax jurisdiction. grubert and altshuler estimated that about 30% of active foreign source income would be in excess credit with a 28% rate, but that this group is dominated by petroleum countries; among manufacturing firms only 18% of income is in excess credit. even with excess credits, it might be possible to provide more separate baskets, such as a basket for oil production income (as was allowed in the past) or a per country limit (with tracing rules) to limit cross-crediting. a major benefit of current taxation of foreign source income is that it would greatly reduce the opportunities for income shifting through transfer pricing, sourcing intangibles in low-tax countries, and even check-the-box. ending deferral tends to score well both on achieving more economic efficiency (and optimality for the united states) and reducing opportunities for international tax avoidance. but what are the drawbacks? one such drawback is the increased incentive for corporate inversions or for originally establishing a foreign headquarters. the joint committee on taxation study suggests the possibility of basing residence on a facts and circumstances basis (such as where management and control of the company is carried out) rather than nominal incorporation. another, and related, issue is the increased incentive to make portfolio investments in other countries. it is not clear, as discussed above, that this ownership non-neutrality would contribute to inefficiency, but it might undermine revenues. one possibility would be to create a tax differential in the united states for stock of domestic versus foreign-owned companies. when a lower dividend tax rate was enacted in 2003, it was not extended to foreign stock where a treaty did not exist; such preferential treatments could be solely limited to stock of companies headquartered in the united states. economic efficiency and structural analyses of alternative u.s. tax policies for foreign investment, jcx-55-08, jun. 26, 2008; 72. harry grubert and rosanne altshuler, “corporate taxes in the world economy,” in fundamental tax reform: issues, choices, and implications, ed. john w. diamond and george r. zodrow, cambridge, mit press, 2008. 494 florida tax review [vol. 9:5 d. revisions in the u.s. corporate tax if direct revisions in international tax rules are not made, is it possible to make basic revisions in the u.s. tax that might mitigate some of the international tax issues? the following revenue neutral reforms might be considered. lower the corporate rate and raise rates at the individual level b under the current u.s. system, taxes on corporate profits at the individual level (dividends and capital gains) tend to be collected (due to tax treaties) on a residence basis. if taxes at the individual level could be increased and taxes at the corporate level decreased, the tax would shift towards a residence-based system without any other changes and without any additional concerns about portfolio substitution. in 2003, relief for double taxation was provided by reducing the tax rate on corporate dividends from the ordinary tax rate to 15% for those in brackets above the 15% rate, and to 5% for others. the 5% rate is now scheduled to fall to zero. capital gains tax rates were lowered from 20% to 15%. according to gravelle, the 35% corporate tax rate could have been rolled back to a 31% rate, or even less, for the same revenue cost if a corporate rate reduction rather than reductions in the individual level tax had occurred. another two to three percentage points would be possible if capital gains are taxed at full rates. even more revenue could be raised by accrual taxation of corporation capital gains.73 additional rate reductions would be possible if non-profits and pension and savings plans were taxed to offset their savings from lower corporate rates. broaden the u.s. corporate tax base and lower the statutory rate b since profit shifting is generally motivated by differences in statutory tax rates, a broader base and a lower statutory tax rate would reduce the amount of profit shifting. some of these options are discussed in gravelle, including a list of preferences mentioned by treasury that could reduce the tax to 27% and a bill, h.r. 3790, introduced by ways and means chairman rangel that could reduce the rate to 30.5%, and other provisions including indexing interest deductions for inflation, eliminating corporate graduated tax rates, and repealing the title passage rule.74 a major difficulty with this approach is that there are a limited number of items that are not extremely controversial or have mixed effects. one of the large revenue raisers in the treasury list is accelerated depreciation, and the cost of investment would likely rise if a rate reduction is traded for slower 73. jane g. gravelle, reform of international taxation: alternatives, crs report rl34115, washington, d.c. library of congress, 2008. 74. jane g. gravelle and thomas l. hungerford, corporate tax reform: issues for congress, congressional research service report rl34229, library of congress, washington, d.c. 2008. the title passage rule allows half of income to be allocated to the jurisdiction in which title passes for purposes of the foreign tax credit limit. it generally functions as an incentive to exports, not foreign investment. 2009] international corporate tax reform 495 depreciation, since investment subsidies have more bang for the buck. similarly, while the production activities deduction is a questionable provision in terms of administration and neutrality, it does operate similarly to a rate reduction and not a great deal may be gained from that trade off. the indexing of interest deductions could also result in a reduction in total capital net inflows into the united states if debt is more mobile than equity, since this provision subsidizes debt capital. restrict the ability to operate in the noncorporate form b the treasury study issued in july of 2007 provided some dramatic evidence about the ease with which mid-sized and even large firms are able to operate in the noncorporate form.75 income from non-corporate business grew from 21% in 1980 to 50% in 2004. while sole proprietorships declined from 17% to 14%, partnerships rose from 3% to 21% and subchapter s firms (incorporated firms that can elect to be taxed as partnerships) from 3% to 15%. subchapter s firms are limited by the number of shareholders b the limit of 10 was raised to 35 in 1982, to 75 in 1996, and to 100 in 2004. the expansion in partnerships came largely after 1990 and presumably reflected the new forms of firms recognized in the states and check-thebox rules in 1997. the treasury also indicated that the u.s. has much more liberal rules for allowing non-corporate status and a more prevalent non-corporate sector. returning to greater restrictions on shareholders for subchapter s and restricting the ability of large firms to operate as partnerships (for example, by requiring corporate status in any case of limited liability) would increase revenues and allow a much lower corporate tax rate. change the basic nature of the tax system b a final approach is to change the fundamental nature of the system. a recent proposal made by kleinbard, for example, would require that all businesses pay the same tax with riskless returns taxed at the individual level and the corporate tax applies to excess returns.76 this approach combines elements of some of the proposals above, particular treating debt and equity and corporate and non-corporate firms the same, is a form of integration, and shifts more of the tax burden back to the individual level. such a proposal might be explored, although it already has its critics and would probably face some barriers, both technical and political.77 75. united states department of the treasury, treasury tax conference on business taxation and global competitiveness: background paper, jul. 30, 2007 at [http://www.ustreas.gov/press/releases/hp500.htm]. 76. see edward kleinbard, rehabilitating the business income tax, the amilton project, discussion paper 2007-09, washington, d.c., the brookings institution, 2007. posted at: [http://www.brookings.edu/~/media/files/rc/papers/ 2007/06corporatetaxes_ kleinbard/200706kleinbard.pdf]. 77. see alvin c, warren, the business enterprise income tax: a first appraisal, tax notes feb. 25, 2008, pp. 921-939. for a rejoinder, see the letter to the editor from kelinbard, tax notes, mar. 3, 2008, pp. 1043-1048. for further reply see warren=s 496 florida tax review [vol. 9:5 v. conclusion our current stance on international taxation involves both misallocation of investment and considerable scope for tax avoidance, not only for avoiding tax on foreign source income but also shifting profits from the domestic economy to foreign jurisdictions. the analysis in this paper suggests that proposals to move to a source-based or territorial tax, which have been proposed by businesses, by some academics, and by the president=s advisory panel, would exacerbate both of those problems. with a territorial system, other provisions such as formula apportionment or current taxation of income earned in low-income systems would likely be needed to limit shifting of profits. a worldwide system, while eliminating the benefits of profit shifting by u.s. firms would face the problem of shifting residency, so that such a shift might need to be accompanied with other measures, such as determining residency by a facts and circumstances rule and perhaps taxing foreign and domestic corporations differently at the individual level. even if we retain the current deferral and credit system there are some provisions without that framework that might address avoidance and misallocation. finally, measures that would shift the tax burden from the firm level to the individual level and/or that would expand the base of corporate taxation and permit lower rates could be considered. the barriers to such changes appear to be largely political, not technical. letter to the editor, tax notes, mar. 17, 2008, pp. 1254-1255 and further rejoinder by kleinbard. mar. 31, 2008, pp. 1417-1419. florida tax review volume 4 2000 number 11 blum and kalven at 50: progressive taxation, “globalization,” and the new millennium michael a. livingston* i. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 732 ii. traditional arguments for (and against) progressivity.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 733 iii. changes in the context of the progressivity debate.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737 a. the new political environment.. . . . . . . . . . . . . . . . . . . 737 b. the changing nature of inequality. . . . . . . . . . . . . . . . . 739 c. globalization and the “race to the bottom”. . . . . . . . . 742 iv. reflecting the changes: toward an ethos of progressivity for the post-cold war world. . . . . . . . 744 a. arguing progressivity: the case for a modest meritocracy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 745 1. politics: the rise of neoliberalism and the reappearance of distributional concerns. . . . . 746 2. economics: “winner-take-all” theory and the limitations of private markets. . . . . . . . . . . . . . 748 3. morality: meritocracy and its measure. . . . . . . 750 4. studying progressivity: encompassing race, gender, and other nontraditional concerns. . . . . . . . . . 755 b. implementing progressivity: toward an international strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 760 v. progressive taxation and american “progressive” discourse. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 766 * professor of law, rutgers-camden school of law. a.b. 1977, cornell; j.d. 1981, yale. 731 732 florida tax review [vol. 4:11 i. introduction 1 almost 50 years ago, walter blum and harry kalven described the case for progressive taxation as "stubborn but uneasy." this article considers2 the extent to which that conclusion remains valid five decades later. i argue that the case for progressivity is today even more uneasy than in blum and kalven's time, as a result of three principal developments: a more conservative political environment, which is generally hostile to redistributive measures; the femininization and minoritization of poverty, which make it easier to rationalize inequality and tend to divide the constituencies in favor of progressive measures; and the globalization of economic life, which suggests that a progressive rate structure may cause the country to lose business to other nations. these developments challenge both the philosophical underpinnings of progressive taxation, which is based on liberal assumptions that are now severely contested, and its political support, which flowed from a cold war consensus that now no longer exists. globalization is particularly significant, for it suggests a practical as well as a theoretical limit on progressive taxation, and raises the specter that progressivity may be swimming against the historical tide. these same developments also present an opportunity. if supporters of progressivity can confront the changes described above and if they can adjust their arguments to the realities of the twenty-first century, then the case for progressivity may yet prove stronger than in blum and kalven's era. however, to accomplish this progressivity supporters must change both their rhetoric and research agenda. on a rhetorical level, scholars must make a more candid and forceful case for progressivity as a means of redistribution, emphasizing the unfairness of today's "winner-take-all" society and the role of irrelevant factors such as race, gender, and immigrant status in pretax income distributions. these arguments suggest that, far from being inconsistent with a dynamic, merit-based society, progressive taxation may be necessary in order to preserve it. progressive taxation should be especially attractive to those who object to affirmative action and similar race-conscious programs but support redistribution based on economic or financial status. 1. i would like to thank philip harvey, marjorie kornhauser, dan shaviro, nancy staudt, and the participants in faculty workshops at the rutgers, temple, and georgetown law schools for helpful suggestions in the preparation of this article. this article was made possible, in part, by generous research assistance from the rutgers law school and a summer research grant from the temple-beasley school of law. 2. walter j. blum & harry kalven, jr., the uneasy case for progressive taxation, 19 u. chi. l. rev. 417, 519 (1952). for a short update by one of the authors, see walter j. blum, revisiting the uneasy case for progressive taxation, taxes, jan. 1982, at 16. the current article focuses primarily on changes taking place since blum’s later effort. 2000] blum and kalven at 50 733 progressivity research should likewise emphasize new subjects. these include the impact of tax rates and other tax provisions on women and minority taxpayers, the interaction of tax and spending policies, such as health and welfare; and similar empirical and interdisciplinary projects. these topics are likely to increase our understanding of progressivity issues and convince doubters of the efficacy of a progressive rate structure. both the research and the rhetoric must address the international aspects of the progressivity question, including the potential for international cooperation in maintaining progressive tax rates and the arguments for redistribution between, as well as within, different societies. the changes above would strengthen the case for progressivity on both an intellectual and practical level. the intellectual case would improve, because scholars would be confronting the changes of the past decades, rather than retreating to theoretical models or yearning for a consensus that no longer exists. the political case would improve, because important groups such as women, minorities, foreigners and governments would be brought into the fray on an issue to which they have heretofore been largely peripheral. the argument might or might not be won, but the battle at least would be joined. part ii of the article considers the classic arguments for and against progressivity and efforts to update those arguments for new developments. part iii considers the changing context of the debate, including changes in political philosophy, the degree and kind of economic inequality, and the emerging global economy. part iv evaluates the arguments for progressivity in light of these changes, and develops a case for progressivity consistent with current reality. part v considers implications for the nature of tax scholarship and the future of the american left. ii. traditional arguments for and against progressivity blum and kalven’s critique of progressivity was written in 1952, at the height of the cold war era. in their article, which later became a book, the3 authors divided the case for progressivity into two principal categories. in the first category were arguments that attempted to justify progressive taxation for reasons other than the overt redistribution of wealth. included were arguments based on the diminishing marginal utility of money; the benefit theory of taxation; and various other formulations relating to benefit, sacrifice, and ability to pay. blum and kalven found these arguments appealing but inconclusive, and subject to quantification problems that made them difficult to apply on a systematic basis. for example, the benefit theory foundered on the difficulty of identifying the benefits of government spending, while marginal utility theories were inconclusive because of the difficulty of quantifying 3. see supra note 2. 734 florida tax review [vol. 4:11 individual utility curves. thus none of these theories, on their own, provided a convincing argument for progressive taxation.4 in the second category were arguments which saw progressive taxation as an overt means of redistributing income. according to blum and kalven, such redistribution might be justified by a feeling that the pre-tax economy did not fairly reward individual talents and abilities, or that the talents and abilities were themselves unfairly distributed in the first place. these arguments were more forceful than the first category, but also more controversial, especially in a society that was organized around capitalist principles and rejected the socialism of the soviet union and similar countries. finding the first category largely unconvincing, and the second politically problematic, blum and kalven concluded that the case for progressivity was "stubborn but uneasy," at least for those unwilling to contemplate the more radical social engineering that a fullscale assault on inequality would entail.5 because blum and kalven addressed the traditional arguments so comprehensively, more recent scholarship has tended to emphasize new intellectual developments, which might provide arguments unavailable at the time blum and kalven were writing. the premiere example is bankman and6 griffith, which combines welfarist theories of distributive justice and optimal tax methodology, neither of which were completely developed in 1952, to make a sophisticated case in favor of progressive taxation. 7 4. see blum & kalven, supra note 2, at 451-86. 5. see id. at 519. 6. for a somewhat more practical discussion, written about halfway between the time of blum and kalven and later articles, see charles o. galvin & boris i. bittker, the income tax: how progressive should it be ? (1969) (debate between advocates of a flat tax on a more broadly defined income base and the advocation of a traditional progressive rate tax). for a classic work of pre-blum and kalven progressivity scholarship, see william vickrey, agenda for progressive taxation (1947). 7. see joseph bankman & thomas griffith, social welfare and the rate structure: a new look at progressive taxation, 75 cal. l. rev. 1905 (1987); cf. lawrence zelenak & kemper moreland, can the graduated income tax survive optimal tax analysis?, 53 tax l. rev. 51 (1999) (optimal tax analysis may support progressive or flat taxation under different theoretical and factual assumptions). in discussing progressivity scholarship, i emphasize work by contemporary legal scholars. economics articles tend to be more empirical in character, although frequently referring to underlying moral and philosophical issues, see, e.g., tax progressivity and income inequality (joel slemrod ed. 1994); richard a. musgrave & peggy b. musgrave, public finance in theory and practice 356-61 (5th ed. 1989) (assessing patterns of progressivity in recent american taxes); but see id. at 218-33 (discussing benefit theory and ability to pay as theoretical approaches to tax equity). 2000] blum and kalven at 50 735 more recent authors have applied rawls, dworkin, nozick, and other philosophers to the tax issue, with the first two of these generally being taken to support a high degree of progressivity, and the third a flat or at least less progressive regime. perhaps the most original approach was that of marjorie8 kornhauser, who combined feminism with more traditional arguments such as the benefit theory and democratic stability to make an eclectic, unconventional case for progressivity. identifying progressivity with a cooperative, feminine model of social relations, kornhauser argued that a measure of redistribution served as a necessary if modest counterpoint to an individualist, maledominated society. 9 the scholarship on progressivity is diverse and wide-ranging, but two principal themes emerge. the first is the predominantly abstract, theoretical character of such scholarship. most articles address the issue of progressivity in a hypothetical, idealized society, with only limited empirical data regarding the actual allocation of income in the united states or other countries. issues like the femininization of poverty, or the concentration of poverty among minorities and immigrant groups, have only recently been reflected in the literature, and discussion of these issues tends to be treated as a separate subject rather than as a part of the mainstream discourse on progressive taxation, although there are some notable exceptions.10 second, as time goes on, tax scholars have placed increasing emphasis on the burden-sharing (i.e., non-redistributive) arguments for progressivity, or at the very least blurred the differences between the two types of arguments, arguing that progressivity is less radical than blum and kalven suggested and that it ought to be acceptable even to those who are generally skeptical about redistributive measures. this reflects the increasing conservatism of american society, but also the structure of the tax field, which favors consensus-style 8. see, e.g., donna m. byrne, progressive taxation revisited, 37 ariz. l. rev. 739, 771-89 (1995) (applying rawls, dworkin, nozick, and richard posner to the issue of progressive tax rates); donna m. byrne, locke, property, and progressive taxes, 78 neb. l. rev. 700 (1999) (applying a similar application of lockean liberal theory); cf. charles r. o'kelley, jr., tax policy for post-liberal society: a flat-tax-inspired redefinition of the purpose and ideal structure of a progressive income tax, 58 s. cal. l. rev. 727, 735-44 (1985) (using rawls, nozick, roberto unger, and other scholars in support of an argument for a flat tax with an expanded tax base and a generous exemption amount); robert e. hall & alvin rabushka, the flat tax (2d. ed. 1995) (arguing for proportionate or flat tax rates on fairness and efficiency grounds); but see stephen b. cohen, the vanishing case for flat tax reform: growth, inequality, saving, and simplification, 33 val. u.l. rev. 819 (1999) (arguing that persistence of high growth rates and economic inequality have largely undermined the case for a flat tax). 9. see marjorie e. kornhauser, the rhetoric of the anti-progressive income tax movement: a typical male reaction, 86 mich. l. rev. 465 (1987). 10. see id., marjorie e. kornhauser, what do women want: feminism and the progressive income tax, 47 am. u. l. rev. 151 (1997) (assessing normative and empirical aspects of women’s support for progressive taxation). 736 florida tax review [vol. 4:11 arguments and has historically proved inhospitable to those who favor radical, nonincremental solutions. this mainstream approach has succeeded in11 building broad support for progressivity, but has resulted in a perhaps overly defensive posture, in contrast with the aggressive self-assurance of many of their opponents. while the scholarly debate continues, a largely separate debate rages in the political forum, where institution of a "flat" (i.e., non-progressive) income tax, or wholesale replacement of the income tax with a consumption, value-added, or similar levy, retain significant popular appeal. this political debate has an odd and at times contradictory character. on the one hand, the rhetorical momentum has shifted toward the flat tax advocates, who support a flat tax as part of a broad program of conservative-inspired political reform. on the other hand, the actual progressivity of the tax system has remained surprisingly high and perhaps even increased during this period, an effect which is more striking if government spending, especially social security, as well as taxes are taken into account. not surprisingly in this situation, public opinion12 remains ambivalent. the idea of a flat tax wins broad sympathy, but support tends to diminish as people become aware of the costs of the proposal, including loss of deductions and credits and higher taxes on low-income individuals. some of the flat tax momentum appears to have dissipated as a result of the economic boom in the 1990's, which has focused attention on tax reduction rather than comprehensive reform, although the idea appears to have made a comeback in the recent presidential campaign. 13 11. see michael a. livingston, reinventing tax scholarship: lawyers, economists, and the role of the legal academy, 83 cornell l. rev. 365, 375-80 (1998) (describing the pragmatic tradition in tax scholarship). 12. on the progressivity of the contemporary tax system, see staff of the joint committee on taxation, distribution of certain federal tax liabilities by income class for calendar year 2000 (jcx-45-00), april 11, 2000 (hereinafter "jct report") (households earning over $200,000 per year are estimated to pay 42.7% of the individual income tax for fiscal year 2000, with the top 1% of income earners paying 33.6% of the tax). these amounts become significantly lower (27.5 and 18.6%, respectively) when excise and payroll taxes are taken into account, although a significant measure of progressivity would likely be restored if the spending of payroll, primarily social security and medicare, tax receipts were taken into account. efforts to combine tax, spending, and regulatory measures and thereby provide an overall measure of the progressivity of government intervention in the economy have typically foundered on the difficulty of measuring the distributive impact of government services, such as military spending and police protection, although the combined measure would likely reveal a high degree of redistribution, particularly as individuals age and become eligible for social security and related old-age benefits. see laurence j. kotlikoff, kent smetters, & jan walliser, distributional effects in a general equilibrium analysis of social security, in the distributional effects of social security reform (martin feldstein ed., forthcoming 2000, description available at http://econ.bu.edu/faculty/kotlikoff). 13. see leslie wayne, flat tax goes from "snake oil" to g.o.p. tonic, n.y. times, nov. 14, 1999, at 1 (noting that three of five republican presidential candidates supported a flat tax at a recent new hampshire debate). on public opinion regarding progressive taxation, see generally karlyn keene, what do we know about the public's attitude on progressivity, 36 2000] blum and kalven at 50 737 iii. changes in the context of the progressivity debate the progressivity debate is thus characterized by a dichotomy between the intellectual and the popular realms. intellectuals tending to support progressive taxation but in somewhat defensive terms, and the populace is intrigued by a flat tax but is also ambivalent and often confused. yet both the intellectual and popular debates threaten to be overtaken by events. these include changes in the activity and philosophy of the post-cold war federal government, in the degree and type of economic inequality, and in the relationship between the united states and the emerging global economy. these changes do not necessarily weaken and in some cases may actually strengthen the intellectual arguments for progressivity, but they change the context for those arguments, so that many of the assertions made by blum and kalven and more recent authors bear revisiting in the new situation. real-world changes, and especially globalization, also impose significant practical obstacles to the maintenance of a progressive tax system, so that progressivity advocates face the frustrating prospect of making a winning academic argument on behalf of a losing political cause. a. the new political environment the most obvious change is the increasing conservatism of american politics, especially in the last twenty years. conservatism takes many forms, but typically includes a gut-level resistance to spending and taxes, especially programs that are perceived as redistributive between income and social classes. thus programs designed primarily to benefit the poor such as welfare and health care reform face strong opposition, while those with large middle class constituencies such as social security and medicare are criticized but nat'l tax j. 371 (1983) (public believes existing tax system to be unfair but displays contradictory attitudes regarding progressive and flat taxes); michael l. roberts, peggy hite, cassie f. bradley, understanding attitudes toward progressive taxation, 58 pub. opinion q. 165 (1994) (public tends to prefer progressive taxation as an abstract matter but may prefer proportional or flat taxes when more concrete questions are asked); deborah a. geier, cognitive theory and the selling of the flat tax, 96 tax notes 241 (april 8, 1996), (assessing how cognitive biases affect people's impressions of flat and progressive tax systems and responses to new tax incentives). see also marvin a. chirelstein, the flat tax proposal–will voters understand the issues?, 2 green bag 2d 147, 148 (1999) (expressing the author's sense that there is considerable "misapprehension" of new flat tax proposals and providing a nontechnical roadmap to combat that misapprehension). the recent presidential campaign suggested further ambivalence toward the tax reform issue, with the republican candidate (george w. bush) advocating tax cuts less extreme than a flat tax, and the democratic candidate (al gore) emphasizing “targeted” tax relief and criticizing the republican proposals for their distributional impact. see martin a. sullivan, news analysis–dueling tax plans: texas two-step gives way to the tennessee waltz, tax notes, oct. 2, 2000, at 10 (comparing bush and gore tax plans). 738 florida tax review [vol. 4:11 remain largely untouched or even incrementally expanded. the issues of14 spending and taxes are closely linked here, because high taxes are unpopular on their own terms and because they are perceived as funding programs that undermine traditional values. the later 1990s have witnessed something of a resurgence of liberal politics, as exemplified by the election of president clinton and similar leaders such as tony blair and gerhard schroeder in european countries, but these leaders have frequently been on the defensive and have in any case followed centrist rather than traditional liberal policies. together with increasing conservatism is a significant change in the nature of government spending. blum and kalven wrote at the height of the cold war, when the federal budget emphasized defense spending and a variety of domestic programs, typically designed to assist poor americans in obtaining education, housing, and other economic benefits. today both defense and discretionary social spending have decreased in relative terms, and an increasing portion of the federal budget is taken up by "entitlement" programs (notably social security) that are financed from sources other than the income tax. the decline in defense spending has been accompanied by a change in national mood. the country feels less threatened by foreign adversaries than at any time in recent history, and even last year’s military action in kosova had some difficulty making front pages. the changes above strike at both of the arguments for progressivity as described in blum and kalven's article. redistributive arguments are obviously harder to make in an atmosphere hostile to redistribution. even if taxes were raised on the rich, the decline in discretionary spending means that relatively little of the money would ever benefit the poor unless accompanied by significant new spending programs. burden-sharing arguments also lose some of their luster. defense is the most obvious form of shared burden. with defense needs somewhat less pressing, many middle-class taxpayers may feel that they are receiving few benefits from federal spending, and thus have little reason to pay high taxes on increasing incomes. to the extent that they accept the benefit theory, voters are likely to use it to argue for user fees and similar charges that directly match levies and benefits, rather than as an argument for progressive income 14. there is an anomaly here, in that the latter programs (especially social security) have a large redistributive component, but at least part of their success consists of hiding this component, and proposals for reform of these programs frequently call for reducing this redistributive aspect. on proposals for the reform of social security, see rebecca e. perrine wade note, the face of social security in the twenty-first century: an analysis of the reform proposals offered by the social security advisory council, 6 elder l.j. 115 (1998) (analyzing the economic and social impact of alternate reform plans produced by the social security advisory council of the department of health and human services); kathryn l. moore, redistribution under a partially privatized social security system, 64 brook. l. rev. 969 (1998) (evaluating effect of various privatization proposals on the redistributive capacity of the social security system). 2000] blum and kalven at 50 739 taxation. all this is really just another way of saying that progressive taxation15 was part of a broad liberal consensus which prevailed during the middle part of this century, and becomes difficult to maintain as that consensus breaks down. instead of floating with the political tide, progressive taxation must now swim bravely against the tide. b. the changing nature of inequality a second change relates to the nature and degree of economic inequality. blum and kalven wrote against the backdrop of a classic industrial society, with a relatively small wealthy or upper middle class and a large working or lower middle class concentrated in agricultural and manufacturing jobs. the implicit purpose of progressive taxation was to redistribute income from the former to the latter, and to some extent to poor people not yet in either of these categories. such a program had a strong intellectual and political appeal, since a majority of the population had relatively modest incomes and thus benefitted, or at the very least appeared to benefit, from progressive taxation. racial and gender differences obviously existed, but were not yet a major part of the tax debate, and blum and kalven allude to them only in passing. however, today's society differs significantly from that of the 1950s. on the positive side, the country has become immeasurably richer, and there is probably a higher percentage of affluent individuals than at any time in american history. but there is also a large and significant minority of disadvantaged individuals, many of them in the second or third generation of this disadvantaged status. the latter are moreover concentrated among women, minorities, and recent immigrant groups, so that the question of class becomes intermingled with issues of gender, race, and immigration policy. by all accounts, economic inequality is growing, as is the concentration of poverty among discrete racial and gender groups.16 15. cf. blum & kalven, supra note 2, at 451-55 (discussing benefit theory as an argument for progressive taxation). 16. on increasing income inequality during the past generation, see, e.g., edward n. wolff, top heavy: a study of the increasing inequality of wealth in america 12 (1995) (most of the economic gain during the 1980s went to the top 1% of income earners with the middle remaining fairly constant and lower wage-earners receiving a declining portion of the economic pie); jct report, supra note 12, at 1 (top 5% of households estimated to account for almost 30% of national income during the 2000 calendar year with top 10% of households accounting for more than 40% of that figure). on the concentration of poverty among women and minority groups–the so-called femininization (and "minoritization") of poverty–see u.s. dep't of commerce, statistical abstract of the united states 1996, nat’l data book, chart no. 736 (recording an increase in female-headed households below the poverty level, from 9.4 million in 1979 to 14.4 million in 1994); id., chart no. 724 (male householders with no wife present earned an average of $27,751 in 1994 while female householders with no husband present earned an average $18,236); melvin l. oliver & thomas m. shapiro, black wealth/white wealth 12, 92740 florida tax review [vol. 4:11 the changing nature of inequality has a curious effect on progressivity. on a theoretical level, increasing inequality would appear to enhance the case for redistribution, by taxation or other means. this is particularly true, when poverty correlates strongly with immutable factors such as race and gender making it difficult to argue that poverty is attributable to lack of effort or ambition on the part of the individuals in question. perhaps the best argument for progressive taxation, that it corrects for injustice in the pretax allocation of income, is as strong as or stronger than it was fifty years ago.17 the difficulty is, of course, in translating this moral case into an effective practical argument for progressive taxation. here three problems present themselves. the first is the simple fact that a wealthy society, even as it presents a stronger moral case for redistribution, is likely to resist it politically. increasing unfairness might in theory cause the better off to support redistributive measures. but the opposite may also occur. the wealthy are emboldened in their efforts to undo transfer programs, and the middle class becomes fearful of sharing its more precarious advantages with the classes below them. race and gender differences may actually enhance this process, making it difficult for the rich to identify with those less fortunate than they are, and enhancing the physical separation of rich and poor which is a feature of all advanced societies. it is important to note that there is no clear line between intellectual and political arguments on this subject. thus, conservatives (and some liberals) argue that rewards should be distributed on the basis of "merit," which is measured by standardized tests and other vehicles that tend to favor the more advantaged parts of society, and criticize progressive taxation for interfering with merit-based awards. similarly, the lower classes, especially single18 mothers, are often cited for immoral conduct which is said to explain their poor economic status. whether such statements are taken to be good-faith arguments or self-serving rationalizations, they contribute to a climate that is increasingly hostile to redistributive measures, on both intellectual and political grounds. a second problem relates to the left, the most likely supporters of progressivity. as poverty becomes concentrated among women, minorities, and other discrete groups, "progressive" people inevitably begin to place less faith in generic remedies like taxation and pay more attention to sectarian concerns. 103 (1995) (conditions for disadvantaged african-americans have deteriorated significantly since 1970 while even middle-class blacks lag substantially behind whites in volume of assets and income security). the concentration of income among wealthy individuals lends a perverse quality to progressivity statistics, since the increasing percentage of taxes paid by upper-income taxpayers is, in part, a reflection of their increasing percentage of income rather than of a more redistributive tax system; what seems clear is that after-tax incomes would be even more skewed toward the wealthy under a proportionate or flat tax regime. see supra note 12. 17. see blum & kalven, supra note 2, at 496-97 (arguing for redistribution based on unfairness of pretax income allocations). 18. see infra text accompanying notes 44-57 (discussing the "meritocracy" concept). 2000] blum and kalven at 50 741 if the problem is discrimination against women or african-americans, why not advocate policies like affirmative action which deal directly with these problems? why make an issue of progressive tax rates, which address only the effects of discrimination, and then only in an indirect, blunderbuss manner? the rise of identity politics, so visible in other areas, here collides full-force with tax policy. tax scholars themselves have become less interested in overall tax structure and more interested in provisions affecting women, minorities, and other discrete, identifiable groups. two left-leaning authors have written that progressivity is itself a "contestable" proposition, given its failure adequately to consider the problems of poorer taxpayers and other methodological flaws.19 even if these ideological problems could be resolved, there remain the practical limitations of progressive taxation in the contemporary economy. progressivity is a good vehicle for redistributing income between the upper and middle segments of society, but is generally less effective at assisting the very poor. many poor people do not pay income taxes at all, and for those that do, sales and payroll levies often remain more important than the income tax. progressive (i.e., higher) taxes on the wealthy might in theory be used to fund direct spending programs that benefit poor individuals, but this depends on numerous political assumptions, and in the current political environment it is unlikely that this would happen. fifty years ago, progressive taxation was20 relatively good at solving the problem of redistribution from the wealthy to the middle and working class, but today progressive taxation is relatively bad at solving the problem of reallocation from a large and mostly contented population to a smaller but growing number of poor. this is obviously a simplification, but it helps to explain the defensive posture of progressivity advocates, and the lack of enthusiasm for the concept among its intended beneficiaries. 19. karen b. brown & mary louise fellows (eds.), introduction, taxing america 9-10 (1996) (arguing that progressivity "depends on a series of contestable proposition," including a focus on income rather than wealth and an emphasis on the effects rather than the causes of income disparities). 20. see supra text accompanying notes 12-13. the role of the poor, as opposed to the working class, in progressive tax theory has always been somewhat ambiguous, because many poor people pay little or no income tax and because theorists have tended to emphasize the effect of progressivity on the rich rather than the poor. most current flat tax proposals include generous exemption amounts that exempt all or most of the poor from taxation. on the role of the poor in progressive tax theory, see nancy c. staudt, the hidden costs of the progressivity debate, 50 vand. l. rev. 919, 958-91 (1997) (arguing that the poor have a right to pay taxes as well as receive government benefits and that both liberal and conservative authors have paid inadequate attention to this right). 742 florida tax review [vol. 4:11 c. globalization and the "race to the bottom" perhaps the biggest cliche of the past decade is the rise of a global economy and the corresponding decline in the importance of national boundaries. "globalization" has in fact been taking place for several decades, but there is a sense that the 1990s, the decade of the internet, cell phones, and the new economic order, marked a point of no return, in which markets became inextricably intertwined and no nation could hope to remain free of the demands of international capitalism. one must be wary of exaggeration-earlier prophecies of the "end of history" have met with dubious fates -but on the21 level of perception, if not reality, something has clearly changed, and tax and nontax public policy will henceforth be made in a new and different environment. globalization, like domestic political changes, has contradictory effects. globalization, at least in the short run, tends to exacerbate economic inequality, pulling the wages of highly skilled workers up to international levels while pushing wages of unskilled individuals down toward the level of third world residents who in theory could and sometimes do replace them. this increased inequality, which results from global economic forces rather than any moral failure on the part of the less skilled workers, provides a further argument in favor of progressive taxation and other redistributive programs. michael knoll has written eloquently of the economic dislocation caused by the new global economy and the need to adjust public policy to cope with this problem.22 but if globalization makes high tax rates sympathetic, it also makes them difficult to maintain. in a global economy, a country that increases tax rates beyond those of competing nations will eventually lose business to those competitors. this is particularly true of taxes on capital, which can more easily be shifted to low-tax jurisdictions than labor or other economic inputs. globalization thus tends to discourage taxation of capital and encourage taxation of labor and other factors; since capital tends, almost by definition, to be owned by wealthier people, progressivity will thus be harder to maintain in a global economy, unless there is substantial cooperation between taxing units. international tax policy thus threatens to recreate the "race to the23 21. see, e.g., norman angell, the great illusion: a study of the relation of power in nations to their economic and social advantage (1911) (arguing that the growth of international trade made international conflict obsolete in the pre-world war i era). 22. michael s. knoll, perchance to dream: the global economy and the american dream, 66 s. cal. l. rev. 1599 (1993). 23. see generally vito tanzi, taxation in an integrating world 134 (1995) (globalization makes it difficult for countries to impose progressive taxes on factors, especially financial capital and highly skilled labor, that can move to countries that impose lower marginal tax rates); sven steinmo, the end of redistribution? international pressures and domestic tax policy choices, challenge, nov.-dec. 1994, at 9 (tax systems in both industrial and third world nations are becoming increasingly regressive as taxes on wealthy individuals and corporations 2000] blum and kalven at 50 743 bottom" between american states, which compete to provide lower taxes and services and attract new jobs and investment. to some degree, this phenomenon is offset by advantages resulting from higher taxes and spending, including an improved infrastructure and a well-educated workforce; but in the immediate term, at least, the impetus appears to be toward lower and less progressive taxes.24 whether it strengthens or weakens the case for progressivity, globalization poses a new intellectual challenge for tax scholars, who are used to thinking in one-country terms. an obvious question concerns the role of poor countries (as opposed to poor people) in progressive taxation. tax brackets for american married couples are now delineated at, approximately, $37,000, $89,000, $140,000, and $250,000, with marginal tax rates increasing from 15% to 28%, 31%, 36%, and 39.6% percent at these respective cutoffs. by contrast,25 the per capita gdp in mexico, a country now linked to the united states by the comprehensive north american free trade agreement (nafta), is approximately $4,300 per year. does it make moral or practical sense to26 redistribute income between americans with taxable incomes of $30,000 and $60,000, when the average mexican enjoys about one-seventh the per capita gdp of the average american? shouldn't both rich and poor americans pay27 higher taxes, with the excess being redistributed to mexicans with much lower are cut and replaced by increases in consumption taxes, social insurance charges, and public sector borrowing); editorial, the taps run dry, the economist, may 31, 1997, at 21 (globalization is forcing governments to shift taxation from "footloose" production factors like profits and savings to less mobile factors like consumption and labor, resulting in increased regressivity). although the most immediate impact of globalization is on business taxes, tax rates on high-income individuals have also decreased sharply in most industrial nations in the past two decades, a development which appears to result at least partly from fears of a "brain drain" if taxes on the most productive individuals are too high. see tanzi, supra, at 32-41 (concluding that income taxes may play a significant role in labor migration, especially for high-income individuals and especially in smaller countries). 24. see robert b. reich, toward a new economic development, indus. wk., oct. 5, 1992, at 37 (tax breaks and subsidies have only a marginal effect on where industry decides to locate; accordingly "the only way to lure global capital while maintaining or increasing people's standard of living is . . . to offer a highly skilled workforce and world class infrastructure"); jeffrey owens, globalisation: the implications for tax policies, fiscal stud., vol. 14, no. 3, at 21 (1993) (globalization leads to increased tax competition but high tax locations which have good infrastructure and a well educated workforce may be more attractive to some high-tech companies than low tax jurisdictions with minimum government expenditures). 25. irc § 1(a). these brackets have been adjusted for inflation annually since 1992. id. § 1(f). (1999). 26. see 1 organisation for economic co-operation and development, nat’l accounts main aggregates 1960-1997 146-47 (1999) (noting that mexican per capita gdp was approximately $4,300 in 1997). the use of mexican per capita gdp probably overstates the hypothetical u.s. taxable income of mexican taxpayers. the taxable income of mexicans, measured by u.s. standards, would be still lower than these gdp figures because of the effect of deductions, exclusions, and other measures. 27. the per capita gdp of the united states in 1997 was approximately $29,300. see id. 744 florida tax review [vol. 4:11 incomes? if this seems too extreme, shouldn't some milder form of redistribution be instituted between the two countries, and isn't this matter at least as pressing as redistribution between the american upper and middle classes? the question seems far-fetched, even bizarre, because most americans, including the american left, have historically thought of foreign policy as subsidiary to domestic concerns. for example, the left has frequently supported protectionist trade legislation in order to help american workers even though the same legislation may hurt still lower-paid workers in other countries. but poor countries are likely to raise precisely this sort of question28 when rich countries ask them to cooperate in tax matters, by harmonizing tax rates, restricting tax havens, or otherwise protecting the existing tax structure. the arguments for progressive taxation, including reduction of income inequality, marginal utility of money, and similar theories, are no less applicable merely because national borders have been crossed. on both a moral and practical level, globalization requires a rethinking of progressive taxation, ranging from implementation problems to the very definition of the progressivity concept. iv. reflecting the changes: toward an ethos of progressivityfor the post-cold war world the preceding pages suggest some of the intellectual and practical challenges that progressivity will face in the foreseeable future. the remainder of the article sets forth a strategy for responding to these challenges. this includes a new rhetorical approach, which emphasizes the redistributive nature of progressive taxation and its role in a highly competitive, merit-based society, and a new research program, which ties progressivity to the issues of gender and racial equity within the united states and the globalization of tax policy outside it. these aspects are closely related, as the rhetoric provides inspiration 28. a dramatic example of left-wing (and some right-wing) reservations about free trade was provided by the late 1999 seattle demonstrations against the world trade organization, which found surprising support in several establishment corners. see, e.g., g. richard shell, protesters have a point on wto: interest groups need to be heard, phil. inquirer, dec. 3, 1999, at a43 (wto should be democratized to reflect interests of nongovernmental as well as governmental constituencies and to recognize the validity of environmental, human rights, and other noneconomic claims); robert e. lighthizer, conceding free trade's flaws, n.y. times, dec. 3, 1999, at 31 (globalization is a positive development but u.s. should ensure that it does not lead to world government or a "race to the bottom" in labor and environmental standards); but see trudy rubin, protesters overestimated wto's power, phil. inq., dec. 8, 1999, at a27 (arguing that seattle protesters should focus on domestic issues rather than attempting to force u.s. norms on developing countries). on tax and trade issues involved in the north american free trade agreement–a sort of regional equivalent of the wto–see generally colloquium on nafta and tradition: forward, 49 tax l. rev. 525 (1994). 2000] blum and kalven at 50 745 for new research projects and the research, in turn, provides support and backing for the rhetorical argument. i wish to be clear at the outset about the scope of my effort. the changes that i propose are, in general, incremental rather than revolutionary, an effort to update blum and kalven rather than discard it and start again. there is no magic bullet for reviving progressivity or repelling the flat tax challenge. what i offer is engagement, a proposal to confront rather than avoid what i believe to be the real issues in the progressivity debate, together with a belief that such engagement will, in the long run, strengthen rather than weaken the argument for progressivity. making a new argument inevitably involves some restatement of points from the earlier, descriptive part of this article. the reader will forgive this repetition, together with the clumsiness resulting from the presentation of a unified position in its separate component parts. a. arguing progressivity: the case for a modest meritocracy begin with rhetoric. the first step in arguing for any proposition is to be honest about its strengths and weaknesses. now as always, the case for progressivity rises and falls with the redistributive argument. the alternate29 arguments—diminishing marginal utility of money, the benefit theory and the breakup of large concentrations of wealth—were dubious even in blum and kalven's day, and intermediate developments have if anything weakened these further. marginal utility, always indeterminate in nature, becomes still more so in a wealthier society, where the differences in consumption patterns tend to be of degree rather than kind. this problem may be sidestepped by focusing solely on extreme cases of wealth and poverty, but at that point becomes essentially a restatement of the case for redistribution, with relatively little added by the utility concept. the benefit theory founders on the lack of any obvious30 29. cf. henry c. simons, personal income taxation 18-19 (1938) ("the case for drastic progression in taxation must be rested on the case against inequality–on the ethical or aesthetic judgment that the prevailing distribution of wealth and income reveals a degree (and/or kind) of inequality which is distinctly evil or unlovely.") 30. it is easy to suppose that the utility of an additional dollar will be greater to a serf than to a lord, or to an individual earning $5,000 per year than to an individual earning ten times that amount. it seems harder to assume that a person earning $50,000 or $75,000 will derive more utility from her next dollar than a person earning $150,000 or $200,000, although these kinds of distinctions are made regularly by today's tax rate tables. most likely, the latter's consumption will involve more luxurious versions of the former's such as a house in a nicer neighborhood or a lexus in place of a camry rather than the satisfaction of essentially different needs; the declining utility implied by this increased luxury may be overwhelmed by the latter's higher appreciation of luxury items, or greater materialism, or other factors that are difficult to quantify in a comprehensive utility theory. one can still argue, rather persuasively, i think, that the latter person has a greater taxpaying capacity, and hence a greater responsibility to contribute to those less fortunate than she is, but this is a redistributive or similar argument rather than an argument based on diminishing marginal utilities in a theoretical sense. to put the same matter somewhat 746 florida tax review [vol. 4:11 correlation between taxes and benefits, and if extended to its ultimate logic would produce a regime of user fees rather than a progressive income tax. concentrations of wealth, if we are seriously concerned about them, are better dealt with by a wealth or inheritance tax. there is no escaping the redistributive or fairness issue. to say that the issue is fairness is not necessarily to make a convincing case for progressivity; for the more unfair the pretax income distribution, the more many may struggle to preserve it. this is particularly true when the political climate is conservative, when poverty is concentrated among discrete and insular groups, and when the merit or just desserts concept is used to rationalize existing income distributions and argue against reallocation. a31 contemporary case for progressivity accordingly requires that we confront these factors, reducing their negative impact and where possible turning them into affirmative arguments for progressive taxation. i consider these issues in turn. 1. politics: the rise of neoliberalism and the reappearance of distributional concerns.—a major spur to the flat tax movement is the rise of political conservatism in the 1980s and 1990s, in the united states and to a lesser degree its major trading partners. the conservative trend is important, because it provides an ideological context for an otherwise parochial issue, tying the flat tax to an overall program of smaller government and reward for individual effort. in this view, the end of the progressive income tax is important both directly, because progressive taxation is an important redistributive program, and indirectly, because the progressive income tax has traditionally provided funding for liberal spending programs. although the conservative movement is hardly spent, there are signs that it may finally be on the wane. the electoral successes of bill clinton in the united states, tony blair in the united kingdom, and gerhard schroeder in germany do not mark a return to traditional liberalism, as all three candidates campaigned on centrist, nonideological platforms. but they do suggest a change in public mood, in which the fear of concentrated economic power has replaced or at least balanced the fear of “big government,” and voters look to government to restrain the excesses of the new global economy. this is particularly true of clinton, who has presented himself as a defender of government programs such as social security and medicare that protect vulnerable groups from the unrestrained operation of the free market. there are clear limitations to this analysis such as the fact that clinton also signed a harsh welfare reform law, and his health care reform package was soundly defeated, but the widespread celebration of private markets and demonization of differently, a wealthy society tends to collapse the differences between redistributive and marginal utility arguments. marginal utility becomes either less persuasive on its own terms or a restatement of the case for redistribution, which rises or falls independent of the utility analysis. 31. see supra text accompanying notes 14-28. 2000] blum and kalven at 50 747 government, a defining feature of 1980s politics, appears to be a thing of the past. this pattern of moderation was also reflected in the 2000 presidential election, in which the republican candidate (george w. bush) emphasized “compassion” over traditional conservative themes and both he and the democratic candidate (al gore) pledged support for middle and working class issues. were the changes above merely short-term political cycles, they would have little relevance for our analysis. but they may be more than that. e.j. dionne, jr. in his book, they only look dead: how progressives will dominate the next political era, argues that the current era, with its rapid economic change and wide diffusion of new technology, is in many ways similar to the progressive era at the beginning of the twentieth century, the era that produced the federal income tax and other progressive-inspired reforms. 32 according to dionne, the economic dislocation resulting from globalization together with a general crisis of faith in political institutions have made conditions ripe for a revival of progressivism, historically characterized by the "effective use of democratic government to temper market outcomes, and to accomplish things that the market could not have achieved on its own."33 dionne, a liberal, is not alone in his analysis. kevin phillips, a leading conservative, has written of the dangers of "arrogant capital" and has argued that distributional issues will likely return to the fore in the near future.34 whether there will be a progressive revival, and what it might mean for tax policy if there is one, remains to be seen. even dionne himself is short on specifics, although he generally supports progressivity and calls for reductions in subsidies to corporations and wealthy taxpayers. however, it seems35 inevitable that a more liberal political culture, one specifically attuned to 32. e.j. dionne, jr., they only look dead: why progressives will dominate the next political era 34-37 (1996) (noting parallels between today's economic and political issues and those arising between 1870 and 1900). 33. see id. at 265, 274. 34. kevin phillips, arrogant capital: washington, wall street, and the frustration of american politics (1994). for further "neoliberal" analyses of contemporary american politics, expressing a wide range of disagreement on basic issues, see, e.g., jeff faux, the party's not over: a new vision for the democrats (1996) (advocating economic nationalism and an avowedly class-conscious approach as a strategy for rebuilding the democratic party after the reagan era); mickey kaus, the end of equality (1992) (expressing skepticism about redistributive policies but calling for a "civic egalitarianism" in which class segregation is reduced and life becomes more democratic). not surprisingly, faux is more or less enthusiastic about progressive taxation, while kaus remains more or less skeptical. see faux, supra, at 197-98 (advocating a combined progressive tax on income, gift, estate, and payroll receipts); cf. kaus, supra, at 170 (characterizing progressive taxes are “pretty weak social egalitarian medicine,” and arguing that “drafting donald trump's son (and daughter) into the armed services would make the social-egalitarian point a lot more forcefully than raising his taxes.”) 35. see dionne, supra note 32, at 304 (opposing flat tax as a form of redistribution to the wealthy from the middle class and calling for a reduction of "corporate welfare" in the form of business tax subsidies). 748 florida tax review [vol. 4:11 distributional and fairness issues, will be more hospitable to progressive taxation than the conservative era which proceeded it. this is particularly true if progressivity advocates can make the case that the pretax income distribution is unfair and becoming more unfair, and if they can also link progressive taxation to a broader agenda of spending and regulatory policies, in the same way that the flat tax forms part of a broader conservative agenda. while not providing an independent argument for progressivity, recent political developments suggest there may be a sympathetic audience for these arguments if they can be adequately made. 2. economics: "winner-take-all" theory and the limitations of private markets.—if fairness is the strongest argument in favor of progressive taxation, the strongest argument against progressivity is that it interferes with the operation of the free market. according to this argument, high taxes36 reduce the incentive for productive labor and make the economic "pie" smaller for everyone, before the issue of distribution is even reached. the incentive argument can be made against any tax system, but is particularly useful against progressive taxation, which (or so the argument goes) punishes the most productive members of society and discourages them from adding to their marginal work product. this argument is crucial to the flat tax movement on both a practical level, because it suggests that the losses from progressivity outweigh its potential gains, and on moral grounds, because it suggests that progressivity punishes the more worthy members of society and rewards less deserving members. of course, the incentive argument relies on the assumption that the pretax marketplace operates more or less efficiently; this assumption has sparked a feisty debate among experts. welfare economists have long suggested that, under certain circumstances, redistribution to lower-income individuals may actually increase efficiency, since these individuals derive more utility from the additional dollars than is lost by the wealthy individuals who lose them.37 economists have further questioned whether high tax rates actually discourage productivity among the wealthiest individuals, who tend to be highly motivated and may have strong nonmonetary reasons for performing at a top level. these arguments are appealing, but difficult to quantify, and, like the flat tax arguments they oppose, rely upon assumptions about human behavior that may be impossible to verify in the real world. during the past decade, some fascinating new evidence has emerged on the behavior of labor markets, especially at the high end. in their book, the winner-take-all society, robert h. frank and philip j. cook argue that the 36. see blum & kalven, supra note 2, at 437-44. 37. the welfare economics theory forms the basis of the diminishing marginal utility argument that is discussed in part iii of this article. for (relatively) recent overview of welfare economics, see amartya sen, on ethics and economics (1987); cf. john rawls, a theory of justice (1972) (approaching distributional issues from the perspective of political theory). 2000] blum and kalven at 50 749 american economy is increasingly characterized by markets, such as those for sports, entertainment, and academia, which judge participants on the basis of relative rather than absolute performance. these markets tend to concentrate rewards in the hands of a very small number of individuals, whose ability and effort may be only marginally greater than other participants in the same market. according to frank and cook, such winner-take-all markets are not38 merely inequitable, because they concentrate rewards among a small number of people, but also inefficient, because similar to a national labor lottery they encourage participation by individuals whose likely returns would actually be higher in other fields. the authors support a progressive consumption tax as39 a means of reducing this inequality and discouraging individuals from entering the already overcrowded winner-take-all markets. two leading tax scholars,40 martin j. mcmahon and alice g. abreu, have expanded upon frank and cook's thesis, arguing that the phenomenon of winner-take-all markets supports progressive taxation on both fairness and efficiency grounds, with high taxes being especially justified on the top 1% of incomes. mcmahon and abreu41 further argue that progressive taxation will not reduce the productivity of highincome individuals because these individuals are motivated by competitive rather than financial success and might actually work harder to compensate for their lost income.42 it is possible to exaggerate the significance of frank and cook's argument, which appears to describe only some sectors of the economy, and at best supports progressive tax rates on a relatively small portion of the population. yet the winner-take-all theory is significant for two reasons. first, the theory suggests that the markets may be seriously flawed in rewarding ability and effort, especially at the high end where the progressivity debate is most visceral. indeed, frank and cook suggests that technological and communication advances, by increasing the size and scope of winner-take-all markets, are actually enhancing these flaws. if this is true, the incentive43 argument may be weaker than is commonly supposed, and the case for progressivity may be strengthened on both fairness and efficiency grounds. second, the winner-take-all concept also undermines, albeit more subtly, the moral argument against progressivity. by questioning the link between income and ability and by suggesting that trivial differences in 38. robert h. frank & philip j. cook, the winner-take-all society. 2-3, 23-25 (1995). 39. see id. at 101-23. 40. see id. at 212-14. 41. martin j. mcmahon, jr. & alice g. abreu, winner-take-all markets: easing the case for progressive taxation, 4 fla. tax. rev. 1 (1999). 42. see id. at 63-65 (contending that top performers in winner-take-all markets are motivated primarily by nonpecuniary factors and would be unlikely to reduce their efforts in response to higher taxation). 43. see frank & cook, supra note 38, at 45, 47-52 (concluding that the computing and telecommunications revolutions are important reasons for the growth of winner-take-all markets). 750 florida tax review [vol. 4:11 performance account for huge variations in income, frank and cook effectively challenge the entire moral basis of pretax income allocations. if pre-tax income is as much attributable to luck, timing, and other factors as to truly significant differences in talent or effort, then this in turn reduces the deference that might otherwise be accorded to pretax outcomes, and reduces the argumentative burden that proponents of redistribution must bear. 3. morality: meritocracy and its measure.—meritocracy also plays an important role in the progressive/flat tax debate because the concept of merit provides the moral or ethical link in an otherwise rather dry economic debate.44 if american society is not fundamentally meritocractic in nature and if it fails to reward people based on their actual ability and effort then there is necessarily a powerful argument for redistribution to correct this unfairness. by contrast,45 if there is a functioning meritocracy, then there remains only weaker arguments that the economy rewards ability and effort, but that ability and perhaps effort were unfairly distributed in the first place, or that need rather than accomplishment should be the basis for the allocation of economic rewards. 46 the second of these arguments looks a little bit like arguing with capitalism, and the first of these looks a little bit like arguing with god. although47 coherent arguments can be made for both these positions, in this country they 44. the terms "merit" and "meritocracy" have a specific historical meaning, involving the substitution of purportedly scientific, achievement-based criteria (including but not limited to standardized testing) for more traditional criteria such as birth, friendship, and so forth in education and other spheres. merit also has a more colloquial meaning, roughly equivalent to "good" or "deserving," that is related to but distinct from its more specific historical meaning. thus, one might argue that the descendants of john harvard merited (i.e., deserved) admission to harvard under the second definition, even if they had relatively average credentials, but this argument would be incoherent under the first definition, which speaks specifically to the substitution of neutral criteria for family or other advantages. i try to use the term according its narrow historical meaning, although like others i slip at times into a broader, less rigorous usage. on the concept of meritocracy, see michael young, the rise of the meritocracy 1870-2033 (1958) (satirically depicting the ambitious beginnings and less-than-satisfying future of meritocracy in british society). for a recent application, suggesting how murky the merit concept can be in actual practice, see nathan glazer & abigail thernstrom, the end of meritocracy: should the sat account for race, the new republic, sept. 27, 1999, at 26-29 (debate between liberal and conservative academics on the propriety of the scholastic aptitude test (sat) adopting a "strivers" score that adjusts performances based on students' race and socioeconomic background). 45. see blum & kalven, supra note 2, at 496-97 (discussing the argument for redistribution based on the unfairness of pretax income allocations). 46. see id. at 498 (discussing argument for redistribution on the basis that talent and ability are unfairly distributed among the population and "everyone's income is [accordingly] equally undeserved"); cf. karl marx, critique of the gotha program: marginal notes on the programme of the german workers’ party (1875) (advocating philosophy of "[f]rom each according to his abilities, to each according to his needs"), in marx’s later political writings 208, 215 (terrell carver trans. & ed., 1996). 47. cf. genesis 18: 22-32 (recounting patriarch abraham’s challenge to god regarding the future of sodom and gomorrah). 2000] blum and kalven at 50 751 tend to be unsuccessful. thus, the case for redistribution remains immeasurably stronger if the link between reward and merit can somehow be broken. this is true in a political as well as moral sense: that society is becoming more meritocractic is a persistent theme in conservative ideology, and has been adopted by some liberals as a reason for downplaying redistributive programs.48 so is this country a meritocracy, or not? it is not possible to answer that question in one brief article, but two points are worth making on this issue. first, it is interesting to observe how tenuous the supposed underpinnings of meritocracy become on close observation, even for those who are relatively conservative in orientation. the most frequently cited method of determining merit, standardized testing, is subject to numerous criticisms on grounds of arbitrariness, incompleteness, and discrimination against racial minorities. in fact, even its advocates admit it is a very incomplete measure of ability, and no measure at all of effort or moral worth. moreover, the belief49 that a free market inherently rewards talent and initiative probably works to some degree within occupations, but is extremely difficult to apply on a society-wide level. it is less an argument than a profession of faith, a collection of simplistic economic principles covered by a thin moral garb. other rationalizations, like the supposed virtue of high achievers or (its flip side) the alleged immorality of the lower classes, are either derivative of the first two or even less subject to empirical verification. these and other explanations are severely undermined by the persistence of race, gender, and immigrant status as factors in the determination of economic status. even the authors of "the bell curve" did not claim that minorities were less virtuous than other americans, but rather that their lower performance was embedded in social and economic patterns that were extremely difficult to change.50 48. cf. kaus, supra note 34, at 18, 23-24 (posing money liberalism (emphasizing economic redistribution) and civic liberalism (emphasizing the breakdown of social distinctions) as two alternate strategies for contemporary liberals). 49. on the efficacy of standardized testing, and its relationship to broader themes in american society, see, e.g., richard j. herrnstein & charles murray, the bell curve: intelligence and class structure in american life (1994) (discussing the importance of standardized testing and other measures of "intelligence" in determining class structure and assessing the consequences of minority groups' lower average performance on such tests); william g. bowen & derek bok, the shape of the river: long-term consequences of considering race in college and university admissions (1998) (assessing discriminatory impact of standardized testing as part of a broader argument in favor of affirmative action in university admissions); nicholas lemann, the big test: the secret history of the american meritocracy (1999) (taking a generally skeptical view of standardized testing in general and the educational testing service (ets) in particular). 50. see herrnstein & murray, supra note 49, at 369-86 (discussing the relationship between social behavior and perceived cognitive ability). on the role of inherited educational and social advantages, and the difficulty of reaching these items under the existing income and estate taxes, see john h. langbein, the twentieth century revolution in family wealth transmission, 86 mich. l. rev. 722 (1987) (suggesting that the estate tax was designed to reach transfers of money and tangible property and that it does not successfully reach intergenerational transfers of educational and social advantage which are today the most important forms of inherited 752 florida tax review [vol. 4:11 second, if a meritocracy once existed in american society, or if it still exists within particular sectors, numerous forces are undermining it on a more macroscopic level. it may be possible to argue that small town america, the world of horatio alger and his like, was predominantly meritocractic, at least for those (primarily, although not exclusively, white males) who had full access to the system and its advantages. perhaps this remains true within a few, highly competitive industries, but it is harder to make that argument for the economy as a whole. to say that a secretary who receives thousands of dollars in a stock bonus from a silicon valley employer has a high degree of merit, or that a steelworker who loses his job to a third world competitor lacks it, seems to me to stretch merit beyond any but the most tautological meaning. concepts like "globalization" or the "winner-take-all" society may help us to rationalize such outcomes, but it is simply common sense to recognize that success or failure in today's economy is a matter of luck, timing, and other factors as well as (no doubt) a significant portion of ability, determination, and effort. to recognize this is not to oppose economic progress, but merely to recognize that it comes at some price in the correlation of individual efforts and rewards. perhaps the issue is not the reality of a functioning meritocracy, but the perception of it, and here there is indeed a significant change in the past decades. whatever the facts, today's economic elite plainly believe that they have succeeded because they are smarter and work harder than their fellow citizens, and appear to have little of the noblesse oblige that characterized other, more traditional aristocracies. here, perhaps, is the true relevance of51 standardized testing and similar indicators: not as perfect or even near-perfect measures of ability, but as somewhat arbitrary measures that still retain enough content to convince successful candidates of their superior entitlement to positions and rewards. here perhaps is the real meaning of suburbanization52 and racial segregation: not creating an elite that is actually better than everyone else, but permitting it to think that it is, or at least (what is effectively the same) wealth). for a recent exchange on the estate tax and its role in the overall tax system, see edward j. mccaffery, the uneasy case for wealth transfer taxation, 104 yale l.j. 283 (1994) (citing rawls and other liberal thinkers in support of a proposal to repeal the income and estate taxes and replace them with a progressive consumption levy); anne l. alstott, the uneasy liberal case against income and wealth transfer taxation: a response to professor mccaffery, 51 tax l. rev. 363 (1995) (arguing that mccaffery overstates the estate tax's role in discouraging savings and understates the political and social impact of unequal concentrations of wealth); see also bruce ackerman & anne alstott, the stakeholder society (1999) (proposing that all americans be granted an $80,000 "stake" in early adulthood to be financed by an annual 9% wealth tax and an additional payback at death for those able to do so). 51. see kaus, supra note 34, at 47-48 ("the more the economy’s implicit judgments are seen as being fair and based on true ‘merit’ (and ‘equal opportunity’) . . . the easier it will be to equate economic success with individual worth, and the greater the threat to social equality."). 52. see frank & cook, supra note 38, at 40 ("in this context, who can blame people for treating the tests as if they measure, not what cynics say they measure (how well you do on tests), or what they’re supposed to measure (how well you’ll perform in college), but something more, something closer to innate personal worth—merit!"). 2000] blum and kalven at 50 753 to avoid thinking too much about its obligations to other, less fortunate segments of the same society. such "us and them" perceptions have already fueled resistance to affirmative action, welfare spending, and other redistributive measures. will they also spell the end of progressive taxation? i think this argument overstates both the self-righteousness of americans and their demand for moral absolutes. most americans are, i suspect, less impressed by high test scores than are most law professors. most seem quite capable of recognizing that economic success results from a combination of merit and other arbitrary factors. there is indeed a selfrighteous arrogance in american culture, but there is also a strain of humility, together with strong egalitarian tendencies and a religious-inspired resistance to the values of the commercial marketplace. the distance between rich and53 poor, both physical and psychological, has also been exaggerated by some commentators. most middle class families were poor within the past two or three generations, and many of them experience economic and personal worries not wholly different from those of their more modest fellow citizens. indeed, the vulnerability of the middle and working classes to economic changes has been a major theme of the past decade and the recent presidential election.. perhaps the best word to describe americans' attitude toward the new economy is ambivalence: the willing and even exuberant acceptance of global capitalism as the most productive (not to mention the only available) economic system, combined with a fear of its potential effects, particularly on more vulnerable members of society and on those noneconomic values (such as family and religion) that are important to substantial parts of the population. progressive taxation is an expression of this ambivalence. it is an implicit recognition that higher incomes are a mixture of skill, luck, and social advantage, and requires that a portion of them be shared with the collective without confiscating them entirely or destroying the incentive to earn them in the first place. it demonstrates that the market, while it plays the primary role in our economic life, is not the be-all and end-all of our society. indeed, the symbolic significance of progressive taxation, as a refutation of the potential arrogance of a (supposedly) meritocractic elite, may be no less important than its economic significance. it is the signature of a modest meritocracy, one that54 53. the conflict between these values is reflected in the famous new yorker cartoon showing a rather glum middle-aged man over the caption: "my protestant ethic netted me a bundle, but my puritan guilt complex won't let me enjoy it." 54. in making this argument, i am indebted to marjorie kornhauser, who has argued that progressivity advances communitarian values but does so in a limited way that ought to be acceptable even to those with a more individualist bent. see kornhauser, supra note 9, at 522 ("it is in [‘neoconservatives'] self-interest to support progressivity for it in turn will support the sense of community which is not only essential under a feminist vision but is also necessary as a precondition to the survival of the form of government the neo needs.") my differences with kornhauser are by and large matters of emphasis rather than philosophy. my vision is (not surprisingly) less tied to feminism than hers, and i emphasize the role of progressivity in responding to developments (notably economic globalization and domestic political changes) that 754 florida tax review [vol. 4:11 tries to reward ability and initiative but recognizes that it does not always do so, and reflects that recognition as a matter of substantive law. in a period when even a conservative can complain of "arrogant capital," such modesty is more important than ever.55 the concept of modesty might equally be applied to progressivity scholars. for it seems to me that scholars do better when they make the case for redistribution in simple, common sense terms than when they resort to evermore sophisticated theoretical models, or divert attention to nonredistributive arguments which, while intellectually appealing, are unlikely to be as persuasive. that does not mean that economics is irrelevant, or that we should ignore alternate concepts like diminishing marginal utility, the benefit theory, and so on. but in the end, as blum and kalven concluded, the argument for56 progressivity rests primarily on the intuitive appeal of redistribution, or in henry simons' memorable phrase, "on the ethical or aesthetic judgment that the prevailing distribution of wealth and income reveals a degree (and/or kind) of inequality which is distinctly evil or unlovely." the events of the past57 generation, when considered rather than rationalized, if anything make this judgment still stronger. the argument can be made directly, and won. 4. studying progressivity: encompassing race, gender, and other nontraditional concerns.—the discussion above emphasizes the rhetoric of progressivity: how should advocates of progressive taxation make their case and respond to flat tax supporters? but scholars do more than make arguments. they (or at least the serious ones) do original research, which sometimes supports existing positions, but is also valuable for its own sake. sometimes their research leads them to abandon previously held positions and embrace new and even opposite ideas. what should the research agenda of progressivity scholars be, and how does it relate to the arguments noted above? three observations suggest themselves, two of them uncontroversial and the third perhaps somewhat less so. the first uncontroversial point concerns the need for more empirical work in order to update our understanding of progressive taxation and tax policy in general. we simply need more information on the nature and degree of economic inequality, public opinion regarding progressive and flat taxes, the effect of global economic changes, and similar issues in order to make the best possible arguments for and against a progressive regime. additional comparative studies, borrowing from the experience of other countries, and further historical research – learning from our own past mistakes – would be of particular value. such research is especially important with regard to the meritocracy (progressive taxation interferes with merit-based reward allocation) and globalization (progressive took place after she wrote. 55. cf. phillips, supra note 34, at 3-26 (identifying the increasing arrogance of political and economic elites as a dominant theme in recent american history). 56. see supra text accompanying note 4. 57. see simons, supra note 29, at 18-19 (1938). 2000] blum and kalven at 50 755 taxation cannot withstand the pressure of international competition) arguments against a progressive regime, for each of these arguments depends heavily on real-world changes in the past decades. to use a litigation analogy, progressivity scholars must be prepared to argue the facts as well as the law, and further empirical work would make their job that much easier.58 a second recommendation concerns the relationship between tax and nontax subjects. as noted above, much of the debate on progressive taxation is really a debate about governing philosophy and, more specifically, the role of government in combating social and economic inequality. it follows that59 scholars should be somewhat less concerned with the progressivity of the tax system per se, and somewhat more concerned with the progressive or redistributive nature of government as a whole, including taxing, spending, and regulatory programs. this is true both for broad numerical measures of60 progressivity and with respect to specific policy issues. for example, in studying the tax system's impact on poor people, scholars should take into account taxes, quasi-tax provisions (e.g., the earned income credit), and nontax provisions like the welfare or minimum wage laws in order to evaluate the government's overall effect on income distribution and the work/welfare tradeoff. taxation and health policy might similarly be studied together, not61 only for the technical interactions between the two subjects, but to compare the arguments for redistribution in both areas and to assess what each field can learn from the successes (or failures) of the other. these sorts of combinations62 are standard fare for social scientists, but are often avoided by legal scholars, reflecting the sometimes arbitrary divisions within the law school curriculum. a more interdisciplinary approach is likely to be both more interesting and more effective. the suggestions above are modest in nature, and i suspect that most tax scholars would support them. a third recommendation is likely to be more controversial, for it involves the very definition of progressivity, and its relationship to race, gender, and other noneconomic concepts. before proceeding to this item, a bit of background is in order. the concept of progressivity has always depended upon the tax base, i.e., the definition of taxable income, as well as tax rates. thus, marginal tax rates of 50% or higher, which prevailed for much of the century, resulted in 58. see michael livingston, confessions of an economist-killer: a reply to kronman's “lost lawyer,” 89 nw. u. l. rev. 1592, 1602-07 (1995) (emphasizing lawyers' skills as fact-gatherers and problem-solvers and their relevance to legal scholarship). 59. see supra text accompanying notes 14-15. 60. scholars have made several sophisticated attempts to measure the combined progressivity of taxing and spending, although they have at times been frustrated by methodological issues. see supra note 12. 61. see, e.g., anne l. alstott, the earned income credit and the limitations of taxbased welfare reform, 108 harv. l. rev. 533 (1994). 62. see, e.g., katharine pratt, funding health care with an employer mandate: efficiency and equity concerns, 39 st. louis u. l.j. 155 (1994). 756 florida tax review [vol. 4:11 less progressivity than they appeared to because of the numerous opportunities for tax shelters and tax avoidance. by contrast, the 1986 tax reform act, which63 collapsed tax rates and thus reduced the nominal progressivity of the system, is sometimes described as increasing (or in any event, not reducing) progressivity, because it reduced tax shelter opportunities and thus made it more difficult for the wealthy to escape paying tax. nomenclatures vary, some64 writers use the term progressivity to refer exclusively to tax rates and preferring "vertical equity" to describe this broader picture, but tax rates obviously mean little without including substantive tax provisions in the analysis. in recent years there has emerged a "critical tax scholarship" which emphasizes the effect of tax policy on women, minorities, and other disadvantaged groups. for example, feminists have studied the role of various tax provisions, including joint returns and the nondeductibility of child care expenses, in discouraging women from entering the marketplace and achieving economic equality. minority scholars have similarly evaluated the impact of65 purportedly neutral tax rules on african-americans and other minority groups.66 for example, the favorable tax treatment afforded to investment as opposed to salary income, although ostensibly a race-neutral distinction, arguably discriminates against african-americans, who tend to have fewer investments than whites with similar incomes.67 although the critical tax project crosses traditional lines, it is typically perceived as raising issues of horizontal equity, that is, arguments that women 63. henry simons likened the combination of high tax rates and a leaky tax base to "digging deeply . . . with a sieve." see simons, supra note 29, at 219. 64. prior to 1986, there were eleven different rates on individual income, ranging from 11% to 50%. after 1986, there were three rates, which have since expanded to five (15, 28, 31, 16, and 39.6%); but enactment of the passive loss rules and other tax shelter limitations arguably make the tax system more progressive than it was before 1986. see generally edward yorio, equity, efficiency, and the tax reform act of 1986, 55 fordham l. rev. 395 (1987) (evaluating the fairness and efficiency impact of the tax reform act of 1986); joseph a. pechman, the future of the income tax, 80 am. econ. rev. 1 (1990) (approving of the 1986 act but calling for further base-broadening measures, including taxation of fringe benefits and reduction of mortgage interest and other personal deductions, in order to restore progressivity to its mid-1970s levels). 65. see, e.g., grace blumberg, sexism in the code: a comparative study of the income taxation of working wives and mothers, 21 buff. l. rev. 49 (1972) (assessing the role of various tax provisions in discouraging women from seeking employment outside the home); nancy c. staudt, taxing housework, 84 geo. l.j. 1571 (1996) (proposing taxation of unpaid housework with a credit to ameliorate potential regressive impact). for a comprehensive treatment of gender issues in taxation, emphasizing the need to consider women at different income levels, see edward j. mccaffery, taxing women (1997). although there is no deduction for child care expenditures, a limited tax credit, not exceeding $1,440 per family, is provided for such expenses i.r.c. § 21. 66. see, e.g., beverly i. moran & william whitford, a black critique of the internal revenue code, 1996 wis. l. rev. 751. 67. see id. at 759-72 (assessing tax benefits for wealth and wealth formation and their impact on black and white taxpayers). 2000] blum and kalven at 50 757 or minorities are treated differently by the tax system than similarly situated white males. indeed, traditional scholars have at times been rather dismissive of critical scholarship on these grounds. thus, it has been suggested that deductibility of child care expenses would discriminate against married couples who have only one, presumptively male, breadwinner–essentially, a horizontal equity argument–and that investment tax incentives are justified for fairness and efficiency reasons quite apart from their alleged racial impact. only rarely68 have these debates been linked to progressive taxation, and indeed, some critical scholars themselves have expressed skepticism about the whole progressivity concept.69 my own belief is that critical tax scholarship is more about vertical than horizontal equity, so that attacks by traditional scholars miss the point to a considerable degree. the argument is not that women or minorities are treated differently from similarly situated white men, but that they are not similarly situated in the first place because of the historic real-world disadvantages that adhere to these groups. that is why provisions that adversely effect women70 or minorities are more suspect than provisions that discriminate between corporations in michigan and texas, why the statements that "joint returns discourage women from working" or "the pension rules discriminate against african-americans" are both different and more powerful than the statements that "joint returns harm some middle-income couples" or "the pension rules discriminate against people with adequate incomes but low retirement savings." that is not to say that progressivity and feminism (or critical race71 theory) are the same thing: by no means are all women and minorities poor, and it is certainly possible to support progressive taxation without any special solicitude for particular groups. yet the two issues are related on both a practical level, because a disproportionate number of women and minorities are in the lower income brackets, and a theoretical level, because of the perceived unfairness in allocations of income and power, especially when they correlate with race, gender, and other irrelevant factors. to put the matter in historical terms, critical tax scholarship may be seen as an expanded form of vertical equity analysis, to encompass a society in which race and gender as well as mathematically defined income categories are an important aspect of the economic and social structure. it emphasizes the tax base side of the equity 68. for a summary of the mainstream critique of critical tax theory, with just a bit of bile thrown in, see lawrence zelenak, taking critical tax theory seriously, 76 n.c. l. rev. 1521 (1998). 69. see supra text accompanying note 19. 70. see michael a. livingston, radical scholars, conservative field: putting "critical tax scholarship" in perspective, 76 n.c. l. rev. 1791, 1797 (1988) (opining that the starting point for critical scholarship is the dissimilarity of status between racial and gender groups). 71. cf. blumberg, supra note 65 (assessing the role of joint returns, the "marriage penalty," and other tax provisions in discouraging women from working outside the home); moran & whitford, supra note 66, at 783-91 (assessing the impact of pension tax provisions on black and white taxpayers). 758 florida tax review [vol. 4:11 question, reminding us that graduated tax rates alone may not be sufficient to achieve a progressive tax system. in many respects, it is the blum and kalven of the twenty-first century. given this background, both parties would benefit if the work of critical tax scholars were integrated with the mainstream debate on progressive taxation, rather than being treated as a separate, essentially peripheral concern. i don't mean that women and minorities should pay lower taxes than72 white males (although suggestions of this kind have been made by very serious people). i do mean that race and gender-based data should be taken into73 account, along with purely economic statistics, both in measuring the overall progressivity of the tax system and in assessing specific legislative proposals. thus, in evaluating, for example, a consumption or flat tax system, scholars would consider its effect on women and minorities as well as on taxpayers in different economically defined income brackets. a tax system would be considered progressive only if it were fair to lower-income individuals, regardless of race or gender, but also if it dealt fairly with disadvantaged groups. particular attention would be paid to provisions (such as joint returns and the capital gain rules) that have disproportionate effects on disadvantaged groups. for their part, critical scholars would recognize the significance of progressivity as a society-wide concept, rather than focusing their attention entirely on group-specific concerns. expanding the progressivity concept would improve both the moral and political case for progressive taxation. the moral case would improve because the argument for redistribution is strongest when inequality results from immutable characteristics, like race, gender, and immigrant status, rather than individual failing. by showing concern for group as well as individual fairness, scholars would demonstrate that progressive taxation is neither anachronistic not wholly symbolic in nature, but incorporates an active concern for injustice in all of its forms. the political case would improve because the74 constituencies favoring some form of redistribution would develop a common agenda rather than working at cross-purposes. progressive taxation may have a special appeal for those who wish to correct race and gender-based disadvantages but are skeptical of affirmative action programs, which benefit the wealthy along with the poor and frequently stigmatize their own intended beneficiaries. it is the ultimate income-based program, providing assistance to 72. a somewhat less developed version of this argument is presented in livingston, supra note 70, at 1812-16. 73. see mccaffery, supra note 65, at 277 (calling for changes designed to "tax married men more, and married women less" although noting that this effect could be achieved by at least facially gender-neutral means). 74. cf. brown & fellows, supra note 19, at 9-10 (arguing that progressivity has limited value as a concept because of its failure adequately to consider poorer taxpayers and other reasons). an expanded definition of progressivity would, i believe, be capable of addressing these concerns. 2000] blum and kalven at 50 759 women, minorities, and white males alike when they are genuinely disadvantaged, but ignoring these factors when not relevant to a person's particular situation.75 it may be objected that a focus on race and gender undermines the consensus for progressive taxation, which is popular precisely because it cuts across political lines. but that consensus is fraying. race and gender are part of the progressivity debate whether or not we want them to be. addressing them directly and forcefully is probably a better strategy than pretending they do not exist. it may further be objected that i have stretched "progressivity" too far: that a solicitude for women or minorities, however admirable on its own terms, is simply different from progressive taxation and must remain conceptually separate in order to avoid doctrinal confusion. this argument ignores the large volume of work on progressivity/vertical equity as a matter of both tax base and tax rates, together with the work of nontax legal scholars, who have demonstrated that inequality may take social or psychological as well as purely economic forms. to some extent, it ignores the work of blum and kalven76 themselves, who, like henry simons before them, recognized that tax policy existed in a broad social context and saw progressivity as part of a wider effort to create a just and stable society. expanding the definition of progressivity,77 to encompass more contemporary forms of inequality, is merely updating the work of these scholars. like traditional measures, this new information does not guarantee political success or even specify what level of progressivity is desired. but it does increase our understanding, resulting in a better debate and the prospect of a more enlightened tax policy. b. implementing progressivity: toward an international strategy whatever the arguments for progressive taxation, the globalization of economic life makes it more difficult to achieve. with borders increasingly porous, a country that maintains high tax rates may see investment flee to other, low-tax jurisdictions, reducing tax revenues and impoverishing the country. 75. see richard j. fallon, jr., affirmative action based on economic disadvantage, 43 ucla l. rev. 1913 (1996) (arguing for a limited form of affirmative action on the basis of economic disadvantage rather than race). 76. on the importance of social or psychological as well as purely economic inequality, see generally feminist jurisprudence (patricia smith ed., 1993) (describing feminism as a struggle against subordination of women on social and economic grounds); the politics of law (david kairys ed., 3 ed. 1998), (collection of articles assessing inequality and other political biases inrd various areas of law). 77. the need to defend redistribution without embracing soviet-style collectivism forced blum and kalven to be quite careful at times in their selection of words. see blum & kalven, supra note 2, at 488-90 (stating that an examination of socialism "would . . . go far beyond the tolerable bounds of an essay of this sort" but assuring readers that mitigating inequality "has not been a socialist monopoly"). 760 florida tax review [vol. 4:11 this is already true of taxes on businesses and investment, which are relatively easy to shift to other countries. in a borderless world, it will be increasingly78 true of individual taxes as well, particularly for highly skilled (and hence highly paid) individuals who are most likely to take their talents from one jurisdiction to another. nations will thus find their freedom to impose steeply progressive79 tax rates restricted, much like states within a traditional federal system. globalization also provides arguments in favor of progressive taxation, since it results in increased inequality (at least in the short run) and thereby enhances the case for redistribution; but these arguments have the force of moral suasion only, while the raw economic logic appears to push in a different direction.80 is globalization the death knell of progressivity? it depends on whom you ask. conservative economists, together with much of the business community, appear to think so, citing practical experience and the supposedly inevitable logic of global markets. they point to the reduction in marginal tax rates in the united states, the united kingdom, and other countries during the past two decades, while taxes on lower and middle income groups, especially when payroll and other social insurance taxes are included, have held steady and in some cases have actually increased. they note further that the factors81 encouraging compression of tax rates, including improvements in communications and the use of transfer pricing and similar tax-shifting mechanisms, have accelerated in recent years. liberal observers are less82 certain. they note that a variety of factors affect the flow of investment, including financial services, infrastructure, technological sophistication, and the availability of a trained and motivated workforce. any of these factors may be more important than marginal tax rates, so that a "tax and spend" jurisdiction may actually wind up more competitive than a low-tax, low-services area.83 these observers tend to see globalization as an excuse rather than a reason for regressive tax and spending policies. both liberals and conservatives point to the experience of american states, which have conducted the expected "race to the bottom" in some cases, but several of whom have maintained relatively high 78. see supra note 23. 79. see tanzi, supra note 23, at 32-41 (assessing the link between labor mobility and personal income tax rates). 80. see supra text accompanying note 22 (opining that globalization may cause economic harm to individuals through no fault of their own and thereby enhance the moral case for redistribution). 81. see steinmo, supra note 23 (stating that countries ranging from the united states to the united kingdom and sweden have cut tax rates on high income individuals during the past decades, typically replacing these revenues with increases in consumption taxes or social insurance fees). 82. see tanzi, supra note 23, at xii-xiii (citing transportation and communication advances, together with the lowering of tariff and other barriers, as factors increasing global economic integration); editorial, the taps run dry, the economist, may 31, 1997, at 21 (noting that transfer pricing and similar tax avoidance mechanisms make it difficult for governments accurately to determine the taxable income of multinationals). 83. see supra note 24. 2000] blum and kalven at 50 761 taxes and services while maintaining or even improving their competitive position.84 one obvious response to tax competition is for governments to cooperate in the fixing (somewhat euphemistically called "harmonization") of tax rates. a form of harmonization is now in effect in europe, where the european union (eu) sets minimum and maximum rates for the valued added tax (vat) and individual nations are permitted to vary their vat rates only within the approved range. the eu has been less successful in harmonizing85 personal and corporate income taxes, owing to significant differences in tax bases and to member states' reluctance to surrender tax policy as a fiscal and political tool. poorer nations in particular have argued that they need reduced tax rates to compete with wealthier countries (such as france and germany), and are likely to demand some form of compensation in return for cooperation in this area. american states have similarly cooperated on various tax issues but have never approached a uniform system of tax bases or tax rates, on a national or even a regional basis.86 84. for example, a number of smaller states, particularly in the south and west, have attracted business with a mix of low taxes, low wages, and a permissive regulatory atmosphere, but many larger states (e.g., new york and california) have enjoyed strong growth using a relatively high-tax, high-wage model, the disadvantages of which are, or so they argue, compensated for by the presence of a highly skilled and educated work force. see reich, supra note 24, at 37 (contrasting "low-wage" and "high-wage" approaches to economic development and suggesting only the latter can create long-term economic growth). for theoretical models of interstate competition within a federal system, see william w. bratton & joseph a. mccahery, the new economics of jurisdictional competition: devolutionary federalism in a second-best world, 86 geo. l.j. 201 (1997) (suggesting that previous models have overstated the advantages of interjurisdictional competition and that uniform federal programs may be superior to state policies in some cases). 85. see european union: economic and social committee: opinion on direct and indirect taxation ¶ 1.1.2 (july 3, 1996), reprinted at 96 tax notes int'l 129-28 (1996). on the broader issue of tax harmonization within the european union, and its implications for north america, see tracy a. kaye, european tax harmonization and the implications for u.s. tax policy, 19 b.c. int'l & comp. l. rev. 109 (1996); stephen g. utz, taxation panel: tax harmonization and coordination in europe and america, 9 conn. j. int'l l. 767 (1994). a value added tax (vat) is an excise tax on the incremental value added to goods (and some services) at each stage of production. for example, if a wood processor bought $10,000 of lumber and sold it as finished wood for $50,000, tax would be imposed on $40,000, ($50,000 $10,000). if a furniture-maker turned the wood into cabinets selling for $500,000, tax would be imposed on $450,000 ($500,000 $50,000), and a tax would be imposed on any additional profit beyond the $500,000 cost to a retail cabinet seller. as a general rule, vats are easier to harmonize than income taxes because they tend to be essentially flat-rate and (at least in a european context) have relatively similar tax bases; they are also easier than income taxes to impose on imports and rebate on exports and thus tend to be popular wherever there is a high level of international commerce. the united states has traditionally resisted imposition of a national vat although state sales taxes have some similar features. 86. examples of voluntary cooperation between states include the multistate tax compact, an organization which advises states on various tax matters, and agreements between specific states (e.g., new jersey and pennsylvania) to collect and (where possible) enforce each other's taxes. a measure of enforced cooperation also results from the american federal system, 762 florida tax review [vol. 4:11 the european and american experiences suggest that harmonization efforts are likely to be most successful when they involve relatively low-rate taxes and are undertaken by jurisdictions that are at similar economic levels and have a long history of cooperation in other spheres. the issue accordingly becomes more complicated when we move from vats to progressive income taxes, and from europe to asia, latin america, and to other developing regions. these latter countries may be less concerned about progressivity than about using lower taxes and regulatory standards to attract new business and encourage economic development. on a practical level, they are likely to demand a range of tax and nontax concessions as the price for harmonizing tax rates or participating in more limited, anti-avoidance efforts. on a philosophical level, they may question the importance of progressivity itself, arguing that redistribution between citizens of wealthy countries is insignificant unless it is coupled with substantial transfers between rich and poor nations. yet the cooperation of such countries is important if progressive tax regimes are to be maintained rather than undermined in wealthy societies. for example, nafta opens the united states’ market to goods manufactured in canada, mexico and potentially to other latin american countries, creating fears that these countries may take business from the united states by a combination of low wages, low taxes, and less stringent environmental and other standards.87 tax cooperation with these countries may be considerably more difficult than within a more homogenous area like the european union. all this suggests that cooperation in maintaining progressive tax rates remains a distant goal, the principal challenges being political rather than academic in nature. yet scholars can play an important role in this process, by asking the right questions and laying the intellectual foundations for the right answers. to do this requires both a short and a long-term strategy. in the short-term, academics should emphasize support for progressive taxation within their own countries and begin a dialogue with like-minded scholars in other (including third world) nations, regarding their vision of progressivity and a strategy for maintaining it in a border-free world. these under which courts have interpreted the due process and commerce clause of the constitution to impose limits on state taxing authority. the presence of a strong federal government differentiates the american experience from the international realm, in which multinational organizations must rely more extensively on voluntary agreements. see generally, walter hellerstein, state and local taxation of electronic commerce: reflections on the emerging issues, 52 u. miami l. rev. 691, 721-23 (1998) (addressing federal constitutional issues in the taxation of internet commerce). 87. see generally colloquium on nafta and taxation, 49 tax l. rev. 525 (1994); arthur j. cockfield, tax integration under nafta: resolving the conflict between economic and sovereignty issues, 34 stan. j. int'l l. 39 (1998). the nafta countries have begun negotiations with other western hemisphere nations on the coordination of trade and tariff policies, but have not yet achieved european-style levels of tax harmonization; accordingly "regulatory emulation"—essentially response by mexico, canada, and other nations to u.s. initiatives—remains the predominant mode in this area. see id. at 45-46. 2000] blum and kalven at 50 763 steps, together with the research agenda described above, are necessary in order to build a base for further cooperation in the construction of a global, progressive tax system. as part of this interim effort, academics should support tax shelter and other anti-avoidance provisions that make it difficult to avoid progressive tax rates by shifting income to low-tax jurisdictions. indeed international tax provisions–like provisions that disproportionately affect women or minorities–should become a regular part of the progressivity debate, together with domestic tax rate and tax base issues. for example, the debates over tax haven corporations, transfer pricing, and similar arrangements are at least partially over the reach of progressive taxation, and worthy of more attention from progressivity scholars. in the long-term, it seems to me that progressivity can be maintained only by active, ongoing cooperation between the major industrial and, eventually, developing nations. here academics can play both a crucial practical and a theoretical role. on a practical level, academic contacts may provide an important first step toward coordination of tax policy between different political cultures. by exchanging ideas and information, scholars will not only improve their understanding of different tax systems, but also will constitute a powerful lobbying group in favor of cooperation, balancing the influence of local interests who will typically seek to undermine or evade progressive taxation. something like this has already happened with respect to taxation of specific transactions involving the internet and emerging financial products, and there is no reason it cannot happen with respect to fundamental tax structure and rates.88 scholars are also uniquely poised to investigate the theoretical questions posed by progressive taxation in the new global economy. a fully international tax system, involving systematic redistribution both between and within different countries, is at least a generation away. for now, the crucial89 issue is tradeoffs: what concessions can the wealthier countries be expected to make in order to secure the cooperation of poorer nations in the coordination of tax systems and the maintenance of progressive tax rates? will the united states and its allies be willing to compensate the countries of latin america, asia, and africa for refraining from overly aggressive tax competition, in much the way that the european union "buys" the cooperation of its poorer members with redistributive spending programs, or the u.s. federal government 88. see generally symposium on taxation and electronic commerce, 52 tax l. rev. 267 (1997). 89. redistribution between nations might take the form of actually sharing revenues, through foreign aid or similar programs, or (less dramatically) by adjusting specific tax provisions that are deemed oppressive by poorer countries. cf. supra text accompanying notes 85-86 (discussing existing efforts at domestic or regional tax harmonization). 764 florida tax review [vol. 4:11 redistributes income (however mildly) between richer and poorer regions?90 should such compensation take the form of direct foreign aid spending, or merely of a greater solicitude for poor country claims with respect to taxing jurisdiction, tax havens, and other technical issues? at what point does it91 become realistic to speak, however gingerly, about an international taxing authority and the supranational determination of tax rates? these are hard questions, involving a mixture of law, economics, and political theory; but for that reason uniquely suited to academic lawyers, who make their living addressing precisely such interdisciplinary conundra. but they are questions92 that have to be answered if the game is to be won. on both a moral and a practical level, progressivity will become increasingly difficult to sustain in individual countries without addressing its international aspect. either scholars and politicians will address the issue directly or it will be lost by default. the experience of environmental law and, to a lesser extent, labor law provides an interesting precedent here. like progressive taxation, environmental and labor law are the products of national reform movements designed to protect citizens from pollution and economic exploitation at the cost of governmental intervention and, perhaps, some loss of economic efficiency. as in the tax area, there is the fear that globalization will undercut domestic reform efforts, as countries with lax regulatory standards are able to undersell those with more stringent requirements. policy-makers have wrestled with the question of what concessions should be made to poorer nations as the 90. the european union (eu), while imposing unitary standards on its member nations in numerous areas, also compensates poorer countries by means of agricultural support payments and other community-wide subsidy programs. see generally the european union: policies & legislation: eu agricultural policy, http://www.eurunion.org/legislat/agweb.htm (mar. 14, 2000). 91. the u.s. has frequently placed domestic tax policy goals, such as prevention of tax avoidance and neutrality between domestic and foreign investments, ahead of the interests of developing countries in formulating its international tax policy, resulting in some resentment on the part of third world nations. see generally karen b. brown, transforming the unilateralist into the internationalist: new tax treaty policy toward developing countries, taxing american (brown & fellows eds.), supra note 19, at 214-32. 92. see anthony t. kronman, the lost lawyer: failing ideals of the legal profession 1-162 (1993) (describing prudence and "practical wisdom" as the key attributes of academic and practicing lawyers); livingston, supra note 58, at 1602-07 (advocating a tax scholarship that emphasizes lawyers' fact-finding and problem-solving abilities). from a philosophical perspective, the arguments for redistribution within individual societies are often equally strong between them: while it is possible to argue that our obligations to other human beings become less extensive the further they are removed from us, it is hard to argue that they are reduced to zero, or that there is a sudden dropoff from an extensive obligation to all citizens of the same country to one of no obligation, whatsoever, outside that country's borders. the argument becomes especially difficult when "globalization" is touted as the principal theme of contemporary history. in order to maintain this position, one must argue that the world is a single entity for wealth creation purposes but reverts magically to separate entities where distributional issues or other moral and political questions are concerned. see generally amartya sen, development as freedom (1999) (suggesting the global nature of economic development and related political issues). 2000] blum and kalven at 50 765 price for securing their cooperation in international labor and environmental initiatives. both environmental and labor law scholars have begun the93 transition from a domestic field with some international aspects to a global field with due attention to domestic concerns. tax scholars must do the same if94 progressivity is not to be overrun by the force of international commerce. capital has already developed a new global consciousness; progressive tax supporters likewise must learn to maintain one. v. progressive taxation and american “progressive” discourse in the pages above, i have offered a broad overview of progressive taxation, where i think it is headed in coming years, and how supporters of progressivity can best prepare to defend it. my conclusion is that the case for progressive taxation remains theoretically strong, but faces significant practical obstacles which place its future in serious and continuing doubt. specifically, i have argued that progressivity advocates must respond to a conservative political climate, a change in the nature and degree of economic inequality; and an increasingly global economy which, if left unchecked, creates a powerful momentum against progressive taxation. my recommendation is that proponents confront these issues directly, updating their arguments and research agenda to reflect such matters as the emerging winner-take-all society, the role of progressive taxation in an a merit-based system, and the continuing role of race, gender, and immigrant status in pretax income allocations. i have further suggested that progressivity scholars must shift from a domestic to an international focus which considers income distributions between countries as well as within them, and that they build links with foreign scholars who share their interest in at least modest income redistribution. the strategy i have outlined goes against the grain of much contemporary tax scholarship, since it crosses both geographic and disciplinary lines and invokes avowedly political 93. see supra text accompanying note 87 (regarding nafta and broader western hemisphere trade negotiations). 94. see andrew l. strauss, from gatzilla to the green giant: winning the environmental battle for the soul of the world trade organization, 19 u. pa. j. int'l econ. l. 769 (1998) (opposing "environmental isolationism" and calling for cooperation on environmental issues through the wto and other multinational organizations); francis lee ansley, rethinking law in globalization labor contexts, 1 u. pa. j. lab. & employment l. 369 (1988) (describing the globalization of labor markets and calling for national and supranational efforts to combat the reduction in labor and safety standards resulting from the globalization process). another interesting parallel is provided by international trade policy, which raises many similar issues to tax policy, but which has historically been categorized by more formal dispute resolution procedures. see robert a. green, antilegalistic approaches to resolving disputes between governments: a comparison of the international tax and trade regimes, 23 yale j. int'l law 79 (1998) (comparing substantive and procedural aspects of the international tax and trade policy regimes). 766 florida tax review [vol. 4:11 arguments on behalf of a progressive tax system. yet only by confronting these arguments can scholars rebuild the case for progressivity and ultimately carry the day. the findings above have implications beyond the progressivity area. the case for progressivity has, in my judgment, been weakened by two widespread tendencies in both tax scholarship and the broader legal academy: (i) compartmentalization of diverse but related subject matters, e.g., tax and spending, domestic and international affairs, etc., and (ii) an often exaggerated reliance on theoretical models drawn from nonlegal disciplines, most notably economics and moral philosophy, at the expense of empirical studies and all too often, common sense. each of these tendencies has benefits but also serious costs. theory is important, but arguments about public policy are inherently practical discussions, requiring healthy doses of historical and political context in addition to more abstract economic and philosophical analyses. tax policy is likewise impossible to separate from the broader debate regarding government and its priorities. an apolitical scholarship, focusing exclusively on specific issues and attempting to "prove" its point by deduction from specific nonlegal theories, is thus unlikely to resolve the problem. an interdisciplinary, empirical scholarship, which borrows from various disciplines and gathers the greatest possible evidence regarding real-world developments, is likely to be more effective. 95 a second implication pertains to the american left, or to those who retain an interest in "progressive" public policy. in a conservative period, there is an understandable tendency for liberals to retreat from partisan advocacy into a more reflective and even defensive mode. this may take the form of avoiding engagement on distributive issues such as progressive taxation, health care and welfare reform. those who are too committed to retreat often attempt to recharacterize these issues in moderate, neutral-sounding language. the problems with the former approach are obvious. but the latter approach is equally dangerous, for it threatens to rob the left of political and emotional energy, trading modest short-term gains for a long-term, strategic defeat. the effort to "depoliticize" progressive taxation and to present it as a consensus, welfare-maximizing policy and to play down its redistributive aspect as well as its implicit race and gender implications, may at times fall into this category. i wonder if this effort is not partially responsible for the defensive posture of progressivity today. one cannot argue the left's program in the language of the political right. an honest commitment to redistribution, even if it alienates some observers, in the long run will be more successful than a stealth argument. progressive taxation is but one example of this phenomenon. f i n a l l y , progressive taxation reminds us that the localization of much of the political left, its nationalist tendencies and its preference for identity-based grievances 95. see livingston, supra note 11, at 397-409 (laying grounds for a "practical reason" tax scholarship that involves a substantial amount of empirical and interdisciplinary work). 2000] blum and kalven at 50 767 over policies that might build broader multinational coalitions, has become selfdefeating in nature. the flat tax is appealing, in part, because it is tied to a96 vision of global capitalism that transcends national boundaries and promises prosperity to everyone. by contrast much of the left still defines progressivity, fairness, and similar concepts in exclusively national or subnational terms. if it is to level the ideological playing field, the left, too, must globalize, and begin to see issues from a universal rather than a local perspective. the transition is a difficult one. will u.s. auto workers ever find common cause with mexican peasants? will the latter ever see the former as disadvantaged in any meaningful way? yet these questions must be confronted if the left is to become more than a pleasant anachronism. on no issue, whether it be taxation, trade, environment, can a progressive movement succeed without facing this issue. what i am seeking is the revival of liberal discourse on tax and other public policy issues, emphasizing traditional problems, but recognizing that times have changed and that old questions must be debated in a new and different context. rather than retreating, scholars should forcefully engage these issues, treating the end of the cold war and the rise of a global economy as an opportunity rather than a cause for lament. intellectuals and politicians should look forward to a changing world rather than backward to an aging and broken consensus. nostalgia is never as good as it used to be. on this point, at least, blum and kalven would surely agree. 96. whether to adopt a more universalist or nationalist stance is currently a major topic of debate among left-liberal thinkers. see richard rorty, achieving our country: leftist thought in twentieth century america (1998) (arguing for liberal nationalism as a framework for advancing distributive justice and other progressive policy goals). florida tax review volume 2 number 1! the recharacterization of cross-border interest rate swaps: tax consequences and beyond bruce a. elvin* i. introduction .............................. .. 633 ii. notional principal contract and swap definitions .................................. 635 a. what are notional principal contracts and swaps? ............................. 635 b. classification and taxation of payments under notional principal contracts ................. 636 c. reasons for off-market swaps and nonperiodic payments ............................... 638 iii. u.s. taxation of off-market interest rate sw aps ...................................... 640 a. example from swap regulations ............... 640 b. recharacterization under regulations section 1.446-3(g)(4) ....................... 641 1. "significant" ......................... 641 2. initial consequences of recharacterization . 642 a. "the loan must be accounted for independently of the swap" .. ....... 642 * j.d. 1993, duke university. this article was written while the author was serving as a wissenschaftlicher assistant, universitdi mdinchen. the author is presently completing new york university's graduate tax program, after which he will be an associate at baker & mckenzie, new york city. the author thanks steve conlon. steve oppenheim. and achim pross for their inspiration, ideas, and time spent discussing numerous issues, professor richard doernberg for his all-around advice, and professor lawrence lokken. stuart leblang, and erika nijenhuis for their thoughtful comments and time spent reviewing earlier drafts of the article. special thanks go to professor klaus vogel and george elvin for their continuous support, and most of all to jim finkel, without whom this article would not have been possible and to whom the author is extremely grateful. florida tax review b. "the time value compontent associated with the loan is not included in the net income or net deduction from the swap . . ., but is recognized as interest for all purposes of the internal revenue code" ................. 642 3. the complicating factor: the contrasting sourcing rules for swap and interest income ........................... 643 iv. consequences of recharacterizing a nonperiodic payment .................................... 644 a. portfolio interest .......................... 645 b. withholding ............................. 64 7 v. time value determination ...................... 648 vi. summary of the u.s. tax treatment ............. 652 vii. double taxation of off-market interest rate sw aps ...................................... 653 a. introduction ............................. 653 b. interest under the model conventions ........... 655 1. definition ......................... 655 2. rationale for the sharing of tax on interest ........................... 655 3. origins of double taxation under an off-market swap .................... 656 c. nonperiodic payment characterization .......... 657 d. potentially applicable tax treaty articles ........ 659 1. article 11: interest ................... 659 2. article 7: "business profits" ............. 659 3. article 21: "other income" .. ............ 660 e. the manifestation of double taxation ........... 661 f. qualification problem ...................... 663 g. mutual agreement procedures ................ 664 1. availability ........................ 665 2. drawbacks to mutual agreement procedures ........................ 666 viii. potential solutions and the consequences of double taxation ............................. 667 a. potential solutions ........................ 667 b. consequences of double taxation .............. 670 ix. conclusion .................................. 671 [vol. 2:11 the recharacterization of cross-border interest rate swaps i. introduction the interaction of domestic tax policies and double taxation treaties has created unintended and potentially serious impediments to the fair and efficient functioning of international financial markets, with particularly significant consequences for cross-border interest rate swaps. the importance of interest rate swaps is well-documented: they reduce and transfer interest rate risk, and they contribute substantially to the liquidity of the world's capital markets.' accordingly, any tax-related interference with interest rate swap markets may have materially negative and unforeseen consequences on many types of domestic and international capital transactions. an apparently inadvertent example of tax-related interference arises from the u.s. treasury regulations on notional principal contracts, promulgated in 1993, under which an off-market interest rate swap with a "large" nonperiodic payment is recharacterized as a package consisting of a swap and an embedded loan bearing interesl2 the resulting conversion of swap income into interest income (for all u.s. tax purposes) creates a variety of tax issues under domestic law and has especially significant and complex ramifications in cross-border cases. in these cases, a withholding tax may be imposed on the interest, and double taxation of the interest is a possibility even in the presence of a tax treaty.3 the withholding tax on u.s. source interest paid to a non-u.s. entity is not necessarily eliminated by the portfolio interest exemption, as may generally be thought, because the exemption does not apply to interest paid to banks, which make up a large portion of swap participants. tax and regulatory authorities in the united states were correct in recognizing that large nonperiodic payments in interest rate swaps were often 1. see u.s. gen. accounting office, report no. gao/ggd-94-133. financial derivatives (1994) [hereinafter gao report]. this report contains a detailed analysis of swaps, as well as of many types of derivatives, and describes their use both in the united states and in other countries. 2. regs. § 1.446-3. the regulations address notional principal contracts generally, but swaps are the most common type of notional principal contract. see infra part ii.a. further, the regulation provisions most extensively analyzed in this article apply specifically to swaps. thus, § 1.446-3 is referred to as the "swap regulations" in this article. see infra parts i1-ii for definitions and discussion of notional principal contracts, embedded loans, "large" nonperiodic payments, and off-market interest rate swaps. 3. according to the commentary to the oecd model convention, the "harmful effects [of double taxation] on the exchange of goods and services and movements of capital. technology and persons, are so well known that it is hardly needed to stress the importance of removing the obstacles that double taxation presents to the development of economic relations between countries." committee on fiscal affairs, organization for economic cooperation and development, model tax convention on income and on capital at i-1. para. 1 (1994) [hereinafter 1994 oecd model]. 19951 florida tax review used to avoid or abuse tax, accounting, or financial disclosure policies. thus, the swap regulations address a real problem. however, in the event of large and relatively quick changes in interest rates, many participants in swaps may wish to alter or terminate their swap obligations. to do this, they may be required to use large nonperiodic payments in order to terminate existing swaps or to hedge them with new off-market swaps. in this situation, confusion and uncertainty created by the swap regulations and the potential for double taxation may have a material effect on swap liquidity and pricing and, consequently, on the proper and efficient operation of the interest rate swap market. in brief, double taxation may result from fundamental conceptual differences among countries as to the nature of the income resulting from nonperiodic payments. where two countries consider the same nonperiodic swap payment to be two different forms of income, potentially fatal double taxation may arise, even if there is a tax treaty between them. the international network of bilateral tax treaties generally alleviates such tax barriers to cross-border transactions. however, as new financial products develop, they often do not fit smoothly into the double-taxationeliminating treaty provisions. such is the case with off-market interest rate swaps, as well as with other complex financial derivatives.4 this article first analyzes the u.s. treatment of off-market interest rate swaps as established by the swap regulations.' it critically examines the re4. efforts are now being made to develop internationally-accepted treatments of derivatives, including swaps. the organization for economic co-operation and development (oecd) is exploring in its working group on innovative financial instruments means of handling derivatives under its model tax convention. also, the taxation of derivatives was one of the main themes at the international fiscal association congress in september 1995. the general report for that congress pointed out, however, that international efforts "have only just begun to attempt the task of forming some international consensus regarding the tax issues and problems that these new types of transactions present." charles t. plambeck et at., tax aspects of derivative financial instruments: general report, lxxxb cahiers de droit fiscal international [c.d. fisc. int'l] 1.1 (1995). see gao report, supra note 1, at 116 (discussing international projects related to derivative regulatory and tax harmonization). an examination of the taxation of internationally-traded financial products is currently being undertaken by the u.s. treasury department in an effort to solve problems such as those discussed in this paper. see michael cosgrove, treasury undertaking broad review of financial services, beerbower says, daily tax rep. (bna) no. 98, at g-2 (may 22, 1995) (reporting on the speech of treasury deputy assistant secretary cynthia beerbower to the aba section of taxation on may 19, 1995). in addition, the treasury plans to issue a new u.s. model income tax treaty, which is expected to address financial instruments. 5. see also steven d. conlon & vincent m. aquilino, u.s. tax considerations for institutional investors acquiring derivative products: a methodology for evaluating tax risks, in the handbook of derivatives & synthetics 759 (robert a. klein & jess lederman eds., 1994) (detailing u.s. taxation of derivative products). for the taxation of another type of derivative product, options, see bruce kayle, realization without taxation? the not-soclear reflection of income from an option to acquire property, 48 tax l. rev. 233 (1993); [vol 2:11 the recharacterization of cross-border interest rate swaps characterization process and explains how recharacterization, while addressing a real problem in some cases, also lays the foundation for the imposition of unexpected, and unwanted, double taxation of cross-border swaps with a u.s. counterparty. the remainder of the article is a broader examination of how and why double taxation of the income resulting from these swaps may arise when one of the contracting parties is a resident of the united states or of another country that were to tax income from such swaps in a manner similar to that of the swap regulations. the final section presents some potential solutions to the double taxation problems discussed in the article. ii. notional principal contract and swap definitions a. what are notional principal contracts and swaps? the swap regulations define a notional principal contract as "a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts."6 more concisely, a notional principal contract is an executory contract whereby two parties agree to make future payments based on an agreed upon index and notional principal amount. types of notional principal contracts include commodity swaps, basis swaps, equity swaps, interest rate caps, collars, floors, currency swaps, and interest rate swaps.7 of these, interest rate swaps are among the most common. an interest rate swap is a contract by which two contracting parties (the counterparties) agree to exchange sets of cash flows with one another. in a typical interest rate swap, the payments from one party are determined by reference to a floating interest rate on a stated principal amount (the notional principal), while the other party bases its payments on a specified for taxation of equity swaps, edward d. kleinbard. equity derivative products: financial innovation's newest challenge to the tax system. 69 tex. l. rev. 1319 (1991): for analysis of the taxation of other types of swaps, lewis r. steinberg, selected issues in the taxation of swaps, structured finance and other financial products, i fla. tax rev. 263 (1993); for discussion of policy approaches towards the taxation of financial products, see alvin c. warren, jr., financial contract innovation and income tax policy, 107 harv. l rev. 460 (1993); for taxation of dispositions of interest rate swaps. see eugene y. ferrer, comment, tax treatment of interest rate swaps at disposal: should swap participants have their cake and eat it too?, 26 u.s.f. l. rev. 283 (1992). see generally reed shuldiner, a general approach to the taxation of financial instruments, 71 tex. l. rev. 243 (1992). 6. regs. § 1.446-3(c)(1)(i). 7. for a comprehensive treatment of financial products, see generally andrea s. kramer, financial products: taxation, regulation, and design (rev. ed. 1991 and supp. 1994) [hereinafter kramer, financial products]. for a discussion of the various types of derivatives and their underlying economics, see generally john c. hull, options. futures, and other derivative securities (2d ed. 1993). 19951 florida tax review fixed rate on the same notional principal amount. the distinctive factor is that the principal is never exchanged. it is merely used as the basis for the two sets of payments and is never borrowed or loaned between the two parties. 8 for example, in a standard interest rate swap between counterparties n and m, m agrees to make annual fixed-rate payments to n equal to 10% of the notional principal amount of $100 million ($10 million annually), and n agrees to make annual payments equal to the floating interest rate on the payment dates multiplied by the $100 million notional principal.9 the net amount owed each year varies with the floating interest rate, which often equals the fixed rate when the contract is made. b. classification and taxation of payments under notional principal contracts under the swap regulations, most payments under notional principal contracts are netted, and the net amount recognized for any year is gross income for the year (if it is a net receipt) or is a deduction (if it is a net payment).'" the regulations provide separately for periodic payments, nonperiodic payments, and termination payments, with certain nonperiodic payments distinguished as "embedded loan" payments. periodic payments under a notional principal contract are those "that are payable at intervals of one year or less during the entire term of the 8. "notional principal" is defined in regs. § 1.446-3(c)(3). 9. the basic swap scenario may be depicted as follows, with payments based on a $100 million notional principal: n --------------------> m floating (10% when swap created) n< ....----------------m fixed (10%) this type of swap is generally entered into because of comparative advantages in borrowing rates. see hull, supra note 7, at 112. in most swaps, a financial institution such as a bank serves as an intermediary. the bank has separate contracts with each party, and n and m are not aware of the other. conceptually, however, it is easier to think of n and m dealing directly with one another, or of m simply being a bank. see robert w. kolb, financial derivatives 130-37 (1993) (discussing standard swaps in more detail). 10. regs. § 1.446-3(d). in the example from the previous footnote, if the floating rate is 9% on the first payment date: n owes: 9% x $100 million = $9 million m owes: 10% x $100 million = $10 million the net amount for the taxable year is the difference between the two gross amounts. accordingly, n has net income of $1 million from this swap for the taxable year ($10 million received, less $9 million paid) and m has a corresponding net deduction. if the payment dates for the two parties are the same, n makes no payment in this year, as only the net amount of $1 million is paid from m to n. [vol 2:11 the recharacterization of cross-border inierest rate swaps contract" and are either fixed in amount or based on a specified index and notional principal amount." in most cases, they are the annual or semiannual payments under the swap based on the interest rates agreed upon by the parties. a periodic payment is prorated among the days in the period, and the amount allocated to each day is recognized as gross income or deduction for the year that includes that day.12 payments are "nonperiodic" if they are made "with respect to a notional principal contract" but are not periodic payments.' 3 examples of nonperiodic payments include the premium for a cap or floor agreement, the premium for an option that is exercisable into a swap, and a lump sum payment for an off-market swap agreement. 4 a nonperiodic payment under a swap is usually allocated over the term of the swap agreement, based on market prices for analogous forward contracts, and the portion allocated to each year is recognized as gross income or deduction for that year."5 a termination payment--"[a] payment made or received to extinguish or assign... rights and obligations.., under a notional principal contract"-is also classified as a nonperiodic payment,' 6 but the original parties to a notional principal contract recognize a termination payment as gross income or deduction when it is received or made.' types of termination payments include "a payment made between the original parties to the contract (an extinguishment), a payment made between one party to the contract and a third party (an assignment), and any gain or loss realized on the exchange of one notional principal contract for another."'" if "too large," lump-sum payments for off-market swaps and certain termination payments no longer fall under the main taxation scheme for swap payments but are treated as embedded loans bearing "interest." this "interest" is not taxed as swap income, but is characterized as interest for all purposes of u.s. tax law. the term "embedded loan" payment describes a lump sum payment that is recharacterized under the swap regulations because a "loan" bearing interest is deemed to be included, or embedded, in the payment. it is mentioned as a separate category of swap related payments because it is subject to its own tax provisions and creates the problems discussed in this article.1 9 11. regs. § 1.446-3(e)(1). 12. regs. § 1.446-3(e)(2). 13. regs. § 1.446-3(0(1). 14. id. 15. regs. § 1.446-3(0(2). 16. regs. § 1.446-3(0(1). 17. regs. § 1.446-3(h)(2). 18. regs. § 1.446-3(h)(1). 19. see regs. § 1.446-3(g)(4). embedded loans are discussed extensively in parts ii-vi. 19951 florida tax review in a cross-border transaction, income under a notional principal contract is sourced in the country of the income recipient.2" since u.s. withholding taxes apply only to u.s.-source income of foreign persons,2 swap payments to a foreign person are not subject to u.s. withholding taxes, even if the payments are made by a u.s. counterparty. however, interest income generally has its source at the residence of the debtor,22 and payments by a u.s. person to a foreign person under a swap agreement may therefore be subject to u.s. withholding taxes to the extent the payments are recharacterized as interest. c. reasons for off-market swaps and nonperiodic payments in new swap agreements, large nonperiodic payments are generally motivated by tax, accounting, or disclosure considerations and, consequently, are often assumed by the counterparties to be little more than disguised loans.23 before the swap regulations were issued, large nonperiodic payments were the basis of several abusive tax practices, including recognizing an up-front payment as income when received in order to roll net operating losses forward and deducting the up-front payment immediately to offset other taxable income.24 it was to curb such abuses that the irs undertook to regulate large nonperiodic payments.25 off-market interest rate swaps with large nonperiodic payments may also be used when a counterparty wants to pay or receive fixed-rate amounts differing from current market rates in order to match the cash-flow on an asset or liability (e.g., a bond).26 in addition, they may be used to obtain "off balance sheet" or undisclosed financing and by parties unable to borrow 20. regs. § 1.863-7(b)(1). 21. irc §§ 871(a)(1), 881(a). 22. irc § 861(a)(1). 23. nonperiodic payments for off-market interest rate swaps are often made when the contract is made and thus are called "up-front" payments. however, similar nonperiodic payments may also be made later during the term of the contract. 24. see lee a. sheppard, safe harbor leasing revisited: using swaps to avoid nol limitations, 41 tax notes 485 (oct. 31, 1988). according to notice 89-21, 1989-1 c.b. 651, including such up-front payments in income when received is not an accurate reflection of income. an acceptable method of accounting is one that recognizes the payment "over the life" of the swap contract. this led to regs. § 1.446-3(g) and the recharacterization discussed in this article. for discussion of notice 89-21, see jeffrey p. cantrell et at., notice 89-21 crashes the interest rate swap party, 45 tax notes 337 (oct. 16, 1989); thomas k. kopp & achim c. pross, u.s. national and international taxation of interest rate swaps, 1994 intertax 365, 370. 25. notice 89-21, supra note 24. 26. see peter c. canellos et al., report on tax accounting for notional principal contracts, n.y. st. b. ass'n tax sec. comm. on financial instruments [hereinafter n.y. st. b. ass'n report], sept. 28, 1989, at 21. [vol 2:11 the recharacterization of cross-border interest rate swaps money for reasons such as restrictive credit agreements, indenture restrictions, or regulatory disclosure considerations. for instance, an off-market swap might be made to evade contractual limits placed on a company's borrowing while on-going debt is being serviced. in these examples the parties are treating the nonperiodic payment as a substitute for a loan, even though the swap contains no contractual obligation for the repayment of the "loan" to the "lender." 27 however, interest rate swaps with large nonperiodic payments do not always derive from abuse or evasion, and such swap payments are necessary to ensure the liquidity of the swap markets. specifically, following a substantial change in market interest rates (e.g., the floating interest rate used in a swap rises from 6% to 10% while the fixed rate remains at 6%),' participants in interest rate swaps that were originally priced at current market rates, without nonperiodic payments, may find that they are making or losing substantially more money on the swap than they expected when they entered into the swap. many of those participants then chose to terminate, "lock in," or alter their existing or potential economic gain or loss, or to completely realize at that time their economic gain or loss. a swap participant may not wish to incur additional losses, or it may desire to ensure its gains on the initial swap. this may be done by terminating its position by extinguishment or assignment, by assigning one leg of its swap position, or by entering into a new offsetting swap. 29 because of the substantial interest rate change since the original swap was established, many of these new contractual arrangements are off-market and require large nonperiodic payments. a winning party wishing to realize its profits immediately must receive a large nonperiodic 27. see infra part v for extensive discussion of this issue. 28. the chart below graphically indicates several periods where interest rate movements of 3-month libor would have created a problem similar to the one described here. 3 monlh tmor mctoaf d yl 24 22 16 1975 1977 197 1931 1903 1=3 my3 vw2 1021 t=9 1=3 -3 xc~t. o&vlils l *©l, 939 .93 .5 t11 6-~ rigs l_~ ". l.9 at'=-t lt=h g3 23. o 31.9 .6 1i .1 9% 2.4736 29. combinations of other swaps, derivatives, and financial instruments may also be used to hedge an existing swap. 1995] florida tax review payment, and a losing party wishing to fix and pay its swap losses at that time must make a large nonperiodic payment. only in the case of a payment for extinguishment made between the original parties to the swap is it certain under the swap regulations that a large termination payment is not subject to recharacterization as a significant nonperiodic payment.30 however, the swap party with the other side of the contract may have no desire to terminate. moreover, if this party recognizes that extinguishment is the only means for the other party to end its swap obligations without the tax problems associated with recharacterization, it could demand a higher than current market price or other unreasonable terms. payments in connection with termination by assignment, as well as payments to assign one leg of the swap, are considered nonperiodic payments subject to recharacterization. 3' an offsetting swap with a nonperiodic payment is also susceptible to recharacterization, as is any new off-market swap. these transactions are the true economic necessity of large nonperiodic payments, as opposed to the more deceptive practices discussed at the beginning of this section. m. u.s. taxation of off-market interest rate swaps a. example from swap regulations example 3 in regulations section 1.446-3(g)(6) (the example) is an off-market swap with a significant nonperiodic payment. the example, given in full below, is followed throughout this article, with the stipulation that counterparty m is a not a u.s. resident. on january 1, 1995, unrelated parties m and n enter into an interest rate swap contract. under the terms of the contract, n agrees to make five annual payments to m equal to libor times a notional principal amount of $100 million. in return, m agrees to pay n 6% of $100 million annually, plus $15,163,147 on january 1, 1995. at the time m and n enter into this swap agreement the rate for similar onmarket swaps is libor to 10%, and n provides m with information that the amount of the initial payment was determined as the present value, at 10% compounded annually, of five annual payments from m to n of $4,000,000 (4% of $100,000,000).32 30. regs. § 1.446-3(h)(4), (5) ex. 1. 31. regs. § 1.446-3(h)(4), (5) exs. 2 & 4. 32. regs. § 1.446-3(g)(6) ex. 3 (emphasis added). graphically, the contract calls for: n -----------------> m libor (10% when contract signed) n< --------------m fixed (6%) + $15,163,147 cash [vol. 2:11 the recharacterization of cross-border interest rate swaps the payment of $15,163,147 on the date of the contract's signingthe up-front nonperiodic payment-compensates for the difference between the fixed 6% m will pay annually and the market rate of a fixed 10% in exchange for the libor. the spread between the two interest rates need not be so large, but the spread's size is the element of the swap that leads to the tax problems discussed here. according to the swap regulations, a swap with "significant nonperiodic payments" is treated as two separate transactions consisting of an on-market, level payment swap and a "loan" bearing interest.33 the time value component of the loan-interest-is "not included in the net income or net deduction from the swap... but is recognized as interest for all purposes of the internal revenue code."' this rule is known as the "embedded loan" rule because a loan is seen as being embedded in the nonperiodic payment. the embedded loan must be accounted for by the parties to the contract on a self-amortizing basis, "independently of the swap."3 further, the principal is only used to compute the time value, or interest, component and does not otherwise impact the parties' net income or net deduction under the swap.36 according to the regulations, the example is a swap with a "significant" nonperiodic payment, and it is therefore recharacterized as including a loan bearing interest.37 this interest is potentially subject to double taxation.38 b. recharacterization under regulations section 1.446-3(g)(4) 1. "significant. "-although the regulations recharacterize a nonperiodic payment only if it is "significant," they do not directly define the libor is the london interbank offer rate and is often the reference rate of interest for floating rate loans in international financial markets. see hull, supra note 7, at 112. 33. regs. § 1.446-3(g)(4). 34. id. (emphasis added). 35. id. 36. regs. § 1.446-3(g)(6) ex. 3(d). 37. the swap counterparties are summarized as follows: n is a: -u.s. counterparty who -receives the nonperiodic payment. -is thus the "borrower," -and makes the "interest" payments. m is a: -non-u.s. counterparty who -makes the significant nonperiodic payment. -is thus the "lender," -and receives the "interest" payments. 38. other possible treatments of interest rate swap premiums, which would not lead to these particular tax problems, are discussed extensively in the n.y. st. b. ass'n report. supra note 26, at 21-22. 19951 florida tax review term "significant. '39 however, examples in the regulations indicate that a nonperiodic payment is not considered significant if it is less than 9.1% of the discounted present value of the fixed payments due under the swap contract,' but is considered significant, and therefore subject to recharacterization, if it is 66.7% or more of the present value of the fixed payments (as is the case with the $15,163,147 paid in the example). 4' thus, any swap with a nonperiodic payment between 9.1% and 66.7% of the present value of the fixed payments is potentially subject to recharacterization as including a loan bearing interest.42 2. initial consequences of recharacterization a. "the loan must be accounted for independently of the swap. "4 -where recharacterization applies, the significant nonperiodic payment is considered to be an interest bearing, self-amortizing loan. the principal of the loan element is considered to be repaid as the loan is amortized under the constant yield method.' the primary function of the principal component is to compute the "interest" that accompanies the repayment of the loan. it is the tax treatment of this interest that may lead to withholding taxes and double taxation in cross-border swaps. b. "the time value component associated with the loan is not included in the net income or net deduction from the swap. . ., but is recognized as interest for all purposes of the internal revenue code. "45-this sentence establishes that the "interest" payments from n to m resulting from the loan element of the recharacterized significant nonperiodic payment are treated as interest, not as payments of swap income to m,46 although origi39. the treasury's failure to provide a bright line test was apparently intentional. see lee a. sheppard, financial products, the switchboard approach, 60 tax notes 942, 943 (aug. 16, 1993) (reporting on a speech of irs attorney alan b. munro, jr. to the aba financial transactions committee on aug. 6, 1993). 40. regs. § 1.446-3(g)(6) ex. 2. the theoretical basis for the embedded loan concept suggests that every up-front payment under a swap, regardless of its size, is an embedded loan. when the payments are less than 9.1%, they are simply not recharacterized. 41. see supra text accompanying note 32. 42. depending on how one interprets the regulations and calculates these percentages, the spread could be between roughly 10% and 40%, rather than 9.1% and 66.7%. 43. regs. § 1.446-3(g)(4). 44. regs. § 1.446-3(g)(6) ex. 3(c). see also stanley c. ruchelman, u.s. tax considerations in international derivative products, 47 bull. int'l fiscal documentation 235, 241 (1993). 45. regs. § 1.446-3(g)(4). 46. the net income or deduction from a notional principal contract, including a swap, is the sum of the periodic payments for the taxable year and the portions of the nonperiodic payments that are allocated to the year. regs. § 1.446-3(d). [vol. 2:11 the recharacterization of cross-border interest rate swaps nating in a swap. therefore, the payments are subject to the general rules on the taxation of interest, rather than the regime established in the swap regulations for swap income. this difference is of importance when both counterparties are u.s. persons.47 in a cross-border swap, particularly when non-u.s. counterparty m makes the significant nonperiodic payment, the impact of the recharacterization is even more critical since withholding tax and related double taxation issues are then raised. 3. the complicating factor: the contrasting sourcing rules for swap and interest income.-the importance of the distinction in cross-border swaps between a payment being treated as swap income or as interest arises from differing income source rules for these types of income. foreign persons are subject to u.s. taxation only on income from u.s. sources and income effectively connected with the conduct of a u.s. trade or business (eci).8 thus, a foreign swap participant not engaged in business in the united states is subject to u.s. taxation only on u.s.-source income.49 47. provisions whose application might be affected by the recharacterization include the straddle rules of § 1092 and the business hedging regulations of regs. § 1.1221-2 and § 1.446-4, which generally treat interest differently from swap income. other impacted issues include restrictions on interest deductions, the allocation of interest expense for purposes of the foreign tax credit, oid information reporting requirements (rcgs. § 1.1275-3(e)), the reporting of interest payments and accruals on old instruments (§ 6049). and "backup" withholding on payments to u.s. persons (§ 3406). see conlon and aquilino, supra note 5, at 782; andrea s. kramer, the tension between straddle rules and investment objectives, address at the institute for international research, (jan. 24. 1995), in 2 tax'n of investors & investments (1995); charles w. wheeler, accounting for business hedges, address at the institute for international research, (jan. 23-24, 1995), in 2 tax'n of investors & investments (1995). 48. various types of u.s.-source income of foreign taxpayers, including interest, is taxed by §§ 871(a) and 881(a), which impose a 30% withholding tax on the income unless it is effectively connected (eci) with the conduct of a u.s. trade or business. in the latter case, it is taxed on a net basis under § i or § 11 and is not subject to withholding taxes. irc §§ 871(a)(1), (b); 881(a); 1441(c)(1); regs. § 1.1441-4(a)(i). these eci principles apply to income from notional principal contracts. regs. § 1.863-7(b)(3). 49. for a general discussion of what constitutes effectively connected income and the trade or business concept, see paul r. mcdaniel & hugh j. ault, introduction to united states international taxation 53 (1989). the terms are defined in § 864 and regs. § 1.864-4. for the application of the effectively connected income tax to financial-market activities, see charles t. plambeck, the taxation implications of global trading, 44 bull. int'l fiscal documentation 527, 534-35 (1990); kopp & pross, supra note 24. however, § 864(b)(2) excludes many forms of trading in securities or commodities from being a u.s. trade or business. a foreign taxpayer believing that its income should be treated as eci, rather than subjected to withholding, must file a form 4224 with the u.s. withholding agent declaring that it is in fact eci. absent receipt of such a form, the u.s. payor should withhold. for a discussion of this requirement, see robert h. dilworth et al., new united states source rules for notional principal contract income, 69 taxes 343-44 (1991). 19951 florida tax review swap income, and notional principal contract income in general, is sourced under the regulations to the residence country of the income recipient, m in the example." thus, if non-u.s. counterparty m receives swap income from u.s. party n, the swap income is not from u.s. sources and is not subject to u.s. taxation unless it is effectively connected with a business carried on by m in the united states. in contrast, interest is generally sourced to the residence of the payor of the interest.5 in the example, the interest is from u.s. sources because the payor is u.s. party n. u.s. source interest may be subject to a u.s. withholding tax when paid to a non-u.s. person, at the statutory rate of 30% or at a lower rate provided by treaty. 2 thus, a nonperiodic payment by a nonu.s. counterparty which is greater than 9.1% of the present value of the fixed payments due under the swap may be recharacterized as a loan bearing interest which may be subject to a withholding tax of up to 30%. in sum, recharacterization will transform swap income that was beyond the scope of u.s. taxation into interest income that will be subject to u.s. withholding, unless exempted by treaty or other internal revenue code provisions. income that appeared to be unencumbered by the demands of u.s. taxation will be drawn into the web of the u.s. tax system. iv. consequences of recharacterizing a nonperiodic payment the withholding tax on u.s.-source interest paid abroad may be eliminated or reduced by two frequently relied upon means: the statutory portfolio interest exemption and double taxation treaties. however, the effectiveness of both of these means is limited in the context of nonperiodic payments in an off-market swap which are recharacterized as including a loan bearing interest. as a result, double taxation may often arise even in the presence of a tax treaty. the portfolio interest exemption to withholding and its possible applicability in the off-market swap context are assessed next, followed by a discussion of the withholding issues associated with interest resulting from recharacterized nonperiodic payments. the remainder of the article addresses why many tax treaties do not effectively eliminate double taxation of these deemed interest payments. 50. regs. § 1.863-7(b)(1) (stating that the "source of notional principal contract income shall be determined by reference to the residence of the taxpayer as determined under section 988(a)(3)(b)(i)"). see also the regulations under § 988. 51. irc § 861(a)(1). 52. irc §§ 871(a)(l)(a), 881(a)(1), 1441(a). see infra part vii for tax treaties. [vol 2:11 the recharacterization of cross-border interest rate swaps a. portfolio interest the deemed interest income payments to m in the example are exempt from withholding tax if they qualify as portfolio interest." it appears that the portfolio interest exemption is most often relied on to avoid withholding from the interest element of large nonperiodic swap payments. the irs was aware before promulgation of the swap regulations that the portfolio interest exemption would play an important role in eliminating withholding on this interest.' however, no firm determination has been rendered by the irs on the portfolio interest exemption's applicability to these payments. it is unlikely that the exemption extends to all cases that could potentially arise under the swap regulations. the portfolio interest exemption applies only if the interest-bearing obligation is in registered form or complies with elaborate requirements designed to keep the obligation out of the hands of u.s. investors." since most swaps are in registered form, it is possible for many nonbank participants in cross-border swaps to comply with the technical portfolio interest 53. sections 871(h)(i) and 881(c)(1) exempt "portfolio interest" from tax under §§ 871 or 881. section 1441(c)(9) confirms that "[iln the case of portfolio interest (within the meaning of section 871(h)), no tax shall be required to be... withheld from such interest." 54. see letter from vincent m. aquilino, esq., chapman and cutler. & steven d. conlon, esq., chapman and cutler, to the commissioner of the internal revenue service (sept. 20, 1991) [hereinafter aquilino & conlon letter]; letter from stephen l gordon, esq., cravath, swaine & moore, to karl t. walhi, esq., internal revenue service (sept. 27, 1991) (commenting on the proposed regulations on tax accounting for notional principal contracts). the absence of explicit mention of portfolio interest in the swap regulations may be an indication that the irs is skeptical as to whether or to what extent the portfolio interest exemption applies to deemed interest payments. 55. more specifically, interest qualifies as portfolio interest only if it is paid on an obligation that either (1) is not in registered form and is described in § 163(f)(2)(b); or (2) is in registered form and the u.s. withholding agent has received a statement that the beneficial owner of the obligation is not a u.s. person. irc § 871(h)(2). to meet the first test, § 163(f)(2)(b) requires that the obligation (i) be subject to measures designed to ensure its sale or resale to a non-u.s. person; (2) pay interest only outside of the united states; and (3) bear a legend on its face stating that a u.s. holder will be subject to u.s. tax laws. irc § 163(f)(2)(b). regulations § 1.163-5(c)(2)(i) elaborates on the (i) restrictions on transferability; (2) restrictions on payment of interest: and (3) the certification of the obligation required for portfolio interest treatment. an obligation is "registered" in the sense of the second portfolio interest test if (1) the instrument is registered as to both principal and interest, (2) rights to the principal and interest on the obligation may be transferred only through a book-entry system: or (3) the obligation is registered with the issuer (or its agent) as to both principal and any stated interest and may be transferred through both methods above. temp. regs. § 5f. 103-1 (c)(1). also, the second portfolio interest test is satisfied only if the u.s. withholding agent receives a statement (form w-8) that the beneficial owner is not a u.s. person. irc §§ 871(hj(2)(b)(ii), 881(c)(2)(b)(ii). 19951 florida tax review requirements. however, if all the requirements are not properly fulfilled, withholding obligations arise and could in turn lead to liability for failure to withhold. 6 to avoid such potential problems, it was suggested to the irs in 1991 that guidelines be provided regarding the extent to which the registration and certification rules must be complied with in the case of an embedded loan from a foreign person.57 no clear answer has yet been provided. even if counterparties are able and willing to comply with the portfolio interest requirements, many swaps involve non-u.s. banks as counterparties, either in the creation or termination of the swap." the term "portfolio interest" does not include interest "received by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business."59 since a recharacterized nonperiodic payment is deemed by the irs to contain a loan, it is likely that foreign banks which are active swap dealers cannot use the portfolio interest exemption. an informal survey of the leading non-u.s. bank swap dealers indicates that many of them have established specially-designed affiliated entities, in jurisdictions with suitable domestic policies and treaty relationships to the united states, to avoid withholding tax requirements on swaps and other derivatives.6 56. withholding is discussed at length infra part iv.b. for the portfolio interest requirement to apply, the u.s. counterparty must receive a signed irs form w-8 from the foreign counterparty. regs. § 35a.9999-5(b), q & a 9. 57. aquilino & conlon letter, supra note 54, at 4. 58. see sean becketti, are derivatives too risky for banks?, econ. rev. fed. reserve bank kansas city, third quarter 1993, at 27 (detailing the significant use of derivatives, and of interest rate swaps in particular, by banks). this article states that in 1992, the notional value of bank holdings of derivatives was $8.6 trillion and growing. id. at 33. another measure used was the replacement cost of their holdings, which is an estimate of the real economic value of the derivatives held. id. in 1992, this cost was $150 billion for bank holdings of interest rate and foreign exchange derivatives. id. banks are well suited to serve as counterparties because they are readily able to address the important element of counterparty creditworthiness: bank creditworthiness is well known, and evaluating the credit of others is an essential aspect of their business. banks thus play an important role in achieving liquidity in swap markets by serving as intermediaries, generally as a counterparty. banks also use interest rate swaps to hedge their own risks as endusers. id. at 32. for further discussion, see board of governors of the federal reserve system, federal deposit insurance corporation, and office of the comptroller of the currency, derivative product activity of commercial banks (1993). 59. irc § 881(c)(3)(a). 60. priv. let. rul. 9421027 (feb. 24, 1994) involves a case that is basically identical factually to the one followed in this article. a foreign bank was attempting to secure a reduced withholding rate under a particular tax treaty for the interest resulting from a significant nonperiodic payment that it made to a u.s. counterparty. while the issue in the letter ruling was that of residence under the treaty, it underscores the importance of the treaty issues discussed infra part vii and provides a concrete example of this situation. [vol 2:11 the recharacterization of cross-border interest rate swaps to recapitulate, the portfolio interest exemption is not a uniformly effective method of eliminating withholding on interest payments under embedded loans. b. withholding withholding is the means used to collect tax on foreign taxpayers' nonbusiness income from u.s. sources.6 unless exempted by treaty or the portfolio interest rule, u.s. source interest income is subject to the withholding tax,62 and since the time value component of the embedded loan is "interest" for all purposes,63 the "interest" payments from u.s. counterparty n to foreign counterparty m may be subject to withholding. in every swap with a nonperiodic payment greater than 9.1% of the present value of the total fixed payments due under the swap, then, n may be required to withhold tax on deemed interest payments to m. the obligation to withhold is imposed on all persons "having the control" of such payments.' the term "persons" is not limited to individuals, but includes all types of entities.65 n has the requisite control of m's income under the swap and is therefore the "withholding agent.'" as such, n is liable for the u.s. withholding tax of m arising from the interest on the embedded loan.67 if n does not withhold, it is liable for the full amount of the tax that it should have withheld.' s if m, in a generous mood, later pays the tax, the agent is only liable for interest on the delayed payments. civil penalties69 and accuracy-related and fraud penalties" may also apply if n fails to withhold.7' 61. sections 1441 and 1442 require withholding from specified payments to nonresident aliens (including foreign partnerships) and foreign corporations. for a detailed discussion of u.s. withholding requirements, see michael rosenberg. the u.s. international tax withholding nightmare, tax plan. int'l rev., apr. 1995, at 3. 62. irc §§ 1441(b), 1442(a). more broadly, these provisions also require withholding on "fixed or determinable annual or periodical gains." irc § 1441(b). 63. regs. § 1.446-3(g)(4). 64. irc §§ 1441(a), 1442. withholding may be reduced or eliminated by treaty. regs. § 1.1441-6(a). see infra part vii for a discussion of tax treaties. 65. van iderstine v. commissioner, 24 b.t.a. 291, 296 (1931). 66. "withholding agent" is defined in § 7701(a)(16) and regs. § 1.1441-7(a). 67. the withholding agent "inherits virtually all the tax obligations and liabilities of the ultimate taxpayer." 1 joseph isenbergh, international taxation '1 14.2, at 415 (1990). see also david i. kempler, dilemmas of a withholding agent: united states tax mgmt. int'l f., june 1995, at 47 (addressing this issue under the laws of the united states). 68. irc § 1463; regs. § 1.1441-7(b)(2). 69. irc § 6672; regs. § 301.6672-i. 70. irc §§ 6662, 6663. 71. withholding agents are required to file forms 1042 and 1042s for income subject to withholding. regs. § 1.1461-2(b), (c). if the agent has not withheld, it must cite the 19951 florida tax review a withholding agent fails to withhold at its own risk. to be certain to avoid liability for failure to withhold, u.s. counterparty n should withhold on every swap-related payment made to foreign counterparty m if the swap entails a nonperiodic payment greater than 9.1% of the present value of the fixed payments, as every such swap-related payment could be seen as containing interest if the nonperiodic payment is recharacterized. this precaution may turn out not to have been necessary if the swap is not recharacterized. further, it may diminish m's return on the swap, and if so, it may adversely impact the relationship between m and n and perhaps m's attitude towards future off-market swaps with u.s. counterparties. many swap contracts, including ones based on the international swap dealers association (isda) model, contain a "gross-up" clause, which requires the counterparty making an income payment (n in the example) to pay the full amount owed to the payee without reduction for any withholding taxes. the income payor must pay the tax from its own funds. because a gross-up clause shifts the economic cost of the withholding tax from the payee to the payor, n should take its higher costs into account when negotiating the terms of the swap contract. in addition, since n bears the cost of withholding, it may also want to limit the transferability of m's rights and obligations under the swap in order to control its withholding liability, as the isda model contract does. this has the consequence of limiting the available counterparties and potential transferees, burdening the efficient functioning of cross-border financing. because of the tax consequences, otherwise promising swaps may be foregone, costs to the parties may be increased, or n may use an offshore subsidiary located in a country with a more favorable interest taxation regime to conclude the contract. v. time value determination for a swap counterparty liable to withhold 30% or a treaty-stipulated reduced percentage of an interest payment, the critical question is, how much is the interest? the initial problem is that there are only "deemed installment payments" of interest;" none of the cash payments is designated in the swap contract as "interest." the only money changing hands is that owed by one counterparty to the other on account of the market interest rate movement. thus, the "interest" is a part of the swap payments. the regulations' explanation of the example presents the following amortization schedule to be used to account for the significant nonperiodic payment of $15,163,147 made by m when the swap contract is entered into authority for its failure to do so. regs. § 1.1461-2(c)(2)(ii). section 6302 and the accompanying regulations govern the deposit by the agent of the tax withheld. 72. regs. § 1.446-3(g)(6) ex. 3(d). [vol 2:11 the recharacterization of cross-border interest rate swaps (january 1, 1995):13 level payment interest principal 1995 $ 4,000,000 $1,516,315 $ 2,483,685 1996 4,000,000 1,267,946 2,732,054 1997 4,000,000 994,741 3,005,259 1998 4,000,000 694,215 3,305,785 i999 4,000,000 363,636 3,636,364 $20,000,000 $4,836,853 $15,163,147 the schedule is based on a constant yield to maturity of 10% compounded annually, which is the interest rate used by the parties in determining the amount of the nonperiodic payment. however, none of the payments in the schedule actually occurs. m's interest income throughout the swap term consists of the amounts in the interest column of the table. the scheduled amount is recognized as interest for each year of the swap, regardless of the amounts of the cash payments between the parties. this leads inescapably to the conclusion that withholding is required even if, for a particular year, the interest component is greater than the net swap payment owed by n-or even if n makes no net cash payment to m. the following examples demonstrate how this can occur. if the floating interest rate remains unchanged at 10% throughout the first year of the swap, the net swap payment to m is $4 million (the 10% floating rate times $100 million, less the 6% fixed rate times $100 million), and the interest component, according to the schedule, is $1,516,315. 74 but, if the floating interest rate drops to 6% on the payment date, no net payment is made because the floating and fixed rates are both 6%.'" however, m still recognizes interest income of $1,516,315, and this amount is subject to withholding by n. because the schedule determined at the time the swap was created controls throughout the life of the swap, n must withhold up to 30% of the $1,516,315 interest in year i even though no cash payments are made. under the regulations, the recharacterized swap is deemed to consist of an on-market swap and a loan, with the gross swap payments being 73. regs. § 1.446-3(g)(6) ex. 3(c). 74. without a treaty reduction, the withholding tax is 30% of the interest amount, $454,896. 75. a drop to 6% is most illustrative of the unusual result. however, any decrease in the floating rate leads to the same problem, though to a different degree. if the floating rate drops to 8% during the first year, the net payment from n to m is s2 million, of which $1,516,315 is interest subject to withholding. 19951 florida tax review applied, in order, to deemed interest, deemed principal, and then to the onmarket swap. the off-market swap in the example is thus bifurcated into two transactions-an on-market swap of 10% fixed payments in exchange for the libor (which is 10% when the swap is made) and an embedded loan of $15,163,147, which is amortized by five annual payments of $4 million each. under this view, if the libor is 6% on the first payment date, the payments for the first year are deemed to consist of a swap payment from m to n of $4 million (10% fixed interest on $100 million, less 6% floating interest) and a loan payment from n to m of $4 million. that the parties have agreed to net the two payments against each other does not relieve n of the obligation to withhold tax from the interest element of the loan payment.76 for example, if n owned m stock and m owned a bond issued by n, n's obligation to withhold from interest on the bond would not be negated merely because the parties agreed to offset the interest against an equal dividend on the stock, resulting in no cash changing hands between n and m. nevertheless, there is no actual, economic loan as there is no contractual obligation to repay even a minimum amount of the up-front payment.7 for example, if the libor falls to 6% during the first year and remains at that level for the remainder of the swap term, m will receive no net cash payments under the swap contract, even though it will have interest income each year of the swap in accordance with the amortization schedule. furthermore, if the libor were to fall to 3.5% and remain there, even the gross payments will not be sufficient to repay the deemed principal.78 in 76. "swap income" is taxed under the swap regulations, and is generally paid, on a net basis. only the difference between the gross amounts owed by n and m actually changes hands as swap income. however, the swap regulations also establish that the deemed interest amounts are not included in this net calculation and are not swap income. therefore, the gross amounts of swap income owed between the counterparties, though not exchanged, convey the interest resulting from a recharacterized nonperiodic payment thus providing a payment for withholding purposes. 77. irc § 163. interest is a charge "for the use or forbearance of money." see deputy v. du pont, 308 u.s. 488, 498 (1940). 78. even with no cash payment from n to m, n will probably not be relieved of its withholding obligation. the tax court has rejected the "assertion that withholding responsibility under section 1441(a) requires actual payment and receipt." casa de la jolla park, inc. v. commissioner, 94 t.c. 384, 392 (1990). the court found that interest had been "constructively received" in that case, and thus there was the requisite control for the withholding obligation of § 1441(a) to apply. id. at 393. presumably, there could be a "constructive payment" made by u.s. counterparty n which would also trigger § 1441. with the opportunity in 1994 to again address the issue of what degree of "payment" is necessary for §§ 1441 and 1442 withholding purposes, the tax court reserved judgment on whether a deemed payment under § 482 triggers the withholding obligation. central de gas de chihuahua, s.a. v. commissioner, 102 t.c. 515, 519 (1994). although arguably limiting slightly the scope of casa de la jolla park, the overall tenor of the decision is that with[vol 2:11 the recharacterization of cross-border interest rate swaps sum, even if the cash flow deviates greatly from the amortization schedule, a counterparty acts at its peril in failing to withhold based on the interest amounts prescribed by the schedule. thus far, the "time value component associated with the loan" has been discussed simply as "interest"-as the regulations refer to it.7 the repayment schedule for the recharacterized significant nonperiodic payment in the example, though, is similar to that for indebtedness (a bond) with original issue discount interest (oid).8 however, since the "loan principal" may fluctuate with the market interest rate, the time value component is not really oid. with old, the stated redemption price at maturity (corresponding to the embedded loan principal plus interest in the swap context) is an amount to which the lender is contractually entitled." the potentially unstable nature of the time value component in a recharacterized nonperiodic payment illustrates concerns highlighted by professor alvin warren-that financial derivatives pose severe difficulties for the u.s. realization-based income tax system because of the reliance on the distinction between fixed and contingent payments.' however, these concerns have not been fully addressed in the policy behind recharacterization. because the "principal" of the embedded loan and deemed interest can fluctuate, return of, and on, the embedded loan portion of the swap is a contingent return, not a fixed return. generally, contingent returns are not taxed until disposition of the asset. as professor warren says, "the rationale for this result is straightforward: whether or not any payments will be received is uncertain."83 a swap does not provide fixed returns, thus underscoring that a recharacterized nonperiodic payment is not really either a fixedholding is necessary to support § 482 transfer pricing adjustments. as no payments are actually made under § 482 to withhold from, the rationale is applicable to the "interest paid" under an off-market swap. the one difference is that there are no payments of any kind made under § 482 allocations, while in the embedded loan context there are generally payments made, albeit of swap income. thus, if withholding could be required when no cash at all changes hands under § 482, it is even more likely that withholding is required in the embedded loan context since there is generally some cash exchanged. for a discussion of this case, though generally disagreeing with its holding, see richard c. stark & michael e. baillif. do section 482 allocations to foreign entities trigger a withholding obligation? 82 j. tax'n 178 (1995j. 79. regs. § 1.446-3(g)(4). 80. oid is the difference between the issue price of a debt instrument and its stated redemption price at maturity. irc § 1273(a)(i). 81. for odd purposes, "the term 'debt instrument' means a bond, debenture, note, or certificate or other evidence of indebtedness." irc § 1275(a). yet, indebtedness is an unconditional, reasonably ascertainable and legally enforceable obligation for the payment of money. see autenreit v. commissioner, 115 f.2d 856 (3rd. cir. 1940). as seen. n does not owe m anything meeting this definition. 82. see warren, supra note 5. 83. id. at 463. 19951 florida tax review return asset or a contingent-payment asset as traditionally conceived. professor warren is correct in saying that in order to respond to new financial products, income tax policy must develop to reduce this reliance on the fixed return/contingent return distinction.' aware of such actual and potential problems with a variety of contingent return debt obligations, the treasury has promulgated new proposed regulations on contingent debt. 85 most other contingent payment debt obligations are now subject to the proposed regulations, which could well have provided a coherent scheme to tax recharacterized nonperiodic swap payments. however, the proposed regulations specifically deny this possibility for notional principal contracts containing embedded loans and establish that the swap regulations are controlling.86 absent new regulations on the taxation of recharacterized swap payments, there really is no coherent way to tax a recharacterized nonperiodic payment so that the economics of the swap always match the tax liabilities.s7 even inclusion under the new proposed contingent debt regulations would only have solved one of the problems-providing a system for determining a time value component which more accurately reflects the economics of the transaction. however, whatever means are eventually used to achieve a more accurate reflection of economics within the framework of recharacterization, the time value component would still be interest, subject to withholding and potentially to double taxation."s vi. summary of the u.s. tax treatment by recharacterizing an off-market swap with a significant nonperiodic payment as including an embedded loan bearing interest, the swap regulations create at least two major tax impediments to cross-border, off-market swaps: withholding tax and the resulting potential for double taxation. interest is 84. see id. at 473 for a discussion of possible policy changes. 85. prop. regs. § 1.1275-4, issued by the irs on december 16, 1994. for a detailed discussion of these proposed regulations, see edward d. kleinbard et al., proposed regulations affecting contingent payment debt obligations, 66 tax notes 723 (jan. 30, 1995). 86. prop. regs. § 1.1275-4(e). the preamble to the swap regulations states that "[t]he irs is working on a project dealing more generally with off-market and prepaid financial instruments." preamble to regs. § 1.446-3. 87. the swap regulations permit the irs to provide alternative methods for nonperiodic payments by revenue ruling or procedure. regs. § 1.446-3(f)(2)(vi). none has so far been provided. 88. in light of the policy behind withholding on certain payments of interest-to ensure the collection of taxes by placing the responsibility on the u.s. person subject to enforcement rather than relying on voluntary payment by a foreign taxpayer beyond the scope of domestic law-any payment similarly representing the time value of money should also be subject to withholding. [vol. 2:11 the recharacterization of cross-border interest rate swaps deemed to exist for all u.s. tax purposes, and withholding tax on the interest is required even when there is no net cash payment from which to withhold. double taxation treaties do not always alleviate double taxation on the deemed interest payment. the following example depicts why double taxation can greatly distort international capital transactions and lead to extensive measures to avoid it. assume a $100 payment is seen as "interest" under the swap regulations, and u.s. tax is withheld at a treaty-established rate of 15%; the payee's country of residence, disagreeing that this income is interest, applies its corporate income tax at 35% to the $100. the income is thus subject to taxes of $15 by the united states and $35 by the payee's country of residence (subject to unilateral double taxation relief); the $100 is subject to $50 in taxes, producing an effective rate of 50%. in contrast, if both parties to the transaction were residents of either the united states or the other country, the effective rate of tax would be 35%. this is double taxation. as seen from this brief example, double taxation can impose unacceptable tax burdens on otherwise viable transactions. a network of bilateral tax treaties between countries around the globe has been developed in an effort to remove these additional barriers to crossborder trade, commerce, and financing. while tax treaties are generally effective in combatting double taxation, in the particular case of off-market swaps, double taxation may nonetheless persist with the consequences of potentially significant reductions in the swap's utility and of reduced liquidity in the swap market. this double taxation is not necessarily limited to situations where the interest is from u.s. sources because it could arise with respect to any country that were to follow a recharacterization policy similar to that of the swap regulations. thus, it is a problem of concern to all countries where financial products are traded internationally. why double taxation may apply to these off-market swaps despite the existence of a treaty is the subject of the remainder of this article. vii. double taxation of off-market interest rate swaps a. introduction in 1989, the new york state bar association predicted that recharacterizing a significant nonperiodic payment in an off-market interest rate swap into a loan bearing interest "would reintroduce the u.s. withholding tax issues for cross-border swaps that [regulations assigning swap income to sources in the recipient's country of residence were] designed to eliminate." 9 this was a prescient assessment, for, as seen, this is precisely what 89. n.y. st. b. ass'n report, supra note 26, at 33. the source rule is found in regs. § 1.863-7. 19951 florida tax review has occurred. withholding on interest income payments in these types of cross-border swaps would not necessarily be problematic but for the fact that a large percentage of tax treaties around the world, including many u.s. treaties, do not effectively alleviate double taxation of income payments originating from a nonperiodic payment recharacterized by one country into a loan bearing interest; in other words, the full amount of the "interest" payment may be subject to tax in both contracting states,90 a case of juridical double taxation.9" this type of double taxation primarily arises when, as under the oecd model convention, the tax treaty between the states of residence of the swap counterparties, n and m, does not grant the exclusive right to tax interest to the residence state of the interest recipient.' if no tax treaty is in force between the state of source (the united states in the example) and m's state of residence, the tax treatment of the "interest" payments is entirely determined by domestic laws. many states subject interest paid abroad to considerable withholding taxes, such as the united states at 30% of gross payments made and canada at 25%. 91 the interest payment is also subject to income taxation in m's state of residence unless this state unilaterally credits all or part of the tax withheld in the source state. double taxation of any amount of swap payments, let alone such a high percentage, materially impacts the viability of many swaps. absent a treaty, such results are of concern, but could be anticipated. more problematic, however, is that even the existence of a tax treaty between the residence 90. tax treaties refer to the two signatory countries as the "contracting states." thus, the term "state" as used in the remainder of this article means "country" unless otherwise specified. 91. describing the circumstances giving rise to double taxation, professor vogel states that "[d]ouble taxation mainly arises today because the vast majority of states, in addition to levying taxes on domestic assets and domestic economic transactions, levy taxes on capital situated and transactions carried out in other countries to the extent that they benefit resident taxpayers." klaus vogel, on double taxation conventions, at 2 (2nd ed. 1991) [hereinafter vogel dtc]. this is what occurs with the interest element of off-market swaps. 92. n and m from the example, supra parts iii-vi, continue to be followed for clarity and continuity. that is, n receives the nonperiodic payment and thus becomes the "interest" payor and n's state of residence is the source state of the "interest." m made the nonperiodic payment and thus is the recipient of the income which n's state of residence (the united states) labels "interest." m's state of residence does not call that income "interest." see supra part iii.a for the full text of the example; infra part vii.b.3-vii.f for the characterization of the income by m's state of residence. the oecd model convention is cited supra note 3. 93. in the united states, the withholding tax does not apply if the interest is effectively connected with a u.s. business or is treated as portfolio interest. see supra parts iii.b.3, iv.1. part xiii of the canadian income tax act imposes the withholding tax on interest, subject to exceptions. see john m. ulmer and john a. zinn, foreign investment in canada, 22 tax planning int'l rev. 3 (1995). [vol. 2:11 the recharacterization of cross-border interest rare swaps states of the swap counterparties may often not eliminate double taxation of all of the payments made under an off-market interest rate swap contract.' b. interest under the model conventions 1. definition.-interest is defined under article 1 1 (the interest article) of both the oecd model convention and the u.s. treasury model convention as "income from debt-claims of every kind."95 the oecd model states that "[i]nterest arising in a contracting state and paid to a resident of the other contracting state may be taxed in that other state" (i.e., in the residence state of the interest recipient m). the oecd model further states: "however, such interest may also be taxed in the contracting state in which it arises and according to the laws of that state. . . ." thus, under the oecd model, the source state is also not prohibited from taxing interest, although the amount of tax may be limited by the interest article." this is the regime for the taxation of interest followed in a significant number of tax treaties currently in force around the world." 2. rationale for the sharing of tar on interest.-reduced source state taxation on interest is a recognition that passive foreign investment is to be welcomed in the source state, yet since the source state is used to generate the income, it is entitled to a part of it. this sharing of tax revenue by the contracting states is exemplary of the sine qua non of tax treaties, which is, as professor klaus vogel says, that "by concluding tax treaties, [states] agree to restrict their substantive law reciprocally."' too further, as he continues, "in those situations in which substantive tax law is expected to 94. for discussion of the problems facing oecd member states in their taxation of a variety of financial instruments, see organization for economic co-operation and development, taxation of new financial instruments (1994) [hereinafter 1994 oecd report]. 95. 1994 oecd model, supra note 3, art. ii, para. 3; united states model income tax treaty, june 16, 1981, art. ii, para. 2 [hereinafter 1981 u.s. model]. both the 1981 u.s. model and an earlier model promulgated in 1977 have been withdrawn because they are significantly out of date. treasury department news release, ivb-1900, july 17, 1992. however, the treasury has not yet issued a new model. 96. 1994 oecd model, supra note 3. art. 1i, para. 1. 97. id. at art.l 1, para. 2. 98. id. if a treaty provides that interest is to be taxed only by the residence state of the interest recipient, double taxation of the interest component is avoided. 99. slightly fewer than one-half of the u.s. tax treaties follow this pattern as well, although the u.s. model convention does provide that interest is to be taxed exclusively by the residence state. article 11(1) uses the phrase "shall be taxable only" to attribute exclusive taxation of interest to the residence state of the interest recipient. see vogel dtc. supra note 91, at 22 for discussion of the differences between the terms "may be taxable" and -shall be taxable"; see also 1994 oecd model, supra note 3. commentary on art. 23, paras. 6-7. 100. vogel dtc, supra note 91, at 19. 1995] florida tax review overlap, the contracting states decide which of them shall be bound to withdraw its tax claim,''. or, as with interest, limit its tax claim, so that the income is not taxed fully twice. 3. origins of double taxation under an off-market swap.-the proper functioning of double taxation conventions is predicated on a common characterization of a particular income item under the substantive tax laws of the contracting states. the interest article of a tax treaty typically defines interest as originating from a debt-claim and apportions the taxation of income that both countries characterize as interest. however, the treaty definition of interest is not sufficiently specific and detailed to ensure agreement among states on the characterization of the income from offmarket swaps involving large nonperiodic payments. is the income "interest" since it derives from a loan bearing interest, i.e. is it "remuneration on money lent"' 2 as in the united states and perhaps in other countries, or is it swap income other than interest? this conflict exists because, as the oecd report explains, "[t]he treatment of payments relating to interest rate swaps under double taxation treaties is dependent upon the characterisation of those payments under the domestic law of the countries concerned."" since the characterization of the payments by one contracting state is generally considered not to bind the other,"' 4 a gap in treaty coverage may arise caused by conflicting characterizations resulting from fundamental, differing perceptions of the essence of nonperiodic swap payments." 5 this income could fall under at least four different articles of many tax treaties, or outside of a treaty altogether. in other words, there may not be a substantive overlap of the domestic laws of the two states as envisioned at the treaty's creation and the treaty may not be able to establish which country shall withdraw or limit its claim.' 6 101. id. 102. 1994 oecd model, supra note 3, commentary on art. 11, para. 1. 103. 1994 oecd report, supra note 94, part i, para. 29. 104. but see john f. avery jones et al., the interpretation of tax treaties with particular reference to article 3(2) of the oecd model-i, i brit. tax rev. 14 (1984), discussed infra part vii.f. 105. professor vogel recognizes that double taxation is possible and not contrary to accepted principles of international law in this situation, because "[d]ouble taxation, resulting from the interaction of domestic laws of two (or more) states, will be consistent with international law as long as each individual legislation is consistent with international law." vogel dtc, supra note 91, at 4. 106. this does not even account for distinctions among countries based on the nature of the underlying transaction or on the type of taxpayer involved, both of which may also differ between states and which may impact the characterization of the swap in the residence state. see 1994 oecd report, supra note 94, part i, paras. 25, 29, and 138. [vol. 2:11 the recharacterization of cross-border interest rate swaps c. nonperiodic payment characterization regular periodic swap payments, including those from an interest rate swap, are generally not considered to be interest income either in the united states or elsewhere, though there is less agreement on what these payments are. ' 7 there is even less agreement on the characterization of lump sum payments. the oecd report concludes, "[w]here a payment stream is commuted as a single payment, ... there is a wide variety of treatments prevailing.' 'i8 as the oecd model commentary notes, "the definition of interest in the first sentence of paragraph 3 [of article i i] is, in principle, exhaustive.... [t]he definition covers practically all the kinds of income which are regarded as interest in the various domestic laws.""'° in other words, for a nonperiodic swap payment to be under article 11(3), there must be a debt claim, but whether a debt claim exists depends on the domestic law treatment of nonperiodic payments. absent a recharacterization under domestic law, as in the united states under the swap regulations, there is no debt claim."0 by recharacterizing a significant nonperiodic payment as a loan and stating that m, the maker of the nonperiodic payment, must recognize interest income whether or not any net payments are received by m, the swap regulations have basically defined a significant nonperiodic payment as including a debt claim, albeit a unique one. this dictates that the united states apply the interest article to this income."' 107. the accepted rationale for this policy is that there is no underlying debt obligation. see kramer, financial products, supra note 7. at 1434. the term "notional principal" reflects that there is actually no principal involved. for the characterization of interest rate swaps in some of the oecd member states, see 1994 oecd report. supra note 94. at 60. 108. id. at part i, para. 25. this disparate treatment of nonperiodic payments is likely to continue due to conflicting domestic interests. one such interest is the capital import/export dichotomy. capital importing states are more likely to see interest in a nonperiodic payment because, under tax treaties following the interest article of the oecd model, they are entitled to tax outgoing interest payments. conversely, capital exporting states may prefer that the exclusive right to tax swap profits belong to the taxpayer's residence country, and thus would see all elements of the swap as falling under a treaty article that precludes taxation at source. 109. 1994 oecd model, supra note 3. commentary on art. 11, para. 21. 110. see supra parts il-vi for discussion of swap payment characterization. if both states view all swap payments as interest, there is also a common application of the interest article. 111. priv. let. rul. 9421027 (feb. 24, 1994) involves a case that is basically identical to the one followed in this article. see supra note 60. the taxpayer, a foreign bank. requested a ruling that it was a resident of a particular u.s. treaty partner, thereby causing the interest article of the treaty to apply to interest received from a u.s. counterparty as a result of a significant nonperiodic swap payment the taxpayer had made to that u.s. party. while 19951 florida tax review for several reasons, comparable recharacterization in other states is improbable, though it may occur. under the taxation and accounting regimes of some countries, there may be no need for recharacterization. the recharacterization and amortization scheme was adopted in the united states in part to preclude income accelerations intended to absorb expiring net operating losses, but operating losses do not expire under some tax systems. further, the recharacterization in the swap regulations may be seen as a product of the u.s. policy to view substance over form." 2 this practice is not universally followed; some national laws require that the form of every transaction be followed." 3 moreover, among countries utilizing a substance-over-form approach, the approach may not always be invoked with respect to the same nonperiodic payment. absent recharacterization for any one of these reasons, a nonperiodic payment is not seen as containing a debt claim. applying the requirement of article 11(3) that there be a debt claim for the interest article to be applicable," 4 a country that does not consider a nonperiodic payment to include a debt claim will not apply the interest article. the oecd model commentary to article 11 also specifies that "references to domestic laws should as far as possible be avoided."".5 this statement is intended to eliminate the inclusion under a treaty's interest article of an item of income which is not from a debt claim. again, absent recharacterization or another means of viewing a nonperiodic swap payment as a loan with interest, there is no debt claim and the interest article does not apply. following recharacterization, there is a debt claim. to recapitulate, if the source state recharacterizes a nonperiodic payment to include a loan bearing interest, as the united states does, it maintains that the interest article is the treaty provision that determines the taxing rights of the treaty partners with respect to interest associated with a significant nonperiodic payment made as part of an off-market interest rate swap. if the other state does not recharacterize, it maintains that another treaty article should be applied to determine the taxing rights to this payment. under tax treaties following article 11 of the oecd model, this disagreement leads to double taxation, absent unilateral relief by the residence country. the ruling does not address whether this interest falls under the interest article, it appears to be an implicit premise of the ruling that it does. it might be inferred from this premise that the service intends to use treaties as the primary means of reducing or removing tax on these interest payments. 112. this policy is apparently accepted by the oecd model commentary. see 1994 oecd model, supra note 3, commentary on art. 1, para. 24. 113. 1994 oecd report, supra note 94, part i, para. 139. 114. see supra text accompanying note 109. 115. 1994 oecd model, supra note 3, commentary on art. 11, para. 21. the quoted words are meant to distinguish the current version of the model convention from the 1963 version, which included a reference to domestic law. [vol. 2:11 the recharacterization of cross-border interest rate swaps d. potentially applicable tax treaty articles the oecd report notes that "there is no consistency in the way countries classify [swap] payments when applying treaties."" 6 the possibilities, in addition to article 11, include article 7 (business profits), article 21 (other income); article 13 (capital gains), and no suitable treaty article at all. 117 unlike oecd model article i1, articles 7 and 21 assign the exclusive right to tax the income falling under them to the residence state of the income recipient unless the profits are "attributable" to a permanent establishment in the source state." 8 1. article 11: interest.-it is possible that a large nonperiodic payment in an interest rate swap could be recast under both states' laws, following provisions similar to the swap regulations; if so, the interest article can readily be applied. however, if the criteria used to determine when to recharacterize a payment are as loose in these states as under the swap regulations, it is unlikely that the states would consistently agree on when a nonperiodic payment should be viewed as a loan, particularly in borderline cases." 9 therefore, even the existence of similar recharacterization policies in both countries does not ensure the proper functioning of the relevant tax treaty. a swap payment could be treated as a loan by one state but not by the other, resulting in a "debt-claim" and "interest" for treaty purposes in the former state and treatment as regular swap income in the latter-the same problem as just discussed where one state does not have a recharacterization policy. 2. article 7: "business profits. "-article 7, which generally applies to income from "active business operations,"'120 allows source taxation of business profits only if they are attributable to a permanent establishment of 116. 1994 oecd report, supra note 94, part i, para. 29. see id. at 60 for a table summarizing the member states' classifications of payments when applying tax treaties. 117. article 13 is a less likely alternative because swap payments are commonly made and received in the ordinary course of the participants' businesses and because swap income usually does not consist of appreciation in property value and is not realized by a sale of property. 118. 1994 oecd model, supra note 3, art. 7, para. 1 and art. 21, paras. 12. it is assumed here that the cross-border off-market swaps under discussion are not attributable to a permanent establishment. for discussion of the consequences of using a permanent establishment in a swap, see kopp & pross, supra note 24. at 378-79. the permanent establishment concept in treaty law is similar to the concept of income effectively connected with a u.s. trade or business under u.s. domestic law. see supra part iii.b.3 for discussion. 119. in the united states, any nonperiodic swap payment between 9.1% and 66.7% of the present value of the fixed payments under the swap contract must be considered borderline. see supra part iii.b. 120. isenbergh, supra note 67, 38.7, at 354. see also vogel dtc, supra note 91. at 321 (discussing the term "business profits"). 19951 florida tax review the taxpayer in the source country. it is the most likely article to be applied for regular swap income payments. however, income from passive investments unrelated to the enterprise's business is not intended to fall under article 7. this line is often unclear, though, such as in the case of banks, which are frequent interest rate swap participants. a bank's interest income results from investments, yet earning interest is the bank's business. to avoid conflict between treaty articles, article 7 "gives priority" to the investment income articles of tax treaties, such as article 11. 21 specifically, article 7(7) provides that "[w]here profits include items of income which are dealt with separately in other articles of this convention, then the provisions of those articles shall not be affected by the provisions of this article."' 22 however, for a state to give priority to article 11 over article 7, it must recognize that there is interest income, and whether it recognizes the presence of interest returns the analysis to the state's treatment of nonperiodic payments under domestic law.2 3 barring a state's characterization of such payments as a loan and their repayment as including interest, article 7 may be applied without difficulty when interest rate swap payments are part of the business profits of an enterprise, as the oecd report confirmed.'24 there can then be a conflict between the residence state of m applying article 7 and a source state that follows the u.s. approach applying article 11. 3. article 21: "other income. "-a similar, if not more important, conflict arises if m's state of residence considers an income payment under a swap to be neither a "business profit" under article 7 nor interest under article 11. a decision that article 7 does not apply would most likely be due to the nature of the swap counterparty, such as a corporate manufacturer end user or even a bank in some situations. if the residence state does not treat large nonperiodic payments as loans bearing interest, neither article 7 nor article 11 is applied by that state. unless the swap payment is treated under 121. vogel dtc, supra note 91, at 377. 122. 1994 oecd model, supra note 3, art. 7, para. 7. 123. for the treatment of nonperiodic payments as interest under domestic law, see supra part vii.b.3. in the united states, the initial indication of how standard interest rate swaps were to be treated was rev. rul. 87-5, 1987-1 c.b. 180, which found that swap income was an "industrial and commercial profit" as the term was used in the particular treaty under review. though the 1981 u.s. model now refers to such profits as "business profits" under article 7, the distinction is not significant because the term still means income "derived from the active conduct of a trade or business." id., 1981 u.s. model, supra note 95, art. 7, para. 7. rev. rul. 87-5 establishes that normal interest rate swap income is not interest, whatever else it may be. for a detailed discussion of why this income is not interest in the united states, see kramer, supra note 7, at 1434-35. 124. 1994 oecd report, supra note 94, part i, para. 140. [vol 2:11 the recharacterization of cross-border interest rate swaps domestic law as a capital gain (article 13),'25 article 21 (other income) becomes applicable in that state by default. -'2 6 article 21, which assigns exclusive tax jurisdiction to the residence state, may often be relied on in this situation in light of the oecd report's conclusion that "it is not as yet generally accepted that all [swap-related] payments are covered by [article 7], the business profits article." 2 7 the distinction between treaty articles is important even though, in the absence of a permanent establishment in the source state, articles 7 and 21 both grant the exclusive right to tax an item of income to the residence state."z this is because a large number of tax treaties lack an other income article. 2 9 in such a case, the swap-related payment may not be covered under the treaty at all. if the residence state of the income recipient, m, finds that the income is not covered by the treaty, the obligation of the source state to follow the treaty becomes less certain. if neither state follows the treaty, the income could be subjected to full taxation in both states, ameliorated only by unilateral relief in the residence state. e. the manifestation of double taxation double taxation arises when treaty partners apply conflicting treaty articles in determining who may tax payments under a cross-border, offmarket interest rate swap with a large nonperiodic payment. where interest payor n is a resident in the united states, thus making the united states the source state of the interest, the united states asserts its right under article i 1 to tax the deemed interest payment arising from the nonperiodic payment. as discussed earlier, the u.s. withholding agent must withhold tax from the "interest" component of its payment to m at the rate specified by the treaty. 130 if the other contracting state, the residence state of a, does not recharacterize the nonperiodic payment and thus views the swap payment as business or other income, it apples article 7 or 21, which provide that there 125. see isenbergh, supra note 67, ul 41.4-41.5, at 421-24 and vogel dtc, supra note 91, art. 13, at 729 for discussion of the treatment of capital gains. 126. article 21 applies to an item of income "not dealt with in the foregoing articles" of the treaty. 1994 oecd model, supra note 3, art. 21, para. 1: 1981 u.s. model, supra note 95, art. 21, para. 1. see vogel dtc, supra note 91, art. 21. at 911 (discussing article 21's applicability). 127. 1994 oecd report, supra note 94, part i, para. 157. 128. 1994 oecd model, supra note 3, art. 7, para. i and ar. 21, para. 1: 1981 u.s. model, supra note 95, art. 7, para. i and art. 21, para. i. 129. 1994 oecd report, supra note 94, part i, para. 157. approximately one-half of the u.s. tax treaties lack an other income article. see klaus vogel et al.. united states income tax treaties art. 21-13 tbl. 1 (1993) [hereinafter vogel et al., usitti. 130. see supra part iv.b for a discussion of withholding in the united states. 19951 florida tax review should be no withholding in the source state and that only the residence state may tax the income. further, unless the residence state, upon examination of the treaty, finds that source taxation is justified, it may not credit the tax at source or exempt the income from residence taxation.' the basic treaty method for avoiding double taxation is stated in article 23, which generally provides the residence state of the income recipient, m in the example, with a choice between exempting or crediting the taxes levied in the source state. 132 however, for interest, article 23 generally provides that any source state tax is to be credited in the residence state of the recipient. unlike article 11, articles 7 and 21 independently avoid double taxation by declaring that only the residence state of the recipient may tax the income falling under them. therefore, when m's state of residence applies article 7 or 21, it may not resort to article 23 to avoid double taxation, even though n's state expects m's to avoid double taxation by applying article 23 in conjunction with article 11. an implicit prerequisite for the use of article 23 is agreement by the residence state that the income falls under the interest article or some other provision allowing taxation at source.,33 in this instance, article 23 is not applicable since it is unlikely that there will be agreement by m's state of residence that the interest article applies, at least when the income's source state is the united states. in short, if the residence state of m does not apply the interest article, it will not arrive at article 23 as the means to alleviate double taxation. as mentioned earlier, recharacterization treats a nonperiodic payment as creating a debt claim. to remain consistent with that treatment, the united states can be expected to call for the interest article to apply to the interest element. however, as discussed previously in part v of this article, there is no fixed debt claim in reality. that means that if m's state of residence maintains that the interest article should not apply because there is no interest, that state is theoretically correct. further, m's state of residence could feel that the interest article does not apply because the "interest" is not paid as interest, a prerequisite for the application of the interest article.' for both 131. vogel dtc, supra note 91, at 128-29. 132. see id., art. 23. the oecd model commentary states that "[ais regards two classes of income (dividends and interest) .... insofar as these provisions confer on the state of source or situs a full or limited right to tax, the state of residence must allow relief so as to avoid double taxation; this is the purpose of articles 23 a and 23 b." 1994 oecd model, supra note 3, commentary on intro., para. 19. 133. vogel dtc, supra note 91, art. 23, at 961. 134. klaus vogel, on double taxation conventions, art. 11, 67.1 (3d ed. forthcoming 1996). see vogel dtc, supra note 91, at 655, for discussion of the "paid as interest" requirement. [vol 2:11 the recharacterization of cross-border interest rate swaps of these reasons, m's state of residence likely will not accept the use of the interest article. therefore, the interest component of the payment made to m, which was withheld against in the source state by n, may also be fully taxed in the residence state of m, resulting in unameliorated double taxation. f. qualification problem the preceding analysis concerning the appropriate treaty article for income from large nonperiodic payments in off-market swaps has been addressing the "qualification" problem of treaties. qualification is the term used to describe how income is characterized for treaty purposes and is one of the most fundamental and long debated issues of treaty law.' article 3(2) of the model conventions attempts to solve the qualification problem by specifying that terms undefined in the treaty should be interpreted in accordance with the meaning of the term in the domestic law of the state applying the treaty.'36 however, article 3(2) is subject to different interpretations. the interpretation implicitly followed in this article is the one more likely to be followed by revenue authorities.'37 namely, both states characterize income independently under their respective domestic laws.' however, as seen, a consequence of this approach in this instance is double taxation. in the case of income resulting from a large nonperiodic payment, the undefined treaty term is "debt-claim." double taxation arises because one of the contracting states considers "debt-claim" to include large nonperiodic payments, while the other state does not. as a result, conflicting treaty provisions are applied. the other leading interpretation of article 3(2) maintains, in essence, that the residence state of the income recipient should accept the source state's qualification of the income as binding.' thus, if the source state taxes the income from a large nonperiodic payment as interest for treaty purposes, the residence state should follow that interpretation. in this instance, 135. see vogel dtc, supra note 91, at 134-35 (enumerating literature on the debate); the other leading exposition on the qualification issue is a. jones et al., supra note 104. 136. 1994 oecd model, supra note 3, art. 3. para. 2: 1981 u.s. model, supra note 95, art. 3, para. 2. article 3(2) in both models states that a term not defined in the treaty shall have the meaning which it has under the law of that state concerning the taxes to which the convention applies. 137. see klaus vogel, double tax treaties and their interpretation. 4 int'l tax & bus. law. 1 (1986). 138. see vogel dtc, supra note 91, at 135-42 (supporting this interpretation of article 3(2) and analyzing at length possible ways to avoid double taxation within the context of article 3(2)). 139. see j.f. avery jones, treaty interpretations, aptirc bull., aug. 1993, at 282; jones et al., supra note 104. 19951 florida tax review this means that both states should apply article 11 so that the residence state credits the taxes paid in the source state, thereby avoiding double taxation. while this approach is appealing in that it avoids double taxation, its utility is limited because it is unlikely to be followed by revenue authorities, particularly in the case of swaps with large nonperiodic payments. by accepting the source state's qualification, the residence state effectively cedes its sovereignty. while this is conceivable in simpler cases, such as where the source state merely has a broader definition of a term so that acceptance of the source state's qualification is not a great infringement on the residence state's authority, the process used by the source state to arrive at the interest qualification of substantial nonperiodic payments is more complicated. 40 the complexity of the recharacterization procedure and its extreme subjectivity make this interpretation of article 3(2) inappropriate as well as unlikely to find acceptance. as neither approach to article 3(2) effectively eliminates double taxation of payments under a swap with a recharacterized nonperiodic payment, the mutual agreement procedure found in most treaties could be used in an effort to resolve the problem. however, as seen in the next section, this procedure may also be of limited effectiveness with respect to income under a swap with a large nonperiodic payment. g. mutual agreement procedures most double taxation treaties provide for a mutual agreement procedure (article 25 of the model conventions), which entitles a taxpayer to request that the competent revenue authorities of the two states consult on the taxpayer's situation if the taxpayer feels that it is being taxed "not in accordance with the provisions" of the tax treaty. 4 ' juridical double taxation qualifies as taxation "not in accordance" with the treaty.'42 as mentioned previously in part vii, the swap-based recharacterized interest payment to taxpayer m is subject to juridical double taxation. that is, tax is withheld in the source state from the interest-which is part of m's profits from the underlying swap transaction-and the income is taxed again in m's state of residence. 43 140. see supra parts ii-v on the recharacterization process in the united states. 141. 1994 oecd model, supra note 3, art. 25, para. 1. 142. see j.f. avery jones et al., the legal nature of the mutual agreement procedure under the oecd model convention-i, 1979 brit. tax rev. 333, 336; sanford h. goldberg, competent authority, 40 bull. int'l fiscal documentation, 431, 433 (1986); vogel et al., usit', supra note 129, at 25-71 (pointing out that article 25 does not apply in certain cases where the treaty acknowledges that double taxation is possible). 143. this is a case of juridical double taxation even if the swap contract contains a gross-up clause. such a clause is merely a contractual arrangement between the counter[vol 2:11 the rechtaracterization of cross-border interest rate swaps 1. availability.-a taxpayer may apply for a mutual agreement procedure to the competent authority of its state of residence." this generally means that interest recipient m, as the party whose profits are subject to double taxation, must apply to the competent authority of m's state of residence-not to the authority of the state imposing the withholding tax (the united states in the example). 4 5 if m believes that it is being taxed not in accordance with the treaty, it may apply for a "specific case" type of mutual agreement procedure. this type allows the competent authorities the broadest discretion in deviating from national law in an effort to alleviate double taxation.' 46 any relief granted is generally only applicable to the particular case. however, relief is not guaranteed, and there are potential drawbacks to consider.147 two other types of mutual agreement procedure are established in article 25.1' these are the interpretative provision and the legislative provision. t49 they provide the competent authority with less flexibility than parties establishing which one of them will bear the cost of the withholding tax on swap payments. in any event, because of the widespread acceptance of economic double taxation as a basis for invoking a mutual agreement procedure (as in the case of transfer pricing), the double taxation discussed in this paper qualifies for article 25. 144. 1994 oecd model, supra note 3, art. 25, para. 1; 1981 u.s. model. supra note 95, art. 25, para. 1. 145. for a u.s. resident, the mutual agreement procedure follows rev. proc. 91-23, 1991-1 c.b. 534, as it may be amended by the revenue procedure proposed in announcement 95-9, 1995-7 i.r.b. 57 (feb. 13). see joseph l. andrus et al., competent authority assistance in tax controversies under the new irs procedures, 50 tax notes 1279 (mar. 18, 1991); robert t. cole and james e. croker jr., u.s. irs proposes to update competent authority procedures, 10 tax notes int'l 541 (feb. 13, 1995). 146. see jones et al., supra note 142, at 335-46; vogel et al., usitt, supra note 129, at 24-30. 147. drawbacks to a mutual agreement procedure are discussed infra part vii.g.2. if the contract has a gross-up clause, an interesting question arises as to which counterparty should apply for the mutual agreement procedure. while the payments to m are the items being taxed not in accordance with the treaty, .4 is receiving its full payments undiminished by withholding tax and is not feeling the pinch of double taxation. n. by virtue of the gross-up clause, is paying the withholding tax from its pocket, yet is not being taxed in contravention of the treaty. the economic cost to the swap is real and may be felt by m in the form of less favorable swap terms offered by n. thus, though m should apply for the mutual agreement procedure, it is unlikely to undertake such a procedure with its potential drawbacks for n's benefit. it is possible that neither n nor m is qualified or interested to apply for a "specific case" type of mutual agreement procedure despite the presence of double taxation. 148. there are generally considered to be three types of mutual agreement procedures contained in article 25 of the model conventions. see jones ct al., supra note 142, at 335; vogel et al., us'itt, supra note 129, art. 25. 149. 1994 oecd model, supra note 3. art. 25, para. 3; 1981 u.s. model. supra note 95, art. 25, para. 3, first two sentences. 19951 florida tax review the specific case procedure. 50 however, they need not be requested by a taxpayer, but may be undertaken by a competent authority itself to resolve "difficulties or doubts arising as to the interpretation or application" of the treaty.' 5' the benefit of such a ruling is its potential prospective effect.'52 the interpretative provision under the u.s. model applies to the double taxation of recharacterized, swap-related interest; the model states that the competent authorities may engage in such a procedure in an effort to agree on "the same characterization of particular items of income."'53 the oecd model commentary states that this procedure is appropriate in cases of "relief from tax deducted from ... interest. '"" thus, under both model conventions such a procedure is possible. 2. drawbacks to mutual agreement procedures.-despite the potential benefit from a mutual agreement procedure, several factors weigh against a swap counterparty requesting, or fully cooperating in, a mutual agreement procedure. one is that the desired relief in a particular case may not be large enough to warrant the costs involved in the procedure. while the competent authority does the negotiating and bears the related costs, the taxpayer must apply for the procedure, file copious amounts of information, and follow the case to its conclusion.'55 further, the procedure will likely take at least two years, 156 and in the quickly evolving world of derivatives, the subject of a prospective ruling may already be outdated by the time it is issued. a potentially weightier hindrance, though, is a counterparty's fear of retaliation by the tax authorities. mutual agreement procedures place taxpayers and revenue authorities in an unusual posture; the taxpayer must rely on the authorities to advocate its case. while the revenue authorities require disclosure of various information in a mutual agreement procedure, it is also in the taxpayer's interest to cooperate as fully as possible if it hopes for a favorable resolution of the case. yet, the disclosure of necessary information may result in the counterparty's tax returns for previous years being scrutinized once again, possibly resulting in the "raising of new issues, 150. vogel et al., usitt, supra note 129, at 24-30. 151. 1981 u.s. model, supra note 95, art. 25, para. 3. 152. for discussion of the legal effect of "interpretative provisions," see jones et al., supra note 142, at 335; vogel et al., usitr, supra note 129, at 25-141. 153. 1981 u.s. model, supra note 95, art. 25, para. 3(c). 154. 1994 oecd model, supra note 3, commentary on art. 25, para. 33; see also id. para. 32 for its scope of applicability. vogel et al. states that mutual agreements "are intended to clarify how national (domestic) tax law is to apply in both states in particular situations." vogel et al., usitt, supra note 129, at 25-31. 155. see rev. proc. 91-23, supra note 145 (listing procedural requirements). 156. see vogel et al., usiti, supra note 129, at 25-20 (providing statistics on processing time and frequency of relief in u.s. cases). [vol 2:11 the recharacterization of cross-border interest rate swaps reopening issues from a closed year, or more intensely auditing of positions taken by the taxpayer in an open year."'" while the united states does not reopen closed years,158 no similar assurances exist concerning open years. the positions of the revenue authorities of many other countries-to whom counterparty m would apply-are even more uncertain.'5 thus, it is not irrational to be wary.' 6 even beyond these risks, there is the consideration that mutual agreement may not be reached. article 25 of the model conventions only requires the competent authorities to negotiate; it does not obligate them to arrive at an agreement.' 6' the oecd commentary observes that this is a point of dissatisfaction among taxpayers. -6 2 while the mutual agreement procedure is often a useful tool to alleviate double taxation, it should only be seen as a potential back stop to prevent such taxation. even when a back stop is needed, it may not always be used or be effective. thus, more direct unilateral or treaty measures must be developed and implemented to alleviate double taxation on income resulting from large nonperiodic swap payments.' 63 viii. potential solutions and the consequences of double taxation a. potential solutions for a swap participant looking for a sure method of avoiding double taxation of payments under a cross-border interest rate swap with a large 157. id. at 25-41. 158. see rev. proc. 91-23, supra note 145, § 3, para. 6. an exception could arise in extraordinary circumstances. id. 159. vogel et al., usirt, supra note 129, at 25-41. 160. another fear of taxpayers is the potential disclosure to competitors of confidential information. see id. at 25-41. 161. 1994 oecd model, supra note 3, commentary on art. 25, para. 2: 1981 u.s. model, supra note 95, art. 25, para. 2; 1994 oecd model, supra note 3, commentary on art. 25, para. 26. 162. 1994 oecd model, supra note 3, commentary on art. 25, para. 45. 163. rev. proc. 91-22, 1991-1 c.b. 526 (undergoing revision in 1995) provides a procedure for advance pricing agreements (apas), which often entail mutual agreement between competent authorities. these agreements are to resolve profit allocation issues between related taxpayers and have been used in the context of global trading. however, it is assumed throughout this article that foreign taxpayer m does not use a u.s. permanent establishment in connection with the swap, but is nonetheless taxed on it. apas are not appropriate in this situation. for discussion of apas and global trading, see notice 94-40, 1994-4 c.b. 351 (discussing global trading apas); kathleen matthews, u.s. and canadian officials discuss apas in the global trading context, 8 tax notes int'l 1362 (may 23, 1994); kopp & pross, supra note 24, at 380; plambeck, supra note 49; ruchelman. supra note 44, at 253. 19951 florida tax review nonperiodic payment made to a u.s. counterparty, there are few certain answers. ensuring that the nonperiodic payment is not significant (i.e. is no greater than 9.1% of the discounted present value of the fixed payments under the swap) avoids recharacterization under the swap regulations." however, economic necessity, such as terminating or offsetting an existing swap, may dictate a larger payment. in that case, double taxation may be avoided by doing the swap through a bank that is a resident of a country whose income tax treaty with the united states provides a zero rate of withholding tax on interest, doing the swap entirely inside of the united states, or not involving a u.s. counterparty at all. each of these alternatives excludes a significant number of potential counterparties, which may reduce the liquidity of swaps. swap participants, therefore, should carefully price and structure new swaps and their trading strategies for terminating existing swaps in order to minimize the impact of unexpected recharacterization. for example, swap participants wishing to use an interest rate swap with a large nonperiodic payment which might be subject to recharacterization could bifuricate that swap into an on-market swap and either a real loan or a consulting or other fee. although the economic consequences of such a structure are slightly different from the originally intended swap, the tax consequences are more certain. several measures could be taken by revenue authorities to alleviate double taxation. in the united states, the service could decide that the portfolio interest exemption applies to interest resulting from a recharacterized nonperiodic payment, even if the interest is paid to a foreign bank. such an interpretation could conceivably be supported by construing section 881 (c)(3)(a) to mean that a bank does not "extend credit" in a swap since the principal may not be repaid. however, since recharacterization is an effort to combat hidden extensions of credit, it seems unlikely that the service will adopt this construction. another possible measure is to alter the swap regulations. specifically, the phrase "except for the interest sourcing rules" could be added to section 1.446-3(g)(4), so that it would read "the time value component ... is recognized as interest for all purposes of the internal revenue code except the interest sourcing rules." the interest, like all swap income, would then have its source in the recipient's country of residence,'65 u.s. withholding tax would not apply, and the issue of whether the interest article applies to the recharacterized payments would be sidestepped. this revision might be supported by focusing on the purpose behind regulations section 1.863-7, 164. see regs. § 1.446-3(g)(4), (6); see also supra part il. however, even under the 9.1% level there could be recharacterization because § 1.446-3(g)(4) allows for the recharacterization of any nonperiodic swap payment by using irc § 956. 165. regs. § 1.863-7(b)(1); see supra part jii.b.3 (discussing sourcing rules). [val 2:11 the recharacterization of cross-border interest rate swaps finalized two years before the swap regulations, which sources income "attributable" to notional principal contracts to the residence of the income recipient. clearly, the policy inherent in this provision is to preempt any u.s. taxation on such income paid abroad. as the regulations now stand, interest income deriving from a large nonperiodic payment, while originating in a swap contract, is not "attributable" to the swap because the swap regulations plainly state that the time value of money component of the recharacterized loan is interest for "all" purposes of the code. double taxation would also be alleviated if the residence state of m, the "interest" recipient, adhered to the source state qualification of the income, as discussed in part vii.f. however, for reasons already discussed, this approach by residence state revenue authorities seems unlikely. conversely, the state of interest payor n, despite recharacterizing the income as interest under domestic law, could conclude that the interest article is not the appropriate treaty article to apply. such a position is theoretically possible by acknowledging that the interest is not "interest" for treaty purposes, supported by the realization that there is no "debt-claim" certain to be repaid. however, this position does not seem likely under the u.s. swap regulations as it is contrary to the theory of the embedded loan recharacterization. nevertheless, if n's state took this approach, it could apply article 7 or 21 and assume that the residence state of the income recipient would apply one of them as well, thus alleviating double taxation. this is a more realistic expectation than hoping that they both apply the interest article. however, this approach could also lead to an absence of treaty coverage on the payment by n and the imposition of withholding tax by the source state. if the transaction is not part of an active business operation of m and thus not under article 7, which applies only to business profits, and if the treaty does not contain an article on other income (article 21 of the models), there would be no treaty coverage. this would even be the case where the treaty provided for exclusive taxation of interest in the residence state of the interest recipient (as under the u.s. model) because, as noted, the interest article would not be applied by n's state. thus, a source state policy of viewing the recharacterized "interest" as not interest for treaty purposes is a double-edged sword. new treaty provisions seem to be a promising means of eventually eliminating double taxation on payments under a swap with a large nonperiodic payment. for instance, a treaty provision could be developed establishing a basic framework for swap payments akin to that currently found in the interest article. the term "swap related payments" could be defined to include any payment resulting from a swap transaction or associated with one. thus, even if a country characterizes a swap related payment as interest, as in the example, it would still fall under the swap article. as under the interest article, swap related payments arising in a 19951 florida tax review contracting state could be taxed in that state and according to the laws of that state, but the tax could not exceed a maximum negotiated rate (which could be zero).166 if the source state imposes tax, the residence state of the recipient would alleviate that tax in conjunction with article 23. in light of the various domestic qualifications possible for this type of swap related payment, a comprehensive treaty provision would greatly reduce the likelihood of double taxation. such a measure would be most useful for new treaties, as insertion into existing ones would require that they be renegotiated. 67 however, any new treaty provision should be broadly applicable to a variety of financial instruments, which this proposal is probably not. therefore, for the present, tax authorities should develop logical domestic tax regimes for financial products with an awareness of their treatment in other countries and of the likely qualification of such instruments under existing treaties. absent measures taken by countries with more developed regulatory and tax systems for financial instruments to promote rational, certain taxation of swaps and to avoid double taxation, the situs of many swaps can readily be moved to countries with more favorable tax systems. relocating is currently the best solution to avoiding the tax and associated liquidity problems discussed in this article. however, for financial markets as a whole and for governments desiring to regulate those markets, swap relocation may have undesirable consequences. b. consequences of double taxation just as tax laws are seldom the reason for undertaking a commercial transaction, tax laws should also not be a reason for foregoing one. nor should tax consequences determine the choice of jurisdiction where a transaction is closed or, with swaps, booked. yet, this will occur if there continues to be a significant likelihood of withholding taxes being imposed, with resultant double taxation, on a swap booked in one country, while there is no chance of such taxation on swaps booked elsewhere. since the swap markets need liquidity, swaps will be relocated as necessary. 166. swap related payments defined as "swap income" in the united states under regs. § 1.446-(3)(d) are sourced in the country of the payment recipient as provided in regs. § 1.863-7(b)(3) and thus are not subject to any withholding under such a swap provision. this is because, as with the interest article, under the "swap article," the swap related payments are taxed according to the laws of the state in which they arise. if the united states, as the state in which they "arise," says that "swap income" is sourced in the state of the payment recipient, according to u.s. law they are not subject to u.s. taxation. 167. it may be easier to insert an other income article (article 21 of the models) into existing treaties. however, if a state insists that the interest article be applied to the "interest" element of swap related income, article 21 would not prevent double taxation. see supra parts vii.d and e. [vol. 2:11 the recharacterization of cross-border interest rate swaps a consequence of driving swaps out of some jurisdictions and into others on tax grounds may be a decrease in regulatory oversight of swaps and an increase in danger to the financial system as a whole. many jurisdictions into which the transactions might move may not only levy fewer, or at least more certain, taxes, but they may well have less developed, or no, active oversight systems for financial products. while those in the financial industry may protest that there is already adequate protection of investors and markets in the derivatives' area, 63 recent history shows that man-made disasters are all too possible. more oversight will not prevent all such damage in the derivatives' market, though there are certainly steps that can be taken to mitigate the number of victims. 16 9 there has been significant discussion in the united states, for instance, of the risks posed by this market and about measures that may be taken to reduce them without interfering with the usage of complex financial products. it has further been recognized that because of global trading, concentration of markets in relatively few hands, and linkages between market participants, these products pose risks to the international financial system as a whole. 70 however, regulatory measures taken in response to these concerns by the united states and other countries with more developed financial markets could be undercut if tax issues force market participants to relocate outside of the regulatory jurisdiction of these countries. if, because of more coherent or favorable tax laws, tax havens or other countries with less sophisticated financial market controls became the regular situs of swaps, a pirate environment could develop with respect to parts of the derivatives industry. ix. conclusion as seems regularly to be the case in the tax field, fiscal authorities and tax laws are constantly under pressure to implement suitable tax pro168. see derivative financial markets, (part 1), 1994: hearings on h. 361 before the subcomm. on telecommunications and finance of the house committee on energy and commerce, 103d cong., 2d sess., (may 10, 1994) (statement of richard c. breeden, e. gerald corrigan, and dennis weatherstone). 169. see gao report, supra note i. the report contains extensive and detailed discussion of all facets of the risks involved with derivatives, including current risk management techniques, accounting problems, and gaps in the regulation of the derivatives industry. id. at 103. the report also includes many recommendations, and points out a need to restructure the u.s. financial regulatory system in light of the increasing global nature of financial markets. id. at 123-29. 170. the risks and regulation of financial derivatives, 1994: hearings on s. 241 before the comm. on banking, housing, and urban affairs of the senate, 103d cong., 2d sess. (may 19, 1994) (statement of charles a. bowsher, comptroller general of the united states). 1995] florida tax review visions to keep pace with rapidly developing business practices.' 7' in the face of this challenge, it is particularly important for the united states and other countries with the most sophisticated oversight of their financial systems to continue to construct tax laws concerning swap and related income that clarify, standardize, and guarantee tax treatment and eliminate the burden of double taxation. such tax laws are necessary to discourage swaps and other financial products from being moved outside of their tax and regulatory jurisdictions. a good example of such a law and one to be followed elsewhere is that of the united states sourcing swap income to the state of the recipient's residence. with this provision, the united states unilaterally prevents double taxation of swap income paid abroad. in contrast, a policy to be less quickly copied is the recharacterization of a large nonperiodic payment under an offmarket swap into a loan bearing interest. as discussed in the first part of this article, though implemented to combat a real problem, many tax uncertainties and unusual results arise from this policy, including not knowing when there will be recharacterization, and thus not knowing when withholding is required. further, when a nonperiodic payment has been recharacterized, it seems unusual indeed that withholding may be due even absent any net cash payment to subject to withholding. in addition, it is this imposition of source state taxation that may lead to unacceptable double taxation. prospective swap participants may understandably shy away from carrying out a swap in a jurisdiction with such a recharacterization provision. when a system for the avoidance of double taxation on income resulting from derivatives is finally developed and incorporated into the tax treaty network, double taxation of such income will regularly be avoided. until then, however, it is the task of domestic policymakers to look for ways to establish a coherent and predictable scheme for the domestic taxation of derivative products that meshes with other practices around the world and avoids tax-related interference with the international flow of capital. 171. recognizing that this is especially true for financial instruments, the treasury department is presently conducting a broad review of the u.s. taxation of financial services in an effort to improve the taxation of both existing and future services, particularly in light of the global nature of the financial industry. see cosgrove, supra note 4, at g-2 (reporting on a speech of treasury deputy assistant secretary (tax policy) cynthia beerbower to the aba section of taxation on may 19, 1995). [vol. 2:11 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 6 2004 number 9 litigation expenses and the alternative minimum taxt brant j. hellwig" and gregg d. polsky introduction ...................................................... 900 i. the am t trap .......................................... 901 a. an example ....................................... 901 b. tax policy implications ............................. 902 c. which method applies? ............................. 903 1. the circuit court split ........................ 903 2. critical analysis of the circuit decisions ......... 906 a. critique of the minority view ............ 906 b. critique of the majority view ............ 908 c. the (i)relevance of state attorney lien law 909 d. the upcoming supreme court cases .................. 910 e. alternative taxpayer arguments ...................... 912 1. partnership argument ........................ 913 2. the transaction cost argument ................ 915 ii. impact of the amt trap ................................ 922 a. plaintiffs'lawyers ................................. 922 b. the defendant ...... .............................. 923 1. widening the settlement gap ................... 923 2. gross ups .................................. 924 c. the courts ...................................... 926 1. plaintiff's defense against motion for remittitur ... 926 2. defendant's defense against petition for fees ..... 927 3 plaintif's malpractice claim against her attorney.. 929 iii. the legislative abdication of responsibility ........... 930 a. legislative proposals .............................. 931 1. exclusion of certain awards from gross income ... 931 2. above-the-line treatment for fees in certain cases 934 b. a comprehensive solution ........................... 938 conclusion .............................................. 939 addendum ............................................... 940 a ppendix ................................................. 945 a s the article was going to press, a modified version of the senate bill described in part iii cleared the congressional conference committee and became effective when president bush signed it into law on october 22, 2004 as part of the american jobs creation act of 2004. this legislative development and its impact on the issues discussed in the article are briefly addressed in an addendum. * assistant professor, university of south carolina school of law. **associate professor, university of minnesota law school. florida tax review introduction one of the chief features of the alternative minimum tax (the "amt") is a broadened tax base, accomplished in part through the disallowance of deductions that are not central to measuring an individual's net income. yet in achieving its objective of limiting deductions, the amt casts a wide net. thus, in certain instances, an individual can be robbed of the tax benefit of expenses that were critical to the production of the income being taxed. an extreme example of this problem is the treatment of certain litigation expenses under the amt. if an individual incurs attorney fees and other associated costs in connection with litigation that produces a taxable recovery and the litigation does not relate to the individuals's trade or business (excluding the trade or business of performing services as an employee), then deduction for litigation expenses is disallowed. this "amt trap" results in the individual being taxed on the gross proceeds of the litigation for amt purposes. the most common lawsuits in which the amt trap arises are employment-related lawsuits, such as those involving discrimination, harassment, whistleblower, and breach of employment contract claims. however, the amt trap also affects other common claims, such as civil rights, intentional infliction of emotional distress, and defamation claims, provided that these claims do not involve personal physical injury.' the amt trap is disconcerting for a number of reasons. first, it so obviously violates the fundamental income tax policy principle that expenses incurred to produce taxable income should not be included in the tax base. second, the adverse consequences of the trap are typically quite severe. third, though a legislative amendment would be relatively inexpensive, such an amendment has not yet been enacted because the victims of the trap lack sufficient political muscle and coordination. fourth, the trap has consumed a tremendous amount of judicial resources. while most of these resources have been devoted to litigating the underlying tax issue, courts have been called upon to address a host of non-tax issues that arise on account of the amt trap. this article discusses the amt trap, beginning in part i with a description of the mechanics of the trap. this part also examines the current circuit court split regarding the tax issue that underlies the amt trap and previews the upcoming united states supreme court decision that will resolve the circuit court split. part ii of the article then considers the implications of the trap on plaintiffs, their lawyers, defendants, and the courts. finally, part iii describes and critically analyzes two bills that have been proposed, but have not yet been enacted, that were designed to solve the amt trap. 1. the trap may also apply to claims for punitive damages even where the underlying claim relates to a personal physical injury. see irc § 104(a)(2) (specifically excluding punitive damages from the scope of the gross income exclusion). [vol. 6:9 litigation expenses and the amt i. the amt trap a. an example assume that paula settles an employment discrimination lawsuit for $1,000,000 and, pursuant to her fee agreement with her lawyer, $400,000 of the settlement is paid directly from the defendant to the lawyer.2 for simplicity purposes, also assume that paula has no other income or deductions. the important tax issue facing paula is whether she may exclude the attorney fee portion of the settlement from gross income and report only $600,000 of gross income on her return (the "exclusion method")3 or whether paula is required to report the entire $1,000,000 as gross income, leaving her with a $400,000 deduction for the attorney's fees paid (the "inclusion and deduction method").4 if, under the latter method, paula's fee deduction were unimpaired, the tax consequences under both methods would be identical, since she would ultimately be taxed only on her net $600,000 recovery. in fact, though, the fee deduction is impaired, most significantly by the amt. under the exclusion method, paula would report only $600,000 of gross income and take the standard deduction of $4,750,' which would result in $595,250 of taxable income. applying the tax rates in section 1(c) to this amount yields a tax due of $189,670.6 paula's after-tax recovery from the lawsuit thus equals $410,331 and her effective tax rate on the recovery is 31.6%. under the inclusion and deduction method, however, the amt will be implicated. the fee deduction is characterized as an unreimbursed employee business expense and, as a result, is classified as a miscellaneous itemized deduction.7 because of this classification, the fee deduction is disallowed in its entirety for amt purposes.8 accordingly, paula's alternative minimum taxable 2. in the typical case, the attorney would also be reimbursed out of the settlement proceeds for costs advanced in prosecuting the case. for tax purposes, whether amounts paid to the attorney represent attorney's fees or reimbursements of costs is immaterial. accordingly, this article refers only to attorney's fees; however, the analysis is equally applicable to costs. 3. see infra notes 20-21 and accompanying text. 4. see infra notes 22-24 and accompanying text. 5. see irc § 63(c). 6. see irc § 1(c) (providing tax rates for single taxpayers). 7. see alexander v. comm'r, 72 f.3d 938,944-47 (1st cir. 1995) (holding that employee's legal fees incurred in connection with litigation arising out of employee's employment constitute unreimbursed employee business expenses); biehl v. comm'r, 351 f.3d 982 (9th cir. 2003) (same). but see laura sager & stephen cohen, how the income tax undermines civil rights law, 73 s. cal. l. rev. 1075, 1096-97 (2000) (arguing that legal fees such as paula's should be treated as reimbursed employee business expenses). 8. irc § 56(b)(1)(a) (miscellaneous itemized deductions disallowed under the amt). 20041 florida tax review income equals $1,000,000, and her ultimate tax liability equals $276,500.9 paula's after-tax recovery on her lawsuit thus equals $323,500 and her effective tax rate on the recovery equals 46.1%.'o therefore, under the exclusion method, paula ends up with $86,831 more after tax than under the inclusion and deduction method. as a result, paula would argue that the exclusion method is the one that should be applied. b. tax policy implications before explaining how the courts have gone about determining which of the two methods is appropriate, it is helpful first to analyze each method from a tax policy perspective. this analysis makes clear that the exclusion method, which results in the taxation of only the taxpayer's net recovery, is the correct one as a matter of policy. it is axiomatic that, under an income tax, the expenses incurred to produce income must be excluded from the tax base." therefore, in paula's case, she should not pay tax on the $400,000 of attorney's fees that she incurs because they are incurred to produce her $600,000 net recovery. this proper result can be achieved either by allowing paula to exclude the $400,000 attorney fee portion of the recovery from gross income (as under the exclusion method) or, alternatively, by requiring her to include the entire $1,000,000 recovery in gross income but then allowing her a full and unimpaired deduction for the attorney's fees (as under the inclusion and deduction method but only if the deduction were unimpaired). therefore, the inclusion and deduction method achieves the wrong policy result primarily because paula's deduction for attorney's fees constitutes a miscellaneous itemized deduction that is categorically disallowed for amt purposes. 2 the amt targets miscellaneous itemized deductions because they, in general, tend to constitute small expenses that have both tenuous relationships to the income that they help to create and "characteristics of voluntary personal 9. irc § 55(b)(i) (providing marginal rates for amt). paula would be taxed on the first $175,000 at a rate of 26% and on the additional $825,000 at a rate of 28%. even though the amt contains a significant exemption, paula would be phased out of the exemption based on her income level. irc § 55(d). 10. in a worst-case scenario, a plaintiff could actually be taxed on 100% or more of their actual recovery. see kenseth v. comm'r, 114 t.c. 399, 425-26 (2000); see also adam liptak, tax bill exceeds award to officer in sex bias suit, n.y. times, aug. 11, 2002, § 1, at 18 (describing case of discrimination plaintiff, who despite obtaining $1,250,000 judgment, ends up with after-tax loss of $99,000). 11. hantzis v. comm'r, 638 f.2d 248, 249 (1st cir. 1981). 12. we say "primarily" because even if the amt were amended to allow the deduction in its entirety, the deduction would still be impaired under the regular tax system pursuant to §§ 67 and 68, though such impairment would tend to be relatively minor. [vol6:9 litigation expenses and the aa4t expenditures."'13 of course, paula's fee deduction lacks all three of these characteristics it is extremely large, has a direct relationship to taxable income (i.e., her recovery), and has no personal consumption elements.4 therefore, paula's deduction for her legal fees should be allowed in full. c. which method applies? 1. the circuit court split while it is abundantly clear that, from a tax policy perspective, only the exclusion method achieves the correct policy result,5 it is not so clear that this result can be achieved under current law. in fact, there has been a great deal of litigation regarding the issue, causing a pronounced federal circuit split.'6 the first, second, third, fourth, seventh, tenth, and federal circuits have determined that the inclusion and deduction method is required even though it yields the wrong policy result,17 while the fifth, sixth, and eleventh circuits have concluded that the exclusion method is appropriate."8 in addition, the juris 13. staff of the joint comm. on tax'n, 100th cong., general explanation of the tax reform act of 1986 78-79 (comm. print 1987). see also deborah a. geier, some meandering thoughts on plaintiffs and their attorneys' fees and costs, 88 tax notes 531, 533-34 (july 24, 2000). 14. see geier, supra note 13, at 534. 15. see robert j. peroni, reform in the use of phaseouts and floors in the individual tax system, 91 tax notes 1415, 1423 (may 28, 2001) (stating that inclusion and deduction method provides "an inappropriate result from a tax policy point of view"); sager & cohen, supra note 7, at 1103 (stating that "tax policy considerations should favor permitting plaintiffs either to deduct fully or to exclude the recovery of attorney's fees"); james serven, oral argument in hukkanen-campbell: taxpayer's last stand?, 93 tax notes 854, 859 (nov. 5, 2001) (stating that "[t]here is simply no public policy or conceptual theory by which the denial of a deduction under the amt for.. .attorney's fees.. .can be plausibly defended"). professors sager and cohen also argue that the effect of the inclusion and deduction method "undermines the national policy of encouraging the pursuit of meritorious civil rights claims." sager & cohen, supra note 7, at 1078. 16. see nat'l taxpayer advocate, 2002 ann. rep. to cong. at 161-166 (describing litigation and circuit split on the issue). 17. alexander v. comm'r, 72 f.3d 938 (1st cir. 1995); raymond v. united states, 355 f.3d 107 (2d cir. 2004); o'brien v. comm'r, 319 f.2d 532 (3d cir. 1963); young v. comm'r, 240 f.3d 369 (4th cir. 2001); kenseth v. comm'r, 259 f.3d 881 (7th cir. 2001); hukkanen-campbell v. comm'r, 274 f.3d 1312 (10th cir. 2001), cert. denied, 535 u.s. 1056 (2002); baylin v. united states, 43 f.3d 1451 (fed. cir. 1995). 18. cotnam v. comm'r, 263 f.2d 119 (5th cir. 1959); srivastava v. comm'r, 220 f.3d 353 (5th cir. 2000); estate ofclarks v. comm'r, 202 f.3d 854 (6th cir. 2000); banks v. comm'r, 345 f.3d 373 (6th cir. 2003), cert. granted 124 s.ct. 1712 (2004). see also gregg d. polsky and stephen f. befort, employment discrimination remedies 2004] florida tax review prudence from the ninth circuit on this issue is particularly bizarre. different panels in this circuit have reached opposing conclusions based on the applicable attorney's lien statute, whereas yet another panel has suggested that the particulars of state attorney lien law are irrelevant. 9 the issue in these cases has been the appropriate characterization of the contingent fee agreement. courts using the exclusion method determine that the fee agreement operates to transfer a portion of the plaintiffs claim to the attorney at the time the fee agreement is executed.20 according to this view, when the attorney is paid, the payment is attributable to the attorney's preexisting interest in the claim. the payment therefore is not included in the plaintiff's gross income.1 on the other hand, courts using the inclusion and deduction method determine either that (i) the contingent fee agreement effects no such transfer of a portion of the claim,22 or (ii) if such a transfer is deemed to occur, the transfer nevertheless is ineffective for tax purposes under the assignment of income doctrine.23 as a result, these courts hold that the plaintiff must include the full amount of the recovery (including the attorney fee portion) in their gross income and then take a deduction for the attorney fee portion.24 and tax gross ups, 90 iowa l. rev. 67, 85 (2004) (providing chart demonstrating circuit split). 19. compare benci-woodward v. comm'r, 219 f.3d 941 (9th cir. 2000) (requiring full inclusion where fee agreement governed by california law) and coady v. comm'r, 213 f.3d 1187 (9th cir. 2000), cert. denied, 532 u.s. 972 (2001) (requiring full inclusion where fee agreement governed by alaska law), with banaitis v. comm'r, 340 f.3d 1074 (9th cir. 2003), cert. granted 124 s. ct. 1713 (2004) (allowing exclusion where fee agreement governed by oregon law). in the midst of these decisions that were decided on the basis of the applicable state attorney's lien law, the ninth circuit declared that the particulars of state law were not relevant in determining the federal tax consequences of the fee payment. see sinyard v. comm'r, 268 f.3d 756, 760 (9th cir. 2001), cert. denied, 596 u.s. 94 (2002) (stating "we do not see how the existence of a lien in favor of the taxpayer's creditor makes the satisfaction of the debt any less income to the taxpayer whose obligation is satisfied"); see also polsky and befort, supra note 18, at 86 (describing split within the ninth circuit). 20. see, e.g., cotnam, 263 f.2d at 125; davis v. comm'r, 210 f.3d 1346, 1347 (1 th cir. 2000); estate of clarks, 202 f.3d at 856; srivastava, 220 f.3d at 364. 21. see, e.g., cotnam, 263 f.2d at 125; srivastava, 220 f.3d at 363. 22. see, e.g., young, 240 f.3d at 376-77. 23. see, e.g., hukkanen-campbell, 274 f.3d at 1314; sinyard, 268 f.3d at 75859. for a full discussion of the assignment of income doctrine in the context of contingent fee arrangements, see gregg d. polsky, a correct analysis of the tax treatment of contingent attorney's fee arrangements: enough with the fruit and the trees, 37 ga. l. rev. 57, 78-92 (2002). 24. see kenseth, 259 f.3d at 884; coady, 213 f.3d at 1199; young, 240 f.3d at 376-78. [vol6.-9 litigation expenses and the amt in determining which method is appropriate, some courts have analyzed state attorney lien law to determine the strength of the attorney's rights and powers with respect to the attorney fee portion of the plaintiff's claim. in general, these courts evaluate the attorney lien law to determine to what extent it grants the attorney a proprietary interest in the plaintiff's cause of action.26 for example, in raymond v. united states,27 the second circuit analyzed vermont's attorney lien common law and concluded that, because vermont law provided the attorney with only a mere security interest and precluded the attorney from taking a proprietary interest in his client's claim, no transfer of any portion of the claim occurred upon execution of the fee agreement.2" as a result, the second circuit determined that the inclusion and deduction method was the proper one.29 in contrast, in cotnam v. comm 'r,3° the fifth circuit analyzed alabama's attorney lien statute and concluded that, because the statute gave attorneys "the same rights as their clients" with respect to the claim, a transfer of a portion of the claim did occur upon execution of the fee agreement." accordingly, the fifth circuit determined that the exclusion method was appropriate.32 other circuits have rejected completely the notion that the nuances of underlying attorney lien statutes have any relevance to the issue. while this group includes circuits that have adopted the inclusion-deduction method,33 it also includes circuits that have adopted the exclusion method.34 for instance, the fifth circuit in srivastava v. comm 'r followed its holding in cotnam that the contingent attorney's fee was not included in the plaintiff's gross income, refusing to distinguish the case based on the fact that the relevant attorney's lien statute in effect in texas was not quite as strong as the alabama statute at issue in cotnam.35 instead, the fifth circuit agreed with the tax court that "the 25. see, e.g., kenseth, 259 f.3d at 883-84; baylin, 43 f.3d at 1455; raymond, 355 f.3d at 117; banaitis, 340 f.3d at 1082-83. 26. for a full discussion of the attorney lien issue, see generally thad davis, cotnam v. comm'r and the income tax treatment of contingency-based attorneys' fees: the alabama attorney's charging lien meets lucas v. earl head-on, 51 ala. l. rev. 1683 (2000). 27. 355 f.3d 107 (2d cir. 2004). 28. id. at 117. 29. id. 30. 263 f.2d 119 (5th cir. 1959). 31. id. at 125. 32. id. at 126. 33. see alexander, 72 f.3d at 942-43; o'brien v. comm'r, 38 t.c. 707, 712; young, 240 f.3d at 372; hukkanen-campbell, 274 f.3d at 1314. 34. srivastava, 220 f.3d at 355; banks, 345 f.3d at 386. 35. srivastava, 220 f.3d at 363-64. 2004] florida tax review answer does not depend on the intricacies of an attorney's bundle of rights against the opposing party under the law of the governing state.3 6 2. critical analysis of the circuit court decisions a. critique of the minority view the minority view, which follows the exclusion method based on the characterization of the contingent fee agreement as resulting in an immediate transfer of a portion of the plaintiff's claim, can be criticized on two grounds. first, it is questionable whether a contingent fee agreement should be considered to result in an immediate transfer of a portion of the plaintiff s claim for tax purposes. second, even assuming such a transfer is deemed to occur, it would appear that a proper application of the tax law still requires the inclusion and deduction method. the minority view holds that, when the fee agreement is executed, an immediate transfer occurs.37 under this characterization, the plaintiff and the attorney emerge from the execution of the fee agreement as co-owners of the claim, with the relative ownership of the claim determined by the percentage contingency fee charged by the attorney. however, it may be more accurate to characterize the contingent fee agreement as a mere promise on the part of the plaintiff to pay to the attorney a contingent amount of money upon final disposition of the claim. under this "mere promise to pay" characterization, upon final disposition the plaintiff will be required to include the entire recovery in gross income (leaving her with a deduction for the fees paid), regardless of whether the parties arrange for the defendant to pay the contingent fee directly to the attorney.38 the issue of whether the fee agreement results in an immediate transfer or, alternatively, is a mere promise to pay, depends on which party is treated as the owner of the attorney fee portion of the claim for tax purposes.39 in determining ownership of an asset, courts have analyzed the "incidents of ownership" to determine which party is, in substance, the owner.40 with respect to the attorney fee portion of the claim, the incidents of ownership are divided. while the attorney would receive the benefit of future appreciation in the value 36. id. at 364. 37. see irc § 83 (property transferred in exchange for services). 38. see old colony trust co. v. comm'r, 279 u.s. 716, at 729-30 (holding that payment of another person's debt constitutes gross income to the debtor). see also polsky, supra note 23, at 93-94. 39. see treas. reg. § 1.83-3(a) (providing that transfer of property occurs when taxpayer "acquires a beneficial ownership interest in such property"). 40. see grodt & mckay realty, inc. v. comm'r, 77 t.c. 1221, 1237 (1981) (analyzing facts and circumstances to determine whether transfer of property occurred for tax purposes). [vol. 6:9 litigation expenses and the amt of his portion of the claim and would bear the risk of loss if such value diminished, the client retains the sole and unrestricted power to make the critical decisions with respect to the entire claim, such as the all-important decision of whether, when, and for how much to settle the claim.4 because of this division of the incidents of ownership, it is not entirely clear whether the fee agreement should be treated as resulting in an immediate transfer of the attorney fee portion of the claim. yet even if the fee agreement can be characterized as effecting an immediate transfer of the attorney fee portion of the claim to the attorney, such characterization would still produce the same results as the inclusion and deduction method. this is so because the transfer by the plaintiff to the attorney of the attorney fee portion of the claim (which has a zero basis in the hands of the plaintiff) in exchange for the attorney's provision of services is one that has tax consequences for the plaintiff. courts in the minority have repeatedly ignored these consequences, concluding without any analysis that, once it is determined that the fee agreement results in an immediate transfer, the plaintiff is required to include only the net recovery in gross income.42 what these courts have failed to recognize, however, is that because the attorney fee portion of the claim is transferred in connection with the provision of services, section 83 governs the tax consequences of the transfer. furthermore, because the attorney's interest in the cause of action is subject to a substantial risk of forfeiture in that the attorney is not entitled to his contingency fee unless he provides services until the claim is liquidated, the tax consequences of the transfer of the attorney portion of the cause of action are held in abeyance until the risk of forfeiture on the attorney's interest in the claim lapses (i.e., upon liquidation of the claim). at that point, the plaintiff realizes gain on the disposition of the attorney portion of the cause of action equal to the contingent fee.43 combining this gain with the recovery on the portion of the claim retained by the plaintiff after execution of the fee agreement leaves the plaintiff with gross income equal to the full recovery. to round matters out, the 41. see polsky, supra note 23, at 104. 42. see polsky, supra note 23 at 75-76; see also brief for amici curiae professor gregg d. polsky and professor brant j. hellwig in support of petitioner, at 14-15, comm'r v. banks, u.s. supreme court docket no. 03-892 (filed june 11,2004) [hereinafter polsky & hellwig brief]. 43. see treas. reg. § 1.83-6(b) (providing that, when property is transferred in exchange for services, the property transferor realizes gain or loss as if the property was sold for its fair market value). for a detailed discussion of the tax consequences for the plaintiff resulting from a hypothetical transfer of the attorney-fee portion of the claim to the attorney, see polsky, supra note 23, at 108-111; polsky & hellwig brief, supra note 42, at 7-13. 2004.] florida tax review plaintiff is entitled to deduct the value of the portion of the claim transferred to the attorney when the attorney's interest in the cause of action becomes vested.' in summary, the cases adopting the minority view strain to characterize the fee agreement as more than a mere promise to pay without realizing that their attempt to achieve the right policy result on this basis should ultimately be futile. once section 83 is appropriately applied to the purported transfer of the attorney fee portion of the claim that occurs upon execution of the fee agreement, the resulting tax consequences are the same as those obtained under the inclusion-deduction method.45 the failure of the courts adopting the exclusion method to fully appreciate or so much as acknowledge the tax consequences of the transfer of the portion of the claim from plaintiff to attorney is a critical error, as it directly affects the outcome in those cases. b. critique of the majority view the cases that hold that the inclusion and deduction method is required achieve the correct doctrinal result, but, in many cases, their analysis is flawed because they inappropriately apply the assignment of income doctrine. the assignment of income argument usually goes as follows: to the extent that the contingent fee agreement operates to cause an immediate transfer of anything, it transfers only the right to the proceeds of the attorney fee portion of the claim and not the attorney fee portion of the claim itself.46 such a transfer is wholly ineffective for tax purposes because such a transfer is a transfer of "income" rather than a transfer of "property" for assignment of income purposes.47 using the familiar lucas v. earl metaphors,48 because the agreement transfers fruit and not tree, the transfer is ignored. as a result, the plaintiff is treated as receiving 44. irc § 83(h). however, the deduction remains miscellaneous itemized deduction, subject to the various limitations that accompany this characterization. see irc §§ 56(b)(1)(a); 67(a); 68(a). 45. see polsky, supra note 23, at 108-111; see also polsky & hellwig brief, supra note 42, at 12-13. 46. hukkanen-campbell v. comm'r, 274 f.3d 1312, 1314 (10th cir. 2001); sinyard v. comm'r, 268 f.3d 756, 758-59 (9th cir. 2001); kenseth v. comm'r, 259 f.3d 881, 883-84 (7th cir. 2001); young v. comm'r, 240 f.3d 369, 376-78 (4th cir. 2001); benci-woodward v. comm'r, 219 f.3d 941, 943 (9th cir. 2000); coady v. comm'r, 213 f.3d 1187, 1190 (9th cir. 2000); 121 f.3d 393, 395-96 (8th cir. 1997); alexander v. i.r.s., 72 f.3d 938, 942-43 (1st cir. 1995); baylin v. united states, 43 f.3d 1451, 1454-55 (fed. cir. 1995); o'brien v. comm'r, 319 f.2d 532, 532 (3d cir. 1963). 47. kenseth, 259 f.3d at 884. 48. 281 u.s. 111, 115 (1930) (using fruit and tree metaphor). [vol 6:9 litigation expenses and the amt the entire settlement amount and then transferring the attorney fee portion to the attorney.49 the flaw in this analysis is that the court-developed assignment of income doctrine does not apply to arm's-length commercial transactions, such as contingent fee arrangements.5" the purpose of the doctrine is to prevent manipulation of the progressive rate structure through the gratuitous deflection of pre-tax dollars to members of a taxpayer's bounty.51 this, of course, is not what is taking place when clients hire attorneys on a contingent fee basis. because of the inapplicability of the assignment of income doctrine, it is completely irrelevant whether the "thing" that is purportedly transferred upon execution of the fee agreement is tree (a portion of the claim itself) or fruit (a right to the proceeds of a portion of the claim) for assignment of income purposes.52 from a practical perspective, it does matter whether the fee agreement is treated as causing an immediate transfer of something (either a portion of the claim or a right to proceeds from such portion) or, alternatively, is treated as a mere promise to pay.53 this determination is academic because, though it affects the mode of analysis, the outcome should be the same in that the plaintiff must include the entire settlement amount in gross income.54 c. the (ir)relevance of state attorney lien law courts in both the minority and majority camps have sometimes scrutinized underlying state attorney lien law in determining whether the contingent fee agreement should be construed to result in an immediate transfer 49. see kenseth, 259 f.3d at 884; young, 240 f.3d at 376-78; coady, 213 f.3d at 1187. 50. see michael asimow, applying the assignment of income principle correctly, 54 tax notes 607, 608 (1992) ("[the] [a]ssignment of income [doctrine] is an indispensable weapon to protect progressivity and to attack tax avoidance schemes. it should not be used to overturn economically rational, nontax avoidance contractual arrangements."); ronald h. jensen, schneer v. comm'r: continuing confusion over the assignment of income doctrine and personal service income, 1 fla. tax rev. 623, 633 (1993) ("[a]ll the [seminal assignment of income] cases . . . involved gratuitous assignments of income."); elliot manning, the service corporation who is taxable on its income: reconciling assignment of income principles, section 482, and section 351, 37 u. miami l. rev. 657, 668-69 (1983). 51. see jensen, supra note 50, at 632 ("the essence ofthe assignment of income doctrine [is]... the concern that the progressive tax rate schedule not be subverted by permitting income to be artificially split among formally separate taxpayers who in fact constitute a single economic unit"). 52. see polsky, supra note 23, at 88-92 ("in an assignment for value case, it does not matter whether the taxpayer transfers fruit or tree"). 53. see supra notes 37-45 and accompanying text. 54. see supra notes 42-45 and accompanying text. 20041 florida tax review of the attorney fee portion of the claim.55 this reliance on state attorney lien law appears misplaced. it is true that, in determining ownership of an asset (in these cases, the attorney fee portion of the claim), it is necessary to analyze the incidents of ownership.56 it is also true that state law is critically important to this analysis, because state law governs the property rights of its residents. in this analysis, however, the incidents of ownership that are important are those that exist in substance and not merely in form. the distinctions among various states' attorney lien statutes lack substantive impact. as the fifth circuit has noted, "the discrepanc[ies in state attorney lien law] do[] not meaningfully affect the economic reality facing the taxpayer-plaintiff.,57 in other words, although there are slightly different nuances in each state's exposition of its attorney lien law, these differences are not meaningful in that, as a practical matter, all attorney lien laws operate in the same way.58 resting a federal tax determination on the basis of these formalistic differences would appear to violate the fundamental notion that tax consequences depend on the substance rather than the form of the transaction. d. the upcoming supreme court cases on march 29, 2004, the united states supreme court granted certiorari on two contingent attorney fee cases, both of which involved circuit decisions that applied the exclusion method.59 in one of the cases, banaitis v. comm 'r, the ninth circuit relied on "the unique features of oregon law" governing attorney liens in reaching its conclusion,60 while in the other case, banks v. comm 'r, the sixth circuit disclaimed the relevance of attorney lien law.6 in deciding these cases, the court has three options. first, it could hold that, regardless of nuances in state attorney lien law, the inclusion and deduction method is required in all cases.62 second, it could hold that, regardless of these 55. see supra notes 25-36 and accompanying text. 56. see supra notes 39-40 and accompanying text. 57. srivastava v. comm'r, 220 f.3d 353, 364 (5th cir. 2000) (emphasis in original). 58. see young v. comm'r, 240 f.3d 369, 378 (4th cir. 2001) (noting that courts relying on state attorney lien law have reached different conclusions even though there was no "relevant distinction" between the state law analyzed). 59. comm'r v. banks, 124 s. ct. 1712 (2004); comm'r v. banaitis, 124 s.ct. 1713 (2004). 60. 340 f.3d 1074, 1082-83 (9th cir. 2003). 61. 345 f.3d 373, 386 (6th cir. 2003). 62. see, e.g., alexanderv. i.r.s., 72 f.3d 938, 942-43 (lst cir. 1995); young v. comm'r, 240 f.3d 369, 372 (4th cir. 2001); hukkanen-campbell v. comm'r, 274 f.3d 1312, 1314 (10th cir. 2001). [vol6:9 litigation expenses and the amt nuances, the exclusion method is required in all cases.63 finally, it could hold that the appropriate method depends on the particulars of the relevant state attorney lien law.' we believe that the state-by-state approach is the least likely outcome. as explained above, the approach is inconsistent with tax law's focus on the substance rather than form.65 in addition, "[g]iven the various distinctions among attorney's lien laws among the fifty states, such a[n] ... approach would not provide reliable precedent.. . or provide sufficient notice to taxpayers.' '66 as a result, the state-by-state approach would lead only to more confusion and litigation regarding the question of whether a particular state's lien law contains the "magic language" to achieve the taxpayer's desired result. in addition, such an approach would likely stimulate the states to race to amend their attorney lien laws in an attempt to add the magic, though substantively meaningless, language. 67 thus, we believe that the court will announce a "national" rule that is completely independent of the various nuances of state attorney lien law. as previously discussed, it would appear that, as a doctrinal matter, the inclusion and deduction method is required regardless of whether one concludes that the execution of the fee agreement results in an immediate transfer of the attorney fee portion of the claim.68 if there is such an immediate transfer, however, the analysis is significantly more complicated, and it has not been addressed in the 63. see, e.g., banks, 345 f.3d at 386; srivastava v. comm'r, 220 f.3d 353,355 (5th cir. 2000). 64. see, e.g., raymond v. comm'r, 319 f.2d 532, 532 (2d cir. 2004) (concluding that inclusion/deduction method applies after analyzing vermont attorney lien law); banaitis, 340 f.3d at 1082-83 (9th cir. 2003) (concluding that exclusion method applies after analyzing oregon attorney lien law). 65. see supra notes 55-58 and accompanying text. 66. banks, 345 f.3d at 385. see also hukkanen-campbell v. comm'r, 274 f.3d 1312, 1314 (10th cir. 2001) (concluding that a "universal standard independent of' formalistic difference in state attorney lien law would be desirable). 67. see, e.g., washington senate bill report sb 6270 (as reported by senate committee on: judiciary, january 22, 2004) at http://www.leg.wa.gov/pub/billinfo/2003-04/senate/6250-6274/6270_sbr.pdf (explaining a proposal to amend washington's attorney lien statute retroactively for the sole "purpose of making attorney's fees taxable solely to the attorney"). cf. patrick e. hobbs, entity classification: the one hundred-year debate, 44 cath. u. l. rev. 437, 515-17 (1995) (describing the proliferation of limited liability company (llc) statutes after the irs issued rev. rul. 88-76, 1988-2 c.b. 360, which announced that llcs would be taxed as partnerships even if they operated in all important respects like closely held corporations). 68. see supra notes 42-45 and accompanying text. 2004] florida tax review lower courts.69 for this reason, we think that the court will most likely determine that a contingent fee arrangement is a mere promise to pay on the part of the plaintiff that does not result in the present transfer of anything.7° as a result, the court would conclude that the inclusion and deduction method is required.7 this would yield the wrong policy result, which the court would rationalize by pointing out that the remedy for this result rests singularly with congress.72 e. alternative taxpayer arguments the briefs filed by the taxpayers in banks and banaitis with the supreme court, together with the various amici briefs filed on their behalf, have raised two interesting alternative arguments that, if accepted, would result in a decision in favor of the taxpayers. the first such argument contends that the contingent fee arrangement constitutes ajoint venture for tax purposes, meaning that the tax consequences resulting from the division of the litigation proceeds would be governed by the partnership provisions contained in subchapter k of the code (the "partnership argument"). the second argument contends that the fee paid to the attorney is not properly analyzed as a deduction in the first place; rather, the argument goes, the fee constitutes a transaction cost that either (a) is capitalized into the basis of the claim that reduces the amount realized when the claim is liquidated, or (b) operates as a direct offset to the amount realized upon disposition of the claim (the "transaction cost argument").73 these alternative arguments are discussed below. 69. for a complete explanation of the tax consequences under the immediate transfer view, see polsky, supra note 23, at 102-111; polsky & hellwig brief, supra note 42, at 7-13. 70. see supra notes 37-38 and accompanying text. 71. see supra notes 31-32 and accompanying text. 72. for discussion on proposed congressional remedies see part iii.a. 73. a third alternative argument was raised by professor stephen cohen in his amicus brief cohen focuses on the tax treatment of the deduction for legal fees paid in the context of employment litigation, arguing that these fees may be deducted abovethe-line as a reimbursed employee business expense under § 62(a)(2)(a). see brief for amicus curiae professor stephen b. cohen in support of respondents, comm'r v. banks, u.s. supreme court docket no. 03-892 (filed aug. 14,2004). as this argument was recently rejected by the ninth circuit in biehl v. comm 'r, 351 f.3d 982, 983 (9th cir. 2003), we will not address it in this article. for discussion of the biehl case, see stephen b. cohen & laura sager, final(?) thoughts on the biehl decision, 99 tax notes 133 (apr. 7,2003); stephen b. cohen & laura sager, "judicial activism" should not prolong the attorney's fee problem, 98 tax notes 377 (jan. 20, 2003); brant j. hellwig, additional thoughts on the biehl decision, 98 tax notes 1417 (mar. 3,2003); brant j. hellwig, judicial activism is not the solution to the attorney's fee problem, 97 tax notes 693 (nov. 4, 2002). [vol. 6:9 litigation expenses and the amt 1. partnership argument the brief filed with the supreme court by the taxpayer in banaitis leads off with the argument that the contingent fee arrangement between a plaintiff and an attorney constitutes a joint venture that is governed by the partnership tax provisions contained in subchapter k of the code.74 seizing upon the broad definition of a joint venture that constitutes a partnership for tax purposes in section 761(a),75 banaitis argues that he and his attorney had combined their property and services in a joint effort to reduce the cause of action into a money judgment in the underlying employment litigation.7 6 the goal of invoking the provisions of subchapter k is to get to section 704(a), which would allocate the income generated by the joint venture (the $8.7 million settlement) among the partners in accordance with the terms of the partnership agreement (in this case, the contingent fee agreement). pursuant to this argument, the gross income realized by banaitis would not exceed his net recovery. even assuming that an individual's retention of an attorney on a contingent fee basis creates a partnership for tax purposes,77 the partnership theory ultimately will not produce the intended result for taxpayers. the fundamental flaw in the argument lies not in the application of section 704(a) to the proceeds of the claim, but rather in the failure to appreciate the tax consequences of the partnership formation. if the execution of the fee agreement 74. brief for respondent at 5-21, comm'r v. banaitis, u.s. supreme court docket no. 03-907 (filed aug. 12, 2004). 75. see id. at 7 (citing podell v. comm'r, 55 t.c. 429, 431 (1970), and s. & m. plumbing co. v. comm'r, 55 t.c. 702, 707 (1971), for the proposition that a joint venture within the meaning of § 761 (a) requires only the following three elements: (1) each of the participants agrees to contribute in a significant manner to the effort of the venture, such as by providing services, money or property; (2) the participants' entitlement to payments depends on the success of the venture; and (3) the amount of each participant's entitlement depends at least to some degree on the amount of income generated by the venture.) 76. id. at 9. 77. the sixth circuit has described the contingent fee arrangement in terms of a partnership or joint venture. see estate of clarks v. united states, 202 f.3d 854, 857 (6th cir. 2001) ("like an interest in a partnership agreement or joint venture, clarks contracted for services and assigned his lawyer a one-third interest in the venture in order that he might have a chance to recover the remaining two-thirds). the tax court, on the other hand, has rejected the argument that the attomey-client relationship constitutes a partnership for tax purposes. see bagley v. comm'r, 105 t.c. 396, 419 (1995) (finding that, on the record, "there is nothing to indicate that the parties intended the contingency fee arrangement to be ajoint venture or partnership"); see also kenseth v. comm'r, 144 t.c. 399, 413 (2000), aff'd, 259 f.3d 881 (7th cir. 2001) ("attorneys represent the interests of clients in a fiduciary capacity. it is difficult, in theory or fact, to convert that relationship into a joint venture or partnership."). 2004] florida tax review operates to form a partnership, then the plaintiff is deemed to have transferred a portion of the underlying partnership capital to the attorney,"8 followed by a contribution of such capital from the attorney to the partnership.79 however, because the attorney's capital interest in the partnership is subject to a substantial risk of forfeiture, section 83(a) operates to defer the tax consequences of the capital shift until the claim is liquidated and the risk of forfeiture is extinguished. under a proper application of section 83 to the formation of the partnership, the plaintiff includes the full amount of the litigation proceeds in 78. while the service has reasoned that, in certain situations, a service partner is not taxed upon receipt of a profits interest in a partnership, the attorney's interest in the partnership cannot be described as a profits interest. see rev. proc. 93-27, 1993-2 c.b. 343. rather, because the attorney is entitled to a certain portion of the entire recovery on the claim (as opposed to a percentage of the increase in value of the claim after the partnership was formed), the attorney has received an interest in the partnership capital upon formation. see id. (defining a capital interest in a partnership as one "that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership" and a profits interest as any interest in a partnership other than a capital interest). the only way that an attorney's interest in the partnership could be characterized as a profits interest is if the claim itself were devoid of value when the fee agreement was executed. that, of course, defies common sense. if the attorney concludes that the claim has no value whatsoever in other words, there is no chance of recovering on the claim then the attorney would not lend her services and advance the litigation expenses on a contingency basis. see kenseth v. comm'r, 114 t.c. 399, 413 (2000), aff'd, 259 f.3d 881 (7th cir. 2001) (noting that the taxpayer's cause of action "had value in the very beginning; otherwise, it is unlikely that [the attorney] would have agreed to represent petitioner on a contingent basis"). 79. this two-step process was outlined by the tax court in mcdougal v. comm 'r, 62 t.c. 720 (1974). in mcdougal, the taxpayer purchased a horse and hired a trainer to nurse the horse back to racing condition, promising the trainer a 50% interest in the horse once the taxpayer recovered his acquisition costs. id. at 721. after the trainer lived up to his end of the bargain, the taxpayer conveyed a 50% interest in the horse to the trainer. id. at 722. the tax court held that this transfer created a partnership among the parties, and recast the transaction into the following two-step process: (1) a transfer of a 50% interest in the horse from the taxpayer to the trainer, followed by (2) the trainer's contribution of his 50% interest in the horse to the partnership. see id. at 725. the first step resulted in the trainer realizing compensation income equal to the value of his 50% interest in the horse. from the taxpayer's perspective, the taxpayer realized a gain on the transfer of the 50% interest in the horse to the trainer. furthermore, the taxpayer was entitled to a deduction for the value of the interest in the horse transferred to the trainer, since the transfer was made in consideration of the trainer's past services. id. at 728. [vol. 6:9 litigation expenses and the amt gross income, and is left with a deduction for the contingent fee paid to the attorney. 80 in short, the theory that the contingent fee arrangement between the plaintiff and the attorney should be taxed under the partnership tax provisions of subchapter k adds nothing to the present-transfer characterization adopted by the minority of the circuit courts of appeal. ultimately, it is the same argument in slightly more elaborate garb. 2. the transaction cost argument through published articles8 and an amicus brief submitted to the supreme court in the banks and banaitis cases,82 professor charles davenport has offered a solution to the attorney fee problem that approaches the issue from a completely different angle. rather than claiming that the portion of the settlement or judgment paid to the attorney is excluded from the plaintiff's gross income based on the plaintiff's prior transfer of a fractional interest in the claim, davenport focuses on the manner in which the plaintiff accounts for the amount paid to the attorney. simply put, davenport argues that the attorney's fee is not properly recovered by way of a deduction. instead, he contends that the attorney's fee constitutes a transaction cost that reduces the plaintiff s amount realized upon liquidation of the claim. under this view, the amount paid to the attorney operates as an offset to the amount recovered on the claim, leaving the 80. for a thorough discussion of the tax consequences which result under the theory that the contingent fee arrangement constitutes a partnership for tax purposes, see gregg d. polsky, contingent fees: why the partnership theory doesn't work, 104 tax notes 1089 (sept. 6, 2004). this article stimulated a volley of letters to the editor debating the merits of the partnership theory. see john a. bogdanski, contingent fees: the partnership theory is sound, 105 tax notes 426 (oct. 18, 2004); gregg d. polsky, contingent fees: the partnership theory isn't sound, 105 tax notes 612 (oct. 25, 2004); douglas kahn, partnership theory won't help taxpayers in contingent attorney fee cases, 105 tax notes 885 (nov. 8, 2004); john a. bogdanski, beating a dead horse with a surrebuttal, 105 tax notes 887 (nov. 8, 2004); john a. bogdanski, tax treatment of contingent attorney fees: the battle rages on, 105 tax notes 1046 (nov. 15, 2004); douglass a. kahn, thoughts on the partnership theory in contingent fee cases, 105 tax notes 1289 (nov. 29, 2004). 81. charles davenport, capitalization of legal fees: professor davenport responds, 97 tax notes 1237 (dec. 2, 2002); charles davenport, why tort legal fees are not deductible, 97 tax notes 703 (nov. 4, 2002); see also deborah a. geier, attorney's fees: davenport has the right idea, 97 tax notes 1627 (dec. 23, 2002) (supporting professor davenport's argument). 82. brief for amicus curiae professor charles davenport in support of respondents, comm'r v. banks, u.s. supreme court docket no. 03-892 (filed aug. 18, 2004) [hereinafter davenport brief]. see also brief for amicus curiae association of trial lawyers of america at 23-30, comm'r v. banks, u.s. supreme court docket no. 03-892 (filed aug. 18, 2004) (supporting davenport's argument). 2004] florida tax review plaintiff with gross income of only the net proceeds. because the attorney's fee would not be recovered through a deduction, it would not fall prey to the various limitations on miscellaneous itemized deductions. to further elaborate on davenport's argument, he argues that the amount paid to the attorney can be conceptualized in one of two alternative ways.3 first, the attorney's fee can be viewed as a cost paid to acquire or to prove title to the cause of action. under this approach, the fee is capitalized into the basis of the cause of action, in the same manner that an expenditure paid to acquire or to perfect title to a parcel of real property is added to the property's basis.' alternatively, the attorney's fee can be viewed as a cost of disposing of the cause of action, similar to a fee paid to a broker to facilitate the sale of real property." davenport has no particular preference for either of the abovedescribed characterizations,86 nor does there exist any particular reason for him to take a stand. under either theory, the plaintiff's amount realized upon liquidation of the claim is offset by the amount paid to the attorney in measuring gross income.87 at first glance, davenport's transaction cost argument is quite appealing. it achieves a proper matching of income with its associated cost from a timing perspective. furthermore, it achieves the desired equitable tax treatment of plaintiffs who pursue successful litigation through a contingency fee arrangement with the attorneys. while the transaction cost argument may well be the conceptually proper approach to determining the tax treatment of 83. see davenport brief, supra note 82, at 8 ("the legal fees in the cases at bar are either acquisition costs, dispositions costs, or both."). 84. see treas. reg. § 1.263(a)-2(a), (c). 85. see treas. reg. § 1.263(a)-2(e) (treating the commissions paid in selling securities as a reduction of the taxpayer's amount realized on the transaction). on this front, davenport places much emphasis on baylin v. united states, 43 f.3d 1451 (fed. cir. 1995). in baylin, the state condemned the taxpayer's real property. the taxpayer sued to contest the condemnation award, and recovered additional sums. id. at 1452-53. the legal fees were treated as a disposition cost added to the taxpayer's basis in the condemned property, reducing the taxpayer's gain on the involuntary sale. id. at 1453. the result in baylin is rather unremarkable, given that the litigation related to the disposition of the taxpayer's real property. 86. see davenport brief, supra note 82, at 8 ("the legal fees in the cases are bar are either acquisition costs, dispositions costs, or both.") 87. see woodward v. comm'r, 397 u.s. 572, 575 (1970) ("it has long been recognized, as a general matter, that costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures."). as davenport notes, the service has proven inconsistent on the issue of whether a disposition cost is first added to basis that is subtracted from amount realized in determining gain, or whether the disposition cost constitutes a reduction to amount realized directly. see davenport brief, supra note 82, at 6 n. 14. however, there exists no practical difference between the two approaches. [vol. 6:9 litigation expenses and the amt legal fees, it has one fundamental flaw. the argument requires that a legal claim entitling the holder to a payment of gross income be treated as a separate item of property for capitalization purposes.88 as explained below, this approach runs counter to the long-standing tax treatment of legal fees. starting with the code, two deduction-authorizing provisions are implicated in litigation aimed at recovering a payment of income: section 162 and section 212. if the suit relates to the plaintiffs trade or business of providing services as an employee (including, in particular, a wrongful termination suit), the relevant statute is section 162(a).89 if the claim does not relate to a trade or business of the plaintiff, then the relevant statute is section 212(1). given that section 162(a) authorizes a deduction for all "ordinary and necessary expenses paid or incurred in carrying on any trade or business" while section 212(1) authorizes a deduction for all "ordinary and necessary expenses paid or incurred . . . for the production or collection of income," a common question arises under both provisions: do legal fees constitute ordinary expenses that give rise to an immediate deduction,9" or do they constitute capital expenditures subject to section 263(a)?9 nothing in the text of the statutes resolves this issue definitively. while the statutes may be unclear as to whether legal fees paid in the prosecution of a cause of action to recover a payment of income give rise to a deduction, the regulations under section 212(1) provide direct guidance on the matter. treasury regulation section 1.212-1(k) does so by distinguishing 88. see davenport brief, supra note 82, at 5 ("once the taxpayers' tort claims are properly characterized as property, an entire new vista for tax treatment opens up."); see also id. at 5 n. 12 ("logically, there is little reason to limit the doctrine of capitalization of transaction costs to property. rather, a properly defined transaction would be the limitation, but amicus does not in this brief argue for application of the doctrine beyond an item properly characterized as property."). 89. see mckay v. comm'r, 102 t.c. 465, 489 (1994) (fees in wrongful termination suit deductible under § 162(a)), vacated and remanded on another issue, 84 f.3d 433 (5th cir. 1996); alexander v. comm'r, t.c. memo. 1995-51, 69 t.c.m. (cch) 1792, 1794. 90. in comm 'r v. tellier, 383 u.s. 687 (1966), the supreme court explained that the purpose of the term "ordinary" in § 162(a) is "to clarify the distinction, often difficult, between those expenses that are currently deductible and those that are in the nature of capital expenditures, which, if deductible at all, must be amortized over the useful life of the asset." id. at 689-90. apart from the requirement of being incurred in a trade or business, the deductions authorized by § 212 are "subject ... to all the restrictions and limitations that apply in the case of a deduction under [§ 162(a)] of an expense paid or incurred in carrying on any trade or business." h.r. rept. no. 77-2333, at 57 (1942), reprinted in 1942-2 c.b. 372, 430. 91. both § 162(a) and § 212(1) are subject to the capitalization rules of § 263. see irc §§ 161, 261; see also indopco, inc. v. comm'r, 503 u.s. 79, 84 (1992) (noting that "[d]eductions are specifically enumerated and thus are subject to disallowance in favor of capitalization."). 2004] florida tax review between legal fees that must be capitalized into the basis of property and those that are currently deductible. the regulation provides as follows: expenses paid or incurred in defending or perfecting title to property, in recovering property (other than investment property and amounts of income which, if and when recovered, must be included in gross income), or in developing or improving property, constitute a part of the cost of the property and are not deductible expenses. attorneys' fees paid in a suit to quiet title to lands are not deductible; but if the suit is also to collect accrued rents thereon, that portion of such fees is deductible which is properly allocable to the services rendered in collecting such rents.92 this regulation makes clear that legal expenses incurred in recovering amounts that must be included in gross income are to be recovered, for tax purposes, by way of a deduction. focusing on the example provided in the regulation, the legal expenses paid in establishing entitlement to and collecting the accrued rent would constitute transactions costs within davenport's theory, as they are directly traceable to the payment of income. thus, under davenport's argument, none of the legal expenses in the example would be deductible; rather, all expenses would be capitalized. in short, davenport's argument runs directly counter to the authority provided in treasury regulation section 1.212-1 (k). while treasury regulation section 1.212-1(k) does not have a counterpart under the regulations interpreting section 162(a), the regulation is consistent with the origin-of-the-claim doctrine articulated by the supreme court in determining whether business related legal expenses constitute deductible expenses under section 162 or capital expenditures under section 263. in the back-to-back cases of woodward v. comm 'r and united states v. hilton hotels,94 the supreme court explained that the tax treatment of legal fees was determined by looking to the origin of the litigated claim. if the litigation concerns the acquisition of property or the defense of title to property, the legal fees must be capitalized; if the litigation concerns the establishment or the defense of entitlement to a payment of income, the legal fees are deductible.95 92. treas. reg. § 1.212-1(k). 93. 397 u.s. 572 (1970). 94. 397 u.s. 580 (1970). 95. see, e.g., leonard v. comm'r, 94 f.3d 523, 526 (9th cir. 1996) (litigation expenses attributable to obtaining pre-judgment interest deductible); mckeague v. u.s., 12 cl. ct. 671, 676-77 (1987) (legal fees incurred to recover lost dividends and lost wages deductible); southland royalty co. v. u.s., 582 f.2d 604, 609-12 (ct. cl. 1978) (litigation costs to determine amount of royalty payments owed under existing lease deductible); boagni v. comm'r, 59 t.c. 708, 714-15 (1973) (litigation costs incurred to establish right to interpleaded royalty payment deductible). [vol. 6:9 litigation expenses and the amt thus, the thrust of the origin-of-the-claim doctrine is that a claim or a cause of action is not itself a separate item of property having a basis into which associated legal costs must be capitalized.96 rather, as its name suggests, the doctrine requires that one look through the claim to the nature of the damages sought in order to determine the tax treatment of the litigation expenses. accordingly, a cause of action entitling the plaintiff to a taxable damages recovery is not properly viewed as property for purposes of determining the tax treatment of legal fees.97 the issue of whether the resolution of a cause of action entitling the plaintiff to a payment of gross income should be treated as a disposition of property was addressed by the first circuit in alexander v. ir.s.98 in alexander, the taxpayer-plaintiff argued that the legal fees paid in the course of 96. the potential of the recently finalized "indopco" regulations under § 263 to change this result is noteworthy. the regulations provide in relevant part that "[a]n amount paid to create or enhance a separate and distinct intangible asset" must be capitalized. treas. reg. § 1.263(a)-4(b)(1)(iii). for this purpose, a "separate and distinct intangible asset" is defined as a property interest of ascertainable and measurable value in money or money's worth that is subject to protection under applicable state, federal, or foreign law and the possession and control of which is intrinsically capable of being sold, transferred, or pledged (ignoring any restrictions imposed on assignability) separate and apart from a trade or business. treas. reg. § 1.263(a)-4(b)(3)(i). whether a legal claim to a payment of income satisfies this definition is questionable. the regulation appears to refer to an item of property that is subject to protection under the law, while a cause of action itself embodies that legal protection. in any event, the indopco regulations were widely viewed as increasing the range of expenditures that could be deducted as opposed to being capitalized. in that light, it is doubtful that the regulation would be read in this context as changing the status quo from deduction to capitalization. see ethan yale, the final indopco regulations, 105 tax notes 435, 450-51 (oct. 25, 2004). 97. this is not to say, however, that causes of action do not constitute property for other purposes; quite clearly, a cause of action constitutes property for state law purposes. in this regard, davenport questions how we reconcile our conclusion that a cause of action constitutes property within the meaning of § 83 with our position that a cause of action should not be treated as a separate item of property for capitalization or disposition purposes. the explanation, however, is simple enough. the regulations under § 83 define property for purposes of that statute broadly to include all "real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future." treas. reg. § 1.83-3(c). because a cause of action clearly constitutes an item of personal property that is something other than a promise to pay in the future, then the transfer of a cause of action in consideration for services is governed by § 83. however, treating a cause of action for a payment of gross income as a separate item of property for capitalization and disposition purposes is inconsistent with the origin-of-the-claim doctrine. 98. 72 f.3d 938 (1st cir. 1995). 2004] florida tax review employment litigation were a cost of disposing of the taxpayer's "valuable intangible assets" (the taxpayer's contract rights and the resulting legal claim) and, as a result, that the fees should offset the amount realized upon the disposition of such property.9 thus, the taxpayer's argument was similar, if not identical, to davenport's transaction cost argument. the first circuit rejected it as follows: [w]hether taxpayer's employment contracts are "property" or "intangible assets" in the abstract is irrelevant to the proper analysis of the characterization of the settlement proceeds and, thus, the property tax treatment of the legal fee.... [h]ere, assuming the settlement was a "cancellation" of taxpayer's contractual rights, what taxpayer fought for, and received, is merely a substitute payment for the compensation and retirement benefits due him under his express and implied employment contracts. because his salary and benefits would have been taxed as ordinary income without any offsetting basis if received in the ordinary course under taxpayer's employment contract, the "substitute" payments can be treated no differently.'00 the first circuit, through the following footnote, elaborated on why the taxpayer's legal fees did not give rise to a basis that could offset the proceeds of the litigation: one might intuitively argue that some sort of "basis" should be recognized when one has to litigate to receive one's due compensation. the fact remains, however, that the code simply does not provide for the offsetting of basis in such circumstances except in limited cases involving capital assets. instead, the code permits litigation expenses to be taken into account by way of deduction.' 99. id. at 941-42. 100. id. at 942-43 (citations omitted). in this portion of the opinion, the first circuit analogized the case to the facts before the supreme court in hort v. comm 'r, 313 u.s. 28 (1941), finding the hort decision to be "particularly instructive." id. at 942. 101. id. at 943 n.9. of course, there exists a technical flaw in the first circuit's explanation. a basis offset is appropriate when there is a disposition of property for tax purposes, whether that the character of the property is capital or ordinary. however, a basis offset is not appropriate when the asset being disposed of constitutes nothing more than a legal right to a payment of gross income. [vol. 6:9 litigation expenses and the amt in this manner, the first circuit applied the origin-of-the claim doctrine to conclude that the taxpayer's legal fees were to be recovered only by way of a deduction. for much of the same reason the first circuit rejected the transaction cost argument in alexander, we believe the united states supreme court should do the same in the banks and banaitis cases pending before it. although davenport's transaction cost argument is sound from a policy standpoint and, as applied in this context, would produce the equitable result, there simply exists too much established doctrine standing in its way. of course, doctrine should not be exalted for its own sake. if the court wanted to jettison the origin-of-theclaim doctrine in favor of a more thoughtful approach to the taxation of legal fees, then so be it.l0 2 but accepting the transaction cost argument would not only entail overturning court-made doctrine, it would also require either ignoring or marginalizing treasury regulation section 1.212-1 (k). furthermore, accepting the transaction cost argument would override settled expectations of those taxpayers who pay their business-related litigation costs by the hour.103 in our view, taking such drastic measures in order to correct congress' failure to afford above-the-line status to all deductible legal fees would be improper. 102. if that were to occur, a loss for the government on the transaction cost argument in the contingent-fee cases would lead to much larger revenue gains in the context of everyday business litigation. furthermore, such an approach would generate additional complexity to the tax treatment of legal fees. suppose a business brought a lawsuit seeking business damages based on improper use of its intellectual property, and that the defendant in the lawsuit responded with a counterclaim seeking economic damages. now, in addition to determining what portion of the legal fees must be capitalized as a cost of establishing title to the intellectual property and what portion of the legal fees must be capitalized as transaction costs in recovering the income payments, the analysis would necessitate an additional allocation to a third category: costs of defending the counterclaim (which presumably would be immediately deductible under § 162(a)). 103. see joseph m. dodge, j. clifton fleming, jr., & deborah a. geier, federal income tax: doctrine, structure, and policy 576 (3d ed. 2004): the irs has never taken this position [the transaction cost approach] with respect to attorney litigation fees, and you can bet that the business bar would vociferously oppose this treatment, since it would require attorneys fees incurred by plaintiffs in connection with multiyear business litigation to be capitalized and offset against the eventual recovery, or deducted as a "loss" at the time the litigation is unsuccessful, instead of being deducted when incurred by the taxpayer. 2004] florida tax review ii. impact of the amt trap the most obvious victims of the amt trap are the plaintiffs, whose taxes go up, often very substantially. importantly, the trap may affect not only "actual" plaintiffs, but also prospective plaintiffs who, because of the trap and its effect on their potential after-tax payoffs, decline to bring suits that they otherwise would prosecute. "04 negative fallout from the trap, however, is not limited to plaintiffs. this part describes how the trap may also significantly affect plaintiffs' lawyers, defendants, and courts. a. plaintiffs'lawyers the amt trap may drive a significant wedge between the interests of a plaintiff and her lawyer at various critical junctures during a lawsuit."5 ordinarily, it would be in the best interests of both the plaintiff and the lawyer to increase the pre-tax recovery because both the plaintiff and the attorney would end up with greater cash. because of the amt trap, however, this would not always be the case. perhaps the classic example involves a lawsuit filed under a statute that provides for fee-shifting, such as title vii.l" 6 such a statute allows a prevailing plaintiff to petition the court to award her reasonable attorney's fees. when a claim is filed under such a fee-shifting statute, the contingent fee agreement usually provides that the attorney will receive the greater of (a) some percentage of the overall recovery (possibly including court-awarded fees) or (b) the amount of court-awarded fees. in some cases where the attorney's fee would otherwise be determined under (b), because of the amt trap, it may actually be in the plaintiffs best interests to not petition for fees. 7 in contrast, it would obviously be in the attorney's best interests for the plaintiff to file the petition, as it would increase his fees. because of this conflict, the aba model rules would require the attorney to advise the client of this conflict and to obtain informed consent prior 104. see sager & cohen, supra note 7, at 1078 (arguing that excessively taxing discrimination plaintiffs "undermines the national policy of encouraging the pursuit of meritorious civil rights claims"). 105. for a complete discussion of these conflicts of interests, as well as other ethical issues raised by the amt trap, see generally gregg d. polsky, the contingent attorney's fee tax trap: ethical, fiduciary duty, and malpractice implications, 23 va. tax rev. 615 (2004). 106. see 42 u.s.c. § 2000(e)-5(k) (providing that prevailing plaintiff in civil rights litigation under title vii is eligible to receive reasonable attorney's fees). 107. see polsky, supra note 105, at 625-26 (explaining why the petition for fees may actually leave plaintiff with less after-tax dollars than if no petition is made). [vol. 6:9 litigation expenses and the amt to the petitioning for fees."8 since a well-advised client might refuse to petition for fees without some assurances that she will not be in a worse economic position after the petition, the attorney might be forced to restructure the fee agreement so as to ensure that the plaintiff receives as many after-tax dollars as she would have received had she not petitioned for fees. since such a restructuring takes money away from the lawyer and gives it to the government, the amt trap would now adversely affect the attorney.09 b. the defendant 1. widening the settlement gap by reducing the after-tax payoff to the plaintiff, while keeping the defendant's outlay constant, the amt trap could become a substantial impediment to settlement in certain cases. as a result, the amt trap would burden defendants as well as plaintiffs. for example, leaving aside the amt trap for now, assume that, a plaintiff would be willing to settle a case for $100,000 pre-tax dollars, which, assuming a 40% tax rate, would leave her with $60,000. the defendant on the other hand is willing to settle the case for $80,000 pre-tax dollars. in such a case, the settlement gap is $20,000 pre-tax dollars the difference between what the plaintiff is willing to accept and what the defendant is willing to pay. now assume that, because of the amt trap, the plaintiffts effective tax rate on her recovery is 60%. in order for the plaintiff to recover the same $60,000 after-tax, the settlement amount would have to equal $150,000. as a result, the settlement gap has widened from $20,000 to $70,000, significantly decreasing the likelihood of settlement."' 108. model rules of prof i conduct r. 1.7(b) (2003) (providing that certain conflicts of interest may be waived by the client through informed consent); model rules of prof 1 conduct r. 1.0(e) (defining "informed consent" as consent "after the lawyer has communicated adequate information and explanation about the material risks of and reasonably available alternatives to the proposed course of conduct"). 109. see also polsky, supra note 105, at 624 (describing other conflicts that may arise during litigation as a result of the amt trap). 110. the increase in the settlement gap caused by the disallowance of a deduction for attorney's fees under the amt was noted by the association of trial lawyers of america (atla) in its amicus brief. atla described the effect of the tax treatment of legal fees under the amt as follows: [a]s many trial lawyers can attest, the include-deduct tax treatment of attorney fees introduces additional complexity, uncertainty, and expense into settlement negotiations. counsel must undertake a thorough review of the tax impact that fees may have on the client and adjust settlement demands upward to avoid an unanticipated and 2004] florida tax review 2. gross ups the discussion in this part thus far has assumed that the increased tax liability resulting from the amt trap could not be shifted from the plaintiff to the defendant through an augmented or "grossed up" award of damages. several recent cases, however, have suggested that a gross up to the damages recovery may in fact be appropriate. if so, defendants will be the most direct victims of the amt trap. the leading gross up case is the recent washington supreme court case of blaney v. int 'l ass 'n of machinists & aerospace workers, dist. no. 160, "i which dealt with washington's law against discrimination (wlad). in blaney, the plaintiff received an award of $638,764 for wages and benefits lost as a result of unlawful discrimination and an additional award of $237,625 for her attorney's fees and costs.1 12 the plaintiff then sought a gross up of $244,753 to offset the additional federal income tax liability that she incurred as a result of the lawsuit." 3 although the opinion is not entirely clear regarding how this gross up was computed or what exactly gave rise to the adverse tax consequences, it appears that the amt trap caused the plaintiff to be taxed more heavily on her lost wages and benefits than if the unlawful discrimination had not occurred and the wages and benefits been earned in due course. " 4 it was this excess tax burden for which the plaintiff requested relief. ' in analyzing the issue, the court first noted that wlad was intended to incorporate the remedial provisions of federal title v11.1'6 the court then cited two federal cases supporting the view that gross ups were appropriate under title vii to offset the adverse tax consequences caused by the bunching of multiple years' wages into a single taxable year.' as a result, the court concluded that gross ups under wlad were permissible: unjust outcome. defendants, as a result, may expect to face more difficult and expensive settlements. amicus curiae brief of the ass'n of trial lawyers of america at 16, comm'r v. banks, u.s. supreme court docket no. 03-892 (filed aug. 18, 2004). 111.87 p.3d 757 (wash. 2004). 112. id. at 759-60. 113. id. at 760. 114. id. at 760, n.2. 115. id. at 761-62. 116. id. at 763. 117. id. the two cases cited in blaney supporting the use of gross ups to offset adverse consequences are sears v. atchison, topeka & santa fe ry. co., 749 f2.d 1451, 1456 (10th cir. 1984) and eeoc v. joe's stone crab, inc., 15 f. supp. 2d 1364, 1380 (s.d. fla. 1998). [vol6:9 litigation expenses and the amt because wlad incorporates remedies authorized by the federal civil rights act and that statute has been interpreted to provide the equitable remedy of offsetting additional federal income tax consequences of damage awards, we hold that wlad allows offsets for additional federal income tax consequences."8 a new jersey state trial court reached a similar conclusion under new jersey's laws against discrimination ("njlad") in ferrante v. sciaretta."19 in that case, the plaintiff recovered $340,659 in back pay and front pay and $895,025 in attorney's fees and costs.2 the plaintiff requested a gross up in the amount of $107,000 to neutralize the adverse tax consequences caused by the amt trap.'21 in analyzing the propriety of a gross up, the court described the similarities in purpose and structure between the njlad and the federal antidiscrimination statutes and, as in blaney, cited federal caselaw that supported gross ups to counteract the adverse tax consequences caused by bunched awards.22 as a result, the court concluded, "defendants will be required to compensate [the] plaintiff for the negative tax consequences of receiving the lump sum award.' ' 23 only one case involving federal law has addressed the propriety of gross ups to counteract adverse tax consequences resulting from the amt trap. in that case, porter v. united states agency for international development,24 the district court concluded that, although it believed it had the power to order a gross up, such an order was inappropriate in that case because the adverse tax consequences were not "established [and] capable of precise calculation."'125 presumably, the court felt that because the d.c. circuit in which it sat had not yet weighed in on the underlying tax issue, it was uncertain whether the amt trap would actually be implicated in the plaintiff-taxpayer's case.126 these three cases suggest that the gross up question may be the next, and perhaps final, stage in the evolution of the voluminous litigation surrounding the amt trap. if successful, gross ups will effectively shift most of the burden of this unfair trap from isolated, uncoordinated, and politically powerless plaintiffs onto much more coordinated and politically powerful 118. blaney, 87 p.3d at 763. 119. 839 a.2d 993 (n.j. super. ct. law div. 2003). 120. ferrante, 839 a.2d at 994. 121. id. at 998. 122. id. at 996. in addition to citing to blaney and sears, see supra notes i i1 and 117, ferrante also cited o'neill v. sears, roebuck & co., 108 f. supp. 2d 443 (e.d. pa. 2000). 123. ferrante, 839 a.2d at 996. 124. 293 f. supp. 2d 152 (2003). 125.:id. at 156. 126. id. at 153-56. 20041 florida tax review defendants.'27 as a result, it is likely that the long-awaited legislative fix would soon occur. c. the courts in addition to its effect on litigants and plaintiffs' attorneys, the amt trap has increased the workload of the courts. we have already described the pronounced circuit court split on the underlying tax issue, which will likely be settled by the supreme court in early 2005.128 this tax litigation alone has taken up a good deal of the judiciary's time and resources. the expended judicial resources, however, have not been limited to litigation concerning the proper tax treatment of contingent legal fees. the amt trap has given rise to litigation over entirely non-tax issues as well. we have already described the two state cases and one federal case that considered the ability of courts to gross up damages recoveries to offset the adverse effects of the amt trap.'29 the amt trap has given rise to litigation over several other tangential issues, which are discussed below. 1. plaintiffs defense against motion for remittitur in spina v. forest preserve district of cook county,30 the plaintiff was awarded $3,000,000 of damages by a jury for damage to her reputation and emotional distress in a title vii case against her employer.3' after the trial, the employer argued that the award was excessive and requested that the trial judge offer the plaintiff a remittitur, which would require the plaintiff either to accept a lower award or retry the case.132 the court agreed with the employer, finding the $3 million award to be ''monstrously excessive" and concluding instead that $300,000 was appropriate. 13 in a last ditch effort to save the $3 million award, the plaintiff pointed to the implications of the amt trap: in a final attempt to retain her clearly excessive $3 million award, plaintiff asks the court to exercise its equitable powers to uphold the jury's award. in this regard, plaintiff notes that, under the internal revenue service's regulations and seventh 127. even though a formal gross up could be implemented only by way of an augmented judgment, defendants in all cases would potentially feel the consequences of the amt trap as the prospect of a judicial gross up would affect settlement values. 128. see supra notes 16-19 and 59-72 and accompanying text. 129. see supra notes 111-127 and accompanying text. 130. 207 f. supp. 2d 764 (n.d. 111. 2002) (memorandum opinion and order). 131. spina, 207 f. supp at 767. 132. id. at 771. 133. id. at 778-79. [vol. 6:9 litigation expenses and the amt circuit caselaw, plaintiffs judgment and any award for attorney's fees will be taxable as income to plaintiff. plaintiff contends that, because plaintiff's attorney's fees and costs will exceed $1 million, a reduction of the jury's award to $200,000, for example, would actually result in plaintiff paying her entire award, plus $154,322 of her own money (money which she does not have) to the irs in income taxes.134 while the court was "not unsympathetic to [the p]laintiff's plight" and acknowledged that the amt trap produced an "anomalous, unjust result," it was wary of "sneak[ing] through the back-door of equitable relief' a clearly excessive award.'35 emphasizing that the plaintiff cited "absolutely no caselaw" to support its position, the court rejected the "invitation to venture down a slippery slope and wade into this legal morass under the guise of equitable relief. 136 what is most interesting about spina is that the plaintiff neglected to argue for a simple gross up based on the amt trap, a position that had at least some authoritative support.137 instead, the plaintiff chose to use the amt trap to defend an award that the court determined was clearly excessive. presumably a gross up request, which unlike the defense to remittitur would be limited to the amount of adverse tax consequences, would have had a greater chance of success. 2. defendant's defense against petition for fees like the plaintiff in spina, there have been cases in which the defendant has attempted to use the amt trap to its advantage in litigating non-tax issues. in shott v. rush-presbyterian-st. luke's medical center,'38 the seventh circuit considered the defendant's use of the amt trap as a defense against the plaintiffs petition for $430,000 of attorney's fees.'3 9 the plaintiff had won $60,000 of compensatory damages pursuant to a claim under the americans with disabilities act. 140 the defendant used the amt trap to argue that the plaintiff had rejected a "substantial settlement offer" early in the litigation.14 1 such an offer is relevant to the determination of a fee award because fees accumulated after the offer is 134. id. at 777. 135. id. 136. id. 137. see supra notes 111-127 and accompanying text (cases allowing grossups). 138. 338 f.3d 736 (7th cir. 2003). 139. shott, 338 f.3d at 744. 140. id. at 739. 141. id. at 744. 20041 florida tax review submitted may be disregarded in this determination.42 an offer is considered substantial for this purpose if "the offered amount appears to be roughly equal to or more than the total damages recovered by the prevailing party."'43 the early settlement offer made by the defendant would have allowed the plaintiff to retain her title and her salary, but would have required no payment whatsoever for damages, attomey's fees, or costs.'" because of the amt trap, this offer of zero dollars would have provided a better after-tax result to plaintiff than that which she achieved by going to trial, according to the defendant.'45 if the plaintiffs petition for fees were successful, the defendant asserted that the plaintiff would actually owe $65,000 in federal income taxes in excess of her $60,000 net recovery. accordingly, the defendant argued that the plaintiff's rejection of the early offer constituted a rejection of a substantial settlement offer and that, therefore, the fees accruing after the offer should be disregarded.'" the court was not persuaded by this argument, however. first, the court pointed out the "overriding problem with [defendant's] position argument is that none of the information upon which it relies in purporting to calculate [plaintiff s] tax liability is in the record."'4 7 as a result, the court could not "say with any assurance that [her] tax liability [would] exceed the damage award.' 4 8 the court went on to doubt that, even if there were no evidentiary problems with the defendant's position, the plaintiff s tax consequences would be relevant to the fee determination: [t]hough we need not decide this issue now, we doubt that it would be appropriate for this court to establish a precedent wherein attorneys would be required to know the tax status of their clients before accepting or rejecting a settlement offer or wherein courts would routinely have to delve into the tax records of the parties to determine an appropriate fee award... [f]ee litigation already places a heavy burden on the federal courts; adding a requirement to calculate the tax status of the parties would only increase that burden.49 142. moriarty v. svec, 233 f.3d 955, 967 (7th cir. 2000). 143. id. 144. shott, 338 f.3d at 743. 145. id. at 744. 146. id. 147. id. 148. id. 149. id. [vol. 6:9 litigation expenses and the amt as a result, the court concluded that it was appropriate, in determining whether a settlement offer was substantial, to compare only the pre-tax results between the offer and the ultimate recovery.150 a similar argument was made in the recent arizona federal case of fiolek v. tucson unified school district.5 in that case, the plaintiff was awarded $50,220 of damages under the ada and sought attorney's fees and costs totaling $567,310. in arguing that the plaintiff's requested fee amount was unreasonable, the defendant pointed out that such a fee award would result in the plaintiff owing $121,938 more in federal income taxes than his $50,220 damages award. according to the defendant, "[i]ssuing a fee award that would cost the plaintiff the entirety of his judgment, plus an additional substantial outof-pocket expense, most certainly would undermine the reasonableness of the fee award."' 152 while the fiolek court has not yet ruled on the fee issue, it would appear that the amt trap should be of no help to the defendant. the impact of the trap depends primarily on the ratio of the attorney's fees to the overall recovery (including fees), which depends entirely on the underlying fee arrangement between the plaintiff and his attorney. to the extent the plaintiff would suffer a loss as a result of a petition for fees, his attorney has an ethical, and likely a legal, obligation to restructure the fee agreement so as to prevent this loss.'53 simply put, the plaintiff's fee arrangement with his attorney is strictly a matter between those two parties and is none of the defendant's business. 3. plaintiffs malpractice claim against her attorney in a case that is closely related to the ethical issues discussed above in section a of this part, the california state court of appeals in jalali v. root'54 considered the merits of a legal malpractice claim based on the amt trap. in jalali, the plaintiff accepted a $2.75 million settlement offer after being instructed by her attorney that her tax liability resulting from the settlement would equal "forty percent of [her] share" of the award.155 because of the amt 150. id. 151. defendant's responsive memorandum in opposition to plaintiff's motion for award of attorney's fees and related non-taxable costs at 21-25, fiolek v. tucson unified sch. dist., (d. ariz. 2004) (no. civ 01-036 tuc dcb). 152. id. at 24-25. 153. for a discussion of the ethical implications raised by the existence of the amt trap, see text accompanying supra notes 105-109. for a more thorough discussion of the topic, see polsky, supra note 105. 154. 1 cal. rptr. 3d 689 (cal. ct. app. 4th 2003). 155. jalali, 1 cal. rptr. 3d at 692. 20041 florida tax review trap, however, the plaintiff's tax liability was actually $310,000 greater than that amount. 1 56 as a result of the attorney's erroneous tax conclusions, a jury awarded the plaintiff this $310,000 difference between what she expected to get and what she actually got.'57 the appellate court reversed on causation grounds, holding that in order to recover damages, the plaintiff was required to show that, but for the bad tax advice, she would have rejected the $2.75 million offer and ultimately recovered a greater amount.5' because the plaintiff failed to produce evidence as to what she would have done had proper advice been given, the court held that her legal malpractice claim must fail. 59 the jalali case as well as the other non-tax cases make clear that the burden of the amt on the judiciary extends well beyond the time and resources spent in deciding the underlying tax issue. absent a legislative fix (or a supreme court decision in favor of the taxpayer), one can expect that this burden will only increase. iii. the legislative abdication of responsibility the continued existence of the amt trap is indefensible. the heightened and potentially confiscatory tax rate on the plaintiffs net recovery creates a myriad of policy problems that are not limited to the plaintiffs tax situation. plaintiffs that are properly advised of the potential tax pitfall may forego pursuing meritorious claims, thereby gutting the private enforcement of civil rights cases (an area in which the amt trap is prevalent) that was intended by congress.1 6' attorneys representing clients in cases where the amt trap lurks may face insurmountable conflicts of interest, as the payment of the fees may produce after-tax losses for the clients.61 even defendants in amt-trap cases are affected. while the nominal incidence of the amt trap may fall upon the plaintiff, the economic incidence of the tax anomaly may be shifted to the defense as tax-savvy plaintiffs hold out for higher settlements to compensate for the untoward tax treatment of their legal fees. furthermore, even the nominal incidence of the tax-trap may be shifted to defendants, as courts might "gross up" the amount of the plaintiffs' damages to compensate for the effective nondeductibility of their legal fees.'62 156. id. at 692. the plaintiff still ultimately ended up with an after-tax recovery of roughly $700,000, though she had expected to end up with about $1,000,000. id. at 696. 157. id. at 692. 158. id. at 696. 159. id. at 695. 160. see sager & cohen, supra note 7, at 1100. 161. see polsky, supra note 105. 162. see generally polsky & befort, supra note 18 (analyzing plaintiff's grossup argument). [vol. 6:9 litigation expenses and the amt courts, 1 63 commentators, " and even the national taxpayer advocate16 for years have urged congress to address the unjust and unfair tax treatment of legal fees under the amt. yet, to date, congress has failed to enact corrective legislation. making congressional neglect of the topic all the more remarkable is that the legislation necessary to fix the improper treatment of legal fees under the amt would be both simple and cheap. although congress has failed to enact corrective legislation, proposals aimed at correcting the amt trap for a discreet set of claims have been introduced, and portions of them have even garnered the approval of the senate. this part will describe and evaluate the various legislative proposals. after doing so, we will propose our own legislative solution, which would operate to eliminate the amt trap in all cases. a. legislative proposals 1. exclusion of certain awards from gross income the primary legislative proposal aimed at correcting the tax treatment of legal fees under the amt is the civil rights tax relief act of 2003. , this piece of proposed legislation was not limited to correcting the defective tax treatment of legal fees in discrimination cases; rather, it went further to provide that all amounts received on a claim of "unlawful discrimination" (other than backpay or frontpay, and punitive damages) would be excluded from gross income.167 the legislation defined unlawful discrimination through an enumerated list of civil rights, pension security, and worker protection statutes 163. see, e.g., alexander v. i.r.s., 72 f.3d 938, 946 (1st cir. 1995) ("[t]he outcome smacks of injustice because taxpayer is effectively robbed of any benefit of the legal fee's below the line treatment"); biehl v. comm'r, 118 t.c. 467,488 (2002), aff'd, 351 f.3d 982 (9th cir. 2003) ("we conclude in this case, as we have in prior cases, that it is the job of congress, if it should decide in its wisdom to do so, to cure the injustice."). 164. see, e.g., deborah a. geier, some meandering thoughts on plaintiffs and their attorneys' fees and costs, 88 tax notes 531, 549 (july 24, 2000) (concluding that "congress should act now.., to fix the problem and do so retroactively for all open tax years"); sager & cohen, supra note 7, at 1103-04. 165. see nat'l taxpayer advoc., fy 2002 annual report to congress, at 16769. 166. the legislation was introduced in the house as h.r. 1155, 108th cong., and in the senate as s. 557, 108th cong. 167. s. 557, 108th cong., § 2 (proposing irc § 140). with regard to awards of frontpay and backpay, the legislation provided for income averaging. id. § 3 (proposing irc § 1302). 2004] florida tax review under federal law. 68 the last two enumerated examples of unlawful discrimination extended the scope of qualifying claims to include any act that was unlawful under: (17) any provision of federal law (popularly known as whistleblower protection provisions) prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted under federal law. 168. the enumerated claims for "unlawful discrimination" include any act that was unlawful under the following statutes: (1) section 302 of the civil rights act of 1991 (2 u.s.c. 1202). (2) section 201, 202, 203, 204, 205, 206, or 207 of the congressional accountability act of 1995 (2 u.s.c. 1311, 1312, 1313, 1314,1315, 1316, or 1317). (3) the national labor relations act (29 u.s.c. 151 et seq.). (4) the fair labor standards act of 1938 (29 u.s.c. 201 et seq.). (5) section 4 or 15 of the age discrimination in employment act of 1967 (29 u.s.c. 623 or 633a). (6) section 501 or 504 of the rehabilitation act of 1973 (29 u.s.c. 791 or 794). (7) section 510 of the employee retirement income security act of 1974 (29 u.s.c. 1140). (8) title ix of the education amendments of 1972 (29 u.s.c. 1681 et seq.). (9) the employee polygraph protection act of 1988 (29 u.s.c. 201 et seq.). (10) the worker adjustment and retraining notification act (29 u.s.c. 2102 et seq.). (11) section 105 of the family medical leave act of 1993 (29 u.s.c. 2615). (12) chapter 43 of title 38, united states code (relating to employment and reemployment rights of members of the uniformed services). (13) section 1977, 1979, or 1980 of the revised statutes (42 u.s.c. 1981, 1983, or 1985). (14) section 703, 704, or 717 of the civil rights act of 1964 (42 u.s.c. 2000e-2, 2000e-3, or 2000e-16). (15) section 804, 805, 806, 808, or 818 of the fair housing act (42 u.s.c. 3604, 3605, 3606, 3608, or 3617). (16) section 102,202,302,503 ofthe americans with disabilities act of 1990 (42 u.s.c. 12112, 12132, 12182, or 12203). civil rights tax relief act of 2003, s. 557, 108th cong., § 2 (proposed irc § 140(b)(1)-(16)). [vol. 6:9 litigation expenses and the amt (18) any provision of state or local law, or common law claims permitted under federal, state, or local law providing for the enforcement of civil rights, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.169 from the standpoint of addressing the improper tax treatment of legal fees under the amt, the proposed civil rights tax relief act of 2003 was underinclusive. while addressing discrimination cases in which the amt trap can be the most egregious due to the operation of fee-shifting statutes, it is doubtful that the legislation would have addressed all types of employment claims. take a garden variety wrongful termination claim, for example. if the damages resulted from a termination in breach of the employment contract and the employee's termination had no discriminatory or retaliatory motive, then it does not appear that the legislation would have excluded the damages (including the amount paid to the attorney) from gross income. 170 in addition, the proposed legislation failed to address a wide variety of other non-physical personal injury claims that give rise to the improper treatment of legal fees under the amt. these include claims for punitive damages, defamation, intentional or negligent infliction of emotional distress, etc. thus, while the terms of the proposed civil rights tax relief act of 2003 would have eliminated the tax defect that serves to stifle the private enforcement of civil rights legislation, the proposal would not have gone far enough to correct the improper treatment of legal fees in all cases. of course, the civil rights tax relief act of 2003 would have done much more than eliminate the amt trap in discrimination cases; it would have excluded from gross income the entire amount of damages recovered on an enumerated claim. excluding the damages received on a claim of unlawful discrimination may be legitimate in its own right, as a number of commentators have questioned the fairness'7' and even the constitutionality'72 of the 1996 169. id. § 2 (proposed irc § 140(b)(17)-(18)). 170. on one hand, one could argue that the statute applies to damages received on account of a breach of employment contract on the theory that the common law of contracts is a provision of local law that prohibits discharge of an employee. however, nothing in the common law of contracts expressly prohibits an employer from discharging an employee in breach of the employment contract. rather, contract law simply subjects the employer to damages on account of such breach. 171. see, e.g., karen b. brown, not coloror gender-neutral: new tax treatment of employment discrimination damages, 7 s. cal. rev. & women's stud. 223 (1998); j. martin burke & michael k. friel, getting physical: excluding personal injury awards under the new section 104(a)(2), 58 mont. l. rev. 167 (1997); mark j. wolff, sex, race, and age: double discrimination in torts and taxes, 78 wash. u.l.q. 1341 (2000); laura sager & stephen cohen, discrimination against damages 2004] florida tax review legislation that restricted excluded damage recoveries under § 104(a)(2) to those received on account of a personal physical injury or physical sickness.'73 yet by reaching beyond the improper tax treatment of legal fees in these cases and seeking an exclusion of the entire damages recovery, the legislation became more difficult to enact. there are undoubtedly members of congress who support the 1996 limitation of section 104(a)(2) to personal physical injuries. furthermore, there are undoubtedly members of congress who are less than enthusiastic about federal civil rights protections. thus, the broader reach of the legislation to exclude the entire damages recovery on the enumerated discrimination claims created ideological hurdles that likely made the legislation difficult, if not impossible, to enact it its entirety. 2. above-the-line treatment for fees in certain cases perhaps in recognition of the political difficulties in passing a full exclusion of damages received on claims of unlawful discrimination, the senate later that year included a trimmed-down version of the civil rights tax relief act of 2003 in its version of the jobs and growth reconciliation act of 2003. the proposal addressed only the tax treatment of legal expenses incurred in a claim of unlawful discrimination.'74 citing the spina decision, republican senator charles grassley, chairman of the senate finance committee, added the provision to the broader tax bill, stating: "if we don't fix this law, it could have a chilling effect on discrimination cases. legitimately wronged people could have little recourse. a out-of-whack tax system is in danger of negating the value of discrimination lawsuits.' in a section captioned "civil rights tax relief," the legislation created an above-the-line deduction for attorney fees and courts costs paid by, or on behalf of, a taxpayer in connection with any claim of unlawful discrimination, to the extent that such expenses do not exceed the amount includible in the taxpayer's gross income for the taxable year attributable to a settlement or judgment resulting from the claim.176 for unlawful discrimination: the supreme court, congress, and the income tax, 35 harv. j. on legis. 447 (1998). 172. see f. patrick hubbard, making people whole again: the constitutionality of taxing compensatory tort damages for mental distress, 49 fla. l. rev. 725 (1997). 173. small business job protection act of 1996, pub. l. no. 104-188, § 1605, 110 stat. 1755 (1996). 174. amendment no. 680 to jobs and growth tax relief reconciliation act of 2003, s. 1054, 108th cong. 175. press release, sen. charles e. grassley (may 13,2003), available at 2003 tnt 93-26. 176. s. 1054, 108th cong., § 521(a) (proposed irc § 62(a)(19) and § 223). it is interesting that the statute limits the above-the-line deduction to the amounts included in gross income on account of the claim. while this limitation would not come into [vol. 6.'9 litigation expenses and the amt the proposal defined a claim of "unlawful discrimination" in virtually the identical manner as the civil rights tax relief act of 2003, except the last catch-all category of claims was expanded as follows: (18) any provision of federal, state or local law, or common law claims permitted under federal, state, or local law (a) providing for the enforcement of civil rights, or (b) regulating any aspect of the employment relationship, including prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.'77 the additional language added to the catch-all category is significant, as it arguably brought into the reach of the statute any employment related claim. taking a garden variety breach of employment contract case as an example, the common law of contracts is state law that regulates the employment relationship. thus, the legal fees paid in prosecution of such a claim could be afforded above-the-line treatment, to the extent they do not exceed the amount included in gross income attributable to the settlement or judgment.'78 on the other hand, given the context of the statute in which the seemingly broad "regulating any aspect of the employment relationship" falls, 79 it is not inconceivable that a court would interpret this phrase as being limited to situations involving the violation of laws specifically prohibiting the discharge, effect in the contingent fee context, it could prove problematic for a taxpayer who pays her attorney on an hourly basis. for instance, suppose that plaintiff sues her employer for wrongful termination and loses after paying her attorney $100,000 in hourly fees. these fees will not be entitled to above-the-line status under the legislative proposal. perhaps the justification is that any legal fees paid in excess of the ultimate recovery would be properly viewed as conferring some elements of personal consumption (i.e., the pleasure of simply taking the defendant to court), justifying their treatment as miscellaneous itemized deductions. however, this explanation is suspect. the payment of the fees combined with the litigation loss likely produces the exact opposite of a consumption benefit to the plaintiff. 177. s. 1054, 108th cong., § 521(a) (proposed irc § 223(b)(18)) (emphasis supplied). 178. but see robert w. wood, "civil rights tax relief' fails: how do you spell relief?, 100 tax notes 401 (july 21, 2003) (questioning whether the legislation reached all types of employment related claims, particularly claims for overtime or benefits). 179. s. 1054, 108th cong. § 54(a) (proposed irc § 62(a)(19)(e)(18). 2004] florida tax review discrimination, or retaliatory conduct. 18 0 the statute is by no means a model of clarity, and it is not difficult to imagine that another round of litigation would be necessary to determine its exact confines. the proposed legislation described above was passed by the senate in its version of the jobs and growth tax relief reconciliation act of 2003, but it did not survive the conference committee.' nonetheless, after years of no action being taken to address the improper tax treatment of legal fees under the amt, getting corrective legislation moved through at least one body of congress was significant. perhaps more significant were the interest groups that backed the legislation. while the movement to correct the amt trap had been viewed as the project of the trial lawyers' lobby, backers of the provision in the senate bill included none other than the u.s. chamber of commerce michael eastman, director of labor law policy at the chamber, stated that "changing the law could make it less expensive for employers to settle claims while allowing plaintiffs to keep more of their awards."'' 8 2 defendants in employment litigation, apparently recognizing that they bore at least a portion of the economic incidence of the improper tax treatment of the plaintiffs legal fees, thus lined up behind the corrective legislation. in a political environment where litigious individuals and the attorneys who represent them appear to be the bane of conservatives' existence, the support of interest groups associated with traditional defendants in employment cases may very well prove to be the turning point in the ultimate enactment of corrective legislation. while the above-the-line deduction for legal fees in certain discrimination cases was not included in the broader 2003 tax legislation enacted by congress, an almost identical proposal has once again passed in the senate this year. under the caption of "civil rights tax relief," the above-theline deduction for legal expenses in certain discrimination cases now appears in section 643 of senate version of the jumpstart our business strength (jobs) act. 183 the only difference between the current legislative proposal and that passed by the senate in 2003 is another expansion of the last catch-all category defining a claim of "unlawful discrimination" for purposes of the statute. the 180. in this regard, one would not ordinarily describe a claim for unpaid salary or benefits as a claim of "unlawful discrimination." as to the potential for a limited interpretation of the catch-all category of claims covered by the proposed § 62(a)(19), the government's reply brief in the banks and banaitis cases suggests it. in the brief, the government describes the corrective legislation as being "narrowly focused on certain civil rights cases." petitioner reply brief at 19, comm'r v. banks, u.s. supreme court docket no. 03-892 (filed sept. 22, 2004). 181. see h.r. rep. no. 108-126, at 192-94 (2003). 182. david s. hilzenrath, panel backs end to "double taxation" on jury awards, wash. post, may 10, 2003, at al1. 183. h.r. 4520, 108th cong. § 643(a) (as amended by the senate). [vol6:9 litigation expenses and the amt catch-all now defines a claim of unlawful discrimination as any act that is unlawful under: (18) any provision of federal, state or local law, or common law claims permitted under federal, state, or local law (i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law." the expansion of the catch-all category was in apparent response to employment attorneys who were concerned that the legislation as previously drafted failed to address claims for overtime and other benefits.185 of course, with the catch-all category so broadly drafted, it makes little sense to define the causes of action covered by the statute in terms of claims for "unlawful discrimination." if the statute were truly intended to cover all employmentrelated claims, then a significant amount of complexity and confusion could have been eliminated if the legislation had been drafted to address legal expenses paid or incurred by the taxpayer in connection with any action relating to the taxpayer's trade or business ofperforming services as an employee. from a revenue standpoint, section 643 of the senate jobs act should not prove difficult to pass. the joint committee has scored the cost of the proposal at $342 million over the 10-year period from 2004 to 2013.186 184. id. § 643(b) (proposed irc § 62(e)(18)) (emphasis supplied). 185. see, e.g., wood, supra note 178, at 402. 186. joint comm. on tax'n, estimated revenue effects of s. 1637, the "jumpstart our business strength ('jobs') act," as passed by the senate, jcx-36-04, at 8 (2004). the year-by-year costs estimates are as follows: period decrease in revenue 2004 $11 million 2005 $ 47 million 2006 $ 28 million 2007 $ 29 million 2008 $ 31 million 2009 $ 34 million 2010 $ 36 million 2011 $ 38 million 2012 $ 42 million 2013 $ 44 million 2004-2013 $ 342 million 2004] florida tax review measured against the roughly $1.7 trillion in tax cuts enacted by the sitting administration,'87 this provision could hardly be described as material. indeed, the $342 million figure over 10 years likely pales in comparison to the value of private and judicial resources that have been expended litigating the tax treatment of legal fees, not to mention the societal costs of litigation concerning legal malpractice claims and tax gross ups that is sure to follow if corrective legislation is not passed. thus, even though mounting deficits have made any form of tax-cutting legislation more difficult to pass, the minimal cost of the limited fix to the amt trap should not be raised as a legitimate obstacle to its passage. like its predecessors, the current legislative proposal contained in the jobs bill is far from perfect. it is a complicated provision that does not address all claims in which the improper tax treatment of legal fees under the amt arises. however, despite these shortcomings, the legislation if enacted would eliminate the amt trap in a wide range of employment litigation where the amt trap is most prevalent. furthermore, by addressing civil rights cases, the legislation would correct the amt trap in instances where, due to fee-shifting statutes, its impact on plaintiffs could be most severe. since this is perhaps the best chance at eliminating a portion of the amt trap, the legislation should be enacted. something is better than nothing. the only downside of the proposed above-the-line deduction for legal expenses in certain cases of unlawful discrimination is that limited reform will likely doom the prospect of more comprehensive corrective legislation being enacted in the future. b. a comprehensive solution the need to correct the improper tax treatment of legal fees exists for all cases that are currently subject to the amt trap not just those relating to unlawful discrimination or broader claims arising in the employment context. there is no justifiable reason why legal fees paid or incurred to prosecute claims id. the spike in lost revenue estimated for 2005 is on account of the legislation applying to all judgments or settlements executed after december 31, 2002. by comparison, the joint committee scored almost identical legislation in the 2003 bill at only $205 million over the 2003-2013 time period. joint comm. on tax'n, estimated budget effects of the "jobs and growth tax relief reconciliation act of 2003," scheduled for consideration by the committee on finance on may 13, 2003, fiscal years 2001-2011, jcx-50-03, at 4 (2003). 187. see joint comm. on tax'n, estimated budget effects of the conference agreement for h.r. 1836, jcx-5 1-01, at 8 (2001) (estimating the total revenue cost of the economic and growth tax relief reconciliation act of 2001 at $1.35 trillion); joint comm. on tax'n, estimated budget effects of the conference agreement for h.r. 2, the "jobs and growth tax relief reconciliation act of2003," fiscal years 2003-2013, jcx-55-03, at 2 (2001) (estimating the total revenue cost of the jobs and growth tax relief reconciliation act of 2003 at $350 billion). [vol. 6:9 litigation expenses and the amt for defamation, intentional infliction of emotional distress, or punitive damages should be relegated to the status of miscellaneous itemized deductions that are subject to complete disallowance under the amt. accordingly, the amt trap should be corrected for all possible situations in which it would otherwise arise. this could be accomplished rather easily by amending section 62(a) to add to its list of above-the-line deductions the following: deductions allowed under sections 162 or 212 which consist of expenses paid or incurred in connection with the prosecution of a cause of action. taking the rules governing the taxation of damage awards under section 104(a) as a given, the amendment to section 62(a) proposed above would reach the legal fees incurred in order to obtain any taxable recovery. yet because section 62(a) is a deduction-ordering statute as opposed to a deduction-granting provision, the proposed amendment would not affect the nondeductibility of legal fees incurred to procure damages that are excluded from gross income.8' thus, the proposed amendment to section 62(a) would address only the tax treatment of legal fees that give rise to the amt trap, while being broad enough to reach any case in which above-the-line treatment is appropriate. conclusion the unjust and unfair tax treatment of legal fees under the amt has been known for years. while the issue of whether a portion of a taxable damages recovery that is paid to the plaintiffs attorney pursuant to a contingency fee arrangement is currently before the supreme court, a plausible interpretive solution to the problem does not appear to exist. simply put, the responsibility for correcting the matter rests with congress. given the wellpublicized tax burden placed on unsuspecting plaintiffs, the additional costs of settlement that properly advised plaintiffs may be able to shift to defendants, and the burdens placed on scarce judicial resources due to litigation concerning not only the plaintiffs underlying tax liability but also issues tangentially related to it (legal malpractice, tax gross-ups, etc.), the failure of congress to act on the matter defies logic. this is particularly so when a comprehensive solution to the improper tax treatment of legal fees could be accomplished through a onesentence provision that, if enacted, would have negligible impact on the federal fisc. looking on the bright side, the senate has recently recognized that the tax treatment of plaintiffs legal fees in discrimination cases simply cannot stand. while this less comprehensive and more complicated legislative fix is not ideal, its enactment would be a welcome sign. by correcting the most visible and economically significant instances of the amt trap, congress will at least demonstrate that it will no longer turn a blind eye to the injustice caused by the tax treatment of litigation expenses under the amt. 188. see irc § 265(a)(1). 2004] florida tax review addendum the portion of the senate version of the american jobs creation act of 2004 that conferred above-the-line status to certain legal fees89 was adopted (with slight modification, as discussed below) by the house-senate conference committee charged with reconciling the differences between the chambers' two bills.'90 accordingly, section 703 of the american jobs creation act of 2004 (hereinafter "act section 703") created a new provision, enumerated as irc section 62(a)(19),91 conferring above-the-line status for attorney's fees and court costs paid in connection with the prosecution of a cause of action for certain claims against the federal government, a private cause of action under the medicare secondary payer statute, and, most significantly, any claim of "unlawful discrimination" as defined in the statute.'92 the full text of the legislation is reproduced in the appendix. the legislation adopted at the conference level was largely identical to that contained in the senate bill; the only change made concerned the effective date of the legislation. whereas the senate bill would have been effective for all fees and costs paid after december 31, 2002, the conference agreement made act section 703 effective only for "fees and costs paid after the date of enactment of [the] act, with respect to any judgment or settlement occurring after such date."'93 that effective date is october 22, 2004, the day that president bush signed the legislation into law. as discussed in part il of the article, act section 703 represents a significant improvement in the law (assuming that contingent attorney's fees and court costs otherwise would be recovered as miscellaneous itemized deductions.) by addressing legal fees incurred in virtually any employmentrelated claim, the legislation corrects the amt trap for the vast majority of 189. for a discussion of the senate bill, see text accompanying supra notes 174-87. 190. see h.r. rep. no. 108-755, at 252-54 (2004). the legislation as originally passed by the house of representatives did not contain a corresponding provision addressing the taxation of attorney fees. see id. at 253. 191. while the legislation clearly intended to create a new provision following the last enumerated classification of an above-the-line deduction under § 62(a), § 62(a)(19) already existed to confer above-the-line status to the deduction under § 223 for contributions to health savings accounts. see irc § 62(a)(19) (prior to amendment by american jobs creation act of 2004, h.r. 4520, 108th cong. act § 703 (2004)). this mistake apparently stems from the fact that the attorney fee legislation had been proposed in bills that were proposed before the pre-existing § 62(a)(19) was inserted into the code. given that the legislation was clearly not intended to strike the preexisting § 62(a)(19), presumably the new provision created by the legislation will be redesignated as § 62(a)(20) by way of a technical correction. 192. american jobs creation act of 2004, pub. l. no. 108-357, § 703 (2004). 193. id. § 703(c). [vol. 6:9 litigation expenses and the amt instances in which it will arise. furthermore, by addressing legal claims arising under anti-discrimination and other statutes that provide for fee-shifting, the legislation fixes the amt trap in the most egregious instances, where the plaintiffs tax liability could, in certain cases, exceed his or her net monetary recovery. however, while act section 703 constitutes a substantial improvement in the law, the legislation by no means constitutes an ideal resolution to the improper and unjust treatment of legal fees under the amt, as discussed below. senator grassley, the apparent senatorial champion of the legislation at the conference committee, issued a press release after the conferees voted on the final conference report stating that "tax relief gets the headlines, but part of tax relief is tax fairness .... it's clearly a fairness issue to make sure people don't have to pay income taxes on income that was never theirs in the first place. that's common sense."'94 measured against the goal of fairness in taxation, however, act section 703 fails in two principal respects. first, the legislation is substantively underinclusive. act section 703 does not fix the amt trap for legal fees incurred in prosecuting punitive damage claims or common law tort claims not involving a personal physical injury (e.g., negligent or intentional infliction of emotional distress, defamation, slander). by creating this "favored" set of legal claims, act section 703 violates the principle of horizontal equity. 95 second, the non-retroactive effective date of act section 703 is disconcerting. if the legislation were intended to correct the acknowledged unfair tax treatment confronting certain litigants, then why was the legislation 194. press release, sen. charles e. grassley (oct. 6, 2004), at http://finance.senate.gov/press/gpress/2004/prglo0604e.pdf (stating that grassley secured inclusion of the legislation in the conference report). see also 150 cong. rec. s 11036 (daily ed. oct. 10, 2004) (statement of sen. baucus congratulating sen. grassley for assuring that the conference report included act § 703). 195. the most economically significant category of claims still subject to the amt would appear to be punitive damage claims. the legislation's denial of relief for punitive damage claimants could possibly be justified on grounds that punitive damages should normatively belong to the broader community, rather than to the plaintiff alone. see generally catherine m. sharkey, punitive damages as societal damages, 113 yale l.j. 347 (2003). a growing number of states have passed legislation pursuant to which a portion of any punitive damage award escheats to the state. see id. at 373-74. by keeping punitive damage claims subject to the amt trap (and therefore subject to excessive taxation), the legislation can be viewed as blessing a federal escheat regime. even if a federal escheat regime is justified on policy grounds, the implementation of it through the amt trap raises three concerns: (i) as noted above, the amt trap remains for non-punitive damage claims, (ii) the decision to implement such a regime through the tax law in this fashion is entirely nontransparent, and (iii) depending on how the supreme court rules in banks and banaitis, such a federal escheat regime might apply to taxpayers residing in some circuits and not others. even if such a federal escheat regime can be justified as a policy matter, it appears to be the product of legislative accident as opposed to thoughtful deliberation. 20041 florida tax review not made retroactively effective for all open tax years or at least for claims recently settled?.9 6 there would appear to be little substantive policy grounds to support non-retroactivity.97 in all likelihood, the decision to reject retroactivity was likely a mere compromise between the house (which had no amt trap provision at all) and the senate (which provided relief on a retroactive basis). furthermore, the revenue effect probably played some role. the estimated cost of making the legislation retroactive to 2003 was roughly $60 million."9 ' given that the final version of the american jobs creation act of 2004 was scored to produce a net $1 million of additional revenue over the 10year budget window, even the relatively minor revenue cost of retroactivity could have proven significant.'99 the enactment of act section 703 raises interesting questions as to what effect, if any, the legislation has on the determination of whether the portion of a plaintiffs recovery that is paid to an attorney pursuant to a contingent-fee arrangement is included in the plaintiffs gross income. on one hand, the corrective legislation is certainly consistent with the conclusion that contingent attorney's fees do not give rise to an exclusion from gross income, but rather a deduction that was (and in many instances, still is) subject to unwarranted 196. because of the nonretroactivity, the amt trap will still apply for certain taxpayers who obtained judgments or settled causes of action during this taxable year (namely, before october 22, 2004) who have not yet paid the additional taxes attributable to the amt trap. indeed, one has to have some empathy for an individual who settled a cause of action giving rise to the amt trap prior to the date of enactment, given that the legislation as proposed and passed by the senate (but not by the conference committee) would have provided retroactive relief. 197. the only conceivable substantive policy justification for nonretroactivity is that perhaps one might view retroactivity as a windfall to a plaintiff who settled his or her claim with the knowledge that it would be subject to extra tax. 198. cf. joint comm. on tax'n, estimated budget effects of the conference agreement for h.r. 4520, the "american jobs creation act of 2004," jcx-69-04, at 6 (estimating the 10-year cost of the legislation having only prospective effect at $327 million); joint comm. on tax'n, comparison of the estimated budget effects of h.r. 4520, the "american jobs creation act of 2004" as passed by the house of representatives, and h.r. 4520, the "jumpstart our business strength ('jobs') act," as amended by the senate, jcx-53-04, at 8 (estimating the 10-year cost of the legislation having limited retroactive effect at $387 million). 199. see joint comm. on tax'n, estimated budget effects of the conference agreement for h.r. 4520, the "american jobs creation act of 2004," jcx-69-04, at 10. it is possible that, because large amounts of tax could depend on the precise time when fees and costs are "paid" and when any settlement "occurs," litigants might attempt to amend earlier an earlier settlement (perhaps calling for a lower payment by the defendant) so that the taxpayer-plaintiff can take the position that the settlement occurred after the effective date. if so, because of the nonretroactive nature of the legislation, litigation might ensue between the irs and the taxpayer regarding the timing of the settlement and payments in respect thereof [vol. 6:9 litigation expenses and the amt limitation. proponents of this interpretation, including the authors, have argued that the amt trap for legal fees requires legislative correction, and now congress has finally complied. on the other hand, one could argue that the corrective legislation has no bearing whatsoever on the inclusion/deduction versus exclusion debate. rather, the legislation only operates to achieve a more equitable result for residents of those circuits in which the legal fees have been found to be deductible.00 a third interpretation of the enactment of act section 703 is that the corrective legislation served to clarify that prior law produced a result favorable to the taxpayer. this argument was made by the taxpayers in the banks and banaitis cases, through supplemental briefing to the supreme court.2' the taxpayers pointed to an exchange occurring on the senate floor several days after adoption of the conference report between senator grassley and senator baucus, in which senator grassley suggested that act section 703 was a mere clarification of pre-existing law that the attorney's fee portion of a recovery was not included in "taxable income whether for regular income or alternative minimum income purposes.,202 this interpretation is flawed in a number of 200. this argument has one particular flaw. if the legislation was intended solely to maintain parity between taxpayers in the majority of circuits holding that contingent legal fees give rise to a deduction and those in the minority of circuits holding that contingent legal fees are excluded from gross income, then there is no reason for the corrective legislation to distinguish among those types of claims that give rise to a taxable damages recovery. 201. joint supplemental brief for respondents at 3-4, comm'r v. banks and comm'r v. banaitis, u.s. supreme court docket nos. 03-892 and 03-907 (filed oct. 22, 2004). 202. the full exchange between the senators appears in the congressional record as follows: mr. baucus. as i understand it, the case law with respect to the tax treatment of attorney's fees paid by those that receive settlements or judgments in connection with a claim of unfaithful discrimination, a false claims act, "qui tam," proceeding or similar actions is unclear and that its application was questionable as interpreted by the irs. further, it was never the intent of congress that the attorneys' fees portion of such recoveries should be included in taxable income whether for regular income or alternative minimum tax purposes. is it the understanding of the chairman that it was the conferee's intention for section 703 to clarify the proper interpretation of the prior law, and any settlements prior to the date of enactment should be treated in a manner consistent with such intent? mr. grassley. the senator is correct. the conferees are 2004] florida tax review respects,"' and it is belied by the conference report accompanying the legislation acknowledging that, under existing law, attorney's fees in this context were generally recovered as a miscellaneous itemized deduction.2" thus, interpreting act section 703 as clarifying that prior law favored the taxpayer overstates the case. a better reading of act section 703 is that it makes no particular statement regarding the interpretation of prior law, but applies only to the extent that legal fees in these instances are determined to be properly recovered by way of a deduction. acting to make it clear that attorneys' fees and costs in these cases are not taxable income, especially where the plaintiff, or in the case of a qui tam proceeding, the relator, never actually receives the portion of the award paid to the attorneys. despite differing opinions by certain jurisdictions and the irs, it is my opinion that this is the correct interpretation of the law prior to the enactment of section 703 as it will be going forward. in adopting this provision, congress is codifying the fair and equitable policy that the tax treatment of settlements or awards made after or prior to the effective date of this provision should be the same. the courts and irs should not treat attorney's fees and other costs as taxable income. 150 cong. rec. s 11036 (daily ed. oct. 10, 2004). 203. to start, it is difficult to imagine how the creation ofa new above-the-line deduction for attorney's fees paid in certain cases supports an interpretation that such fees give rise to an exclusion from gross income or constitute an above-the-line deduction under a different theory (either one of which is necessary for the taxpayer to prevail under prior law). if that were the case, then the new § 62(a)( 19) created by the legislation would be a wholly superfluous provision. second, if act § 703 were intended to serve as a mere clarification of prior law, then there would be no reason for act § 703 to distinguish between the claims to which it applies. last, if act § 703 were intended to serve as a mere clarification of prior law, then there would be no reason for the conferees to negotiate over the effective date of the legislation. 204. h.r. rep. no. 108-755, at 252 (2004). [vol, 6:9 litigation expenses and the amt appendix the american jobs creation act of 2004, pub. l. no. 108-357 sec. 703. civil rights tax relief. (a) deduction allowed whether or not taxpayer itemizes other deductions.-subsection (a) of section 62 (defining adjusted gross income) is amended by inserting after paragraph (18) the following new item: "(19) costs involving discrimination suits, etc.-any deduction allowable under this chapter for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination (as defined in subsection (e)) or a claim of a violation of subchapter iii of chapter 37 of title 3 1, united states code or a claim made under section 1862(b)(3)(a) of the social security act (42 u.s.c. 1395y(b)(3)(a)). the preceding sentence shall not apply to any deduction in excess of the amount includible in the taxpayer's gross income for the taxable year on account of a judgment or settlement (whether by suit or agreement and whether as lump sum or periodic payments) resulting from such claim.". (b) unlawfuldiscrimination defined.-section 62 is amended by adding at the end the following new subsection: "(e) unlawful discrimination defined.-for purposes of subsection (a)(19), the term "unlawful discrimination' means an act that is unlawful under any of the following: "(1) section 302 of the civil rights act of 1991 (2 u.s.c. 1202). "(2) section 201, 202, 203, 204, 205, 206, or 207 of the congressional accountability act of 1995 (2 u.s.c. 1311, 1312, 1313, 1314, 1315, 1316, or 1317). "(3) the national labor relations act (29 u.s.c. 151 et seq.). "(4) the fair labor standards act of 1938 (29 u.s.c. 201 et seq.). "(5) section 4 or 15 of the age discrimination in employment act of 1967 (29 u.s.c. 623 or 633a). "(6) section 501 or 504 of the rehabilitation act of 1973 (29 u.s.c. 791 or 794). 2004] florida tax review "(7) section 510 of the employment retirement security act of 1974 (29 u.s.c. 1140). "(8) title ix of the education amendments of 1972 (20 u.s.c. 1681 et seq.). "(9) the employee polygraph protection act of 1988 (29 u.s.c. 2001 et seq.). "(10) the worker adjustment and retraining notification act (29 u.s.c. 2102 et seq.). "(11) section 105 of the family and medical leave act of 1993 (29 u.s.c. 2615). "(12) chapter 43 of title 38, united states code (relating to employment and reemployment rights of members of the uniformed services). "(13) section 1977, 1979, or 1980 of the revised statutes (42 u.s.c. 1981, 1983, or 1985). "(14) section 703, 704, or 717 of the civil rights act of 1964 (42 u.s.c. 2000e-2, 2000e-3, or 2000e-16). "(15) section 804, 805, 806, 808, or 818 of the fair housing act (42 u.s.c. 3604, 3605, 3606, 3608, or 3617). "(16) section 102, 202, 302, or 503 of the americans with disabilities act of 1990 (42 u.s.c. 12112, 12132, 12182, or 12203). "(17) any provision of federal law (popularly known as whistleblower protection provisions) prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking actions permitted under federal law. "(18) any provision of federal, state, or local law, or common law claims permitted under federal, state, or local law(i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking actions permitted by law." [vol. 6:9 2004] litigation expenses and the amt 947 (c) effective date.-the amendments made by this section shall apply to fees and costs paid after the date of enactment of this act [october 22, 2004], with respect to any judgment or settlement occurring after such date. florida tax review volume 8 2006 special issue recent developments in federal income taxation: the year 2005 ira b. shepard martin j. mcmahon, jr.** 1. a ccountin g ................................................................................ 7 a. accounting methods ....................................................... 7 b . inventories ....................................................................... 8 c. installment m ethod .......................................................... 8 d. year of receipt or deduction .......................................... 8 h. business income and deductions ......................................... 9 a . incom e .............................................................................. 9 b. deductible expenses versus capitalization ....................... 11 c. reasonable compensation ............................................ 13 d. miscellaneous expenses ................................................ 14 e. depreciation and amortization ..................................... 21 f . c redits ............................................................................ 21 g. natural resources deductions & credits ...................... 22 h. loss transactions, bad debts and nols ....................... 29 i. at-risk and passive activity losses .............................. 30 m . investment gain .................................................................... 31 a. capital gain and loss .................................................. 31 b . section 1031 .................................................................. 34 c . section 1033 ................................................................... 36 iv. compensation issues ............................................................ 36 a . fringe benefits .............................................................. 36 b. qualified deferred compensation plans ....................... 39 c. nonqualified deferred compensation, section 83, and stock options ......................................................... 41 d. individual retirement accounts ..................................... 46 v. personal income and deductions ..................................... 47 a . r ates ............................................................................. 47 b. miscellaneous income ......................... 47 c. profit-seeking individual deductions ............................ 48 d. hobby losses and § 280a home office and vacation h om es ........................................................................... 50 e. deductions and credits for personal expenses ............. 50 f. e ducation ....................................................................... 53 * professor of law, university of houston law center. ** clarence j. teselle professor of law, university of florida fredric g. levin college of law. florida tax review vi. corporations ............................................................ 54 a. entity and formation ....................................... 54 b. distributions and redemptions ........................ 56 c. liquidations .................................................... 60 d. s corporations ................................................ 61 e. affiliated corporations ................... 64 f. reorganizations ................................................ 65 g. corporate divisions ......................................... 69 h. miscellaneous corporate issues ....................... 73 vii. partnerships ............................................................... 74 a. formation and taxable years .......................... 74 b. allocations of distributive share, partnership debt, and outside basis ............................................ 74 c. distributions and transactions between the partnership and partners ................................. 78 d. sales of partnership interests, liquidations and merges ....................................................... 85 e. inside basis adjustments ................................... 85 f. partnership audit rules ................................... 85 g. miscellaneous ................................................... 86 viii. tax shelters ............................................................... 86 a. tax shelter cases .............................................. 86 b. identified "tax avoidance transactions" . ........... 104 c. disclosure and settlement .................................. 106 d. tax shelter penalties, etc ................................... 115 e. tax shelters miscellaneous ................................ 118 ix. exempt organizations and charitable giving .. 118 a. exempt organizations ........................................ 118 b. charitable giving .............................................. 120 x. tax procedure ............................................................ 123 a. interest, penalties and prosecutions .................. 123 b. discovery: summonses and foia ...................... 125 c . litigation costs .................................................. 127 d . statutory n otice .................................................. 128 e. statue of limitations .......................................... 129 f. liens and collections ......................................... 130 g. innocent spouse ................................................. 135 h . m iscellaneous ..................................................... 139 xi. witholding and excise taxes ................................. 146 a. employment taxes ............................................. 146 b . excise taxes ....................................................... 148 xii. tax legislation ..................................................... 149 a . e nacted .............................................................. 149 [vol. 8:si recent developments in federal income taxation recent developments in federal income taxation: the year 2005 by ira b. shepard martin j. mcmahon, jr. this recent developments outline discusses, and provides context to understand, the significance of the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the most recent twelve months and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide marty the opportunity to mock our elected representatives. the outline focuses primarily on topics of broad general interest [to the two of us, at least] income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. see viii. c. for restrictions on your use of this outline. i.e., readers are not permitted to use anything contained in this outline for purposes of giving advice to clients on any tax avoidance technique. i. accounting a. accounting methods 1. rev. proc 2006-11, 2006-3 i.r.b. 309 (12/21/05). this revenue procedure provides procedures by which taxpayers may request accounting method changes so they can comply with § 263a cost capitalization under the simplified service cost method and the simplified production method contained in regulations set forth in t.d. 9217. 2006] florida tax review 2. t.d. 9217, guidance regarding the simplified service cost method and the simplified production method, 70 f.r. 44467 (8/3/05). temp. regs §§ 1.263-1t and 1.263-2t have been amended. b. inventories there were no significant developments regarding this topic during 2005. c. installment method there were no significant developments regarding this topic during 2005. d. year of receipt or deduction 1. hightower v. commissioner, t.c. memo. 2005-274 (11/28/05). funds received pursuant to arbitrator's decision regarding forced-buyout of corporate stock were includable in income, even though taxpayer continued to contest the decision, because he accepted the check, endorsed it, and deposited the proceeds in an interest bearing account under his sole control. taxpayer's creation of a separate account did not evidence unconditional renunciation of the right to funds. 2. the writer of a put option does not have income until the year the option expires unexercised. fed. home loan mortgage corp. (freddie mac) v. commissioner, 125 t.c. 248 (11/21/05). the tax court (judge ruwe) held that nonrefundable commitment fees that loan originators pay to freddie mac are not income in the year of receipt by freddie mac; instead, they are premiums for put options and should be treated as such for tax purposes, i.e., they reduce taxpayer's basis in the loans purchased if the option is exercised and they are income in the year the option lapses if the option is not exercised. the premium received by the writer of a put option that is not exercised is ordinary income for the taxable year in which the failure to exercise the option becomes final; if a put option is exercised, the premium received by the writer is an offset against the option price, which reduces the basis of the property acquired pursuant to the put option. 0 the commissioner argued that the nonrefundable portion of commitment fees were income in the year of receipt under the all events test of § 451. 3. anticipated warranty expenses are not deductible in the year taxpayer sold warranted motor vehicles. chrysler corp. v. [vol. 8:si recent developments in federal income taxation commissioner, 436 f.3d 644 (6th cir. 2/8/06), aff'g t.c. memo. 2000-283 (8/31/00). taxpayer was not permitted to deduct anticipated warranty expenses in the year it sold warranted motor vehicles to its dealers because the warranty claims had not yet been made. the court followed united states v. general dynamics corp., 481 u.s. 239 (1987), and distinguished united states v. hughes properties, inc., 476 u.s. 593 (1986), when it followed the tax court in holding that the last event in the fixing of petitioner's liability occurred no sooner than when a warranty claim was filed with petitioner by one of its dealers or by the retail customer. ii. business income and deductions a. income 1. the irs changes position on the tax treatment of rebates. rev. rul. 2005-28, 2005-19 i.r.b. 997 (4/25/05). this ruling holds that a payment made by a seller to a purchaser, the purpose and intent of which is to reach an agreed-upon net selling price, is treated as an adjustment to the sales price rather than a deduction item. therefore, medicaid rebates incurred by a pharmaceutical manufacturer are purchase price adjustments that are subtracted from gross receipts in determining gross income. rev. rul. 76-96, 1976-1 c.b. 23, which held that an automobile manufacturer's rebates paid to retail customers are deductible as ordinary and necessary business expenses under § 162, is suspended in part because the issue is being reconsidered by the irs. 2. if he didn't destroy the daily cash register tapes, it would have been much harder for him to skim. kikalos v. united states, 408 f.3d 900 (7th cir. 5/24/05). taxpayer owned three liquor stores that did not accept credit cards. most of his sales were cash sales. the problem as put by judge posner is "kikalos's stubborn refusal to retain the [daily cash register] tapes has engendered a protracted (since at least 1998) struggle with the internal revenue service." what taxpayer does daily is to manually record the total receipts from each store in a log book, and then destroys the tape. the government used the "percentage markup" method to estimate his income based on taxpayer's purchase invoices. * taxpayer sought to use expert testimony as to his income based upon both the "bank deposits" method and the "increase in net worth" method but the district court ruled that once the government chose the method to base income upon, taxpayer could not introduce evidence of another method. * the seventh circuit reversed the district court's judgment denying a refund of income taxes in the years 1998 and 2006] florida tax review 1999, and held that taxpayer could introduce expert testimony as to his income based upon a method other than the one selected by the government. judge posner's opinion also stated that taxpayer could also introduce his log books into evidence. additionally, judge posner found fault with the jury instructions: these instructions were incorrect (as well as confusing what would a term like "without any rational basis" mean to the average juror?) .... the judge was telling the jury that it was not enough for the plaintiffs to prove that the government's estimate of their tax deficiencies was incorrect. they had to prove that it was irrational. in so ruling, the judge added an element to the statutory entitlement to a refund. all the statute requires is that the taxpayer prove that he overpaid his taxes. it doesn't require him to prove that the government's assessment was not only inaccurate but irrational. suppose nick kikalos was a highly credible witness and the jury believed he'd been scrupulous about transferring the data in the z tapes to his log book, a belief the jury might find corroborated by the results of the alternative indirect methods used by the plaintiffs' expert. we do not see on what basis a jury would be required to disbelieve kikalos's testimony in favor of a rough method of estimation, just because the estimation could not be deemed irrational. there is nothing in the internal revenue code or its implementing regulations to suggest the imposition of so insuperable a burden on a refund plaintiff. a. meanwhile the seventh circuit affirms the tax court judgment sustaining his deficiency for 1997 income taxes. kikalos v. commissioner, 434 f.3d 977 (7th cir. 1/19/06). after the audits for years 1990-1992, taxpayer and the irs executed an "agreement to maintain adequate books and records," which specified the retention of daily cash register tapes. the audit focused on the cigarette sales by kikalos's stores and his treatment of "buydown" payments from cigarette companies for discounts that were supposed to have been passed on to customers. this irs audit was triggered by a bank reporting to the irs that kikalos purchased thirty-one cashier's checks in 1997 in the total amount of $809,734.51 using cash and third-party checks that the tax court found had not been included in income by taxpayer and were largely unreported "buydown" payments. taxpayer had not told his accountant about these "buydown" checks, and the tax court found that they did not overlap with the "buydown" checks that were included in income. the 20 percent negligence penalty was also upheld. [vol 8:si recent developments in federal income taxation 3. when is an advance includable in income, as opposed to it being excludable debt? kams prime & fancy food, ltd. v. commissioner, t.c. memo. 2005-233 (10/5/05). a $1.5 million advance received by the taxpayer-retailer from a supplier that was evidenced by a promissory note with the proper indicia of debt nevertheless was not a true debt, because the parties concurrently entered into a supply agreement pursuant to which the debt would be forgiven if the taxpayer purchased the quantity of product required under the supply agreement over its term; in substance, there was no unconditional obligation to repay the advance because the amounts under the note were due only if the supply agreement was materially breached by taxpayer. 4. coburn v. commissioner, t.c. memo. 2005-283 (12/5/05). debtor's release of collateral to creditor did not give rise to income from discharge of indebtedness income because taxpayer-debtor remained liable for the balance of the debt. b. deductible expenses versus capitalization 1. how to change accounting methods for the 2003 year to comply with the final regulations. rev. proc. 2004-23, 2004-16 i.r.b. 785. this revenue procedure provides an exclusive administrative procedure for taxpayers to obtain automatic consent to change to a method of accounting pursuant to reg. §§ 1.263(a)-4, 1.263(a)-5, and 1.167(a)-3(b), the final capitalization of intangible regulations for the 2003 tax year. a. changing accounting methods for years after 2003 to comply with the final regulations. rev. proc. 2005-9, 2005-2 i.r.b. 303 (12/13/04). this procedure is similar to, but not identical with, rev. proc. 2004-23. b. rev. proc. 2005-17, 2005-13 i.r.b. 797 (3/8/05). this revenue procedure modifies rev. proc. 2005-9 to provide guidance for a taxpayer's second year ending on or after 12/31/03 [for a calendar year taxpayer, the 2005 year]. this makes the five-year prior change scope limitation inapplicable to that year. 2. irs identifies issues to be addressed in forthcoming proposed regulations on tangible property costs. notice 2004-6, 2004-3 i.r.b. 308 (12/22/03). these issues include [using the numbering from the notice]: (1) what general principles of capitalization should be applied? (2) what is the appropriate "unit of property"? (3) what is the starting point for determining whether property value is increased or useful life is prolonged? (11) should the regulations provide "repair allowance" type rules? (12) should the regulations provide a de minimis 2006] florida tax review rule? (13) when should the "plan of rehabilitation" doctrine be applied? (15) are there circumstances where tax treatment should follow financial or regulatory accounting treatment? a. would you like to fly on a jet without its engines? fedex corp. v. united states, 91 a.f.t.r.2d 2003-1940, u.s.t.c. 50, 91 (w.d. tenn. 4/8/03). the district court denied the taxpayer's motion for summary judgment that expenditures for its off-wing engine maintenance program were deductible repairs under reg. § 1.162-4. the court found that there was a genuine issue of fact regarding whether the appropriate unit of property for measuring whether the expenditures added value or materially prolonged life was (1) the entire aircraft, as argued by fedex, or (2) the jet engines and auxiliary power units, as argued by the government. the court concluded that there is no 'entire vehicle' rule of law requiring that repairs be measured against the entire vehicle rather than against components. b. you don't have to, at least in memphis. fedex corp. v. united states, 291 f. supp. 2d 699 (w.d. tenn. 2003). taxpayer was permitted to deduct the costs of engine shop visits for jet aircraft engine inspection, heavy maintenance, and repair because the relevant unit of property was held to be the entire aircraft, not the engine. c. affirmed by the sixth circuit in an unpublished opinion, which holds that engines are part of a jet plane even when they are "off wing." fedex corp. v. united states, 412 f.3d 617 (6th cir. 2/16/05). the $70 million in taxes and accrued interest determined by the irs having capitalized the costs incurred for "off-wing maintenance" of its jet aircraft engines and auxiliary power units in 1993 and 1994 were improperly collected because fedex was entitled to deduct "such maintenance costs" as incidental repairs that did not appreciably prolong the life of the aircraft. 3. just when you thought you were safe from capitalization under § 263(a), § 263a rears its ugly head. rev. rul. 200418, 2004-8 i.r.b. 509 (2/23/04). costs incurred to clean up land that a taxpayer contaminated with hazardous waste by the operation of its manufacturing plant must be capitalized under § 263a and included in inventory costs. rev. rul. 98-25, 1998-1 c.b. 998, and rev. rul. 94-38, 1994-1 c.b. 35, are clarified by providing that the otherwise deductible amounts at issue are subject to capitalization to inventory under § 263a. a. allocating environmental remediation costs of a manufacturer. it's easy just allocate them to inventory produced during the year in which the costs are incurred. rev. rul. [vol. 8:si recent developments in federal income taxation 2005-42, 2005-28 i.r.b. 67 (6/20/05). this ruling extends rev. rul. 2004-18 and sets forth five situations of groundwater cleanup costs which it finds to be allocable under § 263a to the inventory produced during the taxable year the costs are incurred. the ruling also provides for an automatic change of method of accounting. 4. rev. rul. 2004-17, 2004-8 i.r.b. 516 (2/6/04). costs paid or incurred in the taxable year to remediate environmental contamination that occurred in prior taxable years do not qualify for treatment under § 1341. a. reynolds metals co. v. united states, 389 f. supp. 2d 692 (e.d. va. 8/22/05). section 1341 does not apply to environmental remediation expenses relating to prior years' income because in incurring the remediation expenses there is no "restoration of an item of income to an entity from whom the income was received or to whom the item of income should have been paid." 5. ti&rett v. united states, 96 a.f.t.r.2d 2005-5649 (w.d. tenn. 8/3/05), as amended, sept. 2, 2005. amounts paid to corporation by president/minority shareholder of a corporation in satisfaction of his contractual obligation to indemnify corporation against losses from a specific venture that he advocated corporation undertake constituted a capital contribution, not a business expense, because taxpayer had no possibility of personal business profit from the specific venture by the corporation. 6. rev. rul. 2005-47, 2005-32 i.r.b. 261. credit card issuers treat third-party atm surcharge fees incurred by their cardholders as additional amounts loaned to those cardholders. c. reasonable compensation 1. tax court distinguishes exacto spring in case appealable to seventh circuit. menard. inc. v. commissioner, t.c. memo. 2004-207 (9/16/04), reconsideration denied, t.c. memo. 2005-3 (1/6/05). in this decision, appealable to the seventh circuit and presumably governed by the "hypothetical independent investor" test of exacto spring corp. v. commissioner, 196 f.3d 833 (1999), the tax court (judge marvel) nevertheless applied the traditional factor of compensation for ceos of comparable publicly-traded corporations to disallow deduction of $13 million of the $20 million of compensation (which included 5 percent of pretax profits) paid to john r. menard, the ceo and owner of 89 percent of taxpayer's stock rather than applying solely the hypothetical independent 20061 florida tax review investor test. the court focused on language in reg. § 1.162-7(b)(3), which was not discussed in exacto spring, and which provides as follows: in any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. it is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. a. on reconsideration, makes clear that two prongs are required, i.e., (1) that the amounts paid are intended as compensation and (2) that they are reasonable in amount. t.c. memo. 2005-3 (1/6/05). in denying taxpayer's motion for reconsideration, judge marvel reiterated as an alternative ground for her decision that the taxpayer did not intend that its payment be for services in light of (1) it never having paid dividends, (2) the ceo's contractual obligation to repay any portion of the compensation found to be excessive, and (3) the failure of the board of directors to make any effort to evaluate whether the compensation was excessive. d. miscellaneous expenses 1. the irs never seems able to catch up with the movements in the price of gasoline, and more tinkering is in store for 2005. rev. proc. 2004-64, 2004-49 i.r.b. 898 (11/17/04), superseding rev. proc. 2003-76, 2003-43 i.r.b. 924. the optional standard mileage rate for business use of automobiles will increase on 1/1/05 from 37.5 cents per mile to 40.5 cents per mile; the mileage rate for medical and moving will increase from 14 cents per mile to 15 cents per mile; and the mileage rate for giving services to a charitable organization will remain at 14 cents per mile. query whether increasing the deduction for driving to the doctor so it is now greater than the deduction for driving to the charitable board meeting in 2003, the deduction for medical mileage was less than charitable mileage is because many more taxpayers deduct charitable miles than medical miles? a. the irs noticed that fuel prices went up recently, so a 9/1/05 increase in mileage rates is announced. announcement 2005-71, 2005-41 i.r.b. 714 (9/12/05). on 9/1/05, the optional standard mileage rate for business use of automobiles will increase to 48.5 cents per mile, and the standard mileage rate for medical and moving expenses will increase to 22 cents per mile. the rate for charitable miles remains at the statutory [§ 170(i)] 14 cents per mile. [vol. 8:si recent developments in federal income taxation b. under the katrina tax act, the charitable standard mileage rate would be 70 percent of the standard mileage rate for businesses if the use of the vehicle is for the purpose of providing relief related to hurricane katrina. effective for the use of a passenger automobile between 8/25/05 and 12/31/06. c. splitting the difference between the first eight months of 2005 and the last four for 2006. rev. proc. 2005-78, 2005-51 i.r.b. 1177 (12/2/05). mileage rates effective on or after 1/1/06 are as follows: business, 44.5 cents per mile; medical and moving, 18 cents per mile; general charitable contribution deduction, 14 cents per mile (statutory); hurricane katrina charitable contribution deduction, 32 cents per mile (with a hurricane katrina charitable use of automobile reimbursement rate permitted without income effect of up to 44.5 cents per mile). 2. section 201 of the jobs act of 2004 amends § 179 to extend the $100,000 amount for expensing for small businesses through years beginning before 2008. a. rev. proc. 2004-71, 2004-50 i.r.b. 970 (11/19/04). the amount is indexed for inflation, and for 2005, the indexed amounts are $105,000 and $420,000, respectively. b. rev. proc. 2005-70, § 3.18, 2005-47 i.r.b. 979 (10/29/05). for taxable years beginning in 2006, the inflation adjusted amount a taxpayer may elect to expense under § 179 cannot exceed $108,000, and the phase-out threshold begins at $430,000. c. final § 179 regulations. t.d. 9209, section 179 elections, 70 f.r. 40189 (7/13/05). the regulations are amended to take into account the increased limits of the jobs act. 3. section 907 of the jobs act of 2004 amends § 274(e) to limit the deduction in regard to expenses incurred with respect to personal use by "specified individuals" of corporate aircraft or other corporate facilities to the amount treated as compensation and included in the individual's income as wages. specified individuals are those who are subject to the requirements of § 16(a) of the securities exchange act of 1934 or would be subject to such requirements if the taxpayer were subject to the act, which generally means they are officers, directors, or own 10 percent or more of the corporation's stock. this reverses the holding to the contrary in sutherland lumber-southwest, inc. v. commissioner, 114 t.c. 197 (2000), aft'd, 255 f.3d 495 (8th cir. 2001). 2006] florida tax review the amendment is applicable to expenses incurred after the date of enactment (10/22/04). a. implementing the limitation on deduction of airplane costs. notice 2005-45, 2005-24 i.r.b. 1228 (5/27/05). this notice provides interim guidance to taxpayers on the limitation under § 274(e) on the deductible amount of trade or business expenses for use of a business aircraft for entertainment, i.e., personal use, and provides a methodology and examples as to how expenses are to be allocated to flights. applicable to expenses incurred after 6/30/05. 4. this deduction should prove so effective that it will be extended to all business income. section 102 of the jobs act of 2004 adds new § 199 to provide a nine percent deduction for u.s. manufacturing income, i.e., "income attributable to domestic production activities." for corporations, the deduction allowed by § 199 is a percentage of the lesser of "qualified production activities income" or taxable income. for individual taxpayers engaged in manufacturing, the taxable income limitation is replaced by a limitation based on adjusted gross income. the deduction will be phased in over six years, beginning with 2005. the percentage begins at three percent for 2005 and rises to nine percent after 2009, but in no event can the deduction exceed 50 percent of the w-2 wages paid by the taxpayer during the year for which the deduction is sought. irc § 199(d)(5). thus, the deduction is unavailable to a sole proprietor or partnership with no employees. although the deduction is available to individuals, corporations, and pass through entities, only items attributable to the conduct of a trade or business can be taken into account; section 199(d)(5). * qualified production activities income is defined as the excess of "domestic production gross receipts" over the sum of (1) the cost of goods sold allocable to domestic production gross receipts, (2) other deductions, expenses, or losses directly allocable to domestic production gross receipts, and (3) a ratable portion of other deductions, expenses, and losses not directly allocable to domestic production gross receipts or to any other class of income. irc § 199(c)(1). domestic production gross receipts are gross receipts derived from (1) the lease, rental, license, or sale, exchange, or other disposition of (a) "qualifying production property," defined as tangible personal property, computer software, and sound recordings, produced (in whole or in significant part) by the taxpayer in the united states, (b) a "qualified film" produced by the taxpayer, or (c) electricity, natural gas, or potable water produced by the taxpayer in the united states; (2) construction performed within the united states, or (3) architectural or engineering services performed in the united states for united states construction projects. section 199(c)(4)(b) excludes from the definition of domestic production gross receipts [vol 8:si recent developments in federal income taxation any receipts from (1) the sale of food and beverages prepared by the taxpayer at a retail establishment, or (2) the transmission or distribution (as contrasted with the production) of electricity, natural gas, or potable water. 0 because the deduction is a percentage of a specified type of net income, rather than an allowance for actual expenses incurred by the taxpayer, its effect can be viewed as reducing the effective tax rate on qualified production activities income. (indeed, it originated in a proposal to reduce the corporate tax rate generally, but through the legislative process metamorphosed into its current structure.) suppose a taxpayer has $100,000 of qualified production activities income and sufficient income from other sources to be subject to a marginal rate of 35 percent (the highest statutory rate for both individuals and corporations). the § 199 deduction reduces the taxpayer's taxable income derived from qualified production activities from $100,000 to $91,000. at 35 percent, the tax on $91,000 is $31,850, which is an effective tax rate of only 31.85 percent on the $100,000 of qualified production activities income. * section 199 is unique in allowing a deduction equal to a portion of net income generated by a general type of business activity. most tax expenditures for businesses accelerate deductions, provide deductions for amounts not otherwise deductible, allow a deduction related to gross income from a specified activity, or take the form of a credit. most tax experts believe the provision to be so complex, and the distinctions and pigeon-holing of sources of income and the purpose for which deductible expenditures were incurred that are required to calculate the amount of the deduction to be so difficult to ascertain, that the provision cannot be reasonably and consistently administered. a footnote in the conference committee report on the 2004 jobs act unintentionally illustrates the problem even in a simple context. the conferees intend that food processing, which generally is a qualified production activity under the conference agreement, does not include activities carried out at [a] retail establishment. thus, under the conference agreement while the gross receipts of a meat packing establishment are qualified domestic production gross receipts, the activities of a master chef who creates a venison sausage for his or her restaurant menu cannot be construed as a qualified production activity. the report goes on to state: the conferees recognize that some taxpayers may own facilities at which the predominant activity is domestic production as defined in the conference agreement and other 2006] florida tax review facilities at which they engage in the retail sale of the taxpayer's produced goods and also sell food and beverages. for example, assume that the taxpayer buys coffee beans and roasts those beans at a facility, the primary activity of which is the roasting and packaging of roasted coffee. the taxpayer sells the roasted coffee through a variety of unrelated thirdparty vendors and also sells roasted coffee at the taxpayer's own retail establishments. in addition, at the taxpayer's retail establishments, the taxpayer prepares brewed coffee and other foods. the conferees intend that to the extent that the gross receipts of the taxpayer's retail establishment represent receipts from the sale of its roasted coffee beans to customers, the receipts are qualified domestic production gross receipts, but to the extent that the gross receipts of the taxpayer's retail establishment represent receipts from the sale of brewed coffee or food prepared at the retail establishment, the receipts are not qualified domestic production gross receipts. however, the conferees intend that, in this case, the taxpayer may allocate part of the receipts from the sale of the brewed coffee as qualified domestic production gross receipts to the extent of the value of the roasted coffee beans used to brew the coffee. the conferees intend that the secretary provide guidance drawing on the principles of section 482 by which such a taxpayer can allocate gross receipts between qualified and nonqualified gross receipts. the conferees observe that in this example, the taxpayer's sales of roasted coffee beans to unrelated third parties would provide a value for the beans used in brewing a cup of coffee for retail sale. (h. rep. no. 108-755, at 13, n. 27 (2004)) * one is left to wonder whether starbucks is pleased that its lobbyists did such a good job in obtaining as much of a benefit as starbucks gets from this obvious direction to the treasury department regarding what the to-be-promulgated regulations will provide for starbucks or whether starbucks is displeased that it did not get even more advantageous treatment. • this provision resulted from efforts to retain some of the tax expenditure benefits provided to exporters by the extraterritorial income ("eti") regime that, like the domestic international sales corporation ("disc") and the foreign sales corporation ("fsc") regimes before it, were found to violate u.s. obligations under international trade agreements. because the objectionable feature of the eti, fsc, and disc regimes was that they provided tax benefits only for certain export activity and were thus found by the world trade organization to provide for prohibited export subsidies, the [vol 8:si recent developments in federal income taxation new deduction applies regardless of whether the manufactured goods are exported. the deduction of extraterritorial income (eti) will be eliminated in 2007 after being phased out in 2005 [80 percent deduction] and 2006 [60 percent deduction]. a wto panel has found the phase-out to be itself in violation of international trade agreements. a. if the statute appears to have a short shelf-life, the guidance under it should be even more ephemeral. notice 2005-14, 2005-7 i.r.b. 498 (1/19/05). lengthy guidance on the new manufacturing deduction. pending promulgation of what surely will be voluminous regulations governing the allocation of deductions, expenses, and losses for the purpose of calculating qualified production activities income, notice 2005-14 provides interim guidance. b. proposed regulations. reg-105847-05, income attributable to domestic production activities, 70 f.r. 67220 (11/4/05). massive [224 pages] proposed regulations [§ § 1.199-1 through -8] deal with the deduction for u.s. manufacturing income under § 199. the "shrinking back" concept of taking the deduction for only the value of the beans in a cup of brewed coffee, or for the value of the u.s.-manufactured shoelaces on a pair of foreign-manufactured sneakers is being much discussed. 5. the irs attempts to define "insurance" in terms of risk shifting and risk distribution, which means that the insurance company must insure more than one person. note how twelve singlemember llcs may or may not be more than one person. rev. rul. 200540, 2005-27 i.r.b. 4 (6/17/05). this ruling provides guidance to clarify that the elements of risk shifting and risk distribution must be present for an arrangement to be considered insurance for federal income tax purposes, citing helvering v. le gierse, 312 u.s. 531 (1941). four situations are set forth. the first three situations are held to be "not insurance" and they involve an unrelated person receiving premiums to insure the risk of a single taxpayer that operates a large fleet of automotive vehicles in the courier transport business, including (in situation 3) twelve single-member llcs of approximately equal size owned by the same person which are classified as disregarded entities. in situation 4, each of those llcs elects to be classified as an association, and the arrangement is held to be "insurance." * compare the different view of insurance in sears, roebuck & co. v. commissioner, 972 f.2d 858, 861-62 (1992), where judge easterbrook stated: what is "insurance" for tax purposes? the code lacks a definition. le gierse mentions the combination of risk 2006] florida tax review shifting and risk distribution, but it is a blunder to treat a phrase in an opinion as if it were statutory language ... corporations accordingly do not insure to protect their wealth and future income, as natural persons do, or to provide income replacement or a substitute for bequests to their heirs (which is why natural persons buy life insurance). investors can "insure" against large risks in one line of business more cheaply than do corporations, without the moral hazard and adverse selection and loading costs: they diversify their portfolios of stock. instead corporations insure to spread the costs of casualties over time. 6. tool allowance is not paid under an accountable plan. rev. rul. 2005-52, 2005-35 i.r.b. 423 (8/3/05). a tool allowance paid by an employer in the automobile repair and maintenance business to its service technicians based upon the numbers of hours worked by each service technician is not an accountable plan such that the payments are excluded from the employees' gross income and exempt from the withholding and payment of employment taxes because it fails to meet both the "substantiation" and the "return of excess" requirements (although it does meet the "business connection" requirement). the set amount for each hour worked paid by the automobile repair business to the employee-mechanics, who were required to purchase their own tools, as a "tool allowance" was includable in gross income as an itemized employee business expense deduction, because employees were not required to provide any substantiation of expenses incurred for tools and employer did not require employees to return any portion of the tool allowances that exceeded their actual expenses. a. to the same effect. namyst v. commissioner, t.c. memo. 2004-263 (11/17/04). reg. § 1.62-2(f) conditions application of the netting rule [permitting an above-the-line deduction of employee business expenses pursuant to an accountable plan] on the employee being required to return excess advances to the employer. the taxpayer, instead, was required to include expense reimbursements in gross income because although he was required to [and did meticulously] account to the employer for his expenses, the taxpayer was not obligated to return any excess advances to the employer. (1) affirmed. namyst v. commissioner, 435 f.3d 910, 2006-1 u.s.t.c. 50,163 (8th cir. 1/27/06). these payments did not meet the standards set forth in reg. § 1.62-2 for payments to qualify as being part of an "accountable plan" because the payments were not differentiated between reimbursements of expenses and for payments [vol. 8:si recent developments in federal income taxation with respect to tools. the court affirmed the tax court's refusal to treat substantiated payments as made under a qualified accountable plan while treating unsubstantiated payments as payments under a nonaccountable plan because the plan as a whole must meet the requirements of an accountable plan for such treatment. 7. the deduction for the cost of clothing purchased under a "once-wear" policy was disallowed because the clothing was not unsuitable for personal wear. deihl v. commissioner, t.c. memo. 2005287 (12/15/05). the tax court (judge wherry) held inter alia that clothing to be worn only once at conventions or other promotional meetings was not deductible under the test that it must be "not suitable for general or personal wear" as applied objectively. the clothing would not meet that test under a subjective methodology because the court found taxpayer's testimony to that effect "overly broad and exaggerated." pevsner v. commissioner, 628 f.2d 467 (5th cir. 1980), followed. e. depreciation & amortization 1. maguire/thomas partners fifth & grand, ltd. v. commissioner, t.c. memo 2005-34 (2/28/05). the tax court (judge colvin) held that the costs incurred to obtain a zoning change with respect to land are not depreciable, but the costs to obtain a zoning variance relating to a specific building to be constructed on a specific parcel of land are depreciable as part of the cost of the building. 2. section 1245(b)(8), added to the code by the energy tax incentives act of 2005, provides that if a taxpayer disposes of several § 197 intangibles in one transaction, or in a series of related transactions, all the intangibles are treated as a single asset for purposes of calculating § 1245 recapture. f. credits 1. arevalo v. commissioner, 124 t.c. 244 (5/18/05). taxpayer's $10,000 investment in pay phones gave him merely legal title but did not give him the benefits and burdens of ownership with respect to the pay phones; he was therefore not entitled either to depreciation or to the § 44 disabled access credit. in particular, he was not entitled to the credit because the investment in pay phones was not an eligible access expenditure. taxpayer who "purchased" unidentified pay phones that he never possessed or controlled, which continued to be operated and serviced by a corporation related the seller, with respect to which the taxpayer bore no risk of loss and never paid taxes, insurance, or license fees, and from which the taxpayer was 2006] florida tax review guaranteed a minimal fixed return, did not have a depreciable interest in the telephones because he did not have the benefits and burdens of ownership. 2. the katrina tax act provides a "work opportunity tax credit" for hurricane katrina employee survivors and an "employee retention credit" for employers affected by hurricane katrina. 3. section 41(b)(3)(d), added to the code by the energy tax incentives act of 2005, permits taxpayers to take into account 100 percent of contract research expenses paid to eligible small businesses, universities, and federal laboratories. 4. section 41(a)(3), added to the code by the energy tax incentives act of 2005, provides a credit equal to 20 percent of a taxpayer's share of the expenses of an "energy research consortium." to be qualified, a consortium must be an organization described in § 501(c)(3), and must have received payments (including contributions) from at least five unrelated persons during the calendar year (with no more than half of the payments coming from any single person). in contrast with the usual rule under § 41, the energy research consortium credit applies to all described expenditures, rather than only to expenditures in excess of some base amount. g. natural resources deductions & credits 1. the energy tax incentives act of 2005 classified natural gas gathering lines as seven-year property. irc § 168(e)(3)(c)(iv). 2. iowa 80 group, inc. v. irs, 406 f.3d 950 (8th cir. 5/4/05), aff'g 371 f. supp. 2d 1036 (s.d. iowa 2004). floor space of truck stop occupied by a movie theater, arcade, television lounge, restaurant, showers, and laundromat was not devoted to petroleum marketing sales because such features are not normally associated with a service station; taxpayer failed 50 percent test of § 168(e)(3)(e)(iii)). 3. the energy tax incentives act of 2005 added two new classes of fifteen-year property: (1) section 1245 property used in the transmission of electricity at sixty-five or more kilovolts, and (2) certain natural gas distribution lines. irc §§ 168(e)(3)(e)(vii), 168(e)(3)(e)(viii). 4. energy efficient commercial buildings. section 179d, added to the code by the energy tax incentives act of 2005, provides a deduction for the cost of "energy efficient commercial building property" placed in service during 2006 or 2007. qualified property must be installed in a building within the united states as part of (1) the interior [vol. 8:si recent developments in federal income taxation lighting systems, (2) the heating, cooling, ventilation, and hot water systems, or (3) the building envelope, and must be certified as being installed pursuant to a plan designed to reduce the building's total annual energy and power costs by at least 50 percent in comparison to a hypothetical reference building. the deduction may not exceed $1.80 per square foot of the property. the statute directs the treasury department, in consultation with the department of energy, to promulgate regulations setting forth methods of calculating and verifying energy and power costs. in the case of an expenditure made by a public entity (such as a public school), the statute directs the treasury department to promulgate regulations allocating the deduction to the designer of the property in lieu of the owner. 0 if a building does not satisfy the overall 50 percent reduction standard, a partial deduction (limited to $0.60 per square foot) is allowed for system-specific energy efficient property, if a specific system (i.e., (1) interior lighting, (2) heating, cooling, ventilation and hot water, or (3) building envelope) satisfies system specific targets to be established by regulations (with the statute providing an interim target, in the case of lighting system retrofits). 5. the energy tax incentives act of 2005 liberalized § 613a(d)(4); the new limit is 75,000 barrels per day, and it is based on average daily production for the entire year rather than maximum daily production on any day. 6. under § 167(h), added to the code by the energy tax incentives act of 2005, amounts incurred in connection with geological and geophysical exploration within the united states may be amortized ratably over a 24-month period. 7. the energy tax incentives act of 2005 extended the carryback period to five years with respect to a portion of the nols of certain electric utility companies arising in taxable years ending in 2003, 2004, and 2005. irc § 172(b)(1)(i). 8. the energy tax incentives act of 2005 added two new components to the energy credit: (1) a credit equal to 30 percent of the cost of "qualified fuel cell property," and (2) a credit equal to 10 percent of the cost of "qualified microturbine property." the new components of the credit are available only for property placed in service in 2006 or 2007. in addition, the act increases the credit rate to 30 percent for solar energy property, for 2006 and 2007. also for only those two years, the act provides a 30 percent credit for the cost of fiber-optic solar lighting systems. 2006] florida tax review 9. a credit under § 45 is allowed under the energy tax incentives act of 2005 for the production of "indian coal," defined as coal produced from reserves which were owned by (or held in trust by the united states for the benefit of) an indian tribe or its members on june 14, 2005. to qualify for the credit, the coal must be produced by a facility placed in service before january 1, 2009. the credit is available for coal produced during the years 2006 through 2012, and sold by the taxpayer to unrelated persons during the same time frame. the credit amount is $1.50 per ton of indian coal during the years 2006 through 2009, and $2.00 per ton thereafter. 10. the energy tax incentives act of 2005 redesignated § 29 as § 45k, and made it part of the general business credit. it also added a credit for qualified facilities producing coke or coke gas. a qualified facility must have been placed in service before 1993, or after june 30, 1998, and before january 1, 2010. the credit amount is $3.00 (adjusted for post-2004 inflation) per barrel-of-oil equivalent, subject to a ceiling of an average barrel-of-oil equivalent of 4,000 barrels per day. with respect to production from a particular facility, the credit is available only for the fouryear period beginning on the later of january 1, 2006, or the date the facility is placed in service. 11. the energy tax incentives act of 2005 added a third credit to the § 40a mix, the "small agri-biodiesel credit." the credit equals 10 cents per gallon of qualified agri-biodiesel production (which is limited to 15 million gallons per year). it is available only to producers with an annual productive capacity of no more than 60 million gallons. the 2005 act also provides that "renewable diesel" is treated in the same manner as biodiesel for purposes of the bmc and the bc, except that the credit amount is increased to $1.00 per gallon. renewable diesel is defined as diesel fuel derived from biomass using a thermal depolymerization process. all credits under § 40a are scheduled to expire at the end of 2008. 12. credit for production from advanced nuclear power facilities. section 45j, added to the code by the energy tax incentives act of 2005, provides a credit of 1.8 cents per kilowatt-hour of electricity produced at a qualifying advanced nuclear power facility during the eight-year period beginning on the date the facility is placed in service. for a facility to qualify, the taxpayer must have received an allocation of megawatt capacity from the irs, and the facility must have been placed in service before january 1, 2021. if the megawatt allocation to the facility by the irs is less than the facility's rated nameplate capacity, the otherwise allowable credit per kilowatt hour produced by the facility is proportionately reduced. for example, if the megawatt allocation were one-third of the rated nameplate capacity, the credit would be 0.6 cents per kilowatt hour. a [vol 8:si recent developments in federal income taxation taxpayer's annual credit during the eight-year period may not exceed $125 million per 1,000 megawatts of allocated capacity. thus, for example, the credit ceiling for a taxpayer with 200 megawatts of allocated capacity would be $25 million. 13. credits for investments in clean coal facilities. the energy tax incentives act of 2005 introduced two new credits for investments in clean coal facilities. section 48a provides a credit for investments in "qualifying advanced coal projects," defined as projects using integrated gasification combined cycle (igcc) and other advanced coalbased technologies for generating electricity. the credit rate is 20 percent of qualifying investments for igcc projects, and 15 percent for other projects. the credit is available only for projects certified by the irs, following consultation with the energy department. aggregate credits allowed for certified projects may not exceed $800 million for igcc projects, and $500 million for other projects. section 48b provides a 20 percent credit for investments in "qualifying gasification projects," defined as projects involving the conversion of coal, petroleum residue, biomass, or certain other materials into a synthesis gas composed primarily of carbon monoxide and hydrogen. like its companion credit, this credit is available only for projects certified by the irs, in consultation with the department of energy. total credits allocable by the irs are limited to $350 million, of which no more than $130 million may be allocated to any single gasification project. 14. new energy efficient home credit. section 45l, added to the code by the energy tax incentives act of 2005, provides a credit, in the amount of either $2,000 or $1,000, to an eligible contractor (including the producer of a manufactured home) who constructs and sells an energy efficient home to a person who will use the home as a residence. to qualify for the $2,000 credit, the home must be certified (in accordance with guidance to be prescribed by the treasury department) as having a level of annual heating and cooling energy consumption at least 50 percent below the level of a comparable hypothetical reference dwelling unit, with at least onefifth of the energy savings attributable to the building envelope. the $1,000 credit, which applies only to manufactured homes, requires at least a 30 percent reduction in energy consumption, of which at least one-third must be attributable to the building envelope. manufactured homes are also eligible for the $2,000 credit, if they satisfy the usual requirements for that credit. the credit is available only with respect to homes the construction of which is substantially completed after 2005, and which are purchased during 2006 or 2007. the credit is part of the general business credit. 15. energy efficient appliance credit. section 45m, added to the code by the energy tax incentives act of 2005, provides a 2006] florida tax review credit to the manufacturer of certain energy efficient dishwashers, clothes washers, and refrigerators. the credit applies only to appliances produced in 2006 and 2007. in the case of dishwashers, the credit is available only for dishwashers satisfying the (not yet known) energy star standards for 2007. the per-dishwasher credit amount is the product of $3 and the percentage by which the 2007 standards exceed the 2005 standards, subject to a $100 ceiling. in the case of clothes washers, the credit amount is $100 for each washer manufactured in 2006 or 2007 which meets the 2007 energy star standards. for refrigerators, the credit amount rules are rather complex: $75 for a refrigerator manufactured in 2006 and exceeding 2001 energy conservation standards by at least 15 percent, $125 for a refrigerator manufactured in 2006 or 2007 and exceeding 2001 standards by at least 20 percent, and $125 for a refrigerator manufactured in either year and exceeding 2001 standards by at least 25 percent. the credit applies only to appliances which constitute "excess production," which is defined as the excess of the number of appliances produced by the taxpayer in the united states during the calendar year (2006 or 2007) over the taxpayer's average production during the preceding three years (or over 110 percent of the average production over the preceding three years, in the case of refrigerators). the total amount of credits a taxpayer may claim under § 45m, for the two years combined, is limited to $75 million, and the credit allowed in any one year may not exceed 2 percent of the taxpayer's annual average gross receipts for the three preceding taxable years. the credit is part of the general business credit. 16. alternative motor vehicle credit. section 30b, added to the code by the energy tax incentives act of 2005, provides a credit for certain "alternative motor vehicles." the credit is available in the year a qualifying vehicle is placed in service-for either business or personal use by the taxpayer. the credit is generally allowed to the owner of the vehicle, including the lessor of a vehicle subject to a lease. if a vehicle is sold to a tax exempt user, the person who sold the vehicle to the user may claim the credit, but only if the seller clearly discloses the amount of the credit to the user. irc § 30b(h)(6). a taxpayer claiming the credit must reduce his basis in the vehicle by the amount of the credit. the credit has four components: (1) the new qualified fuel cell motor vehicle credit, (2) the new advanced lean bum technology motor vehicle credit, (3) the new qualified hybrid motor vehicle credit, and (4) the new qualified alternative fuel motor vehicle credit. a qualifying fuel cell vehicle is a vehicle, the original use of which commences with the taxpayer, which is propelled by power derived from one or more cells which convert chemical energy into electricity by combining oxygen with hydrogen fuel, and which satisfies certain emission standards established by the environmental protection [vol 8:si recent developments in federal income taxation agency (in the case of cars and light trucks). the basic fuel cell credit amount depends on the gross vehicle weight rating, and ranges from $8,000 for a vehicle with a rating of 8,500 pounds or less (but only $4,000 for a vehicle placed in service after 2009), to $40,000 for a vehicle with a rating of more than 26,000 pounds. the credit is increased, by amounts ranging from $1,000 to $4,000, if the vehicle satisfies specified fuel economy standards. 0 a qualifying advanced lean bum technology vehicle must (1) have an internal combustion engine designed to operate using more air than is necessary for complete combustion, (2) use direct injection, (3) achieve at least 125 percent of 2002 model year city fuel economy, and (4) have been certified as satisfying certain emission standards established by the environmental protection agency. the original use of the vehicle must commence with the taxpayer. the credit for lean bum vehicles has two components. the fuel economy component depends on the vehicle's fuel economy as a percentage of 2002 model year city fuel economy, and ranges from a low of $400 (for at least 125 percent of the 2002 standard) to a high of $2,400 (for at least 250 percent of the 2002 standard). the conservation component depends on the vehicle's gallons of lifetime fuel savings, and ranges from $250 (for savings of at least 1,200 gallons) to $1,000 (for savings of at least 3,000 gallons). the savings are based on an assumption of 120,000 lifetime miles, and are calculated relative to a comparable 2002 model year vehicle. * a new qualified hybrid motor vehicle is a vehicle, the original use of which commences with the taxpayer, which uses both an internal combustion engine and a rechargeable battery system, which meets specified emission standards, and which meets specified minimum standards for maximum available power. for cars and light trucks, the credit amount is the sum of the fuel economy component and the conservation component, determined under the same rules applicable to lean bum vehicles. for other vehicles, the credit is a percentage of the excess of the manufacturer's suggested retail price (msrp) for the vehicle over the msrp of a comparable non-hybrid vehicle 20 percent if the vehicle achieves at least a 20 percent increase in city fuel economy relative to a comparable non-hybrid vehicle, 30 percent for an increase of at least 40 percent, and 40 percent for an increase of at least 50 percent. * a new qualified alternative fuel motor vehicle is a vehicle, the original use of which commences with the taxpayer, which is capable of using only an alternative fuel (natural gas, liquefied petroleum gas, hydrogen, or any liquid consisting of at least 85 percent methanol by volume). the credit is a percentage of the excess of the msrp of the vehicle over the msrp of a comparable non-alternative fuel vehicle generally 50 percent, but increased to 80 percent if the vehicle has been certified as meeting certain emissions standards. a reduced credit is available for vehicles which use a mix of gasoline and an alternative fuel. if a vehicle uses at 2006] florida tax review least 75 percent alternative fuel the credit is 70 percent of the credit which would be available if the vehicle used only an alternative fuel, and if the vehicle uses at least 90 percent alternative fuel the credit is 90 percent of the credit which would be available for a vehicle using only an alternative fuel. * the alternative motor vehicle credit applies to vehicles placed in service after 2005 and purchased before 2015 (for fuel cell vehicles), 2011 (for lean bum vehicles and alternative fuel vehicles), or 2010 (for hybrid vehicles). in the case of hybrid vehicles and lean bum vehicles, the amount of the credit is phased down first to 50 percent of the otherwise available credit, then to 25 percent, and finally to nothing for vehicles sold after the manufacturer has sold 60,000 hybrid and/or lean bum vehicles for use in the united states. as congress surely realized and intended, this phasing down of the credit is likely to impact certain japanese manufacturers sooner than it impacts any american manufacturers. * for business taxpayers the credit is part of the general business credit. when claimed as a personal credit, the credit is allowable only to the extent of the excess of the regular tax (as reduced by specified other credits) over the tentative minimum tax. 17. alternative fuel vehicle refueling property credit. section 30c, added to the code by the energy tax incentives act of 2005, provides a credit equal to 30 percent of the cost of any qualified alternative fuel vehicle refueling property placed in service by the taxpayer. qualifying fuels are ethanol, natural gas, compressed natural gas, liquefied natural gas, liquefied petroleum gas, hydrogen, and mixtures of diesel and biodiesel containing at least 20 percent biodiesel. for a business taxpayer, the credit may not exceed $30,000. the credit is also available to a taxpayer installing a refueling facility on the grounds of his personal residence for personal use, but the maximum amount of the nonbusiness credit is $1,000. the business credit is part of the general business credit, and the personal credit is allowed only to the extent of the excess of the regular tax (reduced by certain other credits) over the tentative minimum tax. the credit is not available for property placed in service after 2009 (or after 2014, in the case of property relating to hydrogen). 18. nonbusiness energy property credit. section 25c, added to the code by the energy tax incentives act of 2005, provides a nonrefundable credit for certain expenditures to improve the energy efficiency of a taxpayer's principal residence. in the case of "qualified energy efficiency improvements" (qeels), the credit equals 10 percent of the cost of the improvements. a qeei is any energy efficient building component (i.e., insulation, exterior windows and doors, and certain coated metal roofs) satisfying criteria established by the 2000 international energy conservation code, if the original use of the component commences with the [vol. 8:si recent developments in federal income taxation taxpayer and the component is expected to remain in use for at least five years. the other category of credit-eligible costs is "residential energy property expenditures" (repes). repes are expenditures for the following types of property, if they are installed in the taxpayer's principal residence and satisfy energy efficiency standards to be promulgated by the secretary of the treasury pursuant to detailed statutory instructions: (1) main air circulating fans, (2) natural gas, propane or oil furnace or hot water boilers, and (3) "energy efficient building properties" (electric heat pump water heaters, electric heat pumps, geothermal heat pumps, central air conditioners, and water heaters using natural gas, propane, or oil). for repes the credit amount is established by schedule: the first $50 of the cost of a main air circulating fan, the first $150 of the cost of a natural gas, propane, or oil furnace or hot water boiler, and the first $300 of the cost of any item of energy-efficient building property. there is a lifetime limit of $500 on the aggregate credits a taxpayer may claim under § 25c, of which no more than $200 may be based on expenditures for windows. the credit is available only for property placed in service in 2006 or 2007. 19. credit for residential energy efficient property. section 25d, added to the code by the energy tax incentives act of 2005, provides a nonrefundable credit for certain expenditures on residential energy efficient property. qualifying property is of three types: photovoltaic property (which uses solar energy to generate electricity), solar water heating property, and fuel cell property (which converts a fuel into electricity using electrochemical means). the property must be installed in a dwelling unit located in the united states and used by the taxpayer as a residence (principal residence, in the case of fuel cell property). expenditures allocable to a swimming pool or hot tub are not eligible for the credit. the credit equals 30 percent of qualifying expenditures, subject to annual ceilings (on the credit amounts, not on credit-eligible expenditures) of $2,000 for photovoltaic property, $2,000 for solar water heating property, and $500 per half kilowatt of capacity of fuel cell property. the credit is available only for property placed in service in 2006 or 2007. h. loss transactions, bad debts, and nols 1. malone v. commissioner, t.c. memo. 2005-69 (4/4/05). parent who provided funds to pay expenses of business conducted by his minor children could not deduct expenses because they were not incurred in his business. 20061 florida tax review i. at-risk and passive activity losses 1. rabinowitz v. commissioner, t.c. memo. 2005-188 (7/27/05). apparel design and distribution business conducted through an s corporation and jet chartering activity conducted as a sole proprietorship, which chartered the jet to the apparel business, as well as to other customers, were two separate activities because there was no organizational relationship other than common ownership, no close economic relationship, and the activities were dissimilar. 2. hubert enterprises. inc. v. commissioner, 125 t.c. 72 (9/21/05). a member of a limited liability company (llc) taxed as a partnership is not at-risk for any amount borrowed by the llc with full recourse against the llc because under relevant state law llc members were not liable for llc's debts and the member did not guarantee the debt. 0 the aggregation of § 1245 property leasing activities of a partnership under § 465(c)(2)(b)(i) applies only to leases in which the property is placed in service in the same year; activities involving leased property placed in service in different years may not be aggregated. 3. rev. rul. 2005-64, 2005-39 i.r.b. 600 (9/26/05). if the owner of an aircraft leases it to others for transportation but provides the services of the pilot and crew with the aircraft, the use of the aircraft by the lessee is incidental to its receipt of the extraordinary personal services provided the lessor, and the activity therefore is not a rental activity for purposes of § 469; if the owner of the aircraft does not provide the services of the pilot and crew the activity is a rental activity for purposes of § 469. 4. d'avanzo v. united states, 67 fed. cl. 39 (7/26/05), appeal dismissed, no. 05-5174, 2006 u.s. app. lexis 4545 (fed. cir. 2/14/06). taxpayer did not offer a contemporaneous written record of the number of hours he spent performing personal services with respect to rental properties; noncontemporaneous log book of hours claimed to have been devoted to real estate activities and testimony at trial, alone, are inadequate evidence to establish that taxpayer devoted requisite number of hours to real estate business activities. 5. ramsburg v. commissioner, t.c. memo. 2005-252 (10/31/05). section 469(g)(1) does not apply to permit deduction of suspended passive activity losses following the distribution by the partnership to taxpayer-partner [in a tax-free distribution under § 731] of assets used by partnership in an activity with respect to which the taxpayerpartner was passive. [vol 8:si recent developments in federal income taxation 6. misko v. commissioner, t.c. memo. 2005-166 (7/6/05). a lawyer practicing through a c corporation had nonpassive losses from renting computer and other equipment to the corporation. temp. reg. § 1.469-1t(e)(3)(i)(d) excludes from the definition of rental activities that are per se passive any rental that is "incidental," as defined in temp. reg. § 1.469-1t(e)(3)(vi), to a nonrental activity of the taxpayer. to qualify for the incidental activity exception the property must predominantly be used in the taxpayer's active trade or business which may be conducted individually, through a closely held corporation in which he is a shareholder, or through a partnership in which he is a partner during the taxable year or during at least two of the five immediately preceding taxable years, and the gross rental income from the property for the taxable year must be less than 2 percent of the lesser of the unadjusted basis or fair market value of the property. this rule can be a sword for the taxpayer. an individual who conducts a business through a corporation, and who owns and leases to the corporation equipment used by the corporation in the conduct of its business, can recharacterize losses from the rental activity as nonpassive losses and deduct those losses against the salary received from the corporation. 7. assaf v. commissioner, t.c. memo. 2005-14 (1/31/05). this case applied the exception contained in temp. reg. § 1.4691t(e)(3)(i)(d) where the taxpayer leased office space to attorneys and provided to its tenants various support services a paralegal, a legal intern, a law clerk, an up-to-date law library, a computer with legal research capabilities, two conference rooms, staff who performed client intake, answered phones, took messages, filed documents at the courthouse and state capitol, typed briefs, took dictation, referred cases, scheduled depositions and court reporters, arranged travel, managed a file room and file storage, and performed legal research because the tenants "leased space exclusively so that they would have the benefit of those services." the regulations provide a special exception to the per se rule where "extraordinary personal services" are provided by (or on behalf of) the lessor in connection with "making such property available for use by customers (without regard to the average period of customer use). temp. reg. § 1.469-1t(e)(3)(ii)(c). this exception applies only where the use by customers of the rented property is incidental to their receipt of services. temp. reg. § 1.469-1t(e)(3)(v). iii. investment gain a. capital gain and loss 1. vision information services, llc v. commissioner, 419 f.3d 554 (6th cir. 8/22/05). outsourcing agreement for use of taxpayer's "business plan" and conditional "exclusive" license of taxpayer's software to 2006] florida tax review fox video, under which taxpayer could "sell" its business model to others if the use of the model was limited to certain products not covered by the taxpayer's agreement with fox video in exchange for fixed installment payments was not a sale or exchange; agreement was for the taxpayer to use its know-how and the software to provide direct-to-retail services on fox video's behalf. the arrangement is merely a nonexclusive license, there has been no sale or exchange and the licensor realizes ordinary income. although § 1235 can apply to an exclusive software license, a conditional "exclusive" license of taxpayer's software to implement a "business plan" to fox video, under which taxpayer retained rights to license use to others if the use of the software and business plan was limited to certain products not covered by the taxpayer's agreement with fox video did not qualify as a transfer of all substantial rights because it did not cover "all practical fieldsof-use." 2. house sales by transferred employees. rev. rul. 2005-74, 2005-51 i.r.b. 1153 (11/30/05). this ruling sets forth three situations relating to whether a transferred employee sold his home to his employer (via the relocation company retained by the employer), or whether he sold it to a third party. the first two were held to be a sale to the employer, either pursuant to an appraisal (situation 1) or an appraisal with an "amended value option" that increases the sale price if a third-party buyer makes a higher offer (situation 2). the third was held to be a sale to a third party buyer, where the relocation company merely pays the employee the value of his equity based on the higher amended value only if the sale to the third party buyer closes (situation 3). the ruling applied a transfer of benefits and burdens of ownership analysis to the various structures of employer sponsored relocation programs involving the purchase of the employee's home by the employer through the employer's agent or to a third party facilitated by the employer's agent. execution of blank deed by employee and delivery to employer's agent company may be consistent with, but does not necessarily evidence, closed sale. a price adjustment contingent on management relocation company receiving a bona fide third party offer at a higher price subsequent to closing with employee does not necessarily mean benefits and burdens of ownership have not passed. a price adjustment contingent on management relocation company entering into contract to resell at a higher price subsequent to closing with employee indicates that benefits and burdens of ownership have not passed. 0 query whether the employee has income because he apparently pays no brokers' commissions on the sale of his house. 3. questioning the collar. irs tech. advice mem. 200604033 (10/20/05), first discussed in a david cay johnston story in the [viol. 8:si recent developments in federal income taxation new york times, 12/30/05. he discusses a then-unreleased tam that says that a loan of shares subject to a prepaid variable forward results in a sale for tax purposes because the agreement provided that the shares that were the subject of the forward contract would be lent to the forward contract counterparty. it also provided that § 1058, which provides for the nonrecognition of gain in some securities lending transactions, does not apply because the taxpayer had given up all indicia of ownership, including most risk of loss and opportunity for gain. the tam distinguished the transaction at issue from the type permitted under rev. rul. 2003-7. a. this collar just plain clean works. rev. rul. 2003-7, 2003-5 i.r.b. 363 (1/16/03). the irs ruled that a shareholder has neither sold stock currently nor caused a constructive sale of stock under § 1259 where he (1) receives a fixed amount of cash, (2) simultaneously enters into an agreement to deliver on a future date a number of shares of common stock that varies significantly depending on the value of the shares on the delivery date [but which does provide a "collar" on the number of shares of stock to be delivered, in effect providing a "collar" on the ultimate sale price], (3) pledges the maximum number of shares for which delivery could be required, (4) has the unrestricted right to deliver the pledged shares or to substitute cash or other shares on the delivery date, and (5) is not economically compelled to deliver the pledged shares. 0 there was not a sale of the pledged shares because the shareholder was not required to relinquish the pledged shares but had an unrestricted right to reacquire them by delivering cash or other shares. there was not a constructive sale under § 1259(c)(1)(c) because due to the variation in the number of shares that might be delivered, the agreement was not a contract to deliver a substantially fixed amount of property for purposes of § 1259(d)(1). 4. irs backs down on its effort to have tax return preparers enter all security sales transactions on schedule d or schedule d-1. on 1/9/06, the irs published on its web site the following notice of clarification of the 2005 instructions for schedule d (form 1040): the irs has received many inquiries about a new instruction that was added on page d-6 of the 2005 schedule d instructions for completing lines 1 and 8. the new instruction states: you must enter the details of each transaction on a separate line. if you have more than five transactions to report on line 1 or line 8, report the additional transactions on schedule d-1. use as many schedules d20061 florida tax review 1 as you need. enter on schedule d, lines 2 and 9, the combined totals from all your schedules d-1. do not enter "see attached" and summary totals from an attachment in lieu of reporting the details of each transaction directly on schedule d or d-1. the new instructions on page d-6 were meant to highlight and clarify [the existing] rules, not to change them. therefore, taxpayers may continue to use a substitute statement to provide all of the same information and in a similar format to lines 1 and 8 of schedules d and d-1. they are not required to use the official version of schedules d and d-1 to provide the details on each transaction. however, the details of each transaction still must be provided with the tax return and not just upon request. a. one of the inquiries was a 12/23/05 letter from the chair of the aicpa tax executive committee, which stated that tax-return preparers traditionally reported the summary totals found on yearend brokerage statements directly onto the schedule d, with a notation to "see attached" brokerage statements [for taxpayers who are involved with numerous security sales transaction during the course of the calendar year]. the letter noted that large corporations that use summary form procedures may state on their return that transactional data details will be made available upon request. 5. david taylor enterrises. inc. v. commissioner, t.c. memo. 2005-127 (5/31/05). "classic cars" sold by automobile dealer whose primary sales were new automobiles were ordinary assets, not capital assets; although the "classic cars" were physically segregated from the new car inventory because sales of classic cars were frequent and substantial, the dealership's accounting treatment of the classic cars did not differ from its accounting treatment of the inventory of new and used cars, and it advertised and otherwise marketed the classic cars for sale. b. section 1031 1. exclusion of gain under §§ 121 and 1031 when a single property is both a personal residence and a business or investment property, either sequentially or simultaneously. rev. proc. 2005-14, 2005-7 i.r.b. 528 (2/3/05) (as corrected). this revenue procedure provides guidance on how a homeowner can exclude gain on the sale or exchange of a home under § 121 and also defer gain from a like-kind exchange on the same property under § 1031. this guidance also clarifies that the property can be [vol. 8:si recent developments in federal income taxation used consecutively or concurrently as a home and a business, i.e., use as rental property or an office in the home, respectively. detailed examples are included. 2. nonrecognition denied caught by a targeted anti-abuse rule. rev. rul. 2002-83, 2002-49 i.r.b. 927 (11/26/02). individual a owned highly appreciated real property held for investment (property 1) and individual b, related to individual a within the meaning in § 267(b), owned real property (property 2), which was not appreciated. in a multiparty like-kind exchange a and b each transferred their properties to a qualified intermediary. c, an unrelated purchaser of property 1, transferred cash to the qualified intermediary, who transferred property 2 to a, property 1 to c, and the cash to b. the irs ruled that pursuant to § 1031(0, a taxpayer a who transfers relinquished property to a qualified intermediary in exchange for replacement property formerly owned by a related party is not entitled to nonrecognition treatment under § 1031 (a) if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property. based on the legislative history [h.r. rep. no. 101-247 at 1340 (1989)], the irs reasoned that the purpose of § 1031 (f) is to deny nonrecognition treatment for transactions in which related parties make like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. accordingly, the irs applied § 1031 (0(4) because the multi-party exchange was "part of a transaction (or a series of transactions) structured to avoid the purposes of § 103 1(f)(1)." a. reality overtakes rev. rul. 2002-83. teruya brothers, ltd. v. commissioner, 124 t.c. 45 (2/9/05). taxpayer transferred properties to a qualified intermediary, who sold them to unrelated third parties and used the proceeds to purchase like-kind replacement property from a related party. judge thornton held that the transactions were economically equivalent to direct exchanges between the taxpayer and related party, followed by the related party's sale of the properties to unrelated third parties, and that they were structured to avoid the purposes of § 1031(0. it further held that taxpayer failed to prove that avoidance was not one of the principal purposes of the transactions under the § 1031(0(4) exception because even though more gain was recognized by the related party on some of the properties, the only tax consequences of the gain recognition were reduction of the related party's net operating loss as opposed to current taxation for taxpayer. 3. new rules on like-kind personal property classes. t.d. 9202, additional rules for exchanges of personal property under section 1031(a), 70 f.r. 28818 (5/19/05). final regulations replace the use 2006] florida tax review of the standard industrial classification (sic) system with the north american industry classification system (naics) for taxpayers that engage in like-kind exchanges of depreciable tangible personal property to determine what properties are of a like class for purposes of § 1031. 0 the regulations are effective to transfers of property made on or after 8/12/04, but may be elected for property transfers made on or after 1/1/97 (open years only). additionally, taxpayers may use the old sic rules for property transfers made on or before 5/19/05. c. section 1033 1. payments made by a state agency to reimburse losses that a "qualifying business" incurred for damage or destruction of real and personal property on account of a disaster. rev. rul. 2005-46, 2005-30 i.r.b. 120 (7/8/05). disaster relief grants under a state reimbursement program are not excludible from gross income under the general welfare exclusion, nor as a gift, nor as a qualified disaster relief payment under § 139, nor as a contribution to the capital of a corporation under § 118; instead, they may be deferred under § 1033. the payments are included in amount realized on the involuntary conversion of the property destroyed and any gain is thus eligible for § 1033 treatment provided that qualified replacement property is acquired. a. amounts received from employer may be excluded as § 139 qualified disaster relief; amounts received from a state agency are excluded as gifts. rev. rul. 2003-12, 2003-3 i.r.b. 283 (12/19/02). amounts received by an individual from an employer to reimburse the individual for necessary medical, temporary housing, or transportation expenses incurred as a result of a flood are not excludable as a gift under § 102, but are excluded from gross income as qualified disaster relief under § 139 if the flood was a presidentially declared disaster. similar amounts received from a state agency are excludable under the administrative general welfare exclusion; and similar amounts received from a charity are excluded under § 102. iv. compensation issues a. fringe benefits 1. guidance on health savings accounts. notice 2004-2, 2004-2 i.r.b. 269 (12/23/03). the irs has issued guidance in q&a form on health savings accounts under new § 223 (added by § 1201 of the medicare prescription drug improvement, and modernization act of 2003). this guidance provides basic information about hsas. this new [vol 8:si recent developments in federal income taxation provision offers health spending accounts without the "use it or lose it" requirement of health fsas. a. notice 2004-23, 2004-15 i.r.b. 725 (3/30/04). the notice provides a safe harbor for preventive care benefits allowed to be provided by a high deductible health plan ("hdhp") without satisfying the § 223(c)(2) minimum deductible. preventive care under the safe harbor includes "annual physicals" (including tests and diagnostic procedures), routine prenatal and well-child care, child and adult immunizations, tobacco cessation programs, obesity weight-loss programs and a long list of "screening services" (for cancer, heart and vascular diseases, infectious diseases, mental health conditions and substance abuse, metabolic, nutritional and endocrine conditions, musculoskeletal disorders, obstetric and gynecologic conditions, pediatric conditions, and vision and hearing disorders); however, it does not generally include any service or benefit intended to treat an existing illness, injury or condition. 0 this notice also provides that the definition of "preventive care" is a question of federal tax law, and not a question of state law. therefore, a service required by state law to be provided on a first-dollar basis is not necessarily a "preventive service," and a plan that complies with state law may well be disqualified from being an hdhp. b. notice 2004-43, 2004-27 i.r.b. 10 (6/18/04). this notice provides transition relief for plans that include statemandated first-dollar coverage. these plans would not be disqualified for that reason alone for months before 1/1/06, provided that the state law was in effect on 1/1/04. c. transition relief for plans with noncalendar year renewal dates. notice 2005-83, 2005-49 i.r.b. 1075 (11/8/05). this notice permits the notice 2004-43 period to extend beyond 12/31/05 until the plan's next renewal date (but not beyond 12/31/06) because health plans may not reduce existing benefits before the plan's renewal date. d. notice 2004-50, 2004-33 i.r.b. 196 (7/23/04). this notice provides that any treatment that is incidental or ancillary to a preventive care service or screening described in notice 200423 also falls within the safe harbor for preventive care. e. notice 2004-25, 2004-15 i.r.b. 727 (3/30/04). this notice provides general transition relief for 2004 from the rule that medical expenses may be paid or reimbursed by an hsa only if 2006] florida tax review they were incurred after the hsa had been established for eligible individuals who establish an hsa before 4/16/05. f. the inability to get general prescription drug coverage is the sticking point for many potential users of hsas. rev. rul. 2004-38, 2004-15 i.r.b. 717 (3/30/04). an individual who had prescription drug coverage that was not subject to the annual deductible of the hdhp is not eligible to make contributions to (or have his employer make contributions to) an hsa. g. rev. proc. 2004-22, 2004-15 i.r.b. 727 (3/30/04). this revenue procedure provides transition relief for the months before 2006 for an individual who is covered by both an hdhp and a separate plan or rider that provides drug benefits on a co-pay basis or in some other manner before the minimum annual deductible of the hdhp is met. h. rev. rul. 2004-45, 2004-22 i.r.b. 971 (5/11/04). this ruling provides guidance on the interactions of the hsa rules with the rules concerning health flexible spending arrangements ("health fsa") (under prop. reg. § 1.125-1, q&a 7) and health reimbursement arrangements ("hra") (under notice 2002-45, 2002-2 c.b. 93). an individual can be eligible for making hsa contributions while being covered by a limited-purpose health fsa or hra, a suspended hra, a postdeductible health fsa or hra, or a retirement hra. 2. notice 2005-8, 2005-4 i.r.b. 368 (1/24/05). this notice provides guidance regarding a partnership's contributions to a partner's hsa and an s corporation's contributions to a 2-percent shareholder-employee's hsa. generally, the contributions are included in the income of the partner or shareholder-employee and are deductible by him or her as hsa contributions. a. rev. rul 2005-25, 2005-18 i.r.b. 971 (4/13/05). a married individual who otherwise qualified as an eligible individual under § 223(c)(1)(a) can contribute to an hsa even if his spouse has nonqualifying family coverage provided that he is not covered under the spouse's plan. 3. reg-138647-04, employer comparable contributions to health savings accounts under section 4980g, 70 f.r. 50233 (8/26/05). these proposed regulations provide guidance for employer comparable contribution to hsas under § 4980g, which provides an excise tax on the failure of an employer to make "comparable contributions" to the [vol 8:si recent developments in federal income taxation hsas of all comparable participating employees [employees in the same category of "self-only" or "family"] when it makes a contribution to any employee's hsa. 4. if the only thing the employee or his family could receive are medical expense reimbursements, then reimbursements under the plan qualify for the § 105(b) exclusion. rev. rul. 2005-24, 2005-16 i.r.b. 892 (4/5/05). reimbursements under an employer-sponsored § 125 salary-reduction medical reimbursement arrangement are not excludable from the employee's gross income under § 105(b) where unused benefits could be paid to the employee in cash or other benefits. however, reimbursements do qualify for the § 105(b) exclusion where they are made under a plan where unused benefits are made available for future medical care expenses of the employee [both before and after retirement] as well as those of the employee's spouse and dependents. 5. in the future, employees may be able to avoid the late december rush at the optometrist's office and have until march 15th to buy eyeglasses. notice 2005-42, 2005-23 i.r.b. 1204 (5/18/05). this notice extends the "use it or lose it" rules for flexible spending arrangements by allowing employers to extend the deadline for reimbursement of health and dependent care expenses up to two and one half months after the end of a cafeteria plan year. 6. rev. rul. 2005-60, 2005-37 i.r.b. 502 (8/25/05). the employer subsidy for maintaining prescription drug coverage is not considered in computing the applicable employer cost when determining whether the minimum cost requirement of § 420(c)(3) is met with respect to transfer of the excess pension assets of a defined benefit plan to a health benefits account which is part of the plan. b. qualified deferred compensation plans 1. "mr. gotbucks, meet senator roth." reg152354-04, designated roth contributions to cash or deferred arrangements under section 401(k), 70 f.r. 10062 (3/2/05). the irs has published proposed regulations relating to an election under § 402a that will be available beginning in 2006 for employees to designate contributions to a 401(k) plan made under a qualified cash-or-deferred arrangement as roth contributions. these contributions will be currently includible in gross income, but qualified distributions will be excludable from gross income. a. final regulations on roth contributions under qualified cash or deferred arrangements under § 401(k). t.d. 20061 florida tax review 9237, designated roth contributions to cash or deferred arrangements under section 401(k), 71 f.r. 6 (1/3/06). these final regulations require a pre-tax alternative elective contribution to the roth contribution. they also require an irrevocable designation to be made by the employee at the time of the cash or deferred election, and they require that roth contributions be maintained by the plan in a separate designated roth account for the employee. a matching contribution will not be permitted to be allocated to a designated roth account. the regulations are effective for taxable years beginning after 12/31/05, but under current law the roth 401(k) provisions do not apply to years beginning after 12/31/10. 2. reg-146459-05, designated roth accounts under section 402a, 71 f.r. 4320 (1/26/06). these proposed regulations provide comprehensive guidance on the taxation of distributions from designated roth accounts. there is no inclusion in income if the distribution is a qualified distribution, which is a distribution that is made after a 5-taxableyear period of participation and that is either made after the employee attains 59-1/2, made after the employee's death, or is attributable to the employee's being disabled. 3. "hercules! hercules! hercules!"' stepnowski v. commissioner, 124 t.c. 198 (4/26/05). in this declaratory judgment case, judge cohen held that an amendment made by petitioner's employer, hercules incorporated, to its pension plan's lump-sum option did not violate the anti-cutback rule of § 411 (d)(6). the amendment was made in 2001 during the gust amendment period and permitted the plan sponsor to use the higher 30-year treasury bond discount rate permitted under § 417(e)(3)(a) in computing the lump sum, as opposed to the lower pbgc rate that was required by that code provision prior to its amendment by the uruguay round agreements act of 1994, pub. l. 103-465. 4. more work for benefits lawyers this time under § 415. reg-130241-04, limitations on benefits and contributions under qualified plans, 70 f.r. 31214 (5/31/05). these proposed regulations provide comprehensive guidance on § 415 limitations on benefits and contributions under qualified plans that are effective for plan years beginning in 2007. they are long. 5. final regulations crack down on abusive § 412(i) plans that understate the value of life insurance contracts distributed from a qualified retirement plan to employees, and require that they be taxed at their full fair market value. t.d. 9223, value of life insurance 1. "show me muscle again, oh, hercules! hercules! hercules!" mama klump in "the nutty professor" (1996). [vol 8:si recent developments in federal income taxation contracts when distributed from a qualified retirement plan, 70 f.r. 50967 (8/29/05), making final proposed regulations published at 69 f.r. 7384 (february 2004). a tax-qualified retirement plan funded entirely by a life insurance contract of an annuity is a "section 412(i) plan." such plans permit employer contributions to the plan to be deducted, with the contributions used to purchase a specially designed life insurance contract, with the cash surrender value temporarily depressed well below the premiums paid at the time the policy is distributed or sold to the employee for the amount of the temporarily depressed cash surrender value. after the transfer, the cash surrender value then increases significantly. 6. under the katrina tax act, withdrawals of up to $100,000 from retirement plans made between 8/29/05 and 12/31/06 for relief relating to hurricane katrina would not be subject to the 10 percent premature withdrawal tax under § 72(t). this exception applies to withdrawals from iras as well. 7. under the katrina tax act, recontributions of withdrawals for home purchases cancelled due to hurricane katrina would be treated as rollovers if made before 3/1/06. 8. under the katrina tax act, loans of up to $100,000 from qualified plans made between 9/24/05 and 12/31/06 for relief relating to hurricane katrina will receive favorable treatment. 9. the principle of poe v. seaborn applies whenever under state community property law a nonemployee spouse has ownership rights in the employee spouse's salary or benefits. dunkin v. commissioner, 124 t.c. 180 (4/22/05, as amended, 5/31/05). the taxpayer reached eligibility for retirement and had he retired his former spouse would have been entitled to receive one-half of his pension. because he continued working and delayed receipt of his pension benefits, under community property law he was required to pay his former wife an amount equal to onehalf of the pension benefits that he had earned during the marriage. the court held that poe v. seaborn rather than lucas v. earl controlled, and thus he was entitled to exclude from gross income the amounts paid to his former wife. c. nonqualified deferred compensation, section 83, and stock options 1. section 409a adds a new layer of rules for nonqualified deferred compensation. section 885 of the jobs act of 2004 adds new § 409a which modifies the taxation of nonqualified deferred 2006] florida tax review compensation plans for amounts deferred after 2004. section 409a has changed the tax law governing nonqualified deferred compensation by making it more difficult to successfully avoid current inclusion in gross income of unfunded deferred compensation. nevertheless, § 409a has not completely supplanted prior law. the fundamental principles of prior law continue in force but have been modified in certain respects. this was later reiterated in notice 2005-1, 2005-2 i.r.b. 274, which reminded taxpayers that although the statute makes a number of fundamental changes, § 409a does not alter or affect the application of any other provision of the code or common law tax doctrine. accordingly, deferred compensation not required to be included in income under § 409a may nevertheless be required to be included in income under § 451, the constructive receipt doctrine, the cash equivalency doctrine, § 83, the economic benefit doctrine, the assignment of income doctrine or any other applicable provision of the code or common law tax doctrine. 0 in order to qualify under § 409a, a plan must require that distributions may be allowed only upon separation from service, disability, death, a specified time (or pursuant to a fixed schedule), change of control in a corporation (to be defined in regulations), occurrence of an unforeseeable emergency, or if the participant becomes disabled; distributions may not be allowed other than upon the permissible distribution events and the plan may not permit acceleration of a distribution except as provided in regulations. in the case of officers, directors and ten percent shareholders of publicly-held corporations and to persons holding the same positions in non-publicly held corporations, distributions upon separation from service may not be made earlier than six months after the date of separation from service. * the plan must provide that compensation for services performed during a taxable year may be deferred only if the election is made before the beginning of the year in which the services are performed (or, if contingent compensation, at least six months before the end of the year in which the services are performed). * a plan may permit changes in the time and form of distribution, so-called "second [deferral] elections" will have to be made at least twelve months before the payment was to have been made, and must postpone the payment for at least five years from the date it otherwise would have been made. additionally, offshore rabbi trusts are not permitted. generally, any such subsequent election to extend the deferral must extend the first payment date by at least five years and cannot be made or take effect within twelve months of the due date of the first payment. [vol 8:si recent developments in federal income taxation * violations of these rules would make immediately taxable all amounts not subject to a substantial risk of forfeiture, plus interest at one percentage point above the underpayment rate plus additional tax of 20 percent of the amount improperly deferred. * these new rules do not apply to nonqualified stock options, incentive stock options and employee stock purchase plans, but apparently do apply to stock appreciation rights. * benefits earned through the end of 2004 are grandfathered if the plan complied with prior law and it was not materially modified after 10/3/04. a. section 409a guidance provides transition rules and excludes stock appreciation rights from the purview of that section. notice 2005-1, 2005-2 i.r.b. 274 (12/20/04). this notice provides in q&a form guidance with respect to the application of § 409a. it answers a variety of interpretive questions regarding the application of § 409a by providing various definitions, including a definition of substantial risk of forfeiture, and guidance on the application of § 409a to various kinds of plans as well as to stock appreciation rights and arrangements between partners and partnerships. the notice provides that § 409a applies whenever a service provider is (a) an individual, (b) a personal service corporation (as defined in § 269a(b)(1)), or a noncorporate entity that would be a personal service corporation if it were a corporation, or (c) a qualified personal service corporation (as defined in § 448(d)(2)), or a noncorporate entity that would be a qualified personal service corporation if it were a corporation. (q&a-8). however, § 409a does not apply if both (a) the service provider is actively engaged in the trade or business of providing substantial services, other than as an employee or as a director of a corporation, and (b) the service provider provides such services to two or more service recipients to which the service provider is not related and that are not related to one another. (q&a-8). * a plan provides for deferral of compensation only if, "under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to (or on behalf of) the service provider in a later year." (q&a-4) compensation is not treated as deferred compensation, however, if it is received after the last day of the service provider's taxable year pursuant to the service recipient's normal payroll period. (q&a-4). furthermore, compensation is not treated as deferred if it is required to be paid and is actually or constructively received by the service provider by the later of: (i) the date two and one half months after the end of the service provider's first taxable year in which the amount is no longer subject to a substantial risk of forfeiture or (ii) the date two and one-half 2006] florida tax review months after the end of the service recipient's first taxable year in which the amount is no longer subject to a substantial risk of forfeiture. * stock options, stock appreciation rights, and other equity-based compensation generally are considered to be deferred compensation subject to § 409a, unless certain specified conditions have been meet. (q&a-4(d)) a nonstatutory stock option is not considered to be deferred compensation for purposes of § 409a if the folowng ,vmd itons have been met: (1) the exercise price may never be less than the fair market value of the underlying stock on the date the option is granted, (2) the option is subject to taxation under § 83, and (3) the option does not include any deferred compensation feature other than deferred income recognition until the later of the exercise or disposition of the option. a stock appreciation right is not deferred compensation if the following conditions are met: (1) the value of the stock the excess over which the right provides for payment upon exercise may never be less than the fair market value of the underlying stock on the date the right is granted, (2) the stock is traded on an established securities market, (3) only such stock may be delivered in settlement of the right, and (4) the right does not include any deferred compensation feature other than the deferral of recognition of income until the exercise of the right. (q&a-4(d)). 0 the notice provides the following standards regarding the existence of a substantial risk of forfeiture: compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. [a] condition related to a purpose of the compensation must relate to the service provider's performance for the service recipient or the service recipient's business activities or organizational goals (for example, the attainment of a prescribed level of earnings, equity value or a liquidity event). any addition of a substantial risk of forfeiture after the beginning of the service period to which the compensation relates, or any extension of a period during which compensation is subject to a substantial risk of forfeiture, in either case whether elected by the service provider, service recipient or other person (or by agreement of two or more of such persons), is disregarded for purposes of determining whether such compensation is subject to a substantial risk of forfeiture. an amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon the refraining from performance of services. for purposes of § 409a, an amount will not be considered subject to a [vol 8:gi recent developments in federal income taxation substantial risk of forfeiture beyond the date or time at which the recipient otherwise could have elected to receive the amount of compensation, unless the amount subject to a substantial risk of forfeiture (ignoring earnings) is materially greater than the amount the recipient otherwise could have elected to receive. for example, a salary deferral generally may not be made subject to a substantial risk of forfeiture. however, where an election is granted to receive a materially greater bonus amount in a future year rather than a materially lesser bonus amount in an earlier year, the materially greater bonus may be made subject to a substantial risk of forfeiture. b. proposed regulations incorporate much of the guidance in notice 2005-1. reg-158080-04, application of section 409a to nonqualified deferred compensation plans, 70 f.r. 57930 (10/4/05). these proposed regulations incorporate much of the guidance provided in notice 2005-1, as well as "substantial additional guidance." they identify the plans and arrangements covered by § 409a and describe the requirements for deferral elections and the permissible timing for deferred compensation payments. they also extend the deadline for "documentary compliance" to 12/31/06, but 1/1/05 remains as the effective date for statutory compliance (although there are transition rules applicable for 2005). prop. reg. §§ 1.409a-1 (definitions and covered arrangements); 1.409a-2 (deferral elections); 1.409a-3 (permissible payments); 1.409a-6 (statutory effective dates). (prop. reg. § 1.409a-3(g)(3) defining unforeseeable emergency as: (1) a severe financial hardship resulting from an illness or accident of the service provider or the service provider's spouse or dependent (as defined in § 152(a)); (2) loss of property due to casualty (including the need to rebuild a home following damage to a home not otherwise covered by insurance, for example, not as a result of a natural disaster), or other similar extraordinary and unforeseeable circumstances arising as a result of uncontrollable events; (3) medical expenses; and (4) funeral expenses of a spouse or a dependent); prop. reg. § 1.409a-1(i) (generally, a qualifying accelerated payment either (1) must be due on an objectively determinable date or according to an objectively determinable fixed schedule at the time the event occurs, or (2) must be within an objectively determinable calendar year following the year in which the event occurs; payment may be upon the earliest or latest of more than one qualified event). prop. reg. § 1.409a-3(h) (permitting acceleration in the event of a conflict of interest, to satisfy a qualified domestic relations order (qdro)), described in 36.09[5], main volume, pursuant to § 414(p)(1)(b), as a de minimis cash-out, or to pay fica taxes. the proposed regulations are proposed to be effective as of january 1, 2007. 20061 florida tax review c. irs gives employers a pass on reporting and wage withholding requirements for 2005. notice 2005-94, 2005-52 i.r.b. 1208 (12/8/05). the notice suspends employers' and payers' reporting and wage withholding requirements for calendar year 2005 with respect to deferrals of compensation within the meaning of § 409a, but fica must be properly paid under § 3121(v)(2). it does not affect a service provider's filing requirements, individual income tax liability and interest on underpayments of tax but the irs will not assert late-payment, failure to pay estimated taxes or accuracy-related penalties against the service provider if he reports and pays any taxes due with in accordance with future published guidance. 2. rev. rul. 2005-39, 2005-27 i.r.b. 1 (6/16/05). unvested shares of restricted stock for which an election under § 83(b) has been made are treated as outstanding stock for purposes of the change of control provisions of § 280g, the golden parachute provisions. 3. rev. rul. 2005-48, 2005-32 i.r.b. 259 (8/2/05). if an employee exercises a nonstatutory stock option more than six months after grant, but it is subject to restrictions on his ability to sell the stock so obtained under rule lob-5 under the securities exchange act of 1934 and during a contractual "lock-up period," then upon exercise of the option he is required under § 83 to include in his compensation income an amount determined without regard to the share-transfer restrictions imposed because these are "lapse restrictions" that are ignored under § 83(a) in valuing the shares. 4. merlo v. commissioner, t.c. memo. 2005-178 (7/20/05). if an employee exercises a stock option outside the period covered by § 16 of the securities exchange act of 1934 but is subject to restrictions on his ability to sell the stock obtained through exercise of the option by contractual provisions imposed by the employer, the stock is not subject to a substantial risk of forfeiture, because full enjoyment of the shares is not conditioned on any obligation to provide future services. d. individual retirement accounts 1. the supreme court holds that iras are exempt from the bankruptcy estate. rousey v. jacoway, 544 u.s. 320 (4/4/05). inasmuch as rights to the funds in an ira are on account of the holder's age and an ira is similar to any other retirement plans, the assets in the plan are exempt from the holder's chapter 7 bankruptcy estate. justice thomas held that the § 72(t) tax penalty of 10 percent on amounts withdrawn before age [vol. 8:si recent developments in federal income taxation 59-1/2 makes the ira one in which the right to receive payments effectively limits their right to payment of the ira balance until that age is reached. 0 the amounts in the rouseys' ira in this case were rolled over from a qualified plan, but the court's decision was not based on that factor. a. bankruptcy act changes on protection of iras. section 224 of the bankruptcy act of 2005, 11 u.s.c. § 522, protects from creditors (1) assets in qualified plans, (2) assets in iras that were rolled over from qualified plans, and (3) other assets in iras of not more than $1 million (indexed). 2. what a way to mess up! coppola v. beeson (in re: joseph c. copola), 419 f.3d 323 (5th cir. 7/25/05). in a per curiam opinion, the court held that a faculty member's pledging of his § 403(b) retirement account as security for alimony payments to his ex-wife totaling $220,000 caused that amount to be deemed distributed and no longer entitled to the exemption from bankruptcy under texas law. 3. rev. proc. 2006-13, 2006-3 i.r.b. 315 (12/29/05). this revenue procedure provides safe harbors for determining the fair market value of an annuity contract in the conversion of a traditional ira to a roth ira. 4. thomas v. commissioner, t.c. memo. 2005-258 (11/1/05). ira distributions before age 59-1/2 to a taxpayer whose disability required scaling back from full-time to part-time work did not qualify for an exception to the § 72(t) penalty under § 72(t)(2)(a)(iii) because the taxpayer was not disabled as defined in § 72(m)(7), which requires that a taxpayer be "unable to engage in any substantial gainful activity." v. personal income and deductions a. rates there were no significant developments regarding this topic during 2005. b. miscellaneous income 1. prejudgment interest in a personal injury lawsuit is not excluded from income. chamberlain v. united states, 401 f.3d 335 (5th cir. 2/18/05). prejudgment interest recovered in a personal injury lawsuit is not excluded from income under § 104(a)(2) because it was 20061 florida tax review compensation for the lost time value of money and is not received "on account of' the personal injury. may prejudgment interest be excluded if there is a settlement? more specifically, post-judgment interest exclusion is permitted by the exclusion of the entire amount of any future payment received pursuant to a structured settlement. does this create a difference between a recovery by way of settlement and a recovery by way of judgment? 2. lindsey v. commissioner, 422 f.3d 684 (8th cir. 9/2/05). although the taxpayer's physician testified that the taxpayer "suffered from hypertension and stress-related symptoms, including periodic impotency, insomnia, fatigue, occasional indigestion, and urinary incontinence" as a result of the emotional distress inflicted by the defendant, the settlement agreement identified the taxpayer's claims as tort claims for damage to his emotions, reputation and character. physical symptoms that are merely manifestations of the underlying emotional distress for which damages are received do not result in the damages being treated as received on account of personal injury if there is no "direct causal link between any physical sickness suffered by [the taxpayer] and [any] damages paid out to him." 3. rivera v. baker west, inc., 430 f.3d 1253 (9th cir. 6/17/05). no portion of settlement of claim for unlawful workplace discrimination and unlawful termination was compensation for physical personal injuries where settlement agreement was silent regarding the nature of the injuries addressed, and the only evidence of the payor's intent regarding the claims settled was a statement that the defendant would pay taxpayer a sum of money "less all lawfully required withholdings." the inference was that the defendant considered that some or all of the payment represented back pay. 4. annuity death benefits are ird. rev. rul. 200530, 2005-20 i.r.b. 1015 (4/28/05). if the owner-annuitant of a deferred annuity contract dies before the annuity starting date, any amounts received by a beneficiary in excess of the owner-annuitant's investment in the contract are includible in gross income as income in respect of a decedent under § 691. these amounts are also subject to the rules of § 72 if the beneficiary receives an annuity rather that a lump-sum. c. profit-seeking individual deductions 1. the alternative minimum tax ("amt") trap for attorneys' fees on large recoveries will continue to be an issue despite [vol. 8:si recent developments in federal income taxation legislation and a supreme court decision. the supreme court decides the amt trap issue in favor of the government, following the majority of courts that have faced this issue. commissioner v. banks, 543 u.s. 426 (1/24/05) (eight to zero). justice kennedy's unanimous opinion held that a contingent fee agreement should be viewed as an anticipatory assignment of income to the attorney by the client. he relied on the assignment of income doctrine cases, e.g., lucas v. earl, 281 u.s. 111 (1930) and helvering v. horst, 311 u.s. 112 (1940), and found this doctrine to be relevant in arm's length transactions as well as family transactions, stating: "we hold that as a general rule, when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee." the court ruled that the attorney-client relationship was governed by agency law and not by partnership law (although, later in the opinion, it refused to rule on the partnership argument because it was raised too late). * the court did not rule on whether attorneys' fees awarded pursuant to claims brought under federal statutes that authorize fee awards to prevailing plaintiffs, noting that banks settled his discrimination case and the fee paid to his attorney was based upon the contingent fee agreement, and was not awarded by a court. a. congress grants relief for civil rights plaintiffs, but not for all clients of plaintiffs' lawyers. amt trap to be closed, but only prospectively and not with respect to taxable recoveries not listed in new § 62(e). section 703 of the jobs act of 2004 added new paragraph (19) to § 62(a) which would permit above-the-line deductibility of contingent attorneys' fees in lawsuits for unlawful discrimination (which is defined in § 62(e) to include 18 separate categories of civil rights-type lawsuits, but not simple defamation, consumer fraud and punitive damages). the provision applies to judgments and settlements occurring after the date of enactment. • congress did not address attorney's fees relating to recoveries for consumer fraud, defamation and possibly employment contract disputes, as well as punitive damages and taxable interest in personal injury cases. b. banks followed for a contingent attorney's fee. allum v. commissioner, t.c. memo. 2005-177 (7/20/05). no part of a $500,000 payment received in 1999 for a civil rights claim may be excluded from gross income because it was not for a personal physical injury or physical sickness. the tax court (judge marvel) further held that the contingent fee the taxpayer paid to his attorney from the settlement proceeds is also included in gross income, based upon the banks case, because general references in a complaint to unspecified physical injuries in 20061 florida tax review a suit for wrongful discharge of employment do not support exclusion of any portion of the settlement under § 104(a)(2). 2. fees paid for mba were deductible because the degree did not qualify the taxpayer for a new trade or business. allemeier v. commissioner, t.c. memo. 2005-207 (8/31/05), motion for fees denied, t.c. memo 2006-28 (2/16/06). orthodontic appliance salesman who was promoted to a management position after starting mba could deduct cost of mba; education was not a "minimum requirement" because promotion was not contingent on beginning or completing mba program, and it did not qualify taxpayer for a new trade or business because the basic nature of taxpayer's work activities did not change as a result of additional education, even though taxpayer was awarded new titles and positions and advanced more rapidly; the mba merely improved pre-existing skills. may an employer avoid both the § 127 dollar limit on reimbursement of the costs of an employee's mba program and the § 127 nondiscrimination requirement by treating payment of such costs as § 132(a)(3) working condition fringe benefit? d. hobby losses and § 280a home office and vacation homes there were no significant developments regarding this topic during 2005. e. deductions and credits for personal expenses 1. when will trust investment advisory fees get up off the § 67 floor? rudkin testamentary trust v. commissioner, 124 t.c. 304 (6/27/05) (reviewed, 18-0). the tax court (judge wherry), in a case appealable to the second circuit, found that amounts paid for investment management advice by trusts set up by a family involved in the founding of the pepperidge farm food products company (which was sold to campbell soup company in the 1960s) are not subject to the § 67(e) exception to the § 67(a) floor of 2 percent of agi (which limits the deductibility of employee business expenses and miscellaneous itemized deductions to amounts exceeding that floor). the court follows the fourth and federal circuits, and adheres to its earlier opinion in the o'neill v. commissioner, 98 t.c. 227 (1992), which was reversed by the sixth circuit, 994 f.2d 302 (1993). . the sixth circuit's rationale was stated as follows: [vol 8:si recent developments in federal income taxation the tax court reasoned that "individual investors routinely incur costs for investment advice as an integral part of their investment activities." nevertheless, they are not required to consult advisors and suffer no penalties or potential liability if they act negligently for themselves. therefore, fiduciaries uniquely occupy a position of trust for others and have an obligation to the beneficiaries to exercise proper skill and care with the assets of the trust. (994 f.2d at 304) 2. no 10-percent-of-agi floor for the deduction of katrina losses. under the katrina and go zone acts, new § 1400s(b) is added, under which individual taxpayers would be permitted to claim casualty or theft losses attributable to hurricanes katrina, rita and wilma regardless of whether the loss exceeds $100, and in addition, these personal casualty or theft losses would be deductible without regard to whether the loss exceeds 10 percent of a taxpayer's adjusted gross income. 3. lofstrom v. commissioner, 125 t.c. 271 (11/22/05). a third-party debt instrument transferred in satisfaction of a state court ordered alimony payment is not "cash" and thus is not alimony for purposes of § 71. (applying reg. § 1.71-it(b), q&a-5 requiring payment solely by cash, check or money order; denying § 215 deduction to transferor). 4. we now have a uniform definition of "child" but it is not very user-friendly. sections 201-208 of the working families tax relief act of 2004 provide a uniform definition of "child" for head of household, dependent care credit, child tax credit, earned income tax credit, and dependent exemption purposes. this changes prior law by making irrelevant the fact that forms 8332 were signed by the custodial parent. instead, what would be required to shift the dependency deduction to the non-custodial parent is a provision in the divorce decree or separation agreement. 0 under the pre-2004 version of § 152(e)(2), the noncustodial parent was treated as having provided over half of the child's support for the year if the custodial parent signed a written declaration that he would not claim the child as a dependent for any tax year beginning within that calendar year, and the noncustodial parent attached the declaration to his return for the taxable year in which he claimed the dependency exclusion. the declaration by the custodial parent could pertain to only one year, or could specify that it applied to two or more years, and a permanent declaration might be made at the time of the divorce. temp. reg. § 1.152-4t(a) q & a 4. the actual signature of the custodial spouse on the declaration was crucial to shifting the exemption to the noncustodial parent. the 2006] florida tax review pre-2004 version of § 152(e)(2) also applied to determine which of the never-married and non-cohabiting parents of a minor child was entitled to the dependency exemption. as amended by the working families tax relief act of 2004, § 152(e)(2) now provides that the noncustodial spouse will be entitled to the dependency exemption for the couple's minor child if a decree of divorce or separate maintenance or written separation agreement between the parents provides either (1) that the noncustodial parent is entitled to the dependency exemption for the child, or (2) that the custodial parent will sign a written declaration that she will not claim the child as a dependent for a particular taxable year. the 2004 amendments change the rules in a number of respects. first, amended § 152(e)(2), rather than deeming the noncustodial parent to have provided over one-half of the child's support, now treats the child as a "qualifying child" under § 151 with respect to the noncustodial parent. this has the effect of assuring (consistently with prior law) that if the right to the exemption is awarded to the noncustodial spouse, that spouse also obtains the right to claim the § 24 child credit. second, under the amended version of § 152(e)(2), unlike under the pre-2004 version, a provision in a divorce instrument awarding the exemption to the noncustodial spouse is effective without any action on the part of the custodial spouse to sign a waiver. furthermore, under the strict wording of the statute, if the divorce instrument does not specifically award the dependency exemption to the noncustodial spouse but directs the custodial spouse to sign the waiver, it appears that the right to claim the exemption is effectively transferred to the noncustodial spouse even if the custodial spouse subsequently refuses or otherwise fails to sign the waiver. thus, the divorce instrument is now the key document, whereas under prior law the written waiver by the custodial spouse was the key document. finally, unlike the pre-2004 version of § 154(e), which permitted parents who were never married to agree that the noncustodial spouse would be entitled to the dependency exemption through a waiver by the custodial parent, the current version of § 152(e)(2) requires a provision in a divorce or written separation agreement. unless the courts interpret the term "written separation agreement" to encompass agreements between parents who were never married, the noncustodial parent of a child whose parents never married will not be able to obtain the dependency exemption with respect to the child. in such a case, § 152(e)(1)(a)(iii) always awards the exemption to the custodial parent. a. but the definition was completely changed in technical corrections under the go zone act of 2005. the gulf opportunity zone act of 2005 contains technical corrections to previously enacted legislation including the working families tax relief act of 2004 and the american jobs creation act of 2004. the custodial parent is defined by the go zone act as the parent having custody of the [vol. 8:si recent developments in federal income taxation child for the greater portion of the calendar year. the working families tax relief act of 2004 had changed the wording of § 152(e) to say that the custodial parent was "the parent with whom a child shared the same principal place of abode for the greater portion of the calendar year." this meant that beginning in 2005, the parent with whom the child lived for the greater portion of the year was the custodial parent (and therefore "in charge" of the personal exemption for that child) even though the other parent had been granted legal custody of the child by the courts. now, the technical correction made by the go zone act of 2005 changes the language to say that the custodial parent "means the parent having custody for the greater portion of the year." this is identical to the definition of the "custodial parent" prior to the amendment of § 152(e) by the working families tax relief act of 2004. therefore, the go zone act of 2005 has changed the definition of the custodial parent back to the old definition effective as of january 1, 2005. the effect of this change is that (as for 2004 and previous years) a parent is the custodial parent if the judge grants the parent legal custody of the child for the greater portion of the year. however, if the parents have joint legal custody, then (as under the law before its amendment by the working families tax relief act of 2004) the parent with whom the child spends the greater portion of the year will be the custodial parent. 5. rev. rul. 2005-11, 2005-14 i.r.b. 816 (3/17/05). interest paid on a home mortgage that has been refinanced is deductible as qualified housing interest for amt purposes if the interest on the mortgage that was refinanced was qualified housing interest, but only to the extent that the amount of the mortgage indebtedness was not increased. f. education 1. education expenses for the current year only. lodder-beckert v. commissioner, t.c. memo. 2005-162 (7/5/05). amounts withdrawn from an ira in 2001 to pay off credit card debt deriving from the payment of tuition in previous years was subject to the 10 percent additional tax of § 72(t)(1). taxpayer incurred the credit card debt in 1999 and 2000 to pay education expenses because her former employer, the state of ohio, was in the process of significantly increasing the amount in her retirement account, which was rolled over into the ira in 2001. the tax court (judge laro) held that the exception from penalty tax in § 72(t)(2)(e) applies only to withdrawals used to pay education expenses for the current taxable year. 2006] florida tax review vi. corporations a. entity and formation 1. section 836(a) of the jobs act of 2004 adds new § 362(e) to provide limitation on the importation, or transfer in § 351 transactions, of built-in losses to corporations. the aggregate basis of the property so received will be limited to its fair market value immediately after the transaction. this rule is applied on a transferor-by-transferor basis. 0 section 362(e)(2) prevents taxpayers from transmuting a single economic loss into two (or more) tax losses by taking advantage of the dual application of the substituted basis rules in § 358 for stock received in a § 351 transaction and in § 362 for assets transferred to a corporation in a § 351 transaction. if the aggregate basis of the property transferred to a corporation in a § 351 transaction exceeds the aggregate fair market value, the aggregate basis of the property must be reduced to its fair market value. thus, for example, if a transfers blackacre, with a basis of $1,000 and a fair market value of $600 to newly formed x corporation in exchange for all of the x corporation stock, x corporation's $1,000 basis in blackacre, determined under § 362(a), will be reduced to $600 under § 362(e)(2). * geriatrics should consider making an alternative election. a and x corporation may jointly elect to reduce a's basis in the x corporation stock, which is otherwise an exchanged basis of $1,000 pursuant to § 358, to its fair market value [presumably $600], with the transferee, x corporation, taking a normal transferred basis under § 362(a) [$1,000]. * the operation of § 362(e)(2) is more complex where multiple assets are involved. when a transferor also transfers some appreciated property to the corporation, § 362(e)(2) does not necessarily result in the basis of every item of loss property being reduced to its fair market value. section 362(e)(2)(a) requires that the aggregate basis of the transferred property be reduced by the excess of the aggregate basis over the aggregate fair market value, and § 362(e)(2)(b) requires that the aggregate basis reduction be allocated among the transferred properties in proportion to the built-in losses in the properties before taking into account § 362(e)(2). assume, for example, that b transferred three properties to newly formed y corporation in exchange for all of the stock: a copyright, fair market value $4,500, basis $3,000; land, fair market value $7,000, basis $9,000; and a machine, fair market value $4,000, basis $5,000. the aggregate fair market value of the three properties is $15,500 and their aggregate basis is $17,000, thus requiring a basis reduction of $1,500 ($17,000 $15,500) with respect to the land and the machine, the two properties with a basis that exceeds fair market value. the land has a built-in loss of $2,000 and the machine has a built-in loss of $1,000. the $1,500 basis [vol 8:si recent developments in federal income taxation reduction is allocated 2/3 to the land ($2000 / ($2,000 + $1,000)), and 1/3 to the machine ($1000 / ($2,000 + $1,000)). thus the basis of the land is reduced by $1,000 (2/3 x $1,500), from $9,000 to $8,000, leaving an unrealized loss of $1,000 ($8,000 basis $7,000 fair market value) inherent in the land and the basis of the machine is reduced by $500 (1/3 x $1,500), from $5,000 to $4,500, leaving an unrealized loss of $500 ($4,500 basis $4,000 fair market value) inherent in the land. a. notice 2005-70, 2005-41 i.r.b. 694. (9/12/05). interim guidance on making § 362(e)(2)(c) elections to reduce to fair market value a transferor's basis in stock received in exchange for loss property. 2. net value requirement in § 351 transfers. see vi.c., below. proposed amendments to reg. § 1.351-1 would add a requirement that there be both (1) a contribution of net value and (2) a receipt of net value as a prerequisite for § 351 to apply. prop. reg. § 1.351l(a)(1)(iii)(a) would provide that stock will not be treated as issued for property if either (1) the fair market value of the transferred property does not exceed the sum of the amount of liabilities of the transferor that are assumed by the transferee in connection with the transfer and the amount of any money and the fair market value of any other property (other than stock permitted to be received under § 351(a) without the recognition of gain) received by the transferor in connection with the transfer, or (2) the fair market value of the assets of the transferee does not exceed the amount of its liabilities immediately after the transfer. prop. reg. § 1.351-1(a)(2), ex. 4, illustrates the rule by concluding that a transfer of real property encumbered by a nonrecourse mortgage in excess of the property's fair market value to a wholly owned corporation, which remains solvent after the transaction, in exchange for additional stock is not subject to § 351. although the example does not recharacterize the transaction, it presumably is a sale on which gain must be recognized and which gives rise to a purchase price basis under § 1012 for the corporation. loss recognition would be subject to possible disallowance under § 267. 3. the member of a single-member llc that operated a nursing home is individually liable for the company's failure to pay withholding and fica taxes because he failed to check the box, so the tax liability was that of a disregarded entity. in the process, the "check-the-box" regulations were held valid. littriello v. united states, 2005-1 u.s.t.c. 50,385 (w.d. ky. 5/18/05). the court held that the "check-the-box" regulations of reg. 301.7701-1 through -3 were valid, and found the sole member of a single-member llc that did not elect to be treated as a corporation liable for unpaid withholding and fica taxes, 2006.] florida tax review because the llc is considered a disregarded entity for federal tax purposes. judge heyburn granted summary judgment and rejected littriello's argument that § 6672 was the government's sole recourse because the irs imposed liability upon him as the owner of a sole proprietorship. a. united states 1, professor gregg polsky 0. same decision on motion for reconsideration, 96 a.f.t.r.2d 2005-5764 (8/3/05): plaintiff has moved to reconsider the court's memorandum opinion and its order dated may 18, 2005, on the grounds that the check-the-box regulations are invalid under morrissey v. commissioner, 296 u.s. 344, 80 l. ed. 263, 56 s. ct. 289, 1936-1 c.b. 264 (1935) as argued in a law review article by professor gregg d. polsky of the university of minnesota law school. polsky, "can treasury overrule the supreme court?," 84 bu. l. rev. 185 (2004). thus, this motion states new grounds for plaintiff's relief. the court will consider the argument even though it amounts to a renewed motion rather than a true reconsideration. when confronted with the question posed by professor polsky's title, one would naturally answer, "no." however, that is not precisely the question before this court nor can it be fairly said that treasury's check-the-box regulations have such an effect. the court has reviewed morrissey in its proper context and does not find that it requires invalidating the check-the-box regulations. certainly, the check-the-box regulations are the subject of academic and theoretical questioning. professor polsky has proposed that the treasury has gone too far in adopting regulations concerning corporations and other associations. however, it is a theory only that the check-the-box regulations violate the internal revenue code definitions because those definitions were made in effect permanent by morrissey. the court does not believe that morrissey forever incorporated in all future treasury regulations a particular definition of an "association." b. distributions and redemptions 1. pushing the envelope on complete termination. hurst v. commissioner, 124 t.c. 16 (2/3/05). this case illustrates that the [vol. 8:si recent developments in federal income taxation "prohibited interest" test is based on a formalistic analysis rather than the totality of the circumstances. all of the taxpayer's stock in a corporation (hmi) in which his son continued as a 51 percent shareholder was redeemed for $2.5 million dollars payable quarterly, with 8 percent interest, over fifteen years. the payment obligation was represented by a promissory note that was secured by all of the corporation's assets, as well as by a crosscollateralization pledge of the son's stock and the stock of the unrelated shareholders. in addition, hmi entered into a ten-year employment contract with the redeemed shareholder's wife, who personally had not owned any stock, giving her a small salary and fringe benefits, including medical insurance, and pursuant to which she performed "various administrative and clerical tasks." finally, at time of the redemption the corporation signed a new lease on the building owned by the redeemed shareholder, in which it conducted its business, pursuant to which it paid rent of $8,500 per month, adjusted for inflation. although the commissioner "acknowledg[ed] that each relationship between the hursts and their old company creditor under the notes, landlord under the lease, employment of a non-owning family member passes muster, he argue[d] that the total number of related obligations resulting from the transaction gave the hursts a prohibited interest in the corporation by giving richard hurst a financial stake in the company's continued success." the tax court (judge holmes) rejected this "holistic view," examining each obligation in turn. the court first addressed the terms of the promissory notes: neither the amount nor the timing of payments was tied to the financial performance of hmi. although the notes were subordinate to hmi's obligation to its bank, they were not subordinate to general creditors, nor was the amount or certainty of the payments under them dependent on hmi's earnings. . . .all of these contractual arrangements had cross-default clauses and were secured by the buyers' stock. this meant that should any of the notes go into default, mr. hurst would have the right to seize the stock and sell it. the parties agree that the probable outcome of such a sale would be that mr. hurst would once again be in control of hmi... • but in lynch v. commissioner, 83 t.c. 597 (1984), revd. on other grounds 801 f.2d 1176 (9th cir.1986), we held that a security interest in redeemed stock does not constitute a prohibited interest under section 302. we noted that 'the holding of such a security interest is common in sales agreements, and . . . not inconsistent with the interest of a creditor. . . ." furthermore, at trial, the hursts offered credible evidence from their professional advisers that these transactions, including the grant of a security interest to mr. 2006] florida tax review hurst, were consistent with common practice for sellerfinanced deals. * second, the lease called for a fixed rent in no way conditioned upon the financial performance of hmi. attorney ron david, who was intimately familiar with the transaction, testified convincingly that there was no relationship between the obligations of the parties and the financial performance of hmi. the transactional documents admitted into evidence do not indicate otherwise. there is simply no evidence that the payment terms in the lease between the hursts and hmi vary from those that would be reasonable if negotiated between unrelated parties. and the hursts point out that the irs itself has ruled that an arm's-length lease allowing a redeeming corporation to use property owned by a former owner does not preclude characterization as a redemption. furthermore, the court did not find the fact that subsequent to the redemption the parities modified both the lease and the note in a transaction in which the corporation surrendered an option to purchase the leased property in exchange for a reduction in the interest rate on the note issued for the stock indicated that hurst's rights under the lease were in fact a retained interest. * third, mrs. hurst did not own any hmi stock. thus, she is not a "distribute" unable to have an "interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor... ." the commissioner is thus forced to argue that her employment was a "prohibited interest" for mr. hurst. and he does, contending that through her employment mr. hurst kept an ongoing influence in hmi's corporate affairs. he also argues that an employee unrelated to the former owner of the business would not continue to be paid were she to work mrs. hurst's admittedly minimal schedule. and he asserts that her employment was a mere ruse to provide mr. hurst with his company car and health benefits, bolstering this argument with proof that the truck used by mrs. hurst was the same one that her husband had been using when he ran hmi. none of this, though, changes the fact that her compensation and fringe benefits were fixed, and again like the notes and lease not subordinated to hmi's general creditors, and not subject to any fluctuation related to hmi's financial performance. her duties, moreover, were various administrative and clerical tasks some of the same chores [vol 8:si recent developments in federal income taxation she had been doing at hmi on a regular basis for many years. and there was no evidence whatsoever that mr. hurst used his wife in any way as a surrogate for continuing to manage (or even advise) hmi's new owners. 0 somewhat surprisingly, perhaps, the court concluded that the fact that a default by the corporation on its obligations to mrs. hurst under the employment contract, as did a default under the lease, also constituted a default on the promissory note to mr. hurst, thereby triggering his right to reacquire the stock did not, under all of the facts and circumstances, constitute a prohibited retained interest. the commissioner argued that "intertwin[ing] substantial corporate obligations with the employment contract of only one of 45 employees . .. [was] proof that the parties to this redemption contemplated a continuing involvement greater than that of a mere creditor." the court responded that "the proof at trial [demonstrated] that there was a legitimate creditor's interest in the hursts' demanding [the cross collateralization provisions]. . . . they were, after all, parting with a substantial asset (the corporations), in return for what was in essence an iou from some business associates. their ability to enjoy retirement in financial security was fully contingent upon their receiving payment on the notes, lease, and employment contract.... the value of that security, however, depended upon the financial health of the company. repossessing worthless shares as security on defaulted notes would have done little to ensure the hursts' retirement. the cross-default provisions were their canary in the coal mine. if at any point the company failed to meet any financial obligation to the hursts, mr. hurst would have the option to retrieve his shares immediately, thus protecting the value of his security interest instead of worrying about whether this was the beginning of a downward spiral. this is perfectly consistent with a creditor's interest, and there was credible trial testimony that multiple default triggers are common in commercial lending." accordingly, the court held that "the crossdefault provisions protected the hursts' financial interest as creditors of hmi, for a debt on which they had received practically no downpayment, and the collection of which (though not 'dependent upon the earnings of the corporation' as that phrase is used in section 1.302-4(d), income tax regs.) was realistically contingent upon hmi's continued financial health .... the number of legal connections between mr. hurst and the buyers that continued after the deal was signed did not change their character as permissible security interests. even looked at all together, they were in no way contingent upon the financial performance of the company except in the obvious sense that all creditors have in their debtors' solvency." 2. the irs was "buffeted" when it attempted to show linkage between taxpayer's borrowings and its investments in portfolio stock. obh. inc. (formerly berkshire hathaway inc.) v. united states, 2005-2 u.s.t.c. 50,627 (d. neb. 10/28/05). the court held that 2006] florida tax review taxpayer is entitled to a full dividends-received deduction because § 246a, which reduces the dividends-received deduction allowable under § 243(a) for dividends that are paid on "debt-financed portfolio stock," was not applicable. the court looked to legislative history (house report), which stated that portfolio indebtedness is debt that is "clearly incurred for the purpose of acquiring dividend paying stock or otherwise directly traceable to such an acquisition." 0 it found that the proceeds of the four borrowings in question were not able to be traced to specific purchases of portfolio stock, i.e., they were not "directly attributable" to portfolio stock purchases. it further held that "directly traceable" should be given a "plain meaning" definition, i.e., that "direct" connotes an "immediate result," and the irs failed to show an immediate connection between the debt proceeds and the stocks. the court further found that the irs tracings do not satisfy the "purpose" test either. * the opinion states that the court is cognizant of the fact that current statutory and regulatory regime makes it virtually impossible for the service to trace debt proceeds and thus assess tax deficiencies under § 246a against companies like obh who engage in numerous investment transactions. however, any decision to loosen the "direct" connection required between debt proceeds and the purchase of dividend-paying stocks must be made by congress or the service, not the courts. in fact, the service, apparently recognizing the difficulty in applying § 246a to companies like berkshire, has already taken steps to alter the necessary linkage required by § 246a. on may 7, 2004, the service issued an announcement requesting comments on whether regulations should be adopted that would supplement the specific tracing rule in § 246a with a pro rata allocation rule to determine the use of borrowings that are not traceable to a specific use. see 69 f.r. 25534. c. liquidations 1. the transfer of something worth nothing (or less than nothing) on a net basis is not a transfer of property for purposes of subchapter c. reg-163314-03, transactions involving the transfer of no net value, 70 f.r. 11903 (3/10/05). these proposed regulations deal with the net value requirement for tax-free transactions under subchapter c, and provide that exchanges under §§ 351, 332 and 368 do not qualify for tax-free treatment where there is no net value in the property transferred or received, with exceptions for e, f and some d reorganizations. * the proposed regulations note, however, that even though a liquidation of a subsidiary might not qualify under § 332, the transaction nevertheless might qualify as a tax-free reorganization under § 368. see prop. reg. § 1.332-2(e), ex. 2. the preamble to the proposed regulations notes that the treasury adopted the approach in spaulding bakeries [vol 8:si recent developments in federal income taxation v. commissioner, 252 f.2d 693 (2d cir. 1963), affg 27 t.c. 684 (1957), and h. k porter co. v. commissioner, 87 t.c. 689 (1986), because it concluded that it is appropriate for a corporation to recognize loss when it fails to receive a liquidating distribution on a class of its subsidiary because the parent corporation would recognize such a loss if the distribution qualified as a reorganization under § 368. 0 the proposed regulations also provide guidance on the treatment of creditors of an insolvent corporation, who will be treated as proprietors to determine whether continuity of interest is preserved. * finally, the proposed regulations provide that the requirements of § 332 are satisfied only if the recipient corporation receives at least partial payment for each class of stock that it owns in the liquidating corporation. a distribution in redemption of less than all of the shares one corporation owns in another corporation, but in which the recipient corporation receives partial payment for at least one class of stock may qualify as a reorganization. d. s corporations 1. members of one (greatly extended) family are treated as one shareholder. section 231 of the jobs act of 2004 amends § 1361 to treat members of a family as one shareholder at the election of any family member. shareholders with a common ancestor going back six generations are members of the same family. * this means that a shareholder and his fifth cousin are members of the same family. this would have the effect of making the entire population of arkansas members of the same family. a. how many s corporation shareholders know the name of any of their great-great-great-great grandfathers? notice 2005-91, 2005-51 i.r.b. 1164 (11/22/05). this provides advance notice of what the regulations will say under § 1361(c)(1)(d) election to aggregate family members for 100 shareholder limit. lists additional shareholders who will be counted in aggregation (trust beneficiaries, etc.) describes the manner by which the election to treat members of a family as one shareholder may be made for taxable years of the s corporation beginning after 12/31/04. "the election is made by notifying the corporation to which the election applies. the notification shall identify by name the member of the family making the election, the 'common ancestor' of the family to which the election applies, and the first taxable year of the corporation for which the election is to be effective." members of the family also include beneficiaries of permitted trusts, etc. a smaller family may be 2006] florida tax review subsumed into a larger family, with members of the larger family all being counted as one shareholder. 2. coggin automotive would be reversed by a proposed regulation. reg-149524-03, lifo recapture under section 1363(d), 69 f.r. 50109 (8/13/04). prop. reg. § 1.1363-2(b)-(d) (2004) would reverse the rule in coggin automotive corp. v. commissioner, 292 f.3d 1326 (11th cir. 2002), for future years and require lifo recapture when a corporation that conducts business through an interest in a partnership makes an s election. a. the regulation is now final. t.d. 9210, lifo recapture under section 1363(d), 70 f.r. 39920 (7/12/05), corrected by, 70 f.r. 46758 (8/11/05), with an effective date of 8/13/04. b. in the tax court, the aggregate theory of partnership taxation was applied. coggin automotive corp. v. commissioner, 115 t.c. 349 (10/18/00). taxpayer originally was a holding company that had a number of controlled subsidiaries engaged in the retail sale of motor vehicles. the subsidiaries maintained their inventories under the lifo method, and all of the corporations filed a consolidated return. in 1993, the taxpayer restructured to make an s election. six new s corporations were formed to become the general partners in six limited partnerships. each subsidiary contributed its dealership assets to a limited partnership in exchange for a limited partnership interest, following which the subsidiaries were liquidated and the taxpayer became the limited partner in each. the commissioner asserted that the taxpayer's conversion to an s corporation triggered the inclusion of the affiliated group's pre-s-election lifo reserves (approximately $5 million) under § 1363(d). the commissioner argued alternatively (1) that the restructuring should be disregarded because it had no purpose independent of tax consequences, and (2) that under the aggregate approach to partnerships, a pro rata share of the pre-s-election lifo reserves (approximately $4.8 million) was attributable to the taxpayer as a partner. the tax court (judge jacobs) rejected the commissioner's first argument, holding that the restructuring was a genuine multiple-party transaction with economic substance, compelled by business realities and imbued with tax-independent considerations. but judge jacobs accepted the commissioner's second argument, holding that application of the aggregate approach [rather than the entity approach] to partnership taxation furthered the purpose of § 1363(d). thus, the taxpayer was treated as owning a pro rata share of the partnerships' inventories and as a result of its election it was required to include $4.8 million of lifo recapture. * in reaching its decision regarding subchapter k, the tax court followed casel v. commissioner, 79 t.c. 424 [vol 8:si recent developments in federal income taxation (1982), applying the aggregate approach to apply § 267 to disallow losses between related parties; holiday village shopping center v. united states, 773 f.2d 276 (fed. cir. 1985), applying the aggregate approach for purposes of determining depreciation recapture when a corporation distributed a partnership interest to its shareholders; and unger v. commissioner, 936 f.2d 1316 (d.c. cir. 1991), in determining permanent establishment. it distinguished as inapposite the entity approach applied in p.d.b. sports, ltd. v. commissioner, 109 t.c. 423, (1997) applying the entity approach for purposes of applying § 1056; madison gas & elec. co. v. commissioner, 72 t.c. 521, 564 (1979), affd, 633 f.2d 512 (7th cir. 1980), applying the entity approach in determining whether expenditures are deductible under § 162 or nondeductible start-up expenditures, and the eighth circuit's decision in brown group, inc. v. commissioner, 77 f.3d 217 (8th cir.1996), vacating 104 t.c. 105 (1995), concluding that the entity approach, rather than the aggregate approach, should be used in characterizing income (subpart f income) earned by a partnership. the differences, the court found, were based on the determination of the relevant congressional intent in enacting the non-subchapter k provision involved in each case. (1) but the eleventh circuit sees things differently, and reverses the tax court. "plain language" requires application of the entity theory, and the aggressive tax plan put together by kpmg worked. coggin automotive corp. v. commissioner, 292 f.3d 1326, 89 a.f.t.r.2d 2002-2826, 2002-1 u.s.t.c. 50,448 (1 1th cir. 6/6/02). expressly applying the gitlitz "plain language" principle, the eleventh circuit (judge hill) reversed the tax court. the court of appeals held that § 1363(d) lifo recapture is triggered only if the corporation electing s status itself directly owned the lifo inventory. since the result turned on "plain language" rather than the purpose of the statutory pattern, judge hill was spared the need to write a lengthy opinion. 3. governments have to collect. t.d. 9183, modification of check the box, 70 f.r. 9220 (2/25/05). these final regulations under §§ 856, 1361 and 7701 clarify that qualified reit subsidiaries, qualified subchapter s subsidiaries and single-owner eligible entities separate from their owners are treated as separate entities for federal tax liability purposes. 4. unincorporated entities making s elections will be deemed to have checked the box as well. t.d. 9203, deemed election to be an association taxable as a corporation for a qualified electing s corporation, 70 f.r. 29452 (5/23/05), corrected by, 71 f.r. 3219 (01/20/06). final regulations that deem eligible entities that file timely s 2006] florida tax review elections to have elected to be classified as associations taxable as corporations. * those making late elections may seek relief under rev. proc. 2004-48, 2004-32 i.r.b. 172. alternatively, they may submit a ruling request under reg. § 301.9100-3 to file a late classification election and under § 1362 to file a late s corporation election. * these provisions apply retroactively, effective back to 7/20/04. * forming an llc that will be taxed as an association in order to make an s election is a procedure employed in order to take advantage of the greater flexibility given to llcs under state law (as compared with corporations). e. affiliated corporations 1. loss limitation rules are provided in temporary and proposed regulations. t.d. 9118, loss limitation rules, 69 f.r. 12799 (3/18/04); reg-153172-03, loss limitation rules, 69 f.r. 12811 (3/18/04). temporary regulation amendments relate to the deductibility of losses under the temporary regulations under § 337(d) and the antiduplication temporary consolidated returns regulations relating to the claiming of a worthless stock deduction with respect to a subsidiary's stock. the proposed regulations cross-reference the temporary regulations. a. basis disconformity rule will be permitted. notice 2004-58, 2004-39 i.r.b. 520 (8/25/04). the irs will permit taxpayers to use the basis disconformity method or other methods, e.g., tracing, for determining the amount of stock loss or basis that is not attributable to the recognition of built-in gain on the disposition of an asset; such stock loss will be allowed. such amount of stock loss will not be disallowed and such amount of subsidiary stock basis will not be reduced. * under the basis disconformity method the loss is disallowed or the basis reduced, as the case may be, in an amount equal to the least of (1) the "gain amount," (2) the "disconformity amount," or (3) the "positive investment adjustment amount." for this purpose, the gain amount is the sum of all gains (net of directly related expenses) recognized on asset dispositions of the subsidiary that are allocable to the share while the subsidiary is a member of the group. the disconformity amount is the excess, if any, of the share's basis over the share's proportionate interest in the subsidiary's "net asset basis." the positive investment adjustment amount is the excess, if any, of the sum of the positive adjustments made to the share under § 1.1502-32 over the sum of the negative adjustments made to the share under § 1.1502-32, excluding adjustments for distributions under § 1.1502-32(b)(2)(iv). [vol. 8:si recent developments in federal income taxation b. regulations are now final. t.d. 9187, loss limitation rules, 70 f.r. 10319 (3/3/05). these final regulations under §§ 337(d) and 1502 follow the rules described in notice 2004-58. f. reorganizations 1. coi and cobe are not required for e and f reorganizations. reg-106889-04, reorganizations under section 368(a)(1)(e) or (f), 69 f.r. 49836 (8/12/04). these proposed regulations would amend reg. § 1.368-1(b) to provide that a continuity of interest and a continuity of business enterprise are not required for a transaction to qualify as a reorganization under § 368(a)(1)(e) [recapitalization] or (f) [mere change in form]. they also provide comprehensive definitions of e and f reorganizations. a. now final. t.d. 9182, reorganizations under section 368(a)(1)(e) and section 368(a)(1)(f), 70 f.r. 9219 (2/25/05). these final regulations promulgated reg. § 1.368-2(m), comprehensively dealing with the definition of a reorganization under § 368(a)(1)(f). these regulations had been issued in identical proposed form in 2004. 2. net value requirement in reorganizations. see vi.c., above. 3. sale vs. reorganization? tribune company v. commissioner, 125 t.c. 110 (9/27/05), as amended, (10/13/05). in this attempted reverse triangular merger, taxpayer's predecessor, the times mirror co. ("tm") wanted to divest its low-basis matthew bender subsidiary ("mb"). tm was represented by e&y, gibson, dunn & crutcher, and goldman sachs. reed elsevier ("reed") was interested in acquiring mb and was willing to pay $1.375 billion to make the acquisition. reed was represented by price waterhouse. in the transaction, reed subsidiaries organized a special-purpose corporation, mb parent, and held relatively low value, nonparticipating preferred stock with 80 percent control. mb parent, in turn owns preferred stock and nonvoting common stock in an acquisition subsidiary that will merge with mb, as well as a nonvoting interest in a single member llc that holds the $1.375 billion of cash. as a result of the merger of mb into the acquisition subsidiary, tm will own all the common stock and the remaining 20 percent voting power of mb parent. even though, tm will not have voting control over mb parent, it will control the llc by virtue of being the sole (nonequity) manager of the llc. * the plan was for the merger of mb into the acquisition subsidiary in exchange for mb parent common and 2006] florida tax review preferred stock to qualify as a tax free reverse subsidiary merger, even though the stock received does not carry with it voting control. at some later date, by mutual agreement, the mb and mb parent preferred stock could be redeemed at face value and the nonvoting common could be redeemed at a formula price, which would leave reed as the sole owner of mb and tm as the sole owner of mb parent, with the ability to liquidate mb parent and the llc without a tax cost. the tax court (judge cohen) held that tm received both common stock in mb parent and the management authority over the llc, which had to be valued separately. inasmuch as the mb parent common stock lacked control over any assets, it was worth far less than $1.1 billion [80 percent of $1.375 billion], and the transaction failed to qualify as a reorganization under § 368(a)(2)(e). moreover, it did not qualify as a "b" reorganization because tm received consideration other than stock, i.e., the management authority over the llc. judge cohen based her conclusion on the facts that tm intended a sale and that mb parent serves no purpose and performs no function apart from tm's attempt to secure the desired tax consequences. 4. when to measure the value of consideration to determine whether continuity of interest exists. t.d. 9225, corporate reorganizations; guidance on the measurement of continuity of interest, 70 f.r. 54631 (9/16/05), corrected by, 70 f.r. 60132-02. as amended, reg. § 1.368-1(e)(2) provides that if the consideration to be provided to the target corporation shareholders is fixed in the binding contract and includes only stock of the issuing corporation and money, the determination of whether the continuity of interest requirement is satisfied is based on the value of the consideration to be exchanged for the proprietary interests in the target corporation as of the end of the last business day before the first date there is a binding contract to effect the potential reorganization. the number of shares of stock of the acquiring corporation that will be exchanged for stock of the target corporation generally is fixed by agreement. at a time significantly in advance of the actual closing of the transaction. the regulation is intended to eliminate uncertainty where the target corporation shareholders receive cash (or debt instruments) in addition to acquiring corporation stock and, at the time the transaction is agreed upon, the amount of the boot equals the value of the agreed upon number of shares of the acquiring corporation stock to be received. otherwise, the transaction might fail to satisfy the continuity of interest requirement if the value of the acquiring corporation's stock declined between the date the parties agreed to the terms of the transaction (the signing date) and the date the transaction closed if the quantitative aspect of the continuity of interest requirement were tested on the closing date rather than the signing date. [vol. 8:si recent developments in federal income taxation * under reg. § 1.368-1(e)(2)(iii), a contract that provides for either the percentage of the number of shares of each class of target corporation stock, or the percentage by value of the target corporation shares, to be exchanged for issuing corporation stock should be treated as providing for fixed consideration, as long as the target corporation shares to be exchanged for issuing corporation stock and the target corporation shares to be exchanged for consideration other than issuing corporation stock each represents an economically reasonable exchange. a condition outside the control of the parties does not prevent an instrument from being a binding contract. examples of a condition outside the control of the parties include the completion of a tender offer being subject to a shareholder vote or the target corporation's shareholders tendering a sufficient amount of target stock. reg. § 1.368-1(e)(2)(iii)(b)(2) provides that if the target corporation's shareholders may elect to receive either stock or money and the maximum amount of money that the target shareholders might receive can be determined, continuity of interest will be tested by assuming that the minimum number of shares will be issued and the maximum amount of money will be received, without regard to the number of shares and amount of money actually exchanged for the target corporation stock. reg. § 1.368-1(e)(2)(iii)(c)(2) provides that stock that is escrowed to secure customary pre-closing covenants and representations or customary target warranties is not treated as contingent consideration, which would render the safe harbor unavailable. however, escrowed consideration that is forfeited is not taken into account in determining whether the continuity of interest requirement has been met. reg. § 1.368-1(e)(2)(v), ex. 2. * the regulations include an example that lowers the administratively sanctioned threshold for adequate quantitative continuity of interest to 40 percent. reg. § 1.368-1(e)(2)(v), ex. (1). conversely, reg. § 1.368-1(e)(2)(v), ex. (2), indicates that stock consideration of 25 percent is insufficient. * the number of shares of stock of the acquiring corporation that will be exchanged for stock of the target corporation generally is fixed by agreement at a time significantly in advance of the actual closing of the transaction. suppose that in a statutory merger the target corporation shareholders receive cash (or debt instruments) in addition to acquiring corporation stock and, at the time the transaction is agreed upon, the amount of the boot equals the value of the agreed upon number of shares of the acquiring corporation stock to be received. the transaction might fail to satisfy the continuity of interest requirement if the value of the acquiring corporation's stock declined between the date the parties agreed to the terms of the transaction (the signing date) and the date the transaction closed if the quantitative aspect of the continuity of interest requirement were tested on the closing date rather than the signing date. prop. reg. § 1.368-1(e)(2) (2004) would eliminate this uncertainty by providing that the determination of whether the continuity of interest requirement is satisfied is based on the value of the consideration to be 2006] florida tax review exchanged for the proprietary interests in the target corporation as of the end of the last business day before the first date there is a binding contract to effect the potential reorganization, if the consideration to be provided to the target corporation shareholders is fixed in such contract and includes only stock of the issuing corporation and money. a condition outside the control of the parties would not prevent an instrument from being a binding contract. examples of a condition outside the control of the parties include the completion of a tender offer being subject to a shareholder vote or the target corporation's shareholders tendering a sufficient amount of target stock. if the target corporation's shareholders may elect to receive either stock or money and the maximum amount of money that the target shareholders might receive can be determined, continuity of interest will be tested by assuming that the minimum number of shares will be issued and the maximum amount of money will be received, without regard to the number of shares and amount of money actually exchanged for the target corporation stock. 5. merging tax somethings into tax nothings is ok, but not the opposite! t.d. 9038, statutory mergers and consolidations, 68 f.r. 3384 (1/24/03), and reg-126485-01, statutory mergers and consolidations, 68 f.r. 3477 (1/24/03). in reg-126485-01, statutory mergers and consolidations, 66 f.r. 57400 (11/15/01), the treasury withdrew the proposed regulations [reg-106186-98, certain corporate reorganizations involving disregarded entities, 65 fr 31115 (5/16/00)] that would have provided that neither the merger of a disregarded entity into a corporation nor the merger of a target corporation into a disregarded entity was a statutory merger qualifying as a reorganization under § 368(a)(1)(a), and proposed more liberal regulations [prop. reg. § 1.368-2(b)(1)]. under the 2001 proposed regulations, a merger of a corporation into a disregarded entity that is wholly owned by another corporation could qualify as a type (a) merger. the treasury department has now promulgated the 2001 proposed regulations, with some modifications, as temp. reg. § 1.368-2t(b) and simultaneously published new identical proposed regulations. * the main point of the regulations is that the merger of a target corporation into an llc wholly owned by another corporation (thereby rendering the llc a disregarded entity) can qualify as a type (a) reorganization [and under more complex structures as a triangular reorganization; that the merger of a corporation into a q-sub [also a disregarded entity] can qualify as a type (a) reorganization; and that a merger into a qualified reit subsidiary can qualify as a type (a) reorganization. * nevertheless, the new regulations introduce significant definitional jargon. the term "disregarded entity" means a business entity (as defined in reg. § 301.7701-2(a)) that is disregarded as an entity separate from its owner for federal tax purposes, including single member corporate-owned llcs, qualified re1t subsidiaries, and q-subs. "combining [vol 8:si recent developments in federal income taxation entity" means a corporation [as defined in reg. § 301.7701-2(b)] that is not a disregarded entity. "combining unit" means a combining entity and all disregarded entities, if any, the assets of which are treated as owned by such combining entity for federal tax purposes. under the proposed regulations, a statutory merger or consolidation under § 368(a)(1)(a) must be effected pursuant to the laws of the united states, a state or the district of columbia. [foreign statutory mergers still do not qualify, but the domestic statute no longer needs to be a "corporate" law.] all of the following events must occur simultaneously: (1) all of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of one other combining unit (the transferee unit); and (2) the combining entity of each transferor unit ceases its separate legal existence [although its formal existence can continue under state law for certain limited purposes that are not inconsistent with the "all of the assets" requirement.]. the examples provide all of the details of the rules: divisive mergers [see rev. rul. 2000-5, 2000-1 c.b. 436] cannot qualify (ex. 1); forward triangular mergers (into a disregarded entity owned by a subsidiary) are allowed (ex. 2 & 4); the merger of a target s corporation that owns a q-sub into a disregarded entity owned by a c corporation qualifies as to both the target s corporation and its q-sub (ex. 3); the owner of the disregarded entity must be a corporation (ex. 5); mergers of disregarded entities into corporations do not qualify (ex. 6); none of the consideration received by the target shareholders may be interests in the disregarded entity (ex. 7); and the target can be tailored by selling assets and distributing proceeds, as long as all of the remaining assets are transferred to the disregarded entity in the merger (ex. 8). a. t.d. 9242, statutory mergers and consolidations, 71 f.r. 4259 (1/26/06). these final regulations adopt proposed regulations (reg117969-00) issued in 2005 based upon temporary regulations (t.d. 9038) issued in 2003. the final regulations replace the requirement in reg. § 1.368-2(b)(1) that a merger or consolidation under § 368(a)(1)(a) be effected under the laws of a state, etc. with more general language that qualifies transactions "effected pursuant to the statute or statutes necessary to effect the merger or consolidation." mergers involving disregarded entities qualify if all the assets and liabilities of the target are transferred to the acquirer and the target ceases to exist. g. corporate divisions 1. the wrath of general utilities repeal rewritten. reg-107566-00, guidance under section 355(e); recognition of gain on certain distributions of stock or securities in connection with an 2006] florida tax review acquisition, 66 f.r. 67 (1/2/01). the treasury revised prop. reg. § 1.355-7 and withdrew proposed regulations (66 f.r. 76) issued in reg-1 16733-98 (64 f.r. 46155, 8/24/99). the proposed regulations provided that whether a distribution and an acquisition are part of a plan is determined based on all the facts and circumstances. they included nonexclusive lists of facts and circumstances to be considered in making the determination and six safe harbors. a. and apparently the government thinks it did a better job on the regulations the second or is this the third? time around. t.d. 8960, guidance under section 355(e); recognition of gain on certain distributions of stock or securities in connection with an acquisition, 66 f.r. 40590 (8/3/01). the treasury has promulgated temporary regulations identical to the proposed regulations, except that the temporary regulations reserve § 1.355-7(e)(6) (suspending the running of any time period during which there is a substantial diminution of risk of loss under the principles of § 355(d)(6)(b)) and example 7 of the proposed regulations (interpreting the term "similar acquisition" in the context of a situation involving multiple acquisitions). b. the third (fourth?) time's the charm. t.d. 8988, 67 f.r. 20632 (4/26/02) (temporary regulations), and reg163892-01, guidance under section 355(e); recognition of gain on certain distributions of stock or securities in connection an acquisition, 67 f.r. 20711 (4/26/02) (proposed regulations). these regulations amend temp. reg. § 1.355-7t and identical prop. reg. § 1.355-7, and set forth new guidelines in the anti-morris trust regulations. the 2002 temporary and proposed regulations disregard the presumption of § 355(e)(2)(b) and provide that "whether a distribution and an acquisition are part of a plan is determined based on all the facts and circumstances." however, temp. reg. § 1.355-7t(b)(2) provides a "super-safe harbor" for an acquisition not involving a public offering that occurs within two years following the date of a distribution the distribution and acquisition "can be treated as part of a plan only if there was an agreement, understanding, arrangement, or substantial negotiations regarding the acquisition or a similar acquisition at some time during the 2-year period ending on the date of the distribution." [italics added]. c. is the fifth time the charm? t.d. 9198, guidance under section 355(e); recognition of gain on certain distributions of stock or securities in connection with an acquisition, 70 f.r. 20279 (4/19/05). final anti-morris trust regulations under § 355(e). * a perceived need for certainty has spawned complicated regulations providing guidance for identifying the [vol. 8:si recent developments in federal income taxation presence of the prohibited plan. these regulations disregard the presumption of § 355(e)(2)(b) and provide that "whether a distribution and an acquisition are part of a plan is determined based on all the facts and circumstances." reg. § 1.355-7(b)(1). in the case of an acquisition not involving a public offering that occurs within two years following the date of a distribution, the distribution and acquisition "can be part of a plan only if there was an agreement, understanding, arrangement, or substantial negotiations regarding the acquisition or a similar acquisition at some time during the two-year period ending on the date of the distribution." reg. § 1.355-7(b)(2) (italics added). the "super safe harbor" implicit in this rule trumps all other facts and circumstances. the regulations add that the existence of an agreement, understanding, arrangement, or substantial negotiations during the two-year period tends to show that the distribution and acquisition are part of a plan, and further describe such an understanding, etc., as merely a factor among the facts and circumstances to be evaluated. see reg. § 1.355-7(b)(3)(i). discussions with an investment banker regarding the acquisition are listed as a second factor indicating the existence of a plan. treas. reg. § 1.355-7(b)(3)(ii). the regulations add that in the case of an acquisition involving a public offering after the distribution, the absence of discussions with an investment banker within the two-year period ending on the date of the distribution is a factor indicating the absence of a plan. reg. § 1.3557(b)(4)(i) * whether there is an agreement, understanding, or arrangement also is a question of facts and circumstances. reg. § 1.355-7(h)(1). a binding agreement is not required, but an agreement, understanding, or arrangement "clearly exists if a binding contract to acquire stock exists." also, an agreement may exist even though the parties have not reached agreement on all significant economic terms. "substantial negotiations" are said to "require discussions of significant economic terms ... by one or more officers or directors acting on behalf of [the corporation's]... controlling shareholders" or "another person or persons with the implicit or explicit permission of one or more of such officers, directors, or controlling shareholders." reg. § 1.355-7(h)(1)(iv). a controlling shareholder is a five percent shareholder who actively participates in the management or operation of the corporation. treas. reg. § 1.355-7(h)(3)(i). in the case of an acquisition involving a public offering, the existence of an agreement, etc., depends on discussions with investment bankers by one or more officers, directors, or controlling shareholders of either the distributing or controlled corporations. treas. reg. § 1.355-7(h)(1)(vi). * under reg. § 1.355-7(e), the acquisition of stock pursuant to an option will result in the option agreement being treated as an agreement to acquire the stock as of the date the option was written, transferred, or modified if the option is more likely than not to be exercised as of such date. 2006] florida tax review * in the case of an acquisition that follows the distribution, the existence of a plan is indicated if within the twoyear period preceding the distribution there was an agreement, understanding, arrangement, or substantial negotiations regarding the acquisition or a similar acquisition. reg. § 1.355-7(b)(3)(i). if the acquisition involves a public offering after the distribution, the presence of discussions during the two-year period preceding the distribution with an investment banker regarding a distribution is a factor indicating the existence of a plan. reg. § 1.355-7(b)(3)(ii). * in the case of an acquisition that precedes the distribution, the existence of a plan is indicated by discussions within the two-year period preceding the acquisition by either the controlled or distributing corporation with the acquirer regarding a distribution. reg. § 1.3557(b)(3)(iii). the absence of discussions regarding a distribution during the twoyear period ending on the earlier to occur of (a) the acquisition, or (b) the first public announcement regarding the distribution, is a factor indicating that the acquisition and distribution were not part of a plan. reg. § 1.355-7(b)(4)(iii). if the acquisition involves a public offering before the distribution, the presence of discussions during the two-year period preceding the acquisition with an investment banker regarding a distribution is a factor indicating the existence of a plan. reg. § 1.355-7(b)(3)(iv). a change in the market or business conditions after the acquisition that results in a distribution that was otherwise unexpected is a factor that indicates that the acquisition and distribution are not part of a plan. reg. § 1.355-7(b)(4)(iv). * in the case of a distribution either before or after the acquisition, the regulations provide that the existence of a corporate business purpose, as defined in reg. § 1.355-2(b), other than a business purpose to facilitate the acquisition, is a factor indicating the absence of a plan. reg. § 1.355-7(b)(4)(v). internal discussions and discussions with outside advisors, with officers and directors of either the distributing or controlled corporations, provide an indication of a business purpose for the distribution. reg. § 1.355-7(c)(1). similarly, the absence of a plan is indicated if the distribution would have occurred at approximately the same time and in similar form regardless of the acquisition. reg. § 1.355-7(b)(4)(vi). reg. § 1.355-7(c)(2) provides that discussions with the acquirer regarding a distribution to decrease the likelihood of an acquisition of either the distributing or controlled corporation by separating it from the corporation that is likely to be acquired will be treated as having a business purpose to facilitate acquisition of the corporation that is likely to be acquired. nonetheless, a distribution that facilitated trading in the stock of the distributing or controlled corporation will not be taken into account in determining whether a distribution and acquisition are part of a plan. reg. § 1.355-7(c)(3). * reg. § 1.355-7(d) provides nine safe harbors from the stormy seas of prohibited plans. [vol. 8:si recent developments in federal income taxation h. miscellaneous corporate issues 1. the sale of shares by a taxpayer to his brother in a closely held corporation claiming a net operating loss deduction resulted in a § 382 change of control that triggered the limitation on nol carryovers. garber industries holding co. v. commissioner, 124 t.c. 1 (1/25/05). the tax court (judge halpern) held that the family aggregation rule of § 382(1)(3)(a)(i) applies solely from the perspective of individuals who are shareholders (as determined under the attribution rules of § 382(1)(3)(a)) of the loss corporation. thus, the sale of stock from one sibling to another that resulted in a more than 50 percent increase in stock ownership by the purchasing sibling triggered the application of § 382. the fact that each sibling and either of their parents would be viewed as a single shareholder did not result in the siblings being treated as a single shareholder where neither of their parents was a shareholder. the court recognized the possibility that the rule it announced might result in arbitrary distinctions between cases in which a parent of the siblings also was a shareholder and cases in which the parent was not a shareholder, but concluded that the announced rule was the one most compatible with the statutory language and legislative history. one of the garber brothers (charles) had his interest in the corporation decreased from 68 percent to 19 percent and the other brother (kenneth) had his interest increased from 26 percent to 65 percent in a 1986 "d" reorganization. in 1988, kenneth sold all of his remaining shares to charles, with the result that charles's interest in the corporation increased from 19 percent to 84 percent. the parents of charles and kenneth were both deceased and, when living, never had any ownership interest in the corporation. * the court refused to follow taxpayers' argument that siblings are treated as one individual under the nol aggregation rule, which provides that an individual and all members of his family described in § 318(a)(1), i.e., spouses, children, grandchildren and parents, are treated as one individual. 0 judge halpern also refused to follow the commissioner's argument that the family aggregation rule does not apply because none of the parents and grandparents of the garber brothers were alive at the beginning of the three-year testing period immediately preceding the 1998 transaction. instead, he concluded that a third interpretation was correct, i.e., that the family aggregation rule of § 382(l)(3)(a)(i) applies from the perspective of individuals who are shareholders of the loss corporation (as determined under the attribution rules of § 382(1)(3)(a)), and that the brothers were unrelated under this perspective. judge halpern held that the family aggregation rule of § 382(1)(3)(a)(i) applies solely from the perspective of individuals who are shareholders (as determined under the attribution rules of § 382(1)(3)(a)) of the 2006] florida tax review loss corporation. thus, the sale of stock from one sibling to another that resulted in a more than 50 percent increase in stock ownership by the purchasing sibling triggered the application of § 382. the fact that each sibling and either of their parents would be viewed as a single shareholder did not result in the siblings be treated as a single shareholder where neither of their parents was a shareholder. the court recognized the possibility that the rule it announced might result in arbitrary distinctions between cases in which a parent of the siblings also was a shareholder and cases in which the parent was not a shareholder, but concluded that the announced rule was the one most compatible with the statutory language and legislative history. a. affirmed by the fifth circuit. 435 f.3d 555 (5th cir. 1/9/06). the court held that the tax court properly interpreted § 382 as applied to a sale of stock between two shareholder brothers when no parent or grandparent was a shareholder of the loss corporation because § 382 incorporates the limited family description from § 318 limits the relatives of a shareholder to spouse, parents, children and grandchildren. vii. partnerships a. formation and taxable years there were no significant developments regarding this topic during 2005. b. allocations of distributive share, partnership debt, and outside basis 1. reg-128767-04, treatment of disregarded entities under section 752, 69 f.r. 49832 (8/12/04). these proposed regulations provide that in determining the extent to which a partner bears the economic risk of loss for a partnership liability, payment obligations of a disregarded entity are taken into account only to the extent of the net value of the disregarded entity except where the owner of the disregarded entity is otherwise required to make a payment with respect to the obligation of the disregarded entity. in recent years an increasing number of partnership interests have been held through limited liability companies (llcs) that are treated as disregarded entities under reg. § 301.7701-1 through reg. § 301.7701-3. in such a situation, even though the limited liability company has an obligation to restore a negative capital account, the owner of the limited liability company, who is treated as the partner, has no such obligation under state partnership law. because only the llc's assets will be available to satisfy its payment obligations as a partner, the owner should be [vol 8:si recent developments in federal income taxation treated as bearing the economic risk of loss for a partnership liability as a result of those payment obligations only to the extent of the net value of the disregarded entity's assets. this result can be reached through a careful reading and application of the current regulations, but prop. reg. § 1.752-2(k) clarifies this treatment by providing that in determining the extent to which a partner bears the economic risk of loss for a partnership liability under reg. § 1.752-2, payment obligations of a disregarded entity are taken into account only to the extent of the net value of the disregarded entity (assets, including the disregarded entity's enforceable rights to contributions from its owner, but excluding the disregarded entity's interest in the partnership and the fair market value of property pledged to secure a partnership liability, minus the disregarded entity's liabilities), except to the extent the owner of the disregarded entity is otherwise required to make a payment with respect to the disregarded entity's obligation. 2. defining the term "liability" in § 752 and fighting duplication and acceleration of losses through partnerships. reg106736-00, assumption of partner liabilities, 68 f.r. 37434 (6/24/03). the treasury has proposed extraordinarily complex, verging on incomprehensible, regulations: (1) defining liabilities under § 752; (2) dealing with a partnership's assumption of certain fixed and contingent obligations in exchange for a partnership interest [prop. reg. § 1.752-7]; and (3) providing rules under § 358(h) for assumptions of liabilities by corporations from partners and partnerships [prop. reg. § 1.358-7]. reg. § 1.752-1 (a)(1)(i) would be amended to include the principles of rev. rul. 8877, 1988-2 c.b. 128; an obligation is a liability to the extent that incurring the obligation: (1) creates or increases the basis of any of the obligor's assets (including cash); (2) gives rise to an immediate deduction; or (3) gives rise to an expense that is not deductible in computing taxable income and is not properly chargeable to capital. prop. reg. § 1.752-7 deals with the assumption by a partnership of a partner's fixed or contingent obligation to make payment that is not one of the three types described in reg. § 1.752l(a)(1)(i) [including accrual method liabilities the deduction for which was deferred under § 453(h)]. unlike temp. reg. § 1.752-6t, the proposed regulations do not reduce the partner's outside basis when the partnership assumes a § 1.752-7 liability. if the partnership satisfies the liability while the partner remains in the partnership, the deduction with respect to the builtin loss associated with the § 1.752-7 liability is allocated to the partner, reducing that partner's outside basis. alternatively, if one of three events occurs that separate the partner from the partnership, then the partner's outside basis is reduced immediately before the occurrence of the event. the events are: (1) a disposition (or partial disposition) of the partnership interest by the partner, (2) a liquidation of the partner's partnership interest, and (3) the assumption (or partial assumption) of the liability by another partner. 2006] florida tax review the basis reduction generally is the lesser of (1) the excess of the partner's basis in the partnership interest over the adjusted value of the interest, or (2) the remaining built-in loss associated with the liability. (in the event of a partial disposition, the reduction is pro rated.) thereafter, to the extent of the remaining built-in loss associated with the liability, the partnership (or the assuming partner) is not entitled to any deduction or capital expense upon satisfaction (or economic performance) of the liability, but if the partnership notifies the partner, the partner is entitled to a loss or deduction. if another partner assumed the liability, the partnership must immediately reduce the basis of its assets by the built-in loss, and upon satisfaction, the assuming partner must make certain basis adjustments to his partnership interest. there are exceptions for (1) transfer of the trade or business with which the liability is associated is transferred to the partnership, and (2) de minimis transactions (liabilities less that 10 percent of the partnership's assets or $1,000,000). unlike under the temporary regulations, there is no exception for transactions in which substantially all of the assets with which the liability is associated are contributed to the partnership. when finalized, the regulations will be effective for transactions occurring after 6/24/03. a. finally, final regulations. t.d. 9207, assumption of partner liabilities, 70 f.r. 30334 (5/26/05). final and temporary regulations provide new rules dealing with a partnership's assumption of certain fixed and contingent obligations in connection with the issuance of a partnership interest. the regulations also provide rules under § 358(h) for assumptions of liabilities by corporations from partners and partnerships. there are also temporary regulations that provide additional rules under § 358(h) for assumptions of liabilities in pre-6/24/03 exchanges. * the regulations ensure that tax losses cannot be duplicated or accelerated by transferring contingent obligations to partnerships. * they also make final temporary regulations that address the "son-of-boss" tax shelter, § 1.752-6t [which were effective 10/19/99]; these provide that the exception contained in § 358(h)(2)(b) [where substantially all of the assets with which the liability is associated are transferred to the person assuming the liability as part of the exchange] do not apply to transactions described in notice 2000-44, 2000-2 c.b. 255. (1) reg-106736-00, assumption of liabilities, 70 f.r. 30380 (5/26/05). proposed regulations that are identical to the temporary regulations contained in t.d. 9207. 3. reg-144620-04, partner's distributive share, 70 f.r. 69919 (11/18/05). the irs published proposed regulations that inter alia provide rules for testing the substantiality of a § 704(b) allocation where [vol 8:si recent developments in federal income taxation the partners are look-through entities or members of a consolidated group and revise the existing rules for determining the partners' interests in a partnership. they provide that the interaction of a partnership allocation with the tax attributes of owners of look-through entities must be taken into account when testing the substantiality of the allocation to a partner that is a look-through entity, and, similarly, tax attributes of a consolidated group must be taken into account with respect to the allocation to a partner that is a member of the consolidated group. 4. burke v. commissioner, t.c. memo. 2005-297 (12/27/05). a partner is taxable on his share of partnership income even though he did not receive any of it. judge wells stated: petitioner argues, however, that the existence of a real controversy between petitioner and mr. cohen rendered the amount of his distributive share indefinite and that the partnership receipts in escrow are "frozen" and therefore unavailable to petitioner. petitioner cites section 703(a) for the proposition that the taxable income of a partnership is computed in the same manner as that of an individual and cites several cases to support his argument that his dispute with his former partner postpones the inclusion of his distributive share because he does not have a claim of right to the income.... the income was earned by the partnership during 1998, and there was nothing conditional or contingent about its receipt. petitioner, therefore, was taxable on his distributive share of the partnership's profits for 1998, even though he did not receive it. see first mechs. bank v. commissioner, 91 f.2d at 279. it is irrelevant that petitioner still may not know the full extent of the partnership income because of the deposits stolen by his partner, mr. cohen; the nonappearance of the deposits on the partnership books is not determinative.... a partner is taxable on his distributive share of partnership income when realized by the partnership despite a dispute among the partners as to their respective distributive shares.. petitioner does not dispute the facts pertinent to the calculation of his distributive share of the partnership's income for the year in issue. rather, petitioner argues that the deposits to the partnership's account for that year are not income to him as a matter of law. as we discussed above, a 20061 florida tax review partner must include his distributive share of partnership income whether or not it is distributed to him. accordingly, we conclude that respondent is entitled to summary judgment on the issue of the calculation of petitioner's distributive share. c. distributions and transactions between the partnership and partners 1. section 833 of the jobs act of 2004 amends §§ 704(c), 734 and 743. a. section 734(b) and § 743(b) basis adjustments will be mandatory with respect to built-in losses or adjustments that exceed $250,000 at the partnership level. such adjustments under §§ 734 and 743 had been heretofore optional, and need not have been made in the absence of a § 754 election. section 734(b) and § 743(b) basis adjustments remain elective if the aggregate reduction to the partnership's basis would not exceed $250,000 or if the adjustment would increase the aggregate basis of the partnership's assets. the purpose of this amendment is to prevent the duplication of losses in a manner than allows a partner to recognize for tax purposes a loss that was not realized economically. * the amendment to § 743 requires adjustments under § 743(b) to the basis of the partnership's assets whenever the aggregate basis of the partnership's assets exceeds the aggregate fair market value of the partnership's assets by more than $250,000. section 743(b) basis adjustments remain elective if the aggregate reduction to the partnership's basis would not exceed $250,000 or if the adjustment would increase the aggregate basis of the partnership's assets. • a special rule for certain "electing investment partnerships" permits the partnership to avoid making the basis adjustment but limits the transferee partner's distributive share of any losses with respect to partnership property to the amount that exceeds the loss recognized by the transferor partner from whom the partnership interest was purchased. irc § 743(e). the definition of a qualifying "electing investment partnership" in § 743(e)(6) is very restrictive and narrowly limits the application of the special rule. the election is made at the partnership level. see notice 2005-32, 2005-16 i.r.b. 895 (4/1/05). the election requires outside basis adjustments to be made. this special rule for certain "electing investment partnerships" permits the partnership to avoid making the basis adjustment but limits the transferee partner's distributive share of any losses with respect to partnership property to the amount that exceeds the loss recognized by the transferor partner from whom the partnership interest was purchased. § 743(e). section 743(0 provides an exception for "securitization partnerships." [vol. 8:si recent developments in federal income taxation * the amendment to § 734 requires adjustments under § 734(b) to the basis of the partnership's assets whenever an aggregate basis reduction in excess of $250,000 results. section 734(b) basis adjustments remain elective if the aggregate reduction to the partnership's basis would not exceed $250,000 or if the adjustment would result in a basis increase. section 734(e) provides an exception for certain "securitization partnerships" as defined in § 743(f). (1) notice 2005-32, 2005-16 i.r.b. 895 (4/1/05). this notice provides interim procedures for partnerships and their partners to comply with changes to the mandatory basis provisions of §§ 734 and 743 (with a couple of examples of a transfer of a partnership interest and a distribution of partnership property). the bulk of the notice relates to the interim procedures to be followed for "electing investment partnerships" and their partners. b. section 704(c)(1)(c), provides that built-in losses are personal to the partner who contributed the loss property. if the contributing partner ceases to be a partner before the loss is realized, as far as the remaining partners are concerned the basis of the property is treated as being equal to its fair market value at the time of the contribution. this provision is intended to prevent the transfer of built-in tax losses from one partner (a low tax bracket, tax exempt, or foreign person) to another partner. although the statute is silent on the point, if the property is depreciable (or amortizable) in the hands of the partnership that fair-market-value-at-date-ofcontribution basis presumably must be adjusted for prior depreciation (or amortization) claimed by the partnership. * there is no time limit on the application of § 704(c)(1)(c). assume, for example, that a, b, and c formed the abc partnership with a and b each contributing cash of $1,000 and c contributing property with a basis of $7,000 and a fair market value of $1,000. the $6,000 built-in loss with respect to the property contributed by c can be allocated only to c. assume further that eight years later c withdraws from the partnership, in which a and b continue as equal partners, and the next year the ab partnership sells the property contributed by c for any price between $1,000 and $7,000. the partnership does not recognize any loss. if, altematively, the partnership sold the property for $700, the partnership would recognize a $300 loss and a and b each would be allocated a $150 loss. note that § 704(c)(1)(c) creates an asymmetrical basis rule. if the property were sold for more than $7,000, the partnership's gain always would be computed with respect to the $7,000 § 723 transferred basis. section 704(c)(1)(c) would operate similarly if instead of c withdrawing from the partnership, which was continued by a and b, c sold the partnership interest to d. in the case of a transferred partnership 2006] florida tax review interest, the transferee partner does not "step into the shoes" of the transferor with respect to the § 704(c) built-in loss. the built-in loss is again eliminated. 0 note that this is the transaction involved in the long-term capital holdings case, as well as the santa monica pictures llc case. 2. section 83 rules prevail on transfers of partnership interests for services. reg-105346-03, partnership equity for services, 70 f.r. 29675 (5/24/05). prop. reg. § 1.83-3(e) and (1) and § 1.721-1(b) will apply § 83 to all partnership interests, without distinguishing between partnership capital interests and partnership profits interests, when the proposed regulations are finalized. these proposed regulations would conform the subchapter k rules to the § 83 timing rules, revise the § 704(b) regulations to take into account the possibility that allocations with respect to an unvested interest may be forfeited, and provide that a partnership generally recognizes no gain or loss on the transfer of an interest in the partnership in connection with the performance of services for that partnership. * under prop. reg. § 1.704l(b)(2)(iv)(b)(1), the service provider's capital account is increased by the amount the service provider takes into income under § 83 as a result of receiving the interest, plus any amounts paid for the interest. under § 83, the economic benefit of receiving a partnership interest in connection with the performance of services is the amount that is included in the compensation income of the service provider, plus the amount paid for the interest. this is the amount by which the service partner's capital account should be increased. 0 section 706(d)(1) provides generally that, if, during any taxable year of a partnership, there is a change in any partner's interest in the partnership, each partner's distributive share of any item of income, gain, loss, deduction, or credit of the partnership for such taxable year shall be determined by the use of any method prescribed by regulations, which takes into account the varying interests of the partners in the partnership during the taxable year. this ensures that partnership deductions that are attributable to the portion of the partnership's taxable year prior to a new partner's entry into the partnership are allocated to the historic partners. * section 83(b) allows a person who receives nonvested property in connection with the performance of services to elect to include in gross income the difference between: (1) the fair market value of the property at the time of transfer (determined without regard to a restriction other than a restriction which by its terms will never lapse); and (2) the amount paid for such property. under § 83(b)(2), the election under § 83(b) must be made within thirty days of the date of the transfer of the property to the service provider. consistent with the principles of § 83, the proposed regulations provide that, if a partnership interest is transferred in connection with the [vol 8:si recent developments in federal income taxation performance of services, and if an election under § 83(b) is not made, then the holder of the partnership interest is not treated as a partner until the interest becomes substantially vested. if a § 83(b) election is made with respect to such an interest, the service provider will be treated as a partner. these principles differ from rev. proc. 2001-43, 2001-2 c.b. 191, which provides that if a partnership profits interest is transferred in connection with the performance of services, then the holder of the partnership interest may be treated as a partner even if no § 83(b) election is made. * prop. reg. § 1.83-3(o would also provide a safe harbor under which a partnership interest received as compensation for services could be treated as having a fair market value equal to its liquidation value, which in the case of a profits-only partnership interest is zero. as under rev. proc. 93-27, 1993-2 c.b. 343, the safe harbor would not apply in the following three specific situations: (1) the partnership's profits are derived from a substantially certain and predictable stream of income, such as from high quality debt or a net lease; (2) the partner disposes of the partnership interest within two years of its receipt; or (3) the interest is a limited partnership interest in a publicly traded limited partnership as defined in § 7704(b). * prop. reg. §§ 1.83-6(b) and 1.7211(b)(2) would provide that a partnership does not recognize any gain or loss upon the transfer of a partnership interest to a new partner in exchange for services to the partnership (although the proposed regulations do preserve the recognition result in mcdougal v. commissioner, 62 t.c. 720 (1974), if the transfer of property in exchange for services creates a partnership). in mcdougal, the property transferred was half of a horse. a as a practical matter, upon admission of a partner it generally is necessary to revalue the partnership's property and adjust the partners' capital accounts to reflect the revaluation. reg. § 1.7041(b)(2)(iv)(/) specifically allows the partnership to revalue its property and adjust the existing partners' capital accounts in connection with the grant of an interest in the partnership (other than a de minimis interest) in consideration of services to the partnership by an existing partner acting in a partner capacity or by a new partner acting in a partner capacity or in anticipation of being a partner. * forfeitable interests: when a transferred partnership interest is subject to a substantial risk of forfeiture, unless an election is made under § 83(b) the holder of the partnership interest is not treated as a partner until the interest becomes substantially vested. see reg. § 1.83-1(a)(1). if a § 83(b) election is made with respect to such an interest, the service provider will be treated as a partner, even though the interest remains forfeitable. these rules raise special problems regarding the tax treatment of allocation of items of gain or loss to a partner during the period in which the partner's interest remains forfeitable. if the partner who receives a forfeitable partnership interest in exchange for services does not make a § 83(b) election 2006] florida tax review with respect to that interest, the partner cannot be allocated any portion of partnership income or loss, and any distributions made to the service provider with respect to the partnership interest are treated as additional compensation and not partnership distributions. but if a service partner who receives a substantially nonvested partnership interest makes a valid § 83(b) election, the service provider is treated as a partner with respect to such an interest, and the partnership must allocate partnership items to the service provider as if the partnership interest were substantially vested. see notice 2005-43, 2005-24 i.r.b. 1221 (5/20/05). further complications arise if a service provider who has received a forfeitable compensatory partnership interest makes a § 83(b) election, is allocated items of partnership income and loss and subsequently forfeits the partnership interest. prop. reg. § 1.704l(b)(4)(xii) would address these issues. the operation of the proposed regulations is described in the preamble as follows: if an election under section 83(b) has been made with respect to a substantially nonvested interest, the holder of the nonvested interest may be allocated partnership items that may later be forfeited. for this reason, allocations of partnership items while the interest is substantially nonvested cannot have economic effect. under the proposed regulations, such allocations will be treated as being in accordance with the partners' interests in the partnership if: (a) the partnership agreement requires that the partnership make forfeiture allocations if the interest for which the section 83(b) election is made is later forfeited; and (b) all material allocations and capital account adjustments under the partnership agreement not pertaining to substantially nonvested partnership interests for which a section 83(b) election has been made are recognized under section 704(b). this safe harbor does not apply if, at the time of the section 83(b) election, there is a plan that a substantially nonvested interest will be forfeited. all of the facts and circumstances (including the tax status of the holder of the substantially nonvested interest) will be considered in determining whether there is a plan that the interest will be forfeited. in such a case, the partners' distributive shares of partnership items shall be determined in accordance with the partners' interests in the partnership under [treas. reg. §] 1.704l(b)(3). generally, forfeiture allocations are allocations to the service provider of partnership gross income and gain or gross [vol. 8:s1 recent developments in federal income taxation deduction and loss (to the extent such items are available) that offset prior distributions and allocations of partnership items with respect to the forfeited partnership interest. these rules are designed to ensure that any partnership income (or loss) that was allocated to the service provider prior to the forfeiture is offset by allocations on the forfeiture of the interest. also, to carry out the prohibition under section 83(b)(1) on deductions with respect to amounts included in income under section 83(b), these rules generally cause a forfeiting partner to be allocated partnership income to offset any distributions to the partner that reduced the partner's basis in the partnership below the amount included in income under section 83(b). forfeiture allocations may be made out of the partnership's items for the entire taxable year. in determining the gross income of the partnership in the taxable year of the forfeiture, the rules of [treas. reg. §] 1.83-6(c) apply. as a result, the partnership generally will have gross income in the taxable year of the forfeiture equal to the amount of the allowable deduction to the service recipient partnership upon the transfer of the interest as a result of the making of the section 83(b) election, regardless of the fair market value of the partnership's assets at the time of forfeiture. in certain circumstances, the partnership will not have enough income and gain to fully offset prior allocations of loss to the forfeiting service provider. the proposed revenue procedure includes a rule that requires the recapture of losses taken by the service provider prior to the forfeiture of the interest to the extent that those losses are not recaptured through forfeiture allocations of income and gain to the service provider. this rule does not provide the other partners in the partnership with the opportunity to increase their shares of partnership loss (or reduce their shares of partnership income) for the year of the forfeiture by the amount of loss that was previously allocated to the forfeiting service provider. in other circumstances, the partnership will not have enough deductions and loss to fully offset prior allocations of income to the forfeiting service provider. it appears that, in such a case, section 83(b)(1) may prohibit the service provider from claiming a loss with respect to partnership 2006] florida tax review income that was previously allocated to the service provider. however, a forfeiting partner is entitled to a loss for any basis in a partnership that is attributable to contributions of money or property to the partnership (including amounts paid for the interest) remaining after the forfeiture allocations have been made. see [treas. reg. §] 1.83-2(a). a. procedures to be followed in order to elect safe harbor treatment. notice 2005-43, 2005-24 i.r.b. 1221 (5/20/05). that the notice contains a proposed revenue procedure issued concurrently with these proposed regulations would allow a partnership, all of its partners, and the service provider to elect to treat the fair market value of a partnership interest as equal to the liquidation value of that interest. if such an election is made, the capital account of a service provider receiving a partnership interest in connection with the performance of services is increased by the liquidation value of the partnership interest received. the notice provides additional rules that partnerships, partners, and persons providing services to the partnership in exchange for interests in that partnership would be required to follow when electing under prop. reg. § 1.83-3(l) to treat the fair market value of those interests as being equal to the liquidation value of those interests. for this purpose, the liquidation value of a partnership interest is the amount of cash that the holder of that interest would receive with respect to the interest if, immediately after the transfer of the interest, the partnership sold all of its assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) for cash equal to the fair market value of those assets, and then liquidated. * section 83 generally provides that the recipient of property transferred in connection with the performance of services recognizes income equal to the fair market value of the property, disregarding lapse restrictions. however, some authorities have concluded that, under the particular facts and circumstances of the case, a partnership profits interest had only a speculative value or that the fair market value of a partnership interest should be determined by reference to the liquidation value of that interest. see reg. § 1.704-1(e)(1)(v); campbell v. commissioner, 943 f.2d 815 (8th cir. 1991); st. john v. united states, 84-1 u.s.t.c. 9158 (c.d. i11. 1983). but see diamond v. commissioner, 492 f.2d 286 (7th cir. 1974) (holding under presection 83 law that the receipt of a profits interest with a determinable value at the time of receipt resulted in immediate taxation); campbell v. commissioner, t.c. memo 1990-162 (1990), affd in part and rev'd in part, 943 f.2d 815 (8th cir. 1991). * the proposed revenue procedure provides that when the regulations are finalized, rev. proc. 93-27 and rev. proc. 2001-43, will be revoked. [vol. 8:si recent developments in federal income taxation * note: practitioners should consider inclusion of provisions in partnership agreements that require all partners to consent to safe harbor treatment of partnership interests granted for services. d. sales of partnership interests, liquidations and mergers 1. effect of partnership mergers on gain recognition under §§ 704(c)(1)(b) and 737(b). rev. rul. 2004-43, 2004-18 i.r.b. 842 (4/12/04). this ruling deals with the application of §§ 704(c)(1)(b) and 737(b) in partnership mergers. the ruling holds that § 704(c)(1)(b) applies to newly created § 704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership in an assets-over partnership merger, but does not apply to newly created reverse § 704(c) gain or loss resulting from a revaluation of property in the continuing partnership. similarly, for purposes of § 737(b), net precontribution gain includes newly created § 704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership in an assets-over partnership merger, but does not include newly created reverse § 704(c) gain or loss resulting from a revaluation of property in the continuing partnership. thus, a distribution of property previously held by the disappearing partnership will trigger gain recognition if the distribution occurs within seven years after the merger. a. rev. rul. 200443 is revoked, and forthcoming regulations will be effective for distributions after 1/19/05. rev. rul. 2005-10, 2005-7 i.r.b. 492 (1/19/05), revoking rev. rul. 2004-43, 2004-18 i.r.b. 842. the irs revoked rev. rul. 2004-43 and announced that it intended to promulgate regulations implementing the principles of rev. rul. 2004-43, which will be effective after january 19, 2005. e. inside basis adjustments there were no significant developments regarding this topic during 2005. f. partnership audit rules 2. ad global fund, llc v. united states, 67 fed. cl. 657 (9/16/05). section 6629(a) provides an extended statute of limitations rather than a separate period of limitations; issuance of final partnership administrative adjustment (fpaa) suspends period of limitations under irc § 6501(a)), motion to certify appeal granted, 68 fed. cl. 663 (2005). 2006] florida tax review g. miscellaneous there were no significant developments regarding this topic during 2005. viii. tax shelters a. tax shelter cases 1. significant government victory in tax shelter case! partnership's in-house tax counsel should have taken nancy reagan's advice when don turlington pitched him a tax planning idea. long term capital holdings v. united states, 330 f. supp. 2d 122, (d. conn. 8/27/04). judge janet bond arterton poured out taxpayers by holding that the tax shelter transaction [under which preferred stock with an inflated basis was contributed to a partnership in a carryover basis transaction] lacked economic substance (or, in the alternative, that the step transaction doctrine required that it be recast into a direct sale of preferred stocks to taxpayers with the result that the basis was equal to the amount they paid) and by upholding the imposition of (in the alternative) both the 40 percent gross valuation misstatement and the 20 percent substantial understatement penalties. after that introductory statement, the remainder of the 198-page opinion was all downhill for taxpayers and their lawyers. * the inflated basis was the result of several cross-border lease-stripping transactions which left a foreign entity holding several million dollars worth of preferred stocks at a basis $385 million greater than value. the lease-stripping transactions were supported by "should" tax opinions issued by shearman & sterling when they were entered into. * taxpayers' in-house tax counsel became interested in the possible utilization of the losses when approached by don turlington, who suggested that the foreign entity contribute the preferred stock to one of taxpayers' related partnerships, after which the foreign entity would have its partnership interest redeemed. king & spalding agreed to furnish a "should" tax opinion that taxpayers could utilize the foreign entity's losses, but did not actually provide the opinion until almost a year after the partnership filed the return that took the losses. * holdings included: (1) the burden of proof did not shift to the government under § 7491 because taxpayers failed to provide a powerpoint presentation and accompanying handout for a presentation of myron scholes to the other eleven of taxpayers' principals and taxpayers' net worth was not unambiguously shown to be under $7 million; (2) the transaction lacked economic substance because the reasonably expected return on it could not have resulted in a profit (with the court calling into question the credibility of the former king & spalding lawyer who was the [vol 8:si recent developments in federal income taxation primary drafter of the opinion); (3) the "end result" variety of the step transaction doctrine the most liberal of the three varieties was applied to conclude that taxpayers acquired the preferred stocks by purchase at a fair market value basis; (4) the gross valuation misstatement resulted from the claimed adjusted basis of the preferred stocks being more than 400 percent of the adjusted basis that was found by the court to equal fair market value; (5) the substantial understatement penalty was applied based upon taxpayers' failure to show any authority that held a transaction devoid of economic substance could produce deductible losses; (6) the § 6664(c) "reasonable cause.., and.., good faith" exception did not apply because taxpayers failed to prove that the king & spalding oral advice provided to it before 4/15/98 [the day it filed the relevant partnership return] satisfied the "reasonable cause" defense because of the vagueness and lack of credibility of testimony as to the content of the oral advice; and (7) the 1/27/99 written king & spalding opinion did not provide reasonable cause because its facts were unsubstantiated and its legal analysis unsatisfactory in that it failed to discuss second circuit cases. judge arterton summarized the opinion as follows: finally, no other evidence such as companion memoranda discussing the application of the second circuit's decisions in goldstein, gilman, grove, blake, and grove, or the tenth circuit's decision in associated to the actual facts of the [foreign entity] transaction was offered to show research for king & spalding's legal analysis and opinions. such background research does not involve obscure or inaccessible caselaw references, is basic to a sound legal product, especially for "should" level opinion and a premium of $400,000. with hourly billing totals exceeding $100,000 there could not have been research time constraints. in essence, the testimony and evidence offered by long term regarding the advice received from king & spalding amounted to general superficial pronouncements asking the court to "trust us; we looked into all pertinent facts; we were involved; we researched all applicable authorities; we made no unreasonable assumptions; long term gave us all information." the court's role as factfinder is more searching and with specifics, analysis, and explanations in such short supply, the king & spalding effort is insufficient to carry long term's burden to demonstrate that the legal advice satisfies the threshold requirements of reasonable good faith reliance on advice of counsel." 2006] florida tax review * myron scholes and robert merton, who shared the 1997 nobel prize in economics were two of taxpayers' twelve principals. taxpayers were the component parts of one of the highest-flying hedge funds until it had to be rescued from collapse by fourteen banks [acting at the instigation of the federal reserve] providing $3.65 billion to take the hedge fund over. * query about where the substantial authority penalty fits when you have told all to a tax professional and he tells you that you have substantial authority but the court finds that the underlying facts are different from the facts that both you and the tax professional believe to be true? * is there a duty on a client to read and understand a tax opinion beyond checking that the facts upon which the opinion is based are correct? a. on the appeal of the imposition of penalties, the second circuit affirms. long-term capital holdings, lp v. united states, 150 fed. appx. 40 (2d cir. 9/27/05) (unpublished). the court stated that taxpayer was not required to "second-guess the advice of its tax experts" but instead that it did not receive relevant tax advice upon which it relied in reporting the $106 million loss, and even if it had received such advice it could not have relied upon the opinion's assumptions of (1) valid and substantial business purpose independent of federal income tax considerations, (2) reasonable expectation of a material pre-tax profit, and (3) no preexisting agreement on the part of onslow trading company to sell its partnership interest to the long-term capital management partnership. the court upheld the 40 percent penalty based upon a basis misstatement [specifically covered by the statute, but different from the typical valuation misstatement to which the penalty has been applied in the past] and held that a misstatement resulting from a legal dispute [as opposed to a factual dispute] was also covered by the penalty and that the 40 percent penalty applied where a transaction is "recast" for tax purposes under the economic substance doctrine. 2. significant taxpayer victory when its summary judgment motion was granted; the contingent liability transaction was upheld despite its being a listed transaction under notice 2001-17. black & decker cor. v. united states, 340 f. supp. 2d 621 (d. md. 10/20/04, revised, 10/22/04). government appeal pending. judge quarles held that the transaction could not be disregarded as a sham because it had economic implications for the parties to the transaction as well as to the beneficiaries of taxpayer's health plans. * under the fourth circuit test in rice's toyota world, inc. v. commissioner, 752 f.2d 89 (1985), a transaction [vol, 8:si recent developments in federal income taxation will be treated as a sham only if the court finds that "the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists." taxpayer conceded for purposes of its motion "that tax avoidance was its sole motivation." the court held that "[a] corporation and its transactions are objectively reasonable, despite any taxavoidance motive, so long as the corporation engages in bona fide economically-based business transactions." * note how judge quarles shifted the second prong of the test from "reasonable possibility of profit" to "bona fide business transaction." * the transaction was a listed tax shelter under notice 2001-17, 2001-9 i.r.b. 730. * in 1998, black & decker sold three of its businesses and realized significant capital gains. that same year, black & decker created black & decker healthcare management inc. (bdhmi), to which it transferred approximately $561 million dollars, with bdhmi assuming $560 million dollars in contingent employee healthcare claims against black & decker. black & decker then sold the bdhmi stock to a third-party for $1 million dollars, and claimed a $560 million loss on the grounds that its basis in the bdhmi stock was $561 million dollars. the court concluded that §§ 357(c)(3) and 358(d)(2) applied and that black & decker's basis in the bdhmi stock properly was not reduced by the amount of the contingent employee healthcare claims. it rejected the irs contention that the claims had to be deductible by the transferee (bdhmi), and, based upon the legislative history of § 357(c)(3), concluded that there was no reduction in basis because the contingent claims were liabilities that would have been deductible by the transferor shareholder had it paid the claims. a. government's summary judgment motion had been denied earlier on a pro-taxpayer rationale. black & decker corp. v. united states, 2004-2 u.s.t.c. 50,359 (d. md. 8/3/04). as the facts were stated in the opinion, in 1998, b & d sold three of its businesses. as a result of these sales, b & d generated significant capital gains. that same year, b & d created black & decker healthcare management inc. ("bdhmi"). b & d transferred approximately $561 million dollars to bdhmi along with $560 million dollars in contingent employee healthcare claims in exchange for newly issued stock in bdhmi. b & d sold its stock in bdhmi to an independent third-party for $1 million dollars. because b & d believed that its basis in the bdhmi stock was $561 million dollars, the value of the 2006] florida tax review property it had transferred to bdhmi, b & d claimed approximately $560 million dollars in capital loss on the sale, which it reported on its 1998 federal tax return. b & d applied a portion of the capital loss to offset its capital gains from selling the three businesses, and carried back and carried forward the remaining capital loss to offset gains in prior and future tax years. (citations omitted) * the court went on to analyze and conclude that §§ 357(c)(3) and 358(d) applied so the basis of the subsidiary's stock is not reduced by the amount of the contingent employee healthcare claims. it rejected the irs contention that the claims had to be deductible by the transferee [the subsidiary], and held that (based upon the 1978 legislative history to § 357(c)(3)) the only requirement is that the claims must be deductible by taxpayer [the transferor corporation]. * section 358(h), added in 2000 and amended in 2002, would preclude this result for assumptions of liability after its 10/18/99 effective date. if the basis of stock received in a § 351 transaction otherwise would exceed its fair market value, § 358(h) requires that the basis of the stock be reduced (but not below the fair market value) by the amount (determined as of the date of the exchange) of any § 357(c)(3) liability that was assumed by the corporation. for this purpose, "liability" is broadly defined to include "any fixed or contingent obligation to make payment, without regard to whether the obligation is otherwise taken into account for purposes of [the income tax]." b. black & decker in the fourth circuit: the holding that basis was not reduced by contingent deductible liabilities was affirmed, but the holding that the transaction did not lack economic substance was reversed and the case was remanded for trial. black & decker corp. v. united states, 436 f.3d 431 (4th cir. 2/2/06), affg denial of government's motion for summary judgment at 2004-2 u.s.t.c. 50,359 (d. md. 8/3/04), rev'g grant of taxpayer's motion for summary judgment at 340 f. supp. 2d 621 (d. md. 10/22/04), and remanding for trial. judge michael's opinion held that the government motion for summary judgment was properly denied because the statute in effect at the time of the transaction permitted taxpayer to do what it did, stating: the irs presses two arguments for why taxpayer cannot claim the § 357(c)(3) exception. the first argument relies on legislative history. the irs focuses on sentences such as the first of the two from the senate report quoted. it contends that congress crafted the exception to protect a parent corporation from a tax double whammy when transferring both assets and associated liabilities to a subsidiary in [vol. 8:si recent developments in federal income taxation exchange for stock. from this perspective, congress wanted to prevent such parent corporations from being twice penalized by (1) deprivation of the right to deduct the transferred liabilities as they accrued and (2) mandatory reduction of the stock basis by the amount of the liabilities transferred. since taxpayer only transferred the health claims but not the assets generating those claims, the irs argues that congress did not intend for taxpayer to benefit from § 357(c)(3). further, the irs reads the quoted phrase "would have given rise to a deduction," s. rep. no. 96-498, at 62, to mean a deduction unavailable to the transferor once the liability has been transferred. the legislative history argument does not persuade us. the prototypical transaction congress had in mind in drafting § 357(c)(3) may well have been one in which a corporation exchanged liabilities as part of a transfer of an entire trade or business to a controlled subsidiary, but nothing in the section's plain language embraces such a limitation. as a result we find no ambiguity in the statute that requires us to parse the congressional record and discern what type of business transactions congress originally envisioned in enacting the section. the senate report's use of the phrase "would have given rise" also does not go as far as the irs would have us take it. on the contrary, we agree with one commentator's observation that this language "does not imply . . . that congress silently contemplated a case in which liabilities are transferred but the deduction is retained by the transferor and [then] concluded that § 357(c)(3) should not apply." ethan yale, reexamining black & decker's contingent liability tax shelter, 108 tax notes 223, 234 (july 11, 2005). the irs's second argument is based on sound administration of the tax laws, because the taxpayer should not be allowed to take the "functional equivalent of a double deduction." appellant's br. at 59. although taxpayer has not claimed the employee health expenses as a deduction (bdhmi, not a party to this suit, claims them instead), the irs argues that taxpayer has the legal right to seek these deductions as health care costs accrue. in the irs's view, the $560 million loss that taxpayer reported effectively accelerates deductions for uncertain future health care costs through the year 2007. such acceleration would contravene 2006] florida tax review the prohibition against claiming a deduction in a given tax year for an estimate of liabilities that have not become fixed by the end of that year. here, receipt of medical care and filing of proper claims forms would fix the annual health care liability. united states v. gen. dynamics corp., 481 u.s. 239, 242-45, 107 s. ct. 1732, 95 l. ed. 2d 226 (1987). again, we are not convinced that the language of § 357(c)(3) is so unclear as to permit us to rely on this policy argument and adopt the irs's reading. in addition, because bdhmi files a tax return separate from taxpayer's and has been taking the deductions for the health care expenses as the expenses are incurred, the "double deduction" argument would only work if we were to treat bdhmi and taxpayer as a single entity. we see no justification on the present record for disregarding the distinct corporate taxpayer identities of bdhmi and taxpayer. rather, we agree with taxpayer: "bdhmi pays the claims; bdhmi takes the deductions not taxpayer." appellee's br. at 27. we conclude that the contingent liability taxpayer transferred to bdhmi falls within the § 357(c)(3) exception for "liability the payment of which ... would give rise to a deduction." therefore, under § 358(d)(2)'s exception to the general rule of § 358(d)(1), the liability need not be treated as "money received" by taxpayer for basis reduction purposes. for this reason the district court's denial of the irs's summary judgment motion was correct. 0 judge michael held that the government was entitled to a trial on the issue of whether the transaction was a sham, stating: the district court's approach to the objective prong strayed from our precedents. although the district court quoted the pertinent language from rice's toyota, see 340 f. supp. 2d at 623, it went on to assert: "a corporation and its transactions are objectively reasonable, despite any taxavoidance motive, so long as the corporation engages in bona fide economically-based business transactions." id. at 623-24. in so reasoning, the district court mischaracterized the rice's toyota test, which focuses not on the general business activities of a corporation, but on the specific transaction whose tax consequences are in dispute. "the second prong of the sham inquiry, the economic substance [vol. 8:si recent developments in federal income taxation inquiry, requires an objective determination of whether a reasonable possibility of profit from the transaction existed apart from tax benefits." rice's toyota, 752 f.2d at 94 (emphasis added). thus, many of the undisputed facts upon which the district court relied in concluding that taxpayer was entitled to summary judgment including the facts that bdhmi "maintained salaried employees" and paid health claims as they came due with bdhmi assets, 340 f. supp. 2d at 624 were simply not germane to the proper inquiry under the second prong of our circuit's sham transaction test. we do not agree with taxpayer's contention that the supreme court's decision in moline properties, inc. v. commissioner, 319 u.s. 436, 63 s. ct. 1132, 87 l. ed. 1499, 1943 c.b. 1011 (1943), supports the district court's analysis of the objective prong under rice's toyota. the court in moline held that a corporate taxpayer, the petitioner, "had a tax identity distinct from its stockholder," an individual, such that gain realized on sales in two tax years were to be treated as income taxable to the corporation, not to the individual; 319 u.s. at 440. to reach this conclusion, the court examined the purposes for the individual's establishment of the corporation. id. at 439-40. the court recognized that in some tax cases "the corporate form may be disregarded where it is a sham or unreal." id. at 439. moline is not implicated, however, by the irs's allegation that under the objective prong of the sham transaction test there was no reasonable profit opportunity in the two-phase transaction taxpayer executed with bdhmi in november and december 1998. the irs is not arguing at this point that bdhmi's corporate identity separate from taxpayer must be disregarded for tax purposes, such that income earned by one is to be attributed to the other. shams under rice's toyota are distinct from shams under moline. in particular, a shareholder's transaction with a controlled corporation may be a sham under rice's toyota even if the corporation is entitled to regard its income as distinct from its shareholder's because the corporation is not itself a sham under moline. hines illustrates the proper analysis under the objective prong of the rice 's toyota. hines involved an irs challenge to investment interest and depreciation deductions stemming from a taxpayer's purchase and lease back to the seller of 20061 florida tax review used computer equipment. we first noted that the payments on the transaction would leave the taxpayer "with a loss of $127,324 over the eight years of the lease" to the seller; 912 f.2d at 739. we next identified all of the possible sources of revenue on the transaction and weighed them against this loss. see id. at 739-40. viewing the evidence in the light most favorable to the taxpayer, which had won at trial, we nevertheless concluded that the transaction "failed to yield any reasonable expectation of a profit." id. at 739. hines clarifies that under this circuit's firmly established rice's toyota standard, the objective prong of the sham transaction test focuses on reasonable expected profits from a transaction. there is no basis here for abandoning our standard by scrutinizing the transaction for its "real economic effects," despite taxpayer's argument that we should do so based on the law of another circuit. see united parcel serv. of am., inc. v. comm'r, 254 f.3d 1014, 1019 (11 th cir. 2001). 0 as illustrated by rev. rul. 95-74, § 357(c)(3) applies not only to cash method accounts payable, but also to liabilities of accrual method transferors that have not yet been allowed as a deduction under the economic performance rules of § 461(h) or because the liability is too contingent. as a result, § 358(d)(2) applies and the transferor shareholder's basis in the stock received in the exchange is not reduced by the liability. aggressive tax planners took advantage of this pattern of the interaction of the various statutory provisions to create artificial double deductions. 3. a second taxpayer victory in a listed contingent liability transaction. coltec industries, inc. v. united states, 62 fed. cl. 716 (10/29/04), government appeal pending. taxpayer transferred its asbestos liabilities to an asbestos case management entity ["garrison"], which was existing shell subsidiary that had no assets, together with a related party note for $375 million and some other miscellaneous assets. it sold about 6.67 percent of the garrison stock to two banks for a total of $500,000 and reported a multimillion dollar loss that saved it over $82 million in taxes. judge susan g. braden found that this transaction satisfied all the requirements of existing law. 0 judge braden rejected the concept of a court applying the economic substance doctrine to tax cases on the ground that taxpayers "must be able to rely on clear and understandable rules established by congress to ascertain their federal tax obligations." after discussing the complexity of the economic substance doctrine, she concluded "that where a taxpayer has satisfied all statutory requirements established by congress, as [vol 8:si recent developments in federal income taxation coltec did in this case, the use of the 'economic substance' doctrine to trump 'mere compliance with the code' would violate the separation of powers." 0 as illustrated by rev. rul. 95-74, 1995-2 c.b. 36, § 357(c)(3) applies not only to cash method accounts payable, but also to liabilities of accrual method transferors that have not yet been allowed as a deduction under the economic performance rules of § 461(h) or because the liability is too contingent. as a result, § 358(d)(2) applies and the transferor shareholder's basis in the stock received in the exchange is not reduced by the liability. aggressive tax planners took advantage of this pattern of the interaction of the various statutory provisions to create artificial double deductions. here, in a transaction subject to § 351, one corporation, garlock, contributed to another corporation, garrison, cash, a $375 million promissory note to garlock from a related corporation, and certain other property. in connection with the transfer garrison assumed $371.2 million of garlock's contingent liabilities for asbestos product liability damage claims (neither of the events necessary to establish the fact of the liability had occurred, i.e., the filing of a lawsuit asserting a claim and an adjudication of liability). shortly thereafter, garlock sold a significant number of the shares of garrison and claimed approximately $370 million of losses, having determined the basis of the garrison stock with reference to an exchanged basis under § 358 that was not reduced to reflect the assumption of the contingent asbestos liabilities. since the liabilities were contingent and the liabilities would have been deductible by the transferor upon payment, the court held that the liabilities were within those described in §§ 357(c)(3)(a) and 358(d)(2), and thus neither § 357(c)(1), requiring the recognition of gain to the extent that the amount of liabilities exceed the basis of the contributed assets, nor § 358(d)(1), requiring the reduction of the transferred basis assigned to the stock, applied. therefore, garlock's basis in garrison properly was the exchanged based of the transferred property, unreduced by the amount of liabilities assumed by garrison, and the loss was allowed. 4. the third taxpayer victory in thirteen days, in a self-liquidating partnership note transaction in which the lion's share of income was allocated to a tax-indifferent party. satisfaction of the mechanical rules of the regulations under § 704(b) transcends both an intent to avoid tax and the avoidance of significant tax through agreed upon partnership allocations so far, this lease stripping transaction works for a burned-out tax shelter. tifd iii-e. inc. v. united states, 342 f. supp. 2d 94 (d. conn. 11/1/04), government appeal pending. this case involved a tax shelter partnership in which 2 percent of both operating and taxable income was allocated to gecc, a united states partner, and 98 percent of both book and taxable income was allocated to partners who were dutch banks, foreign partners who were not liable for u.s. taxes and thus were indifferent to the u.s. tax consequences of their participation in the 2006] florida tax review partnership. because the partnership had very large book depreciation deductions and no tax depreciation, most of the partnership's taxable operating income, which was substantially in excess of book income, was allocated to the tax-indifferent foreign partners, even though a large portion of the cash receipts reflected in that income was devoted to repaying the principal of loans secured by property that gecc had contributed to the partnership. the overall partnership transaction saved gecc approximately $62 million in income taxes, and the court found that "it appears likely that one of gecc's principal motivations in entering into this transaction though certainly not its only motivation was to avoid that substantial tax burden." the court understood the effects of the allocations and concluded that "by allocating 98 percent of the income from fully tax-depreciated aircraft to the dutch banks, gecc avoided an enormous tax burden, while shifting very little book income. put another way, by allocating income less depreciation to tax-neutral parties, gecc was able to 're-depreciate' the assets for tax purposes. the tax-neutrals absorbed the tax consequences of all the income allocated to them, but actually received only the income in excess of book depreciation." nevertheless, the court upheld the allocations. the tax benefits of the ... transaction were the result of the allocation of large amounts of book income to a tax-neutral entity, offset by a large depreciation expense, with a corresponding allocation of a large amount of taxable income, but no corresponding allocation of depreciation deductions. this resulted in an enormous tax savings, but the simple allocation of a large percentage of income violates no rule. the government does not and cannot dispute that partners may allocate their partnership's income as they choose. neither does the government dispute that the taxable income allocated to the dutch banks could not be offset by the allocation of non-existent depreciation deductions to the banks. and . . . the bare allocation of a large interest in income does not violate the overall tax effect rule. 0 because the partnership had very large book depreciation deductions and no tax depreciation, most of the partnership's taxable operating income, which was substantially in excess of book taxable income, was allocated to the tax-indifferent foreign partners, even though a large portion of the cash receipts reflected in that income was devoted to repaying the principal of loans secured by property that gecc had contributed to the partnership. the overall partnership transaction saved gecc approximately $62 million in income taxes, and the court found that "it appears likely that one of gecc's principal motivations in entering into this transaction though certainly not its only motivation was to avoid that substantial tax burden." the court understood the effects of the allocations and concluded that [vol 8:si recent developments in federal income taxation "by allocating 98 percent of the income from fully tax-depreciated aircraft to the dutch banks, gecc avoided an enormous tax burden, while shifting very little book income. put another way, by allocating income less depreciation to tax-neutral parties, gecc was able to 're-depreciate' the assets for tax purposes." * the court found that the creation of castle harbour, a nevada llc, by general electric capital corp. subsidiaries was not designed solely to avoid taxes, but to spread the risk of their investment in fully-depreciated commercial airplanes used in their leasing operations. gecc subsidiaries put the following assets into castle harbor: $530 million worth of fully-depreciated aircraft subject to a $258 million non-recourse debt, $22 million of rents receivable, $296 million of cash, and all the stock of another gecc subsidiary that had a value of $0. two tax-indifferent dutch banks invested $117.5 million in castle harbour under the llc agreement, and the tax-indifferent partners were allocated 98 percent of the book income and 98 percent of the tax income. * the book income was net of depreciation and the tax income did not take depreciation into account [because the airplanes were fully depreciated]. depreciation deductions for book purposes were on the order of 60 percent of the rental income for any given year. * query whether § 704(b) was properly applied to this transaction? * the court (judge underhill) held that satisfaction of the mechanical rules of the regulations under § 704(b) transcended both an intent to avoid tax and the avoidance of significant tax through agreed upon partnership allocations. in this partnership, 2 percent of both operating and taxable income was allocated to gecc, a united states partner, and 98 percent of both book and taxable income was allocated to partners who were dutch banks. the dutch banks were foreign partners who were not liable for united states taxes and thus were indifferent to the u.s. tax consequences of their participation in the partnership. * judge underhill concluded: the government is understandably concerned that the castle harbour transaction deprived the public fisc of some $62 million in tax revenue. moreover, it appears likely that one of gecc's principal motivations in entering into this transaction though certainly not its only motivation was to avoid that substantial tax burden. nevertheless, the castle harbour transaction was an economically real transaction, undertaken, at least in part, for a non-tax business purpose; the transaction resulted in the creation of a true partnership with all participants holding valid partnership interests; and the income was allocated among the partners in accordance 20061 florida tax review with the internal revenue code and treasury regulations. in short, the transaction, though it sheltered a great deal of income from taxes, was legally permissible. under such circumstances, the i.r.s. should address its concerns to those who write the tax laws. the castle harbour case has generated significant commentary suggesting that the court erred in its determination that the allocations had substantial economic effect. see, e.g., karen c. burke, castle harbour: economic effect and the overall-tax-effect test, 107 tax notes 1163 (may 30, 2005). although the allocations might have had economic effect under treas. reg. §1.704-1(b)(2)(ii), the allocations were not substantial under treas. reg. § 1.704-1(b)(2)(iii). the factual analysis is quite complex. because the income stream was completely predictable and under the partnership agreement the end result was that the dutch banks merely recouped their investment plus a guaranteed 8.5 percent return, the allocations were not substantial under treas. reg. § 1.704-1 (b)(2)(iii)(a) because as a result of the allocations, when compared to an allocation of book income that simply reflected the amounts actually to be ultimately distributed to the partners under the agreement, that the after-tax economic consequences of the other partners were enhanced, and there was a strong likelihood that the after-tax consequences to the dutch banks would not be diminished. 5. santa monica pictures, llc v. commissioner, t.c. memo. 2005-104 (5/11/05). the tax court (judge thornton) held that an llc formed to purchase the high-basis, low-value assets of the former parent company of mgm, was not entitled to capital losses on the order of $380 million because the transactions it undertook lacked economic substance and cannot be respected for federal tax purposes, and that the llc lacked basis in any of the assets it sold. judge thornton also imposed the 40 percent gross valuation misstatement and the 20 percent substantial understatement penalties. 6. deductions for interest on policy loans under winn-dixie's pre-1996 hipaa leveraged coli program were denied by both the tax court and eleventh circuit. winn-dixie stores, inc. v. commissioner, 113 t.c. 254 (10/19/99). in 1993, taxpayer entered into a broad-based leveraged corporate-owned life insurance group plan covering approximately 36,000 of its employees. the decision to shift from its existing "key-person" coli program of individual policies [covering 615 managers] was made pursuant to a proposal that emphasized the "tax arbitrage created when deductible policy loan interest is paid to finance nontaxable policy gains." the proposal indicated that taxpayer would have a pretax loss totaling $755 million for its 1993-2052 years, but would have total after-tax earnings of more than $2.2 billion for the same period (as the result [vol 8:si recent developments in federal income taxation of total projected income tax savings of more than $3 billion). the coli policies were terminated in 1997, following 1996 legislation that impacted the plan. judge ruwe held that the coli program lacked substance and business purpose, and thus was a sham. he rejected taxpayer's argument that the policies could conceivably produce pre-tax benefits if some catastrophe were to occur that would produce large, unexpected death benefits. "we are convinced that this was so improbable as to be unrealistic and therefore had no economic significance." the court further found that the possible use of projected after-tax earnings to fund employee benefit plans would not cause the coli plan to have economic substance, noting that, if so, "every sham tax-shelter device might succeed." in light of the $3,000 per year premium paid to insure each employee or former employee, it was irrelevant that there was a relatively small death benefit of $5,000 paid with respect to each dead employee or former employee. judge ruwe rejected taxpayer's position that the § 264 safe-harbor test protected its interest deductions. he noted that the right to an interest deduction is governed by § 163 [and not § 264], citing knetsch v. united states, 364 u.s. 361 (1960). he further quoted, "but we do not agree with [taxpayer's] assertion that the legislative history should be turned into an open-ended license applicable without regard to the substance of the transaction ... knetsch ... involved transactions without substance. congress, in enacting section 264(a)(3), struck at transactions with substance. it is a reductio ad absurdum to reason, as [taxpayer] does, that congress simultaneously struck down a warm body and breathed life into [taxpayer's] cadaver." a. affirmed by the eleventh circuit, which holds that even though the ups insurance scheme has business reality the coli tax shelter is a sham. winn-dixie stores, inc. v. commissioner, 254 f.3d 1313 (1 ith cir. 6/28/01) (per curiam). the eleventh circuit rejected taxpayer's primary argument that congress specifically authorized the interest deduction in the 4-out-of-7 rule of § 264. it concluded that in knetsch the supreme court clearly "rejected an argument based on section 264 that is at least a cousin of winn-dixies's present contention ... that congress's failure to close a loophole in section 264 equated to blessing the loophole." the eleventh circuit concluded that knetsch stood for the proposition that "that the sham-transaction doctrine does apply to indebtedness that generates interest sought to be deducted under section 163(a), even if the interest deduction is not yet prohibited by section 264." 0 the eleventh circuit held that the tax court properly applied the sham transaction doctrine: that doctrine provides that a transaction is not entitled to tax respect if it lacks economic effects or substance other than 2006] florida tax review the generation of tax benefits, or if the transaction serves no business purpose .... the doctrine has few bright lines, but "[i]t is clear that transactions whose sole function is to produce tax deductions are substantive shams." [kirchman v. comm'r, 862 f.2d 1486, 1492 (1lth cir. 1989)]. that was, as we read the tax court's opinion, the rule the tax court followed. nor did the court misapply the rule in concluding that the broad-based coli program had no "function" other than generating interest deductions. the tax court found, without challenge here, that the program could never generate a pretax profit. that was what winndixie thought as it set up the program, and it is the most plausible explanation for winn-dixie's withdrawal after the 1996 changes to the tax law threatened the tax benefits winn-dixie was receiving. no finding of the tax court suggests, furthermore, that the broad-based coli program answered any business need of winn-dixie, such as indemnifying it for loss of key employees .... [t]herefore, the broadbased coli program lacked sufficient economic substance to be respected for tax purposes, and the tax court did not err in so concluding. b. third circuit comes down hard on coli, with lots of language the government will love. internal revenue service v. cm holdinas inc. (in re cm holdings, inc.), 301 f.3d 96 (3d cir. 8/16/02), afj'g 254 b.r. 578 (d. del. 10/16/00). in cmi's bankruptcy, the irs filed proofs of claim for taxes based on the disallowance of interest deductions that cmi claimed for its coli plan (involving policies on 1400 employees). * the district court held no interest deduction was allowable under § 163(a) because the entire transaction was a "sham in substance" that lacked subjective business purpose. apart from tax savings from the interest deduction, cmi could not reasonably expect a positive cash flow from the coli plan in any year and could not expect to benefit from the inside cash value build-up [which continuously remained at zero throughout the plan] or profit from the death benefits on covered employees. interest deductions were disallowed, and § 6662 substantial understatement penalties were imposed because the transaction lacked economic substance. the transaction was entered into without a reasonable expectation of profit in the absence of the interest deductions over the life of the 40-year transaction from either the inside build-up or mortality components of the plan. * the third circuit court of appeals (judge ambro) affirmed on the ground that the "coli policies lacked economic [vol. 8:si recent developments in federal income taxation substance and therefore were economic shams." [the court did not reach the issue of whether the transactions were factual shams.] the court dismissed out of hand the need to examine the "intersection of... statutory details." [p]ursuant to gregory v. helvering, 293 u.s. 465 (1935), and knetsch v. united states, 364 u.s. 361 (1960), courts have looked beyond taxpayers' formal compliance with the code and analyzed the fundamental substance of transactions. economic substance is a prerequisite to the application of any code provision allowing deductions.... it is the government's trump card; even if a transaction complies precisely with all requirements for obtaining a deduction, if it lacks economic substance it "simply is not recognized for federal taxation purposes, for better or for worse." in holding for the government, the court rejected the taxpayer's argument that [based on gregory, knetsch, acm partnership and other cases] the application of the economic sham doctrine properly hinges on the "'fleeting and inconsequential' nature" of the transaction under scrutiny. rather, the court concluded that "[d]uration alone cannot sanctify a transaction that lacks economic substance. the appropriate examination is of the net financial effect to the taxpayer, be it short or long term. the point of our analysis in acmpartnership is that the transactions 'offset one another with no net effect on acm's financial position."' in any event, the court found the coli transactions bore "striking similarities" to knetsch. the court further rejected the argument that for analytical purposes the pre-tax profit should have been "grossed-up" by the anticipated tax benefits because, [t]he point of the analysis is to remove from consideration the challenged tax deduction, and evaluate the transaction on its merits, to see if it makes sense economically or is mere tax arbitrage. courts use "pre-tax" as shorthand for this, but they do not imply that the court must imagine a world without taxes, and evaluate the transaction accordingly. instead they focus on the abuse of the deductions claimed: "[w]here a transaction has no substance other than to create deductions, the transaction is disregarded for tax purposes." [citation omitted] choosing a tax-favored investment vehicle is fine, but engaging in an empty transaction that shuffles payments for the sole purpose of generating a deduction is not. finally, the court rejected the taxpayer's argument that because "the transaction had objective non-tax economic effects.., the court must not look further," and that the district court 2006] florida tax review improperly applied a subjective analysis. rather, the court of appeals read gregory to permit an inquiry into motive. "if congress intends to encourage an activity, and to use taxpayers' desire to avoid taxes as a means to do it, then a subjective motive of tax avoidance is permissible. but to engage in an activity solely for the purpose of avoiding taxes where that is not the statute's goal is to conduct an economic sham." because the court found nothing in the statute to indicate that congress intended to encourage leveraged coli investments, the inquiry into motive was proper. in this regard, it was significant that "the plan was marketed as a tax-driven investment." because the coli "plan had no net effect on camelot's economic position, . . . it fails the objective prong of the economic sham analysis." because there was no "legitimate business purpose behind the plan, . . . it fails the subjective prong as well." penalties were also upheld. c. but a district court finds for the taxpayer in an incredible opinion. dow chemical co. v. united states, 250 f. supp. 2d 748 (e.d. mich. 3/31/03). in a carefully-detailed opinion judge lawson finds that dow did correctly almost everything that camelot and aep did incorrectly. the interest rate on policy loans was not unreasonably high, and a positive pre-tax cash flow was expected. the court found that there was a business purpose for the coli arrangements, i.e., to provide retiree benefits. the premiums for the first three years were payable with policy loans and the premiums for years four through seven were payable 90 percent with partial [cash] withdrawals (from policies whose cash value had been previously borrowed) and 10 percent with cash from the taxpayer. judge lawson found that the partial withdrawals were "shams in fact" because there was no cash value left in the policies to borrow, but that the § 264(c)(1) test was met because of the payments of 10 percent of the premiums by taxpayer with its own cash in years four through seven. the court found that the § 264(c)(1) safe harbor did not require level premiums over the first seven years and that the "premium" for each of years four to seven was the 10 percent paid in cash. judge lawson found that reg. § 1.264-4(c)(1)(ii) (which required level premiums) was invalid, and he rejected the holding in both cmholdings and aep that the four-out-of-seven test required level premiums. 0 in finding that taxpayer expected a positive pre-tax cash flow, judge lawson refused to admit into evidence a statement in taxpayer's protest that could have led to a contrary conclusion on the ground that rule 408 of the federal rules of evidence provides that statements made during settlement negotiations are inadmissible at trial. d. there's no harm in asking? not from asking judge lawson! dow chemical co. v. united states, 278 f.supp.2d 844 (e.d. mich. 8/12/03). the government's motion to amend the court's judgment was granted in part and denied in part, but left intact the same [vol. 8:si recent developments in federal income taxation judgment and basic result. ironically, since the motion opened up all findings of fact, judge lawson reversed his earlier finding that the partial withdrawals in years four through seven were "shams in fact," thus making moot the government's argument relating to the logical consequences of this earlier finding, i.e., that taxpayer did not meet the four-of-seven test because it did not pay the entire premium in each of years four through seven from its own funds. e. the circuit to which dow is appealable (sixth circuit) holds for the government in a coli case. american electric power co., inc. v. united states, 326 f.3d 737 (6th cir. 4/28/03). the sixth circuit court of appeals affirmed the district court finding that taxpayer's coli plan was an economic sham because it would lose a substantial amount of money absent the policy-loan interest deductions. the court declined to decide whether the dividends in years four through seven, generated by circular cashless netting transactions, were factual shams. f. dow is reversed by the sixth circuit. dow chemical co. v. united states, 435 f.3d 594 (6th cir. 1/23/06) (2-1). the sixth circuit reversed and held that the dow coli plans were "economic shams" because there was little likelihood that dow would make substantial cash infusions in the future, so the pre-tax cash flows would at all times be negative, following knetsch v. united states, 364 u.s. 361 (1960). this holding eliminates the court's need to decide the proper discount rate, as well as the issue of the exclusion of dow's tax protest letters under rule 408 of the federal rules of evidence [inadmissibility of statements made during settlement negotiations]. the court further held that there would be little or no inside build-up and that dow's possible mortality gains were limited under the plans. judge ryan dissented on the ground that the majority opinion improperly read knetsch to hold as "a general principle of law that future profits are not even relevant to the economic substance inquiry when the taxpayer's projected future investment in a particular plan is greater than its past investment in the plan, regardless whether the projected future investment is feasible and there is evidence that it is likely to occur;" instead, judge ryan states that knetsch indicated only that the court made a credibility assessment and determined that mr. knetsch did not intend to make the $4 million future investment necessary to pay off the loan. judge ryan would also have found that the dow plans transferred mortality risk to the insurers so mortality gains were possible. 2006] florida tax review b. identified "tax avoidance transactions." 1. silo transactions. interestingly enough, sale-in, lease-out (silo) deals [under which a tax-exempt or foreign entity sells property to the taxpayer and leases it back, with the lessee depositing collateral in defeasance of its obligation] were not made "listed transactions," although president bush's budget proposal seeks a legislative remedy for this widespread perceived abuse. see 2004 tnt 19-3. a. silo transactions were closed retroactive to 3/12/04. section 848 of the jobs act of 2004 adds new § 470 to disallow losses on leases of property for tax-exempt use that were entered into after 3/12/04. the disallowed losses would be carried over to the following year much as disallowed passive activity losses are carried over. there is a safe harbor provision contained in § 470(d). b. silos are now listed transactions even though the door was closed after 3/12/04. notice 2005-13, 2005-9 i.r.b. 630 (2/11/05). this notice distinguishes the silo transaction from the one in franklyon co. v. unitedstates, 435 u.s. 561 (1978). c. relief for partnerships and pass-thru entities who looked like they fed from "silos" in 2004 but really didn't. notice 2005-29, 2005-13 i.r.b. 796 (3/10/05). the service will not apply § 470 to partnerships and pass-thru entities described in § 168(h)(6)(e) for taxable years that begin before 1/1/05 in order to disallow losses associated with property that is treated as tax-exempt use property solely as a result of the application of § 168(h)(6) (describing property owned by a partnership that has both tax-exempt and non-tax-exempt partners). 2. transactions involving significant book-tax differences are removed from the list of reportable transactions because they are covered by schedule m-3. notice 2006-6, 2006-5 i.r.b. 385 (1/6/06). transactions involving significant book-tax differences are removed from the list of reportable transactions. 3. accrual over the term of the notional principal contract of the noncontingent component of the nonperiodic payment to be received at the end of the term is required. rev. rul. 2002-30, 2002-21 i.r.b. 971 (5/6/02). when a notional principal contract provides for payment comprised of noncontingent and contingent components, the appropriate method for the inclusion in income or deduction of the noncontingent component of the nonperiodic payment is over the term of the npc. interest must also be accounted for in a manner consistent with reg. §§ 1.446-3(f)(2) (ii) or (iii), and 1.446-3(g)(4). [vol 8:si recent developments in federal income taxation 0 taxpayer agrees to make quarterly payments to counterparty based on the three-month libor multiplied by a notional principal amount of $100,000,000. in return, at the end of eighteen months, the counterparty will pay taxpayer 6 percent per year multiplied by a notional principal amount of $92,000,000 [or, $8,280,000], and, in addition, the counterparty will either pay taxpayer $8 million times the percentage increase in the stock index, or taxpayer will pay the counterparty $8 million times the percentage decrease in the stock index. the ruling holds that, to offset the taxpayer's deductible quarterly payments, the taxpayer must ratably accrue over the eighteen-month term the $8,280,000 that taxpayer will receive from the counterparty at the end of the term. a. an arrangement similar to that of rev. rul. 2002-30 is identified as a listed tax shelter. notice 2002-35, 2002-21 i.r.b. 992 (5/6/02). the transaction in this notice involves the use of a notional principal contract to claim current deductions for periodic payments made by a taxpayer, while disregarding the accrual of a right to receive offsetting payments in the future. under the npc, taxpayer is required to make periodic payments to a counterparty at regular intervals of one year or less based on a fixed or floating rate index. in return, the counterparty is required to make a single payment at the end of the term of the npc that consists of a noncontingent component and a contingent component. the noncontingent component, which is relatively large in comparison to the contingent component, may be based upon a fixed or floating interest rate; the contingent component may reflect changes in the value of a stock index or currency. * this transaction may be entered into without any initial cash investment by the taxpayer. the counterparty may lend the money to the taxpayer, who pays it back in installments as purportedly deductible payments. the taxpayer may engage in other transactions, such as interest rate collars, for purposes of limiting risk with respect to the npc transaction. * taxpayer seeks to deduct the ratable daily portion of each periodic payment to which that portion relates, but taxpayer does not accrue income with respect to the nonperiodic payment until the year the payment is received. * the proper treatment of the payments is that the nonperiodic payment to be received by the taxpayer at the end of the term of the npc must be accrued ratably over the term of the npc, as set forth in rev. rul. 2002-30. * transactions that are the same as, or substantially similar to, the transaction described are identified as "listed transactions" for purposes of temp. reg. §§ 1.6011-4t(b)(2) and 301.60112t(b)(2). 2006] florida tax review b. certain notional principal contracts are no longer listed transactions. notice 2006-16, 2006-9 i.r.b. 538 (2/13/06), clarifying and modifying notice 2002-35, 2002-21 i.r.b. 992. "this notice clarifies notice 2002-35, 2002-1 c.b. 992, by illustrating certain transactions that are not the same as or substantially similar to the transaction described in notice 2002-35, and thus are not "listed transactions." c. disclosure and settlement 1. the big four settle with the irs on tax shelters. deloitte settled with the irs and agreed to a penalty to be determined after the irs settled with the other three. a. the pwc deal. ir-2002-82 (6/27/02). the irs announced in a news release that it cut a deal with pricewaterhousecoopers (pwc) "to resolve issues relating to tax shelter registration and list maintenance." the irs news release, which is similar to one issued last august regarding merrill lynch, says that without admitting or denying liability, pwc has "agreed to make a 'substantial payment' to the irs to resolve issues in connection with advice rendered to clients dating back to 1995." under the agreement, pwc will provide to the irs certain client information in response to summonses. it will also work with the irs to develop processes to ensure ongoing compliance with the shelter registration and investor list maintenance requirements, according to the release. b. the ey deal. ir-2003-84 (7/2/03). the irs announced in a news release that it has settled ernst & young's potential liability under the tax shelter registration and list maintenance penalty provisions for a nondeductible payment of $15 million. see 2003 tnt 1281. c. the kpmg deal: the price of settling goes up dramatically. ir-2005-83 (8/29/05). the irs and the justice department announced in a news release that kpmg llp has admitted to criminal wrongdoing and agreed to pay $456 million in fines, restitution and penalties as part of an agreement to defer prosecution of the firm. nineteen individuals, chiefly former kpmg partners including the former deputy chairman of the firm [jeffrey stein], as well as a new york lawyer [r.j. ruble], were indicted in the southern district of new york in relation to the "multi-billion dollar criminal tax fraud conspiracy"; three of those indicted [richard smith, philip wiesner and mark watson] were partners in kpmg's washington national tax group. [vol 8:si recent developments in federal income taxation 2. is this really the last chance global settlement initiative? announcement 2005-80, 2005-46 i.r.b. 967 (10/28/05). settlement initiative for twenty-one transactions, not all of them listed as "abusive tax shelters," together with the accuracy-related penalty that will be imposed [varying from 5 percent and 20 percent] unless the transaction was disclosed under announcement 2002-2, 2002-1 c.b. 304, or the taxpayer relied upon a more-likely-than-not opinion from a non-disqualified tax advisor that considered all the relevant facts and did not assume any unreasonable facts. the terms of the settlement require that improperlyclaimed tax benefits be disallowed, but transaction costs will generally be allowed as an ordinary loss. promoters and related persons are not normally eligible for the settlement initiative, and persons engaged in a transaction that had been designated for litigation, persons in litigation, persons against whom the fraud penalty was imposed or considered and persons under criminal investigation are ineligible for the settlement initiative. taxpayers must notify the irs of their intent to participate by 1/23/06 by making an election on form 13750 ("election to participate in announcement 2005-80 settlement initiative"), and sending it, together with all required attachments, to the service. a. frequently asked questions. ("faqs") on the announcement 2005-80 settlement initiative (rev. 12/12/05), 2005 tnt 239-8 and the irs web site. 0 son-of-boss transactions are ineligible for the settlement initiative. b. strong encouragement for taxpayers to use announcement 2005-80 global settlement initiative. section 303 of the go zone act of 2005 amends § 903 of the jobs act of 2004 to provide that the § 6404(g) post-18-month interest suspension will not apply at all to reportable and listed transactions that are still open on 12/14/05 unless the taxpayer is participating in a settlement initiative described in announcement 2005-80 or the irs has determined that the taxpayer "has acted reasonably and in good faith." section 903 of the jobs act of 2004 provided that the interest suspension for reportable and listed transactions would not apply after 10/3/04. 3. proposed revisions to circular 230 related to tax shelters require disclosures in tax shelter opinions of relationship between practitioner and promoter, etc. reg-122379-02, regulations governing practice before the internal revenue service, 68 f.r. 75186 (12/30/03). new proposed amendments, which differ from the 1/12/01 proposed amendments in several ways: (1) § 10.33 prescribes best practices for all tax advisors; (2) § 10.35 combines and modifies the standards 20061 florida tax review applicable to "marketed" and "more likely than not" tax shelter opinions from former §§ 10.33 and 10.35; (3) § 10.36 contains the revised procedures for ensuring compliance with §§ 10.33 and 10.35; and (4) new § 10.37 contains provisions relating to advisory committees to the office of professional responsibility. * under § 10.33 "best practices" include: (1) communicating clearly with the client regarding the terms of the engagement and the form and scope of the advice or assistance to be rendered; (2) establishing the relevant facts, including evaluating the reasonableness of any assumptions or representations; (3) relating applicable law, including potentially applicable judicial doctrines, to the relevant facts; (4) arriving at a conclusion supported by the law and the facts; (5) advising the client regarding the import of the conclusions reached; and (6) acting fairly and with integrity in practice before the irs. * tax shelter opinions covered by § 10.35 are more-likely-than-not and marketed tax shelter opinions; they, however, do not include preliminary advice provided pursuant to an engagement in which the practitioner is expected subsequently to provide an opinion that satisfies § 10.35. the definition of "tax shelter," tracking the one found in § 6662 which was contained in the 2001 proposed regulations, remains the same. the requirements for tax shelter opinions include: (1) identifying and considering all relevant facts and not relying on any unreasonable factual assumptions or representations; (2) relating the applicable law to the relevant facts in a reasonable manner; (3) considering all material federal tax issues and reaching a conclusion supported by the facts and the law with respect to each issue; and (4) providing an overall conclusion as to the federal tax treatment of each tax shelter item, and the reasons for that conclusion and providing an overall conclusion as to the federal tax treatment of each tax shelter item and the reasons for that conclusion. * under § 10.35(d), a practitioner must disclose any compensation arrangement he may have with any person (other than the client for whom the opinion is prepared) with respect to the tax shelter discussed in the opinion, as well as any other referral arrangement relating thereto. the practitioner must also disclose that a marketed opinion may not be sufficient for a taxpayer to use for the purpose of avoiding penalties under § 6662(d), and must also state that taxpayers should seek advice from their own tax advisors. a limited scope opinion must also disclose that additional issues may exist and that the opinion cannot be used for penalty-avoidance purposes. 0 under § 10.36 procedures to ensure compliance are required to be followed by tax advisors with responsibility for overseeing a firm's practice before the irs. these include ensuring that the firm has adequate procedures in effect for purposes of complying with § 10.35. 0 under § 10.37 the director of the office of professional responsibility is authorized to establish advisory [vol 8:si recent developments in federal income taxation committees to review and make recommendations regarding professional standards or best practices for tax advisors. they may also, more particularly, advise the director whether a practitioner may have violated §§ 10.35 or 10.36. a. extended statutory authority granted to treasury with respect to circular 230. section 822 of the jobs act of 2004 amends 31 u.s.c. § 330(b) to permit the imposition of censures and monetary penalties for circular 230 violations. it also clarifies the treasury's authority to impose standards applicable to written tax shelter opinions. b. tax shelter revisions to circular 230 are made final. to paraphrase president clinton, oral opinions are not real opinions. t.d. 9165, regulations governing practice before the internal revenue service, 69 f.r. 75839 (12/20/04). (1) best practices for tax advisors. as to final § 10.33, the preamble states: the final regulations adopt the best practices set forth in the proposed regulations with modifications. these best practices are aspirational. a practitioner who fails to comply with best practices will not be subject to discipline under these regulations. similarly, the provision relating to steps to ensure that a firm's procedures are consistent with best practices, now set forth in § 10.33(b), is aspirational. although best practices are solely aspirational, tax professionals are expected to observe these practices to preserve public confidence in the tax system. 0 these best practices are (1) communicating clearly with the client regarding the terms of the engagement; (2) establishing the facts, determining which facts are relevant, evaluating the reasonableness of any assumptions or representations, relating the applicable law (including potentially applicable judicial doctrines) to the relevant facts, and arriving at a conclusion supported by the law and the facts; (3) advising the client regarding the import of the conclusions reached, including, e.g., whether the client may avoid accuracy-related penalties; and (4) acting fairly and with integrity in practice before the irs. practitioners responsible for overseeing a firm's tax practice must take reasonable steps to ensure that firm's procedures applicable to all personnel in the firm are consistent with these best practices. (2) requirements for covered opinions. as to final § 10.35, the preamble states: 2006] florida tax review under the final regulations, the definition of a covered opinion [i.e., one subject to § 10.35] includes written advice (including electronic communications) that concerns one or more federal tax issue(s) arising from: (1) a listed transaction; (2) any plan or arrangement, the principal purpose of which is the avoidance or evasion of any tax; or (3) any plan or arrangement, a significant purpose of which is the avoidance or evasion of tax if the written advice (a) is a reliance opinion, (b) is a marketed opinion, (c) is subject to conditions of confidentiality, or (d) is subject to contractual protection. a reliance opinion is written advice that concludes at a confidence level of at least more likely than not that one or more significant federal tax issues would be resolved in the taxpayer's favor. written advice will not be treated as a reliance opinion if the practitioner prominently discloses in the written advice that it was not written to be used and cannot be used for the purpose of avoiding penalties. similarly, written advice generally will not be treated as a marketed opinion if it does not concern a listed transaction or a plan or arrangement having the principal purpose of avoidance or evasion of tax and the written advice contains this disclosure. the treasury department and the irs intend to amend 26 cfr 1.6664-4 to clarify that a taxpayer may not rely upon written advice that contains this disclosure to establish the reasonable cause and good faith defense to the accuracy-related penalties. written advice regarding a plan or arrangement having a significant purpose of tax avoidance or evasion is excluded from the definition of a covered opinion if the written advice concerns the qualification of a qualified plan or is included in documents required to be filed with the securities and exchange commission. the final regulations also adopt an exclusion for preliminary advice if the practitioner is reasonably expected to provide subsequent advice that satisfies the requirements of the regulations. written advice that is not a covered opinion for purposes of § 10.35 is subject to the standards set forth in new § 10.37. [vol 8:si recent developments in federal income taxation • there are substantial due diligence requirements for covered opinions.2 all written opinions at the more-likelythan-not (or higher) level for listed transactions or transactions with a principal purpose of tax avoidance or evasion are covered opinions. for other nonexcluded tax shelter opinions, the requirements of § 10.35 can be avoided with a statement that the opinion cannot be relied upon to avoid penaltiesprominently disclosed "in a separate section at the beginning of the written advice in a bolded typeface that is larger than any other typeface used in the written advice." to ensure compliance with requirements imposed by the u.s. internal revenue service, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the u.s. internal revenue code or (2) promoting, marketing or recommending to another party any transaction or tax-related matters addressed herein.3 (3) procedures to ensure compliance. as to final § 10.36, the preamble was silent. * practitioners responsible for overseeing a firm's tax practice must take reasonable steps to ensure that the firm has adequate procedures in effect for all personnel to comply with § 10.35. (4) requirements for other written advice. as to final § 10.37, the preamble states: the final regulations also set forth requirements for written advice that is not a covered opinion. under § 10.37 a practitioner must not give written advice if the practitioner: (1) bases the written advice on unreasonable factual or legal assumptions; (2) unreasonably relies upon representations, statements, findings or agreements of the taxpayer or any other person; (3) fails to consider all relevant facts; or (4) takes into account the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be settled. section 10.37, unlike § 10.35, does not 2. if you have to ask the requirements for a covered opinion, then you probably shouldn't be writing one. cf., "j.p. morgan famously said that if you have to ask the cost of a yacht, you probably can't afford one." david taylor in "a strange downeaster," forbes, 6/20/05. 3. in other words, nothing in this outline may be used to save taxes for any of your clients. 20061 florida tax review require that the practitioner describe in the written advice the relevant facts (including assumptions and representations), the application of the law to those facts, or the practitioner's conclusion with respect to the law and the facts. the scope of the engagement and the type and specificity of the advice sought by the client, in addition to all other facts and circumstances, will be considered in determining whether a practitioner has failed to comply with the requirements of § 10.37. * practitioners may not give written advice based on (1) unreasonable factual or legal assumptions; (2) unreasonable reliance upon representations of the client or any other person; (3) consideration of less than all relevant facts; or (4) the possibility that a return may not be audited, that an issue is not raised on audit, or that an issue will be resolved through settlement. (5) establishment of advisory committees. as to final § 10.38 [§ 10.37 in the proposed regulations], the preamble states: newly designated § 10.38, formerly § 10.37 in the proposed regulations, is adopted as proposed with the following modifications. section 10.38 is modified to clarify that an advisory committee may not make recommendations about actual practitioner cases, or have access to information pertaining to actual cases. the section also is modified to clarify that the director of the office of professional responsibility should ensure that membership of these committees is balanced among those individuals who practice as attorneys, accountants and enrolled agents. (6) the provisions contained in the final regulations will generally become applicable on 6/21/05. c. announcement 2005-31; 2005-18 i.r.b. 996 (5/2/05). minor corrections to § 10.35(b)(2)(ii)(b) and § 10.35(b)(4)(i). d. pre-summer solstice changes to § 10.35 expand the definition of "excluded advice," modify the definition of "prominently disclosed" and revise the definition of "the principal purpose [of tax avoidance]." t.d. 9201, regulations governing practice before the internal revenue service. 70 f.r. 28824 (5/19/05). 0 post-return advice. excludes from the definition of a covered opinion advice given after a tax return is filed [vol 8:si recent developments in federal income taxation unless the practitioner knows or has reason to know that the taxpayer will rely on the advice to claim benefits in a subsequently-filed amended return. * in-house advice. excludes from the definition of a covered opinion written advice provided to an employer in the practitioner's capacity as an employee solely for the purposes of determining the tax liability of the employer. 0 how about "almost more likely than not"? excludes from the definition of a covered opinion negative advice unless the written advice also reaches a conclusion favorable to the taxpayer at any confidence level, e.g., not frivolous, realistic possibility of success, reasonable basis or substantial authority. 0 need not come first to be "prominently disclosed." modifies the definition of "prominently disclosed" to a subjective facts-and-circumstances test of whether the item is "readily apparent" to the particular taxpayer in the context of the opinion. the item must be set forth in a separate section (and not in a footnote) in a typeface that is the same size or larger than the typeface of any discussion of the facts or law. * when is a tax avoidance purpose "consistent with the statute and congressional purpose"? revises the definition of "principal purpose" to be similar to that of reg. § 1.66624(g)(2)(ii), i.e., that the purpose is not to avoid or evade federal tax if the purpose is "the claiming of tax benefits in a manner consistent with the statute and congressional purpose." e. proposed circular 230 changes that do not relate to tax shelters are nevertheless controversial, what with new restrictions on the use of contingent fees, monetary penalties for practitioners and their firms, and public hearings before aljs. reg122380-02, regulations governing practice before the internal revenue service, 71 f.r. 6421 (2/8/06). proposed regulations have been issued based upon consideration of comments received in response to questions posed in an advance notice of proposed rulemaking (anprm) at 67 f.r. 77724 (12/19/02), as well as amendments made to 31 u.s.c. § 330 by the jobs act of 2004. changes include: (1) changing references to the office of the director of practice to the office of professional responsibility; (2) adding to the definition of "practice before the [irs]" in § 10.2(d) "rendering written advice with respect to any entity, transaction plan or arrangement, or other plan or arrangement having a potential for tax avoidance or evasion;" (3) revoking the authorization of an unenrolled return preparer to represent a taxpayer during an examination of a return that he or she prepared; (4) eliminating the ability of a practitioner to charge a contingent fee for services rendered in connection with the preparation or filing of an amended tax return or claim for refund or credit, although contingent fees are permissible for services rendered in connection with the irs's examination 20061 florida tax review of, or challenge to, an amended return or claim for refund or credit filed prior to the taxpayer receiving notice of the examination of, or challenge to the original tax return, § 10.27; (5) adding to the standards applicable with respect to tax return positions in § 10.34, the requirement that a practitioner may not advise a client to submit "a document, affidavit or other paper ... to the [irs]" if (a) its purpose is to delay or impede the administration of the federal tax laws, (b) it is frivolous or groundless, or (c) it contains or omits information in a manner that demonstrates an intentional disregard of a rule or regulation; (6) adding to the sanctions in § 10.50 the authority to impose a monetary penalty on the practitioner who engages in conduct subject to sanction, as well as the authority to impose a monetary penalty on the "employer, firm or entity" of a practitioner acting on its behalf provided that the employer, firm or entity knew of reasonable should have known of such conduct; and (7) modifying the definition of disreputable conduct in § 10.51 to include willful failure to sign a tax return the practitioner prepared or unauthorized disclosure of returns or return information. 0 the most controversial proposed change is a provision in § 10.72(d) that all hearings, reports, evidence and decisions in a disciplinary proceeding be available for public inspection, with protection of the identities of any third party taxpayers contained in returns and return information for use in the hearing. 4. irs settlement terms for executive stock option shelters. announcement 2005-19, 2005-11 i.r.b. 744 (2/22/05). executive stock options settlement initiative. the offer, which extends until 5/23/05, is for payment of tax on the full amount of compensation received, plus interest and a 10 percent penalty (which is half of the 20 percent penalty). the parties must pay employment taxes, but they will be allowed to deduct their out of pocket transaction costs; the corporations will be permitted a deduction for the compensation expense when reported by the executive. employment taxes are also due. the irs has identified forty-two corporations, close to 200 executives and more than $700 million of unreported income involved in the scheme, and will ask that the matter be referred to the audit committee of the board of directors for appropriate review. this transaction was listed in notice 2003-47, 2003-30 i.r.b. 132. * in ir-2005-17 (2/22/05), the transaction is described as follows: the transaction first involves the transfer of stock options by the executive to a related entity, such as a family limited partnership, under terms of an agreement to defer payment to the executive. next, the partnership exercises the options and sells the stock in the marketplace. the executive then takes the position that tax is not owed until the date of the [vol 8:si recent developments in federal income taxation deferred payment, typically 15 to 30 years later, although the executive has access to the partnership assets undiminished by taxes. tax laws require executives to include in income and pay tax on the difference between the amount they pay for the stock and its value when the option is exercised. corporations are entitled to a deduction for the compensation when the options are exercised. d. tax shelter penalties, etc. 1. a non-reviewable penalty for failure to disclose a reportable transaction that applies even if the courts uphold taxpayer's position. section 811 of the jobs act of 2004 adds new § 6707a which provides a new penalty for any taxpayer who fails to include on his tax return any required information on a reportable transaction "of a type which the secretary determines as having a potential for tax avoidance or evasion." the penalty would apply regardless of whether there is an understatement of tax and would apply in addition to any accuracy related penalty. the penalty would be $10,000 for a natural person and $50,000 for other taxpayers; for a listed transaction the penalty would increase to $100,000 for a natural person and $200,000 for other taxpayers. 0 the commissioner could rescind any portion of the penalty if it did not involve a listed transaction and rescinding would promote compliance and effective tax administration. a decision not to rescind may not be reviewed in any judicial proceeding. a. doesn't the commissioner trust his own appeals officers? notice 2005-11, 2005-7 i.r.b. 493 (1/19/05). this notice provides guidance on § 6707a, including a statement that the commissioner's determination whether to rescind a § 6707a penalty "is not reviewable by the irs appeals division or any court." notice 2005-11, 2005-7 i.r.b. 493 (interim guidance regarding application of § 6707a pending issuance of regulations; a single penalty will be assessed for: (1) failure to attach a reportable transaction disclosure statement to an original or amended return; or (2) the failure to provide a copy of a disclosure statement to the office of tax shelter analysis (otsa), if required). 2. modified accuracy-related penalty for reportable transactions. section 812 of the jobs act of 2004 adds new § 6662a which would provide a modified accuracy related penalty on understatements with respect to reportable transactions. it would replace the § 6662 accuracy related penalty for tax shelters and would be in the amount of 20 percent 30 percent if the transaction is not properly disclosed. taxpayers could not rely on an opinion of a tax advisor to establish reasonable cause under new 2006] florida tax review § 6664(d) [applicable to reportable transaction understatements] for any opinion: (a) provided by a "disqualified tax advisor" or (b) which is a "disqualified opinion." 3. notice 2005-12, 2005-7 i.r.b. 494 (1/19/05). this notice provides further guidance, including a statement that the new § 6664(d) defense is not available for the 30 percent penalty. it also provides guidance on when a material tax advisor participates in a transaction: consistent with the legislative history, a tax advisor, including a material advisor, will not be treated as participating in the organization, management, promotion or sale of a transaction if the tax advisor's only involvement is rendering an opinion regarding the tax consequences of the transaction. in the course of preparing a tax opinion, a tax advisor is permitted to suggest modifications to the transaction, but the tax advisor may not suggest material modifications to the transaction that assist the taxpayer in obtaining the anticipated tax benefits. merely performing support services or ministerial functions such as typing, photocopying, or printing will not be considered participation in the organization, management, promotion or sale of a transaction. or, in other words, a "disqualified tax advisor" is any advisor who (a) is a material advisor under § 6111 (as defined in reg. § 301.6112-1) and who participates in the organization, management, promotion or sale of the transaction, or is related (within the meaning of § 267(b) or § 707(b)(1)) to any person who so participates, (b) has a disqualified compensation arrangement (as defined in the notice), or (c) has a disqualifying financial interest identified by the irs; however, a tax advisor, including a material advisor, is not treated as participating in the organization, management, promotion or sale of a transaction if the tax advisor's only involvement is rendering an opinion regarding the tax consequences of the transaction). 4. the audit lottery that can never be won and taxpayer can never get repose! the statute of limitations never expires on listed transactions that are not disclosed. section 814 of the jobs act of 2004 adds new § 6501(c)(10) to extend the statute of limitations for listed transactions which a taxpayer fails to disclose until one year after the transaction is disclosed by the taxpayer or by a material advisor's satisfying the list maintenance requirement in connection with a request from treasury. 5. rev. proc. 2005-26, 2005-17 i.r.b. 965 (4/8/05). guidance on the procedures to be followed by taxpayers and material [vol 8:si recent developments in federal income taxation advisors to disclose previously unreported listed transactions for purposes of the extended statute of limitations. rev. proc. 2005-26, 2005-17 i.r.b. 965 (procedures for disclosing a previously undisclosed listed transaction; taxpayer must submit a form 8886, with appropriate cover letter, to the irs service center at which the original return was filed; an amended return with the form 8886 and cover letter is permitted but not required; a copy of the form 8886 and cover letter also must be sent simultaneously to otsa; date of disclosure of a previously undisclosed listed transaction is the first date upon which all of the following events have occurred: (1) original form 8886 is received by the appropriate internal revenue service center, (2) a copy of the disclosure statement is received by otsa and, (3) if applicable, a copy of the disclosure statement is received by the irs examiner or appeals officer). 6. material advisors are subject to increased disclosure. section 815 of the jobs act of 2004 amends §§ 6111 and 6112 to require increased disclosure on an information return for each reportable transaction by any material advisor [in lieu of tax shelter registration]. "material advisor" is defined more broadly to encompass any person who "provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction" and derives fees in excess of $50,000 for tax shelters for natural persons ($250,000 for tax shelters for other taxpayers). 0 notice 2005-17, 2005-8 i.r.b. 606 (2/28/05). this notice grants an extension of time for material advisors to comply with the new filing requirements under § 6111. this notice was clarified and modified by notice 2005-22, 2005-12 i.r.b. 756. 7. section 816 of the jobs act of 2004 amends §§ 6707 and 6708 to increase the penalty for failure to file a return under § 6111 to $50,000 for listed transactions, the greater of $200,000 or 50 percent of the gross income derived by the person required to file the return [75 percent if the failure was intentional]. 8. section 817 of the jobs act of 2004 amends § 6708 to provide a penalty of $10,000 per day on any material advisor for failure to make available to the irs within 20 business days any investor list required to be maintained under the provisions of § 6112. 9. section 818 of the jobs act of 2004 amends § 6707 to increase the penalty on tax shelter promoters to 50 percent of the gross income to be derived from the activity on which the penalty is imposed. 2006] florida tax review 10. section 820 of the jobs act of 2004 amends § 7408 to allow injunctions (a) against material advisors for violating reporting requirements and (b) for violating any of the circular 230 rules. a. interim guidance for material advisors. notice 2004-80, 2004-50 i.r.b. 963 (11/16/04). this notice provides interim guidance for the disclosure requirements for material advisors under § 6111 by defining the terms "reportable transaction" and "material advisor," and specifying the applicable forms and filing dates. the form is form 8264, as modified by instructions in the notice. (1) several revenue procedures were issued on 10/16/04 to give "angels' list" status to transactions that need not be reported. they are rev. proc. 2004-65 [transactions with contractual protection], rev. proc. 2005-66 [loss transactions], rev proc. 2004-67 [transactions with book-tax differences], and rev. proc. 2005-68 [transactions with brief asset holding periods]. they may be found at 2004-50 i.r.b. 965, 966, 967 and 969, respectively. (2) notice 2005-17, 2005-8 i.r.b. 606 (1/28/05). extension for compliance with the reporting provisions to 3/1/05. (3) notice 2005-22, 2005-12 i.r.b. 756 (2/24/05). additional guidance, and a further extension for compliance with the reporting provisions to 4/30/05. 11. rev. proc. 2005-51, 2005-33 i.r.b. 296 (8/15/05). guidance for persons required to pay penalties under §§ 6662(h), 6662a or 6707a, who are required under § 6707a(e) to disclose those penalties on reports filed with the sec. a failure to disclose shall be treated as a failure to disclose a listed transaction and will be subject to an additional penalty. e. tax shelters miscellaneous there were no significant developments regarding this topic during 2005. ix. exempt organizations and charitable giving a. exempt organizations 1. if intermediate sanctions apply, is revocation far behind? reg-1 11257-05, standards for recognition of tax-exempt status if private benefit exists or if an applicable tax-exempt organization has engaged in excess benefit transaction(s), 70 f.r. 53599 (9/9/05). the [vol 8:si recent developments in federal income taxation provisions of these proposed regulations clarify the relationship between the substantive requirements for tax exemption under § 501(c)(3) and the imposition of § 4958 excise taxes, i.e., intermediate sanctions particular with respect to excess benefit transactions. prop. reg. §§ 1.501(c)(3)1 (g)(2)(ii) and (iii) read: (ii) determining whether revocation of tax-exempt status is appropriate when section 4958 excise taxes also apply. in determining whether to continue to recognize the tax-exempt status of an applicable tax-exempt organization (as defined in section 4958(e) and § 53.4958-2 of this chapter) described in section 501(c)(3) that engages in one or more excess benefit transactions (as defined in section 4958(c) and § 53.4958-4 of this chapter) that violate the prohibition on inurement under this section, the commissioner will consider all relevant facts and circumstances, including, but not limited to, the following (a) the size and scope of the organization's regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred; (b) the size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization's regular and ongoing activities that further exempt purposes; (c) whether the organization has been involved in repeated excess benefit transactions; (d) whether the organization has implemented safeguards that are reasonably calculated to prevent future violations; and (e) whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6) and § 53.4958-7 of this chapter), or the organization has made good faith efforts to seek correction from the disqualified persons who benefited from the excess benefit transaction. (iii) all factors will be considered in combination with each other. depending on the particular situation, the commissioner may assign greater or lesser weight to some factors than to others. the factors listed in paragraphs (g)(2)(ii)(d) and (e) of this section will weigh more strongly in favor of continuing to recognize exemption where the organization discovers the excess benefit transaction or transactions and takes action before the commissioner 2006] florida tax review discovers the excess benefit transaction or transactions. further, with respect to the factor listed in paragraph (g)(2)(ii)(e) of this section, correction after the excess benefit transaction or transactions are discovered by the commissioner, by itself, is never a sufficient basis for continuing to recognize exemption. b. charitable giving 1. section 882 of the jobs act of 2004 amends §§ 170(e)(1) and 6050l which limits the amount of the deduction to the lesser of fair market value or the donor's basis in the property. this limitation was enacted because congress was concerned that "taxpayers with intellectual property are taking advantage of the inherent difficulties in valuing such property and are preparing or obtaining erroneous valuations. in such cases, the charity receives an asset of questionable value, while the taxpayer receives a significant tax benefit." h.r. rep. no. 108-548, pt. 1, 108th cong., 2d sess. 351 (2004). 0 because intellectual property often has no basis in the hands of its creator, to retain an incentive for donations of valuable intellectual property, congress added new § 170(m), which allows the donor an additional deduction equal to a portion of the income recognized by the donee with respect to the donated intellectual property, reduced by the amount allowable as a deduction in the year the property was donated. the amount of the additional deduction is based on a sliding scale that allows a tentative deduction equal to 100 percent of the income attributable to the donated property in the first two years after the contribution. in the third year and every year thereafter the percentage of the income eligible for the additional deduction is reduced by 10 percent each year, but remains at 10 percent for the twelfth taxable year ending after the contribution. however, § 170(m)(4) provides that no additional deduction is allowed with respect to income received or accrued by the donee after the tenth anniversary of the donation, which renders the additional deduction for the twelfth taxable year illusory except in very narrow circumstances in which the donor and donee have different taxable years. the additional deduction based on the donee's income from the property is allowed only to the extent the aggregate tentative deductions calculated under the formula exceed the amount of the initial deduction claimed in the year the property was contributed. assume that the donor properly claimed a deduction of $500,000 with respect to a contribution of intellectual property, and the property generates $400,000 of income in the first year. the donor's deduction will be limited to the $500,000 basis and no additional deduction attributable to the income generated by the property will be allowed. if in the second year the property generates $300,000 of income, the donor will be able to deduct an additional $200,000 as a result of that income, because $200,000 is the amount [vol 8:si recent developments in federal income taxation by which the total income generated by the property ($700,000) exceeds the amount the donor previously deducted ($500,000). as a result of the sliding scale, if in the third year the property generates income of $100,000, the donor will be able to deduct only an additional $90,000 (90 percent). 0 the intellectual property with respect to which the additional deduction under § 170(m) is allowed generally includes patents, certain copyrights, trademarks, trade names, trade secrets, know-how, some software and applications or registrations for such property but excludes property donated to many private foundations. the donor must inform the donee at the time of the contribution that she intends to use this provision. 2. t.d. 9206, information returns by donees relating to qualified intellectual property contributions, 70 f.r. 29450 (5/23/05). the treasury has promulgated temporary regulations on qualified intellectual property contributions. reg-158138-04, 70 f.r. 29460 provides identical proposed regulations. (1) notice 2005-41, 2005-23 i.r.b. 1203. related guidance including notification requirements. 3. does new § 170(0(12) close the door to inflated deductions for motor vehicle contributions? or, is the door left open wide enough to drive a truck for other vehicle] through it? section 884 of the jobs act of 2004 amends § 170(f) by adding new paragraph twelve that requires written acknowledgment of contributions of motor vehicles, boats and airplanes that include the amount of the gross proceeds from any arm's length sale and a statement that the deduction may not exceed such amount. its enactment was prompted by congressional concern that taxpayers who were donating used cars to charities were claiming deductions that far exceeded the amounts that the charities were receiving following the sale, often at auction, of the cars. section 170(d)(12) applies if the claimed deduction is more than $500 and provides different rules depending on what the donee charity does with the vehicle. if the donee uses the vehicle or materially improves it, the taxpayer must obtain from the donee, and include with the tax return, a contemporaneous written acknowledgment that provides certain identifying information and certifies the intended use or material improvement of the vehicle, states the intended duration of the use, and certifies that the vehicle will not be transferred or exchanged for money before the termination of such use or improvement. in this case the amount of the deduction is not affected. however, if the donee sells the vehicle without any significant intervening use or material improvement, the deduction cannot be more than the gross proceeds received from the sale, and other substantiation requirements apply. in addition to the other requirements, the donee's contemporaneous written acknowledgment must 2006] florida tax review certify that the vehicle was sold in an arms-length transaction to unrelated parties, state the gross proceeds from the sale, and inform the donor taxpayer that the deductible amount may not exceed the gross proceeds. 0 donees that fail to furnish the required acknowledgment or furnish a false or fraudulent acknowledgment are subject to a penalty under § 6720, which was also added in 2004. for vehicles sold without intervening use or improvement the penalty is at least the gross proceeds from the sale but could be as much as the sales price on the acknowledgment multiplied by the highest marginal rate under § 1 if that is higher. for other vehicles the penalty is the greater of $5,000 or the claimed value of the vehicle multiplied by the highest marginal rate under § 1. a. how much use is "substantial" when a charity uses a donated vehicle in its own endeavors? notice 2005-44, 2005-25 i.r.b. 1287 (6/3/05). the notice provides interim guidance under the new rules for motor vehicle charitable contribution deductions. the most interesting examples are those where the charity puts the vehicle to use in delivering meals on wheels, where the question is whether the use is a "significant intervening use." example 6 says use of the vehicle to deliver meals only a few times is not. example 7 says that use of the vehicle to deliver meals every day for one year is. example 8 says that driving the vehicle to deliver meals a total of 10,000 miles over a one-year period is. * the gross sales proceeds limitation does not apply to a sale to a needy individual at a price significantly below fair market value, or a gratuitous transfer to a needy individual, in direct furtherance of a charitable purpose of the donee organization of relieving the poor and distressed or the underprivileged who are in need of a means of transportation. 4. glass v. commissioner, 124 t.c. 258 (5/25/05), held that the contribution of a perpetual conservation easement that restricted development of certain portions of the taxpayers' lakefront residential lot, but which did not otherwise affect the taxpayers' use or enjoyment of the property, was a qualified conservation contribution under § 170(h) because it protected a relatively natural habitat of specifically identified wildlife, including bald eagles, and plants. 5. eight revenue procedures that contain sample crut declarations of various sorts make it just a little bit easier to give. revenue procedures 2005-52 through 2005-59, 2005-34 i.r.b. 326, 339, 353, 367, 383, 392, 402 & 412, respectively (8/22/05). sample charitable remainder unitrust declarations that meet the requirements of § 664. [vol. 8:si recent developments in federal income taxation 6. under the katrina tax act, "qualified disaster contributions" made between 8/28/05 and 12/31/05 will be deductible without regard to the 50-percent-of-agi limit. 7. under the katrina tax act, charitable deductions for contributions of food inventory would be permitted up to the lesser of (i) fair market value or (ii) twice basis; the same permitted deduction would apply to contribution of book inventory to public schools. effective for contributions made between 8/28/05 and 12/31/05. 8. sklar v.commissioner, 125 t.c. 281 (12/21/05), as amended, 2/7/06. another context in which taxpayers have repeatedly and unsuccessfully sought to claim charitable contribution deductions for payments with respect to which they have received a quidpro quo is tuition payments to religious schools that provide both secular and religious education. even if tuition can be mathematically prorated between the portion attributable to the secular education and the portion attributable to religious education, or the taxpayer can demonstrate that the tuition exceeds the value of the secular education, the deduction has been disallowed because taxpayers have been unable to demonstrate any charitable intent in paying the tuition. the special exception for religious benefits does not apply to payments to religious schools. x. tax procedure a. interest, penalties and prosecutions 1. the "common law" rule that one country does not prosecute for violation of another country's tax law was not violated here. practitioners should have a level of concern that is "somewhere between chicken little and pollyanna." pasquantino v. united states, 544 u.s. 349 (4/26/05) (5-4). criminal convictions for wire fraud in connection with the transportation of liquor from the united states into canada without paying canadian excise taxes were affirmed. the majority opinion by justice thomas held that the "common law revenue rule" [as it existed when the wire fraud statute was enacted in 1952] under which the tax liabilities of one sovereign will not be enforced by those of another sovereign, i.e. the rule bars "collection of tax obligations of foreign nations," is not violated by this prosecution for wire fraud because the dominant characteristic of the case was the prosecution of fraud, and not foreign tax collection. * the suggestion has been made that a practitioner's reaction to this case should be "somewhere between chicken little and pollyanna." 2006] florida tax review 2. t.d. 9186, qualified amended returns, 70 f.r. 10037 (3/2/05). temp. reg. § 1.6664-2t(c) provides that the amount reported on a "qualified amended return" will be treated as an amount shown as tax on the taxpayer's return for purposes of determining whether there is an underpayment of tax subject to an accuracy-related penalty. generally speaking, an amended return is a "qualified amended return" if it is filed before the irs first contacts the taxpayer concerning an examination of the return. temp. reg. § 1.6664-2t(c)(3). 3. rev. proc. 2005-34, 2005-24 i.r.b. 1233 (5/20/05). this revenue procedure sets forth procedures for appeals of proposed trust fund recovery penalty assessments arising under § 6672, updated to reflect amendments made by the taxpayer bill of rights, p.l. 104-168. effective for penalties proposed on or after 5/20/05. 4. but will he be a "survivor" in the u.s. court for the district of rhode island? a justice department news release, dated 9/8/05, announced that richard hatch was indicted on charges of tax evasion for failing to report about $1,037,000 dollars of income from the television reality series and about $391,000 of income from other sources. http://www.usdoj.gov/opa/pr/2005/september/05_tax463.htm. he was convicted on 1/25/06. see 2006 tnt 17-6. 5. when is disclosure adequate? there are different rules for disclosure of a tax shelter, of transactions that lack reasonable basis and supporting records, and for preparer penalty purposes. rev. proc. 2005-75, 2005-50 i.r.b. 1137 (12/12/05). updates guidance on whether disclosure of a position taken on a tax return is adequate for purposes of the § 3332(d) accuracy-related penalty and the § 6694(a) preparer penalty. * there is a new paragraph in § 4.01(5) cautioning that the entry of an amount on a line will not provide adequate disclosure if it is attributable to a tax shelter or "if it does not have a reasonable basis and supporting records," as well as a limitation on its effectiveness for preparer penalty purposes. * there is also a requirement in § 4.02(l)(d) that the contemporaneous written acknowledgment required under § 170(f)(12) for charitable contributions of motor vehicles be attached to the return. 6. united statel v. hempflin , 96 a.f.t.r.2d 20056578, 2006-1 u.s.t.c. 50,205, (e.d. cal. 9/23/05). in as lawsuit seeking an injunction under §§ 6700 and 7408 against a promoter of scheme: (1) purporting to demonstrate that there is no law requiring individuals to file [vol 8:si recent developments in federal income taxation federal income tax returns or pay income taxes, and (2) insulating purchasers who stopped filing tax returns from any charge of willful failure to file a tax return, the court denied the promoter's motion to dismiss, holding that the first amendment does not protect such "false or fraudulent commercial speech." on 2/22/06 at 2006 u.s. dist. lexis 41582, the court again refused to dismiss on defendant's contention that he had new evidence that the sixteenth amendment was never properly ratified. 7. lewis v. united states, 96 a.f.t.r.2d 2005-6301 (w.d. tenn. 9/12/05). ceo/president who was aware of financial strains on corporation was informed by concerned subordinates on more than one occasion that the payroll taxes were not being paid, and whose "apparent choice to turn a blind eye and a deaf ear to these warnings," while shifting the blame to the cfo was liable for § 6672 penalty. note that both ceo and cfo were responsible persons. 8. sentence of 360 months for torching the colorado springs irs office was upheld. united states v. dowell, 430 f.3d 1100 (10th cir. 12/6/05). the court upheld a conviction under § 7212(a) and 18 u.s.c. § 2 for forcibly interfering with irs employees and administration by setting fire to an irs office. 9. bo v. commissioner, t.c. memo. 2005-150 (6/23/05). with respect to request for interest abatement under § 6404 (which is available for delays resulting only from ministerial acts), judge colvin held that erroneous advice to taxpayer from irs agent, failure to reassign case while agent was on maternity leave, sending agent to on-the-job training, and agent taking annual leave while case was pending were not ministerial acts. however, losing file for over four months and erroneous failure to code file as released from collection due process hearing status were ministerial acts. b. discovery: summonses and foia 1. honi soit qui mal y pense. united states v. bdo seidman, llp, 95 a.f.t.r. 2d 2005-1725, 2005-1 u.s.t.c. 50,264 (n.d. ill. 3/30/05). the district court ruled that only one of 267 documents withheld from irs scrutiny by the intervenors was unprotected by privilege or work produce, or both.4 in ruling that the crime-fraud exception did not apply, judge holderman found that neither the existence of cookie-cutter tax opinions nor the irs listing of substantially similar transactions as abusive tax shelters by the irs was determinative because "the tax code and underlying regulations is [sic] full of complexities and uncertainties." he 4. the unprotected document was an e-mail sent by a bdo employee. 2006] florida tax review further stated that "just because one of bdo's consulting agreements has been found to have [been] fraudulent does not mean that all consulting agreements entered into by bdo were fraudulent." * judge holderman found the test for the § 7525(b) tax shelter exception to be the same as for the crime-fraud exception. * footnote 2 of the opinion sets forth the categories of information contained in the privilege log. inasmuch as the adequacy of another privilege log in this litigation was questioned, the categories in this privilege log might be a useful guide. a. the attorney-client privilege does not attach to communications relating to planning to commit tax fraud. subsequently, at 95 a.f.t.r.2d 2005-2835, 2005-2, u.s.t.c. 50,447 (n.d. ill. 5/17/05), judge holderman found that the remaining document examined in camera presented a prima facie case for being not privileged by reason of the crime-fraud exception, and the intervenors failed to present sufficient explanation to rebut that presumption. the document involved an investment in distressed debt with the sole motive of obtaining a loss for tax purposes. * the government had argued that "document a-40 is not part of legitimate year-end tax planning, but instead is part of the overall abusive sham tax shelter transaction perpetrated by bdo and invested in by intervenor cullio and others." 0 judge holderman refused to quash the summons seeking production of document a-40, which he held related to an "abusive sham tax shelter investment," because the irs made a prima facie case that the crime-fraud exception to the attorney-client privilege applied and taxpayer failed to provide a satisfactory explanation of why the document should not be disclosed under the crime-fraud exception; there were eight indicators of potential fraud: (1) the marketing of pre-packaged transactions by bdo; (2) the communication by the taxpayer to bdo with the purpose of engaging in a pre-arranged transaction developed by bdo or a third party with the sole purpose of reducing taxable income; (3) bdo and/or the taxpayer attempting to conceal the true nature of the transaction; (4) actual or constructive knowledge by bdo that the taxpayers lacked a legitimate business purpose for entering into the transaction; (5) vaguely worded consulting agreements; (6) failure by bdo to provide services under the consulting agreement despite receipt of payment; (7) mention of a particular tax shelter that had been identified by the irs as a "listed transaction"; and (8) use of boilerplate documents. 2. jade trading, llc v. united states, 95 a.f.t.r. 2d 2005-2067, 2005-1 u.s.t.c. 50,320 (fed. cl. 4/22/05). the court (judge williams) held that any claim of executive privilege for background [vol. 8:si recent developments in federal income taxation materials relating to the irs's publication of notice 2000-44 on 8/13/00 (relating to the son-of-boss transaction) and relating to treasury's publication of reg. § 1.701-2 on 5/17/94 (in proposed form) and on 12/29/94 (in final form) had to be asserted only after personal consideration by the commissioner and the secretary, respectively. 0 note that judge williams uses the appellation "irs code" in her opinion. 3. in another opinion on the same date, judge williams denied bdo seidman's motion to quash a subpoena requesting "all form 1040 cover pages, schedule d and schedule k-1 for the years 1999-2000" for forty-six bdo clients who are not parties to the jade trading case [in order to ascertain the amount of capital gains and losses claimed by these taxpayers and the dates on which they were incurred] because § 6103 only prohibits disclosure of taxpayer return information "filed with" or "received by, recorded by, prepared by, furnished to, or collected by" treasury and the irs, and also because courts in tax cases have required brokers to produce records of other customers who used the same broker. copies of tax returns given to bdo by its clients do not fall within the prohibition of § 6103. 4. united states v. norwood, 420 f.3d 888 (8th cir. 8/26/05). the court upholds enforcement of a summons seeking records of offshore bank credit card accounts because the act of production was not self-incriminatory. this is because, based on information obtained from mastercard, the government already knew the name and location of the bank that created the records, the payment card numbers, and the details of a number of discrete transactions involving the cards and the account. it held that the "production of the records has no testimonial significance." a. united states v. elliot, 96 a.f.t.r.2d 2005550, 2005-2 u.s.t.c. 50,522 (w.d. n.c. 7/14/05). summons to produce "daily sheets" that recoded all receipts from taxpayer's dental practice was enforced because the records of gross receipts are "voluntarily prepared business records" that are not privileged under united states v. doe, 465 u.s. 605 (1984), despite the record-keeping requirements of reg. § 1.66011. the act of production was not self-incriminatory because, based on the testimony of taxpayer's accountant, "the existence, authenticity, and [taxpayer's] possession of the documents is a foregone conclusion." c. litigation costs 1. blasius v. commissioner, t.c. memo. 2005-214 (9/14/05). advance notice of proposed rule making (anprm) and proposed regulations are not "applicable published guidance" raising the presumption 2006] florida tax review that the government's position was not justified; nor is the irs chief counsel's "priority guidance plan" to be considered "applicable published guidance." 2. moulton v. united states, 429 f.3d 352 (1st cir. 11/21/05). attorney's fees in case in which § 6672 penalty was upheld for only one of five quarters were denied. the government's position was substantially justified because case was a "close case" and "[t]he closeness.. . was compounded by the fact that, once the irs assessed [penalties] under § 6672, the burden of proof was on [taxpayers] to prove that they were not responsible persons (or that, if they were responsible, their failure to ensure that the taxes were paid was not 'willful"'). d. statutory notice 1. a notice of determination gives the tax court jurisdiction, even if the notice is invalid. myong soo kim v. commissioner, t.c. memo. 2005-96 (5/3/05). the irs erroneously issued an invalid notice of determination on a collection action under § 6330, when it should have issued a decision letter. the tax court (judge marvel) denied the commissioner's motion to dismiss for lack of jurisdiction, but did grant the commissioner summary judgment because the § 6330 hearing request was not made within the thirty-day period following the issuance of the notice of intent to levy. 2. rev. rul. 2005-51, 2005-31 i.r.b. 163 (7/12/05). irs may not use the summary assessment procedures under § 6213(b) when taxpayer filed a return reporting an amount of wages and a tax liability, but attached a form w-2 reflecting a different amount of wages; irs must issue a deficiency notice under § 6212(a). nor is the failure to report wages that were shown on a form w-2 attached to the return a "mathematical or clerical error." in such a case the irs must follow the normal deficiency procedures. 3. freije v. commissioner, 125 t.c. 14 (7/14/05). that a taxpayer has an opportunity to dispute the underlying tax liability in an appeal to the tax court in a § 6330 collection due process proceeding does not cure an assessment made in derogation of the taxpayer's rights under § 6213(a) to a deficiency proceeding in the tax court. where taxpayer's appeal from a determination that a levy should proceed is grounded on a claim that the irs improperly applied a remittance for the year with respect to which the determination was made to an outstanding liability for a prior year, the tax court has jurisdiction to redetermine the deficiency for the year to which the remittance was applied by the irs because it is relevant to computing the unpaid tax for which the taxpayer made the remittance. the [vol 8:si recent developments in federal income taxation irs may not collect erroneous nonrebate refund by summarily applying remittances for a subsequent year to recoup the erroneous refund. e. statute of limitations 1. the statute of limitations when taxpayers litigate identity privilege issues in lawsuits against their tax advisers. john doe 1 v. kpmg llp, 93 a.f.t.r.2d 2004-1808, 2004-1 u.s.t.c. 50,270 (n.d. tex. 4/2/04). judge barefoot sanders denied the government's motion to require the john doe taxpayers to sign consents to extend the statute of limitations, but found instead that the statute was suspended. 0 query why the court did not dismiss taxpayers' lawsuit unless they filed consents to extend the statute of limitations. a. united states v. kpmg llp, 316 f. supp. 2d 30 (d. d.c. 5/4/04). judge hogan adopted the rationale of kmpg (n.d. texas), and finds that the statute of limitations was similarly suspended during the pendency of the action. b. john doe 1 reversed on appeal by the fifth circuit; equitable tolling is inapplicable as an exception to the statute of limitations. john doe i v. kpmg, llp, 398 f.3d 686 (5th cir. 3/28/05). judge jones held that equitable tolling is unavailable to extend the § 6501 statute of limitations. she further held that the general jurisdiction granted by § 7402(a) to district courts to issue appropriate orders to enforce the internal revenue laws does not "authorize[] a court to inject an equitable tolling provision into a detailed, highly specific provision (section 6501)." 2. bacigalupo v. united states, 399 f. supp. 2d 835 (m.d. tenn. 11/15/05). twelve-month limitation period governing claims filed in probate proceedings pursuant to state law did not bar claim for unpaid income taxes filed by the irs against the estate in the probate proceeding; citing united states v. summerlin, 310 u.s. 414 (1940), and united states v. john hancock mutual life ins. co., 364 u.s. 301 (1960). the statutes of limitations provided in the internal revenue code pre-empt any state law statutes of limitations. the united states is not bound by any state law statutes of limitations that might require a claim to be asserted within a period shorter than the period provided by the internal revenue code. 3. pacific gas & electric co. v. united states, 417 f.3d 1375 (fed. cir. 8/10/05), rev'g 55 fed. cl. 271 (2003), rehearing en banc denied on 1/13/06. erroneous overpayment of interest on overpayment of taxes could be setoff against subsequent refund claim. in addition, the 20061 florida tax review government can setoff the erroneous refund against other refunds due to the taxpayer, but the irs cannot set off erroneously paid interest against a taxpayer's timely refund claim with respect to the same year, if the statute of limitations on bringing suit for the erroneous payment of interest has expired. f. liens and collections 1. tax court makes it easier to find abuse of discretion in collection due process hearings. robinette v. commissioner, 123 t.c. 85 (7/20/04) (reviewed, 14-3). in 1995, the taxpayer had entered into an offer in compromise (based on doubts as to collectibility) relating to years prior to 1992, which required that he file timely returns for 1995 through 1999. the returns for 1995 through 1997 were timely filed, but the 1998 return was never received. the taxpayer and his accountant claimed that on the day the 1998 return was due, his accountant prepared it, the taxpayer signed it, and the accountant mailed it using a private postage meter [uh-oh]. the irs declared the compromise in default. after a due process hearing in which the taxpayer claimed good faith compliance and offered alternative proof of mailing, including a copy of the 1998 return, the appeals officer issued a notice of determination to proceed with collection, because the appeals officer would accept only a certified or registered mail receipt as proof of mailing. even though the tax court's review of collection due process hearings is for abuse of discretion, in a reviewed opinion by judge vasquez (in which 5 judges joined), the tax court held that it may consider evidence presented at trial that was not in the administrative record (but not new issues). the court held that the administrative procedures act review provisions do not apply to § 6330(d) proceedings, and admitted taxpayer's testimony that he signed and delivered returns to his accountant for mailing, the accountant's testimony regarding the procedures used to mail the return, and other evidence not in the administrative record indicating that the return was mailed. although the testimony was admitted, it did not prove timely mailing because the accountant used a private meter and the return was not received until several years later when the copy was delivered to appeals. nevertheless, the court held that the taxpayer did not materially breach the offer in compromise and that the appeals officer abused his discretion in declaring the compromise in default. there were an indescribable number of overlapping concurrences by an additional nine judges, in some of which the five "majority" judges joined, and one of which concurring opinions was supported by more judges than supported the "majority" opinion; there were three dissents. a. chief counsel's response. chief counsel notice cc-2004-031 (9/1/04). deborah butler provides guidance to chief counsel attorneys as to how to handle collection due process cases in light [vol. 8:si recent developments in federal income taxation of robinette. the recommended course of action when such evidence is presented to the court is to ask for a remand of the case to appeals for a supplemental determination. b. murphv v. commissioner, 125 t.c. 301 (12/29/05). the tax court (judge halpern) declined to overrule robinette, but excluded taxpayer's proffered testimony as to the nature of his illness which allegedly precluded him from making a larger offer in compromise because taxpayer had "more than an adequate opportunity to provide [the appeals officer] with all of the evidence" and declined to do so. the court went on to state: "an appeals officer does not abuse her discretion when she fails to take into account information that she requested and that was not provided in a reasonable time." c. reversed because the case should have been reviewed based upon the evidence presented to the appeals officer. robinette v. commissioner, 439 f.3d 455 (8th cir. 3/8/06). inasmuch as the tax court reviews the decision of an appeals officer under an "abuse of discretion" standard of review, the record on review under both the administrative procedure act and general principles of administrative law is "ordinarily limited to consideration of the decision of the agency ... and of the evidence on which it was based." 0 judge colloton did not think that because the tax court traditionally conducts de novo proceedings in deficiency cases, congress meant it to conduct such proceedings in collection due process cases. 2. a trap for the unwary deprives tax court of jurisdiction with respect to a petition for lien or levy action. prevo v. commissioner, 123 t.c. 326 (12/14/04). the tax court held it lacked jurisdiction with respect to a petition for lien or levy action filed by taxpayer after she filed a voluntary bankruptcy petition because the tax court petition for lien or levy action was filed in violation of the 11 u.s.c. § 362 automatic stay. judge gerber stated: unfortunately here, where the petition in bankruptcy was voluntary, petitioner has fallen victim to a trap for the unwary. as the notice of determination was issued to petitioner on february 23, 2004, petitioner normally would have had 30 days until march 24, 2004 to file a timely petition for lien or levy action with the court. however, upon the filing of the bankruptcy petition on march 1, 2004, the automatic stay was invoked, and petitioner was barred from commencing a proceeding in this court. n4 further, the 20061 florida tax review automatic stay remained in effect until march 31, 2004 7 days after the 30-day statutory filing period under sections 6320(c) and 6330(d) expired. thus, but for the provisions of section 11 u.s.c. section 362(a)(8) and the lack of a tolling provision analogous to section 6213(f), this court would have jurisdiction over this case. n5 n4 had petitioner first filed a petition with this court and then filed a bankruptcy petition, the proceeding before this court would have been active and then stayed, thereby preserving petitioner's ability to contest respondent's determination. n5 see, however, sec. 6330(d), which provides in part: "if a court determines that the appeal was to an incorrect court, a person shall have 30 days after the court determination to file such appeal with the correct court." we do not decide herein whether our determination in this opinion that we lacked jurisdiction over the petition filed during the pendency of petitioner's bankruptcy case means that we are or are not the "incorrect" court for purposes of the above-quoted flush language. if we were the "incorrect" court, petitioner would have 30 days from the date decision is entered in this case to refile in the "correct" court. that issue, however, is not currently before the court and was not briefed by the parties. a. but the trap does not exist where the irs issued its notices after the taxpayer filed a bankruptcy petition. smith v. commissioner, 124 t.c. 36 (2/8/05). judge gerber distinguished the prevo case, and held the tax court lacked jurisdiction because the irs notices were void because they violated the automatic stay under bankruptcy law. 3. kendricks v. commissioner, 124 t.c. 69 (3/9/05). held that taxpayer could not contest deficiency in a collection due process hearing because she had the opportunity to contest tax liability in prior bankruptcy proceeding. 4. speltz v. commissioner, 124 t.c. 165 (3/23/05), on appeal to the eighth circuit. the tax court (judge cohen) held it was not an abuse of discretion for the irs to reject an offer in compromise based upon "the unfair application of the alternative minimum tax (amt) based on their [vol 8:si recent developments in federal income taxation exercise of incentive stock options (isos) where the stock acquired by exercise of the isos has lost substantially all of its value subsequent to the acquisition of the stock." judge cohen held that § 7122, which authorizes compromise of any civil tax case, did not evince "an intent of congress to override application of specific provisions of the tax laws in every instance in which the liability is perceived to be unfair or inequitable," and continued the tax lien in effect. 5. judge wherry places limits on the use of cdp hearings for delay by permitting continued collection and imposing a penalty under § 6673. burke v. commissioner, 124 t.c. 189 (4/12/05). the tax court (judge wherry) holds that the irs may continue collecting by levy an individual's unpaid taxes during the pendency of his hearings and appeals. this is possible when the irs shows good cause, which is satisfied because taxpayer's liability was determined in previous litigation and affirmed by the ninth circuit, and he used the collection review procedure to espouse frivolous and groundless arguments to delay collection. if a collection due process hearing has been timely requested, § 6330(e)(1) generally prohibits the irs from proceeding to collect unpaid taxes by levy while any appeals from the hearing are pending. the tax court interprets § 6330(e)(1) to refer only to the pendency of the taxpayer's appeal in the tax court (or district court, if that is the proper court) and not to extend to appeals to higher courts. 0 judge wherry also imposed a $2,500 penalty under § 6673 for delay. 6. living care alternatives of utica, inc. v. united states, 411 f.3d 621 (6th cir. 6/2/05). since collection due process hearings are not required to have a record and normal review of administrative decisions requires the existence of a record, "congress must have been contemplating a more deferential review of [collection due process hearing] appeals than of more formal agency decisions." a. olsen v. united states, 414 f.3d 144 (1st cir. 7/8/05). follows living care alternatives, supra, in applying an especially more deferential than usual application of abuse of discretion standard in reviewing irs's determination in collection due process hearings; because taxpayer did not cooperate fully in providing irs with information regarding assets, irs did not abuse discretion in failure to grant relief regarding offer in compromise. 7. wetzel v. commissioner, t.c. memo. 2005-211 (9/12/05). a $15,000 penalty was imposed under § 6673 for filing a frivolous petition to review irs's collection due process determination. 2006] florida tax review 8. reg-150091-02, miscellaneous changes to collection due process procedures relating to notice and opportunity for hearing prior to levy, 70 f.r. 54687 (9/16/05); reg-150088-02, miscellaneous changes to collection due process procedures relating to notice and opportunity for hearing upon filing of notice of federal tax lien, 70 f.r. 54681 (9/16/05). 0 prop. reg. § 301.6320-1(c)(2), q&acl. written request must state the taxpayer's reason for disagreeing with the lien filing. taxpayers are encouraged to use form 12153, request for a collection due process hearing. a taxpayer must request a hearing in writing. * reg. § 301.6320-1(d)(1), q&a-d6; see also prop. reg. § 301.6320-1(d)(2), q&a-d8. face-to-face conference concerning a taxpayer's underlying liability will not be granted if the request or other communication indicates that the taxpayer will only raise irrelevant or frivolous issues. a face-to-face conference concerning a collection alternative, such as an installment agreement or an offer to compromise liability, will not be granted if the alternative would not be available to other taxpayers in similar circumstances, for example, a face-to-face conference will not be offered to a taxpayer who wishes to make an offer to compromise but has not filed a return. a face-to-face conference need not be granted if the taxpayer does not provide the required information. if, however, the taxpayer fails to provide the irs with information that he will raise substantive arguments that are not frivolous or taxprotester type arguments, the irs may deny the taxpayer a face-to-face hearing and provide the hearing by correspondence or telephone. 0 prop. reg. § 301.6320-1(d)(2), q&a-d7. the proposed regulations would clarify that a face-to-face meeting is merely one aspect of a collection due process hearing, and that a review of documentation and notes of oral conversations with the taxpayer can supplement, or constitute in and of themselves, the "hearing." 0 prop. reg. § 301.6330-1(f)(2), q&af7. the proposed regulations would expressly limit judicial review to issues (including a challenge to the underlying tax liability) that were properly raised in the taxpayer's collection due process hearing. 9. clark v. commissioner, 125 t.c. 108 (9/26/05). taxpayer filed timely petition in tax court following receipt of notice of intent to levy. furthermore, the tax court has held that § 6330(d) confers on it the jurisdiction to review an irs determination to levy on the taxpayer's state income tax refund, even though § 6330(t) permits the irs to so levy without first affording the taxpayer a pre-levy hearing. 10. springer v. united states, 96 a.f.t.r.2d 2005-6846 (w.d. okla. 10/6/05). the district court lacks jurisdiction to enjoin a levy for [vol. 8:si recent developments in federal income taxation income tax liability because jurisdiction to review irs's determination in cdp hearing regarding income taxes lies to the tax court. in addition, § 6330(e)(1) authorizes the court to which jurisdiction to seek review of the irs's determination in a collection due process hearing under §§ 6320 and 6330 lies to enjoin any attempt by the irs to levy on the taxpayer's property during the period for which the administrative collection due process hearing and judicial review thereof are pending. 11. drake v. commissioner, 125 t.c. 201 (10/12/05). irs abused its discretion by virtue of an ex parte communication from irs agent to appeals officer assigned to conduct the collection due process hearing, because the communication revealed the irs originating function's perception of the taxpayer's credibility in contravention of the requirements of rev. proc. 2000-43, 2002-2 cb 404; case remanded for a new collection due process hearing. 12. magee v. commissioner, t.c. memo. 2005-263 (11/16/05). levy based on tax liability reported on a joint return but which was not paid may be contested in a collection due process hearing, but claim that the taxpayer's signature on the joint return was forged does not necessarily place the underlying liability in issue. 13. aranda v. commissioner, 432 f3d 1140 (10th cir. 12/20/05). the irs did not abuse its discretion in granting relief from the fraud penalty and interest on the fraud penalty, but not from any portion of the underlying tax deficiency liability, pursuant to § 6015(f), even though taxpayer requested relief under § 6015(b), not § 6015(f), and the irs notice mistakenly referred to relief being granted under § 6015(b). 14. greene-thapedi v. commissioner, 126 t.c. 1 (1/12/06). tax court is divested of jurisdiction where irs applies overpayment from another year to satisfy deficiency after issuing determination in cdp hearing, even though taxpayer is contesting existence of the liability on the asserted grounds that she had not received a deficiency notice; because there was neither an unpaid liability nor a levy, there was no action subject to review; taxpayer had "no independent basis to challenge" the underlying tax liability in the tax court because it could not exercise jurisdiction over a refund claim. g. innocent spouse 1. the commissioner cannot hide the ball in a notice of offset, and then claim that the notice starts the two-year period within which innocent spouse relief must be sought. mcgee v. commissioner, 123 t.c. 314 (10/18/04). section 6015(b)(1)(e) and (c)(3)(b) 2006] florida tax review provides that requests for relief under each of these two subsections must be made not later than two years after "the secretary has begun collection activities." the commissioner sent notices to the taxpayer that refunds were being offset against the joint tax liability, but such notices did not advise the taxpayer of her right to seek relief under § 6015, and the taxpayer did not learn of such rights until the statutory period expired for seeking such relief after a collection activity. the commissioner contended that the notices of offset constituted collection activity which began the running of the limitations period, but the offset notices were not collection-related and thus did not require an advisement of § 6015 rights. the tax court (judge cohen) held that the denial of innocent spouse relief as time-barred was an abuse of discretion since the application of the time limitation was based on the commissioner's inconsistent meanings of collection. the offset was clearly a collection action, and thus the notices of offset were collection-related notices which required an advisement of the taxpayer's rights under § 6015. the commissioner's failure to provide the required notice therefore precluded any finding that the limitations period began to run from the date of the offsets. a. chief counsel notice cc-2005-010 (5/20/05). the irs should not defend cases similar to mcgee pending the issuance of procedures to ensure that future refund offsets will include notice to the taxpayer of the right to claim § 6015 relief. b. chief counsel notice cc-2005-011 (5/20/05). faqs related to litigating § 6015 cases. five topics are covered: (1) the nonpetitioning spouse; (2) the suspension of the collection statute when the taxpayer files a § 6015 claim; (3) the effect of agreements between the irs and the requesting spouse; (4) the actual knowledge defense to a § 6015(c) claim; and (5) procedures under chief counsel notice cc-2004026. 2. friday v. commissioner, 124 t.c. 220 (5/12/05). judge gerber denied the commissioner's motion to remand to the irs for reconsideration of its denial of taxpayer's request for § 6015(b) relief. the tax court held that a stand-alone petition for innocent spouse relief (other than equitable relief under § 6015(f)) pursuant to § 6015(e) "is generally not a 'review' of the commissioner's determination in a hearing, but is instead an action begun in [the tax] court." the clear inference of this holding is that the hearing in the tax court is de novo and not governed by an abuse of discretion standard. 3. no "plain language" limitation of the tax court's jurisdiction in this case. ewing v. commissioner 118 t.c. 494 [vol. 8:si recent developments in federal income taxation (5/31/02). the taxpayer and her husband filed a joint return but did not pay all of the tax shown on the return. subsequently, before the irs asserted any deficiency, the taxpayer requested equitable relief from joint and several liability under § 6015(f). the irs denied relief and mailed a notice of determination that was not mailed to the taxpayer's last known address, but was actually received by the 88th day after it was mailed. the taxpayer's petition for review was postmarked ninety-two days after the mailing of the notice, and was received and filed seven days later. the commissioner moved to dismiss on the ground that the petition was not timely filed. the tax court sua sponte raised the issue of whether it had jurisdiction under § 6015(e) to review the irs's denial of § 6015(f) relief where no deficiency had been asserted. [section 6015(e), granting the tax court jurisdiction to review denials of § 6015 relief, as amended by the consolidated appropriations act of 2001, begins, "in the case of an individual against whom a deficiency has been asserted and who elects to have subsection (b) or (c) apply. . ."]. in a reviewed opinion by judge ruwe, the majority (9-4) held that the tax court has jurisdiction to review an denial of § 6015(f) relief in a stand alone petition where the taxpayer is seeking relief from liability of tax shown on the return, without a deficiency having been asserted. the court further held that the petition was timely because it was filed more than six months after the date she submitted her request for relief [see. § 6015(e)(1)(a)], the irs failed to mail the notice of determination to taxpayer's last known address, and the misaddressed notice prejudiced the taxpayer's ability to file her petition within ninety days after the mailing of the notice. the court concluded that: [t]he language "against whom a deficiency has been asserted" was inserted into section 6015(e) to ... to prevent taxpayers from submitting premature requests to the commissioner for relief from potential deficiencies before the commissioner had asserted that additional taxes were owed.... congress was concerned with the proper timing of a request for relief for underreported tax and intended that taxpayers not be allowed to submit a request to the commissioner regarding underreported tax until after the issue was raised by the irs. there is nothing in the legislative history indicating that the amendment of section 6015(e). . ., was intended to eliminate our jurisdiction regarding claims for equitable relief under section 6015(f) over which we previously had jurisdiction. the stated purpose for inserting the language "against whom a deficiency has been asserted" into section 6015(e) was to clarify the proper time for a taxpayer to submit a request to 2006] florida tax review the commissioner for relief under section 6015 regarding underreported taxes. we conclude that the amendment of section 6015(e) does not preclude our jurisdiction to review the denial of equitable relief under section 6015(f) where a deficiency has not been asserted. in the instant case, petitioner filed a claim for relief from joint and several liability for an amount of tax correctly shown on the return but not paid with the return. because respondent has not challenged the tax reported on the return, no deficiency has been asserted. in this situation, petitioner may be entitled to relief under section 6015(f) because subsection (f) applies where "it is inequitable to hold the individual liable for any unpaid tax or any deficiency." [citations omitted]. 0 judge laro's dissent argued that the tax court lacked jurisdiction to review the denial of § 6015 relief in the absence of a deficiency, because he considered § 6015(e)(1) to be a "clear statutory mandate from congress" limiting the tax court's jurisdiction to review denials of § 6015 relief to deficiency cases. a. ewing v. commissioner, 122 t.c. 32 (1/28/04). in a reviewed opinion by judge colvin, the tax court held that even though the standard for reviewing the commissioner's failure to grant equitable relief under § 6015(f) is abuse of discretion, the tax court's review is not necessarily limited to the facts that were in the administrative record. judges halpern, holmes, chiechi, and foley dissented. b. reversed because the tax court did not have jurisdiction over taxpayer's petition in which she claimed innocent spouse relief. commissioner v. ewing, 439 f.3d 1009 (9th cir. 2/28/06). judge tashima held that the tax court did not have jurisdiction to review wife's petition for equitable relief under § 6015(f) because there was no deficiency asserted against her and she did not elect relief under § 6015(b) or (c), as is required by § 6015(e) in order for the tax court to have jurisdiction on an innocent spouse claim. the phrase in § 6015(e) "against whom a deficiency has been asserted" was added in 2001. 4. rev. rul. 2005-59, 2005-37 i.r.b. 505 (9/12/05). joint return prepared by revenue agent pursuant to § 6020(b) which was signed by both spouses is a valid joint return. form 870, waiver of restrictions on assessment and collection of deficiency in tax and acceptance of overassessment, prepared by revenue agent that was signed by both spouses is a not a valid joint return because form 870 is not verified by a written declaration that it is made under the penalties of perjury. [vol. 8:si recent developments in federal income taxation 5. estate of canehart v. commissioner, 125 t.c. 211 (11/14/05). computation of the deficiency and penalty amounts allocable to the innocent spouse/wife based upon disallowed losses and medical expenses [erroneous items] is to be made under the proportionate allocation method after the disallowed items were allocated equally between the two spouses. the tax court (judge jacobs) held that § 6015(d) does not limit the portion of the deficiency properly allocable to the wife to her proportionate share of the taxable income properly reported on the joint return because her husband received a tax benefit from the filing of a joint return; this which limits the amount of the erroneous items that will be allocated to him (with the excess to be allocated to the wife). & although items are allocated for this purpose as if the spouses had filed separate returns, the allocation does not require that the innocent spouse's ultimate tax liability be limited to the amount that would have been her tax liability if separate returns actually had been filed. the deficiency is not allocated in proportion to taxable income, but rather the deficiency is allocated in proportion to the erroneous items giving rise to the deficiency that are assigned to each spouse. reg. § 1.6015-3(d)(4)(i)(a). 6. aranda v. commissioner, 432 f.3d 1140 (10th cir. 12/20/05). irs did not abuse discretion in granting relief from fraud penalty and interest on the fraud penalty, but not from any portion of the underlying tax deficiency liability, pursuant to § 6015(f), even though taxpayer requested relief under § 6015(b), not § 6015(f), and the irs notice mistakenly referred to relief being granted under § 6015(b). 7. ordlock v. commissioner, 126 t.c. 47 (1/19/06) (reviewed, 10-8). taxpayer is not entitled to a refund of amounts from community property used to pay her husband's tax liabilities understatements because under california state law community property is subject to an obligation of one spouse. h. miscellaneous 1. burton kanter in trouble again. investment research associates. ltd. v. commissioner, t.c. memo. 1999-407 (12/15/99). in a 600-page opinion burton kanter was held liable for the § 6653 fraud penalty by reason of his being "the architect who planned and executed the elaborate scheme with respect to the kickback income payments .... in our view, what we have here, purely and simply, is a concerted effort by an experienced tax lawyer [kanter] and two corporate executives [claude ballard and robert lisle] to defeat and evade the payments of taxes and to cover up their illegal acts so that the corporations [employing the two corporate executives] and the federal government would be unable to discover them." 20061 florida tax review 0 the taxpayers subsequently moved to have access to the special trial judge's "reports, draft opinions, or similar documents" prepared under tax court rule 183(b). they based their motion on conversations with two unnamed5 tax court judges that the original draft opinion from the special trial judge was changed by judge dawson before he adopted it. they were turned down because the tax court held that the documents were related to its internal deliberative processes. see, tax court order denying motion, 2001 tnt 23-31 (4/26/00) and (on reconsideration) 2001 tnt 23-30 (8/30/00). taxpayers sought mandamus from the fifth, seventh and eleventh circuits, but were unsuccessful. a. the tax court's procedures are vindicated and taxpayer ballard loses on appeal on the fraud issue in the eleventh circuit. ballard v. commissioner, 321 f.3d 1037 (11th cir. 2/13/03), affg t.c. memo. 1999-407. the eleventh circuit affirmed the tax court decision and rejected the taxpayers' argument that changes allegedly made by the tax court special trial judge were improper. b. the tax court's procedures are vindicated and taxpayer kanter's estate6 loses on appeal on the fraud issue in the eleventh circuit estate of kanter v. commissioner, 337 f.3d 833 (7th cir. 7/24/03) (per curiam) (2-1), aff'g in part and rev'g in part t.c. memo. 1999-407. c. the tax court's procedures are vindicated but taxpayer lisle's estate wins on appeal on the fraud issue in the fifth circuit. estate of lisle v. commissioner, 341 f.3d 364 (5th cir. 7/30/03), affg in part and rev'g in part t.c. memo. 1999-407. the fifth circuit (judge higginbotham) followed the eleventh and seventh circuits on the nondisclosure of the special trial judge's original report by the tax court. d. justice ginsburg to tax court judges: "you article i judges don't understand your own rules, so let me tell you what you meant when you adopted them in 1983." ballard v. commissioner, 544 u.s. 40 (3/7/05) (7-2), reversing and remanding 337 f.3d 833 (7th cir. 7/24/03) and 321 f.3d 1037 (1 1th cir. 2/13/03). justice ginsburg held that the tax court may not exclude from the record on appeal nor conceal from the taxpayers the original draft reports of special trial judges under tax court rule 183(b). justice ginsburg so held because no 5. kanter's attorney revealed the names of the two judges when asked at oral argument to the seventh circuit as tax court judge julian jacobs and chief special trial judge peter j. panuthos. see the text at footnote 1 of judge cudahy's dissent in the seventh circuit kanter estate opinion, below. 6. burton kanter died on october 31, 2001. [vol 8:si recent developments in federal income taxation statute authorizes the concealment and the rule's "current text" does not warrant it. her reading of tax court rule 183 is that it does not authorize the tax court to treat the special trial judge's rule 183(b) report as a draft subject to collaborative revision. she held that it is particularly important that the process be transparent in fraud cases such as this one. 0 chief justice rehnquist's dissenting opinion, joined in by justice thomas, states that the "tax court's compliance with its own rules is a matter on which we should defer to the interpretation of that court." he concludes that "seminole rock deference" [bowles v. seminole rock & sand co., 325 u.s. 410 (1945)] should extend to an article i court's interpretation of its own rules as well as to an executive agency's interpretation of its rules. he further notes that the issue of compliance with rule 183 was not presented to the supreme court, and that under supreme court rule 14.1(a) the "court does not consider claims that are not included within a petitioner's questions presented." he adds that, "only by failing to abide by our own rules can the court hold that the tax court failed to follow its rules." e. on remand from the supreme court, the seventh circuit remands the case to the tax court. estate of kanter v. commissioner, 406 f.3d 933 (7th cir. 5/9/05). f. ... while the eleventh circuit orders that the special trial judge's report be added to the record. ballard v. commissioner, 2005 tnt 99-26 (11th cir. 5/17/05). the 300-page report may be found at 2005 tnt 107-16. g. tax court proposes new rule on special trial judges' reports. on 7/7/05 tax court chief judge joel gerber announced that the court proposes to amend its rules to provide (in proposed rule 183) substantially the same procedure it had before the 1983 change, which would allow parties to review and file objections to a special trial judge's recommended findings of fact and conclusions of law before the case is reassigned to a presidentially appointed judge for decision. h. tax court releases judges' statements. in an order dated 7/19/05, chief judge gerber of the tax court released statements from chief judge cohen, judge dawson and special trial judge couvillion outlining the procedures followed in the submission, review and adoption of the memorandum opinion in investment research associates, ltd. the statements were that the proposed report submitted by the special trial judge was deemed unsatisfactory by judge dawson and then-chief judge cohen in that the facts found did not support the proposed opinion. after the chief judge's request that judge jacobs take charge of the matter was declined because kanter's lawyer was a close friend, judge couvillion 2006]1 florida tax review withdrew the proposed report the day before a scheduled meeting with judge dawson and chief judge cohen. following the withdrawal, judge dawson and special trial judge couvillion collaborated on the report. i. more fallout from the ballard decision. the tax court identified and located 117 initial opinions submitted by special trial judges under tax court rule 183(b). 2005 tnt 175-2 (9/12/05). four of the opinions were changed (other than that in ballard), with the changes resulting in taxpayer-favorable holdings in three of the four. there is a dispute as to what happened in johnson v. commissioner, t.c. memo. 1992-369, with taxpayer's attorney recalling that special trial judge goldberg congratulated him on his win in the case, and seemed surprised when taxpayer's attorney responded that he had lost the case; special trial judge goldberg disputes that the conversation took place. j. tax court adopts amendments to its rules. tax court press release, 9/21/05. announces that the tax court has adopted amendments to its rules 182 and 183, relating to special trial judges' reports in cases other than small tax cases. the special trial judge's recommended findings of fact and conclusions of law are to be served on the parties, who may file written objections and responses. after the case is assigned to a regular judge, any changes made shall be reflected in the record and "[d]ue regard shall be given to the circumstance that the special trial judge had the opportunity to evaluate the credibility of witnesses, and the finding of fact recommended by the special trial judge shall be presumed to be correct." k. chief counsel notice cc-2005-017 (9/27/05). describes procedures for handling motions filed by previous tax court petitioners "who now seek to vacate decisions based on ballard-type claims in which they argue that the special trial judge's draft opinion was changed before the tax court issued it as a reported opinion." 1. the eleventh circuit remands the case to the tax court after reinstating the special trial judge's report. ballard v. commissioner, 429 f.3d 1026 (11th cir. 11/2/05) (per curiam). the case was remanded to the tax court with the following instructions: (1) the "collaborative report and opinion" is ordered stricken; (2) the original report of the special trial judge is ordered reinstated; (3) the tax court chief judge is instructed to assign this case to a previously-uninvolved regular tax court judge; and (4) the tax court shall proceed to review this matter in accordance with the supreme court's dictates and with its newly-revised rules 182 and 183, giving "due regard" to the credibility determinations of the special trial judge and presuming correct fact findings of the trial judge. [vol. 8:si recent developments in federal income taxation specifically, the eleventh circuit ordered that former chief judge cohen, judge dawson and judge couvillion are not to be involved in the new review. m. as does the fifth circuit. estate of lisle v. commissioner, 431 f.3d 439 (5th cir. 11/22/05) (per curiam). remands the case to the tax court with orders to: (1) strike the "collaborative report" that formed the basis of the tax court's ultimate decision; (2) reinstate judge couvillion's original report; (3) refer this case to a regular tax court judge who had no involvement in the preparation of the aforementioned "collaborative report" and who shall give "due regard" to the credibility determinations of judge couvillion, presuming that his fact findings are correct unless manifestly unreasonable, [in dealing with the remaining issues of tax deficiency]; and (4) adhere strictly hereafter to the amended tax court rule in finalizing tax court opinions. 2. you have a choice of forum for review of the commissioner's refusal to abate interest. beall v. united states, 336 f.3d 419 (5th cir. 6/27/03). the fifth circuit (judge garwood) held that a district court has jurisdiction in a refund suit to review for abuse of discretion the commissioner's refusal to abate interest. judge garwood reasoned that the grant of jurisdiction to the tax court in § 6404(h) was not exclusive. a. a district court disagrees with beall. ballhaus v. irs, 341 f. supp. 2d 1145 (d. nev. 9/29/04). the court refused to follow beall and held that it lacks jurisdiction to review commissioner's refusal to abate interest. b. and the court of federal claims holds that beall is not the "be all and end all" on this issue. hinck v. united states, 64 fed. cl. 71 (2/3/05). judge allegra held that the 1996 amendments to § 6404 gave the tax court jurisdiction to review the failure to abate interest under the "abuse of discretion" standard. before 1996 the federal courts did not have jurisdiction to review abatement decisions, and the 1996 amendments to § 6404 did not do so. 3. proposed regulations reject the mailbox rule and hold that absent actual delivery only registered or certified mail will suffice as proof. reg-138176-02, timely mailing treated as timely filing, 69 f.r. 56377 (9/21/04). proposed regulations under § 7502 would provide that a registered or certified mail receipt is the only prima facie evidence of delivery of documents that have a filing deadline prescribed by the internal revenue laws other than direct proof of actual delivery. 20061 florida tax review a. but taxpayers can still prevail based upon the mailbox rule. why did taxpayers' lawyer play games with love by not taking the petition to the post office? grossman v. commissioner, t.c. memo. 2005-164 (7/5/05). the envelope sent by certified mail that contained taxpayer's petition to the tax court was timely postmarked by a private postage meter but was received by the court after the ninety-day period for filing prescribed by § 6213(a). taxpayer submitted evidence of a delay in delivery of this letter by reason of misdirection and irradiation to eliminate anthrax spores, as well as the testimony of their lawyer's office manager that she mailed the petition on the date it was postmarked by the private postage meter. the tax court (judge goeke) held that taxpayers met their burden of proof that their mailing was timely. 0 for a tax return or other document mailed to the irs, it is rumored that the irs will accept the uncorroborated word of a practitioner believed to be credible as to the date of mailing. 4. speltz v. commissioner, 124 t.c. 165 (3/23/05). the irs properly rejected taxpayer's offer in compromise of amt liability that resulted from incentive stock options even though tax liability exceeded the amount for which the stock subsequently was sold later in the same year the options were exercised. nor will a tax liability be compromised on the grounds that the statute as correctly applied produces a tax liability that is unfair or inequitable. 5. harriaill v. united states, 410 f.3d 786 (5th cir. 3/31/05). application of refund to subsequent year's tax liability is a payment of estimated taxes, not a deposit, and pursuant to § 6513(b) is deemed to have been made on the due date of the return, without extension. a refund request filed within the three year period after late-filed return crediting prior year's refund to tax liability shown on return was not timely. 6. "it is an ill wind...." notice 2005-66, 2005-40 i.r.b. 620 (9/9/05). the irs has postponed until 1/3/06 tax return filing and payment deadlines for taxpayers affected by hurricane katrina, i.e., taxpayers in three counties in florida, six counties in alabama, fifty-two counties in mississippi and sixty-four parishes in louisiana. the postponement was granted pursuant to § 7508a, which grants the irs authority to postpone for a period of up to one year the time for performance of the acts listed in § 7508(a) by taxpayers affected by a presidentiallydeclared disaster. a. ir-2005-112 (8/28/05) and notice 2005-73, 2005-42 i.r.b. 723 (9/22/05). pursuant to the katrina tax act, the deadlines to file tax returns, pay taxes, and perform other time-sensitive acts [vol. 8:si recent developments in federal income taxation is postponed until 2/28/06 for taxpayer affected by hurricane katrina. see 2005 tnt 188-13. 7. service employees international union v. commissioner, 125 t.c. 63 (9/15/05). the tax court lacked jurisdiction to review irs's determination to collect § 6652(c)(1) penalties for exempt organization's failure to file § 6033 annual return. 8. mobil corp. v. united states, 67 fed. cl. 708 (9/22/05). claims on original tax return that were disallowed on audit, combined with the parties' course of dealing during the audit of those claims conducted prior to the expiration of the statute of limitations for filing an administrative refund claim, established all of the elements of a valid informal claim: (1) notice to commissioner, (2) the factual and legal basis of the claim, and (3) a written component. 9. the four-month automatic extension will now be for six months. t.d. 9229, extension of time for filing returns, 70 f.r. 67356 (11/7/05), and reg-144898-04, extension of time for filing returns, 70 f.r. 67397 (11/7/05). final, temporary and proposed regulations (temp. reg. § 1.6081-4t; prop. reg. § 1.6081-4) that allow taxpayers required to file an individual income tax return an automatic six-month extension if taxpayers submit an application on form 4868 ("application for automatic extension of time to file a u.s. individual income tax return") on or before the return due date. * will this mean that return preparers will face a jam-up before october 15th because the former august 15th filers will wait until october to assemble their data? * temp. reg. § 1.6081-5t also allows pass-through entities to file an automatic six-month extension of time to file on new form 7004 ("application for automatic 6-month extension of time to file certain business income tax, information and other returns"). effective for applications for an automatic extension of time filed after 12/31/05. treasury requests comments as to whether pass-through entities should receive a shorter extension of time. 10. user fees for rulings increase. ir-2005-144 (12/19/05). user fees for plrs will increase from $7,000 to $10,000, with lower fees for taxpayers earning less than $250,000 ($625) and taxpayers earning from $250,000 to $1 million ($2,500). the fee for requests for changes in accounting methods for businesses will increase from $1,500 to $2,500. other fees will also increase to be reflected in rev. procs. 2006-1 and 2006-8. 2006] florida tax review 11. in re: john ashton wrav, jr., 433 f.3d 376 (4th cir. 12/29/05). this lawyer properly filed all his income tax returns but did not pay all the taxes due, choosing instead to repay the lenders to his business. he pleaded guilty to a misdemeanor count of willful failure to pay income taxes. the opinion noted that it was not clear that the lawyer's conduct involved deceit, and that deceit was not a necessary element of § 7203. there was no deceit, as the liability was disclosed. the attorney, if anything, was foolish for not simply requesting a payment arrangement. that's not to excuse the failure to pay, but on the spectrum of offenses, from failure to file and willful nondisclosure, this one isn't quite as bad as it sounds. 12. it's good to know that all is normal on the home front despite our military serving in dangerous circumstances overseas. in this cca, the irs denies relief to a reservist serving in a combat zone by using an exact reading of the statute to arrive at the conclusion that a partnership whose principal partner is serving in a combat zone is not entitled to suspension of interest on delinquent payroll taxes. cca 200613030 (12/15/05). legal memorandum determining that a partnership is not entitled to a § 7508 suspension of interest on delinquent payroll taxes while its "principal partner" is serving in a combat zone. xi. withholding and excise taxes a. employment taxes 1. section 251 of the jobs act of 2004 amends various code sections to provide that employment taxes (including withholding) are not required with respect to the spread on the exercise of incentive stock options and employee stock purchase plan stock options. this spread is includable for amt purposes, but not for regular income tax purposes. * there has been for the past several years a freeze in effect on the collection of employment taxes on the exercise of qualified options. 2. although the exercise of a statutory stock option does not result in taxable income, it does result in wages for fica / futa purposes but not until 2003. reg-142686-01, application of the federal insurance contributions act, federal unemployment tax act, and collection of income tax at source to statutory stock options, 66 f.r. 57023 (11/14/01), issued as provided in notice 2001-14, 2001-6 i.r.b. 516. prop. regs. §§ 31.3121(a)-l(k), 31.3306(b)-1(l), and 31.3401(a)-l(b)(15) would provide that the holder of a statutory stock option [§ 422 iso or § 423 espp] receives wages for fica and futa purposes upon exercise of the option, but no withholding is required because no gross income has been [vol 8:si recent developments in federal income taxation received. the amount of the wages received is the excess of the fair market value of the stock over the amount paid. the irs will develop "rules of administrative convenience" permitting employers to deem the wages to have been paid on a specific date or over a specific period of time. a. notice 2001-72, 2001-49 i.r.b. 548 (11/15/01). the irs announced and requested comments on proposed rules regarding the employer's income tax withholding and reporting obligations on the sale by an employee of stock received pursuant to exercise of a statutory stock option. the employer is not required to withhold, but is required to report if the amount is at least $600, unless the employer has made reasonable efforts to determine if reporting is necessary and has been unable to do so. b. notice 2001-73, 2001-49 i.r.b. 549 (11/15/01). the irs announced and requested comments on proposed "rules of administrative convenience" permitting employers to deem the wages to have been paid on a specific date for fica and futa purposes. fica and futa wages could be treated as paid on a pay period, quarterly, semiannually, annually, or on another basis. c. irs extends moratorium on assessment of employment taxes on stock options for two more years. notice 2002-47, 2002-28 i.r.b. 97 (6/27/02). pending the completion of its review and the issuance of further guidance, the irs will not assess fica or futa taxes (nor will it seek federal income tax withholding) upon the exercise of a statutory stock option or disposition of stock acquired by an employee pursuant to the exercise of a statutory stock option. the notice further provides that it is contemplated that any final guidance that would apply employment taxes to statutory stock options will not apply to exercises of statutory stock options that occur before the january 1 of the year that follows the second anniversary of the publication of the final guidance. d. congress makes the world safe for isos and espp stock options (except for the amt). section 251 of the jobs act of 2004 amends various code sections to provide that employment taxes (including withholding) are not required with respect to the spread on the exercise of incentive stock options and employee stock purchase plan stock options. this spread is includable for amt purposes, but not for regular income tax purposes. e. when it's over, it should be over completely. reg-142686-01, withdrawal of notice of proposed rulemaking, application of the federal insurance contributions act, federal 2006] florida tax review unemployment tax act, and collection of income tax at source to statutory stock options, 70 f.r. 38057 (7/1/05). the irs has withdrawn proposed regulations that would have required fica, futa and income tax withholding on incentive stock options and employee stock purchase plan stock options in view of the statutory amendment eliminating such requirements that is applicable to stock options exercised after 10/22/04. b. excise taxes 1. telephone excise tax inapplicable to charges that do not vary by distance, says the eleventh circuit in its latest pronouncement on the "plain meaning" of the tax statutes. american bankers insurance group v. united states, 408 f.3d 1328 (11th cir. 5/10/05). the long distance services provided by at&t to taxpayer were not within the "toll telephone service" to which § 4252(b)(1) applies because the rates do not vary by "distance and elapsed transmission time" and the unambiguous statute uses these terms conjunctively; the "plain meaning" of the statute requires both the time and the distance to vary. even though there are separate charges for calls depending upon where they fall within one of three toll bands used (intrastate, interstate and international), the rates do not vary by distance per se because calls between places closer to one another often cost more than calls between places further apart. the eleventh circuit reversed the district court's grant of summary judgment for the government. a. this one is the most fun to read because of the interplay between majority and dissenting opinions as to the meaning of "and." officemax, inc. v. united states, 428 f.3d 583 (6th cir. 11/2/05) (2-1). federal excise tax on long-distance calls does not apply unless the charges vary based upon both time and distance. the majority opinion held that "and" means "and" but the dissent argued that "and" could also mean "or." when this three percent tax on toll telephone calls was enacted in 1965, there was only one long-distance telephone provider and its charges were based upon both the distance and time of the call [or on a flat rate for unlimited calling on a wats line, to which the tax also applied]. the majority held that a literal reading of the statute was required because a tax should only apply to that which its language taxes. the dissent would "not encourage lawyers to play word games at the expense of the public fisc." b. the irs takes a hard line. notice 2005-79, 2005-46 i.r.b. 952 (11/14/05). the irs will continue to litigate this issue and will continue to assess and collect the § 4251 tax on long distance communications services. [vol 8:si recent developments in federal income taxation c. amtrak's long-distance telephone service is not subject to the excise tax on toll telephone services because the payment was based solely on time. national railroad passenger corp. (amtrak) v. united states, 431 f.3d 374 (d.c. cir. 12/9/05). the court affirmed the district court and concluded that the statute was unambiguous, and the "and" in § 4252 was to be read conjunctively. 2. taxpayer subject to tax on golden parachute payments because statute covers the payment and proposed regulations to the contrary have no legal force until them become final. yocum v. united states, 66 fed. cl. 579 (fed. cl. 7/1/05). on the issue of whether the § 4999 excise tax on "excess parachute payments" applies, taxpayer/executive relied upon proposed regulations to assert the inapplicability of the tax to the transaction in question. judge allegra held that "proposed regulations have no legal force until they become final," and that "these principles [do not] differ simply because the irs allows a proposed regulation to linger unadopted over a long period of time." xii. tax legislation a. enacted 1. the bankruptcy abuse prevention and consumer protection act of 2005 ("bankruptcy act of 2005"), p.l. 1098, was signed by president bush on 4/20/05. 2. the energy policy act of 2005, p.l. 109-58, was signed by president bush on 8/8/05. title xiii (energy policy tax incentives) of the energy policy tax act of 2005 may be cited as the energy tax incentives act of 2005. 3. the highway reauthorization and excise tax simplification act of 2005, p.l. 109-59, was signed by president bush on 8/10/05. 4. kiss me kate.7 or, is it the powerful katrin(k)a?' the katrina emergency tax relief act of 2005 ("ketra" or "katrina tax act"), p.l. 109-73, was signed by president bush on 9/23/05. 5. the gulf opportunity zone act of 2005 ("go zone act of 2005"), p.l. 109-135, was signed by president bush on 12/21/05. the act: (1) provides 50 percent bonus depreciation to businesses 7. for cole porter devotees. 8. for readers of the old toonerville trolley comic strip. 20061 florida tax review rebuilt in the newly created gulf opportunity (go) zone; (2) doubles the amount that may be expensed under section 179 from $100,000 to $200,000 for investments made in the go zone and increase the phaseout floor from $400,000 of annual investments to $ 1 million; (3) allows businesses a fiveyear carryback of net operating losses attributable to investment in the go zone; (4) increases the amount of expensing allowed for reforestation costs of small timber owners within the go zone and within the areas affected by hurricane rita; (5) increases and enhances low-income housing credits within the go zone; (6) increases the rehabilitation tax credit for qualified expenditures within the go zone; (7) increases the cap on new markets tax credits and allocates the increased amounts to entities making low-income community investments in the go zone; and (8) creates additional taxexempt bond authority for states and municipalities within the go zone and allows those states to issue debt service tax credit bonds to help devastated communities meet their debt service requirements as a result of the hurricanes. casinos and other "sin facilities" [see code § 144(c)(6)(b), e.g., massage parlors, liquor stores] are carved out from this bill but compromise language was added that would allow facilities attached to casinos such as parking lots, hotels, and restaurants to claim the tax relief. [vol 8:si login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review florida tax review volume 9 2008 number 2 119 slouching towards a consumption tax and the end of retirement income security by norman stein  i. introduction. ............................................................................ 121 ii. overview of current tax – subsidized retirement system .................................................................. 125 iii. the white house savings proposals .................................. 129 a. dividend exclusion. ................................................................. 129 b. new personal savings accounts. ............................................ 129 1. retirement savings accounts. .................................... 130 2. lifetime savings accounts .......................................... 131 c. employer retirement savings accounts. ................................. 132 iv. critique of white house private savings proposals .................................................................... 134 a. savings initiative and employment-based retirement plans….. ...................................................................... 135 b. efficacy of bush savings proposals for creating retirement income security for middle and lower income workers .............. 144 1. obstacles to rank-and-file utilization of bush savings proposals ............................................................. 145 2. production of retirement income ............................... 147 c. savings initiative and rate of return on retirement savings.. ....................................................................... 150 1 loss of investment opportunities ............................... 150 2. fiduciary protections ................................................. 150 3. education ................................................................... 151 4. costs ........................................................................... 152 5. effect of the proposed income exclusion of stock dividends on investment returns ............................... 152 d. budget and tax considerations ................................................ 153  douglas arant professor of law, university of alabama school of law. i presented a version of this paper at a 2003 symposium on public policy for retirement security at the ohio state moritz college of law. i express my deep appreciation for the inordinately helpful comments of professors grayson m. p. mccouch at san diego and james d. bryce at alabama. 120 florida tax review [vol. 9:2 v. wealth accumulation v. retirement income security ....................................................................... 155 vi. the ersa and national retirement policy .................... 159 vii. conclusion…………………….. ............................................... 162 2008] slouching towards a consumption tax 121 slouching towards a consumption tax and the end of retirement income security by norman stein i. introduction in 2003, the bush administration proposed two ideas 1 that i (and others) feared would undermine the retirement income security of millions of americans. 2 the first idea was to create two new tax-favored personal savings vehicles: the retirement savings account and the lifetime savings account. 3 these tax-benefited accounts, which would have existed outside the employer-based retirement system and replace individual retirement accounts, would each have permitted annual contributions of $7,500 each, or $15,000 in the aggregate. 4 (an individual could also have set up lifetime 1. see, e.g., department of the treasury, general explanation of the administration’s fiscal year 2004 revenue proposals, feb. 3, 2003 (“general explanation”), reprinted in tax notes today, feb. 4, 2003; bush proposes tax freesavings plans, available at usgovinfo.com/library/weekly/aataxfree.htm; q&a about bush tax-free savings proposals, at usgovinfo.com/library/weekly/aataxfree _qu.htm. 2. the 2003 proposal was opposed by pension trade groups generally aligned with business interest (such as the american society of pension actuaries, see, aspa, statement for the record, committee on ways and means, hearing on the presidents’ economic growth proposals, mar. 5, 2003; and the profit-sharing 401(k) council of america, see, martin a. sullivan, economic analysis: does the trickle-down theory for pensions hold water?, 98 tax notes 1180 (2003) (hereinafter, trickle-down theory for pensions), and liberal organizations generally aligned with the interests of consumers, leonard burman, “key thoughts on rsas and lsas,” available at www.urban.org/url.cfm?id+1000600 (urban institute); robert greenstein and joel friedman, “president’s savings proposals likely to swell long-term deficits, reduce national savings, and primarily benefit those with substantial wealth, available at www.cbpp.org/1-20-04tax.htm (center on budget and policy priorities); “progressivity and saving: fixing the nation’s upside-down incentives for savings,” statement of peter r. orszag, joseph a. pechman senior fellow, the brookings institute, before the house committee on education and the workforce, feb. 25, 2004, www.edworkforce.house.gov/hearings/ 108th/fc/pensions022504/orszag.htm brookings institute). former congressman rob portman, a republican who had a strong interest in pension policy and was generally considered close to the white house, also opposed the proposal. see, trickle-down theory for pensions, 98 tax notes at 1180. 3. general explanation, supra note 1, at ¶¶ 414-417. 4. id. 122 florida tax review [vol. 9:2 savings accounts for family members without earned income, into which he could contribute $7,500 annually.) the contributions were to be made on an after-tax basis, but the earnings would be exempt from income tax, a schemata based on the roth ira. 5 the rsa would impose penalties on preretirement withdrawals; the lsa would not. 6 these ideas did not find favor in the congress and were generally opposed by the business community, organized labor, and liberal think tanks, for reasons i will summarize shortly. 7 nevertheless, the white house 8 and members of congress 9 have introduced similar proposals in 2004, 2005, 2006, 2007, and 2008, and the president’s advisory panel on federal tax reform adopted retirement and lifetime savings accounts as part of its blueprint for reform, which was released in late 2005. thus, the idea of these new accounts retains political and intellectual currency, like the proverbial bad nickel, and they, or variations on them, are almost certainly to survive the end of the bush presidency. the second new idea advanced by the white house in 2003 was the exclusion of stock dividends from taxation. 10 depending on which press account you credit, this idea resulted either from president bush’s serendipitous courtesy drop-in on a panel at his waco economic summit in which charles schwab advocated elimination of the so-called double tax on corporate income through exclusion of dividends, 11 or from a direct remark by schwab to him on the same topic. 12 a toned-down variation on this idea was enacted by congress in 2003, with dividend income taxed at a maximum 15% rate, the same rate that now sets the ordinary ceiling on taxation of 5. id. 6. id. cf. irc § 408a (treatment of roth iras). 7. see, supra note 2. 8. see, department of treasury, general explanation of the administration’s fiscal year 2008 revenue proposals (feb. 2007); department of treasury, general explanation of the administration’s fiscal year 2007 revenue proposals (feb. 2006); department of treasury, general explanation of the administration’s fiscal year 2006 revenue proposals (feb. 2005); department of treasury, general explanation of the administration’s fiscal year 2005 revenue proposals (feb. 2004). 9. see, s. 547, 109th cong., 1st sess. (mar. 8, 2005)(senate bill providing for retirement and lifetime savings accounts); h.r. 1161, 109th cong., 1st sess. (mar. 8, 2005) (house bill providing for retirement and lifetime savings accounts). 10. general explanation (2003), supra note 1, ¶ 33. 11. see, cox news service, charles schwab plays cagey with bush, august 17, 2003, available on lexis. 12. see, bill saporito, get ready for class warfare, time magazine, jan. 20, 2003, at 32. 2008] slouching towards a consumption tax 123 capital gain. 13 some observers see the 15% tax rate not as closing the door on the debate on either dividend taxation or the maximum capital gains rate, but rather as a foot in the door toward the elimination of any tax on dividend income or capital gains. 14 and again, the president’s advisory panel on federal tax reform included a plan that would exclude all corporate dividends from income. on the surface, neither the expanded savings account idea nor the exclusion of dividends from income appears to threaten a person’s ability to save for retirement. indeed, the rsa/lsa proposal would seem to increase opportunities to save for retirement, and the elimination of taxes on dividends would seem to make savings, including retirement savings, generally more attractive. 15 but i will suggest in this paper that the proposals, individually and collectively, would negatively influence the creation of retirement savings for many and perhaps most working americans. several of the arguments i develop in this paper relate to my assessment that providing tax-benefited investment alternatives to employersponsored retirement plans would make it less attractive for employers to sponsor retirement plans, resulting in fewer and less generous plans. there is reason to think that middleand lower-income people would not use the new savings arrangements sufficiently to replace the retirement savings they would lose because of the white house proposals’ negative effect on employer-sponsored plans. 16 moreover, the new savings arrangements, by and large, would not require preservation of assets for retirement, 17 nor would they provide mechanisms to help budget the use of retirement assets so that they are not exhausted before death. 18 they would provide fewer spousal protections. 19 they would subject participants to higher administrative costs and might adversely affect the rate of return many working people will realize on their savings. 20 finally, the tax treatment of the new savings arrangements may complicate the possible future task of 13. irc § 1(h)(11) (qualified dividends treated as part of net capital gain). 14. wesley elmore, senate finance panel examines extension of popular tax cuts, 108 tax notes 45 (2005). 15. this is certainly the view of the department of treasury, which in its press release on the proposals contended that “these bold new accounts will give more hardworking americans the chance to save so they can enrich their lives and strengthen their retirement security.” see, bush proposes tax free-savings plans, supra, note 1. 16. see text accompanying notes 120-130, infra. 17. see text accompanying notes 131-141, infra. 18. see text accompanying notes 133, 142-143, infra. 19. see text accompanying note 134, infra. 20. see text accompanying notes 144-152, infra. 124 florida tax review [vol. 9:2 remedying the old age-security problems that i suggest will almost certainly be exacerbated if the white house proposals are ever adopted. 21 the white house proposals also reflect a theme that patricia dilley and i explored in an earlier article: the continuing seismic shift in government retirement policy from collective retirement income security to individual wealth creation. 22 the white house proposals would carry this theme further than anything that has emerged from congress since the enactment of the income tax. in this respect, the proposals share an ideological mooring with the various proposals to privatize social security, which would also sacrifice the idea of shared societal responsibility for the income security of older americans to the idea of individual creation of wealth. 23 on a broader and perhaps even more significant theme, as we amble down the road towards a tax system that favors savings over consumption, we also amble towards interference with our principal strategy to help working people save for retirement: using tax benefits to secure employer sponsorship of retirement savings plans covering a broad cross section of american workers. the white house proposals did include one idea whose broad framework (but not necessarily its details) is attractive: the employer retirement savings account (“the ersa”). 24 the ersa would redesign and streamline the complex and often irrational rules for the numerous employersponsored defined contribution plans, creating a single type of defined contribution format for such plans. this approach would build on rather than abandon the existing employment-based retirement regime and, if stripped from the other bush proposals, could provide a vehicle for debate over how best to balance the employer interests in administrative simplicity and low compliance costs with the societal goal of providing meaningful benefits for individuals who otherwise would not save sufficiently for retirement. this article proceeds as follows: the section immediately below provides an overview of the current employment-based retirement system, followed by a section describing the white house tax proposals as initially proposed in 2003, as modified in subsequent white house budget proposals, and as again modified by the president’s advisory panel on federal tax reform. the next section describes the ways in which the proposals (or 21. see text accompanying notes 153-158, infra. 22. see, norman stein & patricia dilley, leverage, linkage, and leakage: problems with the private pension system and how they should inform the social security reform debate, 58 wash. & lee l. rev. 1369 (2001); cf. edward zelinsky, the defined contribution paradigm, 114 yale l.j. 451 (2004). 23. patricia dilley, taking public rights private; the rhetoric and reality of social security privatization, 41 b.c.l.rev. 975 (2000). 24. general explanation (2003), supra note 1, at ¶ 448. 2008] slouching towards a consumption tax 125 similar proposals) would, if enacted, undercut the retirement income security of many working americans. the succeeding section provides a reflection on the ideological underpinnings of the white house proposal. the final section, using the ersa proposal as a starting place, provides some ideas to improve the ability of working people to prepare for retirement through incremental reforms to the current system. the final section also briefly discusses the shape that fundamental reform should take if we are to abandon the current employer-based system – which would likely be the effective result of a serious move toward a consumption tax – in favor of new ways to create retirement income security for american working people. ii. overview of current tax-subsidized retirement system the internal revenue code endows certain advance-funded retirement arrangements with the benefit of relatively pure income tax deferral. 25 most of the deferral is initially traceable to investment return on employer contributions to employer-sponsored plans in both the private and public sector, although individuals may also contribute to individual retirement accounts 26 or employer plans that accept employee contributions, such as the now-ubiquitous 401(k) plan. 27 the associated tax expenditures for these retirement savings arrangements is projected to exceed $100 billion annually for the next fiscal five years 28 (the period for which tax expenditures are projected). the commonly accepted rationale for the income tax expenditure is to help as many americans as possible create income security for that period of life when they are no longer supporting themselves with wage income. 29 given that the mechanism for the tax expenditure is tax deferral, that the benefits of tax deferral correlate with marginal tax rates, and that individuals with high marginal tax rates are the most likely class of individuals to save adequately for retirement without governmental incentives, the tax mechanism might strike us as an irrational means of effecting the goal of 25. see, e.g., gary boren & norman stein, qualified deferred compensation plans, chapter 1; michael j. graetz, the troubled marriage of retirement security and tax policy, 135 u. pa. l. rev. 851 (1987). 26. irc § 408 (ira); irc § 408a (roth ira). 27. see, e.g., irc § 401(k). for a thoughtful discussion of some of the issues surrounding 401(k) plans and savings behavior, see, alicia munnell & ankia sunden, coming up short (2004). 28. joint comm. on taxation, estimate of federal tax expenditures for fiscal years 2007-2011 (sept. 24, 2007). 29. see, e.g., dan mcgill, fundamentals of private pensions 75 (7th ed. 1996). 126 florida tax review [vol. 9:2 increasing retirement savings for as many working people as possible. understood another way, however, this upside-down tax subsidy is an arguably rational component of a two-step governmental strategy to enlist the private sector in building retirement savings for lowerand moderateincome workers. the strategy is, first, to make the tax benefits of employer-sponsored plans sufficiently attractive to the tax-sensitive people who own and manage businesses so that they will decide to set up plans to capture tax benefits for themselves, and, second, to require such plans, once established , to provide meaningful benefits not only to the people who set them up, but also to lowerand moderate-income workers. 30 the code effects the latter part of the strategy through a series of statutory provisions, most prominently the nondiscrimination rules, which require plans to cover a percentage of a firm’s non-highly compensated employees 31 and to provide them with benefits comparable, as a percentage of pay, to the benefits earned by the highly compensated. 32 the pension economist alicia munnell described this elaborate two-step in this way: “the rationale for favorable tax treatment of qualified plans is that retirement benefits for rank-and-file employees will exist if congress provides tax incentives that induce higher paid employees to support the establishment of employer-sponsored pension plans.” 33 this carrot/stick pension tax regime has been subject to criticism. 34 many firms respond to the tax incentive to create plans, but manipulate the labyrinth complexities of the nondiscrimination rules to minimize benefits for rank-and-file employees and maximize them for more affluent employees, who in the absence of employer-sponsored plans would presumably save for retirement on their own, at least to some extent. 35 moreover, some firms (particularly marginal firms) simply do not respond to the incentives and fail to sponsor pension plans. 36 thus, the system is both 30. see, e.g., daniel i. halperin, tax policy and retirement income: a rational model for the 21st century, search for a national retirement income policy 157 (1987). 31. irc § 410. 32. irc § 401(a)(4). 33. alicia munnell, the economics of private pensions 51 (1982). 34. see, bruce wolk, discrimination rules for qualified retirement plans: good intentions confront economic reality, 70 va. l. rev. 419 (1983). the regime has been called “rube goldbergian.” see, trickle-down theory for pensions, supra note 2. 35. id. 36. employee benefits research institute, 2004 small employer retirement survey (only 28% of employees at firms of fewer than 100 are covered by retirement plans; only 20% of employers with fewer than 25 employees sponsor retirement plans). 2008] slouching towards a consumption tax 127 over-inclusive in that it provides benefits for those who would save for their own retirement without the tax incentives, and under-inclusive because it fails to provide meaningful benefits to many lowand middle-income workers. but the system does provide at least some benefits for many millions of people, with a coverage rate of approximately 50% of the full-time private workforce between ages 25 and 65. 37 while one can argue whether the system is a cup half-full or half-empty, by the numbers we can say that the employer-sponsored retirement system provides an important source of some retirement income security for many individuals. the societal goal of creating adequate retirement income security through tax-benefited savings arrangements requires more than wide participation: it also requires, first, that plan assets are invested prudently and free of conflicts of interest 38 so that investment returns are maximized, and second, that the savings once created are used to provide retirement income. 39 the internal revenue code, and especially title i of erisa, establish a scheme of fiduciary regulation based on traditional trust law and insights from modern portfolio theory, which at least in theory should maximize investment return. 40 in particular, title i of erisa provides that plan fiduciaries act with appropriate prudence and loyalty to participants when they make investments, 41 and that they diversify plan investments in most situations. 42 there are three related concerns to ensure that retirement savings are in fact used for retirement: first, that the savings are not invaded prior to retirement; second, that the savings are not exhausted prior to death; and third, that in appropriate circumstances the savings are available to the surviving spouse of the pensioner. 37. alicia munnell & annika sunden, private pensions: coverage and benefit trends 1, available at www.outfuture.org/articles/200109270824.pdf. 38. see, erisa § 404(a). 39. see, irc §§ 401(a)(9), (11) & (13). 40. see, erisa §§ 403-410. see, generally, daniel fischel and john langbein, erisa’s fundamental contradiction: the exclusive benefit rule, 55 u. chi. l. rev. 1105 (1988). 41. erisa § 404(a)(1), (2). 42. erisa § 404(a)(3). title i of erisa also includes a series of rules prohibiting certain transactions between a plan and parties with a pre-existing direct or in some cases indirect relationship with the plan. see, erisa §§ 406-408, 29 u.s.c. §§ 1006-1008. in addition to the title i prohibitions, the internal revenue code imposes an excise tax on such transactions. irc § 4975. for an early, but still quite useful, summary of the rules, see, arthur h. kroll & yale d. tauber, fiduciary responsibility and prohibited transactions under erisa, 14 real. prop prob. & trust j. 658 (1979). 128 florida tax review [vol. 9:2 the internal revenue code includes a series of rules that address, although imperfectly, each of these concerns. 43 to limit pre-retirement access to retirement assets (i) longstanding treasury regulations prohibit distributions from pension (but not profit-sharing) plans prior to retirement, death, disability, or separation from service; 44 and (ii) the internal revenue code imposes an excise tax on most plan withdrawals prior to age 59.5 from any plan (unless the distribution is transferred to another plan or individual retirement account). 45 to assist individuals to manage their retirement savings, pension plans (but not profit-sharing and 401(k) plans) must provide that the normal form of benefit is a life annuity (although if the plan permits, participants can elect other forms of benefits, including single-sum distributions). 46 to protect the spouse of a pensioner, pension plans must provide that the life annuity for a married participant has a survivor benefit for the spouse (although the participant, with spousal consent, can elect other forms of benefits if permitted by the plan, including a single life annuity). 47 finally, the internal revenue code has provisions designed to ensure that the tax expenditures are limited to the amount needed to create retirement security and are not so extravagant that they result in plans that function more as general tax shelters and estate-planning devices than retirement plans. the most important of these provisions place outer limits on the amount that may be contributed annually to a defined contribution plan and on the size of the retirement annuity payable from a defined benefit plan, for any given individual. 48 the theory here is that the tax subsidy embedded in plan savings should be used to furnish reasonable rather than unduly lavish retirement income levels. 49 in addition, the internal revenue code includes minimum distribution rules that require individuals to begin drawing down their retirement savings in their retirement in order to limit the utility of tax-deferred retirement accounts as a tax-benefited estate planning tool. 50 43. for a thorough treatment of the internal revenue code’s distribution rules, see, diane bennett, et. al., taxation of distributions from qualified plans (2nd ed. 2002). 44. treas. reg. § 1.401(a)-2. 45. irc § 72(t). 46. irc § 411(a)(7). 47. irc § 417. 48. irc § 415. see, generally, norman p. stein, simplification and irc § 415, 2 fla. tax rev. 69 (1994). 49. id. at 4-6. 50. irc § 401(a)(9). see, generally, bennett, supra note 43; william j. turnier, grayson m.p. mccouch, et.al., family wealth management 651-652 (2005). 2008] slouching towards a consumption tax 129 iii. the white house savings proposals the white house budget proposal in 2003 included three proposals that would have implications for the private, generally employment-based, savings arrangements that currently assist americans in creating income security in their retirement. the white house proposals were: (1) the exclusion of dividends from income taxation; (2) the creation of two personal, non-employment based, tax-advantaged savings vehicles, the retirement savings account and the lifetime savings account; and (3) the creation of the employer retirement savings account. a. dividend exclusion the white house initial budget proposal included an exclusion for dividends. the initial purpose of the exclusion was two-fold: 1) to eliminate the so-called double tax on corporate earnings, and 2) to provide incentives for corporations to pay dividends, which a white house press release argued would promote more transparent corporate governance and more honest statements of income. 51 apparently in response to complaints by the corporate managerial class (who might not favor tax incentives to pay dividends 52 ), the white house proposal was revised so that corporations could also avoid double taxation through a shareholder basis adjustment for any retained earnings. 53 congress did not adopt the white house proposal as proposed, but did set an effective maximum tax rate of 15% on both dividends and capital gain from the sale of stock. 54 this provision will sunset for tax years beginning after 2008, unless renewed by congress. b. new personal savings accounts the white house proposed two new personal savings arrangements: the retirement savings account, which is designed to assist people to accumulate retirement assets, and the lifetime savings account, which would allow people to save for any purpose on a tax-favored basis. these accounts 51. see, bush proposes tax free-savings plans, supra note 2. 52. see, jennifer arlen & deborah m. weiss, a political theory of corporate taxation, 105 yale l. j. 325 (1995) (exploration of why corporate management does not lobby for integration of corporate and individual income taxation). 53. see, e.g., david early-hubelbank, bush administration proposes eliminating double tax on corporate earnings, corporate tax bulletin (2003), at http://pmstax.com/corp/div0301.shtml. 54. tax reform act of 2003, at § 1(h). 130 florida tax review [vol. 9:2 would replace the current individual retirement account, to which individuals below a certain income level can currently contribute up to $4,000 per year from earned income. 55 the new arrangements would replace the two types of ira tax arrangements, which are sometimes referred to as “traditional” and “roth” iras. in a traditional ira, neither contributions nor investment earnings are currently taxed, but withdrawals are subject to tax. 56 in a roth ira, contributions are currently taxable, but investments earnings and withdrawals are excluded from taxable income. 57 as with employer plans, early withdrawals from regular iras (prior to the year in which the ira owner attains age 59.5) are generally subject to a 10% penalty tax, and distributions must commence on a ratable basis beginning no later than the april 1 after the ira owner attains age 70.5. 58 both the rsa and lsa differ in important ways from iras. three key differences between iras and both rsas and lsas are: (i) there would be no maximum income limits for contributions to the new savings arrangements; (ii) contributions to the new savings arrangements would have to be made on a roth (that is, after-tax) basis, with account distributions excludable from income; and (iii) there would be no minimum distribution rules requiring that distributions commence during an owner’s lifetime. 59 other differences between iras and the new savings arrangements are discussed below: 1. retirement savings accounts under the 2003 budget proposal, an individual would have been able to contribute up to $7,500 from earned income to an rsa. 60 in subsequent budgets, this amount was reduced to $5,000, perhaps in a nod to deficit control, but also perhaps in capitulation to some usual white house allies who initially opposed the proposals as a threat to employer provided health 55. irc § 408, irc § 219. the $4,000 limit increases to $5,000 in 2008 and thereafter will increase to reflect increases in the cost of living. id. 56. irc § 408. 57. irc § 408a. 58. irc § 408(b), (c). roth iras are also subject to the excise tax on early distributions, but an owner of a roth ira is not taxed to the extent distributions reflect simply already taxed contributions. irc § 408a(d)(4). moreover, distributions from roth iras are not subject to the minimum distributions rules. irc § 408a(c)(5). 59. see, general explanation (2003), supra note 1, at ¶ 11920. 60. id. at 119. 2008] slouching towards a consumption tax 131 care. 61 an individual would also have been able to contribute up to the maximum amount for a non-working spouse. 62 distributions of investment income would have been subject to a 10% excise tax if made before the rsa-owner has attained age 58. 63 roth iras would have been automatically converted into rsas. 64 traditional iras could be converted to rsas on an elective basis by paying income tax on the converted amount and payment of the tax could be spread over a four-year period. 65 2. lifetime savings accounts in the 2003 budget, an individual would have been able to contribute $7,500 annually to an lsa; there was no requirement that the individual have earned income to make such contribution. 66 subsequent budgets have reduced the figure to $5,000. 67 moreover, an individual can contribute to any other person’s lsa, although contributions by or on behalf of any particular individual could not in the aggregate exceed the maximum amount. 68 thus, a married couple with two children could have contributed $30,000 annually to lsas for family members (if the limit were, as initially proposed, $7,500 per individual). there were no restrictions or excise taxes imposed on withdrawals from lsas. it has thus been suggested by some financial columnists that should the bush proposals be adopted, individuals would generally want to contribute the maximum to an lsa before contributing to an rsa, since preage-58 withdrawals from an rsa could result in imposition of excise taxes. 69 although an lsa could be used to save for any purpose, the white house proposal did not eliminate special-purpose savings vehicles currently 61. united states department of treasury, “bush again pushes for rsa, lsa and ersa in fiscal 2006 budget,” at www.pressreleases.newspap.com/pr/ 20052/pr206421.html. see, karen c. burke and grayson m. p. mccouch, lipstick, light beer, and back-loaded savings accounts, 25 va. tax rev. 1101, 1123 (2006). 62. general explanation (2003), supra note 1, at 120. 63. id. 64. id. 65. id. 66. id. at 119-20. 67. united states department of treasury, “bush again pushes for rsa, lsa and ersa in fiscal 2006 budget,” available at www.pressreleases.newspap.com/pr/20052/pr206421.html. 68. general explanation (2003), supra note 1, at 120. 69. see, e.g., christine dugas, et. al., how bush’s retirement system overhaul hits home, usa today, feb. 23, 2003, at 2b. 132 florida tax review [vol. 9:2 available under the internal revenue code (such as coverdale education accounts, qualified state tuition plans, and medical savings accounts). 70 c. employer retirement savings accounts one of the potential virtues of defined contribution plans (compared to defined benefit plans) is their relative simplicity of form. 71 the regulatory structure that governs such plans, however, sometimes perverts this simplicity of form into extreme complexity, in two ways: first, by providing extraordinary flexibility through which firms can design plans that minimize participation and benefits for rank-and-file employees, and second by imposing administrative and compliance complexity as the toll charge for such flexibility. 72 these two types of complexity (although related) can be conceptualized as design complexity, on the one hand, and administrative complexity on the other. to illustrate, consider an employer that wants to minimize benefits for rank-and-file employees. the employer could design its plan to exclude (in some cases) more than 50% of its rank-and-file employees while covering all of its highest paid employees, and could provide benefits that are significantly higher (as a percentage of pay) for the latter than for the former. 73 the tools an employer might use to so design a plan could include cross-testing, 74 a 401(k) structure, 75 integration with social security, 76 70. general explanation (2003), supra note 1, at 120. see, irc § 529 (qualified state tuition plans); irc § 530 (coverdale savings accounts); irc § 223 (health savings accounts). there have been a number of articles highly critical of health savings accounts, and particularly the tax treatment of such accounts. see, leonard e. burman, new health care tax proposals: costly and counterproductive, 110 tax notes 779 (feb. 9 2006); amy b. monahan, the promise and peril of ownership society health care policy, 80 tulane l. rev. 777 (2006); norman stein, the hsa: health savings accounts or health (policy) sabotaged again, 64 nyu institute on federal taxation, employee benefits and executive compensation (2006). in 2006, the white house proposed a dramatic expansion of the tax benefits available to hsas. see, berman, infra. 71. see, generally, edward a. zelinsky, the defined contribution paradigm., 114 yale l. j. 451 (2004). 72. norman stein & peter orszag, cross-tested defined contribution plans: a response to professor zelinsky, 49 buff. l. rev. 629 (2001) (discussing permissible means of discrimination under internal revenue code). 73. id. at 634-39; irc § 410(b)(3). 74. id. 75. irc § 401(k). section 401(k) permits employees to decide whether to participate, and how large a percentage of their compensation to contribute, with generally less exacting nondiscrimination requirements. id. 2008] slouching towards a consumption tax 133 providing small benefits for its lowest-paid workers and large benefits for higher-paid rank-and-file workers, 77 use of a complex average benefits test, 78 a separate-line-of-business test, 79 catch-up contributions, 80 the adoption of different plans for different employees, 81 and the careful fashioning of a vesting schedule. 82 these tools all impose complexity in the design and administration of a plan. some have argued that the law’s complexity discourages some firms from sponsoring plans, 83 but this is not precisely accurate, since an employer can mostly or entirely avoid the complexity by adopting a plan covering all employees under a uniform and simple benefit formula. it would be more accurate to say that some firms are discouraged from adopting defined contribution plans because design and compliance complexity makes it expensive to set up plans that aggressively favor highly-paid employees in coverage and benefits. in some sense, the holy grail of private pension reform would be to quantify the maximum tolerable amount of benefit and coverage disparity between highly and non-highly-paid employees and then put forth a single plan template that accommodates, with minimum complexity, up to but no more than this amount of disparity. 84 this is, i think, the idea of the ersa, 76. irc § 401(l) (describing social security integration requirements); see, also, stein and orszag, supra note 72, at 635; see, generally nancy j. altman, rethinking retirement income policies: nondiscrimination, integration, and the quest for worker security, 42 tax l. rev. 435 (1987) (providing excellent discussion on social security integration). 77. see, generally michael w. melton, making the nondiscrimination rules of tax-qualified retirement plans more effective, 71 b.u.l.rev. 47 (1991). 78. irc § 410(b)(2)(a). see, stein & orszag, supra note 71, at 636-37. 79. see, irc § 414®). 80. see, irc 402(g)(1)(c). this section permits a section 401(k) plan to accept an additional $5,000 contribution from a participant who is at least age 50, without nondiscrimination testing of any sort. id. in many cases, the employees over 50 who will be able to afford this contribution will be higher paid employees. 81. see, treas. reg. § 1.401(a)(4)-3. see, generally melton, supra note 77; stein & orszag, supra note 71, at 637-38. 82. see, stein & orszag, supra note 72, at 638. 83. see, e.g., joseph bankman, tax policy and retirement income: are pension plan anti-discrimination provisions desirable?, 55 u. chi. l. rev. 790, 806 (1988). 84. there is at least one problem with this approach: under current law, a firm will incur various professional and compliance costs if it wishes to design a plan that aggressively favors higher paid employees; the methodologies described in the text can act as a toll charge for such plans. if the statute is modified to make it simpler to minimize coverage and benefits for rank-and-file workers, it is plausible that some firms, no longer facing a toll charge, will reduce coverage for such 134 florida tax review [vol. 9:2 which would create a simplified regulatory structure for all defined contribution plans. it would do so, at least in the administration’s 2003 proposals, by eliminating several complexity-creating tools that under current law are used to create high levels of disparity between highly and non-highly compensated employees, i.e., integration, the average benefits test, and cross-testing. 85 these changes would reduce the amount of disparity between the two groups of employees that employers can effect today through plan design. the rules governing the ersa, in tacit recognition of the loss in plan sponsor ability to use these tools to favor higher-paid employees, would increase the permissible degree of disparity between the two groups for elective contributions and eliminate the “top-heavy rules” – special rules requiring minimum contributions and more accelerated vesting for participants in plans whose benefits are primarily allocable to certain “key” employees. 86 iv. critique of white house private savings proposals the white house private savings initiative (the rsa, lsa, and dividend exclusion) would strongly push the country towards a consumption tax base, 87 which has a political constituency primarily among those employees. it is also plausible that inclusion of such express statutory provisions will result in benefits consultants designing template plans, which will act as the default for most employers, even those who might have been inclined to provide more generous benefits for rank-and-file employees if that had been presented as an option. 85. in the most recent incarnation of the ersa, however, cross-testing would be permitted. see, general explanation of the administration’s fiscal year 2006 revenue proposals dept. of treas., at 129 (feb. 2008). 86. irc § 416. the accelerated vesting provisions of section 416 are moving toward the scrapheap of irrelevancy, as congress improves the overall minimum vesting rules, which currently require all defined contribution plans to satisfy the same vesting rules as section 416. irc § 411(a)(2)(b). in addition, cash balance plans are now subject to 3-year cliff vesting, a more demanding standard than imposed on plans because they are top-heavy. irc § 411(a)(13). 87. there is a rich and growing literature on a consumption tax. the classic articles in the legal academic literature include william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113 (1974); alvin c. warren, jr., fairness and a consumption-type or cash flow personal income tax, 88 harv. l. rev. 931 (1975); william d. andrews, fairness and the personal income tax: a reply to professor warren, 88 harv. l. rev. 947 (1975); alvin warren, would a consumption tax be fairer than an income tax?, 89 yale l.j. (1980); barbara fried, fairness and the consumption tax, 44 stan. l. rev. 961 (1992). as i will discuss briefly in the text of the article, the white house 2008] slouching towards a consumption tax 135 concerned more with national economic growth than with distribution and among those who believe that tax equity is judged better on a lifetime than an annual basis. 88 the proposals might, as their advocates predict, increase aggregate national savings and might improve tax equity by certain metrics of fairness. in doing so, however, they would likely break the back of the employer-sponsored pension system, on which approximately half of working americans rely for retirement savings. 89 the proposals would do this by reducing the number of employer-sponsored plans and by likely reducing both the contribution levels and investment return for rank-and-file employees who participate in the plans that remain. moreover, there is reason to believe that the private savings initiatives would not adequately replace the retirement income security that most working americans would lose from employer-sponsored plans. this section of the paper provides the analysis that undergirds this pessimism about the effects of the white house proposals on retirement income security. the section considers (i) possible effects of the private savings proposals on employer sponsorship and employee use of employment-based retirement plans; (ii) the prospects that middle and lower income workers will use the new savings initiatives to create new retirement savings to compensate for the diminishment of the importance of employersponsored retirement plans; (iii) the effect of the savings initiative on investment return on retirement savings for middle and lower income americans; and (iv) some tax and budget consequences of the savings initiative. a. savings initiative and employment-based retirement plans i have already suggested that scholars and policymakers believe that firms generally sponsor plans in response to preferences of firm owners and savings proposals move us toward a consumption tax in an incomplete, and ill conceived, manner. 88. see, joseph bankman & barbara fried, winners and losers in the shift to a consumption tax, 86 geo. l. j. 539 (1998); michael j. graetz & deborah h. schenk, federal income taxation, principles and policies 36-39 (4th ed. 2002). 89. see, supra note 2. at least one group (the american society of pension professionals and actuaries) that initially opposed the rsa and lsa proposals has, in light of a reduction in contribution limits and modifications to the ersa proposal, now supports the white house savings initiative. compare aspa, statement for the record, committee on ways and means, hearing on the presidents’ economic growth proposals, mar. 6, 2003, http://aspa.org/archive/gac/2003/030503-ecopropsal.htm (last visited jun. 29, 2007) with administration announces revised savings proposals – changes made to address aspa’s concerns available at http://www.aspa.org/archivepages/gac/2004/2004-02-02-savingsproposals.htm. (last visited jun. 29, 2007). 136 florida tax review [vol. 9:2 other highly-paid employees for tax-advantaged deferred compensation, with the nondiscrimination rules then requiring that less well-paid employees also be provided with some benefits. 90 to appreciate the significance of the tax benefits to highly paid individuals in an employer’s decision to establish and maintain a plan, it is useful to think about the question first in a world without an income tax. what are the considerations that would go into plan sponsorship in such a world? i begin with the observation that deferred compensation plans predated the income tax (and thus the tax benefits that our income tax regime confers on qualified plans), so there are certainly non-tax reasons for firms to sponsor pension plans. one of the early motivations for pension plans was to provide for the orderly superannuation of industrial and construction workers, which was thought not only to ensure the retirement of older employees with declining productivity, but also to raise the morale of active workers and thereby increase their productivity. 91 some also saw pension plans as satisfying a moral obligation of the employer to its elderly workers who were no longer capable of working. 92 historically, employers have also been able to use pension plans to create incentives for long job tenures, which can be valuable in industries that invest heavily in their human capital. 93 in addition, some employees may value some degree of deferred compensation at more than its cost to the employer even apart from its tax benefits: employees may value the forced savings aspect of deferred compensation; may enjoy relatively high rates of return due to economies of scale and the professional investment management that plans offer; and, in defined benefit plans, may appreciate both the benefit guarantees and the pooling of mortality risk. but employers also incur significant costs when they sponsor retirement plans. sponsorship of plans imposes design, administrative, and compliance costs on the sponsoring firm. employers 94 also are subject to potential liability to participants if they violate erisa’s complex fiduciary and other rules. 95 defined benefit plan sponsorship requires employers to guarantee investment performance, assume mortality risk, and absorb the 90. see, text accompanying supra notes 29-36. 91. see, generally, arthur cloud, pensions in modern industry (1930); murray latimer, industrial pension systems (1932). 92. see, lee aquier, old age dependency in the united states (1912). 93. see, john langbein & bruce wolk, pension and employee benefit law 29-32 (3rd ed. 2000). 94. employees who are assigned discretionary duties in administering a plan can also be held personally liable under erisa. see, erisa § 3(21)(defining fiduciary), and 502(a)(3) and §§ 502(a)(3), 409 (creating personal liability for fiduciaries in certain situations). 95. see, erisa §§ 502(a)(2), (a)(3), 29 u.s.c. §§ 1132(a)(2), (a)(3). 2008] slouching towards a consumption tax 137 volatility of periodic funding obligations and the resulting need to sometimes make substantial contributions to plans in lean business years. 96 and for some employers, the internal revenue code’s nondiscrimination rules, which require plans to provide benefits to some non-highly compensated employees, impose perhaps the steepest cost of plan sponsorship. 97 some such employees benefit little from the qualified plan tax deferral and some (but certainly not all) will have a strong preference for immediate compensation. 98 thus, some employees for whom the employer provides deferred compensation will not value the compensation at its cost to the employer, which will increase the cost of total compensation for those employees. in addition, the non-tax benefits of employer-sponsored retirement plans have become somewhat attenuated over the last two decades, particularly with respect to a firm’s ability to design a plan to advance human resource strategies. erisa’s vesting rules have limited the employer’s ability to use a plan to encourage long job tenures. 99 moreover, demographers predict that labor markets will begin to tighten as baby boomers reach retirement age 100 and thus some firms may have a reduced interest in retirement plans as a strategy to encourage older employees to retire. 96. irc §§ 412, 430 (funding requirements for defined benefit plans). 97. see, irc § 401(a)(4); treas. reg. § 1.401(a)(4). 98. alicia munnell, the economics of private pensions (1982). 99. irc § 411(a)(requiring that vesting begin no later than five years after employment); irc § 416(b) (requiring vesting to begin no later than three years for “top-heavy” plans). moreover, the pension protection act now requires that all defined contribution plans conform to the rules previously applicable to top-heavy plans, irc § 411(a)(2)(b), and requires cash balance and other hybrid defined benefit plans to provide 100% vesting after three years, irc § 411(a)(13). 100. michael w. wyand, aging issues: retirement of ‘baby boom’ generation poses potential problems for employers, gao says bna’s pension & benefits rep. 2919 (2001) citing older workers: demographic trends pose challenges for employers and workers (report 02-85) (2001)), peter coy & done brady, old. smart. productive.; surprise! the graying of the workforce is better news than you think, business week 78 (jun. 27, 2005), stacy polos & dimitri s. nightingale, employment and training policy implications of the aging baby boom generation, urban institute, jun. 1, 1997, available at http://www.urban.org/template.cfm?navmenuid=24&template=/ taggedcontent/viewpublication.cfm&publicationid=6558. there has also been some interest in phased retirement, where older employees would reduce their hours and replace the resulting lost income by beginning to receive benefits from employer sponsored retirement plans. see, e.g., phased retirement, available at http://www.workforce.com/section/02/feature/23/47/31/. 138 florida tax review [vol. 9:2 it should also be said that non-tax explanations for whatever employee preference for deferred compensation exists, perhaps never strong, are weaker now than in 1974, when congress enacted erisa. the wide availability of mutual funds has made it possible for small investors to benefit from professional money management without the intervention of an employer-sponsored retirement plan. moreover, the market decline of the early 2000s may have made some employees wary of defined contribution plans, 101 and defined benefit plans, which shield employees from market and mortality risk, are themselves in decline, in large measure because of their costs to the firm, especially in industries with aging workforces. 102 and in an increasingly mobile workforce, individuals may be less inclined to want what might be a relatively short-term employer to be entrusted with custody of their retirement savings. this brings us to the question of whether employer-sponsored retirement programs would exist in the absence of the tax deferral that those plans currently effect. at least for small firms, the conventional understanding – that firms generally establish plans to satisfy a tax-driven preference for such plans by firm owners and highly-paid employees – seems accurate. small firms are not likely to derive meaningful non-tax benefits from retirement-plan sponsorship (other than in the recruitment and retention of relatively highly paid employees who value the tax savings), and the fixed costs of plan sponsorship cannot be spread over a large workforce. without the tax benefits realized by firm owners and highly-paid employees, small firm sponsorship of retirement plans would certainly be less common than it now is, perhaps far less common. for large firms, the answer is less clear. such firms are more likely than small firms to be able to use plans to advance human resource goals and have more potential plan participants among whom to spread the fixed costs of plan sponsorship. moreover, we inhabit an existing world, not a world of pure theory, and in that existing world almost all large firms sponsor retirement plans. firm culture and experience with retirement plans may result in increased employee appreciation for such plans. and many large 101. see, fidelity’s study defines new directions for vendors and sponsors, dc plan investing (nov. 9, 2004) (overall participation rates for 401(k) plans declined by 2% between 2002 and 2003); kathy chu, employee 401(k) participation slips – only 76% of eligable workers utilized plans loast year, down from 80% in 2002. wall st. j. (oct. 6. 2004), at c15. (participation declined by 4%). 102. retirement policy: decline in use of defined benefit plans may be due more to workers than firms, 32 bna’s pension & benefits reporter 1114 (2005), available on westlaw at 32 bpr 114 (citing stephanie aaronson & julia cioronado, are firms or workers behind the shift away from db pension plans? fin. and econ. discussion series, division of research & statistics and monetary affairs, fed. reserve board, working paper no. 205-17, 2005). 2008] slouching towards a consumption tax 139 firms have invested resources in educating their employees about the value of retirement benefits. 103 in addition, it can be difficult to take away a benefit that employees have been conditioned to expect. thus, while we can speculate about whether in the absence of tax benefits large firms would decide to sponsor retirement plans if they were not already doing so, it does not seem likely that such firms would immediately extinguish such plans if the tax advantages of such plans were suddenly reduced or even withdrawn. still, it should be said that if the tax benefits were withdrawn or reduced, there would almost certainly be diminished interest in retirement plans among large firms, at least in the long run. the role of collective bargaining should also be noted: unions often bargain for retirement benefits, both for single-employer plans in large firms and for multi-employer plans in some industries with numerous firms and high rates of employee mobility between those firms. 104 tax benefits for their membership may be one reason why unions negotiate for such plans, but there are other reasons as well. 105 unions represent employees at all points on a demographic line through the workforce and older employees nearing retirement can be expected to place a high value on retirement income. unions may also be motivated by the long-term welfare of their membership, which would include retirement income security, even when younger workers may not appreciate the value of retirement benefits. in addition, unions can, and do, educate their membership about the value of retirement income, which may result in some younger workers attaching value to retirement benefits. 106 i would expect, then, that many unions would continue to negotiate for retirement benefits even if the tax advantages embedded in those benefits were reduced. but overall, the tax benefits of qualified plans are an important driver of firm willingness to sponsor retirement plans, particularly for small firms. 107 equally important, under the nondiscrimination rules, the benefits of highly compensated employees are constrained by the benefit levels and participation rates of rank-and-file employees in the plan. as a result of this, some firms, in order to provide higher levels of benefits to highly-paid employees, cover more rank-and-file employees and/or set higher benefit levels for them than they otherwise would. 103. see, hewitt survey reveals new employer trends in retirement, business wire, jan. 18, 2005, http://www.businesswire.com. 104. william c. greenough & francis p. king, pension plans and public policy 44-47 (1976). 105. id. 106. see, u.s. dept. of labor advisory council on employee welfare and employee ret. plans, report of working group on planning for retirement (2001) (noting that labor organizations educate their members about retirement planning). 107. john langbein and bruce wolk, supra note 93, at 30. 140 florida tax review [vol. 9:2 if tax benefits for highly paid employees participating in plans were eliminated or reduced, we would expect, then, to see two effects on qualified retirement plans: fewer firms would sponsor plans (particularly smaller firms), and benefit levels for moderateand lower-income employees would be reduced in some of those plans that remained. there are two ways that the tax benefits of highly paid plan participants can be reduced. one way is direct: either increase the effective tax rate on investment return from the retirement plan, as was the case in a short-lived 15% excise tax on aggregate plan distributions to the extent they exceeded $150,000 annually, 108 or decrease the limits on the benefits that can be provided to higher-paid individuals. the other is indirect: decrease the effective tax rate on investment return outside the retirement plan, which would reduce the comparative benefit of investing inside of an employersponsored retirement plan. the white house savings proposals would have the latter effect: the 2003 proposal would eliminate income tax on dividends or stock appreciation caused by retained earnings and would also eliminate tax on any type of investment held in an rsa or lsa. the concern, then, is that highly paid employees would no longer have incentive to participate in an employer-sponsored retirement plan since they could realize similar aftertax returns by investing in stock or by holding other types of investments in an rsa or lsa. the bush proposals would not, however, entirely eliminate the tax benefits of investing through the medium of a qualified plan, for at least two reasons. first, and most important, to the extent appreciation in stock value resulted from factors other than retained earnings, gain on the stock would be subject to capital gains taxation on stock held for more than one year. second, even if gain on investment were entirely exempted from taxation, the pricing of stock should under normal market conditions adjust upward to reflect the tax-advantaged treatment of dividend distributions. 109 in other words, returns on stock, even though nominally exempt from tax, can be expected to reflect an implicit tax burden. investment assets whose returns were not broadly exempted from income taxation should thus pay a higher before-tax rate of return than the tax-free return on stock, to account for the explicit tax to which such returns would be subject. since holding such assets in a qualified plan would defer the tax until benefit distribution, qualified plans could still carry a tax benefit by investing in assets generating taxable returns. 108. irc 4980a (1996). see, generally, bruce wolk, the new excise and estate taxes on excess retirement plan distributions and accumulations, 39 u. fla. l. rev. 987 (1987). 109. daniel j. mitchell, et. al., pathway to economic growth and tax reform: eliminating the double tax on dividends, the heritage foundation, mar. 28, 2003, available at http://www.heritage.org/research/taxes/bg1640.cfm. 11111* 2008] slouching towards a consumption tax 141 thus, if the white house’s proposal were adopted and included only the elimination of the double tax on corporate earnings, there would likely continue to be some, albeit diminished, demand among high-income taxpayers to participate in qualified plans. 110 but the bush proposals also would create the rsa and lsa, taxexempt private savings vehicles. thus, highly paid individuals could use rsas and lsas until they reached the limits of those accounts. the limits of the accounts in the 2003 white house proposal were nominally $7,500 per individual (but in subsequent proposals less), but contributions could be made to an rsa on behalf of a non-working spouse and contributions could be made to an lsa on behalf of any individual. thus, a single person could have made contributions of $15,000 annually to these accounts as initially conceived; married couples could have made contributions of $30,000 annually; and a married couple with two children could have made contributions of $45,000 annually. these contributions are, however, after tax; the contribution limits are thus higher than nominally identical contribution limits would be for the more familiar pre-tax contributions to an ira or 401(k) plan. for an individual with a 36% marginal tax rate, a $15,000 before-tax contribution is the equivalent of an after-tax contribution of $23,437.50. 111 another way of conceptualizing the difference between after-tax and before-tax contributions is by looking at the cost of the contribution: an after-tax contribution of $15,000 costs the taxpayer $15,000, while a before-tax contribution costs the taxpayer $15,000 plus the $8,437.50 in tax that the taxpayer must pay in the year of contribution. thus, the actual contribution limit for a single taxpayer (with a 36% marginal tax rate) is equivalent to a $23,437.50 before-tax contribution; a couple’s contribution would be the equivalent of a $46,875 before-tax contribution; and a two-child couple’s contribution would be the equivalent of a $70,312.50 before-tax contribution. the individual would have a tax incentive to contribute to an employer plan only to the extent she desired to invest in taxable assets in excess of these amounts. 110. to some extent, this would depend on how large the spread is between the rate of return on stock and the before-tax rate of return on assets generating taxable returns. as long as there is some spread, there will be some tax benefit to investing in such assets through the intermediary of a tax exempt vehicle, such as a qualified retirement plan. it is beyond the scope of this article to predict the amount of the spread between taxable and nontaxable assets and whether the resulting tax benefits to highly compensated individuals would sufficiently offset the costs of plan sponsorship to make plan sponsorship attractive to the employer. 111. this is an illustration of the equivalency of exemption of capital from taxation (through deduction) or exclusion from income) and exemption of taxable income on capital from income taxation. see, generally, e. cary brown, businessincome taxation and investment incentives, in income, employment and public policy, essays in honor of alvin h. hansen (1948). 142 florida tax review [vol. 9:2 the universe of individuals able to invest beyond the indicated levels is certainly not large. thus, to the extent that plan sponsorship, and the generosity of coverage and benefits in plans, hinges on the plan’s utility to highly compensated individuals, the result of the bush initiatives would likely be fewer and less generous pension plans. as suggested earlier, smaller firms are likely to be particularly sensitive to reductions in tax preferences for highly paid individuals. 112 i offer two examples that may be typical of some small-firm responses to the bush savings proposals, if enacted. assume a closely held corporation employing the owner and five other employees. the owner’s compensation from the business last year was approximately $100,000, and she expects to have approximately the same amount of compensation this year. the owner is 55 and last year established a safe-harbor 401(k) plan, 113 to which she contributed $10,000 on behalf of herself. the safe-harbor plan uses a matching formula, which requires a 100% match on the first 3% of compensation, and 50% of the next 2% of compensation. three of the five other employees are eligible to participate in the 401(k) plan and two of them do so. the two employees earn $25,000 each and elect to defer $1,250 each to the 401(k) plan. the sole proprietorship must, under the safe harbor matching formula, contribute an additional $1,000 for each of the electing employees. moreover, if we also assume that the employer incurs $500 in expenses to maintain the plan, the employer will incur $2,500 in direct costs of plan sponsorship. 114 in addition, we can assume that the plan also imposes some indirect costs, including the expenditure of some of her time. finally, let us assume that the owner, who has little savings outside the plan, is concerned about her ability to access savings inside the plan. if the original bush savings proposals had been enacted, the owner could use the $10,000 contribution to make a $7,200 after-tax contribution to an lsa. the owner could now terminate the 401(k) plan, saving the $2,500 additional plan costs. in addition, since an lsa does not penalize premature distributions, the owner will have unrestricted access to the lsa if she needs the money before retirement. the consequence of the owner’s actions is that the two employees who participated in the 401(k) plan will no longer receive matching contributions. 115 112. see, text accompanying supra note 91. 113. irc § 401(k)(12). 114. this may not be strictly accurate, for the employer may through the matching contributions attract more productive workers, but this is speculative. 115. note that the matching contribution not only added to the employees own savings, but also may have been an important incentive for the employees to 2008] slouching towards a consumption tax 143 the second example is a doctor’s office, which employs the doctor and eight other employees. the doctor, who is age 50, earns approximately $300,000 annually and has been saving $45,000 annually in his retirement plan. he has a non-working spouse and two children. in addition to his retirement savings, he saves $30,000 each year outside the plan, which he divides equally between stocks (mostly through a mutual fund), municipal bonds, and real estate. he also contributes $5,000 to section 529 plans for each of his children. his practice currently sponsors two plans: a safe harbor “match” 401(k) plan and an age-weighted profit-sharing plan. 116 he elects to contribute $20,000 to the 401(k) plan (which included a $5,000 “catch-up” contribution) and receives a matching contribution of $8,000, for a total contribution of $28,000. his practice also contributes $17,000 to his account in an age-weighted profit-sharing plan. four of the employees elect to participate in the 401(k) plan and six employees participate in the age-weighted profit sharing plan. the doctor contributes $8,000 in matching contributions to the 401(k) plan and $6,000 to the age-weighted profit sharing plan for the employees. in addition, the doctor pays $500 for administrative expenses for the 401(k) plan and $750 for the age-weighted profit-sharing plan. if the white house’s savings proposals are enacted, the doctor could set up rsas and lsas for himself and his spouse, in which he can deposit $30,000. let us assume, however, that the doctor will want to move $10,000 of his non-plan investments into the lsas, reducing the amount of qualified plan savings that he can shift to the rsa/lsas for himself and his spouse to $20,000. but since the rsa/lsas are made with after-tax contributions, the $20,000 before-tax contribution limit is the equivalent of a $31,250 after-tax contribution (the basis on which his contributions were made to the qualified plans). 117 the doctor can now contribute $31,500 to the lsa/rsas that would have been contributed to the retirement plans, which accounts for all but $13,500 of what the doctor would, but for the rsa/lsa vehicles, have contributed to the practice’s qualified plans. the doctor has a choice of what to do with the $13,500. first, the dividend exclusion, and the shift of some non-plan savings to the lsas, will have increased the future effective aftertax rate of return on those investments, which might result in the doctor deciding to reduce his aggregate savings. a second choice would be to shift some of the $13,500 to lsas for his two children, if that fits with his family wealth-management strategies. this choice would allow the doctor to save at all, since they would not have received the matching contributions if they had not contributed to the 401(k) plan themselves. 116. for details on age-weighted profit-sharing plans, see, orszag & stein, supra note 72. 117. see, supra note 109, and accompanying text. 144 florida tax review [vol. 9:2 achieve the same deferral that he accomplished through qualified plans without the use of any qualified plan. if the doctor makes this choice, his employees will lose the $14,000 that the doctor had been contributing for them and the advantages of a workplace savings program. but suppose that the doctor neither wishes to reduce his savings rate nor establish lsas for his children; in that case, he will still have $13,500 he will want to defer to a qualified plan. one option would be for him to establish a simple 401(k) plan, which requires a matching contribution equal to the first 3% of compensation. 118 the doctor could effectively contribute the entire $13,500 to the plan and his contributions on behalf of his other employees to this plan would be $4,800. he would not need to make any contributions to the age-weighted profit-sharing plan, which he could freeze or terminate. the other employees would thus lose 66% of the employer-provided benefits that would have otherwise been made to their accounts. moreover, some of the doctor’s employees might reduce their elective contributions in response to the reduction in the employer matching contributions. this article does not make a claim that all firms, or even all small firms, would discontinue plan sponsorship or reduce employer-funded benefits for rank-and-file employees in response to the white house savings proposals. nor does it argue that firms that do not currently have retirement plans would never adopt them if the bush savings proposals are enacted. as the article earlier observed, there is an array of reasons that firms sponsor plans, of which the tax incentive for highly compensated employees is only one. 119 but for many firms it is the primary reason, and the bush proposals, by sapping out of the tax law much of the vitality of the tax incentives for employer-sponsored plans, could be expected to reduce both their numbers and their generosity to ordinary working americans. b. efficacy of bush savings proposals for creating retirement income security for middle and lower income workers in the previous subsection, i suggested that the white house savings proposals, by providing tax-advantaged savings opportunities outside qualified retirement plans, would reduce the incentives for highly paid individuals to save in qualified plans. i also suggested that this would result in a universe in which fewer firms sponsored qualified retirement plans and that some of the remaining plans would be less generous. the retirementpolicy question that follows is to what extent rank-and-file employees would use the new private savings vehicles to replace the lost retirement income from their employer-sponsored retirement plans. 118. irc § 401(k)(11). 119. see, supra notes 102-05 and accompanying text. 2008] slouching towards a consumption tax 145 the answer, i fear, is that much of what is lost will not be replaced. i have two concerns in particular: first, that many of the rank-and-file employees who today participate in qualified plans would not utilize the bush personal savings accounts; and second, that much of what is saved in the bush personal savings accounts will be consumed prior to retirement. 1. obstacles to rank-and-file utilization of bush savings proposals there are reasons to suspect that rank-and-file employees may not exhibit a robust response to the bush personal savings proposals, at least compared to their response to qualified retirement plans (when such plans are offered to them). i start with the observation that many rank-and-file employees are what some have referred to as “reluctant savers,” 120 people who find it difficult to save for retirement on their own, because of pressing needs for present consumption. indeed, as this paper earlier suggested, the traditional explanation for the qualified-plan tax expenditure is that qualified retirement plans will create retirement income for reluctant savers. 121 qualified plans can create retirement income for such savers in either of two ways. in plans funded exclusively with employer dollars, the internal revenue code’s nondiscrimination rules require coverage of some rank-and-file employees automatically, without action on their part and without any corresponding reduction in their immediate compensation. in such plans, then, reluctant savers are forced to save for retirement. other plans, primarily 401(k) plans, do not force employees to save: in such plans, an employee must elect to participate, and there is a direct cost to the employee who does so elect: lower immediate compensation. but the law encourages, and arguably coerces, participation among reluctant savers. employees are in part encouraged to participate because their 401(k) contributions enjoy the benefit of tax deferral. 122 more important, to enjoy qualified tax status, 401(k) plans must comply with a special set of nondiscrimination rules, which can be satisfied through annual testing that compares the deferral rate of the highly compensated employees with the deferral rate of rank-and-file employees. 123 in effect, the amount of income that highly-paid employees can defer in a 401(k) plan depends on the amount that non-highly compensated employees defer. thus, many firms encourage employee participation in their 401(k) plans through employer-provided matching contributions and educational programs on the value of saving for 120. daniel halperin, employer-based retirement income – the ideal, the possible, and the reality, 11 elder l. j. 37 (2003)(noting problems of reluctant savers). 121. see, supra notes 29-37, and accompanying text. 122. see, supra note 29-36, and accompanying text. 123. irc § 401(k)(3). 146 florida tax review [vol. 9:2 retirement. 124 and the internal revenue code also offers safe-harbor alternatives that exempt a plan from annual non-discrimination testing if the plan provides either a statutorily defined matching contribution or provides a mandatory non-matching contribution for each participant. 125 moreover, behavioral economists have observed that individuals are more likely to save if they can pre-commit to saving a portion of future earnings: 401(k) plans offer employees a pre-commitment mechanism. 126 thus, qualified plans either compel or encourage rank-and-file employees to save for retirement. the bush personal savings vehicles are voluntary, so reluctant savers will not be compelled to save; in effect, this means that reluctant savers who save only because qualified plans compel them to will lose retirement savings if their qualified plan is terminated or cut back. moreover, the bush savings proposals will offer weaker incentives for voluntary savings than 401(k) plans. indeed, the bush savings accounts offer a single meaningful incentive for participation: the permanent exclusion of investment return on plan contributions from income taxation. 127 they will not provide matching contributions and employers will not have incentive to sponsor savings educational programs. perhaps most important, the bush accounts do not incorporate the pre-commitment mechanism of 401(k) plans. one might respond that vendors of investment products – the fidelities and vanguards of the world – would aggressively market rsas and lsas, and this is certainly probable. what is not probable, however, is that such vendors will be especially interested in establishing such accounts for small investors or that their marketing will be directed to people who will open small accounts. the reason for this prediction is simple: the fixed costs (and potential liabilities) of small accounts likely render such accounts only marginally profitable. 128 indeed, most mutual fund vendors have minimum 124. alicia h. munell & annika sunden, coming up short/the challenge of 401(k) plans 58 (the brookings institution 2004). 125. irc § 401(k)(12). 126. see, generally, deborah m. weiss, paternalistic pension policy: psychological evidence and economic theory, 58 u. chi. l. rev. 1275 (1991). moreover, in response to work by some behavioral economists – most notably richard thaler and shlomo benartzi – a number of section 401(k) plans are using “automatic enrollment,” in which employees must opt out rather than opt in to plan participation. william g. gale, j. mark iwry & peter r. orszag, the automatic 401(k): a simple way to strengthen retirement savings (brookings institute 2005), at www.brookings.edu/views/papers/20050228_401k.pdf. (last visited jun. 30, 2007). 127. it is, of course, possible to revise the bush proposals to provide matching contributions. 128. john waggoner, some mutual funds still let you start small, usa today, (aug. 23, 2001) at d., available at http://www.usatoday.com/money/perfi/ columnist/waggon/2001-08-24-waggon.htm. (last visited jun. 30, 2007). the article 2008] slouching towards a consumption tax 147 contribution requirements; vanguard, fidelity, and t. rowe price, for example, will not open an individual retirement account with less than $1,000 and many of their fund options require substantially higher minimum contributions. 129 moreover, the rsa/lsa accounts will be funded with after-tax dollars. earlier this article discussed how the contribution of an after-tax dollar contribution to a roth-type savings vehicle shields more investment income from taxation than a deductible contribution to a traditional retirement plan, but this is not an advantage to people who cannot afford to contribute beyond the contribution limits for such accounts (and this will be most people). moreover, there is reason to suspect that such individuals generally prefer before-tax to after-tax contributions. 130 thus, the tax incentives for middleand lower-income people to contribute to rsas and lsas may be weaker than the tax incentives for contributions to regular 401(k) plans. the white house proposals would eliminate traditional individual retirement plans, where contributions are made with pre-tax dollars. 2. production of retirement income qualified retirement plans are designed, generally speaking, to provide individuals with a stream of income following their withdrawal from the labor market because of retirement or disability. the internal revenue code, through regulatory restriction 131 and excise taxes, 132 discourages use notes, however, that some mutual funds might pursue the small investor in the expectation that with regular contributions and compounding of investment income, the small account of today will become the large account of tomorrow. 129.see, e.g., https://flagship2.vanguard.com/vgapp/hnw/content/account serv/retirement/atstradiraoverviewcontent.jsp ($2,500 minimum investment for most fidelity investment funds). 130. there are three possible explanations for this preference: first, that individuals have a behavioral preference for reducing taxes in the year of contribution; second, that individuals may fund part of their contribution with the immediate tax savings; and third, that middle and lower income individuals believe that they will have lower marginal tax rates in retirement. i have not been able to find any empirical research on the question posed in the text: whether traditional or roth treatment is a stronger tax incentive for moderate income individuals. but i am reasonably confident that my hunch that before-tax treatment is a more effective incentive than roth treatment for moderate income taxpayers. others seem to share this view. see, karen c. burke and grayson m. p. mccouch, lipstick, light beer, and back-loaded savings accounts, 25 va. tax rev. 1101, 1141 (2006). 131. treas. reg. § 1.401-1(b) (pension plan intended to pay income after retirement). 148 florida tax review [vol. 9:2 of such plans to provide pre-retirement income. in addition, pension plans (but not profit-sharing plans) must make benefits available as life annuities, which relieves participants from the planning necessary to prevent dissipation of retirement savings prior to death. 133 moreover, a participant’s spouse must consent to any benefit form from a pension plan that does not include a survivor’s benefit for the spouse, 134 making it more likely that benefits will not be exhausted before the death of a participant’s spouse. in qualified plans these rules work imperfectly: we know, for example, that pre-retirement leakage occurs, 135 and we know that some spouses consent to distributions that do not include a survivor benefit if the spouse outlives the participant. 136 this can result in participants exhausting retirement savings prio to their death, or married couples exhausting benefits before they both die. but the rules do provide at least some restraints on consuming qualified plan savings in a manner inconsistent with the purpose of the qualified-plan tax subsidy: providing retirement income. the white house savings proposals do not include equivalent restraints on non-retirement use of assets in the new savings accounts, but impose weaker and in some cases no rules limiting pre-retirement consumption or post-retirement exhaustion of rsa/lsa assets. this would, i fear, exacerbate the problem of old-age poverty, at least at the margins. the lsa, to which individuals could contribute $7,500 per family member under the 2003 budget proposal, would impose neither regulatory restriction nor excise tax on pre-retirement withdrawals. 137 the rsa, while imposing no direct regulatory restrictions on premature withdrawals, would impose an excise tax on distributions before age 58, which would discourage some pre-retirement rsa distributions. 138 most individuals, however, would probably choose to contribute first to the lsa (precisely because it does not impose a penalty on early distributions) and only contribute to an rsa to the extent that they are able to contribute in excess of the lsa limits. 139 thus, many individuals who use the new savings proposals will be subject to neither direct nor indirect restrictions on premature withdrawals of income. 132. a 10% excise tax is imposed on most qualified plan distributions made before the year in which the participant attains age 59.5. irc § 72(t). 133. irc § 411(a)(7); treas reg. 1.401-1(c)(1)(i). 134. irc §§ 401(a)(11), 417. 135. munnell and sudden, supra note 122, at 125, et. seq. 136. see, generally, camilla e. watson, broken promises revisited: the window of vulnerability for surviving spouses under erisa, 76 iowa l. rev 461 (1991). 137. general explanation (2003), supra note 1, at 120. 138. id. 139. see, how bush’s retirement system overhaul hits home, supra note 60. 2008] slouching towards a consumption tax 149 moreover, the excise tax on rsas would only apply to withdrawals of investment income, 140 not to withdrawals of the contributions themselves, and if we predict that the shape of withdrawal regulations will follow those applicable to roth iras, withdrawals will be treated as coming from contributions rather than investment income until aggregate withdrawals exceed aggregate contributions. thus, many pre-retirement withdrawals would be tax-free even from an rsa. thus, compared to assets saved in qualified plans, assets saved in the white house savings proposals would be more likely to be used before a person stopped working. 141 moreover, the bush personal savings accounts neither require nor induce individuals to take benefits in annuity form. while an individual could certainly purchase an annuity using plan assets on the commercial insurance market, the cost of commercial annuities is high (especially for relatively small annuities). 142 thus, many holders of rsas and lsas will have to manage their retirement savings, not only investing appropriately but also planning withdrawals to ensure a more or less constant income stream until death. this is a difficult enterprise, and there is little reason for optimism that most americans are equipped to manage their assets in this way. 143 compared to qualified pension plans, then, the bush savings vehicles will probably result in fewer retired individuals receiving a lifetime stream of income after retirement. finally, the bush proposals do not require spousal consent to a form of benefit without a survivor annuity. indeed, nothing in the bush proposal promotes protection of surviving spouses. again, this is a step backward from the rules protecting spouses in qualified plans. 140. general explanation (2003), supra note 1, at 120. 141. footnote about double-bind: if you put limits, fewer people will contribute. 142. see, barry perlman, chris lott, ed dollars, subject: insuranceannuities in the investment far website, available at http://investfaq.com/articles/ins-annuities.html. (last visited june 30, 2007) (annuities usually have a sales load, usually have very high expenses, and always have a charge for mortality insurance. the expenses can run to 2% or more annually). also see, jeffrey r. brown and mark j. warshawsky, longevity-insured retirement distributions from pension plans: market and regulatory issues, national bureau of economic research working paper series, january 2001. available at www.nber.org/papers/w8064. (last visited jun. 30, 2007) (individual annuity markets do not offer actuarially fair prices). 143. see, report of working group on planning for retirement, supra note 105. 150 florida tax review [vol. 9:2 c. white house savings initiative and rate of return on retirement savings the bush savings proposals may have the effect of reducing the rate of return on retirement savings of middleand lowerincome individuals. this section suggests five reasons why this might occur. 1. loss of investment opportunities qualified plan investment programs take one of two forms: assets are either pooled and invested by plan fiduciaries on behalf of all participants or are invested in accordance with the individual instructions of each plan participant (“self-directed plans”). 144 in the latter case, the plan generally offers the participant an array of available mutual funds and other investment opportunities, which are initially chosen by a plan fiduciary. in both types of plans, the employer, or rather the fiduciary selected by the employer, serves in an agency relationship to the plan participants and presumably in most cases is more competent than the participants in managing funds or selecting investment options. moreover, plans, which sometimes have substantial assets to invest, can bargain for investment options that might not otherwise be available to moderateand lower-income individuals. for example, some mutual funds require investors to make a substantial minimum investment that is beyond the means of many individuals. pooled funds, of course, have access to such investments and also to venture capital and real estate opportunities that may not be available to small individual investors, who in any event may not be capable of evaluating them in a sophisticated manner. even self-directed account funds sometimes offer investment funds that would not be available to small investors outside plans. in the rsa/lsa formats, employees would not benefit from the agency of plan fiduciaries or plan bargaining power and would thus lose access to some types of investments, which would undermine their ability to optimize portfolio diversification (and if you believe in such things, the opportunity to invest in assets that offer better risk/return ratios than typical mutual funds). 2. fiduciary protections erisa imposes fiduciary obligations on people who choose how to invest plan funds and/or choose investment options for participants in plans where participants direct investment choices. 145 the obligations include 144. see, erisa § 404(c), 29 u.s.c. § 1004(c). 145. see, pension plan administration: participant-directed accounts, bureau of national affairs. available on westlaw at bna-cbg 221460. (last visited jul. 10, 2007). 2008] slouching towards a consumption tax 151 prudence and loyalty, 146 which require care in selecting, and in monitoring, plan investments. 147 these obligations should in theory, and generally will in practice, discourage plan fiduciaries from investing plan resources in investments that carry uncompensated risk and/or that unnecessarily compromise portfolio diversity. in contrast to qualified plans, rsas and lsas will remove the agency of the employer-designated fiduciaries. individuals, who sometimes will not have extensive training or experience in investment management, will be saddled with the responsibility of investment management, including selecting appropriate investments, monitoring portfolio performance, and periodically adjusting asset allocations. such individuals might lack the sophistication necessary to replicate the professional investment management provided by or through plan fiduciaries. one can respond to this criticism, by noting that participants in selfdirected qualified plans are currently required to choose among investment options. but at least in such plans the investment options themselves are selected by plan fiduciaries. moreover, some observers of qualified plans have suggested that erisa’s encouragement, if not mere tolerance, for participant-directed plans, has been a mistake and should be eliminated or at least reduced. 148 the rsas and lsas move in the opposite direction. 3. education employers sometimes provide investment education to employees participating in self-directed plans. 149 it is not clear that vendors of investment products will provide similar education or advice, and if they do, there is at least some risk that the education may reflect the vendor’s own pecuniary interests. 150 146. erisa § 404(a), 29 u.s.c. § 1004(a). 147. see, pension plan administration: participant-directed accounts, supra note 145. 148. see, susan j. stabile, freedom to choose unwisely: congress’ misguided decision to leave 401(k) plan participants to their own devices, 11 cornell j. l. & pub. pol’y 361 (2002). 149. see, pension plan administration: participant-directed accounts, supra note 143. 150. the pension protection act of 2006 added a prohibited transaction exemption for provision of investment advice by financial firms with potential conflicts of interest in rendering the advice, although the exemption does include some safeguards against abuse. see, erisa § 408(b)(14). 152 florida tax review [vol. 9:2 4. costs plans are able to spread fixed costs among all participants and will also generally be in a better position than individuals to negotiate low costs from fund vendors and service providers. 151 5. effect of the proposed income exclusion of stock dividends on investment returns the white house proposal to eliminate tax on stock dividends should, according to conventional economic analysis, provide a one-time (arguably windfall) gain to holders of stock and should, over time, increase before-tax yields on taxable investment assets (such as productive real estate holdings and debt instruments). 152 however, because there will continue to be some tax-exempt investors who purchase some stock, the discount on stock yields will probably not completely reflect the tax advantage that stock would enjoy. a rational affluent investor, in reaction to the bush savings proposals, could be expected to move qualified stock holdings outside taxsheltered funding vehicles (such as qualified plans and rsa/lsas) and to use tax-sheltered vehicles to hold investments that would otherwise be taxable. by doing so, such an investor could maintain a well-diversified portfolio while maximizing after-tax returns investors of moderate means, however, might not be able to achieve such results. first, they might not have the same access as affluent investors to the full range of taxable investments. second, a moderate-income investor might find it difficult to maintain a diversified portfolio without substantial investment in stock, whose return can be expected to be burdened with a new implicit tax reflecting the exclusion of dividends from the income tax base outside the plan. the effect would be to reduce rates of return on new savings by at least some moderateincome individuals, either because of reduced return on stock investments or reduced portfolio diversification. an interesting result of the exemption of dividends from tax would be that participants in qualified plans would be the only individuals who would effectively pay tax on dividends, since they would pay tax on plan distributions 151. the employer has a fiduciary duty to negotiate for reasonable fees and acceptable service levels from investment vendors. department of labor, employee benefit security administration, understanding retirement plan fees and expenses, available at http://www.dol.gov/ebsa/publications/undrstndgrtrmnt.html. (last visited jun. 30, 2007). 152. see, supra note 109. 2008] slouching towards a consumption tax 153 d. budget and tax considerations the bush savings initiatives will have budgetary and tax implications, implications that may make it more difficult for a future government to address social issues, including issues of old-age poverty, which i suggest in this article would be exacerbated by the bush savings proposals. the joint committee on taxation estimated that the full dividend exclusion proposed in the 2003 budget proposal would cost $235 billion revenue over the ten years following its enactment. 153 the rsa/lsa was expected, in the short term, to raise revenue during its first five years and thereafter to lose revenue. 154 the proposal, then, would increase annual budget deficits as far as the eye can see, or at least as far as the joint committee estimates extend; 155 the increased national debt would burden national fiscal policy in the future. as i argued in earlier sections of this paper, the beneficiaries of the revenue shortfalls would generally be the relatively affluent individuals who are most likely to use the bush savings proposals. the scoring of the joint committee assumes static tax rates. if debt repayment becomes an increasingly large part of the budget, which is certainly a possibility, it may become necessary to increase tax rates to pay for governmental programs, including programs to deal with old-age income insecurity. the bush proposals, however, will have constricted the tax base by eliminating a shareholder level tax on corporate income and by exempting from tax returns on investments held by rsas and lsas, meaning that the increases in tax rates on income remaining in the tax base (primarily wages) will be steeper than they would have to be if the tax base were broader. moreover, since distributions from qualified plans would be included in the tax base, retirees would share in the increased tax burden to the extent that their retirement income is generated by qualified plans but not to the extent it is derived from rsas or lsas, or through investments in stock. this may be disturbing to people concerned with either horizontal or vertical equity, the latter because the more affluent are more likely than the less affluent to derive substantial retirement income outside qualified plans; the former, because of the disparate treatment of different sources of investment income. 153. joint committee on taxation, united states congress, description of revenue provisions contained in the president’s fiscal 2004 budget proposal 123, jcs-7-03 (mar. 2003). 154. id. see, generally karen c. burke and grayson m. p. mccouch, lipstick, light beer, and back-loaded savings accounts, 25 va. tax rev. 1101, 1123 (2006) for a discussion of the revenue effects of the savings account proposals. 155. id. 154 florida tax review [vol. 9:2 it would of course be possible for a future congress to subject the bush savings accounts and stock dividends to some level of tax, but this may prove politically difficult. individuals who invested in such accounts would be able to contend that by choosing to contribute to such accounts with before-tax dollars, they had entered into a contractual-type agreement permanently entitling them to a tax exclusion for any investment income produced by such accounts. this may well be a compelling political argument. 156 moving to reintroduce a second-level tax on corporate earnings may also prove difficult in the future, both on political and policy grounds. politically, corporations and shareholders could be expected to oppose a reintroduction of a shareholder-level tax. moreover, as a matter of first principles, a single-level tax on business income has unambiguous economic advantage, including roughly equivalent tax treatment of debt and equity investments in corporations, and of corporations and other forms of business, and these advantages would make it difficult, and perhaps unwise, to revert to a double tax on corporate income. 157 reintroducing a second level of tax on corporate income would almost certainly depress the value of such stock at a time when older individuals might be selling such stock to provide retirement income. the tax on corporate income could also be increased directly, by increasing corporate tax rates. but there are practical limits on how high a direct tax on corporate income can be without creating strong tax-avoidance incentives and without disadvantaging domestic enterprises in the competition for capital. moreover, as would be the case with reintroducing a shareholder level tax, increasing corporate rates in the future could depress stock values with an adverse effect on retirees. to recap, the bush savings proposals would be expensive, would benefit relatively affluent individuals who can be expected to save for retirement without governmental incentives, and to the extent we later have to pay for revenue costs, might be disproportionately paid for by individuals who would not, as a group, have derived much advantage from the proposals and indeed may have seen their own retirement savings diminished because of them. there is one further troublesome aspect of the proposals that might become manifest in the future: the possibility that heirs of affluent individuals will be able to entirely escape income tax while supporting 156. but see, e.g., daniel shaviro, when rules change: an economic and political analysis of transition relief and retroactivity (university of chicago press, 2000). 157. see, council of economic advisers eliminating the double tax on corporate income, jan. 7, 2003 available at http://www.treas.gov/press/releases/ docs/exclusion.pdf. (last visited jun. 30, 2007). 2008] slouching towards a consumption tax 155 themselves on income from investments. let me illustrate with an extreme example. assume, for example, a couple whose first and only child is born in the year that congress gives birth to the bush proposals. the couple, who have substantial wage income, establish and make maximum annual contributions to rsas and lsas for themselves and an lsa for their child. their savings outside of the plan are invested entirely in long-term stock holdings. if we assume a 6% return on investments, at age 30 the child’s lsa will have accumulated $800,000. assume also at this point that the child begins living on his investment income, which is now $64,000. (this could, of course, be supplemented by additional tax-free income from stock transferred to him by his parents and imputed income from a home.) assume that when the child is 50, his parents die, leaving him the beneficiary of the lsas and rsas. at this point, each of the four accounts will have accumulated $2.3 million, for a total of $9.2 million. the rsa will have to be distributed eventually, but the proceeds, which will be distributed free of tax, can be invested in stock. (again, the total of assets generating tax-free income can be increased by bequeathing the child stock.) in any event, the child, and future generations, could enjoy substantial annual income without ever paying income tax (with capital gains avoided by not disposing of the stock). 158 note that with respect to future generations, this is not exclusively a consumption tax regime; it is a tax on wage income and some but not all business income. non-corporate business income passed through to an rsa or lsa will also receive a permanent exemption from income tax. the regressivity of such a tax system would, to my mind, be hard to justify, even if some affluent individuals continue to receive some wage income. moreover, to ensure a meaningful tax on business income, there would have to be a thorough house cleaning of the corporate income tax, focusing on the aggressive tax planning that minimizes the corporate tax and deliberate preferences whose rationales are weaker in a single-level tax corporate tax system. v. wealth accumulation v. retirement income security the bush administration’s savings proposals reflect two broad and casually related themes: income verses consumption/wage tax base, and social insurance verses wealth creation. 158. it should, of course, be observed that corporate income would be taxed and thus anyone deriving dividend income or capital gain from corporate investments would be subject to an implicit tax. nevertheless, to many wage earners, it may appear that such individuals are escaping all tax liability. 156 florida tax review [vol. 9:2 the first theme is the tax theme of what our nation should settle on as the appropriate tax base. the bush proposals endorse further movement from our current mixed income/consumption tax base toward a purer consumption/wage base model. proponents of a consumption base model argue that unlike an income tax, a consumption base is neutral with respect to lifetime consumption patterns (by not penalizing savings) and thus a fairer tax base. 159 they also argue that an income tax depresses aggregate national savings, and therefore that moving to a consumption tax base will increase our nation’s anemic savings rate. 160 while i favor an income tax over a consumption tax base because i believe that the former is more adaptable to the equitable tax norm that taxes should be apportioned on relative abilities to pay, the preference for one base over another ultimately is a reflection of a proponent’s economic ideas and perhaps ethical values. there is, so far as i can tell, no mediating criteria of truth to resolve the debate over the preferred tax base. 161 but any movement toward a consumption base, in my view, should be conditioned on a national debate of the relative merits of competing bases. the bush proposals, however, do not squarely join this issue, but advocate the proposals simply as a means to help taxpayers save for retirement and other long-term purposes (such as education or saving for a house or a medical emergency). 162 in this sense, the bush proposals are a stalking horse for a move toward a consumption/wage tax, or perhaps more accurately a trojan horse, disguised as a way to help taxpayers to save for retirement rather than as an event signaling a dramatic shift in tax base. moreover, the bush proposals would nudge us only part way toward a consumption tax. as professors karen burke and grayson mccouch have noted, the savings proposals are based on a yield-exempt rather than cash 159. see, notes 87 and 88; see, also, daniel n. shaviro, replacing the income tax with a progressive consumption tax, 103 tax notes 91 (apr. 5, 2004). 160. id. 161. moreover, a number of scholars have argued that a consumption tax with multiple tax rates can have the same degree of progressivity as an income tax, particularly an income tax that defers gain on property until realization. see, e.g., daniel n. shaviro, replacing the income tax with a progressive consumption tax, 103 tax notes 91 (apr. 5, 2004). 162. pamela olsen, assistant secretary of the treasury for tax policy, said of the rsa: the savings options proposed today will give all americans the opportunity and flexibility they need to save for their retirement security and other needs.” department of treasury press release, “ the president’s savings proposals: tax-free savings and retirement security opportunities for all americans,” (feb. 2, 2004), available at http://www.treas.gov/press/releases/js1131.htm. (last visited jun. 30, 2007). 2008] slouching towards a consumption tax 157 flow consumption tax model and fail to address the issue of debt within such a model. 163 how to ensure retirement income for those who will not voluntarily save is itself a difficult issue in designing a consumption tax. in our income tax system, we do two things to encourage such savings: first, we privilege qualified-plan retirement savings over immediate consumption and other types of savings by deferring tax (or carving out a consumption tax niche for retirement savings); second, through the nondiscrimination rules, we employ more coercive measures to force many employers to provide retirement plan coverge for individuals for whom we suspect tax incentives alone would be inadequate to cause them to save adequately for retirement. in a consumption tax regime, all savings are equally privileged and business owners and managers will thus lack tax incentives to have their firms sponsor retirement plans that will provide retirement income for reluctant savers. (this latter point is, of course, a large part of my critique of the bush savings proposals.) it is possible, of course, for a society deriving revenue primarily from a consumption tax base to design policies that will address the issue of myopic retirement savings patterns. 164 a universal and adequate system of social insurance is one approach. other approaches might provide cash or other incentives to employers to establish retirement plans or require all wage earners to save a percentage of their compensation in an individual account to which appropriate fiduciary protections would attach. we might also consider government matching or direct contributions or loans to low and moderate income individuals to save for retirement and/or establishing pre-commitment devices to improve the savings behavior of such individuals. 165 we might also, as a nation, make a greater investment in financial literacy education. the bush proposals, however, do not propose expanding our social security program to reflect retirement-income losses that the proposed movement to a consumption tax might cause. nor do the proposals incorporate incentives and/or mechanisms that might result in retirement savings by otherwise reluctant savers. this should not, of course, be unexpected because the bush administration packaged the rsa and lsa not as a step toward a consumption tax that might diminish the retirement security of low and moderate wage earners but as a self-contained means of increasing savings, including retirement savings, for all americans. 163. karen c. burke and grayson m. p. mccouch, lipstick, light beer, and back-loaded savings accounts, 25 va. tax rev. 1101, 1136 et. seq. (2006)(excellent discussion of these and other issues). 164. see, generally, dallas l. salisbury (ed), tax reform/implications for economic security and employee benefits (employee benefit research institute 1997). 165. id. 158 florida tax review [vol. 9:2 the second broad theme of the bush proposals is the emphasis on individual wealth creation in contrast to a social contract in which wage earners are assured adequate income security in retirement. this preference for individual wealth creation verses social contract is more manifest in the proposals by the bush administration, and others, to convert, at least partly, the social security system from a defined benefit plan to a defined contribution plan. but the private pension system, which the bush proposals would weaken, also exhibits important social-insurance elements. in private-sector defined benefit plans, for example, benefits historically if not still customarily are distributed in annuity form, thus socializing the mortality risk among the employee group and limiting the extent to which benefits can be converted from retirement income to unrestricted and freely transferable wealth. defined benefit plans also limit the extent to which employees are subject to investment risk, both by the employer’s assumption of that risk and by mandatory benefit insurance through the pension benefit guaranty corporation. all plans limit the ability of employees to use resources prior to retirement, and minimum distribution rules moderate the use of plan tax deferral to build tax-advantaged estates (thus helping channel tax benefits to the production of retirement income). finally, and most important, the nondiscrimination rules ensure that at least some of the tax benefits that plans enjoy are used to create retirement income for moderate income wage earners. i do not argue that the private pension system is primarily a system of social insurance, only that it has some elements of such a system. indeed, with the strong movement toward defined contribution plans, and within that trend toward 401(k) plans in particular, the private pension system also reflects themes of individual responsibility and wealth creation. 166 the private pension system, then, is probably best understood as a hybrid system combining ideas of collective and individual responsibility, and the creation of retirement income and of wealth generally. bush’s proposals would nudge, or perhaps shove, the system’s emphasis further toward individual responsibility and creation of wealth. whether this is a good thing or a bad thing is open to debate, and like the debate about the proper tax base, has no correct answer, although few readers of this article will mistake on which side of the debate my own allegiance lies. what i do not think is fairly debatable is that as we move toward individual responsibility and wealth creation, we move further from the ideal of universal retirement income security. the white house, however, pretends otherwise, justifying its proposals as a means for increasing 166. see, colleen e. medill, the individual responsibility model of retirement plans today: conforming erisa policy to reality, 49 emory l. j. 1 (2000). 2008] slouching towards a consumption tax 159 retirement savings among all americans, including those with low and moderate income. if adopted, it would be a national catastrophe for some such individuals as they enter retirement unless we simultaneously adopt new approaches to help them save for retirement. vi. the ersa and national retirement policy our current retirement system is famously, and inaccurately, likened to a three-legged stool. 167 the stool’s purported legs are social security, employer pensions, and private savings. the stool, such as it is, is not sturdy. many americans accumulate little in the way of private savings, and fewer than half of americans in the private work force will receive benefits, and a much smaller percentage meaningful benefits, from employer-sponsored retirement plans. thus, for many americans the more accurate metaphor might be a pair of stilts or a pogo stick. and social security does not provide sufficient income to permit a retiree to live above the poverty level without some other sources of income. this suggests that our national retirement policy, such as it is, is not much of a policy for many working americans. there are three approaches to improve national retirement policy. one approach would consciously move us toward a more comprehensive system of social insurance, either by a direct expansion of the social security program or through a mandate for employers to adopt retirement plans satisfying certain criteria (or a mandate for employees to put aside a percentage of their income for retirement). the idea of a mandated employer system found little political traction in years past and might not find much more today. 168 a second approach is that implicitly advocated by the bush white house in its personal savings proposals: treating the decision to save for retirement as an individual decision for each american, although using tax incentives to nudge tax-sensitive americans to greater savings. for the reasons suggested in this paper, i have doubts about the efficacy of this approach. i am, however, optimistic that this approach faces political obstacles as formidable as those facing the more universal system that i prefer. this leaves a third approach: improving rather than supplanting the existing voluntary employer-based retirement system. since the system is voluntary, it is unlikely that changes to the system can ever result in universal coverage. it is a flawed system and, given that it is based on the voluntary adoption of plans by employers and that employers will generally not want to contribute much to such a system on behalf of workers who 167. munnell, supra note 33, at 2. 168. dana a. muir, from yuppies to guppies: unfunded mandates and benefit plan regulation, 34 ga. l. rev. 195 (1999). 160 florida tax review [vol. 9:2 would prefer cash compensation, it will almost certainly always remain a flawed system. but the system can be improved, and the bush ersa proposal is right in approach even if wrong in some of its details. as this paper earlier described, the ersa attempts to simplify the regulatory regime governing defined contribution plans by jettisoning several inordinately complex internal revenue code provisions that, on the one hand, permit employers to design plans to limit coverage and benefits for lower-income employees and, on the other hand, require some plans that are excessively weighted toward key employees to provide at least minimum benefits to other employees. the 2003 ersa would have been subject to a single set of relatively simple nondiscrimination rules. in effect, the proposed ersa rules identify a comparative level of benefit for rank-and-file employees that is adequate to justify the tax expenditure for the highly compensated and then creates a simple nondiscrimination test that assures that comparative benefit level while minimizing the employer’s design and compliance costs. the department of treasury put it thus: the ersa “simplifies qualification requirements while maintaining their intent of providing broad-based coverage of employees. by reducing unnecessary complexity, the proposal significantly reduces employer compliance costs.” 169 the ersa proposal has, from my perspective, three shortcomings. the first, and obvious, shortcoming is that the ersa proposal is joined to the bush personal account proposals, which this paper has already argued will dampen employer appetite for sponsorship of plans. the proposals, however, are severable. the second problem is that the proposed nondiscrimination rules do not demand sufficient benefits for rank-and-file employees. the nondiscrimination tests are modeled after the rules for section 401(k) plans, and like 401(k) plans allow employers to design their plan either to satisfy a safe harbor or to tie the rate of deferral of highly compensated employees to a multiple of the average deferral rate of other employees. both the safe harbor and the annual deferral-comparison test are less demanding than the tests under current law for section 401(k) plans. presumably the argument for the less restrictive tests is the elimination of rules under current law that accommodate employers who wish to weight plan benefits aggressively toward higher-paid employees. consider first the safe harbor test. to come within a safe harbor, a plan would either have to make nonelective contributions equal to 3% of 169. department of treasury press release, “the president’s savings proposals: tax-free savings and retirement security opportunities for all americans,” (feb. 2, 2004), at http://www.treas.gov/press/releases/js1131.htm. (last visited jun. 30, 2007). 2008] slouching towards a consumption tax 161 compensation or to offer matching contributions of 50% of compensation on the first 6% of pay. 170 given that the maximum matching contribution for an employee would be 3% (50% of 6% of compensation), it is difficult to see why an employer not predisposed to generosity to employees would choose the non-elective deferral approach. in 401(k) plans the safe harbor match for employees contributing 6% of compensation would be 4.5%. 171 thus, most employers would presumably choose the matching safe harbor. there are three problems with a matching safe harbor. first, the employer has no incentive to encourage employees to contribute to the plan since the employer’s cost is increased by such contributions. second, a 50% match on the first dollar contributed may not be high enough to stimulate high rank-and-file contribution rates. in 401(k) plans, the safe harbor requires a 100% match on the first 3% of compensation deferred, and 50% of the next 3% of compensation. 172 third, no matter how high the match, some employees will not elect to defer and thus will not earn retirement benefits. if an employer elects not to use a safe harbor, the deferral rate for highly compensated employees can equal up to twice the deferral rate for other employees, although there is no limit on the former if the deferral rate for the latter is 6% or greater. a problem with this system is that it looks to average deferral rates, so just as with the safe harbors, not all employees will have to save for retirement in order for the plan to satisfy the nondiscrimination rules. moreover, a high deferral rate can be achieved despite low participation rates by making large non-elective contributions on behalf of the lowest paid employees, which is an inexpensive way of raising the average deferral rate for the non-highly compensated group. 173 a more effective, simplified nondiscrimination test might involve a reverse match. under this approach, the employer would make an initial contribution for all participants and highly compensated employees’ elective deferrals would be limited to a statutory multiple of the initial contribution rate the employer made. 174 for example, if congress set the multiple at three and the employer made 3% contributions, all employees, including highly compensated employees, would be permitted to defer an additional 9% of their compensation. this approach avoids complicated annual testing and has 170. general explanation, supra note 2, at 126. 171. irc § 401(k)(12). 172. id. 173. the department of treasury and the irs promulgated treas. reg. 1.401(k)-2, which places limits on but does not eliminate this strategy. see, retirement plans; cash or deferred arrangements under § 401(k) and matching contributions or employee contributions under § 401(m) regulations, 69 fed. reg. 78144 (dec, 29, 2004). 174. orszag and stein, supra note 114, at 669-74 (proposing reverse match nondiscrimination rule). 162 florida tax review [vol. 9:2 the important advantage over a “matching” safe harbor of ensuring that all participants are allocated an initial contribution. it also ties the amount that highly paid employees can defer to the amount being deferred for rank-andfile employees. the third shortcoming of the bush proposals is that they do not attempt to coordinate the proposed rules for defined contribution plans with equivalent rules for defined benefit plans. in some sense, this may be appropriate, since defined benefit plans are today in decline, and providing employers who sponsor them with design flexibility may increase their attractiveness if design flexibility is limited in defined contribution plans. but there is a danger that small firms will adopt aggressive defined benefit plans that will provide little in the way of benefit for lower-paid workers. vii. conclusion this article argues that the bush personal savings proposals – the creation of tax-advantaged personal savings accounts and the exclusion of corporate income from shareholder level tax – will have negative effects on the retirement income security of many americans of moderate means. the article suggests that such savings accounts would reduce the number of employer plans, reduce benefit levels for employees in those plans that remain, provide no alternative means for savings that will be attractive to adversely effected workers, and reduce the rate of investment return for nonaffluent individuals. the proposals would also impose significant revenue cost and might partly immunize the affluent beneficiaries of the proposals from tax increases that might be needed in the future to retire the national debt that would result from the revenue losses. like a policy bad nickel, these ill-advised concepts keep turning up in proposals from the white house, from members of congress, and from the president’s advisory panel on federal tax reform. in contrast, the ersa, if isolated from the personal savings accounts and dividend exclusions, provides a helpful first step toward making useful adjustments to the current system. through an ersa-like approach, we can both reduce expensive compliance burdens and ensure that a reasonable share of the qualified plan subsidy provides meaningful levels of benefits to employees of moderate and low income. of course, such a modification to the system would not result in either universal coverage or benefit adequacy, which can only be achieved through an expanded social insurance system (or some form of mandated savings). but it would do at least some good and no or little harm. 2008] slouching towards a consumption tax 163 florida tax review volume 5 2002 number 8 it does not compute: copyright restriction on tax deduction for developer’s donation of software william a. drennan* i. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 ii. types of intellectual property and methods of transfer.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552 a. patents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553 b. trade secrets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 554 c. trademarks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556 d. copyrights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559 e. computer software – over-lapping ip protection.. . . . 561 1. trade secret protection. . . . . . . . . . . . . . . . . . . 562 2. copyright protection. . . . . . . . . . . . . . . . . . . . . 562 3. patent protection. . . . . . . . . . . . . . . . . . . . . . . . 564 f. other examples of over-lapping ip protection. . . . . . . 564 1. designs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564 2. characters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 565 iii. no tax consequences to charity from assignment or licensing of ip. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566 a. patents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568 b. trademarks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568 c. copyrights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 569 iv. restrictions on claiming a charitable contribution deduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570 a. itemized deduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570 b. 3% and 80% restrictions. . . . . . . . . . . . . . . . . . . . . . . . . 570 c. 50%, 30% and 20% limitations.. . . . . . . . . . . . . . . . . . . 572 d. reduction of charitable deduction for any gain that would be taxed as ordinary income. . . . . . . . . . . . . . . . . . . . . 573 e. reduction of charitable deduction for gain that would be taxed as long-term capital gain on a donation of tangible personal property for an “unrelated use”. . . . . . . . . . 573 f. the partial interest rule. . . . . . . . . . . . . . . . . . . . . . . . . 574 * adjunct professor, washington university school of law in st. louis, missouri 1996-2000, member of the american law institute and the law firm of husch & eppenberger, llc, st. louis, missouri (1985–present); j.d. st. louis university (1985); ll.m. in taxation, washington university (1997); candidate, ll.m. in intellectual property, washington university (2003). 547 548 florida tax review [vol.5:8 v. charitable gifts of ip under current law . . . . . . . . . . 575 a. patents and charitable giving. . . . . . . . . . . . . . . . . . . . 575 1. availability of a full fair market value deduction on the donation of a patent. . . . . . . 575 2. patents and the partial interest rule. . . . . . . . . 576 3. donation of a patent compared to a donation of services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 577 4. potential pitfalls for the donor of a patent. . . . 578 5. the “related use” restriction does not apply. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580 b. trade secrets and charitable giving. . . . . . . . . . . . . . . 581 1. trade secret protection compared to patent protection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 581 2. availability of a full fair market value deduction on the donation of a trade secret.. . . . . . . . . . . . . 582 a. property. . . . . . . . . . . . . . . . . . . . . . . . . 583 b. sale or exchange. . . . . . . . . . . . . . . . . . 586 c. capital asset. . . . . . . . . . . . . . . . . . . . . 588 d. held more than one year. . . . . . . . . . 588 3. the “related use” restriction does not apply. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 589 c. trademarks and charitable giving.. . . . . . . . . . . . . . . . 589 d. copyrights and charitable giving. . . . . . . . . . . . . . . . . 591 1. no full fair market value deduction for the creator’s donation of a copyright. . . . . . . . . . 592 2. the broad reach of the copyright restriction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 594 3. the policies for restricting the amount of the charitable deduction for a donation of a copyright. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 594 a. the revenue act of 1950. . . . . . . . . . . . 594 b. the tax reform act of 1969. . . . . . . . . 597 vi. the charitable deduction for a donation of computer s o f t w a r e e l i g i b l e f o r o v e r l a p p i n g ip protection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599 a. t h e l e v y c a s e a n d r e g u l a t i o n s section 1.1221-1(c)(1). . . . . . . . . . . . . . . . . . . . . . . . . . . 600 b. potential challenges to levy. . . . . . . . . . . . . . . . . . . . . 602 1. construction of regulations section 1.1221-1(c)(1) so that the “patent or invention” clause has meaning. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602 2. regulation was not drafted with software in mind. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603 2002] it does not compute 549 3. levy does not discuss patent protection. . . . . 604 4. conflict with the patent rule. . . . . . . . . . . . . . . 604 5. the most valuable elements of computer software may not be eligible for copyright protection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604 6. the policy for reducing the charitable deduction does not apply to useful business creations such as computer software. . . . . . . . . . . . . . . . . . . . . . . 605 c. considerations for the developer planning a donation of computer software under current law. . . . . . . . . . . . . 606 vii. proposals for excluding computer software eligible for pa t e n t pr o t e c t i o n f r o m t h e ol d co p y r i g h t restriction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608 a. proposal for an irs administrative announcement. . . . 608 b. the artist-museum partnership bill. . . . . . . . . . . . . . . . 608 1. the current bill. . . . . . . . . . . . . . . . . . . . . . . . . 609 2. proposed revision to the bill to address computer software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614 appendix a. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615 appendix b. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617 550 florida tax review [vol.5:8 i. introduction great amounts of wealth can be represented by intellectual property (“ip”), including computer software. computer software creators, and other inventors, artists and authors, may desire to enthusiastically support their favorite charitable endeavors. the tax consequences for the creative genius donating his or her ip to charity will depend on whether his or her creation is protected by patent, trade secret or trademark on the one hand, or copyright on the other. in general, the donor of a patent, trade secret or trademark enjoys favorable tax treatment – he or she is entitled to claim an income tax deduction for the full fair market value of the ip donated. in contrast, as a result of the tax reform act of 1969, the donor of a copyright is not allowed to claim a full fair market value deduction – instead, he or she may claim a deduction only for his or her cost basis in the copyright (which may be very small, or nothing). the following example demonstrates the different income tax results possible. example #1: leonardo da vino is a multi-talented genius who has written a sensational book titled “people will be talking about me for centuries,” which has the literary world abuzz. the book cost leo $800 to prepare, and all rights (including1 the copyright) to the book would sell for $10 million. in addition, leo is also a man of science and has developed new technology that could revolutionize the wine-making industry. all rights to his invention (including the related patent) would sell for $10 million. if leo donates all rights to his new “vino” technology to his favorite church (which will assign all rights in the technology to a commercial firm for $10 million and use the cash to build shelters for the homeless), leo can be entitled to a charitable income tax deduction of $10 million. in2 1. leo’s costs consisted of paper, pencils, and a small amount of depreciation for his computer equipment. as one commentator has noted, “the ratio of cost to market value for creative compositions of any significant market value is very small.” note, tax treatment of artists’ charitable contributions, 89 yale l. j. 144, 148 (1979). for a painter, the greatest cost is often the frame – as a result, the artist would receive a similar charitable income tax deduction whether he or she contributes an empty frame or a framed valuable picture. id. for an author, the charitable deduction may be limited to the cost of pencils and paper. id. (estimating the cost of a 5,000 page herman wouk manuscript at $30 to $40). 2. leo’s ability to claim the deduction may be limited by the 3%/80% restriction of irc § 68(a) (which is discussed in the text accompanying infra notes 132134), and the 30% of adjusted gross income limitation of irc § 170(b)(1)(c)(i) (which is discussed in infra notes 135-140 and accompanying text). charitable deductions that cannot be claimed because of the 30% limitation can be carried forward for up to 5 2002] it does not compute 551 contrast, if leo donates all rights to the book to his favorite church (which will sell all the rights relating to the book for $10 million and establish homeless shelters), leo will be entitled to a charitable income tax deduction of only $800. computer software can be eligible for several different types of ip protection. initially, computer software was protected by trade secret laws. gradually, software was considered a literary work eligible for copyright protection (in 1980 the copyright act was amended to include specific references to computer software). now certain features of software may be eligible for patent protection. as a result, software may be eligible for protection under trade secret law, copyright, and/or patent law. there are no reported cases or rulings considering a charitable contribution by an individual amateur software developer. one case addresses3 a similar issue, and unfortunately concludes that since computer software is “eligible” for copyright protection, the copyright rule should apply, resulting in adverse tax consequences for the software developer. this approach fails to4 recognize that software may also be eligible for patent protection, and further ignores rules and policies which have traditionally provided favorable tax consequences to donors who contribute patent rights to charity. the situation involving software eligible for “over-lapping” ip protection (such as copyright and patent protection) is illustrated by the following example: example #2: as a result of intensive study of the wildlife around the padre island area for many years, world famous marine biologist texas hank has developed new software called “be where they’re biting.” this software will revolutionize the commercial fishing industry. the user will enter certain information regarding weather conditions, air and water temperatures, and geographic conditions, and choose the type(s) of fish desired, and “be where they’re biting” will provide reliable projections on where and when the fish will be biting and preferred fishing techniques. the software will not only reduce costs for the commercial firms, but will also reduce environmental and ecological damage that results from years. id. irc § 170(b)(1)(c)(ii). unless otherwise indicated, all statutory references in the text of this article refer to the internal revenue code of 1986, as amended. 3. the word “amateur” refers to a developer who does not hold computer software as inventory for sale to customers in the ordinary course of his or her trade or business. see irc § 1221(a)(1). 4. levy v. commissioner, 64 t.c. memo (cch) 534, t.c. memo (ria) ¶ 92,471 (1992). 552 florida tax review [vol.5:8 catching and then discarding unwanted fish. texas hank spent $10,000 developing the software and could sell the software (and all related rights) to a commercial firm for $100 million, but he would prefer to donate the software (and all related rights) to his favorite religious denomination which would sell the software (and all related rights) for $100 million and use the money to help the poor. the literary elements of the software (the object code, the source code, and the manuals) would be eligible for copyright protection, and other features of the software (the process and method for assembling and analyzing the data and reaching the conclusions) would be eligible for trade secret or patent protection. as discussed in this article, a tax court case indicates that since the software5 would be eligible for copyright protection, texas hank would be entitled to claim a charitable deduction of only $10,000 (the amount of his cost in developing the software) upon a charitable donation of the software. for the reasons discussed in this article, the author believes that texas hank should be entitled to a charitable income tax deduction for the full fair market value of the software ($100 million) upon a charitable donation of the software. this article will consider: (i) the various types of intellectual property rights and the methods for transferring those property rights to charity; (ii) the tax consequences to a charity exploiting those rights; (iii) the various restrictions that apply when claiming an income tax charitable deduction; (iv) the application of the current income tax rules to charitable gifts of patents, trade secrets, trademarks and copyrights in general; (v) the tax treatment of an amateur software developer’s donation of computer software to charity under current law and the proper tax treatment of such donations; and (vi) proposals to change the current rules so that an amateur software developer would be able to claim an income tax deduction for the full fair market value of donated software when the software is eligible for patent protection. ii. types of intellectual property and methods of transfer this section will describe four types of intellectual property rights (patent, trade secret, trademark and copyright) and the methods for donating6 5. id. 6. while other types of intellectual property, such as rights of publicity, may raise interesting issues for the owner who desires to donate those rights to charity, we will save those issues for another day. 2002] it does not compute 553 such rights to charity. this section will then discuss certain creations (namely, computer software, designs, and characters) which are eligible for more than one type of ip protection. a. patents patent protection is authorized by article i, section 8, clause 8 of the u.s. constitution, which gives congress the power “[t]o promote the progress of science and useful arts, by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries,” and is governed by federal law. the subject matter that may qualify for a “utility patent” is a “process, machine, manufacture, or composition of matter, or any new and useful improvement thereof,” meeting certain conditions. the subject matter7 that may qualify for patent protection is broad – the congressional committee report accompanying the 1952 patent act “inform[s] us that congress intended statutory subject matter to ‘include anything under the sun that is made by man.’”8 an invention must meet three major requirements to be eligible for a utility patent. an invention must: (i) have utility; (ii) be novel; and (iii) be9 10 non-obvious. “utility” requires that the knowledge or ideas be reduced to a11 useful product or process. “novelty” means that the invention must be new12 and different from what was previously known or used. “non-obvious” requires that it must be more than an obvious variation from what was previously known (with reference to a person of ordinary skill in the field of the invention). in addition to utility patents, there are also design patents and plant13 patents. design patents can protect the aesthetic appearance of a product.14 7. 35 u.s.c. § 101. 8. see diamond v. chakrabarty, 447 u.s. 303, 309 (1980) (quoting s. rep. no. 1979, 82d cong., 2d sess., 5 (1952), reprinted in 1952 u.s.c.c.a.n. 2394, and h.r. rep. no. 1923, 82d cong., 2d sess., 6 (1952)). 9. 35 u.s.c. § 101 (the subject matter must be “useful”). 10. id. § 102 (“a person shall be entitled to a patent unless – (a) the invention was known or used by others in this country, or patented or described in a printed publication in this or a foreign country, before the invention thereof by the applicant for patent . . . .”). 11. id. § 103 (whether the invention is “obvious” is judged from the perspective of a “person having ordinary skill in the art to which said subject matter pertains.”). 12. see brenner v. manson, 383 u.s. 519, 534 (1966) (“the basic quid pro quo contemplated by the constitution and the congress for granting a patent monopoly is the benefit derived by the public from an invention with substantial utility.”). 13. 35 u.s.c. § 171. 14. id. § 161. 554 florida tax review [vol.5:8 the term of a u.s. utility patent begins on the date the patent is issued and ends 20 years from the date the patent application is filed. a design patent15 has a term of 14 years from the date of grant. a patent allows the owner to16 prevent others from using, making, offering to sell or selling the invention during the patent term, either through an action for injunctive relief or money damages. the patent holder can even prevent someone who later17 independently discovers the invention from making, using, offering to sell, or selling the invention during the term of the patent. when a patent is issued, the patent application is made public. in addition, a patent application will be made public 18 months after it is filed if the patent has not been issued by that time. a patent provides the inventor18 (and/or his or her licensee or assignee) with a limited monopoly during the term of the patent. when the patent expires, the invention may be produced and used by anyone because it has been publicly disclosed and the term of patent protection has ended. patents have the attributes of personal property and may be assigned19 by a written instrument. pending applications may also be transferred by20 assignment. the assignment, grant, or conveyance should be recorded with the u.s. patent and trademark office (“pto”) within three months of execution; otherwise, a subsequent purchaser of the patent (for valuable consideration) without notice of the prior assignment can become the owner of the patent.21 the patent holder (or applicant) may also transfer rights by a license. for example, the patent owner may license another firm to make, use, and sell products based on the patent in a specified geographic area for a particular period of time. b. trade secrets in contrast to the patent and copyright protections available under federal law, trade secrets are protected under state law. as of july 1, 2000, 15. id. § 154(a)(2). the term can be extended if the patent and trademark office delays in the prosecution of the patent. id. § 154(b). 16. id. § 173 (a design patent cannot be renewed or extended). 17. id. § 271 (a patent also allows the patentee to prevent the importation of infringing goods); §§ 281, 283, 284 (treble damages may be awarded) and 285 (attorneys fees may be awarded in “exceptional cases”). 18. id. § 122(b)(1) (unless the inventor represents that he or she will not seek patent protection outside the u.s.). 19. id. § 261. 20. id. if the assignor’s signature is notarized, it will be “prima facie evidence of the execution of [the] assignment, grant or conveyance of [the] patent or application for patent.” id. 21. id. 2002] it does not compute 555 forty-three states and the district of columbia have adopted the uniform trade secrets act (“utsa”) (several of those states have adopted the utsa with modifications). the subject matter that may qualify for trade secret protection22 is extremely broad. the utsa defines a trade secret as information that: (i) derives independent economic value, actual or potential; (ii) is not generally known and is not readily ascertainable by proper means; and (iii) is the23 subject of reasonable efforts to maintain the secrecy of the information under the circumstances. any information meeting these standards is eligible for24 trade secret protection. many valuable innovations can be profitably exploited and protected as trade secrets but would not be eligible for patent protection. in some situations, inventors may prefer trade secret protection, and decide not to apply for patent protection. initially, the primary method for protecting25 computer software was trade secret protection, and presumably trade secret26 protection could be available today for many software programs. a key difference between trade secret protection and patent or copyright protection is the duration of protection. patent and copyright protection last for a fixed time period. trade secret protection can last forever27 22. 14 u.l.a., 2001 supp., 177. tennessee adopted the utsa effective july 1, 2000. the seven states which have not adopted the utsa as of july 1, 2000 are massachusetts, new jersey, new york, north carolina, pennsylvania, texas and wyoming. 23. “proper means” for acquiring another’s trade secret include: (i) discovering the information by independent research, and (ii) reverse engineering. see e. i. dupont denemours & co. v. christopher, 431 f.2d 1072 (5th cir. 1970), cert. denied 400 u.s. 1024 (1971). 24. the term “trade secret” is defined in utsa § 1(4), reprinted in 14 u.l.a., 438 (1990). 25. in kewanee oil co. v. bicron corp., 416 u.s. 470 (1974), the inventor chose trade secret protection over patent protection, and the u.s. supreme court concluded that state law trade secret protection was not preempted by federal patent law. it should be noted that the inventor who has a choice between patent protection and trade secret protection is subject to two important deadlines. if the inventor files for patent protection, and fails to withdraw the application before the earlier of: (i) when the patent is issued, or (ii) 18 months after the application is filed (unless the inventor seeks no foreign patent protection), the invention will be disclosed to the public and trade secret protection will no longer be available. 35 u.s.c. § 122(b). on the other hand, if the inventor fails to file a patent application within one year of the first public use of the invention (or within one year of the date the invention was first put on sale), patent protection will no longer be available. id. § 102(b). 26. see text accompanying infra notes 68-71; university computing co. v. lykes-youngstown corp., 504 f.2d 518 (5th cir. 1974). 27. the duration of a utility patent generally begins on the date the patent is issued and ends 20 years from the date of filing the patent application. 35 u.s.c. § 154(a)(2). in regards to the duration of a copyright, see text accompanying infra notes 60-62. 556 florida tax review [vol.5:8 if the information remains a secret (but will disappear if the “secret” is discovered by proper means). in assigning or otherwise transferring a trade secret to a charity, the parties would want to enter into a contract providing that the information would continue to be a secret. one court has stated that the key to transferring trade secret protection is that the charity should acquire the right to prevent others from disclosing the information, and the right to sue (and collect from) those who misappropriate the trade secret.28 as with other intellectual property rights, the charity may exploit the trade secret by either: (i) licensing others to use the information, or (ii) selling29 its entire interest in the trade secret to another party. c. trademarks any “word, name, symbol or device” used in commerce that indicates the source of goods, and distinguishes those goods from others can be a trademark. service marks are marks that identify the source of services rather30 than goods. trademarks and service marks can inform consumers about the31 quality (and other characteristics) of the goods because the mark identifies the source of the goods or services. product packaging that is not functional and is 28. e.i. du pont de nemours & co. v. united states, 288 f.2d 904, 911 (ct. cl. 1961). the court of claims concluded that the transfer of these rights supported the assertion that the disclosure of the information was a transfer of property (in the form of a trade secret) rather than the mere providing of services (such as when an attorney gives advice to a client, or when a doctor talks to a patient). presumably the mere disclosure of the information from the inventor to the charity will not jeopardize the trade secret protection, particularly if the inventor agrees that he or she will not disclose the information, and transfers all of his or her rights relating to the invention to the charity. see metallurgical industries inc. v. fourtek, inc., 790 f.2d 1195 (5th cir. 1986) (disclosure pursuant to a confidentiality agreement that is necessary to exploit the trade secret will not prevent the information from being a “secret”). 29. the “licensee” would be required to sign a confidentiality agreement, and would agree that its only right would be to use the information for a specified purpose, such as manufacturing goods in a specific geographic location for a specified period of time. 30. 15 u.s.c. § 1127, lanham act § 45. “since human beings might use as a ‘symbol’ or ‘device’ almost anything at all that is capable of carrying meaning, this language, read literally, is not restrictive.” wal-mart stores, inc. v. samara brothers, inc., 529 u.s. 205, 209 (2000) (quoting qualitex co. v. jacobson products co., 514 u.s. 159, 162 (1995)). 31. 15 u.s.c. § 1127, lanham act § 45. 2002] it does not compute 557 distinctive may qualify for trademark protection as “trade dress.” the shape32 or design of a product itself may also qualify for trademark protection (as trade dress), but unlike product packaging, product design cannot be inherently33 distinctive, so that trade dress protection is only available if the product design has acquired secondary meaning.34 the mere use of a mark (without pto registration) can provide some protection against the use of a confusingly similar mark by competitors. the use of an “unregistered” mark can give the user, within the geographic area of actual use and the “zone of natural expansion,” the right to prevent others from adopting and using a confusingly similar mark.35 greater rights and protections are available if the mark is registered with the pto. key advantages to federal registration include: (i) the registration gives the registrant nationwide constructive use and constructive 32. product packaging can be distinctive because it is either: (i) inherently distinctive, two pesos, inc. v. taco cabana, inc., 505 u.s. 763 (1992), or (ii) has acquired secondary meaning. in two pesos, the u.s. supreme court concluded that the trade dress of a restaurant can be inherently distinctive. 33. wal-mart stores, inc. v. samara brothers, inc., 529 u.s. 205, 209 (2000) (“the breadth of the definition of marks registrable under § 2, and of the confusionproducing elements recited as actionable by § 43(a), has been held to embrace not just word marks, such as ‘nike,’ and symbol marks, such as nike’s ‘swoosh’ symbol, but also ‘trade dress’ – a category that originally included only the packaging, or ‘dressing,’ of a product, but in recent years has been expanded by many courts of appeals to encompass the design of a product.”). 34. id. at 214 (“[p]roduct design cannot be protected under [lanham act] § 43(a) without a showing of secondary meaning.”). “secondary meaning” exists if the plaintiff can “show that the primary significance of the term in the minds of the consuming public is not the product but the producer.” kellog co. v. national biscuit co., 305 u.s. 111, 118 (1938)(quoted in zatarain’s, inc. v. oak grove smokehouse, inc., 698 f.2d 786, 791 (5th cir. 1983)). also if the trade dress is not registered on the pto’s principal register, “the person who asserts trade dress protection has the burden of proving that the matter sought to be protected is not functional”). 15 u.s.c. § 1225(a)(3), lanham act § 43(a)(3). 35. see j. thomas mccarthy, mccarthy on trademarks and unfair competition, § 26.20, p. 26-31 (discussing the “zone of natural expansion,” and citing burger king of florida, inc. v. brewer, 244 f.supp. 293 (w.d. tenn. 1965)). 15 u.s.c. § 1125(a), also known as § 43 of the lanham act, provides a federal cause of action for infringement of unregistered marks. the owner must use the mark in commerce to have a cause of action under § 43(a). if the mark has not been used in commerce, common law protection for the infringement of the unregistered mark is still available, but only in areas of actual use and the zone of natural expansion. this assumes that the user is the first user (also called the “senior user”) in that geographic area. if there is a prior user (who has not abandoned the mark) the new user (often called the “junior user”), may be sued for infringement under section 43(a) of the lanham act and/or state trademark law. 558 florida tax review [vol.5:8 notice, which cuts off potential rights of any future users of the same or similar mark; (ii) the mark may become “incontestable” after five years, which will36 eliminate a number of defenses which others may raise if they use the same or similar mark; and (iii) it provides the right to bring a federal cause of action37 without regard to diversity or minimum amounts in controversy. traditionally,38 an application for federal registration could not be filed until the mark was used “in commerce.” as a result of the trademark law revision act of 1989 an39 40 application can be filed before the mark has actually been used in commerce if in good faith the applicant has a “bona fide intention . . . to use [the] trademark in commerce.” upon the filing of an “intent to use” application, the pto will41 issue a “notice of allowance,” rather than registering the mark. if the applicant42 then files a verified statement that the mark has in fact been used in commerce within six months of the application (the six month period can be extended to one year automatically and to three years for good cause shown) the mark can be registered. if the applicant satisfies this requirement, the initial application43 will be considered “constructive use” entitling the registrant to nationwide priority from the date of the application. federal registration of a mark will44 provide several other advantages, particularly when the trademark owner sues for trademark infringement.45 36. 15 u.s.c. § 1072, lanham act § 22 (constructive notice); 15 u.s.c. § 1057, lanham act § 7(b) (“a certificate of registration of a mark upon the principal register . . . shall be prima facie evidence of the validity of the registered mark and of the registration of the mark, of the registrant’s ownership of the mark, and of the registrant’s exclusive right to use the registered mark, in commerce on or in connection with the goods or services specified in the certificate, subject to any conditions or limitations stated in the certificate.”). 37. 15 u.s.c. § 1065, lanham act § 15. 38. 15 u.s.c. § 1121, lanham act § 39. 39. see zazu designs v. l’oreal, s.a., 979 f.2d 499 (7th cir. 1992) (citing 15 u.s.c. § 1051(a) (modified in 1989)). 40. pub. l. no. 100-667, 102 stat. 3935, codified at 15 u.s.c. § 1051. 41. 15 u.s.c. § 1051(b)(1), lanham act § 1(b)(1). 42. id. § 1063(b)(2), lanham act § 13(b)(2). 43. id. § 1051(d), lanham act § 1(d). 44. id. § 1057(c). 45. advantages from federal registration include: (i) a presumption of validity of the mark and the registrant’s ownership of the mark; 15 u.s.c. § 1057(b), lanham act §7(b); (ii) federal registration functions as constructive notice of a claim of ownership so as to eliminate any claim of good faith adoption and use after the date of registration, 15 u.s.c. § 1072, lanham act § 35; (iii) in federal court, profits, damages and costs are recoverable, and treble damages and attorneys fees are available; 15 u.s.c. § 1117, lanham act § 22; and (iv) the right to have u.s. customs exclude infringing goods. 15 u.s.c. § 1124, lanham act § 42. see j. thomas mccarthy, supra note 35, at § 19.9. 2002] it does not compute 559 the duration of a trademark is perpetual as long as it continues to function as a trademark. 46 a registered trademark or service mark can be assigned “with the good will of the business in which the mark is used, or with that part of the good will of the business connected with the use of and symbolized by the mark.”47 “assignments shall be by instruments in writing, duly executed,” and should48 be notarized. an assignment should include the right to sue for past49 infringements and to recover any damages for past infringement. the assignment of a federally registered trademark should be registered with the pto within three months after the date of the assignment, or before subsequent purchase. otherwise, the assignment “shall be void against any subsequent purchaser for valuable consideration without notice.”50 if a trademark or service mark is licensed, it is necessary for the licensor to retain various rights to ensure that the use of the mark, and the quality of the goods or services associated with the mark will be appropriate. otherwise, the licensee’s use of the mark will confuse consumers, since the mark no longer indicates the same source. an unsupervised license, referred to as a “naked” license, constitutes an abandonment of the trademark. this will terminate the trademark owner’s rights.51 d. copyrights like patents, copyright protection is authorized by article i, section 8, clause 8 of the u.s. constitution, which empowers congress “[t]o promote the progress of science and the useful arts, by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries.” “copyright protection subsists . . . in original works of authorship fixed in any tangible medium of expression.” copyright protection is available52 only for the expression of an idea “fixed in a tangible medium,” and is not53 46. id. § 6:31, at 6-61 (“while a copyright is of limited duration, a trademark lasts as long as the trademark significance of the designation is maintained.”). 47. 15 u.s.c. § 1060(a), lanham act § 10(a). 48. id. 49. notarization is prima facie evidence of execution. id. 50. id. 51. 2 j. thomas mccarthy, supra note 35, §§ 17.06, 18.421 and 18.48. see infra note 215. 52. 17 u.s.c. § 102(a). 53. a work is “fixed” in a “tangible medium of expression when its embodiment in a copy or phonorecord, by or under the authority of the author, is sufficiently permanent or stable to permit it to be perceived, reproduced, or otherwise communicated for a period of more than transitory duration.” 17 u.s.c. § 101 (definition of the word “fixed”). the statute goes on to state that “a work consisting of 560 florida tax review [vol.5:8 available for an “idea, procedure, process, system, method of operation, concept, principle or discovery.” the owner of a copyright has the exclusive54 right to: (i) reproduce the work; (ii) prepare derivative works; (iii) distribute copies; (iv) perform the copyrighted work publicly; and (v) display the copyrighted work publicly.55 although registration with the u.s. copyright office is not necessary for obtaining copyright protection, it affords various advantages: (i) the56 creator cannot sue for infringement of a work without first registering the work; (ii) if the registration occurs within three months of publication or57 before the infringement takes place, the owner may recover attorney fees and statutory damages without proving actual monetary loss (the statutory damages may be within the range of $200 to $150,000); and (iii) the certification of a58 sounds, images, or both, that are being transmitted, is ‘fixed’ for purposes of this title if a fixation of the work is being made simultaneously with its transmission.” id. 54. id. § 102(b). 55. id. § 106. 56. robert p. merges, peter s. menell & mark a. lemley, intellectual property in the new technological age, 372 (2001) (“registration of a copyrighted work with the copyright office has always been ‘voluntary’”). see also infra note 270. 57. 17 u.s.c. § 411(a). 58. id. §§ 412 (establishing the 3-month rule), 504 (permitting the recovery of actual or statutory damages). in feltner v. columbia pictures television, 523 u.s. 340, 355 (1998), the u.s. supreme court held that the seventh amendment guarantees a defendant the right to a jury trial on all issues “pertinent to an award of statutory damages under § 504(c) of the copyright act, including the amount itself.” in a later proceeding involving the same case, the ninth circuit stated: what the supreme court held is that to the extent § 504(c) fails to provide a jury trial right, it violates the seventh amendment and is therefore unconstitutional. however, this holding in no way implies that copyright plaintiffs are no longer able to seek statutory damages under the copyright act. indeed, the position urged by [the defendant in this case] is contrary to the express language of the supreme court’s decision in this case. as the feltner court stated, “if a party so demands, a jury must determine the actual amount of statutory damages under § 504(c) . . . .” feltner, 523 u.s. at 355. the court later reaffirmed this point by stating, “[t]he seventh amendment provides a right to a jury trial on all issues pertaining to an award of statutory damages under § 504(c) of the copyright act, including the amount itself.” id. this language evinces the court’s intent to preserve the plaintiff’s ability to seek statutory damages under § 504(c) of the copyright act. columbia pictures industries, inc. v. krypton broadcasting of birmingham, inc., 259 f.3d 1186, 1192 (9th cir. 2001), cert. denied, 2002 u.s. lx 649. 2002] it does not compute 561 registered work before or within five years after first publication of the work is prima facie evidence of the validity of the copyright.59 a copyrighted work created on or after january 1, 1978, is protected for the life of the author plus 70 years after the author’s death. however, in the60 case of a “work for hire” the protection is 95 years from the date of61 publication or 120 years from the creation of the work, whichever is shorter.62 the owner of a copyright may transfer all of his or her rights to the copyright by assignment. an assignment must be in writing and signed by the owner of the rights conveyed or such owner’s agent. it is advisable to record63 the assignment document with the u.s. copyright office within one month after its execution in the united states; otherwise, a subsequent bona fide64 purchaser (who does not have notice of the prior assignment) who records his or her assignment document first will be treated as the owner of the copyright.65 an assignment document can be valid if it is not notarized, but notarization will be prima facie evidence of the execution of the document.66 also, the owner of a copyright may license the copyright. a license is not technically required to be in writing. however, many states provide that a contract that will not be completely performed within one year must be in writing. thus, most licenses should be in writing.67 e. computer software – over-lapping ip protection computer software can be eligible for patent, trade secret, and/or copyright protection. computer software can function as a literary work, which would suggest copyright protection. as a literary work, computer software is very different from other works, because it is written in source code and object code. source code is written in special machine readable languages, not intended to be read by any individual. while object code can be read by 59. 17 u.s.c. § 410(c). 60. id. § 302(a). prior to the sonny bono copyright term extension act of 1998, the term was for the life of the author plus 50 years. 61. a “work made for hire” is a work prepared by an employee within the scope of his or her employment, or a work that is: (i) specially ordered or commissioned; (ii) falls within one of the nine specific categories listed in the statue; and (iii) the parties have expressly agreed that the work is to be considered a “work for hire.” id. § 101 (definition of “work made for hire”). 62. id. § 302(c). 63. id. § 204(a). 64. id. § 205(d) (if it was executed outside the u.s., it can be filed within two months of the date of execution). 65. id. 66. id. § 204(b). 67. 72 am. jur. 2d, statute of frauds, §§ 10-16 (1974). 562 florida tax review [vol.5:8 individuals, it consists exclusively of “ones” and “zeros”. computer software also can function as a machine, which would suggest trade secret and/or patent protection.68 1. trade secret protection.—prior to 1980, the principal source of ip protection for computer software was trade secret law. initially, software was not sold separately, and its functions were handled by the computer hardware. when selling a computer system and providing supplemental information, a seller might require the buyer (or anyone else having access to the information) to sign a confidentiality agreement so that the information could continue to be secret, and function as a trade secret. under trade secret law, the creator of the69 computer software could enforce his or her rights against an infringer through an injunction, and/or the collection of monetary damages. as discussed above,70 a major advantage of trade secret protection is that the protection can last for as long as the information remains a secret.71 2. copyright protection.—although copyright law does not protect an “idea, procedure, process, system, method of operation, concept, principle or discovery,” amendments to the copyright act in 1976 and 1980 clarify that72 copyright protection is available for computer software. the 1980 computer 68. commentators have stated, “programs are, in fact, machines (entities that bring about useful results, i.e. behavior) that have been constructed in a medium of text (source and object code). the engineering designs embodied in programs could as easily be implemented in hardware as in software, and the user would be unable to distinguish between the two.” pamela samuelson, a manifesto concerning the legal protection of computer programs, 94 colum. l. rev. 2308, 2315-6 (1994). section 101 of the copyright act defines a “computer program” as “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.” 17 u.s.c. § 101. 69. see digital general corp. v. digital computer controls, inc., 297 a.2d 433 (del. ch. 1971), aff’d 297 a.2d 437 (del. 1972). 70. utsa § 2 (injunctive relief) § 3 (damages), reprinted in 14 uniform laws annotated, 449, 455 (1990). 71. see text accompanying supra note 27. it also should be remembered that trade secret protection will by lost when others acquire the information by “proper means,” such as independent discovery, or reverse engineering. 72. 17 u.s.c. § 102(b) (emphasis added); see also h.r. rep. no. 1476, at 57, 94th cong., 2d sess. (1976), reprinted in 1976 u.s.c.c.a.n. 5659, 5670 (“section 102(b) is intended, among other things, to make clear that the expression adopted by the programmer is the copyrightable element in a computer program, and that the actual processes or methods embodied in the program are not within the scope of the copyright law”). 2002] it does not compute 563 software copyright act defines a “computer program” as “a set of statements73 or instructions to be used directly or indirectly in a computer in order to bring about a certain result.” copyright protection is available to “literary works,”74 75 and computer programs can be literary works. the legislative history of the76 1976 amendments states “the expression adopted by the programmer is the copyrightable element in a computer program, and . . . the actual processes or methods embodied in the program are not within the scope of the copyright law.” the structure, sequence, and organization of a computer program is77 protectable by copyright, in addition to the literal computer code. copyright78 protection is only available for a work fixed in a tangible medium, and the legislative history provides that the “fixed” requirement will not be met if the concept is “captured momentarily in the memory” of a computer. screen79 displays (the output of a computer program) may be protectable as audiovisual or pictorial works.80 although the owner of copyrighted computer software as a general rule has the traditional exclusive rights in the copyrighted work under the copyright act, making copies can be an essential part of the ordinary use of a computer81 program by a purchaser of the software. as a result, the copyright act allows the owner of a copy of a computer program to make another copy or adaptation of that computer program if: (i) the copy is created as an essential step in the utilization of the computer program, in conjunction with the machine that is to use the software; (ii) the copy is made for archival purposes and will be destroyed “in the event the continued possession of the computer program should cease to be rightful;” or (iii) the copy is made in connection with the82 maintenance and/or repair of the machine. this allows a software user to83 make “backup” copies, and load the program onto the user’s hard-drive. 73. pub. l. no. 96-517, 94 stat. 3028 (1980) (codified at 17 u.s.c. § 101 et seq.). 74. 17 u.s.c. § 101. 75. id. § 102(a)(1). 76. see whelan associates, inc. v. jaslow dental laboratory, inc., 797 f.2d 1222, 1233 (3d cir. 1986), cert. denied, 479 u.s. 1031 (1987) (“[i]t is well . . . established that copyright protection extends to a program’s source and object codes”). 77. h. r. rep. no. 1476, at 57, 94th cong., 2d sess. (1976), reprinted in 1976 u.s.c.c.a.n. 5659, 5670 (referring to pub. l. no. 94-553, 90 stat. 2541 (1976) (codified at 17 u.s.c. § 101 et seq.)). 78. whelan, 797 f.2d at 1242-3. 79. h.r. rep. no. 1476, at 52-53, 94th cong., 2d sess. (1976). 80. 17 u.s.c. § 102(a)(5), (6). 81. 17 u.s.c. § 106. 82. 17 u.s.c. § 117(a)(1), (2). 83. 17 u.s.c. § 117(c). 564 florida tax review [vol.5:8 3. patent protection.—initially, patent protection did not appear to be available for computer software. computer software was characterized primarily as a mathematical algorithm, and the u.s. supreme court denied patent protection, concluding that a mathematical algorithm is not an “invention” under the patent act. although the court did not directly reverse84 its position that an algorithm by itself is not patentable, in diamond v. diehr,85 the u.s. supreme court concluded that if other process steps or physical structures are included in the patent claims, a patent could issue, even though the algorithm might be the only new concept associated with the patent application. in diehr, the applicant characterized the patent as a method for curing synthetic rubber, rather than a method for calculating numbers. this “characterization” approach apparently was adopted by many computer software inventors, and commentators have stated that “by 1994 there were86 an estimated 14,000 issued software patents in the united states.” in 1996, the87 pto issued “examination guidelines for computer-implemented inventions,” and by 2000, over 40,000 software patents were in force in the united states, with several thousand more issued every year.88 f. other examples of over-lapping ip protection 1. designs.—computer software is not the only creation eligible for over-lapping ip protection. designs may qualify for design patent protection, copyright protection, and/or trade dress protection. at one time, courts used a “doctrine of election” under which an item could only enjoy one type of ip protection, so the inventor or author was required to elect. the “doctrine of89 election” was later rejected in a case involving an application for a watch90 design patent featuring a caricature of former u.s. vice president spiro agnew. the watch had been the subject of several prior copyright registrations. the court of customs and patent appeals concluded that the copyright registrations did not foreclose the opportunity for also obtaining design patent protection.91 the court noted that neither the copyright nor the patent statute made protection 84. gottschalk v. benson, 409 u.s. 63 (1972); parker v. flook, 437 u.s. 584 (1978). 85. 450 u.s. 175, 192 (1981). 86. pamela samuelson, benson revisited: the case against patent protection for algorithms and other computer program-related inventions, 39 emory l. j. 1025, 1089-90 (1990). 87. merges, menell & lemley, supra note 56, 1016 (2001). 88. id. at 1032. 89. see in re yardley, 493 f.2d 1389, 1394 (c.c.p.a. 1974)). 90. in re yardley, 493 f.2d 1389 (c.c.p.a. 1974). 91. id. at 1394. 2002] it does not compute 565 contingent on not having obtained protection under the other statutory scheme, and that each statute set out its own separate degree of protection which is not necessarily equal to the protection afforded by the other statutory scheme. for example, a design patent provides only 14 year protection, whereas a copyright provides protection for a much longer period of time.92 designs also may qualify for both copyright protection and trademark/trade dress protection. the u.s. supreme court has stated that, to93 be copyrightable, a work must possess at least some minimal degree of creativity. as one noted commentator has stated, “picture[s] and logo designs94 used as marks are no less copyrightable pictures and designs merely because they appear on labels and in advertisements. however, such pictures and logos must contain the requisite amount of creativity and originality to be protected under copyright law.” other product designs may qualify for both design95 patent protection and trademark protection.96 2. characters.—characters used to identify the source of goods or services may be eligible for trademark protection. furthermore, if the same character reflects the necessary degree of “original authorship,” the representation of the character in a tangible medium may be eligible for copyright protection. a famous example is walt disney company’s character mickey mouse. mickey can help demonstrate an important difference97 between copyright and trademark protection. if mickey mouse was protected by only copyright, after a fixed period of time, mickey mouse would enter the public domain and anyone could use mickey mouse. the sonny bono copyright term extension act of 1998 extended the duration of copyright protection from the life of the author plus 50 years, to the life of the author plus 70 years. in the case of a work for hire, the duration is now 95 years from the 98 92. id. at 1393-95. 93. mccarthy, supra note 35, § 6.31, at 6-61 (“trademark and trade dress protection can extend to certain pictorial or design works which are also subject to copyright”) (citing frederick warne & co., inc. v. book sales inc., 481 f.supp. 1191 (s.d.n.y. 1979)). “no one would seriously argue that copyright protection for disney characters should be denied merely because they appear on a plethora of goods . . . .” mccarthy, supra note 35, § 6.18, at 6-36. 94. feist publications, inc. v. rural telephone service co., inc., 499 u.s. 340 (1991); see mccarthy, supra note 35, § 6.18, at 6-38. 95. mccarthy, supra note 35, § 6.18, at 6-35, 6-36. 96. kohler co. v. moen, inc., 12 f.3d 632 (7th cir. 1993). 97. merges, menell & lemley, supra note 56, 425 (2001) (discussing duration of copyright protection for mickey mouse). 98. 17 u.s.c. § 302(a), (c). 566 florida tax review [vol.5:8 date of publication or 120 years from creation, whichever is shorter.99 nevertheless, at some point mickey mouse will enter the public domain if only copyright protection is relied upon. however, walt disney company can obtain trademark protection for many mickey mouse symbols, and trademark protection can last for as long as the symbol or device continues to be used as a trademark.100 iii. no tax consequences to charity from assignment or licensing of ip will a charity be obligated to pay income tax on any net income that it generates from the assignment or licensing of ip? charities generally are exempt from federal income tax. however, a charity is required to pay101 income tax on its unrelated business taxable income, frequently referred to as the “unrelated business income tax” or “ubit”. net income earned by a102 charity will be subject to ubit if: (i) the net income is derived from a “trade or business,” (ii) which is regularly conducted, and (iii) which is “unrelated” to the charity’s tax-exempt function. thus, a threshold question will be103 whether the net income realized by the charity from the assignment or licensing of the intellectual property will meet all three of these standards. if any one of the three standards is not met, the ubit does not apply. for these purposes, “the term ‘trade or business’ includes any activity which is carried on for the production of income from the sale of goods or the performance of services.” also, the regulations indicate that any activity104 carried on for the production of income and with a profit motive may be considered a “trade or business.” in determining whether an activity is a trade105 or business, the courts consider whether the activity is conducted for a profit, 99. id. 100. mccarthy, supra note 35, § 6.18, at 6-38 (“an unauthorized seller of tshirts imprinted with disney characters infringes both copyright and trademark rights in characters such as mickey mouse”) (citing walt disney co. v. powell, 698 f.supp. 10 (d.d.c. 1988), aff’d in part, and vacated in part, remanded 897 f.2d 565 (d.c. cir. 1990)). 101. irc § 501(c)(3). the list of organizations exempt from federal income tax include “corporations and any community chest, fund or foundation, organized and operated exclusively for religious, charitable, scientific . . . or educational . . . purposes.” id. 102. irc § 511(a)(1). 103. irc § 513(a). 104. irc § 513(c). 105. regs. § 1.513-1(b); carla neely freitag, unrelated business income tax, 874 tax mgmt. (bna), at a-30. 2002] it does not compute 567 and whether the activity is the type carried on by commercial companies to make a profit.106 in determining whether a trade or business is “regularly carried on” for purposes of the ubit, “regard must be had to the frequency and continuity with which the activities productive of the income are conducted and the manner in which they are pursued” as compared to “comparable commercial activities107 of [taxable] organizations.” thus, if an activity is usually conducted year-108 round by a commercial enterprise, the fact that the charity engages in the activity for only a short period of time would indicate that the charity’s activity should not give rise to ubit. evidence that the charity only engages in the activity once a year, such as an annual dance or similar fund-raising activity, would tend to show that the activity should not be considered “regularly carried on.”109 in regards to the third test for applying the ubit – whether the activity is “substantially related” to the organization’s tax-exempt function – the regulations provide that the activity will not generate ubit if it “contributes importantly” to the organization’s tax-exempt function. in considering110 whether the activity “contributes importantly,” one factor to consider is the size and extent of the business activity in relation to the nature and extent of the exempt function which the activity purports to serve. if the trade or business111 is conducted on a scale larger than is reasonably necessary for the performance of the exempt function, the “excess” business activity does not “contribute importantly.” even if the income generated by a charity from the exploitation of the intellectual property would be subject to the ubit under these general rules, there are two exceptions that could allow the charity to avoid paying income tax on amounts derived from the exploitation of intellectual property. first, section 512(b)(2) excludes “all royalties . . . whether measured by production or by gross or taxable income from the property . . . .” thus, if the charity112 will receive royalties as a result of licensing intellectual property to a third party, those royalties should not be subject to the ubit. the royalty exception 106. united states v. american bar endowment, 477 u.s. 105, 111 (1986) (income derived from the promotion or sponsorship of a group insurance program for members by an organization formed to advance the legal profession and the administration of justice is considered unrelated business taxable income). 107. regs. § 1.513-1(c)(1). 108. id. 109. see regs. § 1.513-1(c)(2)(iii). 110. id. § 1.513-1(d)(2). 111. id. § 1.513-1(d)(3). 112. id. § 1.512(b)-1(b). 568 florida tax review [vol.5:8 is similar to other exclusions for passive income. however, if the charity113 provides substantial services in connection with the activity, the payments may be characterized as a fee for services, subject to the ubit, rather than as a passive royalty. second, section 512(b)(5) excludes from the ubit “all gains114 or losses from the sale, exchange, or other disposition of property other than . . . property held primarily for sale to customers in the ordinary course of the trade or business.” thus, as long as the charity is not in the business of115 regularly assigning intellectual property to “customers,” the charity’s net income from the assignment of intellectual property should not be subject to the ubit. a. patents in revenue ruling 76-297, the irs considered a charity formed to116 promote scientific investigation and research at a university. the organization accepts inventions of individuals associated with the university. the inventor “executes an irrevocable assignment of both his [or her] legal and beneficial rights in the invention to the organization which in return agrees to pay a specified percentage of royalties subsequently received from licensees.” the117 irs concluded that under the facts of the particular arrangement the amounts received by the organization were royalties excluded from the ubit under section 512(b)(2). the irs distinguished a prior ruling in which the charity118 had only bare legal title to the patent and the amounts it received were actually payments for services rendered. b. trademarks in revenue ruling 81-178, the irs considered a tax-exempt labor119 union for professional athletes which solicits and negotiates licensing120 113 for example, interest, dividends, and amounts received from annuities also are excluded from the ubit. irc § 512(b). 114. fraternal order of police v. commissioner, 833 f.2d 717, 723-4 (7th cir. 1987), aff’g 87 t.c. 747 (1986); rev. rul. 73-193, 1973-1 c.b. 262; see freitag, supra note 105, at a-87. 115. irc § 512(b)(5)(b). 116. 1976-2 c.b. 178. 117. id. (emphasis added). 118. rev. rul. 73-193, 1973-1 c.b. 262. 119. 1981-2 c.b. 135. 120. although a labor organization is classified as tax-exempt under irc § 501(c)(5), rather than irc § 501(c)(3) which is the classification for charities eligible to receive tax deductible contributions under irc § 170, the analysis for ubit purposes is the same. 2002] it does not compute 569 agreements with various businesses which desire to use “the organization’s trademarks, trade names, service marks, copyrights and members’ names, photographs, likenesses and facsimile signatures.” the irs stated that,121 “[p]ayments for the use of trademarks, trade names, service marks, or copyrights, whether or not payment is based on the use made of such property, are ordinary classified as royalties for federal tax purposes.” the irs122 concluded that the royalties received by the organization would not be subject to the ubit because of the royalty exclusion of section 512(b)(2), even though the organization retained the right to approve the quality and style of the licensed products. the tax court has held that the income from an “affinity card program” is not subject to the ubit. in an affinity card program, the charity123 encourages its members (through the use of its member list) to use credit cards issued by a particular financial institution bearing the trademark and/or trade name of the charity. the tax court held that the income received by the charity qualifies for the royalty exception of section 512(b)(2) provided that the charity’s activities are kept to a minimum.124 c. copyrights in revenue ruling 69-430, the charity owns the publication rights to125 a book. the ruling states that if the organization transfers its publication rights to a commercial publisher in return for royalties, the royalty income will not be subject to the ubit. however, if the organization had actively exploited the126 121. 1981-2 c.b. at 135. this ruling supports the conclusion that a charity’s income from the exploitation of an individual’s “right to publicity” will not be subject to the ubit. 122. id. at 136. 123. sierra club, inc. v. commissioner, 103 t.c. 307 (1994) aff’d in part, reversed in part, and remanded 86 f.3d 1526 (9th cir. 1996); on remand 77 t.c. memo (cch) 1569 (1999); oregon state university alumni ass’n v. commission, 71 t.c. memo (cch) 1935 (1996), aff’d 193 f.3d 1098 (9th cir. 1999). 124. oregon state university alumni ass’n, 71 t.c. memo (cch) 1935, 193940 (1996) (emphasizing that the services provided by the charity were “de minimis”); see also common cause v. commissioner, 112 t.c. 332 (1999) (amounts received from the rental of a charity’s mailing list qualified as royalties, and as a result, the amounts were not subject to the ubit); planned parenthood fed’n of am., inc. v. commissioner, 77 t.c. memo (cch) 2227 (1999) (indicating that all amounts received may qualify as “royalties” although the organization provides certain services in connection with exploiting its mailing list). 125. 1969-2 c.b. 129. 126. id. at 130. 570 florida tax review [vol.5:8 book itself in a commercial manner, rather than hiring the commercial publisher, the income received would have been taxable under the ubit.127 iv. restrictions on claiming a charitable contribution deduction congress has allowed an income tax deduction for contributions to charitable organizations since 1917. in general, a charitable contribution128 deduction is available for the fair market value of the property contributed.129 from this straight forward beginning, the taxpayer attempting to claim an income tax deduction for a charitable contribution is faced with numerous restrictions and limitations. a. itemized deduction a charitable contribution deduction is an itemized deduction. as a130 result, the taxpayer may only deduct the contribution if he or she is eligible to itemize. to itemize, a taxpayer’s total itemized deductions must exceed the “standard deduction amount.”131 b. 3% and 80% restrictions if the taxpayer’s adjusted gross income is above a certain threshold amount, the taxpayer’s otherwise allowable itemized deductions will be reduced by the lesser of: (i) 3% of the excess of the taxpayer’s adjusted gross 127. id. 128. weidenbeck, charitable contributions: a policy perspective, 50 mo. l. rev. 85, 87 n. 11 (1985). irc § 170(a)(1) (“there shall be allowed as a deduction any charitable contribution . . . payment of which is made within the taxable year.”). 129. regs. § 1.170a-1(c)(1). in general, the deduction is based on the fair market value of the property even if the taxpayer’s basis is greater than the property’s fair market value. for example, if the taxpayer purchases the property for $100 and donates the property when its value is $50, the charitable deduction will only be $50. 130. see irc § 63(d), which provides that any deduction, other than the deduction allowed under irc § 151 (the personal exemption) and the deductions allowed in calculating adjusted gross income under irc § 62, will be considered an “itemized deduction.” charitable contributions are not listed in §§ 62 or 151, and therefore are itemized deductions. 131. the standard deduction is an amount which the taxpayer is entitled to deduct each year even if his or her itemized deductions are less than the “standard deduction.” irc § 63(c). the standard deductions for 2002 are: $7,850 for joint filers and surviving spouses; $6,900 for heads of household; $4,700 for single individuals; and $3,925 for married persons filing separately. 2002] it does not compute 571 income over the applicable threshold amount; or (ii) 80% of the amount of the itemized deductions otherwise allowable. for 2002, the applicable threshold132 amount is $137,300 ($68,650 for married individuals filing separately). medical expenses, investment interest expenses, and casualty or theft losses are not subject to the 3%/80% reduction rule. as a result, the primary itemized133 deductions subject to the 3%/80% reduction rule are: (i) state and local income taxes, (ii) real and personal property taxes; (iii) home mortgage interest; (iv) charitable contributions; and (v) miscellaneous itemized deductions subject to the 2% limitation of section 67(a) (which includes unreimbursed employee expenses, investment expenses, and tax preparation fees). for a higher income taxpayer, the 3%/80% reduction rule can significantly reduce the value of a charitable deduction, particularly if the taxpayer lives in a state that does not impose a state income tax.134 example #3: both texas hank and california cal are single individuals with adjusted gross income of $1 million in 2002. they both rent their homes, so they pay no real estate taxes and claim no home mortgage interest deductions. their itemized deductions subject to the 3%/80% reduction rule are as follows: texas hank california cal 1. state & local income tax -0 $85,000* 2. real & personal property tax $2,000 $2,000 3. home mortgage interest -0-04. charitable gifts $30,000 $30,000 5. misc. itemized deductions -0-0total deductions $32,000 $117,000 reduction amount ($25,600)** ($25,881)*** permitted itemized deductions $6,400 $91,119 132. irc § 68(a). 133. id. § 68(c). 134. state income taxes are allowed as an itemized deduction. irc § 164(a)(3). taxpayers who pay no state income tax may have a small amount of itemized deductions. the states that do not impose an income tax are: alaska, florida, nevada, south dakota, texas, washington and wyoming. new hampshire and tennessee impose an income tax on limited types of income, such as interest, dividends, and capital gains. h.r. rep. no. 389, 104th cong., 2d sess., reprinted in 1995 u.s.c.c.a.n. 1006, 1008, n.6 (report of judiciary committee on public law 104-95, state income taxation of pension income). 572 florida tax review [vol.5:8 * an approximation based on california income tax of $1,876.02 + 9.3% of taxable income above $51,350. see state tax guide – all states (cch), ¶ 905, p. 1328. ** the reduction factor under section 68(a) for texas hank is the lesser of: (i) 80% of the otherwise allowable deduction ($32,000 x 80% = $25,600), or (ii) 3% of his adjusted gross income in excess of the threshold amount: ($1 million $137,300 = $862,700) x 3% = $25,881. *** the reduction factor under section 68(a) for california cal is the lesser of: (i) 80% of the otherwise allowable deductions ($117,000 x 80% = $93,600), or (ii) 3% of his adjusted gross income in excess of the threshold amount: ($1 million $137,300 = $862,700) x 3% = $25,881. in this example, texas hank is able to deduct only 20% of his charitable contribution (a $6,000 deduction on a $30,000 contribution). in contrast, california cal can deduct the full $30,000. cal is obligated to pay the california state income tax in any event, and the reduction amount under section 68(a) is based on cal’s adjusted gross income. in effect, the reduction factor only reduces cal’s ability to deduct the california state income tax. c. 50%, 30% and 20% limitations a taxpayer cannot claim charitable contribution deductions in excess of a certain percentage of his or her “contribution base.” the “contribution base” is simply the taxpayer’s adjusted gross income without regard to any net operating loss carryback under section 172. cash contributions to public135 charities can be deducted up to 50% of the taxpayer’s “contribution base.”136 non-cash contributions can be deducted to the extent of 30% of the taxpayer’s “contribution base.” if the gift is made to a private foundation, rather than137 138 to a public charity, the percentage limitations are 30% and 20% rather than 135. irc § 170(b)(1)(f). 136. id. § 170(b)(1)(a). 137. id. § 170(b)(1)(b)(i). 138. a “public charity” is an organization described in irc § 509(a)(1), (2), or (3). a public charity generally receives at least a certain percentage of its “support” as contributions from the general public, from grants from the government or from other public charities, or from the performance of services related to its charitable purpose. in contrast, a private foundation is an organization described in irc § 501(c)(3), which fails to meet the support tests of irc § 509(a)(1), (2) or (3). a private foundation frequently receives the great majority of its funds from a single individual or a single family group. 2002] it does not compute 573 50% and 30%. if the taxpayer’s contribution deductions are restricted by139 these percentage limitations, the excess amount may be carried over and used in the next five years, subject to the applicable percentage limitations in each of those years. if a contribution cannot be deducted within that five year140 period, it will be lost. d. reduction of charitable deduction for any gain that would be taxed as ordinary income in calculating the amount of the charitable deduction in the case of a non-cash contribution, it is necessary to determine whether a hypothetical sale of the donated property would generate ordinary income or long-term capital gain (for these purposes, a short-term capital gain is treated in the same manner as ordinary income). if a hypothetical sale of the donated property would141 generate ordinary income, the taxpayer’s otherwise allowable charitable contribution deduction will be reduced by the amount of the gain. as142 discussed later in this article, this rule is extremely important in the case of gifts of intellectual property because the gain from the sale of a copyright is always considered ordinary income.143 e. reduction of charitable deduction for gain that would be taxed as longterm capital gain on a donation of tangible personal property for an “unrelated use” if tangible personal property (that would generate a long-term capital gain on a hypothetical sale of the property) is contributed to charity, it is necessary to determine whether the property will be used in a manner that is “related” to the charity’s tax-exempt function. if the tangible personal property will not meet the “related use” test, then the amount of the charitable contribution deduction must be reduced by the amount of any gain that would 139. id. § 170(b)(1)(d) and (e). 140. id. § 170(b)(1)(b) (flush language). 141. a “capital gain” is a gain generated from the sale or exchange of a capital asset, as defined in irc § 1221(a). a capital gain will be “long term” if the taxpayer has held the property for more than one year before the sale or exchange; the capital gain will be “short term” if the taxpayer has held the property for one year or less before the sale or exchange. id. § 1222(1), (3). 142. id. § 170(e)(1)(a). 143. id. § 1221(a)(3); see infra notes 216-220 and accompanying text. 574 florida tax review [vol.5:8 be recognized on a hypothetical sale of the donated property (even if the gain on a hypothetical sale would be taxed as long-term capital gain).144 as has been discussed by many commentators, this is an extremely important rule for an art collector who contributes a work of art to charity.145 if the artwork is donated to a museum that will display the art in its galleries, or to a university that will use the work in an art appreciation class, or to another entity that will use the art in a manner related to the charity’s exempt function, the collector will be able to deduct the full fair market value of the art as a charitable contribution deduction, including the appreciation in value of the art since it was purchased by the collector. in contrast, if the collector146 contributes the artwork to a charity that will sell the artwork (even if the charity will use the money for worthwhile charitable causes), the collector’s charitable deduction will be reduced by the amount of gain that he or she would have recognized on a hypothetical sale of the artwork. in effect, the art collector’s charitable contribution deduction will be limited to the amount the collector paid for the art. f. the partial interest rule a taxpayer generally will not be allowed a charitable contribution deduction for a gift of a partial interest in property. in other words, if a147 taxpayer donates certain rights in property to charity, and retains other rights, he or she will not be allowed any charitable contribution deduction. for example, if a taxpayer donates a copyrighted work, but does not donate the copyright, no charitable income tax deduction will be allowed. thus, in148 144. id. § 170(e)(1)(b). the same reduction rule applies on a contribution to a private foundation, except that the reduction is made for the amount of appreciation regardless of whether the private foundation will use the donated property in a manner related to its tax-exempt purpose. id. § 170(e)(1)(b)(ii). 145. robert anthoine, deductions for charitable contributions of appreciated property – the art world, 35 tax l. rev. 239 (1980); douglas j. bell, changing i.r.c. § 170(e)(1)(a): for art’s sake, 37 case w. res. l. rev. 536 (1987). 146. irc § 170(e)(1)(b)(i); anthoine, supra note 145, at 244-246. 147. irc § 170(f)(3). the exceptions to this rule include: (i) gifts of a remainder interest in a personal residence or farm, (ii) a contribution of an undivided portion of the taxpayer’s entire interest in property, and (iii) a qualified conservation contribution. id. § 170(f)(3)(b). other exceptions include qualifying charitable gift annuities and qualifying charitable remainder trusts. id. § 170(f)(2). 148. arthur anderson, tax economics of charitable giving, 158 (12th ed. 1995) (“a work of art and its copyright generally have been considered to be two interests in the same property”). in 1981, congress passed a limited exception for estate tax purposes. under irc § 2055(e)(4), the copyright and the tangible personal property will be treated as items of separate property for purposes of the estate tax charitable deduction. 2002] it does not compute 575 planning a charitable contribution, it is essential that the taxpayer donate his or her entire interest in the property (assuming that he or she wishes to claim a charitable deduction). the partial interest rule will not apply if the taxpayer donates an “undivided” interest in the property to charity, and the partial149 interest will not apply if the taxpayer donates his or her entire interest in the property to the charity. v. charitable gifts of ip under current law a. patents and charitable giving the nirvana of charitable giving tax treatment is enjoyed by the creative genius whose work results in a patent. an individual donating a patent to charity: (i) will be entitled to a charitable contribution deduction equal to the full fair market value of the appreciated property; and (ii) is free to select the public charity that will receive the gift without regard to whether the charity150 can use the patent in a manner related to its charitable purpose. 1. availability of a full fair market value deduction on the donation of a patent.—an individual donating a patent to charity will be eligible to claim a charitable contribution deduction for the full fair market value of the patent.151 this wonderful result occurs because section 1235(a) provides that the gain 149. irc § 170(f)(3)(b)(ii). 150. in order to claim a charitable contribution deduction for the full fair market value, the donation must be made to a “public charity” (as described in irc § 509(a)(1), (2) or (3)) rather than to a “private foundation.” see supra note 138 for a description of a “public charity” and a “private foundation.” in the case of a donation to a private foundation (other than an “operating” private foundation), the deduction will be reduced by any gain that would have been long-term capital gain on a hypothetical sale of the donated property. irc § 170(e)(1)(b)(ii) (a popular exception to this general rule is for gifts of appreciated marketable securities to private foundations). 151. the legislative history of the revenue act of 1950 provides that this favorable treatment is available to the inventor because “the desirability of fostering the work of inventors outweighs the small amount of additional revenue which might be obtained” if the gains from the sale of inventions, patents, and designs could not qualify for long-term capital gain treatment. s. rep. no. 2375, 81st cong., 2d sess. 44 (1950), reprinted in 1950-2 c.b. at 515 (quoted in, changing i.r.c. § 170(e)(1)(a): for art’s sake, 37 case w. res. l. rev. 536, 559, n.157-158 (1987)). id. (“[t]he inventions of amateur inventors are afforded capital asset treatment, as are the patents secured by both professionals and amateurs”). see also suresh t. advani, characterizing the “new” transfers of intellectual property, taxes, 211, 213 (march 2001) (“[c]ongress apparently considered creators of literary and artistic works less important to the welfare of the nation”). 576 florida tax review [vol.5:8 from the sale of a patent will be taxed as a long-term capital gain. as152 discussed earlier, if the gain on a hypothetical sale of the donated asset would153 be taxed as ordinary income (or short-term capital gain), the amount of the deduction on a charitable donation of that property would be reduced by the amount of that gain. since a gain on the hypothetical sale of a patent would154 be taxed as long-term capital gain, no reduction in the charitable contribution deduction for the appreciation in value is necessary. moreover, it is not even necessary for the patent or the patent application to be in existence for section 1235 to apply. favorable tax treatment is available for the transfer of an inchoate right to obtain a patent (as long as the subject matter is patentable).155 2. patents and the partial interest rule.—as discussed above, as a general rule, a taxpayer who donates only a “partial interest” in property is 152. irc § 1235(a) provides in part that “a transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year . . . .” (emphasis added). a “holder” is an individual who either created the property, or who acquired his or her interest before the invention was “reduced to practice” in exchange for consideration paid to the creator. irc § 1235(b). section 1235 was enacted to assist and encourage individual inventors (by providing favorable tax treatment on the sale of a patent). see s. rep. no. 1622, 83d cong., 2d sess. 439 (1954) (section 1235 was enacted “to provide an incentive to inventors to contribute to the welfare of the nation”), reprinted in charles edward falk, tax planning for the development and licensing of patents and know-how, 557 tax mgmt. (bna) b-301; see also advani, supra note 151, at 212. section 1235 makes no distinction between a “professional” inventor (who might be said to hold his inventions as inventory), and the more casual inventor (who might be described as an upstairs attic inventor). falk, supra at a-22. thus, inventors (and their patents) have been twice blessed by congress – in 1950, congress chose not to include patents in the list of property that cannot qualify for capital gain treatment under irc § 1221(a)(3), see supra note 151; and in 1954, congress enacted § 1235. 153. see supra notes 141-143 and accompanying text. 154. irc § 170(e)(1)(a) (“[t]he amount of any charitable contribution of property otherwise taken into account . . . shall be reduced by . . . the amount of gain which would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value . . . .”). 155. regs. § 1.1235-2(a); s. rep. no. 1622, 83rd cong., 2d sess. 439 (1954), reprinted in falk, supra note 152, at b-301; id. at a-10 (“section 1235 can apply if the product is patentable”); gilson v. commissioner, 48 t.c. memo (cch) 922, 926 (1984) (“[i]t is largely irrelevant that out of the 82 separate contracts, only one or two of [the taxpayer’s] designs were actually patented . . . . for a transfer to come within section 1235, it is sufficient that the taxpayer transfer all substantial rights to a patentable product . . . .”). 2002] it does not compute 577 prohibited from claiming any charitable contribution deduction. however, an156 individual can contribute an “undivided” fractional interest in a patent and claim a deduction for the value of the portion contributed even though the donor has retained for himself or herself valuable rights under the patent. for157 example, the donor can contribute a one-fourth interest in the patent to a charity, retain the remaining three-fourth interest, and claim a charitable deduction for the one-fourth interest donated. in a 1958 ruling, the irs concluded that a deduction would be available if the donor, before making the charitable contribution, granted his wholly-owned corporation a license to practice the patent and sell the resulting products; subsequent developments may prevent a deduction in that situation today.158 3. donation of a patent compared to a donation of services.—the tax consequences for the individual who donates a patent to charity are far more favorable than for the taxpayer who merely donates his or her services to charity. the inventor of a patent will not be required to recognize taxable income on the donation of his or her patent, will not be taxed on any royalties or other income earned by the charity from the exploitation of the patent, and159 156. irc § 170(f)(3). see supra notes 147-149 and accompanying text. 157. section 1235 applies to a transfer of “all substantial rights to a patent, or an undivided interest therein . . . .” (emphasis added) “[a]ll substantial rights” will not be transferred if the transfer is limited in duration to a period less than the remaining life of the patent; the rights granted are limited to particular fields of use, or the grant covers less than all the claims covered by the patent. regs. § 1.1235-2(b)(1)(ii) – (iv). in addition, “all substantial rights” will not have been transferred if the grant of patent rights is limited to a particular geographic area within the country issuing the patent. id. § 1.1235-2(b)(1)(i). 158. in rev. rul. 58-260, 1958-1 c.b. 126, the taxpayer was the inventor and owner of a patented process. the taxpayer granted to a corporation (wholly-owned by the taxpayer and his wife) a nonexclusive right to practice the process and sell the product. thereafter, the taxpayer contributed a one-fourth interest in the patent to charity. the irs concluded that the taxpayer would be entitled to a charitable contribution deduction for the fair market value of the one-fourth interest. in 1969, congress enacted the partial interest rule of irc § 170(f)(3), tax reform act of 1969, pub. l. no. 91-172, § 201(a)(1), and although a deduction is permitted if the taxpayer contributes his or her entire interest in the property, no deduction is allowed if the property was divided for the purpose of circumventing the partial interest rule. regs. § 1.170a-7(a)(2)(i). 159. id. nevertheless, if a donor merely assigns a right to receive royalties to a charity (rather than assigning the patent or an undivided interest in the patent), the donor will be required to include the royalty amount in his or her gross income, and will be eligible for a charitable contribution deduction for the amount of the royalties actually paid to charity. barbara l. kirschten & carla neeley freitag, charitable contributions: income tax aspects, 521 tax mgmt. (bna) 11. this would put the 578 florida tax review [vol.5:8 will be entitled to a charitable deduction for the full fair market value of the patent. while a taxpayer who provides services to charity will not be required to include the value of those services in his or her income, those who provide160 services to charity are not entitled to a charitable deduction for the value of the services. in an early case the irs argued that an inventor should not be161 entitled to a charitable contribution deduction because the donation of the invention was similar to a donation of services, but the tax court rejected that argument, stating that the inventor’s services are “coalesced in the resultant property interests.”162 4. potential pitfalls for the donor of a patent.—not surprisingly, there are a few potential traps for the inventor making a charitable gift. section 1235 (which in effect permits the donor to claim a full fair market value charitable deduction) does not apply to a corporation or other entity. also, section 1235163 inventor in a potentially dangerous situation – he or she would be taxed on the full amount of the royalties received by the charity, but his or her charitable deduction may be limited by the 50% rule of irc § 170(b)(1), and/or the 3%/80% rule of irc § 68(a). under the 50% rule, a taxpayer can only claim charitable contribution deductions for the year (for cash gifts to public charities) up to 50% of his or her modified adjusted gross income (any excess can be carried forward for five years). under irc § 68(a), a taxpayer with taxable income in excess of the threshold amount (in 2002, $137,300, or $68,650 for married individuals filing separately) will have his or her itemized deductions (including charitable contributions) reduced by the lesser of: (i) 3% of his or her adjusted gross income in excess of the threshold amount; or (ii) 80% of the itemized deductions otherwise allowable for the year. see text accompanying supra notes 132-140. thus, the inventor might be taxed on all the royalty income, but the amount of his or her charitable deduction may be limited. 160. for example, an attorney who provides pro bono legal services to his or her favorite charity is not required to include in his or her taxable income the fair value of his or her services. this is an obvious result in the case of a “cash basis taxpayer” because the taxpayer never has actual or constructive receipt of any fees for the services provided to charity. regs. § 1.446-1(c)(1)(i). 161. regs. § 1.170a-1(g); see levine v. commissioner, 54 t.c. memo (cch) 209; t.c. memo (ria) ¶ 87,413 (1987) (attorney was not entitled to claim a charitable contribution deduction for the value of legal services provided to charity; the government had stipulated that the value of the attorney’s services for the year was $7,000). 162. cupler v. commissioner, 64 t.c. 946, 954 (1975) (emphasis added). however, as one commentator has stated, “[t]he fact that intellectual property is the fruit of individual effort has not been lost on the tax law.” advani, supra note 151, at 219. 163. irc § 1235(b); rev. rul. 76-414, 1976-2 c.b. 248; see falk, supra note 152, at a-17 (stating that neither a partnership, trust, estate or a corporation can use section 1235). although a partnership cannot be a “holder” under section 1235, any individual member of the partnership may qualify under irc § 1235(a) as to his or her 2002] it does not compute 579 only applies when there has been a transfer of all substantial rights in a patent, or when there has been a transfer of an undivided interest in a patent. as a result, section 1235 would not be available if the donor merely grants the charity a license to use the patent (which is limited geographically, or covers some but not all of the patent claims or uses). when section 1235 does not164 apply, the tax consequences of the arrangement need to be analyzed under the tax rules that otherwise apply to a sale or exchange of property.165 also, the irs may dispute the taxpayer’s valuation of the donated patent. in valuing a patent, the irs has successfully argued that patent166 validity, technological feasibility, and difficulty of enforcement should be considered. the potential for disagreement is highlighted in the case of smith167 v. commissioner, in which the taxpayer (a patent attorney for hewlett-packard) claimed that the value of his donated patent was over $200,000. the irs and the tax court concluded that the value of the patent was $3,500.168 in addition, if the donor merely gives the prototype, machine or product that is produced from the patentable invention to the charity, but fails to actually assign all or an undivided interest in the patent (or the potential patent) to the charity, a charitable deduction will be allowed for only the fair market value of the prototype, machine, or product, which undoubtedly will be much lower than the fair market value of the object and the patent together. the dangers of this potential pitfall were illustrated by a rather unfortunate taxpayer (john a. cupler ii) who described himself as a “mad scientist.” the tax169 court described mr. cupler as an “extraordinarily gifted and dedicated engineer” who had produced at least 50 patents on inventions in the field of share of the invention owned by the partnership. regs. § 1.1235-2(d)(2). this could be very important if there are several individuals who operate as a partnership with respect to a particular patentable invention. 164. regs. § 1.1235-2(b)(1) (ii)-(iv); s. rep. no. 1622, 83d cong., 2d sess. 438 (1954), reprinted in falk, supra note 152, at b-301. 165. rev. rul. 69-482, 1969-2 c.b. 164 (concluding that “sale or exchange” treatment may be available even if section 1235 does not apply). the proper tax treatment for those who fail to qualify under section 1235 can be subject to considerable debate. see falk, supra note 152, at a-22 to a-27. the tax rules that generally apply to a sale or exchange of property are described below in regards to a sale of a trade secret. see text accompanying infra notes 179-206. 166. smith v. commissioner, 41 t.c. memo (cch) 1427; t.c. memo (ria) ¶ 81,219 (1981). 167. id. for charitable contribution purposes, the “fair market value” of donated property generally is the price at which a willing buyer and a willing seller, neither under any particular compulsion to buy or sell, would reach an agreement on the sale of the property. regs. § 1.170a-1(c)(1). 168. smith, 41 t.c.m. (cch) at 1427. 169. cupler v. commissioner, 64 t.c. 946, 954, n.4 (1970). 580 florida tax review [vol.5:8 precision drilling equipment, and “made a significant contribution to medical knowledge” in preparing an advanced (for that time) cataract removal machine, and a heart-lung machine. mr. cupler donated both machines to charity. in claiming his charitable contribution deductions, mr. cupler valued his donations at $144,500 and $149,990. unfortunately, the irs and the tax court noticed that mr. cupler had failed to assign his (potential) patent rights in the inventions to charity, and concluded that he was entitled to charitable contribution deductions of only $10,000 and $15,000, respectively. 5. the “related use” restriction does not apply.—since a patent is intangible property, the “related use” restriction does not apply to a170 charitable donation of a patent. as discussed above, the “related use” restriction provides that to claim a deduction equal to the fair market value of tangible property, the property must be donated to a charity which will use the property in a manner related to its charitable purpose (for example, a museum may display a donated painting, thereby employing the painting in a “related” use). thus, the individual donating a patent is free to donate the patent to his171 or her favorite public charity and receive the maximum tax benefit, regardless of whether the receiving charity retains the property and uses the property in carrying out its exempt purpose. for example, the donor can contribute the patent to a church which can immediately sell the patent, and the church172 could use the proceeds to help the poor. alternatively, the church might license the patent and receive royalty income that would not be subject to the ubit.173 170. irc § 170(e)(1)(b). see supra notes 144-146 and accompanying text for a general discussion of the “related use” restriction. 171. under irc § 170(e)(1)(b)(i) if the use by the donee of the tangible property is unrelated to the organization’s charitable purposes or functions, the amount of the deduction will be reduced by any long-term capital gain that would have resulted from a sale of the property. see supra notes 144-146 and accompanying text. 172. initially it might appear that the irs or a court could use the “step transaction” or “substance over form” doctrines to conclude that in reality the inventor is selling the patent, and then transferring the sale proceeds to the charity. this tax characterization would not be as favorable to the inventor because he or she would pay tax on the gain from the sale. however, in the context of charitable gifts of appreciated property, the courts have traditionally held that the “step transaction” and/or “substance over form” doctrines will not apply as long as the charity is not obligated to sell the property at the time of the donation. see palmer v. commissioner, 62 t.c. 684 (1974), aff’d 523 f.2d 1308 (8th cir. 1975), acq. rev. rul. 78-197, 1978-1 c.b. 83; grove v. commissioner, 490 f.2d 241 (2d cir. 1973); carrington v. united states, 476 f.2d 704 (5th cir. 1973). 173. irc § 512(b)(2). see supra notes 116-118 and accompanying text. 2002] it does not compute 581 b. trade secrets and charitable giving while the creative genius who gives birth to a trade secret will encounter a more difficult and circuitous route, the path to charitable giving tax nirvana can be attained in the right circumstances — the donor can be entitled to a charitable contribution deduction equal to the full fair market value of the property, even if the charity will not use the property in a manner related to its charitable purpose. 1. trade secret protection compared to patent protection.—frequently, information can be eligible for trade secret protection, but cannot be patented. in some instances, even if patent protection is available, the inventor may prefer trade secret protection over patent protection. as174 described above, generally any information may qualify for trade secret protection if it: (i) has independent economic value; (ii) is not generally known and is not readily ascertainable by proper means; and (iii) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.175 174. for an example in which the inventor preferred trade secret protection over patent protection, see kewanee oil v. bicron corp., 416 u.s. 470 (1974), discussed at supra note 25. an inventor may prefer trade secret protection because patent protection is for a limited duration, but trade secret protection can last for as long as the information remains a secret. the inventor with a patent will have the exclusive right to exclude others from using the innovation for only a fixed period of time – generally 20 years from the date of filing the application. 35 u.s.c. § 154(a)(2). in contrast, the protection afforded a trade secret is potentially perpetual, although it will end once the information is no longer “secret.” for example, the formula for producing a soft drink might be patentable, but once the patent is issued (or if the inventor seeks patent protection beyond the united states, 18 months after the application is filed, 35 u.s.c. § 122(b)), the formula will be disclosed to the public, and the inventor’s exclusive rights will end 20 years after the patent application is filed. 35 u.s.c. § 154(a)(2) (unless the pto has delayed the consideration of the application). in contrast, if no patent application is filed and instead the soft drink inventor relies upon trade secret protection, the inventor can enjoy the exclusive right to exploit the soft drink for as long as it remains a secret. in addition, if the trade secret inventor and a licensee agree that the licensee shall make payments for a fixed period of time, the trade secret inventor may be able to collect royalties under the contract long after the information is no longer secret. see warner-lambert pharmaceutical co. v. reynolds, inc., 178 f.supp. 655 (s.d.n.y. 1959) (involving the formula for listerine®). 175. see supra notes 22-25 and accompanying text. uniform trade secrets act § 1(4), reprinted in 14 uniform laws annotated 438 (1990) (as discussed above, the uniform trade secrets act has been adopted by 43 states and the district of columbia) id. at 2001 supp., 177, and many states have adopted the utsa with modifications. for example, california does not include the “readily ascertainable” language in the definition of a trade secret. see cal. civ. code § 3426.1 (1997). 582 florida tax review [vol.5:8 in contrast, patent protection is only available if a process, machine, manufacture, or composition of matter (or any new and useful improvements thereof) is novel, has utility, and is not obvious. if an invention is eligible176 177 for both trade secret protection and patent protection, the inventor must make a choice because obtaining a patent will cause the public disclosure of the “secret.” in fact, as a result of the 1999 changes to the patent act, secrecy (and thus trade secret protection) generally will be lost no later than 18 months after the patent application is filed, even if the patent has not yet issued.178 2. availability of a full fair market value deduction on the donation of a trade secret.— for the inventor wishing to make a charitable contribution of a patentable invention, the inventor will want to characterize the donation as a contribution of a patent (or the rights to a patent) so that section 1235(a) will apply and the inventor will be allowed to claim a full fair market value deduction for the value of the patent rights. as noted above, section 1235(a)179 can apply even if the inventor has not obtained or applied for a patent, as180 long as he or she transfers the patent rights to the charity.181 the more difficult situation involves the inventor whose work product is a trade secret, but is not patentable. as discussed above, the amount of the charitable contribution deduction will be reduced by the amount of gain that would have been taxed as ordinary income (or short-term capital gain) on a hypothetical sale of the donated property. thus, the key question is whether182 a gain from the hypothetical sale of a trade secret would be taxed as ordinary income or long-term capital gain. unlike the patent inventor who generally can rely on section 1235(a) for a favorable answer in most cases, the trade secret inventor must deal with 176. 35 u.s.c. § 101. 177. 35 u.s.c. §§ 102 (novelty), 103 (non-obvious). 178. 35 u.s.c. § 122(b) (if the applicant certifies that the invention will not be the subject of a patent application in another country, the invention will not be made public by the pto until the patent is issued). 179. if an invention qualifies for both patent and trade secret protection, favorable tax treatment should be available. the regulations and legislative history provide that section 1235 will apply as long as the invention is patentable even if no patent application has been filed. regs. § 1.1235-2(a); s. rep. no. 1622, 83rd cong. 2d sess., 439, reprinted in falk, supra note 152, at b-301. 180. id. 181. presumably if the inventor wishes to assert that he or she donated patent rights, he or she will need to make the donation within one year of the first publication, public use, or offer for sale because after those dates, patent protection is no longer available. 35 u.s.c. § 102(b). 182. irc § 170(e)(1)(a). 2002] it does not compute 583 the general tax rules for determining when a gain will be taxed as ordinary income or long-term capital gain. under general tax rules, four requirements must be satisfied to generate a long-term capital gain: (i) there must be a sale or exchange; (ii) of property; (iii) which is a capital asset; and (iv) which has been held by the taxpayer for more than one year. a. property.—a fundamental issue is whether the trade secret will be considered “property” for tax purposes. if the trade secret is not property, presumably the inventor is merely donating his or her “services,” and as discussed above, a charitable contribution of the taxpayer’s services generates no charitable deduction. the difficulty arises because the invention183 is the “fruit of the inventor’s labor,” and the payment for the invention184 compensates the inventor for his or her services. the tax court has noted that the “difficulty increases when the inventions transferred are not patents, and thus within section 1235, . . . but rather are more amorphous assets such as trade secrets or know-how which might be characterized as capital assets under section 1221.” the irs and the courts generally have held that a secret185 process or a secret formula will be considered property (rather than services). the irs has issued three revenue rulings and two revenue procedures186 187 considering this issue. in revenue ruling 64-56, the irs held that the term “property” for purposes of section 351 of the internal revenue code includes188 anything qualifying as “secret processes and formulas . . . and any other secret information as to a device, process, etc. in the general nature of a patentable invention without regard to whether a patent has been applied for . . . , and without regard to whether it is patentable in the patent law sense . . . other information which is secret will be given consideration as ‘property’ on a case by case basis.” the irs specifically stated that services which are “ancillary189 183. regs. § 1.170a-1(g). see supra notes 159-162 and accompanying text. 184. ofria v. commissioner, 77 t.c. 524, 535 (1981), nonacq. 1983-1 c.b. 1. 185. id. 186. rev. rul. 55-17, 1955-1 c.b. 388, modified by rev. rul. 64-56, 1964-1 (part 1) c.b. 133, amplified by rev. rul. 71-564, 1971-2 c.b. 179. 187. rev. proc. 69-19, 1969-2 c.b. 301, amplified by rev. proc. 74-36, 19742 c.b. 491. 188. irc § 351(a) provides that “no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange, such person or persons are in control . . . of the corporation.” (emphasis added). 189. rev. rul. 64-56, 1964-1 (part 1) c.b. 133 (emphasis added). 584 florida tax review [vol.5:8 and subsidiary” to the transfer of property could qualify as “property.” in190 revenue procedure 69-19, the irs set forth a list of representations which191 a taxpayer must make for the irs to issue a favorable advance ruling that a transfer of information will be treated as a transfer of “property” for purposes of sections 351 and 367 of the internal revenue code. the representations required include: (i) the information being transferred “is afforded substantial legal protection against unauthorized disclosure and use under [applicable] law.” (ii) any services to be performed in connection with the transfer of the information will be merely ancillary and subsidiary to the property transfer (or the transferor will be separately compensated for the services). (iii) “the ‘information’ is secret in that it is known only by the owner and those confidential employees who require the ‘information’ for use in the conduct of the activities to which it is related and adequate safeguards have been taken to guard the secret against unauthorized disclosure.”192 (iv) “the ‘information’ represents a discovery and while not necessarily patentable, the ‘information’ is original, unique, and novel.”193 190. id. at 134. the revenue ruling states that “whether or not services are merely ancillary and subsidiary to a property transfer is a question of fact.” id. ancillary and subsidiary services may include demonstrating and explaining the use of the property, or assisting in the “start-up” of the property transferred. id. 191. rev. proc. 69-19, 1969-2 c.b. 301, amplified by rev. proc. 74-36, 19742 c.b. 491. 192. presumably the disclosure to the charity would not prevent the information from continuing to be considered “secret” for trade secret purposes. see supra notes 2829. 193. rev. proc. 69-19, 1969-2 c.b. 301 (emphasis added). generally, “original, unique, and novel” are not the standards for granting trade secret protection. instead, the uniform trade secrets act merely requires that the information: (i) has independent economic value; (ii) is not generally known and is not readily ascertainable by proper means; and (iii) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy. utsa § 1(4), reprinted in 14 uniform laws annotated, at 438 (1990). as discussed above, see text accompanying supra notes 9-12, the standards for obtaining a utility patent are that “the process, machine, manufacture, or composition of matter, or any new and useful improvement thereon” must: (i) have utility, (ii) be “novel,” and (iii) be non-obvious. 35 u.s.c. §§ 101–103. 2002] it does not compute 585 (v) “the ‘information’ does not represent mere knowledge, or efficiency resulting from experience, or mere skill in manipulation or total accumulated experience and skill of the transferor.” these are representations required to obtain a favorable advance letter ruling from the irs. courts (and presumably the irs) would not require that all these conditions exist to conclude in an actual case that particular information is “property.” in dupont v. united states, the government conceded that a secret process was “property.” in ofria v. commissioner, the taxpayer developed194 195 improvements while producing a fuze bomb coupler for the air force under a defense procurement contract. under the terms of the contract, the taxpayer submitted the improvements to the air force and was paid substantial amounts for the improvements based on the cost savings realized by the air force. the irs argued that the improvements were not “property” and the money received for the transfer of those improvements was taxable as ordinary income rather than capital gain. the tax court held that the improvements (and all related rights therein) constituted “property,” and the transfers constituted the “sale of capital assets.” the tax court stated: in general, it has been held that when an inventor is employed for the purpose of developing inventions for his employer, and the contract between the parties provides that inventions developed during the performance of the contract become the property of the employer, then the payments to the inventor are in the nature of compensation for services, taxable as ordinary income. conversely, if the contract does not provide that the fruits of the inventor’s labor belong to the employer, and the inventor therefore has transferable property rights in his inventions, then payments in consideration of the transfer of these rights are payments in exchange for property and may qualify as gain from the sale of capital assets.196 the tax court went on to state, these facts indicate the existence of a trade secret or other property right, and we thus find that [taxpayers] have established that each of the value engineering proposals 194. 288 f.2d 904, 910 (ct. cl. 1961). 195. 77 t.c. 524 (1981). 196. id. at 535-6 (emphasis added). 586 florida tax review [vol.5:8 incorporated trade secrets, know-how, or unpatented technology protectable as a form of property . . . . although these inventions have not been shown to be patentable, and thus cannot qualify for capital gain treatment under section 1235, they were commercially valuable improvements over the existing art sufficiently akin to patentable inventions to qualify as capital assets under section 1221, either as trade secrets or know-how or unpatented technology.197 the tax court’s language may imply that even if the invention cannot qualify as a trade secret, it might still be considered “property” under section 1221 in the form of “know-how” or “unpatented technology.” b. sale or exchange.—the second requirement for capital gain treatment is a “sale or exchange.” as indicated in the following discussion by the court of claims in dupont v. united states, it is essential that the transaction qualify as a “sale or exchange” rather than the mere provision of services.198 were we to accept [the taxpayer’s] position without qualification, it would be similar to concluding that a lawyer makes a sale of property when he discloses an estate plan to a client, and a doctor makes a sale when he discloses the diagnosis of his patient’s ills [citation omitted]. in another light, however, the transfer of a trade secret may be a transaction equivalent to a sale, in the same manner that a patent assignment is considered a sale. in each case the transferee or assignee gets more than mere information. of greater importance, he obtains what he believes to be a competitive advantage, a means for commercial exploitation and reward. . . . . . . . unlike an estate plan or a diagnosis, a trade secret, as a tool for commercial competition, derives much of its value 197. id. at 540-541 (emphasis added). 198. 288 f.2d 904 (ct. cl. 1961). amounts received for providing services are taxed as ordinary income. irc § 61(a)(1). 2002] it does not compute 587 from the fact of its secrecy. it is truly valuable only so long as it is a secret, for only so long does it provide an advantage over competitors. it follows that the essential element of a trade secret which permits of ownership and which distinguishes it from other forms of ideas is the right in the discoverer to prevent unauthorized disclosure of the secret. no disposition of a trade secret is complete without some transfer of this right to prevent unauthorized disclosure.199 the court of claims in dupont concludes by stating: when the owner of a trade secret gives the right to use the secret and in addition conveys his most important remaining right, the right to prevent unauthorized disclosure (and effectively the right to prevent further use of the trade secret by others) there is a complete disposition of the trade secret. this transaction meets the “sale” requirement of the code and any gain would be entitled to preferential capital treatment.200 thus, a transfer of a trade secret (along with all related rights) can qualify as a “sale or exchange.” in contrast, the granting of a non-exclusive license to use a trade secret will not qualify as a “sale or exchange,” and any consideration received by the inventor will be treated as a royalty and taxed as ordinary income.201 furthermore, a grant of an exclusive license for a limited period of time may result in ordinary income (rather than capital gain) if “substantial rights” have been retained under the facts and circumstances.202 199. id. at 911 (emphasis added). 200. id. at 912. 201. irc § 61(a)(6) (royalty income is taxed as ordinary income). see generally falk, supra note 152, at a-32. 202. compare henry vogt machine co. v. commissioner, 66 t.c. memo (cch) 426 (1993) (the inventor retained the right to license to others in the same geographic territory after 10 years; the court concluded that as a result, the taxpayer retained substantial rights so that the amount received would be taxed as ordinary income), with hooker chemical and plastics corp. v. united states, 591 f.2d 652 (cl. ct. 1979), aff’g 78-2 u.s. tax cas. (cch) ¶ 9500 (cl. ct. 1978) (license was subject to duration limit, but court held that inventor had transferred “all substantial rights” so that gain could be taxed as long-term capital gain). 588 florida tax review [vol.5:8 c. capital asset.—not surprisingly, in order for the sale of an asset to generate long-term capital gain, the asset must be a “capital asset.” under section 1221 of the internal revenue code, all property held by the taxpayer which is not specifically excluded is considered a “capital asset.” the most significant exclusion for the trade secret inventor is for “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer . . . .” also, the gain from the sale of property203 used in a trade or business which is subject to the allowance for depreciation under section 167 of the internal revenue code in some situations may be taxed as ordinary income.204 as a result of the inventory exclusion of section 1221(a)(1), a professional inventor who develops and sells trade secrets on a regular basis (and therefore holds trade secrets as “inventory”) will recognize ordinary income (rather than capital gain) on the sale of the trade secrets. on the other205 hand, the amateur inventor who sells a trade secret will be selling a capital asset. d. held more than one year.—section 1222(3) of the internal revenue code defines a “long-term capital gain” as “gain from the sale or exchange of a capital asset held more than one year . . . .” before the enactment of section 1235, courts held that the “holding period” of a patent commences 203. irc § 1221(a)(1). 204. irc § 1221(a)(2) generally excludes property used in a trade or business which is of a character subject to the allowance for depreciation under section 167 from the definition of a “capital asset.” however, under irc § 1231, a gain from the sale or exchange of depreciable trade or business property will be taxed as a long-term capital gain if the taxpayer’s gains on the sale or exchange of section 1231 assets during the year exceed the taxpayer’s losses on the sale or exchange of section 1231 assets during the year. the tax court has held that a trade secret will not be depreciable under irc § 167 unless it has a reasonably ascertainable useful life. yates industries, inc. v. commissioner, 58 t.c. 961 (1972). since the “life” of a trade secret will end when it is no longer a “secret,” presumably one method for establishing the duration of the useful life would be to estimate the amount of time needed for others to discover the secret by proper means. proper means of discovery include: (i) independent discovery, or (ii) reverse engineering. see e. i. dupont denemours & co. v. christopher, 431 f.2d 1012 (5th cir. 1970), cert denied 400 u.s. 1234 (1971) (discussing “proper means”). 205. falk, supra note 152, at a-33. in contrast, under section 1235, upon the sale or exchange of a patent, there is no distinction between the professional and the amateur inventor – any gain on the sale or exchange of a patent (or a patent application, or the inchoate right to a patent) will be taxed as long-term capital gain. 2002] it does not compute 589 when the invention is “actually reduced to practice.” presumably, a similar206 approach would apply when determining the holding period for a trade secret.207 3. the “related use” restriction does not apply.—as with a patent, since a trade secret is intangible property, the related use restriction of section 170(e)(1)(b) should not apply to a charitable gift of a trade secret. c. trademarks and charitable giving like the trade secret inventor, the owner of a trademark may be able to donate his or her trademark to a charity and deduct an amount equal to the full fair market value of the trademark as a charitable contribution. as discussed above, to obtain a full fair market value deduction on a charitable contribution of property, the gain from a hypothetical sale of the donated property would need to be taxed as a long-term capital gain (rather than ordinary income). traditionally the grant of a perpetual right to exploit a208 trademark, trade name or franchise was considered a capital transaction eligible for long-term capital gain treatment. as discussed above in the case of a209 transfer of a trade secret, the general tax rules that must be met for a taxpayer to enjoy long-term capital gain treatment are: (i) there must be a sale or exchange; (ii) of property; (iii) which is a capital asset; and (iv) which has210 been held by the taxpayer for more than one year. as a result of uncertainty and conflicting court opinions, in 1969 congress enacted section 1253 of the code to provide that under certain situations the transfer of a trademark, trade name or franchise will not be 206. the term “reduced to practice” is used in the patent act. 35 u.s.c. § 102(g). a district court has stated that an invention is reduced to practice by a “demonstration that the inventor’s idea works.” allied chemical corp. v. united states, 66-1 u.s. tax cas. (cch) ¶ 9212 (s.d.n.y. 1966), aff’d. 370 f.2d 697 (2d cir. 1967). see also regs. § 1.12352(e) (“generally an invention is reduced to actual practice when it has been tested and operated successfully under operating conditions. this may occur before or after application for a patent but cannot occur later than the earliest time that commercial exploitation of the invention occurs”). 207. see falk, supra note 152, at a-32. again the donor of a patent has an advantage over the donor of a trade secret. the gain from the sale of a patent will be taxed as long-term capital gain under irc § 1235(a) whether or not the seller has held the patent rights for more than one year. 208. irc § 170(e)(1)(a). 209. seattle brewing & malting co. v. commissioner, 6 t.c. 856, 873 (1946); see generally, charles falk, tax planning for the development and licensing of copyrights, computer software, trademarks, and franchises, 558 tax mgmt. (bna) a-44 (1997). 210. the mere granting of a limited trademark license would not be a “sale or exchange;” rather it would generate royalties taxed as ordinary income. irc § 61(a)(6). 590 florida tax review [vol.5:8 treated as the sale or exchange of a capital asset. prior to the enactment of211 section 1253, taxpayers, the irs, and the courts struggled with cases in which payments for a franchise were made over a series of years and the payments were measured by a percentage of the selling price of the products sold or based on the units manufactured or sold. sometimes the arrangement was treated212 as a license, and sometimes the arrangement was treated as the sale of a213 capital asset. section 1253(a) provides that the transfer will not be treated as214 the sale or exchange of a capital asset if “the transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark, or trade name.” the transferor will be deemed to have retained a significant power, right, or continuing interest if he or she retains “[a] right to payments contingent on the productivity, use, or disposition of the subject matter of the interest transferred, if such payments constitute a substantial element under the transfer agreement.”215 211. irc § 1253(a); s. rep. no. 552, 91st cong., 1st sess. (1969), reprinted at 1969-3 c.b. 554. one commentator has described section 1253 as the “evil twin” of section 1235, stating “[a]lthough both sections focus on the degree of rights retained, code section 1235 is designed as a safe harbor to sweep transactions into capital gain treatment, while code section 1253 takes the negative approach of making sure certain transactions stay out.” advani, supra note 151, at 213. 212. id. 213. if the transaction is treated as a license, the payer (the licensee) would be entitled to a tax deduction as long as the amount paid is an ordinary and necessary business expense, irc § 162(a), and the amounts received by the payee (the licensor) would be taxed as ordinary income. irc § 61(a)(6). 214. if the transaction is treated as the sale of a capital asset, the purchaser would not be entitled to a tax deduction for the full purchase price in the year of purchase (but presumably would be able to amortize the purchase price over 15 years under irc § 197), and any gain for the seller would be taxed as long-term capital gain (assuming the trademark had been held for at least one year). 215. irc § 1253(b)(2)(f). the other “significant power[s], right[s] or continuing interest[s]” (which will preclude treatment as a sale or exchange of a capital asset) listed in the statute are: (i) a right to disapprove any assignment of such interest, or any part thereof; (ii) a right to terminate at will; (iii) a right to prescribe the standards of quality of products used or sold, or of services furnished, and of the equipment and facilities used to promote such products or services; (iv) a right to require that the transferee sell or advertise only products or services of the transferor; and (v) a right to require that the transferee purchase substantially all of his or her supplies and equipment from the transferor. irc § 1253(b)(2)(a) (e). note that if a trademark owner does not retain the rights in clause (iii) above (the right to prescribe the standards of quality of products used or sold, etc.,), the trademark owner likely will be deemed to have abandoned his or her trademark rights (because the trademark owner has granted a “naked” license). see dawn donut co., inc. v. hart’s food stores, inc., 267 f.2d 358 (2d cir. 1959); e. i. dupont de nemours & co. v. celanese corp. of america, 167 f.2d 2002] it does not compute 591 thus, like the trade secret inventor, the trademark owner can be entitled to claim a full fair market value deduction on the donation of his or her trademark, but certain requirements must be met. as with the patent and the trade secret, the related use restriction of section 170(e)(1)(b) should not apply to a charitable gift of a trademark because a trademark is intangible property. d. copyrights and charitable giving in sharp contrast to the tax treatment of a creative genius who donates his or her patent, trade secret, or trademark to charity, the genius who donates a copyright to charity receives almost no reward from the income tax system.216 these tax rules do not encourage the flow of copyrights and related works for the benefit of charitable goals, and can result in similarly situated taxpayers being treated differently.217 484 (c.c.p.a. 1948); j. thomas mccarthy, supra note 35, at §§ 18.42 and 18.48. in effect, in order for a transfer of a trademark to qualify as a sale of a capital asset, the seller basically must transfer all of his or her rights in the trademark. 216. as a result of irc §§ 170(e)(1)(a) and 1221(a)(3), the creator who donates a copyright will be able to deduct only his or her cost basis in the copyright (rather than the fair market value of the copyright). in addition, the “collector” who contributes tangible personal property related to intellectual property rights may find his or her income tax deduction reduced by any gain that would have resulted from a hypothetical sale of the donated property. irc § 170(e)(1)(b)(i) (unless the “related use” test is satisfied). the “related use” restriction can be very important in the copyright area because works of art and manuscripts can be popular collectors’ items and can have significant value. a “collector” is distinguished from a “dealer.” a dealer is regularly engaged in the trade or business of selling the items. the dealer holds the items for sale to customers in the ordinary course of his or her trade or business. as a result, any gain on a sale by a dealer will be taxed as ordinary income, irc § 1221(a)(1), and the amount of any charitable deduction on a contribution of the property will be limited to his or her cost basis. irc § 170(e)(1)(a). in contrast, a “collector” holds the items for the production of income (as an investment), but does not hold the items for sale to customers. as a result, the gain on a sale by a collector can qualify as a long-term capital gain, but a full fair market value deduction will be available on a charitable gift of the item(s) only if the “related use” test will be satisfied. irc § 170(e)(1)(b). 217. joseph m. dodge, the logic of tax: federal income tax theory and policy, 88 (1989) (“horizontal equity: persons in the same position should bear the same tax burden”); comment, changing i.r.c. 170(e)(1)(a): for art’s sake, 37 case w. res. l. rev. 541 (1987) (horizontal equity encompasses the principle that taxpayers [in similar situations] should pay the same tax); joseph a. pechman, federal tax policy, 5 (4th ed. 1983) (horizontal equity aims to “distribute the cost of government fairly . . . among people in approximately the same economic circumstances . . . .”). see also t.d. 8785, 1998-2 c.b. 494, 495 (in discussing regulations on the tax treatment of computer 592 florida tax review [vol.5:8 1. no full fair market value deduction for the creator’s donation of a copyright.—as discussed above, in determining the amount of the charitable income tax deduction, a preliminary question is whether the gain from a hypothetical sale of the donated property would be taxed as long-term capital gain or ordinary income. if the gain on the sale would be taxed as ordinary218 income (or short-term capital gain), the charitable contribution deduction otherwise available is reduced by the amount of the gain, so that the donor can only deduct his or her cost basis in the property. the definition of “capital asset” excludes “a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property,” held by a person who fits one of the following three descriptions:219 “(a) a taxpayer whose personal efforts created such property [the “creator”], (b) in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or (c) a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (a) or (b).”220 since the copyright or composition is not a “capital asset” in these circumstances, the gain from a hypothetical sale would not be taxed as capital gain, and any charitable income tax deduction will be limited to the221 taxpayer’s basis in the donated property.222 in many cases, the taxpayer’s cost basis will be minimal – the author’s basis may be limited to the cost of his or her pencils and paper; the artist’s cost may be only the cost of the paint, brushes, canvas, and frame. the sharp223 programs in cross-border transactions, the irs stated this same concept in the following words: “functionally equivalent transactions should be treated similarly”). 218. irc § 170(e)(1)(a). “before 1950, transfers of patents and copyrights were treated substantially the same for purposes of capital gain taxation.” note, a comparison of the tax treatment of authors and inventors, 70 harv. l. rev. 1419, 1420 (1957). 219. irc § 1221(a)(3) (emphasis added). 220. irc § 1221(a)(3)(a)-(c). 221. any gain on the sale would be taxed as ordinary income. 222. irc § 1012 states that “[t]he basis of property shall be the cost of such property, except as otherwise provided . . . .” 223. see public hearings on general tax reform before the house committee on ways and means, 93d cong., 1st sess. 6118 (1973) (statement of elias newman, president, artists equity association of new york, estimating the cost of producing a rembrandt ink drawing at four cents); id. at 6130 (testimony of mr. newman stating that the manuscripts of composer igor stravinsky, worth $3.5 million, would only yield a deduction equivalent to the cost of pen, paper, and ink if mr. stravinsky were to donate them). see bell, supra note 145, at 543. commentators have stated that, in fact, mr. stravinsky contemplated donating his manuscripts to the library of congress, but elected to sell them as a result of the restrictions on charitable contributions imposed by 2002] it does not compute 593 contrast between the rules for the inventor of a patent or trade secret, and the copyright creator, are demonstrated by the following example: example #4: texas hank has written the definitive field guide to the wildlife on padre island titled “the real animals hide during spring break.” hank’s cost in preparing “real animals” was $250 (mostly paper and pens) and hank could sell all rights to “real animals” to a commercial publisher for $100,000. in addition, hank has patented a new invention called the “binoscope” that is as easy to carry as a pair of binoculars, but has the power of a telescope – an invaluable device for spotting distant wildlife. hank could sell all rights in the “binoscope” to a commercial firm for $100,000. if hank donates all rights to “real animals” to a charity, he will be entitled to a charitable deduction of $250. if hank donates all rights to the “binoscope” to a charity, he will be entitled to a charitable deduction of $100,000. the harshness of this rule also is demonstrated by the fact that if the creator holds the copyright, composition, or similar property at the time of his or her death, the full fair market value will be included in his or her gross estate for federal estate tax purposes.224 rules are in place to prevent the creator from avoiding the section 170(e)(1)(a) restriction. if the creator gives the copyright or composition to a friend or family member (or anyone else), and the donee then makes a charitable contribution of the property, the donee’s charitable income tax deduction will be restricted in the same way as if the creator had made the contribution.225 the tax reform act of 1969. larry d. mcbennett, john paul & john stearns, art update: tax deductions for self-created works of art, 30 fed. b. news & j. 342, 34243 (1983). 224. irc § 2031(a) provides that “[t]he value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.” see bell, supra note 145, at 536. 225. irc § 1221(a)(3)(c) provides that the copyright or composition will not be a capital asset if it is held by “a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of [the creator.]” in the case of property acquired by gift, the donee’s tax basis is the same as the donor’s tax basis immediately before the gift. irc § 1015(a) (in other words, for purposes of calculating gain on a subsequent sale by the donee, a “carryover” basis rule is used; a different rule applies for purposes of calculating a loss on a sale by the donee, but it is not necessary 594 florida tax review [vol.5:8 2. the broad reach of the copyright restriction.—as stated above, section 1221(a)(3) applies to “a copyright, a literary, musical or artistic composition, a letter or memorandum, or similar property . . . .” regulations section 1.1221-1(c)(1) states that any property eligible for copyright protection will be considered “similar property.” the regulation provides that “the phrase ‘similar property’ includes, for example, such property as a theatrical production, a radio program, a newspaper cartoon strip, or any other property eligible for copyright protection . . . .” 226 3. the policies for restricting the amount of the charitable deduction for a donation of a copyright.—the amount of the charitable deduction for a donation of a copyright was not limited to the donor’s cost basis until the tax reform act of 1969. however, the story actually begins in 1950 when the predecessor of section 1221(a)(3) was enacted to provide that the gain from the sale of a copyright would be taxed as ordinary income rather than capital gain. prior to 1950, an amateur author, painter or other creative genius who held a copyright for the requisite period of time (then six months) and realized a gain on the sale of the rights would pay tax on the gain at the long-term capital gain tax rate (rather than the higher tax rate on ordinary income). a. the revenue act of 1950.—in proposing that the gain should be taxed as ordinary income, the house report for the revenue act of 1950 stated: when a person is in the profession of inventing, or writing books, or creating other artistic works, his income from the sale of the products of his work is taxed as ordinary income. this is true whether he receives royalties from the use of his products or sells them outright, since the products of his work are held by him “primarily for sale to customers in the ordinary course of his trade or business” and are, therefore, not treated as capital assets.227 if an amateur receives royalties on his invention or book or other artistic work, they are treated as ordinary income, but if he holds his invention or book or other artistic work for 6 months and then sells it outright he can avail to consider those rules because irc § 1221(a)(3)(c) refers only to the basis for calculating gain on a sale). thus, although the donee is not the creator of the copyright or composition, the tax treatment for the donee will be the same as for the creator. 226. regs. § 1.1221-1(c)(1) (emphasis added). 227. this rule is currently set forth in irc § 1221(a)(1). 2002] it does not compute 595 himself of a loophole which treats such a sale as the sale of a capital asset, not held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. as a result, the taxpayer receives long-term capital gain treatment on the product of his personal effort. there is no question under the income tax law but that a person may be treated as engaging in more than one trade or business at the same time, and when a person writes a book or creates some other sort of artistic work or devises an invention with the idea of realizing income on it he should be treated as being in the trade or business of writing, creating, or inventing, regardless of whether the income from his personal efforts is realized through royalties or through outright sale, and regardless of the fact that this is the first time he may have engaged in such a trade or business. section 290(a) of your committee’s bill provides that when any person sells an invention or a book or other artistic work which is the product of his personal effort his income from the sale is taxed as ordinary income.228 this proposed amendment in 1950 would have treated patents in the same way as copyrights – any gain on a sale would be taxed as ordinary income. the house report appears to focus on the fact that a patent or229 copyright is created with the personal effort of the creator, rather than focusing on the fact that a “property” right is being transferred. however, before enactment, the senate proposed a revised bill under which the gain from a sale of a patent would continue to be taxed as capital gain. in support of this change, the senate report stated: “your committee230 believes that the desirability of fostering the work of such inventors outweighs the small amount of additional revenue which might be obtained under the house bill, and therefore the words ‘invention,’ ‘patent,’ and ‘design’ have been eliminated from this section of the bill.” the conference report231 228. h.r. rep. no. 2319, 81st cong., 2d sess. (emphasis added), reprinted in 1950-2 c.b. 380, 420-21. 229. id. at 445, 446 (as an example, the legislative history states that the gain on a sale of a formula would be taxed as ordinary income). 230. s. rep. no. 2375, 81st cong., 2d sess., reprinted in 1950-2 c.b. 483. 231. id. at 515. one commentator has stated, “[w]hile the justification for this encouragement has not been elaborated, it is clear that inventions, especially when patented, are considered important for our industrial progress and national defense”). 596 florida tax review [vol.5:8 adopted the senate version. thus, congress concluded that the work of232 inventors should be encouraged by allowing the gain on the sale of the rights in an invention to be taxed as long-term capital gain. although the predecessor of section 1221(a)(3) caused any gain on a sale of a copyright to be taxed as ordinary income beginning in 1950, a creator donating a copyright to charity generally was entitled to a deduction for the full fair market value of the donated property until the tax reform act of 1969 (which enacted section 170(e)(1)(a)). as discussed above, section 170(e)(1)(a) reduces the amount of the charitable deduction available by the amount of any note, supra note 218, at 1423-1424. in the hearings prior to the adoption of the 1950 act, a representative for the council for independent businesses stated: our patent system is responsible, to a large degree, for the tremendous and rapid growth of the industrial phase of our economy. although the individual inventor has never been properly rewarded for his advanced thinking, vision, and personal efforts, he deserves the major part of the credit for this great progress. his type of thinking should be encouraged rather than discouraged . . . . if patents produce their proportionate share [of tax], it will only amount to a couple of hundred thousand dollars. for this comparatively picayune sum we would discourage our individual inventor by putting a ceiling over his opportunities, thus inhibiting his desire to create by depriving him of the major part of the reward, which is already pitifully small. so the end result will be to deny the economy of this nation many inventions potentially worth millions of dollars, to say nothing of the loss of patent stimuli to our industrial developments. the experts who wrote this provision call it plugging up a loophole. permitting an inventor to get some reward for his invention is not my idea of a loophole. as for “plugging up,” it will certainly effectively plug up the inventor’s desire to create new and better things for our people to enjoy . . . .the inventor flourishes and brings forth fruit when he feels that he is being nurtured in an atmosphere of freedom and a soil rich in opportunity. revenue revisions of 1950, hearings on h.r. 8920: an act to reduce excise taxes and for other purposes, before the committee on finance united states senate, 81st cong., 2d sess. (1950) (statements of c.e. earle, secretary-treasurer of the council for independent businesses and president of breco manufacturing company), reprinted at madelyn shoheu cantor, tax policy: copyrights and patents, 31 vill. l. rev. 931, 98081 n.225-27 (1986). 232. h.r. rep. no. 3124, 81st cong., 2d sess., reprinted in 1950-2 c.b. 580, 585 (amendments 77 and 78). 2002] it does not compute 597 gain that would have been taxed as ordinary income (or short-term capital gain) on a hypothetical sale of the donated property.233 b. the tax reform act of 1969.—the legislative history of the tax reform act of 1969 sets forth only one reason for the “reduction” rule234 of section 170(e)(1)(a), and this reason has diminished. the stated reason for the rule was the ability of taxpayers at that time to derive a greater after-tax benefit from donating property to charity rather than selling it. the 1969 house and senate reports include the following example: “[a] taxpayer in the 70percent tax bracket could make a gift of $100 of inventory ($50 cost basis) and save $105 in taxes (70-percent of the $50 gain if sold, or $35, plus 70-percent of the $100 fair market value of the inventory, or $70).” the key to this235 example is that the maximum individual income tax rate in 1969 was 70%. thus, in 1969, it could be argued that it really was the government making the charitable donation and not the individual. in contrast, in 2002, the maximum236 federal individual income tax rate is 38.6%. as a result, if this example is considered in 2002, it would provide: a taxpayer in the 38.6% tax bracket could make a gift of $100 of inventory ($50 cost basis) and save $57.90 in taxes (38.6% of the $50 gain if sold, or $19.30, plus 38.6% of the $100 fair market value of the inventory on a charitable donation, or $38.60). in other words,237 if the taxpayer sold the property in 2002, he would end up with $80.70 [$100 minus the tax of $19.30 on the $50 gain]. if the taxpayer donated the property to charity, he would save $38.60 in tax – as a result, the donation would actually cost the taxpayer $42.10 [which is $80.70 $38.60]. thus, as a result of changes in the tax rate, the rationale for enacting section 170(e)(1)(a) has faded considerably. the legislative history of the 1969 act also sets forth two additional reasons that may have influenced the adoption of the “reduction” rule of section 233. see supra notes 141-143 and accompanying text. 234. p. l. 172, 91st cong., 1st sess. § 201(a)(1). 235. h. r. rep. no. 413, 91st cong., 1st sess. 55, reprinted in 1969-3 c.b. 200, 234; s. rep. no. 552, 91st cong., 1st sess., reprinted in 1969-3 c.b. 423, 475. the report states, “[i]n cases where the tax saving is so large, it is not clear how much charitable motivation actually remains. it appears that the government, in fact, is almost the sole contributor to the charity.” id. at 235. 236. id. in this example, if the taxpayer sold the inventory and retained the proceeds, the taxpayer would end up with $65 [$100 minus the tax on the gain of $35]. if the taxpayer donated the property to charity, he would save $70 on his taxes as a result of the charitable contribution deduction [$100 x 70% = $70]. thus, the taxpayer could make a $5 “profit” by giving the property to charity. 237. if the inventory was sold, the taxpayer would pay tax of $19.80, and would keep the balance of $80.70 ($100 $19.30 = $80.70). 598 florida tax review [vol.5:8 170(e)(1)(a). first, the legislative history states that “[t]he large amount of238 appreciation in many cases arises from the fact that the work of art is a product of the donor’s own efforts (as are collections of papers in many cases).”239 congress focused specifically on art when setting forth this rationale – thus, it appears that congress felt that the artist who sells his or her work is being compensated for services. this tax treatment is consistent with the doctor or240 attorney who donates his or her time for charity and is not entitled to a charitable income tax deduction. however, this is in sharp contrast to the241 approach taken in the case of an inventor who sells a patent – the inventor’s efforts are deemed to have “coalesced” in the intellectual “property,” and the inventor is entitled to a full fair market value charitable contribution deduction. if similar taxpayers are to be treated similarly, it could be argued242 that the creator of a copyright or composition (even an artist) should be treated in the same manner as the creative genius who wants to donate his or her patent, trade secret, or trademark to charity – in all cases, the taxpayer’s efforts should be deemed to have “coalesced” in an item of intellectual property. second, the legislative history states that “[w]orks of art are very difficult to value and it appears likely that in some cases they may have been overvalued for purposes of determining the charitable contribution deduction.” again, congress was focusing on art, and not creators of243 copyrights in general. since the tax reform act of 1969, congress has addressed “valuation” concerns by imposing extensive substantiation requirements on a taxpayer who seeks to claim a deduction in excess of $5,000 for a charitable gift of property (other than cash or marketable securities). 238. although these two reasons are stated as support for the “related use” rule of irc § 170(e)(1)(b) (which primarily impacts “collectors” making a donation, rather than creators), they may have been considered significant in imposing the section 170(e)(1)(a) reduction rule on creators of copyrightable works. 239. h. rep. no. 413, 91st cong. 1st sess., reprinted in 1969-3 c.b. 200, 235 (emphasis added). commentators have stated that in addition to concerns about abuses in the art world, the changes to irc § 170(e)(1) were also in response to abuses by politicians’ contributions of their papers to libraries. see bell, supra note 145, at 542. (discussing substantial deductions claimed by president nixon for the donation of his vice presidential papers) (citing s. rep. no. 768, 93rd cong., 2d sess. 10 and h.r. rep. no. 966, 93rd cong., 2nd sess. 10 & h.r. rep. no. 966, 93rd cong., 2nd sess. 10). 240. although the legislative history discusses the artist, the “related use” rule would have no impact on an artist – any gain realized by an artist from the sale of the property would be taxed as ordinary income, and the charitable deduction would be reduced by that gain under the “reduction rule” of irc § 170(e)(1)(a). the “related use” rule would impact the collector who would have a capital gain on the sale of the work. 241. regs. § 1.170a-1(g). 242. see cupler v. commissioner, 64 t.c. 946, 954 (1975). 243. h. r. rep. no. 413, 91st cong., 1st sess., reprinted in 1969-3 c.b. 200, 235-36 (emphasis added). 2002] it does not compute 599 basically, the taxpayer is required to attach irs form 8283 to his or her federal income tax return (form 1040), and the form 8283 requires extensive information regarding the donation, including a qualified appraisal. more244 important, if the charity sells the property within two years of the date of the gift, the charity is required to file form 8282 with the irs, which will report the sale price to the irs. thus, the irs will be able to match the amount of the charitable deduction claimed by the donor with the amount actually received by the charity from the subsequent sale, and if the deduction claimed is significantly higher than the amount received by the charity, the irs will have been notified (and presumably will begin an immediate audit of the donor’s tax return for the year including the donation). vi. the charitable deduction for a donation of computer software eligible for over-lapping ip protection as discussed above, computer software may be eligible for patent, trade secret, and/or copyright protection. in the case of a charitable donation (or245 244. regs. § 1.170a-13(c)(3). 245. see supra notes 68-88 and accompanying text. final regulations issued in 1998 characterizing computer programs for cross-border transactions appear to ignore the availability of patent protection for computer software. see regs. § 1.861-18 (titled “classification of transactions involving computer programs”) (issued sept. 30, 1998, t.d. 8785, 1998-2 c.b. 494). while the regulations apply “only to cross-border transactions,” the preamble to the final regulations states, “treasury and the irs may consider whether to apply the principles of these regulations to all transactions in digitalized information as part of a separate guidance project.” 1998-2 c.b. at 496. the regulations define a “computer program” as “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result . . . a computer program includes any media, user manuals, documentation, data base or similar item if . . . [it] is incidental to the operation of the computer program.” regs. § 1.861-18(a)(3). thus, the definition of “computer program” does not expressly address a process or method contained in computer software that may be eligible for patent protection. although an example in the regulations refers to ‘shrink-wrap licenses,’ the preamble to the regulations states that “the use of the term ‘shrink-wrap license’ in the proposed regulations was not intended to create an inference that the regulations apply only to mass-marketed software.” t.d. 8785, 1998-2 c.b. at 500. the regulations provide that a transfer of a computer program (including the provision of services or know-how, as long as merely incidental to the transfer of the software) will be characterized in one of four ways: (i) as a transfer of a copyright right; (ii) as a transfer of a copyrighted article; (iii) as the provision of services; or (iv) as the provision of know-how. regs. § 1.861-18(b)(1)(i)-(iv). while the regulations do not address patent protection for computer software, the regulations provide a method of analyzing a “mixed” transaction. basically, if a part of the transaction is “de minimis, taking into account the overall transaction and the surrounding facts and circumstances, 600 florida tax review [vol.5:8 a sale), the software inventor will prefer the tax consequences if the software is treated as a patent or a trade secret (rather than as a copyright). the “related use” restriction of section 170(e)(1)(b) should not apply since a donation of computer software (and the related patent, copyright, and/or trade secret rights) should not be considered a gift of “tangible personal property.” a. the levy case and regulations section 1.1221-1(c)(1) only one case has considered whether an individual’s sale of246 computer software will generate long-term capital gain or ordinary income under regulations section 1.1221-1(c)(1), and the reasoning in that case is questionable. in levy v. commissioner, a computer programmer named247 248 david levy developed a software program to monitor and improve the performance of certain ibm teleprocessing software. in 1984, mr. levy sold “all rights and interest in and to the [software], including without limitation, all source and object code and manuals and all other related documents . . . .” to [the transaction] shall not be treated as a separate transaction, but [will be treated] as part of another transaction.” regs. § 1.861-18(b)(2). thus, if a taxpayer transfers patent rights in a process or method embodied in software, along with the related copyright associated with the source code and object code, and provides some confidential information regarding the operation of the computer program that is eligible for trade secret protection, and if the copyrights, the know-how, and the services are de minimis in the context of the patent rights, it may be argued that the transaction should be characterized solely as a transfer of patent rights (rather than as five separate transactions consisting of the transfer of patent rights, the transfer of copyrights, the transfer of copyrighted articles, the transfer of know-how, and the provision of services). while the regulations refer to section 1235, the reference is merely in the context of discussing when a transfer of a copyright right is a sale or a license. a sale occurs if there is a transfer of “all substantial rights” in the copyright, and the principles of sections 1222 and 1235 may be applied in determining whether there has been a transfer of “all substantial rights.” regs. § 1.861-18(f)(1). for a thorough discussion of the regulations, see alan levenson, alan shapiro, robert mattson & ned maguire, taxation of cross-border payments for computer software, 81 tax notes 1551 (1998). 246. an individual can be a “holder” under section 1235(b) (which generally provides for long-term capital gain on the sale of a patent). 247. one commentator basically dismisses the levy case, stating: “[in levy] the court was advised of only one type of protection, but not the other. predictably the decision took into account only the type of protection involved in [the] case and decided the tax issues on that basis.” marvin petry, taxation of intellectual property: tax planning guide, § 10.05[2], pp. 10-37-10-38 (2001). 248. 64 t.c.m. (cch) 534 (1992). 2002] it does not compute 601 an individual for payments totaling approximately $100,000. the buyer then249 sold the software the next year to boole & babbage, inc. for $850,000. as250 if that was not enough bad news for mr. levy, the irs then audited his tax return and argued that the computer software was “similar property” under regulations section 1.1221-1(c)(1), and his gain from the sale of the software251 should be taxed as ordinary income rather than long-term capital gain. mr. levy argued that all he had transferred was the “idea” behind the software, and the “idea” was ineligible for copyright protection. the tax court rejected mr. levy’s argument stating: (i) the definition of a “capital asset” is narrowly construed, and (ii) in fact he had transferred the source code, object code, and252 manuals, and these items were all eligible for copyright protection. as a result, the tax court concluded that mr. levy’s gain on the sale of the software was subject to tax at ordinary income rates. most important, the tax court stated that “the literal language of section 1.1221-1(c)(1), income tax regs., provides that exception to the definition of a capital asset set forth in section 1221(a)(3) includes those assets eligible for copyright protection whether or not such protection is sought.” this language could be of special importance to an253 individual amateur software developer who desires to donate the software and all related rights to charity – it suggests that if property (such as computer software) is eligible for copyright protection, it will not be considered a “capital asset” even if the property is also eligible for patent or trade secret protection. 249. id. at 535. the case does not state the exact amount of payments made to mr. levy, but the amount of tax in dispute was approximately $29,000. presumably mr. levy had little or no tax basis in the software, and he paid a 20% long-term capital gains tax on the sale price. the tax deficiency would represent the difference between the tax if the sale price was subject to ordinary income tax (presumably taxed at a 50% rate) and the long-term capital gain tax rate (20%). thus, the sales price likely was approximately $100,000 [$29,000/(50%-20%) = $96,666]. 250. 64 t.c.m. (cch) at 535. 251. irc § 1221(a)(3) provides that “a copyright, literary . . . composition . . . or similar property . . .” will not be treated as a capital asset. (emphasis added) regs. § 1.1221-1(c)(1) provides that “the phrase ‘similar property’ includes for example, such property as a theatrical production, a radio program, a newspaper cartoon strip, or any other property eligible for copyright protection . . . .” (emphasis added). 252. id. at 535 (quoting united states v. midland-ross corp., 381 u.s. 54, 56 (1965)). 253. id. at 536 (emphasis added). it should be noted that regs. § 1.12211(c)(1) was adopted in 1957. in 1957, it was still necessary for a creator seeking copyright protection to include the copyright symbol ©, year, and the name of the author when publishing the work. as a result of changes in 1976, copyright protection arises automatically when a work is fixed in a tangible medium, so that copyright protection arises without the need for the creator to affirmatively “seek” copyright protection. see 17 u.s.c. § 102(a) (“copyright protection subsists . . . in original works of authorship fixed in any tangible medium of expression.”) (emphasis added). 602 florida tax review [vol.5:8 for the reasons set forth in the next section, the author believes that such an approach is not appropriate. b. potential challenges to levy the interpretation of regulations section 1.1221-1(c)(1) by the tax court in levy, and its application to other situations, can be challenged on a number of grounds. again, section 1221(a)(3) provides that “a copyright, literary . . . composition . . . or similar property . . . .” will not be treated as a capital asset, and regulations section 1.1221-1(c)(1) provides in relevant part: “the phrase ‘similar property’ includes for example, such property as a theatrical production, a radio program, a newspaper cartoon strip, or any other property eligible for copyright protection (whether under state or common law), but does not include a patent or an invention . . . .”254 1. construction of regulations section 1.1221-1(c)(1) so that the “patent or invention” clause has meaning.—first, “it is a cardinal rule of statutory construction that significance and effect should, if possible, be accorded to every word, phrase, sentence, and part of an act.” in order to give255 the phrase “but does not include a patent or an invention” meaning in regulations section 1.1221-1(c)(1), that language should be held to exclude from the definition of “similar property” items eligible for both patent and copyright protection. the regulation should be interpreted to set forth a general rule (“‘similar property’ includes . . . any other property eligible for copyright protection”), and an exception (“does not include a patent or an invention”). under this interpretation, the exception (“does not include a patent or an invention”) should apply to items that can be eligible for both patent and copyright protection. this interpretation is needed because an item eligible256 for patent protection only would not be covered by the general rule (“‘similar property’ includes . . . any other property eligible for copyright protection”), and there would be no need to create an exception for items eligible for patent protection only. 254. regs. § 1.1221-1(c)(1) (emphasis added). 255. 73 am. jur. 2d, statutes, § 120, p. 330. while this is a regulation rather than a statute, the same rule of construction should apply. 256. if the phrase “does not include a patent or an invention” would refer to items that are not eligible for copyright protection, those words would be meaningless in the regulation. if those items were not covered by the general rule, there would be no need to exclude them from the general rule. the phrase “does not include a patent or an invention” should also exclude items eligible for both trade secret and copyright protection. 2002] it does not compute 603 2. regulation was not drafted with software in mind.—second, regulations section 1.1221-1(c)(1) was written in 1957, when the only items257 eligible for both patent and copyright protection likely were designs.258 although the regulation specifically mentions designs, it fails to address designs that are eligible for both patent and copyright protection. the writers259 257. t.d. 6243, 1957-2 c.b. 526, 536. 258. see petry, supra note 247, at § 10.05[2], p. 10-37 (“this is probably because at the time these regulations were written, there were no inventions, other than designs, protectable under both laws.”). 259. as discussed above, a design may qualify for a design patent, copyright protection, and trade dress protection. see supra notes 89-96 and accompanying text. irc § 1221(a)(3) precludes capital gain treatment on a sale of “a copyright, a literary, musical or artistic composition, a letter or memorandum, or similar property . . . .” (emphasis added). in defining “similar property,” the regulations provide: “the phrase ‘similar property’ includes, for example, such property as a theatrical production, a radio program, a newspaper cartoon strip, or any other property eligible for copyright protection (whether under statute or common law), but does not include a patent or an invention, or a design which may be protected only under the patent law and not under the copyright law.” regs. § 1.1221-1(c)(1) (emphasis added). the final clause of the regulation appears to add nothing. the general rule defines “similar property” as “property eligible for copyright protection.” the final clause addresses property that would not be subject to the general rule – the property in the final clause may not be protected under the copyright law. thus, the regulation fails to deal with designs that would be eligible for both patent and copyright protection. a leading commentator has described the standards for patent protection for designs, and copyright protection for designs, and the reason why some designs will qualify only for patent protection, as follows: under the design patent statute, a patent may issue for an “ornamental design for an article of manufacture.” [35 u.s.c. § 171] under the copyright law, as revised in 1976, a copyright may be secured for “the design of a useful [article]” (that is, “an article having an intrinsic utilitarian function that is not merely to portray the appearance of the article or to convey information”) if, and only to the extent that, such design incorporates pictorial, graphic, or sculptural features that can be identified separately from, and are capable of existing independently of, the utilitarian aspects of the article.” [citing 37 u.s.c. § 101,102(a)]. clearly the overlap is not complete. copyright does not extend to all ornamental designs of useful objects. [citing esquire, inc. v. ringer, 591 f.2d 796 (d.c. cir. 1978)] a patentable design must not be dictated solely by considerations of function, however, it need not meet the copyright standard of separate identification and independent existence. chisum on patents, § 1.04[5], pp. 1-459 and 1-460 (1999). 604 florida tax review [vol.5:8 of regulations section 1.1221-1(c)(1) could not have anticipated computer software and the availability of patent protection for computer software (which emerged in the 1980’s and become popular in the 1990’s). more important,260 as discussed below, the drafters of regulations section 1.1221-1(c)(1) likely could not have anticipated that useful business items such as computer software would be eligible for copyright protection. 3. levy does not discuss patent protection.—third, in levy there was no mention that the property was eligible for patent protection, and the tax court did not discuss alternative forms of ip protection. thus, it can be questioned whether the court really applied regulations section 1.1221-1(c)(1) as a “tie-breaker.” the tax court appears to simply state that mr. levy transferred the source code, the object code, and the operating manual, and that all those items were eligible for copyright protection – there is no analysis of a patent issue in levy. 4. conflict with the patent rule.—while regulations section 1.12211(c)(1) provides that “similar property” includes all property eligible for copyright protection, in the case of property also eligible for patent protection, regulations section 1.1221-1(c)(1) would be in conflict with the legislative history and regulations of section 1235. the legislative history and regulations are clear that section 1235 (which provides that any gain on a sale of patent rights will be taxed as long-term capital gain) will apply to a sale of rights in a patentable invention even if a patent application has not been filed.261 5. the most valuable elements of computer software may not be eligible for copyright protection.—as discussed above, the source code, object code, manuals, and the structure and organization of computer software can be eligible for copyright protection. however, the actual “processes or methods262 embodied in the program are not within the scope of the copyright law.”263 thus, the most valuable features of computer software may not even be eligible 260. see supra notes 84-88 and accompanying text. 261. s. rep. no. 1622, 83rd cong., 2d sess., 438, 439 (1954), reprinted in falk, supra note 152, at b-301 (“since the inventor possesses an exclusive inchoate right to obtain a patent, he may transfer his interest, whatever it may be, in any subsequently issued patent before its issuance and before as well as after he has made application for such patent.”); regs. § 1.1235-2(a) (“it is not necessary that the patent or patent application for the invention be in existence if the requirements of section 1235 are otherwise met.”). 262. see supra notes 72-79 and accompanying text. 263. h. r. rep. no. 1476, 94th cong., 2d sess. 57 (1976), reprinted in 1976 u.s.c.c.a.n. 5659, 5670 (referring to pub. l. no. 94-553, 90 stat. 2541 (1976) (codified at 17 u.s.c. § 101 et seq.)). 2002] it does not compute 605 for copyright protection. those valuable features may instead be protected by patent law (or trade secret law). in those cases, the tax consequences should be based on the treatment of the software as property eligible for patent protection (or trade secret protection), rather than as property eligible for copyright protection. it should be noted that many patents (or trade secrets) may be transferred with written instructions or descriptions. while the written instructions or descriptions may be eligible for copyright protection, the availability of this limited copyright protection should not prevent the gain on the sale of the patent (or trade secret) from being taxed at the long-term capital gain rate. one commentator has argued that the copyright rule of regulations section 1.1221-1(c)(1) should not apply if the taxpayer is not relying on copyright protection.264 6. the policy for reducing the charitable deduction does not apply to useful business creations such as ccomputer software.—most important, under the language of the statute, and based on the policy behind the statutes involved, “computer software” should not be treated as “similar property” under section 1221(a)(3). section 1221(a)(3) excludes from the definition of “capital asset” the following: “a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property . . . .” this subsection was last amended in 1969, several years before the copyright act was265 amended (in 1980) to include computer software among the items eligible for copyright protection. the items specifically listed in section 1221(a)(3) – “a literary, musical, or artistic composition, a letter or memorandum” are very different from computer software – computer software often has a specific business application and provides instructions to a machine (and can be said to actually become a part of the machine when used). computer software266 typically derives most of its value from its business use by others, much like a utility patent. in contrast, “literary, musical or artistic compositions or letters or memoranda” are in the nature of artistic activities (rather than business267 activities involving machines). “part of congress’ broad remedial purpose in enacting section 1235 was to ‘provide an incentive to inventors to contribute to the welfare of the nation.’” computer software eligible for patent (and/or268 trade secret) protection can contribute to the productivity and welfare of the 264. see falk, supra note 209, at a-22. 265. p. l. no. 172, 91st cong., 1st sess. § 514(a) (the tax reform act of 1969). 266. see supra note 68. 267. irc § 1221(a)(3). 268. gilson v. commissioner, 48 t.c.m. at 930 (quoting s. rep. no. 1622, 83rd cong., 2d sess. 439 (1954); h. r. rep. no. 1337, 83rd cong., 2d sess. a280 (1954)). 606 florida tax review [vol.5:8 “nation” in the same manner as other inventions. accordingly, the same incentives provided to other inventors should be available to the software developer. the mere fact that the source code, object code, and manuals may be protected by copyright should not change the tax consequences. in many ways computer software with useful business applications will not be “similar” to “literary, musical or artistic compositions or letters or memoranda.”269 c. considerations for the developer planning a donation of computer software under current law the difficulties facing the individual developer who wishes to donate all of his or her rights to computer software under current law can be illustrated by the following example. example #5: world famous marine biologist texas hank has done it again! this time hank has developed new software called “fish forever,” and environmental protection groups, commercial fishing enterprises and several nations cannot wait to start using the software. hank’s cost in developing the software was minimal, but now the software is worth millions. the software can be described as an inventory control and production restraint system. in order to protect and maintain fish populations, nations, environmental groups and commercial fishing enterprises may desire to enter into agreements to measure (and restrict) fishing in certain areas at certain times. a popular slogan for the software is “if you catch too many salmon downstream, too few will make it upstream.” fish forever allows participating fishing enterprises to report their “catch” in an area, and the software will compile the data and compare the “catch” to historical patterns, projected supply, anticipated needs, etc., and issue warnings and/or directives for the next day, week, month or year. while the guidelines and thresholds need to be established by the parties involved, fish forever can allow the system to work smoothly and efficiently. texas hank could assign all of his rights (or assign or license key rights) to a software development company that could exploit the software, and texas hank would receive substantial amounts of money. however, texas hank would prefer that his favorite charity receive all money from the exploitation of fish forever, so that they can use the money to build homeless 269. petry, supra note 247, at 10-37. 2002] it does not compute 607 shelters. hank would like to claim a full fair market value income tax deduction on the charitable contribution. texas hank will want to consider the best way(s) to protect the software so that his favorite charity will be able to successfully exploit the computer software, but hank also needs to consider how his actions may impact the size of his charitable deduction for income tax purposes. if texas hank files the software for copyright protection and then expressly donates270 the “copyright” to his favorite charity, it may be difficult for hank to avoid section 170(e)(1)(a) (and as a result, his charitable tax deduction may be limited to his out-of-pocket expenses in developing the software). in contrast, if texas hank donates his rights in the software and never asserts copyright protection (and never refers to a copyright interest when transferring the software to the charity), texas hank could argue that the software is a trade secret (or is patentable), and that his contribution of the trade secret (or patent) will be eligible for a full fair market value deduction because section 170(e)(1)(a) should not apply. nevertheless, a court might follow the approach taken in levy and conclude that since the software was “eligible” for copyright protection, regulations section 1.1221-1(c)(1) would cause any gain on a hypothetical sale to be taxed as ordinary income (and will prevent texas hank from obtaining a charitable deduction for any value of the software in excess of his cost basis in the software). in documenting the transfer of the software to charity, texas hank is in a particularly difficult planning situation. if the transfer document recites that texas hank is transferring a copyright interest in the software to charity, the irs may assert that section 170(e)(1)(a) applies and that texas hank’s tax deduction is limited to his cost basis in the computer software. on the other hand, if the transfer document makes no mention of the transfer of a copyright interest in the software, the irs may assert that hank has retained a copyright interest, and thus made a gift of only a “partial interest” in the property (because he retained the copyright). under the partial interest rule of section271 170(f)(3), texas hank would not be entitled to any charitable contribution deduction. 270. filing with the u.s. copyright office would be a clear indication of claiming copyright protection. however, filing is not necessary to obtain copyright protection. neil boorstyn, boorstyn on copyright, § 9.05[1], pp. 9-31 (“under the 1976 act, a work created after january 1, 1978 is protected upon creation [citing 17 u.s.c. § 302(a)], that is, when it is fixed for the first time in a copy or phonorecord”). as a result, the irs might assert that the software is a literary work entitled to copyright protection even if texas hank makes no affirmative attempt to claim copyright protection. see also supra note 56. 271. see supra notes 147-149 and accompanying text. 608 florida tax review [vol.5:8 note that since texas hank’s cost basis in the software is minimal, his risk from the potential application of the “partial interest” rule is minimal. in effect, there would not be much difference between deducting nothing (because of the partial interest rule of section 170(f)(3)) and deducting a small amount under the “copyright” rule of section 170(e)(1)(a). as a result, texas hank might be well-advised to refer to the patent rights (and all other rights) in the transfer document but avoid any reference to copyright protection. vii. proposals for excluding computer software eligible for patent protection from the old copyright restriction a. proposal for an irs administrative announcement for the reasons stated above, under current law, neither section 1221(a)(3) (requiring that gain on a sale be taxed as ordinary income) nor the reduction rule of section 170(e)(1)(a) should apply to a charitable contribution of computer software that is eligible for trade secret or patent protection.272 unfortunately, the tax court in levy, in applying regulations section273 1.1221-1(c)(1), indicates that section 1221(a)(3) (and indirectly, the reduction rule of section 170(e)(1)(a)), will apply whenever property eligible for copyright protection is contributed to charity. no amendment of the statute274 should be necessary because the result suggested by levy is not mandated by the statute. nevertheless, the uncertainty caused by the interpretation of regulations section 1.1221-1(c)(1) in levy may have a chilling effect on software developers considering a charitable gift. accordingly, a pronouncement by the irs (in the form of an announcement or revenue ruling) would be appropriate to encourage charitable gifts of computer software eligible for patent protection. a sample revenue ruling is attached as appendix a. b. the artist-museum partnership bill a bill has been introduced in congress that would address certain concerns about donating copyrights (and related rights) to charity, but as currently drafted the bill would help software developers only in limited 272. see supra notes 248-269 and accompanying text. 273. 64 t.c.m. (cch) 534, 536 (1992). 274. the levy case actually holds that the gain from a sale of property eligible for copyright protection will be taxed as ordinary income (rather than being taxed as capital gain). id. at 536. since the gain on the sale would be taxed as ordinary income, the reduction rule of irc § 170(e)(1)(a) would apply to a charitable contribution of the property. 2002] it does not compute 609 situations. as its name suggests, the artist-museum partnership act is designed to encourage artists to donate their paintings, sculptures, and other works of art to museums, but the bill’s language could apply even if the donated property is not “art” and even if the receiving charity is not a museum.275 1. the current bill.—the bill would allow a full fair market value deduction for a charitable contribution of “any literary, musical, artistic or scholarly composition, or similar property, or the copyright thereon (or both).” however, the bill would not reach all copyrights (and compositions276 and similar property), and would impose the “related use” restriction, which277 certain gifts would not satisfy. in order for the donor to obtain a fair market value deduction, the bill requires that the following conditions be satisfied: 275. since the charitable giving rules for works of art have been considered extensively elsewhere, see articles listed at supra note 145, this article will not consider whether the special rules that direct gifts of art work to museums are appropriate. 276. s. bill 694 (emphasis added), the artist-museum partnership act, 107th cong., 1st sess. (april 4, 2001) (sponsored by senator leahy). a similar bill was proposed several years ago. h.r. 1285, the national heritage resource act (feb. 7, 1983); see mcbennett, paul & stearns, art update: tax deductions for self-created works of art, 30 fed. b. news & j. 342 (june, 1983) (“in 1981, the presidential task force on the arts and humanities recommended that the artist receive the same tax treatment as the private collector or other donor for the charitable contribution of a work of art or manuscript.”). 277. the bill provides that the full fair market value deduction will not be available for a donation of letters, memos or similar property which are produced by or for an individual while the individual is an employee of any person (including any government agency or instrumentality), “unless such letter, memorandum, or similar property is entirely personal.” presumably, this provision is a reaction to charitable contribution deductions claimed when various papers relating to presidents eisenhower, johnson and nixon were donated. mcbennett, paul & stearns, supra note 271, at 342; see also supra note 218, at 1423 (“perhaps the best-known transaction was general eisenhower’s sale of crusade in europe for a reported $1,000,000, all of which was taxed as capital gain.”); cantor, supra note 231, at 973 n.190 (“president nixon . . . donated his vice presidential papers and got the full fair market value as a deduction before the passage of the tax reform act of 1969”). also, in a radical departure from current law, see supra note 147-149, the artist-museum partnership bill provides that in these situations the tangible literary, musical, artistic or scholarly composition or similar property will be treated as an item of separate property from the underlying copyright. currently the “partial interest” rule has been interpreted to require that to obtain any charitable deduction whatsoever, it is necessary to always contribute the underlying copyright when an item subject to copyright protection is donated (assuming that the donor owns the copyright). irc § 170(f)(3). see supra note 148. 610 florida tax review [vol.5:8 (i) the charity’s use of the property must be “related to the purpose or function constituting the basis for the donee’s exemption” (commonly referred to as the “related use” requirement); (ii) the property must have been created by the personal efforts of the taxpayer no less than 18 months before the contribution;278 (iii) “the taxpayer receives from the donee a written statement” that the related use requirement will be satisfied; (iv) the written appraisal attached to the donor’s tax return includes evidence of previous sales or displays of the donor’s similar property; and (v) the maximum deduction cannot exceed the donor’s adjusted gross income from the sale or use of property created by the personal efforts of the donor, and “income from teaching, lecturing, performing or similar activity with respect to the property described.”279 many of these restrictions seem reasonable if an artist is donating a work to a museum. example #6: leonardo da vino has created a masterpiece titled “man stretching surrounded by circle.” leo desires to donate this painting to his favorite museum. if the artistmuseum partnership act has been enacted as proposed, leo must wait 18 months, but otherwise he likely will have no significant problem satisfying the requirements for a full fair market value deduction. the appraiser will be able to attach evidence of previous sales, and the amount of the deduction 280 278. the 18 month requirement likely is a reaction to the concern that an artist might create a work with the intention of merely claiming a charitable deduction for the work. the concern is that an artist facing a significant tax bill might attempt to create a work near the end of the year for the sole purpose of creating the work, donating it to charity, and obtaining a tax deduction. the taxpayer who would attempt such a strategy could encounter a number of difficulties, and it is questionable whether a separate statutory provision is needed to deal with this possibility. 279. artist-museum partnership act, 107th cong., 1st sess. (april 4, 2001). 280. presumably, this requirement was included to help identify valuation abuses – prior sales by an artist may be an indication of value for current works; in the case of a completely new artist, it can be more difficult to determine the fair market value of the artwork. 2002] it does not compute 611 likely will not exceed leo’s adjusted gross income for the year from the sale of paintings (because leo is very productive, and his work is selling well).281 three examples of donations meeting the “related use” test are: (i) a gift of artwork to a museum that intends to display the artwork in its galleries; (ii) a gift of artwork to a university that will place the artwork “in its library for display and study by art students;” and (iii) a gift of furnishings used by the charity “in its offices and buildings in the course of carrying out its functions.” however, if the charity plans to sell the property after it is282 received and use the proceeds for its charitable purpose, this will not be treated as a related use.283 the “related use” rule is especially important in the art world, in which substantial value may be tied up in the tangible work of art. this rule will prevent an art collector from claiming a full fair market value charitable284 income tax deduction unless he or she gives the art to a museum or other institution that will use the art in a manner related to the organization’s charitable purpose. the importance of this rule can be illustrated by the285 following example: example #7: leonardo da vino had another masterpiece known as “the lady with the mystic smile” which he painted several years ago. leo sold the painting to his good friend mona lisa when leo was still a starving amateur painter/sculptor/architect/engineer/scientist/writer for $10,000. leo’s career took off shortly thereafter and today “the lady” would sell for $10 million. if mona contributes “the lady” to a museum that will display the painting as one of its works of art, mona will be entitled to a charitable income tax deduction 281. the “adjusted gross income” test likely is another attempt to reduce valuation abuses – the amount of the deduction cannot exceed the amount leo earns during the year from selling other works. 282. regs. § 1.170a-4(b)(3)(i). 283. id. (“if the painting is sold and the proceeds used by the organization for educational purposes, the use of the property is an unrelated use”). 284. this rule would not impact someone who is regularly engaged in the trade or business of selling art (such as an art dealer) and holds the artwork as inventory, because inventory is not considered a “capital asset.” irc § 1221(a)(1). as a result, if the property were held as inventory, the sale of the property would not be eligible for capital gain treatment (because the gain from any sale of inventory will be taxed as ordinary income). 285. a university could also use the art for a “related use” if it used the art in teaching art appreciation classes. regs. § 1.170a-4(b)(3)(i). 612 florida tax review [vol.5:8 of $10 million. however, if mona gives the painting to her favorite church which will sell the painting for $10 million and use the proceeds to build homeless shelters, mona will only be entitled to a charitable income tax deduction of $10,000. the impact of the “related use” rule directs art collectors (who are charitably inclined) to donate their pieces (or in some cases their collections) to museums and other institutions which will display the works, rather than donating those works to public charities that would sell the works and use the proceeds for other charitable purposes.286 while these rules may be appropriate in the context of gifts of art to museums, these restrictions will be arbitrary and exclusionary in other situations. the “related use” restriction will be a major problem for gifts of certain copyrights because it may be unlikely that the donor’s favorite charity (much less any charity) would be able to retain the copyright and fully exploit the copyright in a “related use.” example #8: inspired by a recent trip to brazil, charles has just finished writing a steamy novel titled “rain forest rendezvous.” charles has never written a novel before (and in fact has never written any fiction before) and the subject of the novel has absolutely nothing to do with charles’ occupation. being of a generous nature, charles desires to donate all his rights in “rain forest” to his church which will sell all the rights to a publishing company, and then the church will use the money to support its food pantry service for the poor. under the artist-museum partnership bill, even if charles waits 18 months before making the donation, charles will be prevented from claiming a full fair market value deduction for the gift of “rain forest” for a number of reasons. first, as a new novelist, the appraiser will not be able “include evidence of previous sales or displays of the donor’s similar 286. in a colloquy between congressman frelinghuysen of new jersey and chairman wilbur mills (of the house ways and means committee) before the provision benefitting museums was added to the tax reform act of 1969, congressman frelinghuysen stated, “as a trustee of a metropolitan museum in new york, it does strike me as a harsh provision, because it almost surely will prevent the transfer to a museum of certain gifts of that character . . . . it would seem to me there might have been a proviso saying that if the gift were to a museum, which would keep such tangible personal property, there would not be any tax.” 115 cong. rec. 22571 (1969), quoted in robert anthoine, deductions for charitable contributions of appreciated property – the art world, 35 tax l. rev. 239, 244 (1980). 2002] it does not compute 613 property.” second, since charles will have no income from 287 the sale or use of novels created by his personal efforts, he will not be entitled to any deduction anyway. third, since the church plans to immediately dispose of its rights in the book, it will not be using the property in a “related use.” example #9: texas hank, the world-renowned marine biologist conducting research on padre island, has triumphed again! this time he has developed “survivor strategy” a new computer software program that will manipulate data regarding an animal, plant or other life form, with data regarding the environmental conditions of multiple locations, to predict the chances of survival for a life form in the specified areas. the science world, including countless charitable organizations, cannot wait to obtain the new software because it will be invaluable in deciding how and where to relocate life forms to avoid extinction. software development companies are ready, willing and able to develop and distribute the software and pay hank big dollars, if he will release all his rights in the software. hank desires to donate all his rights to charity, but no single charity has the capacity to produce and distribute the software. hank would prefer to contribute survivor strategy to his favorite charity which could sell all rights in the software to a software development company. if the reduction rule of section 170(e)(1) currently would prevent hank from obtaining a full fair market value deduction, the artist-museum partnership bill likely would not be of any assistance to hank. even assuming that hank waits 18 months to make the contribution, there is no single charity capable of retaining the software and fully exploiting the software (thus, the “related use” test will not be satisfied). furthermore, hank would need to have records of previous sales or displays that could be attached to the written appraisal, and his adjusted gross income for the year from similar activities would need to exceed the value of survivor strategy. 287. artist-museum partnership act, 107th cong., 1st sess. (april 4, 2001). 614 florida tax review [vol.5:8 under the artist-museum partnership bill as currently drafted, the “related use” problem would arise any time the donor desires to contribute computer software that will be of significant benefit to businesses in a particular industry – there will be no charity which can fully utilize the software in a manner related to its charitable function (because the software performs a business function). 2. proposed revision to the bill to address computer software.—the tax reform act of 1969 and the artist-museum partnership bill are concerned primarily with gifts of artwork. apparently, a major aim is to direct charitable gifts of artwork to museums. this is evident from the imposition of the “related use” rule of section 170(e)(1)(b). since it appears that great effort and analysis have been conducted to try to establish rules for gifts of artwork, this article proposes no changes to the artist-museum partnership bill in regards to gifts of artwork (as a result, gifts of artwork would be subject to the “related use” rule). however, in the interest of treating computer software that is eligible for both patent and copyright protection in a manner similar to charitable gifts of patents, a revised version of the artist-museum partnership bill is attached as appendix b, which would exclude charitable gifts of such software from the reduction rule of section 170(e)(1)(a) (and would not impose a “related use” requirement on such gifts). 2002] it does not compute 615 appendix a [sample revenue ruling permitting a full fair market value deduction on a charitable contribution of computer software eligible for copyright protection and patent protection] [summary] the fair market value of an undivided present interest in computer software that is eligible for both copyright and patent protection, which is contributed by the developer of the software to an organization described in section 170(c) of the internal revenue code of 1986, constitutes an allowable deduction as a charitable contribution, to the extent provided in section 170, in the taxable year in which such property is contributed. [text of ruling] advice has been requested with respect to the treatment for federal income tax purposes of the transfer, under the circumstances described below, of an undivided present interest in computer software by the developer of the software to an organization described in section 170(c) of the internal revenue code of 1986. certain processes and methods of the software are eligible for patent protection, and the literary features of the software (such as the source code, the object code and the manuals, as well as the structure, sequence or organization) are eligible for copyright protection. a, an individual, the developer and owner of the software, contributed the software to c, an organization described in section 170(c) of the code. since the transfer of the undivided present interest in the software is a transfer of a substantial interest in property, any royalties attributable to the software, which are earned subsequent to the transfer and paid to c as a result of such transfer, constitute income to the organization and not to a. section 170 of the internal revenue code of 1986 as amended (the “code”) provides in part as follows: (a) allowance of deduction. – (1) general rule. – there shall be allowed as a deduction any charitable contribution (as defined in subsection (c)) payment of which is made within the taxable year. a charitable contribution shall be allowable as a deduction only if verified under regulations prescribed by the secretary. . . . . 616 florida tax review [vol.5:8 (e) certain contributions of ordinary income and capital gain property. (1) general rule. the amount of any charitable contribution of property otherwise taken into account shall be reduced by the sum of: (a) the amount of gain which would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution . . . .) section 1235(a) of the internal revenue code provides in part that “a transfer . . . of property consisting of all substantial rights to a patent . . . by any holder shall be considered the sale or exchange of a capital asset held more than 1 year . . . .” section 1221(a)(3) excludes from the definition of a capital asset, “a copyright, a literary, musical or artistic composition, a letter or memorandum, or similar property held by – (a) a taxpayer whose personal efforts created such property . . . .” section 1.170-1(c) of the income tax regulations provides that if a contribution is made in property other than money, the amount of the deduction is determined by the fair market value of the property at the time of the contribution. section 1.1221-1(c)(1) of the income tax regulations provides in part that “the phrase ‘similar property’ [for purposes of section 1221(a)(3)] includes for example, such property as a theatrical production, a radio program, a newspaper cartoon strip, or any other property eligible for copyright protection (whether under statute or common law), but does not include a patent or an invention, or a design which may be protected only under the patent law and not under the copyright law.” it is held that a deduction will be allowable to a for his contribution of computer software, and such deduction will be allowable for the taxable year in which the property is contributed. the amount of the allowable deduction will be the fair market value of the software, such fair market value being a question of fact to be determined upon the examination of a’s income tax return for the year in which the contribution is claimed as a deduction. 2002] it does not compute 617 appendix b [revised version of the artist-museum partnership act] a bill to amend the internal revenue code of 1986 to provide that a deduction equal to fair market value shall be allowed for charitable contributions of literary, musical, artistic, or scholarly compositions created by the donor, and for charitable contributions of computer software eligible for patent protection donated by an individual developer. be it enacted by the senate and house of representatives of the united states of america in congress assembled, section 1. short title. this act may be cited as the `artist -museum partnership act' . sec. 2. charitable contributions of certain items created by the taxpayer. (a) in generalsubsection (e) of section 170 of the internal revenue code of 1986 (relating to certain contributions of ordinary income and capital gain property) is amended by adding at the end the following new paragraph: `(7) special rule rules for certain contributions of computer software or copyrights and literary, musical, or artistic compositions`(a) in generalin the case of a qualified artistic charitable contribution -or a qualified software charitable contribution -`(i) the amount of such contribution shall be the fair market value of the property contributed (determined at the time of such contribution), and `(ii) no reduction in the amount of such contribution shall be made under paragraph (1). 618 florida tax review [vol.5:8 `(b) qualified artistic charitable contributionfor purposes of this paragraph, the term `qualified artistic charitable contribution' means a charitable contribution of any literary, musical, artistic, or scholarly composition, or similar property, or the copyright thereon (or both), but only if-`(i) such property was created by the personal efforts of the taxpayer making such contribution no less than 18 months prior to such contribution, `(ii) the taxpayer-`(i) has received a qualified appraisal of the fair market value of such property in accordance with the regulations under this section, and `(ii) attaches to the taxpayer's income tax return for the taxable year in which such contribution was made a copy of such appraisal, `(iii) the donee is an organization described in subsection (b)(1)(a), `(iv) the use of such property by the donee is related to the purpose or function constituting the basis for the donee's exemption under section 501 (or, in the case of a governmental unit, to any purpose or function described under subsection (c)), `(v) the taxpayer receives from the donee a written statement representing that the donee's use of the property will be in accordance with the provisions of clause (iv), and `(vi) the written appraisal referred to in clause (ii) includes evidence of the extent (if any) to which property created by the personal efforts of the taxpayer and of the same type as the donated property is or has been– 2002] it does not compute 619 `(i) owned, maintained, and displayed by organizations described in subsection (b)(1)(a), and `(ii) sold to or exchanged by persons other than the taxpayer, donee, or any related person (as defined in section 465(b)(3)(c)). `(c) maximum dollar limitation for q u al i f i e d artistic c h a r i t a b l e contribution; no carryover of increased deductionthe increase in the deduction under this section by reason of this paragraph subparagraph (b) for any taxable year-`(i) shall not exceed the artistic adjusted gross income of the taxpayer for such taxable year, and `(ii) shall not be taken into account in determining the amount which may be carried from such taxable year under subsection (d). `(d) artistic adjusted gross incomefor purposes of this paragraph subparagraphs (b) and (c), the term `artistic adjusted gross income' means that portion of the adjusted gross income of the taxpayer for the taxable year attributable to-`(i) income from the sale or use of property created by the personal efforts of the taxpayer which is of the same type as the donated property, and `(ii) income from teaching, lecturing, performing, or similar activity with respect to property described in clause (i). `(e) paragraph not to apply to certain contributionssubparagraph (a) shall not apply to any charitable contribution of any letter, memorandum, or similar property which was written, prepared, or produced by or for an individual while the individual is an officer or 620 florida tax review [vol.5:8 employee of any person (including any government agency or instrumentality) unless such letter, memorandum, or similar property is entirely personal. `(f) copyright treated as separate property for partial interest rulein the case of a qualified artistic charitable contribution, the tangible literary, musical, artistic, or scholarly composition, or similar property and the copyright on such work shall be treated as separate properties for purposes of this paragraph and subsection (f)(3).'. ‘(g) qualified software charitable contribution. for purposes of this paragraph, the term “qualified software charitable contribution” means a charitable contribution of all patent and other rights relating to computer software, but only if— (i) such contribution is made by an individual who is not regularly engaged in the trade or business of developing and selling computer software, and the software was created by the personal efforts of the taxpayer making the contribution; (ii) one or more features of the computer software contributed is eligible for u.s. patent protection; (iii) the taxpayer-`(i) has received a qualified appraisal of the fair market value of such property in accordance with the regulations under this section, and `(ii) attaches to the taxpayer's income tax return for the taxable year in which such contribution was made a copy of such appraisal; and `(iv) the donee is an organization described in subsection (b)(1)(a), 2002] it does not compute 621 (b) effective datethe amendment made by this section shall apply to contributions made after the date of the enactment of this act in taxable years ending after such date. florida tax review volume 2 1995 number 6 compensatory and punitive damages for a personal injury: to tax or not to tax? douglas a. kahn* 1. introduction ..................... ii. history .......................... a. generally ................... b. punitive damages ............. c. prejudgment interest ........... d. damages for defamation ........ e. damages for discrimination ...... m . tax policy ...................... a. containment of size of award ..... b. return of human capital ......... c. involuntary conversion .......... d. combination of considerations ..... 1. nonconmmercial zone ...... 2. vulturous behavior ....... 3. author's conclusions ..... e. icome-connected damages ...... ........... 329 ........... 330 ........... 330 ........... 332 ........... 335 ........... 336 ........... 337 ........... 340 ........... 340 ........... 341 .. ........... 347 ........... 348 ........... 348 ........... 349 ........... 352 ........... 352 1. given in mitigation of personal loss rather than in substitution for lost income ...... 353 2. administrative convenience ............ 353 f. injuries to nonphysical personal rights ......... 356 g. punitive damages ........................ 358 iv. burke decision and subsequent cases ............ 360 v. punitive damages ............................ 366 a. 1989 statutory amendment .................. 366 1. post-1989 punitive damages in cases involving physical injury ................ 367 2. excludability of punitive damages under pre-1989 law ...................... 370 3. meaning of "physical" ................. 371 * paul g. kauper professor, university of michigan law school. the author is grateful for the helpful suggestions that he received from his colleagues, bruce frier and rebecca eisenberg. 328 florida tax review [vol. 2:6 b. apart from 1989 amendment ................. 371 vi. age discrimination ........................... 378 vii. operation of burke standards ................. 381 compensatory and punitive damages i. introduction since the adoption in 1919 of the revenue act of 1918, damages received on account of personal injuries or sickness have been excluded by statute from gross income.' this exclusion, which does not apply to reimbursements for medical expenses for which the taxpayer was previously allowed a tax deduction,2 is presently set forth in section 104(a)(2). one might expect that a provision having recently attained the ripe age of 75 years without change in its basic language would have a settled meaning. however, recent litigation under section 104(a)(2) bristles with unsettled issues. does the exclusion apply to punitive damages? to prejudgment interest included in a personal injury recovery? to recoveries under various antidiscrimination statutes? the supreme court entered the fray in 1992 with its decision in united states v. burke,3 dealing with the application of section 104(a)(2) to recoveries in employment discrimination cases. the court followed a regulation stating that the exclusion applies only to amounts received, through suit or settlement, "based upon tort or tort-type rights,"' and held that a claim is tort or tort-type only if it can be redressed by a broad range of damages, such as those traditionally allowed in tort cases. specifically, the court found that a recovery under title vii of the civil rights act of 1984 was not within the section 104(a)(2) exclusion because title vii, as it existed when the facts of the case arose, allowed only equitable relief and recoveries of backpay. if the court believed that the burke decision would bring order to this comer of the law, it was sadly mistaken. just how broad must the range of recoverable damages be to make a claim tort or tort-type under burke? is a claim under the age discrimination in employment act of 1967 (adea)which allows recovery of backpay plus, in cases where the employer's violation is willful, an equal amount as "liquidated damages"-tort-type? did the court mean to say that the exclusion applies to all damages received on a tort or tort-type claim, including punitive damages and prejudgment interest, or only to compensation for the personal injury that gave rise to the claim? the court has granted certiorari in a case involving the excludability of adea recoveries,5 and, depending on the scope and clarity of its opinion in 1. revenue act of 1918, pub. l. no. 65-254, § 213(b)(6). 40 stat. 1057, 1066 (1919). 2. irc § 104(a); regs. § 1.104-1(a). 3. 112 s. ct. 1867 (1992). 4. regs. § 1.104-1(c). 5. schleier v. commissioner, 26 f.3d 1119 (5th cir.), cert. granted, 115 s. ct. 507 (1994). 19951 florida tax review that case, it may find it necessary to hear additional cases to settle other issues on which the lower courts have not agreed. a principal purpose of this article is to suggest that these questions should be resolved with a close eye on the history of section 104(a)(2) and the policies supporting it. part ii is a brief discussion of the history of the tax treatment of damages received for a personal injury. part iii is a discussion of policy justifications for excluding from gross income compensatory damages for personal injuries and the absence of any policy justification for excluding punitive damages. this part also examines the policy justification for excluding that portion of a personal injury recovery that compensates for lost wages or profits. part iv discusses the supreme court's decision in burke and the decision's effect in subsequent litigation. part v discusses punitive damages and sets forth the author's reasons for concluding that all punitive damages are included in income. part vi examines whether damages (including liquidated damages) obtained under the adea are within the section 104(a) exclusion. the final part vii briefly discusses the problems inherent in extension of the exclusion to all tort-type claims arising from a personal injury and whether that extension has led to inappropriate results. ii. history a. generally the treasury initially took the position that damages received for personal injury are gross income, analogizing them to the proceeds of accident insurance, which the treasury assumed to be taxable.6 however, in 1918, the attorney general issued an opinion concluding that accident insurance proceeds are not taxable because they constitute a kind of conversion of human capital caused by the injury.7 as a consequence of the attorney general's opinion, the treasury promptly revoked the regulation that declared personal injury damages to be taxable, holding instead that "an 6. "[an a]mount received as the result of a suit or compromise for personal injury, being similar to the proceeds of accident insurance, is to be accounted for as income." reg. 33, art. 4, treas. dec. int. rev. 8 (1918). the history of § 104(a)(2) is recounted in several articles. e.g., margaret henning, recent developments in the tax treatment of personal injury and punitive damage recoveries, 45 tax law. 783, 784-95 (1992); james c. moser, jr., note, miller v. commissioner. the expanding scope of the i.r.c. section 104(a)(2) exclusion "on account of personal injuries," 44 ark. l. rev. 167, 173-82 (1991). 7. 31 op. att'y gen. 304, 308 (1918). the attorney general's opinion was apparently based on doyle v. mitchell bros. co., 247 u.s. 179, 185 (1918), where the court defined "income" as "the gain derived from capital, from labor, or from both combined." [vol. 2:6 comnpensatory and punitive damages amount received by an individual as the result of a suit or compromise for personal injuries sustained by him through accident" is not gross income.' the revenue act of 1918, enacted in 1919, included a provision excluding from gross income "[a]mounts received, through accident or health insurance or under workmen's compensation acts, as compensation for personal injuries or sickness, plus the amount of any damages received whether by suit or agreement on account of such injuries or sickness."9 the ways and means committee report on this provision stated: under the present law it is doubtful whether amounts received through accident or health insurance, or under workmen's compensation acts, as compensation for personal injury or sickness, and damages received on account of such injuries or sickness, are required to be included in gross income. the proposed bill provides that such amounts shall not be included in gross income.'0 thus, the first statutory antecedent of section 104(a)(2) was adopted in order to codify what congress believed to be the state of the law at that time and to eliminate the possibility that case law would follow a different path. the service initially concluded that the statutory exclusion applied only to damages for physical injuries and that damages for nonphysical personal injuries were taxable." however, the service repudiated that view only a few years later and acknowledged that damages (or a settlement payment) for an invasion of a personal right (e.g., defamation or alienation of affection) was not taxable because such receipts are not gain to the taxpayer.12 the board of tax appeals (the predecessor of the tax court) similarly determined that apart from the statutory exclusion, damages for defamation are not gross income because, in the court's view, the term "income" does not encompass them. 3 the service acquiesced in that 8. t.d. 2747, treas. dec. int. rev. 457 (1918). 9. revenue act of 1918, pub. l. no. 65-254, § 213(b)(6). 40 stat. 1057, 1066 (1919). 10. h.r. rep. no. 767, 65th cong., 2d sess. 9-10 (1918). reprinted in 1939-1 (part 2) c.b. 86, 92. 11. e.g., sol. mem. 1384, 2 c.b. 71 (1920) (holding that damages for alienation of affections (although a personal injury) are taxable); sol. mem. 957, 1 c.b. 65 (1919) (holding taxable damages for defamation). 12. sol. op. 132, i-i c.b. 92 (1922). superseded by rev. rul. 74-77, 1974-1 c.b. 33 (holding also that damages received for alienation of affections or for custody of a child are excluded from income). 13. hawkins v. commissioner, 6 b.t.a. 1023, 1024 (1927). acq.. vi-i c.b. 14 (1928). the hawkins opinion implies that if the taxpayer had received punitive damages, they would have been taxable. since the factual events of the case arose before the effective date 19951 florida tax review decision, thereby reaffirming its acceptance of the excludability of damages for nonphysical personal injuries. the exclusion of damages for nonphysical injuries thus was initially grounded on a construction of the term "income" (as employed in the revenue acts) rather than on the statutory antecedent to section 104(a)(2). the determination that such damages are within the statutory exclusion for personal injuries came later. indeed, it was some 45 years later that the courts and the service held that the statutory exclusion of damages for personal injuries applied equally to physical and nonphysical injuries. 14 any lingering doubt about the issue was laid to rest by the supreme court in its 1992 burke15 decision in which a majority of the supreme court held section 104(a)(2) applicable to damages for nonphysical personal injuries and rejected the contrary suggestion made by justice scalia in his concurring opinion. b. punitive damages the tax treatment of punitive damages has a history of its own. in the 1920 decision in eisner v. macomber, the supreme court adopted the circumscribing definition of "income" as "gain derived from capital, from labor, or from both combined."' 6 for some years thereafter, that definition was strictly applied, excluding from gross income any gain not derived from capital or labor. windfall income (including punitive damages), not being derived from capital or labor, was generally held to be exempt from tax. 7 accordingly, punitive damages were not taxed until the supreme court abandoned the "capital or labor" requirement in its 1955 decision in glenshaw glass, deciding instead that gross income included, at a minimum, all "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion."' 8 the characterization of income as derived from capital or labor was useful, according to the glenshaw glass court, but it is not a delimiting definition of that term. the court held that of the 1918 revenue act, the court did not pass upon or even discuss the application of the statutory exclusion to nonphysical personal injuries. 14. see seay v. commissioner, 58 t.c. 32 (1972), acq., 1972-2 c.b. 3. until 1955, it made little difference whether the exclusion was the product of a statutory exclusion or a narrow construction of the term "income." however, when the meaning of that term was broadened by the supreme court's decision in commissioner v. glenshaw glass, 348 u.s. 426 (1955), it became important whether nonphysical injuries were within the § 104(a)(2) exclusion. 15. united states v. burke, 112 s. ct. 1867, 1871 (1992). 16. 252 u.s. 189, 207 (1920) (dealing with the taxation of stock dividends). 17. e.g., highland farms corp. v. commissioner, 42 b.t.a. 1314, 1322 (1940), acq. in result, 1941-1 c.b. 5. 18. commissioner v. glenshaw glass co., 348 u.s. 426, 431 (1955). [vol 2:6 compensatory and punitive damnages exemplary damages received for fraud and punitive damages received for anti-trust violations were gross income. after the decision in glenshaw glass, the service asserted that punitive damages in personal injury actions are also taxable.' 9 however, the service reversed course in revenue ruling 75-45,20 holding that all damages on account of personal injury, whether punitive or compensatory, are excluded from gross income by section 104(a)(2). the ruling dealt with an award for wrongful death in a state where wrongful death awards were punitive in nature.2 1 in two cases decided in 1983, the position taken by the service in revenue ruling 75-45 was deemed by the tax court and by the ninth circuit to be a concession that punitive damages are within section 104(a)(2); relying on that concession, those courts excluded punitive damages from income in cases where the personal injury that gave rise to the taxpayer's claim qualified for section 104(a)(2) treatment.y' the opinions in the cases make clear that the tax court and the ninth circuit rested their holdings on the service's concession, and did not make independent determinations of whether that section is applicable. in revenue ruling 84-108,' the service revoked revenue ruling 75-45, holding that punitive damages are not covered by section 104(a)(2) and are therefore gross income. revenue ruling 84-108 dealt with two situations involving awards for wrongful death. in one situation, state law limited a wrongful death award to the amount necessary to compensate the victim's survivors for their pecuniary loss. the service ruled that these compensatory awards are excluded from gross income by section 104(a)(2). the second situation involved a state law under which wrongful death damages were determined by the degree of fault of the tortfeasor, rather than the amount of loss incurred. the service classified these damages as punitive, and since punitive damages add to a taxpayer's wealth rather than compensating for loss, it held them to be taxable. 19. rev. rul. 58-418, 1958-2 c.b. 18, superseded by rev. rul. 85-98. 1985-2 c.b. 51. 20. 1975-1 c.b. 47, revoked by rev. rul. 84-108, 1984-2 c.b. 32. 21. while the ruling does not state why wrongful death awards in that state were classified as punitive, it is likely that the amount of the award was based on the degree of the tortfeasor's culpability, rather than the extent of the loss suffered by the victim and the victim's family. see rev. rul. 84-108, 1984-2 c.b. 32, 34. 22. church v. commissioner, 80 t.c. 1104, 1110 n.7 (1983): roemer v. commissioner, 716 f.2d 693, 700 (9th cir. 1983). 23. 1984-2 c.b. 32. for an analysis of the positions taken by the commissioner in the 1975 and 1984 rulings, and the courts' construction of the 1975 ruling, see mary j. morrison, getting a rule right and writing a wrong rule: the irs demands a return on all punitive damages, 17 conn. l. rev. 39 (1984). 19951 florida tax review in 1989, in miller v. commissioner,24 the tax court, by a vote of 16 to 2, rejected the reasoning of revenue ruling 84-108 and held that punitive damages obtained in connection with a personal injury claim are within the section 104(a)(2) exclusion. the court held that the reference in section 104(a)(2) to "any damages" means all damages, including punitive damages. while the statute requires that the damages be received "on account of personal injuries or sickness," the court construed that requirement as demanding no more than that there be a causal connection between the damages claim and a personal injury. the court noted that most jurisdictions allow punitive damages only to claimants who suffered actual injuries. it concluded that since an actual injury is a prerequisite to a punitive damages award, such damages are on account of that injury, and if the underlying injury is personal, section 104(a)(2) applies to the punitive damages. the fourth circuit court of appeals reversed the tax court's decision in miller, holding that the presence of a causal link between a personal injury and an award of punitive damages does not satisfy the statutory requirement that the damages be "on account of" a personal injury. according to the court, there must be more than a "but for" causal relationship; the presence of a personal injury must be "sufficient" in itself to qualify the taxpayer to receive the damages." in other words, section 104(a)(2) applies only if the personal injury is "sufficient," and not merely "necessary," to obtain the damages. even if punitive damages are awarded only when there is an actual injury, they are not given unless the tortfeasor's actions are especially reprehensible. the presence of a personal injury therefore is not sufficient, and, in the court's view, punitive damages are therefore taxable. section 7641 of the omnibus budget reconciliation act of 1989 amended section 104(a) to preclude the exclusion of punitive damages received in connection with a claim not involving physical injury or sickness.26 the legislation was adopted after the tax court's decision in miller but before the fourth circuit reversed that decision.27 subject to certain 24. 93 t.c. 330, 340 (1989) (reviewed by the court), rev'd sub nom. commissioner v. miller, 914 f.2d 586 (4th cir. 1990). 25. miller, 914 f.2d at 589-90. 26. pub. l. no. 101-239, § 7641, 103 stat. 2379 (1989). 27. the tax court's decision in miller was issued on september 13, 1989, and the fourth circuit reversed on september 21, 1990. neither the house bill nor the senate bill of the 1989 act contained a provision dealing with punitive damages as such. h.r. 3299, 101st cong., 1st sess. (1989); s. 1750, 101st cong., 1st sess. (1989). the provision addressing punitive damages came out of the conference committee. see h.r. conf. rep. no. 386, 101st cong., 1st sess. 622-23 (1989), reprinted in 1989 u.s.c.c.a.n. 3018, 3225-26. the house bill was introduced on september 20, 1989, and was passed by the house on october 5, 1989. h.r. rep. no. 147, 101st cong., 1st sess. (1989), reprinted in 1989 u.s.c.c.a.n. 1906. the conference committee's version of the bill (which was adopted by the congress and which [vol 2:6 compensatory and punitive damages transitional rules, the amendment applies to amounts received after july 10, 1989. the amendment makes no reference to punitive damages connected with a physical injury, whether received before or after july 10, 1989, and the taxation of these damages is one of the principal topics of this article. as of this writing, no court has passed on the taxability of punitive damages received in a personal injury case after july 10, 1989, but several cases decided since 1989 have involved punitive damages received before that date. three courts of appeals (the fourth, ninth, and federal circuits) have held that punitive damages are taxable,' but the sixth circuit has held them to be excluded by section 104(a)(2). -9 also, several lower court decisions have divided on this issue, and two of them are pending on appeal.30 c. prejudgment interest the exclusion of compensatory damages for personal injury encompasses any portion of the damages that compensates the victim for lost income.31 the exclusion applies both to replacements of lost past income and to amounts received to compensate for diminished future earning capacity resulting from the personal injury. it has not yet been resolved whether the exclusion also applies to prejudgment interest-an amount received to compensate for potential income that was lost because the taxpayer was not able to invest or use the awarded damages during the period between the time was the first version to deal with punitive damages) was promulgated on november 21, 1989. the history of this legislation is described in greater detail later in this article. see infra part v.a.i. 28. hawkins v. united states, 30 f.3d 1077 (9th cir.) (2-1 decision), ccrt. denied, 115 s. cl 648 (1994); reese v. commissioner, 24 f.3d 228 (fed. cir. 1994); commissioner v. miller, 914 f.2d 586 (4th cir. 1990). 29. horton v. commissioner, 33 f.3d 625 (6th cir. 1994) (2-1 decision). 30. e.g., estate of wesson v. united states, 843 f. supp. 1119 (d. miss. 1994) (holding that punitive damages in an action for bad faith are taxable): o'gilvie v. united states, 92-2 u.s. tax cas. (cch) t 50,567, 71 a.f.t.r.2d (p-h) 93-547 (d. kan. 1992) (o'gilvie i1) (holding that punitive damages in a wrongful death case are excluded from gross income by § 104(a)(2)). those cases have been appealed to the fifth and tenth circuits. compare rice v. united states, 834 f. supp. 1241 (e.d. cal. 1993) (holding punitive damages taxable), and kemp v. commissioner, 771 f. supp. 357 (n.d. ga. 1991) (same), with horton v. commissioner, 100 t.c. 93 (1993) (reviewed by the court) (holding that punitive damages arising from personal injury are excluded by § 104(a)(2)), aff'd. 33 f.3d 625 (6th cir. 1994) (2-1 decision), and downey v. commissioner, 100 t.c. 634, 637 (1993) (downey 11) (suggesting that punitive damages are not taxable), rev'd. 33 f.3d 836 (7th cir. 1994), petition for cert. filed, 63 u.s.l.w. 3476 (u.s. dec. 5, 1994) (no. 94-999). 31. rev. rul. 85-97, 1985-2 c.b. 50. 19951 florida tax review of the injury (or the time that suit was filed) and the time of the judgment against the tortfeasor.32 d. damages for defamation the service maintained for a brief period that damages for defamation of an individual's business or professional reputation (as contrasted to personal reputation) was taxable.33 while the service enjoyed a fleeting success on that issue in a 1982 tax court decision, the decision was reversed on appeal,34 and the subsequent cases (including decisions of three courts of appeal) repudiated that view. 3' the tax court itself, in a later case reviewed by the entire court (threlkeld), overruled its prior decision and accepted the view that such damages are excluded from income whether the defamed reputation is business or personal.36 in threlkeld, the tax court stated that section 104(a)(2) excludes from gross income compensatory damages "received on account of any invasion of the rights that an individual is granted by virtue of being a person in the sight of the law., 37 the crucial test is whether the injury is a "personal injury." the court further stated: "to determine whether the injury complained of is personal, we must look to the origin and character of the claim ... and not to the consequences that result from the injury. 38 it is now settled that it is the nature of the taxpayer's claim that determines whether damages are excluded from income. an injury to an individual's reputation damages a personal attribute of the individual, and the fact that a decline in reputation results in a loss of income or profits is merely one manifestation of that injury. if a taxpayer 32. compare kovacs v. commissioner, 100 t.c. 124 (1993) (reviewed by the court) (holding that prejudgment interest is taxable), aff'd (without published opinion), 25 f.3d 1048 (6th cir.), cert. denied, 115 s. ct. 424 (1994), with brabson v. united states, 859 f. supp. 1360 (d. colo. 1994) (holding that prejudgment interest is excluded from income). these cases are discussed later in this article. see also downey v. commissioner, 33 f.3d 836 (7th cir. 1994) (suggesting that prejudgment interest is taxable). cf. pagliarulo v. commissioner, 68 t.c. memo (cch) 9171, t.c. memo (p-h) 94,506 (1994) (holding that interest on a workmen's compensation award is taxable). 33. see rev. rul. 85-143, 1985-2 c.b. 55. 34. roemer v. commissioner, 79 t.c. 398 (1982), rev'd, 716 f.2d 693 (9th cir. 1983). 35. thompson v. commissioner, 866 f.2d 709 (4th cir. 1989), aff'g 89 t.c. 632 (1987); threlkeld v. commissioner, 848 f.2d 81 (6th cir. 1988); bent v. commissioner, 835 f.2d 67 (3d cir. 1987), affg 87 t.c. 236 (1986). 36. threlkeld v. commissioner, 87 t.c. 1294 (1986) (reviewed by the court), aff'd, 848 f.2d 81 (6th cir. 1988). the case involved a recovery for injury to the taxpayer's professional reputation caused by malicious prosecution. 37. threlkeld, 87 t.c. at 1308. 38. id. at 1299 (citation omitted). [vol 2:6 compensator and punitive damages loses a limb in an accident, all damages received for the injury are excluded from income, even to the extent they are received in substitution of items that would have been taxable if the individual had earned and received them (such as lost wages or profits). the most obvious difference between a taxpayer losing a limb and a taxpayer whose reputation is damaged is that the former suffers a physical injury, while the latter's injury is not physical. the effect of the exclusion of compensatory damages for defamation of an individual's professional or business reputation is to accord the same treatment to damages, whether the injury is physical or nonphysical. nevertheless, there is a question whether it is good tax policy to exclude damages for nonphysical injuries. that issue is discussed in parts ii and ii of this article. e. damages for discrimination a related, widely litigated issue is whether damages received by victims of discrimination are excluded from income by section 104(a)(2). the service initially took the position that such damages are taxable because they are merely a substitute for lost income.39 before 1986, the service was generally successful in litigating that position,"o but the results since then have been mixed.4 ' a key authority on this issue is the supreme court's 1992 decision in united states v. burke,42 which involved the applicability of section 104(a)(2) to damages received under title vii of the civil rights act of 1984 because of sex discrimination. the damages at issue in burke were for back wages lost by the taxpayers because of the employer's discriminatory acts. according to the regulations under section 104(a)(2), the term "'damages received'.. . means an amount received... through prosecution of a legal suit or action based upon tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution." ' only damages (or settlements) received pursuant to a claim that qualifies as a tort or a tort-type right can be excluded under section 104(a)(2). the exclusion does not apply to recoveries for violations of rights more accurately described 39. rev. rul. 72-341, 1972-2 c.b. 32. 40. e.g., hodge v. commissioner, 64 t.c. 616 (1975); coats v. commissioner, 36 t.c. memo (cch) 1650, t.c. memo (p-h) 77,407 (1977), aff'd by court order, 626 f.2d 865 (9th cir. 1980). 41. e.g., pistillo v. commissioner, 912 f.2d 145 (6th cir. 1990). rickel v. commissioner, 900 f.2d 655 (3d cir. 1990); downey v. commissioner, 97 t.c. 150 (1991) (downey i), aff'd on reconsideration, 100 t.c. 634 (1993) (reviewed by the court) (downey ri), rev'd, 33 f.3d 836 (7th cir. 1994), petition for cert. filed, 63 u.s.l.w. 3476 (u.s. dec. 5, 1994) (no. 94-999). 42. 112 s. ct. 1867 (1992). 43. regs. § 1.104-1(c). 19951 florida tax review as contract rights.4 for that reason, several courts, including the supreme court, have held that a crucial step in applying section 104(a)(2) is determining the nature of the claim underlying the taxpayer's damages or a settlement. in burke, the supreme court held that the characterization of a claim as tort or tort-type depends upon the breadth of the remedies for such claims. the common law (and present state laws) permit a wide range of remedies for tort victims. recovery is allowed for lost wages or profits, medical expenses, and diminished future earning capacity. in addition to recoveries for pecuniary losses, recovery is also permitted for such nonpecuniary items as pain and suffering, emotional or mental distress, and personal humiliation. punitive or exemplary damages are generally available if the wrongdoer's conduct was intentional or reckless. the court held that if the remedies for a violation of an individual's rights are significantly narrower than those typically available to tort victims, damages or a settlement obtained for the violation is not based on a tort or tort-type claim, and the amounts received are taxable. at the time of the facts of burke, the remedies for title vii violations were restricted to compensation for lost wages and equitable relief, including reinstatement or elevation to a job. the court found that the range of damages then available to a claimant under title vii was too restricted to qualify the claims as tort or tort-type claims, and it held the taxpayers' damages to be taxable. the court contrasted the remedies then provided by title vii with the broad range of remedies under other antidiscrimination statutes, including the remedies under 42 u.s.c. section 1981 for victims of race-based employment discrimination. the court noted that title vii was amended in 1991 to expand the available remedies, but because the facts of the burke case arose before the effective date of that amendment, the court did not pass upon the treatment of damages in cases governed by the amended statute. two types of discrimination are proscribed by title vii of the civil rights act of 1964.4 1 one type is a "disparate treatment" violation-where an employer intentionally discriminated against an individual, with respect to compensation or other employment terms, because of the individual's race, color, religion, sex, or national origin. the second type (a "disparate impact" violation) consists of facially neutral employment practices, not necessary for business purposes, that have a disparate impact on persons within a protected class (e.g., persons within a group classified by race or gender). a violation 44. burke, 112 s. ct. at 1877-78 (justice souter concurring). 45. 42 u.s.c. § 2000(e) et. seq. [vol 2:6 compensatory and punitive damages of the second type can occur whether or not the employer intended that the disparate impact occur.46 the civil rights act of 1991 added a new provision to title vii (section 1981a) that expanded the range of relief available for disparate treatment violations-intentional acts of discrimination by an employer. in such cases, compensatory damages can be awarded for nonpecuniary injuries, and punitive damages are allowable in some cases. this provision does not apply to disparate impact cases, for which the available relief continues to be only backpay and equitable relief. in summary, under the burke construction of section 104(a)(2), compensatory damages received by a discrimination victim are excluded only if the damages claim is of a type that can be redressed by a wide range of remedies. it is not necessary that a range of remedies actually be awarded to the taxpayer; it is only necessary that the claim arise under a law that permits a wide range of remedies. even if the sole remedy actually awarded to the taxpayer is back wages, the damages are excluded if the taxpayer's claim qualifies as a tort or tort-type claim." the service has acknowledged that the section 104(a)(2) exclusion covers compensatory damages for race-based discrimination under 42 u.s.c. section 1981 and compensatory damages received under the amended version of title vii for disparate treatment type of discrimination.' however, damages received under title vii for disparate impact violations are taxable because of the limited range of remedies available for those claims. the courts of appeals are divided over whether compensatory damages received under the age discrimination in employment act of 1967 (adea) are taxable, and the supreme court has granted certiorari from the fifth circuit's unpublished decision on that issue in schleier v. commissioner. 49 46. for a discussion of the employment discrimination provisions of title vii and of the remedies available to victims of violations of those provisions, see arthur w. andrews, the taxation of title vii victims after the civil rights act of 1991. 46 tax law. 755. 76870 (1993). 47. rev. rul. 93-88, 1993-2 c.b. 61. 48. id. in that ruling, the service acknowledged that damages under the americans with disabilities act (42 u.s.c. §§ 12101-12213) are excluded from income. 49. 26 f.3d 1119 (5th cir.), cert. granted, 115 s. ct. 507 (1994). the circuit court split is evidenced by downey v. commissioner, 33 f.3d 836 (7th cir. 1994) (holding that damages received pursuant to an adea claim are taxable), petition for cert. filed. 63 u.s.lw. 3476 (u.s. dec. 5, 1994) (no. 94-999), and schmitz v. commissioner, 34 f.3d 790 (9th cir. 1994) (holding that such damages are excluded by § 104(a)(2)), petition for ccri. filed, 63 u.s.l.w. 3462 (u.s. nov. 23, 1994) (no. 94-944). this issue is discussed below in parts iv and vi. 1995] florida tax review m. tax policy several rationales have been suggested for the exclusion of personal injury damages from gross income. in this part, the author describes and critiques some of those suggestions and offers his own explanation. a. containment of size of award one suggested explanation for the exclusion, which the author does not believe to be sufficiently credible to justify extensive discussion, is that the purpose of the provision is to prevent the awarding of exorbitantly large judgements that, in the absence of the exclusion, might be required to provide a victim with sufficient after-tax dollars to compensate for the injury.5" if personal injury damages paid in a lump sum were taxed when received, there would be a bunching of income in that year. part of the damages could possibly be viewed as a replacement of the appreciation of value in the damaged item that had occurred gradually over many years, and another part of the damages might be a substitute for the loss of income that would have been earned over many years if the victim had not been injured. if the realization of the appreciation of personal rights and the substitution for several years of income were bunched into one year, the rate of tax would likely be in the higher brackets. to provide full compensation, the amount payable to the victim would have to be increased to cover some part of the tax on the damages, that increase in the damages would itself be taxed and cause the imposition of even more taxes for which taxable compensation would be made, and so on. while that is a daunting prospect, there are several reasons to conclude that the containment of damage awards is not the object of section 104(a)(2). in the first place, congress had no reason to believe that state laws on tort damages would be adjusted to pass the benefit of the income tax exclusion to the tortfeasor. in fact, a significant number of states do not do so. the determination of damages is not influenced by section 104(a) unless either (1) the trier of facts (often a jury) is informed that an award to the victim will not be taxed or (2) the calculation of the victim's lost income takes account of the nontaxability of damages by reducing the loss by the amount of income tax that the victim would likely have incurred if the income had been earned rather than lost. state laws are divided on whether to so inform a jury and whether to reduce damages by the tax liability that it is estimated the victim would have incurred. a substantial number of states 50. see edward yorio, the taxation of damages: tax and non-tax policy considerations, 62 cornell l. rev. 701, 719-22 (1977) (rejecting this suggestion). [vol 2:6 compensatory and punitive damages prohibit information about nontaxability from being given to the jury, some states require it to be given, and some states leave the matter to the discretion of the trial judge.5 similarly, the states are divided over whether income taxes should be taken into account in calculating a victim's lost income.52 while the supreme court has required that federal taxes be taken into account in fela cases (thereby reducing the size of the awards)," that has not bound federal courts in cases involving other statutes.-' moreover, if there were concern that the taxation of such damages would create excessively high awards because of bunching problems, the better solution would be to adopt an income-averaging system rather than to exclude damages from income.55 if full taxability would overburden tortfeasors, the exclusion errs more obviously in the other direction, thrusting portions of the costs of torts on the taxpaying public and compromising one of the fundamental policies of tort law-to encourage tort-free behavior by placing on tortfeasors the full costs of their wrongs. b. retumn of human capital while there is uncertainty as to precisely what considerations led congress to adopt the antecedent to section 104(a)(2), the background history of the provision suggests that congress focused on a "return of human capital" theory. the first pronouncement of an exclusion for personal injury recoveries was made by the attorney general in an opinion promulgated in 1918 concerning accident insurance proceeds.the opinion indicates that the rationale for the exclusion was that accident insurance proceeds merely provide a monetary substitution for a personal attribute that was lost as a consequence of an accident. it seems likely that a similar rationale underlay the treasury's 1918 determination that personal injury damages are excludable because the treasury's reversal of its prior regulatory position was made 51. see john e. theuman, annotation, propriety of taking income tax into consideration in fixing damages in personal injury or death action, 16 a.l.rath 589, 594602 (1982). 52. id. at 605-16. 53. norfolk & w. ry. co. v. liepelt, 444 u.s. 490 (1980). 54. e.g., estate of spinosa v. international harvester co., 621 f.2d 1154, 1158 (1st cir. 1980). in purcell v. seguin state bank & trust co., 999 f.2d 950 (5th cir. 1993). the court affirmed an award of compensatory damages for age discrimination in employment. which the lower court determined with a reduction for the income taxes that the plaintiff would have borne on the lost income. 55. the operation of a typical income-averaging provision is described infra note 81. 56. 31 op. att'y gen. 304, 308 (1918). 19951 florida tax review in response to the attorney general's opinion.57 since the 1919 legislation that enacted the antecedent to section 104(a)(2) was intended to codify the positions previously adopted by the treasury and the attorney general, it seems likely that congress was motivated by the same rationale.58 this rationale is sometimes described as a "return of capital" or as a "return of human capital" theory. the human capital theory has recently been criticized by courts and by commentators.59 moreover, even if the theory was the original rationale for the statutory exclusion, it is not necessary to accept the theory as the justification for retaining the exclusion. a statute may be adopted for a reason that is later abandoned, but the statute may be retained for quite different reasons. also, legislators may have a strong visceral belief that a remedy is needed, but not be able to ascertain the principles upon which that belief is founded. thus, even when the legislative history sets forth a rationale for a provision, the rationale actually underlying the legislation may be something quite different because the legislators are then unable to articulate the true rationale. legal realism teaches that the principle underlying a judicial decision may be different from the one expressed in the court's opinion. the true underlying principle may be one that is not fully perceived by the judge when writing the opinion and is only discovered years later after there has been experience with a wide variety of factual circumstances to which a common principle must be applied. the flexibility of the legal system allows the cumulative wisdom of many judges, gained over time, to uncover the controlling principle for an issue when that principle may have been intuitively felt but not fully comprehended by the judges who wrote the opinions in the earlier cases. this flexibility prevents the law from being held captive to premature expressions of only dimly comprehended rationalizations, and the resulting capacity for building on the courts' initial grappling with new issues is a significant part of the genius of the common law. the same process of rationalization can take place with legislation, and the underlying principle for a statute should be determined with the same flexibility that is applied to judicial decisions. this is especially appropriate 57. see supra note 8. 58. see supra notes 9, 10 and accompanying text. also, shortly after the statutory exclusion was enacted, the service characterized excludable damages as substitutes for lost personal rights that are not assignable to other persons and cannot be valued since they are not traded in the market place. sol. op. 132, 1-1 c.b. 92 (1922), superseded by rev. rul. 74-77, 1977-1 c.b. 33. 59. e.g., downey v. commissioner, 97 t.c. 150, 159 (1991) (reviewed by the court) (downey i), rev'd, 33 f.3d 836 (7th cir. 1994), petition for cert. filed, 63 u.s.l.w. 3476 (u.s. dec. 5, 1994) (no. 94-999); hawkins v. united states, 30 f.3d 1077 (9th cir.) (trott, j., dissenting), cert. denied, 115 s. ct. 648 (1994); yorio, supra note 50, at 711-13. [vol. 2:6 compensatory and puniti'e damages in light of the fact that a statute is adopted by the combined vote of several individuals who likely have diverse reasons for their support. it is the function of the courts and of the government agencies that administer a provision to reconcile the terms of a statutory provision with the purposes that it serves and with the overall policies of the larger statutory scheme of which that individual provision is a part. for several reasons, the human capital theory, standing alone, does not adequately justify section 104(a)(2). first, a basic premise of the theory-that personal injury recoveries should not be taxed because they merely replace the unascertainable value of what the victim lost-is inconsistent with the rules generally applied to dispositions of property. on a disposition of property, gain or loss is measured as the difference between the amount realized and the taxpayer's basis for the property.' the value of the asset when sold or destroyed is irrelevant for this purpose. for example, if x owns a rare vase in which she has a basis of $1,000 when it is destroyed by the negligence of y, compensation for the loss received from y is gain to the extent it exceeds x's $1,000 basis, without regard to the vase's value. assume the vase was worth, say, $50,000 before it was destroyed, but x accepts $28,000 as compensation for the loss because she believes that she could not obtain more, given y's financial resources.6 even though the compensation is substantially less than the value of the destroyed item, x recognizes gain of $27,000 (the difference between the amount received and the vase's basis). if damages for the loss of personal rights are to be treated differently, the reason does not lie exclusively in the impossibility of measuring the value of those rights. second, justification for the exclusion does not flow from the difficulties of determining the basis (if any) that a tort victim has in the body parts or personal rights that were damaged. a taxpayer has the burden of establishing basis, 62 and if none can be established, basis is deemed to be zero. since people do not anticipate having parts of their bodies (or personal rights) converted into cash, they do not keep records of any capital expenditures that may have been made in connection therewith, and it might seem appropriate to accord them relief by excluding all or part of their recoveries.6 however, it is highly unlikely that a person has any basis in body parts. most expenditures that might conceivably be attributed to body parts 60. irc § 1001(a). 61. also, assume x purchases no replacement property. if x reinvested all or part of the proceeds in replacement property, all or part of her gain would be deferred under § 1033. 62. e.g., raytheon prod. corp. v. commissioner. 144 f.2d 110. 114 01st cir.). ccrt. denied, 323 u.s. 779 (1944). 63. see joseph m. dodge, taxes and torts, 77 cornell l rev. 143, 152 (1992). 19951 florida tax review (such as purchases of food, clothing, and medical care) cannot be apportioned among them on any rational basis. moreover, to the extent that an allocation is feasible, amounts allocated to particular parts are usually in the nature of maintenance and repairs, and such expenditures cannot be capitalized as basis. although maintenance and repairs can be deducted only when incurred in connection with a business or profit venture, 64 they are not capital expenditures, and so are not included in basis, whether or not they were deductible. 65 it therefore is highly unlikely that anyone has a meaningful basis in body parts, and it would be overly generous to exclude damages received for a personal injury solely because of the understandable failure of persons to keep records of their investment in their bodies. there is a remote possibility that an individual might have a basis in some personal rights. for example, a portion of the amounts expended in obtaining a college or professional education (some portion of which could conceivably be a capital expenditure) might be included in the basis of a person's reputation. even if such an allocation were theoretically justified, no actual allocation is likely to be made because the problems in determining the amount to be allocated are mind-boggling. in the case of compensation received for an injured reputation, one possible solution to the basis problem would be to arbitrarily exclude from income some part of the compensation. however, the basis of a taxpayer's reputation would be quite small and would justify excluding no more than a small amount of compensation. moreover, in the normal course of exploiting one's reputation in business or professional life, no deduction is allowed against the resulting income for the cost of the reputation expended in earning the income. finally, as shown later in this part, when everything is taken into account, the policy justification for excluding damages received for nonphysical injuries is much weaker than the case for physical injuries. third, some courts and commentators have suggested that the human capital theory is undercut by the fact that the section 104(a)(2) exclusion extends to damages in substitution for lost income.' this is a different point from the one that the author makes below in asserting that if the human capital theory were valid and were applied consistently throughout the tax law, gain from a sale of a personal right would not be taxed. the author does not share the view that the statutory exclusion of damages for lost income is inconsistent with the human capital justification. while the recovery of human capital theory does not support the statutory treatment of damages for lost income, that treatment is not inconsistent with the theory; rather, it rests 64. regs. § 1.162-4. 65. see i.t. 4094, 1952-2 c.b. 134 (holding that the cost of repainting a personal residence is not a proper adjustment to its basis). 66. see, e.g., yorio, supra note 50, at 712. [vol 2:6 compensatory and pimitive damages on a separate, independent rationale. the reason for excluding compensation for lost income is discussed below in part 1i.e. this reason does not encompass interest. section 104(a)(2) was amended in 1983 to permit personal injury damages to be received in periodic installments without causing the recipient to be taxed on the interest element in the deferred receipts. if an interest element were to be segregated and taxed, the interest portion could be calculated only if congress settled on a rate of interest, and the computation might be quite complex if future installments are contingent. congress most likely decided against the imputation of interest on periodic payments of damages in order to avoid the administrative burden of making those calculations. however, in requiring the imputation of interest in many other deferred payment contexts, congress has not been deterred by the burden of the calculations. the difficulty of making an imputed interest calculation is of a much lesser order of magnitude than the difficulty of separating income-related damages from a lump sum damage award or settlement, as discussed in part m.e.2 of this article. rather than raising questions as to whether there is a discemable purpose underlying section 104(a)(2), the weakness of the independent justification that underlies the 1983 amendment merely raises the question of whether the adoption of that amendment was wise. the justification for the 1983 amendment, weak as it may be, does not support an exclusion of prejudgment interest. while the computational burden of imputing interest on sums payable in periodic installments would not be overwhelming, it is meaningful. prejudgment interest, on the other hand, is at a specified rate for an easily determinable period of time, and the calculation of the amount of that interest presents no difficulty. finally, and most significantly, the human capital rationale does not jibe with the tax law's treatment of voluntary dispositions of human capital. the section 104(a)(2) exclusion applies only to damages (or to a settlement of a claim for damages) received on account of a personal injury or sickness. it has no application to an individual's voluntary sale of a body part or personal right. federal law prohibits the sale of human organs.67 but, if such a sale were permitted or were made in violation of the law (if, for example, a kidney were sold to a person needing a transplant), the entire amount received by the seller would be taxed as gain. it would not matter that the amount realized merely replaced a part of the seller's human capital or that the organ's basis is unascertainable. the prohibition against the sale of a human organ does not apply to the sale of blood, and it is well established that an amount realized by an individual on a sale of blood is ordinary 67. national organ transplant act, § 301, 42 u.s.c. § 274e(a) (1988). 19951 florida tax review income.68 although damages for an invasion of privacy (e.g., the use of the taxpayer's picture for a commercial or advertising program) are likely excluded from income by section 104(a)(2), an amount received in a voluntary sale of the right to use the taxpayer's picture in a commercial program is taxable. it is clear then that not all payments that substitute a monetary payment for a personal right or human capital are excluded from income. thus, neither the fact of such a substitution nor the unascertainable basis of such items is sufficient by itself to justify an exclusion from income. however, the human capital consideration might be combined with other factors to justify the exclusion provided by section 104(a)(2). the author later considers that possibility. the human capital theory might derive from the tax treatment of damages reimbursing expenditures made by the taxpayer. to the extent a damage recovery is attributable to dollars spent by the taxpayer and therefore is merely substitution for those dollars, it should not be taxable, whether or not section 104(a)(2) applies, unless a deduction was allowed for the expenditures. for example, a reimbursement for an injured person's medical expenses is excluded from income unless a deduction was allowed for the expenditures.69 similarly, if a taxpayer's property was destroyed by wrongful act, damages received for the loss of the property are taxable only to the extent that they exceed the taxpayer's basis for the property. such treatment is no different than the tax treatment that would have applied if the taxpayer had sold the property before it was destroyed. another illustration of this principle arose in a 1939 board of tax appeals case, clark v. commissioner,7° involving a taxpayer who had overpaid a federal tax liability because of poor advice received from his attorney. the court held that the attorney's reimbursement of the amount overpaid was not included in the taxpayer's income. it is possible that the principle of allowing tax-free reimbursement of lost dollars was extended by those who conceived the human capital theory 68. in green v. commissioner, 74 t.c. 1229 (1980), the tax court held that payments received for the sale of blood are gross income. the taxpayer in green did not dispute the taxability of such receipts, but claimed that she should be allowed deductions for expenses related to the sale. nevertheless, the court passed on the issue of taxability. in lary v. united states, 787 f.2d 1538 (1 1th cir. 1986), the court denied a charitable deduction for a blood donation because, if the taxpayer had sold his blood, he would have recognized ordinary income equal to the amount received. no charitable deduction is allowed for the amount of a contribution that would have been ordinary income if the item had instead been sold by the donor for its fair market value. irc § 170(e)(1)(a). 69. irc § 104(a); regs. § 1.104-1(a). a recovery of a previously deducted amount is taxed because the injured-person would otherwise be left with a double tax benefit. 70. 40 b.t.a. 333 (1939), acq., 1957-1 c.b. 4. [vol 2:6 compensatory and punitive damages to cover amounts received in substitution for a loss of personal rights or human capital. that extension has some superficial appeal, but as noted above, it does not withstand scrutiny. the tax treatment of the voluntary sale of such personal rights indicates that the return of human capital rationale is inadequate by itself to explain section 104(a)(2). c. hivoluntary conversion another rationale suggested for section 104(a)(2) is that since the taxpayer did not choose to dispose of the damaged personal right or body part, it seems rapacious to tax damages received as compensation for such a personal loss. relief is provided when damages are received to compensate for a destruction of tangible property. gain is realized to the extent that the damages exceed the taxpayer's basis in the property. the involuntariness of the conversion of the item into cash arouses sympathy because of the forced realization of previously unrealized gain accrued to the property. section 1033 provides relief for a taxpayer in that predicament: if, within a specified period of time, the taxpayer acquires property similar or related in service or use to the destroyed property, the gain realized on the conversion is taxed only to the extent the conversion proceeds exceed the cost of the replacement property. the taxpayer's investment in the destroyed item is rolled over and becomes part of the taxpayer's basis in the replacement property. in effect, the taxpayer's realized gain is deferred, at least in part, until the taxpayer disposes of the replacement property (or until the taxpayer is allowed depreciation deductions for that property if it is depreciable). the question then is whether, in the case of a personal injury recovery, the involuntariness of the conversion of the taxpayer's personal rights or body parts is a sufficient justification for not taxing the damages received. in most such cases, the taxpayer has no means of reinvesting the proceeds in something similar or related in service or use to the destroyed item. if such a replacement can be located, the replacement is usually only partial, and its cost is often substantially less than the amount of damages suffered by the taxpayer, making a section 1033 deferral concept of little value. for example, a lost arm can be replaced with an artificial limb, but an artificial limb replaces only part of the function of the lost arm, and its cost is likely far less than the damages recoverable for the injury. much of what the taxpayer lost cannot be replaced by anything similar in use. since a deferral of gain is not readily available, should the taxpayer be taxed on the entire amount of the gain at the time of receipt or should some relief be accorded? the taxation of damages received in a lump sum in one year may cause a bunching of income that subjects the taxpayer to a 19951 florida tax review large tax because of the operation of the graduated rates,7' and one might at least expect some relief from the bunching effect, perhaps by a form of income-averaging. section 104(a)(2) instead excludes all such damages from income permanently, an approach not well crafted to provide relief from the bunching effect. involuntariness alone is not a sufficient justification for this extraordinary exclusionary treatment since the involuntary conversion of tangible property is not treated so gently. d. combination of considerations. given the sympathy that a personal injury engenders, the section 104(a)(2) exclusion is perhaps warranted by the combination of the fact that a personal right or body part was destroyed (the return of human capital theory) and the involuntariness of the conversion. that is, even though neither factor alone is sufficient, the cumulative effect of the combination of the factors may be sufficient. the whole may well be greater than the sum of its parts. the author believes that there are two additional factors that color the combination of the human capital theory and the involuntariness of the conversion of a body part, and the addition of that coloration makes a compelling case for the exclusion of such damages when given for a physical injury. 1. noncommercial zone.-the tax law is aimed at market transactions. gain on a sale of an item held for personal use, such as a residence or a piece of jewelry, is taxed, but, in such cases, the taxpayer has chosen to place the item into the commercial market by putting it up for sale. moreover, those types of property are commonly bought and sold in the market place and are properly regarded as commercial items. in contrast, noncommercial personal attributes are not traded in the market and lie far outside the zone of properties and activities that comprise the sphere of the tax laws' operation. for example, if two persons exchange their services, each must typically include in income an amount equal to the value of the services received from the other.72 however, when a husband and wife exchange 71. bunching can arise from the recognition in one year of appreciation in the value of the destroyed right that has taken place over many prior years. it can also arise from the receipt of a lump sum payment for a loss of income that would have been earned over several future years if the injury had not occurred. later in this part, the author questions whether damages for a physical injury truly are a substitute for lost monetary value. on the other hand, a proposal to tax such damages rests in part on the premise that the damages are a substitute. if so, that raises a bunching problem that needs to be addressed. 72. regs. § 1.61-2(d)(1). [vol. 2:6 compensatory and punitive damages their services by splitting household chores between them, neither recognizes income.73 similarly, if several persons living in manhattan, each of whom owns a small piece of land on long island on which vegetables are grown, agree to take turns travelling to long island and watering the gardens owned by all of them, they are exchanging services, but they should not be taxed on that exchange because it occurs outside the market. another example of activities within a noncommercial zone is a baby-sitting club in which parents sit for each other's children under a kind of barter arrangement. on the other hand, bartered exchanges can become so structured and substantial that they represent more than joint activities, in which case the parties have moved into the commercial sphere and their bartered exchange should be taxable. when a part of an individual's body is damaged or destroyed, what has been taken from the individual is predominantly of a noncommercial nature. since humans are engaged in commercial activities, their bodies and personal attributes are inexorably entwined with those activities. however, an individual's body and personal attributes are merely used in commercial activities; they are not detached and sold in the market place. it is a rare person who would contemplate the sale of body parts to be removed from him while still alive. if such a transaction were to take place, the individual would have committed the sale of that body part to a commercial venture; there is no reason for the tax law to exempt from taxation the gain from such a sale, and it does not do so. however, if a body part is destroyed or injured, the compensation that the victim receives is not the product of having voluntarily committed that part to a commercial sale. although the victim must actively seek reparations in order to be compensated, that is the consequence of the injury and is not a voluntary entrance into the commercial market. 2. vulturous behavior.--perhaps, the most important consideration that weighs against taxing such damages is the heartlessness of the government profiting from the tort law's attempt to soften the blow that a victim has suffered. monetary damages are not true truly substitutes for a victim's loss, but, at most, some mitigation of it. much of the loss is not monetary, but only monetary damages can be given because no substitute is available to replace what was lost. if the government were to tax damages for the loss of a body part (or for the death of a relative), it would seem to many to have engaged in a vulturous act-analogous to feeding off of the flesh of a dismembered arm or leg or off of the corpse of a recently departed. 73. no statute or regulation expressly exempts a spousal exchange of services from taxation. under § 1041, which was added in 1984. no gain or loss is recognized on an interspousal transfer of property, but the provision does not address the tax consequences of exchanging services. the service has never sought to tax interspousal exchanges of services. and the exclusion of such exchanges is part of the unwritten law of taxation. 19951 florida tax review the compassionate motivation for the exclusion has much greater force when the damages compensate for physical injury than when the injury is not physical. even physical injuries are not always severe, and a minor injury (such as a sprained ankle) does not create so much sympathy that it makes the taxation of damages received for the injury unpalatable. 74 however, there are several reasons why the existence of minor physical injuries detracts little from the validity of the theory that the repression of vulturous behavior is a major justification for the exclusion. while the author has no empirical data, his intuition is that most of the dollars obtained as damages and settlements for physical injuries involve serious harm. the costs of obtaining damages for minor injuries discourage victims from prosecuting their claims, and those who do pursue them obtain only small amounts. since damages for a minor injury are usually small, it is not worth the administrative hassle to establish and enforce criteria to distinguish between major and minor physical injuries. consequently, the sympathy aroused for major physical injuries spills over to provide relief for the less worthy sufferers of minor injuries. it is not uncommon that the compelling concerns that cause the adoption of a relief provision also benefit a limited number of persons who are fortunate enough to fall within the scope of the remedial provision, even though their plight is not the one that triggered its adoption. taxation is a practical enterprise, and it is not always practical to restrict a provision's application to those on whose behalf it was passed. the compassionate justification and the human capital justification apply more readily to damages for noneconomic injuries than to damages for lost income. the justification for excluding damages for lost income is discussed below in part ill.e. the compassionate justification rests (at least in part) on the notion that damages for noneconomic injuries are compensatory in nature. however, many commentators view the function of such damages quite differently, and some believe that damages for noneconomic losses, such as pain and suffering, mental anguish, and humiliation, should not be allowed in negligence cases.75 there are numerous theories as to why tort law typically allows noneconomic damages. one possibility is that, while the victim has suffered a real loss for which compensation should be provided, monetary damages are the only available means of compensation. if no damages were given for noneconomic injuries, the victim might feel that the loss is lightly regarded. 74. see j. martin burke & michael k. friel, tax treatment of employment-related personal injury awards: the need for limits, 50 mont. l. rev. 13, 43-44 (1989) (making that observation). 75. see, e.g., seffert v. los angeles transit lines, 364 p.2d 337, 344-47 (cal. 1961) (traynor, j., dissenting) and the articles cited therein. [vol. 2:6 compensatory and punitive damages the monetary compensation for such losses assures the victim's personal integrity and is testimony that society regards the violation of that integrity as a serious matter. monetary damages for noneconomic loss can be viewed as an effort to assuage the victim's anger at the injury and to reestablish the victim's self-confidence in his personal integrity. 76 if such damages serve only these symbolic purposes, taxation of the damages would not have a rapacious or vulturous appearance because the requirement that the tortfeasor pay is sufficient to secure those purposes. another view describes damages for noneconomic injuries as a punitive measure designed to deter negligent acts. the damages raise the price of negligence in order to make it economically prudent for businesses to expend the amounts needed to provide greater safety. if that view is correct, there is no justification for not taxing the damages. however, it is far from certain that either of the two views described immediately above is correct. the victim has suffered a genuine loss, and while monetary damages are not a substitute for what was lost, they can be seen as an attempt to compensate for that loss by the only means available. compensation is an effort to balance the scales so as to put the victim as near to the same condition that he had before the injury as is feasible. that it is not possible to substitute the same item that was lost, and that the personal loss from a serious injury to a body part cannot be measured in monetary terms, does not mean that the monetary damages given to the victim do not serve a compensatory purpose. each of the several theories as to why damages are provided for noneconomic losses is plausible. a dispositive case cannot be made that one of those explanations is better than another. congress apparently adopted the explanation that the damages for noneconomic losses are designed to mitigate the victim's loss. since that explanation is at least as good as any other, there is no basis to challenge the choice that congress made. in any event, whatever some commentators may believe, the commonly held view of such damages (including the view generally held by american courts) is that they are compensatory and are intended to provide relief for the victim's injury. even if that view does not withstand an economic analysis (and even if such an analysis is considered dispositive of the issue), the prevalence of that view would make the government appear rapacious if it were to tax noneconomic damages. our self-assessment system 76. see louis l. jaffe, damages for personal injury: the impact of insurance, 18 law & contemp. probs. 219 (1953). while recognizing the consolatory role of noneconomic damages, professor white has opined that american courts conceive of such recoveries "'as essentially compensatory rather than as consolatory," at least where the victim suffered physical injury. patricia d. white, pain and suffering and the law, 2 biolaw s:113, s:117 (1988). 19951 florida tax review of taxation relies on a willingness of the populace to report honestly to the government, and that willingness rests on a popular belief that the government's system of taxation is fair. the government should therefore take into account not only whether the taxation of such damages would be vulturous, but also whether it would appear to the general population to be so. while the appearance of fairness is not always a strong enough consideration to control the tax treatment of an item, it should be taken into account, especially in a case such as this where the view that such damages have a noncompensatory nature rests on an opinion that is not widely shared. 3. author's conclusions.-in the author's view, the noncommercial and nonmonetary nature of a destroyed or injured body part and the vulturous portrait that would be painted by the government's profiting from a personal tragedy explain why a suggestion that the damages for such an injury be taxed is typically met with a vigorous renunciation." a body part is not perceived to be a commercial item, the taxpayer never sought to commercialize its value by selling it, and the damages mitigate the loss of a personal attribute the value of which never would have been taxed if the injury had not occurred. the damages received for the loss of a body part are widely viewed as mitigation of the victim's loss. a diversion of a portion of those damages to the government would impair that mitigation. while a strict application of such tax concepts as basis and the measurement of gain lead to the taxation of such receipts, the countervailing considerations are very strong. as with many tax provisions, the appropriateness of retaining them depends upon value judgments. e. income-connected damages personal injury damages compensating for the loss of income (backpay and compensation for the loss of potential future income) are also excluded from income by section 104(a)(2). 78 for convenience, the damages compensating for income loss are sometimes referred to here as "incomeconnected damages." such damages might be viewed as a substitute for 77. the author has often raised this issue with students in his basic income tax course. many students find it difficult even to consider seriously a proposal to tax damages for physical injuries. some years ago, when the author was teaching as a visitor at stanford law school, a student expressed hostility to even examining this issue and made a thinly veiled suggestion that the author's raising the issue for discussion placed his sanity in question. 78. rev. rul. 85-97, 1985-2 c.b. 50. "backpay" has been described as "the differential between the appropriate pay and actual pay for services performed." horton v. commissioner, 100 t.c. 93, 96 n.6 (1993) (reviewed by the court), aff'd, 33 f.3d 625 (6th cir. 1994) (2-1 decision). [vol. 2:6 compensatory and pumitive damages income items that would have been taxable when received. why should damages obtained in lieu of taxable income escape taxation? 1. given in mitigation of personal loss rather than in substitution for lost income.-as previously noted, damages for physical injury do not substitute for the noneconomic aspects of that loss because there is no monetary substitute for such injuries as the loss of a limb or eyesight or of the use of a limb. damages for pain and suffering or for a reduction of the quality of the victim's life style, or amounts received as general damages, do not replace what the victim lost. the income lost because of an injury is more readily measurable than is this personal loss, but even that measurement involves considerable speculation, especially as to income that would have been earned in the future. the exemption of income-connected damages can be justified on the ground that such damages should not be separated from general damages because the total damages merely mitigate the victim's personal loss and do not fully compensate for it. the nature of the compensation package is not changed by the fact that the courts utilize an estimate of income lost as part of the effort to arrive at a just amount of compensation. when a victim suffers a physical injury, the loss cannot be measured in dollars, and the courts can do no more than resort to some conventional devices to arrive at a reasonable amount of mitigation. one of the devices utilized for that purpose is to estimate lost income. the measurement of lost income lends respectability to the enterprise by suggesting greater precision than actually exists. also, income loss is one of the few aspects of the victim's loss (medical expenses being another) that relate to money. since money is all that can be granted to the victim, it is understandable that tort law seizes on a money loss as a measure of part of what must be paid to the victim. but, that should not obscure what damage awards are all about. 2. administrative convenience.-another (and perhaps the principal) reason for not taxing income-related damages is administrative convenience. in weighing this consideration, assume (contrary to the discussion above) that income-connected damages are a substitute for lost income. in fact, they are generally so regarded. frequently, personal injury damages, whether received pursuant to a settlement or to a jury's award, consist of a single undifferentiated amount that is not subdivided among the victim's several losses. whether payment is received in a lump sum or as periodic payments, the portions compensating for lost income (both past and future) typically are not identified. if the income-connected amount of compensatory damages were to be treated differently for tax purposes than the portions attributable to other losses (e.g., pain and suffering), it would be necessary to separate an award 19951 florida tax review or settlement between its income-connected and nonincome-connected portions, and the taxpayer would likely have the burden of proof on that issue. the result would be a significant administrative burden on taxpayers and the service.79 while the burden would not be insurmountable, it would be substantial in most cases. in a typical case, it might not be especially difficult to ascertain the portion of undifferentiated damages attributable to back wages or other predictable income that would have been earned by the victim if the injury had not occurred. however, compensation for the victim's diminished future earning capacity is highly speculative and virtually impossible to determine with any confidence. moreover, the lost income for which damages are obtained would typically have been earned over a period of many years. if income-connected damages were taxed and if the damages were received during a single taxable year, income for many years would be bunched into one taxable year, often causing the tax rate to be much higher than would have been the case if the income had been earned over many years. 80 some form of tax relief would be necessary to prevent over-taxation of the damages. an income-averaging device could provide adequate relief for the bunching of past income," but 79. in roemer v. commissioner, 716 f.2d 693, 696 (9th cir. 1983), the court stated: an individual who wins a personal injury suit [is] usually given a lumpsum award that includes an amount for items that ordinarily would be taxable, such as lost income.... [t]he commissioner has long excluded from income the entire monetary judgment .... the rationale behind the exclusion of the entire award is apparently a feeling that the injured party, who has suffered enough, should not be further burdened with the practical difficulty of sorting out the taxable and nontaxable components of a lumpsum award. 80. the bunching problem is mentioned above in part iii.a in the discussion of whether the congressional purpose for adopting § 104(a)(2) was to constrain the size of tort damages for personal injuries. the author concluded that congress had no such purpose and that an exclusionary provision cannot affect the size of tort damages unless state laws are modified as a consequence thereof, and the states generally have not done so. the bunching problem discussed here is a different issue-whether bunching would be a hardship for the victim and, if so, whether an income-averaging device could adequately mitigate that hardship. 81. income-averaging can be accomplished by treating the income-connected damages as if they were earned ratably over a period of years and by treating the marginal income tax rates applicable to the income in each such year as being the same as would be imposed on the portion of the income that is deemed to be earned in the current year. assume individual t receives $100,000 in year 1 as income-connected damages, and such damages have been made taxable by congress, subject to an income-averaging device that treats income-connected damages as having been earned ratably over a ten-year period beginning with the year of receipt. the tax on t would be determined by (1) adding one tenth of the $100,000 ($10,000) to t's other income for year 1, (2) determining the tax on the resulting amount, (3) computing the tax on 7's taxable income exclusive of the damage income, and (4) [vol 2:6 compenswaory and punitive damages that device probably would not deal adequately with damages for the loss of the capacity to earn income in the future. the estimate of a victim's lost future income could encompass a large number of years, and incomeaveraging over a fixed number of years would be insufficient if the fixed number were less than the number of years for which damages were received. if income-averaging were to be based on the actual number of years for which income-connected damages were obtained, that would require a determination of the number of such years, and the difficulty in making that determination would exacerbate the administrative difficulties of determining the amount of income-connected damages. it is therefore likely that administrative feasibility plays a significant (and perhaps exclusive) role in the decision not to tax income-connected damages. arguably, the judgment that administrative feasibility is important enough to justify the exclusion of such damages from income gives too much weight to that consideration and perhaps overestimates the degree of inconvenience that would result from taxing income-connected damages. but, it is not unreasonable to adjust the tax laws to accommodate administrative difficulties, and many tax provisions owe their existence to that purpose. the exclusion of income-connected damages is buttressed by the suggestion made earlier that these damages are not substitutes for lost income, but rather are part of an imprecise measurement of the amount of mitigation that is fair. since the goal of administrative feasibility is a rational basis for excluding income-connected damages from taxation, there is no inconsistency between that exclusion and the rationale for excluding compensatory damages in general. rather, the exclusion of income-connected damages rests on a separate, independent base, which must be judged on its own merits. in some cases, the damages for lost income are identified. when identified, should they be taxed? there is no administrative burden in such cases, but if those amounts were taxed when identified but not taxed when part of an undifferentiated sum, recipients of personal injury awards would be taxed differently depending upon the happenstance of whether the lost income item is identified. especially in settlements, the tax on separately identified amounts could easily be avoided and would operate principally as a trap for the unwary. the extension of the exclusion to such cases likely stems from an unwillingness to tax differently two sets of victims who received identical damages but with different labels. perhaps, another reason subtracting the latter amount from the tax computed in (2). amount (4) is the tax on one tenth of the income-connected damages at t's marginal tax bracket. the tax on the s100,000 of income-connected damages is therefore 10 times amount (4). see irc § 402(d) (allowing such an averaging device to be used for lump sum distributions from qualified pension and profit sharing plans). 19951 florida tax review not to tax those amounts is the suggestion made above that income-connected damages are not actually substitutes for lost income. f. injuries to nonphysical personal rights it has been established for at least 22 years that section 104(a)(2) also applies to damages for injury to nonphysical personal fights (sometimes referred to as "dignitary" torts).82 nevertheless, the recent expansion of the reach of that exclusionary measure to damages for injuries to rights that, at best, are only marginally personal makes it appropriate to ask whether the policy considerations supporting the exclusion of damages for physical injury apply as well when the injury is exclusively nonphysical. as previously discussed, the policy underpinning of section 104(a)(2) apparently consists of a combination of several factors: (1) the victim's damaged or destroyed human capital is a noncommercial item that the victim never intended to market; (2) the victim was forced into a commercial transaction because money is the only available recompense; (3) the personal nature of the damaged item makes it impossible for the victim to invest the damages in similar property in order to qualify for a rollover of the gain; and (4) the plight of a victim who suffers the loss of a body part through another's tortious act elicits sympathy that makes it repugnant to tax the victim because there would be something vulturous in having the government require the victim to share with it a portion of the recompense received for the loss of part of the victim's person. the exclusion has been extended to damages for loss of reputation, emotional and mental harm, humiliation, and other injuries. examples of actions that cause those nonphysical injuries are defamatory statements, discriminatory treatment, harassment, invasion of privacy, wrongful discharge from employment, malicious prosecution, misrepresentation in a commercial venture, and possibly even failure by an airline to honor a reservation.83 to what extent do the policy considerations listed above support tax-exemption for damages for injury exclusively to a nonphysical personal right? 1. the nonphysical attributes listed above are noncommercial in the sense that while they may be utilized in commercial activities, individuals do not voluntarily separate them from 82. see seay v. commissioner, 58 t.c. 32 (1972), acq., 1972-2 c.b. 3. 83. in hill v. united states, 733 f. supp. 88 (d. kan. 1990), the court held that a settlement of a misrepresentation claim against united airlines was excluded from income by § 104(a)(2). while the court's opinion does not explain the nature of the misrepresentation, the author was informed by an attorney at the department of justice that the taxpayer's claim arose from being bumped from a flight. [vol. 2:6 compensatory and punitive damages their personae and sell them on the market. for example, an individual can exploit his reputation, but he cannot detach it from himself and dispose of it. however, claims arising exclusively from nonphysical injuries (e.g., actions for wrongful discharge or for discrimination in employment) often relate to improper interference with commercial activities. many claims for nonphysical injuries are more closely identified with commercial ventures than is the case for torts involving physical injury. there is thus less justification to treat damages for nonphysical injuries as lying beyond the commercial sphere of the income tax system. 2. the involuntariness of the conversion of portions of the victim's persona into money damages is equally present whether the injury is physical or nonphysical. 3. as with physical injuries, the victim of a nonphysical injury cannot invest the damages in property that is similar or related in service or use. 4. in general, the plight of a victim who has suffered only nonphysical injuries does not arouse anything like the sympathy that is engendered by a physical injury.' an extreme case in which the victim suffered great mental and emotional harm can arouse substantial sympathy. but, even such a case does not attract the degree of compassion that is felt for a victim of serious physical injury such as the loss of a limb or a facial disfigurement. moreover, unlike the case of physical injuries, losses associated with nonphysical injuries are principally pecuniary, although, concededly, the allocation of damages awarded in such cases does not always reflect that dominance. the policy justification for excluding damages is thus weaker when the injury is exclusively nonphysical than when physical injury is involved. a division along a physical-nonphysical boundary is not a perfect basis for delimiting the exclusion. ideally, damages for some types of physical injuries should be taxed, and damages for some types of nonphysical injuries should be excluded from income. in a fantastic world in which there are no transactional costs, a more valid boundary might be one that divided injuries associated primarily with commercial activities from those that have their primary association with noncommercial activities. however, the administra84. see burke & friel, supra note 74. at 43-44. the authors suggest. however, that the victims of discrimination might be worthy subjects of humanitarian tax relief. 19951 florida tax review tive difficulties of applying that standard are daunting. while a distinction along physical-nonphysical lines would not be perfect, it would be easy to administer and would generally be valid. a physical-nonphysical division would be a surrogate for a commercial-noncommercial distinction, and any imprecision in the reach of the exclusion would be relatively minor and justified by the administrative convenience of having a bright-line standard. even if congress were to limit the statutory exclusion to cases involving physical injury, the exclusion should continue to cover damages for nonphysical losses that are byproducts of a physical injury. for example, damages for the emotional harm suffered because of the loss of a limb should be excluded. where the victim of a physical injury also incurs nonphysical injuries from the same wrongful act, there are good reasons not to segregate the damages for nonphysical injuries and tax them. the reasons given in part iii.e for not segregating income-connected damages from damages for noneconomic injuries apply equally when damages cover both nonphysical and physical injuries. also, a nonphysical injury that arises as a byproduct of a physical injury is likely to have a noncommercial nature, making the recovery of human capital theory applicable in those cases. g. punitive damages punitive damages are awarded primarily to punish the tortfeasor and thereby deter willfully or wantonly wrongful behavior.8 ' the existence and size of punitive awards depends upon the degree of the wrongdoer's culpability. while the extent of the injury is taken into account, it is used only as one means of measuring the degree of wrongdoer's culpability. even the severity of criminal sanctions, which are clearly punitive measures, is influenced by the extent of the harm done. for example, the punishment for a drunken 85. restatement (second) of torts § 908 (1977) reads as follows: (1) punitive damages are damages, other than compensatory or nominal damages, awarded against a person to punish him for his outrageous conduct and to deter him and others like him from similar conduct in the future. (2) punitive damages may be awarded for conduct that is outrageous, because of the defendant's evil motive or his reckless indifference to the rights of others. in assessing punitive damages, the trier of fact can properly consider the character of the defendant's act, the nature and extent of the harm to the plaintiff that the defendant caused or intended to cause and the wealth of the defendant. see also cal. civ. code § 3294 (west supp. 1995); pacific mutual life ins. co. v. haslip, 499 u.s. 1 (1991); marc a. franklin & robert l. rabin, cases and materials on tort law and alternatives 622 (4th ed. 1987). [vol 2:6 compensatory and punitive damages driver who injures a pedestrian is usually more severe if the victim dies than if he lives. the resort to the harm done by the wrongdoer as one of the factors for measuring the amount of punitive damages therefore does not detract from the punitive nature of such damages.8 punitive damages are paid to the injured party, rather than to the state, to encourage the victim to act as a kind of private attorney general in enforcing policies of the state,s' and, it has been suggested, because punitive damages can have a compensatory element."s as discussed previously, compensatory damages can also serve a punitive purpose (at least as to damages for noneconomic injuries), but the dominant purpose for compensatory damages is to mitigate the harm that the victim incurred. conversely, while the dominant purpose of punitive damages is to punish the wrongdoer, the suggestion has been made that the manner in which the victim was injured can cause additional harm that may be difficult or even impossible to identify.89 on that theory, one of the roles of punitive damages is to compensate the victim for harm whose existence the victim is unable to demonstrate. however, even if punitive damages do play such a compensatory role, it is a minor feature that pales to insignificance when compared to their principal role-to punish.90 given the predominantly punitive nature of punitive damages, there is no policy justification for excluding them from income. they do not qualify for the return-of-human-capital justification since they are given to punish and deter, not to mitigate a loss of human capital. they do not represent a conversion of a noncommercial item into cash. because they do not replace anything, the unavailability of a suitable substitute for reinvestment is not a factor. finally, since the award is made to the victim (rather than to a government) in order to provide an incentive to bring the suit, the taxation of that award is not rapacious and does not put the government in 86. restatement (second) of torts § 908 cmt. e (1977) states in part: in determining the amount of punitive damages, as well as in deciding whether they should be given at all, the trier of fact can properly consider not merely the act itself but all the circumstances .... in addition, the extent of harm to the injured person can be considered by analogy to the doctrine of the criminal law by which the seriousness of a crime may depend upon the harm done .... 87. see jane mallor & barry roberts, punitive damages: toward a principled approach, 31 hastings lj. 639, 649-50 (1980). 88. e.g., horton v. commissioner, 33 f.3d 625, 631 (6th cir. 1994) (2-1 decision) (quoting with approval from a kentucky supreme court decision). 89. id. at 632. the likelihood that punitive damages serve such a compensatory purpose was greatly reduced, and possibly eliminated, long ago when the law began to allow damage awards for noneconomic injuries. 90. see restatement (second) of torts § 908 (1977), quoted above in note 85. 19951 florida tax review an unflattering light. punitive damages are a windfall that increases the recipient's wealth.91 all accretions to wealth should be taxed unless there is a compelling policy reason not to do so, and no such reason exists as to punitive damages. iv. burke decision and subsequent cases immediately before the supreme court's 1992 decision in united states v. burke,92 the status of the decisional law under section 104(a)(2) was as follows: 1. the exclusion applied to damages for nonphysical personal injuries as well as to those for physical injuries.93 2. the exclusion applied to damages for defamation of an individual whether the defamed reputation was professional or personal.94 3. there was a division of authority as to whether damages received by victims of employment discrimination were excludable.95 4. the prevailing view was that the focus of the inquiry in a section 104(a)(2) case should be on the nature of the taxpayer's claim, rather than on the character of the damages.96 5. to qualify for the exclusion, the taxpayer's claim had to be in tort or be tort-type.97 91. see commissioner v. glenshaw glass co., 348 u.s. 426 (1955). 92. 112 s. ct. 1867 (1992). 93. bent v. commissioner, 835 f.2d 67 (3d cir. 1987); seay v. commissioner, 58 t.c. 32 (1972), acq., 1972-2 c.b. 3. 94. roemer v. commissioner, 716 f.2d 693 (9th cir. 1983); threlkeld v. commissioner, 87 t.c. 1294 (1986) (reviewed by the court), aff'd, 848 f.2d 81 (6th cir. 1988). 95. compare redfield v. insurance co. of north america, 940 f.2d 542 (9th cir. 1991) (excluding such damages), pistillo v. commissioner, 912 f.2d 145 (6th cir. 1990) (same) and byrne v. commissioner, 883 f.2d 211 (3d cir. 1989) (same) with sparrow v. commissioner, 949 f.2d 434 (d.c. cir. 1991), cert. denied, 112 s. ct. 3009 (1992) (taxing such damages) and thompson v. commissioner, 866 f.2d 709 (4th cir. 1989) (taxing damages received as backpay under the equal pay act because they were not given for a tort-type right, but excluding liquidated damages because they were given for a tort-type right). 96. e.g., roemer v. commissioner, 716 f.2d 693 (9th cir. 1983); threlkeld v. commissioner, 87 t.c. 1294 (1986) (reviewed by the court), aff'd, 848 f.2d 81 (6th cir. 1988). 97. regs. § 1.104-1(c); redfield v. insurance co. of north america, 940 f.2d 542 (9th cir. 1991); thompson v. commissioner, 866 f.2d 709 (4th cir. 1989). [vol 2:6 compensatory and punitive damages 6. the tax court had applied the exclusion to punitive damages, but the fourth circuit had reversed, including punitive damages in income."8 the taxpayers in burke had obtained a settlement on their damage claim for sex discrimination under title vii of the civil rights act of 1964. at the time of the settlement, the only remedies provided by title vii were backpay and equitable relief (e.g., reinstatement). 99 the taxpayers paid a federal income tax on their settlement but sought a refund on the ground that the amounts received were excluded from income by section 104(a)(2). after losing in the district court, they prevailed on appeal to the sixth circuit, which decided the case by a divided vote. the supreme court reversed the sixth circuit's decision, holding that the settlement amounts were taxable. the court adopted the regulations' definition of the term "damages received" in section 104(a)(2): an "amount received... through prosecution of a legal suit or action based upon tort or tort-type rights or through a settlement agreement entered into in lieu of such prosecution."'" accordingly, the court concluded that, to qualify for the statutory exclusion, damages must be based on a tort or tort-type claim. the court looked to common law tort concepts in defining the words "tort or tort-type rights." it noted that damages are an "essential characteristic of every true tort" and held that the availability of damages was a sine qua non of a claim's qualifying as a tort. however, not just any old damage award would do. the court said that the "hallmarks of traditional tort liability is the availability of a broad range of damages to compensate the plaintiff 'fairly for injuries caused by the violation of his legal rights."''" the range of damages that may be awarded to a tort victim includes more than an allowance for the victim's pecuniary losses (e.g., for lost wages, medical expenses, and diminished future earning capacity). damages also are permitted for noneconomic losses such as emotional stress and pain and suffering. the victim of a dignitary or nonphysical tort can receive (in addition to reimbursement for pecuniary losses) damages for impairment of reputation and standing in the community, humiliation, and mental anguish and suffering. moreover, the court said, 98. miller v. commissioner, 93 t.c. 330 (1989) (reviewed by the court), rev'd sub nom. commissioner v. miller, 914 f.2d 586 (4th cir. 1990). 99. in footnote 9 of the burke opinion, the supreme court noted that some courts had allowed title vii plaintiffs who were wrongfully discharged to recover damages for -front pay" (projected lost future earnings) when reinstatement was not feasible. 112 s. ct. at 1873. 100. regs. § 1.104-1(c). 101. burke, 112 s. c. at 1871 (quoting from carey v. piphus, 435 u.s. 247. 257 (1978)). 1995] florida tax review "punitive or exemplary damages are generally available in those instances where the defendant's misconduct was intentional or reckless."'' 2 the court did not identify particular types of damages that must be available to qualify a claim as tort-like. however, title vii, as it existed when the taxpayers in burke obtained their settlements, permitted only backpay damages. accordingly, the court concluded that the taxpayer's claims were not tort or tort-type claims, and their settlements were taxable. 3 the majority in burke decided that section 104(a)(2) is not limited to damages for physical injuries. in his concurring opinion, justice scalia contended that the exclusion should not apply if there is no physical injury, but the majority rejected this contention. the majority opinion's response to justice scalia includes a long footnote (footnote 6), one small part of which suggests that the view that section 104(a)(2) applies to nonphysical injuries is supported by a 1989 amendment stating that section 104(a)(2) "shall not apply to any punitive damages in connection with a case not involving physical injury or physical sickness." that part of the footnote has affected the view of some judges as to the excludability of punitive damages. the 1989 amendment and the supreme court's characterization of it is discussed in part v.a of this article. in part v.b, the author discusses the excludability of punitive damages. as could be anticipated, the decision in burke has had a profound effect on subsequent litigation. no more vivid example of that effect can be found than the two decisions of the federal district court of kansas in o'gilvie 1104 and o'gilvie 11105 in o'gilvie i, the court, granting the government's motion for summary judgment, held punitive damages in a wrongful death action to be taxable because they serve no compensatory purpose and therefore are not received "on account of personal injury," as required by section 104(a)(2). o'gilvie i was decided the same day that the supreme court promulgated its burke decision. o'gilvie moved for reconsideration in light of burke. in o'gilvie ii, the court granted the motion and changed its decision entirely. relying on its reading of burke, the court determined that it had erred in its prior ruling by focusing on the nature of the punitive damage award, rather than on the nature of the underlying claim. 102. id. at 1872. 103. as noted in part ii.e, title vii was amended in 1991 to provide a broad range of damages for disparate treatment type violations of that act (intentional discrimination). the amended version did not apply in burke because the facts of the case arose before the effective date of the amendment. 104. o'gilvie v. united states, 92-2 u.s. tax cas. (cch) 50,344, 70 a.f.t.r.2d (p-h) 92-5069 (d. kan. 1992). 105. o'gilvie v. united states, 92-2 u.s. tax cas. (cch) t 50,567, 71 a.f.t.r.2d (p-h) 93-547 (d. kan. 1992). [vol 2:6 compensatory and punitive damages since the underlying claim was tort-type, the court decided that "its previous order is contrary to burke and must be reversed."'6 summary judgment was granted for the taxpayer. at this writing, an appeal is pending in the tenth circuit. in horton v. commissioner,10 7 the tax court, with only three judges dissenting, held that punitive damages in connection with a personal injury claim in tort are excluded from income by section 104(a)(2). the court adhered to its pre-burke decision to that effect in miller, even though miller was reversed by the fourth circuit.'0 8 in horton, the court placed great reliance on the supreme court's opinion in burke, construing burke to hold that once it is determined that the taxpayer's claim was based on tort or torttype rights, any damages obtained pursuant to the claim (including punitive damages) are excluded from income. the court buttressed its reading of burke by noting that the supreme court mentioned punitive damages as one of the remedies typically available for torts and that it was the unavailability of a range of damages that led the supreme court to determine that the damages at issue in burke were taxable. in affirming the tax court's decision in horton, the sixth circuit (in a divided decision) also gave weight to burke. as previously noted, three courts of appeals have recently held that punitive damages are taxable." 9 one of those cases, the ninth circuit's decision in hawkins v. united states, was a divided decision. in his dissent in that case, judge trott gave great weight to the burke decision. the courts are also divided on whether the section 104(a)(2) exclusion applies to damages obtained under the age discrimination in employment act of 1967 (adea)."0 the adea permits equitable relief and the award of only two types of damages: damages for pecuniary losses (backpay) and liquidated damages of an equal amount."' liquidated damages are only allowed for willful violations. before burke, the tax court (overruling several prior decisions of that court) held in downey i that both backpay and liquidated damages received on an adea claim are excluded from income by section 104(a)(2).' 2 the taxpayer in downey obtained a settlement on an adea 106. 92-2 u.s. tax cas. (cch) at 50,567, 71 a.f.t.r.2d (p-h) at 93-548. 107. 100 t.c. 93 (1993) (reviewed by the court), aff'd, 33 f.3d 625 (6th cir. 1994) (2-1 decision). 108. miller v. commissioner, 93 t.c. 330 (1989) (reviewed by the court), rev'd sub nora. commissioner v. miller, 914 f.2d 586 (4th cir. 1990). 109. hawkins v. united states, 30 f.3d 1077 (9th cir.) (2-1 decision), cert. denied, 115 s. ct. 648 (1994); reese v. commissioner, 24 f.3d 228 (fed cir. 1994); commissioner v. miller, 914 f.2d 586 (4th cir. 1990). 110. 29 u.s.c. §§ 621-634. ill. 29 u.s.c. §§ 626(b), 216(b). 112. downey v. commissioner, 97 t.c. 150 (1991) (reviewed by the court). 19951 florida tax review claim that allocated the settlement equally between backpay and liquidated damages. six judges in downey i dissented as to the exclusion of the backpay damages, but they agreed with the majority that the liquidated damages should be excluded. after burke was decided, the service asked the tax court to reconsider downey i in light of burke. after reconsideration, the tax court promulgated a supplemental opinion (downey ii) in which it adhered to its first decision, holding that burke did not alter the majority's view."1 3 the court found that liquidated damages under adea compensate the victim for nonpecuniary losses as well as serving a punitive purpose and that the range of damages available under adea is thus sufficient to qualify a claim thereunder as one for tort-type rights. in downey 111,114 the seventh circuit reversed the tax court, finding that pre-burke appellate decisions on the excludability of adea damages rested on an analytical framework that is inconsistent with burke. the court therefore discarded those cases and focused on the supreme court's treatment of the excludability issue. the seventh circuit concluded that a claim is tort-type only if the available relief includes damages for nonpecuniary losses, such as pain and suffering, emotional distress, and personal humiliation. the adea only provides for pecuniary damages and, in the case of a willful act, liquidated damages of an equal amount. the court noted that there is a dispute as to whether liquidated damages under the adea are punitive or compensatory. however, it concluded that even if compensatory, the liquidated damages are designed to recompense the victim, not for nonpecuniary injuries, but instead for the income loss resulting from the unavailability of the pecuniary amounts until judgment or settlement of the claim for damages. in other words, the liquidated damages are either punitive or a substitute for prejudgment interest. in either event, in the court's opinion, the range of damages under the adea is not sufficient to satisfy the standard set by burke, and all of the taxpayer's damages in downey were taxable. the ninth circuit reached quite different conclusions in schmitz v. commissioner."5 it found that the provision for liquidated damages in adea cases has both compensatory and punitive purposes. the compensatory purpose is to provide relief for damages that are too obscure and difficult to prove. the court held that the restriction of liquidated damages to cases where the employer acted willfully does not make those damages primarily punitive in nature. it concluded that the range of remedies provided by the 113. downey v. commissioner, 100 t.c. 634 (1993) (reviewed by the court). 114. downey v. commissioner, 33 f.3d 836 (7th cir. 1994), petition for cert. filed, 63 u.s.l.w. 3476 (u.s. dec. 5, 1994) (no. 94-999). 115. 34 f.3d 790 (9th cir. 1994), petition for cert. filed, 63 u.s.l.w. 3462 (u.s. nov. 23, 1994) (no. 94-944). [vol 2:6 compensatory and punitive damages adea satisfies the requirement established in burke, and it held that the damages received by schmitz in settlement of his claim were excluded from income." 6 in schleier v. comnnzissioner,17 the fifth circuit affirmed, without written opinion, a tax court decision that adea damages are excluded from income by section 104(a)(2). the supreme court has agreed to review that decision. even when the violation is willful, liquidated damages may not be granted in an adea case if the defendant is the federal government."' since federal employees can receive only backpay, the range of damages available in their adea suits is too narrow for their claims to be tort-type, and their damages are taxable. if the controversy concerning adea for nonfederal employees is resolved by excluding their damages from income, there will be the anomalous result that the adea damages for federal employees will be taxable while all other plaintiffs' adea damages will be excluded. as a consequence of burke, the service now agrees that damages for race-based discrimination under 42 u.s.c. section 1981, for disparate treatment discrimination under title vii, and for violations of the americans with disabilities act are excluded from income, but it continues to tax damages for a disparate impact type violation of title vii." 9 in mckay v. conunissioner,12 the taxpayer, a former corporate officer whose employment was terminated, sued the employer for wrongful discharge, breach of employment contract, rico violations, and punitive damages. a jury awarded damages for lost compensation (both past and future) and, because of the rico violation, trebled the damages to more than $43 million. the jury also awarded punitive damages. to avoid an appeal, taxpayer settled with the employer for $16,744,300. in a settlement agreement negotiated at arms' length, the parties agreed that more than $12 million of the settlement was for the wrongful discharge claim, more than $2 million 116. the ninth circuit noted that several post-burke decisions have held that burke did not change the prevailing pre-burke conclusion that adea damages are excludable. the one court of appeals case that the court cited is purcell v. sequin state bank & trust co., 999 f.2d 950, 960-61 (5th cir. 1993), which addressed the excludability issue in deciding whether adea damages for backpay should be reduced to reflect an exemption from income taxes that the victim would otherwise have incurred. seemingly, the fifth circuit merely accepted without independent examination the tax court's determination in downey 1 that even after burke, such damages are excluded from income. however, in a subsequent case, the fifth circuit affirmed a tax court decision holding that adea damages are excluded from income. schleier v. commissioner, 26 f.3d 1119 (5th cir.), cert. granted, 115 s. ct. 507 (1994). 117. 26 f.3d 1119 (5th cir.), cert. granted, 115 s. ct. 507 (1994). 118. smith v. office of personnel management. 778 f.2d 258 (5th cir. 1985). 119. rev. rul. 93-88, 1993-2 c.b. 61. 120. 102 t.c. 465 (1994). 19951 florida tax review was for the breach of contract claim, and the balance was partial reimbursement of various legal and litigation costs incurred in prosecuting the claims. the agreement stated that no payment was made for punitive damages or for rico violations. the tax court accepted the settlement agreement's allocation. relying on burke, the court held that the more than $12 million for the wrongful discharge claim was excluded from income because wrongful discharge is a tort claim.'2 ' an interesting and unresolved question is whether the injury resulting from wrongful discharge can properly be classified as a "personal injury or sickness" to which section 104(a)(2) can apply. v. punitive damages a. 1989 statutory amendment in 1989, congress amended section 104(a) by adding at the end an additional sentence stating that section 104(a)(2) "shall not apply to any punitive damages in connection with a case not involving physical injury or physical sickness."'22 subject to transition rules, the added sentence applies to amounts received after july 10, 1989. thus, punitive damages received after that effective date in cases involving discriminatory practices, defamation, or other dignitary torts are taxable. the amendment will eliminate much of the controversy concerning punitive damages, but several important issues remain. first, what is the tax treatment of punitive damages in a case in which there has been a physical injury? in precluding the exclusion of punitive damages when there is no physical injury, the language added in 1989 implies that punitive damages are excluded when there is a physical injury. however, care should always be taken in making negative inferences. as is shown below, an examination of the legislative history of the 1989 amendment establishes that congress had no intention of passing on the proper treatment of punitive damages in any circumstance other than where there was no physical injury. second, does the adoption of the 1989 amendment demonstrate that congress believed that pre-1989 law excluded punitive damages from income when received pursuant to a claim for a personal injury? even if the amendment does indicate that congress held that belief, what weight should the courts accord to it? 121. the taxpayer agreed that the balance of the settlement amount was taxable, but contended that some of the litigation and legal expenses were deductible. 122. omnibus budget reconciliation act of 1989, pub. l. no. 101-239, § 7641, 103 stat. 2379. [vol. 2:6 compensatory and punitive damages 1. post-1989 punitive damages in cases involving phkysical injury.-while no case has yet arisen in which punitive damages for a physical injury were received after july 10, 1989, several courts, including the supreme court, have assumed that such damages are excluded by negative inference from the 1989 amendment. for example, in footnote 6 of the opinion in united states v. burke, the court stated: congress' 1989 amendment to section 104(a)(2) provides further support for the notion that "personal injuries" includes physical as well as nonphysical injuries. congress rejected a bill that would have limited the section 104(a)(2) exclusion to cases involving "physical injury or physical sickness." see h.r. rep. no. 101-247, pp. 1354-1355 (describing proposed section 11641 of h.r. 3299, 101st cong. 1st sess. (1989)... ). at the same time, congress amended section 104(a) to allow the exclusion of punitive damages only in cases involving "physical injuty or physical sickness."... the enactment of this limited amendment addressing only punitive damages shows that congress assumed that other damages (i.e., compensatory) would be excluded in cases of both physical and nonphysical injury.' in the italicized portion of the foregoing extract, the supreme court construed the amendment as having both an inclusionary and an exclusionary effect, allowing an exclusion for punitive damages in a case involving a physical injury as well as denying an exclusion where the injury is not physical. in fact, the amendment only addresses cases where there is no physical injury and makes no express statement about the treatment of damages when a physical injury is present. the court did not analyze the amendment; it simply assumed that the denial of an exclusion in nonphysical cases amounted to allowing one in physical cases. the italicized comment is in the middle of a lengthy footnote dealing with whether compensatory damages for nonphysical injuries are excluded by section 104(a)(2). it is dictum and does not appear to be the product of serious thought, much less a consideration of the legislative history. moreover, the comment is unnecessary to the court's point in the footnote-that by precluding an exclusion for punitive damages when the injury is nonphysical, congress implied that section 104(a)(2) applies to compensatory damages for nonphysical injuries. there was no reason for the court to focus on the applicability of the amendment to physical injury claims, and it does not appear to have done so. 123. 112 s. cl 1867, 1871 n.6 (1992) (emphasis added). 19951 florida tax review nevertheless, some judges have taken the supreme court's statement as support for the view that the 1989 amendment authorizes the exclusion of punitive damages in cases involving physical injuries. for example, the statement was cited with approval by the sixth circuit in its affirmance of the tax court's decision that punitive damages are excluded from income by section 104(a)(2).124 in addition, at least two commentators concluded that the amendment impliedly permits the exclusion of punitive damages received after 1989 in a case involving physical injuries.125 the legislative history of the 1989 amendment strongly suggests that this inference is in error. the house bill that ultimately became the omnibus budget reconciliation act of 1989 contained a provision that would have amended section 104(a)(2) to restrict the exclusion, for compensatory as well as punitive damages, to cases involving physical injury or physical sickness. 126 the bill, with that provision, was passed by the house on october 5, 1989. the committee report on the bill indicates that a principal purpose of the amendment was to deny the exclusion to damages in employment discrimination and defamation cases.'27 the senate was not willing to make taxable all damages obtained for nonphysical injuries and therefore refused to adopt the house's limitation. its bill made no mention of section 104 or of the treatment of damages. in a conference committee compromise, the senate agreed to bar the application of section 104(a)(2) to punitive damages in a case involving only nonphysical injuries. this limitation became law with the adoption of the conference bill. 128 the conference committee reported the bill on november 21, 1989."29 two months earlier, on september 13, 1989, the tax court 124. horton v. commissioner, 33 f.3d 625, 631 (6th cir. 1994) (2-1 decision). the supreme court's statement was also quoted by judge trott in his dissenting opinion in hawkins v. united states, 30 f.3d 1077, 1086 (9th cir.) (2-1 decision), cert. denied, 115 s. ct. 648 (1994). 125. arthur w. andrews, the taxation of title vii victims after the civil rights act of 1991, 46 tax law. 755, 766 (1993); david a. jaeger, taxation of punitive damage awards: the continuing controversy, 57 tax notes 109, 114 (oct. 5, 1992). 126. h.r. 3299, 101st cong., 1st sess. § 11641 (1989). 127. h.r. rep. no. 247, 101st cong., ist sess. 1354-55 (1989), reprinted in 1989 u.s.c.c.a.n. 2824-25. 128. omnibus reconciliation act of 1989, pub. l. no. 100-239, § 7641, 103 stat. 2379. 129. revenue provisions of conference agreement on h.r. 3299, omnibus budget reconciliation act of 1989, released by senate finance committee on november 21, 1989, 224 daily tax report, special supplement (nov. 22, 1989). [vol 2:6 compensatory and punitive damages promulgated its reviewed decision in miller v. commissioner,'30 in which a majority of the court held that punitive damages can be excluded under section 104(a)(2). the fourth circuit reversed the tax court's decision on september 21, 1990, ten months after the conference compromise was adopted by congress. consequently, when congress acted, the principal case on the excludability of punitive damages was a recent tax court decision, in which only two judges dissented, holding that they are excluded. the conference committee did not necessarily believe that punitive damages would be excluded in the absence of the amendment. they could well have intended no more than to assure that punitive damages will not be excluded when there was no physical injury, regardless of how the courts might otherwise resolve the question of the excludability of punitive damages. even if the conference committee believed that punitive damages would be excludable without the amendment, that belief probably derived from the very recent, reviewed tax court decision to that effect. the committee could not know that the decision would be reversed on appeal. there is no indication that the committee, or congress as a whole, desired that punitive damages be excluded in cases involving physical injury. to the contrary, the bill's history makes it abundantly clear that congress deliberately chose not to pass on that issue and instead chose to leave that question to be resolved by the courts. the conference bill, as reported on november 21, 1989, contains inked changes in the printed copy. four words were deleted in ink, and one word was added in ink.'31 the unaltered printed copy of the relevant provision is as follows: sec. 7641. limitation on section 104 exclusion. (a) general rule.-section 104(a) (relating to compensation for injuries or sickness) is amended by adding at the end thereof the following new sentence: "paragraph (2) shall not apply to any punitive damages unless such damages are in connection with a case involving physical injury or physical sickness." 130. 93 t.c. 330 (1989) (reviewed by the court), rev'd sub nom. commissioner v. miller, 914 f.2d 586 (4th cir. 1990). the taxpayer in miller had received both compensatory and punitive damages in the settlement of a defamation claim. 131. the conference committee's version of the amendment is set forth in 224 daily tax report, special supplement s-81 (november 22, 1989). the inked changes are marked on the bill as reproduced therein. the conference committee's bill, with those inked changes shown on the bill, also is reproduced in a bulletin of prentice hall that was published at that time; the bulletin is titled: revenue provisions of the omnibus budget reconciliation act of 1989 (title vii), and was published as bulletin 47 extra on november 28, 1989. 19951 florida tax review the printed copy was altered in ink by drawing a line with a deletion symbol through the words "unless such damages are" and by inserting in ink the word "not" between the words "case" and "involving." as reported by the committee, the amendment appeared as follows: 4 sec. 7641. limitation on section 104 exclusion. 5 (a) general rule.--sectlon 104(a) (relating to 6 compensation for injuries or sickness) is amended by adding 7 at the end thereof the following new sentence: "paragraph 8 (2) shall not apply to any punitive damages,y~~~esin connection with a case involving physical v. 7 10 injury or physical sickness." the original printed version of the amendment would have made both a positive and a negative statement, providing that punitive damages in connection with a physical injury are excluded from income and that punitive damages not connected with a physical injury are included in income. the handwritten alteration that was made on the printed text makes only a negative statement: that punitive damages not connected with a physical injury are not excluded from income by section 104. congress did not inadvertently omit to make an explicit statement that punitive damages connected with a physical injury are excluded. to the contrary, the draft containing that statement was altered to avoid taking a position on that issue. it is clear then that the 1989 amendment has no bearing on the excludability of punitive damages in cases involving physical injury. 2. excludability of punitive damages under pre-1989 law.-as the discussion above demonstrates, it is by no means clear that congress believed that section 104(a)(2) applies to punitive damages. congress may have merely wished to assure that the courts would not apply the exclusion when nonphysical injuries are involved. when congress acted, the tax court had recently decided in miller that punitive damages are excluded by section 104(a)(2). while the tax court's decision was later reversed, congress must at least have recognized a possibility of the courts following the tax court's lead. congress explicitly stated a position on the issue only for cases not involving physical injuries. it is highly unlikely that the conference committee deliberately struck from the bill any reference to punitive damages acquired in connection with a physical injury claim because it considered that issue settled and wished to avoid a redundancy. it is far more likely that congress chose to abstain from that issue and leave the matter for the courts to resolve. [vol 2:6 compensatory and punitive damages even if congress believed in 1989 that punitive damages are excluded by section 104(a)(2), that belief has little or no significance. in discussing this issue in hawkins, the ninth circuit quoted the supreme court's statement that "the views of a subsequent congress form a hazardous basis for inferring the intent of an earlier one."' 32 that is especially true here since there is every reason to doubt that congress held that opinion. 3. meaning of "physical."-the sentence added in 1989 refers to "physical injury or physical sickness." if the victim of a dignitary tort has a mental breakdown as a consequence of the humiliation suffered, could section 104(a)(2) apply to punitive damages for the tort because the victim incurred a "physical sickness"? in such a case, the injury inflicted by the wrongdoer is not physical, but one of the consequences of that injury is physical. given the legislative history of the 1989 amendment, it seems that congress intended to bar the exclusion of punitive damages when the tort itself was not a physical intrusion to the person of the victim. the principal purpose of the house bill was to bar the exclusion of damages in discrimination and defamation cases, and the bill as enacted was a compromise that limited that bar to punitive damages in such cases. the purpose of the amendment would be frustrated if the exclusion were held to cover punitive damages in discrimination and defamation cases when the victim became ill as a consequence of the wrongful act. regardless of the ultimate resolution of the issue of whether punitive damages in general are taxable, punitive damages obtained for a dignitary tort should be taxed. b. apart from 1989 amendment as discussed above, the 1989 amendment should be construed to mean only what it says-that the section 104(a)(2) exclusion does not apply to punitive damages received after july 10, 1989 in cases not involving physical injuries. the application of the exclusion to other punitive damages-punitive damages received before july 11, 1989 and punitive damages received on or after that date that are connected with a physical injuryshould be determined without regard to the amendment. section 104(a)(2) applies to "any damages" received "on account of personal injuries or sickness." under the plain meaning rule of statutory construction, the reference to "any damages" could be taken literally to apply 132. hawkins v. united states, 30 f.3d 1077 (9th cir.) (2-1 decision) (quoting from united states v. price, 361 u.s. 304, 313 (1961)), cert. denied. 115 s. ct. 648 (1994). 19951 florida tax review to any form of damages, whether or not compensatory.'33 however, within the four corners of the statute itself, there are signs that the reference to "any damages" is not as expansive as that term might otherwise suggest. the title to section 104 is "compensation for injuries or sickness."'134 section 104(a) contains five subparagraphs, each of which describes a type of receipt that is excluded from income. each of the four subparagraphs that surround section 104(a)(2) involved compensatory payments. subparagraph (a)(1) excludes amounts received under worker's compensation acts as "compensation" for personal injuries or sickness. subparagraph (a)(3) excludes certain amounts received through accident or health insurance for personal injuries or sickness. subparagraphs (a)(4) and (5) deal with pensions, annuities, and disability benefits paid to persons sustaining personal injuries or sickness while serving in the armed forces or in certain government positions. when the antecedent to section 104(a)(2) was adopted as part of the revenue act of 1918, the exclusion for personal injury damages was not contained in a separate subparagraph but was instead combined in a single paragraph with the exclusion for accident and health insurance receipts and the exclusion of compensatory payments received under workmen's compensation laws.135 it was later that these three exclusionary provisions were separated into three subparagraphs. the original inclusion of all three provisions in one paragraph strengthens the evidence that they have a common theme-to exclude certain compensatory payments from income. the supreme court's decision in united states v. burke 36 provides comfort to those seeking to bring punitive damages within the statutory exclusion. burke establishes that the test of excludability turns on the nature of the underlying claim (whether it is tort or tort-type), not the nature of the damages obtained. on the basis of burke, the tax court and the sixth circuit have concluded that since the nature of damages are not to be taken into account, all damages received under a tort or tort-type claim are excluded from income. 13 however, burke deals only with the question of what kinds of claims can qualify for section 104(a)(2) treatment. the court's acceptance of the tort or tort-type requirement was a recognition of the need to distinguish tort claims from contract claims. the major contribution of burke is to 133. this view has been adopted by the tax court and the sixth circuit. e.g., miller v. commissioner, 93 t.c. 330, 338 (1989), rev'd sub nom. commissioner v. miller, 914 f.2d 586 (4th cir. 1990); horton v. commissioner, 33 f.3d 625 (6th cir. 1994) (2-1 decision), aff'g 100 t.c. 93 (1993) (reviewed by the court). 134. emphasis added. a tax statute's title can influence its construction. see house v. commissioner, 453 f.2d 982 (5th cir. 1972). 135. the original 1918 provision is quoted above in the text accompanying note 9. 136. 112 s. ct. 1867 (1992). 137. e.g., horton, 33 f.3d at 625. [vol 2:6 compensatory and punitive damages establish the range of available damages as the standard for whether a claim is tort-like. burke does not require the exclusion of all damages in a tort case. for example, damages compensating for the destruction of property are not excluded by section 104(a)(2) because they are not received on account of a personal injury. courts favoring the exclusion of punitive damages have noted that in burke, the supreme court mentioned punitive damages as one of the types of damages typically provided for tort victims and that the availability of such damages is one of the factors to be taken into account in determining whether the range of available damages is sufficiently broad to characterize a claim as tort-like. but, as judge goodwin observed in writing for the majority in the ninth circuit's decision in hawkins, 3 1 the fact that punitive damages are an indicator that a claim lies in tort does not mean that a punitive damage award was obtained on account of a personal injury. the supreme court did not address that issue in burke. a crucial hurdle for advocates of the excludability of punitive damages is whether the damages are received "on account of personal injuries or sickness," as required by section 104(a)(2). while a personal injury may be a precondition of a punitive damage award, a victim must also show that there was egregious behavior on the part of the tortfeasor. the award is not given for the personal injury, which may only be very slight, but rather is given to punish and deter the wrongdoer. the requirement that the victim have incurred a personal injury, however slight, reflects a kind of noharm/no-foul sentiment. in reversing the tax court in miller, the fourth circuit stated that particular damages satisfy the "on account of' requirement only if the existence of a personal injury is sufficient to enable a court to award the damages. 139 it is not enough merely to be a necessary element. the court found the statutory language to be unclear on the issue, but was convinced by a consideration of the underlying purpose of section 104(a)(2) that more than a but-for causation is required. the court analogized to the induction of a baseball player into the hall of fame. he could not qualify if he were not a ballplayer, but he was not elected to the hall on account of being a ballplayer. in rejecting the fourth circuit's sufficiency test in horton, the sixth circuit noted that the existence of a personal injury is not a sufficient basis for recovery of compensatory damages because the plaintiff must also establish liability by showing negligence or some wrongful act. 40 however, 138. hawkins v. united states, 30 f.3d 1077 (9th cir.) (2-1 decision). ccrt. denied, 115 s. ct. 648 (1994). 139. commissioner v. miller, 914 f.2d 586 (4th cir. 1990). 140. horton, 33 f.3d at 625. 19951 florida tax review section 104(a)(2) presupposes that liability exists. the "on account of personal injury" language is a limitation on the types of damages obtained through litigation or settlement that are excludable, denying the exclusion to, for example, damages for injuries to property. it is reasonable to construe the "on account of' language as requiring more than a fragile nexus between the damage award and the personal injury. the language of the statute is not conclusive as to whether it applies to punitive damages. the language itself can support either proposition, although the author believes that a strong case can be made from the statutory language alone for excluding punitive damages from its protection. the determination of the scope of the statute, especially when the language alone does not conclusively resolve the question of its applicability, should rest on an examination of the policies that justify it. in part iii, the author examines the policies served by the statutory exclusion, concluding in part iii.g that none of those policies are served by excluding punitive damages from income. unless a valid justification for excluding such damages can be ascertained, there is no reason to strain to construe the statute to do so. in an effort to finesse the issue of whether any policy justification for the exclusion applies to punitive damages, some courts have asserted that punitive damages have a compensatory function. 4' the tax court stated in miller: punitive damages have served as a means of compensating plaintiffs for intangible harm and for costs and attorney's fees... . although they may serve these purposes to a lesser extent now than in the past, the fact that punitive damages may possess a compensatory aspect renders it reasonable to afford them the protection of section 104(a)(2).42 the court observes that punitive damages serve to compensate for intangible harm "to a lesser extent now than in the past" because modern tort law allows damages for many intangible harms (such as pain and suffering and emotional distress), leaving no need to provide punitive damages to compensate for such harms. this fact seriously undercuts the contention that a significant function of punitive damages is to compensate for intangible injuries. 141. id. 142. miller v. commissioner, 93 t.c. 330, 341 (1989) (reviewed by the court), rev'd sub nom. commissioner v. miller, 914 f.2d 586 (4th cir. 1990). the statement in the text was quoted with approval by the sixth circuit in horton, 33 f.3d at 629. [vol 2:6 compensatoty and punitive damages as noted in part lfi.g, the principal function of punitive damages is to punish a wrongdoer for outrageous conduct and to deter the wrongdoer and others from engaging in similar conduct in the future." 3 whatever minor compensatory aspect there is to punitive damages is insignificant when compared to their punitive function. the principal factor a trier of fact should consider in determining the amount of punitive damages is the degree of culpability of the wrongdoer. let the punishment fit the crime. the wrongdoer's motives also are taken into account. 44 in many jurisdictions, the wealth of the wrongdoer can be considered.'45 the contention that a victim suffers greater harm from the knowledge that the wrongdoer's actions are egregious was rejected by judge kennedy in her dissent in horton."4 the harm that a victim suffers proceeds from the injury sustained. the evil motivation of the wrongdoer does not aggravate the victim's injury, but it can affect the amount of anger or outrage that the victim feels. as noted in part i.d.2, an award to assuage the victim's anger or outrage is not truly compensatory. while the extent of the harm suffered by the victim may be taken into account in determining the amount of punitive damages, that is not for a compensatory purpose but rather serves as a means of measuring the culpability of the wrongdoer."4 7 even the criminal law looks to the extent of harm done in measuring the severity of the crime and the amount of punishment that is appropriate. whether damages should be characterized for tax purposes as punitive or compensatory should turn on the criteria utilized, under the law pursuant to which the damages are awarded, to determine whether to allow the damages and to set the amount thereof. nontax laws establish rights, powers, and interests, but the tax consequence of possessing those rights, powers, and interests is an issue of tax law. nontax law controls the nature of the items, but it cannot control their characterization for tax purposes. the label that nontax law attaches to a damage award is irrelevant to the tax consequences of receiving the award. the supreme court resolved any doubt concerning this issue some 54 years ago in morgan v. commissioner, where it said: 143. restatement (second) of torts § 908 (1977), quoted supra note 85. 144. restatement (second) of torts § 908, cmts. b and e (1977). 145. restatement (second) of torts § 908, cmt. e (1977) states: the wealth of the defendant is also relevant, since the purpose of exemplary damages are to punish for a past event and to prevent future offenses, and the degree of punishment or deterrence resulting from a judgment is to some extent in proportion to the means of the guilty person. 146. horton v. commissioner, 33 f.3d 625, 632-33 (6th cir. 1994). 147. restatement (second) of torts § 908, cmt. e (1977), quoted supra note 86. 19951 florida tax review state law creates legal interests and rights. the federal revenue acts designate what interests or rights, so created, shall be taxed. our duty is to ascertain the meaning of the words used to specify the thing taxed. if it is found in a given case that an interest or right created by local law was the object intended to be taxed, the federal law must prevail no matter what name is given to the interest or right by state law. 148 this approach has been followed by subsequent courts. for example, in a 1985 case involving whether a decedent (named richard h. black) had a joint tenancy interest in property for federal estate tax purposes, the ninth circuit said: when we interpret the tax code, our inquiry focuses on whether congress intended to impose a tax on a particular property right or interest.... state law-in this instance the law of arizona-defines the powers that the blacks could exercise over the trust property. arizona law, however, does not control our ultimate determination. if the statutory language expresses a congressional purpose to tax the decedent's interest, that interest is includable in the decedent's gross estate regardless of whether state law would label it a "joint tenancy" interest. 49 the label that state law attaches to a damage provision does not control its characterization for tax purposes, whether the label is given by statute or judicial decision. the function of a damage award should be determined by examining the criteria that are used in deciding whether to grant it and for measuring the amount to be awarded. in part fl.e, the author set forth his view that a primary reason for excluding income-connected damages is to finesse the administrative difficulty of segregating income-connected damages from other compensatory damages. does that same consideration apply to punitive damages? would the taxation of punitive damages cause a serious administrative burden? one response to these questions is that congress deliberately chose to exclude income-connected damages from income. there is no evidence that congress made that choice for punitive damages. 148. 309 u.s. 78, 80-81 (1940). 149. black v. commissioner, 765 f.2d 862, 864 (9th cir. 1985). [vol 2:6 compensatory and punitive danages moreover, the courts and the service have dealt for years with the need to segregate punitive and compensatory damages from each other, and the task of making that allocation has not been burdensome. courts typically earmark punitive damages clearly. settlement agreements often describe how the division between compensatory and punitive damages is to be made. in those situations when there has been a lump sum settlement for both punitive and compensatory damages, and in those cases where the parties' allocation has been set aside, 50 the courts and the service have not encountered significant difficulty in making reasonable allocations.' for example, in glenshaw glass, the landmark case that declared punitive damages to be taxable, the tax court 52 allocated a damage settlement between punitive and compensatory elements, and the supreme court approved that allocation.5 3 in coimnissioner v. miller,'5 where the fourth circuit remanded to the tax court for an allocation between punitive and compensatory damages, the fourth circuit listed several alternative means for the tax court to make that allocation. on remand, the tax court appeared to have little difficulty in making the allocation.' also, punitive damages can be awarded in nonpersonal injury cases (e.g., anti-trust cases and fraud cases with corporate plaintiffs), where no statutory or other exclusion applies. if the burden of distinguishing punitive from compensatory damages were severe, an exclusion of punitive damages in personal injury cases would not fully resolve the problem. it is true that in many nonpersonal injury cases, all damages, whether compensatory or punitive, are taxable. however, there are many such cases in which the distinction between punitive and compensatory damages must be made. compensatory damages may be taxable only to the extent the amount recovered exceeds the plaintiff's basis in its goodwill or other damaged property, a limitation inapplicable to punitive damages. in some cases, compensatory damages are not taxable, and, in some cases, the income from compensatory payments is capital gain, while punitive damages are ordinary income. if it were important to avoid the need to distinguish those two types of damages, one would expect a cure to be applied to nonpersonal claims. 150. see, e.g., robinson v. commissioner, 102 t.c. 116 (1994). 151. the manner in which courts have made an allocation between punitive and compensatory damages is discussed in douglas a. kahn, federal income tax § 2.1341, at 103-05 (3d ed. 1994). 152. glenshaw glass co. v. commissioner, 18 t.c. 860 (1952). 153. commissioner v. glenshaw glass, 348 u.s. 426, 428 (1955). 154. commissioner v. miller, 914 f.2d 586 (4th cir. 1990). 155. miller v. commissioner, 65 t.c. memo (cch) 1884, t.c. memo (p-h) 93,049 (1993). 19951 florida tax review a final point on this issue is that a statutory exclusion from income of an item that would otherwise be taxable is a departure from the basic tax scheme. such departures are not extraordinary in the code, but their scope should not be expanded by an especially liberal construction unless the text of the statute, or policy considerations, or the legislative history of the provision indicates that a broader reading is warranted. none of those considerations applies to section 104(a)(2). vi. age discrimination the age discrimination in employment act of 1967 (adea) 156 permits only two types of damages to be awarded for violations of that act. the victim can obtain backpay, and, if the employer's violation was willful, liquidated damages equal to the backpay are awarded. equitable relief can also be granted. apart from liquidated damages, the victim cannot recover damages for noneconomic harm such as emotional distress. 5 7 because of the change that the burke decision caused in the analytical framework employed under section 104(a)(2), pre-burke decisions on the excludability of age discrimination damages are not helpful to the current resolution of that issue and therefore are not discussed here. since burke was decided in 1992, the focus of the courts has been on whether the range of damages available for victims of age discrimination is sufficiently broad to make the victim's claim "tort-type." the courts are divided on this issue. the tax court and the ninth circuit have held that the range of available damages provided by adea is sufficiently broad to warrant exclusion of both backpay awards and liquidated damages under that act.' the seventh circuit has held that all adea damages are taxable. 5 9 without writing an opinion, the fifth circuit has affirmed a tax court decision holding that adea damages are excluded from income, and the supreme court has granted certiorari in that case.160 156. 29 u.s.c. §§ 621-634 (1994). 157. see, e.g., downey v. commissioner, 33 f.3d 836 (7th cir. 1994), petition for cert. filed, 63 u.s.l.w. 3476 (u.s. dec. 5, 1994) (no. 94-999). the damage provision of the adea is set forth in 29 u.s.c. § 626(b) (1994), which incorporates by reference the damage provisions of the fair labor standard act (29 u.s.c. § 216 (1994) [other than subsection (a) thereof]), except that "liquidated damages shall be payable only in cases of willful violations." 158. schmitz v. commissioner, 34 f.3d 790 (9th cir. 1994), petition for cert. filed, 63 u.s.l.w. 3462 (u.s. nov. 23, 1994) (no. 94-944); downey v. commissioner, 100 t.c. 634 (1993) (reviewed by the court), rev'd, 33 f.3d 836 (7th cir. 1994). 159. downey v. commissioner, 33 f.3d 836 (7th cir. 1994). 160. schleier v. commissioner, 26 f.3d 1119 (5th cir.), cert. granted, 115 s. ct. 507 (1994). [vol. 2:6 compensatory and pnfitive damages the question of whether the range of damages provided by adea is broad enough has centered on the characterization of the provision for liquidated damages. that liquidated damages are available only when the employer acted willfully indicates that the damages are designed to punish wrongful behavior and deter future violations. however, neither the tax court nor the two courts of appeals that have promulgated written opinions since burke have characterized the liquidated damage provision as exclusively punitive in nature. the seventh circuit said in downey iii: at the present time, there is a division in the courts of appeals over the character of the adea liquidated damages. some courts have stated that the character of liquidated damages is strictly punitive [citations to decisions of the second, ninth and eleventh circuits omitted], while others have stated that adea liquidated damages replace prejudgment interest [citations to the first, fourth, fifth, and sixth circuits omitted]. this court [in prior nontax decisions] adheres to the position that adea liquidated damages replace prejudgment interest.' 6' the seventh circuit held that a claim qualifies as tort or tort-type under burke only if nonpecuniary damages are permitted. having characterized the liquidated damage provision in adea as not being a substitute for nonpecuniary losses (it is either punitive or a substitute for prejudgment interest),'6" the court concluded that an adea claim is not a tort or tort-type claim and that all adea damages are taxable. while the tax court and the ninth circuit have acknowledged that adea liquidated damages serve a "deterrent or punitive purpose," they hold that the damages also serve a compensatory purpose-to compensate the victim for nonpecuniary losses that are too obscure and difficult to prove.' 63 the ninth circuit's majority opinion in schmitz explained away the requirement of willfulness as follows: in enacting adea, congress was likely attempting to balance the need to compensate victims and deter discrimination with the need to protect businesses from crushing liability. 161. downey v. commissioner, 33 f.3d 836. 839 (7th cir. 1994). petition for cert. filed, 63 u.s.l.w. 3476 (u.s. dec. 5. 1994) (no. 94-999). 162. for the taxability of prejudgment interest included in damage awards for personal injuries, see part h.c. 163. downey v. commissioner, 100 t.c. 634, 637 (1993) (reviewed by the court) (downey ii), rev'd, 33 f.3d 836 (7th cir. 1994); schmitz v. commissioner. 34 f.3d 790, 794 (9th cir. 1994), petition for cert. filed, 63 u.s.l.w. 3462 (u.s. nov. 23. 1994) (no. 94-944). 19951 florida tax review unlike the concurrence, we see nothing "peculiar" in congress's decision to resolve these competing interests by compensating victims of willful discrimination at a higher rate than victims of "nonwillful" discrimination: congress has simply decided as a public policy matter that only victims of willful discrimination should receive obscure and difficult to prove compensatory damages.' 6 judge trott, concurring with the result reached by the majority in schmitz, rejected the majority's view that adea liquidated damages serve a compensatory purpose. judge trott stated that the legislative history of the adea and the decisions of courts of appeals in nontax adea cases (including two decisions by the ninth circuit itself) establish that the adea liquidated damage provision is a punitive measure. judge trott quoted the supreme court's statement in trans world airlines, inc. v. thurston, that "[t]he legislative history of the adea indicates that congress intended for liquidated damages to be punitive in nature."' 65 despite his repudiation of the majority's characterization, judge trott concurred with the result because of his belief that section 104(a)(2) encompasses punitive damages. 66 the requirement that a claim be tort or tort-type has its roots in the regulations. 167 in burke, the supreme court merely accepted that regulatory condition. as previously noted, the apparent purpose of this requirement is to preclude the exclusion from applying to recoveries under claims grounded in contract, which are commercially oriented. unfortunately, the distinction between tort and contract claims is blurred, and the characterization of a claim as one or the other is often arbitrary. 168 in burke, the supreme court apparently adopted the range-of-available-damages test in order to provide a standard for determining excludability that separated personal, noncommercial injuries from commercial ones more effectively than does the tort/contract dichotomy. the court may also have believed that this test is easier to administer than one that requires an inquiry into the legislative purpose for granting a right to damages. when the supreme court established the range-of-available-damages test in burke, it is doubtful that the court anticipated that lower courts would 164. schmitz, 34 f.3d at 795. 165. 469 u.s. 111, 125 (1985). 166. schmitz, 34 f.3d at 796. judge trott had previously dissented in hawkins, the case in which the ninth circuit held that punitive damages are taxable. hawkins v. united states, 30 f.3d 1077, 1084 (9th cir. 1994). 167. regs. § 1.104-1(c). 168. for example, some breaches of contract have been deemed to be so reprehensible that they amount to a tort. see, e.g., e. allan farnsworth, contracts § 12.17 n.19 (2d ed. 1990) and cases cited therein. [vol 2:6 compensatory and punitive damages make the tax treatment of damages turn on speculation as to a legislature's underlying motive for adopting a provision under which damages were granted. the court likely assumed that it would only be necessary to determine what remedies are available for a type of claim. the problem with liquidated damage provisions is that they may serve several functions-some of them punitive and some compensatory. in the case of the adea liquidated damage provision, the prevailing nontax authorities (including decisions of the supreme court) seem to favor either a punitive characterization or one of prejudgment interest. in either case, it seems that the range of damages is not broad enough to satisfy burke. in view of the commercial nature of the injury (the claim arises from wrongful failure, because of the victim's age, to hire, promote, or retain the victim as an employee or a wrongful denial of some other employment benefit), the policy justifications for excluding personal injury damages are generally inapplicable to the adea. since the compensatory nature of adea liquidated damages is doubtful, and since the policy justification for excluding adea damages is weak, adea damages should be taxed. in any event, if the courts are required to speculate as to the motive for the adoption of statutory provisions for damage awards, the administrative feasibility that the range of available damages test likely was designed to provide is lost. it should not be necessary to obtain a psychological profile of the legislators who adopted a provision to determine its tax characterization. the difficulties encountered in determining whether adea damages are excludable are attributable to the inadequacy of the standards of tort-type claims and "range of available damages" that were adopted by the supreme court in burke. in part vii, the author discusses the difficulties caused by those standards and questions whether they lead to rational distinctions. for example, as previously noted, federal employees are barred from receiving liquidated damages under the adea,169 raising the possibility that the adea damages of all employees other than federal employees will be excluded from income-thereby doubly punishing the federal employee. vii. operation of burke standards the burke holdings-following the regulations in limiting the section 104(a)(2) exclusion to recoveries on tort or tort-type claims and defining "tort or tort-type" to require a range of available damages-have not eased the administration of the exclusion, have led to incongruous differences in tax 169. smith v. office of personnel management, 778 f.2d 258, 263 (5th cir. 1985), discussed supra text accompanying note 118. 19951 florida tax review consequences, and may induce persons injured in employment or other commercial disputes arising out of contract breach to forego settlements in order to bring tort actions that might yield tax-free recoveries. similarly, employees offered termination payments as an inducement to retire may negotiate with their employers to have the payments characterized as settlements for tortious injuries. the differentiation between the types of claims for which damages are excluded and those for which damages are taxable appears arbitrary. compensatory damages received for race-based discrimination under 42 u.s.c. section 1981 and for disparate treatment discrimination under title vii are excluded from income, as are compensatory damages under the americans with disabilities act.170 however, compensatory damages for disparate impact discrimination under title vii are taxable, and it is unsettled whether the damages received for adea claims by plaintiffs other than federal employees are excludable, although it is clear that the burke standards require the inclusion in income of adea damages obtained by a federal employee. even the possibility that all plaintiffs other than federal employees can exclude adea damages from income, but federal employees cannot, demonstrates that the burke standards are seriously flawed. damages for wrongful discharge (a truly commercial violation) can be excluded if the jurisdiction provides a tort action for the violation, but damages obtained on a contract theory because of a wrongful discharge are taxable.' 7 1 in mckay, 72 where the plaintiff brought suit for both wrongful discharge and breach of an employment contract, the tax court held that the damages obtained for the former were excluded from income, but the damages for breach of the contract were taxable. where a breach of contract is one that is likely to cause the plaintiff to incur serious emotional disturbance, courts have allowed recovery for pain and suffering.'73 in such cases, the range of damages available on the contract claim seem to be sufficient to characterize it as tort-type under burke. if so, under the approach that some courts (including the tax court) have taken, all damages for breach might be excluded from income. this possibility indicates just how unworkable the burke standards are. moreover, the attempt to find a standard that distinguishes tort claims from contract claims seems to have failed. 170. rev. rul. 93-88, 1993-2 c.b. 61. 171. see mckay v. commissioner, 102 t.c. 465 (1994). 172. id. for a discussion of mckay, see supra text accompanying notes 120-21. 173. see farnsworth, supra note 168, § 12.17. [vol 2:6 compensator , and punitive damages splits in authority have developed since burke on the application of the exclusion to two significant items-punitive damages and prejudgment interest included in personal injury awards.'74 another problem that may have arisen as a consequence of burke is that employment disputes that might have been settled may instead be channelled to the courts in the hope of having settlements characterized as excludable tort damages. the author has no empirical evidence that this has occurred,175 but accounts of such occurrences are circulating among some law firms. these accounts may not be accurate, but the availability of that course of action seems so tempting that it is reasonable to expect it to be pursued. employers often try to buy-out older employees by offering financial inducements for retirement. employers often require employees accepting such offers to sign releases for any claims that might exist against the employers for discriminatory treatment. the requirement of such a release may only be a cautionary measure, and it usually does not cause the transaction to be treated in whole or in part as a settlement of a tort claim.'76 however, it seems likely that knowledgeable attorneys will counsel their clients to lodge tort claims in such cases and negotiate with the employer to structure the settlement as a payment of tort damages rather than as a termination payment. a recent commentary on this topic essentially recommends that procedure.' most of the problems created by the burke standards could be resolved by limiting section 104(a)(2) to damages arising from claims based on physical injury. no standard will preclude difficult issues from arising, but the requirement of a physical injury would go far to minimize administrative difficulties and make a more rational division of damages between those that are taxable and those that are excluded. in burke, the supreme court rejected justice scalia's proposal to restrict section 104(a)(2) to cases involving physical injury, 178 but this issue will soon return to the court.' perhaps, 174. see parts 1i.b, ii.c. 175. however, the facts of the recent case of taggi v. united states, 35 f.3d 93 (2d cir. 1994), lend credibility to the suggestion that this is taking place. see also loren c. rosenzweig, careful planning may establish excludability of damages awarded for age discrimination, 81 j. tax'n 254 (1994) (suggesting that settlements for employment terminations should be structured to maximize the amount characterized as a settlement of tort claims). 176. see taggi, 35 f.3d at 93. 177. see rosenzweig, supra note 175, at 258. 178. in downey iii, judge flaum expressed his admiration for justice scalia's cogent argument for his proposal. downey v. commissioner, 33 f.3d 836, 838 (7th cir. 1994), petition for cert. filed, 63 u.s.l.w. 3476 (u.s. dec. 5, 1994) (no. 94-999). 1995] florida tax review in light of what has transpired in the wake of burke, the court will reconsider the position it took in that case and either construe section 104(a)(2) as limited to physical injuries or adopt some other limiting rule. 179. schleier v. commissioner, 26 f.3d 1119 (5th cir.), cert. granted, 115 s. ct. 507 (1994). [vol 2:6 florida tax review volume 3 1996 number 3 use and abuse of section 704(c) laura cunningham" i. introduction ................................. 94 11. the basic operation of section 704(c) ............ 95 a. contributions of nondepreciable property ......... 95 b. contributions of depreciable property ............ 99 c. whence the ceiling rule? ................... 101 d. what remains of the ceiling rule? ............. 104 e. the regulations .......................... 105 f. traditional method with curative allocations ...... 106 g. remedial allocation method .................. 108 h. anti-abuse rules .......................... 112 ]il. evaluation of anti-abuse rule ................. 115 a. generally ............................... 115 b. survival of the ceiling rule .................. 116 c. interpreting the examples of abuse ............. 117 d. the key: uneconomic rules of cost recovery...... 120 iv. conclusion .................................. 123 appendix .......................................... 126 * associate professor of law, benjamin n. cardozo school of law. the author is grateful to her friends and colleagues noel cunningham. deborah paul. len schmolka. and r. donald turlington for their comments on prior drafts. florida tax review i. introduction it is basic to income taxation that each taxpayer should be taxed on his or her economic income and that only taxpayers who suffer economic losses should derive tax benefits therefrom.' while these tenets are easily stated, they are difficult to enforce, particularly in the partnership setting where lines between the economic interests of partners are often blurred. the substantial economic effect rules of section 704(b) strive mightily to constrain partners' ability to shift income and losses in a manner inconsistent with the partners' economic arrangement. nevertheless, when a partner contributes property to a partnership, the possibility exists that some of the gain or loss inherent in that property may be shifted from the contributor to the other partners. no gain or loss is recognized at the time of the contribution, and the partnership, as new owner of the property, takes the contributor's basis. thus, upon any subsequent sale of the property, the gain or loss, including gain or loss inherent in the property when contributed, is generally treated as that of the partnership entity and, absent a special rule, would be divided amongst the partners. this shifting of gain or loss was tolerated before 1984. under section 704(c), partners were permitted to agree that the subsequent gain or loss would be reported by the contributing partner, but this treatment was never mandatory. moreover, the regulations under section 704(c) contained rules constraining that agreement, the most significant of which came to be known as the "ceiling rule," providing that the gain or loss allocated to the contributing partner could not exceed the partnership's entire gain or loss on the sale. when the ceiling rule applied, precontribution gain or loss was effectively shifted to the noncontributing partners in spite of the partners' agreement to the contrary. in 1984, congress, concluding that the shifting of precontribution gain or loss to noncontributing partners should no longer be tolerated, made the prior permissive rule mandatory: gain or loss inherent in contributed property must now be reported by the contributing partner. it gave the treasury the task of drafting regulations to carry out this mandate. there is language in the legislative history to the 1984 act implying that congress intended the ceiling rule to continue after the 1984 legislation, despite the fact that its effect is inconsistent with the statutory mandate. in any event, the 1. see, e.g., helvering v. horst, 311 u.s. 112 (1940); lucas v. earl, 281 u.s. 111 (1930). there are exceptions to this rule. the most obvious is the rule of crane v. commissioner. 331 u.s. 1 (1947), which permits the holder of property subject to nonrecourse acquisition indebtedness to include the amount of that debt in basis. crane often has the effect of permitting the ostensible owner of property to deduct losses that may ultimately be borne by the holder of the debt. [vol 3:3 use and abuse of section 704(c) treasury decided that it lacked authority to eliminate the ceiling rule and that while it could provide taxpayers with means to avoid or correct ceiling rule distortions, it could not compel them to do so. final regulations under section 704(c) were issued a full 10 years after their legislative authorization. the regulations appear to create clear and concise rules for taxpayers to follow in planning contribution transactions. however, those rules are qualified by an anti-abuse rule which, if broadly construed, could largely obscure the clarity of the main rules. this article examines the section 704(c) regulations in detail, in an attempt to gauge the scope of the anti-abuse rule. part ii describes the history of section 704(c) and the regulations construing it. part iii evaluates the antiabuse rule in particular. it concludes that a narrow reading of the rule is appropriate and consistent with subchapter k as a whole. h1. the basic operation of section 704(c) in explaining section 704(c), i rely on several simple examples and some variations. example i and its variations illustrate the application of section 704(c) to nondepreciable property. example ii and its variations deal with depreciable property.2 a. contributions of nondepreciable property example l a and b form an equal partnership to which a contributes land with a basis of $60 and a fair market value of $100 and b contributes $100 of cash. the land was a capital asset in a's hands and is also a capital asset in the partnership's hands. while a has effectively realized $40 of gain (she received a partnership interest worth $100 in exchange for the land), this gain is not recognized (section 721(a)). the partnership is the owner of the land with a basis equal to a's basis of $60 (section 722). the partnership interest that a now holds is a capital asset in which she has a basis of $60 (section 723). the partnership capital accounting rules require the partnership to account for this transaction for book purposes by giving a credit in her capital account for the land's full fair market value, and the land should be reflected on the asset side of the partnership's balance sheet at that value.' 2. for ease of reference, the facts of the examples are restated in the appendix. 3. regs. § 1.704-1(b)(2)(iv)(b). 4. regs. § 1.704-1(b)(2)(iv)(d). although partnerships are not required to follow the capital account maintenance rules unless they rely upon the safe harbor for substantial economic effect under § 1.704-1(b)(2)(ii), the regulations governing contributed property require partnerships that do not do so to use book capital accounts "based upon the same principles." regs. § 1.704-3(a)(3). 1996] florida tax review as a result, a disparity exists between the partnership's tax and book accounts; the land has a tax basis of $60 but a book value of $100. to reflect these disparities, and to assist in tracing them to the partner to whom they are attributable, the regulations contemplate maintenance of "tax capital" accounts for the partners,5 which essentially reflect each partner's share of the partnership's inside basis, net of liabilities. thus, at formation, the partnership's balance sheet is as follows: assets liabilities and capital basis book cash $100 $100 land 60 100 $160 $200 capital accounts tax book a $ 60 $100 b 100 100 $160 $200 it is apparent from the balance sheet that if the partnership were to sell the land for $100, it would have a tax gain of $40, but no book gain. a's book capital account reflects that she was credited with book gain of $40 when she contributed the property. thus, if any of the $40 tax gain were reported by b, the result would be to tax b on book gain that was enjoyed by a. this shifting of gain was permitted by section 704(c)(1) before the 1984 amendment. under former section 704(c)(1), a and b were permitted to agree to treat the $40 tax gain in the same manner as partnership gains generally, 5. the concept of tax capital accounts first appeared in the regulations under § 704(b). these regulations deal with a problem related to § 704(c): the consequences of a revaluation of partnership property. under § 1.704-1(b)(2)(iv)(f), partnerships are permitted to revalue their assets and restate their capital accounts to reflect current values upon the occurrence of several specified events, the most common of which are the admission of a new partner and the liquidation of a partner's interest. see regs. § 1.704-1(b)(2)(iv)(f)(5). when a partnership restates its capital accounts, the result is the creation of book/tax disparities like those that occur under § 704(c). the § 704(b) regulations, which were drafted after congress enacted new § 704(c), but before regulations were issued under that provision, require that § 704(c) principles be applied in allocating the tax items associated with the revalued property. see regs. § 1.704-1(b)(2)(iv)(f)(4). in examples of how that might be accomplished, the regulations introduce the concept of tax capital accounts. see, e.g., regs. § 1.704-1(b)(5) exs. 13, 14. the regulations under § 704(c) apply both to standard § 704(c) situations (the contribution of appreciated or depreciated property) and to "reverse § 704(c) allocations" (those resulting from revaluations of partnership property under regs. § 1.704-l(b)(2)(iv)(f)). regs. § 1.704-3(a)(6). [vol. 3:3 use and abuse of section 704(c) i.e., in the same proportions as they share book gains. alternatively, section 704(c)(2) allowed them to agree to allocate the gain to the contributing partner.6 the regulations provided rules for allocating built-in gain or loss to the contributor if the partners so elected under old section 704(c)(2)." under those rules, which are continued in the new regulations as the "traditional method," the noncontributing partner is essentially treated as though she purchased an undivided interest in the property for its fair market value at the time of contribution, and allocations of tax items are made consistent with that treatment. as a result, where the contributed property is nondepreciable, only tax gains (or losses) corresponding to book gains (or losses) are allocated to noncontributing partners. in the example, if the partnership sells the property for $100, none of the $40 tax gain is allocated to b because she sustained no book gain. a, on the other hand, has a $40 disparity in her tax and book capital accounts, reflecting the fact that she was credited with a book gain at the time of contribution, which has not yet been matched by a tax gain. therefore all of the corresponding $40 tax gain is allocated to her, fulfilling the basic mandate that tax must follow book, even though the tax allocation follows the book allocation on a delayed basis. this method dutifully accomplishes the goal of former section 704(c)(2) in many cases, as illustrated below: example i, variation 1. the property in example i increases in value and ab sells it for $120, resulting in a book gain of s20 and a tax gain of $60. under their agreement, a and b share the book gain equally, sl0 apiece. under the traditional method, the tax gain is allocated as follows: b, the noncontributing partner, is allocated tax gain equal to her book gain of $10, and a is allocated the balance, $50. by allocating tax gain first to the 6. before the 1984 amendments, § 704(c)(1) and (c)(2) read as follows: (1) general rule. in determining a partner's distributive share of items described in section 702(a), depreciation, depletion, or gain or loss with respect to property contributed to the partnership by a partner shall, except to the extent otherwise provided in paragraph (2) or (3), be allocated among the partners in the same manner as if such property had been purchased by the partnership. (2) effect of partnership agreement. if the partnership agreement so provides, depreciation, depletion, or gain or loss with respect to property contributed to the partnership by a partner shall, under regulations prescribed by the secretary, be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. 7. reg. § 1.704-1(c)(2) (before amendment in 1993). 19961 florida tax review noncontributing partner, the traditional method maintains equality between b's book and tax capital accounts. once this is accomplished, the remaining tax gain is necessarily allocable to the contributing partner, a. in this variation, this allocation has the effect of eliminating entirely the tax/book disparity on the partnership's books. the prior regulations imposed one important limitation on the partners' ability to avoid shifts of gain: the so-called "ceiling rule.",8 under the ceiling rule, the amount that a partnership may allocate among its partners may not exceed the tax gain, income, loss, or deduction that the partnership, as an entity, recognizes for the year. in operation, the ceiling rule can cause serious distortions by shifting a portion of the built-in gain or loss to noncontributing partners.9 example i, variation 2. the land in example i goes down in value, and ab sells it for $70. in this sale, although ab has a book loss of $30, it has a tax gain of $10. a and b suffer book losses of $15 each; however, since the partnership entity has not sustained a tax loss to match its book loss, b cannot claim a tax loss, violating the principle that tax gains and losses should match book gains and losses and thereby creating a tax/book disparity in b's capital accounts. for tax purposes, the entire tax gain of $10 is allocated to a, but this amount is not sufficient to eliminate a's tax/book disparity. immediately after the sale, ab's balance sheet is as follows: assets liabilities and capital basis book cash $170 $170 capital accounts tax book a $ 70 $ 85 b 100 85 $170 $170 although the tax/book disparity has been eliminated on the asset side of the balance sheet, a new one arises between b's tax and book accounts because b has sustained an economic loss that has been taken into account 8. id.; see regs. § 1.704-3(b)(1). 9. see generally r. donald turlington, section 704(c) and partnership book-tax disparities, the ceiling rule and the art of tax avoidance, 46 inst. on fed. tax'n § 26 (1988). [vol 3:3 use and abuse of section 704(c) for book purposes but not for tax purposes: her $15 economic loss has not been matched by a tax loss. on the other hand, a, who enjoyed a book gain of $40 when she contributed the property (and was given a book capital credit of $100) and sustained an offsetting loss of $15 when the property was sold (for a net gain of $25), has only reported $10 of tax gain, effectively (albeit temporarily) shifting $15 of that gain to b (via the deferred loss deduction). these effects, which are compelled by the ceiling rule, will presumably be offset one day when the partnership liquidates or when one or both of the partnership interests are sold.'0 in the meantime, b's loss and a's gain are locked in. b. contributions of depreciable property when the contributed property is depreciable, allocation of gain on sale, as in example i, is not sufficient to accomplish the purpose of taxing the contributing partner on built-in gain because, if book depreciation is matched by real decline in value, there will be no gain on a sale made at the end the property's useful life. the only way to tax the contributor on built-in gain in depreciable property is to increase her share of presale income from the property. under the traditional method, this is done by allocating depreciation away from the contributing partner: the noncontributing partner receives tax depreciation up to her share of book depreciation, and only if tax depreciation remains thereafter is it allocated to the contributing partner. the result is to tax the contributing partner on more than her book share of income from the property, thereby resolving the tax/book disparity over the property's life. the opposite is done for built-in loss. example ii: c and d form an equal partnership to which c contributes equipment with a basis of $80 and a value of $120 and d contributes $120 cash. the equipment originally had a 10-year recovery period, and c elected to use the straight line method of cost recovery. although only four years remain in its recovery period, if cd had purchased the equipment on the date of formation, it would have had a 10-year recovery period. c and d agree to share all book items equally. upon formation, cd's balance sheet is as follows: 10. if the partnership were immediately to liquidate. distributing cash of s85 to each partner, a would recognize gain of $15 under § 731(a)(1), and b would recognize a s15 loss under § 731 (a)(2). similarly, if either partnership interest were sold. the selling partner would recognize deferred gain or loss under § 741. 19961 florida tax review assets liabilities and capital basis book equipment $ 80 $120 cash 120 120 $200 $240 capital accounts tax book a $ 80 $120 b 120 120 $200 $240 cd must recover its transferred tax basis in the property over the property's remaining recovery period, using the same method as c, the straight line method." its book depreciation must be computed at the same rate as its tax depreciation. 2 applying these rules to example ii: 1. cd must recover its $80 tax basis using the straight line method over its remaining recovery period of four years ($20 per year). 2. cd therefore must also recover its $120 book basis using the straight line method over four years ($30 per year). consistent with the general intent of the traditional method to treat noncontributing partners as if each purchased an undivided interest in contributed property for cash, the noncontributing partners are allocated (if possible) the same amount of cost recovery for tax purposes as they are for book purposes. if the partnership's cost recovery deduction exceeds the noncontributors' book share, the contributing partners are allocated the balance. on the facts of example ii, since each partner is entitled to $15 of depreciation for book purposes, the $20 of tax depreciation is allocated $15 to d and $5 to c. thus, although c and d have the same book income, c has $10 more taxable income than d. if we assume for the moment that book income is a surrogate for economic income, c is overtaxed by $10 each year. in this way, c is taxed on the built-in gain over the life of the property. after four years, c has taken into account all $40 of built-in gain, and the difference between the property's book value and tax basis has been entirely eliminated. 11. irc § 168(i)(7). 12. regs. § 1.704-1(b)(2)(iv)(g)(3). a partnership that does not maintain its capital accounts under the safe harbor rules of § 1.704-1(b)(2)(iv) must, for purposes of § 704(c), use book capital accounts applying the same principles. regs. § 1.704-3(a)(3). however, it is not clear whether the book depreciation rules are among the principles that must be followed. for this reason, i assume that cd has chosen to follow the safe harbor rules. [vol. 3:3 use and abuse of section 704(c) when tax basis is less than the noncontributor's share of book basis, the ceiling rule prevents the traditional method from completely eliminating the contributor's book/tax disparity, and shifts some of the built-in gain to the noncontributing partner. in those circumstances, there is insufficient tax depreciation to allocate to the noncontributing partner. example ii, variation 1: c's adjusted basis for the equipment at the time of contribution, and hence cd's initial adjusted basis, is $40. thus, cd is permitted only $10 of annual depreciation for tax purposes. for each of its first four years, cd has s20 of ordinary business income before taking depreciation into account. although d's share of the equipment's initial book value is s60, the total tax depreciation available under the ceiling rule is the s40 tax basis at the time of contribution. thus, it will be impossible to treat d as though she purchased an undivided interest in the property. although cd still has $30 of annual book depreciation, $15 of which is allocable to d, cd only has $10 of annual tax depreciation. under the traditional method, all of this $10 is allocated to d. nevertheless, since this allocation is insufficient to match d's share of book depreciation, it creates a disparity between d's tax and book capital accounts that will grow at the rate of $5 per year. after the first year, the partners' capital accounts are as follows: c d book tax book tax initial balance $120 $40 $120 $120 depreciation (15) (15) (10) ordinary income 10 10 10 10 $115 $50 $115 $120 the $5 disparity that has been created in d's capital accounts will grow to $20 after four years. in effect, the ceiling rule causes d to be overtaxed in the amount of $5 per year for four years, thereby taxing d on a portion of c's built-in gain. resolution of these disparities is deferred until the liquidation of the partnership or a sale of the partnership interests. c. whence the ceiling rule? before the enactment of subchapter k as part of the internal revenue code of 1954, there was significant confusion over the appropriate treatment 19961 florida tax review of contributed property. 3 the source of the confusion was the unresolved dichotomy between taxing partnerships as separate entities or as aggregates of their partners. 4 under a pure entity approach, built-in gain and loss from contributed property would be allocated consistently with all other gains and losses, making no attempt to trace precontribution gain or loss to the contributing partner. under a pure aggregate approach, the noncontributing partner would be treated as though he had purchased an undivided interest in the property for cash, essentially giving the noncontributor a cost basis in the contributed property, even if the transferred basis from the contributing partner is less. methods based on the aggregate approach were coined "deferred sale" or "credited value" approaches. the first was published in 1932, in a general counsel memorandum proposing that the partners account for gain and loss from contributed property using a deferred sale approach, subject to the ceiling rule.' 5 apparently because of the perceived difficulty of applying the aggregate approach to partnerships with multiple partners contributing multiple properties, the general counsel memorandum was subsequently revoked, and was reportedly not followed in the field during the period prior to its revocation.' 6 congress' goal in the partnership provisions of the 1954 code was to resolve the confusion of prior law, and in this context, it did so by enacting sections 704(c)(1) and (c)(2). the legislative history reflects congress' awareness of the shifting potential of section 704(c)(1). however, because the shifts would be resolved upon liquidation of the partnership or sale of a partner's interest, the problem was viewed one of "mere" deferral, prompting the simpler approach of section 704(c)(1). section 704(c)(2) was viewed as an accommodation for taxpayers who wished to account more accurately for built-in gain or loss.' 7 13. see generally s. rep. no. 1622, 83d cong., 2d sess. 89, 93-94 (1954), reprinted in 1954 u.s.c.c.a.n 4621, 4721, 4725-27. 14. see gregory marich & william mckee, sections 704(c) and 743(b): the shortcomings of existing regulations and the problems of publicly traded partnerships, 41 tax l. rev. 627, 635 (1986) ("the ceiling rule and its distortions are a product of the entityaggregate conflict that is deeply embedded within subchapter k"). 15. g.c.m. 10092, xi-i cum. bull. 114 (1932), revoked by g.c.m. 26379, 1950-1 cum. bull. 58. in its recommendations to congress in connection with the 1954 code, the american law institute endorsed the entity approach, in spite of its attendant distortions, primarily because of its simplicity in contrast with the aggregate approach. the all did, however, advocate adoption of an elective aggregate approach. 2 american law institute federal income tax statute 355-56 (feb. 1954 draft). 16. see jackson, et al., a proposed revision of the federal income tax treatment of partnerships and partners, 9 tax l. rev. 109, 123 (1954). 17. this rule is admittedly more complicated than the entity rule, which is provided unless the partnership agreement provides otherwise. however, while the partnership remains in operation, this aggregate rule more [vol 3:3 use and abuse of section 704(c) the legislative history of section 704(c)(2) is cited as the foundation for the ceiling rule. although no express reference to the rule is made, support for it can be found in an example in which property with a basis of $40 and value of $100 is contributed to an equal two-person partnership. the senate report notes that all $40 of depreciation should go to the noncontributor, and makes no reference to any deferred sale mechanism for increasing the depreciation to treat the noncontributor as though he had purchased an undivided interest.'8 the regulations under section 704(c)(2) imposed the ceiling limitation, and it has survived ever since. in sum, the law before 1984 was that income, gain, loss, and deduction from contributed property could be freely shifted among partners unless the partners elected otherwise, and even if they did elect otherwise, the ceiling rule in some cases made it impossible to completely eliminate shifting of income and loss. by 1984, congress and the treasury had become painfully aware of the time value of money, and the shifting permitted by section 704(c)(1) was no longer viewed as revenue neutral. the possibilities of abuse were readily apparent. suppose that in example i a is in the 40% tax bracket and b, because of an expiring capital loss carryforward, could report the built-in gain at no tax cost.19 unless a and b made an election under section 704(c)(2) (unlikely in these circumstances), some of the $40 gain would escape taxation. in 1984, congress thus made mandatory the rule that the entire $40 gain should be reported by a, the contributing partner. the statute now requires that under regulations prescribed by the secretary ... income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution . . .. equitably computes the taxable income of the partners. since this is not a matter involving revenue considerations to the government. and since partners are not compelled to use this rule, your committee believes that partners should be free to choose this more complicated rule for dividing basis of property if they desire the more accurate tax results it brings. s. rep. no. 1622, 83d cong., 2d sess. 4725 (1954). reprinted in 1954 u.s.c.c.a.n. 4621, 4725. 18. id. 19. b might also be a tax-exempt pension fund or a nonresident alien that is brought into the partnership specifically with a view to absorbing a's built-in gain. 20. irc § 704(c)(1). 19961 florida tax review d. what remains of the ceiling rule? although congress made clear that it revised section 704(c) to preclude partners from shifting precontribution gain and loss among themselves, neither the statutory language nor the legislative history states whether congress intended to abandon the ceiling rule. because the ceiling rule results in just the type of distortions that the revised section 704(c) is intended to eliminate, arguably, the statute could be construed to eliminate the rule.2' the more commonly held belief is that congress intended that the ceiling rule continue, or at least that the treasury should not impose aggregate treatment upon taxpayers. 22 the 1984 legislative history authorized taxpayers to rely on the former regulations until new ones were issued, and while the grant of regulatory authority is broad, no suggestion is made that the treasury should adopt some sort of deferred sale method.23 the presumption arising from the legislative history is that the traditional method would continue, although treasury was authorized to provide various means of curing ceiling rule distortions. a decade passed before final regulations were issued under section 704(c), and during this time, there was much debate and speculation over what they would ultimately provide.24 proposed regulations were issued in december of 199225 and were finalized on december 21, 1993.26 21. see, e.g., turlington, supra note 9, at 26-25. 22. see, e.g., new york state bar ass'n tax section discusses regulatory issues under changes made by '84 act, 85 tnt 102-49 (may 22, 1985) (lexis, fedtax library, tnt file). see also marich & mckee, supra note 14; john d. steines, jr., partnership allocations of built-in gain or loss, 45 tax l. rev. 615-65 n.173 (1990). 23. the house report accompanying the 1984 legislation states: it is anticipated that regulations under [§ 704(c)(1)] generally will provide for the same result that is achieved under present law when a partnership elects with respect to all relevant items to provide for sharing of depreciation, depletion, and gain or loss among the partners so as to take into account fully the variation between the basis of the property of the partnership and its fair market value at the time of the contribution. h.r. rep. no. 98-432, 98th cong., 2d sess. pt. 2, at 1209 (1984), reprinted in 1984 u.s.c.c.a.n. 874, 876. in a footnote, the house report suggests that curative allocations of gain on a sale of depreciable property might be appropriate to resolve disparities created by ceiling limited depreciation. id. n.3. this bolsters the argument that congress intended the ceiling rule to remain in place. 24. see, e.g., new york state bar ass'n, supra note 22; marich & mckee, supra note 14. 25. ps-164-84, 1993-1 c.b. 857. 26. t.d. 8500, 1994-1 c.b. 183. the rules on the remedial allocation method were not finalized until december of 1994. t.d. 8585, 1995-1 c.b. 120. [vol 3:3 use and abuse of section 704(c) e. the regulations the regulations begin with the following statement: the purpose of section 704(c) is to prevent the shifting of tax consequences among partners with respect to precontribution gain or loss. under section 704(c), a partnership must allocate income, gain, loss, and deduction with respect to property contributed by a partner to the partnership so as to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of contribution.27 this restatement of the statutory rule, preceded by a statement of the purpose of the statute, is followed by the edict that "the allocations must be made using a reasonable method that is consistent with the purpose of section 704(c)." 28 the balance of the regulations is devoted to fleshing out what the treasury means by "reasonable." the regulations include an anti-abuse rule providing that an allocation is not reasonable if "the contribution of property... and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability."' the regulations describe three allocation "methods" that are "generally" considered reasonable, and state that "other methods may be reasonable in appropriate circumstances."'' the three methods are the traditional method, the traditional method with curative allocations, and the remedial allocation method. the traditional method is basically the same as the method of the old section 704(c)(2) regulations described above, ceiling rule and all. the traditional method with curative allocations provides a means of offsetting ceiling rule distortions in many cases, and the remedial allocation method allows ceiling rule distortions to be avoided altogether. it has been noted that although the final regulations speak of the three methods as separate and distinct, the traditional method is effectively the only "horse in the barn." 3 ' the two other methods only modify that method as necessary to resolve distortions caused by the ceiling rule. the traditional method is a means of applying aggregate treatment to noncontributing 27. regs. § 1.704-3(a)(1). 28. id. 29. regs. § 1.704-3(a)(10). 30. regs. § 1.704-3(a)(1). 31. barksdale hortenstin & gregory j. marich. an analysis of the rules governing partnership allocations with respect to contributed properties: the final regulations under section 704(c), at 12 (1994) (unpublished manuscript on file with author). 19961 florida tax review partners by maintaining an identity in each such partner's book and tax capital accounts, and this goal of book/tax equality is at the heart of each of the three methods in the regulations. for example, if a partnership elects the curative allocation method, but never encounters a ceiling rule limitation, its allocations will be precisely the same as if it had elected the traditional method. nevertheless, because the regulations describe the three methods as alternatives, i describe them separately. yet, it is useful to keep in mind that at the heart of each is the mandate that tax allocations should follow book allocations, and that tax/book disparities should be avoided whenever possible and resolved as quickly as possible when they do arise. f. traditional method with curative allocations partnerships using the traditional method with curative allocations may elect to make reasonable curative allocations to eliminate ceiling rule distortions.32 a "curative allocation" is a tax allocation of an item that differs from the allocation of the corresponding book item. the allocation is meant to "cure" disparities caused by the ceiling rule and is available only if the ceiling rule has created a book/tax disparity. curative allocations must be reasonable in amount and of the same type as the item that was subject to the ceiling rule.33 absent an appropriate item to allocate, a curative allocation cannot be made. to illustrate how the rules work for nondepreciable property, consider the following: example i, variation 3. assume the facts of example i, but further assume that ab invests its $100 of cash in stock that appreciates in value to $150 and that the land declines in value to $70. ab sells the land for $70 (recognizing $30 of book loss and $10 of tax gain) and sells the stock for $150 (recognizing a $50 gain for both book and tax purposes). after these sales, the capital accounts would, in the absence of curative allocations, be as follows: a b book tax book tax initial balance $100 $60 $100 $100 land sale (15) 10 (15) -stock sale 25 25 25 25 $110 $95 $110 $125 32. regs. § 1.704-3(c). 33. regs. § 1.704-3(c)(3). in the case of depreciable property, the period of time over which the curative allocations are made must also be reasonable. [vol 3:3 use md abuse of section 704(c) the ceiling rule has created a book/tax disparity for both partners of s 15. the gain on the stock sale, however, presents a possibility of eliminating the disparity by reallocating gain on the stock for tar purposes in the proportions $40 to a and $10 to b. the regulations permit this, so long as the reallocated amount does not exceed the amount of the ceiling limited item for the taxable year and is of the same type or character as that item. since the amount of the curative allocation equals the amount of the distortion, and since the land and the stock are both capital assets, the curative allocation of the gain on the stock has the same effect as the loss limited by the ceiling rule. the allocation is therefore reasonable and results in the following adjustments to the partners' capital accounts: a b book tax book tax initial balance $100 $ 60 $100 $100 land sale (15) 10 (15) -stock sale 25 40 25 10 $110 $110 $110 sl0 as applied to depreciable property, reconsider variation i of example ni, which is restated here for convenience: exmnple i, variation 1: assume the facts of example ii, except that c's adjusted basis in the equipment at the time of contribution is $40. thus, cd's initial adjusted basis in the equipment is also $40, and cd is permitted only $10 of annual depreciation for tax purposes. in addition, for each of the first four years, cd has $20 of ordinary business income before taking depreciation into account. if cd elects to use the traditional method with curative allocations, it can eliminate the annual distortion caused by the ceiling rule by making curative allocations of its ordinary income. cd has $20 of ordinary income that the partners share equally-$10 each. by allocating $15 of this income for tax (but not book) purposes to c and $5 to d, the ceiling rule distortion is "cured." since this allocation is reasonable in both amount and type, it would be respected. if it is done, the partners' capital accounts are adjusted as follows: c d book tax book tax initial balance $120 $ 40 $120 $120 depreciation (15) (15) (10) ordinary income 10 15 10 5 $115 $55 $115 $115 19961 florida tax review the purpose of curative allocations is easily seen in the context of depreciable property. under the traditional method, the built-in gain in the property is amortized over the life of the property, as it produces income. when the ceiling rule applies, the noncontributor, in the absence of curative allocations, reports more than his or her economic share of the property's income. the curative allocation of additional income to the contributing partner eliminates this distortion.34 g. remedial allocation method the second mechanism for curing ceiling rule distortions is the "remedial allocation method. 35 in essence, this method permits partners to ignore the ceiling rule, ensuring that tax allocations to the noncontributors are always available to match the book allocations to them. as applied to depreciable property, the method recalculates book depreciation in such a way that the noncontributors are treated, to some extent, as though they purchased undivided interests in the contributed property. the partners are authorized to create offsetting tax allocations to match the book allocations, with the result that the net amount allocated equals the partnership's total gain, loss, or deduction. remedial allocations are fictitious, or notional, offsetting tax allocations; their only role is to eliminate disparities between book and tax accounts arising from the ceiling rule. they always equal the disparity and are of a character identical to that of the item limited by the ceiling rule. because they are notional and offsetting, they have no effect on the partnership's taxable income or adjusted bases.36 the partners, however, must treat remedial allocations as actual tax items, and the allocations may therefore affect both tax liability and outside bases.37 as discussed below, the remedial allocation method treats a contribution of property to a partnership in some ways as if it were a sale, with the gain on that sale recognized by the contributing partner only as necessary to neutralize application of the ceiling rule. it is a simplified descendant of the deferred sale method proposed by the ali in 1954. it is the only pure aggregate approach authorized by the regulations. to illustrate how this method applies to nondepreciable property, reconsider variation 1 of example i, where the land falls in value and the ab partnership sells it for $70, resulting in $30 of book loss and $10 of tax gain. the book loss is allocated equally between a and b-$15 each. if the partnership uses the traditional method, the ceiling rule prevents b from receiving a tax loss to match her book loss because there is no tax loss. if, however, 34. see marich & mckee, supra note 14, at 645. 35. regs. § 1.704-3(d). 36. regs. § 1.704-3(d)(4)(i). 37. regs. § 1.704-3(d)(4)(ii). [vol. 3:3 use and abuse of section 704(c) the partnership elects the remedial allocation method, b is allocated tax loss of $15, characterized as if it were from the sale of the land, and a is allocated an offsetting tax gain of $15 of the same character. a thus reports gain of $25 (sum of $10 of partnership gain on the sale and s15 of remedial allocation), and b reports loss of $15, netting out to the partnership's gain of $10 and producing the appropriate result described above that was prohibited by the ceiling rule. under the remedial method, the partners' capital accounts are adjusted as follows: a b book tax book tax initial balance $100 $60 $100 $100 land sale (15) 10 (15) -remedial allocation 0 15 0 (15) $ 85 $85 s 85 s 85 in contrast with the traditional method with curative allocations, these remedial allocations are not dependent on the partnership having other items of income or loss. if ab had used the traditional method with curative allocations, the lack of other capital gains would have blocked the elimination of the disparity created by the ceiling rule. a partnership adopting the remedial allocation method for depreciable property must use a special rule for computing book items (including depreciation) with respect to the property. this rule is loosely based on the notion that the contributing partner sold the property on a deferred basis to the partnership on the date of contribution for its fair market value. to the extent of its transferred basis, the partnership steps into the shoes of the contributing partner for both book and tax purposes and must continue to use the contributing partner's cost recovery method. if the property's value exceeds its basis, the excess is treated for book purposes as if the partnership had purchased the property for this amount, and book depreciation is calculated on this amount using any method of cost recovery that is allowed for property of that type. the partnership then uses the traditional method to allocate the related tax items, with tax allocations to noncontributing partners following book allocations to the extent possible. if the ceiling rule prevents noncontributing partners from receiving tax allocations equal to the corresponding book allocations, the partnership makes offsetting remedial allocations of the appropriate character and amount to both contributing and noncontributing partners. 38. the partnership must also use the appropriate first year convention. see irc § 168(d) (allowing half-year, mid-month, and mid-quarter conventions): regs. § 1.704-3(d)(2) (also allowing first-year convention). 1996] florida tax review to illustrate, assume the partnership in variation i of example ii adopts the remedial allocation method. for book purposes, the partnership is treated as if it acquired two pieces of equipment, one contributed by c with a value and a basis of $40, and one that it purchases for $80 (the excess of the property's value ($120) over its basis ($40)). with respect to the contributed portion, the partnership steps into c's shoes, recovering the $40 of basis for both book and tax purposes using the straight line method over the remaining four years of the property's life-depreciation of $10 per year for both tax and book purposes. with respect to the notionally purchased portion, the partnership may adopt any appropriate method of cost recovery. ignoring conventions, if cd chooses the straight line method over 10 years, the purchased portion provides cd with $8 of book (but not tax) depreciation each year for 10 years. therefore, cd has a book cost recovery deduction of $18 per year ($10 from the contributed portion and $8 from the purchased portion) for the first four years and $8 per year for the remaining six years. cd's initial balance sheet looks as follows: assets liabilities and capital basis book equipment $ 40 $120 cash 120 120 $160 $240 capital accounts tax book c $ 40 $120 d 120 120 $160 $240 for each of its first four years of operation, cd has $2 of income for book purposes and $10 of income for tax purposes, determined as follows: book tax ordinary income $20 $20 depreciation (18) (10) $ 2 $10 for book purposes, c and d are each entitled to one half of both the ordinary income ($10) and the depreciation ($9), a net of $1 each per year. for tax purposes, each is allocated $10 of ordinary income. however, under the traditional method, d is allocated $9 of depreciation, and c only $1. therefore, d has $1 of taxable income, and c $9: [vol 3:3 use and abuse of section 704(c) c d book tax book tax ordinary income $10 $10 $10 $10 depreciation (9) (i) (9) (9) $1 $9 si si at the end of the first four years, the capital accounts of the partnership are as follows: c d book tax book tax initial balance $120 $40 $120 $120 aggregate adjustments 4 36 4 4 $124 $76 $124 $124 during this period, the book/tax disparity in c's capital account declines from $80 to $48 because c takes only $1 a year in depreciation, while her book depreciation is $9. in effect, c over reports taxable income by $8 annually, thereby taking into account $32 of the $80 of built-in gain that was inherent in the property when it was contributed. to this point, the ceiling rule has not applied, and the partnership has not used remedial allocations. the analysis changes thereafter. during years 5 through 10, the partnership continues to have $20 of ordinary income, but its book depreciation is only $8. the partnership's net annual book income is $12, and each partner's share is $6. for tax purposes, the partnership is no longer entitled to any depreciation. although d is charged $4 of depreciation for book purposes, the ceiling rule prohibits any allocation of depreciation for tax purposes. therefore, under the remedial allocation method, the partnership must make two offsetting remedial allocations of $4 each year. each year, the partners' capital accounts have the following adjustments: c d book tax book tax ordinary income $10 $10 $10 $10 depreciation (4) 0 (4) 0 remedial allocation 4 (4) annual net adjustment $ 6 $14 $ 6 $ 6 each year, c reports $8 more taxable income than she has for book purposes. this reduces the disparity between tax and book so that by the end of year 10, the disparity will have disappeared. 19961 florida tax review h. anti-abuse rules as noted above, the treasury's blessing of the three alternative methods for making section 704(c) allocations is subject to a general antiabuse rule, providing that an allocation method is not reasonable if the contribution of property ... and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability. 39 the regulations provide some guidance in interpreting this apparently very broad rule in two examples-one involving the traditional method (example 2) and the other the traditional method with curative allocations (example 3).40 in both examples, an equal partnership is formed with one partner contributing property with a value of $10,000 and an adjusted basis of $1,000 and the other partner contributing $10,000 cash. the property has only one year left in its recovery period, but has a substantially longer economic life, which for purposes of this analysis i assume to be 10 years. 4 1 as is developed in more detail below, central to the potential for abuse in both examples is the fact that the property's recovery period for tax purposes is significantly shorter than its useful life. example 2 illustrates unreasonable use of the traditional method. in this example, the property contributor (c) is in a high marginal bracket, and the cash contributor (d) is in the zero bracket because of a net operating loss deduction that will soon expire. the contribution of property is made "with a view to taking advantage of the fact that the equipment has only one year remaining on its cost recovery schedule although its remaining economic life is significantly longer. '42 under the traditional method, the partnership takes $10,000 of depreciation for book purposes and $1,000 of depreciation for tax purposes in the first year, reducing the partnership's basis in the property to zero for both book and tax purposes and eliminating all of the section 704(c) gain. the partners share the book depreciation equally, while d is allocated all of the tax depreciation. the effect of the ceiling rule is to restrict d's allocation of tax depreciation to $1,000, $4,000 less than his share of book depreciation. 39. regs. § 1.704-3(a)(i0). 40. regs. § 1.704-3(b)(2) ex. 2, (c)(4) ex. 3. 41. in example 2, it is stated that the property's useful life is "significantly longer" than its recovery period, and in example 3, the property has a 10-year economic life. 42. regs. § 1.704-3(b) ex. 2(i). [vol 3:3 use and abuse of secion 704(c) if one views book income and deductions as reflecting economic income and loss, the noncontributing partner is overtaxed by $4,000, all in the first year. this view, however, does not reflect the true economics of the transaction. ideally, d should be treated for tax purposes as though she had purchased for $5,000 an interest in property having a 10-year useful life. using straight line depreciation, d should be allocated s500 of depreciation annually for 10 years. d is actually undertaxed in the first year because she receives $1,000 of depreciation instead of $500. in the absence of a sale, however, she will be overtaxed by $500 for each of the next nine years because there is no tax depreciation. the result at the end of the property's life is that d has been overtaxed by $4,000. therefore, the effect of the ceiling rule in the first year is to lock in the amount of income ($4,000) that will eventually be shifted to d, although the actual shift occurs throughout the property's life. to this point, the ceiling rule distortion is garden-variety: the partnership has insufficient tax depreciation to match the noncontributor's book depreciation. the distinguishing feature of this example, which is apparently what rendered it abusive in the treasury's eyes, is that even though the property has been depreciated down to a book value of zero, its value at the beginning of year two is $10,000, which the partnership realizes both for book and tax purposes through sale. under the partnership agreement, the resulting gain of $10,000 is shared equally for both book and tax purposes. if these allocations were respected, the capital accounts would be adjusted as follows: c d tax book tax book initial balance $1,000 $10,000 $10,000 s10,000 depreciation 0 (5,000) (1,000) (5,000) sale 5.000 5.000 5.000 5,000 $6,000 $10,000 $14,000 $10,000 the interplay of the one-year cost recover), period, the sale, and the traditional method results in a shift for tax purposes of $4,000 of gain from c to d, all occurring in year two. while this shift became inevitable in year one, when the ceiling rule restricts d's depreciation deduction, the shift is actually realized for tax purposes when the property is sold in year two. in that year, d reports $4,000 of gain for tax purposes that should have been reported by c. the regulations note that if the partnership agreement had called for a curative allocation of an additional $4,000 of gain to c, the antiabuse rule would not apply.43 43. regs. § 1.704-3(b)(2) ex. 2ii)(c). 1996] florida tax review the second example of the anti-abuse rule (example 3) involves unreasonable use of the traditional method with curative allocations." the facts of this example are similar to the first, but there are important differences: the bracket positions of the partners are reversed-the property contributor (j) is the zero bracket taxpayer due to a net operating loss deduction, and the cash contributor (k) is in a high bracket; the partnership does not intend to sell the property; and the partnership generates $8,000 of sales income in its first year of operations. under the traditional method with curative allocations, the partnership's $10,000 of book depreciation is shared equally, and the $1,000 of tax depreciation is allocated entirely to k. the partners make a curative allocation of sales income to j to make up for the ceiling rule limitation on k's depreciation deduction: for book purposes, each partner receives $4,000 of sales income, but for tax purposes, all $8,000 is allocated to j. 45 if this were respected, the partners' capital accounts would be adjusted as follows: j k tax book tax book initial balance $1,000 $10,000 $10,000 $10,000 depreciation 0 (5,000) (1,000) (5,000) sales income 8,000 4000 0 4,000 $9,000 $ 9,000 $ 9,000 $ 9,000 the curative allocation eliminates the disparity between the tax and book capital accounts, thereby curing the ceiling rule distortion entirely in the first year. had no curative allocation been made, the partners would have divided the sales income equally over the life of the equipment, and the book/tax disparity created in the first year would have continued indefinitely. nevertheless, the regulations find this to be an unreasonable use of the traditional method with curative allocations. k is undertaxed by $4,500 for year one,46 but would, in the absence of the curative allocation, be overtaxed by $500 in each of the nine succeeding years. the overtaxation is fully offset by the curative allocation made for year one. instead of depreciating its investment in the property over the 10-year life at the rate of $500 per year, the curative allocation effectively allows k to deduct its entire $5,000 investment in the first year. therein lies the abuse: k, the high bracket 44. regs. § 1.704-3(c)(4) ex. 3. 45. see regs. § 1.704-3(c)(4) ex. 3(i). when the regulations were proposed in 1992, the curative allocation of sales income was only $750. prop. regs. § 1.704-3(c)(4) ex. 2(i). this was changed in the final regulations to make the shift more dramatic. 46. k's economic income is $4,500 ($4,000 of sales income, less $500 of economic depreciation), but its taxable income is zero. [vol. 3:3 use and abuse of section 704(c) taxpayer, is essentially allowed to immediately deduct its entire cost of its share of the equipment at no tax cost to either j or the partnership. the builtin gain for which j should ultimately be responsible is accelerated, but since j is currently in the zero bracket, he owes no additional tax. according to the regulations, the curative allocations would be reasonable if they were made over the property's economic life.4 1m. evaluation of anti-abuse rule a. generally the anti-abuse rule has been described by commentators as the "heart" of the section 704(c) regulations8 and as a "potent weapon" in the hands of the service.49 these characterizations reflect a concern that the anti-abuse rule is so broad that it could potentially apply to any contribution transaction if the ceiling rule works to the advantage of the partners by reducing their overall tax liability. the regulations contain a statement belying this notion: "an allocation method is not necessarily unreasonable merely because another allocation method would result in a higher aggegate tax liability. °5 0 however, the treasury refused to establish safe harbors from the anti-abuse rule, leaving open the possibility that the rule might apply even to the remedial allocation method in certain circumstances." i do not agree that the anti-abuse rule will be applied in such a broad fashion, nor do i believe that it should be so applied. while the regulations contain no explicit safe harbors (save the virtually useless one assuring that the traditional method is reasonable if the ceiling rule never applies), i believe that the traditional method is reasonable, and ceiling rule shifts will be tolerated, unless the partners plan the transaction to manipulate the timing of the ceiling rule shifts, or the correction of those shifts through curative allocations, so as to have them occur at minimal tax cost. stated another way, the anti-abuse rule should apply to the traditional method only if the partners accelerate the ceiling rule shift in such a way as to substantially reduce the present value of their tax liability below that which it would have been had the ceiling rule shift occurred over the economic life of the contributed 47. regs. § 1.704-3(c)(4) ex. 3 (ii)(c). 48. william s. mckee et al., federal taxation of partnerships and partners i 10.04[3][a] (2d ed. supp. 1995). 49. gregory j. marich et al., the remedial allocation method: a viable cure for the ceiling rule, 65 tax notes 1267, 1270 (dec. 5. 1994). 50. regs. § 1.704-3(a)(1). 51. see t.d. 8500, supra note 26. at 184 ("the irs and treasury believe it is appropriate to require that all allocation methods satisfy the anti-abuse rule"). 19961 florida tax review property. in the context of the traditional method with curative allocations, the reach of the anti-abuse rule should be limited to curative allocations that are made at no significant tax cost over a period substantially shorter than the contributed property's economic life. in the regulations, the treasury accepted the traditional method's approach of maintaining tax/book disparities as the basic means of applying section 704(c) in all cases, authorizing variations only as necessary to avoid ceiling rule distortions. it apparently believes that it lacks authority to eliminate the ceiling rule. whether or not this assumption is justified, if the ceiling rule is viewed as inviolate, use of the traditional method in most cases must be respected. the basic rule of the traditional method-that tax allocations should follow book allocations to the extent possible-often results in ceiling rule shifts of income, but it should be considered abusive only rarely. those rare cases can be identified in advance: tax allocations following book allocations are potentially abusive when the latter deviate significantly from economic reality because in those cases the timing of the ceiling rule shift can be manipulated. the treasury's illustrations of the anti-abuse rule support the conclusion that the traditional method is reasonable in all but the most unusual circumstances. in the examples, the anti-abuse rule is applied not to override shifts occasioned by the ceiling rule, but to control the timing of the making and correcting of the shifts. the examples illustrate that an anti-abuse rule is needed for two reasons: a ceiling rule that the treasury believed it could not eliminate, and uneconomic cost recovery rules that it cannot fix. as a consequence, the treasury chose to circle the wagons and issue in terrorem regulations whose bark is far worse than their bite. b. survival of the ceiling rule arguments have been made for and against retention of the ceiling rule, but the treasury apparently decided that it lacked authority to repeal it. there is substantial evidence of this, both from informal statements from treasury personnel and in the regulations. when commentators expressed concern about the treasury's authority to override the ceiling rule through the remedial allocation method, the treasury stated that the rule would be elective only, and the regulations state that neither that nor any other method based upon notional tax allocations may be imposed upon taxpayers.52 the 52. in exercising its authority under paragraph (a)(10) of this section to make adjustments if a partnership's allocation method is not reasonable, the internal revenue service will not require a partnership to use the remedial allocation method described in this paragraph (d) or any other method involving the creation of notional tax items. regs. § 1.704-3(d)(5)(ii). [vol 3:3 use and abuse of section 704(c) treasury further stated that because of the elective nature of the remedial allocation method, it cannot be viewed as the baseline for measuring abuse.53 once the ceiling rule is considered inviolate, except at the election of the taxpayer, one might ask why the traditional method, which relies on treasury's basic principle of tax following book, can ever be considered abusive. only in ceiling-limited situations does the method fail to accomplish the stated purpose of section 704(c), and the treasury has accepted the ceiling rule as something it must live with. the answer lies in example 2 of the regulations. c. interpreting the examples of abuse the treasury's only guidance on the scope of the anti-abuse rule is that provided by the examples in the regulations. by varying the facts of example 2, it becomes apparent that the scope of the anti-abuse rule in the context of the traditional method is necessarily quite limited. in that example, the partnership sells the contributed property at the beginning of the second year, after its tax basis and book value have been reduced to zero by depreciation for the first year. assume that rather than selling the property, the cd partnership uses it for its entire useful life, at which point its value is zero. under the traditional method, the ceiling rule limits the allocations for year one, creating a tax/book disparity, because there is insufficient tax depreciation to match the noncontributor's (d's) book depreciation. as the property produces income over its useful life, d will include one half of the income from the property without any offsetting deduction for d's investment in the property. the effect of the ceiling rule, therefore, is to deny to d cost recovery deductions for $4,000 of its investment in the property, thereby shifting $4,000 of the built-in gain from c to d. unlike the example in the regulations, however, the shift of income to d occurs over the life of the property, not entirely in the year immediately following the contribution. does this variation on the facts invoke the anti-abuse rule? contrary to the view of some commentators,54 i do not believe it should. 53. in response to a comment suggesting that the remedial allocation method be used as a baseline, the preamble to the 1994 regulations states: "[tlhe irs and treasury believe that it would be inappropriate to adopt the remedial allocation method as a baseline for measuring whether the partners' aggregate tax liability has been reduced. such a baseline would make the remedial allocation method preeminent, undercutting its elective nature." t.d. 8585, supra note 26, at 121. 54. see mckee et al., supra note 49, 1 10.0413][b], at 510-55 (supp. 19951. 19961 florida tax review the anti-abuse applies only if tax items are allocated "with a view" to reducing the present value of the partners' taxes by shifting built-in gain or loss.55 in example 2, the proscribed "view" is described as an intention to take advantage of the disparity between the property's remaining recovery period and its economic life. the advantage derived from the disparity is not the fact of the ceiling rule shift of income, but the timing of the shift. and, it is not the ceiling rule that provides the abusive result, but the capital accounting rules dealing with cost recovery, for it is those rules that define the extent of the tax/book disparity. disregarding the plan to sell the property at the beginning of year two, the example merely illustrates a garden-variety ceiling rule shift; absent an acceleration of that shift through sale, the partners have not taken advantage of the difference between the cost recovery period and the useful life of the property. the planned sale does not cause the ceiling rule shift; it merely accelerates the shift. had the treasury viewed the shift alone as abusive, the sale would serve no purpose to the example. the effect of including the sale in the facts of the example is, therefore, to limit the scope of the anti-abuse rule to those situations where ceiling rule shifts are accelerated and not allowed to occur over the life of the property. had the treasury wished to extend the reach of the anti-abuse rule to all ceiling rule shifts of income to lower bracket taxpayers, example 2 could have been significantly simpler. true, even if the property is not sold, the shift reduces the present value of the partners' aggregate tax liability below that which it would have been had there been no ceiling limitation (i.e., had they used the remedial allocation method). but, to find that abusive is anomalous. how can taxpayers be penalized for not electing a method that treasury has stated it lacks the power to impose? to find abuse in this case would be nothing more than a back door repeal of the ceiling rule. thus, the distinguishing feature of example 2 appears to be not the fact of a shift of income, but the timing of the shift. apparently, the prohibited abuse occurs where the parties arrange the transaction with a plan to accelerate the shift of income. in this example, the event accelerating the shift is the sale, and the partners could have avoided the anti-abuse rule by allocating the gain on sale to the contributing partner.56 in addition, the 55. reg. § 1.704-3(a)(10). 56. just when the sale must occur to fall within the anti-abuse rule is unclear. for example, should the anti-abuse rule apply if the partnership sells the land in year three, rather than year two? the answer turns on whether the reduction in tax is "substantial" and whether the requisite "view" exists (i.e., whether the sale in year was three planned and sufficiently definite). if the useful life of the property is 10 years, a sale in year three might well result in a substantial reduction in the present value of aggregate tax liabilities, compared to that which would have been incurred had the property been held to the end of its useful life. if the [vol 3:3 use and abuse of section 704(c) regulations require that the allocations be made "with a view" to taking advantage of the disparity between recovery period and useful life. it thus appears that the scope of the anti-abuse rule is quite limited. unless the parties planned the sale at the time of the contribution, and unless the sale actually occurs substantially before the end of the property's useful life, use of the traditional method should be considered reasonable.17 analysis of example 3, illustrating unreasonable use of the traditional method with curative allocations, adds further support to the conclusion that the abuse potential is not in creating shifts of income, but in manipulating the timing of those shifts. as discussed above, in example 3, the curative allocation of $4,000 of sales income to the contributing partner in the first year eliminates the shift of income, but also has the effect of permitting the noncontributor to expense her investment in the contributed property in the first year. this is caused by the requirement that the full cost of the property be recovered for book purposes over the remainder of the contributor's recovery period (in this case, consisting of year one only), a rule that ignores the economic reality that the property has a significant remaining useful life. the regulations note that had the partnership agreement provided for curative allocations over the property's economic life, the allocations would have been reasonable. thus, had the allocations of sales income to j been made at the rate of $400 per year, rather than $4,000 in the first year, they would have property's useful life is three years, the sale in year three likely does not significantly reduce tax liabilities, and the rule should not apply. see regs. § 1.704-3(b)(2) ex. 2(ii. 57. example 2 could be seen as an application of the broader anti-abuse rule of § 1.701-2, which qualifies all of subchapter k. the interaction of c's view, c's and d's bracket position, and the quick sale suggest that c's contribution of low-basis. high-value equipment is driven not by the need of the partnership for this particular equipment for the conduct of its operations but by the favorable tax consequences that flow from the interaction. in this sense, contribution of the equipment (rather than cash or other liquid assets available to c): 1. might be regarded as inconsistent with the overall purpose of subchapter k (in the words of § 1.701-2(a), to "conduct joint business ... activities through a flexible economic arrangement") because use of the equipment in the partnership's business (as opposed to its sale) was not contemplated; 2. might contravene § 1.701-2(a)(1) as not made for "'a substantial business purpose" (as distinguished from the general need of the partnership for working capital which could as well be provided by money or other property contributed by c) and 3. might violate the clear reflection of income requirement of § 1.701-2(a)(3). applying the omnibus anti-abuse rule in this setting requires considerable speculation and second-guessing. presumably, as a general matter, it is not up to the government to decide for the partners' just what ingredients each brings to their combination to yield the greatest chance of success. in the § 704(c) context, the inquiry is more focused and requires less speculation. see regs. § 1.704-2(a). 19961 florida tax review been respected. this makes sense because, except for the first year's deduction of $1,000, k would, under that scenario, write off the cost of the equipment over its economic life. both the traditional method and the traditional method with curative allocations are based on the notion that tax allocations must follow book allocations, thereby taxing the noncontributor as though he had purchased an undivided interest in the property. where book allocations approximate economic income, this basic method taxes the partners economically, and cannot be abusive. the problems arise when book allocations bear little, if any, relationship to economic income, as is the case in both of the abuse examples. in the case of the traditional method, abuse arises only if the ceiling rule shifts are manipulated so as to occur over a period of time shorter than the property's economic life. in the case of the traditional method with curative allocations, abuse may exist if the curative allocations are made over a period substantially shorter than the economic life of the property. because the remedial allocation method requires that the remedial allocations be made over the recovery period for the property, it is not susceptible to abuse.58 d. the key: uneconomic rules of cost recovery the foregoing analysis of the anti-abuse rule indicates that it is intended to deal with problems of timing, not shifts of income per se. it is thus possible to limit the rule to situations where book allocations deviate significantly from economic reality. in both of the examples illustrating the rule, the most significant factors are the disparity between cost recovery period and useful life and the elimination of all built-in gain in one year.59 58. although the recovery periods of § 168 do not, nor were they intended to, reflect economic lives, the book recovery period dictated by the remedial allocation method for any excess of the contributed property's value over its basis-the recovery period under § 168 for newly purchased property-is far more likely to approximate economic life than is the remaining tax recovery period. mckee, nelson, and whitmire have suggested that the remedial allocation method may be abusive when depreciation on contributed property would not be ceiling limited, so that the contributor's depreciation under the remedial allocation method is greater than it would be under the traditional method. see mckee et al., supra note 49, 10.04[3][d] at 10-60. in the example they offer, the contributor's extra tax depreciation during the property's remaining recovery period is offset by later remedial allocations, a result which the authors suggest might be abusive if the contributor is taxable and the noncontributor is not. i disagree that use of the remedial allocation method falls under the anti-abuse rule in such a situation. while the contributor is described as receiving "extra" depreciation deductions under the remedial method as compared to the traditional method, the contributor, by entering into the partnership, gives up substantial depreciation deductions to the noncontributor, and it is difficult to imagine that the contribution would be made "with a view" to reducing the contributor's tax liability when her depreciation deductions are significantly reduced. 59. see joel scharfstein, an analysis of the section 704(c) regulations, 48 tax law. 71, 89 (1994). [vol. 3:3 use and abuse of section 704(c) it therefore becomes necessary to examine the cost recovery rules that create the abuses in the examples. in both examples, one year remains in the property's recovery period at the time of contribution, but economic life is substantially longer. the consequences of this discrepancy are, in example 2, that a sale in year two generates substantial tax gain with little if any economic gain and, in example 3, that the property generates substantial income after its tax basis has been reduced to zero. at first blush, it appears appropriate for the partnership to depreciate the property over its economic life; indeed, if it did so, the perceived abuses would disappear in both cases. to illustrate, consider the results if the partnership in example 3 depreciates its book basis of s10,000 and its tax basis of $1,000 on a straight line basis over the property's economic life of 10 years. in each year, it would have $1,000 of book depreciation, divided equally between the two partners, and $100 of tax depreciation which, under the traditional method, would be entirely allocated to k, the noncontributing partner. if the agreement contained a curative allocation of sales income to j equal to the ceiling-limited depreciation (of $400 per year), the capital accounts at the end of the first year would be as follows: j k tax book tax book initial balance $1,000 $10,000 $10,000 $10,000 depreciation 0 (500) (100) (500) sales income 4.400 4.000 3.600 4.000 $5,400 $13,500 $13,500 $13,500 the result is that the ceiling rule distortion ($400 annually) is contemporaneously eliminated by the curative allocation, but unlike example 3 in the regulations, k effectively deducts its investment in the property over the useful life of the property, rather than all in the first year. there is clearly nothing abusive in this result. it approximates the solution proposed in the regulations, but it goes one better, for in this example no book/tax disparity is ever created for k. similarly, in example 2, if the partnership's book and tax depreciation were spread over the property's economic life, the first year's book and tax depreciation would be $1,000 and $100, respectively. under the traditional method, the book depreciation would be divided equally between c and d, and the tax depreciation would be allocated entirely to c, the noncontributing partner. the planned sale in year two would result in book gain of $1,000 and tax gain of $9,100, of which $8,100 represents built-in gain that must be allocated to c. the book gain of $1,000 is allocated equally between c and d, as is the last $1,000 of tax gain. the effect on the capital accounts would be as follows: 19961 florida tax review c d tax book tax book initial balance $1,000 $10,000 $10,000 $10,000 depreciation 0 (500) (100) (500) sale 8,600 500 500 500 $9,600 $10,000 $10,400 $10,000 in this variation, instead of shifting $4,000 of c's precontribution gain to d, the parties have shifted only $400, a result unlikely to be considered abusive. the culprit leading to the abuses in the examples thus appears not to be any feature of section 704(c), but the depreciation methods used for book and tax purposes. the next obvious question, then, is why the treasury chose the section 704(c) regulations as the forum for eliminating these abuses. although the method of depreciation described above seems quite reasonable, it is not permitted by the code or the regulations. under code section 168(i)(7), the partnership is "treated as the transferor for purposes of computing the depreciation deduction ... with respect to so much of the basis in the hands of the transferee as does not exceed the adjusted basis in the hands of the transferor." thus, in the examples, where the contributing partner had $1,000 of basis in the property and one year left in its recovery period, the partnership's tax deduction for the first year must be $1,000, and cannot be computed over the useful life of the property. this rule does not, however, dictate how the partnership should compute its book depreciation. even if tax depreciation must be taken all in one year, the partnership could nevertheless use the useful life of the property as the measuring rod for book depreciation. were this the case, the first year's tax depreciation in example 3 would be $1,000, and the first year's book depreciation would also be $1,000. under the traditional method, both book and tax would be divided equally because this would provide d, the noncontributor, with tax depreciation equal to its share of book depreciation. on the sale for $10,000 in the second year, there is $9,000 of built-in gain, which can be entirely allocated to c under the traditional method. the remaining $1,000 of tax gain which matches the $1,000 of book gain would be divided equally. the effect on the capital accounts would be as follows: c d tax book tax book initial balance $ 1,000 $10,000 $10,000 $10,000 depreciation (500) (500) (500) (500) sale 9,500 500 500 500 $10,000 $10,000 $10,000 $10,000 thus, it appears possible to live with the rule of section 168(i)(7) and still avoid shifting of gain and losses; in this variation, the ceiling rule never [vol 3:3 use and abuse of section 704(c) comes into play. but consider the situation where the property is retained for its economic life. if book depreciation is based on the economic life of the property, tax depreciation in year one is again $1,000, and is again divided equally. in years two through ten, however, the ceiling rule applies, and even though k is entitled to $500 of book depreciation each year, there is no tax depreciation at all in those years. as a result, the capital accounts after the 10 years are as follows: c d tax book tax book initial balance $1,000 $10,000 $10,000 $10,000 depreciation (500) (5.000) (500) (5.000) $ 500 $ 5,000 $ 9,500 $ 5,000 the result is an even greater tax/book disparity in d's capital accounts than occurs under the method utilized by the regulations. this is caused by the fact that tax depreciation in the first year exceeds d's share of book depreciation, so that some of it is allocated to the contributing partner. thus, not only is the noncontributor deprived by the ceiling rule of sufficient tax depreciation to match its book depreciation, but some of the noncontributor's share is deducted by the contributing partner! the rules for calculating book depreciation are found in section 1.704-1(b)(2)(iv)(g)(3) of the regulations. when that regulation was first issued in 1985, it permitted just the result described above: book depreciation could be computed under any reasonable method, so long as, if the book value was greater than tax basis, book depreciation was not less than tax depreciation. the rules worked well so long as tax depreciation did not exceed the noncontributing partners' share of book depreciation. but when it did, as in the above example, the invariable result was the shifting of depreciation to the contributing partner, a sort of inverse ceiling rule problem. in an attempt to plug that particular hole in the revenue dike, the treasury revised the regulation to require that book depreciation be computed at the same rate as tax depreciation. it is because of this rule that the partnership in example 2 must, for book purposes, depreciate the property completely in the first year, even though its economic life is significantly longer. iv. conclusion so long as the ceiling rule is with us, policy considerations favor a narrow construction of the section 704(c) anti-abuse rule. if the rule is interpreted so broadly as to potentially apply to every transaction in which appreciated or depreciated property is contributed to a partnership, all such transactions will have to be tested against the regulations' stated purpose of section 704(c): preventing shifting of tax consequences among partners with 1996.1 florida tax review respect to precontribution gain or loss.' whenever the traditional method is used and the tax attributes of the contributed property are ceiling limited, the transaction would fail that standard, and the applicability of the anti-abuse rule would turn on the factually difficult issues of whether the requisite "view" was present and whether the resulting reduction in tax liability is "substantial." i do not believe that this would be in the best interest of the tax administration. transfers of assets of ongoing business enterprises are essential parts of many partnership formation transactions. if one accepts the treasury's recent statement of the intent of subchapter k-to "permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity level tax" 6 -allowing a free flow of property into and out of partnerships is an essential element. one of the most potent arguments in defense of the ceiling rule is that forcing contributing partners to include notional income items under some variation of a deferred sale method would violate the nonrecognition rule of section 721. moreover, given the frequency and importance of contribution transactions, the certainty of a rule-based structure is a substantial benefit in this context. much has been written outside of the tax field on the choice between drafting laws as detailed rules or as broad standards.62 the difference between the two approaches has been described as the difference between ex ante and ex post decision making: when a law is drafted as a rule, it is known in advance whether particular transactions or acts fall within or without the law. laws setting out only broad standards create less certainty. it is up to some decision maker-usually, a court or administrative body-to determine whether a transaction or act satisfies the standard. given the frequency with which property is contributed to partnerships, the costs of determining whether a transaction accomplishes or violates the purposes of section 704(c) could, if imposed on every contribution transaction, have the effect of discouraging partnership formations.63 the costs of enforcing such 60. see generally frederick schauer, exceptions, 58 u. chi. l. rev. 871, 893-98 (1991). 61. reg. § 1.701-2(a). 62. see, e.g., h.l.a. hart, the concept of law 126-31 (1961); ronald m. dworkin, the model of rules, 35 u. chi. l.r. 14 (1967); duncan kennedy, form and substance in private law adjudication, 89 harv. l.r. 1685 (1976); frederick schauer, playing by the rules: a philosophical examination of rule-based decisionmaking in law and in life (1991). 63. see louis kaplow, rules versus standards: an economic analysis, 42 duke l.j. 557, 621 (1992), in which professor kaplow concludes, "the central factor influencing the desirability of rules and standards is the frequency with which a law will govern conduct ... when behavior subject to the relevant law is frequent, standards tend to be more costly and result in behavior that conforms less well to underlying norms." [vol 3:3 use and abuse of section 704(c) a standard, in contrast to a clear and understandable rule, would be great as well. limiting the reach of the anti-abuse rule as proposed in this article would not leave the service helpless in the face of abusive transactions. so long as the ceiling rule exists, shifts of income will occur under section 704(c) in perfectly legitimate transactions, even though they might violate the stated purpose of section 704(c). the service will have to live with these shifts. however, where ceiling rule shifts are accelerated by taxpayers exploiting the treasury's own capital accounting rules, which ignore economic reality in calculating book depreciation, the anti-abuse rule may apply, as illustrated in the examples of the regulations. where the ceiling rule does not apply, the traditional method successfully taxes the noncontributor under an aggregate approach, thereby leaving no room for abuse. beyond these situations, except in those few cases where transactions are so contrived as to fall under the general partnership anti-abuse rule of section 1.701-2, the service should permit certainty in planning contributions of property to partnerships. 64 the problem posed in this article is of the treasury's own making. had the treasury abandoned the ceiling rule, the remedial allocation method could be required of all partnerships, and the section 704(c) regulations could be substantially simpler than they have turned out to be. because of its nod to economic reality in computing book items, the remedial allocation method leaves little, if any, opportunity for creating shifts of income. thus, i believe that abandonment of the ceiling rule would have been in the best interests of all. the treasury's refusal to create safe harbors from the section 704(c) antiabuse rule, and its insistence that all contribution transactions are potentially subject to that rule-which derive from its adherence to the ceiling rule-are in no one's best interests. there may be room for in terrorem tax regulations. for example, the passive loss regulations issued under section 469 have successfully eliminated many abusive transactions. some aspects of partnership taxation may deserve similar treatment. but, section 704(c) is too integral to the purpose and intent of subchapter k to be subject to such a rule. 64. section 1.701-2(b) requires that the provisions of subchapter k and the regulations thereunder be applied in a manner "'consistent with the intent of subchapter k" as enunciated in that regulation. this anti-abuse provision clearly has a broader reach than the § 704(c) anti-abuse rule, which limits its focus to the purpose of § 704(c). thus, even if an allocation method passes muster under the § 704(c) anti-abuse rule, it is subject to attack under the broader rule if the contribution transaction as a whole contravenes the intent of subchapter k. to the extent that § 1.701-2(b) is a codification of judicial doctrines, it is appropriate that merely satisfying the narrow § 704(c) anti-abuse rule should not insulate a contribution transaction from attack if it lacks substance. 19961 florida tax review appendix example i. a and b form an equal partnership to which a contributes land with a basis of $60 and a fair market value of $100 and b contributes $100 cash. the land was a capital asset in a's hands, and is also a capital asset in the partnership's hands. at formation, the partnership's balance sheet is as follows: assets liabilities and capital basis book cash $100 $100 land 60 100 $160 $200 capital accounts tax book a $ 60 $100 b 100 100 $160 $200 variation 1. the land in example i increases in value, and ab sells it for $120, realizing book gain of $20 and tax gain of $60. variation 2. the land in example i goes down in value, and ab sells it for $70, realizing book loss of $30 and tax gain of $10. example i: c and d form an equal partnership to which c contributes equipment (basis of $80 and value of $120) and d contributes $120 cash. the equipment originally had a 10-year recovery period, and c elected to use the straight line method of cost recovery. although only four years remain in the recovery period at the time of the contribution, the equipment would have had a 10-year recovery period if cd had purchased it on the date of formation. upon formation, cd's balance sheet is as follows: assets liabilities and capital basis book equipment $ 80 $120 cash 120 120 $200 $240 capital accounts tax book a $ 80 $120 b 120 120 $200 $240 [vol 3:3 1996] use and abuse of section 704(c) 127 variation 1: c's adjusted basis in the equipment at the time of contribution is $40, rather than $80. thus, cd's initial adjusted basis in the equipment is also $40, and cd is permitted only $i0 of annual depreciation for tax purposes. for each of its first four years, cd has $20 of ordinary business income before taking depreciation into account. * professor of law, university of houston law center. ** clarence j. teselle professor of law, university of florida fredric g. levin college of law. 627 florida tax review volume 5 2002 special issue recent developments in federal income taxation: the year 2001 ira b. shepard* martin j. mcmahon, jr.** i. accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629 a. accounting methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629 b. inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631 c. installment method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635 d. year of receipt or deduction . . . . . . . . . . . . . . . . . . . . . 636 ii. business income and deductions . . . . . . . . . . . . . . . . . . . . 638 a. income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638 b. deductible expenses versus capitalization . . . . . . . . . . 640 c. reasonable compensation . . . . . . . . . . . . . . . . . . . . . . . 646 d. miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . 648 e. depreciation and amortization . . . . . . . . . . . . . . . . . . . 652 f. credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 653 g. natural resources deductions & credits . . . . . . . . . . . 657 h. loss transactions, bad debts and nols . . . . . . . . . . . . 661 i. at-risk and passive activity losses . . . . . . . . . . . . . . . . 663 iii. investment gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 665 a. capital gain and loss . . . . . . . . . . . . . . . . . . . . . . . . . . 665 b. interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670 c. section 1031 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671 d. section 1041 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672 iv. compensation issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 678 a. employee compensation: fringe benefits and qualified plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 678 b. section 83 and stock options . . . . . . . . . . . . . . . . . . . . . 683 c. individual retirement accounts . . . . . . . . . . . . . . . . . . . 685 v. personal income and deductions . . . . . . . . . . . . . . . . . . . 687 a. miscellaneous income . . . . . . . . . . . . . . . . . . . . . . . . . . 687 b. profit-seeking individual deductions . . . . . . . . . . . . . . 690 c. hobby losses and § 280a home office and vacation homes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 696 d. deductions and credits for personal expenses . . . . . . . 697 628 florida tax review [vol.5:si e. education: helping pay college tuition (or is it helping colleges increase tuition?) . . . . . . . . . . . . . . . . . 699 vi. corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 702 a. entity and formation . . . . . . . . . . . . . . . . . . . . . . . . . . . 702 b. distributions and redemptions . . . . . . . . . . . . . . . . . . . 703 c. liquidations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 705 d. s corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 705 e. affiliated corporations . . . . . . . . . . . . . . . . . . . . . . . . . 709 f. reorganizations and corporate divisions . . . . . . . . . . . 714 g. personal holding companies and accumulated earnings tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 721 h. miscellaneous issues . . . . . . . . . . . . . . . . . . . . . . . . . . . 722 vii. partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 724 a. formation and taxable years . . . . . . . . . . . . . . . . . . . . 724 b. allocations of distributive share, partnership debt, and outside basis . . . . . . . . . . . . . . . . . . . . . . . . . 725 c. sales of partnership interests, liquidations and mergers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 727 d. partnership audit rules . . . . . . . . . . . . . . . . . . . . . . . . . 728 viii. tax shelters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 731 a. corporate tax shelters . . . . . . . . . . . . . . . . . . . . . . . . . 731 b. individual tax shelters . . . . . . . . . . . . . . . . . . . . . . . . . 750 ix exempt organizations and charitable giving . . . . . . . 751 a. exempt organizations . . . . . . . . . . . . . . . . . . . . . . . . . . 751 b. charitable giving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 754 x. tax procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 755 a. penalties and prosecutions . . . . . . . . . . . . . . . . . . . . . . 755 b. discovery: summonses and foia . . . . . . . . . . . . . . . . . 756 c. litigation costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 756 d. statutory notice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 757 e. statute of limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . 757 f. liens and collections . . . . . . . . . . . . . . . . . . . . . . . . . . . 758 g. innocent spouse relief . . . . . . . . . . . . . . . . . . . . . . . . . . 761 h. miscellaneous . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 766 xi. withholding and excise taxes . . . . . . . . . . . . . . . . . . . . . . 770 a. employment taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 770 b. excise taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 775 2002] recent developments in federal income taxation 629 1. this outline is based on prior current developments outlines presented by the authors at numerous continuing legal education conferences over the past year. among the conferences at which one or both of the authors presented current developments based on this outline during the year 2001: aba tax section midyear meeting, american institute on federal taxation, american petroleum institute, denver tax institute, houston bar association tax section, lewis and clark northwestern school of law tax conference, university of north carolina tax institute, southern federal tax institute, southwestern legal foundation institute on oil and gas law and taxation, state bar of texas tax section, tax executives institute, tennessee tax institute, texas society of cpas (austin chapter) institute, tulane tax institute, university of virginia conference on federal taxation, wednesday tax forum (houston), william & mary tax conference. this current developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the year 2001.1 most treasury regulations, however, are so complex that they cannot be discussed in detail; only the basic topic and fundamental principles are highlighted. amendments to the internal revenue code generally are not discussed except to the extent that they have either led to administrative rulings and regulations or have affected previously issued rulings and regulations otherwise covered by the outline. the outline focuses primarily on topics of broad general interest � income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, but generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. i. accounting a. accounting methods 1. final word on that otherworldly accounting method. t.d. 8929, accounting for long term contracts, 66 f.r. 2219 (1/11/01). the treasury has promulgated final regulations [regs. §§ 1.460-1 through 1.460-6] under § 460. [these regulations were proposed in reg-208156-91, 64 f.r. 24096 (5/5/99).] the final regulations generally follow the proposed regulations with a number of modifications. costs are allocated to long-term contracts under a single standard linked to the uniform capitalization rules of § 263a. subcontracted costs are either direct material or direct labor costs that must be allocated. the look-back rule is modified to apply first in the year in which the long-term 630 florida tax review [vol.5:si contract is completed and accepted. hybrid contracts involving both the manufacture of personal property and the construction of real property can electively be reported under the percentage of completion method. if the customer breaches before completion, previously reported gross income is reversed and the adjusted basis of the retained property equals previously deducted costs. 2. proposed regulations on adopting and changing taxable years. reg-106917-99, changes in accounting periods, 66 f.r. 31850 (6/13/01). the treasury has published proposed amendments to regulations under §§ 441, 442, 706, and 1378 regarding the requirement to obtain the approval of the commissioner to adopt, change, or retain an annual accounting period. prop. reg. §§ 1.441-1 through 1.441-4 generally are substantively the same as temp. reg. §§ 1.441-1t through 1.441-4t, including the general rules for the period for computing tax, numerous definitions, and the requirement that partnerships, s corporations, and pscs generally must demonstrate a business purpose and obtain approval to adopt or retain a taxable year other than their required taxable year, but the proposed regulations are reorganized. � prop. reg. § 1.441-1(c) provides that a taxable year is adopted by filing the first federal income tax return using that taxable year. filing an application for an ein, filing an extension, or making estimated tax payments, indicating a particular taxable year would not constitute an adoption of that year. rev. rul. 57-589 (1957-2 c.b. 298), and rev. rul. 69563 (1969-2 c.b. 104), holding that the filing of an extension and estimated tax payments establishes a taxable year, will be superseded. � the proposed regulations under § 442 continue to require that the taxpayer demonstrate a business purpose for changing taxable years. the proposed regulations use the term �business purpose� rather than the �substantial business purpose� of the temporary regulations, but, according to the preamble, the treasury does not intend the language change to change the standard. under prop. reg. § 1.442-1(b), form 1128 would have to be filed by the 15th day of the third [rather than second] month of the first effective [the short] year. the automatic approval provisions have been deleted in favor of the standards of rev. proc. 2000-11, 2000-3 i.r.b. 309. � prop. reg. § 1.706-1 reflects the 1986 act�s required taxable year rules and the least aggregate deferral standard. generally speaking, the substantive rules incorporate temp. reg. § 1.706-1t, but the proposed regulations elaborate the standards for determining a partner�s interests in profits and capital for purposes of applying those tests � income interests are determined with respect to taxable income, not book income, and capital interests are determined with respect to a hypothetical liquidation. 2002] recent developments in federal income taxation 631 procedural rules for requesting a year other than a required year have been removed in favor of the prop. reg. § 1.442-1 procedures. � prop. reg. § 1.1378-1 would not implement any substantive changes, but procedural rules for requesting a year other than a required year have been removed in favor of prop. reg. § 1.442-1 procedures. a. notice 2001-34, 2001-23 i.r.b. 1302 (6/4/01). the irs has published a proposed revenue procedure dealing with procedures under § 442 for taxpayers outside the scope of the revenue procedures providing automatic approval to adopt, change, or retain, a taxable year [see, e.g., rev. proc. 200011, 2000-3, i.r.b. 309; notice 2001-35, 2001-23 i.r.b. 1314, and rev. proc. 66-50, 1966-2 c.b. 1260] to establish a business purpose and request approval to adopt, change, or retain a taxable year. under the proposed revenue procedure, the irs would no longer weigh the merit of a taxpayer�s stated business purpose against the amount of distortion of income. taxpayers generally would be granted approval to adopt, change to, or retain a natural business year under the proposed revenue procedure. establishing a natural business year generally will be the only circumstance under which a partnership, s corporation, electing s corporation, or psc will be granted approval. other taxpayers that do not establish a natural business year generally would be granted approval under the proposed revenue procedure if they agree to certain additional terms, conditions, and adjustments designed to neutralize the tax effects of substantial distortion of income resulting from the change. b. notice 2001-35, 2001-23 i.r.b. 1314 (6/4/01). this notice provides a proposed revenue procedure that will provide the procedures under § 442 for certain partnerships, s corporations, electing s corporations, and pscs to obtain automatic approval to adopt, change, or retain their taxable years. when finalized, the revenue procedure will supersede rev. proc. 87-32, 1987-2 c.b. 396. 3. brookshire brothers holding, inc. v. commissioner, t.c. memo. 2001-150 (6/22/01). the taxpayer filed amended returns changing its cost recovery period for convenience stores from 31.5 and 39 years to 15 years, as permitted by a specialized program coordinated issue paper. the irs asserted that the change required consent under § 446(e), but the tax court (judge nims) held that treas. reg. § 1.446-1(e)(2)(ii)(b) [providing that a change of useful life is not an accounting method change] applied to changing the § 168 acrs cost recovery period. 632 florida tax review [vol.5:si b. inventories 1. this one �floors� us; now carpets are not inventory, tomorrow. smith v. commissioner, t.c. memo. 2000-353 (11/14/00). a flooring contractor who installed custom ordered, and often custom designed, flooring was not required to maintain inventories or to use the accrual method. judge wells found that smith carpets was a service provider because all floor coverings were specially ordered from the manufacturer to the customer�s specifications and even though the taxpayer maintained a warehouse [to store the flooring pending installation], it did not maintain a stock of goods to sell to the public merchandise within the meaning of reg. § 1.471-1 [although it did maintain a stock of supplies, e.g., padding, glue, etc.] racmp enterprises, inc. v. commissioner, 114 t.c. 211 (2000), was held to be controlling. a. irs changes its litigating position. chief counsel notice cc-2001-10 (2/9/01). until further guidance is issued, the irs will not assert that taxpayers in businesses similar to those in smith are required to use inventory accounts and an accrual method of accounting. the notice specifically applies to construction contractors involved in paving, painting, roofing, drywall, and landscaping. the policy does not apply to taxpayers that are resellers, manufacturers, or otherwise required by § 448 to use an accrual method of accounting [such as c corporations with gross receipts of $5 million or more]. 2. irs ends the small-dollar aspect of its crusade against the cash method, but continues the crusade against �small� taxpayers with gross receipts between $1 million and $5 million. rev. proc. 2001-10, 2001-2 i.r.b. 272 (1/8/01), modifying and superseding rev. proc. 2000-22, 2000-20 i.r.b. 1008 (4/28/00). the commissioner will exercise his discretion to except a �qualifying taxpayer,� i.e., one with average annual gross receipts of $1 million or less [as determined under reg. § 1.448-1t(f)(2)(iv)] from the requirements of accounting for inventories and using an accrual method of accounting for purchases and sales of merchandise. a business that adopts the cash method under this revenue procedure will treat inventory items as materials and supplies that are not incidental under reg. § 1.162-3. this means that the taxpayer must capitalize the cost or actual purchases of goods or materials to be resold or incorporated into manufactured products and offset the capitalized amounts against the amount realized when the goods are resold, but the taxpayer may deduct currently all other manufacturing and handling costs (including labor, warehousing, and other direct and indirect costs that normally must be capitalized under § 263a). an automatic change in accounting method to the cash method under rev. proc. 2000-22 is available under rev. proc. 992002] recent developments in federal income taxation 633 49, 1999-2 c.b. 725. small businesses using an accrual method of accounting that are not required under § 471 to account for inventories may use the automatic consent provisions to change to the cash method. these procedures are effective for tax years ending after december 16, 1999. 3. the small-dollar limit goes up to $10 million of gross receipts, but with significant exceptions. notice 2001-76, 2001-52 i.r.b. 613 (12/11/01). pursuant to the discretion granted the commissioner under §§ 446 and 471, this notice provides a proposed revenue procedure that will allow qualifying small business taxpayers with �average annual gross receipts� of more than $1 million but less than $10 million to use the cash receipts and disbursements method of accounting as described in the proposed revenue procedure with respect to eligible trades or businesses. � ineligible businesses include ones that derive the largest percentage of gross receipts from any of the following activities: (a) mining activities within the meaning of naics codes 211 and 212; (b) manufacturing within the meaning of naics codes 31-33; (c) wholesale trade within the meaning of naics code 42; (d) retail trade within the meaning of naics codes 44-45; and, (e) information industries within the meaning of naics codes 5111 and 5122. a. notice 2001-76 will be available for 2001. notice 2002-14, 2002-8 i.r.b. 548 (2/1/02). the change in method permitted under notice 2001-76 will be available for any taxable year ending on or after 12/31/01. taxpayers must attach a form 3115 to a timely filed (including extensions) income tax return, file a duplicate copy with the internal revenue service's national office, and comply with the provisions of rev. proc. 2002-9, 2002-3 i.r.b. 327. 4. mom-and-pop bulk fuel dealers still must maintain inventories and use the accrual method. cross oil co. v. commissioner, t.c. memo. 2001-126 (5/30/01). the commissioner did not abuse his discretion in requiring an oil and gas distributor to maintain inventories and use the accrual method. the taxpayer, whose gross receipts were between $2 and $3 million, generally maintained an inventory of not more than 2 and ½ weeks worth of goods and had most oil and gas loaded at the refinery and delivered directly to customers. the taxpayer�s business was the sale and delivery of merchandise, and there was not a substantial identity of results between the taxpayer�s hybrid method and the required method. 5. judge chiechi writes a treatise on taxpayer�s impermissible use of lifo inventory. consolidated manufacturing, inc. v. commissioner, 111 634 florida tax review [vol.5:si t.c. 1 (7/20/98). an automobile parts remanufacturer sold reconditioned automobile engines, transmissions, etc. it purchased most of the parts it used, except that it received most of the used engines, used transmissions, and similar used parts it reconditioned (taxpayer�s �used core inventory�), as trade-ins from customers in exchange for a relatively high price reduction in goods sold to customers. (this, of course, meant that the cost of taxpayer�s used core inventory was relatively high.) taxpayer employed a method of reporting the bulk of its goods inventory under lifo, except that it reported its used core inventory under fifo (and lower-of-cost-or-market). the commissioner determined that the taxpayer�s inventory method was contrary to the regulations under § 472 and did not clearly reflect income; the commissioner also determined that the lifo election should be terminated. judge chiechi held that taxpayer�s method of accounting did not clearly reflect income because it contravened § 472 and the regulations thereunder. the commissioner did not abuse her discretion under § 446(b) in terminating the lifo election even though the method might have been acceptable under gaap. reg. § 1.472-1(c) � permitting a lifo election to apply only to costs of all or some of raw materials incorporated into finished goods, while other costs are taken into account under fifo � did not authorize taxpayer�s method, which purported to apply lifo to labor and overhead and some raw materials but fifo to other raw materials. under the taxpayer�s method, lifo did not apply to any entire good, either raw material or finished; and the regulations do not authorize taking labor and overhead into account under lifo separately. the court determined that the �purchase cost� of core parts acquired in exchange-like transactions involving the sale of remanufactured parts in exchange for cash and used core parts to be the stated credit price for the core parts. the commissioner did not abuse her discretion in determining that the lower of cost or market for core parts was determined under reg. § 1.471-4(a) as the bid price for replacement core parts in the market in which it acquired them, not at the scrap amount at which it carried a substantial number of core parts. a. and the tenth circuit says she got it right for the most part. affirmed in part, reversed in part. 249 f.3d 1231, 87 a.f.t.r.2d 2111, 2001-1 u.s.t.c. ¶ 50,400 (10th cir. 5/8/01). the court of appeals agreed that reg. § 1.472-1(a) did not permit the mixed lifo / fifo method employed by the taxpayer and that the commissioner did not abuse her discretion by terminating the taxpayer�s lifo election. with respect to the tax court�s holding that the commissioner did not abuse her discretion in determining that under reg. § 1.471-4(a), the lower of cost or market for core parts was the bid price for replacement core parts in the market in which it acquired them [i.e., the price it paid its customers, from which it acquired a majority of its cores], however, the court of appeals reversed, on the grounds that the 2002] recent developments in federal income taxation 635 commissioner�s method did not clearly reflect income. but the court did not accept the taxpayer�s argument that the �market� was the salvage yard market, since the taxpayer did not purchase cores in that market. [on appeal the taxpayer conceded that its original method of valuing a substantial number of core parts at scrap value did not clearly reflect income.] although the taxpayer�s customer price reflected �price,� as far as �market� was concerned, the proper market was the professional supplier market (as adjusted for certain differences such as transportation and guarantees), because that was the only �open market� in which the taxpayer acquired any cores. the case was remanded for market valuation, and comparison with price, under this standard. 6. she went to the animal fair . . . the elephant sneezed . . . and that was the end of her accounting method. suzy�s zoo v. commissioner, 273 f.3d 875, 2001-2 u.s.t.c. ¶ 50,766, 88 a.f.t.r.2d 6916 (9th cir. 11/21/01), aff�g 114 t.c. 1 (1/6/00). the court of appeals (judge sneed) affirmed the tax court�s decision that the �small reseller� exception to § 263a provided in § 263a(b)(2)(b) did not apply to greeting card business that produced cartoon characters and contracted with independent printers for production of cards and other products bearing the characters likenesses according to taxpayer�s standards. even though the contracts provided that printers owned materials and bore risk of loss during production, taxpayer owned the images and had exclusive rights to the cards; the printers had no right to sell produced cards or cartoon characters to anyone other than taxpayer. thus, the taxpayer was the �producer� of the cards, not a small �reseller� to whom the § 263a(b)(2)(b) exception applied. all costs were subject to capitalization under § 263a. for purposes of the § 481 adjustment, pursuant to § 803(d) of the tra �86, the year of the change was the year ending june 30, 1994, the subject year, not the year ended june 30, 1987, the taxpayer�s first year after the effective date of § 263a. c. installment method 1. the tax relief extension act of 1999 amended § 453 by adding new § 453(a)(2) denying accrual method taxpayers the privilege of installment reporting on any sales of property whatsoever. even though the taxpayer uses the accrual method, however, § 453(a)(2) does not disallow the installment reporting under § 453(l) for dispositions of property used or produced in the trade or business of farming or dispositions of residential lots or time-share condominium units. a. the installment tax correction act of 2000, signed december 28, 2000, retroactively repealed the 1999 addition of § 453(a)(2) and 636 florida tax review [vol.5:si restored the availability of § 453 installment reporting to accrual method taxpayers on the same basis that it was available before the 1999 legislation. b. automatic consent to revoke elections out of installment method. notice 2001-22, 2001-12 i.r.b. 911 (3/19/01). an accrual method taxpayer that entered into an installment sale on or after december 17, 1999, and filed a federal income tax return by april 16, 2001, reporting the sale on the accrual method may revoke its election out of § 453. the taxpayer must file, within the applicable period of limitations, amended federal income tax returns for the taxable year in which the installment sale occurred, and for any other affected taxable year, reporting the gain on the installment method. d. year of receipt or deduction 1. t.d. 8917, section 467 rental agreements involving payments of $2,000,000 or less, 66 f.r. 1038 (1/5/01). former reg. § 1.467-3(b)(1)(iii) provided that if a lease did not require more than $2 million of rent and other consideration and all payments are due in the year to which the rent relates or the preceding or succeeding year, the effect of § 467 was limited to requiring both the lessor and the lessee to take the rent into account in the year to which it relates rather than in the year in which it is paid, thus exempting such leases from the rent-leveling rules. this $2 million safe harbor has been eliminated from the regulations, effective for leases entered into on or after july 19,1999. 2. credit card fees are not payments for �services� under rev. proc. 71-21. american express co. v. united states, 47 fed. cl. 127, 2000-2 u.s.t.c. ¶ 50,575, 86 a.f.t.r.2d 5217 (6/30/00). before 1987, the taxpayer included annual credit card fees in income when the fees were billed. in 1987 the taxpayer changed its method of accounting on the basis of fasb 91 to include the fees ratably over the 12-month period for which they were billed and sought the commissioner�s approval for the change in accordance with rev. proc. 71-21, 1971-2 c.b. 549. the court of federal claims held that the commissioner�s denial of the request was within his discretion, on the ground that rev. proc. 71-21 and g.c.m. 39434 (10/25/85) provide an adequate basis for the determination that the fees were not for services. the g.c.m. viewed card fees as payments for credit, not as payments for �contingent services.� � the court held that barnett banks of florida, inc. v. commissioner, 106 t.c. 103 (1996) (allowing ratable inclusion of refundable credit card fees) was decided on its own facts [which are, in fact, difficult to distinguish] and did not as a mater of law require overturning the 2002] recent developments in federal income taxation 637 2. chevron, usa, inc. v. natural resources defense council, 467 u.s. 837 (1984). commissioner�s discretion in this case. the court further noted that the barnett banks court did not �fully address[] the question of whether there was an adequate basis for the commissioner�s exercise of discretion under rev. proc. 71-21� and that the court of federal claims will not make close factual judgments where there is no abuse of discretion. a. affirmed. irs interpretation of its own regulations is entitled to substantial deference, even if chevron deference was not earned. 262 f.3d 1376, 88 a.f.t.r.2d 5568, 2001-2 u.s.t.c. ¶ 50,596 (fed. cir. 8/23/01). the federal circuit (judge dyk) affirmed, describing the sole issue as �whether the irs properly interpreted its own revenue procedure by treating �services� as not including fees for the acquisition of credit.� even though under the standards of united states v. mead corp., 121 s.ct. 2164, 2171 (2001), �[t]he interpretation of rev. proc. 71-21 contained in the general counsel memorandum and the irs decision under the revenue procedure is not reflected in a regulation adopted after notice and comment and probably would not be entitled to chevron2 deference,� �[t]he supreme court has firmly established that agency interpretations of their own regulations are entitled to substantial deference.� the court distinguished hewlett-packard co. v. united states, 71 f.3d 398 (fed. cir. 1995) [rejecting the commissioner�s determination that a taxpayer�s pool of rotable spare parts used to repair computers it had sold was inventory rather than a § 1231 asset] as involving a factual determination, not an interpretation of a regulations. the court rejected the tax court�s holding in barnett banks of florida, inc. v. commissioner, 106 t.c. 103 (1996) that the annual fee payments received by a credit card company qualified as �services� under rev. proc. 71-21. 3. wicor, inc. v. united states, 263 f.3d 659, 2001-1 u.s.t.c. ¶ 50,576, 88 a.f.t.r.2d 5474 (7th cir. 8/14/01), aff�g 116 f.supp.2d 1028, 86 a.f.t.r.2d 6567, (e.d. wis. 2000). section 1341 does not apply to the restoration to a utility of prior years� overcharges through reduced rates in future years. there was no payment in the later year to which to apply § 1341; the taxpayer merely realized less gross income than it otherwise would have. 4. elective deferral rules are not available without adhering to the conditions. bob wondries motors, inc. v. commissioner, 268 f.3d 1156, 88 a.f.t.r.2d 6489, 2001-2 u.s.t.c. ¶ 50,733 (9th cir. 10/23/01). the taxpayerautomobile dealers elected to report income and deductions on extended warranty agreements under the �service warranty income� method of rev. proc. 638 florida tax review [vol.5:si 3. 131 f.2d 966 (1st cir. 1942). 92-98, 1992-2 c.b. 512, and rev. proc. 92-97, 1992-2 c.b. 510, which permit deferral of customer receipts in turn paid for insurance [to which is added an interest factor] over the life of the agreement [but not more than six years]. however, the taxpayer deviated from rev. proc. 92-97 by amortizing in the first year a full year�s worth of the insurance premium expense rather than a prorated amount based on the actual date of the contract. the ninth circuit affirmed the tax court�s decision upholding the commissioner�s disallowance of the deferral method. elective deferral rules are not available without adhering to the conditions. 5. boylston market3 reigns in the tax court. u.s. freightways corp. v. commissioner, 113 t.c. 329 (11/2/99). an accrual method trucking company was required to capitalize expenditures for licenses and insurance that had an effective period extending beyond the tax year. judge nims held that taxpayer�s argument � whether or not the argument is well taken � that the expenditures should be currently deductible if their benefit extends �less than 12 months into the subsequent tax period� is inapplicable to an accrual method taxpayer. judge nims relied, however, on § 263 and the capitalization rules, rather than on the �clear reflection of income� standard of § 446(b), which also was argued by the commissioner. a. but maybe not in the seventh circuit. u.s. freightways reversed on the capitalization holding and remanded to see if the same result follows under the �clear reflection of income� standard. 270 f.3d 1137, 88 a.f.t.r.2d 6703, 2001-2 u.s.t.c. ¶ 50,731 (7th cir. 2001). the seventh circuit court of appeals (judge wood) reversed the tax court�s decision that § 263 required that the deduction be prorated over the two taxable years. judge wood found the tax court�s distinction of how the capitalization rules applied to cash method taxpayers and accrual method, which resulted in capitalizing u.s. freightways� expenses when like expenses of a cash method taxpayer might not have been required to be capitalized [a point that the tax court did not concede but accepted arguendo for this case] to be untenable. the court of appeals remanded the case to the tax court to consider whether the deduction nevertheless should be prorated over the two taxable years under the "clear reflection of income� standard of § 446(b). ii. business income and deductions a. income 2002] recent developments in federal income taxation 639 1. rev. rul. 2001-20, 2001-18 i.r.b. 1143 (4/10/01). the �purpose� requirement under reg. § 1.110-1(b)(3) does not require a lease agreement to provide that the entire construction allowance is for the purpose of constructing or improving qualified long-term real property. however, only the portion of the construction allowance actually so expended may qualify. 2. a self-inflicted tax wound. catalano v. commissioner, 240 f.3d 842, 2001-1 u.s.t.c. ¶ 50,233, 87 a.f.t.r.2d 2001-874 (9th cir. 2/14/01) (per curiam). the taxpayer, an attorney, leased three yachts to his wholly owned s corporation, which in turn used the yachts for entertaining clients. not surprisingly, the s corporation�s deduction for rental payments was disallowed as expenses for �entertainment facilities� that are nondeductible under § 274(a)(1)(b). also, not surprisingly, the taxpayer nevertheless was required to include the rental receipts in gross income. 3. gaap, schmap! westpac pacific foods v. commissioner, t.c. memo. 2001-175 (7/16/01). the taxpayer was required to include in gross income cash payments received from various manufacturers as �advance trade discounts� upon agreeing to use the manufacturer as its primary or exclusive supplier for various products to be sold in its retail stores. the tax court (judge vasquez) held that reg. § 1.471-3(b), providing that only net invoice price be taken into account in inventory costs, did not justify an exclusion of amounts received that are not related to the purchase of specific goods. that the taxpayer�s accounting method followed gaap did not save the day. 4. money now, taxes, later. nice result, if you can get. smartheath, inc. v. commissioner, t.c. memo. 2001-145 (6/20/01). customer overpayments that were commingled with the taxpayer�s other receipts and routinely applied against the customers� future orders were not includable under the claim of right doctrine because the taxpayer would have been willing to refund the overpayments if requested. 5. apportioning basis to an expectancy. gladden v. commissioner, 262 f.3d 851, 2001-2 u.s.t.c. ¶ 50,597, 88 a.f.t.r.2d 5543 (9th cir. 8/20/01), rev�g and remanding 112 t.c. 209 (4/15/99). the taxpayer was a partner in a partnership engaged in farming that received (indirectly) from the department of the interior payments in exchange for surrender of its rights to a water allotment from the colorado river, which were appurtenant to the land. the tax court held that the gain was a capital gain because the water rights were a property interest. the commissioner�s argument that the transaction resulted in ordinary income under commissioner v. p.g. lake, inc., 356 u.s. 260 (1958), was rejected because use of the water rights themselves did not 640 florida tax review [vol.5:si 4. 503 u.s. 79 (1992). directly produce ordinary income. they were simply one component of the taxpayer�s investment in its business. even though the amounts were received in exchange for the surrender of the rights back to the interior department and the court referred to the payments received by the taxpayer as �relinquishment funds,� there was no discussion of the fact that the rights were terminated in favor of the granting party rather than transferred to a third party in which they continued and therefore arguably there was no �sale or exchange.� (under the 1997 amendments to § 1234a, the surrender of an interest in property would be deemed a �sale or exchange.�) the tax court held, however, the taxpayer, who acquired the land in 1976 and acquired the appurtenant water rights in 1983, could not allocate any portion of the basis of the land to the water rights [under reg. § 1.61-6(a)] to offset the amount realized on the disposition of the water rights in 1992 because the water rights were not vested at the time the land was purchased. � the only issue on appeal was whether the taxpayer could allocate any portion of the basis of the land to the water rights. the ninth circuit (judge fletcher) disagreed with the conclusion that no portion of the basis of the land could be allocated to the water rights. it reasoned that if there had not been an expectation of a subsequent allocation of water rights to the land at the time of its purchase, none of the cost of the land would have been apportionable to the water rights. but because there was an expectation of a subsequent allocation of water rights to the land at the time of its purchase, the land could have commanded a premium that properly should have been allocated to the basis of the water rights. the ninth circuit refused to follow inaja land co., ltd. v. commissioner, 9 t.c. 727 (1947), and permit each taxpayer to apply the amount received against his basis in the land. instead, it remanded for a trial to determine what portion of the cost of the land was a premium paid for the water rights later acquired, or whether it is �impracticable or impossible� to determine what that premium may have been. b. deductible expenses versus capitalization indopco4 aftermath: �deductions are exceptions to the norm of capitalization.� (blackmun, j.) 1. extending expensing of certain environmental remediation costs. as originally enacted in 1997, § 198, �expensing of environmental remediation costs . . . which [are] paid or incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site,� applied only 2002] recent developments in federal income taxation 641 to expenditures paid or incurred between 8/5/97 and 12/31/00. in 1999, congress extended the provision�s sunset date to 12/31/01. a. in the community renewal tax relief act of 2000, p.l. 106-554, the expiration date of this provision was extended until the end of 2003 and the targeted area requirement was eliminated. this means that expenditures paid or incurred after december 21, 2000, with respect to any brownfields site � but not including a cercla site � certified by a state environmental agency qualify for expensing under § 198. b. the 2001 act extended the expensing under § 198 of environmental remediation costs for brownfields sites through 12/31/01. 2. �+*fly the repaired skies of . . . . +* rev. rul. 2001-4, 2001-3 i.r.b. 295 (12/22/00). the irs provided significant guidance regarding the dividing line between repair costs deductible under § 162 and replacement and rehabilitation costs that must be capitalized. the ruling dealt with costs incurred by an airline with respect to work on aircraft airframes in three specific situations involving fully depreciated aircraft. at the time the aircraft were placed in service, it was anticipated that, if maintained, they would be useful for up to 25 years, although they were depreciable under §§ 167 and 168 over seven years. the irs ruled that heavy maintenance expenses generally are deductible under § 162. but costs incurred in conjunction with a heavy maintenance visit must be capitalized to the extent they materially add to the value of, substantially prolong the useful life of, or adapt the airframe to a new or different use. costs incurred as part of a plan of rehabilitation, modernization, or improvement also must be capitalized. � in the first situation, a heavy maintenance, taking 45 days, was performed for the purpose of preventing deterioration of the inherent safety and reliability levels of the airframe. the aircraft was substantially disassembled, inspected, repaired, and reassembled, after which it was tested, and returned to service. although numerous parts were replaced, the maintenance visit did not extend the useful life of the airframe beyond the originally anticipated 25-year useful life, but merely kept it in an efficient operating condition. it was used for the same purposes and in the same manner as prior to the maintenance. the expenses were fully deductible. � in the second situation, significant wear and corrosion of fuselage skins necessitated replacement of a significant portion of all of the skin panels of the aircraft, and the work performed materially added to the value of the airframe. while the aircraft was disassembled for the heavy maintenance, it was upgraded by the addition of a cabin smoke and fire detection and suppression system, a ground proximity warning system, and an 642 florida tax review [vol.5:si air phone system to enable passengers to send and receive voice calls, faxes, and other electronic data while in flight. the expenses incurred with respect to this aircraft had to be allocated between the deductible heavy maintenance and the skin replacement and electrical upgrades, which had to be capitalized. � in the third situation, the aircraft, which was 22 years old and nearing the end of its anticipated useful life, was substantially improved to increase its reliability and extend its useful life. all of the expenses, including what otherwise would have been deductible routine heavy maintenance expenses, on the third aircraft had to be capitalized as part of a plan of general rehabilitation and modernization that materially increased the value and life of the aircraft. in addition, because the work was considered the production of property, under § 263a, allocable indirect costs as well as direct costs had to be capitalized. 3. �[t]he exercise of . . . a sound and reasonable business practice under which a taxpayer . . . acts to minimize its recurring operating costs is not a significant future benefit that requires capitalization of the related nonasset-producing expenditures.� metrocorp, inc. v. commissioner, 116 t.c. 211 (4/13/01) (reviewed, 10-6-1). metrocorp acquired the assets of community [a failed s&l] through a �conversion transaction� in which, as a condition of assumption of community�s deposit liabilities, metrocorp was required to pay the fdic an exit fee of $309,565 and an entrance fee of $43,339 [in five annual installments of $71,518], neither of which were refundable, to shift the deposit insurance from the savings association insurance fund (saif) to the bank insurance fund (bif). in addition, normal deposit insurance premiums were paid. the tax court, in a (10-2-6) reviewed opinion by judge laro, upheld the taxpayer�s deduction of the entrance and exit fees, rejecting the commissioner�s argument that they produced significant long-term benefit and thus were capital. the exit fees were imposed �to protect the integrity of the saif� and were a �final premium� for insurance already received, compensating the saif for a loss of future premium revenues. the purpose of the entrance fee was �to protect the integrity of the bif� by preventing dilution of reserves; it was a nonrefundable fee for first year insurance coverage. the majority said it would not �second guess� taxpayer�s management decision to reduce expenses by structuring its acquisition in such a manner that required the payment of the entrance and exit fees rather than in a manner that left the deposits insured by saif, which would have resulted in higher annual premiums. the majority specifically noted that its decision was based solely on rejecting the commissioner�s significant long-term benefit/indopco argument, and that since the commissioner had not argued that the expenditures were capital because they were incurred in connection with an asset [core deposits], it would not decide the case on that basis; it reserved any discussion 2002] recent developments in federal income taxation 643 of how the case might be decided if that issue were raised. nevertheless, the majority pointed out that unlike the case in lincoln savings, the payments in the case at bar did not create a fund. � judge ruwe (with five judges joining) dissented on the grounds that the deficiency notice was broad enough to include capitalization on the grounds that the fees related to the acquisition of a separate and distinct asset, and that the tax court has inherent power to decide cases on grounds not argued by either part as long as there is no �surprise� or �prejudice.� judge ruwe�s dissent found the fees to be capital because they were incident to the acquisition of a separate and distinct asset, and the saif exit fees, in any event, were not insurance premiums because metrocorp never received any insurance benefit from saif. � judge halpern�s dissent (with five judges joining) focused on the point that the taxpayer failed to prove that the purpose of the payments was an ordinary and necessary business expense. he reasoned that the entrance and exit fee calculation was complex, the legislative history of the statutes requiring the payments did not clearly articulate their purpose, that the majority�s description of their purposes was surmise, and that the taxpayer thus failed to prove that there was no significant long-tem benefit. � judge beghe�s dissent focused on the point that the commissioner�s broad assertion that the payments produced a longterm benefit inherently included the narrower assertion that the payments were part of the cost of the asset acquisition, and the stipulated record clearly established that the fees were paid in connection with the acquisition of assets. furthermore, even if the payments were insurance premiums, they were in the nature of prepaid insurance. thus, the fees should have been capitalized. 4. but the tax court still believes in the capitalization requirement. lychuk v. commissioner, 116 t.c. 374 (5/31/01) (reviewed, 8-1-7). the taxpayers� s corporation was in the business of acquiring and servicing multiyear installment contracts from used car dealers. it acquired each contract at 65 percent of its face value and thereafter collected and kept all principal and interest payments. its primary business activities consisted of credit investigation, credit evaluation, documentation, and monitoring collections on the installment contracts. its key employees performed credit reviews to decide whether to acquire contracts offered to it and processed payments to the selling car dealers. over the two years in question, it acquired 1,513 contracts out of 3,982 offered to it. the corporation deducted all of its expenses, but the commissioner determined that all of the salaries, benefits, and overhead (printing, telephone, computer, rent, and utilities) relating to the corporation�s acquisition of the installment contracts were capital expenditures. [these expenses had been identified by the corporations� auditors and capitalized for 644 florida tax review [vol.5:si financial accounting.] he also required capitalization of expenditures (i.e., professional fees and commissions) relating to an offering of notes in 1993 and a second offering that was planned in 1993 and abandoned in 1994. the commissioner did not attempt to require capitalization of the salaries, benefits, and overhead attributable to servicing the contracts. in total, the commissioner capitalized $213,028 out of $280,222 of total compensation and benefits, including virtually all of the amounts attributable to employees other than the president and vice-president, and over two thirds of the overhead (including rent). � the tax court, in a reviewed opinion by judge laro, held that the salaries and benefits were capital expenditures because these items were directly related to the process of anticipated acquisition of assets with expected useful lives exceeding one year. judge laro�s opinion was grounded primarily on the principles of lincoln savings and loan ass�n, 403 u.s. 345 (1971), idaho power co., 418 u.s. 1 (1974), woodward v. commissioner, 397 u.s. 572 (1970), and helvering v. winmill, 305 u.s. 79 (1938). the court expressly rejected the taxpayer�s argument that the salaries and benefits were deductible because they were fixed costs that flowed from employment and were not occasioned by the acquisitions of the contracts, and distinguished the eighth circuit�s opinion in wells fargo & co. v. commissioner, 224 f.3d 874 (8th cir. 2000), as involving an important factual distinction. in wells fargo, the acquisition in question was �extraordinary� to the taxpayer�s business and to the daily course of the employees� duties; they would have been paid the same salaries anyway. pnc bancorp, inc. v. commissioner, 212 f.3d 822 (3d cir. 2000), rev�g 110 t.c. 349 (1998), however, was found not to be meaningfully factually distinguishable. rather, the tax court expressly rejected the third circuit�s holding [that the recurring nature of the salary expenses that were connected to current income removed them from capitalization] and followed its own prior opinion. but the tax court nevertheless allowed the overhead expenses to be deducted currently because these items were not directly related to the anticipated acquisitions � they would have been incurred even if the corporation�s business had only encompassed servicing the contracts, and their amount did not vary with the number of credit applications processed � and any future benefit received from these expenses was merely �incidental.� a loss deduction under § 165(a) was allowed with respect to the portion of the capitalized salaries and benefits that was attributable to installment contracts that were never acquired. the offering expenditures were capital because they produced significant future benefits, but a § 165 loss deduction was allowed with respect to the offering expenditures attributable to the abandoned offering. � seven judges, in three separate opinions 2002] recent developments in federal income taxation 645 authored by judges ruwe, halpern, and beghe, concurred with the court�s opinion requiring that the salaries and benefits be capitalized, but dissented from the portion of the opinion allowing the overhead to be deducted. the dissenters would have required capitalization of the overhead as well. judge beghe wrote separately only to emphasize the following point: . . . it bears observing that the oft-quoted passage in the opinion of the court of appeals for the seventh circuit in encyclopaedia britannica, inc. v. commissioner, 685 f.2d 212, 217 (7th cir.1982), rev�g. t.c. memo.1981-255, which includes the statement that �the administrative costs of conceptual rigor are too great,� was uttered in the course of sustaining the commissioner�s determination that the costs in issue in that case had to be capitalized. however, the court of appeals then suggested that the distinction between recurring and nonrecurring costs might provide the line of demarcation in some cases, but went on to observe that the distinction wouldn�t make sense when the taxpayer�s sole business was the creation or acquisition of capital assets. although acc�s business includes the servicing as well as the acquisition of capital assets, the relatively short average time the acquired loans remain outstanding raises questions about administrability, the costs of conceptual rigor, and whether the exercise has been worth the candle. these musings lead me to suggest the time has come to request respectfully that the congress step in and enact some brightline rules that will provide guidance to the business community and the internal revenue service and reduce the burdens of compliance and controversy on the public, the service, and the courts. sections 195 and 197 come to mind as possible starting points or models. � see also, fsa 200136010. 5. is there is a de minimis exception to the rule of capitalization if expensing clearly reflects income? alacare home health services, inc. v. commissioner, t.c. memo. 2001-149 (6/22/01). a medicare-certified home health care agency deducted $467,000 and $351,000 for numerous purchases of equipment in the years in question. the equipment items each cost $500 or less and had a life of two years or less; and the expensing treatment was consistent with medicare accounting. the tax court (judge colvin) upheld the commissioner�s position requiring the expenditures to be capitalized because 646 florida tax review [vol.5:si 5. under § 198, certain environmental remediation costs that are paid or incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site may be currently deducted. the taxpayer�s treatment did not clearly reflect income. judge wells distinguished union pacific railroad co., inc. v. united states, 208 ct. cl. 1 (1975), cert. denied 429 u.s. 827 (1976), and cincinnati, new orleans & tex. pac. railway co. v. united states, 191 ct. cl. 572 (1970), both of which allowed a railroad to expenses de minimis capital expenditures under an icc directed accounting method, on the grounds that the deductions in those cases were a much lower percentage of gross receipts � .03% to .07% in the railroad cases compared with .85% and .71% in the instant case � and that the treatment in the railroad cases clearly reflected income. nevertheless, penalties were not upheld because taxpayer had consistently followed the method in the past and had reasonably relied on its return preparer. 6. more capitalized environmental remediation costs.5 united dairy farmers, inc. v. united states, 267 f.3d 510, 88 a.f.t.r.2d 6116 (6th cir. 10/3/01), aff�g 107 f.supp.2d 937, 2000-1 u.s.t.c. ¶ 50,538, 85 a.f.t.r.2d 2235 (s.d. ohio 5/23/00). taxpayer incurred environmental remediation expenses to clean-up pollution caused by prior owners who operated gas stations on the site of a convenience store. even though the taxpayer was unaware of the pollution at the time of the purchase and thus �overpaid� for the property, the expenses were required to be capitalized because they �increased the value of the property.� rev. rul. 94-38, 1994-1 c.b. 35 did not apply. the sixth circuit concluded that �when a taxpayer improves property defects that were present when the taxpayer acquired the property, the remediation of those defects are capital in nature..... [w]hen a taxpayer has improved defects that were present when the taxpayer acquired the property, plainfield-union [water co. v. commissioner, 39 t.c. 333 (1962)] does not apply.� rather, dominion resources, inc. v. united states, 219 f.3d 359 (2000), was more apposite. � on another issue, the court held that accounting fees paid to ernst & young in connection with a corporate reorganization incident to making an s election had to be capitalized. 7. kudos from practitioners; pans from professors. advanced notice of proposed rulemaking (�anprm�) reg-125638-01, guidance regarding deduction and capitalization of expenditures, 67 f.r. 3461 (1/24/02). describes rules and standards treasury and irs plan to propose under § 263(a) [and not under §§ 195, 263(g), 263(h) or 263a] to provide a framework for addressing capitalization issues with respect to expenditures incurred in 2002] recent developments in federal income taxation 647 6. see zaninovich v. commissioner, 616 f.2d 429 (9th cir. 1980) (prepayment of rent for twelve-month period straddling two taxable years deductible when made; an allocation not required because benefits did not extend substantially beyond close of taxable year). acquiring, creating, or enhancing intangible assets. safe harbors and simplifying assumptions including a �one-year rule� under which expenditures relating to short lived intangibles need not be capitalized and �de minimis rules� under which certain types of expenditures under a specified dollar amount are not required to be capitalized. � specifically (a1) loan portfolios would have to be capitalized; (a2) amounts paid for § 197 intangibles would have to be capitalized; (b1) no capitalization would be required under the 12-month rule;6 (b2) prepaid items beyond 12 months would have to be capitalized; (b3) market entry payments would have to be capitalized, but not costs to obtain iso 9000 certification; (b4) amounts paid for government licenses that are valid indefinitely would have to be capitalized; (b5) amounts paid to modify contractual rights would have to be capitalized, but not those paid where the parties do not enter into a new or renegotiated agreement; (b6) amounts paid by a lessor to terminate a lease would have to be capitalized over the remaining period of the lease; (c) transaction costs would have to be capitalized, but this rule would not require capitalization of employee compensation, fixed overhead costs, or costs that do not exceed a specified dollar amount such as $5,000. loan origination costs would be deductible, following the third circuit�s opinion in pnc bancorp, and giving up the irs�s victories in the tax court in pnc bancorp and lychuck. c. reasonable compensation 1. it looks like maybe you can�t always zero out a professional service corporation�s taxable income. pediatric surgical associates, p.c. v. commissioner, t.c. memo. 2001-81 (4/02/01). the tax court (judge halpern) upheld in part the disallowance of deductions for bonuses to the four shareholder-employees of a medical professional corporation that had 20 employees, including two surgeons who were not shareholders. the question, said the court, was not whether the amounts paid were reasonable but whether they were received for services. because the shareholder-physicians were not the only physicians, what the physicians could have earned if self-employed was therefore not determinative. rather, judge halpern examined the acts to determine the portion of the corporation�s profit attributable to the services of the nonshareholder-physicians, and disallowed the deduction to that extent. 648 florida tax review [vol.5:si 2. not all courts accept the hypothetical investor test. eberl�s claim service, inc. v. commissioner, 249 f.3d 994, 2001-1 u.s.t.c. ¶ 50,396, 87 a.f.t.r.2d 2075 (10th cir. 5/4/01). the taxpayer operated a catastrophic claims adjustment service and paid its sole shareholder $4,340,000 and $2,080,000 in compensation, most of which was contingent, for the years in question. the adjusters employed by taxpayer were compensated five to ten percent above industry standard. applying a multi-factor test, the tax court allowed $2,340,000 and $1,080,00, in the respective years, as reasonable compensation to the employee-sole shareholder. the court of appeals, likewise applying a multi-factor test, affirmed. in doing so, the court specifically declined to follow the lead of exacto spring corp. v. commissioner, 196 f.3d 833 (7th cir. 1999), in which judge posner castigated the tax court (and other courts) for reliance on �factors� in resolving �reasonable compensation� cases and held that as long as the payments were intended to be compensation the inquiry turns completely on whether a hypothetical investor would be satisfied with the return on the investment that resulted form the employee/shareholder�s management activities. � the court of appeals summarized its approach and contrasted it with that of other circuits: whatever the relative wisdom of the two approaches, absent en banc rehearing we are bound to the use of a multi-factor approach by our prior decision in pepsi-cola bottling [528 f.2d 176 (10th cir. 1976)]. n6 n6 further, of those circuits that have embraced an independent investor test, only the seventh has gone so far as to jettison the multi-factor approach entirely. others have merely committed to viewing the totality of the circumstances through the �lens� of, dexsil corp., 147 f.3d at 101, or �from the perspective of,� elliotts, 716 f.2d at 1245, a hypothetical outside investor. those circuits have retained the totality of the circumstances approach that this court embraced in pepsicola bottling. 3. the court recited factors, but in the end it was all independent investor based analysis. wagner construction, inc. v. commissioner, t.c. memo. 2001-160 (6/29/01). in a reasonable compensation case [appealable to 2002] recent developments in federal income taxation 649 the eighth circuit], the tax court (judge parr) carefully recited the analysis of the compensation under a ten-factor test. then, in the conclusion, determined the aggregate amount that was reasonable compensation by (1) calculating the dollar amount of a reasonable return on invested capital (based on the evidence regarding a reasonable rate of return [28.2% before-tax] and the amount of invested capital [beginning of the year equity]), (2) adding together the two officer/shareholders� compensation for the year and retained earnings for the year, and (3) subtracting the fair return amount from the latter amount. the court simply announced how much of the aggregate reasonable compensation related to each officer/shareholder. 4. does it look like a trend is developing? damron auto parts, inc. v. commissioner, t.c. memo. 2001-197 (7/30/01). in a reasonable compensation case [appealable to the eleventh circuit], the tax court (judge foley) analysis briefly mentioned various relevant factors. then, focusing entirely on the 39 percent annual compound rate of return [in appreciation], found that the compensation was reasonable because, according to the commissioner�s expert, an independent investor would have been satisfied with a 14.3 percent return. ten percent of aggregate compensation was disallowed, however, because it was for services performed for other related corporations. 5. more creeping influence of the hypothetical independent investor test. b&d foundations, inc. v. commissioner, t.c. memo. 2001-262 (10/3/01). in a reasonable compensation case [appealable to the tenth circuit], judge beghe applied the multi-factor test of erbel�s claim service, inc. v. commissioner, 249 f.3d 994 (10th cir. 2001) and pepsi cola bottling co. of salina v. commissioner, 528 f.2d 176 (10th cir. 1975), [citing the golsen rule] to uphold the commissioner�s disallowance of a deduction for $353,911, out of $1,113,800 of compensation paid to the husband and wife employee/shareholders. notably, judge beghe included an extensive discussion of the return to a hypothetical independent investor as a factor, even though that item was not a factor applied in either erbel�s claim service or pepsi cola bottling co. d. miscellaneous expenses 1. just a de minimis whipsaw. leschke v. commissioner, t.c. memo. 2001-18 (1/26/01). the taxpayer�s s corporation was allowed to deduct the full cost of $61 nut baskets and $100 bills given to employees at christmas. section 274(c) did not limit the deduction to $25 because § 102(c) precluded treating as gifts items given to employees. that the employer did not report the nut baskets [which we, but not the court, note possibly could qualify as de minimis 650 florida tax review [vol.5:si fringe benefits under reg. § 1.132-6] or the $100 bills as compensation on the employees� forms w-2 or withhold taxes did not preclude characterizing the items as deductible compensation. 2. new leveraged lease guidelines. rev. proc. 2001-28, 2001-19 i.r.b. 1156 (5/7/01). this revenue procedure provides guidelines that the irs will apply to advance ruling requests to determine whether leveraged lease transactions will be treated as leases for tax purposes. rev. proc. 75-21, 1975-1 c.b. 715, is modified and superseded. among the many requirements is the continued requirement that the lessor expects to receive a profit from the transaction apart from the tax benefits arising from the transaction. the most significant change is a modification permitting certain restricted investments in the property by the lessee. generally speaking, �severable investments� are eligible, but investments that render the property �limited [to the lessee�s] use� for substantially its entire useful life are disqualified. rev. proc. 2001-29, 200119 i.r.b. 1160 (5/7/01), sets forth the information and representations required to be furnished by taxpayers in requests for advance rulings on leveraged lease transactions. 3. the deduction was more than the includible compensation −−−− and it was legal! sutherland lumber-southwest, inc. v. commissioner, 114 t.c. 197 (3/28/00). pursuant to reg. § 1.162-25t, an employer-corporation that provided private nonbusiness flights on a company owned airplane to employees was permitted to deduct the cost of providing the flights because the fair market value of the flights was included in the employees� reported compensation under reg. § 1.61-21(b). accordingly, pursuant to § 274(e)(2), the limitations of § 274 did not apply even though the airplane otherwise could be considered to be an entertainment facility. furthermore the employer�s deduction was not limited to the lesser amount includable by the employees under special fringe benefit valuation rules in reg. § 1.61-21(g). a. affirmed by: sutherland lumber-southwest, inc. v. commissioner, 255 f.3d 495, 88 a.f.t.r.2d 5026, 2001-2 u.s.t.c. ¶ 50,503 (8th cir. 7/3/01) (per curiam). the court stated: in this case of first impression, we must determine the amount of expenses corporations may deduct on their income tax returns when they allow their officers to use corporate aircraft for personal vacations. . . . confronted by this textual ambiguity, the tax court employed standard canons of construction. . . . the court found the commissioner�s general 2002] recent developments in federal income taxation 651 purpose-based arguments less persuasive than the specific extratextual indications that subsection (e)(2) was meant to remove properly reported entertainment expenses from the ambit of subsection (a), and ruled in favor of sutherland. this conclusion obviated the need to determine whether a corporate aircraft could as a matter of fact and law constitute a �facility used in connection with [entertainment, amusement, or recreation]� under § 274. . . . after a complete review de novo, we agree with the tax court�s well-reasoned opinion, and affirm on the basis of the analysis set forth therein. see 114 t.c. 197 (2000). because we have nothing of substance to add to the tax court�s thorough analysis, further discussion is superfluous. b. acquiescence. 2002-6 i.r.b. 459 (2/11/02). 4. janus-like, the same payments that were deductible compensation in the tax court are travel reimbursements exempt from employment tax in the court of claims. united airlines wins on one theory in the tax court. ual corp. v. commissioner, 117 t.c. 7 (7/13/01) (reviewed opinion; the alignment of the concurring opinions is too convoluted to explain; 3½ dissents). pursuant to union contracts, united airlines paid pilots and flight attendants a per diem allowance regardless of whether they were away from home overnight; flight attendants received $1.50 times the number of hours on duty or on flight assignment; pilots received $1.50 per hour and $1.55 per hour after 4/1/86. [united also paid actual overnight lodging expenses.] united did not require employees to substantiate use of the per diem and there was no written substantiation as to the employees� actual use of the allowances. united originally deducted the per diem payments as travel expenses, and reduced its deductions under § 274(n) after 1987. the commissioner disallowed the deductions for lack of substantiation, and when united argued that the payments should be fully deductible as compensation, the commissioner denied the deduction for want of compensatory intent at the time the payments were made, even though reasonableness was not at issue. the majority, in an opinion by judge laro, allowed the deduction: the presence of such a bona fide employment relationship and such a need to pay per diem allowances in order to secure personal services is enough under the facts at hand to persuade us that united paid the per diem allowances to the employees for their services. . . . respondent places undue emphasis on the fact that the union contracts do not specifically characterize 652 florida tax review [vol.5:si the per diem allowances as personal service compensation. such a characterization by the parties to the contracts is not dispositive as to the characterization of the per diem allowances for federal income tax purposes. the court noted that in a related case pending in the court of federal claims the government was arguing that the same payments were wages for employment tax purposes. � judge ruwe, concurring, cogently, explained that: [t]he relevant statute [§ 162(a)(1)] and regulations [reg. § 1.167-7(a)] do not require an �intent to compensate� as a prerequisite to deductibility under section 162(a)(1). although an �intent to compensate� requirement has been applied by the courts in numerous cases, the instant situation is factually distinguishable from the situation in those cases which involved corporate payments to shareholders or employees in positions of control. [citations omitted] in the context of corporate payments to shareholders, careful scrutiny is required to determine whether the alleged compensation is in fact a disguised dividend. . . . [as the majority opinion correctly states, the payor�s intent is simply a pertinent factor to consider, not a prerequisite to deductibility.] � judge ruwe also thought it necessary to explain exactly why the payments were not travel expenses, i.e., payments for meals for day-trippers simply cannot be travel expenses, and travel expenses under a nonaccountable plan that exceed the relevant per diem allowances, which the amounts in the case did exceed, must be included by the employee and as a corollary are deductible by the employer. � dissent. noting that the period of limitations had expired with respect to the employees [who undoubtedly included nothing], judge swift�s dissent focused on the inconsistency of united�s positions, rather than the inconsistency of the government�s positions. the more significant concern with regard to �inconsistent� characterizations in this case should be with united�s efforts to recharacterize entirely the per diem allowances that united, its employees, and the labor unions, for all other purposes, treated as employee travel expenses. united now, years later, and solely for federal income tax purposes, attempts to inconsistently treat such travel expenses 2002] recent developments in federal income taxation 653 as employee compensation, outside the scope of the substantiation requirements of section 274(d), and fully deductible under section 162(a)(1). an extensive body of case law limits a taxpayer�s ability to change the treatment of reported items of income and deductions. [emphasis in original; footnote omitted] � judge swift also was concerned with the �the casual manner by which the majority opinion bypasses the substantiation requirements of section 274(d).� a. and on a different issue with respect to same items, united air lines wins in the court of claims on a mutually inconsistent theory. united air lines, inc. v. united states, 88 a.f.t.r.2d 5459, 2001-2 u.s.t.c. ¶ 50,577 (ct. cl. 8/10/01). the commissioner simultaneously treated the payments in ual corp., supra, as wages for employment tax purposes. the court of federal claims held that the payments were exempt from fica and withholding because they were intended to reimburse employees for travel expenses and taxpayer should not be required [under reg. §§ 31.3401(a)1(b)(2) and 31.3121(a)-1(h)] retroactively �to demonstrate objective proof� in addition to the union contracts that it had a �reasonable belief� that the reimbursements did not exceed travel expenses. the court noted that in ual corp., the taxpayer had prevailed in deducting the entire amount of the per diem as compensation, but that did not affect its reasoning; it stated that united �in the first instance, will elect its preferred treatment of the reimbursements.� 5. the irs never seems able to catch up with the movements in the price of gasoline. rev. proc. 2001-54, 2001-48 i.r.b. 530 (11/7/01), updating rev. proc. 2000-48, 2000-49 i.r.b. 570. the optional standard mileage rate for business use of automobiles will increase on 1/1/02 from 34.5 cents per mile to 36.5 cents per mile, the mileage rate for medical and moving will increase from 12 cents per mile to 13 cents per mile, and the mileage rate for giving services to a charitable organization will remain at 14 cents per mile. e. depreciation & amortization 1. patton v. commissioner, 116 t.c. 206 (4/13/01). a § 179 election to expense otherwise depreciable assets must be made on the taxpayer�s first return for the year or on a timely amended return [see reg. § 1.179-5(a)], and cannot be modified without the commissioner�s consent. the commissioner did not unreasonably withhold consent to modify the original election [to expense a single $4,100 asset] to apply to other capital expenditures that were 654 florida tax review [vol.5:si reclassified as such on audit after taxpayer deducted them as �supplies.� [it�s also worth noting that although taxpayer originally reported a loss of $38,826 for the year, a bank deposit method audit turned up $135,638 of unreported gross receipts in addition to the erroneous deduction.] 2. section 197 amortization applies to noncompete agreements ancillary to stock redemptions. frontier chevrolet co. v. commissioner, 116 t.c. 289 (5/15/01). the tax court (judge ruwe) held that § 197 applied to a covenant not to compete entered into when a corporation redeemed the stock of its 75-percent owner. the covenant not to compete had to be amortized over 15 years under § 197, even through it was for only a 5-year term because the redemption constituted the acquisition of an interest in a trade or business. [the holding is consistent with reg. § 1.197-2(b)(9), which was not applicable because the case arose prior to its effective date.] 3. what would groucho marx say? important guidance on depreciation for the country club set. rev. rul. 2001-60, 2001-51 i.r.b. 587 (11/29/01). this revenue ruling provides guidance clarifying what golf course land preparation costs can be depreciated. land preparation undertaken in the original construction or reconstruction of push-up or natural soil greens is inextricably associated with the land and, therefore, the costs attributable to that land preparation are not depreciable. however, the costs of land preparation of modern greens that are closely associated with depreciable assets, such as a network of underground drainage tiles or pipes, that the land preparation will be retired, abandoned, or replaced contemporaneously with those depreciable assets are to be capitalized and depreciated over the recovery period of the depreciable assets with which the land preparation is associated. f. credits 1. the peripatetic research credit regulations. a. the final research credit regulations that weren�t. in t.d. 8930, credit for increasing research activities, 66 f.r. 280 (1/3/01), the irs promulgated final regulations relating to the computation of the credit under § 41(c) and the definition of qualified research under § 41(d). the final regulations immediately came under withering criticism from the business sector, and, in an unusual move, in notice 2001-19, 2001-10 i.r.b. 784 (2/1/01), the treasury (secretary o�neill, himself, actually) announced that it will review the �final� regulations by reconsidering the comments submitted and requesting additional comments on the regulations to be received by 4/2/01. any additional changes to the regulations will be made in proposed form. the 2002] recent developments in federal income taxation 655 7. a discovery requirement was applied in united stationers, inc. v. united states, 163 f.3d 440 (7th cir. 1998), cert. denied, 119 s. ct. 2369 (1999), norwest v. commissioner, 110 t.c. 454 (1998), and wicor, inc. v. united states, 116 f. supp. 2d 1028 (e.d. wis. 2000). regulations, including any future changes, will not be effective until the review is complete, except for the retroactive effective date [12/31/85] of the taxpayerfriendly changes to internal-use computer software rules. taxpayers may rely on the final rules pending new regulations. � what the suspended final regulations said. the final regulations covered the requirements to qualify for the credit, rules for computing the credit, and rules for electing and revoking the election of the alternative incremental credit, and take into account the legislative history of the tax relief and extension act of 1999. � the final regulations did not change the definition of gross receipts from that in the proposed regulations. reg105170-97, 63 f.r. 66503 (12/2/98). � the final regulations retained the requirement in the proposed regulations that a taxpayer seek to discover information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering.7 but, in response to comments regarding the discovery requirement, the final regulations made a number of changes. � in order to satisfy the discovery requirement, research must have been undertaken for the purpose of discovering information that is beyond the knowledge that should be known to skilled professionals had they performed a reasonable investigation of the existing level of knowledge in the particular field of science or engineering [instead of technology or science], but there was no requirement that a taxpayer actually conduct such an investigation in order to claim the credit. the regulations also stated, by example, that trade secrets generally are not within the common knowledge of skilled professionals (because they are not reasonably available to skilled professionals not employed, hired, or licensed by the owner of such trade secrets). underlying principles of science or engineering used in the research need not be novel. obtaining a patent [other than a design patent] raises a conclusive taxpayer favorable presumption. � the prescribed four-step process in the definition of experimentation in prop. reg. § 1.41-4(a)(5) was eliminated. � the requirement of experimental record 656 florida tax review [vol.5:si keeping in prop. reg. § 1.41-4(a)(5) was eliminated. � the shrinking-back rule was modified in response to comments. reg. § 1.41-4(b). � the exclusion of most activities after commercial production has commenced was retained. the per se exclusion list retained debugging, but not correction of flaws. � research with respect to internal-use software that satisfied both the general conditions for credit eligibility and the three-part test was eligible for the credit. the final regulations retained the definition of internal-use software and the additional qualifying test in the proposed regulations, but provide a new exception (pursuant to § 41(d)(4)(e)) under which certain internal-use software used to deliver noncomputer services to customers with features that are not yet offered by a taxpayer�s competitors is not subject to the additional tests. following the conference report to the 1999 act, the final regulations clarified that software that is intended to be used to provide noncomputer services to customers is internal-use software, while software that is to be used to provide computer services is not developed primarily for internal use. � the final regulations clarified (1) that the three-part test in the proposed regulations is the high threshold of innovation test, and not a separate requirement, and (2) how the three-part part high threshold of innovation test supplements the discovery requirement. research with respect to internal-use software is credit eligible only if it is intended to exceed, expand, or refine the common knowledge of skilled professionals (as defined in reg. § 1.41-4(a)(3)(ii)) to a degree that is substantial and economically significant. b. the new research credit proposed regulations that are. reg112991-01, credit for increasing research activities 66 f.r. 66362 (12/26/01). the treasury published new proposed regulations under § 41 that expand the definition of qualified research by eliminating the �discovery test� included in the 1/3/01 regulations. � treasury and irs have eliminated in these proposed regulations the requirement that qualified research must be undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering. rather, treasury and the irs believe that the requirement that qualified research be �undertaken for the purpose of discovering information which is technological in nature� is intended to distinguish technological research, which may qualify for the research credit, from non-technological research, which does not. � the proposed regulations repeat the 2002] recent developments in federal income taxation 657 requirement from reg. § 1.174-2(a)(1) by stating that research is undertaken for the purpose of discovering information if it is intended to eliminate uncertainty concerning the development or improvement of a business component. uncertainty, for purposes of this requirement, exists if the information available to the taxpayer does not establish the capability or method of developing or improving the business component, or the appropriate design of the business component. � the proposed regulations revise the shrinking-back rule to conform it to the rule in the legislative history to the 1986 act. these proposed regulations also reiterate that the shrinking-back rule may not itself be applied as a reason to exclude research activities from credit eligibility. � no separate research credit-specific documentation requirement is included in these proposed regulations. � the preamble notes that the service will not generally challenge return positions that are consistent with the proposed regulation. 3. wicor, inc. v. united states, 263 f.3d 659, 88 a.f.t.r.2d 5474, 2001-2 u.s.t.c. ¶ 50,576 (7th cir. 8/14/01), aff�g 116 f. supp. 2d 1028 (e.d. wis. 2000). in an opinion by judge posner, the seventh circuit affirmed the denial of the § 41 research credit to the taxpayer with respect to internal use software that did not �discover� technological information. that andersen consulting, which developed software integrating purchase software into a single system for the taxpayer and which [under the contract] owned the source code for the system software, did not bother to retain a copy of the source code itself was probative that nothing usable by anyone else was �discovered.� 4. no, you can�t have 15 years to amend your return. chrysler corp. v. commissioner, 116 t.c. 465 (6/29/01). chrysler claimed a deduction for foreign income taxes on its 1980, 1981, and 1982 tax returns. on july 24, 1995, chrysler filed amended returns electing to claim the foreign tax credit for those years and amended its 1985 return to claim a refund from a carryover of the foreign tax credits to 1985 (which freed-up itcs from 1985 to carry forward to future years). the tax court (judge laro) upheld the commissioner�s determination that the election to claim the foreign tax credit was untimely. the ten year period for electing the foreign tax credit under § 901(a) and § 6511(a) and (d)(3)(a) [extending the period from 3 years to 10 years] begins with the year with respect to which the foreign tax credit is elected, not [as argued by the taxpayer] the later year to which it is carried. 658 florida tax review [vol.5:si 5. big brother may be watching your mouth, but he won�t give your dentist a tax credit for it. fan v. commissioner, 117 t.c. 32 (6/24/01). dr. fan, who had some hearing-impaired patients, purchased an intraoral camera system [consisting of a camera and monitor, video presentations and educational materials] for use in his dental practice, which was an eligible small business as defined in § 44(b). the system was useful with respect to all of his patients, but because dr. fan considered the system to be a more effective and efficient way to communicate with hearing-impaired patients, he claimed the § 44 disabled access credit for the cost of the system. the tax court upheld the commissioner�s disallowance of the credit on the grounds that the system was not an �eligible access expenditure� as defined in § 44(c). dr fan was already ada compliant; and the system was not marketed as, acquired, or used specifically as an auxiliary aid or service to ensure effective communication to comply with the applicable requirements of the ada. 6. tax credit provisions in the 2001 act. a. the § 51 work opportunity credit was extended through 12/31/01. b. the hiring date for eligibility for the § 51a welfare-to-work credit was extended through 12/31/01. 7. new § 45f was added. starting in 2002, it provides a credit of up to $150,000 to an employer for 25 percent of the employer�s �qualified child care expenditures� and 10 percent of the employer�s �qualified child care resource and referral expenditures.� the credit is available with respect to a broad range of expenditures incurred to provide childcare facilities and services for the taxpayer-employer�s employees. myriad special rules, worthy of any direct spending government subsidy program, are imposed on qualification for this tax expenditure, including a recapture of a credit if a facility ceases to be used for child care after the credit is allowed with respect to the facility. in general, the benefits received by the employees as a result of the expenses for which the employer receives the credit are excludable from gross income under § 129. g. natural resources deductions & credits 1. a § 29 credit no-ruling issue. rev. proc. 2000-47, 2000-46 i.r.b. 482 (11/13/00). rev. proc. 2000-3, § 5, 2000-1 i.r.b. 103, is amplified by adding to the list of issues on which the irs will not issue advance rulings the 2002] recent developments in federal income taxation 659 question of whether a solid fuel other than coke or a fuel produced from waste coal is a qualified fuel under § 29(c)(1)(c). waste coal for this purpose is limited to waste coal fines from normal mining and crushing operations and does not include fines produced (for example, by crushing run-of-mine coal) for the purpose of claiming the credit. a. rulings will again be available. but treasury didn�t revert to pre-suspension ruling standards. rev. proc. 2001-30, 2001-19 i.r.b. 1163 (4/22/01), modified by rev. proc. 2001-34, 2001-22 i.r.b. 1293 (5/8/01). the ruling provides the circumstances under which the service will issue private letter rulings regarding whether a solid fuel produced from coal is a qualified fuel under § 29(c)(1)(c). the circumstances necessary for the service to issue a private letter ruling include the presence of coal feedstock particles no larger than a specific size, and the performance of specific activities in processing the feedstock in order to effectuate a significant chemical change. the chief requirement is that the fuel be �synthetic.� to be synthetic �a fuel must differ significantly in chemical composition, as opposed to physical composition, from the substance used to produce it.� examples of �favorable processes� set forth in the revenue procedure include �gasification [sic] and liquefaction [sic] and production of solvent refined coal that result[s] in substantial chemical changes to the entire coal feedstock rather than changes that affect only the surface of the coal.� b. eleven days later, the treasury did revert to presuspension ruling standards. the world is again safe for sellers of processes and tax advantages. rev. proc. 2001-34 modifies rev. proc. 2001-30 to expand the range of sizes of coal feedstock and to eliminate one particular activity as a necessary part of a process that results in a qualified fuel. 2. the exxon saga: after an initial setback in the tax court, exxon has been meeting with success in the federal circuit on the issue of taking percentage depletion on fixed contract natural gas on representative market or field prices that are greatly in excess of the actual sale price for the gas. a. tax court: taxpayer not permitted to follow the literal language of the regulations. exxon corp. v. commissioner, 102 t.c. 721 (6/6/94). taxpayer was not permitted to follow the literal language of reg. § 1.613-3(a) and use �representative market or field prices� (rmfp) in determining �gross income from the property� for purposes of computing percentage depletion under § 613a(b)(1)(b) [�fixed contract� exception]. even though the regulation states that �the gross income from the property shall be assumed to be equivalent to rmfp� with respect to natural gas transported from 660 florida tax review [vol.5:si the premises prior to sale, the purpose of that provision was to prevent integrated producers from taking depletion deductions on transportation, refining, etc. -and not to permit a taxpayer to take depletion based upon a rmfp price five times the actual sale price of the natural gas to an exxon affiliate. the actual contract sale price was therefore reduced by royalties and transportation expenses to determine �gross income from the property.� b. same issue in court of federal claims. exxon corp. v. united states, 33 fed. cl. 250, 75 a.f.t.r.2d 1733, 95-1 u.s.t.c. ¶ 50,245 (fed. cl. 4/11/95). on the same issue, the court held that while the amount upon which depletion can be taken is not necessarily limited by actual gross income [21 cents], the rmfp calculated by exxon [41 cents] was not a reasonable basis upon which depletion may be taken and [based upon the burden of proof] the complaint was dismissed. but reversed . . . . c. federal circuit holds that rmfp which exceeds actual gross receipts is not precluded, nor is it per se �unreasonable.� exxon corp. v. united states, 88 f.3d 968, 77 a.f.t.r.2d 2521, 96-2 u.s.t.c. ¶ 50,324 (fed. cir. 6/20/96), cert. denied (3/17/97), rev�g and remanding 33 fed. cl. 250, 75 a.f.t.r.2d 1733, 95-1 u.s.t.c. ¶ 50,245 (fed. cl. 1995). court finds taxpayer entitled to calculate its depletion deduction based upon an rmfp of 39 cents based upon the wellhead price that would be realized by nonintegrated producers. the court further held that the court of federal claims should not have limited the price by making an independent assessment of the reasonableness of the price because the § 611(a) language �reasonable allowance . . . in each case� refers to the different types of depletable resource, not to individual taxpayers. d. and you thought you couldn�t deplete more than your gross income. of course you can! exxon corp. v. united states, 45 fed. cl. 581, 2000-1 u.s.t.c. ¶ 50,116, 84 a.f.t.r.2d 7235 (fed. cl. 12/2/99). exxon sought a $172.6 million refund based on percentage depletion for 1975, under § 613a(b)(1)(b), allowing § 613 percentage depletion for natural gas sold under a fixed contract. the long-term contracts in issue were with houston lighting & power co. (hl&p) and with southwestern electric and power co. (swepco). the irs assessed a deficiency for 1975 on the grounds that exxon was not entitled to use the rmfp under reg. § 1.6133(a) to compute percentage depletion because the fixed-contract exception in § 613a(b)(1)(b) did not permit use of the rmfp. exxon filed suit, and the court of claims initially denied the government�s motion for summary judgment, in which the government argued that reg. § 1.613-3(a) did not apply to post-1974 depletion allowed under the fixed contract exception. 2002] recent developments in federal income taxation 661 � on the government�s motion for summary judgment, the court (senior judge gibson) held that: (1) reg. § 1.613-3(a), absent evidence that the regulation systematically causes a material distortion of the �gross income from the property,� was not facially invalid as applied to percentage depletion deduction pursuant to the post-1974 fixed contract exception [even if the rmfp exceeded the actual sales price, which it can under exxon corp. v. united states, 88 f.3d 968 (fed. cir. 1996)], and (2) evidence raised genuine issues of material fact that the regulation produced a result that was arbitrary, capricious, or manifestly contrary to the post-1974 statutory percentage depletion scheme. 40 fed. cl. 73 (1998). after trial, the court held: � first: not all of the natural gas was eligible under reg. § 1.613a-7(c)(5) and (d). exxon failed to prove that its contract with hl&p qualified as a �fixed contract.� the hl&p excess royalty reimbursement and additional gas contract terms permitted exxon, in part, to raise prices after feb. 1, 1975, by amounts tied to the market price for natural gas [which would allow it to recover through price increases increased tax liabilities arising from the repeal of percentage depletion], and the sales prices did in fact increase. exxon did not prove by �clear and convincing evidence� that the price increase did not �to any extent� permit it to recoup tax increases attributable to the repeal of percentage depletion. the contract with swepco, however, was qualified. although the contract had a price adjustment clause under which exxon �could potentially have recovered a portion of its increased income tax liabilities,� the contract qualified as a �fixed contract� because the contract price did not in fact increase after february 1, 1975. � second: for calculating exxon�s 1975 percentage depletion allowance, the rmfp is $0.6831 per thousand cubic feet (mcf) of natural gas that is eligible for percentage depletion. (1) the texas gulf coast/east texas region, rather than the entire state, constituted a �market area that was geographically �representative�� of exxon�s 1975 production from the properties at issue. (2) in determining whether that region was the relevant market area, judge gibson found that exxon�s 1975 �gas well gas production� � comprising 90.24 percent of the gas in issue � was comparable or superior to gas produced and sold generally through the region; only 9.74 percent [casinghead gas] was not comparable and must be excluded from the computation of exxon�s allowance: (3) after determining the appropriate rmfp transaction sample and adjusting for the pre-sale costs of compression and dehydration, the court held that the rmfp for purposes of reg. § 1.6133(a) was $0.6831 per mcf. � exxon had argued that every sale of raw gas 662 florida tax review [vol.5:si 8. in texas, this word is silent when the name of the taxpayer is pronounced. at a delivery point anywhere on the producer�s leased property was a transaction in which the sale price was untainted by transportation before the sale. the court held that exxon failed to support that position, and that it was not feasible to cure tainted transactions by subtracting the transportation cost from the gas sale price. e. affirmed in part, reversed in part. literalism triumphs in the federal circuit. taxpayer celebrates a little bit more. exxon mobil8 corp. v. united states, 244 f.3d 1341, 2001-1 u.s.t.c. ¶ 50,348, 87 a.f.t.r.2d 1508 (fed. cir. 4/3/01). the federal circuit affirmed the court of federal claims holding that percentage depletion should be calculated with respect to an rmfp that exceed the taxpayer�s actual sale price. judge michel rejected the government�s argument that reg. § 1.613-3(a) here would lead to �absurd results,� and would �thwart the obvious purpose� of the 1975 act by noting that treasury considered, but declined to fix, the �perceived anomaly.� he so held because �it is not the province of this court to remedy anomalies in the tax laws that congress and the [treasury] have refrained from correcting.� the 1975 addition of § 613a �may have changed pre-1975 law by redefining what kinds of gas are eligible for percentage depletion, nothing in the regulation changes . . . the method of computing the amount of percentage depletion or eligible gas.� (emphasis in original) � he also affirmed the trial court�s holding that casinghead gas [gas that was dissolved in oil at reservoir conditions but becomes gaseous at atmospheric pressure at the top � or �casinghead � of an oil well] should be excluded from the computation of the rmfp because it was not comparable to its gas well gas. finally, the court of appeals reversed the trial court�s holding that the hl&p contract was not a �fixed price contract,� holding as a matter of law that it was a fixed price contract, thereby entitling exxon to percentage depletion on the gas sold pursuant to that contract. under the contract, exxon could not raise the price of gas unless hl&p exercised its rights under the additional gas clause. that did not alter the fact that the price for the original quantity of gas was fixed from exxon�s perspective. hl&p controlled whether the additional gas clause, and thus the price increase, would be invoked. 3. to �produce� or to �transport� gas, that is the question. saginaw bay pipeline co. v. united states, 88 a.f.t.r.2d 6019, 2001-2 u.s.t.c. ¶ 50,642 (e.d. mich. 8/23/01). natural gas gathering systems are used to 2002] recent developments in federal income taxation 663 transport gas [class 46.0] � not in production [asset class 13.2] � and thus are depreciable over 15 years rather than seven years. the district court described duke energy natural gas corp. v. commissioner, 172 f.3d 1255 (10th cir. 1999), as �wrongly decided.� 4. no second bite at the apple on the definition of �tar sands oil.� shell petroleum, inc. v. united states, 50 fed. cl. 524, 88 a.f.t.r.2d 6448, 2001-2 u.s.t.c. ¶ 50,724 (10/12/01). the government was granted summary judgment that shell did not qualify for the § 29 credit. hydrocarbons produced by means of enhanced recovery techniques in commercial use prior to 4/2/80 are crude oil, not �tar sands oil.� oil produced from tar sands is defined by fea ruling 1976-4 [under the emergency petroleum allocation act], as oil produced from rock types containing �extremely viscous hydrocarbon which is not recoverable in its natural state by conventional oil well production methods including currently used enhanced recovery techniques.� shell was barred by collateral estoppel from litigating the meaning of �currently used enhanced recovery techniques� because it had been previously litigated in shell v. united states, 182 f.3d 212 (3d cir. 1999), which held that shell was not entitled to the § 29 credit for oil produced using the same methods. h. loss transactions, bad debts and nols 1. notice of proposed rulemaking, equity options with flexible terms; qualified covered call treatment, reg-115560-99, 66 f.r. 4751 (1/18/01). section 1092(c)(4) excludes from the definition of a straddle writing a qualified covered call option [which must be publicly traded and not deep in the money] and holding the stock covered by the option. the proposed regulations would permit certain equity options with flexible terms � instruments that have been developed by the securities markets since the current regulations were promulgated � to qualify as long as, among other things, the term is not more than one year and options on the underlying equity with standard terms are outstanding. 2. is reporting interest income a �super factor� in debt/equity analysis? cerand & co., inc. v. commissioner, 254 f.3d 258, 2001-2 u.s.t.c. ¶ 50,518, 88 a.f.t.r.2d 5061 (d.c. cir. 7/6/01). the taxpayer advanced over $1 million to three sibling corporations on �open account.� when the sibling corporations went out of business, the taxpayer claimed bad debt deductions. the tax court upheld the commissioner�s disallowance of the deduction, finding that the evidence relating to the transfers did not treating them as loans: there were no debt instruments or signed agreements; no fixed maturity date or repayment schedule, no predetermined interest rate, repayments were 664 florida tax review [vol.5:si inconsistent and appeared dependent on financial success, and the objective likelihood of repayment was low due to thin capitalization and no historical success. the district of columbia circuit, applying an abuse of discretion standard, vacated and remanded, stating as follows: the critical flaw in the tax court�s analysis is its failure . . . to consider cerand�s contemporaneous treatment of sums received from its sister corporations as in part the payment of �interest,� taxable as income to cerand. over a period of several years, cerand received $414,220 from the three corporations, of which it booked more than $175,000 as interest income. . . . although the tax court abused its discretion by omitting from its analysis a highly significant bit of evidence, we cannot say that, had the court properly weighed this evidence, it necessarily would have reached a different conclusion, because we do not know what weight it assigned to the other evidence. a. on remand, the tax court, not surprisingly, still reaches the same result. t.c. memo. 2001-271 (10/9/01). on remand judge gerber found that the somewhat sporadic reporting of interest that was not uniform in amount or percentage, ranging from 4.7 percent to 11.3 percent, with an average far below the going rate, was inadequate evidence to support a finding a true debtor-creditor relationship. furthermore, purported principal repayments were merely book entries that were offset by larger advances. the bad debt deduction was disallowed. 3. intermet corp. v. commissioner, 117 t.c. 133 (10/2/01), on remand from 209 f.3d 901 (6th cir. 4/20/00). under the pre-1999 version of § 172(f), state tax deficiencies and interest on state and federal tax deficiencies were a specified liability losses subject to a 10-year carryback. judge wells followed host marriott corp. v. united states, 113 f.supp.2d 790 (d.md. 2000), aff�d by order, 267 f.3d 363, 88 a.f.t.r.2d 5176, 2001-2 u.s.t.c. ¶ 50,580 (4th cir. 7/20/01), and distinguished sealy corp. v. commissioner, 107 t.c. 177, aff�d, 171 f.3d 655 (9th cir. 1999) [holding that accounting and other costs to comply with the 1934 securities act and erisa were not specified liability losses]. i. at-risk and passive activity losses 2002] recent developments in federal income taxation 665 9. gitlitz v. commissioner, 121 s. ct. 701, 2001-1 u.s.t.c. ¶ 50,147, 87 a.f.t.r.2d 417 (1/9/01), discussed at vi.d.1. 1. the statute was self-executing; the taxpayer doesn�t have to wait for regulations on self-charged management fees. hillman v. commissioner, 114 t.c. 103 (2/29/00). the taxpayer�s s corporation performed management services for real estate partnerships in which the taxpayer directly or indirectly was a partner. the taxpayer received passthrough nonpassive income from the s corporation and passthrough passive deductions from the partnerships. based on § 469(l)(2) and its legislative history, under circumstances analogous to those in prop. reg. § 1.469-7, 56 f.r. 14034 (4/5/91), permitting the offsetting of �self-charged� interest incurred in lending transactions, the taxpayer offset passive management fee deductions against the corresponding nonpassive management fee income. section 469(1)(2) provides that the irs �shall� promulgate regulations �which provide that certain items of gross income will not be taken into account in determining income or loss from any activity (and the treatment of expenses allocable to such income).� prop. reg. § 1.469-7 permits offsetting of �self-charged� interest incurred in lending transactions, but the irs did not issue any regulation for self-charged items other than interest. under the proposed regulations, a taxpayer who was both the payor and recipient of interest was allowed, to some extent, to offset passive interest deductions against nonpassive interest income. the commissioner argued that the taxpayer could not set off the deductions and income because the irs had not issued regulations for self-charged items other than interest and had thereby limited the offset. the court (judge gerber) held that the substantive set-off rule was self-executing and the taxpayer was entitled to offset the passive management deductions against the nonpassive management income. such selfcharged treatment was congressionally intended not only for interest, but also for other appropriate items, and the commissioner did not argue that there was any distinction of substance between interest and management fees within the self-charged regime. a. well, now, not for this taxpayer and not in the fourth circuit. what �plain meaning� giveth in gitlitz,9 it taketh away in hillman. reversed, 250 f.3d 228, 2001-1 u.s.t.c. ¶ 50,354; 87 a.f.t.r.2d 1731 (4th cir. 4/17/01), rehearing en banc denied, 2001 tnt 150-12 (6/30/01). the court of appeals (judge hamilton) reversed, finding �nothing in the plain language of irc section 469 suggests that an exception to irc section 469(a)�s general prohibition against a taxpayer�s deducting passive activity losses from 666 florida tax review [vol.5:si nonpassive activity gains exists where, as in the present case, the taxpayer essentially paid a management fee to himself.� the court reasoned that hillmans� argument for ignoring the plain language of the statute could prevail only if one of �two extremely narrow exceptions to the plain meaning rule� applied: (1) �when literal application of the statutory language at issue produces an outcome that is demonstrably at odds with clearly expressed congressional intent to the contrary�; or (2) �when literal application of the statutory language at issue �results in an outcome that can truly be characterized as absurd, i.e., that is so gross as to shock the general moral or common sense.�� in the eyes of the court, neither of those situations was present. 2. a rule that usually helps the taxpayer has a dark side. bailey v. commissioner, t.c. memo. 2001-296 (11/07/01). a real estate rental activity involving rentals under short term contracts � less than seven days � is excluded by reg. § 1.469-1t(e)(3) from the definition of rental activities under § 469(j)(8) and reg. § 1.469-9(b)(3). as a result, hours devoted to such an activity are not taken into account in determining the taxpayer�s participation in a real estate rental business for purposes of applying the § 469(c)(7) exception to the passive activity rules [material participation for more than 750 hours in one or more real estate businesses that constitutes more than one-half of taxpayer�s personal services hours for the year]. 3. good hour logbook � poor use of hours. deguzman v. united states, 147 f.supp.2d 274, 88 a.f.t.r.2d 6805, 2001-2 u.s.t.c. ¶ 50,560 (d.n.j. 5/24/01). the taxpayer-wife was a physician with substantial income; taxpayer-husband reported no taxable income, but performed various services relating to real estate activities, including managing rental real estate owned by the taxpayers and managing the leased premises where the wife�s medical practice was conducted. the taxpayers claimed the losses from rental real estate against the wife�s medical income under the § 469(c)(7) exception for professional services, based on approximately 800 hours of real estate �business� activity by husband in each of the years in question. the court held that hours proving services relating to property leased from a third party and used in a non-real estate business are not counted toward meeting the 750-hour requirement. accordingly, because the husband spent approximately 100 hours in each year managing the wife�s medical office facilities, the more-than-750hour requirement was not met and the rental real estate deductions were disallowed passive activity losses. iii. investment gain a. capital gain and loss 2002] recent developments in federal income taxation 667 1. a safe harbor for debt modifications; the debt substitute election is now permanent. a. rev. proc. 99-18, 1999-1 c.b. 736 (3/1/99). this revenue procedure provides for an election to treat a substitution of publicly traded debt instruments as a realization event for federal income tax purposes, even though it does not result in a significant modification under reg. § 1.1001-3 (and is, therefore, not an exchange). the election is made by a written agreement between the issuer and the holders of the debt instruments. under this election, taxpayers do not recognize any realized gain or loss on the date of the substitution, but instead take the gain or loss into account over the term of the new debt instruments. the issuer treats the new instrument as an oid instrument or an instrument with bond premium. the holder takes a substituted basis and treats the new instrument as market discount bond if the redemption price exceeds the substituted basis. the election is applicable to substitutions that occur between 3/1/99 and 6/30/00. b. rev. proc. 2000-29, 2000-28 i.r.b. 113 (6/23/00). this revenue procedure makes the debt substitution election of rev. proc. 99-18 permanent [it eliminates the 6/30/2000 sunset date]. under this election a taxpayer can treat a substitution of debt instruments as a realization event for federal income tax purposes even though there is no �significant modification� under reg. § 1.1001-3; the taxpayer would not recognize any realized gain or loss immediately, but would take gain or loss into account over the term of the new debt instrument. rev. proc. 2000-29 applies to substitutions after march 1, 1999. c. rev. proc. 2001-21, 2001-9 i.r.b. 742 (2/26/01), modifying and superseding rev. procs. 99-18 and 2000-29. the significant changes are: (1) the newly issued debt may be debt issued in a qualified reopening; (2) the outstanding debt may have been issued with premium; and (3) the determination of whether a substitution does or does not result in a significant modification may be made on the substitution date or, in most cases, on the date that is two business days before the date on which the substitution offer commences. 2. the corn products doctrine is dead. long live the § 1221(a)(7) hedging regulations. notice of proposed rulemaking, hedging transactions, reg-107047-00, 66 f.r. 4738 (1/18/01). the tax relief extension act of 1999 added new § 1221(a)(7) to exclude from the definition of �capital asset� any hedging transaction that has been clearly identified as such before the close of the day on which it was acquired, originated, or entered into. this provision in effect largely codified previously promulgated reg. § 1.1221-2]. the treasury 668 florida tax review [vol.5:si has proposed comprehensive amendments to reg. § 1.1221-2 to reflect the enactment and legislative history of § 1221(a)(7). the proposed regulations revise the treasury regulations to reflect the �risk management� standard elucidated in the legislative history. � citing, in the preamble, the legislative history [s. rep. no. 201, 106th cong., 1st sess. 25 (1999)], the proposed regulations claim exclusivity as the means for characterizing gains and losses on hedging transactions as ordinary. if a transaction is outside the regulations, gain or loss from the transaction will not be ordinary even if the property is a surrogate for a non-capital asset, the transaction serves as insurance against a business risk, the transaction serves a hedging function, or the transaction serves a similar function or purpose. a hedging transaction is defined generally as a transaction entered into in the normal course of business primarily to manage the risk of interest rate or price changes or currency fluctuations with respect to ordinary property, ordinary obligations, or borrowings. the preamble states that the definition will include most common types of business hedges. a transaction satisfies the risk management standard if it reduces risk. to enter into a hedging transaction, the taxpayer must have risk when all of its operations are considered (i.e., there must be risk on a �macro� basis). a hedge of a single asset or liability, or pool of assets or liabilities, will be respected as managing risk if the hedge reduces the risk attributable to the item or items being hedged and if the hedge is reasonably calculated to reduce the overall risk of the taxpayer�s operations. transactions that reverse or counteract hedging transactions also are considered to be hedges. a transaction that is not entered into primarily to reduce risk is not a hedging transaction unless specifically treated as such in the regulations. the regulations provide, for example, that a so-called �store-on-the-board� transaction, in which a taxpayer disposes of its production output and enters into a long futures contract with respect to the same product, is not a hedging transaction. a hedge of property or of an obligation is a hedging transaction only if a sale or exchange of the property, or performance or termination of the obligation, could not produce capital gain or loss. in this regard, § 1221(a)(8) provides ordinary gain or loss treatment for consumable supplies held or acquired on or after 12/17/99. a hedging transaction does not include a transaction entered into to manage risks other than interest rate or price changes, or currency fluctuations, unless a regulation, revenue ruling, or revenue procedure provides otherwise. the regulations do not apply where a taxpayer hedges a dividend stream, the overall profitability of a business unit, or other business risks that do not relate 2002] recent developments in federal income taxation 669 directly to interest rate or price changes or currency fluctuations with respect to ordinary property, ordinary obligations, or borrowings. the acquisition of investment assets may not be a hedging transaction, even though the acquisition may involve some risk reduction, because they typically are not acquired primarily to manage risk. for example, even though a taxpayer�s interest rate risk from a floating rate borrowing may be reduced by the purchase of debt instruments that bear a comparable floating rate, the acquisition of the debt instruments is not a hedging transaction. ordinary treatment does not apply to gain or loss from the disposition of stock where, for example, the stock is acquired to protect the goodwill or business reputation of the acquirer or to ensure the availability of goods. the proposed regulations retain the single-entity approach, and the separate-entity election, of the current regulations for hedging by members of a consolidated group. pursuant to § 1221(a)(7), the proposed regulations provide that hedging transactions must be identified before the close of the day on which they are entered into. the item, items, or aggregate risk being hedged must be identified no more than 35 days after entering into the hedging transaction. relief may be granted for inadvertent errors, and, as could have been anticipated, if a taxpayer does not identify a transaction as a hedge but has no reasonable grounds for treating it as anything other than a hedge, the irs can reclassify the gain as ordinary, but the taxpayer is bound to capital loss treatment by the failure to identify the transaction as a hedge. likewise, designation of the transaction as a hedge does not entitle the taxpayer to ordinary loss treatment if the transaction is not in fact a hedge. 3. post-corn products era hedging rules applied. pine creek farms, ltd. v. commissioner, t.c. memo. 2001-176 (7/17/01). transactions in hog futures by a taxpayer engaged in grain farming were not hedges under reg. § 1.1221-2 because they did not manage risks with respect to price changes in ordinary property. the losses were capital losses. activities of the corporation�s major shareholder (an individual) or other corporations he controlled are not attributed to the taxpayer corporation. the regulatory hedging rules are exclusive. 4. effective capital gains rates for the new millennium. for years after 2001, the preferential rates for long-term capital gains, taking into account the 8 percent and 18 percent preferential rates under § 1(h)(2), as well as the creation of the new 10 percent bracket and the gradual reduction under § 1(i)(2) of the 28 percent bracket to 27.5 percent for 2001, 27 percent for 2002 and 2003, 26 percent for 2004 and 2005, and 25 percent for 2006 and thereafter, are as follows: 670 florida tax review [vol.5:si 10 the 14% rate assumes that the § 1202 exclusion is exactly 50%. in some cases the exclusion will be less than 50%, and in such cases the exact effective rate varies widely. 11 a taxpayer in the 27.5% bracket for 2001 [27% for 2002 and 2003, 26% for 2004 and 2005, or 25% for 2006 and thereafter] can have collectibles gain taxed at his normal marginal rate if his other capital gains are small enough in amount that the § 1(h) computation of tax liability exceeds the computation under § 1(a) (d), as applicable. rate application 5% gain on �small business stock,� subject to § 1202 50% exclusion, if otherwise taxable at 10% [beginning in 2002] 7½% gain on �small business stock,� subject to § 1202 50% exclusion, if otherwise taxable at 15% 8% gain on assets held > 5 years if otherwise taxable at 10% or 15%, excluding prior depreciation on real estate 10% gain on assets, other than collectibles, held > one year, if otherwise taxable at 15%, excluding prior depreciation on real estate; and gain on collectibles held > one year if not otherwise taxable at $ 15% 14%10 gain on �small business stock,� subject to § 1202 50% exclusion, if otherwise taxable at $ 25%, depending on year 15% gain on collectibles and on depreciable real estate held > one year to the extent of prior depreciation deductions, if taxpayer is not otherwise taxed $ 25% 18% gain on assets held > 5 years and with a holding period beginning after dec. 31, 2000 (with some exceptions), if otherwise taxable $ 25%, excluding prior depreciation on real estate 20% gain on capital assets, other than collectibles, held > one year, if otherwise taxable $ 25%, excluding prior depreciation on real estate 25% gain, to the extent of prior depreciation deductions on depreciable real estate held > one year, if otherwise taxable $25% 28%11 gain, if otherwise taxable at $ 25% but not $ 28%, on collectibles held > one year 2002] recent developments in federal income taxation 671 12. the aggregate basis increase is increased by the amount by which the basis of any property exceeds the property�s fair market value if a loss would have been allowed under § 165 if the decedent had sold the property, irc § 1022(b)(2)(c), even though a particular item of property may not take a basis in the hands of the heir that exceeds its fair market value. 5. the 18% rate and a tax-free step-up? no way! rev. rul. 2001-57, 2001-46 i.r.b. 488. an individual who elects under § 311(e) of the taxpayer relief act of 1977 to treat his principal residence as being both sold and reacquired for an amount equal to fmv on 1/1/01 � in order to secure the 18% capital gains rate for assets acquired on or after that date and held for five years thereafter � may not exclude from gross income any of the gain recognized from the deemed sale. 6. modified carryover basis at death starting in 2010. the 2001 act repealed the estate tax as of 1/1/10. in this context, congress also enacted § 1022, which will replace § 1014 on 1/1/10. section 1022(a) sets forth a �general rule� under which the basis of inherited property would be the lesser of the decedent�s adjusted basis for the property or the fair market value of the property on the decedent�s date of death. this general rule, however, is limited by an exception in § 1022(b)(1)(a) that provides an aggregate basis increase of up to $1,300,000 for all of the property passing from the decedent.12 the resulting basis cannot exceed the property�s fair market value. section 1022(c) provides a special rule providing an additional basis increase of up to $3,000,000 for property inherited by a surviving spouse of the decedent. this greater spousal basis increase is not available for most terminable interests, although it is available for property passing to certain types of trusts for the benefit of a surviving spouse. section 1022(d)(4) provides that both the $1,300,000 and $3,000,000 basis increase allowances are subject to adjustment for inflation beginning in 2011, which is a year after the changes in the 2001 act sunset. � if a husband and wife own property as joint tenants, the deceased spouse is treated as owning fifty-percent of the property immediately before his or her death. irc § 1022(d)(1)(b). in the case of other joint tenancies, the decedent is treated as owning a percentage of the property proportionate to the consideration provided to acquire and improve the property. if a husband and wife own property as community property, the deceased spouse is treated as owning all of the property. irc § 1022(d)(1)(c). this special rule is analogous to § 1014(b)(6) and permits the basis increase to apply to the entire property rather than only to one-half of the surviving spouse�s interest as is the case in common law states. 672 florida tax review [vol.5:si � the basic $1,300,000 basis increase and the special $3,000,000 spousal basis increase can be pyramided. a surviving spouse who is the sole heir or legatee of the decedent thus can obtain an aggregate basis increase of $4,300,000. see irc § 1022(c)(1). alternatively, another heir can obtain a basis increase of $1,300,000 while the spouse obtains a basis increase of up to $3,000,000. � if the aggregate appreciation in all of a decedent�s assets does not exceed the applicable limit, then no problem of apportioning the basis increase among assets arises. but if the aggregate appreciation in the decedent�s assets exceeds the applicable limit, then the basis increase must be apportioned. section 1022(c) provides that the decedent�s executor shall allocate the basis increase, but provides no rules for how to allocate it. � section 1022(d)(1)(c) denies the basis increase with respect to any property received by the decedent by gift, except from the decedent�s spouse, within three years prior to death. (section 1014(e) currently provides an analogous rule if a decedent acquires property by gift within one year of death.) 7. dad, the accommodation pledgor, escapes tax on the foreclosure, but what about sonny boy? friedland v. commissioner, t.c. memo. 2001-236 (9/10/01). the taxpayer pledged to a bank appreciated stock in a closely held corporation to secure an indebtedness of his adult son to the bank. when the son defaulted on the loan, the taxpayer�s stock was transferred to the bank. judge vasquez held that the taxpayer had no amount realized on the transfer and thus recognized no gain. reg. § 1.1001-2(a)(1) treats as an amount realized only the amount of the taxpayer�s own indebtedness that is discharged by the transfer of property � not the amount of indebtedness of a third party � citing landreth v. commissioner, 50 t.c. 803 (1968) [guarantor does not realized cod income when debtor is discharged from a debt]. b. interest 1. a tough-nosed step transaction approach in the d.c. circuit. del commercial properties, inc. v. commissioner, 251 f.3d 210, 2001-2 u.s.t.c. ¶ 50,474, 87 a.f.t.r.2d 2451 (d.c. cir. 6/8/01), cert. denied, 122 s. ct. 903 (1/14/02). the taxpayer structured a loan transaction from one of its subsidiaries as a back-to-back loan from a canadian affiliate to a dutch affiliate to itself, for the purpose of bringing the loan under the u.s.-netherlands treaty, which exempted the interest, rather than the canadian treaty, which did not. the eighth circuit upheld the tax court�s decision that the back-to-back structure had no business purpose and should not be respected; the dutch affiliate was 2002] recent developments in federal income taxation 673 merely a conduit for the loan from the canadian affiliate. the court interpreted minnesota tea co. v. helvering, 302 u.s. 609 (1938) to stand for the proposition that �a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly, but instead included the step for no other purpose than to avoid u.s. taxes.� c. section 1031 1. reverse exchanges a. here�s a plr in which benefits and burdens of ownership were defined very broadly; query whether it may be relied upon. plr 200111025 (12/8/00). this private letter ruling approved a reverse like-kind exchange that was outside the safe-harbor of rev. proc. 2000-37 [because the transaction predated the effective date, and because the accommodation party held the property for more than 180 days]. the taxpayer held property on which it had granted an option that contained a like-kind-exchange cooperation agreement. with respect to the replacement property, pursuant to a �real estate acquisition agreement�: (1) the accommodation party financed the acquisition through loans (bearing market-rate interest) from a bank and from the taxpayer; (2) the bank loan was guaranteed by the taxpayer; (3) the taxpayer leased the property from the accommodation party under a triple net lease for one year, with an extension option, at a rental that exceeded the accommodation party�s operating costs (including debt service); (4) the taxpayer and the accommodation party agreed to report income treating the taxpayer as a lessee and the accommodation party as the owner; (5) the taxpayer had the option to purchase the replacement property from the accommodation party at fair market value, which was deemed to be the accommodation party�s acquisition cost if the taxpayer purchased the property within 18 months; (6) if the option terminated without the taxpayer purchasing the property, the accommodation party could sell the property and obtain the benefit of certain loss-limiting contract rights if it followed specified procedures, but if the procedures were not followed or the accommodation party kept the property, it bore the benefits and burdens of economic gain or loss; and (7) the taxpayer would provide the accommodation party general environmental release and indemnification. the irs ruled that the transaction qualified as a § 1031 like-kind exchange, citing coastal terminals, inc. v. united states, 320 f.2d 333 (4th cir. 1963), and j.h. baird pub. co. v. commissioner, 39 t.c. 608 (1962), acq., 1963-2 c.b. 4, as authority that reverse exchanges qualified under § 1031. it distinguished decleene v. commissioner, as involving a fact pattern that was not actually a reverse exchange because in that case the purported accommodation party never obtained any benefits and burdens of ownership and there was no integrated 674 florida tax review [vol.5:si plan to obtain the replacement property for the exchanged property. on the plr facts, there was an intent from the outset to effect a like-kind exchange pursuant to an interdependent integrated plan. finally, applying the six factor test for agency of national carbide corp. v. commissioner, 336 u.s. 422 (1949), with the gloss on that test provided by commissioner v. bollinger, 485 u.s. 340 (1988), the accommodation party was not the taxpayer�s agent. 2. the erosion of the glass-steagall act changes the face of likekind exchanges. t.d. 8982, definition of disqualified person, amendments to reg. § 1.1031(k)-1, 67 f.r. 4907 (2/1/02). amendments to reg. § 1.1031(k)1(k)(4) [proposed in reg-107175-00, definition of disqualified person, 66 f.r. 3924 (1/17/01)] generally provide that a bank that is a member of a controlled group that includes an investment banking or brokerage firm as a member will not be a disqualified person [with respect to deferred like-kind exchanges through an intermediary] merely because the investment banking or brokerage firm has provided services to an exchange customer within a twoyear period ending on the date of the transfer of the relinquished property by that customer. the amendments are applicable to transfers of property made on or after 1/17/01. 3. was it a deferred like-kind exchange or an installment sale? only time will tell. smalley v. commissioner, 116 t.c. 450 (6/14/01). in 1994, the taxpayer entered into a deferred exchange agreement through a qualified intermediary under which he relinquished timber-cutting rights on land he owned in fee and in 1995 [within the period required by § 1031(a)(3)], the taxpayer received fee simple interests in three parcels of real estate. in 1994, the transferee paid cash to a qualified escrow account as defined in reg. § 1.1031(k)-1(g)(3). the commissioner asserted that the taxpayer realized gain in 1994 because the timber cutting rights were personalty and thus not like-kind to a fee simple. finding the relevant state [georgia] law characterization of whether timber-cutting rights were realty or personalty �less than a seamless web of jurisprudence,� judge thorton held that in any event, no income was realized in 1994. at the beginning of the exchange period, the taxpayer had a bona fide intent to enter into a deferred exchange of like-kind property within the meaning of reg. § 1.1031(k)-1(j)(2)(iv), and under reg. § 1.1031(k)-1(g)(3) was not in actual or constructive receipt of property in 1994. whether the transaction was a like-kind exchange or an installment sale with payment received in 1995 was a question left to another day [presumably the year in which the replacement land is sold]. oh, by the way, by the time the case had been decided, the statute of limitations had run on 1995 [for which year it 2002] recent developments in federal income taxation 675 13. john�s basis in the property was $130,794. he transferred the land to louise to satisfy a debt totaling $2,153,845, including $1,500,000 in principal, $344,938 in interest, $300,606.08 in attorney�s fees, and $8,300 in collection costs. john reported no capital gain from his use of the appreciated property to satisfy his debt. louise sold the property for $2,265,000 and reported a $100,000 short-term capital gain and $356,500 in interest income. appears that the taxpayer reported the closing of the transaction as a like-kind exchange, not receipt of an installment payment]. d. section 1041 1. for just how long are you a �former spouse� �incident to a divorce� under § 1041? a. for a long, long time. young v. commissioner, 113 t.c. 152 (8/20/99). a former husband defaulted on a $1.5 million promissory note given to his former wife in a divorce settlement in 1989 and satisfied a judgment on the note by transferring real estate, which he had received in the original divorce, to his former wife in 1992. she subsequently sold the property for $2.2 million.13 the value of the real estate equaled the sum of the principal of the note, accrued but unpaid interest, the wife�s attorney�s fees, and certain costs. the tax court (judge foley) held that the husband�s transfer of the real estate was �incident to the divorce.� accordingly, under § 1041, the husband recognized no gain on the transfer and the wife held it at her husband�s adjusted basis. b. affirmed. young v. commissioner, 240 f.3d 369, 2001-1 u.s.t.c. ¶ 50,244, 87 a.f.t.r.2d 889 (4th cir. 2/16/01) (2-1). the court of appeals rejected mrs. young�s argument that she received the property as a �judgment creditor,� finding that the only relevant status was her status as a �former spouse.� the sole reason for the 1992 transfer of the real estate from mr. young to mrs. young was to resolve ongoing disputes that originated in the divorce. had the youngs reached this settlement at the time of their divorce, there is no question that this transaction would have fallen under § 1041. there is no reason for the holding to differ here where the same result occurred through two transactions instead of one. 676 florida tax review [vol.5:si the policy animating § 1041 is clear. congress has chosen to �treat a husband and wife [and former husband and wife acting incident to divorce] as one economic unit, and to defer, but not eliminate, the recognition of any gain or loss on interspousal property transfers until the property is conveyed to a third party outside the economic unit.� blatt v. commissioner, 102 t.c. 77, 80 (1994) (emphasis added) . . . thus, no taxable event occurred and no gain was realized by either mr. or mrs. young until mrs. young sold the 59 acres to a third party. � judge wilkins, in dissent, argued that the 1992 agreement was not a divorce or separation agreement and that this fact raises the presumption that the property transfer was not related to the cessation of the marriage, and that the government failed to show �that the transfer was made to effect the division of [marital] property� as required by temp. reg. § 1.1041-1t(b). . . . because the division of marital property was completed years before the property transfer � when the parties released their marital claims against one another and louise accepted the promissory note � i would hold that the government failed to make the necessary showing. a property transfer is not made for the purpose of effecting a marital property division when the marital property division has already been completed. the youngs completed this division when john delivered the promissory note to louise. his payments on the note did not transfer marital property; the note itself accomplished that. . . . the 1992 property transfer was made simply to satisfy a judgment between them, for reasons bearing no relationship to the fact that the parties were previously married. . . . the majority concludes that the 1992 property transfer should not be treated as a taxable event because that would have been the result had louise agreed to the property transfer as part of the 1989 divorce settlement. . . . [t]he hypothetical transaction offered by the majority and the transaction that actually occurred are not alike. in fact, they differ in the most critical way: in the hypothetical, louise would have obtained the property as a means of severing her economic union with 2002] recent developments in federal income taxation 677 her former spouse, thereby justifying treatment of the transfer as if it were made within a single economic unit, whereas in the actual transaction, the property was transferred after the youngs� economic union had already been completely severed. 2. �tis doubly blessed to get redeemed in divorce than in marital bliss. read v. commissioner, 114 t.c. 14 (2/4/00). mr. and mrs. read (h & w) owned substantially all of the stock of mulberry motor parts, inc. (mmp). when they divorced, the final judgment ordered (1) that w sell to h, or at h�s election to mmp or mmp�s esop plan, all of her mmp stock, and (2) that h, or at h�s election mmp or mmp�s esop plan, pay $838,724 to w ($200,000 down and the balance by interest bearing note). h elected to cause mmp to purchase and pay for w�s stock, and the transaction was so structured. w argued that she was entitled to nonrecognition under § 1041(a) and reg. § 1.1041-1t(c), q&a-9, which treats certain transfers to third parties as a transfer of property by the transferring spouse directly to the nontransferring spouse that qualifies for nonrecognition treatment under § 1041 followed by an immediate transfer of the property by the nontransferring spouse to the third party in a transaction that is not subject to § 1041 � i.e., h would have a redemption treated as a dividend. h argued that § 1041(a) and reg. § 1.10411t(c), q&a-9 were inapplicable because he never had an unconditional obligation to purchase w�s mmp stock, and that accordingly he recognized no income and w recognized gain on the redemption of her stock. the commissioner took the position that he was a mere stakeholder and had issued deficiency notices to both taxpayers in the joined cases to avoid a whipsaw, but the commissioner argued that w �has the better argument.� � the tax court, in a reviewed opinion (9-7) by judge chiechi, agreed with the commissioner and w. the court held that in cases involving corporate redemptions in a divorce setting, the primary-andunconditional-obligation standard that generally applies in �bootstrapacquisitions� [see rev. rul. 69-608, 1969-2 c.b. 42] is not the appropriate standard to apply to determine whether the transfer of property by the transferring spouse to a third party is on behalf of the nontransferring spouse within the meaning of reg. § 1.1041-1t(c), q&a-9. applying the common, ordinary meaning of the phrase �on behalf of� in q&a-9, w�s transfer of her stock to mmp was a transfer of property by w to a third party on behalf of h within the meaning of the regulation. thus, under § 1041(a), no gain was recognized by w and h recognized a dividend. the majority reasoned that hayes v. commissioner, 101 t.c. 593 (1993), did not limit the treatment of a redemption of one divorcing spouse�s stock as a § 1041 transfer by that spouse and a dividend to the nonredeeming spouse. it distinguished blatt v. commissioner, 102 t.c. 77 (1994), because in that case the record did not 678 florida tax review [vol.5:si establish that corporation acted on behalf of husband in redeeming wife�s stock; and the majority attempted to distinguish the tax court�s prior opinion in arnes v. commissioner, 102 t.c. 522 (1994), as involving an instance in which the husband did not have an unconditional obligation to acquire the wife�s stock. � dissents by judges ruwe, halpern, and beghe, all argued in one way or another that the primary-and-unconditionalobligation standard that generally applies in bootstrap-acquisitions was the appropriate standard to apply, nothing in reg. § 1.1041-1t(c), q&a-9 indicated otherwise, and that on the facts h did not have a primary and unconditional obligation to purchase w�s stock. � a joint dissent by judges laro and marvel argued that reg. § 1.1041-1t(c), q&a-9, never should apply to redemptions like those in any of these cases. a. but the contrary case law still prevails in the tax court and the ninth and eleventh circuits � and will prevail until the proposed regulations become final. affirmed sub. nom. mulberry motor parts, inc. v. commissioner, 273 f.3d 1120, 88 a.f.t.r.2d 6182 (11th cir. 9/20/01) (per curiam). the court affirmed the tax court�s decision in read, holding that it was bound by craven v. united states, 215 f.3d 1201, 2000-2 u.s.t.c. ¶ 50,541, 85 a.f.t.r.2d 2229 (11th cir. 2000). after the eleventh circuit relied on the tax court opinion in read in deciding craven in the first place, the eleventh circuit panel in read now finds itself to be bound by its holding in craven. 3. and the treasury comes to the rescue � subchapter c principles apply; otherwise, form controls. reg-107151-00, constructive transfers and transfers of property to a third party on behalf of spouse, 66 f.r. 40659 (8/3/01). because of the inconsistent standards applied by the courts in dealing with redemptions of stock incident to a divorce, the treasury has proposed regulations [prop. reg. § 1.1041-2] to provide greater certainty in determining which spouse will be taxed on stock redemptions occurring during marriage or incident to divorce. reg. § 1.1041-1t(c) q&a-9 no longer will control after the regulations are finalized. � the proposed regulations apply only where the nonredeemed spouse owns stock of the redeeming corporation either immediately before or immediately after the stock redemption. if a corporation redeems stock of one spouse, and that redemption is treated as a constructive distribution to the other spouse under subchapter c principles � the primary and unconditional obligation standard of wall v. united states, 164 f.2d 462 (4th 2002] recent developments in federal income taxation 679 14. ninth circuit applies § 1041 to exclude gain on wife�s stock redemption. arnes v. united states, 981 f.2d 456 (9th cir. 1992). the ninth circuit (judge hall) affirmed a district court�s grant of summary judgment to taxpayer, holding that the divorce-settlement redemption of taxpayer�s stock (in a mcdonald�s franchise corporation she owned equally with her former husband) qualified for exemption under § 1041. the former husband was held to have been relieved of an obligation by the corporate redemption, so a-9 of temp. reg. § 1.1041-1t would treat taxpayer�s stock as having been transferred to her former husband, and then retransferred to the corporation (the �third party�) in a non-§ 1041 transaction. the $450,000 cash is to be treated as paid to taxpayer by the corporation on behalf of her former husband (and presumably constituting a taxable distribution to her former husband). see temp. reg. § 1.1041-1t, a-2, example (3). but tax court holds § 1041 does not apply to tax her husband on the redemption, so neither is taxed. arnes v. commissioner, 102 t.c. 522 (1994) (reviewed, 7 judges dissenting). redemption of wife�s stock [in corporation owned 5050 by husband and wife] was not a constrictive dividend to husband because he did not have a primary and unconditional obligation to purchase wife�s stock, relying on rev. rul. 69-608, 1969-2 c.b. 42. dissents on ground that the ninth circuit has passed on the legal issue, citing golsen v. commissioner, 54 t.c. 742 (1970) aff�d, 455 f.2d 985 (10th cir. 1971), and on the untenable result that neither stockholder will incur tax consequences as a result of the $450,000 stock redemption. the tax court disagrees with the ninth circuit�s arnes case, and judge beghe has the correct answer. blatt v. commissioner, 102 t.c. 77 (1994) (reviewed, 3 judges dissenting). wife�s redemption (pursuant to a divorce decree) of all her stock in a corporation she owned entirely with her husband was not governed by § 1041, and was taxable to her. the court refused to follow the reg. § 1.1041-1t, q&a-9 theory that the redemption was a transfer to the corporation on behalf of her husband, as held in arnes v. united states, 981 f.2d 456 (9th cir. 1992), which the court refused to follow. judge beghe�s concurring opinion stated that the proper interpretation of that regulation should be that no redemption should be considered to be �on behalf of� the cir. 1947) and sullivan v. united states, 363 f.2d 724 (8th cir. 1966) � the redemption is treated as a distribution to the spouse who continues as a shareholder. see also rev. rul. 69-608, 1969-2 c.b. 42. section 1041 applies to the deemed transfer of the stock by the redeemed spouse to the continuing shareholder spouse. section 1041 does not apply to the deemed transfer of stock from the nontransferor spouse to the redeeming corporation. any property actually received by the redeemed spouse from corporation is treated as flowing through the continuing shareholder-spouse, and § 1041 applies to that transfer. in all other cases, the form of the stock redemption will be respected; the redeemed spouse will be taxed on the redemption and the continuing spouse has not tax consequences. the preamble specifically states: [i]f the rules of the proposed regulations had applied in the arnes case,14 because the husband did not have a primary and 680 florida tax review [vol.5:si remaining spouse unless it discharges that spouse�s primary and unconditional obligation to purchase the redeemed stock, as set forth in the examples of rev. rul. 69608, 1969-2 c.b. 42. unconditional obligation to purchase the wife�s stock, the redemption would have been taxed in accordance with its form with the result that the wife would have incurred the tax consequences of the redemption. � a special rule applies if an effective divorce or separation instrument, or a written agreement between the spouses [executed before the due dates of their returns], requires the spouses to file their federal income tax returns in a consistent manner that treats the stock as being redeemed from the continuing shareholder spouse rather than from the spouse from whom it was actually redeemed. in such a case spouses and former spouses will treat a redemption that otherwise would be taxed according to its form as a redemption from the continuing shareholder spouse involving: (1) a deemed § 1041 transfer of the stock by the redeemed spouse to the continuing shareholder spouse, and (2) a deemed § 1041 transfer by the continuing shareholder spouse to the redeemed spouse of the redemption proceeds. iv. compensation issues a. employee compensation: fringe benefits and qualified plans 1. keeping up with ever-changing cafeteria plan rules a. t.d. 8921, tax treatment of cafeteria plans, 66 f.r. 1837 (1/10/01). amendments to the cafeteria plan regulations under § 125 on midyear election changes modify the march 2000 final regulations [t.d. 8878, tax treatment of cafeteria plans, 65 f.r. 15548 (3/23/00), permitting a mid-year cafeteria plan election with respect to medical and group term life insurance by an employee who has a change of status, such as change in marital status or number of dependents, employment, work site, etc., during the year] also to permit employees to elect to increase or decrease group-term life insurance or disability coverage in response to a change-of-status event, including birth, adoption, or death. [employees generally are permitted to make elections between cash or qualified tax free benefits only at the beginning of the plan year.] 2002] recent developments in federal income taxation 681 b. t.d. 8966, additions to final cafeteria plan regulations under § 125, 66 f.r. 52675 (10/17/01). the treasury has promulgated final regulations, in q&a format, relating to cafeteria plans that reflect changes made by the family and medical leave act of 1993. 2. fundamental changes in the treatment of split-dollar life insurance. notice 2001-10, 2001-5 i.r.b. 459 (1/29/01). this notice provides interim guidance on split-dollar life insurance contracts. it notes that the p.s. 58 rates no longer reflect the current fair market value of insurance protection. the notice requires that employer payments be consistently treated as: (1) interestfree loans under § 7872, (2) investments by the employer in the contract, or (3) payments of compensation. the service had long rejected interest-free loan treatment of the employer investment in the cash value of split dollar life insurance, but the enactment of § 7872 in 1984 enables interest-free loan treatment to be used as a valid model. the alternative is to have the true cost of insurance protection reflected in the employee�s income; insurance companies will be required to provide rates at which comparable term policies will be available to the general public (instead of the low-ball rates that had been provided in the past). this notice revokes rev. rul. 55-747, 1955-2 c.b. 228, and provides that, after 2001, p.s. 58 rates may not be used. a. not so fast! irs revokes notice 2001-10 and for future arrangements requires taxation under one of two mutually exclusive regimes. notice 2002-8, 2002-4 i.r.b. 398 (1/3/02), revoking notice 2001-10, 2001-5 i.r.b. 459. when the treasury and service publish proposed regulations providing comprehensive guidance regarding the tax treatment of split-dollar life insurance arrangements, they will provide the following treatment in employment-related arrangements: � if the employer is formally designated as owner of the life insurance contract, then the employer will be treated as providing current life insurance protection and other economic benefits to the employee. a transfer of the life insurance contract to the employee would be taxed under § 83, but an employer would not be treated as having made a transfer of the cash surrender value for purposes of § 83 �solely because the interest or other earnings credited to the cash surrender value of the contract cause the cash surrender value to exceed the portion thereof payable to the employer.� this has the effect of leaving that issue unresolved, and would change the position in notice 2001-10 that the employee would be taxed under § 83 on the transfer of a beneficial interest in the cash surrender value. � if the employee is formally designated as owner, the premiums paid by the employer would be treated as a series of loans by the employer to the employee � if the employee is required to repay the 682 florida tax review [vol.5:si 15. gitlitz v. commissioner, 531 u.s. 206, 2001-1 u.s.t.c. ¶ 50,147, 87 a.f.t.r.2d 417 (1/9/01), discussed at vi.d.1 employer out of insurance proceeds or otherwise. the loans are subject to taxation under the §§ 1271-1275 oid provisions and the § 7872 compensationrelated below-market loan provision. if the employee is not required to repay the employer, then the premiums paid are treated as compensation income to the employee when paid. � the new rules will be effective for arrangements entered into after the date of publication of final regulations. there will be special provisions for valuing current life insurance protection entered into before 1/28/02 (p.s. 58 is ok) and for arrangements entered into before the date of publication of final regulations. 3. new comprehensive employee plan correction guidance (epcrs). rev. proc. 2001-17, 2001-7 i.r.b. 589 (1/19/01), modifying and superceding rev. proc. 2000-16, 2000-6 i.r.b. 518. modifications include: (1) allowing master and prototype sponsors and third-party administrators to correct failures affecting more than one plan sponsor; (2) allowing anonymous �john doe� submissions; (3) adding procedures for seps; and (4) allowing retroactive amendments related to hardship withdrawals, employees participating before they are eligible, and ineligible employers who sponsored a 401(k) plan. 4. would the gitlitz15 court uphold this revenue ruling? rev. rul. 2001-6, 2001-6 i.r.b. 491 (1/19/01). payments in redemption of stock held by an esop that are used to make distributions to terminating esop participants are not deductible as �applicable dividends� under § 404(k)(1), but are disallowed under § 162(k)(1) [and § 04(k)(5)(a), which authorizes the irs to disallow a deduction under § 404(k)(1) for any dividend that, in substance, constitutes an evasion of taxation]. . . . [t]he treatment of redemption proceeds as �applicable dividends� under section 404(k) would produce such anomalous results that section 404(k) cannot reasonably be construed as encompassing such payments. see, e.g., helvering v. hammel, 311 u.s. 504, 510-511 (1941) (the words of a statute must be given �a restricted rather than a literal or usual meaning . . . where acceptance of that meaning would lead to absurd results . . . or would thwart the obvious purpose of the statute.�) 2002] recent developments in federal income taxation 683 5. the 2001 act made extensive technical changes in the rules governing qualified pension plans. the unindexed benefits limit for defined contribution plans has been increased from $90,000 to $160,000. the unindexed contributions limit for defined benefit plans has been increased from $30,000 to $40,000. a. special rules in new § 414(v) allow increased elective contributions to defined contribution plans by employees age 50 or older. the amendments to the qualified pension plan rules permit extensive rollovers between qualified plans and between qualified plans and iras as employees change jobs. more specifically, � for defined contribution plans: (1) the § 415(c)(1)(a) annual addition limit was increased from the lesser of 25% of compensation or $35,000 [$30,000 as indexed through 2001] to the lesser of 100% of compensation or $40,000; (2) the annual elective deferral limitation on § 401(k) plans, § 403(b) annuities, etc., will be increased to $11,000 in 2002, with annual increases of $1,000 until $15,000 is reached in 2006 (after which it will be indexed for inflation); and (3) the annual compensation limit that may be taken into account in determining contributions will be increased from its current $170,000 to $200,000 in 2002 (and indexed thereafter). � employees age 50 and older may make �catch up� additional elective deferrals of $1,000 for 2002, increasing in $1,000 annual increments to $5,000 in 2006 (and indexed for inflation thereafter). � for defined benefit plans, the annual benefit limit will increase from its current $140,000 [$90,000 as indexed through 2001] to $160,000 in 2002, and the annual compensation limit that may be taken into account in determining benefits will be increased to $200,000 in that year as well. � employer contributions must be vested more quickly to either: (1) cliff vesting in two years, or (2) gradual vesting at 20 percentage point increments from the second to sixth year of employment. � beginning in 2006, § 401(k) plans and § 403(b) plans may incorporate a �qualified roth contribution program� pursuant to which participants may elect to have all or a portion of their elective deferrals to the plan designated as after-tax �roth contributions.� rollovers to individual roth iras will be permitted. (1) guidance on § 415 changes. rev. rul. 2001-51, 2001-45 i.r.b. 427 (10/17/01), modifying rev. rul 98-1. provides guidance in q&a form relating to the increases in the limitations of § 415 enacted as part of the 2001 act. specifically, this revenue ruling provides questions and 684 florida tax review [vol.5:si answers on: (1) benefit increases that may be provided as a result of the increased § 415 limitations; (2) plan amendments that may be adopted to take into account the increased § 415 limitations; (3) the effect of the increased § 415 limitations on other qualification requirements; and (4) how the �sunset� provision of egtrra is taken into account for purposes of §§ 412 and 404. (2) how to apply the �ketchup� at the 2001 act picnic. reg-142499-01, proposed regulations on catch-up contributions, 66 f.r. 53555 (10/23/01). these proposed regulations would implement new § 414(v) by providing that an employer plan is not treated as violating any provision of the code solely because the plan permits individuals age 50 or older to make catch-up contributions. catch-up contributions generally are elective deferrals made by a catch-up eligible participant that exceed an otherwise applicable limit and that are treated as catch-up contributions under the plan, but only to the extent they do not exceed the maximum amount of catch-up contributions permitted for the taxable year. see also, announcement 2001-93, 2001-44 i.r.b. 416, for information on how to report participants� elective pension deferrals on form w-2, box 12, and in the totals reported for codes d through h and s. b. small employer tax credit for plan start-up costs. new § 45e provides a nonrefundable credit (for tax years beginning after 2001) equal to 50 percent of the first $1,000 of administrative and retirementeducation start-up costs [paid or incurred in tax years beginning after december 31, 2001] for any small business that adopts a new qualified defined benefit or defined contribution pension plan. the credit is available only with respect to the first three years of the plan�s existence. the employer may elect to claim the credit in the year preceding the first plan year (but not before 2002) and may elect not to claim the credit for a given tax year. only employers that did not have more than 100 employees whose compensation exceeded $5,000 in the preceding year qualify. an employer is not eligible if, during the 3-year period before the first year for which a credit is allowable, the employer established or maintained a qualified plan. controlled group aggregation rules apply for these purposes. the plan must cover at least one nonhighly compensated employee in order to qualify. thus, the credit is not available to a sole proprietor with no employees, or the owner of single member llc that employs only the owner. the credit is part of the general business credit. if the credit is claimed, the onehalf of the expenses with respect to which the credit is allowed are automatically nondeductible; the remaining one-half of the qualifying expenses are deductible to the extent otherwise allowable. thus, if an eligible employer has $5,000 in qualified startup costs, 50 percent of the first $1,000 give rise to 2002] recent developments in federal income taxation 685 a $500 credit, making $500 of the $5,000 in qualified costs nondeductible. but the remaining $4,500 of such costs may be deducted. 6. qualified retirement planning services will become an excludable fringe benefit in 2002. section 132(a)(7), added by the 2001 act, excludes �qualified retirement planning services� beginning in 2002. qualified retirement planning services are defined in § 132(m) as retirement planning advice or information provided to an employee and his spouse by an employer maintaining a qualified pension plan. interestingly, nothing on the face of the statute limits the advice to matters related to the qualified pension plan on which eligibility is based, and the legislative history clearly states that the information and advice is not so limited. it may extend to retirement income planning generally and how the employer�s plan fits into the employee�s overall retirement income planning. the exclusion does not, however, extend to tax preparation, accounting, legal and brokerage services related to retirement planning. the exclusion is subject to a nondiscrimination rule that makes it available to highly compensated employees �only if such services are available on substantially the same terms to each member of the group of employees normally provided education and information regarding the employer�s qualified employer plan.� the legislative history indicates that under this standard the irs should permit employers to limit certain types of advice to individuals nearing retirement. 7. effective date guidance. notice 2001-56, 2001-38 i.r.b. 277 (9/17/01). this notice provides guidance regarding application of the effective date rules for amendments to: (1) § 401(a)(17) [and related sections], increasing the compensation limit [to $200,000] � effective for plan years beginning on or after 1/1/02, even if the plan uses annual compensation for a period beginning before 1/1/02; (2) § 416, regarding determination of top-heavy status � effective for plan years beginning after 12/31/01, even if the determination date is before 1/1/02; and (3) revisions to the regulations relating to hardship distributions under § 401(k)(2)(b)(i)(iv), as mandated by § 636(a) of egtrra � regulations to be effective for calendar years beginning after 12/31/01. 8. sample plan amendments. notice 2001-57, 2001-38 i.r.b. 279 (9/17/01). the irs has published sample plan amendments to conform qualified plans to the changes effected by the economic growth and tax relief reconciliation act of 2001. 9. prolong the gust-o. rev. proc. 2001-55, 2001-49 i.r.b. 552 (11/14/01). the service has extended the gust remedial amendment period under § 401(b) of the code for qualified retirement plans to 2/28/02. for plans 686 florida tax review [vol.5:si affected by the september 11th terrorist attack, the extension is to 6/30/02, with a possible further extension to 12/31/02. � �gust� refers to the following: (1) the uruguay round agreements act, pub. l. 103-465; (2) the uniformed services employment and reemployment rights act of 1994, pub. l. 103-353; (3) the small business job protection act of 1996, pub. l. 104-188; (4) the taxpayer relief act of 1997, pub. l. 105-34; (5) the internal revenue service restructuring and reform act of 1998, pub. l. 105-206; and (6) the community renewal tax relief act of 2000, pub. l. 106-554. 10. flynn v. commissioner, 269 f.3d 1064, 88 a.f.t.r.2d 6586, 20012 u.s.t.c. ¶ 50,737 (d.c. cir. 10/30/01), aff�g t.c. memo. 2000-223. the court of appeals affirmed the tax court�s decision upholding reg. § 1.74761(b)�s �interested parties� rule, which excludes former employees from the group entitled to bring an action under § 7476 seeking a declaratory judgment regarding the status of a qualified plan [except in cases involving plan terminations]. accordingly, the taxpayer lacked standing to challenge the irs�s favorable determination following a plan amendment, even though he may have been adversely affected. 11. flahertys arden bowl, inc. v. commissioner, 271 f.3d 763, 2001-2 u.s.t.c. ¶ 50,770, 88 a.f.t.r.2d 6850 (8th cir. 11/16/01) (per curiam). participant�s plan made loans to taxpayer/corporation [57% owned by participant]. even though erisa § 404(c) excepted participants who direct their own accounts from the definition of fiduciary, § 4975 does not contain any parallel provision and the corporation was a disqualified person under the § 4975 excise tax provisions. but penalties were not upheld, because participant followed the advice of an attorney who advised him that the loans would not violate erisa or cause liability under § 4975. b. section 83 and stock options 1. a deductible redemption, thanks to § 83. riverton investment corp. v united states, 170 f.supp.2d 608, 2001-1 u.s.t.c. ¶ 50,318, 87 a.f.t.r.2d 1430 (w.d. va. 3/6/01). under § 83 non-lapsing restrictions may so limit the employee�s beneficial ownership of property that the property will not be considered ever to have been transferred to the employee. [see reg. § 1.83-3(a)(5), providing �an indication that no transfer has occurred is the extent to which the consideration to be paid the transferee upon surrendering the property does not approach the fair market value of the property at the time of surrender,� and reg. § 1.83-3(a)(5) providing �an indication that no transfer has occurred is the extent to which the transferee does not incur the risk that the 2002] recent developments in federal income taxation 687 value of the property at the time of the transfer will decline substantially.�] the district court held that the taxpayer-corporation could deduct the cost of �repurchasing� stock issued to an employee subject to the condition that it be resold to the corporation upon termination of employment at a price equal to the greater of the amount paid by the employee of 60 percent of book value. the stock was never �transferred�; thus the payment was not in redemption by the corporation. the �repurchase� was simply the payment of compensation. 2. although the exercise of a statutory stock option does not result in taxable income, it does result in wages for fica/futa purposes � but not until 2003. reg-142686-01, proposed regulations on application of the federal insurance contributions act, federal unemployment compensation act, and collection of income tax at the source to statutory stock options, 66 f.r. 57023 (11/14/01). prop. regs. §§ 31.3121(a)-1(k), 31.3306(b)-1(l), and 31.3401(a)-1(b)(9) would provide that the holder of a statutory stock option [§ 422(b) iso or § 423(b) espp] receives wages for fica and futa purposes upon exercise of the option, but no withholding is required because no gross income has been received. the amount of the wages received is the excess of the fair market value of the stock over the amount paid. the irs will develop �rules of administrative convenience� permitting employers to deem the wages to have been paid on a specific date or over a specific period of time. income tax withholding is not required because the individual does not receive income at the time of exercise of an iso or employee stock purchase plan. however, the irs will not assert fica or futa tax that is based upon the exercise of a statutory stock option that occurs prior to 1/1/03. a. notice 2001-73, 2001-49 i.r.b. 549 (12/3/01). the irs announced and requested comments on proposed �rules of administrative convenience� permitting employers to deem the wages to have been paid on a specific date for fica and futa purposes. fica and futa wages could be treated as paid on a pay period, quarterly, semi-annual, annual, of other. b. notice 2001-72, 2001-49 i.r.b. 548 (12/3/01). the irs announced and requested comments on proposed rules regarding the employer�s income tax withholding and reporting obligations on the sale by an employee of stock received pursuant to exercise of a statutory stock option. the employer is not required to withhold, but is required to report if the amount is at least $600, unless the employer has made reasonable efforts to determine if reporting is necessary and has been unable to do so. 688 florida tax review [vol.5:si 3. a contractual forfeiture provision piggy-backed on an extended § 16(b) period isn�t good enough to avoid current recognition. tanner v. commissioner, 117 t.c. 237 (12/10/01). pursuant to an agreement to acquire control of a corporation, the taxpayer signed a lockup agreement that restricted his sale of stock by providing that if he sold any stock within 2 years of its acquisition, he would be subject to § 16(b) of the securities exchange act of 1934. on 6/9/93, the taxpayer received a nonstatutory employee stock option from c; on 9/7/94, he exercised this stock option. he pledged some of this stock as collateral for a loan, and the stock was subsequently sold by the lender. the commissioner determined that the taxpayer realized income in 1994 from the exercise of the stock option based on the difference between the option price and the price the stock was selling for on the date the option was exercised. the taxpayer argued that during 1994 the stock was subject to risk of forfeiture under § 83(c)(3) as a result of the lock-up agreement. judge vasquez held that § 83(c)(3) was inapplicable because the 6-month restricted period under § 16(b) of the securities exchange act of 1934 commenced on the date of grant of the option and had expired on the date of exercise. furthermore, for purposes of § 83(c)(3) the six-month period in § 16(b) cannot be extended by agreement. accordingly, the taxpayer realized income at the time the option was exercised. c. individual retirement accounts 1. they�re taking all the fun out of calculating minimum required distributions from plans and iras. reg-130477-00 and reg-130481-00, required distributions from retirement plans, 66 f.r. 3928 (1/17/01). proposed regulations under § 401(a)(9), etc., substantially simplify the calculation of minimum required distributions from qualified plans, iras, and other related retirement savings vehicles. the changes in the proposed regulations are based on the concept of a uniform lifetime distribution period. the regulations provide a single table that any recipient can use to calculate his or her yearly mrd amount by plugging in his or her age and the prior year-end balance of his or her retirement account or ira. the table eliminates the need to elect recalculation of life expectancy, determine a designated beneficiary by the required beginning date, or satisfy a separate incidental death benefit rule. the proposed regulations will result in reducing mrds for the vast majority of employees and ira holders. although mrds will be calculated without regard to the beneficiary�s age, the regulations will continue to permit a longer payout period if the beneficiary is a spouse more than 10 years younger than the employee. 2002] recent developments in federal income taxation 689 2. �active participation� in a plan turns on accruing any slight benefit, not on having a chance of actually getting anything back from the plan. wade v. commissioner, t.c. memo. 2001-114 (5/14/01). mrs. wade, who was a part-time community college teacher, was an active participant in a qualified plan by virtue of an $84.89 mandatory contribution to a defined benefit plan in a year in which she accrued approximately 1/120th of the service required for benefits to vest. as a result both mrs. and mr. wade, whose combined agi was $77,000, were denied deductions for their $2,000 ira contributions under the § 219(g) agi phase-out rule. 3. ira changes in the 2001 act a. section 25b, which is effective only for the years 2002 through 2006, provides a nonrefundable credit to lowand moderate-income taxpayers making contributions to individual retirement accounts or to employer-sponsored retirement plans. the credit is not available to taxpayers with adjusted gross income over $50,000 (joint returns), $37,500 (heads of households), or $25,000 (all others). below those ceilings, the credit equals a percentage of the taxpayer�s �qualified retirement savings contributions.� the percentage is 50 percent, 20 percent, or 10 percent, depending on the taxpayer�s agi, with the percentage decreasing as agi increases. there are cliff effects as the credit percentage is stepped down. for example for a married couple with an agi of $30,000, the credit is 50 percent of qualified retirement savings contributions; for a married couple with an agi of $30,001, however, the credit is only 20 percent of qualified retirement savings contributions. � the ceiling on credit-eligible contributions is $2,000 for each eligible individual. to be eligible, an individual must be at least 18 years old, and must not be a dependent or a full-time student. �qualified retirement savings contributions� include elective contributions under §§ 410(k), 403(b) and 457, voluntary after-tax employee contributions to a qualified retirement plan, and contributions to iras (regular and roth). the amount of credit-eligible contributions is reduced by taxable distributions received by the taxpayer (or the taxpayer�s spouse) from qualified retirement plans or iras, during a �testing period� extending over more than three years. credit eligible contributions are also reduced by nontaxable distributions from a roth ira. � the credit may be used to offset amt liability, as well as regular tax liability. b. the 2001 act amended § 219 to increase the ceiling on deductible contributions to an ira account to $3,000 for 2002 through 2004, 690 florida tax review [vol.5:si $4,000 for 2005 through 2007, and $5,000 for 2008 and thereafter. beginning in 2008, the $5,000 ceiling will be adjusted annually for inflation. in addition, taxpayers age 50 and older may deduct an additional $500 of contributions for 2002 through 2005 and an additional $1,000 for 2006 and thereafter. 4. kitt v. united states, 2002-1 u.s.t.c. ¶ 50,167, 89 a.f.t.r.2d 497 (fed. cir. 1/10/02). retroactive application of the [july] 1998 irs restructuring act provision subjecting amounts rolled over from a traditional ira to a roth ira and then immediately withdrawn to the 10-percent § 72(t) penalty to an april 1998 withdrawal was constitutional because congress was correcting a mistake in the 1997 taxpayer relief act. united states v. carlton, 512 u.s. 26 (1994), followed. v. personal income and deductions a. miscellaneous income 1. cod income on reduction in fmha mortgage could not be avoided by an agreement to recapture the debt reduction should the farm be sold within ten years. jelle v. commissioner, 116 t.c. 63 (1/31/01). taxpayers owned agricultural property subject to outstanding mortgages totaling $269,828 to the farmers home administration (fmha) that exceeded the $92,057 net recovery value of the property by $177,772. upon payment of the net recovery value, the fmha wrote off the remaining loan balance subject to a �net recovery buyout recapture agreement� under which taxpayers agreed to repay the amounts written off in the event they disposed of the land within a 10-year period; and the fmha issued a form 1099-c [reporting cod income] to taxpayers in the amount of $177,772. taxpayers argued that they did not have cod income until the expiration of the 10-year period. judge nims held that taxpayers had immediate cod income under § 61(a)(12) because there was a present cancellation of liability with only �the mere chance of some future repayment.� the recapture agreement was held not to be a substitute for taxpayers� former obligation. an accuracy related penalty was upheld because taxpayers did not report any tax liability nor did they disclose the cod income for which they received a form 1099-c. taxpayers did not contend that any of the statutory exceptions to cod income was applicable. 2. exempt assets are included for purposes of the § 108(d)(3) insolvency definition; the service had warned about this in tam 199932013. carlson v. commissioner, 116 t.c. 87 (2/23/01). the taxpayers had capital gain in the amount of $28,621 and discharged indebtedness in the 2002] recent developments in federal income taxation 691 amount of $42,142 upon the foreclosure sale of their fishing vessel. they also owned a fishing permit with a fair market value of $393,400, which was arguably an asset exempt from the claims of creditors under alaska law. judge chiechi held that this exempt asset must be included in the determination of whether taxpayers were insolvent. she refused to follow cole v. commissioner, 42 b.t.a. 1110 (1940), because § 108(e)(1) precludes reliance upon the judicial insolvency doctrine except to the extent it was codified in § 108(a)(1)(b). she quoted the supreme court as follows, �section 108(e) precludes us from relying on any understanding of the judicial insolvency exception that was not codified in § 108.� gitlitz v. commissioner, 121 s. ct. 701, 2001-1 u.s.t.c. ¶ 50,147, 87 a.f.t.r.2d 417 (1/9/01). judge chiechi compared the definition of �insolvent� under the bankruptcy code [11 u.s.c. § 101(26)], which expressly excludes exempt property from the calculation, with the definition under § 108(d)(3), which does not do so, and concluded that the difference was intentional and that in intentionally using the different definition congress intended that exempt assets are not to be excluded from the calculation in determining whether the taxpayer is insolvent for purposes of § 108. although an asset of a debtor may be exempt from the claims of creditors under applicable state law, if that asset and the debtor�s other assets exceed the debtor�s liabilities, the debtor has the ability to pay an immediate tax on income from discharged indebtedness. in the instant case, immediately preceding the foreclosure sale on february 8, 1993, the aggregate fair market value of petitioners� assets was $875,251, which included petitioners� fishing permit valued at $393,400 that they claim is exempt from the claims of creditors under the law of the state of alaska. at that time, petitioners� liabilities totaled $515,930. on the record before us, we find that petitioners had the �ability to pay an immediate tax on� . . . the $42,142 of doi income resulting from the foreclosure sale in question. requiring petitioners to include that income in their gross income for the year at issue and pay a tax thereon is a result that is consistent with the intention of congress in enacting section 108(a)(1)(b) and related provisions into the code. � of course, the taxpayers could have avoided this result by filing a bankruptcy petition and having the indebtedness cancelled in that proceeding. � an accuracy related penalty was imposed for taxpayers� failure to include the realized capital gain of $28,621 in income. 692 florida tax review [vol.5:si 16. for 2001, § 6428 provides a rate reduction credit in lieu of the 10 percent rate bracket. 17. beginning in 2005, however, the 2001 legislation will increase the width of the 15 percent bracket for married couples filing joint returns. see § 1(f)(8). in 2009, the 15 percent bracket under § 1(a) will be twice as large as the 15 percent bracket under § 1(c), thus eliminating the marriage penalty in the 15 percent bracket. a. exempt assets counted in insolvency determination. tam 199935002 (5/3/99). the fair market value of any assets exempt from a creditor�s claims under state law is included in determining a taxpayer�s insolvency under § 108(d). the contrary conclusion reached in tam 9130005 was revoked. 3. the tax benefit rule found the pea under the walnut shell. hornberger v. commissioner, 87 a.f.t.r.2d 877, 2001-1 u.s.t.c. ¶ 50,234 (4th cir. 2/15/01) (per curiam, unpublished), aff�g t.c. memo. 2000-042. a grantor trust established by the sole beneficiary of an estate paid interest on the estate tax owed by the estate, and the beneficiary deducted the interest payment. when a portion of the interest was later refunded to the estate, which distributed it to the beneficiary, who transferred it to the trust, the beneficiary was required to include the refunded interest in income under the tax benefit rule. 4. lower rates coming to your neighborhood tax return soon. the economic growth and tax relief reconciliation act of 2001 amended § 1 in a number of ways. first, § 1(i) provides an initial 10 percent marginal rate bracket, carved out of the broader 15 percent bracket, effective as of 2001.16 the upper limit of this new 10 percent bracket, however, is not adjusted for inflation for years before 2009. second, beginning in 2001, the 28 percent, 31 percent, 36 percent, and 39.6 percent rates will be reduced according to the following schedule. taxable year rate to be substituted in § 1 for the 2000 rates: 28% 31% 36% 39.6% 2001 27.5% 30.5% 35.5% 39.1% 2002 & 2003 27% 30% 35% 38.6% 2004 & 2005 26% 29% 34% 37.6% 2006 and thereafter 25% 28% 33% 35% a. the 15 percent bracket rate will not be reduced.17 like all of the amendments to the code in the 2001 act, these changes sunset on december 31, 2010. thus, absent further congressional action, in 2011 § 1 will revert to 2002] recent developments in federal income taxation 693 18. see v.d.1.c. the five brackets in effect for 2000, with inflation adjustments in the dollardenominated bands. b. marriage penalty relief (part 1)18: the 15 percent bracket. the 2001 act increased the width of the 15 percent rate bracket for married couples filing jointly relative to unmarried individuals filing a single return. the upper limit of the 15 percent bracket for married couples filing a joint return will be double the upper limit of the 15 percent bracket for unmarried individuals filing a single return. the effective date is delayed to 2005, and then it is phased in over five years, with the result that the full effect of the changes will not be in force until 2009. like all of the other amendments to the code in the 2001 act, however, these changes sunset on december 31, 2010. b. profit-seeking individual deductions 1. the alternative minimum tax (�amt�) trap for attorneys� fees on large recoveries. a. cases decided in past years by the first, fourth, ninth and federal circuits sprang the amt trap. more circuits climb on board in 2001. attorney�s fees incurred by an individual in a nonbusiness profitseeking transaction are [§ 212] miscellaneous itemized deductions [§ 67] and may not be deducted for amt purposes. to avoid this result, taxpayers in a number of cases in recent years have argued the portion of a taxable damage award retained by the taxpayer-plaintiff�s attorney as a contingent fee is excluded from the taxpayer-plaintiff�s income and treated as income earned directly by the attorney. the tax court and most courts of appeals have reached conflicting results on this question. generally, the tax court holds that attorney�s fee awards paid directly to a plaintiff�s attorney [or the portion of a damage award that is the attorney�s contingent fee that is so paid] are nevertheless includable in the litigant�s gross income, and that the taxpayer then may claim a deduction, subject to any applicable limitations, including disallowance of the deduction for amt purposes if it is a §212 deduction. bagley v. commissioner, 105 t.c. 396 (1995), aff�d 121 f.3d 393 (8th cir. 1997). accord baylin v. united states, 43 f.3d. 1451 (fed. cir. 1995); alexander v. irs, 72 f.3d 938, 96-1 u.s.t.c. ¶ 50,011 (1st cir. 1995), aff�g t.c. memo. 1995-51; coady v. commissioner, 213 f.3d 1187, 2000-1 u.s.t.c. ¶ 50,528 (9th cir. 2000); benci-woodward v. commissioner, 219 f.3d 941, 2000-2 u.s.t.c. ¶ 50,595 (9th cir. 7/18/00). 694 florida tax review [vol.5:si 19. under bonner v. city of prichard, alabama, 661 f.2d 1206 (11th cir. 1981), fifth circuit decisions rendered before the eleventh circuit was created are binding precedent in the eleventh circuit. b. but the fifth and sixth circuits see things differently. (1) in cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959), however, the fifth circuit held that attorney�s fees so paid directly to a plaintiff�s attorney are not includable by the litigant. the court of appeals reasoned that under the alabama attorney�s lien law, the ownership of the portion of the award representing attorney�s fees vested in the attorney ab initio. subsequently, in srivastava v. commissioner, 220 f.3d 353, 2000-2 u.s.t.c. ¶ 50,597 (5th cir. 2000) (2-1), rev�g, t.c. memo. 1998-362, a majority decision of a fifth circuit panel held that cotnam applied to attorneys� fees under texas law because there is no difference in the �economic reality facing the taxpayerplaintiff� between alabama and texas attorney�s liens and any distinction between them does not affect the analysis required by the anticipatory assignment of income doctrine. a dissent by judge dennis distinguished cotnam on the ground that alabama law gives the holders of attorney�s liens greater power than does texas law. (2) estate of clarks v. commissioner, 202 f.3d 854, 2000-1 u.s.t.c. ¶ 50,158, 85 a.f.t.r.2d 405 (6th cir. 2000). the sixth circuit applied, to hold that the taxpayer was not required to include the portion of the taxable interest attached to a damage award excluded under § 104(a)(2) that was paid directly to the taxpayer�s attorney. the court discussed the particularities of the attorney�s fee statutory lien law in cotnam, found the michigan attorney�s fees common law lien law to be similar to the alabama law involved in cotnam, and stated that it was following cotnam. but the court also provided a broader explanation for its decision, concluding that the opinions representing the weight of authority, e.g., baylin v. united states, 43 f.3d 1451 (fed. cir. 1995), inappropriately relied on the assignment of income doctrine cases, e.g., lucas v. earl, 281 u.s. 111 (1930) and helvering v. horst, 311 u.s. 112 (1940), which, while relevant in family transactions, were not relevant in an arm�s length transaction. (3) in the eleventh circuit (as derived from presplit fifth circuit precedents19), under the golsen rule attorney�s fees are not included in the income of alabama taxpayer who received a large punitive damages award. davis v. commissioner, t.c. memo. 210 f.3d 1346, 2000-1 u.s.t.c. ¶ 50,431, 85 a.f.t.r.2d 1567 (2000) (per curiam), aff�g 2002] recent developments in federal income taxation 695 1998-248 (7/7/98). the eleventh circuit panel held that with respect to alabama taxpayers, it was bound by cotnam. c. this year, the fourth, seventh, and tenth circuits join the parade. (1) wisconsin attorney�s fees subject to the amt trap because of assignment of income doctrine. tax court majority holds that it was congress�s doing; dissents state that courts can cure the problem, kenseth v. commissioner 259 f.3d 881, 2001-2 u.s.t.c. ¶ 50,570, 88 a.f.t.r.2d 5378 (7th cir. 8/7/01), aff�g 114 t.c. 399 (5/24/00) (reviewed, 8-5). the tax court adhered to its prior decisions that contingent attorney�s fees paid in an age discrimination settlement are includible in taxpayer�s gross income. the seventh circuit affirmed the tax court�s decision. [kenseth] concedes as he must that had he paid the law firm on an hourly basis, the fee would have been an expense. it would have been a deduction from, not a reduction of, his gross income . . . . we cannot see what difference it makes that the expense happened to be contingent rather than fixed. if a firm pays a salesman on a commission basis, the sales income he generates is income to the firm and his commissions are a deductible expense, even though they were contingent on his making sales. of course there is a sense in which contingent compensation constitutes the recipient a kind of joint venturer of the payor. but the plaintiff concedes, as again he must, that wisconsin law does not make the contingent-fee lawyer a joint owner of his client�s claim in the legal sense any more than the commission salesman is a joint owner of his employer�s accounts receivable. . . . there is nothing exotic about this analysis � nothing, indeed, that depends on the particular contractual setting, that of a contingent-fee contract with a lawyer, out of which this case arises. the settlement of kenseth�s age-discrimination suit against his former employer presumably replaced lost income, which would have been taxable; and many of the expenses of producing that income, such as the cost of commuting, would not have been deductible. so incomplete deductibility here is not surprising or anomalous or inappropriate. we mentioned the commissioned salesman; consider now the operation of a construction business. all receipts are counted as gross 696 florida tax review [vol.5:si income, and outlays to subcontractors and materialmen are deductible, even though these subcontractors have liens on the work and even though the general contractor could say that he just �assigns� a part of the job to the sub. . . . enough; for in any event it is not a feasible judicial undertaking to achieve global equity in taxation . . . especially when the means suggested for eliminating one inequity (that which kenseth argues is created by the alternative minimum income tax) consists of creating another inequity (differential treatment for purposes of that tax of fixed and contingent legal fees). and if it were a feasible judicial undertaking, it still would not be a proper one, equity in taxation being a political rather than a jural concept. indeed the cases that reject the tax court�s position seem based on little more than sympathy for taxpayers. . . . [the cotnam] rationale badly flunks the test of neutral principles. it is often the case that to obtain income from an asset one must hire a skilled agent and pay him up front; that expense is a deductible expense, not an exclusion form income. (2) the fourth circuit rejects cotnam too. young v. commissioner, 240 f.3d 369, 2001-1 u.s.t.c. ¶ 50,244, 87 a.f.t.r.2d 889 (4th cir. 2/16/01), aff�g, 113 t.c. 152 (8/20/99). a former husband defaulted on a $1.5 million promissory note given his former wife in a divorce settlement in 1989 and satisfied a judgment on the note by transferring real estate, which he had received in the original divorce, to his former wife in 1992. the value of the real estate equaled the sum of the principal of the note, accrued but unpaid interest, the wife�s attorney�s fees, and certain costs. the tax court held that under old colony trust co., 279 u.s. 716 (1929), the wife recognized gross income equal to the value the property attributable to her attorney�s fees and costs. in affirming the tax court�s decision, the court of appeals for the fourth circuit rejected mrs. young�s argument that it should follow the reasoning of cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959), to exclude the amount, noting that only the sixth circuit in estate of clarks v. united states, 202 f.3d 854 (6th cir. 2000), has followed cotnam and expressly joined the circuits that have rejected cotnam. (3) the tenth circuit says �us too�. hukkanencampbell v. commissioner, 274 f.3d 1312, 88 a.f.t.r.2d 7283, 2001-2 u.s.t.c. ¶ 50, (10th cir. 12/19/01). attorneys� fees in pre-1991 title vii sex discrimination are includable in plaintiff�s income in computing amt. 2002] recent developments in federal income taxation 697 d. the eleventh circuit applies cotnam in another alabama case. we�re still waiting to hear what the eleventh has to say if the case arises in georgia or florida. foster v. united states, 244 f.3d 1275, 2001-1 u.s.t.c. ¶ 50,392, 87 a.f.t.r.2d 2011 (11th cir. 4/30/01), rev�g 106 f.supp.2d 1234, 2000-1 u.s.t.c. ¶ 50,353, 85 a.f.t.r.2d 1649 (n.d. ala. 3/13/00). taxpayer received a favorable jury verdict that included $1,000,000 of [taxable] punitive damages. under an alabama statute, the trial judge reduced the punitive damage award to $250,000, which was later restored to $1,000,000 when the statute was found to be unconstitutional. taxpayer had agreed to pay her attorney a contingent fee of 50% for the trial. for the appeal, the contingent fee arrangement was amended to treat all post-judgment interest collected as an additional contingent fee. the district court held that under cotnam [263 f.2d 119 (5th cir. 1959)], the taxpayer could treat the originally agreed upon contingent as excluded from gross income and received directly by the attorney, but the post judgment interest paid as the additional contingent fee was includable in gross income and deductible under § 212. at the point that contingent fee arrangement was negotiated, the taxpayer�s claim, which had been upheld by the jury, had value and the �uncertainties� of the appellate process were not sufficient to displace the applicability of the assignment of income principles. the court of appeals affirmed the district court except with respect to the post judgment interest paid as the additional contingent fee. the court of appeals held that the post-judgment agreement was analogous to a pretrial contingency fee agreement, and thus, because the case arose in alabama, under cotnam the interest retained by the attorney as the fee was not includable in the taxpayer�s gross income. the taxpayer was entitled to her litigation costs under § 7430 because the irs was not substantially justified in litigating the issue in the eleventh circuit on the basis of attempting to overturn cotnam as wrongly decided. e. the amt trap snaps shut on attorney�s fees that aren�t even part of the plaintiff-taxpayer�s award. sinyard v. commissioner, 268 f.3d 756, 2001-2 u.s.t.c. ¶ 50,645, 88 a.f.t.r.2d 6034 (9th cir. 9/25/01) (21), aff�g t.c. memo. 1998-364. the taxpayer was required to include in gross income the portion of the settlement of an adea suit that was paid directly to the attorneys as their fee pursuant to the settlement agreement, even though had the suit gone to trial and the taxpayer won, under the adea the defendant would have been statutorily liable for the taxpayer-plaintiff�s attorneys� fees in addition to compensatory damages to the plaintiff. judge mckeown, who wrote the ninth circuit�s opinion in benci-woodward v. commissioner, 219 f.3d 941 (9th cir. 2000), which held that contingent attorneys� fees are included in the successful plaintiff�s gross income, dissented. he reasoned that the instant case was distinguishable from benci-woodward and old colony trust on the 698 florida tax review [vol.5:si grounds that by virtue of the adea statutory attorney�s fees provisions, contingent attorney�s fees incurred in an adea suit never become a debt of the taxpayer and the payment is not an indirect payment of a damage award or settlement to the taxpayer. he focused on the purpose of the adea attorney�s fees provision being to make the plaintiff whole without incurring attorney�s fees. he noted that it is still up to congress to solve the amt trap for contingent attorney�s fees generally. his dissent draws a fine line, but we think he is correct. 2. who says it�s a �net� income tax? what happened to those § 212 deductions? there�s a split in the circuits, but apparently the supremes won�t sing. mellon bank, n.a. v. united states, 265 f.3d 1275, 2001-2 u.s.t.c. ¶ 50,621, 88 a.f.t.r.2d 5800 (fed. cir. 9/7/01, aff�g 2001-1 u.s.t.c. ¶ 50,153, 86 a.f.t.r.2d 6432 (ct. cl. 9/18/00), earlier proceedings at 47 fed. cl. 186, 2000-2 u.s.t.c. ¶ 50,642, 86 a.f.t.r.2d 5321 (fed. cl. 7/17/00). the court of federal claims held that investment advisor�s fees incurred by a trust are excluded from the § 67 haircut on miscellaneous itemized deductions only if the expenses �would not have been incurred if the property were not held in such trust.� the court reached a conclusion similar to that of the tax court and contrary to the sixth circuit in william j. o�neill revocable trust v. commissioner, 98 t.c. 227 (1992) (investment adviser fees paid by irrevocable trust are not �administration fees� excluded from § 67 disallowance rules by § 67(e)), rev�d, 994 f.2d 302 (6th cir. 1993) (investment adviser�s fees that would not have been incurred if property had not been held in trust are not subject to 2 percent floor pursuant to § 67(e)). summary judgment was granted to the government because the taxpayer stipulated that its evidence would not meet the requisite legal standard to prevail. on appeal, the federal circuit (judge meyer) rejected the taxpayer�s argument that investment advisory fees are deductible to a trust without regard to the two percent floor of § 67 because they are occasioned by the trustee fulfilling its fiduciary duty. the court reasoned that the requirement of the second clause of § 67(e)(1), excepting from the floor costs that would not have been incurred if the property were not held by a trust or estate �focuses not on the relationship between the trust and costs, but the type of costs, and whether those costs would have been incurred even if the assets were not held in a trust.� only those trust-related administrative expenses �that are unique to the administration of a trust and not customarily incurred outside of trusts� are fully deductible. the court concluded that the plain language of the statute compelled the result, and found nothing to the contrary in the legislative history. � taxpayer�s attorney has stated that it will not seek certiorari. 2002] recent developments in federal income taxation 699 20. these words appeared on posters throughout the country during world war ii, as well as in numerous internal documents in the clinton white house [referring to monica lewinsky�s failure to keep various things to herself]. 3. loose lips sink ships.20 o�connell v. commissioner, t.c. memo. 2001-158 (6/29/01). the taxpayer was an insurance agent; he also was an avid fisherman who particularly enjoyed billfish (e.g., marlin, and sailfish) tournaments. his s corporation, which owned and occasionally chartered out an ocean going fishing yacht which was used primarily for sport fishing by the taxpayer, lost approximately $1.4 million over seven years. the losses were disallowed under § 183. notably the court quoted an interview the taxpayer gave for marlin magazine, in which he stated: you have to be in competitive offshore fishing for the sport . . . not the money. what you win could never cover the expenses. that�s just a drop in the bucket! . . . if you�re in tournament fishing for the money, you�ll go broke. . . . in my mind, it is inconceivable to make any money at tournament fishing . . . . this is strictly a sport. if a guy only fished one or two tournaments in a year and he won one of them, then he might end up in the black for that year . . . . if you fish them a lot, though, it is really tough. nuf said! 4. state income taxes are always itemized deductions. strange v. commissioner, 270 f.3d 786, 88 a.f.t.r.2d 6752, 2001-2 u.s.t.c. ¶ 50,753 (9th cir. 11/8/01), aff�g 114 t.c. 206 (2000). the taxpayers paid nonresident state income taxes to nine states on net royalty income derived from interests in oil and gas wells located within those states. in calculating total net royalty income, and thus agi, the taxpayers deducted the state income taxes they paid. the court of appeals affirmed the tax court (judge parr) holding that the revision of § 164 by the revenue act of 1964 did not alter the pre-existing law under which state income taxes were deductible only as itemized deductions. state nonresident income taxes [unlike property taxes] are not �attributable� to property held for the production of royalties and, therefore, are not deductible under § 62(a)(4) in computing agi. c. hobby losses and § 280a home office and vacation homes 700 florida tax review [vol.5:si 21. note: heine left his estate to his wife on condition that she remarry, explaining in his will that as a consequence �there will be at least one man to regret my death.� his last words were, �of course god will forgive me; that�s his job.� 1. music may be a spirit without space, but the space in which it is created is deductible. popov v. commissioner, 246 f.3d 1190, 2001-1 u.s.t.c. ¶ 50,353, 87 a.f.t.r.2d 1735 (9th cir. 4/17/01). the taxpayer was allowed a home office deduction for the portion of the rent on her one bedroom apartment (which was occupied by the taxpayer, her husband and four-year-old child) attributable to the living room because the living room was used exclusively to practice the violin in connection with her work as a professional violinist for orchestras and recording studios. the court found that her living room was her principal place of business under the soliman [506 u.s. 168 (1993)] test. the �point of delivery� test does not apply to professional musicians because, quoting the german poet heinrich heine,21 �music stands �halfway between thought and phenomenon, between spirit and matter, a sort of nebulous mediator, like and unlike each of the things it mediates � spirit that requires manifestation in time, and matter that can do without space.�� since most of the taxpayer�s time was spent practicing in her living room � where of course her four-year-old daughter never never got underfoot � that was her principal place of business and the deduction was allowed under § 280a. 2002] recent developments in federal income taxation 701 22. see v.a.4.b. d. deductions and credits for personal expenses 1. deduction and credit provisions in the 2001 act include: a. a �now you see it, now you don�t� increase in the amt exemption. for 2001 through 2004, the 2001 act increased the alternative minimum tax exemption amount to $35,750 for single taxpayers and $45,000 for married taxpayers filing joint returns. b. personal income phaseout (pep) is itself phased-out from 2006 through 2010. the 2001 act amended § 151 to phase-out over time the reduction of the amount allowable as personal exemptions under § 151(d) to increasingly lesser percentages � to 2/3 of the base formulaic reduction amount in 2006 and 2007 and 1/3 of the base formulaic reduction amount in 2008 and 2009. the reduction of personal exemptions is completely eliminated in 2010. see irc § 151(d) and (f). like all of the amendments in the 2001 act, however, these changes sunset on december 31, 2010. thus, absent further congressional action § 151(d) would be revived in its current form in 2011. c. marriage penalty relief: the standard deduction (part 2).22 the 2001 act increases the basic standard deduction for married couples filing a joint return to twice the basic standard deduction for unmarried individuals filing a single return. the effective date of the increase is delayed to 2005 and even then it is phased in over five years, with the result that the full effect of the change will not be in force until 2009. like all of the other amendments to the code in the 2001 act, however, these changes sunset on december 31, 2010. d. pease phase-out. the 2001 act amended § 68 to phase-out the reduction in itemized deductions to increasingly lesser percentages � to 2/3 of the base formulaic amount in 2006 and 2007 and 1/3 of the base formulaic amount in 2008 and 2009 � before eliminating the operation of § 68 completely in 2010. see irc § 68(f) and (g). absent further congressional action, the pease limitation will be resurrected in 2011. e. child credit increased, made partially refundable, and made creditable against both regular tax and amt. the amount of the credit was increased to $600 for taxable years 2001 through 2004, and is scheduled to increase in steps to $1,000 for 2010. the 2001 act amended § 24 to provide for 702 florida tax review [vol.5:si 23. the beginning and end of the phase-out range is increased by $1,000 in 2002, 2003 and 2004, by $2,000 in 2005, 2006 and 2007, and by $3,000 for years after 2007. partial refundablity of the child credit in 2001 through 2010. for 2001 through 2004, the credit is refundable to the extent of ten percent of the taxpayer�s income in excess of $10,000 (indexed for inflation beginning in 2002). irc § 24(d)(1)(b)(i). for 2005 through 2010, the percentage increases to 15 percent. section 24(d) continues to allow families with three or more children a refundable child credit equal to amount by which social security taxes exceed the sum of nonrefundable credits and the earned income credit if that amount exceeds the amount otherwise refundable. irc § 24(d)(1)(b)(ii). the child credit is now creditable against both the regular tax and the alternative minimum tax. see irc § 24(b)(3). f. earned income tax credit (eitc) changes in 2001 act. the 2001 act made a number of changes in the earned income tax credit. first, the �modified gross income concept� in § 32(a)(2)(b), upon which the phaseout is based, was eliminated and the phase-out is based simply on adjusted gross income. this is a major simplification. second, the �marriage penalty� imposed by triggering or accelerating the phase-out when an eligible taxpayer married and filed a joint return with a spouse who had income that affected the phaseout was mitigated somewhat by the addition of § 32(b)(2)(b), which provides higher thresholds for triggering the phase-out on joint returns than on single and head of household returns claiming the credit.23 the �earned income� base for the credit is now limited to earned income that is included in gross income. irc § 32(c)(2)(a). the definition of �qualifying child� is simplified by broadening the relationships that qualify. in addition to a child, grandchild, stepchild, or foster child, brothers, sisters, step brothers and sisters, and descendants of any of them can qualify if the taxpayer cares for the person as the taxpayer�s own child. irc § 32(c)(3)(b). g. you don�t have to rush to establish your msa. the deadline for establishing a medical savings account has been extended to 2002. section 62(a)(18) was added by the 2001 act to allow a deduction for contributions to an msa by a taxpayer who does not itemize deductions. see, announcement 2001-99, 2001-42 i.r.b. 340 (9/29/01). h. more help with day-care costs. starting in 2003, the § 21 dependent care credit percentage increases to 35 percent of eligible expenses. the 2001 act also increased the ceiling amount of employment-related 2002] recent developments in federal income taxation 703 24. the american higher education system is up to the task of increasing tuition sufficiently so as to sop up any increase in savings for college. expenses that qualify for the credit to $3,000 if there is only one qualifying individual or $6,000 if there are two or more qualifying individuals in the household. the maximum dependent care credit thus is $1,050 in the case of one qualifying individual and $2,100 in the case of two or more qualifying individuals. under the 2001 act, the reduction in the credit begins at $15,000 of adjusted gross income rather than $10,000. thus, a taxpayer with more than $38,000 of adjusted gross income is entitled to a credit of only 20 percent of employment-related qualifying expenses. i. adoption credit expanded and made �permanent.� the 2001 act made the § 23 adoption credit a �permanent� provision, subject to sunset after 2010 like all of the other provisions of the 2001 act. in addition, the 2001act increased the ceiling on the credit to $10,000, subject to an annual inflation adjustment. starting in 2003, a $10,000 (as adjusted for inflation) credit is allowed with respect to the adoption of a �special needs� child even if no qualified adoption expenses have been incurred. irc § 23(a)(1)(b). section 23(b)(2) was amended to begin the phase-out of the adoption credit at an adjusted gross income of $150,000, subject to an annual inflation adjustment. apart from the inflation adjustment, it is now completely phased out when adjusted gross income exceeds $190,000. the adoption credit is allowed against the amt permanently (under old law it would not have been for years after 2001). j. adoption assistance tax-free fringe benefits expanded and made permanent by 2001 act. the 2001 act amended § 137 (the exclusion for employer provided benefits under an adoption assistance program) to make it a �permanent� provision, subject, however, to sunset in 2011 like all of the other provisions of the 2001 act. in addition, the ceiling on the exclusion was increased to $10,000, subject to an annual inflation adjustment. the phase-out rule was amended to begin the phase-out when the employee�s adjusted gross income exceeds $150,000, subject to an annual inflation adjustment. apart from the inflation adjustment, the exclusion is completely phased out when the employee�s adjusted gross income exceeds $190,000. e. education: helping pay college tuition (or is it helping colleges increase tuition?24) 704 florida tax review [vol.5:si 1. qualified tuition programs now provide a tax exemption. the 2001 act extensively revised § 529. the most significant change is the amendment of § 529(c)(3)(b) to provide a complete exclusion for in-kind benefits, e.g., tuition waivers, and distributions expended for qualified higher education benefits. section 529 qualified tuition plans thus have been transformed from vehicles to secure an effective assignment of investment income to a lower bracket taxpayer to vehicles to provide tax-exempt income. in addition, § 529(b)(1) has been amended to permit private institutions of higher education to establish trusts that can qualify for § 529 treatment. such private § 529 plans can qualify, however, only with respect to purchases of tuition credits or certificates on behalf of the designated beneficiary; cash contribution to a savings plan are not permitted with respect to private § 529 qualified tuition programs. section 539(c)(3)(c) rollover treatment has been extended to transfers from one plan to another plan on behalf of the same beneficiary. this new rule will facilitate transfers from state qualified tuition plans to new private qualified tuition plans. if a beneficiary receives distributions from both a § 529 qualified tuition plan and from an eira, in the same year and the combined distributions exceed the qualified expenditures, new § 539(c)(3)(b)(vi) requires that qualifying expenses be allocated among distributions from the § 529 plan and the eira to determine how much of the distribution form each is excludable. finally, even though a taxpayer � usually the student�s parent � may claim the hope credit or lifetime learning credit under § 25a with respect to a student, the exclusion under § 529(c)(3) is available � to the student � for distributions from a § 529 plan with respect to the student as long as the distributions from the § 529 plan are not traced to the expenditures with respect to which the credit is claimed. in other words, both benefits are available as long as qualified expenditures for the year equal or exceed the sum of the distributions from the § 529 plan and the base on which the § 25a credit is calculated. a. notice 2001-55, 2001-39 i.r.b. 299 (9/8/01). this notice provides guidance to qualified tuition programs described in § 529 and participants in § 529 programs regarding the restriction on investment direction described in § 529(b)(5), and sets forth a special rule under which a program may permit investments in a § 529 account to be changed annually and upon a change in the designated beneficiary of the account. b. notice 2001-81, 2001-52 i.r.b. 617 (12/11/01). provides guidance regarding record keeping, reporting, and other requirements applicable to § 529 qualified tuition programs in light of the 2001 act amendments. 2002] recent developments in federal income taxation 705 2. eiras get a whole lot better. the 2001 act made a number of changes in the § 530 education ira (eira) rules that are effective beginning in 2002. first, eiras have been renamed �coverdell education savings accounts� in honor of the late senator paul coverdell (r, ga). second, the annual limit on contributions was increased from $500 to $2,000. contributions can qualify for a year as long as they are made during the year or during the following year but before the due date of the tax return for the year to which the contribution relates. irc § 530(f). third, the phase-out rules in § 530 (c) were modified to provide a phase-out range for married taxpayers filing joint returns that is twice the range for single taxpayers. thus, the phase-out range for married taxpayers filing jointly is between $190,000 and $220,000 of adjusted gross income. the 18-year old age ceiling on the eligible beneficiary was removed in the case of �special needs� children. in addition, § 530(b)(2) was amended to extend the exemption from tax to distributions for qualified elementary and secondary school expenses, including expenses of attending religious elementary and secondary schools and the purchase of family computers. finally, a taxpayer may both take advantage of the exclusion under § 530(d)(2) and claim the hope credit or lifetime learning credit under § 25a on behalf of the same student as long as the distributions from the eira are not traced to the expenditures with respect to which the credit is claimed. irc § 25(d)(2)(c)(i). in other words, both benefits are available as long as qualified expenditures for the year equal or exceed the sum of the distributions from the eira and the base on which the § 25a credit is calculated. 3. deductible college tuition � but you have to run the numbers twice. the 2001 act added a special deduction for qualified tuition and related expenses in § 222. section 222 operates completely independently of the rules of reg. § 1.162-5 and is intended primarily to provide a deduction for parents who pay college tuition for their dependent children. the deduction is available to students who are not claimed as dependents by another taxpayer and pay their own tuition. see irc § 222(c)(3). the deduction is limited to tuition and related academic fees and does not extend to room and board. see irc § 222(d)(1), cross-referencing to § 25a(g)(2). as is true with respect to the other tax expenditure provisions intended to subsidize higher education expenses, the deduction is not available for high-income taxpayers. unlike most other tax expenditure benefits, which are phased-out over an income range, however, the § 222 deduction is subject to a cliff-effect disallowance rule. in 2002 and 2003, for single taxpayers whose adjusted gross income does not exceed $65,000 and for married taxpayers filing a joint return whose gross income does not exceed $130,000 the maximum deduction is $3,000. taxpayers whose adjusted gross income exceeds those ceilings may not claim any deduction whatsoever. for 2004 and 2005, a maximum deduction of $4,000 is allowed for single taxpayers 706 florida tax review [vol.5:si whose adjusted gross income does not exceed $65,000 and for married taxpayers filing a joint return whose gross income does not exceed $130,000. a maximum deduction of $2,000 is allowed for single taxpayers whose adjusted gross income does not exceed $80,000 and for married taxpayers filing a joint return whose gross income does not exceed $160,000. taxpayers whose adjusted gross income exceeds the applicable $80,000 or $160,000 ceiling may not claim any deduction. section 222(c) provides elaborate rules designed to deny the deduction if the taxpayer claims the § 25a hope scholarship or lifetime learning credit. section 222(c) also reduces the deduction by any exclusions under §§ 135, 529, or 530. the § 222 deduction is allowed in reducing gross income to adjusted gross income; a taxpayer is not required to itemize deductions to claim the § 222 qualified tuition deduction. section 222 sunsets completely after 2005. 4. expanded deductibility of educational loan interest. the 2001 act amended the § 221 deduction for interest on educational loans in two significant respects. first, § 221(d), which limited the availability of the deduction to interest paid for the first sixty months of the loan repayment period, was repealed. second, the phase-out range under § 221(b) was increased. for years after 2001, the deduction is phased out for single taxpayers whose �modified� adjusted gross income exceeds $50,000 and for married taxpayers filing a joint return whose modified gross income exceeds $100,000. the deduction is completely phased out for single taxpayers whose modified adjusted gross income exceeds $65,000 and for married taxpayers filing a joint return whose modified adjusted gross income exceeds $130,000. these phase-out thresholds continue to be indexed for inflation after 2001. see irc § 221(g). vi. corporations a. entity and formation 1. t.d. 8936, definition of contribution in aid of construction under section 118(c), 66 f.r. 2252 (1/11/01). final reg. § 1.118-2 deals with the exclusion from gross income of qualified contributions in aid of construction received by a regulated public utility that provides water or sewage services. 2. read the dictum; the 1999 amendments to §§ 357(c) and 358(d) wouldn�t have changed the result. seggerman farms, inc. v. commissioner, t.c. memo. 2001-99 (4/25/01). the tax court (judge cohen) held that § 357(c) requires gain recognition when the liabilities assumed by the 2002] recent developments in federal income taxation 707 corporation exceed the transferor shareholder�s basis in the property even if the transferor remains liable as a guarantor. although the case arose prior to the 1999 amendments to § 357(c) and (d), the court noted that the result would not be different under the current statute. the court stated: in 1999, congress enacted changes to section 357(c) that were effective for transactions occurring after october 18, 1998. see miscellaneous trade and technical corrections act of 1999, pub. l. 106-36, sec. 3001(e), 113 stat. 127, 184. the amendment struck the words �plus the amount of liabilities to which the property is subject,� from section 357(c)(1) and essentially provided relief for the taxpayer who transferred assets subject to liabilities and remained personally liable on the debt, but where the corporation did not assume the liability. id. sec. 3001(d)(4), 113 stat. 182. congress also added section 357(d), which provides guidance in determining the amount of liabilities that are assumed and states in section 357(d)(1)(a) that �a recourse liability (or portion thereof) shall be treated as having been assumed if . . . the transferee has agreed to, and is expected to, satisfy such liability (or portion), whether or not the transferor has been relieved of such liability.� id. sec. 3001(b), 113 stat. 182. the 1999 amendment does not apply to these cases, because the transactions in these cases occurred in 1993. even if section 357(d)(1)(a) as enacted in 1999 did apply; petitioners� personal liability on the debt that was transferred to the corporation would continues [sic] to be irrelevant. even after congressional amendments to section 357, congress has refrained from providing relief to taxpayers in petitioners� situation. b. distributions and redemptions 1. recourse debts are assumed only when they really are assumed. t.d. 8964, liabilities assumed in certain corporate transactions, 66 f.r. 49278 (9/27/01). in january [in t.d. 8924, liabilities assumed in certain corporate transactions, 66 f.r. 723 (1/4/01)], the treasury promulgated temp. reg. § 1.301-1t(g), which applies rules similar to those of § 357(d) [for determining when a liability is assumed] for purposes of determining when the amount of a distribution will be reduced under § 301(b). [identical proposed regulations were published in reg-106791-00 (1/3/01).] a recourse debt has 708 florida tax review [vol.5:si been assumed only if, based on all the facts and circumstances, the transferee has agreed to pay the debt regardless of whether or not the transferor has been relieved of liability vis-à-vis the creditor. a transferee is treated as assuming any nonrecourse debt encumbering property it receives, but the amount of the debt assumed is reduced by the lesser of: (1) the amount of the debt secured by assets not transferred that another person or corporation has agreed (and is expected) to satisfy, or (2) the fair market value of the other assets secured by the debt. in september, temp. reg. § 1.301-1t(g) was replaced by final reg. § 1.301-1(g), which is identical to the temporary regulations. 2. e&p is more than just an esoteric accounting concept. rev. rul. 2001-1, 2001-9 i.r.b. 726 (2/26/01). corporate e&p is reduced to reflect the corporation�s deduction under §§ 83(h) and 162 when an employee receives stock upon exercise of a nonstatutory stock option. because this item reduces earnings and profits, § 56(g)(4)(c)(i) does not disallow the deduction of the item in computing adjusted current earnings for amt purposes. 3. don�t you forget it! section 304 trumps § 351. combrink v. commissioner, 116 t.c. 296 (5/15/01), withdrawn and reissued, 117 t.c. 82 (8/23/01). the taxpayer owned all the stock of two corporations, cost oil and links investments. over a number of years, cost oil had lent the taxpayer approximately $175,000. the taxpayer, in turn, had lent approximately $89,000 of that amount, plus an additional $163,000, to links investments, which made book entries of accounts payable to the taxpayer and issued promissory notes to him. subsequently, approximately $175,000 of the loan from the taxpayer to links investments was converted to additional paid-in capital (without the issuance of any shares) and the corporate indebtedness of links investments to the taxpayer was reduced to approximately $77,000. shortly thereafter, the taxpayer transferred all his stock in links investments to cost oil in exchange for cost oil discharging him from his $175,000 debt obligation. the tax court (judge nims) held that the transfer of the links investments stock to cost oil in exchange for cost oil�s release of the taxpayer�s indebtedness was a redemption and a distribution of property under §§ 304 and 317(a). the taxpayer argued that the exception in § 304(b)(3)(b) applied because the transfer could be treated as a § 351 transaction in which cost oil �assumed� the taxpayer�s debt to cost oil and the debt was traceable to his acquisition of stock in links investments. judge nims granted him only limited relief. the court accepted the recapitalization as establishing that $174,000 was used to acquire links investment stock within the meaning of § 304(b)(3)(b)(i). but because the $89,000 of the assumed liability from the taxpayer to cost oil that was traceable to the taxpayer�s investment in links investments exceeded the $77,000 debt from links investment to cost oil that continued to remain 2002] recent developments in federal income taxation 709 outstanding after the transaction, only $12,000 of the $174,000 debt �assumed� by cost oil had been used to acquire stock or equity in links investment. thus, because the taxpayer was the sole stockholder before and after the transfer, $161,000 of the discharged/assumed debt from the taxpayer to cost oil was characterized as a dividend under §§ 302(d) and 301. 4. the mark of the devil? reallocation of $666,000 from covenant not to compete to goodwill produces a double tax. bemidji distributing co. v. commissioner, t.c. memo. 2001-260 (10/1/01). in a [pre-§ 197] sale of the corporation�s assets, no amount was allocated to intangible assets, including goodwill or going concern value, but $1,000,000 was allocated to the shareholder�s covenant not to compete and $200,000 to a two-year consulting contract [compared to $817,461 for the assets]. based on all the facts and circumstances, e.g., the seller�s ability to compete and expert witnesses�s valuation testimony, the tax court (judge parr) found that the value of the covenant was only $334,000 and that $666,000 allocated to the covenant by the taxpayer was really the price of goodwill. thus, the corporation realized an additional $666,000 of gain on the sale if its [zero basis] intangible assets, and the shareholders who received the payments recognized constructive dividends. c. liquidations 1. more check-a-box fallout. t.d. 8970, amendment, check the box regulations, 66 f.r. 64911 (12/17/01), proposed in reg-110659-00 proposed regulations, amendment, check the box regulations, 66 f.r. 3959 (1/16/01). treas. reg. § 301.7701-3(g)(2)(ii) provides that if an unincorporated entity that previously had elected to be taxed as a corporation elects to convert to a partnership, it is treated as distributing all of its assets to its shareholders in a taxable liquidation, followed by the contribution of all the assets to a newly formed partnership. if the entity elects to convert from a corporation to a disregarded entity, it is deemed to have distributed its assets to its owner. sections 332 and 337 can apply if the owner is a corporation. to facilitate application of § 332, the proposed regulations provide that a plan of liquidation is deemed to have been adopted immediately before the deemed liquidation resulting from the election to change entity classification, unless a formal plan of liquidation that contemplates the filing of the elective change was adopted at an earlier date. the amendments are applicable to elections filed on or after 12/17/01, with retroactivity permissible for elections filed on or after 11/29/99 if the parties take consistent positions. d. s corporations 710 florida tax review [vol.5:si 1. cancellation of indebtedness income of insolvent s corporations a. �because the code�s plain text permits the taxpayers here to receive these benefits, we need not address this policy concern [�that, if shareholders were permitted to pass through the discharge of indebtedness income before reducing any tax attributes, the shareholders would wrongly experience a �double windfall��].� gitlitz v. commissioner, 531 u.s. 206, 2001-1 u.s.t.c. ¶ 50,147, 87 a.f.t.r.2d 417 (1/9/01). gitlitz and winn each owned 50 percent of the stock of an s corporation that realized $2,021,096 of cod income. at that time the corporation was insolvent to the extent of $2,181,748. thus all of the cod income was excluded under § 108(a)(1)(b). both shareholders had carried losses that had been suspended under § 1366(d)(1) as well as operating losses that would be further suspended unless the excluded cod income increased their basis in their stock under § 1367(a)(1). b. the tax court followed its reviewed decision in nelson v. commissioner, 110 t.c. 114 (1998), aff�d, 182 f.3d 1152 (10th cir. 7/6/99), which held that a shareholder of an insolvent s corporation may not increase his stock basis under §§ 1367(a)(1)(a) and 1366(a)(1)(a) by the amount of his pro rata share of the corporation�s [excluded under § 108(a)] discharge of indebtedness income on the theory that the cod income was passed-through exempt income. the tax court agreed with the irs that § 108(d)(7)(a) requires that the exclusion of income applies at the s corporation level, so that the reduction of tax attributes applied by § 108(b) also applies at the corporate level and the discharge of indebtedness income never passes through to the shareholder. section 108, through the attribute reduction rules, is generally intended to defer the recognition of income, not to exempt it totally from income. c. affirmed. 182 f.3d 1152, 99-2 u.s.t.c. ¶ 50,646, 84 a.f.t.r.2d 5067 (10th cir. 8/6/99). the court of appeals for the tenth circuit affirmed, but on different reasoning. it assumed that the cod income was �tax exempt income� under § 1366(a)(1)(a) that potentially could passthrough to the shareholders and increase basis. [fn 7] the court agreed with the commissioner and the tax court, however, that § 108(d)(7)(a) requires that the exclusion of income applies at the s corporation level, so that the reduction of tax attributes applied by § 108(b) also applies at the corporate level and the discharge of indebtedness income never passes through to the shareholder. the court further concluded that § 108(d)(4)(a) merely requires that attribute reduction is the last step in the calculations; it does not necessarily defer the attribute reduction until the year following the year in which the excluded cod income is realized. 2002] recent developments in federal income taxation 711 thus, there was no corporate level income to pass through to the shareholders and to increase their basis. furthermore, the reduction in tax attributes under § 108(b) absorbed the shareholders losses carried over from prior years under § 1366(d)(1). d. reversed � a total victory for the taxpayers. the supreme court, in an 8-1 decision by justice thomas, held that the statute�s plain language establishes that cod income realized by an insolvent s corporation that is excluded under § 108(a) is an item of tax-exempt income that passes through to shareholders under § 1366(a)(1)(a) and increases their bases in the s corporation�s stock under § 1367. furthermore, the pass-through occurs before the reduction of the s corporation�s tax attributes under § 108(b), and thus shareholder�s carried-over losses [which § 108(d)(7)(b) treats as a corporate nol for purposes of § 108(b)] to the year in which the cod occurs may be deducted against the basis increase without reduction in that year. any suspended losses remaining then will be treated as the s corporation�s net operating loss and reduced by the discharged debt amount. � justice breyer dissented and would have held that § 108(d)(7)(a) [applying § 108(a), (b), (c), and (g) at the corporate level] precludes any pass through of cod income realized by an insolvent s corporation. in response to the majority�s last paragraph, he stated, �it is . . . difficult to see why, given the fact that the �plain language� admits either interpretation, we should ignore the policy consequences . . . the arguments from plain text on both sides here produce ambiguity, not certainty. and other things being equal, we should read ambiguous statutes as closing, not maintaining, tax loopholes. such is an appropriate understanding of congress� likely intent.� e. and the reasoning of the opinion should partially invalidate reg. § 1.1366-1(a)(2)(viii). as part of its effort to deal with this issue, in t.d. 8852, 64 f.r. 71641 (12/22/99), the treasury amended reg. § 1.1366-1(a)(2)(viii) to provide that cod income excluded at the corporate level under § 108 is not �tax exempt� income for purposes of §§ 1366 and 1367. although the opinion is not a model of clarity, the last sentence states that �the codes� plain text permits the taxpayers here to receive these benefits.� this would indicate that the treasury has no power to alter the result by regulation. but at another point, integral to the analysis the opinion states: �this section [§ 1366] expressly includes �tax-exempt� income, but this inclusion does not mean that the statute must therefore exclude �tax-deferred� income. the section is worded broadly enough to include any item of income, even tax-deferred income, that �could affect the liability for tax of any shareholder.�� this language is not nearly so definitive as to the clarity of the statutory language 712 florida tax review [vol.5:si and leaves open the possibility that the courts might not invalidate the regulation. but we doubt it. f. the technical result in gitlitz sleeps the big sleep, but the method of statutory analysis might have everlasting life. the job creation and worker assistance act of 2002 reversed the result of gitlitz v. commissioner, 121 s. ct. 701 (1/9/01), by providing that excluded cancellation of indebtedness income of s corporations is not to result in an adjustment to the basis of stock in the hands of the shareholders. the statutory rule is applicable to discharges of indebtedness after 10/11/01 (but not to discharges of indebtedness before 3/1/02 pursuant to a plan of reorganization filed with a bankruptcy court on or before 10/11/01). 2. gitlitz notwithstanding, sometimes the shareholder still needs a real economic outlay to get the deductions. grojean v. commissioner, 248 f.3d 572, 87 a.f.t.r.2d 1673, 2001-1 u.s.t.c. ¶ 50,355 (7th cir. 4/13/01), aff�g t.c. memo. 1999-425 (12/29/99). an s corporation shareholder, rather than guaranteeing a loan from a bank to his wholly owned s corporation, as initially demanded by the lending bank, instead acquired a $1.2 million loan participation interest in the bank�s $10 million loan to the corporation. the participation was financed by a borrowing from the bank at an interest rate identical to the interest rate on the loan to the corporation, and the participation was subordinated to the bank�s interest. the shareholder�s note and the corporation�s note had identical terms and the bank automatically credited payments on the corporation�s note against the shareholder�s note. no cash passed hands between the shareholder and bank in the circular transaction, and shareholder made no economic outlay. if the loan was repaid, the two loans would cancel out and the taxpayer never would receive or be out any cash. if the s corporation defaulted, the shareholder would have to make good to the bank a portion of its loss equal to the loan to the shareholder. according to judge posner, ��business realities� cast grojean in the role of guarantor rather than lender; no business realities compelled him to recharacterize his guarantee as a loan participation.� the shareholder thus acquired no additional basis to support passed-through losses. in the course of his analysis, judge posner wrote: the difference between a loan and a guaranty may seem a fine one, since, when the amount is the same, the lender and guarantor assume the same risk (subject to a possible wrinkle, concerning bankruptcy). the difference between the two transactional forms may seem to amount only to this: the loan supplies funds to the borrower, and the guaranty enables funds 2002] recent developments in federal income taxation 713 to be supplied to the borrower. that is indeed the main difference, but it is not trivial or nominal (�formal�). at a high enough level of abstraction, it is true, the difference between providing and enabling the provision of funding may disappear. indeed, at that level, the difference between equity and debt, as methods of corporate financing, disappears. . . . but at the operational level, because of various frictions that some economic models disregard, such as transaction and liquidity costs, really is a substantive and not merely a formal difference between lending and guaranteeing. in contrast, the difference between a guaranty and the form that grojean�s loan participation assumed was nothing but the label. it was a purely formal difference, and in federal taxation substance prevails over form. 3. reg-106431-01, qualified subchapter s trust election for testamentary trusts, 66 f.r. 44565 (8/24/01). these proposed regulations would amend reg. § 1.1361-1 to reflect amendments to § 1361 in 1996 permitting a testamentary trust or a former qualified subpart e trust, whether or not the entire corpus was included in the deemed owner�s gross estate, to be a permitted s corporation shareholder for a 2-year period [rather than 60 days]. the proposed regulations eliminate the special rules for determining whether trusts consisting of community property qualify for the 2-year period. the proposed regulations also provide that former qualified subpart e trusts and testamentary trusts can continue as permitted shareholders after the end of the 2-year period through a qsst election under § 1361(d) or an electing small business trust election under § 1361(e), if eligible. the qsst election must be made within the 16-day-and-2-month period following the end of the s-year period. 4. normal operating income of a timber, coal or iron-ore mining company is not § 1374 built-in gain. rev. rul. 2001-50, 2001-43 i.r.b. 343 (10/10/01). the § 1374 built in gains tax does not apply when a former c corporation (or s corporation that acquired the property from a c corporation) cuts and sells timber during the 10-year recognition period and recognizes gain under § 631(a), (b), or (c) with respect to a timber cutting contract or disposal of timber, coal or iron ore with a retained economic interest. the irs applied by analogy reg. § 1.1374-4(a)(3), ex. (1), which provides that the extraction of oil from a working interest held on the conversion date is not subject to § 1374. section 631 was intended to provide a tax benefit for operating income 714 florida tax review [vol.5:si and there is not indication that the deemed capital gain treatment was intended to result in application of § 1374. 5. if they had followed a different form, maybe they could have gotten some additional basis. estate of alton bean v. commissioner, 268 f.3d 553, 2001-2 u.s.t.c. ¶ 50,669, 88 a.f.t.r.2d 6111 (8th cir. 10/1/01). the eighth circuit (judge hansen) affirmed the tax court�s holding that the shareholders of an s corporation acquired no additional basis in their stock of corporation by virtue of the transfer of assets, subject to liabilities, from a partnership they controlled, to the s corporation, in a transaction originally treated as a sale [on which neither gain nor loss was realized]. even if there was equity in the party in the partnership�s assets, it was the partnership�s equity, not the shareholder/partner�s equity. the partnership was an entity distinct from its partners, and the partners cannot bootstrap their bases in the corporation by transfers made by the partnership. . . . the fact that the partnership was dissolved following the sale in 1992 does not change the form of the transaction that the taxpayers chose to utilize  selling the assets from the partnership to the corporation. once chosen, the taxpayers are bound by the consequences of the transaction as structured, even if hindsight reveals a more favorable tax treatment. e. affiliated corporations 1. the �single entity� approach of consolidated returns carries the day. united dominion industries, inc. v. united states, 121 s. ct. 1934, 2001-1 u.s.t.c. ¶ 50,430, 87 a.f.t.r.2d 2377 (6/4/01), rev�g 208 f.3d 452, 2000-1 u.s.t.c. ¶ 50,310, 85 a.f.t.r.2d 1512 (4th cir. 3/24/00). the taxpayer was the parent of a consolidated group that reported nols for four consecutive years during which a portion of the deductions were product liability expenses (ples) incurred by profitable members of the group. product liability losses (plls) � which are the lesser of the taxpayer�s ples or the taxpayer�s nol � can be carried back for 10 years under § 172(b)(1) [rather than the normal 2 years]. the taxpayer: (1) calculated its cnol under reg. § 1.1502-11(a), and (2) aggregated its individual members� ples. because the cnol was greater than the sum of its members� ples, the taxpayer treated the full amount of the ples as consolidated plls eligible for 10-year carryback. � the court of appeals for the fourth circuit held that under reg. §§ 1.1502-12 and 1.1502-21a the consolidated group could not carry back ples incurred by the profitable members because they did 2002] recent developments in federal income taxation 715 not enter into the consolidated nol. the court reasoned that § 172 refers to specified liability losses, not to specified liability expenses. only that portion of a member�s separate net operating loss attributable to specified liability losses could be taken into account in computing the portion of the consolidated nol attributable to specified liability losses. � the supreme court reversed, applying a �single entity approach� to allow the 10-year carryback. justice souter�s opinion reasoned that there is only a single definition of consolidated net operating loss in reg. § 1.1502-21(f) and no definition in the consolidated return regulations of a component member�s separate nol. he rejected the government�s argument that an individual group member�s separate taxable income (sti) under reg. § 1.1502-12, is analogous to a �separate� nol, and that accordingly a member having positive sti could have no product liability losses. since there is no nol below the cnol, there is nothing for comparison with ples to produce pll at any stage before the cnol calculation. nothing in the code or regulations indicated the essential relationship between nol and pll for a consolidated group would differ from their relationship for a conventional corporate taxpayer. the fact that several member companies throwing off large ples also, when considered separately, generated positive taxable income was of no significance. � justice thomas concurred in the case with the following opinion: i agree with the court that the internal revenue code provision and the corresponding treasury regulations that control consolidated filings are best interpreted as requiring a single-entity approach in calculating product liability loss. i write separately, however, because i respectfully disagree with the dissent�s suggestion that, when a provision of the code and the corresponding regulations are ambiguous, this court should defer to the government�s interpretation. see post, at 1-2. at a bare minimum, in cases such as this one, in which the complex statutory and regulatory scheme lends itself to any number of interpretations, we should be inclined to rely on the traditional canon that construes revenue-raising laws against their drafter. see leavell v. blades, 237 mo. 695, 700-701, 141 s.w. 893, 894 (1911) (�when the tax gatherer puts his finger on the citizen, he must also put his finger on the law permitting it.�); united states v. merriam, 263 u.s. 179, 188, 68 l. ed. 240, 44 s. ct. 69 (1923) (�if the words are doubtful, the doubt must be resolved against the government in favor of the taxpayer.�); bowers v. new york & albany literage co., 273 u.s. 346, 716 florida tax review [vol.5:si 350, 71 l. ed. 676, 47 s. ct. 389 (1927) (�the provision is part of a taxing statute; and such laws are to be interpreted liberally in favor of the taxpayers.�). accord american net & twine co. v. worthington, 141 u.s. 468, 474, l. ed. 821, 12 s. ct. 55 (1891); benziger v. united states, 192 u.s. 38, 55, 48 l. ed. 331, 24 s. ct. 189 (1904). � justice stevens, in his dissent, responded in the following footnote: justice thomas accurately points to a tradition of cases construing �revenue-raising laws� against their drafter. see ante, at 1 (thomas, j., concurring). however, when the ambiguous provision in question is not one that imposes tax liability but rather one that crafts an exception from the general revenue duty for the benefit of some taxpayers, a countervailing tradition suggests that the ambiguity should be resolved in the government�s favor. see, e.g., indopco, inc. v. commisioner, 503 u.s. 79, 84, 117 l. ed. 2d 226, 112 s. ct. 1039 (1992); interstate transit lines v. commissioner, 319 u.s. 590, 593, 87 l. ed. 1607, 63 s. ct. 1279 (1943); deputy v. du pont, 308 u.s. 488, 493, 84 l. ed. 416, 60 s. ct. 363 (1940); new colonial ice co. v. helvering, 292 u.s. 435, 440, 78 l. ed. 1348, 54 s. ct. 788 (1934); woolford realty co. v. rose, 286 u.s. 319, 326, 76 l. ed. 1128, 52 s. ct. 568 (1932). a. tax court had ruled to the contrary, but the sixth circuit court had reversed and also had held for the taxpayer. intermet corp. v. commissioner, 111 t.c. 294 (12/8/98), rev�d, 209 f. 3d 901, 2000-1 u.s.t.c. ¶ 50,382, 85 a.f.t.r. 2d. 1387 (6th cir. 4/20/00). judge wells held that under reg. §§ 1.1502-12 and 1.1502-21a, a consolidate group�s specified liability losses did not include deductions attributable to members of the group that reported positive separate taxable income because the deductions did not contribute to the groups consolidated nol. the court of appeals reversed and allowed them to be carried back under the special rule. the court reasoned that the subsidiaries specified liability loss deduction items reduced the subsidiaries separate taxable income dollar-for-dollar and thus contributed to the consolidated nol. an individual component members taxable income has not independent significance; it is merely a step in computing consolidated nol. there was no basis reg. § 1.1502-21a for treating a specified liability loss as constituting part of the consolidated nol when the member that incurred the 2002] recent developments in federal income taxation 717 deduction had negative taxable income but not when that member had positive separate taxable income [as long as a srly year is not involved]. (1) intermet corp. v. commissioner, 117 t.c. 113 (10/2/01), on remand from 209 f. 3d 901 (6th cir. 4/20/00). see ii.h. above. 2. but the federal circuit doesn�t appear to buy into the single entity theory. regulation § 1.1502-20, which prohibited recognition of loss in the transactions involving, inter alia, �duplicated losses,� was held to be �manifestly contrary to the statute.� rite aid corp. v. united states, 255 f.3d 1357, 2001-2 u.s.t.c. ¶ 50,516, 88 a.f.t.r.2d 5058 (fed. cir. 7/6/01), rev�g 46 fed. cl. 500, 2000-1 u.s.t.c. ¶ 50,429, 85 a.f.t.r.2d 1439 (fed. cl. 4/21/00). rite aid sold a subsidiary (encore) and realized a taxable loss of $33 million and an �economic loss� of $22 million, which it claimed should be deductible. reg. § 1.1502-20, subject to certain exceptions, disallows any loss realized by a member of a consolidated group upon the disposition of the stock of a subsidiary. under reg. § 1.1502-20, the amount of loss that is disallowed is limited to the sum of (1) income or gain resulting from �extra ordinary gains dispositions,� which are defined as dispositions of capital assets, depreciable property used in the trade or business, certain bulk asset dispositions, and discharge of indebtedness income, (2) positive investment adjustments (other than those attributable to extra ordinary gain dispositions), and (3) �duplicated loss,� which is the aggregate of the subsidiaries asset basis and loss carryovers over the value of the subsidiaries assets. any losses in excess of these amounts are deductible. reg. § 1.1502-20 is designed to prevent �duplicated losses� � the deduction by both the parent and subsidiary of the same economic loss. the court of federal claims upheld the validity of reg. § 1.1502-20 and because encore�s built-in loss of $28 million [as calculated by ] exceeded rite aids� economic loss, no loss deduction was allowed. the court pointed out that rite aid could have avoided reg. § 1.1502-20 by finding a buyer who would agree to a § 338(h)(10) election. � the federal circuit (judge meyer) reversed, declaring the �duplicated loss factor� in reg. § 1.1502-20 invalid because it allows a loss that is otherwise allowed by § 165 and is �manifestly contrary to the statute.� because � realization of the loss [on the stock sale] does not stem from the filing of a consolidated return, . . . the denial of the deduction imposes a tax on income that otherwise would not be taxed,� something that § 1502 does not authorize the treasury to do. the federal circuit summarily rejected the government�s argument that reg. § 1.1502-20 is necessary to prevent a double deduction, stating that the subsidiary�s future deductions were not created by the consolidated return rules because the same duplication occurs outside the consolidated return context, and congress has addressed the problem by the 718 florida tax review [vol.5:si enactment of §§ 382 and 383. judge mayer concluded that �the duplicated loss factor distorts rather than reflects the tax liability of consolidated groups and contravenes congress� otherwise uniform treatment of limiting deductions from the subsidiary�s losses.� � b. john williams of shearman & sterling �the new irs chief counsel � represented the taxpayer. a. initially, the irs threatened to keep going. in chief counsel notice cc-2001-042 (8/30/01), the irs advised chief counsel attorneys that it did not agree with the federal circuit decision in rite aid corp. v. united states and that it had filed a petition for rehearing en banc with the federal circuit. b. now, it will change the regulations instead. notice 200211, 2002-7 i.r.b. 526 (2/1/02). the irs still believes that the federal circuit�s analysis and holding in rite aid were incorrect, but it will not appeal. nevertheless, the service announced that �the interests of sound tax administration will not be served by continuing to litigate the validity of the loss duplication factor of § 1.1502-20.� however, �because of the interrelationship in the operation of all of the loss disallowance factors,� the irs will promulgate new rules governing loss disallowance on sales of stock of a member of a consolidated group. interim regulations [to be effective prospectively from the date of their issuance] �will require consolidated groups to determine the allowable loss on a sale or disposition of subsidiary stock under an amended § 1.337(d)-2 instead of under § 1.1502-20.� for transactions (including those for which a return has been filed) completed before promulgation of interim regulations [or for which there is a binding contract before that date] certain choices will be allowed with respect to a disposition of subsidiary stock, including a choice to apply § 1.337(d)-2 as amended. the irs and treasury will consider broadly the regulations necessary to implement § 337(d) with respect to affiliated groups filing consolidated. the irs takes the position that the rite aid holding is very narrow: it is the service�s position that the rite aid opinion implicates only the loss duplication aspect of the loss disallowance regulation and that the authority to prescribe consolidated return regulations conferred on the secretary is limited only by the requirement that the secretary, in his discretion, has determined such rules necessary clearly to reflect consolidated tax liability. 2002] recent developments in federal income taxation 719 3. a kinder and gentler approach to captive insurance. rev. rul. 2001-31, 2001-26 i.r.b. 1348 (6/25/01). the irs will no longer invoke the �economic family� theory of rev. rul. 77-316, 1977-2 c.b. 53, to attack captive insurance arrangements. rev. rul. 77-316 is obsoleted. the irs may continue to challenge certain captive insurance transactions on a case-by-case basis. 4. deferred intercompany transaction timing rules are a method of accounting. reg-125161-01, conforming amendments to section 446, 66 f.r. 56262 (11/7/01). these proposed regulations would conform reg. § 1.4461(c)(2)(iii) to reg. § 1.1502-13(a)(3), promulgated in 1995, which provides that the deferred intercompany transaction rules are a method of accounting, which members are required to apply in addition to their usual methods of accounting. � in general motors corp. v. commissioner, 112 t.c. 270 (1999), the tax court held that the timing rule of former [pre1995] reg. § 1.1502-13(b)(2) was not a method of accounting for purposes of § 446(e). the proposed regulations confirm the irs�s position that the timing rules of current § 1.1502-13 are a method of accounting. 5. the irs acts to eliminate an anomaly that would hurt corporate taxpayers in consolidated returns. reg-137519-01, consolidated returns; applicability of other provisions of law; nonapplicability of section 357(c), 66 f.r. 57021 (11/14/01). a proposed amendment to reg. § 1.1502-80(d) would clarify that liabilities described in § 357(c)(3) are not taken into account as a basis reduction with respect to § 351 transfers to which § 357(c) is inapplicable. f. reorganizations and corporate divisions 1. the wrath of general utilities repeal rewritten. reg-107566-00, notice of proposed regulations, guidance under section 355(e): recognition of gain on certain distributions of stock or securities in connection with an acquisition, 66 f.r. 76 (1/2/01). the treasury has revised prop. reg. § 355-7 and withdrawn proposed regulations issued in reg-116733-98 (64 f.r. 46155, 8/24/99). the new proposed regulations provide that whether a distribution and an acquisition are part of a plan is determined based on all the facts and circumstances. they include nonexclusive lists of facts and circumstances to be considered in making the determination and six safe harbors. � if an acquisition follows a distribution, the distribution and acquisition are considered part of a plan if the distributing corporation (d), the controlled corporation (c), or any of their controlling shareholders intended on the date of the distribution that the acquisition or a 720 florida tax review [vol.5:si similar acquisition occur in connection with the distribution. if an acquisition precedes a distribution, the distribution and acquisition are considered part of a plan if d, c, or any of their controlling shareholders intended on the date of the acquisition that a distribution occur in connection with the acquisition. all acquisitions of stock of a corporation that are pursuant to a plan are aggregated to determine whether the 50 percent threshold of § 355(e)(2)(a)(ii) is met. � facts and circumstances � there are two nonexclusive lists of factors to consider, one list tends to demonstrate that a distribution and an acquisition are part of a plan and the other list tends to demonstrate that a distribution and an acquisition are not part of a plan. the weight of the factors varies and the determination does not depend on merely counting factors. � factors indicating a plan: six factors [3 with respect to pre-acquisition distributions and 2 with respect to postacquisition distributions] focus on whether d, c, or their respective controlling shareholders discussed the second transaction of the pair with outside parties before the first transaction occurred. the seventh factor considers whether the distribution was motivated by a purpose to facilitate the acquisition or a similar acquisition of d or c; evidence of such a purpose exists if there was a reasonable certainty that within 6 months after the distribution an acquisition would occur, an agreement, understanding, or arrangement would exist, or substantial negotiations would occur regarding an acquisition. elaborate �operating rules� describe the impact of numerous scenarios. the eighth factor considers whether an acquisition and a distribution occurred within 6 months of each other, or whether there was an agreement, understanding, arrangement, or substantial negotiations regarding the second transaction (or, if an acquisition is the second transaction, a similar acquisition) within 6 months after the first transaction. the ninth factor considers whether the debt allocation between d and c made an acquisition of d or c likely in order to service the debt. � factors indicating the absence of a plan: five factors [3 with respect to pre-acquisition distributions and 2 with respect to post-acquisition distributions] focus on the absence of any discussions between d, c, or their respective controlling shareholders, with outside parties regarding the second transaction of the pair before the first transaction occurred. one of the factors in each category is that there was an identifiable, unexpected change in market or business conditions after the first transactions that resulted in the second, unexpected transaction. the sixth nonplan factor is the existence of a real and substantial corporate business purpose, other than a purpose to facilitate the acquisition or a similar acquisition, for the distribution [using principles similar reg. § 1.355-2(b)(1)]. the seventh factor is that the distribution would have occurred at approximately the same time and in similar form regardless of the acquisition or a previously proposed similar acquisition. 2002] recent developments in federal income taxation 721 � safe harbors: a distribution and an acquisition are not part of a plan if they are described in one of the safe harbors. (1) an acquisition more than 6 months after a distribution if there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition before a date that is 6 months after the distribution and the distribution was motivated in whole or substantial part by a corporate business purpose other than a business purpose to facilitate an acquisition is not part of a plan. this safe harbor applies if the distribution was motivated in whole or substantial part by a nonacquisition business purpose. (2) an acquisition more than 6 months after a distribution for which there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition before a date that is 6 months after the distribution is not part of a plan. this safe harbor applies where the distribution was motivated in whole or substantial part by a business purpose to facilitate an acquisition of no more than 33% of the stock of either d or c, and no more than 20 percent of the stock of the corporation whose stock was acquired in the acquisition that motivated the distribution was either acquired or the subject of an agreement, understanding, arrangement, or substantial negotiations before a date that is 6 months after the distribution. (3) an acquisition more than 2 years after a distribution if there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition at the time of the distribution or within 6 months thereafter is not part of a plan. (4) an acquisition more than 2 years before a distribution if there was no agreement, understanding, arrangement, or substantial negotiations concerning the distribution at the time of the acquisition or within 6 months thereafter is not part of a plan. (5) if d or c is listed on an established market, an acquisition if the stock is transferred between shareholders of d or c who are not 5percent shareholders is not part of a plan. this safe harbor is subject to certain exceptions. (6) an acquisition of stock by an employee or director in connection with the performance of services, including an acquisition resulting from the exercise of certain compensatory stock options, is not part of a plan. � for all purposes, depending on all relevant facts and circumstances, parties can have an agreement, understanding, or arrangement even though they have not reached agreement on all terms. under certain circumstances, such as in public offerings or auctions of d or c stock, an agreement, understanding, arrangement, or substantial negotiations can exist 722 florida tax review [vol.5:si regarding an acquisition even if the acquirer has not been specifically identified. special rules deal with options. these proposed rules are to be effective upon the publication of final regulations. a. and apparently the government thinks it did a better job on the regulations the second time around. t.d. 8960, guidance under section 355(e); recognition of gain on certain distributions of stock or securities in connection with an acquisition, 66 f.r. 40590 (8/3/01). the treasury has promulgated temporary regulations identical to the proposed regulations, except that the temporary regulations reserve § 1.355-7(e)(6) (suspending the running of any time period during which there is a substantial diminution of risk of loss under the principles of § 355(d)(6)(b)) and example 7 of the proposed regulations (interpreting the term �similar acquisition� in the context of a situation involving multiple acquisitions). 2. when the statute is unhelpful, call on the legislative history of a related provision for some help. rev. rul. 2001-24, 2001-22 i.r.b. 1290 (6/29/01). the irs ruled that the parent acquiring corporation in a § 368(a)(2)(d) forward triangular merger may drop the acquisition subsidiary into a different subsidiary. under reg. § 1.368-1(d)(4), the continuity of business enterprise requirement is met. reg. § 1.368-2(f) provides that a corporation remains a �party to the reorganization� if following an acquisition, stock or assets are transferred in a transaction described in reg. § 1.368-2(k), but reg. § 1.368-2(k) refers only to reverse triangular mergers under § 368(a)(2)(e). if the transaction were recast under the step transaction doctrine as a merger into a second tier subsidiary, the parent would not be a party to the reorganization. because the legislative history of § 368(a)(2)(e) suggests that forward and reverse triangular mergers should be treated similarly, the irs will not apply the step transaction doctrine. the transaction qualifies under § 368(a)(2)(d). section 368(a)(2)(c), which does not apply, is permissive rather than restrictive. 3. �holds� in § 368(a)(2)(e) means the same as �acquire[s]� in § 368(a)(1)(c). rev. rul. 2001-25, 2001-22 i.r.b. 1291 (5/29/01). the irs has ruled that a reverse triangular merger that otherwise qualified under § 368(a)(2)(e) was not disqualified by virtue of the fact that immediately after the merger and as part of a plan that included the merger, the surviving target corporation sold fifty percent of its operating assets to an unrelated corporation for cash. the irs concluded that rev. rul. 88-48, 1988-1 c.b. 117, should be applied to conclude that the �substantially all of the properties� requirement had been met when 50 percent of the target�s assets were sold for cash immediately 2002] recent developments in federal income taxation 723 before the acquisition and the cash was transferred to the acquirer along with the other assets. the reasoning of rev. rul. 2001-25 was as follows. section 368(a)(2)(e) uses the term �holds� rather than the term �acquisition� as do §§ 368(a)(1)(c) and 368(a)(2)(d) because it would be inapposite to require the surviving corporation to �acquire� its own properties. the �holds� requirement of § 368(a)(2)(e) does not impose requirements on the surviving corporation before and after the merger that would not have applied had such corporation transferred its properties to another corporation in a reorganization under § 368(a)(1)(c) or a reorganization under §§ 368(a)(1)(a) and 368(a)(2)(d). 4. does the irs now like the king enterprises step transaction analysis? rev. rul. 2001-26, 2001-23 i.r.b. 1297 (6/4/01). the irs has ruled that a two-step acquisition involving a voting stock for stock tender offer exchange for 51 percent of the outstanding t corporation stock, followed by a merger of a p subsidiary into t in which the remaining 49 percent of the t shareholders receive two-third p stock and one-third cash (the cash being 16.67 percent of total consideration) can qualify as a § 368(a)(2)(e) reverse triangular merger. the ruling assumes that all requirements for a reorganization under §§ 368(a)(1)(a) and 368(a)(2)(e), other than the requirement under § 368(a)(2)(e)(ii) that p acquire control of t in exchange for its voting stock in the transaction, have been satisfied. the ruling also assumes that under general principles of tax law, including the step transaction doctrine as applied in king enterprises, inc. v. united states, 418 f.2d 511 (ct. cl. 1969), the tender offer and the statutory merger are treated as an integrated acquisition by p of all of the t stock. the ruling reaches the same result in a situation in which before the merger, s initiates the tender offer for t stock and, in the tender offer, acquires 51 percent of the t stock for p stock provided by p. 5. from �qualified stock purchase� to �reorganization� with a wave of step transaction doctrine�s magic wand. rev. rul. 2001-46, 2001-42 i.r.b. 321 (9/25/01). p acquired t by merging p�s shell subsidiary s into t in a reverse triangular merger in which the t shareholder�s receive 70 percent p voting stock and 30 percent cash (the acquisition merger). following the acquisition, �as part of the plan,� t merges into p (the upstream merger). the ruling assumes that (1) �absent some prohibition against the application of the step transaction doctrine, the step transaction doctrine would apply to treat the acquisition merger and the upstream merger as a single integrated acquisition by [p] of all the assets of t,� and (2) �the single integrated transaction would 724 florida tax review [vol.5:si satisfy the nonstatutory requirements of a reorganization under § 368(a). the ruling holds that acquisition merger is not a qualified stock purchase under § 338 followed by a § 332 liquidation, but instead is a statutory merger of t into p under § 368(a)(1)(a). no § 338 election is available. the ruling reaches the same result � type (a) merger if the t shareholders receive solely p voting stock [instead of a § 368(a)(1)(e) reverse triangular merger]. � the irs applied rev. rul. 67-274, 1967-2 c.b. 141, holding that if p acquires the stock of t in exchange p voting stock and thereafter liquidates t into p, the transaction is a type (c) reorganization rather than a type (b) reorganization. it distinguished rev. rul. 90-95, 1990-2 c.b. 67 (situation 2), holding that the cash merger of a newly formed wholly owned s into t followed by the merger of t into p will be treated as a qualified stock purchase of t followed by a § 332 liquidation of t. � pursuant to § 7805(b) the irs will not apply the ruling to challenge a taxpayer�s contrary position with respect to an acquisition before 9/25/01, or acquisition of stock of the target corporation meeting the requirements of § 1504(a)(2) by the purchasing corporation pursuant to a written agreement binding on 9/24/01 if: (1) a timely § 338(g) or (h)(10) or § 338(g) has been filed and (2) the taxpayer does not take an inconsistent position. � the irs is considering whether to issue regulations that reflect the principles of the ruling, but nevertheless allow § 338(h)(10) elections pursuant to a written agreement that requires or permits the § 338(h)(10) election. 6. the �active business� of reit. rev. rul. 2001-29, 2001-26 i.r.b. 1348 (6/25/01). a reit can be engaged in the active conduct of a trade or business within the meaning of § 355(b) solely by virtue of functions with respect to rental activity that produces income qualifying as rents from real property within the meaning of § 856(d) of the code. rev. rul. 73-236, 1973-1 c.b. 183 is obsoleted. �the obsolescence of rev. rul. 73-236, which denied § 355 treatment to a distribution of stock by a c corporation that converted to a reit because the reit was not engaged in the active conduct of a trade or business, does not imply a view as to whether a distribution of stock involving a reit election by the distributing or controlled corporation would otherwise satisfy the requirements of § 355, including the corporate business purpose requirement of § 1.355-2(b).� 7. treasury does an �about-face� on mergers into disregarded entities. reg-126485-01, statutory mergers and consolidations, 66 f.r. 57400 (11/15/01). the treasury has withdrawn proposed regulations [reg-10618698, 65 f.r. 31115 (5/16/00)], which would have provided that neither the 2002] recent developments in federal income taxation 725 merger of a disregarded entity into a corporation nor the merger of a target corporation into a disregarded entity was a statutory merger qualifying as a reorganization under § 368(a)(1)(a), and has proposed new more liberal regulations [prop. reg. § 1.368-2(b)(1)]. under the new proposed regulations, a merger of a corporation into a disregarded entity that is wholly owned by another corporation could qualify as a type (a) merger. as the irs is wont to do these days, the new proposed regulations introduce more definitional jargon. the term �disregarded entity� means a business entity (as defined in reg. § 301.7701-2(a)) that is disregarded as an entity separate from its owner for federal tax purposes, including single member corporate-owned llcs, qualified reit subsidiaries, and q-subs. �combining entity� means a business entity that is a corporation [as defined in reg. § 301.7701-2(b)] that is not a disregarded entity. �combining unit� means a combining entity and all disregarded entities, if any, the assets of which are treated as owned by such combining entity for federal tax purposes. under the proposed regulations, a statutory merger or consolidation under § 368(a)(1)(a) must be effected pursuant to the laws of the united states or a state or the district of columbia. [foreign statutory mergers still do not qualify, but the domestic statute no longer needs to be a �corporate� law.] all of the following events must occur simultaneously: (1) all of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of one other combining unit (the transferee unit); and (2) the combining entity of each transferor unit ceases its separate legal existence for all purposes. the examples provide all the details in the rules: (ex. 1) divisive mergers [see rev. rul. 2000-5, 2000-1 c.b. 436] cannot qualify; (ex. 2 & 3) forward triangular mergers (into a disregarded entity owned by s) are allowed; (ex. 4) the owner of the disregarded entity must be a corporation; (ex. 5) mergers of disregarded entities into corporations do not qualify; and (ex. 6) none of the consideration received by the t shareholders may be interests in the disregarded entity. � the regulations will be effective when finalized. 8. backing into control within 5 years of the spin-off backed them right out of § 355. mclaulin v. commissioner, 276 f.3d 1269, 2002-1 u.s.t.c. ¶ 50,156, 88 a.f.t.r.2d 7324 (11th cir. 12/21/01), aff�g 115 t.c. 255 (9/20/00). the taxpayers were shareholders of rpi, an s corporation. until 1993, rpi owned 50 percent of the stock of sunbelt (a c corporation); the other 50 percent was owned by hutto. in 1993, after protracted negotiations regarding whether rpi should purchase hutto�s stock in sunbelt or hutto should purchase rpi�s sunbelt stock, sunbelt redeemed all of hutto�s stock for cash [$828,943], 726 florida tax review [vol.5:si which was borrowed from rpi, and property [$101,000], leaving rpi as sunbelt�s sole shareholder. later on the same day as the redemption, rpi distributed all of the stock of sunbelt to rpi�s three equal shareholders � the taxpayers � in a transaction intended to qualify as a tax-free spinoff under § 355. the stated purposes of the distribution were to relieve rpi from any potential liabilities arising from sunbelt�s operations, to prepare sunbelt to go public, and to preserve rpi�s s election [the controlling version of § 1361(b) for the year in question prohibited the parent of an affiliated group from being an s corporation]. � the tax court (judge halpern) held that because rpi�s distribution of the stock of sunbelt occurred less than 5 years after rpi acquired control of sunbelt in a transaction in which gain or loss was recognized [i.e., the redemption of hutto�s stock], the distribution failed to satisfy the active business requirement of §§ 355(a)(1)(c) and (b)(2)(d)(ii). judge halpern rejected the taxpayer�s �blanket assertion� that a redemption of stock of the other shareholder�s stock, thereby backing the parent into control of the subsidiary, never could be treated as the acquisition of control within 5 years in a taxable transaction. he likewise declined to follow the commissioner�s argument directly to apply rev. rul. 57-144, 1957-1 c.b. 123, which would treat any instance in which a redemption resulted in the acquisition of control within 5 years as a disqualifying acquisition. rather, he emphasized the negotiations leading up to the transaction and the fact that the cash for the redemption came from rpi to conclude that in this case there was no difference between the transaction as it occurred and a direct purchase by rpi. � accordingly, § 335(c)(1) did not apply to provide nonrecognition at the corporate level; under § 311(b), rpi recognized gain on the distribution of the sunbelt stock, and the gain passed through to the rpi shareholders under § 1366(a). [the court did not address the commissioner�s argument that the shareholders failed to prove that the distribution was designed to achieve a corporate business purpose as required by reg. § 1.355-2(b).] � the court of appeals affirmed the tax court�s decision with minimal discussion. the tax court found that the facts of rev. rul. 57-144 were not distinguishable from the present case in any significant way. we agree. . . . . we need make no distinction between indirect control of sunbelt by ridge at 50% ownership and direct control of sunbelt by ridge at 100% ownership. under the plain meaning of the statute, ridge acquired control on january 15th, the 2002] recent developments in federal income taxation 727 moment the taxable hutto redemption occurred. this event resets the five-year clock and renders ridge's distribution of the sunbelt stock taxable, albeit stock that it had held for more than twelve years. as the tax court said, this is not the mere conversion of indirect control to direct control. it is the �acquisition of control where none had existed previously.� g. personal holding companies and accumulated earnings tax 1. knight furniture co. v. commissioner, t.c. memo. 2001-19 (1/29/01). the accumulated earnings tax assessed by the commissioner was not upheld because the taxpayer was reasonably accumulating earnings to redeem dissenting minority shareholders and had a history of funding redemptions with cash. h. miscellaneous issues 1. is it the harbinger of a negotiated tax system? notice 2000-12, 2000-9 i.r.b. 727 (2/12/00). a pilot program existed for pre-filing agreements (pfas), under which large businesses may request examination and resolution of specific issues relating to tax returns expected to be filed between september and december 2000. these pfas would be treated as closing agreements, and would be characterized as confidential return information under § 6103(b)(2)(a). a. pfas available for all lmsb taxpayers. rev. proc. 200122, 2001-9 i.r.b. 745 (2/26/01). this procedure permits a taxpayer subject to the jurisdiction of the irs large and mid-size business division (lmsb) to request the examination of specific issues relating to a tax return before the return is timely filed. if the taxpayer and the service are able to resolve the examined issues prior to the filing of the return, the taxpayer and the irs may finalize their resolution by executing an lmsb pre-filing agreement. it applies only to issues involving the application of well-settled principles of law; it does not apply to issues involving questions of law that are not well settled with respect to the material facts of the issue. lmsb pfas are closing agreements under § 7121, and must comply with rev. proc. 68-16, 1968-1 c.b. 770. b. the community renewal tax relief act of 2000 added § 6103(b)(2)(d) to provide specifically that these closing agreements (as are these pre-filing agreements) would be treated as confidential return information. 728 florida tax review [vol.5:si 2. the final § 338 and § 1060 regulations provide only minor changes from the 2000 temporary regulations. t.d. 8940, purchase price allocations in deemed and actual asset acquisitions, 66 f.r. 9925 (2/13/01). final regulations §§ 1.338-1 through -10, 1.338(h)(10)-(1) and 1.1060-1, [proposed in reg-107069-97, 64 f.r. 43462 (8/10/99), and promulgated as temporary regulations (effective 1/6/00) in t.d. 8858, 65 f.r. 1236 (1/7/00)] clarify the treatment of, and provide consistent rules (where possible) for, both deemed and actual asset acquisitions under §§ 338 and 1060. � reg. §§ 1.338-1 through -10, § 1.338(h)(10)(1) and 1.1060-1 are intended to clarify the treatment of, and provide consistent rules (where possible) for, both deemed and actual asset acquisitions under §§ 338 and 1060. the irs identified three major deficiencies in the prior regulations: (1) their statement of tax accounting rules and their relationship to tax accounting rules for asset purchases outside of § 338; (2) the effects of the allocation rules; and (3) their lack of a complete model for the deemed asset sale (and, in the case of § 338(h)(10) elections, the deemed liquidation) from which tax consequences not specifically set forth in the regulations can be determined. the new regulations also take into account amendments to the code enacted since the different portions of the current regulations were promulgated. � the new regulations have four major aspects: (1) reorganization of the regulations; (2) clarification and modification of the accounting rules applicable to deemed and actual asset acquisitions; (3) modifications to the residual method mandated for allocating consideration and basis, increasing the number of classes to seven; and (4) miscellaneous revisions to the current regulations. old target and new target (and any other affected parties, for example, when a § 338(h)(10) election is made) must determine their tax consequences as if they actually had engaged in the sale and purchase transactions deemed to have occurred under § 338. the consistency rules are unchanged. � the seven classes are: class i � cash and cash equivalents; class ii � cds, securities, foreign currency; class iii � assets the target marks-to-market annually for tax purposes and debt obligations held by the taxpayer, [generally including accounts receivable, mortgages, credit card receivables], but not including debt instruments issued by a related person [determined after the acquisition], contingent debt instruments, or convertible debt; class iv � inventory; class v � all assets not included in the other classes and the stock of target affiliates; class vi � section 197 assets other than goodwill and going concern value; and class vii � section 197 goodwill and going concern value. the change relates to the addition of two new classes of �fast pay� assets, which must receive basis up to fair market value before there is any basis allocated to tangible property. � reg. §§ 1.338-4t and 1.338-5t significantly 2002] recent developments in federal income taxation 729 revise the calculations of aggregate deemed sale price (adsp) and adjusted grossed-up basis (agub), as well as various aspects of tax treatment of the deemed asset sale. under the new regulations, adsp is the grossed-up amount realized on the sale to the purchasing corporation of the purchasing corporation�s recently purchased target stock. amount realized is determined as if old target itself were the selling shareholder. general tax law principles apply in determining the timing and amount of the elements of adsp, and that adsp is redetermined at such time and in such amount as an increase or decrease to the individual constituent elements of the definition of adsp would be required under general principles of tax law. the new regulations also provide a parallel rule for agub. these changes may result in increased disparities between adsp and agub if there is nonrecently purchased stock of the target involved. � old target�s liabilities are taken into account in calculating adsp as if old target sold its assets to an unrelated person for consideration that included the unrelated person�s assumption of, or taking subject to, the liabilities. to be taken into account in agub, a liability must be a liability of target that is properly taken into account in basis under general principles that would apply if new target had acquired its assets from an unrelated person for consideration that included the assumption of, or taking subject to, the liability; the prior rule that liabilities are taken into account in calculating agub (and adsp) only when such liabilities become fixed and determinable is eliminated. old target�s tax liability is deemed not assumed by new target only if the parties have agreed that (or the tax or non-tax rules operate such that) the seller, and not target, will bear the economic cost of that tax liability. 3. the tax court continues on its capitalization spree. illinois tool works, inc. v. commissioner, 117 t.c. 39 (6/31/01). the taxpayer acquired the assets of another corporation [for approximately $126 million] in a taxable transaction in which the taxpayer assumed the target�s liabilities, including a contingent liability for a patent infringement claim, [lemelson v. champion spark plug co., 975 f.2d 869 (1992)], for which it established a reserve of $350,000. subsequently, the taxpayer, as the target�s successor, was held liable for damages, interest, and court costs [totaling over $17 million], which it paid. the tax court (judge cohen) upheld the commissioner�s treatment requiring capitalization of the payments as a cost of acquiring the assets rather than a deductible expense, even though the parties had not adjusted the purchase price to reflect the contingent liability. the liability was known, was considered in setting the price, and was expressly assumed. that the taxpayer considered it highly unlikely that it would be called upon to pay was not relevant. � the commissioner conceded the deductibility 730 florida tax review [vol.5:si of the judgment in two respects: (1) pre-judgment interest accruing after the acquisition date was deductible; and (2) to the extent that the additional purchase price was allocable to assets the taxpayer had disposed of, the judgment was deductible. � note that in many, if not most, cases, the disposition of a portion of target�s assets will not affect the characterization of the payments because, under § 1060 and reg. § 1.1060-1, the capitalized contingent liability will be allocated to class vi and vii amortizable intangibles for which no loss is allowed until the complete disposition of all such intangibles acquired from the target. see irc § 197(f)(1). the grounds for the commissioner�s concession were not clearly articulated in the opinion. vii. partnerships a. formation and taxable years 1. reg-104876-00, proposed regulations, taxable years of partner and partnership; foreign partners, 66 f.r. 3920 (1/17/01). for purposes of applying § 706(b) to determine the partnership�s permitted year, prop. reg. § 1.706-4 would generally disregard foreign partners who are not subject to u.s taxation on a net basis, i.e., foreign partners who are not allocated any effectively connected income or, if claiming treaty benefits, that do not have a permanent establishment. these rules do not apply if the partnership year would be determined with reference to domestic partners no one of which holds at least a 10-percent interest and which in the aggregate hold less than 20 percent of the interests. 2. the profits-only partnership interest safe-harbor is dredged a little wider. rev. proc. 2001-43, 2001-34 i.r.b. 191 (8/3/01), clarifying rev. proc. 93-27, 1993-2 c.b. 343. this revenue procedure provides that whether an interest granted to a service provider is a profits interest is determined at the time the interest is granted, even if, at that time, the interest is substantially nonvested [under reg. § 1.83-3(b)]. if the requirements of rev. proc. 93-27 are met the irs will not treat the grant of the interest or the event that causes the interest to become substantially vested as a taxable event for the partner or the partnership. taxpayers to which this revenue procedure applies do not need to file a § 83(b) election. b. allocations of distributive share, partnership debt, and outside basis 1. reg-106702-00, determination of basis of partner�s interest; special rules, 66 f.r. 315 (1/3/01). prop. reg. § 1.705 would prevent what the 2002] recent developments in federal income taxation 731 irs has determined to be �inappropriate� increases or decreases in the adjusted basis of a corporate partner�s interest in a partnership [consistent with notice 99-57, 1999-2 c.b. 692] resulting from the partnership�s disposition of the corporate partner�s stock [under the general principles of rev. rul. 99-57, 19992 c.b. 678], when: (1) a corporation acquires an interest in a partnership that holds stock in the corporation, (2) the partnership does not have a § 754 election in effect for the year in which the corporation acquires the interest, and (3) the partnership later sells or exchanges the stock, then the increase or decrease in the corporation�s adjusted basis in its partnership interest resulting from the sale or exchange of the stock equals the amount of gain or loss that the corporate partner would have recognized (absent the application of § 1032) if, for the tax year in which the corporation acquired the interest, a § 754 election had been in effect. the proposed regulation is to be effective retroactively to gain or loss allocated on sales or exchanges of stock occurring after 12/06/99. 2. the § 704(b) regulations are so complicated that even the irs doesn�t understand them! interhotel co., ltd. v. commissioner, t.c. memo. 2001-151 (6/22/01), on remand from 221 f.3d 1348, 87 a.f.t.r.2d 807, 20011 u.s.t.c. ¶ 50,501 (9th cir. 5/22/00), vacating, t.c. memo. 1997-44. the taxpayer was a partnership whose primary assets were interests in two lower tier partnerships, one of which owned a hotel subject to a nonrecourse mortgage and with respect to which the upper tier partnership in question was subject to a minimum gain chargeback. the upper tier partnership agreement provided for liquidation according to positive capital account balances but neither required the restoration of negative capital accounts nor provided a qualified income offset as required by reg. § 1.704-1(b)(2)(ii)(d). a�s pro rata partnership interest was stated as 85 percent and b�s interest was stated as 15 percent but, prior to june 20, 1991, pursuant to a special allocation, the partnership income was allocated 1 percent to a and 99 percent to b, while losses were allocated 85 percent to a and 15 percent to b. as of june 20, 1991, a�s capital account was negative $5,920,614, and b�s capital account was positive $14,879,392. as of june 21, 1991, b�s partnership interest was transferred to c, who succeeded to b�s capital account, and the partnership agreement was amended to allocate all partnership income to any partner with a negative capital account, i.e., a, and thereafter in proportion to the partners� pro rata interests, i.e., 85 percent to a and 15 percent to c. � in the first tax court opinion, judge jacobs held that the allocation of all of the post-june 20, 1991 income to a should not be respected, and the partnership�s income was allocated in accordance with the partners� interests in the partnership. because the partnership agreement provided for capital accounts and required liquidating distributions only to partners with positive capital accounts, the hypothetical liquidation test of reg. 732 florida tax review [vol.5:si § 1.704-1(b)(3)(iii) was applied. accordingly, 99 percent of the income was allocated to c, the only partner with a positive capital account. the court held that in applying the hypothetical liquidation test, for purposes of adjusting the partners� capital accounts, a minimum gain chargeback of a lower tier partnership, i.e., a partnership in which the partnership in question owned an interest, was not triggered because lower tier partnerships are not treated as hypothetically liquidating when applying the hypothetical liquidation test. � the court of appeals vacated because the irs conceded �that it erred in convincing the tax court to refrain from including a minimum gain chargeback in the court�s calculations for purposes of the comparative liquidation test.� � on remand. judge jacobs reaffirmed that the allocations did not have substantial economic effect under reg. § 1.7041(b)(2) because the partnership agreement did not require restoration of negative capital accounts or provide a qualified income offset. but in applying the comparative liquidation test, the deemed liquidation of the upper-tier partnership was treated as triggering its share of the minimum gain chargeback of the lower-tier partnerships, and that amount of minimum gain was allocated among the partners to determine their capital accounts pursuant to the hypothetical liquidation. because a would have been allocated the first $5,920,614 of minimum gain in a hypothetical liquidation, allocation of all of the income to a as long as a had a negative capital account was permitted under the regulations. judge jacob rejected numerous irs arguments regarding the constructions of the § 704(b) regulations that he [quite correctly in our opinion] characterized as �erroneous� readings of the regulations. c. sales of partnership interests, liquidations and mergers 1. form controls partnership mergers and divisions. t.d. 8925, partnership mergers and divisions, 66 f.r. 715 (1/3/01). final reg. § 1.7081(c) and amendments to reg. § 1.752-1(f) and (g) [proposed in reg-111119999] provide detailed rules regarding the treatment of partnership mergers and divisions. the tax consequences of mergers of partnerships depend on the form followed under the laws of the applicable jurisdiction, either the �assets-over form� or the �assets-up form� [even if none of the merged partnerships are treated as continuing for federal income tax purposes]. generally, [and if no particular form is chosen] the assets-over form applies. (this approach is consistent with the treatment of partnership to corporation elective conversions under the check-the-box regulations and technical terminations under § 708(b)(1)(b).) but, if as part of the merger, the partnership titles the assets in the partners� names, the assets-up form applies. if partnerships use the 2002] recent developments in federal income taxation 733 interests-over form to accomplish the result of a merger, the partnerships will be treated as following the assets-over form for federal income tax purposes. � under the assets-up form, partners recognize gain under §§ 704(c)(1)(b) and 737 (and incur state or local transfer taxes) when the terminating partnership distributes the assets to the partners. however, under the assets-over form, gain under §§ 704(c)(1)(b) and 737 is not triggered. see regs. §§ 1.704-4(c)(4) and 1.737-2(b). because the adjusted basis of the assets contributed to the resulting partnership is determined first by reference to § 732 (as a result of the liquidation) and then § 723 (by virtue of the contribution), the adjusted basis of the assets contributed may not be the same as the adjusted basis of the assets in the terminating partnership if the partners� aggregate adjusted basis of their interests in the terminating partnership does not equal the terminating partnership�s adjusted basis in its assets. under the assets-over form, because the resulting partnership�s adjusted basis in the assets it receives is determined solely under § 723, the adjusted basis of the assets in the resulting partnership is the same as the adjusted basis of the assets in the terminating partnership. � when two or more partnerships merge under the assets-over form, increases or decreases in partnership liabilities associated with the merger are netted by the partners in the terminating partnership and the resulting partnership to determine the effect of the merger under § 752. a partner in the terminating partnership will recognize gain on the contribution under § 731 only if the net § 752 deemed distribution exceeds that partner�s adjusted basis of its interest in the resulting partnership. � the resulting partnership is treated as a continuation of a merged partnership, if the partners of the merged partnership own more than 50 percent of the capital and profits of the continuing partnership. if the partners of two or more of the merged partnerships own more than 50 percent of the capital and profits of the continuing partnership, the partnership is a continuation of the partnership that contributed the greatest net asset value. � if the merger agreement (or some other contemporaneous agreement) specifies that the resulting partnership is purchasing an exiting partner�s interest in the terminating partnership and the amount paid for the interest, the transaction will be treated as a sale of the exiting partner�s interest to the resulting partnership. � form also will be followed, and the resulting differing tax consequences respected, with regard to corporate divisions if the partnership undertakes the steps of either the assets-over form or the assetsup form. gain under §§ 704(c)(1)(b) and 737 often may be triggered when § 704(c) property or substituted § 704(c) property is distributed to certain partners in the context of partnership divisions. if a partnership divides, the 734 florida tax review [vol.5:si transfer to one new partnership can follow the assets-over form while the transfer to the other follows the assets-up form. all resulting partnerships are bound by the original partnership�s elections. � when a partnership divides into two or more partnerships, a resulting partnership will be a continuation of the original partnership if the partners of the continuing partnership owned more than 50 percent of the capital and profits of the original partnership. other partnerships are new partnerships, and their partners are treated as having had their original partnership interests liquidated in the division. � the rules are generally effective as of 1/4/01, with an elective effective date of 1/11/00. d. partnership audit rules 1. and you thought the partnership level audit rules were procedural simplification. gaf corp. v. commissioner, 114 t.c. 519 (6/29/00) (reviewed, 10-3). the question was whether the transfer of property to a partnership [rhone-poulenc surfactants & specialties, l.p.] was to be treated as a sale or as a contribution to capital � an $80 million question. the irs issued both a statutory notice to gaf and an fpaa to the partnership. judge ruwe, for the majority, decided that a deficiency notice based on �affected items� issued prior to completion of the related partnership-level proceedings is invalid, so the tax court proceeding based on the deficiency notice must be dismissed for lack of jurisdiction. � judge halpern, in dissent, would overrule the maxwell v. commissioner, 87 t.c. 783 (1986), line of cases to the extent they hold the tax court lacks subject matter jurisdiction to redetermine a deficiency attributable until the related partnership proceeding is completed. the minority 2002] recent developments in federal income taxation 735 would not dismiss, but only defer proceeding until consideration of the affected items is appropriate. a. rhone-poulenc surfactants & specialties, l.p. v. commissioner, 114 t.c. 533 (6/29/00) (reviewed, 8-6). this case deals with gaf�s motion for summary judgment [based upon the running of the statute of limitations] in the partnership level proceeding, which was denied. the majority did not view dismissal of the partner-level case as mooting the partnership-level case. b. appeal dismissed because there was no case or controversy. rhone-poulenc surfactants & specialties, l.p. v. commissioner, 249 f.3d 175, 2001-1 u.s.t.c. ¶ 50,412, 87 a.f.t.r.2d 2023 (3rd cir. 5/1/01), dismissing appeal from 114 t.c. 533 (6/29/00). the tax court certified the denial of gaf�s motion for summary judgment for interlocutory appeal under § 7482(a). the court of appeals held that the petition for interlocutory appeal was improvidently granted because the tax court had reserved for decision issues [whether the partnership was a sham and the transaction in question was a sale and not a contribution followed by a distribution] that would affect the ripeness for appeal. if the transaction were a sale, § 6233(a) would not extend the partnership audit rules to gaf because it never held an interest in the purported partnership. 2. final unified partnership audit regulations. t.d. 8965, unified partnership audit rules, 66 f.r. 50541 (10/4/01). the final partnership audit regulations, reg. §§ 301.6221-1 through 301.6233-1, inclusive, are substantially similar to the previously proposed and temporary regulations. numerous clarifying changes have been made to reflect subsequent statutory changes impacting partnership level determinations and judicial interpretations of the temporary regulations. � partnerships with a nonresident alien partner cannot qualify for the small partnership exemption of § 6231(a)(1)(b)(i). � the passive activity loss rules of § 469 are an affected item [reg. § 301.62331(a)(5)-1] that will be directly assessed with respect to individual partners following the partnership level proceeding. � if the irs fails to provide a partner with timely notice of the beginning of an administrative proceeding (nbap) as required by § 6223, the partner may, under reg. § 301.6223(e)-2(c)(2), elect to have either the fpaa, a court decision, a consistent settlement agreement, or conversion to nonpartnership items apply to that partner�s partnership items. � the final regulations clarify that the election must be mailed within 45 days after the mailing of the fpaa, not the nbap. 736 florida tax review [vol.5:si � the final regulations conform to changes in the 1997 act providing that partnership-level proceedings include the determination of applicable penalties at the partnership level, and that partners could raise any partner-level defenses to the imposition of penalties only in a subsequent refund action. � reg. § 301.6224(c)-1 clarifies that a settlement agreement between the tax matters partner and the irs with respect to penalties, like a settlement agreement with respect to partnership items, binds partners other than notice partners and members of a notice group. � reg. § 301.6226(e)-1 clarifies that in the case of a petition filed by a 5-percent group or pass-thru partner, the members of the group or the indirect partners holding an interest in the partnership through the pass-thru partner must deposit the aggregate amount by which their tax liabilities would be increased if the treatment of partnership items on the partners� returns were made consistent with the treatment of partnership items on the partnership return (effective for civil actions beginning on or after 4/2/02). � the final regulations also incorporate the holding of callaway v. commissioner, 231 f.3d 106 (2d cir. 2000), holding that a wife was not bound by the outcome of a unified partnership proceeding where her husband's partnership items converted to nonpartnership items during the proceeding. 3. phillips v. commissioner, 272 f.3d 1172, 2002-1 u.s.t.c ¶ 50,103, 88 a.f.t.r.2d 7092 (9th cir. 12/4/01). irs criminal investigation of tax matters partner hoyt does not disqualify him from consenting to an extension of the statute of limitations. taxpayer argued that transpac drilling venture 1982-12 v. commissioner, 147 f.3d 221 (2d cir. 1998), which held that a tmp under irs criminal investigation had a disabling conflict of interest because his fiduciary duty to his partners conflicted with his desire to ingratiate himself with the irs. judge noonan stated: two circumstances differentiate this case. the irs made no attempt to get waivers from limited partners. the partnerships for which hoyt was being investigated have not been shown to be the partnerships involved in this case. it is not intuitively obvious that hoyt did what is a routine accommodation � signing a waiver in order to avoid immediate assessment by the irs � in order to ingratiate himself in the investigation of his partnerships. phillips has speculated that hoyt so acted; he has not proved it. 2002] recent developments in federal income taxation 737 viii. tax shelters a. corporate tax shelters 1. the saga of the merrill lynch marketed partnership/contingent installment sale corporate tax shelter deals continues. a. tax shelter benefits from § 453 contingent sale partnership tax shelter not allowed because the tax shelter is a sham and �serves no economic purpose other than tax savings.� merrill lynch�s persistence overcomes initial doubts of tax department. acm partnership v. commissioner, t.c. memo. 1997-115 (3/5/97) aff�d, 157 f.3d 231, 98-2 u.s.t.c. ¶ 50,790, 82 a.f.t.r.2d 6682 (3d cir. 10/13/98) (2-1), cert. denied, 526 u.s. 1017 (1999). judge laro found a § 453 contingent sale partnership tax shelter to be a prearranged sham, �tax-driven and devoid of economic purpose,� and �serv[ing] no economic purpose other than tax savings,� following goldstein v. commissioner, 364 f.2d 734 (2d cir. 1966), cert. denied, 385 u.s. 1005 (1967). under the scheme to shelter colgate�s $105 million 1988 capital gain, a partnership was formed in 1989; its three partners were affiliates of (a) a foreign bank (about 90%), (b) colgate (about 9%), and (c) merrill lynch (about 1%). a bank note was purchased by the partnership and immediately sold for a large immediate payment and much smaller future contingent payments. under the contingent payment sale provisions of the temporary regulations [§ 15a.453-1(c)] the partnership�s basis was to be allocated ratably over the several years over which contingent payments could be made, resulting in a large 1989 installment sale gain to the partnership. the lion�s share of that installment sale gain was allocated to the foreign bank (which was not taxable on u.s. source capital gain), followed by the redemption of the foreign bank�s partnership interest. this left colgate as the 90-percent partner. in 1991, the installment sale obligation was sold by the partnership, triggering about $100 million of capital losses, which colgate attempted to use to shelter its 1988 capital gain. � the third circuit affirmed the tax court�s application of the �economic substance� doctrine, which eliminated the capital gains and losses attributable to acm�s application of the ratable basis recovery rule of the contingent installment sale provisions. the third circuit held, however, that out-of-pocket amounts were deductible. b. judge foley finds another merrill lynch § 453 partnership plan does not work because, under the facts, there was no partnership. asa investerings partnership v. commissioner, t.c. memo. 738 florida tax review [vol.5:si 1998-305 (8/20/98). in another merrill lynch § 453 partnership plan to create capital losses to shelter earlier capital gains, alliedsignal lost when judge foley 2002] recent developments in federal income taxation 739 held that the parties to the partnership agreement did not join together for a common purpose of investing in interest-bearing instruments, and they did not share profits and losses. (1) affirmed, asa investerings partnership v. commissioner, 201 f.3d 505, 2000-1 u.s.t.c. ¶ 50,185, 85 a.f.t.r.2d 675 (d.c. cir. 2/1/00). the d.c. circuit�s opinion noted that it disagreed with the tax court�s statements that persons with �divergent business goals� are precluded from having the requisite intent to form a partnership; however, this view was not essential to the tax court�s conclusion that the parties did not intend to join together as partners to conduct business activity for a purpose other than tax avoidance. the court held that there was a single business purpose rule. c. and another deal bites the dust in the tax court. saba partnership v. commissioner, t.c. memo. 1999-359 (10/27/99). brunswick�s transactions that were identical to acm�s were found to lack economic substance. judge nims held that the transactions lacked nontax business purposes and that congress did not intend to favor such transactions �regardless of their economic substance.� he held that fees paid for the organization of the partnership were deductible subject to the limitations of § 709(b) [60-month amortization], but that the fees paid with respect to the sham transactions were not deductible. (1) d.c. circuit vacates and remands saba for reconsideration in light of its opinion in asa investerings. saba partnership v. commissioner, 273 f.3d 1135, 2002-1 u.s.t.c. ¶ 50,145, 88 a.f.t.r.2d 7318 (d.c. cir. 12/21/01), remanding for reconsideration in light of asa investerings t.c. memo. 1999-359 (10/27/99). the court felt this case to be indistinguishable from asa investerings, which was decided on a sham partnership theory, as opposed to judge nims� decision in the tax court, which was grounded on a sham transaction theory. the court of appeals refused to simply affirm the tax court�s decision on the alternative ground that the partnerships were shams. even the government conceded that the sham transaction and sham partnership approaches yield different results; the adjustments under the sham partnership theory would be different from those under the sham transaction theory [although the government apparently conceded at oral argument that under either approach, brunswick could deduct actual losses from the transactions]. the government argued that the court of appeals should apply asa investerings to hold that the partnerships were shams, and remand the case to the tax court for the limited purpose of determining the amount of any necessary adjustments. but the court of appeals accepted the taxpayer�s argument that the �question of whether �an entity should be regarded as a partnership for federal tax purposes is inherently factual,�� and remanded 740 florida tax review [vol.5:si to allow the taxpayer to address the question to the trial court, even though it doubted that the tax court�s �findings are inadequate because of �significant differences�� alleged by the taxpayer �between the actions of [the taxpayer] in this case and those of [the taxpayer] in asa.� indeed, the court of appeals opinion said: �as far as we can tell, the only difference between this case and asa is that brunswick and abn did not meet in bermuda.� in remanding, judge tatel foreshadowed what he expected to be the result on remand: in any case, asa makes clear that �the absence of a nontax business purpose is fatal� to the argument that the commissioner should respect an entity for federal tax purposes. . . . here, the tax court specifically found �overwhelming evidence in the record that saba and otrabanda were organized solely to generate tax benefits for brunswick.� . . . arguably, this broader finding subsumes any factual differences that might exist between this case and asa. . . . although the present record might strongly suggest that saba and otrabanda were sham partnerships organized for the sole purpose of generating paper tax losses for brunswick, fairness dictates that we ought not affirm on this ground. in particular, in presenting its case in the tax court, brunswick may have acted on the mistaken belief that the supreme court�s decision in moline properties, inc. v. commissioner, 319 u.s. 436, 87 l. ed. 1499, 63 s. ct. 1132 (1943), established a two-part test under which saba and otrabanda must be respected simply because they engaged in some business activity, an interpretation that asa squarely rejected. . . . � query the effect of this opinion on the boca investerings case, noted below? d. merrill lynch pays for the contingent installment sale tax shelter. did they pay too soon? news release ir-2001-74 (8/28/01). irs announced that merrill lynch agreed to settle a penalty case the irs had brought against it under §§ 6700 [promoting abusive tax shelters, etc.], 6701 [aiding and abetting understatement of tax liability], 6707 [failure to furnish information regarding tax shelters by persons subject to the requirement to register a tax shelter under § 6111] and 6708 failure to maintain lists of investors in potentially abusive tax shelters] for the 1989-1990 promotion of the contingent installment sale shelter in acm partnership v. commissioner, 157 f.3d 231 (8th cir. 1998), cert. denied, 526 u.s. 1017 (1999), and other cases. 2002] recent developments in federal income taxation 741 742 florida tax review [vol.5:si e. same arrangement as earlier failed shelters, different trial court judge � it�s a business deal, not a shelter. boca investerings partnership v. united states, 167 f.supp.2d 298, 2001-2 u.s.t.c. ¶ 50,640, 88 a.f.t.r.2d 6252 (d. d.c. 10/5/01). american home products entered into a merrill lynch marketed tax shelter virtually identical to those in acm partnership v. commissioner, 157 f.3d 231 (3d cir. 10/13/98), aff�g t.c. memo. 1997-115 (3/5/97), cert. denied, 526 u.s. 1017 (1999), asa investerings partnership v. commissioner, 201 f.3d 505 (d.c. cir. 2/1/00), aff�g t.c. memo. 1998-305 (8/20/98), and saba partnership v. commissioner, t.c. memo. 1999-359 (10/27/99), aff�d, 273 f.3d 1135 (d.c. cir. 12/21/01),. the losses from the transaction sheltered the gain on the sale of a corporate subsidiary. judge friedman held that a valid partnership existed and that the losses were allowable because he found that the taxpayer had both a business purpose and an objective profit potential in entering into the transaction. he applied the test used by the district of columbia circuit in horn v. commissioner, 968 f.2d 1229 (d.c. cir. 1992), [a commodities straddle case], which stated the test as: �to treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of profit exists.� judge friedman found, as matters of fact, that �while potential tax benefits were considered by ahp, it was understood that ahp was not committing to engage in all of the transactions necessary under the merrill lynch presentation in order to give rise to a tax loss.� judge friedman excluded much of the evidence offered by the irs, including [under the attorney client privilege] the tax analysis portions of ahp�s in-house lawyer�s planning memorandum, but not the business planning portions of the memorandum, other internal memos, including one that summarized the installment sale shelter and described the timetable for the bank's exit from the partnership; and the testimony of a former merrill lynch banker who participated in the deal. judge friedman did not credit the testimony of the former merrill lynch banker because he was both impeachable and impeached. 2. modifications of circular 230 are proposed, including the standards for providing advice regarding tax shelters; firms will be required to have procedures to ensure compliance. reg-111835-99, proposed circular 230 regulations, 66 f.r. 3276 (1/12/01). changes proposed to circular 230 include: � § 10.21 would require practitioners to advise a client who had not complied with revenue laws of the manner in which the error or omission may be corrected and the possible consequences of not taking such corrective action. 2002] recent developments in federal income taxation 743 744 florida tax review [vol.5:si � § 10.24 would limit the dissociation from a disbarred or suspended person only to matters constituting practice before the irs. � new § 10.35 would prescribe new standards for tax shelter opinions at the more-likely-than-not (or higher) level of confidence. these would include a requirement to make inquiry as to all relevant facts, and be satisfied that the material facts are accurately and completely described in the opinion. the regulations under §§ 6662 and 6664 will be modified to provide that only opinions that satisfy the standards of circular 230 may be relied upon. � § 10.33 would apply to all tax shelter opinions not governed by new § 10.35, and would also provide a series of requirements for compliance. � § 10.36 would require that a practitioner who is a member of, associated with, or employed by a firm must take reasonable steps, consistent with his or her authority and responsibility for the firm�s practice advising clients regarding matters arising under the federal tax laws, to make certain that the firm has adequate procedures in effect for purposes of ensuring compliance with §§ 10.33, 10.34, and 10.35. 3. corporate tax shelter disclosure and registration requirements. a. registration. t.d. 8876, corporate tax shelter registration, 65 f.r. 11215 and reg-110311-98, 65 f.r. 11215 (3/2/00), modified by t.d. 8896, modification of tax shelter rules, 65 f.r. 49909 (8/16/00) [effective 8/11/00], modified by t.d. 8961, modification of tax shelter rules ii, 66 f.r. 41133 (8/7/01) [effective 8/2/01; but taxpayers may rely on modifications after 2/28/00]. temporary and proposed regulations under § 6111(d) require registration of �confidential corporate tax shelters.� � temp. reg. § 301.6111-2t defines these as �any transaction� [including �all the factual elements necessary to support the tax benefits that are expected to be claimed with respect to any entity, plan, or arrangement�]: (i) a significant purpose of which is the avoidance or evasion of federal income tax; (ii) that is offered to any potential participant under conditions of confidentiality; and (iii) for which the tax shelter promoters may receive aggregate fees in excess of $100,000. registration is to be on form 8264, �application for registration of a tax shelter.� � avoidance or evasion transactions include: (1)�listed transactions� [see, e.g., notice 2000-15, 2000-12 i.r.b. 826]; and (2) transactions structured to produce federal income tax benefits that constitute an important part of the intended results of the transaction and that the promoter expects it to be presented in substantially similar form to more than one 2002] recent developments in federal income taxation 745 potential participant (unless the participant is expected to participate in the ordinary course of its business in a form consistent with customary commercial practice and there is a �generally accepted understanding� that the federal income tax benefits are allowable); as modified in august 2001, this exception is not foreclosed by �an irs position that would be merely arguable or that would constitute merely a colorable claim.� as originally promulgated, the exception to structured transactions required that the understanding that the expected federal income tax benefits are allowable for substantially similar transactions be �long-standing,� but this requirement was eliminated by the august 2001 modifications and replaced by a requirement that to be generally accepted, the structure of the transaction and the treatment has to have been in the public domain for a �period of years.� also, as originally promulgated, the regulations included transactions lacking economic substance � transactions in which the expected pre-tax profit (after foreign taxes and transaction costs) is insignificant relative to the present value of the expected net federal income tax savings � but this requirement was removed by the august 2001 modifications because the treasury believed that transactions in this category would be included in the structured transactions category. � registration will not be required for �excepted transactions,� which are: (1) those [excluding listed transactions] for which the promoter reasonably determines that there is no basis under the standard imposed on taxpayers under reg. § 1.6662-3(b)(3) for denial of any significant portion of the expected federal income tax benefits� [thus this exception is not foreclosed by �an irs position that would be merely arguable of that would constitute merely a colorable claim�]; or (2) those transactions that the irs has determined are not subject to registration requirements. a ruling request procedure is provided.� prior to the august 2001 modifications the standard under exception (1) was �no reasonable basis� under applicable federal tax law. � �conditions of confidentiality� is a facts and circumstances determination, with an exception for written agreements expressly authorizing disclosure. under the august 2000 modifications, restrictions on disclosure of the structure or tax aspects of the transaction reasonably necessary to comply with securities laws are not considered to be a confidentiality agreement. the august 2001 modifications expanded the requirements for authorization of disclosure required to avoid the presumption of confidentiality by adding that any and all materials of any kind, including opinions and analyses provided to the offerees must be subject to disclosure to avoid the presumption. � under the august 2000 modifications, an exclusivity agreement (i.e., an agreement requiring the offeree to pay a fee to a promoter if the offeree engages in the transaction, whether or not the offeree 746 florida tax review [vol.5:si uses the promoter�s services) is a condition of confidentiality. but an exclusivity arrangement ordinarily will not result in an offer being treated as made under conditions of confidentiality if it provides express written authorization for disclosure. limitations on disclosure or use constitute a condition of confidentiality only if the limitations relate to the structure or tax aspects of the transaction and the limitations are for the benefit of any person other than the offeree. � registration is to be made not later than the day on which the first offering for sale is made, with extensions generally until 8/26/00. b. red flagging returns. t.d. 8877, tax shelter disclosure statements, 65 f.r. 11205 (3/2/00), modified by t.d. 8896, modification of tax shelter rules, 65 f.r. 49909 (8/16/00) [effective 8/11/00], modified by t.d. 8961, modification of tax shelter rules ii, 66 f.r. 41133 (8/7/01) [modifications effective 8/2/01; but taxpayers may rely on modifications after 2/28/00]; reg-103735-00, 65 f.r. 11269 (3/2/00). temporary and proposed regulations under § 6011 require corporations to attach statements to their federal corporate income tax returns that disclose tax shelters. � temp. reg. § 1.6011-4t was issued under §§ 6001 [required records provision] and 6011(a) [general requirement of return or statement]. it requires that, for �reportable transactions,� corporations must both attach a disclosure statement to their tax returns [separately mailing a copy to the irs large & mid-size business division] and retain all related documents until the expiration of the statute of limitations. related documents include all marketing materials, all written analyses, all correspondence, etc. under the august 2000 modifications, the required records include all documents and other records related to a transaction subject to disclosure under the regulations that are material to an understanding of the facts of the transaction, the expected tax treatment of the transaction, or the corporation�s decision to participate in the transaction. � a �reportable transaction� is either: (1) a �listed transaction� [see, e.g., notice 2000-15, 2000-12 i.r.b. 826]; or (2) another reportable transaction if it possesses at least two of six of the following characteristics: (a) confidentiality; (b) protection against the possibility that intended tax benefits will not be sustained (including rescission rights, refunds of fees, insurance protection, and indemnities other than customary nonpromoter indemnities); (c) promoter fees in excess of $100,000; (d) expected tax treatment expected to differ by more than $5 million from book treatment; and (e) the participation of a tax indifferent person. as originally promulgated the regulations also included as a factor that the expected characterization for 2002] recent developments in federal income taxation 747 u.s. income tax purposes differs from that for foreign taxes; this factor was eliminated by the august 2001 modifications. � four exceptions are provided: (1) transactions in the ordinary course of business in a form consistent with customary commercial practice if the taxpayer �reasonably determines� that it would have participated irrespective of the expected federal income tax benefits; (2) transactions [in ordinary course and customary commercial practice] if the taxpayer �reasonably determines� that there is a generallyaccepted understanding that the expected federal income tax benefits are allowable for substantially similar transactions; (3) transactions for which the taxpayer �reasonably determines� that there is �no reasonable basis under federal tax law for denial of any significant portion of the expected federal income tax benefits�; as modified in august 2001, this exception is not foreclosed by �an irs position that would be merely arguable or that would constitute merely a colorable claim;� (4) transactions identified in published guidance as being exempt from disclosure. as originally promulgated, the regulations required that the understanding that the expected federal income tax benefits are allowable for substantially similar transactions in exception (3) be �long-standing,� but this requirement was eliminated by the august 2001 modifications and replaced by a requirement that to be generally accepted the structure of the transaction and the treatment has to have been in the public domain for a �period of years.� c. identified �tax avoidance transactions.� (1) intermediary transactions tax shelters. sellers of stock and buyers of assets will now have to care about what is in the black box between them. notice 2001-16, 2001-9 i.r.b. 730 (1/19/01). the irs will challenge the purported tax results of intermediary transactions tax shelters. the transactions generally involve a shareholder who desires to sell stock of a target corporation, an intermediary corporation, and a buyer who desires to purchase the assets, but not the stock, of the target. the shareholder purports to sell the stock of the target to the intermediary. the target then purports to sell some or all of its assets to the buyer. the buyer claims a basis in the target assets equal to its purchase price. � under one version of this transaction, the target is included as a member of the affiliated group that includes the intermediary, which files a consolidated return, and the group reports losses (or credits) to offset the gain (or tax) resulting from the target�s sale of assets. in another form of the transaction, the intermediary may be an entity that is not subject to tax and that liquidates the target with no reported gain on the sale of the target�s assets. � transactions that are the same as or similar to 748 florida tax review [vol.5:si the one described in the notice are �listed transactions.� temp. reg. §§ 1.60114t(b)(2) and 301.6111-2t(b)(2). (2) contingent liability tax shelters. notice 2001-17, 2001-9 i.r.b. 730 (1/19/01). the irs will disallow losses generated by contingent liability tax shelters. the shelter transactions involve the transfer of a high basis asset to a corporation in exchange for stock of the transferee corporation, and the transferee corporation�s assumption of a liability that the transferor has not yet taken into account for federal income tax purposes. the transferor typically remains liable on the underlying obligation. the basis and fair market value of the transferred asset, which may be a security of another member of the same affiliated group of corporations, are generally only marginally greater than the present value of the assumed liability. therefore, the value of the stock of the transferee received by the transferor is minimal relative to the basis and fair market value of the asset transferred to the transferee corporation. (3) ita [irs technical assistance � chief counsel advice] 200117039 (3/13/01). a partnership�s transfer of a stripped lease to a corporation [following a typical lease stripping transaction as described in notice 95-53, 1995-2 c.b. 334] is a taxable exchange and does not qualify under § 351. more specifically, the partnership transferred the note it held from the lease stripping to a controlled corporation in exchange for stock and the corporation�s assumption of the partnership�s obligation to make lease payments. the service concluded that the exchange was substantially similar to the exchange in the contingent liability tax shelter discussed in notice 200117, 2001-9 i.r.b. 730. there was no real purpose for the transactions apart from the creation of an asset, the stock, with a basis in excess of value to generate a tax loss and, therefore, the exchange is taxable. the service further concluded that even if § 351 did apply, the partnership�s basis in the stock would be reduced by the amount of the obligation to make rental payments assumed by the corporation under § 358(d)(1) or the assumption would be a distribution of money under § 357(b) that reduces the partnership�s basis in the stock under § 358(a). (4) �customary� leasing transactions need not be registered as tax shelters. notice 2001-18, 2001-9 i.r.b. 731 (1/19/01). this notice provides an exception from the registration requirements of § 6111(d) and the list maintenance requirement of § 6112 for certain customary leasing transactions. the exception applies to a leasing transaction that: (1) is a lease or sale leaseback between an owner-lessor of tangible personal property and a lessee who is the user of the property; (2) contains terms that are consistent with customary commercial practice for the leasing of similar items of property; (3) qualifies as a lease for federal income tax purposes under rev. proc. 75-21, 2002] recent developments in federal income taxation 749 25. rev. proc. 75-21 was modified and superseded by rev. proc. 2001-28, 2001-19 i.r.b. 1156 (5/7/01). 1975-1 c.b. 71525 or under case law; (4) is not the same as or substantially similar to a listed transaction under reg. § 301.6111-2t(b)(2), including a lease strip or lease in/lease out transaction; and (5) has a lessor and lessee who agree to consistently report the transaction as a lease. (5) basis shifting tax shelter is listed. notice 2001-45, 2001-33 i.r.b. 129 (7/27/01). this notice announces that the irs will disallow benefits from certain �basis shifting� tax shelter transactions that involve a series of pre-arranged steps with the purpose of creating an artificially high tax basis in stock. the transaction involves the use of the attribution rules of § 318 to increase the basis of stock owned by a taxpayer that claims a loss (or reduced gain) upon disposition of that stock. in these transactions, there is a redemption of stock owned by a related person that is tax indifferent. purportedly as a result of the application of the attribution rules of § 318 [e.g., the other person is foreign corporation of which the taxpayer owns an option to acquire 50% or more] the redemption of stock is claimed to be a dividend under § 301 rather than an exchange under § 302(a). the taxpayer takes the position that under reg. § 1.302-2(c) the basis of the redeemed stock is added to its basis for stock in the redeeming corporation. (6) some of these are still being peddled to your clients. notice 2001-51, 2001-34 i.r.b. 190 (8/20/01), superseding notice 2000-15, 2000-1 c.b. 826. the irs has identified sixteen listed transactions for purposes of reg. § 1.6011-4t(b)(2) and § 301.6111-2t(b)(2). the listed transactions include: (1) rev. rul. 90-105, 1990-2 c.b. 69, transactions (deductions for contributions to certain pension plans attributable to future year�s compensation); (2) notice 95-34, 1995-1 c.b. 309, certain trust arrangements (purported multiple employer welfare benefit funds); (3) notice 95-53, 1995-2 c.b. 334, �lease strips�; (4) notice 98-5, 1998-1 c.b. 334, transactions in which the expected economic profit is insubstantial in comparison to the value of the expected ftcs; (5) asa investerings-type and acm-type transactions; (6) treas. reg. § 1.643(a)-8 transactions involving distributions from charitable remainder trusts; (7) rev. rul. 99-14, 1999-1 c.b. 835, lease-in/lease-out [lilo] transactions; (8) notice 99-59, 1999-2 c.b. 761, transactions involving the distribution of encumbered property in which taxpayers claim tax losses for capital outlays that they have in fact recovered; (9) treas. reg. § 1.7701(1)-3 fast-pay arrangements; (10) rev. rul. 2000-12, 2000-11 i.r.b. 744, certain transactions involving the acquisition of two debt instruments the values of which are expected to change significantly at about the same time in opposite directions; (11) notice 2000-44, 2000-36 i.r.b. 255, 750 florida tax review [vol.5:si transactions generating losses resulting from artificially inflating the basis of partnership interests; (12) notice 2000-60, 2000-49 i.r.b. 568, transactions involving the purchase of a parent corporation's stock by a subsidiary, a subsequent transfer of the purchased parent stock from the subsidiary to the parent's employees, and the eventual liquidation or sale of the subsidiary; (13) notice 2000-61, 2000-49 i.r.b. 569, transactions purporting to apply § 935 to guamanian trusts; (14) notice 2001-16, 2001-9 i.r.b. 730, intermediary sales transactions; (15) notice 2001-17, 2001-9 i.r.b. 730, contingent liability § 351 transfer transactions; and (16) notice 2001-45, 2001-33 i.r.b. 129, certain redemptions of stock in transactions not subject to u.s. tax in which the basis of the redeemed stock purports to shift to a u.s. taxpayer. d. irs announces a tax shelter disclosure initiative through 4/23/02 for penalty waivers. announcement 2002-2, 2002-2 i.r.b. 304 (12/22/01). the initiative would result in waiver of any of the § 6662 accuracyrelated penalties if disclosure is made before the earlier of 4/23/02 or the date an issue about the disclosed item is raised during an examination. the disclosure statement must contain, inter alia: (1) the material facts of the item; (2) the taxpayer�s tax treatment of the item; (3) the taxable years affected by the item; (4) the names and addresses of the promoters, solicitors, and recommenders of the item and (if known) the parties who advised the promoter, solicitor or recommender; and (5) an agreement to provide [if requested] all transactional documents, internal memoranda, and materials that provide a legal analysis of the item. � exceptions for transactions that: (1) did not in fact occur; (2) involved fraudulent concealment of the amount or source of any item of gross income; (3) involved concealment of an interest over a foreign financial account; (4) involved the concealment of a distribution from, a transfer of assets to, or that taxpayer was a grantor of a foreign trust; or (5) involved the treatment of personal, household, or living expenses as deductible trade or business expenses. (1) larry langdon memorandum, dated 12/20/01, for lmsb personnel providing guidelines for applying the about-to-be-issued ann. 2002-2, 2001 tnt 247-8 (12/21/01). 4. a $67,000,000 deficiency. mercy! united parcel service v. commissioner, t.c. memo. 1999-268 (8/9/99), rev�d, 254 f.3d 1014, 87 a.f.t.r.2d 2565, 2001-2 u.s.t.c. ¶ 50,475 (11th cir. 6/20/01). ups generally limits its liability for damages to goods in transit to $100, but customers may pay [and ups collects] �excess value charges� (evcs) to insure the packages for greater amounts [even though ups is not licensed as an insurance company]. prior to 1984, ups retained all of the evcs, paid claims, and 2002] recent developments in federal income taxation 751 reported the income and deduction items on its return. beginning in 1984 ups restructured the manner in which it dealt with and reported evcs. although it did not change its practices for dealing with customers in handling receipts and claims, beginning in 1984 ups remitted net [of claims paid] evcs collected from customers and other shippers to an unrelated insurance company (national union), which in turn, after deducting certain fees, remitted the net evcs as a reinsurance premium to opl. opl was a bermuda insurance company that was formed by ups and 97.33% owned by ups�s 14,000 shareholders who received opl stock as a dividend in a taxable spin-off. the opl stock was subject to restrictions on transfer. after this arrangement was established, ups did not report as income the $99,794,790 of evcs collected and remitted to national union in 1984, etc. however, ups performed the same evc functions and activities that it had performed before 1984 [when it had included the evcs in income], and it remained responsible for bad debts or uncollectible items because neither national union nor opl had any control over the customers� premium payments. a. the tax court says it�s a sham. bad news because there were more years in the pipeline for the same transaction with bigger amounts. the tax court (judge ruwe) upheld the irs determination that ups was taxable on the $99,794,790 of evcs under the assignment of income doctrine regardless of the separate existence of opl, which was accepted arguendo. rather, the court found that the entire 1984 arrangement lacked business purpose and economic substance. the court rejected ups�s proffered business purpose � that its continued receipt of evcs was potentially illegal under various state insurance laws � because no state insurance regulator ever questioned the prior practice. ups never sought legal advice on the issue, federal common carrier law probably preempted state law in any event, and if federal law did not preempt state law the 1984 practice was probably as violative of state law as the pre-1984 practice. judge ruwe also was not convinced that the arrangement was designed to facilitate ups rate increases. nor was he impressed by ups claim that a business purpose was to leverage the excess value profits into a new reinsurance company; he noted that �any investment of money into [the subsidiary reinsurer] could accomplish this purpose.� after examining ups�s pre-1984 reinsurance practices [only of claims over $25,000] and the fairly consistent 70 percent ratio of net evcs [over claims paid] retained to total evcs collected judge ruwe did not accept the ups claim that the national union/opl arrangement sufficiently reduced the risk to ups core transportation activity assets to have economic substance. finally, judge ruwe found that there was contemporaneous documentation that the transaction was tax motivated and concluded that the arrangement was �done for the purpose of avoiding taxes� and �had no economic substance or 752 florida tax review [vol.5:si business purpose.� to top it off, because the evc restructuring was a sham transaction, the court denied ups�s deduction for approximately $1 million retained by national union. and for the inevitable icing on the irs�s cake negligence and substantial understatement penalties, plus increased interest for tax-motivated transactions, were sustained. b. mercy indeed, eleventh circuit reverses. was gregory a pyrrhic victory for the government? ups rejoices. but eleventh circuit remands for consideration of the § 482 issue. more news to follow? the eleventh circuit (judge cox) held that the arrangement �had sufficient economic substance to merit respect in taxation.� it created an obligation enforceable by an unrelated party, national union. ups and national union had real insurance policies that gave national union the right to receive the evcs that ups collected. the court noted that, contrary to the tax court�s opinion, opl was an independently taxable entity not under ups�s control and ups lost the stream of income it had earlier gained from the excess-value charges. the court therefore concluded that the transaction was not a sham transfer in which the taxpayer retained the benefits of the income forgone. � the eleventh circuit concluded the insurance policy between ups and national union was a �real insurance policy. . . that gave national union the right to receive the excess-value charges that ups collected.� that national union faced �slim� odds of losing money did not affect that conclusion, and �[a] history of not losing money on a policy is no guarantee of such a future.� � even if national union was merely a conduit for transmission of the excess-value payments from ups to opl, the court considered opl to be independently taxable entity that was not under ups�s control. ups really did lose the income it previously reaped from excess-value charges. the court found this fact to distinguish the case �from the paradigmatic sham transfers of income, in which the taxpayer retains the benefits of the income it has ostensibly forgone.� � finally, the eleventh circuit found that the tax court had misapplied the business purpose test. the appearance of the evc transactions to customers was not relevant. . . . the tax court�s narrow notion of �business purpose�� which is admittedly implied by the phrase�s plain language � stretches the economic-substance doctrine farther than it has been stretched. a �business purpose� does not mean a reason for a transaction that is free of tax considerations. rather, a transaction has a �business purpose,� when we are talking 2002] recent developments in federal income taxation 753 about a going concern like ups, as long as it figures in a bona fide, profit-seeking business. see acm p�ship v. commissioner, 157 f.3d 231, 251 (3d cir. 1998). this concept of �business purpose� is a necessary corollary to the venerable axiom that tax-planning is permissible. see gregory v. helvering, 293 u.s. 465, 469, 55 s. ct. 266, 267 (1935) (�the legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.�). the code treats lots of categories of economically similar behavior differently. . . . there may be no tax-independent reason for a taxpayer to choose between these different ways of financing the business, but it does not mean that the taxpayer lacks a �business purpose.� to conclude otherwise would prohibit taxplanning. . . . the transaction under challenge here simply altered the form of an existing, bona fide business, and this case therefore falls in with those that find an adequate business purpose to neutralize any tax-avoidance motive. � judge ryskamp dissented, stating that the overwhelming evidence demonstrates that ups�s reinsurance arrangements with national union and opl had no economic significance or business purpose outside of ups�s desire to avoid federal income and was therefore a sham transaction. 5. corporate owned life insurance (�coli�) a. deductions for interest on policy loans under winndixie�s pre-1996 hipaa leveraged coli program were denied. winndixie stores, inc. v. commissioner, 254 f.3d 1313, 87 a.f.t.r.2d 2626, 20012 u.s.t.c. ¶ 50,495 (11th cir. 6/28/01) (per curiam), aff�g 113 t.c. 254 (10/19/99). in 1993, taxpayer entered into a broad-based leveraged corporateowned life insurance group plan covering approximately 36,000 of its employees. the decision to shift from its existing �key-person� coli program of individual policies [covering 615 managers] was made pursuant to a proposal that emphasized the �tax arbitrage created when deductible policy loan interest is paid to finance non-taxable policy gains.� the proposal indicated that 754 florida tax review [vol.5:si 26. bye-bye to leveraged company-wide coli. the health insurance portability and accountability act of 1996 § 501 amended § 264 to deny the deduction for interest on loans with respect to company-owned life insurance. there is an exception for key person insurance. phased-in future effective dates and interest rates are provided. the tax and trade relief extension act of 1998 § 4003(i) further amended § 264 to expand the definition of �unborrowed [insurance] policy cash value� to include �inside buildup,� for purposes of the coli pro rata interest disallowance rules. taxpayer would have a pre-tax loss totaling $755 million for26 its 1993-2052 years, but would have total after-tax earnings of more than $2.2 billion for the same period (as the result of total projected income tax savings of more than $3 billion). the coli policies were terminated in 1997, following 1996 legislation that impacted the plan. (1) tax court denies �pre-amendment� benefits �retroactively.� the transaction lacked economic substance and business purpose, and thus was a sham for tax purposes. judge ruwe held that the coli program lacked substance and business purpose, and thus was a sham. he rejected taxpayer�s argument that the policies could conceivably produce pretax benefits if some catastrophe were to occur that would produce large, unexpected death benefits. �we are convinced that this was so improbable as to be unrealistic and therefore had no economic significance.� the court further found that the possible use of projected after-tax earnings to fund employee benefit plans would not cause the coli plan to have economic substance, noting that, if so, �every sham tax-shelter device might succeed.� in light of the $3,000 per year premium paid to insure each employee or former employee, it was irrelevant that there was a relatively small death benefit of $5,000 paid with respect to each dead employee or former employee. judge ruwe rejected taxpayer�s position that the § 264 safe-harbor test protected its interest deductions. he noted that the right to an interest deduction is governed by § 163 [and not § 264], citing knetsch v. united states, 364 u.s. 361 (1960). he further quoted, �but we do not agree with [taxpayer�s] assertion that the legislative history should be turned into an open-ended license applicable without regard to the substance of the transaction. . . . knetsch . . . involved transactions without substance. congress, in enacting section 264(a)(3), struck at transactions with substance. it is a reductio ad absurdum to reason, as [taxpayer] does, that congress simultaneously struck down a warm body and breathed life into [taxpayer�s] cadaver.� (2) affirmed by the eleventh circuit, which holds that � even though the ups insurance scheme has business reality � the coli tax shelter is a sham. the eleventh circuit rejected taxpayer�s primary argument that congress specifically authorized the interest deduction if the 42002] recent developments in federal income taxation 755 out-of-7 rule of § 264. it concluded that in knetsch the supreme court clearly �rejected an argument based on section 264 that is at least a cousin of winndixies�s present contention . . . that congress�s failure to close a loophole in section 264 equated to blessing the loophole.� the eleventh circuit concluded that knetsch stood for the proposition that �that the sham-transaction doctrine does apply to indebtedness that generates interest sought to be deducted under section 163(a), even if the interest deduction is not yet prohibited by section 264.� � the eleventh circuit held that the tax court properly applied the sham transaction doctrine: that doctrine provides that a transaction is not entitled to tax respect if it lacks economic effects or substance other than the generation of tax benefits, or if the transaction serves no business purpose. . . . the doctrine has few bright lines, but �[i]t is clear that transactions whose sole function is to produce tax deductions are substantive shams.� [kirchman v. commissioner, 862 f.2d 1486, 1492 (11th cir. 1989)] that was, as we read the tax court�s opinion, the rule the tax court followed. nor did the court misapply the rule in concluding that the broad-based coli program had no �function� other than generating interest deductions. the tax court found, without challenge here, that the program could never generate a pretax profit. that was what winndixie thought as it set up the program, and it is the most plausible explanation for winn-dixie�s withdrawal after the 1996 changes to the tax law threatened the tax benefits winndixie was receiving. no finding of the tax court suggests, furthermore, that the broad-based coli program answered any business need of winn-dixie, such as indemnifying it for loss of key employees. . . . [t]herefore, the broadbased coli program lacked sufficient economic substance to be respected for tax purposes, and the tax court did not err in so concluding. b. another coli falls ill. irs v. cm holdings, inc. (in re cm holdings, inc.), 254 b.r. 578, 2000-2 u.s.t.c. ¶ 50,791, 86 a.f.t.r.2d 6470 (d. del. 10/16/00), on appeal to the 3d circuit. in cmi�s bankruptcy, the irs filed proofs of claim for taxes based on the disallowance of interest deductions that cmi claimed for its coli plan (involving policies on 1400 employees). the court held no interest deduction was allowable under § 163(a) because the entire transaction was a �sham in substance� that lacked subjective business 756 florida tax review [vol.5:si purpose. apart from tax savings from the interest deduction, cmi could not reasonably expect a positive cash flow from the coli plan in any year and could not expect to benefit from the inside cash value build-up [which continuously remained at zero throughout the plan] or profit from the death benefits on covered employees. interest deductions were disallowed and § 6662 substantial understatement penalties were imposed because the transaction lacked economic substance. the transaction was entered into without a reasonable expectation of profit � in the absence of the interest deductions � over the life of the 40-year transaction from either the inside build-up or mortality components of the plan. � the court specifically rejected the irs�s argument that it should apply the �generic tax shelter test� of rose v. commissioner, 88 t.c. 386 (1987), aff�d, 868 f.2d 851 (6th cir. 1989), to disallow the deductions, and questioned whether the tax court would continue to apply that test. rather, the court exhaustively analyzed the facts. � the § 264(c)(1) �four-out-of-seven� safe harbor test was not met because the premiums in years 4 through 7 were paid through so-called �loading dividends.� pursuant to its coli plan cmi purchased individual, whole life insurance policies, of which it was the owner and beneficiary, on 1,400 employees. in the first three policy years, 1991-1993, cmi paid premiums largely through nonrecourse policy loans. in the fourth through seventh policy years, cmi �paid� the annual premiums largely through a combination of partial withdrawals and loading dividends [premium rebates to cmi]. the court (judge schwartz) found that the loans for the first three years were real, but that the loading dividends were factual shams that were created by circular accounting treatment, and that there thus was a substantial shortfall in the payment of annual premiums due in years four through seven. thus, § 264(a) applied to disallow the deductions because the premiums were financed by systematic borrowing on the policies. the § 264 (c)(1) exception �if no part of 4 of the annual premiums due during the 7-year period (beginning with the date the first premium . . . was paid) is paid under such plan by means of indebtedness� did not apply. the court accepted the irs�s argument that ��annual premiums due� means the nominal annual premiums due less the �loading dividends� that were offset against the contract premiums,� rather than cmi�s argument that annual premiums due meant the �contract-specified premiums.� these were circular netting transactions for the sole purpose of reducing the annual cash premiums paid in those years, and were factual shams. 6. are they intestinal tract bacteria? does this �third strike� mean that coli is eradicated? or, are taxpayers� arguments too appealing? american electric power, inc. v. united states, 136 f.supp.2d 762, 2001-1 2002] recent developments in federal income taxation 757 27. see viii.a.7.c. u.s.t.c. ¶ 50,232, 87 a.f.t.r.2d 917 (s.d. ohio 2/20/01). this opinion largely follows the reasoning in cm holdings, noted above. 7. fifth and eighth circuits agree that twenty first securities marketed american depository receipts (adr) arbitrage transactions do not lack economic substance. a. new rule in the tax court: no more mr. nice guy! (ms. nice gal?). royal dutch shell adrs peddled by an investment banking firm lacked economic substance. compaq computer corp. v. commissioner, 113 t.c. 214 (9/21/99), rev�d, 277 f.3d 778, 88 a.f.t.r.2d 7339, 2002-1 u.s.t.c. ¶ 50,144 (5th cir. 12/28/01).27 compaq recognized a $232 million long-term capital gain in 1992. shortly afterwards, an investment firm [twentyfirst securities corp.] contacted the compaq treasury department with the suggestion that it take advantage of an adr arbitrage transaction. (american depository receipts are transferable units in a trust that represent ownership of foreign stock.) this involved purchases of $888 million of royal dutch shell adrs cum dividend, followed by sales of those adrs ex dividend within the hour for $868 million. compaq then carried back $20 million of loss against the previously recognized gain. it also claimed a $3.4 million foreign tax credit for taxes withheld from the $22.5 million dividend received. judge cohen held that the transaction lacked economic substance because the net cash flow from the transaction without regard to tax consequences was a $1.5 million loss. the foreign tax credit was denied and a negligence penalty was imposed. � judge cohen considered it important that compaq did not perform a cash flow analysis, nor did it investigate the investment. she noted that compaq shredded the spreadsheet provided by the promoter and �has chosen not to disclose any communications� indicating any reliance on the advice of its tax department or counsel. these factors were also important to the court in upholding a negligence penalty. � judge cohen quoted acm partnership for the proposition that the business purpose requirement of the economic substance doctrine is only satisfied when �the transaction [is] rationally related to a useful nontax purpose that is plausible in light of the taxpayer�s conduct and . . . economic situation.� she continued, �this inquiry takes into account whether the taxpayer conducts itself in a realistic and legitimate business fashion, thoroughly considering and analyzing the ramifications of a questionable transaction, before proceeding with the transaction,� citing the ups case. � �the adr transaction was marketed to 758 florida tax review [vol.5:si petitioner by twenty-first for the purpose of partially shielding a capital gain previously realized . . . . [its] evaluation of the proposed transaction was less than businesslike with [the assistant treasurer] committing [compaq] to this multimillion-dollar transaction based on one meeting with twenty-first and on his call to a twenty-first reference. . . . we conclude that [compaq] was motivated by the expected tax benefits of the adr transaction, and no other business purpose existed.� b. but the eighth circuit looks at different adr deals peddled by the same investment banker and concludes that they did have economic substance. was the difference that taxpayer satisfied the new �two-meeting rule,� or was it that taxpayer sought outside advice on securities law and tax law, or was it that foreign withholding taxes did not reduce the amount of dividend income received (so taxpayer had a pre-tax profit)? risk minimization was seen as �prudence,� as opposed to �sham.� ies industries v. united states, 253 f.3d 350, 2001-1 u.s.t.c. ¶ 50,471, 87 a.f.t.r.2d 2492 (8th cir. 6/14/01), rev�g 84 a.f.t.r.2d 6445, 2001-1 u.s.t.c. ¶ 50,470 (n.d. iowa 9/22/99). taxpayer purchased the adrs from tax-exempt organizations, which paid no u.s. taxes, but were subject to foreign withholding on the dividends. the adr arbitrage transaction created foreign tax credits (as in the compaq case). on a motion for summary judgment by the government, judge mcmanus held that the adr transactions �did not change ies�s economic position except for the transactions having resulted in the transfer of the claim to the foreign tax credit to ies.� the court also did not permit deduction of taxpayer�s out-of-pocket costs. � the eighth circuit reversed, finding a business purpose and distinguishing compaq. first, the court rejected the government�s argument that �the tax benefits that were the sole reason for the transactions, [because] each series of adr trade pairs resulted, as pre-planned, in an economic loss.� it rejected the government�s view that �ies purchased only the right to the net dividend � not the gross dividend�� a view which if accepted would result in ies realizing an economic benefit only if it received the foreign tax credit. rather, the court concluded that the profitability of the transaction should be analyzed by considering the gross income realized by ies, not the cash flow. it concluded that �the economic benefit to ies was the amount of the gross dividend, before the foreign taxes were paid. . . . the fact that the taxes were withheld, and then paid, by the foreign corporation that issued the stock represented by the adrs, so that ies received only 85% of the dividend in cash, is of no consequence to ies�s liability for the tax. . . . because the entire amount of the adr dividends was income to ies, the adr transactions resulted in a profit, an economic benefit to ies.� � second, the eighth circuit concluded that the 2002] recent developments in federal income taxation 759 proper inquiry when applying the business purpose test is �whether the taxpayer was induced to commit capital for reasons only relating to tax considerations or whether a non-tax motive, or legitimate profit motive, was involved.� the court described the business purpose test as �a subjective economic substance test,� and invoked gregory [293 u.s. 465, 469 (1935)] for the proposition that �the legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted,� concluding that a �taxpayer�s subjective intent to avoid taxes thus will not by itself determine whether there was a business purpose to a transaction.� � the court rejected the government�s argument that the transactions were shams because there was no risk of loss, focusing on the legal, as opposed to economic, risk of nonpayment of the dividends, and distinguishing compaq by stating: �the risk may have been minimal, but that was in part because ies did its homework before engaging in the transactions. company officials met twice with twenty-first representatives and studied the materials provided. after that, ies consulted its outside accountants and its securities counsel for reassurances about the legality of the transactions and their tax consequences.� the court noted that ies did its own investigation and rejected some of the adr trades that twenty-first proposed. that ies structured the transactions [e.g., making some trades when the u.s. markets were closed, in order to avoid the risk of fluctuations in market price of the adrs between the purchase and sale and to prevent a third party from attempting to break up the trades] to avoid �any more risk than necessary,� was characterized as �good business judgment consistent with a subjective intent to treat the adr trades as money-making transactions.� the court was �not prepared to say that a transaction should be tagged a sham for tax purposes merely because it does not involve excessive risk.� finally, the court emphasized that all of the parties involved were unrelated to ies and engaged in �legitimate business, and the transactions were at arms� length.� � in a footnote, the court noted that in 1997, congress amended § 901(k) to increase to at least sixteen days the amount of time an adr must be held within a thirty-day period that includes the dividend record date in order for the foreign taxes paid on the dividend to qualify for the foreign tax credit. but it attached no importance to that change either way. c. compaq reversed by the fifth circuit. compaq computer corp. v. commissioner, 277 f.3d 778, 88 a.f.t.r.2d 7339, 2002-1 u.s.t.c. 760 florida tax review [vol.5:si 28. see viii.a.7.a. ¶ 50,144 (5th cir. 12/28/01), rev�g 113 t.c. 214 (9/21/99).28 the fifth circuit followed the eighth circuit�s ies opinion and relied heavily on frank lyon co. v. united states, 435 u.s. 564 (1978), to the effect that where �there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with taxindependent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the government should honor the allocation of rights and duties effectuated by the parties.� judge edith jones held that the tax court erred by disregarding the gross amount of the royal dutch shell dividend, and noted that the principles of old colony trust co. treated compaq as having paid the netherlands withholding tax on the dividend. 8. lease-strip transaction by pseudo-black box intermediary fails in the tax court. nicole rose corp. v. commissioner, 117 t.c. 328 (12/28/01). the taxpayer corporation�s stock was sold to an intermediary [which then merged downstream], following which its assets were sold to the prearranged ultimate purchaser. to offset the gains realized on the asset sale, the taxpayer acquired by a § 351 transaction interests in certain equipment leaseback transactions [secured by trusts that resulted in a circular cash flow] that had no foreseeable value, which it immediately transferred to a dutch bank, the sole consideration for which was assumption of taxpayer�s obligations [of which there were in reality none]. taxpayer claimed a $22 million ordinary business expense deduction as a result of the transfer of the leaseback interests. the deduction was denied because the transactions lacked business purpose and economic substance under �any version� of the tests. judge swift held that the transaction lacked business purpose and economic substance even as measured against the eleventh circuit�s broad articulation of the test in ups that �a transaction has a �business purpose� when we are talking about a going concern, as long as it figures in a bona fide, profit-seeking business.� b. individual tax shelters 1. straddle losses outside of § 1092 disallowed where neither economic substance nor profit motive were present. keeler v. commissioner, 243 f.3d 1212, 2001-1 u.s.t.c. ¶ 50,272, 87 a.f.t.r.2d 1224 (10th cir. 3/13/01), aff�g t.c. memo. 1999-18. the tenth circuit upheld the disallowance of losses incurred by the taxpayer in a stock derivatives straddle program for years before § 1092 was extended to straddles involving stock. the transactions 2002] recent developments in federal income taxation 761 were found not to have any economic substance or profit motive, because, among other reasons, their �raison d�etre was tax avoidance.� [in late 1981 the taxpayer closed out the loss side of transactions realizing losses of $7,598,940 � an amount within $3,600 of his gross income; his 1982 losses offset 97% of his gross income.] the offsetting gains were consistently rolled forward. in addition, the transactions were so closely matched, in an artificial market maintained by the promoter, as to negate the possibility of realizing a pre-tax profit. finally, the taxpayer paid significant up-front fees, and had a significant noninterest-bearing margin deposit. 2. notice 2001-40, 2001-26 i.r.b. 1355 (6/25/01). the irs warns taxpayers not to rely on promoters� assertions that §§ 861 through 865 and reg. § 1.861-8 limit taxable �sources� of income to certain foreign-based activities and that income sourced within the u.s. is thereby non-taxable. ix. exempt organizations and charitable giving a. exempt organizations 1. intermediate sanctions regulations are out; break out the supply of 1099s. reg-246256-96, 66 f.r. 2173 (1/10/01); t.d. 8920, 66 f.r. 2144 (1/10/01). the treasury published proposed and temporary regulations under § 4958, which permits the irs to impose excise taxes against disqualified persons who participate in excess benefit transactions with §§ 501(c)(3) and 501(c)(4) organizations. �excess� benefits include benefits provided to insiders that are not reported as compensation. (these rules reflect the spirit under which § 4958 was enacted, which was to tax �excess� benefits provided by charities to insiders (including board members).) a. regulations made final. t.d. 8978, 67 f.r. 3076 (1/23/02). the regulations relating to the excise taxes on excess benefits transactions under § 4958 have been finalized. 2. not-for-profits have to pick their partners carefully, and pay attention to the governing structure of the partnership. redlands surgical services v. commissioner, 113 t.c. 47 (7/19/99). redlands surgical services (rss) was a nonprofit corporation that was affiliated with a nonprofit hospital. rss�s sole activity was participating as the co-general partner with a for-profit corporation in a limited partnership that was the general partner of an operating partnership that owned and operated an ambulatory surgery center. nothing in the partnership agreements or any of the other agreements related to the operation of the surgery center, established any obligation that charitable 762 florida tax review [vol.5:si purposes be put ahead of economic objectives in the surgery center�s operations, and the profits of both partnerships were distributable to for-profit partners as well as rss. after an exhaustive review of the terms of the partnership agreements, relevant contracts, and the actual management practices, on the facts rss was found to have ceded effective control over the operations of the partnerships and thus the surgery center to for-profit parties. rss had surrendered the ability to cause the surgery center to respond to community needs and nothing required the surgery center management to be guided by any charitable or community benefit, goal, policy, or objective. an impermissible private benefit was conferred. the tax court (judge thornton) reasoned: it is no answer to say that none of petitioner�s income from this activity was applied to private interests, for the activity is indivisible, and no discrete part of the operating partnership�s income-producing activities is severable from those activities that produce income to be applied to the other partners� profit. . . . clearly, there is something in common between the structure of petitioner�s sole activity and the nature of petitioner�s purposes in engaging in it. to the extent that petitioner cedes control over its sole activity to for-profit parties having an independent economic interest in the same activity and having no obligation to put charitable purposes ahead of profit-making objectives, petitioner cannot be assured that the partnerships will in fact be operated in furtherance of charitable purposes. in such a circumstance, we are led to the conclusion that petitioner is not operated exclusively for charitable purposes. the court also declined to find that rss qualified for exemption as an integral part of the affiliated not-for-profit redlands hospital. the surgery centers patient population did not overlap substantially with that of redlands hospital and prior cases in which the integral part doctrine was applied were categorized as not involving any private benefit or control, unlike the instant case. rss therefore was not operated exclusively for exempt purposes within the meaning of § 501(c)(3) and its petition for a declaratory judgment of its tax exempt status was denied. � the reasoning of the whole hospital joint venture ruling was applied. rev. rul. 98-15, 1998-1 c.b. 718 (3/4/98) two fact patterns: situation 1 concludes that the exempt hospital will continue to be exempt where it will receive an interest in the combined operation equal in value to the assets it contributed and the board structure gives control of the 2002] recent developments in federal income taxation 763 joint venture to the exempt organization�s appointees. there is a loss of exemption in situation 2, where the joint venture�s governing documents do not require that it serve charitable purposes, board control rests with the taxable entity, and the taxable entity may unilaterally renew the management agreement. both conclusions depend on �facts and circumstances. a. ninth circuit affirms within 10 days of oral argument. redlands surgical services v. commissioner, 242 f.3d 904, 2001-1 u.s.t.c. ¶ 50,271, 87 a.f.t.r.2d ¶ 1249 (9th cir. 3/15/01) (per curiam), aff�g 113 t.c. 47 (1999). specifically, we adopt the tax court�s holding that appellant redlands surgical services �has ceded effective control over the operations of the partnerships and the surgery center to private parties, conferring impermissible private benefit. [redlands surgical services] is therefore not operated exclusively for exempt purposes within the meaning of sec. 501(c)(3), irc 1986.� . . . we also affirm the tax court�s conclusion that the benefit conferred on private parties by the surgery center�s operations prevents redlands surgical services from attaining tax exempt status under the integral part doctrine. 3. campaign finance reform, the internal revenue code, and the constitution. national federation of republican assemblies v. united states, 148 f.supp.2d 1273, 2001-2 u.s.t.c. ¶ 50,456, 87 a.f.t.r.2d 2413 (s.d. ala. 5/31/01). the plaintiff sought a declaratory judgment that §§ 527(i) [requiring registration with the irs of certain political organization] and (j) [requiring political organizations to disclose contribution, with a penalty for failure to comply] are unconstitutional and a preliminary injunction against their enforcement. the government raised the anti-injunction act, § 7421(a), as a defense. the district court [judge vollmer], held that the anti-injunction act did not bar the suit because: (1) § 527(j) imposes a penalty rather that laying a tax and § 6671(a) did not apply to treat this penalty as a tax, and (2) a contributor [who joined in the suit on the grounds that he would be less inclined to contribute if his contribution were disclosed] lacked any other vehicle for challenging the provisions. section 527(i), however, is a tax statute, because it confers taxable status on political organizations, and the challenge to it was subject to the anti-injunction act, but individual plaintiffs lacked standing to challenge § 527(i). 764 florida tax review [vol.5:si 4. fund for anonymous gifts v. irs, 2001-2 u.s.t.c. ¶ 50,649; 88 a.f.t.r.2d 6040 (d. d.c. 9/25/01). although a donor directed fund was a § 501(c)(3) organization, it did not meet the requirements to be a publiclysupported charity so it was a private foundation. the charity did not meet its burden of proof on the public support issue, particularly because of its plans to rely on donors who are personally known to its trustee. 5. notice 2001-78, 2001-50 i.r.b. 576 (12/10/01). provides interim guidance to charities regarding payments made by reason of the death, injury or wounding of an individual incurred as a result of the september 11, 2001 terrorist attacks. the service will treat such payments made by a charity to individuals and their families as related to the charity�s exempt purpose provided that the payments are made in good faith using objective standards. the notice is effective until the earlier of final legislation or 12/31/02. a. the victims of terrorism tax relief act clarifies that payments made by charities are for an exempt purpose even if made without demonstration of financial need if made in good faith under an objective formula consistently applied. b. charitable giving 1. abusive charitable remainder trusts curtailed. reg-116125-99, prevention of abuse of charitable remainder trusts, 64 f.r. 56718 (10/21/99). the treasury issued proposed regulations under §§ 643 and 664 to combat abuses in the use of charitable remainder trusts that occur when distributions in excess of income are made to non-charitable beneficiaries where the trustee borrows money or enters into a forward sale of the trust assets. the trust would be treated as having sold a pro rata portion of its assets to the extent that the distribution: (1) is not characterized as income under § 664(b), and (2) is made from amounts received by the trust that are neither (a) a return of basis nor (b) attributable to a deductible charitable contribution made in cash. a. regulations now final. t.d. 8926, 66 f.r. 1034 (1/5/01). the treasury finalized the regulations under § 664 relating to the elimination of abusive transactions involving charitable remainder trusts. 2. reg-106513-00, definition of income for trust purposes, 66 f.r. 10396 (2/15/01). proposed regulations would revise the definition of income under § 643(b) to take into account recent changes in the definition under state 2002] recent developments in federal income taxation 765 law of trust accounting income. special rules address problems of pooled income funds and charitable remainder unitrusts. x. tax procedure a. penalties and prosecutions 1. eight commonly used tax scams. ir-2001-19 (2/18/01). the service warns taxpayers not to fall victim to eight commonly used tax scams. they include: (1) no taxes being withheld from your wages; (2) �i don�t pay taxes�; (3) african-americans get a special tax refund; (4) �pay the tax, then get the prize�; (5) �untax yourself for $49.95�; (6) social security tax scheme; (7) �i can get you a big refund . . . for a fee!�; and (8) irs �agent� comes to your house to collect. to drop a dime, call 1-800-829-0433, except for #1 (1-800829-1040) and #8 (1-800-366-4484). a. now there are a �dirty dozen.� ir-2002-12 (1/31/02). the common tax schemes include: (1) no taxes being withheld from wages; (2) the concept that �i don't pay taxes -why should you?�; (3) an african american special tax refund; (4) paying the tax and getting a prize; (5) untaxing yourself for $49.95; (6) a social security scheme; (7) the concept that �i can get you a big refund for a fee�; (8) sharing/borrowing earned income tax credit dependents; (9) the concept of �put your money in a trust and never pay taxes again�; (10) improper home-based business; (11) a disabled access credit for pay phones; and (12) an irs agent coming to your house to collect your taxes. 2. you, too, can get free room and board for ten years if you are �misunderstood� by your employees. united states v. mcleod, 251 f.3d 78, 87 a.f.t.r.2d 2274 (2d cir. 5/21/01). the tax loss caused by defendant tax preparer added up to $7,578,925, so the punishment totaled 121 months. the court explained as follows: at the sentencing hearing, however, mcleod challenged the inclusion of the tax loss resulting from the civil audit and disclaimed responsibility for the false returns covered by the audit. he testified that the willingness of his employees to claim false deductions could have only resulted from a misunderstanding. the government rebutted mcleod�s claim 766 florida tax review [vol.5:si with the testimony of an irs agent who testified that the employees told him that mcleod taught them how to prepare returns: to assign the client a refund that is approximately half of their tax due, to give clients charitable deductions equal to 2002] recent developments in federal income taxation 767 approximately ten percent of their income, and to use names of child care providers from a list mcleod supplied, names unknown to the taxpayers. b. discovery: summonses and foia 1. depositions in the tax court! but the circumstances were unusual. glaxosmithkline holdings (americas) inc. v. commissioner, 117 t.c. 1 (7/5/01). the joint application of the taxpayer and irs to perpetuate taxpayer�s officers testimony by deposition was granted even though a deficiency notice had not been issued. the matter was contentious, the § 482 dispute was likely to go to trial, and the executives were foreign residents of advanced age whose testimony was likely to be lost. finally, there was no evidence that the depositions served a discovery purpose. 2. cavallaro v. united states, 153 f.supp.2d 52, 88 a.f.t.r.2d 6083 (d. mass. 7/27/01). a summons was enforced against ernst & young for estate planning documents because e&y was not hired to facilitate communication between the clients and the law firm of hale and dorr, and the law firm represented some � but not all � of the parties represented by e&y. 3. seawright v. commissioner, 117 t.c. 294 (12/18/01). judge thornton held that § 7602(c), which generally requires the irs to notify the taxpayer before contacting a third person in connection with examinations and collections, does not apply to contacts by irs trial counsel with potential witnesses in the course of litigation. this result is consistent with prop. reg. § 301.7602-2(f)(7). c. litigation costs 1. the high price of excessive zeal in representing a client. johnson v. commissioner, 116 t.c. 111 (2/27/01). in a case involving defense of a sham trust arrangement, judge cohen imposed sanctions and costs under § 6673 in the amount of $8,587.50 of irs counsel expenses [at $150 per hour] and $807.06 of expenses against taxpayer�s counsel [joe alfred izen, jr.], who was described, with citations to prior cases, as �having a long history of involvement with sham trusts� for multiplying the proceedings �unreasonably and vexatiously� by �pursu[ing] claims that have been rejected so frequently that they are �entirely without colorable pretext or basis and are taken for reasons of harassment or delay or for other improper purposes�� and by �chronic failure to comply with discovery orders.� 768 florida tax review [vol.5:si 2. request that appeals conference if you expect to prevail and want to collect attorney�s fees. haas & associates accountancy corp. v. commissioner, 117 t.c. 48 (8/10/01). the taxpayer substantially prevailed on the merits in a deficiency proceeding and sought attorney�s fees. in the deficiency proceeding, the taxpayer failed to request an appeals conference, but did make a �qualified offer� pursuant to §§ 7430(c)(4)(e) [which deems the taxpayer to have substantially prevailed if the deficiency is determined to be less than the offer]. the tax court (judge swift) held that, consistent with reg. § 301.7430-1(b)(1), failure to request an appeals conference was, on the facts, a failure to exhaust administrative remedies barring recovery of attorney�s fees. making a �qualified offer� under § 7430(c)(4)(e) does not in and of itself constitute an exhaustion of administrative remedies. d. statutory notice 1. an optional statutory provision? rochelle v. commissioner, 116 t.c. 356 (5/24/01). section 3463(a) of the irs restructuring and reform act of 1998, an unmodified provision, states that the irs �shall include on each notice of deficiency . . . the date determined by [the irs] as the last day on which the taxpayer may file a petition in the tax court.� the taxpayer received an otherwise valid deficiency notice that omitted the last date for filing a tax court petition and filed his petition 56 days late. in a reviewed opinion (10-6) by judge vasquez, the tax court held that the deficiency notice nevertheless was valid and dismissed the taxpayer�s untimely petition. the court held that § 6213(a) [providing that a petition filed by the date indicated on the deficiency notice as the last date is timely] does not result in unlimited time to file a petition if no due date is specified. the taxpayer was not confused, misled, or prejudiced by the notice or the absence of a specified petition filing date. � judge chabot (joined by gale and marvell) dissented, basically on the grounds that �shall� means �shall� and �each� means �each� and that failure to do what the irs is directed to do must have consequences, specifically, rendering the deficiency notice invalid. judge swift would have found the notice valid but would have allowed a �reasonable extension� of time to file as the consequence of noncompliance with § 3463(a) of the 1998 act and would have found the petition timely. judges foley and colvin would have found that the deficiency notice was valid, but that there was no outside date for filing a petition. e. statute of limitations 1. final regulations under § 7502 relating to the treatment of a timely mailing as a timely filing. t.d. 8932, timely mailing treated as 2002] recent developments in federal income taxation 769 timely filed/electronic postmark, 66 f.r. 2257 (1/11/01). under amended reg. § 301.7502-1, in certain situations, a claim for credit or refund made on a late filed original income tax return will be treated as timely filed on the postmark date for purposes of § 6511(b)(2)(a) [consistent with weisbart v. united states, 222 f.3d 93 (2d cir. 2000)]. the same rule will apply to claims for credit or refund made on late filed original tax returns other than income tax returns, including form 720, quarterly federal excise tax return, and form 706, u.s. estate tax return. late filed original tax returns also will be treated as filed on the postmark date. 2. just where on the return do you find �gross income�? harlan v. commissioner, 116 t.c. 31 (1/17/01). this case involved the calculation of gross income for purposes of determining whether the six-year statute of limitations in § 6501(e)(1)(a) applied. the tax court (judge chabot), in a matter of first impression, held that pursuant to § 702(c) the gross income of a partner in a partnership (the upper tier partnership) that holds an interest in another partnership (the lower tier partnership) includes the upper tier partnership�s distributive share of the gross income of the lower tier partnership and not merely the gross income of the upper tier partnership. 3. robinson v. commissioner, 117 t.c. 308 (12/19/01). under § 6501(a), the period of limitations for assessing tax attributable to a constructive dividend is determined with respect to the shareholder�s return, not with respect to the corporation�s return. f. liens and collections 1. sections 6220/6230 judicial review has a bite as well as a bark. mesa oil, inc. v. united states, 2001-1 u.s.t.c. ¶ 50,130, 86 a.f.t.r.2d 7312 (d. colo. 11/21/00). the district court (judge babcok) held that the irs appeals officer had abused her discretion in failing to grant relief from a proposed levy [for unpaid employment taxes] pursuant to a §§ 6220/6230 hearing because the requirement of § 6330(c)(3) that the government�s collection concerns be balanced against the intrusiveness of the collection had not been satisfied. the appeals officer�s decision was based on the fact that the irs had followed proper procedures but it did not take into account the impact that the levy would have on mesa�s continued operation as a going business. the court also stated that there must be enough information in the irs documentation to permit a court to draw conclusions about whether the appeals officer had abused her discretion. 770 florida tax review [vol.5:si a. a.o.d. 2001-05, 2001 w.l. 953160 (8/20/01). the irs has nonacquiesed in mesa oil, inc., �relating to whether a verbatim recording of a collection due process hearing is required under §§ 6230 and 6330 to create a judicially reviewable administrative record.� 2. a hearing isn�t always a hearing. moorhaus v. commissioner, 116 t.c. 263 (4/23/01). the tax court held that the fact that the irs has accorded the taxpayer an �equivalent hearing� following an untimely request for a § 6330 hearing following a notice of intent to levy does not constitute a waiver of the time deadline for requesting a hearing. furthermore, a husband and wife are separate taxpayers for purposes of § 6330. separate notices of intent to levy may be issued to each of them at different time with different time deadlines for requesting a hearing, and one can timely request a hearing while the other�s request is not timely. 3. begging for release of tax liens. t.d. 8951, withdrawal of notice of federal tax lien in certain circumstances, 66 f.r. 33464 (6/22/01). reg. § 301.6323(j)-1 clarifies the standards under which the commissioner will withdraw a lien pursuant to § 6323(j). the regulations provide that the procedure and form to be followed by a taxpayer in filing a written request for withdrawal of a tax lien will be prescribed by the commissioner, but set forth minimum required information. 4. effective date controversy. parker v. commissioner, 117 t.c. 63 (8/21/01). the irs filed a lien against the taxpayer�s property before the effective date of §§ 6320 and 6330; after the effective date the irs notified the taxpayer of its intent to levy on the property and provided the taxpayer an administrative hearing under § 6330. when appeals issued a notice of determination that there was no reason not to levy, the taxpayer petitioned the tax court for review. the commissioner argued that the court lacked jurisdiction because the lien was filed before the effective date of §§ 6320 and 6330 and the lien and levy were a single continuing collection action. the tax court (judge laro) rejected the commissioner�s argument and held that it had jurisdiction under § 6330 to review the determination to levy because liens and levies are separate actions within the collection process. the court did not reach the merits. 5. if we have to sign our tax returns, why doesn�t the irs have to sign assessments? nicklaus v. commissioner, 117 t.c. 117 (9/14/01). a certificate of assessment, form 4340, is valid even if it has not been signed and dated by an irs assessment officer. 2002] recent developments in federal income taxation 771 6. sarrell v. commissioner, 117 t.c. 122 (9/25/01). neither the timely mailed/timely filed rule of § 7502(a) that generally applies to tax court petitions nor the extended filing period under § 6213(a) for petitions from taxpayers receiving a notice addressed outside the united states applies to petitions under § 6330(d). the petition was dismissed for lack of jurisdiction. 7. when a �hearing� isn�t a hearing, but just a letter from the irs. a. lunsford v. commissioner, 117 t.c. 159 (11/30/01) (reviewed, 8-3-5). in deciding the validity of a notice of determination for purposes of ascertaining whether the tax court has jurisdiction to review the irs determination in a § 6330 [due process before levy] proceeding, judge ruwe held that the court will not look behind the face of the notice of determination to inquire as to whether the taxpayer was afforded a proper hearing. meyer v. commissioner, 115 t.c. 417 (2000), is overruled to the extent it is to the contrary. b. lunsford v. commissioner, 117 tc 183 (11/30/01) (reviewed, 7-2-7). a notice of determination to levy under § 6330 can be valid even though the taxpayer was not afforded a face-to-face hearing but instead was provided a documentary response by mail to his inquiry regarding the propriety of the levy. the taxpayer questioned whether there was a valid summary record of assessment and the appeals officer responded by sending the taxpayer a form 4340, certificate of assessments and payments. the majority noted that other cases might arise where the nature of the question requires an actual hearing. seven dissenting judges would have required an actual hearing as a prerequisite to upholding the notice of determination. c. johnson v. commissioner, 117 t.c. 204 (11/30/01) (reviewed, 9-7). section 6330(d) does not confer on the tax court jurisdiction to review an appeals decision not to stay a levy pursuant to an assessed § 6702 frivolous return penalty. section 6330(d) does not expand the tax court�s jurisdiction to types of taxes over which the tax court does not ordinarily have jurisdiction. van es v. commissioner, 115 t.c. 324 (2000), followed. if subject matter jurisdiction is lacking, the tax court will no longer look behind the face of the notice of determination to inquire as to whether the taxpayer was afforded a proper hearing as required by § 6330(b). meyer v. commissioner, 115 t.c. 417 (2000), is overruled to the extent it is to the contrary. commissioner�s motion to dismiss granted. 772 florida tax review [vol.5:si 8. downing v. commissioner, 118 t.c. no. 2 (1/7/02). the tax court held it had jurisdiction under § 6330(d)(1)(a) to review the commissioner�s determination to proceed with collection of the § 6651(a)(2) addition to tax for the failure to pay. 9. aguirre v. commissioner, 117 t.c. 324 (12/28/01). a taxpayer who consents to immediate assessment [by signing form 4589, income tax examination changes] has waived the right to a § 6330 per-levy administrative hearing. that the form 4589 was executed prior to the effective date of § 6330 is not relevant. 10. t.d. 8979, notice and opportunity for hearing upon filing of notice of lien, 67 f.r. 2558 (1/18/02); t.d. 8980, notice and opportunity for hearing before levy, 67 f.r. 2558 (1/18/02). the treasury department has promulgated final regulations on the right to a collection due process hearing following a lien filing under § 6320 and on the right to a similar hearing before levy under § 6330. g. innocent spouse relief 1. when the legislative history is ambiguous, read the statute. tax court majority holds that the test for knowledge under the § 6015(c)(3)(c) separate liability election is the same as that under former § 6013(e)(1)(c), which is that knowledge of an item of omitted income is sufficient to deny relief even if the spouse has no reason to believe that the way the item was reported on the return was correct. cheshire v. commissioner, 115 t.c. 183 (8/30/00) (reviewed, 11-4), on appeal to the 5th circuit. a spouse who has actual knowledge of the transaction giving rise to omitted income has �reason to know� of the understatement and is not entitled to innocent spouse relief under § 6015(b). the taxpayer�s proposed standard based on a prudent taxpayer being expected to know of the understatement was rejected as providing too broad an escape hatch form liability. more importantly, the tax court (judge jacobs) held that for the spouse to be denied apportioned liability relief, § 6015(c)(3)(c) does not require actual knowledge of whether the entry on the return is or is not correct. the applicable knowledge standard under § 6015(c)(3)(c) is �an actual and clear awareness (as opposed to reason to know) of the existence of an item which gives rise to the deficiency (or portion thereof).� thus because when the spouse seeking apportioned liability in cheshire signed the joint return, she was aware of the amount, the source, and the date of receipt of a retirement distribution received by her then husband, she was denied apportioned liability, even though at that time she misunderstood how much of the retirement distribution properly was taxable and thus did not 2002] recent developments in federal income taxation 773 know that the amount of income was understated. the court declined to follow a statement in h. conf. rept. 105-599, at 253 (1998) that �if the irs proves that the electing spouse had actual knowledge that an item on a return is incorrect, the election will not apply to the extent any deficiency is attributable to such item.� the court did, however, find that the commissioner abused his discretion in failing to grant equitable relief from penalties under § 6015(f), even though the failure to grant equitable relief on the underlying deficiency was not an abuse of discretion. the taxpayer relied on her husband�s description of the tax consequences of the transaction and his representations that he had been advised by a cpa and had no reason to doubt him. � judge jacobs writing for the majority held that the wife was properly denied innocent spouse treatment under § 6015(c)(3)(c) where she had knowledge that her husband had received a distribution from his retirement plan. the wife was told by her husband that their accountant had advised him that amounts used to pay off the mortgage could be excluded from income the same way that the portion of the distribution that was �rolled over� was treated. the majority held that the wife does not need to have knowledge of the tax consequences of the item or that the entry on the return is incorrect. the court relied on former § 6013 cases, such as wiksell v. commissioner, 215 f.3d 1335 (9th cir. 2000), aff�g without published opinion t.c. memo. 1999-32, and bokum v. commissioner, 94 t.c. 126 (1990), aff�d, 992 f.2d 1132 (11th cir. 1993), to the effect that knowledge of the legal consequences of an item may be presumed if the spouse has knowledge of the item. � the dissenting opinions (judges parr, colvin, marvel, and gale), based on the legislative history, would limit denial of relief under § 6015(c)(3)(c) to cases in which the spouse actually knew of the understatement of the item). judge colvin�s dissent is based upon the conclusion that § 6015(c) was enacted to make clear that the spouse must have had �actual knowledge that the treatment of the item on the tax return was incorrect� in order to be denied innocent spouse treatment. a. affirmed by �plain meaning� interpretation. 282 f.3d 326, 89 a.f.t.r.2d 2002-900, 2002-1 u.s.t.c. ¶ 50,222 (5th cir. 2/8/02). on appeal, mrs. cheshire argued that the case was an erroneous deduction case that the knowledge-of-the-incorrect-deduction standard was applicable; the irs argued that the case was an omitted income case and that the knowledge-of-thetransaction test was applicable. the court of appeals (judge king) held that mrs. cheshire �knew or had reason to know� of the understatement under both the omitted income standard and the price [887 f.2d 959 (9th cir. 1989)] erroneous deduction standard. thus, § 6015(b)(1)(c) barred innocent spouse relief. section 6015(c) apportioned liability relief was denied because �the term 774 florida tax review [vol.5:si [�item�] refers to an actual item of income, deduction, or credit, rather than the incorrect reporting of such an item.� mrs. cheshire�s argument that § 6015(c)(30(c) precludes relief only if the spouse has knowledge of incorrect tax reporting was inconsistent with the general rule that �ignorance of the tax laws is not a defense to a tax deficiency.� the court declined to interpret the legislative history as compelling a different result for two reasons. first, when interpreting a statute, this court �must presume that a legislature says in a statute what it means and means in a statute what it says there.� [citations omitted.] unless the text of a statute is ambiguous on its face, this court adheres to that statute�s plain meaning. . . . section 6015(c)(3)(c) is not facially ambiguous. second, the legislative history of § 6015(c)(3)(c) is ambiguous. some portions of the history appear to support the commissioner's position. [citations omitted.] other parts of the history, however, suggest that the § 6015(c)(3)(c) exception is intended to cover spouses with knowledge of the transaction giving rise to the deficiency in addition to spouses with knowledge that the tax return is incorrect. [citations omitted.] we decline to allow inconclusive legislative history to affect our interpretation of the plain meaning of § 6015(c)(3)(c). the court of appeals noted that subsequent to deciding cheshire, in king v. commissioner, 116 t.c. 198 (2001), the tax court interpreted the applicable knowledge standard in erroneous deduction cases to be �actual knowledge of the factual circumstances which made the item unallowable as a deduction.� even under this standard, however, the court of appeals concluded that mrs. cheshire was not entitled to relief because her �actual and clear awareness� of mr. cheshire�s retirement distribution satisfied the § 6015(c)(3)(c) knowledge standard for omitted income cases. 2. a little ray of mercy shines through. martin v. commissioner, t.c. memo. 2000-346 (11/08/00). section 6015(c) relief was granted to a wife who had only superficial incomplete knowledge of a complex transaction in which her husband disposed of stock in a purported § 351 transaction, which was designed to fraudulently deceive state insurance regulators, without the actual receipt of any cash or property by either spouse. 2002] recent developments in federal income taxation 775 3. but hark, what light through yonder window breaks. braden v. commissioner, t.c. memo. 2001-069 (3/22/01). judge marvel held that innocent spouse relief was available under § 6015(b)(1) to a husband who prepared a joint tax return that omitted distributions received by his wife from her deceased father�s ira, and from which he received no benefit. because the husband had no knowledge of his [ex by the time case arose] father-in-law�s financial affairs and the estate�s attorney [an ex-irs special agent] had led him to believe that the funds received by the wife were a nontaxable inheritance, the husband did not have �reason to know� under § 6015(b)(1)(c), even though he knew of the receipt, because he did not know that the receipt was from an ira. judge marvel distinguished cheshire v. commissioner, 115 t.c. 183 (2000), aff�d, 282 f.3d 326, 89 a.f.t.r.2d 2002-900, 2002-1 u.s.t.c. ¶ 50,222 (5th cir. 2/8/02), as involving a case in which the spouse denied innocent spouse relief knew of the source of the receipt but misunderstood its includability. 4. �actual knowledge� in § 6015(c)(3)(c) means what it says. culver v. commissioner, 116 t.c. 189 (4/02/01). a husband was granted apportioned liability under § 6015(c) because he had no actual knowledge of his wife�s embezzlement income, even though she channeled funds through their joint account and the total deposits to their account substantially exceeded their combined salaries. section 6015(c)(3)(c) permits the commissioner to defeat the apportioned liability election only if the commissioner carries the burden of proof by a preponderance of the evidence that the spouse seeking apportioned liability had actual knowledge � not merely reason to know � of the unreported amounts received by the other spouse. even though the husband should have inquired about the source of the funds, the standard under § 6015(c)(3)(c) �is not that of a hypothetical, reasonable person, but only that of the [spouse�s] subjective knowledge.� 5. cheshire interpreted: wife is granted § 6015(c) relief because she couldn�t read her husband�s mind. king v. commissioner, 116 t.c. 198 (4/10/01). deductions attributable to taxpayer�s husband�s activities had been disallowed [under § 183(a)] because the husband lacked a profit motive. wife sought apportioned liability under § 6015(c) and the commissioner disallowed the claim under § 6015(c)(3)(c) because the wife knew of her husband�s activity and that the deduction appeared on the return. judge ruwe adopted special trial judge cuvillion�s opinion, which held that taxpayer met all the requirements for § 6015(c) apportioned liability relief because the commissioner could not demonstrate that taxpayer had actual knowledge of the item giving rise to the deficiency at the time she signed the return. where the fact giving rise to the disallowance was her husband�s lack of a profit object at the time he claimed a loss from a cattle-raising activity, the commissioner was 776 florida tax review [vol.5:si required to show that wife had actual knowledge of this �lack of profit objective,� which noted that the cheshire standard �is an actual and clear awareness (as opposed to reason to know) of the existence of an item which gives rise to the deficiency (or a portion thereof).� the opinion noted that a footnote in cheshire � an omitted income case � stated, �we leave to another day the manner in which the actual knowledge standard will be applied in erroneous deduction cases.� the spouse will be determined to have actual knowledge of the item if she only lacks knowledge of the legal (tax) consequences of the operative facts. 6. only one bite at the innocent spouse apple. vetrano v. commissioner, 116 t.c. 272 (4/25/01). section 6017(g)(2) precludes any spouse who has meaningfully participated in a court proceeding involving the taxable year in issue from subsequently electing either innocent spouse relief under § 6015(b) or apportioned liability under § 6015(c). this res judicata-like bar precludes a subsequent stand-alone petition to the tax court, under § 6015(e), for innocent spouse relief or apportioned liability. a taxpayer is limited to a single administrative and judicial process to resolve all issues under § 6015. thus, the tax court (judge whalen) denied the wife�s motion to dismiss, without prejudice, her innocent spouse election raised in deficiency proceeding because dismissal would have to be with prejudice. 7. another route to innocent spouse relief. estate of wenner v. commissioner, 116 t.c. 284 (5/14/01). the tax court (judge laro) held that once its jurisdiction has been properly invoked under § 6404(i) by a petition to review the commissioner�s failure to abate interest, the taxpayer is entitled to raise available affirmative defenses to the underlying tax liability as well. mrs. wenner, who had previously paid the underlying deficiency, was allowed to seek innocent spouse relief under § 6015 with respect to the underlying tax liability, even though she had not previously requested administrative relief. a prior request for administrative relief is required only for a stand-alone petition under § 6015(e). 8. a little retroactive equity. flores v. united states, 51 fed. cl. 49, 2002-1 u.s.t.c. ¶ 50,108, 88 a.f.t.r.2d 7020 (11/28/01). if a portion of the a tax liability that arose before the effective date of § 6015 has been paid and a portion remained unpaid, § 6015(f) equitable innocent spouse relief is available with respect to the entire liability if the facts warrant relief. 2002] recent developments in federal income taxation 777 9. limited apportioned liability relief to wife where husband�s erroneous deductions exceeded his income. mora v. commissioner, 117 t.c. 279 (12/17/01). mrs. mora was denied innocent spouse relief under § 6015(b) because she had �reason to know� of an understatement attributable to her husband�s erroneous tax shelter deductions that offset over two-thirds of the spouse�s combined salary income (of less than $40,000). however, because the tax shelter investment was solely her husband�s and she had no involvement with it or, under the standard of king v. commissioner, 116 t.c. 198 (2001), �factual basis for the denial of the deductions,� judge beghe held that mrs. mora was entitled to § 6015(c) apportioned liability relief. this principle applies to the spouse requesting apportioned liability even if the spouse who owned the limited partnership interest � and thus could not qualify for apportioned liability with respect to the item � had no �factual basis for the denial of the deductions.� nevertheless, mrs. mora received only partial relief because the disallowed deductions exceeded her husband�s income and she received a tax benefit from the excess deductions. to the extent she benefitted from the deductions, § 6015(d)(3)(b) denies relief. 10. proposed § 6015 regulations. reg-106446-98, relief from joint and several liability, 66 f.r. 3888 (1/17/01). the treasury has published proposed regulations under § 6015 to reflect changes in the law made by the irs restructuring and reform act of 1998, where § 6013(e) was replaced with § 6015. they clarify that case law interpreting the language under former § 6013(e) will be used to interpret that same language under § 6015. also, �knowledge or reason to know� of an understatement exists only when either the requesting spouse actually knew of the erroneous item giving rise to the understatement, or a reasonable person in similar circumstances would have known of the item. knowledge of an item under the proposed regulations would be knowledge of the receipt or expenditure. the proposed regulations would further amend reg. § 1.6013-4 to clarify that if a spouse asserts and establishes that he or she signed a joint return under duress, then the return is not a joint return, and he or she is not jointly and severally liable. relief must be requested within two years from the first collection activity, but not before the taxpayer receives a notification of an audit or notice that there might be outstanding liability. finally, the proposed regulations would provide that the nonrequesting spouse must be given notice that the requesting spouse has filed a claim for relief and be given an opportunity to participate in the proceedings. at the request of one spouse, the irs would omit from shared documents information that would reasonably identify that spouse�s location. 11. proposed § 66 regulations for married individuals in community property states who do not file joint returns. reg-115054-01, proposed 778 florida tax review [vol.5:si regulations under § 66, relating to the treatment of married individuals in community property states who do not file joint income tax returns, 67 f.r. 2841 (1/22/02). h. miscellaneous 1. extended time for use of the revised form w-9. announcement 2001-15, 2001-8 i.r.b. 715 (2/3/01). this announcement advises persons required to file information returns of the availability and required use of form w-9, request for taxpayer identification number and certification (rev. december 2000). in response to payor concerns about implementing the new certification requirements, the use of revised form w-9 is optional until july 1, 2001. the major change to the form is that under part iii, certification, a payee must now certify that he or she is a u.s. person (including a u.s. resident alien). payors must use the revised form w-9 for all new solicitations after june 30, 2001. a foreign person may not use form w-9 to furnish his or her taxpayer identification number to the payor after december 31, 2000. instead, foreign payees must use the appropriate form w-8. 2. section 7491 was all bark and no bite here. higbee v. commissioner, 116 t.c. 438, 446 (6/6/01) (vasquez, j.). the burden of proof was not shifted to the commissioner under § 7491 because the taxpayer did not have required documentary evidence to support claimed casualty loss, charitable contribution, unreimbursed employee business expense and rental activity expense deductions. furthermore, § 7491(c), which provides that the commissioner bears the �burden of production� with respect to any penalties, requires only that the commissioner must �[come] forward with sufficient evidence indicating that it is appropriate to impose the relevant penalty� but �need not introduce evidence regarding reasonable cause, substantial authority, or similar provisions,� negating the penalty. the negligence penalty was sustained. 3. the quality of equity is not strained. estate of branson v. commissioner, 264 f.3d 904, 2001-2 u.s.t.c. ¶ 50,622, 88 a.f.t.r.2d 5726 (9th cir. 9/5/01). the ninth circuit held that commissioner v. gooch milling & elevator co., 320 u.s. 418 (1943), in which the supreme court has held that [under the predecessor of § 6214(b)] the tax court lacks jurisdiction to apply equitable recoupment in income tax cases, does not bar equitable recoupment of an income tax overpayment for same year as estate tax deficiency. (the sixth circuit has held to the contrary in estate of mueller v. commissioner, 153 f.3d 302 (6th cir. 1998).) the estate�s estate tax underpayment [resulting from an undervaluation of an asset] and the beneficiary�s income tax overpayment 2002] recent developments in federal income taxation 779 [resulting form the consequent lower-than-appropriate § 1014 basis] were a single transaction to which equitable recoupment applied. 4. 9-11 relief a. notice 2001-61, 2001-40 i.r.b. 305 (9/21/01). the irs announced relief under §§ 6081, 6161, and 7508a for taxpayers affected by the september 11, 2001, terrorist attack. taxpayers who have difficulty in meeting their federal tax obligations because of disruption in the transportation and delivery of documents by mail or private delivery services resulting from the terrorist attack, and who do not otherwise qualify for relief, will have until 11/15/01 to file returns and make payments required to be made from 9/11/01, through 10/31/01. b. notice 2001-63, 2001-40 i.r.b. 308 (9/15/01). the irs postponed the due date for all federal tax obligations falling between 9/10/01 and 9/24/01 until 9/24/01. this postponement of time covers the filing of returns and claims for refund, the payment of tax (including estimated tax payments), making elections, and filing any other federal tax documents. c. notice 2001-68, 2001-47 i.r.b. 504 (11/10/01). this notice expands and clarifies the definition of an affected taxpayer to include missing persons and lists additional acts for which a postponement is granted. the notice also clarifies relief available to s corporations and beneficiaries of trusts who are not themselves affected by the disaster. further, it extends relief for affected partnerships that fail to file returns by magnetic media. deadlines are postponed only if the last day for performing the act involved would otherwise be on or after november 2, 2001. the notice also contains postponements with respect to § 1031 exchanges where the last date for performing an act would fall between 9/11/01 and 11/30/01. (1) announcement 2001-117, 2001-49 i.r.b. 567 (11/10/01). the irs grants relief to partners, shareholders, or beneficiaries that had income tax returns due between 9/11/01 and 11/2/01, but did not file the returns because the taxpayer believed that the irs had granted a 120 day postponement solely by virtue of the taxpayer�s interest in the affected entity. the irs will waive any failure to file penalty if the taxpayer files his return by 12/15/01. similar relief is provided for any failure to pay penalty. (2) announcement 2001-124, 2001-52 i.r.b. 630 (12/11/01). this announcement modifies and expands the relief granted in announcement 2001-117. partners, shareholders, and beneficiaries of an affected taxpayer are eligible for all the relief granted by notice 2001-61 and 780 florida tax review [vol.5:si notice 2001-68. thus, for example, a partner that is an individual income taxpayer with an extended due date of october 15, 2001, for the 2000 return will have until february 12, 2002, to file the return. � if a partner, shareholder, or beneficiary of an affected taxpayer qualifies for relief under this notice because an original due date fell within the specified period, and such partner, shareholder, or beneficiary has already obtained an extension of time to file, the irs will supplement such extension with the relief granted by notice 2001-61 and/or notice 2001-68. thus, for example, a corporate partner with an original due date during the specified period that has obtained the automatic six-month extension of time to file will be granted a six-month extension of time to pay and an additional 120 day postponement of time to file and time to pay. d. notice 2001-69, 2001-46 i.r.b. 491 (10/25/01). the service will not assert that payments made by an employer to an organization described in § 170(c), in exchange for vacation, sick, or personal leave that the employee elects to forgo, constitute gross income or wages of an employee, provided that the payments are made to such organizations before 1/1/03. similarly, the service will not assert that the opportunity to make such an election results in constructive receipt of gross income or wages for employees. e. notice 2001-70, 2001-45 i.r.b. 437 (10/19/01). treasury and the irs intend to issue regulations permitting taxpayers to elect not to apply the mid-quarter convention rules contained in § 168(d)(3) to property placed in service in the taxable year that includes 9/11/01 in its third quarter. � section 168(d)(3) generally provides that, except as provided in regulations, if the aggregate basis of property placed in service during the last three months of the taxable year exceeds 40 percent of the aggregate basis of property (other than property described in § 168(d)(3)(b)) placed in service during the taxable year, the applicable depreciation convention for all property (other than property described in § 168(d)(2)) to which § 168 applies placed in service during the taxable year is the mid-quarter convention. (1) notice 2001-74, 2001-49 i.r.b. 551 (11/10/01). this notice expands notice 2001-70 to also include taxpayers for whom september 11th falls in the fourth quarter. this would cover taxpayers who purchase substantial amounts of property to replace property destroyed on september 11th. f. rev. proc. 2001-53, 2001-47 i.r.b. 506 (11/10/01). lists certain acts, the time for which is postponed by reason of service in a combat zone or a presidentially declared disaster. 2002] recent developments in federal income taxation 781 g. notice 2001-78, 2001-50 i.r.b. 576 (11/22/01). provides interim guidance to charities regarding payments made by reason of the death, injury or wounding of an individual incurred as a result of the september 11, 2001, terrorist attacks. the service will treat such payments made by a charity to individuals and their families as related to the charity's exempt purpose provided that the payments are made in good faith using objective standards. the notice is effective until the earlier of final legislation or 12/31/02. h. congress passed the victims of terrorism tax relief bill on 12/20/01. h.r. 2884 provides tax relief for those who died or were injured in the terrorist attacks on 9/11/01, the oklahoma city bombing in 1995, and bioterrorism involving anthrax on or after 9/11/01 and before 1/1/02. it also clarifies that the secretary has the authority to disregard for up to one year some code provisions by reason of presidentially declared disaster or terrorist or military actions. it also broadens § 6103 to permit treasury to share return information with federal law enforcement and intelligence agencies engaged in terrorist investigations. i. notice 2002-7, 2002-6 i.r.b. 489 (1/24/02). the due date for satisfying the § 412 minimum funding requirements (and the comparable requirements of § 302 of erisa) for those directly affected by the terrorist attack on 9/11/01 for making contributions originally required to have been made between 9/11/01 and 9/23/01 is postponed to 9/24/02, and the date for applying for waivers originally due between 3/15/01 and 2/28/02 is postponed to 3/1/02. 5. notice 2001-62, 2001-40 i.r.b. 307 (10/1/01). the irs has published an updated list of designated private delivery services that qualify for the timely mailing is timely filing or payment rule of § 7502. ups worldwide express plus and ups worldwide express have been added to the list. 6. ihnen v. united states, 272 f.3d 577, 2001-2 u.s.t.c. ¶ 50,786, 88 a.f.t.r.2d 6976 (8th cir. 11/27/01). taxpayers were stopped to obtain a refund of taxes to which they agreed � in a settlement on form 870-ad � where the statute of limitations had run on the irs for the years covered by the settlement agreement. 7. t.d. 8969, payment by credit card and debit card, 66 f.r. 64740 (12/14/01). the irs has promulgated final regulations under § 6311, providing for the payment of taxes by credit card. xi. withholding and excise taxes 782 florida tax review [vol.5:si a. employment taxes 1. how will this affect service in cocco pazzo? 330 west hubbard restaurant corp. v. united states, 203 f.3d 990, 2000-1 u.s.t.c. ¶ 50,225, 85 a.f.t.r.2d 869 (7th cir. 2/15/00). under §§ 3111(a) & (b) and 3121(q), the irs could validly assess the employer�s share of fica with respect to restaurant employees� unreported tips on the basis of an aggregate computation, without determining individual employees� shares. following both the federal and eleventh circuits, the seventh circuit held that the irs is authorized to collect an employer�s fica taxes without first assessing individual employees and crediting their social securities earnings records. judge coffey also deferred to the irs interpretation of § 3121(q). 2. but that same interpretation isn�t reasonable on the west coast. let�s see how it plays in washington, dc, now that certiorari has been granted. fior d�italia, inc. v. united states, 242 f.3d 844, 2001-1 u.s.t.c. ¶ 50,261, 87 a.f.t.r.2d 1118 (9th cir. 3/7/01) (2-1), cert. granted, 122 s. ct. 865 (1/11/02), aff�g 21 f. supp. 2d 1097 (n.d. calif. 9/18/98) (the irs lacks authority to assess the employer�s share of fica without determining the tip income of individual employees). the irs assessment of fica taxes on unreported tip income, which was determined by applying the average tip rate on credit card receipts, applying that rate to the employer�s gross receipts, and then subtracting reported employee tip income was invalid. judge kozinski held that the irs lacks authority to assess employer fica taxes on an estimated aggregate basis because the irs method does not account for tips that might be outside the �wage band� [which excludes tips of less than $20 per month or above the social security wage base] from fica tax. the irs method does not account for the fact that cash tips are usually less than credit card tips, that tip sharing with busboys, dishwashers, etc. may result in employees receiving less than $20 per month, or �for an upscale restaurant like fior d�italia� how many employees� tips exceeded the social security wage base. section 446 authority is unavailing to the irs because it does not apply to fica taxes, and the negative implication of § 446 not applying to fica taxes is that the irs has no authority to rely on estimates in assessing fica taxes. nor does § 3121(q) provide any such authority. although the irs can assess the employer�s share of fica taxes without assessing a deficiency against the employees, it may not do so without auditing the employees� records to determine tip income on an employee-by-employee basis. this does not mean that the irs may assess the employer only if it also assesses each of its employees. three other circuits 2002] recent developments in federal income taxation 783 have rejected this argument and, for reasons well expressed in those opinions, we reject it as well. see 330 west hubbard restaurant corp. v. united states, 203 f.3d 990, 995 (7th cir. 2000); bubble room, inc., 159 f.3d at 565; morrison restaurants, inc. v. united states, 118 f.3d 1526, 1529 (11th cir. 1997). as the government correctly points out, the employer�s portion of fica is separate from the employee�s, and the irs need not collect the one as a condition for collecting the other. having audited an employee and determined the precise amount of fica wages the employee has received, the irs may then choose to assess only the employer, only the employee, or both. if the irs cannot or will not assess the employee for additional fica tax, this will not jeopardize its right to assess the employer. that having been said, it does not follow that the irs can dispense with auditing the employees� records or otherwise determining the amount each employee earned in tips. for the reasons explained, there is no way to determine the employer�s fica tax liability without making an employee-by-employee determination of the taxable tips each has earned. an aggregate assessment based on inaccurate estimates, as used by the irs in this case, is simply not authorized. (footnotes omitted). � judge mckeown, in dissent, would have followed 330 west hubbard restaurant corp. v. united states, 203 f.3d 990 (7th cir. 2000); bubble room, inc. v. united states, 159 f.3d 553 (fed. cir. 1998); and morrison restaurants, inc. v. united states, 118 f.3d 1526 (11th cir. 1997), all of which upheld as reasonable irs assessments based on similar methodology. every circuit court that has addressed the aggregate assessment issue has come to the opposite conclusion from the majority. the majority�s attempt to avoid the weight of circuit authority by suggesting that its position is somehow in line with that of 330 west hubbard restaurant and morrison restaurants is transparently unsuccessful. see maj. op. at 2892 n.9 (�our holding is entirely consistent with those of the seventh and eleventh circuits�). as noted above, both the seventh and eleventh circuits held that the irs has the authority to use the aggregate method with respect to unreported tip income without determining the under-reporting by individual 784 florida tax review [vol.5:si employees and crediting their wage history accounts. see 330 west hubbard restaurant, 203 f.3d at 994, 997; morrison restaurants, 118 f.3d at 1529-30. although the majority agrees that the irs need not assess the employees in order to assess the employer, the majority concludes that the irs may not rely on the aggregate method and must audit the employees. see maj. op. at 2892 & n.9. requiring an audit is simply another way of saying that the irs cannot estimate and that the only way the irs can assess taxes on unreported or under-reported tips is to undertake an individual accounting of employees. this view can hardly be viewed as �entirely consistent� with that of the seventh and eleventh circuits. the irs�s authority to use the aggregate method was at the heart of the cases in those circuits. the majority�s recharacterization can only pretend consistency with these cases. a. supreme court reverses seventh circuit and upholds the irs. united states v. fior d�italia, inc., 122 s. ct. 2117, 89 a.f.t.r.2d 2883, 2002-2 u.s.t.c. ¶50,459 (6/17/02) (6-3). the court held that the irs has broad power under § 6201(a) to determine the method it uses to make assessments, and that its use of the �aggregate estimation method� to determine the total amount of tip income upon which to base an assessment of fica taxes on an employer is reasonable in light of the employer�s stipulation of the accuracy of the calculation. the method used was an amount based upon a percentage of total restaurant checks (extrapolated from the percentage of tips on restaurant checks paid with credit cards) minus the tip income reported by each employee to the restaurant owner. 3. tax court exercises its new worker classification jurisdiction. neely v. commissioner, 115 t.c. 287 (9/27/00). the tax court (judge vasquez) decided that it has jurisdiction under its new § 7436 �worker classification� jurisdiction to decide (in the context of the case) whether the irs is barred by the § 6501 statute of limitations from assessing a deficiency based upon worker classification because the statute of limitations is an affirmative defense. a. neely v. commissioner, 116 t.c. 79 (2/13/01). in exercising its jurisdiction over worker classification cases under § 7436 pursuant to neely v. commissioner, 115 t.c. 287 (2000), the tax court held that the commissioner was barred from assessing additional employment taxes by the three-year statute of limitations under in § 6501(a) because the elements of 2002] recent developments in federal income taxation 785 fraud were not present. the court (judge vasquez) rejected the commissioner�s argument that the failure of taxpayer�s air conditioning contracting business to report as wages and pay employment taxes with respect to cash payments to three workers who demanded to be paid in cash was fraudulent. the elements of fraud are the same in an employment tax case as in the income, estate and gift tax context. taxpayer filed forms-1099 with respect to the workers, who were not regular workers but were hired by foremen at the jobsites, to which they reported directly for work, honestly believed the workers to be �independent contractors,� and fully cooperated with the revenue agent assigned to the case. 4. the scheme worked until a labor dispute arose. united states v. kontny, 238 f.3d 815, 2001-1 u.s.t.c. ¶ 50,197, 87 a.f.t.r.2d 390 (7th cir. 1/4/01), cert. denied, 532 u.s. 1022 (2001). judge posner upheld a criminal conviction and sentencing for fraudulent nonpayment of payroll taxes. kontny thought he could beat both the fair labor standards act and the irc by not paying time-and-a-half for overtime but just not reporting or withholding on straight-time pay for overtime hours. 5. yer out!!! united states v. cleveland indians baseball co., 121 s. ct. 1433, 2001-1 u.s.t.c. ¶ 50,341, 87 a.f.t.r.2d 1706 (4/17/01), rev�g 215 f.3d 1325, 2001-1 u.s.t.c. ¶ 50,469, 85 a.f.t.r.2d 1761 (6th cir. 5/10/00). an award of back pay to baseball players under a settlement is subject to fica and futa taxes in the year the settlement award is paid, and not the year that the wages should have been paid. the supreme court (justice ginsburg) deferred to the irs long-standing interpretation of reg. §§ 31.3111-3 & -2(c) and 31.3301-2(c) & -3(b) as reflected in rev. rul. 89-35, 1989-1 c.b. 280 and rev. rul. 78-336, 1978-2 c.b. 255, even though the regulations themselves do not expressly apply to back pay. 6. united states v. hatter, 121 s. ct. 1782, 87 a.f.t.r.2d 2227 (5/21/01). in a case that has been dragging on nearly a decade, the supreme court held that application of medicare taxes to federal judges taking office before 1983 is constitutional, but that application of increased social security taxes to federal judges taking office before 1984 is unconstitutional under art. iii, sec. 1. 7. north dakota state university v. united states, 255 f.3d 599, 20011 u.s.t.c. ¶ 50,485, 87 a.f.t.r.2d 2522 (8th cir. 6/18/01). early retirement payments to tenured faculty members were held not to constitute wages subject to fica withholding because that the retirement payments to tenured faculty members were payments for a property interest. 786 florida tax review [vol.5:si be careful though also see dol op 99-01 a-suffolk univ. and plr19903032. 8. when a per diem isn�t really a per diem, it�s wages. worldwide labor support of mississippi, inc. v. united states, 2001-2 u.s.t.c. ¶ 50,463, 87 a.f.t.r.2d 2401 (s.d. miss. 5/15/01). per diem travel expense payments to non-local employees by taxpayer, which provided temporary skilled labor to various business were wages, subject to employment tax, and not employee expense reimbursement. the per diem amounts were not paid under an accountable plan [reg. § 1.62-2] and were not eligible for the safe harbor in reg. § 1.62-2(f), because the amount was determined with respect to hours worked and the term of employment, not anticipated expenses. 9. janus-like payments were deductible compensation in a tax court case but now are travel reimbursements exempt from employment tax in the court of claims. united air lines, inc v. united states, 51 fed. cl. 722, 2001-2 u.s.t.c. ¶ 50,577, 88 a.f.t.r.2d 5459 (8/10/01). see ii.d., supra. 10. s corporation shareholders can�t take unreasonably low compensation to avoid employment taxes. veterinary surgical consultants p.c. v. commissioner, 117 t.c. 141 (10/15/01). the taxpayer was an s corporation with a single shareholder, who was the only individual who provided any services on behalf of the corporation. all of the taxpayercorporation�s income was earned by virtue of services provided to a third party by the shareholder. the corporation paid the sole shareholder no salary, and he reported all of its income under § 1366; the income was distributed to him [subject to § 1368]. the corporation paid no employment taxes. judge jacobs held that the shareholder was an employee of the corporation and upheld the recharacterization of the amounts paid to him as salary. section 530 relief was not available because the corporation had no reasonable basis for not treating the shareholder as an employee. accordingly the wage tax deficiency was upheld. that the shareholder personally had paid the maximum employee fica for the year by virtue of employment by another corporation was not relevant to the employer�s wage tax. 11. same scam, same answer. yeagle drywall co., inc. v. commissioner, t.c. memo. 2001-284 (10/15/01). veterinary surgical consultants p.c. v. commissioner, 117 t.c. 141 (10/15/01), was followed with respect to a 99 percent shareholder/officer in case involving a drywall contracting business that treated all of its workers as independent contractors. 2002] recent developments in federal income taxation 787 12. shotgun delivery, inc. v. united states, 269 f.3d 969, 2001-2 u.s.t.c. ¶ 50,700, 88 a.f.t.r.2d 6391 (9th cir. 10/16/01). �mileage reimbursements� paid by an employer-messenger service to its employee drivers were wages because they were not paid under an accountable plan [reg. § 1.62-2]. drivers were invariably paid a total amount, for wages and mileage, equal to 40 percent of delivery charges, with an amount equal to minimum wage denominated �wages� and the remainder denominated �mileage,� without any regard to even approximating actual mileage. 13. full service employment tax litigation in the tax court. ewens and miller, inc. v. commissioner, 117 t.c. 263 (12/11/01). a bakery�s workers were employees, and the bakery was not entitled to relief under § 530 of the revenue act of 1978 [because it had before 1992 treated such workers as employees]. judge vasquez found that the workers who produced and marketed the product were common law employees under the seven-factor test: [(1) degree of control by principal, (2) who made the investment, (3) profit or loss opportunity, (4) whether the worker can be discharged, (5) whether part of principal�s regular business, (6) permanency of the relationship, and (7) the relationship the parties believed they were creating] of weber v. commissioner, 103 t.c. 378 (1994), aff�d per curiam, 60 f.3d 1104 (4th cir. 1995), and that the route drivers were statutory employees under the § 3121(d)(3)(a) agentdriver/commission driver provision. � judge vasquez further held that the tax court�s jurisdiction over worker classification gave it the jurisdiction to decide the correct amounts of employment taxes, as well as to decide the proper additions to tax and penalties. section 7436, which grants the tax court jurisdiction to determine employment status and employment tax deficiencies in connection with such a determination, does not expressly provide jurisdiction to determine § 6656 penalties for underpayment of employment taxes. nevertheless, jurisdiction to determine such penalties is founded on § 6665(a)(2) [providing that any reference in title 26 to a tax imposed by title 26 shall be deemed also to refer to the additions to tax, additional amounts, and penalties provided by chapter 68 of subtitle f] because § 6656 penalty is in chapter 68 of subtitle f and it applies to taxes imposed by title 26, and § 7436(e) does not exclude additions to tax or penalties from the definition of employment tax. b. excise taxes 1. reg-106892-00, deposits of excise taxes, 66 f.r. 10650 (2/16/01). the irs has proposed regulations relating to the requirements for excise tax deposits. 788 florida tax review [vol.5:si florida tax review 137 florida tax review volume 7 2005 number 3 improving the resolution if international tax disputes by hugh j. ault i. introduction ............................................................................................................ 138 ii. existing dispute resolution mechanisms ....................................................... 139 a. the existing mutual agreement procedure (map): is it working? ..................................................................................................... 139 b. structural aspects in the current map process ............................................. 140 1. discretion to accept case .................................................................. 140 2. secondary adjustments ...................................................................... 140 3. authority to from domestic law ........................................................ 140 4. other procedural issues ..................................................................... 141 5. oecd draft progress report 2004 ................................................... 141 iii. supplimentary dispute resolution (sdr) techniques ............................... 142 a. forms of sdr ................................................................................................. 143 1. mediation ........................................................................................... 143 2. advisory opinions .............................................................................. 143 3. arbitration .......................................................................................... 143 b. structural issues in fashioning an arbitration procedure ............................. 144 1. mandatory or optional arbitration ................................................... 144 2. duty to submit .................................................................................... 145 3. triggering event ................................................................................ 145 c. effect of the sdr decision on the map process ............................................ 146 d. review of the arbitral decision ...................................................................... 147 iv. other structural issues .................................................................................... 148 a. selection of the arbitration panel ................................................................... 148 b. arriving at the arbitration decision ............................................................... 148 c. practical questions of implementation .......................................................... 149 v. other developments ............................................................................................. 149 vi. where do we go from here? .............................................................................. 150 138 florida tax review [vol.7:3 *this article is based on a lecture presented on september 23, 2005 at the international tax symposium sponsored by the university of florida levin college of law in connection with the inauguration of its ll.m. in international taxation. **professor of law, boston college law school; senior advisor, oecd centre for tax policy and administration, paris. the views expressed here are those of the author and do not necessarily reflect the position of the oecd or its members. improving the resolution of international tax disputes * by hugh j. ault** i. introduction and background the dramatic increase in international trade and investments and related phenomena under the general heading of globalization have multiplied the situations in which international tax disputes can arise, both between taxpayers and governments but also, and in some ways, more importantly, between governments themselves. these disputes may involve transfer pricing issues, differing income characterization rules, disagreement about the existence of a permanent establishment, or more generally, diverging views on the appropriate exercise of potential taxing rights by the source country jurisdiction and the corresponding obligation of the residence country to provide double tax relief. in the current circumstances, it seems inevitable that the frequency and complexity of international tax disputes will increase and, likewise, the need for some mechanism to solve them is increasingly important. this paper will review briefly the existing mechanisms for dealing with such disputes, looking at their structure and application, and then consider some of the current proposals to modify and improve the procedures, focusing principally on the work at the oecd. 2005] improving the resolution of international tax disputes 139 1. organization for economic co-operation and development, comm. on fiscal affairs, m odel t ax convention on income and on capita l, art. 25 &1 (2005), a t http://www.oecd.org/dataoecd/50/49/35393840.pdf (jul. 15, 2005) [hereinafter 2005 oecd model]. 2. treasury department, united states model income tax convention, sept. 20, 1996, art. 25, 96 t n t 1866 (sep t. 23 , 1996) (lexis , fedt ax lib rary, t n t fi le ) , a t http://www.treas.gov/offices/taxpolicy/library/model1996.pdf (last visited oct. 20, 2005) [hereinafter 1996 u.s. model]. ii. existing dispute resolution mechanisms a. the existing mutual agreement procedure (“map”): is it working? under existing procedures, article 25 of the oecd model convention, taken over1 in various formulations in existing bilateral treaties and in the us model, provides that if the2 taxpayer believes that the actions of one or both of the treaty partners would result in taxation “not in accordance with the convention” he can present the case to the “competent authority” of the country of which he is a resident. if that country cannot or will not resolve the problem unilaterally, it has the obligation under the treaty to “endeavor” through the mutual agreement procedure to seek to resolve the issue with the other country. however, beyond “endeavoring,” there is no obligation to actually resolve the conflict. in addition, under article 25, paragraph 3, the competent authorities can on their own initiative consult together on issues of application and interpretation not directly brought up by taxpayer in a particular case and can also deal with double taxation generally even if not covered by treaty, though most map cases are taxpayer-initiated. a number of issues have come up in the application of the existing map procedure and there has been substantial criticism of the map process from the private sector. the procedure takes too long; it is costly and the taxpayer must incur expenses with no assurance of acceptable outcome. it is often necessary to pay tax in order to get into process and then the interest paid if the taxpayer wins is not adequate or cannot be offset against the interest that the taxpayer has to pay in the other jurisdiction. there is a perceived and real lack of transparence and insufficient taxpayer input in the process with an attendant fear of “package” deals in which the individual case is not considered on its merits but part of a larger tradeoff between the countries. all of these points have come up in a series of consultations with the private sector which the oecd has had on the current state of dispute resolution. 140 florida tax review [vol.7:3 3. see, e.g., rev. proc. 99-32, 1999-2 c.b. 296. b. structural aspects in the current map process beyond these particularized points and observations, there are some important more general legal issues raised by the current structure of the map procedure. 1. discretion to accept case first of all, how much discretion does the competent authority have in taking a case? the model convention says the competent authority “shall” take the case but some countries will not accept a case if the case involves penalties, tax avoidance and the like. is it appropriate that potential double taxation be an additional penalty in these situations? or suppose that the taxpayer did not cooperate in the audit and is trying in effect to get the case redecided de novo at the map level? are these grounds for the competent authority to refuse thecase? in addition, some countries take the position that they will not accept map cases on particular issues. 2. secondary adjustments where the map has been successful in getting an agreed adjustment, another question is how to deal with the secondary adjustment which is necessary to allow the assets to be rearranged in accordance with the initial adjustment. the issue is not fully dealt with in the current commentary. suppose, for example, both states agree that profits in state a should be 100 more and in state b 100 less but the excess cash is still in state b. in some cases, there is a mechanism under domestic law which allows the accounts and cash flow to be adjusted without further tax consequences but if not, which is the case in many countries, a map can3 make that possible and the question should be addressed more directly. 3. authority to deviate from domestic law another question is how much authority does the map have to deviate from domestic law outcomes? suppose there is a court decision in point on the question but not involving this particular case; or suppose a decision of assessment in this case has been made, but the competent authority is willing to reduce it to accommodate a map agreement. here country practices differ and timing of the assessment can be crucial as it can bind the hands of the competent authority in subsequent attempts to reach a mutual agreement. a related issue is the relation to domestic remedies. does the taxpayer have to suspend court procedures to undertake the map? and if he does, is there any way to protect his rights if it turns out that 2005] improving the resolution of international tax disputes 141 4. rev. proc 2002-52, 2002-2 c.b. 242. 5. see 2005 oecd model, supra note 1, art. 25; see also organization for economic cooperation and development, comm. on fiscal affairs, model tax convention on income and on capital commentary, art. 25, ¶¶ 7, 27-28 (oecd) 2000 [hereinafter oecd model commentary]. 6. oecd, centre for taxpolicyand administration,improving the process for resolving international tax disputes, § i, at http://www.oecd.org/dataoecd/44/6/33629447.pdf (jul. 27, 2004) [hereinafter oecd report]. the map is not able to reach an agreement in the time period that is required for the prosecution of the legal proceedings? again, country practices differ. in the united states, it is typical to suspend domestic judicial proceedings while the map is going forward but at4 the end of the day if the taxpayer is dissatisfied with the mapresult, he is free to pursue domestic remedies as long as he has taken the necessary steps to preserve his rights. 4. other procedural issues there are a number of other procedural issues involved in map. the statute of limitations often raises important questions. article 25 states that the taxpayer should be able to implement a map despite domestic statute of 2005] improving the resolution of international tax disputes limitations issues and since this obligation arises out of treaty law,5 it should in principle override conflicting domestic legislation. however, not all countries have adopted this approach. a related question is staying collection when the case is being considered. here, the taxpayer, rather than having to pay the full tax at the outset of the procedure, is given the possibility of posting security to avoid current payment. again country practices differ. another important procedural issue is the role of the taxpayer in the map process. he is nominally a party in interest but often just a stakeholder who does not care where he pays the tax; he just wants to be taxed consistently. despite the importance of the map process to the taxpayer, it is basically a government-to-government procedure and the taxpayer’s role in presenting the case has been limited. 5. oecd draft progress report 2004 the oecd has been doing significant work on these issues. a joint working group was established in 2003 to consider the existing procedures for resolving international tax disputes and a report, improving the process for resolving international tax disputes was made public in july 2004. in addition, the oecd has now posted on its website a summary6 142 florida tax review [vol.7:3 7. oecd, centre for tax policy and administration, cross border tax treaty dispute r e s o l u t i o n : c o u n t r y p r o f i l e s a n d d r a f t p r o g r e s s r e p o r t a t http://www.oecd.org/document/31/0,2340,en_2649_29601439_ 1_1_1_37427,00.html (last visited oct. 20, 2005). 8. see david weissbrodt & muria kruger, norms on the responsibilities of transnational corporations and other business enterprises with regard to human rights, 97 am. j. int’l. l. 901, 91415 (2003) (defining soft law as “recommendations [that] over a period of time may be viewed as interpreting treaties . . . or may serve as the basis for the later drafting of treaties.”); see also david tan, towards a new regime for the protection of outer space as the “province of all mankind,” 25 yale j. int’l l. 145, 181 (2000) (listing “range, flexibility, and frequent adherence by the governments that made such declarations” as advantages of soft law). of country practices in an effort to make the process more transparent. the oecd report also7 foresees the preparation of a manual on effective mutual agreement procedure which would deal with many of the issues that were just mentioned. the manual would survey the operation of the map in member countries and try to establish a kind of “best practices” approach to the questions involved. some of the matters considered may involve changes to the commentary to the oecd model. others would be handled in the context of the manual which would have less legal force but would represent a kind of benchmark of best practices. it would set international standards in a kind of “soft law” way and there could be a mechanism for monitoring the extent to which states follow the practices in the manual.8 iii. supplementary dispute resolution (sdr) techniques while all of these points are important and are being examined in the context of the oecd study, the single most important problem with the existing procedures is that there is no assurance at the end of the day that the map process will reach a conclusion. as previously mentioned, under the existing obligation of article 25, the competent authorities have to “endeavor to agree” but do not have to come to any solution. thus there is clearly, in my view, a need for some type of supplementary dispute resolution mechanism in the context of map which moves in the direction of arbitration. the reference here is to “supplementary dispute resolution,” not as it is often formulated “alternative dispute resolution.” this process is not viewed as alternative to the map but as an extension of it, growing out of it and not a parallel system. in a sense the map itself is an alternative approach, as it represents an alternative to two independent domestic court procedures. 2005] improving the resolution of international tax disputes 143 9. oecd model commentary, supra note 5, art. 25, ¶ 47. 10. see generally, oecd, centre for tax policy and administration, discussion draft on the a t t r i b u t i o n o f p r o f i t s t o a p e r m a n e n t e s t a b l i s h m e n t a t http://www.oecd.org/dataoecd/22/51/33637685.pdf (aug. 2, 2004). a. forms of sdr 1. mediation within the context of map, there are a number of possible supplementary dispute resolutions techniques, some of which are already being used. a number of countries have a procedure where a “stuck” case will be reviewed by a higher level official who has no direct connection with the case in an effort to “mediate” and clarify the positions of the two parties. less frequently there is recourse to the use of a third party mediator who tries to help each side understand the strengths and weakness of each side and find common ground which allows the parties to reach a settlement without actually having any authority to reach a decision himself. 2. advisory opinions interesting, the current commentary to article 25 in the model convention already contains reference to the possibility of the countries getting an “advisory opinion” or of the committee on fiscal affairs being asked to give an opinion on a point of interpretation,9 though there appear to be not reported cases of this process actually being used. 3. arbitration the most discussed and most important form of sdr which might be introduced in the international tax field is some kind of arbitration of international tax disputes. as a wag once said, arbitration seems to be an idea whose time is coming and coming and coming but now it really seems like it might be arriving and this is for several reasons. in the first place, as discussed earlier, the increase in the scope and complexity of international activity will quite likely produce more unresolved cases in the future, increasing the need for a mechanism which will deal with these cases. for example, the developing rules on attributing profits to a permanent establishment, while bringing more order to what has been a somewhat10 unprincipled and chaotic area of tax law, will also raise a number of interpretive questions on which disagreements are possible. secondly, as non-tax barriers to trade and investment are eliminated, tax issues assume greater and greater importance. competing trade and investment disciplines already provide 144 florida tax review [vol.7:3 11. see understanding on rules and procedures governing the settlement of disputes, at http://www.wto.org/english/docs_e/legal_e/28-dsu_e.htm#17 (last visited oct. 20, 2005). 12. oecd model commentary, supra note 5, art. 25, ¶¶ 44.1-44.7. 13. see mcdaniel, trade agreements and income taxation: interactions, conflicts and resolutions, 57 tax l. rev. 275 (2004). 14. oecd report, supra note 6, § iii. 15. convention on the elimination of double taxation in connection with the adjustment of p r o f i t s o f a s s o c i a t e d e n t e r p r i s e s , a r t . 6 8 , a t h t t p : / / e u r o p a . e u . i n t / s m a r t a p i / c i g / s g a _ d o c ? s m a r t a p i ! c e l e x a p i ! p r o d ! celexnumdoc&lg=en&numdoc=41990a0436&model=guichett (last visited oct. 20, 2005) [hereinafter eu convention]. 16. convention between the federal republic of german and the republic of austria for the avoidance of double taxation with respect to taxes on income and capital, aug. 24, 2000, aus.f.r.g., art. 25, 2001 wtd 36-15; doc. 2001.5225. institutional structures to resolve disputes in their fields of competence and the lack of such11 a mechanism in the tax area invites the extension of those other disciplines into this field. some years ago tax people were able to ensure in the gats process that no tax issues involving national treatment and discrimination will be handled in the wto dispute resolution procedures but the issue is still there. the wto cases involving the us fsc/eti regimes are12 a reminder that tax and trade are closely connected. and the failure to provide an adequate13 tax-based dispute resolution mechanism invites those issues being decided by someone else. if arbitration of tax issues is going to be taken more seriously, there are a number of structural issues which must be considered and the following material will discuss some of the most important, all of which are analyzed at greater length in the oecd report.14 b. structural issues in fashioning an arbitration procedure 1. mandatory or optional arbitration the first question is whether the arbitration procedure should be “mandatory” or “optional,” that is, should there be an agreement prior to any actual dispute that all disputes would be submitted to the arbitration procedures or would be the decision to go to arbitration be made on a case-by-case basis? with pre-dispute or mandatory arbitration, the two countries agree in advance that if a map case cannot be resolved it will be required to be submitted to the arbitration process when certain conditions have been met. the agreement to arbitrate is made prior to the existence of an actual dispute and requires arbitration in all cases that cannot be resolved. the eu arbitration convention follows a “pre-dispute” model, as does the15 recent german-austrian convention. most other existing conventions are “post-dispute” and16 2005] improving the resolution of international tax disputes 145 17. convention between the united states of america and the federal republic of german for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital and to certain other taxes, aug. 21, 1991, u.s.-f.r.g., art. 25, s. treaty doc. no. 101-10 (1990); 1708 u.n.t.s. 3. 18. oecd report, supra note 6, § iii.d., ¶ 134. 19. eu convention, supra note 15, art. 7, ¶ 1. require an agreement by both the competent authorities and the taxpayer to submit the particular case in question to the independent panel. 17 one of the important aims of sdr is to ensure that there will be a final resolution of the case which has entered the map process. lack of assured finality is an important reason for taxpayers not to commit the time and resources necessary to a successful resolution of a map. this aim can be best realized by a “pre-dispute” or mandatory agreement to arbitrate. while this potentially involves a greater delegation of authority to the independent panel, it goes further in meeting the objectives of the map by helping to ensure that the map process will reach an appropriate result and on balance seems to be the preferential approach. 2. duty to submit a weaker form of mandatory arbitration which would help to resolve an outstanding question would be to require that the issue to be submitted to sdr if the case could not be resolved by normal procedures. that is, the submission of the cases would be mandatory, which goes beyond optional arbitration since the country could not walk away from the table, but still would not ensure that a binding result would be reached. the duty to submit to some kind of sdr under existing treaties might be derived from the general international law requirement to interpret and apply the treaty in good faith, and might be found to be an obligation under existing treaties. while the oecd report suggests that such an obligation might be derived from existing law, it certainly has not been country practice, an important18 determinant of international law obligations and reasonable people can differ on this point. 3. triggering event any kind of pre-dispute agreement requires some “trigger” to determine when the case will be submitted to the independent panel. a time period is sometimes used. the eu arbitration convention requires that the case be submitted to the “advisory commission” within two years of “the date on which the case was first submitted to one of the competent authorities” when the competent authorities cannot resolve the case in that period to eliminate double taxation. another approach would be to have the case submitted when the competent19 authorities “agreed to disagree,” that is, came to a good faith conclusion that the case would 146 florida tax review [vol.7:3 20. see generally eu convention, supra note 15. not be resolved without recourse to sdr. here it would seem preferable to use a fixed time period, though with the agreement of all of the parties, the period could be extended, e.g., where the case was very close to resolution at the end of the time period. c. effect of the sdr decision on the map process assuming a decision has been reached by an independent panel, what are the effects of that decision? here there are a variety of options a) advisory only, competent authorities may follow or not. this is the weakest form but at least exposes an independent opinion; b) binding to the extent that the competent authorities do not agree to an alternative which relieves double taxation or otherwise resolves the issue. this is the approach taken by the eu convention;20 c) binding on the competent authorities in all events as long as the tp follows; d) binding on the competent authorities and on the taxpayer to the exclusion of domestic judicial remedies. this latter possibility, while the most desirable in terms of a final consistent resolution of the issue, presents one of the most difficult issues in structuring sdr procedures. what is the relation between those procedures and domestic judicial proceedings? while the existing map process varies from country to country, the taxpayer at the end of the day generally has recourse to domestic judicial procedures if he does not wish to follow the map agreement. though the map process may require that the judicial procedures be suspended, recourse to those procedures is ultimately available. on the other hand, arbitration (“alternative” dispute resolution) in most other contexts intentionally removes the substantive matter at issue from the domestic judicial system (though there may be a judicial review of the procedural aspects of the case). in the context of sdr techniques being considered here, one of the important aims is to ensure a single binding and consistent resolution of the matter at issue. as an overall goal, it would clearly seem desirable that the panel decision would be final and binding. while the governments can clearly agree to be bound by the decisions of the panel, the question is whether and to what extent the taxpayer can be bound, as a condition to the availability of sdr, to give up his rights to a judicial consideration of the issues of the case. here practices seem to vary from country to country. for some countries, there is apparently a question as to whether a taxpayer can be asked to give up judicial remedies, and, 2005] improving the resolution of international tax disputes 147 21. the world bank group, international centre for settlement of investment disputes, icsid c o n v e n t i o n , r e g u l a t i o n s a n d r u l e s , p t . a , c h . 4 , § § 1 6 , a t http://www.worldbank.org/icsid/basicdoc/parta-chap04.htm (last visited oct. 20, 2005). 22. north american free trade agreement 9nafta), review anddispute settlement in antidumping and countervailing duty matters, extraordinary challenge procedure, pt. 7, ch. 19, annex 1904.13, at http://www.nafta-secalena.org/defaultsite/index_e.aspx?detailid=173#an1904.13 (last visited oct. 20, 2005). even if he agrees to do so, whether that agreement can be enforced. in such a situation, the taxpayer can in effect “forum shop” between the panel decision and a possibly more favorable judicial determination. despite the theoretical problem, in practice there should be very few situations in which this question would come up. the taxpayer has been offered a solution in which double taxation is avoided, which was his initial goal. it would clearly be appropriate to provide that if the taxpayer did in fact attempt to challenge the panel finding in domestic litigation, the other country would be free to ignore the arbitral decision in determining its assessment (or to go back to its original assessment). in addition, it should be open to the government to present the arbitral decision to the court, so that the court is on notice that the decision was not simply one made by the tax administrators but had been reached by an expert and independent panel. it might also be possible tostipulate that the taxpayer would have to bear the costs of the arbitration procedure if he subsequently refused to be bound by the procedure which offered him a solution to double taxation. d. review of the arbitral decision assuming that the panel decision cannot be collaterally challenged judicially on its substance, a separate question is whether there needs to be some sort of mechanism to allow a challenge based on procedural grounds. one possibility would be to allow the courts of each country to review the arbitral decision on limited procedural grounds such as bias or corruption, exceeding the delegated authority in the decision, violation of the panel’s own procedural rules, etc. this sort of stipulation could be made by the parties in the terms of reference when the arbitral procedure is initially set up. another approach would be to provide for a supra-national reviewing body which would supplant national courts as far as procedural review was concerned. such a procedure is provided for in the world bank’s international centre for the settlement of investment disputes (icsid) dispute settlement and in the north american free trade agreement21 (nafta). in the latter procedure, the bi-national panel decisions concerning trade disputes22 can be reviewed by an extraordinary challenge committee for limited procedural defects. in the context of tax arbitration based on an oecd model, it would be possible to have a review 148 florida tax review [vol.7:3 23. joint council of europe/pecd convention on mutual administrative assistance in tax matters, art. 24, ¶ 3, at http://www.oecd.org/dataoecd/11/29/2499078.pdf (jan. 25, 1998). 24. eu convention, supra note 15, art 9. 25. vienna convention on the interpretation of treaties, arts. 31-33, 23 may 1969, 1155 u.n.t.s. 331, 8 ilm 679. body appointed by the committee on fiscal affairs, or the matter could, under appropriate procedures, be referred to the co-ordinating body envisaged by article 24 of the mutual administrative assistance convention. 23 iv. other structural issues assuming then that it is possible to develop the legal basis for a mandatory, binding arbitration procedure which is the exclusive mechanism for the resolution of international tax disputes, there are a number of interesting and important structural issues which must be resolved in establishing such a procedure. a. selection of the arbitration panel first, and in some ways most important, is the selection of the arbitrators. presumably they would initially be selected by the competent authorities, since the process is still at the end of the day a government-to-government process, though consultation with the taxpayer would be desirable. one would expect that the competent authorities would only select qualified and appropriate candidates, but one way of insuring that result might be to establish a panel of persons who were deemed to be qualified in advance of any particular case. this is the procedure used in the eu convention. another issue is whether a representative of the24 competent authority itself should be on the panel or not. more broadly, there is a question if any governmental employees should be on the panel. in order to make sure the process functions in a timely manner, there also must also be a mechanism to ensure that if one of the parties does not appoint an arbitrator within the time period, one will be appointed by an independent appointing authority. the same applies to the appointment of a chairman if the appointed arbitrators cannot agree on a chairman. b. arriving at the arbitration decision assuming the panel has been established, there must be procedures for determining how it reaches its decision. the first question is what materials should it be able to refer to. since by definition, we are dealing with tax treaty interpretation, presumably any material which would be appropriate under the vienna convention on the interpretation of treaties25 2005] improving the resolution of international tax disputes 149 26. author assertion. 27. see eu convention, supra note 15, arts. 1-3 (defining and limiting the scope of the convention. would be appropriate. this, however, would presumably preclude reference to unilateral sources of interpretation like the us treaty technical explanations which may not be appropriate. another issue is the form of decision of the panel. one option would be so-called “last best offer” or “baseball” arbitration. under this procedure, each party submits to the panel the “last best offer” which it would have been willing to accept and the panel simply selects one or the other of the offers and notifies the parties. this procedure has the advantage of requiring the parties realistically to assess their case and provides for a relatively straightforward result. it really views that arbitral procedure as an extension of the administrative procedure and the most important thing is to get an answer to the question and not necessarily the “right’ answer. this procedure would work well with some cases, transfer pricing for example, where there really is no “right” answer and the most important thing is “an answer” but it would not seem to make much sense in more complex questions of interpretation. another more “quasi-judicial” approach would require a written opinion which sets forth the reasoning of the panel. if the opinion was published, which is a separate question, this would allow the development of a kind of “common law” of treaty interpretation which might help to avoid future disputes. even though the opinion would not be binding on future cases in a common law stare decisis sense, it could certainly have some impact on future cases, just as case law does in civil law systems which do not have a stare decisis principle. c. practical questions of implementation beyond these structural questions, there are a number of important practical issues which must be resolved. who pays the costs, what language, translation and who pays the translators, where does the panel meet, is there the need for some kind of secretariat? all of these matters are important and should be taken into account in establishing an effective arbitration procedure.26 v. other developments the prior discussion has focused primarily on the form which arbitration could take in the context of the work of the oecd but there are other models available for comparison. in the european union, the eu arbitration convention foresees a very special kind of arbitration. in the first place, the procedure is limited in scope to transfer pricing cases and27 150 florida tax review [vol.7:3 28. see international fiscal association (ifa) arbitration proposal, arbitration of disputes arising under income tax treaties: model treaty article and memorandum of understanding, in oecd report, supra note 6, annex 4. 29. see international chamber of commerce (icc) arbitration proposal, arbitration in international tax matters bilateral convention article, in oecd report, supra note 6, annex 5 [hereinafter icc study]. 30. icc study, supra note 29, art. 25a, ¶ 1. cases of attribution of profits to a permanent establishment and does not cover interpretative issues generally. in addition, the competent authorities are members of the panel and are joined by “independent persons of standing” who are selected from a list submitted by each government. finally, after the arbitral decision has been reached, the two competent authorities have the right to take the case back and have six months to arrive at another result, as long as that result, while differing from the result of the arbitration, eliminates double taxation. thus the process really can be viewed as an extension of the administrative process, rather than the arbitration in the strict sense of the term. there are also two private sector proposals, one sponsored by international fiscal association and one developed by the international chamber of commerce. these are, as28 29 one would expect, more in line with “traditional” arbitration structures which give arbitration a more independent role. the icc proposal goes so far as to say the taxpayer can have the right to arbitration even if the competent authority agreement avoids double taxation if the taxpayer nonetheless believes that there is taxation not in accordance with the treaty.30 vi. where do we go from here? the discussion here has been principally about the oecd and the eu, that is, developed countries, but these issues are equally important, if not more important, in relations with developing countries, especially those which have a broad concept of source taxation which is reflected in their treaty positions. it is against this background that the oecd is trying to develop a fair and effective sdr process which would be acceptable to both developed and developing countries in their treaty practice. the oecd work is going forward after the publication of the report last year and it is anticipated that early in 2006 a discussion draft of its tentative proposals which address many of these issues will be made public. in the more distant future there may be the possibility of a multilateral arbitration agreement which would deal as well with the problems of “triangular” cases with more than two countries and the case of relations between two branches where there is no applicable bilateral treaty. the idea of some more comprehensive dispute resolution process in the international area has been around for a long time but as this review of the developments hopefully shows, 2005] improving the resolution of international tax disputes 151 it may in fact be coming close-r to being a reality. page 1 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 1 1993 number 7 should we give away the annual exclusion? robert b. smith* i. introduction ii. the relationship of the federal transfer taxes a. the federal estate tar 1. overview 2. major exceptions b. the federal gift tar 1. 1932 to 1977 2. 1976 tax reform act changes 3. exceptions to the application of the gift tax 4. important continuing advantages of making gifts, including use of the annual exclusion a. removal of appreciation from the donor's estate b. gift tar is calculated on a tax exclusive basis c. the annual exclusion c. the generation-skipping transfer tar d. a brief perspective on the relationship of the annual exclusion to the federal transfer tar system iii. history of the annual exclusion, technical requirements and current uses a. historical development 1. the stated purpose of the annual erclusion 2. the erta changes * assistant professor of law, university of denver college of law, denver, colorado; b.a., western kentucky university; j.d., duke university school of lawllm. in taxation, university of florida college of law. the author wishes to express his appreciation to professors david w. barnes, edward j. roche, jr., and joyce sterling for their insightful comments on earlier drafts of this article, and to sharon hester, for her research assistance. florida tax review b. technical requirements 1. the impact of the present interest requirement 2. withdrawal rights 3. some limited observations on the consequences of recognizing that a withdrawal right gives the withdrawal right holder a present interest c. current uses of the annual exclusion 1. significant wealth transfers a. direct gifts b. use of withdrawal rights and life insurance to leverage the annual exclusion c. supplemental gifts 2. protecting excessive support transfers made to persons to whom a legal obligation of support exists 3. protecting support type transfers made to persons to whom the transferor has no obligation of support 4. protecting normal gifts from tax and reporting 5. summation of current uses iv. problems with the annual exclusion under its present design and given its current uses a. makes avoidance of the transfer tax system easy b. vertical inequity c. horizontal inequity d. disrespect for the law v. various approaches to modification a. reasons to retain and modify b. reviewing the earlier proposals 1. the all/ray model 2. the gutman proposal 3. the report on transfer tax restructuring c. consumption under the transfer tax system: a key to the analysis and modification of the tuition and medical care exclusions 1. introduction 2. consumption viewed through the purpose of the transfer tax system 3. when consumption for another's benefit should be viewed as a transfer for transfer tax purposes d. liberalizing the tuition and medical care exclusions [vol 1:7 slwuld we give away the annual erchsion? e. modifications of the annual erclusion considered 1. reducing the annual exclusion per donee limitation 2. limiting the amount that can be transferred under the annual exclusion in one year by any single donor 3. reducing the annual exclusion available based on the accumulated use of significant amounts of annual exclusion 4. the present interest requirement 5. the amount of the annual exclusion for married couples 6. gift tax reporting f. implementing the most effective and administrable modifications to address the problems of the current annual exclusion 1. choosing among the most direct modifications 2. choosing among the less direct modifications 3. what these changes will accomplish vi. conclusion appendix: the statute as revisited 19931 florida tax review i. introduction united states gift tax law imposes on the transferor a tax at rates of up to fifty percent on property transfers made during the transferor's lifetime for less than full and adequate consideration in money or money's worth.' the tax is calculated on the basis of the fair market value of the property transferred, determined as of the time of the gift.2 the gift tax is a supple1. irc §§ 2001(c)(2)(d), 2501(a)(1), 2502(a), (c), 2512(b); regs. § 25.2512-8. regulations section 25.2512-8 states: transfers reached by the gift tax are not confined to those only which, being without a valuable consideration, accord with the common law concept of gifts but embrace as well sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money's worth of the consideration given therefor. however, a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm's length, and free from any donative intent), will be considered as made for an adequate and full consideration in money or money's worth. a consideration not reducible to a value in money or money's worth, as love and affection, promise of marriage, etc., is to be wholly disregarded, and the entire value of the property transferred constitutes the amount of the gift. regulations section 25.251 l-1(g)(1) states: donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transferor. the application of the tax is based on the objective facts of the transfer and circumstances under which it is made, rather than on the subjective motives of the donor. however, there are certain types of transfers to which the tax is not applicable. it is applicable only to a transfer of a beneficial interest in property. it is not applicable to a transfer of bare legal title to a trustee. these provisions illustrate an important aspect of the federal gift tax provisions, and, indeed, all the related federal transfer taxes, which is: while relevant state law determines the basic property rights of taxpayers (e.g., who is the owner of the beneficial interest in property), federal law determines the tax consequences without regard to the labels imposed by state law. commissioner v. bosch, 387 u.s. 456 (1967). hence, while state law may require that the transferor of property have a donative intent in order for the transfer to be a gift for state law purposes, no such intent is required for there to be a gift for tax law purposes. if, on the other hand, under state law the transferor has not parted with his beneficial interest in the property transferred (for example, when a resulting trust is imposed on the transferee), then no gift tax is imposed on the transfer because the beneficial interest has not been transferred. 2. irc § 2512(a); regs. §§ 25.2511-2, 25.2512-1. regulations section 25.2512-1 adopts a "willing buyer, willing seller" test for valuation. it states: section 2512 provides that if a gift is made in property, its value at the date of the gift shall be considered the amount of the gift. the value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of [vol. 1:7 slwuld we give away the annual erchsion? ment to the federal estate tax, which is imposed on transfers of property at death at rates up to fifty percent. if there were no gift tax, the estate tax could be substantially avoided by making lifetime gifts.3 neither lifetime gifts nor testamentary bequests of property are subject to income tax in the hands of the transferor or the transferee. there are several exceptions to the gift tax, one of which is the annual exclusion.5 the annual exclusion permits an individual to make gifts of up to $10,000 a year to any number of persons without incurring any gift tax.' the annual exclusion is available only if the donee is given a present right of possession or enjoyment as to the value with respect to which the exclusion is claimed.7 as is demonstrated below, the annual exclusion can be used, both directly and indirectly, to permit very large amounts to escape relevant facts. the time that a gift is made is determined under regulations sections 25.2511-2(a) and (b), which provide in part: (a) the gift is not imposed upon the receipt of the property by the donee, nor is it necessarily determined by the measure of enrichment resulting to the donee from the transfer, nor is it conditioned upon ability to identify the donee at the time of the transfer. on the contrary, the tax is a primary and personal liability of the donor, is an excise upon his act of making the transfer, is measured by the value of the property passing from the donor, and attaches regardless of the fact that the identity of the donee may not then be known or ascertainable. (b) as to any property, or part thereof or interest therein, of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another, the gift is complete. 3. richard b. stephens et. al., federal estate and gift taxation, 1 9.01 (6th ed. 1991); irc § 2001(a), (c)(2)(a). the 50% rate applies to taxable transfers in excess of s2,500,000 and was the statutory maximum rate as of the date the writing of this article wvas completed. irc § 2001(c)(2)(d). however, president clinton proposed restoring the maximum rate to 55% on taxable transfers in excess of s3,000,000, which was the maximum rate before 1993. staff of joint comm. on taxation, 103rd cong.. 1st sess., summary of the president's revenue proposals 32 (comm. print 1993). this part of the president's proposals has been adopted in both the house and senate versions of the pending tax legislation and thus the maximum rate may likely rise again to 55%. h.r. 2264. 103d cong., 1st sess. § 14208 (19931: s. 1134, 103d cong., 1st sess. § 8208, (1993). however, for convenience and consistency, the 50% maximum rate is used throughout this article. 4. irc §§ 102(a); 1001(a), (b). 5. see infra part ii b 3. 6. if the total gifts made to one donee within a calendar year exceed s10.000, the annual exclusion applies to the first s10,000 of the gifts. irc § 2503(b). 7. irc § 2503(a), (b); regs. § 25.2503-3: see infra notes 100-02 and accompanying 19931 florida tax review the federal transfer tax system.8 yet, at the same time, the annual exclusion is not large enough to protect some types of transfers that should be protected from gift tax.9 in addition, as it is currently designed and used, the annual exclusion injects vertical inequity into the transfer tax system and contributes to horizontal inequity that exists in the system.'" this article identifies problems with the annual exclusion and suggests modifications that, if enacted, would both eliminate abusive uses of the exclusion and expand sound policy based uses of other exclusions. part ii of the article briefly sets forth the basic structure of each branch of the federal transfer tax system-the estate tax, the gift tax and the generationskipping transfer tax. it then examines the historical relationship between the gift tax and the other federal transfer taxes and demonstrates that the annual exclusion from gift tax is actually an exception to each branch of the federal transfer tax system. part i explores the history and purposes of the annual exclusion and the technical requirements for its use and discusses current uses made of it, some of which uses are inconsistent with its underlying policy justification. part iv explores and analyzes problems in the transfer tax system caused by the annual exclusion as it is currently designed and used. part v discusses possible modifications of the exclusion. this article concludes that, because of enforcement and administration concerns and in order to limit government intrusion into daily life, it is desirable to retain the annual exclusion in some form, but it should be substantially modified. the most desirable modifications are to: (i) reduce the annual exclusion to that amount of incidental gifts made on average by persons with approximately $600,000 of wealth; (ii) place a cap on the annual exclusion of $20,000 per year, per donor; (iii) allow the annual exclusion only for outright gifts or for gifts to trusts that may make distributions only to one beneficiary and that require inclusion of any amount not so distributed in that beneficiary's gross estate; and (iv) expand existing exclusions for tuition gifts and medical care gifts, which exclusions should include expenditures made for housing, food, books and other expenses common to education and to care of the elderly and other persons unable to provide for themselves. attached as an appendix to this article is draft statutory language designed to accomplish the proposed changes in the law. specifically, the statutory language modifies the annual exclusion and creates a gift tax exclusion for transfers for student expenses and for expenses of the elderly and incompetent. 8. see infra part hi c 1. the term "federal transfer tax system" means the gift tax, the estate tax, and the generation-skipping transfer tax taken in combination. 9. see infra part ih c 3. 10. see infra part iv b, c. [vol. 1:7 should we give away the annual erclusion? h. the relationship of the federal transfer taxes to understand the significance of the annual exclusion, the opportunity to avoid federal transfer tax that it represents, and the degree to which it is inconsistent with the general purposes of the transfer tax system, it is necessary to have an understanding of that system and of its historical purposes and development. this part ii provides the appropriate background. a. the federal estate tax 1. overview.-the federal estate tax, originally adopted in 1916, is an excise tax imposed upon the transfer of property at death." a major reason for taxing estates, in addition to generating revenue, was breaking up concentrations of wealth. 2 subject to the exceptions discussed below, the 11. revenue act of 1916, pub. l. no. 64-271, §§ 200-212, 39 stat. 756. 777-80 (1916); irc § 2001(a). 12. with respect to the revenue raising purposes behind its original adoption. see h.r. rep. no. 922, 64th cong., 1st sess. 1-5, and s. rep. no. 793, 64th cong., 1st sess. 1-4, both reprinted in 93 u.s. revenue acts 1909-1950 (b. reams ed.) (1979). as to the purpose of breaking up concentrations of wealth, see the testimony given on the estate tax before the house ways and means committee between october 19 and november 3, 1925, with respect to proposed revenue revisions, reprinted in 7 u.s. revenue acts 1909-1950, at 293-510. especially the statement of rep. ramseyer from iowa, who introduced an article by andrew carnegie to support the notion that an estate tax was an appropriate tax to impose. id. at 398418. there was also substantial testimony in favor of repeal of the estate tax. however, it was not repealed, although the exemption was increased and the rates reduced by the revenue act of 1926, pub. l. no. 69-20, §§ 300-325, 44 stat. 9, reprinted in 97 u.s. revenue acts 19091950, at 67-87. h.r. rep. no. 1, 69th cong., 1st sess. 14-15, reprinted in 97 u.s. revenue acts 1909-1950. again, in testimony before the ways and means committee between october 31 and november 10, 1927, by william c. roberts, representing the american federation of labor, chester h. gray, representing the american farm bureau federation, and rep. ramseyer, reprinted in 8 u.s. revenue acts 1909-1950, at 747-75, the use of the estate tax to break up concentrations of wealth and to redistribute wealth were apparent. finally, in hearings leading up to the revenue act of 1932. pub. l. no. 72-154. 47 stat. 169, reprinted in 9 u.s. revenue acts 1909-1950, at 427-434, the statements of rep. ramseyer again emphasized the use of the tax to prevent concentrations of wealth. the 1932 act substantially increased the estate tax rates and adopted a gift tax as well. revenue act of 1932, §§ 401-509. there has been, through the years, a lively discussion in the literature over whether the transfer tax system should be retained or eliminated or replaced. see, e.g., george cooper. a voluntary tax? new perspectives on sophisticated estate tax avoidance, 1977 colum. l. rev. (1977); joel c. dobris, a brief for the abolition of all transfer taxes. 35 syracuse l rev. 1215 (1984); joseph m. dodge, beyond estate and gift tax reform: including gifts and bequests in income, 91 harv. l. rev. 1177 (1978), charles 0. galvin, to bury the estate tax, not to praise it, 52 tax notes 1413 (sept. 16, 1991); michael j. graetz, to praise the estate tax, not to bury it, 93 yale l. j. 259 (1983); harry l. gutman, reforming federal wealth transfer taxes after erta, 69 va. l. rev. 1183 (1983): david m. hudson, tax 19931 florida tax review tax is imposed on the transfer of all property owned by an individual at death, and on other property as to which the decedent, either at death or within the three years preceding death, had certain types of control or from which the decedent benefited either at death or within the three years preceding death. 3 the tax is calculated on the basis of the fair market value of the property transferred determined as of the date of death or, in some circumstances, as of the date six months after death.' 4 the estate tax applies only to persons who make cumulative transfers, during life and at death, in excess of $600,000.5 the maximum estate tax policy and the federal taxation of the transfer of wealth, 19 willamette l. rev. 1 (1983); thomas a. robinson, the federal wealth transfer taxes-a requiem?, 1 am. j. tax policy 25 (1982); g.p. verbit, do estate and gift taxes affect wealth distribution?, 117 tr. & est. 598 (1978). this article assumes that the federal transfer tax system will be retained, without judging whether it should be. 13. irc §§ 2001(a), 2031, 2033-2045, 2051. section 2001(a) directs that the tax be imposed on the "taxable estate of every decedent who is a citizen or resident of the united states." the taxable estate is defined in section 2051 as the "gross estate" minus deductions that are allowed by sections 2053-56. the gross estate includes the decedent's probate estate. irc § 2033. in general, it also includes property of which the decedent made a gratuitous or partially gratuitous transfer during life and: (i) retained for his life the possession, enjoyment of, or the right to income from the property, or the right to designate the persons who shall possess or enjoy the property or the income therefrom (irc § 2036); (ii) where possession or enjoyment of the property can be obtained only by surviving the decedent and the decedent has a reversionary interest which, immediately before death, exceeds 5% of the value of the property (irc § 2037); or (iii) where the enjoyment of the property was at the decedent's death subject to a power held by the decedent to alter, amend, revoke or terminate (irc § 2038). the major additional categories of property includable in the gross estate are: annuities that were payable to the decedent and which become payable to another at the decedent's death (irc § 2039); the decedent's interest in joint tenancies with right of survivorship or tenancies by the entirety (irc § 2040); property which the decedent had the power to appoint to himself, his estate, his creditors or the creditors of his estate (irc § 204 1); life insurance on the decedent's life over which the decedent had any incident of ownership or which is payable to the decedent's executor (irc § 2042); and property in which a surviving spouse has certain rights and as to which the estate of the first dying spouse was permitted a deduction (irc § 2044). a detailed discussion of each of these provisions is beyond the scope of this article. the interested reader should consult stephens, et al. supra note 3, at 4.08. 14. irc §§ 2031, 2032. as with the gift tax system, the "willing buyer, willing seller" test is used to determine fair market value. see supra note 2; regs. § 20.2031-1(b). 15. irc §§ 2001, 2010. section 2010 provides every citizen or resident of the united states who is subject to the estate tax a credit of $192,800, against the estate tax. under the current rate schedule that credit is sufficient to offset estate tax on property worth up to $600,000. the original estate tax affected persons with estates (net of certain expenses) of $50,000 or more. revenue act of 1916, pub. l. no. 64-271, § 203, 39 stat. 756. there [vol 1:7 should we give away the annual erclusion? rate currently is fifty percent. 6 there is an additional five percent tax, imposed on the portion of an estate between $10 million and $18.34 million, which operates to deny large estates the benefit of both (i) a s192,800 credit against transfer tax available to all other taxpayers, and (ii) the lower estate tax rate brackets applicable to the first $2.5 million in an estate. 7 the potential impact of the estate tax on those to whom it applies has increased because it has been supplemented by the other two elements of the transfer tax system: (i) the federal gift tax, enacted in 1932, which applies to lifetime gratuitous transfers of property; 8 and (ii) the generation skipping transfer tax, enacted in 1986, which applies to transfers benefiting more than one generation of a family. 9 as is discussed below, each of these other transfer taxes makes it more difficult to avoid transfer tax. the potential bite of the transfer tax on transfers of substantial amounts of wealth, and particularly on multigenerational transfers, is fearsome. amounts in excess of $600,000 which do not qualify for any exception are subjected to tax at a rate of thirty-seven percent and the rate increases to fifty percent for taxable transfers over $2.5 million.20 accordingly, the rate of tax imposed on those estates that actually incur it is immediately substantial and can be as much as one-half of the aggregate property. when imposed in conjunction with the generation-skipping transfer tax (discussed below), the rates can reach seventy-five percent.-' this makes have recently been proposals introduced in congress both to reduce and to increase the unified credit. h.r. 1110, 103d cong., 2d sess. (1993); s. 531, 103d cong., 1st sess. (1993); h.r. 4848, 102d cong., 2d sess. (1992). 16. irc § 2001(c)(1). originally, the maximum rate was 10% in 1916 and climbed to 77% at the time the 1954 code was adopted. revenue act of 1916. § 201. irc § 2001 (1954). see discussion supra note 3. 17. irc § 2001(c)(3). this five percent rate applies to amounts in taxable estates between $10,000,000 and $18,340,000. it was adopted as a part of the omnibus budget reconciliation act of 1987, pub. l. no. 100-203. §10401(b)(l) (1987). according to h.r. rep. no. 100-391, 100th cong., 1st sess. 1040 (1987). the purpose of adopting this surtax was to retain the benefits of the graduated rates and the unified credit for smaller estates, while continuing the effectiveness of the estate tax system in its role of maintaining the progressivity of the overall federal tax structure. 18. see infra part 11 b. 19. see infra part ih c. 20. a $192,800 credit available to all taxpayers offsets lax that would otherwise be due on s600,000. irc §§ 2001(c), 2010. once the credit is used up. the first dollar of the taxable estate over $600,000 is taxed at 37% and the rates increase to a maximum of 50% for taxable estates over $2,500,000. irc § 2001(c). 21. the generation-skipping transfer tax can be a flat 50%. irc §§ 2001(c). 2641. with respect to some types of transfers that are ultimately subject to the generation-skipping tax, the estate tax is paid on the property and the full amount of property that remains after estate tax is paid is subjected to generation-skipping tax as well. irc §§ 2611, 2612(a), 2622(a). for example, assume a bequest of s1.000,000 into trust is subject to a 50% estate tax 19931 florida tax review avoidance of estate tax a highly desirable goal for those with considerable amounts of wealth. 2. major exceptions.-there are four significant exceptions to the estate tax. first, testamentary transfers of property to the transferor's surviving spouse, or to certain types of trusts for the lifetime benefit of the surviving spouse, are free of estate tax.22 this is referred to as the "marital deduction., 23 however, property transferred under the marital deduction is ultimately subject to estate tax when the surviving spouse dies, assuming it is not consumed by the survivor.24 thus, the marital deduction defers the (because the taxpayer has already fully used his unified credit and lower estate tax brackets), and that the remaining $500,000 is held in trust for the benefit of the transferor's child for the child's life, remainder to the transferor's grandchild. when the child dies, if the entire trust is subject to generation-skipping tax and the trust assets are still worth $500,000, the $500,000 is taxed again at 50%, leaving $250,000 in the hands of the grandchild. the total transfer tax payment ($500,000 estate tax and $250,000 generation-skipping tax) is 75% of the original $1,000,000 bequest. 22. irc §§ 2056, 2056a. section 2056(a) generally permits a deduction from the gross estate for any amount that passes from the decedent to the decedent's surviving spouse in accordance with the terms of section 2056(c). this deduction is available for amounts passing to the surviving spouse outright or in one of three types of trusts, the terms of which are governed by section 2056(b). section 2056(d) disallows the deduction where the decedent's surviving spouse is not a citizen of the united states out of concern that the property will be removed from the united states by the surviving noncitizen spouse and hence will forever escape estate tax. nonetheless, under section 2056(d)(2), it is possible for a decedent with a surviving noncitizen spouse to defer estate tax on property placed in a trust for the benefit of the surviving noncitizen spouse if the trust satisfies the requirements of section 2056a. the primary requirement is that at least one trustee be an individual citizen of the united states or a domestic corporation. that trustee is responsible for collecting any estate tax ultimately due. 23. this is the term used in the heading to section 2056(a). 24. this is the trade-off imposed for granting the marital deduction. the unlimited marital deduction allowed by current law has its roots in a policy which favors permitting both spouses in a couple to be able to benefit from all the property that both have accumulated, rather than requiring any estate tax to be paid at the death of the first to die. staff of joint comm. on taxation, general explanation of the economic recovery tax act of 1981, at 23134, reprinted in internal revenue acts 1980-1981, 1369 at 1602-05 (west 1982). thus, for these purposes a married couple is considered a single unit. when the surviving member of the couple dies, there is no further reason to delay imposition of the tax. all of the methods by which property can be qualified for the marital deduction when passed from the first spouse to die to the survivor ensure that the property will be included in the estate of the survivor. obviously, if the first-to-die leaves property to the survivor outright, it will be in the survivor's estate to the extent not consumed nor given away under section 2033. of the types of trusts that can be used to take advantage of the marital deduction, one requires that the property in the trust be paid to the survivor's estate, regs. § 20.2056(e)-2(b)(1), ex. (iii); there is a special statute, section 2044, which specifically includes the property from a second type of marital deduction trust in the survivor's estate; and the third type of marital deduction trust must give [vol 1:7 should we give away the amiual e-rclusion? estate taxation of property, but it does not allow avoidance of estate tax. second, testamentary transfers for charitable purposes are free from federal estate tax.25 however, the property which escapes tax under this exception is usually paid to charity and is not available to the transferor's family or to other individual beneficiaries. 6 hence, the family wealth is reduced by such transfers. a third major exception to the application of the estate tax under current law is the unified credit-a $192,800 credit provided to all taxpaythe survivor a general power of appointment over the trust property, which ensures its inclusion in the survivor's estate under section 2041. 25. section 2055 permits an unlimited deduction for estate tax purposes for amounts passing from a decedent to charity. 26. obviously, outright transfers to charity remove the property for which the deduction is granted from the beneficial enjoyment of the decedent's family or other beneficiaries. section 2055(e)(2) also permits an estate tax deduction for so called "split interest" trusts, which are trusts that can benefit charity and private persons. generally, such trusts must be in a form that either: (i) pays an annuity to a charity, with remainder to private persons; (ii) vice versa; (iii) pays a "unitrust" amount (a fixed percentage of the value of the trust assets with the value redetermined annually) to a charity, with remainder to private persons; or (iv) vice versa. hence, the decedent can benefit charity and his family from the same property. with respect to a split-interest trust that pays an annuity to charity, the deduction is granted only for the present value of the annuity, and that value is in fact removed from the decedent's individual beneficiaries as it is paid. irc § 2055(a), (c). if, in the alternative, the remainder passes to charity, the deduction is granted only for the present value of the remainder. id. accordingly, other than to the degree the interest rate assumption used in calculating the present value of the annuity or remainder turns out to be an incorrect estimate of what rates will be during the period involved, the value for which a deduction is granted is also removed from the decedent's beneficiaries other than charity. it should be noted that it is possible for the decedent's individual beneficiaries to have a substantial voice in how the wealth passing to charity is used. for example, through a combination of sections 501(c)(3) and 2055 it is possible for a decedent to establish a private foundation in the form of a trust or corporation and name family members as the trustees or directors. although such foundations are subject to numerous restrictions (see irc §§ 49404946), the decedent's nominees, if they serve, can decide what causes, and therefore, to some extent, what persons, ultimately benefit from the decedent's largesse. it is also possible for the decedent's individual beneficiaries, in their capacity as trustees or directors, to receive compensation for services actually rendered in administering the property for charity. a private foundation, like any other charitable entity. may pay its ordinary and necessary expenses of operation without losing its exempt status. irc §§ 4940(c)(3), 4941 (d)(2)(e); regs. § 53.4940-1 (e)(1). reasonable compensation of officers is an ordinary and necessary expense of operation. id.; bruce g. hopkins, the law of tax exempt organizations, 217-19 (4th ed. 1983). such persons may even benefit in various limited ways directly from the property that produces the wealth that goes to charity. this would occur where one or more of the decedent's individual beneficiaries receive the annuity, unitrust payment or remainder from a split-interest trust. 19931 florida tax review ers. 2 like all credits, it applies to reduce the tax due dollar for dollar. it thus reduces any estate tax due to the extent it has not been consumed through lifetime transfers. 28 based on the present estate tax rate tables, the credit of $192,800 permits $600,000 worth of property to be transferred at death without estate tax.29 one function of the credit is to remove most individuals from the reach of the estate tax and to permit all of their property to pass free of estate tax.3" with proper planning, each spouse in a married couple can utilize his or her unified credit and thus pass to their beneficiaries $1.2 million worth of property and not incur estate tax.31 as noted above, an add on rate of five percent is applied to estates over $10 million, which serves to phase out the benefit of the credit.32 the fourth method of reducing or avoiding estate tax is to make a gift of property. while the gift may be subject to gift tax, that tax is imposed on 27. irc § 2010. 28. see infra note 51 and accompanying text. 29. the current estate tax rate schedule provides that taxable estates over $500,000 and not over $750,000 owe estate tax of $155,800 plus 37% of the excess over $500,000. a $192,800 credit would thus fully protect $500,000 from tax, with $37,000 of credit left. a $37,000 credit at a 37% rate protects another $100,000 from tax for a total of $600,000. irc §§ 2001, 2010. 30. s. rep. no. 144, 97th cong., 1st sess. 124 (1981), reprinted in 1981 u.s.c.c.a.n. 226; staff of joint comm. on taxation, general explanation of the economic recovery tax act of 1981, at 227, reprinted in internal revenue acts of 1980-1981, 1369 at 1598 (west 1982). 31. since each taxpayer is automatically provided the credit, each member of a married couple can pass $600,000 of property without estate tax consequences. this does take some planning, since the unified credit only operates on tax due on property in the taxpayer's taxable estate. if h and w are married and w has $1,200,000 of property and h none, and h dies first, h's unified credit is wasted because there is no tax due against which to apply his credit. when w dies, her unified credit will protect one-half of her property from estate tax, but the other one-half will be taxed. alternatively, if h and w each have $600,000, then each could make use of the credit and protect $1,200,000 from tax. if the survivor needs the benefit of the $600,000 held by the first to die, then the first to die can, at death, leave his or her $600,000 in a trust which can benefit the survivor but is not included in the survivor's gross estate for estate tax purposes. hence, the $600,000 held by the first to die passes free of tax at his or her death because of the unified credit, and is not taxed at the survivor's death because it is not included in the survivor's gross estate. the $600,000 held by the survivor will pass free of tax at the survivor's death under the survivor's own unified credit. hence, the couple can pass $1,200,000 free of tax. note that in order to use the unified credit, the property of the first to die must not qualify for the marital deduction. that is because deductible amounts are not included in the taxable estate (irc § 2051) and thus give rise to no estate tax against which the credit can be applied. for criticism of the complexity the existing system engenders, and a suggestion that the system be altered to allow the credit of the first to die to be passed to the surviving spouse, see robert b. smith, unifying the unified credit, 39 fla. l. rev. 1153 (1987). 32. see supra note 17 and accompanying text. [vol 1:7 sluld we give away the annual exclusion? the value of the gift at the time of the transfer. if the property that is the subject of the gift appreciates after the date of the gift, the appreciation is subject to neither gift tax nor estate tax vis-a-vis the donor. accordingly, a gift under the annual exclusion is an especially attractive way to avoid estate tax because it incurs no gift tax, uses none of the donor's unified credit, and, if the annual exclusion gift appreciates, the appreciation also escapes gift and estate tax. gift tax is also calculated in a way different than estate tax, and in some instances this difference makes it advantageous to make a taxable gift rather than hold the property until death.3 b. the federal gift tax 1. 1932 to 1977.-when the federal estate tax was first introduced in 1916, no federal tax on gratuitous lifetime transfers was enacted with it.3" presumably, it did not take long for advisors to those subject to the new estate tax to urge their clients to make lifetime gifts of substantial amounts of property. since lifetime gifts were not subject to any federal transfer tax and property owned at death was subject to such a tax, gifts were an easy way to reduce the federal estate tax liability. between 1916 and 1932 a couple of interim measures were used in an effort to limit the use of gifts as an estate tax avoidance technique, but neither proved workable." in 1932, congress finally decided to narrow this estate tax escape hatch with a comprehensive set of provisions, the federal gift tax!' the principal purpose of the federal gift tax is to "back-up" the estate tax and prevent the avoidance of estate tax by lifetime transfers." like the estate tax, the federal gift tax is an excise tax on the transfer of property." 33. see infra notes 56-58 and accompanying text. 34. revenue act of 1916. §§ 200-212; revenue act of 1924. §§ 319-324. 43 stat. 253 at 313-16; stephens, et al. supra note 3. 35. in sections 319 through 324 of the revenue act of 1924 congress adopted a gift tax, which was repealed in section 1200 the revenue act of 1926. in the same act, congress adopted a conclusive presumption that gifts made within two years of death were made in contemplation of death and should thus be included in the donor's estate. large gifts made shortly before death so as to avoid the estate tax were thus dealt with by making them subject to the estate tax. revenue act of 1926. § 302(c). however, the conclusive presumption of contemplation of death was held unconstitutional in heiner v. donnan, 285 u.s. 312(1932). 36. revenue act of 1932, §§ 501-31. currently, the gift tax is found in sections 2501-2524. 37. stephens, et al. supra note 3. 38. irc § 2501; branley v. mccaughn. 280 u.s. 124 (1929) (holding the 1924 gift tax, imposed on the transfer of property, to be constitutional as an excise tax, rather than a direct tax which the constitution requires be apportioned among the states in proportion to their population). current law, like the 1924 provisions, provides for imposition of the tax upon the "transfer" of the property, not the property itself or even the ownership of the 1993] florida tax review its purpose suggests, of course, that the gift tax and estate tax should be so integrated that the use of a lifetime gift to transfer property does not provide any transfer tax savings as compared to a testamentary transfer of the same amount.39 accordingly, all gratuitous transfers by one donor should be aggregated and taxed under a single set of rates.4n the transfers may be made at different times during the course of the donor's life and at death, but the total tax collected on the aggregate transfers should be the same as if all the transfers were made at one time and the tax collected then. consistent with this notion, from its inception in 1932, the federal gift tax has required that the tax due on any gift be calculated on an aggregate basis. 4' this is accomplished by aggregating all prior taxable gifts made by the same donor with any current taxable gift, calculating the gift tax due on the total, and reducing the amount so determined by the tax that would have been paid on the previous gifts using the existing rate schedule.42 notwithstanding the central purpose of having both a gift and estate tax, the gift tax as originally enacted, and for nearly forty-five years thereafter, had its own rate structure which was separate from the estate tax rate structure and under which each rate applicable to a taxable gift amount was lower than the corresponding estate tax rate on the same amount passing at death.4 3 further, from 1932 until 1977, lifetime gifts were not taken into property, and thus is an excise tax. 39. if there is to be a tax upon both lifetime and testamentary transfers of property, there is no obvious reason to make the tax on one type of transfer higher or lower than on the other type. to do so would obviously create an incentive to make the type of transfer that is taxed at a lower effective rate. see, e.g., h.r. rep. no. 1380, 94th cong., 2nd sess., 10-15 (1976), reprinted in 1976-3 c.b. 744-49. 40. if transfers made during life and at death are taxed at different rates, the incentive referred to in note 39 will exist. if transfers made during life and at death are taxed at the same rates, but are not taxed cumulatively, then making lifetime gifts and testamentary transfers would enable the transferor to make use of at least the lower rate brackets applicable to each type of transfer, which is itself an incentive to make gifts as well as testamentary transfers. for example, if both types of transfers had separate, identical brackets of 10%, 20%, 30%, 40% and 50%, then it would make sense for a wealthy person to make lifetime gifts sufficient to get to the 50% level, so as to be certain to have used the brackets under 50%. at death, his or her estate would get to use the 10-50% brackets of the separate estate tax again. this opportunity to use lower rates tvice is avoided if all transfers are taxed cumulatively under one rate structure. hence, if at death the taxpayer's estate is "stacked" on top of lifetime gifts the same taxpayer made, and a single rate structure is used, the estate is boosted into the higher brackets and the dual use of lower brackets is avoided. 41. revenue act of 1932, § 502; irc § 2502(a), (b). 42. irc § 2501(a)(1), (2). 43. compare section 401 with section 502 of the revenue act of 1932. also compare the rates set forth in sections 2001 (estate tax) with those set forth in section 2502 (gift tax) of the internal revenue code of 1954, as amended through 1976. [vol. 1:7 should we give away the annual erchsion? account in determining the tax rate applicable to testamentary transfers.' 2. 1976 tax reform act changes.-in the tax reform act of 1976, congress took several steps to integrate the estate and gift tax systems. first, it repealed the separate estate and gift tax rates and adopted a single set of rates to be imposed on all taxable gifts and testamentary transfers." second, it ordained that the value of all taxable lifetime gifts made by an individual after 1976 should be taken into account in determining the transfer tax rate applicable to the same person's estate at death.46 thus, under the post-1976 system, all of an individual's taxable lifetime gifts (except for those made before the change in the law) are added to the value of the property that the individual transfers at his death in order to determine the rate of tax applicable to the property transferred at death.47 the major reason stated for making these changes was vertical equity.48 under the pre-1976 act rules, very wealthy individuals could afford to make large lifetime gifts and take advantage of the lower gift tax rates. however, other individuals who would incur estate tax at death, but who could not afford to make large gifts, were forced to incur the higher estate tax rates on their property. 3. exceptions to the application of the gift tax.-because the 1976 amendments impose the same tax rates on testamentary and lifetime transfers, gifts can also now be taxed at rates of up to fifty percent.4 hence, avoiding 44. thus, for example, from 1932 through 1976. a s250.000 lifetime gift was taxed at a lower rate than a testamentary transfer of s250,000. further, if the person making the $250,000 gift died still owning $500,000 worth of property, the prior transfer of s250,000 was not taken into account in determining the estate tax rate applicable to the $500,000. 45. tax reform act of 1976, § 2001(a)(1), 90 stat. 1846. 46. id. 47. for example, in footnote 44 above, assume that an individual makes total lifetime taxable gifts after 1976 of $250,000 and dies with $500,000 in his estate. after the 1976 amendments, only one set of tax rates apply to both transfers. irc §§ 2001(c), 2502. further, to determine the tax on the $500,000 testamentary transfer, the $250,000 worth of taxable gifts is added to the $500,000 and the amount of tax due on a $750,000 transfer is determined. irc § 2001(b)(l)(a), (b). from the tax due on $750,000. the tax that would currently be paid on a $250,000 transfer is subtracted, thus effectively crediting the taxpayer for the gift tax paid. irc § 2001 (b)(2). the difference is the tax presently due on the $500,000 transfer. thus, all gratuitous transfers are taxed cumulatively. this approach more closely approximates a system under which the transfer tax due on any transfer is the same, whether the transfer is made during lifetime or at death. 48. h.r. rep. no. 94-1380, 94th cong., 2d sess. 10-15, reprinted in 1976-3 c.b. 744-49. 49. irc § 2502(a) (requiring the estate tax rate table set forth at section 2001(c) be used to make gift tax calculations). 19931 florida tax review gift tax on lifetime transfers can be very desirable. there are several exceptions to the gift tax which correspond to the exceptions to estate tax discussed above and which can be used to avoid or postpone transfer tax. gifts to charity are not subject to gift tax, gifts to spouses or into certain types of trusts for spouses are not subject to gift tax, and the first $192,800 of gift tax due is offset by the unified credit.5 thus, due to the unified credit, an individual may make taxable gifts of $600,000 without paying any tax out-of-pocket. if the credit is used to offset tax due on lifetime transfers, it will not be available to reduce estate taxes due at death.5 in addition to these exceptions, which are similar to the exceptions to the estate tax, amounts paid on behalf of any other person as tuition to educational institutions that meet certain criteria (meant to ensure that the institutions are bona fide) are not subject to gift tax.52 neither are amounts paid to a medical care provider for the medical care of any other person.53 finally, there is the annual exclusion from gift tax. under the annual exclusion, an individual may make annual gifts of property to any number of 50. irc §§ 2522 (allowing a deduction in computing taxable gifts for the amount given to charity), 2523 (allowing a deduction for transfers to donor's spouse), 2505 (allowing $192,800 credit against gift tax due reduced by amount of credit previously used). 51. irc § 2001(b). it is not immediately obvious how the calculation required by this section reduces the unified credit available to the decedent's estate if lifetime use of the credit has been made. it does so by requiring that an amount equal to all of a decedent's post1976 taxable gifts be added to the decedent's taxable estate for purposes of calculating the estate tax. while gifts covered by the $192,800 unified credit do not cause tax to be paid outof-pocket, they are, nonetheless, taxable as defined in section 2503, and, thus, are added to the taxable estate. any credit used during life is restored to the decedent's estate and a credit is provided for any out-of-pocket gift tax paid. however, because the prior taxable gifts are added back, these siphon off the benefit of any credit used during lifetime and any gift tax paid. the net result is that the decedent's taxable estate is boosted into higher brackets. 52. irc § 2503(e)(2)(a). 53. irc § 2503(e)(2)(b). the payments must be for medical care as defined in section 213(d)(1), which states: (1) the term "medical care" means amounts paid(a) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body, (b) for transportation primarily for and essential to medical care referred to in subparagraph (a), or (c) for insurance (including amounts paid as premium under part b of title xviii of the social security act, relating to supplementary medical insurance for the aged) covering medical care referred to in subparagraphs (a) and (b). in addition, lodging while away from home primarily for and essential to medical care is also within the medical care definition, if the care is provided by a physician in a licensed hospital or the equivalent thereof, but the amount is limited to $50 per night. irc § 213(d)(2). prescribed drugs are also within the definition. irc § 213(b), (d)(3). cosmetic surgery is not within the definition. irc § 213(d)(9). [vol 1:7 should we give away the atumal erclusion? persons of up to $10,000 each without incurring any gift tax, so long as the gift is not a gift of a future interest in property.' 4. inportant continuing advantages of making gifts, including use of the annual exclusion.-despite the significant 1976 changes, there are still three important advantages to making lifetime gifts rather than testamentary transfers. a. renoval of appreciation from the donor's estate.-as noted above, the transferor is not subject to transfer tax on any appreciation that occurs with respect to the transferred property after the date of the gift. 55 if the same property were held until death, any such appreciation would be subject to estate tax. b. gift tax is calculated on a tax echsive basis.-second, although the estate and gift tax systems now use the same rates to calculate the amount of tax due, the method of making the calculation differs in a way that favors lifetime gifts. when an individual dies, all of his property is subject to estate tax, including the assets used to pay the estate tax." however, gift tax is imposed only on the amount given away by the transferor. the payment of gift tax by the transferor is not viewed as an additional gift, but rather the satisfaction of a legal obligation." thus, the dollars used to pay gift tax are generally not subject to gift or estate tax. s 54. irc § 2503(b). 55. the estate tax generally applies to property in which the decedent has some interest or over which he has some control at death. irc §§ 2031-2044. property the decedent gave away absolutely during life is thus not included in the decedent's estate. see irc § 2031; regs. § 20.2031-1. while an amount equal to any post-1976 taxable gifts is added to the taxable estate, any unified credit used or gift tax paid is effectively used to offset the tax caused by this inclusion. see discussion supra note 51. there are a few types of property interests which, if given away within three years prior to the decedent's death, are brought back into a decedent's estate at date of death values, but these are exceptions. irc § 2035(d)(2). 56. the estate tax is imposed on the decedent's taxable estate. irc § 200 1(bl 1(4). in calculating the estate tax due, no deduction from the gross estate is granted for the payment of estate tax. cf., irc §§ 2051-2056a (listing all deductions permitted for estate tax purposes and not granting any deduction for federal estate tax paid). 57. irc § 2502(c). 58. there is an exception to this rule only where the donor dies within three years after making the gift. irc § 2035(c). in that situation, the gift tax the donor paid is included in his estate and is subject to estate tax. id. unless this exception applies, however, paying gift tax on a specific amount is less burdensome than paying estate tax thereon. to illustrate, assume an individual wants to transfer si million to his children. further assume that the estate and gift tax rate on all gratuitous transfers is a flat 50%. if the 1993] florida tax review c. the annual exclusion.-the third major advantage to making lifetime gifts is the use of the annual exclusion. because the exclusion is calculated on a per year, per donee basis, an individual who has the resources can transfer substantial amounts of wealth under the exclusion. for example, if the individual has nine donees, the individual can give $10,000 to each donee each year, thus transferring a total of $90,000 a year. if the individual is married, the individual and the individual's spouse can each give $10,000 to each donee each year, for a combined gift of $20,000 per donee. if one of the two spouses has $20,000 to give away and the other has no property to give away, the one with the $20,000 can make the gift and the couple can treat the $20,000 gift as a $10,000 gift from each." transfers made under the annual exclusion are completely free of estate or gift tax consequences. with respect to an annual exclusion gift, no transfer tax is due, no unified credit is used, and the gift is not taken into account in determining the tax rate applicable to property transferred at death or to later gifts.60 while the fact that no tax is due on such gifts means annual exclusion gifts do not participate in the second advantage that can accrue to gifts (removal of gift tax paid from the donor's transfer tax base), they do participate fully in the first advantage (any post-gift appreciation is removed from the donor's transfer tax base). hence, if used regularly and fully, the annual exclusion can be a powerful tool for transferring substantial amounts of wealth. individual dies, he must leave $2 million to provide $1 million to the children. that is, on a $2 million estate with a 50% flat rate the estate tax due would be $1 million, leaving $1 million to pass to the children. if the individual gives $1 million to his children during his life, the gift tax due is only $500,000. (fifty percent of $1 million-this assumes the transferor does not die within three years after making the gift.) obviously, $500,000 less in total assets has been used to transfer $1 million to the children than was used in the estate tax situation, notwithstanding the facial identity of rates. there are, however, offsetting costs to making use of this advantage. first, the income that could be earned from the dollars used to pay the gift tax is lost to the donor from the date of the tax payment until the donor's death. second, the basis of property passing at death is adjusted to date of death values, reducing the chance that the beneficiaries will have any gain upon selling the property. irc § 1014. lifetime gifts get a more limited basis adjustment, generally being a portion of any gift tax paid. irc § 1015(d). 59. irc § 2513(a), (b). the election to treat a gift made by one donor as made onehalf by that donor and one-half by that donor's spouse is made annually and applies to all gifts made by either during the year. id. this process is hereinafter referred to as "gift splitting." 60. section 2503(b) directs that the first $10,000 of gifts made to any person by the donor in a year, which are not gifts of future interests, are to be excluded from the determination of the total amount of gifts made by the donor. [vol 1:7 should we give away the annual erclusion? c. the generation-skipping transfer tax the gift tax limits the opportunity to avoid estate tax through lifetime transfers, even though it does not eliminate it. but neither the gift tax nor the estate tax prevents the design of vehicles that permit property to escape the imposition of transfer tax at the deaths of the transferor's children and grandchildren. 61 besides outright gifts to grandchildren or great-grandchildren, if the gift and estate taxes were the only transfer taxes, this plan could be accomplished by placing property in trusts with terms that permitted the transferor's children and grandchildren to benefit from the property, but did not give the transferor's children or grandchildren any of the ownership or control rights that would cause the estate tax to apply to the trust property at their deaths.62 such trusts came to be known as generation-skipping trusts, because ownership of the property and the imposition of estate tax "skipped" one or more generations of the transferor's descendants. in 1976, congress enacted a tax on certain generation-skipping transfers.63 that tax was in effect until 1986 when it was repealed retroactively 4 and replaced with a new tax.6 under the current generation-skipping transfer tax ("gstt"), property held in trusts that benefit multiple generations may be subject to a flat fifty percent tax when distributed to a person more than one generation younger 61. for example, although the federal gift tax provisions apply to a gift to the donor's grandchild, or great-grandchildren, nothing in those provisions takes into account that the gift "skips" the intervening generations of the donor's descendants and thus is not subject to transfer tax in those generations' hands. note that the generation-skipping transfer tax applies regardless of family relation to anyone meeting the age disparity requirements of section 2651(d). 62. using a trust is advantageous in that it may permit the intervening generations to benefit from the property, may increase the number of generations skipped. and may even allow some or all of those generations to be given some control over the trust property. for example, if a trust were created by will for the benefit of the testator's child. then for the child's children, and remainder to the child's descendants living 21 years after the death of the child and all the descendants of the child living at the testator's death, the number of generations where estate tax is skipped would be as high as three, if the settlor had greatgrandchildren living at his death. if the testator so desired, he could name his child as trustee and permit the child to pay income and, if need be, principal to himself for his health. maintenance and support. generally, the power to appoint property to oneself is a general power of appointment (irc § 2041(b)(1)) which causes the property subject to the power to be included in the gross estate of the power holder. irc §2041 (a). however, powers to encroach which are limited to the health, maintenance and support of the power holder are not general powers. irc § 2041(b)(l)(a). 63. tax reform act of 1976, § 2006(a), formerly codified at irc §§ 2601-2622 (1976). 64. tax reform act of 1986, § 1433(c), 100 stat. 2731. 65. id. § 1431(a), codified at irc §§ 2601-2663. 19931 florida tax review than the grantor, or when all the beneficiaries of the trust who are only one generation younger than the grantor have died.66 this roughly approximates the effect of the trust property having been owned by each generation and subjected to estate tax when the members of that generation die.67 the tax is also imposed on any transfers which are made directly to a person who is more than one generation younger than the donor, or in trust for the benefit of only such persons.68 this approximates the result that the gift or estate tax would have caused had the property passed first to the generation immediately following the generation of the donor and then been passed again to the actual recipient. the tax on direct skips is in addition to any estate or gift tax due on the same transfer.69 there are three basic exceptions to the gstf: (i) each taxpayer is granted a $1 million exemption which the taxpayer can allocate to selected transfers7' or, if the taxpayer does not allocate it, it is allocated by statute;7 (ii) if the donor has a deceased child who left surviving children, the donor can make transfers to those grandchildren without incurring gstt on a "direct skip";72 and (iii) there is an exclusion which, to a limited extent, parallels the annual exclusion.73 the annual exclusion to gstt is also 66. irc §§ 2601,2611-2613, 2641(a)(1). in various circumstances, the property held by a trust may be wholly, partially or not at all subject to gstit. the portion of the trust property that is subject to gstr is taxed at a flat 50%. if less than all the trust property is subject to gstt, the effective rate measured on the whole trust property may be less than 50%. for example, if four-fifths of the trust property is subject to gstt, then that four-fifths is taxed at 50%, and the effective rate on the whole trust property is 40%. 67. the approximation is very rough, since the gstt makes no effort to take into account any unused unified credit or unused estate tax brackets available to the "skipped" generation. for example, suppose t dies leaving $1,000,000 in trust to pay income to t's child c for life, remainder to c's child gc at c's death. assume that all of the $1,000,000 is subject to gstt and that when c dies, c's own gross estate for estate tax purposes is only $250,000. c's unified credit would have protected an additional $350,000 from estate tax if c had owned that amount. c did not, so that credit is wasted. the gstt applies to the trust, so $500,000 of tax is due from the trust property. c's unused unified credit can not be used to offset any of this $500,000. further, c's estate tax bracket was 34%, but under the current gsti, the trust cannot use the brackets between 34% and 50%. 68. irc §§ 2612(c), 2613(a), 261 1(a)(3). such transfers are referred to as "direct skips." irc § 2612(c)(1). 69. where a direct skip occurs, the taxable amount for gsti purposes is the amount the transferee receives. irc § 2623. hence, if the transferred property is subject to estate tax, the gstt applies only to the net amount. the payment of the gstt by the transferor on a lifetime direct skip is considered an additional gift to the recipient of the direct skip and this additional gift is subject to gift tax. irc § 2515. 70. irc § 263 1(a). 71. irc § 2632. 72. irc § 2612(c)(2). 73. irc § 2642(c)(3)(a). [vol 1:7 should we give away the annual erclusion? $10,000 per donee. 74 however, it applies to a transfer in trust only if a single individual is the sole lifetime beneficiary of the trust, and, if the individual dies during the trust's existence, the trust terms cause the trust assets to be subject to estate tax as a part of the individual's estate."5 there are further exceptions to the gstt, analogous to those under the gift tax, for transfers that are made to educational institutions for tuition and payments to medical care providers.76 d. a brief perspective on the relationship of the annual exclusion to the federal transfer tax system as the foregoing demonstrates, the general purpose of the united states transfer tax system is to tax gratuitous transfers of property at rates up to fifty percent. the estate tax applies to testamentary transfers. the gift tax, which is intended to prevent those with substantial estates from escaping the effect of the estate tax by making lifetime gifts, applies to inter vivos transfers. the gstr serves as an approximate equivalent of an estate tax or gift tax on transfers that would otherwise not incur estate or gift tax at one or more generations below the transferor's generation. the estate tax was originally enacted for the purposes of preventing concentrations of wealth and generating revenue." the other two taxes, which back up the estate tax, must share in those purposes. through the years congress has made significant changes to the transfer tax system which have made its application more effective with respect to those with significant amounts of wealth and which have tended to make its avoidance more difficult.' the annual gift tax exclusion permits transfers of $10,000 or $20,000 per donee, and, as is illustrated below, often permits transfers of property 74. id. (incorporating by reference the definition of nontaxable gifts under section 2503(b), which sets the $10,000 limit). 75. irc § 2642(c)(2). 76. irc § 2642(c)(3)(b) (defining nontaxable gifts for gstt purposes, in part by reference to section 2503(e), which sets out the gift tax exclusion for tuition and medical care payments). 77. see supra note 12. 78. admittedly, with the adoption of the unified credit in the 1976 act and its increase under the economic recovery tax act of 1981, congress removed a lot of people from the transfer tax system by increasing from s60,000 to s600,000 the size of an estate that escapes tax entirely. further, the reduction in the maximum transfer tax rate from 77% in 1975 to 50% in 1993 represented a substantial reduction in the percentage of their wealth that wealthy taxpayers are forced to pay in transfer taxes. nonetheless, the adoption of the gift tax, its integration with the estate tax, the adoption of the gstt, the enactment of sections 27012704 (dealing with valuation of intra-family transfers for gift tax purposes) and the adoption of the five percent surtax on large estates, viewed in the aggregate, represent an indisputable tightening of the transfer tax system with respect to taxpayers encompassed by it. 19931 florida tax review with a realizable value likely to be greatly in excess of those stated limits. hence, it is a highly valuable opportunity to avoid the gift tax. because the gift property is no longer held by the transferor at death, it is not a part of his estate and thus also escapes estate tax at the transferor's generation so long as the gift is made to a member of a younger generation. accordingly, the annual exclusion is also an exception to the estate tax. further, if an annual exclusion gift also qualifies for the gstt annual exclusion, it is also an exception to gstt. thus, the annual gift tax exclusion should not be viewed as only a gift tax avoidance mechanism, but as a mechanism for avoiding all of the united states transfer taxes and it should be analyzed as such in light of congress' historical tightening of the transfer tax system. the next part of this article explores the historical reasons given for adoption of the annual exclusion, the revisions that have been made to it over the years, the technical requirements necessary for making use of it, the current uses being made of it, and the functions it serves as presently designed. these considerations set the stage for a discussion of problems with the annual exclusion, whether it should be modified and, if so, in what ways. ill. history of the annual exclusion, technical requirements and current uses a. historical development 1. the stated purpose of the annual exclusion.-an annual exclusion was included in the original 1932 enactment of the predecessor to the current gift tax.7 9 the legislative history of the provision reflects only that: a gift or gifts to any one person during the calendar year, if in the amount or of the value of $[5],000 or less, is not to be accounted for in determining the total amount of gifts of that or any subsequent calendar year.... such exemption, on the one hand, is to obviate the necessity of keeping an account of and reporting numerous small gifts, and, on the other, to fix the amount sufficiently large to cover in most cases wedding and christmas gifts and occasional gifts of relatively small amounts.8 0 79. revenue act of 1932, § 504(b). 80. s. rep. no. 665, 72d cong., 1st sess. 41 (1932), reprinted in 1939-1 (part 2) c.b. 496, 525-26. [vol 1:7 slwuld we give away the anutal erciusion? it is clear from this history that the purpose of the annual exclusion is to cover numerous small, normal gifts made annually within families and among friends, and occasional larger wedding and holiday gifts. the $5,000 level in 1932 was a generous exclusion, perhaps overly so for the stated purpose. plainly, however, the legislative history does not contemplate that the annual exclusion would permit an individual to make numerous gifts throughout the year to another individual on normal gift giving occasions and give afull $5,000 to the same donee. that is, taxpayers were not permitted to treat as nongifts presents given throughout the year on various occasions, such as birthdays, holidays, and weddings, so as to be able to treat the full $5,000 annual exclusion as an opportunity to transfer wealth. the $5,000 allowance was permitted for the period 1932-38. it was reduced for years 1939 through 1942 to $4,000,8' and then reduced again in 1942 to $3,000.82 the legislative history reflects that these reductions were effected because the $5,000 allowance was regarded as inducing donors to "build up estates of considerable size for the members of their families,"' and congress was aware that the exclusion enabled donors to distribute large amounts of property free of gift and estate tax.' the reductions in the amount of the exclusion indicate the hostility of congress to the use of the exclusion for such purposes. nonetheless, congress concluded that administrative difficulties would prevent the abolition of the exclusion and, thus, it was reduced but not eliminated.u from 1942 until the effective date of the economic recovery tax act of 1981 ("erta"), the exclusion remained at the level of s3,000. 6 erta, in a single step, increased the exclusion from $3,000 per donee, to $10,000 per donee.87 2. the erta changes.-erta was the first of the reagan era tax bills and it wrought large scale changes to the code. on the income tax side, it reduced ordinary income tax rates, reduced the capital gains tax rate, permitted the transfer of tax benefits between businesses, liberalized the 81. h.r. rep. no. 2330, 75th cong., 3d sess. 17 (1938). reprinted in 1939-1 (part 2) c.b. 817, 830. 82. h.r. rep. no. 2333, 77th cong., 1st sess. 37 (1942), reprinted in 1942-1 c.b. 372, 403. 83. h.r. rep. no. 1860, 75th cong., 3d sess. 61 (1938). reprinted in 1939-1 (part 2) c.b. 728, 772. 84. h.r. rep. no. 2333, supra note 82. 85. id. 86. see staff of joint comm. on taxation, supra note 30. at 273. reprinted in internal revenue acts 1980-81, 1369 at 1644 (west 1982). 87. economic recovery tax act of 1981, pub. l. no.97-24. § 441(a), 95 stat. 172, 319 [hereinafter erta]. 19931 florida tax review depreciation rules, and generally sought to reduce the tax load on americans and spur business activity. 8 erta also made substantial changes in the transfer tax system.89 the changes included the elimination of any dollar or percentage limits on the marital deduction, a near quadrupling of the unified credit, that ultimately increased the amount of property that could be left free of tax to $600,000, a reduction in the uppermost estate and gift tax rates, the aforementioned increase in the annual exclusion, and the addition of the provisions permitting payments for tuition and for medical care to be made free of any gift or estate tax consequences." the reasons given for most of these changes to the transfer tax system were generally persuasive. the marital deduction change was adopted for equitable reasons: to permit both spouses, including the longer living one, to be supported by all the property accumulated by both spouses, rather than having some property used to pay estate tax on the death of the first to die. 9' the increase in the credit was adopted in order to reduce the number of persons affected by the estate tax, leaving the tax intact with respect to those accumulating over $600,000 ($1.2 million for married couples), but eliminating it for most of the population, including many owning small businesses or family farms.9 the upper estate and gift tax rates were reduced on the basis of fairness-the seventy percent maximum in effect 88. see staff of joint comm. on taxation, supra note 30, at 5-7, 17, 20, 72, 98, reprinted in internal revenue acts 1980-81, 1369 at 1379-81, 1391, 1394, 1441, 1467 (west 1982). 89. prior to his election to the presidency, ronald reagan was several times reported to have favored the repeal of the transfer tax system. see, e.g., john m. berry, consensus; conflict over taxes, political in-fighting obscures vital differences in tax-cut proposals, wash. post, july 27, 1980, at f1; lou cannon, on showcase farm, reagan flails carter, wash. post, oct. 1, 1980, at a3; art pine, the tax cut proposal; tax cut in 1981 would help offset greater burden of taxation on january 1, wash. post, july 6, 1980, at ft. erta, while falling far short of repeal of the transfer tax system, substantially diminished the cost of that system for many wealthy taxpayers by increasing the amount exempt from tax from $175,625 to $600,000 (irc § 2505), reducing the maximum rate (over the course of several years) from 70% in 1981 to 50% in 1993 (irc § 2001), increasing the annual exclusion from $3,000 to $10,000 per year, per donee (irc § 2503(b)), and adopting the unlimited marital deduction (irc § 2523). the increases in the exempt amount and the annual exclusion prevent many people from ever incurring any estate or gift tax, although these changes did not relieve taxpayers of the burden of reporting gift transfers that do not qualify for the annual exclusion, or exceed it, but do not require any out-of-pocket gift tax payment due to availability of the credit. 90. erta, supra note 87, at §§ 401, 402, 403, 441(a), (b). 91. see staff of joint comm. on taxation, supra note 30, at 233, reprinted in internal revenue acts 1980-81, 1369 at 1604 (west 1982). 92. id. at 227, reprinted in internal revenue acts 1980-81, 1369 at 1598 (west 1982). [vol 1:7 should we give away the annual erclusion? prior to erta was deemed simply too large a share for government to take, even given the system's purpose of breaking up concentrations of wealth, because it could force sales of successful closely held and family businesses.93 the exclusion of medical care and tuition payments addressed concerns about paying for the medical care of the elderly and the college and graduate school education of young adults who were not legally entitled to support under state law.94 the increase in the annual exclusion came about with relatively little discussion. there was testimony on behalf of small business owners, from estate tax practitioners, and aba section of taxation representatives, which mentioned the reduced purchasing power of the dollar and the need to increase the annual exclusion to place it at a level where the purchasing power of a full annual exclusion gift was commensurate with the purchasing power of the annual exclusion when the $3,000 level had been adopted in 1942.' 5 there was also testimony to the effect that the $3,000 annual exclusion was insufficient to permit an individual to provide college or graduate education to a child at any number of private institutions, where the annual costs far exceeded the $3,000 level, without incurring gift tax liability. other testimony addressed the difficulty of providing financial assistance to elderly members of the family who needed aid not provided by medicare or social security, or younger (but not dependent) members of the family who needed aid not provided by medicaid. 96 of course, these problems were in part corrected by granting the tuition and medical care exclusions. the reasoning behind increasing the annual exclusion 333% and also excluding medical care and tuition payments from the gift tax system was not discussed. the testimony regarding the potential imposition of gift tax on educational and medical expenditures made for another's benefit followed a substantial history of proposals and articles urging that support type transfers be eliminated from the gift tax system.97 the general thrust of these proposals was to exclude from categorization as gifts intra-family transfers 93. h.r. rep. no. 201, 97th cong., 1st sess.. 156 (1981). reprinted in 1981-2 c.b. 376. 94. see staff of joint comm. on taxation, supra note 30, at 273. reprinted in internal revenue acts 1980-81, 1369 at 1644 (west 1982); hearings on s. 395 before the subcommittee on estate and gift taxation of the senate comm. on finance. 97th cong., 1st sess. 154 (1981) [hereinafter hearings] (statement of john a. wallace, chairman of the estate and gift tax comm., american college of probate counsel); id. at 174-75 (joint statement of harvie branscomb, jr. and john nolan, chairman and chairman-elect. section of taxation, american bar association). 95. see hearings, supra note 94. 96. see id. 97. id. at 212-13 (statement of john a. wallace, chairman of the estate and gift tax committee, american college of probate counsel). 19931 florida tax review made in the form of consumable items or used to acquire consumable items.98 congress failed to adopt these broad proposals both in the 1976 reforms and again in 1981. however, by enacting the provisions that permit a gift tax exclusion for tuition and medical care transfers, congress did address, in a limited way, some of the concerns underlying the earlier proposals regarding transfers for support. b. technical requirements section 2503(b) establishes only two technical requirements for use of the annual exclusion. the first requires that the gift, together with all other gifts to that donee in that year, not exceed $10,000 in value if the gifts are to be completely protected from gift tax by the annual exclusion.99 the second requirement is that the gift be of a "present interest" and not of a "future interest."'l the term "future interest" is not defined in the statute, but the regulations define it by reference to its legal meaning, stating that it "includes reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time." the regulations state that a present interest is: "an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain)....""' the fact that a person may have present legal rights with respect to an interest that will not become possessory until some point in the future will not convert that right to future possession into a present interest.'12 98. a.l.i., federal estate and gift taxation recommendations 19 (1969) [hereinafter ali proposal]; see infra part v b. 99. section 2503(b) states: "in the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of such gifts to such person shall not, for purposes of subsection (a), be included in the total amount of gifts made during such year." subsection (a) defines taxable gifts to mean the total gifts made during the year, less certain deductions available. 100. id. 101. regs. § 25.2503-1(b), 3(a). the second part of the quoted regulation acknowledges that the present value of a life estate, life income interest or term for years will qualify for the annual exclusion. this position has been questioned, since clearly most of the benefits to be received by a life tenant or a life income beneficiary will be received in the future, but it has been the position of the regulations for some years. stephens, et al. supra note 3, at i 9.04[3][a]. 102. see fondren v. commissioner, 324 u.s. 18, 20 (1945). the exclusion does not become operable just because the donee has vested rights. in addition, he must have the right presently to use, [vol. 1:7 should we give away the annual erclusion? 1. the impact of the present interest requiremient.-for a variety of reasons, donors often wish to transfer gifts they make to a trust for the benefit of the donee or donees, rather than to make the gifts outright. a transfer in trust may be preferred because the donee is a minor, the donor does not want the donee to obtain present control of the asset being transferred, the donor desires the ultimate benefit of the gift to pass to another, or the donor wants the trustee to be able to flexibly distribute the trusts benefits. 3 the present interest requirement can prevent many transfers into trust from qualifying for the annual exclusion, in whole or in part, because the trust beneficiaries have only future interests or some part of their interest is a future interest. for example, if the terms of a trust provide that all distributions of income or of corpus are in the trustee's discretion, no beneficiary of the trust will have a present unrestricted right to use, possession or enjoyment of the property transferred to the trust. thus, transfers to such a trust will not qualify for the annual exclusion. if the trustee must distribute all or some specified amount of the income to a beneficiary, the beneficiary does have an unrestricted right to enjoyment of that income and the present value of that income stream is a present interest, but other interests in the trust will not qualify for the annual exclusion. there are some transfers for the benefit of minors into trust, or into trust-like vehicles, that do qualify for the annual exclusion, so long as the property is made available to the minor at age twenty-one.104 possess or enjoy the property. these terms are not words of art, like "fee' in the law of seizin ... but connote the right to substantial present economic benefit. the question is of time, not when title vests, but when enjoyment begins. id. (emphasis added). 103. the reasons for entrusting property for the benefit of a minor are obvious. there are various methods to qualify transfers into trusts for minors for the annual exclusion, as discussed infra notes 104-10 and accompanying text. the reasons for transferring property in trust for an adult are less obvious, but plentiful. the adult may be a poor manager of property. alternatively, the adult may be a generally good manager of property, but perhaps took a business risk that turned out poorly and has creditors who would take the transferred property if it were given directly to the adult. the adult may be in poor health and need help managing the transferred property. the asset transferred may be stock of a closely-held business that the donor wants a hand-picked trustee, rather than one or more adult beneficiaries, to vote. the trust may be one used to avoid a generation-skipping transfer tax on the si million exempt amount (irc § 2631(a)) and so may provide for broad distribution authority among the transferor's descendants, yielding no present interest for any beneficiary. the potential reasons for creating a trust for an adult are thus numerous. 104. congress recognized the problem of qualifying transfers to the benefit of minors as a present interest and added section 2503(c) to the code in 1954. s. rep. no. 1622. 83d cong., 2d sess. 127 (1954). under it, a transfer in trust for a person under age 21 is not considered a future interest if the property and its income may be distributed for the benefit of the beneficiary before he attains age 21, and any amount not so expended is payable to the 19931 florida tax review while these methods can be helpful, none of them will be of use to a donor who does not desire to provide the donee a fixed income interest, to permit the donee to receive the property at age 21, or earlier, or to permit the donee to receive the property outright at any time. such a donor must either forego claiming the annual exclusion or rely on withdrawal rights which are discussed below. 2. withdrawal rights.-as a means of satisfying the present interest requirement in connection with transfers in trust, taxpayers' advisors developed plans which gave the trust beneficiaries withdrawal rights with respect to property transferred to the trust.0 5 the trust beneficiary or beneficiaries are granted a right, exercisable with respect to property transferred into the trust and for a limited period of time following the transfer, such as 30 days, to withdraw an amount equal to the lesser of: (i) a pro rata share of the property contributed to the trust; or (ii) the annual exclusion.' °6 such withdrawal rights give each beneficiary an unrestricted right, upon their demand, to use or enjoy the amount subject thereto." 7 beneficiary at age 21 or is subject to a general power if he dies before attaining age 21. irc § 2503(c); regs. § 25.2503-4. in addition, states have adopted statutes based on the uniform transfers to minors act and the uniform gifts to minors act. uniform transfers to minors act, prefatory note (langbein and waggoner, 1992). the minor for whose benefit a transfer is made under these provisions has the interest and rights in the property that satisfy the requirements of section 2503(c). rev. rul. 59-357, 1959-2 c.b. 212. accordingly, transfers to custodianships created under these acts qualify for the annual exclusion where the age at which the custodial property must be paid over to the beneficiary is age 21 or less. rev. rul. 73-287, 1973-2 c.b. 321 (acknowledging that section 2503(c) establishes the maximum limits that may be imposed on a transfer to a minor without making the transfer a future interest, and recognizing that requiring the transfer of property from a custodian to a beneficiary at age 18, rather than age 21, is consistent with section 2503(c)). 105. gilmore v. commissioner, 213 f.2d 520 (6th cir. 1954), is an early case dealing with withdrawal rights held by beneficiaries, indicating that practitioners early on made use of general powers in connection with use of the annual exclusion. 106. sometimes another limitation on the withdrawal right is added to coordinate with section 2514(e). under that section, the lapse of a withdrawal right would generally be considered a transfer by the person holding the right to the other beneficiaries of the trust involved. however, section 2514(e) states that the lapse of a withdrawal right will not be considered a transfer if the amount subject to withdrawal is no greater than $5,000 or five percent of the trust corpus. hence, if it is desirable to prevent the beneficiary with the withdrawal right from being treated as having made a gift transfer of the amount subject to withdrawal upon the lapse of the right, then the amount subject to withdrawal is limited to $5,000 or five percent of the trust corpus. 107. although exercisable only for 30 days, the right of a beneficiary to force the trustee to distribute the property to the beneficiary outright is a right to use or enjoy the property, the sine qua non of a present interest. fondren v. commissioner, 324 u.s. 18 (1945). plainly, however, by limiting the tight to 30 days, the donor of the property reduces the [vol 1:7 should we give away the annual erclusion? these rights were quickly recognized to be sufficient to make a transfer to a trust qualify as a gift of a present interest. after a number of court cases addressing the issue, culminating in crummey v. commissioner,t"s it also became clear that withdrawal rights granted to a minor beneficiary of a trust would convert the minor's interest to a present interest.' hence, the withdrawal right gives the beneficiary a present interest in property, even where the beneficiary is a minor and must depend upon the appointment of a guardian on his or her behalf to exercise the withdrawal right. withdrawal rights provided to contingent remainder beneficiaries have also been held to create a present interest, even though after the lapse of the withdrawal rights the remainder beneficiaries would almost certainly not directly benefit from the trust property." 0 opportunity the donee has to exercise it and probably reduces the likelihood of its use, since events that occur after the 30 days expire can not be taken into account by the donee in deciding whether to exercise the right or not and because the 30 day limit requires the donor to persuade the donee not to exercise the right for only a brief period. 108. 397 f.2d 82 (9th cir. 1968). 109. under crununey, the withdrawal right provides a present interest if, under the applicable state law, the minor, or someone on behalf of the minor, has the right to demand the property from the trustee and a guardian of the property of the minor can be appointed to receive the amount to be withdrawn. 397 f.2d at 87. the ninth circuit rejected the two other primary approaches that had been developed in other cases. id. at 88. one of these approaches treated the withdrawal right as providing a present interest if it were likely to be exercised in light of the totality of the circumstances. stifel v. commissioner. 197 f.2d 107 (2d cir. 1952). the other approach held that where any restrictions on the ability to exercise a withdrawal right were due to the disabilities of a minor the restrictions should be disregarded. kieckhefer v. commissioner, 189 f.2d 118 (7th cir. 1951). in revenue ruling 73-405, 1973-2 c.b. 321. the service announced that it would not raise the present interest issue in connection with a minor holding a withdrawal right where there is "no impediment under the trust or local law to the appointment of a guardian and the minor donee has a right to demand distribution." rev. rul. 73-405, 1973-2 c.b. 321. subsequently, the service has sought to place some additional limits on crununey rights (as such withdrawal rights have come to be known). in revenue ruling 81-7, the service asserted that a crununev right would not provide the beneficiary a present interest where the beneficiary had no knowledge of the right, or the amount of time in which the power could be exercised was unreasonably short, because such a right is illusory. the service also attacked withdrawal rights held by remainder beneficiaries. see infra note 110 and accompanying text. rev. rul. 81-7 1981-1 c.b. 474. for a detailed discussion of the analysis used in this area, see jeffrey g. sherman. "tis a gift to be simple: the need for a new definition of "future interest" for gift tax purposes, 55 u. cin. l rev. 585, 656 (1987). 110. estate of cristofani v. commissioner, 97 t.c. 74 (1991). acq. in result. 199--1 c.b. 1, action on decision, 1992-09 (mar. 23, 1992). the contingent remainder beneficiaries who held withdrawal rights were the donor's grandchildren. if the withdrawal rights were not exercised, none of the trust property would ever be distributed to the grandchildren, unless the donor's child who was the parent of the grandchildren happened to die before the donor, or within 120 days after the donor died. the service argued that the contingent remainder 19931 florida tax review 3. some limited observations on the consequences of recognizing that a withdrawal right gives the withdrawal right holder a present interest.-as was expressly recognized in crummey, withdrawal rights given to minors are not expected to be exercised."' it is probably true that most withdrawal right holders, whether minors or adults, are made aware that the donor would prefer that they not exercise their rights. while legally the holders can exercise such rights, generally they do not." 2 typically, the donor is a parent or grandparent and the donee is willing to honor the expressed preference. an obvious, though usually unstated, pressure to abide by the donor's preference is present because the donee is generally aware that the donor can provide or withhold many additional benefits and that compliance with the donor's preference may be a requisite to obtaining those additional benefits. thus, as a practical matter, a donor's preference that withdrawal rights not translate into current possession is normally realized. nonetheless, the granting of a withdrawal right to a trust beneficiary converts the beneficiary's interest in the amount subject to withdrawal into a present interest, thus permitting that amount to qualify for the annual beneficiaries did not have a present interest. the service asserted that the donor, the grandmother of the remainder beneficiaries, did not intend to provide any benefit to her grandchildren and provided them withdrawal rights only to obtain the benefit of the annual exclusion. the service pointed out that in crummey, the withdrawal right holders were the ultimate primary beneficiaries of the trust, and upon their failure to exercise their withdrawal rights they would still benefit from the trust assets. the tax court rejected the service's argument, finding that there was no understanding or agreement between the donor and her grandchildren that the grandchildren would not exercise their rights. the tax court concluded, on the basis of crummey and other authority, that because the withdrawal rights were legally enforceable, they created a present interest in the property. 111. 397 f.2d at 87-88; stephens, et al. supra note 3, at i 9.04[3]lf], n. 85. withdrawal rights are often granted to the beneficiaries of trusts that are designed to hold insurance on the life of the grantor. see infra part iii c 1 b. if the beneficiaries of such trusts exercised their withdrawal rights, in many such trusts the trustee would not have sufficient funds to pay the insurance premiums and keep the policy in force. 112. for the withdrawal rights to be effective, they must be enforceable. hence, if there were an agreement between the donor and the holders of the withdrawal rights that the rights would not be exercised, that would raise a substantial question as to the enforceability of the withdrawal rights. heyen v. commissioner, 945 f.2d 359 (10th cir. 1991); see cristofani, 97 t.c. at 77, 83; cf. regs. § 20.2036-1(a). section 2036 requires inclusion in a decedent's gross estate of property which the decedent transferred during lifetime for less than full and adequate consideration and with respect to which the decedent retained a life estate or other specified benefits or controls for the remainder of his life. under regulations section 20.2036-1(a), the decedent is treated as having retained "[a]n interest or right ... if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred." regs. § 20.2036-1(a). but the donor could express a preference that the withdrawal right not be exercised without seeking the beneficiary's agreement. [vol 1:7 should we give away the annual erclusion? exclusion. once the withdrawal right expires, usually thirty days after the transfer is made or the beneficiary is given notice of it, the property that had been subject to withdrawal remains in the trust and is governed by the trust terms the donor selected. because the donor can control how property transferred into trust is used by selecting the trustee and the trust terms, withdrawal rights encourage use of the annual exclusion to make transfers of property in a way that does not really give the donee control, or ultimately any benefit in many instances. c. current uses of the annual exclusion the annual exclusion is now used in several ways to avoid the federal transfer tax system. first, it can be used directly and regularly to make significant transfers of wealth, outright or in trust. the value of the annual exclusion is maximized under the commonly held view that annual exclusion gifts constitute a separate category of gifts, the size of which need not be diminished by normal family-type gifts made to the same donees within the same year. 1 4 second, through use of withdrawal rights, as described above, the exclusion permits highly leveraged gifts of life insurance in trust. 115 third, the annual exclusion also protects some transfers that are asserted to be for support, but which are not clearly outside the scope of the transfer tax system." 6 finally, the annual exclusion serves the function congress intended for it-the prevention of transfer tax consequences with respect to normal family, holiday and wedding gifts. 1. significant wealth transfers a. direct gifts.-by increasing the exclusion to $10,000/$20,000 a year, congress opened the door for persons with substantial wealth to make very large transfers over time while effectively avoiding gift, estate, and even generation-skipping transfer tax on those transfers. consider a family with three adult children; each child is married and has two children of his or her own. if the parents have sufficient wealth, each year they can transfer $240,000 to their children, the spouses of their children and their grandchildren. if the parents have a base of wealth sufficient to permit such transfers on a regular basis, it is virtually certain that 113. see infra part iii c 1 a. 114. see infra part iii c 1 c. 115. seeinfra part iii c l b. 116. see infra part iii c 2, 3. 19931 florida tax review the estate of the longest living parent would be taxable at fifty percent." 7 thus, each set of annual gifts permits the family to avoid $120,000 of transfer taxes." 8 the gifts to the grandchildren, totalling $120,000 a year, may also avoid gstt, thus saving another $60,000 in transfer taxes."19 note that over ten years' time, the parents can transfer twice as much as the unified credit would otherwise protect from tax without using up any portion of the unified credit.12 under the same example, those who have such large estates that congress has made the policy judgment to deny them the benefit of the unified credit by the imposition of the five percent add-on tax can use the annual exclusion to give away twice as much as the unified credit would permit with no transfer tax consequences at all.1 if the property given away under the annual exclusion is of a type that is subject to a valuation discount, such as a minority interest in a closelyheld business, the potential for transferring wealth becomes much greater. for example, assume an individual is the controlling shareholder in a familyowned corporation and makes gifts of minority interests in the stock of the business to each of his children each year. the value of those stock gifts may be substantially discounted in recognition of the fact that the shares given do not permit the donee to control the business and the difficulty of marketing a noncontrolling interest in a stock not traded on a regular exchange. 2 2 the tax court has recognized discounts of as much as fifty percent on certain 117. this rate is imposed on taxable transfers in excess of $2.5 million. irc § 2001(c). 118. .50 (estate tax rate) x $240,000 (amount of gifts) = $120,000. 119. the transfers to the grandchildren will avoid gstt if made outright. irc §§ 2642(c)(1), (3). however, if the transfers are in trust, they can avoid gst" only if various requirements are satisfied. irc § 2642(c). the six grandchildren would receive $20,000 each ($10,000 from each donor grandparent). since the gst" is imposed at a flat 50%, the gstt savings available is at least 50% of $120,000 or $60,000. in fact, since the payment of gstr by the donor of a direct skip is itself considered an additional gift by the donor under section 2515, the savings from avoiding gstt is possibly as much as $90,000 under these facts ($60,000 of gstt and $30,000 of gift tax). 120. the unified credit protects $600,000 of property from tax. see irc § 2016(a). therefore, a husband and wife who plan properly can pass $1.2 million free of federal transfer tax. ten years of split annual exclusion gifts to 12 people is $2.4 million, exactly twice as much. 121. as noted previously, section 2001(c)(3) imposes a five percent add-on tax to taxable transfers in excess of $10,000,000 and up to $18,340,000, which has the effect of eliminating the benefit of the unified credit and the lower estate tax brackets. however, the add-on tax would do nothing to reduce the benefit of the use of the annual exclusion. consequently, a large annual exclusion is highly inconsistent with the policy that gave rise to the five percent add-on tax. 122. rev. rul. 93-12, 1993-7 i.r.b. 13; stephens, et al. supra note 3, at i 10.02[2][c]. [vol 1:7 should we give asway the annual erclusion? types of closely-held business interests."m nonetheless, if the stock that was the subject of the gift is later sold as a part of a sale of the entire business by the family, the person who holds the gift stock will be able to realize the full value of the stock without regard to its minority status. accordingly, the value likely to be realized by the donee of such gifts legitimately valued at $10,000 at the time of the gift, can quickly become as much as $20,000, thus effectively doubling the benefit of the exclusion. b. use of withdrawal rights and life insurance to leverage the annual exclusion.-with the recognition that withdrawal rights qualify gifts into trust for the annual exclusion, the door was opened to allow the annual exclusion to be used even when the donor does not want to give the donee permanent control of the gift. withdrawal rights also permit the annual exclusion to be highly leveraged and to avoid gift tax, estate tax and gstt on very large amounts through the purchase of life insurance. the technique used is to make transfers into trust of money subject to withdrawal rights and thereby qualify the transfers for the annual exclusion.'24 the beneficiaries do not withdraw the money and the trustee uses it to purchase insurance on the donor's life. the terms of the trust may provide that the trust assets, including any insurance proceeds, will be used to benefit the donor's spouse and descendants. t2 so long as the amounts of cash placed in the trust qualify for the annual exclusion, there is no gift tax on these transfers. in addition, if the donor, who is the insured person, has no "incidents of ownership" with respect to the insurance, and the insurance is not payable to the insured's estate, the insurance proceeds will not be included in his or her gross estate for tax purposes. 26 if the trust terms do not require distribution of principal to the donor's spouse or children or provide the spouse or any child with a general power to appoint the property to themselves or their estates, the insurance proceeds received by the trust can also avoid estate tax in the estates of the donor's spouse and children.'27 if the donor allocates an 123. e.g., estate of andrews v. commissioner, 79 t.c. 938 & n.l. 942, 957 (1982). 124. see supra part iii b 2. 125. headrick v. commissioner, 93 t.c. 171. aff'd, 918 f.2d 1263 (6th cir. 1990); leder v. commissioner, 89 t.c. 235 (1987), aff'd, 893 f.2d 237 (10th cir. 1989). perry v. commissioner, 59 t.c.m. (cch) 65, t.c.m. (p-h) 1 90,123 (1990). affd, 927 f.2d 209 (5th cir. 1991). 126. cf. irc § 2042 (providing for inclusion where decedent possessed incident of ownership); see also cases cited in note 125. 127. section 2033 directs that a decedent's gross estate includes the value of all property to the extent of "the interest therein of the decedent at the time of his death." irc § 2033. if a decedent has only a life estate in property, or is a beneficiary of lifetime distributions from a trust, the extent of his interest at death becomes zero and nothing is 1993] florida tax review amount of his $1 million gst" exemption sufficient to cover the contributions of cash made to the trust to enable it to pay the insurance premiums, the insurance proceeds received by the trust can even pass to the donor's grandchildren without incurring gstt.'28 thus, for example, for the price of five or ten annual exclusions the donor might enable the trust to purchase life insurance with a face value of $1 million, $2 million or more, and the insurance proceeds can entirely escape transfer tax and income tax at the donor's generation. by using an amount of gstt exemption equal to the premium payments, the donor can also enable the insurance proceeds to escape transfer tax as it passes to the benefit of younger generations. c. supplemental gifts.-it seems virtually certain that the donors of full annual exclusion gifts do not neglect to give their children and grandchildren birthday gifts, holiday gifts, wedding presents and other gifts. this is not to suggest that the donors who can afford to make annual exclusion gifts necessarily intend to violate the law by making a full $10,000 gift and then also making normal birthday and holiday gifts. however, many probably do not consider birthday, holiday and wedding presents and other similar gifts made as something that the government would tax. that is, where the value of such normal and recurring gifts is within the range that persons of similar socioeconomic status give on such occasions, and the gifts are not of investment type assets, the donor may not view such transfers as gifts. rather the donor may view such gifts as a normal family activity which included. accordingly, if an insured person's spouse and children are made beneficiaries of the trust, but have no right to control or demand the trust principal, it will not be included in their estates for estate tax purposes. 128. an individual may allocate any portion of the $1 million exemption from gstr to any transfer. irc § 2631. thus, a portion of the exemption could be allocated to each transfer made to the trust to enable it to pay premiums. if all the property transferred to a trust is exempt from gstt, the appreciation that occurs with respect to that property is also exempt under subsections (a) and (b) of section 2642. under section 2642(a), the amount of a trust's assets subject to gstt is to be a ratio, which is determined by subtracting from i the "applicable fraction" for that trust. the applicable fraction is determined by using a numerator equal to the gsti" exemption allocated to the trust and a denominator equal to the value of the property transferred to the trust. hence, if the exemption allocated is equal to the value of the property transferred, the applicable fraction is 1, and this would make the inclusion ratio 1-1, or zero, meaning none of the trust property would be subject to gstt. section 2642(b) directs that if the gstt exemption is allocated to a gift on a timely filed gift tax return, the value of the transferred property for gsti exemption allocation purposes is its value for gift tax purposes, which is its value on the date of transfer. irc § 2512(a). under section 2642(b), if the exemption is allocated to property transferred at death, the gstt value of the property is its estate tax value, which is usually date of death value. irc §§ 2031, 2032. there are a few exceptions to the valuation rules of section 2642(b) in section 2642(f), but the exceptions would generally be inapplicable to an irrevocable life insurance trust. [vol 1:7 should we give away the annual exclusion? is so common and so unrelated to most taxable activities that there is nothing that suggests any tax event has occurred. gifts of relatively large amounts of investment assets on the other hand are more likely to cause the donor to consider whether such transfers have any tax consequences. if the taxpayer is told that there are tax consequences to transfers in excess of the annual exclusion, he or she might assume that the excess transfers referred to are transfers of investment assets. even the very reference to "annual exclusion" gifts suggests they are a separate category of gifts, rather than one that includes gifts made upon recurring occasions and big events, like weddings. accordingly, it seems highly probable that many donors who take advantage of the annual exclusion to permit the transfer of family wealth, simultaneously make normal, recurring gifts. this activity is, of course, clearly inconsistent with the legislative history regarding the workings of the annual exclusion and with the gift tax laws.' notwithstanding that such practices are plainly inconsistent with the law, the reporting requirements regarding the annual exclusion make it easy for this "double dipping" to occur. first, any gift of $10,000 or less simply need not be reported 3 ' if it meets the other requirements of the annual exclusion discussed above.'-' thus, no return is required to be filed of a full $10,000 annual exclusion gift, that, if reported, would suggest to the service that the donor might be making full use of the annual exclusion to transfer wealth and also be making the normal, recurring gifts."2 where one spouse is making the gift and the other spouse agrees to gift split, then a return is required to reflect the gifts made and the agreement of both spouses to be treated as the donor of one-half of the property given by either in that calendar year. 33 nonetheless, the returns that can be used to reflect the agreement merely list the type of property transferred, the date of the transfer, and the value of the property, and record the consent of the spouse not actually making any transfer.' the returns never raise the question of whether the taxpayer made holiday, birthday or wedding presents to any of 129. see supra part hi a 1. 130. irc § 6019(a)(1). 131. see supra part h b. 132. if the donor erroneously believes that the annual exclusion applies to investment-type gifts under s10,000 per donee, and that the gift tax system does not apply at all to traditional gifts to family and friends at birthdays and holidays, then the donor would likely make both types of gifts and report nothing. 133. irc § 2513; regs. §§ 25.2513-1(c). -2. 134. form 709, united states gift (and generation-skipping transfer) tax return [hereinafter form 709]; form 709-a, united states short form gift tax return [hereinafter form 709-a]. the donor(s) must describe how the value of the gifts was determined. 19931 florida tax review the same donees to whom the annual exclusion gifts were made. 35 it is also easy to avoid the necessity of making the return that is required only to reflect gift splitting. current law permits any amount of property to be transferred from one spouse to the other outright without there being any tax due and there is no reporting requirement for such transfers. 136 although this is a quite reasonable rule with respect to transfers between spouses given the availability of the marital deduction, it does permit an individual who wishes to make a $20,000 annual exclusion gift to use his or her spouse as a conduit for $10,000 per donee, and thereby avoid the requirement of filing any return with respect to the annual gift. 37 2. protecting excessive support transfers made to persons to whom a legal obligation of support exists.-in general, transfers which satisfy an obligation of support imposed by state law should be excluded from the gift tax system.138 while neither the code nor the regulations expressly so provide, a transfer in satisfaction of a legal claim for support should be one for "full and adequate consideration."' 139 nonetheless, transfers which are 135. see form 709, supra note 134; form 709-a, supra note 134. the directions to form 709 do state that the gift tax does not apply to any gift where the gift is under $10,000 and is of a present interest, is a tuition or medical care gift, is to a political organization, or is to a spouse and meets certain additional criteria. nonetheless, the simplicity of the instructions may work against the correct result. the directions do not specifically point out that holiday, birthday, wedding, graduation and other similar gifts count against the $10,000 limit. it is not difficult to imagine a taxpayer reading the instructions and concluding that gifts of the normal family variety are not taxable. 136. irc §§ 2523, 6019(a)(2). 137. for example, assume a married couple where spouse a has substantially more property than spouse b. further assume that they are both agreed that it would be desirable to make annual exclusion gifts of $20,000 to each of their children in the present year. a has two ways to accomplish this transfer. first, a can give $20,000 to each child and then report the gifts on a gift tax return permitting b to treat half of the gift as coming from b. second, a can transfer $10,000 to b and then each spouse can make a $10,000 gift to each child. under the latter approach, no gift tax return is required to be filed. if a gave $10,000 to b subject to an understanding or agreement that the donee spouse would give the property to the ultimate donee, the donee spouse should not be considered the owner and the gift should be considered as one from the first donor to the ultimate donee. absent any enforceable arrangement between the spouses, however, it should not be possible to collapse these steps. 138. boris i. bittker & lawrence lokken, 5 federal taxation of income, estates and gifts 121.4.3 (2d ed. 1993) [hereinafter bittker & lokken]; all proposal, supra note 98; stephens, et al. supra note 3, at 10.02[5]; cf. id. at i 4.15[l][d] n. 26 (discussing relinquishment of support rights of children as consideration, in context of section 2034(b)); gutman, supra note 12, at 1240-49 (discussing administrative convenience rationale for exclusion for reasonable support expenditures and statutory exclusions of tuition and medical expenditures). 139. bittker & lokken, supra note 138; stephens, et al. supra note 3, at 10.0215]; [vol 1:7 should we give away the annual erclusion? for support can surely be so luxurious as to involve a gift element." ' to see how transfers meant as support can result in gifts, consider the situation of an accomplished couple who have built their family business into a great success. they have two children, ages thirteen and seventeen. under the law of the state where they are domiciled, a parent is required to support a child up to the age of eighteen. both the children live at home and all clothing, food, shelter and other such items are provided by the parents. the couple makes regular birthday gifts, holiday gifts and other occasional gifts to the children. in addition, the couple purchased an automobile for the seventeen-year old, that is titled in the name of the father or the mother but is always used by the child. the thirteen-year old regularly receives concert tickets, and was given a mountain bike. the children are taken on a family vacation during the summer and another at christmas. the seventeen-year old also goes on a beach trip with several of her friends during the summer. as described above, such transfers are, in some part, likely to be support required to be provided by state law and not reasonably considered gifts. in general, support is a variable concept that adjusts with the ability to pay.14 certainly, it is common and reasonable to permit a seventeen-year old to have the use of a car, which may reduce the transportation time load on the parents. 42 a bicycle can be a useful form of transportation for a teenager without a driver's license. concerts are a common form of entertainment. on the other hand, to some extent, support is also defined by what others who are similarly situated provide their children.'4 1 suppose, for example, the automobiles provided by similarly situated families average $10,000-$15,000 in value and that the automobile provided by this family to the seventeen-year old is a $30,000 luxury car. assume that the mountain cf. irc § 2516 (acknowledging that property settlement payments made for support of minor children in divorce context are deemed to be for full and adequate consideration). 140. for example, the support of a child may include providing a winter coat. if. however, the coat is an extremely expensive designer original, its value may exceed any support obligation and the transfer may also be part gift. 141. 73 am. jur. 2d support §§ 1, i1 (1974); 83 cj.s. support (1953). see also, david beck & sheldon v. ekman, where does support end and taxable gift begin? 23 inst. on fed. tax'n 1181 (1965). 142. it seems reasonable to think that expenditures which save the time of parents and allow them to produce a better level of support for the family may be support expenditures. providing a car to a child to enable that child to transport himself or herself, and perhaps younger siblings, may free the parents to work more, become involved in school governance affairs, spend time on political matters or take other steps to support the family and better its situation. 143. for example, at one time an automobile was a luxury that few families owned. now, automobiles are hardly luxuries, and driving by a high school parking lot in many parts of the country will convince one that many parents make them available to their children. 19931 florida tax review bikes provided by most families similarly situated cost $500 and the bike provided to the thirteen-year old is the hottest new model with a carbon fiber frame and the best suspension system that cost $2,500, and that the thirteenyear old gets another $1,000 worth of clothing and accessories. imagine that the concert tickets are not the regular ones that sell for $35, but are $500 tickets that permit the holder to come backstage and meet the performers. with respect to the vacations, assume that the average family in the same economic situation as our hypothetical family spends an additional $5,000 to take the kids with them on the summer and christmas vacations, while our hypothetical family spends an additional $12,000 to take the kids to england in the summer and aspen in the winter. let us also assume that the seventeen-year old uses the family beach house for her summer escapade with her friends and the house rental is normally $2,200 a week during the summer. under existing gift tax law, there is some gift element in each of these transfers. if the parents in our hypothetical family have not otherwise used their annual exclusions with respect to the children, the gift elements in these transfers are probably fully protected by the $10,000/$20,000 annual exclusion. however, if the parents have made use of their annual exclusions to make gifts of stock in the family business to the children or into trusts for them, then, under current law, one set of gifts should be reported and some of the parents' unified credit consumed. again, as noted above, given the reporting required with respect to annual exclusion gifts, and the view of annual exclusion gifts as somehow separate, such additional gifts are no more likely to be reported than are the birthday and holiday gifts made by persons who have fully used the annual exclusion to make gifts of stock or land or of some other major family asset. again, this is not to suggest that the donors are intentionally breaking the law; they probably believe that if they are providing their children the same lifestyle as they enjoy, then the transfers are for support, not luxuries which include a gift element. even if the parents are apprised of the gift nature of some part of the transfers made to the children, they may reject that advice as a mere technicality, not a law the government would ever enforce. they may be right, and it is certainly undesirable for the government to get in the business of determining which transfers parents make to their minor children are for support. 44 however, given the likelihood that wealthy parents make support-type transfers which in fact have a gift element in them and also make additional gifts under the annual exclusion, it is reasonable to limit the annual exclusion so that both types of wealth transfer do not escape 144. for a more detailed discussion of why consumptive transfers for support of minors are not a significant transfer tax system concern, see part v c. [vol 1:7 slould ive give away the annual erciusion? taxation. 3. protecting support type transfers made to persons to whom the transferor has no obligation of support.-suppose our hypothetical couple's children have now attained ages nineteen and twenty-three, and that under the applicable law the parents have no obligation to support children over the age of eighteen. the nineteen-year old is now in college and the twenty-three-year old is in graduate school. the parents pay the tuition for each directly to the appropriate school, thus qualifying those payments for the tuition exclusion of section 2503(e). however, the parents also provide each child an apartment, utilities, food, a car and insurance for the car, as well as plane tickets home for some occasions. they also still take each child on vacation and allow each to use the family beach house for a week each summer. because there is no legal obligation to make any such payments, each such payment (other than the excluded tuition) is a gift."" if the annual exclusions with respect to these children are not otherwise used, most of these gifts are probably protected from transfer tax. however, if the annual exclusions are being fully or even partially used to make stock gifts, then current law requires that these other gifts be reported and that the consumption of some unified credit by the donors be acknowledged. even if the annual exclusion is not being otherwise used to make stock gifts, it is not difficult to conclude, given the expense of some educational programs and the related housing and living expenses, that some of those persons supporting adult students are in fact making gifts that exceed the annual exclusion level and that should be reported."4 again, given the reporting system and the sense that such transfers are for support and are at least pursuant to a moral duty, it is very unlikely such transfers are often reported, even if full annual exclusion gifts are also made to the same donee. under existing law a similar problem can arise from providing 145. in some states, such as georgia. the support obligation still ends at the age of majority. e.g., still v. still, 405 s.e.2d 762 (ga. 1991): ritchea v. ritchea. 260 s.e.2d 871 (ga. 1979); coleman v. coleman, 240 s.e.2d 870 (ga. 1977); clavin v. clavin, 238 ga. 421 (1977); crane v. crane, 170 s.e.2d 392 (ga. 1969). other states follow a different rule. and may impose obligations on nondivorced parents to pay for post-secondary education of adult children. see generally jack w. zitter, annotation, post-secondary education as within nondivorced parent & child-support obligations. 42 a.l.r. 4th 819 (1985 & supp. 1992). 146. this would be particularly true where the parent paying the education expenses is a single parent who is limited to a s10,000 annual exclusion per child, rather than the effective $20,000 per child exclusion available when both parents make the transfer. even when both parents are involved, if one actually provides all the value transferred and it exceeds $10,000, they are violating the law if they fail to file a gift tax return and consent to split the gift amount. see discussion supra note 59. 19931 florida tax review support for adult persons who, for example, are in a home for the aged or who live in their own home but need assistance to do so. section 2503(e) permits an exclusion from gift tax for transfers made for the medical care (as defined in section 213(d)) of another, so long as the payment is made to the care provider. the regulations under section 213(d) state that where an individual is in an institution, and his condition is such that the availability of medical care in such institution is not a principal reason for his presence there, only the actual medical care costs, if any, are considered a medical care expense. 147 expenses of lodging and meals are not considered part of the medical care in that situation.44 thus, if a person is in a home for the aged or a nursing home, but needs little if any medical care, the lodging expenses and meal expenses paid by another will not qualify for the section 2503(e) exclusion. similarly, where a care provider who is not a nurse or other medical care provider is paid to stay in the home with an aged person, the expense will not qualify for the medical care gift exclusion. the same would be true of expenses for most retirement communities where many of the residents are not there for medical care. such transfers would qualify for the annual exclusion, to the extent they are present interests (and most would be), but the exclusion may not be large enough to protect all such transfers. 4. protecting normal gifts from tax and reporting.-for many persons who do not make large gifts and who do not or can not provide support that contains a gift element, the annual exclusion continues to serve the role envisioned for it by congress-protecting normal birthday, holiday and other regular gifts from tax and from having to be reported. 5. summation of current uses.-as the foregoing demonstrates, the actual functions of the annual exclusion include: (i) the direct transfer of significant amounts of wealth; (ii) the indirect transfer of even greater amounts of wealth in connection with life insurance trusts; (iii) the transfer of additional amounts indirectly because of the absence of reporting requirements and a sense that annual exclusion gifts are a separate category; (iv) the protection from tax of transfers that are intended as support but exceed any reasonable support standard; (v) the protection from tax of transfers for support purposes made to adults to whom no legal obligation of support is owed, but to whom the donor may feel a moral obligation; and (vi) the protection of normal, recurring gifts made by family and friends from gift tax consequences. 147. regs. § 1.213-1(e)(1)(v)(b). 148. id. [vol 1:7 should we give away the atunial erclusion? iv. problems with the annual exclusion under its present design and given its current uses a. makes avoidance of the transfer tax system easy the annual exclusion is serving a variety of functions in addition to its express purpose of protecting normal family and friend-type gifts from taxation and reporting. the exclusion is so large, and the gift tax reporting requirements so vague, as to permit wealthy persons to make large scale wealth transfers over time with no transfer tax consequences. through the unified credit, the system already provides the equivalent of a $600,000 exemption, which can generate a $1.2 million exemption for married couples who are well advised.'49 the system also provides that if the amount of wealth transferred is over $10 million, a five percent add-on tax applies, thereby denying the transferor the benefit of the $600,000 exemption equivalent. 150 nevertheless, because the annual exclusion is so large and is renewed annually, it can permit wealth transfers greater than the unified credit in appropriate circumstances. the desire to permit support-type transfers to be made without fear of gift tax consequences, whether such transfers are made pursuant to a legal obligation or only a moral duty of support, understandably pressured congress to make the annual exclusion large enough to obviate such fears. however, in doing so, congress opened the door to large wealth transfers by wealthy persons. conversely, the annual exclusion is so small as to fail to protect from gift tax consequences some support-type transfers made to adults whom the donors are not obligated to support, such as adult children in school or elderly family members needing care that is not "medical. " it is inconsistent with the historical development of the annual exclusion, the gift tax system, and the transfer tax system as a whole, to have a gift tax exclusion which permits large wealth transfers to be made tax free. it is particularly inappropriate to have such an exclusion in a gift tax system that fails to protect other transfers that do not and are not intended to avoid the wealth transfer tax system, such as payments for support of adult children or the aged, which are pursuant to a moral obligation and which generally consume the assets transferred. 149. see supra note 31 and accompanying text. 150. irc § 2001(c)(3). the add-on tax terminates after the exclusion equivalent has been recovered. see id. 19931 florida tax review b. vertical inequity the existing annual exclusion directly promotes vertical inequity in the transfer tax system. the system is designed to impose tax on the wealthy. like the income tax system, it is somewhat progressive, purporting to impose a higher tax burden as the amount of wealth transferred increases.' 5 ' the annual exclusion permits this progressivity to be undercut, as is easily illustrated. assume two individuals, a and b. each has survived a spouse and is now unmarried, each is age 65 and healthy, each is eligible for medicare and receives some social security, and each has three adult children. a owns property worth $1.4 million, as follows: principal residence -$350,000 vacation residence -$150,000 investments -$900,000 b owns property worth $5 million, as follows: principal residence -$500,000 vacation residence -$300,000 investments -$4,200,000 if a does not reduce his estate, at death the estate tax due will be $512,800, reduced by the $192,800 unified credit, for an actual payment of $320,000, or twenty-three percent of a's wealth. 52 although a is eligible for medicare and also receives social security, the burden of keeping up two homes, the worries about care that might be needed that medicare does not provide, the desire to travel and enjoy retirement, all indicate a will not be in a position to make the type of regularly recurring substantial gifts needed to reduce his estate tax. in a few years, when he no longer wants both homes, a could sell one of them and that may permit a to make some gifts. however, it is most likely that a will retain the bulk of his wealth until his death because of a desire for security. essentially, a is wealthy enough to be subject to the estate tax, but not so wealthy as to afford to make recurring 151. estate tax rates range from a low of 18% to a high of 50%. irc § 2001(c)(1), (2)(d). because the unified credit "pays" the tax on up to $600,000, the rates that actually apply range from 37% to 50%. irc § 2001(c)(1). 152. the total of $1,400,000 would bear tax of $448,300 plus 43% of the excess over $1,250,000. ($448,300 + $64,500 = $512,800; $512,800 $192,800 = $320,000.) for purposes of simplicity, we are ignoring the deductions available to the estate under section 2053. [vol 1:7 should we give away the annual erchsion? annual exclusion gifts. b's wealth is three-and-a-half times greater than a's. if b does not reduce his estate by gifts or other means, b's estate will pay tax, after subtracting the unified credit, of $2,083,000, which is nearly forty-two percent of his wealth.'53 the forty-two percent b's estate could pay is not far from a 100% increase over the twenty-four percent a's estate is likely to pay, reflecting some significant progressivity in the transfer tax system. b, who is also eligible for medicare and social security, and who has a much greater income producing ability than a, can afford to make regular annual exclusion gifts to his children and their spouses over the next many years, reducing his assets by $120,000 per year, or $1.8 million over fifteen years. assuming he does so, he will die with an estate of $3.2 million, which (assuming it is all taxable) will incur tax of $1,183,000." ' the proper percentage to use in comparison to a's twenty-four percent is determined by dividing b's estate tax due by $5 million, since that is the total amount he will transfer, counting both gifts and testamentary transfers. the percentage of tax his estate bears is now 23.66%, nearly identical to the 24% of a's wealth consumed by estate tax, even though the total wealth transferred by b is still three-and-a-half times that transferred by a. because of his ability to make large gifts each year, b the wealthier taxpayer, can significantly reduce his estate tax burden while retaining ample assets to be assured of his comfortable support. the annual exclusion is a tool he can use to great effect. the less wealthy taxpayer is simply not in a position to make easy use of the annual exclusion. it makes no sense to have a provision that is intended as an administrative convenience but which in operation permits a wealthy taxpayer to avoid $900,000 of tax and to compromise the progressivity of the transfer tax system. c. horizontal inequity in addition to the vertical inequity illustrated above, the annual exclusion also contributes to and magnifies some horizontal inequities in the transfer tax system. this occurs principally in connection with transfers of interests in closely held businesses and life insurance. to illustrate, assume taxpayers a and b each have assets worth $5 million. a's primary assets are a residence and publicly traded stocks and bonds. b's primary assets are a residence and a closely held business. each 153. see irc § 2001(c). note that prior to 1993, the tax on b's estate would have been somewhat higher, at $2,198,000. 154. pre-1993, the tax on $3,200,000 would have been s1.025.800 plus 53% of the excess over $2,500,000 and 55% of the excess over s3,000.000. that is. s1,025,800 + $375,000 = $1,400,800. $1,400,800 $192,800 = $1,208,000. 19931 florida tax review is married, has three children who are married, and each feels comfortable making full, split annual exclusion gifts to each child and each child's spouse. thus, a gives $120,000 to his children and their spouses each year for five years, and so does b. however, because b gives stock in the closely held business, the stock is discounted from its pro rata value by one-third to onehalf. 5 5 a gives publicly traded stocks and bonds, which are valued for gift tax purposes at market price. 156 after five years, during which neither the publicly traded stocks nor the privately held company appreciates, the children of a and b sell the stock, with the children of b participating in a complete sale of the business. a's children receive $600,000. b's children receive $900,000. a has $4.4 million left to pay tax on, while b has only $4.1 million. the sole difference is that b's family owned the entire company and sold the entire business. thus, the recipients of b's gifts realized the full value of these gifts and the premium that is often paid for control of a healthy business, even though they did not own a controlling interest themselves. although this might have happened to a's family, it is less likely where the gift stock is publicly traded, at least since the decline in the number of leveraged buy-outs and mergers. it is especially less likely if a held a fairly diversified portfolio and gave each child a "slice" thereof, since the likelihood that a controlling interest in several of the companies in the portfolio would be sold is slim. admittedly, the annual exclusion is not the root cause of the different results for the two families-valuation is. but, the annual exclusion is a tool that permits b to exploit the opportunity available to his family at no transfer tax cost. differences in valuation of different types of assets may be appropriate, but substantially limiting the annual exclusion would at least make b pay tax (or use unified credit) to utilize to any significant extent the valuation advantage that the asset he owns provides. a similar difference can arise among similarly situated taxpayers where one is insurable and another is not. as noted above, an insurable taxpayer can donate funds to an irrevocable trust, the trust can acquire the life insurance on the taxpayer, and the insurance can be excluded from the insured taxpayer's estate.'57 the funds given to the trust can qualify for the annual exclusion if the trust beneficiaries have withdrawal rights.'58 for 155. a substantial minority interest discount for closely held stock based on lack of control and marketability is very common. john h. bishop & arthur h. rosenbloom, federal tax valuation digest (1982). 156. of course, the market price for small blocks of publicly traded stock already reflects the market's judgment about how much that stock's price should be reduced due to its lack of control. 157. see supra part hi c i b. 158. see supra part mh b 2. [vol 1:7 should we give away the annual erclusion? purposes of comparison, assume that taxpayer a is insurable but taxpayer b is not. a makes transfers of $60,000 per year, for ten years, to a life insurance trust for the benefit of his children and spouse which transfers are protected from gift tax by the annual exclusion. the trust purchases a $12 million policy on a's life. b is not insurable. however, b also makes gifts to a trust of $60,000 per year, for ten years, and those transfers are also protected from gift tax by the annual exclusion. if a and b live long enough, and if the investments made of the $60,000 per year transferred by b are well handled, they could also grow into $12 million. but in the meantime, a's family has the assurance that if a dies the family will obtain instant "appreciation" while b's family will not have that assurance. again, the annual exclusion is not the immediate cause of the difference-the causes are the estate tax treatment of life insurance and the differences in the insurability of different taxpayers. but the annual exclusion, coupled with the use of withdrawal rights, is the tool that makes it easy for taxpayers to take advantage of these primary factors. d. disrespect for the law the annual exclusion, being as large as it is, teaches disrespect for the law to those who are subject to federal transfer tax and who learn something about that system and about the exclusion. such taxpayers can quickly perceive the sizable loophole the exclusion represents and its inconsistency with the general thrust of the transfer tax system. experience shows they are aware, for example, that the personal exemption from income tax is much smaller than $10,000.1"9 they are further aware that the personal exemption against income tax phases out as income goes up,160 while the annual exclusion does not phase out and, in fact, to a limited extent becomes more valuable as wealth increases.' the element of the annual exclusion that seems to generate the most disrespect is the use of withdrawal rights based on crmrmey.6 2 personal experience shows that once clients understand that the annual exclusion requires that the recipient have a present interest in the gift property, and then understand the general legal and practical operation of withdrawal rights, they 159. the personal exemption from income tax is s2,000. adjusted for inflation from 1990. irc § 151(d)(1), (4)(b). of course, additional exemptions may be available to an individual taxpayer for a spouse and dependents. irc § 151(b), (c). 160. irc § 151(d)(3). 161. the annual exclusion becomes more valuable as taxable wealth increases to $2.5 million because under section 2001(c) the estate tax rate increases until the taxable estate reaches $2.5 million. 162. 397 f.2d 82 (9th cir. 1968). 19931 florida tax review often laugh aloud at the silliness of the law. they can not believe that such an empty, formal analysis is followed, in light of the goals of the transfer tax system as a whole. their greatest scorn is for the law's treatment of withdrawal rights given to minors where there is no genuine possibility that the withdrawal rights will be exercised. nearly as laughable to them is the use of withdrawal rights to permit transfers into trust for the benefit of young adults to qualify for the annual exclusion, where the young adults are still dependent on the transferor for support and the transferor does not want the young adult to exercise the withdrawal rights. when clients who want to avoid paying estate tax laugh at the operation of a law that works in their favor, something is wrong. another reflection of the disrespect for the law which the annual exclusion generates can be seen in the heyen case. 163 in heyen, the taxpayer gave blocks of stock valued at less than $10,000 to each of twenty-nine persons. twenty-seven of the twenty-nine "donees" signed blank stock certificates shortly after receiving the stock, so as to permit the stock to be reissued to members of the taxpayer's family. the evidence showed that the nonfamily recipients either agreed in advance to transfer the stock to members of the taxpayer's family, or did not know they were receiving a gift of stock and thought they were merely facilitating some stock transfers. the executor of the taxpayer's estate argued that the gifts to the nonfamily members were valid gifts, that the decision of those persons to make further gifts to members of the decedent's family were voluntary, and thus all transfers were protected by the annual exclusion. the tenth circuit found: the evidence at trial indicated the decedent intended to transfer the stock to her family rather than to the intermediate recipients. the intermediary recipients only received the stock certificates and signed them in blank so that the stock could be reissued to a member of decedent's family. decedent merely used those recipients to create gift tax exclusions to avoid paying gift tax on indirect gifts to the actual family members."6 it is difficult to know how widespread heyen-type activity is. the taxpayer in heyen filed a gift tax return (presumably because additional gifts not within the annual exclusion were made in the same year), and following her death the return was audited, probably in connection with the audit of her estate. had no gift tax return been filed, and had decedent's death occurred 163. heyen v. united states, 945 f.2d 359 (10th cir. 1991). 164. id. at 363. [vol 1:7 should we give away the aual erclusion? several years after the gifts, rather than nine months after, it is questionable whether her actions would have been discovered. the absence of a spate of such cases does not mean that numerous taxpayers have not used a similar approach and been luckier. the lure of large savings that use of multiple exclusions dangles before the taxpayer suggests many may have taken the bait and gotten away. v. various approaches to modification a. reasons to retain and modif, the combined effect of the problems discussed above is sufficient to cause one to wonder whether the annual exclusion should be eliminated. if government intrusion and administrative concerns were not an issue, it might be most desirable to eliminate the exclusion. its elimination would substantially reduce the opportunities of those persons who are targets of the transfer tax system to avoid its application and would also eliminate the other problems discussed above. however, the original concerns of congress regarding the reporting of small gifts are still present. from the taxpayer's perspective, there is a significant issue of governmental intrusion. not every gift represents a transfer of wealth sufficiently substantial as to justify the imposition of obligations to report the transfer and pay tax thereon (or report the use of unified credit). whether it is a wealthy person or a not so wealthy person who takes a friend to dinner to celebrate the friend's birthday or promotion, or other event, neither will likely be willing to tolerate a transfer tax system so severe that the dinner has to be reported on a gift tax return. the kindness of all those who would enliven the day of another by a simple generous gesture should not be clouded by concerns of reporting gifts and calculating credits, especially where no enduring transfer of wealth occurs. in addition, the internal revenue service has very limited resources to deal with the millions of tax returns it already receives each year16 if every transfer in excess of support, very broadly defined, were reported to the service, either it would be hopelessly bogged down, or, as is more likely the case, would simply ignore the returns. furthermore, many, if not most, taxpayers would probably ignore the return requirements. also, defining "support" in the broad manner that would likely be required if the annual exclusion were eliminated would be very difficult and might permit 165. irs statistics show audit rates stable for individuals. increasing for others. daily tax rep. (bna) no. 108, at (lexis) d7 (june 8. 1993) (reporting audit rates for individuals at 0.91% and most other rates around five percent or below). 19931 florida tax review significant untaxed wealth transfers to be made under the new system as easily as they are under the exclusion. 66 nonetheless, change is plainly needed. congress did not acknowledge any change in the annual exclusion's purpose in 1981 when it increased the exclusion limit from $3,000/$6,000 to $10,000/$20,000.167 admittedly, the concerns about the gift taxation of transfers for education and medical care expressed at that time deserved some response and the increased exclusion may have been a part of that response. but, there are other responses that could be made which would not increase vertical inequity in the system or contribute to horizontal inequity. if in 1981 congress intended, without expressly saying so, to change the policy behind the annual exclusion away from the bases of administrative convenience and freedom from government intrusion, it was wrong to do so. there are other ways to permit support-type transfers to be made tax-free, as will be discussed below. accordingly, there is no need to set the annual exclusion at a level intended to protect from tax support-type transfers to adult children and to the ill or infirm, but which also allows significant transfers of wealth having nothing to do with support. if the transfer tax burden is too heavy, congress should change the transfer tax rate structure in an open, direct means of correcting the problem, rather than through an exclusion that some use, some could use but do not because they are not aware of it, and some can not use. taking into account the administrative need for some form of annual exclusion and the demonstrated problems with the current form, there is a preference for designing a system under which: (i) transfers for current support, which do not transfer lasting tangible wealth, are not required to be reported, even if made to persons who are not legally entitled to support; (ii) tax-free transfers that are not for current support are both limited and reported in a useful fashion; and (iii) administrative burdens on taxpayers and the government are not substantially increased. to satisfy these requirements, either "support" must be defined or its definition made unnecessary, and the ability to transfer wealth tax-free for purposes other than support should be substantially reduced. in the sections following, three proposals made by others with respect to these matters are reviewed: (i) the first by the american law institute168 and augmented by a related proposal by professor milton ray;169 (ii) the 166. see infra notes 172-179 and accompanying text. 167. see supra part iii a 2. 168. ali proposal, supra note 98. 169. milton ray, the transfer-for-consumption problem: support and the gift tax, 59 or. l. rev. 425 (1981). [vol. 1:7 should we give away he annual exclusion? second by harry l. gutman; 70 (iii) and a third by a task force on transfer tax restructuring established by the aba section of taxation.' 7 1 all of the proposals would, to some extent, permit transfers for support to be free of gift tax consequences, and would (except one) tighten up the annual exclusion. each of the proposals has some merit, but each also has flaws. following the discussion of these proposals is a discussion of my own proposal for achieving the goals set out above. b. reviewing the earlier proposals 1. the aliiray model.-some years ago, the american law institute and other commentators suggested that transfers for support be excluded from the definition of gifts, and attempted to define "support" for this purpose. 172 the ali proposal excluded from transfer tax any expenditure for the benefit of a resident of the transferor's household, or for the benefit of a minor child of the transferor (whether or not a resident of the household), provided that the expenditure did not result in the transferee obtaining property which would retain "significant value" after the passage of one year from the date of the expenditure. the all proposal also excluded all current educational, medical or dental expenditures for any person and the current costs of food, clothing and maintenance of living accommodations of anyone dependent on the transferor, provided the expenditure was "reasonable" in amount. the annual exclusion was left fully intact as a separate 170. harry l. gutman, reforming federal wealth transfer taxes after erta. 69 u. va. l. rev. 1183, 1244-49 (1983); harry l. gutman, a comment on the aba tax section task force report on transfer tax restructuring, 41 tax law. 653. 657-660 (1987) [hereinafter gutman comment]. 171. task force on transfer tax restructuring, aba section of taxation. report on transfer tax restructuring, 41 tax law. 393 (1987) [hereinafter the restructuring report). in addition to the three proposlas discussed herein, another recent proposal for reform of the annual exclusion was made by john g. steinkamp, common sense and the annual exclusion, 72 neb. l. rev. 106 (1993). steinkamp sharply criticizes the allowance of the annual exclusion for transfers of income interests, transfers of certain indirect outright gifts, and transfers subject to withdrawal rights that lapse if not exercised. he would allow the exclusion only for outright transfers and for transfers in trust where the trust benefits only one beneficiary and that beneficiary (or a guardian for the beneficiary) has a withdrawal right over all the trust property that does not lapse. he does not propose any modification of the tuition or medical care exclusions, nor does he propose an exclusion for support-type transfers made to adults. instead he would rely on the annual exclusion to continue to protect such transfers from the gift tax. id. at 171. he also proposes to index the exclusion for inflation. since he does not propose expanding the exclusions for consumptive, support-related transfers as a means to limit the annual exclusion, his proposal is not discussed in detail here, but certain of his arguments are addressed in various footnotes infra. 172. ali proposal, supra note 98, at 19-21; ray, supra note 169. 19931 florida tax review exception from gift tax under the ali proposal. the ali proposal was also the basis of a more refined proposal made by ray in a 1981 article. 173 ray defined "significant value" (which the ali had not attempted to define), to include the value of property transferred to the donee in one calendar year "which (property) will retain a value in excess of the amount of the annual exclusion ... at the end of the second calendar year following the close of the year of expenditure."'' he expanded the persons to whom such transfers could be made to include not only any person in the transferor's household, but also any person as to whom the transferor could claim a dependency deduction and any person included in a large list of relatives.17 his proposal also included the exclusion for current educational, medical and dental costs proposed by the ali, as well as current food, clothing and living accommodation costs. while the annual exclusion would have been retained in section 2503(b), ray's proposal would have denied a transferor who used his proposed new exclusions in a year the use of the annual exclusion in that same year. both of these proposals reflect: (i) a belief that transfers for "support" should not be a gift for tax purposes, even where the transfer is not one required pursuant to an obligation of support under local law; (ii) a recognition that many transfers made by parents to adult children for education in college and made to others, such as aged parents, for care, which can be viewed as transfers for support even though not required by state law, exceeded the $3,000 annual exclusion limit of the time; and (iii) a conclusion that it is inappropriate to have the law continue in a form that results in large scale violations of the law by those paying for their children's education and helping to pay for the care of others. 176 after concluding that state law was neither uniform nor clear in defining support, the ali and ray offered proposals that would establish a federal transfer tax definition of support-not 173. ray, supra note 169, at 446-50. 174. id. at 449. 175. id. those as to whom a dependency exemption could be taken include any dependent (as defined in section 152) whose gross income for the year is less than the exemption amount, or who is the taxpayer's child and who is either under age 19 during the year or a student under age 24 during the year. "dependent" is defined in section 152(a) to include the taxpayer's descendants, stepchildren, siblings and step-siblings, ancestors, stepparents, nephews and nieces, aunts and uncles, a broad range of in-laws, and members of the taxpayer's household. ray's proposal would allow tax-free transfers to a person defined as a dependent by section 152(a), regardless of whether or not the taxpayer could claim an exemption with respect to that dependent. 176. all of these concerns are legitimate today, as has been demonstrated above. transfers for support of adult children and aged parents may now exceed the $10,000 annual exclusion limit and thus place the donors under a return filing requirement, which is no doubt often ignored. [vol. 1:7 should we give away the annual erclusion? one that would govern for purposes of guiding the determination of support payments in the divorce context, but one determinative of whether any gift had been made that should be included in the tax system. both proposals focused not on the transfer of wealth, which is the general focus of the transfer tax system, but on whether the transfer resulted in a build-up of wealth in the transferee.'" since ray's proposal is more refined, it is examined here. several troublesome issues arise under ray's proposal, as he recognized. for example, determination at the time of the transfer of whether an asset would have a value greater than the annual exclusion at the end of the second calendar year after the year of transfer would often be quite difficult. because the proposal would permit such transfers to be made to a wide range of the transferor's relatives, including descendants, this form of transfer could in fact be used both to remove wealth from the donor and to build up wealth in the hands of the donee without any gift tax being incurred. for example, payment of the rent on a child's apartment or of an automobile lease payment arguably would not create wealth in the donee's hands and so would be excluded from gift tax by this proposal. but, by eliminating that expense for the donee, the donor allows the donee to build up his or her own wealth with savings equal to the amount the donee would otherwise pay on his or her own, and if such payments could be made without gift tax consequences, the donor could also reduce his or her own estate.178 177. that both the all proposal and ray focus on the build-up of wealth in the transferee is revealed by their use of the "significant value" standard, which is measured by the value of the transferred property in the transferee's hands after the passage of one year (the ali proposal) or two years (the ray proposal), and the support type transfers their proposals would exempt from transfer tax. this approach seems contrary to that set forth in regulations section 25.2511-2(a) (quoted supra note 2), which makes it plain that the tax is imposed on the value passing from the donor, not the enrichment of the donee. the regulation is entirely consistent with the measure of the value of property subject to estate tax. irc §§ 2031, 2033. given that the two systems are meant to complement each other, and that their purpose is to tax the transfer, not receipt, of wealth, it is entirely appropriate to focus the valuation function of the gift tax on what is transferred, not the value of the item in the hands of the recipient after the passage of some period of time. nonetheless, as discussed in part v c. it is probably appropriate in some circumstances to examine the value of the asset or benefit transferred shortly after the transfer to determine whether a transfer of wealth ever occurred. if the value transferred is consumed, as it would be in many of the support-type transfers, the all/ray proposals would protect such value from transfer tax. arguably in such case no transfer has occurred. 178. this fungibility aspect could be an interesting consideration in connection with any cash gift, but especially so where the gift is to be valued two years later. if. after the two years expire, the gift is valued at the amount of cash received, the gift will never exceed the exclusion amount assuming it did not exceed it at the time of the gift. however, suppose a cash gift of $9,000 is used by a dependent young adult to pay expenses and the payment 19931 florida tax review "current educational" costs could also be too broad. to illustrate, most people would probably find a sailing trip around the world to be "educational" in some degree, but if someone else pays for such a trip should the transfer involved escape the transfer tax system?"' another provision of ray's proposal that would cause some problems would be the denial of use of the annual exclusion as to any donee with respect to whom the support exclusion were used in the same calendar year. the support exclusion would be the statutory basis for exempting from gift tax (i) any transfers which do not retain significant value at the end of the second calendar year after the year of the gift to any "person in fact dependent on the transferor," (ii) current educational, medical and dental costs, and (iii) food, living and accommodation costs. hence, use of the support exclusion would certainly be required as to all minor children and many young adult children, thus preventing in that year the use of the annual exclusion to make other gifts, especially gifts that might appreciate in value. a person denied the use of the annual exclusion under ray's proposal could make gifts of items that do not retain a value in excess of the annual exclusion after two years. but what if a person who is supporting a minor child also gives the child a piece of jewelry, some stock, or a parcel of real property that appreciates in value so that its value, combined with the value of any gift that did not retain significant value, exceeds the annual exclusion amount? some limitation on the combined use of the support exclusion and the annual exclusion makes sense as to those who are sufficiently wealthy that the law should prevent them from avoiding the transfer tax system. however, this limitation makes little sense as to those who are very unlikely ever to have enough wealth to incur transfer tax, but who do have enough to make an occasional gift of an appreciating asset. they should not be put in the position of reporting such gifts or violating the law for failure to report them. further, while ray's proposal would not permit use of both exclusions, it would permit the use of the full annual exclusion to protect gifts to those not receiving support transfers-such as emancipated children permits the young adult to retain some land inherited from his or her grandparents. in the two years after the cash is received, the property trebles in value. should the gift, when being valued two years later, be viewed as the amount of cash, or the investment it preserved? under current law, gifts are valued when made and it is the property transferred that is valued; hence, the issue is not as directly presented. this fungibility aspect should play an important role in determining when transfers that occur through consumption of value for the benefit of another person should be treated as gifts. see infra part v c. 179. if the focus is on whether the transfer builds up wealth in the donee, then perhaps not. however, as discussed supra note 177, the focus of the transfer tax is on the value transferred, not the wealth received or retained by the donee, and altering that focus can have significant consequences. [vol 1:7 should we give away the annual exclusion? of the wealthy. although at the time of his article and the all proposal the exclusion was only $3,000/$6,000, the current $10,000/$20,000 exclusion would permit the tax-free transfer of substantial wealth. the approach embodied in the ali's and ray's proposals is laudable in some ways, because it seeks to separate "support" type transfers from "gift" type transfers, which would permit the law governing gift transfers to be designed without regard to support issues. the basic difficulty with both the ali and ray's proposals is that defining "support" is very difficult. the definition must remain somewhat flexible, since the concept of what is "support" varies depending on the ability of the supporter to provide and personal choices. yet, it must not make it easy for persons to make transfers that are in fact gifts and hide them under the rubric of support. the all and ray proposals satisfy the flexibility requirement. however, they are not well designed to prevent transfers of wealth. 2. the gutman proposal.-another approach to limiting the annual exclusion has been offered by harry l. gutman.'"' his proposal would: (i) adopt a refined version of the ali/ray proposals;... (ii) deny the annual exclusion for any transfer in trust or to a custodianship; (iii) deny the annual exclusion for any transfer which requires an intermediary to record it (e.g., real estate, stocks, life insurance premium payments, etc.); (iv) set the exclusion level by reference to a "realistic appraisal of the aggregate value of incidental ... gifts an individual would be expected to make to a donee," suggesting at one point that perhaps $600 per donee might be appropriate182; and (v) measure the exclusion on a per donee basis (although a per transfer limitation might be considered). a cornerstone of gutman's proposal is the adoption of some version of the ali/ray proposals to exempt support related transfers from gift tax, which he acknowledges is an important step in permitting the reduction of the annual exclusion. accordingly, the same arguments that support rejection of the ali/ray proposal could be asserted as a basis for rejecting the gutman proposal. however, since the expanded tuition and medical care exclusions proposed in this article are meant to serve the same function as the ali/ray proposals-i.e., permitting the annual exclusion to be redesigned-the rest of the gutman proposal deserves consideration. the next two portions of the gutman proposal are intended to help prevent transfers of certain types of assets under the annual exclusion. 180. see gutman, supra note 170. 181. gutman does not specify the refinements necessary, although he does point out that transfers in trust would cause particular problems and cites to ray's article. gutman. supra note 170, at 1243 n.173. 182. gutman comment, supra note 170, at 658-60. 19931 florida tax review denying the annual exclusion for transfers in trust or to a custodianship would serve as a disincentive to transfers where the donor does not wish the donee to have control of the asset. this might be particularly true of items of significant value or which play a role in controlling other assets, such as stock with special voting rights. gutman's proposal to deny the exclusion for transfers of assets that require recording by an intermediary serves a related function; it would make it more difficult for donors to use the annual exclusion to give away certain types of assets, such as stocks, real estate, vehicles, and others, which the donee can not consume relatively quickly.183 thus, under gutman's proposal the annual exclusion would also exist primarily to protect from taxation value that is consumed in the transfer or shortly thereafter.' 8 if the exclusion were set as low as $600 per donee, or any amount significantly lower than the existing exclusion level, the first question to answer is why other restraints on its use are necessary. admittedly, some of the types of assets that could not be transferred under the annual exclusion if gutman's proposal were adopted could normally be transferred at a discounted value, resulting in an effective increase in the annual exclusion. however, that cost does not seem worth limiting a donor's freedom to use a much smaller exclusion to transfer whatever type of asset the donor prefers." 5 183. gutman also argues that if a transfer is made in trust or recordation is required with respect to the transfer, then the additional requirement of reporting the gift adds no great cost nor administrative burden. gutman comment, supra note 170, at 659. gutman argues that since the reason for the exclusion is to eliminate the necessity of keeping account of small gifts, once someone is recording a gift it will be no real burden for it to be recorded twice, the second time on a gift tax return. this ignores that different persons may be recording the events. for example, a gift of stock is recorded on the books of the corporation, but the donor who would have to file a gift tax return under gutman's approach may have no burden with respect to the first recording of the transfer, but now has a gift tax return to file. as a part of filing the return, the donor now must value that stock, whether it is publicly traded or closely held. valuation of a corporation for the purpose of giving a small amount of stock to a child, where all would agree that the value of the stock is below the exclusion level seems burdensome. nor is it easy to explain to a taxpayer why one person who makes a gift of a $500 item of jewelry does not have to file a return, but another who puts $500 in cash in a trust for a child or grandchild does. 184. thus, gutman states, "if not permitted for the transfer of... assets [the transfer of which must be recorded by an intermediary], the exclusion would be available principally for cash, in-kind property transfers, and transfers of the use of property." id. 185. the proposal for expanded tuition and medical care exclusions set forth in the text below includes restrictions on the types of assets that can be transferred since those exclusions are supposed to be available for only specific purposes and only where the assets transferred are to be consumed. the annual exclusion is supposed to be for wedding, holiday, birthday and other incidental gifts. its purpose is thus much broader than the education and care related exclusions, and it is thus not appropriate to restrict the type of assets given under it. for a "daddy warbucks," giving "little orphan annie" some stock for her birthday may [vol 1:7 should we give away the annual erclusion? in addition, the limitation based on assets would seem to be relatively ineffective. so long as cash can be transferred under the exclusion, which gutman clearly contemplates,' 6 the donee (or a guardian acting for the donee) could purchase the assets that can not be transferred under the exclusion. if the donor/seller has a low basis in the assets, then obviously the sale could cause a gain to the seller. however, that would not be an issue where the donor/seller has a reasonably high basis. further, the doneelbuyer will have a higher basis due to the purchase, which will ultimately reduce the donee/buyer's gain on sale of the asset. also, if the asset purchased is one that could be discounted for gift tax purposes, it could be discounted on the sale, so the donee/buyer could end up with just as much of that asset through purchasing it as could be transferred through a direct gift. the proposal that no transfers in trust qualify for the annual exclusion seems too harsh and unnecessary given a substantial reduction in the amount of the annual exclusion. if any exclusion is permitted, it seems especially harsh to deny its use for transfers (even in the form of cash) to trusts or to custodianships. for example, consider a seventy-five-year old grandparent of a nineteen-year old child. exclusions permitted for tuition and educational expenses incurred in the year of transfer will not allow that grandparent to help pay for the grandchild's later college or graduate school expenses if the grandparent dies while the child is a freshman in college. if the grandparent prefers to use the annual exclusion to build up funds in a trust for the child's education, which will prevent the funds from being squandered, instead of spending the exclusion amount on sweaters and shirts and such, there is no good reason that the grandparent should have to use his or her unified credit rather than the annual exclusion for such a transfer. a rational system should not encourage a grandparent to expend $600, or whatever exclusion amount is permitted, on things that will be quickly consumed, but discourage setting aside that amount for a child's education. an even more compelling argument can be made on behalf of a grandparent of a newborn grandchild, where the grandparent expects that he or she will not be around to use the tuition be as natural, and as appropriate, as it was for other parents to give their child a sweater. it seems extremely restrictive of the government to appear to be telling citizens what they can and can not give for birthday, wedding, graduation, christmas and other holiday gifts. of course, under gutman's proposal, taxpayers would still be free to use their unified credit to make gifts of any assets they want. but the degree of government intrusion is very great when citizens are told they can give their children $600 in cash without filing a return, but not s600 worth of publicly traded stock. 186. gutman's proposal that the exclusion be denied for all assets the transfer of which requires recordation by an intermediary could be viewed as denying the exclusion for transfers by check, which have to be recorded by the donee bank. nonetheless, cash transfers are still eligible for the exclusion under his proposal, as reflected in the quotation in note 184 supra. 19931 florida tax review exclusion when the grandchild reaches college age. we should not restrict the grandparent to choosing bikes, baseball bats and barbie dolls for birthday and christmas presents, when the grandparent thinks it is appropriate to use the exclusion to establish a trust for the grandchild's education or to help the grandchild start a business. further, there are other ways to restrict a donee's control over assets transferred which gutman's proposed restrictions on trusts would not deter. for example, limited partnerships, stock subject to shareholder agreements restricting its sale and other disposition, and nonvoting stock can all be used to transfer wealth without giving the donee control. nor would gutman's proposal to restrict the transfer under the annual exclusion of assets that require recordation prevent the use of these devices to restrict a donee's control, since in many cases cash could be transferred to the donee or the donee's guardian who could invest it in one or more assets subject to such devices. finally, if the $600 amount referenced by gutman were adopted, the administrative burden would increase greatly." 7 many people who now never exceed the $10,000 level, and would not exceed a much lower level of exclusion, would exceed a $600 per donee exclusion with some regularity. many, if not most, engagement rings would have to be reported on gift tax returns, as would many suits of clothes, and many one time gifts (such as the really good bicycle, or the not so good used car, and the airline tickets home at christmas or when somebody in the family dies). while many of the particulars of gutman's proposal are unacceptable for the reasons given, he makes an important point that requires attention in any effort to change the annual exclusion. he reminds us that the only reason that congress has stated for allowing the annual exclusion is administrative simplicity.' if that is the reason for it, then, as gutman points out, the dollar amount of the exclusion should be set by reference to a realistic 187. a portion of gutman's proposal, that dealing with assets requiring recordation by an intermediary, draws upon the notion that the administrative simplicity to be protected by the annual exclusion is the administrative simplicity of the taxpayer. first, an argument can be made that the administrative simplicity to be served is not that of the taxpayer, or at least not that of the taxpayer alone, but is that of the government, either primarily or at least substantially. a very small exclusion, and preventing the exclusion from being used as to certain assets, guarantees that the government will receive a very large number of new gift tax returns, many from people who would otherwise never file a transfer tax return of any kind. the government's resources, already stretched, would not wisely be spent dealing with returns reporting these types of transfers. second, while his proposal would reduce the number of difficult to value assets that could be transferred under the exclusion (real estate, closely held stock, etc.), there could still be many kinds of such assets used to make exclusion gifts (e.g., jewelry, art work and collectibles). thus, his approach would not prevent taxpayers from taking aggressive positions with respect to the value of gifts made under the exclusion. 188. gutman comment, supra note 170, at 658. [vol 1:7 should we give away the annual erclusion? appraisal of the aggregate value of incidental type gifts an individual would expect to make to a single donee.1 9 gutman, however, does not describe how to identify the individual whose gifts should be appraised. if administrative simplicity is the goal, then the exclusion should be set at the level that will keep people who are not otherwise in the transfer tax system out of the system. people who are out of the system are those who have up to $600,000 of wealth ($1.2 million for married couples), because that is the amount of wealth that congress permits to be transferred with no transfer tax. accordingly, the dollar amount of the exclusion should be set at that amount which would cover the holiday, wedding, birthday and incidental gifts which persons with approximately that amount of wealth make on average to one donee, in a year when some larger types of gifts (e.g., wedding and graduation) are made. 3. the report on transfer tav restiructuring.-a task force on transfer tax restructuring was appointed in the mid-1980's by hugh calkins, who was then chair of the section of taxation." ° the task force's report recognized that the existing exclusion permits substantial transfer tax avoidance and suggested that it be revised by adopting an annual $30,000 per donor limit, and that the present interest requirement be replaced so that transfers in trust could qualify for the exclusion only if the transferred amount were for the benefit of a single beneficiary and would be includible in that beneficiary's gross estate to the extent not distributed to or for that beneficiary.' the task force recognized that any per donor limitation which substantially reduced the total amount transferable under the annual exclusion would make it more difficult to protect transfers for the support of emancipated adults from gift tax.'9 accordingly, it suggested that the exclusion for tuition should be expanded to cover other educational expenses, but provided no detailed suggestions on how that might be done. 93 further, the task force noted that the rationale for excluding payments of educational and medical expenses logically extends to other payments for support of nondependents, but concluded that the potential for abuse of an exclusion which extended to other support payments made such an exclusion infeasible." 4 for reasons discussed in detail below, the task force's proposed per donor limitation is a desirable method of limiting the use of the annual exclusion to make large scale transfers of wealth. as the discussion of the 189. id. at 659. 190. the task force prepared the restructuring report, supra note 171. 191. restructuring report, supra note 171, at 401. 192. id. at 402. 193. id. 194. id. 19931 florida tax review all/ray proposals reflects, an exclusion for "support" is probably not workable. however, specific proposals for expansion of the tuition and medical care exclusions are set out below. the proposal to replace the present interest requirement with a "vesting" requirement is desirable for reasons discussed below. the task force shied away from any recommendation about the amount of the per donee limitation, stating that the limits are political and economic issues. it may be that the per donee limit is a political and economic issue. however, if the political issue of why there should be an annual exclusion is settled, and the political and economic issue of who should escape the transfer tax system is settled (people with no more than $600,000), the determination of a per donee limit is reasonably determinable. hence, the issue is one that can be empirically determined and it should be. c. consumption under the transfer tax system: a key to the analysis and modification of the tuition and medical care exclusions 1. introduction.-a key to the all/ray, gutman and task force proposals is the view that the consumption of wealth for the benefit of another is not, in some instances at least, a transfer of wealth that ought to be subject to the transfer tax system. the ali/ray proposals reflect this overtly and in the type of transfers intended to be protected from gift tax. they would exempt expenditures for education, medical and dental care, food, clothing and living accommodations and any other expenditure that would not retain "significant value" after the passage of some specified period of time.'95 gutman's proposal assumes that a refined version of the ali/ray proposals would be adopted and his proposal also accepts the premise that consumption for the benefit of another is, in some instances, a nontransfer for transfer tax purposes. 196 the task force proposal reflects the same view in its suggestion that the tuition exclusion be expanded, and the task force indicated that were it not for the abuse potential, it would favor extending the exclusion to all transfers for support."9 consumption is also a key notion in the expanded tuition and medical care exclusions proposed below. accordingly, it is useful to set forth the analytical basis for the exclusion from the transfer tax system of some consumption transfers. it is also important to set out the keys in determining which consumption transfers are to be excluded, for not all such transfers should be excluded from the transfer tax system. 195. ray expressly discusses consumption as the basis for the exclusions he supports. ray, supra note 169, at 448. 196. gutman, supra note 170, at 1243 n.173. 197. restructuring report, supra note 171, at 401-402. [vol 1:7 slwuld we give away the annual erclusion? 2. consumption viewed through the purpose of the transfer tax system.-determining whether consumption should be an exception to the transfer tax system, and, if it is, defining it for purposes of the exception, is first governed by the purposes of the transfer tax system. the basic purposes of the transfer tax system are to break up concentrations of wealth and to generate revenue. taken to its extreme, a person's consumption of his or her own wealth could be taken into account in calculating how much transfer tax should be imposed on that person. for example, assume that a person spends several thousand dollars over a weekend to take the concorde to paris, where he or she eats and drinks very well, sees some expensive shows, and, when all is done, has nothing material to show for the expenditure. obviously, a transfer of wealth has occurred, albeit one for full and adequate consideration. it could be asserted that it is appropriate to impose a tax in connection with such a transfer on the premise that anyone who can spend so much and get nothing material in return probably has a remaining accumulation of wealth which should be taxed. certainly, if the consumption of one's own wealth were to be viewed as an event that should trigger the imposition of transfer tax, consumption for the benefit of another, where the value obtained on account of the expenditure made is conferred on another and the wealthy person gets nothing in return, should be viewed as a transfer subject to transfer tax. however, congress has not taken its efforts to break up concentrations of wealth through the transfer tax system so far as to tax a person on the consumption of his own wealth. 98 instead, the transfer tax scheme that congress has adopted applies only to transfers to others for less than full and adequate consideratio.' 9 hence, the existing transfer tax system breaks up concentrations of wealth by taxing transfers made to others without consideration. consumption for oneself is, thus, not a taxable event for transfer tax purposes, because the wealthy person gets value back for that given and also, through consumption, contributes to the breaking up of his or her own wealth. plainly, this does not mean that consumption for the benefit of another is outside the scope of the transfer tax system. consumption for the benefit of another undeniably involves a transfer to another for less than full consideration. for example, if, out of friendship, x pays for y to take the paris trip described above, x has transferred to y a benefit equivalent to the cash value of y's expenses and has gotten no benefit in return that could be 198. certainly, there are various taxes that are more likely to affect a wealthy person than others, such as the excise taxes imposed on the purchase of luxury automobiles, boats, planes, jewelry and furs. irc §§ 4001-4007. however. these taxes require the purchase of a specific item, not the general consumption of wealth described in the example. 199. see supra note i and accompanying text. 19931 florida tax review described as having a market value. 3. when consumption for another's benefit should be viewed as a transfer for transfer tax purposes.-under what circumstances, then, if any, should consumption for the benefit of another be treated as excludible from the transfer tax system? in the proposals reviewed above, the factors that are used to determine whether consumption for the benefit of another should be treated as a transfer subject to transfer tax are: (i) the relationship of the donor and the donee (dependent minor children, residents of the household, persons who are described in section 152); (ii) the purpose of the consumption (education, medical care, dental care, food, living accommodations, etc.); (iii) the nature of the asset or assets, if any, acquired as a part of the consumption (items that will not retain a significant value one or two years after the transfer); and (iv) the amount involved (the "significant value" limitation set out in ray's proposal). there is one factor not specifically identified in any of the other proposals, but which relates each of these four factors. that factor is whether the person for whose benefit the consumption occurs is currently able, on account of the transfer inherent in the consumption, to save or make other use of some significant portion of the amount expended on the consumption. this is a key factor in determining when consumption for the benefit of another should be subject to transfer tax. that it is a key factor can be demonstrated by considering the underlying reason for excluding from the transfer tax system any consumption for the benefit of another. the transfer tax system is designed to impose a tax on the transfer of wealth. while the tax due is measured on the basis of the value given up by the donor, there must be a transfer for the tax to apply. the basis for treating consumption for the benefit of another as not a transfer tax event is that nothing of material value exists within some short period after the expenditure occurs; it is as if no transfer occurred."r° accordingly, if substance is to prevail over form, the transfer tax should not apply because the wealth is gone-consumed-not transferred. however, if the donee is 200. gutman makes reference to this analysis where he states, "others would assert that although transferees derive benefit from such payments, the payments are more properly viewed as consumption by the transferor with the result that no 'transfer' has occurred." gutman, supra note 170, at 1241, n.168. although this statement was made in the context of a discussion of transfers in satisfaction of an obligation of support, the same analysis would seem applicable to consumptive transfers that are not in satisfaction of an obligation as well. while it can be argued that a transfer occurred and should be treated as though the donor gave cash to the donee, who then consumed the cash in whatever expenditure actually occurred, this argument ignores the most essential point. whether the donor or donee is viewed as expending the value, that value is gone and should, therefore, escape the transfer tax system because there was no lasting transfer. [vol 1:7 should we give away the atnual erclusion? thereby enabled, at some point in time reasonably close to the time of the transfer, to accumulate or make other use of his or her own wealth because of the transfer, then there has been a lasting transfer of wealth to which the transfer tax system should apply. each of the four factors listed above, relationship of donor and donee, purpose of transfer, assets acquired, and amount transferred, can be justified on the basis that they frequently, alone or in combination, provide some information about the probability that the beneficiary of the consumption is likely to be able to save or make some other use of some significant amount on account of the consumption for his or her benefit. none of the four is a very precise analytical tool, but they are probably the best that can be done and keep the law administrable. for example, the descriptive relationship between a donor and donee may appropriately be considered in deciding whether to exempt a consumptive transfer for the benefit of the donee. it is reasonable to assume that minors do not have other resources they control, and therefore a minor donee is unlikely to be able to use the consumptive transfer to allow him or her to save some amount of his or her own wealth. hence, where a consumptive transfer for the benefit of a minor child occurs, there is usually real consumption of the wealth.20' this argument is less compelling when the donee is an adult. in such case, there is a much greater chance that the consumptive transfer will permit the donee to accumulate wealth of his or her own. accordingly, greater restrictions on what appear to be consumptive transfers in favor of adults are appropriate. the purposes of a consumptive transfer may also affect the judgment of whether the transfer will result in accumulation of wealth. for example, it is probably true that most students, even those in graduate and postgraduate programs, are unlikely to accumulate wealth on account of consumptive transfers for their benefit. accordingly, it may be appropriate to adopt a relatively simple general rule that consumptive transfers related to education are to be excluded, even though some donees will be able to accumulate wealth on account of such tranfers. the same may be true for transfers to help the elderly or ill persons. 201. this analysis would, of course, help support the decision to ignore for federal transfer tax purposes transfers made to minor children pursuant to an obligation of support. there may be an indirect general exception to the conclusion that a consumptive transfer for the benefit of a minor results in the real consumption of wealth. where someone other than a parent of the minor is the donor, the parents of the donee may be afforded an opportunity to accumulate wealth. however, this should not be a very serious problem, as surely most consumptive transfers occur between parents and their children and between spouses. 19931 florida tax review if an asset is acquired in connection with a consumptive transfer, the useful life of the asset acquired also may be indicative of whether the transfer will permit the donee to accumulate wealth. for example, where an airline ticket is acquired and used, nothing remains in the hands of the donee. hence, if the donee is not in a position to accumulate wealth at the time of, or shortly after, the flight, it is unlikely the donee will actually accumulate wealth on account of the consumptive transfer. if, on the other hand, the asset given is a long lived one, the chances that a transfer may occur are probably enhanced. for example, assume that an exclusion for student expenses includes transportation expenses. if this permits the transfer of an automobile to a student, and the student graduates one year after receiving an automobile as a gift, it is possible that the automobile's usefulness will last long enough to permit the donee to accumulate some wealth. hence, in general, the longer lasting the asset, the greater the risk that it will permit the accumulation of wealth by the donee.2"2 if, on the other hand, it is relatively likely that the value of the asset will reduce to zero during the period the donee is unlikely to accumulate wealth, then an expenditure to acquire that asset can be viewed as consumption. the amount of the consumption will also affect the likelihood that the donee will be able to accumulate an amount of wealth on account of the consumptive transfer that is worthy of concern under the transfer tax system. if the donee is not a minor, and the purpose of the transfer is not one that suggests an accumulation is unlikely, then it is reasonable to restrict more severely the amount of the transfer that is excluded. plainly, the analysis of how likely a donee is to accumulate wealth on account of any given consumptive transfer could best be made in light of the most specific set of facts regarding the donee and the expenditure made. for example, an exclusion for education related transfers could be made more precise if each student who has other resources that could be used to pay education expenses (such as a trust established by the student's grandparent) were identified and the exclusion was denied for transfers to such students. but just as plainly, a generally applicable legal system can not deal with that degree of specifics and remain administrable when there are as many consumptive transfers as occur in the united states. thus, relatively broad exceptions to the transfer tax system should be drawn for consumptive transfers using the rough tools listed above to reduce the risk that such 202. obviously, it can be argued that education can be one of the longest lasting assets and, accordingly, transfers for it should not be viewed as consumption. one response to this is that education is valued so highly that its long-lived nature is intentionally ignored for these purposes. instead, the focus is on the fact that the donee has nothing tangible of great material value if all that has been paid for is tuition, supplies, food, clothing, housing (but not a house), transportation (but not ownership of a vehicle), and books. [vol. 1:7 should we give away the annual erciusion? transfers will permit the donees to accumulate wealth. "0 d. liberalizing the tuition and medical care exclusions present law provides unlimited tuition and medical care exclusions for amounts paid to the educational institution or the medical care provider. while these exclusions are helpful in protecting support-related, consumptiontype transfers to persons the donor has no legal obligation to support and should be retained, they are inadequate to make certain that such transfers do not trigger the transfer tax system. the tuition exclusion falls short in failing to exclude from the transfer tax system payments for housing, books, supplies, food, clothing and transportation for students. the medical care exclusion falls short in failing to exclude nonmedical need care for the aged, such as providing for companions, paying for housing in a community for the aged where medical care is available but is not the primary reason the person resides in the community, food, clothing and transportation. if these exclusions were expanded, the largest consumptive transfers related to another's support made by most taxpayers, including the support of adults, would be protected from transfer tax consequences. it would be unnecessary for donors to rely on the annual exclusion to protect such transfers from gift tax consequences.' accordingly, the annual exclusion 203. another factor that might help assess whether a consumptive transfer permits the beneficiary to accumulate wealth is to determine if the donee would have otherwise consumed that amount. for example, consider the situation where x pays for y's flight to paris and an extravagant weekend. if y would not have expended y's own funds to take any such trip or make any replacement expenditure, the expenditures by x does not permit y to save funds y would otherwise have spent. however, there is no easy way to determine whether y would have made such an expenditure if x did not. an objective test. based on the assets available to y, or a subjective test, based on y's intent to take such a trip, would have to be used to assess this factor. the objective test would be very complex, and the subjective test seems unreliable. hence, this factor is unusable. 204. the restructuring report suggested that the tuition exclusion be expanded to cover other items related to education, but did not attempt to provide any detailed suggestions on how to accomplish the expansion. restructuring report, supra note 171. at 402. it may be argued that if all states eventually impose an obligation on parents who have the financial ability to do so to provide post-secondary and even graduate school education to their children, no expansion of the tuition exclusion is necessary, since transfers in satisfaction of obligations to support are not subjected to transfer tax. this argument fails for at least three reasons. first, not all states impose such an obligation and there is no guarantee that they will. see discussion supra note 145. if not all states do so. then it would be inappropriate to have a federal transfer tax system, which should apply uniformly, permitting transfers related to education of adult children to escape gift tax if made in a state that imposes an obligation to make such transfers, while taxing such transfers made by parents who feel a moral obligation to do so but who are domiciled in states that do not impose a legal obligation to provide such support. second, even if all states did eventually impose such 19931 florida tax review could be revised without severely affecting support related transfers made to persons to whom the transferor does not have a legal duty of support. obviously, changing the tuition and medical care exclusions to permit additional transfers for the purposes described above could also open the door to abuses. for example, permitting gift tax free transfers for "housing" a student or an elderly person could mean purchasing and transferring to the donee a $300,000 home. "transportation" could mean transferring a plane or an expensive car that most people would view as a significant gift. none of these assets is short lived, and the amount involved is relatively large. hence, under the analysis of consumptive transfers set out above, neither should be protected from transfer tax. to prevent such potential abuses, payments of these expenses would have to be limited in ways relatively easy to check and to enforce. these limits will be designed based on the factors identified above as useful in limiting the use of consumptive transfers to make wealth transfers. the expanded tuition exclusion could be stated as an exclusion for student living expenses which would apply to transfers for the expense categories listed above and made to persons who are enrolled in and attending at least half-time an educational institution (as defined in section 170(b)(1)(a)(ii)), and who are in good standing at the time the transfer is made. having limited this exclusion to such students, it does not seem necessary to limit the use of this exclusion to donors and donees within a particular set of relationships, so long as the purpose for which the transfer can be made, the amount of the transfer, and the types of assets acquired are reasonably limited.0 5 the amount of this exclusion could be subject to a dual cap, the an obligation, it is not at all certain they would impose it with respect to children who graduate from college or graduate school, are emancipated for several years, and then return to school. hence, some exclusion would need to be available for such returning students. third, if states can eliminate gift tax consequences by changing their support standards, what will prevent them from largely eliminating the gift tax for their wealthy citizens by requiring those that can, to provide their children, even adult children, all the necessaries and comforts they can provide consistent with their wealth, and without regard to the ability of the child to support himself or herself? in such a situation a federal standard to govern and limit such transfers would have to be developed or the federal transfer tax system would be severely breached. 205. while the exclusion could be limited to children, grandchildren, nieces, nephews, etc., there seems little reason to impose such a limitation. most such transfers will undoubtedly occur intra-family. nonetheless, if someone wants to pay the educational expenses of an unrelated person, there is no greater reason to tax that transfer than to tax an intra-family transfer of the same kind, given the other safeguards recommended. note that while the relationship of the donor and donee is not defined, a similar limitation on the exclusion is achieved by requiring that the donee must be at least a half-time student enrolled in an educational institution. [vol 1:7 should we give away the annual erclusion? lesser of expenses actually incurred or a specified dollar amount.-' the specified dollar amount could be fixed in relation to the average expenses incurred for housing, transportation, food, clothing, books and supplies at relatively expensive institutions. the exclusion would be unavailable for expenses paid or reimbursed from any other source, such as other family members, a trust or a scholarship. to prevent some major opportunities for exploitation, the statute should not protect the transfer of ownership of any real property or any tangible asset with a value in excess of a specified dollar amount, although it should allow the use of such assets. this should help prevent the transfer of long lasting assets under this exclusion. additionally, transfers would be limited to those amounts and assets necessary for the current school year. to make the valuation of the transferred items easier, transfers could qualify for the exclusion only if made in cash or in the form of the item to be used (e.g., a book). the ultimate limit on the use of this exclusion would be that it could not be used as to any one donee for more than twice the number of years that a full-time student would require to obtain the degree sought by the donee. while it would be possible to tighten up the safeguards against abuse of such an exclusion by providing that only payments made to vendors could qualify for the exclusion, that would add such a substantial amount of complexity that it does not seem desirable. 7 however, a reasonable additional safeguard against abuses of this exclusion would be to require the taxpayer claiming it to report that transfers had (or had not) been made in reliance on the exclusion, to list the social security numbers and relationships of all persons to whom such transfers had been made, and to retain receipts, canceled checks, or other records documenting the amounts transferred in reliance on the exclusion.' the law would also specify that taxpayers whose income tax returns are examined can also be required to produce this documentation. this could substantially reduce the number of those who would attempt to abuse the student living expense exclusion, and there would be no additional returns required to burden taxpayers or the internal revenue service. a similar approach could be taken with respect to expenses of caring 206. since the tuition exclusion itself would remain in place, the dollar amount limit need not encompass tuition too. the dollar amount limit should be indexed to the consumer price index. 207. for example, paying the vendor directly for books, for gasoline for the student's vehicle, for groceries, or for food at the fast food restaurant, would all be difficult compared to paying tuition directly. while it could be accomplished in many cases with a parent-paid credit card in the hands of the student, that is not always feasible nor desirable. 208. this report could be made on a special schedule attached to the taxpayer's income tax return, but easily detached and transferred within the internal revenue service to those having expertise in gift matters. 1993] florida tax review for the aged or others who need nonmedical care. the basic approach would be to permit transfers for housing, wages of caretakers to whom payments would not qualify for the medical care exclusion, food, clothing and transportation to be made free of gift tax, if made to pay or reimburse payment of expenses actually incurred and not paid from any other source. like the student expense exclusion, this exclusion should place an annual cap on the transfers equal to the lesser of the amount actually required or a specified dollar amount. the specified amount should be related to the expense of a good home for the aged (which should be large enough to encompass food and a caretaker for those living at home), clothing and transportation. in addition, the transfers should be in the form of cash or the property to be used, and transfer of the ownership of real estate and any tangible asset with a value in excess of a stated dollar amount would be prohibited. reporting could be handled in the same manner described above. unlike the student expense exclusion, there would be no limit on the number of years that such transfers could be made, since there is no accurate method of predicting how long they will be required. the likelihood of this exclusion being abused to transfer substantial wealth to transferees who are significantly older than the transferor might seem minimal, and one might wonder if any safeguards are required in this context. generally, an older transferee could be expected to predecease the transferor. accordingly, wealth transferred to an older transferee could be expected to be subjected to estate tax in the transferee's hands at an earlier date than it would have been in the transferor's hands, and thus one might expect such transfers would only be made if necessary and if the wealth will be consumed. however, safeguards are nonetheless desirable because of the unified credit and the gstt exemption. if a wealthy person has an aged parent who needs care and who does not have enough assets to use his or her unified credit or gstt exemption fully, or has just enough assets to use the unified credit, the parent's credit or exemption may provide the wealthy child an opportunity. if gift tax free transfers could be made to the parent under the expanded care exclusion which permitted the parent to accumulate or retain wealth to use his or her unified credit or gstt exemption, this wealth could be left to the transferor's children or grandchildren without incurring transfer tax in either the parent's estate or the wealthy child's estate. to minimize this risk effectively would probably mean requiring that the person to whom the transfer is made be a person of reasonably limited means, who must actually consume the transferred assets. also required would be some documentation of the donee's status and the use of the transferred assets. unfortunately, such requirements lead to the same type of detailed regulation found in the abominable medicaid regulations which govern that program's payment of nursing home care and require proof of the [vol 1:7 should we give away the annual erclusion? income and assets available to the recipient.' on balance, it is better to accept some potential abuse of this exclusion than to go down the labyrinthine path blazed by the medicaid approach. the potential abuse may not be that great. many persons of wealth have parents and grandparents who already have sufficient assets to use the unified credit and gst" exemption. further, transfers under the exclusion must be outright to the donee or expended directly for his or her benefit. hence, the donor will, in many cases, be taking a risk that the donee's accumulated wealth will be disposed of at the donee's death in some manner other than that which the donor expects. if the donee's will or other testamentary plan leaves his or her property to charity or to some branch of the family other than the donor's, the donor's plan may backfire. in addition, requiring that the donor and donee have some particular relationship in order to make use of this exclusion would prevent a heyen-type use of this exclusion." if this exclusion is not limited to persons who bear a stated relationship to the donor, such as parent, grandparent, aunt, uncle, great-aunt or great-uncle, then it could be used to provide benefits to adult children or grandchildren of the donor who are in a position to accumulate wealth, or to nonfamily members who can be induced to accumulate wealth and leave it to the donor's family. for example, the donor could pay the apartment rent or automobile lease payment of an adult child, who in turn could accumulate that amount. on the other hand, if the persons to whom such transfers can be made are limited to a specified group, the potential for abuse is reduced, but donors then may not be able to claim the exclusion with respect to gifts to some deserving donees (e.g., the best friends of the donor's deceased parents, who were really the donor's primary care givers and who now need help paying for their expenses of living in a senior citizen's complex). given the potential for abuse, limiting the use of the exclusion to persons bearing one of the specified relationships to the donor listed above, or who are incompetent, is a reasonable course of action. by limiting the availability of this exclusion to the donor's parents, grandparents, aunts, uncles, great-aunts and great-uncles, the potential for using the exclusion to build up wealth in a large number of people who can be induced to leave it 209. these regulations are very complex and quite harsh in limiting the amount of income and assets a person can have in order to qualify for public payment of nursing home costs. see, e.g., joel c. dobris, medicaid asset planning by the elderly: a policy view of expectations, entitlement and inheritance, 24 real prop., prob. and tr. j. 1 (spring, 1989); clifton b. kruse, jr., discretionary trusts: insulating trust assets for elders and incapacitated persons from consideration by medicaid and other public support providers, 17 am. college of trust and estate counsel notes, no. i (summer, 1991). 210. see supra notes 163-64 and accompanying text. 19931 florida tax review back to the donor's family is reduced. if incompetent persons are the only other donees who qualify under this exclusion, then the opportunity to use the exclusion to build up wealth in others, including children or grandchildren, is still reasonably limited. a person would be considered incompetent for this purpose if a court has found the person to be incompetent or if the donee's regularly attending physician has certified, in writing and under penalties of perjury, that the donee is incompetent. a copy of the court decision or the physician's certificate could be required to be filed with the return reporting the reliance on the exclusion. e. modifications of the annual exclusion considered assuming that the changes proposed to the tuition and medical care exclusions are adopted, the annual exclusion could be modified in several direct and indirect ways. several possible approaches to its modification are discussed below, followed by the selection of the modifications which will best accomplish the goals described in section a of this part v. 1. reducing the annual exclusion per donee limitation.-a simple way to limit the use of the annual exclusion to avoid transfer tax is to reduce the amount of the exclusion, as congress did in 1939 and 1942. it could be reduced from $10,000 per donee to the amount that persons with $600,000 of wealth give on average to a single donee for birthdays, holidays, weddings, graduation and such regularly occurring events as the annual exclusion was intended to cover. for purposes of discussion, an estimate of $5,000 will be used. this is a very straightforward approach. if a taxpayer has only a few donees, it substantially reduces the amount of wealth the donor can transfer. obviously, even if many donees are available to the taxpayer, such a reduction will cut the amount the taxpayer can transfer under the annual exclusion in half (assuming the $5,000 per donee limitation). however, if there are numerous donees available, the gross amount the taxpayer could give away during life, especially if married, might still amount to several hundred thousand dollars. moreover, a simple reduction in the amount of the exclusion may also affect some persons who are not targets of the wealth transfer system (generally, persons with a gross estate under $600,000), but who can afford to make occasional gifts in excess of $5,000, such as an automobile, furniture or a contribution toward the purchase of a home. the excess over $5,000 would be a taxable gift. such excess would usually use up some unified credit, but would not require any out-of-pocket payment. however, the use of credit does require the filing of a gift tax return. nonetheless, the number [vol 1:7 should we give away the annual frchsion? of people affected should not be excessive. 2 ' 2. limiting the amount that can be transferred under the annual exclusion in one year by any single donor.-another way to limit the use of the annual exclusion to avoid transfer tax would be to place a cap on the amount that a single donor could transfer under the exclusion in any one year.212 for example, the annual exclusion might be limited to $10,000 per donee, as under current law, but each donor's transfers under the annual exclusion could be limited to $20,000 per year in the aggregate. thus, if an individual had two children, he or she could, as under current law, give $10,000 to each of them. if the donor had four children, all of whom were married, and each of them had two children, the donor could still give as much as $10,000 to any one donee, but the aggregate gifts the donor could make under the annual exclusion to the children, their spouses and the grandchildren would be limited to $20,000, instead of $160,000 as under current law. this approach, implemented without any reduction in the per donee limitation, would prevent the use of the annual exclusion to make the type of large wealth transfers described above, where the donor has numerous donees available.2 13 however, under this approach, a donor with only a couple of 211. see infra note 214. steinkamp, supra note 171, at 170-72, would leave the size of the exclusion unchanged, but would index it for inflation. however, under his approach the exclusion would still function to protect support related transfers to adults from gift tax, and thus could not reasonably be reduced in amount. however, by choosing that approach, steinkamp leaves the exclusion at a size he acknowledges permits substantial wealth transfers. id. at 169-170. he believes that replacing the present interest requirement with a provision which denies the exclusion for transfers of future interests, and permits transfers in trust to qualify for the exclusion only if the trust benefits a single beneficiary and the beneficiary (or a guardian) must have a nonlapsing withdrawal right, will prevent the exclusion from causing serious leakage in the transfer tax system. this ignores the practical controls donors of wealth can exercise over donees (e.g., "use the withdrawal right and you will never see another penny-), and the types of assets that can be given outright but leave the donor in control, such as family partnership interests, nonvoting stock, stock subject to shareholder agreements, fractional interests in land, and other such assets. 212. i originally thought about a per donor limitation several years ago while in practice. it occurred to me after having tried to explain to a client the differences between the income and gift tax consequences of cruimney rights. i realized that the per donor limitation could be made the sole limitation, eliminating the per donee limit and, with it. the present interest requirement and the use of crnnuneyv rights. the restructuring report. supra note 171, at 401, which i later read, suggested that a per donor limitation be adopted together with a replacement for the "present interest" requirement and a s100 de minimis per donee exclusion that would permit tax free and reporting free transfers of small amounts to other donees even after the donor had fully consumed the overall per year limit. 213. see supra part iii c i a. 19931 florida tax review donees could transfer the same amount of wealth as he or she can transfer under current law. thus, a married couple with two children could, over 10 years, give $400,000 to the children under current law and under this proposal. this approach is unlikely to cause very many persons who are not targets of the wealth transfer system to file any gift tax returns they do not have to file now, since it leaves the per donee limitation at $10,000 per person. thus, it is perhaps less likely than the straightforward reduction in the per donee limit to increase the reporting burden on those who are not targets of the system. 3. reducing the annual exclusion available based on the accumulated use of significant amounts of annual exclusion.-a somewhat different type of mechanism that could be used to prevent the use of the annual exclusion to transfer large amounts of property would be to reduce the annual exclusion available to those who make frequent and substantial use of it. this could be accomplished as follows: (i) leave the per donee annual exclusion limit at $10,000 and require each taxpayer to report gifts made to a single donee within a year that, in the aggregate, exceed a smaller stated dollar amount, such as $5,000; (ii) if the taxpayer reports in the aggregate such gifts totalling more than $30,000, or some other specified amount, then the taxpayer's annual exclusion would be reduced, prospectively, to $5,000 per donee; and (iii) if the taxpayer's aggregate reported gifts over $5,000 exceed $50,000, the taxpayer's annual exclusion would be reduced to $2,500 per donee. compared to present law, this system would require additional reporting, in that under current law an individual can give $10,000 per donee without reporting the gift. however, the number of people who make gifts in excess of $5,000 to any donee in a year, assuming expanded tuition and medical care exclusions, should be fairly small.2 14 hence, the number of 214. the number of gift tax returns (forms 709) received in 1990 was 147,700, with a projected decline in 1991 to 143,800. selected historical data, 10 statistics of income bulletin 53, 87 (winter 1990-1991). however, the number of gift tax returns projected to be filed in 1998 is 207,000. bonnie l. nichols, projections of returns to be filed in fiscal years 1991-1998, 10 statistics of income bulletin 47, 52 (winter 1990-1991). since the reference in the bulletin is to form 709, this should mean that the reports made, and estimated to be made in the future, were of taxable gifts. (however, if the reference to form 709 in the bulletin includes the 709 short form, which can be used by spouses who split gifts that are within their combined annual exclusion, then even some of these returns may have reported, or may be expected to report, nontaxable gifts.) reducing the exclusion to $5,000 may increase the number of returns several fold. but some significant amount of the increase that might otherwise occur should be eliminated by the liberalization of the tuition and medical care exclusions. further, some number of those who now choose to make annual exclusion gifts [val 1:7 should we give away the annual exclusion? additional individuals required to file returns and the amount of time the irs would have to devote to them should not be overwhelming. further, merely exceeding the $5,000 per donee, per year limit would not trigger any immediate tax payment obligation. it would simply require the taxpayer to start reporting and recording the cumulative total of gifts made in excess of $5,000, whether under the annual exclusion or taxable, with a prospective reduction in that taxpayer's annual exclusion once the cumulative reported amount exceeds $30,000 and a further reduction when the reported cumulative total exceeds $50,000. this approach has the benefit of reducing the benefit of the annual exclusion for those who are likely, ultimately, to owe some substantial amount of transfer tax and who should not be permitted to avoid the transfer tax system, while retaining the benefit of the exclusion to others. compared to the present annual exclusion, this approach does add the complexity of a cumulative recordkeeping system for transfers in excess of $5,000, rather than $10,000. however, the burden would be primarily on taxpayers, rather than the irs, and the burden should not be particularly heavy even for taxpayers. 215 4. the present interest requirement.-as discussed in part iii b, under existing law a transfer qualifies for the annual exclusion only if it is a transfer of a present interest.26 outright gifts and transfers to custodianships established under the uniform gifts to minors act (ugma) or the uniform transfers to minors act (utma) also qualify.2t7 transfers to trusts which have the terms specified in section 2503(c) of the code also qualify for the annual exclusion. the custodianships and section 2503(c) trusts essentially guarantee a minor who is the donee of a gift that he or she is the only person who can benefit from the transferred property and that he or she will either receive the property or at least have the opportunity to obtain full control of it on or before attaining age twenty-one.up to the $10,000 limit, and who might add to the number of people who have to file returns if they continued making such gifts after the adoption of a smaller limit, would likely reduce the gifts they make to equal the smaller limit and thus not make gifts that have to be reported. hence, even if the reduction in the annual exclusion limit would by itself increase the number of returns five-fold, for example, the countervailing factors should keep the increase to a factor much smaller than that. 215. cumulative gift tax reporting is required under current law for gifts that are taxable. irc § 2502. 216. see supra part ei b 1, 2. 217. see supra note 104. 218. the custodians of transfers made under either ugma or utma are obligated to distribute the custodianship assets to the person for whose benefit the custodianship was created atage 21, although some enacting states have opted for age 18. utma § 20tlh (1991); 19931 florida tax review another method of qualifying transfers for the annual exclusion under current law is to provide the beneficiary a withdrawal right with respect to property transferred to a trust. permitting withdrawal rights to qualify gifts into trust for the annual exclusion is a farce, since it has been widely recognized that such rights are not likely to be exercised.2" 9 the present interest requirement could be altered in at least three ways, each of which would have some impact on the use of the annual exclusion. it could be eliminated, so that gifts could qualify for the annual exclusion even if they are gifts of future interests. second, it could be replaced with a provision under which transfers could only qualify for the annual exclusion if made outright or to a trust for one beneficiary, the terms of which force the property to be included in the beneficiary's gross estate to the extent it is not distributed to or for the benefit of that beneficiary.22 ° third, it could be altered so that its requirements can be satisfied only by outright transfers.22' some guidance as to which is the appropriate approach may be provided by the legislative history underlying the present interest requirement. that history states that the present interest requirement was adopted to simplify the valuation of interests as to which the exclusion could be claimed.222 that is, the present interest requirement prevented any claim that the annual exclusion applied to remote or contingent future interests which are very difficult to value and the donee of which is difficult to identify.223 if the primary intent behind the present interest requirement was to make valuation of the transferred interest easier, this goal could be achieved by any of the three approaches. for example, if the law were changed and a $20,000 per donor cap were placed on the annual exclusion, transfers could d.c. code ann. § 21-320 (1992); la. rev. stat. ann. § 770 (west 1992); okla. stat. tit. 58, § 1221 (1992); r.i. gen. laws § 18-7-21 (1992). code section 2503(c) and its regulations require that the trust beneficiary receive all remaining trust property upon attaining age 21. irc § 2503(c)(2)(a); regs. § 25.2503-4(a)(2). regulations section 25.2503-4(b)(3) permits the beneficiary to extend the trust, but nonetheless the beneficiary must have a right to receive the trust property at age 21. 219. see supra notes 111-112 and accompanying text. 220. this was recommended in page 401 of the restructuring report, supra note 171. 221. implicitly, this would eliminate crummey withdrawal rights as a means for qualifying for the exclusion. gutman has proposed that no transfer in trust qualify for the annual exclusion. gutman, supra note 170, at 1245. for reasons discussed above (see supra pp. 415-16), that approach is too harsh. 222. s. rep. no. 665, 72d cong., 1st sess. 41 (1932), reprinted in 1939-1 (part 2) c.b. 496, 525. 223. id. [vol 1:7 should we give away the annual erchsion? be made under the annual exclusion without regard to whether any present interest existed in any donee and without regard to how many persons shared an interest in the amount transferred, so long as the donor retained no interest in the transferred property or any such retained interest was disregarded in determining how much of the exclusion the gift consumed. " of course, this would entail giving up a per donee limit on the exclusion. that is because without a present interest requirement, as to many transfers in trust, numerous assumptions and calculations would be necessary to value the interest of each trust beneficiary. for example, if a trust receives a gift of $20,000, and the trustee is permitted to make discretionary distributions of corpus among multiple beneficiaries, valuing one beneficiary's interest would require numerous assumptions to be made about the value of his or her interest. permitting the annual exclusion for transfers in trust only if the trust has a single beneficiary and requires the property to be included in the beneficiary's gross estate to the extent not paid to or for that beneficiary serves the goal of easy valuation that the present interest requirement was designed to serve. this "vesting" approach also permits the use of both a per donee and a per donor limitation on the exclusion. such transfers would be just as easy to value as those made under a per donor cap alone. finally, if only outright transfers qualified for the annual exclusion, the valuation obviously would not involve calculating the value of the interests of different beneficiaries, as there could never be more than one recipient of any one gift. again, the valuation purpose of the present interest requirement would be served. 5. the amount of the annual ercusion for married couples.-under current law, each member of a married couple has available a full annual exclusion. if a and b are married and a does not have the resourc6s to utilize the annual exclusion, b can make a gift to a third person of up to twice the amount of the exclusion. if a consents, the gift will be treated as using both a's and b's exclusion.--5 a simple way to reduce the power of the annual exclusion to transfer wealth is to limit each member of a married couple to an annual exclusion 224. there is already precedent for ignoring the value of a retained interest when determining the value of the interest transferred. section 2701 deals with valuation of equity interests and, sometimes, in valuing a business interest given away. directs that the value of an interest retained by the transferor in the same business be ignored. section 2702 directs that the value of income interests retained by transferors of remainder interests be ignored in valuing the property given away, with the result that the transferor can be taxed as though the gift was not of only the remainder but of the entire property. 225. see supra note 59 and accompanying text. 19931 florida tax review that is one-half of the exclusion available to a single person. although giftsplitting by spouses would still be permitted under this approach, the total amount a married couple could give any one donee would be limited to the amount a single person could give that donee. 6. gift tax reporting.-an additional change that could be made to help control the use of the annual exclusion would be to revise the gift tax forms and directions to make it clear that all gifts reduce the exclusion. a reference to the gift tax reporting requirements could also be included in the income tax return and its directions, explaining that the annual exclusion is available but also explaining that all gifts, including those for birthdays, holidays, weddings, graduations and all such events, use up the exclusion. f. implementing the most effective and administrable modifications to address the problems of the current annual exclusion 1. choosing among the most direct modifications.-of the six possible changes discussed above, those that would most directly affect the annual exclusion are: (i) reducing the per donee limitation in all cases (the "per donee" model); (ii) limiting the exclusion on a per donor basis (the "per donor" model); and (iii) reducing the annual exclusion based on cumulative use made thereof (the "cumulative use" model). because these possible changes have the greatest potential impact on the exclusion their relative merits are discussed first. thereafter, the other three proposed modifications are discussed and suggestions made as to which of them to implement. each of these possible modifications has its strengths and weaknesses when adjudged against the goals earlier identified for any changes to the annual exclusion. 226 the per donee and cumulative use models would cause all taxpayers making gifts in excess of $5,000227 to any one donee to have 226. see supra p. 408. one of the persons who commented on this article pointed out that transfers under the annual exclusion (or even larger gifts) could be viewed as transfers that help break up concentrations of wealth, and, thus, should be encouraged rather than discouraged or taxed. obviously, this approach is inconsistent with the revenue raising purpose of the transfer tax system and could be rejected on that basis. however, there is also a policy basis for rejecting that approach. the justification for taxing concentrations of wealth as they are transferred from the owner is to support the progressivity of the income tax system. gutman, supra note 170, at 1212-16. by permitting gifts to break up the wealth without it being taxed, this progressivity function is compromised. 227. the $5,000 amount has no magical qualities, other than the fact that it represents a substantial reduction in the current level of the exclusion. the amount selected should be determined by studying the incidental gift level of those congress has chosen to exempt from the transfer tax system through the unified credit. [vol 1:7 should we give away the annual erclusion? to report those gifts, and, under the cumulative use model, gifts over $2,500 would have to be reported by some taxpayers. thus, more taxpayers would likely file gift tax returns under these approaches than under the current $10,000 annual exclusion, and the returns would have to be processed by the government. the cumulative use model would require taxpayers to keep cumulative records of gifts over $5,000 per donee in order to determine when they have exceeded the $30,000 or $50,000 gift levels that trigger reductions in the annual exclusion. the per donee model would also require cumulative, lifetime reporting of gifts over $5,000 per donee, because under that model the excess over $5,000 would either consume some of the donor's unified credit or would actually cause gift tax to be due if the donor's credit had previously been consumed. while current law also requires cumulative reporting of gifts, because the exclusion is $10,000 per donee, fewer people are likely to have to report. the per donor model (assuming no change in the $10,000 per donee model) would not so clearly increase the number of gift tax returns filed and the number of taxpayers required to involve themselves with a cumulative reporting system. since it does not reduce the per donee limitation, it would not increase the number of returns required from any set of persons who never give over $10,000 to one donee and over $20,000 in a year. most persons who can make gifts in a year of more than that amount (or over $40,000 in a year for a married donor) are almost certainly wealthy enough to be justifiably caught up in the transfer tax system and its reporting requirements. thus, purely from an administrability viewpoint, the per donor model may have advantages vis-a-vis the other models that are likely to increase the amount of gift tax reporting by a somewhat larger number of persons. if a per donor model were adopted and the per donee limit were eliminated, the annual exclusion would be made quite simple. however, since such a per donor model would likely have to be established at a limit high enough to accommodate donors with multiple donees, such as $20,000, donors with only one or two donees would be able to transfer as much or more wealth as they can transfer now under the exclusion. as to which of the models would be most effective in curtailing the use of the annual exclusion to transfer significant amounts of wealth, it seems likely the answer will vary, depending upon: (i) the number of potential donees the donor has; (ii) whether the donor is willing and able to make a gift of a large amount under the unified credit (up to $600,000); (iii) if the large gift is made, whether the property given appreciates or not; and (iv) if the large gift is made and appreciates, at what rate does it appreciate. the following examples will illustrate some of the variations. first, assume a taxpayer who: (i) has five potential donees; (ii) can afford to make lifetime gifts up to $50,000 under the annual exclusion; (iii) thereafter, can afford to make annual gifts of $5,000 per donee; and 19931 florida tax review (iv) can not afford to make a large gift under the unified credit. after giving up to $50,000, this taxpayer will be able to make $25,000 worth of tax-free gifts annually under the cumulative use model, which is more than the taxpayer could give under the per donor model, which limits such gifts to $20,000 per year. the total transferred is also more than could be transferred tax free under the per donee model, which does not permit any $10,000 gifts before reducing the exclusion to $5,000. now, consider a taxpayer with five donees who can afford to make lifetime gifts of $50,000 under the annual exclusion and $600,000 under the unified credit. the additional $600,000 gift would, under the cumulative use model, cause the taxpayer's annual exclusion to be reduced to $2,500 per donee. hence, the taxpayer loses the ability to get $12,500 (5 x $2,500) out of his estate each year. however, by making the $600,000 gift, he has also removed from his estate all the appreciation (if any) on the $600,000. if the $600,000 gift appreciates at an average annual rate of 2.0834%, the person who can make such a gift can better avoid estate tax under the cumulative use model by making the large gift and suffering the reduction in the annual exclusion.228 the taxpayer who can make the $600,000 gift will be able to avoid even more estate tax under the per donee model than under the cumulative use model, assuming that the taxpayer has five donees and a life expectancy in excess of two years after making the first set of five gifts under the annual exclusion. this is because under the per donee model, the annual exclusion is always $5,000. thus, the taxpayer can only make a first round of annual exclusion gifts totalling $25,000, instead of the $50,000 that could be made under the cumulative use model. however, after the $600,000 gift, the taxpayer can continue to make $5,000 gifts under the per donee model, rather than $2,500 gifts as under the cumulative use model. with five donees, the $25,000 difference in the first round of gifts can be made up in two years of $5,000 gifts instead of $2,500 gifts. 29 if, however, one assumes a taxpayer with no more than three donees, the greatest amount of estate tax could generally be avoided under the per donor model (if the $10,000 per donee and $20,000 per donor limitations are used). this will be true without regard to whether the taxpayer can make a 228. if the $600,000 gift appreciates at 2.0834% annually, the gift property will grow by $12,500 in the first year after the gift is made, and thereafter will grow by an amount larger than $12,500 per year (because of the compounding effect). since the growth in the gift property escapes estate and gift tax in the hands of the donor, the growth in the $600,000 gift more than replaces the reduction in the annual exclusion if the average growth is 2.0834% or more. 229. this two year "make-up" will always occur so long as the taxpayer is assumed to have the same number of donees under each of the two models discussed. [vol 1:7 slwuld we give away the annual exclusion? $600,000 gift, as long as the donor can make the maximum annual exclusion gifts possible for more than three years. that is because with three or fewer donees, the effective per donee limitation under the per donor model is $6,666.66 or more, which is greater than the $5,000 limit under the cumulative use model after $30,000 worth of gifts are made. it is also greater than the $5,000 limit allowed under the universal reduction model." ° if the taxpayer had four donees, could afford to make a $600,000 gift, and has a more than a two year life expectancy after the first gifts are made, the taxpayer could avoid more estate tax under the per donor limitation than under the cumulative use model. that is because under the cumulative use model, after the $600,000 gift is made, the exclusion will be reduced to $2,500 per donee, while the effective per donee limit under the per donor model will be $5,000 where four donees are assumed. in fact, such a taxpayer could avoid more estate tax under the per donor model than the cumulative use model so long as the number of donees is less than eight, and his life expectancy is more than fourteen years after the first gifts are made. absent empirical data on how many taxpayers can and do utilize the annual exclusion, how many taxpayers can and do give away $600,000 (or some substantial portion thereof), the average number of donees the average donor has, and the life expectancy that donors have at the time they make such gifts, which model will actually be most effective at curtailing the use of the annual exclusion to avoid transfer taxes is not determinable with any real certainty. since not all of this information is readily available to the government under the existing reporting system, the choice could not be made on an empirical basis until a substantial amount of information could be collected and analyzed. accordingly, until such information becomes available, the choice can only be made based on judgment and experience. based on the analysis set forth above, a combination of the per donee and the per donor models would be effective and reasonably simple to implement.' -" compared to present 230. if the donor has three donees, under the cumulative use model he could make one $10,000 gift to each donee in one year, but in each year thereafter he could give only $5,000 per donee tax free under that model. thus, he could give s30.000 in year one, and $15,000 in each succeeding year. by the end of the third year, he would have transferred $60,000. under the per donor model, he could give $20,000 each year. by the end of the third year under that model, he could again have transferred s60.000. in the fourth year and each year thereafter, he could give away only s 15,000 under the cumulative use model, but $20,000 under the per donor model. 231. the restructuring report, supra note 171, at 401. suggested that a per donor limitation be adopted as a means of preventing large scale wealth transfers under the exclusion by those with many donees, but did not recommend any reduction in the per donee limitation. unless $10,000 per donee turns out to be the average amount of annual exclusion-type gifts made by persons who have $600,000 or less of property, which seems unlikely, failing to 19931 florida tax review law, this combination (assuming the $5,000 exclusion amount) would halve the amount any taxpayer with four or fewer donees could transfer under the annual exclusion, and would cut the amount in less than half for taxpayers with more than four donees. certainly, the per donor and cumulative use models could also be combined. this offers the possible further reduction in the annual exclusion to $2,500, which, if reducing tax-free wealth transfers were the only goal, might be compelling. however, under the cumulative use model, some taxpayers will incur an obligation to file a return with respect to gifts to one donee in excess of $2,500, while no taxpayers will incur this obligation under the per donee model. thus, the combination of the per donor and cumulative use models has the potential for requiring more returns to be filed. but an even more important element in choosing the per donee/per donor joint model as opposed to a cumulative use/per donor model is the "explainability" of the law. the $20,000 per donor cap is not particularly complex to explain in its own right. thus, assuming that it would be adopted with either of the other models, it would not be a factor in choosing between the other two. however, the mere ease of stating and applying the per donee model, compared to the complexity of stating and applying the cumulative use model, is a significant factor favoring the per donee model. 2. choosing among the less direct modifications.-changing the present interest requirement, reducing the annual exclusion amount available to married persons, and adopting new reporting requirements would less directly affect the annual exclusion than would the modifications discussed above. nonetheless, each of these possible changes would affect the use of the exclusion and determining which, if any, of them should be adopted is worthwhile. reduce the per donee limitation is unacceptable. gutman, on the other hand, argues that if the per donee limit is reduced to an appropriate amount, there is no need to adopt a per donor cap also. gutman comment, supra note 170, at 659. the logic of gutman's position is irrefutable. however, it seems likely that on an issue like this, which has the potential to affect a substantial number of taxpayers and to cause the government a substantial administrative burden, lawmakers will choose to pick an amount at the high end of any range of figures presented to them. thus, it seems desirable to have an overall cap which will reduce large scale wealth reduction through use of the exclusion. steinkamp, supra note 171 at 170-71, argues that using only a per donee exclusion is consistent with the purpose of the exclusion to protect ordinary gifts, which are made to individual donees, and that if the exclusion is too large then the per donee limit should be reduced. however, if the per donee limit is set large enough to cover recurring gifts (such as birthdays and holidays), and also to cover special occasion gifts (such as weddings and graduations), a per donor limitation should seldom prove to be too restrictive. [vol. 1:7 should we give away the annual erclusion? retaining a per donee limitation, as recommended above, requires that there be a present interest requirement or some substitute for it in order to make it possible to value the amount transferred to each donee. while a per donee limit is desirable to retain, the use of meaningless withdrawal rights to create a present interest should be eliminated. gutman would eliminate the use of withdrawal rights to create a present interest by denying the annual exclusion for transfers into trust, an approach that would also limit or make more difficult the transfer of certain types of assets under the annual exclusion.' the type of assets transferred is an appropriate thing to limit in consumption type transfers, but it is not an appropriate thing to limit for the types of gifts that the annual exclusion was meant to protect. the suggestion of the aba task force to require an annual exclusion gift in trust to be usable for only one beneficiary, and, to the extent not so used, to be includible in that beneficiary's gross estate, will permit a per donee limit to be retained and eliminate the use of withdrawal rights given solely to make a transfer a present interest. this approach also preserves for donors the use of trusts as vehicles to hold annual exclusion gifts. accordingly, using a "vesting" approach to replace the present interest requirement is the most desirable alternative. reducing the annual exclusion available to a married person by fifty percent presents a difficult choice. doing so would be based on the premise that a married couple should be treated as one person for transfer tax purposes. there are other transfer tax provisions that do this. perhaps the most significant one is the unlimited marital deduction, which treats the married couple as a unit and allows deferral of all gift and estate tax liability 232. gutman, supra note 170, at 1245-46; gutman comment. supra note 170, at 658-59. steinkamp, supra note 171 at 174-78, argues that transfers in trust should qualify only if the trust benefits a single beneficiary and the beneficiary (or a guardian therefor) can withdraw the property at any time. his argument is that the exclusion is meant to cover incidental gifts and that most such gifts are made in a way that gives the donee control over the gift property, and thus gifts in trust should qualify only if they provide the donee essentially the same control. steinkamp's approach and that recommended herein are perhaps more alike than they are different, since each replaces the existing present interest requirement with an approach that assures the beneficiary some degree of benefit and control. to the extent they are different, steinkamp would presumably argue that the nonlapsing withdrawal right included in his proposal would give the donee more control than the "vesting" approach recommended by this article, and that the nonlapsing withdrawal right will reduce the use of the exclusion to make large transfers of wealth. however, as discussed supra note 211. nonlapsing withdrawal rights can be, and probably often are, illusory. it also seems unnecessary to assume that incidental gifts must be gifts over which the donee obtains immediate control. so long as the beneficiary must ultimately receive the benefit of the gift and can control the ultimate disposition of it, there seems to be little room for abuse of the system. 19931 florida tax review on property given or left by one spouse to the other. spouses are also treated as one person for certain purposes under chapter 14 of the code (dealing with valuation of transfers) and for purposes of section 6166 (dealing with the payment of estate tax in installments.233 hence, the treatment of spouses as one person for purposes of the annual exclusion could be said to be consistent with the treatment of spouses for some other transfer tax purposes.2 "u however, for purposes of other significant transfer tax provisions, such as the unified credit and the $1 million exemption from gstt, spouses are treated as separate persons. each spouse has a unified credit and each has his or her own gst-i exemption.235 one could argue that congress has been inconsistent in the way it has treated married couples for transfer tax purposes. but this may not be an instance of congressional inconsistency. rather, the purposes served and the effects caused by the provisions treating spouses as one person may be sufficiently different from those served and caused by the other provisions to justify the different treatment. for example, the marital deduction provision is designed to make it easier for the surviving spouse to be supported and it affects primarily the timing of transfer taxation. the chapter 14 provisions that treat spouses as one person also primarily affect the timing of transfer taxation, and section 6166 simply permits estate tax to be paid in installments. on the other hand, the unified credit and the gst exemption are expressly designed to permit the transfer of certain amounts of wealth by an individual without tax. if married couples were treated as one person for purposes of these latter two provisions, so that each person had a credit and exemption one-half the size of that permitted single persons, the law would no doubt significantly and unjustifiably affect the decisions of some persons with respect to marriage. the annual exclusion, like the unified credit and the gstt exemption, actually affects the amount of transfer tax paid. this suggests that, as with those other provisions, the spouses should be treated as separate persons in connection with the exclusion. the purpose of the exclusion is, of course, to permit regular birthday, wedding, holiday, graduation and other type family gifts to be made without any reporting and without any cumulative transfer tax consequences. in a bygone era, where the great majority of married couples stayed together, and 233. irc §§ 2701(a)(1)(b), (e)(2)(a), (d)(3)(b); 6166(b)(2)(b), (d). 234. there are numerous instances in which spouses are treated as one person for income tax purposes. e.g., §§ 267(a)(1), (b)(1), (c)(4); 318(a)(1); 1361(c)(1). however, because the purposes and policies of the income and transfer tax systems are so different, the treatment of spouses as one person for income tax purposes is not persuasive as to the proper treatment of spouses for purposes of the annual exclusion. 235. irc §§ 2010, 2631. [vol. 1:7 slwuld we give away tie annual exclusion? the children and grandchildren of one spouse were usually the descendants of the other spouse also, -36 and more generally one spouse may have held most of the property and the other spouse very little, limiting the annual exclusion available to a married couple to the same as that available to a single person might have been feasible. today, there are many second and third marriages, an individual often has children and grandchildren from a prior marriage who are unrelated to the individual's current spouse, and often both spouses in a marriage have substantial amounts of property. hence, spouses today may often have donees who are very important to them that they do not share, and each may feel strongly about giving the full amount of the annual exclusion to the donees he or she wishes to benefit. if, in fact, the annual exclusion amount is reduced to a level that is consistent with the purposes congress stated in adopting the annual exclusion, it would be very difficult to justify cutting a married person's annual exclusion amount in half. finally, the gift tax and income tax return should be altered to make clear and effective explanations of the annual exclusion. everyone should understand that birthday, holiday, wedding and other such gifts really do consume the annual exclusion. the forms and directions should also explain the expanded tuition and medical care exclusions. 3. what these changes will accomplish.-it is true that the approaches selected will not elininate the problems caused by the present annual exclusion. 7 however, if the present interest requirement is replaced as recommended, the gift and income tax returns are revised as suggested, and the per donor and per donee models are jointly adopted, many of the problems will be greatly reduced and the wealth transfer opportunity that the annual exclusion now represents will be seriously limited. the amount of wealth transferable under the annual exclusion by taxpayers with many or few donees would be greatly reduced. the vertical inequity and horizontal inequity caused or contributed to by the annual exclusion will also be reduced.23 vi. conclusion the annual exclusion presently serves several functions it was not intended to serve and should not serve. it has been presented by congress as a kind of administrative simplification, intended to permit the types of 236. it is assumed that most annual exclusion gifts are made to children and grandchildren of the donors. 237. see supra part iv. 238. see the examples of vertical and horizontal inequities discussed supra part iv b, c. 19931 florida tax review recurring gifts that occur among families and friends to be made without generating gift tax consequences. yet, at its present level it permits major wealth transfers to be made tax-free, both directly (through gifts) and indirectly (through protecting life insurance premium payments from tax, and by seeming to be a category separate from recurring family and friend type gifts). in serving that function it causes some vertical inequity (those who are more wealthy can lower the effective transfer tax rates on the transfer of their wealth through regular use of the exclusion), and contributes to horizontal inequity (by making it less costly for those who can do insurance planning to avoid transfer taxes). rather than being a simple exception to gift tax that permits small, regularly recurring gifts to be made, it is an effective and substantial exception to all of the federal transfer taxes, and, as currently constituted, is inconsistent with the general purposes of the transfer tax system. further, it presently serves, albeit inadequately, the function of protecting gifts made for support related purposes to persons to whom the transferor no longer has an obligation of support, such as nontuition transfers to students and nonmedical care transfers to the elderly and incompetent. in some instances it is entirely inadequate to protect the transfers from gift tax consequences, given the cost of education and of nonmedical care for the elderly and incompetent. accordingly, the exclusion should be revised so that it serves primarily the function for which it was adopted. the revisions that should best accomplish that goal are: (i) to reduce the exclusion to a substantially lower amount, such as $5,000, per donee, per year; (ii) to place a cap on each donor's annual exclusion gifts in any calendar year, such as $20,000; (iii) to revise the gift and income tax returns to make it clear to taxpayers that holiday gifts, birthday gifts and other types of recurring gifts are charged against the annual exclusion limit; (iv) to replace the present interest requirement so that the gifts must either be outright or for the benefit of a single donee in whose gross estate any unexpended amount will be included; and (v) to liberalize the tuition and medical care exclusions from gift tax so as to permit transfers for support of students, elderly and incompetent persons to be made free of gift tax without having to rely on the annual exclusion to protect those transfers from gift tax. the appendix following sets forth statutory language designed to accomplish these revisions. [vol. 1:7 should we give away te amual exclusion? appendix: the statute as revised the relevant portions of the revised section 2503 would read as follows: (b) exclusions from gifts.(1) in general. subject to the limitations set forth in paragraphs (2) and (3) of this subsection (b), the first $5,000 of gifts made by a donor to any person during the calendar year shall not be included in the total amount of gifts made by the donor during such year. (2) $20,000 annual cap. the total amount excluded under paragraph (1) of this subsection in one calendar year shall not exceed $20,000. (3) other requirements. a transfer to or for the benefit of an individual will not be excluded from the donor's total amount of gifts for the year under this subsection unless it is(a) outright, or (b) if not outright, during the life of such individual no portion of the corpus nor of the income therefrom may be distributed to or for the benefit of any person other than such individual, and at the death of such individual the corpus and income not so distributed will be includible in his gross estate. (e) exclusion for certain transfers for tuition, medical care, student expenses and care of elderly and incompetent persons.(1) in general.-any qualified transfer shall not be treated as a transfer of property by gift for purposes of this chapter. (2) qualified transfer.-for purposes of this subsection, the term "qualified transfer" means the following. (a) any amount paid on behalf of an individual as tuition to an educational organization described in section 170(b)(1)(a)(ii) for the education or training of such individual. (b) any amount paid to any person who provides medical care (as defined in section 213(d)) with respect to an individual as payment for such medical care. (c) in a calendar year, the lesser of [a specified dollar amount] (adjusted for the cost-of-living index) or the total amount actually transferred outright to or expended for the benefit of, a student, where such amount is used within 19931 florida tax review the school year in which it is transferred for the housing, transportation, feeding, clothing, or providing of necessary books, supplies and fees of the student which are not paid from any other source. at the time of the transfer, the student must be registered at and attending an educational organization as defined in section 170(b)(1)(a)(ii) for not less than one-half the number of credit hours considered a full time load at such organization and must be in good standing at such organization. the number of years within which a qualified transfer may be made under this subparagraph (c) to any one student by a donor shall not exceed twice the number of years that a full-time student would require to obtain the degree that the donee student is seeking at the time the transfer is made. only transfers in the form of cash or in the kind of property to be used by the student for housing, transportation, to eat, clothing or books for classes shall be permitted as qualified transfers under this subparagraph. (d) in a calendar year, the lesser of $ (adjusted for the cost-of-living index) or the total amount actually given outright to, or expended for the benefit of, the donor's parent, grandparent, aunt, uncle, great-aunt or greatuncle or any incompetent person (as defined by the secretary in regulations), where such amounts are used currently for the housing, transportation, feeding, clothing or caretaking expenses of the donee not paid from any other source. only transfers in the form of cash or in the kind of property to be used by the donee for housing, transportation, clothing or to eat shall be permitted as qualified transfers under this subparagraph. (e) for purposes of subparagraphs (c) and (d) of this paragraph (2), no transfer of ownership of any real property or of any other tangible asset with a value greater than [a specified dollar amount] (adjusted for the cost-ofliving index) shall be a qualified transfer. [vol 1:7 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 1 1993 number 9 book review the merger puzzle reform of the taxation of mergers, acquisitions, and lbos. by samuel c. thompson, jr. durham, n.c.: carolina academic press, 1993. p. 278. reviewed by john a. miller* in tax law we generally do not question the utility and function of rules. as a matter of convenience and, perhaps, as a matter of conviction, we usually assume that law determines outcomes in a more or less linear fashion. this assumption of tax law's determinacy allows us to get on with the business of tax and with the theory of tax. if the rules are determinate, it is appropriate to consider how the rules apply to a given case and to consider whether the rules should be changed to bring about some improvement in legal outcomes. in an earlier article, i broadly defended tax law's determinacy while suggesting that we should have greater acceptance in our rule making for the inevitable role of judgment in the application of law to facts.' in that article i took particular note of two aspects of tax thought that can contribute to indeterminacy: the rule maker's search for "symmetry and wholeness in the law," and the planner's search for "certainty and narrow truth."2 both the quest for symmetry and the quest for certainty represent legitimate efforts to define the law as it should be and as it is. but they proceed from profoundly different perspectives and often yield different outcomes. the rule maker's belief in symmetry rests on grounds of equality and neutrality.3 those principles exalt economic substance over outer form. thus, for example, a bequest that serves as compensation should be taxed as compensation rather than excluded from income as a bequest.4 the planner's belief in specificity and certainty rests upon the taxpayer's right to have notice of the law and upon her right to keep for herself so much of her * associate professor of law, university of idaho college of law. 1. john a. miller, indeterminacy, complexity, and fairness: justifying rule simplification in the law of taxation, 68 wash. l. rev. 1 (1993). 2. id. at 13. 3. see id. at 13-14 and the authorities cited therein. 4. wolder v. commissioner, 493 f.2d 608 (2d cir. 1974). florida tax review property as the government has not demanded. as judge learned hand intoned "there is not even a patriotic duty to increase one's taxes."6 the right to keep that which is not demanded supports technical outcomes to technical questions. in long established areas of tax law the clash between the rule maker's quest for symmetry and the planner's quest for certainty has produced an uneasy balance. the contest continues because the parties have conflicting goals. however, both parties understand the other's moves and accept the legitimacy of certain of those moves as having been established by rule, precedent, or by long practice. after all, equality and neutrality are valid principles and so are rights to notice and to keep what has not been demanded. thus, when the planner makes a certain move the rule maker may concede the case even though that concession may defeat the goal of economic neutrality because the rules allow that move and force that concession. nowhere in the law of taxation is the contest between the values of symmetry and certainty more refined than in the realm of corporate acquisitions. while the doctrine of substance over form has long been exalted,7 the planner still may claim that the rules are his to manipulate.' in his book, reform of the taxation of mergers, acquisitions, and lbos, ucla law professor samuel c. thompson, jr. proposes to bring a new balance to this intricate contest. it is a book written from the rule maker's perspective with an appreciation for the legitimate concerns of the planner. professor thompson has attempted to render coherent and evenhanded an area of tax law that traditionally has punished the ignorant and rewarded the well informed and the well heeled. he puts forward a program of reform in three areas: tax free reorganizations, taxable corporate acquisitions, and leveraged buyouts ("lbos"). in each of these areas he proposes conservative changes that, nonetheless, taken as a whole would radically alter the current corporate tax landscape. in language as terse as the american commander's reply ("nuts!") to the surrender request at bastogne, 9 professor thompson lays out a detailed plan for an economically neutral tax policy toward mergers, acquisitions, and lbos. he forthrightly acknowledges that "[i]t is 5. see miller, supra note 1, at 14 and the authorities cited therein. 6. helvering v. gregory, 69 f.2d 809, 810 (2d cir. 1934), affd, 293 u.s. 465 (1935). 7. see, e.g., cortland specialty co. v. commissioner, 60 f.2d 937 (2d cir. 1932), cert. denied, 288 u.s. 599 (1933). 8. see, e.g., esmark, inc. v. commissioner, 90 t.c. 171 (1988), aff'd, 886 f.2d 1318 (7th cir. 1989). 9. for a brief account of the battle of the bulge, which included the siege of bastogne, see mark starr, take no prisoners, newsweek, apr. 29, 1985, at 20. [vol 1:9 the merger puzzle the purpose of this book to persuade congress to enact the comprehensive proposals offered here" (p. 10). whether it will have that effect remains to be seen, but there is much "offered here" that is worthy of study. professor thompson possesses the credentials to justify giving him a good listen. he has served with the treasury's tax policy office. he has practiced in the acquisitions area with a prominent chicago-based law firm. he has taught the subject matter of this book at several distinguished law schools. he has published widely in the field of business taxation. in short, he has spent many years preparing himself for this latest undertaking. perhaps because of this, it is no book for tax neophytes. however, for those with a grounding in the field, it is an unusually accessible and coherent treatment of the issues addressed. this is because of professor thompson's rigid adherence to a workable format. this format includes a consistent effort to orient the reader to the current state of the law, to describe the various proposals for reform that have been put forward previously, and then to set out thompson's own proposals. the book is also structured so that the chapters can be read out of order without undue loss of coherence. this last feature involves some repetitiousness for the straight-through reader, but thompson's concise and pithy writing style minimizes that discomfort. thompson's succinctness creates other discomforts, however. chief among them is a tendency to state his conclusions with little underlying explanation. his authoritarian approach would be more aggravating if it were proffered by someone less competent or if it were more radical. as it is, however, the sense of certainty that thompson conveys and the moderation of his aims tend to cause one who, like myself, is merely an interested bystander to give him the benefit of the doubt. whether the active players in this area of tax law will be as persuaded is an open question. the essentially conservative nature of thompson's approach is implicit in his early announcement that "[t]his book calls for a comprehensive revision of the merger, acquisition and lbo provisions of the code within the context of the present classical system" (p. 11)." the focus for most of his recommendations is the "stand-alone" target corporation (pp. 25-26). in general he does not propose major changes in the current law with respect to target shareholders (p. 28)." but, if adopted, his proposals for revision of the reorganization concept in section 368 will certainly impact them. thompson's position is that current law is based on correct tax policy (pp. 44-48, 54).12 thus, rather than abandoning the reorganization concept, 10. emphasis added. 11. the operative provisions for tax free reorganizations. irc §§ 354-62, are left largely intact (pp. 68-69). 12. for example, "congress was correct in adopting the anti-mirror legislation because unbounded deferral is fundamentally inconsistent with the concept of a corporate tax" 19931 florida tax review as others have proposed, 3 he favors reformation that renders the reorganization definition consistent and not subject to manipulation (pp. 47-48). "parity" is the central concept of his approach to reorganizations. to that end he favors not only retention of the doctrine of continuity of interest but also extension of a uniform version of that doctrine to all types of reorganizations (including reverse subsidiary mergers). the key feature of this uniform version is the requirement that the target shareholders receive voting common stock as 80% of the consideration for their interests in the target (pp. 8384)."4 he would bolster this version of the doctrine, which is much tougher than current law, 15 by codifying the holding in mcdonald's restaurants of illinois, inc. v. commissioner (p. 77).16 his chief justification is that "[t]he general rule that swaps of property are taxable prevents an erosion of the tax base.... nonrecognition is [only] appropriate where the taxpayer continues to have an interest in the property exchanged' (p. 54). he is also convinced that "[c]orporate acquisitions in which a substantial part of the consideration paid is stock of the acquiring corporation are more economically desirable than transactions in which an acquisition is financed substantially with debt, such as junk bonds" (p. 56). thompson also presses for a uniform substantially all test with exceptions only for spinoffs that satisfy section 355 (pp. 6268). 17 (pp. 45-46). 13. thompson's chief foil for much of his analysis is a study draft prepared by william d. andrews, the reporter for the american law institute's federal income tax project dealing with subchapter c of the internal revenue code. william d. andrews, reporter's study draft, 1989 a.l.i. fed. income tax project (june 1). 14. he sets out five principles for this uniform doctrine. first, stock of the acquiring corporation's grandparent and great grandparent corporations will satisfy continuity of interest. second, only voting common stock will satisfy continuity of interest. third, 80% of the consideration for the acquisition must be such stock, fourth, this rule should not be avoidable by means of reverse acquisitions where the actual target is the nominal acquiror. nor should it be avoidable by means of a § 351 transaction. fifth, there should be codification of less important rules governing which shareholders are to be counted (i.e., historic shareholders), holding periods, effect of creeping acquisitions, etc. (pp. 59-62). 15. under current law, a straight merger requires that only 50% of the consideration received by the target shareholders take the form of equity in order to satisfy the doctrine of continuity of interest. see rev. rul. 66-224, 1966-2 c.b. 114. moreover, the form of equity received need not be voting common stock. see, e.g., john a. nelson co. v. helvering, 296 u.s. 374 (1935) (holding nonvoting preferred stock satisfies continuity of interest). 16. see mcdonald's restaurants of ill., inc. v. commissioner, 688 f.2d 520 (7th cir. 1982) (holding step transaction doctrine applies to post-merger dispositions of acquiror's stock by target shareholders to defeat finding of continuity of interest). 17. this proposal basically adopts rev. proc. 77-37, 1977-2 c.b. 568 (substantially all means 90% of net assets and 70% of gross assets). it also partially overrules helvering v. elkhorn coal co., 95 f.2d 732 (4th cir.), cert. denied, 305 u.s. 605 (1938) (substantially all includes target's pre-spinoff historic assets). other than in the spinoff context thompson's [vol 1:9 the merger puzzle while many aspects of his plan tighten current law, thompson's commitment to parity also leads to several liberalizations. for example, he would eliminate the trap posed by the bausch & lomb doctrine by permitting creeping c reorganizations (p. 74). '8 thompson also proposes to liberalize the rules with respect to transfers of the target's assets within an affiliated group (pp. 82-83). he would permit sole proprietors to incorporate for the express purpose of engaging in a tax free reorganization (pp. 91-93).19 in addition, he would broaden the availability of post-spinoff reorganizations (pp. 88-90). and he would permit disposition of a subsidiary in a reorganization followed by a tax free distribution of the acquiring corporation's stock to the stockholders of the target's parent corporation (pp. 93-95). this last proposal would thus create parity between such a transaction and its economic twin, a section 355 spinoff followed by a nontaxable acquisition of the spinoff corporation. despite the fact that thompson grounds his offerings on the laudable theme of neutrality, his proposals for tax free reorganizations will certainly strike some planners as too harsh. however, his position with respect to taxable asset acquisitions is certain to find some supporters in this same community. thompson's view is that taxable asset acquisitions often make good sense from a business perspective,' and that the two tiers of tax imposed by the repeal of general utilities has unduly restricted their use (pp. 97-98).2" but even here his proposal is less generous than those of others who have written on the subject.?' he proposes a limited carryover basis option along lines previously described by professor george k. yin (pp. 99104).2 the key feature of the proposal is that a carryover basis in the target's assets (with no target level tax) "would be available [but] only where there is an acquisition of substantially all of the [target's] assets" by a single substantially all test would look at the target's historic assets (p. 67). 18. see bausch & lomb optical co. v. commissioner, 267 f.2d 75 (2d cir.) (holding that acquiror's pre-existing target stock was boot in an attempted c reorganization), cert. denied, 361 u.s. 835 (1959). 19. this reverses rev. rul. 70-140, 1970-1 c.b. 73. 20. the asset acquisition is the most direct route for avoiding the target's liabilities. 21. he also points out that his approach creates parity between taxable forward triangular mergers and taxable reverse triangular mergers (pp. 103-04). 22. see, e.g., martin d. ginsburg et al., reexamining subchapter c: an overview and some modest proposals to stimulate debate, in corporate tax reform: a report of the invitational conference on subchapter c 39, 57 (george k. yin rptr. & george mundstock assoc. rptr., 1988). 23. see george k. yin, carryover basis asset acquisition regime?: a few words of caution, 37 tax notes 415 (oct. 26, 1987). yin's proposal has roots in the 1989 al study. for a more sweeping carryover basis proposal, see glenn b. coven. taxing corporate acquisitions: a proposal for mandatory uniform rules, 44 tax l rev. 145 (1989). 19931 florida tax review acquiror (p. 99). taking a more restrictive view than yin, thompson would apply the substantially all test to the target's historic assets (pp. 100, 103).24 another liberalizing element in thompson's plan is an option for carryover basis (and nonrecognition) with respect to goodwill in otherwise cost basis acquisitions of stand-alone targets (pp. 110-12). as thompson recognizes, this proposal may seem less significant with the enactment of provisions allowing for the amortization of purchased goodwill (p. 112). 2 he argues, however, that a modified version of the proposal should still be enacted because the tax cost of current gain recognition on purchased goodwill will continue to unduly limit the use of taxable asset acquisitions (p. 113).26 nonrecognition with respect to goodwill is in thompson's view simply another product of the quest for economic neutrality in the tax system between taxable stock acquisitions and taxable asset acquisitions (pp. 114-15). an extension of this policy, that planners will find less palatable, is thompson's proposal for a mandatory section 338 election in certain stock acquisitions. he would have taxable stock acquisitions satisfy the substantially all test in order for the target to continue its basis (pp. 117-19). otherwise a mandatory section 338 election would force the target to recognize gain. in short, taxable stock acquisitions must be like other acquisitive reorganizations except for the failure to satisfy continuity of interest. the intent is to create parity between stock and asset acquisitions. "carryover basis treatment applies to both types of transactions provided the substantially all test is satisfied, and if that test is not satisfied, then in both types of transactions the target corporation is subject to taxation and there is a step-up in basis for its assets" (p. 119). other than the continuity of interest proposal, the proposal to extend the substantially all test may be the most controversial. one can say that in their economic substance taxable asset acquisitions and taxable stock 24. according to thompson, this approach is like old § 337 before the repeal of general utilities without the step-up in basis. under yin's proposal the test would be applied to the target's assets held at the time of the acquisition. yin, supra note 23, at 421. this would permit pre-acquisition sales of assets that would be fully taxable without affecting the validity of the carryover basis transaction. 25. the omnibus budget reconciliation act of 1993 contains such a provision. it added new § 197 to the code which allows amortization of purchased goodwill and other intangibles over a 15-year period. omnibus budget reconciliation act of 1993, pub. l. no. 103-66, § 13261, 107 stat. 312. 26. however, at least one commentator thinks that the new provision permitting amortization of intangibles will significantly increase the number of taxable asset acquisitions. see george brode, jr., structuring taxable acquisitions of intangibles under section 197, 60 tax notes 1011 (aug. 16, 1993). [vol. 1:9 the merger puzzle acquisitions are the same.27 but is this sufficiently true to justify this mandatory section 338 election? consider the buyer that purchases the stock of a corporation without making any changes in its management or operations. its purpose was simply to make a sound investment. does such a buyer stand in the same relationship to the target's assets as the corporation that purchases those assets directly? though we may say that the corporate shell is a fiction, it is a fiction that by long usage has become true. in a sense the fiction is dead.2g the corporation is a real entity. if this is so, when we buy the corporation it is not the same as when we buy its property. the economic substance of a stock acquisition is a stock acquisition not an asset acquisition.29 the form of the transaction gives it its substance." of course, in any given case this could be a close question. often a stock acquisition is simply a mechanism for obtaining the target's assets (pp. 97-9 8 ).3 but whether we should make this assumption the paradigm for the taxation of stock acquisitions is not obvious. however, by limiting his proposal for a mandatory section 338 election to those cases where the substantially all test is not met, thompson's approach is sufficiently conservative to draw much of the heat from this "form as substance" argument. in addition to addressing reform in the areas of tax free reorganizations and taxable acquisitions, thompson addresses some concerns over the use of equity conversion transactions ("ects"). ects include both leveraged buyouts and recapitalizations where debt replaces equity. again taking the moderate line, he proposes to limit the deductibility of interest on acquisition indebtedness in lbos but only to the extent that the debt exceeds seventyfive percent of the acquisition price (p. 175).'2 the application of this rule would be limited to lbos of publicly held corporations (p. 161). similarly, his proposal for limiting the interest deduction on debt distributed to a corporation's own shareholders would only apply in the publicly held arena. 27. see yin, supra note 23, at 417 (noting that a stock acquisition followed by a § 332 liquidation allows the parties "to achieve indirectly the economic equivalent of a direct asset acquisition of the target without the double tax result"). 28. for a fuller explanation of my meaning, see john a. miller, liars should have good memories: legal fictions and the tax code, 64 u. colo. l. rev. 1. 25 (1993). 29. of course the same is not true of a stock acquisition that is merely a prelude to a subsidiary liquidation. 30. see joseph isenbergh, musings on form and substance in taxation. 49 u. chi. l. rev. 859, 879 (1982) (book review); miller, supra note 1, at 37.40. 31. thompson asserts that since the repeal of the general utilities doctrine "most acquisitions of stand-alone target corporations are structured as stock purchases without a section 338 election" (pp. 97-98). it is plain that he believes many, and perhaps most, of these acquisitions would be structured as asset acquisitions if the two levels of tax could be avoided. it is reasonable to assume that he is correct. 32. this rule will apply equally to both asset and stock acquisitions (p. 175). 19931 florida tax review the gist of this proposal is that no deduction will be allowed a publicly held corporation "for interest on debt that is directly or indirectly issued in (or in facilitation of) an extraordinary redemption or extraordinary dividend" (p. 170). extraordinary redemptions or dividends are distributions the purpose of which is to convert equity interests into debt interests. the justification for these limitations on the deduction of interest has several facets, but chiefly thompson is concerned with preventing the economic harms associated with excessive leveraging. these harms include increased bankruptcies," reduced research and development (pp. 148-49), and decreased efficiencies resulting from defensive ectso his reason for limiting his proposals to publicly held corporations is that he believes acquisitions of closely held corporations promote efficiency (pp. 164-65). credit market failures in the acquisitions of publicly held companies, thompson asserts, was the real problem in the 1980s takeover binge (pp. 166-67). the pencil sketch i have just offered does not do justice to the comprehensiveness of professor thompson's efforts to set out a new program3 5 and to distinguish that program from the wealth of proposals offered by others. but at least the outlines of his proposed regime should be apparent. it is a workable plan, i think. not too radical. not too timid. by sticking with the present framework for tax free reorganizations, thompson's approach has a familiar quality that may make it more salable. yet it is a 33. he takes particular note of the acquisition of federated department stores by campeau, inc. and the savings and loan debacle (p. 147). 34. he takes particular note of unocal's over-leveraging to protect itself from a takeover by boone pickens' mesa petroleum (p. 149). 35. his efforts at completeness extended to the drafting of statutory language implementing each of his proposals (pp. 256-76). near the end of his book, thompson considers the impact that enactment of one of the various integration plans currently being proposed by the ali and treasury would have on his proposals (pp. 209-43). see dep't of the treasury, report of the department of treasury on integration of the individual and corporate tax systems, taxing business income once (jan. 6, 1992); william d. andrews & alvin c. warren, jr., tax advisory group draft no. 21, reporter's study, 1992 a.l.i. fed. income tax project (mar. 2). since the publication of professor thompson's book ali has issued another draft of its study. see alvin c. warren, jr., reporter's study of corporate tax integration, integration of the individual and corporate income taxes, 1993 a.l.i. fed. income tax project (mar. 31). thompson argues that his reorganization proposals and the proposed interest deduction limitations would retain much of their importance. he suggests that the carryover basis proposals would largely become moot under an integration regime, as would the need for mandatory § 338 elections (p. 235). this is because with only one level of tax being imposed on taxable acquisitions in an integrated system the acquiror will prefer a step-up in basis. the reason i do not discuss this part of thompson's book in the main text is that i do not see integration as a near-term political possibility. of course i may be wrong in this assumption. [vol 1:9 the merger puz-le clear departure from the tangled jumble of confusing and often contradictory elements found in present acquisitions law. it is a lucid plan of sustained vision. overall, thompson suggests, the plan should be revenue positive if enacted (p. 22).6 in the current political climate, probably any major tax proposal would need to have this effect. the moderate assault he mounts on excessive leveraging should be acceptable to both congress and to wall street. business should be pleased with the carryover basis provisions. who, then, would oppose its enactment into law? those who think they have better plans, planners who have mastered all the ways to manipulate current law to the advantage of their clients, and the clients of those planners, to name a few. most of us would agree that economic neutrality is a desirable goal. but the question is whose version of neutrality should we adopt? professor thompson's conservative approach to this question represents a commendable incrementalism. by seizing upon radical ideas from a range of points of view and softening them into something that could form the basis for a consensus, he has performed a valuable service. however, law is a malleable product, and we should not expect much peace and harmony even should professor thompson's proposals find their way into the code. economic neutrality is an elusive goal not only because we don't always agree on whose paradigms to embrace, but because it is often more appealing in the classroom than in the boardroom. planners and their clients do not go away when the old planning opportunities are shut down. they adapt. rule makers can change the rules, but they cannot stop the contest. 36. this makes sense given the stringency of his continuity of interest test and his insistence upon a uniform substantially all test. but thompson admits that he has made no effort at a revenue analysis (p. 235). 19931 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 3 1997 number 8 the deceptively disparate treatment of business and investment interest expense under a cash-flow consumption tax and a schanz-haig-simons income tax j. clifton fleming, jr.* i. introduction a cash-flow consumption tax is assessed annually on individuals. in simplified terms, the base is calculated for each taxpayer by combining the year's gross receipts and savings withdrawals and then subtracting the year's business and investment expenses and the year's additions to savings.' progressive rates are applied to the resulting sum.2 these computations are intended to confine the cash-flow tax burden to an individual's annual consumption and to remove nonconsumption expenses and current savings from the tax base. * associate dean and professor of law, brigham young university. copyright © 1997 by j. clifton fleming, jr. thanks to joseph m. dodge, deborah a. geier, christian e. kimball, lawrence lokken and martin j. mcmahon, jr., for commenting on earlier drafts and to calvin h. johnson for helpful advice at a critical juncture. 1. see 1 u.s. treas. dep't, tax reform for fairness, simplicity and economic growth 191-93 (1984) [hereinafter treasury i]; u.s. treas. dep't, blueprints for basic tax reform 113-43 (1977) [hereinafter blueprints]. for lawyers, at least, the leading explanation and defense of a cash-flow consumption tax is still william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113 (1974). 2. a flat-rate could be employed instead of progressive rates under a cash-flow tax. see treasury i, supra note 1, at 191. but if a flat-rate consumption tax were desired, it would generally be much simpler to use a value added tax, which cannot practically employ progressive rates, instead of the more complex cash-flow tax. see j. clifton fleming, jr., scoping out the uncertain simplification (complication?) effects of vats, bats and consumed income taxes, 2 fla. tax rev. 390, 419-21 (1995). thus, a cash-flow consumption tax is often understood as implying progressive rates. see michael j. graetz, implementing a progressive consumption tax, 92 harv. l. rev. 1575, 1579 (1979). nevertheless, the cash-flow consumption tax examples in this article will all assume a flat-rate tax in order to simplify the analysis. 3. see aba section of taxation committee on simplification, complexity and the personal consumption tax, 35 tax law. 415, 416 (1982); blueprints, supra note 1, at 113, 135. disparate treatment of business & investment expense interest by contrast, the base for a theoretically correct schanz-haig-simons (shs) income tax! is each individual's annual consumption plus current additions to savings.5 thus current receipts which are otherwise taxable remain in the tax base, even if they are saved, and withdrawals from earlier savings are not currently taxed since they were assessed in a prior year.6 stated differently, the shs tax base has two components-current consumption and current savings (including current appreciation accruing to earlier investments)-whereas a cash-flow consumption tax has only a single component--current consumption in spite of their differences, however, both a cash-flow consumption tax and an shs tax require that dollars paid out as business or investment expenses be eliminated from the base. this is necessary under a cash-flow consumption tax because business and investment expenses are not consumptions and it is necessary under an shs tax because these expenditures are neither consumption nor additions to savings.9 since business and investment outlays have no place in the base of either tax, intuition suggests that 4. we are accustomed to applying the name "haig-simons" to a classical accretion income tax. but before robert haig and henry simons had popularized an income tax base equal to the sum of consumption and savings, georg schanz had already advocated a similar approach. (for those who are curious about schanz's formulation, get out your germanenglish dictionaries and see georg schanz, der einkommenbegriff und die einkommensteuergesetze, 13 finanz archiv 23 (1896).) thus, fairness suggests that schanz's name should be linked with haig and simons and should come irst. schanz-haig-simons is, however, a mouthful and this article will use the abbreviation "shs." although. the present federal income tax is often described as an shs system, it departs in many ways from the shs model. see, e.g., jerome kurtz, the interest deduction under our hybrid tax system: muddling toward accommodation, 50 tax l. rev. 153. 158-61 (1995); edward j. mccaffery, tax policy under a hybrid income-consumption tax, 70 tex. l. rev. 1145, 1149-55 (1992); andrews, supra note 1, at 1128-40. 5. the most famous description of the shs tax base is the following: "personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question." henry c. simons, personal income taxation 50 (1938). 6. see joseph m. dodge et al., federal income tax: doctrine, structure and policy 27, 33 (1995); andrews, supra note 1, at 1116. 7. kurtz, supra note 4, at 161; treasury i, supra note 1. at 191; aba, sec. of tax'n, supra note 3, at 416; alvin c. warren, jr., would a consumption tax be fairer than an income tax?, 89 yale lj. 1081, 1084 (1980); blueprints, supra note 1. at 2, 113. "the income-versus-consumption tax debate is about the treatment of savings." mccaffery, supra note 4, at 1155. 8. see david f. bradford, untangling the income tax 94. 96 (1986); blueprints, supra note 1, at 119-20; andrews, supra note 1, at 1149, 1151. see also, treasury 1, supra note 1, at 191; aba, sec. of tax'n, supra note 3, at 419. 9. alvin c. warren, jr., accelerated capital recovery, debt, and tax arbitrage, 38 tax law. 549, 557 (1985); blueprints, supra note i, at 3, 64, 133; stanley s. surrey, pathways to tax reform 20-21, 259 (1973). see also simons, supra note 5, at 54. 19971 florida tax review business and investment interest expenses would be treated identically under a cash-flow consumption tax and an shs tax. but they are not. this article will investigate why the shs tax and the cash-flow consumption tax take different structural approaches to the treatment of business and investment interest outlays in spite of the fact that both systems share the general objective of removing current business and investment costs from the tax base.' hi. cash-flow consumption tax treatment of business and investment interest expense the relevant literature uniformly concludes that there are two theoretically correct, economically equivalent methods for handling interest expense under a cash-flow consumption tax-(l) give the debtor a deduction for both interest expense and principal payments if the borrowed funds are included in the debtor's tax base (the inclusion/deduction approach) and (2) deny the debtor a deduction for both interest expense and principal payments if the borrowed funds are excluded from the tax base (the exclusion/no deduction alternative)." at the theoretical level, at least, these alternatives are regarded as applicable regardless of whether the borrowed money is put to a personal use or applied to an income-producing activity." 10. this article does not address the issue of whether an shs tax should allow a deduction for interest on debt incurred to finance personal consumption. with respect to that controversy, see, e.g., kurtz, supra note 4; marvin a. chirelstein, federal income taxation: a guide to the leading cases and concepts 164-69 (7th ed. 1994); stanley a. koppelman, personal deductions under an ideal income tax, 43 tax l. rev. 679, 713-28 (1988); william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309, 376 (1972). nor does this article address the controversy over whether interest expense incurred on debt related to tax favored income should be deductible under an shs tax against only the favored income. see, e.g., chirelstein, supra, at 130-33; calvin h. johnson, is an interest deduction inevitable?, 6 va. tax rev. 123 (1986); surrey, supra note 9, at 259-63. 11. kurtz, supra note 4, at 164; warren, supra note 9, at 553 n.16; aba, sec. of tax'n, supra note 3, at 417-18; blueprints, supra note 1, at 124-25, 135; graetz, supra note 2, at 1600, 1618-19; andrews, supra note 1, at 1137, 1154-55. it must be noted, however, that the theoretical equivalence of these two methods for handling debt under a cash-flow tax is dependent on conditions, such as constant tax rates, that may not always exist in the real, nontheoretical world. see generally warren, supra note 9, at 551-52; aba, sec. of tax'n, supra note 3, at 418; graetz, supra note 2, at 1600, 1602. nevertheless, this caveat is not discussed herein because this article focuses on whether doctrines applicable to a perfectly functioning cash-flow consumption tax demonstrate that business and investment interest should be nondeductible under an shs tax. 12. see authorities cited supra note 11. [vol 3:8 disparate treatment of business & investment erpense interest m. shs treatment of business and investment interest expense an shs regime provides a sharp contrast to the cash-flow consumption tax's alternatives for handling business and investment interest expense. first, an shs tax does not have alternative methods. there is only one shs approach to business and investment interest outlays. under this single approach, genuinely borrowed amounts are never included in the tax base 3 but the related interest expense is, nevertheless, deductible if the borrowed funds are used for income producing purposes.'4 clearly, this shs allowance of a deduction for interest expense with respect to debt excluded from the tax base is a construct that fits neither the inclusion/deduction approach nor the exclusion/no deduction option for handling interest payments under a cash-flow consumption tax. v. why is interest deductible in an shs regime even though the related debt is excluded from the tax base? the preceding observation raises the central issue of this article. it is settled that a fully-implemented shs income tax would exclude all bona fide borrowing from the tax base but would, nevertheless, allow an explicit deduction for interest paid on debt employed in business activities and investments.'" this is because debt used in this way would generate gross income inclusions from which related interest expense should be subtracted to arrive at the net amount available for consumption or saving. but is this settled view correct in light of the cash-flow tax command that there be no explicit interest deduction, not even with respect to debt employed in profitmaking activities, if the debt proceeds are excluded from the tax base at the time of the borrowing? does the cash-flow tax teach that one of the most accepted conventions of shs taxation-deductibility of business and investment interest outlays-is wrong and that all interest expense should be nondeductible in an shs regime since all bona fide debt is excluded from the tax base? an answer to this question requires a closer look at the operation of a cash-flow consumption tax. v. borrowing under a cash-flow consumption tax the effects of the apparently disparate approaches to handling borrowing under a cash-flow consumption tax can be illustrated in a debtfinanced consumption setting by considering their application to the following example: 13. see andrews, supra note 1, at 1137. 14. see, e.g., chirelstein, supra note 10, at 129, 164-65; kurtz, supra note 4, at 159; warren, supra note 9, at 557-59; surrey, supra note 9, at 259. 15. see authorities cited supra note 14. 19971 florida tax review example 1: individual a wishes to engage in $100 of debt-financed consumption on 1/1/1. the loan principal and 10% interest will be due on 1/1/2. a 40% flat-rate cash-flow consumption tax is applicable. assume that the tax is immediately payable whenever a tax base item is received 6 and that 10% per annum is the correct interest rate for time value of money calculations. illustration 1a-inclusiondeduction: a's borrowing goes into the tax base on 1/1/1 so that a 40% tax is immediately due. thus, a must borrow $166.67 on 1/1/1, pay a $66.67 tax ($166.67 x .40)17 and consume the remaining $100. on 1/1/2, a earns $183.34 of wages and pays off the lender ($166.67 of principal and $16.67 of interest). because a is allowed a full deduction for this payment, no tax is due on the 1/1/2 wages. consequently, $183.34 of earnings has been required to support $100 of debt-financed consumption and $66.67 of tax has been paid. illustration lb-exclusion/no deduction: a's borrowing is excluded from the tax base so that she needs to borrow only $100 which she immediately consumes on 1/1/1. since her 1/1/2 $110 payment ($100 of principal and $10 of interest) to the lender is nondeductible, she must earn $183.34 of taxable wages on 1/1/2, pay a $73.34 tax ($183.34 x .40) and pay the remaining $110 of after-tax wages to the lender. 16. this assumption applies throughout the examples in this article. it creates an obvious departure from a real-world cash-flow consumption tax because in the real world, tax liability would be computed on the basis of sumative computations made at the end of a 12 month accounting period and tax would be payable after the close of the period. nevertheless, this assumption is employed because it reduces the number of time value of money adjustments that are required. additionally, this assumption eliminates the need to deal with distortions that can occur where a debt-financed investment is made at the beginning of a year and then liquidated at the close of the same year under a cash-flow regime that calculates tax exclusively at year-end. for examples, see aba, sec. of tax'n, supra note 3, at 424; graetz, supra note 2, at 1604. furthermore, this assumption does not interfere with the basic inquiry of this article which is whether a perfectly functioning cash-flow consumption tax demonstrates that the deduction of business and investment interest should be disallowed in an shs regime. 17. the examples in this article assume that funds used to pay the tax are, themselves, included in the tax base. this is the approach employed in the current federal income tax and it is followed here because it is familiar and it does not distort the results of the simple examples used in this article. thus, to have $100 for consumption after tax, a must borrow $166.67 before tax ($166.67 [$166.67 x .40] = $100). for a discussion of this issue in the context of a more complex cash-flow consumption tax, see aba, sec. of tax'n, supra note 3, at 431-33; graetz, supra note 2, at 1582-84. [vol 3:8 disparate treatment of business & investment expense interest in other words, both approaches to the treatment of borrowing require $183.34 of wages to support $100 of debt-financed consumption. granted, the tax payments in the two scenarios look different-$66.67 in illustration 1a and $73.34 in illustration lb. the difference is illusory, however, because the $66.67 tax is due on 1/l/1 while the $73.34 tax is paid on 1/1/2. applying our 10% interest assumption, $66.67 is simply the 1/1/1 cost of a $73.34 payment on 1/1/2. consequently, in present value terms, the amount of tax paid under the two approaches to handling debt-financed consumption is identical in each case.' 8 thus, a comparison of the two methods for handling debt-financed consumption under a cash-flow tax shows that they are indeed equivalent in terms of wages required to fund consumption and in terms of tax liability. for purposes of this article, however, it is more important to note that these approaches have an additional point of equivalence. to be specific, under our 10% after-tax interest assumption, the $183.34 of principal and interest that is deducted on 1/1/2 in illustration 1a has a 1/1/1 value of $166.67 which exactly equals the $166.67 of loan proceeds that were included in the 1/1/1 tax base in illustration 1a. in other words, the 1/1/2 deduction of principal 18. see blueprints, supra note 1, at 124-25. an alternative way to understand the equivalence of the tax payments in illustrations ia and lb is to note that at the time money is borrowed on fair-market terms, the principal amount of the loan equals the present value of the wages required to pay off the loan principal and interest at maturity. see dodge et al., supra note 6, at 411-12. 414. thus, in present value terms, a tax on the loan proceeds at the time of borrowing (as occurs under the inclusion/deduction approach) is equal to a tax on the wages required to pay the principal and interest ultimately due on the loan (as occurs under the exclusion/no deduction method). see blueprints, supra note 1, at 133. yet another way to see the equivalence of the tax payments in illustrations ia and ib is to note that if individual a had used 1/1/1 wages to finance her sl00 of 1/1/1 consumption, $166.67 of i/1/1 wages would have been required. the treasury would have immediately collected a $66.67 tax ($166.67 x .40) and would have had no further financial interest in a's consumption out of those wages. debt-financed consumption works in a similar way under a cash-flow tax. thus, in illustration ia, individual a used $66.67 out of s166.67 of loan funds to make the 1/1/1 tax payment. at that point, the treasury's financial interest in a's consumption use of the borrowed $166.67 was fully satisfied. when a earned s 183.34 on 1/1/2 and paid off the lender ($166.67 of principal and $16.67 of interest), no tax liability should have attached because the treasury's claim was fully satisfied by the i/i/i tax payment out of borrowed funds. the only way to achieve this correct result is to allow a to offset the $183.34 of 1/1/2 wages with a 1/1/2 deduction for the $183.34 payment of principal and interest to the lender. this is precisely what the inclusion/deduction approach does. by contrast, in illustration 1b, the exclusion of a's borrowed funds from the tax base allowed a to finance the $66.67 tax payment due on the $i00 of i/i/i consumption by effectively borrowing the $66.67 from the treasury until 11/2. accordingly, under our 107o after-tax interest assumption, a owed $73.34 to the treasury on 1/l/2. a's 111/2 tax payment of that amount satisfied this obligation. 1997] florida tax review and interest effectively offsets the 1/1/1 inclusion of loan proceeds so that the taxpayer is left as if none of the borrowed money had been taxed in illustration ia. 9 conversely, the $100 of loan proceeds excluded from a's income on 1/1/1 in ilustration 1b has a 1/1/2 value of $110 exactly equal to the nondeductible amount of principal and interest paid to the lender on 1/1/2. thus, the 1/1/1 exclusion of principal and the 1/1/2 nondeduction of principal and interest cancel each other and leave a as if the $100 borrowing had never affected the tax base in illustration lb.2 ° in short, both methods for handling debt-financed consumption under a cash-flow consumption tax effectively eliminate consumer borrowing from the tax base even though the inclusion/deduction method (illustration ia) engages in the formality of treating loan funds as income in the borrowing year." the result is the same-i.e. borrowing is effectively eliminated from the tax base-where the loan funds are used for business or investment purposes.22 nevertheless, the allowance of an interest expense deduction under the inclusion/deduction method (illustration 1a) is not based on the rationale that the interest is an income producing cost. this is clearly apparent from the fact that the deduction permitted in illustration 1a relates to consumer debt. 19. see blueprints, supra note 1, at 133. 20. see blueprints, supra note 1, at 124-25, 133. as mentioned in the text at supra note 17, the $73.34 tax paid in illustration lb is simply the 1/1/2 value of the $66.67 tax paid on i/l/1 in illustration ia. 21. what, then, is included in the cash-flow tax base with respect to debt-financed consumption? illustrations ia and lb show that the 40% tax actually applies to the taxpayer earnings that are ultimately used to pay for the consumption and tax thereon. (as indicated in supra note 16, example 1 assumes that funds used to pay tax are included in the tax base.) thus, in illustration ia, the $100 of i/1/1 consumption and the applicable tax were ultimately paid for with $183.34 of i/1/2 wages when the debt was retired. forty percent of $183.34 is $73.34 which, under our 10% after-tax interest assumption, is simply the 1/1/2 value of the $66.67 tax that was paid with borrowed money on 1/1/1. in other words, in 11/2 value terms, the 1/1/i tax paid in illustration ia equals 40% of the $183.34 of 11/2 wages used to fund the 1/i/i consumption and tax thereon. to complete this analysis, note that the 60% after-tax portion of the $183.34 wages is $110, which is merely the i/1/2 value of the $100 consumed on 1/1/1. likewise, in illustration 1b, the 1/1/i consumption was ultimately paid for with $183.34 of 1/1/2 wages when the taxpayer delivered $110 to the lender and $73.34 to the treasury on 11/2. this $73.34 i/1/2 tax payment is simply 40% of the $183.34 of 11/2 wages used to pay off the lender and the tax collector. the 60% after-tax portion of the $183.34 1/1/2 wages is $110, which equals the 1/1/2 value of the $100 consumed on i/1/1. to recapitulate, illustrations ia and ib show that both methods for handling debtfinanced consumption under a cash-flow tax have the effect of (1) excluding the consumer debt from the tax base and (2) applying the tax to the earnings that are ultimately used to pay for the consumption and the tax thereon. 22. see authorities cited supra note 11; blueprints, supra note 1, at 133. i[vol 3:8 disparate treatment of business & investment expense interest instead, interest expense is deductible under the inclusion/deduction method because the deduction is a component of a mechanism which effectively eliminates from the cash flow tax base the earlier inclusion of related loan proceeds. vi. the need for a business and investment interest expense deduction under an shs tax unfortunately, a deduction for business and investment interest outlays cannot be explained under an shs tax as a mere component of a mechanism which cancels out the earlier tax base inclusion of borrowed money. this is because bona fide loan proceeds are always excluded from shs income on the front end-no back end mechanism is needed to negate an earlier inclusion. thus, the cash-flow tax justification for an interest deduction does not work under an shs regime. nevertheless, a deduction for business and investment interest outlays is required under an shs tax regardless of the fact that the related debt is not part of the shs base. example 2 illustrates this seeming conflict between the treatment of business and investment interest expenses under a cash-flow consumption tax and an shs tax. example 2: individual a borrows $100 on 1/i/l. the loan principal and 10% interest are due on 1/1/2. a uses the borrowed money to make a 1/1/1 purchase of a bond paying $100 of principal and 10% interest on 1/1/2. an shs tax regime is applicable. thus, the $100 of loan proceeds are excluded from gross income and a takes a $100 basis in the bond. on 1/1/2, a collects $100 of bond principal that is offset by her $100 basis and she makes a nondeductible $100 principal payment to the lender. on 1/1/2, a also collects $10 of bond interest but there is no profit because a must pay $10 of 1/1/2 interest expense to her lender. under a cash-flow consumption tax, a would not be allowed to deduct the $10 1/1/2 interest expense because the related debt was excluded from her 1/1/1 income. but the bond investment is an economic wash and the only way to make the shs tax system reflect this fact is to allow a a $10 1/1/2 deduction. denial of the deduction for interest expense leaves a with $10 of taxable income from an investment that yielded no economic gain. thus, the correct shs answer requires a to be allowed a deduction for her 1/1/2 interest outlay regardless of the i/1/1 exclusion of the loan proceeds for her tax base.' 23. see andrews, supra note 1, at 1137. 24. see warren, supra note 9, at 557-59. 19971 florida tax review why does example 2 work this way? to some thoughtful analysts, the answer comes quickly because it flows obviously from a simple metaphor-borrowing is negative saving and since the positive return on positive saving (interest income) is part of shs income, the negative return on negative saving (interest expense) is clearly deductible in computing the shs tax base.' this metaphor does not, however, readily explain the apparent conflict between the shs system, which allows an interest deduction in example 2, and a cash-flow consumption tax, which would not allow an interest deduction in example 2 inasmuch as the related debt is excluded from a's income. in addition, the preceding metaphor would compel an unlimited deduction for personal interest expense 6 under the current federal income tax, and this result is strenuously resisted by some thoughtful commentators. 7 for these reasons, this article chooses not to rely on a metaphorical justification for the outcome of example 2. instead, this article looks for an explanation that (1) reveals why example 2 correctly gives rise to an interest expense deduction when a cash-flow consumption tax would deny a deduction but (2) does not require the controversial conclusion that personal interest should be deductible under the current federal income tax. the explanation that seems to satisfy the foregoing criteria is that example 2 mandates a $10 interest expense deduction simply because the related $10 of 1/1/2 bond interest is includable in a's shs income. this is dramatically different from life under a cash-flow consumption tax which effectively exempts income from property so that there is no need to deduct related interest expense in order to arrive at net income. vii. debt-financed investment under a cash-flow consumption tax: there's more going on than meets the eye the validity of the preceding explanation can be usefully tested by starting with a consideration of the cash-flow tax's handling of cash investments. discussions of the cash-flow consumption tax typically recognize that investments can be accounted for thereunder with equivalent results by either (1) allowing a deduction for the cost of the investment but taxing all of the returns (including recovery of "principal") when consumed (the deduction/retum inclusion method) or (2) disallowing a deduction for the investment's cost but excluding all returns thereon from the tax base (the 25. see melvin i. white, proper income tax treatment of deductions for personal expense, 1 comm. on ways and means, tax revision compendium 365, 366 (comm. print 1959). 26. see id. 27. see, e.g., kurtz, supra note 4, at 230-33; johnson, supra note 10, at 127-29. [vol 3:8 disparate treatment of business & investment expense interest no deduction/return exclusion method).2 for purposes of this article, the most important point about these two alternatives is that when tax rates are constant, they both exclude returns on capital from the tax base.29 the exclusion is implicit under the deduction/return inclusion method and explicit under the no deduction/return exclusion method. example 3 illustrates these points. example 3: individual a has $166.67 of 1/l/1 taxable wage income to invest pursuant to the deduction/return inclusion alternative under a 40% cash-flow consumption tax that is immediately payable on tax base items." ten percent per annum is the correct interest rate for time value of money calculations. if a decides to consume the $166.67, she will deliver $66.67 of tax to the treasury ($166.67 x .40) and will have $100 left for consumption. but on 1/1/1, she uses her wages to purchase a $166.67 face amount bond which pays principal and 10% interest on 1/1/2. since the amount paid for the bond is deductible, the taxpayer does not incur a 1/i/l $66.67 tax and she has the full $166.67 available for investment. she collects a total of $183.34 ($166.67 principal and $16.67 interest) on 1/1/2, pays a $73.34 tax ($183.34 x .40) and has $110 left. now assume that a makes the 1/1/1 bond purchase under the no deduction/return exclusion approach. in this scenario, she does not claim a deduction for the purchase price and the tax applies. thus, she pays $66.67 of her $166.67 of wages to the treasury on 1/1/1 ($166.67 x .40 = $66.67) and uses the $100 remainder to buy the bond. on 1/1/2 she collects $110 of principal and interest, pays no tax thereon and has the full $110 available for consumption-the same result as under the deduction/return inclusion alternative.3 1 (furthermore, the tax payments are the same in both situations when measured on a present value basis-the $73.34 tax paid on 1/1/2 under the deduction/return 28. see kurtz, supra note 4, at 163; dodge et al., supra note 6, at 416-20; bradford, supra note 8, at 68; warren, supra note 9, at 55 1-52; treasury i, supra note 1, at 191. 194; aba, sec. of tax'n, supra note 3, at 417-18; blueprints, supra note i. at 123; andrews, supra note 1, at 1126, 1150. see also nicholas kaldor, an expenditure tax 76-77, 196-98 (1955). 29. see william d. andrews, fairness and the personal income tax: a reply to professor warren, 88 harv. l. rev. 947, 954 (1975); alvin c. warren, jr., fairness and a consumption-type or cash flow personal income tax, 88 harv. l rev. 931, 938-41 (1975) and authorities cited supra note 28. 30. see supra note 16. 31. see bradford, supra note 8, at 68; aba, sec. of tax'n. supra note 3. at 417. for a discussion of the conditions that must exist in order for these equivalent results to occur, see warren, supra note 9, at 551-52; aba, sec. of tax'n, supra note 3, at 418. 425: graetz, supra note 2, at 1601-02; andrews, supra note 29, at 953. 19971 florida tax review inclusion alternative is simply the 1/1/2 value of the $66.67 tax paid on 1/1/1 under the no deduction/return exclusion approach. 2 this means that the higher tax due under the deduction/return inclusion alternative is actually the same as under the no deduction/return exclusion approach but with an interest charge imposed for the later payment.) in short, capital income is expressly excluded from the tax base by the no deduction/return exclusion method and is effectively excluded from the tax base by the deduction/return inclusion approach. 33 the preceding analysis has the same effect with respect to income in an active business setting. example 4 illustrates this point. example 4: as in example 3, individual a has $166.67 of 1/1/1 wages that would be subject to a 40% cash-flow consumption tax that is immediately payable on tax base items? 4 ten percent per annum is the correct interest rate for time value of money calculations. however, the wages are used on 1/1/1 to pay current business expenses of a one-shot venture conducted by a as a sole proprietor. since these expenses are deductible, no 1/1/1 tax is due on the wages and a has the full $166.67 available to put into the venture. this is the only capital involved. the venture terminates on 1/1/2 and yields a 10% profit so that total proceeds from the enterprise are $183.34 ($166.67 + [.10 x $166.67]). a pays a $73.34 tax ($183.34 x .40) at that point and has $110 left for consumption. the same result would occur if no deduction were allowed for the 1/1/1 expenses but the venture proceeds received on 1/1/2 went untaxed. with no 1/1/1 deduction, a $66.67 1/1/1 tax would be due ($166.67 x .40) and only $100 would be available to fund the 1/1/1 expenses of the one-shot venture. assuming a 10% profit, the enterprise would yield $110 of tax-free proceeds on 1/1/2 and a could consume $110-the same result as when the 1/1/1 expenses were currently deducted and the 1/1/2 venture proceeds were taxed. furthermore, the tax liabilities are the same on a present value basis under the two alternatives for handling the business expenses.35 examples 3 and 4, when combined with example 1, demonstrate that there are two factors at work in the cash-flow consumption tax's treatment of debt-financed business expense and debt-financed investment. first, the 32. see blueprints, supra note 1, at 123. 33. see authorities cited supra note 28. 34. see supra note 16. 35. see supra text accompanying note 32. [vol. 3:8 disparate treatment of business & investment expense interest two methods for handling yields (deduction/return inclusion and no deduction/return exclusion) have the effect of excluding capital income from the tax base.36 second, the two methods for handling debt (inclusion/deduction and exclusion/no deduction) have the effect of excluding borrowing from the tax base.3" this means that the explicit interest deduction allowed under the inclusion/deduction method is part of the mechanism for removing debt from the cash-flow consumption tax base and is not part of the computation of net taxable income from capital because business and investment capital income is fully excluded from the base by the normal workings of the cash flow tax. this proposition is illustrated by example 5. exampe 5: individual a borrows $100 on 1/l/1 with which to pay 1/1/1 current business expenses of a one-shot venture conducted by a as a sole proprietor. no other capital is involved in the enterprise. the loan principal and 10% interest are due on 1/l/2. a 40% cashflow tax is immediately payable on tax base items. 3 ' assume that the correct interest rate for time value of money computations is 10%. on 1/1/2 the venture terminates and yields $110 of proceeds which are immediately delivered to the lender in satisfaction of a's principal and interest obligation. the venture is an economic wash and no tax should be due. both methods for handling the loan reach this result. illustration 5a-inclusion/deduction: a's $100 borrowing goes into the tax base on l/1/1 but a gets a simultaneous $100 business expense deduction because the $100 outlay is like savings or investment-i.e. it is not consumption. consequently, no 1/l/1 tax is due.39 indeed, $40 of 1/1/1 tax is saved because of the deduction. on 1/1/2, a adds the $110 of venture proceeds to the tax base but claims an offsetting $110 deduction for her payment to the lender of $100 of principal and $10 of interest. accordingly, there is no 1/1/2 tax liability. in fact, it looks like $44 of 1/1/2 tax is averted by the 1/1/2 deduction. but something different has actually happened. since the initial proceeds of a market rate loan have a present value equal to the principal and interest ultimately due thereon,' the $110 of 1/1/2 deductible principal and interest is nothing more than the 1/l/2 value of the $100 borrowed on 1/1/1. this means that the 1/l/2 principal and interest deduction of $110 merely appeared to shelter 36. see supra text accompanying notes 28-31. 37. see supra text accompanying notes 18-17. 38. see supra note 16. 39. see aba, sec. of tax'n, supra note 3, at 422. 40. see dodge et al., supra note 6, at 411-12, 414. 19971 florida tax review the $110 of venture proceeds from a 1/1/2 tax of $44. no 1/1/2 shelter was needed for the venture proceeds because the 1/1/1 $100 business expense deduction had already effectively removed the $110 of 1/1/2 proceeds from the tax base.41 instead, the actual effect of the 1/1/2 deduction is to cancel the 1/1/1 inclusion of loan proceeds.42 in other words, the 1/1/2 $110 deduction for the principal and interest payment retroactively removed the $100 of 1/1/1 borrowed money from the tax base and the $100 1/1/1 business expense deduction prospectively eliminated the $110 of 1/1/2 venture proceeds from the tax base. illustration 5b-exclusion/no deduction: the $100 borrowing does not go into the 1/1/1 tax base. (this effectively offsets the nondeduction of the 1/1/2 $110 principal and interest payment.)43 nevertheless, a gets a 1/1/1 deduction for the $100 business expenditure. this deduction shelters $100 of otherwise taxable 1/1/1 wages and saves $40 of 1/1/1 tax. on 1/1/2, a adds the entire $110 of venture proceeds to the tax base. there is no offsetting deduction for the 1/1/2 principal and interest payment because the 1/1/1 exclusion of the borrowed $100 has eliminated the need for the 1/1/2 principal and interest deduction. but this means that the 1/1/2 tax base is $110 and that a incurs a $44 1/1/2 tax. however, under our 10% interest assumption, the $40 of 1/1/1 tax savings from the 1/1/1 business expense deduction have a $44 1/1/2 value that effectively reduces a's tax liability to zero-the same as in illustration 5a."' 41. see supra text accompanying notes 28-35. an alternative way to make this point is to note that the 1/1/i $100 business expense deduction sheltered $100 of otherwise taxable 1/1/1 wages and produced a $40 1/1/1 tax saving. the 1/1/2 value of this saving is $44, which exactly cancels out the tax that would otherwise be due on the $110 of venture proceeds once the i/1/2 deduction for the $110 principal and interest payment is understood as sheltering the 1/1/i loan amount instead of the 1/1/2 venture proceeds. 42. see blueprints, supra note 1, at 133; supra text accompanying notes 19-22. 43. see supra text accompanying notes 19-20. 44. some analysts and commentators have argued that taxpayers should not be permitted to use the exclusion/no deduction approach with respect to loans that finance deductible investments because the creation of current savings deductions with excludable borrowed money would create an appearance problem, would permit tax deferral that disrupts the timing of government receipts and would result in tax savings if the taxpayer were in a lower bracket in the year that the investment is liquidated and the loan is paid off. see treasury i, supra note 1, at 192; aba, sec. of tax'n, supra note 3, at 435. see also graetz, supra note 2, at 1606-09. these arguments and any responses are outside the scope of this article. the point of illustration 5b is simply that the exclusion/no deduction treatment of borrowing can be combined with current deduction of business and savings outlays to produce a theoretically correct result when tax and interest rates are constant. [vol. 3:8 disparate treatment of business & investment expense interest in other words, the $100 1/i/ business expense deduction effectively eliminated the $110 1/1/2 venture proceeds from the tax base.45 the 1/1/2 interest deduction allowed in illustration 5a, when coupled with the 1/1/2 $100 principal deduction, simply equals the 1/1/2 value of the $100 of loan proceeds that were included in the 1/1/1 tax base. stated differently, the 1/1/2 interest expense deduction in illustration 5a is not grounded on the view that it is a current expense of a's one-shot venture. the 1/1/2 interest deduction is simply part of a 1/1/2 adjustment that cancels out the 1/1/1 debt inclusion, thus effectively excluding the loan proceeds from the tax base so that mustration 5a constructively accomplishes the same result that is directly accomplished by the explicit 1/1/1 exclusion of the debt proceeds in illustration 5b. if the rationale for allowing the 1/1/2 interest deduction in illustration 5a were that the interest expense was a cost of the venture that had to be deducted in order to calculate the venture's net yield, then the same rationale would require a $10 1/1/2 interest expense deduction in illustration 5b so that the 1/1/2 tax base would be $100 instead of $110. this would create a $40 1/1/2 tax liability which, when matched against the $44 1/1/2 value of the 1/1/1 tax savings, would leave a with $4 of net tax savings instead of the tax wash that she ought to have. to recapitulate, the explicit interest deduction in illustration 5a is part of an adjustment that causes the related loan proceeds to be effectively excluded from the tax base-a result identical to that accomplished by the express 1/1/1 exclusion of the borrowed money in illustration 5b. the loan interest is not deducted as a business expense under either illustration 5a or 5b because, as explained in connection with examples 3 and 4, the operation of the cash-flow consumption tax effectively removes the entire yield on a's $100 of business expense from the tax base. thus, a business expense deduction for the loan interest is neither necessary nor appropriate. now return to example 2. if a cash-flow consumption tax were applicable there, the $10 of bond interest would either be constructively excluded from a's income because a would claim a $100 savings deduction on 1/1/1 (which effectively shelters the 1/1/2 interest receipt from tax even though a nominal tax would be applied on 1/l/2)6 or a would claim no 1/1/1 deduction for the bond purchase but would then be allowed to expressly exclude the 1/1/2 interest receipt from income. since the interest receipt is entirely tax-free in both cases, a deduction for the related interest expense is not necessary for purposes of calculating net taxable income. thus, the cashflow tax would not permit a 1/1/2 interest expense deduction unless a had 45. see supra text accompanying notes 28-36. 46. see supra examples 3 and 4. 19971 florida tax review first included the $100 of borrowed funds in her 1/1/1 income so that an interest deduction, combined with a 1/1/2 principal deduction, was required to cancel the earlier inclusion. by contrast, an shs tax requires a to report her 1/1/2 interest receipt in example 2 regardless of the fact that she was not allowed a 1/1/1 savings deduction to effectively shelter the 1/1/2 receipt.47 this absence of shelter for a's 1/1/2 interest receipt means that a 1/1/2 deduction of the related interest expense is necessary for purposes of computing net taxable income even though the related debt was excluded from the shs tax base. otherwise, a will be taxed on nonexistent gain. the points demonstrated by example 2 are equally applicable where borrowed money is used to finance business operations instead of to acquire an investment. example 6 illustrates this point. example 6: as in example 2, individual a borrows $100 on 1/1/1 under terms requiring the payment of principal and 10% interest on 1/1/2. the loan funds are used on 1/1/1 to pay business expenses of a one-shot venture conducted by a as a sole proprietor. the only capital in the venture is the $100 provided by a. the venture terminates on 1/1/2 and yields $110 of ordinary business income which is immediately paid to the lender. assume that, under the applicable rule for distinguishing between capital expenditures and currently deductible business outlays, the $100 1/1/1/ expenditure is deductible on 1/1/1 even though the related income is not reported until 1/1/2.48 a 40% shs tax is applicable but since there is no economic profit, no tax should be due. with an interest deduction, a's 1/1/2 shs tax base is $100 ($110 venture proceeds $10 interest) because no deduction is allowed for the $100 principal payment. thus, a owes a $40 1/1/2 tax with respect to a venture that was an economic wash. however, the 1/1/1 tax deduction saved $40 of tax which, assuming a 10% after-tax interest rate, has grown to $44 on 1/1/2 so that a has no net tax liability on 1/1/2 and, indeed, has $4 left over. a's $4 surplus in example 6 does not indicate that the 1/1/2 interest deduction was improper. instead, it reflects a timing problem with the 47. see generally andrews, supra note 1, at 1121, 1126, 1150. 48. the current federal income tax frequently allows a present deduction for expenses that produce future income. see, e.g., rev. rul. 96-62, 1996-53 i.r.b. 6 (training costs are currently deductible even though they benefit future business activities); rev. rul. 94-12, 1994-1 c.b. 36 (incidental repair expenses are currently deductible even if they provide benefits to future income producing activities); rev. rul. 92-80, 1992-2 c.b. 57 (expenditures for institutional or goodwill advertising are currently deductible even though they benefit future business activities). [vol. 3:8 disparate treatment of business & investment expense interest deduction of the business expenses. this point can be illustrated by considering the results if the $100 business expense deduction had been delayed from 1/1/1 to 1/1/2 when the related income was realized and the interest expense was paid. a's 1/1/2 tax base would have then been zero 9 and there would have been nothing left over. by contrast, if the business expense deduction had been moved to 1/1/2 but the 1/1/2 interest expense was not deductible, then a would have had a $10 1/1/2 tax base' and a $4 tax liability with respect to a zero profit venture. thus, a's 1/1/2 interest deduction is proper. the $4 surplus in example 6 is attributable to the fact that $100 of expenses were deducted one year before the related income was taxed;51 it does not impugn a's 1/1/2 interest deduction. viii. inclusion of borrowed funds in the shs tax base the conventional conception of an shs tax base is that borrowed funds are excluded. however, our analysis of cash-flow consumption tax treatment of borrowing and shs treatment of business and investment interest expense suggests the possibility of a different approach. could we get proper shs results by following the consumption tax alternative of including business and investment loan funds in the tax base while allowing a deduction for principal and interest payments (thus neutralizing the initial taxation of the borrowed money) coupled with a second deduction of the interest payments (thus avoiding the over-taxation of income that would otherwise occur under an shs tax)? example 7 indicates an affirmative answer. example 7: individual a plans to finance the purchase of a $100, 10%, one-year bond by borrowing for one year at 10%. obviously, this investment will be a wash that produces no economic gain. under the normal shs practice of excluding borrowing from the tax base but allowing a deduction for business and investment interest expense, a will get the same results as in example 2-i.e. a's 1/1/2 interest expense deduction will offset a's 1/1/2 receipt of bond interest and leave a with zero taxable income from an investment 49. $110 gross receipts 100 business expense deduction 10 interest expense 0 taxable income 50. $110 gross receipts 100 business expense deduction $ 10 taxable income 51. see authorities cited supra note 48. 19971 florida tax review that produced zero economic gain. now assume that a is under an shs regime requiring inclusion of borrowed funds in the tax base but permitting a deduction for payments of principal and interest. she borrows $166.67 for one year at 10% interest on 1/1/i, pays a $66.67 tax ($166.67 x .40) and uses the remaining $100 of loan funds to make a 1/1/1 purchase of a bond paying $100 of principal and 10% interest on 1/1/2. when 1/1/2 arrives, a pays $183.34, consisting of $166.67 of principal and $16.67 of interest, to her lender and deducts both amounts. the deductions save $73.34 of tax ($183.34 x .40 ) which is the present value (assuming a 10% interest rate) of the $66.67 tax that a paid on 1/1/1. in other words, when the $16.67 interest expense deduction is combined with the $166.67 principal deduction on 1/1/2, the effect is a recovery by a of the 1/1/1 tax paid on the loan proceeds. this is a correct outcome because the borrowed money was not an accession to wealth that triggers an shs tax. but this means that a's 1/1/2 $16.67 interest expense has been "used up" in correcting for the 1/1/1 taxation of the borrowed money. there is nothing left to offset a's 1/1/2 bond interest receipt. thus, a is facing a 40% tax on $10 of interest income from an investment that yielded no economic gain. the path to the correct tax result is to allocate the $16.67 of 1/1/2 interest expense between the $66.67 of 1/1/1 debt that was used to fund the 1/1/1 tax payment and the $100 of debt that was invested in the bond. assuming that federal income tax payments would be nondeductible under this shs regime, no deduction should be allowed for the $6.67 of 1/1/2 interest expense allocable to the $66.67 of debt that funded the 1/1/1 tax payment. the $10 of 1/1/2 interest expense allocable to the $100 of borrowed money invested in the bond should, however, be deducted a second time. this partial double deduction will exactly offset the $10 of 1/1/2 interest income and leave a with neither a tax gain nor loss on an investment that was an economic wash. as example 7 illustrates, if we make a include her borrowing on the front end, we can get her to the correct shs results by allowing a deduction on the back end for her principal payment plus a partial double deduction of her interest expense. stated differently, it is possible to operate an shs tax regime which requires that borrowed amounts be included in income. this observation invites an inquiry into how the structure of our current income tax would change if debtors were required to include borrowed funds in gross income but that is a complex matter beyond the scope of this article. for present purposes, the principal role of example 7 is to emphasize that an interest expense deduction can serve two discrete functions-it can be part of an adjustment that removes previously-included debt from the tax base [vol 3:8 disparate treatment of business & investment expense interest and it can be a device for reducing gross income to net income. if a particular tax regime requires the performance of both functions, then example 7 also shows that a partial double deduction for business and investment interest outlays is appropriate. ix. conclusion the cash-flow consumption tax and the shs income tax employ seemingly conflicting approaches to the deduction of business and investment interest expense. to be specific, the cash-flow regime allows a deduction for such interest only if the related debt is included in the tax base whereas business and investment interest is always deductible under an shs tax even though the related debt is never part of the base (unless the debt is bogus or is ultimately canceled). the apparent conflict is, however, deceptive because the interest expense deduction serves different functions in these two different taxing regimes. in the cash-flow system, business and investment capital income is wholly excluded from the tax base with the result that a deduction for related interest expense is not required to arrive at a net taxable amount. instead, the cash-flow consumption tax employs an interest expense deduction as part of an adjustment mechanism that removes previously included borrowings from the tax base. thus, an interest deduction is not appropriate under a cash-flow regime unless the related debt was part of the base at an earlier time. by contrast, an shs tax always excludes borrowed amounts from its base so that no interest expense deduction is necessary to assist in canceling the prior inclusion of borrowed sums. but an shs regime invariably includes business and investment income in the base. consequently, an shs deduction for business and investment interest expense is required to reduce related gross income to a net amount even though the debt which generated the interest outlay was not a previously included item. this illustrates the point that the propriety of an interest expense deduction depends on the role which is assigned to the deduction in the particular tax system. 19971 florida tax review volume 19 2016 number 2 article tax fairness by convention: a defense of horizontal equity ira k. lindsay 79 i florida tax review volume 19 2016 number 2 the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; 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subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 3 1998 number 11 lifting the shroud obscuring estate of hubert: the logic of the income and estate tax treatment of estate administration expenses joseph m. dodge* 1. introduction ................................ 648 a. the statutory framework .................... 648 b. the opinions in the supreme court ............. 653 c. should estate administration expenses be deductible for estate tax purposes? ............ 659 d. should anticipated administration expenses reduce the value of the gross estate? .......... 661 e. is the valuation of marital deduction bequests "symmetrical" with valuation for estate-inclusion purposes? .............................. 663 f. income tax treatment of estate administration expenses ........ ...................... 669 g. is an estate tax deduction for estate administration expenses a practical necessity? .... 671 h. administration expenses and the charitable deduction ............................... 672 i. the next step ............................ 675 * joseph m. dodge is the william h. francis, jr., professor of law at the university of texas school of law. professor dodge has a b.a. from harvard (1963). an ll.b. from harvard law school (1967). and an ll.m. (in taxation) from new york university school of law (1973). professor dodge is the author of texts, casebooks, monographs, and articles on taxation, and is active in professional organizations and e-mail bulletin boards. florida tax review i. introduction in commissioner v. estate of hubert, the supreme court upheld a tax court decision that $1.5 million of estate administration expenses charged against the income of a marital deduction bequest did not reduce the marital deduction for estate tax purposes.' in hubert, the marital deduction bequest was a residuary bequest, and estate administration expenses were payable out of the residue, but the executors had discretion to allocate such expenses between principal and income.2 pursuant to what is known as the "section 642(g) election," the expenses charged against income were deducted for purposes of computing the taxable income of the estate as a separate taxpayer,3 and were not deducted for estate tax purposes.4 this comment both critiques hubert on a doctrinal basis and explores what should be the proper income and estate tax consequences of estate administration expenses. 5 a. the statutory framework property is included in the gross estate at its fair market value at the date of death.6 in arriving at the taxable estate, a deduction is allowed under section 2053 for debts and claims against the decedent arising before death7 and for estate administration expenses, the most important of which are fees for services provided by the estate personal representative, attorneys 1. 520 u.s. -, 117 s. ct. 1124 (1997), aff'g 63 f.3d 1083 (11th cir. 1995) (2-1 decision), aff'g 101 t.c. 314 (1993) (reviewed) (2 dissents on this issue). 2. hubert, 117 s. ct. at 1128. 3. see estate of hubert v. commissioner, 101 t.c. 314, 348 (1993) (beghe, j., dissenting). the estate is a separate taxpayer for income tax purposes that computes net income in essentially the same manner as an individual, except as otherwise provided in subchapter j of the code. see irc § 641(b). income tax deductions for administration expenses are allowed under irc § 212(1), (2), dealing with expenses relating to the production of income and income-producing property. 4. the estate tax deduction for estate administration expenses is found in irc § 2053(a)(2). 5. some of the post-hubert drafting and expense allocation options are explored in scott h. malin & bennett s. keller, planning for the allocation of administration expenses to income under hubert, 84 j. tax'n 213 (1997). 6. see irc § 203 1(a). the gross estate can, at the executor's election, be valued on the alternate valuation date (subsequent to the decedent's death) as prescribed by irc § 2032. 7. see irc § 2053(a)(3) (providing for deduction "for claims against the estate."); regs. § 20.2053-4 (specifying that claims may be deducted only if "existing at the time of" the decedent's death). [vol 3:11 lifting ite shroud obscuring estaie of hubert representing the estate, and other professional service providers such as appraisers, and court costs.8 section 2056(a) allows a marital deduction for the "value of any interest in property which passes . . . from the decedent to the surviving spouse .... ." this rule means that a deduction is allowed only for interests that the spouse actually receives, not for interests that she might have received (but didn't receive). the "passing" requirement is easily confused with the "terminable interest rule" of section 2056(b)(i), which disallows the marital deduction where the spouse actually receives interests that might have been cut off by conditions precedent or subsequent.9 nevertheless, both the passing requirement and the terminable interest rule have a common purpose, which is to preclude a deduction being taken, as of the decedent's death, for interests that will not, or might not, appear in the surviving spouse's transfer tax base. the terminable interest rule tends to operate on an all-or-nothing basis, whereas the passing requirement can operate to disallow a transfer in whole or in part.'0 under section 2056(b)(5) and (b)(7), a marital deduction is allowed for the entire value of trusts in which the surviving spouse has, inter alia, an income-only interest for life." the marital deduction trusts in hubert fell under these provisions. the regulations state that an income interest will not satisfy the qualification rules if the income interest is illusory.' 2 an example of an illusory income interest is where the trust is locked into investments that do not yield income. the expenses charged to income in hubert were less than the gross income of the estate, and the practice was sporadic. also, hubert involved an estate with a limited duration, as opposed to a trust. hence, the government did not contend that the income interest was illusory so as to wholly disqualify the marital deduction. nevertheless, the parties and the various opinions in hubert discussed the illusory-income-interest 8. see irc § 2053(a)(2); regs. § 20.2053-3(a)-(c). 9. this confusion is discussed in joseph m. dodge, redoing the estate and gift taxes along easy-to-value lines, 43 tax l. rev. 241, 34549 (1988). 10. the passing requirement is also elaborated upon in irc § 2056(c), mostly relating to non-probate property, where the focus is on the "from the decedent" aspect. section 2056(b)(4), a key statutory provision in the hubert litigation, focuses on the "to his surviving spouse" aspect. 11. section 2056(b)(5) qualifies a trust for the marital deduction if it gives the surviving spouse both a lifetime income interest and a general power of appointment as to the corpus, a "gpa" trust. section 2056(b)(7) permits an election to qualify a trust in which the surviving spouse has a lifetime income interest in the absence of a general power of appointment if the trust constitutes "qualified terminable interest property," a "qtip" trust. 12. see regs. § 20.2056(b)-5(f). 19981 florida tax review regulations as being potentially relevant. 3 in fact, they are not relevant in the sense that the value-passing issue, referred to in the preceding paragraph, is analytically distinct from the qualification issue. section 2056(b)(4) states that, in determining the value of the interest that passes to the surviving spouse, there shall be "taken into account" taxes, encumbrances, and "any obligation imposed by the decedent" on the marital bequest. regulation section 20.2056(b)-4(a) on its face appears to be relevant to the facts in hubert: § 20.2056(b)-4 marital deduction; valuation of interest passing to surviving spouse. (a) in general. the value, for purposes of the marital deduction, of any deductible interest which passes from the decedent to the surviving spouse is to be determined on the date of the decedent's death .... the marital deduction may be taken only with respect to the net value of any deductible interest which passed from the decedent to his surviving spouse .... in determining the value of the interest in property passing to the spouse account must be taken of the effect of any material limitations upon her right to the income from the property. an example of a case in which this rule may be applied is a bequest of property in trust for the benefit of the decedent's spouse but the income from the property from the date of the decedent's death until distribution of the property to the trustee is to be used to pay expenses incurred during the administration of the estate. [emphasis added.] paragraph (b) of regulations section 20.2056(b)-4 deals with bequests subject to an "encumbrance" (such as a mortgage or lien) or an "obligation imposed by the decedent." the discussion of the latter refers to situations where the surviving spouse, as a condition of receiving the bequest, must give up a claim against the estate or some other property interest that she owns. encumbrances and obligations reduce the net amount passing to the surviving spouse. although paragraph (b) does not specifically mention administration expenses, nevertheless administration expenses charged against the marital 13. see hubert, 117 s. ct. at 1130-31 (plurality opinion), 1135-36 (concurring opinion), and 1140 (scalia, j., dissenting). the parties stipulated that qualification was not at issue. in theory, a restriction on an income right could result in "partial" disqualification. an example would be where the surviving spouse has a right to a fraction of the income. see regs. § 20.2056(b)-5(b) and (f)(1); rev. rul. 69-56, 1969-1 c.b. 224; charles davenport, hubert fog thickens after supreme court decision, 75 tax notes 434, 436 (apr. 21, 1997). however, hubert did not involve a restriction on an ongoing income right, and the problem could have been adequately dealt with under the value-passing rubric. [vol 3:11 lifting the shroud obscuring estate of hubert bequest also reduce the net amount passing to the surviving spouse.'4 however, if (unlike hubert) the personal representative has discretion to allocate such expenses to the marital bequest,' 5 it might be argued that section 2056(b)(4) does not literally apply, because there is no "encumbrance" or "obligation imposed by the decedent."' 6 on the other hand, section 2056(b)(4) is only illustrative of facts that can reduce the value of the marital deduction under the "passing" or "valuation" rubric.' 7 as paragraph (a) of 14. there is no reference to the effect of the payment of administration expenses on the marital deduction in the legislative history, although there is reference to the payment of claims: the interest passing to the surviving spouse from the decedent is only such interest as the decedent can give. if the decedent by his will leaves the residue of his estate to the surviving spouse and she pays, or if the estate income is used to pay, claims against the estate so as to increase the residue, such increase in the residue is acquired by purchase and not by bequest. accordingly, the value of any such additional part of the residue passing to the surviving spouse cannot be included in the amount of the marital deduction. see s. rep. no. 80-1013, pt. 2, at 6 (1948) (emphasis added). i take this passage simply to reiterate the basic point, stated in irc § 2056(a), that the deductible amount cannot exceed the amount includible with respect to the same property interest, and that estate income is not separately included in the gross estate. the date-of-death value of the residue encompasses future income-including income received during estate administration--because the value of any asset is the present discounted value of all future returns (of principal and income). the passage correctly concludes that treating an increase in the residue resulting from the use of estate income to pay claims would result in counting estate income twice in calculating the marital deduction: once when included in the date-ofdeath value of the residue and again when it subsequently increases the residue by reason of discharging claims. counting the income twice would be incorrect in any event because the increase in the residue attributable to the payment of claims is exactly cancelled out by the diversion of income from the residue to a non-marital use. it does not follow that a "real" diversion of estate income to a non-marital use (i.e., a diversion that does not indirectly augment the marital share) would fail to reduce the marital deduction: a marital deduction for the date-of death principal assumes that both principal and income passes to the surviving spouse; insofar as this assumption is incorrect, the value passing to the surviving spouse is less than the date of death value. 15. in hubert the administration expenses were to be charged (in part) to the marital share; the executor's discretion related only to whether the expenses should be charged to the principal or the income of such share. see hubert, 117 s. ct. at 1128. 16. see irc § 2056(b)(4)(b). 17. as originally enacted, the predecessor of irc § 2056(b)(4) was not located within the terminable interest rule of irc § 2056(b). see irc § 812(e) (1939). as amended by revenue act of 1948, § 361(a), 62 stat. 110. the text of § 2056(b)(4) begins with, "in determining for purposes of subsection (a) the value of any interest in property passing to the surviving spouse for which a deduction is allowed by this section-." the senate report to the predecessor of § 2056(b)(4) states that it is offered for purposes of clarification. see s. rep. no. 80-1013, pt. 2, at 6 (1948). in short, nothing in the structure or history of irc 19981 florida tax review regulations section 20.2056(b)-4 indicates, the specific items enumerated in section 2056(b)(4) (encumbrances and obligations) are not exhaustive.' 8 therefore, the failure of section 2056(b)(4) to specifically mention administration expenses is not important. 9 and indeed there is universal agreement that estate administration expenses actually charged against the principal of a marital bequest reduces the marital deduction.2" the parties and judges in hubert focused intently on the abovequoted regulation, since it specifically refers to administration expenses that are charged to income. however, the last sentence of the regulation is not directly "on point" because it refers to a situation in which the income "is to be used" to pay administration expenses,2 ' whereas in hubert the fiduciary had discretion to charge administration expenses against the principal or income of the marital bequest. finally, section 642(g) states that estate administration expenses claimed as estate tax deductions under section 2053 cannot also be deducted for estate income tax purposes. in hubert, the expenses were deducted for estate income tax purposes, 22 not for estate tax purposes under section 2053. normally, if administration expenses are deducted for estate tax purposes, the marital deduction under section 2056 is reduced pro tanto, since otherwise the same expenses would yield a double estate deduction for the same dollars.23 § 2056(b)(4) suggests that it is the exclusive locus of rules pertaining to the value of interests passing to the surviving spouse. section 2056(b)(4) is merely illustrative of general "passing" principles. 18. see also s. rep. no. 80-1013, pt. 2, at 6 (1948) (stating that the predecessor to irc § 2056(b)(4)(b) is based on principles generally applicable in valuing the net bequest). 19. see ballantine v. tomlinson, 293 f.2d 311, 313 (5th cir. 1961). 20. see hubert, 117 s. ct. at 1131; rev. rul. 55-225, 1955-1 c.b. 460 (administration expenses chargeable to marital deduction principal do not "pass" to surviving spouse). the taxpayer in hubert made this concession on the basis of its "symmetry" theory: since estate income is not separately included in the gross estate, reductions in such income must be ignored for purposes of valuing the gross estate and the marital deduction. (for the illogic of this argument, see supra note 14.) conversely, argued the taxpayer, since inclusion and deduction refers to the principal of assets, reductions in principal must reduce the deduction. the logic of the symmetry theory would seem to dictate that reductions in the principal of the marital deduction would also reduce the amount included in the gross estate, but this issue was not argued in hubert, and if it had been argued the inclusion value would not have been reduced. see section e infra. 21. see regs. § 20.2056(b)-4 (last sentence). 22. see supra note 3. 23. suppose w dies leaving $200,000 to b and the residue to h. assume that w's gross estate is $1 million and that administration expenses (charged against the principal of the residue) are $50,000. w's taxable estate is $200,000 (i.e., the bequest to b is fully taxable). if w's estate were to obtain a deduction of $50,000 for administration expenses and a marital deduction of $800,000, there would be a double deduction to the extent of $50,000. the double-deduction problem is solved by the "value passing" rule: only $750,000 passes to h, [vol. 3:11 lifting the shroud obscuring estate of hubert a way of stating the holding of hubert is that deducting the expenses for income tax purposes does not per se require a dollar-for dollar reduction in the estate tax marital deduction if the expenses are charged against income for trust accounting purposes pursuant to an executor's discretion. professor charles davenport has shown that not reducing the marital deduction in hubert allows the expenses to reduce both estate taxable income and the taxable estate, contrary to the spirit, if not the letter, of section 642(g). 2' example: h's gross estate is $50 million. h's will leaves $10 million to b and the residue to w. estate administration expenses, payable out of the residue, are $1 million. estate income is $3 million, all of which eventually passes to the residue. administration expenses are charged against the income of the residue and are deducted for income tax purposes. under hubert, the marital deduction of $40 million is unreduced, and produces a taxable estate of $10 million (the bequest to b). thus, there is a $1 million income tax deduction and a $40 million estate tax deduction, despite the fact that both deductions derive from the same $40 million fund. if the income tax deduction were taken but the expenses were charged against the principal of the residue, the marital deduction would concededly be reduced to $39 million. similarly, if the expenses were claimed for estate tax purposes and charged to the principal of the residue, there would be no income tax deduction and total estate tax deductions of $40 million ($1 million under section 2053 and $39 million under section 2056). the effect of the holding in hubert is that administration expenses that reduce the marital bequest income can be deducted elsewhere while not reducing the marital deduction. this result is out of sync with the result for near-identical scenarios. b. the opinions in the supreme court there were four opinions in the supreme court. the plurality opinion of justice kennedy (joined by chief justice rehnquist and justices stevens and ginsburg) took the position that the values of both the gross estate and the marital deduction were to be determined solely as of the date of death on the basis of present-value analysis.' if this premise were carried through to and so the marital deduction is limited to $750,000. in addition, irc § 2056(b)(9) expressly precludes double estate tax deductions for the same interest in property. 24. see charles davenport, a street through hubert's fog, 73 tax notes 1107 (dec. 2, 1996). 25. hubert, 117 s. ct. at 1128-29. 19981 florida tax review its logical conclusion, then it would not matter whether administration expenses were charged to income or to corpus. present-value analysis makes no distinction between income and corpus. nevertheless, the plurality opinion homed in on regulations section 20.2056(b)-4(a), quoted above, and discovered the phrase "material limitations upon her right to income" (emphasis added) in the third sentence and "a case in which this rule may be applied' (emphasis added) in the fourth sentence.26 it was noted that the government argued for a per se rule that income actually used to pay administration expenses must reduce the marital deduction dollar for dollar. the plurality noted that the trustee had discretion as to how to pay the administration expenses and that the trust income was quite large. therefore, it could not be concluded, as of the decedent's death, that the mere possibility of allocating some expenses to income would necessarily amount to a "material" limitation on the wife's right to income.28 by way of comment, since the possible exercise of discretion cannot be valued,29 the result should hinge on which party has the burden of proving value (or the lack thereof). the plurality seems to ignore the maxim that a person claiming a tax benefit (such as a deduction) has the burden of proof on such factual issues as value. it would seem to be up to the estate to prove immateriality, but the estate would not be able to establish immateriality ex ante where the executor has discretion to allocate administration expenses to the income or principal of the marital bequest.3" in addition, the alternative in hubert to allocating expenses to the income of the marital bequest was to allocate them to the principal of the marital bequest (as opposed to a non-marital transfer), and an allocation to principal would concededly have reduced the marital deduction.3 thus, any 26. id. at 1131. 27. id. at 1128. 28. see hubert, 117 s. ct. at 1132. for a similar, if more detailed, interpretation of the plurality opinion, see jonathan g. blattmachr & madelin rivlin, drafting for estate administration expenses after hubert, trusts & estates, august 1997, at 57, 58-59. 29. see holbrook v. united states, 575 f.2d 1288 (9th cir. 1978) (an interest subject to discretion has no value for purposes of the § 2013 credit). 30. although "immateriality" is itself a "legal" standard, the only "fact" relating to that standard is that the trustee had discretion to charge estate administration expenses against income. thus, the percentage of income actually used to pay administration expenses would not be a relevant fact under the plurality's view of the case. see infra note 32. there is no mention in the plurality or concurring opinions of the possibility that georgia law might have restrained the exercise of the executor's discretion. 31. see hubert, 117 s. ct. at 1139, 1140 (scalia, j., dissenting) (noting agreement of the plurality, concurrence, and both parties). see also estate of roney v. commissioner, 33 t.c. 801, 804 (1960), aff'd, 294 f.2d 774 (5th cir. 1961). [vol 3:11 lifting the shroud obscuring estate of hubert exercise of discretion to charge expense against either income or corpus would necessarily reduce the value of the marital bequest. 32 the plurality opinion dealt with professor davenport's doublededuction argument based on section 642(g)33 by stating that section 642(g) does not expressly prohibit taking an income tax deduction that merely fails to reduce the estate tax marital deduction.3 however, the no-doublededuction rule of section 642(g) makes sense only on the understanding that claiming the deduction for income tax purposes increases the taxable estate pro tanto either by foregoing an estate tax deduction or by reducing the marital deduction.35 in response, the plurality makes the undisputed point 32. as judge halpem's dissenting opinion in the tax court points out, the case of estate of wycoffv. commissioner, 506 f.2d 1144 (10th cir. 1974), affg 59 t.c. 617 (1973), would seemingly have led the lower courts to the contrary result in hubert. estate of hubert v. commissioner, 101 t.c. 314, 334-45 (1993) (halperin, i., dissenting). in wycoff, the executor had discretion to allocate death taxes to the principal of either the marital trust or the non-marital trust. wycoff, 506 f.2d at 1147. it was held that the marital deduction was reduced by the amount of taxes that could have been charged to the marital trust. id. at 1149-50. in hubert, the administration expenses could also have been charged against the principal of the marital trust. hubert, 117 s. ct. at 1128. although death taxes are explicitly referred to in irc § 2056(b)(4)(a), there is no meaningful distinction between taxes and administration expenses. see estate of roney, 33 t.c. at 804. it is true that in hubert the administration expenses were actually charged to income, hubert, 117 s. ct. at 1128, but that also should not have mattered. cf. home v. commissioner, 91 t.c. 100 (1988) (expenses chargeable to corpus but actually paid out of income reduced charitable deduction); alston v. united states, 349 f.2d 87 (5th cir. 1965). since valuation is to be made as of the decedent's death, the mere possibility of being charged against principal should be fatal, as was the case in wvcoff. similarly, the fact that the actual allocation to income was valid under state law would also be irrelevant. having missed the point of wycoff, and treating the charge against income as being controlling, the tax court and eleventh circuit majority opinions in hubert seem merely to distinguish the rule pertaining to charges against principal, and various cases applying that rule, without really explaining why charges against income would not also reduce the value of the marital bequest. that, of course, is the ultimate issue since, even if iwycoff was properly decided, it could be avoided by giving the executor discretion to allocate expenses either to the principal of the nonmarital bequest or to the income of the marital bequest. curiously, the government failed to cite wycoff in its supreme court brief. 33. see supra note 24 and accompanying text. 34. hubert, 117 s. ct. at 1133. 35. see hubert, 117 s. ct. at 1146 (scalia, j., dissenting). in seeming accord is patricia a. metzer, the deduction of an estate's administration expenses: section 642(g) of the internal revenue code and its impact, 21 tax l. rev. 459, 467-69 (1966). section 642(g) was added to the code by the revenue act of 1942, which also added the predecessor of § 212. prior to the 1942 act, administration expenses were not deductible for income tax purposes. see united states v. pyne, 313 u.s. 127 (1941). congress could (and should) have repealed the estate tax deduction for administration expenses, but instead it simply aimed to prevent a deduction under each tax. the 1942 legislative history is not illuminating. see h.r. rep. no. 77-2333, at 75-76 (1942); s. rep. no. 77-1631, at 136 (1942). insofar as the 1998] florida tax review that the marital deduction does not include the post-death income itself;36 therefore, payment of expenses out of such income does not reduce the deduction.37 that argument proves too much. the logic of the argument would lead to the conclusion that, if estate income was used to pay administration expenses, the estate could claim an estate tax deduction under section 2053 without reducing the marital deduction.3 8 it is true that section 2056(b)(9)-a provision ignored by everyone in the hubert litigation-states that "nothing in this section or any other provision of this chapter shall allow the value of any interest in property to be deducted under this chapter more than once with respect to the same decedent." but the logic of hubert is that a section 2053 deduction derived from using estate income to pay administration expenses is not a deduction for the same "interest in property" (i.e., the principal) that generated the marital deduction. alternatively, the mandate against double deductions for the same interest in property would not apply, because failing to reduce the marital deduction would not in itself constitute a "deduction." such a construction of section 2056(b)(9)-which exactly echoes the plurality's construction of section 642(g)-is too absurd to require comment. justice o'connor wrote a concurring opinion (joined by justices souter and thomas) in which she declined to join the plurality opinion's present-value theory.39 presumably, it would follow that the critical fact would be the allocation to income that was actually made. nevertheless, the concurring opinion proceeded to ridicule the treasury, the irs, and government counsel for its inconclusive and confusing regulations, 40 enactment of § 642(g) was based on revenue concerns, that rationale is undermined by the holding in hubert. 36. see hubert, 117 s. ct. at 1133. see generally maass v. higgins, 312 u.s. 443, 446-47 (1941). 37. see hubert, 117 s. ct. at 1133-34 (o'connor, j., concurring). the concurring opinion ignored the no-double-deduction argument, except to note that the hubert problem was not solved by the language of the code. id. at 1135. the nonresponsiveness of the plurality and concurring opinions to the argument based on irc § 642(g) might perhaps be attributed to the government allegedly raising the point for the first time in its oral argument before the supreme court, see id. at 1133 (plurality opinion), except that the double deduction argument was actually set out in the government's reply brief, dated sept. 11, 1996, well before the oral argument or the appearance of professor davenport's article. reply brief for the petitioner at 17-18, hubert, 117 s. ct. (no. 95-1402). 38. it is clear that the crucial fact in hubert to both the plurality and concurring opinions was that the expenses were charged against estate income, not that they were deducted for income tax purposes. see infra note 52. 39. hubert, 117 s. ct. at 1136 (o'connor, j., concurring). 40. see hubert, 117 s. ct. at 1139. the "material limitation" sentence of regs. § 20.2056(b)-4(a) makes perfect sense without the sentence that follows (referring to estate [vol. 3:11 lifting the shroud obscuring estate of hubert rulings,4 and litigation posture.4 2 the concurring opinion, like the plurality opinion, focussed on the "material limitation" phrase in the regulation. the opinion ultimately sided with the taxpayer because the government eschewed any attempt to define "material" or to apply that concept to the facts of the case, so that the tax court's factual determination of immateriality controlled. 43 by way of comment, the concurring opinion misses the point. on the record, the fact that the trustee had apparently unlimited discretion to charge administration expenses against either the income or corpus of the marital bequest easily satisfied the "materiality" test on its face. indeed, viewed correctly as of the date of death, such discretion was the only relevant "fact" bearing on the value-reduction issue; the actual amounts of income so used were, at least in theory, immaterial.' it is true that the government treated the actual charges against income as being relevant, but the government's approach actually can be seen as a concession: the government could have argued that, in general, the marital deduction is to be reduced by the maximum amount of expenses that could be charged against income. however, in hubert, such an approach would have been redundant, because income). thus, if the marital trust is locked into a low-yield asset, such could constitute a material limitation for valuation purposes. the sentence referring to estate income would have been clearer if it had said that the material limitation rule "is to be applied" (instead of "may be applied"), but "may be applied" is susceptible to a construction that is to be applied when the circumstances so warrant. see hubert, 117 s. cl at 1143 (scalia, j., dissenting). in the present context, "may be applied" is not equivalent to "might be applied," which expression necessarily reflects contingency or permissibility. the taxpayer has no option or election as to whether the rule will apply, and regulations, which set forth rules of law, do not need to refer to the obvious fact that the service has enforcement discretion. 41. see hubert, 117 s. cl at 1136 (o'connor, j., concurring) ("no matter how poorly drafted or ill conceived [rev. rul. 69-561 might be. . ."). for example, rev. rul. 6956, 1969-1 c.b. 224, confuses the effect of certain administrative powers on the qualification of an interest for the marital deduction and the valuation of that interest. even worse, in rev. rul. 93-48, 1993-2 c.b. 270, 271, the service conceded that the marital (or charitable) deduction was not reduced by interest on death taxes allocated to income. as the concurrence points out, hubert, 117 s. cl at 1137-38, this ruling is inconsistent with the government's position in hubert. for a discussion of the background of the ruling, see infra note 58 (noting that the government lost the interest expense issue in the courts because of its untenable distinction between administration expenses that supposedly "accrue" at death (executor's fees, etc.) and those that don't (interest)). 42. see hubert, 117 s. cl at 1138-39. the government made no attempt to define "materiality" or even to obtain a remand to the tax court on materiality as a factual issue. 43. id. 44. see supra note 32. the possibility of using marital assets to pay expenses would harmonize the "passing requirement" with the "terminable interest rule"--or could even be seen as triggering the terminable interest rule-which disallows the marital deduction to the extent that the marital bequest, as of the date of death, is subject to contingencies. 19981 florida tax review amounts not charged to income would have been charged to principal.45 since the tax court also missed the boat on the importance of discretion, the tax court's decision was not supported by the "evidence" and should have been reversed without remand. in other words, there was no genuine factual dispute, and there was no point in treating the case as if it hinged on "materiality," which in any event is a legal concept, not a factual (or quantitative) one. justice scalia (joined by justice breyer) dissented. the scalia opinion relied principally on the statutory mandate of section 2056(b)(4)(b), which calls for valuation of the marital deduction with reference to what actually passes to the surviving spouse, net of encumbrances and the like.46 justice scalia went on to argue that the regulation's use of the term "material" can mean "a limitation that is relevant or consequential to the value of what passes. '47 for example, not every charge against income would reduce the value of the property, because the charge could already be "built into" the valuation. examples would include capital gains taxes and other transaction costs of disposing of assets in the future and expected repairs on tangible property. the scalia opinion noted that reading "material" to mean "substantial," an indeterminate quantitative test, would produce a case-by-case quagmire.4 ' finally, if one relies on present value theory, as did the plurality, using income to pay expenses affects value just as much as using principal.49 justice breyer's separate dissent relied on the spirit of the "net value" concept under the "passing" requirement of the marital deduction. 0 the opinion also cited the purpose of section 642(g) to prevent double income and estate tax deductions.5' due to the fractured majority, it is hard to say what-other than the result-hubert stands for. the plurality opinion's marital deduction presentvalue theory was rejected by five justices. as mentioned earlier, since the critical fact in hubert was charging the expenses against income (as opposed to claiming them as income tax deductions), hubert could be expansively read to sanction the taking of an estate tax deduction for administration expenses allocated to income and which would not, after hubert, reduce the 45. since amounts charged to principal would reduce the marital deduction, reducing the marital deduction by the amounts actually charged against income would produce the correct overall result. 46. hubert, 117 s. ct. at 1139 (scalia, j., dissenting). 47. id. at 1142. 48. id. at 1142, 1145. 49. id. at 1144. 50. id. at 1147 (breyer, j., dissenting). 51. id. [vol 3:11 lifting the shroud obscuring estate of hubert marital deduction.52 thus, there would appear to be the possibility of a double estate tax deduction for the same amount.5 3 on the other hand, it appears that the government would have won the case if it had been willing to treat "materiality" as the crucial issue to be won on the facts. it also appears that the government would have won if the regulations and rulings were more explicit and less confused.-" perhaps the government would have won if it had argued the economics and the structure of the code rather than conduct exegeses of its own unclear regulations. but my purpose here is only partly to critique the hubert opinions. i turn next to a "big picture" view of the estate and income tax treatment of estate administration expenses. c. should estate administration erpenses be deductible for estate tax purposes? estate administration expenses can currently be deducted for income tax purposes or estate tax purposes, but not both." this approach is incorrect. in a conceptually pure estate tax, administration expenses would not be deductible; deduction should be had, if at all, under the income tax. an estate tax deduction should be allowed for debts and claims arising before death. the net estate is assets less liabilities at the time of death. estate administration expenses arise after death, and should be ignored for purposes of computing the net estate. 6 this point is magnified in the 52. the plurality opinion does not even mention that the expenses were deducted for income tax purposes. the concurring opinion labors under the misapprehension that the decision to take the deduction for income or estate tax purposes hinges on the trust accounting allocation of expenses. see hubert, 117 s. cl at 1134. in fact, the choice of which tax to take the deduction against has nothing to do with the trust accounting allocation. see regs. § 1.642(g)-i, -2. thus, the concurring opinion does not appear to be aware of the possibility that, as a result of the outcome in hubert, expenses can be allocated to income and yet be deducted for estate tax purposes. professor davenport's article did not raise the possibility of double estate tax benefits-probably because no one would have thought such a result to be possible-and the government's oral argument based on professor davenport's article did not raise this possibility either. see davenport, supra note 24; oral argument transcript, hubert, 117 s. ct. (no. 95-1402). 53. see steve r. akers, planning for post-death expenses in light of hubert, 75 taxes 263, 264 (1997). that such a construction should be resisted is argued in the text. see supra text accompanying notes 23-24. 54. see hubert, 117 s. cl at 1139 (o'connor, j., concurring); see also supra notes 40-41 and accompanying text. 55. see irc § 642(g). 56. a leading treatise argues that estate administration expenses should be deductible for both estate and income tax purposes. the argument for estate tax deductibility is simply that such expenses reduce the amount receivable by legatees. see m. carr ferguson. james j. freeland & mark l. ascher, federal income taxation of estates. trusts, and 19981 florida tax review case where estate administration expenses are charged against income: such expenses simply don't reduce the net estate but only reduce post-death accretion.57 the argument for estate tax deduction, cited by professor davenport, is that estate administration expenses entail a charge against the estate that attaches (if not "accrues" in the income tax sense) by reason of death." it is true that a large estate is likely to incur estate administration expenses, but no liability is incurred until the estate representative is authorized to pay them. the expenses arise because services are performed for the estate after the decedent's death. the largest category of such expenses, commissions, can be waived. the amount of expenses can vary widely because of such factors as will contests and unique assets. getting rid of the estate tax deduction for estate administration expenses would offer the beneficial side effect of rendering irrelevant the beneficiaries § 4.2.6, at 4:24 (2d ed. (1997)). it is true that there is no general principle against deducting the same thing for each tax, since the income and estate taxes are separate taxes. see kleberg v. com'r, 31 b.t.a. 95, 100 (1934). indeed, deductions in respect of a decedent are allowed under both taxes. see irc §§ 642(g) (last sentence), 691(b). (deductions in respect of a decedent are certain deductions incurred by the decedent before death but not paid until after death; hence; they are a form of claim against the decedent as opposed to being an administration expense.) but the estate tax is a tax on what the decedent had at death, not on what the legatees might receive. see knowlton v. moore, 178 u.s. 41, 48-49 (1900) (historical antecedent of estate tax was the probate duty). the false logic of deducting administration expenses for estate tax purposes would dictate a deduction for losses incurred (whether realized or unrealized) during the period of estate administration. as a historical matter, deduction for estate administration expenses was not allowed for income tax purposes until the revenue act of 1942 enacted the predecessor of irc § 212(1) and (2). see supra note 35. prior to 1942, an estate tax deduction might have been thought to have been better than nothing. 57. there is nothing in the regulations under irc § 2053(a)(2) that prevents the taking of an estate tax deduction where administration expenses are charged against income. 58. the supreme court accepted certiorari in hubert due to a conflict between the decision of the eleventh circuit in that case and the sixth circuit's decision in estate of street v. commissioner, 974 f.2d 723 (6th cir. 1992). hubert, 117 s. ct. at 1128. the latter case, in holding for the government on the hubert issue, appeared to rely on the notion that estate administration expenses accrue at death. street, 974 f.2d at 727-28. as argued below, whether or not an item accrues at death is irrelevant. what is crucial is that funds are diverted from the surviving spouse to other purposes in the course of estate administration prior to the actual funding of the bequest. street also held that interest on estate taxes paid out of a marital bequest did not reduce the marital deduction, on the theory that such interest accrues after death. id. at 729. this holding was accepted by the service in rev. rul. 93-48, 1993-2 c.b. 270. it is my view that neither administration expenses nor interest accrues at the decedent's death, but that both, if paid out of marital bequest income, should reduce the marital deduction. hence, i disagree with street on the interest issue, as well as with estate of richardson v. commissioner, 89 t.c. 1193 (1987), and i disagree with prof. davenport's contention that interest on deferred death taxes is distinguishable in any relevant sense from executor's fees. see davenport, supra note 24, at 111 i. [vol 3:11 lifting the shroud obscuring estate of hubert confusing doctrine surrounding which of such expenses are nondeductible because they benefit individual legatees rather than the estate.59 as an aside, the statutory alternate valuation date rule' is also not justified. as with estate administration expenses, post-death asset depreciation should be reckoned under the income tax, not the estate tax. of course, congress is not required to operate under a pure model. repeal of so much of section 2053 as pertains to administration expenses and the alternate valuation date election would not be high on anyone's tax reform priority list. d. should anticipated administration erpenses reduce the value of the gross estate? it is an accepted principle of valuation that a reduction in the value of property by reason of death is to be taken into account, at least if the reduction in value (a) pertains to the asset itself, (b) is bona fide, and (3) is not a device to achieve a tax-free gratuitous transfer.6 the theory behind the principle is that estate tax valuation looks to the future. 62 valuation in general is based on reducing future returns to present value. it might be argued that estate administration expenses produce a real decline in value of the gross estate on account of death. however, current valuation doctrine would not allow estate administration expenses to be taken into account for gross estate valuation purposes. first, valuation pertains to particular assets, not the gross estate as an entity. although some administration expenses might pertain to particular assets, most of them (taking inventory, paying creditors, preparing tax returns, 59. see regs. § 20.2053-3(d)(2); estate of smith v. commissioner. 510 f.2d 479 (2d cir. 1975); estate of park v. commissioner, 475 f.2d 673 (6th cir. 1973); estate of jenner v. commissioner, 577 f.2d 1100 (7th cir. 1978). 60. irc § 2032. 61. irc §§ 2703 and 2704 make sense only because of the background rule that value is generally affected by restrictions, etc., that arise by reason of death. 62. see united states v. land, 303 f.2d 170 (5th cir. 1962); goodman v. granger. 243 f.2d 264, 269 (3d cir. 1957) (restriction lapsing at death is ignored; value is that which survives death). this principle is usually cited in connection with the valuation of assets for estate inclusion purposes. the plurality opinion in hubert, 117 s.ct. at 1129-30, cites ithaca trust co. v. united states, 279 u.s. 151 (1929), for this proposition as it pertains to deductible interests (as opposed to assets). ithaca trust held that actuarial tables were to be used in valuing a charitable remainder interest for purposes of the then charitable deduction, despite knowledge of the noncharitable lead beneficiary's actual (short) life span. 279 u.s. at 292. a commitment to use actuarial tables, which is codified in irc § 7520, is not controlling with respect to matters of discretion, such as whether to charge estate administration expenses against income or principal. the possible exercise of discretion is incapable of actuarial valuation. see supra note 29. 19981 florida tax review and defending will contests) relate to the estate as a whole. administration expenses are not the equivalent of liens or restrictions on particular assets. second, the core valuation rule, which is the hypothetical willingbuyer willing-seller test, looks to the value of the asset, not the net amount to be received by the estate or legatees. thus, future sales commissions that would be owed under an agency contract, even if entered into before death, are ignored for valuation purposes.63 such items represent post-death economic loss apart from any valuation discount. administration expenses are indistinguishable in this respect from sales commissions. third, the willing-buyer willing-seller test disregards the identity, characteristics, or predictable actions of the legatees, the mechanics of estate transfers, or even the fact that an estate transfer is involved.64 thus, the value of property subject to a specific legacy would not be reduced because the legatee is committed to a certain use of the property.65 in contrast, facts that are specific to certain assets or types of assets are properly taken into account. 6 thus, a rental property that is located in a high-property tax area 63. see estate of smith v. commissionerr, 57 t.c. 650, 659 (1972), acq., 1974-2 c.b. 4, affd on other issue, 510 f.2d 479 (2d cir. 1975); rev. rul. 83-30, 1983-1 c.b. 224. 64. see john a. bogdanski, federal tax valuation 4-72 to 4-74 (1996); ahmanson found. v. united states, 674 f.2d 761, 768-69 (9th cir. 1981) (no discount where control block was carved up into minority interests by act of making bequests to separate legatees); estate of curry v. united states, 706 f.2d 1424, 1427-29 (7th cir. 1983) (same); propstra v. united states, 680 f.2d 1248, 1251 (9th cir. 1982) (family relationships ignored). the socalled blockage discount allowed by regs. § 20.2031-2(f) is ambivalent: it would appear to apply regardless of whether a sale is to be made by an estate or another party, but the rule may be colored by an anticipation that the estate will in fact unload the property on the market all at once (and to that extent the rule is, in my view, incorrect). see estate of smith, 57 t.c. at 657-58 (blockage discount awarded on assumption that ouvre of deceased sculptor would be offered on the market at the same time). but see estate of prell v. commissioner, 48 t.c. 67 (1967) (blockage discount denied where the asset could have been liquidated in an orderly fashion). the rule that the value of an enterprise is to be reduced on account of the death of the "key man" is conceptually proper, since the reduction in value is attributable to the loss of human capital, and the human capital of the deceased person was never an asset of the type subject to estate tax. 65. section 2032a, which values certain real estate at its actual use committed to by family-member legatees, would be superfluous if normal valuation rules took into account legatee facts. 66. see united states v. cartwright, 411 u.s. 546 (1973) (value of mutual funds is redemption price, not issue price); worthen v. united states, 192 f. supp. 727, 730 (d. mass. 1961) (lack-of-marketability discount for closely-held stock); rev. rul. 59-60, 1959-1 c.b. 237, amplified by rev. rul. 77-287, 1977-2 c.b. 319 (treating valuation of restricted stock, including stock subject to s.e.c. restrictions on marketability). in ahmanson foundation, 674 f.2d at 768, the court stated that the value of an asset could be affected by directions in the will such as a recapitalization or a direction to destroy. this statement appears to be dictum. the only case cited in ahmanson foundation is provident national bank v. united states, 581 f.2d 1081 (3d cir. 1978), which involved a post-death recapitalization, [vol 3:11 lifting the shroud obscuring estate of hubert should be discounted with reference to expected diminished future net rentals.67 the existence and amount of administration expenses is essentially a fact relating to the legatees and the mechanics or fact of estate transfer, and therefore should be ignored for valuation purposes. in sum, administration expenses would not be taken into account for purposes of valuing assets included in the decedent's gross estate, even if there were no estate tax deduction for such expenses. 6 if they were taken into account, it would be necessary to discount them to present value as of the decedent's death.69 e. is the valuation of marital deduction bequests "symmetrical" with valuation for estate-inclusion purposes? the plurality opinion in hubert seemed to operate under the assumption that valuation for both inclusion and deduction purposes must be actually dealt with the issue of valuation for purposes of the marital deduction, and the taxpayer argued that the recapitalization increased the value of the marital bequest. a recapitalization is distinguishable from a direction to destroy property because a recapitalization merely rearranges interests already dissolved in corporate solution into a new configuration. moreover, the third circuit appeared to assume (erroneously) that the value for the marital deduction had to be equal to the value of the amount included. finally. provident national bank is inconsistent with the later case of estate of chenoweth v. commissioner, 88 t.c. 1577 (1987), which held that a marital bequest of a controlling interest would increase the value of the marital bequest relative to the nonmarital minority-interest bequest. the important holding in ahmanson foundation is that gross estate valuation is not affected by the identity of the legatees. it is possible to distinguish the effect of the identity of the legatee from the effect of directions in the will, but i find the distinction wholly unconvincing, since the correct inquiry pertains to the asset as owned by the decedent at death, not the asset as it is processed through the decedent's estate. cf. rev. rul. 81-286, 1981-2 c.b. 177 (claim owned by a decedent does not disappear from the gross estate where the will directs that the claim be cancelled by the executor). see generally, ray d. madoff, taxing personhood: estate taxes and the compelled commodification of identity, 17 va. tax rev. _ (forthcoming may 1998). in any event. hubert did not involve a change in an asset mandated by a will provision. 67. it is critical to this example that the property cannot be moved. in contrast, a car garaged in a high crime area would not be discounted because of the possibility of theft or vandalism. 68. of course, it would be improper both to allow estate administration expenses as an estate tax deduction and to allow the same expenses to reduce asset values. for a case in which the estate succeeded in obtaining a double tax benefit with respect to the underwriters' commissions pertaining to specific securities, see estate of joslyn v. commissioner, 566 f.2d 677 (9th cir. 1977), rev'g 63 t.c. 478 (1975), but in that case the irs improperly allowed the valuation discount and then tried unsuccessfully to bar the deduction of estate administration expenses. 69. it might be argued that the payment of debts and claims are not discounted back to death, but these items have accrued as of the decedent's death, and are likely to be paid off in a short period of time. moreover, if the creditor charges market interest, the present value of the claims equals the face amount thereof. 19981 florida tax review as of the decedent's death, determined by present value terms, and, therefore, identical.70 as a matter of both the statute and doctrine, this assumption is partly correct and partly incorrect. it is correct insofar as valuation is to be determined as of the date of death; also, the amount deductible cannot exceed the corresponding amount includible. it is incorrect insofar as to what postdeath facts are to be taken into account in determining such value. as noted above, in valuing assets for purposes of inclusion in the gross estate, legateespecific and estate-specific facts are ignored. in contrast, the value of the marital deduction depends on what the surviving spouse is, viewed at the date of death, actually to obtain.7' a leading "pure" valuation case (i.e., one not involving section 2056(b)(4)) concerning deductible bequests of closely-held stock imposed a minority interest discount upon the deductible bequest although no such discount was available for estate-inclusion purposes.72 similarly, the leading case under section 2056(b)(4), united states v. stapf,7 3 reduced the value of the marital deduction, but not the value of included assets, on account of an obligation imposed by the decedent's will upon the surviving spouse to transfer the latter's property to a third party as a condition for receiving the bequest. the fact that valuation for inclusion and deduction purposes may be asymmetrical is not inconsistent with the proposition that valuation for both purposes should be "as of' the decedent's death. thus, if the facts that reduce the bequest are triggered by a post-death event, the reduction in the deduction should, in theory, be figured on the basis of present value.74 this point perhaps explains why section 2056(b)(4) states that encumbrances, etc., be "taken into account" in valuing the deduction (as opposed to mandating a dollar-for-dollar reduction). however, if the encumbrance, etc., and the amount thereof can be determined as of the date of death, and the only 70. the taxpayer's brief in hubert principally relies on this argument. brief for respondent at 16, hubert, 117 s. ct. (no. 95-1402). at least one commentator also makes this assumption. farhad aghami, payments out of post mortem income: impact on estate tax marital and charitable deductions, 49 tax law. 707, 737-40 (1996). 71. see provident nat'l bank v. united states, 581 f.2d 1081, 1086-87 (3rd cir. 1978). 72. ahmanson found. v. united states, 674 f.2d 761, 771-72 (9th cir. 1981) (charitable bequest). accord, estate of chenoweth v. commissioner, 88 t.c. 1577 (1987). 73. 375 u.s. 118 (1963). 74. the amicus brief of the tax section of the florida state bar erroneously argued that the government's position in hubert would demand reduction of the marital deduction by post-death depreciation or reductions in net income. brief for amicus curiae the tax section of the florida bar in support of respondent at 8 n.9, hubert, 117 s. ct. (no. 95-1402). the possibility of post-death depreciation or reductions in net income is already factored into the asset values. in contrast, post-death charges of administration expenses to income are not taken into account in asset values. see supra pp. 629-31. [vol 3:11 lifting the shroud obscuring estate of hubert uncertainty is the time of discharge, transfer, or payment with respect to the encumbrance, etc., it would not be unreasonable to require a dollar-for-dollar reduction in the deduction. administration expenses are a close call; those that are determinable as a percentage of the estate principal might be deemed to reduce the deduction dollar for dollar;, those that are not determinable as a precentage of the estate principal should be reduced to the present value as of the date of death. in any event, the present-value norm dictates that the reduction in the deduction should occur regardless of whether the charge is mandatory or discretionary or whether it is made against the corpus or income of the marital bequest. in hubert the parties agreed, and the court (without elaboration) endorsed the view that the marital deduction would indeed be reduced if the estate administration expenses were in fact (pursuant to the exercise of the executor's discretion) charged to principal, regardless of whether deducted for estate tax purposes or income tax purposes.7 5 this "rule" is compatible with only one principle, namely, that the marital deduction is to be reduced when the legatee of the qualifying bequest in fact obtains less than the gross bequest due to payments or distributions incurred in the estate transmission process. 76 this concession should have been fatal to the taxpayer in hubert. another version of the symmetry argument is as follows: (i) the amount included in the gross estate is the "principal" of assets, i.e., excluding post-death income; the deduction is for the same principal included in marital bequests; therefore, charges against income per se cannot reduce the deduction. 7 basically, the argument is a non sequiturthe date-of-death principal for inclusion purposes is the present value of all future returns, both "principal" and "income";7 8 the marital deduction assumes that the surviving spouse will be the transfer tax owner of both principal and income; 79 therefore, the possibility of diverting principal or income to a non-marital use should reduce the marital deduction. valuation for inclusion purposes refers to specific assets. in valuing assets, the future income stream is considered, since the value of any asset is determined by reducing future returns (of 75. see supra notes 20 and 31. 76. asset depreciation to the date of funding the marital bequest due to market forces would not result in reduction of the marital deduction because the value of the deductible assets is determined as of the decedent's death. 77. see brief for respondent at 13-14, 20, hubert, 117 s. ct. (no. 95-1402); brief amici curiae of the american council on education and united way of america in support of respondnet at 4-6, hubert, 117 s. c. (no. 95-1402). 78. therefore, including actual post-death income in the gross estate would amount to including the same income twice. 79. see infra note 90. 19981 florida tax review principal and income) to present value. however, in valuing assets for inclusion purposes, charges against income or principal that are specific to the estate transmission process are, as described in the preceding section, ignored. for purposes of valuing the marital deduction, what is valued is the "interest" that "passes" to the surviving spouse, not specific assets. the "value passing" requirement mandates consideration of predictable charges against that interest. charges against either the income and principal of the marital deduction bequest reduce the value of the interest passing to the surviving spouse. a principal purpose of the section 2056(b)(4) value-reduction rule is to deny qualification for amounts which will escape the surviving spouse's gross estate.8" stated differently, falling to reduce the marital deduction would violate the core purpose of the marital deduction that deductible amounts appear in the surviving spouse's gross estate (unless consumed by the surviving spouse).8 for example, assume h, the decedent, has a gross estate of $2 million, and $200,000 of administration expenses are incurred, to be charged against the residue. h leaves a specific bequest of $1 million to c and the residue to w. if the marital deduction is not reduced, h's taxable estate is reduced by $1 million but only $800,000 is includible in w's gross estate.82 80. see s. rep. no. 80-1013, pt. 1, at 28 (1948) (referring to "estate splitting," which means shifting tax base from decedent or donor spouse to surviving or donee spouse); northeastern pa. nat'l bank & trust co. v. united states, 387 u.s. 213, 221 (1967). in estate of alexander v. commissioner, 82 t.c. 34 (1984), aff'd 760 f.2d 264 (4th cir. 1985) (unpublished table decision), the decedent created a trust in which the widow had the right to all of the income plus a general power of appointment over a specific dollar amount. the deduction was allowed in the amount of the specified dollar amount. the government argued that this arrangement violated the "specific portion" requirement of § 2056(b)(5). the effect of this decision was to exclude corpus appreciation from the widow's gross estate. arguably, the government should have only tried to reduce the value of the marital deduction, but valuation under the estate and gift tax assumes that all economic return takes the form of "income" (rather than appreciation). stated differently, the reduced value of the corpus component would have been made up for by the income component. estate of alexander is also distinguishable in that there were no charges against income or corpus, and the potential appreciation was not limited to the period of estate administration. reaffirming the basic norm that the marital deduction should result in deductible interests being fully included (net of consumption) in the surviving spouse's transfer tax base, congress in 1992 overturned northeastern pennsylvania national bank and estate of alexander by enacting irc § 2056(b)(10). 81. id. 82. this argument is distinguishable from the argument based upon a purpose of the passing requirement to prevent a marital deduction for amounts that pass to a third party. thus, the government's position is not weakened by a showing that no third party benefits from charging administration expenses to marital-bequest income. a third party would benefit where there is a nonmarital bequest that could have borne the burden of administration expenses, but not if the entire net estate is the subject of marital-deduction transfers. [vol 3:11 lifting the shroud obscuring estate of hubert it might be argued that economic waste is a legitimate form of estate tax avoidance. that argument raises the issue of whether a charge of estate administration expenses against a marital bequest is the equivalent of economic waste by the surviving spouse. administration expenses are "caused" by the fact that the decedent has left an estate subject to administration, not by the independent consumption decisions of the surviving spouse. this point, incidentally, is not the equivalent of arguing that estate administration expenses "accrue" at death, an argument that has caused the government grief in both hubert' and elsewhere.' it is sufficient to distinguish transmission-at-death-related expenditures from consumption by the surviving spouse. although, in a vacuum, it would not be irrational to treat the two categories of waste the same, the distinction is clearly made by the structure of the marital deduction within the estate tax, as embodied in: (1) estate inclusion valuation principles, (2) the passing requirement,' (3) section 2056(b)(4), (4) the acknowledged rule reducing the marital deduction by estate charges against corpus,6 (5) the terminable interest rule (and its exceptions),' and (6) the bar against deducting administration expenses for both income tax and estate tax purposes.s a more subtle argument directed to the hubert situation would be that, if expenses are charged against the income of the marital bequest, the amount included in the surviving spouse's gross estate (the corpus) under section 2041 or 2044-which apply by reason of the form of the marital trust-will not be reduced. 89 thus, in the hypothetical set forth in the 83. the government's brief in hubert unfortunately relied heavily on this argument. brief for the petitioner at 14, 16, 24, 26-27, hubert, 117 s. c. (no. 95-1402). 84. see hubert, 117 s. ct. at 1134-35 (o'connor, j., concurring). this theory was adopted by the sixth circuit with the consequence that the government lost on the issue of the effect of interest on death taxes. estate of street v. commissioner, 974 f.2d 723, 729 (6th cir. 1992); see also supra note 58. 85. see irc § 2056(a). 86. see supra notes 20 and 31. 87. see irc § 2056(b)(1), (3), (5)-(8). the marital deduction qualification rules are designed to assure that deductible transfers will, because of their form, appear in the surviving spouse's tax base, see supra note 81, but there is no principle that the deductible amount appear dollar-for-dollar in the surviving spouse's tax base. the amount actually to be included in the surviving spouse's tax base is a function of actual (as opposed to estimated) economic return and consumption by the surviving spouse. see supra note 10. 88. see irc § 642(g). 89. this appears to underlie the argument made by the american college of trust and estate counsel in its amicus brief. see motion for leave to file amicus curia brief of the american college of trust and estate counsel urging affirmation and brief of the amicus curiae in support of respondent at 4, hubert, 117 s. c. (no. 95-1402) ("if, however, there is sufficient estate income to pay those expenses and the corpus is kept intact, then the surviving spouse or charity will eventually receive not only the full bequest, but also will have 19981 florida tax review preceding paragraph, if the income on the residue during administration is greater than $200,000, and administration expenses are charged against income, the corpus included in w's gross estate will be $1 million. the trust income-which will augment the surviving spouse's potential section 2033 gross estate as and when distributed to her-will be reduced. the marital deduction is allowed "on condition" that the surviving spouse be deemed the transfer tax owner of both corpus and income.90 not to reduce the deduction when expenses are charged against income would allow the surviving spouse in such case a free deduction against her own estate (actually, a reduction in her section 2033 gross estate) not available to surviving spouses who are beneficiaries of marital trusts in which corpus was so charged; at that point, equal consumption by the income-reduced spouse as by her corpus-reduced counterparts would leave the income-reduced spouse ahead of the transfer tax game. to restate the foregoing more succinctly, the deductible value as of the decedent's death is the present value of that same amount as of the surviving spouse's death as augmented by income accrued to the surviving spouse's death, all of which (as it actually exists at the surviving spouse's death) is to be includible (net of consumption) in the surviving spouse's gross estate. estate income used for administration expenses reduces the amount includible in the surviving spouse's gross estate and should (perhaps as reduced to present value) also reduce the amount deductible.9' thus, the rule of section 2056(b)(4) is conceptually sound, and the principle that it embodies should, contrary to hubert, be applied regardless of whether administration expenses are charged against the income or corpus of marital bequests. the principle, however, is the "passing" requirement itself. it is not necessary to attempt-as the government did in hubert-to fit estate administration expenses into the "encumbrance or obligation" language of section 2056(b)(4)(b). 92 a larger investment base that can generate more gross income, using the assumptions stated in the appendix."). 90. the marital deduction is allowed for outright bequests, irc § 2056(a), singlelife annuities, irc § 2039, marital remainder trusts, regs. § 20.2056(b)-4(d), power-ofappointment trusts, irc § 2056(b)(5), qtip trusts, irc § 2056(b)(7), and estate trusts, regs. § 20.2056(c)-2(b)(1)(iii). a "marital remainder trust" is a trust providing income to a nonspouse beneficiary for life or for a term of years and vested remainder in fee simple to the surviving spouse or the surviving spouse's estate. an "estate trust" is a trust in which income can be accumulated, but no income can be paid to a third party, and both the corpus and accumulated income must be paid to the surviving spouse's estate. in all of these forms, the income with respect to the deductible interest is actually owned, or is deemed for transfer tax purposes to be owned, by the surviving spouse. 91. see davenport, supra note 24, at 1110. 92. see supra notes 17-18 and accompanying text. [vol 3:11 lifting the shroud obscuring estate of hubert at this point, estate administration expenses charged against the marital bequest would reduce the marital deduction without (under the ideal regime) being deductible independently under section 2053. in effect, an amount equal to estate administration expenses would be treated as a taxable bequest, even though it is never acquired by a legatee. although this result seems counter-intuitive, it would be consistent with the fact that death taxes are also included in the tax base despite the fact that they reduce bequests. taxing the economic waste attendant upon the transmission of property at death fulfills the logic of an estate tax, as opposed to alternative tax modes, such as an inheritance tax, an accessions tax, or including gratuitous receipts in income. of course, in the vast majority of estates, the taxable "bequest" of estate administration expenses would not generate estate tax, due (mainly) to the unified transfer tax credit. and, of course, under current law the estate can obtain an estate tax deduction for such expenses. also, the estate tax is not the only tax in the picture. there is the income tax. f. income tax treatment of estate administration erpenses estate administration expenses should be taken into account under the income tax, since such expenses represent fees for services performed over time after the death of the decedent. under current law, estate administration expenses are deductible for purposes of computing the taxable income of the estate as a separate taxpayer under the income tax. this result flows from the supreme court decision in trust of bingham v. contmissioner,93 which imposed an expansive construction upon the language of section 212(2) ("management ... of property held for the production of income"). the expenses in trust of bingham related to litigation and the distribution of assets in termination of a trust, but these functions were held to be connected with the management of incomeproducing property. the result has been incorporated into the regulations, where it is extended to estate administration expenses,' despite the fact that the estate's personal representative generally has no duty to invest. estates should be thankful for this result because estate administration expenses are, from the vantage of the legatees, capital expenditures in whole or in part.95 the possibility of capitalization was not raised in trust of bingham-perhaps because trusts are distinguishable from estates-but presumably capitalization is a moot issue even for estates given the regulations under section 212. nevertheless, if the capitalization issue were 93. 325 u.s. 365, 373-74 (1945). 94. see regs. § 1.212-1(i). 95. see estate of davis v. commissioner, 79 t.c. 503 (1982) (concerning outlays to establish heirship in order to obtain an inheritance from the estate of howard hughes). 19981 florida tax review to to be squarely faced as a matter of first impression, it would be hard to ignore the fact that estate administration expenses are incurred on behalf of legatees principally so that the latter may acquire possession and marketable title to estate assets and cash.96 the "caretaking" aspect of estate administration is derivative of the fact that it takes time to collect assets and pay creditors (including tax collectors). acquisition costs are capital expenditures.97 ergo, estate administration expenses are capital expenditures. and how would such costs be actually treated? the conventional treatment of acquisition costs would be to add them to the cost basis. however, the basis in this case is not cost but, thanks to section 1014, fair market value at the date of death. in an analogous situation involving a partgift part-sale transaction, the regulations under section 1015 provide in part that the taxpayer obtains the greater of (a) the "free" (here, the transferor's) basis or (b) the cost basis.98 since in the death-transfer situation, the free (section 1014) basis would normally exceed the cost basis (estate administration expenses), the latter would usually vanish without a trace. in other words, capitalization of estate administration expenses would (usually) produce no income tax benefits whatsoever. this result is correct. estate administration expenses relate to the acquisition of cash and property. those that relate to cash are simply a nondeductible offset to cash that is tax free under section 102. outlays relating to tax-exempt income are not deductible.9 therefore, no tax benefit would adhere to administration expenses allocable to cash. the same analysis applies to estate property because the section 1014 basis is the medium in which the section 102 exclusion is carried.' ° to add acquisition costs to the section 1014 basis of property would produce the equivalent of allowing a deduction for obtaining tax-free income. the foregoing does not preclude the possibility that some estate administration expenses might be viewed as being properly deductible, sooner or later. thus, expenses allocable to the management and conservation of income-producing property, or for the production or collection of (includible) income, might be allowed. also, since income in respect of a decedent (ird) 96. see generally jesse dukeminier & stanley m. johanson, wills, trusts, and estates 38, 48 (5th ed. 1995). 97. see woodward v. commissioner, 397 u.s. 572 (1970). 98. see regs. § 1.1015-4(a)(1). 99. see irc § 265(a)(1); regs. § 1.212-1(a)(1). 100. the § 1014 basis preserves the integrity of the § 102 exclusion. if the property had a zero basis, the exclusion would disappear when the property is sold or realized. the estate situation is distinguishable from that of acquisition costs in obtaining § 103 bonds, which costs should be capitalized. in the § 103 bond situation, a true cost basis exists for the assets; it is the interest income from the asset (not the gain) that is tax free. any costs relating to the tax-free interest should produce no tax benefits. [vol. 3:11 lifting the shroud obscuring estate of hubert does not take a section 1014 basis, estate costs of acquiring and securing such property might, to the extent such costs exceed the carryover basis (which is often zero), be allowable. however, if the "origin test" were applied in the estate situation, 1 it would follow that all estate administration expenses are capital expenditures on the theory that they have their origin, or raison d'etre, in the fact of acquiring property and cash from a decedent.'2 in any event, the threat of full capitalization, or at least the problem of allocating estate administration expenses among the categories of section 1014 asset acquisition costs, ird acquisition costs, costs allocable to includible income, and costs allocable to excludable income, is finessed by the expedient of constituting the estate as a separate taxpayer apart from the legatees. thus, everything the estate does is viewed as "management and conservation," and none of it as "acquisition" because it is the legatees who are actually doing the acquiring. the analogy is to a business which obtains property for others, such as a broker. the costs of operating the brokerage business are deductible expenses to the broker. the fees paid by the clients individually are capital expenditures to them. that is true of legatees who personally incur expenses to acquire their legacies or inheritances, but this rarely happens because that is precisely the job of the estate. the acquisition expenses incurred by the estate are not attributed to the legatees. there is nothing inevitable about treating estates as separate taxpayers. estates could be ignored, and the legatees treated as direct owners of their bequests. a variation of this approach would be to treat the estate as a pass-through vehicle so that accounting would occur at the estate level but items of income, expense, and capital expenditure would be allocated among the legatees according to their interests in the estate." this approach is probably better than the current approach on both conceptual and simplicity grounds. g. is an estate tax deduction for estate administration expenses a practical necessity? to sum up the foregoing, estate administration expenses should be reckoned under the income tax, not the estate tax. despite this conclusion, it might be thought that allowing the estate tax deduction (as an option) is a 101. the origin test has been held to apply in the context of acquisition costs. see woodward, 397 u.s. at 572. 102. indeed, the origin test was applied in davis, 79 t.c. at 503 (1982). 103. see sherwin kamin, a proposal for the income taxation of trusts and estates, their grantors, and their beneficiaries, 13 am. j. tax pol'y 215, 254-63 (1996); joseph m. dodge, simplifying models for the income taxation of trusts and estates, 14 am. j. tax pol'y 125 (forthcoming 1997). 19981 florida tax review practical necessity to prevent possible loss of at least some of the deductions. such loss would occur where estate administration expenses for the year exceed estate income for the year because the resulting net loss is not an nol-since the deductions are not "business" deductions. 1 4 only nols (and capital loss deductions) can be carried over to other taxable years of the estate. in addition, unused nol and capital loss carryforwards, plus excess (non-nol and non-capital loss) deductions in the year of termination, can be carried over from the estate to the legatees.'0 5 however, excess deductions in the year of termination (resulting from estate administration expenses) can only be used by a legatee in her taxable year in which the estate terminates; such excess deductions do not create carryforwards at the legatee level.' °6 in short, under current income tax law (and assuming no estate tax deduction), the income tax losses attributable to estate administration expenses could be lost to some extent. estate representatives would lie under a tax inducement to generate income to absorb the deductions, space the deductions to match income, or postpone the deduction to the year the estate terminates in hopes that the excess deductions in that year could be absorbed by high-bracket distributees. the solution is to treat estate administration expenses as business deductions so as to allow the creation of nols that can be carried over to other years of the estate and of its distributees who bear the economic burden of such expenses. although, as noted above, administration expenses at the legatee level might best be treated as capital expenditures, that problem would be cured by a statutory rule that treated nol carryovers from an estate as nol carryovers at the distributee level. i do not personally favor the nol approach. i am merely conceding that congress would likely be disposed to allowing the deduction of estate administration expenses somewhere in the tax system. assuming this to be the case, it is more appropriate to allow them for income tax purposes than for estate tax purposes. h. administration expenses and the charitable deduction in hubert there was also a charitable bequest under the residue, and a portion of total administration expenses were chargeable against the income or corpus of the charitable bequest in the executor's discretion. thus, the issue was raised as to whether a charge against charitable bequest income 104. see irc § 172(d)(4) (nonbusiness deductions in excess of nonbusiness income not included in nol computation). 105. see irc § 642(h). 106. see regs. § 1.642(h)-2(a). [vot. 3:11 lifting the shroud obscuring estate of hubert would reduce the charitable deduction. both the parties and the supreme court agreed that (1) an actual charge to the corpus of the charitable bequest would reduce the charitable deduction and (2) an actual charge to the income of the marital bequest would raise the same issue (and would call for the same answer) as under the marital deduction."'7 in short, the result of hubert is equally applicable to the marital and charitable deductions. my conclusion is this conflating of the marital and charitable deductions is correct, notwithstanding the fact that there are some differences between the two deductions. one such difference is that there is no charitable deduction analogue to section 2056(b)(4)(b), which refers to "encumbrances" and the like, although section 2055(c) is a charitable deduction counterpart to section 2056(b)(4)(a), which takes into account death taxes charged against a marital bequest.10 8 as stated earlier, 9 section 2056(b)(4)(b) merely provides clarification with respect to certain aspects of the "passing" requirement of section 2056(a). therefore, the omission from section 2055 of a similar encumbrance-related provision has little or no significance. potentially more serious is the fact that the charitable deduction has no explicit "passing" requirement. on the other hand, the charitable deduction is allowed only for bequests, etc., "to or for the use" of a charity.' the regulations provide that a deduction is allowed only for interests that can be presently valued and which are not subject to meaningful contingencies."' if there is a will contest, the charitable deduction is the amount actually passing to the charity under the will contest." indeed, if the charitable interest cannot be ascertained at the decedent's death, the fact that it is ultimately fixed pursuant to a court order will not be sufficient to save the deduction." 3 contingent bequests to charity are not deductible unless the 107. hubert, see 117 s. ct. at 1129. 108. see irc § 2055(c). this provision is the successor to irc § 812(d) (1939) which overturned the result of edwards v. slocum, 264 u.s. 61 (1924). slocun denied the government's effort to require "deducting from the exempted estate the amount of the tax to be paid, or in other words, adding the amount of the tax to the taxable estate" under prior law, revenue act of 1924, ch. 18, § 401, 40 stat. 1057, 1096. see also harrison v. northern trust co., 317 u.s. 476 (1943) (upholding application of irc § 812(d) (1939). 109. see supra notes 17-18 and accompanying text. 110. irc § 2055(a)(2). 111. see regs. § 20.2055-2(a). compare ahmanson found. v. united states, 674 f.2d 761, 771 (9th cir. 1981), (charitable deduction won't be disallowed on account of a greater-than-negligible possibility of a reduction pursuant to a will compromise). 112. see toulmin v. united states, 462 f.2d 978, 982 (6th cir. 1972). 113. see merchants nat'l bank of boston v. commissioner, 320 u.s. 256 (1943): estate of marine v. commissioner, 990 f.2d 136 (4th cir. 1993), aff'g 97 t.c. 368 (1991) (charitable bequest subject to discretionary invasion for private individuals). 19981 florida tax review contingency is susceptible to actuarial valuation." 4 no reason can be conceived for allowing a charitable deduction for property or an interest therein that does not, or might not, pass to a charity on account of the exercise of an election provided for in the governing instrument. in sum, the passing requirement-as well as a mild common-law version of the terminable interest rule' '5 -is implicit in the charitable deduction." 6 thus, in an outright residuary bequest to charity,"' the deduction should be reduced by administration expenses charged to principal or residual income. as in the marital deduction context, an estate tax or income tax deduction can be obtained for such expenses, and the same expenses should not produce a second tax benefit in the form of a failure to reduce the charitable deduction. in the case of split-interest charitable transfers (charitable lead or remainder interest with the other interest being noncharitable), the structure of the charitable deduction differs from that of the marital deduction. in the marital deduction, the surviving spouse is the deemed transfer tax owner of both the income and remainder interests. the charitable deduction does not treat the charity as the owner of all interests. but this point only suggests that the charitable-deduction situation is easier to analyze than the marital deduction situation. the charitable deduction is "final," and there is no concern with what ends up in the potential tax bases of either the charitable beneficiary (which is nontaxable in any event) and the noncharitable beneficiary. in other words, the problem is simply that of valuing what passes to the charity, and the guiding principle should be that the charitable deduction not be allowed for amounts that may be diverted to noncharitable purposes pursuant to the exercise of discretion. in applying that principle, 114. see humes v. united states, 276 u.s. 487 (1928); griffin v. united states, 400 f.2d 612 (6th cir. 1968); rev. rul. 59-143, 1959-1 c.b. 247; rev. rul. 68-336, 1968-1 c.b. 408. 115. the charitable deduction version disallows deduction for a charitable interest only if it is subject to contingencies that cannot be actuarially ascertained. see supra note 114. conditions subsequent are disregarded where the chance of divestiture is remote. see rev. rul. 67-229, 1967-2 c.b. 335. thus, the charitable deduction terminable interest rule is significantly milder than the marital deduction version, which is statutory. 116. see harrison v. northern trust co., 317 u.s. 476, 480 (1943) (charitable deduction reduced by tax payable out of charitable residue). 117. in a residuary bequest, the legatee is usually entitled to the net income. in the case of a specific monetary (i.e., pecuniary) bequest, there is usually no income right. in effect, such a bequest creates an immediate dollar claim in favor of the pecuniary legatee that is unaffected by estate income and expenses. hence, a pecuniary charitable bequest would be reduced (for charitable deduction purposes) only if expenses, etc., were actually charged against the amount of such bequest. [vol. 3:11 lifting the shroud obscuring estate of hubert administration expenses that reduce what the charity receives should reduce the charitable deduction to an appropriate extent. i. the next step hubert did not construe the code to preclude reduction of the marital or charitable deduction for administration expenses allocated to income pursuant to an executor's discretion. because section 2056(b)(4) was viewed as not speaking directly to the facts of hubert, the plurality and the concurring opinions relied on the regulations purporting to interpret the passing requirement as embellished upon by section 2056(b)(4)." 8 neither the parties nor the court suggested that the regulations were invalid. basically, the plurality and concurring opinions construed the regulations in a way that raised a factual issue of "materiality" that the government refused to explicitly address, although in fact any burden on the government was satisfied because all administration expenses had to reduce the income or principal of the marital and charitable bequests. the government is now faced with two alternatives. it can try to live with the "materiality" test and apply it on a case by case basis. or it can revise the regulations in a way that makes it clear that any estate charge against the income or corpus of a marital or charitable bequest reduces the deduction." 9 the amended regulation should eliminate the "materiality" test because the administrative discretion of the irs can deal with tie minimis situations. the marital or charitable deduction should be reduced by expenses and charges incurred during the estate transmission process that are not already factored into valuation for gross estate inclusion purposes. since administration expenses are not properly factored into the valuation of assets for gross estate inclusion purposes, administration expenses chargeable to a marital bequest always reduce the value passing to the surviving spouse. moreover, the deduction should be reduced by the maximum amount of estate administration expenses that can be charged against the income or principal of the marital or charitable bequest pursuant to an executor's discretion, although the irs should be allowed to use hindsight where appropriate (i.e., all the administration expenses have been accounted for when the estate tax return is filed). executors should be allowed to enter into agreements with the irs in which the executor undertakes not to allocate charges against the marital or charitable share (assuming the executor has a choice). 118. see supra text accompanying notes 25 and 43. 119. see hubert, 117 s. ct. at 1139 (o'connor, j.. concurring) (open invitation for the government to revise regulations to accord with litigating position). 19981 florida tax review the amended regulation should address the issue of whether the charges should be taken into account on a present-value or dollar-by-dollar basis. the charges should be reduced to present value only where the actual date of payment is known. otherwise, the reduction should be on a dollar-fordollar basis, on the theory that the estate cannot satisfy its burden of proving when the future charges will be paid. the irs should revoke revenue ruling 93-48,2' which allows interest on deferred estate taxes to be deducted for income tax purposes without reducing the marital deduction. interest on deferred estate taxes is an estate administration expense"' and not a category of consumption by the surviving spouse. all costs relating to the estate transmission process that are charged to the income or principal of a marital or charitable bequest should reduce the marital or charitable deduction. 120. 1993-2 c.b. 270. as discussed earlier, the ruling was prompted by government litigation reverses brought about by the government's own faulty theory. see supra note 58. the irs can acquiesce in the result of cases without embracing the rationale. 121. see rev. rul. 79-252, 1979-2 c.b. 333 (interest on estate tax is deductible for estate tax purposes under irc § 2053). [vol 3:11 florida tax review volume 3 1997 number 10 more on accounting for the assumption of contingent liabilities on the sale of a business charlotte crane* i. introduction ................................ 616 hi. summary of professor halperin's conclusions .... 617 i. why is a bank loan different from a contingent liabilrry .................................... 619 iv. the premises underlying surrogate taxation ..... 623 v. what if the seller's deferral had nothing to do with surrogate taxation? . . . . . . . . . . . . . . . . . . . . . . 627 vi. what is an assumed liability? . . . . . . . . . . . . . . . . . . . 635 vii. reconsidering the alternatives for accounting for the assumption of contingent liabilities ..... 636 a. professor halperin's preferred method .......... 637 b. first alternative method: accounting for price adjustments as amounts are paid .............. 638 c. professor halperin's second alternative method ... 640 viii. what if the expected value cannot be accurately determined? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641 ix. should the accounting for a cash purchase be the only norm for evaluating possible accounting treatments? . . . . . . . . . . . . . . . . . . . . . . . . 643 x. conclusion .................................. 645 * professor of law, northwestern university school of law. i want to thank professor halperin for his patience in our correspondence over many years on this and related subjects. any errors remain my own. this project also benefited from the financial support of the linthicom foundation and the research assistance of michael d. cohen. florida tax review i. introduction in his article "assumption of contingent liabilities on sale of a business," which appeared in this journal last year,' professor daniel halperin ably describes the stakes involved in properly accounting for contingent liabilities assumed by a buyer in asset acquisitions. his primary conclusion is that a buyer of a business who assumes contingent liabilities should not be allowed, as some have urged, a deduction upon payment on these liabilities. although i agree with much of professor halperin's analysis and almost all of his conclusions, i disagree with some of his underlying assumptions about the universal nature of contingent liabilities. professor halperin's analysis relies heavily on the related underlying assumptions that (1) there is always a legitimate reason for deferring a deduction until the person to whom the contingent liability is owed has been identified and that person has taken the amount into income and (2) more often than not, the expected value of the payments to be made on the liability can reasonably be valued in advance. if either of these assumptions is unfounded, the problems posed by contingent liabilities are more difficult than professor halperin's analysis might suggest, although his ultimate resolution of the situation may nevertheless be the best one available. this comment will explore professor halperin's underlying assumptions regarding contingent liabilities and examine the stakes involved in fashioning tax accounting rules that rely upon them. it will attempt to demonstrate that at least some liabilities, including some contingent liabilities,2 are different from the liabilities upon which professor halperin's analysis is based. this difference may not easily be accommodated in an income tax based on realization. nevertheless, this difference may undermine both the assumption that there is a legitimate reason for deferring a payor's deduction until the ultimate payee is known and has been taxed, and may make it substantially more difficult to establish an appropriate value for the liability in advance of payment. 1. daniel i. halperin, assumption of contingent liabilities on sale of a business, 2 fla. tax rev. 673 (1996) [hereinafter halperin, assumption]. 2. as did professor halperin, these comments will ignore those contingent liabilities that represent payments for which no payor would ever be entitled to an offset against income, whether as a current deduction or an addition to basis. such liabilities include federal income taxes and amounts limited by the provisions of §§ 162(c) and 162(0. the former most likely should be accounted for at the time of sale by requiring the seller to take an amount into income without offset. the latter are policy deviations from the results which would be produced by strict adherence to technical notions of income, and, as such, their implementation in transactions involving the assumption of such liabilities is more appropriately viewed as a matter of policy as well. [vol 3:10 accounting for the assunption of contingent liabilities my disagreement with professor halperin about the variations among contingent liabilities has little practical consequence if (as may well be the case) workable tax accounting rules cannot be fashioned to accommodate the differences among such liabilities and other deferred payments. it may also be true that failing to deal with these cases separately will not produce intolerable results. nevertheless, i fear that some readers may ignore his conclusions because, from their point of view, he seems to be concerned only with the easy cases for which his assumptions seem reasonable. since professor halperin's analysis does not appear to have taken these harder cases into account, readers who are concerned primarily with the harder cases are likely to reject his analysis too quickly. when professor halperin ignores the variations among contingent liabilities, he may make it too easy for critics to reject his conclusions as extreme. ii. summary of professor halperin's conclusions professor halperin would require that buyers assuming contingent liabilities include the expected value of the liabilities in the basis of the assets acquired at the time of the acquisition. if the payment on the liability is made "as expected," no further deduction would be allowed, even for an interest component.4 this treatment differs from the accepted treatment of assumed fixed liabilities, in that when fixed liabilities are assumed there is both immediate basis available for the use of the loan proceeds and an allowance for interest,5 frequently taken as such interest accrues, and certainly taken no later than payment. this proposed treatment for contingent liabilities is a variant of the device familiar to readers of professor halperin's earlier work involving surrogate taxation.6 professor halperin also acknowledges that an equivalent result could be obtained by allowing the buyer full deductibility of any amounts actually paid when they are paid, but only after requiring, somewhat artificially, inclusion of income either at the time of the sale or, with an adjustment for the passage of time, at some later time. (the equivalence of these choices and the options available when payments are not made as expected are explicated more fully below.) 3. halperin, assumption, supra note 1. at 688-700, 711. 4. id. 5. this allowance is generally a deduction, unless the nature of the project is such that interest should be capitalized. throughout these remarks. "allowance of a deduction" will be used, unless indicated otherwise, on the assumption that the item is one that would have given rise to a deduction no later than when paid if no transfer of assets had occurred. 6. daniel i. halperin, interest in disguise: taxing the "time value of money," 95 yale l.j. 506 (1986) [hereinafter halperin, disguisel. 1997] florida tax review at the heart of professor halperin's analysis is his demonstration that allowing the buyer a deduction for an assumed contingent liability plus interest when payment is made would be equivalent to allowing the buyer a deduction for the liability at the time of the sale. therefore basis credit should be allowed only for the liability itself (with adjustment if this allowance is deferred), with no additional deduction for interest paid. he demonstrates this equivalence by first pointing out the windfall that would accrue to the seller of a business if it were allowed a deduction for the interest paid on a fixed, but as yet undeducted liability, such as deferred compensation. this is the context in which surrogate taxation has been most readily accepted, and is not surprisingly professor halperin's starting point. professor halperin's reasoning is straightforward and familiar. if an employer and an employee agree to defer for one year payment of compensation (professor halperin uses $100) for work already performed, the tax rules should leave them (considered together) no better off than they would be if the compensation were paid currently. presumably the employee could have earned interest on the compensation only at the after-tax rate of interest. therefore the employee could have taken the money, paid tax on it and invested the rest, and, assuming a 40% tax rate and a 10% interest rate, ended up after one year with $63.60 [net wages: $100 ($100 x .40)] + [net interest: ($60 x. 10) ($60 x .10)(.40)]. given that the employer which defers payment need only equate the employee's situation with this $63.60 result, it need only pay $106 at the end of the year ($106 ($106 x .40) = $63.60). therefore the employer must not be allowed to deduct the compensation as if it had been paid or to deduct a pre-tax interest amount, because then it could earn more than it logically should be required to pay the employee. (if it invests the unpaid $100 at 10%, and pays tax on the $10, it will have $106 to pay the employee. if it has any better tax treatment, it will be able to deduct the tax savings and earn more.) the employer can be allowed only a deduction for this $106, the amount originally owed with an adjustment for the deferral. this adjustment for the deferral gives the employer a deduction of $106 at the end of the year, a deduction which has the same value to the employer as a deduction of $100 at the time the compensation was earned.7 the lesson demonstrated is that so long as the employee is not taxed as the compensation is earned, the employer cannot be allowed a deduction as the compensation is earned without producing a lower tax burden simply as a result of the deferral of payment this lowering of the tax burden is 7. halperin, assumption, supra note 1, at 678-81 (relying on halperin, disguise, supra note 6, at 511, 522-23). 8. under professor halperin's approach, as is generally the case under current law, the deduction is allowed when the payment is made. the amount allowed as a deduction is greater than the amount that would have been allowed at the earlier time. this larger deduction [vol 3:10 accounting for the assunption of contingent liabilities prevented by giving the employer a deduction for the full amount of the payment only at the time of payment, and not allowing the employer to accrue and deduct interest. this deduction of the amount actually paid effectively compensates the employer for the delay in its deduction because, assuming unvarying tax rates and the use of the correct discount rate, a deduction of the future value of any given payment will have the same economic effect as a deduction of the present value of the payment in an earlier year.9 this same principle must be followed when the employer's business is sold in a taxable transaction, and the obligation to pay the employee is assumed by the buyer. the buyer's liability must be treated in a way that requires him to set aside an amount no less than the seller would have had to set aside to provide the employee with an after tax amount of $63.60. the treatment that produces this result requires the buyer to add the amount paid to the basis of the assets acquired when it is paid, or in the alternative, to add the present value of the liability to the basis of assets acquired. in either case, there should be no further deduction when the amount is actually paid.' 0 m. why is a bank loan different from a contingent liability? the deferred payment (and related contingent payment") situations are to be contrasted, in professor halperin's analysis, with the situations involving the proceeds of an ordinary bank loan. in the case of an ordinary bank loan, the amount of the proceeds are generally available to be deducted (or added to basis, depending upon the use of the proceeds) when received and used; amounts subsequently paid to the lender for the use of its money are deductible as interest. if a buyer of the business assumes this bank compensates the employer for the deferral of its deduction. it is in ordinary circumstances the same as the amount that would be allowed if the employer were allowed a deduction for the original amount, together with an additional element of interest at the implicit after-tax rate. 9. in the ordinary case, the correct interest rate is the rate that the taxpayer could earn after-tax. thus, if the after-tax discount rate is 10%. a deduction of s91 in year i will have the same economic impact as a deduction of s100 in year 2 or si10 in year 3. assuming a 30% tax rate, such deductions would give the taxpayer a current benefit of s27, s30, or s33, respectively. the savings in years 1 or 2 could be invested to produce an overall yield of s33 in year three. 10. halperin, assumption, supra note 1. at 684-85. the present value for these purposes is computed at the after-tax rate of return, since the buyer will incur tax liability on the interest earned if it has set aside a fund to meet the obligation. 11. "all contingent liabilities fall into the second of the two categories described in part 1-typified by the deferred compensation arrangement-because the seller is allowed no deduction, basis, or other tax attribute until the contingency is resolved." halperin. assumption, supra note 1, at 688-89. 19971 florida tax review liability, the buyer is entitled to add the principal amount to basis, and to deduct the interest paid or accrued." professor halperin asserts that contingent liabilities assumed in asset transfers must be treated like deferred compensation because they, like deferred compensation, have not yet been taken into account by the seller.'3 ideally, the purchaser should be allowed basis for the expected economic value of the liability at the time of the purchase. in the alternative, an allowance for this amount, adjusted for deferral, should be given when the liability is paid. but in no event should there be a separate deduction for the interest component of the amount paid."4 if such liabilities had been taken into account by the seller, as the use of the proceeds of a bank loan are, then apparently professor halperin would allow a deduction for an interest component. there is something circular about professor halperin's sorting of liabilities into these two classes: those which have given rise to tax attributes for a seller/obligor (the classic bank loan that bears interest) and those which have not (the compensation payment which has been deferred). the fact that the proceeds have been taken into account by the seller/obligor should not, in itself, be a reason for distinguishing between these two types of liabilities. the real distinction between these cases is the prior fact that the typical lender will have lent after-tax funds, while the typical employee will be deferring tax on the deferred payment, and will therefore, in effect, have lent before-tax funds. 12. in the body of the text, professor halperin does not consider the question of how much interest on such liability should be deducted or when it should be deducted. these issues are considered only in the abstract, in appendix i. halperin, assumption, supra note 1, at 712-14. in theory, only the present value of the liability, calculated using the after-tax discount rate of the buyer, should be treated as the liability assumed by the buyer and added to the basis of the assets purchased. unless there is a renegotiation of the debt, however, the terms of the debt will not be restated, and the tax accounting for the assets purchased will produce imperfect results. if the discount rate faced by the buyer is higher than that faced by the seller when the debt was first incurred, the seller will have gain relating to the debt mischaracterized as gain on assets, and the buyer will have an overstated purchase price and an understated interest cost. if the discount rate faced by the buyer is lower than that faced by the seller when the debt was first incurred, the seller should have a loss relating to the debt, and the buyer will have an understated purchase price and an overstated interest cost. (this summary assumes that the buyer's burden should be the measure of the seller's gain or loss on its debt position. other more complicated approaches could be used.) 13. professor halperin outlines these two classes of liability in halperin, assumption, supra note 1, at 676-77. 14. halperin, assumption, supra note 1, at 684-86. [vol 3:10 accowzting for the assumption of contingent liabilities one can ordinarily assume that loans are made with funds that are after-tax to the lender.' 5 when the loan proceeds are transferred to the borrower, there is no additional value added to the tax base. there has only been a transfer of previously included values. therefore the transfer of the funds can be ignored without omitting any values from the overall tax base.' 6 as a normative matter, interest on this ordinary bank loan will be deductible to the payor. there is no reason not to allow a deduction of interest on amounts that represent earnings on values that have already been taxed, especially when, in general, these interest earnings can readily be taxed to their owner, the lender. 7 there is no untaxed principal, and no untaxed interest. since both parties will be aware of this treatment, the negotiated interest can be assumed to be stated at a pre-tax rate. on the other hand, the typical employee has not yet taken into income the amount that he is, in effect, lending the employer. to the extent that this value has not yet been accrued, there has been a value omitted from the overall tax base. in professor halperin's deferred compensation situations, for instance, the earned compensation should have been taxed to the employee. because it has not yet been taxed to the employee, the employer's deduction is deferred until payment. when the compensation is paid, both the employer and the employee are taxed in ways that put them in the same position that they would have been had the compensation been paid and accrued earlier. the employer is allowed a deduction that includes an interestlike increment to make up for the deferral of the deduction for the payment, and the buyer similarly must take into account an amount that includes an interest-like increment to make up for the deferral of the inclusion. because the employer will, in fact, be paying the employee's income tax on the interest on the not-yet transferred fund, the employer and employee can be 15. not all loan proceeds are made with values that can be assumed to be after-tax. for instance, sales with deferred payments that are accounted for on the installment method. amount to loans of pre-tax values. the interest charge under § 453b. and the rules precluding installment treatment of recapture gain under this section have substantially limited the circumstances in which loans can be made with pre-tax proceeds. similarly, before the 1984 changes to the methods for reserving for bad debts, some lenders could effectively deduct a substantial part of their loan proceeds, making them effectively pre-tax to that extent. 16. it appears that professor halperin would be willing to allow the retransfer of such after-tax funds, even when a traditional loan is not involved. professor halperin simply assumes that the proceeds of a bank loan can be retransferred to a third party without the third party taking the amount into income. halperin, assumption. supra note 1. at 682 n.19. 17. if interest is not charged to the lender, only the interest deduction should be subject to the same surrogate taxation device. a deduction should be allowed not as interest accrues, but only as it is paid or taken into account by the lender. no adjustment needs to be made to account for the principal, since it has already been taxed to the lender, and has not been deducted by the lender on the transfer to the borrower. 1997] florida tax review assumed to have agreed that the interest-like increment should be accruing at an after-tax interest rate. under these assumptions, the allowance of deferred deductions for principal, with compensation to the employer for this deferral, is appropriate. 8 in sum, i believe that the criterion professor halperin chooses to focus on, whether the liabilities in question have given rise to tax attributes for the seller/obligor, does not provide the true distinction between these two types of liabilities. the link identified by professor halperin between the seller/obligor's tax attributes and the deductibility of interest is useful only because, in most situations, the rule for allowing the seller/obligor's tax attributes to be taken into account provides a good substitute test for determining the likelihood of prior income inclusion by the effective lender. there is much in the relevant tax accounting rules that conditions the seller's ability to take a deduction into account upon the likelihood that the ultimate recipient has taken the amount into income. the fact that the amount has been taken into account by the seller is only a likely indicator of the fact that the ultimate recipient has taken the amount into income. both the granting of tax attributes to the seller and the allowance of an interest deduction are conditioned on the likelihood that the ultimate recipient has taken the amount in question into income, and that, therefore, no amount has been omitted from the tax base. surrogate taxation is only necessary when values that should have been included in the tax base will remain excluded or their inclusion is deferred. deferred payment for values previously created by an employee, in effect, leaves those values out of the overall tax base during the period of the deferral. professor halperin's surrogate taxation compensates for this omission from the tax base (and the fact that the taxpayers can earn interest on what would have been paid in taxes). in professor halperin's compensation example, the $100 of compensation will be omitted from the tax base from the time that it was owed to the employee until the time that it is paid. the employer, therefore, can earn the interest on what could be viewed as the government's share of that $100, or $40 (assuming a 40% tax rate.) the government can reclaim this lost interest by, in effect, taxing the earnings of the $100 twice, once as it accrues in the employer's hands, and again on payment to the employee. thus, the $10 earnings taxed once at 40% leaves 18. halperin, assumption, supra note 1, at 679; halperin, disguise, supra note 6, at 519-24. professor halperin's preference for characterizing the deduction as a grossed-up deduction for principal with no deduction for interest allows one to understand his underlying analysis more clearly. unless there is a difference between the interest rate that is appropriate when compensating the payor for the delay in the deduction and the interest rate that is appropriate when calculating the interest rate charged by the payee, the results are the same no matter how the deduction is characterized. [vol. 3:10 accowting for the assumption of contingent liabilities $6, and taxed again leave $3.60. this $3.60, combined with the after-tax amount available to the employee after payment, leaves the employee with $63.60, the same amount she would have had available had the compensation payment not been deferred. 9 in sum, the real distinction between the bank loan and the deferred compensation cases is not whether the seller/obligor has been allowed to take the liability into account, but the prior fact that the typical bank lender will have lent after-tax funds, while the typical employee will be deferring tax on the deferred payment. in the case of the bank loan, there is no reason not to allow the liability to be taken into account immediately and allow a deduction for interest. in the case of the deferred compensation, the seller's treatment must reflect the fact that the employee has not taken the payment into income. iv. the premises underlying surrogate taxation as the prior analysis reveals, the starting point for professor halperin's analysis is the need to protect the tax base from inappropriate omissions that can result from discrepancies in the timing of deductions by payors and inclusion by payees. the importance of these insights (and professor halperin's contributions to their acceptance and implementation throughout the code) cannot be overstated. nevertheless, it is useful to consider the premises on which the approach relies, and to consider the circumstances under which it is appropriate to extend principles of surrogate taxation beyond professor halperin's deferred compensation examples. the first premise is that there is one ascertainable point in time at which to take into account any value includible in the income tax base and that, starting with this point in time, it can be assumed the value could have generated an additional interest-like return that the payee is in fact claiming. the second is that all values, once created, remain in the system, either in their original form or as inputs to the production of some other value, and that they remain available as a source of an additional interest-like return. both of these premises are true frequently enough that they appropriately constitute a starting point for discussions of timing in tax accounting; neither are so universally true that the possibility of their nonapplicability should be totally ignored. 19. if the deferral were for two years, the amount left for the employee after current payment and taxation would have been $67.42 (s63.60 + (s6.36 s2.54)). to leave the same value in the hands of taxpayers, the employer must be taxed on the earnings as they accrue (leaving $106 at the end of the first year and $112.36 at the end of the second), with the entire amount taxed to the employee on receipt ($112.36 (si 12.36 x .40) = $67.42). 1997] florida tax review the limits of the first premise-that there is no ambiguity about the precise time at which a value can be said to exist, and that an interest-like return is therefore accruing untaxed-can be demonstrated by moving from questions regarding employee compensation to self-created assets. suppose a farmer harvests 400 bales of hay at a time when hay costs $3 a bale. he stores the hay in his barn, expecting to feed it to his own livestock. 0 although there has been $1,200 of value added, it is a value that the tax law does not attempt to include in the tax base.2 ' (this exclusion may be theoretically wrong, nevertheless, the tax law has never thought the problem to be so significant as to require the extraordinary efforts necessary to overcome the administrative problems inherent in trying to include them.) the farmer will be taxed on the value that he has added through producing the hay, but only if and when he sells his livestock. only at that point will tax accounting acknowledge the value he has created. no existing tax accounting rules will attempt to make up for the failure to tax the value the farmer added to the economy but did not commit to the market, even though several years may have passed while the hay was stored in his barn. furthermore, if he feeds the hay to his son's show pony, the value will never be accounted for. suppose instead that a drought hits a neighboring region. the owner of a racetrack is attempting to secure as much hay as he can, and contacts the farmer. the farmer agrees to ship 400 bales the next day for $3.50 a bale. the farmer has $1,400 (400 x $3.50) of income (no later than when he is paid), and the racetrack has $1,400 of deduction (assuming the hay will be consumed within a relatively short period of time. 2) the farmer, like professor halperin's employee, should have income at this point in time, and any arrangements between the farmer and the racetrack owner to lessen the 20. hay was deliberately chosen as a crop for which the most substantial contributions to the added value can be assumed to be the farmer's own land and labor, with relatively few purchased inputs. under the assumption that there are few purchased inputs, questions regarding the timing of the deductions for the purchased inputs can be avoided. if there are substantial purchased inputs, it is likely that they should not be allowed unless and until the farmer recognizes gain with respect to the hay. 21. the text does not attempt to address the underlying question whether, as a normative matter, the income tax should tax all accretions to wealth or all accretions to wealth that are transferred in the market. since it is clear that the current tax law omits virtually all wealth unless it is committed to the market, it seems appropriate to use that norm here. the ambiguity identified in the text, however, exists even assuming this norm. see, e.g., noel b. cunningham & deborah h. schenk, how to tax the house that jack built, 43 tax l. rev. 447 (1988). 22. note that if the farmer does in fact divert self-created value from nonmarket to market use, he should be entitled to take into account his after-tax investment in such value. there is no norm, however, for determining whether he is entitled to take such costs into account as of the time the investment was made, or as of the time of the conversion. [vol 3:10 accounting for the assumption of contingent liabilities tax burden through payment arrangements are properly subject to surrogate taxation. suppose instead that, on learning of the drought, the farmer suspects that hay will become even dearer than it is now, and he is unwilling to part with his hay so soon at such a low price. he agrees to ship the 400 bales now, but insists on being paid an amount that will vary depending upon the level to which market price of hay eventually rises. that price will not be determined until the next taxable year. should the farmer have income at the time the deal is struck? probably, for at this point, the farmer is essentially the same as professor halperin's employee. assuming that this is correct, for what period, and for what amount will surrogate taxation be appropriate? should we attempt to tax the farmer the same as if he had agreed to sell the hay at the time when it was first baled? it seems unlikely that the later decision to take the hay to market should affect the treatment of the time that passed before the decision to go to market, but it would not be incoherent to do so. 3 or should we attempt to tax the farmer as if he had agreed to the spot price at the time he agrees to sell to the owner, and require surrogate taxation from that point and measured from that value? this seems far more appropriate and certainly more consistent with current law. the reason is that, once the farmer is dealing with the owner, we can assume that he is in a position to charge interest for the delay in payment and that the racetrack owner's use of the hay will allow him to pay such interest. until that time, we could not be sure that the farmer could command any price, much less a price with interest, for his hay. after that time, the presumption that he could charge interest seems more appropriate.2'4 because the farmer and the owner have control over the terms of their agreement, it may be appropriate to assume that they have consciously agreed to defer payment, and that surrogate taxation is therefore appropriate. but the first premise behind surrogate taxation (that payees can all command an interest-like rate of return on all values from their initial creation) is likely to be met only after the farmer and the owner strike a deal. the second premise vital to surrogate taxation is that all values once created are never destroyed. these values are instead always used up in the course of creating other values or consumed in a way consistent with their remaining in the tax base. therefore transferors of value can be assumed to 23. in this example, if the later market transaction affected the taxation of earlier events, the payment, when ultimately made, would be viewed as a lower price, but with a higher rate of interest charged. 24. the text ignores one troubling complication. is any future increase in the price of the hay a separate asset, which, as a normative matter, need not have been included in the tax base as of the time the deal was struck, or is it part of the value that the farmer is effectively deferring? 19971 florida tax review be implicitly charging interest, because those to whom they have transferred value will in turn put that value to further productive use?2 if the farmer sells to the racetrack owner, the owner will presumably buy the hay only if he can expect to use it to create other values. the farmer's labor has produced the value of the hay, and presumably this value will be used up in the course of the operations of the racetrack. without surrogate taxation, the value of the hay could be kept out of the tax base by deferring payment to the farmer so long as the farmer is willing to accept the owner's credit. without surrogate taxation, both parties can benefit from arranging their affairs to take advantage of this omission. therefore, in the ordinary case, the owner should not be able to take into account the cost of the hay until the farmer has included it in his income. but what if the weather changes abruptly and an undetected leak in the racetrack owner's barn renders the hay useless? from the point of view of the overall tax base, there are no more values that should be included than there would be if the farmer had never produced the hay. although he has not ultimately received anything in return, the owner must still pay the farmer next year based on hay prices in the interim. 6 to replicate the tax base that would have been available had the farmer never produced the hay, we would have to allow the owner to transfer a fund of cash to the farmer without any net diminution by tax. there are no current tax accounting norms that inform us which point of comparison-as if there had never been any hay or as if the hay continued to have value-is correct. the problem lies in the failure of income tax theory to define precisely when realization is normatively appropriate. on the one hand, the government's claim to a share of the earnings from a fund (the hay) that no longer exists seems tenuous. if realization is appropriate only when values are sufficiently concrete that they can be presumed to be commanding an interest-like return, then the never-any-hay baseline is by analogy most appropriate for the destroyed-hay situation. on the other hand, if cash had been paid by the owner initially, the government would have received its share earlier, and the earnings on this share would not have been contingent on the fund's ability to produce such a return. 25. owners of self-created assets could also be assumed to be implicitly charging themselves interest as they await the sale of the second stage of self-created assets. thus, in the normal course, the farmer bales the hay under the expectation that his later livestock sales will provide him adequate compensation for the labor and incidental costs that he incurs while baling, plus a modest rate of return for the delay in receiving such compensation. his behavior, however, is equally consistent with being unable to anticipate a price sufficient to justify the additional costs of bringing the hay to market. 26. note that to the extent that the owner actually bought the hay as insurance against the possibility that he would not be able to obtain hay, the treatment suggested by the text would undertax the overall transaction. [vol. 3:10 accounting for the assumption of contingent liabilities any difference between taxation of the farmer and the taxation of the employee is attributable to reliance on notions of realization. professor halperin's invocation of surrogate taxation is premised on the notion that values created through waged labor should be realized as the employee exchanges labor for a promise to pay. in a realization-based income tax, the norm for the inclusion of gains on property is generally to ignore new value (as well as increases and decreases in previously included values) until it is subject to a market transaction, regardless of the circumstances under which it arose. the value of self-constructed assets, like the farmer's hay while it remains in the farmer's barn, does not fit easily into either category. the destruction of the purchased hay brings the norms for wage income (and the need to tax the farmer currently) into conflict with the norms under a realization-based income tax for asset income (which tolerate deferrals of both gains and losses). v. what if the seller's deferral had nothing to do with surrogate taxation? professor halperin ably demonstrates that in the most common situations, allowing a buyer a deduction for that part of a payment attributable to a contingent liability in effect accelerates the deduction of the liability compared to the treatment that the seller would enjoy if the business assets had not changed hands. when such treatment is allowed and the economic effect is analyzed taking into account the timing of the deductions involved, the buyer is effectively allowed to deduct the amount as of the time of the transfer of assets and liability assumption, when ordinarily the seller's deduction would have been required to await payment. if an assumed contingent liability represents a value received by the seller and not yet included in the tax base, such an acceleration is, as professor halperin demonstrates, inappropriate. professor halperin also acknowledges that there may be circumstances in which there is no need for surrogate taxation, because the ultimate payee is not deferring income and there is no value remaining omitted from the tax base.27 however, he asserts that these can only be situations in which the seller's deduction is being delayed without warrant. if the seller's deduction is delayed without warrant, he asserts, the rule requiring the seller's deferral should be changed, not the treatment of the liability assumption in connection with a sale of assets. implicit in his discussion is the notion that the sale of a business could not justify a change in the timing of the deduction: 27. haiperin, assumption, supra note 1, at 694. 19971 florida tax review the potential payees of some contingent liabilities may not be deferring tax on the corresponding income. without an income deferral, the payor could possibly be allowed the equivalent of an interest deduction. however, if, in the absence of the sale of the business, the seller's deduction for the item would have been delayed until payment, it effectively does not get an interest deduction in connection with the payment of contingent liabilities. if this treatment is considered unwarranted, it should be corrected whether or not a sale takes place. i see no reason for a different result merely because the business has been sold. thus, if the seller would not get an interest deduction, neither should the buyer. the entire payment should be nondeductible.28 this comment should give the reader familiar with the notion that a sale is ordinarily a realization event some pause. after all, sales do make an enormous difference in a realization-based income tax, for many losses will be allowed only upon a sale. if the contingent liability in fact represents a net loss to the tax base (rather than a deferred payment for value added in connection with the transaction in question), there is no reason that the overall tax treatment of the liability should not be more favorable as a result of a sale. it is not hard to imagine situations in which sellers have previously unrealized losses triggered by the sale of a business. suppose the seller had, in the course of conducting its business, caused the contamination of the soil on land it owned. (assume for the moment that there will be no accompanying obligation to clean up the soil, but that the land is clearly worth less than it would otherwise be, and that it is worth less than its basis in the seller's hands.) surely the sale of the land would be an appropriate time to recognize this loss in value. indeed, an argument could be made that an allowance of the loss only on a sale does not provide the seller with an adequate tax treatment of the lost value. perhaps a more technically correct treatment (absent the traditional limitations of realization) would have been to allow the seller to take this loss in value into account as the seller took into account its income from the use of the land. nevertheless, the seller will in fact take this loss into account on the sale, and only because of the sale. it seems to me that there are at least two situations in which an obligation to pay in the future is tantamount to an unrealized loss that could appropriately be triggered by a sale of a business. both involve an appropriation by the seller/obligor of value that has unquestionably been destroyed or 28. id. [vol. 3:10 accounting for the assumption of contingent liabilities committed to a use that will produce no future value for the seller or buyer as of the time of the sale. suppose, for instance, that instead of contaminating its own soil, the seller/obligor had inadvertently caused the destruction of some of the value of its neighbor's land. although the degree of damage has not been determined yet and the neighbor's ultimate recourse has not yet been established at the time of the asset transfer, the seller/obligor clearly will be ultimately liable for some sort of damages at the time of the sale. how should the neighbor be viewed for tax purposes? has she merely transferred new value to the seller/obligor for which she has not yet been compensated, just as the uncompensated employee had in professor halperin's initial analysis? if so, professor halperin's analysis seems appropriate. or is it possible that something less susceptible to professor halperin's analysis has occurred? the assumption that the underlying events that gave rise to the contingent liability produced value, which will be omitted from the tax base unless the neighbor is taxed directly or through surrogate taxation, simply may not hold. the neighbor will likely have suffered a decline in value in her land. this value may be replaced by the later payment by the seller, perhaps with interest. the transaction can be viewed as essentially a forced loan of value from the neighbor to the seller/obligor. so long as the value appropriated by the seller from the neighbor was an after-tax value, there is no obvious reason not to accord the entire transaction the same treatment given to a more conventional loan. under this treatment, the seller/obligor should be accorded a basis allowance for the use of the loan proceeds at the time they are extended, and the interest component should be fully deductible. if the seller/obligor's actions had caused an absolute loss reasonably measured at $100 of after-tax values owned by the neighbor, and if the seller/obligor has no future value left to show for these appropriated values, this amount should be deductible to the seller. when this amount, plus 10% interest, is repaid to the neighbor a year later, an additional deduction of $10 should be allowed. under professor halperin's reasoning, so long as the loan is of after-tax values, the seller/obligor should be allowed an immediate deduction for the use of the "loan proceeds" (so long as the equivalent purchase would have been deductible), and for interest later paid.' anything less than this would, under professor halperin's own analysis, result in overtaxation. 30 the rules for taxing any delayed payment by the seller/obligor should ensure that the same economic burden is imposed 29. id. at 693-94. 30. again, the astute reader will discern that this overtaxation is the same overtaxation inherent in realization limitations on taking losses into account. the argument is essentially that surrogate taxation is not appropriate when the ultimate recipient has unrealized losses, or indeed, that surrogate realization of losses is no less appropriate in certain cases than surrogate realization of income. 19971 florida tax review on the seller in order to achieve the same net effect on the neighbor as if payment had been made at the time of the loss. if the seller/obligor had paid the neighbor immediately upon the destruction of the property, the neighbor would have received $100, totally offset by basis. if this amount were then invested at 10% with a 40% tax rate, the neighbor would have $106 at the end of the second year. but the neighbor's use of basis in the destroyed property will be delayed when she is only allowed to use it as an offset to the proceeds she receives in year two. the rules chosen for the seller/obligor's deduction should therefore in effect allow a surrogate for the delayed use of the neighbor's basis in the destroyed property. without a deduction in the first year, the seller can set aside only $60 of the $100 that it might have paid initially, which will earn $6 before tax, and the seller will enjoy a tax benefit of $40 in the second year. the seller will therefore be able to transfer $106 to the neighbor. but the deferred use of the neighbor's basis will shield only $100 of the payment, and she will be left with only $103.60. if the seller/obligor is allowed a deduction at the time of the destruction, it can set aside the full $100, and earn $10, which, when paid to the neighbor, will put the neighbor in the same position as if she had been paid (and allowed to use her basis) immediately. note that the same result can be reached by acknowledging the loss when it first occurs by giving the neighbor an immediate deduction for her loss, without regard for the possibility of payment, and deferring the seller/obligor's deduction. (this treatment is not generally allowed because of the possibility of reimbursement. 3 ) a deduction of $100 at the time of the destruction would have produced a tax benefit of $40, which would earn after-tax interest of $2.40 after a year has passed. again, without a deduction, the seller/obligor will only be able to pay $106 in the second year. but the receipt of $106 without basis offset in the second year would have produced a net after-tax receipt of $63.60, for a total after-tax position of $106. the above analysis simply demonstrates that at least some contingent liabilities may be the result of absolute losses to the tax base, not just transfers of values new to the tax base, for which no tax accounting has yet been made. these liabilities arise under circumstances best understood as a forced borrowing coupled with a destruction of the loan proceeds. when a liability arises from the destruction of after-tax values, the transaction could be given a tax treatment no more onerous than that accorded to bank loans. as professor halperin himself has argued, the fact that the liability is contingent, whether because the seller's liability is not clear as a matter of 31. see, e.g., regs. § 1.165-1(d)(2); halliburton co. v. commissioner, 946 f.2d 395 (5th cir. 1991). [vol. 3:10 accounting for the assunption of contingent liabilities law or because the extent of destruction cannot be ascertained, should not be determinative of its appropriate treatment. the determinative factor should be whether the overall transaction involves a deferral of the inclusion of a value in the overall tax base (as professor halperin's compensation entails) or a deferral of a deduction for a loss to the overall tax base (as in the case of the contamination of the neighbor's land.) in other situations, the loss may not be of values already taxed, and yet a sale may nevertheless be an appropriate time to take a loss into account. reconsider the case in which the seller/obligor had contaminated its own soil and not that of a neighbor. assume that there is no obligation to replace the wealth of another, but the seller/obligor has an obligation to clean up the soil in the future. the seller/obligor's business would clearly be worth less as a going business as a result of this future obligation. barring some special treatment, however, this loss would be deferred for tax purposes until payment on the obligation was made.32 would it nevertheless be appropriate to take this loss into account at the time the business is sold? is a sale supposed to make a difference with respect to the aggregate tax treatment of such unaccrued liabilities? existing law provides surprisingly little guidance with respect to this question, partly because the occasions in which unaccrued liabilities are in fact sold or otherwise subject to clear-cut realization events, outside of sales of businesses, are few. (the fanciful nature of the following should serve as an indication of how unlikely it is that the issue in question will be starkly raised, outside of the context of traditional debt instruments.) imagine that a was a roofing contractor, and after completing various jobs was obligated to provide for the repair of many of the roofs in her neighborhood. assume further that with each year that passes, it becomes more and more likely that a roof will in fact fail, and a claim on a will be made. b, also a roofing contractor, was similarly obligated with respect to all of the roofs in his neighborhood, 500 miles away. although both have booked all of the income associated with these jobs, neither uses an accounting method that allows any reserve for the future work that may be necessary. suppose further that they both decided to move, and swap repair obligations as well as neighborhoods. has there been a realization event with respect to these liabilities? there clearly has been a change in legal obligations: entirely different people now have claims against a and b. how does the possibility of such 32. for further consideration of the appropriate treatment of this sort of future liability to the seller, see halperin, disguise, supra note 6. at 528-31; donald w. kiefer, the tax treatment of a "reverse investment": an analysis of the time value of money and the appropriate tax treatment of future costs. 26 tax notes 925 (mar. 4. 1985): emil m. sunley, observations on the appropriate tax treatment of future costs. 22 tax notes 719 (feb. 20, 1984). 19971 florida tax review a swap triggering realization of gain or loss with respect to these liabilities mesh with traditional timing rules for taking into account liabilities? can such economic burdens be "realized" as the result of a sale before the traditional all events test has been met, or before the standard for economic performance under section 461(h) has been met?33 can they be viewed as "anti-assets," the existence of which should be acknowledged at the time of a sale?' the answer may well be that they should not. note, however, that if a and b had been entitled to payments from their former customers as each year passed in which their roof did not leak, arguably a swapping of such rights should be treated as a realization event with respect to an asset.35 the important point here is that professor halperin overlooks the possibility that the transfer of position that requires a future payment could appropriately be viewed as a realization event with respect to a position that is tantamount to an "anti-asset." perhaps such "anti-assets" could be acknowledged in those limited situations in which an unpaid loss to one taxpayer definitely will not give rise to an increase in wealth to another taxpayer. if such "anti-assets" were acknowledged, there is no reason not to allow the seller a deduction at the time of the sale. returning to the contamination of the land example, the only real point of dispute should be whether this loss should be measured by an abstract notion of the decline in the market value of the land (and thus 33. the application of § 461(h) in the hypothetical may be problematic: the taxpayer has performed, and been paid for, the original roof work, but must, if claims are made, provide or pay for additional services. the transfer of these additional services will have no tax effect on the recipients, who are treated as merely having received something for which they have already paid. (note that this fact distinguishes the hypothetical from the superficially similar mooney aircraft case, in which the warranty involved the payment of cash. mooney aircraft, inc. v. united states, 420 f.2d 400 (5th cir. 1970). most observers would conclude that the payment of a mooney bond would be an event that must be taken into account for tax purposes, since the recipients were to receive cash. it is much less clear whether there would be agreement regarding what that tax treatment should have been.) 34. this question is related to, but not the same as the question of whether gains or losses on previously accounted for liabilities should be taken into account. section 1274(c)(4) suggests that liabilities associated with single assets are not to be taken into account upon the sale of those assets. this rule will characterize the gains and losses, but will not otherwise mismeasure income. this treatment can result in mismeasurement of income when combined with other accounting anomalies. see, e.g., charlotte crane, the effect of market discount and premium on the measure of corporate gain on liquidation under section 336, 17 j. corp. tax'n 119 (1990). 35. if the position were an asset position, the amount taken into income as a result of the exchange would become basis, and, if later payments received exceeded this amount, the excess of payments over basis would be income. if the position were an anti-asset position, the excess amounts over the amount originally deducted should be deductible at future realization events. [vol 3:10 accounting for the assumption of contingent liabilities limited by the pre-contamination value of the land) or by the total economic burden that the future payments represent. (note that there is no reason to assume that these two amounts will be equivalent.) although rules allowing a deduction for the loss at the time of the contamination might appropriately take into account whether the seller/obligor had adequate basis in the land and in other assets that would bear the economic burden of cleanup, there should be no such problem at the time of the sale, when, presumably, all of the gains in properties held by the seller will be recognized. as of the time of the sale, any value against which the claims might be made can be assumed to be after-tax. note that in the contaminated land situation, there is no particular reason to look to the tax treatment of the ultimate recipient to determine the appropriate tax treatment of the overall transaction. this as yet unidentified taxpayer will not be compensated for values "lent" to the seller/obligor at the time of the contamination. she will, instead, be compensated for values that she creates and that are essentially new to the tax base as she performs the cleanup. there is no untaxed principal owed to her when the future payments can first be predicted, nor is there any untaxed interest in the interval between the contamination and the cleanup payments. these cleanup payments are very different from professor halperin's deferred compensation payment, the tax treatment of which must be deferred until the recipient takes the compensation into income. the seller/obligor is not denied a deduction for the future payments only because the taxpayer that will perform the cleanup has not taken the amount into income. the seller/obligor is denied the deduction for the cleanup payments primarily because the loss in value represented by the future obligation is too vague to be taken into account. since the only reason the seller was denied a deduction for such anticipated payments prior to a sale is because the liability simply was too amorphous to be "realized" prior to a sale, should a sale, the classic moment at which gains are to be "realized," also be a presumptively appropriate time for "realizing" losses?36 surely the problem cannot be that the loss cannot be quantified, since professor halperin himself relies on being able to quantify the loss at the time of the sale. professor halperin's deferred 36. the reader should not lose track of the fact that although the cash sales price will of course reflect the economic burden of the cleanup expense assumed by the buyer, this lowered cash amount will not guarantee a tax result equivalent to loss recognition, because ordinarily the liability for the future payment assumed will be included in the seller's amount realized. as professor halperin's analysis reveals, tax treatment equivalent to recognition of the seller's loss at the time of sale can be achieved in several ways. either by explicitly allowing the seller the loss, or by adjusting the buyer's accounting for payments on the liability. see halperin, assumption, supra note 1. 19971 florida tax review compensation case clearly does not represent such a loss; the employee presumably added value to the employer's enterprise and his compensation is in effect a sharing of that value. to allow a deduction for payment without including an amount in the employee's income would, in effect, keep that value out of the overall tax base during the period of deferral. there are two other types of contingent liability for which professor halperin's insistence on taxation of the seller/obligor to make up for the failure to tax the ultimate payee may not be appropriate. in these situations, there may be considerable doubt about whether the ultimate recipient should ever be taxed upon payment. the first type of contingent liability involves payment of amounts that, for various reasons, under ordinary circumstances are not included in the income tax base of the recipient. potential tort judgments frequently represent values that have already been destroyed, in the form of the physical integrity of individuals who have been injured but who have not yet made claims. these ultimate payees do not have basis in the ordinary sense in their physical integrity. but they do not have to include amounts in income when they are compensated for an impairment of this physical integrity by a third party who acted wrongfully. in such cases, surrogate taxation of the seller/obligor serves only to limit the exclusion that is otherwise allowed. although it is highly likely that this limitation is appropriate (since otherwise taxpayers can arrange for deferred payment in order to maximize this exclusion), there is no easy answer to the question whether, as a normative matter, the tax law treats the amounts lost by tort victims through "forced loans" to tort-feasors as beforeor aftertax values. the second additional type of contingent liability also involves doubt about the propriety of insisting upon including an amount in the recipient's income before a deduction can be allowed to a payor. many contingent liabilities may in effect be warranty payments, that is, payments made by the seller/obligor to remedy some shortcoming in the product transferred, unrelated to any measure of particular value transferred by or injury incurred by the ultimate recipient.37 generally, we do not tax recipients of such payments. either they are only being paid a return of capital, or they are enjoying what is in effect a bargain purchase, since the price that they paid may not have accurately reflected all of the seller's costs. this tax treatment may not always be correct, since there may be circumstances in which there 37. frequently such payments are made when there is a discontinuity between the value paid to the seller at some point in the past and the value that the seller has promised to provide in return. the seller may have in effect promised its customers that, in the aggregate, the value of the units it has transferred will approach the average price paid, but that some customers will have received units worth less, and will deserve some sort of rebate. when these ultimate recipients are paid, their receipts may be accounted for not as gains, but as receipts for an amount for which they have already paid. [vol 3:10 accounting for the assumption of contingent liabilities is an interest component or a component in the nature of liquidated damages for lost profits built into the terms of the warranty. but even if it is not technically correct to leave ultimate recipients totally untaxed, there seems to be no reason to insist on a tax treatment for warranty liabilities transferred in asset sales that assumes that warranty payments should be taxed to the recipients when, generally, that is not the case. vi. what is an assumed liability? professor halperin correctly points out that perhaps the thorniest issue with respect to the assumption of contingent liabilities is the identification of those payments that should be associated with assumed liabilities and those that should be merely regarded as part of the buyer's operating costs after the purchase. the answer, it seems to me, is both clear and unworkable. if total purchase price must equal total fair market value of assets, and if transactions that include assumed liabilities are to be accounted for in a way that is as close to a cash purchase as possible, all commitments to make future payments that reduced the amount of cash a buyer would be willing to pay must be counted as assumed liabilities. an assumed liability is therefore any position with a negative net present value, that is, any unavoidable future payment with a present value greater than the present value of the benefits to be enjoyed in the future associated with that payment. (this is simply a more rigorous version of the test proposed by professor halperin, that the distinction between an assumed liability and the buyer's own liability is "whether the potential liability relates to past or future income.' ' s) any such excess burden can be assumed to have been taken into account by the buyer, and produced a reduction in the cash price paid. any commitment to make a future payment can have this characteristic, regardless of its resemblance to a period or current cost. an unfavorable loan or rental agreement, indeed, an unfavorable wage rate, is an assumed liability in this sense. if a buyer could have paid $5,000 a month for very similar rental space, but must take over a lease for $7,000 a month for the first two years after the purchase of a business, that buyer will pay about $17,000 less for the assets transferred than he otherwise would have paid. with each rental payment, the buyer is effectively paying $5,000 of current rent, and $2,000 of the price for the assets purchased. the problem, of course, is in associating future payments with potential future benefits. for most payments, there simply is no way to trace payment directly to future benefit, even when the amount of the required future payment is fixed. the payments to be made to professor halperin's 38. halperin, assumption, supra note 1, at 690. 19971 florida tax review employee could be merely compensation for prior completed work, or they could be designed as an incentive for the employee, or as an incentive for other employees, or they, more probably, could be some combination of the three. in this respect, the identification of an assumed liability involves essentially the same calculation as the identification of the component of any expenditure that must be capitalized. the price a buyer is willing to pay for a business will depend not just on what price the individual assembled assets being purchased could command if sold separately, but what the costs of future operations will be. the apparent price of assembled assets will be reduced if the buyer anticipates greater future operations costs than other buyers might; the apparent price of assembled assets will be increased if the buyer anticipates lesser future operations costs than other buyers might. it seems grossly impractical, however, to try to account for all such discounts and premiums in ways other than they would have been accounted for had the business remained in the hands of the seller. it may make more sense, however, to try to identify as assumed liabilities those commitments to make future payment that are closely tied to a prior value transferred to the seller under terms that suggest that most of the value to be received by the owner of the assets has in fact been received before the sale of the assets. only if the value to be received after a sale is negligible should a commitment to make a future payment be considered an assumed liability. vii. reconsidering the alternatives for accounting for the assumption of contingent liabilities professor halperin uses as a starting point the proposition that the sale of assets in which liabilities are assumed should be taxed no differently than the sale of assets in which cash is the only consideration given. in a cash sale, all gain is recognized, and a buyer is allowed cost recovery for the purchase price. therefore, in order to replicate the treatment of a cash sale, an amount must be taken into income (or an amount paid with no accompanying deduction) with a present value equal to the expected value of the liability,39 and cost recovery must be allowed for this amount as of the time of the sale. (these items will be offsetting, except to the extent that cost recovery is delayed and therefore provides deductions with a present value as of the time of the sale lower than the nominally equivalent income inclusion.) therefore, in order to replicate the tax treatment of a cash sale, the 39. in a cash sale, this gain is generally thought of as the seller's gain. in the case of assumed liabilities that have not yet been taken into account by the seller, however, the seller's gain will be offset (absent character differences) by the allowance of a deduction for the amount of the liability. [vol. 3:10 accounting for the assamption of contingent liabilities expected value of a liability must be reasonably ascertainable. although, as explored more fully below, there may be many circumstances in which such a determination of the expected value is difficult, the alternatives which require such a determination are worth explicating if only to make clearer the nature of the errors introduced when such a determination is not made. a. professor halperin's preferred method under the analysis outlined by professor halperin, the assumption of contingent liabilities in connection with asset sales should be accounted for by allowing the buyer basis, as of the time of the purchase, to the extent of the expected value of the liabilities assumed. (this same amount would have been paid in cash by the buyer had the liabilities not been assumed, and must be included in the basis to be allocated to the assets purchased in order to assure that the appropriate cost recovery is allowed.) if the liability is resolved for an amount equal (in present value terms) to this expected value, then no further adjustments need to be made. if, however, the liability is resolved in a way that is unfavorable to the buyer, the buyer should be allowed an additional deduction. this deduction, however, should be allowed only to the extent that the resolution value exceeds the expected value, adjusted for the passage of time. on the other hand, if the resolution value is less than the expected value, adjusted for the passage of time, the buyer should recognize income as of the time that the contingencies are resolved. year 1 year 2 year 3 year 4 present value of cost recovery as of year i payment as cost recovery 33.33 44.45 14.81 7.4 94.6 expected: allowed 106 in year 2 payment cost recovery 33.33 44.45 14.81 7.4 94.6 more than allowed expected: 200 in year 2 loss allowed 94 88.6 200-106--94 183.2 payment cost recovery 33.33 44.45 14.81 7.4 94.6 less than allowed expected: 56 52.8 50 in year 2 gain recognized 41.8 50-106=56 halperin's preferred method: immediate basis inclusion with limited adjustment for resolution 19971 florida tax review this method works reasonably well when it is anticipated that there will be a definite time at which the contingency will be resolved. to the extent that there is no such time, and therefore possible resolution gains are not taken into account, the buyer will have been allowed cost recovery on a price that she has never paid. it also works effectively when there is a high level of confidence about the ability to identify the payments associated with assumed liabilities. if payments are not so identified, excess deductions may be claimed, as payments are misclassified as current costs as they are paid. to avoid this result, professor halperin suggests relaxing the standards for connecting payments with particular assumed contingent liabilities. a buyer would be allowed to deduct and add to basis any payment that would be associated with such assumed liabilities, but "on the dates projected for the expected payments [as of the time of the sale] the buyer could be required to forgo deductions equal to the anticipated payments, or to include an equivalent amount in income, regardless of whether actual events are consistent with the estimate. 4 ° b. first alternative method: accounting for price adjustments as amounts are paid the problem associated with cost recovery for costs never incurred could also be solved by postponing the allowance of cost recovery under professor halperin's preferred alternative method, that is, by deferring the allowance of cost recovery until payments are actually allowed on the liability. cost recovery would be allowed for the amounts actually paid, when paid, to the extent of the expected value of the liability adjusted for the passage of time.41 a new recovery period would begin with each payment on the contingent liability. to the extent that amounts are paid in excess of this expected value, adjusted for the passage of time, deductions would be allowed. 40. halperin, assumption, supra note 1, at 694. 41. id. at 697-700. [vol 3:10 accounting for the assumption of contingent liabilities year year year year year present 1 2 3 4 5 value as of year 0 payment as cost recovery 35.32 47.11 15.69 7.84 94.6 expected: allowed 106 in year 2 payment more cost recovery 35.32 47.11 15.69 7.84 94.6 than expected: allowed 200 in year 2 loss allowed 88.6 200-106=94 94 183.2 payment less cost recovery 35.32 47.11 15.69 7.84 94.6 than expected: allowed (on 50 in year 2 amount actually paid, and amount taken into income) gain recognized 56 52.8 50-106=56 41.8 halperin's preferred alternative method: deferred basis inclusion with adjustment for resolution evaluating the results of this method in the event that the liability is resolved in the buyer's favor is more problematic. if the liability is resolved in the buyer's favor, the buyer has in effect enjoyed a bargain purchase. it is unclear whether, in terms of realization, this bargain element should be taken into account by the buyer. in order to replicate the results of a cash sale, however, this bargain element must be taken into account. if the bargain element is taken into account, cost recovery on this amount should be allowed, a complicating detail which professor halperin overlooks. in sum, the alternative preferred method cannot mimic the tax results of a cash sale unless, when the contingency is resolved in the buyer's favor, two abstract adjustments are made, one including the favorable resolution in income, and the other allowing cost recovery on this newly included amount.4 42. the current treatment allowed in the case of sales to which § 338 (outlined in temp. regs. § 1.338(b)-3) applies, resembles this treatment; but because (1) it does not clearly allow for an increment above the original price resulting from the passage of time, and (2) it does not allow a deduction for resolutions more burdensome than anticipated, or for gain for resolutions less burdensome, it will produce results equivalent to a cash sale only when the burden of the liability is correctly predicted. 19971 florida tax review c. professor halperin's second alternative method both the preferred method and the first alternative approach require relatively complex adjustments throughout the period during which the contingent liability remains outstanding. the preferred method requires adjustments only at the time the contingency is resolved. this method will produce no error in the total definition of the tax base when the contingency is resolved against the buyer, for the buyer will be allowed a deduction that (assuming appropriate discount rates are used) reflects the economic burden the liability ultimately borne. it will, however, produce a relatively large error when the contingency is resolved in favor of the buyer, since the buyer has been given basis credit for an amount that has not and may never be paid. only if some arbitrary resolution mechanism is introduced will this basis credit ever be undone. the first alternative method requires the use of abstract cost recovery, based on the actual characteristics of the assets purchased in the sale, but with allowances unrelated to the presence of these assets as of the time cost recovery begins. if the basis for which this abstract cost recovery is allowed would have been allowed other than through cost recovery allowances (for instance, because the assets have been resold) additional abstract adjustments would be necessary. these complex adjustments could be avoided by using a second alternative method.43 this method would in effect assume in advance that the contingency is resolved without the buyer making any payment at all, but nevertheless allow the buyer cost recovery for the fair market value of the assets acquired. under this method, the buyer takes into income the expected value of the assumed liability at the time of the acquisition and is allowed a deduction for all amounts subsequently paid. 43. this method is suggested by professor halperin as a variant of his preferred method. halperin, assumption, supra note 1, at 696-97. [vol 3:10 accountiig for the assumption of contingent liabilities year 1 year 2 year 3 year 4 present value as of year 0 payment as cost recovery 33.33 44.45 14.81 7.4 94.6 expected: allowed 106 in year 2 upfront income 100 ijo inclusion deduction for 106 100 payment 94.6 payment more cost recovery 33.33 44.45 14.81 7.4 94.6 than expected: allowed 200 in year 2 upfront income 100 100 inclusion deduction for 200 188.6 payment 183.2 14.8133.33cost recovery allowed upfront income inclusion deduction second alternative method: buyer's income inclusion and deduction of ll other amounts this second alternative method has several distinct advantages: first, it comports with a recharacterization of the liability assumption in which the seller pays the buyer cash for the liability assumption (giving the seller sale treatment and the buyer income) and then the buyer uses this cash to purchase assets from the seller (giving the seller an amount realized and the buyer basis in the assets so acquired). because this method merely reflects a recharacterization of the sale transaction, it could be adopted without enabling legislation. finally, as professor halperin acknowledges, this method minimizes the distortion involved in choosing discount rates. viii. what if the expected value cannot be accurately determined? although assumed liabilities may be identifiable, the fact that they are identifiable does not mean that they are quantifiable. for instance, a seasoned buyer of smaller mining operations may be able to predict, in the aggregate, the upside and downside risks of its purchases. a certain number of properties will have more remaining reserves than predicted; a certain number payment less than expected: 50 in year 2 44.45 47.1 41.7 19971 florida tax review will have less. similarly, a certain number will have more environmental problems than predicted, but others will have less. the agreement between a buyer and a seller regarding the sum of these possibilities does not indicate that they would have agreed to anything about the burdens or benefits associated with any particular risk involved in the purchase. indeed, the buyer may be taking into account the overall risks involved in a series of purchases separately negotiated with a series of sellers. assuming the buyer assigns a particular value to a particular risk in one of a series of asset purchases may be entirely unrealistic. the buyer may instead, simply by reviewing the way in which each business has been conducted in the past and using his overall knowledge of the industry, make aggregate assumptions about the liabilities he will find that he has assumed. two approaches to accounting for contingent liabilities are available if one assumes that the expected value of these liabilities cannot be ascertained either as of the time of sale or in retrospect. the first would require capitalization of all amounts paid with respect to assumed contingent liabilities as if all amounts paid were in effect part of the purchase price for assets.44 this approach clearly imposes a greater tax burden than would be required had cash been paid. but with the introduction of section 197 and the general availability of fifteen year amortization for all intangibles, the burden of this extra tax has been substantially reduced.45 the other alternative would allow current deductions for all payments made with respect to assumed current liabilities.4 6 as professor halperin's 44. current law seems clearly to require this result, although it is ambiguous whether the capitalization should be as of the time of payment using a new recovery period, or as of the time of the sale, with or without an adjustment for the passage of time. case law has simply required the capitalization of all amounts paid. see, e.g., david r. webb co. v. commissioner, 77 t.c. 1134 (1981), aff'd 708 f.2d 1254 (7th cir. 1983); pacific transport co. v. commissioner, 483 f.2d 209 (9th cir. 1973), rev'g per curiam, 29 t.c. memo. (cch) 133, 39 t.c. memo. (p-h) 70,040 (1970), cert. denied, 415 u.s. 948 (1974) and reh'g denied, 416 u.s. 952 (1974). the regulations under § 338 provide a variant on this approach, apparently allowing basis when the liability is fixed (rather than when paid). thus, current authority suggests directly tying all payments to assets acquired, an approach that clearly will overstate the value of assets acquired when contingencies are resolved unfavorably to the buyer. 45. assuming a 6% after-tax interest rate, a payment technically entitled to an immediate deduction is reduced by 15-year amortization to a series of future deductions worth about 64% of the value of an immediate deduction. without amortization under § 197, the denial of an immediate deduction would have produced basis only available on a later taxable sale of assets. 46. this treatment has been proposed, among other places, by the new york state bar association tax section. richard l. reinhold, report on the federal income tax treatment of contingent liabilities in taxable asset acquisition transactions, 49 tax notes 883 (nov. 19, 1990). [vol. 3:10 accounting for the assuinption of contingent liabilities analysis reveals, this treatment would produce the same result as allowing a deduction at the time of the sale for the expected value of the liability. (it would also provide an automatic adjustment for the resolution value, to the extent that the amount actually deducted varied from this expected value.) to the extent that the contingent liability related to arrangements, like deferred compensation, that involve values that will be omitted from the tax base unless surrogate taxation is used, the overall transaction will be undertaxed under this alternative. the benefit to the taxpayer of accelerating the deduction as an offset to income for the amount paid on the liability would depend upon the cost recovery that would have been allowed on the assets acquired had the expected value been known and properly accounted for.47 to the extent, however, that the contingent liability relates to arrangements in which surrogate taxation is not appropriate, the degree of undertaxation will be less. (there may be a lesser tax burden as a result of the sale of the assets than there would have been without the sale, as will generally be the case when losses recognized on assets as a result of the sale are greater than gains so recognized.) from a practical standpoint a comparison of the alternatives for accounting for assumed contingent liabilities must take into account the effects of the likely errors involved in the implementation of these alternatives. under all methods, there will be an advantage to understating, if not ignoring completely, the expected value of the contingent liability, at least if one assumes that payments that are not treated as payments on the expected value of the liability are entitled to current deduction. this advantage will always be the difference between the value of current deduction for the expected value of the liability, and the value of the cost recovery that would have been available had the expected value of the liability been assigned a proper cost recovery. indeed, the understatement of a contingent liability and the ignoring of the fact of the liability assumption involve exactly the same potential error: avoiding the drag on deductions involved in proper capitalization and cost recovery. ix. should the accounting for a cash purchase be the only norm for evaluating possible accounting treatments? professor halperin's analysis began with the proposition that all transactions in which liabilities are assumed should receive the same tax 47. a current deduction with a present value of i has been allowed instead of cost recovery with a present value of .64 if the acquired assets were primarily intangibles for which 15-year amortization is available under § 197; about .44 if the acquired assets were primarily commercial real estate; of undeterminable value if the assets were primarily unimproved real estate for which cost recovery would be allowed only upon sale. 1997] florida tax review treatment as transactions in which only cash is given as consideration. this starting point assumes that it is possible to identify a cash price that represents the fair market value of the assets in question, without regard for the tax treatment anticipated in connection with the future use of the assets. this may be an ill-conceived notion. the price of virtually any asset will reflect the tax treatment of the ongoing business anticipated by the buyer. although it may be possible to assign to any individual asset a cash price and a technically correct tax accounting treatment of that cost, it seems unlikely that this will be possible (and certainly not worthwhile) for sales of business assets. each such sale will have associated with it commitments to make future payments-at both favorable and unfavorable prices. each such commitment will produce a deviation from the cash price for the individual assets, and will increase the likelihood that no technically correct tax accounting will be possible. to the extent that the most likely tax accounting will be favorable to the buyer, the buyer may be willing to pay more than otherwise; to the extent that the most likely tax accounting will be unfavorable, the buyer will be willing to pay less than otherwise. reproducing the tax treatment of all cash sales therefore may not be the only criterion for evaluating the accounting treatment afforded assumed contingent liabilities. indeed, to the extent that establishing the technically correct treatment in every case is futile, the possible accounting treatments should be evaluated primarily according to whether the consequences of getting the accounting wrong are tolerable. at least two factors determine whether tax accounting errors will be tolerable. the first is the degree to which taxpayers can take advantage of these errors, and the second is the range of disparity in the ability of taxpayers to take advantage of these errors. if a taxpayer truly has no control over its ability to take advantage of a tax accounting error, then (although the error may create a windfall) the consequences of the error are likely to be tolerable. similarly, virtually any tax accounting error would be tolerable if every taxpayer could be assumed to be equally able to take advantage of (or to be burdened by) the accounting error, so long as a limit exists that prevents arbitraging to such an extent that no tax base remained. most tax accounting errors, however, fall somewhere in the middle. some taxpayers are better able to take advantage of favorable tax accounting errors than others, but not to so great an extent that the benefit of the error is entirely capitalized in the asset involved. some taxpayers are disadvantaged to a sufficient degree that the activities in which they are involved bear a heavier tax, and perhaps attract less capital than they otherwise would. choosing among technically imperfect tax accounting rules requires predicting which effects are most likely, and which of these effects are most tolerable. in choosing the tax treatment of assumed contingent liabilities, predictions need to be made about the taxpayers most likely to be affected. [vol. 3:10 accounting for the assumption of contingent liabilities under all of the technically correct methods, taxpayers can obtain real tax advantages by characterizing portions of the purchase price as contingent liabilities, and then underestimating the expected value of that liability.48 given this reality, it may be more appropriate to simply adopt an accounting treatment that is less favorable than cash to avoid the possibility for abuse of a more favorable method. on the other hand, some industries may be able to avoid assumptions of contingent liabilities in connection with asset transfers because insurance is more readily available for the risks inherent in that industry. 9 if so, there may be identifiable classes of taxpayers that are put at a disadvantage because they may be unable to avoid the consequences of assumed contingent liabilities and the onerous accounting methods that they require. nevertheless, we might be willing to tolerate the error if the effects are felt uniformly throughout an industry and there is little possibility that asset transfers within that industry will be burdened more than asset transfers in other industries. if a particular industry is intolerably affected, and especially if a substantial portion of the liabilities faced by the industry reflect destroyed values rather than merely transferred values, then selective use of more favorable accounting treatments may be appropriate. x. conclusion professor halperin's analysis of the appropriate tax accounting for contingent liabilities is correct to the extent that all contingent liabilities represent obligations to pay for values that have not yet been included in the tax base. his conclusions are based on the assumption that all contingent liabilities should be treated similarly for the purposes of tax accounting, and that none should be given as favorable tax accounting treatment as fixed liabilities. it is possible, however, that at least some contingent liabilities are in effect borrowings of after-tax values, and thus have more in common with traditional bank borrowings than with deferred compensation. thus, to the extent that contingent liabilities represent either (1) obligations to repay for values that were previously included in the tax base but for which an income offset has been deferred or (2) obligations to repay 48. an advantage could also be gained from underestimating the discount rate used to compare actual payments with the estimate of expected value. with such an underestimate, fewer favorable resolutions would be identified as such and more resolutions would be assumed to be unfavorable. 49. if insurance is available, the overall taxation of the asset transfer will be less than that urged by professor halperin if, and to the extent that, tax accounting for insurance effectively allows an immediate deduction for a reserve against the liability. 1997] 646 florida tax review [vol. 3:10 for values that are not ordinarily included in the tax base, professor halperin's proposed treatment may lead to overtaxation. (the degree of overtaxation involved will depend upon clarification of the as-yet undeveloped norm for realization of gains and losses with respect to liabilities transferred in connection with sales of assets.) although it may be possible for some taxpayers to establish that the liabilities related to their businesses warrant more favorable tax treatment than that proposed by professor halperin, this possibility alone is not enough to warrant more favorable treatment across the board than that advocated by professor halperin. indeed, good arguments can be made that the appropriate treatment of assumed contingent liabilities should be more, rather than less, onerous than the most technically correct method, especially if all taxpayers are equally able to arrange the terms of the sale of assets in such a manner so as to avoid this more onerous treatment. florida tax review volume 18 2015 number 1 i article toward income tax accounting consistency: eliminating accrual, depreciation, and the existing tax treatment of borrowing joseph m. dodge 1 florida tax review volume 18 2015 number 1 ii the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117634, gainesville, florida 32611-7627. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352)273-0904 or email ftr@law.ufl.edu. copyright © 2015 by the university of florida florida tax review volume 18 2015 number 1 iii editor-in-chief martin j. mcmahon, jr. james j. freeland eminent scholar in taxation university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar in taxation dennis a. calfee professor of law michael k. friel professor of law david m. hudson professor of law emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar in taxation charlene luke professor of law grayson mccouch professor of law adam smith visiting assistant professor samuel c. ullman adjunct professor of law board of advisors hugh j. ault boston college bradley t. borden brooklyn law school j. martin burke university of montana charlotte crane northwestern university jasper l. cummings, jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina kerry a. ryan st. louis university graduate editors alisa french paul hankin john hodnette laura michael hughes m. blair james young hei jo michael schwartz mark westenberger executive assistant keyosha r. monroe florida tax review volume 18 2015 number 1 iv information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: “articles,” “commentaries,” and “book reviews.” the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manual. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 18 2015 number 1 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 2 1995 number 8 interpreting tax legislation: the role of purpose deborah a. geier* i. introduction ................................ 493 ii. what is statutory purpose? . . . . . . . . . . . . . . . . . . . . 494 a. structure as purpose ....................... 497 b. nontax code provisions ..................... 502 c. purpose as legislative history ................ 503 d. lack of purpose .......................... 505 e. evolving purpose ......................... 507 11. the role of purpose and institutional values .... 507 a. the relationship of congress, the courts, and the treasury department .................... 507 b. the importance of rhetoric .................. 513 * associate professor of law, cleveland-marshall college of law, cleveland state university; visiting associate professor of law, university of florida college of law, spring 1995. a.b., 1983, baldwin-wallace college; j.d., 1986, case western reserve law school. this paper was delivered in abbreviated form at the january 1995 meeting of the american association of law schools, tax section. i want to thank professor daniel halperin for asking me to participate and my panel colleagues for their insightful comments: professor bill popkin, tax court judge jim halpern, and les samuels, assistant treasury secretary for tax policy. i also thank larry lokken for his substantial comments on a draft of the manuscript. it has been my great luck that my visit with the university of florida college of law has coincided with a visit by robert s. summers, mcroberts research professor of law at cornell university. i have had illuminating talks with bob summers regarding statutory interpretation and am indebted to him for them. because my mentor in law school (erik m. jensen of case western reserve law school) was a protege of bob's, bob and his wife dorothy have referred to me as his "intellectual grandchild," a status i am honored to have. copyright © 1995 by deborah a. geier interpreting tax legislation: the role of purpose i. introduction "sex illegal in missouri? perhaps." (i knew that would get your attention.) that was the headline of an article in the cleveland plain dealer in november 1994.' the article described a missouri statute enacted the preceding august that, if read literally, outlaws all sex in missouri. one of the legislators is quoted in the article as saying that "[njo one is going to be prosecuted for having normal sex,"2 a statement i don't dare touch. the connection that this newspaper article has with the topic i discuss here is that tax law has a rich history of nonliteral interpretation in order to avoid results that one person or another has considered to be inconsistent with the purpose of the statute as a whole. this tradition is illustrated by the common law doctrines variously named substance over form, sham transaction, step transaction, business purpose, and assignment of income. in other instances, however, we have an extremely form-conscious approach, such as the approach to bootstrap acquisitions in the zenz v. quinlivan3 context. how do we make sense of it all? interest in statutory interpretation has been renewed over the last decade, probably prompted-at least in part-by the confluence of two events that have nothing to do with tax law: the elevation to the supreme court of antonin scalia (whose literal textualist approach to statutory language is now embedded in the court's opinions) and the attention paid to literature theorists, the so-called deconstructionists, who seized upon the notion that language is indeterminate. all of a sudden language and its interpretation were once again center stage after a long hiatus during which the theory behind the language dominated academic discourse. although a voluminous literature on approaches to statutory interpretation has been published during the last ten years,4 the authors of these 1. joe lambe, sex illegal in missouri? perhaps. cleve. plain dealer. nov. 25, 1994, at 26a. 2. id. 3. 213 f.2d 914 (6th cir. 1954). the tax treatment of a bootstrap acquisition, in which money from the corporation being acquired partially finances the acquisition, depends on the transaction form chosen by the parties. assume that seller, an individual, owns all the shares of x corp.; buyer wishes to acquire x corp. but has only 50% of the purchase price. if seller causes x corp. to distribute 50% of its fair market value as a dividend and then sells the shares to buyer, seller has ordinary dividend income on the distribution to the extent of earnings and profits and capital gain or loss on the stock sale. on the other hand, if seller causes x corp. to redeem one half of his shares and sells the remaining one half to buyer, the redemption distribution is treated as a disposition of the stock, entitling seller to recovery of basis and capital gain. 4. for a fairly lengthy listing of such articles, see deborah a. geier, commentary: textualism and tax cases, 66 temp. l. rev. 445, 448 n.8 & 456 n.42 (1993). 19951 florida tax review pieces, with the notable exception of bill popkin and a few others, did not come from the realm of tax.5 i think that is unfortunate because tax lawyers have never stopped dealing with and teaching and thinking about statutory interpretation. i believe tax law is a particularly fruitful field in which to examine these issues for several reasons: its sheer volume and length, its complexity, its use for nontax policy purposes, and perhaps most of all, its internal structure, which is not explicit in the statutory language but is implicit in a tax on income with a realization requirement, a characterization regime, and other structural components. i can say with assurance that nothing you shall read here will be startling or new to you, but sometimes sewing together the familiar bits and pieces of fabric into a larger quilt can help the viewer see the bits and pieces in a new light as part of a larger, more cohesive whole. i want in a short space to provide a broad road map of my views regarding how one should approach the task of interpreting the code and how purpose informs this task. the article starts with a brief exploration of the uncertainties surrounding the essential terms of the debate. within the context of these uncertainties, it then explores several roles that purpose plays in different statutory situations. it concludes with some thoughts about the institutional issues at stake in the debate and a caution about reliance in statutory interpretation on what professor robert summers calls a statute's "ultimate purpose." ii. what is statutory purpose? what do we mean by statutory purpose and how is that purpose identified? some reduce the issue to a tension between approaching a statute's terms literally on the one hand and, on the other, deviating from a textualist approach in order to effectuate the statute's underlying purpose in the view of a particular interpreter's notions of what that purpose is. one reason for this stark dichotomy is the ascendancy within the realm of political economy of public choice theory, which denies that any single purpose, or 5. pieces on statutory interpretation written by tax scholars include paul l. caron, tax myopia, or mamas don't let your babies grow up to be tax lawyers, 13 va. tax rev. 517, 531-54 (1994); michael livingston, congress, the courts, and the code: legislative history and the interpretation of tax statutes, 69 tex. l. rev. 819 (1991); william d. popkin, law-making responsibility and statutory interpretation, 68 ind. l.j. 865 (1993); william d. popkin, an "internal" critique of justice scalia's theory of statutory interpretation, 76 minn. l. rev. 1133 (1992); william d. popkin, judicial use of presidential legislative history: a critique, 66 ind. l.j. 699 (1991); william d. popkin, the collaborative model of statutory interpretation. 61 s. cal. l. rev. 543 (1988) [hereinafter collaborative model]; lawrence zelenak, thinking about nonliteral interpretations of the internal revenue code, 64 n.c. l. rev. 623 (1986). [vol. 2:8 interpreting tax legislation: the role of purpose any combination of public-spirited purposes, prompts particular legislation.' it is a cynical theory that examines the adoption of legislation from the economic point of view of gains and losses won by politicians for proposing, supporting, or opposing legislation. when the debate is stated in these terms, literal textualists such as justice scalia say that "the ordinary meaning of [the statutory] language accurately expresses the legislative purpose."7 because the statute's words embody political compromises, bought and paid for, they ought to be strictly construed in order to give effect to those compromises. others, not so cynical, continue to look to other tools to glean a purpose by which to interpret the language. overarching these discussions, as thus defined, are issues surrounding the origin (and validity) of law, concerns that cannot be ignored. law, according to textualists such as justice scalia, can be only the literal language adopted by congress and signed by the president; consultation of other tools is illegitimate judicial lawmaking. i'll return to this notion in due course.' in the tax world, most see the tension between textualism and purposivism as arising when a taxpayer wants a textualist approach and the irs wants to deviate from the textual, form-conscious approach in favor of a purposive approach. this perception is exemplified by the hoary substanceover-form doctrine (with its variants, the step transaction and business purpose doctrines), under which the irs challenges the taxation of a transaction according to its form in favor of taxation according to the transaction's underlying substance. 6. see generally william n. eskridge, jr.. politics without romance: implications of public choice theory for statutory interpretation, 74 va. l. rev. 275 (1988); edward l. rubin, beyond public choice: comprehensive rationality in the writing and reading of statutes, 66 n.y.u. l. rev. 1 (1991). 7. cipollone v. liggett group, inc., 112 s. ct. 2608, 2633 (1992) (scalia. j., concurring in the judgment in part and dissenting in part) (quoting morales v. trans world airlines, inc., 112 s. ct. 2031, 2036 (1992) (emphasis omitted)l. 8. the influence of justice scalia's particular brand of literal textualism seems to be waning; witness his dissent, joined only by justice thomas, in united states v. x-citement video, 115 s. ct. 464, 473 (1994) (scalia, j., dissenting). it has long been accepted in the common law that the absence of a scienter requirement in the criminal law should not be lightly imputed and that a statute should be interpreted, where possible. to avoid constitutional issues regarding its validity. justice scalia downplayed these doctrines in x-citeient video, refusing to interpret a statute that prohibited "knowingly" transporting, shipping, receiving, distributing, or reproducing a visual depiction involving "'the use of a minor engaging in sexually explicit conduct" as requiring a showing that the defendant knew the performer was a minor. his view was roundly rejected by the majority. the less drastic plain-meaning approach to statutory interpretation that predates scalia is still with us, however. see infra notes 16-21 and accompanying text (discussing justice brennan's plain-meaning approach in duberstein). there is yet much else to pursue here. 19951 florida tax review a more recent and controversial example of this common take on the debate is the acrimony surrounding the recent issuance of the partnership antiabuse regulation.9 in its final form, the regulation provides in part that "even though the transaction may fall within the literal words of a particular statutory or regulatory provision," a partnership can be disregarded if it "is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter k."' another part of the regulation provides that "[t]he commissioner can treat a partnership as an aggregate of its partners in whole or in part as appropriate to carry out the purpose of any provision of the internal revenue code or the regulations promulgated thereunder."" i return to this regulation later. i believe, however, that characterizing the debate merely as a tension between a (presumably pro-taxpayer) textualist approach and a (presumably pro-irs) purposive approach is a simplistic reduction of the nuances that flavor the role of purpose in tax interpretation. it would seem that literal interpretations conflicting with statutory purpose would benefit the government, on average, about as often as they benefit taxpayers. beyond that, purpose is, in my opinion, a vague umbrella term for several distinct notions that we need to tease out if we are to think more precisely about the appropriate role of what we call purpose in interpreting the tax code. i seek to do that here using cases that most tax lawyers are familiar with to illustrate my points. (for the benefit of nontax lawyers among the readers, i describe the cases in some detail.) i provide examples that i think demonstrate most persuasively that, at least in tax and i think in all statutes, there is no one-size-fits-all approach to all statutory language in every case. a true respect for purpose may in fact require a textualist approach in some cases, a notion foreign to most debates on the topic, which presume that a textualist approach is antithetical to a purposive approach. a true respect for purpose may demand a nonliteral approach in other cases. a broad understanding of purpose should inform a third class of cases that don't involve a choice between a literal or nonliteral reading of particular words. this third class of cases, where language can be informed by purpose to reach results not inconsistent with the statutory text, is often ignored in the literature, which focuses most heavily on instances where language must either be construed literally or abandoned. a fourth class of cases deals with, in essence, the absence of statutory language-cases 9. see infra note 60 and accompanying text (citing sources discussing the controversy). 10. regs. § 1.701-2(b). 11. regs. § 1.701-2(e)(1). [vol 2:8 interpreting tax legislation: the role of purpose in which there is no dispute regarding the language of the code and in which the transaction at issue literally fits within the language, but the transaction may yet not fit within the purpose of the provision. these cases often implicate common law rules in tax, such as the substance-over-form doctrine. finally, considering instances of either an evolving purpose or an apparent absence of purpose provides us with a fuller understanding of the role of purpose in interpreting legislation in general and tax legislation in particular. a. structure as purpose first-and very fundamental-point: one component of statutory purpose in the income tax is the fundamental structure underlying the income tax. by "structure," i mean the theoretical construct that overarches the sum total of the entire internal revenue code and is intended to be captured by it. it includes such ideas as the same dollars should not be taxed to the same person more than once or deducted by the same person more than once. it includes the notion that what we are trying to reach under an income tax is, essentially, consumption and net increases in wealth. it also encompasses such constraints as the distinction between ordinary income and capital gain and the realization requirement. this component of purpose is perhaps unique to the income tax, as i sought to demonstrate in an earlier article.,2 pure social policy legislation (including those components of the income tax that are not fundamental to structure, discussed below in part b) may be more legitimately subject to the critique of the public choice theorists. but the fundamental structure of the income tax (though it surely is premised on prior social choices regarding the best way to finance government) is a larger constraint, a larger purpose, that must inform interpretation of those provisions that implicate it. code provisions ought to be construed so as not to damage this fundamental structure, even if doing so requires that a statutory term be construed in a nonliteral (nontextual) fashion. recall helvering v. owens, 3 where the taxpayer's personal-use automobile was damaged in a fenderbender, reducing its value from $225 to $190. the irs sought to limit the taxpayer's deduction for the casualty to the $35 loss in value attributable to the casualty. the taxpayer pointed to what is now section 165(b), which provides that the amount of the loss deduction is calculated using "the adjusted basis provided in section 1011 for determining the loss from the sale or other disposition of property," and argued that a literal reading of that 12. geier, supra note 4. 13. 305 u.s. 468 (1939). 19951 florida tax review provision permitted deduction of his original cost basis of $1,825, less the $190 value of the car after the collision. the supreme court agreed with the irs, a result now found in the regulations. 4 that result is correct if it is permissible to look to the fundamental structure of the code in determining the outcome. the diminution of the car's value before the collision was nondeductible personal consumption that could not be deducted without fundamental damage to the structure of the income tax. one way to read owens is that the court, in effect, though not expressly, held that the adjusted basis of the car had to be reduced by the nondeductible personal-consumption loss for purposes of computing the deduction for a personal casualty loss, even though such a reduction to basis is not listed in section 1016 and thus not reflected in the section 1011 basis referenced in section 165(b).'5 commissioner v. duberstein 6 is an example of a situation in which structure, and thus purpose, was ignored in favor of a plain-meaning approach to statutory language, even though the court would not have had to ignore a statutory directive, as it did in owens, to protect the statutory structure. duberstein is an example of that class of cases rarely discussed in the literature in which a sensitivity to purpose (in the sense of structure) could have allowed the court to reach an informed result that would not have been inconsistent with the statutory language-a result that even a textualist could love. duberstein involved a cadillac that berman, a businessman, had given duberstein, a fellow businessman who had steered some business his way. at first duberstein refused the car, but eventually he accepted it. 14. regs. § 1.165-7(b)(1). 15. the basis of personal-use property is not expressly reduced to reflect personal consumption. when such property is sold for less than original cost, the failure to reduce basis for personal-consumption losses does no damage since the artificial loss cannot be deducted. on a sale of a consumer asset that has retained its value or appreciated (e.g., a personal residence or jewelry), the gain is understated because of the failure to reduce basis to reflect personal consumption. see generally richard a. epstein, the consumption and loss of personal property under the internal revenue code, 23 stan. l. rev. 454 (1971) (noting that the basis of personal-use property should, theoretically, be reduced by personal-consumption loss in value). there is another way to read owens. section 165(c)(3) allows a loss on personal-use property to be deducted only if it "arise[s]" from casualty or theft. if § 165(b) and (c)(3) are read as an integrated structure, the only plausible reading of the section as a whole is that the deduction equals the lesser of adjusted basis or the loss resulting from the casualty. in contrast, if business or investment property is totally destroyed by casualty, the deduction should equal the adjusted basis, even if the adjusted basis is higher than the value lost in the casualty, because the decline in value before the casualty would eventually have been deductible absent the casualty, either through depreciation or on a sale or exchange. and regs. § 1.1657(b)(1)(ii) so provides. 16. 363 u.s. 278 (1960). [vol. 2:8 interpreting tax legislation: the role of purpose berman deducted the cost of the cadillac as a business expense, and duberstein argued that he could exclude the car as a gift under section 102(a), which provides that "gross income does not include the value of property acquired by gift, bequest, devise, or inheritance." the service asked the court to rule as a matter of law that transfers in a business context could never be excludable gifts. justice brennan, writing for the court, declined, adopting instead the test tax professors all know and love, which looks to the plain meaning of the term "gift" by examining whether the donor made the transfer out of generosity. the court held that whether a transfer is a gift within the meaning of section 102(a) is a question of fact to be determined upon application of the fact-finder's "experience with the mainsprings of human conduct to the totality of the facts of each case."' 7 "what controls is the intention with which payment, however voluntary, has been made."'" a gift proceeds from a "'detached and disinterested generosity' ... 'out of affection, respect, admiration, charity or like impulses, ,,.. rather than from "'the constraining force of any moral or legal duty' .. or from 'the incentive of anticipated benefit.' ,,0 if the court had chosen to do so, it could have easily crafted an opinion adopting the irs's position. a textualist interpreter could have reasoned that the lumping together of "gift, bequest, devise, or inheritance" in section 102(a) implies that the exclusion should be limited to transfers in personal contexts-that the purpose of the statute is to limit the exclusion to transfers in the personal sphere. this interpretation could have been buttressed by appealing to a different sort of purpose premised on structure: a business gift, which is deducted as a business expense, should not be excludable by the recipient because the deduction-exclusion combination would allow business profits to escape even a single layer of taxation. a one-tax-cycleper-gift rule is implicit in the structure of gift treatment under the code because personal gifts, which are not deductible by the donor, must come from after-tax income.2' i return to duberstein and the ramifications of the court's interpretive choice in part mh. 17. id. at 289. 18. id. at 286 (quoting bogardus v. commissioner, 302 u.s. 34, 43 (1937) (dissenting opinion)). 19. id. at 285 (quoting commissioner v. lobuc, 351 u.s. 243, 246 (1956) and robertson v. united states, 343 u.s. 711, 714 (1952)). 20. id. (quoting bogardus v. commissioner. 302 u.s. 34. 41 (1937)). 21. irc § 262(a). while gifts can be deducted if made to a charity, the § 170 deduction, one can argue, is premised on nontax grounds and is therefore outside the fundamental structure of an income tax. but see william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309, 314-15 (1972) (arguing that charitable contributions should not be considered personal consumption). 19951 florida tax review a more controversial example of a court ignoring fundamental structure is the tax court's first decision in brown group,22 withdrawn in september 1994. under subpart f, 3 an anti-tax haven regime, certain kinds of income of a controlled foreign corporation (cfc) are taxed to u.s. shareholders of the cfc, even if no dividends are distributed. in brown group, the court held that income earned by a foreign partnership controlled by a cfc was not subpart f income of the partnership (and thus could not be subpart f income of the cfc), even though the cfc's distributive share of the partnership's income would clearly have been subpart f income if earned directly by the cfc. the court refused to characterize the partnership's income at the partner (cfc) level. the cfc's distributive share of partnership income was thus not currently included in the income of the cfc's u.s. shareholder. david shakow criticized the decision as contrary to the structural constraints of the partnership rules (subchapter k),24 and michael mcintyre criticized it as contrary to the structural constraints of subpart f.25 the brouhaha caused the tax court to withdraw its decision, and its revised opinion came down the other way: the interposition of the partnership between the subpart f income and the cfc was ignored, with the result that the cfc was treated as receiving the subpart f income directly.26 most common law doctrines in tax can be described and justified under the structure rationale. for example, by providing higher marginal rates for persons with greater income, congress implied that it should not be possible to shift income artificially from higher-income to lower-income individuals or entities. this structural attribute spawned the assignment of income doctrine.27 by providing one set of rules for dividends and another for corporate reorganizations, congress implied in the statutory structure that there is a substantive difference between these two types of transactions and 22. brown group, inc. v. commissioner, 102 t.c. 616 (1994) (withdrawn, reconsideration granted). 23. irc §§ 951-964. 24. david j. shakow, how now brown k, 63 tax notes 1761 (june 27, 1994). 25. michael mcintyre, tax court's brown group decision threatens subpart f, 65 tax notes 371 (oct. 17, 1994). 26. brown group, inc. v. commissioner, 104 t.c. no. 5 (1995). this result is consistent with the provision in the partnership antiabuse regulation that requires a partnership to be viewed as an aggregate of its partners whenever necessary to carry out the purpose of any code or regulation provision. see supra notes 1011 and accompanying text. the final regulations, where this provision was added, were developed after the first decision in brown group was announced and withdrawn. the provision may have been added to address situations like brown group. 27. see, e.g, helvering v. horst, 311 u.s. 112 (1940); helvering v. clifford, 309 u.s. 331 (1940); blair v. commissioner, 300 u.s. 5 (1937); poe v. seabom, 282 u.s. 101 (1930); lucas v. earl, 281 u.s. 111 (1930). [vol 2:8 interpreting tax legislation: the role of purpose that a transaction that is in substance a dividend should be taxed as such, even if it is cloaked in the form of a reorganization. in the famous case of gregory v. helvering, 2 for example, the supreme court disallowed treatment of a transaction as a tax-free corporate reorganization because of a lack of a "business purpose" for the structuring of the transaction, even though the reorganization provisions did not explicitly require that a reorganization have a business purpose. the distribution of assets to mrs. gregory in the course of the purported reorganization was therefore treated as a dividend. in other words, although there was no statutory language denying mrs. gregory reorganization treatment, that treatment was, under the circumstances, inconsistent with the purpose of the reorganization provisions and with the statutory structure that differentiates between dividends and reorganizations. the lack of a business purpose was latched upon, but the statute's purpose, in the form of statutory structure, might have been the better measure, for it is easy to come up with a business purpose when it is convenient to do so.' another example of a court invoking a common law doctrine to protect statutory structure is goldstein v. commissioner, t' where mrs. goldstein, who had recently won the irish lottery, borrowed at 4% interest to buy government bonds paying 2.5% interest. she prepaid interest on the loan in the same year in which she received the lottery winnings and sought to deduct the prepaid interest against the winnings. the market did not indicate a likelihood that the bonds would increase sufficiently in value to make a profit on the investment, but the tax savings, if allowed, made the uneconomical investment worthwhile. even though the statute said only that interest was deductible, the court denied the interest deduction because of the taxpayer's lack of profit motive for the debt-financed investment. the lack of profit motive, not required by statute at the time,3' was simply a common law doctrine that the court invoked in order to protect the statute's larger structure. the purpose of business and investment deductions is to reduce gross income from the business or investment to a net profit (in order to tax income, not gross receipts). if a taxpayer enters into a transaction without a profit motive (i.e., for personal reasons), the deduction would be a personal28. 293 u.s. 465 (1935). 29. see, e.g., alan gunn, were reports of brown group's impending death greatly exaggerated? letter to the editor, 65 tax notes 640 (oct. 31, 1994) (noting that the tax court found facts that might have satisfied the requirement that the partnership was formed for a "business purpose"). 30. 364 f.2d 734 (2d cir. 1966). 31. section 183 (prohibiting deduction of net losses arising from activities not engaged in for profit) was not enacted until 1969, and § 183 was not made applicable to the interest deduction until 1986. 19951 502 florida tax review [vol. 2:8 consumption deduction unnecessary in ensuring a tax on income instead of gross receipts. in sum, the structure underlying the internal revenue code and created by the sum of its sections provides a powerful tool in statutory interpretation of tax legislation. and that statutory structure could come within the umbrella of statutory purpose. b. nontax code provisions the code includes many provisions intended to induce changes in behavior, or effect wealth transfers, for nontax reasons based on economic or social policy. there are times when courts are asked to deviate from the plain meaning of the code, by either the taxpayer or the irs, because the requesting party thinks the literal interpretation is bad policy, even though not inconsistent with any structural attribute of the code. because policy choices in a statute are the province of congress, courts should not, in my view, deviate from a textualist approach to statutory language when no structural value is implicated. a textualist approach effectuates the policy choice made by congress or forces congress to amend the statute if its terms lead to results inconsistent with the intended policy. my example is hernandez v. commissioner," which dealt with the terms "contribution or gift" in section 170, allowing the deduction for charitable contributions. under a literal approach to those terms, a transferor makes no contribution or gift to the extent a quid quo pro is received in exchange. for example, cash transfers to a church by parents of students enrolled in the church school are not deductible charitable contributions when the payments purchase the education services. 3 the taxpayers in hernandez made cash transfers to the church of scientology in exchange for services known as "auditing" and "training," described as follows. scientologists believe that an immortal spiritual being exists in every person. a person becomes aware of this spiritual dimension through a process known as "auditing." auditing involves a one-to-one encounter between a participant (known as a "preclear") and a church official (known as an "auditor"). an electronic device, the e-meter, helps the auditor identify the preclear's areas of spiritual difficulty by measuring skin responses during a question and answer session. although auditing sessions are conducted one on one, the content of each session is not individually tailored. 32. 490 u.s. 680 (1989). 33. see rev. rul. 83-104, 1983-2 c.b. 46. interpreting tax legislation: the role of purpose the preclear gains spiritual awareness by progressing through sequential levels of auditing, provided in short blocks of time known as "intensives." the church also offers members doctrinal courses known as "training." participants in these sessions study the tenets of scientology and seek to attain the qualifications necessary to serve as auditors.... scientologists are taught that spiritual gains result from participation in such courses. the church charges a "fixed donation," also known as a "price" or a "fixed contribution," for participants to gain access to auditing and training sessions. these charges are set forth in schedules, and prices vary with a session's length and level of sophistication .... this system of mandatory fixed charges is based on a central tenet of scientology known as the "doctrine of exchange," according to which any time a person receives something he must pay something back. in so doing, a scientologist maintains "inflow" and "outflow" and avoids spiritual decline.: the supreme court held in hernandez that to the extent a quid pro quo is received in exchange for a payment to a church, the payment is not a "contribution or gift" within the meaning of section 170(a), even if what is received is a religious benefit, not a benefit that could be purchased in the marketplace. whether a charitable deduction should be allowed for money paid to a church in exchange for religious benefits is a policy choice that should be made by congress. the court ensured that congress would have to make that choice by adopting a literal interpretation of the words "contribution or gift." c. purpose as legislative history in addition to pertaining to structural norms and constraints, "purpose" can take the form of the history of a provision. i don't mean legislative history in the sense of specific rules inserted in committee reports-i am uncomfortable with that 5-but rather the context in which legislation was drafted, the wording of bills passed by one house but altered 34. 490 u.s. at 684-85 (footnotes and citations omitted). 35. while detailed rules inserted in committee reports should not, in my view, be given the status of law by a court, there is a meaningful distinction between these rules and generalized statements of purpose in a committee report. the latter can be very helpful in providing a grounding for the structural approach, which is ultimately grounded in the statutory language. 19951 florida tax review in conference, and the state of the old law. and such a purpose may mean that a literal, form-conscious approach should control. my example is section 1041 and marital property settlements, which are one-time transfers made in connection with a transaction (divorce) not typically undertaken for tax purposes. these transfers are also often undertaken by common folk without tax counsel based on the assumption that they have no immediate tax consequences. under section 1041 (a) and (b), transfers of property incident to divorce are not realization events for the transferor and may be excluded from income by the transferee as though received by gift, and if the property settlement is in-kind rather than in cash, the transferee takes a basis in the property equal to the basis in the hands of the transferor. this means that a transferor in a high tax bracket may transfer property that will produce income to a transferee in a low bracket, just the kind of transaction that, outside of the divorce context, raises assignment of income flags. the irs has unevenly and inconsistently invoked the assignment of income doctrine to trump the nonrecognition and exclusion rules in sections 1041(a) and (b)(1), arguing that in some instances taxation should not follow the property under section 1041 but should stay with the transferor, particularly if the property is deferred compensation, a common ingredient in property settlements.36 if h transfers to w rights to future payments that represent h's accrued interest in deferred compensation (considered owned solely by him in a common law state), the service might argue that even though w receives the cash, h is taxed either at the time of the transfer of title (how much?) or when w receives the cash years down the road. similarly, if h and w live in a community property state and w receives a cash payment to compensate her for a surrender of her marital interest in deferred compensation nominally owned by h, the service might argue that the payment is taxable to w, notwithstanding section 1041(b)(1). among the reasons prompting enactment of section 1041 were the uncertainty regarding who would be taxed on property settlements, the reality that such uncertainty created traps for the unwary, the whipsaw often experienced by the government when neither party paid tax, and the inconsistency of results depending on whether the parties lived in a community property state or common law state. as i once described in much more detail than i can afford here, the history of section 1041 indicates that it was meant to bring uniformity and certainty to the area of property settlements by allowing form to control.3" the rulings in which the service invoked the assignment of income doctrine seem irreconcilable, give no 36. see deborah a. geier, form, substance, and section 1041, 60 tax notes 519 (july 26, 1993) (describing cases and rulings). 37. id. [vol 2:8 interpreting tax legislation: the role of purpose coherent guidance regarding when the service is going to apply the doctrine, demonstrate how unworkable the doctrine is in this context, and undermine section 1041 by frustrating ex post the results of the parties' negotiations. d. lack of purpose a statutory provision that lacks an identifiable purpose makes life difficult. when purpose cannot be identified, all we have is the language, including that of both the original enactment and any amendments, and disagreement surrounding the interpretation of the language is not unusual because there is no larger structural or social-policy value that can guide meaning. section 104(a)(2), which allows an exclusion from gross income for "damages received on account of personal injuries or sickness," is such a provision. outlays incurred to create human capital, such as the costs of education, are generally nondeductible (and thus taxable). one would therefore think that compensation received for the loss of human capital would likewise be taxable, yet section 104(a)(2) allows an exclusion. the lack of a good explanation of why personal injury damage awards should not be taxed-either as a structural matter or as a matter of nontax social policy-contributes terribly to the difficulty in interpreting its meaning and scope. section 104(a)(2) has thus spawned much disagreement among judges interpreting its meaning and provides a study of how the lack of identifiable purpose confounds statutory interpretation. in the early tax world, personal injury damage awards were not considered "income" because they were not gains from labor or capital or both combined, which was the touchstone definition of income in the supreme court's 1920 decision in eisner v. macomber. " contributing to these early notions were conceptions of income borrowed from trust accounting, under which capital contributions (and gains from sales of corpus) were not income (which went to the beneficiaries) but were rather the means by which income was produced. income was commonly thought of as the recurring receipts produced by capital, such as the annual rent or crop proceeds earned from blackacre. because blackacre was the capital producing the periodic income, it was thus not income itself. similarly, nonrecurring receipts, such as lump sum windfalls, were considered capital receipts that would produce income, but were not themselves income. such notions likely contributed to the enactment of the predecessor to section 104(a)(2) in 1918. because taxpayers could rely upon the definition of income in excluding their personal injury damage awards, the statutory exclusion seemed to have little independent significance, and it is not surprising that the 38. 252 u.s. 189 (1920). 1995] florida tax review predecessor to section 104(a)(2) was carried forward in the 1954 code without debate. one year later, however, the supreme court decided glenshaw glass,39 holding that income includes all accessions to wealth, clearly realized, over which the taxpayer has complete dominion. because personal injury damages fit comfortably within this definition, the meaning and scope of section 104(a)(2) became important for the first time. it has been troublesome ever since. with the rejection of the antiquated notions of income upon which the original exclusion was likely premised and with no modem rationale having satisfactorily replaced it, the justification for the section 104(a)(2) exclusion has been a matter of scholarly debate.40 when purpose in any of the guises that i have discussed cannot be identified, all we have is language. for that reason, justice scalia's textual approach to section 104(a)(2) in the burke case4' made a lot of sense to some.12 scalia would have limited the exclusion for "personal injuries or sickness" to damages received on account of physical injuries and "perhaps" injuries to mental health.43 he would have ruled invalid a treasury regulation defining "personal injuries" to mean tort or tort-like injuries, which can include such nonphysical injuries as defamation, even though the validity of the regulation's tort-based approach was not argued either below or before the supreme court. although the structural rationale for section 104(a)(2) is difficult to articulate, fairly convincing legislative history accompanying a 1989 amendment to section 104(a) implies that the exclusion is not limited to physical injuries." by "legislative history," i don't mean committee reports; rather, i mean legislative history in the form of statutory language passed by the house that would have replaced the word "personal" with "physical" in section 104(a)(2), combined with statutory language that came out of the conference committee that retained the word "personal" in the general clause but disallowed the exclusion of punitive damages in cases not involving "physical" injuries. that legislative documentation implies that congress chose to continue to allow, consistent with dozens of lower court decisions, 39. 348 u.s. 426 (1955). 40. see, e.g, joseph m. dodge, taxes and torts, 77 cornell l. rev. 143 (1992); douglas a. kahn, compensatory and punitive damages for a personal injury: to tax or not to tax? 2 fla. tax. rev. 337 (1995). 41. united states v. burke, 112 s. ct. 1867, 1874 (1992) (scalia, j., concurring in the judgment). 42. see, e.g., william d. popkin, the tax treatment of statutory torts, letter to the editor, 54 tax notes 1570 (mar. 23, 1992) (urging justices to do essentially what justice scalia did in order to force congress to decide once and for all the extent to which it wishes damages for nonphysical injuries to be excludable). 43. burke, 112 s. ct. at 1875 (scalia, j., concurring in the judgment). 44. see geier, supra note 4, at 470. [vol 2:8 interpreting tar legislation: the role of purpose the exclusion of compensatory damages for those nonphysical injuries considered to be "personal." consistent with this conclusion, the majority opinion refused to limit the scope of personal injuries to physical injuries and accepted the tort-like test. it struggled with defining a tort, concluding that the factor differentiating a tort-like injury from other injuries is the breadth of the available remedies for the injury. if the scope of available remedies is sufficiently broad, as in a common law tort, the injury sued upon is tort-like. the story of section 104(a)(2) demonstrates the difficulty in interpretation when purpose is ambiguous. had congress not enacted the 1989 amendment, justice scalia's literal approach to the statutory language would have made sense. but that approach is not consistent with the amendmenl perhaps this saga illustrates the limits of statutory interpretation on the part of a judge; there are times when congress really does need to step in to clarify a statute's purpose. in the case of section 104(a)(2), that would mean enacting a statutory definition of "personal." e. evolving purpose purpose can evolve over time. section 162, the business expense deduction, contains a provision, section 162(a)(1), that explicitly allows a deduction for a "reasonable" salary. the provision was originally adopted in 1918 to allow a reasonable salary to be deducted for purposes of an excess profits tax, even though no salary was actually paid because profits were being plowed back into the business." the provision's original purpose was entirely pro-taxpayer. today, it is a provision raised by the commissioner against taxpayers to disallow deductions for what are in fact disguised dividends or disguised payments for property.' the purpose of the provision has thus evolved over time so that now its purpose is chiefly seen as protecting the double tax in our classical corporate tax structure. interpretation of the provision must likewise evolve, an example of the kind of dynamic statutory interpretation described in the nontax context by william eskridge.47 i. the role of purpose and institutional values a. the relationship of congress, the courts, and the treasury department now let me step back and say a few words about the institutional 45. erwin n. griswold, new light on "a reasonable allowance" for services, 59 harv. l. rev. 286 (1945) (discussed in william d. popkin, fundamentals of federal income tax law 239 (1994)). 46. see regs. § 1.162-7. 47. william n. eskridge, jr., dynamic statutory interpretation. 135 u. pa. l rev. 1479 (1987). 19951 florida tax review issues at stake here. recall that the duberstein court ignored structure and took a plain meaning approach to the statutory term "gift." later, congress stepped in, enacting sections 274(b)48 and 102(c) 49 to make it less likely (though not impossible) that a transfer in the business context would escape even a single layer of taxation. these amendments would have been unnecessary had the duberstein court consulted the structure underlying gift treatment. the duberstein approach-plain meaning interpretation that ignores structure and causes statutory amendment-is always available, true. but is that the only legitimate approach? for example, was the decision of the owens court,50 which ignored the literal words of the statute in order to protect the fundamental structure, an illustration of unconstrained discretion that exemplifies judicial lawlessness by ignoring the words passed by congress? a decision outside of the rule of law because, on its face, it flouted explicit language in the code? i don't believe so. the owens court's decision was consistent with the fundamental structure of the scheme that congress created, not antagonistic to it. as professor popkin has argued, the law should be viewed as a joint undertaking between congress and the courts in the sense that the courts should not deliberately undermine a statutory scheme in the name of bowing to congress as the sole source of law.5 congress's law also includes that larger statutory structure. looking at the world that way provides both a validation of judicial common law doctrines in tax and a constraint on their proper use. in some cases, they are appropriate judicial tools that ensure that the fundamental structure of the income tax created by congress is not frustrated. the doctines are inappropriate, however, in situations where purpose of a different sort counsels against their use-where, as in the case of section 1041, form should control in my view because of the history underlying its enactment. some argue, from an institutional viewpoint, that literal interpretation is necessary in order to force congress to avoid ambiguity or sloppiness in its drafting of statutes. but the blame does not always lie, as apparently was the case in missouri, 52 with the legislature being sloppy or failing to articulate clearly what the statute reaches. the fault sometimes lies in the constraints of statutory drafting and the limits of language itself. statutes must be written in self-executing commands rather than in expository form; 48. section 274(b) prohibits the deduction (except for $25) of business gifts. 49. section 102(c) prohibits the exclusion by an employee of gifts from an employer. duberstein did not deal with an employer and employee. 50. see supra notes 13-15 and accompanying text. 51. see collaborative model, supra note 5. 52. see supra notes 1-2 and accompanying text. [vol 2:8 interpreting tax legislation: the role of purpose they cannot contain paragraphs describing the overarching idea intended to be captured by the necessarily constrained language. the charge of congressional sloppiness might be more compelling with respect to legislation dealing purely with social policy, where hard decisions must be made and consensus is often difficult to achieve. indeed, that is why i believe a much more literal approach should be taken with respect to nontax code provisions, as described above in part ii.b. but with respect to the core structure of the income tax, at least, congress often uses the best words that it could have chosen in the situation to capture an idea-"capital expenditure, ' ".cost,"' "gift,"55-but the words nevertheless cannot be given meaning without resort to the larger statutory structure of an income tax. for example, the words "income from discharge of indebtedness" in section 61(a)(12) are probably the best words that congress could have chosen to capture the idea that the borrowing exclusion is lost when loans are not repaid, triggering an income inclusion when the assumption that the loan would be repaid proves to be false. yet, an overly textualist approach to these words, ignoring the larger structure of the taxation of loan proceeds, has caused some courts to wonder whether a loan that is not enforceable can ever create debt-discharge income--a ridiculous inquiry, in my view, caused solely by deliberate ignorance of the larger statutory structure. if a taxpayer borrows $1,000 from a loan shark at usurious interest rates, spends the money on personal consumption, learns that such loans cannot be enforced under state law and thus refuses to repay, the taxpayer should be charged with $1,000 of income? the borrowing exclusion was premised on the assumption that the taxpayer would repay; when that assumption proves to be false, the loan proceeds are an accession to wealth, clearly realized, over which the taxpayer has complete dominion. as i wrote elsewhere: the debt is not "discharged," the argument goes, if it could not be enforced. but the lack of enforceability simply is the impetus for the failure of the debtor to repay 53. indopco, inc. v. commissioner, 503 u.s. 79 (1992). see geier, supra note 4, at 477 n.122 (discussing the court's construction of the term "capital expenditure-). 54. philadelphia park amusement co. v. united states, 126 f. supp. 184 (ct. ci. 1954). see geier, supra, note 4, at 474-77 (discussing the court's nonliteral construction of the term "cost"). 55. commissioner v. duberstein, 363 u.s. 278 (1960), discussed supra notes 16-21 and accompanying text. 56. see, e.g., schlifke v. commissioner, 61 t.c. memo (cch) 1697. 1698, t.c. memo (p-h) 91,019 (1991) (noting that the enforceability of a debt obligation is a "sub-issue" that "inheres" in the issue of debt-discharge income). 57. the income is likely to be offset by a deduction for extraordinary medical expenses. 19951 florida tax review fully the originally excluded loan proceeds which creates the accession to wealth in the first place. not only should the tax law avoid placing a favorable premium on entering into loan agreements that are unenforceable (as compared to enforceable loan agreements that are not enforced in fact), it is a catch-22 to argue that the very unenforceability which created the debt cancellation (because it prevented the creditor from collecting the debt in full) saves it from taxation. the debt in tufts was, in fact, unenforceable to the extent that it exceeded the fair market value of the collateral, and yet the court confirmed that an accession to wealth occurred on the failure to repay that debt, even though it analyzed that accession to wealth as gain under section 1001. that accession to wealth should not escape taxation outside the transfer context, as it would if the unenforceability of debt prevented taxation of [debt-discharge income] when the debt is not repaid in full; the same accession to wealth occurs in both the transfer context and the nontransfer context. such nonissues as unenforceability cloud the fundamental tax point confirmed in tufts that the prior loan proceeds were received free of tax on assumptions that prove to be unwarranted when the loan proceeds are not in fact fully repaid with aftertax dollars-for whatever reason. the prior receipt coupled with the failure to repay in full should be the beginning and end of the inquiry under debt-discharge theory.5 s "such a reliance on the dictionary definition of words focuses on nonissues that arise because of an excessive solicitude to the perceived exactitude of the meaning of words severed from their structural context as part of the internal revenue code. ' 59 one problem with all of this is that those readers who agree with me thought this way before i began my discussion, and those who disagree with me will not have been persuaded. and people do disagree. for example, william s. mckee of king & spalding-former tax legislative counsel and partnership tax guru-was reported to have said, with reference to the new 58. deborah a. geier, tufts and the evolution of debt-discharge theory, i fla. tax rev. 115, 155 (1992). 59. id. at 169. the unrepaid principal of an unenforceable debt obligation may escape taxation for other tax reasons but not because the debt obligation is unenforceable. see id. at 186 n.217 (discussing whether the unenforceable debt in the zarin case should go untaxed when not repaid under a common law rule analogous to § 108(e)(5), which excludes debt discharge income resulting from a reduction of purchase money debt). [vol 2:8 interpreting tax legislation: the role of purpose partnership antiabuse regulation i earlier mentioned, that "taxpayers are entitled to take the benefit of unintentional ... glitches in the law that tax advisers find by applying a literal reading of the law until the government somehow stops them."' although i may not convince such hard-boiled proponents of literalism, i should at least describe the kind of statutory world they advocate. the internal revenue code contains 1,339,000 words.6' a textualist approach to statutory language that frustrates purpose in any of the senses that i have discussed here-or a deviation from textualism in those instances demanding it-requires congress to enact more legislation, as it had to do after duberstein. the code can only become inexorably longer and more complicated as congress must overturn decision after decision by statutory amendment, a cumbersome device intentionally made difficult by the framers. (since statutory proposals that would lose revenue must be matched, under budget laws enacted in the 1980s, by proposals that would raise revenue, the response that congress can always fix a wrong tax decision is far too facile today.62) and as the code becomes more textual through statutory detail and 60. lee a. shepherd, partnership antiabuse rule: dirty minds mect mrs. gregory, 64 tax notes 295, 296 (july 18, 1994) (quoting ms. shepherd's paraphrase of mr. mckee's position). several respected commentators have, however, supported the regulations. joseph bankman, the proposed partnership antiabuse rule: appropriate response to serious problem, commentary, 64 tax notes 270 (july 1 , 1994) (hereinafter bankman); peter l faber, it's important to pave the way for antiabuse rules, letter to the editor, 64 tax notes 1237 (aug. 29, 1994); daniel i. halperin, the partnership antiabuse reg: a reasonable step in the right direction, letter to the editor, 64 tax notes 823 (aug. 8, 1994); new york state bar association, tax section, committee on partnerships, report on the proposed partnership antiabuse rule, 64 tax notes 233 (july 11, 1994) (generally supporting the regulation). 61. guy gugliotta, deciphering a code that is mostly just taxing, cleve. plain dealer, nov. 27, 1994, at 6c. 62. thus, i strenuously disagree with professor edward zelinsky's statement that "[the code is highly correctable legislatively." edward zelinsky, albertson's: why courts shouldn't override clear statutory language, 66 tax notes 1691, 1700 (mar. 13. 1995). for example, a huge problem encountered by those who advocate overturning the revenue raising result in commissioner v. soliman, 113 s. ct. 701 (1993) (narrowing deductions for home offices), is that such an enactment would be marked as a revenue losing provision (as compared with present law under soliman) and thus must be matched by revenue raising provisions under budget law constraints. no longer are tax provisions debated solely on the merits. indeed, some tax proposals that virtually everyone opposes on tax policy grounds are nevertheless supported solely because they may raise revenue to pay for revenue losing provisions. a prime example is the retention of the "neutral cost recovery system" in the recent tax bill proposed by chairman archer. see archer to stick with "contract" in panel markup, 95 tnt 42-10 (mar. 2, 1995) (lexis, fedtax library, tnt file) ("even one tax cut that has virtually no support among its intended beneficiaries--the neutral cost recovery system-will be left intact because omitting it would create a revenue shortfall."). albertson's itself was "highly correctable legislatively" only because of the happenstance that an enactment over19951 florida tax review complexity, it breeds inappropriate textualist advice by practitioners and then textual judicial decisions, often causing yet more amendments and more institutional pressure on the agency. as commissioner margaret richardson said last summer, the tax law has become "so complex that mechanical rules have caused some tax lawyers to lose sight of the fact that their stock-in-trade as lawyers should be sound judgment, not an ability to recall an obscure paragraph and manipulate its language to derive unintended tax benefits." 63 the cycle perpetuates itself, which is one reason why i believe this issue has become more pronounced as time goes on. on the flip side of the coin, the approach described here requires a lot of the lawyer-and judge for that matter. the lawyer cannot facilely rely on the language before him or her but rather must have a good grasp of that larger statutory and conceptual structure and of history in order to appreciate whether a textual or nonliteral approach is required. outside these polar extremes, the lawyer and judge must be adept at gleaning purpose in order to construe effectively language on the continuum between those two ends, such as in duberstein, or to approach effectively a case in which specific language is not at issue but the form of the transaction implicates statutory structure, such as in gregory and goldstein. this level of mastery is not easily achieved, particularly in light of the catch-22 that failure to operate in this way often contributes to the statutory amendments and growing complexity that makes this approach difficult. are we asking too much of our lawyers? are we asking too much of our judges?' from the institutional perspective, perhaps the culmination of the issues discussed here was the issuance of the partnership antiabuse regulation i quoted earlier, which provides that a partnership can be disregarded if it is used in a manner inconsistent with the "intent of subchapter k" or in order "to carry out the purpose of any provision of the internal revenue code or the regulations. 65 we gave gotten to the point at which statutory interpretation directives to ignore the literal words of a statute in certain situations in favor of implementing the statute's purpose are being encapsulated in turning it would be marked as a revenue raising provision (which could, ironically, have been used to fund such things as overturning soliman). see infra notes 80-86 (discussing the albertson's decision). 63. wall st. j., aug. 10, 1994, at al. 64. in this vein, i think it's interesting to note that it seems to me that, oddly enough, it is often the tax court-the specialized court with, we presume, intimate knowledge of these matters-that more often, though of course not always, takes the textual approach. brown group, discussed supra notes 22-26 and accompanying text, is just one example. the generalist judge sometimes is more quick to let go of the literal language. 65. see supra notes 9-11 and accompanying text. [vol 2:8 interpreting tax legislation: the role of purpose treasury regulations.66 one can't help but wonder whether the perceived need for such regulations is a direct result of the breakdown in consensus regarding how we should approach statutory language and the absence of language, either as a practitioner or as a judge. the presence of the regulation's statutory interpretation directives raises another practical issue in my mind. what will be its likely effect on the resolution of litigated cases? more specifically, some have taken issue with the regulation by arguing that it is unnecessary because the government can always invoke purpose or the substance-over-form doctrine without the regulation. it is a litigating strategy with a long history. professor bankman has responded by stating that redundancy doesn't seem a significant harm and, more important, the regulation sends an important message by "signal[ing] the legal community the treasury's clear intent to go after a class of abusive transactions in subchapter k."'67 the regulation thus has, in his view, "a valuable in terrorem effect in deterring the most aggressive behavior of the private tax bar."6 i believe the regulation has that salutary effect, but i wonder whether it also gives more force to the argument made under it because of the deference courts give to valid regulations.69 in other words, would the service's litigating position in cases like brown group have been strengthened by encapsulating its litigating strategies in a regulation? should it? should the government get a leg up in litigation by instructing a judge through regulations that the literal words of the statute should be ignored in favor of the government's view of the transaction? how might a judge approach the claim? b. the importance of rhetoric in this final section, i return to the topic discussed in the introductory section of part 1-what is statutory purpose?-and add a cautionary note about proper use of the term "purpose" in light of the examples discussed in part ii. 66. see hal gann & roy strowd, the recent evolution of antiabuse rules, 66 tax notes 1189 (feb. 20, 1995) (recounting the growing tendency of the treasury to issue regulations that provide that the literal language of the code or regulations should be ignored if necessary to effectuate the statute's or regulation's purpose). 67. bankman, supra note 60, at 271. 68. id. at 272. 69. see chevron u.s.a., inc. v. natural resources defense council. inc., 467 u.s. 837 (1984) (holding that if congress did not address the precise question at issue, the agency's construction of the statute should be accepted so long as "permissible," even if a court would have construed the statute differently). 19951 florida tax review i have thus far outlined my views in several discrete situations regarding how statutory purpose ought to inform statutory interpretation in the realm of tax, with an eye toward institutional consequences. i have advocated a literal approach in some situations, but in others, i believe it is defensible to depart from the literal terms of the statute to give effect to the statute's larger structure. i have, however, been careful not to invoke congress's intent or ultimate purpose in enacting the statute, which is an approach often perceived as located at the opposite end of the spectrum from literalism. i have done so for much the same reason that professor summers and his colleague geoffrey marshall reject appeals to a statute's ultimate purpose.7° summers and marshall argue that formal values require statutory interpretation to be rooted primarily in the ordinary and technical language of the statute. they argue that appeals to a statute's ultimate purpose (which they distinguish from the statute's "immediate purpose" 71) undermine formal values, such as predictability, dispute avoidance, and like cases being treated alike. they also believe that interpretation based on ultimate purpose does nothing to curb strong-willed judges from implementing what they see as the correct policy for the country.72 the argument from ordinary or technical meaning is much broader than some might think. according to summers and marshall, ordinary or technical meaning is different from "plain" or "clear" meaning, as those terms are often used by judges. it covers "technical meaning," "special meaning," "harmonization" of statutory language, and a consciousness that the language user is an educated user with a background of general knowledge, and sometimes special knowledge, who has used language every day with little 70. see generally robert s. summers & geoffrey marshall, the argument from ordinary meaning in statutory interpretation, 43 n. ireland legal q. 213 (1992); robert s. summers, the formal character of law, 51 cambridge l.j. 242 (1992). 71. summers & marshall, supra note 70, at 221. a statute's "immediate purpose," according to summers and marshall, is the implementive purpose that can be gleaned from the face of the statute. that is, legislators use language purposively, and a statute allowing an interest deduction, for example, thus has an "immediate purpose" of allowing a deduction for interest as that concept is ordinarily understood in the tax law. the "ultimate purpose" of why the statute allows an interest deduction might not be apparent on the face of the statute. 72. the authors write: [t]he ordinary meaning of the statute serves to constrain wilful judges (of the left and of the right), thereby confining them not only within their sphere of competence but also within their appropriate judicial role. courts lack institutional competence to make fully-fledged legislative judgments about ends and means, and ought not to substitute their judgment for that of the legislature anyway. this erodes the very phenomena of legislation and of legislative power itself. id. at 226. [vol 2:8 interpreting tax legislation: the role of purpose or no confusion. some of the examples they give might surprise some who call themselves textualists. for example: suppose a statute limits the amount of contributions to electoral expenditures by persons who "promote or favour the election of a candidate." does a person who campaigns against a candidate at an election "promote or favour the election of a candidate"? on the face of it the phrase "opposing a candidate's election" does not mean "promoting a candidate's election" and someone who had done the first might say that he had not in the ordinary sense of the words done the second. nonetheless, a competent, generally knowledgeable and specially informed ordinary language user who was familiar with or had the factual background of elections and electoral machinery drawn to his attention might come to agree that his doing of the one act was equivalent to his doing of the other, given the language and the immediate purpose of the statute evident on its face and inferable from the ordinary meaning of the language used." a literal textualist might construe the statute not to apply to the person opposing a candidate's election. marshall and summers do not argue that the argument from ordinary or technical meaning is always available. they concede that sometimes the language is too unclear.74 what i have called interpretation based on the "structure" of the internal revenue code could, in the nomenclature of summers and marshall, come within at least the harmonization aspect of the argument from ordinary or technical meaning. for example, my suggested approach to the definition of "gift" in duberstein based on structure could be restated as an argument for construing the word in terms of other code sections that explicitly or implicitly implement the one-tax-cycle-per-gift rule. similarly, my structural argument about owens, which required a nonliteral construction of the defined term "adjusted basis," could be squarely placed in the statute by citing those provisions, such as sections 167(a) and 262, that make it clear that personal-consumption loss in value not attributable to the casualty itself should not support a deduction. summers and marshall concede that even "technical" terms, such as "adjusted basis," can have a "special meaning" if required to harmonize the statute on its face. a special meaning includes "a 73. id. at 223. 74. id. at 216. 19951 florida tax review meaning of a technical word that is not the technical meaning of that technical word."75 people such as justice scalia, in my opinion, have given ordinarymeaning argumentation something of a bad name by misapplying it in some cases and, ironically, might have contributed to a shunning of a more linguistically anchored approach to statutory interpretation. by shunning a linguistically anchored approach, we abandon the values of formality, values that are important to all law and legal institutions. because i believe that justice scalia sometimes gets ordinary-meaning argumentation wrong, 76 i rejected the language of his literal textualism and embraced the language of purposivism. yet, i, too, wish judges to be constrained from using outcomebased approaches and have thus struggled to fashion my own set of constraints, outlined both here and elsewhere, within the nomenclature of purpose." perhaps my desire to cabin proper interpretation could be translated into the language of ordinary or technical meaning, as fashioned by summers and marshall. if the same results are reached under my approach as the approach articulated by summers and marshall," why quibble about the language 75. id. 76. i disagree, for example, that ordinary or technical meaning argumentation requires that the interpretation of words in one statute should govern the interpretation of words in a completely unrelated statute. see morales v. trans world airlines, inc., 504 u.s. 374 (1992) (scalia majority opinion in which interpretation of the words "relating to" as construed in a prior case dealing with the employee retirement income security act (erisa) was imported wholesale into interpretation of "relating to" in the airline deregulation act). i disagree with justice scalia's disregard of long-accepted common law rules that affect statutory interpretation and represent widely accepted values. see supra note 8 (describing scalia's opinion in the x-citement video case). i also disagree with his minimization of subsequent statutory amendment that gives rise to implications inconsistent with his literal textual reading of the earlier language. see supra notes 41-44 and accompanying text (describing scalia's opinion in the burke case). 77. see geier, supra note 4; geier, supra note 36. even my substantive piece in the florida tax review is an application of what i have called a structural analysis to a particular issue. see geier, supra note 58. 78. one of the areas in which professor summers and i disagree is my comfort with the evolution of § 162(a)(1). see supra notes 45-47 and accompanying text. he generally believes that without statutory amendment, the meaning of a statute cannot change. i, on the other hand, am comfortable with the notion that a statute's meaning can change without statutory amendment, so long as the evolution in meaning can either be supported by an argument based on what professor summers would call "harmonization" and what i have called "structure" or can be supported by a well-recognized evolution in the meaning of a term in popular culture. thus, i am comfortable with the use of § 162(a)(1) as a sword (instead of as a shield, as it was originally used) to protect the double tax system because that system is apparent on the statute's face. similarly, i am comfortable with the supreme court's holding that the word "charitable" in § 501(c)(3), allowing "charitable" organizations to be tax-exempt, [vol. 2:8 interpreting tax legislation: the role of purpose used to describe the approach? because the rhetoric of opinions is terribly important. summers and marshall fear that if the rhetoric of ultimate purpose is used to reach a result that could have been reached using an ordinary or technical meaning interpretation, that language of ultimate purpose may invite the judge in a different case to go beyond the constraints of ordinary-meaning argumentation to reach substantive results compatible with the judge's policy views. i agree with their discomfort with appeals to a statute's ultimate purpose, as they describe it. appeals to purpose should be limited, in my view, to those purposes apparent on the face of the statute and its legislative history, as i have defined it.' to illustrate what i mean, i use the controversial albertson's decision, which was first decided by the ninth circuit in december of 1993." after an uproar ensued over the decision,8' the court vacated it and granted a rehearing.' its second opinion reversed the prior decision.' albertson's had "nonqualified" deferred compensation arrangements with some of its top executives and directors. under a deferred compensation plan, whether qualified or nonqualified, employees generally include deferred no longer includes educational institutions that discriminate on the basis of race, bob jones univ. v. united states, 461 u.s. 574 (1983), even though § 501(c)(3) was enacted when plessy v. ferguson, 163 u.s. 537 (1896) (affirming separate but equal doctrine), was the law of the land and had not been amended. see generally geier, supra note 4, at 484-86 (discussing the bob jones case). 79. see supra notes 35 and 44 and accompanying text. 80. albertson's, inc. v. commissioner, 12 f.3d 1529 (9th cir. 1993). 81. a sampling of the commentary on albertson's in tax notes includes zelinsky, supra note 62, edward j. abahoonie, ninth circuit's albertson's rip-flop outrages practitioner, letter to the editor, 66 tax notes 898 (feb. 6, 1995); edward j. abahoonie, critics of albertson's suffer from tax myopia, letter to the editor, 63 tax notes 913 (may 16, 1994); jasper l. cummings, jr., statutory interpretation and albertson's, 66 tax notes 559 (jan. 23, 1995); daniel halperin, albertson's: more outrage, viewpoint. 63 tax notes 1771 (june 27, 1994); daniel halperin, halperin reiterates his complaints about albertson's, letter to the editor, 63 tax notes 483 (apr. 25, 1994); daniel halperin. ninth circuit's decision in albertson's is outrageous, viewpoint, 62 tax notes 1083 (feb. 21, 1994); charles i. kingson, some definitional issues ignored in the albertson's decision. letter to the editor, 64 tax notes 681 (aug. 1, 1994); daniel s. knight, albertson's parrying and thrusting misses the point, letter to the editor, 63 tax notes 483 (apr. 25, 1994); william d. popkin, albertson's and statutory interpretation, letter to the editor, 64 tax notes 1207 (feb. 20, 1995); meegan m. reilly, ninth circuit did the right thing in albertson's-or did it?, viewpoint, 65 tax notes 1322 (dec. 12, 1994); steven j. willis, albertson's: less emotion and more reason would be helpful, viewpoint, 64 tax notes 961 (aug. 15, 1994); steven j. willis, leave albertson's alone, 63 tax notes 1481 (june 13, 1994); edward a. zelinsky, the ninth circuit's albertson's decision: right for 1983. wrong for today, 63 tax notes 231 (apr. 11, 1994). 82. 12 f.3d 159 (1994). 83. 42 f.3d 537 (1994). 19951 florida tax review compensation in income only when received.' if the plan is qualified, the employer may nevertheless deduct its contributions to the plan as they are paid into the pension trust; thus, the employer gets an immediate deduction, even though the amounts will not be taxed to employees until years later. if the plan is nonqualified, however, section 404(a)(5) delays the employer's deduction for the "compensation" until "the taxable year in which an amount attributable to the contribution is includable in the gross income of employees participating in the plan." thus, unlike the case of a qualified plan, the employer deduction under a nonqualified plan is deferred to match the employee's income inclusion. albertson's nonqualified arrangement provided that an interest-like component would be added to the deferred compensation to compensate the recipients for the time value of the deferral. the issue in the case was whether the interest-like component was deductible as it accrued or whether section 404(a)(5) delayed deduction until the amounts were paid to the recipients. one can envision three approaches to this issue of statutory interpretation. under an ultimate purpose approach, the interpreter would first try to identify the ultimate purpose of the delayed deduction in section 404(a)(5) for nonqualified plans and would then ask whether deductions for accruals of the interest-like component would be inconsistent with that purpose. this was the approach taken by the ninth circuit in its final decision, which held the accruals nondeductible until paid. the court believed that the ultimate purpose of delaying the employer deduction under nonqualified plans, while allowing immediate deductions for contributions to qualified plans, was to encourage the use of qualified plans, which must satisfy complex minimum funding, participation, and vesting requirements and avoid discrimination in favor of highly compensated individuals. if substantial amounts could be deducted before inclusion by the employees in the case of a nonqualified plan, the court reasoned, the ultimate purpose of section 404(a)(5) would be frustrated. thus, the deduction was denied. since section 404(a)(5) disallows immediate deduction only of "compensation," a literal textualist, such as justice scalia, would look up the word "compensation" in the dictionary, finding that it means payments for services rendered. an adherent of this approach would likely conclude that accruals of the interest-like component were deductible because this component compensates for the time value of the deferral in payment of compensation, not for the services rendered. this approach was, essentially, the one taken by the ninth circuit in its first decision in the case. 84. under a nonqualified plan, the tax is deferred until payment only if the employee uses the cash method of accounting, which nearly all employees do. [vol 2:8 interpreting tar legislation: the role of purpose there is yet a third approach. in my world (and perhaps in the world of professors summers and marshall), the court would have disallowed the deduction by using what i call a structural analysis. the statute's immediate implementive purpose (that which could be gleaned from the face of the statute) is to defer the employer deduction for amounts paid to employees under a nonqualified plan until the employees are taxed on these amounts. that is, it creates a matching regime, much like those found in other code sections with respect to payments between related parties. ' 5 that structural aspect of the nonqualified plan rules would be frustrated by allowing a deduction for an interest-like component before those amounts were paid to the employees and included in their income. moreover, the interest-like component involved in albertson's was the portion of the payments to the employees that the contract labelled "interest." virtually all of the code's time value of money rules evidence that, in drawing the distinction between interest and principal, economic substance is determinative and labels in the contract are not.86 allowing deduction of what the contract called interest would be inconsistent with these structural principles. for both of these structural reasons, the deduction should be disallowed. in my view, the ninth circuit got it wrong the first time by taking a literal textualist approach, but though it got to the right result the second time, it arrived there by the wrong route. searching legislative history for the ultimate purpose that congress, or some of its members, had in mind in enacting section 404(a)(5) or, absent such evidence, trying to reconstruct an ultimate purpose that might have prompted congress to act as it did provides just the kind of constraint-free atmosphere that leads to poor results from an institutional point of view. the court should have stopped after identifying the matching principle embedded in the statute (and identifying the structural treatment of interest under the time value of money provisions) and disallowed deduction on those grounds. by going further and appealing to congress's ultimate purpose in enacting the matching principle, the court legitimizes that approach and thereby opens the door in other cases to similar appeals to ultimate purpose. 85. see, e.g., irc §§ 83(h), 267(a)(2). 1271-1275. 86. see, e.g., irc §§ 483, 1271-1275. 19951 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle 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keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 1 1993 number 9 partnership securities sinon friedman" i. introduction ii. basic premises a. capital account system b. entity and aggregate approach c. standard fact pattern i. cash as consideration for partnership securities a. the receipt of a capital interest for cash b. the receipt of a partnership option for cash 1. entity analysis 2. aggregate analysis 3. choice of characterization c. the receipt of a profits interest for cash 1. entity analysis 2. aggregate analysis 3. choice of characterization iv. services as consideration for partnership securities a. the receipt of a capital interest for services 1. aggregate analysis 2. entity analysis 3. choice of characterization b. the receipt of a partnership option for services 1. consensus view-hybrid analysis 2. entity analysis 3. choice of characterization c. the receipt of a profits iterest for services 1. revenue procedure 93-27 2. general principles-consensus aggregate view 3. general principles-entity analysis 4. choice of characterization v. conclusion * of counsel, milbank, tweed, hadley & mccloy, new york. n.y. j.d., 1980, yale law school. florida tax review i. introduction the convergence of the individual and corporate tax rates and the repeal of the general utilities doctrine have increased the cost of doing business in corporate form and the attractiveness of operating a business as a partnership.' that attractiveness has been reinforced by the growing availability of limited liability companies.2 the proliferation of partnerships has increased the interest in partnerships' issuing securities similar to those issued by corporations-capital interests, options and profits interests that are the partnership equivalent of "stock appreciation rights."3 however, there has been little discussion of the tax consequences of partnerships issuing securities apart from the long-standing debate as to whether the recipient of a partnership profits interest for services should be subject to tax.4 that debate has been resolved, as a practical matter, by revenue procedure 9327,5 in which the internal revenue service ruled that, subject to certain exceptions, the receipt of profits interests for services is not taxable. this 1. see william b. wasserman et al., tax planning opportunities through the use of partnerships in corporate transactions, tax strategies for corporate acquisitions, dispositions, financings, joint ventures, reorganizations, and restructurings 1992, practising l. inst. 643, 647-48; louis b. freeman, some early strategies for the methodical disincorporation of america after the tax reform act of 1986: grafting partnerships onto c corporations, running amok with the master limited partnership concept, and generally endeavoring to defeat the intention of the draftsmen of the repeal of general utilities, 64 taxes 962, 962-64 (1986). 2. william b. brannan, lingering partnership classification issues (just when you thought it was safe to go back into the water), 1 fla. tax rev. 197, 249-50 (1993). 3. james r. hamill, using options to compensate service providers at the formation of a new entity, 76 j. tax'n 138, 138 (1992). 4. 1 william s. mckee et al., federal taxation of partnerships and partners 5.01.10 (2d ed. 1990 & cum. supp. no. 2 1993); 1 arthur b. willis et al., partnership taxation §§ 45,46 (4th ed. dec. 1991 & supp. june 1993). the extensive literature preceding campbell v. commissioner, t.c. memo 1990-162 (cch), rev'd, 943 f.2d 815 (8th cir. 1991) is summarized in barksdale hortenstine & thomas w. ford, jr., receipt of a partnership interest for services: a controversy that will not die, 65 taxes 880 (1987). the extensive postcampbell literature includes sheldon i. banoff, status of service partners remains unclear despite eighth circuit's reversal in campbell, 75 j. tax'n 268 (1991); w. lesse castleberry, commentary: campbell-a simpler solution, 47 tax l. rev. 277 (1991); terence f. cuff, current issues in partnership taxation, in 49 n.y.u. inst. on fed. tax'n ch. 13 (1991); terence f. cuff, campbell v. commissioner: is there now "little or no chance" of taxation of a "profits" interest in a partnership?, 69 taxes 643 (1991); laura e. cunningham, taxing partnership interests exchanged for services, 47 tax l. rev. 247 (1991); thomas w. henning, the receipt of a partnership interest for services, in 44 u.s.c. inst. of fed. tax. 1600 (1992); leo l. schmolka, commentary: taxing partnership interests exchanged for services: let diamond/campbell quietly die, 47 tax l. rev. 287 (1991). 5. rev. proc. 93-27, 1993-24 i.r.b. 63 (july 6). revenue procedure 93-27 is discussed infra part iv.c.1. [vol 1:9 partnership securities resolution makes timely an analysis of the consequences to the partnership and other partners of a partnership's issuance of partnership securities. this article, through a series of examples, considers the possible consequences under current law of the receipt by a partner of a capital interest, an option and a profits interest for either cash or services. these consequences differ depending on whether a partnership is viewed as an entity or aggregate.6 the article recommends the adoption of an entity approach that permits the consequences of a partnership's issuance of securities to resemble those of corporate issuances. this recommendation requires reconsidering the accepted view of the tax consequences of a partnership's issuing a capital interest for services. ii. basic premises a. capital account system the article relies on the capital account system of regulations section 1.704-1(b). under that system, each partner's interest in a partnership at any time is reflected in the partner's capital account. the capital account equals a partner's (or its predecessor in interest's) contribution to the partnership, increased by any income allocated to the partner and decreased by any losses allocated to, and any distributions made to, the partner. contributions made in property are reflected in the partner's capital account at the property's fair market value net of associated liabilities. income and loss (including depreciation or amortization deductions) as to contributed property are based on the property's gross fair market value at contribution, which also represents the property's initial book basis. on liquidation, a partnership must distribute the proceeds of liquidation to its partners in accordance with the partners' capital account balances. thus, if a partnership were to sell its assets for their book basis, each partner must be distributed the current balance in its capital account. if the partnership's assets are sold for an amount other than their book basis, the proceeds of sale must be distributed to the partners in accordance with their capital accounts as adjusted for the allocation of any gain or loss realized on the sale. to enable this rule to correspond to economic reality, when a new partner is admitted to a partnership that holds appreciated property, regulations section 1.704-1(b)(2)(iv)(f) permits the partnership to revalue its property and adjust the book basis of its property to the property's fair market value at the time of revaluation and to adjust the partners' capital accounts 6. the difference between the entity and aggregate approaches is discussed infra part 19931 florida tax review as if the property had been sold for its fair market value and the resulting gain or loss allocated to the partners. if the book basis and tax basis of contributed property differ, section 704(c)(1)(a) requires that income, gain, loss and deduction with respect to the contributed property be allocated to take that difference into account. differences in the book and tax basis of assets resulting from partnership revaluations under regulations section 1.704-1(b)(2)(iv)() must also be taken into account under section 704(c) principles.8 generally, and subject to specific rules and exceptions, book-tax differences are to be taken into account on an asset by asset basis by allocating to partners that are not responsible for a book-tax difference the tax income, gain, and deduction that the property would have generated had there been no book-tax difference and allocating any remaining attributes to the partners responsible for the book-tax difference. 9 b. entity and aggregate approach as used in the article the term "entity approach" refers to the approach that treats a partnership as a separate entity, like a corporation, distinct from either the assets it owns or the partners that own interests in it. under the entity approach, a person receiving a partnership interest is viewed as receiving an interest in that entity and not an interest in the entity's underlying assets. the term "aggregate approach" refers to the approach that 7. this description of the capital account system is blatantly oversimplified and no attempt will be made to discuss its infinite complexities. technically, the code and treasury regulations do not require the use of capital accounts at all. the proper use of capital accounts provides no more than a safe harbor within which the internal revenue service will respect a partnership's allocation of income and loss. within this permissive system, the revaluation of capital accounts to reflect fair market values on a contribution of property is itself merely permissive. despite the modest legal status of capital account analysis, capital accounts are often used as an overarching method of determining partnership tax consequences. for example, mckee uses a capital account analysis to distinguish between distributions and § 707(c) guaranteed payments, mckee et al., supra note 4, 13.03[l][b], and prop. regs. § 1.704-3(a)(2) provides that a partnership that does not maintain capital accounts under regs. § 1.704-1(b)(2)(iv) must maintain similar accounts to comply with § 704(c). this article follows that analytic tradition. 8. regs. § 1.704-1(b)(2)(iv)(])(4). 9. this article will generally apply the classical method of reconciling book-tax differences described in prop. regs. § 1.704-3(b). the other methods described in the proposed regulations attempt to mitigate the effect of the ceiling rule, the rule that permits a partnership, in taking into account book-tax differences, to use only an asset's actual tax attributes. for example, under the ceiling rule, the depreciation allocable to any partner with respect to an asset cannot exceed the total depreciation attributable to the asset. by a careful choice of examples, the article avoids considering the ceiling rule. [vol 1:9 partnership securities treats a partnership as a collection of assets and the acquisition of a partnership interest as the acquisition of an interest in those assets. the article's use of the "aggregate approach" is a simplification of the general use of the term to treat a partnership as a number of persons (partners) that own indirect interests in the partnership assets.'0 under the full-fledged aggregate approach, a new partner's receipt of a partnership interest is viewed in two steps: first, the new partner is deemed to acquire a portion of each continuing partner's undivided interest in partnership assets in exchange for a portion of the consideration provided by the new partner; second, the new partner is deemed to contribute its newly acquired interest in the partnership assets and the continuing partners are deemed to contribute the consideration they received from the new partner to the partnership. the article avoids this double deemed contribution to the partnership by treating the new partner's receipt of a partnership interest as a taxable acquisition of an undivided interest in the partnership assets from the partnership followed by the new partner's contribution of those assets to the partnership. the partnership is viewed as allocating any income it realizes on the deemed sale to the continuing partners. the results of the article's approach are substantially similar to the results of the full-fledged aggregate approach. for example, the gain recognized by the continuing partners is the same. similarities and differences in the effects of the two versions of the aggregate approach are discussed in footnotes." c. standard fact patterz in the examples that follow, unless otherwise specified, a and b are partners in partnership p. each has invested 100 in return for a 50% partnership interest, and the partnership has used the 200 to purchase an asset (the "asset"). c wishes to join p. at times, c will join immediately, prior to any property appreciation. at other times, c will do so after the asset has appreciated to 400. generally, there will have been no income, loss, depreciation or other tax consequences during the period the asset appreciates. after c's admission, the asset will be placed in service and will be depreciable over ten years. 10. for a discussion of the entity and aggregate approaches to partnerships, see mckee et al., supra note 4, 1.02; willis et al., supra note 4. § 4. 11. the article does not discuss the cases under the 1939 code, which held that, under an aggregate theory of partnerships, a partner could not realize services income from a partnership to the extent the partner was deemed to be paying himself. see, e.g.. commissioner v. moran, 236 f.2d 598 (8th cir. 1956). 19931 florida tax review mii. cash as consideration for partnership securities a. the receipt of a capital interest for cash after the asset has appreciated to 400, c contributes 44.44 to p in exchange for a 10% partnership interest. the consequences of c receiving a capital interest for cash are certain. neither the partnership nor any partner has gain, loss or other tax consequences." c's contribution is a revaluation event under regulations section 1.704-1(b)(2)(iv)(f). p's balance sheet after the revaluation and cash contribution would be: asset book tax partner book tax asset 400 200 a 200 100 cash 44.44 44.44 b 200 100 c 44.44 44.44 total 444.44 244.44 444.44 244.44 after c's admission, under section 704(c) principles, p's annual depreciation of 20 is allocable 4 to c, and 8 each to a and b. (in addition, if c's cash bought a new asset with a 10-year life, or made a capital improvement to the asset of 44.44, c would be entitled to annual depreciation of .444 and b and c each would be entitled to 2 of depreciation.) this result is the archetypal entity analysis. for purposes of comparison, the consequences of an aggregate approach might be noted. under that approach, c would be viewed as purchasing 10% of p's property from p for 10% of its value (40). p would recognize gain of 20 (amount 12. irc § 721. this generalization is subject to an important exception for partnerships that own § 751 assets, certain assets the sale of which would produce ordinary income. if a partnership is leveraged, the admission of a new partner may reduce each partner's share of the partnership's debt under the rules of regs. § 1.752 (regs. § 1.752-2 in the case of recourse debt; regs. § 1.752-3(a)(3) in the case of nonrecourse debt). the reduction in a partner's share of partnership debt is deemed to be a cash distribution from the partnership to that partner. irc § 752(b). to the extent an existing partner is deemed to receive that cash distribution in exchange for a new partner's receipt of an interest in the partnership's § 751 assets, the distribution is deemed a taxable exchange between the distributee partner and the partnership on which both the partnership and the partner may recognize gain or loss. irc § 751(b). this possibility may be an important disincentive against the granting of partnership options. in practice, the possibility that the admission of a new partner would cause a § 751 exchange is often ignored, sometimes on the basis of a provision in the partnership agreement that purports (with varying qualifications), on the admission of a new partner, to allocate potential ordinary income to the existing partners. [vol 1:9 partnership securities realized of 40 less allocable basis of 20) and allocate that gain equally, 10 each, to a and b. c would then be deemed to contribute the purchased property interests, together with 4.44 of cash, to p. p would hold the asset with a basis of 220 (180 for the initial 90% and 40 for the portion deemed contributed by c). p's balance sheet, after a regulations section 1.704l(b)(2)(iv)(f) revaluation, would be: asset book tax partner book tax asset 400 220 a 200 110 cash 44.44 44.44 b 200 110 c 44.44 44.44 total 444.44 266.44 444.44 266.44 after the transaction, under section 704(c), p's annual depreciation of 22 is allocable 4 to c and 9 each to a and b.' 3 the principal difference between an entity and aggegate approach is that under the aggregate approach existing partners a and b recognize gain. b. the receipt of a partnership option for cash c pays 4 for an option entitling c to acquire a 10% partnership interest for 25 (a small premium over current market value of 200). the 4 is placed in a non-interest bearing account. c exercises its option when the asset has appreciated to 400. 1. entity analysis.-the grant of an option is generally not a taxable event,14 so that p's grant of an option to c should have no tax consequences. it is tempting to treat p as having received 4 of tax exempt income, allocable 2 each to a and to b. in that case, a's and b's bases in their partnership interest and their capital account balances would each be increased to 102. this result has been suggested by the tax court.'5 however, because p's income is deferred rather than fully exempt, it is more 13. the results (including p's balance sheet and the § 704(c) implications) generally would be the same if a and b were viewed as directly selling undivided 10% interests in the asset to c. c would be viewed as paying 20 to each of a and b, each of whom would recognize 10 of gain. a and b would then each be deemed to contribute the 20 of cash they received from c to p, while c would be deemed to contribute its purchased asset (with a basis of 40) plus 4.44 of cash to p. 14. rev. rul. 58-234, 1958-1 c.b. 279. 15. helmer v. commissioner, 34 t.c.m. (cch) 727, 731 n.4. (1975). 19931 florida tax review appropriate that p's receipt of 4 from c be viewed as having no tax consequences. 6 c is not yet a partner and has no capital account. the analysis of c's exercise of the option is more difficult. when the asset is worth 400, c contributes 25 to p in exchange for a 10% interest in the partnership. immediately after c's exercise of its option, p's balance sheet, including its partners' capital accounts, should be revalued pursuant to regulations section 1.704-1 (b)(2)(iv)() to reflect the fair market value of the partnership's property. that property has a fair market value (taking into account the total of 29 contributed by c) of 429. the partners' business understanding requires that c be entitled to 10% of p's capital and have a capital account balance of 42.9, and that a and b should each have a capital account balance of 45% of 429 or 193.05. there are three routes by which a, b and c can reach their required capital account balances. first, c could be viewed as being the recipient of a taxable capital shift of 13.9 (its capital account of 42.9 over its actual contributions of 29). that would appear to be the least tenable interpretation as a taxpayer generally does not realize income on the exercise of a favorable option." second, c can be viewed as having contingently become a partner at the time it acquired its option, so that on c's exercise of its option and p's revaluation of its assets under regulations section 1.704-1(b)(2)(iv)(j(2), a and b are each entitled to 45% of the asset appreciation and c to 10% of that appreciation. a and b would then each have capital account balances of 190 and c a capital account balance of 49. to achieve the economically required capital account balances, there would have to be a capital shift of 6.1 from c to a and b, and a and b would each recognize income of 3.05. that position is more tenable. the 6.1 capital shift represents the premium paid by c for the privilege of allowing it to defer its decision as to whether to become a partner. third, c's aggregate contribution of 29 can be viewed as its acquisition of a 10% interest in a partnership with total assets of 290 (the asset valued at 261 and a total cash contribution of 29) and its becoming entitled to 10% of any subsequent appreciation. c's acquisition of a 10% interest in p when p's assets have a value of 290 corresponds to the following p balance sheet: 16. mckee et al., supra note 4, 6.02[3][a]. 17. this generalization follows from the rule that the option holder's basis in property acquired on the exercise of an option equals the amount paid for the property plus the amount paid for the option. rev. rul. 58-234, 58-1 c.b. 279, 286; realty sales co. v. commissioner, 10 b.t.a. 1217 (1928), acq., c.b. vii-2, 33 (1928). the rule does not apply to the exercise of options on § 1256 contracts. irc § 1234(c)(1). [vol 1:9 partnership securities asset book tax partner book tax asset 261 200 a 130.5 100 cash 29 29 b 130.5 100 c 29 29 total 290 229 290 229 under section 704(c) principles, p's annual depreciation of 20 is allocable 2.61 to c and 8.695 each to a and b. taking into account the asset's appreciation of 139 to 400 after c's deemed admission, p's balance sheet would be: asset book tax partner book tax asset 400 200 a 193.05 100 cash 29 29 b 193.05 100 c 42.9 29 total 429 229 429 229 the allocation of depreciation is unaffected. this final analysis, which results in no gain to a, b or c, seems preferable. it permits the treatment of options to acquire partnership interests to parallel the treatment of options to acquire corporate stock. in addition, it is consistent with a literal reading of section 721, which states: "no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership."' 8 c has received a partnership interest in exchange solely for two cash contributions. however, regulations section 1.721-1(b)(1) can be read to cause section 721 not to apply: normally, under local law, each partner is entitled to be repaid his contribution of money or other property to the partnership (at the value placed upon such property by the partnership at the time of the contribution) whether made at the formation of the partnership or subsequent thereto. to the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), section 721 does not apply.' 9 18. irc § 721(a). 19. regs. § 1.721-1(b)(1). 19931 florida tax review appreciation that has economically accrued prior to the admission of a new partner can be treated as the equivalent of a contribution of money or other property by the other partners,2" and p's transfer of a partnership interest to c can be viewed as the satisfaction of an obligation created by the option agreement. regulations section 1.721-1(b)(1) should not be read so expansively to cause any of a, b or c to recognize gain. causing c to recognize gain is, as noted above, inconsistent with the ordinary treatment of exercising favorable options. causing a and b to recognize gain on c's "bargain" contribution of cash for a partnership interest is not consistent with a and b not being required to recognize gain on c's contribution of full value for a partnership interest.21 2. aggregate analysis.-under the aggregate analysis, c is treated as paying p 4 for an option to acquire 10% of p's property. there are no tax consequences to a, b, c or p as a result of p's receipt of that payment. if c exercises its option to acquire 10% of p's property, c should be treated as paying 26.1 (and not 29) for 10% of the asset, because c's 29 contribution also entitles it to 10% of its 29 cash contribution. p would then recognize gain, measured by the excess of the amount realized (26.1) over the allocable basis of the property (20) or 6.1 and would allocate that gain 3.05 each to a and b. the gain corresponds to the possible capital shift to a and b discussed above. c would then be viewed as contributing the purchased 10% of the asset with a basis of 26.1 plus 2.9 of cash to c. p would have a stepped-up basis in the asset of 206.1. c's deemed contribution of property to p requires a revaluation of the partners' capital accounts. while the matter is not certain, the best analysis of the revaluation is the two-step analysis adopted above. first, c is deemed to exercise its option when p's total assets have a value of 290. at that time, p's balance sheet would be: asset book tax partner book tax asset 261 206.1 a 130.5 103.05 cash 29 29 b 130.5 103.05 c 29 29 total 290 235.1 290 235.1 20. the arguments for treating unrealized appreciation at the time of the admission of a new partner as the equivalent of the old partners' capital are summarized in willis et al., supra note 4, § 45.02. 21. if c does not exercise its option, p will recognize ordinary income of 4. rev. rul. 58-234, 1958-1 c.b. 279, 283. it will allocate that income equally between a and b, increasing their bases in their partnership interests and their capital account balances to 102 each. [vol. 1:9 partnership securities the remaining unrealized gain of 139 would be allocated 10% to c and 45% each to a and b resulting in the following p balance sheet: asset book tax partner book tax asset 400 206.1 a 193.05 103.5 cash 29 29 b 193.05 103.5 c 42.9 29 total 429 235.1 429 235.1 under section 704(c) principles, p's annual depreciation of 20.61 is allocable 2.61 to c and 9 each to a and b." 3. choice of characterization.-under the aggregate theory, a and b are required to recognize the gain inherent in 10% of the asset at a deemed valuation of 261. there seems to be no reason to require that income recognition. if c had, without prearrangement, contributed 29 to p for a 10% interest at a time when the asset had a value of 261, a and b would not be required to recognize income. the result should be no different if c receives its p interest as a result of exercising its option. while c's possession of an option has allowed c to acquire an interest worth more than 29, this accession to c's wealth does not seem a good reason to tax a and b. in addition, section 721 should apply to protect a and b from income recognition. 22. the results of the aggregate analysis differ if c is viewed as paying a and b 2 each for an option to acquire 10% of their interests in the asset. if c is viewed as acquiring an option against p, a's and b's capital account balances and bases in their p partnership interests are not increased until c either exercises its option or allows it to expire unexercised. if c pays 2 to a and b directly, a and b are treated as contributing 2 each to p. immediately increasing the capital account balances and the bases of their p interests. the total increase in a's and b's bases and capital account balances ultimately remains the same, 2. if c allows the option to lapse and 3.05 if c exercises the option. in the latter case, c would be deemed to purchase 10% of a's and b's interest in the asset for 13.05 each. 2 paid for the option and 11.05 paid on the exercise of the option. a and b would each realize 3.05 of gain. a and b would then be treated as contributing the 11.05 purchase price to p, and c as contributing the purchased interest (with a value of 40 and a basis of 26.1) as well as 2.9 of cash to p. the momentary difference in a's and b's bases may make a difference if p treats a's and b's early deemed contribution of 2 as a revaluation event or if a or b sell their interests prior to the lapse or exercise of c's option. these differences suggest that if an aggregate approach is to be used, c should be viewed as acquiring an option against p rather than against a and 1993] florida tax review c. the receipt of a profits interest for cash immediately after p's formation, c contributes 10 to p in exchange for a 10% profits interest. 1. entity analysis.-while c's contribution of cash for a partnership interest would appear to result in no gain or loss to a, b, c or p under a literal reading of section 721, regulations section 1.721-1 (b)(1) (quoted above in part iii.b. 1.) may cause section 721 not to be applicable. on an immediate p liquidation, a and b would each be entitled to 50% of all partnership capital, so that c has given up the right to be repaid its capital, but c did not give up its right to capital "as compensation for services (or in satisfaction of an obligation)." whether or not regulations section 1.72 1-1(b)(1) applies, treating c's contribution as tax-free does not appropriately reflect the shift of c's capital to a and b. there are two ways of justifying the shift of c's capital to a and b under an entity theory, neither of which is totally satisfactory. first, c could be treated as never becoming a partner, but as having purchased 10% of p's future income. the purchase would be treated as an effective assignment of future p income for consideration of the kind discussed in p. g. lake v. commissioner' and estate of stranahan v. commissioner.24 the effects of the assignment would be that (i) p would recognize the entire consideration it received as an ordinary income substitute for future income and would not be allowed to offset that income with any portion of its basis in its assets; (ii) in the future c (and not p) would recognize income with respect to the 10% of its income p had sold; and (iii) c would have a basis of 10 in its purchased right to receive 10% of p's income and, if it could demonstrate that the intangible right had a reasonably determinable life, would be able to amortize its basis of 10 over that life.5 thus, p would have 10 of ordinary 23. 356 u.s. 260 (1958). 24. 472 f.2d 867 (6th cir. 1973). 25. the classic article on assignment of income is charles s. lyon & james s. eustice, assignment of income: fruit and tree as irrigated by the p.g. lake case, 17 tax l. rev. 293 (1962). there is little authority as to how c should recover its basis in its profits interest. the most likely result is that c should amortize the basis over the expected life of the profits interest. see mckee et al., supra note 4, supp. i 5.08a[3]. because an income interest often does not have a determinable useful life, this result may require c to recognize income without basis offset until it realizes a capital loss on p's liquidation. it might appear fair to allow c basis recovery under an open transaction analysis on the theory that c's payment has accelerated p's income recognition so that c should receive 10 of tax-free "pre-taxed" income. castleberry, supra note 4, at 282, provides an ingenious justification of that approach based on associated patentees v. commissioner, 4 t.c. 979 (1945). however, there seems to be no authority for that approach. even when the open transaction doctrine was in greater favor, [vol 1:9 partnership securities income on that sale which it would allocate 5 each to a and b, increasing each of their capital account balances to 105. c would not have a capital account in p and would have a basis of 10 in its right to receive 10% of p's income. this solution solves the partnership accounting problems most simply and there is authority that the holder of a profits interests should not be treated as a partner.' that authority, however, is highly fact specific and arises primarily out of atypical, tax-motivated transactions. -7 while it may be appropriate to treat the holder of a profits interest as not being a partner in some circumstances, that cannot be correct as a general rule. a partner is a person that has "in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise." ' a holder of a profits interest may have manifested that intent: it might be recognized as a partner under state law, hold itself out as a partner to others and be a general partner liable for its share of partnership liabilities. it would typically file tax returns as a partner. in addition, the holder would have contributed capital used in the partnership's business (though it would have abandoned its claim to that capital) and would be vitally concerned with the partnership's profitability. any rule that a holder of a profits interest is never a partner also creates major administrative difficulties. in the typical partnership, all profits are not automatically distributed to the partners. if any profits are retained, the holder of a profits interest will accumulate a capital account. does that holder immediately become a partner on its obtaining a capital account, or must the capital account reach some minimum, non-de minimis level? based on the internal revenue service's ruling guidelines, a capital account equal to 1% of all partners' capital accounts would, at least in the case of a general profits interests were required to be amortized over their estimated life. latendresse v. commissioner, 26 t.c. 318 (1956), affd, 243 f.2d 577 (7th cir. 1957). more recently, the service has attempted to limit the open transaction doctrine to "rare and extraordinary cases." regs. § 15a.453-1(d)(2)(iii). 26. see mckee et al., supra note 4, 1 3.02[51 and authorities cited therein; willis et al., supra note 4, § 3.04. 27. typical transactions involve either attempts to shift income within a family, poggetto v. commissioner, 306 f.2d 76 (9th cir. 1962), or between a shareholder and his corporation, merryman v. commissioner, t.c. memo 1988-72 (cch) 1988, or attempts by the commissioner or a taxpayer to recharacterize transactions initially characterized in a different fashion, luna v. commissioner, 42 t.c. 1067 (1964) (assertion that agreement formed a partnership characterized by the court as an "afterthought") and connelly v. commissioner, 46 b.t.a. 222 (1942), acq., 1942-1 c.b. 4 (attempt by commissioner to recharacterize contractual rights). 28. commissioner v. culbertson, 337 u.s. 733, 742 (1949). 19931 florida tax review partner, be sufficiently large to guarantee partner status." major changes in tax result should not follow from relatively small changes in economic substance. this "cliff' effect can be avoided by treating c as a partner solely to the extent of its capital interest and as a holder of an assigned income interest as to the remainder of its interest. however, this approach is impractical. it would change (and substantially complicate) the anticipated tax treatment of numerous general partners that have a 1% capital investment, and "overrides" in the form of substantial profits interests. the second way of justifying the shift of c's capital to a and b under an entity theory would be to view c as receiving an initial capital account of 10 and then transferring its capital to a and b in a taxable transaction that requires a and b to recognize income of 5 and c to recognize a loss of 10. a's and b's income would give each a capital account balance of 105 and c's loss would give c a capital account balance of zero. this solution is simple and straightforward. there is also probably general agreement that a and b deserve their income recognition. c, however, is being permitted to expense the cost of purchasing an asset with a life that may substantially exceed one year. nonetheless, permitting that deduction is consistent with the traditional capital account analysis. any partnership with significant net losses could achieve substantially the same result by giving c an initial capital account of 10 and having the partnership agreement provide that c is allocated the first 10 of net losses and a and b are allocated the first 5 of net profits each. these allocations would almost certainly be respected and would, indeed, be mandated under the section 704(b) regulations, if c subordinated the return of its capital to a's and b's return of their capital.30 if p were not projected to have significant net losses, the same result could be achieved in most, if not all, cases by giving c its capital account balance and allocating c the first 10 of items of deduction. 2. aggregate analysis.-the aggregate analysis yields another less than totally satisfying option for dealing with the receipt of a profits interest for cash. c may be treated as purchasing a nonpartnership profits interest from p and recontributing that profits interest to p for a partnership profits interest. p would have income of 10 on the sale of that profits interest and would allocate that income equally to each of a and b, providing each with 29. rev. proc. 89-12, 1989-1 c.b. 789 (stating that the service will generally recognize a general partner with a 1% partnership interest as a partner). 30. the transaction could be bifurcated into c's receipt of a 5% capital interest for 10 and its receipt of a 5% profits interest as a fee for subordinating its capital to a's and b's capital and allocating the first 10 of net profits to a and b. such a bifurcation analysis would make the tax treatment of any but the simplest partnerships incomprehensible. [vol 1:9 partnership securities capital account balances of 105. c's contributed profits interest would be treated, for purposes of maintaining capital accounts and regulations section 1.704-1(b)(2)(iv)(b), as having a fair market value equal to its liquidation value of 0 (and a basis of 10). 3' in that event, p's balance sheet immediately after the contribution would be as follows: asset book tax partner book tax asset 200 200 a 105 105 prof. int. 0 10 b 105 105 cash 10 10 c 0 10 total 210 220 210 220 c would have contributed an asset with built-in loss, i.e., one whose basis exceeded its fair market value. under section 704(c), all amortization attributable to the asset would be allocated solely to c. c would thus be allocated 10% of p's income and would be allowed to offset against that allocation whatever amortization of its profits interest was appropriate. 2 this characterization produces the same correct tax results as the first entity option discussed above, but without the complications of not permitting c to be a partner. it has two related disadvantages-its treatment of fair market value is artificial and the combined tax bases of the asset and profits interest, exceeds the combined value of the asset and profits interest, raising the issue of whether the excess is properly depreciable.33 3. choice of characterization.-assuming that c is treated as a partner, the major difference between the entity and aggregate approach is whether c is allowed an immediate deduction for the cost of its profits interest or is required to amortize that interest over some appropriate life. both alternatives pose difficulties. the first requires stretching the capitalization rules to give c an immediate deduction; the second requires stretching the meaning of fair market value to treat an asset acquired for 10 as worth 31. treating fair market value as determined solely by liquidation value, while economically wrong, is implicit in both the test for substantial economic effect in the § 704(b) regulations and in the determination of responsibility for recourse debt under § 752. it is one example of the difficulties created by the capital account system not taking into account present value of money concepts. 32. the same results would follow if c were viewed as acquiring a 5% profits interest in the asset from a and b in exchange for 5 each. a and b would each recognize income of 5 and would be treated as each contributing 5 of cash to p. c would be treated as contributing its purchased profits interest. 33. see, e.g., pleasant summit land corp. v. commissioner, 863 f.2d 263 (3d cir. 1988); estate of franklin v. commissioner, 544 f.2d 1045 (9th cir. 1976). 19931 florida tax review 0. while the second view is more conservative and more likely to be adopted by the internal revenue service, the first is at least as tenable. iv. services as consideration for partnership securities a. the receipt of a capital interest for services after p's asset has appreciated to 400, c receives a 10% capital interest in p for services. there is a general consensus that receipt of a capital interest for services should be subject to an aggregate analysis. 4 because of that consensus, the aggregate analysis will be considered first. 1. aggregate analysis.-under section 83, c must recognize ordinary income and, subject to the capitalization rules, p is entitled to a deduction.35 in addition, p is deemed to distribute an undivided 10% interest in the asset to c in exchange for c's services and c is deemed to recontribute that 10% interest in exchange for a partnership interest. while it is often assumed that the value to be assigned the 10% interest for purposes of maintaining book capital accounts is 40,36 that amount does not appear correct if c's services must be capitalized. in that case, the value of p's asset should be increased by the value of the services. if c is to have a 10% interest in the asset as enhanced by its services, p's asset must be worth 444.44 and c's 10% interest must be worth 44.44.7 34. mckee et al., supra note 4, 5.08[2]; willis et al., supra note 4, §§ 45.08-.09; 1 j. bonn, taxation of partnerships § 4:63 (1987); proposal by individual members of committee on partnerships of section of taxation of american bar association to amend the regulations under the internal revenue code of 1986 to define a partnership interest, and to clarify the tax treatment of compensatory transfers of both forms of partnership interests, 87 tax notes today 91-24 (may 11, 1987). 35. regs. § 1.83-6(a)(1). 36. see mckee et al., supra note 4, 5.08[2][b], ex. 8. 37. c would be required to contribute 44.44 of cash to receive a 10% interest in a partnership with assets of 400 (10% = 44.44/444.44). that amount would be unchanged if p then used c's cash to purchase services that had to be capitalized from a third party. the amount should remain unchanged if c, instead of providing cash to pay for the services, provides the services. it also should not matter whether the asset created by c's services is a tangible asset, an intangible asset (such as syndication costs), or whether c will perform its services in the future (in which case the created asset is prepaid services). note that the issue here is not whether c's services are "really" worth 40 or 44.44 in some abstract sense, but the amount to be assigned c's services for book capital account purposes so that p's books are logically consistent. that amount is related to "real" value because of the rule that a partner's opening capital account balance should reflect the value of the partner's contribution to the [vol 1:9 partnership securities if c performs services with a value of 44.44 and is paid with a 10% interest in the asset, which it contributes to p, (a) the asset's value is increased by 44.44 to 444.44 and the tax basis of the asset is increased by 44.44 (p's section 83 deduction, which it was required to capitalize) to 244.44; (b) c has ordinary income of 44.44; and (c) p has gain of 20 (amount realized of 44.44 less allocable basis of 24.44') on satisfying its liability with appreciated property, which it allocates 10 each to a and b. this increases their book and tax capital account balances and the bases of their p interests to 110. c, which holds its 10% interest with a book and tax basis of 44.44, is then treated as contributing the 10% interest in the asset to p. after the contribution, p's total basis in the asset is 264.44 (initial basis of 200, asset created by services of 44.44 and step-up of 20 corresponding to the gain recognized by b and c). p's balance sheet, after the regulations section 1.704-1(b)(2)(iv)(f) revaluation (permitted because of c's deemed contribution to p) is: asset book tax partner book tax asset 444.44 264.44 a 200 110 b 200 110 c 44.44 44.44 total 444.44 264.44 444.44 264.44 under section 704(c) principles, p's annual depreciation of 26.44 is allocable 4.44 to c and 11 each to a and b.39 if payment for c's services can be deducted currently, the simplest approach is to view the services as momentarily increasing the value and tax basis of the asset, with that increase being immediately offset by a deduction. partnership and because p's continuing partners have implicitly valued c's services in agreeing to the percentage interest in p to which c is entitled. 38. if the value of the distributed 10% interest is 44.44, the interest must be the post-services interest, so that its basis is the post-services basis of 24.44. 39. the result is the same if the aggregate approach is applied to a and b. though the path is somewhat more tortuous. c is treated as transferring a 45% interest in its services (worth 20) to a and b in exchange for a 10% interest in their 45% share of the asset (also worth 20, taking into account the asset's enhancement by c's services). a and b would each recognize 10 of gain. a and b would then each be deemed to hold an interest in c's services with a basis of 20 and to contribute c's services to p (with a and b thus increasing the bases of their partnership interest by 10 and p increasing the basis of its assets by a total of 20). c would be deemed to contribute its newly acquired 10% interest in the asset together with a 10% interest in its services for a 10% interest in p. c's contribution of 10% of its services should be viewed under the entity approach, with c being allocated 4.44 of income and receiving a 4.44 basis in its services and p holding the services with the same 4.44 basis. after these contributions, p would have a total basis of 264.44 in the asset 19931 florida tax review in that case, the analysis immediately above would be applicable, except that p would be entitled to a 44.44 deduction, which it would allocate 45% each to a and b and 10% to c. this would result in the following p balance sheet: asset book tax partner book tax asset 400 220 a 180 90 b 180 90 c 40 40 total 400 220 400 22040 this analysis probably produces the same balance sheet as the more traditional analysis in which the value of c's services is treated as being 40, c recognizes 40 of income, and p realizes a deduction that it allocates solely to a and b.4' 40. the transaction is analogous to a transaction, using a circular flow of cash, consisting of the following steps: (i) the asset initially has a value of 400 and a basis of 200; a and b have capital account balances and bases in their p partnership interests of 100. (ii) c performs services worth 44.44 for a promise to be paid 44.44 of cash. the asset's value increases to 444.44 and its tax and book basis increases to 244.44. there is no change to a's and b's capital account balances and bases in their p interests. (iii) c purchases a 10% interest in the asset for 44.44 cash. p owns 90% of the asset with a value of 400 and a basis of 220 and 44.44 of cash. p recognizes 20 of tax and book gain on the sale, which it allocates 10 each to a and b. a's and b's capital account balances and their bases in their p interests are increased to 110. (iv) p pays c for its services with the 44.44 of cash. (v) c contributes its 10% of the asset (with a value and basis of 44.44) to p for a 10% interest. p owns 100% of the asset with a value of 444.44 and a basis of 264.44. c has a capital account balance and a basis in its p interest of 44.44. p revalues its pre-contribution property, its 90% interest in the asset. that 90% interest has a value of 400 (90% of 444.44) and a book basis of 220 (90% of 244.44) so that p has 180 of unrealized gain on a deemed sale, which, if realized, would be allocated 90 each to a and b. under regs. § 1.704l(b)(2)(iv)(t(2), a's and b's book capital account balances are increased to 200. their tax capital account balances remain 110. (vi) p is allowed a deduction of 44.44, which it allocates 4.44 to c and 20 each to a and b. c's capital account balance and its basis in its p interest are reduced to 40. a's and b's book capital account balances are reduced to 180 and the bases of their p interests and their tax capital account balances are reduced to 90. 41. while the p balance sheets may be identical, the tax effect to c may not be. under the analysis in the text, c has 44.44 of compensation income and a deduction of 4.44; under the traditional analysis, c has 40 of compensation income. the results would differ if, for example, c's deduction were treated as a passive loss. [vol 1:9 partnership securities 2. entity analysis.-section 83 would also apply under an entity analysis, but c's receipt of a 10% capital interest would be accounted for solely by c's recognition of income and p's corresponding recognition of a deduction, and a and b would not be required to recognize income. for the entity analysis to be tenable, c's services must be viewed, if they are not currently deductible, as increasing the value of the asset to 444.44 and the asset's tax basis to 244.44. p, having paid c for services (which c has taken into income), should be entitled to a cost basis in the services. if c had contributed cash and p bought capitalizable services from a third party, p would be entitled to the additional basis. similarly, if c had received the property created by its services in exchange for services performed for a third party and contributed the property to p, c and p would have tax basis in the property. by contrast, if c had performed services on its own behalf, created property and contributed the property, c, and consequently, p, would have a zero basis in the property, but c would not have any income4 2 c's performance of services in exchange for a capital interest should be treated as a contribution of the services, permitting a revaluation under regulations section 1.704-1(b)(2)(iv)() and triggering the applicability of section 704(c). if p's payment for c's services is capitalized, p's balance sheet would be: asset book tax partner book tax asset 444.44 244.44 a 200 100 b 200 100 c 44.44 44.44 total 444.44 244.44 444.44 244.44 under section 704(c) principles, p's annual depreciation of 24.44 is allocable 4.44 to c and 10 each to a and b. if p is entitled to deduct its payment to c for services, the deduction should be allocated 10% to c and 45% to each of a and b. p's balance sheet would be: 42. thus, if c had a contract right that had risen to the level of property, irc § 721 would apply to protect c from income or gain. see stafford v. united states. 435 f. supp. 1036 (m.d. ga. 1977), rev'd and remanded, 611 f.2d 990 (5th cir. 1980), modified. 552 f. supp. 311 (m.d. ga. 1982), rev'd and remanded, 727 f.2d 1043 (11 th cir. 1984). however, p and c would have a zero basis in the contract right. 1993] florida tax review asset book tax partner book tax asset 400 200 a 180 80 b 180 80 c 40 40 total 400 200 400 200 under section 704(c) principles, p's annual depreciation of 20 is allocable 4 to c and 8 each to a and b. 3. choice of characterization.-the entity approach has merit: it is simple, its results are consistent with the effect of a partner acquiring an interest for a cash contribution that the partnership uses to purchase services or of a stockholder acquiring stock for services, and the statutory requirement of section 83 that the service provider recognize ordinary income and the service recipient be allowed a deduction is met. the principal justification43 for adopting the aggregate approach is that it causes p (or a and b) to recognize gain as a result of its transfer of property to c as mandated by regulations section 1.83-6(b): except as provided in section 1032, at the time of a transfer of property in connection with the performance of services the transferor recognizes gain to the extent that the transferor receives an amount that exceeds the transferor's basis in the property. in addition, at the time a deduction is allowed under section 83(h) and paragraph (a) of this section, gain or loss is recognized to the extent of the difference between (i) the sum of the amount paid plus the amount allowed as a deduction under section 83(h) and (ii) the sum of the taxpayer's basis in the property plus any amount recognized pursuant to the previous sentence. the regulations' reference to section 1032 explicitly exempts a corporation's issuances of its own stock for services from gain recognition. the lack of any reference to partnership provisions can be read as intentionally requiring partnerships to recognize gain. 44 43. the arguments for the aggregate approach discussed here are summarized in mckee et al., supra note 4, 1 5.08[2][b]. 44. one cannot assume that the explicit reference to § 1032 requires that a transferor recognize gain in any transaction that does not literally satisfy § 1032. if a subsidiary issues parent stock for services, under regs. § 1.83-6(d), the parent is viewed as contributing its stock to the subsidiary and the subsidiary as transferring the stock to its employee. the subsidiary arguably has a zero basis in its parent stock and the transfer by the subsidiary of parent stock [vol 1:9 partnership securities as a practical matter, the consensus that regulations section 1.83-6(b) requires a partnership transferring a capital interest for services to recognize gain (as it does under an aggregate approach) means that adopting an entity approach raises a substantial risk of internal revenue service challenge. however, it is not clear that the regulation actually requires gain recognition. the regulation applies to an actual transfer of appreciated property for services. in the case of deemed transfers, the regulation is silent as to what property should be deemed transferred. under the most literal reading, in the case of the transfer of a capital interest for services, the property transferred by the partnership is a partnership interest. by analogy to the treatment of corporate stock, it can be argued that a partnership has a zero basis in its own interest. the partnership should then be required to recognize gain equal to the total value of the services. that reading seems unusually harsh and leaves unclear how the partnership's gain should be reflected in the bases of the partnership's assets.45 if the literal reading is abandoned, it seems as reasonable to view a partnership as transferring cash for services as to view it as transferring an interest in some or all of its assets. a partnership viewed as transferring cash would not need to recognize gain. p, a and b would not recognize gain if p borrowed money to pay service provider c and then repaid its borrowing by obtaining a cash contribution from unrelated new partner d. p, a and b are in the identical economic situation if c and d are the same person and a circular flow of cash is avoided. other arguments advanced for a and b recognizing gain are also not determinative. the statement in regulations section 1.721-1(b)(1) that section 721 does not apply to the extent "any of the partners gives up any part of his right to be repaid his contributions ... in favor of another partner as compensation for services" can be read to require no more than that the service provider be taxable on its receipt of a partnership interest. indeed, the next sentence in the regulation explicitly states that the value of the interest transferred as compensation is income under section 61 .6 regulations section 1.721 -1 (b)(2) provides that to the extent the value of a partnership interest is compensation for services, the payment is to be does not come under section 1032. under a literal reading of rcgs. § 1.83-6(b), the subsidiary should recognize gain. however, without discussion, the service ruled that "[blecause section 83 applies to the transfer of the p [parent] stock to b [service provider], s [the subsidiaryl does not recognize gain or loss on the transfer of the p stock." rev. rul. 80-76. 1980-1 c.b. 15. 45. see mckee et al., supra note 4, 5.01-.10 (causing p to recognize gain measured by the value of the partnership interest transferred to the service provider would cause a discrepancy between the partners' outside bases and the bases of the assets in the partnership). see also 1 william s. mckee et al., federal taxation of partnerships and partners 5.03[1][c] (1st ed. 1977). 46. regs. § 1.721-1(b)(1). 19931 florida tax review treated as a guaranteed payment for services under section 707(c). while it is generally true that the transfer by a partnership of appreciated property in satisfaction of a guaranteed payment would cause the partnership to recognize gain, that truism begs the question of what property is to be deemed transferred as compensation for services. finally, it has been argued that a partnership's failure to recognize gain on a transfer of a capital interest for services would leave the partnership with inadequate basis in its assets and would expose the service recipient to double taxation on the value of its services. under the entity theory, the service recipient is in the same position as a person that has contributed cash to a partnership holding appreciated assets in exchange for a partnership interest and is equally eligible for the relief granted by section 704(c) principles. while the adequacy of that relief has historically been limited by the "ceiling rule," that limitation has been alleviated by proposed regulations section 1.704-3. in any event, there is no need for being more solicitous of the ongoing taxation of a person that recognizes income on becoming a partner in exchange for service than of a person that becomes a partner upon making a cash contribution, one that presumably is made with after-tax dollars. b. the receipt of a partnership option for services c, in exchange for services, receives an option entitling c to acquire a 10% partnership interest for 25. c exercises that option in two years, when the asset has appreciated to 400. assuming, as is generally true, that a p option does not have a readily ascertainable value within the meaning of regulations section 1.83-7(b), p's grant of an option to c has no tax effect to any of p, c, a or b. the effect of exercising the option depends on whether an aggregate or entity analysis rule is adopted. the consensus would be to adopt an entity view of c's acquisition of an interest for a 25 cash contribution and an aggregate view of the compensatory portion of the acquisition.47 1. consensus view-hybridanalysis.--on c's exercise of its option, c recognizes ordinary income equal to the excess of the value of the interest received over its purchase price for the interest and, subject to the capitalization rules, p has a corresponding deduction.48 assuming that the value of c's services has been included in the asset's appreciation to 400, the asset's 47. mckee et al., supra note 4, 5.08[2][b]. 48. regs. § 1.83-7(a). [vol 1:9 partnership securities pre-services value was 382.5. after the services are taken into account, p has assets of 425 and c's interest has a value of 42.5.4' thus c's income and p's deduction each equal 17.50. c is deemed to receive 25/42.5 of its interest for cash in a tax-free transaction and to receive 17.5/42.5 of its interest for services in a transaction in which p is to recognize gain. the portion of c's interest in p attributable to services (17.5/42.5 x 10% = 4.12%) represents a 4.12% interest in the asset and a 4.12% interest in p's cash of 25. c is deemed to have had distributed to it a 4.12% interest in the asset with a fair market value of 16.47 and a basis to p, taking into account the 17.50 increase in basis resulting from c's services,5" of 8.96. p recognizes 7.5 of gain, half of which is allocable to each of a and b. c is deemed to contribute its 4.12% of the asset (with a basis and value of 16.47) to p. that contribution increases p's basis in the asset to 225. p's balance sheet would be: asset book tax partner book tax asset 400 225 a 191.25 103.75 cash 25 25 b 191.25 103.75 c 42.5 42.5 total 425 250 425 250 under section 704(c) principles, p's annual depreciation of 22.5 is allocable 4 to c and 9.25 each to a and b. if p can deduct the value of c's services and the asset is to have a value of 400 after the deduction, the asset can be viewed as being initially worth 400 (not 382.5), having its book value increased by c's service and then decreased by the deduction. in that case, p's total assets (prior to taking account the deductibility of c's services) have a value of 444.44, c's 10% interest has a value of 44.44, c's services have a value of 19.44 and the asset has a value of 419.44 and a basis of 219.44. c has acquired 25/44.44 of its interest for its cash contribution and 19.44/44.44 (43.74%) of its interest for services. thus c has acquired 4.37% of the asset, with a value of 18.35 49. this assumption, which is economically realistic because c's services have taken place in the past, makes this example not strictly comparable to the examples above in which the initial value of the asset is 400. if the initial value of the asset is 400 and c's capitalized services increase its value, p would have total assets of 444.44, an asset of 419.44. and cash of 25, and c's services would be worth 19.44. 50. although there is no reason to believe that c's services resulted in precisely a 17.50 increase in the value of the asset, p implicitly bought c's services at a contingent price that varies with the value of a 10% interest in p at the time of c's exercise of its option. to the extent the services created a capital asset, its basis to p should be its cost to p. 1993] florida tax review and a basis to p of 9.6. p has gain of 8.75, which it allocates equally to a and b. p's balance sheet would be: book 419.44 25 tax 228.19 25 444.44 253.19 partner book tax a 200 104.375 b 200 104.375 c 44.44 44.44 444.44 253.19 after deducting the 19.44 value of c's services, the balance sheet would be: asset asset cash total book 400 25 425 tax 208.75 25 233.75 partner a b c book 191.25 191.25 42.5 425 tax 95.625 95.625 42.5 233.75 under section 704(c) principles, p's annual depreciation of 20.875 is allocable 4 to c and 8.4375 each to a and b. p's balance sheet differs somewhat from the balance sheet that would result under the traditional analysis in which c's services have a value of 17.5, c recognizes 17.5 of income and p has a deduction of 17.5 that is allocable solely to a and b. under that analysis, the percentage of its interest that c acquired for services would differ, i.e., it would be 17.5/217.5 or 4.12%, and that difference would cause the gain recognized by a and b to also differ. 2. entity analysis.-if p must capitalize its payment to c for services and if the post-services value of the asset is 400, the pre-services value of the asset must be 382.5. on c's exercise of its option, c recognizes ordinary income of 17.5 and p increases the basis of the asset to 217.5. p's balance sheet would be: asset asset cash total book 400 25 tax 217.5 25 242.5 partner a b book 191.25 191.25 42.5 425 tax 100 100 42.5 242.5 under section 704(c) principles, p's annual depreciation of 21.75 is allocable 4 to c and 8.875 to each of a and b. if p deducts its payment to c for services and if the post-deduction value of the asset is 400, the pre-deduction value of the asset must have asset asset cash total [vol 1:9 partnership securities been 419.44. p's balance sheet, not taking into account the 19.44 deduction, would be: book 419.44 25 tax 219.44 25 partner a b 444.44 244.44 book tax 200 100 200 100 44.44 44.44 444.44 244.44 the 19.44 deduction should be allocated 10% to c and 45% each to a and b. p's balance sheet would be: asset asset cash total book 400 25 tax 200 25 partner a b book 191.25 191.25 42.5 425 tax 91.25 91.25 42.5 225 under section 704(c) principles, p's annual depreciation of 20 is allocable 4 to c and 8 to each of a and b. 51 3. choice of characterization.-the principal difference between the hybrid and the entity characterization is whether p (or b and c) is to be deemed to recognize income on p's payment for c's services. these issues are discussed in part i.b.3. and part iv.a.3. above. it is sufficient to note here that the analysis of the entity characterization is substantially more straightforward. c. the receipt of a profits interest for senices c receives a 10% profits interest, with a fair market value of 10, for services. 1. revenue procedure 93-27.-the treatment of the receipt of a profits interest for services has been substantially simplified by the internal revenue service's issuance of revenue procedure 93-27, which provides that if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner 51. because the aggregate analysis is unlikely to be applied to c's purchase of a portion of its interest for a contribution of 25, that possibility is not discussed. asset asset cash total 19931 florida tax review capacity or in anticipation of becoming a partner, the internal revenue service will not treat the receipt of such an interest as a taxable event for the partner or the partnership.52 if the revenue procedure applies, a service partner's receipt of a profits interest is not a taxable event to the partner or the partnership. the revenue procedure is subject to two implicit and three explicit exceptions, which if interpreted broadly would reintroduce the uncertainties the revenue procedure was intended to cure. first, the partner receiving a profits interest must provide service in "a partner capacity or in anticipation of becoming a partner., 53 this requirement will often be straightforward, but may cause difficulties. for example, a developer, investment banker or other employer may give key employees profit interests in partnerships in which the employer is a partner and for which the key employees perform services. it would be artificial to require that the employees enter into separate service agreements with the partnerships and administratively difficult to monitor the precise amount of work the employee performs on behalf of any specific partnership. alternatively, an individual service provider may act as a general partner through an s corporation and hold her profits interests directly or, for estate planning reasons, have some of the profits interests held by members of her family. the internal revenue service could (but probably should not) insist that the s corporation is the only service provider and that either (i) all affiliated holders of profits interests should be taxable on receipt of their interests or (ii) the s corporation received all the profits interests and distributed them to its stockholder and her family in a dividend that triggered gain under section 311. second, the profits interest must qualify as such. a profits interest is defined as a partnership interest other than a capital interest.54 a capital interest is an interest that would give the holder a share of proceeds if the partnership's assets were sold at their fair market value and the proceeds distributed in a complete liquidation of the partnership.55 that definition can be interpreted to cause a cliff effect. if the partners agree that the service partner is to receive a share of asset appreciation in excess of a fixed amount intended to represent the asset's current value, but their estimate of current value is deemed by the internal revenue service or a court to be one dollar too low, the service partner would be entitled to a share of the one dollar on an immediate liquidation of the partnership. the entire value of the interest 52. 1993-24 i.r.b. 63 (july 6) at § 4.01. 53. id. § 4.01-.02. 54. id. § 2.02. 55. id. § 2.01. [vol 1:9 partnership securities would then, arguably, be includable in its income. it would be better to interpret the rule by bifurcating the service provider's interest into that capital interest that would be owned by a person entitled to the same liquidating distribution as the service holder and to treat the remaining interest as a profits interest. the revenue procedure does not state whether the valuation of the partnership assets should take into account the increase in their value attributable to the services being rendered by the recipient of the profits interest. thus, it is not clear whether a profits interest granted upon the formation of a partnership entitling a service partner to a portion of the partnership's capital after the other partners have been returned their capital qualifies under the revenue procedure if the partner's services are not immediately deductible. the practical approach would be to ignore the effect of the services on value and to allow the service partner to share in the appreciation that its own services creates. third, the revenue procedure does not apply if "the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a highquality net lease. 56 that exclusion is probably based on the theory that a predictable stream of income alleviates valuation problems. it is not clear whether the exclusion is intended to apply if, as is common, a portion of the income stream is predictable. for example, a partnership may own debt securities of varying quality that have an average yield of 9% and in which the general partner is entitled to 20% of the profits after all partners have received a return on capital of 7%. the 7% return may be a market return which is less than the 9% return on individual loans because the partnership's having assembled a diversified portfolio of loans has reduced credit risk. the general partner expects that most of his 20% return will reflect his (unpredictable) skill in trading the securities, but he has also "locked in" a share of the 2% strip. the exclusion should not apply in this situation. fourth, the revenue procedure does not apply if "within two years of receipt, the partner disposes of the profits interest."' this exclusion is probably based on the facts of diamond v. commissioner," and prevents the use of the partnership form to transform ordinary income into capital gains. because the reclassification of the receipt of a profits interest as a taxable event may cause a partnership and nonrecipient partners to recognize gain, this exclusion raises the administrative problem of the action of the service recipient having consequences to unrelated parties. rather than 56. id. § 4.02. 57. id. § 4.02(2). 58. 56 t.c. 530 (1971), aff'd, 492 f.2d 286 (7th cir. 1974). 1993] florida tax review recharacterizing the transaction in which the service partner received its interest, it would be simpler to provide that any gain realized by the recipient on its sale of a partnership interest within two years is ordinary income. finally, the revenue procedure does not apply if the interest received is "a limited partnership interest in a 'publicly traded partnership"' 59 within the meaning of section 7704(b). this exclusion may be based on the theory that interests in publicly traded partnerships are readily valued and easily traded. if so, the exclusion should be limited to publicly traded interests in publicly traded partnerships. the publicly traded interests would generally be capital interests. in campbell v. commissioner,' the eighth circuit held that the receipt of a profits interest in a partnership was not taxable in large part because that interest was not readily susceptible to valuation even though there were arm's length transactions that established the value of a capital interest in that partnership. 2. general principles-consensus aggregate view.-if the revenue procedure does not apply, the tax consequences of a partner's receipt of a profits interest for services must be determined under general principles. though the revenue procedure may create a negative implication that any receipt of a profits interests excluded from the application of the revenue procedure is taxable, it can be argued with equal plausibility that the internal revenue service simply did not reach those situations. thus, all the customary arguments for the receipt of a profits interest not being taxable remain available.6' the consensus is that the aggregate analysis should apply.62 under that analysis, assuming c is treated as a partner for the reasons discussed above under part iii.b.i.,63 section 83 applies to c's receipt of a profits interest for services. c would have 10 of income and p would have a corresponding deduction, subject to capitalization. in addition, p would be treated as distributing a profits interest in the asset to c in payment for c's services and c would be viewed as contributing that profits interest to p for a partnership profits interest. p would have 10 of income on it sale of its profits interest, which it would allocate 5 each to a and b.' 59. rev. proc. 93-27, 1993-24 i.r.b. 63 (july 6) at § 4.02(3). 60. 943 f.2d 815 (8th cir. 1991). 61. the arguments for exemption are summarized in hortenstine & ford, supra note 4, at 899-900, mckee et al., supra note 4, supp. 5.02[1][c] and willis et al., supra note 4, § 46.03-.04. 62. see horntenstine & ford, supra note 4, at 899-900; mckee et al., supra note 4, supp. 5.02[1][c]; willis et al., supra note 4, 46.03-.04. 63. if c's interest is not vested, assume that c has made a § 83(b) election. 64. mckee et al., supra note 4, supp. i 5.08a[2], ex. 8.2. [vol. 1:9 partnership securities if c's services are not currently deductible, p's assets would have an increased total fair market value (and book basis) of 210. while economically, the asset stripped of the profits interest has a value of 200 and the profits interest has a value of 10, on a liquidation basis, the asset has a value of 210 and the profits interest a value of 0.65 p's balance sheet would be: asset book tax partner book tax asset 210 210 a 105 105 prof. int. 0 10 b 105 105 c 0 10 total 210 220 210 220 under section 704(c) principles, c would be entitled to amortize the profits interest over its life and a and b would be entitled to all the depreciation on the asset. in summary, under the aggregate analysis, if p could not currently deduct its payment to c, each of a, b, and c would recognize gain or income, with c's income being offset by its amortization of its profits interest and a's and b's gain being offset by additional depreciation deductions attributable to the asset. if p can currently deduct its payment to c, that deduction would reduce the book and tax basis of the asset and should, therefore, be allocated solely to a and b, offsetting their income recognition. p's balance sheet would be as follows: asset book tax partner book tax asset 200 200 a 100 100 prof. int. 0 10 b 100 100 c 0 10 total 200 210 200 210 3. general principles-entihy analysis.-under the entity analysis, section 83 applies to c's receipt of a profits interest in p, with c recognizing income of 10 and p being entitled to a corresponding deduction, subject to capitalization. if c's services are capitalized, these services increase the asset's value and basis by 10. on a sale of the asset for its 210 value, a and 65. this analysis assumes that c does not share in the increase of value caused by c's services. in practice, the increase in value attributable to c's services may not be considered in the partners' definition of the point at which c begins to participate in profits, so that c effectively does share in the appreciation attributable to its services. in that case, on a sale of the asset for 210, a and b should each be entitled to 104.5 and c to 1; the asset should have a book basis of 109 and the profits interest a book basis of 1. 19931 florida tax review b would each be entitled to 105 and c would be entitled to 0. thus, a and b should have book capital account balances of 105. the increase in a's and b's capital account balances can be treated in a manner analogous to the treatment of c's acquisition of a profits interest for cash in part iii.c. 1. c can be viewed as contributing services with a value and a basis of 10, receiving a positive capital account balance of 10 and then transferring that positive capital account balance to a and b in a taxable transaction in which a and b recognize income and c is entitled to a loss. on that analysis, p's balance sheet, before taking into account p's deduction for its payment for c's services, is: asset book tax partner book tax asset 210 210 a 105 105 b 105 105 c 0 0 total 210 210 210 210 c's deduction would offset its section 83 income of 10. under section 704(c) principles, all depreciation attributable to the asset would be allocated solely to a and b. this result is somewhat anomalous in that the net effect of treating c's receipt of a profits interest as taxable is to tax not c but a and b. taxing a and b, however, reflects the increase in their book capital accounts caused by c's services.' if p can deduct its payment to c currently, the deduction should be allocated to a and b, the only persons with positive capital account balances. the resulting p balance sheet would be: 66. an alternate method of accounting for a's and b's increased book bases is to treat c as having contributed services with a book value, based on liquidation value, of 0 and a tax basis of 10. that contribution entitles p to revalue its assets. on the revaluation, a and b are allocated the asset's unrealized appreciation. that allocation is not a taxable event, so that a's and b's tax bases are not affected. p's balance sheet would then be: asset book tax partner book tax asset 210 200 a 105 100 services 0 10 b 105 100 c 0 10 total 210 210 210 210 under § 704(c) principles, deductions attributable to the amortization of the tax basis of the services would be allocated to c. if the services enhanced the asset, it would be reasonable to amortize the basis of the services over the asset's depreciation schedule. this is artificial, but defers any tax to a and b. [vol 1:9 partnership securities asset book tax partner book tax asset 200 200 a 100 100 b 100 100 c 0 0 total 200 200 200 200 the result is identical to treating p's transfer of a profits interest to c as not being a taxable event-none of a, b, c or p has income recognition.67 4. choice of characterization.-the issues in choosing between an entity or aggregate analysis are essentially similar to those discussed in part iii.c. above. if c's services must be capitalized, although neither an entity or an aggregate analysis is totally satisfactory, the two analyses are equally tenable. if c's services may be deducted, an entity analysis has the advantage of being equivalent to treating c's receipt of a partnership interest as not being a taxable event, the result that applies under revenue procedure 93-27. v. conclusion the consequences of issuing partnership securities are less clear and less well understood than the consequences of issuing corporate securities. the discussion above amply demonstrates that these issuances are open to multiple interpretations with substantially different results. the lack of clarity as to the effects of issuing partnership securities is especially troubling because issuance of these securities may create adverse tax consequences to both the recipient and the other partners. the possibility of triggering untoward tax results may impede reasonably straightforward business transactions. authoritative advice would be helpful, whatever the substantive content of that advice. there is no advantage to the internal revenue service in maintaining uncertainty. in the case of abusive transactions, uncertainty can discourage the abuse through an in terrorem effect, but there is nothing intrinsically abusive in partnerships' issuing securities for either cash or services and no need to discourage these issuances. uncertainty also minimizes tax revenue; taxpayers are unlikely to follow a less than certain path (whatever its theoretical merits) that will maximize taxes. as a substantive matter, it would appear that the better view would be to adopt the entity theory. generally, while partnerships represent an 67. if the analysis in footnote 66 is followed, the deduction for p's services should be allocated to c. the resulting balance sheet would be the same as that above and none of a, b, c, and p would recognize income. on allocating p's deduction so as to offset all income to p's partners, see martin b. cowan, receipt of an interest in partnership profits in consideration for services: the diamond case, 27 tax l. rev. 161. 174-78 (1972). 19931 florida tax review amalgam of the aggregate and entity theories, the entity theory predominates unless there is a affirmative reason to adopt the aggregate theory.63 as discussed in detail above, the entity theory provides reasonable results in all cases. further, under the entity theory, the consequences of issuing partnership securities resemble the consequences of issuing corporate securities in more cases than under the aggregate theory. 69 such resemblance is advantageous, partially because it simplifies the tax law, and more importantly, because laymen's expectations as to the effect of issuing securities are set by the corporate model. to the extent that tax consequences follow lay expectations, business transactions proceed more smoothly and tax compliance is facilitated. clearly, lay expectations cannot determine the substantive content of tax law. equally clearly, defeating lay expectations imposes substantial transaction costs-the costs of educating laymen as to the requirements of substantive law and the greater costs of restructuring business understandings so as to minimize potential tax problems. the costs are multiplied where, as here, the correct, "sophisticated" treatment is so uncertain. if straying from the corporate model is costly, the corporate model should be followed unless there is an affirmative technical reason not to do so. there is such a reason in the case of the acquisition of a profits interest for cash. under the capital account system, a partner cannot avoid taxation if cash is credited to its capital account. the consensus that the receipt of a capital interest for services should be subject to an aggregate analysis does not appear to be based on equivalently strong reasons. it is not technically inevitable and is particularly counterintuitive. businessmen understand that the recipient of property may be required to recognize income and that the payor of property may be entitled to a deduction; they even understand that the deduction may be capitalized. they less readily understand why, as the aggregate analysis requires, "innocent" partners should recognize income. the consensus view should be reconsidered. abandoning it should not mean foregoing substantial revenue. it is likely that most taxpayers ignore the consensus position altogether, while the well advised structure their transactions so as to avoid it. 68. willis et al., supra note 4, § 4.04. 69. the consequences of issuing partnership securities under an entity theory differ from those of issuing corporate securities in the case of the issuance of a profits interest for cash or, to the extent not covered by rev. proc. 93-27, services. [vol 1:9 florida tax review florida tax review volume 20 2016 number 2 article international tax reform by means of corporate integration bret wells florida tax review volume 20 2016 number 2 information for subscribers the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. for volume 20, the subscription rate is $125.00 in the united states and $145.00 elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. for volume 20, subscriptions and changes of address should be sent to florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. beginning with volume 21, the florida tax review will be published by the university of florida press on behalf of the graduate tax program of the university of florida levin college of law. for subscription information and queries relating to volume 21 and subsequent volumes, please contact the johns hopkins university press, p.o. box 19966, baltimore, md 21211; phone 1-800-548-1784; jrnlcirc@press.jhu.edu. all correspondence of a business nature, including advertising, should be addressed to the university of florida press, 15 nw 15th st., gainesville, fl 32603; phone 352-392-1351; http://upress.ufl.edu. florida tax review volume 20 2016 number 2 editor-in-chief charlene luke professor of law university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar dennis a. calfee professor of law patricia e. dilley professor emeritus michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law martin j. mcmahon, jr. james j. freeland eminent scholar adam smith visiting assistant professor lee-ford tritt professor of law samuel c. ullman adjunct professor of law steven j. willis professor of law board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university– bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate student editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell kathleen duggan pfahlert florida tax review volume 20 2016 number 2 information for contributors the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law. the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the florida tax review prefers electronic submissions sent via expresso (law.bepress.com/expresso); articles may also be e-mailed to ftr@law.ufl.edu as a microsoft word document. if a hard copy submission is necessary, please mail your article to editor-in-chief, florida tax review, university of florida levin college of law, 309 village drive, gainesville, fl 32611. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. all citations should follow the bluebook uniform system of citation (20th ed.); some modifications will, however, be made by our editors to conform to the florida tax review style manual. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the florida tax review. florida tax review volume 20 2016 number 2 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations promulgated under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 9 2010 number 9 economics & economic substance by terrance o'reilly* i. intro ductio n ....................................................................................... 756 ii. state of the commentary .............................................................. 758 a. the classic themes .............................................................. 758 b. variations .............................................................................. 762 c . codification .......................................................................... 765 d . sum m ary ............................................................................... 767 ii. economics of economic substance ........................................... 769 a. the economic irrelevance of economic substance .............. 769 b . imp licit taxes ........................................................................ 775 c. shaviro's marginal efficiency cost of funds analysis ........ 779 d. risk bearing as the essence of economic substance ........... 781 e. section 7701(o): a meaningful change in economic p osition ................................................................................. 784 f. the noble dream .................................................................. 787 iv . c o nclusion ........................................................................................ 790 associate professor of law, willamette university college of law. 755 florida tax review the economic substance doctrine has no basis in economics. the fact that a transaction has an after-tax profit but not a pretax profit is not an indication of inefficient resource allocation. nor does economic analysis suggest that denying tax benefits to arrangements lacking economic substance will reduce the deadweight loss of taxation. because a pretax profit requirement has no economic foundation, it is irrelevant whether the calculation of pretax profit takes account of implicit taxes. both the conventional definition of economic substance based on pretax profit and competing formulations that give less or no weight to pretax profit appear to be based on reverse engineering to isolate features that unappealing transactions in high-profile litigation have shared. all these formulations fail to answer the critical questions surrounding the economic substance doctrine: why lack of economic substance is intrinsically bad, and why intrinsically bad transactions are more likely to lack economic substance. some supporters of the doctrine concede its lack of economic logic but defend it based on its practical effectiveness. this line of defense is generally based on anecdotes unconnected to the actual content of the doctrine and fails to explain why a pretax profit test should be a relatively effective means of targeting objectionable transactions. i. introduction judge: what's the matter with him? moe: oh, he thinks he's a chicken. judge: why don't you do put him in an institution? moe: we can't we need the eggs!' tax law's economic substance doctrine has no basis in economics and it's tempting to add something unkind about substance. even some prominent supporters of the doctrine concede about as much yet still favor the application of the doctrine on the basis that it works in practice, if not so well in theory.2 but evidently arbitrary pretext doctrine or useful fiction principle doesn't have the same ring to it. 1. listen, judge (1996) [1952]. 2. daniel shaviro & david weisbach, the fifth circuit gets in wrong in compaq v. commissioner, tax notes 511 (jan. 28, 2002) at 513 ("the doctrines do not seek to achieve logical precision.... they are simply devices for roughly identifying a socially harmful set of transactions."); id at 515 ("the pretax profit doctrine is not designed to measure some ultimate economic value."); see also daniel shaviro, economic substance, corporate tax shelters and the compaq case, [vol. 9:9 economics and economic substance without getting bogged down here in what it means to say something is a principle or doctrine of tax law, we know that there is an economic substance doctrine that is applied in tax cases and is the subject of an extensive scholarly literature. the doctrine has enforced the principle that a transaction with "no reasonable prospect of a profit" cannot be the basis for tax benefits.3 deductions, for example, are denied under the economic substance doctrine despite compliance with "the literal terms" of the internal revenue code: "over the last seventy years, the economic substance doctrine has required disregarding, for tax purposes, transactions that comply with the literal terms of the tax code but lack economic reality'a (depending on the venue, other elements have been attached to the doctrine. for example, in the fourth circuit, the doctrine has required that "the taxpayer 'was motivated by no business purposes other than obtaining tax benefits. "' ) now section 7701(o) introduces a two part test, requiring a meaningful change in a taxpayer's economic position and a substantial purpose for undertaking the transaction, in each case disregarding federal tax advantages-although, in the spirit of enigmatic oracles extending back to tax notes int'l 1581 (oct. 2, 2000), at 1582. ("[i]t is hard to see any direct policy reason why the tax authorities should care what risks a taxpayer such as compaq chooses to take or shun."); alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 989-90 (1981); joseph bankman, the economic substance doctrine, 74 s.cal. l. rev. 5, 18 (2000) ("[t]he same transactions, considered in isolation, will be treated differently. an aggressive play ... works if it is discovered 'accidentally' in the course of ordinary business operations but ... not ... if it is part of a prearranged plan that is unrelated to business operations. this produces results that are in one respect arbitrary. these results, however, may be justified on pragmatic grounds."). 3. see e.g. bb&t corp. v. u.s., 523 f.3d 461, 471 (4th cir. 2008); black & decker corp. v. u.s., 436 f.3rd 431, 441 (4th cir. 2006); goldstein v. commissioner, 364 f.2d 734, 740 (2d cir. 1966) (rejecting deductions with respect to "transactions without any realistic expectation of economic profit" conducted "'solely' to secure a large interest deduction."); klamath strategic investment fund v. u.s., (5th cir. may 15, 2009), at 10. 4. coltec indus. v. u.s., 454 f.3d 1340, 1351, 1352 (fed cir. 2006). 5. bb&t corp v. u.s., 523 f.3d 461, 471 (4th cir. 2008) (quoting rice's toyota world, inc. v. commissioner, 752 f.2d 89, 91 (4th cir. 1985). in the 6th circuit, a transaction cannot be the basis for tax benefits unless (i) "'the transaction has ... practicable economic effects other than the creation of income tax [benefits]' and (ii)" 'the taxpayer was motivated by profit to participate in the transaction."' dow chemical co. v. u.s., 435 f.3d 594, 599 (6th cir. 2006); see also ups v. commissioner, 254 f.3d 1014 (11th cir. 2001). for a survey of variations in the formulation of the economic substance doctrine, see yoram keinan, the economic substance doctrine (2008). 2010] florida tax review delphi,6 these criteria only apply "[i]n the case of any transaction to which the economic substance doctrine is relevant.",7 ii. state of the commentary a. the classic themes over the years a fair amount has been written about the economic substance doctrine, so it may be useful to summarize some of the landmarks that have already been surveyed. in a 1981 article, alvin warren anticipates many salient points that appear in the later literature. warren maintains that strict enforcement of a rule requiring a transaction to be profitable before taxes would be untenable: "[w]here congress has enacted an incentive for the very purpose of inducing changes in taxpayer behavior it can be argued that application of the requirement of a pretax profit would interfere with the congressional goal, perhaps even creating perverse results.",8 warren observes that tax benefits that are successful in encouraging investment tend to depress perhaps eliminate pretax returns in the affected activity until after tax returns match other investments.' he concludes that "the requirement of economic profit should not be applied to transactions involving provisions specifically enacted by congress as incentives." 9 6. see, e.g., w. geoffrey arnott, nechung, a modem parallel to the delphic oracle?, 36 greece & rome 152, 155 (1989); carol doughrety, pindar's second paean: civic identity on parade, 89 classical philology 205, 211 (1994) ("podaliros received an oracle to found a city where if the sky falls, it will not be felt."); herbert richards, notes on the attic orators, 20 the classical rev. 292, 298 (1906) ("the real point is that the god, as was his way .... g[a]ve[] a 'sign' or intimation which might bear more than one meaning, the sense intended varying with the character of the man to whom it was given."). 7. p.l. 111-148, § 1409(a), effective for transactions entered into after march 30, 2010. 8. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 991 (1981); see also joseph isenbergh, musings on form and substance in taxation, 49 u. chi. l. rev. 859, 876 (1982); joseph bankman, the economic substance doctrine, 74 s.cal. l. rev. 5, 24 (2000) ("if tax benefits are fully embedded in asset price, then, at the margin, investments in all tax-favored assets should provide a subpar and perhaps even negative pretax return."). 9. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 985 (1981). (the journal is addressed primarily to practitioners, which explains the lack of detail about certain aspects of economic substance that continue to interest tax law commentators.) see also sacks v. commissioner, 69 f.3d 982, 992 (9th cir 1995) ("if the commissioner were permitted to deny tax benefits when the investments would not have been made but for the tax advantages, then only those investments would be made which would [vol9:9 economics and economic substance warren also acknowledges that the line between intended and inadvertent tax benefits might be difficult to identify. he proposes "plac[ing] the burden of persuasion" on a taxpayer claiming an activity was intended to be stimulated by the code.'0 warren recognizes that a requirement that a transaction have a projected pretax profit is not congruent with economic efficiency. the doctrine cannot be justified on the grounds that "the tax system should generally be neutral, distorting economic behavior as little as possible," because the economic substance doctrine is frequently applied to transactions that "exploit, rather than create, the distortionary effect of the tax system."'" further, while an investment principle favoring a positive after tax return has an obvious utilitarian justification, demanding just some positive pretax profit "is arbitrary because a very small economic profit will validate a transaction that may be dominated by tax considerations."' 2 although warren considers it arbitrary to place the threshold of economic substance at merely some positive pretax return, he also maintains, without much argument, that demanding a full market rate of return is "logically -have been made without the congressional decision to favor them. the tax credits were intended to generate investments in alternative energy technologies that would not otherwise be made because of their low profitability."); joseph bankman, the economic substance doctrine, 74 s.cal. l. rev. 5, 11 (2000) ("[a] transaction that is clearly supported by the text, intent, and purpose ... will withstand judicial scrutiny regardless of whether it otherwise meets the economic substance test."); david p hariton, tax benefits, tax administration & legislative intent, 53 tax lawy. 579 (2000); david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax. l. rev. 29, 38 (2006). 10. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 992 (1981); david p hariton, tax benefits, tax administration & legislative intent, 53 tax lawy. 579, 581 (2000) ("unfortunately, congress's intent is not always clear."); david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax. l. rev. 29, 37 (2006) ("the hardest job a court has in the case of a tax-motivated transaction that lacks business purpose and economic substance is determining whether the purported tax results of the transaction are reasonably consistent with congressional intent.") 11. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 989 (1981). 12. id at 987; cf. daniel shaviro & david weisbach, the 5th circuit gets in wrong in compaq v. commissioner, tax notes 511 (jan. 28, 2002) at 513 ("discussions of pretax profit, in some ways, are always surreal. the only meaningful number is after tax profits."). 2010] florida tax review insupportable"' 3 because "capital markets will take preferential tax treatment into account in setting relative prices.' 4 warren also regards any threshold between a merely positive pretax return and the market rate of return as arbitrary;15 nevertheless, he supports the prevailing benchmark any positive pretax profit 6 on the grounds that "unintended opportunities for taxpayer gain" must be restricted; he maintains that the requirement does do that.'7 although warren does not think that any recognized tax policy or economic principle points to the any-positive-profit threshold in particular, he appreciates its simplicity.' 8 warren's rationale for an economic substance doctrine is echoed by other commentators. daniel shaviro, for example, maintains that "[i]f we did not use economic substance tests to challenge the reality of the cubbyholes taxpayers try to exploit, we would in effect have created a regime of pure electivity to claim whatever losses and ignore whatever gains one likes."' 9 13. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 989 (1981). 14. id at 987. 15. id at 987. 16. id at 985. "[t]he sum of positive and negative cash flows should be positive after discounting for risk, but not for the passage of time." id. at 990. 17. id. at 990, 991-92; see also daniel shaviro & david weisbach, the 5th circuit gets in wrong in compaq v. commissioner, tax notes 511 (jan. 28, 2002) at 513 ("the doctrines do not seek to achieve logical precision.... [they] are merely rough sorting devices."). 18. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 989-90 (1981). 19. daniel n. shaviro, in defense of requiring back-flips, 26 va. tax. rev. 815 (2007); daniel shaviro & david weisbach, the 5th circuit gets in wrong in compaq v. commissioner, tax notes 511 (jan. 28, 2002) at 512-13; see also david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax. l. rev. 29, 33 ("a government cannot allow tax benefits to arise from such transactions if it hopes to impose and enforce an income tax.... no government can foresee, let alone draft, rules that produce the 'right' tax results under every conceivable permutation of facts that can be constructed by taxpayers in an increasingly complex financial world."); peter c. canellos, a tax practitioner's perspective on substance, form and business purpose in structuring business transactions, 54 smu l. rev. 47, 65 (2001) ("the tax court, in particular, seems to have accepted the view that the strain on the tax system would be unbearable if tax-motivated transactions had to be sustained merely because they manage to encapsulate an uneconomic tax rule, however clear by its terms."); 1 randolph e. paul & jacob mertens, jr, the law of federal income taxation § 306 (1934) ("the subtler forms of avoidance are sometimes too elusive to be reached by curative statutory provisions; the courts seem to be coming to realize that they only can deal with many of these evils by a more flexible attitude toward the meaning of statutory words employed and a more sensitive regard for congressional purpose."). [vol9:9 economics and economic substance warren says next to nothing about how the scope of legislative intent is to be fixed, even though the economic substance doctrine is frequently applied when the text of a statute, legislative history and other conventional tools of statutory interpretation are not particularly revealing. writing at about the same time as alvin warren, joseph isenbergh forcefully questions the legitimacy and logic of landmark economic substance cases, such as goldstein v. commissioner.20 isenbergh suggests that the pretax profit requirement discovered in goldstein cannot be derived from conventional methods of statutory interpretation and is instead "an aesthetic response to a transaction thought unappealing. ' 21 another influential commentator, joseph bankman, makes a similar point: "[t]he [economic substance] doctrine is only loosely connected to more conventional interpretive techniques or approaches. decisions in which the doctrine is discussed or invoked often contain a separate discussion in which text, intent, and purpose are applied to the issue at hand. the doctrine itself, however, is discussed and applied without significant discussion of text, intent, and purpose. 22 isenbergh does not buy the defense that judicial fabrication of doctrines like economic substance is essential because the most carefully thought out and drafted tax statutes contain loopholes that permit tremendous abuses: "few myths so persistent are as easily dispelled. it is hard to think of a single case that has ever permanently staunched any fissure in the congressional dyke. 23 according to isenbergh, such doctrines do not benefit the government so much as tax advisors: "the heavier the layers of judicial divination superimposed on the internal revenue code, the richer tax lawyers are apt to get. ' 24 in a variation on warren's position that the economic substance doctrine should be applied selectively and perhaps supporting isenbergh's criticisms a number of commentators have suggested that the economic 20. 364 f.2d 734 (2d cir. 1966). 21. joseph isenbergh, musings on form and substance in taxation, 49 u. chi. l. rev. 859, 876 (1982); see also milton sandberg, the income tax subsidy to "reorganizations," 38 colum. l. rev. 98, 112 (1938) (suggesting a "visceral interpretation" of the result in gregory v. helvering, 293 u.s. 465 (1934): "despite their vehement disavowal of interest in tax avoidance motive, the judges were shocked by so ingenious and fantastic a piece of tax engineering."). 22. joseph bankman, the economic substance doctrine, 74 s.cal. l. rev. 5, 11 (2000). 23. joseph isenbergh, musings on form and substance in taxation, 49 u. chi. l. rev. 859, 880 (1982). 24. id at 883 20101 florida tax review substance doctrine, and related doctrines, are basically pretexts for suppressing perceived tax shelters. according to peter canellos, "[p]romoters are foolish in believing (or persuading clients to believe) that the outcome turns on some requisite pre-tax profit.... once a judge sees the transaction as a shelter ... the result is predictable taxpayer loses.").25 daniel shaviro and david weisbach seem to take the position that the economic substance doctrine should only be taken seriously to smack down bad transactions: "the pretax profit doctrine is not designed to measure some ultimate economic value. instead it is supposed to help sort socially harmful tax arbitrages from real business transactions, and it must be interpreted in that light., 26 b. variations the works of bankman, isenbergh and warren are distinguished by the breadth and durability of their analyses. subsequent scholarship has refined or challenged their conclusions on some points. david hariton emphasizes that an economic substance standard based on pretax profit can be evaded by adding an investment of capital to a transaction.27 hariton recognizes that courts have occasionally finessed this difficulty with one ad hoc device or another when they are intent on imposing discipline,28 but he predicts that "any effort to apply the doctrine more broadly will serve only to deprive the doctrine of any coherent meaning and thereby render it useless., 29 hariton favors construing economic substance to mean instead that a "transaction gives rise to unique economic risk that is significant in relation to the tax benefits claimed."30 25. peter c. canellos, a tax practitioner's perspective on substance, form and business purpose in structuring business transactions, 54 smu l. rev. 47, 65); see also joseph bankman, the economic substance doctrine, 74 s.cal. l. rev. 5, 15 (2000) ("[c]ourts have ... show[n] a willingness to lump together transactions connected to a taxpayer's ordinary business operations, but treat as discrete each element in tax shelters."). 26. daniel shaviro & david weisbach, the 5th circuit gets in wrong in compaq v. commissioner, tax notes 511 (jan. 28, 2002) at 515. 27. david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax l. rev. 29, 48-50, 52 (2006). 28. id at 50; see also id at 30 ("it is always possible to isolate tax planning steps or structures and observe that they have no tax-independent business purpose or economic substance.") 29. id at 31. see also id. at 34 ("[j]udges and commentators who insist on applying the economic substance doctrine to every aggressive tax position that offends them are actually doing the devil's work.") (emphasis added) 30. id. [vol9:9 economics and economic substance michael knoll supports the prevailing standard that rejects the tax benefits associated with transactions lacking pretax profit, but argues that the test must take account of implicit taxes. 3' according to knoll, failure to recognize implicit taxation caused erroneous application of the economic substance test in cases in which the government challenged millions of dollars of foreign tax credits. in these cases, compaq v. commissioner32 and ies industries v. commissioner,33 pretax profit would be positive if and only if dutch withholding taxes on dividends were counted as taxes.34 for example, a corporation purchases $1 million in foreign stock, followed by receipt of a $100,000 dividend and quick resale of the stock ex dividend for $915,000; the dividend attracts $15,000 foreign withholding tax and potentially permits a $15,000 u.s. foreign tax credit and $85,000 capital loss deduction. excluding foreign and domestic tax considerations, the transaction has a $15,000 pretax profit ($1,015,000 income versus $1,000,000 costs). after foreign and domestic taxes, assuming the foreign tax credit and the capital loss are legitimate, the profit in this case would be about $10,000, as shown in table 1 below. table 1 costs income stock transfers $1,000,000 $915,000 dividend 100,000 withholding tax and 15,000 15,000 foreign tax credit us income tax 34,000 28,900 total $1,049,000 $1,058,900 for a corporate taxpayer subject to a 34% rate, the dividend income creates a $34,000 income tax liability; a $15,000 foreign tax credit is allowed for the $15,000 foreign withholding tax and the $85,000 loss on the resale of the stock shelters capital gain income otherwise subject to income tax of $28,900 ($28,900 is 34% of $85,000). taxes thus add $43,900 on the plus side and $49,000 on the minus side, leaving the corporation $9,900 in the black after taxes. 31. michael s. knoll, compaq redux: implicit taxes and the question of pre-tax profit, 26 va. tax rev. 821, 84344 (2007). 32. 277 f.3d 778 (5th cir. 2001). 33. 253 f.3d 350 (8th cir. 2001). 34. michael s. knoll, compaq redux: implicit taxes and the question of pre-tax profit, 26 va. tax rev. 821, 826-29 (2007). 2010] florida tax review if, however, the foreign withholding tax is counted as just another expense, rather than as a part of the corporation's tax liability, the pretax profit vanishes. further, if the corporation incurs significant transactions costs, as it did in the disputed cases, then there is a pretax loss. for this reason, the tax court concluded in the compaq case that the transaction lacked economic substance. 35 but the court of appeals held that "pretax income is pretax income regardless of the timing or origin of the tax," concluded that there was a pretax profits, and reversed.36 knoll does not fault the court of appeals for treating foreign withholding tax as a tax. but knoll still thinks there was no pretax profit in the deal. in knoll's view, the court of appeals overlooked an implicit tax subsidy in the price of the stock: the $15,000 foreign withholding tax on the anticipated $100,000 dividend presumably reduced the initial sale price by $15,000, from $1,015,000 to $1,000,000. knoll argues that, economically, implicit taxes have the same status as explicit taxes and must also be netted out in determining pretax profit. he concedes that the magnitude implicit taxes may be difficult to identify, but concludes that "it is important for courts to try.",3 7 knoll would place the "burden of persuasion" on "the party who is arguing that implicit taxes should be incorporated in the analysis. ' 38 daniel shaviro evaluates the economic substance doctrine in terms of economic efficiency. he does not claims that pretax profit is, in itself, relevant to the efficient allocation of resources. instead, he contends that the potential benefit of imposing an economic substance criterion is that this will discourage undesirable transactions.39 presumably a pretax profit test discourages some transactions. shaviro does not attempt an economic argument that the transactions inhibited by a pretax profit requirement are generally undesirable or that a pretax profit test significantly reduces undesirable transactions. he does, however, recognize that a pretax profit tax might be finessed by modifying a transaction in various ways, and that these modifications can be costly and unproductive.40 requiring an animal 35. 113 tc 213, 222 (1999), rev'd 277 f.3d 778 (2001). 36. 277 f.3d 778, 784 (5th cir. 2001). 37. michael s. knoll, compaq redux: implicit taxes and the question of pre-tax profit, 26 va. tax rev. 821, 856 (2007). 38. id. at 857. 39. daniel n shaviro, economic substance, corporate tax shelters and the compaq case, tax notes int'l 221, oct. 2, 2000 at 1600; id. at 1608 ("the aim is simply to generate frictions that will reduce the net social cost of taxpayer exploitation of otherwise ineradicable tax planning opportunities.") 40. daniel n shaviro, economic substance, corporate tax shelters and the compaq case, tax notes int'l 1581, oct. 2, 2000 at 1600. david weisbach takes a similar approach in analyzing tax avoidance generally. david a. weisbach, an economic analysis of anti-tax-avoidance doctrines, 4 am. l. & econ. rev. 88, 100 (2002). [vol 9:9 economics and economic substance sacrifice to obtain tax benefits would work similarly. it would discourage some taxpayers, but some people would perform the rite, which nobody really wants.4' shaviro does not explore whether imposing a pretax profit requirement is more effective than requiring animal sacrifice or some other ritual, but he does propose a framework for evaluating the economic consequences when an ordeal, if it does not deter, aggravates. his economic analysis of the economic substance doctrine is based on the marginal efficiency cost of funds (mecf), which is a measure of the change in deadweight loss from raising a dollar of tax revenue from a particular tax policy. 42 from this perspective, he comes to the robust conclusion that "it is plausible" that the economic substance doctrine enhances economic efficiency.43 c. codification the health care and education reconciliation act of 2010 included a "clarification of economic substance doctrine." this provision includes pretax profit as an element, but more generally would recognize a "meaningful" change in economic position as a sign of economic substance. according to section 7701(o), "a transaction has economic substance only if' (a) the transaction changes in a meaningful way (apart from federal tax effects) the taxpayer's economic position, and (b) the taxpayer has a substantial purpose (other than a federal tax purpose) for entering into such transaction. 41. no animals were harmed in the production of this paper. the author does not actually advocate the imposition of an animal sacrifice requirement as a condition for obtaining tax benefits under federal, state or local law. 42. joel slemrod & shlomo yitzhaki, the costs of taxation and the marginal efficiency cost of funds, 43 imf staff papers 172, 185 (1996). 43. daniel n shaviro, economic substance, corporate tax shelters and the compaq case, tax notes int'l 1581, oct. 2, 2000 at 1604 ("so it is plausible that the use of an economic substance approach to deter [high-basis, low value tax shelters] will have sufficiently favorable general equilibrium effects, at least up to a point, to make it appealing on efficiency grounds if its static ration of deterrence to inducing acceptance of greater undesired risk is good enough."); id at 1607 ("[t]he use of an economic substance approach to deter cross border dividend stripping transactions might well be desirable if [the level of marginal efficiency cost of funds] was sufficiently favorable."). 2010] florida tax review this clarification recognizes realization of pretax profit as a meaningful change in economic position, but only if the projected profit is sufficiently large relative to tax benefits: the potential for profit of a transaction shall be taken into account ... only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. 44 the statute calls for regulations "requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases. ' ' 5 apparently this provision assumes that certain transactions that might fail these tests, but are clearly intended to be eligible for favorable tax treatment, are simply not subject to the economic substance doctrine. for the provision states that the requirement only applies "[i]n the case of any transaction to which the economic substance doctrine is relevant '4 6 and the house report states: if the tax benefits are clearly consistent with all applicable provisions of the code and the purposes of such provisions, it is not intended that such tax benefits be disallowed if the only reason for such disallowance is that the transaction fails the economic substance doctrine as defined in this 47provision. 44. section 7701(o)(2)(a) 45. section 7701(o)(2)(b). 46. section 7701(o)(1). 47. h. rep. 111-443 at 296 n.124 (2010). the legislation also enhances the penalties associated with the application of the economic substance doctrine, or "any similar rule of law." section 6662(b)(6); see also §§ 6662a(e)(2)(b), 6664(c)(2), 6676(c). the report of the joint committee on taxation describes a new "strict liability penalty" for deficiencies attributable to a determination that a transaction lacks economic substance, because there is no "reasonable cause" exception to the penalty-20 percent of the deficiency, raised to 40 percent "if the taxpayer does not adequately disclose the tax treatment..." joint committee on taxation, technical explanation of the revenue provisions of the "reconciliation act of 2010," as amended, in combination with the "patient protection and affordable care act" (jcx-18-10), march 21, 2010, at 157. [vol 9:9 economics and economic substance d. summary there are recurring observations and themes in the extensive literature on the economic substance doctrine: 1. although in the case law there is some diversity in the formulation of the economic substance doctrine,48 the conventional definition of economic substance focuses on whether a transaction has "a reasonable opportunity for profit apart from the income tax consequences of the transacttion.' 49 if economic substance is absent, tax benefits may be denied even if a transaction "compl[ies] with the literal terms of the tax code."50 2. among the leading cases are the supreme court cases gregory v. helvering5" and knetsch v. united states,52 and the 2nd circuit case 53goldstein v. commissioner. compaq v. commissioner recently provoked a significant literature. 4 3. a taxpayer can neutralize the economic substance doctrine by incorporating a sufficient net equity position into the transaction.5 4. despite its perhaps shaky theoretical foundation and hypothetical schemes for neutralizing it, the economic substance doctrine discourages tax 48. see yoram keinan, the economic substance doctrine (2008). 49. compaq, 277 f.3d at 782. michael s. knoll, compaq redux: implicit taxes and the question of pre-tax profit, 26 va. tax rev. 821, 823-24 (2007); james m. peaslee, creditable foreign taxes and the economic substance profit test, tax notes, 29 january 2007, 443, 443 ("in broad terms, the common-law economic substance doctrine requires that a transaction generating net tax benefits have a nontax purpose to be recognized. that purpose is most often the expectation of a nontrivial pretax profit (that is, a profit disregarding tax effects).") 50. coltec indus. v. u.s., 454 f.3d 1340, 1351, 1352 (fed cir. 2006). 51. 293 u.s. 465 (1935). 52. 364 u.s. 361 (1960). 53. 364 f.2d 734 (2nd cir. 1966). 54. 277 f.3rd 778 (5th cir. 2001). 55. david p. hariton, sorting out the tangle of econ substance, 52 tax lawy. 235, 249 (1999) ("[w]here a tax-motivated transaction takes the form of an investment, the taxpayer can always contribute enough net equity to assure that there will be significant net profit (even after taking transaction costs into account)."); david p. hariton, tax benefits, tax administration & legislative intent, 53 tax lawy. 579, 583 (2000) ("[p]rofit is merely a function of the amount of net equity and the term of the investment, and it is therefore arbitrary and manipulable."); michael schler, economic substance and foreign tax credits, tax notes (feb. 12, 2007) ("[t]he economic substance doctrine is not good at stopping transactions that have at least a small amount of economic substance, even if they also have a relatively large amount of tax benefits."). 20101 florida tax review shelters because of taxpayer reluctance to incur risk in order to claim additional tax benefits.56 5. the economic substance doctrine is inapplicable to tax benefits intended by congress.57 6. it is often hard to determine which claimed tax benefits fall within the scope of congressional intent.58 7. lack of economic substance is not intrinsically bad, but absence of economic substance nevertheless is useful in identifying many tax shelters.5 9 8. requiring merely some pretax profit is arbitrary, but perhaps justified in the name of simplicity, since any threshold is necessarily arbitrary. 60 9. application of an economic substance requirement is (or should be) reserved for tax shelters.61 10. judicial imposition of an economic substance requirement is a somewhat unconventional approach to statutory interpretation.62 11. judicial imposition of an economic substance requirement is not a legitimate application of statutory interpretation.63 56. joseph bankman, the economic substance doctrine, 74 s.cal. l. rev. 5, 29 (2000). 57. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 991 (1981); bittker & lokken, federal taxation of income, estates and gifts 4.3.4a (2008); david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax l. rev. 29, 55 (2006); joseph bankman, the economic substance doctrine, 74 s.cal. l. rev. 5, 11-12 (2000). 58. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 992 (1981); david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax l. rev. 29, 37 (2006). 59. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 989 (1981); daniel shaviro & david weisbach, the 5th circuit gets in wrong in compaq v. commissioner, tax notes 511 (jan. 28, 2002) at 513. 60. alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 987 (1981). 61. see peter c canellos, a tax practitioner's perspective on substance, form and business purpose in structuring business transactions, 54 smu l. rev. 47, 51-52 (2001); daniel shaviro & david weisbach, the 5th circuit gets in wrong in compaq v. commissioner, tax notes 511 (jan. 28, 2002) at 513, 515. 62. joseph bankman, the economic substance doctrine, 74 s.cal. l. rev. 5, 11 (2000). 63. joseph isenbergh, musings on form and substance in taxation, 49 u. chi. l. rev. 859, 876 (1982). [vol9:9 economics and economic substance 12. judicial imposition of an economic substance requirement is a heroic, commendable application of statutory interpretation because it is not possible for the government to anticipate tax planning opportunities introduced by new tax legislation.64 13. the focus on statutory interpretation "is a red herring" because the economic substance doctrine can always be codified.65 14. the economic substance doctrine will ultimately be undermined if the government is too aggressive and indiscriminate in asserting it.66 15. the economic substance doctrine should incorporate implicit taxes in calculating pretax profit.67 16. the economic substance doctrine is sound but the pretax profit tax is not its essence, or is not relevant.68 since the codification of economic substance only applies to transactions undertaken after march 30, 2010, it should be some time before case law confronts its implications. il. economics of economic substance a. the economic irrelevance of economic substance because of the effect of conventional taxation on prices throughout the economy, the fact that an investment has an after-tax profit but lacks a 64. see peter c canellos, a tax practitioner's perspective on substance, form and business purpose in structuring business transactions, 54 smu l. rev. 47, 51-52 (2001); 1 randolph e. paul & jacob mertens, jr, the law of federal income taxation § 306 (1934); cf. daniel shaviro, the story of knetsch: judicial doctrines combating tax avoidance, in tax stories 313, 315, 369 (paul caron ed. 2003); daniel n shaviro, economic substance, corporate tax shelters and the compaq case, tax notes int'l 1581, oct. 2, 2000 at 1607. 65. david a. weisbach, ten truths about tax shelters, 55 tax l. rev. 215, 219 (2002). for discussion of this claim, see brian galle, interpretative theory and tax shelter regulation, 26 va. tax rev. 357 (2006). 66. george k yin, "the problem of corporate tax shelters: uncertain dimensions, unwise approaches," 55 tax l. rev. 405, 407 (2002); david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax l. rev. 29, 34 (2006). 67. michael s. knoll, compaq redux: implicit taxes and the question of pre-tax profit, 26 va. tax rev. 821, 84344 (2007); cf charlotte crane, some explicit thinking about implicit taxes, 52 smu l. rev. 339, 361 (1999). 68. david p. hariton, sorting out the tangle of econ substance, 52 tax lawy. 235 (1999); peter c. canellos, a tax practitioner's perspective on substance, form and business purpose in structuring business transactions, 54 smu l. rev. 47, 51-52 (2001); charlene d. luke, risk, return and objective economic substance, 27 va. tax rev. 783, 793-804 (2008). 20101 florida tax review pretax profit is not a sensible test of economic substance or economic efficiency. although some academic supporters of an economic substance requirement do repudiate any economic rationale for the doctrine, 69 they do not explain why the various tests lack economic significance. in the absence of taxes, the existence of a positive or at least nonnegative profit is relevant to economic efficiency. further, once taxes are introduced, some profitable projects may not be efficient and some efficient one may be unprofitable. so the notion that pretax profit is germane to efficiency has superficial appeal. this section of the paper explains why, despite the connection between profit maximization and efficiency, the economic substance doctrine's distinction between pretax profit and after-tax profit is not sound as a matter of economic theory. in a world without any taxes, it would make sense to say that investments in projects with positive returns have economic substance, because prices signal the relative costs and benefits of outputs produced and resources consumed.7 ° so if solid gold paperweights command a price of $200 but require $500 of gold to make, it is not only unprofitable to produce them: the relative prices indicate that alternative uses of gold yield outputs people prefer to sold gold paperweights. further, the relative prices of inputs signal the relative scarcity of inputs. if labor is scarce, for example because the working age population is small, or because of the value people place on leisure time higher wages will induce producers to use more capitalintensive methods of providing goods and services. to pursue this analysis further and consider the implications of taxes on profits and efficiency, the following discussion applies some basic principles of supply and demand and public finance economics. stripped down to economic fundamentals, a business plan is a specification of an output target, q, and a production strategy: a combination of inputs, labor, l, and capital, k, say, and a production method that yields the output q. economic profit, 0, is revenue minus factor costs: e] = pq (wl + rk), where p is the sales price of the product and w and r are the prices of the factors, labor and capital, respectively. with competitive product and factor markets, if economic profit d is negative (the business plan is unprofitable), then there is some other way of using the resources that would make at least 69. daniel shaviro & david weisbach, the 5th circuit gets in wrong in compaq v. commissioner, tax notes 511, 515 (jan. 28, 2002); daniel shaviro, economic substance, corporate tax shelters and the compaq case, tax notes int'l 1581, 1582 (oct. 2, 2000); alvin c warren, jr, the requirement of economic profit in tax motivated transactions, 59 taxes 985, 989-90 (1981). 70. see william j baumol, economic theory and operations analysis 506ff (4th ed 1977); hal varian, microeconomic analysis (3rd ed 1992). [vol9:9 economics and economic substance one person better off and no one else worse off7 the definition of a pareto optimum, the conventional benchmark of economic efficiency.72 in the long run it is not pareto optimal to produce when profits are negative; there is a deadweight loss. in an economy there are thousands of product and factor markets, and competitive markets without any taxes will produce some equilibrium of production levels, factor use and distribution of goods and services to consumers. the equilibrium will be pareto optimal and none of the producers will be using an unprofitable production plan.73 in general, economic equilibrium depends on the technology available at the time, the resources of the economy, how those resources are distributed among people, and people's preferences (preferences for various consumption goods and services, preferences for work in general and for particular types of work and so on). a more equal initial distribution of resources, for example, is likely to result in a different equilibrium: consumption goods will probably be distributed more equally, different levels of goods will be produced and the ways in which factors are deployed in production is likely to be different. but the equilibrium would still be pareto optimal and producers would not be running unprofitable operations. there are many possible pareto optimal ways of organizing production, claiming resources from various owners and distributing the goods and services. thousands or millions of ways a little more of this, a little less of that, more to her, less to him. in general, none of these ways would entail unprofitable business plans. this is all hypothetical some degree of taxation and market failure is inevitable. but it seems to be an essential paradigm for explaining why the profit motive is compatible with sound economic organization. theoretically, you could add in a government and finance it without interfering with the pareto optimal functioning of competitive markets, but taxation would have to be lump sum: tax liability could not depend on the levels of goods or services a taxpayer demanded or of resources, including labor, that a taxpayer supplied. in practice, taxes do vary according to the demand and supply of resources by taxpayers; this leads to some deadweight loss of taxation, which means that the equilibrium reached after taxes is not pareto optimal, assuming that consumers, producers and suppliers or 71. see andreu mas-collel et al, microeconomic theory 552 (1995); gerard debreu, theory of value 95 (1959). 72. see, e.g., liam murphy & thomas nagel, the myth of ownership 50 (2002); jules l. coleman, risks & wrongs 18 (1992); harvey s. rosen & ted gayer, public finance 35-36 (8th ed 2008). 73. see gerard debreu, theory of value 94-95 (1959); john rawls, a theory of justice 240 (rev ed. 1999); see also george j. stigler, the theory of price 180-83 (4th ed 1987). 2010] florida tax review resources all take taxes into account in their respective economic decisions.74 keeping the deadweight loss of taxation under control is one of the principal concerns of tax scholarship (whether or not the terminology is employed), alongside distributional, political and administrative issues. now, given a tax scheme, we could imagine the equilibrium that would result if everything else were kept the same but lump-sum taxes were (feasible and) employed and compare that equilibrium with the equilibrium with conventional (income, excise and property) taxes. we are supposing that the equilbria raise the same revenue, but the prices in the lump-sum tax equilibrium accurately reflect the relative scarcity of resources and the relative value of goods, while prices in conventional-tax equilibrium are distorted by taxes. for example, taxation of labor income artificially inflates the (after-tax) cost of labor. because of the accuracy of relative prices in the lump-sum equilibrium, there is no deadweight loss from taxation. figure 1, below, compares the effects of a conventional tax with a lump-sum tax in a single market.75 figure 1 s p p0 q, q0 q in figure 1, line d1 s represents the demand curve for a product and line s represents the product's supply curve with lump-sum taxation. the 74. see harvey s. rosen & ted gayer, public finance 334-35 (8th ed 2008); richard w. tresch, public finance 59-60 (2nd ed 2002); liam murphy & thomas nagel, the myth of ownership: taxes and justice 23 (2002); joel slemrod & jon bakija, taxing ourselves 131-34 (4th ed 2008). 75. see, e.g., bernard salani6, the economics of taxation 15-58 (2003). [iol9:9 economics and economic substance equilibrium price, po, and quantity, qo, are set by the intersection of supply and demand. suppose that revenue is raised via excise taxes, and for this product, an excise tax t is imposed on the buyer per unit purchased; total tax liability is tq, where q is the volume. now with a pretax per-unit price p, the effective price after tax is p + t. so the amount demanded at any market price p is given by the level of dls at p t: the conventional-tax demand curve d, lies below lumps-sum tax curve d1s at distance t. the market price of the good falls from p0 to p*; buyers pay p* as a pretax price and an after-tax price p'=p* + t. in this case, conventional taxation reduces the quantity of the taxed product, increases the effective price paid by buyers and reduces the price going to suppliers. there is a deadweight loss based on the reduction in quantity, u q = q0 q1, below the quantity that would result under lump-sum taxes.76 although the spread between the pretax and post-tax price is the full amount of the tax, t, the price reduction up=p'-p* caused by the conventional tax is less than t, because producers would be unwilling to satisfy demand if the price fell by the full amount of the tax; buyer demand for the product is strong enough-sufficiently inelastic-that buyers are willing to take on some of the burden of the tax. it is an unfortunate consequence of conventional taxation that it distorts prices, which generally depresses output-a deadweight loss. if taxpayers based all their economic decisions on undistorted prices, sending the same amount of taxes to the government anyway, the deadweight loss from taxation would be eliminated. this would be lump-sum taxation by another name. but with conventional taxation, neither the pretax prices nor after-tax prices are the same as the undistorted prices of lump-sum taxation.77 that is 76. see harvey s. rosen & ted gayer, public finance 340 (8th ed 2008). 77. for simplicity, i illustrate this using an excise tax on a particular good, but the argument can be adapted to the case of an income tax. for an illustration of the economic correspondence between income taxation and excise taxes, see terrance o'reilly, principles of efficiency tax law: apocrypha, 27 va. tax rev 583, 589 (2008). in the case of an income tax that is equivalent to a uniform excise tax on goods included in the tax base, figure 1 can represent the demand for taxed output at two different tax rates. in the case of a complex income tax that, because of a variety of rates, exclusions, deduction, realization and recognition rules, etc., effectively imposes different tax rates on different goods, figure 1 could represent the impact of effectively including a particular good in the tax base by changing the deductibility of expenditures on the good under an income tax. if all production exhibited constant returns to scale, the entire amount of an excise tax imposed on sellers could be passed on to consumers. then the pretax price would approximate the price without taxation. this would happen, however, only if factors were not taxed and factors were neither substitutes nor complements of taxed goods. if inputs are taxed, this will distort the prices of even untaxed consumption goods. with constant returns to scale, producers' after-tax economic profits are 2010] florida tax review the heart of the problem with treating pretax profit as a significant metric of economic substance, as the next few paragraphs explain in more detail. suppose that with lump-sum taxation the profit 78 for a business plan with output level q and input levels k and l is pq (wl + rk). with conventional taxation, after-tax profit for the same plan is p*q (w*l + r*k) t(p*q,w*l,r*k) and pretax profit is p*q (w*l + r*k), where p*, w* and r* represent the product and factor prices as they have adjusted to conventional taxes and t represents the tax on taxable income. conceivably, t could be a tax on economic profit: t= t [p*q (w*l + rk)] for some marginal rate t, but the tax base for actual income taxes tends to be determined by adjustments to accounting profit, which is systematically different from economic profit.79 under some circumstances, t may effectively be negative say when accelerated depreciation provides deductions above economic depreciation and losses in one division of an enterprise offset income in another division. from these profit expressions it is evident that even if a business plan would be profitable under lump-sum taxation, it is not necessarily profitable with conventional taxation. of course, that is one of the reasons why there is a deadweight loss from conventional taxation: taxes render some economically sensible projects unprofitable. in particular, because conventional taxes alter product and factor prices, an investment project with a positive return under lump-sum taxation may have a negative pretax return generally zero, so raising revenue from producers of intermediate goods would entail effective taxation of their outputs. and if factors were, for example, substitutes for taxed consumption goods, the increased effective price of such consumption goods would lead to increased demand for their inputs, raising their costs of production and even their pretax prices. even if no factors were also consumption goods, factor prices could be increased in a similar fashion if a substitute for a taxed goods is excluded from the tax base; increased demand for such a substitute on account of taxation of another good could bid up the price of factors used in the production of both consumption goods, distorting the pretax price of the taxed good. 78. since lump-sum taxation would not impose tax based on the level of business activity, we can ignore taxation in the determination of business profit. 79. see koopmans v. farm credit services of mid-america, 102 f.3rd 874, 876 (7th cir 1996); susan rose-ackerman, unfair competition and corporate income taxation, 34 stan. l. rev. 1017, 1025 n.28 (1982). [vol9:9 economics and economic substance under conventional taxation. for example, suppose that with lump-sum taxation, all the equilibrium product and factor prices equal 1, q = 10 and k = l = 4. profit with lump-sum taxation is then 2: d = 1(10) [1(4) + 1(4)]. suppose that with conventional taxes, the price of the product happens to stay the same but factor prices increase from 1 to 1 2. (pretax factor prices might rise if, for example, factor costs were deductible at accelerated rates for tax purposes. the scale of the effect is exaggerated in the example for simplicity's sake.) then pretax profit with conventional taxation is negative: [] = -2 = 10 [(1 v/) 4 + (1 '/2) 4]. yet after-tax profit could be positive: suppose t = q/2 (k + l), so that after-tax profit equals +1. this example illustrates why negative pretax profit is not a meaningful indicator of wasteful or economically undesirable investments. an economically efficient investment, profitable when prices are not distorted by conventional taxation, may be unprofitable in terms of pretax profit. with some notable exceptions, profitably or potential profitability is the benchmark for investment decisions in modem economies, and this appears to be roughly compatible with principles of economic efficiency even though product and factor prices are distorted by taxation, regulatory constraints and, in many markets, a degree of market power. in practice, economic actors generally consider after-tax prices, aftertax costs, and after-tax profits in making economic decisions, and though the distortions induced by taxes degrade the quality of the signals after-tax prices provide, there seems to be no economic principle indicating that when prices are distorted in these ways, pretax profit would provide a better approximation to profit under lump-sum taxation than after-tax profit. depending on various factors, including the elasticities of supply and demand in markets, pretax prices or after-tax prices may be closer to undistorted prices. as a general principle, a pretax profit criterion for economic substance has no economic foundation. b. implicit taxes michael knoll argues that proper application of the pretax profit test requires that implicit taxes be taken into account. in light of the discussion of pretax profit in the previous subsection, disputes about the proper measurement of pretax profit might seem to have about as much practical significance as a controversy about the maya calendar. actually, the thrust of the previous subsection is that knoll focuses his discussion of implicit taxes too narrowly. if all implicit taxes were taken into account, the result would be recovery of lump-sum prices (or perhaps prices absent any government spending and taxation). then pretax profit, so determined, would reliably indicate whether an investment were compatible with economically-efficient resource allocation. the problem with knoll's approach is that there is no reason to think that the tiny fraction of adjustments to after-tax profit that the 2010] florida tax review parties to a dispute would be able to quantify is any closer to lump-sum pretax profit than the familiar after-tax profit that motivates billions of economic transaction every year. this subsection begins by elaborating on knoll's basic point that, from the standpoint of economic theory, implicit taxes and subsidies are on the same footing as legal taxes and subsidies: whether a tax or subsidy of a particular size is provided to buyers or sellers, the revenue raised, the distortion to output (and resulting deadweight loss) and the effective prices to producers and their customers is approximately the same. from this perspective, however, it seems it must also be conceded that taxes and subsidies in related markets can be on the same footing as taxes and subsidies in the first market. but knoll's principal conclusion is that ignoring implicit taxes makes application of a pretax profit test unreliable. the subsection concludes by suggesting that knoll's position actually implies that the pretax profit test is only reliable in a world of lump-sum taxation, an implication with essentially no practical consequences. figure 1 in the previous subsection illustrates the change in equilibrium price from an excise tax imposed on purchasers of a product. figure 2, below illustrates the effect of providing a subsidy to buyers accelerated depreciation would be an instance. figure 2 s p. p _ qo q, q figure 2 represents a tax subsidy of s per unit to buyers of the product. in this case, the subsidy shifts the demand curve up by the amount of the tax, s. with no tax, or lump-sum taxation, the equilibrium price is p0 and the equilibrium quantity is qo. the tax subsidy shifts demand to d,; the [vol9:9 economics and economic substance equilibrium quantity after tax is qj. from the point of view of the producer, there is only one price: p*. from the buyer's point of view, p* is the pretax price and p' is the after-tax price: each unit purchased by the buyer is accompanied by tax savings of s. buyers and producers share the benefit of the subsidy. buyers benefit from an effective price reduction of p p', after tax, and producers from an actual price increase from p0 top*. the price rise here is less than the amount of the subsidy, for reasons similar to those discussed in connection with figure 1. figure 3, below, illustrates the effect of providing a subsidy of s to producers (only). figure 3 $s ss po q0 q, q providing a subsidy to sellers shifts the supply out and down down by the amount of the subsidy, s. the same subsidy s provided to sellers should lead to about the same increase in production, from qo to q1, and cause the market price to fall from po to p'. (there is no shift in demand in this case, but the demand shift in the previous case is depicted for comparison.) as far as buyers are concerned, there is one price, p'. reduced from po on account of the subsidy. to a seller, p' is the pretax price and p * the after tax price, with p* above p0, but not by as much as the subsidy (because demand will not support a higher volume without a decline in the pretax price). whether the tax subsidy is provided to buyer or seller, the same output level results, buyers face an effective price of p' and sellers face an effective price p *, with p * -p'= s. in the first case, however, buyers have an explicit tax subsidy, in the second, the tax benefit is implicit. for suppliers, 20101 florida tax review the situation is reversed implicit tax benefit in the first case, explicit benefit in the second. suppose you thought that the subsidy s in the first case were inadvertent and that buyers should have to show a profit based on the pretax price, p*. then perhaps you would also believe that if there were instead an inadvertent subsidy on the supplier side, buyers should still use price p*, even though the market price is p', because the price p' is an artifact of a producer tax subsidy in other words, you may say, as knoll does, that p* is the buyer's pretax price in any case, because in the second case the buyer benefits from an implicit tax subsidy of s. as stated in subsection a, however, the pretax price has no particular economic significance versus the after-tax price; in general, there is no reason to think one or the other is a better approximation to the price that would prevail under across-the-board lump-sum taxation, p0. at least recognition of implicit taxes might seem to provide consistency to the economic substance doctrine, but consistency is not so easily realized. suppose, for example, that instead of an explicit tax subsidy on producers, there were an explicit tax subsidy given to the producer of an important factor of production of suppliers in this market. such a tax subsidy in a related market could shift the supply curve in the original market in the same way as the shift depicted in figure 3. a tax break for the steel industry, for example, could increase the supply of manufacturing equipment, increasing equipment output and lowering equipment prices. buyers and sellers in the original market would then all face price p'. in principle, however, it would seem as if buyers in the original market should be able to demonstrate a pretax profit based on the price p*--if, in fact, there were a principled reason to think p *, rather than p0 or p', had greater relevance to investment decisions. as a matter of economics, there is an implicit tax benefit to buyers in the first market in each case: a subsidy to producers in the first market or a subsidy to producers in a factor market. or for that matter, a subsidy to suppliers in a factor market of a factor in the production of the first market product. and in practice, prices in any market are influenced by taxes and tax benefits all along the supply chain.80 sort it all out and you would recover an economically significant number, the relative price of a product with lump-sum taxes, or no taxes. but in the absence of lump-sum taxation, the practical importance of even that price would be limited: it is unlikely to be a more reliable guide to efficient resource allocation than an actual after-tax price unless all markets operate on the 80. see harvey s. rosen & ted gayer, public finance 320-29 (8th ed 2008); see also don fullerton & gilbert e. metcalf, tax incidence, in 4 handbook of public economics 1789 (alan j. auerbach & martin feldstein eds. 2002); joel slemrod & jon bakija, taxing ourselves 78 (4th ed 2008). [vol9:9 economics and economic substance 81basis of the prices that would prevail under lump-sum taxation. an economy in which all markets operate as they would with lump-sum taxes would obviously be, for all practical purposes, an economy with lump-sum taxation, not income taxation. c .shaviro's marginal efficiency cost of funds analysis daniel shaviro is a leading advocate for the application of economic principles in tax legal scholarship. 82 shaviro uses an economic concept called the marginal efficiency cost of funds (mecf) to evaluate the economic substance doctrine.83 the mecf is conventionally expressed as eirimr, where dr represents the additional revenue that would be gained if, in response to a change in tax policy, taxpayers did not change their consumption, investment, labor or production, and mr represents the change in revenue taking into account taxpayers' adjustments. in a world without taxes, the introduction of a small lump-sum tax does not change economic behavior significantly (although a reduction in income forces reduced consumption), so dr and mr are the same and mecf is one. a tax on emails unless they contain the disclaimer "this e-mail is not subject to tax" in the header or body would have an extremely high mecf because of the adjustments to the tax that taxpayers would make. the expense of the adjustments would be deadweight loss because the tax would not raise appreciable revenue. at least in the case of excise taxes on various goods, it can be rigorously shown that if the mecfs of the taxes on individual goods differ, then some improvement in deadweight loss should be possible until the mecfs are all the same.84 it has been suggested that if it is possible to identify two sources of tax revenue, one with a mecf significantly higher than another, that the deadweight loss of taxation can be reduced by increasing reliance on the source with a lower mecf and reducing reliance on the source with the higher mecf.85 a mecf close to one is an indication of an economically efficient tax. in the case of an excise tax on a single good, the rough intuition is that taxes should distort economic behavior as little as possible. if mecf is close 81. see harvey s. rosen & ted gayer, public finance 351-52 (8th ed 2008) ("multiple taxes and the theory of the second best"). 82. see, e.g., daniel n. shaviro, an efficiency analysis of realization and recognition rules under the federal income tax, 48 tax l. rev 1 (1992). 83. daniel n. shaviro, economic substance, corporate tax shelters and the compaq case, tax notes, jul. 10, 2000, at 222. 84. joram mayshar, on measures of excess burden and their application, 43 j pubecon 263, 266 (1990). 85. joel slemrod & shlomo yitzhaki, the costs of taxation and the marginal efficiency cost of funds, 43 imf staff papers 172, 185 (1996). 2010] florida tax review to one, that suggests that taxpayers do not change their behavior much when that tax rate is increased. the mecf of a tax policy can also be small even if activities targeted by the tax are reduced significantly, but taxpayers increase taxable activities enough to offset the revenue lost by the adjustments. suppose, for example, shoes were heavily taxed, except for yellow shoes. and it is a use tax, so no point dyeing at home. consumption of yellow shoes is quite high. now the tax rate on yellow shoes is raised and people significantly shift from purchases on now taxable yellow shoes to taxable purchases of brown and black shoes. even though the tax increase causes a big change in one market, it causes offsetting changes in other markets that compensate, in terms of efficiency the tax increase actually improves relative prices. so we might think that the economic substance doctrine represents sound tax policy in spite of its theoretical shortcomings if caused less economic distortion than, say, the corporate income tax. the argument would not be that the economic substance doctrine is a good way of raising revenue because taxpayers will not respond to the existence of the doctrine and will persist in undertaking transactions without economic substance in spite of the denial of tax benefits; presumably the logic is rather that they will shift resources to more valuable activities that also happen to generate more tax revenue. two things stand out in shaviro's application of the marginal efficiency of cost of funds concept to the economic substance doctrine. first, the analysis has almost nothing to do with the actual content of the doctrine. all that matters is the observation, often repeated in the literature, that investors are reluctant to "'purchase a shelter if it carries with it any significant business risk.' 8 6 the only evidence for this proposition is anecdotal: some very prominent tax lawyers have made this observation. in any event, an animal sacrifice requirement would also have a deterrent effect, and there seems to be no economic principle distinguishing an animal sacrifice requirement from a pretax profit requirement. it may be appropriate to appeal to instinct as a basis for preferring a pretax profit test over some other criterion. but then the marginal efficiency of cost of funds is not doing any real work, nor are economic principles in general. the other striking thing about shaviro's use of the mecf is that it only permits him to conclude: the mecf does not demonstrate that the economic substance doctrine is necessarily a bad thing. shaviro focuses on the type of transaction challenged by the government in the compaq case. applying the mecf in that context, he concludes: "the use of an economic substance approach to deter cross-border dividend stripping might well be 86. daniel n shaviro, economic substance, corporate tax shelters and the compaq case, tax notes int'l 1581, oct. 2, 2000 at 1603, quoting joseph bankman, the economic substance doctrine, 74 s.cal l. rev. 5, 30 (2000). [vol9:9 economics and economic substance desirable if the ratio of static [mr to or] that was achieved was sufficiently favorable. 87 in other words, the economic substance approach is sound if the mecf is low enough. the same thing could be said about any tax policy. a further limitation of shaviro's application of the mecf is the failure to compare the pretax profit requirement mecf with the mecf of alternative tax policies. elsewhere i have argued that mecf analysis is generally of limited usefulness for the sorts of issues of interest to tax legal scholars.88 but to be even of limited use, mecf analysis seems to require a suggestion that one tax policy instrument is likely to have a different mecf than an alternative's. d. risk bearing as the essence of economic substance instead of pretax profit, the existence of economic substance could be identified by risk.8 9 support for this benchmark is based on the observation that "prospective purchasers [of tax shelters] continue to be highly risk-averse in considering these deals." 90 no principle of economics, however, associates efficient resource allocation or the desirability of investment with an investment's degree of risk. there is no reason to think that the more worthwhile an investment is, the riskier it is likelier to be. further, as alex raskolnikov has noted, "forcing taxpayers to bear risk has no connection to income measurement or any other fundamental goal of our 87. id. at 1607. the quoted language appears in a discussion of the value of the economic substance approach under current law. shaviro comes to similarly ambiguous conclusions applying the mecf concept to safe harbor leasing, id at 1601-03, and high-basis, low value shelters, id at 1603-04. shaviro comes to a stronger conclusion about cross-border dividend stripping supposing that irc §§ 904 and 1211 did not exist, but does not employ the mecf framework to get there. 88. see terrance o'reilly, principles of efficient tax law, 27 va. tax rev 583, 613-15 (2008). 89. david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax l rev 29, 31, 54 (2006); daniel n shaviro, economic substance, corporate tax shelters and the compaq case, tax notes int'l 221, oct. 2, 2000 at 1608. 90. daniel n shaviro, economic substance, corporate tax shelters and the compaq case, tax notes int'l 221, oct. 2, 2000 at 1608; joseph bankman, the economic substance doctrine, 74 s.cal l rev 5, 28 (2000) ("[c]orporate purchasers [of tax shelters] generally will not purchase a shelter if it carries with it any significant business risk"); david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax l rev 29, 54 (2006) ("[n]o one seems willing to lose real money just to claim questionable tax benefits. when one gets to the bottom of the facts in one of these shelter cases, one invariably discovers that all of the significant economic risks have been hedged away"). 2010] florida tax review tax system."9 ' in addition, although the focus in this paper is on whether the economic substance doctrine has any connection to economic principles, it may be worth pointing out that a risk requirement does not appear substantially harder to finesse than a pretax profit requirement. 92 the presumption that tax-shelter purchasers are very risk averse does not support using risk as the standard of economic substance absent some indication that only or primarily tax-shelter purchasers are risk averse. one of the foundations of the economic substance doctrine is that the tax laws are vulnerable to abuse by taxpayers who satisfy the literal requirements of the internal revenue code to achieve results not intended by the government. but at this point there is no general principle of tax law that tax benefits are unavailable unless the plain language and the intended purpose of a statute are both satisfied.9 3 let's use u to stand for the universe of activities consistent with a particular tax provision's plain language but beyond the intent of the statute's drafters. let rf designate riskless activities. (this is just shorthand for very low risk even transactions with aaa entities involve some counterparty risk.) then tax benefits under this statute would be denied only to transactions in the intersection of u and rf, as shown by the shaded portion of figure 4, below. 91. alex raskolnikov, relational tax planning under risk-based rules, 156 u penn l rev 1181, 1187 (2008); see also daniel shaviro, risk based rules and the taxation of capital income, 50 tax l rev 643 (1995). 92. cf. alex raskolnikov, relational tax planning under risk-based rules, 156 u penn l rev 1181, 1187, 1188 (2008) ("[a]s far as frictions go, risk is not a particularly effective one.... to make things worse, the government cannot assume that risk-based rules actually result in the imposition of a meaningful risk. that these rules fail to deter most tax planning involving financial assets is hardly a matter for debate."). 93. new york state bar association tax section, report on the treasury's proposal to codify the economic substance doctrine, 88 tax notes 937 (aug. 14, 2000) ("although a finding that allowance of a claimed tax benefit was not contemplated by the applicable provisions is necessary to disallowance, such a finding is not sufficient."). [vol.9:9 economics and economic substance figure 4 by the way, it does not appear that anyone is supposing that rf is a subset of u or vice versa. hariton, for example, stresses the importance of determining whether a transaction is consistent with the purpose of a statute, an exercise that would be unnecessary if everything in rf were included in u. if u were a subset of rf, an economic substance requirement would be superfluous. it would only be necessary to examine purpose, since everything lacking purpose would lack economic substance. in the literature, it is not entirely clear why tax benefits should be allowed with respect to any activities in u. presumably activities in rf are thought to be particularly wasteful. say w is the set of especially wasteful activities. it is not plausible to maintain that only risk-free activities are egregiously wasteful even limiting consideration to the types of activities that are regularly undertaken by rational taxpayers. it is perhaps conceivable that all risk-free activities are extremely wasteful, but no one seems to advancing that position. figure 5 below shows the potential relationships among the sets u, r and w. 2010] florida tax review figure 5 u rf ideally it seems we would wish to deny tax benefits to activities within the intersection of u and w: activities that are wasteful and outside the scope of congressional intent. (principles of democratic government make wasteful activities outside u off limits.) some of the activities in that subset are caught by the proposed rule tying economic substance to risk, but the proposed criterion is likely to be very far from the mark, based on the arguments presented in favor of the rule. e. section 7701(o): a meaningful change in economic position section 7701(o)(1), which equates a transaction's economic substance with a meaningful change in the economic position of the taxpayer, is nominally broader than a pretax profit test. a committee report accompanying this provision, however, was unable to come up with a single example of a meaningful change in economic position other than pretax profit.94 moreover, even pretax profit does not suffice unless it is "substantial" relative to the potential tax benefits.95 evidently then, the provision actually imposes a more demanding requirement. the provision grafts onto a criterion unsupported by any recognized economic rationale an additional arbitrary requirement. since the ratio of potential pretax profit to tax benefits has no foundation in principles of tax policy, there can be no sound basis for a determination of when that ratio becomes substantial. 94. h. rep. 111-443 at 298 (2010). 95. § 7701(o)(2)(a). [vol9:9 economics and economic substance little consideration appears to have been given to the fraction of routine transactions that would meet the specified test, presumably because it is anticipated that most of the heavy lifting would be done by internal revenue service discretion, and a court's decision, whether the economic substance doctrine is "relevant., 96 in other words, under the proposal, the focus of an economic substance analysis would shift to assessing whether "the tax benefits are clearly consistent with all applicable provisions of the code and the purposes of such provisions. 97 an indiscriminate fraction of transactions satisfying the meaning, but not presumed purpose, of a tax statute, would fail to receive tax benefits on account of insufficient expected pretax profit. while there are a number of generic difficulties in establishing the purpose of legislation, there is a particularly prominent dilemma applicable to tax laws. unwelcome, undesired consequences inevitably result from raising revenue. 98 for example, the primary purpose of the corporate income tax is to raise revenue, with the unavoidable fallout that some businesses choose a less suitable form of organization.99 legislative intent is therefore a specious filter for applying the economic substance test in the typical case in which a tax shelter is challenged. after all, it is unlikely that there will be many cases in which any version of an economic substance test proves decisive when a transaction satisfies the literal terms of a statute but legislative history expressly identifies the transaction as beyond the provision's intended scope. in theory, therefore, the provision amounts to subjecting the clarified economic substance test to virtually all transactions satisfying the language of the code unless they are expressly blessed in legislative history. as a practical matter, however, this would simply force the irs and the courts to specify when the economic substance doctrine was really relevant. the contours of this "clariflication] and enhance[ment]"' 00 of the economic substance doctrine are so nebulous that it is impossible to assess whether it is on balance beneficial or harmful. 96. section 7701(o)(1). the house report does suggest several types of transactions that should not be affected by the provision, although it fails to explain whether the reason is that the economic substance doctrine is irrelevant in those cases, or that it is evident that the criteria of a meaningful non-tax change in position and non-tax purpose are always present. h. rep. 111-443 at 296 (2010). 97. h. rep. 111-443 at 296 n. 124 (2010). 98. see liam murphy & thomas nagel, the myth of ownership 98 ("[t]ax distortions in some form are unavoidable."); see generally harvey s. rosen & ted gayer, public finance 331-50 (8th ed. 2008). 99. see alan j. auerbach, taxation and corporate financial policy, in 3 handbook of public finance 1284 (alan j. auerbach & martin feldstein, eds. 2002). 100. h. rep. 111-443 at 295 (2010). 2010] florida tax review it would be intriguing to see the supreme court attempt to harmonize this new iteration of economic substance with accepted principles of statutory interpretation. suppose we were to say that the economic substance doctrine is relevant if there is a significant suspicion that a deduction, although allowable by a statute, would not have been within congress's intentions: congress defined a set s, and while the definition does includes x as an element, the inclusion of x was not contemplated, expected or intended. conceptually this seems very different than familiar rationalizations in tax law, such as the definition of an statutory merger as a reorganization, § 368(a)(1)(a), in which the meaning of the term reorganization has been construed to require significant stock consideration, continuity of business enterprise, and so on, although these conditions were not included in the relevant statutory text.1 ' in these familiar cases, the theory seems to be that the words of a tax provision must be understood in the proper context. so in the case of an a reorganization, the term statutory merger does not mean just any merger valid under state corporate law. the legislative history of the new economic substance provision does not, however, adopt this interpretive strategy. instead, it maintains that "the fact that a transaction does meet the requirements for specific treatment under any provision of the code is not determinative of whether a transaction or a series of transactions of which it is a part has economic substance.' 0 2 this formulation seems to suggest not only that the meaning of a provision may diverge from the result of a literal reading-a fairly routine outcome in statutory interpretation' ° 3-but further, more creatively, that the meaning of a provision cannot always be taken literally. new legislation that required every transaction-or specified transactions-to possess economic substance, in addition to meeting the requirements of any other tax provision, would alter the affects of many provisions of the code without, however, altering their meanings. but the new § 7701(o) does not adopt this approach either; it does not supplement the code in that way. from the perspective of the legislative history, transactions that fall within the meaning (and not just the literal terms) of a particular tax statute may be penalized for lacking economic substance, but there is no general requirement that transactions have economic substance. nor is there a description of a category of transactions that must have economic substance. from this perspective, the economic substance doctrine would not only lack a basis in economics. it would not appear to have a coherent foundation in conventional statutory interpretation. (this observation about § 7701(o), or at least its legislative 101 see, e.g., pinellas ice & cold storage co. v commissioner, 287 u.s. 462, 469 (1933); see also boris i. bittker & james s. eustice, federal income taxation of corporations and shareholders 12.21[2] (7th ed. 2000). 102. h. rep. 111-443 at 296 (2010). 103. e.g., lewis v. united states, 523 u.s. 155, 160 (1998). [vol9:9 economics and economic substance history, echoes similar points about the economic substance case law made by joseph bankman and joseph isenbergh, discussed in § ii.a and summarized in items 10 and 11 of§ ii.d.) f. the noble dream the inspiration for the economic substance doctrine seems to be the conviction that certain transactions are transparently wasteful in a way that no legislature could have meant to sanction. courts and most supporters of the doctrine do recognize that taxes and regulation inevitably distort business decisions. so while absent taxation one might expect a business to follow path x in figure 6, below, something like path y might be justified in the real world to achieve a worthwhile economic objective. figure 6 x b > on the other hand, deliberately setting out on a course like path z, in figure 7, below, is suspect. figure 7 path z seems clearly wasteful of resources on account of its loop: even an outside observer with no special knowledge of the business terrain can be confident that a course such as path z* in figure 8, below identical except that the loop is excised is a more efficient means of realizing whatever business objective path z would accomplish. 20101 florida tax review figure 8 b another analogy would be the route chosen by a taxi driver. in an urban area with one-way streets, left turn restrictions, traffic calming devices, constructions zones, toll roads and toll bridges and so on, the best course between two points may not be the shortest. a passenger from out of town would generally not in a position to second guess. but even an outsider would be able to recognize that it should not be necessary to intentionally pass over the same segment more than once. if actual business transactions could be represented as paths in space, it should not be objectionable to deny tax benefits to any transaction containing segments that loop back over the same point multiple times. at least the burden could be placed on the taxpayer to explain the business exigency of such a course. (it might be legally compelled, for example under securities law, corporate law or foreign law.) in the real world, courts may be able to recognize, case by case, that certain business transactions contain series of steps that are effectively redundant: whatever business objective a particular transaction might achieve, the objective could be accomplished just as well with fewer resources, no greater risk, at least as much profit, etc., if the steps were eliminated. this section has shown that lack of pretax profit does not isolate such cases. neither do the other proposed definitions of economic substance discussed herein. it is hardly obvious that there must be a simple criterion that correlates with the kind of unambiguously wasteful steps characteristic of the most egregious tax shelters. on its face, the recent legislation defining economic substance in terms of a meaningful change in economic position might seem to be in the spirit of a prohibition on redundant steps. it might be appropriate for the courts to interpret the provision along those lines. there is reason to suspect, however, that a meaningful change in economic position is intended to be understood as a meaningful enhancement in economic position. as noted in the previous subsection, the only example of a meaningful change in economic position addressed in the text of § 7701(o) or its legislative history is the existence of a significant positive pretax profit. targeting transactions that do not enhance a taxpayer's economic position is very different from targeting those that contain a series of steps [iol9:9 economics and economic substance that do not change that taxpayer's position at all. as david hariton has observed, productive transactions typically contain steps that, in isolation, fail to enhance the taxpayer's economic position. thus the specification of what constitutes the transaction can determine the outcome of the application of the economic substance doctrine.'04 since no economic principles establish the proper scope of a "transaction," this form of economic substance doctrine is arbitrary or indeterminate. in contrast, a doctrine focusing on offsetting steps need not be sensitive to the specification of a transaction. it could apply to a series of actions from one or more transactions if the net effect of just those activities were no change in position and, presumably, there were a material net cost in money, time or risk for those activities. such a formulation would not consider many alternatives means of reaching the same business objective, only those alternatives that eliminated actual steps without altering the result. changes in position would not be restricted to enhancements of economic position, since that either amounts to an unjustified requirement of pretax profit or simply has no relation to conventional economic concepts at all. a doctrine in that form might not address many dubious shelters or be particularly difficult to evade. neither of those potential limitations necessarily justifies a broader doctrine, however, unless the broader doctrine can be grounded in defensible standards. in any event, this discussion of offsetting steps or loops is not intended to recommend an alternative definition of economic substance; it is only intended to suggest a conceptual framework in which economic substance could have some connection, however abstract, with economics or with familiar tax policy objectives. even if there were a satisfying definition of economic substance based on the concept of unequivocally superfluous segments or something similar, it would remain subject to two severe difficulties identified in the economic substance literature. first, it would not be possible to maintain that the legislature could not have intended that tax benefits attach to transactions lacking economic substance, so defined. some tax provisions clearly sanction economically wasteful steps.105 it seems likely that any definition of 104. david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax l rev 29, 30, 40-47 (2006); joseph bankman, the economic substance doctrine, 74 s.cal l rev 5, 15 (2000)("in theory, by expanding or contracting the number of related events, a decisionmaker could reach virtually any result it wanted under the doctrine."); cf. david p. hariton, the frame game: how defining the "transaction" decides the case, 63 tax lawy. 1, 4, 7-9 (2009). 105. see, e.g., david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax l rev 29, 35-36 (2006); donald l. bartlett & james b. steele, the great energy scam, time (oct. 13, 2003), at 60 (irc § 45k, credit for producing fuel from a nonconventional source); john murawski, progress says it wins tax dispute, the news and observer (raleigh, nc), feb. 14, 2010] florida tax review economic substance faces the very awkward implication that even the unambiguous language of a statute must sometimes be supplemented by a review of its legislative history. second, this economic substance requirement would still provide an incentive for undertaking even more wasteful activity that was not so transparently wasteful. this kind of dilemma is not limited to tax law, of course. all sorts of legal rules have the potential to make an existing problem worse or to simply channel undesirable behavior elsewhere. conceivably an economic substance requirement might be justified primarily on cosmetic grounds when it is uncertain whether the benefits from inhibiting targeted transactions outweigh the costs imposed by stimulating other transactions. the spectacle of attaching tax benefits to manifest dissipation might be deemed politically intolerable. perhaps pushing some tax shelter activity out of sight preserves political support for other tax policy goals. no rigorous scholarship appears to corroborate this possibility, however. iv. conclusion there is no economic substance to the economic substance doctrine. in some tax shelter cases, courts were able to find that a taxpayer did not realize a pretax profit, and seized on that as the basis for ruling for the government. the economic substance doctrine has been on the books for a while now, yet in the intervening years, no credible explanation of why a lack of pretax profit should matter has emerged. the position that congress obviously did not intend to sanction transactions motivated solely by tax benefits fails to support a pretax profit requirement. that position simply assumes the unjustified premise that the absence of a pretax profit is a meaningful benchmark. if several tax shelters had used entities organized under the laws of guam, it seems unlikely that the courts would have thought to invalidate the transactions on that basis absent some express language on point. but lack of pretax profit was apparently considered a plausible pretext, and it has acquired a patina of economic logic over time. remarkably, however, no one has attempted to show that profitable transactions lacking pretax profit are more likely to be economically wasteful or that profitable, economically undesirable transactions are more likely to lack pretax profit. occasionally one connection or the other is simply asserted as more or less obvious. for example, daniel shaviro and david weisbach have suggested that "the requirement of pretax profit is often effective because if you must pay a shelter promoter a fee but are otherwise trying to do nothing, you are 2006, at di. ("it costs progress energy more money to produce synfuel than it can make by selling it. but the value of the tax credit exceeds the operating loss...."). [vol9:9 economics and economic substance almost bound to end up with a pretax loss.' 0 6 that could not be the foundation of the celebrated economic substance doctrine, however. at best, that could serve as the foundation of the anti-promoter fee doctrine. of course, there is no doctrine holding that paying someone a fee is not deductible; it depends on the nature of the service provided. so the crux of shaviro and weisbach's argument in support of the economic substance doctrine appears to be that if you are doing something pointless, you are not likely to have a significant pretax profit. but shaviro and weisbach back away from their claim, noting that "a pretax profit requirement may be ineffective if the taxpayer builds a positive return into the deal by advancing money to the promoter at a below market but positive interest rate. 10 7 more important is the neglect in the literature of the converse: is it true that when you are doing something worthwhile and you have an after-tax profit, you are likely to have a pretax profit too? i have noted in § iii that conventional economic theory does not support the converse; i have not seen an argument in the literature to the contrary. say we did observe that some objectionable shelters make heavy use of companies organized under the laws of guam. and we can see a reason why some objectionable shelters might do this it does not seem to be purely coincidental. but we do not see anything intrinsically objectionable about guam business organizations and we do not believe that all objectionable shelters necessarily rely on guam business entities. moreover, we cannot be certain that few legitimate businesses make use of guam companies. maybe at the end of the day tax penalties would be imposed on the use of guam organizations, without really settling whether the costs imposed on legitimate activities outweigh the benefits from placing some modest hurdles in the way of tax shelters. it would seem odd, however, to think that that outcome was compelled by competent statutory interpretation that the result was evidently congress's intent all along despite the absence of references to guam in any statute. it would be more obvious in this case that the economic substance doctrine would be a curious name for the rule, even though applying that name to the pretax profit test is as misleading. perhaps we would recognize in this case, however, that the merits of the penalties basically turned on empirical questions about costs and benefits, not on theoretical explorations about the nature of guam businesses or guam law. i suspect that the reason that the literature on the economic substance doctrine focuses on theoretical or doctrinal disputes, rather than the empirical question of the costs and benefits of the doctrine, is the perceived need to harmonize the content of the doctrine with a now considerable body of case 106. daniel shaviro & david weisbach, the 5th circuit gets in wrong in compaq v. commissioner, tax notes 511 (jan. 28, 2002) at 513. 107. id. at 513 n.l1. 2010] florida tax review law. although shaviro and weisbach's argument is highly leveraged on their assumptions coming in, they are right about the central point the contours of the economic substance doctrine should be evaluated based on costs and benefits. unfortunately, the logic and rhetoric of the case law is grounded in legislative intent, not costs and benefits. 10 8 for that reason, it is hard to see the basis for shaviro and weisbach's assertion that "the recent performance of the generalist appeals courts in [the economic substance/business purpose area] has frequently been appalling."' 1 9 the precedents that the appellate courts could contemplate in deciding the compaq and jes cases do not seem to lucidly express the principle that shaviro and weisbach think is fundamental: "we use multiple, sometimes conflicting doctrines, to try and filter out the transactions that seem likely to be relatively bad." 0 the case law that inspires the plausibly beneficial anti abuse doctrines characteristic of united states federal income tax law may become a drag on innovation and fine tuning of anti abuse provisions if new developments must be reconciled to misguided or obsolete, but authoritative, precedents. there have been competing formulations of economic substance that give less or no weight to pretax profit. because § 7701(o) refers to a "meaningful" change in economic position, and suggests that pretax profit is not the only indication of such a change, these alternatives are not off the table, at this point. for example, david hariton has maintained that economic substance is a question of "whether the taxpayer incurs unique economic risk by entering into the transaction that is itself substantial in relation to the amount of the tax benefits in question...... according to charlene luke, the relevant inquiry is whether "the after-tax return on the suspect transaction [is] substantially higher than the return on economically comparable market transactions."'" 2 these proposals also seem to be based on reverse engineering to isolate features that unappealing transactions in high-profile litigation have shared. the critical questions surrounding the pretax profit test are likewise passed over: why lack of economic substance, so defined, is intrinsically bad, and why intrinsically bad transactions are more likely to lack economic substance. 108. see yoram keinan, the economic substance doctrine (2008). 109. id. at 511. 110. id. at 513. 111. david p. hariton, when and how should the economic substance doctrine be applied?, 60 tax l rev 29, 55 (2006). 112. charlene d. luke, risk, return and objective economic substance, 27 va. tax rev 783, 785 (2008). [i1ol9:9 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 3 1998 number 12 partnership distributions: options for reform karen c. burke* i. introduction ................................ 678 ii. hot asset exchanges: the statutory framework .................................. 680 a. goals and shortcomings of section 751(b) ........ 680 b. repeal of section 751(b) and optional basis adjustnents ............................. 686 c. 1982 ali proposals: full fragmentation ......... 690 m. replacing section 751(b) with a fullrecognition model ............................. 693 a. extending the subchapter s model ............. 693 b. deemed-sale approach ..................... 695 c. hot asset exchanges and partnership revaluations ............................. 699 iv. preserving nonrecognition treatment through basis adjustments .............................. 704 a. hot asset exchanges and inside basis adjustments . 704 b. coinplete or partial liquidations involving hot asset exchanges .......................... 708 1. complete liquidations ................ 708 2. partial liquidations .................. 710 3. cash distributions ................... 712 4. linit on gain recognized .............. 712 c. a compromise proposal: more gain recognition ... 713 v. prospects for the future of section 751(b) ....... 717 a. radical simplification: repeal of section 751(b) .... 717 b. mandatory revaluation and gain recognition ..... 720 c. expanding the section 704(c) approach .......... 725 vi. conclusion .................................. 728 * professor of law, university of minnesota law school. professor burke is a consultant to the american law institute's federal income tax project-taxation of passthrough entities. although she has benefited from discussions in connection with the all project, none of the views expressed here should be attributed to the all or other participants in the project. florida tax review i. introduction the rise of new forms of limited liability business entities, coupled with changes in the federal tax rules for classifying such entities, has precipitated an influx of businesses that are treated as partnerships for federal tax purposes.' some commentators welcome what they perceive as a process of de facto integration that promises eventually to make an elective regime of pass-through taxation available for all nonpublicly-traded businesses.2 to the extent that the partnership model, as currently embodied in subchapter k, represents a coherent and well-functioning body of law, such a sanguine view may be justified. however, as the preliminary work of the american law institute (ali) project on pass-through entities suggests, the intricate provisions of subchapter k may be "dysfunctional" in important respects. 3 indeed, subchapter k may have reached an important turning point. the 1954 code drafters stressed simplicity and flexibility while allowing partners considerable latitude in allocating tax benefits and burdens among themselves.4 with the benefit of hindsight, this tolerant attitude toward shifting tax consequences among partners appears to undermine broader tax policy goals. concern about the flexibility of partnership taxation-particularly the ease of entry and exit-has led some partnership reformers to veer in the opposite direction.5 recent legislative attempts to confine the broad nonrecognition policy of section 72 1-especially with respect to contributions of property with built-in gain or loss, disguised sales, and distributions of 1. see generally william a. klein & eric m. zolt, business form, limited liability, and tax regimes: lurching toward a coherent outcome?, 66 u. colo. l. rev. 1001 (1995); karen c. burke, the uncertain future of limited liability companies, 12 am. j. tax pol'y 13 (1995); susan pace hamill, the limited liability company: a catalyst exposing the corporate integration question, 95 mich. l. rev. 393 (1996); george k. yin, the taxation of private business enterprises: some policy questions stimulated by the "check-the box" regulations, 51 smu l. rev. 125 (1997). 2. see generally jerome kurtz, the limited liability company and the future of business taxation: a comment on professor berger's plan, 47 tax l. rev. 815 (1992). 3. see american law institute, federal income tax project-taxation of passthrough entities, tentative draft memorandum no. 2, at 2 (1996) [hereinafter ali, passthrough entities, tentative draft memorandum no. 2]. 4. beyond stressing the need for "clarification," the 1954 code drafters emphasized the goals of "simplicity, flexibility, and equity as between the partners." s. rep. no. 1622, 83d cong., 2d sess. 89 (1954), reprinted in 1954 u.s.c.c.a.n. 4621, 4722. 5. for contrasting views on the need for fundamental structural reform, compare mark p. gergen, reforming subchapter k: contributions and distributions, 47 tax l. rev. 173 (1991) [hereinafter gergen, contributions and distributions] with john p. steines, jr., commentary-unneeded reform, 47 tax l. rev. 239 (1991) [hereinafter steines, unneeded reform]. [vol 3:12 partnership distributions: options for reform previously contributed property-signal congressional ambivalence about subchapter k's unrivaled flexibility.6 while contributions and distributions often present different facets of similar problems,7 the lenient distribution rules of section 731 have, for the most part, escaped similar scrutiny.' this relative neglect of partnership distributions is all the more surprising since the "collapsible partnership" rules of section 751(b) represented the 1954 code's primary bulwark against income-shifting. 9 because of its daunting complexity and limited enforceability, section 751(b) has been described as the "achilles heel" of subchapter k."0 while section 751(b) is intended to safeguard against the use of distributions to shift ordinary income and capital gain, it also has a significant impact on the timing of recognition. thus, section 751 (b) offers a useful starting point for examining proposed reforms of the partnership distribution rules. part ii of this article examines the rationale for section 751 (b) within the general nonrecognition scheme of the 1954 partnership model and discusses proposals for its modification or repeal. part i1 considers whether the nonrecognition policy of section 731 should be replaced, as some writers have suggested, with entity-level taxation or a deemed-sale approach." part iv explores an alternative approach based on mandatory basis adjustments to prevent partners from manipulating partnership distributions to shift unrealized appreciation.' 2 finally, part v suggests that section 751(b)-type 6. see irc §§ 704(c)(1), 707(a)(2)(b), 737; see also regs. § 1.701-2 (warning against use of partnership rules to accomplish results inconsistent with the "intent" of subchapter k). unless otherwise indicated, all irc citations refer to the internal revenue code of 1986, as amended through august 31. 1997. 7. see gergen, contributions and distributions. supra note 5. at 182 ("why different generations have focused on different parts of a single problem is puzzling."). 8. in 1997, the allocation rules of § 732(c) for distributed property were amended. see taxpayer relief act of 1997, pub. l. no. 105-34 [hereinafter 1997 actl. § 1061, 111 stat. 945; see also irc § 731(c) (requiring gain recognition on certain distributions of marketable securities). for an overview of recent proposals to reform subchapter k, see staff of the joint committee on taxation, 105th cong., 1st sess., review of selected entity classification and partnership tax issues (comm. print 1997) [hereinafter selected partnership tax issues). 9. see irc § 751(b). in 1997, congress amended § 751(a) but left § 751(b) substantially intact. see irc § 751(a) (as amended by the 1997 act, § 1062, 111 stat. at 946) (eliminating the "substantial appreciation" requirement for inventory). 10. see james s. eustice, subchapter s corporations and partnerships: a search for the pass through paradigm (some preliminary proposals), 39 tax l rev. 345. 383 (1984). 11. see generally curtis j. berger, w(h)ither partnership taxation?. 47 tax l. rev. 105 (1991); philip f. postlewaite et al., a critique of the ali's federal income tax project-subchapter k: proposals on the taxation of partners, 75 geo. lj. 423, 464-89 (1986); see also gergen, contributions and distributions, supra note 5, at 202-10. 12. see generally william d. andrews, inside basis adjustments and hot asset exchanges in partnership distributions, 47 tax l. rev. 3 (1991); noel b. cunningham. needed reform, tending the sick rose, 47 tax l. rev. 77 (1991). 19981 florida tax review treatment be extended to all non-pro rata distributions of partnership assets through mandatory revaluations and special allocations. the article concludes that improvement of the existing nonrecognition regime, rather than a radical shift toward entity-level taxation, is both practicable and desirable. ii. hot asset exchanges: the statutory framework a. goals and shortcomings of section 751(b) in 1954, the ali identified several major policy objectives concerning the treatment of partnership distributions. 3 it was considered desirable to defer recognition of gain whenever a liquidating distribution consisted mainly of property other than cash, on the ground that immediate taxation might impede flexibility in the choice of business form. 4 to avoid possible "confusion," the ali considered that distributions in partial liquidation of a partner's interest should be treated under the same rules as current distributions that do not reduce a partner's interest.1 5 another major objective was to prevent the use of partnership distributions as a technique for converting ordinary income into capital gain. 6 finally, the ali sought to ensure consistent taxation of a disposition of a business interest by providing similar treatment for a sale of a partnership interest and a sale of partnership assets followed by a distribution. 7 from the outset, the disproportionate distribution rules of section 751 (b) represented the most significant exception to the broad nonrecognition scheme for current and liquidating distributions. section 751(b) generally treats a distribution that alters the partners' interests in so-called "hot assets" (defined, for this purpose, as unrealized receivables and substantially appreciated inventory) as a deemed exchange between the partnership and the distributee partner.'8 section 751(b) serves two related 13. the ali described partnership taxation under the 1939 code as "one of the most complex and confused subjects in the entire area of the income tax." j. paul jackson et al., a proposed revision of the federal income tax treatment of partnerships and partners-american law institute draft, 9 tax l. rev. 109, 112 (1954) [hereinafter jackson et al., proposed revision]. 14. see id. at 154. 15. j. paul jackson et al., the internal revenue code of 1954: partnerships, 54 colum. l. rev. 1183, 1211 (1954) [hereinafter jackson et al., partnerships] (noting that "[a] rule requiring recognition of gain or loss every time a distribution reduced a partner's interest would be complex to apply"). 16. see jackson et al., proposed revision, supra note 13, at 154. 17. see id. 18. see irc § 751(c), (d). the budget reconciliation act of 1993 amended the "substantial appreciation" test and added a new anti-abuse rule for inventory acquired for a "principal purpose" of manipulating the test. see pub. l. no. 103-66, § 13206(e)(1), 107 stat. 467 (amending § 751 (d)(1)). the 1997 act eliminated the substantial appreciation requirement [vol 3:12 partnership distributions: options for reform purposes: (1) to prevent the conversion of ordinary income into capital gain and (2) to prevent shifting of ordinary income among partners."9 the legislative history indicates that section 75 1(b) was originally intended primarily as a backstop to section 751 (a), which requires a selling partner to treat a portion of her gain as ordinary income on a sale of a partnership interest.' although the house version of section 751 applied to both sales and cash liquidating distributions, 2' the senate added a separate provision, section 751(b), applicable to "certain distributions treated as sales or exchanges." 22 section 751(b) was apparently added in response to objections that the house version applied to cash distributions, but not to inkind distributions of section 751 property.' in the case of a cash liquidating distribution, section 751(b) serves much the same function as section 75 1(a), the conceptually simpler provision relating to sales of partnership interests. where applicable, section 751(b) requires that the distributee partner treat a portion of the liquidating distribution as ordinary income just as if she had sold her partnership interest to an outsider or to the continuing partners.24 since the continuing partners are in effect acquiring the distributee's interest, the implicit purchase price should be reflected in their basis in the partnership's assets. any partnership assets involved in the section 751(b) exchange take a "cost" basis in the in connection with sales of partnership interests. see irc § 751(a), (b) (as amended by the 1997 act). the definition of unrealized receivables includes certain recapture items. see irc § 751(c) (flush language). 19. see william s. mckee et al., federal taxation of partnerships and partners 21.01[2], at 21-4 (3d ed. 1997). 20. see irc § 751(a); see also dale e. anderson & melvin a. coffee, proposed revision of partner and partnership taxation: analysis of the report of the advisory group on subchapter k (second installment), 15 tax l. rev. 497, 525-28 (1960). 21. according to the house report, "it]he treatment thus provided upon the sale of an interest in [ordinary income assets] is also extended to any distribution by the partnership to a partner which has the same effect as a sale of such ordinary income [assetsl." see h.r. rep. no. 1337, 83d cong., 2d sess. 71 (1954). reprinted in 1954 u.s.c.c.a.n. 4017, 4097. 22. see s. rep. no. 1622, supra note 4, at 98-99 (1954). reprinted in 1954 u.s.c.c.a.n. at 5034; see also anderson & coffee, supra note 20. at 528 ("in effect, the senate prevented the avoidance of the rules of section 751(a) by a distribution of section 751 property to one partner."). 23. the american bar association (a.b.a.) commented that the house version would permit significant tax avoidance if the partnership's ordinary income assets were distributed to a low-bracket taxpayer. see anderson & coffee, supra note 20, at 527. 24. indeed, the transaction could be structured as a distribution of cash to the continuing partners immediately following a purchase of the retiring partner's interest. see andrews, supra note 12, at 11. this article does not address special problems that may arise if liquidating payments are made to a retiring partner over a period of years. see irc § 736. see generally james e. tierney, reassessing sales and liquidations of partnership interests after the omnibus budget reconciliation act of 1993, 1 fla. tax rev. 681 (1994). 19981 florida tax review hands of the partnership as constituted following the distribution. if the partnership has a section 754 election in effect, the optional basis adjustment provisions of section 734(b) ensure that "inside" basis' is adjusted to reflect any gain (or loss) recognized by the distributee on the nonsection 751(b) portion of the distribution. 6 for example, assume that c receives a cash liquidating distribution of $300 when the equal abc partnership has the following balance sheet: assets basis value capital basis value cash $300 $300 a $200 $300 inventory 150 300 b 200 300 land 150 300 c 200 300 total $600 $900 total $600 $900 under section 751(b), c is treated as if she had received her proportionate share of the hot asset (worth $100) in a current distribution; under section 732(a), c takes a basis of $50 in her one-third share of the hot asset, reducing her outside basis to $150. on the deemed exchange of her share of the hot asset for cash, c recognizes $50 of ordinary income ($100 fair market value less $50 basis) and the partnership takes a cost basis in the purchased portion of the hot asset. finally, the partnership is treated as distributing to c in liquidation of the rest of her partnership interest the remaining $200 of cash, triggering $50 of capital gain to c.27 if the partnership has a section 734(b) election in effect, the basis of the partnership's land will be increased to $200 to reflect the $50 of gain recognized by c on the nonsection 751(b) portion of the distribution.28 the continuing partners thus receive a cost basis in c's former share of the partnership's hot asset and land, preserving their respective shares of ordinary income ($50) and capital gain ($50). but for section 751 (b), c would recognize $100 of capital gain ($300 cash less $200 25. "inside" basis refers to the partnership's basis in its assets; "outside" basis refers to the partner's basis in her partnership interest. 26. see irc §§ 734(b), 754. on a cash liquidating distribution, § 734(b) plays a role analogous to § 743(b). see andrews, supra note 12, at 11-12. since the continuing partners have made a pro rata purchase, a single adjustment to the common basis of the partnership's property accomplishes the desired result. cf. irc § 743(b) (flush language) (adjustment is personal to the transferee partner). 27. see irc § 731(a)(1) (recognizing gain on cash distribution in excess of outside basis). 28. under the optional basis adjustment rules, a partnership may adjust the basis of retained partnership property if, as a result of a distribution, the distributee recognizes gain (or loss) or takes a basis different from the partnership's basis in distributed property. see irc §§ 734(b), 754. allocation of the basis adjustment is governed by § 755. see irc § 755. [vol. 3:12 partnership distributions: options for reform basis), thereby effectively shifting her $50 share of ordinary income to the continuing partners.' as illustrated by the above example, section 751 (b) serves to forestall potential rate arbitrage among partners. while the 1986 act reduced the rate difference between ordinary income and capital gain, the 1997 act has restored a substantial capital gains preference." nevertheless, section 751 (b) may be too complex to warrant its retention merely as a safeguard against shifting of ordinary income and capital gain. in the absence of section 751 (b), other provisions of subchapter k would generally prevent permanent elimination of ordinary income in connection with a disproportionate distribution.3 whatever the original purpose of section 751(b), however, it has arguably come to play an important role in the timing of recognition as well as in the characterization of income.32 under current law, the principal impact of section 751(b) is to accelerate recognition of ordinary income when there is a shift in the partners' interests in section 751 property, thereby preventing excessive deferral. one commentator has described section 751 (b) as "[olne of subchapter k's least understood and most widely ignored provisions."33 the reputation of section 751 as "the most complex part of subchapter k"' relates mainly to its operation in connection with distributions of property other than cash. in these situations, section 751 (b) gives rise to a hypothetical exchange between the partnership (as constituted after the exchange) and the distributee. in the deemed exchange, the partnership is treated as transferring the "excess" property (i.e., the disproportionate part of the distribution consisting of hot assets or other partnership property) to the distributee, and the distributee is treated as surrendering property of equal value but of a different class from the class of the excess property received. as a result of the deemed exchange, both the distributee and the partnership may recognize gain or loss, and both the excess property and the other property surrendered take a cost basis. 29. the basis allocation rules of § 755 would prevent any basis adjustment to the partnership's ordinary income assets as a result of gain recognized on the liquidating distribution. see regs. § 1.755-1(b)(1)(ii); prop. regs. § 1.755-1(c)(i)(ii); infra notes 66-68 and accompanying text. 30. see irc § 1(h). 31. see irc §§ 732(c) (providing that a distributee partner's basis in distributed inventory and unrealized receivables cannot exceed the partnership's basis for such assets), 735 (preserving ordinary character of gain or loss on distributed unrealized receivables and inventory). 32. see andrews, supra note 12, at 46; cunningham. supra note 12, at 89-90. 33. see berger, supra note 11, at 147. 34. american law institute, federal income tax project: subchapter k. proposals on the taxation of partners 8 (1984) [hereinafter all tax project]. 19981 florida tax review to illustrate the operation of section 751 (b) in a nonliquidating distribution, assume that the abc partnership in the above example distributes one-half of its land (worth $150) to c, reducing her interest in the partnership from one-third to one-fifth. 35 as revealed by the "partnership exchange table" in the margin,36 c has relinquished an interest in section 751 assets worth $40 for an equivalent amount of nonsection 751 assets. in the deemed exchange, the partnership is treated as transferring $40 worth of land (with a basis of $20) to c, and c is treated as surrendering $40 worth of hot assets (with a basis of $20). as a result of the deemed exchange, c recognizes $20 of ordinary income attributable to her share of hot assets relinquished and the partnership's basis in the hot assets is increased to $170; on the deemed exchange of the land, the partnership recognizes $20 of capital gain allocated equally among the non-distributee partners (a and b),37 increasing their outside bases. finally, the partnership is treated as making a current distribution to c of land (with a fair market value of $110 and a basis of $55). c takes a basis of $95 in the land ($40 cost basis plus $55 basis of distributed land); c's outside basis is reduced to $125 ($200 basis less $20 basis allocated to c's share of hot assets deemed distributed and $55 basis of distributed land).38 35. prior to the distribution, the fair market value of c's partnership interest ($300) represented one-third of the fair market value of all of the partnership's assets ($900). after the distribution to c of land worth $150, the fair market value of c's partnership interest ($150) represents one-fifth of the fair market value of the remaining partnership assets ($750). 36. to determine the assets involved in the deemed § 751(b) exchange, c's predistribution interest in partnership assets must be compared with the total of c's postdistribution interest in the remaining partnership assets and the assets distributed: partnership exchange table gross value + gross value gross value = increase of c's postof assets of c's pre(decrease) distribution distributed distribution in c's 115 interest 1/3 interest interest non § 751 assets cash $60 $ 0 $100 ($40) land 30 150 100 80 total $90 $150 $200 $40 § 751 assets inventory $60 $ 0 $100 ($40) see mckee et al., supra note 19, 21.03[3], at 21-14 to 21-16. 37. see regs. § 1.751-1(b)(2)(ii). 38. the partnership's post-distribution balance sheet would be as follows: assets basis value capital basis value cash $300 $300 a $210 $300 inventory land total 170 75 $545 300 150 $750 b c total 210 125 $545 300 150 $750 [vol. 3:12 partnership distributions: options for reform the hypothetical section 751(b) exchange imposes a tax "whose purpose is totally obscure" on those partners who are treated as surrendering nonsection 751 assets in the deemed exchange.39 rather than serving any discernible policy goal, exchange treatment is apparently an unintended consequence of the particular statutory mechanism chosen by congress in 1954.40 more recently congress has attempted to prevent shifting of built-in gain or loss by mandating deemed-sale treatment for certain distributions of section 704(c) property." the consequences of these distributions are determined as if such property had actually been sold for cash at fair market value,42 with appropriate adjustments to inside and outside basis. 3 if, in the example above, c were treated as selling her relinquished share of hot assets for fair market value, c would recognize $20 of ordinary income, increasing her outside basis and the basis of the partnership's hot assets. the deemed sale would trigger no gain to a and b, since their share of the partnership's hot assets has not decreased.44 because disproportionality is measured by shifts in the gross value of hot assets, rather than hot asset appreciation, section 751 may not even achieve its intended purpose of preventing shifts in potential ordinary income.45 for example, assume that the equal abc partnership owns cash plus two items of property: inventory #1 with a basis of $30 and a fair market value of $30, and inventory #2 with a basis of zero and a fair market value of $60. if a receives a liquidating distribution of her share of the cash and inventory #1, section 751 (b) is not triggered even though the distribution leaves the remaining partners with a disproportionate share of the partnerthe partnership may elect to revalue its assets in connection with the distribution. see regs. § 1.704-1(b)(2)(iv)(f); see also infra notes 139-53 and accompanying text. in the absence of a general revaluation, the partnership must adjust the partners' capital accounts to reflect the fair market value of any distributed property as if such property had been sold for its fair market value. see regs. § 1.704-1(b)(2)(iv)(e)(1). 39. see andrews, supra note 12, at 46. 40. see cunningham, supra note 12, at 92. 41. see irc § 704(c)(1)(b). this provision applies to a distribution of § 704(c) property within the seven-year period following its contribution. id. if such a distribution is made to a partner other than the contributing partner, the contributing partner will recognize gain or loss to the extent of the property's built-in gain or built-in loss. id. 42. see irc § 704(c)(1)(b)(i). 43. see irc § 704(c)(1)(b)(iii); regs. § 1.704-4(e)(1) & (2). 44. since a and b should each remain liable for s50 of the partnership's hot asset gain, c must be allocated $30 of the remaining appreciation of s 130 (s300 fair market value less $170 basis) inherent in the partnership's hot assets. thus, c should obtain the entire benefit of the $20 adjustment to the basis of the partnership's hot assets. see infra notes 13953, 136-38 and accompanying text. 45. see mckee et al., supra note 19, 21.0112], at 21-6. 19981 florida tax review ship's built-in ordinary income. 6 this apparent flaw could be eliminated by requiring that disproportionality be measured in terms of the hot asset gain that would be recognized by the partners if the partnership sold all of its section 751 property immediately before the distribution.47 although section 751 (b) has been roundly criticized for its complexity and potential inequity, commentators express sharply differing views concerning its continued role within subchapter k. some recommend that section 751(b) be repealed outright or retained merely as a backstop to section 751(a).48 others propose that any non-pro rata distribution (current or liquidating) be treated as a constructive sale,49 with the result that gain would be triggered whenever a partner relinquished an interest in some partnership assets for other partnership assets, even if no hot assets were involved. a less radical proposal would preserve and extend the current role of section 751(b) in preventing excessive deferral, while simplifying and rationalizing its operation." b. repeal of section 751(b) and optional basis adjustments shortly after enactment of section 751 (b), the 1957 advisory group on subchapter k recommended its repeal." the advisory group considered that income-shifting was already possible under section 704 and could be addressed adequately through anti-avoidance rules. some shifting of ordinary income and capital gain among partners was viewed as a reasonable price for significant simplification of the distribution provisions. the 46. see regs. § 1.751-1(b)(1)(ii), (g) ex. (3)(c). 47. see infra notes 159-61 and accompanying text. 48. see ali tax project, supra note 34, at 51-55; a.b.a. tax section recommendation no. 1974-1i, reprinted in 27 tax law. 839, 842 (1974); staff of the joint committee on internal revenue taxation, summary of the subchapter k advisory group recommendations on partners and partnerships 158 (1959) [hereinafter advisory group]. 49. see postlewaite et al., supra note 1i, at 597-98, 606-07; see also berger, supra note 11, at 154-55. 50. see andrews, supra note 12, at 6, 52-55. 51. according to the advisory group, § 751 needed to be "simplified even though in so doing some of the theoretically correct results of [§ 751(b)] may be lost." advisory group, supra note 48, at 158. 52. see id. at 160. in the legislative hearings, arthur b. willis indicated that "[w]e would rather see ... an in terrorem provision put in as a club against the misuse of the distribution area, and eliminate ... the complexities that we have under present section 751(b)." advisory group recommendations on subchapters c, j, and k of the internal revenue code: hearings before the committee on ways and means, house of representatives, 86th cong. 73 (1959) (statement of arthur b. willis, chairman of the advisory group) [hereinafter hearings]; see also anderson & coffee, supra note 20, at 539. 53. see advisory group, supra note 48, at 160. [vol 3:12 partnership distributions: options for reform advisory group believed, however, that repeal of section 751 (b) should not open new opportunities for converting ordinary income into capital gain. under pre-1954 law, it was possible to obtain a step-up in the basis of ordinary income property by distributing such property in exchange for all or a portion of a partner's interest.55 for example, if inventory with a basis of $4,000 and a fair market value of $10,000 was distributed in liquidation to a partner with an outside basis of $10,000, the basis of the inventory was stepped up to fair market value. thus, the distributee would recognize no ordinary income on sale of the inventory and the other partners might be left with only appreciated capital gain assets. to close this loophole, the 1954 code drafters enacted section 732(c), which prevents the distributee from taking a basis in unrealized receivables or inventory in excess of the partnership's basis in such assets."6 the 1954 code also established carryover-basis treatment under section 732 as the general rule for other distributed property, eliminating the so-called "proportional allocation" rule under the pre-1939 code.' in addition, section 735 was enacted to preserve the ordinary income character of distributed hot assets in the hands of the distributeef 8 the 1957 advisory group felt that these provisions were generally adequate to deal with the problem of conversion of ordinary income into capital gain.59 it recognized that, in the absence of section 751 (b), partners could reduce their overall tax burden by distributing ordinary income assets to a low-bracket partner who could then sell such assets.' although the advisory group was willing to tolerate this type of income-shifting as the price for eliminating section 751 (b), it proposed to amend the basis allocation rules of section 755. under the proposed revision, any upward basis adjustments under section 734(b) would be allocated solely to nonsection 751 assets. 6t thus, the withdrawing partner would be eligible for capital gain treatment on a distribution of cash in exchange for section 751 assets, but the 54. see id. at 147. 55. see g.c.m. 20,251, 1938-2 c.b. 169, 169 (partner's outside basis allocated among distributed assets in proportion to their fair market value at time of distribution). 56. see irc § 732(c). 57. see 2 american law institute, federal income tax statute: february 1954 draft 358 (1954); h.ir rep. no. 1337, supra note 21, at 69, reprinted in 1954 u.s.s.c.a.n. at 4095 (carryover-basis rule "avoids the complexities of present law which requires that a portion of the basis of the distributee for his interest in the partnership be assigned to property distributed"). 58. see irc § 735(a) (five-year taint for inventory; permanent taint for unrealized receivables). 59. see supra notes 51-53 and accompanying text. 60. see advisory group, supra note 48, at 158. 61. see id. at 158, 170-71. 19981 florida tax review continuing partners would receive no basis step-up in the partnership's hot assets. the treasury strenuously opposed repeal of section 751(b) on the ground that it would provide greater latitude for income-shifting from highbracket to low-bracket taxpayers.62 moreover, the proposed amendments to the basis allocation rules were open to the criticism that they would allow "upward adjustments ... to the basis of depreciable [capital] assets of the partnership in connection with a distribution of section 751 assets." 63 under these proposals, upward basis adjustments could be allocated to any nonsection 751 asset, which included depreciable capital assets. thus, it would be possible to boost the basis of depreciable capital assets, thereby generating higher depreciation deductions. both the treasury and the organized bar also objected to the repeal of section 751(b) and the proposed changes to sections 734(b) and 755, on the ground that this would introduce an unwarranted disparity in the tax treatment of redemptions and sales of partnership interests.6' in spite of the recommendations of the advisory group, legislation introduced in 1960 retained section 751 (b) virtually intact.6 under current law, section 755 governs the allocation of optional basis adjustments among partnership assets. section 755 contains both a general rule and a special rule: the general rule requires that any adjustment be allocated "in a manner which has the effect of reducing the difference between the fair market value and the adjusted basis of partnership properties, 66 while the special rule requires that adjustments attributable to capital gain assets be allocated solely to capital gain assets and adjustments attributable to other assets be allocated to such assets.67 the special rule, sometimes referred to as the "basis segregation rule,"6 is intended to prevent the shift of basis from capital gain to ordinary income assets. 62. hearings, supra note 52, at 657 (jay glasmann, representing the treasury); see also anderson & coffee, supra note 20, at 538-39. 63. see anderson & coffee, supra note 20, at 539-40. the treasury's objections stemmed from the proposed elimination of the "basis segregation rule" of § 755, which divides property into (1) capital assets and § 1231 assets and (2) other property. see infra notes 66-68 and accompanying text. 64. the a.b.a. recommended limiting § 751 (b) to cash liquidating distributions. see hearings, supra note 52, at 995 (legislative recommendations of a.b.a.). 65. see h.r. 9662, 86th cong., 2d sess. 27-30, 148-50; see also arthur b. willis, willis on partnership taxation 17-18 (1971) (discussing congress' failure to enact proposed revisions). 66. see irc § 755(a); see also regs. § 1.755-1(a); prop. regs. § 1.755-1(c)(2). 67. see irc § 755(b); see also regs. § 1.755-1(b)(1)(i); prop. regs. § 1.755l(c)(1)(i). if a distribution triggers recognition of gain (or loss), the § 734(b) adjustment must be allocated solely to capital gain assets. see regs. § 1.755-1(b)(1)(ii); prop. regs. § 1.755l(c)(1)(ii). 68. see andrews, supra note 12, at 26. [vol 3:12 partnership distributions: options for refonn in focusing narrowly on the character of gain from a sale as ordinary or capital, congress apparently overlooked the potential for shifting basis from nondepreciable capital assets to depreciable capital assets.' because depreciable property generates ordinary deductions, inflating the basis of such property presents the same conversion potential that the basis segregation rules are presumably intended to prevent.70 for example, consider an equal three-member partnership which owns section 1250 real property with a fair market value of $1,000 and a basis of $100; the partnership's only other assets consist of $1,000 cash and nontraded securities with a basis and fair market value of $1,000. the partnership uses the cash to redeem one partner whose outside basis is $700, triggering $300 of capital gain under section 731(a) and a corresponding section 734(b) upward adjustment to the basis of the depreciable property. the continuing partners benefit from the higher basis of the real property through increased depreciation deductions. this basis-shifting technique is feasible because unrecaptured section 1250 gain is not treated as a separate noncapital asset for purposes of section 751 or the basis segregation rules of section 755.7i by contrast, if the partnership owned section 1245 property, the cash distribution would trigger recognition of hot asset gain equal to the reduction in the distributee's share of section 1245 recapture.72 although section 755 generally prevents outright shifts of basis between capital gain assets and ordinary income assets, it is fair to describe the basis allocation rules as "complex and not wholly rational."' one 69. see id. at 35-37. in certain limited circumstances, the regulations under § 732(d) may prevent shifting of basis from nondepreciable property to depreciable property. see irc § 732(d); regs. § 1.732-1(d)(4). these rules apply, however, only to distributions occurring after the purchase or inheritance of a partnership interest. see supra. 70. see andrews, supra note 12, at 36. section 732(c) affords similar potential for shifting basis from capital assets to depreciable property in connection with a partnership distribution. see irc § 732(c) (allocating basis among distributed assets in accordance with fair market value rather than relative bases); prop. regs. § 1.732-1(c). the 1997 act changes to § 732(c) may lessen the need for mandatory § 732(d) basis allocations. 71. assuming that the real property has been depreciated under the straight-line method, the recapture provisions will be inapplicable. see irc §§ 168(b)(3) (denying accelerated depreciation for residential and nonresidential real property), 1250(a)(1) (generally limiting depreciation recapture to the excess of accelerated over straight-line depreciation). the 1997 act created a special statutory rate of tax on so-called "unrecaptured § 1250 gain." see irc § 1(h)(6); see also infra note 225 and accompanying text. 72. section 751(c) bifurcates depreciable property subject to recapture into (1) a § 751(c) unrealized receivable with a zero basis and a fair market value equal to the potential recapture and (2) the rest of the property. see regs. § 1.751-1(c)(5) and mckee et al., supra note 19, 21.05[1], at 21-45 to 21-46; see also regs. § 1.1245-1(e)(2) (allocations of depreciation recapture). 73. see eustice, supra note 10, at 386 n.206. 19981 florida tax review commentator has suggested that repeal of the optional basis adjustment provisions would permit repeal of section 751(a) and (b).7 4 while eliminating section 734(b) would move subchapter k closer to an entity model, the basis adjustment provisions serve an important function, under an aggregate model, in preserving unrealized gain or loss for later taxation. the existing optional basis adjustment rules are defective, however, because a partnership generally makes such adjustments only when they are beneficial. of course, once a section 754 election is in effect, the partnership will generally be required to make section 734(b) and section 743(b) adjustments, even if such adjustments are detrimental. although congress clearly recognized that failure to make basis adjustments could give rise to distortions, the elective system was intended to provide administrative simplicity." several commentators have suggested that section 734(b) adjustments be mandatory rather than elective, in order to eliminate the current bias in favor of taxpayers.76 in connection with mandatory section 734(b) adjustments, it would also be desirable to amend section 755 to prevent shifting of basis from nondepreciable to depreciable property.77 c. 1982 all proposals: full fragmentation in its 1982 study, the ali urged repeal of section 751(b) on the ground that it "is extraordinarily complex" and "produces too harsh a result for the policy it is intended to enforce."78 the ali argued that a "fullfragmentation approach" would be "easier to understand than" existing section 751 and thus more likely to be observed in practice.79 under the full-fragmentation approach, the character of the transferor (distributee) partner's gain or loss would be determined as if she had disposed of her share 74. see e. george rudolph, collapsible partnerships and optional basis adjustments, 28 tax l. rev. 211, 222 (1973). 75. see ali tax project, supra note 34, at 195-96; see also regs. § 1.701-2(d) ex. 9 (failure to make § 754 election is "consistent with the intent of subchapter k"; anti-abuse rules inapplicable even though "principal purpose" for selection of distributed assets was to achieve particular basis result). 76. see ali tax project, supra note 34, at 217-18 (recommending mandatory § 734(b) adjustments only in the case of a cash liquidating distribution). for a more farreaching proposal, see andrews, supra note 12, at 22-24 (suggesting that congress repeal § 734(a) and make § 734(b) adjustments compulsory). see also richard g. cohen & lori s. hoberman, partnership taxation: changes for the 90's, 71 taxes 882, 885-86 (1993); selected partnership tax issues, supra note 8, at 32-33, 36-37. 77. see infra notes 178-81 and accompanying text. 78. see all tax project, supra note 34, at 51-52. 79. see id. at 23. [vol 3:12 partnership distributions: options for reforni of the underlying partnership assets.8o the all considered that the problem of valuation would be no greater under full fragmentation than under existing law. in 1954, the ali had rejected the full-fragmentation approach in order to minimize the number of partnerships subject to section 751.8 by expanding the category of unrealized receivables to include depreciation recapture, however, congress greatly increased the intrusiveness of section 751.82 the ali predicted that repeal of section 751(b) would have little impact on revenue, since the narrowing of rate differences lessened the incentive to shift income from high-bracket to low-bracket partners." because other provisions of subchapter k would prevent conversion of ordinary income to capital gain, the ali viewed the deterrence of incomeshifting as an insufficient justification for retaining section 751 (b).' on balance, the ali concluded that "the complexity [section] 75 1(b) introduces into subchapter k appears to overshadow its benefits." the full-fragmentation rule applied only to sales of partnership interests and cash liquidating distributions, thereby apparently restoring the 1954 version of section 751 as it existed prior to the senate amendment.' perhaps the most striking feature of the full-fragmentation approach was that it resulted in substantially less than "full" fragmentation when applied to many common types of partnership distributions.87 for example, the fullfragmentation rule was inapplicable to (1) any distribution of cash in partial liquidation of a partner's partnership interest, and (2) any current or liquidating distribution in which the distributee partner received both cash and other property (or solely other property). in the case of a three-person partnership holding appreciated inventory and land, the ali noted that the full-fragmentation rule would have no operative effect if one partner's interest were completely liquidated in exchange for the partnership's land.s the distribution would be nontaxable under section 731, even though the ordinary 80. see id. at 40-41. thus, both a direct sale of a business and an indirect sale through disposition of a partnership interest would be subject to the fragmentation rule of williams v. mcgowan, 152 f.2d 570, 572 (2d cir. 1945). 81. see jackson et al., proposed revision. supra note 13, at 145-46. 82. see all tax project, supra note 34, at 53. depreciation recapture was not enacted until 1962. see revenue act of 1962, pub. l. no. 87-834, § 12, 26 stat. 960, 1032. 83. see ali tax project, supra note 34, at 52 (noting that, "[iln the absence of very substantial tax saving," business considerations could be expected to impede tax-motivated non-pro rata distributions of nonfungible property among partners). 84. see id. at 55 n.l1. 85. id. at 52. 86. see supra notes 21-23 and accompanying texl 87. see ali tax project, supra note 34, at 35. 88. see id. at 54-55. 19981 florida tax review income attributable to the appreciated inventory was shifted entirely to the nondistributee partners. in a critical assessment of the ali's 1982 study, one commentator has suggested that the ali's description of its proposal as requiring "full" fragmentation represents a remarkable "understatement." 89 upon closer examination, however, the ali's 1982 proposals seem entirely congruent with a narrow conception of section 751 (b) as a backstop to section 751 (a). the 1982 ali study emphasized that "the purpose of [section 751] is not to impose a tax merely because a partner is exchanging an interest in one asset for an interest in another asset."" the only purpose of making the section 751 (b) exchange taxable was to prevent income-shifting, a purpose which might have been accomplished by "tainting" the distributed (or retained) property.9' although immediate taxation was considered administratively simpler than complex tracing rules, this approach was never intended to replace nonrecognition principles generally by treating all economic exchanges of partnership property as taxable.9 in 1982, the ali considered but rejected several reforms to subchapter k based on concerns about administrability and potential noncompliance with overly complex rules.93 in light of recent statutory provisions aimed at income-shifting in other areas, however, the 1982 all study's tolerant attitude toward income-shifting in connection with section 751(b) distributions may seem anachronistic. nevertheless, proposals to repeal section 751(b) continue to surface, as shown by a recent proposal to substitute a tax-avoidance standard for the existing statutory provision.94 this proposal would treat a disproportionate distribution as a taxable event only if it resulted in a "significant" shift in potential ordinary income and had a "principal purpose" of tax avoidance.95 while such a tax-avoidance standard would likely reach only the most egregious cases, the revenue loss might be relatively insignificant given the apparently low level of compliance 89. see postlewaite et al., supra note 11, at 596. 90. ali tax project, supra note 34, at 50. 91. see id. 92. see id. at 50-51. 93. for example, the all considered but rejected a "deferred-sale" approach to contributions of appreciated property, as finally enacted by congress in 1984. see id. at 13638; see also irc § 704(c) and regs. § 1.704-3; gregory j. marich & william s. mckee, sections 704(c) and 743(b): the shortcomings of the existing regulations and the problems of publicly traded partnerships, 41 tax l. rev. 627, 635-36 (1986). see generally laura e. cunningham & noel b. cunningham, simplifying subchapter k: the deferred sale method, 51 smu l. rev. 1 (1997). 94. see william b. brannan, the subchapter k reform act of 1997, 75 tax notes 121, 135-36 (1997). 95. see id. at 136; cf. regs. § 1.701-2 (general anti-abuse rules). [vol 3:12 partnership distributions: options for reform with existing section 751 (b).9 6 if the permissiveness of the current nonrecognition rules is a cause for unease, however, a simpler solution is available: congress could repeal section 751(b) and require gain recognition whenever a distribution results in an economic exchange among the partners. it[. replacing section 751(b) with a full-recognition model a. extending the subchapter s model by comparison to subchapter k, subchapter s treats property distributions much less favorably. perhaps influenced by the experience with section 751(b), the 1958 drafters of subchapter s opted to treat a distribution of appreciated property as a taxable event.97 recently, curtis j. berger has proposed that subchapter s principles be extended to subchapter k.9, in general, berger would require recognition of gain or loss whenever a partnership distributes appreciated or depreciated property.9 moreover, any disproportionate distribution that reduces a partner's interest in the partnership would be treated "as a taxable exchange, in the corporate fashion."'' berger's approach is premised on his choice of the s corporation model as the preferred form of organization for small business.' in seeking to harmonize the distribution rules of subchapters s and k, he considers "the corporate rule, or some slight variant thereof, by far the more defensible."'0 2 he would continue to treat partnership contributions as taxfree, under section 721, in order to "facilitate the creation and growth of joint business ventures."' 3 once the partnership's business has commenced, 96. see cunningham, supra note 12, at 93 (commenting, in another context, that "[s]ince § 751(b) is virtually ignored under current law, as a practical matter, there is no downside risk"); see also ali, pass-through entities, tentative draft memorandum no. 2, supra note 3, at 137 (remarking on low level of compliance with § 751(b)). 97. see eustice, supra note 10, at 383. of course, s corporations remain subject to § 341, the collapsible corporation provision. see irc § 341; a.b.a. tax section. comm. on s corporations subcomm. on the comparison of s corporations and partnerships, report on the comparison of s corporations and partnerships (pl 2), reprinted in 44 tax law. 813, 855 (1991) (proposing to exempt s corporations from § 341). 98. see berger, supra note 11, at 108. 99. see id. at 109. 100. see id. at 153. 101. see id. at 107 (referring to subchapter k as "the code's fair haired child-); cf. kurtz, supra note 2, at 832 (suggesting that proposed changes are unnecessary because limited liability companies will become the "vehicle of choice"). 102. see berger, supra note 11, at 154. 103. see id.; see also daniel n. shaviro, an efficiency analysis of realization and recognition rules under the federal income tax. 48 tax l. rev. 1. 49 (1992) (arguing that § 721 nonrecognition treatment may be "efficient" because contributions "may have little 19981 florida tax review however, he finds the rationale for continued nonrecognition treatment less compelling, and upon liquidation the justification for nonrecognition "virtually disappears" given the unlikelihood that the existing business will continue to be carried on."° thus, berger would treat a distribution of partnership property as a taxable event on the theory that it represents a partial disinvestment. to avoid deterring the formation of partnerships, he would nevertheless allow a tax-free distribution of contributed property to the contributing partner, but only to the extent of any pre-contribution gain (or loss). 105 although berger apparently would retain section 751(a), he claims that his proposal "would make [section] 751(b) almost redundant."' 10 6 a non-pro rata current or liquidating distribution of cash could nevertheless give rise to shifting of ordinary income and capital gain.1°7 moreover, cash liquidating distributions and sales of partnership interests would no longer be treated equivalently. in the absence of a section 734(b) adjustment, inside basis would not be adjusted to reflect the "purchase" of the withdrawing partner's interest following a liquidating distribution of cash. as a result, both the distributee and the continuing partners would be taxed twice on unrealized appreciation in partnership assets attributable to the redeemed interest. °' perhaps such temporary "double taxation" might be viewed as roughly offsetting the conversion of a withdrawing partner's share of ordinary income into capital gain on a cash liquidating distribution. 9 berger also proposes to adopt section 302-type rules for "substantially disproportionate" distributions in redemption of a partner's interest."' the rationale for this aspect of the proposal remains unclear. the corporate rules attempt to distinguish redemptions treated as taxable exchanges under nontax significance and be highly tax elastic"; hence, taxing contributions would be "futile"). but cf. postlewaite et al., supra note 11, at 465-73 (arguing that gain or loss should be recognized on contributions); david r. keyser, a theory of nonrecognition under an income tax: the case of partnership formation, 5 am. j. tax pol'y 269, 288-95 (1986) (arguing that "pooling" of assets should be treated as a sale). 104. see berger, supra note 11, at 154-55. 105. see id. at 155-56. berger predicts that the partnership form would continue to survive, even if stripped of most of its tax advantages, because it would still offer greater flexibility than the corporate form. see id. at 171. 106. see id. at 156. 107. see id. at 156 n.214. 108. the continuing partners would eventually recognize less gain (more loss) upon sale or liquidation of their partnership interests. 109. see rudolph, supra note 74, at 223-24 (noting potential double taxation). although berger asserts that his proposals would "eliminate the need for the §§ 754-734(b) election," this claim is overly broad. see berger, supra note 11, at 156. 110. see berger, supra note 11, at 153. [vol. 3:12 partnership distributions: options for reform section 302 from those treated as dividends under section 301.11 ' in the pass-through regime of subchapter s, sophisticated tax advisors readily grasp the advantages of obtaining favorable section 301 treatment by structuring a redemption to avoid the section 302(b) safe harbor for distributions not "essentially equivalent" to a dividend." 2 to the extent that a redemption does not trigger exchange treatment under section 302(b), it generally produces tax-free basis recovery to the redeemed s shareholder." 3 by reducing the redeemed s shareholder's interest in pre-distribution ordinary income, such a redemption may accomplish "just the sort of shift that section 751(b) seeks to tax in the partnership context.""' 4 in focusing on the tax treatment of the distributee partner, berger fails to discuss the partnership-level tax consequences of a redemption." 5 he also fails to indicate whether he would adopt a full look-through approach in determining the character of any gain (or loss) recognized by the distributee partner. since subchapter s does not provide an especially coherent solution to the problem of income-shifting, the corporate model may fall short of its initial promise. berger would also repeal the liability-sharing rules of section 752 in order to harmonize the outside basis rules of subchapters s and k. 16 otherwise, a partnership could circumvent the requirement of gain recognition on distributions of appreciated property relatively easily by borrowing against the property and distributing the proceeds." 7 since repeal of section 752 seems unlikely, it is necessary to look beyond berger's amalgam of corporate and partnership principles."' b. deemed-sale approach if full-recognition treatment is viewed as desirable, the most obvious approach would be to treat any distribution that reduces a partner's interest 111. see irc §§ 301, 302. 112. if a redemption is not considered a taxable exchange, § 302(d) provides that the distribution will be treated under the rules of § 301; § 1368 (governing § 301-type distributions by s corporations) provides for tax-free recovery of a shareholder's basis before any gain is recognized. see irc §§ 301, 302(d), 1368(b). sec eustice, supra note 10, at 383 n.197; deborah h. schenk, federal taxation of s corporations § 12.03[2] (rev. ed. 1992). 113. see eustice, supra note 10, at 383 n.197. 114. see id. at 383. 115. see gergen, contributions and distributions, supra note 5, at 203. 116. see berger, supra note 11. at 114-15. 117. see id. at 156 n.213. 118. gergen recommends an approach that is "similar" to but "slightly more complicated" than berger's proposal. gergen would require several separate accounts for partnership liabilities in order to preserve nonrecognition treatment for distributions out of partnership borrowing. see gergen, contributions and distributions, supra note 5. at 201,22937; cf. steines, unneeded reform, supra note 5, at 245 (gergen's proposal would "result in exceeding complexity: a thicket of rules and a multitude of accounts"). 19981 florida tax review as a deemed sale of an equivalent portion of the redeemed partner's interest in partnership assets. deemed-sale treatment is consistent with the approach recommended by philip f. postlewaite in his comprehensive critique of the 1982 ali study. relying on an "analysis of efficient capital markets," postlewaite rejects the assumption that "economic realities mandate tax deferral treatment for partnership distributions" and dismisses concerns about lack of liquidity as a justification for continued deferral." 9 deemed-sale treatment is arguably appropriate because the withdrawing partner presumably could either insist upon a cash liquidating distribution or raise funds to pay the tax by selling (or borrowing against) the distributed property. 120 therefore, a distributee who retains the distributed assets should be treated as selling her partnership interest for cash and then purchasing the distributed assets for their fair market value.' 2 ' under the deemed-sale approach, a current pro rata or non-pro rata distribution of property would be treated as if such property had been sold immediately prior to the distribution, triggering gain (or loss) to the partnership.' 22 pro rata distributions of cash or nonappreciated property would generally be tax free, on the theory that such distributions represent merely the receipt of partnership earnings previously taxed to the partners as a portion of their distributive share of partnership profits or a return of the partner's capital.'23 line-drawing would be necessary to distinguish between non-pro rata distributions which result in a shift in the partners' proportionate interests in the partnership and a series of non-pro rata distributions which in the aggregate leave the partners' interests in the partnership unchanged. to the extent that other partners do not receive an equivalent amount of partnership property within some reasonable period, the excess portion of any non-pro rata distribution would be treated as a partial liquidation of the recipient's partnership interest, triggering recognition of gain or loss. 24 treating a disproportionate distribution as a partial liquidation arguably "reflects the economic realities of the transaction."'5 to avoid economic distortions, the other partners should generally insist on a reduction in the percentage ownership interest of the non-pro rata recipient following a disproportionate distribution, because otherwise partnership allocations in accordance with the partners' pre-distribution percentage interests in the partnership will no longer correspond to their post-distribution economic 119. see postlewaite et al., supra note 11, at 596-97. 120. see id. at 597. 121. see id. at 597-98. 122. see id. at 606-07. 123. see id. at 607. 124. see id. at 606. 125. id. [vol 3:12 partnership distributions: options for reform interests.', full-fragmentation and gain recognition would eliminate any disparity between the partnership's inside basis and the continuing partners' outside bases. 127 under the deemed-sale approach, a partially redeemed partner would be treated as owning two separate partnership interests-one redeemed and the other continuing. the redeemed portion would be treated as if sold for its fair market value, triggering proportionate recognition of unrealized gain (or loss) inherent in the partnership's retained assets.1'2 any gain or loss attributable to distributed property would be taken into account immediately before the redemption. to illustrate the operation of the deemed-sale approach, assume that c receives a distribution of land #2 when the equal abc partnership has the following balance sheet: assets basis value capital basis value cash $120 $120 a $120 $180 inventory 60 180 b 120 180 land #1 120 150 c 120 180 land #2 60 90 total $360 $540 total $360 $540 since the fair market value of the distributed property ($90) is equal to onehalf of the value of c's entire partnership interest ($180), the deemed-sale approach would treat one-half of c's interest (one-sixth of the total partnership) as redeemed. 29 the abc partnership would be treated as if it had "sold" land #2 to c for $90, triggering $30 of capital gain to be allocated equally among the partners. each partner would increase her outside basis to reflect her share of the gain recognized. in addition, c would be treated as if she had sold one-half of her interest in the remaining partnership assets (inventory and land #1), or one-sixth of the total value of each asset. accordingly, c would recognize $20 of ordinary income and $5 of capital gain (one-sixth of the appreciation inherent in the inventory and land #1). the abc partnership would increase its basis in each asset to reflect any gain 126. a mandatory agreement specifying the percentage reduction in the distributee's partnership interest would generally be respected. see id. at 598-99. 610. 127. deemed-sale treatment would eliminate the need for the § 734(b) basis adjustment provisions. see id. at 620 (§ 734(b) basis adjustments no longer necessary if carryover-basis rule eliminated). cf. supra note 109 and accompanying text (berger proposal). 128. see postlewaite et al., supra note 11, at 604. 129. a redemption of one-half of the value of c's partnership interest reduces her interest in the abc partnership from one-third to one-fifth. 19981 florida tax review recognized on the distribution, and c would take a basis of $90 in land #2, its fair market value. 130 the abc partnership's post-distribution balance sheet would be as follows: assets basis value capital basis value cash $120 $120 a $130 $180 inventory 80 180 b 130 180 land #1 125 150 c 65 90 total $325 $450 total $325 $450 each partner's tax capital account, share of inside basis and share of unrealized appreciation corresponds to her continuing percentage interest in the partnership. 31 thus, c's remaining tax capital account and share of inside basis is $65, or one-fifth of the partnership's total capital and inside basis. upon a sale of the partnership's remaining assets, c would be taxed on her remaining one-fifth of the appreciation in the inventory and land #1, resulting in $20 of ordinary income and $5 of capital gain. the other partners would each be taxed on $40 of ordinary income and $10 of capital gain (twofifths of the appreciation in the inventory and land #1). each partner's predistribution share of the partnership's total ordinary income and capital gain is preserved to the extent not recognized immediately. the deemed-sale approach produces harsher results than if c had instead sold one-half of her partnership interest (with a basis of $60) for its fair market value of $90. upon a sale of one-half of her interest, c would recognize $20 of ordinary income and $10 of capital gain attributable to her one-sixth share of the inventory and capital assets. 32 by contrast, the deemed-sale approach triggers additional gain of $5 to c because she is deemed to sell one-third (not one-sixth) of her interest in the distributed property (land #2) plus one-sixth of her interest in the remaining partnership assets. 33 thus, the deemed-sale approach arguably overtaxes c by eliminating deferral of her share of unrealized appreciation in the distributed property. 130. c's outside basis of $120 would be increased by the $35 gain recognized and reduced by the $90 basis of the distributed property in c's hands, leaving c with a remaining outside basis of $65. 131. each partner's tax capital account initially reflects the tax basis of contributed property; the partnership must maintain separate book capital accounts whenever property is contributed with a basis different from its fair market value (or whenever the partners' capital accounts are restated to reflect the fair market value of partnership property). see regs. §§ 1.704-1(b)(2)(iv)(d)(3), 1.704-1(b)(2)(iv)(f). 132. see irc §§ 741 and 751(a). 133. c's one-sixth share ($5) of unrealized appreciation in land #2 could be preserved by assigning such property a basis of $85 (rather than $90) in c's hands. [vol. 3:12 partnership distributions: options for reform c. hot asset exchanges and partnership rev'aluations the deemed-sale approach, modelled on the treatment of partial dispositions outside subchapter k, is simpler than existing section 751 (b). it would ensure that the partners' post-distribution tax capital accounts and shares of unrealized gain (or loss) generally correspond to their continuing percentage interests, thereby simplifying partnership accounting. notwithstanding these potential advantages, the deemed-sale approach may be viewed as unacceptable by those who believe that nonrecognition treatment serves important policy goals. it is useful, therefore, to consider whether the aggregate approach of existing section 751 (b) might be improved and extended. by contrast to the deemed-sale approach, current subchapter k does not treat a reduction in a partner's interest as a partial liquidation of a separate interest.3' while section 7516b) requires fragmentation of a partner's interest, the method of computing gain reflects a strict aggregate approach. in the preceding example, section 751 (b) would compute c's gain on the deemed exchange as if she had sold only two-fifths (not one-half) of her interest in the partnership's hot assets.' 35 although the distribution represents one-half of the total value of c's partnership interest, her percentage interest in the partnership has been reduced from one-third (331/3%) to one-fifth (20%). thus, c has transferred 13-1/3% of the partnership's total hot assets (or two-fifths of her original one-third interest) to a and b, and her retained one-fifth interest has absorbed a portion of the hot asset appreciation attributable to her redeemed interest. "' consistent with a pure aggregate approach, section 751 (b) requires c to pay tax only on her share of hot assets shifted to the other partners. the current method of computing gain under section 751 (b) gives rise to discontinuities among the continuing partners' tax capital accounts, shares of inside basis, and shares of unrealized appreciation. in the deemed section 75 1(b) exchange, c would be treated as relinquishing two-fifths of her original one-third share of inventory (with a fair market value of $24 and a 134. any distribution other than a liquidating distribution is treated as a current distribution. see regs. § 1.761-1(d). 135. see andrews, supra note 12, at 69; s. rep. no. 1622, supra note 4. at 98-99, reprinted in 1954 u.s.c.c.a.n. at 5045-47. 136. prior to the redemption, one-third of the total hot asset appreciation ($40) was attributable to c's one-third interest. consequently, one-sixth of the total hot asset appreciation ($20) was attributable to the redeemed one-half of c's one-third interest. however, upon the redemption, § 751(b) would require c to recognize only s16, or four-fifths (s161s20), of the total hot asset appreciation attributable to the redeemed interest. consequently, after the redemption, c's remaining one-fifth interest would be responsible for total hot asset appreciation of $24, i.e., its original one-sixth share ($20) plus one-fifth of the redeemed interest's share ($4). see andrews, supra note 12, at 69. 19981 florida tax review basis of $8) in exchange for a commensurate increased interest in land #2. accordingly, c would recognize $16 of ordinary income, and the partnership's basis in the inventory would be increased from $60 to $76.' since section 751(b) taxes c on only two-fifths (not one-half) of her original share of the hot asset appreciation, she should remain taxable on her retained threefifths share (one-fifth of the total). upon a sale of the inventory, the other partners should apparently receive the entire benefit of the $16 increase in inside basis, requiring a special allocation of gain to distinguish c from the other partners.1 38 the analysis would be different if, in connection with the distribution, the partnership elected to "book up" the partners' capital accounts and revalue its assets. 139 following a revaluation, section 704(c) principles (so-called "reverse-section 704(c) allocations") govern in determining the allocation of the partnership's tax items with respect to revalued property. 40 the consequences of a general revaluation upon redemption of a partner's interest are thus similar to those in connection with admission of a new partner when a partnership holds appreciated property. although a general revaluation is optional in connection with redemption of a partner's interest, the section 704(b) regulations warn that the absence of such a revaluation (or an equivalent special allocation of pre-distribution gain or loss) may have 137. see regs. § 1.751-1(b)(3)(iii). under current § 751(b), the partnership would be treated as exchanging an interest in a portion of land #2 (with a fair market value of $24 and a basis of $16) for an increased interest in the partnership's hot assets; the partnership's recognized gain of $8 should presumably be allocated entirely to a and b. see regs. § 1.75 1i (b)(3)(ii). 138. before taking into account the basis adjustment, the partnership has $120 of potential hot asset gain. c's one-fifth share of the remaining hot asset gain ($24) plus her hot asset gain recognized on the distribution ($16) equals her pre-distribution share ($40) of the partnership's hot asset gain. since a and b should be taxed on total hot asset gain of $80, they must receive the benefit of the entire $16 adjustment to inside basis ($120 hot asset gain less $16 basis adjustment less $24 gain allocated to c). see andrews, supra note 12, at 69. 139. a revaluation is permitted (i) in connection with a contribution of money or other property to the partnership by a new or existing partner in exchange for a partnership interest; (ii) in connection with a liquidation of the partnership or a distribution of money or other property to a retiring or continuing partner in exchange for all or a portion of her partnership interest; or (iii) in accordance with generally accepted industry practices in the case of securities partnerships. see regs. § 1.704-1(b)(2)(iv)(f)(5). see generally richard w. harris, federal taxation of partnership asset revaluations, 14 va. tax rev. 257 (1994). 140. see regs. § 1.704-1(b)(1)(vi). once partnership property has been revalued, capital accounts must subsequently be adjusted for the partners' distributive shares of book items with respect to the revalued property, and § 704(c) principles must be applied in determining the partners' distributive shares of tax items with respect to such property to take account of book/tax disparities arising from the revaluation. see regs. §§ 1.7041(b)(2)(iv)(f)(i)-(4), 1.704-1(b)(2)(iv)(g). [vol 3:12 partnership distributions: options for reform significant adverse tax consequences.' 4 ' a general revaluation may also be desirable to avoid conferring an unintended economic benefit on those partners whose interests increase when another partner's interest is reduced. a book-up prevents an economic shift by ensuring that any unrealized gain or loss inherent in existing partnership property will be allocated in accordance with the partners' pre-distribution sharing ratios. any postdistribution gain or loss will be allocated in accordance with their altered sharing ratios. since a revaluation effectively "locks in" the partners' pre-distribution shares of net unrealized appreciation, it might be expected to render section 751(b) inapplicable. 42 this will generally be the case whenever the partnership holds only zero-basis section 751 property, such as unrealized receivables and depreciation recapture, and the distributee receives only nonsection 751 property. 43 for example, assume that the abc partnership purchases land for $210 which appreciates in value to $300. each partner has a basis of $120 in her partnership interest. when the partnership also has $90 of zero-basis unrealized receivables and cash of $150, c receives a s90 cash distribution which reduces her interest from one-third to one-fifth. immediately before the distribution, the partnership's assets are restated to reflect fair market value and the partners' capital accounts are increased to reflect their share of unrealized appreciation in the partnership's assets. accordingly, abc will have the following post-distribution balance sheet: assets basis value capital basis value cash $ 60 $ 60 a $120 $180 receivables 0 90 b 120 180 land 210 300 c 30 90 total $270 $450 total $270 $450 since the book-up preserves c's entire pre-distribution share of the partnership's unrealized appreciation in the accounts receivable ($30), there should be no deemed exchange to trigger section 75 1(b). as a result of the revaluation, the distribution leaves unchanged the partners' respective shares of hot asset appreciation. special allocations will be required, however, to ensure proper allocation of the tax gain corresponding to the booked-up gain. section 704(c) principles presumably require that c's share of the "common" basis of partnership assets be allocated among such assets in proportion to the total inside basis of such assets. following this approach, 141. see regs. § 1.704-1(b)(iv)(5) (last sentence). 142. see mckee et al., supra note 19, 21.0318], at 21-25. 143. see id. 144. see id. at 21-28. 19981 florida tax review c should have a one-ninth share ($30/$270) of the basis of each partnership asset; with respect to the unrealized appreciation in each asset, c's share is equal to one-third of the difference between the partnership's common basis and the gross value of each asset. thus, c has a one-third share of the appreciation inherent in the partnership's unrealized receivables ($30) and land ($30), corresponding to her share of the booked-up gain. based on these assumptions, c has the following post-distribution interest in the basis, unrealized appreciation and gross value of each partnership asset: gross undivided assets basis + appreciation = value 1/5 share cash $ 6.67 $ 0 $ 6.67 $12.00 receivables 0 30.00 30.00 18.00 land 23.33 30.00 53.33 60.00 total $30.00 $60.00 $90.00 $90.00 c's share of the total gross value of partnership assets ($90) is equal to the gross value of her remaining one-fifth interest ($90). when the individual partnership assets are divided into separate basis and gain components, however, the results seem somewhat strange. under the section 704(c) approach, c's share of the gross value of individual partnership assets differs from the amount determined as if she owned an undivided one-fifth interest in each asset. such disparities arise because the revaluation "freezes" c's share of pre-distribution appreciation but cannot prevent changes in her share of the partnership's common basis.'45 c's one-ninth share of the partnership's common basis ($30) represents her pre-distribution one-third share of the partnership's common basis ($120) reduced by the entire basis of the distributed property ($90). thus, c winds up with less than a one-fifth share of the partnership's post-distribution common basis.'46 the section 704(c) approach appears to conflict with the "undivided interest" approach which the section 751(b) regulations use to determine the partnership exchange table. the undivided interest approach assumes that c retains a one-fifth interest in the gross value of each partnership asset.'47 as illustrated above, the undivided interest approach is apparently flawed and does not correspond to the results reached under the section 704(c) approach. 48 until the section 751(b) regulations are revised, however, 145. see id. at 21-25. 146. if the distributed property represented one-half of c's former interest in terms of both basis ($60) and value ($90), c would have exactly a one-fifth share of the partnership's post-distribution common basis ($60/$300). 147. see regs. § 1.751-1(g) ex. 5. 148. see mckee et al., supra note 19, 21.03[8], at 21-28 to 21-29. [vol 3:12 partnership distributions: options for reform partners should presumably be entitled to rely on the undivided interest approach to determine the initial consequences of the section 751(b) exchange. since the section 704(c) approach generally preserves the partners' respective shares of hot asset gain, a book-up should render section 751(b) inapplicable in many common situations. it would be extremely helpful, however, if the regulations expressly sanctioned the use of a book-up to avoid section 751(b) gain. the only support for the book-up approach is an oblique reference in one example involving admission of a new partner. in the example, partnership property is revalued when the partnership owns depreciable property subject to a nonrecourse debt. 49 although the admission of the new partner triggers a deemed distribution of cash under section 752, the example provides that no minimum gain chargeback is triggered to the existing partners.'o while there is no mention of section 751(b), the result would clearly be different if the deemed section 752 distribution were treated as triggering a shift in hot assets.15' the section 751(b) regulations should also be revised to reflect the consequences of a book-up when a partnership owns hot assets.5' although a book-up may render section 751(b) inapplicable with respect to many distributions of nonsection 751 property, there are situations in which a book-up cannot prevent a section 751(b) shift. assume that a partnership holds nonzero basis hot assets and the distributee receives only nonsection 751 assets. even though a revaluation freezes the distributee's share of hot asset appreciation, section 751 (b) will nevertheless be triggered if the distributee's share of the gross value of the partnership's hot assets is reduced. under the section 704(c) approach, the distributee's share of the gross value of hot assets depends on her share of common basis plus her share of unrealized appreciation. if a distribution reduces the distributee's percentage share of common basis (but does not alter her share of unrealized appreciation), her share of the gross value of the partnership's assets is 149. see regs. § 1.704-2(m) ex. 3(ii). 150. id.; see also regs. § 1.704-2(d)(4) (decrease in partnership minimum gain attributable to revaluation added back for purposes of determining any net increase (decrease) in partnership minimum gain for current year). 151. see mckee et al., supra note 19, 21.03[8], at 21-30 to 21-31; cf. rev. rul. 84-102, 1984-2 c.b. 119 (disproportionate distribution of cash triggers gain under § 751(b); book-up not addressed). see also francis j. emmons & s. richard fine, coping with irs' ruling which applies sec. 751 on the admission of new partners, 62 j. tax'n 160 (1985); william t. carman, revenue ruling 84-102-an erroneous conclusion?. 2 j. partnership tax'n 371 (1986). 152. the existing § 751(b) regulations expressly sanction an agreement to treat a distribution of one class of partnership property as reducing the distributee's interest only in that class of property. see regs. § 1.751-1(b)(1)(ii). a book-up, which freezes the distributee's interest in hot assets, may have a similar effect. 19981 florida tax review necessarily reduced.'53 thus, section 751(b) will be triggered even though the distributee's share of hot asset gain is unchanged. this treatment reflects the underlying flaw in the measurement of hot asset shifts under existing section 751(b). the anomaly would be eliminated if the provision were revised to focus on shifts in hot asset appreciation (rather than gross value). the examples above assume that the partnership distributes only nonsection 751 assets and the distributee retains an interest in the partnership's remaining hot assets sufficient to avoid triggering section 751 (b). if a nonliquidating distribution includes hot assets, a book-up cannot necessarily prevent a section 751(b) shift because a portion of the hot assets are no longer in partnership solution. similarly, a hot asset shift may occur when a partner's interest is entirely liquidated, since the distributee retains no share of the partnership's remaining assets. although the section 704(b) regulations virtually mandate a book-up (or equivalent special allocations) when a portion of a partner's interest is relinquished, the partnership is burdened with the need for continuing special allocations. thus, a revaluation may prove quite cumbersome. unfortunately, the section 704(b) regulations provide virtually no guidance concerning the effect of a revaluation in connection with a hot asset distribution. iv. preserving nonrecognition treatment through basis adjustments a. hot asset exchanges and inside basis adjustments william d. andrews has recently proposed several changes in the treatment of partnership distributions, ranging from relatively minor technical revisions to far-reaching structural reforms.'4 the general tendency of these proposals is to prevent the use of distributions to shift unrealized appreciation among partners and to remedy defects in the existing basis allocation rules. more specifically, andrews suggests mandatory section 734(b) basis adjustments to eliminate loss duplication and basis-stripping transactions. 155 153. for example, assume that a distributee's share of the partnership's common basis is reduced from one-third to one-ninth as a result of a cash distribution, when the partnership owns a hot asset with a basis of $30 and a fair market value of $90, the distributee's one-ninth share of the common basis of the hot asset ($3.33) plus her one-third share of the unrealized appreciation ($20) is less than her former one-third share of the asset's gross value ($30). see supra notes 144-46 and accompanying text. 154. see generally andrews, supra note 12. 155. for an illustration of these transactions, see louis s. freeman & thomas m. stephens, using a partnership when a corporation won't do: the strategic use and effects of partnerships to conduct joint ventures and other major corporate business activities, 68 taxes 962, 993-95 (1990). [vol 3:12 partnership distributions: options for reform in connection with these proposals, andrews also suggests revisions in the treatment of hot asset distributions. the andrews proposals would modify the definition of hot assets and change the basic statutory mechanism of section 751(b) from "exchange" to "sale" treatment." 6 hot asset exchanges would trigger gain to the extent that a partner's share of hot asset appreciation cannot be preserved through appropriate basis adjustments. to prevent shifting of basis from nondepreciable to depreciable property, these proposals would modify the method of allocating basis adjustments under section 755. in addition, the categories of section 751(b) assets would be expanded to include a separate class of "tepid" assets. 157 the andrews proposals would eliminate the substantial appreciation test and would apply a full look-through approach in determining a partner's share of hot assets.158 to ensure that section 751(b) achieves its intended purpose, these proposals would focus on shifts in a partner's proportionate share of hot asset appreciation rather than the gross value of hot assets."' furthermore, by treating a disproportionate distribution as a simple "sale" rather than an "exchange,"' 6 the andrews proposals would eliminate unnecessary recognition of gain when a partner's interest in cold assets (rather than hot assets) decreases, thereby simplifying the operation of section 751(b). a partner would recognize gain only to the extent that the net decrease in her share of appreciation in hot (or tepid) assets cannot be preserved through basis adjustments. the transaction would be treated essentially as a sale of the partner's relinquished share of hot (or tepid) asset appreciation for cash, followed by a contribution of the cash consideration to the partnership.' 6 ' the "selling" partner would increase her outside basis and tax capital account by the amount of gain recognized, and the partnership would receive a corresponding increase in its basis in hot (or tepid) assets. the andrews proposals would maximize nonrecognition by adjusting the basis of distributed property and the partnership's inside basis to preserve shares of unrealized gain (or loss) of the appropriate character. section 751 (b) would be modified to require each partner and the continuing partnership to make such basis adjustments following a distribution as needed to preserve their respective pre-distribution shares of unrealized gain (or loss) in the 156. see andrews, supra note 12. at 52. 157. see id. at 53-54. tepid assets would consist essentially of § 1250 real property. see infra notes 178-180 and accompanying text. 158. see andrews, supra note 12, at 52. 159. see id. at 48. 160. see id. at 46 ("as a conceptual matter, there is no reason to insist on the exchange model."). 161. see id. at 46 n.159; cunningham, supra note 12, at 92 n.66. 1998] florida tax review partnership's hot assets and other property. 62 basis reallocation represents the key to preserving shares of unrealized gain. following a distribution, each partner's basis in hot assets would be set equal to the fair market value of her share of the distributed (or retained) hot assets less her pre-distribution share of hot asset appreciation (but not less than zero). 63 gain would be recognized only to the extent that the fair market value of the partner's postdistribution share of hot assets is insufficient to absorb the required basis adjustments."6 under the andrews proposals, carryover of basis adjustments would no longer be permitted. 65 basis adjustments that cannot be implemented currently ("prevented adjustments") would result in recognition of gain (in the case of a negative adjustment) or loss (in the case of a positive adjustment). 66 an election would be allowed, however, to reduce the basis of "hotter" property to defer recognition of gain (or increase the basis of "cooler" property to defer recognition of loss).167 any basis adjustments would be allocated in the manner prescribed by section 755, which would be revised to parallel more closely other statutory nonrecognition provisions.'68 consistent with current law, revised section 755 would allocate basis adjustments initially among property within particular classes so as to eliminate disparities between basis and fair market value. 16 9 any remaining basis adjustments would be allocated in proportion to the respective fair 162. see andrews, supra note 12, at 53, 55. 163. see id. at 53. if § 751(b) were eliminated as a separate provision, the rules of §§ 731 and 732 could be revised to specify appropriate gain recognition and basis consequences. see id. at 55 n.178. 164. see id. at 53. 165. cf. regs. § 1.755-1(b)(4). under current law, if a basis adjustment cannot be made because the partnership lacks property of the appropriate character (or there is insufficient basis to absorb a negative adjustment), the adjustment is applied to after-acquired property of the appropriate character. see id. under these rules, a required basis adjustment may be suspended indefinitely. see also prop. regs. § 1.755-1(c)(4) (carryover adjustment). 166. see andrews, supra note 12, at 37, 39. 167. see id. rather than recognize loss immediately, the taxpayer could elect to suspend the basis increase for allocation to after-acquired property of the appropriate character. see id. 168. see id. at 17 (comparing inside basis adjustments to recently repealed § 1034(e) which determined the adjustments to basis of new residence); see also irc §§ 1033 (substitute property in connection with involuntary conversion), 1017 (basis adjustments to avoid cancellation-of-indebtedness income). 169. see andrews, supra note 12, at 31. andrews refers to this method of reallocating basis as the "enlightened net adjustment allocation." see id. at 31-32. he rejects as excessively complex an alternative "proportional reallocation" method that would treat a distribution as an exchange of the continuing partners' interests in the distributed property for the withdrawing partner's interest in the retained partnership assets. see id. at 29-31; see also cunningham, supra note 12, at 85-86. [vol 3:12 partnership distributions: options for reforn market value of the assets (if the adjustment is positive) or in proportion to the respective bases of the assets (if the adjustment is negative). thus, the current prohibition on adjustments that increase the disparity between basis and fair market value (so-called "wrong-way" adjustments) 7 1 would be eliminated. this prohibition makes sense in the case of a sale of a partnership interest because the basis adjustments are intended generally to give the purchaser the equivalent of a cost basis.' 7' following a distribution, however, the section 734(b) basis adjustments serve a quite different purpose: basis adjustments that increase the disparity between basis and fair market value may be essential to preserve shares of unrealized gain (or loss) for future taxation.1 72 by making section 734(b) basis adjustments mandatory, the andrews proposals would eliminate the ability to exploit the current elective regime when the failure to adjust inside basis is beneficial to the continuing partners. these proposals would also cure a technical defect in the existing section 734(b) adjustmenlt 73 under current law, the section 734(b) adjustment is determined by reference to the distributee partner's outside basis rather than her share of the partnership's inside basis. 4 although this formula often works well, it invariably reaches the wrong result when a partner's outside basis differs from her share of inside basis.7 5 under the andrews proposals, the section 734(b) adjustment would be determined by reference to the partner's share of inside basis, a concept already employed by the section 743(b) regulations. 7 6 thus, the section 734(b) adjustment would be 170. see regs. § 1.755-1(a)(1)(iii). but see andrews, supra note 12, at 28 n.96 (noting that "the blanket prohibition [on wrong-way adjustments] cannot mean what it seems to say"). see also prop. regs. § 1.755-1(c)(2) (permitting wrong-way adjustments). 171. see supra note 26 and accompanying text. 172. see andrews, supra note 12, at 17. proposed regulations under § 755 recognize the need for separate rules for allocating basis adjustments under §§ 743(b) and 734(b). see prop. regs. §§ 1.755-1(b) (§ 743(b) adjustments), 1.755-1(c) (§ 734(b) adjustments). 173. see andrews, supra note 12, at 13; see also a.b.a. tax section recommendation no. 1974-9, reprinted in 27 tax law. 839, 869-72 (1974); selected partnership tax issues, supra note 8, at 32-33. 174. more technically, the § 734(b) adjustment is determined by reference to §§ 731 and 732, both of which refer to the partner's outside basis. see irc §§ 731, 732, 734(b). 175. such a discrepancy is likely to occur, for example, if a partnership interest is acquired by purchase or inheritance when the partnership does not have a § 754 election in effect. in this situation, the § 734(b) adjustment preserves the pre-distribution inequality between the partners' aggregate bases in their partnership interests and the partnership's aggregate basis in its assets. see mckee et al., supra note 19, 25.0113], at 25-8. 176. under the § 743(b) regulations, a partner's share of inside basis is equal to the "sum of [the partner's] interest as a partner in partnership capital and surplus, plus [her] share of partnership liabilities." regs. § 1.743-1(b)(1); see prop. regs. § 1.743-1(d)(1) under which a partner's share of inside basis is equal to the "sum of the transferee's interest as a partner 19981 florida tax review "equal to the difference between (1) the amount of money plus the inside basis of other property distributed and (2) the reduction in the distributee's share of inside basis resulting from the distribution."'77 the andrews proposals would expand the categories of section 751 property from two (hot assets and other property) to three by adding depreciable property as a separate class of "tepid assets. 178 such property would occupy an intermediate position in the continuum between hot assets (unrealized receivables and inventory) and cold assets (nondepreciable capital gain assets).'79 since depreciation recapture would continue to be treated as an unrealized receivable, this change would affect primarily section 1250 real property. 8 ' the purpose of these rules is to "prohibit reallocation of basis from nondepreciable capital assets to depreciable property, as well as reallocation from capital gain to ordinary income property.''. although additional categories of assets would permit even finer distinctions to be drawn, the improved accuracy might not warrant the resulting complexity.'82 the andrews proposals would also modify the manner in which basis is allocated among distributed assets so that the rules would parallel those for allocating inside basis adjustments. 8 3 under proposed section 732(c), each distributed asset would initially take a basis in the distributee's hands equal to its basis in the partnership's hands; any required adjustments to basis would then be allocated under the rules of proposed section 755.'14 thus, the basis allocation rules of section 732(c) would be conformed to those of section 755. b. complete or partial liquidations involving hot asset exchanges 1. complete liquidations.-although the andrews proposals are technically complex, they can be illustrated relatively simply in the context in the partnership's previously taxed capital, plus the transferee's share of partnership liabilities." since partnership liabilities generally cancel out, the amount of the § 734(b) adjustment may be determined by comparing the amount of cash and the basis of property distributed with the distributee partner's interest in partnership capital computed on a tax (rather than book) basis. see andrews, supra note 12, at 13 n.45. 177. see andrews, supra note 12, at 22. the proposed method of determining the § 734(b) adjustment also reaches the correct result when § 704(c) allocations are present. see cunningham, supra note 12, at 81 n.14. 178. see andrews, supra note 12, at 53-54. 179. see id. at 53. 180. see id. at 53-54; cunningham, supra note 12, at 92. 181. andrews, supra note 12, at 38. 182. see id. at 54. 183. see id. at 31, 40. 184. see id. at 40. accordingly, § 732(c) adjustments would be determined partly by reference to the fair market value of distributed property. see irc § 732(c) (as amended by the 1997 act). [vol 3:12 partnership distributions: options for reform of a distribution in complete liquidation of a partner's interest. assume that the equal abc general partnership distributes $400 cash and depreciable real property worth $300 to a in complete liquidation of her partnership interest when abc has the following balance sheet: assets basis value capital basis value cash $ 700 $ 700 a $ 500 $ 700 inventory 180 300 b 500 700 real property 60 300 c 500 700 securities 560 800 total $1500 $2100 total $1500 $2100 following the distribution, a and the continuing bc partnership would be required to adjust their bases in the distributed and retained assets to reflect increases (or decreases) in their respective shares of appreciation in each category of assets.18 5 under proposed section 732(c), a would initially take a basis in the real property equal to the partnership's basis in the distributed property ($60). the required section 751 adjustments would be equal to the net increase (decrease) in a's share of unrealized appreciation in each category of property. 8 6 the $160 positive adjustment for tepid assets would increase a's basis in the real property from $60 to $220, preserving her predistribution share of appreciation in tepid assets ($80). since a received no property other than cash and tepid assets, the prevented negative adjustments for hot and cold assets potentially trigger recognition of income. a must recognize $40 of ordinary hot asset gain.'87 to avoid immediate recognition 185. prior to any required basis adjustments, the offsetting increases (decreases) in the partners' respective shares of appreciation in each category of assets can be determined as follows: exchange chart withdrawing increase continuing bc increase partner a before after (decrease) partnership before after (decrease) hot assets $40 $ 0 ($40) hot assets $80 s120 s40 tepid assets 80 240 160 tepid assets 160 0 (160) cold assets 80 0 (80) cold assets 160 240 80 compare cunningham, supra note 12, at 93 ("appreciation chart") with mckee et al.. supra note 19, 21.03[3], at 21-14 to 21-15 ("partnership exchange table"). 186. the difference between a's outside basis (s500) and the partnership's basis in the distributed property ($460) is equal to the net increase (decrease) in shares of unrealized appreciation with respect to a and the partnership. 187. under proposed § 755, the basis of "cooler" property may not be reduced to avoid immediate recognition of gain. see andrews. supra note 12, at 38-39. 19981 florida tax review of $80 of cold asset gain, however, a may elect to reduce her basis in the real property from $220 to $140. 188 with respect to the bc partnership, the $40 positive adjustment for hot assets increases the basis of the inventory from to $180 to $220. the $80 positive adjustment for cold asset appreciation increases the basis of the securities from $560 to $640. since the bc partnership does not hold any tepid assets after the distribution, the $160 negative adjustment to tepid assets triggers gain, unless the partnership elects instead to reduce the basis of the inventory from $220 to $60. assuming such an election, the bc partnership's post-distribution balance sheet would be as follows: assets basis value capital basis value cash $ 300 $ 300 b $ 500 $ 700 inventory 60 300 c 500 700 securities 640 800 total $1000 $1400 total $1000 $1400 b and c each continue to have a $200 share of unrealized appreciation in partnership assets (two-thirds of the partnership's pre-distribution unrealized appreciation). 2. partial liquidations.-the andrews proposals would treat a redemption of a portion of a partner's partnership interest as a partial liquidation."5 9 as under the deemed-sale approach, the distributee's partnership interest would be bifurcated into a redeemed and a continuing interest.'9° while a complete liquidation of a partner's interest leaves the distributee with no outside basis, tax capital account or share of inside basis, a "straight-up" partial liquidation removes only a ratable share of these amounts. 91 the redeemed portion of the distributee's partnership interest would be determined by comparing the value of the distribution to the total value of such interest, and the distributee's outside basis would be reallocated between the distributed property and her continuing partnership interest. the 188. a's outside basis ($500) is increased by the gain recognized ($40) and decreased by the basis of the distributed property in a's hands ($400 cash plus $140 basis of real property). on a sale of the real property, a would recognize gain of $160 ($300 fair market value less $140 basis). thus, a's pre-distribution gain of $200 is recognized or preserved. 189. see andrews, supra note 12, at 65-66. 190. bifurcated treatment is necessary under both models to maintain proportionality between the continuing partners' shares of unrealized appreciation and their post-distribution percentage interests in the partnership. 191. the andrews proposals may also be applied to more "irregular distributions" in which the reduction in the distributee's partnership interest is not strictly proportional. see andrews, supra note 12, at 73-75. [vol 3:12 partnership distributions: options for reform partnership's basis in undistributed assets would also be reallocated to the extent necessary to preserve the continuing partners' shares of unrealized appreciation in each class of partnership property. assume that c receives a distribution of depreciable real property, reducing her interest in the equal abc partnership from one-third to onefifth, when the partnership has the following balance sheet: assets basis value capital basis value cash $120 $120 a $120 $180 inventory 60 180 b 120 180 real property 60 90 c 120 180 securities 120 150 total $360 $540 total $360 $540 c would be treated as if she had disposed of one-half of her partnership interest based on the value of the distribution. the redeemed portion of c's interest has a basis of $60 and a fair market value of $90; in exchange for the real property, c gives up a one-sixth interest in the partnership's unrealized appreciation in undistributed assets.' 92 in c's hands, the basis of the real property would be increased from $60 to $85 to reflect the $25 positive adjustment for tepid assets. since c receives only tepid assets, the prevented negative adjustment to hot assets triggers $20 of ordinary income. c may elect to reduce her basis in the real property from $85 to $80 to reflect the $5 negative adjustment for cold assets. with respect to the continuing abc partnership, the $20 positive adjustment to hot assets increases the basis of the inventory from $60 to $80. the $5 positive adjustment to cold assets increases the basis of the securities from $120 to $125. since the partnership no longer holds any tepid assets, the $25 negative adjustment for tepid assets will trigger immediate recognition of gain, unless abc elects instead to reduce the basis of the inventory from $80 to $55. assuming such an election, the abc partnership's postdistribution balance sheet would be as follows: 192. the pre-and post-distribution appreciation in each asset category attributable to c's redeemed one-sixth interest and to the continuing abc partnership is as follows: exchange chart abc c's redeemed increase partnership increase interest (1/6) before after (decrease) (5/6) before after (decrease) hot assets $20 $ 0 s(20) hot assets s100 s120 s20 tepid assets 5 30 25 tepid assets 25 0 (25) cold assets 5 0 (5) cold assets 25 30 5 1998] florida tax review assets basis value capital basis value cash $120 $120 a $120 $180 inventory 55 180 b 120 180 securities 125 150 c 60 90 total $300 $450 total $300 $450 each partner's post-distribution outside basis, tax capital account and share of inside basis corresponds to her continuing interest in the partnership. the partnership's post-distribution unrealized appreciation of $150 is allocated four-fifths to a and b ($60 each) and one-fifth to c ($30) in accordance with their continuing percentage interests in the partnership. 93 3. cash distributions.-under current law, a cash distribution must exhaust the distributee's entire outside basis before any gain is triggered. 194 the andrews proposals would dramatically change this result by requiring proportional gain recognition when a cash distribution results in a partial liquidation. while this result "may come as a shock to some who are steeped in the ways of subchapter k,"'195 the current treatment of disproportionate cash distributions is arguably too lenient. other statutory nonrecognition provisions generally require recognition of gain to the extent of any "boot" received. 196 therefore, even proportional gain recognition would represent relatively lenient treatment of partnership distributions of cash."9 4. limit on gain recognized.-the partial-liquidation approach avoids the need for special allocations by preserving proportionality between the partners' shares of unrealized gain (or loss) and their continuing interests. nevertheless, partial-liquidation treatment may have unexpectedly harsh consequences in the case of a small redemption of a majority partner's interest. the larger the distributee's retained interest in the partnership, the greater the disparity between the amounts of hot asset gain taxed under 193. by contrast, under the deemed-sale approach, the entire appreciation in the distributed property would be taxable immediately, and c would also recognize her redeemed one-sixth share of the unrealized appreciation inherent in the inventory and securities. see supra notes 128-130 and accompanying text. 194. see irc § 731(a)(1). 195. andrews, supra note 12, at 67. 196. see irc §§ 351(b) and 1031(b). but cf. irc § 356(a)(2). see also gergen, contributions and distributions, supra note 5, at 207-08 (proposing "backloaded" basis recovery). 197. see andrews, supra note 12, at 67 ("proportional gain recognition rule... is mild by comparison" to other boot rules). a proportional gain recognition rule might also eliminate much of the need for the complex disguised sale rules. see id. at 68. see also irc § 707(a)(2)(b); regs. § 1.707-4 through -9. [vol. 3:12 partnership distributions: options for reform current section 751(b) and the partial-liquidation approach, respectively. 98 to mitigate this problem, the andrews proposals would limit the amount of recognized gain (or loss) to no more than 150% of the amount "recognized under the method now used under [section] 751(b)."'19 whenever the section 751(b) limit applied, special allocations would be required to ensure proper allocation of the partnership's subsequent income.' c. a compromise proposal: more gain recognition the andrews proposals seek to maximize nonrecognition treatment of disproportionate distributions: hot (or tepid) asset gain would be triggered only to the extent of any prevented basis adjustments. the most obvious objection to the andrews proposals is that they are too complicated. indeed, one commentator has suggested that the proposed three-class allocation scheme may "obfuscate" the "elegance and relative simplicity" of the andrews proposals. 201 moreover, the opportunity to reallocate basis among partnership assets may give rise to tax-motivated transactions that seek to exploit such rules. several of the technical refinements in the andrews proposals could be implemented even if other proposed reforms were set aside for further study. for example, the basic statutory mechanism of section 751 (1) might be modified to permit "sale" rather than "exchange" treatment, even without an expansion of the existing categories of hot assets. instead of preserving hot asset gain through basis reallocation, it would be possible to require immediate recognition of any net shift in hot asset gain.' by limiting opportunities for strategic shifting of asset bases, this approach would mitigate the need for complex basis allocation rules and multiple classes of partnership property. by contrast with current law, hot asset shifts would be measured in terms of unrealized appreciation (rather than gross value). ' 3 198. see andrews, supra note 12, at 70. if a minority partner's interest is redeemed, both approaches reach comparable results; for example, § 751(b) treats a redemption of onehalf of a one-third partner's interest as a transfer of two-fifths of her interest. see id. at 70 n.225. 199. see id. at 70-71. 200. but see cunningham, supra note 12, at 102 (questioning whether § 75 l(b) limit "would be worth the necessary complexity"). 201. see id. at 92. 202. american law institute, federal income tax project-taxation of passthrough entities, tentative draft memorandum no. 3, at 66 (1997) [hereinafter ali. passthrough entities, tentative draft memorandum no. 3]. 203. see id. at 67; see also id. at 69 (eliminating substantial appreciation requirement for inventory). 19981 florida tax review under this proposal, it would be necessary first to identify the partnership's hot assets and then to determine the amount of any shift in the distributee's share of net hot asset gain (or loss) as a result of a distribution. for this purpose, the distributee's share of hot asset gain (or loss) at the partnership level would be based on her respective preand post-distribution sharing ratios; the distributee's share of hot asset gain (or loss) in distributed hot assets would be determined as if she received a basis in such assets equal to their bases in the partnership's hands. 2 0 4 after determining the net increase (or decrease) in the distributee's share of hot asset gain (or loss), the next step would be to determine the tax consequences both to the distributee and to the nondistributee partners. a disproportionate distribution would trigger recognition of hot asset gain (or loss) to either the distributee or the partnership (allocated entirely to the nondistributee partners), but not both. if the distributee's share of net hot asset gain (or loss) is reduced, the distributee would recognize ordinary income (or loss) equal to such net decrease. similarly, if the distributee's share of net hot asset gain (or loss) is increased, the partnership would recognize ordinary income (or loss) equal to such net increase. appropriate adjustments would occur to the partnership's basis in hot assets and the partners' outside bases to reflect any gain (or loss) recognized on the deemed sale; such adjustments would occur immediately before the distribution. to illustrate, assume that c receives a distribution of inventory #2, reducing her interest in the equal abc partnership from one-third to onefifth, when the partnership has the following balance sheet: assets basis value capital basis value cash $120 $120 a $120 $180 inventory #1 60 180 b 120 180 inventory #2 60 90 c 120 180 securities 120 150 total $360 $540 total $360 $540 immediately before the distribution, c has a $50 share of the partnership's hot asset gain (one-third of the total). following the distribution, c has a $24 share of appreciation in inventory #1 (one-fifth of the total) and inventory #2 carries out $30 of appreciation ($90 fair market value less transferred basis of $60).205 since c's share of net hot asset gain increases from $50 to $54, the nondistributee partners (a and b) must each recognize $2 of ordinary 204. see id. at 69; see also id. at 71 n. 169 (bona fide special allocations would be respected). 205. it is assumed that the partnership does not elect to book up its assets or specially allocate the partnership's pre-distribution hot asset gain. [vol 3:12 partnership distributions: options for reform income, increasing their outside bases and the basis of inventory #2 immediately before the distribution. the basis of inventory #2 is increased to $64 ($60 basis increased by $4 gain recognized) in c's hands, leaving her with an outside basis of $56 in her continuing partnership interest. -06 the abc partnership's post-distribution balance sheet is as follows: assets basis value capital basis value cash $120 $120 a $122 $180 inventory #1 60 180 b 122 180 securities 120 150 c 56 90 total $300 $450 total $300 $450 a and b each have a two-fifths share ($48) of the appreciation in inventory #1, preserving their $50 share of hot asset gain ($48 plus $2 gain recognized). in addition, c has a one-fifth share ($24) of the appreciation in inventory #1 plus the unrealized appreciation ($26) inherent in inventory #2, preserving her $50 share of hot asset gain. the unrealized appreciation in the securities ($30) is allocated four-fifths to a and b ($12 each) and one-fifth to c ($6); thus, the partners' pre-distribution shares of cold asset gain ($10) are overstated or understated.0 7 this "temporary" misallocation of cold asset gain would be corrected upon liquidation of the partnership: a and b would each receive a capital loss of $2, while c would report a capital gain of $4.' a distribution that reduces but does not eliminate a partner's interest would be treated as a current distribution rather than a partial liquidation with respect to the distributee.' 9 current distribution treatment preserves the distributee's transferred basis in the distributed property, shifting any basis shortfall (or excess) to her retained interest.' 0 it also minimizes the 206. by comparison, the andrews proposals would require no recognition of gain on the distribution. c would take a basis of $60 in inventory #2 (offsetting $5 positive adjustment to hot assets and $5 negative adjustment to cold assets), and the partnership would have a $5 negative adjustment to hot assets and a $5 positive adjustment to cold assets. see andrews, supra note 12, at 71-73. 207. the partners could presumably avoid such distortions by specially allocating the gain inherent in the securities. indeed, the § 704(b) regulations may require such special allocations. see supra notes 139-53 and accompanying text. 208. with respect to a and b, the capital loss of s2 corresponds to the difference between each partner's two-fifths share of the partnership's common basis ($120) and her outside basis ($122); with respect to c, the capital gain of $4 corresponds to the difference between a one-fifth share of the partnership's common basis (s60) and c's outside basis (s56). 209. see ali, pass-through entities, tentative draft memorandum no. 3. supra note 202, at 58 (no partial-liquidation rule at the distributee level). 210. thus, c receives a basis of $64 in inventory #2, leaving her with a shortfall of $4 in the basis of her retained interest ($56). 19981 florida tax review likelihood that the distributee will recognize gain on a cash distribution. while a partial-liquidation rule would treat the distributee as surrendering a discrete portion of her partnership interest, the rules of subchapter k "generally treat an ownership interest as a single, undivided interest, rather than a series of individual interests. 2 1' nevertheless, the lack of a partialliquidation rule may produce peculiar results in terms of the relationship between the distributee's share of unrealized appreciation within the partnership, her outside basis, and the fair market value of her continuing interest. for example, assume that the abc partnership above has no hot assets and distributes $90 cash (rather than inventory #2) to c in redemption of one-half of her interest. c would treat the current distribution of cash as tax-free, reducing her outside basis from $120 to $30. the partnership's postdistribution balance sheet would be as follows: assets basis value capital basis value cash $ 30 $ 30 a $120 $180 capital asset #1 60 180 b 120 180 capital asset #2 60 90 c 30 90 capital asset #3 120 150 total $270 $450 total $270 $450 c's remaining partnership interest has a fair market value of $90 and a basis of $30. although c has a continuing one-fifth interest, she has less than a one-fifth share of the partnership's post-distribution common basis. a partialliquidation rule would eliminate these distortions by requiring that c recognize gain of $30 on the distribution, i.e., the excess of the cash distribution ($90) over the allocable basis of her redeemed one-half interest ($60). c would end up with a continuing partnership interest having a fair market value of $90 and a basis of $60-half of her former interest in terms of both value and basis. the partnership would also be entitled to increase the basis of its assets by $30, i.e., the excess of the cash distribution ($90) over the reduction in c's share of inside basis ($60).212 the unrealized appreciation of $150 inherent in the partnership's assets ($450 fair market value less $300 basis) would be allocated four-fifths to a and b ($120) and one-fifth to c ($30), preserving their pre-distribution shares of partnership gain. the partial-liquidation rule ensures that each partner's tax capital account, share of inside basis, and share of unrealized appreciation correspond 211. ali, pass-through entities, tentative draft memorandum no. 3, supra note 202, at 58. 212. see supra note 177 and accompanying text. [vol 3:12 partnership distributions: options for reform to her continuing interest in the partnership. as a result, no special allocations are necessary to ensure that the partners remain taxable on the proper amounts of gain at the partnership level. in the absence of a partial-liquidation rule, it would be inappropriate to provide an upward adjustment to the partnership's inside basis to reflect the gain that should have been recognized at the distributee level.2"' although such an upward basis adjustment would ensure that a and b are taxed on only their pre-distribution share of gain ($120), c would be left with too small a share of the gain inside the partnership ($30).214 the partial-liquidation rule thus reaches the correct result at both the distributee and partnership level. it may be objected that a partial-liquidation rule would "violate the nonrecognition objective unnecessarily."2 5 without a partial-liquidation rule, however, special allocations would continue to be necessary to properly align the partners' continuing interests in the partnership's cold asset gain. thus, a partial-liquidation rule seems essential to permit the partnership's accounting to go forward on a simplified basis and minimize the need for special allocations. the compromise proposal is attractive because of its ability to preserve a transferred basis in distributed property in the hands of the distributee, thereby avoiding frequent basis reallocations. this goal is in tension, however, with the need to treat a distribution as a partial liquidation at the distributee level in order to simplify the partnership's post-distribution accounting. if thoroughgoing partialliquidation treatment is deemed unacceptable, it will be difficult to avoid complex special allocations to preserve the partners' pre-distribution shares of unrealized appreciation. v. prospects for the future of section 751(b) a. radical sirnplification: repeal of section 751(b) one proposal for radical simplification of the partnership distribution provisions would involve outright repeal of section 751(b). as the 1957 advisory group on subchapter k recognized, repeal of section 751(b) would open the door to shifting of ordinary income and capital gain among partners. 213. compare al, pass-through entities. tentative draft memorandum no. 3. supra note 202, at 32 (partial-liquidation treatment at partnership level) with id. at 41-42 (current-distribution treatment at distributee level). 214. while additional gain of $30 would be preserved in c's low basis in her partnership interest, such gain could be deferred until sale of c's interest or liquidation of the partnership. 215. ali, pass-through entities, tentative draft memorandum no. 3. supra note 202, at 57. 19981 florida tax review the advisory group nevertheless considered that repealing section 751(b) would strike a workable balance between "simplicity" and the desire to minimize tax planning opportunities.1 6 forty years later, while section 751(b) continues to be perceived as monstrously complex, the prospects for outright repeal seem relatively dim. in light of recent attacks on incomeshifting within subchapter k, congress is unlikely to look favorably on proposals to relax the distribution rules even further. indeed, the 1997 act has arguably revitalized the role of section 751(b) by restoring a significant capital gains preference. it is not surprising, therefore, that most partnership reformers accept the continuing need for some form of section 751(b). in the absence of section 751(b), partners could use distributions to shift the character of income among themselves in a manner that reduces their overall tax burden.217 yet the case for retaining section 751(b) may be less strong than it appears at first glance. in other situations, the section 704(b) regulations rely on a general anti-abuse rule to safeguard against "character" allocations intended to improve the partners' overall tax position with little or no economic risk.18 thus, the anti-shifting function of section 751(b) might be viewed as statutory "overkill." as a practical matter, it is possible that the in terrorem effect of an anti-abuse rule might be nearly as effective as section 751(b) in curbing abusive income-shifting techniques. presumably, sophisticated taxpayers who take advantage of income-shifting opportunities are also well aware of the potential scope of a broad anti-abuse rule. for other taxpayers, even existing section 751(b) may not have much of a deterrent effect if the "common assumption" is correct that the provision is "often honored in the bre[a]ch. 219 it might be objected that repeal of section 751(b) would open the door to conversion of ordinary income into capital gain. the chief potential for such conversion appears to lie in the operation of the basis adjustment provisions of section 755. if section 751(b) were eliminated, the problem would be acute if upward basis adjustments could somehow be allocated to the partnership's hot (or tepid) assets. a relatively simple cure would be to allow upward basis adjustments only for truly "cold" assets, i.e., nondepreciable capital assets. 22° if this change were made, outright repeal of section 216. see supra notes 51-61 and accompanying text. 217. see ali, pass-through entities, tentative draft memorandum no. 3, supra note 202, at 66. 218. see regs. § 1.704-1(b)(2)(iii)(a) (overall-tax-effect rule). 219. ali, pass-through entities, tentative draft memorandum no. 3, supra note 202, at 171-72. 220. see id. at 50 (defining term "cold asset"); see also selected partnership tax issues, supra note 8, at 34-35. [vol 3:12 partnership distributions: options for reform 751(b) would not provide an opportunity to convert ordinary income into capital gain or improperly inflate the basis of depreciable property. restricting upward basis adjustments to a single class of cold assets, however, might create serious problems in the case of prevented adjustments. under current law, prevented adjustments are suspended and may never be used because of the prohibition on wrong-way adjustments. ' allowing a long-term capital loss for prevented upward adjustments would be too generous to taxpayers with offsetting capital gains, and at the same time would generate potentially unusable capital losses for other taxpayers. if wrong-way adjustments were permitted, the partnership could create an artificial capital loss by purchasing a cold asset to obtain an inflated basis for purposes of a subsequent sale. thus, it would probably be necessary to provide an arbitrary amortization period for prevented upward basis adjustments.'m the argument for retaining section 751(b) might be considerably strengthened if the provision functioned more broadly as a limitation on nonrecognition, rather than as an anti-shifting backstop to section 751(a). indeed, the most sophisticated defense of section 751(b) is that it has come to represent mainly a timing provision, whatever the 1954 code drafters may have intended.'m but that rationale suggests that section 751(b), in its present form, is too narrow, and should be extended to reach cold asset exchanges as well as hot (or tepid) asset exchanges. if section 751(b) is reformulated as a recognition provision, it seems sensible to trigger gain whenever the partners' shares of unrealized appreciation in specific categories of assets cannot be preserved. the existing classification of partnership property within two broad classes-hot and cold assets-allows considerable potential for manipulation of basis adjustments. while a three-class system would provide more accuracy, it might be argued that even three classes are not enough. indeed, the 1997 act has created multiple categories of capital assets: gain from disposition of a capital asset will be taxed at different rates depending on the type of capital asset, the taxpayer's holding period and applicable marginal rate, and the extent of any statutory recapture. "4 in 1997, congress recognized that the anomalous treatment of section 1250 real property created problems in connection with the restoration of a capital gains preference. 221. see supra notes 165 & 170 and accompanying text. 222. see selected partnership tax issues, supra note 8, at 34 n.72. 223. see supra note 32 and accompanying text. 224. see irc § 1(h) (as amended by the 1997 act); see, e.g., irc § lh)(5)(b) ("collectibles gain" upon sale of an interest in a pass-through entity): irc § l(hj(6) (unrecaptured § 1250 gain); see also all, pass-through entities, tentative draft memorandum no. 3, supra note 202, at 48. 19981 florida tax review instead of tightening the recapture rules, however, congress created a special statutory rate for unrecaptured section 1250 gain.2 ' congress made no corresponding change to include unrecaptured section 1250 gain in the definition of unrealized receivables for purposes of section 75 1(b). the 1997 act highlights the most glaring defect in the existing twoclass allocation system: lumping unrecaptured section 1250 gain together with nondepreciable capital assets. this defect could be remedied by treating the section 1250 recapture component of real property as an unrealized receivable for purposes of hot asset classification. if a distribution resulted in a net reduction in a partner's share of unrecaptured section 1250 gain, the relinquished share of appreciation would be taxed immediately as capital gain eligible for the special statutory rate for such gain. treating depreciable real property in the same manner as other depreciable property might largely eliminate the need for a separate class of tepid assets. except for this modification, the existing classification of hot and cold assets could be retained. it might then be possible to expand section 751 (b) to play a broader role as a recognition provision whenever a distribution results in a net shift in a partner's interest in hot or cold assets. b. mandatory revaluation and gain recognition preserving shares of unrealized appreciation within different categories of assets could be accomplished by requiring a revaluation of partnership property following a distribution, coupled with special allocations. indeed, the section 704(b) regulations already appear to mandate a similar approach, although they fail to clarify the operation of section 704(c) principles in this context. requiring a revaluation and appropriate gain recognition would thus seem to represent an alternative to the andrews approach. since the section 704(b) regulations virtually mandate a revaluation whenever a partner's interest is relinquished, the proposed change could be viewed as relatively minor. a more far-reaching proposal would be to extend hot asset treatment to exchanges involving nonhot assets: hot or cold asset gain would be recognized whenever a non-pro rata distribution leaves the partners with altered shares of such gain. the chief drawback of mandatory revaluations is that the partnership would be required to account for pre-distribution gain or loss through special allocations. to illustrate, assume that c receives a distribution of inventory #2, reducing her interest in the equal abc partnership from one-third to one225. see irc § 1(h)(1)(b), (h)(6). under the new provision, the amount of gain that would have been treated as ordinary income if the property had been § 1245 property will be taxed at a special statutory rate (25% maximum). [vol 3:12 partnership distributions: options for reform fifth. immediately before the distribution, the partnership's assets are revalued: assets basis value capital basis value cash $120 $120 a s120 $180 inventory #1 60 180 b 120 180 inventory #2 60 90 c 120 180 securities 120 150 total $360 $540 total $360 $540 the partnership's post-distribution balance sheet is as follows: assets basis value capital basis value cash $120 $120 a $120 $180 inventory #1 60 180 b 120 180 securities 120 150 c 60 90 total $300 $450 total $300 $450 following the distribution, c has a one-fifth share of the partnership's common basis ($60/$300) and a one-fifth share of the gross value of the partnership's assets ($90/$450). applying section 704(c) principles, c has a one-third share of the unrealized appreciation in the securities ($10) and a one-sixth share of the unrealized appreciation in inventory #1 ($20). c's onesixth share of the partnership's remaining hot asset gain is equal to her predistribution one-third share of total hot asset gain ($50) less her preserved share of hot asset gain in distributed inventory #2 ($30). since there is no net increase (decrease) in c's share of hot asset gain, the distribution should not trigger section 751(b). the partnership's remaining hot asset gain of $100 ($120 less c's $20 share) should be allocated entirely to a and b, preserving each partner's pre-distribution share of hot asset gain ($50). each partner would continue to be allocated a one-third share ($10) of the unrealized appreciation in the securities. assume that c instead receives a distribution of $90 cash (rather than inventory #2) and the partnership's assets are revalued immediately before the distribution. the partnership's post-distribution balance sheet is as follows: assets basis value capital basis value cash $ 30 $ 30 a $120 $180 inventory #1 60 180 b 120 180 inventory #2 60 90 c 30 90 securities 120 150 total $270 $450 total $270 $450 c has a one-ninth share of the partnership's common basis ($30/$270) and a one-fifth share of the gross value of the partnership's assets ($90$450). 1998] florida tax review since each partner's pre-distribution one-third share of the unrealized appreciation in inventory #1 ($40), inventory #2 ($10) andthe securities ($10) is unchanged, section 751(b) should be inapplicable. hot asset gain (or loss) should be triggered whenever there is a net increase (decrease) in a partner's share of hot asset gain (or loss), taking into account the effect of a revaluation. for example, assume that c instead receives a distribution of one-half of inventory #1 (with a basis of $30 and a fair market value of $90). following the distribution, the partnership has unrealized appreciation of $60 in the remaining one-half of inventory #1 ($90 fair market value less $30 basis) and unrealized appreciation of $30 in inventory #2 ($90 fair market value less $60 basis). thus, the partnership's total hot asset gain has been reduced from $150 to $90; $60 of hot asset gain has been shifted to c outside the partnership, i.e., the difference between the fair market value of one-half of inventory #1 ($90) and one-half of its predistribution basis in the partnership's hands ($30). in determining the consequences of the hot asset shift, c should be treated initially as taking a transferred basis of $30 in inventory #1. since there is a net increase of $10 in c's share of hot asset gain ($60 outside the partnership less $50 pre-distribution share), the distribution should trigger ordinary income to a and b equal to the net increase in c's share of hot asset gain. a and b would be treated as selling their relinquished shares of hot asset appreciation in inventory #1 ($10) for cash, triggering $5 of ordinary income to each partner; a's and b's outside bases and tax capital accounts would be increased to reflect the gain recognized.226 immediately before the distribution, the partnership's basis in the distributed half of inventory #1 would be increased from $30 to $40 to reflect the gain recognized. accordingly, c would take a basis of $40 in inventory #1, leaving her with a $50 share of hot asset gain ($90 fair market value less $40 basis) in inventory #1. the partnership would have the following postdistribution balance sheet: assets basis value capital basis value cash $120 $120 a $125 $180 inventory #1 30 90 b 125 180 inventory #2 60 90 c 80 90 securities 120 150 total $330 $450 total $330 $450 226. the transaction may be viewed as a sale by the nondistributee partners of a one-sixth interest in the distributed portion of inventory #1 (with a basis of $5 and a fair market value of $15) for cash, followed by a contribution of the cash consideration to the partnership. see supra notes 160-61 and accompanying text. [vol. 3:12 partnership distributions: options for reform applying section 704(c) principles, the unrealized appreciation in inventory #1 ($60) and inventory #2 ($30) should be allocated equally to a and b, preserving their $45 share of hot asset gain inside the partnership. each partner would continue to be allocated a one-third share (s10) of the unrealized appreciation inherent in the partnership's securities. the existing section 751(b) regulations focus on a partner's share of the gross value of hot assets following a distribution. in some circumstances, a partner's booked-up share of hot asset appreciation may exceed the gross value of her remaining interest in the partnership, as measured by her postdistribution book capital account. section 751(b) should be triggered to the extent that the book value of the partner's interest is less than her preserved share of hot asset gain.227 for example, assume that the equal abc partnership has $60 cash, inventory worth $150 (with a basis of $75), and nontraded securities worth $90 (with a basis of $15), and each partner has an outside basis of $50 equal to her share of the partnership's common basis. if the partnership's assets are revalued and the securities are distributed to c in redemption of 90% of her partnership interest, the partnership would have the following balance sheet (assuming section 751(b) is inapplicable): assets basis value capital basis value cash $ 60 $ 60 a $ 50 $100 inventory 75 150 b 50 100 total $135 $210 c 35 10 total $135 $210 c's booked-up share of the partnership's hot asset gain ($25) exceeds the gross value of her remaining partnership interest ($10). if c sold her partnership interest for $10, her recognized ordinary income under section 751(a) would apparently be limited to $10, or $15 less than her $25 share of hot asset gain on sale of the inventory. to eliminate this distortion, c should be required to recognize $15 of ordinary income immediately, increasing the basis of her partnership interest and the partnership's basis in the inventory. if shifts in cold asset gain were treated as taxable, a and b would each recognize their $25 share of appreciation in the distributed securities immediately. each partner would increase her outside basis to reflect the gain 227. see mckee et al., supra note 19, 21.03[8], at 21-30 to 21-31. 228. under § 751(a), c would apparently recognize a capital loss of s35, the excess of her outside basis ($35) over the amount paid for her share of non-§ 751 assets (zero). see regs. § 1.751-1(a)(2). alternatively, c could be required to recognize s25 of ordinary income and $50 of capital loss on sale of her partnership interest, preserving the proper character and overall amount of gain. see prop. regs. § 1.751-1(a)(2) (apparently reaching proposed alternative result). 19981 florida tax review recognized, and the basis of the securities would be increased immediately before the distribution. c would take a basis of $65 in the distributed securities equal to their basis in the partnership's hands ($15 basis increased by $50 gain recognized), and c's outside basis would be reduced to zero ($50 increased by $15 ordinary income and decreased by $65 basis of distributed securities). the partnership's post-distribution balance sheet would be as follows: assets basis value capital basis value cash $ 60 $ 60 a $ 75 $100 inventory 90 150 b 75 100 total $150 $210 c 0 10 total $150 $210 upon a sale of the inventory, the ordinary income would be allocated $50 to a and b ($25 each) and $10 to c. c's share of cold asset appreciation ($25) would be preserved in the distributed securities. although the 1954 code drafters were apparently concerned mainly with the problem of shifting ordinary income and capital gain, cold asset exchanges present a related problem of deferral. since most partnerships are likely to have some section 751 assets in any event, the additional burden of determining shifts in cold asset gain seems quite small. of course, the distributing partnership would be burdened with the need for continuing special allocations, but the section 704(b) regulations already in effect require such allocations. nevertheless, the complexity of the section 704(c) approach may seem daunting. indeed, if it were possible to begin with a clean slate, the andrews proposals would offer a much simpler means of reaching essentially the same result. while the andrews proposals may be viewed as perfecting the 1954 model of subchapter k, they arguably fit less comfortably within the current framework. under the section 704(b) regulations and recent statutory amendments, mandatory special allocations of gain (or loss) have become ubiquitous. while the andrews proposals might provide welcome relief from the complexity of such special allocations, they might also cause some unexpected problems. the existing regulations provide virtually no guidance concerning the interaction among section 734(b) adjustments, section 704(c) allocations and other regulatory allocations.2 29 partial-liquidation treatment would increase the likelihood of mandatory basis adjustments among retained and distributed assets. such adjustments might provide opportunities for inflating basis when low-basis property is distributed in partial liquidation of 229. but see prop. regs. § 1.743-1(d) (coordinating §§ 704(c) and 743(b)). [vol 3:12 partnership distributions: options for reformn a partner's interest.230 it might also be necessary to specify when a sale of distributed property should be imputed to the partnership.?' in the absence of generous basis reallocation provisions to permit continued deferral, a partial-liquidation rule would give rise to frequent recognition of gain (or loss) on distributions. by contrast, the section 704(c) approach would continue to treat a non-pro rata distribution that reduces (but does not eliminate) a partner's interest as a current distribution. since basis reallocation itself may prove troublesome, the additional complexity of the section 704(c) approach may be viewed as tolerable, particularly for sophisticated partnerships. if less complex partnerships wish to avoid a revaluation and attendant special allocations, however, the andrews proposals may well provide an attractive alternative. thus, mandatory book-ups could be required unless the partners agree to treat a non-pro rata distribution as a partial liquidation at both the distributee and partnership levels. c. expanding the section 704(c) approach expanding section 751(b)-type treatment to cold asset shifts may seem an unjustified departure from the general nonrecognition rules of subchapter k. the distribution provisions are not alone in permitting temporary deflection of income.'2 nevertheless, it is puzzling why distributions of nonsection 751 assets have remained relatively immune to incomeshifting concerns.23 in connection with contributions of partnership property, section 704(c) applies rigorous assignment-of-income principles to prevent shifting of built-in gain; similarly, reverse-section 704(c) allocations prevent deflection of unrealized appreciation in partnership assets to a newlyadmitted partner.' the core notion of section 704(c) is that a contribution of partnership property (or admission of a new partner) is an economic 230. see andrews, supra note 12, at 66. 231. see id.; all, pass-through entities, tentative draft memorandum no. 3, supra note 202, at 57 (andrews proposals might give rise to difficult court holding-type analysis). 232. for example, the substantial economic effect regulations generally ignore timevalue-of-money concerns and are likely to invalidate "shifting" and "transitory" allocations only in situations in which tax-avoidance is the dominant motive. see regs. § 1.7041(b)(2)(iii)(b)-(c); cf. mark p. gergen, reforming subchapter k: special allocations. 46 tax l. rev. 1, 43 (1990) (proposing elimination of special allocations and apportionment of risks and rewards solely through extra-partnership contractual arrangements) [hereinafter gergen, special allocations]. 233. see andrews, supra note 12, at 63; cunningham. supra note 12. at 103 (failure of the statute and regulations to address book-tax disparities attributable to distributed property); cf. supra notes 140-53 and accompanying text. 234. see john p. steines, jr., partnership allocations of built-in gain or loss. 45 tax l. rev. 615, 615 (1990) [hereinafter steines, partnership allocations). 19981 florida tax review exchange, even though gain is deferred under section 721 .235 thus, section 704(c) may be viewed as "vindicating" the nonrecognition policy of section 721 by ensuring that the deferred gain is eventually taxed to the partner to whom such gain was originally attributable. while simple in concept, section 704(c) surely rivals section 751(b) in the complexity of its operation. simultaneously, concern that section 704(c) lacks adequate "triggers" has led congress to expand the types of transactions that trigger recognition of built-in gainy6 others have maintained that efforts to expand section 704(c) principles may pose an implicit challenge to the fundamental nonrecognition policies of section 721 and 731, since all contributions and distributions in effect represent economic exchanges. 27 nonrecognition treatment upon partnership formation adds to the complexity of subchapter k because of the need to trace contributed property. similarly, nonrecognition treatment for partnership distributions requires elaborate rules to safeguard against impermissible shifting of unrealized appreciation. extending section 751(b)type treatment to cold asset shifts represents an attempt to strike a balance between preserving the general nonrecognition rules of subchapter k and curbing excessive deferral of gain. some may view such changes as unnecessary or even counter to the "fundamental premises" of subchapter k.238 by contrast, other critics may insist that stronger measures are needed to prevent unwarranted opportunities for deferral that cannot be easily duplicated outside subchapter k.23 9 thus, defenders of subchapter k's broader nonrecognition policy may bear a heavy burden of persuasion. 235. see id. at 638. 236. see irc §§ 704(c)(1)(b), 737. moreover, "ceiling-rule" shifts may prevent built-in gain from being fully taxed to the partner responsible for § 704(c) (or reverse§ 704(c)) property. see laura cunningham, use and abuse of section 704(c), 3 fla. tax rev. 93, 115-17 (1996); cf. regs. § 1.704-3(a)(10) (anti-abuse rule). 237. see steines, partnership allocations, supra note 234, at 655 ("section 704(c) reform has unwittingly become a subterfuge for challenging the most basic rules of subchapter k .... ); see also id. at 616 (analyzing proposals for expansion of § 704(c) and concluding that "only a very narrow expansion, if any, is necessary to prevent tax avoidance"). 238. see rebecca s. rudnick, enforcing the fundamental premises of partnership taxation, 22 hofstra l. rev. 229, 359 (1993) ("exchange treatment is counter to subchapter k's flexibility and fungibility."). according to rudnick's view, once assets are contributed to the partnership "pool," the bases of partnership assets and the partners' bases in their partnership interests are fungible; thus, there is no need to allocate basis to particular distributed assets and then create a fictional cross-exchange among the partners. see id. at 359 n.542. 239. for example, § 1031 is relatively restrictive concerning the types of exchanges that may qualify for nonrecognition treatment. see, e.g., irc § 103 1(a)(2)(d). [vol 3:12 partnership distributions: options for reform some commentators seek to rationalize these nonrecognition policies as facilitating efficient "pooling" and "unpooling" of partnership assets.2 ° others argue that the pooling rationale cannot justify nonrecognition treatment when assets leave the partnership solution since the partners have effectively terminated their original investment.24 upon liquidation of the partnership (or an individual partner's interest), the nontax benefits are likely to outweigh the tax cost of immediate recognition. thus, requiring gain recognition in this situation might not significantly impair efficient pooling or risk-sharing during formation or operation of a partnership.242 nevertheless, it might be necessary to apply a similar rule to current distributions of partnership property to avoid distorting the choice between current and liquidating distributions.243 in the case of current distributions, nonrecognition treatment may be justified by the relatively easy "avoidability of the tax through alternative arrangements." 244 assume that one partner wishes to own a particular asset but that the other partners are unwilling to incur tax on the distribution. without a formal distribution of the property, the partnership could use special allocations, leasing arrangements, and other comparable techniques to achieve the desired economic result at lower tax cost. "5 thus, more stringent recognition rules might merely encourage retention of property in partnership solution when the property could be deployed more efficiently outside the partnership. 246 of course, there may be limits on the extent to which partners can shift the economic incidents of ownership without triggering the general anti-abuse rules or disguised sale rules. 47 these rules 240. see rudnick, supra note 234, at 355-60 (arguing that liberal rules for "unpooling" transactions are economically efficient). 241. see supra notes 104-05 & 119-21 and accompanying text. 242. see berger, supra note 11, at 155 n.208 (arguing that, for most investors, the prospect of an eventual tax upon liquidation is not likely to loom large at the outset). 243. see ali, pass-through entities, tentative draft memorandum no. 2. supra note 3, at 148. 244. shaviro, supra note 103, at 50. 245. see id.; rudnick, supra note 238, at 361-62; see also gergen, special allocations, supra note 232, at 34. 246. because a current distribution of property would trigger gain to the nondistributee partners, they might have an incentive to prevent such distributions or extract concessions from the distributee partner. see generally hideki kanda & saul levmore, taxes, agency costs, and the price of incorporation, 77 va. l. rev. 211 (1991). 247. see regs. § 1.701-2; irc § 707(a)(2)(b); see also regs. § 1.707-3b)(2)lviii) (warning that "distributions, allocations or control of partnership operations... designed to effect an exchange of the burdens and benefits of ownership of property" may be evidence of a disguised sale); regs. § 1.707-3(f), ex. 8 ("mixing bowl" transaction, rebutting presumption that transfers occurring more than two years apart are outside the disguised sale rules); notice 90-56, 1990-2 c.b. 344 (attacking installment sale transaction). 19981 florida tax review are relatively blunt instruments, however, and it may be extremely difficult to "unscramble" such transactions, particularly when the actual distribution of property is delayed for several years.248 it may seem somewhat opportunistic to defend the permissiveness of the distribution rules on the ground that stricter rules would be self-defeating due to their easy avoidability. indeed, dissatisfaction with the flexibility of partnership allocations generally, as well as with the perceived shortcomings of the disguised sale rules, may fuel more radical proposals to curb the permissiveness of the distribution rules.249 unless subchapter k is restructured along much more restrictive lines, however, requiring full gain recognition on partnership distributions is likely to place additional stress on the existing rules that permit flexible tailoring of economic arrangements. vi. conclusion the permissive partnership distribution rules have only recently begun to receive sustained critical attention. although section 751 (b) has long been viewed as a bulwark against income-shifting, its potential benefits are undermined by complexity and noncompliance. some commentators assert that the "futile attack" on income-shifting could be abandoned if section 751(b) were simply repealed." although the rationale for retaining section 751(b) in its present form is hardly compelling, expanded section 751(b)-type treatment for all non-pro rata distributions of partnership assets would help to curb excessive deferral. because partnerships are already generally required to revalue property in connection with relinquishment of a partner's interest, existing section 704(c) principles could be adapted to accomplish this goal. if more thoroughgoing reform is considered desirable, the andrews proposals offer a promising avenue for those who seek to refine and improve the existing nonrecognition regime. while the 1954 code drafters viewed flexibility as a hallmark of subchapter k, critics have recently expressed concern that such flexibility creates a need for anti-abuse rules. moreover, as illustrated by the recent experience with the section 701 regulations, such rules may be complex and imprecise at the same time. if subchapter k is viewed as "an impenetrable tax-avoidance machine, ' '""1 eliminating nonrecognition treatment may seem to offer the only satisfactory solution to existing anomalies in the partnership distribution rules. even such a radical change is unlikely to prove satisfactory, 248. see mckee et al., supra note 19, 13.02[3][b], at 13-17 to 13-18. 249. see generally berger, supra note 11; gergen, contributions and distributions, supra note 5; gergen, special allocations, supra note 232. 250. see, e.g., eustice, supra note 10, at 383-84. 251. steines, unneeded reform, supra note 5, at 245. [vol 3:12 partnership distributions: options for reform however, since other features of subchapter k might be exploited to subvert a recognition rule. while some reformers may relish the prospect of curtailing the flexibility of subchapter k, others believe that subchapter k "for the most part, has it right ' 252 and that only incremental reform is needed. for many-perhaps most-reformers, the main challenge is to make simplified forms of business taxation available to those who need them most, while preserving the structure of subchapter k for those who desire its flexibility and accuracy. although no single approach is likely to command unanimous support, the current proposals represent a solid foundation for future reform. 252. kurtz, supra note 2, at 821. 19981 florida tax review volume 1 december 1992 number 3 a note on horizontal equity louis kaplow" i. introduction richard musgrave has recently offered a new defense of the concept of horizontal equity (he)-the requirement of equal treatment of equals-as an independent norm in assessing tax policy.' this defense is significantly more elaborate than the brief sketch he offered in his pioneering treatise2 or in his subsequent work on the subject musgrave's latest contribution is important because prior literature developing and applying he measures gives little justification for this norm. the gap in the literature remains, however, because musgrave assumes what must be demonstrated and suggests an index of he that is implausible. ii. distributive justice and horizontal equity as an independent norm musgrave first seeks to establish he as an independent norm.' by this, he means to suggest that some degree of efficiency and vertical equity (ve)-the proper redistribution among unequals-should be sacrificed in order to reduce violations of he. his method is to examine various views of entitlement and distributive justice (entitlements to earnings, ability to pay, maximum welfare, and the veil construct) and observe that, for all the views he surveys, he is realized while the implications for ve differ. from this, he concludes that he is of independent significance in the relevant sense. there are two fundamental problems with his argument. * professor of law, harvard law school and faculty research associate. national bureau of economic research. i am grateful for comments from steven shavell. 1. see richard a. musgrave. horizontal equity. once more. 43 nat'l. tax j. 113 (1990). for an extended treatment of the subject by the author of this commentary, see louis kaplow, horizontal equity: measures in search of a principle. 42 nat'l. tax j. 139 (1989). 2. see richard a. musgrave, the theory of public finance 160-61 (1959). 3. see richard a. musgrave, et, ot and sbt. 6 1. pub. econ. 3 (1976). 4. see musgrave, supra note 1, at 114-17. florida tax review first, the logic is deficient on its own terms. he arises under each theory as a by-product of the norm rather than as having independent significance. musgrave indicates this in the context of individual discussions,5 and the point is obvious for many theories. for example, it has long been recognized that if one seeks to maximize welfare, he will be satisfied in the process (if the structure of the problem is sufficiently simple). whatever rule is best for one individual will necessarily be best for another who is equal in all relevant respects. the fact that many distributive theories have this property without giving he independent significance provides no justification for musgrave's induction that he should be seen as having independent significance.6 moreover, since most (including musgrave) would ultimately adopt a particular theory (or perhaps a mix of two), the fact that he is incidentally satisfied in other theories would be of little relevance. second, musgrave's major criticism of views not giving independent weight to he is that one must account for second-best policy settings. yet this very criticism undermines musgrave's claim for the principle. after all, he is achieved as a by-product in so many distributive theories because they are usually explicated in a first-best world, or at least one with few complications. it has been demonstrated that such theories may not respect he when they are elaborated in a second-best setting.8 to illustrate, assume that the only administratively feasible way to redistribute wealth from the rich to the poor involves omitting some of the rich from the tax base or excluding some of the poor from receiving transfers (perhaps because some individuals live in remote areas). clearly, neither a maximum welfare perspective nor a rawlsian approach (derived from a veil construct)9 would oppose such redistribution because it violated he. (they would indicate that the distributive objective is satisfied incompletely.) musgrave does not attempt to offer an example involving he violation that any relevant distributive theory would count as decisive against an otherwise desirable policy. i" 5. for the entitlement to earnings theory, musgrave states that "he is thereby satisfied," id. at 114, not that it is an independent requirement. for maximum welfare, he notes that "[s]ince he is implied already in the least aggregate sacrifice rule, so [sidgwick] argued, no independent normative role for he is needed." id. at 115. for the veil construct, he notes that "conformity" is assured. id. at 116. 6. the only other support musgrave offers for he in these discussions is that some famous proponents of some theories stated that he was important. he does not, however, indicate the basis for such statements or defend them. 7. see musgrave, supra note 1, at 117-20. 8. see, e.g., joseph e. stiglitz, utilitarianism and horizontal equity: the case for random taxation, 18 j. pub. econ. 1 (1982) (analyzing a context in which he and maximum welfare conflict). 9. see john rawls, a theory of justice 54-192 (1971). 10. he does construct an example in which he argues that he should be decisive, but he never links the example to any of the distributive theories he surveys in the article. see [vol 1:3 a note on horizontal equity ii. an index of horizontal equity musgrave develops indexes for total welfare cost, he, and "vertical equity adjusted" (vea)." the latter two are defined in a manner that constitutes a decomposition of the former. he measures the welfare cost from failing to treat equals equally. that is, the index registers the welfare gain that would result from treating pre-reform equals equally (equal to the group average). this, of course, is a gain from equalizing income, often associated with ve. in contrast, vea measures the welfare gain from equalization of income after all the equalization within groups of pre-reform equals has been accomplished. (it is called vertical equity adjusted because it excludes a portion of inequality normally included in ve, in order that it may be called he instead.) these indexes are applied to a numerical illustration for the purpose of suggesting the workability of he as an independent norm. the most fundamental problem with his construction of an index of he is that it is never linked to any normative principle.'2 the measures are all based on changes in welfare, suggesting a maximum welfare perspective. yet, if that were the perspective, the total welfare measure would suffice, so his proposed he index would be of no interest." second, musgrave does not offer any method for weighing he, vea, and total welfare cost. this omission is extremely significant. for example, in his illustration in which he is said to be decisive, total welfare is the same for both options. 4 for one, the affront to he is greater and for the other the affront to vea is greater. he prefers the one in which the he violation is less. but since he grants that we care about vea as well, there is no basis for his preference without defending that a greater weight be given to what he calls he than to vea. no such defense is attempted. third, musgrave's decomposition of total welfare into he and vea is extremely problematic, in that the relative magnitude of these two measures will be determined by happenstance. to illustrate, consider three reforms (amusgrave, supra note 1, at 119-20. in particular, his index and example are constructed largely using the maximum welfare principle, which, as he states, does not support his position. thus, his position must derive from some other norm, but no such other norm is offered. 11. see id. at 117-19. 12. thus, musgrave simply states that "he performance is measured by....id. at 117 (emphasis added). later, his "he index for the entire group is thus given by....id. at 117 (emphasis added). no statement that precedes or follows suggests the origin for either use of "is. 13. in particular, attaching greater weight to he than vea involves a particular privileging of certain parts of the status quo distribution. no justification for any status quo privileging from a welfarist perspective appears in musgrave's discussion-much less one for privileging the particular aspects captured in musgrave's he measures but not others. 14. see musgrave, supra note i, at 119. 1992] florida tax review c), each affecting a different pair of individuals in the following manner:n '5 pre-reform wealth post-reform wealth first second first second a: 100 100 150 50 b: 101 99 150 50 c: 99 101 150 50 thus, for example, reform a affects two individuals whose initial wealth is 100 each; it leaves them with a wealth of 150 and 50. musgrave's indexes would measure a large he violation (due to the increased inequality, registered by a utilitarian measure) with respect to the reform affecting pair a and none with respect to pairs b and c. of course, it might appear that this is an artifact of the way the example is constructed, but this is not the case. this arbitrary character of the measure is the very essence of what musgrave advances as he. 6 in particular, he rejects measures proposed by others that include any effects on individuals not initially equal. the peculiar property of he, as advanced by musgrave, is that individuals just above the pre-reform equals and those just below-whether moved much further apart by a reform (pair b) or whether crossing over and ending up far apart (pair c)-are ignored entirely in the he measure. (they are included in the vea measure, but musgrave privileges increments to the he measure over identical increments to the vea measure.) as another way to see the problem, consider some sequences of reforms. one reform moves pair a to 101 and 99; later, another reform moves them to 150 and 50. the first reform registers a tiny violation of he and the second involves none. alternatively, one reform moves pair b or c to 100 each; later, another reform moves them to 150 and 50. the first involves no he violation and the second a large one. thus, a trivial change in the structure of the reforms reverses the result: the reform that involves massive he violation results in little if decomposed into two reforms, and the reforms involving no violation of he result in massive violation if each is 15. musgrave contrasts individuals' wealth under various policies not to their prereform wealth but rather to their wealth under the ideal policy. the text refers to pre-reform wealth instead because this is how he typically has been used in the past, both in academic discussions and in political debate about tax reform. in addition, knowing all individuals' wealth, and which individuals would have equal wealth, under an ideal policy (which, if we knew what it was, we might then simply enact) is entirely impractical. and approximate knowledge is insufficient: in musgrave's scheme, the text demonstrates that whether resulting inequality involves violations of he or vea depends on individuals' precise wealth in the benchmark scenario. 16. even if one defines equals liberally, say to include a band of 10, his index would have the same property with respect to individuals on each side of the band. [vol 1:3 a note on horizontal equity decomposed into two. the problem with musgrave's he index has been recognized before: giving significant weight to the happenstance of precise initial equality and none if there is slight initial inequality is unappealing. it is difficult to imagine any distributive principle that would support an approach that involves radical discontinuities of this sort. thus, many indexes developed in the past decades have counted rank changes, measured distances, or examined correlations between distributions. some of these alternatives avoid the discontinuity problem partially; others avoid it completely. what all have in common is a merging of the concepts of he and ve wherein the original notion of he is lost in the process. 7 musgrave recognizes this collapse of he into ve in the literature, and his stated purpose is to avoid it. in the process, however, he loses any claim to a plausible notion of equity. moreover, he does not avoid the collapse, except in a semantic sense. after all, his independent index of he is precisely a measure of ve, as he admits. the only difference is that he applies his he measure only to subsets of the population-those that are, by chance, precise pre-reform equals. his vea index also is a measure of ve that is applied to subsets of the population-everyone not initially equal to anyone else and everyone in one group of equals to the extent their wealth differs from others' wealth. the indexes he offers involve a separation of ve into two components."8 but since both components derive from the same normative origin and involve identical forms of measurement, it is difficult to understand why they should have such different normative import. iv. conclusion in the end, musgrave's proposed he index cannot be compelling so long as there remain fundamental problems with his attempt to derive he as an independent norm. in addition, his index lacks a clear connection to any theory of distributive justice. rather, it is directly contraindicated by the theories he examines, because such theories would not give independent weight to he in second-best settings in the manner musgrave suggests. that musgrave's he index is simply a component of traditional ve measures suggests the possibility that a primary motivation for he actually involves an implicit appeal to considerations of ve. after all, treating equals unequally increases inequality, which is undesirable from many ethical 17. this literature is discussed and criticized in kaplow, supra note i. 18. musgrave explicitly notes that his total welfare measure can be seen as a conventional measure of ve. see musgrave, supra note 1, at 117. much of his development involves separating this measure into the two components. 1992] 196 florida tax review [vol 1:3 perspectives. 9 it is precisely this inequality-no more-that musgrave's he index measures. 19. this view of he is explored further in kaplow, supra note 1. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 2 1994 number ] u.s. federal income taxation of u.s. branches of foreign banks: selected issues and perspectives yaron z reich' 1. introduction ................................. 3 ii. effectively connected income .................... 4 a. overview . ................................ 4 b. specific categories of income .................. 6 1. interest income and gains from debt securities .......................... 6 2. dividends and gains on stock ............ 15 3. fee income ......................... 15 4. letter of credit and guaranty fees ........ 16 5. income fronz foreign currency transactions, swaps, options, forward contracts and other financial hedging transactions ...... 16 c. practical solutions; future prospects ............ 25 1. advance pricing agreements ............. 25 2. possible revisions to the rules for determining ecl from global trading activities ... 30 3. hnplications for other eci rules .......... 35 iml. expenses and losses of the branch ................ 36 a. expenses and losses other than interest .......... 36 b. interest expense ........................... 38 1. sumnmry of the interest allocation regulations ......................... 38 2. policies underlying the interest allocation regulations ......................... 41 iv. the branch profits tax and branch level interest tax .................................. 57 * partner, cleary, gottlieb, steen & hamilton, new york, new york. j.d. 1978, columbia law school; ll-m. (taxation) 1984, new york university school of law. the author acknowledges with gratitude the assistance of kirk van brunt and david m. goldman in the preparation of this article. an earlier version of this article was presented to the tax club in new york in december 1993. 2 florida tax review [vol. 2:1 a. overview ................................ 57 b. coordination among the bpt, blit and interest allocation regulations, and their application to bank branches ............................ 62 v. conclusion ................................... 65 19941 u.s. federal income taxation of u.s. branches of foreign banks 3 i. introduction the title of this article notwithstanding, the united states does not in fact tax the u.s. branches of foreign banks;' branches are not regarded as distinct entities for most federal income tax purposes. rather, the united states taxes foreign corporations (including banks) that are engaged in a trade or business within the united states on taxable income that is effectively connected with the conduct of that u.s. trade or business.2 but the story is not so simple. various provisions of the code and regulations-including especially regulations section 1.882-5, providing for the determination of the deductible interest expense of a foreign bank attributable to its u.s. trade or business, the branch profits tax, and the branch level interest tax-treat u.s. branches of foreign banks as separate entities, to one degree or another. also, most income tax treaties provide that there should be attributed to a u.s. branch (a permanent establishment) the business profits that it might be expected to earn if it were a distinct and separate entity. moreover, in recent years, the nature of international banking has evolved considerably. many banks now actively trade and deal in foreign currencies; in interest rate and foreign currency forward and futures contracts, options, and swaps; and in various equityand commodity-derivative products, as well as in securities. these activities have resulted in a tremendous expansion of the volume and type of transactions involving multiple branches of these banks, both in providing financial products to customers and in hedging the risks assumed by the banks. the involvement of multiple branches in these transactions takes a variety of forms, including transactions between branches (such as swaps, sales of property, loans, and forward contracts) and joint efforts to provide products to customers. these developments have placed considerable pressure on the concepts that traditionally have been applied in determining the amount of a foreign bank's taxable income for u.s. federal income tax purposes, including the extent to which a branch should be disregarded as a separate entity. in addition to exploring the nature of a branch for federal income tax purposes, this article considers in some (but by no means comprehensive) detail certain selected aspects of the concept of "effectively connected income," the rules under regulations section 1.882-5 for determining the deductible interest expense of a foreign bank, and the relationship between 1. the term "u.s. branch" is used in this article in a nontechnical sense to include any branch, agency, or other business office operated by a foreign bank in the united states under a banking license granted by a u.s. federal or state bank regulatory authority. 2. irc § 882(a)(1). florida tax review the interest allocation rules and the branch profits tax and branch level interest tax.3 ii. effectively connected income a. overview a foreign bank that operates a branch in the united states is almost certainly engaged in a u.s. trade or business and is therefore subject to federal income tax on its taxable income that is effectively connected with the conduct of the u.s. trade or business.4 if the foreign bank is eligible for the benefits of an income tax treaty, its eci5 generally is subject to u.s. tax only if it is "attributable" to a "permanent establishment" maintained by the foreign bank in the united states. a u.s. branch of a bank is a permanent establishment for these purposes and, while the "effectively connected" and "attributable" concepts are not synonymous, they are sufficiently analogous to produce the same tax consequences in most (but not all) of the situations discussed in this article.6 a foreign banking corporation's eci is taxed in essentially the same manner as a u.s. domestic banking corporation's income is taxed. thus, such eci is subject to a 35% net income tax.7 special considerations relevant to the calculation of deductions allowed in arriving at the bank's net taxable income (ecti)-and particularly the special rules for determining deductible 3. among the subjects relevant to the taxation of foreign banks that are not covered in this article are (1) issues facing foreign banks that are not materially different from those facing domestic banks, (2) the increasingly complicated and onerous record-keeping and reporting requirements (such as those found in §§ 6038a, 6038c, 6114, and 6662(e)), and (3) the very important subject of state and local income taxation. 4. irc §§ 864(c), 882(a). 5. in this article, "eci" refers to gross income effectively connected with a u.s. trade or business, while "ecti" refers to effectively connected taxable income (eci minus allocable deductions). 6. accordingly, except as otherwise noted, the discussion below, which is phrased in terms of eci, also should apply for purposes of determining profits attributable to a u.s. permanent establishment of a foreign bank. on the relationship between the "effectively connected" and "attributable" concepts, see rev. rul. 81-78, 1981-1 c.b. 604 (interpreting the polish-u.s. treaty). one important difference is that the residual force of attraction principle in § 864(c)(3)--treating all u.s. source, non-fixed or determinable annual or periodical income [hereinafter non-"fdap" income] as effectively connected with the taxpayer's u.s. trade or business-is inapplicable under most treaties. id. at 605. see also rev. rul. 91-32, 1991-1 c.b. 107. 7. irc §§ 11, 882(a). the bank also may be subject to the alternative minimum tax under §§ 53-59 and, pursuant to § 906, may be entitled to claim a credit for foreign income taxes on foreign source ec. [vol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 5 interest expense-are discussed in part i below. in addition, the bank may be subject to the branch profits tax and branch level interest tax under section 884, which are discussed in part iv. u.s. source income of the bank that is not eci but is "fixed or determinable annual or periodical income" (fdap), including dividend and interest income, is subject to a 30% gross withholding tax unless eligible for an exemption or a reduced rate of withholding under the code or an applicable tax treaty.' as discussed below, the interplay between the net income taxation of eci and the treatment of u.s. source, non-eci fdap income has influenced both the regulations and the tax planning of foreign banks. in general, in defining eci, the code and regulations provide separate rules for different categories of income, including (1) u.s. source fdap and capital gains, (2) income from notional principal contracts, (3) income from foreign exchange transactions, (4) other u.s. source income, and (5) foreign source income. while these rules are relatively straightforward, some uncertainties exist as to their application in particular transactional settings, and the results mandated by some of these rules are not sensible or justifiable. the rules for determining eci of a foreign bank apply an "all or nothing" approach: particular income is either eci in its entirety or not at all. the rules do not provide for an allocation of income among different branches of a bank based on, for example, each branch's relative contribution towards the generation of that income.' this approach may have the advantage of avoiding difficult allocation questions, but it can result in u.s. tax being imposed on more or less than the branch's economic income. as 8. irc § 881(a). three important exemptions from withholding under the code are: (1) interest on a bank deposit (which may include a deposit with an affiliate), irc § 881(d); (2) interest or original issue discount on an obligation with an original maturity of 183 days or less, irc §§ 871(g)(1)(b)(i), 881(a); regs. § 1.12731(c)(5); and (3) "portfolio interest." irc § 881(c). see infra note 155 for a general discussion of what constitutes a "deposit." very generally, portfolio interest is non-eci interest received by a foreign person on a registered obligation (provided the beneficial owner certifies its non-u.s. status) or on a foreign-targeted bearer obligation that satisfies certain requirements, provided in each case that the obligation is issued after july 18, 1984. however, portfolio interest does not include interest received by (1) a bank on an extension of credit under a loan agreement entered into in the ordinary course of its trade or business, (2) a "10 percent shareholder," or (3) a controlled foreign corporation from a related person. irc § 881(c). 9. in contrast, § 863(b) treats certain types of income (including income from personal property produced in a foreign country and sold in the united states or vice versa) as derived partly from u.s. sources (and consequently as eci) and partly from foreign sources (and consequently exempt from u.s. tax). section 863(a) authorizes the internal revenue service (irs) to issue regulations providing for the allocation and apportionment of items of gross income, expenses, losses, and deductions, other than those specified in §§ 861(a) and 862(a), to sources within or without the united states. florida tax review discussed below, more often than not the rules result in over-inclusion of income subject to u.s. taxation. moreover, consistent with the notion that the foreign bank is the taxpayer and is being taxed on its income that is effectively connected with its u.s. trade or business, transactions between the u.s. branch and another office of the bank generally are not given effect in determining eci, on the theory that a branch is an integral part of the taxpayer corporation and a corporation cannot contract with itself. accordingly, a loan or swap contract between the u.s. branch and the home office is ignored for u.s. tax purposes, regardless of whether the transaction is taken into account in determining the profits and losses of the u.s. branch for regulatory or financial reporting purposes or in determining the taxable income of the non-u.s. branch for foreign tax purposes. in light of the foregoing, it is important for foreign banks to evaluate carefully whether they are likely to incur double taxation on income that is eci but is also subject to tax in a foreign jurisdiction, and to consider ways to minimize such double taxation. b. specific categories of income 1. interest income and gains from debt securities.-typically, a substantial portion of the income of a u.s. branch of a foreign bank consists of interest on debt securities and gain from the sale, exchange, or redemption of those securities.'0 regulations section 1.864-4(c)(5) contains a special rule for determining whether such income is eci in the case of a foreign corporation that is engaged in the "active conduct of a banking, financing or similar business in the united states."" in general, a foreign bank with a u.s. 10. in this discussion, the term "securities" includes any type of debt instrument, including, for example, loans, loan participations, treasury or other governmental securities, and notes or bonds issued by individuals, partnerships, corporations, or other persons. the term also includes any evidence of an interest in, or right to subscribe to or purchase, any of the foregoing items. see regs. § 1.864-4(c)(5)(v). 11. a foreign corporation is engaged in the active conduct of a banking, financing, or similar business if it carries on a business in the united states the activities of which consist of any one or more of the following activities carried on, in whole or in part, in the united states: (a) receiving deposits of funds from the public, (b) making personal, mortgage, industrial, or other loans to the public, (c) purchasing, selling, discounting, or negotiating for the public on a regular basis, notes, drafts, checks, bills of exchange, acceptances, or other evidences of indebtedness, (d) issuing letters of credit to the public and negotiating drafts drawn thereunder, (e) providing trust services for the public, or (f) financing foreign exchange transactions for the public. [vol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 7 branch that is licensed as a bank by a u.s. bank regulatory authority is subject to this special rule. under this special eci rule for banks, interest income and gain or loss from a debt security are eci if the security is "attributable" to the u.s. branch and the other requirements described below are satisfied. this special rule generally applies regardless of whether the income, gain, or loss is u.s. source or foreign source,' 2 but it applies to gain or loss (as opposed to interest income) only if the gain or loss arises from the sale or exchange of a security that is a capital asset in the hands of the bank. 3 however, u.s. regs. § 1.864-4(c)(5)(i). the fact that the taxpayer is subject to the banking and credit laws of a foreign country is taken into account, but it is the character of the business conducted in the united states that is determinative. id. 12. for the application of this rule to foreign-source interest income, see irc § 864(c)(4)(b)(ii); regs. § 1.864-5(b)(2)(i), -6(b)(2)(ii)(b). however, interest income from a foreign corporation is never eci if the bank owns stock of the corporation (directly or by attribution) carrying more than 50% of the voting power. irc § 864(c)(41(d). in general, under § 865(e)(2) and (3), gain from the sale, exchange. or redemption of debt securities attributable to a u.s. branch (under the principles of § 864(c)(5. including regs. § 1.864-4(c)(5)) is u.s. source gain, and therefore eci, either under the special eci rule for banks or under § 864(c)(3), discussed below. see infra note 89 and accompanying text regarding the treatment of losses. in general, under § 865, gain or loss from the sale or exchange of debt securities that are not attributable to a u.s. branch is foreign source and is exempt from u.s. tax, except as discussed infra note 14. 13. regs. § 1.864-4(c)(5)(ii). debt securities that are capital assets in the hands of the bank should be subject to this rule even if the gain or loss is ordinary by virtue of § 582(c). see regs. § 1.582-1(d) (indicating that § 582(c) addresses the character of gain or loss, not whether the debt securities are capital assets); harvey p. dale, effectively connected income, 42 tax l. rev. 689, 700 (1987) (reaching the conclusion stated in the preceding sentence, after expressing the view that the provision is ambiguous). on the other hand, under § 1221(1), debt securities that are inventor) of the u.s. branch or are held for sale to customers in the ordinary course of the u.s. branch's business are not capital assets, and gain or loss on their sale or exchange is therefore not subject to the special eci rule for banks. similarly, under burbank liquidating corp. v. commissioner, 39 t.c. 999 (1963), affd in part, rev'd in part, 335 f.2d 125 (9th cir. 1964). mortgage loans (and perhaps other loans) made by a bank in the ordinary course of its business are "notes receivable acquired for services rendered" (the service of making loans) and therefore are not capital assets under § 1221(4). see federal nat'l mortgage ass'n v. commissioner, 100 t.c. no. 36 (1993). as a result of the enlarged scope of § 1221(4), the special eci rule for banks may apply to a significantly narrower category of gains from the disposition of debt securities than probably was envisioned when the regulations were promulgated. the recent enactment of § 475, which requires dealers to mark-to-market securities (other than, in general, securities not held primarily for sale to customers in the ordinary course of the trade or business), has focused attention on the classification of debt securities held by banks. see, e.g., banks concerned about broad, uncertain scope of mark-to-market rules, 93 tnt 229-2 (nov. 8, 1993) (lexis, fedtax lib.. tnt file); tax bill provision could cause fundamental change in banking, 93 tnt 165-3 (aug. 9, 1993) (lexis, fedtax lib., tnt file); see also temp. regs. § 1.475(b)-i. florida tax review source gain or loss from debt securities that do not qualify for the special eci rule for banks is eci under section 864(c)(3).14 in general, a security is considered attributable to a u.s. branch for purposes of the special eci rule for banks if the branch actively and materially participates in soliciting, negotiating, or performing other activities required to arrange the acquisition of the security. the u.s. branch need not have been the only active participant in arranging the acquisition.15 moreover, the focus is on the acquisition of the security, not on its subsequent use in a business. thus, securities that are transferred by a foreign office of the bank to its u.s. branch, and in whose acquisition the branch did not participate, are not attributable to the u.s. branch and therefore do not generate eci.6 on the other hand, with one exception discussed below, a security that is attributable to the branch, as a result of the branch's participation in its acquisition, always gives rise to eci so long as the security continues to be held by the bank.' 7 the regulations do not define "active and material 14. under § 864(c)(3), all u.s. source income, gain, or loss (other than fdap income and capital gains or losses described in § 864(c)(2)) is eci if the taxpayer has a u.s. trade or business. however, if a foreign bank is eligible for the benefits of an income tax treaty, such income, gain, or loss generally is not subject to u.s. taxation unless it is attributable to a u.s. permanent establishment. in general, gain or loss from debt securities that are attributable to a u.s. branch (under the principles of § 864(c)(5), including regs. § 1.864-4(c)(5)) is u.s. source and therefore is eci. irc §§ 865(e)(2), (3). see supra note 12 and infra note 89. this analysis should apply to gain or loss on all debt securities that would be subject to the special eci rule for banks but for the fact that the debt securities are not capital assets (e.g., by virtue of § 1221(1) or (4)). also, if debt securities are not attributable to the u.s. branch but are described in § 1221(1) (inventory and property held for sale to customers in the ordinary course of a trade or business), gain (and, in general, loss) on their disposition is u.s. source if title to the securities passes to the buyer in the united states. irc §§ 861(a)(6), 865(b); regs. § 1.861-7. however, if debt securities described in § 1221(1) are attributable to the u.s. branch, the gain or loss is foreign source (and therefore exempt from u.s. federal income taxation) if title to the securities passes to the buyer outside the united states, the securities are sold for use or disposition outside the united states, and a non-u.s. office of the bank materially participates in the sale. irc §§ 864(c)(4)(b)(iii), 865(e)(2)(b). 15. regs. § 1.864-4(c)(5)(iii). 16. as explained in part iii.b, a corollary effect of not attributing these assets to the branch is that they are not taken into account in allocating interest expense to the branch. as a result, the interest expense deduction of the branch is reduced proportionately. 17. in view of this "once attributable, always attributable" rule, § 864(c)(7) (which provides that gain on the disposition of an asset that ceases to be used in connection with a u.s. trade or business is eci if the disposition occurs within 10 years after such cessation) generally does not apply to securities subject to the special banking rule. while § 864(c)(7) conceivably could apply to debt securities that are subject to the exception for "other securities" (discussed infra text accompanying note 20), such a result does not appear to make sense as a practical or a policy matter. [vol 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 9 participation," although they provide a list of activities that do not by themselves cause a security to be attributed to the united states."s once it is determined that a security is attributable to the u.s. branch, special rules determine the extent to which interest and gain thereon are eci. in general, all interest and gain on a debt security that is subject to the special eci rule for banks is eci if the security either (a) was acquired (1) as a result of or in the course of making loans to the public, (2) in the course of distributing the securities to the public, or (3) for the purpose of satisfying the reserve or other similar requirements imposed by a banking authority, or (b) is payable on demand or at a fixed maturity date of not more than one year, or was issued by the united states or any agency or instrumentality thereof. 9 if a debt security attributable to a u.s. branch is not described in (a) or (b) (e.g., a long-term corporate bond, foreign or municipal government bond, or mortgage pass-through security), interest income (and gain or loss) on the security may be eci only in part under a formula prescribed by the regulations. under the formula, interest income (as well as gain or loss) from these "other securities" is eci in its entirety if the securities represent 10% or less 18. the regulations provide that a security is not attributable to a u.s. branch merely because the branch (1) collects or accounts for the interest, gain, or loss from the security, (2) exercises general supervision over the activities of the persons directly responsible for carrying on the solicitation, negotiation, or performance of other activities required in the acquisition of the security, (3) performs merely clerical functions incident to the acquisition of the security, (4) exercises final approval over the execution of the acquisition of the security, or (5) holds the security in the united states or records the security on its books and records as having been acquired by the branch or for its account. regs. § 1.864-4(cj(5(iii(b). foreign banks often maintain shell branches in the bahamas or cayman islands that are operated by personnel of u.s. branches. under the "active and material participation" test. the interest income and gain on securities booked in these shell branches are eci. 19. regs. § 1.864-4(c)(5)(ii) (paraphrased). for these purposes, securities issued by fnma, freddie mac, or gnma are treated as securities issued by an instrumentality of the united states government, but mortgage pass-through securities (which are guaranteed but not issued by such an instrumentality) are not so treated. see rev. rul. 84-10, 1984-1 c.b. 155 (holding that fnma mortgage pass-through certificates are considered as representing -loans secured by an interest in real property" under § 7701(a)(19)(c)(v) to the extent the underlying real property is described in that provision). this ruling and other rulings cited therein do not treat such pass-through securities as obligations of the united states or an instrumentality thereof under § 7701(a)(19)(c)(ii). this difference in the treatment of mortgage pass-through securities may create planning opportunities since these securities may qualify for the special rule for "other securities" (described infra text accompanying note 20) and for the portfolio exemption from withholding tax. florida tax review of the u.s. branch's assets; the proportion of interest income (and gain or loss) from "other securities" that constitutes eci declines to the extent such securities constitute more than 10% of the branch's assets.2° the practical consequences of the special eci rule for banks are simply stated: if the u.s. branch actively and materially participates in the acquisition of a security, then with limited exceptions all income and gain derived from the asset is taxable as eci. this is so even if the branch is not the sole material participant in the acquisition of a security (for example, if the home office participates equally in the acquisition). conversely, if the branch's participation in the acquisition is not "active and material," none of the income is eci. if a foreign bank is not eligible for the benefits of an income tax treaty that exempts u.s. source interest income from the 30% gross withholding tax, it usually wishes to ensure that loans to u.s. borrowers will give rise to eci, so that only net interest income from the loans (after deducting the cost of funding) is subject to u.s. tax.2" thus, it is necessary for the bank to ensure that its u.s. branch "actively and materially" participates in the acquisition of the security. this requires particular care where, as often is the case with foreign banks, the u.s. branch is not the only, or even the principal, participating office in arranging the loan. for example, a foreign bank may have a longstanding relationship with a foreign-based multinational group. the multinational group negotiates a global line of credit with the bank's home office, a portion of which is made available to the group's u.s. subsidiary. seeking to avoid u.s. withholding tax on interest paid by the u.s. subsidiary, the bank arranges to have its u.s. branch make all advances under the line of credit to the u.s. subsidiary. with proper care and sufficient planning, it should be possible to ensure that the u.s. tranche of the line of credit, but not other portions, will give rise to eci. 20. regs. § 1.864-4(c)(5)(ii). more specifically, the portion of the interest income from such "other securities" that is treated as eci equals the u.s. source interest income on the securities, multiplied by a fraction the numerator of which is 10% and the denominator of which is the percentage of total u.s. assets that consist of "other securities" (in each case based on monthly average book values). id. a similar fraction (with minor adjustments) applies to determine the percentage of gain (or loss) on such "other securities" that is treated as ec. id. for example, assume the u.s. branch of a foreign bank has total u.s. assets with an average book value for a particular year of $25 million, the average book value of the branch's "other securities" is $10 million, and the interest received on the "other securities" for the year is $1 million. the denominator of the fraction is 40% ($10 million/$25 million), and the portion of the interest that is eci is: 10%/40% x $1 million = $250,000. 21. as discussed in part iii.b, the deduction for interest expense is computed under a special formula, and does not involve a direct tracing of interest expense against interest income. [vol 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 11 in revenue ruling 86-154 (situation 3), the irs held that a loan made by a u.s. branch of a foreign bank to a u.s. subsidiary of a multinational corporation was "attributable" to the u.s. branch even though the loan was pursuant to a global line of credit solicited, negotiated, and approved by the bank's home office. before the loan was made, officers of the u.s. branch negotiated the collateral for the loan and obtained from another u.s. branch of the bank an independent credit analysis of the u.s. subsidiary (but not of the parent company) and an evaluation of the collateral. although the u.s. branch was instructed by the home office to fund the loan (subject to the u.s. branch's normal credit analysis and loan review procedures), the ruling concludes that the u.s. branch's participation in acquiring the loan was active and material. the ruling acknowledges that the home office's active and material participation in the loan transaction did not preclude the u.s. branch from actively and materially participating in the acquisition of the loan.' the significance of this ruling is that u.s. branches that are strongly requested to participate in funding loan commitments negotiated by the home office can have the loans attributed to the u.s. branch, at least so long as each of the following conditions is satisfied: (1) the decision to participate in the loan transaction is made by the u.s. branch in accordance with its normal lending procedures; (2) employees of the u.s. branch conduct direct negotiations with the borrower regarding certain aspects of the loan, such as collateral levels; (3) an independent credit analysis of the borrower is performed by either the lending u.s. branch or another u.s. branch; (4) the loan is funded directly to the borrower by the u.s. branch and recorded on the books of the u.s. branch; and (5) the borrower is an unrelated party. although not specifically required by the ruling, it is highly advisable for the u.s. branch to maintain in its files contemporaneous written documents evidencing the performance of these activities. where the foreign bank does not actively negotiate the loan (for example, where the bank participates in a syndicated loan that is negotiated and managed by another bank), the u.s. branch should be considered to "actively and materially participate" in the acquisition of the participation interest if it performs a significant portion of the activities that are typically performed by a loan participant and that were actually performed by the bank 22. 1986-2 c.b. 103. 23. id. florida tax review in connection with the u.s. branch's participation in the particular loan. however, if the u.s. branch's participation interest is acquired after (and not as part of) the initial funding of the loan, the participation likely falls within the "other securities" basket described above, in which case, depending upon the facts, a portion of the resulting income might not be eci. if the borrower is related to the foreign bank, the bank should be particularly vigilant in adhering to the foregoing conditions and in contemporaneously documenting the active and material participation of the u.s. branch. in revenue ruling 86-154 (situation 2),24 the irs stated that it will closely scrutinize related party loans and, absent contemporaneous written documentation or other clear evidence of active and material participation by the u.s. branch, the branch will be presumed not to have actively and materially participated in acquiring the loans. in that situation, the irs concluded that the branch did not actively and materially participate in the acquisition of a related party loan merely by funding the loan, booking it, and servicing it throughout its term where the home office performed all the essential functions in making the loan, including a review and evaluation of the borrower's capital needs and creditworthiness. 5 the special eci rule for banks is relevant not only for foreign banks wishing to avoid withholding tax on u.s. source interest income, but it must also be carefully considered by foreign banks wishing to ensure that particular loans do not give rise to eci.26 for example, if situation 3 of revenue ruling 86-154, described above, had involved the u.s. branch of a middle eastern bank and a european-based multinational borrowing group, and the u.s. branch also performed a credit analysis of the canadian subsidiary and evaluated the collateral provided by that subsidiary, it is quite likely that any advances to the canadian subsidiary under the global line of credit, even if funded and booked by a foreign branch of the bank, would be attributable to the u.s. branch and therefore would give rise to eci. similarly, in what probably is a common fact pattern, a foreign bank enjoying the benefits of 24. id. 25. id. depending on the circumstances, it is possible that even if a related party loan is attributable to the u.s. branch, it might be viewed as not arising "in the course of making loans to the public" and therefore as falling in the "other securities" basket, in which case a portion of the resulting income might not be ec. 26. the concerns discussed in the text increased as a result of a 1984 amendment of the special eci rule for banks, which eliminated a requirement that, in addition to "active and material participation" and satisfaction of the other conditions described above, the security had to be held by or for the u.s. branch and recorded on its books and records. this booking requirement was deleted because the irs was concerned that it had the effect of making eci treatment elective, thereby enabling foreign banks that were eligible for exemption from withholding tax under treaties to avoid paying u.s. tax on loans arranged by their u.s. branches but booked elsewhere. see lr-34-80, 1982-2 c.b. 877; t.d. 7958, 1984-1 c.b. 174. [vol 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 13 a tax treaty exempting u.s. source interest from withholding tax runs the risk of having income and gains on various loans that are funded and booked by non-u.s. offices treated as eci if a u.s. branch participates in essential functions necessary to the acquisition of the loan (such as performing the credit analysis of the u.s. or latin american subsidiaries of a multinational borrowing group). two aspects of the foregoing situations are potentially troublesome for foreign banks seeking to avoid eci. first, it is not clear what level of involvement is treated as "active and material participation." for example, is performing a credit analysis, without negotiating any terms (such as collateral) sufficient? what if the borrower (or its parent) is headquartered in the united states and employees of the u.s. branch assist in maintaining the client relationship but do not negotiate the terms of a particular loan? what if they act as an intermediary in forwarding terms between the borrower and the home office and discussing the parties' respective positions, but do not have independent negotiating authority? second, once the threshold of "active and material participation" is crossed, all income from the loan is eci, regardless of the relative involvement of the u.s. branch and other offices of the bank. as a result, the bank may be exposed to double taxation, particularly if it (or another taxing authority) considers the loan to have been generated primarily by another office, which, for example, funds or books the loan. one approach for dealing with these problems might be to replace the all or nothing approach of the existing rules with an allocation formula that takes into account the relative economic contributions of various offices of a bank. i do not favor that solution, for reasons discussed in part ii.c.3. instead, further guidance should be provided regarding the application of the "active and material participation" standard to common situations that are not addressed in the regulations or in revenue ruling 86-154. in addition, a more appropriate balance between u.s. and foreign taxing jurisdictions should be struck by adding an exception to the special eci rule for banks. under this exception, interest income on a debt security issued by a foreign corporation (and gain or loss on the security) would not be attributable to the u.s. branch and therefore would not be eci if a foreign office of the bank actively and materially participates in the acquisition of the loan, funds the loan, and records it on its books.2' under the proposed exception, if a non-u.s. office 27. more specifically, in addition to debt securities issued by foreign corporations, the exception should apply to any such debt security that gives rise to foreign source interest income, which also includes interest received from a foreign noncorporate resident or from a domestic corporation at least 80% of the gross income of which during a three-year testing period is active foreign business income. irc §§ 861(a), (c); 862(a)(1). also, under several income tax treaties, interest on a loan to a non-u.s. permanent establishment of a u.s. florida tax review of a foreign bank makes a loan to a non-u.s. subsidiary of a multinational group, interest on the loan would not be eci even if the u.s. branch of the bank is involved in the acquisition of the loan (for example, by participating in negotiations with the u.s. parent or in performing a credit analysis). on the other hand, if the loan is made to a u.s. corporation, the interest would generally be eci if the u.s. branch of the bank actively and materially participates, regardless of the level of involvement of a foreign office. regulations section 1.864-5(c)(5)(vi) provides that interest income and gains from debt securities that are not eci under the special eci rule for banks may be eci under the "asset-use" and "business activities" tests (which generally apply in determining eci in the case of fdap income and capital gains arising from a nonbanking business),28 if such interest income and gains are connected with a nonbanking u.s. trade or business of the foreign bank, such as trading in stocks or securities for the bank's own account. given that most banks trade in securities for their own account-usually as an integral part of their banking business and often in separate trading accounts as wel129-it is not entirely clear whether and under what circumcorporation is foreign source if the loan was incurred in connection with the business of the permanent establishment and the interest was borne by it. see, e.g., convention between the united states of america and the kingdom of the netherlands for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, dec. 18, 1992, u.s.-neth. art. 12, para. 4, k.a.v. 3507 [hereinafter "u.s.-neth. treaty"]; convention between the united states of america and japan for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, mar. 8, 1971, u.s.-jap. art. 6, para. 2, 23 u.s.t. 967 [hereinafter "u.s.-jap. treaty"]. it appears that policy arguments can be made on both sides of the issue of whether, in the absence of such a treaty provision, the united states should cede its taxing jurisdiction to a foreign country where a foreign bank's non-u.s. branch makes a loan to a non-u.s. permanent establishment of a u.s. corporation under those circumstances. the proposed exception is modeled on §§ 864(c)(4)(b)(iii) and 865(e)(2)(b), which provide that income from a foreign person's sale of inventory property outside the united states that is attributable to a u.s. office of the taxpayer nonetheless is foreign source and is not eci if the property is sold for use, consumption, or disposition outside the united states and a non-u.s. office of the taxpayer participates materially in the sale. 28. irc § 864(c)(2); regs. § 1.864-4(c)(2), (3). the cited provisions state that fdap income or gain or loss from the sale or exchange of a capital asset is eci if it is from u.s. sources and (1) it is derived from assets used or held for use in the conduct of the u.s. trade or business (the asset-use test) or (2) the activities of the u.s. trade or business were a material factor in the realization of the income, gain, or loss (the business activities test). 29. because many foreign banks are dealers in stocks and securities outside the united states, they are not eligible for the safe harbor under § 864(b)(2), providing that trading in stocks and securities for the taxpayer's own account is generally not a u.s. trade or business. as discussed supra note 14, if the branch is itself engaged in dealer activities, income from u.s. sales of stocks, debt securities, and other financial instruments held in inventory by [vol 2:1 19941 u.s. federal hzcome taxation of u.s. branches of foreign banks 15 stances this rule might permit a bank to avoid the 10% limitation for "other securities" giving rise to eci, described above. 2. dividends and gains on stock.-the special eci rule for banks described above also applies to dividends (both u.s. source and foreign source) and gains from stock." stock is likely to be "attributable" to a u.s. banking branch-and therefore to give rise to eci under the special eci rule for banks-only if it (1) was acquired as additional consideration for making a loan, 3' (2) was pledged by a borrower as collateral for a loan and was acquired by foreclosure upon a loan default, 32or (3) was acquired by the bank in the course of its distributing such stock to the public." as in the case of debt securities, dividends and gain on stock may also be eci under the asset-use or business activities test if the stock is held in the conduct in the united states of a business of trading in stocks and securities for the bank's own account or as a securities dealer. stock of a banking subsidiary cannot be attributable to the u.s. branch under the special banking rule,' and it is virtually never eci under the asset-use or business activities tests.35 3. fee incomne.-banks earn various types of fee income for services they provide, either in connection with lending activities or in connection with other financial or advisory activities. these fees include commitment fees,36 loan origination and servicing fees,3 placement fees, and advisory fees. this income is u.s. source if the services are performed in the united the branch or otherwise held for sale to customers in the ordinary course of the branch's business is eci under § 864(c)(3). 30. regs. § 1.864-4(c)(5)(ii). 31. see regs. § 1.864-4(c)(5)(iv)(a). 32. see regs. § 1.864-4(c)(5)(iv)(b). 33. see regs. § 1.864-4(c)(5)(ii)(a)(2). 34. regs. § 1.864-4(c)(5)(ii). 35. see i.r.s. t.a.m. 8940005 (may 15, 1989). 36. loan commitment fees that represent charges for agreeing to make funds available rather than for the actual use or forbearance of money generally are treated as compensation for services rather than interest. see, e.g., rev. rul. 70-540. 1970-2 c.b. 101 cf. rev. rul. 74-395, 1974-1 c.b. 46 (commitment fee discounted from loan proceeds was interest). 37. see, e.g., metropolitan mortgage fund, inc. v. commissioner, 62 t.c. 110 (1974); rev. rul. 70-540, 1970-2 c.b. i01; see also bank of america v. united states. 680 f.2d 142, 150 (ct. cl. 1982) (holding negotiation fees received in connection with export letters of credit are for personal services). however, fees that are not earned for specific services, or which exceed reasonable compensation for services actually performed, may be interest (or original issue discount). see, e.g., regs. § 1.1273-2(g)(2) (which, taken together with regs. § 1.1275-2(a), provides that a bank lender should treat "points" as original issue discount rather than as fee income); wilkerson v. commissioner, 70 t.c. 240 (1978). rev'd on other grounds, 655 f.2d 980 (9th cir. 1981); rev. rul. 69-188, 1969-1 c.b. 54, 55. florida tax review states,38 in which case it is eci.39 as a practical matter, if a loan is attributable to a u.s. branch under the rules described above, fee income received in connection with the loan likely is also eci. 4. letter of credit and guaranty fees.-commissions earned on the issuance, confirmation, or acceptance of letters of credit (as well as similar fees earned in the course of providing other forms of guaranties or credit support in respect of the obligations of another person) are not interest and therefore are not covered by the rules described in paragraph 1 above. however, such commissions and fees have been analogized to interest for purposes of determining their source.40 under this analysis, if the person whose credit is being confirmed or otherwise guaranteed is a u.s. person, the commission income is u.s. source and is therefore eci if the u.s. branch materially participates in the issuance of the letter of credit or other form of credit support. 4' however, if the commission or fee is received for confirming or guaranteeing the credit of a foreign person, it is from foreign sources and not eci, even if the u.s. branch issues the credit support. 5. income from foreign currency transactions, swaps, options, forward contracts, and other financial hedging transactions.-as mentioned in the introduction, banks have expanded their activities in recent years beyond lending and other traditional banking activities. many international banks now conduct active businesses in interest rate and currency swaps, forward contracts, options, and other instruments designed to hedge interest rate and currency risks, as an integral part both of servicing customers 38. irc § 861(a)(3). 39. irc § 864(c)(3). however, where the bank is eligible for the benefits of an income tax treaty, such income generally should be exempt as business profits not attributable to a u.s. permanent establishment if the services are performed by employees of a non-u.s. branch that are present in the united states on a temporary basis and the income is not attributable to the u.s. branch. 40. bank of america, 680 f.2d at 149 (analogizing commissions earned on bankers acceptances to interest). see centel communications co. v. commissioner, 920 f.2d 1335 (7th cir. 1990) (holding shareholder guaranties were not performance of personal services taxable under § 83 in exchange for stock, but were more closely analogous to loan transaction). but see priv. let. rul. 8508003 (nov. 9, 1984) (treating loan guaranty fee as services income); i.r.s. t.a.m. 7822005 (feb. 22, 1978). 41. regs. § 1.864-4(c)(3)(i) (business-activities test). if the branch does not materially participate in the issuance of the letter of credit or other form of credit support, the income is generally subject to a 30% u.s. withholding tax. however, if the bank is eligible for the benefits of an income tax treaty, the income is usually exempt from tax as business profits not attributable to a u.s. permanent establishment. see, e.g., priv. let. rul. 7306191420a (june 19, 1973) (stating line of credit commitment fees paid to u.k. banks not engaged in a trade or business in the united states are "industrial or commercial profits" exempt from u.s. tax under the u.s.-u.k. income tax treaty). [vol. 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 17 and of managing their own interest rate and currency exposures. most international banks provide foreign currency (forex) liquidity to the marketplace by entering into spot and longer-term forward forex contracts with their customers, who frequently take delivery of the physical currency under the contract. some banks also act as dealers or traders with respect to equityand commodity-derivative products. to a significantly greater degree than traditional banking activities, the conduct of a swaps, forex, or derivatives business typically involves what has come to be referred to as global trading-the participation of several offices of the bank in a single transaction or a series of related transactions (e.g., hedges of customer transactions). 42 the reasons for this global trading phenomenon-and the level, extent, and nature of the involvement of multiple offices of the bank-vary depending on how the bank has organized these 42. these activities and the tax issues raised by the involvement of multiple branches have been the subject of several recent excellent articles and other papers, and this article therefore provides only a cursory description of them. see generally ernst & young. tax implications of cross-border trading by international banks. 51 tax notes 765 (may 13, 1991); kpmg peat marwick, report on the taxation of global trading of certain financial instruments, 21 highlights & documents 1983 (may 22, 1991); charles thelen plambeck. the taxation implications of global trading, 48 tax notes 1143 (aug. 27. 1990): leslie b. samuels & patricia a. brown, observations on the taxation of global securities trading. 45 tax l. rev. 527 (1990); letter from lawrence r. uhlick, executive director and general counsel, institute of international bankers, to charles cope, esq., associate international tax counsel, department of the treasury (sep. 17, 1993), 31 highlights & documents 51 (oct. 1, 1993) [hereinafter the "lib cross-border paper"]; letter from edward i. o'brien, president, securities industry association, to the honorable fred t. goldberg. jr., comm'r, internal revenue service, and to the honorable kenneth w. gideon, assistant secretary, department of the treasury (dec. 28, 1990), 20 highlights & documents 293 (jan. 9, 1991). in contrast to some commentators, this article uses the term "global trading" to refer to the full gamut of issues raised by the involvement of multiple branches of a bank in these activities. compare lb cross-border paper, supra. at 53: as a threshold matter, it is important to recognize that the cross-border interbranch trading issue is separate from the tax issue raised by "global trading." the interbranch trading issue, which relates to the determination of which trading transactions are to be taken into account for tax purposes. generally arises when the various branches of a bank are independently trading in foreign exchange, swaps or other financial products. the global trading issue, which relates to the apportionment of the income from the bank's trading transactions, generally arises when various branches of the bank have cooperated in soliciting, negotiating or arranging particular transactions. as a practical matter, it may be appropriate to develop different solutions for particular interbranch trading issues (such as interbranch transfers of foreign currency, discussed infra text accompanying notes 55-63). nonetheless, i believe that as a conceptual and policy matter, the interbranch trading issue is more closely intertwined with the other global trading issues than the 1ib cross-border paper suggests. florida tax review activities, and also depending upon the particular product involved and the nature of the transaction. thus, depending on the product, type of transaction, and bank, a transaction may involve marketing personnel, traders, risk managers, management, credit analysts, and other personnel from different offices. in some cases, the activities associated with specific groups of transactions may be concentrated, or conducted exclusively, at individual branches, so that each branch develops and manages its own "book"' 3 of, say, interest rate swaps and forward contracts with its customers (and related hedges). in other cases, there may be greater interaction among branches in trading and managing a book. the level of central management, coordination, and support may vary, as may the frequency and types of interbranch transactions. thus, certain types of activity-for example, dealing in foreign currencies-typically involve numerous and frequent interbranch transactions even though customer transactions are concentrated at individual branches and each branch often maintains its own book of forex contracts. depending on the bank and the type of activity, branches might independently hedge, in the over-the-counter market or through instruments traded on stock or commodities exchanges, the risks of their customer transactions, or they might enter into interbranch swaps or other interbranch transactions with respect to all or a portion of such risks. the latter situation often occurs where the management of particular types of risks (and the books on which these risks are placed) are concentrated in a particular branch (or the home office) for reasons such as expertise, efficiency, and proximity to the principal trading market for instruments relating to the risk involved. global trading activities raise the most difficult contemporary issues regarding the taxation of u.s. branches of foreign banks. section 988(a)(3) and regulations section 1.988-4 contain rules for determining when gain or loss from foreign currency swaps, options, spot and forward contracts, and similar financial instruments are eci.44 regulations section 1.863-7 contains analogous rules for determining when income from 43. the term "book" refers informally to a taxpayer's trading positions at any given time, either in the aggregate or in respect of certain categories of positions. a book will usually contain transactions with customers and related hedges, and may also contain proprietary trading positions. 44. in general, such contracts and instruments are subject to the § 988 eci rules if any payment to be made or received thereunder is denominated in a nonfunctional currency of the u.s. branch or is determined by reference to the value of one or more nonfunctional currencies. the § 988 eci rules also apply to a disposition of nonfunctional currency. regs. § 1.988-1(a)(1). for these purposes, a spot contract to buy or sell nonfunctional currency within two business days is treated as a direct purchase or sale of the currency (rather than a forward contract) unless the contract is disposed of or otherwise terminated prior to making or taking delivery of the currency. regs. § 1.988-2(d)(1)(ii). in general, any currency other than the u.s. dollar is a nonfunctional currency of the u.s. branch. regs. § 1.985-1(b). [vol. 2:1 1994) u.s. federal income taxation of u.s. branches of foreign banks 19 non-forex "notional principal contracts" (including interest rate swaps)" are ec. in general, gain from non-forex forward contracts, futures contracts, and options, as well as from stocks, securities, and commodities used to hedge the bank's derivatives positions, are tested under the general rules under sections 865(e)(2) and (3) and 864(c)(2) and (3) (and regulations section 1.864-4(c)) to determine whether the gain is ecl therefore, as explained below, the same eci analysis generally applies to all of these types of income and gains. regulations section 1.9884(c) and 1.863-7(b)(3) provide, respectively, that forex gain or loss and non-forex notional principal contract income are u.s. source and eci if, "under principles similar to those set forth in § 1.8644(c) [they arise] from the conduct of a united states trade or business." 7 regulations section 1.864-4(c) prescribes the rules for determin45. for purposes of regs. § 1.863-7. a notional principal contract is -a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts." regs. § 1.8637(a)(1). this definition also appears in regs. § 1.446-3, although unlike regs. § 1.863-7, that provision lists equity swaps as an example of a notional principal contract. the irs is studying whether, for purposes of regs. § 1.863-7, certain equity swaps should be subject to the same source rule as interest rate swaps. t.d. 8491, 1993-33 i.r.b. 6. 6-7 (oct. 25) (preamble to the § 446 swap regulations). the apparent concern is that absent a different rule, equity swaps may erode the u.s. withholding tax on dividend income. see generally edward d. kleinbard, equity derivative products: financial innovation's newest challenge to the tax system. 69 tex. l. rev. 1319 (1991). however, given the identity of the definitions in regs. §§ 1.863-7 and 1.446-3, unless and until the irs issues special source rules, most practitioners are comfortable concluding that income on equity swaps should be sourced in the same manner as income on interest rate swaps, although the issue is not entirely free from doubt. see richard l. reinhold, tax issues in equity swap transactions, 57 tax notes 1185. 1190-91 (nov. 23, 1992); lewis r. steinberg, selected issues in the taxation of swaps, structured finance and other financial products, 1 fla. tax rev. 263. 288-89 (1993). however. regardless of the concern regarding the source of equity swap income, it appears likely that the rules for determining whether such income is eci are unlikely to differ from the rules set forth in regs. § 1.863-7. a similar definition of notional principal contracts also is contained in regs. § 1.9881(a)(2)(iii)(b)(2), dealing with forex notional principal contracts, but it is limited to an instrument where the underlying property to which the instrument ultimately relates is currency or property the value of which is determined by reference to an interest rate (which includes a currency swap but not a commodity-index or equity-index swap). 46. for descriptions of § 864(c)(2), (3) and the regulations thereunder and of § 865(e)(2), (3), see supra notes 12, 14, and 28; see also § 865(j)(2) (granting regulatory authority to apply § 865 to "income derived from trading in futures contracts, forward contracts, options contracts, and other instruments"). 47. this rule is an exception to the rules contained in regs. §§ 1.988-4(a). (b); 1.863-7(b)(1), (2), under which such gain, loss, or income is sourced by reference to (1) the residence of the taxpayer or (2) the qualified business unit (qbu) of the taxpayer on whose florida tax review ing eci from fdap income and capital gains, including the asset-use test, the business activities test, and the special eci rule for banks discussed above. while regulations sections 1.988-4 and 1.863-7 do not provide explicit guidance as to which of these tests should apply,48 where the u.s. branch actively and materially participates in arranging a notional principal contract, the income associated with that transaction is eci under both the special eci rule for banks and the general business activities test. indeed, the business activities test (unlike the special eci rule for banks) looks merely to "whether the activities of the trade or business conducted in the united states were a material factor in the realization of the income, gain or loss."49 thus, it is quite possible that a lower threshold of involvement in a transaction by the u.s. branch than "active and material participation" suffices to generate eci from financial instrucments held by banks in connection with their global trading activities. in any event, under the business activities test, income or gain from positions in such financial instruments is likely to be eci, even if the u.s. branch did not participate in the acquisition of a position but, for example, only in its disposition (or termination). moreover, as noted above, these provisions apply an all or nothing approach: once the threshold is crossed, all of the income from a particular transaction is eci. application of the foregoing rules to the forex, swaps, and other derivatives activities of a foreign bank clearly results in a substantial overinclusion of income for u.s. tax purposes because the rules fail to take into account the relative contributions of the u.s. branch and other offices of the bank. as a result, these rules can expose a foreign bank to a significant risk of double taxation as the united states taxes the entire amount of income generated by transactions that are viewed by the bank and other taxing authorities as attributable to a great extent to another jurisdiction. for example, assume that a foreign bank with a worldwide interestrate swaps business manages its book of dollar-denominated interest rate swaps in new york and manages its book of u.k. pound sterling swaps in london. the new york branch quotes the price for, and enters into, a dollar interest rate swap with a u.k. customer in a transaction in which marketing personnel in london conduct all discussions and negotiations with the books the item is properly reflected (but, in the case of non-forex notional principal contract income, only if the qbu is outside the united states and the taxpayer's residence is the united states). 48. it has been suggested that the cross reference was left deliberately vague in order to incorporate all these tests. see samuels & brown, supra note 42, at 560 n. 163. regs. § 1.863-7(b)(3) was recently applied, in a nonbanking context, in priv. let. rul. 9348015 (aug. 31, 1993). 49. regs. § 1.864-4(c)(1)(i) (emphasis added). [vol 2:1 1994] u.s. federal incone taxation of u.s. branches of foreign banks 21 customer. conversely, the london branch quotes the price for, and enters into, a sterling interest rate swap with a u.s. customer in a transaction in which marketing personnel in new york conduct all discussions and negotiations with the customer. under the rules described above, the entire amount of gain on both swap transactions is eci.' the u.s. rules are inconsistent with common business practices (and the rules of other taxing jurisdictions) in another significant respect. interbranch transactions, including interbranch swaps and other hedges, generally are ignored for u.s. tax purposes, on the ground that a taxpayer cannot enter into a contract with itself."' thus, if the u.s. branch were to seek to hedge its net interest rate exposure under its interest rate swap book by entering into a swap with its home office, amounts paid or received by the u.s. branch under the interbranch swap would have no u.s. tax consequences. a related feature of the u.s. tax rules is that there is no clear basis for integrating assets held by the u.s. branch with positions taken by the home office to hedge those assets. (this is referred to as the "split hedge" problem.) thus, if the home office enters into a swap with a third party to hedge the net interest rate exposure of the u.s. branch (whether or not the u.s. branch enters into an interbranch swap with the home office), there is no assurance that the home office's third party swap can be integrated with the u.s. branch's net position for u.s. tax purposes. if the interbranch swap and the home office's swap with a third party are both disregarded in determining u.s. tax, the bank may incur u.s. tax liability on income or gains on the positions held by it (as a result of favorable movements in interest rates), even though the bank was hedged and therefore realized an offsetting loss on the third-party swap entered into by the home office. a number of approaches have been suggested for dealing under existing law with the dual problems of the disregard of interbranch transac50. as discussed in part iil.a, expenses incurred by the london branch in connection with those transactions should be deductible in computing ecti. however, none of the net profit from the transactions would be allocated to the london branch for u.s. tax purposes. it is possible that this result would be different for a bank entitled to the benefits of an income tax treaty, although irs rulings suggest otherwise. see supra note 6, infra notes 52, 108-09 and accompanying text, and infra text accompanying note 116. 51. regs. §§ 1.863-7(a)(1), 1.988-1(a)(10). however, interbranch transactions involving a transfer of nonfunctional currency or of contracts or instruments relating to nonfunctional currency are taken into account under § 988 if, as a result of the interbranch transfer, (1) the currency or other item ceases to be subject to § 988 (because the currency is the functional currency of the transferee branch) or (2) the source of forex gain or loss could be altered. regs. § 1.988-l(a)(10)(ii). the treatment of interbranch transactions involving foreign currency is discussed infra notes 55-63 and the accompanying text. florida tax review tions and "split hedges," none of which is completely satisfactory.5 2 one approach for dealing with the "split hedge" problem that may be defensible as a technical matter would be to apply the general rules for allocating and apportioning deductions so as to assign to a u.s. swaps or derivatives business the third-party hedging losses properly allocable thereto, even if they arise from positions entered into by a foreign branch under a "split hedge."53 it is unclear, however, how such allocation and apportionment would be determined, especially where the foreign branch does not hedge specific risks but, rather, hedges the overall net exposure of the bank's activity. also, this approach is unsatisfactory as a tax policy matter. by failing to fully integrate hedged activities, it allows the irs to be whipsawed because it does not provide a rationale for attributing hedging gains realized by a foreign branch to the u.s. branch to offset losses on its positions.' if applied literally to foreign currency dealing activities of foreign banks, the rules described above for determining eci from forex transactions and for the treatment of interbranch transfers of foreign currency can produce anomalous and inconsistent consequences. in connection with their forex dealing activities, which typically are conducted on a decentralized, local branch basis, foreign banks often engage in extensive interbranch transfers of foreign currency, often amounting to many thousands of individual transac52. see, e.g., samuels & brown, supra note 42, at 560-64, for a discussion of various approaches and the difficulties they raise. in this regard, it has been argued that tax treaties may provide a basis for recognizing interbranch swaps and other interbranch hedging transactions, as well as for taking into account gain or loss on the non-u.s. legs of "split hedges," because under tax treaties eci must be "attributable" to the u.s. permanent establishment and the profits to be attributed to the u.s. permanent establishment are those that it might be expected to earn if it were a distinct and separate enterprise dealing on an independent basis with the enterprise of which it is a permanent establishment. id. at 575-78. as discussed in part hi.b, the irs has rejected a similar argument in the context of the allocation of interest expense to eci, and, while not explicitly mentioning tax treaties, it has declined to recognize interbranch transactions in regs. §§ 1.863-7(a)(1), 1.988-1(a)(10). however, although the interest expense regulations do not permit a direct deduction for the amount of interest paid or accrued by the branch, they do provide for a deduction for interest expense that can be viewed as resulting in a clear reflection of ecti. in contrast, by failing to provide a mechanism for combining "split hedges" or, alternatively, for recognizing interbranch hedging transactions, the provisions dealing with income and deductions from hedging transactions do not result in a clear reflection of ecti. 53. regs. §§ 1.882-4(b)(1), 1.861-8. 54. in the context of the so-called arkansas best problem of whether the character of gain or loss on hedging transactions is ordinary or capital, the irs recently dealt with a somewhat analogous whipsaw concern by requiring taxpayers to identify (and retain records regarding) hedging transactions excluded from capital asset treatment. temp. regs. § 1.12212(c). the accompanying notice solicits comments on how a taxpayer should identify a global or other aggregate hedge. t.d. 8493, 1993-35 i.r.b. 16, 18 (nov. 8). [vol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 23 tions each year. for example, a branch may enter into a foreign currency forward contract with a customer and acquire the currency for delivery under the contract by entering into a spot contract with another branch." as indicated above, an interbranch transfer of nonfunctional currency gives rise to taxable gain or loss (computed as if the nonfunctional currency had been sold at its fair market value) if the source of forex gain or loss could be altered as a result of the interbranch transfer.5 ' thus, a non-u.s. branch's transfer of foreign currency to a u.s. branch should generally be respected for u.s. federal income tax purposes because the source of forex gain or loss is altered from non-u.s. (and exempt from u.s. tax) to u.s. (and ecj)y in that event, the u.s. branch's basis in the foreign currency is the currency's fair market value at the time of the interbranch transaction." on the other hand, where the u.s. branch transfers foreign currency to a non-u.s. branch (and the currency is not the functional currency of that branch), the interbranch transaction is likely to be ignored for u.s. federal income tax purposes because, "under principles similar to those set forth in § 1.864-4(c)," the u.s. branch is viewed as a material factor in the realization of the income, gain, or loss, which therefore continues to be u.s. source and eci.59 in that event, the bank is generally required to trace the foreign currency in some reasonable manner and to treat the sales proceeds therefrom 55. spot contracts are treated as direct transfers of the nonfunctional currency (rather than as forward contracts) if the currency is delivered pursuant to the contract. see supra note 44. 56. regs. § 1.988-1(a)(10)(ii), discussed supra note 51. an interbranch transfer of nonfunctional currency is also a taxable event if the currency is the functional currency of the transferee branch. these exceptions to the general rule that interbranch transactions are ignored also apply to interbranch transfers of forex forward, option, swap, and similar contracts (and debt instruments) that had been entered into with another taxpayer. however, it is relatively rare for such contracts themselves to be transferred between branches, as opposed to having the branch that entered into the customer transaction enter into a similar contract with another branch to hedge its exposure. 57. see supra notes 47-49 and accompanying text. 58. in general, this basis is thereafter accounted for by the u.s. branch in accordance with its method of accounting for inventory of foreign currency. 59. see supra notes 15-18 and 47-49 and accompanying text. it might be possible to argue, however, that the gain or loss should not continue to be u.s. source and eci, and that therefore the interbranch transaction should be respected, because "principles similar to those set forth in § 1.864-4(c)" should be interpreted to include the principle of § 864(c)(4)(b)(iii), under which non-u.s. source gains from the sale of inventory that is attributable to a u.s. office nonetheless is not eci if a non-u.s. office participates materially in such sale. while it is difficult to find persuasive technical support for this argument, it is not entirely unreasonable to interpret the principles of regs. § 1.864-4(c) as being articulated in the context of, and subsuming, the overall statutory scheme, which includes § 864(c)(4)(b)(iii). florida tax review as eci.6° in contrast, where the u.s. branch transfers dollars to a non-u.s. branch, a subsequent disposition of those dollars by the non-u.s. branch should be exempt from u.s. federal income taxation. 61 apart from any administrative inconvenience of a rule that requires the foreign bank to trace foreign currency transferred from its u.s. branch to a foreign branch after it becomes part of the inventory of the foreign branch, treating all gain (or loss) from the disposition of such currency by the nonu.s. branch as eci is inconsistent with the economics of the transaction and with the likely treatment of the transaction by the taxing jurisdiction in which the non-u.s. branch is resident. moreover, while the rules relating to interbranch forex transactions' may seem reasonable in the abstract, it is difficult as a practical or policy matter, in the case of a dealer in foreign currency, to justify a rule that distinguishes between interbranch transfers of nonfunctional currency by the u.s. branch and interbranch transfers of nonfunctional currency to the u.s. branch. indeed, it is difficult to imagine that this distinction was carefully considered and intended by the drafters of these regulations. accordingly, particularly in view of the fact that the regulations already take into account interbranch transfers of foreign currency to the u.s. branch of a foreign currency dealer, the most sensible solution would be to extend such treatment to transfers by the u.s. branch. in this regard, the issues raised by interbranch transfers of nonfunctional currencies are similar to those raised by the other global trading activities of foreign banks, which were described in this part li.b.5 and are explored further in part ii.c below. while a revision of the regulations to provide in all cases for the recognition 60. the tax accounting rules for inventory do not provide guidance as to how such tracing should be done where the item of foreign currency that is sold cannot specifically be identified. see generally leslie i. schneider, federal income taxation of inventories § 17.07 (1993) (suggesting reasonable approaches for dealing with analogous problems). in practice, it is usually the case that an interbranch transfer of foreign currency occurs when the transferee branch needs such foreign currency to cover a position with a customer, so that tracing should not be a problem in those situations. 61. such a transfer of dollars by the u.s. branch to a non-u.s. branch should be viewed no differently than any other repatriation of money by the u.s. branch. although the repatriation could give rise to branch profits tax implications (see part iv.a), the u.s. branch should never recognize gain or loss as a result of the repatriation and should not be viewed as a "material factor in the realization" of subsequent gain or loss by the non-u.s. branch (in whose hands the dollars are likely to be nonfunctional currency) upon a disposition of the dollars by that branch. while the transfer of dollars by the u.s. branch to a non-u.s. branch does not involve a transfer of nonfunctional currency by the u.s. branch, and therefore is not covered by regs. § 1.988-1(a)(10), if the non-u.s. branch acquires the dollars in exchange for other foreign currency, the transfer of such other currency to the u.s. branch is covered by that provision. id. 62. see supra notes 47, 51 and accompanying text. [vol 2:1 1994] u.s. federal hzconme taxation of u.s. branches of foreign banks 25 of interbranch transfers of foreign currency by forex dealers appears to be entirely consistent with the general approaches discussed in part h.c, the details of these regulations should take into account the considerations discussed in part i.c, including especially the need to ensure that these interbranch transactions are entered into at arm's length terms.6 c. practical solutions; future prospects 1. advance pricing agreements.-the rules for determining eci from the forex, swaps, and other derivatives businesses of foreign banks are simply not workable, and banks that engage in these businesses with any material level of global trading activity, including interbranch transactions and split hedges, do so at their own peril as a u.s. tax matter. fortunately, there is now a solution available for those banks that are willing to incur the expense-in terms of funds, time, and management resources-to obtain advance pricing agreements (apas) from the irs. significantly, the apa process may be coordinated with agreements with other taxing authorities, either under tax treaty provisions for mutual agreements by competent authorities, or otherwise. thus, if other taxing authorities are willing to enter into such agreements, a foreign bank may be able to obtain the agreement of the principal relevant taxing authorities as to the manner in which the business activities that are the subject of the apa will be taxed. the apa is, as its name suggests, an agreement between the taxpayer and the irs setting forth, prospectively, the transfer pricing methodologies (tpms) for allocating income and deductions among the united states and other taxing jurisdictions.64 under the apa request procedure, the taxpayer 63. for example, the regulations might provide for strict scrutiny of the terms of interbranch transactions if there is a pattern of interbranch transfers of currency that are not made to satisfy the immediate needs of the transferee branch in respect of transactions with third parties, in order to determine whether appreciating currencies are being "parked" outside the united states while depreciating currencies are being "parked" in the united states. the recognition of an interbranch transfer of foreign currency should not be affected by whether the foreign currency is transferred in connection with a larger interbranch transaction that is ignored for federal income tax purposes (or that is taken into account under other applicable rules). for example, the result recommended in the text should apply (and the foreign currency should be treated as sold for its fair market value) if the u.s. branch delivers nonfunctional currency to a non-u.s. branch pursuant to the terms (upon the maturity) of a long-term forward contract between those branches, even if the forward contract is ignored entirely. if the interbranch forward contract is taken into account, there may also be gain or loss in respect of the contract pursuant to § 988(c)(5) and regs. § 1.988-2(d). 64. the procedures to be followed in requesting an apa and the scope and effect of an apa are set forth in rev. proc. 91-22, 1991-1 c.b. 526. as corrected by rev. proc. 9122a, 1991-1 c.b. 534. the irs also has been willing to have apas apply retroactively to specified open tax years. for a description of the apa program, see generally robert e. florida tax review proposes a tpm for specific categories of transactions, and provides data showing that the tpm produces results in those situations that are consistent with the arm's length standard of section 482. the irs evaluates the request and, if it reaches an agreement with the taxpayer as to an acceptable tpm, the irs and the taxpayer execute an apa. the apa is a binding contract, and it has a stated term, which can be renewed by agreement of the parties. if the taxpayer complies with the terms and conditions of the apa, the irs will regard the results of applying the tpm as satisfying the arm's length standard of section 482 and will not contest the application of the tpm to the subject matter of the apa.65 although the apa process and any resulting agreement are confidential, it is generally understood that a number of foreign banks and other dealers in financial products have submitted requests for apas, and that several such agreements have been finalized to date. several of these agreements have involved tax authorities from other countries. the irs has announced its intention to publish generic guidance regarding approaches taken in apas with respect to specific industries once a sufficient number of apas in the industry have been issued to ensure that the identity of particular taxpayers cannot be determined. 66 recently, in notice 94-40, the irs described its experience in concluding apas with several taxpayers that have functionally fully integrated operations in the global trading of commodities and derivative financial products.67 from reports regarding finalized and pending apas and from notice 94-40, it appears that taxpayers and the irs have sought to devise tpms that are appropriate to the economics of the particular business activities involved ackerman, et al., irs, office of associate chief counsel (international), the advance pricing agreement (apa) program: a model alternative to the dispute resolution process, 12 daily tax report l1 (jan. 19, 1994). see also irs, advance pricing agreements (apas), fs-94-5, 33 highlights & documents 487 (apr. 12, 1994), providing an update of the apa program as of march 31, 1994. 65. like other contracts, however, an apa may be canceled or renegotiated as a result of a mistake of fact or a change in underlying facts or assumptions, or revoked on account of misrepresentations or fraud. rev. proc. 91-22, supra note 64, § 10.05-07. 66. u.s. dep't of the treasury & irs, tax compliance in a global economy: statement of policy and action plan, 93 tnt 257-16 (dec. 20, 1993) (lexis, fedtax lib., tnt file). see international taxes: irs beginning work on advance pricing agreement guidance, culbertson says, 61 daily rep. executives, mar. 4, 1992, at 6-7. 67. notice 94-40, 1994-17 i.r.b. (april 25), 33 highlights & documents 488 (apr. 12, 1994). according to the notice, global trading operations are functionally fully integrated if there is centralized management of risk and personnel, so that a single global book is maintained under the supervision of a head trader (rather than separate books for different trading locations), and the trading authority for that book is "passed" from trading location to trading location at the close of each trading day for that trading location. [vol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 27 but that, to the extent possible, are relatively simple to implement and monitor. where the business activities in different locations have a high degree of interrelationship and the business can be regarded as truly multijurisdictional in nature, the tpms apparently have involved the computation of a single worldwide profit or loss from the activity' and its apportionment among taxing jurisdictions based on a multifactor apportionment formula, with different weighting accorded to the different factors. the factors selected have included, inter alia, (1) relative compensation in each jurisdiction of the principal producers of economic value in the transactions (e.g., traders), (2) relative compensation of management and other staff, and (3) level of business activity, or business assets, in each jurisdiction (determined on an appropriate basis for the business involved). for example, in notice 94-40, the irs indicated that in the apas for functionally fully integrated global trading businesses, these factors have reflected (1) the relative value of the contribution of each location to the overall profit from the business activity (the "value factor"), which has typically been measured by the relative compensation in each location of the principal producers of economic value in the transactions (e.g., traders); (2) the relative potential risk to which a particular trading location exposes the worldwide capital of the taxpayer (the "risk factor"), measured based on the unique characteristics of the particular taxpayer;69 and (3) the extent of the activity of each location (the "activity factor"), typically measured by the relative compensation of key support people at each location or by the relative net present value of the cash flows from the transactions executed at each location. it is interesting that the irs and other governments apparently have accepted such a formulary approach, which might be criticized as departing from the traditional approach in section 482 arm's length allocation inquiries and as adopting the formulary apportionment method employed by states and 68. where appropriate, the worldwide profit from the activity has been computed after deduction of amounts paid (or deemed paid) to particular branches or affiliates as compensation for routine services or capital, when a judgment was made that an arm's length fee was more appropriate than a sharing in overall profits or losses. also. where appropriate, the worldwide profit from the activity has been computed after deduction and allocation to particular locations of certain expenses incurred by those locations (such as office supplies, rent and communications). however, expenses that are required to be computed under specific provisions of the code and regulations, such as interest expense deductions discussed infra part i.b, have been allocated under those provisions. see notice 94-40. 69. according to notice 94-40, the risk factor provides an important indication of the contribution of each trading location to the production of gross profits. this factor has been measured in several ways, such as the maturity weighted volume of swap transactions at the end of the year (determined by multiplying the notional amount of each swap transaction entered into by its maturity) entered into in each location. florida tax review rejected by the irs and other foreign governments as inconsistent with internationally accepted standards.70 in contrast to traditional statutory applications of the formulary apportionment method, however, each apa has been tailored to the specific economic conditions of the taxpayer involved, and the parties have selected, defined, and weighted the various formulary apportionment factors so as to take into account those specific economic conditions. consequently, the formulary method tpm may fairly be viewed as an effort to reflect, through a simplified formula, the results of an arm's length allocation in a manner that is consistent with the principles underlying section 482. indeed, notice 94-40 indicates that the irs considers the apas utilizing such an approach to be applying a profit split method under section 482.7t where business activities are concentrated at the local level in each jurisdiction, the irs apparently has been inclined to adopt a natural home/separate entity approach, under which the profit for each local office that serves as a central location for particular financial products or types of transactions (natural home) is determined on a stand-alone basis and that office is treated as compensating other offices on an arm's length basis for their contributions of services or property. in such apas, apparently the irs is willing to take interbranch transactions into account in determining the profits and losses of each office, and is willing to limit the ecti of the banks from the global trading activities covered by the apa to the separately determined taxable income of the u.s. branch. even at this relatively early stage in the evolution of apas as a means of addressing the global trading problems of foreign banks, several important observations can be made. although an apa is supposed to be only an agreement between the irs and a taxpayer on transfer pricing methodologies producing arm's length results under section 482, the irs apparently has been willing to enter into apas that, in effect, override the rules described above for determining a bank's eci. under the code and regulations, the principal issues confronted by foreign banks with respect to global trading activities are not arm's length 70. for a recent exchange of views on the relative merits and disadvantages of utilizing formulary apportionment to deal with transfer pricing issues in the international context, see generally eric j. coffill & prentiss willson, jr., federal formulary apportionment as an alternative to arm's length pricing: from the frying pan to the fire?, 59 tax notes 1103 (may 24, 1993); jerome r. hellerstein, federal income taxation of multinationals: replacement of separate accounting with formulary apportionment, 60 tax notes 1131 (aug. 23, 1993); benjamin f. miller, a reply to "from the frying pan to the fire," 61 tax notes 241 (oct. 11, 1993). 71. the profit split method is set forth in prop. temp. regs. § 1.482-6. although the formulary apportionment approach utilized in these apas does not conform to any of the specific profit split methods described in prop. temp. regs. § 1.482-6(c), it should qualify as an acceptable profit split method under prop. temp. regs. § 1.482-6(c)(5). [vol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 29 pricing questions under section 482, particularly inasmuch as the banks are engaged in business in the united states directly through branches rather than through affiliates.72 rather, the principal issues they confront relate to the amount of income that is treated as eci under the all-or-nothing rules described above. that the irs nonetheless is willing to deal with these issues in a constructive manner under the apa process is both remarkable and refreshing, although not at all surprising. for several years, the irs has been aware of the problems raised by global trading of financial instruments. 73 indeed, it has been suggested that when the irs was considering the issue of eci from notional principal contracts and section 988 transactions, the drafters of the proposed regulations had difficulty formulating an appropriate rule and used the vague crossreference, "under principles similar to those set forth in § 1.864-4(c),"'74 in the hope and expectation that commentators would provide assistance. whether that story is apocryphal or true, it is clear that the irs is now acutely aware that the rules are unsatisfactory. however, it has not yet been able to devise a replacement acceptable to it because of the complexities involved. under these circumstances, resort to the apa process by the irs as an interim, stop-gap measure is appropriate and sensible. in addition to providing critically needed relief to taxpayers that would otherwise be adversely impacted by unworkable rules, the apa process is a real-life experiential and experimental laboratory for the irs, providing it with valuable knowledge that can assist it in devising acceptable and workable rules and the experience of formulating those rules in conjunction with other countries that have a significant interest in global trading activities. viewed from this perspective, the apa process can be considered a step towards a more universal and permanent set of rules for determining a bank's eci from global trading activities. while the irs has not publicly articulated this view of the future, i believe that this evolution is inevitable, 72. even where a foreign taxpayer conducts global trading activities in the united states through an affiliate rather than through a branch-as often is the case with securities firms and occasionally with banks-the affiliate may be treated as a "branchof the taxpayer for u.s. tax purposes under the code and applicable treaties, which would give rise to eci and to income attributable to a permanent establishment. see generally samuels & brown. supra note 42, at 572-74. 73. see, e.g., t.d. 8258, 1989-2 c.b. 127 (soliciting comments regarding the application of temp. regs. § 1.863-7(b)(2)-(3) in circumstances involving global trading); announcement 90-106, 1990-38 i.r.b. 29 (sept. 17) (soliciting comments about issues raised by global trading of financial instruments that may be addressed by proposed regulations under §§ 482, 864, and other code provisions). 74. regs. §§ 1.863-7(b)(3), 1.988-4(c), discussed supra notes47-49 and accompanying text. florida tax review if for no other reason than to preserve the legitimacy of the apa process. unless the existing apa process in the global trading area is viewed as an interim step towards a revision of the applicable substantive rules, it will become increasingly vulnerable to criticism that it is "private law," especially to the extent that it is perceived as overriding provisions of the code and regulations and not merely as setting out factually based tpms for section 482 allocation issues. the foregoing is not intended to imply that the eventual, permanent solution necessarily will not involve an apa-type process. it may well be that, because of the highly varied global trading patterns of different taxpayers and categories of transactions, and because of the multijurisdictional nature of the issue, the irs will require, or continue to make available, an apa process. however, i believe that eventually the rules for determining eci will be revised to more closely comport with the results available under apas. 2. possible revisions to the rules for determining eci from global trading activities.-it may be premature to suggest how the rules for determining eci from financial instruments involved in global trading activities are likely to be revised. it seems to me, though, that revised rules-which should be reflected in amended regulations and in other forms of guidance-are likely to incorporate the following features: (a) abandonment of the all or nothing approach of the existing regulations in favor of a section 482-type, arm's length allocation analysis.75 conceptually, such an analysis, which takes into account the relative economic contributions of different offices, seems more appropriate than the existing rules,76 and the irs has implicitly recognized this point in the apas in global trading situations. 75. the suggested revisions could be implemented as modifications of the source rules contained in regs. §§ 1.863-7 and 1.988-4 (pursuant to regulatory authority under §§ 863(a) and 988(a)(3)(a)), and, in the case of gain or loss from the sale or exchange of stocks and securities (and of other financial instruments not covered by the foregoing provisions), through regulations under §§ 865(e)(2), (j), 864(c)(5). in addition, discrete aspects of the global trading issue may appropriately be addressed through specific rules, such as the approach proposed above for recognizing interbranch transfers of nonfunctional currency by foreign currency dealers. see supra note 63 and accompanying text. 76. for a general discussion of reasons why a § 482-type analysis is appropriate for global trading activities and of the relative merits of various approaches based on such an analysis, see generally the articles and papers cited supra note 42. [vol 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 31 (b) setting forth, perhaps in a revenue procedure, acceptable allocation methodologies and the general circumstances in which each methodology may be utilized. (c) requiring taxpayers to establish an allocation methodology that is consistent with the approaches set forth in the revenue procedure and to establish the reasonableness of the method chosen, or to document and establish the reasonableness of an alternative methodology. 77 (d) requiring taxpayers to maintain records and to file relevant summary information with their tax returns regarding the methodologies they have selected.78 (e) imposing accuracy-related penalties under section 6662 for failure to comply with the applicable allocation guidelines or the associated procedural requirements. careful consideration should be given to the appropriate scope of any revisions to the eci rules. the revised rules should apply to all foreign persons that are dealers in stocks and securities, in notional principal contracts, or in forex or interest rate forward contracts, options, warrants, or similar financial instruments. except as noted below, the revised rules should apply to all such financial instruments, stocks, and securities that are held in connection with the foreign person's dealer activity, including those held as hedges for inventory and similar property. indeed, it appears appropriate for any such revised rules generally to apply to any "security" held by a "dealer" (as those terms are defined in section 475) to which the mark-to-market rules of section 475 apply. however, as noted in part ii.c.3 below, any revisions to the eci rules probably should not apply to a debt instrument if interest on the instrument is covered by the special eci rule for banks,7 9 even if the instrument is held for sale to customers and is subject to section 475. also, in general any such revisions to the eci rules should not apply to interest rate or forex positions that are identified as hedges of such a debt instrument or as hedges of the bank's liabilities.'0 finally, the revised rules generally 77. use of an alternative methodology might be conditioned upon filing an apa request. 78. cf. temp. regs. § 1.6662-6(d) (setting forth documentation requirements for avoiding accuracy-related penalties). where appropriate, taxpayers might be required to make contemporaneous identifications of hedging and other transactions, or to record relcvant market pricing information. cf. § 1256(e)(2)(c); regs. § 1.988-5(a)(8); temp. regs. § 1.1221-2(c). 79. regs. § 1.864-4(c)(5), discussed in part ii.b.i. 80. see infra note 126 and accompanying text, where the recommendation is made that income and loss arising from such hedges should be treated as eci to the extent that the debt securities or liabilities to which they relate give rise to ec. as indicated below, consideration should also be given to the appropriate treatment of hedges conducted on a florida tal review should not apply to securities, notional principal contracts, or other financial instruments that are held for investment, arbitrage, or other trading purposes and are not subject to section 475, because these investments generally are made on a local, rather than global, level. it has been suggested that the irs might be reluctant to revise the eci rules to adopt a section 482-type approach for global trading because it believes that any resolution of global trading issues requires the cooperation of other taxing jurisdictions, in order to prevent abuses and a one-sided loss of tax revenues by the united states as well as to minimize banks' exposures to double taxation. consequently, it might be contended that revised eci rules for global trading activities should permit a taxpayer to adopt a particular allocation method only if the method is also used for all relevant foreign income tax purposes. such a requirement likely would significantly curtail potential abuses and minimize the risk of double taxation. however, such a requirement is not a condition to the adoption of an allocation method under section 482, and it is difficult to see why global trading should be treated differently in this regard. moreover, it may be harsh to penalize taxpayers that are required for foreign tax purposes to adopt a method that is unacceptable for u.s. tax purposes.8' at a minimum, however, it would seem appropriate to require taxpayers to indicate on their tax returns if they utilize inconsistent methods for foreign tax purposes. in addition to the question of consistency between the allocation methods selected for u.s. and foreign tax purposes, there is the question of consistency (or, quite frequently, the lack of consistency) in the rules for determining taxable income for u.s. and foreign income tax purposes. even if similar allocation methods are utilized for u.s. and foreign tax purposes, a bank may suffer double taxation or may avoid full taxation of its income from global trading activities if the tax base is determined by different rules under u.s. and foreign law. in general, it is not appropriate or feasible to address this consistency problem in revised rules of general application for determining eci from global trading activities.8 2 instead, resolution of serious inconsistencies should continue to be handled on a case-by-case basis through apas and agreements with competent authorities, subject to the constraints imposed by explicit provisions of the code and regulations. global, or overall portfolio basis, without specific identification of offsetting positions. 81. in appropriate circumstances, the irs may execute an apa without reaching agreement with the competent authority of a treaty partner, although the taxpayer must show good and sufficient reasons for such an apa. rev. proc. 91-22, supra note 64, § 7.08. 82. to the extent that one source of such inconsistencies is that interbranch transactions are not recognized for u.s. tax purposes, this problem presumably would be mitigated under certain allocation methodologies under generally applicable revised rules. [vol 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 33 among the more difficult issues that need to be addressed in formulating revised rules along the lines suggested above are the types of allocation methodologies that would be acceptable for u.s. tax purposes and the circumstances under which each methodology may be utilized. as mentioned above, the irs apparently is exploring different basic typologies of tpms, including in particular a worldwide formulary apportionment tpm and a natural home/separate entity method. other typologies are also conceivable, including (1) hybrid methods that employ elements of both a natural home/separate entity method and a worldwide formulary apportionment method, and (2) methods that rely more directly on the arm's length allocation methods prescribed in the regulations under section 482. given the range of possible methodologies, the irs will need to decide whether and under what circumstances taxpayers should have the freedom to choose a particular type of tpm.s' several considerations are relevant in this regard, including (1) the complexities involved in applying the methodologies, (2) the degree to which the methodologies produce results, in different types of circumstances, that are consistent with an arm's length analysis, (3) the extent to which the methodologies are consistent with general u.s. tax principles, (4) the ease and likelihood of coordinating those rules with applicable foreign tax rules, and (5) the potential that the irs might be whipsawed if taxpayers are able to choose a method that is most favorable to them. while i do not propose to explore these issues in great detail in this article, i have the following general observations. in the apa process the irs, to its credit, appears to be favoring methods that are simpler to apply8 over more complex methods that, at least in theory, might produce allocations that more closely reflect the application of an arm's length standard to specific factual situations. the decision to utilize, where appropriate, either a worldwide formulary apportionment method or a natural home/separate entity method may reflect the practical judgment that more complex methods-which for example might take into account more factors or dissect individual transactions into a greater number of components-are not likely to result in greater accuracy. moreover, this decision may reflect the view that it is less important to have an economically accurate determination of the amount of income to be taxed by each jurisdiction than it is to have relatively simple rules that provide 83. in dealing with an analogous issue, the temporary regulations under § 482 apply a "best method" rule, under which the "method that provides the most accurate measure of an arm's length result under the facts and circumstances of the transaction under review" must be utilized. temp. regs. § 1.482-1(b)(2)(iii). contrast to prior versions of the § 482 regulations, which set out a hierarchy among methods. see, e.g.. regs. § 1.482-2(e)(l)(ii) (1989). 84. even these simpler methods, however, involve complex analyses and detailed negotiations. florida tax review certainty and are generally fair. this decision may also reflect the view that these approaches are the easiest to apply in bilateral and multilateral agreements among tax authorities. it is noteworthy that both the formulary apportionment method and the natural home/separate entity method depart to some extent from conventional u.s. tax principles. as indicated above, formulary apportionment has generally been considered incompatible with the arm's length standard under section 482, although in appropriate circumstances it may be an acceptable application of the profit split method.85 and, to the extent that a natural home/separate entity method takes interbranch transactions into account for tax purposes, it might be considered inconsistent with the principle that a corporation is a single entity that cannot contract with itself, although (as discussed below) this approach should not be troublesome in the context of a section 482-type analysis. undoubtedly, there are situations in which the choice between a worldwide formulary apportionment method and a natural home/separate entity method is obvious, based on the manner in which the particular foreign bank conducts a particular type of global trading business. however, many businesses have some features that are more consistent with a worldwide allocation approach and other features that are more consistent with a natural home/separate entity approach. in these hybrid situations, each method by itself is likely to produce imperfect results, and the irs should try to ensure that it will not be whipsawed as each taxpayer chooses the method that produces more favorable results for it.86 in this regard, depending on the factors selected and their relative weighting, the results under a formulary apportionment method may not fully reflect the profitability or contributions of particular locations. similarly, a natural home/separate entity method may not fully reflect the contributions of particular locations (including synergistic contributions to the business as a whole), especially if the profit or loss of offices other than the natural home for a product is fixed through the terms of an interbranch transaction and the 85. also, as noted above, in contrast to traditional statutory applications of the formulary apportionment method, each apa has been tailored to the specific economic conditions of the taxpayer, so that the formulary method tpm may fairly be viewed as an effort to reflect, through a simplified formula, the results of an arm's length allocation. see supra note 71 and accompanying text. 86. even apart from any whipsaw concerns, the results under a formulary apportionment method are likely to differ from the results under a natural home/separate entity method (as often is the case when the results of different allocation methods under § 482 are compared with one another). indeed, in contrast to a formulary apportionment method, under a natural home/separate entity method, the u.s. branch could have a loss for income tax purposes in respect of particular transactions or the aggregate global trading activity even if the bank as a whole has a profit from those transactions or the aggregate global trading activity. [val 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 35 overall profit and loss on the product is concentrated in the product's natural home office. therefore, in these hybrid situations, it may be appropriate to employ a formulary apportionment method for certain aspects of the business activity and a natural home/separate entity method for other aspects of that activity. an important concern under any approach that permits interbranch transactions to be taken into account is whether taxpayers are setting the terms of the interbranch transactions in a manner that shifts profits to foreign offices. the extent to which this should be a serious concern in any given situation depends on a number of factors, including: the size and frequency of interbranch transactions; the frequency of comparable customer transactions and the extent of their comparability to the interbranch transactions; the availability of market pricing information; the proximity and pricing relationship between interbranch transactions and customer transactions; the extent to which other branches compete with third parties for the business of the u.s. branch; and, in some circumstances, the extent to which the interbranch transactions serve as a basis for compensation and performance evaluations. in general, in those situations in which taxpayers are permitted to take interbranch transactions into account in determining eci from global trading activities, they should be prepared to provide evidence enabling the irs to verify that the terms of the interbranch transactions are at arm's length. in addition, in appropriate circumstances the irs might require that the periodic (e.g., daily, weekly, or monthly) results of interbranch transactions fall within an acceptable range of comparable third party transactions during that period. subject to the foregoing caveats, i believe that interbranch transactions are an important and useful device for determining, within the context of a section 482-type analysis, what portion of a bank's profit or loss from global trading should be attributed to u.s. sources and taxed as eci. in my view, this conclusion is not inconsistent with the principle that interbranch transactions have no effect for u.s. federal income tax purposes because a corporation cannot contract with itself, inasmuch as the interbranch transactions would not be given effect in themselves but simply would be evidence of the appropriate allocation that should be made under the arm's length principles of section 482. surely, it should be permissible in the context of a section 482 analysis, subject to appropriate conditions and safeguards, to take into account a bona fide, contemporaneous effort by a taxpayer, duly recorded in the form of interbranch transactions, to achieve an allocation of income or loss from a transaction between the u.s. and foreign branches that participated in the transaction, by reference to what the terms of an unrelated third-party transaction would be. 3. implications for other eci rules.-the thrust of the preceding argument has been that the all-or-nothing approach of the existing rules for florida tax review determining eci (and the source of income) do not produce proper results for global trading activities of foreign banks and that these rules should be replaced by a method that utilizes the principles of section 482. if indeed such an approach is adopted, one question that might arise is whether the revised rules should be limited to global trading or whether they should instead have a more general application. in the context of foreign banks, for example, should such an approach replace the "active and material participation" rule under regulations section 1.864-4(c)(5) for determining whether interest income and gain from debt securities is eci? as discussed in part ii.b.1 above, the "active and material participation" rule does have its shortcomings, attributable in some measure to the allor-nothing nature of that test, and it may result in the overinclusion or underinclusion of income. nevertheless, on this particular question, i subscribe to the notion that "if it ain't broke too badly, don't fix it." despite its shortcomings, the "active and material participation" rule is straightforward and reasonably simple to apply, particularly in comparison to a section 482type analysis. a similar observation can be made about the other eci rules discussed in part i.b. 1-4 above. while the existing rules for determining eci in these situations may not give full effect to the economic contributions of different offices of a taxpayer, the results in most cases are generally acceptable. moreover, these results generally are consistent with foreign tax laws, so that taxpayers do not face serious double taxation problems. furthermore, as discussed in part ii.b. i above, the principal problems with the "active and material participation" rule can be addressed through clarification and refinement. because of its complexities, the section 482-type analysis should be reserved for a bank's global trading activities (and other similar situations), where the existing rules produce results that are uneconomic and are inconsistent with foreign tax laws, thereby giving rise to severe double taxation problems that cannot be readily addressed through simple tinkering with the existing rules. i. expenses and losses of the branch a. expenses and losses other than interest in computing its taxable income that is effectively connected with a u.s. trade or business, a foreign bank is permitted to claim deductions to the extent they are connected with eci. 87 the determination of whether deductions (other than interest expense, which is discussed in part iii.b below) are 87. irc § 882(c)(1); regs. § 1.882-4(b)(1). deductions are allowed only if a tax return is filed within the time period prescribed by regs. § 1.882-4(a). [vol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 37 connected with a bank's eci is made in accordance with the rules, contained in regulations section 1.861-8, for allocating and apportioning deductions between u.s. and foreign source income. under these rules, expenses that are incurred by a foreign bank as a result of, or incident to, activities that generate eci are deductible, as is a proportionate share of expenses that relate generally to all of the bank's income (based on the relative portion of the bank's total gross income that is eq). as in other contexts, the amount of deductions is determined on the level of the bank as a whole, and interbranch transactions are ignored. however, as a result of the foregoing allocation rules, deductions of the u.s. branch (viewed as if it were a separate entity, except in respect of interbranch transactions), generally are allowed.' thus, a foreign bank generally may deduct amounts payable to other persons by a u.s. branch in the conduct of its activities, including rent or depreciation on its office space, salaries of u.s. employees, other u.s. branch office expenses, and state taxes. to the extent that a non-u.s. office of the bank provides identifiable services to the u.s. branch (such as centralized data processing or clearing and custody functions for securities positions held by the u.s. branch), a portion of the expenses incurred in providing those services may be deducted in computing ecti. it is advisable for the bank to maintain documentation supporting the methodology for determining any deductions that are claimed. finally, a portion of the general overhead of the bank, including salaries and other costs attributable to the bank's senior management, should be allocable to the u.s. branch, based upon the proportion of the bank's total gross income that constitutes eci. while not entirely clear, it is generally believed that under current law a loss on the sale of an asset (whether capital or ordinary) by a foreign bank is deductible (subject to applicable limitations) for u.s. tax purposes if the asset would have generated eci if it were sold at a gain. 9 with respect 88. limitations may apply to the extent expenses are attributable to assets or activities of the u.s. branch that do not generate eci. other rules of general application may limit the amount or timing of deductions, including provisions limiting the availability of deductions for expenses and losses incurred in transactions with related parties. see. e.g., § 267. 89. see temp. regs. § 1.861-8(c)(1) (suggesting that the general allocation rule applies to § 1221(1) assets); § 1.861-8(e)(7) (regarding capital assets and § 1231 assets); § 1.988-4(c) (regarding forex loss). regs. § 1.863-7(b)(3), however, discusses notional principal contract income but not losses. also. § 865(j)(1) grants the irs authority to promulgate regulations dealing with the treatment of losses from the sale of personal property. in this regard, see staff of joint comm. on tax'n, 99th cong.. 2d sess., general explanation of the tax reform act of 1986 at 923 (1987) [hereinafter 1986 bluebook] ("it is anticipated that regulations [under § 8650)(1)] will provide that losses from sales of personal property generally will be allocated consistently with the source of income that gains would generate but that variations of this principle may be necessary"). presumably the irs would exercise florida tax review to the bad debt deduction for worthless loans, regulations section 1.1662(d)(4) provides that the special presumptions of worthlessness that apply to charge-offs of debt for regulatory purposes apply to a foreign bank only with respect to loans the interest on which is eci. b. interest expense 1. summary of the interest allocation regulations.-a foreign bank's deduction for interest expense (u.s., or deductible, interest expense) is not calculated simply as the interest paid or accrued by the branch on the liabilities reflected on its books. rather, regulations section 1.882-5 (the interest allocation regulations) sets out a three-step formula for determining u.s. interest expense. these rules were promulgated in final form in 1981 (the 1981 regulations). in 1992, proposed regulations were issued that would replace the 1981 regulations, effective for taxable years beginning after the regulations are issued in final form. although the two sets of regulations differ in certain significant respects, they share a common framework involving a three-step formula. the first step in the formula is to determine the average total value of the "u.s. assets" of the bank during the taxable year. under the 1981 regulations, the u.s. assets are those assets that "generate, have generated or could reasonably have been or be expected to generate income, gain, or loss" that is eci.90 the 1992 proposed regulations would, with certain exceptions, adopt the narrower, detailed definition of "u.s. assets" that is contained in the regulations under section 884, which implement the branch profits tax.9' such authority to preclude a deduction for losses on notional principal contracts or forex contracts that are booked in and managed by a non-u.s. office, even if the u.s. branch materially participates in the disposition of the contract. 90. regs. § 1.882-5(b)(1). 91. prop. regs. § 1.882-5(b)(1). the relationship between the interest allocation regulations and the branch profits tax is explored in part iv.b below. although it is not entirely clear what practical effect the adoption of the § 884 definition would have, the § 884 definition is significantly narrower than the definition in the 1981 regulations because, subject to certain exceptions, it requires that all income and gain from an asset must be eci in order for the asset to be a "u.s. asset." regs. § 1.884-1(d)(1). appropriately, however, regs. § 1.884-1(d)(2)(vii) provides that "other securities" described in regs. § 1.864-4(c)(5)(ii)(b)(3) (see supra note 20 and accompanying text) are u.s. assets in the same proportion that the income, gain, or loss from those securities is ec. (a similar proportionate allocation rule should be adopted for purposes of the interest allocation regulations and the branch profits tax in other contexts as well. see infra note 128.) also, regs. § 1.884-1(d)(2)(vi) provides that, in general, a debt instrument is a u.s. asset, notwithstanding that gain therefrom would not be eci, if all income from the debt instrument during the taxable year is eci and the yield on the debt instrument equals or exceeds the applicable federal rate. with respect to inventory, regs. § 1.884i(d)(2)(ii) provides in general that inventory property is a u.s. asset in the same proportion as the amount of gross receipts from the sale [vol. 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 39 the second step in the formula is to determine the amount of "u.s. liabilities." in general, u.s. liabilities are computed by multiplying u.s. assets by either a "fixed ratio" or an "actual ratio."9 under the 1981 regulations, the fixed ratio for foreign banks is 95%, whereas under the 1992 proposed regulations, the fixed ratio is 93%.93 instead of using the fixed ratio, a foreign bank can determine its u.s. liabilities based on the actual ratio of its average worldwide liabilities to its average worldwide assets.94 of "such property" for the three preceding taxable years that is eci bears to the total amount of gross receipt from the sale or exchange of "such property" during the three-year period. this provision appears to be unduly complicated (perhaps even to the point of being unadministrable) and may produce inappropriate results, if it is interpreted to require a foreign bank to determine its u.s. assets (for purposes of the interest allocation regulations and the branch profits tax) by applying the foregoing three-year formula to all debt securities (or, possibly, to broad categories of debt securities) held by the bank anywhere in the world as inventory or primarily for sale to customers in the ordinary course of its trade or business. the 1992 proposed regulations under § 882 would modify the § 884 definition to exclude real property from u.s. assets except in the year in which gain or loss is recognized under § 897(a)(1). see prop. regs. § 1.882-5(b)(1)(ii)(a)(l). in effect, under the 1992 proposed regulations, a branch would be denied an interest deduction for the portion of its debt that is allocable to its investment in real property, including real property acquired through foreclosure on mortgage loans as well as office buildings owned and occupied by the u.s. branch. this rule is both harsh and difficult to justify, and it has been criticized by commentators. see, e.g., new york state bar ass'n, report on proposed regulations section 1.882-5, 92 tnt 189-51 (sept. 18, 1992) (lexis, fedtax lib., tnt file) [hereinafter the nysba report]. another modification is that stock, the dividends on which are eci. would not be a u.s. asset to the extent of the dividends received deduction. prop. regs. § 1.8825(b)(2)(iii)(b). it is possible that this exclusion is viewed by the irs as implementing § 864(e)(3), enacted in 1986, which provides that in allocating and apportioning interest expense, stock generally is not taken into account to the extent of the dividends received deduction allowable under § 243. however, there is some confusion regarding what was intended in this regard, and this rule has also been criticized by commentators. nysba report, supra. 92. once adopted, either method must usually be used for all subsequent years. regs. § 1.882-5(b)(2); prop. regs. § 1.882-5(c)(3). 93. regs. § 1.882-5(b)(2); prop. regs. § 1.882-5(c)(3). for a nonbanking business, the fixed ratio is 50% under both the 1981 regulations and the 1992 proposed regulations. a "banking business" for these purposes means a banking, financing, or similar business as defined in reg. § 1.864-4(c)(5)(i). see supra note 11. 94. the 1992 proposed regulations would cap the actual ratio at 96%. prop. regs. § 1.882-5(c)(2)(i). the preamble to the 1992 proposed regulations provides the following justification: at present, u.s. banks generally are required to maintain a "leverage ratio" (i.e., equity to assets) of 4%. as a result of the passage of the federal deposit insurance corporation improvement act of 1991, the federal reserve board and the treasury department are required to prepare, for submission to congress, a report providing guidelines for florida tax review in the third and final step, the u.s. interest expense is calculated as the amount of u.s. liabilities, as determined under the second step, multiplied by an appropriate interest rate. under the 1981 regulations, taxpayers have the choice of using either the "branch book/dollar pool" method or the "separate currency pools" method to perform this calculation. the 1992 proposed regulations would permit use only of a modified form of the branch book/dollar pool method. in general, under the branch book/dollar pool method, the amount of u.s. liabilities computed in step two is compared with the amount of actual liabilities shown (or, under the 1992 proposed regulations, properly reflected) on the books of the u.s. branch (booked liabilities).95 adjustments are then made based on whether the bank is considered to have borrowed in the united states to fund activities outside the united states (that is, the u.s. branch is overleveraged, as evidenced by the fact that booked liabilities exceed u.s. liabilities), or the u.s. branch is considered to be funded in part with borrowings by the bank outside the united states (because u.s. liabilities exceed booked liabilities, indicating that the branch is underleveraged). if booked liabilities equal or exceed u.s. liabilities (so that the branch is considered overleveraged), the interest expense allocable to the u.s. branch is based on the actual interest expense of the u.s. branch on booked liabilities, reduced to reflect any excess of booked liabilities over the u.s. liabilities computed in step two. 96 in contrast, if u.s. liabilities exceed booked liabilities, the interest expense allocable to the u.s. branch consists of two components: (1) the interest expense on booked liabilities, plus (2) determining whether the capital of foreign banks conducting banking operations in the united states is equivalent to the capital standard for u.s. banks. 57 fed. reg. 15039-40 (1992). see nysba report, supra note 91, for a critique of this cap. 95. the 1992 proposed regulations contain extensive rules for determining whether a liability is a booked liability. prop. regs. § 1.882-5(d)(2). these rules include special provisions relating to (1) liabilities of shell branches located in the bahamas or cayman islands (see supra note 18), (2) high interest rate liabilities, and (3) situations where there is a significant discrepancy between the currency denomination of booked liabilities and the currency denomination of u.s. assets. 96. in this case, the u.s. interest expense under the 1981 regulations equals the product of the average u.s. liabilities for the year and the average interest rate for the year on the branch's booked liabilities. regs. § 1.882-5(b)(3)(i)(a). the 1992 proposed regulations would modify this calculation by providing that u.s. interest expense equals the interest expense paid or accrued by the u.s. branch in respect of booked liabilities, multiplied by a "scaling ratio." the scaling ratio is a fraction, the numerator of which is booked liabilities less u.s. liabilities (as determined under step 2) and the denominator of which is booked liabilities. prop. regs. § 1.882-5(d)(3). [vol. 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 41 interest computed on the excess of u.s. liabilities over booked liabilities (excess liabilities).97 as an alternative to the branch book/dollar pool method, the 1981 regulations permit taxpayers to elect a "separate currency pools method," under which interest expense is separately computed for each currency in which the branch has borrowed. in general, under the separate currency pools method, u.s. interest expense equals the product of booked liabilities in a particular currency, as adjusted,9" and the foreign corporation's average worldwide interest rate for that particular currency. the 1992 proposed regulations would eliminate the separate currency pools method." the interest allocation regulations require all inter-branch transactions to be disregarded in applying the three-step formula. thus, loans between the u.s. branch and the home office are ignored for purposes of determining the u.s. assets, u.s. liabilities, booked liabilities, and interest expense on booked liabilities. °° 2. policies underlying the interest allocation regulations.-at first blush, the interest allocation regulations appear to be complicated and unwieldy, both in concept and in practice. closer examination of the regula97. under the 1981 regulations, component (2) generally is calculated using either the average interest rate on u.s. dollar liabilities shown on the books of the bank's non-u.s. offices or, if this rate is not reasonably determinable, using a method that reasonably approximates the actual rate (such as a libor-based rate) that is consistently applied from year to year. regs. § 1.882-5(b)(3)(i)(b). the 1992 proposed regulations arc generally less favorable in that component (2) would be computed at a rate equal to 90% of the daily average for the taxable year of libor for demand deposits. (in the case of taxpayers other than banks, under the 1992 proposed regulations, the interest rate used for component (2) would be 110% of libor.) prop. regs. § 1.882-5(d)(4). 98. the adjustment consists of multiplying booked liabilities in a particular currency by a fraction the numerator of which is the branch's total u.s. liabilities (determined by the second step of the formula) and the denominator of which is the branch's total booked liabilities. regs. § 1.882-5(b)(3)(ii)(a). 99. according to the preamble to prop. regs. § 1.882-5.57 fed. reg. 15038. 15040 (1992): the separate currency pools method is eliminated because (1) it is difficult to reconcile this method with the interest paid and excess interest elements of the branch taxes of section 884, (2) it only reduces and does not eliminate the problems of weak and strong currencies which the regulation originally was intended to solve, (3) auditing overseas interest rates is extremely difficult, and (4) the availability of currency swaps permits fungibility among currencies to be achieved (thereby undermining the underlying assumption of the method), as is evident by the fact that a true interest rate can be ascertained only by determining the effect of all interest rate and currency swaps. 100. regs. § 1.882-5(a)(5); prop. regs. § 1.882-5(b)( 1 )(iii). (c)(2)(ii)(b). (d)(2)(iv. florida tax review tions and their evolution reveals that they reflect, to varying degrees, several competing and interrelated themes and concerns. necessarily, the balance that has been struck between the competing policy considerations underlying the regulations is not perfect; indeed, the relative weights accorded to these considerations have shifted over time, and presumably will continue to change. rather than discuss the technical aspects of the interest allocation regulations, which have already been the subject of extensive commentary, °' this article focuses on some of the underlying policy considerations. among the competing and interrelated themes and concerns reflected in the interest allocation regulations are the following: fungibility vs. separate entity. the regulations are influenced to a great extent by the principle that money is fungible and that liabilities (and related interest expense) are not specifically traceable to particular activities, assets, income, or geographic locations. the regulations, however, also make important concessions to the view that a branch should be treated as a separate entity. administrability vs. accuracy. the regulations seek to reduce the administrative burdens of taxpayers and the irs in determining the amount of deductible interest expense. however, the simplifying formulas and other rules contained in the regulations make it somewhat difficult to maintain that they are an accurate measure of the amount of interest expense attributable to eci. ensuring a minimum level of u.s. taxable income. some indications exist that one policy goal underlying the regulations is to ensure that foreign banks with u.s. branches pay some minimum level of u.s. tax. coordination with other provisions and with hedging techniques. an important factor in the formulation of the 1992 proposed regulations is the need to correlate the interest allocation regulations with the branch profits tax and branch level interest tax. the 1992 proposed regulations also recog101. on the 1992 proposed regulations, see, e.g., peter j. connors, et al., new interest expense allocation rules pose practical difficulties for foreign banks, 77 j. tax'n 368 (1992); nysba report, supra note 91; letter from lawrence r. uhlick, executive director & general counsel, institute of international bankers, to shirley d. peterson, comm'r, internal revenue service, 92 tnt 184-31 (aug. 17, 1992) (lexis, fedtax lib., tnt file) [hereinafter iib comment letter]. on the 1981 regulations, see, e.g., john 0. hatab, u.s. taxation of foreign banking in the united states-an overview, 41 inst. on fed. tax'n § 27 (1983). [vol 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 43 nize the need to coordinate the interest allocation regulations with new financial developments, including currency and interest rate hedges, as well as with the rules under section 988 relating to forex gain or loss. these themes are examined in detail below. a. fungibility and its limnits.-historically, one of the most important principles underlying the interest allocation regulations has been the notion that because money is fungible, all borrowings equally support all activities of a bank (or other taxpayer), wherever they are undertaken. "2 under this fungibility principle, the amount of liabilities (and interest expense) attributable to a foreign bank's u.s. trade or business should bear the same ratio to its u.s. activities (however measured) as the ratio of the bank's worldwide liabilities (or interest expense, as the case may be) bears to the bank's worldwide activities. as explained below, however, this concept has been limited significantly in successive versions of the interest allocation regulations. before 1977, both foreign corporations (in determining their ecti) and u.s. corporations (e.g., in determining their foreign source income for purposes of applying the foreign tax credit limitation under section 904) generally allocated interest expense based on the factual connection between the item of interest expense and particular items of gross income. if a factual connection could not be established, the interest expense generally was apportioned on the basis of the ratio of the taxpayer's gross income from u.s. 102. see 1986 bluebook, supra note 89, at 947 ("the act adds new code section 864(e), which generally adopts a one-taxpayer rule and other rules for expense allocation for purposes of [the international rules] for income arising outside the united states and for foreign taxpayers .... generally, money is to be treated as fungible, and interest expenses are to be prorated on the asset method.") while the regulation in which the following statement appears no longer governs the allocation of interest expense for purposes of determining ecti of a foreign taxpayer, the classic statement of fungibility is as follows: the method of allocation and apportionment for interest set forth in this section is based on the approach that, in general, money is fungible and that interest expense is attributable to all activities and property regardless of any specific purpose for incurring an obligation on which interest is paid .... the fungibility approach recognizes that all activities and property require funds and that management has a great deal of flexibility as to the source and use of funds. when money is borrowed for a specific purpose, such borrowing will generally free other funds for other purposes, and it is reasonable under this approach to attribute part of the cost of borrowing to such other purposes. temp. regs. § 1.861-9(a). florida tax review sources to its worldwide gross income. 13 in practice, most foreign banks apparently determined their u.s. interest expense based on the interest expense shown on the books of their u.s. branch (the so-called "separate entity method")." 4 eventually the irs began to assert that, regardless of its factual connection with particular items of gross income, money in fact is fungible and interest expense therefore should always be treated as attributable to all gross income. however, the irs was rebuffed in several cases involving u.s. taxpayers on the basis of the literal language of the statute and the then existing regulations. °5 in response, the irs amended the regulations in 1977 (finalizing changes that were proposed in 1973) to adopt the fungibility principle for allocating and apportioning interest expense.'06 the 1977 regulations required, with limited exceptions, that interest be ratably apportioned based on relative u.s.-to-worldwide assets (or, subject to certain limitations, relative u.s.-to-worldwide gross income). the 1977 regulations applied to both u.s. and foreign corporations. it was soon realized, however, that as applied to u.s. branches of foreign banks, a full-fledged fungibility approach produced harsh results in some cases and bizarre windfalls in others. in general, the 1977 regulations favored foreign banks whose overall cost of funds was higher than their cost of u.s. dollar funds (so-called "soft currency" borrowers), and treated harshly foreign banks whose cost of u.s. dollar funds exceeded their average borrowing cost (so-called "hard currency" borrowers). in particular, japanese and german banks were severely disadvantaged under the 1977 regulations because their yen or deutschemark borrowing costs were significantly lower than their u.s. dollar borrowing costs. instead of allowing a deduction for the full amount of interest expense on the u.s. dollar borrowings of their u.s. branches, the 103. regs. § 1.861-8(a) (1966), adopted in 31 fed. reg. 11144 (1966). see commercial union assur. co. ltd. v. commissioner, 144 f.2d 994 (2d cir. 1944); third scottish am. trust co., ltd. v. united states, 37 f. supp. 279 (ct. cl. 1941); balfour, williamson & co., ltd. v. commissioner, i t.c. memo 852 (1943). 104. on the use of the separate entity method by foreign banks before the 1977 regulations, see charles t. crawford, allocation of interest expense for foreign branch banking operations in the u.s., 10 tax adviser 236 (1979); see also hatab, supra note 101, § 27.03[2]. 105. see, e.g., chicago, milwaukee, st. paul & pac. r.r. v. united states, 404 f.2d 960, 974 (ct. cl. 1968); missouri pac. r.r. v. united states, 392 f.2d 592, 604-06 (ct. cl. 1968); f.w. woolworth v. commissioner, 54 t.c. 1233, 1271-73 (1970), nonacq., 1971-2 c.b. 4. 106. regs. § 1.861-8(e)(2), t.d. 7456, 1977-1 c.b. 200 (1977), which modified and adopted prop. regs. § 1.861-8(e)(2), published in 38 fed. reg. 15840 (1973). the articulation of the fungibility principle in former regs. § 1.861-8(e)(2) is substantially the same as that found in temp. regs. § 1.861-9(a), quoted supra note 102. [vol 2:1 19941 u.s. federal income taxaion of u.s. branches of foreign banks 45 1977 regulations required these banks to compute u.s. interest expense based on their lower overall costs of funds. several japanese, german, and u.k. banks (as well as others) that were confronted with this situation contended that the income tax treaties between those countries and the united states specifically permitted use of the separate entity approach to compute a u.s. branch's interest expense. ' in revenue ruling 78-423,'08 however, the irs rejected this argument, and held that the 1977 regulations were compatible with the japanese-u.s. income tax treaty and had to be applied by japanese banks to determine their interest deductions. the irs has continued to adhere to its view that the fungibility principle of allocating interest expense is compatible with income tax treaties, and has issued similar rulings under the 1981 interest allocation regulations in the context of the japanese and u.k. income tax treaties." nonetheless, the irs responded to the foregoing concerns by issuing the 1981 interest allocation regulations, which significantly curtail the fungibility principle in this context and contain important accommodations to the separate entity approach. for example, under the separate currency pools method, the interest rate for a particular currency continues to be based on the bank's worldwide interest rate for that currency, but it is taken into account only to the relative extent of the actual liabilities of the u.s. branch (vs. worldwide liabilities) in that currency. the branch book/dollar pool method gives even greater weight to a separate entity concept. essentially, notwith107. for example, u.s.-jap. treaty, supra note 27, art. 8(2) provides that: there shall in each contracting state be attributed to the permanent establishment the industrial or commercial profits which would be attributable to such permanent establishment if such permanent establishment were an independent entity engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the resident of which it is a permanent establishment. similar language appears in most other u.s. income tax treaties. 108. 1978-2 c.b. 194. see infra note 116 and accompanying text for a discussion of rev. rul. 78-423. 109. rev. rul. 85-7, 1985-1 c.b. 188 (u.s.-jap. treaty); rev. rul. 89-115, 1989-2 c.b. 130 (u.s.-u.k. treaty). see prop. regs. § 1.882-5(a)(3) (stating that "[tlhe rules of this section also apply for purposes of determining the interest expense attributable to business profits of a permanent establishment under u.s. income tax treaties."). this position was recently reaffirmed in connection with a number of newly concluded income tax treaties, see treasury department technical explanations of the u.s.netherlands and u.s.-mexiean income tax treaties, 2 tax treaties (cch) '1 6121, 36,447-125 and 2 tax treaties (cch) 1 5943, 35,829-11, respectively, and was endorsed by the senate foreign relations committee in its reports on those treaties, 2 tax treaties (cch) 1 6119, 36,447-45 and 2 tax treaties (cch) 5945, 35,867 (interpreting the provisions of those treaties regarding the allowance of deductions for interest in determining the profits of a permanent establishment as incorporating, for u.s. tax purposes, the interest allocation regulations). florida tax review standing the three-step formula described above, this method can best be viewed as a modified separate entity method. although it is set forth in step three of the formula, the real starting point for determining the amount of deductible interest is the interest expense shown on the books of the u.s. branch, which is then adjusted to the extent the branch is underleveraged or overleveraged, compared with the bank as a whole. the 1992 proposed regulations, by eliminating the separate currency pools method, further tilt the balance towards a modified separate entity approach. one important reason for dropping the separate currency pools method is the need to correlate the interest allocation regulations with the branch profits tax and the branch level interest tax, which are rooted in a view of the u.s. branch as a separate entity. the preamble to the 1992 proposed regulations notes that it would have been "difficult to reconcile [the separate currency pools] method with the interest paid and excess interest elements of the branch taxes of section 884."110 in summary, in the context of the interest allocation regulations, the fungibility principle has been interpreted by the irs to mean only that the level of leverage of the branch must be comparable to that of the bank as a whole, not that the interest rate applied to the branch's liabilities (or the amount of deductible interest expense) must be comparable to that of the bank as a whole. this more limited interpretation of the fungibility principle-which in my view is justified in light of the considerations discussed in this part of the article-stands in contrast to the application of the principle in the context of the interest allocation rules under temporary regulations section 1.861-9 (e.g., for purposes of the foreign tax credit limitation), which generally require that worldwide interest expense be apportioned on the basis of assets. as applied in the interest allocation regulations, the fungibility principle effectively requires the branch to have the same ratio of equity capital to assets, for tax purposes, as the bank as a whole, thereby imposing a uniform debt-to-equity ratio on the u.s. branch and the bank as a whole. as in the case of other efforts to deal with the debt-equity question,"' this rule can be viewed in part as an attempt to require taxpayers to report a minimum level of taxable income, a theme that is developed further below. 110. 57 fed. reg. 15038 (1992), quoted supra note 99, at 15040. while the reasons advanced by the preamble have merit, it also is generally believed that the irs became concerned that the separate currency pools method permitted foreign banks to "overstate" u.s. interest deductions because their u.s. dollar borrowings outside their u.s. branches typically bear higher interest rates than their u.s. branch borrowings. 111. see, e.g., irc § 163(j)(2)(ii) (providing that corporations with debt/equity ratios in excess of 1.5 to 1 may be subject to "earnings stripping" rules); § 385 (authorizing the irs to prescribe regulations classifying interests in corporations as debt or as equity). ivol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign baniks 47 the imposition of a uniform level of leverage on all business activities and transactions entered into by a u.s. branch can result in disparities between the bank's economic profit and loss and its ecti from certain activities, and can render ostensibly profitable activities or transactions uneconomic on an after-tax basis. this unfortunate result is most likely to arise where the branch engages in economically integrated financial transactions involving higher levels of leverage than the overall level of leverage of the bank as a whole. for example, banks (including u.s. branches of foreign banks) often hold sizeable amounts of u.s. treasury securities, and they often engage in "repo" transactions.1 12 the function of the repo transactions depends on the bank and its reason for holding treasury securities. thus, a bank that holds treasuries in its dealer inventory, or because of their liquidity or the low regulatory capital charges involved, may find that repo transactions are an effective technique for financing the u.s. treasuries at attractive rates. indeed, because a repo typically represents an overnight secured borrowing, with a loan principal amount generally equal to the fair market value of the repoed securities, the bank can earn a positive spread between its interest income on the treasuries and its repo interest expense. banks that act as securities dealers may use repos as part of a "matched book" business in which the bank "repos in" securities from borrowers and "repos out" securities to lenders, earning in effect a commission. for tax purposes, repos traditionally have been viewed as secured money loans that give rise to interest expense (in the case of a repo) or 112. in a repo transaction, one party sells ("repos out") securities, typically u.s. treasury obligations or obligations of u.s. government-sponsored agencies. to a second party, and simultaneously ag.rees to repurchase identical securities from the buyer on a specified date at a specified price. the repurchase price reflects a time value component that may be stated as a premium above the selling price or as a separate "repo rate" applied to the selling price. the economic effect of the sale and repurchase transaction is to provide the party that repos out the securities with the use of cash at an attractive interest rate. a "reverse repo" is simply the same transaction viewed from the perspective of the other party: the purchase ("reversing in") of securities with a simultaneous agreement to resell identical securities to the original seller at a later date. in a typical repo transaction, the securities are marked-to-market daily. and the repo "seller" (i.e., the money borrower) is obligated to provide additional collateral (or refund cash) if the value of the securities falls. as a result, the degree of overcollateralization required of repo sellers is very small, ranging from perhaps one to two percent in the case of a nondealer participant down to zero in the case of inter-dealer repo transactions. in addition. securities reversed in by a dealer (when it lends money) may be "rehypothecated"-that is, used by the dealer (whether through sale or otherwise) in its trade or business until the original reverse repo transaction is unwound. florida tax review interest income (in the case of a reverse repo). " ' as indicated above, in a typical repo of treasury securities, the principal amount of the loan generally equals the fair market value of the repoed treasury securities, so that the securities are fully leveraged, with virtually no equity. therefore, unless the u.s. branch is sufficiently underleveraged (before taking into account the treasury securities and the repo transactions) so that it can absorb the 100% leverage ratio attributable to the repoed treasuries, the interest allocation regulations result in effect in a disallowance of a portion of the interest expense on the repoed treasury securities.1 14 on the other hand, the fungibility principle benefits banks where they engage in business activities that are typically less leveraged. for example, a u.s. branch should be able to apply the fixed ratio for banks or its actual ratio to compute its u.s. interest expense on a leveraged lease that is leveraged at only 80%. similarly, the bank can apply those ratios to a securities trading division of its u.s. branch that is leveraged at a lower level, even though if the securities trading operation were conducted through a nonbank foreign corporation, it would be required to utilize its actual (presumably lower) ratio or the 50% fixed ratio. b. separate entity approach and its limits.-as described above, the interest allocation regulations give a considerable measure of recognition to the branch as a separate entity, particularly insofar as they take into account the interest expense reflected on the books of the branch. however, the irs has emphatically refused, both in published rulings and in the interest allocation regulations, to permit a bank to determine its deductible interest expense solely on the basis of the branch's records, or to recognize interbranch loans or other interbranch transactions. in this regard, the irs' position-and its interpretation of u.s. income tax treaty provisions-differs from that of most other countries and from the oecd's interpretation of the oecd model convention (upon which most of the relevant u.s. tax treaty provisions are based)." 5 the irs's rationale is most clearly set forth in revenue ruling 78423: 113. rev. rul. 79-134, 1979-1 c.b. 76; rev. rul. 77-59, 1977-1 c.b. 196; rev. rul. 74-27, 1974-1 c.b. 24. 114. in contrast, the interest allocation rules under temp. regs. § 1.861-10(c) provide an exception to the general fungibility principle for certain integrated financial transactions (although this exception is not available to securities dealers). 115. see org. for economic co-operation and dev., the taxation of multinational banking enterprises, in oecd, transfer pricing and multinational enterprises: three taxation issues (1984) [hereinafter oecd report]. the oecd report expresses the view that, under the oecd model convention, bank branches should be treated as separate entities and interbranch transactions should be recognized. [vol. 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 49 the reference in article 8(2) of the [japan-u.s.] convention to attributing profits to the permanent establishment as if it were an independent entity relates only to the computation of the profits of the permanent establishment in the dealings of such permanent establishment with the home office and with any other branch of the foreign resident that may exist. this reference does not mean that the united states branch must be taxed as though it were a separate entity. the resident taxpayer is the foreign bank itself, consisting of the home office and the branch, p and p-1, respectively. consistent with this analysis, article 8(l) provides that the united states may tax a japanese resident on the "industrial and commercial profits of such resident ... [that] are attributable to" p1. in determining the amount of such profits, article 8(3) of the convention permits the deduction of expenses that are "reasonably connected" with such profits, regardless of where the expenses are incurred. however, the independent entity concept of article 8(2) does not determine what expenses are "reasonably connected" with such profits. further, article 8(3) is not to be interpreted as allowing the permanent establishment of p to allocate the interest deduction in a manner different from other united states taxpayers. the convention does not provide a specific rule for tie allocation of expenses. thus, in the absence of such a rule, article 2(2) of the convention indicates that the general domestic law of the united states is to be applied for the purpose of determining the expenses "reasonably connected" with the profits of a united states permanent establishment. with respect to the allocation and apportionment of the foreign bank's worldwide interest expense, the general allocation rule for the taxpayer in the instant case is found in section 1.861-8 [now found in section 1.882-5] of the regulations." 6 critics of the irs' position have argued that it is inconsistent with u.s. income tax treaties, that it exposes foreign banks to double taxation as a result of the lack of conformity in the determination of their interest 116. 1978-2 c.b. 194, 195 (emphasis added). florida tax review expense for u.s. and foreign tax purposes, and that the interest allocation regulations that are necessary to implement the irs' position require foreign banks to engage in complex and costly computations and to incur administratively burdensome recordkeeping obligations." 7 i do not wish to express a comprehensive view as to whether a challenge to the irs' interpretation of the relevant treaty provisions might have merit as a technical legal matter. however, it seems to me that the irs' position that a u.s. branch should not be treated solely as a separate entity for purposes of determining its deductible interest expense is more consistent with the general approach of the u.s. tax law to the taxation of branches of foreign corporations, as discussed in this article,"1 8 and permits a better balance to be struck among the various policies that should underlie the determination of a branch's deductible interest expense. moreover, congress weighed in on the matter in 1987, stating in the legislative history of section 842 that "the conferees believe that the current regulatory provisions for determining liabilities allocable to a foreign corporation's u.s. business are fully consistent with the treaty obligations of the united states."' '9 particularly in view of the foregoing and as discussed below, whether interbranch loans can, within the framework of existing law, or should, as a policy matter, be taken into account in any way under the interest allocation regulations is at best unclear. 120 the treatment of interbranch loans touches 117. e.g., institute of international bankers, taxation of u.s. activities of international banks, 19 highlights & documents 45 (oct. 1, 1990) (lexis, fedtax lib., tnt file). see crawford, supra note 104. 118. see, e.g., infra part v. indeed, since 1986, § 864(e)(2) generally requires (unless the irs determines otherwise, pursuant to § 864(e)(7)(f)) that interest expense be allocated utilizing an asset-based fungibility concept, rather than by treating a branch as a separate entity. the interest allocation regulations, in effect, reflect the irs' judgment that neither a pure fungibility approach nor a pure separate entity approach is appropriate for determining the deductible interest expense of a foreign corporation. 119. h.r. rep. no. 495, 100th cong., ist sess. 985 (1987). section 842(b) applies to foreign insurance companies and is somewhat analogous to the interest allocation regulations, although § 842(b) imputes bottom-line net income, not simply expenses, to the u.s. insurance business of the foreign insurer. the § 842(b) formula begins with the "booked" insurance liabilities of the u.s. business. these liabilities are then used to derive a minimum amount of deemed u.s. assets and the imputed u.s. assets are, in turn, deemed to earn a certain minimum investment return. unlike the 1981 regulations and the 1992 proposed regulations, however, the § 842(b) formula is based on data of comparable domestic insurers. the impetus for this income imputation scheme was the underlying policy goal of reducing "the potential competitive advantage the present-law rules create [for foreign insurers]." h.r. rep. no. 391, 100th cong., 1st sess., pt. 2, at 1109 (1987). 120. while approving the irs' position that interbranch loans generally should not be respected, congress appears to have granted the irs some latitude on the matter: the conferees are aware that some corporations attempt to establish actual debtor-creditor relationships for funds between a branch and a home office [vol. 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 51 upon the various themes and concerns underlying the interest allocation regulations, including, significantly, the fungibility principle (codified in section 864(e)(2)) and whether a u.s. branch can or should be treated solely as a separate entity for purposes of determining its deductible interest expense.12 1 consequently, it is relevant to consider whether the balance that was struck in the interest allocation regulations-appropriately, in my view-between the fungibility and separate entity concepts can effectively be preserved through an alternative approach (such as, for example, by imposing a minimum equity capital level on the u.s. branch while otherwise treating it as a separate entity for purposes of the interest allocation regulations). in addition, it is relevant to evaluate the considerations discussed in paragraphs c and d, below, including whether and to what extent the perceived benefits in simplifying the administrability of the interest allocation regulations are outweighed by complications arising from the need to ensure that the terms of the interbranch loans are at arm's length and do not reduce the branch's taxable income below an acceptable level. or between one branch and another. the conferees question the legitimacy of such arrangements from a tax perspective since only one legal entity is involved. nonetheless, if companies are able to legally establish such relationships, it is intended that the regulations address these relationships and possibly treat the excess interest as incurred on each type of interbranch "loan." the conferees are concerned that taxpayers may artificially structure interbranch loans in a manner different from their external liabilities in an attempt to reduce or eliminate the tax on excess interest. the conferees, therefore, expect the regulations to address this concern. h.r. conf. rep. no. 841, 99th cong., 2d sess. 11-649 (1986). while this statement was made in the context of § 884, it is equally relevant for purposes of the interest allocation regulations by virtue of § 884(c)(2)(c), see infra part iv.b. 121. in theory, interbranch loans could be taken into account in a nianner consistent with the balance that has been struck between the fungibility and separate entity concepts in the interest allocation regulations. within the framework of the three-step formula of the interest allocation regulations, interbranch loans simply could be treated as booked liabilities and assets of the u.s. branch, in which case any booked interest expense on the interbranch loans would be subject to scaleback under step three if the branch is ovcrlevcraged. also, interbranch loans could continue to be disregarded for purposes of determining the u.s. assets and u.s. liabilities under steps one and two of the formula, so that whether (and if so the extent to which) a branch is overleveraged or underleveraged would be determined without regard to interbranch loans. in that event, however, the principal effect of recognizing interbranch loans would merely be to substitute the actual interest rate on the interbranch loans for the rate prescribed by the interest allocation regulations (which is 90% of libor under the 1992 proposed regulations) if and to the extent the u.s. branch is underleveraged. such a limited recognition of interbranch loans would not really achieve the principal benefits sought by proponents of such recognition-simplifying the administrability of the interest allocation regulations and enabling foreign banks to achieve greater conformity between their u.s. and foreign tax treatment of interest expense and thereby reducing the risk of double taxation. florida tar review in light of the foregoing considerations, it is not at all clear whether any material benefits would be derived from recognizing interbranch loans for purposes of determining a foreign bank's deductible interest expense.122 c. correlation with other provisions and with hedging techniques.as indicated above, an important factor in the formulation of the 1992 proposed regulations is the need to correlate the interest allocation regulations with the branch profits tax and branch level interest tax. the interrelationship between these provisions is discussed further in part iv.b below. the 1992 proposed regulations also recognize that in determining interest expense attributable to eci, it is necessary to take into account forex gain or loss on relevant liabilities, as well as income and loss in respect of currency and interest rate hedges of relevant liabilities, since these items affect the true borrowing cost of the bank. however, under the 1992 proposed regulations, these items are taken into account only if the branch is overleveraged and the scaling ratio applies. thus, under the 1992 proposed regulations, income or gain from a notional principal contract that is eci (or loss or expense that is allocable to eci) and that is identified as a hedge of a booked liability is reduced by the application of the scaling ratio. 23 a similar rule applies for forex gain or loss under section 988 that is eci and is attributable to a booked liability. 24 these rules need to be further refined and coordinated with the rules for determining eci in respect of notional principal contracts and forex gain or loss (discussed above in parts ii.b.5 and ii.c) to develop a comprehensive approach to integrating hedges and forex gain or loss, on the one hand, with both the income (and income-producing assets) and interest expense (and liabilities) to which they relate, on the other hand, for purposes of determin122. in my view, however, the treatment of interbranch loans should not be determined by whether as a legal matter a taxpayer can contract with itself since, as discussed in part ii.c.2 above, interbranch transactions can legitimately be relied upon, subject to appropriate conditions and limitations, as an indicator of the amount of income or expense that should appropriately be taken into account in determining ec. 123. prop. regs. § 1.882-5(d)(3)(iii). the proposed regulations refer to temp. regs. § 1.861-9(b)(6) for rules governing the identification of a notional principal contract as a liability hedge, but at present that provision does not provide rules for financial services entities. in any event, the proposed regulations do not adequately deal with situations in which a bank hedges its liabilities on a more general or global basis. 124. prop. regs. § 1.882-5(d)(3)(iv). it would be helpful if the irs clarified when forex gain or loss on a hedge of a booked liability (whether directly traceable or as part of a general hedge) is "attributable" to the booked liability. [vol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 53 ing ecti.v' in this regard, expanding upon the "scaling ratio" rule of the 1992 proposed regulations, ecti would generally be more accurately measured if income and loss from notional principal contracts and other financial instruments that (1) are identified by a foreign bank as constituting hedges of assets or liabilities of the bank and (2) are entered into and booked by the same branch as the assets or liabilities that they hedge, are treated as eci if and only to the extent that the assets or liabilities to which they relate give rise to eci. 6 also, it would be desirable for the interest allocation regulations to provide explicit guidance regarding the extent to which notional principal contracts, forward contracts, options, and similar financial instruments are to be treated as "liabilities" and "assets" for purposes of the interest allocation regulations. by providing only for a "scaling ratio" rule, the 1992 proposed regulations implicitly take the position that notional principal contracts are not liabilities for these purposes. this result is proper, because the purpose of the interest allocation regulations is to determine the portion of the actual interest expense incurred on actual liabilities of the foreign bank that should be allocated to its u.s. branch and deducted in computing eci. this portion is determined based on the relative amounts of liabilities and assets of the branch compared to those of the bank as a whole. in all material respects, conventional notional principal contracts are executory contracts, result in no 125. for example, it has been noted that in requiring an automatic scale-down in forex gain or loss on a booked liability whenever the u.s. branch is overleveraged, the proposed regulations fail to take into account the relationship between the booked liability and the asset that it funds, and can thereby "unhedge" for u.s. federal income tax purposes positions that are economically hedged. this might occur if, for example, the booked liability, denominated in a foreign currency, funds an interbranch loan that is denominated in the same foreign currency. see lib comment letter, supra note 101. 126. the results under this approach generally would correspond to the results under a natural home/separate entity method for allocating income from notional principal contracts. where, however, a formulary apportionment method is adopted for allocating the bank's income from its dealing activity in notional principal contracts, this approach would provide an appropriate exception for contracts and similar financial instruments that are identified as hedges of assets or liabilities of the bank. this approach also would complement the modification to the special eci rule for foreign banks that is proposed supra text accompanying note 27. see also supra text accompanying note 80. additional complications are raised where the hedging transaction and the corresponding assets or liabilities are entered into and booked by different branches. in the case of assets, the existence of a "split hedge" might suggest that the eci or non-eci status of the asset should be reexamined. cases involving portfolio-wide or global hedges also raise complications, and may not be easily susceptible to a hedging identification rule. florida tax review' debt proceeds to the obligor, and do not bear interest.17 thus, they should be treated no differently for purposes of the interest allocation regulations than, say, an executory contract of a construction company to build a house or of a tenant to pay rent in respect of future periods, which obviously are not regarded as liabilities for these purposes. if notional principal contracts were taken into account as liabilities for these purposes, severe distortions could result in the application of the allocation formula. in view of the purpose and mechanics of the interest allocation regulations, it seems clear that notional principal contracts (as well as forward contracts, options, and similar financial instruments) should be treated as assets for purposes of the interest allocation regulations if and to the extent that the bank (or other non-u.s. taxpayer) has a tax basis in the contracts (or other instruments) that is attributable to the expenditure of cash or other property (for example, by reason of purchasing a contract from another dealer). it is less clear whether notional principal contracts should be treated as assets for these purposes in other circumstances. in this regard, the mark-to-market rules of section 475 will dramatically increase the number of circumstances in which notional principal contracts (and similar financial instruments) held by a bank will have a tax basis (and a fair market value that is determined annually for tax purposes). 127. a conventional notional principal contract (e.g., an interest rate swap that is priced "at market" and provides only for annual periodic payments, without any premium or nonperiodic payments) is a nonexecutory contract that gives rise to a corresponding liability and asset only to the extent of any accrued but unpaid amounts due thereunder. under regs. § 1.446-3(e), amounts under the contract accrue on a daily basis, but for practical administrative reasons (and because these accrued amounts do not require actual debt or equity funding), it would be sensible to ignore such amounts (as an asset or liability) for purposes of the interest allocation regulations. immediately after each periodic payment is made, the contract reverts to being entirely executory. guidance should be provided as to the extent to which any premium, embedded loan, or other nonperiodic payments under a notional principal contract (within the meaning of regs. § 1.446-3(e)(3)) should be treated as giving rise to liabilities (and assets) for purposes of the interest allocation regulations. under general tax principles, an executory contract is ignored until performance occurs. e.g., lucas v. north texas lumber co., 281 u.s. 11 (1930) (holding taxpayer does not realize gain upon entering into an executory contract to sell property); hallack & howard lumber co. v. commissioner, 18 b.t.a. 954 (1930) (holding taxpayer does not incur a deductible expense upon entering into an executory contract calling for the other party to perform services); rev. rul. 57-29, 1957-1 c.b. 519 (holding taxpayer's obligations under an executory contract are ignored prior to performance for purposes of determining taxpayer's basis in the contract). notwithstanding that notional principal contracts are largely executory contracts and, it is submitted, should not be treated as liabilities or (subject to certain exceptions) as assets for purposes of the interest allocation regulations, in other contexts, it may be appropriate to treat them as real positions. see, e.g., regs. § 1.1092(d)-1(c) (treating such contracts as an interest in personal property for purposes of the straddle rules). [vol. 2:1 1994) u.s. federal income taxation of u.s. branches of foreign banks 55 on one hand, taking the mark-to-market basis (or, if elected, fair market value) of such contracts and instruments into account would be consistent with the treatment of securities for these purposes.' the potential for distortion would be diminished if, for purposes of the interest allocation regulations, banks are also permitted to mark-to-market their contracts, instruments, and securities that are not attributable to their u.s. branch. on the other hand, requiring non-u.s. positions to be marked-to-market would increase administrative complexities, especially if this must be performed at the most frequent regular intervals for which data are reasonably available.129 moreover, because the tax basis that results from the application of section 475 is not attributable to any actual equity or debt funding, it would not advance the objectives of the interest allocation regulations to take such basis into account. indeed, unnecessary distortions would be created if and to the extent that the ratio of u.s. to foreign assets is materially changed as a result of these contracts and instruments being taken into account. 30 the preamble to the 1992 proposed regulations requests comments on the coordination of the interest allocation regulations with section 864(c)(7) and regulations section 1.988-l(a)(10), which "potentially apply to the interbranch transfer of third party liabilities and hedges (which in theory 128. if notional principal contracts and other financial instruments are taken into account as assets for purposes of the interest allocation regulations, it would be necessary to provide appropriate rules for positions that have negative value to the bank. under which such negative value would presumably be netted against the basis (or value) of other positions. in addition, if such assets are taken into account for these purposes and if revised rules for determining eci from global trading activities involving such assets are adopted as suggested supra part ilc, then for purposes of the interest allocation regulations, the assets associated with such global trading activities should be treated as u.s. assets to the extent of the proportion of the income from those assets that is treated as eci. this approach. it is submitted, is consistent with the general approach of the code and regulations to interrelating income and balance sheet items for purposes of coordinating eci. the interest allocation regulations, the bpt, and the blit (discussed infra parts iv.b and v). and should not be considered inconsistent with § 864(e)(2), which provides that interest expense must be allocated on the basis of assets rather than gross income. a similar approach should apply for purposes of the branch profits tax. see supra note 91. 129. see regs. § 1.882-5(a)(4); prop. regs. §§ 1.882-5(b)(3), (c)(21(iv). 130. even though it is suggested that notional principal contracts and similar instruments should not be treated as liabilities or (subject to certain exceptions) as assets for purposes of the interest allocation regulations, a foreign bank should treat as assets and liabilities any positions in physical securities (and related financings) entered into to hedge its exposure under these contracts and instruments, just as a construction company that entered into an executory contract to build a house should take into account the raw materials that it acquires to satisfy its obligations under the construction contract and debt that it incurs to finance the raw materials. florida tax review occurs when they are scaled back).' 3 ' to my mind, it would be unfortunate and unwarranted to treat the adjustments in u.s. liabilities (and related hedges) that are made (and adjusted each year) for purposes of determining the amount of deductible interest expense under the interest allocation regulations as representing actual transfers of property for purposes of applying section 864(c)(7) and regulations section 1.988-1(a)(10). d. administrability, ensuring a minimum level of taxable income, and arriving at an appropriate determination of taxable income.-these three themes, which are both interrelated and, to a degree, inconsistent with each other, are all evident in the interest allocation regulations. a rigorous application of the basic three-step allocation formula of the regulations with a view to deriving, with a high level of accuracy, the appropriate amount of u.s. interest expense, would require a bank (and the irs) to engage in complicated and costly calculations and would impose significant record-gathering, record-keeping, and audit burdens. for example, a bank that elects to determine the actual ratio of u.s.-to-worldwide liabilities under step two of the formula must convert all its assets and liabilities to a single currency (using applicable exchange rates for each determination date) 32 and determine the average value of its assets and average total amount of its liabilities "at the most frequent regular intervals (such as daily, weekly, monthly, or quarterly) for which data for all assets, or liabilities are reasonably available."'13 the interest allocation regulations ease these substantial burdens by permitting or requiring taxpayers to utilize simplifying assumptions and formulas. the most significant departure from precision is the election to utilize a fixed ratio of liabilities to assets in step two, instead of computing the actual ratio. 3 the 1992 proposed regulations would further ease administrative burdens by eliminating the separate currency pools method and by requiring taxpayers to utilize readily ascertainable interest rates (90% of libor in the case of banks) to compute u.s. interest expense on excess liabilities. 35 131. 57 fed. reg. 15040 (1992). see supra notes 17 and 51 for a discussion of these provisions. 132. regs. § 1.882-5(a)(3); prop. regs. § 1.882-5(c)(2)(iii)(b). 133. regs. § 1.882-5(a)(4); see also prop. regs. § 1.882-5(b)(3), (c)(2)(iv) (requiring the computations to be made no less frequently than quarterly). 134. see supra note 93 and accompanying text. 135. see supra note 97. as mentioned supra note 97, under the 1981 regulations, interest expense on excess liabilities generally is calculated by using the average interest rate on u.s. dollar liabilities shown on the books of the bank's non-u.s. offices or, if that rate is not reasonably determinable, by using a method that reasonably approximates the actual rate (such as a libor-based rate) that is consistently applied from year to year. in practice, many banks have found it extremely difficult and impractical to determine the average interest rate [vol 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 57 while these provisions undoubtedly simplify the application of the interest allocation regulations, the regulations continue to impose substantial administrative burdens, particularly in the determination of u.s. assets under step one. for example, a foreign bank must compute its total u.s. assets for each taxable year based on the average of the sums of the adjusted tax bases (or, if elected, fair market values) of its u.s. assets on the most frequent, regular intervals for which data is reasonably available (and, under the 1992 proposed regulations, no less frequently than quarterly).,1it is also clear, at least from the 1992 proposed regulations, that the irs is seeking, through the same provisions that simplify the administrability of the regulations, to ensure that u.s. branches of foreign banks pay a minimum level of u.s. tax. thus, for example, the 1992 proposed regulations would reduce the fixed ratio for banks from 95% to 93%, would cap the actual ratio at 96%, and would require banks to utilize 90% of libor as the interest rate on excess liabilities.'37 this may be in response to a perception that foreign banks are not bearing their "fair share" of the tax burden, or it may simply be the tradeoff that the irs expects banks to accept in exchange for greater simplicity and an easing of administrative burdens. iv. the branch profits tax and branch level interest tax a. overview enacted in 1986, the branch profits tax (bpt) and the branch level interest tax (blit) are intended to equalize the position of foreign corporations doing business in the united states through branches with that of foreign corporations doing business in the united states through subsidiaries. on u.s. dollar liabilities booked in non-u.s. offices, and have therefore utilized a liborbased rate that, in their view, reasonably approximates the actual rate. however, upon audit, a bank would be required to establish that the selected rate is a reasonable approximation of the actual rate (which itself may be difficult to ascertain). 136. regs. § 1.882-5(a)(2), (4); prop. regs. § 1.882-5(b)(2)(i), (3). to further complicate matters, for purposes of the bpt, u.s. assets must be determined as of particular determination dates (generally the close of the taxable year). based on their adjusted tax bases for earnings and profits purposes. regs. § 1.884-1(c)(2), (d)(6). 137. see supra notes 93, 94, 97 and accompanying text. the 1992 proposed regulations have also increased administrative burdens on taxpayers that elect to apply the actual ratio. for example, large banks would have to compute the sum of their worldwide assets and liabilities no less frequently than monthly. prop. regs. § 1.882-5(c)(2)(iv). in their comments on the proposed regulations, the institute of international bankers observed that "[we are] not aware of any international bank that would be able to comply." 11b comment letter, supra note 101. thus the 1992 proposed regulations seem to be pushing banks to elect the greater simplicity of the fixed ratio, but at a higher tax cost. the rule excluding real estate from u.s. assets until the year of disposition (see supra note 91) might have been similarly motivated. florida tax review both branches and subsidiaries are subject to u.s. federal income taxation on a net income basis. however, before the bpt, the after-tax profits of a u.s. branch could be remitted to the home office of the foreign corporation free of additional tax, whereas foreign corporations operating through u.s. subsidiaries were and continue to be subject to withholding tax on dividend distributions from subsidiary to foreign parent. similarly, interest paid by a u.s. subsidiary generally is u.s. source and therefore subject to withholding tax (subject to applicable exceptions), whereas, before 1987, u.s. interest expense of a u.s. branch was not subject to withholding tax."' the bpt eliminates this disparity in the treatment of remitted earnings by imposing a tax on a foreign corporation that has a u.s. branch, in addition to the normal u.s. tax on eci. like the dividend withholding tax, the bpt is generally imposed at 30%, which rate may be reduced if a tax treaty applies (subject to rigorous antitreaty shopping rules requiring the foreign corporation to be a "qualified resident" of the treaty country). 139 in seeking to approximate the effects of the dividend withholding tax, the drafters of the bpt faced several practical difficulties. as noted above, branches of foreign corporations are not regarded as separate entities for u.s. tax purposes. thus, before the bpt, they were not required to account separately for their earnings and profits (the basic measure of a dividend for u.s. tax purposes). moreover, since a branch by its nature is not legally separate from its home office, and funds may flow freely between the u.s. branch and the home office, it was necessary to devise a surrogate for the cash payments that, if made out of earnings, would trigger the dividend withholding tax. the bpt addresses these considerations by introducing the concept of "dividend equivalent amount" and by requiring foreign corporations with u.s. branches to keep account of their post-1986 "effectively connected earnings and profits" (ecep) and of changes in their "u.s. net equity." through these concepts, a balance sheet is constructed for the branch, which reflects the assets and liabilities associated with the u.s. branch and which permits the calculation of amounts that are deemed to be remitted to the home office (and therefore subject to the bpt). the bpt is imposed on a foreign corporation's dividend equivalent amount. the dividend equivalent amount equals the corporation's earnings and profits for the taxable year that are attributable to eci (ecep), adjusted to take account of any change during the taxable year in the corporation's u.s. net equity (u.s. assets, less u.s. liabilities). the adjustment for changes 138. so-called secondary withholding taxes on dividends and interest paid by a foreign corporation were applicable only if, in general, 50% or more of the foreign corporation's gross income during a three-year testing period was eci. irc § 861(a)(1)(c), (2)(b) (before amendment in 1986). 139. see infra notes 145-50 and accompanying text. [vol. 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 59 in u.s. net equity, which may be either positive or negative, is designed to identify when earnings of the branch have been reinvested in the branch's u.s. trade or business and when they should be considered to have been repatriated. the corporation's dividend equivalent amount is reduced by any increase in u.s. net equity during the taxable year (reflecting a reinvestment of ecep in the united states) and increased by any reduction in u.s. net equity during the taxable year (to the extent of ecep for previous years that was deemed reinvested and therefore not taxed). thus, decreases in u.s. net equity generally increase the bpt and vice versa." ° the purpose of the blit is to ensure that interest expense incurred by a branch on liabilities associated with its u.s. trade or business is treated in a comparable manner to interest expense incurred by a u.s. subsidiary. in general, the blit consists of two separate, but related, rules. first, the blit provides that interest actually paid by the branch to third parties (booked or branch interest) is treated as if paid by a domestic corporation.' thus, such interest is sourced in the united states and is subject to a 30% u.s. withholding tax unless it is eligible for an exemption or reduction under the code (including the exemptions for portfolio interest and for interest on bank deposits) or, in the case of a "qualified resident" of a treaty country, under an income tax treaty. this first rule does not itself impose a tax; it simply re-sources interest paid (which in turn has implications for the imposition of tax under generally applicable rules). the second aspect of the blit is the tax on "excess interest."'4 in general terms, under this rule, where a branch is considered underleveraged and excess liabilities are imputed to it under the interest allocation regulations, the excess of the interest deduction over the interest paid by the branch is deemed to be paid to the foreign corporation by a wholly-owned u.s. subsidiary. as a result, the excess interest is subject to u.s. tax at 30% unless an exemption or reduced rate is available under a tax treaty and the foreign corporation is a "qualified resident" of the treaty country."' in effect, the 140. irc § 884(a)-(d). 141. irc § 884(f)(1)(a). this rule does not apply to the extent the amount of branch interest exceeds the amount of deductible interest expense. irc § 884(f)(1); regs. § 1.884-4(b)(6). 142. irc § 884(f)(1)(b). 143. because the branch is treated as a wholly-owned u.s. subsidiary, the portfolio interest exemption does not apply. irc § 881(c)(3)(b). however, as discussed infra note 156 and accompanying text, the regulations enable a foreign bank or other foreign corporation to reduce its excess interest by 85%. the symmetry between a u.s. branch and a u.s. subsidiary that is created by the blit with respect to excess interest extends to the "earnings stripping" rules under § 163(j), so that, to the extent that excess interest is subject to a reduced rate of blit as a result of an income tax treaty, the u.s. branch could be denied an interest deduction under § 163(j). prop. florida tax review underleveraged branch is treated as a separate entity that has borrowed from its parent to the extent it is underleveraged. thus, although actual interbranch loan transactions are ignored for purposes of the blit,'" the blit replaces such interbranch loans with deemed loan transactions. fortunately for them, many foreign banks are "qualified residents" of countries having favorable income tax treaties with the united states, and therefore are exempt entirely from the bpt and blit on excess interest, or are subject to substantially reduced rates)45 for example, banks that are qualified residents of germany, italy, japan, the netherlands, switzerland, and the united kingdom are exempt from the bpt, 146 and banks that are qualified residents of france, germany, the netherlands, and the united kingdom are exempt from the blit on excess interest (but, except for the regs. § 1.163(j)-8. usually, the earnings stripping rules are not of concern to foreign banks because they generally do not have net interest expense. however, earnings stripping could become a problem for foreign banks that engage in extensive derivatives, securities dealing, or other activities in the united states and have a substantial amount of eci other than interest. 144. regs. § 1.884-4(b)(4). 145. see § 884(e), (f)(3). very generally, a foreign bank is a "qualified resident" of a tax treaty jurisdiction if one of the following conditions is met: (a) the bank's stock is "primarily and regularly traded on one or more established securities markets" in its country of residence or the united states or both, or over 90% of its stock (by vote and value) is owned, directly or indirectly, by a corporation that is a resident of the same foreign country as the bank or of the united states, and is publicly traded in its country of residence or the united states or both. regs. § 1.884-5(d), (b) more than 50% (by value) of the bank's stock is beneficially owned (directly or by attribution) by one or more qualifying stockholders that are treated as residents either of the foreign country of which the foreign bank is resident or the united states, documentation is maintained establishing that this ownership requirement is satisfied, and the foreign bank satisfies a "base erosion" test limiting deductible payments to persons that are not residents of such country or the united states. regs. § 1.884-5(a)(1), (b), (c). (c) the bank is engaged in the active conduct of business in its country of residence and maintains a substantial presence in that country, and its u.s. trade or business is an integral part of such active business. regs. § 1.8845(e) (containing special, generally favorable rules and presumptions for applying this test to foreign banks). (d) the irs determines, in its sole discretion, that the bank should be treated as a qualified resident because the use of the treaty by the bank's shareholders is not inconsistent with the purposes of the bpt or the blit (as the case may be), including the prevention of treaty-shopping. regs. § 1.884-5(0. 146. regs. § 1.884-1(g)(3). [vol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 61 united kingdom, not from the blit on branch interest). 47 banks that are qualified residents of australia, canada, france, and various other countries are subject to the bpt at reduced rates, 148 and banks that are qualified residents of australia, canada, italy, japan, switzerland, and various other countries are subject to the blit on excess interest at reduced rates.' 49 on the other hand, many other banks, including banks in hong kong, most latin american countries, 150 and the middle east are subject to the bpt and blit at the statutory rates. 147. regs. § 1.884-4(b)(8)(i) (branch interest), (c)(3) (excess interest); convention between the united states of america and the french republic with respect to taxes on income and property, july 28, 1967, u.s.-fr. art. 10, paras. 1, 7, 19 u.s.t. 5280, 5294; convention between the united states of america and the federal republic of germany for the avoidance of double taxation with respect to taxes on income, aug. 29, 1989, u.s.-ger. art. 11, paras. 1, 5, k.a.v. 713; u.s.-neth. treaty, supra note 27, art. 12, paras. 1. 6. k.a.v. 3507; convention between the government of the united states of america and the government of the united kingdom of great britain and northern ireland for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains, dec. 31, 1975, u.s.-u.k. art. 11, paras. 1, 6, 31 u.s.t. 5668, 5680. branch interest that is not otherwise exempt from withholding tax (see supra text accompanying note 141) may be exempt from withholding tax under a tax treaty with the recipient's country, provided that in the case of a recipient that is a foreign corporation, it is a qualified resident of that country. regs. § 1.884-4(b)(8)(ii). 148. regs. § 1.884-1(g)(4)(b) (australia (15%), canada (10%), france (5%)). 149. the rates are 15% in the case of canada and italy, 10% in the case of australia and japan, and 5% in the case of switzerland. convention between the government of the united states of america and the government of australia for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, aug. 6, 1982, u.s.-austl. art. 11, para. 2, t.i.a.s. 10773, 29; convention between the united states of america and canada with respect to taxes on income and capital, sep. 26. 1980. u.s.-can. art. 11, para. 2, t.i.a.s. 11087, 12; convention between the government of the united states of america and the government of the republic of italy for the avoidance of double taxation with respect to taxes on income and the prevention of fraud or fiscal evasion, apr. 17, 1984, u.s.-it. art. 11, para. 2, t.i.a.s. 11064, 16; u.s.-jap. treaty, supra note 27, art. 13, para. 4, 23 u.s.t. at 990; convention between the united states of america and the swiss confederation for the avoidance of double taxation with respect to taxes on income, may 24, 1951, u.s.-switz. art. 7, para. 1, 2 u.s.t. 967, 990. 150. but see convention between the government of the united states of america and the government of the mexican states for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, sep. 18, 1992, u.s.-mex., arts. 11, 1 ia, k.a.v. 3508 (providing that banks that are qualified residents of mexico are subject to the bpt at a reduced rate of 5% and to the blit at a reduced rate of 10% (which rate will fall to 4.9% beginning january 1, 1999).) florida tax review b. coordination among the bpt, blit and interest allocation regulations, and their application to bank branches the concepts "u.s. assets" and "u.s. liabilities" play important roles in both the bpt and the interest allocation regulations, and section 884(c)(2)(c) provides that regulations interpreting these concepts for purposes of the bpt and the interest allocation regulations should be consistent with each other. consequently, with certain exceptions, the 1992 proposed interest allocation regulations adopt the detailed definition of "u.s. assets" that is contained in the bpt regulations, and the bpt regulations in turn define "u.s. liabilities" by reference to the interest allocation regulations.15 1 however, as discussed in part ii.b above, under the interest allocation regulations, in the case of an underleveraged u.s. branch, "u.s. liabilities" include not only booked liabilities of the branch, but also the excess of u.s. liabilities (as determined under step two of the interest allocation regulations formula) over booked liabilities. if these excess liabilities are included in "u.s. liabilities" for purposes of determining "u.s. net equity" under the bpt, a bank with an underleveraged u.s. branch could incur a bpt liability even though the u.s. branch has not remitted any earnings to its home office but has merely had its u.s. net equity reduced as a result of the allocation of excess liabilities under the interest allocation rules. absent special relief, the benefit that such an "underleveraged branch" would obtain from increasing its u.s. interest expense as a result of the excess liabilities (generally, 35% of the interest expense) would be outweighed by a 30% bpt on the full amount of the excess liabilities (to the extent such amount results in an increase in the bank's dividend equivalent amount). such relief is provided by the regulations under section 884, which permit a bank to elect to reduce its u.s. liabilities for any taxable year by an amount that does not exceed the excess of u.s. liabilities over booked liabilities.1 2 if a bank makes this election, u.s. liabilities are reduced for purposes of the bpt, the blit, and the interest allocation regulations.'53 in short, if the branch is willing to forego the interest deduction, it can avoid 151. prop. regs. § 1.882-5(b)(1), regs. § 1.884-1(e)(1). however, for purposes of the interest allocation regulations, "u.s. assets" equal the average of the adjusted tax bases of those assets (or, if elected, their fair market values) during the taxable year, whereas for purposes of the bpt, "u.s. assets" equal their adjusted tax bases for earnings and profits purposes as of particular determination dates (generally, the close of the taxable year). see supra note 136 and accompanying text. see also supra note 91. similarly, for purposes of the interest allocation regulations, "u.s. liabilities" is based on an average for the taxable year, whereas for purposes of the bpt, "u.s. liabilities" is measured as of particular determination dates (generally, the close of the taxable year). regs. § 1.884-1(e)(1). 152. regs. § 1.884-1(e)(3). 153. regs. § 1.884-i(e)(3)(iii). [vol 2:1 1994] u.s. federal income taxation of u.s. branches of foreign banks 63 any bpt (and blit) that otherwise may result from its u.s. liabilities being greater than its booked liabilities. the blit is also closely related to the interest allocation regulations. while some definitional disparities exist,' the amount of "branch interest" under the blit generally corresponds to the amount of interest on "booked liabilities" under the interest allocation regulations. since "excess interest" for purposes of the blit is defined as the excess of u.s. interest expense (determined under the interest allocation regulations) over "branch interest," the amount of "excess interest" also generally corresponds to the amount of u.s. interest expense in excess of the branch's actual interest expense on booked liabilities under the branch book/dollar pool method. as indicated above, the 30% blit generally applies to excess interest unless a reduction or exemption is available under an income tax treaty. however, the bl1t regulations provide that a bank may treat as interest paid on a deposit (and therefore exempt from tax under sections 881(d) and 871 (i)(2) and (3)) an amount of excess interest equal to the greater of (1) the ratio of the amount of its interest-bearing deposits as of the close of the taxable year to the amount of all interest-bearing liabilities of the bank on that date,' 154. for example, unlike the 1992 proposed regulations, the definition of branch interest for banks does not expressly contain a contemporaneous booking rule. compare prop. regs. § 1.882-5(d)(2)(iii)(a) with regs. § 1.884-4(b)(2). also, branch interest includes socalled "high interest rate liabilities" of banks, which would not be recognized under the 1992 proposed regulations. compare prop. regs. § 1.882-5(d)(2)(iii)(b) with regs. § 1.884-4(b)(2). in addition, branch interest is not subject to the "matching rule" in the 1992 proposed regulations which, in general, requires that the amount of liabilities booked in a particular currency be within ten percentage points of the amount of u.s. assets denominated in that currency (unless the taxpayer establishes that the mismatch is representative of its worldwide position in that currency). compare prop. regs. § i.882-5(d)(2)(v) with regs. § 1.884-4(b(2). 155. questions can arise as to the amount of a foreign bank's total deposit liabilities if the bank has significant liabilities that are not labeled "deposits" but do not have materially different characteristics from liabilities that clearly are deposits. although there is no precise distinction between deposits and other liabilities for federal income tax purposes, and the authorities do not clearly articulate their reasoning, the most significant factors appear to be: (1) the regulatory treatment of the obligation; (2) the role of the obligation in the overall funding structure of the issuing institution; and (3) the characteristics of the obligation. including the depositor's intent in advancing funds to the bank. regulatory treatment. in general, a liability that is treated as a deposit for regulatory purposes is treated as a deposit for federal income tax purposes. rev. rul. 81-30, 198 1-1 c.b. 388 (negotiable and nonnegotiable long-term certificates of deposit issued by a u.s. thrift institution that were treated as "savings accounts" eligible for federal deposit insurance): rev. rul. 73-505, 1973-2 c.b. 224 (nonnegotiable time deposits with fixed terms up to 15 years); rev. rul. 70-436, 1970-2 c.b. 148 (5-year negotiable certificates of deposit). role of liability in overall funding. in several cases under the predecessor to § 581 and the former excess profits tax, courts established a principle that a liability is treated as a deposit, regardless of how it is labeled, if it has the characteristics of a bank deposit and florida tax review or (2) 85%.156 thus, the maximum blit on excess interest is 4.5% (30% of 15%). a number of interrelated considerations need to be taken into account in planning with respect to the bpt, blit, and the interest allocation regulations. these considerations include: (1) whether the bpt or the blit is eliminated or reduced under an income tax treaty; (2) the amount of the branch's expected dividend equivalent amount for the year (which in turn depends, inter alia, on its profits and on whether the amount of its assets is expanding or contracting); (3) whether the branch should incur additional booked liabilities and whether it is underleveraged or overleveraged; (4) the impact on the bpt, blit, and interest allocation regulations of electing to reduce excess u.s. liabilities; and (5) whether the branch has available net operating losses or credits to reduce its tax liability. if a bank is not eligible for any treaty protection from the bpt or the blit, it should ordinarily prefer to have its u.s. branch maintain leverage, based on booked liabilities, at least comparable to that of the bank as a whole (or, if elected, to the fixed ratio under the interest allocation regulations). virtually all interest on booked liabilities is likely to be exempt from withholding tax, 157 whereas if the branch is underleveraged, its excess interest is subject to the blit (albeit at a maximum rate of 4.5%). in addition, if the u.s. branch maintains such a comparable leverage based on booked liabilities, its deductible interest expense is likely to approximate plays a similar role in funding the institution's lending business. e.g., morris plan bank v. smith, 125 f.2d 440 (2d cir. 1942); staunton indus. loan corp. v. commissioner, 120 f.2d 930 (4th cir. 1941). see g.c.m. 39155 (mar. 1, 1984) (distinguishing and disagreeing with contrary authorities). terms; depositor's intent. courts have also distinguished deposits from other types of bank liabilities in that deposits are offered to the public at large using standardized documentation that is not separately negotiated with individual lenders. e.g., commissioner v. valley morris plan, 305 f.2d 610, 617-18 (9th cir. 1962). this reflects the general intent of a depositor, who seeks merely to invest funds in relative safety at a competitive return, with that of a nondepositor lender, who generally requires a more significant yield and financial covenants to compensate for additional risk. 156. regs. § 1.884-4(a)(2)(iii). an equivalent rule-effectively allowing the blit to be reduced by 85% by identifying liabilities as booked liabilities of a u.s. business-is also provided for foreign corporations other than banks. regs. § 1.884-4(b)(1)(v), (3). 157. interest paid to u.s. persons (and to foreign persons in whose hands the interest income is eci) is not subject to withholding (unless the backup withholding provisions of § 3406 apply), while non-eci interest paid to non-u.s. persons generally qualifies for exemption either as interest on a bank deposit (under §§ 871(i)(2)(a) and 881(d)) or as portfolio interest (under §§ 871(h) and 881(c)). if the branch is overleveraged, the amount of deductible interest expense will not be materially affected, see supra note 96 and accompanying text, and the amount of branch interest in excess of deductible interest expense will not be subject to the blit on branch interest, see supra note 141. [vol 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 65 closely its actual interest expense on booked liabilities, thereby enabling the branch to avoid the less favorable rules that would otherwise determine its deduction in respect of excess interest.' in any event, if the branch is underleveraged to any extent, it can avoid bpt liability by electing to reduce its excess liabilities, but at the cost of forgoing an interest deduction on such excess liabilities. in the absence of treaty protection from the bpt, such an election usually makes sense.' 9 in contrast, if the bank has treaty protection from the bpt but not from the blit, the election is frequently not advantageous.10 if a bank is exempt from the bpt under an income tax treaty, it may prefer to underleverage its u.s. branch and overleverage other branches. in that event, although the amount of its interest expense deduction should not be materially affected under the interest allocation regulations,' 6 the bank might also be eligible for an interest deduction, for foreign tax purposes, in its overleveraged branches in respect of the liabilities that in effect are being used to fund assets of the u.s. branch. 62 v. conclusion when banks, or other businesses, engage in cross-border activities, each of the foreign jurisdictions in which they conduct business must address 158. see supra notes 97 and 135. also, by minimizing the amount of excess interest, a bank with a potential earnings stripping problem can avoid the adverse effect of § 163(j). see supra note 143. 159. for example, consider the case of a foreign bank that experiences a reduction in u.s. net equity for the year of $100 because it has s100 of excess u.s. liabilities, and has excess interest of $10. as a result, the bank faces a potential bpt of 530 (30% of s100), as well as blit of s.45 (30% of 15% of 510). however, the bank may claim an interest deduction of $10 on the excess liabilities, which results in 53.50 in tax savings. thus, the bank has a net additional tax liability of $26.95 as a result of the $100 of excess liabilities. if the bank makes the election to reduce excess u.s. liabilities, it avoids this $26.95 of net additional tax liability. 160. for example, under the facts set out in the preceding note, the foreign bank is potentially subject to a blit of 5.45, but the interest deduction is worth s3.50. thus, the bank is better off incurring the blit tax if it can utilize the interest deduction. 161. however, the amount of deductible interest expense in excess of the interest expense properly shown on the books of the branch is determined under the special, less favorable, rules described supra notes 97 and 135. 162. the efficacy of this technique for claiming a duplicate deduction for interest expense depends on a number of u.s. and foreign tax (as well as other legal) considerations. for example, a bank may be constrained as to how much leverage it can place on a particular branch, for tax or regulatory purposes, or it may be required to offset the increased interest expense attributable to the overleveraging of a foreign branch with interest income on interbranch loans. the blit should also be taken into account in determining the net benefit from such a technique (although, as indicated above, the maximum blit should be only 4.5%), as should the earnings stripping rules. see supra note 143. florida tax review the questions of when, to what extent, and how to tax the profits attributable to the activities relating to the taxing jurisdiction. different tax systems take different approaches to these questions. many tax systems subject a foreign bank to net income taxation only when the bank has a permanent establishment, or branch, in the taxing jurisdiction. once this threshold is crossed, these tax systems generally treat the branch as a separate entity for purposes of determining tax liability. under these tax systems, the taxable profit of a foreign bank's local branch generally is determined by taking into account the gross income and expenses properly shown on the books of the branch, including income and expenses (e.g., interest) arising from transactions with other branches of the bank (so long as those transactions are entered into on an arm's length basis). the oecd model tax treaty provisions dealing with permanent establishment and business profits reflect this approach. 63 the code and regulations take a different approach, both to the question of the threshold of taxation and the determination of taxable income. the threshold-"engaged in a trade or business within the united states"-clearly is lower than having a permanent establishment and does not require the existence of a formal branch or permanent establishment. the basis of taxation-income effectively connected with the conduct of a u.s. trade or business-logically follows from this threshold. as discussed in part hi above, eci is determined under certain straightforward rules, based on the source and category of income. similarly, as discussed in part iii above, expenses are taken into account to the extent they are connected with eci. simply stated, the u.s. tax rules relating to foreign banks are eci-based, not branch-balance sheet based. significantly, although the permanent establishment and business profits provisions of u.s. income tax treaties raise the threshold of taxation of foreign businesses from "engaged in a u.s. trade or business" to having a permanent establishment, the irs does not interpret these provisions as supplanting the eci-based system with a branch-balance sheet/separate entitybased system. tax treaties typically state that a u.s. permanent establishment should be attributed the business profits that it might be expected to make if it were a distinct and separate person. according to the irs, this treaty rule merely imposes a requirement that arm's length standards be utilized to determine the profits attributable to a u.s. permanent establishment; it does not replace the basic eci rules of the code with a tax accounting system that treats a branch as a separate entity.64 163. see oecd report, supra note 115. 164. see supra note 109 and accompanying text. [vol 2:1 19941 u.s. federal income taxation of u.s. branches of foreign banks 67 the bpt and but provisions are engrafted onto this eci-based system. a "branch" under the code is a construct, the balance sheet of which consists of the assets that give rise to eci and the liabilities (and net equity capital) attributable to those assets. it therefore may be useful to consider a "branch" under the code in dynamic, functional terms, as an eci-based "branch without walls," in contrast to the more static, actual-balance-sheetbased concept of a branch under a separate entity approach. it is also important to recognize that the concept of a "branch" has only limited relevance under the code-principally in the context of the bpt, blit and interest allocation regulations, but not for purposes of determining eci. as described above in parts iii and iv, the code and regulations reflect a sophisticated and intricate interplay between the balance sheet-based bpt and blit, on the one hand, and the taxable income-related provisions for determining eci and deductible interest expense, on the other hand. the interest allocation regulations are particularly interesting in this regard because, as a result of the fungibility and separate entity concepts that underlie those rules, they take into account balance sheet items-assets and liabilities-to arrive at the amount of interest expense that is deductible from eci in determining ecti. notably, however, the interest allocation regulations use the interest expense shown on the books of the branch as a reference point in arriving at deductible interest expense. despite efforts to correlate the bpt, blit, and interest allocation regulations, these rules continue to be complex to administer in practice. moreover, while (or, perhaps, because) the interest allocation regulations reflect a delicate balance among several principles and concerns, it is unclear whether they yield an economically accurate measurement of the interest expense attributable to eci. the rules relating to the determination of eci from global trading activities of foreign banks are severely flawed, and are in need of immediate repair. although the apa program provides a valuable interim solution for banks confronted with global trading issues, the integrity of the system will be called into question if a "private law" track is permitted to develop. as discussed in part ii.b above, the rules relating to the determination of eci from global trading activities should be revised to adopt a section 482-type analysis, consistent with the approaches taken in apas. consistent with those approaches, and notwithstanding that the code and regulations do not treat branches as separate entities, it is appropriate to permit foreign banks to adopt section 482 transfer pricing methodologies that rely on interbranch transactions to determine the arm's length profit that should be treated as ecti, provided certain conditions are satisfied. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 3 1996 number 5 the devolution and inevitable extinction of the continuity of interest doctrine david s. miller" i. introduction ................................ 189 ii. the pure past but sordid history of the continuity of interest doctrine ................ 191 a. the birth of the reorganization provisions ....... 192 b. the original continuity of interest doctrine ...... 195 c. the statuton' continuiti, of interest doctrine ...... 198 d. the deadwood decisions: post1934 cases interpreting pre-1934 law .................... 201 e. resurrection: the emergence of a new judicial continuity of iterest doctrine ................ 205 iii. the new judicial continuity of interest doctrine in full bloom ............................... 207 a. expansion of the continuity doctrine beyond the original parenthetical ................... 208 1. d reorganizations ................... 209 2. section 355 ........................ 210 3. f reorganizations ................... 212 b. remote continuity.......................... 214 c. post-reorganization target shareholder conduct . .. 218 d. double duty-the application of the continuity of interest doctrine to integrated asset purchases .... 222 e. the specter of historic shareholder continuity .... 226 iv. the decline of the continuity of interest doctrine .................................... 230 a. limitations on remote continuit. ............... 230 * associate, cadwalader, wickersham & taft. new york, new york; b.a., 1986, university of pennsylvania; j.d., 1989, columbia university: ll.m. (taxation). 1994. new york university school of law. the author thanks david w. feeney for his comments on a previous draft of this article. florida tax review b. the all but elimination of continuity from section 338 integrated transactions ............ 231 c. continuity without stock .................... 239 v. the end of continuity as we know it ........... 241 a. the consequences of continuity ............... 241 1. abuse potential ..................... 241 2. unadministrability ................... 243 3. economic inefficiency ................. 243 4. unfairness ......................... 244 5. uncertainty ........................ 244 6. inconsistent and anomalous treatment ..... 245 7. inconsistency with the tax policies of nonrecognition ..................... 246 b. constructing a valid policy for a strong form of continuity ............................. 248 c. alternative conceptions of continuity ........... 250 1. the corporate lawyers' approach of ginsburg & levin ................... 250 2. continuity as an anti-abuse rule ......... 251 3. bifurcation ........................ 252 4. restricted scope .................... 252 5. objective continuity test determined exclusively at the corporate level ........ 254 vi. conclusion .................................. 257 [vol. 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrine 189 i. introduction the continuity of interest doctrine, in its present form, is the extrastatutory requirement that the historic shareholders of a target company must retain a quantum of equity interest in the acquiror in order for an acquisition to qualify as a reorganization entitled to tax-free treatment. if sufficient stock of the acquiror is not retained by the target's shareholders for a long enough period, the transaction is not a tax-free reorganization, and the target corporation and target shareholders (including those that did retain the acquiror's stock) are subject to tax on their gains. on the other hand, because the doctrine is not an anti-abuse rule, if the continuity of interest requirement is not met, the target and its shareholders are entitled to recognize any loss on the transaction. this summary of the doctrine and its consequences is, of course, greatly simplified. every aspect of the continuity of interest doctrine carries with it a formidable array of complex issues. for example, for how long must the target's shareholders have held their stock to be considered "historic" shareholders? what types of interests in the target qualify as equity for purposes of the test? what type and quantum of continuing interest in the acquiror is required, and for how long and in what form must it be retained?' some of these questions have recently attracted significant attention as a result of a tax court case, j.e. seagram corp. v. commissioner,2 newly issued regulations under section 338,' and an announcement that the internal revenue service is considering a comprehensive reassessment of the doctrine.4 this article does not attempt to answer these metaphysical questions or purport to assert what the law should be (although a few suggestions are made along the way).5 instead, the article makes a simple prediction: the 1. this list should not be regarded as exclusive. a fair measure of the number and extent of the issues raised by the continuity of interest doctrine is § 610 of martin d. ginsburg & jack s. levin, mergers, acquisitions and buyouts (1995). a comprehensive study, which devotes 75 pages (divided into 15 separate sub-sections) and over 80 examples to the topic. 2. 104 t.c. 75 (1995). the case was appealed to the second circuit court of appeals, but was settled before that court made its decision. 3. 60 fed. reg. 54942 (1995). 4. juliann avakian martin, irs considers guidance on postreorganization sales and continuity of interest, 96 tnt 55-9 (mar. 19, 1996) (lexis, fedtax library, tnt file); 'seagram' could lead to re-evaluation of continuity of interest. solomon says, daily tax report (bna) (nov. 6, 1995) (lexis, fedtax library. bnadtr file). 5. one could fill a small public library with articles and treatise chapters devoted to either or both of these objectives. a small sampling: boris 1. bittker & james s. eustice, federal income taxation of corporations and shareholders (6th ed. 1994); peter l. faber, postreorganization sales and continuity of interest, 68 tax notes 863 (aug. 14. 1995); peter l. faber, continuity of interest and business enterprise: is it time to bury some sacred florida tax review continuity of interest doctrine in its present form will not survive for long. crystal balls aside, this forecast is not as radical as it might first appear. the continuity doctrine, which was developed by courts before the enactment of the statutory "solely for voting stock" requirement of c reorganizations, wasintended to prevent corporations from receiving tax-free treatment on sales of substantially all of their assets for cash and short-term notes of the acquiror. in 1934, congress codified this expression of the doctrine for b and c reorganizations in the solely for voting stock requirement, and with that statutory change, the judicial rule should have died. instead, subsequent courts, failing to recognize the original purpose of the judicial doctrine or the significance of the statutory amendment, began to apply it to statutory mergers. and the service, flush with victory and blind to the evils of the double-edged doctrine it was forging, implied in the representations required for favorable private letter rulings that the continuity of interest doctrine requires the former shareholders of a target to maintain a relationship with each other as shareholders in the combined entity after the acquiror's tax-free acquisition of target. today, the doctrine is wielded to break otherwise valid tax-free reorganizations with equal vigor by the service (which asserts it against taxpayers to cause gain recognition) and taxpayers (who, by failing to meet the continuity requirement, can claim a loss). not surprisingly, this double duty has not left the doctrine unscathed. most recently, the tax court in seagram took pains to limit further expansion of the doctrine when it was asserted by a target shareholder seeking to claim a loss. on the other hand, the doctrine has acquired new meaning as the mechanism to cause taxable gain only for the historic minority shareholders who receive and retain acquiror's stock in a merger following a qualified stock purchase under section 338. this article advances what should be an unremarkable proposition-a doctrine whose policy basis evaporated over 60 years ago and exists without any express or implicit basis in the statutes, which is as often invoked by taxpayers to recognize loss as by the service to impose tax on gain, which in its present form is the source of significant instability and uncertainty, and which leads to results that are as inequitable and counterintuitive as they are economically inefficient-cannot survive for long. in the course of developing this argument, the article explores how this wayward doctrine went astray and how its course might be corrected. cows? 34 tax law. 239 (1981); william t. hutton, musings on continuity of interest-recent developments, 56 taxes 904 (1979); jere d. mcgaffey & kenneth c. hunt, continuity of shareholder interest in acquisitive corporate reorganizations, 59 taxes 659 (1981); robert a. rizzi, continuity of interest and reorganizations: toward a unified theory, 17 j. corp tax'n 362 (1991); bernard wolfman, continuity of interest and the american law institute study, 57 taxes 840 (1979). ivol 3:5 1996] devolution & inevitable ertinction of the continuir" of interest doctrine 191 the article is divided into five parts. part ii presents the history of the doctrine, from its sensible judicial origins to its legislative codification in 1934, and explains the subsequent judicial decisions that freed the doctrine from its statutory mooring and permitted it to drift, untethered, into a new, modem form. part m explores the fullest expression of the doctrine, which today is perhaps most brashly reflected in the "anti-yoc heating" regulations promulgated under section 338. part iv identifies the doctrine's vulnerability. in the face of significant contrary policies, the doctrine is subject to legislative, judicial, and regulatory constriction, and part iv describes some of the limitations that tenderly rein continuity's strongest form. finally, part v examines some of the unfortunate aspects of the doctrine that remain today-abuse potential, unadministerability, inefficiency, unfairness, and inconsistency-and pauses to reexamine the doctrine in its best light and glean from its strongest form a defensible policy rationale. part v asserts that any justification for the doctrine's strong form is inconsistent with our modem tax system and argues that the doctrine's strength will continue its ebb to a modified form that is more consistent with its original purpose. part v presents some alternative conceptions of the doctrine that might replace its current form. ii. the pure past but sordid history of the continuity of interest doctrine the modem continuity of interest doctrine is really the result of a big mistake. this part makes the point by tracing the doctrine's development through four stages. first, following the birth of the reorganization provisions, the doctrine was sensibly developed by the second circuit in cortland specialty co. v. commissioner,6 and the supreme court in pinellas ice & cold storage co. v. commissioner,7 to interpret a parenthetical clause in the fledgling definition of reorganization and exclude from that definition asset sales for cash and short-term notes. in the second stage, congress intervened in 1934 to replace the judicial continuity doctrine established in cortland and pinellas with its own more restrictive statutory rule-the "solely for voting stock" requirement-which disallowed tax-free treatment for certain acquisitions that would have passed the cortland-pinellas test. in the third stage of the doctrine's adolescence, courts continued to apply the old judicial doctrine of cortland and pinellas to pre-1934 tax years. these cases were consistent with the teachings of cortland and pinellas that an asset sale should qualify as a tax-free reorganization only if the consideration is consistent with that of a state-law merger. 6. 60 f.2d 937 (2d cir. 1932). cert. denied, 288 u.s. 599 (1933). 7. 287 u.s. 462 (1933). florida tax review in its fourth and final stage of development, the judicial continuity doctrine was reborn in roebling v. commissioner,8 which ignored the 1934 legislation and revived the doctrine, applying it even to statutory mergers (which were the model for tax-free reorganization treatment in the first place), once resurrected, the new judicial doctrine flourished, germinating from a test that distinguished merger-like tax-free reorganizations from taxable asset sales to an incipient basis for denying tax-free treatment as a result of the preand post-acquisition conduct of the acquiror, the target, and even the target's former shareholders. a. the birth of the reorganization provisions the revenue act of 1918 contained the first reorganization provision, providing that no taxable gain or loss occurs when, "in connection with the reorganization, merger, or consolidation of a corporation," a person receives "in place of stock or securities owned by him new stock or securities of no greater aggregate par or face value."9 mergers and consolidations were terms of art under state law, requiring compliance with restrictive conditions (or the grant of legislative approval) and giving rise to specific consequences. among the requirements were that the acquiror and target carry on the same or similar businesses, the shareholders of the target acquire an equity (or other permanent) interest in the acquiror, and, after the merger, the target dissolve.'0 the most significant consequence of a state law merger was the acquiror's liability for the target's legal obligations." the term "reorganization," on the other hand, was not generally defined under state law and was not generally applied to transactions with multiple corporations. in regulations, treasury defined "reorganization" broadly, but maintained the state law 8. 143 f.2d 810 (3d cir. 1944), cert. denied, 323 u.s. 773 (1944). 9. revenue act of 1918, § 202(b), 40 stat. 1057, 1060. one serious deficiency of the 1918 act was that the target was subject to tax even as a result of a reorganization. this failing was remedied in 1924. see revenue act of 1924, §§ 203(b)(3), (e), (f), (g), 43 stat. 253, 256-57. 10. see, e.g, del. laws c. 241 (1833); pa. laws no. 1 (1837); n.j. acts c. 90 (1853); mass. laws c. 74 § 1 (1827); mass. laws c. 50 § 1 (1840). see generally comment, statutory merger and consolidation of corporations, 45 yale l.j. 105, 106 & n.4, 109 & nn.16-18 (1935) (citing cases). 11. see, e.g., state v. jefferson lake sulphur co., 36 n.j. 577, 178 a.2d 329 (1962), cert. denied, 370 u.s. 158 (1962); camben safe-deposit & trust co. v. burlington carpet co., 33 a. 479, 480 (n.j. ch. 1895); la porta v. enten corp., 125 a.d. 2d 367, 509 n.y.s. 2d 91 (2d dep't 1986); greene v. woodland ave. & west side st. r.r., 62 ohio st. 67, 79, 56 n.e. 642, 646-47 (1900); see also eldon bisbee, consolidation and merger, 6 n.y.u. l. rev. 404, 414 (1929); comment, statutory merger and consolidation of corporations, 45 yale l.j. 105, 122 n.90 (1935) (citing statutes and cases prior to 1918). [vol 3:5 19961 devolution & hevitable errinction of the continuity of interest doctrine 193 merger and consolidation requirement that the target be dissolved and, in the case of an upstream merger, required that both companies be affiliated.'in 1921, congress significantly broadened the definition of reorganization by including a b-type stock acquisition with a majority threshold (as opposed to the 80% requirement under current law) and a c-type asset acquisition. section 202(c)(2) of the 1921 act provided: the word "reorganization," as used in this paragraph, includes [a] a merger or consolidation (including the acquisition by one corporation [b] of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation, or [c] of substantially all the properties of another corporation), [e] recapitalization, or [f] mere change in identity, form, or place of organization of a corporation.' 3 the decision to include a stock acquisition as a reorganization was the subject of heated debate in the senate,14 but the addition of the parenthetical clause "to include" an asset acquisition does not appear to have been 12. in general, where two (or more) corporations unitc their properties, by either (a) the dissolution of corporation b and the sale of its assets to corporation a, or (b) the sale of its property by b to a and the dissolution of b, or (c) the sale of the stock of b to a and the dissolution of b... the term "reorganization," as used in section 202 of the statute, includes cases of corporate readjustment where stockholders exchange their stock for the stock of a holding corporation, provided the holding corporation and the original corporation, in which it holds stock, are so closely related that the two corporations.., are thus required to file consolidated returns. regs. 45, art. 1567 (1921). 13. revenue act of 1921, § 202(c)(2), 42 stat. 227. 230 (1921) (emphasis added). the predecessor paragraphs to modem § 368(a)(1) are bracketed and the key c reorganization phrase is italicized. the relevant language was reenacted without substantive change in 1924, 1926, 1928, and 1932. see revenue act of 1924, § 203(h)(1), 43 stat. 253. 257; revenue act of 1926, § 203(h)(1), 44 stat. 9, 14; revenue act of 1928. § 112(i). 45 stat. 791, 818: revenue act of 1932, § 112(i), 47 stat. 169, 198. as described below in note 18, d reorganizations were added in 1924. 14. one senator argued that the exchange of a majority interest in a target corporation for stock in a corporate conglomerate was the equivalent of a sale and should be taxed as such. 61 cong. rec. 6560, 6566 (1921). the majority nevertheless voted for a broad definition of a tax-free stock acquisition for two reasons. first. in a "country-wide" corporation, it was often impossible to coordinate an exchange offer with more than a majority of the shareholders. see id. at 6564 (senator watson). second, in the absence of the provision, a shareholder with a depreciated majority interest could contribute his interest to a newlyformed holding company in exchange for stock and claim a loss. see id. (senator smoot). this was probably not an unusual transaction in 1921 during the economic downturn that followed the end of world war i. florida tax review discussed at all. nevertheless, contemporaneous sources indicate that asset acquisitions were included because some states had not yet passed statutes authorizing mergers and consolidations and other states prohibited mergers and consolidations with out-of-state corporations. therefore, in drafting the revenue act of 1921 and subsequent acts, congress sought to provide for the situation presented where an attempt was made to effectuate a practical merger or consolidation without compliance with the technical requirements of state laws, or where there is no state law, covering the readjustment which has taken place.15 however, in expanding the definition of reorganization to cover the merger-like acquisition of substantially all the assets of a target corporation, congress neglected to include the requirement of state merger laws at that time: the consideration had to include acquiror stock. 16 (incidentally, it took 15. mark eisner, taxation affecting corporate reorganizations, in some legal phases of corporate financing reorganization and regulation 403, 419 (1931). these reasons were still present in 1934, when the house of representatives proposed a repeal of the b and c reorganizations, and the senate convinced the house to retain them (in restricted form) for the same reasons. see part ii.c. 16. see, e.g., outwater v. public service corp., 103 n.j. eq. 461, 143 a. 729 (1928), aff'd, 104 n.j. eq. 490, 146 a. 916 (1929) (putative merger whereby shareholders of target would receive preferred stock of acquiror that was redeemable at option of acquiror after three years was invalid under state law; target shareholders must obtain equity or other permanent or perpetual interest in target). in ounvater, the court held: continued membership, until dissolution, is an inherent property right in corporate existence. a merger is but fusion of corporate assets and franchises and an allocation of stock in the merged company, and works a conversion not a destruction of that right. in the ordinary case of merging going concerns and the conversion of share for share upon parity of value, all rights, including voting rights, are reserved to the stockholders. id. at 465; see also moore v. splitdorf elec. co., 114 n.j. eq. 358, 168 a. 741 (1933). see generally william l. clark & william l. marshall, a treatise on the law of private corporations § 359 at 1089 (1903) ("[tlhe statute or the agreement, or both, generally provide that the consolidated corporation shall issue shares of its stock to the stockholders of the consolidating corporations..."); walter chadwick noyes, a treatise on the law of intercorporate relations § 64 at 105 (1902) (same); ernest l. folk, iii, et al., folk on the delaware general corporation law 14 n.13 (2d ed. 1990) (delaware did not permit cash consideration until at least 1941); homer hendricks, developments in the taxation of reorganizations, 34 colum l. rev. 1198, 1220 (1934) ("[i]n the usual form of strict merger or consolidation, the corporation which acquires the properties of another issues some stock or securities of its own. in this way the interests of the owners of the merging or consolidating corporations are continued in the enterprise, but the former owners may or may not control the resulting organization"). see also pinellas ice & cold storage co. v. commissioner, 57 f.2d 188, 190 [vol 3:5 1996] devolution & inevitable -rtinction of the continuity of interest doctrine 195 congress until 1968, when it enacted section 368(a)(2)(d), to require explicitly that for certain statutory mergers, the consideration must include stock to qualify as a reorganization.) b. the original continuity of interest doctrine the continuity doctrine developed as a sensible judicial interpretation of a poorly-drafted statute that expanded the definition of tax-free reorganization to include merger-like asset transfers without specifying the requisite consideration. the cases to first invoke the doctrine involved corporate taxpayers that transferred substantially all of their assets in exchange for cash and short-term notes of the acquirors in transactions that failed to qualify as statutory mergers or consolidations. invariably, the taxpayer claimed that the asset sale was a reorganization as defined in the statute, and not a taxable sale.7 under the 1926 act (the earliest revenue act to be interpreted on this issue), tax-free treatment was available to a target only to the extent that (1) the transaction was pursuant to a plan of "reorganization" (i.e., "a merger or consolidation (including the acquisition by one corporation of ... substantially all of the properties of another corporation)"),18 and (2) the consider(5th cir. 1932), affd, 287 u.s. 462 (1933) ("as applied to corporations, the terms 'merger' and 'consolidation' have well known legal meanings .... in either event, the resulting corporation acquires all the property, rights and franchises of the dissolv ed corporations, and their stockholders become its stockholders" (emphasis added)). congress also declined to address whether the target must liquidate after the transaction, as would generally be the case in a statutory merger or consolidation under 192 1 law, and was in fact required under existing regulations. see supra note 12. in helvering v. minnesota tea co., 296 u.s. 378 (1935). the supreme court held that dissolution of the target was not required by the statute. see also watts v. commissioner, 75 f.2d 981 (2d cir. 1935, aff'd, helvering v. watts, 296 u.s. 387 (1935). in 1984, however. the liquidation requirement for a c-type asset acquisition was reimposed by congress. deficit reduction act of 1984. pub. l. no. 98-369, § 63(a), 98 stat. 494, 583 (adding irc § 368(a)t2)(g)). 17. see, e.g., pinellas ice & cold storage co. v. commissioner, 21 b.t.a. 425 (1930), aff'd, 57 f.2d 188 (5th cir. 1932), aff'd. 287 u.s. 462 (1933): cortland specialty co. v. commissioner, 60 f.2d 937 (2d cir. 1932); sarther grocery co. v. commissioner, 63 f.2d 68 (7th cir. 1933); prairie oil & gas co. v. motter. 66 f.2d 309 (10th cir. 1933): worchester salt co. v. commissioner, 75 f.2d 251 (2d cir. 1935): le tulle v. scofield. 308 u.s. 415 (1940). 18. section 203(h) of the 1926 act provided: [t]he term "reorganization" means (a) a merger or consolidation (including the acquisition by one corporation of [b] at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation or [c] substantiall all the properties of another corporation), or [d] a transfer by a corporation of all or part of its assets to another corporation if immediately after the transfer the florida tax review ation for the transaction consisted of "stock or securities" of the acquiror (or another corporate party to the transaction). 9 in each of the transactions, the taxpayer undoubtedly satisfied the literal definition of reorganization. moreover, since the term "securities" was undefined by congress for purposes of the reorganization provisions (as it has remained to this day), but had been defined broadly in other contexts,20 the taxpayers had good reason to feel optimistic. nevertheless, in pinellas ice co. and cortland specialty co., the first two cases to consider the issue, the supreme court and second circuit concluded that both conditions were failed. in each case, the consideration consisted of cash and notes (which, in cortland, matured serially, with the longest having a 14-month term, were unsecured, and were "doubtless readily marketable," and in pinellas had a 4-month term and were well-secured).l each court concluded that although congress failed to define "security," it could not have intended the word to include instruments, such as the notes, that were effectively cash equivalents. although this rationale was sufficient to dispose of the cases, the courts also concluded that the transactions failed to qualify as "reorganizations." acknowledging that the literal language of the reorganization definition included all asset transfers, regardless of the consideration, the courts concluded that the parenthetical language of the phrase, "merger or transferor or its stockholders or both are in control of the corporation to which the assets are transferred, or [e] a recapitalization, or [f] a mere change in identity, form, or place of organization, however, effected. (emphasis added). the bracketed letters correspond to the analogous provisions of modem law. clause [d] (which was (b) in the statute) was added in 1924 to enlarge the scope of the definition of reorganization. see revenue act of 1924, § 203(h), 43 stat. 253, 257; house comm. on ways and means, 68th cong., ist sess., reprinted in j.s. seidman, seidman's legislative history of federal income tax laws 697 (1953). 19. section 203(b)(3) of the 1924 act provided for nonrecognition "if a corporation a party to a reorganization exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in another corporation a party to the reorganization." section 203(e) of the 1924 act subjected the target to tax on any gain to the extent the consideration consisted of money or property other than stock or securities (boot). 20. see schedule a of title xi of the 1918 act, revenue act of 1918, 40 stat. 1057, 1135 (imposing stamp tax on "all instruments, however termed, issued by any corporation with interest coupons or in registered form, known generally as corporate securities"). section 23(k)(3) of the 1938 act used substantially the same definition to distinguish debt instruments that give rise to capital losses from bad debts, which permit ordinary deductions. revenue act of 1938, 52 stat. 447, 462. thus, it was unclear whether short-term debt instruments could be securities or whether the holder's interest had to be secured. see neville coke & chemical co. v. commissioner, 148 f.2d 599, 601-02 (3d cir. 1945), cert. denied, 326 u.s. 726 (1945) (discussion of confusion over whether time or some other factor is crucial). 21. cortland, 60 f.2d at 940; pinellas, 287 u.s. at 464. [vol 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrine 197 consolidation (including the acquisition by one corporation of... substantially all of the properties of another corporation)," must be read in the context of the words "merger or consolidation" that precede it.y since "the general purpose of [all state merger and consolidation statutes] has been to continue the interests of those owning enterprises, which have been merged or consolidated, in another corporate form,"' the courts held that an asset transfer is a reorganization only if the target corporation receives consideration of a type that is consistent with statutory mergers and consolidations (i.e., stock or securities);2' otherwise, the transfer is indistinguishable from a mere sale. it is this second rationale for denying reorganization treatment that became known as the continuity of interest doctrine. the pinellas and cortland courts nicely wove the "stock or securities" requirement of the statute into the continuity-based distinction between a merger-like reorganization and a taxable asset sale. thus, the c7ortland court suggested that reorganization treatment might have been available had the consideration received by the target been "securities,' though not stock, [that] created such obligations as to give creditors or others some assured participation in the properties of the transferee corporation,"2' 6 and the supreme court in pinellas noted that cortland's interpretation "harmonizes with the underlying purposes of the provisions in respect of exemptions and gives some effect to all the words employed."'this interdependency between the reorganization definition and the stock or securities 22. see also le tulle v. scofield, 308 u.s. 415, 420 (1940) ("the section is not to be read literally, as denominating the transfer of all the assets of one company for what amounts to a cash consideration given by the other a reorganization"). 23. cortland, 60 f.2d at 939. 24. see id. at 939-40; pinellas, 287 u.s. at 469-70 (citing cortland, 60 f.2d at 937, 939, 940). 25. had the taxpayers in pinellas, cortland. and the other early continuity cases consulted a sufficiently wily tax advisor before embarking on their respective transactions, their problems could have been ameliorated by first liquidating the target by distributing its assets to its shareholders and then having the shareholders sell the assets. under regulations dating back to the 1918 act, in kind liquidating distributions were tax-free to the dissolving company. see regs. 69, art. 548 (1926); regs. 45, art. 547 (1918): hellebush v. commissioner, 24 b.t.a. 660, 667 (1931), aff'd, 65 f.2d 902 (6th cir. 1933). the shareholders would have been taxed on the liquidating distribution, but this would not have been a significant acceleration of the income they recognized upon the maturity of the short-term debt obligations. see koppers coal co. v. commissioner, 6 t.c. 1209 (1946). section 337 of the 1954 code effectively overruled cortland and pinellas by permitting a tax-free sale of assets prior to a liquidation. it was not until general utilities was repealed in 1986 that cortland and pinellas were restored as good substantive law. 26. cortland, 60 f.2d at 940. 27. pinellas, 287 u.s. at 470. florida tax review requirement was later (and still remains in part) reflected in the regulations28 and was maintained by case law through 1939, when the second circuit held in commissioner v. tyng29 that because 20and 40-year convertible bonds were clearly "securities," the transaction necessarily satisfied the continuity of interest requirement for tax-free treatment under the 1928 act. 30 the cortland and pinellas courts, having decided that the transactions at issue failed to qualify as reorganizations because the consideration failed to include any stock or securities of the acquiror, left open the question of whether any specific quantity of acquiror's stock or securities must be received by the target. contemporaneous commentators assumed that "[tihe issuance of any substantial amount of stock or securities should be sufficient to bring the transaction within the parenthetical language." 3' c. the statutory continuity of interest doctrine in 1933, following the cortland and pinellas decisions and facing the prospect that the existing definition of reorganization might nevertheless permit corporate taxpayers to claim tax-free treatment on a sale of assets for short-term debt instruments, a subcommittee of the house ways and means committee recommended a wholesale repeal of the tax-free reorganization provisions until "a more desirable method of treatment could be built up."32 the treasury opposed the repeal on the grounds that tax-free treatment was 28. see, e.g., regs. 101, § 112(g)-i (1934) ("[alccordingly, under the act, a shortterm purchase money note is not a security of a party to a reorganization, . . . and a sale is nevertheless to be treated as a sale, even though the mechanics of a reorganization have been set up"); regs. § 1.368-2(a) ("[i]f the properties are transferred for cash and deferred payment obligations of the transferee evidenced by short-term notes, the transaction is a sale and not an exchange in which gain or loss is not recognized"). 29. 106 f.2d 55 (2d cir. 1939), rev'd, helvering v. tyng, 308 u.s. 527 (1940). see infra text accompanying notes 54 to 58, which discusses how the divorce of the stock or securities requirement from the judicial continuity of interest doctrine under pre-1934 law was a prelude to the judicial resurrection of the doctrine under post-1934 law. 30. tyng, 106 f.2d at 59 ("[live different circuit courts of appeal, besides our own, and the court of claims as well, have decided that the receipt of 'securities' results in the retention of a continuity of interest necessary for a reorganization"). ultimately, the supreme court held that the target or its shareholders must receive some equity in the acquiror. see le tulle v. scofield, 308 u.s. 415 (1940), discussed infra parts iii.b and iv.a. 31. hendricks, supra note 16, at 1220 (emphasis added); see also cortland, 60 f.2d at 940 ("even if the transfer to deyo was an exchange in pursuance of a 'plan of reorganization,' the property received by cortland had to include some 'stock or securities'" (emphasis added)). 32. see subcomm. of house comm. on ways and means, 73rd cong., 2d sess. 8-9, 37-42 (1934), reprinted in j.s. seidman, seidman's legislative history of federal income tax laws 332 (1953); see also h.r. rep. no. 704, 73rd cong., 2d sess. 13 (1934), reprinted in 1939-1 c.b. 554, 563. [val 3:5 1996] devolution & inevitable ertinction of the continuity of interest doctrine 199 appropriate for legitimate reorganizations in which only "paper gains" were realized and, because the economic tide was turning, several reorganizations in progress at the time would give rise to the recognition of losses if they were taxable.33 the full ways and means committee was persuaded by the treasury's arguments and proposed to retain the basic concept of tax-free reorganizations but to deny tax-free treatment for asset acquisitions of the type that were the subject of cortland and pinellas. under the ways and means proposal, the definition of reorganization would have been confined to "(1) statutory mergers and consolidations; (2) transfers to a controlled corporation, 'control' being defined as an 80-percent ownership; and (3) changes in the capital structure or form of an organization."' u these amendments were approved by the full house. the senate finance committee applauded the policies behind the house's proposal but, with respect to asset acquisitions, made the following observation: not all of the states have adopted statutes providing for mergers and consolidations; and, moreover, a corporation of one state can not ordinarily merge with a corporation of another state. the committee believes that it is desirable to permit reorganizations in such cases, with restrictions designed to prevent tax avoidance. t the finance committee proposed an expansion to the house's definition by permitting c-type asset acquisitions but requiring that the consideration consist "solely" of acquiror's "voting stock." the committee also restricted tax-free "mergers and consolidations" to those specifically provided for under state "statutory" law (as opposed to those pursuant to private legislation, as had also been common). congress passed the bill, as modified by the senate finance committee: the term "reorganization" means [a] a statutory merger or consolidation, or [b] the acquisition by one corporation in exchange solely for all or a part of its voting stock: of at least 80 percentum of the voting stock and at least 80 percen33. 78 cong. rec. 2512 (1934). 34. h.r. rep. no. 704, supra note 32, reprinted in 1939-1 c.b. 564. 35. id. at 598. see george s. hills, definition-"reorganization" under the revenue act of 1934, 12 tax magazine 411, 411 (1934) ("a cursor), examination of the business corporation laws of the forty-eight states discloses that fifteen states have no statutory provision for 'merger' or 'consolidation,' sixteen states have statutory provisions limited to domestic corporations, and seventeen states have statutory provisions covering domestic corporations and foreign corporations"). florida tax review tum of the total number of shares of all other classes of stock of another corporation; or [c] of substantially all the properties of another corporation, or [d] a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its shareholders or both are in control of the corporation to which the assets are transferred, or [e] a recapitalization, or [f] a mere change in identity, form, or place of organization, however effected.36 with these changes, congress replaced the judicial continuity of interest doctrine with a more explicit-and restrictive-statutory version.37 these amendments met the house's original concerns by preempting any attempt of taxpayers to obtain tax-free treatment for a pinellas-type transaction and met the treasury's and the senate's objective of permitting tax-free asset acquisitions that were "sufficiently similar to mergers and consolidations as to be entitled to similar treatment."38 additionally, voting stock consideration was not made a condition of tax-free treatment for statutory mergers or consolidations, even though in 1934, under the laws of various states, there was no requirement that a plan of merger or consolidation provide for solely voting stock consideration and, in fact, some "modern" state statutes permitted mergers without any equity consideration.39 thus, 36. revenue act of 1934, § 112(g)(1), 48 stat. 683, 705. the letters in brackets are redesignated to correspond to current law. 37. see helvering v. southwest corp., 315 u.s. 194, 198 (1942) ("[tlhe continuity of interest test is made much stricter [by the 1934 act]"); comment, corporate reorganization to avoid payment of income tax, 45 yale l.j. 134, 140-41 (1935); hugh satterlee, the income tax definition of reorganization, 12 tax magazine 639 (1934); hills, supra note 35, at 412; hendricks, supra note 16, at 1202 ("[tlhe intent of congress is thus made plain ... [f]or future transactions, the views of the board of tax appeals ... regarding the interpretation to be given to section 112(i)(1)(a) of the 1932 and prior acts are made inapplicable"); erwin n. griswold, securities and continuity of interest, 58 harv. l. rev. 705, 711 (1945) (since "the definition of reorganization in the statute has now been changed so as to include only a 'statutory merger or consolidation,' or an exchange of property 'solely for voting stock,'" the definition of securities is "no longer of any particular importance" in determining whether a "reorganization" has taken place). 38. h.r. rep. no. 704, supra note 32, reprinted in 1939-1 c.b. 598. 39. see, e.g., ark. dig. stat. § 170112 (crawford & moses, supp. 1931) ("[tlhe agreement may provide for the distribution of cash, notes or bonds in whole or in part, in lieu of stock to the stockholders of the constituent corporations or any of them"); see also cal. civ. code § 361 (deering 1931); fla. comp. gen. laws ann. § 6562 (skillman 1927); nev. comp. laws § 1638 (hillyer 1930); ohio gen. code § 8623-67 (page, supp. 1935); tenn. code ann. § 3750 (williams 1934); ill. rev. stat. c. 32 § 62 (cahill & moore 1935) (permitting distribution of "shares or other securities or obligations of the new corporation"). see generally henry winthrop ballantine, ballantine on corporations § 291 at 686 (1946); comment, corporate reorganization to avoid payment of income tax, 45 yale l.j. 134, 141 & n.48 (1935). [vol 3:5 1996] devolution & ievitable extinction of the contbiuity of interest doctrine 201 congress confirmed that for statutory mergers and consolidations, the state requirements, such as a formal plan of merger, shareholder vote, and dissenters' rights, and the consequences-such as liability for the target's legal obligations-were sufficient to distinguish those transactions from sales, and that any requirements as to the nature of the consideration would be defined by state law.40 d. deadwood decisions: post-1934 cases interpreting pre-1934 law following the 1934 act and until at least 1940, the judicial continuity of interest doctrine continued to be applied as cases involving tax years before 1934 advanced through the courts. these cases were entirely faithful to three principles deriving from the cortland and pinellas decisions. first, although the literal language of the parenthetical describing b and c reorganizations would permit tax-free treatment to a target upon a "sale" of substantially all of its assets-regardless of the consideration-the parenthetical should be read to require consideration that is consistent with a statutory merger or consolidation.4' second, the cases were consistent with the view that the continuity of interest required for transactions described in the parenthetical describing b and c reorganizations was not required for other reorganization transactions. for example, in schoo i. commissioner,2 the court held that the exchange of preferred stock for 25-year bonds in a recapitalization was a reorganization, even though the shareholder's continuity of interest was broken by the transaction. the court made clear that the continuity of interest requirement was relevant only in determining whether a c-type asset transfer was sufficiently similar to a merger to deserve like treatment." courts have long recognized that the receipt of voting stock is not necessary in a statutory merger. see, e.g., john a. nelson co. v. helvering, 296 u.s. 374 (1935). 40. see satterlee, supra note 37, at 688 ("the history and structure of the reorganization provisions prior to the revenue act of 1934 indicate that any requirement of a continuity of interest was consciously and advisedly omitted from the definition of reorganization in clause a"). 41. helvering v. minnesota tea co., 296 u.s. 378, 385 (1935) (target or its shareholders must acquire a "definite" and "material" interest in acquiror "in order that the result accomplished may genuinely partake of the nature of merger or consolidation"); coleman v. commissioner, 81 f.2d 455, 457 (10th cir. 1936) ("[dlid the transaction smack enough of a 'merger or consolidation' that it can fairly be said to fall within the parenthetical phrase?"); worcester salt co. v. commissioner, 75 f.2d 251, 252 (2d cir. 1935) (-the transaction must at least 'partake of the nature of a merger or consolidation' "); see john a. nelson co. v. helvering, 296 u.s. 374 (1935) (nonvoting preferred stock is adequate consideration for a tax-free c-type asset acquisition). 42. 47 b.t.a. 459 (1942). 43. id. at 461; see also commissioner v. neustadt's trust, 131 f.2d 528 (2d cir. 1942) (1936 act); crofoot v. commissioner, 4 t.c. memo (cch) 97. t.c. memo (p-h) florida tax review finally, courts continued to emphasize that the parenthetical clause was intended to expand the definition of reorganization and should be construed liberally, so long as it did not allow tax-free treatment for disguised asset sales. for example, in john a. nelson co. v. helvering,44 the court held that the target need not receive voting securities; in nelson and in helvering v. minnesota tea co.,45 the court held that even though a statutory merger or consolidation would generally require the target to dissolve, no such requirement was imposed by the parenthetical; 46 and in helvering v. alabama asphaltic limestone co.,47 the court held that the sale by a bankrupt corporation of all its assets to a committee of its creditors for cash and stock of a newly-organized corporation owned by the creditors, which the bankrupt corporation, in turn, distributed to its creditors in satisfaction of its debts, constituted a tax-free reorganization. in alabama asphaltic, the court disabused the view, "followed by some courts," that "a substantial ownership interest in the transferee company must be retained by the holders of the ownership interest in the transferor., 48 stressing once again that reorganizations include "transactions which are beyond the ordinary and commonly accepted meanings of [merger and consolidation]," the court held that the insolvent target's distribution of the acquiror stock to its bondholders was sufficiently similar to the analogous distribution by a solvent target to its shareholders to warrant tax-free treatment for the target on the transfer of its assets. nevertheless, three deadwood supreme court decisions, while consistent with the narrow purposes of the judicial doctrine as applied under the pre-1934 statute, were subsequently-and unfortunately-interpreted as dramatically expanding the continuity of interest requirement and sparking resurrection of the judicial doctrine under post-1934 law. 45,036 (1945); annis furs, inc. v. commissioner, 2 t.c. 1096 (1943) (1934 act); kirby v. commissioner, 35 b.t.a. 578 (1937) (1926 act and 1928 act), modified on other grounds, 102 f.2d 115 (1939). as discussed below, the judicial continuity doctrine was not applied to d reorganizations under post-1934 law. see infra notes 73-74 and accompanying text. 44. 296 u.s. 374 (1935). see also united states v. adkins-phelps, inc., 400 f.2d 737 (8th cir. 1968) (continuity satisfied notwithstanding acquiror's right of first refusal to purchase its shares from target shareholder at par); schweitzer & conrad, inc. v. commissioner, 41 b.t.a. 533 (1940) (nonconvertible preferred stock with no right to vote, redeemable at any time and mandatorily redeemable after six months if a certain level of earnings was achieved; held, sufficient). 45. 296 u.s. 378, 385 (1935). 46. however, in 1984 congress legislatively imposed a liquidation requirement on targets in c reorganizations. deficit reduction act of 1984, pub. l. no. 98-369, § 63(a), 98 stat. 494, 583 (adding irc § 368(a)(2)(g)). 47. 315 u.s. 179 (1942). 48. id. at 183. [ vol 3:5 1996] devolution & inevitable frtinction of the continui" of interest doctrine 203 groinan v. comnnzissioner49 and hehvering %,. bashford each involved a b-type acquisition of a target's stock by a newly-formed subsidiary of a parent corporation. in each case, the acquisition was immediately followed by the target's liquidation into the subsidiary. the consideration for the transfer was cash, parent stock, and stock of the subsidiary. it was clear in each case that the transaction qualified as a reorganization, and the sole issue was whether the parent's stock was stock of a "party to the reorganization" so that the target shareholders would not have to recognize on receipt of it. in gronan, the court approached the question quite logically by starting with section 112(i)(2) of the 1928 act, which defined "party to a reorganization" as "including" a corporation resulting from a reorganization and "both" corporations in a stock acquisition. after concluding that subsidiary and target were parties to the reorganization, the court held that the parent was not encompassed by the statutory definition or any other ordinary meaning of the term "a party to the reorganization." the groman court next considered whether the subsidiary could be ignored or otherwise regarded as the parent's alter ego. to answer this question, the court delved into the purposes of the reorganization provisions, stating that the statute permitted tax-free treatment to target shareholders only if their interest "continues to be definitely represented in a substantial measure in a new or different [corporation, and] then to the extent, but only to the extent, of that continuit., of interest .. in light of this requirement of a close relationship between target shareholders and acquirors, the court held that the statute did not permit the actual acquiror (the subsidiary) to be ignored or the acquiror's parent otherwise to be deemed the "other" party to the reorganization. this conclusion was also reached in bashford, where the target shareholders dealt exclusively with parent, which contributed the target stock to its subsidiary in exchange for subsidiary stock that it transferred to the target shareholders. (in groman, the subsidiary had received parent stock and the subsidiary dealt exclusively with the target shareholders.) groman and bashford are stinted and formalistic interpretations of the "party to a reorganization" definition, but they adhere to the statutory language and have nothing to do with the extra-statutory continuity of interest doctrine. in context, it is clear that by referring to "continuity of interest," the court was not referring to the continuity of interest doctrine used to distinguish merger-like transactions from taxable sales and whose failure disqualifies the entire reorganization. instead, the court was explaining the 49. 302 u.s. 82 (1937). 50. 302 u.s. 454 (1938). 51. groman, 302 u.s. at 89 (emphasis added). florida tax review statutory mechanism that permits tax-free treatment to target shareholders only to the extent they receive stock or securities-representing a "continuity" of their former proprietary interest-of the true acquiror, and not in some other corporation. nevertheless, the court's reference to "continuity of interest" has caused groman and bashford to be misunderstood as being more than cases interpreting the term "a party to a reorganization" and as announcing, instead, an expansion of the judicial continuity of interest doctrine whose failure (at least under pre-1934 law) disqualified an otherwise valid reorganization. 2 this view inexplicably persists today despite their double legislative repeal: first in 1934 when congress undercut the decisions by requiring that the consideration in b-type stock acquisitions consist solely of acquiror voting stock (and not parent stock as well), thereby legislatively foreclosing groman and bashford transactions, and, again, when congress expressly permitted triangular reorganizations in piecemeal legislation enacted over the 17 years from 1954 to 1971. the third deadwood decision that eventually helped resurrect judicial continuity was le tulle v. scofield.4 in le tulle, the supreme court interpreted pre-1934 law to require that, in a tax-free c-type asset acquisition, the consideration must consist of equity of the acquiror. the acquiror in the case obtained the target's assets solely for acquiror bonds payable serially over 11 years. although the court did not specifically hold that the bonds were "securities," that much seemed clear. nevertheless, the court held that the transaction failed to qualify as a reorganization. le tulle was faithful to the court's consistent view that the 1921 act parenthetical was intended to expand the definition of reorganization to include, among other transactions, asset acquisitions that sufficiently resembled state mergers and consolidations. however, by requiring the consideration in a tax-free c-type asset acquisition to include at least some acquiror equity, le tulle effectively limited tax-free asset acquisitions to transactions that could have qualified as statutory mergers in 1921, when the tax-free reorganization provision was first enacted and state merger and consolidation laws generally required at least some acquiror stock consideration. 55 however, state merger law evolved considerably after the 1921 act, and by 1931, when the le tulle transaction took place, many states permitted the acquiror's consideration to consist of non-equity securities, and some states 52. see, e.g., g.c.m. 35117 (nov. 15, 1972) ("[t]he concept of remote continuity originated" in groman and bashford); g.c.m. 39150 (mar. 1, 1984). general counsel memoranda 35117 and 39150 are discussed infra part iii.b. 53. the legislative repeal of groman and bashford is discussed infra part iv.a. 54. 308 u.s. 415 (1940). 55. see supra note 16 and accompanying text. t[vol 3:5 19961 devolution & inevitable extinction of the continuiry of interest doctrine 205 even permitted all-cash consideration. 6 thus, the le tulle transaction could have been consummated as a statutory merger under the laws of these states. since the purpose of the parenthetical clause was to permit transactions that did not qualify as statutory mergers to be treated as tax-free reorganizations, it is odd that the supreme court would deny reorganization status to a transaction that could have been completed as a statutory merger. in addition, by requiring that the target receive acquiror stock, the court severed continuity's moorings in the statutory "stock or securities" requirement that judge hand had been so careful to preserve in cortland and tyng and which had been extolled in pinellas.58 thus, for the first time, the supreme court implied that the continuity of interest doctrine might be regarded as a requirement wholly independent of the statutory language. even a transaction that satisfied every literal requirement of the 1921 act and satisfied the cortland and pinellas test because the acquiror received substantially all of the assets of the target in exchange for acquiror's "stock or securities" might nevertheless fail to qualify as a tax-free reorganization unless target received stock of the acquiror. e. resurrection: the emergence of a new judicial continuity of interest doctrine roebling v. commissioner 9 is the first case to hold that the judicial continuity of interest doctrine survived the 1934 act. no less significantly, the court held for the first time that, despite the clear statutory language to the contrary, a statutory merger failed to qualify as a reorganization.' in 56. see supra note 39 and accompanying text. oddly, the treasury had recognized that legal advance in a 1927 published ruling, which treated a three-corporation consolidation as a reorganization, even as to a corporation whose shareholders were entirely cashed out. 1.t. 2364, vi-1 c.b. 13. see infra note 61 for a discussion on this ruling. 57. prior to le tulle, circuit court decisions were unanimous that if the target received securities of the acquiror, a sufficient continuity of interest would necessarily be retained. see commissioner v. tyng, 106 f.2d 55, 59 (2d cir. 1939) (citing cases), rev'd. helvering v. tyng, 308 u.s. 527 (1940). 58. see pinellas, 287 u.s. at 470 (cortland "harmonizes with the underlying purpose of the provisions in respect of the exemptions and gives some effect to all the words employed" (emphasis added)). 59. 143 f.2d 810 (3d cir. 1944), cert. denied, 323 u.s. 773 (1944). 60. in morgan mfg. co. v. commissioner, 124 f.2d 602 (4th cir. 1941). two corporations agreed that if the acquiror paid the liabilities of the target to its shareholders, the target would merge into the acquiror under state law, and the target's shares would be canceled. the court held that even though the merger qualified as such under local law, it was not a tax-free reorganization. however, the decision was not based on continuity of interest, but on the authority of gregory v. helvering, 293 u.s. 465 (1935), the court finding that the substance of the transaction was a sale of the target's assets for the amount of liabilities owed to its florida tax review roebling, the south jersey gas, electric and traction co. (south jersey) was merged under new jersey law into the public service electric and gas company (pse&g), with pse&g surviving and the former shareholders of south jersey receiving 100-year bonds of pse&g in exchange for their south jersey stock. the court held that the judicial continuity of interest doctrine survived passage of the 1934 act and, on the authority of le tulle v. scofield, also held that continuity was relevant in a statutory merger. each of these conclusions was clearly wrong. under the 1918 act and every subsequent revenue act, the paragon for reorganization treatment was the statutory merger. in 1921, congress expanded the definition of reorganization to additionally include similar transactions that failed to qualify as mergers under state law. from cortland and pinellas, courts had identified acquiror stock consideration as the salient characteristic of those transactions. however, until roebling, it was clear that a statutory merger or consolidation was a tax-free reorganization, even if the consideration was cash.6 in roebling, the court turned seven revenue acts and twelve years of case law on their collective heads, and held that the very model of a tax-free reorganization-a statutory merger in which the target's shareholders received securities of acquiror-failed to qualify as a reorganization.62 the roebling court compounded its error by ignoring the revenue act of 1934, by which congress had entirely replaced the judicial continuity of interest doctrine with a solely for voting stock requirement that was applicable only to b and c reorganizations. the 1934 act further affirmed that statutory mergers and consolidations were exempt from any continuity requirement by setting those transactions apart from asset and stock acquisitions in a separate clause that contained no voting stock requirement. the court's decision also finds no support in le tulle, which construed the c reorganization definition to require that the target's shareholders receive acquiror stock, despite the subsequent liberalization of state merger law that permitted a statutory merger solely for debt (or even cash) consideration. le tulle did not disqualify a statutory merger from shareholders. the court also indicated that the terms of the merger agreement, which required the target shareholders to receive stock in the surviving corporation, were not in fact met. 61. see i.t. 2364, vi-i c.b. 13, declared obsolete in rev. rul. 69-44, 1969-1 c.b. 312, which involved a consolidation of three corporations, m, n, and 0, into a new corporation p. the ruling holds that the transaction is a reorganization with respect to each corporation, even though 0 received only cash, which it distributed to its shareholders. since the consideration received and distributed by 0 was not stock or securities, 0 and its shareholders recognized gain or loss. 62. see satterlee, supra note 37, at 688 ("the history and structure of the reorganization provisions prior to the revenue act of 1934 indicate that any requirement of a continuity of interest was consciously and advisedly omitted from the definition of reorganization in clause a"). [vol 3:5 1996] devolution & inevitable ertinciion of the continityi of interest doctrine 207 reorganization treatment. moreover, even if le tulle was correct under pre1934 law, when congress revisited the definition of reorganization in 1934, placing "statutory mergers or consolidations" in a separate clause, many contemporary state merger statutes permitted target shareholders to receive only nonequity securities of the acquiror." finally, in citing for support the regulations, which provided in a general "purpose" clause (as they do to this day) that continuity of interest is "requisite to a reorganization,"' the court ignored several aspects of the regulations. first, the regulations were in fact satisfied in roebling because they reflected (and to some extent still reflect) judge hand's pre-le tulle opinion in commissioner v. tyng that while short-term notes indicate a sale, a debt security of the acquiror is sufficient to establish continuity.' these regulations made clear that compliance with the specific requirements of clauses (a) through (e) of section 112(g)(1) would satisfy continuity because the transactions described in those clauses are, by definition, sufficiently distinguishable from a mere sale.66 thus, under the regulations, a statutory merger in which the target shareholders received only acquiror nonequity securities qualified as a reorganization. ih. the new judicial continuity of interest doctrine in full bloom if le tulle supplied the breeze that loosened the continuity of interest doctrine from its statutory roots in the "stock or securities" requirement, and gromnan and bashford the gust that floated the doctrine into fertile soil, roebling is the thunderstorm that allowed the new judicial doctrine to sprout. this part summarily describes the doctrine in its fullest bloom, a technicolor 63. see supra note 39 and accompanying text. 64. regs. 86, § 112(g)-i (1934). 65. regs. 101, § 112(g)-i (1938) ("purpose") ("there is not a reorganization if the holders of the stock and securities of the old corporation are merely the holders of short-term notes in the new corporation.... accordingly, under the act, a short-term purchase money note is not a security of a party to a reorganization. . .. and a sale is nevertheless to be treated as a sale, even though the mechanics of a reorganization have been set up"). 66. the regulations stated: the application of the term "reorganization" is to be strictly limited to the specific transaction set forth in section 112(g)t{). the term does not embrace the mere purchase by one corporation of the properties of another corporation, for it imports a continuity of interest on the part of the transferor or its stockholders in the properties transferred. if the properties are transferred for cash and deferred payment obligations of the transferee evidenced by short-term notes, the transaction is a sale and not an exchange. regs. 101, § 112(g)-2 (1938) (emphasis added). florida tax review spectacle that retains its color in the recent "anti-yoc heating" regulations issued under section 338. the discussion is divided into five topics. first, this part describes the application of the doctrine to d and f reorganizations and even section 355 divisive transactions. the use of continuity to disqualify a transaction from these provisions is surprising because the early continuity cases stress that it was applicable only to the stock and asset acquisitions described in the original parenthetical clause. second, this part examines the remote continuity doctrine, which unexpectedly developed from groman and bashford, cases that had nothing to do with the continuity of interest doctrine and in which the court found that the transactions at issue were reorganizations. third, this part discusses the controversial expansion of continuity to disqualify otherwise valid reorganizations based on post-reorganization conduct of the target's shareholders. fourth, this part examines the use of the continuity doctrine as an alternative basis for finding that an acquiror that purchases stock of a target and then merges the target into a subsidiary as part of single integrated transaction is entitled to a stepped-up basis in the target's assets. finally, this part discusses the possible expansion of continuity to disqualify otherwise valid reorganizations based on target shareholders' preacquisition conduct. a. expansion of the continuity doctrine beyond the original parenthetical the original purpose of the continuity of interest doctrine, to distinguish a merger-like stock or asset acquisition from a cash purchase of the target's assets, had no application to the other types of reorganizations, as early case law recognized.67 nevertheless, the doctrine is now said to be an extra-statutory requirement of d68 and f reorganizations (where a virtually 100% continuity requirement is imposed), 69 and even section 355 divisive transactions.7" the application of continuity to d reorganizations, while perhaps justifiable on policy grounds in a few situations,7 is not supported by the statute or the original case law. in contrast, the application 67. see, e.g., hickok v. commissioner, 32 t.c. 80 (1959) (holding continuity inapplicable to e reorganizations (recapitalizations)); microdot, inc. v. united states, 728 f.2d 593 (2d cir. 1984); golden nugget, inc. v. commissioner, 83 t.c. 28 (1984). the service now acknowledges that the continuity of interest doctrine does not apply to e reorganizations. see rev. rul. 77-479, 1977-2 c.b. 119; rev. rul. 77-415, 1977-2 c.b. 311. 68. see bittker & eustice, supra note 5, 12.26 at 12-92 to 12-93. 69. see rev. rul. 79-289, 1979-2 c.b. 145; rev. rul. 79-250, 1979-2 c.b. 156; rev. rul. 78-441, 1978-2 c.b. 152; rev. rul. 75-561, 1975-2 c.b. 129. 70. see regs. § 1.355-2(c)(1), (2). 71. this topic is discussed below in part v.c.4. [vol. 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrine 209 of continuity to f reorganizations and corporate divisions should be understood as an example of evolutionary convergence: the appearance of a concept analogous to the historic continuity requirement of pinellas and cortland, but unrelated as a matter of pedigree. 1. d reorganizations.-d reorganizations have their genesis in section 203(h)(1)(b) of the 1924 act, which included as a reorganization "a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred." ' the original continuity cases were inapplicable because cortland and pinellas interpreted the parenthetical clause describing b and c reorganizations and d reorganizations were not included in that clause or intended as surrogates for statutory mergers. the "control" requirement of modem section 368(a)(1)(d) provided the closest analogy, and at times it was referred to by the courts as the continuity requirement of d reorganizations. the courts made clear, however, that the statutory definition of control, while similar to the continuity concept of cortland and pinellas, superseded it. this point is made in weicker v. howbert," where assets of a distributing corporation were transferred to its newly-organized subsidiary and the subsidiary was split-off, with a shareholder of the distributing company exchanging all but one of her shares for a 73% stake in the split-off subsidiary and another exchanging some of his shares for the remainder of the former subsidiary's stock. the court ruled that the transaction did not qualify as a d reorganization under the 1928 act because, after the split-off, the distributing company's shareholders did not together control the former subsidiary (the single share retained by one of the shareholders being ignored): "in order to [be a d reorganization], there must be a continuity of interest on the part of the transferor corporation or its stockholders in the transferee corporation amounting to a control by the former of the latter."7 in 1954, congress relaxed the control requirement of d reorganizations by permitting it to be met if former shareholders of the distributing corporation were in control of the controlled corporation after the transaction.75 the current regulations insist that the judicial continuity test is a 72. revenue act of 1924, 203(h)(1)(b). 43 stat. 253. 73. 103 f.2d 105 (10th cir. 1939). 74. id. at 109. see also williamson v. commissioner, 27 t.c. 647, 660 (1957) ("the transaction, therefore, fails to qualify as a corporate [d] reorganization because it fails to comply with the provisions of the statute intended to result in a continuity of interest by the transferor corporation or its stockholders, or both, in the transferee corporation-). 75. irc § 368(a)(1)(d) (1954). see s. rep. no. 1622, 83d cong., 2d sess. 273-74 (1954), reprinted in 1954 u.s.c.c.a.n. 4785, 4912. florida tax review condition of all reorganizations but also appear to acknowledge that, for d reorganizations, the statutory control test has replaced it.76 nevertheless, issues continue to exist as to whether a transaction that otherwise qualifies as a d reorganization is disqualified if the acquiror's consideration consists of some of its stock but not a sufficient amount to satisfy traditional continuity thresholds, 77 and whether the remote continuity doctrine (discussed below in part iii.b) disqualifies a d reorganization if the target's assets are dropped into a subsidiary before or after the acquisition.78 2. section 355.79 -the current regulations under section 355 provide that judicial continuity is a requirement of tax-free divisive transactions, independent from the statutory control and business purpose tests.8" this requirement is especially surprising since section 355 sprouted from d reorganizations, which historically were not required to meet judicial continuity, and since the provision permitting tax-free divisive transactions was in 1954 plucked from its place as an addendum to the reorganization provisions and placed in section 355. section 355 lists several requirements for tax-free treatment but conspicuously omits to include a continuity requirement. nonrecognition for corporate divisions was first granted by the 1924 act,81 which permitted a tax-free distribution, "in pursuance of a plan of reorganization," of the stock or securities of a corporate party to a reorganization to a shareholder of that (or another) corporate party. this provision disappeared and reappeared in the statute, and finally was revamped in 1954 and moved to its present location in section 355. the 1924 act also introduced the d reorganization, and it was understood that divisions could be d reorganizations. 8 2 section 355 of the 1954 code set out the conditions for tax-free treatment under that provision and eliminated the requirement that a tax-free division be a reorganization. this change severed all ties with the continuity of interest doctrine. nevertheless, while it does not appear that any court 76. regs. § 1.368-1(b) provides: "requisite to a reorganization under the code are ... (except as provided in section 368(a)(1)(d)) a continuity of interest .... (emphasis added). 77. see bittker & eustice, supra note 5, 12.26[21 at 12-92 to 12-93. 78. see ginsburg & levin, supra note 1, § 702.2 at 662-65. 79. for a discussion of the continuity requirement under the § 355 regulations, see benjamin g. wells, continuity of interest under the new section 355 regulations, 16 j. corp. tax'n 203 (1989). 80. regs. § 1.355-2(c). 81. revenue act of 1924, 203(c), 43 stat. 253. 82. see generally charles s. whitman, iii, draining the serbonian bog: a new approach to corporate separations under the 1954 code, 81 harv. l. rev. 1194, 1199-1200 n.25 (1968) (providing an excellent review of the history of § 355). [vol 3:5 19961 devolution & inevitable ertinction of the continui" of interest doctrine 211 flunked an otherwise valid section 355 transaction for lack of continuity, the seventh circuit in redding v. commissioner3 suggested (without any apparent authority) that an otherwise valid section 355 distribution might be rendered taxable by a prearranged sale by the shareholders of more than 50% of the stock received in the controlled company.84 subsequent to the 1986 amendments to section 355 that helped effectuate a repeal of the general utilities doctrine, but prior to the issuance of final regulations under section 355, government officials recognized the difficulty of importing a continuity doctrine into section 355 and struggled to find a statutory basis for such a requirement. 5 the regulations by fiat require continuity as a separate element of a section 355 transaction, in addition to the statutory "business purpose" and "device" tests, despite the absence of any statutory basis.8 6 quite apart from this separate continuity requirement, a transaction or series of transactions in which the shareholders of a distributing company are able to cash-out their newly received stock tends to indicate a device for the distribution of earnings and profits or the lack of a valid business purpose, either of which is sufficient grounds for denying tax-free treatment. in light of congress' broad grant of regulatory authority, the section 355 continuity requirement should be viewed as an element of those statutory tests.'s 83. 630 f.2d 1169 (7th cir. 1980). 84. id. at 1180 n. 22. see also pamela b. gann, taxation of stock rights and other options: another look at the persistence of pahner r. commissioner, 1979 duke l j. 911. 975 (1979) (discussing possible applicability of continuity test to § 355 transactions, and cited by the redding court). the reference to 50% was an apparent allusion to rev. proc. 77-37. 1977-2 c.b. 568, modified by rev. proc. 86-42, 1986-2 c.b. 722, discussed infra part ill.e. 85. see prop. regs. § 1.355-2(b) (1977) (stating that continuity is an aspect of business purpose); lee a. sheppard, section 355 and continuity of interest. 39 tax notes 911, 912 (may 23, 1988) (quoting then-tax legislative counsel dana trier -continuity of interest is an aspect of device, but that's not the whole point ... continuity of interest comes from the business purpose clause, not the device clause, which has its o%% n continuity of interest aspect"). 86. regs. § 1.355-2(c)(1) ("this continuity of interest requirement is independent of the other requirements under section 355"). 87. a recent legislative proposal would in effect add a statutory continuity requirement to § 355. in march 1996, the clinton administration announced a proposal that would subject the distributing company to tax on the appreciated value of the controlled company unless the "historic" shareholders of the distributing company (generally, those shareholders that owned stock continuously for the two years preceding the distribution) maintain a 50% interest in the vote and value of each of the distributing and controlled companies for a continuous two-year period immediately after the distribution. see department of the treasury, general explanations of the administration's revenue proposals (mar. 1996); joint committee on taxation, description of revenue provisions contained in the president's fiscal year 1997 budget proposal (released on mar. 19, 1996) (jcs-2-96) (mar. 27. 1996). florida tax review 3. f reorganizations.-the use of continuity to bust putative f reorganizations had nothing to do with preventing tax-free treatment for insubstance asset sales, as did cortland and pinellas, but instead was the courts' attempt to corral a rampant section 368(a)(1)(f), which was unloosed by the service as a weapon against liquidation-reincorporation transactions but before long had turned on its master.88 in 1961, after congress failed to pass legislation curbing tax-free liquidation-reincorporations, the service asserted the f reorganization as a means to attack transactions in which an operating company was liquidated and reincorporated with shareholders receiving cash and/or notes but maintaining the same proportionate equity interests in the new corporation.8 if the form of the transaction was respected, the shareholders could claim capital gain or loss on the liquidation. if the transaction was recast as a reorganization, no loss would be recognized, and the liquidation proceeds were taxable as boot (typically, as a dividend). although an f reorganization must be "a mere change in identity, form or place of organization, '' "° the service's argument that it should also encompass multiple operating company transactions was wildly successful. in davant v. commissioner,9 a group of shareholders with parallel ownership of two operating companies caused one to purchase the assets of the other and then liquidated the transferor. the service argued in the tax court that the transaction was not only a d but also an f reorganization. the service later realized the evils that would result from such a holding and attempted to bag its own errant theory by abandoning the f reorganization argument when it went before the fifth circuit. however, the effort was in vain. all on its own, the court held that the transaction was both a d and an f reorganization.92 almost immediately, taxpayers claimed the spoils of the service's pyrrhic victory in davant. an f reorganization is the only acquisitive transaction that permits the acquiror to carryback a net operating loss from a year after the acquisition to offset income of the target in a preacquisition year.93 thus, if after an f reorganization, the acquiror operates at a loss in a post88. the rise of the f reorganization is recounted in patricia ann metzer, an effective use of plain english-the evolution and impact of section 368(a)(l)(f), 32 tax law. 703 (1979) and richard crawford pugh, the f reorganization: reveille for a sleeping giant? 24 tax l. rev. 437 (1969). 89. see rev. rul. 61-156, 1961-2 c.b. 62. 90. irc § 368(a)(1)(f). 91. 366 f.2d 874 (5th cir. 1966), cert. denied, 386 u.s. 1022 (1967). 92. davant's litigation history is recounted in rev. rul. 69-185, 1969-1 c.b. 108. 93. irc § 381(b) (flush language), (b)(3). also enjoying this benefit is a single corporation undergoing an e-type recapitalization. see irc § 381(a)(2). also, the taxable year does not terminate as a result of an e or f reorganization. [val. 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrine 213 acquisition year, it may use the losses to offset the target's preacquisition income and obtain a refund. if the reorganization is not an f, any tax benefit from the net operating loss might be delayed or lost altogether. now sensitive to the revenue loss that the unleashed f reorganization could wreak on the fisc, the service attempted first to claim the desirable aspects of f reorganizations only for itself, arguing that they should continue to be liquidation-reincorporation busters but denying the loss carryback benefits to taxpayers engaging in multiple operating company acquisitions. these arguments failed to convince the courts.' ultimately, the service conceded universal application of the desirable aspects of f reorganizations, but proposed a narrow interpretation of the definition of an f reorganization. under revenue ruling 75-561,9 the service required for f reorganizations of multiple operating companies that (1) both corporations be engaged in the same or an integrated business, (2) the businesses remain unchanged after the acquisition and, most relevant to this discussion, (3) there must be a "complete identity of shareholders and their proprietary interests in the transferor corporations and acquiring corporations." with that ruling, a "super continuity" requirement for f reorganizations was born. the courts accepted these strictures (with a de minintis exception),96 and they appear to remain the law notwithstanding congress' ultimate (but, alas, probably incomplete) solution to the f reorganization mess: to limit the application of section 368(a)(1)(f) to a single corporation.9 94. see, e.g., rev. rul. 69-185, 1969-1 c.b. 108 (describing the service's litigation position and listing the courts that rejected it). 95. 1975-2 c.b. 129. 96. see, e.g., romy hammes, inc. v. commissioner. 68 t.c. 900 (1977): berger machine products, inc. v. commissioner, 68 t.c. 358 (1977); rev. rul. 78-441. 1978-2 c.b. 152 (permitting an f reorganization with a less than 1% ownership shift). 97. see tax equity and fiscal responsibility act of 1982, pub. l. no. 97-248. § 225(a), 96 stat. 324, 490. with this change, one might hope that f reorganizations, like e recapitalizations, might entirely escape a continuity requirement. see rev. rul. 77415, 1977-2 c.b. 311 (no continuity requirement for recapitalizations, which involve only one corporation). the service seems to be moving slowly towards that conclusion. see rev. rul. 96-29. 1996-24 i.r.b. 5 (stating that the step transaction doctrine is not applied to disqualify an f reorganization that is part of a series of transactions that ultimately results in a change in shareholder ownership). however, at least two factors suggest that the service is unlikely to entirely relinquish its f reorganization continuity requirement. notwithstanding the unambiguous statutory language, the legislative history indicates that congress intended to prohibit only f reorganizations involving multiple operating companies, leaving the door ajar for multicorporate f reorganizations. h.r. rep. no. 760, 97th cong.. 2d sess. 541 (1982). reprinted in 1982 u.s.c.c.a.n. 781, 1315 (stating that the new limitation "does not preclude the use of more than one entity to consummate the transaction provided only one operating company is involved"). moreover, treating all mergers into shell companies as f reorganizations might florida tax review although this f reorganization continuity requirement is lumped together with the requirement of a, b, and c reorganizations, it does not share their common ancestry in cortland and pinellas; instead, it should be regarded as an interpretation of the statutory language that limits f reorganizations to the "mere change in identity, form, or place of organization,' 98 which arguably does not occur when such a change is part of a bigger plan to change stock ownership. nevertheless, it is worth noting that some of the most famous of the continuity cases involve f-reorganizations, and their holdings have been adopted as generally applicable continuity lore.99 b. remote continuity as discussed above in part ii.e, the supreme court held in groman and bashford that, where the consideration consists of stock or securities of two corporations, one of the corporations may be not be a "party to the reorganization," with the result that its consideration is boot. within a few have broader consequences. for example, the forward subsidiary merger of a target company into a newly-formed subsidiary of a corporate parent would be an f reorganization and a sale of stock if the merger failed to qualify under § 368(a)(2)(d) (or as an a, b, or c reorganization), rather than (1) a taxable sale of the target's assets, (2) a contribution by parent of target's assets to the newly-formed subsidiary, and (3) a liquidating distribution by the target of the consideration. cf. revenue ruling 69-6, 1969-1 c.b. 104 (a merger not qualifying as a reorganization is treated as the sale of target's assets and a liquidating distribution of the consideration received). treatment as an f reorganization and a sale of stock would subject the transaction to only a shareholder level of tax, exempting the target from corporate tax. the tax section of the new york state bar association has recommended (as part of the yoc heating report discussed infra part iv.b) that the continuity requirement for f reorganizations be abrogated for the second step of a two-part transaction in which a parent company makes a qualified stock purchase of target and then merges the target into the parent's newly-formed subsidiary. (it would probably exceed the service's good graces to allow target minority shareholders to receive parent stock in the merger.) this recommendation is the sensible result for an innocuous transaction that is consistent with the original purpose of the f reorganization. it recognizes that, after the 1982 amendment, the strict continuity requirement of f reorganizations is no longer necessary to prevent taxpayers from capitalizing on the ability of the acquiror in an f reorganization to carry post-acquisition net operating losses to preacquisition years, and it also highlights that the historical continuity requirement of cortland and pinellas has no application to f reorganizations, which are governed by rules specific to the purpose behind § 368(a)(l)(f). 98. irc § 368(a)(1)(f). 99. see, e.g., yoc heating corp. v. commissioner, 61 t.c. 168 (1973). the yoc heating court was careful to cite only f reorganization cases as authority for its continuity holding, thus retaining (if only theoretically) the distinction between f reorganizations' special continuity requirement and the more generally applicable judicial continuity of interest doctrine. see id. at 178 (citing helvering v. southwest corp., 315 u.s. 194 (1942) and berghash v. commissioner, 43 t.c. 743 (1965), aff'd, 361 f.2d 257 (2d cir. 1966)). [vol 3:5 1996] devolution & inevitable ertinction of mhe continuity of linterest doctrine 215 years, those decisions were expanded beyond situations where the target received consideration from two corporations. for example, in anheuser-busch, inc. v. helvering,"5 ' the target's shareholder received only acquiror stock, but the acquiror subsequently transferred the target's assets to a subsidiary. the court held that the parent stock was "other property" received in a reorganization. this holding was not a necessary consequence of groman and bashford. the anheuser-busch court could certainly have concluded that where the consideration consists of stock or securities of one corporation, that party is the true acquiror, and any subsequent transfer is independent of the reorganization. nevertheless, anheuser-busch is not inconsistent with a reading of bashford that determines the true acquiror by following target's assets and therefore denies "party" status to the parent of an ultimate operating company. and, anheuser-busch remained true to the basic issue in groman and bashford: was the putative acquiror a party to the reorganization, or should its stock or securities be treated as "'other property" (boot)? the transaction in anheuser-busch was recharacterized as a tax-free reorganization of target into subsidiary in which target's shareholder received "other property." this holding confirms that the parent's stock supplied the requisite continuity, even though it was not stock of a party to the reorganization. had the transaction failed continuity, it would not have been a reorganization, and the parent stock received by target's shareholder would have been sales proceeds and not "other property." the service no longer treats groman and bashford as "party" cases that cause certain consideration to be treated as "other property," but instead as the foundations of a "remote continuity" doctrine that entirely disqualifies a reorganization (including a statutory merger) if the target's assets are separated from the acquiror's consideration by an intervening impermissible entity. "' presumably, the theory behind this view is that continuity requires that a quantum of the consideration must consist of stock of the true acquiror, and if all of the consideration received by target shareholders is stock of a nonparty, none of the consideration counts for continuity purposes. however, this interpretation is entirely inconsistent with the groman, bashford, and anheuser-busch decisions, which all acknowledge that the acquisitions 100. 115 f.2d 662 (8th cir. 1940). 101. see, e.g., g.c.m. 35117 (nov. 15, 1972) ("the transaction will not qualify as a tax-free reorganization under code § 368(a)(1)(a) ... unless s is a 'party to the reorganization' .... "); g.c.m. 35486 (sept. 20. 1973) ("the term 'continuity of interest' has come to be employed by the courts, the service. and the commentators as a reference to the various litmus-like qualifications imposed on tax-free reorganizations."): g.c.m. 39150 (mar. 1, 1984). see also ginsburg & levin. supra note 1. §§ 610.11.1. 610.11.2, at 630-37. florida tax review considered in those cases qualified as reorganizations.102 this interpretation is also inconsistent with the original purpose of the continuity of interest doctrine to distinguish merger-like asset acquisitions from sales, based on the nature of the consideration. anheuser-busch, in particular, could certainly have been accomplished as a state law merger solely for acquiror stock, followed by the drop down, without invoking the concern in pinellas and cortland that the target (or even its shareholders) get cashed out. and, while early merger statutes did not permit third-party consideration, there is no suggestion that the form in bashford would not have been respected as a valid state law merger. in any event, some liberal merger statutes that were in place by 1934 expressly permitted stock or securities of a subsidiary or parent of the acquiror to serve as consideration. moreover, there is nothing inconsistent with the parent's stock providing sufficient equity interest to satisfy the continuity doctrine, but at the same time not being stock of a party to the reorganization. 0 3 cortland and pinellas were concerned with the treatment of a target that received cash equivalents in a putative reorganization; le tulle further required that the target receive consideration assuring some continued participation in target's former business. the anheuser-busch transaction satisfied that test. although the target's shareholder received equity in a holding company, the economic effect was no different than had an operating acquiror obtained target's assets directly. the distinction between groman and bashford as "party" cases or as establishing a remote continuity doctrine is subtle but important. consider the alternative consequences to the target in a transaction in which the target merges into a second-tier subsidiary of the acquiror, and the target shareholders' consideration consists 10% of the second-tier subsidiary's stock and 90% of grandparent stock.'°4 if groman and bashford are about continuity of interest, a finding of "discontinuity" would cause a transaction that otherwise qualifies as a reorganization to be a taxable sale. the second-tier 102. see, e.g., anheuser-busch, 115 f.2d at 666 ("the board concluded ... 'the subsidiary and not the parent was a party to the reorganization.' we agree with the board's conclusion"). 103. an analogous issue is likely to arise if the clinton administration's current proposal to treat certain preferred stock as boot becomes law. under nelson, preferred stock is good consideration for continuity purposes, but under the administration's proposal, it would be boot. for the reasons discussed in the text, there is nothing inconsistent with this result. 104. cf. g.c.m. 39150 (mar. 1, 1984) (dropping less than all of target's assets into a partnership owned 99% by acquiror may defeat reorganization status, depending on facts and circumstances). it is important that target shareholders receive some stock or securities of a party to the reorganization in order to fit within the statutory requirements of § 361(a) and (b). [val 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrine 217 subsidiary would not accede to target's tax attributes or its asset bases; the target would recognize gain or loss equal to the difference between the value of its assets and their bases; and the acquiror's consideration (second-tier subsidiary and grandparent stock) would be received by the target's shareholders in liquidation of the target. if, on the other hand, gronan and bashford are "other property" cases, the transaction would be a reorganization, and the second-tier subsidiary would take the target's attributes (including its net operating losses) and asset bases (increased by any gain recognized by the target); if the target distributes all of the consideration to its shareholders, it would recognize no gain or loss, and its shareholders would recognize gain (but not loss) only to the extent of the "other property" (grandparent stock).05 the service's dogmatic adherence to remote continuity is perhaps best revealed in its approach to partnership drop-downs. the service treats a drop-down of the target's assets to a 99%-owned partnership as an action that breaks the continuity of a contemporaneous merger, notwithstanding the legislative repeal of gromnan and bashford discussed below in part iv.a." dropping fewer than all of the target's assets into a 99%-owned general partnership makes or breaks continuity, based on a "facts and circumstances" test.107 this position renders the reorganization provisions of the code almost entirely elective for intra-group transactions (subject perhaps to the partnership anti-abuse regulations),1rs a conclusion confirmed by the service's enforcement of the remote continuity doctrine even for reorganizations among wholly-owned entities of a single corporate parent.t moreover, it appears that the service continues to insist that grandparent stock may not be used as consideration in a statutory merger, but that 105. see irc § 361(b) (no gain or loss to target on the exchange): § 361(c) (target recognizes gain with respect to appreciated property that is distributed): § 354(a) (target shareholders do not recognize gain or loss with respect to acquiror stock): § 356(a), (c) (target shareholders recognize gain, but not loss, with respect to parent stock); § 362(b) (basis to acquiror). 106. see g.c.m. 39150 (mar. 1, 1984); g.c.m. 35117 (nov. 15. 1972). see generally alfred d. youngwood & deborah b. weiss, partners and partnerships-aggregate vs. entity outside of subchapter k, 48 tax law., 39, 57-60 (1994). a service official recently stated that g.c.m. 39150 and 35177 are under reconsideration. see juliann avakian martin, irs considers guidance on post reorganization sales and continuity of interest, 96 tnt 55-9 (mar. 19, 1996) (lexis, fedtax library, tnt file) (quoting nelson f. crouch, chief of branch 1: "the gcms are out there... and we don't like them anymore"). 107. g.c.m. 39150 (mar. 1, 1984). 108. regs. § 1.702-1. 109. see g.c.m. 39150 (mar. 1, 1984) (discussing continuity in the context of a partnership whose partners are the corporate subsidiaries of a single parent). florida tax review sections 368(a)(2)(c) and 368(a)(2)(d) can be used concurrently to achieve tax-free treatment." 10 in addition, the service regards pre-transaction drop-downs by a target as analytically indistinguishable from the post-transaction drop-down at issue in anheuser-busch. arguably, pre-transaction drop-downs are a step removed from anheuser-busch, and two steps away from bashford, because there is no doubt that the acquiror is the true acquiror and not a broker for its subsidiary, as the court found in bashford. however, if one accepts the anheuser-busch expansion of groman-bashford, treating parent stock as other property in a post-reorganization drop-down of the target's assets to a subsidiary, there is some merit to the service's conclusion that the same result should obtain in a pre-transaction drop-down. as a conceptual matter, however, in keeping with gromnan and bashford, the issue should be whether the target or target's partnership is the true "party to the reorganization," and not whether the transaction lacks continuity. 1' the original continuity of interest doctrine, as expressed in pinellas and cortland, is singularly concerned with the nature of the consideration and not with its spacial relationship to target's assets. c. post-reorganization target shareholder conduct perhaps the most significant expansion of the continuity of interest doctrine is its use to disqualify a reorganization based on target shareholders' intent and subsequent conduct. heintz v. commissioner' 2 was apparently the earliest decision to take this uneasy step, and the principle was firmly 110. see, e.g., rev. rul. 74-564, 1974-2 c.b. 124 (use of grandparent stock does not qualify under § 368(a)(2)(e); transaction nevertheless qualifies as a b reorganization); rev. rul. 74-565, 1974-2 c.b. 125 (same). see generally james a. nitsche, asset remoteness problems persist in affiliated group acquisitive reorganizations, 83 j. tax'n 94 (1995); robert a. rizzi, continuity of interest and reorganizations: toward a unified theory, 17 j. corp. tax'n 362, 366-68 (1991). thus, apparently, a direct merger of the target into a secondtier subsidiary for grandparent stock may be taxable, but a merger of the target into a first-tier subsidiary for parent stock, followed by a drop-down of target assets into a second-tier subsidiary, is generally tax-free. see, e.g., rev. rul. 64-73, 1964-1 c.b. 142. cf. rev. rul. 83-34, 1983-1 c.b. 79 (successive § 351 drop-downs are permissible); rev. rul. 77-449, 19772 c.b. 110 (same). 111. in commissioner v. first nat'l bank, 104 f.2d 865 (3d cir. 1939), the target transferred 86% of its assets to a newly-formed acquiror in exchange for acquiror stock and, pursuant to a plan, transferred that acquiror stock to the shareholders of acquiror's parent corporation for parent stock. the court held that the target had engaged in a reorganization but, under groman and bashford, the parent was not a party to that reorganization and was subject to tax. see ballwood co. v. commissioner, 84 f.2d 733 (3d cir. 1936) (predating groman and bashford); electrical sec. corp. v. commissioner, 92 f.2d 593 (2d cir. 1937) (predating groman and bashford). 112. 25 t.c. 132 (1955). [vol 3:5 1996] devolution & inevitable ertinction of the continuirv of interest doctrine 219 planted in mcdonald's restaurants of illinois r. commissioner."' heintz and mcdonald's involved similar facts: target shareholders, desiring cash for their shares, accepted acquiror stock on the condition that the acquiror assist them in selling the stock to unrelated investors shortly thereafter." 4 the taxpayers in each case drew the continuity sword and argued that the side agreement severed continuity and caused the transaction to be a taxable sale."15 in each case, the taxpayers prevailed."' these "shareholder conduct" cases are expansions-rather than necessary consequences-of the original continuity cases, for several reasons. first, the analysis in the original decisions was directed solely at the corporate level, and examined only the nature of the consideration given by the acquiror in order to determine whether the transaction was more like a merger or a sale. in heintz and mcdonald's, the inquiry was focused at the shareholder level, and continuity was found lacking even though the target and its shareholders indisputably received acquiror stock in form and in substance. target shareholders were under no compulsion to sell the acquiror's stock, they bore the risk of market fluctuations in the price of the stock, and there was no assertion that the stock should not be treated as equity for federal income tax purposes as a result of the side agreement between target shareholders and the acquiror. 17 thus, the acquiror's stock quite clearly conferred, first in the 113. 688 f.2d 520 (7th cir. 1982), rev'g mcdonald's of zion v. commissioner. 76 t.c. 972 (1981). 114. in heintz, the transactions were structured as a stock exchange follow ed immediately by a liquidation of the subsidiary: in mcdonahl's. the target merged into the acquiror under a state statute. 115. in heintz, target shareholders argued for sale treatment to recognize capital gains rather than ordinary "boot" income. in mcdonald's, the acquiror sought sale treatment to achieve a stepped-up basis in the target's assets. 116. in contrast, in united states v. adkins-phelps. inc., 400 f.2d 737 t8th cir. 1968), the acquiror prevailed in asserting that a statutory merger was a reorganization. notwithstanding the agreement of the target's sole shareholder not to sell acquiror stock without offering it first to the acquiror at par value and the subsequent sale of acquiror stock back to acquiror at par. to similar effect are commissioner v. fifth ave. bank of new york. 84 f.2d 787 (3d cir. 1936) (an option exercised by 99% of target shareholders to sell their acquiror stock for cash to acquiror's subsidiary did not defeat continuity); daisy m. ward v. commissioner, 29 b.t.a. 1251 (1934), nonacq. 1934-1 c.b. 31. aff'd sub nom helvering v. ward, 79 f.2d 381 (8th cir. 1935) (where target shareholders had. and exercised, an option to resell their acquiror stock back to acquiror. reorganization respected as separate from salej. 117. compare farr v. commissioner, 24 t.c. 350 (1955, where the court found continuity to be met in a split-off under § 112(g)l1)td) (1939). even though its purpose was to permit sale of distributing company stock to a third party (which was accomplished). the court stressed that "petitioner remained free to retain her entire interest in [the distributing company], [the buyer] was under no obligation to purchase any interest, and the petitioner alone had the risks and the benefits of [the distributing company'sl continuing operations." farr, 24 t.c. at 367. florida tax review target and then in its shareholders, a "proprietary stake" in the acquiror that was "definite and material,"'" 8 and certainly exceeded the equity risk that is sufficient to establish continuity under established case law." 9 second, in contrast to the historical continuity cases, the cash ultimately received by target shareholders in heintz and mcdonald's came not from the acquiror, but from unrelated secondary purchasers of target shareholders' acquiror stock. unless these public shareholders are treated as the true acquirors of the target's assets, which is difficult to understand given the interposition of the acquiror, these shareholder conduct cases are clearly distinguishable from the asset sales in pinellas and cortland. in addition, since target shareholders bore the risk of market fluctuations in the value of the acquiror stock, the transaction was economically dissimilar from a direct sale of target stock for a cash equivalent. 2 the fact that the historic roles of the litigants were reversed (taxpayers were asserting the absence of continuity) should have alerted the courts to the possibility that something was essentially different about these cases. suddenly, the parties to a transaction that satisfied the statutory elements of a reorganization could, through side agreements, escape the package of beneficial and adverse tax consequences accompanying that characterization. continuity was now the taxpayer's weapon. finally, the shareholder conduct cases introduced a cloak of uncertainty to the reorganizations area by hinging momentous tax consequences not simply on the nature of acquiror's consideration provided to target, but on the post-acquisition conduct of a critical mass of unrelated target shareholders. the result is uncertainty for taxpayers and unadministrability for the service. the courts should have immediately recognized the unworkable nature of the test they were creating. these shareholder conduct cases are better explained as a corollary of the step transaction doctrine that permits interdependent events to be 118. helvering v. minnesota tea co., 296 u.s. 378 (1935). 119. see, e.g., john a. nelson co. v. helvering, 296 u.s. 374 (1935) (preferred stock redeemable at stated intervals was sufficient to establish continuity); united states v. adkins-phelps, inc., 400 f.2d 737 (8th cir. 1968) (where acquiror had right of first refusal to purchase its shares at par from target shareholder, continuity satisfied); schweitzer & conrad, inc. v. commissioner, 41 b.t.a. 533 (1940) (nonconvertible nonvoting preferred stock, redeemable at any time and mandatorily redeemable after six months if earnings exceeded specific threshold, was sufficient equity stake for continuity purposes). see also rev. rul. 6822, 1968-1 c.b. 142 (preferred stock, redeemable at 10% per year after one year, is sufficient equity consideration if acquiror has no present intention to redeem). 120. see mcdonald's of zion v. commissioner, 76 t.c. 972, 997 n.43 (1981) (the market price of mcdonald's stock on receipt was $66-3/8 per share; the stock was sold for $71-318); heintz v. commissioner, 25 t.c. 132, 139 (1955) (acquiror stock was worth $50 when received but was sold for $30). [vol. 3:5 1996] devolution & inevitable ertinction of the continuity of interest doctrine 221 integrated and, in certain circumstances, permits taxpayers to disavow their form if the tax treatment of the entire transaction is consistently reported." in any event, it is important that these cases involved a concerted plan between the target shareholders and the acquiror. revenue procedure 77-37,'2which lists the representations necessary to obtain a private letter ruling, in effect offers a continuity safe harbor on the issue of extracurricular intent and conduct if the target's 1% (or for publicly-traded targets 5%) shareholders represent to the acquiror their plan and intention to retain acquiror stock representing at least 50% of the value of the target's outstanding stock immediately before the transaction. (the target's management must also represent that it knows of no plan or intention on the part of the remaining target shareholders to dispose of acquiror stock in excess of the 50% threshold.) revenue ruling 66-23' concludes that a five-year holding period of unrestricted rights of ownership should "ordinarily" suffice. however, taxpayers that drift (intentionally or inadvertently) from these quantitative and temporal havens risk dangerously dark and murky waters. commentators assert that the service could bust an otherwise valid reorganization for all of the parties if a sufficiently large shareholder engages in a short-sale-against-the-box with respect to acquiror stock,'24 even though 121. see generally penrod v. commissioner, 88 t.c. 1415, 1428 (1987) ("the resolution of this issue turns on the application of the so-called step transaction doctrine." explaining heintz and mcdonald's on that ground and finding continuity to be present despite sale of acquiror's stock with acquiror's assistance): estate of christian v. commissioner, 57 t.c. memo (cch) 1231, 1239, t.c. memo (p-h) 89,413 at 89-2014 (1989) (same). see also ericsson screw machine products co. v. commissioner. 14 t.c. 757 (1950). severe restrictions on taxpayers' ability to invoke the step transaction doctrine are noted in pittsburgh realty inv. trust v. commissioner, 67 t.c. 260, 274-78 (1976). see also estate of durkin v. commissioner, 99 t.c. 561 (1992). see generally ginsburg & levin, supra note 1, § 608 at 536-56. 122. 1977-2 c.b. 568, as modified by rev. proc. 86-42, 1986-2 c.b. 722. 123. 1966-1 c.b. 67; see also rev. rul. 78-142, 1978-1 c.b. i11. 124. see ginsburg & levin, supra note 1. § 610.6.3 at 599-600. this issue has sparked the passion of tax practitioners on both sides. see robert willens & andrea j. phillips, do equity swaps affect satisfaction of continuity of interest? 95 tnt 132-28 (lexis, fedtax library, tnt file) (answer "no" for short-sales-against-the-box and equity swaps); jared m. rusman, equity swaps and post-transaction continuity of interest, 96 tnt 128-110 (lexis, fedtax library, tnt file) ("serious risk" that an equity swap or shortagainst-the-box could break continuity); robert willens & andrea j. phillips. continued interest in the continuity of interest debate, 96 tnt 137-88 (lexis, fedtax library. tnt file) ("vigorously contest[ing] several of mr. rusman's assertions" and "eagerly await[ing mr. rusman's response, should he choose to submit one"). mr. rusman has of yet not answered the challenge. florida tax review such a shareholder could truthfully make the representation required by revenue procedure 77-37.'25 d. double duty-application of the continuity of interest doctrine to integrated asset purchases continuity was expanded to a fourth category of cases involving integrated transactions in which an acquiror purchased stock but took additional steps in order to treat the transaction as an asset sale. although the continuity doctrine provided a convenient basis to permit the stock sale to be treated as an asset sale, its invocation in these cases led to a great deal of confusion. in a line of cases beginning before pinellas, courts unanimously held that where a taxpayer expresses an unambiguous intention to purchase the assets of an incorporated company but for various business reasons is able to accomplish the asset purchase only by purchasing the company's stock and dissolving the corporation, the acquiror would be permitted (and, in fact, required) to treat the stock purchase and subsequent dissolution as a single integrated transaction for which the acquiror obtains a cost-rather than a carryover-basis in the target's assets.1 6 the cases applied this "integrated transaction doctrine" whether the target was dissolved (1) by upstream merger with127 or liquidation into 128 the acquiror, (2) pursuant to a merger of the 125. in a short-sale-against-the-box, the shareholder retains the acquiror stock but borrows other acquiror stock and sells it into the market. since the shareholder does not dispose of the acquiror stock received in the acquisition, the representation is not breached. 126. see, e.g., security indus. ins. co. v. united states, 702 f.2d 1234 (5th cir. 1983); american potash & chem. corp. v. united states, 399 f.2d 194 (ct. cl. 1968); united states v. m.o.j. corp., 274 f.2d 713 (5th cir. 1960); cannonburg skiing corp. v. commissioner, 51 t.c. memo (cch) 844, t.c. memo (p-h) 86,150 (1986), aff'd sub nom. russell v. commissioner, 832 f.2d 349 (6th cir. 1987); estate of mcwhorter v. commissioner, 69 t.c. 650 (1978), affd without written opinion, 590 f.2d 340 (8th cir. 1978); yoc heating corp. v. commissioner, 61 t.c. 168 (1973); long island water corp. v. commissioner, 36 t.c. 377 (1961); southwell combing co. v. commissioner, 30 t.c. 487 (1958); american wire fabrics corp. v. commissioner, 16 t.c. 607 (1951); kimbell-diamond milling co. v. commissioner, 14 t.c. 74 (1950), aff'd per curiam, 187 f.2d 718 (5th cir.), cert. denied, 342 u.s. 827 (1951); schumacher wall board corp. v. commissioner, 33 b.t.a. 1211 (1936); warner co. v. commissioner, 26 b.t.a. 1225 (1932). 127. cannonburg skiing corp. v. commissioner, 51 t.c. memo (cch) 844, t.c. memo (p-h) 86,150 (1986), aff d sub nom. russell v. commissioner, 832 f.2d 349 (6th cir. 1987); estate of mcwhorter v. commissioner, 69 t.c. 650 (1978), aff'd without written opinion, 590 f.2d 340 (8th cir. 1978). see also kass v. commissioner, 60 t.c. 218 (1973). 128. see, e.g., security indus. ins. co. v. united states, 702 f.2d 1234 (5th cir. 1983); united states v. m.o.j. corp., 274 f.2d 713 (5th cir. 1960); commissioner v. ashland oil & ref. co.. 99 f.2d 588 (6th cir. 1938); southwell combing co. v. commissioner, 30 t.c. 487 (1958); koppers coal co. v. commissioner, 6 t.c. 1209 (1946); warner co. v. commissioner, 26 b.t.a. 1225 (1932). [vol. 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrine 223 target into the acquiror's subsidiary, -'2 or (3) following an asset transfer by the target to the acquiror's subsidiary." as discussed below, these decisions were partially codified, first in 1954 and then in 1982 under current section 338. despite the uniform holdings of these cases, their legal bases varied depending upon the method that the taxpayer used to dissolve the target. prior to 1936, the courts could respect each independent step of the transaction because the target's liquidation was a taxable event to its shareholders and therefore gave the acquiror a stepped-up basis in the target's assets."' after the enactment of section 112(b)(6) of the revenue act of 1936, which provided for tax-free liquidations with substituted basis, the liquidation of the target into a corporate acquiror following a stock purchase did not provide the acquiror with a stepped-up basis under the statute. instead, courts permitted stepped-up bases by applying the common law principle of substance over form to disregard the transitory ownership of target stock and treat the stock purchase and liquidation as a single asset purchase by the acquiror under an integrated transaction doctrine. 32 if the acquiring company purchased target stock and the acquiror then either merged the target into (or caused it to transfer its assets to) a new or existing subsidiary, the continuity of interest doctrine was added to and combined with the integrated transaction doctrine as an additional pillar of support against the service's assertion that the merger was a tax-free reorganization giving rise to a carryover basis.' since continuity was originally designed to deny corporate targets reorganization treatment on sales of their assets for cash or short-term notes, it was serving double duty as a 129. superior coach of florida. inc. v. commissioner, 80 t.c. 895 (1983); long island water corp. v. commissioner, 36 t.c. 377 (1961). in superior coach, the acquirors were individual majority shareholders of an existing corporation who purchased target stock and caused the target to merge into their existing corporation, with former target shareholders receiving stock of their corporation. in long island water, target shares were purchased by a parent company and contributed to a newly-formed subsidiary, and the target was then merged upstream into the subsidiary. 130. yoc heating corp. v. commissioner. 61 t.c. 168 (1973) finvoling an asset transfer); american wire fabrics corp. v. commissioner, 16 t.c. 607 (1951): schumacher wall board corp. v. commissioner, 33 b.t.a. 1211 (1936). 131. see, e.g., commissioner v. ashland oil & ref. co.. 99 f.2d 588, 591 (6th cir. 1938); koppers coal co. v. commissioner, 6 t.c. 1209, 1221 (1946). 132. see koppers coal co., 6 t.c. 1209 (1946). in kimbell-diamond milling v. commissioner, 14 t.c. 74 (1950), aff'd per curiam, 187 f.2d 718 (5th cir.). cert. denied, 342 u.s. 827 (1951), where the target's assets had a higher basis than the price paid for target stock, it was the service, not the taxpayer, that argued for integrated transaction treatment. 133. prairie oil & gas co. v. motter. 66 f.2d 309. 311 00th cir. 1933); yo heating corp. v. commissioner, 61 t.c. 168. 171 (1973): carter publications. inc. v. commissioner, 28 b.t.a. 160, 164 (1933). florida tax review basis for permitting taxpayers to treat an integrated stock purchase and merger as an asset purchase. this doctrinal expansion produced no distortions when the sole issue was whether the acquiror obtained a cost basis in the transferred assets. however, the continuity of interest doctrine was far too blunt an instrument to provide the correct answer when it was applied to the target in these cases. under the law after 1936 and before 1954, if a purchase of target stock and the target's subsequent merger into the acquiror was treated under the integrated transaction doctrine as a liquidation of the target and the sale of its assets by target shareholders to the acquiror, the target was not affected by the recharacterization. under the statutes then in effect, a corporation generally recognized no gain or loss on distributing its assets in liquidation, and the cumberland case"3 permitted this rule to apply if the shareholders had first unsuccessfully attempted to sell their stock to the acquiror and then liquidated target and sold its assets. 35 the cumberland holding certainly appears to have applied to a stock sale by target shareholders, followed by a merger of the target into the acquiror or acquiror's subsidiary, if the transactions were recharacterized under the integrated transaction doctrine as a liquidation of the target followed by an asset sale by target shareholders. however, since a failure of continuity historically resulted in the target being treated as selling its assets to the acquiror, the logical extension of applying the continuity of interest doctrine to these cases appears to be a corporatelevel tax on the target-a result entirely ignored by the courts that applied the doctrine to taxable years between 1936 and 1954. 36 this suggests either that the continuity doctrine cited as a rationale for these cases was no longer the doctrine of cortland and pinellas, or else that courts were applying an integrated transaction doctrine, and not continuity. this distinction remains important under current law. example. target is a wholly-owned subsidiary of a corporate seller, and the two corporations file a consolidated return. acquiror 134. united states v. cumberland pub. serv. co., 338 u.s. 451 (1950). 135. see generally bittker & eustice, supra note 5, 10.05[5] at 10-31 to 10-34 and 9110.41, at 10-84 to 10-89. section 337 extended nonrecognition treatment to targets that sold their assets in the 12-month period prior to liquidation. 136. see commissioner v. ashland oil & r. co., 99 f.2d 588, 593 (6th cir. 1938) (hamilton, j., dissenting on grounds that target should be subject to tax on deemed asset sale). cf. carter publications inc. v. commissioner, 28 b.t.a. 160 (1933) (taxing the target on deemed asset sale under continuity of interest theory, as applied to tax year before 1936). between 1954 and 1987, this result was codified in § 334(b)(2), which gave the acquiror a stepped-up basis in target's assets without subjecting the target to tax on any appreciation in the value of its assets. see infra note 156 and accompanying text. [vol 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrine 225 purchases 79% of target's stock 137 from seller for cash and, as part of an integrated transaction, merges target upstream into acquiror, with seller receiving acquiror stock for the remaining 21% of target's stocks. if the integrated transaction doctrine is applied, target is treated as first having liquidated tax-free into seller, 3 and seller is treated as selling target's assets to acquiror. seller recognizes gain or loss equal to the difference between the value of the consideration received and target's basis in its assets, and acquiror holds target's assets with a cost basis. continuity has no place in this analysis because the merger is disregarded and the liquidation is deemed to occur prior to the asset transfer. on the other hand, if the continuity of interest doctrine is applied, target recognizes gain on either of two theories. first, the stock purchase by acquiror could be respected, but if so, the upstream merger of target into acquiror fails continuity because acquiror is not target's historic shareholder.139 under this analysis, seller has gain or loss equal to the difference between the value of the consideration received and its basis in the target stock, and, after being deconsolidated from seller, target is treated as making a taxable sale of its assets to acquiror in the upstream merger.1' ° alternatively, the stock purchase by acquiror could be ignored, and target could be viewed as merging directly into acquiror, with seller receiving acquiror stock and cash.' the 21% equity consideration received by seller is insufficient to satisfy traditional tests of continuity. acquiror obtains a stepped-up basis under either theory, but, under the second, target's gain or loss occurs while it is still a member of seller's consolidated group.4 2 137. this percentage is important because it bypasses the statutory result imposed by § 338 that is discussed infra part iv.b. 138. irc § 332. seller acquires target's assets with a carryover basis. see irc § 334. 139. this was the apparent rationale of kass and superior coach. see superior coach of florida v. commissioner, 80 t.c. 895, 906-07 (1983); kass v. commissioner, 60 t.c. 218, 222-23 (1973). 140. whether target's gain or loss is properly includible in seller's or acquiror's consolidated return is another matter. see regs. § 1.1502-76(b)(l)(ii)(b)(4) (providing an exception to next-day rule for prearranged transactions) and (b)(2)(ii)(c) (providing an exception to ratable allocation rule for items that result in substantial distortion). 141. king enterprises, inc. v. united states, 418 f.2d 511 (ct. cl. 1969) (applying this analysis to treat as an a reorganization the upstream merger of target into acquiror following acquiror's purchase of target stock for consideration consisting 51% of acquiror stock). 142. other uncertainties exist. if the first continuity analysis described in the text were applied literally, it would deny reorganization treatment on the second step merger even if the stock purchase was entirely for acquiror stock. florida tax review under either theory, the transaction is taxable to a minority shareholder of target. regardless of whether the transaction is viewed as a liquidation followed by an asset sale, or as a stock sale followed by a busted reorganization (a taxable asset sale) and then a liquidation of target, the minority shareholder is subject to tax. it was more or less the second theory that the tax court used in kass v. commissioner143 as its basis for taxing one of target's minority shareholders on her receipt of acquiror stock.'" thus, although courts in these integrated transaction cases often appended the continuity doctrine as an alternate basis to find that an otherwise valid reorganization could be combined with an antecedent stock purchase and treated as a single asset purchase, the expansion of the continuity doctrine to reach this result only muddled the law. moreover, these aspects of the integrated transaction doctrine (and its interaction with continuity) have been further complicated by the enactment of section 338, the repeal of general utilities, and certain recently promulgated regulations which would significantly limit-but not eliminate-the application of continuity to many integrated transactions. these developments are discussed below in part iv.b. e. the specter of historic shareholder continuity lurking behind the integrated transaction cases is the possibility, suggested by the service and commentators, that those cases may not be limited to an acquiror's concerted effort to purchase a target's assets. instead, the cases might establish the continuity of interest doctrine as requiring a continuous thread of ownership linking the target's shareholders before the from time to time, courts have suggested that the first analysis is proper. see russell v. commissioner, 832 f.2d 349 (6th cir. 1987); kass v. commissioner, 60 t.c. 218 (1973), aff'd without published opinion, 491 f.2d 749 (3d cir. 1974). however, when push has come to shove, and the issue is squarely presented, the second analysis has been adopted (albeit not expressly). see king enterprises v. united states, 418 f.2d 511 (ct. cl. 1969). 143. 60 t.c. 218 (1973), aff'd without opinion, 491 f.2d 749 (3d cir. 1974). see also russell v. commissioner, 832 f.2d 349 (6th cir. 1987). 144. in kass, the acquiror first purchased more than 80% of the target's stock for cash and then merged the target upstream into the acquiror, with minority shareholders who had retained their target stock (including the taxpayer) receiving acquiror stock in exchange for their former target stock. the court held that because the acquiror had purchased the target's stock as part of a plan to absorb the target by merger, the acquiror could not be treated as one of the target's historic shareholders for continuity purposes. accordingly, the merger failed to qualify as a reorganization, and the target's minority shareholders recognized gain or loss on their exchange of target stock for acquiror stock. the kass transaction arose after the enactment of § 334(b)(2) of the 1954 code, but it appears that the court's conclusions are applicable to transactions before 1954. the status of kass after the enactment of § 338 is discussed below in part iv.b. [vol. 3:5 1996] devolution & inevitable ertinction of the continuity of interest doctrine 227 acquisition to the combined corporation's shareholders afterwards. under this view, if a sufficient number of target shareholders sell their stock in the dawn before an acquisition, the continuity fiber could snap. the nightmarish consequences of such a rule, if applied rigorously to a publicly held target, would be that even unsuspecting target shareholders could blow a reorganization (for all parties) by selling too many of their shares during the prelude to a proposed acquisition, regardless of whether the other parties to the transaction assisted or were even aware of the sales. these fears are fanned by revenue procedure 77-37,4 which states the conditions for private letter rulings confirming the tax-free status of acquisitions. it requires a representation that the target's 1% shareholders (5% shareholders for public targets) intend to retain acquiror stock representing at least 50% of the value of the target's outstanding stock immediately before the transaction and a representation that the target's management has no contrary knowledge with respect to the rest of the shares. target stock sold, redeemed, or otherwise disposed of "prior to" the transaction is taken into account in applying the 50% test. thus, revenue procedure 77-37 suggests that the service might view continuity as threatened even in the absence of directed efforts by the acquiror to purchase target's stock for cash. anxiety is heightened by an example in regulations under section 355 that finds continuity to be lacking where, pursuant to a plan, a 50% shareholder of a distributing company sells its stock and the company then splits-off its subsidiary to the other 50% "historic" shareholder."' the example concludes that continuity is lacking because the distributing corporation's historic shareholders retain none of its stock (one selling out before the split-off and the other exchanging distributing corporation stock for stock of the controlled subsidiary). the example appears to confirm that preacquisition conduct of the target's shareholders is relevant to continuity analysis. indeed, it does not take a particularly vivid imagination to portend from these authorities a grand scheme of continuity reflecting a triple expansion of the post-acquisition shareholder conduct cases. first, heintz and mcdonald's would apply regardless of whether other parties to the transaction actively assist the target shareholders' sales; second, heintz and mcdonald's would apply to the sale of target stock prior to the acquisition; and third, these cases could be asserted by the service, not just by taxpayers. under this alternative reality, the essence of continuity would be the relationship of historic shareholders to each other, and a substantial shift in that relationship would affect all parties. 145. 1977-2 c.b. 568. 146. regs. § 1.355-2(c)(2) ex. 3. florida tax review some of these doomsday apprehensions were at least temporarily consoled by the tax court's recent opinion in j.e. seagram corp. v. commissioner.147 in seagram, conoco, a public company, was the subject of two competing tender offers by seagram and a dupont subsidiary. seagram, which succeeded in acquiring only 32% of the target in its tender offer, conceded defeat to the dupont subsidiary, which had acquired 46% of conoco's stock. seagram, along with other target shareholders owning in the aggregate some 16% of the target, tendered its shares for dupont stock that was worth substantially less than the price paid by seagram in its tender offer. subsequently, conoco was merged into the victorious dupont subsidiary, with shareholders holding the remaining 6% of conoco's stock being squeezed out for dupont stock. it was not the service that sought to realize practitioners' worst fears by taxing the target and its former shareholders. instead, it was seagram, the defeated bidder, that shot a newly whittled continuity arrow with hopes of killing the reorganization. seagram had paid dearly for the target stock acquired for cash in its own tender offer and sought to recognize loss on its exchange for dupont stock. it argued that its recent cash purchase, although unassisted by the target (and vehemently opposed by the ultimate acquiror), nevertheless disqualified it as a historic shareholder. and, since the dupont subsidiary purchased 46% of conoco's stock for cash, that left a mere 22% (100% less dupont's 46% acquired for cash and seagram's 32%) of conoco's historic shareholders who could be said to have received dupont stock. this amount, seagram claimed, was insufficient to establish continuity. the court dismissed this argument and validated the reorganization in an opinion that faced practitioners' fears directly. it acknowledged that seagram's position could cast a long shadow on acquisitions of public companies by conditioning reorganization status on the independent actions of numerous target shareholders. more importantly, the court returned the continuity of interest doctrine a step closer to its historical roots. continuity depends, the court held, solely on the nature and amount of the acquiror's consideration. since dupont's subsidiary obtained a majority of conoco's stock for stock of dupont, continuity was maintained. this holding at once captures the essence of cortland and pinellas, which distinguished taxable sales of target assets from tax-free reorganizations based on the nature and amount of the acquirors' consideration, and rebukes the suggestion that the shareholder conduct cases of heintz and mcdonald's and the integrated transaction decisions are relevant as continuity 147. 104 t.c. 75 (1995). the case is discussed in ginsburg & levin, supra note 1, § 610.10 at 627-30; jasper l. cummins, jr., seagram files brief with second circuit, 69 tax notes 223 (oct. 9, 1995). [vol 3:5 1996] devolution & inevitable extinction of the continuit. of interest doctrine 229 of interest precedents. instead, these decisions should be viewed as extensions of the step-transaction doctrine, which permits several steps of a single transaction to be treated as one if all of the parties cooperated to achieve a particular result. equally important, the seagram decision offers taxpayers and the service alike stability and administrability. under the decision, the characterization of a transaction as a reorganization or a taxable sale may be determined definitively at the moment of the acquisition, based on the objective nature of acquiror's consideration. the seagram opinion has been criticized, largely on two grounds.' first, commentators have dismissed as "misplaced" the court's concern about the ability of public targets to engage in tax-free reorganizations without tracking large volumes of pre-acquisition trading in target stock. under their view, revenue procedure 77-37 which, for purposes of the representations necessary to obtain a favorable ruling, treats less-than-5% shareholders as historic, should have allayed the court's fears. this view raises two preliminary questions. first, should the representations required to obtain a private letter ruling preclude the service from proceeding against taxpayers that fail to obtain a ruling? second, is the 50% threshold of revenue procedure 77-37-which quite clearly is higher than the case law establishes' 49-a hindrance to tax-free acquisitions of public targets? even conceding affirmative answers to these questions, the view of these critics simply illuminate another reason why the seagram court's decision represents sound tax policy. if seagram's arguments were accepted, a target shareholder realizing a loss on its exchange could argue that, notwithstanding the safe harbor, continuity was failed under traditional standards. for example, these arguments, if accepted, would open the door to an argument that continuity is broken if (1) 50% of the target's stock is held by less-than-5% shareholders, (2) the balance is held by a taxpayer who purchased for cash immediately before the acquisition, and (3) the taxpayer is able to demonstrate that 60% of the target stock held by less-than-5% shareholders was sold for cash in contemplation of the transaction. moreover, the seagram position would encourage inconsistent tax positions and whipsaw of the government. alternatively, these commentators would accept the seagram result, but only if seagram had the intent of acquiring the target but no intent of exchanging its stock for dupont stock. this test, however, would rest the status of reorganizations on the subjective intent of significant target shareholders-hardly a basis for stable, predictable, and consistent results. 148. see ginsburg & levin, supra note 1, § 610.10 at 628-29. 149. see infra notes 194-196 and accompanying text. florida tax review iv. the decline of the continuity of interest doctrine despite the historic and continued vigor of the continuity of interest doctrine, its tangled branches have undergone significant pruning by congress, the service, and the courts. this part examines a variety of limitations that have restrained continuity from breaking otherwise valid reorganizations. the discussion is divided into three subheadings. first, this part describes the legislative limitations on the remote continuity doctrine. second, this part considers the partial codification of the integrated transaction doctrine in section 338 and the anti-yoc heating regulations, which all but eliminate continuity as a requirement for a reorganization following a qualified stock purchase. finally, this part traces the abolition of continuity as a doctrine of disqualification for mutual savings bank and mutual savings and loan association reorganizations. a. limitations on remote continuity as discussed above in part iii.b, one of the earlier expansions of the continuity of interest doctrine was the development of a remote continuity aspect that could defeat otherwise valid reorganizations depending on the spacial relationship between the target's assets and the acquiror's consideration. starting in 1954, congress began the piecemeal repeal of the remote continuity doctrine by adding to section 368(a)(1)(c) an anti-groman parenthetical clause-"(or in exchange solely for all or part of the voting stock of a corporation which is in control of the acquiring corporation)"--and by enacting an anti-bashford provision, section 368(a)(2)(c). the parenthetical in section 368(a)(1)(c) permits the use of parent stock in c reorganizations, while section 368(a)(2)(c) permits the target's assets to be dropped down to a subsidiary following an a or c reorganization. in 1964, an antigroman parenthetical was added to section 368(a)(1)(b), permitting parent stock to be used as consideration in a b reorganization. finally, congress added section 368(a)(2)(d) in 1968 and section 368(a)(2)(e) in 1971, thereby permitting triangular forward and reverse mergers to qualify as a reorganizations. accompanying each amendment was an expansion of the definition of a party to a reorganization. 5 0 150. see irc § 368(b). for a discussion of issues that remained after these statutory changes, see m. carr ferguson & martin d. ginsburg, triangular reorganizations, 28 tax. l. rev. 159 (1973). [vol 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrinze 231 several years after these statutory changes were completed, the service largely abandoned its view that consideration remoteness (which it had asserted even within a wholly-owned group) could break continuity.15' today, although there are lingering remoteness issues, 152 remote continuity remains a significant impediment only with respect to partnership dropdowns, the use of grandparent (rather than parent) voting stock,' and the use of consideration from two different parties.'-' and, based on the public statements of service officials, remote continuity may soon undergo further limitations. 55 b. the virtual elimination of continuity front section 338 integrated transactions as discussed above in part iii.d, the continuity of interest doctrine became a convenient reason for treating the integrated stock purchase and merger of the target into the acquiror's subsidiary as an asset purchase, permitting the subsidiary a cost basis in target's assets. in 1954, congress 151. see rev. rul. 84-30, 1984-1 c.b. 114; g.c.m. 39100 (may 13. 1983). in 1981, the service ruled that consideration remoteness resulted when the target's parent distributed acquiror stock to its own shareholders after the transaction, thereby separating the consideration (held above by the parent's shareholders) from the target's assets (held below in acquiror). g.c.m. 38660 (mar. 19, 1981). in rev. rul. 95-69, 1995-42 i.r.b. 4 (oct. 16), the service held that a partnership/shareholder's distribution of acquiror stock to its partners on a pro rata basis does not defeat continuity. 152. for example, is the conclusion in rev. rul. 84-30, supra note 151. limited to transactions among a wholly-owned group? for a discussion of this issue, see ginsburg & levin, supra note 1, § 610.11.1 at 631-32. 153. see james a. nitsche, "asset remoteness" problems persist in affiliated group acquisitive reorganizations, 83 j. tax'n 94, 97 (1995). 154. the anti-groman parentheticals permit solely voting stock consideration from either the acquiror "or" its parent, and not acquiror "and/or" its parent. see irc § 368(a)( i)(b) (parenthetical), (c) (parenthetical). however, the regulations state: as used in section 368, as well as in other provisions of the internal revenue code, if the context so requires, the conjunction 'or' denotes both the conjunctive and the disjunctive, and the singular includes the plural. for example, the provisions of the statute are complied with if 'stock and securities' are received in exchange as well as if 'stock or securities' are received. regs. § 1.368-2(h). section 368(a)(2)(d) is clear that only parent-and not subsidiary-stock may be used. see irc § 368(a)(2)(d)(i). section 368(a)(2)(e) is ambiguous on this point. 155. see juliann avakian martin, irs considers guidance of postreorganization sales and continuity of interest, 96 tnt 55-9 (mar. 19, 1996) (quoting nelson f. crouch. chief of branch 1, remarking on general counsel memoranda 39150 and 35117, which conclude that continuity may be broken on a post-reorganization drop-down to a partnership: "the gcms are out there ... and we don't like them anymore"). florida tax review confirmed acquirors' ability to achieve a cost basis in certain integrated stock purchases by enacting section 334(b)(2), and it reaffirmed this treatment in 1982, when it substituted the present section 338 for section 334(b)(2). however, by eliminating the need to rely on a judicial doctrine to achieve the desired result, congress further complicated continuity analysis. this confusion continues, but, under recently issued regulations, the continuity of interest doctrine is significantly limited for integrated qualified stock purchase and merger transactions. section 334(b)(2) was enacted as part of the 1954 code to replace the subjective integrated transaction doctrine with an objective test, which permitted the acquiror a cost basis in the target's assets if it made a "qualified stock purchase" of at least 80% by value of the target's stock (excluding certain preferred stock) and liquidated the target in a transaction meeting various requirements. 56 the treatment of nonqualifying stock purchases followed by liquidations and of qualified stock purchases followed by statutory mergers and other asset transfers that failed to qualify as liquidations was left to common law. in 1982, congress replaced section 334(b)(2) with section 338, which permits acquirors to elect to treat a qualified stock purchase as an asset purchase, but treats the target as selling its assets for fair market value to a new target that does not succeed to the original target's corporate tax attributes. under pre-1987 law, this deemed asset sale was tax-free to the target (except to the extent of certain recapture income).'57 in an oft-quoted passage, the conference report accompanying section 338 states that the provision was "intended to replace any nonstatutory treatment of a stock purchase as an asset purchase under the kimbell-diamond doctrine."'' 58 in revenue ruling 90-95, 159 the service relied on this language in interpreting section 338 as preempting and reversing the kimbell-diamond doctrine with respect to a qualified stock purchase followed by the target's liquidation where a section 338 election is not made."6 in other words, a 156. sections 334(b)(2) and 337 left a doctrinal anomaly that rendered the statutory result inconsistent with the continuity of interest theory underlying prior case law: the acquiror was permitted a cost basis in the target's assets, which is consistent with an asset purchase, but the target was not taxed, and the stock seller's gain or loss on the sale was measured by reference to stock basis (which together are more consistent with a stock sale than a deemed liquidation followed by an asset sale). 157. see irc § 337 (1954). 158. h.r. conf. rep. no. 760, 97th cong., 2d sess. 536 (1982), reprinted in 1982-2 c.b. 600, 632. 159. 1990-2 c.b. 67. 160. as discussed supra part iii.d, the kimbell-diamond doctrine would treat an integrated stock purchase and liquidation as a deemed asset purchase in which purchaser acquires the assets with a cost basis. i[vol 3:5 19961 devolution & inevitable extinction of the continuit. of interest doctrine 233 nonelecting acquiror purchasing 80% or more of target's stock for cash and liquidating target as part of an integrated transaction (the facts of kimbell diamond) is not treated as purchaser of the target's assets; instead, each step is "awarded independent significance," and the acquiror absorbs the target with a carryover basis in its assets. 6 ' in october 1995, following the recommendations of the new york state bar association, 6 2 the service promulgated regulations that significantly limit the application of the continuity doctrine, extending the result of revenue ruling 90-95 beyond the second-step liquidation transaction that was the subject of kimbell diamond to include a qualified stock purchase for which a section 338 election is not made, followed by a reorganization.'" the regulations interpret section 338 to require, in effect, that a non-electing acquiror be treated as a historic shareholder of the target, but only with respect to the acquiror, its subsidiary, and the target. thus, under the regulations, the qualified stock purchase of target stock by the acquiror, followed by a merger of the target into the acquiror's wholly-owned subsidiary, is a tax-free reorganization for target and subsidiary, and the subsidiary takes the target's assets with a carryover basis. the regulations effectively reverse yoc heating corp. v. commissioner,"6 where an acquiror purchased 85% of a target's stock for cash and notes and, as part of an integrated transaction, caused the target to transfer its assets to acquiror's newly formed subsidiary. in the latter step, the target's minority shareholders received cash in exchange for their target stock, the acquiror received additional shares of its subsidiary, and the target liquidated. the service argued that the second-step was a d or f reorganization and that the acquiror's subsidiary therefore received the target's assets with a carryover basis (which was less than the sum of the acquiror's purchase price and the cash paid by subsidiary for the minority shareholders' target shares). the taxpayer disputed this assertion and claimed the benefit of section 334(b)(2), the kimnbell-diamnond doctrine, or the integrated transaction doctrine to obtain a stepped-up cost basis in the acquired target assets. the tax court, in allowing a cost basis, held that while section 334(b)(2) and the broader kimnbell-diamond doctrine applied only to liquidations, the asset transfer by the target to acquiror's subsidiary also was 161. irc § 334(b). 162. new york state bar ass'n tax section. report on reorganizations of target corporations following a qualified stock purchase under section 338. 94 tnt 205-11 (oct. 19, 1994) (lexis, fedtax library, tnt file). 163. regs. § 1.338-2(c)(3). 60 fed. reg. 54942 (oct. 27, 19951. the regulations were proposed in february, 1995. see 60 fed. reg. 9309 (feb. 17. 1995). 164. 61 t.c. 168 (1973). accordingly, the regulations are commonly known as the anti-yoc heating regulations, and are referred to as such from time to time in this article. florida tax review not a reorganization because it failed the continuity of interest test. the court held further that the integrated transaction doctrine provided authority for a stepped-up basis equal to the cash paid by the acquiror for target stock plus the cash paid by subsidiary to the target's minority shareholders. 6 5 however, while the regulations reverse yoc heating and deem continuity to be satisfied with respect to acquiror and target, they retain the continuity of interest doctrine-and deem it to be failed-with respect to the target's minority shareholders, even if they receive acquiror or subsidiary stock in the transaction, unless the combined transactions otherwise satisfy the continuity requirement. accordingly, minority shareholders of target in a section 338 integrated stock purchase and merger generally recognize gain or loss. this result preserves the result of kass v. commissioner.'66 the preamble to the regulations explains the service's view that congress intended a section 338 election to be the exclusive means for acquiring a cost basis in a target's assets following a qualified stock purchase and that a merger of the target into a wholly-owned subsidiary therefore should not result in a cost basis unless the election is made. deeming continuity to be met for target, acquiror, and subsidiary is "the simplest and most effective means" of achieving that result. 167 the preamble asserts that retaining a continuity requirement for minority shareholders is appropriate because "the legislative history does not indicate any intention to provide reorganization treatment for all purposes to exchanges of stock incident to asset transfers after [qualified stock purchases]." the legislative history of section 338 does not "indicate any intent to eliminate the continuity of interest requirement generally ....16 neither the policy behind section 338 nor its legislative history compels the approach of the anti-yoc heating regulations. after the repeal of general utilities, an acquiror cannot make a qualified stock purchase, decline to make a section 338 election, merge the target into the acquiror's whollyowned subsidiary and simply claim a cost basis in target's stock, as could the taxpayer in yoc heating. instead, if the second-step merger is integrated with the stock purchase or fails to satisfy continuity, the target recognizes gain or loss on the transfer of its assets in the merger,69 which is exactly what 165. as discussed above in note 99, the yoc heating court applied the continuity test for f reorganizations, which arguably is different in purpose, history, and application from the more generally applicable continuity of interest doctrine that originated in cortland and pinellas. 166. kass is described in supra note 144. 167. 60 fed. reg. 54942, 54943 (oct. 27, 1995). 168. 60 fed. reg. 9309, 9310 (feb. 17, 1995). 169. this result occurs whether the target is viewed as liquidating and its shareholders as making the sale, or the merger is viewed as a taxable asset sale. [vol. 3:5 1996] devolution & hievitable extinction of the continity of interest doctrine 235 happens with a section 338 election. the legislative history to section 338 that was relied upon in the preamble as the basis for overruling yoc heating states only that congress intended to replace common law "under the kimbell-diamnond doctrine." as described above, the tax court in yoc heating (which was decided nine years before section 338 was enacted) took pains to hold that the kinbell-diamnond doctrine applied only to a second-step liquidation, and not to a second-step reorganization. thus, if congress intended to overrule yoc heating, it would not have done so by mentioning only kimbell-diamnond. moreover, if by citing only kimnbell-dianmond and not yoc heating, congress intended to replace common law treatment for liquidations only, it would have no occasion for addressing the continuity of interest requirement. thus, congress' silence is not necessarily a basis for selectively taxing the target's minority shareholders on a merger following a qualified stock purchase. although the preamble to the regulations offers no further insights to the statutory basis or other reasons for the new rules, the new york state bar association report (the bar report) that precipitated them offers several reasons for the treatment of both the corporate parties and the target's minority shareholders. first, the bar report notes that, in the most straightforward case, in which the acquiror after a 100% qualified stock purchase merges the target into acquiror's wholly-owned subsidiary, tax-free treatment and a carryover basis could have been achieved by having acquiror's subsidiary make the stock purchase with funds contributed by the acquiror and then causing the target to liquidate into the subsidiary. alternatively, where the target's minority shareholders receive subsidiary stock in a merger following the qualified stock purchase, the same result could be achieved by the acquiror and the target's minority shareholders contributing target stock to the subsidiary for subsidiary stock in a tax-free section 351 exchange and causing target to liquidate.17' since the result of a qualified stock purchase and merger can be accomplished tax-free by alternative means, the bar report argues that the direct transaction should also be tax-free. stated another way, no valid policy is served by imposing a corporate-level tax on a target corporation that is merged into a nonelecting acquiror's subsidiary following 170. see supra text accompanying note 165. it was necessary for congress to make clear that a § 338 election was the exclusive means to obtain a cost basis in an integrated qualified stock purchase and liquidation transaction. in american potash & chem. corp. v. united states. 399 f.2d 194 (cl. ct. 1968), the court held that § 334(b)(2) did not preempt the kimbell-diantond doctrine and that a taxpayer failing to satisfy § 334(b)(2) could still obtain a cost basis under kimbell-diamond. 171. other paths to this happy result are traversed in ginsburg & levin. supra note 1, § 610.9 at 616-22. florida tax review a qualified stock purchase. since the only bar to this treatment is the continuity of interest requirement, the most direct path to achieve this result (short of reexamining the entire continuity doctrine) is to deem continuity to be satisfied selectively. however, this leaves the nagging question of why the continuity of interest requirement was not entirely eliminated for section 338 integrated transactions and why the regulations continue to apply it to cause the target's minority shareholders to recognize gain or loss on the exchange of target for subsidiary stock. the bar report offers several reasons for this result. first, if the economically similar result were accomplished without a qualified stock purchase but simply by merging target into subsidiary with the consideration consisting of more than 80% cash, the continuity of interest doctrine would deny tax-free treatment to minority shareholders receiving subsidiary stock. accordingly, the target's minority shareholders should not be entitled to tax-free treatment solely as a result of the acquiror's qualified stock purchase. the argument that like transactions should be taxed similarly has great appeal. absent a wholesale rejection of the continuity of interest doctrine (which would allow tax-free treatment to minority shareholders in either situation), if under any similar transaction, minority shareholders would be subject to tax, the regulations might be justified in maintaining the status quo. however, if the acquiror purchases target stock in a qualified stock purchase and together with target minority shareholders contributes target stock to the acquiror's subsidiary for subsidiary stock in a section 351 transaction, both acquiror and target minority shareholders would receive the subsidiary stock tax-free. the subsidiary could then liquidate the target taxfree into subsidiary and receive the target's assets with a carryover basis. thus, the rationale for not taxing the corporate parties in a yoc heating transaction-that a nontaxable result can be achieved in an alternative structure-might also justify the conclusion that the continuity of interest doctrine should not be a bar to tax-free treatment for the minority shareholders. 1 7 2 172. section 351 treatment is not available if target minority shareholders receive acquiror stock. there is no evident reason for taxing target minority shareholders if they receive acquiror stock, while not taxing them if they receive subsidiary stock, especially after the statutory repeal of groman and bashford. see supra part iv.a and infra part v.a.6. however, parent stock consideration may be possible in a tax-free transaction. if the target is recapitalized before the merger by making its common stock mandatorily exchangeable for parent stock, this e-type recapitalization would apparently be respected, even though it is a component of a larger transaction. see rev. rul. 76-223, 1976-1 c.b. 103 (two step transaction in which preferred stock of target was converted into 19% of voting common stock and acquiror acquired remaining 81% of voting common stock for voting stock of acquiror qualified as a recapitalization followed by a b reorganization); priv. let. rul. 9207028 (nov. [vol. 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrine 237 second, the bar report argues that it is appropriate to tax minority shareholders because existing law (e.g., kass) denies tax-free treatment to the target's minority shareholders and, absent a compelling reason, regulations under section 338 should not change this result. 17" although kass held that minority shareholders in a section 334(b)(2) liquidation/merger were subject to tax, kass (and for that matter yoc hearing) was decided prior to the enactment of section 338. the legislative history of section 338 indicates that congress intended to "replace any nonstatutory treatment of a stock purchase as an asset purchase." the only reason the yoc heating court treated the stock purchase as an asset purchase was the continuity of interest doctrine. if congress really had the reversal of yoc healing in mind when it enacted section 338, it is far more likely that its stated intent to "replace any nonstatutory treatment" meant that the entire continuity doctrine should be abandoned in the context of a qualified stock purchase followed by a merger, rather than that it be retained only with respect to minority shareholders. this result is also more consistent with the statutory framework. section 368(a)(1) defines a reorganization for all parties to a transaction, and if a reorganization is found, the balance of part iih of subchapter c determines the consequences of the transaction for each party. the regulations reject that framework and impose another, in which "reorganization" is defined party by party. perhaps the service has the regulatory authority to promulgate such a rule, but even if congress intended section 338 to reverse yoc healing, it likely did not intend to adopt the regulations' mechanism, rather than simply deeming the nonstatutory continuity requirement to be satisfied for all parties. finally, the bar report argues that minority shareholders should be taxed because the nature of their investment has changed. this argument simply begs the ultimate question of whether the continuity of interest doctrine is an appropriate basis to deny minority shareholders tax-free 19, 1991) (recapitalization as part of an integrated merger respected as separate transaction), discussed infra text accompanying note 185. of course, exchangeable stock presents issues that are beyond the scope of this article. see generally kenneth h. heitner & jonathan m. kushner, to bifurcate or not to bifurcate: the answer becomes less clear. 46 tax law. 43 (1992). in addition to its yoc heating recommendations, the bar report proposed that the continuity of interest requirement be jettisoned (even for minority shareholders) for the merger of a target into a newly-formed subsidiary in a transaction that would otherwise qualify as an f reorganization. see supra note 97. this proposal has not of yet been accepted or rejected by the service. it is not clear as a policy matter why a merger into an existing subsidiary should be taxable to minority shareholders for failure of continuity, but the identical merger into a newly-organized subsidiary should be tax-free. 173. the preamble also suggests that the service saw sonic merit to this argument. see 60 fed. reg. 54942, 54943 (oct. 27, 1995) ("extension of reorganization treatment to the minority shareholders in this case would inappropriately alter general reorganization principles. and would not be grounded in the policies of section 338"). florida tax review treatment since all reorganizations change the nature of all target shareholders' investments. the continuity of interest doctrine was originally developed to distinguish merger-like reorganizations from asset sales on the basis of the consideration received by the target. as described above in part iii.d, applying the continuity doctrine to integrated transactions is wholly inconsistent with its original purpose because its invocation has no effect on the target. nevertheless, the doctrine did serve as a convenient basis to permit a purchaser of target stock to obtain a stepped-up basis for the assets after the target is merged into the acquiror's subsidiary. and, application of the continuity doctrine to integrated stock purchase and merger transactions did allow for consistent treatment of the acquiror's subsidiary (which, under madison square garden,74 received target's assets with a full step-up to fair market value) and target's minority shareholders (who, under kass, recognized gain or loss on the transaction). with the enactment of section 338, failing continuity is no longer necessary to permit the subsidiary to achieve a cost basis; instead, that treatment is elected under section 338.175 thus, section 338 and its legislative history can be seen as a legislative rejection of the application of continuity to integrated qualified stock purchase and merger transactions. ironically, the bar report's suggestion to the service that it tax only the minority shareholders in a merger following a qualified stock purchase may imperil the original purpose of the report-to facilitate these transactions. under the laws of many states, parents of subsidiaries with minority shareholders have a fiduciary duty to treat the minority shareholders fairly with respect to transactions with the parent (and, presumably, with the parent's other subsidiaries).'76 according to one court, this duty is breached when the parent receives something "to the exclusion of, and detriment to, the minority stockholders of the subsidiary."' 177 it is an open question as to whether, without some additional compensation, this standard is satisfied by a merger that allows a parent to combine the business of two subsidiaries but subjects to tax only the minority shareholders that receive stock of the surviving corporation. 174. madison square garden corp. v. commissioner, 500 f.2d 611 (2d cir. 1974). 175. one must consider whether continuity is necessary where a § 338 or § 338(h)(10) election is made. 176. see generally david a. drexler, et al., delaware corporation law and practice §§ 15.11, 15.59 (1996). 177. sinclair oil corp. v. levien, 280 a.2d 717, 720 (del. 1971) ("self dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary"). [vol. 3:5 1996] devolution & inevitable eiinction of the continuity of interest doctrine 239 c. continuity without stock despite the service's success in le tulle, where the court severed the stock or securities requirement from the definition of reorganization, holding that some acquiror stock was required to be received by the target in order for an acquisition to be a reorganization, the service has not hesitated to distance itself from that requirement where contrary policies predominate. in paulsen v. conmzissioner,"'7 the supreme court, at the service's urging, held that the statutory merger of a state stock savings and loan into a federal mutual was not a reorganization for lack of continuity. in the merger, the target's shareholders exchanged their stock for passbook savings accounts in the mutual. the service argued that the transaction failed the continuity requirement because the passbook accounts were not equity in the mutual. the court ruled for the service, but based its opinion on the narrower ground that the passbook accounts were "cash equivalents,"'79 which were not an adequate interest in the acquiror to satisfy the continuity test. paulsen is consistent with the teachings of cortland and pinellas that an asset transfer entirely for cash or cash equivalents is more like a sale than a tax-free transaction. although the paulsen court was without statutory basis in applying the continuity doctrine to a statutory merger," there is at least some historical support and strong policy reasons for requiring at least some acquiror equity consideration in even a statutory merger. as discussed above, in 1934, when congress introduced the statutory continuity requirement of solely voting stock consideration for b and c reorganizations, implicitly reaffirming that no continuity is required for a statutory merger, most states' laws required that the consideration in a statutory merger include stock or securities of the acquiror. although a reorganizations continue to be defined by reference to state laws (presumably current laws), which reflect relaxed merger requirements since 1934, it was not unreasonable for the paulsen court to, in effect, interpret the phrase "statutory merger or consolidation" by reference to the law in 1934, when congress last considered the issue. moreover, a contrary holding, allowing a merger or consolidation with only cash consideration, would entirely eliminate the distinction between tax-free transactions and taxable sales. the paulsen court, in holding that the acquiror's consideration in a reorganization may not consist entirely of "cash equivalents," therefore adopted a pragmatic approach that was consistent with cortland and pinellas and as loyal to the statutory language as countervailing 178. 469 u.s. 131 (1985). 179. id. at 140. the position upheld in paulsen was first asserted by the service in 1969. see rev. rul. 69-6, 1969-1 c.b. 104. 180. see supra part ii.c. florida tax review policy views would permit. it is notable that the court in paulsen did not prohibit a statutory merger solely for securities of the acquiror. the service soon found that the requirement it succeeded in imposing in paulsen-that the target or its shareholders must receive equity in the acquiror-would imperil tax-free treatment for other transactions involving mutual savings banks and mutual savings and loans. first, in a conversion of one of these institutions into a stock corporation, depositors in the mutual typically receive a "liquidation account" that preserves only their rights to the assets of the mutual on its liquidation (and only then to a limited extent). depositors are also usually issued subscription rights for stock, but these rights normally require a cash payment by the holder on exercise. under traditional debt/equity analysis, an instrument, such as the liquidation account, that provides a fixed return and does not provide for any meaningful upside potential or downside risk in the issuer, or voting rights, is not ordinarily treated as stock.' 8' thus, since neither the target nor its shareholders receive acquiror stock for target assets, the transaction apparently fails the service's exposition of the continuity doctrine. nevertheless, in two published rulings, the service held that in the merger of one mutual into another, the liquidation accounts are a sufficient equity interest for continuity of interest purposes. 82 in revenue ruling 80-105,' the service further held, on the basis of the earlier rulings, that the conversion of a mutual into a stock institution is an f reorganization. next, the service was faced with whether such a converted entity could be acquired in a triangular reorganization. in a triangular merger of a former mutual into a subsidiary of a stock corporation, only actual shareholders in the target receive parent stock; the former passbook holders retain their liquidation accounts in the acquiring subsidiary. thus, the lingering gromanbashford problem was presented in spades: if passbook holders and stockholders in the former mutual hold equity and the passbook holders receive an interest in subsidiary, while the stockholders receive an interest in the parent, is the parent or the subsidiary the "party to the reorganization?" or, to take the service's view of groman and bashford, the transaction flunks remote 181. see generally william t. plumb, jr., the federal income tax significance of corporate debt: a critical analysis and a proposal, 26 tax l. rev. 369 (1971). 182. see rev. rul. 69-646, 1969-2 c.b. 54; rev. rul. 69-3, 1969-1 c.b. 103. in dictum, the paulsen court rationalized these rulings by comparing what target shareholders received with what they gave up; since passbook holders held only a nominal equity interest, they need receive nothing more. this reasoning is tangled in the branches of continuity dogma. the continuity question is whether, at the corporate level, the consideration tendered by the acquiror renders the transaction more sale-like or more merger-like. only if the consideration received by the target is sufficiently merger-like is the consideration received by target's equity holders tested for "stock or security" status under § 354. 183. 1980-1 c.b. 78. [vol. 3:5 1996] devolution & inevitable extinction of the contiuuity of interest doctrine 241 continuity. however, in a triumph of policy over doctrine, the service, in a series of private rulings, adopted the inconsistent position that, although the liquidation accounts sufficed as a continuing interest in mutual-mutual mergers and mutual to stock conversions, they are not considered stock of the acquiror that could blow a triangular reorganization.' the final hoop involved the consequences of an integrated transaction in which a mutual savings bank converts into a stock savings bank (with passbook holders in the mutual receiving liquidation accounts in the stock institution) and the new stock bank merges into a newly-formed subsidiary of an acquiror with former passbook holders receiving cash for their liquidation accounts.s' if liquidation accounts are treated as equity in the former mutual for purposes of qualifying the first step of the transaction as an f reorganization, the immediate cash-out of that equity interest in the second step of the transaction defeats the first-step f reorganization. this time, to reconcile the irreconcilable, the service held that the first-step conversion is not an f reorganization, as revenue ruling 80-105 held, but is instead an e-type recapitalization, which has no continuity requirement." v. the end of continuity as we know it parts i through iv of this article show how the continuity doctrine escaped its rationale and was applied indiscriminately without regard to its historical purpose, and how only significant contrary policies have forced congress, the service, and the courts to reexamine its outer boundaries. this part begins by examining some of the consequences of the current continuity of interest doctrine from a tax policy perspective. it concludes that the consequences of the doctrine reflect such poor tax policy that revision is inevitable, and considers some alternative conceptions of continuity that could form the basis of a new doctrine of more limited scope. a. the consequences of continuitn 1. abuse potential.-continuity has always been a doctrine of universal application. historically, it has been invoked by taxpayers seeking 184. see, e.g., priv. let. rul. 8942058 (july 25. 1989). priv. let. rut. 8739053 (june 30, 1987). 185. see priv. let. rul. 9207028 (nov. 19. 1991). for a more detailed history and analysis of mutual conversions and acquisitions, see robert j. jones, et al., irs clarifies conversions of financial institutions from mutual to stock form, 6 j. bank tax'n 9 (1992); gregory j. soukup, the continuity-of-proprietary-interest doctrine and thrift institution mergers, 12 j. corp. tax'n 141 (1985). 186. this ruling suggests that a recapitalization that is the first step of an integrated transaction is respected as such, and not collapsed into the other steps. florida tax review to recognize losses or avoid other undesirable consequences of reorganization status, with the same frequency and zeal as it has been invoked by the service.187 when the service applies the doctrine expansively to force recognition of gain, it invites taxpayers to assert the doctrine to recognize loss. for example, the service apparently maintains that remote continuity may be lost by an acquiror's transfer of a target's assets to a partnership largely owned by the acquiror (or even wholly-owned by an acquiror group).' 88 when asserted by taxpayers, this position effectively permits taxpayers to elect out of reorganization treatment by engaging in an economically insignificant transaction. additionally, in a private acquisition that hugs the boundaries of continuity thresholds, different parties may take inconsistent positions as to the existence of continuity, with, for example, target shareholders realizing gain on their receipt of acquiror stock reporting a taxfree reorganization and those with losses claiming that continuity was lacking. in this respect, the seagram case is interesting not only as a substantive decision, but as a roadmap of tax-planning potential for target shareholders wishing to deduct losses with respect to their exchanged target shares. in seagram, escape from the reorganization provisions appears to have been an afterthought for a large target shareholder but, had the decision gone the other way, seagram's progeny would almost certainly have involved clever prearranged transactions in public deals. a private letter ruling issued on the basis of the representations required by revenue procedure 77-37 may also open the door to inconsistent treatment. so long as less-than-5% noninsider shareholders of a public target own at least 50% of the target's stock, and at least 50% of the consideration in the acquisition consists of acquiror stock, continuity is deemed met, regardless of whether all of the target's shares immediately before-or the acquiror's equity consideration immediately after--changes hands. current continuity law suggests that, notwithstanding a private ruling recognizing reorganization status, the target or target shareholders with information about preor post-acquisition sales could report the transaction as taxable, without affecting the other parties' treatment.8 9 this abuse potential of continuity 187. reorganization status may give rise to adverse tax consequences that could be avoided by qualifying the transaction under some other nonrecognition provision and simultaneously breaking continuity. for example, preferred stock issued in a b reorganization may be § 306 stock, but preferred stock issued in a § 351 transaction is not § 306 stock. all other things being equal, taxpayers might choose to flunk continuity to avoid § 306. see rev. rul. 79-274, 1979-2 c.b. 131 (for purposes of § 306, § 368(a)(1)(b) and not § 351, governs if a transaction qualifies under both). 188. see supra note 101 and accompanying text. 189. likewise, for reorganizations clearly busted under the continuity doctrine, but which might arguably qualify for tax-free treatment under § 351, the continuity doctrine suggests additional potential for inconsistent treatment. [vol 3:5 19961 devolution & hievitable ertinction of the continuity of interest doctrine 243 is compounded if the representation protocol of revenue procedure 77-37 is a safe harbor for taxpayers, even in the absence of a private letter ruling, as some suggest. 90 the anti-yoc heating regulations, by requiring inconsistent treatment of the corporate parties, on the one hand, and the target's shareholders, on the other, sanction what might be regarded as a similar abuse. for example, assume that a target's basis in its assets and the target shareholders' aggregate basis in their stock each exceed the value of target. if the shareholders sell 80% of the stock for cash to an unrelated parent company, and the parent company merges the target into its wholly-owned subsidiary without making a section 338 election, the target shareholders recognize loss on all of their target stock, including the 20% exchanged for stock of the parent, while the parent retains the benefit of the target's high asset basis. while complexity, uncertainty, and inconsistency might be regarded as inevitable taxpayer tools in any sophisticated tax system, a test that depends upon subjective elements and ill-defined rules, as does the current continuity doctrine, is an invitation to abuse. 2. admzinistrability.-the seagran case, viewed from the government's perspective, also reveals the unadministerability of a doctrine that depends on the intent and conduct of the acquiror and unrelated target shareholders, that does not require disclosure or consistent treatment, and that is vaguely-defined by uncertain criteria. if seagram had ultimately succeeded in its litigation (seagram lost in the tax court and the case was settled before a decision on appeals), the service would have faced tremendous whipsaw potential from conoco's public shareholders who are not likely to amend their returns to report gain. and, seagram's failure in the tax court certainly does not prevent the conoco shareholders that realized losses on receipt of dupont stock from making similar claims on their open tax returns (especially now that the case will not win appellate level imprimatur). the code could be amended to provide for disclosure and universal characterization of reorganization transactions, as it does in other contexts,' 9' or to provide for unified audit procedures,192 but the system is unequipped for the continuity doctrine in all of its present glory. 3. economic efficiency.-the current continuity rule creates basic economic inefficiencies. first, because under revenue procedure 77-37 only 5% or greater shareholders of a public target can adversely affect continuity, 190. ginsburg & levin, supra note 1, § 610.10 at 629. 191. see, e.g., irc § 385(c) (issuer's characterization of instrument as equity or debt is binding on holders unless contrary position is disclosed). 192. see, e.g., irc §§ 6221-6233 (unified audit procedures for partnerships). florida tax review the doctrine places a premium on their actions. this premium may be magnified if some 5% shareholders are unable (or unwilling) to indicate their intent with respect to the acquiror stock they will receive. (for example, mutual funds routinely decline to represent that they have no plan or intention to sell acquiror stock.) 193 this artificial premium generated by the tax law is inefficient because one historic 5% shareholder, by declining to give the necessary representation or threatening to dispose of acquiror shares immediately after receipt, can potentially stall an acquisition that would increase value for all target shareholders. second, the continuity representation of revenue procedure 77-37, by deeming all less-than-5% shareholders of a public target to be historic holders of target stock and long-term holders of acquiror stock, regardless of actual conduct, permits these shareholders to cash out. by also requiring that no more than 50% of acquiror's aggregate consideration consist of nonequity, revenue procedure 77-37 requires that target shareholders who cash out must use their own brokers to sell acquiror stock. the practical effect of this requirement is simply an added cost for these target shareholders: their broker's commission. finally, by virtue of the favorable representation for public targets-all less-than-5% (as opposed to 1%) noninsider target shareholders are counted as good for continuity purposes-the tax law encourages acquisitions of public as opposed to private targets because it is generally easier to be assured of tax-free treatment. none of these inefficiencies is justified by any countervailing policy reason, and each of them could be reduced or eliminated by a lower continuity threshold. 4. fairness.-fairness concerns are always raised when an acquiror's post-reorganization use of target assets or the actions of a majority of the target shareholders has the potential to affect minority target shareholders. these concerns are also raised under the anti-yoc heating regulations, which tax only minority shareholders on a qualified stock purchase-merger transaction. as mentioned earlier, these fairness issues present interesting questions under state law. 5. uncertainty.-it is unclear what percentage of the acquiror's consideration must consist of stock in order to satisfy the continuity of interest test. revenue procedure 77-37 provides that a favorable private letter ruling will be issued only if the historic target shareholders, as a group, exchange at least 50% by value of the total outstanding target stock for 193. see ginsburg & levin, supra note 1, § 610.10 at 630. [vol 3:5 1996) devolution & inevitable ertinction of the continuity of interest doctrine 245 acquiror stock. in john a. nelson co. v. helvering,'" the supreme court found that continuity was satisfied when 38% of the target shareholders' consideration consisted of stock. the sixth circuit has found continuity to be satisfied when only 25% of target shareholders' consideration consisted of acquiror stock.195 on the other hand, the tax court found 16% to be inadequate in kass v. commissioner.'" these ranges of acceptability create uncertainty, which tends to interfere with transactions at the fringes and otherwise to contribute to the heartburn of tax lawyers. 6. inconsistent and anomalous treatment.-the existence of a continuity requirement for some nonrecognition transactions but not others results in anomalous treatment when economically similar transactions are characterized differently. for example, the service apparently maintains that the use of grandparent stock as consideration for a merger violates the remote continuity doctrine, but a direct acquisition followed by a double drop-down of the target's assets to a second-tier subsidiary is tax-free.',9 second, because the continuity test is concerned only with consideration received by the target's shareholders, a "cash out merger" of target into acquiror fails continuity, but the transaction can be made tax-free by reversing the parties."' third, it is sometimes possible to use other nonrecognition provisions without a continuity requirement-such as section 35 1-to reach the same results as a reorganization.' 9 finally, nonconvertible, nonvoting preferred stock that is redeemable at any time and mandatorily redeemable if earnings exceed a specific threshold is considered a sufficient equity stake for continuity purposes, -° but a reorganization is flunked on continuity grounds if the acquiror agrees to assist the target shareholders in selling acquiror stock, even if the shareholders bear real equity risk for six months.20' these opportunities all perpetuate anomaly and elevate form over substance. 194. 296 u.s. 374 (1935). 195. miller v. commissioner, 84 f.2d 415 (6th cir. 1936). 196. 60 t.c. 218 (1973), aff'd without opinion, 491 f.2d 749 (3d cir. 1974j. 197. see supra note 110. 198. see bittker & eustice, supra note 5, 1 12.21191 at 12-39; ginsburg & levin. supra note 1, §§ 610.12-610.13 at 637-40. 199. see, e.g., rev. rul. 84-71, 1984-1 c.b. 106 (failed reverse triangular merger treated as a § 351 transaction). see generally ginsburg & levin, supra note 1, § 610.14 at 640. see also ginsburg & levin, supra, § 610.15 at 640-41 (use of recapitalization to bypass continuity). 200. see schweitzer & conrad, inc. v. commissioner, 41 b.t.a. 533 (1940). 201. see mcdonald's restaurants of illinois v. commissioner. 688 f.2d 520 (7th cir. 1982) (merger occurred on april 1, 1973; stock was sold on october 3. 1973). florida tax review 7. tax policy ofnonrecognition.-a full discussion of the continuity doctrine requires at least some mention of the basic policies behind tax-free acquisitions and a consideration of whether the modem expression of the continuity doctrine is consistent with those policies. two categories of policies are frequently cited as supporting tax-free treatment for reorganizations."oz from the target shareholders' perspective, a "paper transaction," in which the shareholders' investment acquires new legal form but is economically unchanged, is viewed as not being an appropriate event to trigger recognition of gain or loss.20 3 also, even if the target shareholders' investment changes dramatically (as often occurs when an operating target merges into an operating acquiror), the illiquidity or possibly difficult valuation of the newly-received shares (especially in a private deal), and the notion that a passive exchange should not be a taxable event, possibly requiring a sale of the investment to pay taxes, all argue against current taxation."w at the corporate level, the policies are somewhat different. in addition to policies against the conversion of dividends into liquidation proceeds (e.g., in a liquidation-reincorporation transaction) or the artificial generation of losses (for example, by having an operating company with high basis assets sell those assets to a shell owned entirely by its former shareholders), the reorganization provisions act as a subsidy for-or, at least, do not discourage-certain corporate transactions meeting specific statutory descriptions.20 5 these policies are tempered by a generalized tax policy against expanding nonrecognition to situations that are not intended to benefit from such favorable treatment. this countervailing policy is difficult to apply at the corporate level where the statutory policies supporting tax-free treatment are based largely on form and are at times indeterminate. however, it has been clear for over 60 years that cash asset sales are not deserving of nonrecognition treatment. the continuity of interest doctrine has served as one 202. see generally staff of joint comm. on taxation, 99th cong., 1st sess., federal income tax aspects of mergers and acquisitions, reprinted in dtr (bna) no. 62 (april 1, 1985); bittker & eustice, supra note 5, 12.01[1] at 12-7 to 12-9; sheldon s. cohen, conglomerate mergers and taxation, 55 a.b.a. j. 40 (1969); john dane, jr., the case for nonrecognition of gain in reorganization exchanges, 36 taxes 244 (1958); jerome r. hellerstein, mergers, taxes, and realism, 71 harv. l. rev. 254 (1957); milton sandberg, the income tax subsidy in reorganization, 38 colum. l. rev. 98 (1938); stanley s. surrey, income tax problems of corporations and shareholders: american law institute tax project-american bar association committee study on legislative revision, 14 tax l. rev. 1 (1958); william j. turnier, continuity of interest-its application to shareholders of the acquiring corporation, 64 cal. l. rev. 902, 910-16 (1976). 203. s. rep. no. 617, 65th cong., 3d sess. 5 (1918). 204. see hellerstein, supra note 202, at 262, 266. 205. see id. at 276-77; sandberg, supra note 202, at 98. [vol. 3:5 1996] devolution & inevitable extinction of the continuity of interest doctrine 247 mechanism to distinguish corporate transactions that advance corporate nonrecognition policies from those, such as asset sales for cash, that do not. however, the use of continuity to disqualify a reorganization on the basis that it does not advance corporate-level policies sometimes clashes with the policies that support nonrecognition treatment at the shareholder level. application of continuity in these cases to disqualify a reorganization elevates the corporate policies over the shareholder policies. for example, if only 10% of the acquiror's consideration for target assets consists of acquiror equity-an insufficient amount to satisfy the modem continuity test-the corporate-level policies are advanced by denying the transaction tax-free treatment because it more resembles a sale than a merger and therefore is beyond the intended scope of the corporate-level subsidy. however, because continuity has not historically developed as a doctrine that taxes only the party for which tax-free treatment is inappropriate, applying the doctrine to the entire transaction, and taxing target shareholders who receive illiquid acquiror stock, conflicts with one of the important shareholder-level policies. moreover, while the continuity of interest doctrine is helpful in identifying transactions that at the corporate level are not deserving of nonrecognition treatment, it is not needed to distinguish those transactions in which tax-free treatment is inappropriate at the shareholder level. sections 354 and 356 ensure that target shareholders receiving cash and other nonsecurity boot are subject to tax on any gain realized on the transaction, notwithstanding reorganization status. this conflict between corporate-level policies against tax-free treatment and those favoring nonrecognition treatment at the shareholder level is inevitable without a statutory mechanism at the corporate level that taxes the target's realized gain in respect of assets transferred for nonqualifying consideration. the continuity doctrine could be understood to reflect the view that it is worse to allow a corporate target to escape taxation on an asset sale than it is to tax a target shareholder deserving of tax-free treatment. but there is no evidence that congress ever made that choice. and the conflicting policies suggest that continuity should bust an otherwise qualifying reorganization only where the reasons for taxing the target are clear. on the other hand, it is clearly inappropriate to use continuity to bust a putative reorganization that does not look like an asset sale at the corporate level if doing so would result in taxing target shareholders deserving of nonrecognition treatment. the seagram case and the anti-yoc heating regulations demonstrate this point best. at the corporate level in seagram, the transaction had all of the hallmarks of a reorganization. the dupont group's consideration for conoco's assets consisted over 50% of stock, which traditional notions of continuity regard as sufficient to distinguish the acquisition from a taxable florida tax review sale, and no other corporate-level considerations were identified that are inconsistent with tax-free treatment. at the shareholder level, the dupont stock, while neither illiquid nor difficult to value, was received under circumstances that are entirely consistent with the tax-free treatment of shareholders under the reorganization provisions. application of the continuity doctrine to disqualify the reorganization therefore would not advance either corporateor shareholder-level policies. to the contrary, the doctrine, if applicable, would permit seagram to recognize a loss in a transaction that, from its perspective, is indistinguishable from any other taxfree transaction and-owing to the blunt nature of the continuity doctrine-could result in the taxation of conoco and other conoco shareholders that received dupont stock. application of the continuity of interest doctrine to tax minority shareholders under the anti-yoc heating regulations is even more contrary to congressional policies. the regulations express a policy decision, supported by the legislative history to section 338, that the relevant corporate-level policies support nonrecognition treatment. yet, regardless of the shareholder level policies that could be advanced by nonrecognition treatment (especially if acquiror's stock is illiquid and difficult to value), the regulations apply the dull edge of continuity to tax the minority shareholders on purely doctrinal grounds. b. constructing a valid policy for a strong form of continuity it is certainly possible to conceive of a policy rationale for a strong form of the continuity doctrine that would deny reorganization status to a corporation undergoing significant equity shifts. historically, our classical tax system has tended to impose a corporate level of tax on those entities whose interests are freely transferable. 2°6 today, by virtue of the ease of qualifying an entity as a partnership (including the recently proposed check-the-box regulations), 2 7 the corporate-level toll charge effectively applies only to operating entities whose interests are treated as liquid (publicly traded) under section 7704. to the extent that the reorganization provisions (by deferring corporate tax that would otherwise be imposed) represent an exception to the corporate-level toll charge for liquidity, it may be appropriate to condition this exception upon the equity holders foregoing their liquidity for some period. the continuity doctrine is such a condition. 206. see regs. § 301.7701-2(e) (distinguishing partnerships from corporations based on, among other things, whether their interests are freely transferred). 207. see prop. regs. §§ 301.7701-1 to -3. [vol 3:5 1996] devolution & inevitable ertinction of the continuitn of interest doctrine 249 a related policy, expressed for partnerships in section 708, measures liquidity by actual transfers and subjects to tax even equity holders that remain invested if the ownership of the entity shifts significantly over a short period of time. continuity could be considered a similar rule, subjecting shareholders to tax if their brethren abuse the transferability privileges enjoyed by the group as a whole.20 however, if the continuity doctrine is a system for exacting a lock-up of corporate ownership interests in exchange for deferral of corporate-level tax, one would expect that a target corporation and its shareholders should not be able, by failing continuity, to recognize loss.109 moreover, if the continuity doctrine is a mechanism for moderating the toll charge when equity holders restrict transfers of their interests, its application is hopelessly imprecise. the doctrine is an absolute test: full nonrecognition is permitted for targets experiencing significant shifts in ownership, so long as the shifts are not greater than the continuity threshold. on the other hand, the target and its shareholders are fully taxed on their gains if the threshold is exceeded by even one selling shareholder. moreover, analogies to section 708 are, on close scrutiny, inapposite. the continuity doctrine does not depend on the relative percentage interests of the former target group in the new combined enterprise; in contrast to section 708, a corporate minnow is permitted to swallow a whale tax-free without severing continuity. ' 0 the section 708 comparison breaks down entirely in the context of a publicly traded corporation, where the relationship among shareholders regularly shifts without consequence. placing significance on this relationship for nontrading shareholders only proximate to an acquisition is inappropriate. finally, this rationale for continuity does not embrace the remote continuity doctrine, which can break continuity even if 208. see stanley s. surrey & william c. warren. federal income taxation 1120 (1953) ("the congressional policy is that while such readjustments may produce changes in the conduct of a business enterprise, these changes do not involve a change in the nature or character of the relation of the owners of the enterprise to that enterprise sufficient to warrant taxation of gain [or] allowance of loss"). 209. partners in an operating partnership (i.e., with assets other than cash or marketable securities) that experiences a § 708 event are not permitted to claim a loss. see irc § 731(a)(2). 210. when partnerships merge, the partnership whose members on more than 50% of the capital and profits interests in the surviving entity is deemed to continue; the other partnership terminates (possibly subjecting its members to tax). irc § 708(b)t2)la). thus, the merger of a tiny partnership into a huge partnership is taxable for members of the tiny partnership; in contrast, a merger of a tiny target corporation into a huge acquiror can be entirely tax-free. moreover, recently proposed regulations under § 708(b)(i)(b) would altogether eliminate tax for partners whose partnership experiences a § 708 event. see prop. regs. § 1.708-1(b)(1)(iv). florida tax review the target's shareholders retain their acquiror stock and is without parallel in subchapter k. c. alternative conceptions of continuity the preceding discussion suggests that while the continuity doctrine is useful in some limited form to distinguish a taxable sale from a tax-free reorganization, the current doctrine has little statutory, historic, or tax policy basis. although conceivable policy rationales for the strong form do exist, they have never been articulated by congress or the service, and at best are a crude mechanism to advance those policies. the balance of this part suggests alternative and limited conceptions of continuity that could be the basis for a coherent doctrine. 1. the corporate lawyers' approach of ginsburg & levin.-professor martin d. ginsburg and jack s. levin, in their seminal treatise on the taxation of corporate transactions, advocate a restricted but still strong form of the continuity doctrine. they argue that the requirement that the target shareholders as a group maintain a substantial equity participation in the acquiror's enterprise following an acquisition is good tax policy.2'1 in general, they would abandon the remote continuity doctrine and measure continuity based on beneficial interests in the target, whether directly or indirectly held.2 12 they would codify revenue procedure 77-37 as a bright line test binding the service and taxpayers alike. however, they support the anti-yoc heating regulations' treatment of the minority shareholders in an integrated qualified stock purchase and merger.2 3 they would permit taxpayers to assert the failure of continuity on equal terms with the service, and they argue that the taxpayer should have prevailed in the seagram case.2 1 4 in many respects, the ginsburg and levin position represents practitioners' tempered continuity wish list. by rejecting remote continuity, they disclaim one aspect of the doctrine that most often interferes with legitimate business structures. by arguing for codification of revenue procedure 77-37, they express the tax lawyer's preference for clear rules that do not impede most transactions, as well as the savvy realization that wars are won battle by battle. their failure to criticize the taxation of minority shareholders under the anti-yoc heating regulations may reflect the nature of their client base: typically, acquirors and targets who benefit from the rule, rather than minority shareholders who are harmed. and, their unequivocal 211. ginsburg & levin, supra note 1, § 610 at 566. 212. id. §§ 610.11.1-610.11.3 at 630-37. 213. id. § 610.19 at 612. 214. id. § 610 at 626-30. [vol 3:5 1996] devolution & inevitable ertinction of the contihuityl. of interest doctrine 251 support for a doctrine that permits taxpayers to elect in and out of reorganization treatment by invoking continuity (even if that treatment is inconsistent with the treatment accorded to other parties to the transaction) reflects their desire to retain maximum flexibility for their corporate clients who might alternatively wish to defer gain or recognize loss. although ginsburg & levin's suggestions would introduce modest improvements in current law, they do not appear to be supported by any comprehensive policy or basis. also, they would perpetuate many of the detrimental consequences of the continuity doctrine described above in part v.a. 2. continuity as an anti-abuse ruie.-recent administrative practice suggests that if the continuity doctrine were first introduced today, it would be phrased as an anti-abuse rule whose failure would permit the service to bust an otherwise qualifying reorganization, but would not be available to the target or its shareholders as a basis for deducting a loss on a transaction that otherwise meets the statutory reorganization definition. '1 transforming the continuity doctrine into an anti-abuse rule would be consistent with cortland and pinellas, which fashioned the doctrine to prevent taxpayers from obtaining reorganization treatment for transactions that are, in substance, taxable sales. it would, however, run contrary to heintz and mcdonald's, which suggest that continuity is equally available to taxpayers. it would also be inconsistent with the integrated transaction cases, to the extent that they rely on the continuity doctrine. (however, these cases may be discounted as of limited precedential value to the extent they have been overturned by section 338 and the anti-yoc heating regulations.) making continuity an anti-abuse rule would obviously eliminate the whipsaw potential for the service under the present doctrine, and it would also improve administrability and curb anomalous treatments of economically similar transactions. whether a regulatory anti-abuse rule would eliminate uncertainty, increase economic efficiency and fairness, and advance the tax policies of the reorganization provisions would depend upon the details of the regulations issued to effectuate the change (including any safe harbors they might provide). for instance, if failure of continuity continues to affect target shareholders receiving acquiror stock, the transformation would not advance the policies behind nonrecognition treatment at the shareholder level. it appears that continuity as an anti-abuse rule has some appeal to the clinton administration. in march 1996, it introduced a proposal to tax the distributing company in a section 355 transaction if a requisite amount of continuity (as defined in the proposal) does not exist for two years before and 215. see, e.g., regs. § 1.701-2; temp. regs. § 1.1275-2(g). florida tax review two years after the transaction. no loss would be allowed for a distribution that failed this test.216 although reasonable minds could differ on the issue, the treasury probably has power to remove the continuity weapon from taxpayers' hands. while continuity originated as a judicial interpretation of the definition of reorganization, it appears today to be entirely an administrative creature. in the most recent supreme court case to consider the doctrine, paulsen v. commissioner,2 17 the court appeared most moved by the doctrine's specific mention in the reorganization regulations and the service's consistent administrative practice in asserting it.218 in litigation, the service has argued unsuccessfully that the continuity doctrine should be treated as an anti-abuse rule (especially in the f reorganization context discussed above in part iii.a.3), but the treasury has never promulgated this view in regulations. although anti-abuse continuity regulations would be controversial, the power to issue them should exist. 3. bifurcation.-a third conception of continuity, which is without any grounding in current practice, would be to limit the effects of a continuity failure to the corporate level. under this approach, an otherwise valid reorganization that lacked continuity (e.g., a statutory merger in which only 20% of the consideration was acquiror stock) would be a taxable event for the target, but would be tax-free for target shareholders receiving acquiror stock or securities. the transaction could be treated as a wholly taxable event for the target, or the target's gain or loss could be more precisely measured by reference to the nonqualifying consideration. this approach would go far towards advancing the tax policies behind nonrecognition treatment for target shareholders that do not cash out their investments and, at the same time, advance the policies that deny deferral for targets that engage in what amounts to a taxable sale. however, while it would generally ameliorate the condition of target shareholders subject to tax on the receipt of illiquid acquiror stock, it would not spare them from the indirect effects of the corporate tax paid by the target on its recognized gains. moreover, a bifurcation approach would not necessarily eliminate uncertainty, inefficiencies, unfairness, or the inconsistent treatment of economically similar transactions. 4. restricted scope.-as discussed above, because reorganizations under sections 368(a)(1)(b), (c), and (e) must meet statutory continuity 216. the proposal is described in somewhat more detail in note 87. 217. 469 u.s. 131 (1985). 218. see paulsen, 469 u.s. at 136 ("known as the 'continuity-of-interest' doctrine, this requirement has been codified in regs. §§ 1.368-1(b), 1.368-2(a)"), 142 (discussing revenue rulings). [vol 3:5 1996] devolution & inevitable ertincion of the continuin. of interest doctrine 253 requirements (e.g., a solely for voting stock requirement), the extra-statutory judicial continuity doctrine could be eliminated as a requirement for these types of transactions. continuity could remain for acquisitive a and d reorganizations, to distinguish them from taxable sales, but the threshold requirement for continuity could be restated as a fixed percentage of the acquiror's consideration. removing b and c reorganizations from continuity's application is consistent with the 1934 act, which replaced the judicial continuity doctrine for these transactions with the solely for voting stock test that applies only at the corporate level. thus, a stock or assets acquisition satisfying the solely for voting stock requirement would qualify as a b or c reorganization, regardless of what the target's shareholders did with their stock (or stock of the acquiror) before or after the acquisition. subsidiary mergers under section 368(a)(2)(e), which requires that the former shareholders of the surviving corporation receive sufficient stock in the surviving corporation to constitute control, could also be exempted from the continuity doctrine. as with a and c reorganizations, the statutory requirement could be read to supplant the extra-statutory continuity test. section 368(a)(2)(d) subsidiary mergers present a more difficult question. section 368(a)(2)(d) codifies le tulle by requiring that stock of the parent be included in the consideration. a reasonable inference from the statutory language, which does not specify a threshold, is that any meaningful amount should suffice. however, the original version of section 368(a)(2)(d) would have required that the consideration for a forward subsidiary merger consist "solely" of parent stock. an equally reasonable interpretation (and one endorsed by the commentators) is that congress relied on the continuity of interest doctrine to ensure that a pinellas-cortland transaction could not be consummated through a subsidiary merger. as this article suggests, there is historical support for not applying any continuity test to statutory mergers and consolidations. however, although significant differences remain between statutory mergers and asset transfers that do not qualify as mergers under state law,2"9 state merger requirements have been liberalized significantly in the 62 years since the 1934 act. thus, the purpose of the original continuity doctrine-to distinguish in a meaningful way between asset sales and mergers (in the 1934 sense of the word)-would not necessarily be served by relying on state law definitions. by the same token, although the judicial continuity doctrine has not been generally applied to d reorganizations, to the extent that a target could engage in an effective asset sale for cash, but literally qualify the 219. for example, the acquiror assumes liability for the target's obligations in a statutory merger, but not in an asset transfer. florida tax review transaction as a d reorganization, tax-policy supports at least some continuity doctrine for d reorganizations.22 ° however, as to a and d reorganizations (and possibly section 368(a)(2)(d) subsidiary mergers), the promulgation of regulations setting a fixed continuity threshold would be a significant improvement, importantly advancing administrability and reducing uncertainty. the treasury should have the authority to promulgate such a rule, and should not be constrained by judicial thresholds fashioned in the absence of regulatory guidance. moreover, if this absolute threshold was lower than the 50% representation required by revenue procedure 77-37, but high enough to ensure that some real portion of the acquiror's consideration consists of stock, continuity could be returned to a test for distinguishing a taxable sale from a merger-like reorganization, but not one that acts as an obstacle to nonabusive tax-free combinations. this change would not be a panacea. if the test was still applied at the shareholder level so that solely stock consideration would not assure tax-free status, it would not fully eliminate uncertainty or inadministrability. also, if lack of continuity continues to affect shareholder taxation, as well as the taxation of the corporations, this change would not eliminate the unfairness of minority shareholders being taxed on the receipt of acquiror stock in a busted reorganization or the potential for future seagram-type litigation. 5. objective continuity test determined exclusively at the corporate level.-finally, the tax court's view in seagram could be codified, returning continuity to an objective test depending only on the nature and amount of the acquiror's consideration, without regard for the preor post-acquisition conduct of target shareholders or the use of the target's assets. under this view, cases like superior coach and kass would be understood as resting entirely upon the integrated transaction doctrine (and not continuity), and the shareholder conduct cases would be understood as resting solely upon the taxpayer's limited ability to invoke the step transaction doctrine where all relevant parties agree to take consistent tax positions. it is this evolved but limited form of continuity that, while far from perfect, shows the most promise for the doctrine's long-term survival. this alternative, if adopted, would create a historical anomaly: continuity could deny reorganization treatment to statutory mergers and consolidations (the model for nonrecognition treatment), but would generally not apply to other types of reorganizations. however, the application of continuity to statutory mergers and consolidations is supported by the relevant policies. although the code is devoid of additional qualification requirements 220. see bittker & eustice, supra note 5, 12.26[21 at 12-92 to 12-93. [vol. 3:5 1996] devolution & inevitable ertinction of the continuit. of interest doctrine 255 for a statutory merger or consolidation, it would exalt form over substance to permit local law definitions to dictate federal income tax consequences, especially in the flexible world of state corporate statutes. as the recent experience with limited liability company legislation so aptly demonstrates, states are not beyond passing legislation solely to facilitate desired federal income tax results. at this late date, congress' lack of foresight in drafting section 368(a)(1)(a) to hinge on state law definitions can be excused. presumably, if roebling had gone the other way, and a statutory merger with solely cash consideration had been held to be a reorganization, congress would have intervened with a stock consideration requirement for statutory mergers. accordingly, continuity should continue to apply to statutory mergers and consolidations. so evolved-or devolved to its embryonic form-continuity would serve the purpose for which it was designed: exposing the naked corporate asset sale that is draped in the robes of a reorganization. it would not, however, endanger those tax-free acquisitions, such as the seagram transaction, that bear all the characteristics of a reorganization at the corporate level. continuity's breath should extend no further. there is no need to deny reorganization treatment at the corporate level solely as a result of a shift in the target shareholders remaining invested in the wake of the acquisition. from the corporate perspective, the transaction is unaffected by the identity of the combined entity's shareholders. to ensure that sections 354 and 356 are sufficient to prevent the betrayal of shareholder-level policies, it may be appropriate to tighten the definition of "stock or securities," whose receipt gauges the extent of the target shareholders' tax-free treatment. for example, it is consistent with these shareholder-level policies to require that a target shareholder actually bear equity risk with respect to acquiror stock for some period of time in order to receive the stock tax-free.2' accordingly, rules could be promulgated to deny the deferral of gain on a shareholderby-shareholder basis if market risk in the acquiror is hedged with an equity swap, short sale, or other device.y however, it frustrates the congressional policies favoring shareholder nonrecognition treatment to subject target 221. the clinton administration has taken a small step toward this requirement by proposing that certain preferred stock be characterized as boot. as discussed in note 103, enactment of this proposal should not affect preferred stock's privileged status as good consideration for continuity purposes. thus, a statutory merger solely for such preferred stock would be tax-free at the corporate level, but taxable at the shareholder level. 222. the clinton administration has already taken a large step in this direction with its "short-against-the-box" proposal, which would tax any appreciation in stock that is subject to a "constructive sale." see revenue reconciliation bill of 1996. § 9512 (submitted to congress on march 19, 1996). florida tax review shareholders remaining fully invested in the combined entity's equity to taxation at the whim and fancy of their fellow shareholders. thus, the tax court's decision in seagram is the correct result and should be codified. the wisdom of seagram should extend to the shareholder conduct and integrated transaction cases. the results of those cases are defensible on the narrower grounds of step transaction-rather than the continuity of interest doctrine-and their holdings should be so limited. the same rationale should apply with even greater force to a section 338 transaction. as the legislative history to that section indicates, congress intended that the subsequent conduct of the target's majority shareholder would not subject the target to corporate-level tax. in confirming the exemption of the corporate parties to a qualified stock purchase and merger from the modem continuity doctrine, congress surely did not intend to frustrate the policies supporting minority shareholder nonrecognition by subjecting them to taxation on the involuntary receipt of possibly illiquid acquiror stock. thus, the anti-yoc heating regulations should permit tax-free treatment to minority shareholders that receive acquiror stock in the second-step merger. the concept of remote continuity should be put to bed once and for all. to hinder the acquiror's use of target assets following an otherwise valid reorganization only frustrates legitimate business planning. congress' piecemeal anti-groman and anti-bashford legislation should be interpreted as a cautious correction of a complex statute, rather than a policy statement that transactions not specifically addressed are prohibited. moreover, continued adherence to a doctrine as formalistic as the remote continuity doctrine only invites abuse. continuity's sustained utility depends not only upon a restricted mandate but also upon a clear assignment. accordingly, its equity requirement should be set as an absolute threshold that is objectively determinable at the time of the acquisition. 223 an absolute threshold would cure uncertainty, improve administrability, and eliminate inconsistent treatment, although it would not be perfect. even if it is imposed at the lower thresholds established by the courts (e.g., between the 16% that was insufficient in kass and the 25% that was sufficient in miller), it would perpetuate the inevitable conflict with the policies that favor nonrecognition for target shareholders who receive acquiror stock in a reorganization busted for lack of continuity (and are taxed, in addition to indirectly bearing the target-level tax on recognized gains). nevertheless, in the absence of a statutory mechanism to 223. this proposal has some commonality with the clinton administration's proposal to tax the distributing corporation on a § 355 transaction if a four-year (two before, two after)/50% continuity threshold is not met. the proposal is described in general terms in note 87. [vol 3:5 1996] devolution & inevitable extinction of the continuity of hterest doctrine 257 tax only the target corporation on such an asset transfer, a low absolute threshold would minimize the conflict. although any regulatory solution to the continuity mess would be controversial, these limitations would bring continuity closest to its historical source and in line with the relevant tax policies. these improvements are within the treasury's power. vi. conclusion continuity is an endangered doctrine. having wandered from its natural role of distinguishing at the corporate level between taxable asset sales and tax-free reorganizations, the modem continuity doctrine is now vulnerable to predators. congress attacked the doctrine by significantly limiting remote continuity, and the service thinned the doctrine further with the anti-yoc heating regulations and its rulings ignoring continuity concerns in mutual savings and loan association mergers. most recently, the seagram court preyed on the wearied and over-extended doctrine, and the service has indicated that it may join the chase. continuity must adapt or face extinction. continuity should devolve to its original form and again serve the important but modest function of disqualifying reorganizations that resemble taxable asset sales. the service should confirm the demise of remote continuity and the inapplicability of continuity to the shareholder conduct and integrated transaction cases, and it should modify' the anti-yoc heating regulations to allow tax-free treatment to minority shareholders. finally, continuity should be expressed by an absolute equity threshold, determinable at the time of the acquisition and binding on taxpayers and the service alike. florida tax review volume 4 1999 number s estate and gift tax effects of selling a remainder: have d'ambrosio, wheeler and magnin changed the rules? ronald h. jensen' l. introduction .................................... 539 ii. judicial interpretation of "adequate and full consideration" ............................... 541 m. what is "adequate and full consideration" in a simple sale of a remainder 9 . . . . . . . . . . . . . . . . . . . . 549 a. critique of the gradow and the d'ambrosiowheeler views of "adequate and full consideration" . ............................ 549 b. the irs's "legitimate" concern: value manipulation-and congress's response .......... 558 c. tax considerations in selling a remainder today: the effects of section 2702 and the holdings of the d'ambrosio trilogy............... 562 1. sales of remainders in high-growth properties to family members ............. 565 2. sales of remainders to nonfamily m embers ............................. 566 3. sales of remainders by persons who are ill, but not too ill, for private annuities ..... 567 4. sale of a remainder in a residence to a family member ....................... 568 iv. the effect of the d'ambrosio trilogy on spousal elections ....................................... 569 a. tales of tax avoidance ........................ 569 1. the untutored estate plan ................ 569 2. the spousal election will as an estate tax saving plan ........................ 570 * professor of law, pace university school of law. a.b. yale university (1961): ll.b. harvard law school (1964). i would like to thank pace law school for the research grant that made this article possible and david l gerstner, my research assistant, both for his research assistance and for the fruitful discussions we had about the issues in this article. florida tax review a. where w's life estate in h trust is worth less than c's remainder in w trust ............. 570 b. where w's life estate in h trust is worth more than c's remainder in w trust ............. 571 3. modifications to avoid section 2702; the marital deduction; and emergency needs of the surviving spouse .................. 574 a. section 2702 .................... 574 b. the marital deduction ............ 576 c. emergency needs of w ............ 577 4. the "fly in the ointment"-uncertain income tax effects ...................... 581 a. exchange made by h's estate ....... 581 b. exchange made by w .............. 584 b. searching for the true nature of a spousal election .................................... 585 1. no "bona fide sale"................... 585 2. a spousal election as mutual, but separate, gifts by h and w ............... 589 3. a spousal election as the creation of reciprocal trusts ....................... 591 a. the rationale of the reciprocal trust doctrine ................... 591 b. the lehman rationale applied to spousal elections .............. 595 c. estate of magnin, spousal elections and the reciprocal trust doctrine ....................... 601 v. conclusion ...................................... 605 [vol 4:8 estate and git tax effects of selling a remainder i. introduction for over two-thirds of a century, federal estate tax law has expressly provided that property transferred by a decedent during his lifetime will nonetheless be subject to estate tax if he retains the right to the property's income for the remainder of his life.' this rule-now embodied in section 2036 of the internal revenue code'-reflects congress's belief that such transfers are inherently testamentary: the transferor continues to enjoy the "transferred" property for the rest of his life, while his beneficiary obtains the property only upon the transferor's death. during the same period, "bona fide sale[s] for an adequate and full consideration" have been excluded from the operation of this provision.4 the rationale for this exclusion is that a transfer of property for which the transferor 1. the first statutory provision expressly mandating this result was § 302(c) of the revenue act of 1926 as amended by the joint resolution of march 3, 1931. h.rj. res. 529, 71st cong. (1931). previously, the government had argued for the same result under the general provision requiring inclusion in the decedent's gross estate of any property he transferred where the transfer was "intended to take effect in possession or enjoyment at or after his death." this language was contained in § 202(b) of the revenue act of 1916. ch. 463, 39 stat. 756, 777-78 (1916), and was carried over in subsequent revenue acts. see, e.g., revenue act of 1918, ch. 18, § 402(c), 40 stat. 1057, 1097 (1919); revenue act of 1921, ch. 136, § 402(c), 42 stat. 227. 278 (1921); revenue act of 1924, ch. 234, § 302 (c), 43 stat. 253, 304 (1924): revenue act of 1926, ch. 27, § 302(c), 44 stat. 9,70 (1926). however, the supreme court ruled this language did not encompass a lifetime transfer of property in which the decedent retained a life estate in may v. heiner, 281 u.s. 238 (1930), overruled in part by commissioner v. estate of church. 335 u.s. 639 (1949), and in three decisions decided on the same day in 1931: burnet v. northern trust co., 283 u.s. 782 (1931); mccormick v. burnet, 283 u.s. 784 (1931); and morsman v. burnet, 283 u.s. 783-84 (1931). one day after the 1931 decisions were handed down, congress enacted the joint resolution of march 3, 1931, legislatively overruling them and may v. heiner. for the history of congress's response to may v. heiner, see commissioner v. estate of church, 335 u.s. at 639-40. 2. unless otherwise stated, all section references are to the internal revenue code of 1986 as currently in effect. section 2036(a) provides: the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom. 3. see estate of church v. commissioner, 335 u.s. 632, 646 (1949) ("[tlrusts reserving life estates with remainders over at grantors' deaths are... effective substitutes for wills."). 4. irc § 2036(a) (parenthetical clause). 19991 florida tax review receives full value does not diminish the size of his estate, and thus there is no need to subject the transferred property to estate tax.5 an issue that has vexed courts, estate planners, and commentators is how to ascertain the adequacy of consideration when a property owner sells a remainder interest in the property and retains a life estate. for the exclusion to apply, must the consideration received for the remainder simply equal the value of the remainder or must it equal the value of the entire property? a substantial body of case law--developed largely in the context of the so-called "widow's election"--holds the consideration must equal the full value of the property.6 however, the third circuit in d'ambrosio in 1996' and the fifth circuit in wheeler in 19978 held that consideration received in a simple sale of a remainder is adequate-and hence the exclusion applies-where the consideration merely equals the actuarial value of the remainder on the date of sale. more recently, the ninth circuit in magnin, overruling one of its own decisions, adopted the d'ambrosio-wheeler test for "full consideration."9 (this article will sometimes refer to d'ambrosio, wheeler, and magnin collectively as the "d'ambrosio trilogy"). this issue is of more than academic interest. if the holdings of the d'ambrosio trilogy are correct, existing case law regarding the widow's election (hereinafter "spousal election") is arguably wrong. if so, estate tax planners will have acquired a valuable tool, albeit one subject to serious income tax risks, that would apparently enable a couple to pass one-half or more of their combined property to the next generation free of any gift or estate tax in many cases and to enjoy significant transfer tax savings in virtually every case. 0 5. in estate of frothingham v. commissioner, 60 t.c. 211, 215 (1973), the court stated: thus, where the transferred property is replaced by other property of equal value received in exchange, there is no reason to impose an estate tax in respect of the transferred property, for it is reasonable to assume that the property acquired in exchange will find its way into the decedent's gross estate at his death unless consumed... in much the same manner as would the transferred property itself had the transfer not taken place. 6. see, e.g., pittman v. united states, 878 f. supp. 833 (e.d.n.c. 1994); wheeler v. united states, 77 a.f.t.r. 96-612 to 96-613 (w. d. tex. 1996), rev'd, 116 f.3d 749 (5th cir. 1997); d'ambrosio v. commissioner, 105 t.c. 252 (1995), rev'd, 101 f.3d 309 (3d cir. 1996), cert. denied, 520 u.s. 1230 (1997); gradow v. united states, 11 cl. ct. 808 (1987), aff'd, 897 f.2d 516 (fed. cir. 1990); united states v. past, 347 f.2d 7 (9th cir. 1965); estate of gregory v. commissioner, 39 t.c. 1012 (1963). 7. d'ambrosio v. commissioner, 101 f.3d 309 (3d cir. 1996), cert. denied, 520 u.s. 1230 (1997). 8. wheeler v. united states, 116 f.3d 749 (5th cir. 1997). 9. estate of magnin v. commissioner, 184 f.3d 1074 (9th cir. 1999). 10. see infra part iv for a discussion of possible tax advantages of spousal election wills. [vol. 4:8 estate and git tax effects of selling a remainder part ii of this article traces the evolving judicial interpretation of the "adequate and full consideration" exclusion found in section 2036. part i examines the proper application of the "adequate and full consideration" exclusion to simple sales of remainders such as those involved in d'ambrosio and wheeler and concludes that the holdings in those cases are indisputably correct. it then analyzes the possible planning opportunities these decisions offer, particularly in light of section 2702. part iv examines the effect of the d'ambrosio trilogy on spousal elections. this part outlines the potential gift and estate tax savings this device affords and then considers how such elections should be analyzed for purposes of the "adequate and full consideration" exclusion. it concludes that spousal elections in virtually every case should be governed by the reciprocal trust doctrine. under this approach, spousal elections do not constitute sales of remainders, and hence the holdings of the d'ambrosio trilogy should not apply. indeed, in many cases, the existing position of the internal revenue service and the courts produces excessively generous results to taxpayers. however, in the relatively few cases where the reciprocal trust doctrine should not apply, the current treatment of spousal elections should change to conform to the holdings in d'ambrosio, wheeler, and magnin. ii. judicial interpretation of "adequate and full consideration" spousal elections have played a central role in molding judicial interpretation of the phrase "adequate and full consideration." these elections originated in community property states where each spouse possesses a current, vested one-half interest in all property acquired by the couple during marriage. " in a spousal election will, the deceased spouse attempts to dispose of both his share and the surviving spouse's share of the community property. since the deceased spouse can only dispose of his share of the community property, state courts hold that such wills impose an election on the surviving spouse: she must either allow her share of the community property to pass under the decedent's will, in which case she receives the benefits provided for her in the vill, or else retain her share of the community property, in which event she forfeits all such benefits.2 following convention-and actuarial experience-this article assumes that husband h dies first survived by his wife iv. unless otherwise indicated, the following facts apply: h's will purports to leave all the community property in trust, with income payable to w for her life and principal payable upon her death 11. see generally roger a. cunningham et al., the law of property §§ 5.14 -. 16 (2d ed. 1993) (overview of state community property laws). 12. see, e.g., in re smith's estate, 40 p. 1037 (cal.1895); graser v. graser, 215 s.w.2d 867 (tex. 1948); dakan v. dakan, 83 s.w.2d 620 (tex. 1935). 19991 florida tax review to their child c. w chooses to let her share of the community property pass to the trust created under h's will. for purposes of clarity, the trust that ws share of the community property passes into will be referred to as w trust, and the trust that h's property passes into will be referred to as h trust. when w elects to allow her share of the community property to pass under h's will, she in effect "transfers" her property to w trust. since she "retains" a life estate in that trust, the trust will be included in her gross estate pursuant to section 2036, unless w's election constitutes "a bona fide sale for an adequate and full consideration."13 the "consideration" w receives for making the election is seemingly her life estate in h trust. the question confronting the courts was how to determine whether this "consideration" was "adequate and full." should this consideration (i.e., w's life estate in h trust) be measured against the full value of her property that passes into w trust or merely the value of the remainder that w gives c in her share of the property? in the early cases, the courts apparently found the answer self-evident, holding without discussion that the value of w's life estate is "adequate" consideration only if it equals the full value of the property transferred to w trust.4 the courts seemed to have thought along these lines: w has transferred her entire share of the community property to the testamentary trust established under h's will; therefore, the consideration received for this transfer is adequate only if it equals the value of the property transferred. 5 what this approach overlooks is that while w transferred title to her entire share of the community property, economically she transferred only a remainder interest since she continued to enjoy the economic benefit of her retained life estate.' 6 13. irc § 2036(a)(1). 14. united states v. past, 347 f.2d 7 (9th cir. 1965) (divorce settlement); estate of gregory v. commissioner, 39 t.c. 1012 (1963). some early cases found the consideration inadequate without specifying the appropriate measure. see, e.g., united states v. gordon, 406 f.2d 332 (5th cir. 1969); estate of vardell v. commissioner, 307 f.2d 688 (5th cir. 1962). in these cases, the value of w's life estate in h trust was less than either the remainder in wtrust or the total value of w trust; hence, there was no need to specify the appropriate yardstick in determining the adequacy of consideration. thus in vardell, the value of w's legal life estate in h's property was approximately $454,000, less than either the value of remainder in iv's property (approximately $684,000) or the total value of such property (approximately $1,241,000). estate of vardell, 35. t.c. 50, 53 (1960), rev'd on other grounds, 307 f.2d 688 (5th cir. 1965). this was also true in gordon, 406 f.2d at 335 (value of w's life interest in h's share (approximately $18,500) was less than the value of the remainder in her share (about $34,800) or the total value of her share (about $53,300)). 15. past, 347 f.2d at 13-14 (wife's life estate worth $143,346 "from her husband's contribution" was less than the $243,989 "decedent contributed to trust"); estate of gregory, 39 t.c. at 1017 (wife's life estate worth $60,635 in portion of trust contributed by husband is "clearly not adequate and full consideration" for the $65,925 contributed by wife to trust). 16. cf. regs. § 25.2512-5(d)(2) ("when the donor transfers property in trust or otherwise and retains an interest therein, generally, the value of the gift is the value of the [vol 4:8 estate and git tax effects of selling a remainder the courts in these cases permitted w's estate, pursuant to section 2043(a), 7 to offset w's gross estate by the consideration she received for making the election, that is, the value of her life estate in h trust.'8 the irs as well as the courts now uniformly allow this offset." note, however, that this relief is severely limited and much less beneficial than the "adequate and full consideration" exclusion. when the exclusion applies, w trust is completely eliminated from w's gross estate. in contrast, the section 2043(a) offset merely reduces w's gross estate by the value of her life estate in h trust leaving the balance of w trust taxable. moreover, the courts have limited the amount of the offset to the value of w's life estate as of the election date.' thus, while the amount included in w's gross estate under section 2036(a) will increase to reflect any appreciation in the value of w trust occurring between ws election and her death, the offset under section 2043(a) remains fixed?2' property transferred less the value of the donor's retained interest."): regs. § 25.2702-1(b) ("the amount of the gift, if any, is then determined by subtracting the value of the interests retained by the transferor or any applicable family member from the value of the transferred property."). 17. section 2043(a) provides: if any one of the transfers, trusts, interests, rights, or powers enumerated and described in sections 2035 to 2038, inclusive, and section 2041 is made, created, exercised, or relinquished for a consideration in money or money's worth, but is not a bona fide sale for an adequate and full consideration in money or money's worth, there shall be included in the gross estate only the excess of the fair market value at the time of death of the property othervise to be included on account of such transaction, over the value of the consideration received therefor by the decedent. 18. see, e.g., past, 347 f.2d at 14, estate of vardell, 307 f.2d at 693estate of gregory, 39 t.c. at 1019-20. 19. in litigation involving spousal elections, the irs has conceded that the surviving spouse's estate is entitled to a § 2043 offset equal to the value of the life estate she received in the deceased spouse's property valued on the date of its receipt. see, e.g.. gradow v. united states, 11 cl. ct. 808, 809-10 (1987), aff'd, 897 f.2d 516 (fed. cir. 1990); estate of gregory, 39 t.c. at 1020 (irs conceded issue on brief). the irs also allows a § 2043 offset in simple sale-of-remainder cases equal to the amount of consideration the decedent received valued on the date of the sale. see, e.g., wheeler v. united states, 116 f.3d 749, 753 (5th cir. 1997); d'ambrosio v. commissioner, 101 f.3d 309, 311 & n. 1 (3d cir. 1996). cert. denied, 117 s. ct. 1822 (1997). 20. see, e.g., estate of magnin v. commissioner. 184 f.3d 1074, 1082 (1999): united states v. righter, 400 f.2d 344 (8th cir. 1968); estate of gregory, 39 t.c. at 1021 (for purposes of § 2043(a), "relevant value of her life estate in [husband's] property was the value at the time of transfer"); regs. § 20.2043-i. 21. conversely, the § 2043(a) offset is not reduced when the value of the transferred property decreases in value between the date of transfer and the transferor's death. the propriety of freezing the § 2043(a) offset at the consideration's value on the date of its receipt is challenged in charles l b. lowndes, consideration and the federal estate and gift taxes: transfers for partial consideration, relinquishment of marital rights, family 19991 florida tax review the courts in the early cases may have failed to thoroughly analyze whether the consideration received was to be measured against the value of the remainder interest or the value of the fee in the transferred property because the facts in those cases showed the consideration was inadequate regardless of which measure was used.22 this was not true in gradow2 where the court of claims for the purpose of deciding a motion for summary judgment assumed that the value of w's life estate in h trust exceeded the value of the remainder interest annuities, the widow's election, and reciprocal trusts, 35 geo. wash. l. rev. 50, 56-60 (1966). professor lowndes advocates a "proportional rule" under which the § 2043(a) offset would equal the transferred property's date-of-death value multiplied by a fraction, the numerator of which is the consideration received and the denominator of which is the value of the property, with both the consideration and the property being valued on the date of transfer. see id.; see also dodge et al., 50-5th t.m., transfers with retained interests and powers, at a86 to a-87 (1992) (each endorsing proportional approach) and keith e. morrison, the widow's election: the issue of consideration, 44 tex. l. rev. 223, 242-44 (1965). judge learned hand's decision in helvering v. united states trust co., 111 f.2d 576 (2d cir. 1940) appears to be the only judicial endorsement of this approach. the tax court rebuffed the taxpayer's attempt to use a proportional approach in estate of magnin v. commissioner, 71 t.c. memo (cch) 1856,69 t.c. memo (ria) 96,025 at 248 (1996); aff d, 184 f.3d 1074 (9th cir. 1999), stating "it is well settled that the consideration received is to be valued at the time of the transfer." 22. in estate of gregory v. commissioner, 39 t.c. 1012 (1963), w's life estate in h trust was worth only $12,000, while the total value of the property wallowed to pass into w trust was $66,000, and the remainder interest in wtrust was $53,000. see id. at 1017. thus, the consideration received (i.e., w's life estate in h trust) was inadequate whether measured against the full amount of property wallowed to pass into wtrust or the remainder interest in that trust. (the value of remainder was determined by taking the factor for determining w's life estate, 0.1967, see id. at 1015, determining its reciprocal, 0.8033, and multiplying the reciprocal by the value of the amount wcontributed to wtrust, $66,000, see id. at 1017. all figures in this footnote are rounded to the nearest $1,000.) under the figures used by the majority in united states v. past, 347 f.2d 7 (9th cir. 1965), the test employed to determine adequacy of consideration would make a difference. under its figures, w's life estate in h's contribution, $143,000, see id. at 14 n.7, was greater than the value of the remainder interest in the property she contributed, $101,000 (i.e., contribution of $244,000 less her life estate therein, $143,000), but less than the full amount of her property contribution, $244,000, see id. at 14. however, as judge ely pointed out in dissent, the majority overvalued h's contribution to the trust. since h's total interest in the community was worth $401,000, and since he received $294,000 outright in the settlement, his maximum contribution to the trust was $107,000 ($401,000 $294,000), making iv's contribution $380,000. see id. at 16. using these figures and the government's actuarial tables, judge ely computed the value of w's life estate in h's contribution at $63,000 and the remainder interest in w's contribution at $157,000. see id. at 17 n.2. thus, the consideration wreceived (i.e., her life estate in h's contribution, having a value of $63,000) was inadequate whether measured against w's contribution to the trust ($380,000) or the value of the remainder in her contribution ($157,000). 23. gradow v. united states, 11 cl. ct. 808 (1987), aff'd, 897 f.2d 516 (fed cir. 1990). [vol 4:8 estate and git tax effects of selling a remainder in w trust but was less than the value of the fee interest in that trust.24 despite this factual difference, the court reiterated the holding of the prior cases that consideration in a spousal election is adequate only if the life estate iv receives in h trust equals or exceeds the value of the entire property placed in w trust. s the gradow court offered two justifications for its holding, one based on the statute's language and the other on its policy. the court referred to the introductory language of section 2036(a): "the gross estate shall include... all property ... of which decedent has at any time made a transfer." it then asserted that "[flundamental principles of grammar dictate that the parenthetical expression which then follows-'(except in the case of a bona fide sale.. .)'-refers to a transfer of the same property, i.e., the one-half of the community property she placed into trust."' in other words, the requirement of "'adequate and full consideration," which is found in the parenthetical expression, refers back to "all property" transferred by the decedent. hence, adequacy of consideration must be measured by the full value of w's property that she allowed to pass under h's will. the court also noted that the justification for the "adequate and full consideration" exemption found in section 2036 (and the other retained interest provisions) is that the amount included in a transferor's gross estate is not diminished by a transfer for which the transferor receives full compensation and hence no need exists to add the transferred property back into his gross estate.' in light of this rationale, the court held that the exception requires "at a minimum, [that] the sale accomplish an equilibrium for estate tax purposes,"' that is, that the consideration received fully replenish the amount removed from the estate by the transfer. the court asserted this purpose would be frustrated if the consideration received were deemed adequate so long as it merely equaled the actuarial value of the remainder. if that were so, the court insisted, "the exception [for a bona fide sale] would swallow the rule. a young person could sell a 24. id. at 809-10. the court granted government's motion for partial summary judgment where parties stipulated that iv's life estate in h's property was worth less than her share of the community, even though taxpayer asserted that the value of such life estate exceeded the value of the remainder she gave up in her share. see id. 25. the court first found that the formula stated in the prior cases--that adequacy of the consideration wreceived (i.e., iv's life estate in h trust) should be measured against the total value of the property she allowed to pass into iv trust-would have been followed by the courts in those cases even if such consideration had exceeded the value of the remainder wgave up in wtrust. see id. at 811 & n.3. it then concluded that this approach was correct. see id. at 813. 26. id. at 813. 27. see id. at 813-14. 28. id. at 814. 19991 florida tax review remainder for a fraction of the property's worth, enjoy the property for life, and then pass it along without estate or gift tax consequences." 9 the taxpayer countered that where a remainder is sold for its current actuarial value, the amount received, when invested and compounded at the rate used in the government's tables in valuing that remainder, would grow over the transferor's life expectancy to the property's value as of the date of the transfer.3 hence, the transfer of the remainder would cause no reduction in the transferor's gross estate, and the purpose of the "adequate and full consideration" exception would be fully satisfied. but the court rejected this contention, stating that: the fond hope that a surviving spouse would take pains to invest, compound, and preserve inviolate all life income from half of a trust, knowing that it would thereupon be taxed without his or her having received any lifetime benefit, is a slim basis for putting a different construction on § 2036(a) than the one heretofore consistently adopted.31 at the same time the courts were applying this rule in the estate tax context, they were applying the opposite rule in gift tax cases. section 2512(b) provides that a taxable gift occurs only to the extent that "the value of the property [transferred] exceed[s] the value of the consideration" received. 32 thus no taxable gift takes place if a transferor receives "adequate and full consideration." in contradistinction to their rulings in estate tax cases, the courts held that consideration in a spousal election is "adequate and full" for gift tax purposes if the consideration merely equals the value of the remainder.33 thus, w makes no taxable gift by allowing her property to pass under h's will, so long as the value of the life estate she receives in h trust equals or exceeds the value of the remainder she gives to c in w trust.34 the irs acquiesced in these holdings in 1964.35 when confronted with this discrepancy, the courts could do 29. id. at 815. 30. see id. 31. id. at 816. 32. irc § 2512(b). 33. turman v. commissioner, 35 t.c. 1123 (1961), acq., 1964-2 c.b. 7. see also siegel v. commissioner, 26 t.c. 743 (1956), acq., 1964-2 c.b. 7, affd, 250 f.2d 339 (9th cir. 1957). 34. even where there is a taxable gift, the amount of the gift is limited to the amount by which c's remainder in wtrust exceeds w's life estate in h trust. put differently, w's gift of a remainder in her property to c is offset by the value of the life estate she receives in h trust. siegel v. commissioner, 26 t.c. 743 (1956), acq., 1964-2 c.b. 7, aft'd, 250 f.2d 339 (9th cir. 1957). 35. see 1964-2 c.b. 7 (acquiescing to the holdings in turman v. commissioner, 35 t.c. 1123 (1961) and siegel v. commissioner, 26 t.c. 743 (1956), aff'd, 250 f.2d 339 (9th cir. 1957)). [vol 4:8 estate and git tax effects of selling a remainder little more than respond that one case involved the gift tax while the other involved the estate tax.36 all the foregoing cases involved spousal elections. prior to gradow, no court had held that the amount received in a simple sale of a remainder-as contrasted with a spousal election-must equal the value of the underlying fee to constitute "adequate and full consideration." indeed, the service had ruled privately that the consideration received by a fee owner who simply sells a remainder interest in his property is adequate if it merely equals the actuarial value of the remainder as determined under the government's tables.3' but after gradow, the service started issuing rulings holding that consideration in a sale of a remainder is inadequate unless it equals the full value of the underlying fee.3 the tax court39 and a number of federal district courtse followed suit and endorsed the government's new position. it was these rulings that the courts of appeal in the third and fifth circuits firmly rejected in d'ambrosio' and wheeler. 42 the court in d'aybrosio disputed the contention of the gradow court that, "fundamental principles of grammar dictate" that the phrase "adequate and full consideration" as used in section 2036 must be read as applying to the entire "'property" transferred by the decedent. 43 the d 'ambrosio court asserted that the gradow court had ignored the words following "property" in section 2036; specifically, it had failed to note that the actual language used in the statute was "all property to the extent of any interest therein" transferred by the decedent.' the d'ambrosio court concluded that the phrase "adequate and full consideration" refers back to the "interest" the decedent transferred, not to the 36. see gradow v. united states, 11 cl. ct. 808,816 n. 12(1987), aff'd, 897 f.2d 516 (fed. cir. 1990)-an estate tax case involving a spousal election-where the court stated, "as legal support, [taxpayer] points to commissioner r. siegel, 250 f.2d 339 (9th cir. 1957). siegel was a gift tax case, however, and was distinguished later on that basis by the same court in [united states v.] past, 347 f.2d [7] at 13 n.4 [9th cir. 1965]." 37. see tech. adv. mem. 78-06-001 (oct. 31, 1977); tech. adv. mem. 81-45-012 (july 20, 1981). 38. see tech. adv. mem. 91-33-001 (jan. 31, 1990). 39. see d'ambrosio v. commissioner, 105 t.c. 252 (1995), rev'd, 101 f.3d 309 (3d cir. 1996), cert. denied, 520 u.s. 1230 (1997). 40. see pittman v. united states, 878 f. supp. 833 (e.d.n.c. 1994): parker v. united states, 894 f.supp. 445, 447 (n.d. ga. 1995) (expressing "reservations about correctness of gradow"); wheeler v. united states, 77 a.f.t.r. 2d (ria) 1045 (w. d. tex. 1995), rev'd, 116 f.3d 749 (5th cir. 1997). 41. d'ambrosio v. commissioner, 101 f.3d 309 (3d cir. 1996). cert. denied. 520 u.s. 1230 (1997). 42. wheeler v. united states, 116 f.3d 749 (5th cir. 1997). 43. d'anbrosio, 101 f.3d at 314-15. 44. id. at 314. see irc § 2036(a). 19991 florida tax review "property" of which such "interest" is a part. hence, consideration is adequate if it merely equals the value of the "interest" transferred, that is, the remainder.45 the opinions in both d'ambrosio and wheeler agreed with gradow that the "adequate and full consideration" exception should apply only where the consideration received was sufficient to fully replenish the depletion in the transferor's estate caused by the transfer.46 however, they rejected the gradow court's concern that a transferor's gross estate would not be fully replenished where the consideration was limited to the actuarial value of the remainder. they pointed out that if such consideration is invested at the yield used in the government's tables to compute the present value of the remainder, it will grow over the life of the transferor (if he lives his full life expectancy) to the date-oftransfer value of the underlying fee. hence there will be no diminishment in the transferor's gross estate.4 indeed, there will be an excessive inclusion of value in the transferor's gross estate under the gradow approach for then his gross estate will include both the date-of-death value of the underlying fee and the consideration received for the transferred remainder plus all the income that accumulated on such consideration.48 moreover, the court in d'ambrosio dismissed the concern expressed in gradow that the transferor might consume all or part of the consideration received, or the income earned thereon, so that there would not be a full restoration of value in the transferor's gross estate. the court first noted that the "[t]ax law... imposes no burdens on how a person spends her money."49 it acknowledged that if the income from w's retained life estate were inadequate to support her, she would have to "invade the consideration she received in exchange for her remainder."5 but it argued that the amount of this invasion, and hence the depletion in her gross estate, would be "to no different an extent than [if] ... she retained the fee simple interest.' the impact of d'ambrosio and wheeler on spousal election cases is unclear. the court in d'ambrosio made no distinction between a simple sale of a remainder and a spousal election, and appears to have simply found gradow-a spousal election case-wrongly decided. 2 the wheeler opinion is more circumspect, stating it found the third circuit's rejection of gradow 45. d'ambrosio, 101 f.3d at 315. 46. id. at 312-13; wheeler v. united states, 116 f.3d 749, 761-62 (5th cir. 1997). 47. see d'ambrosio, 101 f.3d at 316-17; wheeler, 116 f.3d at 762. 48. see d'ambrosio, 101 f.3d at 316. 49. id. 50. id. 51. id. 52. see id. [vol. 4:8 estate and git tax effects of selling a remainder "persuasive' but adding it saw "little utility in revisiting the federal estate tax ramifications of the widow's election device .... the ninth circuit's recent decision in magnin, however, bears directly on spousal elections, since the exchange in that case is analytically indistinguishable from what occurs in a spousal election. in a spousal election, w exchanges a remainder in her property for a life estate in h's property. in magnin, a son exchanged a remainder in his property for voting control and a life income interest in his father's property.' the transaction inmagnin was therefore quite different from the simple sales of remainders in d'anbrosio and wheeler. unfortunately, the magnin court followed d'anbrosio and wheeler without considering whether these differences compelled a different analysis. i believe they do, and in part iv, i develop that analysis and apply it to the facts of magnin. ill. what is "adequate and full consideration" in a simple sale of a remainder? a. critique of the gradow and the d'ambrosio-wheeler views of "adequate and full consideration" in gradow, the court found the phrase "adequate and full consideration" referred back and thus applied to the "property" transferred by the decedent, 5 while the court in d'anbrosio found the phrase referred back and applied to the "interest therein" (i.e., the remainder) transferred by the decedent." in fact, it is unlikely that the draftsperson intended "adequate and full consideration" to modify either the words "property" or the "interest therein" transferred by the decedent. in the original 1931 formulation of section 2036, the draftsperson tagged the exception for "a bona fide sale for an adequate and full consideration" on at the end of a long subsection dealing with both gifts in contemplation of death and transfers with retained life estates." the language regarding the 53. wheeler v. united states, 116 f.3d 749, 757 n.7 (5th cir. 1997). the court also noted that "the widow election cases present factually distinct circumstances that preclude the wholesale importation of gradow's rationale into the present case." id. at 756. 54. see estate of magnin v. commissioner, 184 f.3d 1074, 1075 (9th cir. 1999). 55. gradow v. united states, 11 cl. ct. 808, 813 (1987). aff'd, 897 f.2d 516 (fed cir. 1990). 56. d'anbrosio, 101 f.3d at 314-15 (3d cir. 1996). 57. the 1931 predecessor to § 2036(a) read as follows: the value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated(c) to the extent of any interest therein of which the decedent has at any time made a transfer, by trust or otherwise, in contemplation of or intended to take effect in possession or enjoyment at or after his death, including a transfer under which the transferor has retained for his life or any period not 19991 florida tax review "adequate and full consideration" exception was placed so far away from the terms "property" and "interest therein" that it is highly unlikely that the drafter expected or intended the reader to read the latter phrase as modifying the earlier ones. indeed, the language relating to "adequate and full consideration" was separated from the rest of the subsection by a semi-colon. the meaning of the exception must therefore be found in the words of the exception itself; not by tying the words of the exception to words found in remote portions of the section. what the language of the exclusion requires is that there be a "bona sale for an adequate and full consideration." when is there a "bona fide sale for an adequate and full consideration"? surely this contemplates a transfer in which the buyer pays fair value (or what she believes is fair value) for what she gets, and the seller receives fair value (or what she believes is fair value) for what she gives up. what the buyer "gets" and the seller "gives up" in a sale of a remainder is the remainder itself-not the underlying fee-and thus adequacy of consideration should be determined solely with reference to the remainder. it is implausible that congress intended the words "a bona fide sale for an adequate and full consideration" to impose a requirement that the buyer pay substantially in excess of fair value for what she is buying. indeed, as several commentators have pointed out, if the buyer were to pay the full value of the underlying property when she acquires only a remainder, the buyer-under established gift tax principles-will normally be making a gift to the seller of the amount by which the value of the fee exceeds the value of the remainder.58 the gradow construction has the strange result of almost always limiting the "bona fide sale" exception to cases of gifts." ending before his death (1) the possession or enjoyment of, or the income from, the property or (2) the right to designate the persons who shall possess or enjoy the property or the income therefrom; except in the case of a bona fide sale for an adequate and full consideration in money or money's worth. revenue act of 1926, § 302(c), ch. 27, 44 stat. 9, 70 as amended by h.r.j. res., 71st cong., 3d sess., 46 stat. 1516 (1931) (emphases added). 58. see martha w. jordan, sales of remainder interests: reconciling gradow v. united states and section 2702, 14 va. tax rev. 671, 682-83 (1995); steven a. horowitz, economic reality in estate planning: the case for remainder interest sales, 73 taxes 386,388 (1995). 59. theoretically, the buyer could avoid gift tax treatment if he could show that his purchase was "made in the ordinary course of business (a transaction which is bona fide, at arm's length, and free from any donative intent)" since the regulations deem such purchases to be made for "adequate and full consideration." regs. § 25.2512-8 (as amended in 1992). however, since the purchase price for the remainder would be grossly excessive and since such purchases are almost always between family members, a buyer in this situation would find it difficult to establish that his purchase was at arm's length and free from donative intent. [vol 4:8 estate and git tax effects of selling a remainder moreover, congress when it created the exception for "bona fide sale[s] for an adequate and full consideration" clearly intended it to apply to at least some sales where the seller retains a life interest, or put differently, where the seller sells a remainder. otherwise, the exception would never apply. but no rational, good faith buyer ever buys a remainder for the full value of the underlying fee. the gradow construction of the exception renders it meaningless surplusage. the approach of the d'anbrosio and wheeler courts also better carries out the purpose of the "adequate and full consideration" exception, which is to exempt from transfer tax those transfers which do not reduce the transferor's gross estate. when the seller of a remainder receives consideration equal to the remainder's actuarial value, that amount, when invested and compounded at the rate of return used in the government's actuarial tables, will grow over the transferor's life (provided he lives his life expectancy) to an amount equal to the value of the underlying fee as of the date of the transfer.' thus, the transferor's gross estate will be no less than it would have been if the remainder had not been sold (assuming no change in the underlying property's value)." t 60. for example, assume that a who has a five year life expectancy sells a remainder in her property blackacre (fair market value: $500,000) at a time when the interest rate used for valuing remainders is 6%. the actuarial value of the remainder based on the government tables on the date of sale is $373,629. see internal revenue service, actuarial values, alpha volume (publication 1457) 3-10 (1989) [hereinafter actuarial values] (remainder factor for a 5 year term at 6% compounded annually is 0.747258; 0.747258 x s500.000 = s373,629). if a sells the remainder for this amount, reinvests the proceeds at 6% interest compounded annually and lives exactly her life expectancy of five years, the accumulated value of the invested proceeds will be $500,000 on the date of her death. thus, there will be no depletion in her estate. year amount at year-beginning + income during year @ 6% = amount at year-end 1 $373,629 $22,418 s396,047 2 396,047 23,763 419,810 3 419,810 25,189 444.999 4 444,999 26,700 471,699 5 471,699 28,302 500,001t note, however, that ifa uses any part of the sale proceeds or even sonte of the income therefrom to finance consumption in excess of what she was previously consuming, the size of her gross estate will be reduced. *the one dollar discrepancyis due to rounding; all numbers are rounded to the nearest dollar. all computations in this article were made on a hewlett-packard hp12c programmable financial calculator. 61. the approach advocated in the text is fully consistent with united states v. allen, 293 f.2d 916 (10th cir. 1961), cert. denied, 368 u.s. 944 (1961). in that case, mrs. allen sold her retained life estate in a trust she had created to her son for an amount slightly in excess of its actuarial value. the trial court found that her transfer of her life estate was made in 1999] florida tax review of course, in some cases, the transferor will die prematurely, in which case his gross estate will be not be fully replenished by reinvestment of the sale proceeds, while in others the transferor will outlive his life expectancy, in which event the amount of the reinvested proceeds should exceed that value of the underlying fee on the date of the sale. likewise, in some cases, the return realized by the seller of the remainder will be greater than that assumed in the government's tables while in other cases it will be less. but as the supreme court recognized in another context, "the united states is in business with enough different taxpayers so that the law of averages has ample opportunity to work."'6 moreover, the gradow construction of "adequate and full consideration" results in an excessive inclusion of value when a fee owner sells a remainder for its actuarial value, since then the seller's gross estate will include not only the underlying fee at its date-of-death value, but also the consideration received for the sale of the remainder together with all income that has accumulated on that consideration. assume that a, who has a five-year life expectancy, sells a remainder interest in blackacre (which has a current fee value of $500,000) to b at a time when the interest rate used for valuing remainders is 6%, reserving a life estate to herself. if a sells the remainder for its actuarial value of $373,62963 rather than its fee value of $500,000, blackacre will, according to gradow, be included ina's gross estate at its date-of-death value, i.e., $500,000 if blackacre does not change value. however, a's gross estate will also include the consideration a received for the remainder and the income that accumulates on it. if a reinvests her sale proceeds of $373,629 at 6% interest compounded annually and lives exactly her life expectancy of five years, the proceeds will grow to $500,000 by "contemplation of death." consequently, the trust principal was includible in her gross estate under § 2035 as then in effect unless the sale was for an "adequate and full consideration." id. at 917. on appeal, the majority opinion held that the consideration was inadequate, since the purpose of the statute was to include in the gross estate the same amount that would have been if no transfer had occurred. id. at 917-18. if mrs. allen had retained her life estate until death, the full date-of-death value of the trust principal would have been included in her gross estate pursuant to § 2036. obviously, the consideration mrs. allen received for her life estate did not replenish her estate for the amount that had been removed from it (i.e., the value of the trust principal); indeed, it only reimbursed her for the income she otherwise would have received from her life estate. full replenishment could be accomplished only by including the trust principal at its date-of-death value. in contrast, where a remainder is sold for its actuarial value, the amount included in the seller's gross estate will equal the value of the entire property at the time of transfer if she lives her full life expectancy and invests the sale proceeds. see supra note 60. hence the equilibrium sought by the court in allen will be achieved. paul r. mcdaniel et al., federal wealth transfer taxation 304 (4th ed. 1999). see also discussion of this issue in wheeler v. united states, 116 f.3d 749, 759-61 (5th cir. 1997). 62. northeastern pa. nat'l bank & trust co. v. united states, 387 u.s. 213, 224 (1967) (quoting gelb v. commissioner, 298 f.2d 544, 551-52 (2d cir. 1962)). 63. see supra note 60. [vol 4:8 estate and git tax effects of selling a remainder the time of her death.' 4 the estate will be entitled to an offset under section 2043(a) for the consideration a received for the sale of the remainder, that is, $373,629.' thus, the gradow approach causes $626,371 to be included in a's gross estate when a sells the remainder [$500,000 + $500,000 $373,629], as contrasted with only $500,000 when a retains the fee.6 a's gross estate has been substantially increased-not simply replenished-as a result of the sale. use of the gradow approach frustrates the very "equilibrium for estate tax purposes" which that court sought to achieve.67 the gradow court rejected these arguments because of its skepticism that the seller of the remainder would "take pains to invest [the sale proceeds], compound [them], and preserve inviolate all life income" from the reinvested proceeds.' if, as the court feared, the seller consumes just some of the income earned on the sale proceeds, those proceeds will not grow back over the seller's life expectancy to the property's date-of-sale value.69 a frequent response to this argument is that there will be no reduction in the seller's gross estate even if he consumes some of the proceeds (or the income thereon), since use of the proceeds for consumption "frees up" other property that the seller would have otherwise used to pay for his consumption. thus, the sale proceeds (and accumulations thereon) either directly or indirectly will find their way into the seller's gross estate.7" this argument does not give the gradow court its just due, since it "fondly" assumes the seller's level of consumption is unaffected by his sale of the remainder.7 this is by no means certain. a sale of a remainder increases the 64. see supra note 60. 65. see supra notes 17-21 and accompanying text. 66. in either case (that is, whether a sells the remainder in blackacre or not), a's gross estate will also include any income a receives from blackacre that remains unconsumed at a's death. 67. gradow v. commissioner, 11 cl. ct. 808, 813-14, aff d, 897 f.2d 516 (fed cir. 1990). 68. id. at 816. 69. see supra note 60 (providing example). a's estate in that example will be fully restored to its pre-sale size (i.e., $500,000). only if both the proceeds from the sale of the remainder, $373,629, and the income thereon are kept intact and reinvested at 6% compounded annually. 70. see, e.g., jordan, supra note 58, at 695-96. 71. the size of the seller's gross estate will be unaffected where he maintains his presale level of consumption, even if he consumes part of the sale proceeds or the income thereon. consider the case of c, a person who owns a single asset that yields insufficient income to pay for his current level of consumption. if c sells a remainder interest in the property and maintains his pre-existing level of consumption, he will no doubt consume part or all of the sale proceeds and/or the income thereon. this will reduce the size of his gross estate, but the size of the reduction will be no greater than if he had retained the fee interest in the property. in the latter case, c would have needed to "invade the principal" of his property (for example, by selling a 19991 florida tax review seller's income, and people tend to increase their consumption as their income increases.72 after selling a remainder, the seller will receive not only income from the underlying property, as he did before the sale, but also income on the reinvested proceeds. (note that this increased income will not increase the size of the seller's gross estate, since the increased income is needed just to restore his gross estate to its presale size.) although people may be inhibited from "dipping into principal," this inhibition probably does not extend to the income earned on the proceeds from a sale of principal. indeed, many people sell principal, like nonincome producing property, just so they can consume the income that the reinvested proceeds produce. if the sale of a remainder causes the seller to consume more, his gross estate will be reduced.73 the correct response to this concern is that it is irrelevant whether the seller consumes part or even all of the consideration he receives (or any of the income thereon). no gift occurs where a person sells his property for "adequate and full consideration." the theory is that the sale has not diminished the seller's gross estate, and hence there is no need to impose a gift tax to protect the integrity of the estate tax. this result is not changed by the possibility that the partial interest in it or by mortgaging it) to maintain his existing level of consumption, and this would have reduced his gross estate by the same amount as occurred when he sold the remainder interest. see d'ambrosio v. commissioner, 101 f.3d 309, 316 (3d cir. 1996), cert. denied, 520 u.s. 1230 (1997). the weakness in this analysis is the dubious assumption that c's consumption would remain the same regardless of whether he sold the remainder. if he did not sell the remainder, c, given the "traditional reluctance to 'dip into principal,"' would probably at some point have curtailed his expenditures to prevent further erosion of his dwindling principal. see stanley m. johanson, revocable trusts, widow's election wills, and community property: the tax problems, 47 tex. l. rev. 1247, 1287 (1969). 72. see johanson, supra note 71, at 1287-88. professor johanson writes that where there is an increase in overall income, "it is likelythat parkinson's second law would come into play: 'expenditure rises to meet income.' items that might have been regarded as luxuries at a lower income level would now become 'necessities."' id. at 1288 (footnote omitted). 73. note that a surviving spouse may also adjust her level of consumption as a result of her spousal election. ifw retains her share of the community andforgoes life income interest in h trust: marriage effects savings by reducing the duplication of fixed expenses that two people incur when living apart (e.g., lodging and utilities), but these savings disappear when the marriage ends. if w continues to live in the same lodging as she did before h's death, she must pay from her income alone the rent, mortgage interest expense, real estate taxes, etc., that were paid from w's and h's joint income when h was alive. theoretically, wcould make up for this shortfall by invading her principal, but "[gliven widows' traditional reluctance to 'dip into principal'-particularly when . . . principal would be consumed at a fairly rapid rate, ... she would likely adjust her living scale accordingly." johanson, supra note 71, at 1287. if wallows her property to pass under h's will thereby receiving a life income interest in both h trust and wtrust: the amount of income available for w's consumption may increase following h's death (h's expenses having ceased), and in this case "it is likely that parkinson's second law would come into play: 'expenditure rises to meet income."' id. at 1288. [vol. 4:8 estate and git tax effects of selling a remainder seller may (or in fact does) consume the proceeds, even though this means that his gross estate will be less than it would be if he had retained the property until his death. a taxpayer is always free to "beat" the estate tax through consumption or dissipation of his assets. likewise, the possibility that the seller of a remainder may consume the proceeds, unproductively invest them, or let them lie fallow should not disqualify the proceeds as "full and adequate consideration."'74 some might argue that section 2036 should still apply because every transfer of a remainder is potentially testamentary, even when effected by a sale. section 2036 treats a gratuitous transfer of a remainder, coupled with a retained life estate, as a testamentary substitute. this is because the decedent continues to enjoy the property throughout his life, just as if he had retained ownership of the fee, and the remainderman comes into possession of the property only upon the decedent's death, just as if the decedent had kept the fee and devised it to him at death. furthermore, the remainderman realizes a net economic benefit upon the transferor's death, just as if the decedent had left him a bequest or devise. the first two of these factors will also be present where the fee owner sells a remainder interest for its actuarial value. unlike the case of a person who sells his property in fee simple absolute and thereby terminates his interest in the property, a fee owner who sells a remainder continues to enjoy the underlying property for the rest of his life, while the buyer takes possession of the property only upon the seller's death. if, in addition, the buyer realizes a net economic benefit from his receipt of the property at the seller's death (after taking into account his payment of consideration), all the reasons for treating the transfer of the remainder as testamentary may arguably be said to exist. the case for applying section 2036 would be particularly strong where the seller had donative feelings for the buyer (e.g., where the buyer was a natural object of his bounty).75 note, however, that where the seller lives out her life expectancy and the remainderman buys the remainder for its actuarial value, the remainderman 74. wheeler v. united states, 116 f.3d 749,762-63 (5th cir. 1997). 75. this analysis may underlie professor jordan's assertion that § 2036 should apply in a "non-arm's length" sale of a remainder even if the seller receives "adequate and full consideration": while it may be the case that the consideration received in a non-arm's length transfer is sufficient to prevent depletion of the taxpayer's gross estate, the donative character of the transaction combined with the taxpayer's retention of an interest in the property is nevertheless sufficient to make the transfer testamentary in nature. therefore, the most appropriate result is to include the property in the taxpayer's gross estate. jordan, supra note 58, at 717-18. professor jordan does not explain how she would resolve in the case of a "non-arm's length transaction" the problem of over-inclusion of value that results when the "seller's" gross estate includes both the consideration received for the remainder and the underlying property itself, although she recognizes the problem where the seller and the remainderman are unrelated. id. at 689-92. 1999] florida tax review derives no economic benefit upon the seller's death unless the property has appreciated. the net economic benefit a remainderman realizes upon the seller's death is the date-of-death value of the property less (1) the consideration he paid for the remainder, and less (2) the income thereon which he has forgone by paying that consideration to the seller. under the government's actuarial tables, the total amount of these subtractions will exactly equal the fee value of the property where the property does not appreciate. consider a in the above example who sold a remainder in blackacre to b for its actuarial value of $373,629 while she retained a life estate for herself. since b has foregone the additional $126,371 he could have earned on the $373,629 he paid a during the five years that she survived,76 the total economic cost to b of the purchase is $500,000. his receipt of blackacre at a's death, assuming it is still worth $500,000, is economically a "wash." obviously, section 2036 should not apply where the decedent confers no benefit on her supposed beneficiary. on the other hand, if blackacre appreciates, b will realize a net economic gain upon a's death.77 here a's sale of the remainder to b may be said to be functionally indistinguishable from the normal case covered by section 2036: (1) a continued to enjoy the property during her life; (2) possession of the property passed to b only at a's death; and (3) at her death, a conferred a net economic benefit on b. indeed, this transaction may have been intentionally donative. a may have expected the property to appreciate and wanted to pass this anticipated increment on to b as a gift, but structured the transfer so that she could continue her lifetime enjoyment of the property while also avoiding any current economic loss. 78 76. see supra note 60, where it is shown that $373,629 will grow to $500,001 over five years (the actuarially-determined remainder of a's life) when it is invested at 6% interest compounded annually. 77. this of course assumes that had b retained the consideration he paid a for the remainder, it would have grown in his hands at the same rate as that used in determining the remainder's present value (i.e., 6% compounded annually) rather than the greater growth rate realized on blackacre. 78. b could also realize an economic gain if a fails to live out her actuarially determined life expectancy. in that case, b will forgo a return on the consideration he paid a for a shorter period than envisioned by the actuarial tables, and thus his loss of return will be less than the amount by which blackacre's value was discounted in determining the remainder's present value. sellers in poor health may actually anticipate this type of "gain" and intend it as a gift when they sell a remainder interest to a close family member at its actuarially determined value. arguably such gain should be taxed. of course, a buyer of a remainder will incur an economic loss if the seller outlives her life expectancy, but tax planners can be counted on to avoid this technique where the seller's health is robust. see infra text accompanying notes 79-81 for an alternative approach that could be used to measure and tax this type of gain or loss. the current regulations attempt to limit tax avoidance by prohibiting the use of the actuarial tables to value an individual's interest where "there is at least a 50 percent probability that the individual will die within 1 year." regs. § 20.7520-3(b)(3). however, taxpayers may [vol 4:8 estate and git tax effects of selling a remainder consequently, a plausible case exists for applying section 2036 to tax any appreciation that occurs between the time the remainder is sold and the seller's death. one way of accomplishing this is to include the underlying property in the seller's gross estate at its date-of-death value but then allow the estate an offset for the consideration paid and the imputed income thereon from the date of sale through the date of death.79 if the underlying property does not appreciate and the seller lives out her life expectancy, this approach will produce the same result as excluding the property from the seller's gross estate, since the offset will exactly equal the property's value. this is because offset is the amount that the consideration, when invested at the imputed interest rate, will grow to over the seller's life expectancy. this amount will equal the property's date-of-death value when there is no appreciation. 0 on the other hand, this way of applying section 2036 will capture any appreciation that occurs in the underlying property while such appreciation would escape taxation if section 2036 did not apply.8" apparentlyuse them in all other cases (e.g., where there is an 80% chance that an individual will fail to live out his 5-year life expectancy but only a 40% chance that he will die within one year). see regs. § 20.7520-1(a)(1) and infra text accompanying notes 119-20. 79. use of the actual growth in the consideration (i.e., income plus appreciation) would arguably be more accurate but presents difficult tracing problems. imputed income, based on the applicable federal rates, is more practicable. cf. lowndes, supra note 21, at 56-60 (discussing tracing problems in an analogous case of determining the § 2043 offset). professor dodge argues that use of an "actual consideration" approach is not conceptually mandated in that situation. dodge, supra note 21, at a-87. 80. consider again the case presented in note 60 where a, having a life expectancy of five years, sells a remainder in blackacre (fair market value: $500,000) for its actuarial value of $376,629. assume also thata lives exactly her actuarially-determined life expectancy of five years and that blackacre does not appreciate. as can be seen below, the method suggested in the text for applying § 2036 produces the same result as if § 2036 did not apply. where blackacre does not appreciate § 2036 applies but § 2036 offset for consideration not applicable and imputed income thereon consideration & income thereon actually in estate (based on an assumed yield of 6% per annum) $500,000 $500,000 date-of-death value of blackacre not included 5500,000 offset (as described in text) not applicable (s500.000) net amount included in gross estate $500,000 5500,000 81. assume the same facts as in the example in supra note 80, except that blackacre appreciates to $700,000. as can be seen below, the method of applying § 2036 described in the text (date of-death value of property minus consideration minus imputed income on consideration) will tax the appreciation of $200,000 whereas such appreciation goes untaxed if § 2036 does not apply. 1999] florida tax review the trouble is that no matter how appealing this approach may be as a matter of policy, it is incompatible with the current statutory framework. first, section 2043(a) takes no account of the income or other growth realized on the consideration following the date of sale, but fixes the offset at the consideration's value on the date of its receipt.8 2 secondly, this approach employs hindsight while the present "adequate and full consideration" exception focuses on the facts existing on the date of sale. under the suggested approach, section 2036 would have operative effect only if underlying property had appreciated by the time of the seller's death, a fact that is unknown and unknowable at the time of the sale. in contrast, the current "adequate and full consideration" exception asks: was the sale a "bona fide sale for adequate and full consideration"? this answer depends on the facts existing and known on the date of sale. if a person sells property in an arm's length transaction for its fair market value on the date of sale, this condition is satisfied. the possibility that the property may (or in fact does) subsequently appreciate in no way negates the existence of a "bona fide sale for adequate and full consideration."83 the decisions in d'ambrosio and wheeler are clearly correct under the existing statutory framework. b. the irs's "legitimate" concern: value manipulation-and congress's response was the government's position in d'ambrosio and wheeler simply a case of perverse obduracy? i do not think so. i believe instead that the where blackacre appreciates § 2036 applies but § 2036 offset for consideration not applicable and imputed income thereon consideration & income thereon actually in estate (based on an assumed yield of 6% per annum) $500,000 $500,000 date-of-death value of blackacre not included $700,000 offset (as described in text) not applicable ($500,000) net amount included in gross estate $500,000 $700,000 82. see supra notes 20-21 and accompanying text. 83. see united states v. righter, 400 f.2d 344, 348 (8th cir. 1968) (whether a transfer is a "bona fide sale for an adequate and full consideration" can only be decided "at the time of the transfer and cannot be deferred and made to hang on future fortuitous circumstances of longevity and of income"). cf. joseph m. dodge, redoing the estate and gift taxes along easy-to-value lines, 43 tax l. rev. 241, 244 (1988) (transfer tax system should be revised to avoid "reliance on estimates of, or speculation about, future events.... hndsight... should be used whenever possible.") id. [vol. 4:8 estate and git tar effects of selling a remainder government was using its conceptually flawed position on "adequate and full consideration" to foreclose a tax avoidance opportunity made possible by the then existing valuation rules. prior to the enactment of section 2702, taxpayers could structure the transfer of a remainder combined with a retained income interest so that government's actuarial tables would substantially overvalue the retained income interest and correspondingly undervalue the remainder. for example, in the case of a person transferring a remainder interest in trust while retaining a life income interest, the trustee could invest the trust funds in companies that plow their earnings back into their businesses rather than paying them out as dividends. "growth stocks" in publicly held companies and stock in almost all closely held corporations fall in this category. retention of a corporation's earnings, of course, increases the value of its stock thereby ultimately benefiting the trust remaindermen, but by the same token reduces and possibly eliminates altogether the value of a transferor's retained income interest. since the government's tables assume that all income is being paid to the income beneficiary, using the tables in this case will overvalue the income interest and undervalue the remainder. by investing in these types of stocks, the income that the tables assume is being paid to the income beneficiary is shifted to the remainderman in the form of stock appreciation. this ability to create disparities between economic value and table value offered an opportunity for tax avoidance. the facts of d'ambrosio provide an excellent illustration.' the decedent and her son were sole shareholders of a corporation.' the decedent, who held noncumulative convertible preferred stock worth $2,350,000, sold a remainder interest in her stock to the corporation for a private annuity valued at approximately $1,320,000.' not a single penny of dividends was paid on this stock during the approximately three years decedent lived following the sale.87 decedent's retained income interest in the stock provided her with no economic benefit. nevertheless, the government surprisingly-maybe shockingly-conceded that the value of her income interest was $1,030,000.88 correspondingly, the remainder was valued at only 84. the transaction in d'anibrosio occurred before the effective date of § 2702. decedent's sale of the remainder occurred in 1987. see d'ambrosio v. commissioner, 105 t.c. 252, 253, rev'd, 101 f.3d 309 (3d cir. 1996), cert. denied, 117 s. ct. 1822 (1997). section 2702 applies to transfers after october 8, 1990. omnibus budget reconciliation act of 1990, pub. l. no. 101-508, § 11602(e)(1)(a)(i), 104 stat. 1388-1 (1990). 85. see d'ambrosio, 105 t.c. at 253. 86. see id. at 253-54. the numbers in the text have been rounded to the nearest $10,000. 87. see id. at 254 n.4. 88. since the total value of the stock was $2,350,000, and the stipulated value of the remainder interest was $1,320,000, the resulting value of the income interest was s1,030,000. 19991 florida tax review $1,320,000 [$2,350,000 $1,030,000 = $1,320,000]. this enabled the estate to argue that the decedent had received "adequate and full consideration" for the remainder, namely the $1,320,000 annuity, and thus that section 2036 did not apply. adding "icing on the cake," the decedent died prematurely after receiving only $590,000 of annuity payments.8 9 as a result of the taxpayer's ultimate victory in d'ambrosio, the decedent succeeded in transferring $2,350,000 of value (the stock's date-of-death value)9" via the corporation to her son (its only other shareholder), while her estate was replenished for this transfer by only $590,000 of annuity payments. thus, approximately $1,760,000 of value was passed to her son free of all gift and estate tax.9 this result was the combined effect of valuing the decedent's income interest at $1,030,000, when its economic value to her was effectively zero, and her premature death which caused her to receive only $590,000 from an annuity valued at $1,320,000. congress enacted section 2702 to prevent results like this. section 2702 provides that where a person transfers property in trust to or for the benefit of a family member, any interest he retains will be valued at zero for gift tax purposes unless it is a "qualified interest."' when a person gratuitously transfers property, he makes a taxable gift to the extent the property's fair market value exceeds the value of any interest he retains.93 consequently, if he transfers a remainder to a family member while retaining a nonqualified interest, his taxable gift will be the full value of the transferred property since his retained interest will be valued at zero. on the other hand, if he retains a qualified interest, his see id. the tax court noted that because of the stipulation, it was relieved from deciding "whether decedent's reserved life estate in a noncumulative preferred stock from which she received no dividends following the transaction at issue actually had value." id. 89. id. at 254. 90. see id. 91. the approximate amount listed in the text as passing free of estate and gift taxes, $1,760,000, was computed by subtracting the annuity payments decedent received, $590,000, from the value of the stock at her death, $2,350,000. this computation assumes that decedent did not consume any portion of her annuity payments so that they were fully included in her gross estate. any portion of the payments she consumed would of course reduce the amount included in her gross estate, thereby increasing the net tax savings. conversely, the amount passing tax free would be reduced to the extent she earned income on her annuity payments that remained unconsumed at the time of her death. 92. irc § 2702(a)(1), (a)(2)(a). 93. see regs. § 25.2512-5(d)(2) ("when the donor transfers property in trust or otherwise and retains an interest therein, generally, the value of the gift is the value of the property transferred less the value of the donor's retained interest."); regs. § 25.2702-1(b) ("the amount of the gift, if any, is then determined by subtracting the value of the interests retained by the transferor or any applicable family member from the value of the transferred property."). [vol 4:8 estate and git tax effects of selling a remainder retained interest will be valued in the normal manner under the government's actuarial table.94 the two principal types of qualified retained interests are a qualified annuity interest (a "grat interest") and a qualified unitrust interest. 95 in a grat, the holder of the retained interest is entitled to receive annually a fixed dollar amount regardless of the property's actual income or value,96 while in a unitrust he is entitled to receive each year a fixed percentage of the property's fair market value (including any accumulated income) determined annually. 97 in a grat, the dollar amount remains fixed while in a unitrust the payout percentage remains fixed. qualified interests are designed to frustrate any attempt to shift value from the holder of the retained interest to the remainderman. this is achieved by requiring the trust to pay each year to the holder of the qualified interest either a fixed dollar amount (the annuity amount) or a fixed percentage of the trust's value (the unitrust amount) regardless of the trust's actual income. thus, even if a trustee invests exclusively in nondividend paying stocks (such as the preferred stockin d'ambrosio), the trust will nonetheless be required to pay each year either the annuity amount or the unitrust amount to the holder of the retained interest. this permits more accurate valuation of the retained interest and precludes the manipulative shifts of value that occurred in d'ambrosio. under the regulations, a person who sells a remainder to a family member and retains a nonqualified interest (e.g., a common law life estate) is treated as making a gift to the remainderman.98 the amount of the gift is the property's value less the consideration received for the renainder." in effect, the regulations treat the seller as transferring the entire property (not just the remainder) in exchange for the consideration received. if d'ambrosio occurred today (and the government again accepted the table values as the true values of the various interests), the decedent, who had retained a nonqualified common law 94. see irc § 2702(a)(2)(b). 95. see irc § 2702(b)(1), (2). a noncontingent remainder interest is also a qualified interest if all the other interests in the trusts are either qualified annuity or unitrust interests. see irc § 2702(b)(3). moreover, § 2702 does not apply to "regular" personal residence trusts and qualified personal residence trusts. such a trust consists of the grantor's residence in which he retains either a lifetime or term interest. see irc § 2702(a)(3)(a)(ii); see regs. §§ 25.27025(b), 25.2702-5(c). 96. see irc § 2702(b)(1). however, the regulations permit the fixed dollar amount of the distribution to decrease from year to.year, see regs. § 25.2702-3(e), ex. 3. and also permit the amount to increase but by no more than 120% of the annuity amount paid during the preceding year. see regs. § 25.2702-3(b)(1)(ii)(b). 97. see irc § 2702(b)(2). the regulations permit the unitrust amount to be increased up to 120% of the unitrust percentage paid for the preceding year. regs. § 25.2702-3(c)( 1 uii). 98. see regs. §§ 25.2702-4(a). 25.2702-4(d), ex. 2. 99. see regs. § 25.2702-4(d), ex. 2. 19991 florida tax review life estate in the preferred stock, would be deemed to have made a taxable gift of $1,030,000, that is, the value of her preferred stock, $3,250,000, less the value of her annuity, $1,320,000. in one way, this result is harsher than if the decedent had retained the stock outright and bequeathed it to her son, since payment of the tax is accelerated from the date of death to the date of sale. enactment of section 2702 should eliminate most, if not all, of the irs's concerns about possible tax abuses arising under the old valuation rules. whatever merit the service's position on adequacy of consideration may once have possessed no longer exists. the service should now hold that in a simple sale of a remainder, payment of the remainder's actuarial value constitutes "adequate and full consideration." c. tax considerations in selling a remainder today: the effects of section 2702 and the holdings of the d'ambrosio trilogy because of section 2702, selling a remainder to a family member will be less tax efficient today even if the holdings of the d'ambrosio trilogy are followed. section 2702 effectively compels a grantor establishing a grat00 to base his annual annuity payment on an interest rate that is at least as high as the rate used under section 7520 in valuing term and remainder interests (the "section 7520 rate"). otherwise the grantor will be deemed to be making a gift for tax purposes. however, the section 7520 rate will almost invariably be higher than the actual income yield from the trust. consequently, to avoid a gift tax upon the establishment of a grat, the annual payment to the grantor must be set at an abnormally high amount, and these enlarged payments, unless consumed by the grantor, will inflate his gross estate. this phenomenon is best illustrated by a concrete example. suppose p, aged 55, establishes a trust of $100,000 in which she reserves a life estate, and sells the remainder interest to her child c. if the section 7520 rate at the time is 6%, the present value of the c's remainder will be $30,473.10' for p to avoid gift tax liability on her sale of the remainder, the annual annuity payment she receives from the grat must be fixed using an interest rate at least as high as the section 7520 rate. here that rate is 6% so the grat must pay p $6,000 annually [6% of $100,000]. if the payment were less, only a part of the trust's assumed income of $6,000 would be considered paid 100. a taxpayer trying to avoid the draconian rule of§ 2702(a)(2)(a) valuing retained interests at zero will normally use a grat rather than a unitrust if the trust property is expected to appreciate. the annual payments in a unitrust will increase as the trust property appreciates-and thus inflate the transferor's gross estate-while such payments will remain constant in a grat. 101. see actuarial values, supra note 60, table s (6.0) at 1-20. [vol. 4:8 estate and git tax effects of selling a remainder out, and the balance would be viewed as retained for future distribution to the remainderman c. the present value of these assumed income accumulations over p's anticipated lifetime would constitute a taxable gift to c. section 7520 requires that life estates, remainders and similar interests be valued by assuming an income yield of 120% of the federal midterm rate (i.e., the average market yield on u.s. debt obligations having a remaining maturity of more than three years but no more than nine years).0" the rub is that this rate will almost invariably exceed the actual income yield from the trust. almost all trusts invest a significant portion of their funds in stock. 3 the section 7520 rate however is based on the yields on government debt securities (augmented by a 20% premium). since the early 1960s, these yields have consistently exceeded the dividend rates on equities, and hence the section 7520 rate, being keyed to yields on government securities, will almost invariably exceed the actual income yields of a trust that has a significant investment in stocks." 4 suppose the actual rate of income realized by the trust in the above example is 4%. before the enactment of section 2702, there would almost certainly be no gift tax liability if c paid $30,473 for the remainder (its table value based on an assumed yield of 6%) even though the actual annual income yield was only4%, i.e., $4,000.05 under current law, the annual grat payment 102. see irc §§ 7520(a), 1274(d)(1). 103. see robert b. wolf, defeating the duty to disappoint equally-the total return trust, 32 real prop., prob. & tr. j. 45, 51 (1997) ("most corporate fiduciaries are reluctant to invest less than one-half of their long-term portfolios in equity securities, simply because of the duty of impartiality [as between the income beneficiary and the remaindermanl and the historical truth that fixed income investments yield dramatically less in total return over long periods of time"). 104. one study found that income returns, as opposed to total returns, on long-term government bonds and intermediate-term government bonds exceeded the income returns on large company stocks every year during the period 1959 through 1995. see ibbotson associates, stocks, bonds, bills, and inflation 1996 yearbook 40-41, table 2-6. moreover, the spread has been increasing. in 1959, the spread between the income return on long-term government bonds and large company stock was only 0.70 percentage points (4.01% vs. 3.31%) but by 1995 the spread had increased to 4.69 percentage points (7.60% vs. 2.911%). id. consequently, it will be virtually impossible for a trust which has a significant stock investment to generate an income yield equivalent to that of government bonds. as of january 1, 1997, intermediate government bonds were yielding about 6.5% while the standard & poor's 500 stock index was yielding about 2%. if the portfolio were an even mix of stocks and bonds, the net yield (after charging trustee's fees of 0.35% to income) would be only 3.9%, substantially less than the 6.5% yield on intermediate-term government bonds. see wolf, supra note 103, at 50-51. 105. the rule applied by the courts was that the actuarial tables must be used unless it was shown that their use produces a "substantially unrealistic and unreasonable result, and a more reasonable and realistic means of determining value is available." o'reilly v. commissioner, 973 f.2d 1403, 1408 (8th cir. 1992). in rev. rul. 77-195. 1977-1 c.b. 295, the service held that the 6% actuarial tables then in effect had to be used in valuing a life estate, even though the trust was funded with stock of a company that had paid an average dividend in 1999] florida tax review would have to be $6,000 to avoid gift tax liability, and these enlarged payments in turn will augment p's gross estate. this enlargement of p's gross estate can be avoided by fixing the annuity payment below the amount determined under the section 7520 rate, but in that case p will be deemed to make a taxable gift to c. if the annual annuity payment to p were fixed at $4,000 to reflect the trust's actual income, p would be deemed to make a taxable gift to c of $23,176.116 to avoid a taxable gift, p would have to charge c an additional $23,176 for the remainder, and this amount (and earnings thereon) would be included in p's gross estate. alternatively, the trust might invest exclusively in fixed income securities and thereby attempt to match its actual return with the section 7520 rate. this approach however will probably produce inferior investment results, since the economic return on equity investments (income plus appreciation) has historically outperformed the return on debt instruments. 7 in short, selling a remainder today to a family member presents a series of unappealing choices. nevertheless, selling a remainder can still, in certain cases, produce beneficial tax results if the d'ambrosio trilogy's view of adequate consideration prevails. each of the preceding 10 years of 3% and the trustee was forbidden to dispose of the stock. see also vernon v. commissioner, 66 t.c. 484 (1976) (holding that 6% actuarial tables had to be used in valuing life income interest when trust funded with stock paying an average annual yield of 3.75% over preceding seven years despite settlor's nonbinding admonition to trustee not to sell stock). a variation of two percentage points (4% vs. 6%) when the trustee's ability to change investments is unrestricted seems well within the variance permitted by these authorities. the courts have occasionally rejected use of the tables. see o'reilly, 973 f.2d 1403 (rejecting use of 10% tables in valuing remainder when trust funded with stock historically yielding about 0.2% and trustees relieved of duty to diversify or increase income); hanley v. united states, 105 ct. cl. 638 (ct. cl. 1945) (rejecting use of 4% tables in case of portfolio yielding 3.09% on valuation date when trustees' reinvestment of funds were restricted to loweryielding government and municipal bonds). 106. the value of the remainder interest in a grat is determined by subtracting the value of the annuity from the principal of the trust. regs. § 25.2702-1(b); see also regs. § 1.664-2(c) (valuation of remainder in a charitable remainder trust). thus: value of trust principal $100,000 less value of annuity 46,351 value of remainder 53,649 less consideration received 30473 amount of gift $ 23,176 the value of the annuity was determined by multiplying the annual annuity payment, $4000, by the factor for a lifetime annuity of a person aged 55 when the interest rate is 6%, 11.5878. see actuarial values, supra note 60, table s (6.0) at 1-20. all figures rounded to the nearest dollar. 107. see wolf, supra note 103, at 57-60. [vol. 4:8 estate and git tax effects of selling a remainder 1. sales of remainders in high-growth properties to family members.-if the holdings of the d'ambrosio trilogy are followed, sales of a remainder in a grat to a family member can be tax advantageous where the economic growth in the trust property (this is, its income plus appreciation) exceeds the section 7520 rate.1as in that case, only a portion of the grat's growth will be used to fund the annual annuity payments to the grantor. the balance will be kept in the trust and will pass to the remainderman upon the trust's termination. if the remainderman paid full actuarial value for his remainder interest, there will be no gift tax on the establishment of the trust, and under the holdings of the d'ambrosio trilogy, no estate tax at the grantor's death. " since the grat will be excluded from the grantor's gross estate, the portion of the growth not used to fund the annual annuity payments passes to the remainderman free of any transfer tax."' the actual reduction in the grantor's gross estate-and thus the tax benefit of this strategy, if any-depends not only on the rate of growth in the grat property, but also on the offsetting increases in the grantor's gross estate resulting from her receipt of consideration from the sale of the remainder, her annuity payments, and any growth on those amounts."' 108. see lawrence p. katzenstein, economic and valuation planning opportunities: grits, grats, gruts and qprts, sb90 ali-aba 1221 (1997). mr. katzcnstcin points out that if the grat's rate of economic growth exceeds the § 7520 rate, the grantor will be able to transfer the excess amount to family members without transfer tax cost. see id. at 1223-27. see also jonathan g. blattmachr & georgiana j. slade, partial interests-grats. gruts, qrpts (section 2702), 836 tax mgmt. (bna) § iv.f.2. at a-42 (1996) (noting that grat is effective transfer tax technique only where grat earns more than the applicable § 7520 rate). 109. see supra notes 33-35 (gift tax), and 7-9 (estate tax). 110. assume m, having a life expectancy of five years, establishes a grat with property having a value of $100,000 when the § 7520 rate is 6%; fixes the annual annuity payment at $6,000 (based on the § 7520 rate of 6%); and sells the remainder interest therein to n, a family member, for its actuarial value of $74,726. actuarial values, supra note 60, table b (6.0) at 3-10. assume that m exactly lives out her life expectancy of five years and that the grat property realizes economic growth of 15% during that period. because the annuity payments remained fixed at $6,000 while the actual economic growth in the grat was 15%, the grat will have grown from $100,000 when m created it, to s 160,682 when she died-an increase in value of $60,681: value of grat growth in value of annuity payment value of grat year at year-beginning grat during year during year at )ear-end 1 $100,000 $15,000 ($6,000) s109,000 2 109,000 16,350 (6,000) 119,350 3 119,350 17,903 (6,000) 131,253 4 131,253 19,688 (6,000) 144,940 5 144,941 21,741 (6,000) 160,681 111. for example, assume in the case described in the preceding footnote that u realized a 10% growth rate on the consideration she received for the remainder (i.e., s74,726) 1999] florida tax review an obvious risk in this strategy is that the economic growth in the grat property may fail to exceed the section 7520 rate; indeed, it is always possible that the grat property may experience a loss. if so, the strategy may boomerang, since the amount removed from the grantor's gross estate (i.e., the value of the grat upon the grantor's death) is likely to be less than the amount added back to her gross estate by the consideration received for the remainder, the annuity payments, and any growth in these amounts. nevertheless, taxpayers who are convinced that the total economic return on the underlying property will significantly outpace the section 7520 rate may want to consider selling a remainder to a family member. if they live outside the third, fifth or ninth circuits, they must also assess the likelihood of their circuit following the holdings of the d'ambrosio trilogy. moreover, their planners will need to determine how to fund the annual annuity payments since income alone will probably be insufficient to cover them. 2. sales of remainders to nonfamily members.-section 2702 applies only to transfers made to or on behalf of a member of the transferor's family. "2 "member of the family" is broadly defined as meaning the transferor's ancestors and lineal descendents and those of his spouse, the transferor's siblings, spouses of the foregoing persons, and the transferor's own spouse."3 although and on her annual $6000 payments from the grat. in that case, the reduction in m's gross estate would be $44,158 rather than the $60,681 appreciation in the value of the grat: amount in m's gross estate if she retains property instead of selling remainder: value at m's death of property (i.e., $100,000 compounded annually at 15% for 5 years) $201,136 amount in m's gross estate if she creates grat and sells remainder therein: value at m's death of consideration received for remainder + growth thereon (i.e., $74,726 compounded annually at 10% for 5 years) $120,347 plus value of annuity payments + growth thereon (i.e., $6,000 annual payments compounded annually at 10%) 36,631 value at m's death of property replacing remainder 156,978 net reduction in m's gross estate by selling remainder 44,158 note that the actual period that the decedent lives after the sale of the remainder will also affect the amount of the reduction, if any, in her gross estate. 112. see irc § 2702(a)(1). 113. irc §§ 2702(e), 2704(c)(2). [vol. 4:8 estate and git tax effects of selling a remainder comprehensive, this definition omits the transferor's nephews, nieces, cousins, their respective descendants, as well as any unmarried "significant other" of the transferor. a taxpayer may therefore sell a remainder to any of these persons (or any other non-family member) and retain a nonqualified interest (e.g., a common law life estate) in the property without triggering section 2702. the great advantage of avoiding section 2702 is that both the seller's retained interest and the remainder will be valued in the normal fashion using the applicable section 7520 rate. indeed, according to the regulations, the section 7520 rate is to be used regardless of the trust's actual income yield so long as the income beneficiary may compel the trustee to "make the trust corpus productive consistent with income yield standards for trusts under applicable state law.""' 4 this is so even if the state-mandated minimum yield is "substantially below the section 7520 interest rate" on the valuation date. ' 5 these rules provide an opportunity for transferring value to nonfamily members free of transfer tax. if the owner of a property sells a remainder interest therein to a nonfamily member for the remainder's present value (as computed by using the section 7520 rate), there will be no gift tax at the time of the sale, and under the d'ambrosio trilogy holdings, no estate tax when the owner dies.' 6 however, if-as is usually the case-the section 7520 rate exceeds the trust's actual income yield," 7 the income interest will be overvalued and the remainder undervalued.' this "bargain element" in the sale of the remainder passes free of all gift and estate tax to the remainderman. 3. sales of remainders by persons who are ili, but not too ili, for private annuities.-at first glance, it would seem that one in ertremis could 114. regs. § 20.7520-3(b)(2)(v), ex. 2. the gift tax regulations contain a comparable provision. regs. § 25.7520-3(b)(2)(v), ex. 2. 115. see regs. § 20.7520-3(b)(2)(v), ex. 2. these regulations appear to assume a degree of specificity concerning "income yield standards for trusts under applicable state law," id., which does not exist. the restatement of trusts recognizes a "fiduciary duty to make the trust estate productive of trust accounting income." restatement (third) of trusts § 227 cmt. i. (1990). however, the amount of income which the trustee must try to generate is dependent on the "trust's circumstances and terms." id. to assure the applicability of the actuarial tables, it may be advisable to explicitly grant the income beneficiary the right to compel the trustee to make the trust corpus "productive consistent with income standards for trusts under applicable state law." however, to the extent the income beneficiary fails to exercise this right, he may be deemed to have made a taxable transfer of the amount he was entitled to, thereby possibly triggering gift and estate tax liability. cf. dickman v. commissioner, 465 u.s. 330 (1984). given the vague nature of state law on this subject, this possibility appears highly unlikely except in the most egregious cases. 116. see supra notes 33-35 (gift tax), and 7-9 (estate tax). 117. see supra notes 103-04 and accompanying text. 118. see discussion supra part m b. 1999] florida tax review dramatically reduce his gross estate by selling a remainder in his property for an annuity having the same actuarial value as the remainder. because of the seller's foreshortened life, the actuarial tables will overvalue his retained income interest and correspondingly undervalue the remainder. this, in turn, will permit the remainder to be sold for less than its true worth and yet be considered sold for "adequate and full consideration." furthermore, because the seller lives for a shorter period than indicated by the actuarial tables, the amount he receives under his annuity (and thus the amount included in his gross estate) will be less than the annuity's actuarial value. to prevent this windfall, the regulations under section 7520 proscribe use of the government's actuarial tables where the person whose interest is being valued "is known to have an incurable illness or other deteriorating physical condition" on the valuation date and "there is at least a 50 percent probability that the individual will die within 1 year."' 9 the corollary is that the tables will, indeed must, be used where the individual has more than a 50% chance of surviving a year.120 apparently this is so even if his poor health makes it unlikely that he will live out his full actuarial life expectancy. a person in this condition (i.e., in poor health but having a more than a 50% chance of surviving one year) can reduce his gross estate by selling a remainder interest in his property for a private annuity having the same actuarial value as that of the remainder, provided he fails to live out his full life expectancy. since the actuarial values of the annuity and the remainder are equal, the sale will be for "adequate and full consideration." thus there will be no gift tax liability, and under the d'ambrosio trilogy holdings, no estate tax.'2 ' any amounts the seller receives under the annuity (and any income thereon) which remain unconsumed at death will be included in his gross estate, but because of his shortened life, these amounts should be significantly less than the value eliminated from his estate. 4. sale of a remainder in a residence to a family member.-a transfer of a remainder interest in a trust whose sole asset consists of the income beneficiary's residence (a "personal residence trust") is exempt from the 119. regs. § 25.7520-3(b)(3) (gift tax regulations). if the individual survives by 18 months or longer after the gift is completed, he is presumed not to have been terminally ill on that date "unless the contrary is established by clear and convincing evidence." id. the estate tax regulations have a comparable provision that contains certain exceptions not found in the gift tax regulation. see regs. § 20.7520-3(b)(3) (estate tax regulations). 120. see regs. §§ 20.7520-1(a)(1), 25.7520-1(a)(1). 121. see supra notes 33-35 (gift tax), and 7-9 (estate tax). if the sale is to a family member, the seller must retain a qualified interest to avoid having it treated as a gift. see irc § 2702(a). [vol 4:8 estate and git tax effects of selling a remainder provisions of section 2702."2 the regulations provide that the transfer of a remainder interest in a "qualified personal residence trust" (a "qprt"), which is similar to a personal residence trust but more flexible, is also exempt.'" therefore, the regular valuation rules will prevail, and if the remainder is sold for its actuarial value, there will be no gift tax liability, and under the holdings of the d'ambrosio trilogy, no estate tax. the sale of a remainder interest in a personal residence trust or a qprt will be an attractive option where the value of the residence is expected to appreciate at a greater rate than the return on the reinvested sales proceeds. iv. the effect of the d'ambrosio trilogy on spousal elections a. tales of tax avoidance the spousal election technique offers opportunities for substantial transfer tax savings, particularly if the holdings of thed'ambrosio trilogy extend to this technique. consider the following cases. 1. the untutored estate plan.-h and w, who live in a community property state, have each decided to leave their respective shares of the community in trust, with income payable to the survivor for life and principal passing to their child c upon the survivor's death. a scrivener, lacking in tax sophistication, prepares wills implementing this plan. h predeceases w, and at the time of his death, each spouse's share of the community is worth $1,000,000. at w's death, the value of her property has increased to $1,500,000. assuming that h's executor forgoes a qtip election 24 so as to equalize the two estates, the tax consequences will be as follows: 122. irc § 2702(a)(3)(a)(ii). the specific requirements for qualifying as a "personal residence trust" are set out in regs. § 25.2702-5(b). 123. the requirements for qualifying as a qprt are set out in regs. § 25.2702-5(c). a qprt has been summarized as follows: a qualified personal residence trust must satisfy the general requirements applicable to a regular personal residence trust, but is permitted (1) to hold cash and other assets that are related to the residence; (2) to sell the residence and reinvest the proceeds in another residence; (3) to receive or make improvements to the residence; and (4) to be converted into a qualified annuity trust. as a result of its flexibility, a qualified personal residence trust, rather than a regular personal residence trust, generally will be used by taxpayers wishing to avoid section 2702. richard b. stephens et al., federal estate and gift taxation i 19.03[3][d][iii] (7th ed. 1996) (footnotes omitted). 124. h's executor could elect under § 2056(b)(7) to treat his bequest as "qualified terminable interest property" (i.e., "qtip") and thus qualify for the marital deduction, since w has a "qualifying income interest for life." 19991 florida tax review case 1 h's estate: $1,000,000 less the $650,000 exclusion amount (§ 2010)'" $350,000 w's estate: $1,500,000 less the $650,000 exclusion amount (§ 2010) 850,000 total value of property subject to transfer tax $1,200,000 2. the spousal election will as an estate tax saving plan.-in this scenario, h and w go to a sophisticated tax planner who proposes a plan having the same testamentary effect as the plan in case 1 but with significant transfer tax savings. under his plan, each spouse leaves all of the community property (including the other spouse's share) in trust with income payable to the survivor for life and principal payable to c on the survivor's death. this, of course, gives the survivor a spousal election. h and w enthusiastically adopt this plan because of its purported tax benefits and because it carries out their dispositive wishes. h dies first, and w elects to let her share of the community pass under h's will into w trust. as in case 1, each spouse's share of the community at the time of h's death is worth $1,000,000, and w's share (which is now in w trust) grows to $1,500,000 by the time of her death. the transfer tax consequences will depend on the absolute and relative values of w's life estate in h trust and c's remainder in w trust. a. where w's life estate in h trust is worth less than c's remainder in w trust.-assume that at h's death the present value of w's life estate in h trust is $400,000 and that the present value of c's remainder in w trust is $600,000. for gift tax purposes, w is treated as exchanging the remainder interest in w trust for the income interest in h trust. 26 consequently, she will be deemed to make a gift of $200,000, that is, the value of the remainder she gives to c in w trust, $600,000, less the income interest she receives in h trust, $400,000. the method for determining the estate tax effect of the election is less certain. under gradow, w's transfer of a remainder to c in w trust would not be supported by adequate consideration, since the value of her life estate in h trust (i.e., the consideration she received for setting up w trust) is less than the value of her property she allowed to pass into w trust.'27 the d'ambrosio 125. the "exclusion amount" is the amount of wealth that may be transferred without transfer tax by reason of the unified credit. see irc §§ 2010 & 2505. the exclusion amount for 1999, $650,000, is used in the examples throughout this article. the exclusion amount is scheduled to increase over a nine-year period and ultimately to reach $1,000,000 in the case of estates of decedents dying in 2006 and thereafter. see irc § 2010(c). 126. see supra notes 33-35 and accompanying text. 127. see supra notes 23-31 and accompanying text. [vol 4:8 estate and git tax effects of selling a remainder trilogy courts arguably would find the consideration adequate so long as w's life estate in h trust equals or exceeds the value of the remainder she transferred to c in w trust.128 however, the result here is the same regardless of which test is used. the consideration received, w's $400,000 life estate in h trust, is inadequate whether measured against the value of the remainder w surrendered, $600,000, or the full value of the property she let pass into iv trust, $1,000,000. however, w's estate is entitled to reduce w's gross estate by the value of her life estate in h trust (i.e., the $400,000 consideration w received), pursuant to section 2043. ignoring for the time being the effect of section 2702, and assuming again that h's executor forgoes a qtjp election, the transfer tax results will be as follows: case 2 h's estate: $1,000,000 less the $650,000 exclusion amount (§ 2010) $350,000 w's gift $600,000 (c's remainder in w trust) less $400,000 (w's life estate in h trust) and less $200,000 of the exclusion amount (§ 2505) -0w's estate: $1,500,000 less $400,000 consideration (§ 2043) and less the $650,000 exclusion amount (§ 2010)1"9 450.000 total value of property subject to transfer tax: $800,000 behold the magic wrought by the tax planner! by using a spousal election, the planner has reduced the total amount subject to transfer tax by $400,000 while producing nearly the same testamentary result as in case 1. b. where w's life estate in h trust is worth more than c's remainder in w trust.-assume that the value of c's remainder in iv trust is $400,000 and w's income interest in h's estate is $600,000. even if gradow is still good law, the result will probably be better than in case 2, simply because the increased value of w's life estate ($600,000 vs. $400,000) should produce 128. see supra notes 41-54 and accompanying text. 129. w's estate is entitled to the full benefit of the "estate tax" exclusion amount even though a part of the "gift tax" exclusion amount was used to determine the portion of w's gift (i.e., c's remainder in wtrust) that was subject to gift tax. that gift is not an "adjusted taxable gift" within the meaning of § 2001(b), since the full value of the underlying property will be included in w's gross estate pursuant to § 2036. see irc § 2001 (b) (last sentence). accordingly, the gift is not included under § 2001(b)(1)(b) in the computation of w's estate tax and therefore does not "absorb" any part of the $650,000 "estate tax" exclusion amount. 19991 florida tax review a corresponding larger offset under section 2043. if so, the tax results, again assuming h's executor does not make a qtip election and again ignoring the effect of section 2702, will be as follows: case 3 h's estate: $1,000,000 less the $650,000 exclusion amount (§ 2010) $350,000 w's gift $400,000 (c's remainder in w trust) less $600,000 (w's life estate in h trust) -0w's estate: $1,500,000 less $600,000 consideration (§ 2043) and less the $650,000 exclusion amount (§ 2010) 250,000 total value of property subject to transfer tax: $600,000 the above computation assumes that the $200,000 increase in the value of w's life estate (from $400,000 to $600,000) results in a corresponding increase in the section 2043 offset. this can be disputed. if one views h's estate as having "sold" w a life estate in h trust in exchange for her gift of a remainder to c in her property, h's estate has transferred something worth $600,000 (i.e., w's life estate in h trust) but received something worth only $400,000 (i.e., c's remainder in w trust). one may argue that only $400,000 of the $600,000 value of w's life estate should be viewed as "consideration" paid by h's estate, since that is the only value h's estate received for its money.130 under this view, the remaining $200,000 would be treated as a bequest from h to w."3 if this analysis is adopted, the total amount subject to transfer tax will be $400,000-the same as when w's life estate in h trust was worth only $400,000 (case 2)-since the section 2043 offset is limited to the actual consideration paid. however, the underlying rationale of the gradow line of cases strongly supports the contrary result. those cases measure the adequacy of the consideration w receives (i.e., her life estate in h trust) by comparing it to the value of the property she transfers into w trust.132 this implicitly views w's life estate in h trust as "consideration," not only for the remainder w gives to c, but also for all of the property she transfers into w trust. if so, the entire value of 130. see johanson, supra note 71, at 1307-09. 131. see herbert e. schwartz & alan d. liker, the widow's election, 1 univ. miami inst. est. plan., ch. 67-10, 67.1032 (1967) ("the typical approach to an exchange by related parties of property of unequal values ... is to presume-for income as for gift tax purposes-that the party receiving the smaller consideration has made a gratuitous transfer."). 132. see sources cited supra note 6. [vol. 4:8 estate and git tax effects of selling a remainder w's life estate will count as "consideration' for purposes of the section 2043 offset, since h's estate has received something (i.e., the entire amount w permitted to pass into w trust) having more value than what it gave up (i.e., w's life estate in h trust). there are some suggestions in the case law supporting this result. 133 consequently, if gradow is still good law, the result where w's life estate in h trust is worth more than c's remainder in w trust, will be at least as good-and likely better-than where the values of the life estates and remainders are reversed. but if thed'anbrosio trilogy has effectively overruled gradow, the tax saving becomes astounding. in that case, section 2036 will no longer apply and hence no part of w trust will be included in her gross estate, since w's transfer of the remainder in w trust (value: $400,000) to c in return for her life estate in h trust (value: $600,000) will be for "adequate and full consideration:" case 4 h's estate: $1,000,000 less the $650,000 exclusion amount (§ 2010) $350,000 w's gift $400,000 (c's remainder in iv trust) less $600,000 (w's life estate in h trust) -0w's estate: nothing included under §2036 -0total value of property subject to transfer tax: $350,000 note that without significantly changing the final dispositive result, use of a spousal election has reduced the amount subject to transfer tax by $850,000 from what it would have been under the untutored plan. the results of cases 1-4, based on existing law, are summarized below: 133. see united states v. past, 347 f.2d 7, 13-16 (9th cir. 1965) (allowing a § 2043 offset for the full value of w's life estate in h tnst, even though under its figures the life estate's $143,000 value exceeded the $101,000 value of c's remainder in iv trust); see also supra note 22 for a further discussion of past, cf. gradow v. united states, 11 cl. ct. 808, 810 (1987), aff'd, 897 f.2d 516 (fed. cir. 1990) ("case law generally supports the conclusion that... [the § 2043] offset includes the actuarial value... of a life estate in [h's] share."). 19991 florida tax review total amount subject to transfer tax the untutored plan (case 1) $1,200,000 the spousal election: w's life estate in h trust [$400,000] < c's remainder in w trust [$600,000] (case 2) $800,000 w's life estate in h trust [$600,000] >c's remainder in w trust [$400,000]; gradow still good law (case 3) probably $600,000 (but no more than $800,000) w's life estate in h trust [$600,000] >c's remainder in w trust [$400,000]; d'ambrosio trilogy overrules gradow (case 4) $350,000 3. modifications to avoid section 2702; the marital deduction; and emergency needs of the surviving spouse a. section 2702.-section 2702 applies to the typical spousal election, because w, by allowing her share of the community to pass to w trust, is transferring property in trust for the benefit of a family member, c, while retaining an interest for herself. if the draconian valuation rule of section 2702(a)(2)(a) applies, w will be deemed to have made a gift of the entire value of w trust-not just the remainder-to the extent it exceeds the value of her life estate in h trust. hence the estate tax savings resulting from the spousal election will be eroded by w's increased gift tax liability. h can avoid this result by giving w a qualified annuity interest in w trust, thereby making it a grat.' m w's interest will then be valued in accordance with the normal actuarial tables (rather than arbitrarily at zero), and the value of c's remainder will be limited to the remaining value of the property w transfers into w trust."5 the downside is that a grat invariably results in larger annual payments to w than a common law life estate, and these increased payments, if not consumed, will increase the size of w's gross estate.13 6 134. although § 2702(a)(2)(a) can be avoided if w trust is structured either as a unitrust or a grat, w should normally retain a qualified annuity interest where the trust property is expected to appreciate in value. this is because w's annual payments in a unitrust will increase as the value of the trust property appreciates-and thus inflate her gross estate-while such payments will remain constant in a grat despite any appreciation. 135. see irc § 2702(a)(2)(b), (b)(1). 136. see supra notes 102-07 and accompanying text. [vol 4:8 estate and git tax effects of selling a remainder however, this effect can be limited to w trust, since there is no need to make h trust a grat. 137 if the value of w's life estate in h trust exceeds the value of the remainder she gives to c, the resulting tax savings will almost always exceed the disadvantage caused by the increased payments to w (assuming that the d'ambrosio trilogy holdings govern spousal elections). in that case, section 2036 will not apply since w will have received "adequate and full consideration" for her transfer. this not only reduces the total amount subject to transfer tax, but in many cases "frees up" w's unified credit. this was the situation in case 4 above, where use of the spousal election reduced the amount subject to transfer tax by $850,000, but also freed up w's entire unified credit. w can use this "newly-liberated" unified credit to shelter gifts or testamentary dispositions of the increased distributions she receives from w trust and any noncommunity property she possesses. even if the value of w's separate (i.e., noncommunity) property exceeds the exclusion amount, so that her unified credit is not "freed up," the estate tax savings of excluding w trust from w's gross estate will be substantial. moreover, w can always use her annual exclusion (if she is not otherwise doing so) to rid her estate of any unconsumed distributions from the grat. the benefits of this approach will not be as great if w's life estate in h trust is worth less than the remainder she gives to c. then section 2036 will apply, and w's estate's only consolation will be a section 2043 offset equal to the value of w's life estate in h trust computed as of h's death. this approach will nevertheless be attractive if h intends to give w all of his income from his estate in any event. then the allowance of the section 2043 offset is a pure "freebie.""t3 this was the situation in case 2 above where adoption of the spousal election approach reduced the total amount subject to transfer tax by $400,000. this saving will help offset any enlargement of w's estate caused by the increased annual payments from the grat (i.e., w trust). 137. ironically, § 2702 is not used to value the consideration ivreceives in a spousal election (i.e., her interest in h trust) but is used to value the property she transfers in the same transaction (i.e., the remainder in w trust). this result seems compelled by the statute's language. section 2702 applies to "any interest in ... trust retained by the transferor or any applicable family member." irc § 2702(a)(1) (emphasis added). neither the decedent h nor his estate is retaining any interest in the property transferred to h trust. likewise, iv, an "applicable family member" of h while he was alive, is not "retaining" any interest in the property transferred to h trust, since she had no interest in that property prior to the transfer. see regs. § 25.2702-2(d), ex. 3. 138. it will not be a "freebie" if h would otherwise have directed that some or all of the income from his property be paid to another beneficiary during w's life. for example, h may feel that whas sufficient income from her own property and that any additional income will only inflate her taxable estate. he may also wish to minimize the overall income tax burden by having income from his property spread among multiple beneficiaries who may be in a lower tax bracket than w. h's use of the spousal election technique precludes these tax savings. 19991 florida tax review moreover, the trustee of h trust can, within reason, offset the effect of excessively high distributions from w trust by adopting a "high growth-low income" investment strategy for h trust. this is possible because h trust need not be a grat or a unitrust and therefore is not subject to the payout requirements of those interests. if, for example, the section 7520 rate (and hence the rate for computing the fixed annuity amount payable from w trust) is 6% at the time of w's election and the prevailing income yield in trusts is then 4%, the trustee may be able to reduce (and even eliminate) the effect of the high payouts from w trust by investing the funds of h trust in growth stocks yielding 2-3%. this strategy would be particularly attractive if h's executor did not make a qtip election for h trust. then any increase in the value of the principal of h trust resulting from the "high growth-low income" investment strategy will pass tax free at w's death. conversely, any invasion of principal in w trust occasioned by the need to fund's w's high fixed payments from that trust will reduce any amount taxable at her death. this strategy will not reduce the value of w's interest in h trust (and thus the section 2043(a) offset), provided the beneficiary can compel the trustee "to make the trust corpus productive consistent with income yield standards for trusts under applicable state law."' 39 this is so even if the state minimum yield is "substantially below the section 7520 interest rate on the valuation date."' 40 b. the marital deduction.-in the above cases, we assumed that h's executor did not make a qtip election. that is often advisable where w's life estate in h trust is worth less value than the remainder she gave c in her property. in that case, w has not received full consideration for her transfer, section 2036 will apply, and w trust (less the section 2043 offset) will be included in w's gross estate. if h's executor makes a qtip election, both the portion of h trust for which the election was made and w trust (less the offset) will be included in w's gross estate, 141 and the resultant "bunching" will push up the effective estate tax rate under the progressive rate schedule. on the other hand, if h's executor does not make a qtlp election, these amounts will be split between the two estates and may result in a lower aggregate tax. 42 a frequent 139. regs. § 25.7520-3(b)(2)(v), ex. 2. see also supra notes 114-15 and accompanying text. 140. regs. § 25.7520-3(b)(2)(v), ex. 2. 141. see irc § 2044(a), (b)(1)(a) (property for which qtip election was made is included in surviving spouse's gross estate). 142. on the facts of case 2, see supra pages 571-72, the decision of h's executor not to make a qtip election reduced the aggregate amount of taxes paid by the two estates. the marginal tax rates for h's taxable estate ($1,000,000) and w's taxable estate ($1,100,000) were 39% and 41% respectively. had h's executor made a qtip election, no tax would be due at h's death, but the marginal tax rate on w's taxable estate (now increased to $1,450,000) would have been 43%. these figures assume that h's executor made the qtip election for only the portion [vol 4:8 estate and git tax effects of selling a remainder reason for avoiding estate equalization is h's desire to maximize w's income.143 where no qtip election is made, estate tax will be due at h's death, thereby diminishing the amount of principal available for generating income for tv. however, this should be less of a concern if w trust is in the form of a grat and w is therefore receiving an extraordinarily high return from that trust. moreover, equalizing the estates will often result in more wealth passing to the next generation.'" on the other hand, h's executor should make a qtip election where w's life estate is worth more the remainder she gives to c, assuming the d'ambrosio trilogy holdings apply to spousal elections. then section 2036 will not apply and w trust will not be included in w's gross estate. in this situation, a qtip election provides the benefits of tax deferral without any offsetting disadvantages. h's executor will be able to make a qtip election so long as iv is entitled to all of the income from h trust. 45 this can be accomplished by structuring h trust either as a common law life estate or even as a grat, provided in the latter case that w is assured of the greater of the fixed annual payout amount or the trust's income.'" the size of the marital deduction, however, will be reduced by the value of the remainder iv is required to give c to obtain her life income interest in h trust. 47 c. emergency needs of w.-h may wish to guard against the possibility of w's receiving too little, for example, where an unexpected emergency occurs. h can achieve this objective without tax detriment by giving of the h trust not sheltered by the unified credit, and that h trust, unlike iv trust, did not appreciate in value. if h trust appreciates, the case for estate equalization is strengthened. the effect of the credit for state death taxes was disregarded. to achieve equalization of the estates, one must take into account various other factors including the amount of noncommunity property owned by the respective spouses, the rate of growth in the value of w's property, and the maximum marital deduction that h's estate can take under united states v. stapf, 375 u.s. 118 (1963). 143. see, e.g., mcdaniel et al., supra note 61, at 689 (listing as an advantage of maximum tax deferral "provision of a larger pool of assets specifically dedicated to the support of the surviving spouse"). 144. see id. at 688-89 ("[i1f the aim is to maximize the amount passing to the next generation and a constant rate of growth is projected, equalization as a strategy may be the better choice."). 145. irc § 2056(b)(7) permits qtip elections for property in which the surviving spouse possesses a "qualifying income interest for life," which requires among other things that the surviving spouse be "entitled to all the income from the property," payable at least annually for life. irc § 2056(b)(7)(b)(i), (ii). 146. see regs. § 25.2702-3(b)(1)(iii) (paying the annuitant income in excess of the fixed annuity payment does not disqualify the retained interest as a "qualified annuity interest," but the right to receive such excess is not considered in valuing such interest). 147. see united states v. stapf, 375 u.s. 118, 127 (1963). 1999] florida tax review the trustee a discretionary power to invade the principal of h trust on w's behalf.148 he can also give w a power to invade the principal of h trust limited to an ascertainable standard relating to her health, education, support or maintenance. although this is a "power of appointment," it is not a general power of appointment. 49 hence, w's release of the power will not be a taxable gift nor will her retention of it until death cause h trust to be included in w's gross estate. 50 although this type of power undoubtedly enhances the value of w's interest in h trust, it would normally not count in determining the value of the consideration w received for purposes of the section 2043 offset or the section 2036 exclusion, since a power that is contingent upon this type of future unknown event (e.g., sickness) cannot be actuarially valued. 5' h can also give w a noncumulative power to withdraw each year from h trust the greater of $5,000 or 5% of its principal (a "5 and 5 power"). w will not be treated as making a taxable gift if she allows it to lapse.'5 2 however, any amount w could have withdrawn at her death under an unlapsed power will be included in her gross estate. 53 a 5 and 5 power can be actuarially valued. 5 4 consequently, giving w this power in h trust should increase the value of her life estate, and hence the section 2043 (a) offset, and also make it more likely that w's estate will satisfy the "adequate and full consideration" exception to section 2036."5 on the other hand, h should not give w or the trustee any power over the principal of h trust. h should be particularly wary of giving w a power to 148. sections 2036 through 2038 will not apply because wis not the "transferor" of h trust; section 2041 will not apply because whad no power over h trust at her death. 149. see irc §§ 2041(b)(1)(a), 2514(c)(1). 150. section 2514(b) treats only the exercise or release of a general power as a "transfer" of property by the power holder, and § 2041(a)(2) only includes in the gross estate property over which the power holder held a general power at the time of his death. 151. cf. robinette v. helvering, 318 u.s. 184 (1943). in estate of pardee v. commissioner, 49 t.c. 140 (1967), the court refused to value the effect of a divorce court's continuing power to increase decedent's support obligation if the need arose, because any such increase was "dependent upon a contingency beyond decedent's control." id. at 149. 152. see irc § 2514(e). 153. see irc § 2041(a)(2). 154. see, e.g., rev. rul. 79-211, 1979-2 c.b. 319 (value of decedent's 5 and 5 power, as determined "[o]n the basis of recognized actuarial principles," qualified for credit for tax on prior transfers under § 2013(a)). 155. professor johanson asserts that a 5 and 5 power should not be counted in computing the value of wtrust since there is no certainty that wwill exercise it. see johanson, supra note 71, at 1301. this seems almost certainly wrong since the value of an interest is measured by the powers it confers rather than the donee's subsequent decision whether to exercise such powers. thus, the holder of a "crummey" power is treated as receiving a present interest gift equal to the value of the property he could withdraw, even if he fails to exercise it. see crummey v. commissioner, 397 f.2d 82 (9th cir. 1968). [vol 4:8 estate and git tax effects of selling a remainder invade the principal of w trust which cannot be quantified (e.g., a power to invade for w's happiness). where such open-ended powers exist, iv may be unable to establish that she has "transferred" anything to anybod. 56 if there is no transfer, then there is no "consideration," since there can be no consideration for a transfer that never occurred.' 57 w's estate would not qualify for either the section 2043 offset or the" bona fide sale" exclusion under section 2036, since both these benefits depend upon there being a transfer for "consideration."'8 h should also avoid giving w even a quantifiable power to invade the principal of w trust for herself, such as a 5 and 5 power. such a power will reduce the value of w's transfer to c and therefore increase the likelihood that w received full consideration for that transfer. on the other hand, release or even a lapse of such a power will be a taxable gift to the extent of the amount released (less any applicable annual exclusion).'5 9 w's power is not a "power of appointment" within the meaning of the gift and estate tax law, since iv, rather than a third party, created the power."6 consequently, the exemption from gift tax accorded by section 2514(e) to lapses of 5 and 5 powers created by others does not apply.'1 6 156. see johanson, supra note 71, at 1302-11. 157. see johanson, supra note 7 1, at 1302 ("in order to qualify for a section 2043(a) consideration offset, the wife must give something up in exchange for the interest she receives from her husband"); see also stephens et al., supra note 123, at i 4.08[7[d] n. 129 (if whas not made a completed gift, "the bargain or exchange aspect of the widow's election seems to disappear."). 158. if something in fact passes to the remainderman at iv's death, it will be because of w's post-election decision not to exercise her power of invasion. iv's receipt of a life estate at the time ofher election therefore cannot have been the "consideration" or inducement for w's subsequent decision not to invade. see johanson, supra note 71, at 1303; cf. robinson v. commissioner, 675 f.2d 774 (5th cir.), cert. denied 459 u.s. 970 (1982) (holding for gift tax purposes that i's receipt of a life estate in h trust at the time of her election was not "consideration" for her subsequent release of a special power of appointment over w trust). 159. w's retention ofa 5 and 5 power over her property which passed into iv trust makes her transfer incomplete to the extent she can revest the property in herself. regs. § 25.2511-2(c); her relinquishment of that power "completes" the transfer making it subject to the gift tax. regs. § 25.2511-2(0; cef. robinson, 675 f.2d at 777-78 (holding iv's release of a "special power of appointment" she had reserved over wtrust was a taxable gift). 160. regs. § 25.2514-1(b)(2) (for gift tax purposes, "the term 'power of appointment' does not include powers reserved by a donor to himself."); regs. § 20.2041-1(b) (2) (same for estate tax); robinson, 675 f.2d at 778. 161. cf. robinson, 675 f.2d at 778-79, where the court observed that if iv's power to appoint trust principal among h's and her children had not been created by iv(for example, if it had been granted by h to w over h trust), it would have been a special power of appointment and its release would not be a taxable gift.). however, since it was a power iv created over property she transferred to iv trust, its release constituted her completion of a taxable gift. id. 19991 florida tax review moreover, any property subject to a power of withdrawal over w trust that w has not exercised or released by the time of her death will be included in her estate under section 2038 as a power to "alter, amend, revoke or terminate" exercisable at w's death. 62 neither the section 2043(a) offset nor the section 2036 exclusion for "adequate and full consideration" will apply since w's receipt of a life estate in h trust at the time of her election cannot have been the "consideration" or inducement for her subsequently-made decision not to exercise the power. 63 giving the trustee of w trust a power to make discretionary payments to w is also problematic. in many states, the settlor's creditors can satisfy their claims out of trust property where the trustee can make discretionary payments to the settlor' 6 since this effectively enables the settlor to enjoy the trust corpus by incurring debts and then relegating her creditors to the trust, she is treated for tax purposes as possessing a power to revest the trust property in herself. 65 where this is the law, giving the trustee of w trust a power to make discretionary payments to w is the same as giving the power to w and presents the same problems as those discussed above. even where this is not the law, giving a discretionary power of invasion to the trustee of w trust may entail risks. one commentator has argued that no section 2043 offset should be permitted, since there is no guarantee that the remainderman will receive anything. 1661 disagree with this position, since w has surrendered all power to deprive the remainderman of his interest and indeed has made a completed gift for gift tax purposes. 67 nevertheless, caution may advise against giving the trustee discretionary power over the principal of w trust even here. 162. section 2038(a)(1) provides that property which the decedent transferred after june 22, 1936, will be included in his gross estate "where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power.., to alter, amend, revoke, or terminate." see robinson, 675 f.2d at 779 (dictum). 163. see authorities cited supra note 158. 164. see ware v. gulda, 117 n.e.2d 137 (mass. 1954) (massachusetts law). 165. see outwin v. commissioner, 76 t.c. 153 (1981). 166. johanson, supra note 71, at 1309 ("if the trustee's discretionary power is so broad that there is no assurance that anything of value will ever be received by the remainderman, the wife has not made a transfer to which section 2043(a) should apply."). 167. see rev. rul. 77-378, 1977-2 c.b. 347. when professor's johanson's article, supra note 71, was published, the service had intimated in rev. rul. 62-13, 1962-1 c.b. 181, that a trustee's broad discretionary power to invade trust property for the settlor's benefit, in and of itself, rendered the settlor's transfer incomplete for gift tax purposes. in rev. rul. 77-378, issued after professor johanson's article, the irs clarified rev. rul. 62-13 by specifically stating that a trustee's wholly discretionary power to benefit the settlor does not render the settlor's transfer incomplete. [vol 4:8 estate and git tax effects of selling a remainder 4. the "fly in the ointment"-uncertain income tax effects.-the present estate and gift tax treatment of a spousal election presupposes that wand h's estate are "exchanging" a remainder for a life estate (and vice versa) and therefore raises the specter of there being a taxable "exchange" for income tax purposes. apparently, the government has never asserted this position in a litigated case, and no court has directly ruled on it.'6 nevertheless, the arguments for finding a taxable exchange are strong, and if successful, the consequences would be severe. a. exchange made by h's estate.-one may question whether h's estate has engaged in an exchange at all. although h's estate has indubitably transferred a life estate in h trust to w, it has not received any property or goods in return. 69 moreover, h's offer of a life estate to w is almost always motivated, at least in part, by a desire to benefit w as well as the remainderman c. arguably, therefore, the benefits conferred on w and on c should both be viewed as bequests. 170 indeed, the internal revenue service itself at one time viewed w as receiving her interest in h trust as a beneficiary under h's will rather than as a purchaser. 171 it even rejected a request that the regulations be amended to 168. prior to the enactment of § 167(e), the courts held that wobtained an amortizable "cost basis" in her life estate in h trust equal to value of the remainder she surrendered in her share of the community (or the value of the life estate she received, if less). see gist v. united states, 296 f. supp. 526 (s.d. cal. 1969), aft'd, 423 f. 2d 1118 (9th cir. 1970); see estate of christ v. commissioner, 54 t.c. 493 (1970), aftd, 480 f.2d 171 (9th cir. 1973); see kuhn v. united states, 392 f. supp. 1229 (s.d. tex. 1975). this conclusion was based on the premise that w"bought" her life estate by transferring a remainder in her share of the property to c, see kuhn at 1235-40-a premise that necessarily implies that the estate had "sold" wher life estate in h trust in a taxable transaction. see joseph m dodge, retentions, receipts, transfers, and accumulations of income and income rights: ruminations on the post-byrum role of estate tax sections 2036, 2037, 2039 and 2043(a), 58 tex. l rev. 1,72 n.342 (1979) ("if there is a purchase .... there must be a sale.") the irs has never asserted this position and no court has ever so held. under current law, iv is prohibited from amortizing her basis in her life estate, if, as almost always is the case, the remainderman is a related party. see irc § 167(e). 169. see dodge, supra note 83, at 293 n.220 ("but here, neither the decedent nor his estate receives property or services."). 170. see id. 171. the irs argued in gist, 423 f.2d at 1120, and kuhn, 392 f. supp. at 1235-36. that in a spousal election wacquires her life estate in h trust as "beneficiary" of h's will rather than as a "purchaser" (citing helvering v. butterworth, 290 u.s. 365 (1933)), and thus has no "cost basis" to amortize. professor morrison supports this view arguing that treating iv as a "beneficiary" achieves the objectives of the income tax law (i.e., "assurance that all income from estates and trusts is taxed once, and only once; that the income is attributed to the proper taxpayer and that ordinary income is not converted into capital gains") while avoiding the complications which 1999] florida tax review include a statement to this effect on the ground the result was "too obvious.., to warrant a specific statement."' 72 nevertheless, the failure of the service to explicitly rule on this issue and the case law on related issues have led to a continuing concern that a spousal election is a taxable event.' if it is, the election can probably best be understood by viewing h's estate as "selling" a life estate in h trust to w for a remainder interest in w trust, and then transferring the remainder to c as a bequest from h. if h had directed his executors to sell blackacre and give the proceeds to c, h's estate would be taxed on any gain (at least if blackacre were subject to estate administration),1 74 while the payment of the proceeds to c would be treated as a bequest. similarly in this case, h's estate may be viewed as "selling" a life estate in h trust for the remainder in w trust, and then transferring the "sale proceeds" (i.e., the remainder) to c as h's agent in carrying out his bequest .' the weakness in this analysis is its failure to recognize the donative elements involved in a spousal election. ultimately, proper income tax treatment of a spousal election depends on its true nature-an issue discussed later in this article. if h's estate is regarded as making a taxable exchange, the consequences will be severe. the "amount realized" will be the value of c's remainder in w trust (or w's life estate in h trust if less). 176 since the life estate that h's estate ensue when w is treated as a "purchaser." keith e. morrison, the widow's election and its alternatives, 1971 tex. tech. tax inst. 141, 150 (1971). 172. tech. mem. 1971-7142 (july 30, 1971). the irs rejected a request by a practitioner that the regulations be amended to specifically provide that h's estate does not make a "sale" of the life estate in h trust for purposes of § 1001 (e) in a spousal election on the ground that the rule sought "was too obvious, particularly in view of § 1.661(a)-2(f)(1), to warrant a specific statement." id. the service's citation of this regulation, which deals with the income tax treatment of estate and trust distributions to beneficiaries, was consistent with its then position that wtakes as a beneficiary and not a purchaser in a spousal election. the service may not be as firm in that view today. in the action-on-decision on kuhn-which was decided after gist and christ-the service stated it was reexamining the position it had "taken in widow's election cases" and was considering publication of a revenue ruling on the subject. see action on decision 1976-54 (jan. 16, 1976). however, no ruling was ever issued. 173. see gary c. randall, estate planning and community property, 28 idaho l. rev. 807, 831 (1992). 174. see irc § 641(a)(3) (income received by estate during period of administration taxable to estate). see rev. rul. 57-133, 1957-1 c.b. 200 (income from real property subject to estate administration includible in estate's taxable income even though title vests immediately in devisee). 175. cf. dodge, supra note 168, at 72 n.342 (h's estate, in making the exchange, is acting as "an 'agent' executing the wishes of the decedent in carrying out a 'bequest"'). 176. the amount h's estate realizes is limited to the lesser of c's remainder in w trust or w's life estate in h trust. if the value of the remainder w transfers in her property exceeds the value of the life estate she receives, the excess is viewed as a "gift" from w to c rather than additional consideration to h's estate. conversely, if the value of w's life estate [vol 4:8 estate and git tax effects of selling a remainder is "selling" is a term interest, the estate's basis in it will be zero by reason of section 1001(e).17 thus, the estate will recognize gain on the "sale" equal to the remainder's full value on the date of the "sale," i.e., the day of the election,""5 (or the value of w's life estate on such day if less).'79 if h's estate is treated as selling a property interest, the gain will qualify for capital gain treatment."ts more likely the estate will be treated as making an anticipatory sale of income and will therefore recognize ordinary income under the teaching of cormnissioner v. p. g. lake, inc. 1 t rubbing salt into the wound, section 167(e) exceeds the value of c's remainder in w trust, the excess is treated as a bequest from h to iv. see schwartz & liker, supra note 131, at 10-22, 10-23; see norman h. lane, the widow's election as a private annuity: boon or bane for estate planners, 44 s. cal. l rev. 74, 93 (1971). the courts in estate of christ and kuhn adopted this approach: they limited the amount of t's amortizable cost basis to the value of the life estate she received in h trust and treated the excess value of the remainder as a gift from iv to c. estate of christ v. commissioner, 54t.c. 493,530 (1970), aff'd, 480 f.2d 171 (9th cir. 1973); kuhn v. united states, 392 f. supp. 1229, 1239-40 (s.d. tex. 1975). see also dodge, supra note 168, at 72 n.342. 177. section 1001(e) states that in determining gain or loss from the disposition of a "term interest in property"--defined as either a term of years or a life estate in property or an income interest in a trust--the portion of the adjusted basis of such interest determined pursuant to § 1014 shall be "disregarded," i.e., treated as zero. irc § 1001(e)(l), (e)(2). thus, if a spousal election is viewed as a taxable "sale," the estate's adjusted basis in the life estate it conveys to w will be zero since the basis of the property the estate received from h is determined pursuant to § 1014. see irc § 1014(a), (b)(1). 178. in estate of christ v. commissioner, 480 f.2d 171, 173 (9th cir. 1973). the court held that the proper date for valuing 1ws life estate in h trust was "the date of the distribution to the trust and the date ... [iv's] election became irrevocable" rather than the date of h's death. 179. see lane, supra note 176, at 93. 180. see mcallister v. commissioner, 157 f.2d 235 (2d cir. 1946), cert. denied, 330 u.s. 826 (1947); see allen v. first nat.'l bank, 157 f.2d 592 (5th cir. 1946) cert. denied, 330 u.s. 828 (1947); see bell's estate v. commissioner, 137 f.2d 454 (8th cir. 1943); see rev. rul. 72-243, 1972-1 c.b. 233 (irs will follow mcallister). 181. 356 u.s. 260 (1958). most commentators have concluded that if a spousal election is a taxable "exchange," p.g. lake probably requires any resulting gain to be taxed as ordinaryincome. seejames j. freeland et al., what are the income tax effects of an estate's sale of a life interest?, 34 j. tax'n 376, 377 (1971); schwartz & liker, supra note 131. at 10-22 ("it appears likely that.., the estate will be deemed to have realized ordinary income"); dodge, supra note 21, at a-91 (ordinary income treatment is the "more likely result"). others are less certain: see, e.g., carol l wilson, the widow's election viewed in the light of the 1976 tax reform act and the 1975 california probate code revision, 28 hastings li. 1435, 1445 (1977) ("[n]o one is certain how the gain will be characterized"); ralph gano miller jr. and philip p. martin jr., voluntary widow's election: nation-wide planning for the million dollar estate, 1 calif. west. l. rev. 63, 78 (1965) (ordinary income treatment "possible, but not probable"). those arguing for ordinary income treatment note that where the courts allowed capital gain treatment (see mcallister, first nat'! bank and bell's estate, supra note 180), the transferor had transferred all the interest he had. in contrast, in a spousal election, h's estate, 19991 florida tax review will prevent w from amortizing her "cost basis" in her life estate in h trust, if w, as is almost always the case, is related to the remainderman. 18 2 b. exchange made by w.-if there is a taxable exchange, the results should be nowhere near as calamitous to w as to h's estate. w should realize little or no taxable gain, since her basis in her share of the community will be "stepped-up" (or "stepped-down") to its fair market value on the date of h's death (or alternate valuation date if applicable). 183 in determining w's gain or loss on the exchange, this basis will be allocated between the remainder and w's retained life estate in w trust based on their respective actuarial values on the day of the exchange"s the "amount realized" will be the value of the life estate w receives in h trust (or the value of c's remainder in w trust if less).8 5 w's gain, if any, will therefore be the excess of the amount so realized over her adjusted basis in the carved-out remainder and will be taxed as capital gain8 6 neither w nor h's estate nor h trust will be able to recognize any loss realized on the exchange since they are "related parties."'8 7 the uncertain income tax consequences make a spousal election a risky proposition. tax planners may nonetheless wish to consider using it given the lack of any direct authority holding that a taxable "exchange" has occurred and in light of the technique's significant transfer tax advantages-particularly if the d'ambrosio trilogy has effectively overruled gradow. which starts out holding the entire fee interest, "carves out" and transfers only a part of its interest to w, arguably making the situation more analogous to that found in p. g. lake. an old case allowed capital gain treatment where the owner of a fee interest carved out a legal life estate, sold it to her husband and retained the remainder for herself. see estate of camden, 47 b.t. a. 926 (1942), nonacq., 1943 c.b. 28, aff'd, 139 f.2d 697 (6th cir. 1943). its viability is questionable in light of the supreme court's later decision in p. g. lake. see charles s. lyon & james s. eustice, assignment of income: fruit and trees as irrigated by the p.g. lake case, 17 tax l. rev. 295, 326 (1962). 182. a "related person" is any person who bears the same relationship to the taxpayer as that described in § 267(b) or (e). irc § 167(e)(5)(b). the disallowed amortization deductions are added to the basis of the remainder interest. see irc § 167(e)(3)(b). 183. section 1014 provides that a surviving spouse's share of the communityproperty shall receive a new basis equal to property's fair market value as of the decedent's death (or the alternate valuation date if applicable) if at least one-half of the whole of the community interest in such property is included in the decedent's gross estate. see irc § 1014(a)(l)-(2), (b)(6). 184. see rev. rul. 77-413, 1977-2 c.b. 298. section 1001(e) will not apply because w is not selling a "term interest." irc § 1001(e)(1), (2). 185. see supra note 176 for reason the amount realized is limited to the lesser of the value of w's life estate in h trust or c's remainder in w trust and authorities so holding. 186. the service recognizes that gain realized on the sale of a "carved-out" remainder interest qualifies for capital gain treatment. see hunter v. commissioner, 44 t.c. 109 (1965). 187. irc § 267(a)(1), (b)(1), (b)(6), (b)(13). [vol 4:8 estate and git tax effects of selling a remainder b. searching for the true nature of a spousal election the estate and gift tax consequences of a spousal election set out above are disquieting. by using this technique, the surviving spouse may be able to transfer her entire property (or a significant portion of it) to lower generation beneficiaries without payment of any estate or gift taxes. this defeats congress's intent that a married couple's property should be subject to transfer tax when it passes to the next generation.'88 presently the only judicially recognized barrier to this result is the conceptually flawed position that only the full fee value of the underlying property constitutes "adequate and full consideration" for the transfer of a remainder interest. is there any theory, consistent with transfer tax doctrine and proper valuation that can avoid this apparently unjustified tax benefit? the balance of this article will consider three theories proposed by the commentators: no bona fide sale.-a spousal election is not a "bona fide sale," and thus the exception to section 2036 does not apply."s mutual gifs.-w's transfer of a remainder in her property to c, a natural object of her bounty, is motivated by her love for c rather than in "consideration" of a life estate in h trust. likewise, h's transfer of a life estate in h trust to w is induced by his love for w-not in "consideration" of iv's transfer of a remainder to c. since this theory views h and w as each making gifts of their own property in concert, it is sometimes called the "mutual gifts" theory. 190 reciprocal trusts.-a spousal election creates reciprocal trusts and is governed by the doctrine of the same name.' 9 ' 1. no "bona fide sale. "-as noted above, current case law interprets the phrase "adequate and full consideration" differently for the gift tax than it does for the estate tax. in the case of the gift tax, w's transfer of a remainder to c in her property is considered supported by full consideration if w's life estate in h trust merely equals the actuarial value of that remainder. " in contrast, the gradow line of cases holds that, for estate tax purposes, w's transfer of the remainder to c is supported by full consideration only where w's life estate in h trust equals or exceeds the full value of the property passing into iv trust.'93 188. see united states v. stapf, 375 u.s. 118, 128 (1963) (congress's purpose in enacting the marital deduction was "to permit a married couple's property to be taxed in two stages and not to allow a tax-exempt transfer of wealth into succeeding generations."). 189. jordan, supra note 58, at 716-23. 190. see lowndes, supra note 21, at 69-71; johanson, supra note 71, at 1288-95. 191. lowndes, supra note 21, at 76-8 1; johanson, supra note 71, at 1288-95. 192. see supra notes 33-36 and accompanying text. 193. see supra notes 14-16, 22-25 and accompanying text. 19991 florida tax review professor jordan has proposed an ingenious solution that reconciles the results in these cases and at the same time prevents w's estate from escaping tax on the disposition of her property. professor jordan notes that under section 2512(b), w can avoid gift tax if she merely receives "full consideration" on her transfer of the remainder in w trust. however, to avoid inclusion of w trust in w's gross estate, section 2036 requires not only that w receive "full consideration," but also that she receive it in a "bona fide sale." this "additional requirement" of a "bona fide sale" explains, according to professor jordan, why, in the case of a spousal election, there can be estate tax liability (which requires a "bona fide sale"), and at the same time, no gift tax liability (which does not). 194 professor jordan believes that a spousal election invariably produces a result that is testamentary in nature. as a result of w's election, she retains enjoyment of her property until death, while the transfer of her property upon her death to the remaindermen-who almost always are her own issue-is "donative in character." '95 in contrast, a "bona fide sale" involves "an arm's length exchange" where "both parties seek to receive value equal to that which they surrender."'1 96 professor jordan summarizes her position as follows: "if property is transferred in a transaction that is donative in character and the taxpayer retains the benefits of the property until death, the property is included in the taxpayer's gross estate even though adequate consideration was receivedfor the remainder interest.' 9 7 it is difficult to envision an exchange being "donative in character" where the transferor obtains full value for her transfer. 98 even were that possible, it would not justify including the transferor's property in her gross estate. the universally recognized purpose of the "adequate and full consideration" exception to sections 2036 through 2038 is to exclude transfers that do not deplete the transferor's estate.' 99 as professor jordan recognizes, if the transferor receives "full consideration" for the transferred property, no depletion occurs in the transferor's estate.2"' this is equally true whether the transfer be deemed "donative in character" or not. professor jordan also 194. jordan, supra note 58, at 716-18. 195. id. at717. 196. id. at 718. 197. id. at 717 (emphasis added). 198. professor jordan may envision a case where the transferor did not consciously seek to realize full value for her property but in fact received an objectively fair value. this is interpretation consistent with her definition of an "arm's length exchange" as one in which "both parties seek to receive value equal to that which they surrender." id. at 718 (emphasis added). 199. see supra note 5 and accompanying text. 200. see jordan, supra note 58, at 692-96. [vol 4:8 estate and git tax effects of selling a remainder recognizes that requiring inclusion of the transferor's property in her gross estate where she obtains "full consideration" in the exchange "creates double taxation" (i.e., taxation of both the transferred remainder and the consideration received therefor),." again this is equally true and equally unjust whether the transfer be deemed "donative" or otherwise. in short, the policy reasons for excluding transferred property where the transferor has received full value are equally valid whether the transfer is "donative" or not, and both cases should be treated alike. professor jordan apparently finds support for her position in a gift tax regulation 2 and estate of friedman v. commissioner.230 but these authorities merely hold that a transfer, which is bona fide, at arm's length and free from donative intent, will be considered as made for "adequate and full consideration," even should the irs or a court later find the consideration inadequate. they provide no support for the converse proposition that a "donative" transfer is taxable even though made for "full and adequate consideration." the rule in the gift tax regulations is designed to prevent bad business bargains from being converted into taxable gifts.2 this policy is simply irrelevant where adequate consideration is received. the most likely purpose of the "bona fide sale" language in the exception to section 2036 is exclude "sham" sales from its scope. 05 for example, a transaction where the purported seller retains the benefits and burdens of ownership of the property he purportedly sells will not qualify as a "bona fide sale." the exchange occurring in a spousal election, however, is not a "sham," since it effects a real change in the rights of the parties (e.g., iv surrenders all interest in and power over the remainder in her property; the life estate in h trust passes to w instead of another beneficiary). the cases hold that a transfer not induced or motivated by the transferee's reciprocal transfer but instead by a donative impulse does not qualify for the exclusion in section 2036.206 but this does not explain the purpose of the words "bona fide sale" since those words are not needed to reach this result. the requirement that there be "consideration" is sufficient. a transfer not induced by the transferee's reciprocal action is not made for "consideration." when used in the law, the word "consideration" means that which induces or motivates the 201. id. at 689-92. 202. regs. § 25.2512-8. 203. 40 t.c. 714 (1963). 204. see 5 boris l bittker & lawrence lokken, federal taxation of income, estates and gifts 121.4.5 (2d ed. 1993). 205. see charles b. lowndes et al., federal estate and gift taxes '114.8 (3d. ed. 1974). 206. see mollenberg's estate v. commissioner, 173 f.2d 698 (2d cir. 1949); see giannini v. commissioner, 148 f.2d 285 (9th cir. 1945), cert. denied, 326 u.s. 730 ( 1945); see safe deposit & trust co. v. tait, 295 f. 429 (d.c. md. 1923). 19991 florida tax review other party's performance. 217 if the "bona fide sale" language were needed to impose this requirement, persons making simultaneous transfers of equal value to each other would never owe a gift tax, even if such transfers were motivated solely by donative impulses and without regard to the other's transfer, since section 2512(b) contains no "bona fide sale" requirement. the value of one transfer would always offset the value of the other. but this is not the law; there is no offset unless one transfer is the "inducement" for the other. the word "consideration" standing by itself achieves this result. judicial construction of the phrase "bona fide sale" and congressional action support neither the meaning nor the significance professor jordan would attribute to it. courts have found transfers to be "bona fide sale[s]" even where the transferor appeared motivated, at least in part, by donative impulses. 0 8 in one case, the decedent in "consideration" of his intended wife's release of her dower rights established a trust providing income to the decedent for his life, then income to his wife for her life, and then principal to certain beneficiaries. 9 this transfer was donative in part, since one of the decedent's objectives was to benefit his wife. as the court stated, the "evident intent of [the decedent] was to make provision for [his intended wife], for his four children, and for the management and disposition of his property free from the restraint of dower rights., 210 despite the presence of a donative intent, the court found the transfer to be a "bona fide sale.",211 207. the second restatement of contracts states that something constitutes "consideration" only if it is "bargained for," that is, that "it is sought by the promisor in exchange for his promise and is given by the promisee in exchange for that promise." restatement (second) of contracts § 71 (1979). the comments add that "in the typical bargain, the consideration and the promise bear a reciprocal relation of motive or inducement: the consideration induces the making of the promise and the promise induces the furnishing of the consideration." id., cmt. b. see also oliver wendell holmes, the common law 230 (mark dewolfe howe ed., 1963) ("[i]t is the essence of a consideration, that ... it is given and accepted as the motive or inducement of the promise"). for this reason, a promise made after an action has already been performed is not consideration for that action, since the action was not induced by the subsequently-made promise. see e. allan farnsworth, contracts § 2.7 (3d ed. 1999). in giannini v. commissioner, 148 f.2d 285 (9th cir. 1945), cert. denied, 326 u.s. 730 (1945), the court adopted this concept of "consideration" as something "bargained for" in holding that the "adequate and full consideration" exception did not apply. the court held that decedent's transfer to a trust in which the decedent was an income beneficiary was not in "consideration" of his parents' simultaneous transfer to the trust, since the parents' transfer "resulted ... not from bargaining, but from... [their] largess." id. at 287. 208. see ferguson v. dickson, 300 f. 961, 962 (3d cir. 1924); see mccaughn v. carver, 19 f.2d 126 (3d cir. 1927). 209. see ferguson, 300 f. at 962. 210. see id. at 962. 211. see id. at 963. [vol 4:8 estate and git tax effects of selling a remainder congress has legislatively overruled these "dower" cases. what is significant is the way it did so. congress accomplished its objective-not by changing the "bona fide sale" requirement-but by modifying the "consideration" requirement: first by substituting the phrase "adequate and full consideration" for the phrase "fair consideration ' 12 and then by expressly providing that a release of dower or curtesy rights did not constitute "a consideration in 'money or money's worth.""'2 3 in short, congress was not concerned that donative-tinged transactions were considered "bona fide sale[s]" but rather that they were found to be supported by sufficient "consideration." professor jordan makes many telling points when she argues as a matter of policy that the surviving spouse's property in a spousal will election should be included in her gross estate.-'4 however, this result cannot be achieved by relying on the requirement of a "bona fide sale." 2. a spousal election as mutual, but separate, gifts by h and w.-in some cases, a spousal election may simply carry out the dispositive plans that each spousehad already individually decided upon. where this is true, it is wrong to say that h and w are exchanging property in "consideration" of each other's transfer, since their respective transfers are not induced by the reciprocal transfer of the other. they are merely doing what they would have done in any event. where this is the case, neither w nor her estate should be allowed any of the offsets or exclusions provided for under sections 2512(b), 2043, and 2036. these provisions apply when a transferor receives "consideration" for his transfer. in tax law, substance prevails over form and the amounts the transferor receives must be real "consideration," that is, they must be the actual "inducement" or "motivation" for her transfer.15 if her transfers are in fact "gifts" she would have 212. merrill v. fahs, 324 u.s. 308, 312 (1945). since courts had held that "'fair consideration' included the relinquishment of dower rights," congress was "led... to substitute in the 1926 revenue act, the words 'adequate and full consideration.' . . . congress undoubtedly intended the requirement of 'adequate and full consideration' to exclude relinquishment of dower and other marital rights." id. at 312. see also commissioner v. bristol, 121 f.2d 129 (1st cir. 1941) and empire trust co. v. commissioner. 94 f.2d 307 (4th cir. 1938) (holding that the "adequate and full consideration" language required that property the decedent had transferred in exchange for release of his spouse's marital rights be included in his gross estate). 213. revenue act of 1932, pub. l. no. 72-54, ch. 209, § 804, 47 stat. 169, 280 (1932) (amending the revenue act of 1926, ch. 27, § 303(d), 44 stat. 9,73 (1926)). however. the courts held that this change was merely declaratory of what the law had been under the "adequate and full consideration" language and that congress had acted out of an excess of caution. see commissioner v. bristol, 121 f.2d at 135; see empire trust co. v. commissioner, 94 f.2d at 309-10. 214. see jordan, supra note 58, at 720-23. 215. see supra notes 206-07 and accompanying text. 19991 florida tax review made in any event, then she did not make the transfers in "consideration" of the other party's transfer, and no offset or exclusion is allowed. where this analysis applies, the tax consequences of a spousal election are as follows: w's establishment of w trust constitutes a completed gift of a remainder to c. since c is w's child, section 2702 will apply and w will be taxed on the entire value of the property placed in w trust unless her interest is a qualified interest. since w's transfer of the remainder to c was not induced by, or put differently, was not made in "consideration" of her receiving a life estate, neither the exception under section 2036 nor the offset under section 2043 will apply. this analysis may also solve the income tax problem: since w's transfer of a remainder to c was not made in an "exchange" but rather as a "gift," there is no taxable event. 16 the weakness of the foregoing analysis is its failure to recognize the amount of real bargaining and even coercion often involved in spousal elections. the above analysis implicitly assumes that each party would have made their transfers irrespective of what the other did. in fact, the election posed to w exerts real pressure on w-amounting in some cases to coercion-to allow her property to pass in a manner different from what she would normally prefer. left to her own druthers, w would usually prefer to retain ownership of her property outright rather than place it in w trust. there are two reasons for this: w would want to maintain her ability to invade the principal of her property at will should the need or desire arise, and secondly, w would like to retain until death her ability to determine how her property will pass.217 the hard fact is that the choice given to win h's will-either let her property pass under h's will or else forgo all benefits in his estate-frequently "coerces" or "locks in" w to a disposition she would prefer to defer and one that she might ultimately decide not to make. indeed, h may have used the election will format precisely because of its coercive effect. for example, h might use the device to assure himself that w leaves her property to his child c." 8 this would be especially true if w and c are estranged, or if c is h's child by a prior marriage. h may also be concerned that w will remarry and make provision for her new spouse to the prejudice of their children's interest. h might employ the spousal election will model because he 216. see irc §§ 102 (a), 1001(a); see boris i. bittker & martin j. mcmahon, jr., federal income taxation of individuals 28.3 (2d ed. 1995) (gift of appreciated property is nontaxable event). 217. see dodge, supra note 168, at 66-68; see also morrison, supra note 21, at 226 n.21 (describing as "untenable" the argument that wwould have made the same transfer even if no spousal election since w, by making the election, "makes a definite decision which she might otherwise postpone until her death with all the intervening uncertainties."). 218. see johanson, supra note 71, at 1264. by restricting w's interest to an income interest in the entire community estate, h can assure that it will pass to couple's children "without undue dissipation." [vol. 4:8 estate and git tax effects of selling a remainder is concerned about w's spendthrift proclivities and therefore wants to limit her ability to spend principal." 9 or h might be concerned about w's lack of business and financial experience and therefore want her property to be held in a trust where a professional trustee will manage it.3' likewise, h may believe that the nature of the community property (e.g., a closely held business) requires unified management.' l given the strong desire of most surviving spouses to retain the control over both the use and disposition of their principal until death, the "mutual gift" approach should be used in only extreme cases. before invoking this approach, the irs should be required to show by a preponderance of the evidence that iv would have set up a trust having the same dispositive provisions as w trust even if there had been no spousal election, andfiirther that she would done so shortly after h's death. professor dodge has suggested that this showing is likely only where w was infirm, bordering on incompetency, or quite wealthy at the time of h's death.' otherwise, it is quite likely that the offer of a life estate in h trust did in fact induce w to let her property pass under h's will. 3 3. a spousal election as the creation of reciprocal trusts a. the rationale of the reciprocal trust doctrine.-several commentators have argued that spousal will elections come within the purview of the reciprocal trust doctrine. 4 in my opinion, these commentators have failed to convincingly explain why the doctrine should apply. their use of the doctrine seems little more than invoking a doctrine to reach a desired result. to determine the propriety of applying the doctrine, we must first understand its rationale. 219. see johanson, supra note 71. at 1264. 220. see id. (stating that h may want to "'protect his wife... against improvident investments or bad advice from relatives"). see also wilson, supra note 181, at 1436 (providing a comprehensive list of nontax reasons for using the spousal election will format). 221. see johanson, supra note 7 1, at 1264; wilson, supra note 181. at 1436. 222. see dodge, supra note 168, at 69. 223. professor dodge suggests this approach may be used where h and w join in setting up an inter vivos trust which provides that one-half of the income be paid to each during their joint lives, then income to the survivor, then remainder to c. since whas no assurance of receiving any additional benefits under this arrangement (because she may predecease h, her inter vivos commitment to "an arrangement that provides her no certain benefits, current or future, smacks of a simple gratuitous transfer by" iv, effective upon h's death, of a remainder to c. see dodge, supra note 168, at 69-70. however, even here, iv may simply be responding to the coercion by h: h may have told wthat unless she joined in the setting up of the trust, he would exclude her from his will. in at least some marriages, husbands can exert more coercion over their wives while alive than dead. 224. see lowndes, supra note 21, at 76-77; lowndes et al., supra note 205, § 9.8, at 195-96; johanson, supra note 71, at 1288-95. 19991 florida tax review the doctrine is generally recognized as having originated in lehman v. commissioner.22 5 the decedent and his brother set up trusts. 226 the trusts established by decedent provided that income was to be paid to his brother for life, authorized his brother to withdraw $150,000 from the trusts, and directed that principal be paid to his brother's issue upon his brother's death.227 his brother's trusts contained reciprocally identical provisions, that is, they provided that income be paid to decedent for life, authorized decedent to withdraw $150,000 from the trusts, and directed that principal be paid to decedent's issue upon the decedent's death.22 ' ruling in favor of the commissioner, the court held the trusts purportedly created by decedent's brother were in substance created by decedent. 229 the court cited scott on trusts that "[a] person who furnishes the consideration for the creation of the trust is the settlor, even though in form the trust is created by another."23 ° it ruled that "the transfer by decedent's brother, having been paid and bought for by the decedent, was in substance a 'transfer' by the decedent." 231 consequently, the $150,000 that the decedent could withdraw from the trust nominally created by his brother was included in his gross estate as that part of decedent's "transfer" over which he retained a power "to alter, amend, or revoke., 232 the effect of the doctrine, when it applies, is to "uncross" or "switch" grantors. 233 thus, in lehman the decedent was treated as creating the trust nominally created by his brother, and his brother was treated as creating the trust nominally created by the decedent. the underlying rationale of the theory is that the decedent has created a trust nominally created by another, since he "paid and bought for" it by setting up a reciprocal trust for that other person's benefit. 225. 109 f.2d 99 (2d cir. 1940), cert. denied, 310 u.s. 637 (1940). 226. see id. at 100. 227. see id. 228. see id. 229. see id. 230. see id. 231. lehman v. commissioner, 109 f.2d 99, 100-01 (2d cir. 1940), cert. denied, 310 u.s. 637 (1940). 232. id. at 101. although the decedent retained a life income interest in the trusts he was deemed to have created, the full principal of the trusts was not included in his gross estate as transfers "intended to take effect in possession or enjoyment at or after [decedent's] death," id., since those trusts were created before the enactment of the joint resolution of march 3, 193 1, h.r.j. res. 529, 71 st cong., 3d sess., 46 stat. 1516 (1931), which amended § 302(c) of the revenue act of 1926, 44 stat. 9, 70 (1926), and overruled may v. heiner, 281 u.s. 238 (1930). see id. and supra note 1. 233. see, e.g., rev. rul. 74-533, 1974-2 c.b. 293; bischoff's estate v. commissioner, 69 t.c. 32 (1977); exchange bank & trust co. v. united states, 694 f.2d 1261 (fed cir. 1982). but see estate of green v. united states, 68 f.3d 151, 153 (6th cir. 1995) (court, assuming arguendo that trusts were "interrelated," refused to "uncross" grantors because grantors did not retain an economic benefit in the transferred property). [vol 4:8 estate and gil tax effects of selling a remainder in united states v. estate of grace, the supreme court rejected the contention that the government needed to show, before invoking the doctrine, that each trust was the "bargained-for quid pro quo" for the other. ' the government merely had to show that the trusts were "interrelated" (for example, that they were created at about the same time, were set up pursuant to a common plan, and had similar terms), and that their creation "to the extent of mutual value, leaves the settlors in approximately the same objective economic position as they would have been in if each had created his own trust with himself, rather than the other, as life beneficiary." 5 the grace decision leaves the underlying rationale orjustification for the reciprocal trust doctrine in doubt. 6 arguably, grace rejected the lehman rationale and replaced it with a "net effect" rationale. under this interpretation, each party is treated as the creator of the trust nominally established by the other, simply because each party is in the same position he would have been had he in fact setup the other trust. in other words, since the transaction had the same "net effect" as one covered by section 2036, it should be treated in that manner. a less sweeping interpretation of grace is that it relaxes or eases the evidentiary burden needed to invoke the doctrine for practical and administrative reasons but leaves unaltered the underlying justification for the doctrine. the court noted that requiring a finding that each trust was created as the quid pro quo for the other would necessitate "perilous" inquiries into the subjective intent of the parties where at least one of them, and possibly both, are deceased, and where the transaction may have occurred many years before. 7 the court noted the difficulty of showing subjective intent in intrafamily transactions where the parties rarely bargain in the same conscious, explicit manner that business people do. 8 the court also observed the high probability that such transactions were tax-motivated. 9 i prefer this view of grace, but some of the language in the decision points in the other direction. grace did not adopt a "pure" net effect rationale, since the court also required that the two trusts be "interrelated. ' 24 0 apparently, the doctrine does not apply if two people-without knowledge of the other's intent or actions-separately create trusts naming the other as income beneficiary, since such trusts would not be viewed as "interrelated., 2 4' it is difficult to justify this 234. 395 u.s. 316, 324 n.9 (1969). 235. see id. 236. see discussion of this issue in lowndes et al., supra note 205, at § 9.8. 237. estate of grace, 395 u.s. at 323. 238. see id. at 324. 239. see id. at 323. 240. id. at 324. 241. the dissenting opinion in the court of claims in grace, alluding to o. henry's "gift of the magi," stated that the reciprocal trust doctrine would not apply "even if the chance 19991 florida tax review result under the net effect rationale, since the settlors are just as much in the same economic position as if each had created a trust naming himself as income beneficiary. moreover, the "net effect" rationale seems to conflict with case law holding that taxpayers are not required to structure transactions in a manner producing the highest possible tax.242 the fashion in which taxpayers structure their transactions is normally respected for tax purposes so long as it has substantive economic effect. 43 the creation of reciprocal trusts would certainly have economic substance in some cases. for example, the establishment of reciprocal trusts with significantly different investments would appear to have economic substance since it markedly changes the nature of the investments from which each grantor derives his income.2' still the supreme court's rationale in grace remains unclear. i contend, however, that regardless of how one interprets grace, the lehman rationale provides the only proper basis for applying the reciprocal trust doctrine in the context of spousal elections. while grace may have broadened the rationale for applying the reciprocal trust doctrine, the court recognized that the lehman rationale of bargained-for consideration is still a valid justification for applying effect of ... independent transfers is to leave [the transferor] in the exact situation he would have been in had he transferred his property retaining an interest or power similar to that granted by his benefactor." 393 f.2d 939, 952 (ct. cl. 1968) (judges davis and nichols dissenting), rev'd, 395 u.s. 316 (1969). the supreme court cited this dissenting opinion with approval but not specifically on this point. see lehman, 395 u.s. at 322. it has been stated that "[p]resumably, the requirement that the trusts be 'interrelated' would preclude, as it should, an application of the doctrine where two settlors quite unknowingly and coincidentally happened to create similar trusts for each other." stephens et al., supra note 123, at 4.08[7][d] n. 137. 242. see gregory v. helvering, 69 f.2d 809, 810 (2d cir. 1934), aff'd, 293 u.s. 465 (1935). it was stated by judge learned hand that "anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose the pattern which will best pay the treasury .... id. at 810. 243. see david p. hariton, sorting out the tangle of economic substance, 52 tax law. 235 (1999). the author states that tax-motivated transactions will be respected under this principle so long as they "meaningfully alter the taxpayer's economic position (apart from their tax consequences) as compared to not undertaking them." id. at 241. even where they lack economic substance, they will respected unless the "tax benefits themselves are unreasonable and unwarranted in light of the objective rules which give rise to them." id. in fidelity-philadelphia trust co. v. smith, 356 u.s. 274 (1958), the supreme court respected the form of a transaction for estate tax purposes which had minimal, if any, economic substance apart from reducing estate tax. the decedent purchased combined life insuranceannuity contracts where any loss of the issuer on the life insurance contracts would be counterbalanced by its gain on the annuity contracts. the decedent irrevocably assigned the insurance policies. although the net effect of the transaction was the same as if decedent had retained a life income interest in the total amount paid for the combined contracts, the court refused to apply the predecessor of § 2036, since the policies and the annuities were separate items of property. fidelity-philadelphia trust co., 356 u.s. at 280. 244. cf. cottage savings ass'n. v. commissioner, 499 u.s. 554 (1991). [vol 4:8 estate anti git tax effects of selling a remainder the doctrine in cases having theappropriate facts.2 5 more importantly, unlike the facts in grace, a court in a spousal election case cannot ignore w's subjective intent and decide the case solely on the basis of the transaction's net effect. in such cases, w's estate is claiming either an offset or an exclusion on the ground that wreceived "consideration" for her transfer of the remainder in her property to c.246 the courts have properly held that for the taxpayer to prevail the purported consideration must be the actual "inducement" or "motivation" for iv's transfer.247 consequently, the court must necessarily pass upon w's intent in establishing w trust. if w's estate establishes that w transferred a remainder in her property to c solely to obtain a life estate in h trust, the court must allow the offset or the exemption, since this result is statutorily mandated. this is so even if the transfers are interrelated; indeed, it is so because they are interrelated, that is, because w's transfer was induced by her receipt of a life estate in h trust. if the court finds that w's establishment of w trust was unaffected by the election, that is, that she would have established a trust similar to iv trust at or about the time of the election in any event, the court will deny the offset and the exclusion.2' however, as we have seen, this will rarely be the case.249 if-as is more likely to be the case-the court finds that iv would not have established w trust at that time but for the election, must it then allow the offset or exclusion? in this situation, the lehnan rationale provides the proper conceptual tool for analysis. application of this approach will usually, though not always, result in disallowance of both the offset and the exclusion. b. the lehman rationale applied to spousal elections.-lehnan applies a "unitary" approach to the creation of reciprocal trusts, that is, it views each party as creating the entirety of the other party's trust and not just the portion that personally benefits him.-t ' 245. united states v. estate of grace, 395 u.s. 316. 324 n.10 (1969) ("we do not mean to say that the existence of "consideration"... can never be relevant, in certain cases, inquiries into the settlor's reasons for creating the trusts may be helpful in establishing the requisite link between the two trusts."). 246. see irc §§ 2512(b), 2036(a) (parenthetical expression), and 2043(a). 247. see supra notes 206-07 and accompanying text. 248. see supra part iv.b.2. 249. see id. 250. one consequence of the unitary approach is that where the reciprocal trust doctrine applies, the amount included in the decedent's gross estate is determined by reference to the value of the property in the trust nominally created by the other transferor. see rev. rul. 74-533, 1974-2 c.b. 293. professor dodge argues that one might logically apply the doctrine by treating the decedent as transferring his own trust but "retaining" his interest or power in the other trust. under such an approach, the amount includible in decedent's gross estate would be determined by reference to the date-of-death value of the trust he purported to create. see dodge, supra note 21, at a-60 to a-61. he concludes, however, that the approach used (i.e., the 19991 florida tax review in lehman itself, for example, the court viewed the decedent as creating not only those portions of his brother's trust that personally benefited him (i.e., his life estate and his power to withdraw $150,000) but also the portion of his brother's trust that benefited decedent's issue (i.e., the remainder). assuredly this is correct. the brother did not give the remainder in his property to decedent's issue because of his love for them; he gave it because the decedent had reciprocally given a remainder in his property to the brother's issue." in contrast to the reciprocal trust doctrine, the courts in analyzing spousal elections apply a "fragmented" approach. h is not viewed as causing w to create the entirety of w trust but rather as inducing her to relinquish only the remainder." 2 i contend that the "unitary" approach of the reciprocal trust doctrine better captures reality in most spousal elections than the "fragmented" approach currently used. what h is attempting to do by giving w an election is to induce w to dispose of her property in a comprehensive manner that will benefit not only c but also w herself. after all, h's donative feelings run to w as well as to c. it is contrary to our knowledge of human relationships to assume, as the current approach does, that h is offering the election solely to benefit c. indeed, h may desire w to place her property in trust and to limit her interest to that of an income beneficiary out of genuine concern for w. although most people today may regard such concerns as paternalistic, if not sexist, they may nevertheless represent h's honest feelings of concern and affection for w. h may be concerned about w's lack of business and financial experience, and may therefore want to induce her to place her property in trust where an experienced, professional trustee will manage it." h may be concerned that given w's lack of experience in managing property, she might imprudently consume principal to her own disadvantage, and therefore limit her interest to that of an income beneficiary.' in any event, h is seeking to have w commit herself to dispose of her property in a manner benefiting herself as well as c. if h were solely "unitary" approach) "derives from the broader indirect-transfer principle that causes the trust to be includible in the first place," i.e., the principle that the decedent has indirectly funded the other trust. id. at a-61. 251. similarly, the court in commissioner v. warner, 127 f.2d 913 (9th cir. 1942), applied the reciprocal trust doctrine where each of three brothers purported to create a trust for family members of a different brother. thus, jack warner was treated as the grantor of a trust nominally created by his brother albert for the benefit of jack's family, since simultaneously jack had created a trust for the benefit of his brother harry's family and harry had created a trust for the benefit of albert's family. see id. at 915. 252. see supra notes 33-36 and accompanying text. 253. see supra note 220 and accompanying text. 254. see supra note 219 and accompanying text. [vol 4:8 estate and git tax effects of selling a remainder concerned with c, he could have accomplished his objective more effectively simply by leaving his property outright to c. h is seeking a "package deal" from w. h is attempting to secure this package from wby offering her in turn a package she finds attractive. in making her decision, w will be influenced not only by the enticement of a life estate in h trust, but also by the way h ultimately disposes of his property. certainly this is the case where the life estate w receives is worth less than the remainder she surrenders. then wwill be sustaining an economic loss by allowing her property to pass under h's will and will not rationally do so unless she derives a psychic benefit from h's leaving a remainder interest to c. even where the life estate offered w is worth more than the remainder she must surrender, w will rarely be indifferent to how the property in h trust ultimately passes. iv may very well be unwilling to give up access to her principal and her ability to determine how her property will pass at death, unless she is happy with h's designation of the remainderman." 5 if h left the remainder in his property to his mistress who was 25 years younger than w, w will be loathe to allow her property to pass under h's will no matter what the value of her income interest in h trust. the "unitary" approach-which recognizes that h is offering iv a "package deal" in h trust in return for a "package deal" in w trust-better reflects reality than the "fragmented" approach-which views h and w as just undertaking an exchange of a life estate for a remainder. the reciprocal trust doctrine therefore properly applies to most spousal elections. h is inducing w to dispose of her property in a certain way (i.e., creating w trust) by disposing of his property in a certain way (i.e., creating h trust). put more crudely, h is "buying and paying for" w trust by his establishment of h trust, and conversely, w is "buying and paying for" h trust by alloving her property to pass under h's will. h should therefore be treated as the grantor of iv trust and w as the grantor of h trust. unlike the "mutual gift" theory, this approach recognizes both the bargaining and donative aspects that usually co-exist in an election: it recognizes that w's decision to allow her property to pass under h's will was partially induced by the prospect of receiving a life estate in h's property (the bargaining aspect), but it also recognizes that w's decision was partially induced by h's designation of c-her child-as remainderman (the donative aspect). this approach resolves the appropriate gift tax treatment of the transaction. since w is viewed as the grantor of h trust, she should be treated as making a gift of the remainder in that trust to c.26 since the remainderman, c, 255. see supra note 217 and accompanying text. 256. the irs uses the "fragmented" rather than the "unitary" approach in determining gift tax liability. see rev. rul. 69-505, 1969-2 c.b. 179. assume a creates a trust, with income payable to b for life, remainder to c, and b, in an interrelated transaction, creates b 1999] florida tax review is her child, section 2702 will apply, and unless w retains a "qualified interest" in h trust, she should be treated as making a gift of the entire value of that trust. this approach differs fundamentally from existing law, where both the courts and the irs permit w to offset her gift of a remainder in w trust by the value of the life estate she receives in h trust.7 there is a section 2512(b) consideration offset in the transaction, but it is different from the one recognized by the courts and the irs. to understand this, we must once again delve into the conceptual foundations of the reciprocal trust doctrine. consider this case: a transfers blackacre in trust with income payable to b for life, remainder to b's issue, and b, in an "interrelated" transaction, transfers whiteacre in trust with income payable to a for life, remainder to a's issue. under the reciprocal trust doctrine, b is treated as the real grantor of a's trust; b is therefore viewed as transferring blackacre. how can this be when blackacre belonged to a? the answer is that the reciprocal trust doctrine necessarily requires that a and b be viewed as first exchanging beneficial interests in blackacre and whiteacre. the reciprocal trust doctrine, properly analyzed, involves two constructive steps: the two parties first exchange beneficial interests in their respective properties, and each party subsequently transfers the property he physically holds (but which now beneficially belongs to the other) as the other party's agent. in terms of the above example, a and b first exchange their beneficial interests in blackacre and whiteacre. a then transfers blackacre (which he now holds on b's behalf) as b's agent; and b transfers whiteacre (which he now holds on a's behalf) as a's agent. the following example may clarify this point. assume d owns greenacre having a fair market value of $500,000. if d accepts $500,000 from e in consideration for transferring greenacre, at e's behest, to a trust for the benefit of e and e's issue, d in effect has sold greenacre to e for $500,000, and trust, with income payable to a for life, remainder to c. rather than treating a as the grantor of b trust and b as the grantor of a trust for gift tax purposes, the service bifurcates the transaction. first, a and b are treated as exchanging their respective life estates in the two trusts. thus a makes a taxable gift to b to the extent, if any, that the value of b's life estate in a trust exceeds the value ofa's life estate in b trust; b's gift, if any, is determined in the same manner. then each party is treated as making a gift of the remainder in the trust he or she purportedly created (i.e., a is treated as making a gift of the remainder in a trust). see id. this approach is inconsistent with the approach the irs uses for estate tax purposes. see rev. rul. 74-533, 1974-2 c.b. 293. if the gift tax approach were followed, the irs would include the value of a trust ina's gross estate under § 2036, since the gift tax approach viewed a as having transferred the remainder in a trust. however, the service bases the amount included in a's gross estate solely on the value of b trust. see id. the service's gift tax approach is also inconsistent with the underlying rationale for applying the reciprocal trust doctrine, that is, that each transferor is the grantor of the other party's trust. see supra note 250 and accompanying discussion. 257. see supra notes 33-35 and accompanying text. [vol 4:8 estate and git tax effects of selling a remainder then, acting as e's agent, transferred greenacre to the trust. this is what happens when the reciprocal trust doctrine applies. in the context of a spousal election, w should thus be viewed as first exchanging ownership of her share of the community for ownership of h's share of the community 58 w should then be viewed as transferring her share of the community, which she now holds on behalf of h's estate, to iv trust as the agent for h's estate. likewise, h's estate should be viewed as transferring h's share of the community to h trust as w's agent, thereby making iv the grantor of that trust. the section 2512(b) gift tax consideration offset applies to the first constructive step-w's exchange of her beneficial interest in her share of the community for h's share of the community. w realizes no gift tax liability on this constructive "exchange" because the values of the properties being exchanged are equal. 9 since w fully utilizes the consideration she receives as an offset in the first constructive step, she may not use it again in the second constructive step. thus, w is not entitled to any offset in her deemed creation of h trust. since w is viewed as the grantor of h trust in which she has retained a life estate, the entire value of h trust will be included in her gross estate under section 2036. the consideration w received in the election was not for her deemed creation of h trust but rather in the constructive exchange of her share of the community for h's share of the community. consequently, neither the section 2036 exclusion nor the section 2043 offset will apply.2 ° 258. some have asserted that the supreme court's decision in united states v. stapf, 375 u.s. 118 (1963), validates current law, which views a spousal election as an "exchange" by wof a remainder in her property for a life estate in h's property. see morrison. supra note 21, at 226-27. indeed, the decision seems to implicitly assume that a spousal election involves an "exchange" between wand h's estate. see lowndes, supra note 21, at 73-74 (the court of appeals "apparently considered the widow's election a transfer for consideration" and the supreme court "without close analysis of the issue, seems to have made the same assumption"); morrison, supra note 21, at 226 (stapf recognized the "validity of intraspousal transfers and exchanges."). but the existence of an "exchange" is fully consistent with the reciprocal trust doctrine, since the doctrine likewise assumes an "exchange," namely, an exchange of w's share of the community for h's share of the community (i.e., the first constructive step). 259. in many cases, w's share of the community will be larger than h's share, since death taxes and administration expenses will have depleted his share. in that case, the amount of w's property that she is treated as exchanging for the creation of h trust is limited to the value of h trust, and the excess amount in wtrust will be treated as a transfer by wresulting in a gift. grace limits application of the reciprocal trust doctrine to the "extent of mutual value" transferred by the parties, i.e., the smaller amount. united states v. estate of grace, 395 u.s. 316, 324 (1969). see also supra note 176. 260. although a definitive answer of this question is beyond the scope of this article, use of the reciprocal trust doctrine may also resolve the income tax treatment of a spousal will election. since the values of w's share and h's share that are exchanged for each other are equal, and since each of these shares acquires the same basis, that is, their values on the day of 19991 florida tax review however, there will be cases where the "fragmented" approach of the current law better fits the facts of a spousal will election than the "unitary" approach of the reciprocal trust doctrine. consider the case where w is indifferent, or even antagonistic, toward c, h's child by a prior marriage, but allows her property to pass under h's will because the life estate she receives in h trust is worth substantially more than the remainder she gives to c in her trust. clearly, the fragmented approach better explains what is happening here than the unitary approach. in this case, w should be allowed, as under current law, to offset the amount of her "gift" to c by the value of the life estate she receives in h's property. here, w's receipt of that life estate constitutes the real "consideration" for her relinquishment of the remainder to c. likewise, the value of w's life estate in h trust constitutes "consideration" for purposes of the section 2043 offset. again this result conforms to the existing law. however, the adequacy of the consideration w received (i.e., her life estate in h trust) should be measured against the value of the remainder she gives to c and not the value of the property w places in w trust in determining whether the exclusion from section 2036 applies. to this limited extent, the holdings of the d'ambrosio trilogy should change the existing law in spousal elections. the cases where the fragmented approach applies should be few in number. since the normal desire of every parent is to benefit her children, there should be a strong presumption that the parent's decision to accede to the election was partially motivated by the benefits it conferred on her children. other reasons for a strong presumption in favor of the unitary approach are the high likelihood that the spousal election device will be used for tax avoidance; the difficulty of determining the intent of deceased persons to transactions that may have occurred many years before; and the fact that parties in an intrafamily transactions rarely deal with each other on a conscious arm's length basis. the same factors that led the supreme court to relieve the government of the need to prove a bargained-for, quid pro quo consideration before invoking the reciprocal trust doctrine support a strong presumption here.26' to invoke the fragmented approach, w's estate should be required to show by clear and convincing evidence that w's decision to allow her property to pass under h's will was not influenced by h's designation of c as the remainderman.262 whenever courts are called on to determine subjective intent, h's death (or the alternate valuation date), see irc § 1014(b)(6), the deemed exchange of the two shares should not produce any significant amount of taxable gain. 261. see supra text accompanying notes 237-39. 262. the suggested presumption is analogous to the rule applicable to divorce settlements that provide benefits to the payor's adult children. the irs and the courts treat such benefits as gifts by the payor spouse, unless he can prove otherwise. see spruance v. commissioner, 60 t.c. 141 (1973); rev. rul. 77-314, 1977-2 c.b. 349. [vol. 4:8 estate and git tax effects of selling a remainder they necessarily place great weight on objective factors in judging the genuineness of the party's alleged intent. 3 here, two objective showings should normally be required. first, w's estate should be required to show that iv was antagonistic, or at least indifferent, to the remaindermen designated in h's will. this might be true, for example, where the remaindermen were h's children by a prior marriage. secondly, w's estate should be required to show that iv possessed a reasonable basis for believing that her economic position would be improved by allowing her property to pass under h's will. this showing could be established by use of the government actuarial tables or other convincing valuation techniques. an absolute rule eliminating the need to determine subjective intent cannot be applied in spousal elections. unlike the situation in grace, w's estate is statutorily entitled to an estate tax offset or exclusion if it shows that w's receipt of a life estate was the inducement for the relinquishment of the remainder in her property. however, the above requirements should make use of this approach administratively feasible as well as satisfying the requirements of the law. c. estate of magnin, spousal elections and the reciprocal trust doctrine.-although magniz264 is not technically a spousal election case, analytically it involved the same type of exchange. only the identity of the parties differed: the exchange occurred between father and son rather than husband and wife. consequently, the ninth's circuit's decision to apply the d'ambrosiowheeler test for "full consideration" to magnin is strong precedent for extending this test to spousal elections, and as such, the case deserves close scrutiny. in magnin, the combined stock holdings of decedent and his father constituted voting control of a company operating women's clothing stores. s the father desired control of the business to remain "in the family" and consequently did not want his son to leave his stock to any of the women he had it is unclear whether the suggested presumption can be judicially developed or would require legislative approval. section 7491 provides generally that in any income, estate, or gift tax controversy, the commissioner has the burden of proof with respect to any factual issue on which the taxpayer has introduced credible evidence. the senate finance committee report. in explaining this provision, speaks of the prior "general rule of presumptive correctness of the commissioner's determination." s. rep. no 174, 105th cong., 2d sess. 43 (1998). arguably, § 7491 applies only to this general presumption, and not to judicially created presumptions limited to special situations; however, the statute's language does contain such a limitation. 263. for example, under § 183 a taxpayer is entitled to deduct his ordinary and necessary expenses if he engages in an activity with the intent of making a profit, even if his expectation of a profit is unreasonable. however, the taxpayer's intent is determined by reference to objective standards. see regs. § 1. 183-2(a). 264. estate of magnin v. commissioner, 184 f.3d 1074 (9th cir. 1999). 265. estate of magnin v. commissioner, 71 t.c memo (cch) 1856, 1858, t.c. memo (ria) 196,025, at 239, 241 (1996). 19991 florida tax review started dating following his wife's death.2" the decedent, on the other hand, was concerned he might lose control of the company following his father's death, which he valued for social, political and business reasons.267 to accommodate these objectives, decedent and his father entered the following agreement. the father agreed to leave his stock in four trusts, one for the benefit of decedent and one for each of the decedent's three children.268 onehalf of the father's stock was to go to the decedent's trust in which the decedent was to have a life income interest. 269 the father designated decedent as the sole trustee of all four trusts with sole power to vote the stock thereby assuring the son of continued control of the company.27 in return, the son agreed to leave all his stock in the company to his children upon his death.27' the decedent was enjoined from transferring or encumbering his shares but was permitted to give them to his children.272 decedent agreed that if the company was dissolved, or all its stock acquired, he would place the proceeds in a trust in which he would enjoy a life income interest with the remainder passing to his children at death. 273 following his father's death all the company's stock was bought by an outside corporation, and decedent, in accordance with the agreement, placed the proceeds from the sale of his stock in a trust having the terms described above.274 when the decedent died, the irs asserted that this trust was includible in his gross estate under section 2036 since he had retained a life estate in it.275 the estate countered that the decedent had received full consideration for his transfer of the remainder interest to his children, namely, voting control and a one-half life income interest in his father's stock.276 the court found there was "some"' or "an element" of bargained-for consideration in the transaction,27 but, following gradow, found the consideration decedent received inadequate since it did not equal the full value of his stock he agreed to transfer to his children.278 on appeal, the ninth circuit 266. see id. 267. see id. 268. see magnin, 71 t.c. memo (cch) at 1859, t.c. memo (ria) at 241-42. the father also agreed to leave to these trusts shares he owned in a separate corporation that operated a women's clothing store in reno, nevada. see id. 269. see magnin, 71 t.c. memo (cch) at 1858-59, t.c. memo (ria) at 243 (describing provisions of decedent's trust). 270. see magnin, 71 t.c. memo (cch) at 1858-59, t.c. memo (ria) at 241-42. 271. see id. 272. see id. 273. see magnin, 71 t.c. memo (cch) at 1859, t.c. memo (ria) at 243. 274. see id. 275. see magnin, 71 t.c. memo (cch) at 1861, t.c. memo (ria) at 244-45. 276. see magnin, 71 t.c. memo (cch) at 1861, t.c. memo (ria) at 245. 277. magnin. 71 t.c. memo (cch) at 1862, t.c. memo (ria) at 246. 278. see magnin, 71 t.c. memo (cch) at 1863, t.c. memo (ria) at 247. [vol 4:8 estate and gir tax effects of selling a remainder reversed and remanded, holding per d'anbrosio and wheeler that the "full consideration" requirement would be met if the estate could establish that the consideration received (i.e., the one-half life income interest and voting control in his father's stock) equaled or exceeded the present value of the remainder interest decedent agreed to transfer to his children.279 note that if the estate makes this showing, decedent and his estate will escape all transfer tax on decedent's transfers to his children. both the tax court and the circuit court applied a "fragmented" approach to the case. unfortunately, neither court considered possible application of thelehman "unitary" approach. the fragmented approach views a transaction like this exclusively in terms of an exchange of a remainder interest in one party's property in return for a life interest in the other party's property. each party is viewed as indifferent to, and unaffected by, whatever other disposition the other party makes of his property; thus the balance of his disposition is viewed as irrelevant in determining the tax effects of the transaction. this assumption of indifference is rarely true in a spousal election, and does not appear to have been the case in magnin. consider father's situation. was his sole interest in the transaction to protect his grandchildren? was he indifferent, or even antagonistic, to his son's continuing control of the business? the facts tell a different story. even before their agreement, the father had provided in his will for his stock to pass in trust for the benefit of his son and his son's children; his son was also to serve as sole trustee thereby assuring him of continuing control of the business.' the agreement merely precluded him from revoking this provision; in other words, it continued the status quo.2 1 was he opposed to having his son operate the business? although the father and son had different ideas as to how the business should be operated, the father had turned operating control over to his son almost 15 years before their agreement.2it thus appears likely that the father-from love, a sense of paternal obligation, or both-wanted his son to retain control of the business provided the rights of his grandchildren were protected. indeed, if he opposed his son's continued control of the business and was solely motivated by his grandchildren's welfare, he might better have achieved these objectives by leaving his shares outright to his grandchildren. 279. estate of magnin v. commissioner, 184 f.3d 1074 (9th cir. 1999). 280. see magnin, 71 t.c. memo (cch) at 1859, t.c. memo (ria) at 242. 281. see id. 282. see magnin, 71 t.c. memo (cch) at 1857, t.c. memo (ria) at 240. the father turned operation of the business over to his son in 1937; the agreement was made in 1951. see id. after 1937, the father concentrated his efforts on a successful factoring business he had started. see id. 19991 florida tax review was the son's sole interest in the transaction to obtain voting control of his father's shares? was he indifferent, or even antagonistic, to his children receiving his father's shares upon his death? there was no evidence of this. although the court made no finding to this effect, one might surmise some tension existed between the decedent and his children since they disliked his second wife.283 but there is nothing to suggest that the son disliked his children, or objected to their receiving his father's shares after the son's death.28" on the contrary, his children had worked with him in the business from early in their lives and apparently continued to work with him in the business during the rest of decedent's life.2" 5 decedent appointed his oldest son executor of his estate, suggesting a relationship of trust and love.286 most likely, the decedent was attracted to a solution where his father's shares would "remain in the family" and ultimately pass to his children. indeed, his agreement with his father benefited his children by obligating his father to leave one-half of his shares in trusts for their benefit. these facts suggest the presence of both donative and bargaining elements in the transaction. the tax court seems to have recognized this when it found the transaction involved merely "some" bargained-for consideration, or as it expressed the thought elsewhere, "an element of' bargained-for consideration.287 since donative impulses were almost certainly present, the lehman "unitary" approach provides a better way of characterizing the transaction. father and son were bargaining. the father wanted a solution that would allow his son to continue running the business but at the same time would protect his grandchildren. the son wanted to assure his continued control of the business but probably also wanted his children to have an interest in the business following his death. the father proposed a package deal: "i will leave my shares so that you can vote them during your lifetime and so they will pass to your children upon your death. in return, you will continue to own your shares subject 283. see magnin, 71 t.c. memo (cch) at 1858, t.c. memo (ria) at 240. the father also disliked decedent's second wife. see id. 284. the decedent may have preferred to leave some or all of his own shares to his second wife, at least for the period she survived him. as far as the opinion reveals, no evidence was presented on how he wanted to leave his own shares. however, there is no reason to suppose he was unhappy about his father's shares passing to his children after his (i.e., the son's) death. indeed, as the text develops, the circumstances suggest he would have wanted his children to have an interest in the business following his death. 285. see magnin, 71 t.c. memo (cch) at 1858, t.c. memo (ria) at 240. the opinion states that his children continued working in the business during their adulthood, except that his daughter reduced her day-to-day activities following her marriage. her husband entered the business and was ultimately placed in charge of store operations. see id. 286. see magnin, 71 t.c. memo (cch) at 1856, t.c. memo (ria) at 239. 287. magnin, 71 t.c. memo (cch) at 1862, t.c. memo (ria) at 246. [vol. 4:8 estate and git tax effects of selling a remainder to some restrictions on their transfer but will leave them to your children on your death." each party's package was designed to appeal to the other and induce his acceptance. consequently, the father "bought and paid for" the son's disposition of his shares and the son "bought and paid for" the father's disposition of his shares. the decedent should therefore have been treated as the transferor of his father's shares, and to the extent his father's disposition gave him a life income interest, it should have been included in his gross estate pursuant to section 2036.288 since the normal desire of every parent is to benefit his children, there should be a strong presumption in these cases that the parent's decision to enter the agreement was motivated, in part, by the benefits it conferred on his offspring. otherwise, the danger that such agreements will be used as cover for making a tax-free, donative transfer to one's children is too great. in magnin, the estate fell far short of overcoming this presumption. v. conclusion in a simple sale of a remainder, the actuarial value of such remainder should be treated as "consideration" for gift and estate tax purposes. the contrary position of the irs and some courts is erroneous and should be abandoned. perhaps, this erroneous view was borne out of concern that taxpayers could manipulate a transfer so that the actuarial value of a remainder would understate its true economic worth. if so, the enactment of section 2702 removes any possible justification for continued adherence to that position. a spousal election should normally be analyzed under the "unitary approach" of lehman. under this approach, h will be treated as establishing iv trust and w as creating h trust. consequently, iv will subject to a gift tax on the full value of the remainder passing in h trust to c and, unless iv's retained interest is a "qualified interest," on the full value of the property passing to that trust. since this approach views w as "retaining" a life estate in h trust, the full value of that trust will be included in her gross estate pursuant to section 2036. under this approach, neither w nor her estate will qualify for a section 2512(b) gift tax offset or a section 2043 estate tax offset. 288. since his father's disposition, which the lehman analysis treats as having been made by the decedent, gave the decedent a life estate in only one-half of his father's shares, only that portion would be included in decedent's gross estate. his father's disposition gave the decedent voting control of all his shares, but § 2036(b)-which treats a retention of voting power in a controlled corporation as a retention of beneficial enjoyment-would not apply because father's transfer occurred prior to june 22, 1976. see revenue act of 1978, pub. l no. 95-600, § 702(i)(3), 92 stat. 2763, 2931 (1978). the agreement was made in 1951 and the father died in 1953. see magnin, 71 t.c. memo (cch) at 1858-59, t.c. memo (ria) at 24119991 606 florida tax review [vol. 4:8 however, the fragmented approach of current law should apply if w and her estate establish by clear and convincing evidence that w's decision to allow her property to pass under h's will was uninfluenced by h's designation of c as remainderman. where this showing is made, w will be liable for a gift tax only on the amount, if any, by which the value of the remainder she surrenders exceeds the actuarial value of the life estate she receives in h trust. w trust should be included in w's gross estate under section 2036 only if her life estate in h trust is worth less than the remainder in w trust on the date of the election, and even then, w's estate should be permitted to reduce w's gross estate by the value of the life estate on the day of election. florida tax review 1 florida tax review volume 9 2008 number 1 the case for residency-based taxation of financial transactions in developing countries by yoram keinan * i. introduction .......................................................................................... 3 ii. basic principles of international tax rules ........................... 10 a. overview ..................................................................................... 10 b. source-based and residency-based taxation ............................ 12 c. active v. passive income ............................................................. 14 d. the rationale behind the active/passive distinction ................. 17 e. residency-based taxation .......................................................... 18 f. determining the source of income ............................................. 19 g. the role of tax treaties in allocating income between the source and residency country .................................................. 20 iii. taxation of cross-border financial transactions ............. 22 a. general ....................................................................................... 22 b. taxation of interest, dividends and capital gains .................... 24 1. taxation of cross-border interest and dividends ......... 24 2. taxation of interest ........................................................ 25 3. taxation of dividends and total return swaps ............. 27 4. capital gains ................................................................. 29 5. the “race to the bottom” .............................................. 29 6. the eu savings directive .............................................. 36 7. conclusions .................................................................... 37 * yoram keinan is a visiting professor at the university of michigan law school and an adjunct professor at georgetown law center. he is also an of counsel with greenberg traurig llp in new york. as an of counsel at greenberg traurig, he specializes in united states taxation of financial products and institutions and represents major investment banks and financial institutions in the united states. prior to joining greenberg traurig, mr. keinan served as a senior manager with ernst & young’s national tax department in washington, d.c., as an associate with shearman & sterling and as a manager with ernst & young’s tax department in israel. he received his m.p.a. and i.t.p. (international taxation) from harvard, ll.m. (taxation), and s.j.d. from university of michigan. 2 florida tax review vol. 9:1 c. taxation of derivative transactions .......................................... 37 1. overview ........................................................................ 37 2. risk management and hedging ..................................... 41 3. cross-border aspects of derivatives ............................. 43 4. taxation of cross-border derivatives under treaties ................................................................... 51 d. investing and trading in securities ............................................ 53 e. credit default swaps (cdss) ..................................................... 56 iv. harmful tax competition ............................................................ 58 a. overview ..................................................................................... 58 b. the oecd project on harmful tax competition ....................... 58 1. general .......................................................................... 58 2. tax havens ..................................................................... 61 3. potentially harmful preferential tax regimes .............. 61 4. the oecd follow-up report (2000) ............................. 63 c. summary ..................................................................................... 65 v. conclusion .......................................................................................... 66 2008] the case for residency-based taxation 3 i. introduction the globalization process does not permit a country that wishes to be involved in this process to take an independent stand in choosing its tax system, especially with respect to financial transactions. 1 choosing tax rules that are unacceptable in the world’s leading countries could adversely affect an economy’s competitiveness in the world’s capital markets. 2 the growth in international capital movements is a contributory factor in this respect. 3 in 1923, a committee comprised of four economists submitted a report to the league of nations that set forth the basic principles underlying international tax principles, most of which still prevail today. 4 upon the issuance of the league of nations report in 1923, two generally recognized regimes for 1. see harmful tax competition: an emerging global issue (1998), ¶ 21 [hereinafter “oecd report (1998)”] (“globalization has also been one of the driving forces behind tax reforms, which have focused on base broadening and rate reductions, thereby minimizing tax induced distortions. globalization has also encouraged countries to assess continually their tax systems and public expenditures with a view to making adjustments where appropriate to improve the ‘fiscal climate’ for investment. globalization and the increased mobility of capital has also promoted the development of capital and financial markets and has encouraged countries to reduce tax barriers to capital flows and to modernize their tax systems to reflect these developments. many of these reforms have also addressed the need to adapt tax systems to this new global environment.”). 2. id. ¶ 22 (“the process of globalisation has led to increased competition among businesses in the global market place.”). 3. see reuven s. avi-yonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1575-76 (2000) (“the mobility of capital has resulted in international tax competition, in which sovereign countries aim to attract both portfolio and direct investment by lowering their tax rates on income earned by foreigners.”); chris edwards & veronique de rugy, international tax competition: a 21st-century restraint on government, 27 tax notes int’l 63, 66-67 (2002) (“world economies have become more tightly integrated in recent decades. rapid growth in cross-border investment has been a key dimension of that integration. in past decades, many countries erected barriers to foreign investment, but today most countries realize that foreign investment means new jobs, new factories, and access to leading-edge technology. as a result governments have removed the shackles they once placed on international investment flows.”). 4. see report on double taxation, submitted to the financial committee by professors bruins, einaudi, seligman, and sir josiah stamp, league of nations doc. no. e.f.s. 73.f.19, 40 (1923) [hereinafter “league of nations report (1923)”]. professor hugh ault defines this report as “the intellectual base from which modern treaties developed.” see hugh j. ault, colloquium on corporate integration: corporate integration, tax treaties and the division of the international tax base: principles and practices, 47 tax l. rev. 565 (1992). 4 florida tax review [vol. 9:1 international tax have emerged – residency (or global) and source (or territorial). 5 in a residency-based tax regime, residents are taxed on their worldwide income. 6 in a territorial regime, by contrast, residents are not taxed on foreign source income, and foreign taxpayers are taxed on income generated in the source country. 7 over the years, there has been a significant degree of convergence among countries; as of today, most tax jurisdictions, whether developed or developing, use both source and residence taxation to some extent. 8 according to professor reuven avi yonah, most countries follow an “international tax regime” in both their internal laws and tax treaties. 9 the question addressed by this article is whether a developing country (hereinafter “country d”) is better off adopting a source-based or residencybased taxation regime (or a combination thereof) for cross-border financial transactions. 10 financial transactions add an important dimension to the general conflict between source-based and residency-based regimes since money is fungible. 11 thus, when a non-resident wishes to invest overseas, the investor can easily switch from one country to another, and will do so if the tax rules in country d could result in a heavier tax burden. 12 5. see jeffrey m. colon, financial products and source basis taxation: u.s. international tax policy at the crossroads, 1999 u. ill. l. rev. 775, 780 (1999). 6. see gregory may, the u.s. taxation of derivative contracts, 95 tni 189-8 (this article is an updated version of the national report published in 85b cahiers de droit fiscal international 615 (1995) for the 49th congress of the international fiscal association on september 17-21, 1995). 7. id. see also generally reuven s. avi-yonah, the structure of international taxation: a proposal for simplification, 74 tex. l. rev. 1301 (1996). 8. see avi-yonah (1996), supra note 7, at 1303-05 (describing this process as the creation of an “international tax regime.”). 9. id. at 1303 (“[a] coherent international tax regime exists that enjoys nearly universal support and that underlies the complexities of the international aspects of individual countries’ tax systems.”). 10. see generally avi-yonah (2000), supra note 3, at 1639-48 (discussing the pros and cons of the two alternatives); victor thuronyi, taxation of new financial instruments, 24 tax notes int’l 261 (2001). 11. id. see also yaron z. reich, taxing foreign investors’ portfolio investments: developments & discontinuities, 98 tax notes today 114-71 (jun. 15, 1998) (“one important policy consideration would seem to favor having the source country forgo the taxation of passive income, particularly portfolio investment income. investment capital is highly mobile, and investors often can choose from among alternative investment opportunities around the world.”). 12. see edwards & de rugy, supra note 3, at 67 (“portfolio flows can be shifted in and out of foreign investments quickly and are more sensitive to short-term returns than is fdi.”). 2008] the case for residency-based taxation 5 nevertheless, for developing countries, choosing between source-based and residency-based taxation is not easy. 13 on the one hand, a source-based regime would allow country d to keep more tax revenues from non-residents. 14 assuming that country d has source rules similar to most other countries with respect to financial transactions, a source-based regime would allow country d to tax income derived by non-residents from interest and dividends paid by domestic entities. 15 on the other hand, non-residents from countries that have a residencybased taxation regime would be less inclined to invest in country d, since their home country would impose tax on such non-residents’ activity in country d. this might result in double taxation if no treaty applies, and there is no other relief from double taxation. 16 furthermore, as set forth below, residency-based taxation promotes capital export neutrality (cen). 17 as this article concludes, the adoption of a residency-based taxation regime for financial transactions by developing countries would benefit country d in terms of attracting foreign investment. 18 residency-based taxation for financial transactions is generally consistent with the principle established by the league of nations report (1923), pursuant to which passive income should generally be taxed by the residency country. 19 residency-based taxation for financial transactions would also make country d’s tax rules consistent with the current rules in the majority of developed countries (see table 1 below) and reduce compliance costs, since the 13. see avi-yonah (2000), supra note 3, at 1639-48. as to financial transactions in particular, see thuronyi, supra note 10, at 261. 14. avi-yonah (2000), supra note 3, at 1640-41 (discussing the need for tax revenues in developing countries). 15. id. 16. id. at 1641-48. 17. avi-yonah (2000), supra note 3, at 1605 (“if a country adopts the residence principle, taxing at the same rate capital income from all sources, then the gross return accruing to an individual in that country must be the same, regardless of which country is the source of that return. thus, the marginal product of capital in that country will be equal to the world return to capital. if all countries adopt the residence principle, then capital income taxation does not disturb the equality of the marginal product of capital across countries which is generated by a free movement of capital.” quoting assaf razin & efraim sadka, international tax competition and gains from tax harmonization, 37 econ. letters 69, 69-70 (1991)). 18. id. at 1582 (“the standard economic advice to small, open economies is to avoid taxing capital income at its source, because the tax will be shifted forward to the borrowers and result in higher domestic interest rates.”). 19. see ault, supra note 4, at 568 (stating that in the league of nations report (1923), “the right to tax business income, including the income of affiliated companies, was assigned to the source state. the right to tax income from business securities, however, was assigned exclusively to the residence state.”). 6 florida tax review [vol. 9:1 collection of source-based taxation on interest and dividend income earned by nonresidents is very impractical in many instances. residency-based taxation, however, would shift revenue from developing to developed countries in the short-run, but as discussed below, it would benefit country d in the long-run. in adopting residency-based taxation regime with respect to financial transactions, for the purpose of encouraging foreign investment, country d would not be alone. 20 as professor colon emphasizes: over the last eighty years, the united states has encouraged passive foreign investment in u.s. capital markets by generally exempting foreign investors from u.s. tax on all income arising from dealings in u.s. debt and equity securities. this tax policy reflects a view that the benefits from increased foreign investment, such as lowering the cost of capital for u.s. firms and increased market liquidity, outweigh any foregone tax revenue. 21 similar preferences have been included in tax treaties to which the united states is a party. 22 part ii of this article describes the fundamentals of source-based and residency-based taxation in general, and with respect to financial transactions in particular. part iii is divided into three chapters, each of which discusses one of the following tax issues: (i) taxation of portfolio interest, dividends and capital gains earned by nonresidents; (ii) taxation of cross-border derivatives; and (iii) taxation of non-residents trading or investing in securities in country d. the united states has recognized the need to attract foreign lenders when it enacted the portfolio interest exemption in 1984. 23 in addition, the united states has enacted other provisions that exempt portfolio investment, including: (i) the exemption for interest paid on bank deposits, 24 (ii) the exemption for original issue discount (“oid”) on a debt obligation having an original maturity of 183 days or less, 25 and (iii) the exemption for most capital 20. see table 1 below (describing the withholding rates for interest and dividend income earned by non-resident in several countries). 21. colon, supra note 5, at 784 (footnote omitted). 22. id. at 785 (“the favorable tax treatment of foreign investment reflected in the internal revenue code also parallels the favorable tax treatment accorded passive foreign investment income in bilateral income tax treaties, which generally exempt or significantly reduce source basis taxation on investment income earned by foreign persons.”). 23. irc §§ 871(h) and 881(c). 24. irc §§ 871(i) and 881(d). 25. irc § 871(g)(1)(b)(i). 2008] the case for residency-based taxation 7 gains of foreign investors. 26 as discussed in greater detail below, many countries have followed the united states in enacting low or zero withholding tax on interest paid to non-residents. 27 as intended, the enactment of the portfolio interest exemption has resulted in a significant increase in portfolio investment in the united states. 28 chapter iii(b) proposes that country d establish a similar exemption for portfolio investment in bonds and stock of domestic corporations; if country d wishes to encourage foreign investors to lend money to domestic companies or to invest in such companies’ stock, it should exempt from tax portfolio interest and dividends income derived by such foreign investor as well as capital gains on the sales of such instruments. 29 the united states has yet to adopt portfolio dividend exemption, and while this article does not suggest that the united states adopt portfolio dividend exemption, this article suggests that country d will apply equal treatment for income from interest and dividends. 30 with respect to capital gains from selling bonds and stock of local companies (other than inventory), most countries, including the united states, have viewed the source of such gains and losses as the seller’s residency. part ii of this article will suggest that country d adopts this principle, leaving the sole jurisdiction to tax capital gains to the residency country. 31 26. irc §§ 871(a)(2) and 881(a). 27. see table 1 below. see also avi-yonah (2000), supra note 3, at 1581 (“the united states’ enactment of the portfolio interest exemption has resulted in a classic ‘race to the bottom.’ one after another, all the major economies have abolished their withholding taxes on interest for fear of losing mobile capital flows to the united states.”). 28. avi-yonah (1996), supra note 7, at 1315; edwards & derugy, supra note 3, at 86. 29. edwards & de rugy, supra note 3, at 86 (“the term portfolio investments is used . . . to describe investments in stocks and debt and other securities of u.s. issuers (and derivatives relating thereto) by non-u.s. persons that do not directly, indirectly, or constructively own a substantial equity interest in the u.s. issuer, where such investments are not effectively connected with a u.s. trade or business of such non-u.s. persons.”). 30. see reich, supra note 11 (advocating an adoption of portfolio dividend exemption in the united states); peter r. merrill, et al., tax treaties in a global economy: the case for zero withholding on direct dividends, 90 tni 90-8 (“the recent proliferation of free trade areas bolsters the argument for zero withholding on direct dividends. the full benefits of an integrated regional market require elimination of barriers to capital flows – including withholding taxes – as well as trade flows.”). 31. see generally irc § 865(a). 8 florida tax review [vol. 9:1 chapter iii(c) discusses taxation rules for cross-border derivatives. 32 in general, derivatives are mainly used for either hedging 33 or speculation purposes. with respect to hedging, it is generally accepted that risk management is a crucial element in every business’s growth. 34 thus, country d would clearly want to encourage local businesses to manage their risk by entering into derivatives with foreign counter-parties (assuming that the local banks could not satisfy this need). 35 nevertheless, foreign counter-parties will hesitate to enter into hedging transactions with domestic businesses in country d if income from such transactions will be subject to tax in the source country. 36 this article will suggest, therefore, that country d establish that income from derivatives would be taxed by the residency country of the recipient of the income. 37 the united 32. for an excellent overview of the cross-border aspects of derivative transactions, see h. david rosenbloom, source-basis taxation of derivative financial instruments: some unanswered questions, 50 u. miami l. rev. 597 (1996). see also yoram keinan, united states federal taxation of derivatives: one way or many?, 61(1) tax lawyer 81, 143-6, 155-7 (fall 2007) (discussing the cross-border tax rules for derivatives in the united states). 33. id. at 597-98 (“a derivative financial instrument is a device used to shift risk from one party to another. on this fundamental point, derivatives resemble insurance, a concept familiar to anyone who has purchased a vehicle or home. in an insurance transaction one party pays a fee, or premium, to another. in return, the other party undertakes the risk of paying the first party up to a specified amount in the event of a specified occurrence (such as a theft or fire). if the occurrence comes to pass, the first party has a claim against the second, which gives value to the insurance contract. that value depends on, or derives from, the occurrence, which is typically beyond the influence or control of either party, and the extent of the resulting loss. if the occurrence does not come to pass, the contract expires without having any value to the first party. yet, such a transaction is sensible because, during the specified period, the insured was relieved of the risk of suffering loss as a result of the specified event by shifting the economic burden of that risk to the insurer.”). see also keinan (2007), supra note 32, at 87-8. 34. see colon, supra note 5, at 777 (“financial instruments permit firms to transfer financial price risks to other investors better able or more willing to bear such risks. financial instruments help firms to lower their financing costs and hedge more efficiently in both specific transactions, such as the purchase or sale of products in foreign currency, as well as in strategic cash flow hedging.”). 35. see generally tax aspects of derivative financial instruments, 49th ifa cong. res. (cannes 1995) [hereinafter “ifa report (1995)”]. see also thuronyi, supra note 10, at 264. 36. id. 37. see, e.g., treas. regs. § 1.863-7(b) (setting forth for a similar rule in the united states (that only applies to periodic payments on notional principal contracts). see also similar rules in canada and the united kingdom discussed below; rosenbloom, 2008] the case for residency-based taxation 9 states has adopted similar source rules for periodic income from notional principal contracts with the clear purpose of allowing domestic business more access to the foreign derivatives markets. 38 as for other derivative contracts (options, forwards and futures), there are no specific source rules in the u.s., but in general, the income from such contracts is taxed by the residency country. 39 the result is that income from all types of derivative contracts, which is not effectively connected to a domestic trade or business in the source country, is rarely taxed by the source country. 40 this will be my suggestion for country d as well. with regard to derivatives entered into for speculation purposes, these rules would be covered under the proposal for securities trading set forth below. this article also suggest that that tax treaties include similar provisions. as of today, only a few countries have source rules for income from derivatives, and tax treaties do not address the allocation of tax on such income. 41 my proposal would, therefore, be that treaties contain a specific provision to deal with income from derivative transactions. chapter iii(d) discusses taxation rules applicable to those non-residents who generally invest or trade (as opposed to deal) in securities, including derivatives, in country d. in general, participation of non-residents in the domestic securities markets will clearly increase the quantity and quality of trades in the domestic markets. such an enhancement in the capital markets’ activity would clearly benefit all investors in country d’s capital markets, domestic and nonresidents, since it will make the markets more liquid and efficient. having liquid and efficient capital markets has been viewed as an important element in developing countries’ economic growth. the united states has also recognized the benefit of foreign participants in the domestic stock markets and determined that investment and trading activity does not constitute a u.s. trade or business. 42 this article will suggest a similar approach; country d supra note 32, at 603 (stating that the “international consensus” is that the source country does not impose tax on income from derivatives earned by non-residents). 38. see reich, supra note 11 (“the rules for determining the source of income from notional principal contracts offer another example of the favorable tax treatment of foreign investors.”). 39. see reuven s. avi-yonah & linda z. swartz, u.s. international tax treatment of financial derivatives, 97 tax notes today 64-91 (1997) (discussing the source rules for derivatives in the united states and generally concluding that the united states rarely taxed income from derivatives earned by non-residents, unless such income is effectively connected to a u.s. trade or business). 40. the only notable exception is significant non-periodic payments that are treated as embedded loans and, therefore, are sourced according to the residency of the payor. see id. 41. see generally may, supra note 6; thuronyi, supra note 10. 42. see irc §§ 864(b)(2)(a) and (b). see also linda carlisle, derivatives 10 florida tax review [vol. 9:1 should establish that all income from trading in securities, including capital gains, interest, dividends, and income from derivatives, would be taxed by the residency country. part iv discusses the question of whether the above three suggestions would result in country d’s engagement in a “harmful tax competition,” using the principles set forth by the oecd in its 1998 landmark report on harmful tax competition. 43 i conclude in this article that if country d adopts my suggestions, it will not be treated as engaging in harmful tax competition. part v concludes that to sustain economic growth, country d should adopt residency-based taxation for financial transactions, which would allow it to attract foreign investors. in particular, the benefits for the developing country would be: (i) allowing domestic companies to raise capital by issuing bonds and stock to foreign investors, for lower finance costs; (ii) allowing domestic companies better access to the global derivatives markets, which will enhance their risk management activity; and (iii) allowing nonresidents better access to the domestic capital markets, which would enhance the efficiency and liquidity of the markets. ii. basic principles of international tax rules a. overview the fundamental distinction underlying the international tax regime of every tax jurisdiction is between residency-based (or global) regime and sourcebased (or territorial) regime. 44 every tax jurisdiction must, therefore, make a choice between one of these two regimes or a combination thereof. graetz and o’hear (1997) described the basic dilemma of international taxation that each country faces as follows: despite the seismic changes in the world economy that have occurred in the last seven decades, the fundamental dilemma of international taxation that confronted thomas sewall adams, his treasury colleagues, and the congress in the infancy of the trading now has a “safe harbor”, 16 j. tax’n inv. 178 (1999) (“since the revenue act of 1936, the u.s. tax laws have encouraged foreign investors to conduct securities and commodities trading activities in the u.s. by providing “safe harbors’ that exempt gains realized from such trading activities from u.s. tax.”). 43. see generally oecd report (1998), supra note 1. 44. see, generally, the league of nations report (1923), supra note 4, at 25 (establishing two bases for a country’s imposition of tax: where income is produced (the source jurisdiction) and where it is consumed or saved (the residence jurisdiction)). see also colon, supra note 5, at 780. 2008] the case for residency-based taxation 11 income tax remains essentially unchanged. when income is earned in one country by a citizen or resident of another country, both the country where income is earned (the source country) and the country where the investor or earner resides (the residence country) have legitimate claims to tax the income. the basic task of international tax rules is to resolve the competing claims of residence and source nations in order to avoid the double taxation that results when both fully exercise their taxing power. 45 the influential league of nations report (1923) established the “doctrine of economic allegiance” principle, pursuant to which there are four sources for justification of taxation: (1) production of wealth; (2) possession of wealth; (3) enforcement of rights over property; and (4) disposition of wealth. 46 the league of nations report (1923) gave equal treatment to all four, but as of today, most countries apply one of the following regimes: residency, source, or a combination thereof. 47 the league of nations report (1923) also discussed the issue of double taxation. 48 obviously, if all countries apply the same regime, or if all countries sign tax treaties with each other, then double taxation will never arise. nevertheless, since countries are free to choose any regime they want, and the treaty network is still incomplete, then double taxation frequently arises. the classic double taxation situation arises when a resident of country r, whose international tax regime is residency-based regime, derives income that is sourced in country d. 49 in this case, country d would most likely wish to tax such income as the source country, while country r would wish to tax the same income as the residency country. in the absence of a treaty or domestic relief, the taxpayer could be subject to double taxation on the same exact income. the league of nations report (1923) generally concluded that the source country should have the first priority to tax income derived therein. 50 45. michael j. graetz & michael m. o’hear, the “original intent” of u.s. international taxation, 46 duke l.j. 1021, 1033 (1997). 46. league of nations report (1923), supra note 4, at 25. 47. see avi-yonah (1996), supra note 7, at n. 10. 48. see league of nations report (1923), supra note 4, at 40-42. 49. other two potential double taxation situations are: (i) residence-residence: when two countries can claim residence as jurisdiction on the same individual or corporation; and (ii) source-source: when two countries each claim to be the source of the income. the latter could arise if income is derived from a process that takes place in more than one country. 50. league of nations report (1923), supra note 4, at 40 (“a survey of the whole field of recent taxation shows how completely governments are dominated by the 12 florida tax review [vol. 9:1 nevertheless, the league of nations report (1923) also suggested that income items should be classified according to whether the primary economic activity giving rise to the income takes place in the source country or in the residence country. 51 this division is generally referred to as between active and passive income (as discussed below). 52 b. source-based and residency-based taxation in a residency-based tax regime, residents are taxed on their worldwide income, while non-residents are taxed only on their income derived in the source country. 53 examples of countries utilizing this regime are the united states, japan, and the united kingdom. 54 in contrast, in the case of source-based taxation, residents are not taxed on foreign source income and non-residents are taxed on income derived in the source country. 55 examples of countries utilizing the source-based regime are germany, france and the netherlands. 56 nevertheless, most countries apply a combination of these two regimes. 57 in particular, global regimes very frequently allow for deferral or an exemption for active income that is earned through foreign subsidiaries; thus, certain types of foreign source income are not taxed by global regimes. 58 in addition, there are desire to tax the foreigner. . . . from this flows the consequence that, when double taxation is involved, governments would be prepared to give up residence rather than origin as establishing the prime right.”). 51. id. at 40-2. 52. id. see generally avi-yonah (1996), supra note 7. 53. daniel j. frisch, the economics of international tax policy: some old and new approaches, 47 tax notes, 581 (apr. 30, 1990); colon, supra note 5, at 780; rosenblom, supra note 32, at 605-06. 54. see rosenbloom, supra note 32, at 605-06. 55. edwards & de rugy, supra note 3, at 83. 56. id. at table 10-2. territorial regimes seek to tax all taxpayers including resident taxpayers only on domestic (e.g., french) source income. thus, all taxpayers, whether residing in france or abroad, only pay tax on french source income. id. see also frisch, supra note 53, at 584. 57. id. at 83. 58. for example, in the united states, a u.s. resident that earns foreign source active income directly is subject to u.s. tax. nevertheless, if the u.s. resident owns 100% of the shares of a foreign corporation (which under u.s. law is not a u.s. resident), fundamentally, even though the u.s. resident controls the shares of the foreign corporation, the corporation is treated as a separate legal entity from the shareholder. thus, income earned by the corporation is not subject to u.s. tax because it is foreignsource income of a non-resident. the shareholder, therefore, can shift the income to the corporation. if the corporation is incorporated in a “tax haven,” the result would be no current taxation of the foreign source income of the corporation. this would amount to 2008] the case for residency-based taxation 13 certain forms of foreign source passive income of residents that are taxed even by territorial regimes. source-based taxation generally has been justified on the grounds that the source country provides the taxpayer (resident or non-resident) with benefits that allow such taxpayer to generate the income. 59 source-based taxation is also consistent with the concept of capital import neutrality (cin). 60 residency-based taxation, on the other hand, has been generally justified on the grounds that it is consistent with the ability-to-pay principle (equity) and that it promotes efficiency in the form of capital export neutrality (cen). 61 it is generally accepted that cen is the better guide for cross-border investment (both direct and portfolio investment). 62 in general, the united states exercises income tax jurisdiction on both a source and a residency basis. 63 pursuant to irc section 61: “except as otherwise virtually complete exemption in present value terms if the deferral lasts long enough. u.s. tax will be imposed only on one of two events either: (i) when the foreign corporation actually pays the dividends to the u.s. resident then there is tax because this is income of the u.s. resident; or (ii) when, the u.s. resident can sell the shares, and that would be a capital gain subject to tax too, although at a reduced rate of tax under u.s. rules. those two events certainly would trigger the tax, but both events are also completely under the control of the u.s. resident. the u.s. internal revenue code contains a complex set of overlapping anti-deferral regimes, all of which result either in current taxation of the foreign source income to controlling u.s. shareholders or in an interest charge on the income when it is repatriated to the u.s. 59. michael j. graetz, the david r. tillinghast lecture: taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 54 tax l. rev. 261, 298 (2001) (“the idea that the source country has a fair claim to the income produced within its borders is also grounded in the view that foreigners, whose activities reach some minimum threshold, should contribute to the costs of services provided by the host government, including, for example, the costs of roads and other infrastructure, police and fire protection, the system for enforcement of laws, education, and the like. the services a nation provides may contribute substantially to the ability of both residents and foreigners to earn income there.”); colon, supra note 5, at 781 (“source basis taxation is explicitly tied to a benefit and burden rationale of taxation; the source country has provided either services or protection that have enabled the income to be earned and therefore has the primary right to tax such income.”). 60. see frisch, supra note 53, at 584-5. 61. see merrill et. al., supra note 30, at 1389 (“‘efficiency’ refers to the allocation of capital to its most productive uses, i.e., those that result in the highest pretax rate of return. in an international context, efficiency requires that the effective tax rate on investment abroad by a u.s. company be equal to the effective tax rate on domestic investment, a principle referred to as capital export neutrality (cen).”). 62. see avi-yonah (2000), supra note 3, at 1610. 63. may, supra note 6 (“source-based jurisdiction applies to the fixed or determinable periodic amounts realized from u.s. sources by nonresident foreign 14 florida tax review [vol. 9:1 provided in this subtitle, gross income means all income from whatever source derived. . . .” irc section 2(d), however, mandates that “[i]n the case of a nonresident alien individual, the taxes imposed by sections 1 and 55 shall apply only as provided by section 871 or 877.” 64 the united states internal revenue code, therefore, limits the tax liability of non-resident individuals (irc section 2(d)) and foreign corporations (irc section 11(d)), to u.s. source income by reference to irc sections 871 or 877 (individuals) and irc section 882 (corporations). 65 thus, while u.s. residents are taxed on their worldwide income, for non-resident aliens, the tax is limited to u.s. source income. 66 c. active v. passive income consistent with the “international tax regime,” in the vast majority of countries including the united states, passive income and active income are subject to different treatments. 67 this distinction is contained not only in domestic laws but also in all three treaty models. 68 in most cases, determining what types of income constitute “passive” income and what types of income constitute “active” income is easy; the test is whether the activity that gives rise persons. residence-based jurisdiction extends to u.s. citizens and residents, domestic corporations, and foreign persons doing business in the united states.”). for an excellent overview of the u.s. international tax regime, see jcx 40-99, joint committee on taxation, reports on international taxation (jun. 28, 1999), reprinted in 1999 tnt 124-8. 64. non-residents are generally taxed on all income that is effectively connected with the conduct of a trade or business in the united states. see irc § 864(c)(4). 65. a foreign person is engaged in a u.s. trade or business if her activities (or the activities of an agent acting on her behalf) are considerable, continuous, and regular. see pinchot v. comm’r, 113 f.2d 718, 719 (2d cir. 1940). foreign persons engaged in a u.s. trade or business are taxed at graduated rates on income effectively connected with such trade or business. see irc § 864(c); treas. regs. §§ 1.864-3 through 1.864-7. in computing effectively connected income, foreign persons are allowed to deduct allocable expenses. see irc §§ 873 and 882(c). 66. for the definition of “non-resident alien,” see irc § 7701(b)(1)(b) (defining who is a nonresident alien individual) and irc § 7701(a)(5) (defining what is a foreign corporation and partnership). 67. see reich, supra note 11 (“broadly speaking, income can be divided into two categories: active and passive. active income corresponds to earned income from the conduct of business activities, including receipts of a business enterprise and wages of an individual. passive income is investment income, such as interest, dividends, and gains from the sale of stocks and security that is not earned by the taxpayer in the ordinary course of business (for example, as a securities dealer or a bank)”). 68. avi-yonah (1996), supra note 7, at 1306-07. 2008] the case for residency-based taxation 15 to the income is such that a taxpayer controls it. 69 in the case of passive income, the taxpayer generally has little or no direct control over the production of income. 70 common examples of passive income include income from dividends, interest (including oid), rent and royalties. 71 in the case of active income, generally, the taxpayer has direct control over the production of income. examples of active income include income from services and business income. 72 the fundamental principle in most countries, as reflected not only in domestic laws but also in numerous tax treaties, is that active income is taxed primarily at the source, where the activity took place, while passive income is taxed at the residency country, where it reflects a return on capital. 73 this concept was introduced by the league of nations report (1923). 74 in general, the league of nations report (1923) established that the source country should have the first right to tax income derived thereon (the “first bite” principle). 75 the united states generally follows the active/passive distinction; passive income is subject to a gross-based withholding tax, and no deductions are allowed. 76 pursuant to irc sections 1441 and 1442, u.s. withholding tax applies to a payment if: (i) the payment constitutes a fixed or determinable, annual or periodical amount (fdap); (ii) the payment has a united states source; and (iii) the payment is not effectively connected to a united states trade or business. 77 if all three requirements are satisfied, a withholding tax of 30% applies, unless the rate is reduced by an applicable income tax treaty or domestic law relief. 78 congress and treasury, however, can exempt non-resident taxpayers from withholding tax by either (i) exempting a certain type of income from the 69. id. at 1309-10. 70. this is generally referred to as “portfolio” income. id. 71. id. see also reich, supra note 11. 72. id. 73. see avi-yonah (1996), supra note 7, at 1306; reich, supra note 11. 74. see avi-yonah (1996), supra note 7, at 1305-06, citing the league of nations report (1923), supra note 4, at 18. 75. in the absence of a treaty, it is the obligation of the residency country to alleviate double taxation by either (i) exemption of the foreign source income, or (ii) foreign tax credit. see league of nations report (1923), supra note 4, at 40. 76. see irc § 871(a), pursuant to which income of non-residents not connected with a u.s. trade or business, other than capital gains, is subject to a 30% gross tax. in contrast, under irc § 871(b), income of non-residents, which is connected with a u.s. trade or business, is subject to graduate rates of tax (i.e., net tax), similar to the rates that apply to residents. 77. treas. regs. § 1.1441-2(a). 78. irc § 871(a). 16 florida tax review [vol. 9:1 fdap definition, 79 or (ii) setting forth that a certain type of income is not u.s. source income. 80 further, congress and treasury may provide that certain activities will not give rise to a trade or business in the united states. 81 on the other hand, in the united states, and also consistent with the “international tax regime,” a non-resident’s active income (i.e., income effectively connected with a u.s. trade or business) is taxed as if it were income of a u.s. resident – that is, it is taxed at the graduated rates that apply to residents. 82 tax treaties generally follow the same approach; rather than giving the source country the first bite and allowing credit or exemption in the residency country, treaties simply provide for primary jurisdiction to tax active income to the source country, and primary jurisdiction to tax passive income to the residency country. 83 in particular, tax treaties reflect the active or passive distinction in two ways: (i) define what constitutes an active business operation in the source country (a “permanent establishment”) 84 and give the source country the primary 79. see treas. regs. § 1.1441-2(b)(2)(i) (exempting from the fdap income definition gains derived from the sale or property, including market discount and option premiums). see also irc § 871(h) (portfolio interest exemption) and irc §§ 871(i)(2)(a) and (b), pursuant to which there is no withholding tax on u.s. source interest paid by u.s. banks and on dividends paid by u.s. corporations with significant foreign business activities. 80. for example, pursuant to irc §§ 861(a)(1)(a) and (b), interest paid by a u.s. taxpayer with significant foreign business activities to a foreign person is foreign rather than u.s. source income, contrary to the general source rules pertaining to interest. 81. see the discussion below pertaining to the securities trading safe harbor under irc § 864(b)(2). 82. irc §§ 871(b) (individuals) and 882 (a) (corporations). 83. organization for economic co-operation and dev., model tax convention on income and capital, 1 tax treaties (cch) p 191 (sept. 1, 1992) [hereinafter “oecd model treaty”], articles 7, 10, 11 (providing that passive income is taxed by the residency country while active income may be taxed in the source country); united nations dep’t of int’l economic & social affairs, united nations model double taxation convention between developed and developing countries, u.n. doc. st/esa/102, u.n. sales no. e.80.xvi.3 (1980) [hereinafter “u.n. model treaty”], articles 7, 10, 11 (following in general the oecd model treaty, but advocating more source-based taxation of passive income); internal revenue service, u.s. treasury dep’t convention between the united states of america and for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital, 1 tax treaties (1996) [hereinafter “u.s. model treaty”], articles 7, 10 and 11 (applying the same principles). 84. oecd model treaty, articles 5 and 7; u.n. model treaty, articles 5 and 2008] the case for residency-based taxation 17 right to tax the income that is attributable to that operation; and (ii) seek to reduce as much as possible the taxes levied by the source country on passive income (such as income from dividends, interest, and royalties) derived from within it, leaving the right to tax that income to the residency country. 85 according to professor avi yonah (1996), however, the tax treaties do not completely achieve their goal of dividing the worldwide taxing jurisdiction between source and residence countries for the following two reasons. 86 first, the permanent establishment concept reflects a compromise; not all active business income is taxable primarily by the source country because the source country imposes tax on only income that is attributable to a permanent establishment. 87 second, the taxation of passive income at its source is not completely abolished, but is reduced in most treaties to the lowest possible levels (0%-15%). d. the rationale behind the active/passive distinction in general, the different treatment of active and passive income in domestic laws and tax treaties has been justified on several grounds. first, the taxation of active business income represents the taxation of the profits of the firm, while the taxation of passive income represents the taxation of the division of those profits. 88 second, the generation of active income is generally under the taxpayer’s control, while passive income is generally in the form of “portfolio” income. 89 for this purpose, “portfolio” income does not include income derived 7; u.s. model treaty, articles 5 and 7 (all defining the term “permanent establishment”). the u.n. model treaty attempts to lower the threshold of the permanent establishment standard, thereby allowing developing countries more sourcebased taxation. 85. see oecd model treaty, articles 10(2)(b) (dividends), 11(2) (interest) and 12(1) (royalties); u.n. model treaty, articles 10-12; u.s. model treaty, articles 10-12. 86. avi-yonah (1996), supra note 7, at 1307-08. 87. some treaties, especially the u.n. model treaty, contain a “force of attraction” rule, as discussed below. 88. michael graetz and itai grinberg, taxing international portfolio income, 56 tax l. rev. 537, 547 (2003) (“it may be simpler analytically, however, to regard income from [foreign direct income] as representing the profits from conducting business activities abroad the profits of the firm and income from [foreign portfolio income] as representing passive investment income the profits realized by investors in the firm.”). 89. avi-yonah (1996), supra note 7, at 1309. see also background and issues relating to the taxation of foreign investment in the united states (jcs 1-90) (“the portfolio investor generally does not have control over the assets that underlie the financial claims.”). 18 florida tax review [vol. 9:1 by controlling shareholders, since in such a case, even passive income (e.g., dividends) would be under the control of the recipient. 90 finally, another justification for the distinction between active and passive income relates to who earns the income; while active income is earned basically by large, publiclytraded corporations, passive income is earned by individuals or small entities. 91 e. residency-based taxation while this article suggests residency-based taxation only for financial transactions, some of the arguments for more general residency-based taxation principles may also support this article’s conclusions. 92 many commentators over the years have advocated the adoption of pure residency-based taxation. 93 as set forth above, one of the major arguments in support for a residency-based regime is that it promotes equity since the ability-to-pay principle is violated in a sourcebased taxation regime. 94 furthermore, it is generally accepted that a pure residency-based regime is more efficient because it is compatible with the goal of capital export neutrality (cen), which requires that the decision to invest in a given location not be affected by tax rates. 95 thus, as a commentator observed, elimination of withholding taxes by the source country promotes optimal allocation of capital investment across countries: 90. id. 91. graetz & grinberg (2003), supra note 88, at 547 (“foreign portfolio income often is earned today by both individuals and corporations, while fdi virtually always is made by corporations.”). 92. see generally, graetz & o’hear (1997), supra note 45, at 1033-41 (describing the history of the united states’ international tax policy and the support for the residency-based regime). 93. robert a. green, the future of source-based taxation of the income of multinational enterprises, 79 cornell l. rev. 18, 29 (1993). 94. id. 95. graetz (2001), supra note 59, at 270 (“achieving [worldwide] efficiency typically is said to involve two kinds of neutralities. the first is capital export neutrality (cen), which is neutral about a resident’s choice between domestic and foreign investments providing the same pretax rates of return. cen requires that a resident of any nation pays the same marginal rate of income taxation regardless of the nation in which she invests. cen is not only neutral about where such investments are made but also is indifferent about which country collects the tax revenue when capital originating in one country produces income in another. typically, economists regard cen as essential for worldwide economic efficiency, because the location of investments would be unaffected by capital income taxes.”). 2008] the case for residency-based taxation 19 assuming that withholding taxes at source under bilateral agreements generally are modest (or nil) and creditable against the tax liability in the residence country, the taxes at home will determine the overall tax level on the saver, independent of the source of the income. in this situation, interest arbitrage will tend to equalize pretax rates of return internationally. as the gross return to capital in equilibrium is equal to the marginal product of capital, it follows that a universal use of the residence principle will result in equalized marginal products of capital across countries, and thus entail an optimal international allocation of investment, maximizing future world output. 96 residency-based taxation is also simpler because countries do not need to establish source rules; residents are taxed on their worldwide income regardless of where the source is. finally, if each country taxes only its own residents and all countries agree on the definition of a “resident,” there should be no dual residency problems. f. determining the source of income unless all countries move to a pure system of residency-based taxation, source rules would be required to determine which country has the first jurisdiction to tax an item of income. 97 in the vast majority of countries, however, most types of income and deductions do not have a defined source, and the source of income and deductions is therefore determined on a case-by-case basis. with respect to complicated items of income or deductions, defining the source is very difficult, because it is hard to pinpoint the correct economic source of the income or deduction. 98 96. john norregaard, tax treatment of government bonds, 15 tax notes int’l 143, citing razin, assaf, efraim sadka, and chi-wa yuen, 1996, a pecking order theory of capital inflows and international tax principles, imf working paper 96/26 (washington: international monetary fund), tax notes int’l, 47 (jan. 1, 1996). 97. see may (1995), supra note 6 (“source rules play a critical role in defining the scope of u.s. tax jurisdiction. they identify the u.s.-source income over which the united states asserts primary jurisdiction. they also determine the extent to which, through the foreign tax credit system, the united states will curtail its residence-based claims and effectively yield tax jurisdiction to a source country.”). 98. see jcx 40-99, supra note 63 (“the source of income for u.s. tax purposes is determined based on various factors. the relevant factors include the location or nationality of the payor, the location or nationality of the recipient, the location of the recipient’s activities that generate the income, and the location of the assets that generate the income.”). 20 florida tax review [vol. 9:1 in many countries including the u.s., source rules can be divided into two categories: (i) formal rules, and (ii) economic rules. formal rules do not attempt to trace the economic source of the income but seek to achieve administrative ease and certainty. economic rules, on the other hand, do attempt to trace the economic source of the income, but rather result in more litigation and uncertainty. the main difference between the formal and economic rules is that the formal rules are relatively easy to administer from both the taxpayers’ and the tax authorities’ perspectives, because they are bright line rules and simply require one single determination such as residency of the payor, residency of the seller or passage of title, to establish the source. the economic rules, on the other hand, involve more difficult determination such as, for example, where a patent or copyright was actually used, which is sometimes not easy to determine, especially if it is used in many countries. economic source rules are therefore harder to avoid by the taxpayer because as opposed to formal rules, they are not significantly under the taxpayer’s control. g. the role of tax treaties in allocating income bbetween the source and residency country according to professor hugh ault, “from the beginning, treaties have involved the allocation of taxing claims and the international division of revenue.” 99 as set forth above, in the absence of a treaty between the source country and residency country, the source country has the right to tax all income (passive and active) derived therein. 100 to serve its most important role of preventing double taxation, tax treaties generally shift tax revenue from the source country to the residency country. 101 this division was also established by the league of nations in 1928, in its first model treaty, as described in more detail below. 102 generally, in all existing treaties, passive income is mostly taxed by the residency country (rates at source are between 0%-15%), while active income is taxed by the source country. 103 99. see ault (1992), supra note 4, at 567. 100. see generally league of nations report (1923), supra note 4. 101. see colon, supra note 5, at 786 (“treaty signatories usually agree to eliminate or substantially reduce source basis taxation on income earned by residents of the other country, for instance, dividends, rents, royalties, and interest.”). 102. see report presented by the general meeting of government experts on double taxation and tax evasion, league of nations, doc. c.562.m.178. 1928 ii (oct. 31, 1928) (hereinafter “league of nations report (1928)”). 103. id. see also jcx 40-99, supra note 63. 2008] the case for residency-based taxation 21 source-based taxation of active income is limited, however, under all three treaty models to income that is “attributable” to a “permanent establishment” at the source country. 104 in both the united states and oecd models, there is no “force of attraction” rule; therefore, only income that is attributable to a permanent establishment is taxed by the source country, while income that is not attributable to such permanent establishment is subject to the rates set forth in the treaty for other types of income. 105 as a result, whether the source country can tax a certain item of income would depend on how high the permanent establishment threshold is set. in general, the permanent establishment threshold for physical presence is higher than the u.s. trade and business requirement; thus, a treaty allows non-u.s. residents to conduct more business in the u.s. without being subject to tax in the u.s. in 1928, the league of nations issued a model for bilateral income tax treaty for the reciprocal relief of double taxation of international income, which still serves as the basis for the following model income tax treaties: (i) u.n. model treaty; (ii) oecd model treaty; and (iii) u.s. model treaty (for treaties to which the united states is a party). 106 obviously, the u.n. model treaty is the most favorable to source countries, because it is designed for developing countries; the u.n. model treaty normally allows more source-based taxation 104. see jcx 40-99, supra note 63 (“under the u.s. model, one treaty country may not tax the business profits of an enterprise of a qualified resident of the other treaty country, unless the enterprise carries on business in the first country through a permanent establishment situated there. in that case, the business profits of the enterprise may be taxed in the first country on profits that are attributable to that permanent establishment.”). 105. id. (“the u.n. model adds a limited ‘force of attraction rule’ which would allow the country in which the permanent establishment is located to attribute to the permanent establishment sales in that country of goods or merchandise of the same or similar kind as those sold through the permanent establishment, and to attribute to the permanent establishment other business activities carried on in that country of the same or similar kind as those effected through the permanent establishment.”). 106. graetz & o’hear (1997), supra note 45, at 1023. see also jcx 40-99, supra note 63 (“the preferred tax treaty policies of the united states have been expressed from time to time in model treaties and agreements. the organization for economic cooperation and development (the ‘oecd’) also has published model tax treaties. in addition, the united nations has published a model treaty for use between developed and developing countries. the treasury department, which together with the state department is responsible for negotiating tax treaties, last published a proposed model income tax treaty in september 1996 (the ‘u.s. model’). the oecd last published a model income tax treaty in 1992 (‘the oecd model’). the united nations last published a model income tax treaty in 1980 (‘the u.n. model’).”). 22 florida tax review [vol. 9:1 than the u.s./oecd models. 107 the u.s. model treaty, on the other hand, is the least favorable to source countries, because it is designed for the u.s., a capital exporter. the motivation of a developing country to enter into a treaty with a developed country is obvious because a tax treaty creates stability. specifically, many developing countries do not have stable regimes, and the existence of a tax treaty protects foreign investors from sudden increases in the tax rates. stability is often more important for u.s. investors than the actual tax rates. further, a tax treaty would provide foreign investors with information about current taxes. finally, a tax treaty would bring the developing country closer to the community of developed countries. iii. taxation of cross-border financial transactions a. general income and deduction items from financial transactions generally include: (1) interest and dividend income/deduction on debt and equity instruments (ordinary income); (2) ordinary income/deductions from other types of financial instruments (e.g., notional principal contracts); and (3) capital gains/losses. for each of the above items, there are three different tax related issues: (1) the character of the income (ordinary v. capital), (2) the time when the income or deduction is recognized, and (3) whether the income has domestic or foreign source (and whether it is taxed by the source country or not). 108 this article focuses only on the third issue. as of today, only a few countries have enacted a comprehensive set of rules pertaining to taxation of financial instruments. 109 as victor thuronyi indicates, however, not all countries need a comprehensive set of tax rules for financial instruments: “countries that (i) do not have reduced rates (or exemption) for capital gains, (ii) base their corporate income tax on the financial accounting rules, and (iii) have kept their corporate income tax rules simple therefore may not need extensive special rules for [financial instruments] in their domestic legislation.” 110 nevertheless, the increasing use of financial instruments in many countries, developed and developing, requires a new assessment of the 107. for example, the u.n. model treaty increases the scope of permanent establishment to include more activities, such as reducing the length of construction work that is viewed as a permanent establishment from twelve to six months. 108. see thuronyi, supra note 10, at 261. 109. id. these countries include the united states, united kingdom, canada, australia, and new zealand. 110. id. at 264. 2008] the case for residency-based taxation 23 need to at least establish basic principles for cross-border transactions. 111 in recent years, several countries have been updating their income tax systems to address the taxation of financial transactions. 112 a fundamental distinction in the context of cross-border investment is between direct and portfolio investment. 113 as opposed to taxation of cross border direct investment, the tax literature on taxation of portfolio investment is relatively thin. 114 nevertheless, cross -border portfolio investment has been booming in recent years, and it can no longer be ignored. 115 according to reich, “portfolio investment” generally means “investments in stocks and debt and other securities of u.s. issuers (and derivatives relating thereto) by non-u.s. persons that do not directly, indirectly, or constructively own a substantial equity interest in the u.s. issuer, where such investments are not effectively connected with a u.s. trade or business of such non-u.s. persons. . . the dividing line between portfolio investments and relatedparty investments varies, and may for example be 5%, 10%, or 50%, depending on the particular statutory or regulatory provision.” 116 direct investment is generally defined as any type of investment other than “portfolio investment.” many countries, developed and developing, face a serious conflict between imposing higher rates on passive income sourced therein to generate revenue and providing tax relief to attract foreign investors. 117 in the case of financial transactions, the conflict becomes even harder, since money is fungible, and foreign investors can easily switch their investments from one country to another in response to tax burden. 118 in 1991, the oecd praised the benefits of globalization: capital markets in oecd countries are increasingly integrated as member countries have removed controls on international 111. see e.g., the united kingdom finance act of 2002. 112. id. see also recent tax reforms in mexico. 113. graetz & greenberg (2003), supra note 88, at 538. 114. id. 115. id. 116. see reich (1998), supra note 11. see also jcx 40-99, supra note 63. 117. see leif muten, international experience of how taxes influence the movement of private capital, 8 tax notes int’l 743, 744 (1994). 118. graetz and greenberg (2003), supra note 88, at 549 (“in contrast [to direct investment], portfolio investment dollars are volatile and move rapidly throughout the world seeking the highest return possible for a given level of risk. [footnote omitted] in portfolios managed by investment professionals, investments in one foreign country are frequently interchangeable with investments in countries with similar risk/return profiles. [footnote omitted] one consequence is that portfolio investment dollars abroad may substitute for investments at home.”). 24 florida tax review [vol. 9:1 investment and foreign exchange regulations. at the same time, the proportion of international activities accounted for by large multinational enterprises (mnes) has increased. one consequence of this gradual liberalization and globalization is that international capital flows may have become more sensitive to differences in the tax regimes between countries. 119 nevertheless, seven years later, the oecd report (1998) on harmful tax competition alerted that “the process of globalization has led to increased competition among businesses in the global market place.” 120 thus, the conflict that many countries face today is between reducing the tax burden of financial transactions to attract foreign investors and not being criticized at engaging in harmful tax competition. 121 this article suggests that country d generally follow the footsteps of the united states in taxation of certain cross-border financial transactions. this way, it can successfully attract foreign investment, but will not be viewed as engaging in harmful tax competition. b. taxation of interest, dividends and capital gains 1. taxation of cross-border interest and dividends in the united states as well as many other countries, the source of income from dividend and interest is the residency of the payor. 122 the rationale behind this formal rule is that it is administratively hard to tax interest from a foreign corporation to foreign holders, but easier to tax interest and dividend from a u.s. payor (using withholding). in contrast, as described in greater detail below, the source of income from periodic payments on a notional principal contract is the recipient’s residency. 123 other countries, such as mexico for example, attempt to trace the economic source of interest income. 124 119. john norregaard & jeffrey owens, taxing profits in a global economy, 4 tax notes int’l 491 (summarizing ‘taxing profits in a global economy: domestic and international issues’ (oecd 1992)). 120. oecd report (1998), supra note 1, at ¶ 22. 121. see generally avi-yonah (2000), supra note 3. 122. irc §§ 861(a)(1) (interest) and 861(a)(2) (dividends). see also jcx 4099, supra note 63. 123. treas. regs. § 1.863-7. 124. see juan guerrero, mexico publishes new rules on public debt instruments, 38 tax notes int’l 472 (apr. 28, 2005) (“article 195 of the income tax law establishes that for interest income, the source is considered to be located in mexico if capital is placed or invested in mexico, or if the interest is paid by a resident of mexico or by a nonresident with a pe in mexico. for that reason, if a mexican 2008] the case for residency-based taxation 25 tax rates applicable to interest and dividend differ among countries; in some countries, such income is taxed on the basis of the taxpayer’s marginal rate while in others the ordinary rates applicable to interest and/or dividend are fixed. 125 several countries, including the united states, have also adopted a regime pursuant to which the rate of tax applicable to capital gains is lower then the maximum ordinary rates. 126 in the u.s., there are two possible tax regimes that could apply to nonu.s. residents deriving interest and dividends income in the u.s.: (i) non-u.s. persons that are engaged in a “trade or business” in the united states are subject to u.s. tax at the usual rates for individuals or corporations, as the case may be, on income that is “effectively connected” with such u.s. trade or business, 127 and (ii) non-u.s. persons that are not so engaged, or that derive interest or dividend income that is not effectively connected to a u.s. trade or business, are subject to withholding tax of 30%, unless reduced by a treaty or applicable domestic rule. 128 2. taxation of interest congress has generally exempted interest income (but not dividend income) derived in the united states by non-residents in two ways: (i) treating the income as non-u.s source income, or (ii) exempting such income from u.s. tax even if it is treated as u.s. source income. 129 examples of the former group resident pays interest to a nonresident, it will be considered mexican-source income, and the nonresident will be required to pay income tax in mexico on the interest payment.”). cf. israel, where in 2003, newly added section 4a to the income tax ordinance adopted source rules that are similar in many aspects to those in u.s. tax laws as well as under most treaties. in particular, the current law provides that the source of interest income is the place of residency of the debtor. see yoram keinan, and shlomo katalan, israel’s income tax reform: roads not taken, 28 tax notes int’l 941 (sept. 24, 2002). 125. see edwards & de rugy, supra note 3, at 79 (“tax competition has spurred other tax reforms. a group of nordic countries has installed dual income tax systems that feature a low flat rate on capital income (interest, dividends, and capital gains) but retain progressive rates on labor income. denmark, finland, norway, and sweden implemented such reforms a decade ago. the netherlands and austria have recently enacted similar reforms, and other european countries have moved in that direction.”). 126. see generally yoram keinan and shay menuchin, taxation of financial instruments in israel, 31 tax notes international 897 (sept. 8, 2003). 127. irc § 864(c). as discussed above, in the case of a treaty, the standard would be income that is “attributable” to a “permanent establishment” in the united states. 128. irc § 871(a)(1)(a) (individuals); irc § 881(b)(1)(a) (corporations). 129. see colon, supra note 5, at 783, note 25. 26 florida tax review [vol. 9:1 are irc §§ 861(a)(1)(a) and (b), pursuant to which interest paid by a u.s. taxpayer with significant foreign business activities to a foreign person is foreign rather than u.s. source income, contrary to the general source rules pertaining to interest. 130 the most notable example of the latter group is the “portfolio interest exemption,” which is the most significant exemption from gross tax on fdap income in the united states. 131 since 1984, interest paid to a nonresident who does not control 10% or more of the payor is generally exempt from u.s. tax, subject to limitations. 132 congress specifically indicated that the portfolio interest exemption was enacted “to allow u.s. corporations (and the u.s. treasury) direct access to the eurobond market.” 133 as two commentators indicate “the portfolio-interest exception is perhaps the purest example of enlightened selfinterest and realism in attracting foreign capital.” 134 in general, under the portfolio interest exemption, interest earned by non-residents is exempt from withholding tax unless it is paid to: (i) a “10% shareholder” or other related person; 135 (ii) a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business; 136 or (iii) a controlled foreign corporation from a related person. 137 with respect to tax treaties, the united states clearly follows the same principle – pursuant to the u.s. model treaty, the rate of withholding for interest 130. id. another example discussed below is the source rules for income on a notional principal contract pursuant to treas. regs. § 1.863-7(b) (residency of recipient). see also jcx 40-99, supra note 63. 131. id. 132. pub. l. no. 98-369, 98 stat. 494. thus, interest on a loan from a foreign parent to a u.s. subsidiary is not exempt if the parent owns 10% or more of the u.s. subsidiary’s stock. see avi-yonah (2000), supra note 3, at 1579-80. 133. j. comm. on tax’n, 98th cong., 2nd sess., general explanation of the revenue provisions of the deficit reduction act of 1984, at 392 (the stated purpose of the exemption was “to allow u.s. corporations (and the u.s. treasury) direct access to the eurobond market.”). see also the 1984 joint committee on taxation (jct) report accompanying the legislation (tax treatment of interest paid to foreign investors (jcs23-84, apr. 28, 1984) (“if the primary effect of repeal is to cause foreign investors to shift from short to medium term u.s. securities . . . , then medium term interest rates would decline. . . . [t]his would benefit the us economy by stimulating investment in plant and equipment. . . . proponents of repeal of the . . . withholding tax argue that the attractiveness of u.s. bonds in the international bond market is greatly diminished by the withholding tax, so that the tax is a barrier to international trade in assets.”). 134. dan r. mastromarco & lawrence a. hunter, the u.s. anti-savings directive, 2002 tnt 247-28. 135. irc § 871(h)(3). 136. irc § 881(c)(3)(a). 137. irc § 881(c)(3)(c). 2008] the case for residency-based taxation 27 under article 11 is zero. 138 the oecd model treaty permits up to 10% of withholding rate for interest, 139 and as illustrated in table 2 below, it is very rare for interest income to be taxable at more than 10% by the source country. finally, the u.n. model treaty suggests higher rates for passive income in general, and for interest in particular (which leaves more tax revenues in the source country), but allows different rates on a case-by-case basis. 140 3. taxation of dividends and total return swaps as set forth above, the source of dividend income is generally the residency of the payor in many countries including the united states. 141 to date, there is no portfolio dividend exemption in the united states; 142 u.s. withholding tax on inbound transactions by foreign investors may be avoided by using various types of derivatives, because, as discussed in greater detail below, the source of certain types of income from certain derivatives is generally the residency of the recipient. 145 in particular, withholding on dividends has been avoided by using total return equity swaps; instead of buying the shares directly, the foreign investor enters into a swap with a u.s. bank and pays the value of the shares to the bank. 146 in return, the bank pays the foreign investor an amount equal to the dividend paid by the u.s. corporation (“the dividend equivalent amount”). as of today, there is no u.s. withholding tax on the payment of the 138. see jcx 40-99, supra note 63. this rate is however, negotiable, (e.g., with mexico the rate for interest is 4.9%; with japan the rate for royalty is 10%). 139. id. 140. id. 141. irc § 861(a)(2)(a). 142. see reich, supra note 11; merrill et. al., supra note 30, at 1389 (“the recent proliferation of free trade areas bolsters the argument for zero withholding on direct dividends. the full benefits of an integrated regional market require elimination of barriers to capital flows – including withholding taxes – as well as trade flows.”). 145. see generally thuronyi, supra note 10 (describing various abusive situations); reich, supra note 11, citing the preamble to prop. treas. regs. § 1.864(b)-1, issued june 11, 1998; preamble to regulations issued under irc § 446(b), t.d. 849, 58 fed. reg. 53125 (oct. 14, 1993) (“[t]he irs is considering whether notional principal contracts involving certain specified indices (e.g., one issuer’s stock) should be excluded from the general sourcing rules of §§ 861 through 865. . . .”); preamble to proposed regulations regarding certain payments made pursuant to a securities lending transaction, 1992-1 c.b. 1196 (“the service is considering whether the proposed regulations should apply to dividend equivalent payments made in connection with certain notional principal contracts, such as an equity index swap structured to replicate the cash flows that would arise from an installment purchase of one or more equity securities.”). 146. id. 28 florida tax review [vol. 9:1 dividend equivalent amount from the u.s. bank to the foreign investor because, as discussed in greater detail below, the source rule for periodic payments on a notional principal contract is the residency of the recipient. on the other hand, while the dividends paid to the u.s. bank are taxable to the bank, the bank may deduct the payment of the dividend equivalent amount as business expenses, and thus the net income to the bank is zero. at the end of the contract, the bank will return the initial investment, adjusted for changes in the price of the shares of the u.s. corporation. 147 as a result, even though there is no formal exemption for dividends paid by u.s. corporations to foreign investors, such payments are rarely taxed in the u.s. in my view, there is no reason to distinguish between portfolio interest and dividend – both should be exempt if the above conditions for portfolio holding are met. 148 according to reich (1998), there are two main reasons for enacting portfolio dividend exemption in the united states: a portfolio dividends exemption would align the u.s. tax treatment of dividend income of portfolio investors with the exemption that applies to all other portfolio investment income from stocks, securities, and related derivatives, thereby further fostering the open capital markets that are a featured and hallowed goal of u.s. international economic policy. . . . a portfolio dividends exemption also would resolve the problem of how to deal with the disparity in treatment between dividends and returns on derivatives-based investments in u.s. stocks. 149 the same arguments could be made in the case of developing countries. thus, my suggestion to country d would be to have the same exemption for interest and dividends earned by non-residents, as long as it satisfies the portfolio investment standard. similarly, tax treaties should not have different rates for interest and dividend income. 150 147. id. 148. see reich, supra note 11 (elaborating that “the withholding tax on dividends paid to foreign investors may serve as a significant barrier to certain types of investments by foreign investors in u.s. equities.”). 149. id. 150. see generally, merrill et. al., supra note 30, at 1389. 2008] the case for residency-based taxation 29 4. capital gains in the united states, as well as many other countries, the source of capital gains (other than gain from sale of inventory) is the residency of the seller (i.e., formal rule). 151 the source of capital gain on sale of real estate is the place of the real estate (economic rule). 152 thus, capital gain on the sale of shares in a u.s. corporation by a foreign shareholder or sales of other securities (including derivatives) is generally not u.s. source income. 153 nevertheless, this rule creates a potential unwarranted inconsistency between capital gains on sale of stock and dividends payable on the same stock, because the amount of gain from a sale of stock should essentially equal the corporation’s current accumulated earnings plus the present value of its future earningsboth represent earnings that if distributed, would give rise to dividend income sourced according to the residency of the payor. thus, if a u.s. corporation distributes a dividend to its foreign shareholder, the income is u.s. source income. nevertheless, if the corporation never distributes dividends and the shareholder sells the shares for a gain, it is foreign source income even though the gain represents the same value that would have been received as dividends. thus, in my view, foreign holders should be taxed similarly whether the domestic corporation pays dividends or not, and this could be achieved, again, by exempting dividends from the source country’s tax. 5. the “race to the bottom” the result of the united states’ enactment of the portfolio interest exemption in 1984 has been a classic “race to the bottom” because many other countries have followed the united states and abolished their withholding tax on interest for fear of losing mobile capital flows to the united states. 154 151. irc § 865(a). in the case of sales of inventory, there is a split between formal and economic rules. for purchased inventory, the source of income is the place of passage of title. for income from produced inventory, 50% of the income is sourced in accordance with the place of production and 50% in accordance with the place of sale. for intangibles, the source of income is the place of passage of title. 152. irc §§ 861(a)(5) and 862(a)(5). 153. see reich, supra note 11 (“non-eci capital gains recognized by foreign investors from the sale of u.s. portfolio securities (including gains on options, futures, and forward contracts) are generally exempt from u.s. income and withholding tax.”). 154. avi-yonah (2000), supra note 3, at 1581. see also edwards & de rugy, supra note 3, at 72, citing sven-olaf lodin, “international tax issues in a rapidly changing world,” international bureau of fiscal documentation bulletin, jan. 2001, at 6. the authors indicate that “one survey of 19 major economies found that the withholding tax on bank interest has been more than cut in half in the past decade.” 30 florida tax review [vol. 9:1 as further elaborated by graetz and greenberg (2003): most corporate tax rates in oecd countries today are in the range from 25% to 35%. by imposing these corporate income taxes, source countries exercise their right to tax international business income. on the other hand, source countries today rarely exercise any right to tax interest income earned by foreign portfolio lenders and, where bilateral treaties are in force, tend to tax portfolio dividend income at a zero to 15% withholding rate. 155 table 1 shows how major developed countries tax income from interest and dividends derived by non-residents. 156 table 1 country interest (w/h) dividends (w/h) belgium 15% 157 25% 0%15% – 25% denmark 0% 158 30% 0% 159 28% france 16% 25% country interest (w/h) dividends (w/h) germany 0% 160 35% 0% greece 10% 29% 161 0% ireland 20% 0% 20% 162 citing from harry huizinga and gaetan nicodeme, “are international deposits taxdriven?” european commission economic paper no. 152, july 2001, at 31-2. 155. graetz & greenberg (2003), supra note 88, at 548-9. see also john norregaard, tax treatment of government bonds, 15 tax notes int’l 143 (“the increase in international mobility of capital has led to significant downward pressures on these withholding rates, and has led a number of countries to abolish them since the mid1980s.”). 156. these numbers are taken from ernst & young’s corporate tax guide (2006). 157. belgian sourced interest is subject to a 15% withholding tax if the underlying agreement was concluded on or after 1 march 1990. 158. when certain conditions are met. 159. dividends are exempt from withholding tax if certain conditions are met. 160. thirty-five percent withholding on overthe-counter transactions. 161. this withholding tax applies to interest paid to foreign entities that do not have a permanent establishment in greece. 162. there is an exemption for non-residents if certain conditions are met. 2008] the case for residency-based taxation 31 country interest (w/h) dividends (w/h) italy 0% 163 12.5% 27% 0% 12.5% 164 27% 165 luxembourg 0% 20% netherlands 0% 25% portugal 15% 20% 15% 166 25% 167 spain 15% 15% united kingdom 20% 0% united states 0% 168 30% 30% japan 15% 20% 20% australia 10% 0% 30% new zealand 15% 169 19.5% 170 30% 171 33% 172 canada 25% 25% russia 15%-20% 9% 15% 173 brazil 15% 0% mexico 10% 29% 0% argentina 15.05% 35% 0% singapore 15% 0% hong kong 0% 0% philippines 20% 35% 0% 15% 35% norway 0% 25% sweden 0% 30% switzerland 35% 35% these low rates of tax on interest and dividend income by source countries are consistent with the vast majority of tax treaties. 174 as set forth above, all three tax treaty models advocate lower rates for passive income and in many cases, the rate on interest income is reduced to zero. 175 in general, most 163. interest derived by nonresidents on deposit accounts. 164. dividends paid to resident individuals with non-substantial participation. 165. dividends paid to non-residents. 166. paid to residents. 167. paid to non-residents. 168. portfolio interest is exempt. 169. withholding tax for non-residents. 170. withholding tax for residents (individuals). 171. withholding tax for non-residents. 172. withholding tax for residents. 173. the 15% rate applies if either the payor or the recipient of the dividend is a foreign legal entity 174. interest is defined under article 11 of both the oecd model treaty and the u.s. model treaty as “income from debt-claims of every kind.” 175. id. (“interest arising in a contracting state and paid to a resident of the 32 florida tax review [vol. 9:1 treaties reduce the rates on income from interest and dividends to no more than 15% at the source country, and therefore, allow the residency country to collect most of the tax on such income. 176 furthermore, most treaties provide that capital gains tax on sales of securities is collected by the residency country. 177 thus, when countries adopt portfolio interest exemption provisions similar to the u.s., they simply conform their internal tax laws to what a treaty would normally mandate for such income. table 2 shows how the above countries tax income from interest and dividends derived by non-residents under their tax treaties. 178 table 2 country interest (w/h) dividends (w/h) belgium 5% 25% 10% 20% denmark 0% 0% 25% france 0% 20% 0% 25% germany 0% 25% 0% 20% greece 0% 40% ireland 0% 15% 0% italy 0% 27% 0% 27% luxembourg 0% 0% 20% netherlands 0% 0% 20% portugal 10% 15% 10% 15% spain 0% 15% 0% 15% united kingdom 0% 25% united states 0% 30% 0% 30% japan 0% 20% 0% 20% australia 10%-12% 15% 25% new zealand 10% 15% 15% canada 0% 25% 0% 25% russia 0% 15% 5% 15% brazil 12.5% 15% 0% mexico 4.9% 15% 0% 15% other contracting state may be taxed in that other state. . . . however, such interest may also be taxed in the contracting state in which it arises and according to the laws of that state. . . .”). 176. id. see oecd model treaty (suggesting rates of 5% to 15% on dividends, 10% on interest, and 0% on royalties; u.s. model treaty (suggesting rates of 5% to 15% on dividends, and 0% on interest and royalties). 177. id. see article 13 of all treaty models. 178. these numbers are taken from ernst & young’s corporate tax guide (2006). 2008] the case for residency-based taxation 33 argentina 0% 20% 10% 15% singapore 0% 15% country interest (w/h) dividends (w/h) hong kong philippines 10% 15% 15% 25% norway 0% 25% sweden 0% 25% switzerland 0% 15% 0% 15% as set forth above, the enactment of the portfolio interest exemption clearly achieved its goal in the united states. 179 developing countries have even more incentive to follow these rules. 180 as two commentators indicate: high tax rates are more difficult to sustain in the new economic environment. that is particularly true for taxes on capital, which include taxes on business profits and taxes on individual receipts of dividends, interest, and capital gains. basic economic theory suggests that high taxes on capital create an increasing drag on growth as capital mobility increases. high taxation of capital causes capital flight, thus reducing domestic productivity, wages, and incomes. 181 when the source country attempts to impose tax on interest and dividends derived by foreign investors in domestic bonds and stock, the after-tax return for the foreign investors will be reduced by virtue of the withholding tax, 179. dan r. mastromarco and lawrence a. hunter, the u.s. anti-savings directive, 2002 tnt 247-28 (“for nearly two decades, u.s. law has encouraged foreigners to invest in u.s. banks and debt securities by imposing no tax on interest earned on foreign deposits, except in very narrow circumstances. the policy is estimated to have attracted approximately $1 trillion to the united states. reversing this policy risks driving hundreds of billions of dollars out of the united states.”). 180. see avi-yonah (2000), supra note 3, at 1582 (“the standard economic advice to small, open economies is to avoid taxing capital income at its source, because the tax will be shifted forward to the borrowers and result in higher domestic interest rates.”). 181. see edwards and de rugy, supra note 3. the authors quote from the 1991 oecd report: “a domestic corporate tax increase will therefore tend to cause an outflow of corporate capital, and in the long run, the resulting shortage of capital in the domestic economy will drive up the pre-tax rate of return to wage earners, because the lower capital intensity of domestic production will reduce labour productivity and real wage rates. part of the burden may also fall on owners of immobile factors of production such as falling land rents and land prices.” organization for economic cooperation and development, taxing profits in a global economy (paris: oecd, 1991), at 34. 34 florida tax review [vol. 9:1 and this will create a disincentive to invest in the source country. 182 this is particularly true for small open economies such as country d, which generally accept world interest rates as a given. 183 heavy tax burden will be an unwarranted result for developing countries that strive for foreign investment. furthermore, as set forth above, residencybased taxation promotes cen, and with respect to passive income, it is even clearer. 184 taxation of portfolio investment by residency countries has been viewed by many commentators as the most efficient regime: from the point of view of worldwide efficiency, there would seem to be no reason for tax rules to distort the decisions of portfolio investors. if a foreign equity or debt investment offers an investor a higher rate of return than a domestic one, it is reasonable to conclude that the money can best be used abroad. thus, the best tax regime would seem to be one that taxed investors the same whether they choose the foreign or domestic security. in short, the cen approach can be resuscitated as a solid basis for taxation of income from portfolio investments. 185 nevertheless, while normally, interest income is taxed by the residency country, it could be avoided by establishing a company in a tax haven, which does not have withholding on interest. it is also common for residency countries not to have adequate resources to enforce their rights to tax the income that was 182. leif muten, international experience of how taxes influence the movement of private capital, 8 tax notes int’l 743, 744 (1994) (“if the goal is to facilitate foreign financing of domestic enterprises, and to keep foreign borrowing by government from looking too expensive, there is some appeal to leaving interest payments to foreign residents outside the tax system. assuming full shifting to the debtors, foreign borrowing will not be made more expensive by such a policy, i.e., from the point of view of the national economy.”). 183. id. see also avi-yonah (2000), supra note 3, at 1582. 184. see avi-yonah (2000), supra note 3, at 1605, quoting from assaf razin & efraim sadka, international tax competition and gains from tax harmonization, 37 econ. letters 69, 69-70 (1991) (“if a country adopts the residence principle, taxing at the same rate capital income from all sources, then the gross return accruing to an individual in that country must be the same, regardless of which country is the source of that return. thus, the marginal product of capital in that country will be equal to the world return to capital. if all countries adopt the residence principle, then capital income taxation does not disturb the equality of the marginal product of capital across countries which is generated by a free movement of capital.”). 185. see frisch, supra note 53, at 587. 2008] the case for residency-based taxation 35 forgiven by the source country. 186 thus, professor avi yonah has cautioned that portfolio income that is not taxed by the source country would escape taxation because it would not be taxed by the residency country either. 187 in this case, he points out, cen will be violated because “the investor would prefer to invest in the host country rather than in the home country, even if the pretax yield on the domestic investment were higher.” 188 i share the same concern; residency countries must make all the necessary effort to exercise their taxing rights and make sure that the interest or dividend income is taxed thereon. thus, in order to achieve cen, residency countries should enforce their rights to collect the tax on portfolio investments made in other countries. 189 this will require exchange of information among countries. 190 as discussed immediately below, the european union has adopted a directive pursuant to which interest earned by a taxpayer from one member state in another member state will be taxed by the latter state, provided that countries will share all the necessary information. 191 in addition, the oecd has recently revised article 26 of the oecd model treaty to require more exchange of information. these measurements are expected to increase the flow of information between countries and ensure that more passive income is taxed by residency countries. 6. the eu savings directive 186. see generally avi-yonah (2000), supra note 3. 187. id. at 1583-4 (“although it is not desirable to tax capital on a source basis, it is not administratively feasible to tax capital on a residence basis. . . .”). see also id at 1585 (“in the absence of withholding taxes or effective information exchange, income from foreign portfolio investments frequently escapes being taxed by any jurisdiction.”). 188. id. at 1604. 189. see graetz & greenberg (2003) supra note 88, at 586 (“the key difficulty for residence-based taxation of international portfolio income results from the widespread underreporting and evasion that now occurs. any solution to that problem necessarily will require both unilateral and multilateral actions. the good news is that the united states has already taken a major step forward in its information reporting requirements for qualified financial intermediaries, and recent actions in both the oecd and the eu offer promise of vastly improved multinational cooperation. the advent of new financial innovations and the persistence of financial tax havens and bank secrecy ensure, however, that there will be many opportunities for improvement for years to come.”). 190. see, generally, cynthia blum, sharing bank deposit information with other countries: should tax compliance or privacy claims prevail? 2005 tnt 44-28. 191. see “council directive 2003/48/ec on taxation of savings income in the form of interest payments” (hereinafter “savings directive”). 36 florida tax review [vol. 9:1 council directive 2003/48/ec on taxation of savings income in the form of interest payments was issued on june 3, 2003. the purpose of the savings directive was: to enable savings income, in the form of interest payments made in one member state to ‘beneficial owners’ [footnote omitted] who are individual residents for tax purposes in another member state, to be made subject to effective taxation in accordance with the laws of the latter member state. the scope of the savings directive is limited to taxation of savings income in the form of interest payments on debt instruments. in my view, the most important element of the savings directive was to establish a structured mechanism for exchange of information: where the beneficial owner is resident in a member state other than that in which the paying agent is established, the directive stipulates that the latter must report to the competent authority of its member state of establishment a minimum amount of information, such as the identity and residence of the beneficial owner, the name and address of the paying agent, the account number of the beneficial owner or, where there is none, identification of the debt claim giving rise to the interest, and information concerning the interest payment. the savings directive illustrates that the principle established by the league of nations report (1923), pursuant to which passive income should be taxed by the residency country, still prevails. what the savings directive further illustrates is that applying residency-based taxation for income from financial transactions must go hand-in-hand with a comprehensive exchange of information guidance. in addition, the oecd has recently modified article 26 (exchange of information) of the oecd model treaty and has adopted a model tax information exchange agreement, both of which address the issue of exchange of information. under both agreements, exchange of information is mandatory rather than elective and overrides bank secrecy provisions in domestic laws. 192 192. see prepared testimony of reuven s. avi-yonah, irwin i. cohn professor of law, university of michigan law school before the u.s. senate permanent subcommittee on investigations, hearing on offshore transactions (aug. 01, 2006), published in 2006 tnt 148-42. 2008] the case for residency-based taxation 37 7. conclusions in general terms, foreign investors in country d should not be taxed on interest and dividends received from domestic payors, thereby leaving the tax jurisdiction for such income to the investor’s residency country. as set forth in greater detail below, such a regime would not constitute a harmful tax competition; 193 exempting foreign portfolio investment from tax in country d would simply make country d’s tax regime similar to other tax regimes in developed and developing countries. this treatment would also be consistent with the relevant provisions in the majority of income tax treaties. 194 thus, whether country d has an income tax treaty with the foreign investor’s residency country or not would not matter since in either case, the residency country will collect the tax. i would also suggest that country d sign tax treaties with major counterparties that will be consistent with these principles. c. taxation of derivative transactions 195 1. overview a derivative instrument is a “contract between two parties that specifies conditions – in particular, dates and the resulting values of the underlying variables – under which payments, or payoffs, are to be made between the parties.” 196 derivative instruments generally include options, forwards, futures and notional principal contracts. 197 according to david rosenbloom, to some 193. for a seminal article on tax competition, see charles tiebout, a pure theory of local expenditures, journal of political economy, oct. 1956, pp. 416-24. see also oecd report (1998), supra note 1, at 14 (defining harmful tax competition as “free riding” that “may hamper the application of progressive tax rates and the achievement of redistributive goals.”). 194. see ault, supra note 4, at 571 (“the treaty structure has been developed explicitly to allocate taxing claims with respect to international income.”). 195. for an excellent overview of what are derivatives, who uses them, for what purposes, and how they are taxed (and how should derivatives be taxed), see may, supra note 6, and rosenbloom, supra note 32, both of which were written in connection with the ifa report (1995). an in-depth discussion on these issues is beyond the scope of this article. 196. m. rubinstein, rubinstein on derivatives § 1 (1999). see also keinan (2007), supra note 32, at 87. 197. see plambeck, rosenbloom & ring, general report, in 85b cahiers de droit fiscal international, 660-661 (kluwer 1995) (“in general, financial instruments are contractually created rights and obligations to transfer specified amounts of money at 38 florida tax review [vol. 9:1 extent, a derivative instrument resembles an insurance contract because it is “a device used to shift risk from one party to another.” 198 options: an option is an agreement pursuant to which the buyer of the option has the right but not the obligation to buy from, or to sell to, the seller, a pre-specified number of units of underlying asset, for a pre-specified price (strike price) at or before a specified date in the future (expiration date). 199 an option is defined for u.s. tax purposes as a contract pursuant to which the writer of the option undertakes an obligation to sell to the option holder, or purchase from the holder, specific property at a fixed or determinable price and time. 200 generally, options, like forward contracts (discussed immediately below), are treated as open transactions for united states tax purposes. 201 specified points in time. the terms of the payments express the risks and rewards accepted by each of the parties to the contract. a derivative financial instrument is one under which the payment rights and obligations of the parties (and therefore the value of the contract) derive from the value of an underlying cash or physical market (e.g., foreign exchange, securities, commodities) or from particular indices or combinations of indices.”). 198. rosenbloom, supra note 32, at 597. 199. see federal home loan mortgage corporation v. comm’r, 125 t.c. no. 12 (2005) (the tax court provided an excellent overview on the economics of option contracts). a call option is a contract that allows the holder to buy a specified quantity of stock from the writer of the contract at a fixed price for a given period. thus, if the market value of such stock were to fall below the price specified in the option contract, the holder normally would not exercise the option and would allow it to lapse. on the other hand, if the market value of the underlying stock were to rise above the price specified in the option contract, the holder probably would exercise the option before it lapses. a put option is a contract that allows the holder to sell a specified quantity of stock to the writer of the contract at a fixed price during a given period. thus, if the market value of the stock that is the subject of the option were to rise above the price specified in the option contract, the holder of the put normally would not exercise the option and would allow it to lapse. on the other hand, if the market value of the underlying stock were to fall below the price specified in the option contract, the holder most likely would exercise the put before it lapses. see also keinan (2007), supra note 32, at 88-91. 200. rev. rul. 78-182, 1978-1 c.b. see also avi-yonah & swartz (1997), supra note 39. 201. id. irc § 1234(b) governs the treatment for the grantor of options in property, which means options on stock, securities, commodities, and commodities futures, provided the option is not otherwise subject to irc § 1256 as described above. for a grantor of an option in property (see below), gain or loss is not recognized until the option lapses or expires, is exercised or closed. id. the premium received is recognized when such sale, exchange, expiration, or closing (offsetting) transaction occurs. when the option is exercised, this event is, generally, treated as a non-taxable 2008] the case for residency-based taxation 39 example of a call option: on january 1, 2007, a holder of the call option pays $10 to the writer of the option, for the right to purchase ibm stock at $100 from the writer, on or before september 1, 2007 (the “expiration date”). the current stock price is $90. example of a put option: on january 1, 2007, a holder of a put option pays $10 to the writer for the right to sell ibm stock at $100 to the writer on or before september 1, 2007. the current stock price is $90. forward contracts: a forward contract is an agreement pursuant to which the buyer agrees to buy from the seller an underlying asset for a fixed price (delivery price) on a single specified date in the future (delivery date), where the terms are initially set so that the present value of such a contract is zero. 202 as rosenbloom observes: “the key difference between [options and forward contracts] is that a holder of an option has a right, for which it has generally paid a fee or premium, but no obligation. in contrast, the forward creates mutual obligations and mutual rights and, since either party may gain as a result of the contract, it is common that no funds, or premiums, change hands at the inception of the contract.” 203 a forward contract is defined for u.s. tax purposes as a “privately negotiated contract that provides for the sale and purchase of property for a specified price on a specified date.” 204 similar to options, until the forward contract is sold, exchanged, settled or allowed to lapse, the transaction is treated as open, and any gain or loss to the parties is deferred. 205 upon the delivery, a seller’s gain or loss on a forward contract is capital to the extent the asset underlying the forward contract would be a capital asset in the taxpayer’s hands. 206 purchase of the underlying asset by a holder of a call or grantor of a put, but as a taxable sale by the other party to the option. see also keinan (2007), supra note 32, at 97-100. 202. see m. rubinstein, rubinstein on derivatives § 2.2. (1999). see also keinan (2007), supra note 32, at 91-3. 203. rosenbloom, supra note 32, at 599. 204. glass v. comm’r, 87 t.c. 1087, 1101 (1986). 205. see david s. miller, taxpayers’ ability to avoid tax ownership: current law and future prospects, 51 tax lawyer 279, 305 (footnotes 101-104 and accompanying text). see also keinan (2007), supra note 32, at 100. in contrast, in the united kingdom, derivatives “are taxed on income account in the amounts recognized for accounting purposes, provided that the accounts use either an accruals or mark-tomarket method.” see robert moncrieff, next steps for debt and derivatives: the u.k. finance act 2002, 4(1) journal of taxation of financial products (2003). 206. see may (1995), supra note 6 (explaining that “that result seems relatively unsurprising in the case of a forward. no cash passes until the performance date, and the seller does not become entitled to anything until the contract period has elapsed.”). 40 florida tax review [vol. 9:1 example of a forward contract: a contract entered into on january 1, 2007 between a buyer and seller, pursuant to which the seller will sell the buyer 1,000 shares of ibm stock for $100, on september 1, 2007. futures contracts: futures contracts are economically similar to forward contracts except that they are: standardized; traded at regulated futures exchanges; used by clearing organizations; subject to daily mark-to-market system; and can be closed before maturity. 207 futures contracts are subject to mark-to-market treatment in the u.s. pursuant to irc section 1256. 208 notional principal contracts: a notional principal contract is a financial instrument that provides for the payment of amounts by one party to another, at specified intervals calculated by reference to a specified index, upon a notional principal amount, in exchange for specified consideration or a promise to pay similar amounts. 209 notional principal contracts include interest rate swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, and similar agreements. 210 a swap is a contract pursuant to which the parties agree to exchange payments calculated by reference to a notional amount. 211 example of an interest rate swap: on january 1, 2007, a and b enter into a swap with a notional amount of $1,000 pursuant to which, on every january 1 and july 1, party a will pay party b an amount equal to 5% of the notional amount, and party b will pay a an amount equal to libor times the notional amount. the amounts from each party are netted. in the united states, the notional principal contracts regulations group all payments under notional principal contracts into three categories: (i) periodic payments; (ii) non-periodic payments; and (iii) termination payments. 212 a party to a notional principal contract must annually include in gross income any “net income” from the contract or is allowed to deduct any net cost. 213 specifically, all taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a periodic payment and a non-periodic payment for the taxable year to which such portions relate. 214 a non-periodic payment must be amortized 207. avi-yonah and swartz (1997), supra note 39. see also keinan (2007), supra note 32, at 93-4. 208. id. see also may (1995), supra note 6. 209. treas. regs. § 1.446-3(c)(1)(i). 210. irc § 1256 contracts, debt instruments, options and forward contracts do not constitute notional principal contracts. treas. regs. § 1.446-3(c)(1)(ii). 211. see avi-yonah and swartz (1997), supra note 39. see also keinan (2007), supra note 32, at 104-05. 212. see generally treas. regs. § 1.446-3. see also may (1995), supra note 6. 213. treas. regs. § 1.446-3(d). 214. treas. regs. §§ 1.446-3(e)(2)(i) and 1.446-3(f)(2)(i). 2008] the case for residency-based taxation 41 and recognized over the contract term in a manner that reflects the economic substance of the contract. 215 a termination payment is recognized by the original party to the contract as income or deduction when the contract is extinguished, assigned, or exchanged. 216 2. risk management and hedging businesses routinely use derivatives to manage risks related to movements in commodities and securities prices, currencies, and interest rates. 217 instruments available to manage such risks include options, futures and forward contracts, and notional principal contracts. 218 businesses can hedge assets or liabilities, and can also hedge these exposures only in part or only for a limited time. 219 as set forth above, rosenbloom (1996) observed that: a derivative usually insures against a financial risk, such as the chance that a particular currency will rise or fall in value, that the price of a commodity such as corn will rise above or fall below a particular level, or that interest rates will move in a particular direction. 220 most countries do not have specific tax rules for hedging transactions. in the united states, prior to 1993, the tax treatment of hedging transactions (in particular, the character of gains and losses) was entirely a matter of case law and administrative practice. 221 in 1988, the supreme court in arkansas best corp. v. 215. id. 216. treas. regs. § 1.446-3(h)(2). 217. see generally, david c. garlock, federal income taxation of debt instruments, chapter 17.01[a] (2005 ed). 218. id. 219. see avi-yonah & swartz (1997), supra note 39. 220. rosenbloom, supra note 32, at 598 (illustrating with the following example: “the holder of an option to purchase 100,000 deutsche marks at 1.3 dm to the dollar is not required to demand payment, and presumably will not do so unless the event insured against the risk occurs (for instance, the deutsche mark rises to 1.1:1). if that occurs, the holder of the option has an economic incentive to require the option writer to sell deutsche marks at the option price of 1.3 dm to the dollar to the extent specified in the option contract. the holder’s gain upon the exercise of the option will precisely mirror the risk that 100,000 deutsche marks would rise above the designated level.”). 221. see corn products v. comm’r, 350 u.s. 46 (1955). the taxpayer, a manufacturer of corn products, in order to protect itself against the risk of fluctuations in 42 florida tax review [vol. 9:1 comm’r held that gain or loss on the sale or exchange of an asset is capital unless the asset falls within one of the specifically enumerated exceptions in section 1221. 222 in fannie mae v. comm’r, the irs argued that arkansas best required the taxpayer to treat its hedging losses as capital, but the tax court disagreed and held for the taxpayer. 223 in the same year and specifically in response to the court’s decision, the irs issued temporary regulations governing hedging transactions, followed by final regulations in 1994. pursuant to irc section 1221(b)(2), “[t]he term ‘hedging transaction’ means any transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily (i) to manage risk of price changes or currency fluctuations with respect to ordinary property which is held or to be held by the taxpayer, (ii) to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer, or (iii) to manage such other risks as the secretary may prescribe in regulations.” 224 example of hedging prices of commodities: corporation x is a corn processor that uses grain corn to manufacture products such as corn starch. on july 1, x enters into a contract to deliver to a customer a fixed quantity of starch at a fixed price in october. because of limited storage space, x will not purchase the corn needed to fulfill the starch contract until september. if the market price of corn increases between july and september, x’s profit on the starch contract would be reduced or eliminated. 225 to protect itself against such risk, x enters into a long futures contract on corn (e.g., a contract to buy corn). in september, x will buy and take physical delivery of the corn needed to fulfill the starch contract, and at the same time settle the futures contract by either making or the price of corn, engaged in the purchase and sale of corn futures. the taxpayer argued that the corn futures contracts were capital assets and that profit and losses from their sales were entitled to preferential tax treatment under the capital asset provisions. the court found that the futures transactions constituted “an integral part of [the taxpayer’s] manufacturing business” and the gains and losses were given ordinary tax treatment. see, in general, keinan (2007), supra note 32, at 131-5. 222. arkansas best v. comm’r, 485 u.s. 212 (1988). 223. federal nat’l mortgage ass’n v. comm’r, 100 t.c. 541 (1993). 224. irc §1221(b)(2). may (1995), supra note 6, elaborates that “the definition [of hedging transaction] contains several key requirements. first, the taxpayer must identify the relevant contract or other position as a hedge. second, the hedged item must be an ordinary, rather than a capital, asset or obligation. third, changes in the value of the hedge must offset changes in the value of the hedged item. finally, after taking into account the taxpayer’s other positions, the hedge must reduce the taxpayer’s overall exposure to the relevant risk.” 225. see garlock (2005), supra note 217, at 17.01[a]. 2008] the case for residency-based taxation 43 receiving a termination payment of cash. 226 the amount paid or received to terminate the futures contract will offset a decrease or increase in x’s cost of corn, and thus profit on the starch contract. the result is that x has effectively locked in the future purchase price of the corn needed to fulfill the customer order, and x’s profit will not be affected by changes in the price of corn. 227 in general, hedging transactions are awarded a favorable treatment in the united states. 228 the rationale is clear – hedging transaction should be encouraged, since risk management is a crucial element in the economy. 229 as discussed in greater detail below, taxation of income from cross-border derivatives that serve as hedging transactions could have a significant impact on the ability of domestic businesses to manage their risk of doing business. 230 thus, as this article suggests, country d should encourage foreign counterparties to enter into hedging transactions with domestic businesses by allowing the residency country to tax income from such transactions. 3. cross-border aspects of derivatives as opposed to portfolio investment, there is more “international consensus” concerning taxation of cross-border derivatives. 231 the forty-ninth congress of the international fiscal association (“ifa”) focused on tax aspects of derivatives and issued its recommendations with respect to cross-border aspects of derivatives. 232 the ifa report (1995) that resulted from the 226. id. 227. id. 228. see generally treas. regs. § 1.1221-2 (matching ordinary gains with ordinary losses on the hedging transaction and the hedged item) and treas. regs. § 1.446-4 (matching hedging gains and losses to gains and losses on hedged items). 229. see conference report for the omnibus budget reconciliation act of 1993, h.r. rep. no. 213, 103d cong., 1st sess. 616 (1993) (emphasized the importance of hedging transactions to the united states economy). see also thuronyi, supra note 10, at 264. 230. see e.g., david garlock, yoram keinan, howard leventhal, and alan munro, proposals regarding the taxation of credit default swaps, 18 j. tax’n f. inst. 5 (2005) (advocating residency-based taxation for credit default swaps). 231. see rosenbloom, supra note 32, at 602-3, citing the ifa report (1995), supra note 35, at 684-6. see also thuronyi, supra note 10, at 270 (agreeing that such a consensus exists but providing two examples of countries (mexico and greece) that withhold on income from derivatives under their domestic laws). 232. see generally ifa report (1995), surpa note 35. see also rosenbloom, supra note 32 at 602-3 (“the only ‘pure’ international issue raised by such instruments pertains to taxation in the country of source on a gross basis. it is here that close analysis of the special features of derivatives is required, and here, if anywhere, that derivatives place pressure on the international rules. the question posed is whether the country from 44 florida tax review [vol. 9:1 conference set forth that the international consensus for taxation of cross-border derivatives is that the source country generally does not impose tax earned by non-resident on income from derivatives. 233 absent tax considerations, local businesses typically would be indifferent between entering into a derivative with a domestic or foreign counterparty – price is the dominant consideration. 234 however, if a payment to or from a foreign counterparty would be subject to withholding tax in country d, that consideration undoubtedly would outweigh any price differential, so the effect of a withholding tax would simply be to drive away foreign counterparties from the domestic market – an unwarranted result, in my view. 235 in the case of developing countries, the vast majority of derivative transactions will be between local businesses and foreign counterparties because the local derivative markets are probably undeveloped. 236 thus, participation of foreign parties in the domestic market is essential not only because it increases the liquidity in the market, but also because it provides access to derivatives to more domestic businesses by virtue of providing more choices and better prices. 237 another consideration relevant to foreign counterparties is whether entering into a derivative transaction with domestic counterparties could be treated as the conduct of a trade or business in country d. 238 this too could have the practical effect of barring foreign counterparties from the domestic derivative market in country d. this issue is discussed below in the next chapter. in general, the united states uses “a residencebased sourcing rule to waive source-based claims on the derivative instrument income of nonresident foreign persons.” 239 thus, unless the gain on a derivative is connected with a u.s. trade or business or u.s. real estate, it is not u.s.-source income. 240 as set which payment is made under a derivative financial instrument should have the right to impose tax on that payment.”). 233. see ifa report (1995), supra note 35, at 684-6; rosenbloom, supra note 32, at 603. 234. in general, foreign counter-parties provide domestic businesses with better prices than domestic counter-parties. 235. see generally, ifa report (1995), supra note 35. see also thuronyi, supra note 10, at 271 (“the result [of withholding tax] will be that the withholding tax will, in effect, preclude domestic taxpayers from entering into derivative agreements with taxpayers resident in non-treaty partners. . . .”). 236. thuronyi, supra note 10, at 264. 237. id. at 271. 238. see prop. treas. reg. § 1.864(b)-1. 239. see may, supra note 6. 240. id. see also charles t. plambeck et al., general report [hereinafter general report] in 80b cahiers de droit fiscal international 653 (1995). a similar 2008] the case for residency-based taxation 45 forth above, the definition of fdap income in the u.s. is very broad and includes various types of income. 241 the income need not even be annual or periodical, so a single payment could also constitute fdap. 242 nevertheless, certain specific exceptions exist, one of which is for gains from the sale of property, including option premiums. 243 there is no specific exception from fdap income for payments under a notional principal contract; nevertheless, pursuant to treas. reg. section 1.8637(b), if the foreign counterparty is not engaged in a u.s. trade or business, a domestic payor of periodic payments under a notional principal contract is not required to withhold on its periodic payments to the foreign counterparty because the payment will be treated as having a foreign source. 244 the source of the periodic payments under a notional principal contract is the residence of the recipient of the income and not the residence of the payor. 245 while this looks like a formal source rule, according to david hariton (on behalf of the new york state bar association tax section) the effective source of income from notional principal contracts contained in treas. reg. section 1.863-7 is where the activities relating to the notional principal contract itself took place. 246 other countries, however, have attempted to trace the risk being managed by derivatives; in argentina and columbia, for example, income from derivatives has domestic source if the undertaken risk is therein. 247 approach is applied in the united kingdom. see moncrieff, supra note 205 (“payments made in respect of derivative contracts have traditionally fallen outside withholding tax requirements and this has been confirmed in the 2002 rules.”). 241. treas. regs. § 1.1441 2(b)(1)(i). 242. treas. regs. § 1.1441-2(b)(1)(ii). 243. treas. regs. § 1.1441-2(b)(2)(i). 244. the definition of a notional principal contract under treas. reg. § 1.8637(a) is the same as that under treas. regs. § 1.446-3(c). see also treas. regs. § 1.14414(a)(3), pursuant to which payments with respect to a notional principal contract described in treas. regs. § 1.863-7(a) are not subject to u.s. withholding tax. 245. treas. regs. § 1.863-7(a). see also treas. regs. § 1.988-4(a) for foreign currency swaps. special rules apply to payments on notional principal contracts that are classified as “embedded loans.” 246. see david p. hariton (on behalf of the new york state bar association tax section), credit default swaps, 40 tax notes int’l 545, at note 120 (“while regs. §1.863-7 is often thought of as providing a rule that notional principal contract payments to a foreign person are foreign source, that is not true if the payments constitute effectively connected income. in that case, the payment is treated as u.s.-source income. regs. § 1.863-7(b)(3).”) 247. guillermo o. teijeiro, argentine anti-avoidance rules: application under domestic and international conventional law, 32 tax notes int’l 67 (aug. 21, 2003), citing argentina income tax law, first section (unnumbered) after § 7, “[r]isk is considered situated in argentina whenever the party to the transaction obtaining the 46 florida tax review [vol. 9:1 as of today, there are no specific source rules in the united states for gains or losses on options, forward contracts and futures contracts. 248 in addition, there are no source rules for income from other types of payments under a notional principal contract (i.e., non-periodic and termination payments). 249 thus, under the normal source rules for sales of property contained in irc section 865, the source of gain from such derivative contracts is similar to the source of capital gain. 250 while the general consensus among countries is that income from crossborder derivatives is taxed by the residency country, several alternatives to reach such result have emerged. 251 in canada, for example, a different approach but with similar result is applied. 252 in general, if a non-resident does not have trade or business in canada, payments received by such non-resident under options, forward contracts or swaps are generally not subject to canadian tax if none of these payments can reasonably be characterized as interest, dividend, or rental payments (which is normally the case). 253 similarly, in the united kingdom: income is a resident in argentina or a domestic permanent establishment of a foreign company.” id. see also mario andrade, a tax overview of derivatives transactions in colombia, 22 tax notes int’l 3080 (june 1, 2001) (“if the transaction is cross-border between a resident and a nonresident, it must be determined where the coverage service is rendered. if the services are rendered by a colombian resident, any payment abroad is considered as national-source income subject to colombia’s 35% corporate income tax, plus an additional 7% remittance tax, net of income tax, for a fixed 39.55% rate.”). 248. see avi-yonah & swartz (1997), supra note 39. see also keinan (2007), supra note 32, at 143. irc § 865(j)(2) gave the irs the authority to issue regulations pertaining to the source of income from forward contracts, but such regulations have yet to be issued. id. 249. id. 250. see keinan (2007), supra note 32, at 143. see also may, supra note 6 (explaining that “the income realized from forwards, futures, and options is gain. unless the gain is connected with a u.s. business or u.s. real estate, [ footnote omitted] it is not u.s.-source income because it takes its source from the recipient’s foreign residence.”); david f. levy, towards equal tax treatment of economically equivalent financial instruments: proposals for taxing prepaid forward contracts, equity swaps, and certain contingent debt instruments, 97 tnt 188-98 (sep. 25, 1997). 251. see rosenbloom, supra note 32, at 603, citing the ifa report (1995), supra note 35. 252. see bernstein, jack, jondahl, sky & nicholls, andrew, the canadian treatment of derivatives, 37 tax notes int’l 587 (2005). 253. id. 2008] the case for residency-based taxation 47 payments made in respect of derivative contracts have traditionally fallen outside withholding tax requirements and this has been confirmed in the 2002 rules. however, although derivative payments themselves may not be subject to withholding tax, derivative contracts may include items such as interest payments that are currently, and that continue to be, subject to the withholding tax provisions. 254 the source rules pertaining to periodic payments on notional principal contracts in the united states were first established by the irs in 1987, 255 and shortly after were regulated under treas. regs. section 1.863-7(b). although not stated formally, the reason for the special rule was to permit cross-border notional principal contracts without the impediment of a withholding tax. 256 this principle is consistent, of course, with the recommendations in the ifa report (1995) that is discussed below. i can think of no reason why this policy should not equally apply to developing countries. 257 as stated above, the opposite policy would not result in the collection of any tax revenues; it would simply eliminate foreign persons as potential counter-parties for derivative transactions. in general, derivatives are mainly used for hedging and speculation purposes. 258 with respect to hedging, it is generally accepted that risk management is a crucial element in every 254. see generally moncrieff, supra note 205. 255. see rev. rul. 87-5, 1987-1 c.b. 180. two years before, the new york state bar tax ass’n section issued a report that advocated no withholding tax on swap payments. see new york state bar association examines whether payments to foreigner in interest rate swap agreement are subject to withholding, 85 tnt 11852. 256. see rosenbloom, supra note 32; thuronyi, supra note 10. 257. see in general keinan (2007), supra note 32. 258. rosenbloom, supra note 32, at 597-98 (“a derivative financial instrument is a device used to shift risk from one party to another. on this fundamental point, derivatives resemble insurance, a concept familiar to anyone who has purchased a vehicle or home. in an insurance transaction one party pays a fee, or premium, to another. in return, the other party undertakes the risk of paying the first party up to a specified amount in the event of a specified occurrence (such as a theft or fire). if the occurrence comes to pass, the first party has a claim against the second, which gives value to the insurance contract. that value depends on, or derives from, the occurrence, which is typically beyond the influence or control of either party, and the extent of the resulting loss. if the occurrence does not come to pass, the contract expires without having any value to the first party. yet, such a transaction is sensible because, during the specified period, the insured was relieved of the risk of suffering loss as a result of the specified event by shifting the economic burden of that risk to the insurer.”). 48 florida tax review [vol. 9:1 business’s growth. 259 thus, country d would clearly want to allow local businesses to manage their risk by entering into derivatives with foreign counterparties (assuming that the local banks could not satisfy this need). 260 nevertheless, foreign counterparties will hesitate to enter into hedging transactions with businesses in country d if income from such transactions will be subject to tax in the source country. as set forth above, the ifa report (1995) reached several resolutions to promote sensible, consistent worldwide taxation of derivatives. 261 the ifa report (1995) first acknowledged that countries should recognize the importance of derivative transactions and remove tax impediments to the use of derivative instruments. 262 in accordance with general tax policy principles, the ifa report (1995) concluded that the tax rules for derivatives should be fair, simple, and practical: (i) different classes of taxpayers and different instruments that are economically similar should be similarly treated; (ii) the rules must apply consistently over time as derivative instruments change; and (iii) the use of derivative instruments should have definite and predictable results. 263 the ifa report (1995) also discussed the appropriate source rules for income from derivatives and set forth that: countries should not impose source basis taxation on income derived by non-residents from derivative instruments in the absence of a branch or permanent establishment to which such income is attributable. 259. colon, supra note 5, at 777 (“financial instruments permit firms to transfer financial price risks to other investors better able or more willing to bear such risks. financial instruments help firms to lower their financing costs and hedge more efficiently in both specific transactions, such as the purchase or sale of products in foreign currency, as well as in strategic cash flow hedging.”). 260. see andrade, a tax overview of derivatives transactions in colombia, 22 tax notes int’l 3080 (june 1, 2001) (“operations with derivatives have recently started to expand in colombia. normally, investors and economic agents choose those types of operations when market fluctuations make the return on an investment or the feasibility of a transaction riskier. because of the volatility of some indexes of the region – such as interest rates, the exchange rate, and the prices of basic products – more national and foreign investors are making use of those instruments.”). 261. tax aspects of derivative financial instruments, 49th ifa cong. res. (cannes 1995). see also michael cosgrove, ifa stresses role of derivatives, calls on nations to establish new tax regimes, 65 bna’s banking rep. 507 (1995). 262. see avi-yonah & swartz (1997), supra note 39. 263. id. 2008] the case for residency-based taxation 49 the ifa report (1995) observed that the general practice not to impose withholding tax at source on payments made under derivative financial instruments. this is appropriate and should be universally adopted. furthermore, apart from withholding tax, profits, gains and losses with respect to derivative instruments should be exempted from tax at source under domestic law or applicable income tax treaties on the ground that they represent: business profits, exempt from tax in the absence of a permanent establishmentcapital gains; or“other income” exempt under the “other income” article of an applicable treaty. 264 victor thuronyi (senior counsel (taxation) with the international monetary fund) stated that the same rationale should apply to developing countries: in the case of certain [new financial instruments], particularly derivatives, tax policy concerns militate against the imposition of a withholding tax because the payments under some financial instruments may not be closely correlated with the income actually earned. this is particularly the case for swap payments. there is a risk, therefore, that if a gross basis tax is imposed at source, taxpayers simply will not enter into the type of transaction subject to withholding, because the withholding would be out of proportion to the amount of income involved. [footnote omitted] such a policy may deny to domestic companies the risk-shifting benefits that new financial instruments can provide. 265 264. see the ifa report (1995), supra note 35, at ¶2.3. ¶ 2.4 elaborating that “in imposing residence taxation on income derived from derivative instruments, the residence principle should be: (a) reinforced by application of a country’s anti-deferral regimes, where appropriate; and (b) clarified in the case of global trading, split hedging, and inter-branch transactions. in this connection, countries should consider entering into advance pricing agreements in appropriate cases. in computing the taxable income of a branch of a foreign taxpayer, inter-branch or branch/home office transactions in derivative instruments are taken into account in some countries but not in others. the treatment of these transactions should be harmonized and the oecd should be encouraged to continue its work on the subject.” 265. see thuronyi, supra note 10, at 261, citing for this view c. plambeck, h.d. rosenbloom, and d. ring, “general report,” 85b cahiers de droit fiscal international (1995); l. lokken, “taxation of derivatives and new financial instruments,” in report of the ad hoc group of experts on international cooperation in 50 florida tax review [vol. 9:1 mr. thuronyi specifically acknowledges that domestic businesses will benefit from more access to risk-shifting instruments if the source country will not withhold on such instruments. another potential policy argument for these proposed source rules is that, in contrast to payments on stock or debt, where the recipient has invested capital in an income-producing asset in country d, a derivative is merely a contractual arrangement that gives rise to cash flows on a notional amount. 266 furthermore, while interest and dividends can flow only to the investor, cash flows on notional principal contracts can flow in either direction. while country d may wish to reserve the right to tax on income from capital invested therein, there is no reason for a priority claim for taxation of cash flows on contractual cash flows out of the country. 267 as set forth above, in the united states, the irs and several commentators have raised the concern that with respect to equity swaps, such source rules could be used to replicate payments subject to u.s. withholding, such as dividends from a u.s. corporation, and convert such payments into exempt swap payments. 268 these concerns, however, should not apply if consistent with my proposals in the previous part, interest and dividends are largely exempt from withholding tax. tax matters on the work of its eighth meeting (u.n. 1998). 266. see generally garlock, et. al. (2005), supra note 230. 267. id. 268. see reich, supra note 11; preamble to prop. treas. reg. §1.864(b)-1, (june 11, 1998); preamble to the § 446 regulations, t.d. 849, 58 fed. reg. § 53125 (oct. 14, 1993) (“[t]he irs is considering whether notional principal contracts involving certain specified indices (e.g., one issuer’s stock) should be excluded from the general sourcing rules of irc §§ 861 through 865. . . .”); preamble to proposed regulations under irc §1058, 1992-1 cb 1196 (“the service is considering whether the proposed regulations should apply to dividend equivalent payments made in connection with certain notional principal contracts, such as an equity index swap structured to replicate the cas[h] flows that would arise from an installment purchase of one or more equity securities”); new york state bar ass’n tax section, “report on the imposition of u.s. withholding tax on substitute and derivative dividend payments received by foreign persons,” highlights & documents, june 5, 1998, p. 2869; aviyonah & swartz (1997), supra note 39. 2008] the case for residency-based taxation 51 4. taxation of cross-border derivatives under treaties the characterization of payments for treaty purposes is important because different characterization could mean different rates imposed on income from cross-border financial instrument. 269 in addition, special issues may arise if the payment is characterized inconsistently in the country of source and the country of residency. 270 “the existing network of tax treaties places significant constraints on countries’ freedom of action in imposing a withholding tax on derivatives.” 271 generally, income from derivatives could fall under business income (article 7), dividends (article 10), interest income (article 11), capital gain (article 13) or other income (article 21). 272 under all provisions, according to both the u.s. and oecd treaty models, income would generally be taxable only in the residency country. 273 there is little doubt that when income from derivatives is attributable to the non-resident’s permanent establishment in the source country, such income should be taxed by the source country under article 7. 274 of course, as discussed above, this will require a two-step determination of whether the non-resident has a permanent establishment in the source country and if so, whether the income is attributable to such permanent establishment. the dividend article of many u.s. tax treaties generally defines dividends as “income from shares . . . as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares” in the country where the distributing company resides. 275 according to may (1995), this could establish the authority to tax payments under an equity swap. 276 269. for example, as discussed above, if a payment is classified as interest, it may be subject to lower rate then if such payment would be treated as a dividend. 270. for examples of how foreign investors can avoid u.s. withholding taxes using derivatives, see gregory may, flying on instruments: synthetic investment and the avoidance of withholding tax, 73 tax notes 1225 (1996). 271. thuronyi, supra note 10, at 268. 272. see bruce a. elvin, the recharacterization of cross-border interest rate swaps: tax consequences and beyond, 96 tni 32-21 (citing from organization for economic co-operation and development, taxation of new financial instruments (1994); thuronyi, supra note 10, at 268-9. 273. id. 274. id. 275. see may, supra note 6, (citing the 1981 u.s. model income tax treaty, article. 10(3)). 276. id. see also avi-yonah & swartz (1997), supra note 39. 52 florida tax review [vol. 9:1 as to the interest article, in general, payments under a derivative are not treated as interest because they are not compensation for the use of money. 277 the only case where payments under a derivative could be subject to the interest provision is in the case of a significant non-periodic payment in a notional principal contract that could be treated as an embedded loan under the source country’s domestic laws. 278 furthermore, some treaties do not follow the existing treaty models as far as the “other income” article is concerned, or do not contain an “other income” article. 279 “moreover, under the u.n. model treaty, ‘other income’ arising in a contracting state may be taxed in that state [(i.e., the source country)]. . . . 280 thus, a country which has followed the u.n. model in its treaties will be able to impose a tax on payments under derivatives if it wishes, in circumstances where these payments are properly characterized as other income.” 281 as of today, there is no specific provision in any tax treaty that allocates the tax on income from derivatives. 282 it is, therefore, strongly suggested that countries will consider adopting a specific provision in their tax treaties to address this issue. consistent with the international consensus over the appropriate treatment of income from derivatives discussed in this article, such a provision should specify that income from a derivative transaction should generally be taxed by the residency country, unless it falls under other treaty provisions such as interest (e.g., in the case of embedded loans), dividend or business income. obviously, the u.s., oecd, and u.n. must assist in revising their treaty models to include specific rules for derivatives. 277. thuronyi, supra note 10, at 269. 278. id. (illustrating as follows: “party a makes a payment to party b of u.s. $1,000, then b pays a u.s. $100 for five years and u.s. $1,100 in the sixth and final year. this is nothing but a loan at 10% annual interest, even though the payments are called swap payments. under a rule that treated as interest the implicit interest due to differences in timing of payments under a swap, an appropriate portion of the payments would be characterized as interest.”). 279. thuronyi, supra note 10, at 269. the “other income” article exists in most u.s. treaties and in most cases, it allows the country of residency to tax unspecified “other income.” see generally, treaties with germany, france and the netherlands, and article 21(1) to the 1996 u.s. model income tax treaty. 280. id. 281. id. 282. see oecd report (1994) (“there is no consistency in the way countries classify [derivatives] payments when applying treaties.”). 2008] the case for residency-based taxation 53 d. investing and trading in securities as set forth above, if a foreign person conducts business activities in the united states, it will generally be subject to u.s. income tax on its income that is effectively connected with that trade or business. 283 this standard is generally accepted in most countries as well as in tax treaties (only the standard is slightly different, namely income that is “attributable” to a “permanent establishment”). 284 the u.s. internal revenue code provides safe harbor exceptions, however, for business activities that consist of (i) trading in securities and commodities through an independent agent in the united states (if the taxpayer does not maintain a u.s. office through which the transactions are effected), and (ii) trading in securities and commodities for the taxpayer’s own account (if the taxpayer is not a dealer). 285 in general, these safe harbors are applicable to traders and investors in securities but not to dealers. 286 “securities” are defined for this purpose as “any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing; and the effecting of transactions in stocks or securities includes buying, selling (whether or not by entering into short sales), or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, on margin or otherwise, for the account and risk of the taxpayer, and any other activity closely related thereto (such as obtaining credit for the purpose of effectuating such buying, selling, or trading).” 287 while these safe harbors were originally enacted prior to the explosion in the use of derivatives, the treasury and the irs have endeavored to modernize the rules by issuing proposed regulations that would extend the safe harbors to trading in a wide variety of derivatives, including “interest rate, currency, equity [and] commodity notional principal contract[s].” 288 in many cases, derivatives are 283. see inverworld v. comm’r, 71 t.c. memo (cch) 3231, 3237-18, 1996 t.c. memo (ria) ¶ 96,301, 2104 (1996). 284. see generally, jack bernstein, et. al., the canadian treatment of derivatives, 37 tax notes int’l 587 (2005). 285. pursuant to irc § 864(b)(2)(a)(ii), a non-resident is not treated as being engaged in a trade or business within the united states for trading in stocks or securities on its own account, either directly or through an agent. irc §864(b)(2)(b) provides a similar safe harbor for trading in commodities. 286. see irc §§ 864(b)(2)(a)(ii)-(b)(ii). for the definition of a “dealer” for this purpose, see david hariton, credit default swaps, 40 tax notes int’l 545, 572 (2005) (“dealers transact with customers, while traders and investors act for their own account.”). 287. treas. regs. § 1.864-2(c)(2)(i)(c). 288. prop. treas. regs. § 1.864(b)-1, 63 fed. regs. 32164-166 (according to 54 florida tax review [vol. 9:1 entered into for the purpose of hedging positions in stocks, securities, or commodities, and the securities and commodities trading safe harbors apply to such derivatives. 289 thus, non-residents trading in securities and derivatives in the united states are not treated as having income that is effectively connected to a u.s. trade or business. 290 dealers in derivatives and securities, however, will be subject to u.s. tax, as discussed below. the united states congress first enacted the securities trading safe harbor in 1936 to provide certainty that non-residents who merely trade stocks and securities would not be subject to the net income tax regime. 291 the two-prong rationale for the enactment was that: (i) ordinary income from u.s. stocks and securities (e.g., interest and dividends) would be subject to u.s. taxation through the withholding tax on fdap income, and (ii) activities beyond the scope of the safe harbor (e.g., dealers) would be subject to net tax if the taxpayer was engaged in a trade or business or had an office in the united states. 292 thirty years later, the foreign investors tax act of 1966 expanded the safe harbors to include trading activities conducted by or on behalf of a non-u.s. resident taxpayer through a u.s. office for the foreign taxpayer’s own account. 293 the unmistaken purpose of these safe harbors was to encourage foreign persons to invest in u.s. capital markets without subjecting them to u.s. income tax. 294 the safe harbors are generally very broad and aimed at various types of the irs, regulations on the safe harbor provisions in irc §864(b) have not been issued since 1972. since then, it says, the “use of derivative financial instruments has increased significantly.” to reflect that development, the service says, new regulations addressing the ways taxpayers customarily use derivative transactions are needed). 289. treas. regs. §§ 1.864-2(c)(2)(i), (d)(2)(i). 290. see may, supra note 6. 291. revenue act of 1936, pub. l. no. 74-740, § 211(b), 49 stat. 1648, 171415 (1936); s. rep. no. 74-2156, at 21 (1936). 292. id. 293. foreign investors tax act of 1966, pub. l. 89-809, § 102(d), 80 stat. 1539, 1544 (1966); s. rep. no. 89-1701, at 16-17, 22-23, 32-33 (1966). 294. h. rep no. 89-1450, at 6 (1966). see also hariton (2005), supra note 286 (“for foreign entities, a special statutory rule provides that foreign entities that are traders or investors (but not dealers) in securities or commodities may carry on their securities activities in the united states without being subject to u.s. net income tax, but subject to u.s. withholding tax applicable to investment flows. under congressional policy dating back to the 1940s, those safe harbor rules have been amended by congress and interpreted by the irs in a manner that encourages offshore investors, including special purpose vehicles managed by u.s. investment advisers, to invest and trade in u.s. securities.”); colon, supra note 5, at 783-84 (“to encourage foreigners to invest in u.s. capital markets without becoming engaged in a u.s. trade or business, congress enacted two statutory safe harbors in the foreign investors tax act of 1996, one for trading in securities and commodities through an independent agent and the other for 2008] the case for residency-based taxation 55 passive investments. 295 the volume of trading does not matter, as long as there is no fixed place of business in the u.s. 296 another important reason for the safe harbor was that taxing such nonresidents on gains from trading in securities is impractical. as set forth in the legislative history of irc section 864(b): [a] nonresident alien will not be subject to the tax on capital gains, including so-called gains from hedging transactions, as at present, it having been found administratively impossible effectually to collect this latter tax. it is believed this exemption from tax will result in considerable additional revenue from the transfer taxes and from the income tax in the case of persons carrying on the brokerage business. 297 i believe that similar securities trading safe harbors should be available to investors and traders in country d because the same policy considerations that led the united states’ congress to encourage passive investment by foreign investors in the united states are even more applicable to developing countries. as to tax treaties, as discussed above, the source country generally can tax gains attributable to a “permanent establishment.” thus, non-resident with no “permanent establishment” in the host country will be taxed in the residency country: trading for the taxpayer’s own account in securities and commodities.”); reich, supra note 11. 295. see h.r. rep. no. 89-1450, at 55-56; s. rep. no. 89-1707, at 80 (“a nonresident alien individual or foreign corporation who is not a dealer in stocks or securities is not engaged in trade or business within the united states by reason of trading in stocks or securities for the taxpayer’s own account, irrespective of where the activities instrumental to such trading are performed or how the actual trading transactions are effected. it is immaterial whether the corporation or individual conducts the trading activities and effects the stock or security transactions himself or through his employee or uses agents in the united states, whether independent or dependent, to perform any or all the functions instrumental to such trading. it is also immaterial whether any such employee or agent, wherever located, is authorized to exercise his own discretion in trading activities conducted, or in effecting transactions, on behalf of his employer or principal. moreover, the volume of stock or security transactions affected during the taxable year is not material . . . . [emphasis added.].” 296. id. see also treas. regs. §§ 1.864-2(c)(1) and (d)(1). 297. senate report no. 74-2156, at 21 (1936). 56 florida tax review [vol. 9:1 a foreign person engaged in derivative transactions has a u.s. permanent establishment if the person or a dependent agent has a u.s. office through which it regularly takes material steps to acquire, manage, or dispose of derivative contracts. [footnote omitted] as a practical matter, foreign persons in the derivatives business will have a permanent establishment if they have a fixed place of business under the u.s. domestic rules. 298 e. credit default swaps (cdss) a recent debate in the united states over the appropriate tax treatment of cross-border cdss illustrates that the united states still considers tax measurements to attract foreign counter-parties to transact with domestic businesses. 299 in a typical cds transaction one party (the “protection buyer”) enters into a contract with another party (the “protection seller,” typically a foreign party) to obtain the right to a payment in the event of a default (the “default”) 300 by a third-party obligor (the “reference entity”) on a debt obligation issued by that entity (the “reference obligation”). the protection buyer need not own the reference obligation. the protection buyer pays the protection seller either a single lump sum or periodic payments. 301 in return, the protection buyer has the right to receive either (i) a cash payment, equal to the difference between the reference obligation’s value at the date the cds was established and its value at 298. see may, supra note 6. 299. see notice 2004-52, 2004-32 i.r.b. 168 (aug. 9, 2004). 300. in general, a default constitutes an issuer’s “failure to make payments on any of its obligations when due,” typically upon insolvency or bankruptcy. see david z. nirenberg & steven l. kopp, credit derivatives: tax treatment of total return swaps, default swaps, and credit-linked notes, 87 j. tax’n 82 (1997). credit events may also include “a specified price change in the[ reference entity]’s debt or a rating downgrade.” frank partnoy, the siskel and ebert of financial markets?: two thumbs down for the credit rating agencies, 77 wash. u.l.q. 619, 677 (1999). thus, a default may indicate “a decline in the creditworthiness of the [issuer] of the reference [obligation].” jonathan talisman and joseph mikrut, writers make second request for guidance on credit default swaps, 2002 tnt 148-34 (july 02, 2002). 301. the periodic payments generally consist of “a fixed number of basis points applied to a notional principal amount” (equal to the reference obligation’s value at the time the cds is entered into). see nirenberg & kopp (1997), supra note 300, at 89. normally, the protection buyer will stop making payments when the default occurs, and in the absence of default, will continue making the payments until maturity of the cds. however, several other alternatives could be contemplated, including, for example, continuing making payment even after the default. 2008] the case for residency-based taxation 57 the time of the default, or (ii) the right to deliver the reference obligation to the protection seller for cash equal to its face amount. 302 a cds can cover the credit risk of a single reference obligation, various debt obligations of a single reference entity, or a group of reference obligations issued by different entities. 303 in general, taxpayers other than dealers enter into cdss for one of the following reasons: (i) a holder of a reference obligation can become a protection buyer to hedge the credit risk associated with holding the reference obligation; (ii) a trader or investor with a portfolio of less risky obligations can become a protection seller in order to enhance the yield on that portfolio (at the cost of undertaking additional risk); or (iii) a trader or investor can use a cds, either as a protection buyer or protection seller, to take a synthetic long or short position with respect to a reference obligation as part of its overall strategy of trying to maximize returns. 304 in regard to the cross-border aspects of cdss, the irs raised two questions in notice 2004-52: (i) whether a payment to or from a foreign counterparty should be subject to withholding tax in the u.s., and (ii) whether entering into cds contracts with u.s. counterparties could be construed as the conduct of a u.s. trade or business. in response to the irs’s request for comments, several commentators have indicated that the same reasons that lead congress to enact the securities trading exception and the source rules for periodic payments on notional principal contracts should apply to cdss. 305 302. id. physical settlement generally reflects the net economics of cash settlement because the protection buyer is compensated for the reduction in the reference obligation’s value by allowing it to sell the reference obligation to the protection seller at par. in the event the protection buyer decides to deliver a different obligation, such a different obligation should approximate the post-default amount of the reference obligation. see isda offers treasury documents on treatment of credit default swaps, 2003 tnt 232-17 (nov. 21, 2003). 303. frequently, a cds will reference multiple obligations. the protection seller will pay the protection buyer in the event one or more of those reference obligations are in default, regardless of whether the protection buyer actually holds any of the defaulting obligations. see bruce kayle, will the real lender please stand up? the federal income tax treatment of credit derivative transactions, 50 tax law. 569 (1997), n. 12. in addition, some cds contracts allow either the protection buyer or the protection seller to add or remove a reference obligation or obligor from the application of the contract. see isda comments (2003), supra note 302. 304. see garlock, et. al. (2005), supra note 230. 305. id. 58 florida tax review [vol. 9:1 iv. harmful tax competition a. overview as discussed above, professor avi yonah (2000) has cautioned in his influential article on globalization and tax competition that the enactment of the portfolio interest exemption in the united states in 1984 created a “race to the bottom” among nations. 306 this “race to the bottom” among countries, according to professor avi yonah, could be viewed as tax competition; not only do source countries not withhold on interest, but also residency countries do not have the ability to levy their taxes on such income; interest income, therefore, escapes taxation by either the source country or the residency country. 307 professor avi yonah wrote his article shortly after the issuance of the oecd report (1998), which contains thoughtful analysis of the elements of international tax competition and what measurements should be taken by both oecd and non-oecd members to curb such competition. 308 in 2000, the oecd issued a follow-up report which, among other things, identified several potentially harmful preferential tax regimes.” 309 both reports are discussed in greater detail below. b. the oecd project on harmful tax competition 1. general according to professor avi yonah, “[a] major contribution of the oecd report is that it lists factors to be used in identifying tax havens.” 310 while the report only addressed tax competition in oecd countries, it emphasized the need for dialog with non-oecd member countries. 311 paragraph 28 of the oecd report (2000) elaborated that: 306. avi-yonah (2000), supra note 3, at 1581. 307. id. at 1583-85. 308. the oecd report (1998), supra note 1, was approved by the oecd council, with abstentions from luxembourg and switzerland, on 9 april 1998, and was presented to ministers on april 27-28, 1998. see oecd report (1998), supra note 1, at 3. the report addressed harmful tax practices in both member and non-member countries. id. at 8, ¶ 5. 309. see “towards global tax co-operation, report to the 2000 ministerial council meeting and recommendations by the committee on fiscal affairs” (oecd 2000) (hereinafter “oecd report (2000)”). 310. avi-yonah (2000), supra note 3, at 1659. (citation omitted). 311. see oecd report (1998), supra note 1, at ¶ 13 (“the committee recognizes that since the problems discussed in this report are of an inherently global 2008] the case for residency-based taxation 59 harmful tax competition is by its very nature a global phenomenon and there-fore its solution requires global endorsement and global participation. countries outside the oecd must have a key role in this work since a number of them are either seriously affected by harmful tax practices or have potentially harmful regimes. thus, the oecd project on harmful tax competition is expected to impact not only member states but also many other countries, developed and developing. 312 nevertheless, while the oecd report (1998) “focuse[d] on geographically mobile activities, such as financial and other service activities,” 313 it did not specifically address the issues of portfolio interest. 314 the oecd report (1998) indicates that “tax havens” and “harmful preferential tax regimes” (see both definitions below) have the potential to cause harm by: – distorting financial and, indirectly, real investment flows; – undermining the integrity and fairness of tax structures; – discouraging compliance by all taxpayers; – re-shaping the desired level and mix of taxes and public spending; – causing undesired shifts of part of the tax burden to less mobile nature, it is critical that as many countries as possible are involved in the dialogue. the broader the economic grouping of countries engaged in this dialogue, the greater the effectiveness of any solutions proposed, since this would minimize any displacement of activities to jurisdictions with harmful tax practices outside of the participating countries. any displacement of activities may put more pressure on the implementation of counteracting measures if such activities are re-established in jurisdictions which operate non-transparent harmful tax practices. it is for these reasons that the committee has attached particular importance to associating non-member countries with its analytical and policy discussions on harmful tax competition.”). 312. see oecd report (2000), supra note 309, at 22, ¶ 30: it is important to take forward the work of the forum with regard to eliminating harmful tax practices on a global basis. to this end, the committee will encourage non-member economies to associate themselves with the 1998 report and to agree to its principles; and hold regional seminars that will encourage and assist non-member economies to remove features of their preferential regimes that are potentially harmful. 313. oecd report (1998), supra note 1, at 8, ¶ 6. 314. id. at 9-10, ¶ 12. 60 florida tax review [vol. 9:1 tax bases, such as labour, property and consumption; and – increasing the administrative costs and compliance burdens on tax authorities and taxpayers. 315 thus, if a certain tax regime contains all these elements, it should be treated as “harmful.” 316 nevertheless, regimes that only contain some of these elements may be somewhere in the spectrum between being valid regimes or harmful tax regime. 317 the oecd report (1998) distinguishes between three types of situations in which the tax levied in one country on income from mobile activities such as financial and other service activities is lower than the tax that would be levied on the same income in another country: i. tax havens the first country is a tax haven and, as such, generally imposes no or only nominal tax on that income. 315. id. at 16, ¶ 30. 316. id. at 16, ¶ 31. 317. id. in a study conducted four years later, the cato institute observed that [o]f the six, it appears that at least four harms – ” distorting financial and, indirectly, real investment flows,” “undermining the integrity and fairness of tax structures,” “discouraging compliance by all taxpayers,” and “increasing the administrative costs and compliance burdens on tax authorities and taxpayers” – are probably more true of high-tax regimes. see chris edwards & veronique de rugy, cato study on international tax competition, 2002 tnt 85-51, at ¶ 102 (may 2, 2002). ii. potentially harmful preferential tax regime the first country collects significant revenues from tax imposed on income at the individual or corporate level but its tax system has preferential features that allow the relevant income to be subject to low or no taxation. 2008] the case for residency-based taxation 61 iii. non-harmful tax competition the first country collects significant revenues from tax imposed on income at the individual or corporate level but the effective tax rate that is generally applicable at that level in that country is lower than that levied in the second country. 318 the oecd report (1998) does not deal with the third category (which is therefore not discussed in this article), and distinguishes between the first category (“tax havens”), and the second category (“potentially harmful preferential tax regimes.”) 319 2. tax havens a tax regime could be considered a “tax haven” if: (a) [it] imposes no or only nominal taxes and offers itself, or is perceived to offer itself, as a place to be used by non-residents to escape tax in their [residency country]; (b) [its] laws or administrative practices prevent the effective exchange of relevant information with other governments on taxpayers benefiting from the low or no tax jurisdiction; (c) [its laws] lack transparency and (d) [it has no] requirement that the activity be substantial [which] would suggest that [it] attempt[s] to attract investment or transactions that are purely tax driven. 320 this article does not endorse adopting any of these tax-haven elements. thus, my proposed residency-based regime for financial transactions should not result in country d being treated as a tax haven under the above standards. the remainder of this article will focus only the second category (i.e., the “potentially harmful preferential tax regimes.”). 318. oecd report (1998), supra note 1, at 19-20, ¶ 40. 319. id. at 20-21, ¶ 44. 320. id. at 22, ¶ 52. 3. potentially harmful preferential tax regimes pursuant to paragraph 59 of the oecd report (1998), there are 62 florida tax review [vol. 9:1 four key factors [that] assist in identifying harmful preferential tax regimes: (a) the regime imposes low or zero effective tax rate on the relevant income; (b) the regime is “ring-fenced;” (c) the operation of the regime is non-transparent; and (d) the jurisdiction does not effectively exchange information with other countries. 321 a harmful preferential tax regime exists only where the relevant income is subject to low or zero effective tax rate [the first factor] and one or more of the other factors [also exists]. 322 while my proposal would probably satisfy the first factor because it would eliminate source-based taxation on several types of passive income, country d could easily avoid becoming a harmful preferential tax regime by making sure that it would not fall under any of the other three factors, as discussed below. 323 “ring-fencing” for this purpose includes: (i) exclusions of residents “from taking advantage of [the regime’s tax] benefits,” and (ii) prohibiting “enterprises which benefit from the regime from operating in the domestic market.” 324 “non-transparency” includes: “[(i) favorable] application of laws and regulations, [(ii)] negotiable tax provisions, and [(iii)] a failure to make widely available administrative practices.” 325 finally, “[t]he lack of effective exchange of information in relation to taxpayers benefiting from the operation of a preferential tax regime is [also] a strong indication that a country is engaging in harmful tax competition.” 326 in my view, there is no reason why country d would not be able to avoid all of these three conditions. in fact, as illustrated in table 3 below, many 321. id. at 25, ¶ 59. 322. id. at 26, ¶ 59. 323. other less important factors identified by the oecd report (1998), supra note 1, include: [(i)] an “artificial definition of the tax base;” [(ii)] a “failure to adhere to international transfer pricing principles;” [(iii)] the exemption of foreign source income from tax; [(iv)] a negotiable tax rate or base; [(v)] “secrecy provisions” such as bank secrecy laws or bearer debt; (vi) membership in “a wide network of tax treaties;” [(vii)] selfpromotion as “tax minimization [sic] vehicles;” and [(viii)] the “encouragement of tax-driven operations.” see avi-yonah (2000), supra note 3, at 1660, (quoting from the oecd report (1998), supra note 1 at 30-34, ¶ 68-79.) 324. oecd report (1998), supra note 1, at 26-27, ¶ 62 and box ii. 325. id. at 1, ¶ 63. 326. id. 2008] the case for residency-based taxation 63 countries, including the u.s., that provide for preferential treatment of income from financial transaction (i.e., fall under condition number 1), have been able to avoid being classified by the oecd as “potentially harmful preferential tax regimes.” 4. the oecd follow-up report (2000) in 2000, the oecd issued a follow-up report which, among other things, identified several potentially harmful preferential tax regimes. 327 as illustrated by table 3, the list of such potentially harmful preferential tax regimes does not include the united states or any other jurisdiction solely because it applies any of the three proposals discussed in this article. 328 furthermore, as of today, none of such practices has been defined as creating a potential for harmful tax competition. table 3 country regimes [footnote omitted] insurance australia offshore banking belgium co-ordination centres finland aland captive insurance regime italy trieste financial services and insurance centre [footnote omitted] ireland international financial services centre portugal madeira international business centre luxembourg provisions for fluctuations in re-insurance companies sweden foreign non-life insurance companies financing and leasing belgium co-ordination centres hungary venture capital companies hungary preferential regime for companies operating abroad iceland international trading companies ireland international financial services centre 327. see oecd report (2000), supra note 309, at 12, ¶ 10. 328. id. supra note 311, at 12-13, ¶ 10-11. ireland shannon airport zone italy trieste financial services and insurance centre [footnote omitted] 64 florida tax review [vol. 9:1 luxembourg finance branch netherlands risk reserves for international group financing netherlands intra-group finance activities netherlands finance branch spain basque country and navarra co-ordination centres switzerland administrative companies fund managers greece mutual funds/portfolio investment companies [taxation of fund managers] ireland international financial services centre [taxation of fund managers] luxembourg management companies [taxation of management companies that manage only one mutual fund (1929 holdings)] portugal madeira international business centre [taxation of fund managers] banking australia offshore banking units canada international banking centres ireland international financial services centre italy trieste financial services and insurance centre [footnote omitted] korea offshore activities of foreign exchange banks portugal external branches in the madeira international business centre turkey istanbul offshore banking regime headquarters regimes belgium co-ordination centres france headquarters centres germany monitoring and co-ordinating offices greece offices of foreign companies netherlands cost-plus ruling portugal madeira international business centre spain basque country and navarra co-ordination centres switzerland administrative companies switzerland service companies distribution centre regimes belgium distribution centres 2008] the case for residency-based taxation 65 france logistics centres netherlands cost-plus/resale minus ruling turkey turkish free zones service centre regimes belgium service centres netherlands cost-plus ruling shipping [footnote omitted] canada international shipping germany international shipping greece shipping offices greece shipping regime (law 27/75) italy international shipping netherlands international shipping norway international shipping portugal international shipping register of madeira miscellaneous activities belgium ruling on informal capital belgium ruling on foreign sales corporation activities canada non-resident owned investment corporations netherlands ruling on informal capital netherlands ruling on foreign sales corporation activities united states foreign sales corporations c. summary to summarize, my proposed regime for country d should not constitute “harmful tax competition” for several reasons. first, as discussed above, taxation of passive income by the residency country rather than the source country is consistent with the principles set forth by the league of nations in both the 1923 report and the 1928 treaty model. this regime is an integral part of the “international tax regime” and has become so fundamental in domestic laws, as well as tax treaties, that it is hard to classify it as a “harmful” regime. second, as set forth above, the oecd report (1998) contains several elements, the existence of which could result in classifying the tested tax regime as a potential harmful preferential tax regime. the list included four factors and the existence of the first one plus any of the other three could result in classifying the tax regime as a potential harmful preferential tax regime. nevertheless, in my view, while country d would most likely satisfy the first prong, it could easily avoid falling under any of the other three elements. my recommendation, of 66 florida tax review [vol. 9:1 course, would be to ensure that none of these three elements exist in country d. third, the portfolio interest exemption has never been described by the oecd as creating harmful tax competition. 329 furthermore, the oecd report (2000), which identified various tax regimes as tax havens or potential harmful preferential tax regimes, has not identified any of the three proposals set forth in this article as creating harmful tax competition. 330 finally, the oecd report (1998) acknowledged that developing countries may have valid reasons to provide tax incentives to foreign investors even if such policy may be viewed as engaging in tax competition. 331 specifically, the oecd report (1998) stated that “countries with specific structural disadvantages, such as poor geographical location, lack of natural resources, etc., frequently consider that special tax incentives or tax regimes are necessary to offset non-tax disadvantages, including any additional cost from locating in such areas.” 332 v. conclusion developing countries typically struggle between the need to raise tax revenue and the need to attract foreign investors. 333 the decision is even harder in the case of financial investments that are not only highly mobile but also sensitive to taxation. withholding taxes has the same effect as tariffs by virtue of raising the domestic costs of capital. 334 as this article concludes, residency-based taxation for financial transaction is recommended to developing countries for the following reasons: (i) globalization and mobility of capital, (ii) harmonization of the tax system with that existing in developed countries and participating in tax treaties, and (iii) promoting equity, efficiency and simplicity. my proposed regime will speed up country d’s integration in the 329. cf. marshall j. langer, harmful tax competition: who are the real tax havens?, 90 tax notes 665, 668-69 (jan. 05, 2001) (reviewing the oecd report (2000) and arguing that the portfolio interest exemption should be viewed as an attribute of harmful tax competition). 330. oecd report (2000), supra note 309, at 12-14, ¶ 11. 331. oecd report (1998), supra note 1, at 15, ¶ 27. 332. id. see also avi-yonah (2000), supra note 3, at 1639-48. 333. see generally, avi-yonah (2000), supra note 3, at 1639-48. 334. merrill et. al. supra note 30, at 1388-9 (“a country that imposes withholding taxes and other barriers to the importation of capital will restrict domestic investment, thereby lowering labor productivity and wages. thus, for the same reason that countries have sought tariff reductions through the gatt and free trade agreements, it generally is in every country’s self interest to seek reciprocal elimination of withholding taxes.”). 2008] the case for residency-based taxation 67 globalization process, which in itself has an impact on the size and composition of the public’s financial asset portfolio and capital movements. as a practical matter, country d can learn from other countries’ experience and adopt rules that are consistent with common practices in the tax and accounting arenas in major developed countries. such consistency will enhance country d’s role in the process of globalization of capital markets. furthermore, residency-based taxation in general and for financial transactions in particular has been praised as a method to promote equity and efficiency. equity is promoted because residency-based taxation better reflects the ability to pay principle. such a regime would also be efficient since it will minimize the tax system’s impact on investment decisions by reducing the distortions caused by the tax system. 335 finally, residency-based taxation will reduce compliance costs, since the source-based taxation on interest and dividend income earned by nonresidents is very impractical in many instances. residency-based taxation, however, would shift revenue from developing to developed countries in the short-run, but as discussed in this article, it would benefit country d in the long-run. 335. see rosenbloom, supra note 32, at 606 (“financial market participants often inveigh against source taxation, particularly source taxation on a gross basis, on the ground that such taxation interferes with marketplace efficiency.”) traders article syo final edits 7-22-08 florida tax review 1113 ____________________________________________________________ volume 8 2008 number 10 a structural critique of trader taxation by shu-yi oei* i. introduction ........................................................................... 1114 ii. r ules governing the taxation of securities traders ..................................................................................... 1116 a. rules with respect to deductions................................... 1119 b. rules with respect to character of income.................... 1124 c. the irc section 475(f) mark-to-market election.......... 1125 d. summary......................................................................... 1126 iii. “t rader” taxation : a tale of two concepts ............... 1128 a. the importance of being “engaged in a trade or business”.....................................................................1129 b. the “to customers” requirement and the character of income ……………………………………………….1138 c. the intersection of disjoint concepts: a structural look at trader taxation.......................................................... 1143 iv. some critiques of trader taxation ................................. 1147 a. non-structural criticisms............................................... 1147 b. structural criticisms....................................................... 1150 c. summary......................................................................... 1156 v. structural remediation by the courts and the legislature ...................................................................... 1157 a. court decisions regarding capital asset classification: minimizing the “to customers” requirement............... 1157 b. the enactment of irc section 475(f)............................. 1162 c. an argument for change................................................ 1165 vi. conclusion …………………………………………………...1167 * harvard law school, j.d., 2003; harvard divinity school, m.t.s., 2003; brown university, a.b., 1999. associate, bingham mccutchen llp, boston, ma. the views expressed in this article are solely the views of the author and do not necessarily represent the views of the firm. the author is grateful to jessica a. lapointe for her comments on prior drafts. 1114 florida tax review [vol. 8:10 section i: introduction taxpayers who are securities traders are subject to unusual treatment under the tax law.1 such a taxpayer is, like any other merchant or businessperson, allowed to deduct various expenses incurred in his business of trading securities but, unlike any other merchant or businessperson, is simultaneously allowed to treat gains and losses from the sale of such securities as capital, rather than ordinary, gains and losses. such capital gains and losses may be taxed at reduced rates and subject to other different tax treatments.2 since the enactment of irc section 475(f) in 1997, traders have also been allowed to make a special election to “mark to market” gains and losses from their securities-trading activities.3 making this election allows a trader to recognize gains and losses on the securities he holds as if those securities were sold at fair market value on the last business day of the trader’s taxable year, and to convert such gains or losses to ordinary, rather than capital, gains or losses.4 the distinctive tax treatment of securities traders has been frequently pointed out, and various commentators have noted that, although the standards for qualifying for trader treatment are uncertain, favorable planning opportunities arise upon achieving such classification.5 however, 1. harrison b. mccawley, transactions in stock, securities and other financial instruments, 184-4th tax mgmt. (bna) a-1 – a-4(1); irs tax topic 429, available at http://www.irs.gov/taxtopics/tc429.html (last visited jan. 26, 2008). 2. under present law, taxpayers who hold “capital assets” over a long-term holding period (generally, more than 12 months) will be subject to reduced tax rates on disposition of that asset. irc §§ 1(h)(1), 1222(3), 1222(4). the history of and reasons for the differential tax treatment of capital assets is a subject that has been much discussed. see leonard e. burman, the labyrinth of capital gains tax policy: a guide for the perplexed (brookings instit. press 1999). 3. taxpayer relief act of 1997, pub. l. no. 105-34, §§ 1001(b), (d)(4), 111 stat. 788, 906-08 (1997). 4. irc § 475(f). 5. see, e.g., glenn p. schwartz, how many trades must a trader make to be in the trading business, 22 va. tax rev. 395, 409-10 (2003); burgess j.w. raby & william l. raby, effect of “sporadic” activity on securities trader status, 103 tax notes 1375 (june 14, 2004) [hereinafter raby, effect of “sporadic” activity]; burgess j.w. raby & william l. raby, nondealer security losses: capital or ordinary? 115 tax notes 45, 46 (apr. 2, 2007) [hereinafter raby, nondealer security losses]; lee a. sheppard, news analysis: making traders mark to market, 76 tax notes 721 (aug. 11, 1997); burgess j.w. raby & william l. raby, ordinary deductions, but capital losses for securities traders, 74 tax notes 611 (feb. 3, 1997) [hereinafter raby, ordinary deductions but capital losses] (referring to trader status as a “tax oddity”); burgess j.w. raby & william l. raby, trader, gambler, or investor, & tax consequences thereof, 85 tax notes 1665 (dec. 27, 2008] a structural critique of trader taxation 1115 the structural elements of the tax law underlying trader tax treatment and the problems created by this statutory structure have somewhat escaped scrutiny. this article approaches the unusual treatment of traders through a structural lens. by focusing on the structure of the statutory tax rules that apply to securities traders, this article explains at the outset how the unusual treatment of securities traders today has occurred due to a long-standing, legislatively created structural disjuncture at the point where the capital asset rules and the “trade or business” concept intersect. this disjuncture was created by the 1934 introduction of the “to customers” requirement into the capital asset statute, that is, the requirement that property otherwise held for sale in the ordinary course of the taxpayer’s trade or business must also be held for sale “to customers” in order to escape being treated as a capital asset.6 prior to the 1934 introduction of the “to customers” requirement, the statute was essentially symmetrical in the sense that whether or not a trader–taxpayer was in a “trade or business” led to basically all of the tax consequences to that taxpayer. the introduction of the “to customers” requirement has led to a statutory scheme in which one standard determines the character of the gain or loss from the sale of securities of the trader–taxpayer, but a completely different standard (the trade or business requirement) gives rise to almost all of the other consequences with respect to deductions from gross income that apply to a trader. this article explores some of the problems created by this disjuncture in the structure of the current tax rules that apply to traders, and argues that the effects of this structural disjuncture would be even more pronounced if not for the interventions of the courts and the legislature, which, from a structural standpoint, have served to minimize the impact of this disjuncture without eliminating it altogether. given the volatility inherent in the statutory structure of the trader tax rules, and given that the courts and the legislature have already taken steps to minimize the impact of the disjoint statutory structure, it is the position of this article that a different approach needs to be taken in taxing traders. specifically, the “to customers” requirement should be eliminated altogether, traders should be taxed like dealers (including with respect to the accounting method required), and the irs should supplement court decisions, which make trader status difficult to attain, with stringent and concrete guidance of its own. such an approach would reduce complexity and add a degree of rationality to the taxation of traders that is missing from the current approach. section ii of this article briefly outlines the tax treatment of securities traders under current law, and discusses the basic differences 1999) [hereinafter raby, trader, gambler, or investor]; kaye a. thomas, trading, but not a trader, 104 tax notes 274 (july 19, 2004). 6. revenue act of 1934, pub l. no. 73-216, § 117(b), 48 stat. 680, 714 (1934). 1116 florida tax review [vol. 8:10 between the tax treatment of securities traders, dealers, and investors. section iii delves into a structural analysis of the actual tax concepts that underlie the differing tax treatments of traders, dealers, and investors and shows that, while the majority of the tax consequences to a securities trader on the deductions side are based on whether the taxpayer is “engaged in a trade or business,” the character of such trader’s gains or losses is determined based on whether the assets bought or sold are capital assets under the capital asset statute, irc section 1221. as a result of the 1934 introduction of the “to customers” requirement into irc section 1221, the gating item in determining whether such assets are capital assets lies not with whether or not the taxpayer is engaged in a trade or business, but rather with whether she has customers to whom such securities are being sold. section iii then argues that these rules represent an intrinsically problematic asymmetry in the statutory structure that creates odd tax results for the securities trader and that needs to be examined critically. section iv surveys some of the criticisms that have been lodged against the way traders are taxed, and offers some new critiques of trader taxation from a structural perspective. section v shows that the reason the structural asymmetry and volatility in the statutory rules wrought by the “to customers” requirement have not been more problematic is because of structural remediation efforts by the courts and the legislature: courts have outright ignored the “to customers” requirement outside of the securities context, and congress has taken steps – via the creation of the irc section 475(f) “mark-to-market” election – to ameliorate the nonsensical results created by the statutory structure without actually addressing the fundamental problem caused by the statutory language. in section vi, this article concludes that since (i) the structure of the statutory rules has the potential to cause pervasive problems, (ii) courts are essentially creating a judicial fix by ignoring the statutory language of the capital asset statute in other contexts, (iii) congress has essentially created its own opt-in solution to the problem, and (iv) the courts and the irs have taken steps to render attainment of trader classification difficult, the “to customers” requirement in the capital asset definition should be eliminated, and a different approach taken, in order to effect a more efficient and equitable statutory structure. the approach recommended in section vi of this article would minimize the problems associated with the tax treatment of traders, and would ease the degree of complexity and irrationality embedded in trader taxation, and would do so without necessarily creating further abuses or difficulties in place of the current ones. section ii: rules governing the taxation of securities traders broadly speaking, the tax law distinguishes between three different classes of taxpayers in determining the tax consequences to a taxpayer who 2008] a structural critique of trader taxation 1117 buys, sells, or holds securities: traders, dealers, and investors.7 the tax consequences of buying, selling, and holding such securities differ significantly depending on the classification of the person doing the buying, selling, or holding.8 traders in some sense occupy the middle ground between dealers and investors. therefore, it is essential to understand the meaning of the terms “investor” and “dealer” in order to understand “trader” classification. “investor” is the default tax classification of most taxpayers owning securities. therefore, a typical individual who holds stocks and securities will usually be assumed to be an investor, absent circumstances suggesting otherwise.9 an investor, unlike a dealer or a trader, is one who purchases and sells securities for the principal purpose of realizing gains from appreciation in the value of the security over a relatively long period of time.10 therefore, an investor’s holding period for securities is usually longer than that of a trader.11 in direct contrast to investors in securities, those taxpayers classified as dealers are taxpayers that are in the business of buying and selling securities to customers, and are usually broker–dealers registered with the sec and licensed by state securities regulators.12 “dealer” has been defined in treasury regulations as “a merchant of securities, whether an individual, partnership or corporation, with an established place of business, regularly engaged in the purchase of securities and their resale to customers.”13 as discussed further below, dealers generally hold securities as inventory, seek to profit on the resale of those securities at marked up prices (having bought them at a lower cost), and may engage in hedging transactions to minimize risk.14 dealers therefore act like merchants with respect to securities they buy and sell. “trader” classification is reserved for those taxpayers who are not securities broker–dealers but who have managed to establish to the irs that they are not investors. in everyday parlance, the term generally refers to those individuals who actively buy and sell securities held over the short 7. see thomas, supra note 5, at 274. 8. id. 9. mccawley, supra note 1, at a-4; see also federal tax coordinator (ria) 2d at ¶ l-1112 (“[m]ost taxpayers who manage their own investments will be treated as investors rather than traders”). 10. mccawley, supra note 1 at a-4; see also raby, effect of sporadic activity, supra note 5, at 1375. 11. see generally raby, effect of sporadic activity, supra note 5 at 137576; federal tax coordinator (ria) 2d at ¶¶ l-1112, l-1112.1. 12. mccawley, supra note 1, at a-2. 13. treas. regs. § 1.471-5. 14. mccawley, supra note 1, at a-2; see also federal tax coordinator (ria) 2d at ¶ i-6205 (“a dealer…intends to profit by earning a ‘mark-up’ from laboring as a middleman”). 1118 florida tax review [vol. 8:10 term for their own account, such as individuals who engage in online trading of stocks and securities.15 the term has a similar meaning in the tax law, although a taxpayer has to meet certain specific requirements in order to be considered a trader for tax purposes, and not every online trader or day trader will qualify to be treated as a trader under the tax law.16 a trader, unlike a dealer, does not hold securities as inventory to be sold to brokerage clients, but instead tends to engage primarily in speculation in securities and seeks to profit from short swings in the market.17 as will be elaborated later in this article, traders are distinct from investors in that they are engaged in the “trade or business” of trading in securities.18 the united states supreme court first drew a clear distinction between the category of “investor” and that of “trader” in snyder v. comm’r, a case in which it held that a margin trader had not shown that his trading operations constituted a trade or business.19 the court noted (justice brandeis writing) that the board of tax appeals had held that a taxpayer who “devotes a major portion of his time to speculating on the stock exchange” could treat his losses as incurred in the course of a trade or business, but that the taxpayer in snyder had not shown that he had devoted the requisite time and effort to his stock transactions, and therefore had not shown that he should be properly characterized as a “trader on an exchange, who makes a living buying and selling securities.”20 thus, the possibility of claiming the status of being a trader was born.21 the question of whether a 15. see, e.g., black’s law dictionary 1501 (7th ed. 1999) (defining “trader” as “3. one who, as a member of a stock exchange, buys and sells securities on the exchange floor either for brokers or for on his or her own account”); webster’s new world college dictionary 1517 (4th ed. 1999) (defining “trader” as “3. a stockbroker who trades esp. for his own account rather than customers’ accounts”); see also schwartz, supra note 5, at 399-405 (discussing the emergence of day trading by members of the public). 16. see section iii, infra; see also mccawley, supra note 1, at a-4. 17. mccawley, supra note 1, at a-2 see also federal tax coordinator at ¶ i6205 (“[a] trader … intends to profit solely from advantageous purchases of stocks or securities or from rises in the values of stock or securities during the time he holds them”). 18. see section iii, infra. 19. snyder v. comm’r, 295 u.s. 134 (1935). 20. id. at 139 (citing schwinn v. comm’r, 9 b.t.a. 1304 (1928); elliott v. comm’r, 15 b.t.a. 494 (1929); hodgson v. comm’r, 24 b.t.a. 256 (1931); schermerhorn v. comm’r, 26 b.t.a. 1031(1932)). 21. id.; see also comm’r v. groetzinger, 480 u.s. 23, 33-34 (1987) (noting justice brandeis’ “impli[cation] that a full-time trader may qualify as being in a trade or business”). 2008] a structural critique of trader taxation 1119 holder of securities is a trader or an investor for tax purposes has been approached by many courts over several decades.22 in some sense, the terms “dealer,” “trader,” and “investor” are merely shorthand descriptions for how these taxpayers are treated under the tax law.23 put another way, to say that a taxpayer is a trader or a dealer or an investor is simply to say that the taxpayer is subject to the tax rules that apply to that class of taxpayers. the following summarizes some of the major tax rules that may apply to each of these types of taxpayers, depending on how they are classified. in brief, traders and dealers in securities will be entitled to take certain ordinary deductions incurred in their securities trade or business, while investors will not. traders, unlike dealers, however, will be entitled to treat their gains and losses from the sales of securities as capital gains and losses, rather than ordinary gains and losses. a. rules with respect to deductions as is the case with other taxpayers, the tax picture of the taxpayer who holds securities is made up of income, gains, and profits, as well as deductions for expenses and losses. many of the cases in which courts are called upon to determine whether a taxpayer is a trader, as opposed to an investor, arise on the deductions side, in the context of needing to determine whether that taxpayer is entitled to take certain deductions. taxpayers who are classified as investors will generally be denied “trade or business”– related deductions, which can be quite valuable, while taxpayers who are either dealers or traders are allowed such deductions. the following are some of the “trade or business”– type deductions that may be allowed to traders (and dealers) in securities, but that are denied investors. i. irc section 162 deductions perhaps the most significant deduction allowed to traders and dealers that is denied to mere investors is the deduction under irc section 162 for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”24 irc section 162 deductions are 22. see, e.g., higgins v. comm’r, 312 u.s. 212 (1941); chen v. comm’r, 2004 t.c.m. (ria) ¶ 2004-132; archaya v. comm’r, no. 9461-05 (7th cir. 2007) (fed. r. app. p. 32.1 nonprecedential disposition). 23. boris i. bittker & lawrence lokken, federal income taxation of income, estates & gifts, at ¶ 47.2 (3d ed. 2005) (“the terms ‘dealer’ and ‘trader,’ which do not appear in § 1221(a)(1) itself, are simply labels – the ‘dealer’ referring to a taxpayer who holds securities for sale to customers in the ordinary course of a trade or business and the ‘trader’ to a taxpayer who does not have ‘customers’ even though he or she buys and sells securities with great frequency”). 24. irc § 162. 1120 florida tax review [vol. 8:10 deducted on the taxpayers schedule c (profit or loss from business) and are “above the line” deductions that reduce adjusted gross income.25 mere investors, on the other hand, not being in a trade or business, are not eligible for irc section 162’s trade or business deductions, and instead will deduct most of their investment expenses under irc section 212 as “below the line” itemized deductions.26 such itemized deductions are subject to limitations, such as the 2% floor on miscellaneous itemized deductions, and may be completely eliminated if the taxpayer is subject to the alternative minimum tax.27 ii. applicability of investment interest limitations irc section 163 generally allows a deduction for all interest paid on indebtedness during the taxable year, but limits the deductibility of “investment interest” to “net investment income.”28 investors will therefore only be able to deduct their interest expenses to the extent that they have “net investment interest,” that is, the excess of “investment income” over “investment expenses.”29 traders and dealers, however, who are actively engaged in a trade or business, may be able to take unlimited interest expense deductions, although their ability to take such interest deductions may be limited if the trader or dealer is found to not “materially participate” in the trade or business activity to which the interest expense relates.30 25. see schedule c to form 1040, available at http://www.irs.gov/pub/irspdf/f1040sc.pdf (last visited jan. 19, 2008). 26. irc § 212 (providing that “[i]n the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year – (1) for the production or collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax”); see also schedule a to form 1040, available at http://www.irs.gov/pub/irspdf/f1040sab.pdf (last visited jan. 19, 2008); see also federal tax coordinator (ria) 2d at ¶ l-4005 (listing some of the deductions that have been allowed investors under irc § 212). 27. irc § 67(a); treas. reg. § 1.67-1t(a)(1)(ii)); see, e.g., mayer v. united states, 67 t.c.m. (cch) 2949, 2949-5 n. 11 (1994); see also raby, ordinary deductions but capital losses, supra note 5, at 612 (discussing mayer). 28. irc § 163. 29. irc § 163(d)(4). 30. “investment interest” is defined as interest on indebtedness that is properly allocable to “property held for investment,” and “net investment income” is defined, generally, as the taxpayer’s net income from “property held for investment” plus certain gains from the disposition of such property. irc § 163(d). generally, gain from dispositions that is included in “investment income” is the excess of any net gain over any net capital gain from dispositions of property held for investment, subject to an election to include the taxpayer’s net capital gain as “investment 2008] a structural critique of trader taxation 1121 therefore, traders who hold large amounts of debt, which exceed their income from investments, will be at an advantage as compared to investors who attempt to do the same.31 iii. election to deduct certain depreciable property traders and dealers may be able to elect to deduct expenses for certain depreciable property under irc section 179(a).32 that section provides that “[a] taxpayer may elect to treat the cost of any section 179 property [i.e., certain depreciable property] as an expense which is not chargeable to capital account” and that “[a]ny cost so treated shall be allowed as a deduction for the taxable year in which the section 179 property is placed in service.”33 however, one of the requirements for qualification as “section 179 property” is that the property must be “acquired by purchase for use in the active conduct of a trade or business.”34 therefore, investors who, unlike traders and dealers, are not engaged in the “active conduct of a trade income” by foregoing favorable capital asset treatment with respect to such gain. since “property held for investment” includes property that produces, in general, interest, dividends, annuities, or royalties “not derived in the ordinary course of a trade or business,” or gain or loss on the disposition of property producing such income (irc §§ 163(d)(5), 469(e)(1)), traders and dealers for whom such income is, in fact, “derived in the ordinary course of a trade or business” are not considered to hold “property held for investment” (in this case, securities), and their interest expense incurred to purchase such securities will not be subject to the limitations on investment interest. however, the trader or dealer may nonetheless be subject to the investment interest limitations if the interest is held by the trader or dealer in an activity involving the conduct of a trade or business that is not a “passive activity within the meaning of the code and with respect to which the trader or dealer does not “materially participate.” if the trader or dealer does not “materially participate” in the trade or business, then the property held by the trader or dealer may be treated as “property held for investment” the interest expense may be subject to the limitation on investment interest notwithstanding the existence of the trade or business. irc § 163(d)(5); see also rev. rul. 2008-12, 2008-10 irb 520 (feb. 19, 2008) (non-corporate limited partner’s distributive share of partnership interest expense allocable to securities trading was subject to investment interest deduction limitation, where limited partners did not “materially participate”). 31. see also instructions to 2007 internal revenue service form 1040 schedule d, at d-3 (“[t]he limitation on investment interest expense that applies to investors does not apply to interest paid or incurred in a trading business”), available at http://www.irs.gov/pub/irs-pdf/i1040sd.pdf (last visited jan. 6, 2008). 32. irc § 179(a). such property would include tangible macrs property and certain computer software, if such property meets certain other requirements. irc §§ 179(d)(1)(a); 168. 33. irc § 179(a). 34. irc § 179(d)(1)(c). 1122 florida tax review [vol. 8:10 or business” will not be eligible to expense such property as a deduction under irc section 179 but must instead capitalize their costs. iv. election to deduct certain start-up expenditures under irc section 195, a taxpayer who begins an active trade or business during a taxable year may elect to deduct certain start-up expenses rather than capitalizing them.35 a trader or dealer in securities, being in the trade or business of trading, may be eligible to elect to take such deductions in the year he starts his trade or business of trading. however, such an election would not be available to an investor, since an investor is not similarly engaged in a trade or business. v. home office deductions unlike investors, traders and dealers may be able to take a deduction for expenses incurred for a “home office.” irc section 280a(a) generally disallows deductions that might otherwise be allowable with respect to the use of a “dwelling unit” that is also used by the taxpayer as a residence during the taxable year.36 therefore, an investor who has a “home office” may not take any deductions attributable to that home office. however, irc section 280a(c)(1) creates an exception for the portion of the “dwelling unit” that is used exclusively and regularly by the taxpayer as its “principal place of business for any trade or business.”37 therefore, a trader who is engaged in the trade or business of trading and who uses a home office as the principal place of his business may be able to deduct expenses incurred for that home office, while an investor will not. vi. other deductions in addition to the deductions mentioned above, dealers and traders may be able to take various other deductions for trade or business–related expenses. these deductions may include depreciation deductions and net operating loss deductions.38 35. irc § 195. 36. irc § 280a. 37. irc § 280a(c)(1). 38. irc §§ 167, 168, 172. see hart v. comm’r, 73 t.c.m. (cch) 1684 (1997), aff’d 135 f.3d 764 (3d cir. 1997) (investor taxpayer was denied net operating loss deduction); ball v. comm’r, 80 t.c.m. (cch) 184 (2000) (investor taxpayer was denied deductions for office expenses, interest and depreciation). 2008] a structural critique of trader taxation 1123 vii. application of irc section 469 “passive loss” rules the application of the passive activity loss rules to traders is also worth noting. these rules were enacted in 1986 to prevent individuals from using passive losses from tax shelters to reduce taxable income by offsetting such passive losses against non-passive income.39 the passive loss rules define a “passive activity” as any activity involving the conduct of any “trade or business” in which the taxpayer does not “materially participate.”40 however, for purposes of the passive loss rules, the term “trade or business” includes an “activity in connection with a trade or business” as well as an activity with respect to which expenses are allowable as a deduction under irc section 212.41 since investors may take deductions under irc section 212, both traders and investors have the potential to be subject to the passive loss limitations of irc section 469. however, in the case of a trader (or dealer) taxpayer who actively carries out his trading or dealing activities himself, such trading activity should not normally be considered a passive activity, as long as that taxpayer “materially participates” in such activity.42 therefore, if the trader–taxpayer shows a business loss on schedule c after taking these deductions, such loss should normally be available to offset ordinary, non-passive income, (including personal services income). such deductions would therefore be beneficial to a trader or dealer as offsets to ordinary income. whether the investor would be subject to the passive loss rules would ultimately depend on whether that investor “materially participates” in managing his investments and on whether that investor’s income is portfolio income, or is otherwise excluded from treatment as passive income.43 39. tax reform act of 1986, pub. l. 99-514, § 501(a), 100 stat. 2085, 2233-41 (1986). 40. irc § 469(c)(1). 41. irc § 469(c)(6). 42. irc § 469(c), (h). as discussed in section iii below, an individual trader who is actually actively involved in trading would likely be regarded as “materially participating” in the trade or business of trading, and in such case, the deductions described in this section ii should not be regarded as losses from a passive activity. see treas. reg. § 1.469-5t(a). see also treas. reg. § 1.4691t(e)(6)(ii),(iii) (activity of trading personal property for the account of owners of interests in the activity is not a passive activity, without regard to whether such activity is a trade or business activity; for example, a partnership securities trader is treated as conducting such an activity for the account of its partners, so the activity is not a passive activity). but see dean v. irs, 2007 wl 445938 (w.d. wash.) (passive loss limitations barred taxpayer’s claim to carry back his share of familyowned partnership’s securities activities loss where taxpayer failed to show material participation). 43. see, e.g., mayer v. comm’r, 67 t.c.m. (cch) at 2951 (taxpayer who was an investor materially participated in securities activities, so such activities were 1124 florida tax review [vol. 8:10 b. rules with respect to character of income while traders and dealers are treated similarly to each other (and differently from investors) with respect to their eligibility for deductions allowable under irc section 162 and other business-related deductions for expenses incurred in carrying on a “trade or business,” their treatment diverges with respect to the character of the income realized upon the sale of such securities. securities dealers will realize ordinary gains and losses on sales of securities they hold as inventory (that is, most of the securities they hold).44 such ordinary income treatment is akin to that accorded to other kinds of merchants who hold their goods as inventory or “stock in trade” to be sold to their customers at a profit.45 on the other hand, a securities trader’s profit or loss from his trading activity will generally be considered capital gain or loss, although it will usually be short-term capital gain or loss, since traders by definition usually seek to profit from short-term swings in the market.46 such short-term capital gain or loss will be taxed at ordinary income rates under present law, rather than at the more favorable rates accorded to capital assets with a long-term holding period.47 however, traders are not altogether precluded from realizing long-term capital gain or loss from those investments held for longer periods of time, although (as discussed below) the existence of too many of such securities may be evidence of non-trader status.48 furthermore, as capital losses, the trader’s losses may only be offset against capital gains, and individual taxpayers may only deduct $3,000 of their excess capital losses against their taxable (ordinary) income.49 dealers, on the other hand, may deduct their losses, which are ordinary, against ordinary income. not subject to passive loss limitations under irc § 469; income from securities investments was portfolio income); see also irc § 469(e)(1)(a). 44. mccawley, supra note 1, at a-2. however, apart from having inventory securities, a dealer may also hold some securities for his own account as investment. if the securities dealer “properly identifies” a security as held for investment rather than inventory, then he will have capital gain or loss on the sale of that security. irc § 1236(a). 45. irc § 1221(a)(1). 46. see, e.g., kemon v. comm’r, 16 t.c. 1026, 1033 (1951); see generally mccawley, supra note 1, at a-3. 47. irc §§ 1(h), 1222, 1223. 48. see, e.g., moller v. u.s., 721 f.2d 810 (fed. cir. 1983); mayer v. u.s., 32 fed. cl. 149 (1994); mayer, 67 t.c.m. (cch) at 2949-5; estate of yaeger v. comm’r, 889 f.2d 29, 34 (2d cir. 1989); see also infra section iii. 49. irc §§ 172(d)(2), 1211(b), 1212(b); jamie v. comm’r, 2007 t.c.m. (ria) ¶ 2007-022 (trader–taxpayer’s losses were capital losses deductible only to the extent of capital gains, plus $3,000). 2008] a structural critique of trader taxation 1125 c. the irc section 475(f) mark-to-market election since the enactment of irc section 475(f) in 1997, traders, like dealers, have had the option of “marking-to-market” their securities-trading gains and losses, thereby converting such gain or loss into ordinary gain or loss.50 under irc section 475(f), securities traders who make the mark-tomarket election may recognize gain or loss on any security held in connection with his securities-trading trade or business as if that security were sold at fair market value on the last day of the taxable year, and may take any such gain or loss into account for such taxable year.51 because “[r]ules similar to the rules of [irc section 475(d)]” will apply to the securities with respect to which such an election is made, any such gain or loss on a disposition of a security will be treated as ordinary, not capital, income or loss.52 for the election to be effective, the taxpayer must generally have filed a statement not later than the due date of the original federal income tax return for the taxable year immediately preceding the election year, and that statement must be attached either to that return or, if applicable, to a request for a filing extension.53 this means that the taxpayer may not generally wait until he has experienced losses throughout the tax year before making the election; late filing relief will not usually be granted for the mark-to-market election where the taxpayer is believed to be making the election with the benefit of hindsight.54 once the mark-to-market election is made, the trader’s losses from his trades, having been rendered ordinary, are recognized at the close of the trader’s tax year as if sold for fair market value and may be deducted against his ordinary income, and presumably may also be carried backward and forward like “normal” net operating losses as offsets to ordinary income.55 50. taxpayer relief act of 1997, pub. l. no. 105-34, §§ 1001(b), (d)(4), 111 stat. 788, 906-08 (1997). 51. irc § 475(f). 52. irc § 475(f)(1)(d); irc § 475(d)(3). 53. rev. proc. 99-17, 1999-1 c.b. 503, at § 5.03 (feb. 9, 1999) (as modified and superseded). 54. see, e.g., irs priv. ltr. rul. 200736018 (sept. 7, 2007) (securities trader’s request for extension to make irc § 475(f) mark-to-market election was denied for lack of reasonable action and good faith, where taxpayer could not demonstrate that his pursuit of relief did not rely on hindsight); irs priv. ltr. ruls. 200209052-54 (mar. 1, 2002); irs priv. ltr. rul. 200709015, (mar. 2, 2007); contra vines v. comm’r, 126 t.c. 279 (2006) (taxpayer was not getting benefit of hindsight and was allowed late filing relief where he had made no trades and incurred no added gains or losses between election due date and date the late election was filed). 55. for a general discussion of the mark-to-market election, see steven d. conlon & vincent m. aquilino, principles of financial derivatives: u.s. and international taxation, at ¶ b3.08[2] (1999) (updated nov. 2007); boris i. bittker, 1126 florida tax review [vol. 8:10 in addition to affecting the character of a trader’s income, the making of a mark-to-market election also has an effect on timing of income recognition: a trader who does not in fact dispose of his stock or securities in a given year will nonetheless be able to recognize gains and losses from those securities as if they had been sold at the taxable year’s end. thus, a trader (or dealer), by making the mark-to-market election, may be able to trigger gain or loss recognition in a way that is only available to an investor if that investor actually sells his stock or securities. finally, a securities trader will not be subject to the self-employment tax on his gain or loss from securities trading, even if that trader makes a irc section 475(f) mark-to-market election. as a general rule, a securities trader who has not made a mark-to-market election under irc section 475(f) will not be subject to the self-employment tax imposed by irc section 1402 (i.e., the tax imposed on a taxpayer’s “net earnings from self employment”), since capital gains and losses are excluded from the “net earnings from self employment” under the statute.56 it should be noted that although making a mark-to-market election under irc section 475(f) generally converts a trader’s income and losses to ordinary income and losses for purposes of the income tax law, any such gain or loss remains capital gain or loss for selfemployment tax purposes.57 d. summary the main differences between investors, traders, and dealers are summarized in the following table: martin j. mcmahon, jr. & lawrence a zelenak, federal income taxation of individuals, at ¶ 28.08 (3d ed. 2002) (updated nov. 2007). 56. irc § 1402(a)(3)(a); treas. reg. § 1.1402(a)-6(a). 57. irc § 475(f)(1)(d). 2008] a structural critique of trader taxation 1127 character of income from securities activities deductions allowable for securities activities mark-to-market election investors traders dealers income is treated as capital gain or loss, reported on form 1040 schedule d (capital gains & losses). may be short-term or longterm capital gain or loss depending on holding period. losses are subject to irc § 1211(b) limitations. unless mark-to-market election is made, income is treated as capital gain or loss, reported on schedule d (capital gains & losses). may be short-term or longterm capital gain or loss depending on holding period. losses are subject to irc § 1211(b) limitations. income and loss from sale of inventory securities is ordinary income or loss reported on schedule c (profit or loss from business). losses are deductible against ordinary income. expenses are itemized under irc § 212. deductibility is subject to 2% floor on agi, and may be eliminated under amt computation. “trade or business” deductions are not allowed. other limitations may apply. schedule c “trade or business” deductions are allowable. schedule c “trade or business” deductions are allowable. no mark-to-market election is available. irc § 475(f) mark-tomarket election may be made, converting income and loss to ordinary income and loss. mark-to-market election may enable income recognition, even if securities are not disposed of. irc § 475 mark-tomarket accounting is required. in summary, traders, like investors, have their gains and losses from their securities-trading activities treated as capital gains and losses.58 58. as pointed out by some commentators, trader–taxpayers who file form 1040 will therefore have a schedule c that shows substantial expenses (deducted 1128 florida tax review [vol. 8:10 however, unlike investors (and like securities dealers), traders are eligible for various elections and deductions for expenses incurred in their trade or business of trading. also unlike investors, traders are eligible to make a mark-to-market election to convert their gains and losses from capital gains and losses to ordinary gains and losses, and to otherwise affect the time at which they realize such gains and losses. in sum, traders are the only category of taxpayers entitled to capital gains and losses, but ordinary deductions, for their securities activities. section iii: “t rader” taxation : a tale of two concepts what are the standards, then, that lead to classification as a trader and the resulting unusual tax treatment? while the above discussion demonstrates that there are many tax consequences to a taxpayer that depend on whether a taxpayer is classified as a trader, dealer, or investor, most of these tax consequences boil down to the application of two competing concepts. this section shows that this situation – wherein two competing concepts underpin and create a trader’s unusual tax treatment – was introduced into the statutory structure as a result of the 1934 introduction of the “to customers” requirement. the first concept, which can be broadly stated as “whether or not the taxpayer is in a ‘trade or business’” is a long-standing, though ill-defined, concept in the tax code, which is critical in determining whether a taxpayer may be classified as a trader and entitled to deductions for expenses incurred in securities trading. the second concept, which is generally an inquiry into whether the taxpayer has “customers,” was “newly” introduced into the analysis in 1934, and has become crucial in affording capital income and loss treatment to a trader–taxpayer, notwithstanding the fact that such taxpayer has been found to be in the “trade or business” of trading.59 fundamentally, the oddness of allowing traders capital asset treatment along with ordinary deductions stems from the fact that, while the majority of the tax consequences to a securities trader are based on whether or not the taxpayer is “engaged in a trade or business,” the character of such trader’s gains or losses is determined based on whether the assets bought or sold are capital assets under the capital asset statute, and more specifically whether they are held for sale “to customers.” under irc § 162) but little or no income (since gains and losses will be capital). see generally raby & raby, nondealer security losses, supra note 5. 59. revenue act of 1934, pub. l. no. 73-216, § 117(b), 48 stat. 680, 714 (1934). 2008] a structural critique of trader taxation 1129 a. the importance of being “engaged in a trade or business” the notion of engagement in a “trade or business” is a concept that underlies the vast majority of the tax rules applicable to traders outlined in section i above. this statement is in some ways a tautological observation, because to call a taxpayer a trader under the tax law in fact essentially means that that taxpayer is “trading in securities as a trade or business” and will be subject to the tax consequences applicable to such a taxpayer.60 however, the point should not be obscured for all its apparent obviousness. a finding that a taxpayer is engaged in a trade or business as a securities trader gives rise to a number of important tax consequences precisely because of the way in which the concept of “engagement in a trade or business” is embedded in the various tax statutes dealing with deductions that are discussed above.61 while there may be variations in the exact standards that must be met for a taxpayer who is engaged in the “trade or business” of trading (or dealing) securities to qualify under each individual tax statute, the state of being engaged in a trade or business is undeniably an important criterion underlying a number of those statutory rules. for purposes of this article, an understanding of the “trade or business” concept is therefore essential to understanding the current statutory structure, and the interplay of the current tax rules, with respect to securities traders. for example, as discussed in section ii above, the “trade or business” standard comes directly into play with respect to the deduction allowable under irc section 162 for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”62 traders and dealers may qualify to deduct expenses incurred in their “trade or business,” while mere investors cannot.63 also as discussed above, a taxpayer’s eligibility to deduct “investment interest” may depend on whether he is engaged in a trade or business.64 whether the taxpayer is conducting a “trade or business” is also central to whether he may take a “home office” deduction under irc section 280a.65 likewise, whether a taxpayer is engaged in a “trade or business” determines the taxpayer’s entitlement to elect certain tax treatments, such as the election to take 60. see yaeger, 889 f.2d 29. compare irc § 475(f) (mark-to-market election is available “[i]n the case of a person who is engaged in a trade or business as a trader in securities”(emphasis added)); with thomas, supra note 5 at 274 (“[t]o call someone a securities trader means nothing more or less than to say he is engaged in trading securities as a trade or business”). 61. see supra section ii. 62. irc § 162. 63. irc § 212; irc § 67(a); treas. reg. § 1.67-1t(a)(1)(ii)). see, e.g., mayer, 32 fed. cl. 149. 64. irc § 163(d)(1). 65. see irc § 280a(c)(1)(a). 1130 florida tax review [vol. 8:10 deductions for, rather than depreciate, certain depreciable property known as “section 179 property” and the election to deduct start-up expenses under irc section 195.66 finally, the irc section 475(f) mark-to-market election for which securities traders are eligible will only be available “[i]n the case of a person who is engaged in a trade or business as a trader in securities.”67 the exact standard for eligibility for the deductions and other favorable tax items do vary in their details, and traders and dealers attempting to qualify for such items may have to satisfy certain other criteria as well as being in a trade or business. for example, in order to take irc section 162 deductions, the taxpayer must not only have been conducting a “trade or business,” but the expense must also have been “ordinary and necessary” and must have been “incurred … in carrying on” that trade or business.68 to be excepted from the irc section 163(d) investment interest limitations, the income of the trader or dealer must have been derived in the “ordinary course” of the trade or business.69 to take a deduction for a home office, the home office must be the “principal place” of the trader’s or dealer’s trade or business.70 to be eligible for the election under irc section 195, the trade or business conducted by the taxpayer must be “active.”71 however, these variations in the exact requirements do not detract from the fundamental observation that, as a general matter, conduct of a trade or business is a critical gating item – a taxpayer–trader or dealer who conducts a 66. irc §§ 179(a), (d)(1)(c); §§ 195(a), (c)(1). section 179 property generally includes tangible property which is “section 1245 property” (i.e., certain categories of property with respect to which depreciation is allowed) and which is “acquired by purchase for use in the active conduct of a trade or business.” irc § 179(d)(1)(c). under irc § 195, a taxpayer may elect to deduct some amount of “start-up expenditures,” which are, generally, otherwise deductible expenditures incurred in creating (or investigating the creation or acquisition of) “an active trade or business,” and certain other income-producing activities performed in anticipation of such activity becoming “an active trade or business.” irc §§ 195(a), (c)(1). thus, only traders and dealers who create and conduct an “active trade or business” will be eligible to elect to deduct such start-up expenses, while investors will be forced to capitalize any such expenses. 67. irc § 475(f) (emphasis added). the language of irc § 475(f) clarifies the perhaps obvious point that if the electing taxpayer is not “engaged in a trade or business” as a trader, the mark-to-market election is not available to that taxpayer. at least one author has noted that the act of marking the mark-to-market election does not in itself make a taxpayer a trader. raby, nondealer security losses, supra note 5, at 48 (“[t]he election itself is not what makes the taxpayer a trader of course. the taxpayer’s activity must qualify him, her, or it as a security or commodity trader or commodity dealer”). 68. irc § 162. 69. irc § 163(d). 70. irc § 280a. 71. irc § 195. 2008] a structural critique of trader taxation 1131 trade or business and ordinarily incurs expenses in such trade or business has a chance of meeting the requirements for application of some or all of the tax rules described above. a taxpayer who does not conduct a trade or business has no chance of qualifying for any of those tax treatments. the significance of the “trade or business” threshold concept is echoed in court decisions distinguishing traders from other securities-buying taxpayers. these court decisions reflect the importance of the trade or business standard in determining the tax consequences to a taxpayer. once the courts have determined whether the taxpayer is in a trade or business, the correlative tax results swiftly follow. in paoli v. comm’r, for example, the court was asked to determine whether the taxpayer was subject to the investment interest limitation under irc section 163(d).72 the court first distinguished between investors, traders, and dealers, and stated that “[b]oth traders and dealers engage in the trade or business of buying and selling securities, whereas the activities of an investor do not qualify as a trade or business.”73 the court said that the taxpayer had to qualify as “a trader who is engaged in a trade or business” in order to be eligible for a full deduction. in estate of yaeger v. comm’r, the court was called upon to decide the same issue. the court likewise stated that the “issue turned on whether yaeger’s stock market activities constituted investment activity or the activity of trading in securities as a trade or business,” and determined that the taxpayer was an investor not engaged in such trade or business, rather than a securities trader.74 similarly, in boatner v. comm’r, the court, in deciding whether the taxpayer’s expenses could be deducted in determining adjusted gross income rather than being itemized as expenses, stated that it must consider the question of whether petitioner was engaged in the trade or business of buying and selling stocks. if so, petitioner was a “trader” as opposed to an “investor” and was eligible to deduct his business expenses.75 in moller v. comm’r, the court had to decide whether the taxpayer was a trader engaged in a trade or business who was therefore entitled to a “home office” deduction under irc section 280a, or an investor who was not so entitled.76 the court stated that “[t]he principal question in the instant case [was] whether the taxpayer’s investment activity was a trade or business.”77 in chen v. comm’r, the tax court considered whether a taxpayer who was a full-time engineer was a securities trader entitled to make a market-to-market election rendering his losses ordinary, or whether 72. paoli v. comm’r, 62 t.c.m. (cch) 275 (1991); see also paoli v. united states, 92-1 ustc ¶ 50102 (1991) (involving earlier years). 73. 62 t.c.m. (cch) at 280. 74. yaeger, 889 f.2d 29. 75. boatner v. comm’r, 74 t.c.m. (cch) 342 (1997), aff’d, 164 f.3d 629 (9th cir. 1998). 76. moller v. comm’r, 721 f.2d 810, 811 (1983). 77. id. at 813. 1132 florida tax review [vol. 8:10 he was an investor subject to the rules on capital loss limitations.78 the court recognized the three distinct categories of dealer, trader, and investor in securities, and stated that “[i] in order to qualify as a trader (as opposed to an investor) petitioner’s purchases and sales of securities…must have constituted a trade or business.”79 the above cases demonstrate that, in accordance with the requirements of the applicable statute, court inquiries have focused on the threshold question of whether the taxpayer in question was in a trade or business. however, despite its multiple appearances in the code, the term “engaged in a trade or business” is not defined in the code.80 courts have therefore had to resolve the question themselves, and have, in general, looked at a variety of different factors in making this determination. in the specific context of securities traders, courts have developed a fairly consistent list of factors they examine when making this determination: generally, court determinations come down to (1) the frequency, extent, and regularity of the taxpayer’s activity and (2) the nature of the income derived from the activity and the taxpayer “investment intent” in performing the activity.81 i. whether the taxpayer’s activity is frequent, regular, and continuous in order to be considered to be in the trade or business of securities trading, the taxpayer’s activity must be frequent, regular, and continuous enough to so qualify. this was evident in fuld v. comm’r, an early case involving the question of whether the taxpayers were engaged in the trade or business of trading.82 in fuld, the tax court determined, and the second circuit agreed, that the taxpayers’ activities were continuous and intensive enough to constitute engagement in the securities-trading trade or business.83 78. chen v. comm’r, t.c.m., 2004-132, 2004 t.c.m. (ria) at 852. 79. 2004 t.c.m. (ria) at 854. 80. see, e.g., bittker & lokken, supra note 23 at ¶ 20.1 (“[t]he term ‘trade or business’ is not defined by the statute or the regulations; neither is there an authoritative judicial definition”); see also bittker, mcmahon & zelenak, supra note 55, at ¶ 11.01[2]. 81. moller, 721 f.2d at 813; yaeger, 889 f.2d at 33; cameron v. comm’r, 2007 t.c.m. (ria) ¶ 2007-260, 94 t.c.m. (cch) 245; mayer v. u.s., 32 fed. cl. 149 (1994); chen, 2004 t.c.m. (ria) at 854; see also instructions to 2007 internal revenue service form 1040 schedule d, at d-3 (describing requirements to be classified as a securities trader), available at http://www.irs.gov/pub/irspdf/i1040sd.pdf (last visited jan. 6, 2008). 82. fuld v. comm’r, 139 f.2d 465 (2d cir. 1943), aff’g 44 b.t.a. 1268 (1941). 83. fuld, 139 f.2d at 468-69. 2008] a structural critique of trader taxation 1133 the taxpayers, a brother and sister, had made long-term investments prior to october 1930 but had changed their approach in october 1930 to engage in short-term speculation.84 in holding that the brother and sister taxpayers were engaged in a trade or business on and after october 1930, the tax court found that (1) the brother had devoted an average of eight hours a day to studying texts and services, charting prices, conferring with his broker, attending meetings, and consulting corporate executives; (2) the sister had no trade or business other than buying and selling securities, and she, too, studied services, read corporate annual reports, charted prices, attended meetings, and consulted with corporate executives; (3) the main source of livelihood of both taxpayers was from their securities transactions; (4) the taxpayers maintained no business offices and had no customers to whom they sold securities; and (5) the taxpayers never sold short and never held themselves out to the public as dealers (although the brother was registered with the sec as a dealer).85 the tax court also found that in 1933 the brother made about 249 sales of securities held for more than two years and about 98 sales of securities held for two years or less, and the sister in 1933 made about 229 sales of securities held for more than two years and about 89 sales of securities held for two years or less.86 on the basis of these findings, the tax court found that, from october 1930 until 1933, the taxpayers were “engaged in the business of trading in securities.”87 the tax court in fuld thus primarily emphasized the continuity and the intensity of the taxpayers’ efforts in determining that they were in the “trade or business” of securities trading, while also considering the frequency of trades.88 on appeal, the tax court’s findings were affirmed by the second circuit.89 the requirements of continuity, frequency, and intensiveness have continued in existence to more recent cases. in chen, discussed above, for example, the court noted that to be considered a trade or business the taxpayer’s trading activity must be frequent, regular, continuous, and substantial, and cannot be sporadic.90 in chen, the taxpayer’s securitiestrading activities took place only sporadically, with 94% occurring between february and april, and no transactions occurred in six of the other nine months of the tax year.91 the court determined that the trading activity covered only part of one taxable year and was not the only (or even the 84. fuld, 44 b.t.a. 1269-70; see also 139 f.2d at 466. 85. fuld, 44 b.t.a. at 1270; see also 139 f.2d at 467. 86. fuld, 44 b.t.a. at 1271; see also 139 f.2d at 467. 87. fuld, 139 f.2d at 467. 88. fuld, 44 b.t.a. at 1272. 89. fuld, 139 f.2d at 469. 90. chen, 2004 t.c.m. (ria) at 854 (citing moller, 721 f.2d at 813; boatner v. comm’r, 74 t.c.m. (cch) 342 (1997)). 91. chen, 2004 t.c.m. (ria) at 852, 854. 1134 florida tax review [vol. 8:10 primary) activity via which the taxpayer produced income, and that the taxpayer therefore failed to qualify as a trader.92 in mayer, on the other hand, the court considered the taxpayer’s trading activity to be “substantial” where the taxpayer had over 1,100 executed sales and purchases in each of the years at issue.93 in cameron, the court held that the taxpayer’s trading activity was not adequate to be considered a trade or business, where the taxpayer did not trade five days a week, and traded on more than 10 days a month in only two months.94 the taxpayer’s trading activity consisted of 46 purchases and 14 sales in 2002, and in 2003 he completed 109 purchases and 103 sales.95 it should be noted that, in those cases in which the taxpayer has successfully claimed trader status, the securities-trading activity has usually been that taxpayer’s only income-producing activity, or at least his primary one. for instance, in chen, the court noted that [i]n the cases in which taxpayers have been held to be traders in securities, the number and frequency of transactions indicated that they were engaged in market transactions almost daily for a substantial and continuous period, generally exceeding a single taxable year; and those activities constituted the taxpayers’ sole or primary incomeproducing activity. conversely, where, as in this case, (1) the taxpayer’s daily trading activities covered only a portion of a single taxable year, and (2) securities trading was not the sole or even primary activity in which the taxpayer engaged for the production of income, trader status was denied. daily trading in securities for only a quarter of a single taxable year is reasonably characterized as “sporadic” rather than “frequent, regular, and continuous,” and, therefore, insufficient to achieve trader status.96 in moller, too, the court stated that “[i]n the cases in which taxpayers have been held to be in the business of trading in securities for their own account, the number of their transactions indicated that they were engaged in 92. chen, 2004 t.c.m. (ria) at 845-55; see also boatner v. comm’r, 74 t.c.m. (cch) 342 (taxpayer’s 75 securities transactions during the taxable year fell short of being “frequent, regular, and continuous.”) 93. mayer, 67 t.c.m. (cch) 2949, 2949-4 – 2949-5 (1994). 94. cameron v comm’r, 2007 t.c.m. (ria) ¶2007-260 at 1510. 95. id. the court also noted that the taxpayer collected unemployment compensation during 2003, which further undermined his claim that he was engaged in a trade or business during that year. id. 96. chen, 2004 t.c.m. (ria) at 845-55 (citations omitted). 2008] a structural critique of trader taxation 1135 market transactions on an almost daily basis.97 this standard means that a taxpayer claiming trader status who is engaged in another income-producing occupation must show that being a trader is his full-time primary occupation, rather than an occasional hobby, no matter how seriously he takes his trading.98 therefore, the cases above demonstrate that the taxpayer seeking to qualify as a trader in the “trade or business” of trading must prove that his trading activity is substantial enough to constitute such trade or business. commentators have pointed out that the exact level of trading activity required in order to be a trader is not clear.99 however, what is clear is that the standard applied by the courts is generally extremely high.100 ii. nature of the income derived from the activity and the taxpayer’s intent in order to be considered a trader, the taxpayer must also meet certain requirements regarding his intent with respect to holding, buying, or selling the securities, and regarding the character of the income derived from his securities activities. generally, the courts have held that investors hold securities for the “production of income,” while traders derive profits from the “direct management of purchasing and selling” securities.101 traders, unlike investors, “buy and sell securities with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis.”102 therefore, the taxpayer’s holding period of 97. moller, 721 f.2d at 813-14 (citing levin v. comm’r, 597 f.2d 760, 765 (ct. cl. 1979); fuld, 139 f.2d 465). 98. see thomas, supra note 5, at 275-76 (“the internal revenue service has sometimes suggested that a taxpayer should not be considered a trader unless the activities constitutes his sole or primary income-producing activity. … to deny trader status to such a taxpayer because he maintains other employment would be arbitrary and unfair, and contrary to the body of law on this subject”). 99. see, e.g., schwartz, supra note 5, at 399; see also, generally, buagu, musazi, and krishna rana, on the tax classification of day stock traders as investors or traders, american accounting association 2004 mid-atlantic region meeting paper (jan. 7, 2004) (presenting analytical model to help judges distinguish between investors and traders without arbitrariness); avi o. liveson, cases illustrate nature and level of investment activities needed to attain trader status, 82 j. tax’n 290 (1995). 100. see federal tax coordinator (ria) 2d at ¶ l-1112 (“[p]roving that one’s investment activities rise to the level of carrying on a trade or business is a difficult hill to climb”). 101. yaeger, 889 f.2d at 33. 102. id. 1136 florida tax review [vol. 8:10 the securities and the source of the taxpayer’s profit are significant in determining whether the taxpayer is in the trade or business of “trading.” that a distinction exists between the nature and type of income earned by traders and that earned by mere investors was recognized by the supreme court itself in 1941 in higgins v. comm’r, where the court held that “[n]o matter how large the estate or how continuous or extended the work required [to oversee taxpayer’s estate] may be, such facts are not sufficient as a matter of law to permit the courts to reverse the decision of the board [of tax appeals, that the taxpayer’s activities did not amount to the carrying on of a business]” and that “no amount of personal investment management would turn [taxpayer’s] activities into a business.” 103 the holding in higgins demonstrates that there is a difference between mere management of one’s own personal investments (which tend to be held for appreciation over the longer term), and the active trading that is required in order to constitute being in the trade or business of securities trading. yaeger v. comm’r is another good example of this difference. in yaeger, the court found that the taxpayer was an investor rather than a trader, even though he had initiated over 2000 securities transactions in 1979 and 1980, and had “pursued his security activities vigorously and extensively.”104 the court pointed to the fact that most of the taxpayer’s securities were held for over a year, and he did not sell any securities held for less than three months.105 the court found that the taxpayer had realized his profits from both dividends and interest, and that his “emphasis on capital growth and profit from resale indicate[d] an investment motivated activity.”106 notably, the court stated that “no matter how large the estate or how continuous or extended the work required may be, the management of securities investments is not the trade or business of a trader.”107 thus, the unacceptably long holding period of the taxpayer’s securities betrayed the fact that the taxpayer was not trying to capture short-term market swings, and hence was not a trader. the court of appeals for the federal circuit also addressed the nature of the taxpayer’s income and the taxpayer’s intent in moller v. comm’r.108 the court noted that “in order to be a trader, a taxpayer’s activities must be directed to short-term trading, not the long-term holding of investments, and income must be principally derived from the sale of securities rather than from dividends and interest paid on those securities.”109 103. higgins, 312 u.s. at 216, 218. 104. yaeger, 889 f.2d at 33. 105. id. at 34. 106. id. at 34 (citing miller v. comm’r, 70 t.c. 448, 457 (1978)). 107. id. at 34 (citing higgins, 312 u.s. at 218). 108. moller, 721 f.2d 810. 109. id. at 813. 2008] a structural critique of trader taxation 1137 the court concluded that the taxpayers were investors rather than traders because they were “primarily interested in the long-term growth potential of their stocks” and “did not derive their income from the relatively short-term turnover of stocks, nor did they derive any significant profits through the act of trading.”110 the court noted that interest and dividend payments constituted over 98% of taxpayers’ gross income for 1976 and 1977, and in 1976 their profit from the sale of securities was only $612, while in 1977 their sales resulted in a loss of $223.111 hence, in order to show “engagement in a trade or business,” which is required in order to qualify for trader classification, a taxpayer must not only demonstrate that his securities activities are continuous, substantial, and frequent (rather than sporadic), but he must also show an intent to profit from short swings in the market, rather than from interest, dividends, or long-term appreciation. once the taxpayer meets these dual requirements to be considered a trader engaged in the “trade or business” of securities trading, then, as discussed above, the taxpayer has the potential to be eligible for certain tax deductions and elections, such as irc section 162 trade or business deductions, irc section 280a home office deductions, unlimited interest deductions under irc section 163, the election to deduct “section 179 property,” the election to deduct start-up expenses under irc section 195, and the mark-to-market election under irc section 475(f).112 this result stems from the fact that the “trade or business” test underpins the statutory language of each of these deductions. as further discussed in section iii.b. below, the same “trade or business” test is also used to underpin the analysis in determining the character of a trader’s income. however, since 1934, another standard (discussed below) has also been applied to making this determination. 110. moller, 721 f.2d at 813. 111. id. at 812. 112. see, e.g., yaeger, 889 f.2d at 29 (finding that taxpayer was an investor not engaged in a trade or business meant that he was subject to the irc § 163(d) investment interest limitation); paoli, 62 t.c.m. (cch) 275 (same); hart, 73 t.c.m. (cch) 1684 (same); boatner, 74 t.c.m. (cch) at 345 (determination that taxpayer was not engaged in the trade or business of buying and selling stock meant that he was not eligible for business deductions but rather had to itemize deductions); moller, 721 f.2d 810 (finding that taxpayer was an investor and not in the “trade or business” resulted in disallowance of irc § 280a home office expense deductions); cameron, 2007 t.c.m. (ria) ¶ 2007-260, 94 t.c.m. (cch) 245 (taxpayer who was an investor, not a trader, was disallowed irc § 162 trade or business deduction); mayer, 67 t.c.m. (cch) 2949 (same). 1138 florida tax review [vol. 8:10 b. the “to customers” requirement and the character of income while most of the important tax consequences (on the deductions side) to a taxpayer who buys, sells, and holds securities depend, at a threshold level, on whether the taxpayer is engaged in or conducting a “trade or business,” a trader’s gain and loss from his securities-trading activities are treated as capital gain or loss despite the fact that the trader may be engaged in a trade or business. this “character of income” issue is not determined based on whether a trade or business is being conducted, but instead depends on whether the securities held by such trader are “capital assets” within the meaning of irc section 1221.113 conceptually, a trader’s gains and losses are treated as capital gains and losses because courts have held that the securities in which a trader trades are “capital assets” within the meaning of the statute, and do not fall within any of the exceptions to capital asset treatment. by way of background, the term “capital asset” is defined in irc section 1221 not in positive terms, but rather by carving out certain types of property that are not “capital assets.”114 the code states that the term includes any “property held by the taxpayer (whether or not connected with his trade or business)” other than certain enumerated assets.115 over time, many exceptions to the term “capital asset” have entered the statute, which now includes exceptions for “stock in trade of the taxpayer,” property properly included in “inventory,” property that is “held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business,” real or depreciable personal property used in a taxpayer’s trade or business, certain intellectual property, accounts or notes receivable acquired in the ordinary course of trade or business in exchange for services or from the sale of stock in trade, certain commodities–derivative financial instruments held by commodities–derivatives dealers, certain hedging transactions, and supplies regularly used or consumed by a taxpayer in the ordinary course of his trade or business.116 these exceptions appear to generally concern property held by a taxpayer in a trade or business, rather than for long-term investment.117 however, the exceptions are interpreted quite narrowly, and, particularly since the demise of the corn products doctrine, an asset must usually fall within one of the exceptions explicitly set out in the code in order to be exempt from capital asset treatment.118 113. irc § 1221. 114. irc § 1221(a). 115. irc § 1221(a). 116. irc § 1221(a). 117. see generally note, judicial treatment of “capital assets” acquired for business: the new criterion, 65 yale l.j. 401 (1995); see also corn products refining co. v comm’r, 350 u.s. 46 (1955), discussed at infra note 118. 118. in corn products refining co. v comm’r, 350 u.s. 46 (1955), the united states supreme court held that purchases and sales of corn futures were not 2008] a structural critique of trader taxation 1139 with respect to traders, the courts have historically analyzed whether such trader’s stocks and securities may be excepted from capital asset treatment as property “held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”119 in this regard, courts have universally found that, unlike dealers, traders do not have customers (despite the fact that some party is obviously buying the securities sold by such trader), and therefore their securities do not fall within this exception. these court holdings therefore result in capital asset treatment for trader sales of securities. the findings of the courts that traders do not sell “to customers” appear to fall in line with the intent of the legislature in adding the “for sale to customers” exception to “capital asset” treatment. prior to 1934, the statute merely carved out from “capital asset” treatment “property held by the taxpayer primarily for sale in the course of his trade or business.”120 there was no additional requirement that the property be held for sale “to customers,” and a taxpayer determined to be in the trade or business of trading was automatically entitled to ordinary gain and loss treatment on the sale of those securities.121 the requirement that the property had to be held primarily for sale “to customers” to qualify for exception from capital asset purchases and sales of capital assets, even though the futures did not come within the literal language of any of the exclusions from capital asset classification. the court stated that “the transactions were vitally important to the company’s business as a form of insurance” and that “the capital asset provision of § 117 must not be so broadly applied as to defeat rather than further the purpose of congress” and concluded that “the definition of a capital asset must be narrowly applied and its exclusions interpreted broadly.” id. at 50, 52. however, the court subsequently held in arkansas best corp. v. comm’r, 485 u.s. 212 (1988) that the disposition of bank stock was a disposition of a capital asset, even though such bank stock was acquired for a business purposes, where the stock did not fall within any of the exceptions listed in the capital assets statute, and noted that the taxpayer’s tax motivation is irrelevant. the court clarified in arkansas best that corn products does not create a general exemption from capital asset status for any assets acquired for a business (rather than an investment) purpose. id. at 221. 119. irc § 1221(a)(1)(emphasis added); see king v. comm’r, 89 t.c. 445 (1987), kemon, 16 t.c. 1026; marrin v. comm’r, 73 t.c.m. (cch) 1748 (1997), aff’d, 147 f.3d 147 (1998). 120. revenue act of 1924, ch. 234, § 208(a)(8), 43 stat. 253, 263. the statute, as amended in 1924, defined “capital asset” as “property held by the taxpayer for more than two years (whether or not connected with this trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale in the course of his trade or business.” see also, generally, fuld, 139 f.2d 465. 121. see schwinn, 9 b.t.a. 1304, see also fuld, 139 f.2d at 469 (discussing law change). 1140 florida tax review [vol. 8:10 treatment was introduced into the statute by section 117(b) the revenue act of 1934.122 the report of the senate finance committee stated that the policy reason behind this change was “to prevent tax avoidance by excluding from the category of a ‘capital asset’ property held by the taxpayer primarily for sale ‘to customers’ in the ordinary course of his trade or business, instead of merely property held by the taxpayer primarily for sale in the course of his trade or business.”123 the conference report on this provision was even more explicit, stating that “[t]he senate amendment confines the exclusion to property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, thus making it impossible to contend that a stock speculator trading on his own account is not subject to the provisions of section 117.”124 the enactment of this provision was apparently undertaken in part because some taxpayers had paid no federal income tax in the preceding tax years because they had used their (then ordinary) losses on securities sales to offset vast amounts of income from other sources, and because of congressional concerns about protecting national revenue during a depressed period.125 therefore, it is clear that the addition of the “to customers” requirement to the statute was squarely aimed at preventing stock traders (or “speculators” as they were then called) from contending that they were eligible for ordinary gain and (more pertinently) ordinary losses from their trading activities. in the light of this statutory change and the legislative commentary accompanying that change, courts began to decide that, even if a taxpayer were a trader found to be engaged in the trade or business of securities trading, and entitled to all of the tax treatments accorded to a taxpayer engaged in a trade or business, his gain and loss from the sale of securities were capital gain and loss for the simple reason that a trader, unlike a dealer, has no customers. one of the early cases addressing the issue was kemon v. 122. revenue act of 1934, pub l. no. 73-216, § 117(b), 48 stat. 680, 714 (1934). with respect to the “to customers” provision, § 117(b) was substantially identical in form to what is currently irc § 1221(a)(1). 123. burnett v. comm’r, 40 b.t.a. 605, 608 (1939), aff’d by comm’r v. burnett, 118 f.2d 659 (5th cir. 1941) (quoting senate finance committee report to 1934 revenue act at 12). 124. h. rep. no. 1385, 73rd cong. 2d sess. at 22. 125. peter miller, the “capital asset” concept: a critique of capital gains taxation, 59 yale l.j. 837, 844 (1950) (citing latham, taxation of capital gains, 23 calif. l. rev. 30, 34 n.13 (1935)); see also joseph byron cartee, note, a historical essay and economic assay of the capital asset definition: the taxpayer and courts are still mindfully guessing while congress doesn’t seem to (have a) mind, 34 wm. & mary l. rev. 885, 909 (1993) (noting that the “to customers” addition was made to prevent professional traders in securities from taking ordinary loss deductions). 2008] a structural critique of trader taxation 1141 comm’r.126 in kemon, decided in 1951, the tax court had to decide whether the taxpayer, a partnership whose principal activity was the buying and selling of unlisted securities for its own account, was a trader taxed at capital gains rates or a dealer taxed at ordinary income rates. the court held that the taxpayer was a securities trader, rather than a dealer, and was entitled to capital gain treatment on its sales of securities.127 in so holding, the court discussed the legislative history of section 117(a)(1) in some detail, noting that the “crucial phrase” “to customers” had been added to the statute specifically so that a speculator trading on an exchange on his own account could not claim that the securities that he sold were other than capital assets, and that “[t]he theory of the amendment was that those who sell securities on an exchange have no customers.”128 the court then famously explained: in determining whether a seller of securities sells to “customers,” the merchant analogy has been employed…those who sell “to customers” are comparable to a merchant in that they purchase their stock in trade, in this case securities, with the expectation of reselling at a profit, not because of a rise in value during the interval of time between purchase and resale, but merely because they have or hope to find a market of buyers who will purchase from them at a price in excess of their cost. this excess or mark-up represents remuneration for their labors as a middle man bringing together buyer and seller, and performing the usual services of retailer or wholesaler of goods.… contrasted to “dealers” are those sellers of securities who perform no such merchandising functions and whose status as to the source of supply is not significantly different from that of those to whom they sell. that is, the securities are as easily accessible to one as the other and the seller performs no services that need be compensated for by a mark-up of the price of the securities he sells. the sellers depend upon such circumstances as a rise in value or an advantageous purchase to enable them to sell at a price in excess of cost. such sellers are known as “traders.”129 126. kemon, 16 t.c. 1026. 127. id. the court’s holding was with respect to securities held for more than six months. the court said that it did not need to determine whether securities held for six months or less were capital assets, because those securities had been reported in full. 128. kemon, 16 t.c. at 1032 (quoting burnett v. comm’r, 40 b.t.a. 605, 118 f.2d 659; wood v. comm’r, 16 t.c. 213. 129. kemon, 16 t.c. at 1032-33 (citations omitted). 1142 florida tax review [vol. 8:10 the essence of this “merchant” analogy used by the court in kemon seems to be that (1) unlike merchants, securities traders depend on market changes, rather than buying at cost and selling at a higher price, and (2) securities traders, unlike dealers, do not act as “middlemen” whose profit is essentially compensation for their services and, more generally, do not add any value to the process that would explain the profit.130 while the court’s analysis in kemon incorporates more far-reaching concepts than the literal words “to customers” that are contained in the statute, the court’s interpretive gloss on the statutory wording, as well as the court’s conclusion that a trader does not have customers, has since been adopted by other courts.131 for example, the “merchant” analogy and conclusion articulated in kemon was accepted by the tax court in marrin v. comm’r, where the court decided that the taxpayer did not have customers and was therefore a trader instead of a dealer.132 like the court in kemon, the marrin court recognized that the “to customers” requirement was “of paramount importance.”133 the court concluded that since “[a]ll of the securities transactions of petitioner for the years in issue were undertaken on an exchange and effected through broker–dealers” and “[a]ll such transactions were for petitioner’s own account,” the taxpayer was “[l]acking customers” and was not eligible for ordinary loss treatment on his sales of securities.134 the court rejected the taxpayer’s arguments that (1) the broker–dealers handling his orders were his customers, and that, (2) alternatively, under an agency theory, the customers of the broker–dealers should be regarded as his customers.135 the court decisions above, together with the legislative history of the “capital asset” definition, illustrate that the reason that traders are given capital gain and loss treatment on the sale of their traded securities is that they do not meet the “to customers” requirement in the capital asset statute, which must be met in order to fall within an exception to the capital asset definition.136 in this regard, the judicial interpretations have fallen in line 130. id. 131. see marrin, 73 t.c.m. (cch) 1748 (1997); king, 89 t.c. 445 (1987); wood v. comm’r, 16 t.c. 213 (1951); see also chief couns. adv. 200817035 (apr. 25, 2008) (citing kemon). 132. marrin, 73 t.c.m. (cch) at 1751. 133. id. at 1750 (noting that “this court and other have used the ‘to customers’ requirement to distinguish between securities ‘dealers’ who are intended to come within the capital asset exclusion of § 1221(1) and mere ‘traders’ who are not”). 134. id. at 1751. 135. id. at 1751-52. 136. another case in which the “to customers” requirement was articulated was king, 89 t.c. 445, a case involving whether a commodities trader was subject to the irc § 163(d) investment interest limitation. the court noted in king that “a primary distinction for federal tax purposes between a trader and a dealer in 2008] a structural critique of trader taxation 1143 with the sentiment articulated in the 1934 legislative history of the capital asset statute, and have interpreted trader transactions in a manner consistent with the legislative intent. while one might argue that to say that a securities trader has no customers is illogical, the courts have not bought this argument. it may be true that, examined literally, or at least from the standpoint of economics, the fact that when a securities trader sells his securities some party in the market obviously has bought them from that trader means that the trader has “customers.”137 however, the courts have rejected this “economic” argument and have, with the aid of judicial glosses and interpretation, held that a securities trader does not have “customers” notwithstanding the fact that he buys and sells securities on a “frequent,” “regular,” and “continuous” basis.138 c. the intersection of disjoint concepts: a structural look at trader taxation the above analysis shows that, while most of the tax consequences to a taxpayer who buys, sells, and holds securities are controlled by a threshold inquiry into whether that taxpayer conducts a “trade or business” of buying, selling, or holding securities,139 the proper character of the securities or commodities is that a dealer does not hold securities or commodities as capital assets if held in connection with his trade or business, where as a trader holds securities or commodities as capital assets whether or not such assets are held in connection with his trade or business. a dealer falls within an exception to capital asset treatment because he deals in property held primarily for sale to customers in the ordinary course of his trade or business. a trader, on the other hand, does not have customers and is therefore not considered to fall within an exception to capital asset treatment.” id. at 458 (footnote omitted). 137. see, e.g., archaya, 225 f.app’x 391 (7th cir. 2007) (fed. r. app. p. 32.1 nonprecedential disposition) (taxpayer argued that the people who bought the securities he had sold were “customers”); marrin, 73 t.c.m. (cch) at 1751 (taxpayer argued that broker–dealers were his customers, or, alternatively, that the customers of the broker–dealers were his customers under agency law); see also, generally, groetzinger, 480 u.s. at 33-34 n.12 (citing boyle, what is a trade or business? 39 tax lawyer 737, 763 (1986) (“it takes a buyer to make a seller and it takes an opposing gambler to make a bet”). 138. see archaya, 225 f.app’x 391 (7th cir. 2007) (“that characterization [that people who bought securities were customers] may be useful for some economic purposes but is not relevant to the legal analysis”); marrin, 73 t.c.m. (cch) at 1751 (rejecting taxpayer’s argument that broker–dealers were his customers). 139. as discussed, some of these tax consequences are entitlement to irc § 162 trade or business deductions, entitlement to unlimited interest deductions under irc § 163, entitlement to home office expense deductions under irc § 280a, and 1144 florida tax review [vol. 8:10 taxpayer’s income is determined instead based on whether the taxpayer has “customers” to whom he sells those securities. the applicable exception in irc section 1221(a)(1) from capital asset treatment requires that the property at issue be “held by the taxpayer primarily for sale ‘to customers’ in the ordinary course of his trade or business.”140 it is clear from the language of the statute that, in order to come within this exception, the taxpayer needs to first of all be in a “trade or business” of buying, selling, and holding securities. this is the same gating item that must be satisfied in order for the taxpayer to be entitled to the other tax treatments discussed above, whose availability also hinges on whether the taxpayer is in a “trade or business.” however, the “to customers” requirement represents an additional hurdle that must be overcome to attain ordinary income treatment, a hurdle that is not a requirement with respect to any other aspect of the treatment of a securitiesbuying, selling, or trading taxpayer. as discussed above, courts have determined, based on the legislative history of the provision, that this hurdle is insurmountable for securities traders.141 this disjuncture between two competing concepts gives rise to the atypical treatment of securities traders. looking at the issue from a different angle, while the requirements laid down by the courts for a taxpayer to show that he is engaged in a trade or business are not trivial, and in fact can be quite onerous, there has never been a requirement that the taxpayer demonstrate that he is engaged in providing goods and services “to customers” in order to be found to be in a trade or business. this notion was explicitly rejected by the supreme courts holding in comm’r v. groetzinger, a case that held that a full-time gambler, who was not holding himself out as selling anything to anyone, was engaged in the trade or business of gambling.142 in direct contrast to the development of the trade or business doctrine, however, a post-1934 trader must make just such a showing (which the courts have decided that he cannot do) in order to be subject to ordinary income treatment as opposed to capital asset treatment. entitlement to elect start-up expenditure deductions under irc § 195. see also, e.g., irc §§ 172, 179. 140. irc § 1221(a)(1) (emphasis added). 141. see archaya v. comm’r, 225 f.app’x 391 (7th cir. 2007); marrin, 73 t.c.m. (cch) at 1751. 142. comm’r v. groetzinger, 480 u.s. 23 (1987). the court in groetzinger famously rejected a prior observation by justice frankfurter in a concurring opinion in deputy v. dupont that “carrying on any trade or business … involves holding one’s self out to others as engaged in the selling of goods and services.” groetzinger at 29 (quoting dupont, 208 u.s. 488, 499 (1940) (dissent, j. frankfurter)). the supreme court’s position in groetzinger has carried over from the gambling area into the securities area such that in none of the cases distinguishing traders and investors has a court ever held that a trader requires advertising or otherwise “holding oneself out to customers” as providing goods and services as one of the tests in evaluating engagement in a trade or business. 2008] a structural critique of trader taxation 1145 the disjuncture between the application of the trade or business concept and the “to customers” requirement to traders, which has been wrought by the 1934 addition of the “to customers” requirement to the capital assets definition, comes into stark contrast upon comparing court decisions before the addition of that language with decisions after the statutory addition. as discussed above, after the addition of the “to customers” language, courts have focused on the fact that traders, unlike dealers, have no “customers,” and therefore get capital gain or loss treatment on the sale of their securities. prior to the 1934 addition, however, the standard used by the courts to determine eligibility for ordinary income treatment of securities-trading gains and losses was, in fact, essentially identical to that used for determining the aforementioned other aspects of the securities traders tax picture. that is, it was identical to the “trade or business” standard. to illustrate the point, in schwinn v. comm’r, an early case dealing with the law prior to the 1934 addition, the tax court was called upon to decide whether losses from the sale of stock by the taxpayer could be treated as ordinary losses rather than capital losses.143 the court noted that under section 208(a)(8) of the revenue act of 1924, the term “capital asset” meant property held by the taxpayer for more than two years (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale in the course of his trade or business.144 therefore, the court said that the determining issue in its analysis was whether “the petitioner’s speculations … [were] of such a nature as to properly be regarded as his trade or business” (emphasis added).145 the court held that the taxpayer had devoted “the largest part of his business time to, and made the most money from, speculating” and had spent “[l]arge sums of money … in his marginal dealings,” and that, therefore, the resulting losses occurred “with respect to property held primarily for sale in the course of the petitioner’s trade or business” (i.e., were ordinary losses).146 the court therefore essentially applied the “trade or business” standard—the same standard applied to other aspects of the taxpayer’s tax return picture—in deciding whether or not the taxpayer’s losses were ordinary. 143. schwinn, 9 b.t.a 1304. 144. id. at 1307 (emphasis added). 145. id. at 1307. 146. id. at 1308-09. 1146 florida tax review [vol. 8:10 the court’s analysis in schwinn demonstrates that the disjuncture between courts’ analyses with respect to the “nature of income” issue and the courts’ analyses with respect to other aspects of a trader’s tax picture clearly came about as a result of the 1934 addition of the “to customers” requirement into the statute, and was not present before that.147 prior to this congressional addition, courts applied the same standard (that is, they inquired into whether the trader or “speculator” was in the trade or business of securities trading) in determining all facets of that taxpayer’s tax picture.148 the standard, although non-trivial, was comparatively internally consistent, with the same requirements determining the character of gain and the deductions available. the addition of the “to customers” requirement, however, necessitated a second level of inquiry, and rendered the standards for determining the taxpayer’s character of income and for determining his deductions different from one another. while most aspects of a securities trader’s tax treatments are still determined based on whether that taxpayer is in the “trade or business” of trading, the nature of that taxpayer’s income and losses now depends on the taxpayer additionally meeting a totally different standard: the taxpayer must also show that the securities he traded were held for sale “to customers.”149 by introducing a new requirement relating to the existence of customers to the “character of income” side of the taxpayer’s equation, the “to customers” requirement has added a layer of complexity into the analysis surrounding trader taxation, and has caused the taxation of traders to be imbalanced or asymmetrical with respect to the inquiries applied to income and deductions, respectively. prior to the 1934 introduction of the “to customers” requirement, the statute was essentially symmetrical. after the 1934 addition of the “to customers” requirement, the statutes were rendered asymmetrical, creating the present-day unusual treatment of traders. 147. see also bryce v. keith, 257 f. 133 (e.d.n.y. 1919) (interpreting section 2(b) of october 3, 1913 act of congress, the court held that since decedent’s stock transactions were carried on over a considerable period, were complicated, involved a lot of money, and required much time and attention, losses therefrom were “incurred in trade” within the meaning of the statute, and taxpayer was entitled to deduct such losses from ordinary income); see also, generally, penrose v. skinner, 298 f. 335 (d. colo. 1923). 148. schwinn, 9 b.t.a. 1304; bryce, 257 f.133. 149. as the court in king cogently put it, the “to customers” requirement places the securities trader (as well as, arguably, any taxpayer in a trade or business who is not engaged in selling “to customers”) is in an “unusual situation”—that of being “a taxpayer engaged in a trade or business which produces capital gains and losses.” king, 89 t.c. at 460. 2008] a structural critique of trader taxation 1147 section iv: some critiques of trader taxation the asymmetrical taxation of traders created by the introduction of the “to customers” requirement as described in section iii has been subject to a number of criticisms. this section discusses some of the criticisms that have historically been leveled at the taxation of traders, and offers some further critiques from a structural standpoint. a. non-structural criticisms i. fairness, as compared to other businesspersons • favorable capital gains rates for traders one of the biggest critiques of trader taxation has been that it is not “fair” as compared to the taxation of other taxpayers in a trade or business.150 it is certainly very odd that a taxpayer who engages in the trade or business of trading should have his income and losses treated differently from any other taxpayer in the trade or business of buying or selling anything else, merely due to the fact that the trader, unlike a dealer or other merchant, sells his “goods” on an anonymous exchange and supposedly does not have “customers.”151 an individual taxpayer who is a trader will, in fact, have a form 1040 schedule c (profit or loss from business) that reports sizeable “trade or business” expenses but no income from the securities trading (since these gains and losses are capital), and his income from trading will show up instead as capital gain or loss on schedule d.152 this treatment is especially problematic from the standpoint of fairness, where a trader, having taken schedule c deductions, is in a position to have some of his income taxed at reduced long-term capital gain rates. while it is no doubt true that much of the securities trader’s capital gain will be short-term capital gain, which is taxed at ordinary income rates, traders are not altogether precluded from taking long-term capital gains treatment on their securities that have a long term holding period. the current treatment of traders may stem, in part, from the fact that traders are in the trade or business of buying and selling securities, which are commonly thought of as capital assets. on the other hand, however, if traders are in the trade or business of trading, they should 150. see, e.g., miller , supra note 125 (“[s]peculation is a way of securing a living in whole or in part. this income should be treated exactly the same as the income of a merchant, a lawyer, or a wage earner…” (citation omitted)). 151. see id. 152. see schedules c and d to form 1040, available at http://www.irs.gov/pub/irs-pdf/f1040sc.pdf and http://www.irs.gov/pub/irspdf/f1040sd.pdf (last visited jan. 19, 2008); raby, nondealer security losses, supra note 5, at 46 (noting trader’s unusual schedule c). 1148 florida tax review [vol. 8:10 be treated like any other taxpayer who conducts a trade or business, rather than being afforded capital asset treatment along with ordinary deductions.153 • electiveness of the mark-to-market election in addition to getting comparatively favorable capital gain rates on their long-term capital gains, traders, unlike dealers, enjoy these potentially reduced tax rates for income earned (along with favorable business deductions), while also enjoying the choice of making with an optional mark-to-market election to take ordinary losses as of the year end. mark-tomarket treatment (and the timing and character-of-income benefits of the same) is not elective for dealers.154 ii. fairness, as compared to investors another set of criticisms focuses on the taxation of traders as compared with that of ordinary investors. • availability of expense deductions as discussed above, traders are able to take various business deductions that are denied to investors.155 this puts the ordinary investor at a disadvantage as compared to a trader, since investors cannot take deductions for expenses incurred in making their investments, no matter how extensive, while traders may be eligible for such deductions.156 related criticisms are that the differential treatment of investors and traders promotes speculation, and may tend to favor more sophisticated or wealthy taxpayers who partake more actively in speculative trading of stocks and securities.157 153. see, e.g., miller , supra note 125; see also, e.g., raby, trader, gambler, or investor, supra note 5, at 1665, 1667 (noting that trader classification “offers some real tax inducements” and that securities traders “for tax purposes, have the best of two worlds”). 154. irc § 475; see also conlon & aqulino, supra note 55, at ¶ b3.08[1]; sheppard, supra note 5 at 721-22. 155. see section ii, supra. 156. higgins, 312 u.s. 212; see also, e.g., raby, trader, gambler, or investor, supra note 5, at 1665, 1667. 157. see, generally, john w. lee iii, the capital gains “sieve” and the “farce” of progressivity 1921-1986, 1 hastings bus. l. j. 1 (2005); john w. lee iii, class warfare 1988-2005 over top individual income tax rates: teeter totter from soak-the rich to “robin-hood-in-reverse”, 2 hastings bus. j. 47 (2006); maureen a. maloney, capital gains taxation: marching (oh-so-slowly) into the future, 17 man. l. j. 299 (1988). 2008] a structural critique of trader taxation 1149 • availability of ordinary income treatment due to mark-to-market election the mark-to-market election available to traders under irc section 475(f) is also subject to criticism. perhaps most importantly, the mark-tomarket election allows traders, but not investors, to choose to convert gains and losses to ordinary gains and losses.158 such converted ordinary losses recognized by a trader would be deductible against other kinds of ordinary income, a result that could be more favorable for the taxpayer (and more harmful for the revenue collector) than that with capital losses.159 it seems inconsistent, for example, that between two individuals sitting in front of a home computer engaging in the online buying and selling of stocks and securities, the one considered a trader would be allowed to opt for ordinary treatment while the other (the investors) could make no such choice.160 the choice to make a mark-to-market election also provides a degree of retroactive tax planning available to a trader that is not available to an investor.161 • availability of accelerated recognition due to mark-to-market election the making of the mark-to-market election also enables traders to recognize gains and losses at the end of the tax year, by creating the tax fiction that the trader has sold all of his securities at the end of the tax year.162 therefore, in addition to being able to take valuable deductions and potentially offset ordinary losses, a trader can also accelerate income recognition through the making of such an election, while an investor (in addition to taking capital losses) is forced to postpone such recognition until actual disposal of the securities. again, this result appears unfair. iii. uncertain standards finally, the taxation of traders has also been criticized on the grounds that the standards that must be met in order to demonstrate 158. irc § 475(f). 159. securities trader denied ordinary loss treatment because of late mark-to-market election, 108 j. tax’n, vol. 1 (jan. 2008) (“allowing all taxpayers who trade securities to place their losses on schedule c and treat them as ordinary losses instead of reporting them on schedule d and characterizing them as capital losses could have an enormous negative impact on the public fisc”). 160. see, e.g., http://www.etrade.com (last visited jan. 19, 2008). 161. see section v.c, infra. 162. irc § 475(f). 1150 florida tax review [vol. 8:10 engagement in a “trade or business” as a trader are not entirely clear.163 while it is apparent, as discussed above, that courts will look at the frequency, regularity, and continuity of the taxpayer’s securities activities as well as the nature of the income derived from the activity (i.e., short term vs. long term) and the intent of the taxpayer, the exact standards with respect to factors such as the holding period of securities and the volume of trading are not clear or are overly fact dependent.164 therefore, it can be difficult for a taxpayer to know whether or not he qualifies for trader treatment. the factspecific nature of the analysis with respect to whether a taxpayer qualifies as a trader also makes irs enforcement difficult and breeds unnecessary and costly litigation.165 b. structural criticisms in addition to the above criticisms, the current taxation of traders is also problematic from a structural standpoint. whatever other fairness-based critiques of trader taxation may be made, the lopsided tax treatment of traders also stems from the fact that the tax rules on the gain side and on the deductions side of that treatment are different, and the statute is therefore asymmetrical between the gains side and the deductions side. this asymmetry itself causes ongoing problems in the taxation of traders. it is not surprising that since one set of tax rules (the trade or business requirement) underlies the majority of the aspects of a trader’s tax treatment while a separate and additional requirement (the capital asset rules) determines character of income, the intersection of the two sets of rules would not be perfectly seamless and unproblematic. most notably, because of the structure of the statutory rules, the magnitude of the difference between the taxation of traders and the taxation of other taxpayers in a trade or business is dependent on the rate differentials between ordinary and capital treatment at any given point in time, leading to an embedded volatility in trader taxation. furthermore, in the light of ever more widespread trader activity, this volatility has the potential to be proliferated in ways never before possible. 163. see, e.g., schwartz, supra note 5, at 399 (arguing for more specific guidance). 164. id. 165. see also jack robinson & richard s. mark, on-line transactions intensify trader vs. investor question, 66 practical tax strategies 80 (feb. 2001) (correctly determining whether a taxpayer is a trader or an investor “is difficult, not only because of the complexity of the law in this area but also because the case law deals with taxpayers in the pre-internet age”). 2008] a structural critique of trader taxation 1151 i. embedded volatility whether or not the treatment of traders is “fair,” the main concern from a structural standpoint is not so much that traders get favorable capital gain taxation as opposed to other taxpayers, but that exactly how favorably or differently traders are treated as compared to other taxpayers is dependent on a changing variable, namely, the way in which capital assets are treated under the code. this notion is clearly illustrated by looking at the differences between capital asset taxation in 1934 and capital asset taxation today.166 at the time the “to customers” requirement was introduced into the statute in 1934, the tax treatment resulting from “capital asset” classification under the tax law was fundamentally different than from the treatment of capital assets presently.167 unlike the present-day situation, capital gains were not taxed at reduced rates across the board in 1934.168 instead, for taxpayers other than corporations, a certain fraction of the capital gain or loss was not taken into account in computing net income, depending on the holding period of the capital asset, but the rest was taxed at ordinary income rates.169 so, for example, 100% of the gain or loss was recognized with respect to capital assets held for a year or less, 80% of the gain or loss was recognized for capital assets held for more than a year but not more than two years, 60% for capital assets held for more than two but not more than five years, and so forth.170 under the system of taxing capital gains then in existence, a trader in 1934 holding capital assets for slightly over a year would have been not have been taxed at as low an effective tax rate as a present-day trader.171 put another way, if the 1934 system of taxing capital gains were in effect today, then an individual trader taxed at a maximum marginal rate of 35% would be taxed at an effective rate of 28% on securities held for just over a year.172 166. miller , supra note 125, at 845 (citing hendricks, federal income tax: capital gains and losses, 49 harv. l. rev. 262 (1935)) (noting that despite capital classification, a 1934 trader would have had a large proportion of capital gains taxed at ordinary income rates). 167. compare irc § 1(h)(1) with revenue act of 1934, pub l. no. 73-216, § 117(a), 48 stat. 680, 714. 168. id. 169. id. see generally bonner menking, making sense of capital gains taxation, 39 u. kan. l. rev. 175, 177-78 (1990) (discussing this “inclusion ratio” concept); frederick l. pearce, capital gains and losses, s.c. l. q. 168, 170 (1953). the 1934 code also provided that the amount of capital losses allowed was limited to the amount of capital gains plus $2,000. irc § 117(d) (1934). 170. revenue act of 1934, pub l. no. 73-216, § 117(a), 48 stat. 680, 714. a corporation was taxed in full on its capital gains. 171. miller , supra note 125, at 845. 172. such a hypothetical trader would be taxed on 80% of such capital gain at a 35% rate, giving rise to an effective marginal rate of 28% (because 80% x 35% rate = 28%). 1152 florida tax review [vol. 8:10 this is obviously a much less favorable rate than the current usual 15% rate on long-term capital assets.173 hence, at the time of the 1934 addition of the “to customers” requirement, the prohibition against ordinary loss treatment for speculator losses that was enacted by that addition would not necessarily have given rise to very favorable treatment of such speculators on the gain side, and there would presumably have been less reason to be concerned about the flip side of the new legislation.174 as discussed above, however, under the present-day scheme of taxing certain capital assets at reduced rates and the rates currently in effect, a trader with capital gains held for over a year will be taxed at a maximum rate of 15%, which is significantly less than the ordinary income tax rates that would be experienced by dealers or other taxpayers in a trade or business. the method of taxing traders that has continued to the present day therefore seems particularly inappropriate in the light of changes in the taxation of capital gains since 1934, and not only because of the magnitude of the rate differential under current law. from a structural point of view, this inappropriateness also stems from the fact that by mandating capital asset treatment for securities held for sale by traders (who have no “customers”), the method of taxing traders that was introduced by congress in 1934 in effect links the “gain side” of trader taxation to the way in which capital gains are taxed at any given point in time. specifically, this method of taxing traders makes the extent to which trader taxation is more or less favorable than the taxation of investors or dealers dependent on the effective capital gains tax rates presently in existence. quite apart from being a favorable system for traders given the current differential between capital and ordinary tax rates, a system that links the degree of favorableness of trader taxation to the treatment of capital assets at any given point in time is a system that by definition contains embedded irrationality. this is particularly so since capital asset taxation is a “live” and hotly debated area of the law, and is an area that has endured many modifications and reversals over the years.175 in sum, from a structural standpoint, pegging the taxation of traders to capital assets taxation therefore ensures an innate volatility in the treatment of traders as compared to other types of investors. if the tax rate on capital gains were to fall as compared to the rates on ordinary income taxation, then traders would be afforded a correspondingly larger advantage over other taxpayers in a trade or business; if the capital gain tax preference were to be 173. irc § 1(h). 174. this observation has been made by at least one commentator. miller , supra note 125, at 845. 175. see, e.g., gregg a. esenwein, capital gains tax rates and revenues, cong. research. serv. rep. rs 20250 (apr. 4, 2007), available at tax analysts 2007 tnt 74-16; burman, supra note 2; menking, supra note 169, at 177-78 (1990); see also, generally, john w. lee iii, supra note 157. 2008] a structural critique of trader taxation 1153 repealed entirely, then the taxation of traders would presumably be more in alignment with the taxation of other taxpayers.176 ii. structural proliferation a second and related structural defect in the treatment of traders is that the embedded volatility in the structure of trader taxation has the potential to be more problematic and widespread than ever before, given current-day exigencies. first, there are many more taxpayers who have the potential to qualify as traders today than there were in 1934. commentators have pointed out the role of the internet and other economic factors, which have led to a vast increase in the amount of trading done by individuals and in the number of traders.177 this means that any problems caused by the asymmetry and potential volatility of trader taxation under the law have the potential to be multiplied in scope. in contrast to 1934, rather than the handful of speculators whose attempts at using their losses against ordinary income needed to be thwarted, there is now a larger number of traders who have the potential to treat their gains as capital gains, while attempting to deduct trade or business expenses from these same activities. with the growth of the “trader” phenomenon, the problems caused by the embedded volatility inherent in trader taxation discussed above have the potential to be seriously magnified. second, it should also be noted that while this article focuses mainly on what may be thought of as the “base case” of trader taxation – the case of an individual trader filing form 1040 with schedules c and d – modern-day exigencies have ensured that the structure of the tax rules concerning traders will have implications far beyond the basic scenario involving the prevention of a lone speculator from offsetting ordinary income with trading losses. unlike in 1934, today’s traders are not just individual taxpayers speculating in securities but may also include several individuals grouped together to engage in trading via entities such as investment funds or other investment pools. most notably, the statutory rules governing the taxation of traders apply not only to the solo trader but may also apply to the taxation of partnership traders such as hedge funds and other investment funds (typically 176. for an illustration of how the gap between ordinary income and capital gain has changed between 1998 and 2010 (hypothetically), see joann m. weiner, news analysis: saving private equity, 117 tax notes 309, 311 (oct. 22, 2007) (figure 1). 177. see, e.g., schwartz, supra note 5, at 399; robinson & mark, supra note 165; see also, generally, http://www.etrade.com (last visited jan. 19, 2008), http://www.tdameritrade.com (last visited jan. 19, 2008), http://www.fidelity.com (last visited jan. 19, 2008), http://www.schwab.com (last visited jan. 19, 2008), as examples of websites via which an individual sitting at home may easily be able to trade in stocks and securities. 1154 florida tax review [vol. 8:10 non-registered investment funds that are formed as offshore partnerships and that employ various investment strategies to make gains). the fund partnership itself typically receives capital treatment on the profits from the sales or exchanges of their investments, since the assets held by hedge funds are generally capital assets.178 under the partnership tax rules, this treatment would generally be passed through the partnership to the partners therein.179 therefore, investors in the fund will also be taxed on their distributive share of the gain realized by the fund at capital gain rates, with any losses being treated as capital losses.180 similarly, under current law, fund managers, as “carried interest” partners, also receive capital gain and loss treatment on such sales and exchanges that are allocable to the carried interest that they usually hold in the fund, since the carried interest is characterized as a share of partnership profits, rather than as compensation, under present law.181 as is the case for individual traders, gain from the sale of capital assets held for more than a year will therefore normally qualify for the 15% long-term capital gain rates under current law.182 at the same time, some funds may also take the position that they are traders for tax purposes.183 as with any other taxpayer attempting to qualify as a trader, however, the determination of whether the partnership is in fact a trader will largely be based on the fund’s holding period of its assets, with longer-term holding periods suggesting investor rather than trader status, as well as on the frequency, 178. weiner, supra note 176, at 310 (describing the capital asset treatment of general partner interests in private investment fund structures). 179. id.; see also irc §§ 702, 703, 704. 180. irc §§ 702, 703, 704. 181. see rev. proc. 93-27, 1993-2 cb 343 (ruling that the receipt of a partnership profits interest for services is not a taxable event so long as the person receives that interest either as a partner or in anticipation of becoming one. the procedure does not apply if (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from highquality debt securities or a high-quality net lease; (2) the partner disposes of the profits interest within two years of its receipt; or (3) the profits interest is a limited partnership interest in a publicly traded partnership under section 7704), clarified by rev. proc. 2001-43, 2001-2 cb 191, 8/03/2001. contrast campbell v. comm’r, 59 t.c.m. (cch) 236, rev’d, 943 f.2d 815 (8th cir. 1991); st. john v. united states, no. 82-1134 (c.d. ill. nov. 16, 1983) (holding that receipt of partnership profits interest is a taxable event under irc § 83). 182. irc §§ 1(h)(1), 1222(3), 1222(4). 183. see, e.g., rev. rul. 2008-12, 2008-10 irb 520 (feb. 19, 2008) (partnership trader in securities); see lee a. sheppard, are hedge funds in a trade or business?, 114 tax notes 140 (jan. 15, 2007) [hereinafter sheppard, trade or business] (citing arden dale, moving the market – tracking the numbers/outside audit: hedge-fund tax break raises flags; come april 15, the difference between “trader,” “investor” can be a substantial sum, wall. st. j., dec. 26, 2006, at c-3). 2008] a structural critique of trader taxation 1155 regularity, and continuity of the fund’s trades.184 as with individual investors, if the fund is a trader (i.e., is in a trade or business of trading), it may take irc section 162 business deductions and other business deductions, which are passed through to its partners. if the fund is instead an investor, its partners will be limited to irc section 212 deductions. it is therefore possible that a “trader” fund will be allowed trade or business–type deductions, while simultaneously being taxed at reduced rates on the disposition of those assets with a long-term holding period. needless to say, the amounts at stake will be much larger in the partnership–trader context than in the individual trader context, since partnerships involve funds contributed from multiple partners. the favorable capital asset treatment that hedge fund managers get on their carried interest, especially as compared to other taxpayers who receive amounts as compensation and are taxed at ordinary rates, has recently been subject to a good deal of criticism and the threat of reform.185 a variety of proposals to tax hedge fund managers at ordinary income rates have already been brought to the table.186 to the extent that one is already concerned about the allegedly inequitable treatment with respect to the character of income received by fund managers, the fact that the fund may simultaneously be allowed to claim trade or business–type deductions upon claiming trader status makes the inequity even worse. disgruntlement regarding fund entitlement to the trade or business deductions that come with trader status may be further fueled in the case of hedge funds that change from a short-term to a long-term strategy (for example, a fund shifting toward private equity investments). the changing investment strategies of such funds (which may depend on factors such as the current economic climate) may raise further questions regarding the continuing eligibility of such funds for “trader” classification in the light of their longer-term holding 184. see, e.g., yaeger, 889 f.2d at 33; moller, 721 f.2d at 813-14; see also sheppard, trade or business, supra note 183, at 143. such determination may also, in reality, be decided by how zealously irs enforcement accurate classification upon examining the returns. 185. see, e.g., lee a. sheppard, hedge funds managers’ 15 percent tax on 20 percent of the profits, 110 tax notes 1380 (mar. 27, 2006) [hereinafter sheppard, hedge funds managers]; darryl k. jones, debunking the carried interests myths: part i, 116 tax notes 799 (aug. 27, 2007); but see press release, united states treasury, testimony of treasury assistant secretary for tax policy eric solomon on the taxation of carried interests, tpr hp-489 (july 11, 2007) (on file with author). 186. jeremiah coder, forum panelists discuss “endgame” of private equity tax debate, 116 tax notes 1103 (sept. 24, 2007). 1156 florida tax review [vol. 8:10 period of their assets.187 questions regarding fairness may also arise with respect to funds with substantial losses that claim trader status and make a mark-to-market election under irc section 475(f) in order to convert such losses from capital to ordinary losses.188 while the rules applicable to fund partnerships claiming to be traders are the same underlying rules as those applicable to individual traders (albeit channeled through the partnership tax rules), the aggregate nature of investment funds accentuates the magnitude of the problem with respect to the favorable tax treatment that traders receive. if nothing else, the amounts at issue are larger in the case of these grouped investors than ever before, and the parties more sophisticated. in sum, with the emergence of various private equity investment arrangements, the business of “speculating” or “trading” has become more large-scale and common, with the result that larger and larger sums of money are at stake. it is therefore probably fair to say that the extension of trader status on a “group” or systemic level to entity or fund traders was not on the radar screen in 1934, when the “to customers” requirement was enacted. to the extent that one is concerned about fairness in the tax treatment of traders as compared with other categories of taxpayers, the real or perceived inequity in the trader tax rules may be magnified when applied to grouped (rather than individual) traders. c. summary despite its good intentions, the introduction of the “to customers” requirement into the statute in 1934 has wrought a disjuncture in the previously symmetrical treatment of taxpayers in a trade or business, with the securities trader’s tax treatment squarely at the heart of this disjuncture. the treatment of traders has been subject to a number of fairness-based criticisms. in addition, there are also problems stemming from the structure of the statute itself: trader taxation is currently linked to the ever-volatile minefield of capital asset taxation and therefore itself contains innate volatility. this volatility is magnified, given the modern-day phenomenon of “grouped” trading. from a policy standpoint, this is not a desirable or rational state of affairs. section v of this article argues that, from a structural standpoint, the courts and the legislature have, purposefully or not, already taken steps to remedy this situation, and that the structural problems caused by the current method of taxing traders would be even more severe but for these legislative and judicial steps. 187. see generally dale, supra note 183; see also, generally, fuld, 139 f.2d 465 (involving taxpayers changing from a long-term investment strategy to a shortterm strategy). 188. irc § 475(f). 2008] a structural critique of trader taxation 1157 section v: structural remediation by the courts and the legislature as discussed in section iv above, the asymmetrical tax rules applicable to the gains and deductions side of trader taxation is problematic for a variety of reasons. this section argues that the reason the impact of the statutory asymmetry is not even more far reaching is because of the actions of the legislature and the courts (whether or not intended) in minimizing the effects of the asymmetry. from a structural standpoint, such judicial and congressional efforts are best seen as effecting an architectural remediation in order to inject more symmetry into the statutory structure by limiting the impact of the asymmetrical rules in certain important situations, notwithstanding the letter of the statutory tax rules. a. court decisions regarding capital asset classification: minimizing the “to customers” requirement the structural problems inherent in the statute should not be limited to traders. this statement may appear counterintuitive, since the unusual result of allowing capital gain and loss treatment while also allowing various trade or business deductions is particularly a characteristic of traders. however, the asymmetrical structure of the statute has the potential to impact classes of taxpayers other than traders. even though the legislative history of the 1934 amendment to the capital asset definition reflects that the addition of the “to customers” requirement was aimed squarely at “speculators” who were attempting to offset other income against the losses from securities speculation, the actual language of the statute as enacted did not in any way limit the “to customers” requirement to speculators.189 this is still true of the statute in its present form, which merely states that the term “capital asset” does not include “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”190 had it intended to do so, congress could just as easily have created an exception to “capital asset” treatment exclusively applicable to securities. this, congress did not do. it is an important tenet of statutory interpretation that courts should give effect to each and every word in a statute, and that if the language of a statute is clear, courts should not go outside of the statute’s plain meaning in 189. revenue act of 1934, pub. l. no. 73-216, § 117(b), 48 stat. 680, 714 (1934). 190. irc § 1221(a)(1). 1158 florida tax review [vol. 8:10 interpreting the statute.191 it is equally a statutory interpretation tenet that courts should only resort to legislative history if the plain meaning of a statute is unclear.192 in this case, the plain meaning of the statute is perfectly clear: property must be held for sale “to customers” in order to come within the irc section 1221(a)(1) exception to the capital asset definition.193 despite this plain statutory requirement however, courts have simply ignored the “to customers” requirement outside the securities context.194 with respect to almost every other type of taxpayer, courts have held that anyone purchasing from a taxpayer engaged in a trade or business is a “customer.”195 for example, in the real estate context (real estate being, aside from stocks and securities, probably the most commonly analyzed group of capital assets), courts have not for the most part given effect to the “to customers” requirement and instead have understood any buyer of a taxpayer’s property to be a “customer.”196 with respect to real estate, courts have, in fact, held 191. 2a norman j. singer, sutherland states and statutory construction § 46.06 (6th ed. 2006) (“[i]t is an elementary rule of construction that effect must be given, if possible, to every word, clause and sentence of a statute. a statute should be construed so that effect is given to all its provisions, so that no part will be inoperative or superfluous, void or insignificant.... no clause sentence or word shall be construed as superfluous, void or insignificant if the construction can be found which will give force to and preserve all the words of the statute” (citations omitted; internal quotations omitted)); see also id. at § 46.01 (“when the language of the statute is clear and not unreasonable or illogical in its operation, the court may not go outside the statute to give it a different meaning.”). 192. singer, supra note 191, at § 48.01 (“[g]enerally, a court would look to the legislative history for guidance when the enacted text was capable of two reasonable readings or when no one path of meaning was clearly indicated. ... it is said that extrinsic aids may be considered only when a statute is ambiguous and unclear. however, ambiguity is not always considered a prerequisite to the use of extrinsic aids. … the supreme court has also said: ‘unless exceptional circumstances dictate otherwise, judicial inquiry into the meaning of a statute is complete once the court finds that the terms of the statute are unambiguous.’” (citations omitted). 193. irc § 1221(a)(1). 194. bittker & lokken, supra note 23, at ¶ 42.2.1 (“[t]he term [to customers]…has been construed to embrace anyone who purchases the taxpayer’s assets, with the result that it has virtually no operative significance except in the case of traders in securities and commodities, who are distinguished from dealers in these assets on the theory that traders do not sell to ‘customers’”). 195. id. 196. see bittker & lokken, supra note 23, at ¶ 47.2.3 (“[b]ecause the courts have not recognized a comparable activity of “trading” in real estate, persons whose real estate transactions are comparable in scale and frequency to those of a trader in securities are almost certain to be classified as dealers subject to ordinary income and loss treatment” (citing goodman v. united states, 290 f.2d 915 (ct. cl.), cert. denied 393 u.s. 824 (1968), a case in which lawyers who invested in real estate as 2008] a structural critique of trader taxation 1159 that all sales are sales “to customers” even in situations where the taxpayer in question has had only one customer. for example, in s.h. inc. v comm’r, the court held that a taxpayer, who purchased single plot of land and improved it to the specifications of one specific buyer who was previously committed to acquiring it, had customers and realized ordinary income, even though he had only one customer, and even though the sale was not one in a series of transactions.197 similarly, in guardian industrial corp. v. comm’r, the court held that silver waste that the taxpayer extracted from the chemical solution used in taxpayer’s photo-finishing business was for sale “to customers” in the trade or business, even where it was sold to only one customer under a long-term contract.198 the court noted that [w]hile the term “to customers” sometimes has been analyzed in isolation to determine whether property is described in sec. 1221(1), the question of whether a taxpayer is selling to customers is relevant chiefly in the case of persons dealing or trading in securities or commodities… outside the dealer/trader area, the term has been given such a broad meaning that separate consideration of it would not assist us in deciding the instant case.199 this broad interpretation of the words “to customers” in the capital asset statute can also be found in early court cases. for example, in black v. comm’r, the tax court in 1941 held that a real estate developer of residential property who had acquired an interest in a building but incurred losses when the lessee of the building became insolvent had held his interest “primarily minority members recognized ordinary income on the sale of such interests, even though the properties were not developed, subdivided or otherwise altered but were sold in the same condition as when acquired, and noting that a securities trader in the same situation with respect to his securities would not be afforded ordinary treatment)); see also william a. friedlander, to customers: the forgotten element in the characterization of gains on sales of real property, 39 tax l. rev. 31 (1983) (arguing that courts have erroneously ignored the “to customers” requirement in the real estate context and should instead give it appropriate effect). 197. s.h. inc. v comm’r, 78 t.c. 234, 243 (1982) (“the fact that [buyer] was petitioner’s only customer as of the time of the sale does not deny [him] of ‘customer’ status. a restricted group of purchasers may qualify as customers and it has been said that in real estate transactions a sale to any purchaser is, in effect, a sale to a customer” (citing pointer v. comm’r, 48 t.c. 906, 917 (1967)). 198. guardian industrial corp. v. comm’r, 97 t.c. 308, 317 n.2 (1991), aff’d, 21 f.3d. 427 (6th cir. 1994). 199. guardian industrial corp., 97 t.c. at 317 n.2 (citations omitted). 1160 florida tax review [vol. 8:10 for sale to customers in the ordinary course of his trade or business.”200 the court rejected the commissioner’s theory that “customers” only included customers for residential sales (which were the sales the taxpayer primarily dealt in his business), and stated that [w]here, as here, one is regularly engaged in the business of buying and selling real estate, as was petitioner, any person who can be found to buy such property is a customer, as that term is ordinarily understood, and where such property is held for sale under such circumstances it must be deemed to be held for sale to customers within the meaning of the statute.201 thus, it would seem that almost since the enactment of the “to customers” requirement in 1934, courts have given almost no effect to those words outside of the securities context. furthermore, courts in the real estate context have also ignored the judicial gloss placed by courts such as in kemon in the securities context on the words “to customers,” that is, the courts’ emphasis that while traders sell in the same markets in which they buy the property for sale (securities) and rely on price changes to make a profit, dealers tend to (like merchants) buy and sell in different markets, purchasing stock with the expectation that they will make a profit from finding a market of buyers to buy the property in excess of cost.202 instead of giving effect to the judicial interpretation of the “to customers” in kemon, courts in the real estate context have, instead, for the most part relied on a recitation of a list of factors in determining whether the taxpayer is in a trade or business, with these same factors also suggesting ordinary income treatment.203 such factors have included the following: the 200. black v. comm’r, 45 b.t.a. 204 (1941). 201. black, 45 b.t.a. at 210 (emphasis added) (citing goodman v. comm’r, 40 b.t.a. 22 (1939)). 202. see, e.g., kemon, 16 t.c. at 1032-33. 203. redwood empire savings & loan ass’n v. comm’r, 628 f.2d 516, 517 (9th cir. 1980) (whether real estate held by a savings and loan association was a capital asset held primarily for sale to customers in a trade or business depended on “a number of factors,” such as “the nature of the acquisition of the property, the frequency and continuity of sales over an extended period, the nature and the extent of the taxpayer’s business, the activity of the seller about the property, and the extent and substantiality of the transactions” (citations omitted)); austin v. comm’r, 263 f.2d 460, 462 (9th cir. 1959) (whether real property was held primarily for sale to customers in the course of his trade or business was a question of fact, and “[s]everal tests or factors have been considered by the courts to indicate whether certain properties were held by a taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, such as the nature of the acquisition of the 2008] a structural critique of trader taxation 1161 purpose of acquiring and holding the property; the existence and extent of improvements and/or subdivisions made to the property before selling it; the frequency, number, and continuity of sales; the “busyness” of the taxpayer’s business (including the relation of the real estate activity to the taxpayer’s primary occupation, if any); the extent of sales efforts (including advertising or lack thereof, solicitations, and the listing of property for sale through brokers or directly); and other miscellaneous factors.204 this analysis is not the same analysis as that considered by courts in the securities context in interpreting whether the taxpayer gets capital rather than ordinary treatment. the courts in the securities area have, since 1934, come to their conclusion by ruling that securities traders per se have no “customers,” which essentially obliterates the significance of the inquiry regarding whether the taxpayer is in a “trade or business” in determining capital asset treatment.205 in fact, ironically, the standard employed by courts in the real estate context in deciding the appropriateness of capital asset treatment actually comes closer to the analysis employed by courts in the securities context when deciding whether or not the taxpayer is involved in conducting a “trade or business” at all.206 it also comes closer to the analysis employed by the courts before the “to customers” requirement was added to the statute in 1934.207 thus, from a structural standpoint, courts in contexts outside of the securities context have not only ignored the “to customers” requirement but have, in fact, replaced that analysis with one identical to the analysis regarding whether the taxpayer was engaged in a trade or business in the first place. in doing so, the courts have in effect brought a judicially created symmetry back into the tax law, replacing the architectural asymmetry property, the frequency and continuity of sales over an extended period, the nature and the extent of the taxpayer’s business, the activity of the seller about the property, and the extent and substantiality of the transactions” (citations omitted)); bistline v. united states, 145 f. supp. 800 (9th cir. 1958); see also higgins, 312 u.s. at 217 (“[t]o determine whether the activities of a taxpayer are ‘carrying on a business’ requires an examination of the facts in each case”). 204. see redwood empire, 628 f.2d at 517; austin, 263 f.2d at 462; see also, e.g., frank h. taylor & son, inc. tc memo 1973-82; united states v. winthrop, 417 f.2d 905, 910 (5th cir. 1969); gault v. comm’r, 332 f.2d 94 (2d cir. 1964); maddux construction co. v. comm’r, 54 t.c. 1278 (1970); see generally phyllis zinicola, real estate and section 1221: business as a pattern of activity in the definition of a capital asset, 35 tax law. 225 (1982) (noting use of the “factors” analysis in the real estate context); t.c. fitzgerald jr., distinguishing between dealer and investor sales of real estate, 4 s.c.l.q. 309 (1952) (analyzing some of the factors examined by courts and making recommendations on how to maintain “investor” treatment). 205. kemon, 16 t.c. 1026; marrin, 73 t.c.m. (cch) 1748. 206. see section iii.a, supra. 207. schwinn 9 b.t.a. 1304; see also section iii.c, supra. 1162 florida tax review [vol. 8:10 wrought by introduction of the “to customers” requirement into the tax law. by ignoring the “to customers” requirement, the courts have, with respect to real estate and other types of capital assets (other than stocks and securities), minimized the potential impact of the statutory asymmetry caused by the introduction of the “to customers” requirement into the statute. b. the enactment of irc section 475(f) the 1997 introduction of the irc section 475(f) mark-to-market accounting election for traders in securities and commodities is another example of “structural remediation,” this time by congress. under irc section 475(f), a securities trader may elect to mark-to-market his securities held in connection with his trade or business at the end of each taxable year; that is, he may elect (1) to treat such securities as if they were sold by the trader at fair market value on the last business day of the year and (2) to take the gain or loss on such “phantom” sale into income for that year as ordinary gain or loss.208 the mark-to-market election, once made, applies to the year of the election and all subsequent taxable years of the trader, and may not be revoked without the irs’s consent.209 thus, the making of a mark-to-market election affects the timing of income recognition by a trader: by forcing the electing trader to recognize gain or loss on securities at the end of the taxable year even if the trader has not disposed of the securities, marking securities to market may result in income recognition before actual receipt of any proceeds from a disposition. it also affects the character of income recognized by the trader, causing such gain or loss to be taxed as ordinary gain or loss.210 in effect, therefore, a securities trader who makes a mark-to-market election converts what would otherwise be capital gain or loss, reported on schedule d, into ordinary income or loss, which is reported on form 4797 208. irc §§ 475(d)(3)(a), (f)(1)(a); rev. proc. 99-17, 1999-7 i.r.b. 52; for this purpose, a “security” is defined to include shares of corporate stock, interests in widely held or publicly traded partnership or trusts, notes, bonds, debentures or other evidences of indebtedness, certain notional principal contracts, certain interests or derivative financial instruments in the above securities, and certain clearly identified hedging transactions. irc § 475(f)(2). 209. irc § 475(f)(3). 210. irc § 475(d)(3)(a)(i). the statute also provides a special rule for dispositions, whereby if gain or loss is recognized with respect to a security to which the mark-to-market rule would otherwise have applied before the close of the tax year (i.e., through a sale or other disposition), the income or loss would also be treated as ordinary income or loss. irc §§ 475(f)(1)(d); 475(d)(3)(a)(ii). see hr rep. no. 148, 105th cong., 1st sess. 445 (1997). 2008] a structural critique of trader taxation 1163 and eventually tied in to the taxpayer’s form 1040.211 making the election may be particularly beneficial to a securities trader who has incurred irrecoverable losses from his trading activities and who wants to use those losses to offset ordinary income. by making the irc section 475(f) mark-tomarket election, the securities trader can convert his capital losses to ordinary losses, which can be used to offset ordinary gains.212 thus, the irc section 475(f) mark-to-market election, by allowing the trader to elect ordinary treatment, has the potential, upon being made, to significantly undermine the intent of congress when it enacted the “to customers” requirement in 1934 to prevent “speculators” from taking ordinary loss deductions for their losses from securities-trading activities, although it mitigates against possible inequities by also requiring ordinary gain treatment and by being essentially irrevocable.213 from a structural standpoint, the mark-to-market election also eliminates some of the structural incongruities inherent in the treatment of a non-electing trader that are caused by the impossibility of satisfying the “to customers” requirement in irc section 1221(a)(1). rather than reporting expenses and deductions based on general satisfaction of a “trade or business” requirement on schedule c while simultaneously reporting gains and losses as capital gains and losses on schedule d, an electing trader’s tax return would show ordinary gains and losses, along with “trade or business”–related deductions.214 thus, structurally speaking, making the mark-to-market election brings a trader’s tax picture closer in line with that of other taxpayers engaged in a trade or business by “reversing” the statutory asymmetry discussed in section ii and iii above. to bring the point home, it is useful to look at the origin of the irc section 475 mark-to-market election provision. irc section 475(f), as enacted by the 1997 taxpayer relief act, was an amendment to essentially allow securities traders to elect the same treatment that had already been mandatory for securities dealers since the enactment of irc section 475 in by the omnibus budget reconciliation act 1993.215 prior to the 1993 211. see internal revenue service form 4797, available at http://www.irs.gov/pub/irs-pdf/f4797.pdf (last visited jan. 15, 2008); internal revenue service form 4797 instructions, available at http://www.irs.gov/pub/irspdf/i4797.pdf (last visited jan. 15, 2008); internal revenue service form 1040 line 14, available at http://www.irs.gov/pub/irs-pdf/f1040.pdf (last visited jan. 15, 2008). 212. compare irc §§ 172(d)(2), 1211(b), 1212(b). 213. the mark-to-market election, once made, may not be revoked except with the consent of the secretary. irc § 475(f)(3). 214. see, e.g., raby, nondealer security losses, supra note 5 at 46 (“[t]he schedule c for an electing trader … shows gross receipts and cost of sales as well as expenses, and looks more conventional”); compare irs form 4797 and instructions, supra note 211. 215. 1993 omnibus budget reconciliation act, p.l. 105-34, § 13223(a). 1164 florida tax review [vol. 8:10 enactment of irc section 475, securities dealers were required to maintain an inventory of securities that they held for sale to customers, but were allowed to choose between three methods of valuing that inventory: a cost method, a lower-of-cost-or-market-value method, or a mark-to-market (i.e., fair market value) method.216 irc section 475, as enacted in 1993, mandated the use of the third, mark-to-market method for securities dealers, reflecting a congressional belief that the first two methods understated a dealer’s income and that marking-to-market at year end was most clearly reflective of income and was also easy to administer.217 as enacted in 1993, irc section 475 required securities dealers to mark-to-market their securities held at the end of the taxable year, that is, to compute the gain or loss recognized for the year as if the securities were sold for their “fair market value” on the last business day of the year, with such gain or loss being ordinary income or loss. irc section 475(f) merely makes the treatment already required of securities dealers elective for traders, thereby offering traders the option of bringing their tax treatment in line with that of securities dealers. by making the irc section 475(f) election, the electing trader gets the same treatment as securities dealers with respect to the character and timing of the income side of the equation, as well as with respect to the business deductions side of the equation. the election therefore basically “converts” his asymmetrical treatment under the general tax rule for non-electing traders to the symmetrical, structurally sound treatment accorded to securities dealers, effectively bringing the treatment of traders in line with that of dealers. a non-electing trader, however, would not likewise have his asymmetrical treatment converted into the structurally sound tax treatment experienced by investors. finally, it should be noted that the term “dealer in securities” is defined in irc section 475(c)(1) as “a taxpayer who (a) regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business; or (b) regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.”218 ironically, therefore, the irc section 475(f) mark-to-market election for traders therefore brings the statutory structure 216. peter j. connors, the mark-to-market rules of section 475, 543-1st tax mgmt. (bna) a-3 at n.11 (citing ways and means committee report to 1993 omnibus budget reconciliation act at 224, 1993-3 c.b. vol. 3 at 240; senate finance committee report at 129, 1993-3 c.b. vol. 4 at 139). 217. id. 218. irc § 475(c)(1)(a) (emphasis added); see also, generally, § 1236(a) (“gain by a dealer in securities from the sale or exchange of any security shall in no event be considered as gain from the sale or exchange of a capital asset” unless (1) “clearly identified” as held for investment or (2) the security was not, at any time after the close of such day (or such earlier time), held by such dealer primarily for sale to customers in the ordinary course of his trade or business” (emphasis added)). 2008] a structural critique of trader taxation 1165 full circle: it allows traders, a group accorded capital gain and loss treatment specifically because they have no customers, to in effect opt in to the treatment accorded to securities dealers, a group that is specifically defined in irc section 475(c) by reference to the existence of their customers. like the courts in ignoring the “to customers” requirement with respect to taxpayers other than securities traders, the legislature, in enacting the irc section 475(f) mark-to-market election for traders, has made significantly moot the legislatively enacted (and court-aided) distinction made between those taxpayers in a trade or business who have customers and those who do not. c. an argument for change the above discussion demonstrates that the courts and congress have already taken steps to minimize the impact of the “to customers” requirement in situations not involving traders, as well as in the trader context. one should also not lose sight of the fact that courts (and the irs) have also done their part by ensuring that it is difficult to qualify as a trader under current law.219 as discussed in section iii above, proving that one is a trader is a non-trivial undertaking. the taxpayer in question must show that his trading behaviors are frequent, regular, continuous, non-sporadic, and must also show that the gain he realizes from the activities are of the appropriate type.220 while court decisions have varied on a case-by-case basis, the standard is generally quite onerous. in part because of the difficulty of qualifying as a trader before the courts, a repeal of the “to customers” requirement would not necessarily result in the feared widespread abuse by traders taking such losses as ordinary losses. provided that this high standard is properly applied by courts, sporadically trading taxpayers, taxpayers who hold securities with a too-long holding period (including taxpayers that are investment funds), and “dilettante” taxpayers who buy and sell securities as a hobby would not qualify for trader treatment. furthermore, as discussed in section v.b, above, a trader who has suffered large and irrecoverable losses is already able to make the irc section 475(f) election to convert such losses into ordinary losses under present law. it is true that the trader is generally required to make the election by the due date (without regard to extensions) of the original federal income tax return for the taxable year immediately preceding the year the taxpayer wants to election to be effective, thereby eliminating the benefits of 219. see section iii.a, supra; see also rev. rul. 2008-12 (imposing investment interest limitation on non-materially participating limited partner’s distributive share of partnership income). 220. id. 1166 florida tax review [vol. 8:10 retroactive tax planning.221 however, it would be naïve to think that this deadline eliminates all the benefits of retroactivity. for example, an individual trader expecting to suffer large losses in july 2008 might well be able to make an informed guess as to whether it would be wise to make the election with his 2007 tax return on april 15, 2008, thereby converting those losses to ordinary losses for the 2008 taxable year. in light of the difficulty of qualifying for trader treatment and the widespread availability of the mark-to-market election, a repeal of the “to customers” requirement need not lead to increased abuses, such as traders taking runaway deductions of ordinary trading losses against other income. such repeal would also reduce the degree of complexity currently involved in taxing traders. this article therefore recommends a two-pronged approach to dealing with the problems with the current rules on trader taxation. first, for the reasons extensively argued above, the “to customers” requirement in irc section 1221(a)(1) should be repealed and the currently optional markto-market accounting method made mandatory. with these steps, the taxation of traders would be brought more or less in line with that of dealers, including with respect to the requirement that mark-to-market accounting be used for securities held in the trader’s trade or business. this is arguably what the mark-to-market election already does in the first place. repealing the “to customers” requirement and imposing on traders the symmetrical tax treatment (and mark-to-market accounting approach) currently required of dealers would eliminate the statutory asymmetry and its associated problems, and would also eliminate the simultaneous complexity and inadequacy of having an elective mark-to-market election in the first place.222 second, once the “to customers” requirement has been repealed, and the gains and losses of traders rendered ordinary, the irs could then help to prevent taxpayer abuses by promulgating more specific and stringent guidance regarding the precise requirements that must be met in order to qualify for trader 221. rev. proc. 99-17, 1999-7 i.r.b. 52, section 5.02. however, for taxpayers for which a tax return was not required to be filed for the tax year preceding the election year, the election must be filed no later than two months and 15 days after the first day of the election year. 222. see, e.g., james s. eustice, abusive tax shelters: old “brine” in new bottles, 55 tax law rev. 135, 142 & n.39 (2002) (“the current realization-based income tax, lacking extensive mark-to-market rules for readily tradable assets, leaves the timing of gain or loss recognition in the hands of the holder of the property…taxpayers’ ability to select which gains or losses are to be recognized for tax purposes, and when that event is to occur, is a common theme in many tax shelter transaction planning scenarios”; “[w]hile § 475 has imposed a mark-tomarket regime for certain traded securities, it has done so only on a limited basis for limited classes of taxpayers”); sheppard, supra note 5, at 721-22 (arguing that markto-market accounting should be required for securities traders). 2008] a structural critique of trader taxation 1167 taxation.223 such guidance could, for example, state exactly what level of activity is required to qualify as a trader or could clarify that partnership and individual “traders” that undergo a change in investment strategy from shortterm to long-term investments during the tax year are not considered traders. this guidance could perhaps be incorporated into federal income tax return filings by requiring taxpayers claiming trader status to declare or certify on their tax returns that they have fulfilled certain requirements (for example, by making such taxpayers check a box stating that they are claiming trader status). such an approach would make it harder for taxpayers to claim trader status while making it easier for the irs to identify taxpayer abuses. this two-pronged approach would go a long way toward ameliorating the problems, discussed above, associated with the current tax treatment of traders. it would also help to discourage taxpayers who do not qualify as traders from taking the position that they are in fact traders, thereby reducing litigation costs. such an approach would therefore eliminate much of the complexity, irrationality, and costs inherent in the current statutory structure, including the costs of fact-specific litigation, and the costs of the complexity surrounding the making of the irc section 475(f) mark-to-market election for traders. section vi: conclusion this article has argued that, in addition to a number of policy concerns, there are significant structural problems in the current treatment of taxpayers who are traders in securities. the current structure of the statute leaves the degree to which the treatment of traders is fair or unfair especially sensitive to capital gain rate changes. furthermore, the current statutory structure is prone to widespread proliferation and abuse, given the increased magnitude of trading activities in the present day. these structural problems stem from the requirement that, in order to be subject to ordinary income or loss treatment on sales of securities held in their trading business, traders must sell such securities “to customers,” which courts have held that traders do not do. the 1934 addition of the “to customers” requirement came about as a response to the “abusive” behaviors of a small group of securities speculators and was aimed at preventing them from using ordinary deductions from their losses from speculation to offset other ordinary income.224 however, as with many other narrowly focused “anti-abuse” provisions that have been introduced into the code, the small differences intended by the introduction of these two words have become 223. see also schwartz, supra note 5, at 436-37. 224. h.r. conf. rep. no. 73-1385, (2d sess.), at 22 (1934); see also peter miller, supra note 125, at 844-45 & n.38 (1950); bittker & lokken, supra note 23, at ¶ 47.2. 1168 florida tax review [vol. 8:10 magnified in the light of modern-day exigencies and changes in the tax law, and have hence led to unforeseen difficulties. this article has also shown that there have already been “structural remediation” attempts by the courts and by congress, which serve to effect a de facto repeal of the “to customers” requirement and to render the statutory structure less imbalanced. in light of these remediation attempts, this article has advocated a two-prong approach towards reinventing trader taxation: the elimination of the “to customers” requirement and simultaneous requirement of dealer-like mark-to-market accounting, and promulgation of strict and concrete guidance containing clear and stringent standards for “trader” qualification. such an approach would help to correct the current statutory imbalances and would also help promote rationality and eliminate unnecessary complexity in the taxation of traders. done properly, these goals could also be accomplished without opening up additional loopholes for abuses by traders. florida tax review volume 1 1993 number 8 harper and its aftermath eric rakowski" i. introduction it. the court's opinions in harper i. retroactivity by default or equal treatmern iv. the future of chevron oil v. the remedial requirements of the due process clause a. preand post-deprivation due process b. equitable discretion in choosing remedies c. offsetting bonuses and retroactive tax increases d. possible congressional action e. states' pass-on defense f. interest on refunds vi. additional state-law issues affecting remedies a. extending vs. invalidating exemptions b. contractual constraints on taxing state pensions c. extra compensation and gift clauses vii. conclusion * acting professor of law, university of california at berkeley (boalt hall). for helpful comments, i am indebted to paul mishkin and david shapiro. 445 florida tax review i. introduction in davis v. michigan department of treasury,' the supreme court ruled that states may not tax the pensions of former federal workers without imposing a like tax on the retirement income of former state employees. noting that michigan had agreed to refund the state income taxes paul davis had paid on his federal pension over the years in controversy, the court stated that he was entitled to a refund.2 it then remanded the case to allow the michigan courts and state lawmakers to determine how state and federal retirees were to be treated equally in the future-both taxed according to the same schedule or exempted from tax-and to resolve the thousands of refund claims by federal pensioners that had been or might be filed.3 davis provoked a whirlwind of activity in state courts and legislatures across the country, because two dozen states taxed state retirement income more lightly than federal pensions, contrary to the supreme court's understanding of the doctrine of intergovernmental tax immunity.4 davis left no doubt that states must equalize the taxation of federal and state retirees following the issuance of the court's opinion. but the court's bare mention of michigan's concession to refund davis's taxes failed to answer clearly the question of whether states owed some form of retroactive relief to all similarly situated federal retirees who had paid higher taxes than had state pensioners. not surprisingly, in view of the number of courts that issued rulings, the enormous sums at stake,5 and the confusion swirling around the supreme court's recent retroactivity rulings, state courts disagreed over whether the fourteenth amendment's due process clause mandates a remedy for past wrongs. many, including virginia's supreme court, concluded that 1. 489 u.s. 803 (1989). 2. id. at 817. 3. id. at 817-18. the court has since declared that its reasoning also applies to retirement benefits paid by the federal government to former military personnel, not only to former civil servants like davis. see barker v. kansas, 112 s. ct. 1619 (1992). 4. a list of those states may be found in harper v. virginia dep't of taxation, 401 s.e.2d 868, 871 n.2 (va.), vacated and remanded, 111 s. ct. 2883, affd, 410 s.e.2d 629 (va. 1991), rev'd and remanded, 113 s. ct. 2510 (1993). see also davis v. michigan department of treasury: a review of the subsequential litigation, lexis, fedtax library, stn file, elec. cit. 92 stn 121-23; jasper l. cummings, jr., et al., status of davis-type state court litigation, special report, 51 tax notes 631 (may 6, 1991). 5. by one estimate, the aggregate cost of refunding the unconstitutionally excessive portion of state income taxes on federal pensions for all open tax years exceeds $2 billion. see ian k. louden, high court remands federal retiree benefits cases; lets stand charitable organization gambling case, lexis, fedtax library, stn file, elec. cit. 91 stn 133-17. this estimate preceded the court's decision in barker, which greatly exacerbates states' fiscal difficulties. virginia alleged that its refund liability alone would amount to approximately $440 million. see harper, 401 s.e.2d at 873. [vol. 1:8 harper and its aftemiath davis established a requirement of equal treatment solely for the future.6 accordingly, they refused to order refunds to federal retirees or to impose a retroactive tax on state pensions to secure equality after the fact. in harper v. virginia department of taxation,7 decided june 18, 1993, the supreme court reduced, but by no means eliminated, the considerable uncertainty over davis's retroactive impact. five justices held that, because the court applied its ruling retroactively to davis himself in sanctioning the refund michigan offered to make, all state courts must apply davis retroactively and offer relief consistent with the court's earlier account of due process in mckesson corp. v. division of alcoholic beverages." two justices concurred in the judgment, not because they considered the court bound by the perfunctory application of its holding to the parties before it in acknowledging michigan's concession to refund davis's taxes, but because they adjudged the court's interpretation of the intergovernmental tax immunity doctrine in davis insufficiently novel to warrant purely prospective application. 9 finally, two justices dissented, arguing that davis was so surprising a decision and the burden on the states of affording retroactive relief so onerous that retroactive application could not be justified."0 this article describes and assesses the court's reasoning in harper and examines the decision's likely ramifications. although the court's holding might well be correct, its explanation of that result is unconvincing. justice thomas's majority opinion is also disappointing, because it leaves for another day-at what will predictably be a significant cost for states and private litigants-the looming question of what principles should steer courts in determining whether unexpected civil decisions applying federal law have retroactive effect. after outlining the larger retroactivity battle to come, the article explores the sketchy remedial requirements that mckesson imposes and sets forth the principal controversies that await resolution as harper's implications are debated in the various state courts. several of these matters, such as the amount of equitable remedial discretion state courts enjoy and whether interest on tax refunds is constitutionally mandatory, will probably wend their way to the supreme court eventually. the court might also feel compelled to rule, probably in a future commerce clause case, on whether states may reduce their refund obligations insofar as commercial taxpayers have passed part or all of the tax burden on to suppliers or consumers. 6. harper, 401 s.e.2d at 874. 7. 113 s. cl 2510 (1993). 8. 496 u.s. 18 (1990). 9. harper, 113 s. cl at 2526 (kennedy, j., concurring in part and concurring in the judgment) (joined by white, j.). 10. id. at 2535 (o'connor, j., dissenting) (joined by rehnquist, cj.). 19931 florida tax review whether any of these issues returns to the supreme court through harper-inspired litigation depends, in part, on congress. because the purpose of the intergovernmental tax immunity doctrine, codified at 4 u.s.c. § 111, is to protect the federal government and the states from discriminatory levies on one another's activities, congress may waive or lessen any claim to compensation for davis-type discrimination. it may do so whether that claim is lodged directly by the federal government or whether it takes the form of refund suits by former federal employees. congress could thus save the states hundreds of millions of dollars in refunds (if states chose refunds as a remedy, which in at least some cases they need not do) at little or no cost to the federal treasury. it might thereby align, with more precision than any other constitutionally permissible remedy, the cost of providing retroactive relief by the states with the economic harm that the federal government suffered at their hands. even if congress did not act, states might avail themselves of a similar solution. to the extent that state law and the due process clause allow, states might impose retroactive taxes on state retirees while paying them an offsetting bonus to cover the state and federal tax liability resulting from those retroactive taxes and the bonus itself. or, less awkwardly, states might enter into a settlement agreement with the federal government to pay washington approximately the amount that the internal revenue service would receive from state pensioners through that formally complicated and administratively much more troublesome series of interlocking transactions. should a state and federal executive officials choose this course, without congressional authorization, another trip to the supreme court might be necessary. i conclude by examining a number of state-law issues that are likely to shape harper's impact in at least some jurisdictions. although challenges under state constitutions' extra compensation and gift clauses to legislative attempts to increase pensions while subjecting them to state income tax will probably come to naught, breach-of-contract actions against states that begin taxing retirement pay might significantly constrain states' remedial options. ii. the court's opinions in harper harper produced four opinions, representing two conflicting views about the significance of a single sentence in the court's opinion in davis: "the state having conceded that a refund is appropriate in these circumstances, see brief for appellee 63, to the extent appellant has paid taxes pursuant to this invalid tax scheme, he is entitled to a refund."" five justices 11. davis, 489 u.s. at 817. [vol 1:8 harper and its aftemaih believed that this statement constituted a ruling that the court's holding in davis applied retroactively to the parties in that case, and that, because it would be inappropriate to rule in favor of one plaintiff without ruling similarly on all equally meritorious claims, davis applies retroactively in harper and in all other cases presenting the same intergovernmental tax immunity issue. the four remaining justices disagreed. they denied that this casual sentence in davis foreclosed further consideration of the decision's retroactive effect. the four divided, however, over whether the due process clause compels davis's retroactive application. writing for a bare majority, 2 justice thomas concluded that davis applies to pre-decisional tax disparities between state and federal retirees in nearly half the states. he rested his conclusion on two distinct propositions. the first is that the court applied its ruling in davis retroactively as well as prospectively. justice thomas justified this reading of the court's earlier opinion by reference to a general presumption about constitutional adjudication, as well as by an inference from the court's language. the presumption is that the court's decisions apply retroactively, approving or invalidating conduct that antedates those decisions, unless the court stipulates otherwise.13 in james b. beam distilling co. v. georgia, 4 justice souter wrote that when the court "did not reserve the question whether its holding should be applied to the parties before it, . . . it is properly understood to have followed the normal rule of retroactive application in civil cases."' 5 justice thomas explicitly endorsed this "express reservation" rule in harper.6 12. justice thomas's opinion was joined by justices blackmun, stevens. scalia, and souter. 13. see harper, 113 s. ct. at 2516-17. 14. 111 s. ct. 2439 (1991). 15. id. at 2445 (citation omitted) (opinion of souter j.). although only justice stevens joined justice souter's opinion, the quoted sentence can fairly be read to represent the views of a majority of the justices when beam was decided because three justices then maintained that the court's holdings always apply retroactively. id. at 2449-50 (blackmun. j., concurring in the judgment) (joined by marshall and scalia, jj.); see id. at 2450-51 (scalia, j., concurring in the judgment) (joined by marshall and blackmun, jj.). 16. harper, 113 s. ct. at 2518. there is no foundation for the claim that: because beam assigns determinative consequence to the manner in which a new rule is applied when first announced, it effectively requires that a court consider the retroactivity issue in the same case in which the rule is promulgated, rather than simply grant relief and defer extensive analysis of retroactivity to subsequent cases. note, the supreme court, 1990 term-leading cases: application of new rules in civil cases, 105 harv. l. rev. 339, 344 n.47 (1991). nothing in the opinions written or joined by justices souter, stevens, and white in beam indicates that a new rule need be applied either retroactively or prospectively when first announced. a court could, in their view, apparently decide the merits issues and leave the question of retroactive application for a later day. of 19931 florida tax review plainly, nowhere in davis did the court expressly postpone judgment on the backward reach of its holding. by default, it therefore applied retroactively. indeed, justice thomas contended, the court's statement in davis that the appellant was entitled to a refund, in accordance with michigan's announced intention to pay him one if he prevailed on the merits, was an affirmative indication of the court's desire to apply its holding to past conduct, not merely fateful silence. it "constituted a retroactive application of the rule announced in davis to the parties before the court."' 7 the second proposition on which the court's decision hinged is that the equal treatment of similarly positioned parties, so far as the retroactive impact of a decision about federal law is concerned, is more important than correcting any error that might have been made in applying the initial merits decision retroactively or only prospectively. again relying on justice souter's separate opinion in beam, which justice thomas said "controls" the outcome in harper on this point,'8 the majority held that "the legal imperative 'to apply a rule of federal law retroactively after the case announcing the rule has already done so' must 'prevainl] over any claim based on a chevron oil analysis.' ,, 9 thus, whether or not the court was right to retroactively apply the sitting justices, only justices blackmun and scalia would, judging from their opinions in beam, unfailingly dispose of the retroactivity issue with the merits, and then only because they regard all decisions as retroactive. justice thomas's opinion in harper, by echoing the "express reservation" rule that justice souter set forth in beam and by not condemning the court's procedure in american trucking ass'ns v. scheiner, 483 u.s. 266 (1987), which left the retroactivity question for resolution in american trucking ass'ns v. smith, 496 u.s. 167 (1990), confirms that the court can put the retroactivity issue aside for future determination after tackling the merits of a case. perhaps it will someday abandon this view in favor of the rule of automatic retroactivity that some justices favor. see infra part iv. but the court has not done so yet. 17. harper, 113 s. ct. at 2518. 18. id. at 2517. beam involved the retroactive impact of the court's decision in bacchus imports, ltd. v. dias, 468 u.s. 263 (1984). bacchus declared unconstitutional a hawaii statute that taxed locally produced alcoholic beverages less heavily than imported alcoholic beverages. id. at 265. beam concluded that the court had applied its decision in bacchus retroactively to the parties in that case, and that "principles of equality and stare decisis" required that a decision invalidating a similar georgia preference for alcoholic beverages produced from georgia-grown products likewise apply retroactively. beam, 111 s. ct. at 2446 (opinion of souter, j.). 19. harper, 113 s. ct. at 2518 (quoting beam, ii1 s. ct. at 2446 (opinion of souter, j.)). in chevron oil co. v. huson, 404 u.s. 97 (1971), the court had to decide whether a state statute of limitations, which federal law had incorporated, should apply retroactively. prior to the court's decision recognizing the state statute of limitations as the proper one, precedent suggested that a longer, federal limitations period existed. in deciding whether the longer or the newly recognized shorter statute of limitations should govern suits filed before the shorter limitations period was announced, the court weighed three sets of considerations culled from earlier cases. first, "the decision to be applied nonretroactively [vol 1:8 harper and its aftermath its ruling in davis to the parties before it-and it did so, as justice o'connor pointed out in her harper dissent, without briefing or even any recognition at oral argument that the issue was properly presentedk-all states facing refund actions premised on davis are bound to give the decision retroactive effect. "selective prospectivity"-the practice of applying a ruling retroactively to the parties whose suit resulted in a decision on the merits but prospectively to all others-once favored to facilitate dramatic law-changing criminal decisions but since repudiated, is now dead in civil cases too. after declaring davis retroactive, the court summarily rejected virginia's claim that it had an adequate and independent state ground for its refusal to apply davis retroactively.2' virginia had maintained that it need not provide compensation because, as a matter of state law, rulings striking down state tax statutes are given only prospective effect.y this claim, as justice thomas noted, was an affront to the supremacy clause, which "does not allow federal retroactivity doctrine to be supplanted by the invocation of a contrary approach to retroactivity under state law.'-must establish a new principle of law, either by overruling clear past precedent on which litigants may have relied, or by deciding an issue of first impression whose resolution was not clearly foreshadowed." id. at 106 (citation omitted). second, the history, purpose, and effect of the new rule should be consulted to determine whether retroactive application would advance or hinder its operation. id. at 106-07. third, the equities must be weighed, particularly any hardship or unfairness that retroactive application might work. id. at 107. the court has recently made clear that the first consideration operates as a threshold: if it is not satisfied, a decision applies retroactively, regardless of how it rates along the other two dimensions (although there is plainly a substantial overlap between an assessment of novelty and the third prong's balancing of the equities). see ashland oil, inc. v. caryl. 497 u.s. 916. 918 (1990) (per curiam); national mines corp. v. caryl, 497 u.s. 922, 923 (1990) (per curiam). 20. see harper, 113 s. ct. at 2530 (o'connor, j., dissenting). 21. the virginia supreme court originally held that davis applies purely prospectively under the supreme court's three-pronged test for the retroactive application of civil decisions in chevron oil. harper v. virginia dep't of taxation, 401 s.e.2d 868 (va. 1991). the supreme court vacated and remanded in light of beam. ill s. ct. 2883 (1991). on remand, the virginia supreme court affirmed its earlier holding, concluding that the court did not apply its ruling in davis retroactively. 410 s.e.2d 629 (va. 1991). the supreme court then reversed and again remanded. 113 s. c. 2510 (1993). 22. harper, 410 s.e.2d at 873-74. 23. harper, 113 s. ct. at 2519 (citation omitted). by contrast, "the federal constitution has no voice upon the subject" of states' decisions to make judicial rulings on state-lmv issues entirely prospective; to apply them to the parties in court but otherwise to enforce them prospectively; or to render them fully retroactive, thereby affording relief to future litigants whose claims remain ripe and those whose cases are pending at the time of decision. see great n. ry. v. sunburst oil & refining co., 287 u.s. 358, 364 (1932); see generally walter v. schaefer, the control of "sunbursts": techniques of prospective overruling, 42 n.y.u. l. rev. 631 (1967). 19931 florida tax review finally, the court addressed the question of remedies. mckesson held that if a state provided "a form of 'predeprivation process,' for example, by authorizing taxpayers to bring suit to enjoin imposition of a tax prior to its payment, or by allowing taxpayers to withhold payment and then interpose their objections as defenses in a tax enforcement proceeding initiated by the state," it need not provide refunds or impose a retroactive tax on favored taxpayers should a tax statute be declared unconstitutional.24 virginia had argued in its brief that federal retirees had a constitutionally adequate prepayment remedy if they wished to challenge the constitutionality of the state's tax on federal pensions. however, because the virginia courts had not adjudicated this claim, the supreme court declined to construe the relevant statutes and pass judgment on their sufficiency as a matter of federal law. if virginia did not offer a pre-payment remedy satisfying due process requirements-which the court did nothing to specify, beyond quoting from mckesson-then it must, justice thomas wrote, provide the "meaningful backward-looking relief' that mckesson demands.' extending the tax preference for retired state workers retroactively to federal retirees, and refunding the excess tax the latter paid, would certainly fulfill this obligation. but, as the court explained in mckesson, other options are available. a state could, for example, tax state retirees retroactively at the same rate that applied to federal pensioners (assuming that retroactive taxes were compatible with due process guarantees and state-law constraints). or it could combine retroactive taxes and refunds to achieve "in hindsight a nondiscriminatory scheme., 26 because it was for the state, not the supreme court, to choose among the various alternatives that would remedy the earlier wrong, the court reversed and remanded the case to the virginia supreme court for further proceedings. in a separate opinion, justice kennedy, joined by justice white, concurred in the court's result but not in the pivotal section of its reasoning. he first expressed his conviction that the purely prospective application of civil decisions is sometimes appropriate. then, in what might be an overly anxious reading of the majority opinion (although justice thomas evidently did not rewrite his draft to quiet the worry that both justice kennedy and justice o'connor voiced), justice kennedy denounced "the court's broad 24. mckesson corp. v. division of alcoholic beverages, 496 u.s. 18,36-40 (1990). 25. harper, 113 s. ct. at 2519 (quoting mckesson, 496 u.s. at 31). 26. id. at 2520 (quoting mckesson, 496 u.s. at 40). 27. id. justice scalia, who joined the court's opinion in full, added a long concurrence criticizing justice o'connor's dissent. id. (scalia, j., concurring). he reiterated his antipathy to purely prospective decisionmaking and repeated his call, see beam, 111 s. ct. at 2450 (scalia, j., concurring in the judgment), for a return to a rule of automatic retroactivity for civil cases. [vol 1:8 harper and its aftermath dicta... that appears to embrace in the civil context the retroactivity principles adopted for criminal cases in griffith v. kentucky."'2 justice kennedy further agreed with the dissent that chevron oil's tripartite test should be used to determine whether a civil decision applies retroactively. that test, he asserted, should take precedence over a litigant's claim to the same treatment as the parties to an earlier case in which the court announced a ruling on the merits without fully considering the retroactivity issue. employing the chevron oil test, justice kennedy concluded that davis should be given retroactive effect.' far from announcing a new principle of law, davis was, in justice kennedy's view, "a mere application of plain statutory language and existing precedent." hence, he agreed with the court's disposition of the case if not its rationale. justice o'connor's dissent, which chief justice rehnquist joined, parted company with justice kennedy's assessment of davis's novelty. she argued at length that chevron oil was better read to deny retroactive effect to davis, particularly in light of the burden that applying davis retroactively would impose on states if they had to tender refunds to former federal workers. justice o'connor also emphasized the unexpected character of the court's order striking down tax disparities that had been on the books of nearly half the states for decades and that had hitherto passed unchallenged. 32 the most powerful section of justice o'connor's dissent assailed the court's assumption that its resolution of harper was dictated by its retroactive application of davis. the debate over the import of that single cryptic sentence in davis-"the state having conceded that a refund is appropriate... [davis] is entitled to a refund." 3-she said, "is as meaningless as it is indeterminate."' the court's longstanding rule, which it affirmed earlier that very term in brecht v. abrahamson23 is that the court is not bound by its tacit resolution of issues that it did not squarely address following briefing and oral argument.3 6 the record, she noted, revealed plainly that the court did not give adequate consideration to the retroactivity 28. harper, 113 s. ct. at 2525 (kennedy, j.. concurring in part and concurring in the judgment) (citation omitted). griffith v. kentucky, 479 u.s. 314 (1987). held that federal criminal decisions apply retroactively to all cases awaiting trial or still on direct review. 29. harper, 113 s. ct. at 2525 (kennedy. j.. concurring in part and concurring in the judgment). 30. id. at 2526 (kennedy, j., concurring in part and concurring in the judgment). 31. id. at 2526-27 (o'connor, j., dissenting). 32. id. at 2533 (o'connor, j., dissenting). 33. davis, 489 u.s. at 817. 34. harper, 113 s. cl at 2529 (o'connor, j., dissenting). 35. 113 s. ct. 1710 (1993). 36. see id. at 1718. 19931 florida tax review question when it decided davis.37 in conclusion, after defending the possibility of purely prospective constitutional holdings, justice o'connor turned to remedial issues. she noted that the court, most clearly since its decisions in mckesson and american trucking ass'ns v. smith,3" has distinguished between declaring that a ruling has retroactive application-retroactivity as "choice of law"-and specifying what remedies, if any, its retroactive application entails. because harper passed judgment on only the first type of retroactivity, she chided the court for its brief remarks about virginia's possible remedial obligations, an issue she thought not yet before the court.39 more specifically, she disparaged justice thomas's suggestion that if virginia failed to provide taxpayers with a constitutionally adequate prepayment remedy, it would have to provide some type of compensation for its misdeeds, whether by way of a refund to federal retirees or a retroactive tax on former state workers: in my view, and in light of the court's revisions to the law of retroactivity, it should be constitutionally permissible for the equities to inform the remedial inquiry. in a particularly compelling case, then, the equities might permit a state to deny taxpayers a full refund despite having refused them predeprivation process.4" justice o'connor claimed that justice stevens's dissent in american trucking and justice souter's separate opinion in beam should be read as applauding the notion that courts have broad equitable discretion in crafting remedies when rulings apply retroactively. in cases more compelling than florida's predicament in mckesson, the views of justices stevens and souter, as justice o'connor construed them, would allow courts to take actions that lie outside mckesson's narrow compass. whether or not her reading of their opinions is correct,4 justice o'connor ended by announcing her view that 37. harper, 113 s. ct. at 2530 (o'connor, i., dissenting). 38. 496 u.s. 167 (1990). american trucking held that the court's earlier commerce clause decision in american trucking ass'ns v. scheiner, 483 u.s. 266 (1987), did not apply retroactively. 39. harper, 113 s. ct. at 2530 (o'connor, j., dissenting). 40. id. at 2537 (o'connor, j., dissenting). 41. justice o'connor's reading of mckesson, and by extension justice souter's references to mckesson, stands in marked contrast to her interpretation of the court's holding in mckesson when it was decided. at that time she wrote: "the dissent [in american trucking] suggests that federal courts should weigh equitable considerations only in determining the scope of relief a federal court should award. this is precisely backwards. as previously discussed, mckesson makes plain that equitable considerations are of limited significance once a constitutional violation is found." american trucking, 496 u.s. at 184 (plurality opinion). apparently, justice o'connor believes it important that equitable [vol 1:8 harper and its aftennath if the equities of a dispute are to play no part, via chevron oil's analysis, in determining whether a holding applies retroactively, they ought to be considered in ascertaining what relief retroactive rulings permit or require.4" m. retroactivity by default or equal treatment whether a finding that a decision applies retroactively has any practical effect naturally depends upon the remedial implications of that finding. if, for example, equitable considerations are ignored in assessing the retroactive impact of a decision, as justice o'connor fears will happen if the court abandons chevron oil, but they are permitted to shape the remedial calculus and even in some instances to block all compensation for past wrongs, then declaring a decision retroactive might be of little consequence. what matters is the bottom line: which actions, if any, a party must take as a result of having behaved in a way that the court's current understanding of federal law prohibits. assuming, however, that at least in the case of state taxes that discriminated against a group of taxpayers in violation of federal law, either refunds to victims or retroactive taxes on beneficiaries or some blend of the two is constitutionally required-as mckesson might be read to hold and as justice thomas's references to mckesson in harper further suggest -the court's opinion in harper is striking in two ways. first, its approval of the view, first expressed by justice souter writing for only himself and justice stevens in beam, that all of the court's rulings apply retroactively unless the court expressly reserves judgment on the issue, is enormously important. to be sure, the court's embrace of this view was not wholly novel. five justices subscribed to this principle in beam, as the three who concurred in the judgment without joining justice souter's opinion would automatically have applied all rulings retroactively. but in harper, for the first time, five members of the court signed a single opinion certifying this principle. they did so, moreover, notwithstanding the departure of justice marshall, who cast one of the votes for automatic retroactivity in beam. because justice white has never assented to this view, his replacement by justice ginsburg will not endanger the slim majority that professes it; considerations inform the relief that a court finally awards in a civil case. if those considerations are to play no role at the first stage of the court's analysis, contrary to justice o'connor's preferred approach, then they warrant consultation at the next stage. if chevron oil is not to furnish the test for retroactivity, she would read the court's precedents to permit lending the equitable considerations it enunciates some force in molding a remedy. 42. harper, 113 s. ct. at 2538 (o'connor, j., dissenting). 43. see infra part v for detailed consideration of the remedial implications of mckesson and harper. as i explain in sections c and d of that part, intergovernmental tax immunity cases are in some ways special. 19931 florida tax review whether the future resignation of justice blackmun or another member of the majority coalition will have that result cannot yet be known. the court's newly gilded "express reservation" rule will apparently have an immediate and patently unfair impact in at least one case recently before the supreme court. in kraft general foods, inc. v. iowa department of revenue,44 the court held that by granting a state corporate income tax deduction for dividends received from domestic subsidiaries but not for dividends received from foreign subsidiaries, iowa facially discriminated against foreign commerce in violation of the commerce clause. the court's opinion did not mention remedies or the holding's retroactive application; the justices merely reversed and remanded for further proceedings not inconsistent with their opinion.45 after harper, however, it seems clear that kraft applies retroactively to the parties in that case, because the court did not preserve the issue for future litigation. yet, under the circumstances, that result is procedurally offensive. in its brief, iowa noted that the retroactivity issue, though raised by the state, had not been passed on by the lower courts.46 consideration of the issue would have been inappropriate because they had, without exception, upheld the challenged provision. nor had kraft addressed the issue either in its petition for certiorari or in its merits brief. aware of beam's holding, however, that because the court did not reserve the retroactivity question in bacchus, its decision in that case applied retroactively, iowa explicitly "urge[d] that, if the iowa law is held to be unconstitutional, this court expressly state that the court is not ruling on the question of retroactivity but is expressly reserving the question for the iowa courts to decide on remand."'47 in addition, although iowa did not advance an argument under chevron oil or some other precedent for prospective application of the court's decision should it lose on the merits, the state noted that the retroactivity question was complicated. iowa had agreed, as a condition of receiving payment of the disputed taxes, that kraft and a former affiliate would receive refunds if kraft prevailed. this agreement, the state alleged, harbored significant ambiguities. it also antedated beam's repudiation of selective prospectivity, and thus might have been premised on an understandable mistake of law. iowa asked that the state courts be allowed to sift these matters before the supreme court pronounced on them.48 in its reply brief, kraft contended, in one short paragraph invoking two dusty and apparently irrelevant precedents it did not discuss specifically, that prospective applica44. 112 s. ct. 2365 (1992). 45. id. at 2372. 46. brief for respondent at 36, kraft (no. 90-1918). 47. id. at 37. 48. id. [vol. 1:8 harper and its aftermath tion of the court's commerce clause holding, if kraft should win, was not warranted under chevron oil.49 it further stated that iowa's agreement to refund kraft's taxes if iowa lost went to the issue of remedies, not retroactivity, and so could be ignored when the court passed on the choice-of-law issue-a questionable claim after beam and, still more it now appears, after harper. despite this inadequate briefing on the question of retroactivity, despite the absence of any state court consideration, despite iowa's plea that the court not decide the issue if it ruled against iowa on the merits, and despite any mention of this crucial issue by the court itself, harper's "express reservation" rule seems to require that the retroactivity question be decided against the state. yet it is hard to believe that the court intended this result when it reversed and remanded without even mentioning iowa's agreement with kraft or flagging the wider question of whether the court's decision reaches backwards as well as forwards. if, moreover, this was the court's silent intention, the absence of any explanation for the ruling betrayed its duty of candor.50 the second, perhaps more astonishing, innovation in harper, and the source of much of the injustice that harper might work when annexed to the "express reservation" rule, is the court's unbending insistence that once a 49. see reply brief for petitioner at 16, kraft (no. 90-1918) (citing cook v. pennsylvania, 97 u.s. 566 (1878); hale v. bimco trading, inc., 306 u.s. 375 (1939)). cook found that a pennsylvania tax on auctioned goods imported from abroad that did not apply to domestic goods violated the commerce clause. cook, 97 u.s. at 573. because the auctioneer who challenged the tax had not paid it, no retroactivity issue arose, and the court did not discuss the matter. see id. at 570. likewise, in hale the court upheld an injunction on the collection of an inspection fee and minimum quality standards that applied solely to imported cement. hale, 306 u.s. at 380-81. no question of retroactive application was presented and no dicta were offered on the question. 50. unfortunately, shirking is not unprecedented. the practice of hiding premises essential to the court's holding, though beyond condoning in the vast bulk of cases, had an alarming forerunner in one of its decisions from the preceding tern. in lampf, pleva, lipkind, prupis & petigrow v. gilbertson, i11 s. ct. 2773 (1991). the supreme court established a uniform federal statute of limitations for suits under section 10(b) of the securities exchange act of 1934 and rule l0b-5. despite the fact that the parties briefed the retroactivity issue, that the united states, in an anicus brief, asked the court to remand so that the lower courts might address the question in the first instance, and that until that decision the court "ha[d] never applied a new limitations period retroactively to the very case in which it announced the new rule so as to bar an action that was timely under binding circuit precedent," id. at 2786 (o'connor, j., dissenting), five members of the court held that the plaintiffs' claims were untimely, without even mentioning the retroactivity issue. see id. at 2782. nor could the majority claim ignorance of the import of its unexplained action, given that beam was decided the very same day and that, as justice o'connor noted in dissent, the court's election to apply its decision retroactively contravened several of its earlier decisions. lampf, and now kraft, might be regrettable anomalies, without heirs. one hopes that they are. the worry is that they signal a more dire trend towards rule by fiat rather than reason. 19931 florida tax review decision is applied retroactively to one set of parties, it must be applied retroactively to all similarly situated litigants. in the case of kraft itself, this principle of equal treatment might cost iowa $30 million," without its now being able to offer any objection to the decision's retroactive reach. and the holding in kraft could well impose additional liabilities on other states, again without their being able to challenge this result because the die was cast in kraft and they were not parties to the action. 2 in most circumstances, of course, the principle of treating like cases alike is a just and venerable one. litigants are, moreover, frequently affected by legal actions contested by others. but the principle of treating like cases alike cannot be applied blindly, without considering the correctness of the initial decision to be extended to all. that would be to raise stare decisis to an absolute command, blocking the reconsideration and overruling of obsolescent or misguided holdings. furthermore, the principle seems neither sensible nor fair when the rule being applied universally was not the considered choice of a court of law following briefing and argument, but was rather the accidental result of an unobserved background presumption.53 51. see rick phillips, iowa: dor says kraft will cost $30 million in refunds, 3 state tax notes 884 (dec. 14, 1992) (reporting iowa department of revenue and finance's estimate that its potential refund liability stemming from kraft is $25-30 million and that it would deny refunds, pending the court's decision in harper, on the theory that kraft applies prospectively only). phillips's article does not say what fraction of the total figure is covered by iowa's prior refund agreement with kraft and its one-time affiliate. 52. according to a report by one lawyer, pennsylvania altered a provision of its corporate income tax that resembled iowa's unconstitutional treatment of foreign dividend income following the decision in kraft. see joseph bright, pennsylvania revenue department issues policy statement on kraft decision, 3 state tax notes 527 (oct. 12, 1992). it would not be surprising if a refund suit, in which the retroactivity of kraft must be presumed, were filed in harper's wake (if none already has been filed), assuming that a suit would still be timely in pennsylvania. another lawyer writes that a provision of florida's income tax relating to subpart f income might also fall after kraft. see k. lawrence gragg, united states: kraft should help resolve florida issue of foreign-source income deductions, 5 tax notes int'l 131 (july 20, 1992). if kraft controls on the merits, it would be difficult to argue that its retroactivity holding also does not govern any subsequent litigation in florida. it is, naturally, a further question whether the same remedial requirements would apply in all these cases, even if all the tax provisions were invalid retroactively. i discuss this issue in part v.b. 53. this presumption does have the advantage of providing states with an incentive to litigate the retroactivity issue from the start, lest it be resolved against them, and might be defended insofar as it expedites the resolution of disputes. but that general justification hardly extends to iowa's conduct in kraft, because the state did raise the issue in iowa's courts. they simply had no occasion to pass on it because they, unlike the supreme court, held in iowa's favor. from the supreme court's perspective, there is good sense in permitting state courts to offer an initial judgment on questions of this kind, after briefing by both sides. the court's holding in harper, however, denies them that opportunity if, as seems inevitable, the "express reservation" rule applies. lampf provides an equally stunning example of the injustice of [vol 1:8 harper and its aftennath a second example of egregious unfairness comes from harper itself. when davis was argued, nobody connected with the case had any inkling that a concession in michigan's brief-that davis himself deserved a refund if michigan's tax scheme was unconstitutional-could conceivably cause the retroactive application of the court's decision to hundreds of thousands of taxpayers in two dozen states. as justice o'connor noted in her harper dissent, the issue of davis's implications for past conduct was not decided by the michigan courts, the question presented did not seem to encompass it,' and a short colloquy at oral argument appeared to indicate that the matter was not before the court.55 of all the parties and amici, michigan alone discussed the question of remedies in its brief, almost as an afterthought. yet the court has now found that brisk reference by a single party sufficient to bind michigan and a sea of other states battling over perhaps two billion dollars. what is most puzzling, in view of the court's action in harper, is that michigan's one-paragraph statement that davis was entitled to a refund,56 to which the court fastened its holding in harper, was succeeded by a far longer argument that the court ought not to decide the refund issue with respect to the state's many other federal retirees." rather, michigan contended, the court should remand so that the state courts and the michigan legislature could address the question first.58 what the court never attempted to explain in harper is why its silence with respect to this plea in its davis opinion should be construed as a rejection of michigan's more carefully argued point.59 applying this background presumption in favor of retroactivity thoughtlessly. see supra note 50. there, too, the court entirely ignored the parties' discussion of the appropriateness of ruling retroactively. 54. harper, 113 s. ct. at 2530 (o'connor. j., dissenting). 55. id. (o'connor, j., dissenting) (citing transcript of oral argument at 37-38. davis v. michigan dep't of treasury, 489 u.s. 803 (1989) (no. 87-1020)). 56. brief for appellee at 63, davis v. michigan dep't of treasury, 489 u.s. 803 (1989) (no. 87-1020). 57. id. 58. id. 59. in fact, michigan's claim that iowa-des moines nat'l bank v. bennett. 284 u.s. 239 (1931), compelled a refund for davis himself was incorrect. brief for appellee at 63, davis v. michigan dep't of treasury, 489 u.s. 803 (1989) (no. 87-1020). the court's later opinion in mckesson made this clear. michigan had read the case to mean that the taxpayer who brought suit in a case like davis was entitled to a cash refund. however, the mckesson court construed iowa-des moines national bank to corroborate its holding that either refunds or retroactive taxes would remove the earlier unconstitutional tax disparity satisfactorily. see mckesson, 496 u.s. at 39-40. so the state's concession that an adverse ruling should automatically trigger retroactive relief to a single taxpayer was founded on a legal error the court did not, at least in advance of mckesson, detecl to be sure, a stronger claim is that iowa-des moines national bank stands for the proposition that some form of retroactive relief 1993] florida tax review finally, davis was decided prior to the court's announcement in beam-if "announcement" is the right term for the collective implication of statements scattered across three separate opinions-that a resolution of the retroactivity issue for one set of parties, no matter how ill-considered, holds for all similarly placed litigants.' michigan was not on notice that its concession might have the dramatic impact harper assigns it. the unfairness of extrapolating so wildly from michigan's concession in davis is manifest.6' as justice o'connor noted,62 that extrapolation was also inconsistent with the court's precedents. the supreme court has never considered itself constrained by rulings it has made sub silentio, whether through inadvertence or knowing inattention. for the reasons just given, as well as the huge monetary sums at stake, davis seems a particularly poor case in which to abandon this practice. justice thomas's failure to speak to this issue, after justice o'connor raised it pointedly, testifies to the absence of any sound reply. is required. but the host of intervening retroactivity decisions surely took precedence or at least had to be distinguished or overruled before the court could reach the conclusion it now says it reached in davis. 60. see beam, i l1 s. ct. at 2443-48 (opinion of souter, j.); id. at 2449-50 (blackmun, j., concurring in the judgment); id. at 2450-51 (scalia, j., concurring in the judgment). 61. this last argument from unfair surprise would perhaps pack less punch if, in harper, the court had relied not on michigan's concession in davis but rather on its own disposition of barker v. kansas, 112 s. ct. 1619 (1992). barker extended davis's holding to federal military retirees, and it was decided almost a year after justice souter set forth the "express reservation" rule in beam, although before the significance of his statement was generally recognized. in barker, the court reversed and remanded without reserving the retroactivity question. id. at 1626. after beam, this simple remand apparently entails that all davis-type rulings have retroactive effect. the court could have strengthened its argument in harper had it grounded its ruling in barker as well as, or instead of, in davis. for reasons it did not state, however, the court did not cite barker in this respect. perhaps the explanation is that, although barker and beam together entail harper, the court offered no more justification for its implicitly retroactive holding in barker than it did in davis. indeed, although barker postdated beam, the unfairness of the court's tacit resolution of the retroactivity issue under the "express reservation" rule in barker rivals the unfairness it worked in kraft. in barker, too, the lower courts had not passed on the retroactivity question because the state had consistently prevailed on the merits. the question was not explicitly posed in the parties' petitions for certiorari, nor was it broached in their briefs to the court. a single amicus brief, relying on justice souter's reference in beam to the significance of reserving the retroactivity issue, requested that the court do precisely that-reserve the issue-because of the question's complexity and the absence of adequate briefing and argument. brief of arizona, arkansas, georgia, iowa, montana, oklahoma, utah, virginia, & wisconsin as amici curiae in support of respondents at §§ ii-iii, barker (no. 91-611). as in kraft, the court ignored this plea to withhold judgment, by its new rule resolving the issue definitively without attempting any vindication. 62. see harper, 113 s. ct. at 2529-30 (o'connor, j., dissenting). [vol 1:8 harper and its aftermath perhaps davis should, in the end, be applied retroactively in every state. powerful arguments have been advanced for a rule of automatic retroactive application in civil cases, perhaps accompanied by more flexibility in the choice of remedies than mckesson appears to license.' but the court's opinion hardly justifies this conclusion. it does not even try. harper is, however, the law of the land. and it offers three immensely important lessons for future litigants in civil cases that present what might be considered novel federal legal issues-at least so long as chevron oil escapes overruling. first, parties ought, without fail, to argue the retroactivity question along with the merits of the case. it would be folly to expect the court explicitly to reserve judgment on this question on its own initiative. there is, in fact, no guarantee that the court will do so even if one or more of the parties requests that the retroactivity issue be left for another day. remember iowa's plea in kraft. second, when arguing the retroactivity point, litigants should stress the importance of the court's addressing it directly and carefully. kraft and lampf, pleva, lipkind, prupis & petigrow v. gilbertson, 64 in which the court ruled on the merits without mentioning the question of retroactivity despite briefing by the parties, ought to remain exceptions, not establish a new norm of unaccountability. third, if a novel substantive argument is presented in a case that is before the supreme court or an appellate court with jurisdiction over one's own case, and if its resolution might control the disposition of a similar issue in one's own case, one should consult with counsel in that potentially controlling case to ensure that the retroactivity issue is argued satisfactorily. if it is not, consider seeking leave to file an amicus brief. recall the price that virginia and many other states paid in harper for michigan's brief in davis. iv. the future of chevron oil harper cemented bean's repudiation of selective prospectivity in civil cases.65 the court made clear that henceforth it will not apply a novel civil ruling to the parties before it while declaring its ruling prospective with respect to all other similar claims.' one disappointing aspect of harper is that the court did not also settle the fate of pure prospectivity in civil cases-a ruling that a statute or action will violate federal law only after the ruling has been announced. 67 this issue goes well beyond the situation 63. see infra parts iv, v.b. 64. 111 s. cl 2773 (1991). see supra note 50 for discussion of lampf. 65. harper, 113 s. ct. at 2517. 66. id. at 2516-17. 67. a purely prospective ruling, as the court ordinarily understands the term, can and generally does supply declaratory or injunctive relief. 19931 florida tax review presented in davis and harper. it affects virtually all important commerce clause cases that pose new legal questions or that seek to upset current doctrine, 68 as well as changes in the rules governing statutes of limitations69 and sundry other matters.70 many commerce clause cases involve refund claims amounting to millions of dollars, and successful challenges to the constitutionality of electoral or administrative procedures that break new ground could prove enormously disruptive if courts are barred from softening their impact on completed events. 71 had the court not chosen to yoke the fate of a multitude of states to michigan's careless concession in davis, the future of pure prospectivity would almost certainly have been resolved in harper. the opportunity was squandered, but it will come round again. when it does, one cannot say with confidence what the court will do, partly because a justice's views about retroactivity are invariably intertwined with views about the proper scope of a court's remedial discretion in cases in which a ruling does apply retroactively. justices o'connor and kennedy, along with chief justice rehnquist, would use chevron oil's three factors72 68. see, e.g., american trucking ass'ns v. smith, 496 u.s. 167, 187 (1990) (plurality opinion) (concluding that american trucking ass'ns v. scheiner, 483 u.s. 266 (1987), does not apply retroactively); bacchus imports, ltd. v. dias, 468 u.s. 263, 276-77 (1984) (implicitly deciding, as the court later found in beam, that the court's ruling invalidating a hawaii tax that discriminated against alcoholic beverages produced outside the state applied retroactively); national can corp. v. washington dep't of revenue, 749 p.2d 1286, 1295 (wash.), cert. denied and appeal dismissed, 486 u.s. 1040 (1988) (finding that tyler pipe indus. v. washington dep't of revenue, 483 u.s. 232 (1987), applies only prospectively). 69. see, e.g., goodman v. lukens steel co., 482 u.s. 656, 662-64 (1987) (finding statute-of-limitations ruling under 42 u.s.c. § 1981 retroactive, because no contrary, misleading precedent existed when plaintiffs filed suit); saint francis college v. ai-khazraji, 481 u.s. 604, 608-09 (1987) (declaring statute-of-limitations ruling under 42 u.s.c. § 1981 prospective because plaintiff relied on circuit precedent that was later overturned); chevron oil, 404 u.s. at 97 (holding statute-of-limitations ruling not retroactive). see infra note 159 for a discussion of chevron oil and later statute-of-limitations cases. 70. see, e.g., arizona governing comm. v. norris, 463 u.s. 1073, 1105-07 (1983) (holding state retirement plan violated title vii because the state, through intermediaries, discriminated on the basis of sex by paying lower monthly retirement benefits to women; ruling declared prospective to forestall severe financial hardship for state); northern pipeline constr. co. v. marathon pipe line co., 458 u.s. 50, 87-89 (1982) (declaring unconstitutional a broad congressional grant of jurisdiction to bankruptcy courts but staying judgment for three months to permit congress to repair the defect without disrupting the interim administration of the bankruptcy laws). 71. see, e.g., buckley v. valeo, 424 u.s. 1, 142-43 (1976) (refusing to invalidate retrospectively decisions of the federal election commission); cipriano v. city of houma, 395 u.s. 701, 706-07 (1969) (per curiam) (invalidating bond authorization process but applying ruling only to bond issues that had not yet been authorized and for which time specified by state law for challenge had not yet expired). 72. see supra note 19 (outlining chevron oil's three factors). [vol. 1:8 harper and its aftemiath to determine whether a ruling has retroactive effect. if they lost on this point, however, at least two of them would attempt to take these same factors into account in assessing remedies.73 in contrast, justices blackmun, stevens, and scalia favor applying all civil decisions retroactively, just as all criminal decisions apply retroactively following the court's decision in griffith v. kentucky.74 at least justices stevens and blackmun, however, seem prepared to continue employing chevron oil as "a remedial principle for the exercise of equitable discretion by federal courts and not ... a choice-of-law principle."75 this declaration suggests that their view might not be so far apart from that of the american trucking plurality, except that they would apparently restrict the use of this principle to nontax cases.76 justices souter, thomas, and ginsburg have not revealed their views. in his opinion in beam, justice souter wrote that "[w]e do not speculate as to the bounds or propriety of pure prospectivity" -an ambiguous statement that justice white read, without contradiction by justice souter, to suggest that pure prospectivity might be an atavism doomed soon to perish.78 and justice thomas, in his 73. see harper, 113 s. ct. at 2537-38 (o'connor, j.. dissenting) (joined by rehnquist, cj.). 74. 479 u.s. 314, 328 (1987). 75. american trucking ass'ns v. smith, 496 u.s. 167, 220 (1990) (stevens, j., dissenting). for criticism of justice stevens's characterization of chevron oil's threc-part test as remedial, see david f. shores, recovery of unconstitutional taxes: a new approach, 12 va. tax rev. 167, 192-94 (1992). 76. see american trucking, 496 u.s. at 220-24 (stevens. j., dissenting). justice stevens, in an opinion joined by justice blackmun, seemed to indicate that relief in tax cases should be governed by mckesson's more restrictive remedial scheme, without any weight being given to equitable discretion by state courts on remand. see id. at 225 (stevens, j., dissenting) (asserting in american trucking that scheiner should be applied retroactively and that relief should be gauged in light of mckesson). for further discussion of the place of equitable discretion in fixing remedies under mckesson, see infra part v.b. justice blackmun's failure to engage in a chevron oil analysis in his opinion for the court in lampf perhaps reflects a change of heart about the discretion that federal courts have in fixing the retroactive impact of statute-of-limitations decisions, although it is risky to infer anything from silence. see lampf, pleva, lipkind, prupis & petigrow v. gilbertson, ill s. ct. 2773. 2782 (1991). 77. beam, i11 s. ct. at 2448 (opinion of souter, j.). 78. see id. at 2449 (white, j., concurring in the judgment). the significance for justice souter of rejecting pure prospectivity, if he decides that it should be rejected, is unclear. in beam, for example, he stated that even when a ruling does apply retroactively, that still "permits litigants to assert, and the courts to consider, the equitable and reliance interests of parties absent but similarly situated. conversely, nothing we say here precludes consideration of individual equities when deciding remedial issues in particular cases." id. at 2448 (opinion of souter, j.). whether justice souter would say that this general rule must give way to the stricter remedial requirements that mckesson seems to impose in all cases of discriminatory state taxation is a distinct, and unanswered, question. for a discussion of justice souter's views, see infra text accompanying notes 141-56. 19931 florida tax review opinion for the court in harper, went out of his way to avoid taking sides in the debate, 79 although his references to griffith might betray a leaning towards automatic retroactivity. 8 likewise, the views of justice ginsburg are a mystery, as are those of whoever else joins the court before it returns to this controverted issue. the longevity of chevron oil as the decisive test for retroactivity, as well as the implications of its demise, are therefore uncertain. there is something to be said for adopting a rule of automatic retroactivity, at least if flexibility is built into the doctrine of constitutional remedies under the due process clause. but there is less than some have claimed. justice stevens argued in american trucking, for example, that if a state tax was unconstitutional under case law that preceded a novel supreme court decision permitting taxes of that kind, and if taxpayers filed a timely challenge to the tax, then applying chevron oil as the american trucking plurality favored-as a choice-of-law rule-would apparently decree that the novel decision not be given retroactive effect.8' thus, he said, a court would have no choice but to force the state to correct, through refunds or otherwise, what in a more benighted day were deemed misdeeds, even though the supreme court had since pronounced the tax constitutional.82 it would, however, be odd, indeed perverse, to hold a state liable for anticipating improvements in the court's constitutional understanding, and to make it pay for actions that the constitution in fact permits. a rule of automatic retroactive application, by contrast, would not offend intuition in this way. i wonder whether justice o'connor and the other members of the american trucking plurality would, or ought to, be discomfited by justice stevens's argument. most likely, they would conclude that, in the circumstances described, the new rule's purposes, together with equitable concerns, militate in favor of its retroactive application. thus, they too would probably excuse the state from paying refunds or providing some other type of redress. why, they might ask, does their mere consideration of the chevron oil factors in determining whether a rule applies retroactively expose them to ridicule? aren't these the factors on which the determination of retroactivity ought, in all cases, to turn? nevertheless, in other respects the american trucking plurality's approach is more difficult to defend. a rule of automatic retroactivity in civil cases, such as justice stevens advocated, would establish uniformity with the court's routine approach to deciding criminal cases. and uniformity would have an appeal beyond whatever aesthetic advantage accrues to symmetry or 79. see harper, 113 s. ct. at 2516 n.9. 80. see id. at 2516-18. 81. see american trucking, 496 u.s. at 218-19 (stevens, j., dissenting). 82. id. [vol 1:8 harper and its aftermath simplicity. suppose that the plaintiffs in american trucking had refused to pay arkansas's highway use tax, that they had subsequently lost in both civil and criminal proceedings, and that the civil and criminal cases were both still pending when scheiner was decided. griffith would mandate the reversal of their criminal convictions. but, as richard fallon and daniel meltzer point out, the american trucking plurality's view would render those taxpayers civilly liable, notwithstanding the dismissal of the criminal charges against them." of course, civil and criminal remedies need not keep step, as fallon and meltzer note. but what seems incomprehensible is the reason that justice o'connor must give for their divergence in this hypothetical case: griffith makes clear that the criminal penalty associated with the tax was unconstitutional when it was imposed, but the tax itself, according to her theory, was not then unconstitutional, even though both rested on the same precedents and both were invalidated by the court's unforeseen ruling in scheiner. this explanation is nonsensical. justice o'connor might reply that this theoretical embarrassment is of trivial importance. under the reading that she and several other justices share of chevron oil, remedial concerns explicitly influence judgments of retroactive constitutionality as a choice-of-law matter, under the approach that justice stevens prefers, they do not, but they exercise equal force at the next stage of the remedial calculus. hence, she might rejoin, there is not necessarily any functional difference between her view and his. if justice o'connor were to reply in this way, however, she would need to explain why, if the two approaches converge functionally, there is any reason to insist on her interpretation of chevron oil and its allied test for determining retroactivity, conceived as a choice-of-law rather than as a remedial principle. what little she does say is unconvincing. in american trucking, and more recently in her harper dissent, justice o'connor offered two reasons for distinguishing criminal cases, in which a rule of automatic retroactivity is appropriate, from civil cases, in which, she thinks, it is not.' first, she said, allowing a court to hold that the retroactive application of a new criminal rule would be inequitable and therefore cannot be required would typically favor the government's reliance interests over the criminal defendant's interests in vindicating his constitutional rights, relative to a rule that always decreed new criminal rules retroactive.85 as the constitutional rights of criminal defendants were interpreted more expansively in the late 1960s and early 1970s, it was the government 83. richard h. fallon, jr. & daniel j. meltzer, new law, non-retroactivity, and constitutional remedies, 104 harv. l. rev. 1731, 1767-68 (1991). 84. see american trucking, 496 u.s. at 198-99 (plurality opinion); harper, 113 s. ct. at 2530-31 (o'connor, j., dissenting). 85. american trucking, 496 u.s. at 198 (plurality opinion). 19931 florida tax review alone that benefitted from prospective changes in the law, relative to a baseline of automatic retroactivity.86 but novel civil holdings, she contended, are not apt to favor defendants over plaintiffs. moreover, justice o'connor argued, there is no reason for according special protection to any set of civil litigants, as there is for safeguarding criminal defendants." second, and more important, civil plaintiffs often gain from a purely prospective ruling, because they usually seek a more advantageous legal regime for the future as well as relief for past wrongs. most criminal defendants, however, care only about avoiding or reversing their convictions. hence, justice o'connor asserted, they would have little incentive to fight if they might not profit from any new ruling established in their case.8 ' no comparable carrot is needed in civil cases. neither of these reasons is persuasive. to the extent that the empirical claim regarding criminal cases that underpins justice o'connor's first argument is sound, it need not hold for the future. as justice scalia observed, that criminal prospectivity generally benefitted public authorities in a given case "was a consequence, not of the nature of the doctrine, but of the historical 'accident' that during the period prospectivity was in fashion legal rules favoring the government were more frequently overturned.,, 89 history need not repeat itself. if it did not, then the contrast justice o'connor wished to draw between civil and criminal cases would vanish. of course, it was, as justice scalia suggested, no accident that the court's use of nonretroactivity during the johnson and nixon years eased the pain of its rulings on law enforcement officials. that was the perceived price of securing greater freedom for the future. what is more important than justice scalia's logical point is that the governmental bias of nonretroactivity in criminal cases is paralleled by a governmental bias in a critical group of civil cases. as fallon and meltzer have remarked, "in many important classes 86. at least the government benefitted in the very short term, if a particular decision was applied nonretroactively and so did not upset prior convictions. over time, the government's interests-if it makes sense to treat the state's interests as adverse to the rights of its citizens-arguably were frustrated because the availability of prospective holdings removed the deterrent that severe governmental dislocation presented, thereby enabling the court to rule against the government more freely in widening the scope of personal liberties. it is precisely that consequence of nonretroactivity that justice scalia and others have deplored. see, e.g., harper, 113 s. ct. at 2522-24 (scalia, j., concurring); beam, ill s. ct. at 2444 (opinion of souter, j.). 87. harper, 113 s. ct. at 2530-31 (o'connor, j., dissenting). 88. id. (o'connor, j., dissenting). 89. id. at 2521 n.l (scaiia, j., concurring) (citation omitted). justice scalia perforce assumes that the due process clause does not block the application of novel, law-changing criminal rules against defendants-at least not to any greater degree than it prevents their application to civil plaintiffs or defendants. this assumption might be questioned. [vol 1:8 harper and its aftermath of civil cases-including both tax refund cases and constitutional tort actions-nonretroactivity rules systematically favor the government (or its officials) at the expense of constitutional rightholders."' 9 as a logical matter, this need not be so. it is theoretically possible that a state will lose from the chevron oil rule in some tax refund cases. if, for example, an unexpected ruling declared constitutional a state tax that was unlawful under earlier precedents, the state could conceivably be harmed by a chevron oil approach if the ruling were not retroactive and the state was therefore required to pay back the money it had collected or offer some other type of relief to those who had paid the tax. the number of these cases, however, is apt to be tiny, because few states enact taxes that they expect, under established law, to be found unconstitutional, and because a consideration of the equities under chevron oil might often counsel against applying the new, tax-upholding rule prospectively only. fallon and meltzer's point is therefore sound, as a practical observation. hence, even if justice o'connor is correct in discerning a bias in favor of the government when a cousin of chevron oil furnished the retroactivity rule for criminal cases, that bias exists, at least as persistently, in the civil cases that most concern her. if "the generalized policy of favoring individual rights over governmental prerogative can justify the elimination of prospectivity in the criminal area," 91 it should also be able to do so in civil tax cases of constitutional stature.92 justice o'connor's second reason for treating civil retroactivity differently from criminal retroactivity is equally infirm. it is undoubtedly true that criminal defendants are usually interested only in retroactive relief, whereas civil litigants frequently desire injunctive relief as well. but this statistical difference surely cannot justify denying retroactive relief to taxpayers and other civil plaintiffs who do not request injunctive relief, perhaps because the offending tax has already been repealed, or who, as in harper, will likely achieve no more tangible benefit in the future than seeing state retirees taxed more heavily or additional sums of money passing from the state treasury to the internal revenue service. conversely, criminal defendants can be expected to pursue legal challenges even if it is not certain, but only possible, that if they prevail, the court's ruling will apply retroactive90. fallon & meltzer, supra note 83, at 1769 n.208. 91. harper, 113 s. ct. at 2530 (o'connor, j., dissenting). 92. if the fact that individual rights are at stake is what matters to justice o'connor, it is worth noting that the court has held that plaintiffs do have a right, under 42 u.s.c. § 1983, to sue and recover for taxes that violate the commerce clause. see dennis v. higgins, 111 s. ct. 865 (1991). the commerce clause, the court concluded, does not merely empower the federal government and tacitly limit state chauvinism: it confers rights on people and businesses to ply their trades free from certain types of discrimination. see id. at 870-71. justice o'connor joined the court's opinion in full. 19931 florida tax review ly to them. what have they to lose by litigating? justice o'connor's distinction appears especially vulnerable because there seems to be no reason to establish a bright-line rule in this area. certainly, justice o'connor has not suggested one. and simply to say that half a loaf-some protection in the future-is enough without addressing the merits of the claim that a whole loaf is constitutionally required, for the same reasons that the court found compelling in revising its approach to criminal cases, is plainly inadequate. as justice scalia complained, it is unclear why, "if a receipt-of-some-benefit principle is important, we should use such an inaccurate proxy as the civil/criminal distinction, or how this newlydiscovered principle overcomes the 'basic norms of constitutional adjudication,' on which griffith v. kentucky, 479 u.s. 314, 322 (1987), rested."93 perhaps justice o'connor's real concern is with litigants' incentives to sue, which affect the celerity with which constitutional errors are corrected. but if her contention is that the chevron oil approach to retroactivity in civil cases produces the optimal level of constitutional challenges, she needs to show how she arrived at this conclusion, and why a rule of automatic retroactivity would prompt too many civil suits. her opinions have thus far offered no clues. these arguments are all negative in character. they parry attempts to justify using one rule to ascertain civil retroactivity and another to determine whether new federal criminal decisions apply retroactively. are there persuasive positive arguments for univocal treatment, apart from uniformity's capacity to avoid what seems a theoretical anomaly in the hypothetical variant of american trucking described above? in my opinion, there are. but these reasons are etherial, more considerations of naturalness and simplicity than of constitutional necessity or concrete advantage to judicial decisionmakers or any group of potential litigants. article iii's command that federal courts decide cases or controversies cannot plausibly be read to bar applying a decision purely prospectively, if that means resolving the merits of a case but offering no remedy for past wrongs.' what the griffith court called "the 93. harper, 113 s. ct. at 2522 n.1 (scalia, j., concurring) (citation omitted). 94. justice scalia stated in his american trucking concurrence that "the case-orcontroversy requirement of article h, § 2, cl. 1 .... surely requires retroactivity with respect to the parties immediately before the court." american trucking, 496 u.s. at 204 (scalia, j., concurring in the judgment). although this view was articulated forcefully 30 years ago, see note, prospective overruling and retroactive application in the federal courts, 71 yale l.j. 907, 930-33 (1962), the court rejected it soon thereafter. see linkletter v. walker, 381 u.s. 618, 622 n.3 (1965). the court's initial repudiation of this reading of article in was rightly criticized. see paul j. mishkin, foreword: the high court, the great writ, and the due process of time and law, 79 harv. l. rev. 56, 59 n.13 (1965). but after three decades of retroactivity rulings, it is clear that justice o'connor was correct in replying to justice scalia that "this court [has n]ever held that nonretroactivity violates the article 11i requirement that [vol 1:8 harper and its aftermath nature of judicial review," 95 however, buoys the thought that the court's announcement of what the law is resounds in all directions, into the past as well as forward into the future. justice scalia, in his separate opinions in recent retroactivity cases," has articulated forcefully the traditional, blackstonian understanding that in issuing a ruling, courts declare their reasoned belief about what some legal provision means. although that belief might be erroneous, it nevertheless remains a belief about what the interpreted provision requires and, so long as its legal surroundings have not changed decisively, therefore necessarily did require. this view has, i think, an immediate appeal, at least when married to the conviction that past errors in judges' understanding of some legal provision, on which people might prudently but mistakenly have relied, can sometimes justify not penalizing past illegalities. the view championed by justice o'connor-that an action is constitutional if taken prior to a declaration by the court that the constitution forbids it, so long as previous precedents strongly encouraged what is concededly a misreading of the constitution-is, by contrast, almost bizarre. the more natural approach is to ask first what federal lav requires and then, if a party's past conduct was inconsistent with that interpretation, to ask whether the drafting of the provision or established practice or contrary judicial readings of the law justify or excuse what is now considered illegal behavior, and thus mitigate this court adjudicate only cases or controversies." american trucking. 496 u.s. at 200 (plurality opinion). to be sure, justice o'connor took just the opposite view of article iii only one year before, when she argued against considering novel claims raised by habeas petitioners because awarding retroactive relief to one who persuaded the court to author a new constitutional rule would be" 'an unavoidable consequence of the necessity that constitutional adjudications not stand as mere dictum.' "teague v. lane, 489 u.s. 288, 315 (1989) (plurality opinion) (quoting stovall v. denno, 338 u.s. 293, 301 (1967)). but as richard fallon and daniel meltzer have convincingly shown, justice o'connor's view in american trucking is unquestionably the right one. see fallon & meltzer, supra note 83, at 1797-1807. the court has often decided the merits of a case and then denied relief-for example, by concluding. after finding some constitutional error, that the error was harmless or that relief was barred by sovereign immunity. indeed, as justice douglas noted in denouncing the suggestion that article in requires a court to grant relief to the prevailing party as a "pretense ... too transparent to need answer," the tradition of "producing only dictum through a 'case or controversy' " dates back to marbury v. madison. desist v. united states, 394 u.s. 244, 256 (1969) (douglas, i., dissenting). justice scalia's reading of article iii would be a radical departure from past practice, unless the sovereign immunity and harmless error cases were treated as consistent with it. if they were so read, however, the fight over the import of article 1ll's case-orcontroversy requirement would apparently become empty. 95. griffith v. kentucky, 479 u.s. 314, 322 (1987). 96. see american trucking, 496 u.s. at 200 (scalia. j., concurring in the judgment); beam, 111 s. ct. at 2450 (scalia, j., concurring in the judgment); harper, 113 s. ct. at 2520 (scalia, j., concurring). 19931 florida tax review whatever relief would ordinarily be due.97 a majority of the justices seems to be coming around to this view. justices blackmun and scalia enunciated it in beam, and justice thomas's repeated references in harper to the griffith court's reasons for making all criminal rulings automatically retroactive suggest that he and justices stevens and souter, who joined his opinion in full, might be ready to declare their allegiance to it as well. perhaps significantly, the worries expressed by justices o'connor and kennedy about the court's dicta on this point were not quelled by any accommodating changes in justice thomas's opinion for the court.9" to repeat, the arguments on behalf of this approach are not overwhelming if a finding of retroactivity does not foreclose the choice of remedies, for justice o'connor's reading of chevron oil could be functionally equivalent to the view that retroactivity is automatic but that chevron oil supplies the overarching remedial principle in all civil cases. the paramount question is always what actions are constitutionally required as a result of a party's having acted in a way that the best current understanding of the constitution or federal statutory law does not countenance. whether it is framed solely as a question of remedies, or as a question of retroactivity and of remedial discretion, is of small importance. simplicity and logic favor bringing all the remedial considerations together at one analytical stage rather than two. but there may be little practical benefit to doing so. substance is what matters. it is therefore essential, whether questions of retroactivity or remedies are partitioned or combined, that the court confront them together, as it did in deciding american trucking and mckesson simultaneously. this time, however, it must speak more plainly.9 97. see, e.g., fallon & meltzer, supra note 83, at 1764-77; shores, supra note 75, at 215-16. 98. see harper, 113 s. ct. at 2525 (kennedy, j., concurring in part and concurring in the judgment); id. at 2527-28 (o'connor, j., dissenting). 99. among the questions the court will have to answer is whether to continue using chevron oil's three-factor test-either to determine whether old or new law applies to predecisional conduct or to determine, at the remedial stage, what relief to order-or whether to replace it with a different set of considerations for making these determinations. chevron oil has earned abundant criticism over the years, partly because the novelty of a new decision has been all but decisive in every case in which the court has applied it, partly because it is unclear how the other factors are to be weighed in reaching an overall assessment, and partly because, whatever sense they make in statute-of-limitations cases, chevron oil's three factors do not, in the opinion of some writers, apply naturally or helpfully to other types of cases. see, e.g., carl d. ciochon, note, nonretroactivity in constitutional tax refund cases, 43 hastings l.j. 419, 453 (1992). alternative approaches have been suggested. see, e.g., fallon & meltzer, supra note 83, at 1824-33; shores, supra note 75, at 213-16. [vol 1:8 harper and its aftermath until the court dispels the confusion fogging these matters, is chevron oil good law? this is a complicated question, partly because the court's holding in that case is hardly pellucid. lower courts may not, of course, rule inconsistently with a supreme court holding that is precisely on point, even if that precedent is doddering and almost certain to fall. as the court said just a few years ago in reprimanding a court that anticipated the march of legal history: "if a precedent of this court has direct application in a case, yet appears to rest on reasons rejected in some other line of decisions, the court of appeals should follow the case which directly controls, leaving to this court the prerogative of overruling its own decisions."'" the difficulty in heeding this injunction, so far as chevron oil is concerned, is twofold: whether the court has overruled or significantly limited its holding in chevron oil is not clear, just as it is obscure what the court takes chevron oil to hold. these issues are intertwined. chevron oil has never been explicitly overruled, and in harper the court continued to treat it as a live precedent.'.. if, however, the decision is regarded as establishing a threshold test for the retroactive application of a civil decision, as justice o'connor has consistently understood it, then chevron oil enjoys, at best, a twilight existence. in american trucking, five justices expressly rejected the view that this reading of chevron oil encapsulates. their doing so, albeit not in a single opinion, arguably (though insecurely) satisfies the rodriguez de quijas standard for overruling" assuming that an interpretation, rather than a holding, can be said to have been "overruled." it is true that two of the five justices who broke with justice o'connor in american trucking have since resigned. but their votes are not expunged by their departure, and their replacements have shown no sympathy for justice o'connor's interpretation of chevron oil, even if they have not openly disavowed it. one of justice o'connor's allies-justice white-has also left. to the extent that chevron oil continues to shape decisionmaking, it appears to be as a principle for resolving the issue presented in chevron oil itself: whether to dismiss a claim that fell within the limitations period as the legal community understood it when the claim was filed, but that fell outside that limitations period as it came to be defined after the claim was filed but before the case was finally decided. and even there, chevron oil's directive has grown garbled. 3 whether chevron oil survives, and what import it has if it does, are thus highly debatable questions. 100. rodriguez de quijas v. shearson/american express, inc., 490 u.s. 477, 484 (1989). 101. see harper, 113 s. cl at 2516 & n.9. 102. see rodriguez de quijas, 490 u.s. at 484. 103. see infra note 159 for a discussion of the confusion surrounding the court's approach to the retroactive reach of statute-of-limitations decisions. 19931 florida tax review v. the remedial requirements of the due process clause after deciding the retroactivity question against virginia, the supreme court remanded in harper so that the state courts might consider an assortment of remedial issues. much litigation in states in which davis-type suits are pending will now focus on the implications of the due process clause, in tandem with the doctrine of intergovernmental tax immunity, for remedying the wrong that virginia and other states committed by taxing state and federal retirees differently. these remedial issues might also prompt legislative debate and action, either by state lawmakers or by congress. of course, the problem of remedies under the due process clause is more capacious than davis-inspired tax refund suits alone suggest. in other instances, too, particularly in connection with commerce clause cases like kraft and statute-of-limitations cases like lampf, courts are bound to probe the remedial demands of the due process clause. the sunset of chevron oil as a choice-of-law principle should augment controversy. this part explores the major remedial issues that mckesson, beam, and harper have spawned. several of these issues, such as the constitutional necessity of paying or charging interest on awards that are constitutionally mandated and the legitimacy of pass-on defenses in cases in which the nominal taxpayer did not bear the full burden of an unlawful tax, will almost surely return to the supreme court. this part also outlines what might well be less costly ways for states to respond to davis violations than they may have explored thus far. a. preand post-deprivation due process in mckesson, the court held unanimously that "[i]f a state places a taxpayer under duress promptly to pay a tax when due and relegates him to a postpayment refund action in which he can challenge the tax's legality, the due process clause of the fourteenth amendment obligates the state to provide meaningful backward-looking relief to rectify any unconstitutional deprivation."'' the question of whether duress is present is plainly one of federal law.105 although the supreme court has defined "duress" increasingly liberally, to include financial sanctions for nonpayment even if they are not imminent,' " the court has not read the due process clause to prohibit 104. mckesson, 496 u.s. at 31 (footnotes omitted). 105. see, e.g., philip m. tatarowicz, right to a refund for unconstitutionally discriminatory state taxes and other controversial state tax issues under the commerce clause, 41 tax law. 103, 121-23 (1987). 106. see mckesson, 496 u.s. at 38-39 & nn.20-21. at one time, a formal protest at the time of payment was also required, either as a matter of statute or of federal common law, to render payment to the federal treasury involuntary. see, e.g., united states v. new [vol 1:8 harper and its aftermath the denial of refunds for taxes paid "voluntarily" in this shrunken sense. for this purpose, a tax is paid voluntarily when it might have been challenged before payment without incurring a serious penalty for nonpayment." thus, the court said in mckesson, so long as a state chooses "to provide a form of 'predeprivation process,' for example, by authorizing taxpayers to bring suit to enjoin imposition of a tax prior to its payment, or by allowing taxpayers to withhold payment and then interpose their objections as defenses in a tax enforcement proceeding initiated by the state,"' t s it need not offer any retroactive relief if the tax is found to be constitutionally infirm, although a state is free to supply redress beyond the constitutional minimum if it wishes. the court referred to these passages from its opinion in mckesson when it remanded in harper, noting that "the 'availability of a predeprivation hearing constitutes a procedural safeguard... sufficient by itself to satisfy the due process clause."' ' 9 unless the various state legislatures act swiftly to cure the constitutional harm that statutes inconsistent with davis worked in past years, two issues relating to the sufficiency of taxpayers' pre-deprivation opportunities to challenge the differential taxation of state and federal retirees might surface in state courts following harper. both are ubiquitous concerns. they arise regularly in challenges to state taxes based on the commerce clause, the york & cuba mail s.s. co., 200 u.s. 488 (1906); chesebrough v. united states, 192 u.s. 253 (1904). this precondition to recovery was later abandoned at the federal level. see george moore ice cream co. v. rose, 289 u.s. 373, 375-76 (1933). the duress needed to render a tax payment involuntary also had to be imminent, "to release [a taxpayer's] person or property from detention, or to prevent an immediate seizure of his person or property." new york & cuba mail s.s., 200 u.s. at 494 (quoting railroad co. v commissioners. 98 u.s. 541, 544 (1878)). 107. see mckesson, 496 u.s. at 38-39 n.21. at common law, taxpayers could sue only for payments made to the government under duress, so far as such suits were consistent with sovereign immunity. because payments made under a mistake of law-as opposed to those resulting from factual errors-were deemed voluntary, taxpayers generally could not recover payments under statutes later declared invalid. this doctrine led to harsh and inequitable results. see, e.g., clifford l. pannam, the recovery of unconstitutional taxes in australia and the united states, 42 tex. l. rev. 777, 779-89 (1964) (criticizing the artificiality of the voluntary payment rule); john d. mccamus, restitutionary recovery of moneys paid to a public authority under a mistake of law: ignorantia juris in the supreme court of canada, 17 u. brit. colum. l. rev. 233, 234 (1983) (decrying the voluntary payment rule as "ill-designed to capture within its rubric those cases touched by its underlying rationale"). many states have, as a matter of state law, repealed the voluntary payment rule and permitted refund suits for taxes paid voluntarily or involuntarily. see, e.g., note, the voluntary-payment doctrine in georgia, 16 ga. l. rev. 893, 900-03 (1982) (describing georgia's statutory repudiation of the voluntary payment rule with respect to tax payments). for discussion of the rule's recent reincarnation in georgia, see infra text accompanying notes 121-28. 108. mckesson, 496 u.s. at 36-37. 109. harper, 113 s. cl at 2519 (quoting mckesson, 496 u.s. at 38 n.21). 19931 florida tax review equal protection clause, and other constitutional provisions, not just in davis-related litigation. conflicts among state court approaches to these issues might well elicit further guidance from the supreme court, especially if more states enact prepayment challenge mechanisms to forestall potentially devastating refund suits. the first issue is whether the existence of some procedure for contesting the constitutionality of a state tax prior to payment and without penalty permits a state to deny retroactive relief for a constitutional infraction if a taxpayer did not raise such a challenge but elected instead to pay the tax and seek a refund pursuant to an alternative procedural route. the court's language in mckesson suggests that the mere existence of an adequate predeprivation procedure does relieve a state from the obligation of providing refunds, even if state law furnishes taxpayers with the additional option of pursuing a refund after paying the tax. two precedents from ninety years ago-united states v. new york & cuba mail steamship co."' and chesebrough v. united statesl''-which the court has not disowned, buttress this conclusion."' neither mckesson nor these older precedents, however, license states that do have pre-deprivation procedures for challenging a tax's constitutionality to deny refunds unfairly if a taxpayer forgoes a pre-deprivation challenge. thus, if a state refund statute requires rather than permits state tax officials to refund unconstitutional taxes-unlike the federal statutes under which refunds were sought in new york & cuba mail and chesebrough-the state's refusal to pay refunds in davis-type cases could presumably be attacked on state-law grounds as well as under the due process or equal protection clause. likewise, if davis-type refund claims were singled out for unfavorable treatment under a refund statute that grants discretion to state tax officials-and the magnitude of these claims might make denials tempting-federal retirees who were adversely affected could 110. 200 u.s. 488 (1906). 111. 192 u.s. 253 (1904). 112. both cases involved suits by taxpayers who had paid federal taxes without protesting what they alleged was the unconstitutionality of the taxes. both taxpayers sought refunds under statutes authorizing the commissioner of internal revenue to repay taxes that were wrongfully collected; when their requests were denied, they entered pleas in federal district court. the supreme court ruled in both cases that the taxpayers had paid the taxes voluntarily, in part because they had failed to satisfy the common-law precondition of protesting the illegality of the taxes when they paid them. see new york & cuba mail s.s., 200 u.s. at 494-95; chesebrough, 192 u.s. at 263-64. the court therefore found that no refund was required. the court noted that the refund statutes permitted rather than mandated repayment-the commissioner was "authorized" to refund illegally collected taxes or "may" make allowance for taxes that were wrongfully collected-and it held that the commissioner was therefore not compelled to refund taxes that were paid without putting the government on notice of the taxpayers' allegations of unconstitutionality. [vol. 1:8 harper and its aftermath probably sue under state law or under one or both of these constitutional provisions. it is too early to say whether any post-harper litigation is likely to track this course."13 the second issue that might spur litigation, as state officials try to avoid prising large refunds from embattled treasuries, is whether there in fact existed a prepayment remedy, of which federal retirees could have availed themselves, that was constitutionally sufficient to warrant the denial of retroactive relief to those who ignored that pre-deprivation procedure. this issue might well come to the fore on remand in harper itself. in its brief to the supreme court, virginia contended that it had no obligation to provide refunds or to tax state retirees retroactively because federal pensioners could have challenged their tax assessments administratively prior to paying state income tax. by forgoing this possible remedy, the state argued, they relinquished any federal constitutional claim they might have had to backward-looking relief." 4 in response to the federal retirees' claim that the department of taxation lacked authority under state law to declare a tax unconstitutional, hence that meaningful prepayment relief could not be obtained, virginia countered that the commissioner could nevertheless exonerate a taxpayer from paying taxes, even if the commissioner could offer no official pronouncement on the tax's constitutionality. but the state produced no authority for this claim in its brief. the federal retirees, for their part, denied that the commissioner could excuse payment on the basis of a constitutional flaw that only the courts could recognize officially." ' the 113. one opinion granting partial but not full refunds for davis violations under an interpretation of the state law of remedies, based on the premise that mckesson's remedial scheme does not apply because state law allows pre-deprivation challenges, is that of the arizona tax court in bohn v. waddell, 807 p.2d 1, 3 (ariz. t.c. 1991). aff'g 790 p.2d 272 (ariz. t.c. 1990). the court's decision ordering partial refunds was later vacated on the ground that the taxpayers had first to exhaust their administrative remedies before suing in state court. see estate of bohn v. waddell, 848 p.2d 324 (ariz. ct. app. 1992). by contrast. in sizemore v. rinehart, 611 so. 2d 1064 (ala. civ. app. 1992), writ quashed as improvidently granted, 611 so. 2d 1069 (ala. 1993), the court ordered that refunds be paid despite the availability of pre-deprivation relief that the taxpayers had apparently chosen to pass up. 114. brief for respondents at § ii.c, harper (no. 91-794). 115. see reply brief for petitioners at § h, harper (no. 91-794). the taxpayers' brief also raised the first issue identified: even if a prepayment remedy was available, they averred, that fact was irrelevant, because state law also provided a refund mechanism. indeed. after davis the virginia legislature extended the statute of limitations for filing refund claims to accommodate federal retirees seeking post-payment redress. the petitioners in harper maintained that denying retroactive relief because an administrative challenge was possible prior to payment (if a meaningful challenge was indeed possible) would contravene the legislature's plain intention to afford relief. it appears that they might further argue that denying refunds when refunds are routinely made available to other taxpayers who decline to seek administrative relief before paying would constitute unlawful discrimination under the 19931 florida tax review supreme court declined to rule on this point, because remedial issues were not properly before it and the state-law question of the commissioner's powers had not been decided below." 6 it may now fall to the virginia courts to resolve the issue. it is important to stress that while the existence of an avenue for prepayment challenge is a question of state law, the sufficiency of any prepayment procedure to absolve a state from providing retroactive relief must be measured under the due process clause, according to standards that the supreme court has not yet articulated in detail. certainly, the prepayment procedure must promise complete relief without being unduly tortuous or costly. as the court said in atchison, topeka & santa fe railway co. v. o'connor,"' "it is reasonable that a man who denies the legality of a tax should have a clear and certain remedy."".8 equally plainly, it cannot be a remedy that the state or its courts discovered or created and made a precondition to relief for constitutional flaws only after taxpayers had paid their taxes and filed claims for refunds. as the supreme court stated without dissent in brinkerhoff-faris trust & savings co. v. hill," 9 after missouri had attempted to do precisely that: "whether acting through its judiciary or through its legislature, a state may not deprive a person of all existing remedies for the enforcement of a right, which the state has no power to destroy, unless there is, or was, afforded to him some real opportunity to protect it.' 20 equal protection clause. if the rule of prepayment challenge, on pain of losing all chance of relief, was unheralded until the retirees' large refund claims rolled in, they might also contest the newly announced policy under the due process clause. state law might furnish some additional basis for suit. 116. harper, 113 s. ct. at 2520. 117. 223 u.s. 280 (1912). 118. id. at 285. the court quoted this sentence with approval repeatedly in mckesson, 496 u.s. at 32, 39, 40, 43, 51. 119. 281 u.s. 673 (1930). 120. id. at 682 (footnote omitted). brinkerhoff-faris involved a suit alleging that a state tax violated the equal protection clause. the taxpayer had sued in equity to enjoin collection of the tax, maintaining that no relief was available at law, either by way of defense in an enforcement proceeding or by paying the tax under protest and claiming a refund. the taxpayer further alleged that it had not sought an administrative remedy because, just six years before, the missouri supreme court had declared it "preposterous" and "unthinkable" that the tax commission could grant the relief the taxpayer sought. id. at 676. on appeal, the missouri supreme court declared, contrary to its earlier holding, that the taxpayer could have obtained a remedy from the tax commission, yet that it could no longer secure relief because too much time had elapsed for it to bring its claims before the commission. id. at 677. the united states supreme court held that "in refusing relief because of the newly found powers of the commission, the court transgressed the due process clause of the fourteenth amendment." id. at 677-78. the missouri supreme court's surprising reversal of its earlier holding had left the [vol 1:8 harper and its aftermath the question of how much surprise regarding the proper procedural route for contesting a tax's unconstitutionality is consonant with federal due process standards can arise with respect to post-payment procedures too. georgia provides an example. in reich v. collins," the georgia supreme court correctly anticipated the holding in harper, concluding that davis applies retroactively under the court's analysis in beam."2 because the taxpayer who challenged georgia's tax on federal but not state retirement income sued for a refund under a statute specifying that a taxpayer "shall be refunded any and all taxes or fees which are determined to have been erroneously or illegally assessed and collected from him under the laws of this state," and because the refund statute applied to taxes "whether paid voluntarily or involuntarily,"" a refund order seemed the natural resolution of the case. instead, the georgia supreme court announced, without citing precedent or legislative history or related statutory language, that the statute "does not address the situation where the law under which the taxes are assessed and collected is itself subsequently declared to be unconstitutional or otherwise invalid."'24 the court continued: we take this opportunity to hold that in cases in which a taxing statute is declared unconstitutional or otherwise void, a taxpayer must have made a demand for refund at the time the tax is paid or at the time his tax return is filed, whichever occurs last. failure to do so bars any future claim.' in mckesson, the court reaffirmed the established principle that states may permissibly require taxpayers to file a protest as a precondition to claiming a refund."u the refund statute under which reich sued, however, contained no protest requirement. and the georgia supreme court pointed to no prior authority for the prerequisite it announced. it may be that some authority exists, which the court overlooked or chose not to cite. but assuming that none does, it is hard to see how the court's decision comports with due process. one would expect the taxpayer to raise that due process objection-which appears to be timely 27-now that the supreme court has taxpayer without any genuine opportunity to prosecute its claim. 121. 422 s.e.2d 846 (ga. 1992), vacated and remanded. 113 s. ct. 3028, cert. denied, 113 s. ct. 3037 (1993). 122. reich, 422 s.e.2d at 847. 123. ga. code ann. § 48-2-35(a) (1993). 124. reich, 422 s.e.2d at 849. 125. id. 126. see mckesson, 496 u.s. at 45. 127. see, e.g., brinkerhoff-faris, 281 u.s. at 673 (finding a due process claim 19931 florida tax review remanded the case to the georgia supreme court for reconsideration. in brinkerhoff-faris, the court did say that "[h]ad there been no previous construction of the statute [governing the tax commission's powers] by the highest court, the plaintiff would, of course, have had to assume the risk that the ultimate interpretation by the highest court might differ from its own." 28 but the court was there referring to a statute setting forth the tax commission's responsibilities that on its face did not preclude the commission from considering a constitutionally based refund claim. had the missouri supreme court not ruled as it did several years before, administrative redress would have appeared a sensible option to taxpayers. in georgia, there appears to have been no reason at all for taxpayers to have supposed, prior to the georgia supreme court's decision in reich, that a protest was essential to recovery. whatever the merits of a due process attack on the court's holding in reich, state officials who wish to persuade a court in cases like harper to excuse the state from paying large refunds or from imposing retroactive taxes might invoke reich as a suggestive precedent for creating hitherto unknown procedural obstacles to recovery. 29 these issues will have to be litigated timely when filed after a court's surprising ruling effectively denied the taxpayer any opportunity to challenge the constitutionality of a tax). 128. id. at 682 n.9. 129. south carolina offers a somewhat different example of unfairness to taxpayers so far as refund procedures are concerned. in bass v. south carolina, 395 s.e.2d 171 (s.c, 1990), vacated and remanded, 111 s. ct. 2881 (1991), aff'd, 414 s.e.2d 110 (s.c. 1992), vacated and remanded, 113 s. ct. 3025 (1993), the south carolina supreme court held that taxpayers who had sued for a refund under a refund statute with a three-year statute of limitations were not entitled to any relief. most of the court's initial holding was devoted to an argument that davis did not apply retroactively. but the court added that, were it to examine issues of state law, it would hold that the suit was barred because the only avenue to recovery was under a different refund statute that carried a protest requirement. after the supreme court vacated and remanded following its decision in beam, the south carolina supreme court reaffirmed its prior holding on the basis of the procedural bar it had mentioned earlier. its former decisions, the court said, could not have misled the retirees as to the correct route to relief. the court then noted, however, that "the tax commission has issued administrative interpretations stating that [the refund statute under which the retirees had sued] applies to income tax refunds." 414 s.e.2d at 113. not only that: "after the davis decision was announced, the tax commission issued several press releases in which it advised the retirees that they could 'protect themselves against the expiration of the three-year statute of limitation' by writing a letter to the tax commission or by filing an amended return for the 1985 tax year." id. nevertheless, the court refused to estop the state from arguing that the retirees' claims were barred: "while we agree with the retirees that it is very unfortunate the tax commission has instilled false hopes . . ., we are not bound by [its] misinterpretation ...." id. the court refrained from saying why equitable considerations did not impel it to apply its decision prospectively. it is also not clear from the court's opinion whether the tax commission regularly granted income tax refunds under the statute that formed the basis for [vol 1:8 harper and its aftermath state by state, with little chance of review by the supreme court. the question of whether notice of the proper remedial course in a given state was constitutionally sufficient is too specific, and the standard by which it must be answered too hazy, to tempt the court to reconsider state courts' determinations, except perhaps when they appear truly egregious. taxpayers may find the going hard. 130 the federal retirees' suit or, if it did, whether the retirees have challenged, or may still challenge, the denial of their refunds under the equal protection clause. one commentator, after recounting taxpayers' difficulties in obtaining redress for illegal taxes in south carolina since the nineteenth century, noted that the refund statute under which the federal retirees had sued was intended, in the words of the tax study commission that drafted it, to establish an equitable system for claiming refunds "without vast technicality." william j. quirk, taxpayer remedies in south carolina, 37 s.c. l. rev. 489. 509 (1986) (quoting the first annual report of the tax study commission). designed to replace a tax system "so fraught with technicality and expense as to be practically unavailable for the vast majority of taxpayers," id. at 510 (quoting report), the statute, as construed by the south carolina supreme court, appears to have been a conspicuous failure. 130. a recent case from vermont yields a cautionary tale. in american trucking ass'ns v. conway, 508 a.2d 408 (vt. 1986), cert. denied, 483 u.s. 1019 (1987). the vermont supreme court held that taxpayers could not recover fees paid under a statute it found to violate the commerce clause because "the state cannot be sued without its consent for injuries resulting from the exercise of functions essentially governmental in character." and imposing taxes "could be performed only by a governmental entity." id. at 413. this result was manifestly unjust and, it appears, unconstitutional, because state law also provided no vehicle for challenging the tax prior to payment. see louis e. wolcher, sovereign immunity and the supremacy clause: damages against states in their own courts for constitutional violations, 69 cal. l. rev. 189 (1981) (arguing that the supremacy clause obligates state courts to order constitutionally adequate remedies notwithstanding the failure of state law to provide for them). in williams v. vermont, 589 a.2d 840, reh'g denied, 589 a.2d 840 (vt. 1990). cert. denied, 112 s. ct. 81, and cert. denied, 112 s. ct. 590 (1991), the vermont supreme court overruled that portion of its opinion in american trucking ass'ns that left plaintiffs with no opportunity to contest a tax prior to payment and no chance to obtain refunds after a successful challenge, reasoning that this complete foreclosure of relief violated the due process clause as construed in mckesson. see id. at 848-49. in doing so. however, the court appeared to require taxpayers to pay a tax they considered unconstitutional, to seek prospective relief in state court, and then, if they prevailed, to seek a refund from vermont's commissioner of motor vehicles that he was only doubtfully authorized to provide and whose decision might not even be reviewable in the vermont courts. again, the supreme court refused to hear the case on writ of certiorari. only now, in yet another case, does some straightforward path to relief seem available. in barringer v. griffes, 964 f.2d 1278 (2d cir. 1992), the court of appeals granted an injunction on vermont's collection of a motor vehicle tax by a taxpayer challenging its constitutionality. the court concluded that the tax injunction act of 1937. 28 u.s.c. § 1341 (1988), does not bar federal court interference in the face of vermont's intransigence: "a careful reading of the opinion in williams leaves the reader with the uneasy feeling that if there is a judicial remedy available to the [plaintiffs] in vermont, it cannot fairly be said to be plain." 19931 florida tax review b. equitable discretion in choosing remedies beyond peradventure, the most salient question after harper is the extent to which states have discretion in choosing a suitable remedy in cases in which a federal constitutional ruling applies retroactively. the transfer of hundreds of millions of dollars depends on the correct answer to this question in virginia alone. but the question has wider significance, because its answer affects the disposition of all civil holdings that do not overrule precedent or are not doctrinally surprising. it will, of course, become even more pressing if, as seems increasingly likely, the court holds that all civil decisions apply retroactively, and thereby either overturns chevron oil or interprets it, as justice stevens suggested in his american trucking dissent, as "a remedial principle for the exercise of equitable discretion by federal courts and not ... a choice-of-law principle applicable to all cases on direct review."'' following the court's paired decisions in american trucking and mckesson, the scope of a state's discretion in remedying the wrongs worked by an unconstitutional tax appeared narrow once the supreme court held that its ruling applied retroactively. these cases fell within mckesson's iron remedial frame. if a state failed to provide an adequate prepayment procedure for challenging a tax, it must, at a minimum, either: (1) refund the tax paid by those whose claims were not procedurally barred, if the tax was beyond the state's power to impose, or, in the case of an unconstitutional tax disparity, pay sufficient refunds to remove the unlawful difference in treatment after the fact; or (2) in the case of an unlawful disparity (as opposed to a tax beyond the state's power to levy), collect back taxes from those who benefitted from the unconstitutional preference in whatever amount would "create in hindsight a nondiscriminatory scheme," to the extent that the due process clause permits retroactive taxes of this kind; 32 or (3) in the case barringer, 964 f.2d at 1284. perhaps this decision will goad the vermont legislature into devising a clearer remedy in order to forestall taxpayers from obtaining injunctions in federal court. whether or not it does, it illustrates the difficulty that taxpayers sometimes encounter in attempting to secure redress for unconstitutional taxation in recalcitrant state courts. 131. american trucking, 496 u.s. at 220 (stevens, j., dissenting). 132. because taxation "is neither a penalty imposed on the taxpayer nor a liability which he assumes by contract," but rather "a way of apportioning the cost of government among those who in some measure are privileged to enjoy its benefits[,] ... its retroactive imposition does not necessarily infringe due process." welch v. henry, 305 u.s. 134, 146-47 (1938). the general due process test for retroactive legislation is whether it has "a legitimate legislative purpose furthered by rational means." general motors corp. v. romein, 112 s. ct. 1105, 1112 (1992). the most important factor in assessing the constitutionality of retroactive taxation is the degree to which it unfairly surprises a taxpayer in circumstances in which he might have acted differently to avoid or reduce the tax had he known it would be imposed. compare united states v. heinszen & co., 206 u.s. 370 (1907) (upholding statute ratifying [vol 1:8 harper and its aftennath of an unconstitutional disparity, combine retroactive taxes and refunds to remove the past inequality as completely as would the first two options.", both the plurality and the dissent in american trucking agreed that this rule left states with little or no leeway. it is, justice o'connor said, precisely because "mckesson makes plain that equitable considerations are of limited significance once a constitutional violation is found,""' that is, it is because "mckesson's holding. . . places substantial obligations on the states to provide relief, [that] the threshold determination whether a new decision should apply retroactively is a crucial one, requiring a hard look at whether retroactive application would be unjust."' 35 justice stevens, dissenting in american trucking, said nothing to contradict justice o'connor's reading of mckesson. chevron oil, in his view, was a remedial principle applicable to statute-of-limitations cases, not tax cases. "[c]onsideration of reliance might be appropriate" if the period for filing suit changes and in certain other instances, but not when state taxes violate the constitution."' ' there are, to be sure, passages in mckesson itself suggesting that the remedial rule it endorsed for tax cases was not as draconian as it appeared. the court did not, for example, dismiss equitable considerations as irrelevant to ascertaining a state's constitutional obligation to remedy its mistakes. indeed, it acknowledged that "within our due process jurisprudence, state interests traditionally have played, and may play, some role in shaping the contours of the relief that the state must provide to illegally or erroneously deprived taxpayers."' 37 the court also spent several pages discussing florida's claim that the court's order of retroactive relief was unjust.' the court's conclusions, however, were uncompromising. at least with respect to taxes collected after mckesson's announcement, it averred unambiguously technically illegal collection of tariffs six years before) and anderson v. mt. clemens pottery co., 328 u.s. 680 (1946) (rejecting challenge to portal-to-portal act, which amended earlier legislation retroactively by nine years to correct misunderstanding that would have been costly to employers) with coolidge v. long, 282 u.s. 582 (1931) (invalidating retroactive succession tax that trust settlor could not reasonably have anticipated) and untermyer v. anderson, 276 u.s. 440 (1928) (striking down retroactive gift tax). 133. see mckesson, 496 u.s. at 40-41. states are free to provide more relief than the constitutional minimum. id. at 52 n.36. but few are likely to show such magnanimity. indeed, in the case of an unconstitutional tax disparity, additional compensation will typically not be an option at all, for granting more relief than a party is due could easily create an inequality in treatment that itself discriminates unlawfully against former beneficiaries of the tax disparity. 134. american trucking, 496 u.s. at 184 (plurality opinion). 135. id. at 181 (plurality opinion). 136. see id. at 221-23 (stevens. j., dissenting). 137. mckesson, 496 u.s. at 50. 138. id. at 44-51. 19931 florida tax review that a state's ability to hedge tax payments and refund actions with procedural requirements "suffices to secure the state's interest in stable fiscal planning when weighed against its constitutional obligation to provide relief for an unlawful tax.""' in addition, the court held that florida lacked a persuasive claim to special treatment for its conduct-which of course preceded the court's ruling-because its discriminatory liquor excise tax was conspicuously unconstitutional. 140 what the court's discussion of the equities surrounding backwardlooking relief in florida's own case possibly suggests, however, is that while states have at their disposal adequate procedural protections for the future, now that mckesson's holding is plain for all to study, states might not have had adequate warning in the past. according to this reading, each claim that retroactive relief would be inequitable for this pre-mckesson period must be assessed separately. from the court's reasoning in mckesson, one might infer that any case that failed to satisfy chevron oil's first prong-because it did not establish a new principle of law by overruling precedent or by deciding an issue of first impression whose resolution was not clearly foreshadowed-would probably not qualify for a full or partial exemption from mckesson's remedial requirements. but cases that passed that test, perhaps along with some that were surprising but not quite surprising enough to meet chevron oil's test for nonretroactivity, might qualify. i advance this possible reading of mckesson tentatively, for the court's opinion is enigmatic. this interpretation allows one to understand most of what the court said. but it might not be the only plausible gloss, and perhaps some of what it explains was mere confusion or what the justices would now regard as error. one obvious difficulty it encounters is that, at least when mckesson was decided, it is hard to imagine many cases involving pre-mckesson unconstitutional taxation that satisfied chevron oil's first prong-by laying down a new principle of law in defiance of precedent or other legal indicators-yet still reached the stage at which mckesson's analysis became relevant. tax cases that meet chevron oil's threshold requirement for nonretroactivity will ordinarily not prompt any remedial inquiry, because the remaining considerations (the purpose of the new rule, equitable arguments) are unlikely to tip the verdict in favor of retroactive application. likewise, it is difficult to conceive of many rulings that would 139. id. at 45 (emphasis added); see also id. at 50 ("such procedural measures would sufficiently protect states' fiscal security" in the future.). 140. "[e]ven were we to assume that the state's reliance on a 'presumptively valid statute' was a relevant consideration to florida's obligation to provide relief," id. at 45-46, the court said-suggesting, perhaps, that a state's reliance was never relevant (but then why consider the hypothetical?)-florida's liquor excise tax could hardly be so characterized because it was transparently unlawful after bacchus. [vol 1:8 harper and its aftennath apply retroactively under chevron oil but be so dimly foreshadowed as to warrant an exemption from mckesson's remedial obligations. perhaps, however, the court was not concerned about how widespread the problem was: it simply wanted to cover all possible cases. and there is at least one set of cases-those in which the court, perhaps carelessly, applied its ruling retroactively to pre-mckesson conduct and later felt bound to do the same in a relevantly similar situation, despite the possibility that chevron oil's test for nonretroactivity was satisfied-that it might have thought deserved more careful scrutiny for justified reliance and other equitable factors. counting against the thesis that the court had these cases specially in mind is the hard fact that it never mentioned them as an object of concern. notice that if this reading is correct-a large "if'-it leaves open the possibility that states guilty of davis infractions might not have to comply with mckesson's requirements even if they collected state income taxes under duress, because the challenged conduct in davis-related cases almost invariably occurred before davis was decided, and thus also before mckesson was announced. it would not be surprising if states that continue to litigate after harper advance an argument along the lines i have sketched. to the extent that davis's novelty lies at the core of any weighing of the equities that the court might have deemed appropriate, it is worth recalling that only four justices have offered opinions as to whether davis satisfies chevron oil's first condition. in harper, justices kennedy and white said that it did not, whereas justice o'connor and chief justice rehnquist disagreed. the remaining five did not address the question. based on a fairly strict reading of mckesson as the court seemed to understand its ruling when the case was decided, one could argue that remedial considerations might excuse states-the equitable case would still have to be made 4 -from offering complete refunds, fully compensatory 141. justice o'connor attempted to build such a case in her harper dissent, emphasizing the surprising character of davis, the good faith of state officials, yawning budget deficits in many states, the burden that refunds would place on innocent taxpayers not complicit in the government's wrong, and the alleged injustice in forcing a state like virginia to pay refunds that are ten times larger than the benefit it reaped from its constitutional violation. see harper, 113 s. ct. at 2534-38 (o'connor, j., dissenting). the tenfold difference between benefit and penalty that justice o'connor claimed was taken from statements at oral argument by counsel for virginia. see tr. of oral argument at 33, 36, harper (no. 91-794) (dec. 2, 1992). virginia's deputy attorney general did not say how she arrived at the benefit figure, which is absent from the state's brief. it does not seem possible to square justice o'connor's claim that virginia realized some benefit with the assertion in her harper dissent that "it makes no difference to the state or the [state] retirees whether the state increases state retirement benefits in an amount sufficient to cover taxes it imposes, or whether the state offers reduced benefits and makes them tax-free. the net income level of the retirees and the impact on the state fisc is the 19931 florida tax review retroactive taxes, or some union of the two for conduct that antedated mckesson. several passages in justice souter's opinion in beam appear either to strengthen this reading (or at least not to contradict it) or to constitute a subtle recasting of mckesson's understanding of the scope of remedial discretion in state tax cases, one that amplifies the discretion that states have in choosing a suitable remedy. for example, after rejecting "relying on the equities of the particular case" to determine whether a decision applies retroactively at the first, choice-of-law stage,142 justice souter said that courts may nevertheless consider at that stage "the equitable and reliance interests of parties absent but similarly situated."' 43 that is to say, they may, in justice souter's judgment, consider equitable and reliance interests generally, across the range of affected cases, in determining whether a decision applies retroactively.'" in addition, justice souter continued, "nothing we say here [about ignoring the equities of the particular case in determining whether, as a choice-of-law matter, a decision applies retroactively] precludes consideration of individual equities when deciding remedial issues in particular cases."'' 45 what justice souter meant by this last sentence is obscure. it is possible that he merely intended to refer to the apparently small role that equitable considerations might play within mckesson's straitjacket. after all, he nowhere suggested, when referring to mckesson by name, that he considered the court's circumscribed approach deficient. he did say that the bearing of these unspecified "reliance interests" on the selection of a suitable remedy was "a matter with which mckesson did not deal."'146 but he could there have been alluding to the fact that the court said nothing in mckesson about how these reliance interests, in the rare instances in which they come same." harper, 113 s. ct. at 2534 (o'connor, j., dissenting). what justice o'connor overlooks is that increases in state retirement benefits are subject to federal income tax as well as state income tax, so that it costs the state more, if it desires to keep state retirees in the same after-tax position, to pay higher pensions while taxing them than it does to pay lower pensions while exempting them from tax, at least if state retirees claim the standard deduction instead of itemizing their deductions on their federal income tax return. this difference is presumably the benefit to the state to which virginia's deputy attorney general alluded, as well as the federal government's loss. for further discussion, see infra part v.c. 142. beam, i i 1 s. ct. at 2447 (opinion of souter, j.). 143. id. at 2448 (opinion of souter, j.). 144. justice souter did not explain how a court should go about making this general judgment. his opinion seems to contemplate the parties' introducing, and the court's evaluating, evidence about a range of cases not currently before the court-a highly unusual proposal. for additional reflections on justice souter's discussion of equitable discretion, see infra note 159. 145. beam, 111 s. ct. at 2448 (opinion of souter, j.). 146. id. (opinion of souter, j.). [vol. 1:8 harper and its aftermath into play, may shape the choice of remedies, because the court there concluded that florida's invocation of equitable concerns was unavailing." 7 in that case, justice souter would not have been trying to expand the minor part that the court allotted to equitable considerations. he would, instead, have been underlining an omission that the court did not need to consider in mckesson and that might need to be addressed only very infrequently. if, however, justice souter's sentence about considering "individual equities when deciding remedial issues in particular cases" is read broadly, its thrust appears incompatible with mckesson. construed in this way, it would also yield what one commentator described as "a conceptually confusing and redundant two-tiered approach to retroactivity questions.""' justice souter might then be seen as contemplating an untidy, two-step process: a court announcing a new rule must first determine whether the rule applies prospectively or retroactively for purposes of adjudicating the rights of the parties. if the rule is applied retroactively, the court must then fashion a remedy, based in part on consideration of the same reliance interests that are likely to influence the retroactivity decision. 49 it is impossible to say whether justice souter-and presumably justice stevens, the only colleague who joined his opinion'--contemplated this approach. its silliness, together with justice stevens's unwillingness to advocate anything like a double look at equitable considerations in his american trucking dissent, 5 ' count against this reading. but justice souter's reference to the role of reliance interests in fashioning a remedy as "4a matter with which mckesson did not deal"'" is admittedly ambiguous. one can expect some litigants, most notably state attorneys arguing against 147. mckesson, 496 u.s. at 44-51. 148. note, supra note 16, at 346. 149. id. (footnote omitted). 150. none of the other justices spoke to the question of a court's discretion in ordering remedies in constitutional tax cases should a decision apply retroactively. 151. in american trucking, justice stevens argued that the court's decision in scheiner should apply retroactively to the parties in american trucking because the court had already applied its decision retroactively to the parties in scheiner itself. american trucking, 496 u.s. at 212 (stevens, j., dissenting) (discussing american trucking ass'ns v. scheiner, 483 u.s. 266, 297-98 (1987)). thus, justice stevens believed that anerican tnicking should be decided by the same logic that later prevailed in bean and harper. he concluded, without further argument, that mckesson's remedial constraints therefore applied. id. at 224 (stevens, j., dissenting). he said nothing about reviewing equitable considerations not mentioned in mckesson itself. 152. beam, 111 s. ct. at 2448 (opinion of souter, j.). 19931 florida tax review refund orders after harper, to try to draw support from these words, even though justice souter did not speak for more than two justices, and spoke only doubtfully for justice stevens if his words are given this wider extension. in view of their unclarity and the lack of five justices on the opinion, and in the absence of further elaboration by a majority of the justices, courts surely ought to ignore justice souter's statements, and continue to regard mckesson as determinative. it would not be surprising, however, if some ascribed unmerited significance to justice souter's words, particularly given the perceived blow to state coffers-regardless of whether that perception is inaccurate' 53 -that refund orders would entail. the error of doing so after harper is all too evident. harper did little to clarify the court's understanding of civil retroactivity. the court shied away from adopting a rule of per se retroactivity, which would-quite sensibly-focus discussion of any constitutionally relevant equitable concerns at the remedial stage of the analysis."5 nor did the court endorse taking reliance interests and fairness into account in determining whether a decision applies retroactively, as justice o'connor favors. instead, justice thomas's opinion took no stand on how chevron oil should be read; it merely tracked beam's equal treatment argument. what the court did accomplish, however, though small, is nonetheless significant. a majority of the court seemed, after the disarray that beam produced, to reaffirm its commitment to mckesson's rigid remedial constraints. in discussing virginia's remedial obligations, the court eschewed citing, quoting, or rephrasing justice souter's confusing statements in beam about the possible role that reliance interests might play in molding a state's duty to repair its wrongs. to the contrary, the court referred, without qualification, to mckesson's palette of remedial options, saying plainly that if a state failed to offer a satisfactory pre-deprivation remedy, it "may either award full refunds to those burdened by an unlawful tax or issue some other order that 'create[s] in hindsight a nondiscriminatory scheme. ' "' whatever the purport of justice souter's musings in beam-and perhaps they stemmed from a misreading of mckesson-a 153. in some instances the cost to the state of retroactive relief might be considerably less than the cost of refunding taxes paid by federal retirees, because the legislature might, if state law permits, impose retroactive taxes on former state workers that it offsets with retroactive pension increases to cover the increase in state workers' state and federal taxes. see infra part v.c. if mckesson gives state courts some discretion to mitigate remedies in view of equitable considerations, they ought to review the options available to lawmakers-including the one described-in deciding what relief is judicially appropriate. so far, however, state courts have indicated no readiness to do so. 154. the court might well do this in time. see supra part iv. 155. harper, 113 s. ct. at 2520 (quoting mckesson, 496 u.s. at 40) (emphasis added). part v.c. of this article describes how little states might in fact have to do to render their past conduct nondiscriminatory in retrospect. [vol. 1:8 harper and its aftermath majority of the court appears in harper to have reestablished that mckesson's narrow choice of remedies governs the provision of relief in davis-type cases. 156 whether mckesson will continue to supply the blueprint for remedies in constitutional tax cases if the court adopts a rule of automatic retroactivity for civil and criminal cases alike is a matter for speculation. although six of the present justices joined the court's opinion in mckesson, including those sentences stating that in the future states' ability to establish various procedural requirements for claiming tax refunds or challenging a tax deprives them of compelling equitable arguments for loosening mckesson's remedial restrictions, justice o'connor's plurality opinion in american trucking suggests that three of the justices nevertheless thought that equitable concerns should have some bearing on the ultimate resolution of constitutional tax cases, at the very least those cases involving pre-mckesson taxation.'57 the court will surely have to take up this question again, to determine how retroactivity as a choice-of-law matter is to be ascertained and, relatedly, if retroactivity is established, how states may go about rectifying their unconstitutional actions. some commentators have argued that states should be granted more liberty to deny relief in tax cases than mckesson appears to allow if retroactivity as a choice-of-law matter becomes automatic, 156. justice o'connor's contrary claim in dissent is based on a tendentious reading of mckesson, justice stevens's american trucking dissent, and justice souter's opinion in beam. evidently, her object is to achieve, via an expansion of the role that equitable considerations play in mckesson's remedial analysis, the same final result that she believes would, or should, have emerged had the court not begun to drift away from using the chevron oil test to determine retroactivity as a choice-of-law matter and had it not refused. wrongly. to reconsider its decision to apply davis retroactively to the parties in that case. this aim leads her to read earlier opinions selectively, omitting passages her view cannot accommodate. for example, she quotes justice stevens's statement in his american trucking dissent that chevron oil furnishes a principles of remedial discretion for the federal courts, without acknowledging that he did not consider it the appropriate remedial test in tax cases, for which, he thought, mckesson provided a complete analytical framework. she also overlooks the court's statement in mckesson that the state's ability to employ various procedural protections generally suffices to preclude any mitigation of its remedial obligations. nor is her attempt to give decisive significance to justice souter's puzzling statements about reliance interests in beam-by referring to his opinion for only himself and perhaps justice stevens as "controlling"-even the least bit persuasive. see harper, 113 s. cl at 2526-39 (o'connor. j., dissenting). 157. justice o'connor's plurality opinion in american trucking did not. however, confront the question of whether the chevron oil analysis for determining retroactivity that she endorses would, for all post-mckesson taxation, necessarily weigh against the state and therefore in favor of retroactive taxation because states can protect themselves procedurally against unfair surprise. by joining justice brennan's opinion in mckesson, she might be thought to have committed herself to this position. but her harper dissent suggests the reverse. what the other justices who sided with her in american tricking think appropriate is unknown. 19931 florida tax review even though flexibility might tend to erode the discipline imposed by mckesson's stiff rule.'58 but the justices have not spoken to this suggestion or said anything that indicates how far they believe states may go in tempering mckesson's remedial strictures with such equitable considerations as the unpredictability of a new ruling or the cost of retrospective compliance. the justices have also been sphinx-like with respect to whether mckesson's reasoning is limited to tax cases or perhaps only to commerce clause cases, with the underlying substantive constitutional provision furnishing the remedial content to the due process clause requirement of backward-looking relief, or whether mckesson's at once categorical and tentative remedial analysis is intended to sweep more broadly. the sooner the court settles these matters, the better, not only because of their importance to much commerce clause litigation, on which large sums of tax revenue or refunds turn, but because of the disordered state in which the court's recent decisions have left the law governing retroactivity and remedies in statute-of-limitations cases and other nontax disputes.'59 in the meantime, the remedies states may 158. see shores, supra note 75, at 214-15; fallon & meltzer, supra note 83, at 1832. 159. when american trucking was decided, at least eight justices appeared convinced that chevron oil's tripartite test was the proper standard for measuring whether a statute-of-limitations decision impinged on a claim filed prior to that decision, either because it governed the choice of law (the american trucking plurality's view) or because it governed the choice of remedies (justice stevens in dissent). it also was clear that the question of whether a law-changing statute-of-limitations decision applied to a party's claim depended upon the extent to which that particular party had reasonably relied on a different rule, not on whether most actual or potential plaintiffs had or might have reasonably relied on the old rule in filing when they did or in waiting to sue. compare saint francis college v. alkhazraji, 481 u.s. 604 (1987) (holding race discrimination claim not time barred under 42 u.s.c. § 1981, despite intervening supreme court decision shortening the statute of limitations, because plaintiff relied on third circuit precedent declaring, inconsistently with the intervening supreme court decision, that a longer statute of limitations applied) with goodman v. lukens steel co., 482 u.s. 656 (1987) (holding section 1981 claim time barred because, unlike in saint francis college, there was not yet any third circuit precedent contrary to the supreme court's later decision when the plaintiffs filed their claim). three recent opinions have disturbed the settled order. in beam, justice souter stated that "the chevron oil test cannot determine the choice of law by relying on the equities of the particular case." beam, 111 s. ct. at 2447 (opinion of souter, j.). the court's opinion in harper quoted this sentence, giving it an authority it lacked in justice souter's opinion for two justices in beam. harper, 113 s. ct. at 2516 n.9. however, the meaning of this sentence is murky. justice souter followed it with a citation to a first circuit decision and a student note that rejected the notion that statute-of-limitations cases should be decided by reference to the reliance interests of individual plaintiffs. beam, 111 s. ct. at 2447 (opinion of souter, j.). this decision and note appear inconsistent with the court's approach in saint francis college and goodman, which the court decided after both were written. but justice souter did not mention saint francis college and goodman, let alone explicitly cast doubt on them. so have they been overruled sub silentio? or did justice souter in beam, and perhaps the majority in [vol 1:8 harper and its aftermath embrace for davis infractions are bounded by the rules that mckesson announced. c. offsetting bonuses and retroactive tax increases many states feared a ruling that davis applies retroactively because they believed that mckesson would leave them with no practicable option other than ordering large refunds to federal retirees. the alternative of taxing state pensioners retroactively would be unfair and politically difficult; it might also breach former state workers' employment contracts or otherwise violate state law.16° in a recent article, i argued that mckesson gives states a third option: states may impose a retroactive tax on state retirees sufficient to eliminate the tax disparity between them and federal retirees for all open tax years, and simultaneously issue to those same state retirees a bonus to offset the increased state tax they would owe on their pension payments during the open tax years and on the bonus itself, as well as to offset the additional federal income tax they would owe on the bonus.' 6' harper, intend to reject selective prospectivity at the choice-of-law stage. but to permit a caseby-case weighing of reliance interests in statutc-of-limitations cases at the second, remedial stage, which is where justice stevens said in his american trucking dissent that chevron oil comes into play? justice souter's denial, later in the same paragraph in beam, that he did not intend to "preclude[ ] consideration of individual equities when deciding remedial issues in particular cases," beam, 111 s. ct. at 2448 (opinion of souter, j.), lends support to this reading. but then his citations to the first circuit decision and note are unfathomable. the lower federal courts have already begun to split on this question. compare cooperativa ahorro y credito aguada v. kidder, peabody & co., 777 f. supp. 153, 156 & na (d.p.r. 1991) (rejecting case-by-case approach), rev'd on other grounds and remanded, 993 f.2d 269 (1st cir. 1993) with robinson v. caulkins indiantown citrus co., 771 f. supp. 1205, 1211-14 (s.d. fla. 1991) (concluding that the court's rejection of selective prospectivity at the choiceof-law stage did not overrule saint francis college or repudiate case-by-case equitable determinations at the remedial stage). adding to the uncertainty is the supreme court's decision in lampf, pleva, lipkind, prupis & petigrow v. gilbertson, 111 s. ct. 2773 (1991). which applied its novel statute-oflimitations decision retroactively without performing a chevron oil analysis or considering equitable considerations in any way, despite being chastised on this score by a dissenting opinion to which the court did not respond. did the court intend to jettison the approach it adopted in saint francis college, even though it did not refer to that decision? that conclusion seems unlikely. but then why did the court ignore altogether the plaintiffs argument for nonretroactive application? only the court can unscramble this imbroglio. 160. see infra parts vi.b-c. 161. see eric rakowski, harper and retroactive remedies: why states' fears are exaggerated, 59 tax notes 555 (apr. 26, 1993) [hereinafter rakowski, harper and retroactive remedies]. the article also appeared under the same title in 4 state tax notes 983 (apr. 26, 1993). i defended these conclusions further in eric rakowski, rakowski responds: there's more to harper than large refund payments, letter to the editor, 4 state tax notes 1318 1993] florida tax review these paired measures would in some, though perhaps not in all, states cost less on balance than paying full refunds to federal retirees. whether they would be cheaper depends upon a number of variables, including the ratio of one-time federal workers claiming refunds to state pensioners who would qualify for bonuses, the marginal federal and state income tax rates that state workers face or faced, and the necessity or absence of any need to increase the bonus to cover interest on the retroactive taxes imposed on state workers. 62 each state interested in responding to davis in this manner must perform its own calculation. critically important for the majority of states is a variable from which my earlier analysis abstracted: the number of state pensioners who would itemize their deductions for the tax years at issue if they were to receive a retroactive bonus and have that bonus and their income from those earlier years taxed at the same state income tax rate that applied to federal retirees.1 63 as david richardson has pointed out, 64 the federal government suffers no disadvantage in hiring employees, and thus appears to have no claim of any substance under the intergovernmental tax immunity doctrine as the court understood it in davis,165 if a state exempts state retirees' (may 31, 1993) (replying to eugene 0. duffy, suggested approach for states after harper faces 'host of legal barriers,' letter to the editor, 4 state tax notes 1246 (may 24, 1993)) [hereinafter rakowski, letter to the editor]. 162. see rakowski, letter to the editor, supra note 161, at 1319. for a discussion of the constitutional significance of interest, see infra part v.f. state law might require the payment of interest even if the due process clause does not. 163. in my simplified numerical example, "i ignore[d] throughout the dependence of federal income tax liability on state income taxes when taxpayers itemize deductions on their federal returns." see rakowski, harper and retroactive remedies, supra note 161, at 559. that simplifying assumption now seems to me to distort significantly the likely impact of the possible response to davis i sketched. the cost to states that embrace the plan i outlined probably would be much lower than the simple example in my earlier article might have been thought to suggest. states that did not perform the calculus i described might therefore find the plan more attractive-perhaps by tens of millions of dollars-than my article might have made it seem. 164. see david m. richardson, federal income taxation of states, 19 stetson l. rev. 411, 438-40 & n.168 (1990). 165. the vice of michigan's tax scheme, according to the court in davis, was that the tax exemption for state workers' pensions allowed the state to pay them less than the federal government had to pay its workers, whose pensions were taxed in michigan and other states. this purported edge in hiring was, of course, highly speculative. how many former state or federal employees considered the differential taxation of pensions in less than half the states in deciding whether to accept work with a state government or with the federal government? nevertheless, it was this theoretical edge that the court found offensive to the doctrine of intergovernmental tax immunity. the reason for the edge, according to the court, was that the state could not have increased all state workers' pensions by some set amount while taxing those pensions (at the same rates to which federal pensions were subject) in [vol. 1:8 harper and its aftermath pensions from state income tax while taxing federal retirees' pensions (as michigan and many other states did), so long as those state retirees would claim an itemized deduction for state income taxes they paid were their pensions taxed by the state. in their case, it should be practically irrelevant, for intergovernmental tax immunity purposes, whether the state provides a higher retire-ment benefit that is taxable by the state or a lower retirement benefit that is exempt from state tax. in either case, federal taxable income will be the same. consider a simple example. suppose that a state pays a retired state worker an annual pension of $50,000 that is exempt from state income tax. suppose further, to keep the example transparent, that the retiree has no other income and that if the state had paid the former worker a pension of $54,000 that was taxable, he would owe the state $4,000 in state income tax. does it matter at all to the federal government, either in its role of employer or in its role as tax collector, whether the state pays the retiree an untaxed pension of $50,000 or whether it pays him $54,000 but takes back $4,000 in taxes? the answer is that it makes no difference, so long as the retiree deducts state taxes from his adjusted gross income in calculating his federal taxable income.' 66 the federal government need not offer higher salaries or pensions to attract good workers if a state exempts state retirement income from tax than the federal government would have to offer were the state to tax state retirement pay but raise that pay by the amount of the tax, provided that state retirees would clain a deduction for state income tares they paid in the event that their pensions were taxed by the state. the harm to the federal government on which the court based its ruling in davis'67 does not exist in these cases.' 68 precisely the amount of the increase, and thus have created a wash from the perspective of the state treasury. justice kennedy explained: in order to provide the same after-tax benefits to all retired state employees by means of increased salaries or benefit payments instead of a tax exemption, the state would have to increase its outlays by more than the cost of the current tax exemption, since the increased payments to retirees would result in higher federal income tax payments in some circumstances. davis, 489 u.s. at 815 n.4. while this statement is true in virtue of the qualifying clause -in some circumstances," its central claim is false whenever a state retiree claims a federal deduction for state income taxes he or she has paid. for a discussion of some minor discrepancies between a salary increase with an offsetting federal deduction and no salary increase at all, see infra note 168. 166. see irc § 63(a) (defining "taxable income" as adjustable gross income minus allowed deductions); irc § 164(a)(3) (authorizing a deduction for state income taxes paid). 167. see supra note 165. 168. a slightly higher salary coupled with an offsetting federal income tax deduction for state income taxes paid might not be exactly equivalent, for federal income tax purposes, to a lower salary not taxed at the state level. but the differences are likely to be 19931 florida tax review when would the federal government be harmed? the federal government could claim injury with respect to state workers who would continue to take the standard deduction on their federal income tax returns even if their state pensions were taxed and concurrently increased by the amount of the tax. because their taxable income would rise by the amount of the pension increase and would not be reduced equally by an itemized deduction for state taxes paid, the united states treasury would profit by the amount of tax due on the increase, by comparison with a regime in which the state paid lower pensions and exempted them from state income tax. if the state, in competing with the federal government as an employer-the perspective for judging discrimination endorsed in davis-were to return these nonitemizing state retirees to the same after-tax position as they would be in were their pensions lower but not taxed by the state, it would have to increase their pensions not only by the amount of state income tax they would owe, but also by the amount of the additional federal tax they would owe on additions to their pensions above the untaxed pension baseline. the amount of the additional federal tax is what the state would save by paying lower pensions and not taxing them, relative to a world in which it provided its retirees with the same after-tax income by paying higher pensions while subjecting them to state income tax. this, therefore, is the harm that the federal government can be said to suffer under davis, which gives rise to a right of redress under the doctrine of intergovernmental tax immunity. for example, suppose that a state retiree receives a pension of $20,000 tax-free from the state. in addition, suppose that the state income tax ordinarily due on income of $20,000 is $500, that the marginal state income tax rate above $20,000 is 5%, and that the marginal federal income tax rate above $20,000 is 15%. finally, set aside all other possibly relevant factors, such as personal exemptions and the panoply of state and federal income tax deductions. if the state had to tax the retiree's pension but wanted to leave her in the same after-tax position, how much more would the state have to minuscule. as david richardson notes, because certain expenses are deductible only to the extent that they exceed two percent of adjusted gross income, irc § 67, a higher salary will mean that less can be deducted under this section; conversely, because the ceiling on federal deductions for charitable contributions is tied to adjusted gross income, irc § 170(b)(l), (d)(1), increasing a state retiree's gross salary raises the limit on these deductions. see richardson, supra note 164, at 439 n.168. most retirees, however, are unlikely to qualify for deductions under section 67 or bump up against the ceiling on charitable contribution deductions, particularly if carryovers are taken into account. other deductions that depend upon adjusted gross income, such as the casualty loss deduction, irc § 165(h)(2), and the medical expense deduction, irc § 213(a), also are unlikely to be affected. in rare cases in which they do come into play, the increase in the federal government's tax revenue, if a state pays more and taxes away the addition rather than exempts retirement pay from tax, will almost always be piddling. [vol. 1:8 harper and its aftermath pay? if the retiree itemizes deductions on her federal return, the answer is $526.32. on balance, making her income taxable would cost the state nothing, because it would recoup in full the increase in her pension. if the retiree does not itemize and continues to forgo itemization on her federal return despite having to pay state income tax, the answer is $625. of that amount, the retiree would return $531.25 to the state ($500 plus 5% of the $625 addition). the difference of $93.75 (15% of the $625 addition) would cover the increase in the retiree's federal income tax liability as a result of raising her pension while subjecting it to state income tax. this difference of $93.75 is the harm to the federal government that justice kennedy apparently had in mind in declaring a state income tax exemption for state but not federal workers a violation of the doctrine of intergovernmental tax immunity. it is, as i mentioned, debatable whether the federal government was harmed in any way, given that most potential employees are ignorant of the tax consequences of their retirement pay when choosing between state and federal employment, as well as unsure in which state they will retire. but no more accurate measure of the injury to the federal government has been proposed. if the court's analysis in davis is correct, the federal government was injured by michigan's discriminatory tax scheme only insofar as the state refrained from taxing the state pensions it paid to retirees who would have availed themselves of the standard deduction on their federal returns had their pensions been taxed. there are reasons for thinking that the court's analysis overstates the federal government's injury; indeed, there are reasons for thinking that the federal government cannot properly be said to have suffered any harm at all, and thus that davis was wrongly decided."9 but if one 169. david richardson offers two reasons for this conclusion. first, he says, any harm that the federal government suffered as a result of the standard deduction was selfinflicted. congress plainly could have enacted a tax code that required taxpayers to itemize all their deductible expenses in computing their taxable income. under that regime, a state tax exemption for state retirees could not have disadvantaged the federal government in any significant way, because state taxes would routinely have been deducted. instead, congress adopted a standard deduction that made available to some taxpayers deductions to which they otherwise would not have been entitled, to save the internal revenue service the administrative expenses that more complicated returns would entail and to ease the compliance burden on taxpayers. if congress's generosity in this regard compelled the federal government to incur additional hiring costs in competing with public employers at the state level. congress had only itself to blame. it can be presumed to have waived the federal government's right to nondiscrimination in state taxation to this extent. second. richardson argues. citing old colony trust co. v. commissioner, 279 u.s. 716 (1929). the federal government could have chosen to treat state tax exemptions for state retirees as a form of compensation. and could have imposed federal income tax on the value of this benefit. if, by deciding not to gross-up state pensions, it handicapped itself in its role as an employer, it cannot rightly require states to compensate it for its disability. see richardson, supra note 164, at 439 n.168. there is no evidence that the court considered either of these intriguing arguments 19931 florida tax review in davis. should they have altered its conclusion? a careful answer to that question would require more extended argument than i can offer here. a few thoughts must suffice. the first argument assumes that the federal government's consent to nondiscriminatory taxation of its employees in 4 u.s.c. § ill does not take as given whatever provisions the internal revenue code contains, and that the doctrine of intergovernmental tax immunity does not do so either. the second assumes that section i11 and the intergovernmental immunity doctrine do not operate against the backdrop of the federal government's established practices with respect to imputing taxable income. both assumptions call for some justification. it is true that the standard deduction, introduced in 1944, postdated the public salary tax act of 1939, of which section 111 was a part, as well as the older doctrine of intergovernmental tax immunity. but there is nothing to suggest that congress intentionally waived part of the protection that section 111 or the doctrine of intergovernmental tax immunity afforded when it created a standard deduction for the convenience of taxpayers and its own administrative officials. of course, intentional waiver might not be necessary: a court might hold congress responsible for an unintended ramification of its action. the question here is which presumption to make. richardson's argument might be strengthened by adducing some reason for the presumption he favors. why should the federal government's magnanimity, in making available a standard deduction, commit it to a further generous act-the waiver of its right to equal treatment under 4 u.s.c. § 111 and the intergovernmental tax immunity doctrine? one wonders whether congress can fairly be held fiscally responsible for not noticing that its protection against discrimination by states could be undermined by the enactment of a standard deduction that neglected to exclude state employees who are not subject to state income tax in states in which federal employees are. richardson's first argument also poses the question of how the relevant counterfactual judgment should be cast. after all, the federal government could presumably eliminate deductions for state income taxes. thus, the only reason that there is no discrimination against the federal government in the case of state retirees who would itemize if state pensions were taxed by the state is that the federal government's tax policy creates that result. but why take that part of the tax code as given while treating the standard deduction as a variable, a removable source of the federal government's disadvantage in recruiting workers? there may be a sound answer to this question, but richardson's article does not supply it. richardson's second argument encounters problems of scope and precedent. because the value of the state income tax exemption received by state retirees was potentially taxable by the federal government under old colony, he contends, the federal government was not harmed by it, except insofar as it allowed itself to be harmed by not taxing that benefit. and any injury the federal government brings on itself, richardson says, cannot ground a claim to compensation. the problem with this argument is that it threatens to make 4 u.s.c. § 111, and much of the intergovernmental immunity doctrine, a nullity. if the federal government's power to cure any instance of differential state income taxation by imputing income to the beneficiaries deprived it of any right to redress, section 111 would be an empty string of words. indeed, it is hard to see how the federal government could ever demand recompense, under the doctrine of intergovernmental tax immunity, for the discriminatory taxation of its employees or others with whom it deals. the federal government enjoys wide latitude in determining what benefits to treat as imputed income. although a property tax benefit is farther from the facts of old colony than an income tax benefit for state workers, the federal government could surely impute income to the beneficiaries. if richardson's argument were right, there apparently would never be any ground for suit under the intergovernmental [vol 1:8 harper and its aftermiath takes as given the court's holding in davis, the overall magnitude of the federal government's injury is difficult to assess. how large a fraction of the group of state retirees this set of would-be users of the standard deduction comprises in states guilty of discriminatory taxation under davis is impossible to say without much more information than anybody except the internal revenue service possesses. retired workers frequently do not claim large deductions for home mortgage interest, and if pensions are comparatively small or the state income tax rate is low, state retirees might not amass itemized deductions large enough to induce them to forgo the standard deduction for an itemized listing of their federal income tax deductions. but some undoubtedly would. it would be difficult for a state to take into account the impact of itemization by state retirees under the hypothetical scenario of higher past pensions coupled with state taxation of those pensions in calculating retroactive bonuses and retroactive taxes under the possible response to davis i described, except in those simple cases-probably a small minority-in which the retroactive state tax would exceed the federal standard deduction for the relevant tax years. but this factor, along with the others mentioned above (such as the different marginal state and federal tax rates that apply to different categories of retirees), might be considered in reaching a settlement with the federal government for any harm that it suffered as a result of past discrimination against federal retirees. striking such an agreement would, of course, be beyond the power of state courts considering refund claims. there is, however, no reason why state officials, under executive or legislative direction, could not propose one. whether their federal counterparts would be inclined to cooperate cannot be known until a state attempts to initiate negotiations. if a state offered to pay more than the internal revenue service stood to gain from taxes on state refunds to federal retirees 170 or on the immunity doctrine, except if a state imposed a tax that fell fairly directly on the federal government itself. but this understanding of the doctrine, based on the federal government's authority to impute income, enjoys no precedential support. the supreme court's tax immunity decisions all take as given the federal tax system, including current rules for imputing income, in divining discriminatory tax treatment by states. see, e.g., moses lake homes, inc. v. grant county, 365 u.s. 744 (1961) (enjoining state tax that fell more heavily on federal lessees than state lessees, instead of noting that the federal government could have taxed state lessees on imputed income); phillips chemical co. v. dumas indep. sch. dist., 361 u.s. 376 (1960) (same). richardson's argument would hold the federal government to a standard that the court has never shown any inclination to adopt. these are unpolished reflections. but they serve to indicate why the court might be reluctant to start down the path that richardson has lighted. 170. the internal revenue service would probably reap a meager harvest from refunds to federal retirees. many of those retirees are likely to have taken the standard deduction on their federal income tax returns during the years that their pensions were taxed. 19931 florida tax review retroactive bonuses to state workers under the plan i sketched in my earlier article, the federal government would plainly have a financial incentive to come to terms. 7 ' should a settlement of this kind be achieved, state courts would, it seems, be permitted, under the reasoning of davis, to deny federal retirees' refund claims, because the harm to the federal government would have been repaired to its satisfaction. 172 if their state taxes are refunded, they will have no additional federal income tax liability, because they derived no tax benefit earlier from an itemized deduction for the state taxes they paid. see irc § 111(a); rev. rul. 79-15, 1979-1 c.b. 80. the fact that the federal government-the entity that the intergovernmental immunity doctrine safeguards-would receive but a small fraction of this recovery highlights its poverty as a proxy for direct payments to the federal treasury. although the prospect of having to pay refunds will deter states in the future, refunds will not set the federal government in the position it was entitled to occupy in the past. they would do so only if the federal government were not forced to pay higher salaries or pensions to make up for states' discriminatory tax treatment, because the federal government or its workers anticipated a successful law suit against the states. and that they clearly did not do. in addition, the fact that refunds to federal retirees would, in most states, probably dwarf the harm to the federal government over the years covered by the refunds, and thus vastly exceed the amount of direct compensation needed to repair the injury, throws into relief the wastefulness of this remedy from many states' perspective. 171. a number of considerations would predictably shape any settlement between a state and the federal government, in addition to the number of state retirees affected, the expected number of itemizers under the counterfactual scenario i described, federal and state marginal tax rates, the number of federal retirees who have sued or might still sue for refunds, and any interest that might be owed on refunds or that might be charged on back taxes and thus incorporated into retroactive bonuses to state workers. for example, the harm to the federal government stretches back decades in most cases. in negotiating a settlement, federal representatives would not be limited by the state statute of limitations applicable to refund actions by federal retirees, except insofar as the aggregate refund award set a ceiling to the amount that states would pay by way of settlement. hence, the federal government need not take the harm that it suffered over the refund limitations period as an upper limit on the settlement amount. another factor would be administrative costs. states would have an incentive to settle to avoid the cost of providing refunds to numerous federal retirees or of paying retroactive bonuses to state workers while taxing them simultaneously. states' desire to avoid incurring these costs would enhance the federal government's negotiating position. on the other side, the federal government would have to take into account the likelihood that, if states paid refunds to large numbers of federal retirees, a significant fraction of those retirees would not declare the income on their federal returns. its negotiating stance would be correspondingly weakened. 172. state courts would not be required to deny refunds to federal retirees in the event of a settlement, so far as the doctrine of intergovernmental tax immunity is concerned. that doctrine serves as a shield to either a state government or the federal government. if a state chose, by way of a settlement and refunds, to treat the federal government more favorably than it treats itself, the federal government would be in no position, and have no incentive, to complain. nor could the state invoke the doctrine against itself, because it protects a state only against the depredations of its national counterpart. prudence alone should, however, persuade a state to shun prodigality. [vol, 1:8 harper and its aftermath states that would save a substantial sum of money, relative to refunding the discriminatory portion of the taxes federal retirees paid, by taxing state workers retroactively while alleviating their tax burden through bonuses, should find that pair of steps an attractive option. 7' a settlement of the sort just described might be still more alluring. in either case, states should not have to fear opposition from state retirees, inasmuch as their aftertax position would not be worsened under either plan. federal pensioners would naturally oppose both of these possible responses. they would prefer to have their state income tax payments refunded, rather than see their position unchanged, even though relative to their past expectations any refund would be a windfall. one critic of the constitutionality of my original proposal-david shores-has argued that the federal retirees' complaint would not be merely a rhetorical plea for a benefit to which they have no title: it would, he says, be justified.' 74 if states are unwilling to impose a retroactive tax on former state workers without any offsetting bonus, he contends, then mckesson mandates that states pay the refunds for which federal retirees have sued. presumably, he would object equally to any settlement between a state and the federal government that deprived federal retirees of refunds or the satisfaction of seeing their retired state counterparts pay retroactive taxes without any relief from their former state employer.1 7 5 for reasons i have detailed elsewhere, 176 shores's argument seems to me misguided. the doctrine of intergovernmental tax immunity, on which the court's holding in davis was premised, developed to protect the federal government from discrimination by state authorities, and states from unjust treatment by congress. it was not designed to protect individuals. to be sure, individuals would often benefit if they sued, in effect, in the federal government's stead. but they were not the doctrine's intended beneficiaries, 173. not surprisingly, virginia, the state that will have to pay out the most money if refunds are ordered, is therefore considering implementing this plan. see juliann avakianmartin, harper decision leaves many questions unanswered, may raise new ones, 59 tax notes 1740 (june 28, 1993) (quoting virginia's deputy attorney general gail marshall). but see infra note 240. 174. see david f. shores, unconstitutional state taxes: is there a painless remedy?, 59 tax notes 1274 (may 31, 1993). 175. this conjecture is grounded in shores's reading of davis. according to which federal retirees were not "merely nominal parties." because shores believes that davis "suggests even-handed treatment of state and federal retirees was itself a goal." he contends that "meaningful relief would seem to require either a refund to federal retirees or a tax on state retirees that is not rendered meaningless by a counterpayment." id. at 1275 (footnote omitted). 176. see eric rakowski, what purpose does intergovernmental tax immunity serve?, 59 tax notes 1277 (may 31, 1993). 19931 florida tax review and the purpose of allowing them to bring suit was to vindicate the rights of the states and the federal government when governmental entities did not take action themselves. because the options i described would compensate the federal government, through increased federal income tax revenue on the bonuses paid to state retirees or through a direct settlement payment, for the wrong that it suffered, it would satisfy mckesson's command to create what in hindsight is a nondiscriminatory scheme." the federal government would in retrospect have suffered no disadvantage in hiring workers, because it would not, in retrospect, have had to pay them higher pensions than states did to put them on an after-tax par with state retirees. any additional amount it paid in the past would have been recouped in the added federal income tax on state workers' bonuses, or through the settlement agreement in which it acquiesced. the situation, after either plan was implemented, would be exactly the same as if states had taxed state pensions all along, and had paid their workers higher pensions in recognition of their taxable character. needless to say, notwithstanding the justice of these remedies, 78 federal 177. in her harper dissent, justice o'connor begins from the right premise: "the purpose of the intergovernmental immunity doctrine is to protect the rights of the federal sovereign against state interference. it does not protect the private rights of individuals .... " harper, 113 s. ct. at 2534 (o'connor, j., dissenting). but she draws an at least partly contestable conclusion: that retroactive relief "would not vindicate the interests of the federal government" but only "line[ ] the pockets of the government's former employees." id. with regard to state workers who would have itemized their federal deductions if their pensions had been subject to state income tax, justice o'connor is correct. with respect to other state retirees, the truth of her claim depends upon whether david richardson's argument is right. see supra note 169. if it is not, then justice o'connor's claim is, so far as these retirees are concerned, erroneous. it is by lining the pockets of federal retirees, if a state chooses to refund illegally collected taxes, that the federal government's interest is vindicated. to be sure, the federal government would not itself collect the cash directly, and the state would end up paying far more than the harm that the federal government apparently suffered. but refunds would unquestionably serve the purpose of deterring states from enacting tax policies that compel the federal government to offer higher salaries or retirement benefits in a perfectly competitive market than states must offer to secure comparable employees. some remedies cost more than others, and only some swell the federal treasury. but their object is identical. 178. one might think the scheme imperfectly just, because it would leave federal retirees who sued without compensation for bringing a law suit that redounded to the benefit of the federal government. two points should, however, be borne in mind. first, attorneys' fees and costs might nevertheless be available under state or federal law, at least for the expense of obtaining injunctive relief (which would typically permit recovery of the bulk of litigation costs). second, after mckesson, the risk of coming away empty-handed, because a state might choose retroactive taxes over refunds, is visible to all. not rewarding those who gamble and come up dry is no more unfair than denying a prize to those who buy losing lottery tickets. whether the resulting incentives to sue are optimal, and whether the federal government might do well to reimburse the costs of a successful suit from which it, but not the plaintiffs, prospers, are independent questions. [vol 1:8 harper and its aftennath pensioners in some states may have enough political muscle to block their legislative adoption or approval. they might, instead, extract a better deal for themselves than the constitution compels states to provide. that they are able to secure an advantageous result does not, however, demonstrate that they deserve all that they get. it is worth repeating that the combinations of retroactive bonuses and taxes i sketched and the settlement arrangement i described are only two possible remedies that states may choose. they can certainly fulfill mckesson's mandate of equal treatment, instead, by paying refunds to federal workers, even if that would go further toward depleting the state treasury while yielding only a trickle of revenue to the federal government." one should also bear in mind that these two options would probably have to be adopted by state legislatures, if they are to be selected at all. in the absence of a legislative initiative, state courts are generally confined to granting or denying refunds under applicable state and federal laws. finally, it is possible, though not likely, that state law would stymie the implementation of the scheme incorporating retroactive pension increases for state workers even though the federal constitution sanctions this remedy."w d. possible congressional action the davis court's analysis of michigan's unequal taxation of state and federal retirees was predicated on a fact too obvious to merit discussion: "that intergovernmental tax immunity is based on the need to protect each sovereign's governmental operations from undue interference by the other."'8 ' the doctrine provides each sovereign with a drawbridge against discriminatory taxation by the other. in 4 u.s.c. § i11, which codifies the doctrine of intergovernmental tax immunity on the federal side,"s the united states "consents to the taxation of pay or comapensation for personal service as an officer or employee of the united states," so long as officers and employees are not disadvantaged by the taxing entity in virtue of having their salaries paid by the federal government. the united states can, however, consent to less favorable treatment by states as well: drawbridges can be lowered. the fiscal difficulties that many states fear if they pay refunds to federal retirees can be removed immediately and entirely through congressional legislation waiving retroactively the federal government's insistence on 179. see supra note 170 (explaining why refunds would generate little federal income tax). 180. for a possible objection based on state constitutions' extra compensation or gift clauses, see infra part vi.c. 181. davis, 489 u.s. at 814. 182. see id. at 810-14. 19931 florida tax review the nondiscriminatory taxation of its officers and employees. to my knowledge, this resolution to the litigation and potential fiscal travails that succeeded davis has not been suggested, let alone considered with any seriousness, by federal lawmakers. one wonders why not. unlike national legislation governing the taxation by one state of incoming mailorder sales by businesses in other states, which the court in quill corp. v. north dakota 183 barred in most instances without congressional authorization, this issue does not necessarily pit one state against another. it is true that the aggregate of states is hurt to the extent that the federal government foregoes tax revenue it would otherwise have received on state refunds to federal retirees or on retroactive bonuses to state pensioners. federal spending must decrease or the federal government's debts, which weigh on states and their citizens indirectly, must increase if less tax is collected. but if states not confronting refund suits refuse to bear this cost, there is an easy reply. congress could pass a bill waiving the federal government's right to relief under the doctrine of intergovernmental tax immunity only if a state pays to the united states treasury an amount greater than or equal to what the internal revenue service would likely collect in taxes on remedial payments by the offending state. weighing the various considerations described in the preceding section that bear on possible settlement agreements should allow the sum to be set fairly. it is hard to imagine any sound reason for federal lawmakers to oppose giving this option to states that were surprised by the davis decision and now face financial dislocation if they must pay a penalty that far exceeds the harm suffered by the federal government. states that have already written checks or given tax credits to federal retirees might, understandably, regret having acted as speedily as they did were congress to enact legislation offering a cheaper remedy to states that moved more slowly. but they would in no way benefit if congress refrained from passing this legislation: their position would remain unchanged. so what justification could they offer for blocking a law easing other states' burdens? misery's partiality to company might explain, but it cannot excuse, some hesitation. even if some states, for whatever reason, stood in the way, possible beneficiaries might be able to bribe them to step aside. the legislative proposal sketched above could be modified to provide cash payments to states 183. 112 s. ct. 1904 (1992). quill held in part that a state may not require a business based in another state to collect use tax for it on goods shipped into the state unless the business has the "substantial nexus" with the state necessary to empower the state to impose that tax collection obligation notwithstanding the limitations on extraterritorial taxation implicit in the dormant commerce clause. id. at 1911-16. the court noted that congress has the power to lift mail-order businesses' commerce clause immunity from taxation by importing states if it chooses. id. at 1916. [vol 1:8 harper and ts afterrnath that have already settled with federal retirees, financed by levies on those states that benefit from the united states' partial waiver of its right to redress for the competitive disadvantage it suffered in hiring workers. choose the amounts properly and a bill that benefits everybody-except federal retirees hoping to obtain a windfall in the form of unanticipated tax refunds-might be written. one may only speculate whether a failure of imagination or fear that the ire of federal retirees will outweigh the gratitude of other voters for saving the state money has thus far kept senators and representatives from proposing a legislative solution to the problems davis has spawned. e. states' pass-on defense one remedial issue that merits discussion, though it is not cleanly presented in intergovernmental tax immunity cases, such as davis, that do not involve commercial taxpayers, concerns the pass-on defense to a complete tax refund that some states' laws recognize. does the due process clause permit tax authorities that choose to remedy unlawful discrimination by refunding taxes they collected improperly to reduce refunds, insofar as the disadvantaged taxpayers succeeded in passing the illicit burden on to customers or sellers? states have sometimes sought to lessen their refund liability-mckesson and bacchus offer two examples'"-by contending that restoring the entire discriminatory portion of the tax would leave taxpayers with a windfall. the injury they suffered, the states' argument runs, was less than the unlawful amount of tax they paid, because taxpayers managed to pass part or all of it forward to consumers or intermediate purchasers or backward to workers or suppliers. rewarding them with a refund that exceeds the harm they suffered is, in this view, more than justice requires, and therefore more than the constitution should be read to mandate." 5 184. see mckesson, 496 u.s. at 46-49; bacchus, 468 u.s. at 276-77. 185. there is some, albeit indirect, support for this claim. the supreme court has recognized that "the elimination of unforeseen windfall profits" is a legitimate state interest that can sustain state regulations that substantially impair contractual obligations. see, e.g., energy reserves group, inc. v. kansas power & light co., 459 u.s. 400, 411-12 (1983); united states trust co. v. new jersey, 431 u.s. 1, 31 n.30 (1977). when a state is itself a party to a contract, however, the court has been reluctant to defer to state legislators' assessment of the reasonableness and necessity of impairing contracts to serve an alleged public purpose. indeed, the court has rarely considered a state's impairment of its own contractual obligation justified. see energy reserves group, 459 u.s. at 412 n.14. it is not clear whether the court would look equally skeptically on states' claims that eliminating taxpayer windfalls is a legitimate state undertaking in commerce clause cases and related instances of unlawful taxation. that the states themselves, as tax collectors, would be the sole beneficiary of the policy should not be decisive. the court has, after all, upheld statutes allowing the recovery of "excessive profits" on wartime contracts, when the federal 1993j florida tax review states that offer this argument often do so with little regard for consistency. if the damage that a taxpayer suffered is the proper measure of compensation, then in cases in which the taxpayer's injury exceeded the tax paid-which might happen, for instance, if the taxpayer lost goodwill or substantial market share or if the taxpayer went out of business-there seems no reason to limit the state's liability to the tax that was actually paid. yet states advancing the pass-on defense never show any willingness to accept this tort measure of damages without qualification. restitution, for them, sets a ceiling to compensation. likewise, if part of the burden of the tax has been passed on, it follows that somebody has suffered from the unconstitutional discrimination in addition to the taxpayer. again, however, states invoking the pass-on defense have not acknowledged an obligation to repair this part of the injury caused by the discriminatory tax. instead, they would deny the ultimate bearers of the tax standing to sue. it is, moreover, hard to find-one is tempted to say "impossible" to find-any example of a state's trying to justify the more fundamental claim that the due process clause aims not at preventing a state's unjust enrichment-the retention of an unlawfully extracted tax-but only at relieving the harm (up to a limit) experienced by the nominal taxpayer (forget about others injured by it). my goal in this section is not to appraise the sufficiency of these arguments as appeals to justice or as persuasive considerations in determining what the due process clause demands. nor shall i consider what role the creation of efficient incentives to lawful legislation or the conservation of treasury would alone gain from the tax. see lichter v. united states, 334 u.s. 742 (1948). it has also refused to allow a plaintiff to obtain punitive damages against a municipality under 42 u.s.c. § 1983: [plunitive damages imposed on a municipality are in effect a windfall to a fully compensated plaintiff, and are likely accompanied by an increase in taxes or a reduction of public services for the citizens footing the bill. neither reason nor justice suggests that such retribution should be visited upon the shoulders of blameless or unknowing taxpayers. city of newport v. fact concerts, inc., 453 u.s. 247, 267 (1981) (footnote omitted). however, the fact that any resulting tax refund windfall would owe its existence to the state's own illicit conduct in levying the tax and in not permitting the tax to be challenged prior to payment might, in conjunction with the considerations set forth in the text, outweigh or estop the state's claim that windfalls could not be justified at its expense. fact concerts by no means settles the question. the purpose of a refund order in constitutional tax cases is not to punish but to restore what a taxpayer was wrongly forced to pay. unlike torts by government officials, moreover, states may protect themselves against liability by providing taxpayers with a forum for attacking possibly wrongful action before it occurs. the alleged analogy between punitive damages and total refunds is not without power, however, for the burden of complete refunds would indeed fall on unsuspecting citizens, and in some instances recipients would be compensated in excess of the harm they suffered. [vol 1:8 harper and its aftermath judicial resources should play in teasing out the implications of the due process clause. nor, finally, is it my concern to say what value, if any, there is in maintaining consistency across legal domains that present similar problems. thus, i shall not speculate here as to whether the court's blanket rejection of the pass-on doctrine for both offensive and defensive purposes in its antitrust decisions should or would influence its approach to this remedial issue in constitutional due process cases." these are topics for a separate article. 87 instead, my object is to explore the extent to which this issue remains open after mckesson, and thus what latitude state courts might have in fashioning remedies until the court provides more luminous guidance. the court opened its discussion in mckesson by saying that if a state were free to choose not to return tax payments that did not, in fact, burden the nominal taxpayers because they were able to pass the tax on to suppliers, consumers, or others with whom they did business, the defendant "state could not refuse to provide a refund based on sheer speculation that a 'pass-on' occurred."' 88 although the court's discussion of this matter is ambiguous, this sentence might be read to say that a state may only reduce the refunds it pays in pass-on situations if the state is able to carry the evidentiary burden of showing that a pass-on occurred.'" if this was the court's view, the 186. see hanover shoe, inc. v. united shoe mach. corp.. 392 u.s. 481 (1968) (repudiating defensive use of pass-on doctrine); illinois brick co. v. illinois, 431 u.s. 720 (1977) (rejecting offensive use by indirectly injured party); kansas v. utilicorp united. inc., 497 u.s. 199 (1990) (declining to make an exception to illinois brick even though anticompetitive overcharge to regulated utility had been passed on entirely to consumers, on whose behalf state sued as parens patriae). for a powerful criticism of the court's claim that judges cannot handle the issues of economic incidence presented by the pass-on theory and of the court's decision to subordinate compensatory justice to adjudicative efficiency, see robert g. harris & lawrence a. sullivan, passing on the monopoly overcharge: a comprehensive policy analysis, 128 u. pa. l. rev. 269 (1979); see also william m. landes & richard a. posner, the economics of passing on: a reply to harris and sullivan, 128 u. pa. l. rev. 1274 (1980); robert g. harris & lawrence a. sullivan, passing on the monopoly overcharge: a response to landes and posner, 128 u. pa. l. rev. 1280 (1980). 187. although it antedates mckesson, one helpful discussion of the state and federal case law regarding the pass-on defense in tax cases, as well as the moral and efficiency arguments supporting and opposing its recognition, is william j. woodward, jr., "passing-on" the right to restitution, 39 u. miami l. rev. 873 (1985). 188. mckesson, 496 u.s. at 46 (footnote omitted). 189. one reason for the ambiguity is the court's noting that neither side had had an opportunity to offer evidence regarding the economic burden of the tax. id. at 46 n.30. in the absence of evidence, according to the court. the florida supreme court simply presumed that the tax had been passed on. id. it is possible that the court's main worry was that the plaintiff had not been afforded a chance to show that it bore some or all of the tax, or that it has not been fairly informed that it bore the burden of making that showing if it was to recover the tax that had been wrongfully extracted from it. but the court's discussion seemed 19931 florida tax review omission of any authority for the proposition is strange, given that the one case the court discussed in the next paragraph-united states v. jefferson electric manufacturing co. -upheld a federal statute placing on taxpayers the burden of establishing that they did not pass the tax on to their customers. the court made no attempt to reconcile its assertion that florida could not presume or speculate that a tax was passed on with its earlier holding in jefferson electric. nor did it say, more exactly, what burden of proof a state would have to sustain, if indeed it was centering the burden on states rather than taxpayers. perhaps these shortcomings are immaterial, however, because following this introductory discussion the court's opinion suddenly shifted ground. the court declared its earlier musings irrelevant: "[w]e reject respondents' premise that 'equitable considerations' justify a state's attempt to avoid bestowing this so-called 'windfall' when redressing a tax that is unconstitutional because discriminatory."' 9 ' as were its speculations on issues of proof if states could enlist this defense, however, the court's justification for this claim is puzzling. the inadequacy of the court's justification makes one wonder whether the justices truly intended this principle to rule out weighing equitable considerations in all constitutional tax cases in which refunds would confer windfalls on wronged taxpayers. even if the justices did intend the principle to apply universally, it remains to be seen whether they will revisit the issue more deliberately once the gaps in their reasoning are identified. the court first noted that in jefferson electric it enforced a rule laid down by congress prohibiting a taxpayer from recovering taxes it had paid to the federal government to the extent that the taxpayer had passed those taxes on to its customers or business associates.9' the court then distinguished the florida excise tax challenged in mckesson by pointing out that in jefferson electric the pass-on defense the court had upheld applied to tax overassessments, that is, charges imposed by federal officials in excess of what the tax code authorized. in contrast, the taxpayer in mckesson challenged unconstitutionally high taxes authorized by statute.' 93 but why should it matter whether the overcharge was statutorily authorized or contrary to some tax statute, so long as the taxpayer was forced to pay too much, in violation of applicable law? to focus not on procedural unfairness but rather on florida's failing to show that the mckesson corporation suffered less harm than the unlawful tax it had paid. 190. 291 u.s. 386 (1934). 191. mckesson, 496 u.s. at 47. 192. id. 193. see id. at 47-48. [vol 1:8 harper and its aftermialh the court's reply made no reference to the presumed or possible discriminatory intentions of tax collectors or legislators. it did not argue, for example, that the erroneous but good-faith assessment of a tax resembles a tort resulting from the performance of an essential governmental function, and thus that immunity might attach, whereas legislative action should be seen in a different, more culpable or at least less excusable, light. rather, its answer was that the florida tax preference not only left the mckesson corporation poorer, "it placed petitioner at a relative disadvantage in the marketplace visal-vis competitors distributing preferred local products."'" the court explained: to whatever extent petitioner succeeded in passing on the economic incidence of the tax through higher prices to its customers, it most likely lost sales to the favored distributors or else incurred other costs (e.g., for advertising) in an effort to maintain its market share. the state cannot persuasively claim that "equity" entitles it to retain tax moneys taken unlawfully from petitioner due to its pass-on of the tax where the pass-on itself furthers the very competitive disadvantage constituting the commerce clause violation that rendered the deprivation unlawful in the first place.9 -9 the first of these two reasons for complete restitution-that a taxpayer's economic injury, in the form of additional costs, decreased market share, or smaller profit margins, might exceed whatever portion of the tax it failed to pass on-is hardly compelling. the court was, of course, correct in saying that a taxpayer's injury might exceed that portion of the unconstitutional tax liability it bore. but this possibility in no way justifies a complete refund in each case. after all, these additional costs and reduced profits will sometimes be less than that portion of the tax the taxpayer managed to pass along, in which case the taxpayer's total injury would be less than the full amount of the unconstitutional portion of the tax it paid. surprisingly, in view of the quoted sentence, the court itself appeared aware of this possibility. it said, for example, that mckesson "most likely lost sales to the favored distributors or else incurred other costs" in the same amount that it passed on the unconstitutional portion of the tax,t96 not that mckesson necessarily suffered a setback of precisely this magnitude. and the court explicitly noted that mckesson might have passed the full tax along without competitive injury if its sales were pursuant to cost-plus contracts, although it dismissed this 194. id. at 48. 195. id. at 48-49 (footnotes omitted). 196. id. (emphasis added). 19931 florida tax review concern by saying that florida never argued that mckesson was itself in this position.'97 the court's reference to this factual issue therefore raises an important question about the sweep of its analysis: does the apparently categorical rule it laid down admit of an exception if a state, unlike florida in mckesson, could prove that a taxpayer would be made better off by a complete refund than it would have been had an equal tax been imposed on its competitors? the court proffered no answer.'98 the court's second reason-that florida lacked an equitable justification for retaining taxes that mckesson passed on because tax-shifting was a means by which florida achieved its unconstitutional objective-is harder to evaluate because it is unclear precisely what the court wished to claim. if its contention was that florida lacked clean hands and that conferring a windfall on an innocent plaintiff is preferable to permitting a state to retain a like benefit to which it is not constitutionally entitled, then the assertion is not obviously correct. after all, allowing the state to keep the money meant allowing citizens as a group, who were not complicit in some intentional wrong, to profit from the mistake. why they are less deserving of the money than businesses that were taxed excessively (but which, by hypothesis, were reimbursed for taxes they did not shift) is by no means evident. in fact, this conclusion seems dubious, because it is exactly those citizens who, in the guise of consumers, likely bore part of the burden of the tax that was passed on, yet who have no way of recovering the overcharge. there is, however, a more persuasive reading of the second quoted sentence. the court might have been arguing that even if a partial refund gives formerly disadvantaged taxpayers profits or losses equal to what they would have earned were they and their competitors subject to the same tax rates, their competitors are in at least some cases better off, because they have received an implicit subsidy, probably in the form of larger profit margins, during the period of differential taxation. if that is so, then anything short of a total refund will place those taxpayers who suffered from discriminatory treatment at a permanent disadvantage, and the commerce clause's guarantee of competitive parity will be flouted. 197. see id. at 48 n.32. 198. nor did the court explain why, if removing taxpayer injury is the dominant worry, taxpayers who suffer harm more severe than their entire nominal tax liability-perhaps because they were placed at so serious a competitive disadvantage that they were driven out of business-may nevertheless obtain, under the due process clause, no more relief than a refund of the illegal taxes they paid. see id. at 49 n.33. here again, the court did not venture beyond assertion. and, as in other instances, it confounded its apparently conclusive pronouncement on the reach of the due process clause by saying, immediately afterwards: "petitioner has not sought in this action to recover any actual damages it may have suffered." id. why note mckesson's omission unless it is relevant to future attempts to obtain relief, notwithstanding the court's unqualified claim that the due process clause rebuffs them all? [vol 1:8 harper and its aftermath although this argument has considerable merit, ' " it is not obviously the court's argument.200 nor is it apparent that it succeeds. for one thing, it fails to distinguish the situation presented in mckesson from that which the court faced in jefferson electric, where the court approved the pass-on defense together with an evidentiary burden on the taxpayer.2 ' just as florida's tax preference "placed petitioner at a relative disadvantage in the marketplace vis-a-vis competitors distributing preferred local products,"' so too the federal government's overassessments subjected jefferson electric to costs not suffered by those of its rivals who were not similarly overassessed. the power of this argument also depends upon the limits to permissible state subsidies, which the court nowhere explores in mckesson and which remains a complex and unsettled area of commerce clause doctrine.20 3 "nothing in the purposes animating the commerce clause," the court has said firmly, "prohibits a state, in the absence of congressional action, from participating in the market and exercising the right to favor its own citizens over others.," but if a state may discriminate in favor of its citizens through its purchases, may it also do so through unattached cash 199. a clear statement of it may be found in alan d. viard, pass-on defense doesn't pass muster, letter to the editor. 52 tax notes 1094, 1095-97 (aug. 26, 1991). viard's letter responds to a weak analysis of states' remedial obligations under mckesson and beam in martin lobel, refunding unconstitutional taxes, special report. 52 tax notes 581 (july 29, 1991). 200. one reason for reluctance in attributing it to the court is the court's hesitation, noted above, to require complete refunds if a state is able to show that a taxpayer suffered no competitive injury from the tax, perhaps because it passed on the entire tax pursuant to costplus contracts. see mckesson, 496 u.s. at 48 n.32. if a state may interpose the defense the court considers, then the argument for a complete refund based on the competitive disadvantage suffered by taxpayers who were not able to reap the same subsidy or increased profits cannot be correct. what makes the court's stance still more difficult to divine is that this hesitation in the second paraggaph of footnote 32 of the court's opinion follows the court's acknowledgement in the footnote's first paragraph that a taxpayer might suffer competitive injury if a tax disparity allowed its competitors to boost their profits while the taxpayer's profits remained constant. if the footnote's first paragraph is correct, then the court's hesitation in the second paragraph is unwarranted. nothing in the court's opinion indicates, however, whether the court would stand by the first paragraph if the price were abandoning the possible exception it outlines in the second. 201. united states v. jefferson elec. mfg. co., 291 u.s. 386, 400-02 (1934). 202. mckesson, 496 u.s. at 48. 203. some of the connections between permissible tax policy and the court's rulings on state subsidies under the commerce clause are discussed in rakowski, harper and retroactive remedies, supra note 161, at 560-61. 204. hughes v. alexandria scrap corp., 426 u.s. 794, 810 (1976) (upholding a legislative scheme that offered a bounty to processors of abandoned automobiles tiled in maryland but that favored in-state processors over out-of-state processors). 19931 florida tax review subsidies, as opposed to implicit subsidies that take the form of elevated prices that the state agrees to pay for goods produced within the state? and, if cash subsidies are permitted, what about tax breaks that serve the same purpose? if tax breaks are permissible, however, what distinguishes them from incomplete refunds of an unconstitutional tax to competitors of those who could, by hypothesis, have been given the tax breaks? the court has been reluctant to step on this logical conveyor belt,20 5 and it seems unlikely to allow this line of reasoning to dissuade it from demanding fully equal treatment, via refunds or retroactive taxes, for victims of discriminatory state action that infringed the commerce clause. a narrow construction of the market-participant doctrine-one that limits state subsidies to state purchases or near equivalents, as in alexandria scrap-seems the safest avenue for protecting the dormant commerce clause from the logical erosion just outlined. but the vagaries of the court's few opinions in this area, and the shifting sentiments expressed by certain justices,2 °6 leave some play for doubt. in view of the ambiguities described above, the best that can be said is that mckesson's call for a complete refund in cases in which a tax has been passed on is halting and ill-explained.2 °7 205. for example, in new energy co. v. limbach, 486 u.s. 269 (1988), the court struck down a tax credit for ethanol sold by fuel dealers if the ethanol was produced in ohio or in another state that granted an equivalent tax benefit for ethanol produced in ohio. without dissent, the court distinguished this indirect subsidy from a permissible direct subsidy through the state's own sales or purchases: "to be sure, the tax credit scheme has the purpose and effect of subsidizing a particular industry, as do many dispositions of the tax laws. that does not transform it into a form of state participation in the free market." id. at 277. 206. justice scalia, for example, has repeatedly denounced the court's dormant commerce clause rulings as mistaken, the unhappy child of the court's overreading of the commerce clause over a century and a half ago. see, e.g., american trucking, 496 u.s. at 202-04 (scalia, j., concurring in the judgment); tyler pipe indus. v. washington dep't of revenue, 483 u.s. 232, 259-65 (1987) (scalia, j., concurring in part and dissenting in part). yet he wrote the opinion for a unanimous court constricting the reach of the marketparticipant doctrine in new energy co., 486 u.s. at 271, even though a broadening of that doctrine would effectively eviscerate the dormant commerce clause, a goal he plainly desires. at one time at least, justice stevens seemed to endorse the chain of reasoning that leads from a state's entry into the market to state subsidies to tax breaks and, presumably, to the economically equivalent withholding of tax refunds. in his concurring opinion in alexandria scrap, he stated that the commerce clause does not curtail "a state's power to experiment with different methods of encouraging local industry. whether the encouragement takes the form of a cash subsidy, a tax credit, or a special privilege intended to attract investment capital, it should not be characterized as a 'burden' on commerce." alexandria scrap, 426 u.s. at 816 (stevens, j., concurring). perhaps, however, justice stevens has had a change of mind, for he joined the court's opinion in new energy co. and has not reiterated his earlier view. 207. a further obscurity appears in the court's response to florida's argument that it may invoke the pass-on defense as a matter of state law, because florida's waiver of [vol 1:8 harper and its aftermath any doubts that emerge from a close reading of mckesson concerning the court's rejection of the pass-on defense in tax cases find corroboration in justice souter's opinion in beam. in discussing the court's remand order in bacchus imports, ltd. v. dias,' which explicitly left to the state courts the task of evaluating hawaii's pass-on defense in the first instance, justice souter said nothing to suggest that the court erred in remanding on this issue.20 he might have noted in beam that no pass-on defense was available, or at least would now be regarded as available, for the reasons the court adduced in mckesson, whatever the court might have thought when it remanded in bacchus. but justice souter remained mute, as did the other justices in their three additional opinions. whether states may invoke the pass-on defense in constitutional tax cases after mckesson and beam is therefore doubtful, but not absolutely certain. the court's reasons for rejecting it, if that is what it did in mckesson, are also opaque. states eager to stanch the drain on their resources in commerce clause decisions and other commercial tax cases that go against them might yet test the soft spots in mckesson's language and impel the court to finish the job of decision and explication it started there. because pensioners bear the entire burden of any income tax they pay, however, davis-related cases will not furnish a proper springboard for challenges of this kind. f. interest on refunds one issue that states will inevitably confront in intergovernmental tax immunity cases, however-whether they pay refunds to federal retirees to correct past inequalities in taxation, whether they subject state pensioners retroactively to the same taxes that federal retirees paid, or whether they adopt the combination of retroactive taxes and offsetting bonuses outlined in part v.c.-is whether they must, as a constitutional matter, pay interest on the refunds to federal employees or charge interest on state workers' retroactive tax liability. mckesson, harper, and, indeed, the entirety of the sovereign immunity extends only to the payment of refunds insofar as the incidence of a tax falls on the taxpayer. the court rejoined that it "need not consider the import of this contention," because the state's brief, in the court's opinion, misdescribed florida law. mckesson, 496 u.s. at 49 n.34. the court's reading of the florida decision on which the state relied in its brief does, in fact, seem right. the state was overreaching. but the court's refusal to pronounce on the form of florida's argument invites wonder, because it calls into question the court's assertion that a complete refund is constitutionally required. the court ought to have explained the ground for its narrow rejection of florida's argument more clearly, to ward off any doubts about the pass-on doctrine it did not intend to engender. 208. 468 u.s. 263 (1984). 209. see beam, i l1 s. ct. at 2445 (opinion of souter. j.). 19931 florida tax review court's recent due process jurisprudence concerning retroactivity and remedies, are silent on this important point.21 insofar as davis-type suits are resolved judicially rather than legislatively, state courts will probably invoke provisions of state income tax laws that specify when interest is to be paid and describe how it is to be calculated on both refunds and retroactive taxes. in doing so, however, mckesson' s reasoning obligates them to ask whether these provisions of state law satisfy whatever standard is implicit in the federal due process clause." l if the due process clause, as construed in mckesson, requires that interest be taken into account, then, to the extent that these provisions require that too little interest be paid on refunds, judges must, under the supremacy clause, ask more of the state than its laws currently offer. the same is true if interest is required on retroactive taxes imposed on state retirees: a figure that is too low could conceivably infringe the rights of federal retirees or of the federal government. 22 needless to say, if a state did not provide for the payment of any interest on refunds or retroactive taxes, judges would have to face the question of mckesson's demands with even more earnestness in ordering relief under davis and harper. although the court has not straightforwardly addressed this question, mckesson's reasoning strongly supports the conclusion that the payment of adequate interest is constitutionally mandatory to remedy typical instances of unlawful discriminatory taxation.2i " the court's opinion stressed repeatedly the imperative of placing the two sets of taxpayers who had been treated 210. given the length of time that has elapsed since the tax years in dispute, the amount of interest at stake is large, both absolutely and relative to the initial amount of tax that formed the basis for suit. for example, if one assumes an interest rate of 8%, a refund with interest in 1993 of a $10 tax paid in 1986 would total approximately $17.14 in 1993 dollars. 211. in hagge v. iowa dep't of revenue, lexis, strax library, iowa file, elec. cit., 1993 iowa sup. lexis 164 (july 21, 1993), the iowa supreme court ruled, after harper, that the state must refund taxes paid on their federal pensions by the retired federal workers who sued. the court did, however, permit the state to pay the refunds over a period of four years, with interest. id. at *14. the court did not ask whether the rate of interest that state law prescribed was constitutionally adequate or excessive. 212. although in intergovernmental tax immunity cases the only worry is whether the interest paid or charged is too low, because that doctrine does not forbid a state from handicapping itself, in equal protection and perhaps certain other tax cases, a state might also have to guard against paying too much interest. the danger is that it will replace one form of unlawful discrimination with another, privileging the group of taxpayers that was once disfavored. 213. the court's references to "a refund of the excess tax paid," mckesson, 496 u.s. at 35, to "refunding the tax previously paid," id. at 39, to "a full refund of its tax payments," id., and similar locutions, without any reference to interest, are plainly not dispositive, because the court did not consider the question of interest explicitly. [vol 1:8 harper and its aftermath differently on as nearly an equal footing as is still possible. a state's overriding obligation is to "calibrat[e] the retroactive assessment [or refund] to create in hindsight a nondiscriminatory scheme."2 4 unless interest is paid on refunds or demanded of those who are taxed retroactively, a large portion of the disparity would survive uncorrected. it seems unlikely that the court would tolerate this discrepancy, given that the harm to one set of taxpayers from neglecting interest would be substantial and that the same predeprivation procedures that the court thought sufficient to overcome states' equitable objections to retroactive relief would apply with equal force to states' objections to paying or charging interest.2 5 the takings clause offers a useful analogy. "because exaction of a tax constitutes a deprivation of property," the state must provide taxpayers with a meaningful opportunity to recover their property if it has been taken unlawfully.21 6 but the takings clause does not permit a state to return the property without paying the owner for the use it has temporarily made of it or for the use that the owner had to forgo while the property was kept from him by the state.217 the state must furnish compensation even for temporary regulatory takings. 218 if the property taken is cash, the measure of its use value, and thus the compensation that is due, is some rate of interest. the court's insistence in harper, mckesson, and a raft of earlier cases that states have some latitude in structuring a constitutionally acceptable solution, together with its readiness to settle for less than perfect remedies,2 19 renders it unlikely that the court would find that the due process clause mandates a specific rate of interest. a band of interest rates, of uncertain breadth but roughly tracking a secure investment return, would 214. id. at 40. 215. richard fallon and daniel meltzer advance a parallel argument regarding a state's decision to refund unlawfully collected taxes in installment payments, an option the court mentioned in mckesson: [u]nless the states are required to pay interest, stretching out refund payments would obviously reduce the real economic value of the remedy. it is unclear whether the court, which said clearly that refunds cannot be denied because of fiscal dislocation. would allow them to be diluted for the same reason. to allow this sub rosa evasion. however, would force courts to wrestle with the same sorts of issues that mckesson's principal holding seems wisely tailored to avoid. fallon & meltzer, supra note 83, at 1829 n.554 (citation omitted). 216. mckesson, 496 u.s. at 36. 217. see first english evangelical lutheran church v. county of los angeles, 482 u.s. 304, 318-22 (1987). 218. id. 219. see mckesson, 496 u.s. at 41 n.23 ("[a] good-faith effort to administer and enforce such a retroactive assessment [on previously favored taxpayers] likely would constitute adequate relief, to the same extent that a tax scheme would not violate the commerce clause merely because tax collectors inadvertently missed a few in-state taxpayers."). 19931 florida tax review probably pass constitutional muster. where state law provides for interest on tax refunds and belated tax payments, the fact that the same rate holds both for and against the government and that it applies to all refund and nonpenalty late payment cases might bolster (if not conclusively) an argument for the rate's constitutional sufficiency. unless a state unreasonably singled out certain classes of claimants for poor treatment, discriminated against all taxpayers seeking refunds without granting them the alternative of predeprivation relief, or stipulated an exceedingly low rate of interest on tax refunds, the court would be loath to interfere with a state's effort to comply with the constitution's remedial requirements. if interest were denied altogether, however, the court might feel bound to grant certiorari to prevent a miscarriage of justice.22 even if this analysis is correct in constitutional tax cases, it might conjure special doubts with respect to davis-type litigation, paying interest on refunds, or charging interest on retroactive taxes, seems constitutionally 220. one state court has ruled that the payment of interest in davis-type cases is not constitutionally required when refunds are made. pendell v. department of revenue, 847 p.2d 846 (or. 1993). in pendell, the oregon supreme court reached this conclusion because "[n]either mckesson nor other supreme court cases applying mckesson's principles mention the subject of interest, much less indicate that interest would be required." id. at 850. the court further reasoned that if the supreme court is prepared to allow states to enact short statutes of limitations for refund suits, "there is no reason to infer that a state's decision to decline to offer interest would be so egregious as to deprive the taxpayers of a meaningful remedy." id. this argument is unconvincing. by omitting a discussion of interest, the court's opinion cannot plausibly be read to have decided against its constitutional necessity. moreover, that states may require taxpayers to pay under protest to obtain a refund or to file for one shortly after paying a contested tax is irrelevant to the amount that states must pay back if they take a taxpayer's money under duress. if the oregon supreme court's test of "egregiousness" were constitutionally allowable, then states should be permitted to return, say, 80 cents on each tax dollar collected in violation of the federal constitution. mckesson makes clear, however, that such a rule would not comply with the due process clause because it would fail to remove the unconstitutional discrimination. in chicago freight car leasing co. v. limbach, 584 n.e.2d 690, 694-95 (ohio 1992), the ohio supreme court also concluded that the failure of a state to pay interest on refunds of illegally collected taxes does not violate the due process clause. the court's reasoning, however, is confused. a federal court ruled that, under a federal statute, it was prohibited from granting retroactive relief. id. at 692. the ohio court nevertheless held that a refund was required as a matter of state law. id. at 693. whether interest must be paid must therefore also be purely a matter of state law, because federal law, as the federal district court construed it without quarrel from the state courts, mandates no retroactive relief whatsoever. hence, mckesson's remedial requirements never came into play in that case. the ohio supreme court, insofar as it believed itself to be ruling on the question of whether federal law requires that interest be taken into account whenever federal law demands retroactive relief, mistook the issue before it. [vol, 1:8 harper and its aftermai imperative if the aggrieved taxpayer bringing suit is the party that some constitutional provision-such as the commerce clause or the equal protection clause-endeavors to protect against discriminatory treatment. in these cases, interest is necessary to set the injured party in the same position as its formerly favored counterpart. but intergovernmental tax immunity cases might seem different. the aim of the intergovernmental tax immunity doctrine is to protect governments from unfair taxation by one another. in davis and harper, the true claimant was the federal government, not the federal retirees who sued. hefty interest payments to one-time federal workers, at great cost to a state, would vastly exceed the interest component of the federal government's past injury or, viewed in reverse, the monetary time value of the state's past advantage in hiring workers. likewise, imposing burdensome interest charges on the retroactive tax liability of state retirees-a remedy that would add nothing to federal coffers-seems excessively demanding as a remedy for a far smaller harm to the federal government. the constitution, the argument runs, surely cannot require this remarkable disparity between the harm to the sovereign and the price that the state or its workers must pay in recompense. there is some truth in these reflections. certainly, the interest due on the nominal value of the federal government's past injury is considerably less than the amount of interest that states would typically have to pay to federal retirees, if they decided to pay refunds. it is also likely to be less than the interest that states would have to impose on state workers' retroactive tax liabilities. it does not follow, however, that the preceding account of the due process clause's requirements entails that states are condemned to unjust treatment, because they have no choice but to follow one of these two unattractive routes. states need not adopt either course. just as states have a constitutionally permissible third option in correcting the underlying wrong-the option of compensating the federal government directly, as described in sections c and d above-so they have a third option here: making a payment directly to the united states in the amount of the interest that has accrued on the underlying injury to the federal government. nothing requires a state to avail itself of a more expensive alternative. if a state elects instead to refund the taxes paid by federal workers, interest payments will be part of removing the disparity that formerly existed between the tax treatment of state and federal retirees. the logic of that manner of creating equality after the fact requires those payments, if the federal government is not compensated directly. it is, however, important to underscore that any interest paid by a state in excess of the interest owing on the monetary value of the federal government's injury is paid because a state, through action or inaction, chooses that more costly course over a less painful remedy. 19931 florida tax review vi. additional state-law issues affecting remedies as state courts and state legislatures grapple with refund suits following the court's decision in harper, state law will in some instances add to the constraints that the due process clause imposes. this part surveys the three most prominent state law issues that are likely to surface. a. extending vs. invalidating exemptions after davis, the two dozen states affected by the decision altered their laws to comply with the court's mandate of equal treatment for the future. some extended the tax exemption formerly enjoyed by state retirees to federal retirees. others withdrew the tax advantage that state pensioners had enjoyed. in these cases, lawmakers typically raised pensions for the future simultaneously so as to leave state retirees' after-tax position no worse than it would have been, out of a concern for fairness or because they dreaded the political or legal consequences of not doing so. states must now retroactively extend or remove the privilege that state retirees enjoyed, if they have not already supplied compensation for the earlier disparity or they are not shielded by having had in place an adequate pre-deprivation remedy. the choice of a retroactive exemption or retroactive tax will turn entirely on state law and legislative desire. state courts compelled to rule on the issue will generally find it beyond their power to withdraw the exemption from state workers retroactively, and thus will limit their inquiry to whether federal retirees are entitled to refunds; if they are, courts will also have to ask whether they may sue singly or as a class, for how many years they may claim relief, and how large their refunds ought to be. legislatures are not similarly constrained in their choice of a remedy. they might consider the potentially far less costly alternatives described in part v.c. both judges and lawmakers must navigate the legal shoals described below, however, in righting a state's earlier misdeeds. b. contractual constraints on taxing state pensions the federal due process clause, as interpreted in mckesson, permits a state to cure an unlawfully discriminatory tax by subjecting the beneficiaries to retroactive taxes to achieve parity after the fact, as well as by paying refunds to those victimized by the unequal treatment to attain the same end. similarly, the constitution allows states to erase the disparity in the future by spreading the benefit more widely or by shrinking it so far that the unlawful discrimination disappears. but state law might not permit state authorities to operate with so free a hand. taxing the pensions of state workers, either retroactively or even solely in the future, might breach a state's contract with [vol 1:8 harper and its aftermath its former workers or contravene statutory or state constitutional provisions barring the reduction or taxation of state retirement benefits. hughes v. oregon" illustrates this fence of a state's own making. the oregon legislature decided in 1991 to make state retirement benefits henceforth subject to state income tax, as federal retirement pay had been and would be."' at the same time, the legislature voted to increase state workers' pensions, although by an aggregate amount that was less than the newly imposed tax liability. " the oregon public employees union promptly sued.224 in a complex opinion, the oregon supreme court held in hughes that one of two parallel statutory changes making retirement benefits taxable constituted an impairment of the state's contract with its workers.' in the court's view, amending a provision of the public employee retirement act, as codified, to remove state retirees' exemption from state income taxation violated the oregon constitution's contract clause.226 te purported change was therefore a nullity insofar as it related to benefits accrued for work performed prior to the effective date of the legislation. 7 the court held, however, that a second statutory change, which removed state retirees' income tax exemption from the state income tax law (rather than the codified retirement act), did not impair the state's contract with its employees but that it did breach that contract.228 the court declined to specify a remedy for breach of contract,' although an increase in pension benefits to fully offset their taxability should, one would think, be adequate compensation for the breach. hughes stands as a warning that some states-perhaps most states-will not be able to shift even part of the cost of complying with davis onto state retirees, regardless of whether lawmakers are willing to brave the political tempest that lowering state workers' nominal after-tax wages typically unleashes. pension agreements between states and their employees' unions usually cannot be abrogated by the state without cost, with respect to work that has already been performed and rights that have vested. thus, laws 221. 838 p.2d 1018 (or. 1992). 222. id. at 1023. 223. see state developments: oregon, daily rep. for executives (bna), at h-7 (july 5, 1991). 224. state developments: oregon, daily rep. for executives (bna), at h-4 (oct. 4, 1991) ('the increased benefits ... were not considered sufficient compensation for the pension taxation according to [the oregon public employees union], said james coon, the portland lawyer who filed the petition."). 225. 838 p.2d at 1033. 226. id. at 1035. 227. see id. at 1024-35. 228. id. at 1036. 229. id. at 1036 n.36. 1993] florida tax review stripping state workers of their tax exemption for state pensions will likely be found to impair or breach those contracts or to run up against some other legal barrier. this restraint will rarely chafe in non-davis cases. taxes that discriminate unlawfully under the commerce clause, for example, can generally be stretched to cover a privileged group without fear of legal challenge, particularly insofar as the tax increase is prospective. but these restraints significantly narrow the range of responses that states might make to the court's decisions in davis and harper. c. extra compensation and gift clauses in coping with davis, some states have found or will find it cheaper to withdraw the state income tax exemption for state retirees-retroactively or prospectively or both-and to increase pension payments to keep their after-tax retirement income constant than to confer a similar exemption on federal retirees. at least a few of the states that tread this path, whether for the future or retroactively," ° might run up against a state constitutional obstacle, should they manage to skirt any difficulties posed by their contractual or statutory obligations to state workers not to tax their pensions. unlike potential breaches of contract, this second hindrance cannot be removed by a consensual agreement between the state and its former employees. the constitutions of numerous states, including many that were guilty of davis infractions, contain provisions barring the state from granting additional compensation to employees or contractors after their services or the terms of their contract have been completed, or from bestowing gifts or gratuitously forgiving public debts.23' the primary aim of these provisions is, of course, to prevent lawmakers from squandering public resources, whether by funnelling them to their cronies without any offsetting benefit to the state or by paying more than they must for some advantage the state has received. these constitutional provisions might nevertheless be enlisted in support of suits challenging increases in pensions after state workers have retired, even if those increases are intended merely to counterbalance the withdrawal of state pensioners' income tax exemptions. those most likely to sue are federal retirees. ironically, their purpose in invoking these constitu230. part v.c, supra, discusses the retroactive combination, which faces the same hurdles as its prospective twin, but which must also meet (as i argue it does) the objection that it is only a subterfuge that fails to provide constitutionally sufficient backward-reaching relief under the standard set forth in mckesson. 231. see, e.g., ala. const. art. iv, § 68; ark. const. art. v, § 27; colo. const. art. v, § 28; ga. const. art. iii, § vi; iowa const. art. iii, § 31; mich. const. art. xi, § 3; miss. const. art. iv, § 96; s.c. const. art. mi, § 30; wis. const. art. iv, § 26. [vol 1:8 harper and its aftermiath tional provisions designed to protect the public purse would be to rifle it. they stand to benefit financially if the state must exempt them from state income tax to the same degree that it exempted or continues to exempt state pensioners; they gain nothing if the state may discontinue state workers' exemptions and instead supplement their pensions while simultaneously taxing them. one suit of this type has already been filed. it proved unsuccessful. in mcclead v. pima county,232 the arizona court of appeals ruled that the state's extra compensation and gift clauses' -" did not proscribe a prospective increase in state workers' pensions to cancel their new state income tax liability. the court based this result, however, on what might seem a tenuous ground. it did not declare that the taxpayers who brought suit lacked standing, although in the absence of a legislative amendment passed ten years before it might have done so.24 the court held, rather, that the extra compensation clause applied solely to payments made from the public treasury, and that the pension increases were instead paid from separate pension funds which the arizona constitution's limitations did not reach. " ' this seems an odd happenstance on which to rest so crucial a ruling. perhaps the court did not care, however, so long as the tool did the job." 6 in any event, the court's rejection of the plaintiffs' gift clause challenge was simpler and more predictable. pension increases, it said, were not gratuities but deferred compensation.2 7 moreover, the announced increases did not offend the purpose of the gift clause because the legislature's goal was to avoid cheating state workers and to honor their pension rights while meeting the state's federal constitutional obligations in the least costly manner, not to raid the public fisc for the sake of lawmakers' friends." the plaintiffs' claim was therefore doubly flawed. it is hard to say how future suits will fare in other states, should they be launched. mcclead might in retrospect appear prophetic; it might also seem an oddity. given the large sums at stake, however, it would be curious if similar dramas were not played out in a host of other states. whether the 232. 849 p.2d 1378 (ariz. ct. app. 1992). 233. ariz. const. art. iv, pt. 2, § 17; art. ix, § 7. 234. see mcclead, 849 p.2d at 1382-83. 235. id. at 1385-88. 236. the court did note a possible alternative rationale for its decision which the california supreme court invoked long ago. see sweesy v. los angeles county, 110 p.2d 37 (cal. 1941). once pension rights vest, the state of arizona had argued, benefits may be increased without fear of violating the extra compensation or gift clause. the arizona court of appeals withheld judgment on the issue, finding additional support for its holding unnecessary. mcclead, 849 p.2d at 1389 n.19. 237. mcclead, 849 p.2d at 1388. 238. id. at 1388-89. 19931 florida tax review prospect of litigation will deter state legislatures from withdrawing income tax exemptions from state retirees while compensating them for the loss of this benefit will almost certainly depend upon the savings that states could reap from this action. a state's response is also likely to take account of any shadow that earlier constructions of the state's extra compensation or gift clause and its rules governing standing cast over this apparently economical choice. vii. conclusion "this court's retroactivity jurisprudence has become somewhat chaotic in recent years," justice o'connor wrote in harper.239 its most recent contribution to that jurisprudence does little to dissipate the confusion. by basing its decision on beam's repudiation of selective prospectivity, the court left uncertain the vitality of purely prospective holdings in civil cases. it also failed to clarify the role, if any, that chevron oil still plays in determining whether a new decision applies retroactively in statute-oflimitations cases or more generally. in addition, the court's newly manufactured "express reservation" and "equal treatment" rules for retroactive application ensure that many litigants will suffer genuine and unfair hardship as the court delays in deciding which approach to adopt towards civil retroactivity. its cryptic assertions about the ways in which equitable considerations can shape remedies in particular cases if a new constitutional holding applies retroactively, both in state tax cases and in other civil disputes, will fuel much litigation, error, and annoyance. there is some certainty. davis itself applies retroactively. moreover, despite some instability in the court's opinion in mckesson, it also appears that states that are guilty of davis violations must now eliminate in full the inequality they created for all open tax years, unless they provided federal retirees with a meaningful opportunity to contest the constitutionality of taxing their pensions while exempting pensions paid to state workers. eliminating the inequality means paying refunds to federal retirees, taxing state pensions retroactively, or combining the two to erase past discrimination. in light of mckesson's reasoning, the payment or recovery of interest seems constitutionally mandatory, though some state courts are likely to demur. given many states' contractual liability to their retired workers, simply taxing pensions retroactively will be legally as well as politically impossible. refunds to federal retirees may seem the only practicable option. one important exception to this conclusion, which state legislatures are constitutionally able to embrace, is to tax state pensions retroactively but to 239. harper, 113 s. ct. at 2526 (o'connor, j., dissenting). [vol 1:8 harper and its afiennath offset those taxes and any resulting federal taxes by a bonus designed to keep state pensioners as well compensated as they were. this option would presumably provide adequate damages even if it breached the state's employment contracts with its former workers. whether it would contravene state constitutional provisions barring the payment of extra compensation or gifts to workers whose employment contracts have been completed is a separate question-a question, however, that many state courts would probably answer negatively. another attractive alternative to refunds, which might prove even less expensive than retroactive taxes and bonuses, is to enter into a settlement with the federal government. these and other issues will now be litigated in state courts and debated in state legislatures. in light of the legal uncertainty surrounding the constitutional law of civil remedies and the potential political costs of continued sparring, settlements between state authorities and federal retirees can be expected. 240 nevertheless, davis-related cases are apt to generate enough novel case law to provide the supreme court with plentiful opportunities to disperse the mist enveloping civil retroactivity and remedial doctrine, unless congress resolves the remaining disputes through national legislation. congress could confer a large boon on a number of states, at no cost to the federal government, by allowing states to pay the federal government directly for the harm it likely suffered as a result of their having taxed federal pensions but not state retirement income. whether congress will place the interests of federal and state treasuries above some federal pensioners' desires for unearned gains remains to be seen. 240. see, e.g., andrea l.t. peterson, governor urges settlement with federal pensioners, 5 state tax notes 300 (aug. 9, 1993) (reporting governor wilder's call for a postharper settlement with federal retirees in virginia). 19931 florida tax review volume 1 1993 number 10 irc §§ 7431 and 7433: civil remedies for abusive practices by the irs r. tracv sprouls" i. introduction ii. liability for unauthorized disclosures a. section 7431: civil damages for violation of section 6103 1. there must have been a release of a return or of return information 2. the information must have been return information of the taxpayer bringing the suit 3. the release must have been a "disclosure" 4. the release must have been made by an officer or employee of the united states 5. the person making the disclosure must have acted "knowingly or by reason of negligence" 6. the release must have been in violation of section 6103 7. good faith defense b. elvis johnson: liability under the federal tort claims act for violation of section 6103 1. no ftca claim can be based on the violation of federal law 2. the claim was preempted by section 7217 it[. liability for collections activities: section 7433 iv. coordination of sections 7431 and 7433: overlap and gaps a. overlap b. gaps in coverage 1. no liability for abuses during assessment phase 2. liability for negligent collections activity 3. limit on damages under section 7433 v. conclusion * underwood, wilson, berry, stein & johnson, p.c., amarillo, texas; university of new mexico, j.d. 1981, university of florida, ll.m. (taxation) 1993. the author wishes to express his appreciation to professor michael a. oberst for his comments on the initial draft of this article. florida tax review i. introduction a government must have revenue to exist, and a government the size of the present-day united states government requires a staggering amount of revenue.' as the revenue assessing and collecting branch of the government, the internal revenue service performs the crucial function of ensuring the steady and continuous flow of revenue. to enable it to perform this function, congress and the courts have granted the service broad powers of investigation and seizure that are denied most other law enforcement agencies by statutory and constitutional safeguards, and have generally shielded the service from accountability to the taxpayers involved or to any other authority.2 in 1976, however, congress began enacting legislation intended to ensure the proper exercise by the service of its extensive powers, and to prevent the misuse of the massive database that the service has constructed on american taxpayers. given the ever-expanding use of the tort system in the united states as a means of private law enforcement, it is not surprising that one of the tools chosen by congress to police the service was the taxpayer lawsuit for damages against the federal government. this article will focus on two provisions, section 7431 (and its substantive base, section 6103) and section 7433, in which congress established this method of accountability.3 1. in 1992, for example, the federal government revenues totalled $1,075,000,000,000 (while government expenditures totalled even more, $1,475,000,000,000). harry e. figgie, jr. & gerald j. swanson, bankruptcy 1995 143 (1992) (citing the office of management and budget as the source of these figures). 2. david burnham, a law unto itself 21 (1989). this combination of power and unaccountability has inevitably resulted in a fear and hatred of the service. in his testimony before the senate in 1987, one tax practitioner told the senators that "[t]he irs is the most hated organization in the united states. people would rather deal with the kgb." taxpayers bill of rights: hearings on s. 579 and s. 604 before the subcommittee on private retirement plans and oversight of the internal revenue service of the senate committee on finance, 100th cong., 1st sess. 177 (apr. 10, 1987) [hereinafter hearings on s. 579 and s. 604] (testimony of jack warren wade, jr., author of "power to tax"). 3. outside the scope of this article are two other provisions of the code enacted in 1988 that authorize actions for damages against the united states: § 7430 (concerning claims for attorneys' fees in cases where the taxpayer prevails and the government has taken an unreasonable position) and § 7432 (concerning claims for damages based on the government's refusal to release a lien). for a general discussion of § 7430, see marilyn devin, tax court review of irs's position: when may taxpayers recover legal fees?, 68 j. tax'n 368 (june 1988). also outside the scope of this article are other provisions of the code that will, under appropriate circumstances, offer some protection and/or redress to the taxpayer and third parties, other than an award of damages. see irc § 742 1(a) (allowing injunction or judicial review of specific service activities under limited circumstances); irc § 7605 (prohibiting [vol 1:10 irc §§ 7431 and 7433 ideally, from the taxpayers' point of view, the statutes should cover the continuum of internal revenue service activity, allowing the recovery of damages for injuries sustained as a result of any improper exercise of the service's powers. in fact, however, the statutes leave large, and again from the taxpayers' point of view, unjustifiable, gaps in the coverage. these gaps, together with pending legislation designed to address some of these gaps are also discussed. in analyzing these provisions, or any other legislation that purports to place significant limitations on the powers of the service, one fact must be kept in mind: if the constant flow of revenue to the government stops, the government stops as well. despite all the speechmaking and posturing and even, perhaps, sincere concerns about the need to curb abuses by the service, the government cannot afford to enact legislation that would significantly interfere with the service's enforcement of the tax laws or interrupt the constant flow of revenue into the government coffers.! ii. liability for unauthorized disclosures the internal revenue code requires taxpayers, lenders, employers, and others to provide information to the service and authorizes the service to tap other sources of information. consequently, the service's files have become a repository of extensive, detailed information regarding the financial affairs of american taxpayers. congressional investigations into watergate revealed that the white house had obtained access to this information and had used it for purposes unrelated to the collection of taxes.' this revelation raised serious concerns on the part of members of congress about the use of unnecessary examinations or investigations of taxpayer note that although an injunction is prohibited under § 7421(a), the taxpayer can assert impropriety in response to the service's action to obtain an order to enforce summons or an action to collect deficiency or to collect refund); irc § 7426(a) (allowing civil actions by third-parties to recover surplus proceeds of levy and sale by internal revenue service). 4. in fact, § 7431 and § 7433 were themselves in no small part enacted to enhance, not limit, the service's ability to administer the tax laws in such a way as to produce revenue most efficiently by encouraging the voluntary compliance aspect of our tax system. see, e.g., hearings on s. 579 and s. 604, supra note 2, at 152 (testimony of jack warren wade, jr.); taxpayer rights issues: hearings on s. 2400 before the subcommittee on oversight of the internal revenue service of the senate committee on finance, 98th cong., 2d sess. 129 (mar. 19, 1984) (written statement of edwin i. davis, referring specifically to the ombudsman program); proposals for administrative changes in internal revenue service procedures: hearings before the subcommittee on oversight to the house committee on ways and means, 94th cong., 1st sess. 2, 6-7 (1975) [hereinafter proposals] (testimony of hon. jerry litton; testimony of senator lowell p. weicker). see also id. at 7 (testimony of senator lowell p. weicker). 5. see infra note 7. 1993] florida tax review the service to further political ends, about the potential for abuse of privacy, and even about the continued existence of the "voluntary assessment" system that is considered critical to the efficient administration of the tax law in this country.6 these concerns led congress to enact section 6103 in 1976.7 although various subsections of section 6103 have been amended since its enactment, the basic scheme remains the same: subsection "a" of section 6103 prohibits all disclosures of "return information" except those "authorized by this title," subsection "b" provides relevant definitions, and the remaining subsections of section 6103 provide numerous specific exceptions to the general prohibition of subsection "a."' at the same time that it enacted section 6103, congress enacted two provisions as the enforcement mechanisms of that section, one criminal and one civil. the criminal arm, now codified at section 7213(a), provides that 6. rep. jerry litton, one of the sponsors of legislation proposed to address this misuse of information, made this point in his statement to the house subcommittee on oversight during its hearings on the proposed legislation. regarding the issue of potential abuse of privacy by disclosure of internal revenue service information, he said: the important point that we have to establish first is that the irs is there for one purpose: to collect taxes to run the country, not to collect information on the lives of private citizens like some gestapo agency to turn over to whoever may be in power in the government. this, in my opinion is the sole purpose of the irs and the objective of our bill. ... the documented use of the internal revenue service as an intelligence body to derive information harmful to enemies of the nixon administration and helpful to its friends, flaunts the fundamental principles on which our government was founded. the method in which taxpayers voluntarily comply with our tax laws and, in most cases, fully report their earnings is the envy of most other nations where dishonesty is often the rule rather than the exception. if taxpayers become convinced that the confidential data they each submit is being used for political purposes, how long will it be before taxpayer compliance and trust in our system of taxation is forever lost? see proposals, supra note 4, at 3, 6-7 (testimony of hon. jerry litton). see also id. at 7 (testimony of senator lowell p. weicker). regarding the concern that misuse of internal revenue service information would impair the voluntary assessment system, see joint committee explanation at 314, 1976-3 c.b. (vol. 2) 326. 7. tax reform act of 1976, pub. l. 94-455, § 1202(a), 90 stat. 1667. this legislation might also be viewed, as many viewed the watergate scandal itself, as another episode in the continuing power struggle between the legislative and executive branches of the federal government. there was no overt reference to such a motive in the legislative history. 8. for purposes of this article, one of the most important exceptions is § 6103(k)(6), which authorizes disclosures in the course of tax administration, including assessment and collection activity. see infra note 61 and accompanying text. [vol 1:10 irc §§ 7431 and 7433 the unauthorized disclosure of return information in violation of section 6103(a) is a felony, punishable by a fine of up to $5,000 and/or up to five years in prison.9 a. section 7431: civil damages for violation of section 6103 the first civil mechanism which congress devised for the enforcement of section 6103 was codified in 1976 as section 7217, the predecessor of the present section 7431.' section 7217 authorized an action for damages against any person who "knowingly or by reason of negligence" made a disclosure of return information unauthorized under section 6103." the section authorized both actual and punitive damages, with a statutory minimum of $1,000, plus costs.' 2 except for a very brief reference to negligence in the general explanation of the tax reform act of 1976,' 3 the legislative history indicates that congress's primary motive in enacting this legislation was to prevent the intentional use of information gathered by the internal revenue service, pursuant to policy decisions made at the highest levels, for purposes other than proper tax administration. the inclusion of negligence in section 7217 indicates that congress must have had another goal as well, since negligence has nothing to do with such an organized, policy-directed misuse of information. rather, the authorization for a negligence-based claim was intended to protect taxpayers' right to privacy from the unintentional or careless actions of an individual, not made in furtherance of a carefully formulated service policy. in addition to the numerous specific exceptions in section 6103 to the general rule of nondisclosure, section 7217(d) provided significant protection from liability in the form of a "good faith" defense, i.e., no liability would 9. section 7213(a) significantly increased the already-existing criminal penalties for disclosure of return information, making the crime a felony rather than a misdemeanor, increasing the maximum imprisonment from one year to five, and increasing the maximum fine from $1,000 to $5,000. 10. the former § 7217 was enacted by pub. l. 94-455. § 1202(e) and repealed in 1982 by pub. l. 97-248, § 357(b)(1). 11. note that this is different from present law under § 7431. which authorizes claims against any person other than a federal officer or employee, in which case the claim must be brought against the government. 12. according to the general explanation of the tax reform act of 1976, "congress also decided that, in order to redress any injury sustained and to aid in the enforcement of the confidentiality rules, a civil action for damages should be provided to any person injured by a willful or negligent disclosure in violation of the act." 1976-3 c.b. (vol. 2) 355-56. 13. id. 19931 florida tax review arise because of a disclosure which results from a good faith, but erroneous, interpretation of section 6103.4 in 1982, congress reexamined the civil enforcement mechanism provided by section 7217 and, redesignating it as section 7431, retained all but one of the substantive provisions.'" the one (very significant) change made was to provide that, where an employee of the federal government makes an unauthorized disclosure, the cause of action lies against the government rather than against the individual. 6 congress made this change because it believed that the united states could be expected to exercise control over its own employees, so that the action should more appropriately lie against the united states. 17 to maintain a cause of action against the united states under section 7431(a),' 8 a taxpayer must show that: 1. there has been a release of a return or of return information; 2. the return or information was that of the taxpayer bringing the suit; 3. the person making this disclosure was an officer or employee of the united states; 4. this release constitutes a "disclosure"; 5. the disclosure was made knowingly or by reason of negligence; and 6. the disclosure was in violation of some provision of section 6103. even if the taxpayer can show all six of these elements, the government can still avoid liability by showing that the disclosure resulted from a good faith, but erroneous, interpretation of section 6103.19 as a 14. pub. l. 94-455, § 1202(e), codified at § 7217(b), redesignated § 7217(c) by pub. l. 95-6000, § 701(bb)(7)(a), repealed by pub. l. 97-248, § 357(b)(1). 15. tax equity and fiscal responsibility act of 1982, pub. l. 97-248, § 357. 16. all persons other than federal officers or employees remained subject to personal liability. id. 17. general explanation of the revenue provisions of the tax equity and fiscal responsibility act of 1982, at 434. 18. section 7431(a)(1) provides: disclosure by employee of united states. if any officer or employee of the united states knowingly, or by reason of negligence, discloses any return or return information with respect to a taxpayer in violation of any provision of section 6103, such taxpayer may bring a civil action for damages against the united states in a district court of the united states. 19. section 7431(b) provides that "[n]o liability shall arise under this section with respect to any disclosure which results from a good faith, but erroneous, interpretation of [vol 1:10 irc §§ 7431 and 7433 waiver of sovereignty, section 7431 must be strictly construed in favor of the government.2° the question of waiver is a jurisdictional one.2, 1. there must have been a release of a return or of return information.-section 7431 (e) adopts the definitions of "return" and "return information" provided in section 6103(b). under that section, a "return" is defined to include any tax or information return, declaration of estimated tax, or claim for refund, together with any amendment, supplement and attachment;' "return information" includes virtually any information that might be contained in the internal revenue service's files, including the taxpayer's identity and financial information, and any information concerning tax determination or collection.2 given the very broad definitions of these terms, plaintiffs have generally had no difficulty proving this element. there are, however, some significant issues lurking here. section 6103." 20. haywood v. united states, 642 f. supp. 188, 191 (d. kan. 1986) (citing ruckelshaus v. sierra club, 463 u.s. 680, 685 (1983)). 21. id. 22. section 6103(b)(1) defines "return" as: any tax or information return, declaration of estimated tax, or claim for refund required by, or provided for or permitted under, the provisions of this title which is filed with the secretary by, on behalf of, or with respect to any person, and any amendment or supplement thereto, including supporting schedules, attachments, or lists which are supplemental to, or part of, the return so filed. 23. section 6103(b)(2) defines "return information" as: (a) a taxpayer's identity, the nature, source, or amount of his income, payments, receipts, deductions, exemptions, credits, assets, liabilities, net worth, tax liability, tax withheld, deficiencies, overassessments, or tax payments, whether the taxpayer's return was, is being, or will be examined or subject to other investigation or processing, or any other data, received by, recorded by, prepared by, furnished to, or collected by the secretary with respect to a return or with respect to the determination of the existence, or possible existence, of liability (or the amount thereof) of any person under this title for any tax, penalty, interest, fine, forfeiture, or other imposition, or offense, and (b) any part of any written determination or any background file document relating to such written determination .. , which is not open to public inspection under section 6110. the flush language of § 6103(b) specifically excludes from this definition "data in a form which cannot be associated with, or otherwise identify, directly or indirectly, a particular taxpayer." 19931 florida tax review a. the "immediate source" rule.-in thomas v. united states,24 the service had followed its long-standing policy of issuing a press release to publicize a judicial victory over a taxpayer. the press release, which was issued after the tax court's opinion, contained information that fell within the definition of "return information" in section 6103(b); all of this information was also contained in the tax court's opinion. the taxpayer brought suit under section 7431, claiming that the press release constituted an unauthorized release of return information under section 6103. first, the court noted a conflict between the circuits regarding whether the release of return information previously included in the public record constituted the unauthorized "disclosure" of that information. 25 the court then ruled that it did not have to enter the fray, because it did not reach that issue. the court found the press release was not a publication of the taxpayer's return information, but rather a publication of the tax court opinion: [t]he definition of return information comes into play only when the immediate source of the information is a return, or some internal document based on a return, as these terms are defined in section 6103(b)(2), and not when the immediate source is a public document lawfully prepared by an agency that is separate from the internal revenue service and has lawful access to tax returns. the tax court is such an agency.26 on the initial reading of the opinion, this "immediate source" rule appears to be a simple and satisfactory method of avoiding the controversial "disclosure" issue. further analysis, however, shows that this approach is not as simple as it first appears and that it raises other, rather thorny, issues. the immediate source rule allows the government to rebut the "return or return information" requirement by showing four elements: first, that an agency separate from the internal revenue service lawfully obtained the taxpayer's return or return information; second, that this separate agency made an authorized disclosure of the information; third, that the disclosure was made in a public document; and, fourth, that the service's subsequent disclosure was based on the information contained in the separate agency's disclosure.27 24. 890 f.2d 18, 19 (7th cir. 1989). 25. see infra part ii.a.3. 26. thomas, 890 f.2d at 20-21. 27. see id. at 21. [vol. 1:10 irc §§ 7431 and 7433 the first objection to the "immediate source" rule is that there is no support for it in either the statutory language or legislative history. on the contrary, the definition of "return information" given in section 6103(b) is very broad and straightforward, and contains no suggestion that information otherwise falling within its terms might be redefined by virtue of the context in which it is disclosed. statutory construction aside, application of the seventh circuit's "immediate source" rule to common fact patterns requires some interesting and troubling conclusions, which can best be illustrated by a series of hypothetical situations. for example, assume that taxpayer's identity and amount of income reported, and deductions claimed (information within the definition of "return information") were included in a pleading filed by counsel for the service' in a tax court proceeding,' and that the service subsequently issued a press release based on the pleadings, reciting the return information. under the "immediate source" rule, taxpayer will be able to satisfy the "return or return information" element of liability under section 7431 because the underlying disclosure (the pleading) was prepared by the service, not by an agency separate from it. suppose, instead, that the pleading, containing the identical return information, was filed in federal district court, where the internal revenue service was represented by attorneys from the justice department. here, under the "immediate source" rule, taxpayer will not be able to satisfy the "return or return information" requirement, and therefore cannot establish liability under section 7431, because the underlying disclosure was made by an agency separate from the internal revenue service." the "immediate source" rule, by focusing inquiry on the immediate source of the information rather than on the nature of the information itself, creates a situation where the very same information from ultimately the same source can co-exist in both protected and unprotected forms. suppose that, in the thomas case itself, the plaintiff had (somehow) been able to prove that the internal revenue service had taken the information contained in its press release from the pleading of the service's counsel, rather than from the tax 28. in the tax court, the internal revenue service is represented by attorneys from within the service, not attorneys from the justice department. see irc § 7452. 29. this is an authorized disclosure under § 6103(h)(4). see infra part iia.3. 30. see t/wmas, 890 f.2d at 21. perhaps a question might be raised as to whether the justice department in this hypothetical is "separate" from the internal revenue service within the meaning of the thomas opinion, which does not define this term. regardless of the answer to this question, the analysis of the "immediate source" rule is still valid, since the same conclusion would be reached if the underlying disclosure was made by a state attorney general in a state tax case; the state attorney general is certainly "separate" from the internal revenue service. 19931 florida tax review court's opinion. in the language of the thomas holding, the "immediate source" of the information is now the underlying pleading, and the information is therefore still protected "return information" even though it has already been disclosed in a tax court opinion and even though a press release based on that judicial opinion would not be actionable. viewed in light of the damage potentially caused by the service's disclosure, the factual distinctions in these hypothetical situations do not justify the difference in the results. the identical information has been publicly released in the service's press release, regardless of whether the underlying pleading was filed by the service's counsel or by the justice department and regardless of whether the service copied the facts from the pleading or from the tax court opinion. the potential injury to the taxpayer is the same in each case.3 ' b. erroneous information.-another potential issue under the "return or return information" requirement of section 7431 is whether erroneous information comes within the definition of protected "return information. 32 section 6103 defines "return information" as, in essence, any information concerning the taxpayer's financial or tax situation, including amount of income, which was "received by, recorded by, prepared by, furnished to, or collected by" the internal revenue service for tax administration purposes. there is no express requirement that, to qualify as "return 31. the "immediate source" rule becomes much more rational (and interesting) if § 7431 is interpreted as granting taxpayers a privilege in the information which the service has assembled concerning them, similar to the attorney-client privilege. this is a variation of the "loss of confidentiality" defense that the government has raised, which is discussed infra note 38 and part ii.a.3. if this interpretation is in fact the theoretical underpinning of the "immediate source" rule, the thomas opinion certainly contains nothing to make this clear, and it has not been picked up by any other courts. 32. a disclosure of erroneous information by the service can arise in one of three ways: first, if the source of the information, whether it is the taxpayer or someone else, provides erroneous information to the service; second, if correct information is supplied to the service, but is recorded incorrectly in the service files and the disclosure is based on the erroneous information as it appears in the file; or, third, if the information is correctly supplied and recorded, but the person making the disclosure incorrectly relates the information contained in the files. although some secondary issues may differ depending on the precise manner in which the situation arose, all three are similar enough in nature that the following discussion, which focuses on the third possibility, applies equally to the other two. the author has found no reported decision expressly addressing the issue under discussion. for examples of cases involving this situation but not directly addressing it, see mallas v. kolak, 721 f. supp. 748 (m.d.n.c. 1989) (holding that disclosure of incomplete, outdated information is actionable), aff'd, 993 f.2d 1111 (4th cir. 1993); haywood v. united states, 642 f. supp. 188 (d. kan. 1986) (holding that procedurally proper disclosure of erroneous information is not actionable). [vol. 1:10 irc §§ 7431 mid 7433 information," the information be correct as supplied to or recorded by the service. a strict reading of the statute thus supports the conclusion that erroneous information is included in "return information;" a looser reading of the statute will support the contrary conclusion. support for both positions can be found in the congressional purposes underlying the legislation, depending on which of the two underlying purposes is emphasized. for example, assume that a taxpayer has correctly reported income of $1,000 for a particular taxable year. also assume that the service makes an unauthorized disclosure regarding the taxpayer for political reasons, but erroneously states that he had income of $500. a court could look at this situation and find that the service made an unauthorized disclosure of the taxpayer's "amount of income" and, strictly construing the statutory language, rule that such a disclosure falls within the definition of return information, regardless of whether the specific amount disclosed is accurate. such a ruling would be consistent with the congressional purpose of preventing misuse of service information for political reasons. the accuracy of the information wrongfully disclosed is irrelevant to this policy. another court, however, could look at the same situation, and focus on the specific information disclosed, i.e., that the taxpayer's amount of income was $500. since this was not in fact the amount of the taxpayer's income, it cannot be considered information regarding the taxpayer. since the information does not concern the taxpayer, it cannot be defined as his "return information," and there has therefore been no disclosure of return information and no violation of sections 6103 and 7431. this approach is supported by an emphasis on the other congressional purpose, to prevent the negligent or intentional invasion of taxpayers' right to privacy, since a taxpayer cannot have a reasonable expectation of privacy in information that by definition does not actually concern him. the spirit of the legislation, based on promoting taxpayer rights and preserving the institutional integrity of the internal revenue service, supports the imposition of liability for the disclosure of erroneous information. even if the information being disseminated by the service is erroneous, it is nonetheless being represented as information pertaining to the taxpayer. such a disclosure is no less damaging to the taxpayer's business and reputation merely because the information is false. on the contrary, the very fact that it is erroneous suggests that it may be even more damaging. likewise, the intentional disclosure of erroneous information for political purposes is at least as far outside the legitimate function of the service as is the disclosure of correct information for political purposes. 19931 florida tax review 2. the information must have been return information of the taxpayer bringing the suit.-in haywood v. united states,33 the plaintiff's husband had died with an unpaid tax liability incurred in years when he filed separately; the plaintiff was not jointly liable. even after it was advised of the facts, the internal revenue service sent a notice of levy to the plaintiff's employer, levying her salary. this notice correctly stated the existence and amount of the tax liability but incorrectly stated that the plaintiff was jointly liable with her late husband's estate. the only correct "return information" of the plaintiff's that was disclosed by the levy was her name and social security number. in dismissing the plaintiff's section 7431 cause of action, the court reasoned that two types of information were released by the notice of levy. the first was the plaintiff's correct name and social security number. regarding this information, the court simply found that there was not an improper "disclosure," since the information was already known to the employer.34 the second type of information was that regarding the plaintiff's late husband's deficiency, incorrectly attributed to her. the court characterized this situation as one where the government had mistakenly levied on a third party's property, and held that sections 6103 and 7431 were neither intended nor designed to address that situation, concluding that the plaintiff's sole remedy lay under section 7426, which authorizes an action for recovery by third parties of property wrongfully levied. the haywood court correctly determined the rather limited scope of sections 6103 and 7431. the purpose of these statutes is to prevent the misuse of the service's formidable information-gathering powers by prohibiting the use of its information for political or other reasons not related to proper tax administration. in furtherance of that goal, section 7431 was fashioned to address one specific situation, creating a cause of action for the improper use of information regarding the complaining taxpayer. it was not designed to apply to situations such as the one presented in haywood, which are more properly the province of section 743335 or section 7426.36 33. 642 f. supp. 188, 192 (d. kan. 1986). 34. id. the reasoning of the court was similar to that used by the courts adopting the government's "loss of confidentiality" argument regarding disclosure of information contained in public records. see discussion infra part ii.a.3. 35. see infra part iii. note that § 7433 was enacted after haywood and therefore was not discussed in the opinion. 36. it should be noted that the situation presented in haywood is different from that discussed supra part il.a. l.b. (regarding the unauthorized disclosure of erroneous information). in haywood, the service erroneously attributed one taxpayer's information to another taxpayer and then commenced otherwise proper collection procedures based on that attribution, including a disclosure that would have been authorized had the attribution been correct. the [vol 1:10 irc §§ 7431 and 7433 to constitute protected return information of the taxpayer, however, it is not necessary that the information be obtained or prepared specifically in regard to the plaintiff's tax liability. in mallas v. united states,37 the fourth circuit imposed liability for the release of information that fell within the section 6103(b) definition of "return information," which had been prepared in connection with the determination of the tax liabilities of thirdparties, who were investors in plaintiff's project. 3. the release must have been a "disclosure. "-section 6103(b)(8) defines "disclosure" as "the making known to any person in any manner whatever a return or return information." this statutory element has become an issue in cases where return information was released in a manner not authorized under section 6103(a), but where the information either was already known to the person to whom it was released or had previously been introduced into the public record by way of pleadings or evidence in some judicial proceeding. in determining whether there has been an unauthorized "disclosure," the courts have developed two, mutually exclusive approaches;" the method issue here is whether the incorrect attribution somehow taints the subsequent disclosure, subjecting the service to liability under § 7431; the conclusion correctly reached in havwood is that it does not. the discussion in part h.a.i.b., however, concerns the service's disclosure of erroneous information, where the disclosure would be unauthorized even if the information had been correct. the issue here is whether information that the service identifies as a taxpayer's return information comes within the definition of "return information" and thus within the protection of §§ 6103 and 7431 even though it is erroneous and therefore not, in fact, information contained in the taxpayer's return. hybrid situations can be similarly analyzed. assume, for example, that the service makes a disclosure of what it identifies as taxpayer's return information but which is in fact information from third party's tax return. if the disclosure is otherwise authorized, it should be treated as haywood-type disclosure, properly the subject of actions under §§ 7426 or 7433, but not § 7431. if, on the other hand, the disclosure would be unauthorized even if the service had used taxpayer's correct return information, it should be treated as any other unauthorized disclosure of erroneous information. the source of the erroneous information is irrelevant to a determination of the service's liability. 37. 993 f.2d 1111, 1114 (4th cir. 1993). 38. see, e.g., lampert v. united states, 854 f.2d 335. 337-38 (9th cir. 1988) (comparing lampert court's approach with that taken by the tenth circuit in rodgers v. hyatt, 697 f.2d 899 (10th cir. 1983)), cert. denied, 490 u.s. 1034 (1989). the court in thomas v. united states, 890 f.2d 18 (7th cir. 1989), may implicitly have been propounding a third approach, based on a taxpayer privilege existing in the return information, and similar to the "loss of confidentiality" argument discussed below. that opinion, through its "immediate source" rule, seems to maintain the protection of § 6103 and § 7431 on any document prepared internally by the service, regardless of whether the information contained therein has been otherwise publicized. once the information has been legally disclosed by an agency 19931 florida tax review of analysis chosen invariably determines the outcome. 39 the courts that side with the government on this issue look beyond the statutory language to the congressional purpose underlying sections 6103 and 7431, which they define as the protection of the taxpayers' right to privacy. these courts, led by the ninth circuit in lampert v. united states,4" have unanimously held that the condition precedent to the protection afforded by sections 6103 and 7431 is the confidentiality of the information, reasoning that if the information is already in the public record or is already actually known to the individual receiving the information from the government, the information has lost its confidentiality, and the taxpayer can have no reasonable expectation of privacy and therefore no remedy under section 7431. the second group of courts, led by the tenth circuit in rodgers v. hyatt,41 frames the issue as one of simple but strict statutory analysis. these courts hold that the questions of "confidentiality" and "right to privacy" are irrelevant to a determination of liability under section 7431, and that the only question is whether the disclosure was authorized. as one court said: "in light of that explicit statutory and legislative history, this court concludes that it cannot judicially carve any additional exceptions to section 6103's general ban against disclosures."42 the government's "loss of confidentiality" argument, adopted by lampert, is flawed for at least three reasons. first, the "loss of confidentiality" argument, as expressed in lampert and later cases, is based on the premise that the sole public policy underlying the legislation is protection of separate from the internal revenue service (e.g., in a tax court opinion), the service is allowed to publicize information taken from that source, even though the identical facts in its own files remain "privileged" information. 39. perhaps because this statute is relatively new, this issue has arisen in only a few cases. although the two positions are well-defined, they have not yet established themselves as the clear "minority" or "majority" view, contrary to the government's identification of the more restrictive definition of "disclosure" (the pro-government definition) as being the majority view. rubel v. united states, 89-1 u.s. tax cas. (cch) 9149, 62 a.f.t.r.2d (p-h) 88-5468 (w.d.n.c. 1988). 40. 854 f.2d 335 (9th cir. 1988), cert. denied, 490 u.s. 1034 (1989). see also haywood v. united states, 642 f. supp. 188 (d. kan. 1986) (finding that notice of levy wrongfully included taxpayer's name and social security number but information was already known to the recipient). 41. 697 f.2d 899 (10th cir. 1983). rodgers was decided under § 7217. since the relevant language in § 7217 regarding the definition of "disclosure" is identical to that in § 7431, its holding is equally applicable to the later statute, and is routinely so cited. see also chandler v. united states, 687 f. supp. 1515 (d. utah 1988), aff'd, 887 f.2d 1397 (10th cir. 1989); husby v. united states, 672 f. supp. 442 (n.d. cal. 1987); malis v. united states, 87i u.s. tax cas. (cch) 9212, 59 a.f.t.r.2d (p-h) 87-988 (c.d. cal. 1986). 42. chandler, 687 f. supp. at 1519 (quoting with approval johnson v. sawyer, 640 f. supp. 1126, 1133 (s.d. tex. 1986), aff'd, 980 f.2d 1490 (5th cir. 1992)). [vol 1:10 irc §§ 7431 and 7433 the taxpayers' right to privacy. if the government can show that the specific information involved in that case is somehow no longer "confidential," so the argument goes, then the taxpayer had no reasonable expectation of privacy and is therefore entitled to no remedy under section 7431. a review of the legislative history shows that this premise is wrong. although protection of the right to privacy in individual cases was one of the congressional purposes, congress was also motivated by a much broader, "institutional" concern: that the internal revenue service was, as a matter of policy, being used as an intelligence gathering and disseminating agency by the executive branch.43 sections 6103 and 7431 were intended to bring immediate and very tight controls to the practice of releasing return information for purposes unrelated to proper tax administration. congress sought to achieve this goal by prohibiting the release of any return information for any purpose not expressly authorized by section 6103 or some other section of the code. this second congressional purpose is not satisfied by a showing that the information was not within the taxpayer's reasonable expectation of privacy. second, the defense is mooted by the plain statutory language. as the courts in rodgers and its progeny have stated, there is no requirement in the statute that the return information be "confidential," whatever that may mean, before it falls within the protection of sections 6103 and 7431 ." further, even if "confidentiality" were a prerequisite for protection under sections 6103 and 7431, that status is clearly provided by the opening sentence of section 6103(a), which flatly provides that all "[r]eturns and return information shall be confidential." (emphasis added.) there is no provision in sections 6103 or 7431 or elsewhere for the loss of that status. finally, laying aside for the moment these flaws in the theory of the "loss of confidentiality" defense, the courts have improperly applied it as a question of law, rather than the question of fact that it is. as it has been presented and adopted, the defense assumes that information available in a "public record" is, by virtue of that fact alone, completely outside of the taxpayer's right of privacy. the fourth circuit rejected that assumption in mallas v. united states,45 holding that there is no exception to section 6103(a)'s disclosure prohibition that would permit the disclosure of return information simply because it was available to the public through a public record. the court describes as a "fiction" the notion that any information 43. see supra note 6 and accompanying texl 44. rodgers, 697 f.2d at 906. 45. 993 f.2d 1111, 1121 (4th cir. 1993). 19931 florida tax review contained in a public document is thereby known to the whole world, so that further disclosure can do no additional harm.46 the fourth circuit in mallas was correct. even accepting the interpretation of the statutes adopted by the ninth circuit in lampert, focusing solely upon the taxpayer's reasonable expectation of privacy, these statutes do not create the black and white dichotomy that the lampert court apparently envisioned, and cannot be applied easily to any situation other than the extremes. when the return information has been included in a judicial opinion, as in the thomas case discussed above,47 it is surely beyond argument that the taxpayer no longer has a reasonable expectation of privacy in that specific information. the converse is equally clear: a taxpayer most certainly does have a reasonable expectation of privacy in return information contained only in internal revenue service files. in the vast middle ground, however, the conclusions are much more difficult to draw. in the majority of cases addressing the issue,4" the return information has been included in court pleadings but not in a published opinion. unless the court file has been sealed by the court, such documents are public records, legally accessible by the media and the general public. in reality, however, this access is unexercised in all but the highest profile cases. although the information may technically fall outside of whatever definition of "confidential" the government may argue, it is still within the taxpayer's reasonable expectation of privacy. if the "loss of confidentiality" defense is to be recognized at all, it must be applied on a case-by-case basis, with the outcome turning on a resolution of a question of fact: whether the taxpayer had a reasonable expectation of privacy under the specific circumstances presented in that case. the application of this defense also raises a more basic policy concern. the government has asserted this defense even where it was the only party that played any role in either placing the information in the public record or subsequently disclosing it:49 the government assessed the tax that led to the dispute, the government filed the criminal information containing the information, and then the government publicized it. it takes no great effort to imagine the potential for abuse in this situation, where the government could make an end run around the intended protection of sections 6103 and 7431. 46. id. at 1120 (quoting with approval thomas v. united states, 890 f.2d 18, 21 (7th cir. 1989)). 47. see supra part ii.a.l.a. 48. see cases cited supra notes 40-41. 49. this was the situation in lampert, as discussed in the trial court's opinion, figur v. united states, 662 f. supp. 515 (n.d. cal. 1987), aff'd sub nom. lampert v. united states, 854 f.2d 335 (9th cir. 1988), cert. denied, 490 u.s. 1034 (1989). [vol 1:10 irc §§ 7431 and 7433 the converse situation, where the taxpayer himself places the information in the public record, does not present any more palatable a context for the "loss of confidentiality" argument. in this situation, the government is arguing that, by filing a tax court petition or a claim for refund and pleading the facts necessary to state a cause of action, the taxpayer is waiving the confidentiality of any return information included in the pleading and thus waiving the protection of sections 6103 and 7431. in effect, the government is putting the taxpayer to an election: he can choose either to file in court or to maintain the statutory protection of his return information. as the court in husby v. united states said, "congress could not have intended such an absurd result."50 although the court in malis v. united states5' agreed with the courts in rodgers and husby, and extended the statutory protection to the situation where the taxpayer himself had made the information part of the public record, it also correctly noted that the taxpayer's own prior disclosure of the information could have a very important effect on his potential recovery under section 7431: even though the prior release of the information would not preclude a finding of liability, it could negate the proximate cause nexus between the unauthorized governmental disclosure and plaintiff's alleged damages.52 4. the release must have been made by an officer or employee of the united states.-as with the "return information" requirement, this element has not yet been the source of much controversy. two points should 50. 672 f. supp. 442, 444 (n.d. cal. 1987). in husby. the service was apparently arguing that the inclusion of any return information in the tax court petition constituted the waiver of all return information relevant to that case. id. see also chandler v. united states, 687 f. supp. 1515 (d. utah 1988) (service arguing waiver of confidentiality upon tiling of injunctive suit), aff'd, 887 f.2d 1397 (10th cir. 1989). 51. 87-1 u.s. tax cas. (cch) 9212, 59 a.f.t.r.2d (p-h) 87-988 (c.d. cal. 1986). 52. 87-1 u.s. tax cas. (cch) at 87,351, 59 a.f.t.r.2d (p-h) at 87-992. even in the total absence of proximate cause between the subsequent disclosure and the asserted damages, a plaintiff is still entitled to a recovery of at least the minimum statutory damages of $1,000 and his costs. irc § 7431(c). the courts have split on the question of whether a plaintiff who is not entitled to actual damages is nonetheless entitled to punitive damages. cases holding against plaintiffs on this issue include smith v. united states, 730 f. supp. 948 (c.d. 111. 1990), aft'd, 964 f.2d 630 (7th cir. 1992). cert. denied. 113 s. ct. 1015 (1993); william e. schrambling accountancy corp. v. united states, 689 f. supp. 1001 (n.d. cal. 1988), rev'd on other grounds, 937 f.2d 1485 (9th cir. 1991). cases holding in favor of plaintiffs include mallas v. united states, 993 f.2d i i ii(4th cir. 1993); malis v. united states, 87-1 u.s. tax cas. (cch) [ 9212, 59 a.f.t.r.2d (p-h) 87-988 (c.d. cal. 1986) (citing mid-south music corp. v. united states. 85-2 u.s. tax cas. (cch) j 9782. 56 a.f.t.r.2d (p-h) 85-6250 (m.d. tenn. 1985)). 19931 florida tax review be noted, however. first, the statute subjects the government to potential liability for the disclosures by any employee, not just those working for the internal revenue service. 3 second, the statute does not require that the person be acting in his capacity as a federal employee (i.e., within the course and scope of his employment) at the time the disclosure is made.-4 at first glance, this element might appear to be a non-issue, since a taxpayer failing to prove that the person making the disclosure was an officer or employee of the united states for purposes of section 7431(a)(1) would simply proceed under section 7431 (a)(2), which authorizes an identical action for damages against any person not an officer or employee of the united states." this could, however, be a critical issue to both the taxpayer and the government. from the government's perspective, the materiality of the issue is obvious: if the person making the disclosure was not its officer or employee, the government is not liable. this is also an important issue from the taxpayer's standpoint, since the infinitely deep pocket of uncle sam would be replaced by the much shallower pocket of the individual.56 53. the actions of judges, as government officers or employees, can just as easily subject the government to liability under § 7431 as can the actions of internal revenue service agents. a release of return information in a court opinion is permitted under § 6103(h)(4), which authorizes disclosure "in a federal or state judicial or administrative proceeding pertaining to tax administration" where, among other limitations, the taxpayer is a party. if a judge were to release such information under other circumstances, however, such as in an extrajudicial setting or in another action to which the taxpayer was not a party, he would subject the government to liability under § 7431. 54. the specific provision, contained in the flush language of § 6103(a), is somewhat muddled: "[n]o officer or employee of the united states ... shall disclose any return or return information obtained by him in any manner in connection with his service as such an officer or any employee or otherwise or under the provisions of this section." it is not clear whether the phrases "in any manner" and "in connection with his service" modify "disclose" or "obtained." when read together with the phrase "or under the provisions of this section," the most logical interpretation is that they modify "obtained," so that the subsection prohibits any disclosure of information (regardless of whether the disclosure is related to the employment), whether that information was obtained in connection with his service, or obtained under the provisions of § 6103, or otherwise obtained. this question is rendered moot, however, by the phrase "or otherwise." even if "in any manner in connection with his service" modifies "disclose," the immediately following phrase "or otherwise" would extend the prohibition to all other disclosures. 55. such a situation would arise, for example, where an unauthorized disclosure of return information is made by a state tax official who was provided with return information by the service under the provisions of § 6103(d). 56. a summary judgment ruling dismissing the government might also complicate the taxpayer's pre-trial discovery, since the extensive discovery powers over parties to the litigation would no longer apply to the government, the source of much of the relevant information. [vol 1:10 irc §§ 7431 and 7433 5. the person making the disclosure must have acted "knowingly or by reason of negligence. "-section 7431 provides for liability where "any officer or employee of the united states knowingly, or by reason of negligence, discloses any return or return information."' this language goes far beyond establishing the standard by which liability is to be determined. it also sharply limits the government's potential liability by restricting the cause of action to claims based on the intent or negligence of only the specific person making the disclosure. neither the legislative history nor the reported cases directly address this issue. it is clear from the reported opinions, however, that this interpretation of the statute is the accepted standard."8 for example, in flippo v. united states, "9 a mistake or delay by the internal revenue service in updating its files led an agent to issue a notice of lien based on old information that erroneously indicated that the plaintiff had not paid a deficiency assessed against him. in ruling that there was no showing of negligence or intentional misdeeds, the court discussed only the actions of the agent making the disclosures and not those of the employees who failed to timely update the files or, at a higher level, to institute the proper procedures to ensure timely updating. the "knowingly or by reason of negligence" language is a hold-over from section 7217, the predecessor to section 7431, under which only the individual officer or employee making the disclosure was potentially liable for damages. in the context of that prior statutory scheme, the limitation makes sense: absent some sort of vicarious liability not relevant here, an individual cannot be held liable for someone else's intentional or negligent wrongdoing. this limitation is, however, neither necessary to the current statutory approach nor conducive to achieving the congressional purposes. as discussed above, the congressional purposes underlying sections 6103 and 7431 were to prevent the intentional, policy-based disclosure of return information for reasons other than tax administration and to prevent the violation of citizens' right to privacy by the intentional or negligent disclosure of return information. if the government is not liable for the negligent or intentional actions of any person involved in an erroneous disclosure except the final actor, the service can, by design or neglect maintain an outmoded, inefficient, or chronically unreliable system or procedure that may with great frequency result in inappropriate disclosures of return information. as long as the last employee in the chain relies on the information provided to him 57. irc § 743 1(a). 58. but cf. johnson v. sawyer, 640 f. supp. 1126 (s.d. tex. 1986). aff'd in part and modified in part, 980 f.2d 1490 (5th cir. 1992) (reserving ruling on question of whether only government employee directly involved in press release could be held liable under § 7217). 59. 670 f. supp. 638 (w.d.n.c. 1987), aff'd, 849 f.2d 604 (4th cir. 1988). 1993] florida tax review by this system or procedure, the government is not liable. in effect, it is shielded by its own incompetence. such a result frustrates both of the congressional purposes, but especially the concern for taxpayers' right to privacy. 6° to close this large gap in taxpayer protection, congress should amend the language of section 7431 to provide expressly for liability whenever negligent or intentional actions on the part of any governmental officer or employee, whether alone or in concert, result in an unauthorized disclosure of information. the cost, in terms of required modernization, monitoring of employees, and liability, however, may be more than congress is willing to pay to protect the rights of individual taxpayers. there is no legislation currently pending to amend this facet of section 7431. 6. the release must have been in violation of section 6103.-generally speaking, to further the congressional goal of preventing the misuse of information gathered by the internal revenue service, section 6103 provides a blanket prohibition on the disclosure of such information "except as authorized by this title." the succeeding subsections of section 6103, which provide exceptions to the general rule of nondisclosure, are drafted to permit only the minimum disclosure necessary to achieve specific purposes. section 6103(k)(6), for example, authorizes disclosure of return information by agents in connection with audits, collections, and civil or criminal tax investigations.6 the statute allows such disclosure, however, 60. this is not to say that actionable negligence occurs any time a disclosure is prompted by incorrect information from service personnel or computers. if the incorrect information is the result of an isolated problem and the service takes reasonable actions both to correct any harm to that specific taxpayer and to ensure that the underlying problem does not recur, then the service has not acted knowingly or negligently. any more stringent standard would be unreasonable. see christensen v. united states, 733 f. supp. 844, (d.n.j. 1990), affd, 925 f.2d 416 (3d cir. 1991). if, however, the underlying cause of the erroneous information is a recurrent problem, of which the service is aware but which it has made no attempt to correct, then it would be reasonable to impose liability. 61. section 6103(k)(6) provides that: an internal revenue officer or employee may, in connection with his official duties relating to any audit, collection activity, or civil or criminal tax investigation or any other offense under the internal revenue laws, disclose return information to the extent that such disclosure is necessary in obtaining information, which is not otherwise reasonably available, with respect to the correct determination of tax, liability for tax, or the amount to be collected or with respect to the enforcement of any other provision of this title. such disclosures shall be made only in such situations and under such conditions as the secretary may prescribe by regulation. [vol. 1:10 irc §§ 7431 and 7433 only "to the extent that such disclosure is necessary" to achieve the defined purposes; each of the other authorization provisions is similarly limited. disclosures in excess of the specific authorization are actionable.62 a difficult question is presented where the assessment underlying the collection is erroneous: is an otherwise authorized disclosure made in connection with the procedurally-proper effort to collect an erroneous assessment still "authorized" under section 6103(k)(6)? this question highlights a gap in the statutory scheme to provide damages for improper activities by the internal revenue service.' in flippo v. united states,6' an agent mistakenly thought that the plaintiff had not paid an assessed deficiency, and disclosed return information in the course of his efforts to collect that deficiency. the court held that this disclosure was not actionable under section 7431 because of what the court interpreted as congressional intent that section 7431 should not interfere with the collection of taxes. the court held that section 7431 simply does not apply to any action taken in the process of tax collection, even where the collection effort is mistaken. in husby v. united states6" and rorex v. traynor,' however, the courts reached the contrary conclusion, holding that such a disclosure is not authorized under section 6103(k)(6) and is therefore actionable under section 7431. the court in husby ruled that section 6103(k)(6) authorizes the disclosure of information only to the extent that it is necessary to the collection of valid tax deficiencies, stating: "the plain language of this subsection authorizes only disclosures which are necessary in obtaining information related to official duties. the disclosures at issue clearly were not although the language of this section is somewhat murky, and might be interpreted to authorize disclosures only during the investigative phase, any doubt as to the broader scope of this authorization is resolved by reference to §§ 6323 and 6331, which are incorporated into § 6103(a) by the phrase "as authorized by this title." 62. e.g., heller v. plave, 657 f. supp. 95 (s.d. fla. 1987) (decided under § 7217. in which the court also noted that regs. § 301.6103(k)(6)-l(a) provides similar restrictions on disclosures). on a side issue relevant to this point, the court in timmerman v. swenson. 79-2 u.s. tax cas. (cch) 9588, 44 a.f.t.r.2d (p-h) 79-5727 (d. minn. 1979). citing § 6103(k)(6) and regs. § 404.6103(k)(6)-l(b) (now § 301.6103(k)(6)-l(b)). held that where the taxpayer had disappeared with outstanding tax deficiencies, the service was authorized to send levies to any financial institution in the area, hoping to locate property belonging to the taxpayer. the fact that some of the levies were sent to banks not holding the taxpayer's property did not render the levies improper so as to form the basis for § 7217 liability. 63. see infra text accompanying notes 106-18 for a discussion of liability under § 7433 for collection activities undertaken pursuant to an erroneous assessment. 64. 670 f. supp. 638 (w.d.n.c. 1987), aftd, 849 f.2d 604 (4th cir. 1988). 65. 672 f. supp. 442 (n.d. cal. 1987). aff'd sub nom. united states v. lisle, 1993 u.s. app. lexis 20987 (9th cir. 1993). 66. 771 f.2d 383 (8th cir. 1985) (decided under § 7217). 19931 florida tax review necessary to official duties because the underlying assessment was improper." 6 7 although the husby court expressly based its ruling on the "plain language" of the statute, it in fact went beyond the statutory language, reading into the statute an implicit requirement that the underlying assessment be valid. in rorex, revenue agent traynor served a notice of levy on plaintiffs' bank, despite the fact that plaintiffs had timely made all payments due under an installment settlement agreement with the service. in his defense to plaintiffs' claims under section 7217, the predecessor to section 7431, traynor argued that his disclosure of return information was authorized by section 6103(k)(6). the court rejected this defense, noting that such a holding "would open a significant loophole in section 7217 in that internal revenue service employees could disclose return information about any taxpayer simply by making the disclosure in the form of a notice of levy. the employees would never be subject to liability under section 7217.... although the holdings in husby and rorex advance the goals of taxpayer protection, they do so only by expanding upon the language of the statute. the flippo court's ruling, denying governmental liability, is correct, based upon a strict interpretation of the statute. congress has, whether intentionally or not, created a very large gap in its scheme of taxpayer protection. the present statutory scheme, strictly construed, will not impose liability for disclosures made in the course of collection activities that are based on an assessment, regardless of how completely unjustified and unsupported that assessment may be.69 7. good faith defense.-section 7431 (b) provides that "[n]o liability shall arise under this section with respect to any disclosure which results from a good faith, but erroneous, interpretation of section 6103." the courts that have addressed the issue agree that the determination of "good faith" is to be made using an objective standard, defined as whether the agent's conduct violated clearly established statutory or constitutional rights, as interpreted in regulations and manuals, of which a reasonable agent would have known.7" 67. 672 f. supp. at 445. cf. william e. schrambling accountancy corp. v. united states, 689 f. supp. 1001 (n.d. cal. 1988)(holding that where levy was based on correct assessment, but proper notice not given, liability under § 7431 could be imposed), rev'd on other grounds, 937 f.2d 1485 (9th cir. 1991). 68. rorex, 771 f.2d at 386. 69. for further discussion of this gap in coverage, see infra part iv.b. 70. see huckaby v. united states dep't of treasury, irs, 794 f.2d 1041, 1048 (5th cir. 1986). [vol 1:10 irc §§ 7431 and 7433 this standard has been applied, for example, to hold agents not liable under section 7217 based on their misinterpretation of section 6103 as allowing the disclosure of return information to assist state tax administrators with an investigation into personnel matters." another court found that the existence of a split in authority on the "loss of confidentiality" defense would support a "good faith" defense.7this latter interpretation of the "good faith" defense puts the government in the enviable heads-i-win-tails-you-lose position of being able to argue, in any circuit except the tenth, that it is not liable for a disclosure of information already in the public record because either the information was not protected, or the service just thought it was not protected. it is unlikely, at least in the short run, that the government will lose many cases on this issue. by the express terms of section 743 1(b), the "good faith" defense applies only to misinterpretations of section 6103, not to alleged mistakes of facl73 it must be noted, however, that an implicit "good faith" defense with regard to factual issues exists by virtue of the "knowingly or by reason of negligence" element of section 7431(a)(1), discussed above. this implicit defense would apply, for example, if the person making the disclosure relies on erroneous information supplied to him by other governmental employees (or by anyone else). b. elvis johnson: liability under the federal tort claims act for violation of section 6103 no discussion of governmental liability for the unauthorized disclosure of return information under section 6103 would be complete without reference to the recent case of johnson v. sawyer,7' in which the plaintiff was awarded approximately ten million dollars for the service's publication of return information in press releases.75 although the size of the verdict may be an encouraging portent for future actions by taxpayers, changes in the law since the johnson claim arose have rendered johnson of questionable value as legal precedent. 71. rueckert v. gore, 587 f. supp. 1238 (n.d. i11. 1984). aff'd in result only sub nom. rueckert v. irs, 775 f.2d 208 (7th cir. 1985). 72. rubel v. united states, 89-1 u.s. tax cas. (cch) 1 9149, 62 a.f.t.r.2d (p-h) 88-5468 (w.d.n.c. 1988). 73. see husby v. united states, 672 f. supp. 442 (n.d. cal. 1987). 74. slip opinion, docket no. 91-2763 (oct. 14, 1993). supplementing and modifying 980 f.2d 1490 (5th cir. 1992), aff g in part and modifying in part 640 f. supp. 1126 (s.d. tex 1986). 75. it should be noted immediately that liability in jolmson was found under the federal tort claims act, not § 7217 or § 743 1. joluson, slip opinion at . 980 f.2d at 1492. 19931 florida tax review in johnson, the plaintiff, a prominent businessman, had entered into a plea arrangement with the department of justice, whereby he pleaded guilty to tax evasion in return for, among other consideration, the agreement by the department of justice that it would not issue a press release concerning his case. also pursuant to the plea agreement, the pleadings did not include certain identifying information, including the plaintiffs address and the nickname by which he was universally known. following the entry of the plea, the internal revenue service (not justice) issued press releases which included the identifying information intentionally excluded from the court records.76 the plaintiff filed this action for damages against the agent under section 7217, the predecessor of section 7431, asserting that the press releases violated the provisions of section 6103. because section 7217 created a cause of action against only against the individual agents, plaintiff could not assert liability against the government based on that statute. rather, he asserted a more imaginative claim against the government, based on the federal tort claims act (fitca).77 to maintain a claim under the ftca, a plaintiff must show that he suffered damages caused by the negligent or wrongful act or omission of an employee of the federal government, committed while acting within the scope of his office or employment, and that the act or omission occurred under circumstances where the united states, if a private person, would be liable to the plaintiff in accordance with the law of the place where the act or omission occurred.78 in johnson, the plaintiff based his ftca claim alternatively on two separate state torts: first, the tort of public disclosure of private facts (a form of invasion of privacy), which is independent of section 6103; and second, the tort of negligence per se, based on a violation of section 6103. the government asserted an array of defenses against the ftca claim.79 for purposes of this discussion, the most important of these are, 76. johnson, slip opinion at _, 980 f.2d at 1492-93. 77. id. at __, 980 f.2d at 1494. 78. 28 u.s.c. § 1346(b) (1988). 79. in addition to the two defenses discussed in the text, the government raised, and the fifth circuit rejected, the following defenses: (1) the action sounded in contract, not in tort. the court found this to be a simple mischaracterization of the plaintiff's claims, which were based on a violation of § 6103. johnson, 980 f.2d at 1500-01. (2) the information disclosed was no longer confidential under § 6103, since it was included in court documents, i.e., the "loss of confidentiality" defense discussed supra part ii.a.3. the court avoided the controversy inherent in this defense, noting that the press releases contained information not contained in the court records. slip opinion at -, 980 f.2d at . [vol 1:10 irc §§ 7431 and 7433 first, that no ftca claim can be based on the violation of federal law and, second, that the claim was preempted by section 7217. the fifth circuit rejected all of the government's defenses, holding the united states was indeed liable under the ftca and affirmed the trial court's multi-million dollar judgment in favor of plaintiff.8' 1. no ftca claim can be based on the violation of federal law.-in response to the negligence per se cause of action as a basis for the ftca claim, the government argued that no ftca claim can be based on the violation of federal law. the court acknowledged that this statement is irrefutable under the language of 28 u.s.c. 1346(b), which requires that the united states be liable under the laws of the relevant state. as the court noted, however, plaintiff's argument had a twist to it. johnson does not contend simplistically that § 6103 creates a duty the breach of which constitutes a state tort, or that the violation of that statute ipso facto creates ftca liability. rather, he asserts that, for purposes of the state tort of public disclosure of private facts, § 6103 sets a standard of care for those actors who owe the duty, and that, under texas tort law, the violation of such a statutory standard of care is negligence per se when one to whom the duty is owed is damaged by violation of this standard of care." the court analyzed the plaintiff s negligence per se argument, and agreed that the violation of section 6103 did in fact establish a state cause of action under the texas negligence per se doctrine, by creating an applicable standard of care.8 (3) the claim was barred by the "discretionary function exception" to the ftca. the court ruled that this exception "does not shield the government from liability for acts of its agents taken in furtherance of a general discretionary policy-such as the irs policy to deter tax evasion" through publicity of cases such as plaintiffis. 980 f.2d at 1503. (4) the claim was barred by the "tax assessment and collection" exception to the ftca. the court ruled that the actions of service officers in preparing and issuing press releases did not constitute the assessment or collection of taxes, so that this exception did not apply. id. at 1503-04. 80. slip opinion at 980 f.2d at 1505-06. 81. slip opinion at _. surprisingly, this argument was not discussed in the opinion of the district court, which based its finding of liability on state law theories of respondeat superior and negligent supervision of employees. johnson v. sawyer, 760 f. supp. 1216, 1231-32 (s.d. tex. 1991), aff d in part, modified in part and remanded in part, 980 f.2d 1490 (5th cir. tex. 1992). 82. judge garwood filed a strong dissent in the case, based primarily on his opinion 19931 florida tax review since the causes of action in johnson arose, the relevant federal law has been amended in a manner quite significant to the court's holding on this point. as discussed above, section 7217 was repealed, replaced by section 7431. the major difference in the two code provisions is that section 7431 authorizes an action for damages against the united states, rather than against the federal employee as under section 7217. under general principals of negligence per se, that doctrine does not apply where the legislature has already provided a civil remedy for the negligent violation of the standard set forth in the statute.83 in johnson, decided under section 7217, this was not an issue, since that statute did not address the question of a claim against the united states. section 7431 expressly provides such a claim, however, and therefore prevents the application of the doctrine of negligence per se. 2. the claim was preempted by section 7217.-holding that a remedial statute must be both comprehensive and exclusive to be preemptive of the ftca, the court found no evidence of congressional intent that section 7217 "be the exclusive remedy for each and every section 6103 violation.'" rather, the court found, section 7217 merely provides a remedy against the governmental employee for violations of section 6103, and congress did not purport to make section 7217 preemptive of the ftca" as with the negligence per se issue, subsequent changes in the law have undermined the future application of the court's reasoning on this point. the only remedy provided under section 7217 was a suit for damages against the individual; the statute was silent with regard to liability on the part of the united states. this silence enabled the johnson court, speaking in the context of an action asserting the liability of the united states, to find that the statute was not exhaustive. on this point, the provisions of section 7431, the successor to section 7217, are significantly different: section 7431 expressly provides for liability on the part of the united states. even though congress did not include any language in section 7431 regarding the exclusivity of that remedy, it is very unlikely that any court, even the fifth circuit, would find that section 7431 has not preempted ftca liability. that the majority had improperly expanded the waiver of sovereign immunity under the ftca by incorporating the entire federal code into state law under the doctrine of negligence per se. johnson, 980 f.2d at 1509 (garwood, j., dissenting). 83. see, e.g., restatement (second) of torts § 287 (1965) (providing that: "[a] provision for a penalty in a legislative enactment or an administrative regulation has no effect upon liability for negligence unless the penalty is found to be intended to exclude it"). 84. johnson, slip opinion at -, 980 f.2d at 1501. 85. id. [vol 1:10 irc §§ 7431 and 7433 m. liability for collections activities: section 7433 h.r. 4333, the house bill that eventually became the technical and miscellaneous revenue act of 1988, originally contained no provisions regarding the protection of taxpayers' rights.' the senate version of the legislation, however, contained the taxpayer bill of rights, which provided, among other protections, that a taxpayer could sue the federal government for damages for careless, reckless, or intentional disregard by an internal revenue service employee of any provision of federal law or any regulation under the code in the determination or collection of any federal tax.' the joint house and senate conference adopted the senate version, with some significant modifications,8 and the taxpayer bill of rights was subsequently enacted as section 6241(a) of the technical and miscellaneous revenue act of 1988.89 under the express language of section 7433,9 a plaintiff must show 86. h.r. conf. rep. no. 1104, 100th cong., 2d sess. 229. reprinted in 1988 u.s.c.c.a.n. 5048, 5288. 87. id. 88. h.r. conf. rep. no. 1104, 100th cong., 2d sess. 229, reprinted in 1988 u.s.c.c.a.n. 5048, 5289. the conference report noted the following significant modifications between the senate version and the version finally enacted. first, the cause of action can be based only on allegations of reckless or intentional disregard by an internal revenue service employee, and not on mere negligence or carelessness. second, the actions complained of must be in connection with the collection of tax; an action may not be maintained on actions taken in connection with the determination of tax. third, the reckless or intentional disregard must be of the code or regulations thereunder, a cause of action may not be maintained on the alleged violation of any other federal law or regulation. fourth, the conference agreement deleted a provision in the senate bill which would have barred recovery if the taxpayer was contributorily negligent. fifth, the conference agreement placed a cap on damages of $100,000, whereas the senate bill had no such limitations. sixth, jurisdiction was given to the federal district courts, and not the tax court. seventh, with the exception of the remedy provided in § 7432 for failure to release a lien, this provision would provide the exclusive remedy for recovering damages resulting from reckless or intentional disregard of a provision of the code, or a regulation promulgated thereunder, by an internal revenue service employee engaged in the collection of any federal tax. id. 89. pub. l. no. 100-647, 102 stat. 3342 (1988). 90. section 7433 provides, in pertinent part: (a) in general. if, in connection with any collection of federal tax with respect to a taxpayer, any officer or employee of the internal revenue service recklessly or intentionally disregards any provision of this title, or any regulation promulgated under this title, such taxpayer may bring a civil action for damages against the united states in a district court of the united states. except as provided in section 7432, such civil action shall be the exclusive remedy for recovering damages resulting from such actions. 19931 florida tax review the following elements to prevail in an action against the united states: (1) that an officer or employee of the internal revenue service (2) disregarded a provision of the internal revenue code or of any regulation promulgated thereunder; (3) that this disregard was reckless or intentional; (4) that the disregard occurred in connection with the collection of federal tax with respect to the plaintiff; and (5) that the disregard was the proximate result of actual direct economic damages sustained by the plaintiff. if the plaintiff proves all of these elements (as well as follows the procedural requirements of section 7433(d)), he is entitled to a maximum recovery (including costs) of $100,000. these elements impose three significant restrictions on the cause of action under section 7433. first, the statute targets only actions performed in connection with the collection process. abuses connected with the assessment process are not covered and no action will lie, regardless of how grievous the abuses may be. the senate bill did not limit the scope of the coverage to collections, but would have included abuses committed in the determination phase, as well. the legislative history of the senate bill provides some insight into the compromise bill's limitation to the collections area. the senate bill was the result of hearings dating back to 1984, in which the senate heard (b) damages. in any action brought under subsection (a), upon a finding of liability on the part of the defendant, the defendant shall be liable to the plaintiff in an amount equal to the lesser of $100,000 or the sum of(1) actual, direct economic damages sustained by the plaintiff as a proximate result of the reckless or intentional actions of the officer or employee, and (2) the costs of the action. (d) limitations. (1) requirement that administrative remedies be exhausted. a judgment for damages shall not be awarded under subsection (b) unless the court determines that the plaintiff has exhausted the administrative remedies available to such plaintiff within the internal revenue service. (2) mitigation of damages. the amount of damages awarded under subsection (b)(1) shall be reduced by the amount of such damages which could have reasonably been mitigated by the plaintiff. (3) period for bringing action. notwithstanding any other provision of law, an action to enforce liability created under this section may be brought without regard to the amount in controversy and may be brought only within 2 years after the date the right of action accrues. [vol 1:10 irc §§ 7431 and 7433 testimony regarding extensive abuses in the collections process.9' in his testimony before the senate oversight subcommittee, jule r. herbert, jr., president of the national taxpayers legal fund, identified two important reasons why the collections area is perhaps more prone to abusive practices by the internal revenue service than the area of assessment: first, although as many as fifty percent of taxpayers being audited are represented by tax practitioners, less than five percent are represented during the collection process; and, second, even when taxpayers are represented in the collection process, tax practitioners themselves know very little about internal revenue service collection procedures.92 in response to inquiries as to the necessity of providing additional taxpayer protection during the collection process, then commissioner lawrence b. gibbs made comments9" in opposition to the legislation that, ironically, effectively pointed out the need for that very protection. in attempting to show that sufficient safeguards already existed to protect taxpayers, commissioner gibbs noted that a cause of action under the bivens9 doctrine is available for taxpayers whose constitutional rights are violated by revenue agents under color of law. in an apparent effort to show that there was no real abuse by his agents, commissioner gibbs also noted that, although over 1,000 bivens actions were filed against internal revenue service employees from 1980 to 1986, none of those actions was ultimately successful.95 in light of the testimony that the subcommittee had already heard regarding the very real abuses that do occur, the astounding failure of the bivens plaintiffs could hardly have reassured the senators that no further protection was needed.96 91. see, e.g., hearings on s. 579 and s. 604, supra note 2. at 55 (testimony of thomas l. treadway) (relating abuses visited upon him and his companion during collection of taxes erroneously assessed against him, as result of which both lost their businesses). see also reprints of reader's digest articles introduced into the hearings record: john barron. tyranny in the internal revenue service, reader's dig., aug. 1967, at 42robert s. holzman with ann dear, needed: new curbs on the irs. reader's dig., jan. 1977, at 87: john barton. the tragic case of john j. hafer and the irs, reader's dig., jan. 1969. at 53. 92. taxpayer rights issues: hearings on s. 2400, supra note 4. at 92-93 (testimony of jule r. herbert, jr., president of national taxpayers legal fund). 93. hearings on s. 579 and s. 604. supra note 2. at 233 (statement of lawrence b. gibbs, commissioner, internal revenue service, accompanied by james i. owens, deputy commissioner, thomas coleman, acting associate commissioner for operations, and jack petrie, taxpayer ombudsman). 94. bivens v. six unknown named agents of fed. bureau of narcotics, 403 u.s. 388 (1971). 95. hearings on s. 579 and s. 604, supra note 2, at 243 (internal revenue service comments on taxpayer bill of rights legislation submitted by lawrence b. gibbs, commissioner of internal revenue service). 96. an outstanding example of the inadequacy of the bivens action to protect 1993] florida tax review in proposing the additional protection for taxpayers, the senate was concerned not only about the denial of taxpayers' rights but, as with sections 6103 and 7431, about the continued viability of the voluntary assessment system. in his statement submitted to the senate oversight committee, the chairman of the united states chamber of commerce small business taxation subcommittee, focusing on the service's "heavy handed collection tactics," warned that "in too many cases, honest individual and small business taxpayers have experienced such frustrations in their dealings with the service that the very idea of volunteerism in the tax collection process is threatened." 97 the other two restrictions on the cause of action provided by section 7433 reveal a marked contrast between section 7431 and section 7433 with regard to both the difficulty of establishing liability and the damages available to a plaintiff once liability is established. under section 7433, the plaintiff must prove that the internal revenue service's employee's actions were reckless or intentional. it will not suffice to show that the actions were negligent, or even grossly negligent. contrast this with the significantly lower burden of proving the "knowingly or by reason of negligence" requirement under section 7431. even after the plaintiff has scaled the higher barrier to establish liability, he is entitled only to significantly lower damages. under section 7433, the plaintiff's damages are limited to his "actual, direct economic damages" up to a maximum of $100,000; punitive damages are not authorized. this is in contrast to the damages allowed under section 7431, which include "actual" (not "actual, direct economic") damages and punitive damages, with no maximum amount. thus, the baseline lev -! of scienter on the part of the internal revenue service employee that is necessary for the finding of any liability under section 7433, would be sufficient for an award of punitive damages under section 7431, damages which are not even available under section 7433. from the conference report, it appears that these restrictions were the result of a compromise between the senate and the house. the senate bill would have required only a showing of negligence, rather than the "reckless or intentional" requirement of the compromise bill; and the senate bill had no limitation on the amount of damages recoverable. there is, unfortunately, taxpayers' rights is the case of lojeski v. boandl, 788 f.2d 196 (3d cir. 1986). the third circuit reversed the trial court's judgment in favor of the plaintiff, finding that, despite the continued and entirely unjustified harassment of the plaintiff and the liens and levies upon her property, there had been no violation of her constitutional or statutory rights. 97. hearings on s. 579 and s. 604, supra note 2, at 179-80 (statement of james d. mccarthy, chairman of the united states chamber of commerce small business taxation subcomm.). [vol 1:10 irc §§ 7431 and 7433 no public record of the conference committee's deliberations to indicate why the conferees adopted these amendments. the very existence of the limitations suggests that the conferees must have been concerned that unlimited liability would have undesirable effects of some sort. perhaps they were concerned that the government's collection activities would expose it to liability with such frequency that significant restrictions had to be imposed. it seems more likely, however, that the conferees were concerned that unlimited liability would threaten government revenues in ways more serious, and much more difficult to predict, than the relatively minor cost of damage awards. to the extent that congress intended for the statute to deter improper collection activities, and not merely to compensate injured taxpayers, it must have expected that the threat of liability would induce the internal revenue service to employ both education and coercion to ensure that its agents would not engage in any actionable activities. given this expected mechanism, it would be reasonable for congress to assume that, as the financial threat posed by the statutory cause of action was increased, the service would pursue its program of deterrence with increased vigor and that the more vigorously the program was pursued, the more likely it would be to intimidate agents into refraining from the more aggressive collection tactics, even in circumstances where they would be entirely proper. such inhibition of agents in their collection efforts would not only reduce revenues directly, it could also have an indirect effect. less aggressive collections would likely reduce the incentive for taxpayers to engage accurately and promptly in the voluntary self-assessment process. in the face of such an unpredictable cost, the limitations on damages would appear to be a reasonable compromise. in comparing governmental liability under section 7433 with the relatively unlimited liability under section 7431, it must be remembered that section 7431 does not restrict collections activities; rather, section 7431 (d)(6) expressly authorizes disclosure of return information in connection with tax administration, including collections activities.9" indeed, one of the reasons underlying the enactment of sections 6103 and 7431 was to enhance collections by encouraging voluntary compliance. very few cases have been decided under section 7433, and most of those either simply reiterate the requirements of the statute without lucidating comment of any sort, or summarily describe the court's determination of fact questions. with one exception, discussed below, the cases do not raise any significant issues. a few points worth noting have come out of the cases, however. 98. see also flippo v. united states, 670 f. supp. 638 (w.d.n.c. 1987) (holding that § 7431 does not apply to disclosures made in connection with collections activities), afftd, 849 f.2d 604 (4th cir. 1988). 19931 florida tax review as with any waiver of sovereign immunity, section 7433 must be strictly construed in the government's favor.99 as might be expected with a statute that grants the right to sue the internal revenue service, section 7433 has attracted a lot of action from tax protestors."° only the taxpayer with regard to whose tax liability the collection efforts were directed has standing to sue under section 7433.1°' "collection" is to be given its ordinary meaning: making an assessment is not a collection action; a notice and demand for payment does constitute a collection action, as does filing a notice of tax lien; where the assessment incorporates a demand for payment in same document, it is a collection action."° section 7433 waives sovereign immunity only where an agent has violated the taxing statutes or regulations. rights created by internal revenue service policy alone do not fall within the waiver; even if a plaintiff may have substantive administrative rights created by that 99. gonsalves v. irs, 975 f.2d 13 (1st cir. 1992); v-1 oil co. v. united states, 813 f. supp. 730 (d. idaho 1992). 100. see, e.g., rogers v. united states dep't of treasury, no. 91-35132, 1992 u.s. app. lexis 1570 (9th cir. jan. 28, 1992) (not for citation); zegzula v. united states, no. 9035777, 1992 u.s. app. lexis 13439 (9th cir. june 2, 1992) (not for citation). it was perhaps in recognition of this fact that congress enacted § 6673(b)(1), which authorizes the court to impose a penalty of up to $10,000 for "frivolous or groundless" positions maintained by a taxpayer in an action under § 7433. 101. god's helping hands v. united states, 92-1 u.s. tax cas. (cch) 50,262, 69 a.f.t.r.2d (p-h) 92-897 (d. minn. 1992). the procedural facts of god's helping hands are rather interesting, if irrelevant to the topic at hand. the government had filed liens against land owned by the plaintiff corporation, on the theory that the corporation was the alter ego of james and joan noske. the corporation brought this § 7433 action based on those collection efforts, but the court here dismissed the § 7433 claim for lack of standing. the court, with no expression of regret, noted the catch-22: plaintiff could possibly assert a section 7433 action if it conceded that it is in fact the alter ego of james and joan noske. by making such a concession, however, plaintiff would be conceding the validity of the tax liens and levies it challenges in this case, and its action would necessarily be without merit. 92-1 u.s. tax cas. at 84,028, 69 a.f.t.r.2d at 92-898. all but one of the noskes' own § 7433 claims were dismissed for failure to state a claim; the court granted the government's motion for summary judgment on the one remaining § 7433 claim. noske v. united states, 92-2 u.s. tax cas. (cch) 50,429 (d. minn. 1992). 102. miller v. united states, 763 f. supp. 1534 (n.d. cal. 1991). [vol 1:10 irc §§ 7431 and 7433 policy, courts cannot enforce those rights because of sovereign immunity. 10 3 one lien may give rise to causes of action under both section 7432 and section 7433: the section 7433 action could be based on the unauthorized filing of the lien, and the section 7432 action on the intentional or negligent failure to release it.'"' as discussed above, section 7433 is expressly limited to collections. the question has arisen of whether liability can be based on otherwise proper activities undertaken to collect an erroneous assessment. the federal district court in alaska addressed this question in miklautsch v. gibbs"° and held that a cause of action does lie under those circumstances. in miklautsch, the tax court had ruled that a tax shelter in which the plaintiffs had invested was a sham, and that neither the income reported nor the deductions claimed were to be given any tax effect. contrary to this ruling, the service assessed a deficiency based on the income from the tax shelter and, when plaintiffs failed to pay the deficiency, began collection procedures. the plaintiffs then filed this action, asserting governmental liability on a number of theories, including section 7433. the district court denied the government's motion to dismiss, noting, but rejecting, the service's argument that section 7433 is inapplicable where procedurally-correct collection methods are used, regardless of whether the underlying tax is correctly assessed. in rejecting that argument, the court clearly identified one of the serious shortcomings of section 7433, its limitation to collection procedures. then, without citation to authority, the court concluded that congress could not have intended such a limitation, saying: under the irs's view, the irs could arbitrarily-and without any justification whatsoever-assess a tax, and then collect on that tax with impunity so long as procedurally proper methods were employed. it was the intent of congress to protect taxpayers, not to allow the irs to wrongfully bring a person to financial ruin so long as its collection methods were procedurally correct.'06 as a matter of fact, however, this limitation is clearly, if unfortunately, the expression of congressional intent. as noted above, the senate's 103. gonsalves v. irs, 975 f.2d 13 (1st cir. 1992). 104. information resources, inc. v. united states, 950 f.2d 1122 (5th cir. 1992). 105. 90-2 u.s. tax cas. (cch) 1 50,587 (d. alaska 1990). 106. id. at 86,026. 1993] florida tax review version of the legislation had provided that an action would lie for abusive assessment practices as well as for abusive collection activities. the compromise bill, however, expressly limited the coverage to the collection process, a fact noted in the conference report.10 7 the miklautsch court also sought support for its holding in a very strained reading of the statute itself. the court turned the limiting phrase, "in connection with any collection of federal tax," on its head, reading it to allow a damages action based on any act in disregard of any provision in the code, so long as there is an eventual "forced collection" of a tax.' the court expressed its expansive reading of section 7433 as follows: under a proper interpretation of section 7433, where a tax has been wrongfully assessed, and the irs goes ahead and enforces collection on that tax, an action shall lie. it is true congress chose not to extend section 7433 to damages arising from the wrongful determination of a tax alone. yet, all this means is that where a tax is wrongfully assessed but the taxpayer voluntarily remits payment, there is no action for damages because there has been no enforced collection."° as before, the court cited no authority for this surprising proposition. the court's holding raises significant questions that must be answered before the court's interpretation of section 7433 can be applied. when does "enforced collection" begin? when does it end and "voluntary payment" begin? does the mailing of a deficiency notice constitute "enforced collection," or does that term apply only to a demand letter, or only to notices of liens and levies, or only to the actual execution of the liens and levies? if only to the last, is the service exempt from liability for any action connected with the others? if a taxpayer responds to a notice of deficiency, demand, or notice of lien or levy by paying the tax assessed, is that "voluntary payment," thus removing liability? the court, unfortunately, failed to define the two terms, "voluntary payment" and "enforced collection," which are critical to its decision and which are not used in the statute or in the legislative history. from the facts of the case and from the rationalization of its holding,"0 it appears that the 107. h.r. conf. rep. no. 1104, 100th cong., 2d sess. 229 (1988), reprinted in 1988 u.s.c.c.a.n. 5048, 5289. 108. miklautsch, 90-2 u.s. tax cas. (cch) at 86,026. 109. id. at 86,026-27. 110. in the miklautsch case itself, the collections actions complained of were the seizures of three properties owned by the plaintiffs and the levy on their bank accounts and [vol 1:10 irc §§ 7431 antd 7433 court viewed only the actual seizure of assets to be the potential source of liability for the service. apparently, under the miklautsch court's reasoning, if the service can utilize abusive assessment and collection practices well enough that the taxpayer is sufficiently terrorized or demoralized to pay an assessed tax (whether correctly or erroneously assessed) before the service has to engage in the actual seizure of assets, then there can be no liability. only where the service uses those tactics inexpertly, and is unable to coerce a "voluntary" payment, will it be liable to the taxpayer. surely this is not what congress, or even the miklautsch court, intended. it is certainly not what congress enacted in section 7433."' although the court was apparently oblivious to this effect of its ruling, it did realize that its expansive reading of the scope of section 7433, taken together with the exclusive remedy provision of that section, in fact worked to the government's benefit. indeed, the court found this to be further support for its interpretation of the statute. the court correctly noted that one clear purpose of the statute is to limit the government's liability for internal revenue service collection activities, by expressly making the remedy provided under section 7433 the exclusive damages remedy for such actions 1 2 from that jumping-off point, however, the court somehow divined that it was congress's intent that section 7433 also be the exclusive remedy for "capricious and arbitrary assessment[s]."1' the court, again, provided no authority for this conclusion, but reasoned that a contrary holding would: their grandchildren's trust accounts. id. at 86,023. in trying to justify its insertion of these concepts into the statute, the court stated: the distinction between enforced collection and voluntary payment is sensible in that a taxpayer who has voluntarily paid is not likely to suffer the severe damage that occurs when the irs brings its full collection powers to bear. moreover, a taxpayer who voluntarily makes payments usually does so in cash which can easily be recouped by way of a refund. when the irs collects an outstanding tax, it does so by seizures and levies on property, creating losses that (as this case demonstrates) cannot be recovered in an ordinary refund action. id. at 86,027. 111. the flaws in the miklautsch court's reasoning are exposed from another angle as well: where the service has engaged in the behavior of properly attempting to collect an erroneously assessed tax, the miklautsch holding would require that the government's liability stand or fall on whether the taxpayer voluntarily pays the tax prior to instituting the action. but there is no such provision in § 7433. where the government engages in improper collection activities, regardless of whether the tax is properly assessed, the taxpayer's voluntary payment of the tax is irrelevant. 112. irc § 7433(a). 113. miklautsch, 90-2 u.s. tax cas. (cch) at 86,027. 19931 florida tax review open[] the door to whatever causes of action creative lawyers could conjure up. in this case alone, plaintiffs have asserted causes of action under rico, bivens, and the federal tort claims act. under any one of these theories, the damages could well exceed $100,000. under this view, the government becomes exposed to potential liability far in excess of $100,000. such is a result congress sought to avoid." 4 because the court found that section 7433 provided the exclusive remedy for the actions complained of, the court dismissed plaintiffs' damages claims under bivens, rico, and the federal tort claims act. recognizing that "this is a hollow victory for plaintiffs,""' 5 the court appeared to express regret that it was forced to so hold, announcing with surely unintended irony, "this court cannot ignore a clear congressional mandate."' 16 the miklautsch opinion shows quite well both the need for taxpayer protection from procedurally proper collections actions based on erroneous assessments, and the fact that section 7433 does not provide that protection. the attempts by the district court to interpret that statute so as to authorize a cause of action in this situation serve only to emphasize the statutory language and legislative history expressly limiting the statute to abusive collections activities. iv. coordination of sections 7431 and 7433: overlap and gaps a. overlap as discussed above, the enactment of sections 6103 and 7431 arose out of congressional concerns that information collected by the internal revenue service was being used for purposes unrelated to proper tax administration. section 7431 does not, therefore, create a cause of action for disclosures legitimately related to tax administration, including collection efforts." '7 conversely, section 7433 is expressly limited to, and the exclusive remedy for, improper practices during the collection process. statutory construction compels the conclusion that, in a situation where both sections 114. id. 115. id. at 86,028. 116. id. one cannot help wondering if perhaps the court did not actually begin from its conclusion that congress intended that there be only limited liability in any action involving, ultimately, the collection of a tax. 117. see, e.g., elias v. united states, 91-1 u.s. tax cas. (cch) 50,040, 67 a.f.t.r.2d (p-h) 91-438 (c.d. cal. 1990), affd, 974 f.2d 1341 (9th cir. 1992); flippo v. united states, 670 f. supp. 638 (w.d.n.c. 1987), aff'd, 849 f.2d 604 (4th cir. 1988). [vol 1:10 irc §§ 7431 and 7433 might arguably apply,1 8 section 7433 controls. in the ordinary case, the courts have generally had little difficulty in reaching the same conclusion.n 9 b. gaps in coverage 1. no liability for abuses during assessment phase.-a more difficult question arises in a situation not directly addressed by either statute, where an otherwise authorized disclosure of information or otherwise proper collection effort is based on an erroneous assessment. because congress has provided no direct action for improper assessment of tax deficiencies, taxpayers have sought to mold their claims for such activities to fit the definitions of section 7431 and section 7433. although some courts have extended section 7431 liability to such situations with little apparent violence to the statutory language or legislative history," ° the same is not true with regard to section 7433 actions.' under the present statutory scheme, taxpayers have no adequate recourse for damages caused by the disregard of proper assessment procedures or by the procedurally proper collections (and, in some jurisdictions, the disclosures) that follow. the taxpayer is, of course, entitled to have the assessment reversed following an administrative orjudicial determination that it was erroneous, and to the return of the seized property (or the proceeds from the sale thereof). in many cases, however, such a limited remedy will be completely inadequate to restore the direct, economic damages sustained by the taxpayer as a result of the unjustified seizure of property and interruption of business, to say nothing of collateral injuries such as damage to the taxpayer's credit and reputation. the danger created by this gap in the coverage, which is most egregious in the collections area, is that the internal revenue service is under no direct pressure to prevent or avoid unjustified assessments or overassessments. the worst that can happen, after all, is that the service will have to 118. an example of such a situation would be where an unauthorized disclosure (to the wrong person, or of incorrect information) is made by way of a procedurally-flawed collection activity, such as in the case of a levy without proper notice to the taxpayer. 119. see, e.g., traxler v. united states, 88-2 u.s. tax cas. €i 9627, 63 a.f.t.r.2d 89-577 (e.d. cal. 1988); flippo v. united states, 670 f. supp. 638 (w.d.n.c. 1987). aff'd, 849 f.2d 604 (4th cir. 1988). 120. see supra text accompanying notes 64-67. 121. the opinion in miklautsch, discussed supra part 111, illustrates the ungainly results that obtain when a court tries to fill this gap judicially, yet still cling to a pretense of honoring the statutory language. 1993] florida tax review return property that was improperly taken, and then only if the overassessment is discovered, contested, and ruled erroneous. at least with regard to collections based on erroneous assessments, this gap in coverage cannot be judicially corrected unless the courts abandon the language and legislative history of section 7433, as demonstrated by the opinion in miklautsch.'2 the only rational and effective solution is for congress to address the issue by either expanding the coverage of section 7433 to include disregard of assessment provisions or enacting new legislation specifically directed toward assessment-based abuses. congress is, in fact, aware of this gap in the present statutory provisions. in his testimony before the senate oversight subcommittee in february of 1992, the general counsel for a national small business group stated that many of the group's members "have described the experiences of undergoing internal revenue service employment tax audits as 'living in hell,' being 'coerced by terror tactics' and as being 'victimized by legalized extortion.' ,123 among the specific abuses cited were: internal revenue service auditors unfairly contacting a taxpayer's customers and workers, which is at least intimidating to the third parties and may in fact destroy the business relationships involved; internal revenue service auditors using threats of jeopardy assessments to obtain waivers of the statute of limitations; internal revenue service auditors refusing to disclose workers' tax returns to a taxpayer even in cases where the auditors themselves have relied upon those returns to impose an employment tax liability on the taxpayer, as the workers' employer; and internal revenue service auditors using the audit process as a method of building the government's best case against 122. see supra part m. 123. taxpayer bill of rights 2: hearings on s. 2239 before the subcommittee on private retirement plans and oversight of the internal revenue service of the senate finance committee, 102d cong., 2d sess. 256, 257 (feb. 21, 1992) (testimony of harvey j. shulman, general counsel, national association of computer consultant businesses, addressing the abuses that occur during the assessment of employment taxes). [vol 1:10 irc §§ 7431 and 7433 the taxpayer, rather than as an impartial fact-gathering process. 24 legislation now pending before the house of representatives, the taxpayer rights amendments of 1993,2 addresses this problem, expanding the coverage of section 7433 to include improper actions during the assessment or determination phase as well as the collections phase. when he introduced the legislation, representative joel hefley noted that agents are not only aware of this flaw in the statutory scheme, but are in fact exploiting it. he said: what is happening here is pretty obvious. irs agents are using the knowledge that they can't be sued for actions taken during the determination process to intimidate and harass taxpayers into paying excess taxes.... until the irs actually presents an official tax bill, they are immune from recourse.... [h]arassment and mistreatment by irs agents can occur during the determination process as well as the collection process.26 the legislation proposed by representative hefley would simply insert language into the current section 7433 to authorize a cause of action for damages caused by governmental activities during the assessment phase. although this proposed amendment does possess the virtue of simplicity and does extend statutory coverage to an area now unregulated, it does not directly address the problem of collections based on erroneous assessments. the amended statute could reasonably be interpreted strictly to compartmentalize assessment activities and collection activities, since it mentions them only as separate concepts. assume, for example, the following scenario. the internal revenue service erroneously assessed a deficiency against a taxpayer. during the assessment phase, the agents engaged in no activity that could be proved to have caused any damage to the taxpayer, except that it formed the basis of the subsequent collection activities. procedurally proper collection activities do, however, result in direct economic damages to the taxpayer. a court could interpret section 7433, as amended by the proposed legislation, as indicating legislative approval of the current case law holding that the assessment and collection phases are to be kept separate and distinct. since 124. id. 125. h.r. 1145, 103d cong., 1st sess. § l(a)(l) (1993). 126. 139 cong. rec. e455, e456 (daily ed. feb. 25, 1993) (comments of rep. joel hefley, introducing the bill). 1993j florida tax review the activities during the assessment phase did not directly result in any damages, the taxpayer will be unable to collect an award for those activities; since the collection was based on an assessment, the government will not be held liable for those activities. although the amendment proposed by representative hefley is a step in the right direction, section 7433 should be amended to provide protection for the taxpayer during the assessment period, certainly, but the amendment should also clearly provide that collection activities and disclosures cannot be based on an erroneous assessment. 2. liability for negligent collections activity.-as discussed above, the protection afforded by section 7433 against the disregard of proper collection procedures is expressly limited to willful or reckless actions; the merely negligent disregard of the relevant provisions is not actionable. to escape liability, the government need only show that the internal revenue service agent involved was simply not aware of the particular provision violated. the government fisc is therefore better served, under the present statutory scheme, by maintaining a staff of poorly-informed but zealous agents to press all manner of collection tactics, proper and improper, resulting in the maximum collection of taxes without running the risk of governmental liability in the event that an abused taxpayer should protest. the expansion of liability to include negligent activities would reduce, if not eliminate, the shield of ignorance that the law now provides, encouraging the proper training and restraint of collections agents. this expanded protection for the taxpayer will, of course, have a price tag. the imposition of negligence liability under section 7433, by encouraging the proper training of agents, would lower revenues in two ways. first, conscientious agents would be informed of the law, which would restrain their more overreaching (and productive) collection activities. second, the governhment would be subjected to liability for damages for the actions of the unscrupulous or overzealous agents who continue to engage in improper collections activities even after being advised of the impropriety of those actions. the house of representatives has taken note of the omission of negligence from section 7433, and legislation is currently pending before the house to include negligent behavior within the coverage of section 7433.1 -7 curiously, the senate's 1993 taxpayer rights legislation.2 has no such provision, even though the senate proposed the inclusion of negligent actions in the original legislation leading to the enactment of section 7433 in 1988 127. h.r. 1145, 103d cong., ist sess. § l(b)(1) (1993). 128. s. 542, 103 cong., 1st sess. (1993) (taxpayer bill of rights 2). [vol 1:10 irc §§ 7431 and 7433 and again in amendments proposed in 1992,' 9 and despite being advised of the effect of its omission.130 3. limit on damages under section 7433.-as discussed above, one of the odd discrepancies between the remedy provided by section 7431 and that provided by section 7433 is that, even though a plaintiff under section 7433 has a significantly higher burden to carry regarding the willful or intentional nature of the internal revenue service employee's actions, the damages recoverable are significantly limited compared to those allowed under section 7431. under section 7433, the taxpayer is limited to a recovery of $100,000, while there is no limit on damages under section 7431; under section 7433, the taxpayer cannot recover punitive damages, which are available under section 743 1. the 1993 version of the taxpayers bill of rights 2'31 addresses the first of these limitations. it contains a provision that would raise the cap on damages under section 7433 from $100,000 to $1,000,000. if damages are limited, as they are under section 7433, to the taxpayer's "actual, direct economic damages," any further limit, even one as generous as the proposed $1,000,000, is difficult to justify. congressional insistence on maintaining a limitation on damages, especially when this provision is contrasted with section 7431, could be interpreted as an acknowledgement that unlimited liability under section 7433 would have a serious effect on government revenue, either directly through the cost of the damages awards or indirectly through the ripple effects that this liability would have on the amount of revenues collected by the internal revenue service. in any event, the limitation seems to reflect a balancing of the rights of taxpayers with some other governmental interest, which congress has never identified. barring an adequate explanation of the need for such a limitation, a more appropriate amendment would be to lift the cap on damages entirely. 129. the 1992 version of taxpayer bill of rights 2 provided for an amendment to include negligent actions in § 7433's coverage. s. 2239, 102d cong., 2d sess. § 505(a) (1992). 130. in his testimony before the senate subcommittee on oversight in 1991, david keating, executive vice-president of the national taxpayers union, noted that although congress has expanded the liability of taxpayers and tax preparers for negligent actions, "incredibly, congress refuses to require the irs to exercise reasonable caution in using its vast array of enforcement powers." taxpayers bill of rights 2: hearings on s. 2239 before the subcommittee on private retirement plans and oversight of the internal revenue service of the senate committee on finance, 102d cong., 1st sess. 135, 135 (dec. 10, 1991) (statement of david keating, executive vice-president of the national taxpayers union). 131. s. 542, 103d cong., 1st sess. § 504(a) (1993). 19931 florida tax review v. conclusion in sections 7431 and 7433, congress has taken the first steps in an effort to use the civil justice system as a check on the extensive powers of investigation and seizure which congress and the courts have granted the service. in whole, the causes of action which these statutes authorize appear to be effective tools to accomplish that end. an analysis of the statutes and a review of the case law, however, reveal some gaps and ambiguities in the coverage that must be addressed. section 7431 imposes liability for the unauthorized disclosure of return information, incorporating the substantive provisions of section 6103. the scope of this protection is not clear, however, and the courts have struggled with the question of whether it extends to information previously disclosed in public records. although legislative action might clarify the scope of coverage, this may well be an area more suitable to judicial resolution, with the evolution of standards flexible enough to adapt to a wide variety of factual settings. section 7431 is also ambiguous as to whether its prohibition applies to the unauthorized disclosure of erroneous information. the congressional purposes behind the legislation would be advanced by including such disclosures within the ambit of the statute. although the courts should have no difficulty finding that coverage in the statutory language, a few courts have, in fact, interpreted it to the contrary. the statute should be amended to remove the ambiguity. another issue that has arisen in the application of section 7431 is whether a cause of action will lie for a procedurally correct disclosure of return information made in the course of collecting an erroneous assessment. as desirable as such a cause of action may be, at least from the taxpayers' point of view, it is not provided in section 7431, which was designed to prevent the use of internal revenue service information for political and other purposes without interfering with the routine administration of taxes. it was not intended to provide a remedy for damages caused by an erroneous assessment or by the collection activities based on such an assessment. this issue is more properly addressed by section 7433, as discussed below. a final issue that arises under section 7431 is whether the government is liable for the unauthorized disclosure of return information where the unauthorized disclosure was proximately caused by the negligence, not of the person actually making the disclosure, but of other governmental officers or employees. the statute is, at best, ambiguous on this point. to further the congressional purposes, the statute should be amended to provide expressly for liability in such cases. in a sense, section 7433 is a rather broad statute, providing governmental liability for the violation of any tax provision during the collection of [vol. 1:10 19931 irc §§ 7431 and 7433 605 taxes. there are three significant limitations on this liability, however, which should be removed by amendment. first, the statute applies only to reckless or intentional violations of the law, not to negligent violations. second, the statute provides liability only for actions occurring during the collections phase of tax administration, leaving taxpayers with no remedy for abusive practices during the assessment phase or for collections based on erroneous assessments. third, the statute limits the government's liability to a maximum of $100,000. the removal of each of these limitations would further the congressional purpose of providing taxpayers statutory protection from abusive practices in the administration of taxes. the us * professor of law and co-director, center for international and comparative law, saint louis university school of law, a.b. washington university, m.a., j.d. the university of chicago. the author wishes to thank professor nancy staudt, washington university school of law, for sharing the constitutional law portion of her tax database before its publication, margaret mcdermott, associate law librarian, saint louis university school of law, mary khouri, a third year law student, now a practitioner, and lavinia pascariu, an ll.m. student, for research assistance. the author presented an early draft of this article at a faculty workshop at saint louis university school of law in september, 2003 and thanks the participants, including two visiting colleagues from the university of the ruhr, bochum, germany, dean and professor dr. roman seer and professor dr. helmut siekmann, for their comments. the author also presented a draft of this article at the critical tax theory workshop at seattle university school of law in april, 2005 and thanks the participants in the workshop and especially the organizer, professor lily kahng, for their attention and comments. finally, thanks to ilene ordower for reading, correcting grammar and commenting on the article. 259 florida tax review volume 7 2006 number 5 horizontal and vertical equity in taxation as constitutional principles: germany and the united states contrasted by henry ordower* i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261 ii. overview comparison of the german and u.s. taxing structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266 iii. the united states – constitutional arguments generally fail as to federal statutes but not state statutes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281 a. miscellaneous taxpayers’ successes . . . . . . . . . . . . . . . . . . . 282 b. bill of rights decisions – federal law challenges . . . . . . . 286 c. bill of rights cases (due process and equal protection) state law challenges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290 d. commerce clause decisions . . . . . . . . . . . . . . . . . . . . . . . . . 297 e. state-federal taxing issues . . . . . . . . . . . . . . . . . . . . . . . . . . 299 f. “frivolous” constitutional arguments . . . . . . . . . . . . . . . . . 300 2006] florida tax review 260 iv. germany – human dignity, equal rights, and due process tax decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301 a. disposable income – equal rights and human dignity . . . . 302 b. marriage penalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318 c. assessment, collection and the equality principle . . . . . . . . 323 d. retroactivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326 e. value dependent taxes and the equality principle . . . . . . . . 327 f. turnover tax and the equality principle . . . . . . . . . . . . . . . . 328 v. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 261 horizontal and vertical equity in taxation [vol.7:5 1. the tax law report for the xviith congress of the international academy of comparative law scheduled for july 2006 complements this article and provides a broader comparative review of constitutional tax law. the author of this article and general reporter for the tax program for the congress designed the congress topic: restricting the legislative power to tax: intersections of taxation and constitutional law. (program at http://www2.law.uu.nl/priv/aidc/index1.asp). for the national report from the united states that addresses some of the issues this article raises, see tracy kaye and stephen mazza, restricting the legislative power to tax, am. j. of comparative law (2005). 2. das grundgesetz in german. the term “basic law” tends to alternate with “constitution” in the literature. the basic law serves the same functions in germany as of the constitution in the united states with the material difference that the procedure for amending the basic law is simpler than the emendation procedure for the u.s. constitution. compare art. 79 of the basic law that requires a two-thirds majority in each house of parliament to change the basic law with the us procedure under art. 5 of the u.s. constitution requiring ratification by three-fourths of the state legislatures (or the electorates of three-fourths of the states). on the other hand, the basic law permits no amendments to arts. 1-20 that describe the basic rights although clarification and embellishment is permissible. article 146 anticipates that germany eventually will adopt a constitution that will replace the basic law. except as noted to the contrary, the english language text of quotations is from the press and information office of the federal government, basic law for the federal republic of germany (christian tomuschat & david curry, trans) (1998). 3. article 93 of the basic law also gives the constitutional court authority to resolve conflicts between federal and state law and between the laws of different states. 4. das bundesverfassungsgericht in german. while the german constitutional court publishes its decisions, unlike u.s. decisions, it does not disclose the names of the parties to the case. hence, german decisions become known by their citations or by some characteristic of the case. customary citation form in germany (that this article follows) is “bverge” (decisions of the federal constitutional court) followed by a volume number and a page number. 5. article 100 establishes the referral process and requires the court involved to suspend the proceedings until the federal constitutional court resolves the constitutional issue. the basic law requires referral only if the constitutional issue is critical to the outcome of the case. 6. u.s. const. art. iii, § 2. i. introduction1 germany’s basic law assigns primary jurisdiction over2 constitutional issues to germany’s constitutional court and requires other3 4 courts to suspend their proceedings and refer constitutional issues that are critical to resolution of any pending case to the constitutional court. in the5 united states, the supreme court has broad appellate and, in some cases, original jurisdiction; and its authority to review legislative action for conflict6 2006] florida tax review 262 7. marbury v. madison, 5 u.s. 137, 177 (1803) (establishing the supreme court’s power to review legislative acts for constitutionality). 8. rules of the united states supreme court, rule 10 (2005) provides discretionary supreme court review of a decision of a u.s. court of appeals or the highest court of any state by writ of certiorari. 9. nancy staudt and peter wiedenbeck recently assembled a database which identifies supreme court decisions in federal tax matters during the years 1913-2000. the database will soon be published at http://law.wustl.edu. the overall database seeks to identify all supreme court decisions addressing federal taxes during the years 19132000 and omits decisions addressing state taxes. 10. id. (identifying 157 decisions in which the court addressed constitutional questions in resolving the federal tax issue). i am grateful to professors staudt and wiedenbeck for making the constitutional decisions’ portion of the database available to me to use in this project. the total number of decisions is somewhat greater than 157, as the version of the database i used missed a few cases, including those cited infra in note152-53. see discussion infra in part iii. 11. id. the database discloses only 17 decisions in which the taxpayer won (some only partially) and several of those cases were criminal cases involving the issue of self-incrimination. 12. eisner v. macomber, 252 u.s. 189 (1920) (determining that the 16th amendment permits congress to tax only realized gain); nichols v. coolidge, 274 u.s. 531 (1927) (limiting retroactive application of the estate tax on foreseeability grounds). 13. u.s. const. amend. i-ix (protecting certain basic rights and individual liberties including freedom of speech, assembly and religion). on the history of the bill of rights generally, see akhil reed amar, the bill of rights as a constitution, 100 yale l.j. 1131 (1991). 14. no one has compiled a database of these decisions so their number is less certain than for decisions involving federal taxing statutes. 15. u.s. const. art. i, § 8, cl. 3. the commerce clause provides that congress shall have the power “to regulate commerce with foreign nations, and among the several states, . . . . ” implicit in the grant of power to the federal government is the with the constitution became clear early in the court’s history. unlike7 germany, however, lower courts also have jurisdiction to decide constitutional issues, subject of course to eventual supreme court review. 8 while the u.s. supreme court has resolved many tax controversies,9 with taxpayers raising constitutional questions in a number of cases addressing questions of federal tax law, only infrequently has the court10 found a federal taxing statute to violate a constitutionally protected right or privilege. rarely has the supreme court looked to the constitution and11 decided that a federal tax law violated the constitution. never has the12 supreme court held a federal tax law to conflict with the bill of rights.1 3 many more decisions involve challenges to state tax statutes as in conflict with the u.s. constitution. often those state law cases combine claims14 under several provisions of the constitution, including the commerce clause, due process, and equal protection. in reviewing state tax15 16 17 263 horizontal and vertical equity in taxation [vol.7:5 denial to the states of the power to burden interstate commerce, through discriminatory taxation, for example. am. trucking ass’ns v. mich. pub. serv. comm’n, 125 s. ct. 2419, 2422 (2005). 16. u.s. constitution amend. v. the due process clause reads in part: “no person shall . . . be deprived of . . . property, without due process of law. . . .” u.s. const. amend. xiv § 1 applies the requirement of “due process” to the states: “nor shall any state deprive any person of life, liberty, or property, without due process or law.” 17. u.s. const. amend. xiv, § 1, last clause. the equal protection clause reads in part: “nor deny to any person within its jurisdiction the equal protection of the laws.” the equal protection clause is not part of the 5th amendment and the supreme court has held that it does not apply to the united states. steward machine co. v. davis, 301 u.s. 548, 584 (1937) (upholding the constitutionality of the social security act). subsequently, however, the courts have determined that the equal protection clause of the 14th amendment must be read into the 5th amendment, supra note 16 (quoting the relevant part) so that the provision applies to the united states as well as the states. weinberger v. wiesenfeld, 420 u.s. 636, 638 n.2 (1975) (dictum stating that equal protection analysis under the 5th amendment is to be the same as under the 14th amendment). 18. see discussion infra in part iii b. 19. western and southern life ins. co. v. state bd. of equalization of cal., 451 u.s. 648 (1981) (holding a retaliatory state tax to be rationally related to the state’s proper objectives). see text accompanying note 262 infra. 20. allegheny pittsburgh coal co. v. county comm’n of webster county, 488 u.s. 336 (1989) (prohibiting non-uniform assessment of tax on real property); camps newfound/owatonna v. town of harrison, 520 u.s. 564 (1997) (prohibiting taxing real estate of camp for non-residents of state while exempting real estate of camps for residents). 21. nat’l bellas hess v. dep’t of revenue, 386 u.s. 753 (1967) (limiting the state’s power to impose collection responsibility for use taxes on non-resident vendors with no substantial presence in the state). 22. a database similar to the staudt and wiedenbeck database, supra note 9, is not available for the german decisions. however, the website for the university library at marburg, http://www.ub.uni-marburg.de/fachinfo/infjur03.html, discloses that statutes for compliance with constitutional standards, the court consistently has applied its “rational basis test,” its least intrusive standard of review.18 under that test, a statute is valid so long as the legislature has a rational basis for its enactment. the decisions predominantly uphold the state taxing19 statute. occasionally, the court limits states’ taxing power or their tax20 collection authority over non-residents. 21 the german constitutional court, on the other hand, has rendered many decisions in tax controversies on constitutional grounds. those22 2006] florida tax review 264 there is a looseleafed, reference work for the decisions of the german constitutional court, nachschlagewerk der rechtsprechung des bundesverfassungsgerichts. 23. decisions of constitutional court, however, have had little impact upon the structure and administration of the turnover tax (umsatzsteuer) in germany although the federal government raises roughly one-half of all its tax revenue through the value added tax. see, bundesreferat i a 6, ergebnis der 122. sitzung des arbeitskreises “steuerschätzungen” vom-4. bis 6.-november-2003 in frankfurt for statistics on distribution of collections. the turnover tax is substantially the same as a value added tax. this article addresses the absence of constitutional decisions concerning the value added tax, discussed infra in part iv f infra. 24. bverge 6, 55 (jan. 17, 1957), discussed infra in part iv b. 25. id. 26. bverge 13, 261, 271 (dec. 19, 1961, 2d senate), bverge 13, 274 (december 19, 1961, 2d senate) and bverge 13, 279 (dec. 19, 1961, 2d senate). 27. bverge 6, 273 (february 21, 1957) and bverge 8, 51 (jun. 24, 1958). 28. bverge 93, 121 (jun. 22, 1995, 2d senate) (holding the wealth tax, as applied, to violate the equality principle); bverge 93, 165 (jun. 22, 1995, 2d senate) (likewise the inheritance tax), discussed infra in part iv e. 29. bverge 82, 60 (may 29, 1990), discussed infra in part iv a. 30. bverge 110, 94 (mar. 9, 2004, 2d senate), discussed infra in part iv e. 31. article 1-12, 13 –17, and 20 describe and guarantee certain basic rights and liberties and include the protections found in the bill of rights (amendments 1-9 of the u.s. constitution). 32. see u.s. const. amend. i-ix, xiii-xv. constitutional tax decisions have played and continue to play a meaningful and ongoing role in shaping tax law and administration in germany. the23 constitutional court employs a more exacting standard of review than rational basis and requires a compelling justification for legislation that results in any distributional inequalities causing like taxpayers to pay unequal amounts of tax. in germany, constitutional protections of24 individual liberties have rendered unconstitutional such matters as mandatory joint assessment of married couples, retroactive application of rate25 increases, deductibility of political contributions, value-based taxes that do26 27 not apply the same valuation standard to all properties, income taxation of28 the subsistence minimum, and, quite recently, a tax that the government29 was unable in practice to assess and collect uniformly. 30 while the provisions protecting individual liberties and relationships are more extensive and detailed in the german constitution than in the31 united states constitution, that distinction may be one without a material32 difference. both constitutions protect substantially identical groups of human rights, including speech, assembly, religion, personal dignity, racial equality 265 horizontal and vertical equity in taxation [vol.7:5 33. article 3 of the basic law guarantees equal rights without regard to sex in germany. the u.s. constitution provides no similar protection but statutes and court decisions do. while a proposed amendment to the u.s. constitution failed to gather the approval of sufficient states to make it part of the constitution, u.s. supreme court decisions have applied equal protection analysis in striking down statutes that discriminated against women, for example, frontiero v. richardson, 411 u.s. 677 (1973) (holding that requiring service women to establish their husband’s dependency but not requiring husbands to do so with respect to their wives was unconstitutional), weinberger v. wiesenfeld, 420 u.s. 636 (1975) (holding that the social security act discriminated against women who left surviving husbands and dependent children). 34. see generally boris i. bittker and martin j. mcmahon, jr., federal income taxation of individuals ¶1.1 (1988). 35. article 3 of the basic law. 36. u.s. const. amend. xiv § 1. this amendment by its terms does not apply to the federal government but only to the states. nevertheless, the courts have applied the equal protection principle to the federal government as well. supra note 17. william b. lockhart et al., constitutional law cases – comments – questions at 1202 (1991). 37. the principle of the rule of law (das rechtstaatprinzip) flows from art. 20 of the basic law: “[t]he federal republic of germany is a democratic and social federal state . . . .” (die bundesrepublik deutschland ist ein demokratischer und sozialer bundesstaat.) 38. u.s. const. amend. v and as applied to the states through amend. xiv, § 1. 39. victor thuronyi, comparative tax law 64-100 (the hague 2003) (“thuronyi” in the following) lays a foundation for comparative constitutional law study of taxation and discusses briefly the major german and u.s. cases. 40. see discussion infra part iv. and so forth. yet, the united states constitution has played at best an33 incidental and only indirect role in the development of u.s. tax law.34 this article explores how the german constitutional court and the united states supreme court approach constitutionally based arguments in their tax decisions. the article focuses its attention primarily on distributional fairness in taxation. most cases involving fairness issues address the equal rights guarantees in germany and the corresponding equal35 protection under u.s. law or apply the rule of law provision of the german36 constitution corresponding to the due process concept in the u.s. the37 38 article seeks to develop hypotheses to account for the differences in approach and outcome between in the two courts. 39 part ii of the article introduces the basic tax equality concepts of horizontal and vertical equity, and, in providing a brief overview comparing german and u.s. taxing structures, observes that neither system protects vertical equity (although germany compensates in part for regressivity through its protected subsistence minima). part iii examines the u.s. cases40 that address or resolve constitutional arguments under the u.s. constitution. part iii emphasizes tax decisions that apply the bill of rights and the 14th 2006] florida tax review 266 41. the article will not address the relationship between germany and the other members of the european union or ongoing efforts to harmonize taxation throughout the european union. 42. basic law art. 106. 43. basic law art. 105. amendment to the constitution. part iii a describes a few taxpayer successes in non-bill of rights cases. part iii b highlights how the supreme court rejects taxpayers’ claims under the bill of rights in federal tax cases. part iii c turns to taxpayers’ challenges to state tax laws under the 14th amendment. part iii d complements the discussion of the equal protection cases in part iii c with some of the supreme court’s commerce clause decisions where the court applies a stricter equality standard. part iii e reviews issues relating to the federal government’s power to tax state activity and vice versa. a brief part iii f glances at the screening process by which the court insulates itself from “frivolous” constitutional arguments. part iv discusses decisions of the german constitutional court under the german basic law’s due process, equal protection, human dignity and social state provisions. more specifically, part iv a traces the constitutional jurisprudence limiting the power of the legislature to tax the subsistence minimum as a matter of equality and protection of human dignity. part iv b examines the decisions that interdict marriage penalties on the bases of equality and protection of marriage principles. part iv c describes and discusses the recent decision mandating practical ability to assess and collect a tax as a condition to its imposition on equality principle grounds. part iv d looks to the constitutional court’s approach to retroactive taxation under rule of law principles. part iv e observes direct application of the equality principle to the wealth and inheritance taxes. part iv f reviews some turnover tax cases to demonstrate that horizontal equity in the turnover tax is required but vertical equity is not. part v offers hypotheses to explain the reasons for the greater receptivity to constitutional challenges in the german constitutional court relative to the united states supreme court.41 ii. overview comparison of the german and u.s. taxing structures german tax legislation is predominantly federal. while the basic law reserves revenues from certain taxing sources to the states and municipalities and permits the states and municipalities to legislate in42 specific areas, in practice, taxing legislation is federal. state and local43 legislatures may set some tax rates where federal legislation authorizes them 267 horizontal and vertical equity in taxation [vol.7:5 44. for example, § 25 of the real property tax law of 1973 (aug. 8, 1973, as amended through dec. 12, 2000) [das grundsteuergestez (grstg) 1973, §25] (at http://bundesrecht.juris.de/bundesrecht/ grstg_1973/index.html)specifically authorizes the communities to establish the rate of tax, and to fix any increase from the previous calendar year no later than june 30 of any year. 45. the income tax law, version of oct. 19, 2002, as amended through jun. 6, 2005 [das einkommensteuergesetz (neugefasst durch bek. v. 19.10.2002 i 4210, (2003 i 179), zuletzt geändert durch 28 g v. 21. 6.2005 i 1818)] (estg followed by a s e c t i o n n u m b e r i n t h e f o l l o w i n g ) ( a t http://bundesrecht.juris.de/bundesrecht/estg/index.html). 46. the company tax law of 1977, version of oct. 15, 2002, as amended through dec. 12, 2004 [das körperschaftsteuergesetz 1977 (neugefaßt durch bek. v. 15.10.2002 i 4144, zuletzt geändert durch art. 4 g v. 15.12.2004 i 3416)] (kstg f o l l o w e d b y a s e c t i o n n u m b e r i n t h e f o l l o w i n g ) ( a t http://bundesrecht.juris.de/bundesrecht/kstg_1977/index.html). the customary translation of the körperschaftsteuer is the corporate tax but that seems an insufficient description for a reader in the u.s., as the tax reaches all german limited liability entities as well, including the most common entity, the gemeinschaft mit beschränkter haftung (limited liability company). kstg § 1. under u.s. tax law, limited liability entities are tax transparent (tax conduits) under subchapter k of the internal revenue code of 1986, as amended (the “code”). 47. the turnover tax law of 1980, version of feb. 2, 2005 [das umsatzsteuergesetz 1980 (neugefasst durch bek. v. 21.2.2005 i 386)] (ustg followed b y a s e c t i o n n u m b e r i n t h e f o l l o w i n g ) ( a t http://bundesrecht.juris.de/bundesrecht/ustg_1980/index.html). 48. basic law art. 106, ¶ 3. 49. id. ¶ 5a. 50. a tax is direct if the party who pays the tax also bears the burden of the tax. while an income tax is a classical direct tax, considerable disagreement concerning corporate income taxes arises because many economists argue that entities shift the burden of the tax to their customers through product and service pricing. absent competition from non-taxable sellers and service providers, neither the entity, through decreased profits, nor its owners would bear the incidence of the entity level tax. interestingly, that argument overstates the point, as even individuals who provide goods or services arguably could pass the incidence of income taxes on to their customers through higher prices so long as there is no non-taxable competition. compare thuronyi, supra note 39, at 54-7. 51. see generally klaus tipke & joachim lang, steuerrecht, ch. 9 (17th ed. köln 2002) (“tipke & lang” in the following). 52. id. ch. 11. to do so. the principal taxes, income, company, and turnover,44 45 46 47 respectively, are federal taxes that the basic law requires the federal government to share with the states and the states to share with the4 8 municipalities. the income and company taxes are direct taxes on the49 50 income of individuals in the case of the income tax and the income of51 companies in the case of the company tax. most tax commentators consider52 2006] florida tax review 268 53. id. ch. 14. 54. ustg, supra note 47, § 1. 55. id. § 15. 56. see generally tipke & lang, supra note 51, at 555. 57. value added taxes generally are imposed at each step in a distribution process on the increase in value that the taxable step adds. customarily, the taxing statute either subtracts vendor’s purchase price from the vendor’s resale price and subjects that remainder to the tax or computes the tax on the vendor’s resale price and subtracts the value added tax paid earlier in the process. thus, for example, a manufacturer buys raw materials that were subject to the value added tax and transforms them into a finished good. it is the increased value of the finished good over the raw material that is the subject of the tax. 58. sales taxes are also consumption taxes but differ from value added taxes as the taxable event is the purchase by the end user. the vendor collects the tax at point of sale by adding the tax to the sale price. sales for resale are exempt from the tax. for example, see mo. rev. stat. § 144.010 (2005) (defining sales at retail) and mo. rev. stat. § 144.020 (2005) (imposing the tax on sellers engaged in the business of selling at retail). 59. the internal revenue code of 1986, as amended (the “code” or “irc” followed by a section number in the following), is title 26 of the united states code. chapter 1 of the code unifies the treatment of all income-based taxes, both individual and entity. 60. a more significant difference lies in the administration of the tax, the united states relies on self-assessment, irc § 6011, while the tax collector assesses all taxes in germany. see generally roman seer, besteuerungsverfahren: rechtsvergleich usa-deutschland 51-58 (heidelberg 2002), for a brief explanation of the german assessment system. 61. irc § 1. 62. irc § 11. the turnover tax to be an indirect tax. its base is the value of goods or53 services and the taxable event is delivery of goods or services for compensation. the statute allows a credit for the turnover tax paid earlier in54 the delivery process if the taxpayer received the goods or services for further distribution. accordingly, the burden of the turnover tax falls upon the55 ultimate consumer because the tax becomes part of the price. the turnover56 tax is a consumption tax like the value added tax and is comparable to sales57 taxes common to almost all states in the united states.58 by comparison, the united states integrates its individual and corporate income taxes into a single taxing structure under the internal revenue code. nevertheless, the distinction between one taxing statute and59 two is insignificant. the code applies one set of rates to individuals and a60 6 1 different set to corporations. numerous other differences between the rules62 applicable to individuals and those applicable to corporations permeate chapter 1 of the code. for example, differing rules apply to various classes of deductions for individuals, but not corporations, as all corporate 269 horizontal and vertical equity in taxation [vol.7:5 63. irc § 62 applies only to individuals and allows certain deductions for individuals as adjustments to gross income, while other deductions are itemized deductions allowable in determining taxable income under irc § 63 and allowable only if the individual elects to itemize. individuals itemize if the deductions allowable under irc § 63 exceed in the aggregate the standard deduction amount under irc § 63(c). corporations’ deductions are allowable in arriving at taxable income under § 63 with no election to itemize and no standard deduction as an alternative. 64. irc § 151. 65. irc § 1(h). 66. kstg § 1. 67. subchapter s of the code, irc § 1361 et seq. corporations that may elect to be s corporations would not operate in corporate form in germany at all. most likely they would be limited liability companies (gemeinschaften mit beschränkter haftung) with stock companies (other than limited partnerships on shares – kommanditgesellschaften auf aktien) being only large, publicly traded entities in germany. 68. german limited liability companies are gemeinschaften mit beschränkter haftung (gmbh). while they are statutory entities in germany as they are in the u.s., federal law authorizes and governs them in germany. see generally the law governing limited liability companies of aug. 1, 1986, most recently amended july 19, 2002 (gmbhg in the following). 69. kommanditgesellschaften auf aktien. 70. subchapter k of the code, irc § 701 et seq. governs partnerships, both general and limited, and provides for full tax transparency so that the entities’ owners are taxable on their shares of the entities’ income and the entities are not taxable. regs. § 301.7701-3 classifies u.s. limited liability companies as partnerships for federal income tax purposes but classifies most foreign limited liability entities as associations taxable as corporations for u. s. tax purposes. u.s. partnerships and limited liability companies may elect to be associations taxable as corporations, and foreign limited liability companies, including the german gmbh, may elect to be partnerships for u.s. tax purposes. regs. § 301.7701-3(c). partnerships and limited liability companies that are publicly traded and engage in the active conduct of business rather than investment deductions are fundamentally trade or business deductions; individuals63 receive an allowance for personal exemptions and corporations do not; and64 a reduced rate of tax applies to individuals’ long term capital gains. the65 german company income tax has a much broader reach than does the u.s. corporate income tax. all corporations in germany are subject to tax at corporate level, while corporations meeting specific ownership6 6 requirements in the u.s. may elect tax transparency, so that their owners are subject to tax on the entities’ income rather than the entities themselves.67 the german tax applies as well to all entities that enjoy any form of limited liability, including limited liability companies and limited partnerships on68 shares. most similar entities in the united states such as limited liability69 companies and limited partnerships are transparent for federal income tax purposes but may elect to be taxed as corporations.70 2006] florida tax review 270 activities are treated as corporations for tax purposes. irc § 7704. regs. § 301.7701-2, 3 resolved the classification issue in the u.s. the issue has a fascinating history in the u.s. see generally w illiam s. mckee, william f. nelson & robert l. whitmire, federal taxation of partnerships and partners ¶ 3.06-3.07 (1996). 71. currently pending before congress is a proposal to replace the internal revenue code with a single, national sales tax. fair tax act of 2003, h.r. 2, 5 (108th cong. 1st sess.). see william g. gale, the national retail sales tax: what would the rate have to be?, 107 tax notes 889 (2005) (explaining the tax base and presenting economic data critical of the proposal). see generally rethinking the tax code, hearing before the joint economic committee (108th cong. 1st sess.) (nov. 11, 2003) (includes statements promoting and opposing the value added tax); edward j. mccaffery, a new understanding of tax, 103 mich. l. rev. 807 (2005) (discussing consumption taxes); john k. mcnulty, flat tax, consumption tax, consumption-type income tax proposals in the united states: a tax policy discussion of fundamental tax reform, 88 cal. l. rev. 2095 (2000) (discussing various proposals for reform, including a value added tax). 72. see infra note 168 and accompanying text (concerning whether a national consumption tax might be unconstitutional as a prohibited direct tax). 73. only alaska, montana, new hampshire and oregon do not impose a general, statewide sales tax or equivalent. 2003 all states tax handbook ¶ 210 (2003). 74. illinois uses a retail occupation tax model and delaware a gross receipts model. id. 75. 12 csr 10-3.888 (70,2006) (delivery outside the state of missouri exempt from sales tax if buyer claims exemption). 76. 2003 all states tax handbook, supra note 73, ¶ 210 77. most states impose a tax on telecommunication services. id. at ¶ 259. 78. exceptions exist for services of altering or installing a product but the imposition of the tax is not uniform from state to state. id. at ¶ 253 shows a lack of uniformity in taxation of leasing of goods, ¶ 254 repair and installation, and ¶ 255-a for alterations. although at times some legislators and tax theoreticians have proposed enactment of a national consumption tax, the united states has no71 national consumption tax. most states, however, impose a consumption tax72 in the form of a sales or gross receipts tax on the sale of goods for73 74 consumption in the state. sales of goods by an in-state vendor for delivery outside the state generally are exempt from the tax. states having a sales-75 type tax impose a complementary use tax in order to tax the consumption in the state of goods transported into the state for consumption that were not subject to sales tax in another jurisdiction. with the exception of76 telecommunications services, states generally impose no consumption-77 based tax on rendition of services within the state. accordingly, incidence78 of a consumption tax in the u.s. is far narrower than in germany. in 271 horizontal and vertical equity in taxation [vol.7:5 79. for those states that impose a statewide sales tax, rates range from colorado’s low of 2.9% to california’s high of 7.25%. california includes a uniform 1.25% local tax while other states have varying local sales taxes in addition to the statewide tax. thus, mississippi and rhode island share the high end at a state level tax of 7%. id. at ¶ 250. 80. ustg § 12. uniformity of consumption tax in germany diminishes as local governments impose specialized consumption taxes on consumption of beverages, amusements, including hunting and fishing, ownership of dogs, etc. basic law art. 105, ¶ 2a authorizes these local taxes. 81. vertical equity is a means concept – the greater the taxpayer’s means as measured by income, the greater the share of the overall income tax burden the taxpayer should bear. richard a. westin, wg&l tax dictionary at 835 (2000). in its tax decisions, the german constitutional court remains mindful of vertical, as well as horizontal, equity principles. for example, bverge 82, 60, supra note 29, at 89. 82. horizontal equity requires that identically situated taxpayers bear identical shares of the tax burden. westin, supra note 81, at 338. horizontal equity is conceptually neutral with respect to progression or regression in taxation. 83. progressive taxation injects vertical equity into the tax system by imposing a greater proportional tax burden, customarily through graduated rates, on taxpayers with greater incomes. for a concise discussion of progressive taxation in the u.s., see walter j. blum and harry kalven, jr., the uneasy case for progressive taxation (chicago 1953, revised 1963). see for germany, tipke & lang, supra note 51, at 113 (identifying the principle of redistribution of wealth through progressive taxation as a function of the social state principle, basic law art. 20, rather than the equality principle, basic law art. 3, that requires equal taxation of like situated taxpayers). for an excellent overview of the literature and problems with progressive taxation debate, see nancy c. staudt, the hidden costs of the progressivity debate, 50 vand. l. rev. 919 (1997). 84. blum & kalven, uneasy case, supra note 83, at 4. 85. u.s. federal gift and estate taxes, chapters 25 and 20 of the code respectively, are examples of taxes that are fundamentally progressive relative to wealth. relative to income, however, both the gift and estate taxes may be regressive for several reasons. gifts are excludable from the gross income of the recipient under irc § 102. gifts of appreciated property from higher income tax bracket taxpayers to lower bracket taxpayers draw less income tax upon sale of the property than they would have if the higher bracket taxpayer sold the property because the donee becomes taxable on the gain. the donee takes the donor’s adjusted basis in the property under irc § 1015 for addition, the states determine their own rates of tax on sales, so that the79 rates are not uniform as the rate is under the german turnover tax.80 vertical equity principles complement fundamental horizontal81 equity assumptions in both the german and u.s. income tax systems and82 underlie structural decisions that lead to an expressed, although not necessarily an actual, preference for progressive taxation in both countries.83 while progressive taxation is the disproportional increase in taxpayers’ tax burdens as those taxpayers’ wealth and incomes increase, this article84 addresses progressivity relative to income, rather than wealth, as it85 2006] florida tax review 272 purposes of determining the donee’s gain. gifts at death, however, eliminate the taxation of all historical gain in the property, as the donee’s adjusted basis becomes the fair market value of the property at the date of the donor’s death (or the alternate valuation date) under irc §1014. 86. westin, supra note 83, at 555. 87. estg § 32a. rates in germany climb both in steps and in a linear progression that is a function of the amount by which a taxpayer’s income exceeds the zero rate or exempt amount (grundfreibetrag). for an explanation of the rate structure, see tipke & lang, supra note 51, at 426-27. each taxpayer enjoys a basic zero bracket on the initial €7,664 of income. while the statute employs the same terminology (freibetrag – exempt amount) for the allowances for dependent children under estg § 32, for example, those amounts reduce taxable income under estg § 2, as do personal exemptions under u.s. tax law, irc § 151, and, accordingly, retard the rate progression. on the other hand, various exclusions from income such as unemployment compensation, while exempt from tax, count toward determining the rate of tax on the next euro of income. estg §32b. 88. irc § 1(a) – (d), (i). the rates set forth in irc § 1(i) will return to the rates appearing in irc § 1(a) after 2010, as provided in § 901 of the economic growth and tax relief reconciliation act of 2001, p.l. 107-16, (107th cong., 1st sess. 2001) (egtrra in the following). 89. irc § 1(h) taxes unrecaptured § 1250 gain, defined in irc § 1(h)(6), at a 25% rate and collectibles gain, defined in irc § 1(h)(5)(a), at a 28% rate. 90. irc § 1202 excludes half the gain on qualified small business stock from gross income (a zero rate) and taxes the remaining gain at 28%. 91. irc § 1(h). this net capital gain provision taxes various types of net capital gain at differing rates ranging at maximum from 15 to 28%. in addition, the range will narrow to 20 to 28% as the provisions of egtrra sunset, see supra note 88. irc §1(h)(11) treats most corporate dividends as an increase to net capital gain taxed at the lower rates. irc § 1222(11) defines net capital gain as the excess of net long term capital gains (§ 1222(7), over net short term capital losses (§ 1222(6)). 92. germany added the solidarity supplement law in 1993 and replaced in 1995 (solidaritätszuschlaggesetz 1995), currently, the applicable version was published oct. 15, 2002 and amended dec. 23, 2002. discusses the combined effect of income and consumption taxes. thus, increasing tax rates as a taxpayer’s amount of income increases signals the presence of progressive taxation. both german and u.s. personal income8 6 taxes employ graduated rate structures with positive rates in germany ranging from a minimum of just over 16% (0% if one views capital gain as income) to a maximum of 45% (a 29% range) and in the u.s. from a87 minimum of 10% to a maximum of 35% on ordinary income and, with88 exceptions for certain categories of net capital gain, a minimum of 5% to a89 90 maximum of 15% for net capital gain (a 25% range on ordinary income, but a 35% range integrating ordinary income and net capital gain). germany91 also imposes a 5.5% surtax to support the cost of reunification, but92 273 horizontal and vertical equity in taxation [vol.7:5 93. tipke & lang, supra note 51, at 390. disposition of income producing property, capital gain, is disposition of the income source, not income. thuronyi, supra note 39, at 236-7. in light of the recent constitutional court decision on assessment and collection, bverge 110, 94, supra note 30, discussed infra in part iv c, even the limited inclusion of capital gains under the german system has become narrower. 94. this observation may be somewhat surprising as one often associates a developed welfare system like germany has with tax progression. germany’s taxes are higher than u.s. taxes so that germany may support its welfare system, but they are not necessarily more progressive, just steeply progressive. 95. estg § 32a. germany does not apply differing rate schedules to married and single individuals, so that joint assessment under estg § 26b combines the incomes and then splits them into two taxpayers for computational purposes even though they remain jointly liable for the tax. joint assessment renders spouses jointly and severally liable for the combined tax debt. abgabeordnung (tax code) § 44 ¶ 1 (version of october 10, 2002, most recently amended sept. 22, 2005) (neugefasst durch bek. v. 1.10.2002 i 3866; 203 i 61 zuletzt geändert durch art. 4 abs.22 g v. 22. 9.2005 i 2809) (at http://www.gesetze-im-internet.de/ao_1977/__44.html). despite joint assessment, however, either spouse may request separate assessment on his or her separate income only at any time before payment in full of the jointly assessed tax liability. abgabeordnung § 268. 96. irc § 1(f). the rate schedules under irc § 1 (a) – (d) set the maximum rates for 1992, but the brackets adjust for the increase in the cost of living, measured by the u.s. department of labor’s consumer price index for all-urban consumers that the u.s. department of labor publishes. 97. irc § 1(a) sets forth the 1992 level of $250,000, and the bracket adjustments in 2005 under irc § 1(f) will cause the maximum rate to affect married individuals filing jointly on their incomes in excess of $326,450. rates at http://www.irs.gov/formspubs/article/0,,id=133517,00.html. for purposes of comparison, this article assumes that the euro and the dollar are equal in value. during much of 2002 a dollar was worth approximately 15% more than the euro and the converse has been true since 2003. 98. supra note 87. 99. irc § 1(a) – (d). generally does not tax capital gain. structurally, both the german and the93 u.s. income taxes appear progressive, as their rates increase with income. the u.s. income tax, however, is somewhat more progressive in its rate structure than the german income tax. under the german income tax,94 all income in excess of €52,152 (€104,304 for married individuals electing joint assessment) draws the maximum 45% rate, while under the u.s. rate95 schedule, the rate brackets are broader and adjust for inflation so that a96 married couple filing a joint federal income tax return reaches the maximum 35% rate on incremental taxable income only in excess of $326,450 for the tax year 2005. the u.s. does not use a linear progression as germany97 does, but rather a series of five rate brackets (six if one counts the zero98 99 2006] florida tax review 274 100. irc § 151. 101. irc § 63(c). 102. irc § 32 (providing a refundable credit for taxpayers within a narrow band of wage and self-employment based income). 103. lest a reader think the u.s. more generous in its welfare type benefits than germany, germany provides a broad range of direct subsidies to its low income and indigent citizens and lawful residents, including unemployment supplements, child supplements, social insurance, universal health insurance, and a government pension system. see generally claus offe, the german welfare state: principles, performance, and prospects after unification (john s. brady, beverly crawford, and sarah elise wiliarty eds. 2000), the postwar transformation of germany: democracy, prosperity, and nationhood 202 (john s. brady, beverly crawford, and sarah elise wiliarty eds., 1999). 104. irc §151(d)(4) for personal exemptions and irc § 63(c)(4) standard deduction. 105. irc §151(d)(4) reduces the personal exemptions by 2% for each $2,500 of income over a threshold amount. the threshold is $150,000 for married individuals filing joint returns. the egtrra, supra note 88, beginning in 2006, phases out the exemption’s phase out subject to the sunset under § 901 of egtrra. egtrra, supra note 88. 106. irc § 68 diminishes itemized deductions for higher income individuals thereby adding both progressivity and complexity. in addition, irc § 67 limits certain deductions to their aggregate amount in excess of two percent of the taxpayer’s adjusted gross income. the two percent floor grows with income and forces disallowance of ever greater amounts of those deductions. these features, phase-outs, and deduction limitations, increase the effective rate of tax for taxpayers with specific characteristics. some of the features create a tax bubble, that is, an increase in rate at certain income levels followed by a subsequent decrease in rate as income increases further. see generally gregory g. geisler & ernest r. larkins, current year tax laws that cause low visibility of an individual’s effective marginal tax rate, 101 tax notes 627 (2003); martin a. sullivan, the rich get soaked while the super rich slide, 101 tax notes 581 (2003). rate resulting from the combined effect of personal exemptions and the100 standard deduction ). further, the u.s. income tax includes a negative101 income tax feature for low-wage workers in the form of the earned income credit and germany does not.102 103 in addition, the personal exemption amounts and the standard deduction increase to reflect positive changes in the cost of living. in upper104 income ranges, u.s. tax rules add further progression by phasing out the deduction for personal exemptions and limiting the availability of various105 deductions for taxpayers who elect to itemize. the german concept106 corresponding to the u.s. personal exemptions are the basic exempt 275 horizontal and vertical equity in taxation [vol.7:5 107. estg § 32a establishes the grundfreibetrag. 108. estg § 32 (6) and estg § 31 assures the non-taxability of a subsistence minimum for all taxpayers without regard to overall income. 109. decisions of the german constitutional court, bverge 82, 60 (may 29, 1990), supra note 29, for example, preclude the german parliament from reducing or eliminating personal exemptions and the subsistence minimum exemption that the basic exempt amount embodies. see detailed discussion of these decisions later in part iv a. 110. extrapolating from some limited statistics available for 1998, it appears that between 4 and 5% of german taxpayers would be subject to the highest income tax rate in germany while less than one-half of one percent would reach the highest u.s. rate on a euro-dollar equivalence. verteilung der markteinkommen und der einkommensteuerschuld in deutschland: eine auswertung anhand von e i n k o m m e n s t e u e r l i c h e n v e r a n l a g u n g s d a t e n , t a b e l l e 9 2 ( a t http://www.sachverstaendigenrat-wirtschaft.de/download/ziffer/z822_846j03.pdf). 111. married taxpayers having combined income exceeding the minimum level for the maximum german rate of tax of 104,000 (on a euro-dollar equivalence) represented approximately 8% of u.s. taxpayers who filed returns in 2002. brian balcovic, high income tax returns for 2002, table 2, at http://www.irs.gov/pub/irssoi/02hiinco.pdf. note that the estimates do not include individuals who do not file returns. those with combined incomes exceeding the u.s. entrance to the top rate of $326,450 represent significantly less than 2% of returns filed, as approximately 1.89% of the u.s. returns have income in excess of $200,000 so that the number with income in excess of $300,000 is significantly smaller. id. at 6 and table a. 112. a phase-out would tax the subsistence minimum for taxpayers subject to the phase-out. taxing the subsistence minimum violates the principle established in the constitutional court decisions discussed further infra in part iv a. amount and the exempt amounts for dependent children. these107 108 exemptions are available to all taxpayers, including those with the largest incomes. 109 if one assumes middle and upper incomes in germany and the u.s. are comparable, middle-income taxpayers in germany tend to become less distinguishable from upper income taxpayers, than are their american counterparts, with respect to tax progression positioning. german middleincome taxpayers have the same basic exemption as the highest income taxpayers and the same dependency allowances as the highest income taxpayers with the same number of dependents. since they reach the maximum rate of tax at only €104,304 in the case of joint filing, they tend to pay the same proportional tax as the upper income taxpayers. the german110 income tax approaches a two-rate system applicable to all taxpayers, a zero rate on part of the income and 45% on the rest. by comparison, married u.s. taxpayers filing jointly with $104,000 of taxable income would have three brackets representing together 140% of their rate before topping out. in111 addition, the phase-out of the personal exemptions would further distinguish the middle-income taxpayer, as there is no phase-out in germany.112 2006] florida tax review 276 113. bverge 93, 121, supra note 28, at 138 translating: “die steuerliche gesamtbelastung . . . in der nähe einer hälftigen teilung zwischen privater und öffentlicher hand . . .” (referring to the estimated yield from property for purposes of the wealth tax). obviously, the split ignores the value added tax and the social insurance imposts. but see bverfge, 2 bvr 2194/99 (jan. 18, 2006), at http://www.bundesverfassungsgericht.de/entscheidungen/rs20051011_1 bvr123200, rejecting a challenge to a combined effective rate of income and municipal business (gewerbesteuer, infra note 430) exceeding 50% as violating this 50-50 principle and holding that the 50-50 principle does not establish an absolute ceiling on permissible taxation. 114. bundesministerium der finanzen referat i a 6, supra note 23, tabelle 2. see statistisches bundesamt deutschland, kassenmäßige steuereinnahmen deutschland, at http://www.destatis.de/indicators/d/lrfin02ad.htm (disclosing that the turnover tax in 2003 produced approximate 21.5% of revenues while the personal income tax produced 35.9%). adding other consumption taxes to the turnover tax, the percentage increases to 33.5%. 115. ustg § 4 (12a) exempts rent from the turnover tax except for transient use of property, hotel rooms for example. 116. in the united states as well. 117. grundsteuergesetz 1973 (grstg in the following) § 1 authorizes the communities (municipalities) to determine the rate of tax so that the rate is not uniform throughout germany. the community imposes the tax on the value of the real property, rather than directly on the rent that the owner derives from the real property, under grstg § 2. rent is the fee for services or sales price term for the price a buyer pays for the use of property. while the base for the property tax is property value rather than price for use, the real property tax, nevertheless, resembles a consumption tax in that the value of real property used to produce income is a function of the income, that is, the rent. germany establishes valuation methodology statutorily with its valuation law (bewertungsgesetz, neugefasst durch bek. v. 1. 2.1991 i 230, zuletzt geändert durch whatever progressivity the income tax introduces into the federal taxes in germany and the united states, other features of the overall tax system undercut progressivity. the constitutional court, discussing the wealth tax, stated the principle that, with respect to the individual’s production: “the total tax burdens remain . . . a division of around half for private and half for public use.” germany raises approximately the same113 amount of tax revenue with its turnover tax as it does with its income tax.114 the turnover tax diminishes the progressivity present in the income tax by placing a larger proportional tax burden on lower income taxpayers than on higher income taxpayers. lower income taxpayers lack discretionary income because they tend to have to expend all their income in order to provide for basic consumption of their necessities such as food, clothing, transportation and housing. of those necessities, only the rental expenditure for housing is exempt from the turnover tax. however, even in the case of rental housing,115 most tenants are not free from indirect taxes. tenants generally bear the116 burden of their shares of the property owner’s real property tax, as the117 277 horizontal and vertical equity in taxation [vol.7:5 art. 14 g v. 20.12.2001 i 3794, bewg followed by a section number in the following). the general valuation law confirms this relationship as valuation of residential rental property (bewg § 76 (1) 1.) refers to bewg § 79 that begins with annual income and applies a multiplier. the multiplier relates to the type of use that produces the rent. bewg § 80 refers to the statutory supplements to fix the multiplier, and the statutory supplements are a function of the size of the community and the nature and age of the building construction. 118. a rental pricing model would anticipate that rent is a function of the landlord’s costs, including property tax and maintenance, in providing the rental property plus profit, a pricing model that does not differ materially from the pricing of goods. while the landlord may fix the rent by examining the overall market, presumably the market generalizes the model. however, models for pricing rentals abound and use a variety of formulae. see, for example, bill veneris, setting rental rates is a balancing act, rental management (2004), at http://www.rentalmanagementmag.com/ newsart.asp?artid=1407; kenneth t. rosen & lawrence b. smith, the priceadjustment process for rental housing and the natural vacancy rate, 73 the am. econ. rev. 779 (1983); joseph l. pagliari, jr. & james r. webb, on setting apartment rental rates: a regression-based approach, 12 the j. of real est. res. 37 (2001). 119. ustg § 4(8) exempts the sale of corporate stocks and bonds. 120. ustg § 12 (1) 121. ustg § 12 (2) 10. 122. ustg § 12 (2) 1 and anlage (supplement). property owner passes it along with other expenses through the rental price. individuals with greater incomes may expend more overall and,118 therefore, pay more tax than the low income individual, but they are far less likely to expend all their income than are lower income individuals. since money devoted to investment does not attract the turnover tax, the greater119 one’s income, the smaller the percentage of that income that becomes subject to the turnover tax, as the taxpayer devotes an ever smaller percentage of her income to consumption. a tax burden that decreases as a proportion of income as income increases is regressive. germany’s turnover tax, unlike its income tax, has no exemption amount, but seeks to ameliorate its inherent regressivity through a dual rate system. the general turnover tax rate is 16%, but a 7% rate applies to120 many necessities including, public transportation and foodstuffs, other than121 those a vendor sells for consumption on the premises, but not clothing that1 2 2 is taxed at the full rate. the reduced rate applies without regard to the characteristics of the consumer, low income or high income. the reduced rate diminishes the tax burden on all taxpayers and may introduce limited progressivity in the middle income range, as middle income taxpayers may spend a very large percentage of their income on consumption weighted toward the higher rate items. in addition, the amount of the subsistence minimum that remains exempt from income tax for all taxpayers presumably 2006] florida tax review 278 123. exemption of the subsistence minimum occurs through various exemptions, e.g., stg § 32 (describing various exemptions [freibeträge], and the zero rate bracket [grundfreibetrag], estg § 32a). the constitutional court identifies a relationship between indirect taxes and the amount of the subsistence minimum that defines the exempt amounts. bverge 87, 153 at 156 (sept. 25, 1992, ii senat), discussed infra in the text commencing with note 385. this article discusses the dichotomy between mandatory and discretionary expenditures and the exemption of the mandatory expenditures (subsistence minimum) from the income tax further in part iv a. 124. unlike the u.s., germany does not tax capital appreciation. supra note 93. if, in order to generate a consistent measure of regressivity across taxing systems, one views capital appreciation or even only realized gains from the disposition of capital investments as income that draws a zero rate of tax, the presence of regressivity in the german system is likely to emerge relative to low income taxpayers as well as middle income taxpayers. 125. for this analysis see the appendix to this article. 126. see supra notes 72 79 and accompanying text for a discussion of those consumption taxes. 127. for example, illinois and missouri reduce the rate for food. all states tax handbook, supra note 73, at ¶ 250. 128. for example, passenger car rentals in new york and liquor in arkansas. id. 129. stewart dry goods co. v. lewis, 294 u.s. 550, reh’g. denied, 295 u.s. 768 (1935) (kentucky’s graduated rate tax on gross retail sales violated equal protection because not rationally related with any certainty to ability to pay). see discussion infra in part iii b. includes the various indirect taxes that individuals must pay. under the123 german definition of income that generally excludes capital gains,124 regressivity would arise only with respect to high-income taxpayers who invest rather than consuming their income and then only vis à vis other middle or upper income taxpayers who consume a greater percentage of their respective incomes. 125 in the u.s., consumption taxes at state level inject regressivity into the combined federal and state tax system. like the german turnover tax,126 some of the state sales taxes use dual or multiple rate structures to ameliorate the regressivity of the sales tax or burden limited types of expenditures127 more heavily. most states tax sales of goods, but not the performance of128 services under their consumption tax, leaving the taxation of services to the income tax while sales of goods are subject to both income and sales taxes. low income individuals tend to consume proportionally fewer services that do high income individuals, so that this characteristic of the sales tax system adds additional regressivity overall. the supreme court has not held regressive taxation to be unconstitutional even though it determined that a graduated state tax on retail sales violated the epc because gross sales was not a measure of profitability to which a graduated rate tax might apply.129 279 horizontal and vertical equity in taxation [vol.7:5 130. irc §§ 3101(a), 3111(a) (employee, employer respectively social security tax for old-age, survivors, and disability insurance). see steward machine co. v. davis, supra note 17, 301 u.s. 548 (1937) (determining that the social security tax neither violates the uniformity clause, despite limitations on its applicability to specific industries and numbers of employees, nor the reservation of powers to the states clause of u.s. constitution (10th amendment) and is, therefore, constitutional). some argue that the social security tax, for example, is not a tax, even though it is an involuntary imposition. see thuronyi, supra note 39, at 45 for a discussion of what constitutes a tax. 131. irc § 1401(a) (tax on self-employment income for old-age, survivors, and disability insurance). 132. irc § 1401(b) (hospital tax on self-employment income), §§ 3101(b), 3111(b) (employee, employer respectively hospital tax). 133. irc §§ 3101(a), 3121(a) (defining wages). 134. irc §§ 1401(a), 1402(a) (defining self-employment income). 135. irc § 86 taxes as much as half the social security benefits that certain middle and higher income individuals receive and thereby adds a little progressivity in connection with social security benefits. 136. irc § 1402(b) defines self-employment income as limited by the social security act § 230 contribution and benefit base so as to form the ceiling. the base does increase for inflation. similarly, irc § 3121 limits wages for purposes of irc §§ 3101(a) and 3111(a) in the same manner. 137. william g. gale & jeffrey rohaly, three-quarters of filers pay more in payroll taxes than in income taxes, 98 tax notes 119 (jan. 6, 2003). 138. supra note 102 and accompanying text. 139. h.r. rep no. 94-19, at 10 (1975); more directly, s. rep. 94-36, (94th cong., at 11 (1975) (reading in part: “[t]he credit is set at 10% in order to correspond roughly to the added burdens placed on workers by both the employee and employer social security contributions.”) 140. id. the senate report certainly suggests that senate tax writers believed that the employee bore the burden of both the employer’s and the employee’s share of social security taxes. at the federal level, moreover, the social security, self-130 employment, and medicare taxes introduce considerable regressivity into131 132 the tax laws because they tax income from wages and self-employment,133 134 but not investment, and because the social security and self-employment135 taxes do not even reach all employment and self-employment income.136 employed, low income individuals pay social security tax even when they are exempt from federal income tax. congress designed the earned income137 credit, in part, to compensate for the social security tax low wage earners138 would have to pay. through lower wages, employees tend to bear the139 burden of both their own and the employer’s share of the social security tax. 140 2006] florida tax review 280 141. for general information on german social insurance programs, see willem adema, donald gray & sigrun kahl, labour market and social policy occasional papers – no. 58 – social assistance in germany, oecd doc. jt00137448 (2003), at http://www.oecd.org/dataoecd/2/60/34004521.pdf. 142. with a contribution rate of 9.55% (19.1% total) on gross earnings up to €54,000. oecd, germany 2002 – tax-benefit country chapter – benefits and wages § 10.2 (2004), at http://www.oecd.org/dataoecd/41/43/2491133.pdf. 143. with a contribution rate of 3.25% (6.5% total) on gross earnings up to €54,000. id. 144. with a contribution rate of 7.00% (14% total) on gross earnings up to €40,500. id. 145. with a contribution rate of 0.85% (1.7% total) on gross earnings up to €40,500. id. 146. see supra note 130. 147. supra note 136 and accompanying text. germany likewise has a series of wage and self-employment income based taxes to finance social insurance programs, including a national141 pension program, unemployment insurance, universal health care142 143 insurance, and long-term care insurance. employer and employee make144 145 equal contributions with respect to the employee’s salary. while the governing statutes call the payments contributions to insurance or pension plans, the imposts are mandatory, not elective. so the payments are the equivalent of taxes as are the social security and medicare taxes in the united states. also, like the united states, the tax base in each instance relates to146 services income but not investment income, so that the series of insurance payments tends toward the regressive. germany’s social insurance contributions distinguish themselves from united states contributions in that they have very moderate wage and self-employment income caps.147 both the german and the u.s. tax systems rely heavily on an income tax to raise governmental revenues. within the income taxes, both systems appear to adopt the concept of vertical equity through progressive taxation. yet, neither the german nor the u.s. tax system consistently adheres to progressivity as fundamental to tax structure. rather, both systems permit considerable regressivity in the combined impact of assorted taxes, the u.s. with its social security and self-employment taxes and germany with its turnover tax. with that observation by way of background, notions of fairness that may underlie either or both systems must remain on the horizontal plane – tax fairness, and courts’ intervention to assure fairness remains a matter of treating like taxpayers alike. 281 horizontal and vertical equity in taxation [vol.7:5 148. e.g., regan v. taxation without representation, 461 u.s. 540 (1983) (unsuccessfully arguing that exclusion from irc § 501(c)(3) classification for lobbying denied equal protection vis á vis veterans organizations), discussed infra in text accompanying note 215. 149. nancy staudt & peter wiedenbeck, supreme court tax database (soon to be published on http://law.wustl.edu), supra note 9. the database identified 157 decisions in which the supreme court resolved a case involving federal tax law on constitutional grounds. 150. id. there are, however, cases involving state taxation that the court decided on equal protection grounds. e.g., allegheny pittsburgh coal co. v. county comm’n of webster county, 488 u.s. 336 (1989), (prohibiting non-uniform assessment of tax on real property); camps newfound/owatonna v. town of harrison, 520 u.s. 564 (1997) (prohibiting taxing real estate of camp for non-residents of state while exempting real estate of camps for residents) discussed infra part iii b. 151. nichols v. coolidge, 274 u.s. 531 (1927) (on foreseeability grounds). 152. untermyer v anderson, 276 us 440 (1928). 153. darusmont v. united states, 449 us 292 (1981) (holding that retroactive imposition within a taxable year of the minimum tax on tax preference items constitutional). see generally charles b. hochman, the supreme court and the constitutionality of retroactive legislation, 73 harv. l. rev. 692 (1960); brian e. raftery, comment: taxpayers of america unite! you have everything to lose a constitutional analysis of retroactive taxation, 6 seton hall const. l.j. 803 (1996). 154. united states v. carlton, 512 u.s. 26 (u.s., 1994) (holding that retroactive application of a technical correction to a tax statute denying taxpayer a deduction does not violate due process). iii. the united states – constitutional arguments generally fail as to federal statutes but not state statutes. although taxpayers have challenged federal tax classifications on equal protection grounds, the database for a recent empirical study of u.s.148 supreme court decision-making in tax cases discloses no case in which149 taxpayers were successful. on the other hand, the supreme court was150 receptive to a due process challenge to retroactive application of the estate tax and the gift tax as applied to transfers at death or by gift before151 152 enactment of the tax. more recently, however, retroactivity arguments challenging the minimum tax and a technical correction have failed.153 154 hence, unlike the german constitutional court, the u.s. supreme court has proven unsympathetic to applying equal protection analysis to the distributive effects of taxing statutes and has retreated from the earlier application of due process analysis to the retroactive application of tax law changes. most constitutional federal tax jurisprudence involving no criminal question developed in the early decades of the post 16th amendment years. more than two-thirds of the federal law, constitutional decisions date to 1940 2006] florida tax review 282 155. staudt & wiedenbeck’s supreme court tax database, supra note 9. 156. id. 157. id. 158. see united states v. hatter, 532 u.s. 557 (2001) (overruling evans v. gore, 253 u.s. 245 (1920), with respect to the operation of the compensation clause); see also infra note 182 discussion in accompanying text. 159. south carolina v. baker, 485 us 505 (1988), reh. den. 486 us 1062 (1988), infra note 291 discussed in accompanying text. 160. irc § 103. interest on local government obligations is also exempt from federal income taxation under irc § 103 as local governmental units derive their authority and federal law considers them to be part of the state from which they derive their authority. jewell cass phillips, municipal government and administration in america 36 (new york 1960). 161. camps newfound/owatonna v. town of harrison, 520 u.s. 564 (1997) (prohibiting taxing real estate of camp for non-residents of state while exempting real estate of camps for residents), supra note 20; metropolitan life insurance co. v. ward, 470 u.s. 869 (1985) (rejecting alabama’s tax preference for in-state insurers), discussed infra part iii c. 162. nat’l bellas hess v. dept. of revenue, 386 u.s. 753 (1967) (limiting the state’s power to impose collection responsibility for use taxes on non-resident vendors with no substantial presence in the state), supra note 21, discussed infra part iii d. 163. u.s. const. art. i, § 2, cl. 3 provides in part: “representatives and direct taxes shall be apportioned among the several states . . . according to their respective numbers . . . .” or earlier. of the post-1940 decisions, fully one-third involve criminal155 matters while none of the 1940 or previous decisions resolves a criminal issue. moreover, on federal questions, decisions predominantly have156 supported the government’s power to tax. taxpayers have won in the supreme court with constitutional arguments in only slightly more than 10% of the cases that reached the supreme court (including the criminal cases).157 and, in more recent years, the supreme court has overruled or limited its early decisions that were favorable to the taxpayer. for example, the court158 in 1988 firmly established the federal government’s power to tax interest that states pay on their indebtedness and congress’ power to limit the statutory159 exemption for interest on state obligations. taxpayers have enjoyed greater160 success in asserting limitations on a state’s power to tax residents and nonresidents differently and on transactions involving interstate commerce. 161 162 a. miscellaneous taxpayer successes the u.s. constitution requires that congress apportion direct taxes among the states. the supreme court resolved some of the uncertainty163 concerning the meaning of a direct tax as it rejected an early income tax 283 horizontal and vertical equity in taxation [vol.7:5 164. pollock v. farmers’ loan and trust co., 157 u.s. 429, 583 (1895). 165. id. at 583. 166. pollock v. farmers’ loan and trust co., 158 u.s. 601, 622 (1895). 167. id. at 622. 168. the 16th amendment reads: “the congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” recently, the subject of direct taxes and apportionment has reemerged and led to renewed debate among tax commentators with respect to proposals in congress and among tax commentators advocating national sales taxes or other consumption taxes. one commentator has argued that a consumption tax or value added tax might violate the apportionment requirement and is not covered by the 16th amendment. erik m. jensen, the taxing power, the 16th amendment, and the meaning of “incomes,” 33 ariz. st. l. j. 1057 (2001). another disagrees and insists that the direct tax/apportionment restriction had to do with slavery and has no continuing significance. calvin h. johnson, purging out pollock: the constitutionality of federal wealth or sales taxes, tax notes 1723 (dec. 30, 2002). their debate continued further in tax notes in 2003. erik m. jensen, the constitution matters in taxation, tax notes 821 (aug. 11, 2003); calvin h. johnson, barbie dolls in the archeological dig: professor johnson responds, tax notes 832 (aug. 11, 2003). more recent additions to this discussion include erik m. jensen, interpreting the 16th amendment (by w ay of the direct-tax clauses), 21 const. comm. 355 (2004); erik m. jensen, the taxing power: a reference guide to the united states constitution (westport, 2005); calvin johnson, righteous anger of the wicked states: the meaning of the founders’ constitution (cambridge, 2005); leo p. martinez, the trouble with taxes: fairness, tax policy, and the constitution, 31 hastings const. l.q. 413, 413-446 (2004). unclear from the language quoted earlier in note 163 supra is whether a value added tax model of the consumption tax might be an indirect tax and not subject to apportionment at all, despite general acknowledgment that the burden of the tax fall upon the ultimate consumer of the goods or services that are subject to the tax, so long as its rate is uniform throughout the united states. article i, § 8 [1] of the u.s. constitution grants to congress the power to tax “but all duties, imposts and excises shall be uniform throughout the united states; . . . .” other consumption tax models tax income but defer the imposition of any tax when the taxpayer invests, rather than consumes, the income. supra note 50 (discussing the distinction between direct and indirect taxes). insofar as it taxed income from real property. the court held that a tax on164 real property certainly was a direct tax and concluded that a tax on the income from real property was the same as a tax on the property itself. therefore, it was a direct tax requiring apportionment. on rehearing, the165 court extended its holding to income from personal property. taxing that166 income also was a direct tax that, absent apportionment by population, the constitution prohibited. however, the enactment of the 16th amendment167 in 1913 removed the apportionment barrier to the income tax. 168 2006] florida tax review 284 169. 252 us 189 (1920). for an extensive discussion of macomber and the constitution, see henry m. ordower, revisiting realization – accretion taxation, the constitution, macomber, and mark to market, 13 va. tax rev. 1 (1993). 170. id. in macomber, a corporation distributed a stock dividend to all common shareholders of record in the corporation, so that each shareholder’s voting and participation rights remained unchanged despite the stock dividend. the shareholders received no cash or other property. the court viewed taxing the distribution as taxing unrealized appreciation in the value of the shares. id. 171. id. 172. koshland v. helvering, 298 u.s. 441 (1936) (holding a dividend of common stock on preferred to be taxable); helvering v. gowran, 302 u.s. 238 (1937), reh’g. denied, 302 u.s. 781 (1938) (holding a distribution of preferred shares on common where preferred shares were already outstanding to be taxable). 173. irc § 1256. 174. irc § 475. 175. see, stanley s. surrey, the supreme court and the federal income tax: some implications of the recent decisions, 35 ill. l. rev. nw. u. 779 (1941); deborah h. schenk, a positive account of the realization rule, 57 tax l. rev. 355 (2004) (arguing that a realization based tax system makes sense, but rejecting any constitutional realization requirement; however, missing absence of evidence of change in the supreme court’s view of the issue since macomber) but see ordower, revisiting realization, supra note 169. in an early post-16th amendment decision, the definition of income confronted the supreme court. in eisner v. macomber, a taxpayer169 successfully challenged imposition of an income tax on corporate dividends payable in the corporation’s own shares – so-called “stock dividends.” congress expressly included stock dividends in the tax base for the income tax, but the court held that the 16th amendment did not empower congress to tax appreciation in the value of the taxpayer’s property before the taxpayer’s relationship to the property changed. it is the change in the170 taxpayer’s relationship to the property that generates the taxable event. when the taxpayer sells or exchanges the appreciated property, the taxpayer’s relationship to the property changes and a taxable event occurs. similarly, when, in the case of a stock dividend as in macomber, the taxpayers’ rights171 relative to the rights of other shareholders change or may change, a taxable event occurs. since the supreme court resolved the question in the172 taxpayer’s favor in macomber on constitutional grounds, congress nevertheless has taken several steps toward taxing unrealized appreciation in mark-to-market rules applicable to commodities contracts and inventoried173 securities. taxpayers have not challenged those statutes with the effort17 4 required to reach the supreme court and many commentators conclude that macomber is no barrier to taxing unrealized appreciation.175 285 horizontal and vertical equity in taxation [vol.7:5 176. see discussion infra part iii b. 177. the compensation clause guarantees federal judges “a compensation, which shall not be diminished during their continuance in office, . . . .” u.s. const. art. iii, § 1. 178. united states v. hatter, supra note 158, 532 u.s. 557, 571 (2001). 179. evans v. gore, 253 u.s. 245 (1920), overruled by united states v. hatter, 532 u.s. 557 (2001). 180. irc § 3101(b). 181. irc § 3101(a). 182. united states v. hatter, 532 u.s. at 576, supra note 158. 183. irc § 4461. 184. united states v. united states shoe corp., 523 u.s. 360, 367-70 (1998). 185. the export clause states: “no tax or duty shall be laid on articles exported from any state.” u.s. const. art. i, § 9, cl. 5. 186. irc § 4371. 187. united states v. ibm, 517 u.s. 843, 863 (1996). while taxpayers consistently have lost federal tax cases in which they raised bill of rights claims, taxpayers in recent years have met176 somewhat greater success with other constitutional claims. for example, the supreme court held that the compensation clause of the constitution is no177 barrier to imposition of a non-discriminatory tax on federal employees and other citizens, including judges, because there is no risk that congress might impose the tax to influence judicial decisions. in so holding, the court178 overruled its earlier compensation clause decision that broadly prohibited imposing a new tax on judges’ salaries. the decision gave taxpayers a179 partial victory by permitting extension of the medicare tax, but not the180 social security tax, to sitting federal judges. the court distinguished the181 medicare tax from the social security tax because the social security tax was discriminatory. most other federal employees could elect whether or not to participate in social security, but judges and a limited group of high-level federal employees were required to participate in social security.182 similarly, taxpayers successfully argued that the ad valorem harbor maintenance tax that the united states imposed on export shipments was183 indeed a tax that the export clause prohibited, rather than a user fee.184 185 likewise, a nondiscriminatory federal excise tax on insurance premiums186 violated the export clause insofar as it reached insurance premiums paid on export shipments. 187 2006] florida tax review 286 188. see blodgett v. holden, 275 u.s. 142 (1927) (per curiam); untermyer v. anderson, 276 us 440 (1928), supra note 152 (holding that the imposition of the gift tax on gifts completed in the year of enactment of the gift tax, but before introduction and enactment of the gift tax legislation, to be impermissible retroactive taxation). see also nichols v. coolidge, 274 u.s. 531 (1927) (imposing estate tax on gifts completed before enactment but structured that they would come within the statutory inclusion of gifts intended to take effect on death was held to be impermissible as retroactive taxation). 189. congress has since substituted an objective three year of death rule for the subjective concept of a gift in contemplation of death. irc § 2035, as amended by pub. l. no. 94-455, § 2001(a)(5) (2d sess. 1976). compare, however, schlesinger v. wisconsin, 270 u.s. 230 (1926) (rejecting a six year of death presumption of contemplation of death); heiner v. donnan, 285 u.s. 312 (1932) (rejecting a two year of death presumption of contemplation of death). the current federal statute makes no presumption of contemplation of death. rather, it simply includes gifts made within three year of death in the decedent’s gross estate. 190. milliken v. united states, 283 u.s. 15 (1931). 191. id. at 22. the court has reached a similar conclusion when confronted with inclusion of life insurance proceeds in the decedent’s estate when the decedent paid premiums. united states v. manufacturers nat’l bank of detroit, 363 u.s. 194 (1960). but where the right to proceeds of policies vested in the beneficiaries before enactment of the estate tax, the imposition of the estate tax was held to be invalid. lewellyn v. frick, 268 u.s. 238 (1925). 192. see brushaber v. union pac. r.r., 240 us 1, 24 (1916) (permitting the first income tax act to tax incomes retroactively to the date earlier the same year that the 16th amendment took effect) and blodgett v. holden, 275 u.s. 142 (1927), supra note b. bill of rights decisions – federal law challenges taxpayers enjoyed early victories with due process clause arguments against retroactive application of the gift and estate taxes to gifts the taxpayer completed before enactment of the tax. those victories seem a188 function of lack of warning to taxpayers, rather than a reflection of a fundamental limitation on retroactive tax changes. hence, the court distinguished a change in the estate tax base that included gifts in contemplation of death from precedent dealing with due process189 challenges to the unanticipated imposition of a new tax. the court190 observed that retroactive application of the change worked no injustice. gifts in contemplation of death were equivalent to transfers at death. the taxpayer reasonably could have anticipated the risk that congress would change the law to include gifts in contemplation of death, as many states already included such gifts in their inheritance tax base. compare the supreme191 court’s early decision permitting the first, post-16th amendment income tax statute to reach income the taxpayer realized during the taxable year before enactment of the statute but after adoption of the amendment to the constitution. more recent decisions have given the united states still192 287 horizontal and vertical equity in taxation [vol.7:5 188 (prohibiting retroactive application of the gift tax to a period before the congress began to consider the tax). 193. irc § 2010. 194. united states v. hemme, 476 u.s. 558, 571 (1986). 195. irc § 2035 includes completed gifts that the decedent made within three years of death in the decedent’s estate. 196. united states v. hemme, 476 u.s. at 567-568 (distinguishing blodgett v. holden, 275 u.s. 142 (1927), supra note 188, on the basis of surprise, and limiting untermyer v. anderson, 276 u.s. 440 (1928), supra note 188, to the enactment of wholly new taxes). 197. welch v. henry, 305 u.s. 134, 148 (1938). 198. united states v. carlton, 512 u.s. 26 (1994). 199. irc § 2057 (repealed in 1989). 200. carlon, 512 u.s. at 26. 201. id. greater authority to impose tax law changes retroactively. for example, reduction of the decedent’s unified estate and gift tax credit for gift tax193 exemptions the taxpayer claimed under prior law was permissible even194 though the tax benefit of the claimed exemption disappeared as the gift became part of the decedent’s estate under the three year of death rule. in195 so holding, the court expressly limited its earlier decisions to those instances in which the taxpayer had no notice of the change or contemplated change in the law and elected a course of action before congress enacted a new tax as opposed to altering an existing tax. and in upholding a retroactive196 extension of a state income tax to dividends that previously had been exempt, the court, in alluding to the planning issue with a retroactive gift tax, observed that “[w]e cannot assume that stockholders would refuse to receive corporate dividends even if they knew that their receipt would later be subjected to a new tax . . .” 197 congress generally seeks to avoid the potential retroactivity problem by announcing publicly proposed tax changes and making them effective no earlier that the date of that announcement. however, where a taxpayer planned a transaction to exploit a flaw in a statute, neither the taxpayer’s planning nor the absence of a public announcement in advance of the effective date of the change was a barrier to retroactive application of the statute as changed. the statute in question and in effect at the decedent’s198 death allowed a deduction for one-half the value of employer securities that an estate sold to an employee stock option plan. the estate purchased199 shares on the market, sold them to an employee stock option plan, and claimed the deduction – correctly applying the statutory provision as then in effect. the retroactive statutory change limited the statute to sales of shares200 that were includible in the decedent’s estate, so the estate in carlton received no deduction. the court viewed the change as a rational limitation of the201 2006] florida tax review 288 202. id. at 32. 203. “congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; . . . .” u.s. const. amend. i. 204. united states v. lee, 455 u.s. 252, 257 (1982). 205. id. at 259-60. 206. bob jones univ. v. united states, 461 u.s. 574, 592-593 (1983). 207. irc § 501(c)(3). donor may not deduct contributions to organizations that do not have tax exempt status under irc § 501(c)(3). 208. bob jones univ. v. united states, supra note 206, at 595. 209. irc § 170 allows a federal income tax deduction for gifts to charities, including churches. 210. walz v. tax com. of the city of new york, 397 u.s. 664, 674-675 (1970). 211. id. at 674. statute to those instances that congress originally contemplated reaching, with the benefit targeting transition of ownership from decedents to employees of the business in which the decedent was involved before death. retroactive application was modest and the change was not arbitrary.202 taxpayers have fared no better in the supreme court with 1st amendment based, religious freedom tax claims, than they have with due process clause claims. with respect to the establishment clause and the free exercise clause, for example, the supreme court has refused to exempt203 amish taxpayers from the social security tax, even though the court acknowledged that their religious beliefs precluded the amish from participating in any governmental social welfare system. free exercise of204 their religion had to yield to the need for uniform, nondiscriminatory taxation to provide a fiscally sound social security system. the courts similarly205 determined that religious organizations advancing racial segregation principles operated contrary to public policy and accordingly were not206 entitled to tax exempt status. the court held that the fundamental policy207 against racial discrimination means that “[r]acially discriminatory educational institutions cannot be viewed as conferring a public benefit within the ‘charitable’ concept . . .” that tax exempt status requires. 208 although the supreme court has never addressed directly the issue of whether the subsidy provided to churches through the federal income tax deduction violates the principle of church-state separation under the 1st amendment, it permitted new york’s exemption of churches from209 property taxes to stand despite the state subsidy inherent in the exemption.210 the court reasoned that the absence of an exemption might lead to greater state entanglement because “[e]limination of exemption would tend to expand the involvement of government by giving rise to tax valuation of church property, tax liens, [and] tax foreclosures. . . .” and the court has211 acknowledged that there is a subsidy in the charitable contribution deduction, 289 horizontal and vertical equity in taxation [vol.7:5 212. hernandez v. comm’r, 490 u.s. 680, 694 (1989). 213. id. at 693. 214. “congress shall make no law . . . abridging the freedom of speech . . .” u.s. const. amend. i. 215. regan v. taxation with representation, supra note 148, at 540, 545. 216. irc § 501(c)(4) exempts not-for-profit organizations that promote social welfare, among other activities, from the federal income tax. 217. generally, irc § 170(c)(2) limits the charitable contribution deduction to organizations that are public charities and exempt under irc § 501(c)(3). irc § 501(c)(3) status is unavailable to any organization that devotes a substantial part of its activities to lobbying. 218. the 14th amendment of the u.s. constitution reads in part: “nor shall any state deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws.” 219. irc § 170(c)(3) allows a charitable contribution deduction for gifts to veterans’ organizations, exempt under irc § 501(c)(19), notwithstanding their lobbying activities. 220. regan v. taxation without representation, 461 u.s. 540, supra note 148, at 550. this type of distinction does not require “strict scrutiny,” that is, a more stringent review than “rational basis,” which requires a compelling state interest to justify the classification. 221. id. at 550-551. but that the subsidy is neutral with respect to the issue of religious establishment, as it provides a deduction for gifts to all religious, as well as many secular, entities. denial of the deduction for fixed fees for212 scientology auditing, even if a fundamental religious practice, nevertheless was correct because the donor received a quid pro quo that is inconsistent with a charitable gift, and was similar to religious school tuition, for which taxpayers receive no deduction.213 a freedom of speech claim that a public interest, lobbying214 organization advanced in favor of its right to receive tax deductible contributions also failed to persuade the supreme court. the taxpayer215 enjoyed tax exempt status but its lobbying activities precluded it from216 securing that type of tax-exempt status that would allow its donors a deduction for contributions to the organization. the court also rejected the217 taxpayer’s argument that the statute denied the organization equal protection of the law relative to veterans’ organizations which could receive218 deductible contributions even though they engaged in lobbying. the court219 deferred to congress’ authority to discriminate among organizations in order to give a benefit, so long as its basis for dissimilar treatment was rational.220 the court observed that congress may have chosen for veterans’ organizations to receive additional tax benefits in the form of contributions to the organizations deductible by the donor, despite the organizations’ lobbying, because of their members’ historical service to the country.221 2006] florida tax review 290 222. on standard of review distinguishing the rational basis test from strict scrutiny that the court applies to suspect classifications, see generally lockhart et al., constitutional law, supra note 36, ch. 10. 223. the marriage penalty customarily refers to the additional tax that a married couple pays over two single individuals with the same combined income. thus, in a single income married household, joint filing permits income splitting and a lower tax than the comparable tax payable by an unmarried individual with the same income, but in a dual income married household, the combined income often causes the tax payable to be greater than the combined tax that two single individuals would pay. compare irc § 1(a) (joint filing) with irc § 1(c) (unmarried, single filing). the rate bracket size for married individuals filing joint returns is less than twice the rate bracket size applicable to single individuals. irc § 1(f)(8) phases out the marriage penalty for the 15% marginal bracket only. the statute returns to its pre-2003 formulation, thereby restoring the marriage penalty at all brackets under the general sunset provision, § 901 of the economic growth and tax relief reconciliation act of 2001, pub. l. no. 10716, § 901 (1st sess. 2001). separate filing does not eliminate the marriage penalty, as a separate rate bracket schedule applies to married individuals filing separate returns. the brackets for that schedule are exactly one-half the married filing jointly brackets and preserves the marriage penalty. irc § 1(d). 224. the court denied certiorari in one instance. johnson v. united states, 422 f.supp. 958 (n. ind. 1976), aff’d.per curium sub. nom. barter v. u.s., 550 f.2d 1239 (7th cir. 1977), cert. denied, 434 u.s. 1012 (1978). one may not assume that the denial of a petition for certiorari discloses anything concerning the supreme court’s view as to the substance of the case. compare the german constitutional court’s prohibition of mandatory joint assessment in bverge 6, 55 (jan. 17, 1957), discussed in text accompanying and following infra note 419. 225. 284 u.s. 206 (1931). c. bill of rights cases (due process and equal protection) – state law challenges the early twentieth century saw many challenges to state taxes that included or relied on claims that the state tax violated due process and equal protection under the 14th amendment. those due process and equal protection arguments met greater success when advanced against state taxing statutes than they did against federal statutes, although the supreme court deferred generally to the state legislatures’ choices with respect to their tax objects and structures. using its least intrusive standard of review, the “rational basis test,” the supreme court struck down state taxing schemes222 only when the justices thought the classifications of taxpayers or tax objects to be arbitrary. the state could classify taxpayers and treat them differently from one another as long as it had a reasonable purpose for doing so. while the united states supreme court has not addressed the issue of the so-called “marriage penalty” under the federal income tax, in223 224 hoeper v. tax commission of wisconsin, the supreme court determined2 2 5 that a wisconsin joint income taxation statute violated the due process 291 horizontal and vertical equity in taxation [vol.7:5 226. id. at 215-216. against the backdrop of hoeper, the district court in johnson v. united states, 422 f.supp. 958 (n.d. ind. 1976), supra note 224 carefully analyzed the federal marriage penalty against due process and equal protection arguments and concluded that the federal statute did not violate the constitution. the court distinguished the statute in hoeper from the federal statute that did not require married taxpayers to aggregate their incomes. id. at 967-968. the leading supreme court precedents on the issue of the right to marry and privacy within marriage, griswold v. connecticut, 381 u.s. 479 (1965) (holding that the state may not restrict the freedom of the marital unit to use birth control devices), loving v. virginia, 388 u.s. 1 (1967) (striking down a statute that prohibited marriage between individuals of different races); boddie v. connecticut, 401 u.s. 371 (1971) (including the right to divorce within the fundamental right to marriage and limiting the application of a filing fee to indigent plaintiffs), led the court to conclude that marriage was a fundamental right, so the court had to apply strict scrutiny under the equal protection clause to the taxing statute as a burden on that right. id. at 969-971. the court noted, however, that the courts give particular deference to legislatures’ design of taxing statutes and noted further that the joint bracket schedule benefits some marriages while burdening others. id. at 971-972. and see supra note 223 on the marriage penalty. pointing out that statistical evidence demonstrates that most unmarried taxpayers do not live alone, the court handily rejected the government’s argument that married taxpayers enjoy economies from maintaining a single household and can afford, therefore, to pay a higher tax. id. at 972. nevertheless, the district court upheld the statute. finding that the history of taxation provided the compelling interest necessary to support the burden on some married couples. the first income-splitting statutes permitted married individuals to pay a tax of twice the tax imposed at single rates on one-half the marital unit’s combined income, thereby doubling the bracket size for the marital unit. (germany continues to employ that true income splitting scheme with double rate brackets under its income tax. estg § 32a (5).) as a result of that structure, unmarried individuals reached the next bracket at twice the rate as married individuals with identical income in single income marriages. in order to diminish the disparity in income tax burden between single taxpayers and comparable single income marital units, congress established the married filing jointly rate schedule. further, congress sought to treat all marital units the same whether single or dual income units by adopting the married filing separately schedule. the government’s objective to achieve those two goals provided a sufficiently compelling government interest to support the marriage penalty. johnson, 422 f.supp. at 973. taxpayers’ appeal of the district court’s decision proved fruitless. aff’d. per clause. the statute in hoeper required married couples to aggregate their incomes and pay tax according to a single rate schedule applicable to both single and married taxpayers. graduated surtaxes caused the amount of tax payable to be greater than it would have been had each spouse’s income been separate from the other spouse for tax purposes. the court viewed the aggregation as causing one taxpayer to become subject to tax on another person’s income in violation of due process, as state law gave neither spouse an interest in the other’s income as community property law would. 226 2006] florida tax review 292 curium sub nom. barter v. u.s., 550 f.2d 1239 (7th cir. 1977), cert. denied 434 u.s. 1012 (1978). 227. 416 u.s. 351 (1974). 228. id. at 352. 229. id. at 352. 230. breedlove v. suttles, 302 u.s. 277 (1937), overruled by harper v. virginia state bd. of elections, 383 u.s. 663 (1966). 231. a poll tax is a capitation tax. westin, supra note 81, at 529. 232. breedlove, supra note 230, at 282. the decision precedes most of the racial discrimination cases and includes language that later decisions would eschew: “[i]n view of burdens necessarily borne by them [men] for the preservation of the race, . . . .” id. the term “race” in the decision is probably racially neutral as referring to human race, although the appellant is: “a white male citizen 28 years old.” id. at 280. 233. u.s. constitution, amend. 19, enacted in 1920, guarantees the right to vote without regard to sex. 234. breedlove, supra note 230, 302 u.s. at 284. with three justices dissenting, the supreme court expressly upheld sex-based tax discrimination at the state level against an equal protection argument in kahn v. shevin. in that case, a widower unsuccessfully227 challenged florida’s property tax exemption for widows, which did not apply to widowers. the court found that the disparity between women’s and228 men’s incomes provided a rational basis for the state distinguishing between the two and providing for a discriminatory benefit for the class of widows in order to reduce “the disparity between the economic capabilities of a man and a woman.” in an earlier decision, the court similarly upheld that a229 2 3 0 georgia poll tax exemption for women, who do not vote, against an equal231 protection challenge. the court viewed the poll tax exemption as rationally related to statutory economic responsibilities because, under georgia law, men were financially responsible for the family, and thus would bear the burden of a poll tax on both the wife and the children. the appellant did232 not raise, nor did the court address on its own, the issue of whether the tax exemption might discourage women from exercising their recently acquired franchise in order to avoid the tax. the court did emphasize that, in the233 case at hand, the poll tax was not a disguise in order to deny men the right to vote, by making payment of the tax a condition to voting registration.234 despite taxpayers’ failures to persuade the supreme court to invalidate statutes in several sex discrimination cases, there is a line of supreme court decisions prohibiting states from discriminating among classes of taxpayers. the bulk of taxpayer successes in those cases involved classifications that discriminate against non-resident taxpayers. yet, there are 293 horizontal and vertical equity in taxation [vol.7:5 235. hoeper v. tax comm. of wisconsin, 284 u.s. 206, (1931). supra note 225. 236. davis v. michigan dep’t of treasury, 489 u.s. 803, 817 (1989) (holding, on statutory not equal protection grounds, that a state may not tax retired federal employees’ pensions while exempting the retired state employees’ pensions). 237. 488 u.s. 336, 345 (1989). compare the german constitutional court ruling the wealth tax unconstitutional because the valuation of real property failed to adjust for current market values, bverge 93, 121, supra note 28, discussed infra in part iv e. 238. id. at 342-343. 239. proposition 13 was a voter initiative that added article xiiia to the california constitution in 1978. article xiiia limits ad valorem taxes to 1% of the cash value of the real property as fixed in the 1975-1976 assessment, subject to annual increase no greater than 2% per year. following a non-exempt transfer, such as a gift from parent to child, reassessment to current cash value is permissible. article xiiia also requires a vote of the people to approve any statutory tax increase in any california tax. 240. nordlinger v. hahn, 505 u.s. 1, 17-18 (1992). 241. the court rejected any higher level of scrutiny than rational basis to support the constitutional provision and implementing statutes. id. at 11. 242. id. the court did not offer this latter rational in allegheny. note that the property tax increase on sale should adversely affect the sale price, as the buyer will have to pay a comparatively high tax. moreover, the limit on assessment increases locks existing owners into their property, as moving within california is likely to cause them to pay materially higher real estate taxes. several cases, like hoeper, in which residence is not a factor. for235 236 example, in allegheny pittsburgh coal co. v. county commission of webster county, west virginia, the supreme court held that the equal237 protection clause required that the county assess property for tax purposes substantially uniformly. while no state statute specifically authorized the assessor to assess recently purchased properties at their arms’ length sale price, but not increase assessments on other properties to reflect current market values, the assessor adopted that practice. hence taxes remained stable for properties that did not change ownership and increased for properties that changed ownership. this practice created a large disparity in relative tax burden of similar properties in violation of equal protection.238 later, when similar assessment disparities arose from proposition 13 in california, the court upheld the tax. the court distinguished allegheny239 240 determining that the proposition 13 limitation that created the disparity had the rational purposes of preserving neighborhood stability and protecting241 existing owners from rapid increase in taxes. a new owner did not require that protection because the new owner could decide not to buy in light of the expected increase in tax.242 2006] florida tax review 294 243. carmichael v. southern coal & coke co., 301 u.s. 495, 513 (1937) (for example, exempting agricultural workers may be rational because of the administrative difficulties of collection). 244. louisville gas & electric co. v. coleman, 277 u.s. 32, 38 (1928). 245. id. at 40 (holding that the building and loan exemption serves the public purpose of encouraging home ownership). 246. quaker city cab co. v. pennsylvania, 277 u.s. 389, 402 (1928). 247. hill v. stone, 421 u.s. 289 (1975) (rejecting the texas dual box system that required approval of bond issues and taxes by two classes of voters, one class consisting of owners of property subject to assessment in the municipality and a second class composed of the first class plus all non-owners. the system in effect provided super-voting rights to owners.) 248. tax concept that “people with greater ability to pay should pay higher taxes.” westin, supra note 81, at 835. 249. see generally leo p. martinez, the trouble with taxes: fairness, tax policy, and the constitution. 31 hastings const. l.q. 413 (2004). 250. brushaber v. union p. r. co., supra note 192, 240 u.s. at 25 (1916). 251. steward machine co. v. davis, supra note 17, 301 u.s. 548 (1937), helvering v. davis, 301 u.s. 619 (1937). and see discussion of the regressive structure of the tax, supra, in part ii. the exclusions of specific types of workers, and of employers with fewer than eight employees, from the social security tax and accompanying state unemployment taxes did not violate the equal protection clause because the exemptions bore a rational relationship to the purpose of the act. on the other hand, the court rejected a distinction in a recording tax243 based upon the length of the mortgage and held the distinction between five years or more and less than five years to be arbitrary. yet, the court244 accepted the statute’s exemption, even for mortgages longer than five years, if the lender was a building and loan association. similarly, a business tax245 imposed on the gross receipts of a corporation but not on the gross receipts of an individual engaged in the same business was not acceptable under the equal protection clause since it was arbitrarily discriminatory. and,246 likewise, disparity in voting rights on tax matters as function of property ownership did violate equal protection. 247 the court has never held that equal protection requires vertical equity, so that equal protection neither demands progressivity nor prohibits248 regressivity in taxation. both the federal government and the states have249 great flexibility in determining their tax rates and tax bases. a progressive rate structure received express approval from the court. and, without250 addressing the regressive impact of its rate structure, the court also upheld the social security act. in the 1930s, the court heard a series of chain and251 department store cases that involved state taxes basing tax graduation upon the size of the enterprise, as measured by either revenue or number of stores 295 horizontal and vertical equity in taxation [vol.7:5 252. supra note 129. 253. id. at 557. 254. id. at 559. 255. id. at 563. 256. louis k. liggett co. v. lee, 288 u.s. 517 (1933). 257. supra note 130, at 566. 258. 294 u.s. 87 (1935). 259. id. at 97. 260. state board of tax comm’rs v. jackson, 283 u.s. 527 (1931). 261. hooper v. bernalillo county assessor, 472 u.s. 612 (1985). 262. western and southern life insurance company v. state board of equalization of california, supra note 19, 451 u.s. 648 (1981). the case also establishes that discriminatory classifications of taxpayers require only a rational state interest and basis to withstand constitutional challenge under the equal protection clause rather than meeting a higher standard of constitutional review. id. at 657. in the chain. in stewart dry goods co. v. lewis, the court took a harsh2 5 2 view of kentucky’s graduated tax imposed on gross retail sales stating that: “the operation of the statute is unjustifiably unequal, whimsical and arbitrary . . . .” the court distinguished a graduated rate structure applied to profit253 from one applied to gross revenue because gross revenue provides no information about profit. according to the court, the state’s rationale that greater sales meant a greater ability to pay the tax was not rational. the254 court expressed a strong preference for a graduated income tax or a flat rate sales tax. similarly, the court stuck down a license tax that increased in255 amount on all stores in a chain whenever the chain opened a new store in another county. to the contrary, justice cardozo, who dissented in stewart2 5 6 dry goods, wrote the majority opinion in fox v. standard oil co. of new257 jersey upholding west virginia’s graduated, flat license tax. the amount258 per unit of the west virginia tax increased as the number of units in the chain of vendors increased. the court considered the increase rationally related to the benefits that a member of a chain derives from the chain organization. similarly, a graduated fee based upon the number of stores259 under the same ownership and management withstood equal protection challenge as well. 260 the equal protection clause has played a greater role with respect to discrimination based upon residence. a new mexico statute, which provided an annual property tax exemption to vietnam war veterans who were residents in the state on a specific date, discriminated against nonresidents who later became residents and were denied equal protection to those veterans. similarly, while a retaliatory tax on out of state insurers261 passed equal protection examination in california, an alabama gross262 premiums tax that imposed a higher rate on out of state insurers in order to 2006] florida tax review 296 263. metropolitan life insurance company v. ward, supra note 161; see also wheeling steel corp. v. glander, 337 u.s. 562 (1949) (invalidating ohio’s ad valorem tax on intangible property of a foreign corporation despite the statute’s reciprocity provision). 264. id. at 878. 265. id. at 882-3. 266. allied stores of ohio, inc. v. bowers, 358 u.s. 522 (1959) (exempting out of state taxpayers who store goods in ohio from personal property tax). 267. madden v. kentucky, 309 u.s. 83 (1940) (upholding a tax on out of state bank deposits fivefold as great as the tax on in state deposits). 268. general motors corp. v. tracy, 519 u.s. 278, 306 (1997). promote alabama-based businesses violated equal protection standards.263 unlike the california tax that was designed to promote interstate commerce by discouraging other states from imposing higher taxes on out-of-state insurers, alabama’s domestic preference tax created barriers to entry into the alabama market that were “purely and completely discriminatory” against out of state insurers. moreover, the court observed that the domestic264 preference tax bore no rational relationship to the state’s objectives. while the structure of the tax encouraged out of state insurers to invest in alabama assets by reducing the tax rate relative to the level of alabama investment, it did not require alabama insurers to invest in alabama assets at all. 265 but even in those cases where geography is critical, the court is reluctant to reject a state taxing scheme when it can find a rational basis. when the tax scheme discriminates against in-state taxpayers in order to encourage investment by out-of-state taxpayers by exempting them from tax, the court finds no equal protection violation. similarly, when the tax266 discrimination directly affects residents and only incidentally non-residents because it favors in-state business, the court has relied on state legislatures’ knowledge of local conditions and collection opportunities to uphold the tax. another example of a tax that withstood the equal protection challenge267 deals with natural gas in ohio. in ohio, local distribution companies enjoy an exemption from the use tax for the natural gas while both in-state and outof-state independent producers of natural gas are not exempt. the court held that the exemption was permissible regulation of natural gas distribution in order to protect that market. 268 in an earlier decision, the court found a rational basis in vermont’s efforts to achieve a very rough equivalence between dividends from domestic corporations that were subject to vermont franchise tax and foreign corporations that were not subject to the tax. only dividends from foreign corporations were subject to income tax in vermont. yet, the discrimination against those dividends met equal protection standards because exempt vermont dividends had borne an equivalent indirect tax burden through the 297 horizontal and vertical equity in taxation [vol.7:5 269. colgate v. harvey, 296 u.s. 404 (1935). 270. id. at 422. 271. id. at 425. 272. illinois c. r. co. v. minnesota, 309 u.s. 157 (1940). 273. mich. comp. laws § 208.1 (2005), (repealed for years beginning after 2009), as in effect at the time of the case, imposed a value added tax that apportions the value added that is subject to tax in michigan for taxpayers operating in more than one state based upon three factors: property, payroll and sales. 274. trinova corp. v. michigan dep’t of treasury, 498 u.s. 358 (1991). 275. id. at 380. 276. butler bros. v. mccolgan, 315 u.s. 501, 509 (1942). 277. 7a u. l. a. 331 (1990 cum. supp.) (approved in 1957 by the national conference of commissioners on uniform state laws and the american bar association). 278. trinova corp. v. michigan dep’t of treasury, 498 u.s. at 380. franchise tax. the court observed: “absolute equality in taxation cannot be269 obtained, and is not required under the 14th amendment.” in the same270 case, however, the court held that vermont’s exemption of interest earned from vermont loans from tax discriminated against out-of-state loans in violation of the equal protection clause.271 several decisions address challenges to formulary apportionment methods that states use to reach part of the income of out of state taxpayers. the court held apportionment of railroad revenue based on the ratio of instate freight car miles to system car miles to be an acceptable method under equal protection challenge. more recently, michigan’s single business272 tax apportionment of value added to michigan in order to subject that value273 added to tax in michigan withstood both due process and commerce clause challenge that it discriminated against interstate commerce. the formula274 was internally consistent. the court approved the three factor formula for275 income and the national conference of commissioners on uniform state276 laws adopted it for income that the uniform division of income for tax purposes act apportions. since the tax is a tax on business operation in277 michigan, the apportionment formula is not unfair.278 d. commerce clause decisions many of the state taxation, equal protection cases include claims under the commerce clause as well. application of the commerce clause to taxation matters conceptually overlaps due process and equal protection to prevent several states from unfairly taxing the same resources. accordingly, the taxpayer must have sufficient contacts with the state to become subject to 2006] florida tax review 298 279. see for example national bellas hess v. department of revenue, supra note 21; see generally quill corporation v. north dakota, 504 u.s. 298 (1992) (prohibiting a state from requiring an out-of-state vendor without permanent establishment in the state and having an insufficient nexus with the state to pay use taxes on its sales into the state). 280. internet tax freedom act. act oct. 21, 1998, pub. l. no. 105-277, div c, title xi, 112 stat. 2681-719; nov. 28, 2001, pub. l. no. 107-75, § 2, 115 stat. 703, provides: sec. 1100. short title. this title may be cited as the “internet tax freedom act.” sec. 1101. moratorium. (a) moratorium. no state or political subdivision thereof shall impose any of the following taxes during the period beginning on october 1, 1998, and ending on november 1, 2003; (1) taxes on internet access, unless such tax was generally imposed and actually enforced prior to october 1, 1998; and (2) multiple or discriminatory taxes on electronic commerce. 281. eric parker, mtc to congress: stop federal preemption on internet tax issues, 108 tax notes 630 (2005) (reporting on multistate tax commission opposition to pending legislation). 282. bacchus imps. v. dias, 468 u.s. 263 (1984). the court applied this rule retroactively to georgia’s excise tax in james b. beam distilling co. v. georgia, 501 u.s. 529 (1991). 283. am. trucking ass’ns v. mich. psc, 125 s. ct. 2419 (2005). 284. allied-signal, inc. v. director, div. of taxation, 504 u.s. 768, 781 (u.s. 1992) (finding no unitary business and relying on the indicia of a unitary business: functional integration, centralization of management and economies of scale). see the state’s taxing authority. this requirement of sufficient contact with the2 7 9 state became particularly important to the increasing volume of internet commerce. congress, under the commerce clause, imposed a moratorium on taxation of internet activities that limits the states’ authority to impose tax on internet access. the multistate tax commission opposes extension of the280 moratorium, as well as further restrictions on the states’ taxing authority.281 taxpayers do win in the supreme court on commerce clause grounds when the state statute favors in-state over out-of-state taxpayers as long as the reason for the discrimination is to favor in-state individuals and businesses. for example, hawaii’s liquor excise tax discriminated against out of state producers in violation of the commerce clause. but michigan’s282 flat registration fee for trucks making deliveries in michigan did not burden commerce. taxpayers argued that the fee economically discriminated against truckers who made few deliveries in michigan, as michigan did not apportion the fee based upon mileage or some economic measure of the usage of michigan roads.283 in addition, there is a line of cases under the commerce clause that distinguishes unitary from non-unitary business. in the case of a unitary284 299 horizontal and vertical equity in taxation [vol.7:5 generally jerome r. hellerstein and walter hellerstein, state and local taxation cases and materials, 562-565 (st. paul 2001) (offering various formulations of the unitary business principle, not necessarily requiring operational interdependence but some integration of activities). 285. container corp. of am. v. franchise tax bd., 463 u.s. 159 (1983) (california’s formulary apportionment of worldwide income permissible and fair as applied to a domestic corporation): barclays bank plc v. franchise tax bd., 512 u.s. 298 (1994) (same, as applied to both domestic subsidiary of a foreign corporation and foreign corporation with foreign parent doing business in california). see, supra note 277 and accompanying text for the three factor apportionment method. 286. allied-signal, inc. v. director, div. of taxation, supra note 284; asarco, inc. v. idaho state tax commissioner, 458 u.s. 307 (1982) (rejecting the state’s attempt to apportion income from intangibles that were not part of a unitary business). 287. pollock v. farmers’ loan & trust co., 157 u.s. 429, reh., 158 u.s. 601 (1895), supra note 164. 288. id. at 619. “[s]o far as this law operates on the receipts from municipal bonds, it cannot be sustained, because it is a tax on the power of the states, and on their instrumentalities to borrow money, and consequently repugnant to the constitution.” id. at 630. 289. willcuts v. bunn, 282 u.s. 216, 229 (1931). business, the state may apportion the taxpayer’s income from its entire unitary business and tax the apportioned amount. if the business is not285 unitary, the state may tax only the income attributable to activities within the state. 286 e. state-federal taxing issues the federal government’s power to tax states, and the states’ power to tax the federal government have been issues of controversy over the years. the progression of cases demonstrates the supreme court’s retreat from its early, broad-based rejection of inter-governmental taxation. early supreme court decisions reflected the concern that the power to tax gave the federal government the power to control or destroy state and local governments, and conversely. an early case, held the income tax act of 1894287 unconstitutional as it taxed the interest on state and local bonds. in that case, the court saw no difference between taxing income and taxing the source of the income and held that congress lacked the power to tax municipal bonds. subsequently, the court held that taxing gain from the sale of state2 8 8 bonds, the interest on which was exempt from tax, would not undermine the state’s ability to borrow or cost of borrowing. more recently, the supreme289 court overruled that part of the holding in pollack v. farmers’ loan and 2006] florida tax review 300 290. supra note 164 at 583. 291. south carolina v. baker, supra note 159, at 505, 525. 292. collector v. day, 78 u.s. 113, 128 (1871). 293 new york ex rel. rogers v. graves, 299 u.s. 401 (1937). 294. james v. dravo contracting co., 302 u.s. 134 (1937) (permitting taxation of income from federal government contracts); metcalf & eddy v. mitchell, 269 u.s. 514 (1926) (permitting taxation of income from state government contracts). 295. mcculloch v. maryland, 17 u.s. 316 (1819) (prohibiting the state of maryland from taxing a united states bank). 296. graves v. new york, 306 u.s. 466, 483 (1939). 297. id. at 484-485. 298. davis v. michigan dep’t of treasury, 489 u.s. 803, 817 (1989) (holding that exemption of state retirees’ pensions from the state income tax while taxing federal retirees’ pensions violates the constitutional principle of intergovernmental tax immunity). 299. supra note 5 and accompanying text. 300. see discussion of discretionary jurisdiction by writ of certiorari supra note 8 and accompanying text. trust and determined that congress could choose to tax interest on state290 obligations. 291 taxation of the compensation of state employees followed a like development. initially, the court determined that taxing the salary of a state judge was impermissible taxation of the state, authority that the constitution reserved to the state itself. similarly, the court held that a state may not tax292 an employee of the federal government. but the court gradually narrowed293 the limitation and ultimately overruled its early decisions, determining that294 intergovernmental tax immunity doctrine was not a barrier to a non-295 discriminatory tax on the salaries of federal employees. such a non-296 discriminatory tax poses no threat to governmental functions. if, however,297 the tax discriminates in favor of employees of the state taxing government or against employees of federal government, it is unconstitutional not as a matter of equal protection, but as a matter of the intergovernmental tax immunity principle. discriminatory taxes potentially do undermine298 governmental functions by placing a greater burden on them than on state functions. f. “frivolous” constitutional arguments many constitutional claims that the german constitutional court might decide will never reach the supreme court because the u.s. supreme court has greater control over its docket than does the german constitutional court. even if a taxpayer makes a strong constitutional argument, the299 taxpayer may not compel the supreme court to hear the argument. lower300 301 horizontal and vertical equity in taxation [vol.7:5 301. graves v. comm’r, 579 f.2d 392 (6th cir. 1978), cert. denied, 440 u.s. 946 (1979) (religious convictions against war did not support quakers’ claim for a war tax credit). 302. broad range of cases. see generally marjorie e. kornhauser, legitimacy and the right of revolution: the role of tax protests and anti-tax rhetoric in america, 50 buffalo l. rev. 819 (2002). 303. supreme court rule 10, supra note 8. 304. part iii c supra. 305. davis v. michigan dep’t of treasury, supra note 299. 306. supra part iii. 307. part iv a infra. 308. bverge 93, 121 (jun. 22, 1995, 2d senat) (holding that the valuation principles of the wealth tax violate art. 3 (equal rights) and the tax is confiscatory in violation of art. 14 (property rights guarantee) as it applies to unproductive property); bverge 93, 165 (jun. 22, 1995, 2d senat) (holding valuation principles in inheritance and gift tax laws inconsistent with art. 3 (equal rights) as they do not reflect current values of all properties fairly). discussion infra part iv e. see also thuronyi, supra note 39, at 329-30. courts reject religious freedom arguments and protester arguments against301 the validity of the income tax and social security tax. 302 the trend in the supreme court seems non-interventionist. legislatures are best suited to make decisions with respect to tax classifications and structures. while the court continues to accept cases where there is a conflict in the circuits concerning the interpretation of a tax statute, the constitution generally no longer comes into play unless a state303 taxing statute treats out-of-state taxpayers or federal employees materially304 less favorably than its residents or state employees.305 v. germany – human dignity, equal rights and due process tax decisions as the u.s. supreme court applies an unintrusive, rational basis review to constitutional questions in tax controversies, the german306 constitutional court examines tax legislation with a more critical eye. unlike the supreme court’s inactive role at the intersection of taxation and constitutional law development, the constitutional court has been instrumental in shaping fundamental elements of german income tax law307 and has prompted the legislature to abolish wealth, gift and inheritance taxes. the supreme court has grafted few constitutional limitations onto308 federal and state governments’ taxing authority. only the most arbitrary legislative selections of structure, base or taxpayer classifications fail to meet the supreme court’s constitutional examination. dissimilarly, the german constitutional court has applied germany’s basic law expansively and comprehensively to tax controversies. the court aggressively limits 2006] florida tax review 302 309. see discussion supra in part ii. 310. basic law art. 1 ¶ 1. 311. basic law art. 20 ¶ 1. 312. bverge 40, 121, 133 (jun. 18, 1975) (determining that the employment insurance fund need not provide for disabled orphans beyond age 25 and allowing the legislature to determine how to provide assistance to such individuals so long as each citizen receives social assistance to provide a subsistence consistent with human dignity), and, from the tax perspective, see bverge 82, 60, 85, discussed in detail infra commencing with the text accompanying note 357 (requiring the exemption of a subsistence minimum from the income tax). an early case, however, did not support the premise of a state subsistence guarantee. bverge 1, 97, 104 (dec. 19, 1951, 1st senat) (denying a remedy under the human dignity, equality, family protection and social state principles for inadequate social welfare assistance to a war widow with dependent children who was unable to work). 313. bverge 40 at 133 translating “die mindestvoraussetzungen für ein menschenwürdiges dasein.” 314. bverge 107, 27 (dec. 4, 2002). legislative authority in tax matters. the constitutional court has actively reviewed german federal tax legislation and has identified numerous basic law limitations upon the german parliament’s freedom to structure tax legislation, including a strict concept of equality in taxation under horizontal equity principles. but, while mindful of issues of vertical equity, the constitutional court has not read the basic law to require vertical equity; so that both progressive tax structures like the income tax and regressive tax structures like the turnover tax inhere simultaneously in the german tax law. 309 a. disposable income – equal rights and human dignity the first article of the basic law protects human dignity: “[h]uman dignity shall be inviolable. to respect and protect it shall be the duty of all state authority.” combined with the social state principle, the310 311 constitutional court determined that the state must guarantee each citizen a subsistence amount consistent with human dignity. on the tax side, this312 principle that the state has a duty to assure each citizen “the basic needs for a humane and dignified existence” grew into a limitation on the power of the313 state to tax non-disposable income. as the discussion in the succeeding paragraphs clarifies, non-disposable income is that portion of the citizen’s income that the citizen must dedicate to providing the family with the necessities of life. expenditures necessary to producing the income diminish income available for necessities. a recent decision of the constitutional court develops from and elaborates upon the constitutional protection of non-disposable income.314 under the german income tax law, taxpayers who maintain a second 303 horizontal and vertical equity in taxation [vol.7:5 315. estg § 9 ¶ 1, nr. 5. 316. family separation payments (trennungszuschläge) that do not exceed the amount deductible for duplicative living expenses are excludable. estg § 3 nr. 13. 317. id. and estg § 9 ¶ 1, nr. 5. 318. bverge 107, 27 at 37 (discussing the reasoning of the federal financial court (bundesfinanzhof) for rejecting the taxpayers’ appeals of adverse lower court rulings). the federal financial court (bundesfinanzhof) is the highest appellate court for tax matters. 319. irc § 162(a). u.s. taxpayers may deduct their expenses for meals and lodging when they are away from home on business. while the u.s. statute addresses the matter as expenses of travel away from home on business and does not grant expressly a duplicative living expense deduction, the statute limits the concept of temporarily away from home on business to a one year duration. 320. id. after a year at most, the taxpayer’s tax home shifts to the place of employment. note, however, that germany views some expenses as related to income production and deductible that the u.s. views as wholly personal and non-deductible, commuting expenses for example. compare regs. § 1.162-2(e) with estg § 9 ¶ 1, nr. 4. 321. estg § 3 nr. 13 and § 9 ¶ 1, nr. 5. household because their place of employment is remote from the location of their principal residence may deduct the duplicative living expenses as an expense of income production. similarly, taxpayers who receive315 supplementary payments from their employers to compensate for the additional cost of a second household when the employer assigns the employee temporarily to a remote location may exclude the payments from their income. in 1995, effective for the tax year 1996, the legislature added316 a durational limit to the deduction or exclusion, so that expenditures for the second residence after two years of employment at the remote location ceased to be deductible and supplementary payments ceased to be excludable. designed to limit revenue loss from the dual household317 deduction and the exclusion from income of the supplementary payments, the durational limit assumed that taxpayers ordinarily would relocate their permanent residence to the employment location when the term of employment became permanent. more than two years suggests permanence and predominating personal rather than business reasons for continuing dual household maintenance. united states’ tax law follows a similar pattern318 with respect to the deduction for temporary living expenses while an individual is away from home on business, although the durational limit in a single location is one year. however, unlike germany, the united states319 allows no deduction to a u.s. taxpayer who changes her permanent place of employment even when separated from her family.320 a married taxpayer whose principal place of employment differed from his spouse’s principal place of employment successfully challenged the durational limit under the german income tax law. the taxpayer was a321 2006] florida tax review 304 322. bverge 107, 27 at 35. 323. estg § 9, ¶ 1, nr. 5.in addition to the deduction for duplicative living expenses allows a deduction for the cost of travel to the principal residence and back to the place of employment weekly. 324. bverge 107, 27 at 35-6. 325. estg §3 , nr. 13. the separation payment is one to compensate the taxpayer for duplicative living expenses when the assignment is not sufficiently permanent to support permanent relocation. 326. the equality principle (german: gleichheitssatz) is in art. 3, ¶ 1 of the basic law and reads as follows: “[a]ll persons shall be equal before the law.” 327. bverge 107, 27 at 46-7. 328. id. the court may emphasize income taxation because the case before it is an income tax case but, more likely, because other taxes, especially the turnover tax, by their nature tend to be regressive and, accordingly, vertically inequitable. see discussion of regressivity in the german tax system supra in part ii. 329. id. at 46. author’s translation. emphasis added. 330. id. at 47. professor who changed positions from a university in frankfurt (main), germany to berlin, germany, and his self-employed wife, for valid business reasons, retained her geographical center of business activity and household in frankfurt. the professor maintained a secondary, smaller residence in322 berlin and sought to deduct his expenses for maintaining this residence and for weekly trips home to frankfurt. in a companion case, the taxpayer was323 a criminal commissioner whom the state of rhineland-palatinate assigned to a national office in berlin and who received a separation payment from the324 state. the taxpayer sought to exclude this separation payment from income. in both instances, the constitutional court concluded that the3 2 5 durational limitation violated the equality principle of the basic law.326 the constitutional court’s decision built upon a fifty-year decisional history under the equality principle. while the court identified the fundamental taxation guidelines of horizontal and vertical equity that emanate from the equality principle and should drive taxation structures, only horizontal equity was critical to fair taxation. vertical equity is327 important to the income tax classification but impractical for other tax bases. the court expressed the function of the guidelines as follows: 328 in the interests of constitutionally mandated equality of tax burden . . ., taxpayers who have the same ability to pay should be taxed equally (horizontal tax equity), while (in the vertical direction) taxation of higher incomes should be measured against the taxation of lower incomes.329 within the context of horizontal equity, the court determined that a comparison of taxpayers’ ability to pay is a function of net income. in330 305 horizontal and vertical equity in taxation [vol.7:5 331. estg § 9. 332. estg § 12 nr. 1 (disallowing deduction for expenditures associated with the taxpayer’s standard of living even if they contribute to the production of income). 333. estg § 9, ¶ 1, nr. 5. 334. bverge 107, 27 at 48. 335. the mandatory, and, therefore, non-taxable expenditures group themselves around a subsistence minimum that the court discusses in detail in its decision, bverge 87, 153 (sept. 25, 1992, 2d senat), infra note 385, and accompanying text. 336. estg § 12, nr. 1. 337. bverge 107, 27 at 49. the court cites its earlier decisions at bverge 99, 246, 253, discussed in text accompanying infra note 399, (accepting an incremental needs standard in fixing the subsistence minimum that the income tax must exempt, while the social welfare system used a per capita system) and bverge 82, 60, 86, discussed infra note 357 and accompanying text (observing that a subsistence minimum must remain free from the income tax). by comparison, the united states takes an ambiguous approach to childcare expenditures, allowing a credit for a portion of dependent care expenses for some taxpayers under irc § 21. determining net income, expenditures necessary to production of income generally are deductible, but not expenditures that, while incidental and331 helpful to income production, relate to the taxpayer’s specific standard of living and personal choices. for example, a taxpayer may deduct332 duplicative living expenses necessary to employment at a location remote from home. yet, said allowable deduction may not exceed some average or333 customary level of living expenses that does not take the taxpayer’s individual standard of living choices into account, even if extravagant or luxurious expenditures are more consistent with the taxpayer’s general standard of living and possibly necessary in order to meet the expectations of the taxpayer’s business contacts. the court viewed the excess expenditures over some general standard of living as discretionary and non-deductible rather than as deductible mandatory expenditures.334 the dichotomy between mandatory and discretionary expenditures, according to the court, determined the permissibility of the state’s taking funds through taxation that the taxpayer otherwise would devote to the expenditure. although ordinary living expenditures generally are not335 deductible, the court pointed out by citing its earlier decisions that aspects33 6 of childcare and education expenditures are not discretionary and, accordingly, funds necessary for them are not taxable to the degree that fully discretionary funds are. with respect to income production, certain337 expenditures that are personal in nature are essential, that is nondiscretionary, to income production and, therefore, deductible. as an 2006] florida tax review 306 338. id. at 50. estg § 9, ¶ 1, nr. 4 permits a deduction for commuting costs. under u.s. tax law, commuting costs are personal and non-deductible. regs. § 1.1622(e). parking expense, however, is deductible if the employer arranges for the employee to pay for parking through a compensation reduction arrangement under irc § 132(f)(4). 339. id. 340. the commentary on the case refers to it as the kettenabordnung decision (chain delegation or assignment decision) because it involves several delegations of the taxpayer to the same work locale but no permanent assignment. the court uses the term “kettenabordnung” in referring to the criminal commissioner’s serial assignments. id. at 52. 341. id. 342. basic law art. 3 ¶ 1. 343. bverge 107, 27 at 52-3. example, commuting expenses are deductible although the selection of the location of one’s residence, and, indirectly commuting cost, is personal. 338 the preceding analysis took the court to the duplicate living expense issue. the finance committee of the bundesrat, which introduced the twoyear time limitation, viewed deductibility of temporary living expenses of a second household as a matter of legislative grace by recognizing the business necessity that affects ability to pay tax. on the other hand, the committee did not recognize attribution of long-term dual housekeeping at a single work location as a business necessity. 339 in the case of the criminal commissioner, the constitutional court, however, considered the two-year durational limit to be inconsistent with business reality because the court was unable to distinguish multiple extensions of a taxpayer’s assignment to a single work location from a340 series of assignments lasting more than two years in the aggregate to a series of different locations. in both instances, the uncertainty of temporary assignments rendered permanent relocation impractical. since the statutory341 distinction between a single location and multiple locations caused the deduction limitation to treat similar abilities to pay dissimilarly, by treating the multiple location worker more favorably than the multiply assigned single location worker, the statutory distinction violated the equality principle.342 the two-year durational limitation on the deduction for dual household costs also was flawed as it applied to married individuals, who both worked outside the home. if the spouses’ principal occupation locales343 differ, the expense of maintaining a second household is an income production expense that the tax law must take into consideration without regard to the duration of the arrangement. the court compared two families with similar spousal combined earnings. both families may incur duplicative living expenses in order to produce income when one spouse changes his or 307 horizontal and vertical equity in taxation [vol.7:5 344. estg § 9, ¶ 1, nr. 5. 345. basic law art 3. 346. bverge 107, 27 at 52-3. 347. estg § 9, ¶ 1 nr.4. 348. basic law art. 6, ¶ 1 provides: “[m]arriage and family shall be under the special protection of the state.” 349. bverge 107, 27 at 53. 350. bverge 6, 55 (jan. 17, 1957), infra note 419 and accompanying text (prohibiting mandatory joint assessment of married individuals to produce a marriage penalty from a differential rate schedule). 351. bverge 107, 27 at 56. the court also reserved judgment as to whether or not the durational limit might violate basic law art. 12 ¶ 1 (protecting the individual’s right to choose a profession freely) and basic law art. 3 ¶ 2 (guaranteeing equal rights without regard to sex). her place of employment. initially, the tax law acknowledges that the dual expense is a cost of producing income and allows a deduction. the single344 earner family may eliminate the duplication because the family may relocate to the new place of employment. if the family chooses to continue to maintain dual residences, the dual residence expenditure is clearly discretionary. on the other hand, maintenance of dual residences is mandatory for the dual earner family so long as the spouses’ respective places of employment differ from one another. accordingly, a two-year durational limit to the deduction was not rational, as it limited a deduction for non-discretionary expenditures necessary to the continued production of income. by treating discretionary and non-discretionary expenditures the same, the tax law failed to distinguish between dissimilarly situated taxpayers and violated the basic law’s equality principle. so while the345 statute purported to treat the families identically, it failed to account for a material and non-discretionary expenditure. with respect to other non-346 discretionary expenditures, the tax law permitted deductions to both spouses for other duplicative career expenditures, such as commuting expenses. 347 while the equality principle may have sufficed to enable the constitutional court to find the durational limit for dual household expenses unconstitutional in both cases, the court relied heavily on the family and marriage protection principle in rendering its decision in the dual career case. insofar as the durational limit assumed that the family normally348 would move to the work location of one spouse, it denied the family the ability to create its own structure. ability to relocate is a function of the specific marital model that includes only a single wage earner. four349 decades earlier, the court rejected such a model as a justification for tax rules. the court concluded that tax legislation must respect the basic right350 of families to select their own structures and treat all the structures the same based upon ability to pay given the freely chosen structure. 351 2006] florida tax review 308 352. supra note 334 and accompanying text. 353. bverge 82, 60 (may 29, 1990, 1st senat) and bverge 87, 153 (sept. 25, 1992, 2d senat). 354. bverge 87, 153 (sept. 25, 1992, 2d senat). this article discusses this decision in some detail infra commencing with the text accompany note 385. 355. irc § 262. on the other hand, congress exercised its “legislative grace” and allowed various deductions, including personal exemptions and a minimum standard deduction. irc § 63. 356. the longstanding premise underlying tax deductions is: “[t]he power to tax income . . . is plain and extends to the gross income. whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefore can any particular deduction be allowed. new colonial ice co. v. helvering, 292 u.s. 435, 440 (u.s. 1934). how far taxpayers will push the limits of the decision should prove interesting. the court’s language on both the mandatory-discretionary distinction and on freedom to structure the family was broad. taxpayers seem likely to test the mandatory expenditure analysis by claiming a miscellany of essential payments as mandatory and deductible. in the united states, a taxpayers’ organization would quickly emerge to finance litigation to expand the scope of the deductible, mandatory expenditure concept. similarly, a variety of family structures would soon claim deductions for duplicative living expenses. claim of a deduction for the continued maintenance of separate residences for couples who are working in different locations at the time of marriage seems a logical next step. nevertheless, the dual household case broadened the range of expenditures that the court viewed as non-discretionary and, accordingly, not subject to the income tax. earlier constitutional court decisions352 distinguished mandatory or non-discretionary expenditures from discretionary expenditures that constitute disposable income. from an353 american perspective, those decisions reached the remarkable conclusion that, while the income tax laws may burden disposable income freely, income that a taxpayer must devote to meeting the basic needs of the taxpayer and the taxpayer’s family is exempt from taxation. the leading case from a decade earlier than the dual household expense case required that the legislature exempt a subsistence minimum for each individual and family from income taxation. in the united states, by contrast, the general rule is354 that personal, living, or family expenses are not deductible, whether essential or not. the legislature may choose to tax gross income and allows355 deductions only as a matter of its beneficence. 356 the earlier of the decisions addresses the question as to whether the equality and family protection principles of the basic law require that measurements of income for both income tax and social welfare program 309 horizontal and vertical equity in taxation [vol.7:5 357. bverge 82, 60 (may 29, 1990, 1st senat). 358. bverge 82 at 102. 359. the constitutional court addresses itself directly to the exemption for children in bverge 82, 198 (jun. 12, 1990, 1st senat), discussed in text commencing with infra note 380. 360. id. at 63. 361. the german income tax separates sources of income into seven groups and determines and combines the net income within each source group to form the tax base. estg § 2(1). with specific limits based upon the taxpayer’s aggregate income, the taxpayer may deduct losses from one source group in whole or part against income from other source groups and may deduct his or her spouse’s losses from the taxpayer’s otherwise positive income in determining income subject to tax. estg § 2(3). 362. bverge 82 at 65. purposes be consistent with one another. the constitutional court357 acknowledged that the underlying policies that set taxation and welfare structures may differ from one another and those structures may apply differing income measurements in order to achieve the policy goals of the laws. the social program allowed families with children a direct payment358 per child – a child supplement. a cash subsidy complemented the exemption for children in the income tax law and provided families with additional resources. while all families with children received the subsidy, families3 5 9 with higher incomes received only the base amount subsidy, while families with lower incomes received the base amount plus an additional subsidy.360 the statute that determined the amount of the subsidy measured income differently from the income tax law. specifically, the subsidy statute determined the individual’s subsidy amount by aggregating his positive income from the various income groups under the income tax law but, unlike the income tax law, permitted neither the loss from one income group to offset the income from other groups nor the losses of the individual’s spouse to offset the individual’s income.361 the individual challenging the statute before the constitutional court suffered a loss from his leasing activities. while the loss was deductible across income groups for income tax computations, it was not deductible in determining his income for purposes of fixing the child supplement. accordingly, he received only the base amount of the child362 supplement rather than the larger supplement he would have received with the diminished income. the minister for youth, family and health argued successfully that the reduction in the child supplement should be a function of economic income rather than taxable income. taxable income, the minster argued, takes various non-economic adjustments into account that the legislature designed to provide tax subsidies for reasons that had functions unrelated to ability to pay. hence the child supplement rules for computing income approximate better true economic income and provide a better 2006] florida tax review 310 363. id. at 72-3. 364. basic law art 3 ¶ 1. 365. basic law art. 6 ¶ 1. 366. basic law art. 20 ¶ 1. 367. bverge 82 at 99. 368. id. 369. id. at 100-1. 370. id. at 101. 371. id. at 79-80 372. id. at 81-2. 373. id. at 95. but compare the decision in the subsistence exemption case discussed in the following commencing with the text accompanying infra note 380. measurement of need for the increased supplement than does taxable income. while the minister conceded it is not possible to measure economic income under any set of rules perfectly, the child supplement rules are as or more reasonable than the income tax computation rules. 363 the constitutional court accepted the minister’s argument and held that neither the equality principle, the protection of family principle, nor364 365 the social state principle required a uniform base for measurement of366 income under the child supplement and income tax laws. the legislature367 correctly may factor out tax subsidies and losses from activities that the3 6 8 individual does not enter with a profit making intent when ascertaining the369 family’s need for the increased child supplement. the court found that disregarding true economic losses in a computation that prohibits offsetting losses from one income group against income in another group would eliminate the formidable administrative task of separating economic from non-economic tax losses. hence that the imperfection failed to recognize some economic losses were constitutionally permissible. 370 in examining the structure of the child supplement, the court discovered that the supplement did not appear to be a fundamental element of the state’s guarantee to each citizen of subsistence consistent with human dignity. the child supplement was independent of that subsistence minimum and was based on a far higher living standard than was the subsistence minimum. accordingly, the state could eliminate the child supplement if371 the legislature chose to do so. similarly, the family protection principle permits, but does not require, the state to provide the family with a child supplement to income. and the court noted that the combination of the372 child supplement and the tax savings from the dependent children exemption generally is far less than the actual cost of supporting a child such that exemption amounts and child supplements seem to serve a purpose other than subsistence and are not subject to as strict scrutiny as subsistence guarantees might be.373 311 horizontal and vertical equity in taxation [vol.7:5 374. id. at 85. the court in the dual household cases, bverge 107, 27, supra note 314, expanded this minimum nontaxable amount to include essential family expenditures that diminish disposable income. this and the following discussion would seem unnecessary to the resolution of the case before the court and one would label the observations as dicta in u.s. legal analysis. 375. id. at 85-86 (relying on the dignity principle of basic law art. 1, ¶ 1, the social state principle of basic law art. 20 ¶ 1 and the family protection principle of basic law art. 6 ¶ 1). here the court refers to the income tax (and possibly other direct taxes) only, as no exemption from the turnover tax exists for low-income families. 376. id. at 86. in the course of its analysis of the income computation method for the child supplement, the court observed that taxing the subsistence minimum would diminish the taxpayer’s resources to meet basic needs. that diminution, in turn, might compel the state to provide a direct subsidy to the taxpayer to guarantee the subsistence minimum. given the choice between374 protecting the subsistence minimum from income taxation and requiring a state subsidy to increase the taxpayer’s resources to the subsistence minimum, the court determined that exemption of the subsistence minimum from tax was the better choice. in addition, rather than taxing all income, but assuring the taxpayer a net income amount at least equal to the subsistence minimum, the court exempted the subsistence minimum amount from income taxation for all taxpayers in order to protect horizontal equity. hence, the income tax laws must not tax that portion of the family’s income equal to the subsistence minimum. any other approach would cause families with375 dependent children to be at a disadvantage relative to other families, assuming that income in excess of the subsistence minimum is disposable.376 an example illustrates the court’s reasoning: compare two families having equal amounts of disposable income, two adult members, one with a dependent child and one without, and a tax rate of 50%. assume that the subsistence minimum for a two adult family is $10,000 and $5,000 more for a dependent child. the first family has income of $30,000 and the second income of $25,000. a tax rate of 50% on all income leaves the first family with disposable income of zero ($30,000 x .50 = $15,000 tax payable in full and leaving the family with the subsistence minimum of $15,000 after tax) and the second family with disposable income of $2,500 ($25,000 x .50 = $12,500 tax from $25,000 leaves $2,500 disposable over the $10,000 subsistence minimum). if, on the other hand, only disposable income is taxable, each family is left with the same amount of disposable income – $7,500 ($15,000 disposable subject to $7,500 tax at 50%). 2006] florida tax review 312 377. id. at 87. referred to supra note 377 and accompanying text. 378. id. at 90. 379. bverge 82, 60, discussed in text commencing at supra note 353. 380. bverge 82, 198 (jun. 12, 1990, 1st senate). the income tax exemption for children appeared in estg § 32 ¶ 8 for the years at issue in the case. the exemption now is at estg § 32 ¶ 6. 381. id. at 206-7. 382. bverge 82, 60 at 83 and following. 383. bverge 82, 198 at 208. 384. basic law art. 3 ¶ 1 and art 6 ¶ 2 respectively. 385. bverge 87, 153 (sept. 25, 1992, 2d senat), supra note 123. 386. id. at 159. the equality principle, in conjunction with the family protection principle, requires that tax law treat taxpayers with dependent children the same as taxpayers without dependent children, as though expenses of raising children are expenses that diminish the individual’s ability to pay tax as opposed to discretionary personal expenses that the tax law may disregard in assessing tax. having defined ability to pay tax in terms of disposable377 income, the court, without expressly so stating, concluded that horizontal equity demands equal treatment of taxpayers with like amounts of disposable income. vertical equity does not support any other approach, so that the legislature must achieve progressivity through increasing rates of tax on increasing amounts of disposable income.378 following its analysis in the child supplement case, the379 constitutional court, in a decision it released a couple of weeks later, directly addressed the adequacy of the income tax exemption amount for children. despite the court’s holding in the earlier case that measurement380 of income for child supplement purposes could differ from measurement of income for income tax purposes, the court confirmed in this later decision that a subsistence minimum encompassing all family members must remain free from the income taxation. adopting the methodology it applied in the381 child supplement case of converting the child supplement into an exemption equivalent and adding it to the exemption amount, the court held that the382 supplement and exemption combined for the years at issue failed to free the subsistence minimum from taxation. that failure violated the equality and383 family protection principles of the basic law.384 the relationship between the social welfare system and the income tax laws and the adequacy of the income tax exemptions confronted the constitutional court again a short while later. taxpayers argued that the385 basic law required an income tax exemption for all taxpayers that was no lower than the subsistence minimum that the social welfare system established. in order to determine whether the basic law required that386 level of exemption, the court traced the history of income tax law in 313 horizontal and vertical equity in taxation [vol.7:5 387. id. at 155 (author’s translation). the original german reads: “die deutsche einkommensteuer belastet traditionell nur das verfügbare einkommen und stellt die zur finanzierung des existentiellen bedarfs benötigten einnahmen . . . von der besteuerung frei.” 388. id. at 156 (author’s translation). the quote suggests that the subsistence minimum increases as indirect taxes increase. but while protecting the subsistence minimum as defined to encompass the cost of necessities including the turnover tax on the necessities, that exemption inures to the benefit of all taxpayers. the exemption tends to work against vertical equity by precluding nuances of progression among taxpayers with materially differing sums of “disposable” income. compare statements in the legislative history to the earned income tax credit in the u.s., irc § 32. congress intended the earned income credit to enable low-income families to meet the rising cost of living and to offset partially the regressive effect of the social security tax on employed low-income individuals. h.r. 2166, h.r. report 94-19 at 10 (94th cong. 1st sess., feb. 25, 1975) and more directly, s.rep. 94-36 (94th cong. 1st sess., mar. 17, 1975) at 11 that reads in part: “[t]he credit is set at 10% in order to correspond roughly to the added burdens placed on workers by both the employee and employer social security contributions.” the senate report suggests that senate taxwriters believed that the employee bore the burden of both the employer’s and the employee’s share of social security taxes. unlike the subsistence minimum exemption in germany, the earned income credit phases out as taxpayers’ incomes increase. 389. id. at 169 citing basic law art. 2 ¶ 1. 390. id. at 170, citing with approval bverge 82, 60, 89, discussed in detail supra note 357 and accompanying text. 391. id. at 170-71. germany through its exempt amounts observing that “[t]he german income tax traditionally burdens only disposable income and frees receipts necessary to financing of basic needs . . . from taxation.” the court identified the387 income tax exemption as a function of the relationship that the income tax bears to the indirect taxes, including the value added tax, by noting that freeing the subsistence minimum from the income tax “compensated for the heavy burden that indirect taxes imposed on poorer people.” 388 following that historical structure, the court determined that personal freedom and free development of the individual’s personality, both389 freedoms that taxation tends to restrict, require that each taxpayer be left with an amount after income taxation that is not less than the subsistence minimum. at the same time, the court observed that a structure that exempts the subsistence minimum must not disregard the principle of vertical equity, which requires progressivity in the income tax.390 while the subsistence minima social welfare allowances do not necessarily constitute a perfect measure of subsistence, they provide a baseline below which the income tax may impose no burden. but whereas391 the social welfare system provides social assistance based upon local conditions, subsistence minima established by the social welfare 2006] florida tax review 314 392. id. at 172. 393. id. at 174-5. 394. id. at 176. 395. id. at 178. note that taxpayers who, two years earlier, successfully argued that the exemptions for children were inadequate to meet the subsistence minimum received relief in bverge 82, 198, discussed supra beginning with note 380. 396. id. at 180. 397. id. at 171. 398. supra note 388 and accompanying text. as subsistence minima relate in part to the burden of indirect taxes that each individual bears, those minima must include indirect taxes and eliminate the regressivity of the indirect taxes through either direct welfare payments that guarantee human dignity (including payment of indirect taxes) or exemption from the income tax of amounts necessary to the meet the minima including the indirect taxes. 399. bverge 99, 246 (nov. 10, 1998, 2d senat). this decision is one of three the constitutional court issued on the same day addressing the same issue but for different taxpayers and taxable years. the other cases are bverge 99, 268 (nov. 10, 1998, 2d senat) and bverge 99, 273 (november 10, 1998, 2d senat). administration are only rough estimates of the minima. the federal legislature must exempt an amount from the income tax that will protect the subsistence minimum in as many instances as possible. in any event,392 statistics demonstrate to the court that existing exemptions fail to meet subsistence minima. the court also rejected the notion that specific393 exemptions not applicable to all taxpayers compensate for the inadequacy of the general exemptions.394 mindful of the burden that requiring refunds might impose on the german treasury, the court chose to apply its decision with respect to subsistence minima and the income tax prospectively. social welfare395 assistance would be available to taxpayers whom the income tax provisions might leave with insufficient resources to meet their subsistence needs.396 despite prospective application, the constitutional court firmly established an income tax exemption zone around the subsistence minimum and looked to the social welfare system to define that minimum, including the effect of397 indirect taxes on the individual. 398 in late 1998, the constitutional court traced a more detailed methodology for determining the amount of the tax-free subsistence minimum for children. the court specified that while the social welfare399 exemption amount generally would continue to provide the floor for the minimum, certain departures from social welfare computational methods were permissible. for example, with respect to incremental housing needs for an additional child, social welfare used a per capita computation, but the court accepted an incremental need standard that took into account that no additional common area space (kitchens, bathrooms) was necessary when a 315 horizontal and vertical equity in taxation [vol.7:5 400. id. at 263. 401. id. 402. id. at 264-5. 403. id. at 265. see supra note 382 and accompanying text. 404. id. the computational intricacy of this concept is important. the court’s underlying fairness principle is that progressive rates commence for all taxpayers at the same point: income in excess of the subsistence minimum for the family. the subsistence minimum is exempt from income tax. see the example in the text following supra note 375. like any deduction, the subsistence minimum exemption is more valuable for taxpayers subject to higher maximum rates of tax than taxpayers subject to lower maximum rates, since deductions reduce tax at the margin. as the constitutional court views the subsistence minimum as an exemption from tax, consistency demands that, in evaluating a direct subsidy like the child supplement as satisfying part of that subsistence exemption, it must convert the subsidy into its exemption equivalent amount. that means that the court must take tax rates in account. accordingly, it requires a larger subsidy for higher rate individuals to convert into the same exemption amount for lower rate individuals. hence a $1,000 subsidy to a 20% bracket taxpayer is the same as a $5,000 exemption, but only a $2,500 exemption to a 40% bracket taxpayer. so a $2,000 exemption is needed for the 40% bracket taxpayer to protect the same subsistence minimum of $5,000. if that outcome seems rather peculiar since a direct subsidy covers the same amount of expenses for each family, it is nevertheless inherent in defining the subsistence minimum as an exemption rather than providing a refundable credit against tax to all taxpayers in an amount equal to the subsistence minimum. to a limited extent germany does just that by providing welfare assistance to individuals whose incomes are less than the subsistence minimum. see the bundessozialhilfegesetz (federal social welfare law) (jun. 30, 1961, version of mar. 23, 1994, as amended through nov. 25, 2003). family adds a child. while accepting a shortfall tolerance of as much as400 15% of the subsistence minimum for a child between the tax exemption and social welfare amounts, that tolerance would diminish if the computation for tax purposes rejects social welfare’s questionable computational conventions such as per capita. 401 the court required that the subsistence minimum remain free of income tax at all income levels and marginal rates of tax. as german law402 provided a child supplement for each child, as well as an income tax exemption for each child, conversion of the child supplement into its exemption equivalence became necessary to ascertain whether the combination of the supplement and the exemption together left the subsistence minimum per child exempt from taxation. conversion of the403 child supplement into a deduction equivalent must operate at each taxpayer’s maximum marginal tax rate, lest taxpayers with children bear a disproportional tax burden relative to taxpayers without children or to taxpayers in higher marginal brackets exempt from tax on the full family subsistence minimum. for the tax year in question, taxpaying families with404 one child and with marginal rates of 40% or more do not enjoy a full 2006] florida tax review 316 405. id. at 266. 406. id. at 267-8. 407. supra note 395 and accompanying text. 408. bverge 101, 297 (jul. 12, 1999, 2d senat). 409. estg § 4 (5) 6b. compare the u.s. restrictions on home office deductions in irc § 280a. 410. bverge 101, supra note 408, at 310. 411. basic law art. 6. 412. bverge 102, 127 (may 24, 2000, 1st senat), bverge 112, 164, 2 bvr 167/02 (jan. 11, 2005, 2d senat) (at: http://www.bverfg.de/entscheidungen/ rs20050111_2bvr016702.html), bverge 112, 268, 2 bvl 7/00 (mar. 16, 2005) (at: http://www.bverfg.de/entscheidungen/ls20050316_2bvl000700.html), cases discussed in text following this note. 413. id. bverge 112, 164, 2 bvr 167/02. subsistence exemption. while the constitutional court left the federal405 financial court to fashion the appropriate form of remedy, the constitutional court was unwilling to apply its holding prospectively only, as it had done40 6 in the earlier subsistence case. 407 the constitutional court has shown itself to tolerate legislative and administrative imprecision in the application of the equality principle as needed to allow for generalized approaches to taxation. for example, the court allowed a generalized approach to the deduction for home office expenditures. the statute on home office expenditures distinguished408 among home offices used 50% or less for business for which there was no deduction; home offices used more than 50% for business but that were not the center of the taxpayer’s business activity for which the statute limited the deduction to a specific amount; and home offices used exclusively as the center of the taxpayer’s business activity for which all expense were deductible. the taxpayer argued that the statute allowed the full cost of an409 outside office, which placed home offices at a disadvantage. the court, however, accepted the need to generalize in the law and permitted the statute to stand, even though it might result in some home office users being placed at a disadvantage. 410 nevertheless, the legislative wish to generalize and categorize may not conflict with the equality principle in conjunction with the protection of family principle. confronted with possible disparate treatment of families411 relative to one another or families without children, recent decisions affirm both the constitutional court’s commitment to a family subsistence minimum free from income taxation and a level playing field for all taxpayers without regard to family status. 412 in the first of these cases, the taxpayer could not claim the child413 exemption and did not receive the child supplement for her adult child because the child, who otherwise met the requirements for a continuing 317 horizontal and vertical equity in taxation [vol.7:5 414. bverge 112, 268, 2 bvl 7/00, supra note 412 (mar. 16, 2005). 415. estg § 33c (allowing the deduction for parents who are working or attending school or training). compare the limited tax credit under u.s. law, irc § 21. 416. under the current statute, the floor is a fixed sum per child. exemption and supplement, earned income in excess of the statutory limit. under a statutory “cliff,” the benefit recipient lost the benefits under both the income tax law and the social security law as soon as a child’s income exceeded a fixed sum. the taxpayer argued that the loss of benefits provision was unfair because it did not provide for any phased structure and that the computational structure in the case of her child was unfair. the court reached the second, but not the first argument, in finding for the taxpayer. unlike customary employment relationships in germany that require the employer to reduce the employee’s compensation by the employee’s share of social insurance payments, that withholding-type rule did not apply to the child’s employment relationship. accordingly, the child’s employer did not withhold. even though the child had to make the payments in any event, the child’s income was measured for loss of benefits on a pre-social insurance contribution basis. other employment relationships deducted social insurance payments from income first, so that other children with comparable gross incomes measured their incomes for loss of benefit purposes after social insurance payments were taken into account. the income measurement affected the taxpayer’s child adversely relative to similarly situated individuals with comparable incomes. the constitutional court held that the equality principle required consistent measurement of income for all taxpayers, so that the taxpayer’s child, so viewed, received income that was less than the loss of benefits amount. the court noted that it need not answer the other argument in this case because the income measurement issued controlled the outcome for the taxpayer. in the second of the two decisions, the constitutional court turned414 its attention to childcare expenditures that are deductible as costs of income production. the income tax provision allowing the childcare deduction415 placed both a floor and a ceiling on the deductible amount. although the taxpayer did not challenge the ceiling, the court commented that the ceiling seemed a reasonable accommodation to control excessive expenditures that were in fact discretionary, rather than necessary, to facilitate parental employment or training. the floor during the year at issue was an imputed sum based upon the taxpayer’s filing status and income. only expenditures416 in excess of that imputed amount were deductible. the court observed that the statute placed parents with childcare expenses at a disadvantage relative to individuals with no children. since childcare expenditures were not discretionary but mandatory for working parents, the floor rendered some portion of childcare expenses non-deductible. the floor resulted in income 2006] florida tax review 318 417. compare the discussion of the two residence household, in text accompanying and following supra note 337. 418. bverfge 112, supra note 412, at 279. 419. bverge 6, 55 (jan. 17, 1957). 420. under § 32 of the income tax law of 1951 (einkommensteuergesetz 1951 in the version from jan. 17, 1952), married couples were in tax class ii, individuals with children in class iii and other taxpayers in class i. additional exempt amounts applied to classes ii and iii and the tax tables imposed a smaller tax on the incomes of taxpayers of up to 5000 german marks who were in classes ii and iii than the tables imposed on class i taxpayers. moreover, one spouse’s losses offset the other spouse’s income. under current law, the brackets are effectively twice the individual brackets. estg §32a (5) assesses a spouse on half the marital unit’s income at individual rates and doubles the amount of tax computed in that manner. u.s. law with its separate rate schedules for individual and married taxpayers continues to resemble the earlier german model, the joint filing brackets are broader than unmarried individual bracket but not twice as broad, and married filing separately brackets are half the breadth of the joint brackets. irc § 1(a), (c), (d). note, however, that irc § 1(f)(8) makes the joint filing brackets equal to twice the single individual brackets for the 15% bracket for the 2003 and 2004 tax years and again for 2008 through 2010 with smaller sizes for the intermediate years. 421. for example, a single earner family with income of 5000 german marks drew a tax 652 marks in class ii while a class i taxpayer would have paid 810 marks. einkommensteuergesetz 1951 table b. taxation of non-disposable income, and diminution of the income tax free family subsistence minimum in violation of equality principle combined with the protection of family principle. the court emphasized that the principle417 of horizontal equity in taxation, especially as it might affect decisions whether or not to have children, was particularly robust.418 b. marriage penalties relatively early in the post-war period, the constitutional court addressed a challenge to the mandatory joint assessment of married individuals under the income tax laws. rate brackets in effect for 1951, the419 tax year at issue in the case, applicable to jointly assessed couples were somewhat broader at lower incomes than individual brackets, but not twice individual brackets. the rate structure did benefit some couples. if the420 couple had a principal income earning spouse and the other spouse earned a small amount of income or no income, joint assessment was beneficial to the couple, as the joint brackets would free a larger amount of income from tax than would separate filing at individual rates. where both spouses earned421 substantial income or comparable amounts of income, separate assessment at 319 horizontal and vertical equity in taxation [vol.7:5 422. if married taxpayers each had income of 2500 marks (total 5000), each would pay 235 marks for a total tax of 470 marks if they were separate class i taxpayers, but 652 marks on the combined income as class ii taxpayers. einkommensteuergesetz 1951 table b. 423. id. at 56. einkommensteuergesetz 1951 §26. 424. section 43 of the implementing regulation to the income tax law (einkommensteuer-durchführungsverordnung in the version of jan. 17, 1952) §43. 425. bverge 6 at 83 raising the basic law art. 3 issues within the group of married individuals but not relying on them for the decision. 426. id. at 64. 427. id. at 67. 428. id. at 65-66. perhaps the recitation of the history and its link to the national socialists compelled the court to conclude that the joint assessment was unconstitutional, as one cannot imagine that the court would subscribe to a rationale emanating from the politics of that regime. individual rates would result in a smaller tax burden for the marital unit than would joint assessment. 422 while the statute nominally required joint assessment for all spouses who lived together for four months or more during the assessment period,423 the implementing regulation excluded from the joint assessment base income that the wife earned from employment (rather than self-employment) so long as the husband was not her employer. the regulation placed the sub-424 classification of self-employed, married women at a disadvantage relative to employed married women as well as to both employed and self-employed married men. the constitutional court easily could have decided the case on narrow equality principle grounds as discriminatory against the sub-class. instead the court chose not to address that discrimination as its decisional basis. 425 after disposing of the procedural limitation that pre-constitutional law might impose on the constitutional court’s jurisdiction, the court426 traced the rather interesting history of the peculiar selection of selfemployed, married women for mandatory joint assessment on their earnings. early tax laws in prussia assessed family income as a unit and427 later freed certain household members from common assessment. legislation from 1921 separated the wife’s services’ income from her income from other sources and permitted separate assessment of that service income. during the period that the national socialist party controlled the german government, the government included the wife’s income from services again in the joint assessment. according to the secretary of finance at that time, the goal of the inclusion was for the political purpose of forcing women out of the labor market. the subsequent exception for income from services as an employee became necessary, as the war demanded that women return to the work force to support the war effort.428 2006] florida tax review 320 429. basic law, art 6, ¶ 1. 430. such an increased tax burden on the spouses that attaches to the conclusion of marriage … is inconsistent with art. 6, ¶ 1 of the basic law. bverge 6 at 70. (author’s translation). 431. id. at 82 relying on art. 3, ¶ 2 in addition to art. 6. 432. id. 433. spouses may elect joint or separate assessment under current law. estg § 26 (1). as the tax is measured as if each spouse received half the income, joint assessment is advantageous for single earner marital units and two earner units in which one spouse, if assessed separately, would not pay tax at the margin at the maximum rate. for other units, joint assessment produces the same tax liability as separate assessment would. 434. gewerbesteuer probably translates better as a business enterprise tax but as municipal governments impose the tax, common translation is as above. 435. bverge 13, 290 (jan. 24, 1961). 436. basic law, art 3. 437. basic law, art 6. the constitutional court examined the protection of marriage principle that the basic law includes and rejected mandatory joint429 assessment in so far as it burdened rather than benefitted marriage.430 arguments in favor of joint assessment were that the mandatory joint assessment was permissible to educate spouses and to shape the marital relationship in the best interests of the family and the state. the court firmly rejected both arguments on protection of marriage and sexual equality grounds. interpretation of the protection of marriage principle must be431 consistent with other constitutional protections. equal rights means that the432 spouses always must remain free to select the structure of the relationship without any economic pressure from the state, in the form of an increased tax burden, to choose one earner rather than two earner household status. thus, the constitutional court left no opening for modification of the joint assessment that would impose a greater tax burden on a married couple than on two unmarried individuals. 433 similarly, the constitutional court ruled that the disallowance of a deduction for salary paid to one’s spouse in computing one’s liability for the municipal business tax was unconstitutional as it likewise violated both434 435 the equality principle and the protection of marriage provision. although436 437 the income tax laws permitted a deduction for salary paid to one’s spouse, the municipal business tax at issue in the case denied the deduction. the legislative reasoning for denying the deduction was to protect the tax base. as business owners could not deduct payments to themselves because such payments would undercut the tax base, they should not be able to undercut the base by hiring their spouses – a seemingly transparent way to avoid the deduction limit for the salary of the business proprietor. despite this rationale, the constitutional court saw the disallowance as favoring non321 horizontal and vertical equity in taxation [vol.7:5 438. bverge 6, 55, supra note 419. see discussion in text accompanying and following the cited note. 439. estg § 26. in the absence of an election, joint assessment is presumptive under estg § 26(3). 440. the german tax law refers to the method as income splitting. estg § 32a (5). 441. bverge 108, 351, 355 (1st senat, oct. 7, 2003). 442. bverge 61, 319 (mar. 11, 1982). 443. id. at 351. 444. id. at 345-6. 445. id. at 346; see also tipke/lang, supra note 51, at 122. note, however, that the court does not address the imputed, but untaxed income, that the spouse working at home generates. neither germany nor the u.s. taxes imputed income from labor for one’s immediate family and does not even take cost savings from avoiding the cost of payment to a third party for housework into account. see generally nancy c.staudt, taxing housework, 84 geo. l.j. 1571 (1996) (arguing that failure to tax housework forces many women into the labor market to find a value and appropriate compensation for their labor). 446. basic law, art. 3 ¶ 1 spousal employees over spousal employees in violation of equality principles and as a tax burden on marriage. the limitation on deductibility would not arise if the individuals lived together but did not marry. following the constitutional court’s decision prohibiting mandatory joint assessment of married couples, the german legislature revised the438 income tax law to permit, but not require, married taxpayers to elect joint assessment. married couples who elect joint assessment combine their439 incomes, determine the tax for an individual on one-half that combined income and double the amount of tax. while joint assessment and income440 splitting is beneficial to taxpayers for whom it moderates tax progression, joint assessment will never result in a greater tax than the combined tax the couple would pay on their separately assessed incomes. 441 elective joint assessment for married couples was not without controversy. single taxpayers with dependent children argued that they too should enjoy the tax benefit of income splitting because of the cost of caring for children. while acknowledging that a married couple without children442 enjoyed a more favorable tax position through income splitting than unmarried individuals with dependent children, the constitutional court was unwilling to find fault with income splitting. instead, the constitutional443 court determined that splitting was not a tax subsidy but rather enabled couples to structure their economic arrangements within the marriage without concern for the tax impact of the choice. essentially, splitting444 assigns value to one spouse’s work at home caring for the household and children equal to that of the other spouse’s work for compensation,445 consistent with the equal rights and marriage protection provisions of the446 2006] florida tax review 322 447. basic law, art. 6 ¶ 1. 448. discussed supra in part iv a. 449. bverge 61, supra note 442, at 353-4. 450. id. at 354. 451. bverge 108, 351, supra note 441. 452. statistically far more women in germany and the u.s. receive maintenance or alimony than men, hence the selection of a feminine pronoun for the recipient of maintenance. 453. bverge 108, 351, supra note 439, at 353 citing the civil code (das bundesgesetzbuch) § 1578 ¶ 1, sentence 1. 454. estg §§ 26, 32a (5). 455. estg § 10 (1) 1. under current law, the payer’s deduction may not exceed €13,805 per annum. estg § 22 1a includes the maintenance payment in the recipient’s income only to the extent of the payer’s deduction. according to the constitutional court, the payer must indemnify the recipient who consents to the inclusion in her income from the tax cost of the inclusion. bverge 108, 351, supra note 441 at 356. the indemnification is not a statutory requirement but the result a fair exchange of consent for the indemnity as confirmed in case law. see palandt bürgerliches gesetzbuch (civil code) 1489 (munich 1999). u.s. law provides similarly for actual income splitting through alimony (without a ceiling on the deduction and inclusion) under irc §§ 71, 215. the payer’s deduction is an adjustment to gross income under irc § 62(a)(8), and not an itemized deduction under irc § 63, so that the deduction provides a tax benefit to the payer even if the payer does not itemize his deductions. basic law. as to the single parent issue, the court acknowledged the447 validity of the claim on other grounds and viewed the issue in the similar light to its subsistence minima decisions. holding that the deductions and448 exemptions available to single individuals with dependent children were inadequate to free the basic costs of caring for children from taxation, the449 court directed the legislature to eliminate the problem but left to the legislature the task of formulating the necessary remedy. 450 more recently, the constitutional court reviewed the interplay of income splitting and maintenance obligations to a former spouse following divorce. the amount of maintenance payable to a former spouse who451 cannot support herself is a function of the marital standard of living that452 preceded the divorce (taking in account likely changes that already had affected the marital standard before the divorce). in turn, standard of living45 3 is a function of available resources and takes taxes payable into account. to the extent that the couple elected and derived a benefit from joint assessment and income splitting before divorce, the divorce terminates availability of454 the election. after divorce, a limited form of actual income splitting becomes available. a former spouse paying maintenance may deduct some or all of the maintenance payments so long as the recipient consents to including the maintenance payment in her income. loss of the more general income455 splitting election may increase the payer’s income tax and diminish resources 323 horizontal and vertical equity in taxation [vol.7:5 456. estg §§ 26, 32a (5). 457. in the instances before the constitutional court, the increase in resources was a function of the applicable tax table to use for the wage tax (lohnsteuer), a tax collection method that is similar to wage withholding in the united states irc § 3401 et. seq. 458. bverge 108, 351, supra note 441. 459. id. at 352, one case comes from the state appellate court in brunswick (oberlandesgericht braunschweig) and the other from the state appellate court in stuttgart (oberlandesgericht stuttgart). 460. id. at 369. 461. bverge 110, 94 (mar. 9, 2004, 2d senate), supra note 30. 462. basic law art. 3 ¶ 1. 463. in german: ein strukturelles vollzugsdefizit (author’s translation). 464. compare the u.s. exemption of the capital gains of non-resident aliens and foreign entities not engaged in a u.s. trade or business. irc. §§ 871(a) and 881(a) do not include capital gain in the income that is subject to withholding. congress exempted capital gains because it was impractical to collect tax on the gain. see rohmer v. comm’r, 153 f.2d 61, 64 (2d cir. 1946), cert. denied, 328 u.s. 862 (1946) (permitting taxation of royalties under the predecessor to irc. § 871 and discussing legislative history of inability to tax capital gains). available to him with which to pay maintenance. the divorce court must take that diminution of resources into account in fixing the maintenance obligation. when the individual who is obligated to pay maintenance remarries, the new marriage entitles the spouses to elect joint assessment and income splitting. income splitting in the new marriage may decrease the456 maintenance paying individual’s tax burden and increase his economic resources accordingly. in the combined cases before the constitutional457 court, divorced spouses who received maintenance payments in such458 remarriage situations successfully claimed in the lower courts that the protection of marriage principle entitled them to share in the increased resources that the new income splitting election generated. the459 constitutional court ruled, however, that the income splitting opportunity belonged to the new marriage, so that, that protection of marriage principle required that any increased resources remain with the new marriage.460 c. assessment, collection and the equality principle perhaps the most radical and far-reaching of the constitutional court’s tax decisions was its recent securities speculation case. in that decision the461 court held that the equality principle precluded assessment and collection462 of the speculation profits’ tax from trading in securities because most taxpayers easily evaded that tax. thus, the structural deficiency inherent in the execution of the tax law was unfair to honest taxpayers. 463 464 2006] florida tax review 324 465. eisner v. macomber, 252 u.s. 189 (1920), see supra note 169 and accompanying text. 466. bverge 26, 302, 312 (july 9, 1969, 2d senat). 467. see, supra note 93 and accompanying text. 468. bverge 110, 94, 95-6 quoting in part § 23 of the income tax law as in effect in 1998 referring to speculation activities. under current law, the provision refers to private sale activities and encompasses securities the taxpayer has held for no more than one year. estg § 23(1) 2. compare short term capital gain under irc § 1222(1). 469. id. at 98. the constitutional court cites decisions of the federal financial court to explain that the statute in question, estg § 23, in the case of land speculation, sought to distinguish those taxpayers who held land in order to derive income from operation or farming of the land from those taxpayers who primarily speculated in the value of the land itself by buying and selling land over relatively short holding periods. 470. estg § 38 (employer withholding of wage tax); § 43, 44 (entity withholding on dividends, creditor withholding on interest). 471. germany lacks the extensive array of information reporting that ch. 61, subch. a, part iii, irc. §6031 et seq., requires of u.s. persons. see discussion in roman seer, besteuerungsverfahren, supra note 60 at 62-63 and 128 (tabelle 15, kontollmitteilungspflichten). 472. colloquial (author’s translation of the equally colloquial ‘ins blaue hinein’ that the court uses at bverge 110, 94, 115). 473. id. at 114-15. unlike the possible constitutional barrier to taxing unrealized gains in the united states, there is no constitutional barrier to taxation of capital465 gain in germany. however, germany did not (and does not) treat466 individuals’ capital gains as income, except that the gains from speculation467 in securities having a holding period in the taxpayer’s hands of not more than six months. the statute sought to tax those gains that might result from the468 conduct of trading activity, rather than simple capital appreciation, while enjoying a possible income benefit from the investment through dividend or interest income. 469 the statute, however, did not provide for a withholding tax on those gains or for informational reporting by third party intermediaries. the470 471 taxing agency lacked authority to go on a fishing expedition into private472 and third party records, and privacy rights prevented banks and other third parties from providing information on transactions to the taxing authorities in the absence of an express and specific reporting obligation. moreover, during the years at issue, the tax authorities made no meaningful effort to identify short term trading profits from securities through regular audit activities. hence there was little threat of detection to encourage taxpayers to report honestly. while the statute imposed a reporting obligation on taxpayers,473 the constitutional court observed that the tax acted as a penalty for honest taxpayers who reported their activities but generally failed to reach taxpayers 325 horizontal and vertical equity in taxation [vol.7:5 474. id. at 104. compare bverge 84, 239 (jun. 27, 1991) (holding for similar reasons that taxation of interest income was unconstitutional but delaying application of the decision to give the tax authorities time to equalize collection of the tax). 475. as the court relies on the indirect evidence from market conditions yielding considerable profits without offsetting losses during the years at issue to support its conclusion of unequal tax burdens, the court reserves judgment as to any unconstitutional impact of enforcement of the statute in years after 1998 when market losses may have offset the market gains. id. at 140-141. 476. id. at 111. 477. estg § 23(1). 478. bverge 110, 94 at 132. 479. civil law legal systems assign a major role to notaries who prepare transfer documents and handle many of the tasks that attorneys carry out in the united states. 480. grunderwebsteuergesetz § 18. 481. bverge 110, 94 at 132. 482. schattenwirtschaft (shadow economy). who did not report voluntarily. in substance but not in form, the statute474 imposed a greater tax burden on honest taxpayers than it did on dishonest taxpayers, and as such, violated the equality principle. 475 the constitutional court expressly limited its decision to the trading of securities during the taxable years of 1997 and 1998. while the essence476 of the decision was the lack of enforcement that rendered assessment and collection from honest taxpayers a violation of horizontal equity principles, the decision might extend to other activities, including independent personal services. the court sought to anticipate and prevent those arguments by identifying differences in assessment and collection for other activities. with regard to short term dealing in real estate that the same statute governs, as477 opposed to holding real estate for income production or personal use, the court noted that information reporting prevented the level of tax evasion present with respect to securities trading because transfers of land require478 participation of a notary and there is a reporting obligation for tax on real479 property acquisition. with respect to leasing activities, the income from480 which taxpayers might not report, the court noted that taxpayers generally hold the property for extensive periods and have an incentive to report income because they will wish to deduct their losses from the activity. 481 in other areas where germany has a serious problem with the underreporting of income, the court found that the taxing authority’s collection efforts differ materially from those for short term securities trading. for example, the constitutional court anticipated and dismissed the possible argument of taxpayers, who were not employees and, therefore, were not subject to the withholding mechanisms of the wage tax. those taxpayers might argue that the underreporting problem in the underground economy causes the taxation of the income from the services of honest482 2006] florida tax review 326 483. like the u.s., germany has a substantial segment of its economy that escapes taxation because service providers receive payments in cash that the service recipient does not report. the german term for such work is schwarzarbeit (black work or black market work) and was estimated to represent some 16% of germany’s gross domestic product in 2001, increasing gradually from 12% in 1990. annette mummert and friedrich schneider, 58 finanzarchiv 286 (2001), estimated to be 643 billion german marks in 2001 (€329 billion). id. note, however, that insofar as the unreported income in germany involves low wage workers, as it does in the u.s., those workers would not pay income tax in any event because of the subsistence minimum that is exempt from income tax. the unreported income becomes subject to the turnover tax just as fully reported income does when the workers consume goods and services, so there is no loss of revenue that the government otherwise would collect. see discussion of the relationship between the turnover tax and the subsistence minimum exemption supra in part ii. hence the revenue loss with such work primarily is a function of taxes and mandatory contributions for social welfare. 484. translating bverge 110, 94 at 112: “das verfassungsrechtliche gebot tatsächlich gleicher steuerbelastung durch gleichen gesetzesvollzug ….” 485. bverge 110, 94 at 133. 486. id. at 133-34. 487. bverge 13, 274 (dec. 19, 1961, 2d senate). 488. bverge 13, 261 (dec. 19, 1961, 2d senate). 489. bverge 13, 279 (dec. 19, 1961, 2d senate). however in this case the rate was set nine months into the year, so that the earlier cases might have sufficed to decide this case as well. taxpayers who do report to be unfair because their tax burden exceeds that of dishonest taxpayers whom the tax system cannot identify and control. thus483 they might argue that taxation of independent service income would similarly violate the equality principle, as “the constitutional requirement of actual identical taxation burden through identical law enforcement” would be484 lacking. to that argument, the constitutional court observed that unconditional tax audits for such income, as contrasted with the dearth of audit activity for short term securities trading, posed more than an incidental risk of discovery for the underreporting taxpayer. thus, unlike securities trading, the assessment system does not invite under reporting or nonreporting of income from services. similarly, the taxing authorities485 programmatically and actively seek to discover offshore investment in order to tax income from that capital. 486 d. retroactivity an early series of three decisions established the principle that a rate increase during a tax year may apply to the whole year, but that a rate487 increase may not apply to a closed year unless taxpayers reasonably488 anticipate that an unset rate must become fixed. the outcome of the first489 327 horizontal and vertical equity in taxation [vol.7:5 490. darusmont v. united states, 449 u.s. 292 (1981). 491. wilgard realty co. v. comm’r, 127 f2d 514 (ca2, 1942), cert. denied 317 us 655 (1942). debate concerning this issue of retroactivity continues in the u.s. see articles cited supra note 153. congress often announces effective dates in advance of enactment so that taxpayers are on notice of pending, retroactive changes. 492. article 20 of the basic law generates the rechtstaatprinzip. 493. bverge 93, 121, supra note 28, (jun. 22, 1995). the wealth tax law of 1974 (vermögensteuergesetz), (in the version of nov. 14, 1990, most recently amended by the law of sept. 14, 1994) applied to the case. 494. bverge 93, 165, supra note 28, (jun. 22, 1995). the inheritance and gift tax law of 1934 (erbschaftsteuerund schenkungsteuergesetz), (in the version of feb. 1 9 , 1 9 9 1 , l a s t a m e n d e d s e p t . 2 7 , 1 9 9 4 ) (c u r re n t v e r s io n a t http://bundesrecht.juris.de/bundesrecht/erbstg_1974/index.html)applied to the case. 495. basic law art. 3(1). compare, supra note 237 and accompanying text, discussion of allegheny pittsburgh coal co. v. county commission of webster county, west virginia, 488 u.s. 336. 496. valuation law (bewertungsgesetz), version of feb. 1, 1991 (current version available at http://bundesrecht.juris.de/bundesrecht/bewg/index.html). cited case matches the result in the united states. but the strict limitation490 that the second case imposes to limit retroactivity to the current year does not apply in the united states when the change is a rate or base change, rather than the imposition of a new tax. the german cases rely on the rule of law491 principle emanating from the constitutional definition of germany as “a democratic and social federal state.” the principle requires that citizens492 have the opportunity to know what the law is so that they may conform their behavior and modify their transactions to use the law most effectively. e. value dependent taxes and the equality principle the constitutional court held both the wealth tax and the493 inheritance tax to be inconsistent with the equality principle. both taxes49 4 495 used the valuation standards and methods that the valuation law provided.496 other than rental real property and real property used as part of a business for which capitalization of earnings provided the value, fixed values applied to real property under the valuation law. the fixed values were 1964 assessment values multiplied by 1.4. since securities were valued at market and productive property at capitalization of earnings or, in the case of property not in production, but productive, capitalization of estimated earnings as productive, the values of those properties were reasonably up to date. real property, on the other hand, tended to be undervalued substantially, as the overall real estate market had advanced considerably since 1964. applying the same rate of tax to real estate as to other property meant that taxpayers whose wealth or inheritance concentrated itself in real estate paid disproportionately lower taxes than taxpayers who owned or 2006] florida tax review 328 497. bverge 93 at 144 and at 176. the wealth tax has not been in effect since jan. 1, 1997. the inheritance tax continues to apply and the parliament amended the valuation law to use more realistic multipliers for real property in order to approximate current fair market values. valuation law supp. (bewg anlagen) 6-8 in the version last amended dec. 20, 2001. 498. id. at 138, supra note 113 and accompanying text. 499. id. at 137. 500. id. at 176. 501. bverge 43, 58 (oct. 26, 1976, 1st senat). 502. bverge 101, 151 (nov. 10, 1999, 2nd senat). received other property. that disparity violated the equality principle and rendered both statutes unconstitutional. 497 with respect to the wealth tax, the constitutional court expressed concern about the level of all taxes on production and stated that the principle of halves prevented taxes from confiscating the property itself, half of the production for private use and half to public use. further, in order to498 equalize the burden between productive and unproductive property, the court stated that all values for productive property must use an estimated, rather than an actual production, for capitalization in order to provide a level field of valuation. the court did not express the same confiscation concern49 9 about the inheritance tax, although it did observe that the inheritance tax should not be so high as to jeopardize continuation of a going concern by diminishing its resources. 500 f. turnover tax and the equality principle the constitutional court held that the equality principle was violated when medical unions that provided laboratory services to practitioners were exempt from the turnover tax, but independent laboratories were not. the501 court was concerned that the turnover tax exemption provided a tax advantage that interfered with free competition. similarly, the constitutional court held that the equality principle prohibits imposition of a higher turnover tax rate for medical practitioners operating through entities rather than as sole practitioners. these cases were concerned with competition502 between or among individuals and entities operating in the same economic activity, rather than the impact of the tax upon the consumer who bears the burden of the tax. in other cases, the constitutional court has proven far less receptive to claims of unequal treatment of taxpayers under the turnover tax than under other taxes. the court held that a significantly lower turnover tax rate for small businesses with gross receipts under 60,000 german marks than for other enterprises was a reasonable exercise of legislative discretion and did not violate the equality principle. with the significant general rate increase, 329 horizontal and vertical equity in taxation [vol.7:5 503. bverge 37, 38 (mar. 19, 1974, 1st senat). 504. bverge 31, 145, 179 (jun. 9, 1971, 2d senat). 505. bverge 36, 321 (mar. 5, 1974, 1st senat). 506. id. at 340-1. the legislature carved out the exception because it was concerned that the small businesses would not be able to pass the higher rate onto their customers. in a case addressing the credit for the pre-tax on imported milk503 powder, failure to adjust the computation for the specific industry, rather than using a generalized computation, did not violate the equality principle. some inequalities were unavoidable with efficient tax administration.504 imposition of the full rate of turnover tax on musical recordings, while reductions in rate or exemptions from the turnover tax existed for many other cultural endeavors, including books, theater productions, and concerts, did not violate the equality principle. the court held that the legislature50 5 analyzed and grouped cultural activities, in part, on the basis of which activities would need a tax diminution in order to retain their profitability, a political decision properly within the expertise of the legislature. records enjoyed a strong market position. no case raised the question of the506 regressive impact of the turnover tax on consumers. v. conclusion relative to the limited impact of u.s. supreme court constitutional jurisprudence on taxation, the german body of constitutional law based taxation decisions is vast. while the u.s. supreme court confirms the power of the legislature to classify taxpayers so long as those classifications have a rational basis, the german constitutional court’s decisions reflect near hypersensitivity to classifications of taxpayers that may limit those taxpayer’s individual rights in any manner or cause some taxpayers to receive less favorable tax treatment than others. explanatory hypotheses for these differences include: 1. that the constitutions differ, such that german constitutional protections are more robust than comparable u.s. protections, whether that robustness is intrinsic or a function of the existence of a specialized constitutional court. 2. unlike the u.s. supreme court, the german constitutional court has no simple method like denial of certiorari to enable it to refuse to hear significant constitutional questions. moreover, the german court’s tunnel vision compels it to resolve constitutional questions rather than resorting to statutory grounds for a finding, so that it defers less to the legislature than does the u.s. supreme court. the constitution court may view its role as a 2006] florida tax review 330 507. ashwander v. tennessee valley authority, 297 u.s. 288, 341 (1936) (justice brandeis concurring but stating the principle that courts should dispose of cases without deciding constitutional issues whenever possible). 508. see generally h.w. koch, a constitutional history of germany at 342-3 (london 1984). 509. basic law for the federal republic of germany (agreed anglo-american translation) (1949). the states of west germany adopted the basic law in may 1949 with the preamble reading in part: “conscious of its responsibility before god and mankind, filled with the resolve to preserve its national and political unity and to serve world peace as an equal partner in a united europe, . . .” the preamble also intends the basic law to apply to those germans who could not participate in the process, i.e., the german democratic republic. parliament amended the preamble to include the former mandate to ferret out constitutional infirmity and resolve it against the administration and legislature. 3. that, alternatively, united states’ constitutional protections are more durable; the court reverses its precedents only rarely. the supreme court is very careful and conservative in offering constitutional protection. 4. the supreme court is a court of general jurisdiction and prefers to decide cases on grounds other than the constitution rather than addressing the constitutional issue. the strong united states tradition of separation of507 powers causes the court to avoid, whenever possible, conflict with the legislature and to leave most policy matters to the legislature under the court’s policy of judicial restraint. 5. that the differences reflect maturation. earlier in united states’ constitutional history, the supreme court more readily struck down tax provisions but with time, it became more respectful of legislative choices. perhaps the same development will occur in germany as the constitutional court matures. support exists for each of these hypotheses. germany’s history suggests that the first hypothesis is valid. it explains the emphasis on individual rights and the constitutional court’s reluctance to permit any limitations of those rights. emerging from the barbarism of its world war ii period, during which the national socialist german government mandated violation of human rights on an unprecedented scale, occupied west germany adopted its basic law and established a court to protect rights under that basic law. the basic law508 confirmed germany’s present and future commitment to protection of human dignity, rule of law and absolute prohibition of discrimination. the basic law guarantees showed a germany committed to distancing itself from its repressive and genocidal past and facilitated germany’s reentry into a civilized and peaceful europe as an equal participant. west germany509 331 horizontal and vertical equity in taxation [vol.7:5 gdr states and to emphasize germany as part of a united europe following reunification in 1990. 510. basic law art. 1 – 20. 511. basic law art. 79 (3). 512. for example, basic law art. 11 expressly guarantees the right to travel, a right established by interpretation, inter alia, of the 5th amendment of the u.s. constitution. “the right to travel is a part of the ‘liberty’ of which the citizen cannot be deprived without due process of law under the 5th amendment.” kent v. dulles, 357 u.s. 116, 125 (1958) 513. basic law art. 93. the constitutional court’s jurisdiction is slightly broader but in no way pertinent to tax law. 514. supreme court rule 10, supra note 8. 515. basic law art. 100. positioned the individual rights guarantees in the basic law in order to give them paramount importance. unlike the u.s. constitution that emphasized the structure of the government and added individual rights as an afterthought in the bill of rights, protection of individual rights appears at the beginning of the basic law. furthermore, the delineation of basic510 rights is specific with express protections of marriage, family, prohibitions on discrimination on the basis of sex, and, the first article directing all state power to protect human dignity. and, unlike most other provisions of the basic law, germany prohibits emendation of the individual rights guarantees. while the same protections, other than sex discrimination, exist511 under the u.s. constitution, many of them have emerged through constitutional interpretation.512 as to the second hypothesis, the basic law limits the constitutional court’s jurisdiction to constitutional questions. thus, if the court513 addresses a tax question at all, it must view the tax controversies in constitutional law terms. the u.s. supreme court, on the other hand, easily may avoid constitutional questions by determining that a taxing statute is inapplicable to a specific factual situation on technical grounds. the supreme court controls statutory interpretation. furthermore, the constitutional court does not have the same autonomy as the supreme court with respect to its docket. review by the supreme court generally lies within the court’s discretion. the basic law requires lower courts to refer514 constitutional issues to the constitutional court and suspend their proceedings until the constitutional court rules whenever a basic law interpretation is critical to resolution of a case. lacking the luxury of non-515 constitutional interpretation, the german constitutional court either must decide the constitutional question that caused referral or determine that, contrary to the other court’s analysis, the constitutional question is not critical to the case. if the constitutional court decides that the constitutional issue is not critical to the case, it must remand the case to the referring court 2006] florida tax review 332 516. spector motor service, inc. v. mclaughlin, 323 u.s. 101 (1944) (suspending decision on constitutionality of a state tax pending state court resolution of applicability of the tax); also ashwander v. tennessee valley authority, 297 u.s. 288, supra note 507. 517. basic law art. 100. 518. “to abide by, or adhere to, decided cases.” black’s law dictionary 4th edition 1577 (st. paul 1951). 519. south carolina v. baker, supra note 159, at 524 acknowledges the gradual overruling of pollock v. farmers’ loan and trust co., 157 u.s. 429 (1895), with respect to the issue of intergovernmental tax immunity. 520. consider the controversial issue of abortion. since the decision in roe v. wade, 410 u.s. 113 (1973), the court is composed of different judges from those who rendered the decision. yet, while the court has limited or distinguished subsequent cases, it has not overruled roe v. wade. 521. burnet v. coronado oil & gas co., 285 u.s. 393, 406 (1932) (brandeis, dissenting). even if it differs from the lower court on a substantive, but nonconstitutional, issue in the case. given that choice, the constitutional court may choose to exercise jurisdiction in instances where the u.s. supreme court may choose to avoid the constitutional question. perhaps the516 constitutional court, whether or not consciously, protects its own relevance by deciding issues on constitutional grounds that another court might have resolved on non-constitutional grounds. moreover, the basic law denies other courts the power to avoid constitutional issues. if a constitutional issue is significant to the case, referral of the constitutional issue to the constitutional court is mandatory.517 lest courts risk being viewed as insensitive to individual rights, they, especially early in the post-war period, may have opted to identify constitutional issues and refer the case to the constitutional court. over sensitivity to constitutional matters after the war was certainly preferable to under sensitivity. the third hypothesis emerges from the common law’s reliance on a system of precedents and the rule of stare decisis. once the supreme court518 elects to decide an issue on constitutional grounds, its decision is the law of the land, despite subsequent legislative enactments. only when the weight of later decisions have so limited or distinguished an earlier opinion, such that overruling the earlier decision is almost inevitable, does the court reverse its position. changes in the composition of the court may result in the court’s519 greater willingness to limit the holding in an earlier decision or to distinguish a case before the court from existing precedent, but overruling earlier520 decisions is exceptional: “[s]tare decisis is usually the wise policy, because in most matters it is more important that the applicable rule of law be settled than that it be settled right.”521 333 horizontal and vertical equity in taxation [vol.7:5 522. spector motor service, inc. v. mclaughlin, 323 u.s. 101, 105 (1944). 523. doc v. united states house of representatives, 525 u.s. 316, 343 (1999). 524. valley forge christian college v. americans united for separation of church & state, 454 u.s. 464, 474 (1982) (plaintiff lacking standing because of no injury to itself from the purported transfer of property in violation of the establishment clause). 525. marbury v. madison, 5 u.s. 137, 177 (1803) (establishing the supreme court’s power to review legislative acts for constitutionality). clinton v. city of new york, 524 u.s. 417, 450 (1998) (ruling “line item veto” to be unconstitutional, kennedy concurring and discussing the importance of separation of powers). the fourth hypothesis goes to the united states’ governmental system, separation of powers and judicial review. as a general policy matter, the supreme court avoids constitutional questions whenever possible. in abstaining from deciding a constitutional challenge to a state tax statute until the state court interprets applicability of the tax, the court writes: 522 if there is one doctrine more deeply rooted than any other in the process of constitutional adjudication, it is that we ought not to pass on questions of constitutionality – here the distribution of the taxing power as between the state and the nation – unless such adjudication is unavoidable. similarly, in a case challenging a statistical sampling that the census bureau proposed in order to apportion representation in the house of representatives, the court concluded that the census act did not authorize the sampling method. since the court decided the case on statutory grounds, it did not address the constitutional challenges. the court’s reluctance to523 exercise judicial review of statutes is understandable as it places the court into conflict with the legislature. since the constitution delegates the legislative function to congress, judicial review, in the court’s tradition, remains extraordinary. chief justice rehnquist emphasized this point:524 proper regard for the complex nature of our constitutional structure requires neither that the judicial branch shrink from a confrontation with the other two coequal branches of the federal government, nor that it hospitably accept for adjudication claims of constitutional violation by other branches of government where the claimant has not suffered cognizable injury. separation of powers is entrenched in the american legal tradition,525 and judicial restraint is essential to prevent ongoing struggles between the branches of government. 2006] florida tax review 334 526. estg § 3 2. (exempting welfare payments from the income tax). 527. bverge 87, 153 (sept. 25, 1992, 2d senat), supra note 123, discussed in text accompanying note supra 385. 528. pub. l. no. 104-193 (104th cong, 1st sess., aug. 22, 1996). 529. see discussion supra part iii d. 530. am. trucking ass’ns v. mich. psc, 125 s. ct. 2419 (2005). 531. data exists for the federal cases, see supra notes 157-159. the state cases are an unscientific estimate. 532. supra notes 153-156 and accompanying text. 533. see discussion supra part iii e. while a similar separation of powers exists under germany’s system, parliamentary systems tend to place less emphasis on separation of powers, so that judicial restraint may not be quite as compelling as in the united states. for example, the german constitutional court resolved the problem that welfare recipients might receive more after tax income from welfare526 than some workers with income equal to the amount of a welfare payment by exempting a subsistence minimum, substantially equivalent to public welfare assistance, from the income tax. in the united states, congress has527 adjusted that problem in part with the limitation on welfare benefits in the personal responsibility and work opportunity reconciliation act of 1996.528 the fifth hypothesis may be weaker than the other hypotheses. under the commerce clause, the supreme court’s interest in preserving equality in taxation across state borders does not appear to have diminished. on the other hand, the court increasingly tolerates small, level5 2 9 fees and taxes that, on equality principles, should be greater for taxpayers who use state resources more than others. the greatest number of530 constitutional tax decisions in both federal and state cases concentrates531 itself in the late 1920s through 1940. as the court matured in its approach to taxation, taxpayers enjoyed fewer successes, although the number of successes was quite small even earlier. and the court reversed its position on at least two issues: retroactive taxation and federal taxation of state532 payments. whether the german constitutional court will continue its533 judicial activism in taxation as its body of tax decisions grows or not remains an open question. 335 horizontal and vertical equity in taxation [vol.7:5 appendix a note on regressivity and the income tax exemption/welfare benefit of a subsistence minimum. under the german system, the combined turnover tax and income tax tends to be regressive at middle incomes but not at the lowest incomes. this characteristic is easy to illustrate through a simplified example. assume that there is a flat rate turnover tax of 16% on all goods and services, including rent, but each taxpayer is exempt from the income tax on an amount equal to the subsistence minimum of 100. the statutory subsistence minimum is the cost per person of basic necessities – food, clothing, transportation and housing – grossed up to include the turnover tax that is an embedded, rather than an add-on, tax unlike u.s. sales taxes. hence basic necessities cost approximately 86.20 and the tax on those necessities is approximately 13.80. on a pre-tax basis, the subsistence exemption amount applicable to all taxpayers is 86.20. individuals whose incomes are less than 100 receive a welfare payment to increase their incomes to 100. assume further that the minimum income tax rate is 20% and, given the steep progressivity in rates, assume a two bracket system with the higher rate of 48% on incremental euro incomes over 300. all taxpayers pay 13.80 of their first 100 income in combined turnover and income tax. a taxpayer with any income in excess of the subsistence amount pays at least 20% combined tax, even if he or she invests every euro over 86. accordingly, at the lowest incomes, the turnover tax allows no regressivity because no taxpayer will pay less than 13.8% tax on each euro. however, taxpayers with incomes over 100 may experience regressivity as income increases. for example, compare two taxpayers with incomes of 1000 and 2000 respectively who consume the first 1000 of income and invest any income over 1000: 1000 1. 13.8% turnover in 1000 = 138 2. income tax @ 20% on 200 = 40 3. income tax @ 48% on 700 = 336 total = 514 as % of 1000 total income =51.4% 2000 1. steps 1. – 2. are same = 178 2. income tax @ 48% on 1700 = 816 total = 994 as % of 2000 total income = 49.6% and this would drop to 48.3% at 10,000. the regressivity begins to emerge at 1100 and becomes more pronounced as the income disparity increases. page 1 page 2 page 3 page 4 page 5 page 6 _hlt112038603 page 7 _ref113169767 _ref113169767 _ref113175152 _ref113175152 page 8 _hlt112564639 _ref113687203 _ref113687203 _ref113175021 _ref113175021 _ref108427235 _ref108427235 _ref99593765 _ref99593765 _ref109207214 _ref113446943 _ref113446943 page 9 _ref112574668 _ref112574668 _ref107828096 _ref107828096 _ref98816576 _ref98816576 page 10 _ref55979963 _ref113606089 _ref113606089 _ref98775441 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_ref61414436 page 58 _ref61088330 _ref61088330 _ref61259237 _ref61259237 _ref61345645 _ref61345645 _ref61149188 page 59 _ref61164205 _ref61164205 page 60 _ref61426907 _ref61426907 _ref98840936 _ref98840936 page 61 page 62 _ref114300716 _ref114300716 _ref114897608 _ref114897608 page 63 page 64 _ref58062116 _ref58062116 page 65 page 66 page 67 _ref82579700 _ref82579700 _ref82765303 _ref82765303 page 68 page 69 page 70 page 71 page 72 page 73 page 74 page 75 page 76 _ref113533418 _ref113533418 page 77 page 78 _ref113267856 _ref113267856 page 79 page 80 page 81 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 19 2016 number 1 i article the pact act as indicium of the due process validity of the marketplace fairness act eric s. smith 1 florida tax review volume 19 2016 number 1 ii the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states, plus sales tax where applicable and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117634, gainesville, florida 32611-7627. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352)273-0904 or email ftr@law.ufl.edu. copyright © 2016 by the university of florida florida tax review volume 19 2016 number 1 iii editor-in-chief martin j. mcmahon, jr. james j. freeland eminent scholar in taxation university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar in taxation dennis a. calfee professor of law michael k. friel professor of law david m. hudson professor of law emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar in taxation charlene luke professor of law grayson mccouch professor of law adam smith visiting assistant professor samuel c. ullman adjunct professor of law board of advisors hugh j. ault boston college bradley t. borden brooklyn law school j. martin burke university of montana charlotte crane northwestern university jasper l. cummings, jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina kerry a. ryan st. louis university graduate editors alisa french paul hankin john hodnette laura michael hughes m. blair james young hei jo michael schwartz mark westenberger executive assistant keyosha r. monroe florida tax review volume 19 2016 number 1 iv information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: “articles,” “commentaries,” and “book reviews.” the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manual. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 19 2016 number 1 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review vol ume 8 2007 number 7 common markets, common tax problems by ruth mason i. introduction .......................................... 600 ii. common tax problems .................................. 605 a. state tax discrimination ............................ 605 b. double taxation and harmonization of the tax base ...... 611 1. business taxation ........................... 611 2. individual taxation .......................... 617 c. foreign tax relations .............................. 619 1. european tax treaties: competence and m ultilateralism ................................ 619 2. u.s. state taxation and the foreign commerce clause ............................. 622 d. subsidies, tax incentives, and interstate competition ..... 624 iii. conclusion ......................................... 628 florida tax review common markets, common tax problems by ruth mason* it began with george washington himself, when he wrote to lafayette: i am a citizen of the greatest republic of mankind. i see the human race united like a huge family by brotherly ties. we have made a sowing of liberty which will, little by little, spring up across the whole world. one day, on the model of the united states of america, a united states of europe will come into being. the united states will legislate for all its nationalities.' i. introduction the united states and the european union are different in more ways than it is possible to briefly enumerate, but their foundations had a striking similarity of purpose: to increase citizens' welfare by uniting a collection of independent states, each with its own politics, culture, and economy. of course, the unification of the u.s. states never as divided politically, culturally, or economically as the countries of europeis an achievement largely in the past. in contrast, significant integration in europe has taken place in our own time. although the united states and the european union have similar goals, the political structure and degree of unification differ substantially in each region. the united states is a single country, with a unified polity and a powerful central government, whereas the european union is a collection of 27 * associate professor and nancy & bill trachsel corporate law scholar, university of connecticut school of law. she can be reached at ruth.mason@law.uconn.edu. this essay was presented at the university of florida levin college of law's annual international tax symposium on september 21, 2007. the author would like to thank larry lokken for his commentary on the essay at the symposium. the author also thanks yariv brauner, joann martens weiner, and especially walter hellerstein for their helpful comments. 1. andr6 fontaine, open democracy, farewell to the united states of europe: long live the eu!, (2001), available at http://www.opendemocracy.net/democracyeuropefuture/article 344.jsp. [vol 8:7 common markets, common tax problems independent countries and peoples with a weak central government.2 the purpose of this essay is to explore the common tax problems confronting the u.s. and european union (eu) common markets. the degree of independence of the central government from the states differs in the united states and the european union. the u.s. central government is largely independent of the states. although the federal congress includes two senators from each state, the citizens of the states directly elect the senators, who represent the people's interests, rather than the interests of the states, per se. representation in the house of representatives is proportional to population, and representatives are also directly elected by residents each of congressional district. in contrast, the eu central government is much less independent from the member states. although the european union has a directly elected parliament, the european parliament has little power. most of the central government's power is concentrated in the council of the european union, composed of ministers of the member states.' such ministers are often unelected members of the national government of the member states, and therefore may be seen as representing the interests of the government of their member state more than the interests of the residents of that state. further differences can be seen in each region's tax system. as the sine qua non of a strong central government, the power to levy taxes is congress's first enumerated power in the constitution.4 the u.s. federal government collects taxes from individuals and other taxable entities according to uniform federal laws that apply throughout the geographic territory of the united states. albeit not legally reserved to the states, the sales tax base is reserved to the states by tradition, and sales and property taxes constitute the source of the majority of state and local tax revenue.' although the u.s. states have tax authority independent from the federal government, the federal government is 2. see walter hellerstein & charles e. mclure jr., lost in translation: contextual considerations in evaluating the relevance of the u.s. experience for the european commission's company taxation proposals, 58 bull. int'l bureau fiscal doc. 86, 88 (2004) ("the eu follows more closely the confederation model, with decisions being made jointly by the member states rather than by a higher level of government, which barely exists and, contrary to the situation in the us, has little power"). but see ingolf pernice, the framework revisited: constitutional, federal and subsidiarity issues, 2 colum. j. eur. l. 403, 413 (1996) (arguing that the "financial weakness" of the community obscures a significant source of its power: its unfettered ability to regulate by unfunded mandate to the member states). 3. for tax purposes, the european council consists of the finance minister of each member state. for more on the ec tax legislative process, see ruth mason, primer on direct taxation in the european union 4-14 (2005) [hereinafter mason, primer]. 4. u.s. const. art. i, § 8, cl. 1. 5. see report of the president's tax advisory panel on federal tax reform, simple, fair, and pro-growth: proposals to fix america's tax system 202 (2005) (noting that a likely obstacle to adoption of a federal value-added tax was that states would view it as "an intrusion on their traditional sales tax base"). 2007] florida tax review the big player in american taxation: it annually raises twice the taxes raised by all the u.s. states combined.6 the european community itself exercises almost no tax authority,7 although it is guaranteed a certain percentage of value-added tax revenues and other funding8 in the form of transfers from the member states.9 since the ec treaty grants no explicit tax powers to the european union, the member states are the principal taxing authorities. moreover, the requirement of member state unanimity to enact community tax legislation ensures that taxation will remain under the control of the member states indefinitely." likewise, the principle of "subsidiarity," which forbids action at the eu level except when the policy objective cannot be achieved at the state level, also suggests that the member states will remain the principal actors for tax matters." member states assess and collect both direct and indirect taxes, and in contrast with the united states (where the largest source of federal revenue is income and payroll taxes) in europe, indirect taxes represent a substantial source of national tax revenue. value-added taxes have been largely harmonized in the european union, but income taxes are unharmonized, leaving each state 6. see u.s. census bureau, census of governments (calculating combined state and local tax revenues for fiscal year 2002 at nearly $1 trillion); office of management & budget, budget of the u.s. government (calculating 2002 federal revenues at over $1.8 trillion). 7. the community levies income taxes on its own employees, who are exempt in their home states from income tax on their community government wages. it also collects levies on coal and steel. 8. the european union's non-debt funding derives principally from: (1) duties on coal and steel and imposts collected for the purpose of enforcing the common agricultural policy, (2) a fixed percentage of the vat revenues collected by each state, (3) contributions by each member state of a fixed percentage of its gross national income (gni). see sijbren cnossen, tax policy in the european union: a review of issues and options (cesifo, working paper no. 758, 2002) available at http://ideas.repec.org/p/ces/ceswps/_758.html; lerke osterloh, harmonization and public finance in germany and europe, 2 colum. j. eur. law 519 (1996). the percentage contributions have varied over time, but the eu budget is small relative to the member states' national budgets. the latest agreement capped the european union's own resources at 1.24% of the gni of the european union. see communication from the commission to the council and the european parliament, adaption of the ceiling of own resources and of the ceiling for appropriations for commitments following the entry into force fo decisions 2000/597/ec, eurotom, com (2001) 811 final. 9. see the consolidated version of the treaty establishing the european community, art. 268-280, dec. 29, 2006,2006 o.j. (c 321) e/i [hereinafter ec treaty] (setting forth fiscal and budgetary rules, and stating that the european union's "budget shall be financed wholly from own resources," but not conferring on any eu institution the positive right to tax). 10. id., art. 94. 11. id., art. 5. [vol. 8:7 common markets, common tax problems free to determine both the rates of tax and the taxable base. as a result, a resident of france with the same income from the same sources as a resident of estonia may be subject to vastly different taxes. while the federal government collects two-thirds of annual taxes in the united states, in europe, the member states collect virtually all taxes. 2 notably, the formation of the united states predated the advent of the state income taxes, 13 whereas member state tax systems were in place well before the formation of the european union. this difference may affect the degree of resistance in each region to involvement by the central government in state tax policy. despite these differences in the structure of government and the division of tax powers, certain tax issues in the united states and the european union are similar. these include questions of horizontal federalism involving how membership in the common market affects the interaction of the states with each other and with each other's residents. for example, both the ec treaty and the u.s. constitution have been interpreted to ban discriminatory taxation by the states. this means that states generally cannot treat interstate or intracommunity commerce worse for tax purposes than they treat purely domestic commerce. the ban on discriminatory state taxation represents a significant constraint on state tax power. additionally, since neither the u.s. states nor the eu member states entirely surrendered their tax sovereignty when joining their respective unions, vertical federalism questions also arise concerning which level of government is better suited or legally entitled to engage in certain tax functions. 4 in the european union, which is not a true fiscal federal system, 5 and in which the central government has virtually no tax powers and a relatively small budget, vertical federalism questions principally concern such issues as whether the member states should negotiate bilateral tax treaties directly with each other and third countries, or whether that task should be performed by the 12. much of the budget of the european union is pre-committed to agricultural subsidies. see references in supra note 8. 13. see hellerstein & mclure, supra note 2, 96-98 (discussing what they call the "implications of nationhood" on the limits of the comparison between u.s. state taxation and eu member state taxation). 14. for more on tax assignment and fiscal federalism issues generally, see robert p. inman & daniel l. rubinfeld, designing tax policy in federalist economies: an overview, 60 j. pub. econ. 307 (1996). 15. in 1996, professor lerke osterloh recounted french president jacques chirac's view that "the union is neither a federation in the german sense nor simply a free-trade area as the british government wishes, and some aspects of the fiscal constitution, but not all of them, seem to confirm this statement." osterloh, supra note 8, at 521. osterloh concluded that "the tax laws within the eu are characteristic more of a free trade zone than a federation." id. at 529. 2007] florida tax review community, which could negotiate bilateral tax treaties with third countries on behalf of the whole european union. the u.s. and eu states also share challenges facing any state operating in a multi-jurisdictional tax setting. among these challenges are tax competition, allocation of taxable income in light of the fact that the geographic "source" of an item of income may be uncertain, and avoidance of double taxation. these challenges may be especially acute in the u.s. and eu common markets due to extensive interstate investment and economic activity.16 the purpose of this essay is to identify some of the tax problems common to both the united states and the european union and to explore potential solutions. as the length of the essay suggests, i do not purport to discuss comprehensively each topic, or to cover every tax challenge common to the united states and european union. 7 instead, my hope is that this essay will become part of the ongoing trans-atlantic dialog concerning our common tax problems and solutions that may work in both places.'" of course, the significant differences between the united states and the european union mean that tax lessons learned in one jurisdiction may only be applied in the other with considerable caution.' 9 16. cf. daniel shaviro, an economic and political look at federalism in taxation, 90 mich. l. rev. 895 (1992) (arguing that the greater elasticity of response to locational tax disparities in the modem united states, as compared to the early united states, means that inefficiencies caused by discriminatory taxes are more important today). 17. although not covered in this essay, many other tax challenges common to both regions come to mind, including the treatment of cross-border dividends, crossborder loss relief, dispute resolution mechanisms for unresolved cases of double taxation, compliance issues, taxation of electronic commerce, and so on. of particular interest in the united states might be the european success at harmonizing indirect taxes. 18. see, e.g., martin sullivan, lessons from europe on state corporate taxes, 40 state tax notes 407 (2006); hellerstein & mclure, supra note 2. 19. see hellerstein & mclure, supra note 2, at 89 (noting characteristics that tend to make u.s. state taxation and consequently, its defects less significant than eu member state taxation, including such factors as diffusion of state tax benefits through the system of formulary apportionment, relatively low state income tax rates, and deductibility of state taxes from the federal tax base). [vol. 8:7 common markets, common tax problems i. common tax problems a. state tax discrimination probably the tax area in which the united states and the european union most resemble each other is the prohibition of state tax discrimination.2 both common markets ban tax discrimination by one state against residents of a fellow state.2' in the united states, the constitution prohibits discriminatory state taxes under the commerce, privileges and immunities, and equal protection clauses.22 of these provisions, the commerce clause has the broadest implications for state taxation. under the supreme court's "dormant" commerce clause jurisprudence, the states may not use their tax systems to unjustifiably burden or discriminate against interstate or foreign commerce. 4 likewise, the european court of justice (ecj) has interpreted the fundamental freedoms of the ec treaty to prohibit discriminatory member state taxes.2 5 unfortunately, neither court has given clear guidelines as to what constitutes tax discrimination. in both jurisdictions, the basic features of a discriminatory tax are the same: the state favors domestic economic activities over out-of-state activities. discrimination may also occur when a state 20. see generally comparative fiscal federalism: comparing the court of justice and the u.s. supreme court's tax jurisprudence (reuven avi-yonah, james r. hines, jr. & michael lang eds., 2007). 21. for comprehensive analysis of u.s. state taxation, see jerome r. hellerstein & walter hellerstein, state taxation (3d. ed. 1999 & supp. 2007). for concise analysis ofdirect taxation in the european union, see mason, primer, supra note 3. for comprehensive analysis of direct and indirect taxation in the european union, see b. j. m. terra & peter wattel, european tax law (2005); paul farmer & richard lyal, ec tax law (1995). 22. see hellerstein & hellerstein, supra note 21. 23. u.s. const. art. i, § 8, cl. 3, provides "congress shall have power... [t]o regulate commerce with foreign nations, and among the several states, and with the indian tribes." compare the privileges and immunities clause, which only applies to natural persons who are u.s. citizens. see u.s. const. art. iv, § 2, providing that "[t]he citizens of each state shall be entitled to all privileges and immunities of citizens in the several states" (emphasis added). 24. see, e.g., complete auto transit, inc. v. brady, 430 u.s. 274 (1997). 25. ec treaty, supra note 9, art. 39 (freedom of movement of workers), arts. 43, 48 (freedom of establishment), art. 49 (freedom to provide services), arts. 56, 58 (freedom of capital movement). article 49 of the ec treaty provides for the freedom to provide services with the following language: within the framework of the provisions set out below, restrictions on freedom to provide services within the community shall be prohibited in respect of nationals of member states who are established in a state of the community other than that of the person for whom the services are intended. 2007] florida tax review differentiates between resident and nonresident taxpayers and either singles out nonresidents for worse tax treatment, or singles out residents for special tax benefits.26 however, in neither jurisdiction is a mere difference in taxation of domestic and cross-border situations sufficient to prove discrimination. this is so because the supreme court and the ecj each recognize a variety of circumstances that justify different treatment for domestic and cross-border situations. the most important limitation on the scope of discrimination is the requirement of comparability. under the jurisprudence of both courts, states must treat domestic and cross-border situations the same for tax purposes only when the domestic and cross-border situations are "similar., 27 both courts have been criticized for giving insufficient content to the notion of "similar" tax situations.28 failure by both courts to articulate clear standards by which state taxes will be judged has led to significant legal uncertainty for taxpayers, states, and other courts bound by the supreme court's and the ecj's judgments.29 the supreme court has even criticized its own dormant commerce clause jurisprudence in tax discrimination cases, calling it a "quagmire" and a "tangled underbrush., 30 perhaps due to the difficulties in identifying tax discrimination, commentators' recommendations concerning the future of judicial review of state taxes in each jurisdiction span a wide spectrum. some say the courts 26. for more on the standards applied in tax discrimination cases in the united states and the european union, see the references cited supra note 21. 27. see case c-279/93, finanzamt kb1n-altstadt v. schumacker, 1995 e.c.r. 1-225, 30 ("discrimination can arise only through the application of different rules to comparable situations or the application of the same rule to different situations"). cf. lunding v. n.y. tax appeals tribunal, 522 u.s. 287, 311 (1998) (using the term "similarly situated residents" in a tax discrimination case disposed under the privileges and immunities clause). 28. for criticism of u.s. jurisprudence, see edward a. zelinsky, restoring politics to the commerce clause: the case for abandoning the dormant commerce clause prohibition on discriminatory taxation, 29 ohio n.u. l. rev. 29 (2002); shaviro, supra note 16. for criticism of european jurisprudence, see ruth mason, flunking the ecj's tax discrimination test, 45 colum. j. transnat'l l. 72 (2008); michael j. graetz & alvin c. warren, jr., income tax discrimination and the political and economic integration of europe, 115 yale l. j. 1186 (2006). 29. the supreme court itself acknowledged that its "case-by-case" approach under the dormant commerce clause "left much room for controversy and confusion and little in the way of precise guides to the states." boston stock exch. v. state tax comm'n, 429 u.s. 318, 329 (1977) (quoting northwestern states portland cement co. v. minnesota, 358 u.s. 450, 457 (1959)). 30. northwestern states portland cement, 358 u.s. at457-8. see also wardair canada, inc. v. florida dept. of revenue, 477 u.s. 1, 17 (1986) (burger, c. j., concurring in part and concurring in judgment) (referring to "the cloudy waters of this court's 'dormant commerce clause' doctrine"). [vol. 8:7 common markets, common tax problems should expand their review of state taxes,3 others want to narrow it," and still others want to terminate it completely.33 in the united states, the call to significantly restrict dormant commerce clause review of state taxes has come from members of the court itself.34 but despite widespread recognition of the 31. see, e.g., peter d. enrich, saving the states from themselves: commerce clause constraints on state tax incentives for business, 110 harv. l. rev. 377 (1996) (arguing that the supreme court should strike down certain business tax incentives offered by states under the dormant commerce clause). see also servaas van thiel, a slip of the european court in the d case (c-376/03): denial of the most-favoured-nation treatment because of absence of similarity?, 33 intertax 454 (2005) (arguing that the ecj should interpret the fundamental freedoms to encompass a right of most-favored-nation treatment under tax treaties). 32. see, e.g., shaviro, supra note 16 (arguing in favor of congressional harmonization of state tax bases, which would have the effect of limiting judicial review of state taxes); graetz & warren, supra note 28 (arguing for judicial restraint in europe). 33. zelinsky, supra note 28 (arguing that the supreme court should abandon dormant commerce clause review of state taxes); cf. julian n. eule, laying the dormant commerce clause to rest, 91 yale l.j. 425 (1982) (suggesting that the supreme court abandon dormant commerce clause jurisprudence generally and instead rely on the privileges and immunities clause to address discriminatory state regulations). see also frans vanistendael, the ecj at the crossroads: balancing tax sovereignty against the imperatives of the single market, 46 eur. tax'n 413, 413 (2006) (noting that during negotiations for the proposed european constitution, member state representatives considered whether to strip the ecj of direct tax jurisprudence). 34. justice scalia, never a fan of the dormant commerce clause, has harshly criticized the court's majority opinions in tax discrimination cases. see, e.g., am. trucking ass'n, inc. v. smith, 496 u.s. 167, 202 (1990) (scalia, j., concurring) (noting his disagreement with the court's "typically destabilizing" dormant commerce clause jurisprudence). in schneier, justice scalia stated that he would only strike down state tax statutes that facially discriminate between residents and nonresidents. am. trucking ass'n, inc. v. scheiner, 483 u.s. 266, 304 (1987) (scalia, j., dissenting) ("the same tax is imposed on in-state as on out-of-state trucks; that is all i would require."). justice scalia has also argued that the practical results we have educed from the so-called "negative" commerce clause form not a rock but a 'quagmire' .. .. nor is this a recent liquefaction. the fact is that in the 114 years since the doctrine of the negative commerce clause was formally adopted as holding of this court,.. . and in the 50 years prior to that in which it was alluded to in various dicta of the court. . . our applications of the doctrine have, not to put too fine a point on the matter, made no sense. tyler pipe indus., inc. v. wash. state dep't of revenue, 483 u.s. 232, 259-260 (1987) (scalia, j., concurring in part and dissenting in part) (citations omitted). justice thomas has also criticized the court's dormant commerce clause jurisprudence as "failed," a "morass," and "virtually unworkable in application," and he recommended abandoning it in tax cases in favor of scrutiny under the import-export clause. see camps newfound/owatonna, inc., v. town of harrison, 520 u.s. 564, 610-611 (1997) (thomas, j., dissenting). 20071 florida tax review problems with the judicial standards for state tax discrimination, surprisingly few concrete suggestions for improvement have been made in this area.35 one solution to these problems might be to abandon judicial review of state taxes altogether. this could be accomplished in europe by stripping the ecj of its jurisdiction to review income tax cases. a suggestion to do just that was made during recent negotiations over the european constitution.36 however, the suggestion was not adopted in the final draft of the proposed constitution, perhaps due to recognition of the important pro-integration role played by the court of justice in taxation. since tax legislation in the european union requires unanimous agreement by the member states, there have been few legislative directives covering direct taxes.37 instead, most of the progress in removing tax barriers to cross-border trade and investment has resulted from tax cases brought in national courts by private litigants and referred to the ecj for preliminary ruling.38 abandoning review of state taxes might be a better option for the united states. unlike europe, the united states is already so well-integrated politically and economically that perhaps tax discrimination is no longer a major problem.39 while removal of discriminatory taxes may have been necessary at the formation of the union, we might conclude that the supreme court's early vigilance served its purpose. however, successful state tax discrimination claims in the modem era, which articulate important principles and protections, tend to undermine the argument that review of state taxes is no longer necessary in the united states.40 35. but see ruth mason, made in america for european tax: the internal consistency test, 49 b.c. l. rev. (forthcoming 2008) (suggesting that the ecj apply the internal consistency test to income tax cases as a first step towards rationalizing its review of member state taxes); for more on the internal consistency test, see infra text accompanying notes 62-64. see also shaviro, supra note 16 (proposing that congress harmonize the state tax base, leaving the states with authority only to determine their tax rates). 36. see vanistendael, supra note 33, at 413. 37. ec treaty, supra note 9, art. 94. 38. see servaas van thiel, removal of income tax barriers to market integration in the european union: litigation by the community citizen instead of harmonization by the community legislature? 12 ec tax rev. 4 (2003) (arguing that, jealous oftheir national tax sovereignty, the member states have blocked tax legislation at the community level). 39. see zelinsky, supra note 28, at 31 (calling the nondiscrimination principle as applied to state taxes "a historic anachronism, now unnecessary for policing state taxes"). 40. see, e.g., camps newfound/owatonna, inc., v. town ofharrison, 520 u.s. 564 (1997) (holding that a state could not deny property tax exemptions to charities that served out-of-state residents when it granted such exemptions to charities serving state residents); west lynn creamery, inc. v. healy, 512 u.s. 186 (1994) (holding that a state could not "conjoin" a nondiscriminatory tax assessed on both in-state and out-of[vol. 8:7 common markets, common tax problems moreover, it is difficult to say how u.s. courts could completely avoid review of state taxes. even in the unlikely scenario that justices scalia and thomas convinced the rest of the court to abandon dormant commerce clause review of state taxes, tax discrimination has frequently been held to violate the privileges and immunities clause4' and, in a few cases, the equal protection clause.42 due to the obligation to review state taxes under those provisions, federal courts would have to apply some conception of tax discrimination, even if they did not review state taxes under the dormant commerce clause.4 3 of course, one important difference between the supreme court and the ecj is that the supreme court can choose which cases it hears. the supreme court is notoriously parsimonious in granting certiorari in tax cases," and this reluctance to hear tax cases may help achieve the same effect urged by those who would like the court to narrow or abandon its review of state taxes. still, lower courts in the united states also perform judicial review, and they have much less control over their dockets. another option might be to transfer the review function to another government institution. perhaps review of state taxes could be performed by a federal agency in the united states or the commission in europe. commentators have also suggested that the review function could be performed by the state or central legislature.45 however, transferring competence to review state taxes from the courts to another government institution would not solve the state interests with a subsidy to in-state interests that had the effect of rebating the tax only to in-state interests); container corp. of am. v. franchise tax bd., 463 u.s. 159 (1983) (establishing the internal consistency test and the four-part test for reviewing state taxes under the commerce clause). 41. see, e.g., lunding v. n.y. tax appeals tribunal, 522 u.s. 287 (1998); travis v. yale & towne mfg. co., 252 u.s. 60 (1920). 42. see, e.g., metropolitan life ins. co. v. ward, 470 u.s. 869 (1985). 43. professor zelinsky suggests that, if the supreme court were to adopt his proposal to abandon dormant commerce clause review of state taxes, taxpayers who felt they were victims of tax discrimination "should generally take their complaints to congress or to the legislature levying those taxes." zelinsky, supra note 28, at 88. however, he envisions that courts would still review state taxes under the privileges and immunities clause and the three complete auto factors not dealing with discrimination: nexus, fair apportionment, and reasonable relation to the government services provided. id. at 83 (citing complete auto transit, inc. v. brady, 430 u.s. 274 (1977)). review of state taxes under privileges and immunities requires courts to develop and apply a conception of tax discrimination. 44. bob woodward & scott armstrong, the brethren 362 (1979) (noting that justice brennan's typical reaction to a certiorari request in a tax case was, "this is a tax case. deny."). 45. see, e.g., shaviro supra note 16, at 954 (briefly considering and rejecting the notion that congress would do a case-by-case review of state taxes); cf. zelinsky, supra note 28, at 88 (arguing that aggrieved taxpayers should seek legislative repeal of discriminatory taxes). 2007] florida tax review difficult problem of clearly defining what constitutes tax discrimination. moreover, political economy analysis suggests reasons why judicial review may have certain advantages over review by other institutions. under the current systems in the united states and the european union, taxpayers initiate constitutional challenges to state taxes. a taxpayer, who typically bears legal costs for lost cases, may be more efficient than government agencies at choosing which state taxes to challenge.46 additionally, by bringing such challenges, the taxpayer becomes an effective co-enforcer of the ban on discriminatory taxes. in contrast, relying solely on governmental institutions, such as congress, a federal administrative agency, or the european commission, to root out tax discrimination may be less effective than private enforcement due to the possibility that those institutions could be captured by the states. the european commission is already empowered to challenge member state laws before the ecj, but it has brought very few tax challenges. private litigants' high ratio of success in tax cases suggests that there are gaps in the commission's enforcement of the ban on member state tax discrimination. the commission even acknowledged its own lack of zealous advocacy when it resolved in 2001 to bring more tax cases before the ecj.47 likewise, there is significant evidence that congress is reluctant to interfere with state taxes.48 46. some parties in europe and the united states have brought multiple challenges to state tax legislation. see, e.g., references to cases brought in the united states by american trucking associations in supra note 34. see also joined cases c283/94, c291/94 and c-292/94, denkavit int'l bv v. bundesamt fiir finanzen, 1996 e.c.r. 1-5063; case c-170/05, denkavit int'l bv, 2006 e.c.r. 1-11949. 47. the commission wrote: [w]hile the commission regularly submits its observations to the ecj in tax cases brought by individual taxpayers, it has itself brought only a limited number of infringement proceedings against member states in the area of direct taxation .... [t]he commission now intends to adopt a more pro-active strategy generally in the field of tax infringements and be more ready to initiate action where it believes that community law is being broken. . . . there is a particular imperative in the direct tax field: the current approach of leaving the development of case law in the area of direct taxation to chance by simply reacting to cases taken by taxpayers to the ecj is not a proper basis for progress towards agreed community objectives. communication from the commission to the council, the european parliament and the economic and social committee, tax policy in the european union priorities for the years ahead, at 22-23 com (2001) 260 final. 48. cf. kathryn l. moore, state and local taxation: when will congress intervene? 23 j. legis. 171 (1997) (using empirical evidence to confirm the prediction of political choice theory that congress would be reluctant to interfere with state taxes); see also shaviro, supra note 16, at 952-4 (arguing that congress is unlikely to intervene to eliminate discriminatory taxes because vested interest in such taxes lies with business taxpayers who benefit from them and state and local governments that provide them, [vol. 8:7 common markets, common tax problems if review of state taxes for discrimination should not be transferred to another government institution or abandoned altogether, special efforts should be made to rationalize the standards applied by courts to these cases. some suggestions for limited improvements have been made in the literature, but comprehensive, predictable, and clear standards are needed in this important area of the law in both the united states and the european union. b. double taxation and harmonization of the tax base harmonization of state taxes could solve the state tax discrimination question if under the harmonized system the states treated domestic and crossborder situations the same. this could involve adoption of a harmonized tax base coupled with a policy of dividing tax revenue among the states according to a uniform apportionment formula.49 however, because harmonization would significantly reduce state tax autonomy, it is probably not politically feasible. moreover, diversity among state tax systems is thought to have a variety of benefits that would be lost through harmonization. for example, state tax autonomy allows the state to respond quickly and flexibly to voter preferences, and the presence of competing tax jurisdictions imposes budgetary discipline on each state.5" despite these and other benefits of tax competition, diversity of tax laws in common markets produces significant compliance costs and locational distortions. for this reason, u.s. states have undertaken a variety of harmonization projects (with only moderate success), and policy-makers in the european union have urged the adoption of comprehensive business tax harmonization in europe. 1. business taxation the state tax base for business income is substantially harmonized in the u.s. states."' the reason for this is that almost all the states use the federal whereas the harms of discriminatory taxes are diffuse, so that no particular group will champion their eradication). 49. formulary apportionment is discussed at greater length, infra part ii.b. 1. 50. for discussion of the advantages and disadvantages of inter-jurisdictional fiscal competition, with particular emphasis on the european union, see wallace e. oates, fiscal competition and the european union: contrasting perspectives, 31 regional sci. & urb. econ. 133 (2001). 51. the states distinguish between business income, which is generally taxed by formulary apportionment, and non-business income (including investment income), which is taxed according to source and residence rules. business income is defined as "income arising from transactions and activity in the regular course of the taxpayer's trade or business," while all other income is non-business income. unif. div. of income for tax purposes act § l(a), 7a u.l.a. 336 (1985) [hereinafter uditpa]. 2007] florida tax review tax base as the starting point for determining business income.52 use of the federal income tax base reduces the risk that businesses will be subject to tax on different (and overlapping) tax bases in each state. this "piggy-backing" on the federal tax base is an example of voluntary tax base harmonization no law or court decision requires states to use the federal tax base. they do it because it is easier: it reduces compliance expenses for enterprises doing business in the state, and it reduces the states' enforcement costs because they can rely on federal enforcement mechanisms. the u.s. states retain control over revenue by setting their tax rates.53 because there is no federal income tax in europe, the eu member states do not have this option. despite reliance on the federal tax base, at least three features of state taxation introduce disharmonies in the united states. first, many states deviate from the federal tax base. any deviations, unless also adopted by every other state, will result in disparities in the calculation of the same enterprise's income by different states. such disparities could result in income gaps or overlaps across the u.s. states. gaps result in non-taxation of an enterprise's income, while overlaps result in double or multiple taxation. second, not all states use the same taxable unit.54 while some states tax each legal entity separately, others allow various forms of consolidation, and still others see the "unitary" business as the appropriate taxable unit.55 such a unitary business may consist of more than one legal entity, and states have even historically sought to tax a portion of the income of foreign entities that were part of a unitary business active in the state.56 third, if an enterprise conducts business in more than one u.s. state, each state must determine how much of the enterprise's overall income it will tax. an enterprise's overall income is generally divided among the states using formulary apportionment. apportionment formulas use the presence of the enterprise's factors of production in each state including 52. see harley duncan & leann luna, lending a helping hand: two governments can work together, 60 nat'l tax j. 663, 666 ("all but two corporate income tax states (arkansas and mississippi) and the district of columbia use federal income as [the] starting point their taxable base"). for more detailed discussion of the methods of taxation of business income used by the u.s. states, see hellerstein & hellerstein, supra note 21, 7.02; joann martens-weiner, company tax reform in the european union (2006). 53. each u.s. state sets its tax rate independently of the other states and of the federal government. see references in supra note 52. 54. see martens-weiner, supra note 52, at 68, noting that the "taxable unit can generally be defined as a single entity, as a consolidated group, or as a unitary combined group." martens-weiner further notes that although the u.s. states use different taxable units, the canadian provinces tax on the basis of legal entity and do not allow consolidated or "combined" income reporting for related corporations. id. at 69. 55. the "unitary" business is a concept that includes, but is not limited to, vertically integrated businesses. see generally id. at 68-72 (discussing tax avoidance opportunities created by the single entity approach). 56. see discussion of worldwide combined reporting, infra part ii.c.2. [vol. 8:7 common markets, common tax problems property, payroll, and sales to apportion taxable income to each state. however, the states do not all use the same formula, which means that the same income could be apportioned to more than one state (double taxation) or to no state (non-taxation). 7 state tax policy-makers are aware of these disharmonies, the locational distortions they create, and the administrative burdens they impose.5" states have addressed some of these problems under the rubric of the multistate tax compact, which established the multistate tax commission (mtc), a body composed of representatives of the tax administrations of the member states. the mtc provides a forum through which states work to resolve tax problems. specifically, efforts were made to introduce a consistent apportionment formula through the 1957 uniform division of income for tax purposes act (uditpa). however, since only about half the states have adopted uditpa, it has not brought uniformity to state apportionment formulas.59 disparities in state apportionment formulas have been challenged under the dormant commerce clause, but the supreme court has held that disparate apportionment formulas do not violate the constitution. in the court's view, the constitution provides no mandate for state tax uniformity, and no guidelines as to what uniform standards might look like. 60 as a result, the supreme court will only strike down a state apportionment formula under very limited circumstances. 61 an "internally inconsistent" formula, one that would inevitably result in double or multiple taxation if every state adopted it, violates the commerce clause, but formulas that result in "some [tax] overlap" without being internally inconsistent must be upheld because the constitution prescribes no uniform state tax formula.62 the supreme court has expressly stated that congress has the power under the commerce clause to impose a uniform 57. compare the canadian provinces, which use a common formula that allocates overall income to each province according to that province's portion of the company's total payroll and sales. see martens-weiner, supra note 52, at 34. 58. see shaviro, supra note 16, at 920-9 for discussion and estimates of state tax compliance costs. 59. hellerstein & mclure, supra note 2, at 90. see generally bartley hildreth, matthew n. murray & david l. sjoquist, interstate tax uniformity and the multistate tax commission, 58 nat'l tax j. 575 (2005) (discussing the history and activities of the mtc and its success at achieving state tax harmonization). 60. see, e.g., moorman mfg. co. v. bair, 437 u.s. 267 (1978). see also hellerstein & mclure, supra note 2, at 90 ("the us supreme court... has steadfastly refused to take an active role in prescribing specific state tax rules or in requiring uniformity"). 61. hellerstein & mclure, supra note 2, at 94 ("the us supreme court has accorded the states virtually unlimited discretion in determining the formulas they use to apportion income"). 62. moorman mfg. co. v. bair, 437 u.s. 267 (1978). 2007] florida tax review apportionment formula on the states,63 and many commentators have called for greater uniformity in state taxation, but congress has so far declined to legislate. 64 at present, the eu member states have no common system for taxing business profits. every taxpayer reports its income to each country in which it is taxable according to the separate accounting method with arm's-length pricing. under this method, which is the same method used by the united states and other countries to calculate taxable income in the international tax setting, taxpayers report their income to each eu member state as determined under the disparate income tax laws of the 27 jurisdictions. 65 gaps and overlaps in member state tax bases and problems with determining arm's-length prices lead to non-taxation and double taxation of enterprises with business activities in more than one state. additionally, the absence of a common tax base multiplies compliance costs for enterprises and states. the proposed common consolidated corporate tax base would provide a uniform eu-wide tax base, and importantly, a uniform method to apportion taxable income among the member states in which an enterprise does business.66 each member state would retain the autonomy to set its own tax rate. in the article contained in this volume and in her book, joann martens weiner advocates formulary apportionment for europe because it is "better suited to avoid double taxation problems in the european union than the arm's63. see id., 437 u.s. at 280 ("it is clear that the legislative power granted to congress by the commerce clause of the constitution would amply justify the enactment of legislation requiring all states to adhere to uniform rules for the division of income. it is to that body, and not this court, that the constitution has committed such policy decisions."). 64. see, e.g, shaviro, supra note 16 (arguing that congress should harmonize the state tax bases). but see moore, supra note 48 (giving reasons why congress is unlikely to impose uniformity on the states). 65. for a concise explanation of separate accounting, see martens-weiner, supra note 52, at 3. 66. see communication from the commission to the council, the european parliament and the economic and social committee, towards an internal market without tax obstacles a strategy for providing companies with a consolidated corporate tax base for their eu-wide activities, com (2001) 582 final (oct. 23, 2001) [hereinafter 2001 communication on common consolidated corporate tax base]; martens-weiner, supra note 52. using available data, martens weiner shows how selection of employment as the sole factor in the apportionment formula might apportion taxable income to the various member states. see martens-weiner, supra note 52, at 37. she then shows how unilever's 2001-2004 income might be apportioned under four different apportionment formulas, each involving some combination of property, payroll, and sales. id. at 38-40. martens weiner also notes that the member states may apportion income according to national macroeconomic factors, such as national income, rather than company-specific factors. id. at 47. [vol. 8:7 common markets, common tax problems length transfer pricing system."67 she also argues that while it may be politically infeasible for formulary apportionment to be the primary method for allocating taxable income of multinational enterprises to countries generally, the economic integration experienced in the european union over the last decades has "largely made national eu member state borders irrelevant," and a move to formulary apportionment for europe would reflect that economic reality.6" harmonization presents advantages, such as reducing compliance costs (including transfer pricing documentation) and the risk of double taxation within the community. as the member states continue to consider proposals for corporate tax base harmonization and formulary apportionment, they will continue to look to the experience of the united states and other federal tax systems. however, because they have the advantage of hindsight, the member states can evaluate the advantages and disadvantages of those tax systems. proponents of formulary apportionment for europe hope to avoid some of the imperfections of the american system by insisting on uniformity of the tax base and the apportionment formula.69 while u.s. states' ability to deviate from each other on matters of tax policy gives them flexibility and may promote productive competition among the states, as noted above, tax disparities introduce significant inefficiencies. in the absence of adoption of a common consolidated tax base and apportionment formula, the member states will continue to tax corporate income according to separate accounting, with each state defining its own source rules. cross-border loss offsetting among related companies will continue to pose a problem for enterprises operating in more than one member state.7° under the current separate accounting system in europe, double taxation 67. martens-weiner, supra note 52, at 9. see also joann martens weiner, practical aspects of implementing formulary apportionment in the european union, 8 fl. tax rev. 630 (2008) [hereinafter, martens weiner, formulary apportionment]. 68. martens weiner, formulary apportionment, supra note 67, at 9. 69. see martens-weiner, supra note 52. professors hellerstein and mclure put their recommendation in strong terms when they wrote that "the eu should avoid the chaos that occurs because the [u.s.] states have excessive latitude (e.g. the lack of uniformity in, inter alia, apportionment formulas and definitions of groups)." see hellerstein & mclure, supra note 2, at 98. 70. martens weiner noted in 2006 that although austria, denmark, and italy allowed foreign subsidiaries' losses to offset domestic profits, the remaining member states that allowed loss offsetting limited it to related domestic companies. martensweiner, supra note 52, at 19. to some extent, these rules must be altered to comply with the ecj's recent ruling in marks & spencer that a parent company's state that allows domestic loss offsetting must allow the losses of a subsidiary established in another member state to offset domestic income in cases where there is "no possibility" for the loss to be used in the subsidiary state. see c-446/03, marks & spencer plc v. halsey, 2006 e.c.r. 1-10,837. see also michael lang, the marks & spencer case-the open issues following the ecj's final word, 46 eur. tax'n 54, 67 (2006) (describing challenges to the implementation of the ecj's ruling). 2007] florida tax review of business income is relieved by credit or exemption, depending on the domestic laws of the relevant taxing states and their bilateral tax treaties. although recent accession of new member states created gaps in the eu tax treaty network, most intra-community income is covered by tax treaties.7 however, where no double tax relief is required by a tax treaty or a member state's domestic law, the ecj has suggested that the ec treaty imposes no additional obligation on eu member states to relieve double taxation on intracommunity income.72 at the same time that europe looks to the united states as a model for a common consolidated tax base, the u.s. states should look more closely at the european proposals, which envision a uniform tax base and uniform apportionment method. if the european union ultimately succeeds in establishing a uniform corporate tax system, despite the member states' incredible tax diversity,73 it might help convince the u.s. states that their tax differences are not intractable, and that base and formula harmonization may be feasible. harmonization of the base and formula need not mean abandonment of tax competition or total surrender of member state tax autonomy, since even under a harmonized tax base, states could control how much revenue they raise by retaining control over their tax rate. as noted previously, the european proposals for a common tax base with formulary apportionment envision that the member states would independently set their tax rates.74 moreover, harmonization might produce other benefits by reducing the influence of taxpayer lobbyists. business taxpayers favor state tax diversity for the arbitrage opportunities such diversity offers. some commentators have argued that states' attempts to attract investment by offering tax holidays and other tax incentives itself constitutes unconstitutional tax discrimination that should be struck down by the supreme court under the dormant commerce clause,75 while others have argued in favor of congressional harmonization of 71. georg kofler & ruth mason, double taxation: a european "switch in time?" 14 colum. j. eur. l. 63 (2007) (describing the comprehensiveness of the intraeu treaty network). 72. case c-513/04, kerckhaert & morres v. staat, 2006 e.c.r. 1-10967 (holding that a member state had no obligation to relieve double juridical tax on a cross-border portfolio dividend). for analysis and criticism of that case, see mason & kofler, supra note 71. 73. see martens-weiner, supra note 52, at 18 (noting that using a set of "ten central tax base elements," such as method of depreciation, the european commission could not fmd any common approach among the member states). 74.2001 communication on common consolidated corporate tax base, supra note 66; martens-weiner, supra note 52, at 97. cf. shaviro, supra note 16 (making the same proposal for u.s. states). 75. see enrich, supra note 31. [vol 8:7 common markets, common tax problems state taxes in order to promote greater tax neutrality in the allocation of investments across the u.s. states.76 2. individual taxation with respect to individual taxation, there are no serious plans in either jurisdiction to harmonize tax bases or to apply a uniform formula for apportioning taxable income among the states. although the u.s. states use the federal tax base as the starting point for calculating an individual's taxable income, deviations abound." rather than apportioning individuals' income among the states, the u.s. states tax individuals' income according to source and residence rules. to prevent double taxation, residence states offer credits for taxes paid to fellow states on income sourced there.78 however, because states have disparate source and residence rules, non-taxation and unrelieved double taxation may both occur. additionally, some states, such as new york, have aggressive source rules, making double taxation of commuters from neighboring states more likely. 79 new york state courts have largely approved these aggressive source rules, and the supreme court has not agreed to hear appeals from the new york courts on this matter.80 there is no federally defined tax base in the european union. member states tax individuals according to domestic source and residence rules, avoiding double taxation through credits and exemption, as provided under domestic law and in tax treaties.8 ' as mentioned previously, in an important case last year, the ecj held that the ec treaty does not require member states to relieve double taxation on intra-community income.82 interestingly, both the supreme court and the ecj have considered the constitutional status of personal tax benefits. in the united states, it is unlawfully discriminatory for a host state to categorically deny nonresidents a variety of personal tax benefits granted to resident taxpayers, including personal exemptions and certain personal deductions. 83 although a host state may deny 76. see shaviro, supra note 16. 77. for more on u.s. state taxation, see hellerstein & hellerstein, supra note 21, 20. 78. see id., at 20.10. 79. zelinsky v. tax appeals tribunal, 801 n.e.2d 840 (2003), cert. denied, 541 u.s. 1009 (2004) (upholding under the dormant commerce clause new york's rule considering personal services income to be sourced in new york if paid by a new york employer, even if the services are performed in another state, unless the services are performed outside new york for the convenience of the employer). 80. see, e.g., id. 81. in contrast, the u.s. states do not employ treaties to relieve double taxation. 82. case c-513/04, kerckhaert & morres v. staat, 2006 e.c.r. 1-10967. 83. travis v. yale & towne mfg. co., 252 u.s. 60 (1920) (personal exemption). 2007] florida tax review nonresidents deductions for most personal expenses, particularly those that have a special nexus with another state, a host state may be required to allow nonresidents to deduct at least a pro rata share of personal expenses that lack nexus with another state.' the court's rulings in this area have curious implications. for example, home mortgage interest has geographic nexus with the state wherein the home is located, so a host state would not have to allow a nonresident taxpayer a mortgage interest deduction for a home located in another state, even if it allows its own residents to deduct their mortgage interest. however, the court has held that since alimony has no special nexus with any state, a host state that allows a resident to deduct alimony cannot categorically deny a nonresident pro rata alimony deductions." as a result of the approach to personal expenses taken by the supreme court, u.s. states generally follow what in europe has been called the "proportionality method;" they allow nonresidents to deduct personal expenses in proportion to their host state income. 6 in contrast, in the landmark schumacker case, the ecj placed the onus to account for personal expenses primarily on the taxpayer's home state by holding that a host state need only account for personal expenses if the home state is unable to do so, for example because the taxpayer has no taxable income in his or her home state. 7 this approach by the ecj has led to the widespread adoption of so-called "schumacker-rules," under which host states deny nonresidents all personal expenses, unless the nonresident's income in the host state exceeds a high statutory threshold.8 when functioning optimally, both the u.s. proportionality method and the eu schumacker method should result in entitlement to a full complement of personal tax benefits, 9 but it is interesting to see how differences in judicial approaches influenced legislative solutions to a tax problem common to the united states and the european union. in both common markets, if greater tax harmonization is desired, for example, to reduce compliance costs and locational distortions or to reduce the 84. see lunding v. new york tax appeals tribunal, 522 u.s. 287 (1998) (alimony). 85. id. 86. hellerstein & hellerstein, supra note 21, 20.06[2] [b]. "proportionality" is a term used in the european tax context. see, e.g., case c-385/00, de groot v. staatssecretaris van financien, 2002 e.c.r. 1-11819 (holding that the netherlands discriminated when it denied personal tax relief in proportion to residents' exempt foreign-source income). 87. case c-279/93, finanzamt kdln-altstadt v. schumacker, 1995 e.c.r. i225. 88. the income threshold may be expressed as a percentage of the taxpayer's overall income (e.g., at least 90% of the taxpayer's overall income), or a dollar amount, or both. see, e.g., case c-391/97, gschwind v. finanzamt aachen-aubenstadt, 1997 e.c.r. 1-5451. 89. for analysis of when these rules break down, see ruth mason, connecticut yankees & the european court (2007) (work-in-progress on file with author). [vol 8:7 common markets, common tax problems likelihood of unrelieved double taxation, then harmonization must be accomplished through the central legislature or by cooperation among the states. the high courts of both common markets have made it clear that uniform rules for taxation and for relief of double taxation will not be imposed judicially.9" c. foreign tax relations the united states has a true federal fiscal system. long-standing debates in the united states concern whether the federal or state government is better suited to assess certain taxes and make certain expenditures. 9' in contrast, due to the fact that the eu central government largely lacks tax powers and has a very small budget, vertical federalism debates in the european union tend not to focus on taxing and spending issues. instead, the principal vertical federalism issue for european taxation concerns tax relations with third countries. there is considerable debate about the scope of the european union's "external tax competence," its ability to negotiate tax treaties and other tax agreements with third countries. although it is clear that in the united states the power to enter into tax treaties with other countries belongs to the federal government, questions arise over the extent to which federal tax policy and foreign policy limit state tax powers. 1. european tax treaties: competence and multilateralism at present, the member states exclusively exercise the tax treaty power. the ecj has repeatedly acknowledged the member states' competence to negotiate tax treaties.92 indeed, the ec treaty expressly provides that member states should enter into such treaties with each other with the goal of eliminating double taxation within the community,93 and the ec treaty fails to provide expressly for the external tax competence of the european union. thus, the member states have the authority to negotiate tax treaties both with each other and with third countries. the controversies in europe concern whether the community shares competence with the member states to enter into tax agreements with third countries, and whether there are certain subject matters in which the community is exclusively competent to enter tax agreements with 90. see moorman mfg. co. v. bair, 437 u.s. 267 (1978); case c-513/04, kerckhaert & morres v. staat, 2006 e.c.r. 1-10967. 91. see david a. super, rethinking fiscal federalism, 118 harv. l. rev. 2544, 2564 (2005). cf. wallace e. oates, an essay on fiscal federalism, 37 j. econ. lit. 1120 (1999); robert p. inman & daniel l. rubinfeld, rethinking federalism, 11 j. econ. perspectives 43 (1997); joel h. swift, fiscal federalism: who controls the states' purse strings? 63 temp. l. rev. 251 (1990). 92. see case c-336/96, gilly v. directeur des services fiscaux du bas-rhin, 1998 e.c.r. 1-2793. 93. see ec treaty, supra note 9, art. 293. 20071 florida tax review third countries.94 space constraints do not permit comprehensive review of the arguments on these issues, and their resolution awaits judgment by the ecj. while the legal entitlement of eu member states to enter into tax treaties is clear, it is constrained by community law. the fundamental freedoms of the ec treaty prohibit nationality discrimination, presumably even when that discrimination is accomplished through a tax treaty. 95 commentators have observed that tax treaties currently in force in the eu may contain limitations on personal scope that have indirectly discriminatory effects. in particular, tax treaty limitations on benefits (lob) clauses may restrict the application of tax treaties in such a way as to disproportionately exclude residents of eu member states not party to the particular tax treaty. indeed, that is their very purpose. 96 despite this arguably discriminatory effect, the ecj recently approved use of lob clauses in tax treaties, at least when both contracting states are eu member states.97 its decision suggests that the ecj's attitude toward member state tax treaties will be deferential. 94. see richard lyal, note on the external competence of the european community in tax matters the example of the agreement with switzerland on the taxation of savings, in the eu and third countries: direct taxation (michael lang & pasquale pistone, eds., 2007). lyal argued that although the member states retain tax treaty competence, the community was exclusively competent under the erta doctrine to enter into the taxation of savings agreement with switzerland and to extend to switzerland the benefits of the parent-subsidiary directive and the interest and royalty directive, although he noted the council's disagreement with some of his conclusions). see also pasquale pistone, general report, in the eu and third countries: direct taxation 17, 53-55 (michael lang & pasquale pistone, eds., 2007). 95. case c-307/97, compagnie de saint-gobain, zweigniederlassung deutschland v. finanzamt aachen-irmenstadt, 1999 e.c.r. 1-6161 (holding that a member state must grant to permanent establishments of eu companies benefits equivalent to those available under tax treaties to resident companies). but see case c376/03, d. v. inspecteur van de belastingdienst, 2005 e.c.r. 1-5821 (finding no mostfavored-nation requirement for tax treaties under ec law). 96. for discussion of the lob issue under ec law, see christiana hji panayi, double taxation, tax treaties, treaty shopping and the european community (2007). 97. case c-374/04, test claimants v. comm'rs of inland revenue (act group litigation), 2006 e.c.r. 1-11673. there is no reason to think that the ecj would show as much regard for the need of the united states (or any other third country) to prevent treaty shopping as it showed for the united kingdom's need to prevent treaty shopping in act group litigation. in fact, prior non-tax cases suggest that the ecj might take a jaundiced view of a bilateral treaty that countenanced discrimination against eu nationals by a non-member state. for example, the open skies cases involved exclusion by the united states of eu nationals from benefits under bilateral air transportation treaties with member states on the basis of nationality-linked criteria. in those cases, the ecj held that by countenancing nationality discrimination by the united states, the eu treaty partners themselves committed nationality discrimination. for more on open skies, see ruth mason, u.s. tax treaty policy and the european court of justice, 59 tax l. rev. 65 (2005) [hereinafter mason, treaty policy]. [vol 8:7 common markets, common tax problems commentators have also considered whether a single multilateral tax treaty covering all of the member states would be superior to the current network of hundreds of bilateral tax treaties.98 supporters of multilateralism argue that a single treaty could be more efficient, harder for treaty-shoppers to abuse, and it might help put to rest persistent questions about the compatibility of particular tax treaty provisions with ec law." however, despite the potential advantages of multilateralism, there is a strong bias in favor of the extant (and extensive" °) bilateral tax treaty network.'' a less aggressive multilateral approach might involve the development of an official eu model bilateral tax treaty for use by the member states when entering or renegotiating treaties. these proposals would not necessarily involve a transfer of treaty-making powers to the community government, and could even be accomplished outside the ec infrastructure, either independently of any supranational organization, or under the auspices of the oecd. the ability to address shared tax challenges outside the formal community legal structure might be important to the member states, which have resisted coordinating their efforts through the community for fear of relinquishing too much control over their tax systems.0 2 notice also that if the eu member states adopt a common consolidated tax base, they will have to decide on what might be called its "external" components. for example, would consolidation stop at the european "water's edge," as proposed by the commission? 10 3 or would the apportionable tax base 98. for proposals regarding multilateral tax treaties, with special emphasis on the european union and a draft text of a multilateral treaty, see multilateral tax treaties (michael lang ed., 1997). 99. mason, treaty policy, supra note 97; michael lang, the concept of a multilateral tax treaty 189, in multilateral tax treaties (michael lang ed., 1997); helmut loukota, multilateral tax treaty versus bilateral treaty network 83, in multilateral tax treaties (michael lang ed., 1997). 100. the intra-eu treaty network alone comprises well over 300 bilateral tax treaties. see mason & kofler, supra note 71, at note 17. 101. see loukota, supra note 99, at 94-96 (arguing, inter alia, that past failures of multilaterialism and the divergence among national tax systems is cause for pessimism about the prospects of a multilateral tax treaty); see also mason, treaty policy, supra note 97, at 121-130 (arguing that political realities in the european union, including divergent interests among the member states, make a multilateral treaty unlikely). 102. see discussion transcript, symposium: international tax policy in the new millennium: panel iv: the pursuit of national tax policies in a globalized environment (comments of kees van raad), 26 brook. j. int'l l. 1711, 1721 (2001) (arguing that the multilateral eu arbitration convention on transfer pricing was structured as a treaty, rather than a council directive in order to keep "the agreement outside of the reach of the ec court"). 103. the committee of experts recommended limiting eu consolidation to the european "water's edge." martens-weiner, supra note 52, at 31, n. 19. 2007] florida tax review comprise the worldwide unitary profits of any vertically integrated entity doing business in europe? 2. u.s. state taxation and the foreign commerce clause because (1) the u.s. states cannot enter into treaties with foreign govemments,'o° (2) the states generally have not entered into double tax compacts with each other,15 and (3) bilateral tax treaties between the united states and other countries do not affect state taxation,0 6 the tax treaty controversy has not arisen in the united states as it has in europe. however, that does not mean that state tax policy lacks an international dimension. just as the interstate commerce clause forbids states from discriminating against interstate commerce, the supreme court has held that the foreign commerce clause forbids states from discriminating against foreign commerce. this means, for example, that a state may not include in a company's taxable income dividends from foreign, but not u.s., subsidiaries.' 7 the most significant controversies concerning the u.s. states and foreign tax relations have concerned some states' inclusion of foreign-source income in the state tax base. until the 1990s, california and several other u.s. states imposed "worldwide combined reporting" requirements on companies engaged in business within their territory. worldwide combined reporting had the effect of including the foreign income of companies affiliated with the taxpayer in the apportionable base, even if those affiliates were themselves established outside the united states. all that was required in order to include the profits of the related foreign affiliate in the apportionable tax base was that the in-state company and the foreign affiliate were engaged in a single "unitary business," a concept variously defined in state law.'08 several taxpayers challenged 104. u.s. const. art. i, § 10, cl. 3. 105. although the constitution's compact clause provides that "[n]o state shall, without the consent of congress... enter into any agreement or compact with another state, or with a foreign power," the supreme court has interpreted the provision to require congressional consent only when the compact would result in an "increase of political power in the states, which may encroach upon or interfere with the just supremacy of the united states." virginia v. tennessee, 148 u.s. 503, 519 (1893); see also united states steel corp. v. multistate tax comm'n, 434 u.s. 452 (1978) (rejecting compact clause challenge to the multistate tax compact). 106. the federal government has the authority to enter into tax treaties that constrain state taxes, but it has not generally exercised that authority. see peter h. blessing & carol dunahoo, analysis of united states income tax treaties 1.03[1][b] (2006); see also infra note 111 and accompanying text for discussion of the attempt to narrow the exercise of state tax powers in the u.s.-u.k. tax treaty. 107. kraft general foods, inc. v. iowa dep't of revenue, 505 u.s. 71 (1992). 108. see, e.g., container corp. of am. v. franchise tax bd., 463 u.s. 159, 165-68 (1983). see also hellerstein & hellerstein, supra note 21, 8.09. [vol 8:7 common markets, common tax problems worldwide combined reporting under the foreign commerce clause, arguing that the practice created a risk of multiple taxation and prevented the federal government from "speaking with one voice in regulating foreign trade."'" however, the supreme court repeatedly upheld the application of worldwide combined reporting requirements to both u.s. and foreign multinationals.' despite the court's blessing, the persistence of mandatory worldwide combined reporting met with so much protest from u.s. trading partners that federal legislation limiting state taxation to the u.s. "water's edge" was proposed, but not adopted. the united kingdom even convinced u.s. tax treaty negotiators to include a provision in a proposed bilateral tax treaty that would have prevented the application of worldwide combined reporting requirements to u.k. companies doing business in the united states. however, due to extensive lobbying by the states, the senate refused to ratify the tax treaty unless the provision was read out of it."' it is a testament to the strength of state tax sovereignty that none of the efforts initiated at the federal government level to impose water's edge as a legal limitation on state taxation succeeded: (1) the supreme court refused to hold worldwide combined reporting was an unconstitutional tax on extraterritorial income, (2) congress was unwilling to preempt state taxes through legislation, even though it has ample power to do so under the foreign commerce clause, 12 109. the foreign commerce clause imposes these two additional requirements on states when taxing foreign commerce. see japan line, ltd. v. county of los angeles, 441 u.s. 434, 452 (1979) (holding that california could not, consistently with the commerce clause, levy a fairly apportioned property tax on japanese containers that were subject to an unapportioned property tax in japan because california's tax would (1) inevitably result in international multiple taxation and (2) interfere with federal uniformity in regulating foreign trade). 110. barclays bank plc v. franchise tax board, 512 u.s. 298 (1994) (upholding application to foreign company); container corp. of am. v. franchise tax bd., 463 u.s. 159 (1983) (upholding application to u.s. company). the supreme court recognized that worldwide combined reporting could lead to double taxation, but it was not convinced that separate accounting would not also lead to double taxation, since both systems by necessity have arbitrary aspects. see container at 190-191. the court also held that worldwide combined reporting did not threaten the federal government's foreign tax policy, especially since tax treaties do not generally affect state tax powers. id. at 197; see barclays at 321-322, 326. for criticism of the court's ruling in barclays because it robbed the "one voice" doctrine of "any real significance" beyond the doctrine of federal preemption, see hellerstein & hellerstein, supra note 21, 8.16[3][b]. 111. the senate entered a reservation to the proposed treaty stating that the relevant article would not be interpreted to apply to state and local taxation. see blessing & dunahoo, supra note 106, 1.03[1][b]. 112. see hellerstein & mclure, supra note 2, at 90 ("congress has rarely enacted statutes to limit state taxing power, and the statutes that have been enacted have generally been quite narrow in scope."). 20071 florida tax review and (3) the senate would not ratify a tax treaty limiting the states' ability to tax. ultimately, however, federal, international, and private sector pressure proved successful, and the states themselves passed legislation limiting the application of worldwide combined reporting." 3 d. subsidies, tax incentives, and interstate competition all the issues discussed so far raise the issue of tax competition. states discriminate against nonresidents in order to provide their own residents with a competitive advantage. at the same time, states define their tax base and rates with interstate competition in mind: they want to retain domestic investment and attract investment by outsiders. favorable business tax rules and a comprehensive program for relief of double taxation may help to stimulate such investment. in addition to non-tax considerations, individuals and businesses consider the particular mix of tax liability and public services offered by a particular state when making locational decisions. 1 4 state tax autonomy facilitates competition among states, but some commentators claim that unbridled competition may result in a destructive "race to the bottom," jeopardizing states' ability to raise sufficient revenue to fund their public policies. such competition may be especially fierce in a common market in which people, business, and capital are free from legal constraints on crossborder movement. 115 113. see generally hellerstein & hellerstein, supra note 21, 8.17; see also moore, supra note 48, at 198-200 (describing states' adoption of "water's edge" limitations in response to threatened federal legislation and pressure from business); martens-weiner, supra note 52, at 13, n. 23 (describing how in its opinion in barclay's bank, the "supreme court noted that 'a battalion of foreign governments' had 'marched to barclay's aid,' deploring worldwide combined reporting in diplomatic notes, amicus briefs, and even retaliatory legislation"). 114. charles m. tiebout, a pure theory of local expenditures, 64 j. pol. econ. 416 (1956) (showing that under certain assumptions, residents will sort themselves into local jurisdictions by preference for level of taxes and government services). empirical research supports the notion that in the international context, patterns of investment are responsive to taxes. see, e.g., james r. hines, jr., altered states: taxes and the location of foreign direct investment in america, 86 american econ. rev. 1076 (1996) (finding that differences in state tax rates affected the location of foreign direct investment within the united states, particularly where foreign investors could not credit u.s. state taxes against their home country tax liability). 115. see enrich, supra note 31 (arguing that the u.s. states are engaged in a destructive competition to provide business tax incentives); communication from the commission to the council and the european parliament: a package to combat harmful tax competition in the european union, com (1997) 564 final (may 11, 1997) (discussing tax competition among the eu member states). but see oates, supra note 50, at 137 (characterizing the studies on inter-jurisdictional tax competition as finding that such competition results in suboptimal equilibria, rather than a "race to the [vol. 8:7 common markets, common tax problems subsidies and tax incentives highlight the advantages and disadvantages of tax competition. in the united states, the states are permitted to use their tax systems to compete for business, investment, and residents, as long as they do not discriminate against interstate commerce. 1 6 but whether tax incentives constitute unconstitutional discrimination is unclear.'" 7 the u.s. supreme court in west lynn creamery held that states could not "conjoin" a nondiscriminatory tax assessed on both in-state and out-of-state interests with a subsidy granted only to in-state interests if the effect of the combination of the tax and subsidy resulted in harsher taxation of out-of-state than in-state interests." 8 however, bottom" or a "downward spiral in public sector activities"); cf. clayton p. gillette, business incentives, interstate competition, and the commerce clause, 82 minn. l. rev. 447 (1997) (arguing more generally that regulatory competition between the states may be constructive). 116. quoting the supreme court, the sixth circuit in cuno noted that: [t]he commerce clause "does not prevent the states from structuring their tax systems to encourage the growth and development of intrastate commerce and industry," nor does it prevent a state from "compet[ing] with other states for a share of interstate commerce" so long as "no state [ ] discriminatorily tax[es] the products manufactured or the business operations performed in any other state." cuno v. daimlerchrysler, inc., 386 f.3d 738, 742-43 (6th cir. 2004), vacated in part, 126 s. ct. 1854 (2006) (quoting boston stock exch. v. state tax comm'n, 429 u.s. 318, 336-37 (1977)). for discussion of cuno, see infra notes 117 to 120 and accompanying text. 117. for the argument that business tax incentives violate the dormant commerce clause, see enrich, supra note 31. but cf. zelinsky, supra note 28 (arguing that because the court cannot meaningfully distinguish subsidies from discriminatory taxes, it should abandon its dormant commerce clause review of state taxes altogether). 118. west lynn creamery, inc. v. healy, 512 u.s. 186 (1994) (striking down a tax on both in-state and out-of-state dealers selling milk into massachusetts when the proceeds of the tax were distributed only to massachusetts dairy farmers). the court stated that: nondiscriminatory measures, like the evenhanded tax at issue here, are generally upheld, in spite of any adverse effects on interstate commerce, in part because '[t]he existence of major in-state interests adversely affected... is a powerful safeguard against legislative abuse.... .' however, when a nondiscriminatory tax is coupled with a subsidy to one of the groups hurt by the tax, a state's political processes can no longer be relied upon to prevent legislative abuse, because one of the in-state interests which would otherwise lobby against the tax has been mollified by the subsidy. id. at 200 (citations omitted) (quoting minnesota v. clover leaf creamery co., 449 u.s. 456, 473, n. 17 (1981). 2007] florida tax review in dicta, the court gave its approval of subsidies funded from general revenues." 1 9 the sixth circuit in cuno recently held an ohio investment tax credit to violate the commerce clause because it discriminated against interstate commerce. 2 the sixth circuit concluded that ohio's tax incentive was unconstitutional because it provided a tax advantage when new property was put into service within ohio, but not when property was put into service in other states.'"' ohio imposed more burdensome taxation on companies doing business in ohio that decided to expand into other states than those that decided to expand into ohio, a practice the court found coercive.' 22 however, the circuit court distinguished the investment tax credit from direct subsidies, suggesting, as has the supreme court, that direct subsidies do not violate the commerce clause.'23 although the supreme court granted certiorari in cuno, it did not reach the merits of the constitutional challenge to state tax incentives because it held that the taxpayers did not have standing to challenge the incentives in the first place. still, several similar cases challenging state tax incentives under the dormant commerce clause are pending in lower courts, so the supreme court 119. west lynn at 199 n. 15 ("we have never squarely confronted the constitutionality of subsidies, and we need not do so now. we have, however, noted that '[d]irect subsidization of domestic industry does not ordinarily run afoul' of the negative commerce clause.") (quoting new energy co. of ind. v. limbach, 486 u.s. 269, 278 (1988) 120. cuno v. daimlerchrysler, inc., 386 f.3d 738 (6th cir. 2004), vacated in part, 547 u.s. 332 (2006) (invalidating under the commerce clause a tax credit extended by ohio against its franchise tax to daimlerchrysler in exchange for the company's location of assets in toledo). in reaction to the sixth circuit's decision in cuno, federal legislation was introduced to expressly authorize states to offer such tax subsidies, which would address any commerce clause infirmity inherent in them. see economic development act of 2005 (s. 1066). notably, the sixth circuit in cuno held that property tax abatements granted by ohio and toledo to daimlerchrysler did not run afoul of the commerce clause. see cuno, 386 f.3d at 746-48. 121. cuno, 386 f.3d at 743-46. 122. id. at 746. in analyzing the plaintiffs' argument that state tax incentives are unconstitutional if they are coercive, the circuit court referred to walter hellerstein & dan t. coenen, commerce clause restraints on state business development incentives, 81 comell l. rev. 789, 806-09 (1996). 123. "although the defendants liken the investment tax credit to a direct subsidy, which would no doubt have the same economic effect, the [supreme] court has intimated that attempts to create location incentives through the state's power to tax are to be treated differently from direct subsidies despite their similarity in terms of endresult economic impact." cuno at 746. [vol. 8:7 common markets, common tax problems may answer this important question sometime soon. how it should answer the question is a matter of considerable controversy in the united states.l 4 in the european union, the status of subsidies and tax incentives is somewhat clearer: they are prohibited as "state aids," unless the commission approves them.'25 compared with the united states, less energy has been invested in europe in the question of whether tax incentives and subsidies are sufficiently different to warrant different constitutional treatment. both direct subsidies and subsidies granted through the tax system are clearly covered by the prohibition on state aids, which governs aid granted in "any form whatsoever."' 26 indeed, there have been many successful challenges by the commission of tax provisions under the prohibition on state aids. 27 but the role of the commission as gatekeeper of member state subsidies and tax incentives could be criticized on at least two grounds. first, the commission has not adequately defined what constitutes a state aid, 18 and second, the commission may be insufficiently zealous in challenging state aids. still, while some subsidies and tax incentives may go unchallenged by the commission, and others have been expressly approved by the commission, in principle, state aids, 124. see references in supra note 115; see also dan t. coenen, business subsidies and the dormant commerce clause, 107 yale l. j. 965 (1998); dan t. coenen & walter hellerstein, suspect linkage: the interplay of state taxing and spending measures in the application of constitutional antidiscrimination rules, 95 mich. l. rev. 2167 (1997) (offering guidelines for when the supreme court should strike down state subsidies). 125. see ec treaty, supra note 9, art. 87 ("... aid granted by a member state ... in any form whatsoever which distorts or threatens to distort competition .. shall, in so far as it affects trade between member states, be incompatible with the common market"); see id. arts. 88-89 (requiring member states to inform the commission of plans to implement or alter state aids and requiring commission approval to do so); see also hanno e. kube, competence conflicts and solutions: national tax exemptions and transnational controls, 9 colum. j. eur. l. 79 (2003); raymond h.c. luja, assessment and recovery of tax incentives in the ec and wto: a view on state aids, trade subsidies and direct taxation (2003); wolfgang sch6n, taxation and state aid law in the european union, 36 common mkt. l. rev. 911 (1999). 126. ec treaty, supra note 9, art. 87 127. see, e.g., case c-156/98, germany v. comm'n, 2000 e.c.r. 1-6857 (successfully challenging tax relief offered by germany in the former east german regions because it did not comply with the exceptions to the ban on state aid for former east germany). 128. see kube, supra note 125, at 99. identifying a subsidy granted through the tax code requires determination of the normal baseline of taxation, a notoriously difficult problem that arises in several contexts, including tax expenditure budgets and trade treaties. for suggestions about how to define subsidies for trade treaty purposes, see paul r. mcdaniel, trade agreements and income taxation: interactions, conflicts and resolutions, 57 tax l. rev. 275, 275-90 (2004) (suggesting reference to domestic tax expenditure budgets). 20071 florida tax review including those granted through the tax system, violate ec law if they distort competition among the member states. another important limitation on state tax competition in the european union, for which there is no analog in the united states, is the code of conduct for business taxation, under which the member states undertook to cease and roll back certain "harmful" tax practices, identified as such by the european commission.1 9 harmful tax measures include offering outside investors lower tax rates than those generally available to residents of the host country, granting tax benefits to nonresidents who have no real economic activity in the host state, departures from the oecd transfer pricing guidelines, and lack of transparency in the tax system. the code of conduct is not legally binding on the member states, but rather represents a political commitment among the states to refrain from engaging in harmful tax competition. iii. conclusion george washington's particular vision of a united states of europe similar to the united states of america that would legislate for all the nationalities of europe has not come to pass. however, while it is important to be mindful of the vast differences in both government structure and fiscal systems in the united states and the european union, a tour of some of the tax problems common to both jurisdictions suggests that tax policy-makers in each jurisdiction may benefit from examining approaches taken in the other. in particular, the nature of the debates in europe and the united states over the future of state taxation are similar in that they acknowledge a tension between the benefits of greater tax harmonization, including efficiency, simplicity and reducing opportunities for tax avoidance, and the benefits of state tax autonomy, including flexibility, responsiveness, experimentation, and fiscal discipline. 129. see communication from the commission to the council and the european parliament: a package to combat harmful tax competition in the european union, com (1997) 564 final (may 11, 1997). see also conclusions of the ecofin council meeting, 1998 o.j. (c 2) 1; commission notice on the application of state aid rules to measures relating to direct business taxation, 1998 o.j. (c 384) 3. [vol. 8:7 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 19 2016 number 10 article tie tax hedging rules revisited dr. yoram keinan florida tax review volume 19 2016 number 10 the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. the subscription rate, payable in advance, is $125.00 in the united states and $145.00 elsewhere for the current volume. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352) 273-0658 or email ftr@law.ufl.edu. copyright c 2016 by the university of florida florida tax review volume 19 2016 number 10 yariv brauner professor oflaw karen burke richard b. stephens eminent scholar in taxation dennis a. calfee professor oflaw patricia e. dilley professor emeritus jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university emily snider carvalho brandon c. gardner devon goldberg editor-in-chief charlene luke professor oflaw university of florida associate editors university of florida michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law martin j. mcmahon, jr. james j freeland eminent scholar board of advisors leandra lederman indiana university bloomington omri marion university of calfornia, irvine gregg d. polsky university of georgia graduate editors jessica e. griffin william carroll mcdonald adam smith visiting assistant professor lee-ford tritt professor oflaw samuel c. ullman adjunct professor oflaw steven j. willis professor oflaw james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university ofpennsylvania philip nodhturft, iii benjamin m. pamell katheleen duggan pfahlert florida tax review volume 19 2016 number 10 information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: "articles," "commentaries," and "book reviews." the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word sent via expresso (law.bepress.com/expresso). articles may be emailed to ftr@law.ufl.edu. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow the bluebook: a unform system of citation (20th ed.); 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otherwise, it will be automatically renewed. for volume 20, subscriptions and changes of address should be sent to florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. beginning with volume 21, the florida tax review will be published by the university of florida press on behalf of the graduate tax program of the university of florida levin college of law. for subscription information and queries relating to volume 21 and subsequent volumes, please contact the johns hopkins university press, p.o. box 19966, baltimore, md 21211; phone 1-800-548-1784; jrnlcirc@press.jhu.edu. all correspondence of a business nature, including advertising, should be addressed to the university of florida press, 15 nw 15th st., gainesville, fl 32603; phone 352-392-1351; http://upress.ufl.edu. copyright © 2017 by the university of florida florida tax review volume 20 2017 number 7 iii editor-in-chief charlene luke professor of law university of florida associate editors university of florida yariv brauner hugh culverhouse eminent scholar karen burke richard b. stephens eminent scholar dennis a. calfee professor of law patricia e. dilley professor emeritus michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law martin j. mcmahon, jr. james j. freeland eminent scholar adam smith visiting assistant professor lee-ford tritt professor of law samuel c. ullman adjunct professor of law steven j. willis professor of law board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university– bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate student editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell kathleen duggan pfahlert executive assistant jessica e. joseph florida tax review volume 20 2017 number 7 iv information for contributors the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law. the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the florida tax review prefers electronic submissions sent via expresso (https://www.bepress.com/products /expresso/); articles may also be e-mailed to ftr@law.ufl.edu as a microsoft word document. if a hard copy submission is necessary, please mail your article to editor-in-chief, florida tax review, university of florida levin college of law, 309 village drive, gainesville, fl 32611. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. all citations should follow the bluebook uniform system of citation (20th ed.); some modifications will, however, be made by our editors to conform to the florida tax review style manual. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the florida tax review. florida tax review volume 20 2017 number 7 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations promulgated under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 8 2007 number 3 will u.s. investment go abroad in a territorial tax: a critique of the president's advisory panel on tax reform by james r. repetti i. introductio n ..................................................................................... 304 ii. the efficiency effects of a territorial system .................. 306 a. analysis of claimed benefits ................................................... 306 b. the altshuler-grubert article ................................................. 311 1. the effective tax rate determinations ...................... 313 2. analysis of historic data: foreign investment in low-tax countries by companies subject to a territorial tax ................................................................ 318 3. analysis of historic data: foreign investment in low-tax countries by u.s. companies with excess credits ................................................................ 320 c. does foreign investment complement u.s. investment? ....... 322 iii. c o nclusion ..................................................................................... 324 florida tax review will u.s. investment go abroad in a territorial tax: a critique of the president's advisory panel on tax reform by james r. repetti" i. introduction the report of the president's advisory panel on federal tax reform' (the "report") recommends the u.s. adopt a territorial tax system that would exclude income earned by u.s. taxpayers actively conducting foreign businesses. this exclusion would also apply to dividends received from controlled foreign corporations to the extent such dividends were attributable to the corporation's conduct of active foreign businesses.2 the report justifies this recommendation by stating that a territorial system is simpler than the current global approach employed by the u.s. and that a territorial tax will improve efficiency. in an accompanying article, professor mcdaniel has demonstrated that simplicity cannot be achieved under a territorial or global system. under either system, the u.s. will have to address source issues, transfer pricing issues and irc section 367 concerns. this article focuses on the report's efficiency arguments for a territorial tax. the report asserts that a territorial tax will permit u.s. multinationals to compete more effectively in low-tax jurisdictions and will eliminate the tax bias against repatriating earnings.3 the report anticipates that its proposal might generate concern about a potentially significant efficiency problem whether a territorial system would cause u.s. businesses to allocate more jobs and assets overseas to low-tax countries. it says: at first glance, one might assume that exempting active foreign source income from u.s. taxation would lead to a substantial reallocation of u.s. investment and jobs world wide. a careful * professor of law and thomas carney scholar, boston college law school. this article was presented at the 2006 annual symposium on international taxation at the university of florida levin college of law graduate tax program. the author thanks yariv brauner, mark brodin, j. clifton fleming, jr., marjorie komhauser, paul mcdaniel, martin mcmahon and diane ring for helpful comments to earlier drafts. he also thanks joshua gutierrez and kevin walker for research assistance and cassandra desmond for help in preparing this manuscript. 1. report of the president's advisory panel on federal tax reform, simple fair and pro-growth: proposals to fix america's tax system 134 (nov. 2005) (hereinafter "report"). 2. id. 3. id. [vol 8:3 will u.s. investment go abroad in a territorial tax study of how location incentives for u.s. multinational corporations may change under a territorial system similar to the one proposed for the simplified income tax plan provides different results. researchers found no definitive evidence that location incentives would be significantly changed, which suggests that the territorial system the panel has proposed would not drive u.s. jobs and capital abroad relative to the current system. 4 the study referred to by the report to support its conclusion is where will they go if we go territorial? dividend exemption and the location decisions of u.s. multinational corporations, by rosanne altshuler and harry grubert.5 in their careful study, altshuler and grubert say that they cannot "make any firm prediction of how location behavior would change if the u.s. were to adopt a dividend exemption system."6 they further note that "the analysis provides no consistent or definitive evidence that dividend exemption would induce a large outflow of investment to low-tax locations."7 the report relies heavily on the altshuler-grubert article to bolster its assertion that the territorial system would not adversely affect u.s. production. note, however, that the altshuler-grubert article does not conclude that a territorial system would have no effect on the investment of u.s. capital. the report correctly states that the altshuler-grubert article found no evidence that a territorial system "would induce a large outflow.... ." the report incorrectly uses this lack of evidence to leap to the inference that "the territorial system the panel has proposed would not drive u.s. jobs and capital abroad...."' this inference is inappropriate. as lawyers, we have been trained that a lack of evidence means that no conclusion can be reached.9 although the report uses the absence of conclusive findings to support the assertion that there will be no adverse effect, a careful reading of the altshuler-grubert article reveals that altshuler and grubert view their results as inconclusive. they are very careful to point out that their analysis produces mixed results about whether an exemption system would lead to more foreign direct investment ("fdi") by u.s. multinationals. indeed, as this article will discuss, the 4. id. at 135 (emphasis added). 5. rosanne altshuler & harry grubert, where will they go if we go territorial? dividend exemption and the location decisions of u.s. multinational corporations, 54 nat'l tax j. 787 (2001). 6. id. at 807. 7. id. 8. report, supra note 1, at 135. 9. for example, in a criminal prosecution, the defendant is found "not guilty" when the prosecutor fails to produce evidence that shows beyond a reasonable doubt that the defendant committed the crime. the prosecutor's failure to produce evidence does not mean that the defendant is "innocent." 2007] florida tax review altshuler-grubert paper leaves many unanswered questions that make it impossible to conclude what effect a territorial tax will have on domestic investment. this article is organized as follows. it first explains that the benefits of a territorial tax suggested by the report, increased competitiveness of u.s. multinationals in low-tax countries and increased dividend repatriation, cannot be viewed in isolation.'0 instead, it is necessary to analyze these benefits in the context of the increased excess burden" a territorial tax will impose on domestic investment. the key to determining the increase in excess burden is the extent to which the tax will increase foreign investment in low-tax countries at the expense of domestic investment. 2 thus, the report's reliance on the altshuler-grubert article as support for its conclusion that a territorial tax will not increase investment in low tax countries is of critical importance. this article describes the analysis used by altshuler and grubert in order to illustrate the inconclusive nature of their findings. 3 it also raises additional issues not addressed in their article that will have to be resolved in order to determine the effect of an exemption system on domestic investment. 4 given the uncertainty surrounding how u.s. multinationals will respond to a territorial tax and professor mcdaniel's persuasive explanation that a territorial tax will not be simpler than a global tax, this article concludes that report has failed to make a convincing case for a territorial system. ii. the efficiency effects of a territorial system a. analysis of claimed benefits the report justifies its recommendation for a territorial tax by asserting that this system will eliminate the tax impediment to repatriating earnings and will make u.s. multinationals more competitive. a complete analysis, however, 10. see infra text accompanying notes 15-27. 11. in determining the efficiency of an income tax, economists often refer to the term "excess burden." the excess burden represents the welfare loss created by a tax that exceeds the tax revenue generated by that tax; see e.g. richard a. musgrave & peggy b. musgrave, public finance in theory and practice 444 (1973); harvey s. rosen, public finance 307 (7th ed. 2005). an income tax has an excess burden because it creates a disparity (or "tax wedge") between the income paid to the taxpayer and the after-tax income received by the taxpayer. id. at 310-12. this difference causes the taxpayer to vary his behavior from the way he would have behaved in a tax-free world. for example, a tax on wages may cause a taxpayer to work more or less hours in response to the tax. similarly, a tax on savings may cause a taxpayer to save more or less in response to the tax. this behavioral change creates a welfare loss to the taxpayer in addition to the taxes paid. id. at 319-20. 12. see infra text accompanying notes 42-53 and 58-65. 13. see infra text accompanying notes 40-72. 14. see infra text accompanying notes 53-57 and 66-82.. [vol. 8:3 will u.s. investment go abroad in a territorial tax requires that such benefits not be viewed in isolation. it is necessary to consider these benefits in the context of other welfare effects that a territorial tax may have. this part will first analyze the claimed benefits of a territorial tax and then shift the analysis to the broader context of the efficiency effects of such a system. the impact of a territorial tax on dividend repatriation will in part depend on whether the new view or traditional view of dividends applies. under the new view, a permanent elimination of a dividend tax on repatriation would have no effect on dividend payments. 5 the new view posits that the tax on repatriation is irrelevant to a decision to retain or distribute earnings because the tax will be incurred when the earnings are ultimately transferred to the parent. 6 the only relevant consideration for retention of earnings by a mature subsidiary is whether the after-tax return on investment of the retained earnings exceeds the after-tax return that could be earned by the parent in the event the earnings were repatriated. 7 thus, where the foreign subsidiary is in a low-tax country, the decision whether earnings should be retained will depend on whether the after-tax return from retention will be higher than the after-tax return available from an identical investment in the u.s. the amount of a permanent tax that will be assessed on the dividend repatriating the earnings will not affect the decision to retain the earnings. in contrast, under the traditional view, eliminating a tax on dividends should increase dividend payments.' 8 the traditional view of dividends posits that a tax on dividends affects the amount of dividends paid. it theorizes that corporations pay dividends despite the tax burden because dividends confer benefits to stockholders, such as reduced agency costs, in addition to the actual 15. david hartman borrowed learning from the new view ofdividends, which had previously been applied to domestic dividends, to argue that a permanent tax on repatriation should not in theory affect a mature foreign subsidiary's decision to retain earnings since the earnings are "trapped," i.e. the earnings will inevitably be subject to a dividend tax when paid. david g. hartman, tax policy and foreign direct investment, 26 j. of pub. econ. 107, 115-16 (1984). see j. clifton fleming. jr., robert j. peroni, & stephen e. shay, fairness in international taxation: the ability-to-pay case for taxing worldwide income, 5 fla. tax rev. 299, 304 n.10 (2001) for an excellent discussion of some ofthe nuances of hartman's analysis. see also dept. of the treasury, integration of individual and corporate tax systems: taxing business income once, ch. 13 pp. 116-18 (1992) for analysis of the new view in the context of domestic tax policy. for a discussion of the new view's perspective on how dividend taxation affects the decision to transfer new capital to a foreign subsidiary, see infra text accompanying notes 23-26. 16. hartman, supra note 15, at 115-16. 17. id. at 116-17. 18. see e.g. george r. zodrow, on the "traditional" and "new" views of dividend taxation, 44 nat'l tax j. 497, 503 (1991). for a discussion of the traditional view's perspective on the impact of dividend taxation on capital contributions to a foreign subsidiary, see infra text accompanying notes 23-26. 20071 florida tax review dollar amount paid.'9 lower taxes should result in higher dividend payouts under the traditional view because the after-tax value of the dividend will have increased.2" the empirical evidence is mixed as to which theory provides a better explanation of reality, but recent studies suggest that dividend taxes affect distributions by foreign subsidiaries.2 consequently, it seems at least plausible that a territorial system would encourage more dividend payments by foreign subsidiaries to their u.s. parents. this does not mean, however, that eliminating the tax on dividends would necessarily increase domestic investment. increased dividends from foreign subsidiaries may subsequently be invested in low-tax countries. adopting a territorial tax will in theory create an incentive for u.s. corporations to transfer new investment to low-tax countries since the return on such investment would now be subject to lower rates.22 since the tax rate in the u.s. would exceed the rate in the low-tax country, the pre-tax rate of return on investment in the u.s. would have to exceed the pre-tax return in the low-tax country to keep investment in the u.s. this incentive that a territorial tax will create to transfer new capital to low-tax countries exists regardless of whether the new view or traditional view of dividends applies. although the new view posits that a tax on dividends is irrelevant to a decision to retain or distribute earnings, 23 the new 19. zodrow, supra note 18, at 497, 503. 20. id. 21. for a summary of the literature supporting the applicability of the traditional view to dividend payments by foreign subsidiaries, see harry grubert, comment on desai and hines, "old rules and new realities: corporate tax policy in a global setting", 58 nat'l tax j. 263, 267-268 (2005). it should be noted that the empirical evidence that taxation affects dividends does not mean that the new view is incorrect. that evidence is also consistent with the new view because the new view posits that only permanent taxes on dividends are irrelevant. see rosanne altshuler, t. scottnewlon & william c. randolph, do repatriation taxes matter? evidence from the tax returns of u.s. multinationals, in the effects of taxation on multinational corporations 253, 256 (martin feldstein, james r. hines jr. & r. glenn hubbard eds., 1995). if corporations expect tax rates to change, the new view predicts that tax rates become relevant in deciding when to pay dividends because payments should be timed to take advantage of low rates. thus, the empirical results may simply reflect the frequency of statutory rate changes in the u.s. and the ability of corporations to time dividend payments so that they will occur in periods when effective tax rates are low as a result of effective tax planning. 22. see e.g. j. clifton fleming jr. & robert j. peroni, exploring the contours of a proposed u.s. exemption (territorial) system, 109 tax notes 1557, 109 tax notes 1557, 1570 (dec. 19, 2005); staff ofjoint comm. on taxation, 106th cong., 1st sess., description and analysis of present-law rules relating to international taxation, at 75 (comm. print 1999). 23. see hartman, supra note 15, at 115, 116-17. [vol. 8:3 will us. investment go abroad in a territorial tax view, like the traditional view of dividends, considers a tax on dividends to be relevant to the decision whether new capital should be invested in a foreign subsidiary.24 this occurs because the value of equity received for the capital transfer is directly related to the tax assessed on repatriation of the subsidiary's earnings.25 the value of the investment in the subsidiary is the discounted present value of the subsidiary's expected after-tax income stream. thus, the lower the tax assessed on the repatriation is, the greater the value of the investment will be.26 the adoption of an exemption system will increase the expected return from capital transfers to foreign subsidiaries in low-tax countries and as a result would encourage new investment, all other factors remaining the same. similarly, an exemption system will encourage increased investment in branches located in low-tax countries since the retum on such investment would only be subject to the low tax rate. clearly, the effects of a territorial tax on investment have to be viewed as part of a larger picture. it is not sufficient to merely observe that a territorial tax will increase dividends from subsidiaries in low-tax countries. any benefits that are actually generated by a territorial tax may be offset by an increase in the excess burden on domestic production because of the incentive created for overseas investment. similarly, the goal of increasing the competitiveness of multinationals in low-tax countries by adopting a territorial system is not a useful policy objective. it is always possible to make a business more competitive by reducing its tax burden. the picture is only complete when the impact of the tax preference on other activities and welfare is accounted for. to obtain a complete picture, this article will view the report's proposal through application of traditional tax policy tools that examine efficiency effects of tax changes in order to assess possible welfare effects. the debate about efficiency in international tax has usually focused on concerns about capital export neutrality and capital import neutrality.27 capital export neutrality ("cen") requires that income from domestic and foreign investments be taxed at the same tax rate. implementing cen would require that foreign income be taxed immediately (i.e. there would be no deferral)28 and that there be an unlimited foreign tax credit.29 capital import neutrality ("cin"), which 24. hartman, supra note 15, at 117, 119-20; zodrow, supra note 18, at 497 and 503. 25. id. 26. id. 27. see e.g. michael j. graetz, the david r. tillinghast lecture: taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies, 54 tax l. rev. 261, 270-71 (2001). 28.id. at 271; robert j. peroni, back to the future: a path to progressive reform of u.s. international income tax rules, 51 u. miami l. rev. 975, 981(1997) 29. see e.g. graetz, supra note 27, at 271; stephen e. shay, clifton fleming, jr. & robert j. peroni, the david r. tillinghast lecture:"what's source got to do with it?" source rules and u.s. international taxation, 56 tax l. rev. 81, 108 (2002). 2007] florida tax review is what a territorial tax system would seek to accomplish, requires that investments in foreign countries be taxed at the same rate as the rate applied to investments by residents in that country.30 this means that income earned in a foreign country would be exempt in the resident country. it is very difficult to achieve both cin and cen because all residence and source countries would have to exempt foreign income and apply the same tax rates to and have the same tax base for their resident income.3 both cen and cin create efficiency distortions. cen introduces a tax wedge between savings and consumption since savings are taxed in an income tax more heavily than consumption, but does not drive a tax wedge between domestic and foreign investment since both are taxed equally.32 in contrast, cin drives a wedge between foreign and domestic investment because the income thereon is taxed differently. cin does not drive a wedge between savings in the foreign country and consumption since the return on savings in the foreign country is not taxed in the resident country.33 the current u.s. system represents a compromise between cen and cin. cen is not achieved because foreign income from active business operations is not taxed currently under subpart f and the foreign tax credit is limited?4 cin is also not achieved because dividends from foreign operations are taxed, although deferral can reduce significantly the effective rate of tax.35 a territorial tax will increase the excess burden on domestic investment since it will increase the tax wedge between domestic and foreign investment, i.e. it will increase the tax cost of domestic production in comparison to foreign production.36 at the same time, a territorial tax will decrease the excess burden 30. see e.g. graetz, supra note 27, at 270-71. 31. see e.g. graetz, supra note 27, at 272; joint comm. on tax'n, 102d cong., 1st sess., factors affecting the international competitiveness of the united states 5 (comm. print 1991). 32. alberto giovannini, capital taxation, economic policy 346, 366-67 (oct. 1989). 33. id. see graetz, supra note 27, at 272-73. 34. robert j. peroni, supra note 28, at 975, 977-78. 35. id. 36. the excess burden is a function of the elasticity of the compensated demand curve for the item being taxed and the square of the tax-exclusive tax rate. jane gravelle, the economic effects of taxing capital income 30 (1994); john creedy, the excess burden of taxation and why: it (approximately) quadruples when the tax rate doubles, new zealand treasury working paper 3/29 p. 17 (2003). the elasticity of the demand curve is in turn a function of the willingness of the taxpayer to substitute another item for the item being taxed. the less willing a taxpayer is to substitute the item being taxed with another item, the less elastic the item is. a territorial tax increases the excess burden on domestic investment because it motivates the taxpayer to substitute foreign investment for domestic investment. the magnitude of the increase in excess burden will depend upon the relative substitutability of foreign investment for domestic investment (i.e. the elasticity of domestic investment). [vol. 8:3 will u.s. investment go abroad in a territorial tax on savings since foreign income will be exempt. whether there is a net efficiency gain or loss is determined by comparing the size of the decreased excess burden on savings to the increased burden on domestic investment. the difficulty in ascertaining this net benefit or cost is that theory cannot predict whether the decrease in excess burden for savings will be less than the increase of the excess burden for domestic investment.37 the magnitude of the excess burdens will depend upon the relative substitutability of consumption for savings and of foreign investment for domestic investment, both of which are empirical questions.3" the u.s. treasury department has suggested that cen is preferable to cin because cen maximizes global39 and national welfare.40 this is based on the view that foreign investment is more readily substituted for domestic investment than consumption for savings. if this is correct, cen would allocate investment among countries in the most efficient manner since the tax burden borne by such investments would be the same and saving would not be significantly affected. b. the altshuler-grubert article since theory cannot predict the net effect of a territorial tax on excess burdens, the issue whether the territorial tax will increase efficiency is an empirical question. as discussed above, the magnitude of the excess burden 37. giovannini, supra note 32, at 367; thomas horst, a note on the optimal taxation of international investment income, 94 q.j. econ. 793, 797 (1980). see musgrave & musgrave, supra note 11, at 451 (making this point in the context of comparing a consumption tax to an income tax); congressional budget office, revisiting the individual income tax 46 (1983) (same); gravelle, supra note 36, at 31 (same). 38. giovannini, supra note 32, at 367; horst, supra note 37, at 797. see supra note 36, for a discussion of how the excess burden is calculated. 39. treasury dep't., the deferral of income earned through u.s. controlled foreign corporations: a policy study 26-36 (2000) (hereinafter "treasury subpart f study"); richard e. caves, multinational enterprise and economic analysis 229-31 (1982). 40. treasury subpart f study, supra note 39, at 36-42. 41. id. at 30 n. 14,36-42; graetz, supra note 27, at 272. the low substitutability for savings means that the response of savings to tax is inelastic and, therefore, the excess burden is low. see supra note 36, which discusses the manner in which excess burden is calculated. not everyone would agree that a low elasticity for savings means that the excess burden is low. see martin a. feldstein, the effect of taxes on efficiency and growth, tax notes 679, 683 (may 8, 2006). feldstein argues that the reduction in savings is not the relevant consideration in measuring the excess burden of a tax on savings, but rather that the relevant consideration is the reduction in future consumption that will occur as a result of the tax. in feldstein's view, inelasticity in savings would be irrelevant to the excess burden created by a tax on savings. 20071 florida tax review imposed on domestic investment by a territorial tax is a function of the extent to which foreign investment may be readily substituted for domestic investment.42 the report relies heavily on the altshuler-grubert article, which is the only empirical study of the extent to which the u.s. tax system affects u.s. investment in low-tax countries,43 to conclude that a territorial tax will not encourage investment in low-tax countries by u.s. corporations." as discussed below, this reliance is misplaced since the results of altshuler and grubert's careful analysis are mixed. altshuler and grubert examine the potential effect of adopting an exemption system by analyzing a number of different aspects of foreign investment. their approach can be divided into three broad categories. first, they calculate the effective tax rate on foreign investment by u.s. firms under the current global system and under the proposed territorial system to determine whether the territorial system would create an incentive to invest in low-tax countries. their calculations suggest that foreign investment would not increase under a territorial system because the effective tax rates in a territorial system would not differ significantly from the current effective rates.45 second, they utilize historic data to predict how u.s. firms would respond to a territorial system by examining the investment decisions of foreign firms already subject to a territorial system. this analysis yields mixed results. third, they use historic data to determine the probability that u.s. multinational firms will increase investment in low-tax countries under a territorial system. their analysis of u.s. multinational behavior indicates that foreign investment would increase in a territorial tax, although the magnitude of the response would be small. 42. see supra note 36, which discusses the principle that the excess burden is a function of the elasticity of the compensated demand curve for the item being taxed and the square of the tax exclusive tax rate. the elasticity of the demand curve is in turn a function of the willingness of the taxpayer to substitute another item for the item being taxed. 43. for studies that have analyzed the impact of the host country's tax system on the location of foreign investment, see e.g. altshuler & grubert, supra note 5, at 801; james r. hines, jr., lessons from behavioral responses to international taxation, 52 nat'l tax j. 309-13 (1999). 44. whether such investment is a substitute for or complement to domestic investment is another important issue in determining the efficiency effects of a territorial tax that is not addressed in the altshuler-grubert article. see infra text accompanying notes 73-82, for further discussion. 45. for an earlier analysis that also argued that effective tax rates should not differ significantly between the current u.s. system and a territorial system, see terrence r. chorvat, ending the taxation of foreign business income, 42 ariz. l. rev. 835, 843-44 (2000). [vol. 8:3 will u.s. investment go abroad in a territorial tax 1. the effective tax rate determinations in their effective tax rate analysis, altshuler and grubert compare the effective tax rates that would apply to u.s. investment in low-tax countries if the u.s. adopted a territorial system to the rates that currently apply. they assume a territorial system similar to that proposed by the report dividends from a controlled foreign corporation conducting an active foreign business would not be taxed, but interest and royalties paid by such corporation would. they calculate that under the current u.s. system the effective tax rate on dividends of income earned in low-tax countries for firms that are "excess credit ' is equal to the effective rate that would apply to such companies under a territorial system.47 thus, they argue a territorial system would not increase the incentive for excess-credit firms to invest in low-tax countries as compared to the current u.s. system. they also find that the effective tax rates on income earned in low-tax jurisdictions would increase in a territorial system for firms that are currently "excess limitation."'4 in reaching this surprising conclusion, they make two important assumptions, which will be described more fully below. given that a territorial tax would not change the effective tax rate for excess-credit firms and would actually increase the rate for excess-limitation firms, they determine that a territorial system is unlikely to encourage more investment in low-tax jurisdictions as compared to the current system. 46. a firm is excess credit if its foreign tax payments exceed the amount that may be claimed as a foreign tax credit. in that situation, the firm is in the same tax posture as though the u.s. had adopted an exemption system. for example, if a u.s. taxpayer pays 1,000 of foreign tax on 4,000 of foreign income and the u.s. tax on that income is 800, the u.s. taxpayer will not owe any u.s. tax with respect to that income. this is the result that would have occurred had the u.s. adopted an exemption system. paul r. mcdaniel, hugh j. ault & james r. repetti, introduction to united states international taxation 89 5th ed. (2005). 47. altshuler & grubert, supra note 5, at 798. 48. id. at 790. a firm is excess limitation when its foreign tax payments are less than the u.s. limit on the foreign tax credit for such income. in this situation, a firm will pay u.s. income tax on the foreign income to the extent the u.s. tax exceeds the foreign tax. for example, assume that a firm pays 1000 of foreign tax on income of 4000, and that the u.s. tax on that income is 1500. after claiming the 1000 foreign tax credit, the taxpayer will still owe 500 in u.s. tax. the rationale for altshuler and grubert's surprising result is discussed, infra, at the text accompanying notes 49-52. 2007] florida tax review altshuler and grubert's results are reproduced below. altshuler and grubert table 3 effective tax rates for investment abroad in a low tax country investment comprised of: all all 85 % tangible and tangible intangible 15 % intangible assets assets assets dividend exemption 4.8% 35.0% 9.3% current system (assuming 25% of firms in excess credit) 1.7 26.3 5.4 excess limitation firms 0.7 35.0 5.8 excess credit firms 4.8 0.0 4.1 assumptions statutory and effective tax rates: * the u.s. statutory tax rate is 35% * the host country statutory tax rate and effective tax rate is 7% investment financing: tangible capital receives economic depreciation allowances and no investment tax credits intangible capital generates royalty income, which is deductible in the host country but taxable in the united states "other" overhead expenses (expenses besides interest and r&d) account for 10% of the pre-tax required rate of retum (net depreciation) on capital marginal tangible investment is funded one-third with debt and two-thirds with equity the required after-tax rate of return on capital equals the real interest rate firms repatriate 7% of net host tax earnings on marginal tangible capital and gross-up dividends for the purpose of the foreign tax credit at 15% the deadweight loss from restricting dividend repatriations for firms in excess limitation is 1.7% of net host tax earnings on marginal tangible capital [vol. 8:3 will u.s. investment go abroad in a territorial tax interest and "other" overhead deductions: * under the current system, firms in excess limitation deduct 50% of interest expense and 75% of "other" overhead expenses against the u.s. or other high-tax income. firms in excess credit deduct 100% of interest expense at the 7% rate and lose the advantage of deducting overhead at the 35% rate. under exemption, allocation rules require that all expenses be allocated against exempt income. firms deduct 100% of interest expense at the 7% rate and lose the advantage of deducting overhead at the 35% rate. there are several interesting features in their results that merit further attention. as shown in column one, the aggregate current effective tax rate for a firm with excess credits investing in a low-tax country is calculated to be 4.8%. altshuler and grubert determine that the effective tax rate in a territorial system for such firms would be the same. this is expected since firms with excess credits are essentially exempt from u.s. tax on dividend repatriations. but, surprisingly, altshuler and grubert calculate that the current effective tax rate for firms that are excess limitation is lower than the rate that would exist in a territorial system. this is surprising because one would expect firms that are excess limitation to incur currently a higher tax liability than they would in a territorial system since excess limitation means that they will pay a u.s. tax on foreign income.49 altshuler and grubert make two significant assumptions that account for this unexpected result. first, they assume that firms in our current system are subject to an effective u.s. tax rate of only 3.3% on dividend repatriations because they can time the repatriation of their foreign subsidiaries' income to minimize tax.5" second, they assume that excess-limitation firms currently are able to allocate 75% of their overhead expenses (other than interest and research and development expenses) to high-tax jurisdictions such as the u.s. and, as a result, generate significant tax savings from such deductions.5' in contrast, they assume that in a territorial system such firms would be required to allocate their overhead expenses to the exempt income, thereby generating no u.s. tax benefit.52 altshuler and grubert also predict that a territorial system will increase the tax burden on royalty income from licensing intangibles. royalty income is taxable in our current global system, but since a territorial system would lack foreign tax credits for income not subject to u.s. tax, the credit would not be available in a territorial system to shelter royalty income. their calculations in column two show that excess credit firms, which own a subsidiary whose assets consist entirely of intangibles and which receive 49. see supra note 48. 50. altshuler & grubert, supra note 5 at 797-98. 51. id. at 795, 801. firms that are excess credit are assumed not to deduct the overhead expenses against high-tax income because this would reduce the foreign tax credit. 52. id. at 795. 2007] florida tax review distributions from that subsidiary solely in the form of royalties, would move from a situation where none of their royalty income is currently taxed to one where all royalty income is taxed in a territorial system. similarly, in column three, when they calculate the effective rates for firms that have an asset mix consisting of 85% tangible and 15% intangible (with the return on the intangibles being received in the form of royalties), they again determine that the effective tax rates in low-tax jurisdictions under the current system are less than for an exemption system. as a result, they conclude that moving to a territorial system is unlikely to encourage more investment in low-tax jurisdictions, as compared to the current system, since a territorial system will not reduce the tax burden.53 altshuler and grubert's effective tax rate calculations are very interesting and impressive. the calculations raise two questions, however, that need to be resolved. the first is the reasonableness of the assumption that firms that are excess limitation can deduct 75% of overhead expenses from high-tax income. altshuler and grubert do not explain the rationale for this assumption. moreover, their article provides no sensitivity analysis of what would happen if that assumption were changed. it would be very helpful to see what the effective tax rate would be for firms that are excess limitation if they could only allocate a smaller amount of their overhead to high-tax income. the second and more important issue pertains to altshuler and grubert's use of an effective u.s. tax rate of only 3.3% on dividend repatriations in our current system. they calculate this low effective rate based of the assumption that firms can currently time the repatriation of their foreign subsidiaries' income to minimize tax.54 this is certainly true for existing multinational firms that have experience in managing foreign earnings and can cross credit or use credit carryovers to minimize tax. firms lacking experience in managing dividend repatriations may believe, however, that they face an effective u.s. tax rate in our current system that is much higher than the 3.3% rate that altshuler and grubert calculate for experienced firms. as a result, the current u.s. tax scheme may present a much greater deterrent to new firms making foreign investments for the first time than for experienced firms. stated another way, it is possible that the adoption of an exemption system will eliminate uncertainty about the tax burden, and as a result decrease the risk associated with foreign capital transfers. this reduction in tax risk may encourage firms that previously had little or no fdi to increase it. to see this, consider that firms experienced in fdi that are analyzing a new equity investment have a history of managing foreign earnings that enables them to anticipate fairly accurately the extent that they will be able to cross credit taxes in high and low jurisdictions and generate tax carry forwards. this history enables the experienced firms to calculate what the tax burden will 53. id. at 790. 54. id. at 797-98. [vol. 8:3 will us. investment go abroad in a territorial tax be on the repatriation of foreign investments. in contrast, firms lacking experience in fdi are not able to predict as accurately what their foreign tax credit position will be when they make foreign investments and when such investments mature. moreover, such firms would lack a sufficiently large pool of fdi that would enable them to cross credit and use other strategies to reduce u.s. tax. this uncertainty and inability to use tax-reducing devices increases the risk of foreign investments for the inexperienced firm in relation to domestic investments. this may on the margin deter foreign investment as compared to domestic investment since the firm will select investments that present the best risk-adjusted after-tax return.5 in comparing a foreign investment to a domestic investment that have equal after-tax returns that are not adjusted for tax risk, the inexperienced firm will select the domestic investment because its expected after-tax return will be higher than foreign investment with the less certain tax treatment. the adoption of an exemption system will eliminate this tax risk and, therefore, make foreign investment more attractive to firms that had previously avoided foreign investment, since tax planning will no longer be required to calculate the after-tax return of the foreign investment. the role that tax risk plays in making foreign investments is consistent with literature that has shown that large firms make more foreign investments than small firms because they can better handle the risk of overseas investments.5 6 this view is also consistent with the observations that one of the deterrents to domestic companies in making foreign investments is the fixed costs of acquiring knowledge about "learning how things are done abroad."57 it is reasonable to expect that the lack of experience needed to predict the availability of credits to shelter repatriation on the part of new entrants into foreign markets would also act as a deterrent. 55. it might be argued that this uncertainty only exists if the company plans on repatriating the earnings. however, it seems likely that companies would plan to repatriate at least part of the earnings for investment in the united states since the united states is a strong market. see e.g. hartman, supra note 15, at 115 (noting that 40% of foreign subsidiary earnings were paid to u.s. parents in 1980). empirical evidence from 1992 suggests that the extent to which a u.s. parent repatriates its earnings from foreign subsidiaries is related to the tax rate of the foreign country. grubert & mutti found that foreign subsidiaries of u.s. parents in 1992 repatriated only 6.1% of their earnings when they operated in a country with a tax rate of less than 10%. in contrast, subsidiaries operating in countries with tax rates of more than 30% repatriated 53.9% of their earnings that year. harry grubert & john mutti, taxing international business income: dividend exemption versus the current system 30 table 2 (2001). 56. see, e.g., thomas horst, firm and industry determinants of the decision to invest abroad: an empirical study, 54 the rev. of econ. and stat. 258,259 (1972); bernard m. wolf, industrial diversification and internationalization: some empirical evidence, 26 j. of indus. econ. 177, 179 (1977). 57. neil m. kay, penrose and the growth of multinational firms, 26 managerial and decision econ. 99, 102 (2005); caves, supra note 39, at 13. 2007] florida tax review the result is that predicting the impact of a territorial system by determining effective tax rates is very complex. we need to consider firms that previously had no fdi. even if a territorial system did not encourage mature firms to increase foreign investment, it might encourage firms, which had previously not made foreign investments, to do so for the first time. 2. analysis of historic data: foreign investment in low-tax countries by companies subject to a territorial tax as discussed, above, the effective tax rate calculations are not helpful in predicting the response of domestic investment to the adoption of a territorial tax because the effective tax rate is only determined for firms that have experience in making foreign investments. moreover, the effective tax rate calculations failed to explain the rationale for the assumption that firms that are excess credit limitation can allocate 75% of their overhead expenses to high-tax income. in addition to the effective tax rate calculations, altshuler and grubert used historical data to determine whether a territorial system would increase fdi by looking to see whether fdi by companies resident in countries that already have an exemption system (canada and germany) differed from fdi by u.s. companies. specifically, altshuler and grubert looked to see whether investments in low-tax jurisdictions in asia (singapore and malaysia) and in europe (ireland) by canadian and german companies differed from investments made by u.s. companies in those regions. if canadian and german companies had more investment in low-tax countries than u.s. companies, that would suggest that u.s. companies would similarly increase investment in lowtax countries under a territorial system. the results, which are mixed, are reproduced below. altshuler and grubert table 1 u.s., german, and canadian foreign direct investment in manufacturing in 1998 u.s. germany canada asia singapore and malaysia as a share of total asia 0.269 0.153 0.066 europe ireland as a share of european union (except germany) 0.067 0.016 0.170 ratio of ireland to u.k. 0.181 0.095 0.278 sources: survey of current business (sept. 2000), deutsche bundesbank: kapitalverflechtung mit dem ausland (may 2000), and data released by request from statistics canada, balance of payments division. [vol. 8:3 will us. investment go abroad in a territorial tax altshuler and grubert conclude that the "cross-country comparison gives a mixed picture of how location incentives may change under dividend exemption."" they observed that in asia, u.s. affiliates held a larger share of investment in low-tax countries than germany and canada. almost 27% of manufacturing fdi of u.s. firms in asia was located in singapore and malaysia in 1998. in contrast, the percentage for germany was only 15% and for canada it was under 7%. they interpret this as suggesting that exempting dividends from u.s. taxation may not induce a significant reallocation of investment across low-tax jurisdictions in asia. 9 altshuler and grubert further note, however, that the "evidence from europe . . . presents a more guarded prediction."6 the data for germany suggests that a territorial system will not encourage increased u.s investment in low-tax countries since german affiliates hold a substantially smaller share of fdi in ireland (as a share of their investment in the european union) than u.s. affiliates: 1.6% versus 6.7%. the canadian experience suggests the opposite, however. canadian firms have significantly more fdi in ireland than u.s. firms. canadian investment in ireland accounts for 17% of the stock of canadian fdi in the european union. in contrast, u.s. firms located only 6.7% of their european investment in ireland. further, the ratio of canadian investment in ireland relative to canadian investment in great britain is 28% while it is only 18% for u.s. companies. altshuler and grubert conclude: thus, the canadian experience in europe hints that dividend exemption may have some effect on the location decisions of the u.s. mncs [multinational corporations]. taken as a whole, however, the evidence from the fdi data presents a mixed picture.6' in summary, the comparison of fdi by countries with an exemption system (canada and germany) to fdi by the u.s. gives mixed results. there appears to be no difference between the two systems for investment in asia. in europe, however, there is a significant difference between canada and the u.s. for fdi in low-tax countries. this suggests that at least in the case of canada, a territorial tax encourages more investment in low-tax foreign countries. 58. altshuler & grubert, supra note 5, at 792. 59. id. 60. id. 61. id. 20071 florida tax review 3. analysis of historic data: foreign investment in low-tax countries by us. companies with excess credits in the last part of their article, altshuler and grubert used 1996 tax return data for u.s. multinational corporations to predict the effect of adopting an exemption system. they sought to do this by asking whether corporations that did not expect to pay taxes on repatriations because they had significant foreign tax credit carryovers were more likely to invest in low-tax jurisdictions than in high-tax jurisdictions. a tendency by such corporations to invest in lowtax jurisdictions would suggest that the adoption of an exemption system would similarly encourage multinationals to invest in low-tax jurisdictions since having foreign tax carryforwards is somewhat equivalent to being exempt from tax. to test this they used regression analysis to determine whether companies with significant foreign tax credit carryovers had a higher probability of investing in low-tax countries than in high-tax countries. the dependent variable in their regression model was simply assigned the number one if a multinational has at least one subsidiary in a country or zero if it had no subsidiary in that country.62 the independent variables included various measures of the extent to which a multinational had significant excess foreign tax credits and the effective tax rates of the various countries in the data sample.63 they found that corporations not expecting to pay u.s. tax were more likely to have a subsidiary in low-tax jurisdictions than in high-tax countries, although the magnitude of the response was small.' they concluded that "[i]f firms without foreign tax credit carryforwards ...behave similarly under dividend exemption, there may be some reallocation of foreign direct investment to low-tax jurisdictions." ' the third part of altshuler and grubert's analysis raises several questions. first, as altshuler and grubert point out, there is the question of how firms without foreign tax credit carryovers would behave under an exemption system. importantly, firms that do not have excess credits include many domestic businesses that have not yet made significant foreign investment. as discussed earlier,' both the new view and traditional view posit that taxes on dividends affect decisions to transfer new capital to a foreign subsidiary. thus, it is possible that firms have been discouraged from making foreign investment in the form of new capital transfers because of the tax due on repatriation. elimination of that tax could induce firms to increase significantly their foreign investment in low-tax jurisdictions in the form of capital contributions or acquisitions. for example, the task force on international tax reform has 62. altshuler & grubert, supra note 5, at 803. 63. id. at 804. 64. altshuler & grubert, supra note 5, at 807. 65. id. 66. see supra text accompanying notes 23-26. [vol 8:3 will us. investment go abroad in a territorial tax suggested that a territorial tax would encourage a u.s. firm that manufactures and sells all its products in the u.s. to relocate its manufacturing plant to ireland and sell its product back to the u.s. so that it could benefit from the low irish corporate tax and repatriate its earnings free of u.s. tax.67 the second problem with the regression results is that the regression model altshuler and grubert use does not take into account the magnitude of investment in each country. as a result, the regression results really provide no help in predicting how multinationals will respond to an exemption system. the dependent variable that altshuler and grubert employed (a value of one if the multinational had at least one subsidiary in a country and zero if not) does not reflect the amount of investment the multinational made in each country but only reflects that the multinational had a subsidiary there. testing to see whether it is more probable that a multinational not expecting to pay u.s. tax will locate a subsidiary in a low-tax jurisdiction than in a high-tax jurisdiction tells us nothing about the relative amounts of investment in the various countries since the subsidiary might represent an investment of one billion dollars or one thousand dollars. moreover, even if all subsidiaries were the same size, the test would still not be helpful because the dependent variable is assigned a value of one regardless of the number of subsidiaries in that country. for example, a u.s. multinational might have one subsidiary in country a, 100 subsidiaries in country b and no subsidiary in country c, and the dependent variable would be one for country a and also one for country b and zero for country c. the small response that altshuler and grubert found for the probability that multinational firms with excess credit will invest in low-tax jurisdictions is irrelevant since the magnitude of investment was not considered. even if the regression had used the amount of investment as a dependent variable, the results still might be suspect. the data that altshuler and grubert examined showed the tax posture of u.s. multinationals in 1996 and the location of their subsidiaries in 1996. presumably most of the investment in the subsidiaries occurred in years other than 1996. accordingly, the tax posture of the multinationals in 1996 is not nearly as helpful as the tax position of the u.s. multinationals in the years in which the investment occurred. but even data about the tax posture of u.s. multinationals for the years in which fdi occurred may not be helpful. it is possible that a large portion of investment by multinationals in their foreign subsidiaries occurred in the form of retained eamings.68 in an earlier study, grubert and mutti observed that profitable controlled foreign corporations repatriated on average 67. report of the task force on international tax reform, 59 tax law. 649, 723 (2006). 68. hartman, supra note 15, at 115 (noting that in 1984 earnings retained by foreign subsidiaries accounted for approximately three quarters of direct foreign investment). 20071 florida tax review only 6.1% of their after-tax earnings in low-tax countries in 1992.69 under the new view of dividends, the tax on dividends to the parent is irrelevant to the decision whether the subsidiary's earnings should be retained because the tax will be incurred regardless of when the earnings are transferred to the parent.70 the only relevant consideration for retention of earnings by a mature subsidiary is whether the after-tax return on investment of the retained earnings would exceed the after-tax return that could be earned by the parent in the event the earnings were repatriated. 7' thus, the tax posture of the parent may not have played a significant role in foreign investment to the extent it was funded through retained earnings. if the new theory is an accurate description of dividend behavior,72 only new capital transfers would have been affected by the u.s. tax system. in summary, the regression analysis of the 1996 data does not provide very useful information about the likely response of u.s. firms to a territorial tax because the analysis fails to account for the magnitude of foreign investment in low-tax countries. the dependent variable used by altshuler and grubert merely registered that a u.s. firm had at least one subsidiary in each foreign country without measuring the amount of that investment. in addition, the analysis did not account for the response of transferring new capital overseas by u.s. firms that currently do not have any foreign investment. c. does foreign investment complement u.s. investment? as shown above, the efficiency effects of a territorial tax are unclear because of the lack of conclusive evidence about the effect of such a tax system on foreign investment. another uncertainty in the analysis is whether it is possible to view foreign investment as complementary to domestic investment. that is, if a territorial tax encourages fdi, is it nevertheless possible that an increase in fdi will increase u.s. domestic investment because it expands the market for u.s. exports and, as a result, the need for production in the u.s.?73 if this were the case, fdi would not be readily substitutable for domestic 69. harry grubert & john mutti, supra note 55, at 30. 70. hartman, supra note 15, at 115-17. 71. id. 72. empirical evidence supporting the applicability of the new view to foreign subsidiaries is mixed. recent studies suggest that divident taxes affect the dividend behavior of foreign subsidiaries. see supra note 21. 73. see e.g., martin a. feldstein, the effects of outbound foreign direct investment on the domestic capital stock, in the effects of taxation on multinational corporations 43, 49 (martin feldstein, james r. hines jr., & r. glenn hubbard, eds.) (1995). [vol. 8:3 will us. investment go abroad in a territorial tax investment and, as a result, the territorial tax would not significantly increase the excess burden on domestic investment.74 unfortunately, the empirical results and the analysis of the empirical results are mixed. a report recently prepared by the staff of the joint committee on taxation 75 that addresses whether fdi is a substitute for u.s. investment, observes that overseas production increases u.s. production. the report stated:76 generally, empirical studies find either no effect or a positive effect of overseas production in a host-country market on home-country exports to that country. one survey of the empirical literature reports that, on average, studies find one dollar of overseas production by u.s. affiliates generates $0.16 of exports from the united states. the evidence suggests that overseas production does displace certain types of domestic production as the parent firm shifts to more capital intensive and skill intensive domestic production. note that this quote, however, does not focus on the impact of foreign investment on u.s. investment, but rather on the impact of foreign production on u.s. production. it is not clear how strong the connection is between u.s. production and u.s. investment. for example, an increase in u.s. production will not correspond to an increase in u.s. investment to the extent that there was excess capacity in u.s. production facilities. empirical studies of the effect of fdi on domestic investment have been mixed. analysis of investment data for several oecd countries from the 1970's and 1980's suggests that outbound fdi reduces domestic investment on approximately a dollar-for-dollar basis.77 the same results were obtained in analyzing data for oecd countries from the 74. see supra note 36, and the text accompanying supra note 38, for a discussion of the relationship between the substitutability of foreign investment for domestic investment and excess burden. 75. staff of the joint committee on taxation, 109th cong., 2d sess., the impact of international tax reform: background and selected issues relating to u.s. international tax rules and the competitiveness of u.s. businesses 61-62 (comm. print, 2006). 76. id. at 62 (citations omitted). the joint committee staff cited as authority, robert e. lipsey, home and host country effects on fdi, 7-19 (nat'l bureau of econ. research, working paper no. 9293, 2002), and robert e. lipsey, outward direct investment and the u.s. economy, in the effects of taxation on multinational corporations (martin feldstein, james r. hines, jr. & r. glenn hubbard eds. 1995) 77. see e.g., feldstein, supra note 73, at 57. 2007] florida tax review 1980's and 1990's.78 other studies, however, find no relationship,79 while others suggest that fdi and domestic investment may complement each other.80 professors desai, foley and hines found that when they analyzed data consisting of domestic and foreign investments by u.s. multinationals instead of aggregate national data for oecd countries, u.s. domestic investment by u.s. multinationals increased at the same time that fdi increased. they argue that this suggests that, at least in the case of u.s. multinationals, fdi complements u.s. domestic investment.8 the authors caution, however, that their results may be seriously biased by the omission of other important variables, which means there may in fact be no causal relationship between the observed simultaneous increases in fdi and domestic investment." the result is that the answer to the question whether fdi is a substitute for u.s. investment or a complement to it is unclear. more research is needed to determine what the impact of increased fdi will be on u.s. investment. m. conclusion the report justifies its recommendation for a territorial tax by asserting that a territorial system will eliminate the tax impediment to repatriating earnings and will make u.s. multinationals more competitive. a complete analysis requires that such benefits not be viewed in isolation. to determine whether a territorial tax scheme makes sense, it is necessary to determine whether other harmful impacts of a territorial system will outweigh these benefits. a territorial tax will increase the excess burden on domestic investment since it will increase the tax wedge between domestic and foreign investment, i.e. it will increase the tax cost of domestic in comparison to foreign investment. at the same time, the excess burden on savings will decrease since foreign income will be exempt. the issue for a territorial tax is whether the decreased excess burden on savings is less than the increased burden on domestic investment. unfortunately, theory cannot predict whether the decrease in excess burden for savings will be less than the increase of the excess burden for domestic investment. the magnitude of the excess burden will depend upon 78. mihir a. desai, c. fritz foley & james r. hines jr., foreign direct investment and the domestic capital stock, 6-7 (nat'l bureau of econ. research, wroking paper no. 11075, 2005). 79. see e.g., david g. harris, the impact of u.s. tax law revision on multinational corporations' capital location and income-shifting decisions, 31 j. of acct. res. 111, 132-36 (1993). 80. desai, foley & hines, supra note 78, at 7. 81. id. 82. id. at 9. [vol. 8:3 will u.s. investment go abroad in a territorial tax the relative substitutability of consumption for savings and foreign investment for domestic investment, which are empirical questions. the report's reliance on the altshuler-grubert article as support for its conclusion that a territorial tax will not increase investment in low-tax countries is of critical importance since it goes to the heart of the issue about the substitutability of foreign investment for domestic investment. this article argues, however, that the report's reliance is misplaced because altshuler and grubert's empirical results are mixed. moreover, this article suggests that to determine the effects of a territorial tax, it will be necessary to expand the empirical inquiry. altshuler and grubert's assumption that u.s. multinationals can allocate 75% of their overhead expenses to high-tax jurisdictions, such as the u.s., should be justified and subjected to sensitivity analysis. in addition, the effective tax rate calculations should also determine the effective tax rates under our current global system that apply to corporations making foreign investments for the first time since it is likely that such corporations face a much higher effective rate than corporations that already have significant fdi. lastly, the dependent variable that altshuler and grubert use in their regression analysis to predict whether it is more likely that multinationals will invest in low-tax counties than in high-tax countries in a territorial system does not provide useful information because it does not account for the magnitude of fdi by u.s. multinationals. altshuler and grubert's dependent variable is assigned a value of one if the multinational has at least one subsidiary in a particular country and a value of zero if the multinational has none in that country. this does not reflect the amount of investment the multinational has made in those jurisdictions, but only reflects that the multinational had at least one subsidiary there. testing to see whether it is more probable that a multinational will invest in low-tax jurisdictions than in high-tax jurisdictions by observing whether the multinational has at least one subsidiary in each such jurisdiction does not inform about the relative amounts of investment since the subsidiaries might represent an investment of one billion dollars or one thousand dollars. the result is that we face many uncertainties in regard to the effect of a territorial system. we do not have sufficient information about the impact of a territorial tax on foreign investment. contrary to the report's conclusion, the altshuler-grubert article does not support the conclusion that a territorial tax will not increase foreign investment. indeed, theory predicts that a territorial tax will increase the incentive for u.s. multinationals and for firms with no prior foreign investment to increase capital transfers to foreign subsidiaries in low-tax countries. we also lack information about the impact of fdi on domestic investment. all this missing information seriously compromises the report's conclusion that a territorial tax will not harm u.s. welfare because it prevents us from determining the increase in excess burden that such a tax will impose on domestic investment. 2007] florida tax review the territorial tax proposal represents a significant variance from the norm governing the u.s. tax system that all income should be taxed.83 such a variance should be justified only where it can be shown that the benefits outweigh the costs. given professor mcdaniel's findings that a territorial tax would not be simpler than a global tax, and this article's analysis of the efficiency effects of the proposed tax, the report has not made a case for a territorial tax. 83. see michael j. mcintyre, guidelines for taxing international capital flows: the legal perspective, 46 nat'l tax j. 315, 321 (1993) (an exemption system is in effect a spending provision); fleming, peroni & shay, supra note 15 at 344-46 (arguing that deferral of foreign income or an exemption of foreign income is a tax expenditure because it is a departure from the norm of taxing income and that such departure needs to be justified). [vol. 8:3 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe 1. associate professor of law, barry university school of law. j.d., drake university school of law, ll.m., georgetown university national law center, m.b.a., loyola university of chicago, ph.d., southwest university. the author would like to acknowledge the able research assistance of ms. melissa logan on this article and the committee hearings on enron. 2. theodor seuss geisel, dr. seuss: oh, the places you’ll go! 19 (random house 1990). florida tax review volume 5 2002 number 10 watchdogs that failed to bark: standards of tax review after enron harold s. peckron1 you will come to a place where the streets are not marked. some windows are lighted. but mostly they’re darked. a place you could sprain both your elbow and chin! do you dare to stay out? do you dare to go in? how much can you lose? how much can you win?2 853 florida tax review volume 5 2002 number 10 watchdogs that failed to bark: standards of tax review after enron harold s. peckron i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 855 ii. the enron imbroglio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 856 a. special investigative committee report . . . . . . . . . . . . 856 b. advisors’ response: shredding of documents . . . . . . . 862 iii. pre-enron standards of tax review . . . . . . . . . . . . . . . 864 a. standards of tax review . . . . . . . . . . . . . . . . . . . . . . . 865 1. aba formal opinion 352 and model rules of professional conduct . . . . . . . . . . . . . . . . . . . . . . . . . . 866 2. aicpa statements on responsibilities in tax practice and code of professional conduct . . . . . . . . . 867 3. treasury circular 230 . . . . . . . . . . . . . . . . . . . . . . . 870 4. treasury regulations and the 2000-01 tax shelter regulations disclosure . . . . . . . . . . . . . . . . . . . . . . . . . 872 5. internal revenue code of 1986 and the civil penalty provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 876 b. application of the standards to tax shelter cases . . . . 877 1. pro-taxpayer cases . . . . . . . . . . . . . . . . . . . . . . . . . 878 a. repurchase agreement (repo) corporate inversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 879 b. contingent installment sale notes . . . . . . . . 881 c. dividend stripping transactions . . . . . . . . . 884 d. offshore special purpose entities . . . . . . . . 887 e. pro-taxpayers synopsis . . . . . . . . . . . . . . . . 891 2. pro-government cases . . . . . . . . . . . . . . . . . . . . . . . 892 a. contingent installment sales notes . . . . . . . 892 b. equipment leasing trusts . . . . . . . . . . . . . . 893 c. corporate owned life insurance . . . . . . . . . 897 d. pro-government synopsis . . . . . . . . . . . . . . 900 iv. public policy and moral considerations affecting standards review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 901 1. public policy demensions . . . . . . . . . . . . . . . . . . . . 901 2. moral considerations . . . . . . . . . . . . . . . . . . . . . . . . 903 854 florida tax review [vol.5:10 v. post-enron standards of tax review . . . . . . . . . . . . . . 908 a. enhanced regulatory review . . . . . . . . . . . . . . . . . . . . 908 1. discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 908 2. quality control . . . . . . . . . . . . . . . . . . . . . . . . . . . . 909 b. enhanced due diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . 909 c. enhanced policy and ethical view . . . . . . . . . . . . . . . . . . . . 910 d. paradigm: janitors insurance tax shelter . . . . . . . . . . . . . . 910 1. factual background . . . . . . . . . . . . . . . . . . . . . . . . . 910 2. tax advisor’s review . . . . . . . . . . . . . . . . . . . . . . . . 911 3. advisor’s recommendation . . . . . . . . . . . . . . . . . . . 912 vi. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 913 2002] watchdogs that failed to bark 855 2. anne tergesen, the fine print: how to read those key footnotes, bus. wk., feb. 4, 2002, at 94. 3. richard w. stevenson & jeff gerth, safeguards didn’t stop enron’s fall to earth, orlando sentinel, jan. 20, 2002, at all. numerous safeguards failed in the case of enron. as robert litan, director of economic studies at brookings institution stated: this was a massive failure in the governance system. you can look at the system as a series of concentric circles, from management to directors and the audit committee to regulators and analysts and so forth. this was like a nuclear meltdown where the core melted through all the layers. 4. id. enron: a simple question of right and wrong, usa today, jan. 22, 2002, at 12a. 5. rich karlgaard,enron end notes, forbes, mar. 4, 2002, at 37. 6. see howard m. schilit, financial shenanigans 2 (mcgraw-hill, 1993). the badges of fraud tend to surface early on in a financial fraud case. such badges of fraud include recording revenue before it is earned, creating fictitious revenue, creating profits with nonrecurring transactions, shifting current year income or expenses to future years or vice versa, and failing to record or disclose liabilities. id. see also in re zzzz best securities litigation, 864 f.supp. 960 (c.d. cal. 1994). (showing an example of a substantial financial fraud from inception). 7. a “futures” is an agreement to buy or sell a standardized asset, e.g., energy commodity, at a fixed price at a future time. see bryan a. garner, handbook of business law terms 273 (west pub. co. 1999). 8. karlgaard, supra note 5. 9. daniel fisher, blowback, forbes, nove. 12, 2001, at 46. the rise of “special purpose entities”, i.e., partnerships, artificially boosted earnings by blowing back earnings to the corporate partner, enron. id. 10. report of investigation by the special investigative committee of the board of directors of enron corp. (feb. 1, 2002) at 36-40, [hereinafter report], at http://news.findlaw.com/hdocs/enron/sicreport/sicreport 020102.pdf. i. introduction enron corporation, which was the seventh-largest u. s. corporation2 prior to its collapse, will long be a case study on various corporate governance3 and ethical4 failures. but the most frightening aspect of enron is that it was never designed or intended to be a massive fraudulent scheme from its inception,5 unlike many substantial financial frauds.6 it began by simply trading energy futures7 and eventually expanded to trading futures in commodities well beyond the company’s expertise.8 to continue its positive financial performance, the company required its advisors to develop “blowback” strategies ensuring continued stock price appreciation.9 these so-called “strategies” were largely concerned with tax and accounting planning scenarios and off-balance sheet entities.10 the attorney and 856 florida tax review [vol.5:10 11. id. at 24-26, 72, 132. 12. id. at 4-5. 13. the accounting firm of arthur andersen llp was charged with criminal obstruction of justice charges by its shredding of documents, many of which pertained to the special purpose entities created by enron. the indictment resulted in the 89 year-old firm to lose the majority of its publicly traded corporate clients and all of its international operations resulting in a financially devastated partnership. see u. s. c h a r g e s a n d e r s e n w i t h o b s t r u c t i o n o f j u s t i c e a t <http://www.msnbc.com/news/723939> (last visited mar. 15, 2002). 14. report, supra note 10. 15. report, supra note 10, at 147. 16. report, supra note 10, at 64. 17. report, supra note 10, at 77. 18. report, supra note 10, at 203. accountant advisors who reviewed these prospective business transactions agreed with their ultimate design and implementation.11 yet, with hindsight, it is clear that such devices lacked economic substance.12 the purpose of this article is to examine the standards of tax review in light of enron. in particular, a major focus will be the evolving nature of these standards and how a tax advisor should augment them. failure to modify existing review standards may come at a very high price.13 it is clear that tax advisors have come to a place where the streets are not marked and have much to lose. to recognize these higher stakes of tax review, this article will survey the causes of the enron imbroglio, pre-enron standards of tax review, tax policy and moral considerations in establishing a standard of review and the emerging post-enron standards of tax review. ii. the enron imbroglio to fully comprehend the magnitude of the enron case and the failure of its advisors in terms of their standards of accounting and tax review, a background of the olio of events needs to be reviewed. in this regard, the special investigative committee report and the advisors’ response under the circumstances are illuminating. a. special investigative committee report perhaps the seminal document on the enron imbroglio is the special investigative committee report of the board of directors of enron corporation14 (hereinafter report). therein, the substance of the most significant transactions is analyzed with their significant accounting,15 corporate governance,16 management oversight17 and public disclosure18 issues examined. 2002] watchdogs that failed to bark 857 19. report, supra note 10, at 125-164. 20. john r. emshwiller & rebecca smith, murky waters: a primer on enron partnerships, wall st. j., jan. 21, 2002, at c1. in all, enron had about 3500 subsidiaries and affiliates, many of them special purpose entities. id. 21. report, supra note 10, at appendix a. a special purpose entity or vehicle is an entity created for a limited purpose, with a limited life and limited activities, and designed to benefit a single company. id. 22. fasb, accounting research bulletin no. 51, consolidated financial statements (1959). ordinarily, the majority holder of a class of equity funded by independent third parties should consolidate (assuming the equity meets certain criteria dealing with size, ability to exercise control, and exposure to risk and rewards). if there is no independent equity, or if the independent equity fails to meet the criteria, then the presumption is that the transferor of assets to the spe or its sponsor should consolidate the spe. this presumption in favor of consolidation can be overcome only if two conjunctive conditions are met: 2. 3% outside investor spe (partnership) 1. sells or transfers asset enron corp 3. financier (bank) to fully understand the complexities of certain arrangements, a description of the corporate strategy will be reviewed as identified in the report.19 assuming that enron wanted to purchase other companies’ stocks as an investor, it would negotiate a price to raise capital to make the purchase. unlike this rather typical transaction, enron created thousands20 of special purpose entities21 to produce gains in lieu of liabilities on its corporate books. the following steps, espoused by outside counsel and monitored by outside accountants, created this vast array of internecine entities: step 1: transfer or sale of an enron asset to partnership (spe) thereby creating a book gain to enron and a transfer of the asset with its concomitant debt. such debt is removed from enron’s balance sheet. step 2: enron controls 97% of the spe and an outside investor owns 3% of the partnership. pursuant to an accounting rule,22 as 858 florida tax review [vol.5:10 first, an independent owner or owners of the spe must make a substantive capital investment in the spe, and that investment must have substantive risks and rewards of ownership during the entire term of the transaction. where there is only a nominal outside capital investment, or where the initial investment is withdrawn early, then the spe should be consolidated. the sec staff has taken the position that 3% of total capital is the minimum acceptable investment for the substantive residual capital, but that the appropriate level for any particular spe depends on various facts and circumstances. distributions reducing the equity below the minimum require the independent owner to make an additional investment. investments are not at risk if supported by a letter of credit or other form of guaranty on the initial investment or a guaranteed return. second, the independent owner must exercise control over spe to avoid consolidation. this is a subjective standard. control is not determined solely by reference to majority ownership or day-today operation of the venture, but instead depends on the relative rights of investors. therefore, enron’s related-party transactions were constructed to meet the two part test of non-consolidation. see also fasb, financial accounting series exposure draft: consolidated financial statements: purpose and policy (feb. 23, 1999) at http://www. fasb.com (last visited may 1, 2002). 23. id. 24. report, supra note 10, at 49. 25. report, supra note 10, at 50. 26. report, supra note 10, at 58-60. 27. report, supra note 10, at 58-60. interpreted by the securities and exchange commission (sec),23 this structure allows enron to treat the spe on an unconsolidated basis. step 3: enron’s bank acts as financier for the 97% capital interest. the partnership loan is guaranteed by enron and generally hypothecated with enron shares.24 repayment of loan was from partnership assets or their sale upon liquidation of the partnership or spe.25 as long as the value of the partnership assets continues to grow, the debt owed to the bank is amortized.26 however, once the asset value declined or the enron shares declined in value, the spe is in financial difficulty.27 2002] watchdogs that failed to bark 859 28. report, supra note 10, at 43. the extent of the officers and advisors’ hubris in forming spes reached its zenith when key spes were named after star wars characters, e.g., jedi, chewbacca, etc. the report noted the internal machinations which enron developed so that its special purpose entities were within the unconsolidated entity definition. one such “arrangement” was known as chewco:28 in 1993, enron and the california public employees’ retirement system (“calpers”) entered into a joint venture investment partnership called joint energy development investment limited partnership (“jedi”). enron was the general partner and contributed $250 million in enron stock. calpers was the limited partner and contributed $250 million in cash. because enron and calpers had joint control, enron did not consolidate jedi into its consolidated financial statements. in 1997, enron considered forming a $1 billion partnership with calpers called “jedi ii”. enron believed that calpers would not invest simultaneously in both jedi and jedi ii, so enron suggested it buy out calpers’ interest in jedi. enron and calpers attempted to value calpers’ interest (calpers retained an investment bank) and discussed an appropriate buyout price. in order to maintain jedi as an unconsolidated entity, enron needed to identify a new limited partner. fastow initially proposed that he act as the manager of, and an investor in, a new entity called “chewco investments” – named after the star wars character “chewbacca”. although other enron employees would be permitted to participate in chewco, fastow proposed to solicit the bulk of chewco’s equity capital from third-party investors. he suggested that chewco investors would want a manager who, like him, knew the underlying assets in jedi and could help manage them effectively. fastow told enron employees that jeffrey skilling, then enron’s president and chief operating officer (“coo”) had approved his participation in chewco as long as it would not have to be disclosed in enron’s proxy statement. both enron’s in-house counsel and its longstanding outside counsel, vinson & elkins, subsequently advised fastow that his participation in chewco would require (1) disclosure in enron’s proxy statement, and (2) approval from the chairman and ceo under enron’s code of conduct of business affairs (“code of conduct”). as a result, kopper, an enron employee who reported to fastow, was substituted as the proposed manager of chewco. unlike fastow, kopper was not a senior officer of enron, so his role in chewco would not 860 florida tax review [vol.5:10 29. report, supra note 10, at 43-45. require proxy statement disclosure (but would require approval under enron’s code of conduct). enron ultimately reached agreement with calpers to redeem its jedi limited partnership interest for $383 million. in order to close that transaction promptly, chewco was formed as a delaware limited liability company on very short notice in early november 1997. as initially formed, kopper (through intermediary entities) was the sole member of both the managing member and regular member of chewco. enron’s counsel, vinson & elkins, prepared the legal documentation for these entities in a period of approximately 48 hours. enron also put together a bridge financing arrangement, under which chewco and its members would borrow $383 million from two banks on an unsecured basis to buy calpers’ interest from jedi. the loans were to be guaranteed by enron. enron employees involved in the transaction understood that the chewco structure did not comply with spe consolidation rules. kopper, an enron employee, controlled chewco, and there was no third-party equity in chewco. there was only debt. the intention was, by year end, to replace the bridge financing with another structure that would qualify chewco as an spe with sufficient outside equity. ben f. glisan, jr., the enron “transaction support” employee with principal responsibility for accounting matters in the chewco transaction, believed that such a transaction would preserve jedi’s unconsolidated status if closed by year end.29 such hyperbole to qualify an illegitimate transaction as legitimate met with the board’s conclusion in the report that perhaps enron employees placed their own economic or personal interests ahead of their fiduciary duty to enron. chewco played a central role in enron’s november 2001 decision to restate its prior period financial statements. in order to achieve the off-balance sheet treatment that enron desired for an investment partnership, chewco (which was a limited partner in the partnership) was required to satisfy the accounting requirements for a non-consolidated spe, including having a minimum of 3% equity at risk provided by outside investors. but enron management and chewco’s general partner could not locate third parties willing to invest in the entity. instead, they created a financing structure for chewco that – on its face – fell at least $6.6 million (or more than 50%) short of the required third-party equity. despite this shortfall, enron accounted for chewco as if it were an unconsolidated spe from 1997 through march 2001. 2002] watchdogs that failed to bark 861 30. report, supra note 10, at 41-42. 31. report, supra note 10, at 4. 32. report, supra note 10, at 4. 33. report, supra note 10, at 4. 34. report, supra note 10, at 5. we do not know why this happened. enron had every incentive to ensure that chewco met the requirements for nonconsolidation. it is reasonable to assume that enron employees, if motivated solely to protect enron’s interests, would have taken the necessary steps to ensure that chewco had adequate outside equity. unfortunately, several of the principal participants in the transaction declined to be interviewed or otherwise to provide information to us. for this reason, we have been unable to determine whether chewco’s failure to qualify for non-consolidation resulted from bad judgment or negligence, or whether it was caused by enron employees putting their own economic or personal interests ahead of their obligations to enron.30 finally, the board did conclude in its report that most of the significant transactions were designed to accomplish favorable financial statement results and not to achieve bona fide economic objectives or transfer risk.31 in essence, the report was stating that most of the spe transactions lacked economic substance.32 but it is equally clear in the report that the structuring of the transactions, allowing for off balance sheet debt financing and superfluous transactions to offset losses which resulted in reported earnings to be inflated by almost $1 billion,33 lay squarely at the feet of the advisors.34 enron’s original accounting treatment of the chewco and ljm transactions that led to enron’s november 2001 restatement was clearly wrong, apparently the result of mistakes either in structuring the transactions or in basic accounting. in other cases, the accounting treatment was likely wrong, notwithstanding creative efforts to circumvent accounting principles through the complex structuring of transactions that lacked fundamental economic substance. in virtually all of the transactions, enron’s accounting treatment was determined with extensive participation and structuring advice from andersen, which management reported to the board. enron’s records show that andersen billed enron $5.7 million for advice in 862 florida tax review [vol.5:10 35. report, supra note 10, at 5. while the report does not specifically address the issue of outside legal counsel’s involvement, it is clear that vinson & elkins did render “sale opinion” letters reviewing business transactions (spes) as to their compliance with legal requirements. see, e.g., mike france, et al. one big hassle, bus. wk., jan. 28, 2002, at 38-39. 36. united states v. arthur andersen, llp, indictment crh-02-121 at ¶ 3, 10-12, available at http://news.findlaw.com/hdocs/docs/enron/usandersen030702ind.pdf. connection with the ljm and chewco transactions alone, above and beyond its regular audit fees.35 b. advisors’ response: shredding of documents the background of the enron imbroglio would not be complete without a recognition and analysis of the “shredding” incident by arthur andersen, llp, enron’s principal accountant of 16 years.36 it also demonstrates the standard for the shredding of documents in tax and non-tax cases. based upon a federal indictment dated march 7, 2002, the grand jury charged the following, in pertinent part: on or about october 16, 2001, enron issued a press release announcing a $618 million net loss for the third quarter of 2001. that same day, but not as part of the press release, enron announced to analysts that it would reduce shareholder equity by approximately $1.2 billion . . . by friday, october 19, 2001, enron alerted the andersen audit team that the sec had begun an inquiry regarding the enron “special purpose entities” and the involvement of enron’s chief financial officer. the next morning, an emergency conference call among high-level andersen management was convened to address the sec inquiry. during the call, it was decided that documentation that could assist enron in responding to the sec was to be assembled by the andersen auditors. after spending monday, october 22, 2001, at enron, andersen partners assigned to the enron engagement team launched on october 23, 2001, a wholesale destruction of documents at andersen’s offices in houston, texas. andersen personnel were called to urgent and mandatory meetings. instead of being advised to preserve documentation so as to assist enron and the sec, andersen employees on the enron engagement team were instructed by andersen partners and others to destroy 2002] watchdogs that failed to bark 863 37. id. at ¶ 6, 9-12. 38. see, e.g., spies v. commissioner, 317 u. s. 492, 499, (1943). 39. id. immediately documentation relating to enron, and told to work overtime if necessary to accomplish the destruction. during the next few weeks, an unparalleled initiative was undertaken to shred physical documentation and delete computer files. tons of paper relating to the enron audit were promptly shredded as part of the orchestrated document destruction. the shredder at the andersen office at the enron building was used virtually constantly and, to handle the overload, dozens of large trunks filled with enron documents were sent to andersen’s main houston office to be shredded. a systematic effort was also undertaken and carried out to purge the computer hard-drives and e-mail system of enron-related files. in addition to shredding and deleting documents in houston, texas, instructions were given to andersen personnel working on enron audit matters in portland, oregon, chicago, illinois, and london, england, to make sure that enron documents were destroyed there as well. indeed, in london, a coordinated effort by andersen partners and others, similar to the initiative undertaken in houston, was put into place to destroy enronrelated documents within days of notice of the sec inquiry. enron-related documents also were destroyed by andersen partners in chicago. on or about november 8, 2001, the sec served andersen with the anticipated subpoena relating to its work for enron. in response, members of the andersen team on the enron audit were alerted finally that there could be “no more shredding” because the firm had been “officially served” for documents.37 such alleged response by enron’s accountants is tantamount to the intentional keeping of a double set of books.38 indeed, the supreme court concluded in spies v. commissioner39 that an affirmative willful intent to defeat and evade tax could be inferred from the deliberate shredding of tax documents. however, no such inference arises in tax or non-tax disputes if no obligation to preserve evidence is found, but once so found, counsel should advise the client 864 florida tax review [vol.5:10 40. see turner v. hudson transit lines, inc., 142 f.r.d. 68, 79 (1991) (where corporate counsel failed to inform the client and counsel with his corporate client were joint and severally liable for damages). 41. id. at n. 36, para. 13. 42. see, e.g., wm. t. thompson co. v. general nutrition corp., 593 f.supp. 1443, 1446, 1455 (c.d. cal. 1984); telectron, inc., v. overhead door corp., 116 f.r.d. 107-110 (s.d. fla. 1987); carlucci v. piper aircraft corp., inc., 775 f.2d 1440, 1443, 1454 (11th cir. 1985). 43. report, supra note 10. 44. even the report alludes to this in describing the overly complex arrangements employed by the advisors through their repeated use of off-shore spes. report, supra note 10, at 68, 81. 45. the role of the board of directors in enron’s collapse. s. rep. no. 10770 (2002 rule 13.4(a)). 46. enron corp. and subsidiary companies: subsidiary companies and limited partnerships, 10k filing (as visited may 1, 2002) available at http://www.sec.gov/archives/edgar/data/72859/0000072859-97-000009.txt. 47. id. 48. id. accordingly.40 here, the grand jury charged that enron’s accountants knowingly, intentionally and corruptly, inter alia, destroyed documents to impair their availability for use in official proceedings.41 such alleged knowing and purposeful destruction can result in significant sanctions.42 consequently, in addition to dubious advice on the many enron spes, the alleged shredding of documents by the same advisors indicates a likely disregard for any moral or legal standards of review. what, then, were the operative standards of transaction review pre-enron? there are several tax transaction standards of review that had been successfully applied in so-called “tax shelter” (spe) cases. iii. pre-enron standards of tax review it is important from the preceding information contained in the report that numerous consolidated techniques were employed to satisfy key accounting rules and, once discovered, efforts were allegedly made to “cover up” such planning scenarios.43 the tax planning used at enron, once again endorsed by its tax advisors, is also highly suspect.44 indeed the senate finance committee is examining enron’s federal tax returns from 1985 to 2001 to review the tax shelters and other such tax strategies it employed.45 a perusal of sec filings discloses that enron located more than 140 subsidiaries in tax haven countries in the netherlands,46 as well as the cayman islands47 and bermuda.48 2002] watchdogs that failed to bark 865 49. id. at 82-89, 119-128. 50. id. 51. see generally report, suptra note 10. 52. though this tax planning device is permissible it does indicate the degree of aggressiveness of the enron tax planning. see, e.g., curt anderson & brad foss, enron to release tax records to senate, toronto star, feb. 16, 2002, at sports, ii. 53. report, supra note 10, at 3, 37. the board’s special investigative committee was established on october 28, 2001 to conduct an investigation of relatedparty transactions arising from the period of the early 1990’s through 2001. id. 54. aba comm. or prof’l responsibility, formal op. 85-352 (1985) [hereinafter aba opinon 85-352]; aba model rules of prof’l conduct (2001) [hereinafter mrpc]. neither the mrpc or aba formal opinion have the effect of law. thus, each state has the authority via the legislature or the state supreme court to adopt the provisions of the mrpc. 55. aicpa, statements on responsibility in tax practice (1991) [hereinafter srtp]. aicpa, code of professional conduct (1997) [hereinafter cpc] <http://www.aicpa.com> (last visited may 2, 2002). 56. practice before the internal revenue service, 31 c.f.r. pt. 10 (2002) [hereinafter circular 230] in addition, the report is riddled with use of spes in “hedging” transactions49 and derivatives50 which tend to shift economic risk without loss of tax deductions.51 and enron was one of the first issuers of “trust preferred” securities that allowed enron to issue debt through a subsidiary and claim the interest deduction on its tax return without reflecting the debt as a liability on its balance sheet.52 a. standards of tax review enron’s accounting and legal tax advisors had several fundamental standards of tax review and disclosure available to them during the period covered in the report.53 each pertinent standard of tax review and disclosure affecting transactions involving potential tax shelters are discussed below: source of standard issuer party affected 1. aba formal opinion 85-352 american bar assoc. attorneys at law and model rules of professional conduct (mrpc)54 2. aicpa statements on american inst. of cpas cpas who are responsibilities in tax practice aicpa members (srtp) and code of professional conduct (cpc)55 3. treasury circular 23056 internal revenue service persons who practice before the irs 866 florida tax review [vol.5:10 57. temp. regs. § 1.6011-4t (2000); notice 2001-51, 2001-34 i.r.b. 190. 58. irc §§ 6651, 6654, 6662, 6663, 6672, 6674, 6682, 6694, 6695, 6701, 6702. the tax standard in criminal fraud cases, unlike the civil tax review and disclosure standards, has never varied. it is willfulness of the taxpayer’s conduct and the willfulness standard requires a voluntary, intentional violation of a known legal duty, e.g., failure to pay tax is intentional and not due to negligence or mistake. see, e.g., united states v. pomponio, 429 u. s. 10 (1976); united states v. bishop, 412 u. s. 346 (1973). 59. bernard wolfman, et al., standards of tax practice § 101.2 (boston: little, brown and company 1997). 60. mrpc, supra note 54. 61. mrpc, supra note 54. in general, other relevant rules for tax lawyers are found in rules 1.3, 1.4, 1.6, 4.1, and 7.4 dealing with diligence, communication, confidentiality, disclosure and specialization, respectively. id. source of standard issuer party affected 4. treasury regulations and internal revenue service taxpayer engaged the 2000-01 tax shelter in transactions disclosure regulations57 covered by the regulations 5. internal revenue code of u. s. congress all taxpayers 1986 and the civil penalty provisions58 1. aba formal opinion 85-352 and model rules of professional conduct – first is the aba tax standard of review found in aba opinion 85352 and its pertinent sections of the mrpc. the standard of tax review may best be summarized as follows: the practitioner also owes a duty, albeit less well defined, to the tax system as a whole. the practitioner is not free to do whatever it is that the client demands, regardless of the client’s willingness to incur the risk of penalty. the practitioner’s duty to the system is based, in part, on a general obligation – derived from the practitioner’s status as a professional – to encourage compliance with the law (including the tax laws).59 to this end, encouraging client compliance with the law, the mrpc dictate key rules that generally set the standard for the tax lawyer.60 of particular impact are rules 1.1, 1.2(d), and 3.1 dealing with a lawyer’s competence, good faith standard, and frivolous action, respectively.61 for the tax lawyer this means that the lawyer representing a client in a tax matter, or rendering advice thereto, must be competent to do so through knowledge, skill, thoroughness and 2002] watchdogs that failed to bark 867 62. mrpc, supra note 54, at rule 1.1. 63. mrpc, supra note 54, at rule 1.2(d). 64. mrpc, suptra 54, at rule 3.1. 65. id. in 54 supra. 66. aba opinion 85-352, supra note 54. unfortunately for tax practitioners at no place in aba opinion 85-352 does it quantify the realistic possibility standard, e.g., if the realistic possibility is only 33% is this sufficient or must it be at least 50%? see paul j. sax , et al., report of the special task force on formal opinion 85-352, 39 tax law. 635, 640 (1986) (asserting that the unadopted report would suggest that a 33% rule is sufficient for the realistic possibility standard). 67. there are six principles recited in the cpc: professional responsibility, public interest should be paramount, integrity, objectivity and independence, due care, and scope and nature of services. cpc, supra note 55. 68. cpc, supra note 55. there are eleven rules applicable to all professional accounting services, including tax: independence integrity and objectivity general standards compliance with standards accounting principles confidential client information contingent fees acts discreditable advertising and other forms of solicitation commissions and referral fees 505 form of organization and name preparedness.62 similarly, a tax lawyer must discuss the legal consequences of any proposed (planning) course of conduct and make a good faith effort to determine the validity, scope, meaning or application of the law.63 finally, a tax lawyer is precluded from bringing or defending frivolous actions but must demonstrate a good faith argument for, inter alia, any modification of the law.64 the preceding rules address the question in tax planning scenarios of a “good faith” belief. this was defined in aba opinion 85-352.65 a good faith belief required some “realistic possibility” of success if the matter is litigated. thus, a tax lawyer has demonstrated a good faith belief in the validity of a position in accordance with the realistic possibility standard if that position is warranted in existing law or can be supported by a good faith argument for an extension, modification, or reversal of existing law.66 2. aicpa statements on responsibilities in tax practice and code of professional conduct – second is the srtp which flows from the cpc. the cpc applies to all member cpas in all fields of practice, e.g., tax, and contains principles67 and rules.68 but it is the srtp that merits a tax cpa’s attention for 868 florida tax review [vol.5:10 69. srtp, supra note 55, at introduction. 70. srtp, supra note 55, at no. 1. 71. srtp, supra note 55, at no. 2. 72. srtp, supra note 55, at no. 3. 73. srtp, supra note 55, at no. 4. 74. srtp, supra note 55, at no. 5. 75. srtp, supra note 55, at no. 6. 76. srtp, supra note 55, at no. 7. 77. srtp, supra note 55, at no. 8. 78. srtp, supra note 55, at no. 1, § 2.a. 79. srtp, supra note 55, at interpretation no. 1-1. 80. srtp, supra note 55, at interpretation no. 1-1 § 5. 81. this is the standard that is higher than a non-frivolous or not patently improper standard. thus, if a position taken on a tax return is based upon tax authorities, the return position will generally satisfy the reasonable basis standard. see regs. § 1.6662-3(b)(3). 82. the substantial authority standard is an objective standard and is less stringent than the more likely than not standard (the standard that is met when there is greater than 50% likelihood of the position being upheld). regs. § 1.66624(d)(1),(2). it sets forth the acceptable standards for tax practice and review. unlike the cpc, the srtps are merely advisory and lack the authority mandated by the cpc.69 the srtp contains eight statements, excluding the introduction, and addresses the following tax matters: tax matter, tax return positions,70 answers to questions on returns,71 certain procedural aspects of preparing returns,72 use of estimates,73 departure from a position previously concluded in an administrative proceeding or court decision,74 knowledge of error: return preparation,75 knowledge of error: administrative proceedings,76 form and content of advice to clients.77 in addition, unlike the preceding aba opinion 85-352, the srtp no. 1 contains interpretation no. 1-1, which sets forth the tax standard known as the “realistic possibility” standard78 and further identifies it with elaborate specificity.79 it places the realistic possibility standard on a continuum running from a less stringent reasonable basis standard to the far more strict standards of substantial authority and more likely than not.80 /______________________/___________________________________/ reasonable realistic substantial basis standard81 possibility authority and more standard likely than not standards82 2002] watchdogs that failed to bark 869 83. srtp, supra note 55, at interpretation no. 1-1. 84. srtp, supra note 55, at interpretation no. 1-1. 85. srtp, supra note 55, at interpretation no. 1-1. like aba opinion 85-352, the interpretation chooses not to quantify the realistic possibility standard in terms of percentage odds. rather, it sketches for the cpa what indicia are the sine qua non of the standard: in determining whether a tax return position meets the realistic possibility standard, [a cpa] may rely on authorities in addition to those evaluated when determining whether substantial authority exists. . . accordingly, [cpas] may rely on wellreasoned treatises, articles in recognized professional tax publications, and other reference tools and sources of tax analyses commonly used by tax advisors and preparers of returns. in determining whether a realistic possibility exists, [the cpa] should do all of the following: • establish relevant background facts. • distill the appropriate questions from these facts. • search for authoritative answers to those questions. • resolve the questions by weighing the authorities uncovered by that search. • arrive at a conclusion supported by the authorities. [the cpa] should consider the weight of each authority [in order] to conclude whether a position meets the realistic possibility standard. in determining the weight of an authority, [the cpa] should consider its persuasiveness, relevance, and source. thus, the type of authority is a significant factor. other important factors include whether the facts stated by the authority are distinguishable from those of the [client] and whether the authority contains an analysis of the issue or merely states a conclusion.83 in a nutshell, a tax cpa, like his or her brethren the tax lawyer, should not take a position on a return resulting from a tax transaction, e.g., tax shelter, unless he or she has a good faith belief that the position has a “realistic possibility” of being sustained.84 if the tax advisor fails this standard of tax review then disclosure is mandated provided the position is non-frivolous.85 870 florida tax review [vol.5:10 86. circular 230, supra note 56. 87. circular 230, supra note 56, at §10.3(a). 88. circular 230, supra note 56, at §10.3(b). 89. circular 230, supra note 56, at §10.3(c). 90. circular 230, supra note 56, at §10.3(d). 91. circular 230, supra note 56, at §10.4(a). 92. circular 230, supra note 56, at §10.2(e). 93. circular 230, supra note 56, at §10.34. 94. aba opinion 85-352, supra note 55. 95. see srtp and cpc, supra note 55. 96. circular 230, supra note 56, at § 10.34(a)(1),(d)(1). 3. treasury circular 230 – the third standard of tax review originates from the u. s. treasury as circular 230.86 circular 230 requires attorneys,87 cpas,88 enrolled agents89 and actuaries90 to be technically competent and adhere to ethical standards.91 practice before the irs, in addition to client representations, includes preparing and filing all necessary documents.92 of interest to taxpayer representatives is the irs requirement of the threshold tax standard whenever a tax advisor renders advice on tax return positions.93 while the standard is the same as espoused by the aba94 and aicpa95 positions, being one of “realistic possibility”, it goes further in defining this standard and clearly identifies the likelihood of its successful application.96 (a) realistic possibility standard. a practitioner may not sign a tax return as a preparer if the practitioner determines that the return contains a position that does not have a realistic possibility of being sustained on its merits (the realistic possibility standard) unless the position is not frivolous and is adequately disclosed to the internal revenue service. a practitioner may not advise a client to take a position on a return, or prepare the portion of a return on which a position is taken, unless – (1) the practitioner determines that the position satisfies the realistic possibility standard; or (2) the position is not frivolous and the practitioner advises the client of any opportunity to avoid the accuracy-related penalty in section 6662 of the internal revenue code [of 1986] by adequately disclosing the position and of the requirements for adequate disclosure. (b) definitions. for purposes of this section: (1) realistic possibility. a position is considered to have a realistic possibility of being sustained on its 2002] watchdogs that failed to bark 871 97. id. 98. id. § 10.34(d)(1). 99. id. § 10.34(a)(2). 100. id. § 10.33. 101. see aba opinion 85-352 and mrpc, supra note 54; see also srtp and cpc, supra note 55. 102. circular 230, supra note 56, at § 10.33(a)(5). 103. id. § 10.33(c)(3). merits if a reasonable and well informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits. the authorities described in 26 cfr 1.6662-4(d)(3)(iii), or any successor provision, of the substantial understatement penalty regulations may be taken into account for purposes of this analysis. the possibility that a [position] will not be [challenged by the service (e.g., because the taxpayer’s return may not be audited or because the issue may not be raised on audit)]. . . may not be taken into account.97 thus, the realistic possibility standard of tax review is met if the tax advisor reasonably concludes that the tax position has approximately a 33% or greater likelihood of being sustained.98 absent this, disclosure and a nonfrivolous standard is imposed on the advisor.99 circular 230 also delineates the standard of review in tax shelter opinion cases.100 unlike the aba and aicpa standards,101 circular 230 addresses the standard of review for an overall evaluation of a tax shelter opinion.102 once the tax advisor determines that he or she is being asked to render a tax shelter opinion,103 then the question arises as to what standard the irs will accept to evaluate the opinion on a favorable basis: (c) overall evaluation. (i) where possible, the practitioner must provide an overall evaluation whether the material tax benefits in the aggregate more likely than not will be realized. where such an overall evaluation cannot be given, the opinion should fully describe the reasons for the practitioner’s inability to make an overall evaluation. opinions concluding that an overall evaluation cannot be provided will be given special scrutiny to determine if the stated reasons are adequate. 872 florida tax review [vol.5:10 104. id. at § 10.33(a)(5)(i)-(ii). 105. id. at § 10.33(a)(5)(iii) 106. see, e.g., regs. § 1.6662-4(d)(2). 107. circular 230, supra note 56, at § 10.34(d)(1). 108. 66 fed. reg. 3276, 3295 (proposed jan. 12, 2001). 109. id. 110. id. at § 10.33(a). 111. compare circular 230, supra note 56 at § 10.33(a)(1)(ii) with 66 fed. reg. 3276, §10.33(a)(1)(ii). 112. see regs. §§ 1.6662-3, 4. 113. notice 2001-51, 2001-34 i.r.b. 190, supra note 57. 114. regs. §§ 1.6662-3, 4. (ii) a favorable overall evaluation may not be rendered unless it is based on a conclusion that substantially more than half of the material tax benefits, in terms of their financial impact on a typical investor, more likely than not will be realized if challenged by the internal revenue service.104 in the event that the advisor’s opinion does not constitute a favorable overall evaluation, this fact must be prominently disclosed in the tax shelter offering materials.105 the standard for tax shelter opinions rendered by an advisor is the “more likely than not” standard which means that there is greater than a 50% likelihood of the opinion being upheld.106 this standard is a higher threshold of review than that of realistic possibility (where only a 33% likelihood is necessary on review);107 thus, the irs in circular 230 is stating that tax shelter opinions must comply with far greater scrutiny than a tax return position. it is interesting to note that the irs recently proposed amendments to circular 230 in the area of tax shelter opinions.108 the irs proposes that the advisor be far more circumspect in relying on client provided information.109 now, every item in the opinion must be addressed and comply with the more likely than not standard.110 in essence, a tax advisor must now, perhaps correctly so, be responsible for client inaccuracies which he or she relied upon in rendering the tax shelter opinion as opposed to establishing a good faith belief in such items.111 4. treasury regulations and the 2000-01 tax shelter regulations disclosure – fourth are the standards set forth in the treasury regulations that specifically address both tax review of taxpayer positions112 and tax shelter disclosures.113 standards of tax review regulations are largely addressed at the accuracy related penalty provisions of section 6662.114 the accuracy related penalty may adhere if a tax advisor fails to meet the substantial authority 2002] watchdogs that failed to bark 873 115. regs. §§ 1.6662-4(d)(1),(2), 1.6662-4(a). 116. regs. §§ 1.6662-3(b)(3). 117. see, e.g., circular 230, supra note 56, at § 10.34. 118. id. see aba opinion 85-352 and mrpc, supra note 54. 119. see srtp and cpc, supra note 55. 120. see circular 230, supra note 56. 121. see mrpc, supra note 54, at rule 3.1. 122. see regs. § 1.6662-3(b)(3). 123. according to the 2003 regulations at temp. regs. §301.6111-2t, a confidential corporate tax shelter is defined as: any transaction (i) a significant purpose of the structure of which is the avoidance or evasion of federal income tax. . . . for a direct or indirect corporate participant; (ii) that is offered to any potential participant under conditions of confidentiality. . .; and (iii) for which the tax shelter promoters may receive fees in excess of $100,000 in the aggregate. . . 124. see, e.g., notice 2001-51, 2001-34 i.r.b. 190, supra note 57. 125. temp. regs. § 1.6011-4 t (2000) (before amendments in 2001 and 2002). 126. see notice 2001-51, 2001-34 i.r.b. 190, supra note 57. standard115 – which is more stringent than either the reasonable basis standard116 or the realistic possibility standard,117 as set forth in the aba,118 aicpa119 and circular 230120 pronouncements. therein lies the quandary. an attorney has a duty to zealously represent a client and obtain the most efficacious tax result for the taxpayer.121 for example, a client has suggested an intuitive tax treatment of an item that results in a lower tax liability based on a review of the regulations. this intuitive approach followed by the client is, however, contrary to another final regulation. the possibility of a section 6662 accuracy related penalty exists because of the higher standard. hence, section 6662 regulations would allow the zealous tax lawyer’s inconsistent position provided it was nonfrivolous122 and fully disclosed on the client’s tax return. however, this will, in all likelihood, invite an audit of the taxpayer’s return. so while the lawyer’s realistic possibility standard is met, the higher standard of substantial authority trumps it assuring potential involvement with the irs. the preceding example can be exacerbated if the tax treatment of the item involves a tax shelter.123 then numerous treasury regulations are triggered, regardless of the standard of review, that mandate disclosure.124 these so-called “tax shelter” regulations set a higher standard of tax disclosure if the subject matter of the item is classified as a tax shelter. to be exact, there are two principal sets of tax shelter disclosure regulations known as the 2000125 and 2001126 tax shelter regulations. 874 florida tax review [vol.5:10 127. the 2000 tax shelter regulations listed ten tax shelter transactions and six additional were included in the 2001 regulations. id. 128. the “persons” subject to disclosure are any taxpayers who are corporations, promoters, solicitors, organizers, and those responsible for registering confidential corporate tax shelters. such disclosure standard is comprehensive; it not only requires tax return disclosure but also amended returns, filing statements, foreign entity involvement, e.g., offshore corporations or trusts, etc. id. at § 4t(a)-(d). 129. the sixteen listed tax shelter transactions subject to a disclosure standard are set forth at notice 2001-51, 2001-34 i.r.b. 190, as follows: 1. rev. rul. 90-105, 1990-2 c.b. 69 (transactions in which taxpayers claim deductions for contributions to a qualified cash or deferred arrangement or matching contributions to a defined contribution plan where the contributions are attributable to compensation earned by plan participants after the end of the taxable year (identified as “listed transactions” on february 28, 2000)); 2. notice 95-34, 1995-1 c.b. 309 (certain trust arrangements purported to qualify as multiple employer welfare benefit funds exempt from the limits of §§419 and 419a of the internal revenue code (identified as “listed transactions” on february 28, 2000)); 3. notice 95-53, 1995-2 c.b. 334 (certain multiple-party transactions intended to allow one party to realize rental or other income from property or service contracts and to allow another party to report deductions related to that income (often referred to as “lease strips”) (identified as “listed transactions” on february 28, 2000)); 4. transactions described in part ii of notice 98-5, 1998-1 c.b. 334 (transactions in which the reasonably expected economic profit is insubstantial in comparison to the value of the expected foreign tax credits (identified as “listed transactions” on february 28, 2000)); 5. transactions substantially similar to those at issue in asa investerings partnership v. commissioner, 201 f.3d 505 (d.c. cir. 2000), and acm partnership v. commissioner, 157 f.3d 231 (3d cir. 1998) (transactions involving contingent installment sales of securities by partnerships in order to accelerate and allocate income to a tax-indifferent partner, such as a tax-exempt entity or foreign person, and to allocate later losses to another partner identified as “listed transactions” on february 28, 2000); 6. treas. reg. §1.643(a)-8 (transactions involving distributions described in §1.643(a)-8 from charitable remainder trusts (identified as “listed transactions” on february 28, 2000)); 7. rev. rul. 99-14, 1999-1 c.b. 835 (transactions in which a taxpayer purports to lease property and then purports to immediately sublease it back to the lessor (that is, lease-in/lease-out or lilo the two sets of regulations establish sixteen127 itemized tax shelter transactions that must be disclosed128 on the taxpayer’s tax return.129 in 2002] watchdogs that failed to bark 875 transactions) (identified as “listed transactions” on february 28, 2000)); 8. notice 99-59, 1999-2 c.b. 761 (transactions involving the distribution of encumbered property in which taxpayers claim tax losses for capital outlays that they have in fact recovered (identified as “listed transactions” on february 28, 2000)); 9. treas. reg. § 1.7701(1)-3, (transactions involving fast-pay arrangements as defined in § 1.7701(1)-3(b) (identified as “listed transactions” on february 28, 2000)); 10. rev. rul. 2000-12, 2000-11 i.r.b. 744 (certain transactions involving the acquisition of two debt instruments the values of which are expected to change significantly at about the same time in opposite directions (identified as “listed transactions” on february 28, 2000)); 11. notice 2000-44, 2000-36 i.r.b. 255 (transactions generating losses resulting from artificially inflating the basis of partnership interests (identified as “listed transactions” on august 11, 2000)); 12. notice 2000-60, 2000-49 i.r.b. 568 (transactions involving the purchase of a parent corporation’s stock by a subsidiary, a subsequent transfer of the purchased parent stock from the subsidiary to the parent’s employees, and the eventual liquidation or sale of the subsidiary (identified as “listed transactions” on november 16, 2000)); 13. notice 2000-61, 2000-49 i.r.b. 569 (transactions purporting to apply §935 to guamanian trusts (identified as “listed transactions” on november 21, 2000)); 14. notice 2001-16, 2001-9 i.r.b. 730 (transactions involving the use of an intermediary to sell the assets of a corporation (identified as “listed transactions” on january 18, 2001)); 15. notice 2001-17, 2001-9 i.r.b. 730 (transactions involving a loss on the sale of stock acquired in a purported §351 transfer of a high basis asset to a corporation and the corporation’s assumption of a liability that the transferor has not yet taken into account for federal income tax purposes (identified as “listed transactions” on january 18, 2001)); and 16. notice 2001-45, 2001-33 i.r.b. 129 (certain redemptions of stock in transactions not subject to u.s. tax in which the basis of the redeemed stock is purported to shift to a u.s. taxpayer (identified as “listed transactions” on july 26, 2001)). notice 2001-51, 2001-34 i.r.b. 190, supra note 57. 130. temp. regs. § 1.6011-4t(a). see also 65 fr 11205-02 at 11206. 131. temp. regs. § 1.6011-4t(a). general terms, a disclosure standard is required for a reportable transaction.130 this is a listed transaction that satisfies the projected tax effects test.131 such test mandates disclosure whenever the tax benefit or savings exceeds certain dollar 876 florida tax review [vol.5:10 132. id. 133. id. 134. id. see also temp. regs. § 301.6111-2t(c) as to the definition of confidentiality. 135. temp. regs. § 1.6011-4t(a). 136. irc §§ 6651, 6654, 6662, 6663, 6672, 6674, 6682, 6694, 6695, 6701, 6702. 137. see, e.g., temp. regs. § 1.6662-4(d)(1),(2). 138. see regs. § 1.6662-3(b)(3). 139. see regs. § 1.6662-4(d)(1), (2). 140. id. 141. see regs. § 1.6694-2(b)(1). 142. irc § 6694. 143. regs. § 1.6694-2(b)(1) compare the circular 230 identical realistic possibility standard with the preceding irc § 6694 standard. see circular 230, supra note 56, at § 10.34(a)(2). thresholds132 (reduction of tax liability by $1 million in a taxable year or by $2 million for any combination of taxable years). a second category of reportable transactions subject to disclosure entered into after february 28, 2000 – which need not be a listed transaction – are those expected to reduce tax liability by more than $5 million in a taxable year or more than $10 million in any combination of taxable years133 provided the tax shelter either participated in a confidential transaction134 or contracted for the downside protection that the tax benefits may not be obtained.135 these regulatory tax review and disclosure standards impose a higher threshold on tax advisors, particularly in the area of tax shelters, and demand that the advisor weigh the client’s proposed transaction far more carefully. 5. internal revenue code of 1986 and the civil penalty provisions – last are the civil penalty provisions set forth in the internal revenue code of 1986.136 as discussed earlier, the tax review standard, as set forth in the treasury regulations,137 identifies the reasonable basis,138 substantial authority,139 and more likely than not140 standard (especially in tax shelter cases). the realistic possibility standard141 is used in the preparer civil penalty statute at section 6694.142 under the regulations of that section the realistic possibility standard of tax review is defined as requiring that a reasonable and well-informed person, knowledgeable in the tax law, would conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits.143 hence, the statutory authority of the civil penalty provisions generally involve a determination of the appropriate tax review or disclosure standard by identifying the underlying regulatory guidance. 2002] watchdogs that failed to bark 877 144. see regs. § 1.6662-4(d)(1), (2). 145. see regs. § 1.6694-2(b)(1). 146. see regs. § 1.662-4(d)(2), (5). 147. a decision rule is merely a statement of the condition. for instance, what is the appropriate standard of review or disclosure and it identifies the condition of rejection (a lower standard) versus the condition of non rejection (a higher standard) in a tax planning context. however, such “threshold” rules should not be applied without considering the surrounding facts and ultimate flexibility in the planning situation. for more discussion on threshold decision rules, see j. edward russo & paul j. h. schoemaker, decision traps 123-128 (doubleday 1989). 148. compare ups v. commissioner, 254 f.3d 1014 (11th cir. 2001), with winn-dixie stores, inc. v. commissioner, 254 f.3d 1313 (11th cir. 2001) cert. denied, 122. s. ct. 1537 (2002). focus hereunder is on corporate tax shelters. individual taxpayer shelters were virtually eliminated through the enactment of irc § 465 (at-risk rules), and irc § 469 (passive activity loss rules), though only the most blatant forms of individual tax (evasion) shelters persist. examples include tax exempt trusts and business structuring; offshore accounts, banks, businesses, trusts and foundations; “dropping out” of the system by stopping all withholding and social security taxes; tax-exempt “private” insurance companies; and charity-like or religious entities established for personal use <http://finance.senate.gov/040501jntest.pdf>. 149. temp. regs. § 1.6011-4t(a). as a general rule, the standard of review and disclosure supporting the statutory authority is that of substantial authority144 and realistic possibility145 for tax review and more likely than not146 for tax shelter disclosures. the code with its regulatory authority places the tax advisor in the position of first identifying the highest possible standard of review or disclosure and then meeting such standard. this decision rule appears to offer the greatest prophylactic from applying a lesser standard espoused by a private regulatory body.147 but even with these standards of review, courts have chosen to find acceptable and nonacceptable tax shelter constructs as the following cases demonstrate. b. application of the standards to tax shelter cases to fully discern how the realistic possibility standard and, in the case of tax shelter opinions, the more likely than not standard are applied to prospective transactions, recently decided tax shelter cases provide a hindsight reflection of their successful application by tax advisors. recent special purpose entity and corporate tax shelter cases have met with varying success.148 it is not sufficient that a tax advisor merely apply a standard because in tax shelter transactions disclosure is generally mandated.149 rather, an advisor should review the relevant case authorities in identifying and classifying the appropriate jurisdictional and jurisprudential response to the standard. that is, in a proposed corporate tax shelter transaction is there a 33% or greater (realistic 878 florida tax review [vol.5:10 150. id. 151. 80 t.c.memo (cch) 686 (2000), t.c. memo (ria) § 54122 (2000). 152. 167 f.supp. 2d 298 (d.c. cir. 2001). 153. 277 f.3d 778 (5th cir. 2001). 154. 253 f.3d 350 (8th cir. 2001). 155. 254 f.3d 1014 (11th cir. 2001). 156. 157 f.3d 231 (3d cir. 1998). 157. 117 t.c. 328 (2001). 158. 254 f.3d 1313 (11th cir. 2001), cert. denied, 122 s. ct. 1537 (2002), t.c. memo (ria) § 54122 (2002). possibility) or greater than 50% (more likely than not) likelihood that the tax shelter will be sustained on its merits? apparently the various court’s views of this likelihood may differ substantially from that of the tax advisors.150 with this in mind, a taxpayer profile of successful versus unsuccessful tax shelter cases needs to be developed. such a profile will facilitate a perspective on the complexities inherent in the “typical” corporate tax shelter. tax court, district and appellate court cases are highlighted in the table below with the tax shelter profiled in each case. pro-taxpayer cases tax shelter profile salina partnership lp, repurchase agreement fpl group, inc. v. commissioner151 corporate inversion boca investerings partnership v. contingent installment sale united states152 notes compaq computer corp. v.commissioner153 multi-party dividend stripping transactions ies industries, inc. v. united states154 dividend stripping transactions ups v. commissioner155 offshore special purpose entities pro-government cases tax shelter profile acm partnership v. commissioner156 contingent installment sale notes nicole rose corp. v. commissioner157 equipment leasing trusts winn-dixie stores, inc. v. commissioner158 corporate owned life insurance 1. pro-taxpayer cases – taxpayers have been successful in at least five significant tax shelter cases of recent vintage. perhaps a common thread will emerge in their review thereby making application of a prospective tax review standard, viz., realistic possibility, less onerous. 2002] watchdogs that failed to bark 879 159. salina p’ship lp v. commissioner, 80 t.c. memo (cch) 686 (2000). 160. the tax court defined these as follows: repurchase agreements (repos) and reverse repurchase agreements (reverse repos) are frequently used by dealers in government securities, financial institutions, and others as methods for temporary cash management, interest rate arbitrage, or the borrowing of securities used in the course of a dealer’s business. in a repo transaction, the first party (e.g., a dealer) sells securities (generally u. s. treasury and federal agency securities) to a second party (e.g., a customer) and simultaneously agrees to repurchase a like amount of the same securities at a stated price (generally greater than the original sales price) on a fixed, future date. repo transactions, from the viewpoint of the seller (such as a dealer), provide financing to acquire newly issued government securities or other portfolio assets; from the viewpoint of the purchaser, a repo transaction provides a means by which funds can be invested for a desired period while holding as collateral a virtually risk-free asset in the event the seller breaches its agreement to repurchase. see price v. commissioner, 88 t.c. 860, 864 n. 9 (1987). id at 690 n. 4. 161. id. at 693-694. 162. id. at 688. a. repurchase agreement (repo) corporate inversion in the special purpose entity case of salina partnership lp, fpl group, inc. v. commissioner,159 the tax shelter device successfully employed was a repo corporate inversion.160 this shelter is specifically designed to offset unrelated capital gains while creating a built-in loss on the partnership basis.161 here, a large publicly traded utility company, fpl, incurred corporate restructuring capital losses in excess of $581 million on the sale of an unrelated subsidiary.162 fpl’s investment banker suggested a repo inversion structured as follows: • fpl would purchase a 98% limited partnership interest in salina, a domestic limited partnership. • a tax haven jurisdiction (netherlands) would be the location of the two percent foreign general partner. • salina would then enter into short-sale agreements for u. s. securities where their face exceeded the repo sales price. • salina would secure the borrowed securities by an amount less than their face value. 880 florida tax review [vol.5:10 163. id. at 688-90. 164. id at 695. since the short sale constituted more than 50% of the partnership’s capital and profits, it is a termination. 165. see irc § 721. 166. a partnership has technically two bases in relation to a partner, i.e., the partner’s basis in the partnership interest (outside basis) and the partnership’s basis in the partnership property (inside basis). see irc §§ 722, 723. see also 1 william s. mckee et al., federal taxation of partnerships and partners 6.01 at 6-3 (warren, gorham & lamont. 3d ed. 1997). 167. salina, 80 t.c. memo (cch) at 692. 168. id. at 693. 169. id. at 693-696. 170. karr v. commissioner, 924 f.2d 1018, 1022-1023 (11th cir. 1991). 171. salina, 80 t.c. memo (cch) at 695. • between the borrowing date and the repo option date, salina would then purchase the securities from a third party at a lower price, and • at the repo date, when the short-sale is closed, salina would realize a short-term capital gain.163 under partnership tax rules, the short rule is treated as a technical termination of the partnership.164 but since the legal life of the partnership continues, it is treated as a constructive capital contribution to the partnership by the respective partners.165 now the partner’s outside basis166 reflects this increase and the u. s. partner (fpl) simply takes its distributive share of the shortterm capital gain (ordinary income) of salina amounting to over $344 million, which it then offsets against losses carried over from prior years.167 the irs challenged the $344 million short-term gain for the taxable year ending in 1992 contending that the salina entity was a mere sham and the outside basis of the partner was improperly computed.168 the issue before the tax court was twofold: whether the special purpose entity, the salina partnership, was a mere sham and whether its short sales of partnership investments that gave rise to the substantial outside basis of fpl proved in error.169 under the sham transaction doctrine, a transaction albeit proper in form, may lack economic substance.170 application of the more likely than not standard, substantial authority standard or even the realistic possibility standard would all necessitate a finding of a non sham transaction in a tax shelter case. in that regard, the tax court had no difficulty in finding precisely that result.171 considering all the facts and circumstances, we conclude that fpl entered into the salina transaction to achieve a valid business purpose independent of tax benefits. the record 2002] watchdogs that failed to bark 881 172. id. 173. id. at 700. 174. id. at 696. 175. id. at 700. 176. id. 177. id. at 695. of course once the more likely than not standard is satisfied, it trumps the realistic possibility standard. compare regs. § 1.6662-4(d) with circular 230 at § 10.34. 178. id. at 694. 179. id. 180. 167 f.supp. 2d 298 (d.c. cir. 2001). demonstrates that fpl entered into the salina partnership for the primary purpose of enhancing the return on its short-term investments. each of fpl’s representatives testified convincingly on this point. moreover, their testimony was bolstered by their detailed review and consideration of the proposed investment and the minutes of the board of director’s meeting approving the investment.172 the court then disposed of the short sales of the partnership investments as being allowable under irc section 752.173 that section allows for an increase in the outside basis when liabilities are assumed.174 since the investments by the partnership were legitimate liabilities pursuant to section 752(a), despite its highly technical nature as a repurchase agreement (repo) corporate inversion tax shelter, the transaction is permissible for tax purposes.175 this tax shelter device, the repo corporate inversion tax shelter, generally will be sustained as a planning arrangement.176 it satisfies the more likely than not standard and realistic possibility standard provided, taxpayer did not intend, as here, to create a sham.177 rather, this case points to a legitimate economic transaction designed by taxpayer’s investment banker and operated as an investment vehicle until its termination.178 thus, a cogent business purpose must be evident for its success.179 b. contingent installment sale notes boca investerings partnership v. united states180 was yet another unique form of tax shelter. this shelter’s construct was clearly identified by the district court: the seven proposed steps are generally the same, and are summarized as follows: (1) partnership is formed among a united states company, a subsidiary of that united states company (which together would 882 florida tax review [vol.5:10 181. id. at 311. 182. id. 183. id. 184. salina, 80 t.c. memo (cch). 185. boca investerings, 167 f.supp.2d at 364. initially own 10% of the partnership) and a foreign financial institution (which would initially own 90% of the partnership; (2) partnership purchases corporate bonds/capital assets; (3) partnership sells corporate; bonds/capital assets in exchange for cash and an installment note; (4) united states companies increase their partnership interest by purchasing portion of foreign company’s interest; (5) united states companies contribute additional assets to the partnership; (6) partners’ interests are partially redeemed by distributing installment note to united states companies and cash to foreign company; and (7) united states companies sell installment note to a third party.181 once again, under partnership tax rules, the sale of a high basis asset by the partnership triggered a capital loss and the sale of the partnership interest by the u. s. taxpayer partner resulted in a gain.182 thus, this shelter, much like the repo corporate inversion model, generates both losses and gains.183 and, like the salina184 case the commissioner argued that the special purpose entity (partnership) was a mere sham.185 the district court viewed the formation and operation of the partnership as legitimate and with economic substance: the foregoing discussion establishes that the “four basic attributes” of a partnership identified in s & m plumbing co. v. commissioner are present here. the record in this case establishes that (i) all four partners intended to, and did, organize boca as an investment partnership, (ii) all four contributed substantial capital to the partnership, (iii) all four participated on the partnership committee and jointly controlled boca, since the agreement of owners of 95% of the partnership was required in order to take action, and (iv) all four jointly shared in the income, gain, losses, and expenses from boca’s investments pursuant to the partnership agreement. see also luna v. commissioner, 42 t.c. at 1077-78. in addition, there was a legitimate business purpose for the creation of the 2002] watchdogs that failed to bark 883 186. id. at 372-373. 187. id. at 375. 188. id. at 376. partnership. since there was a legitimate partnership and legitimate business purposes for its creation, organization and investments, it is irrelevant if ahp was motivated in part to organize boca as a partnership by a device to reduce taxes.186 in further elucidating its vision of the economic substance of the partnership’s activities, the district court noted: the controlling authority with respect to economic substance in this circuit is horn v. commissioner, 968 f.2d 1229 (d.c. cir. 1992). in horn, the d. c. circuit set forth the following test for determining whether a transaction should be considered a sham for tax purposes. “to treat a transaction as a sham, the court must find (1) that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and (2) that the transaction has no economic substance because no reasonable possibility of profit exists.” horn v. commissioner, 968 f.2d at 1237 (quoting friedman v. c.i.r., 869 f.2d 785 (4th cir. 1989). the questions to ask are whether the transaction had “a reasonable prospect, ex ante, for economic gain (profit)” and “whether the transaction was undertaken for a business purpose other than the tax benefits.187 the decision in horn also makes plain that a transaction is not a sham and will be recognized for tax purposes if the taxpayer satisfies either part of the test for economic substance – if either (1) using a subjective analysis, the transaction has a nontax business purpose, or (2) using an objective analysis, the transaction has a reasonable possibility of generating a profit.188 in this case, plaintiffs have established by a preponderance of the evidence that the transactions financing the purchase and sale of the ppns had economic substance because those transactions had a non-tax business purpose. since satisfaction of either prong of the test is sufficient to demonstrate that a transaction has economic substance, the court need not draw any conclusions regarding the second prong – whether, using an objective analysis, the transactions had a reasonable prospect of making a profit. that said, the court does find that the great weight of evidence, including the expert testimony presented at trial – particularly that of ms. rahl and mr. 884 florida tax review [vol.5:10 189. id. at 377. 190. id. at 328, 331. 191. id. 192. irc § 453. see also regs. § 15a.453-1(c)(3). 193. boca investerings, 167 f.supp.2d at 387-388. 194. circular 230, supra note 56, at § 10.34(a)(2). 195. see n. 109 supra. 196. 253 f.3d 350 (8th cir. 2001). 197. 277 f.3d 778 (5th cir. 2001). 198. see ies industries, 253 f.3d at 351; compaq, 277 f.3d at 779. 199. see salina p’ship lp, fpl group, inc. v. commissioner, 80 t.c. memo (cch) 686 (2000), t.c. memo (ria) ¶ 54122 (2000). 200. see boca investerings p’ship v. united states, 167 f.supp.2d 298 (d.c. cir. 2001). 201. arbitrage is the simultaneous buying and selling of securities, e.g. adrs, in different markets seeking a favorable price differential. tax arbitrage occurs when differential tax rates on different kinds of income are used to a taxpayer’s advantage. see, e.g., alan gunn & larry d. ward, federal income taxation 389. see also g. hirt & s. block, fundamentals of investment management 493. fong – support plaintiffs’ position that the transactions in this case also satisfy the second prong of the sham transaction/economic substance test. as plaintiffs’ experts testified at length, there was – from an objective, ex ante perspective – a reasonable possibility that the transactions at issue could have turned a profit.189 therefore, this elaborate contingent installment sales tax shelter, with its purchase and sale of privately placed notes190 and libor notes,191 did demonstrate economic substance and compliance with section 453.192 such legal conclusion by the court193 supports the realistic possibility194 and the more likely than not195 standards of tax review. c. dividend stripping transactions two cases use a tax shelter technique known as “dividend stripping.” in ies industries, inc. v. united states196 and compaq computer corp. v. commissioner197 the multi party dividend stripping with foreign stock transactions was employed.198 unlike salina199 and boca,200 however, this tax shelter arrangement was fairly direct. taxpayer entered into a tax arbitrage201 2002] watchdogs that failed to bark 885 202. american depository receipts, or adrs, allow u. s. investors to trade foreign company stock by trading adrs on listed u. s. stock exchanges. adrs are not foreign stocks, per se, but represent interests in foreign stocks through trust certificates held in foreign bank trusts. see, e.g., scott besley & eugene f. brigham, essentials of managerial finance 648 (12th ed. 2000). 203. compaq, 277 f.3d at 779. 204. see id. at 780. 205. id. 206. id. 207. id. transaction using american depository receipts or adrs.202 as the fifth circuit court in compaq computer so eloquently described adrs: an adr is a trading unit, issued by a trust, that represents ownership of stock in a foreign corporation. foreign stocks are customarily traded on u.s. stock exchanges using adrs. an adr transaction of the kind at issue in this case begins with the purchase of adrs with the settlement date at a time when the purchaser is entitled to a declared dividend – that is, before or on the record date of the dividend. the transaction ends with the immediate resale of the same adr with the settlement date at a time when the purchaser is no longer entitled to the declared dividend – that is, after the record date. in the terminology of the market, the adr is purchased “cum dividend” and resold “ex dividend.”203 like the preceding case, taxpayer was approached by an investment firm (the same investment firm, twenty-first securities corporation, proposed this shelter in both cases).204 the compaq computer shelter had the following elements: • taxpayer’s investment firm purchased $887 million in adrs cum dividend from its netherlands client royal dutch and immediately resold $868 million in adrs ex dividend to the same client.205 • the net dividend (after payment of $3.4 million in netherlands tax) of $19 million was paid to taxpayer.206 • on compaq’s 1992 income tax return it reported $20.7 million in capital losses on the purchases and resales, $22.5 million in gross dividend income, and a foreign tax credit of $3.4 million for the netherlands tax withheld.207 886 florida tax review [vol.5:10 208. id. 209. compaq computer corp. v. commissioner, 113 t.c. 214 (1999). 210. id. at 222. 211. id. at 223-225. 212. ies industries, inc. v. united states, 253 f.3d 350 (8th cir. 2001). 213. compaq, 277 f.3d at 782-783. • compaq then used the capital loss to offset a $231.7 million capital gain it had realized on an unrelated transaction.208 the commissioner contended that the multi party dividend stripping transactions lacked economic substance and the tax court agreed.209 that court condemned the transaction as lacking economic substance because it gave the illusion of profit while simultaneously resulting in a tax credit of $3.4 million – far in excess of compaq’s tax liability of $640,000, allowing for a tax credit offset against unrelated transactions.210 moreover, there was no tangible evidence of substantive ownership of royal dutch adrs and was solely motivated by the expected tax benefits.211 in reversing the tax court, the fifth circuit found that the eight circuit court had ruled as a matter of law in ies industries212 that an adr dividend stripping transaction identical to the case at hand did not lack economic substance.213 thus, the fifth circuit court found that the transaction, like the eighth circuit, embodied a valid business purpose. [a]s to business purpose: even assuming that compaq sought primarily to get otherwise unavailable tax benefits in order to offset unrelated tax liabilities and unrelated capital gains, this need not invalidate the transaction. see frank lyon co., 435 u.s. at 580, 98 s.ct. at 1302. yet the evidence in the record does not show that compaq’s choice to engage in the adr transaction was solely motivated by the tax consequences of the transaction. instead, the evidence shows that compaq actually and legitimately also sought the (pre-tax) $1.9 million profit it would get from the royal dutch dividend of approximately $22.5 million less the $20.7 million or so in capital losses that compaq would incur from the sale of the adrs ex dividend. although, as the tax court found, the parties attempted to minimize the risks incident to the transaction, those risks did exist and were not by any means insignificant. in light of what we have said about the nature of compaq’s profit, both pre-tax and post-tax, we conclude that the 2002] watchdogs that failed to bark 887 214. id. at 786-787. 215. 253 f.3d 350. 216. 277 f.3d 778. 217. these multiparty dividend stripping tax shelter transactions are not without their critics. see, e.g., marc d. teitelbaum, compaq computer and ies industries – the empire strikes back, 20 tax notes int’l 791 (2000); david p. hariton, sorting out the tangle of economic substance, 52 tax law. 235, 273 (1999); peter c. canellos, a tax practitioner’s perspective on substance, form and business purpose in structuring business transactions and in tax shelters, 54 smu l.rev. 47, 54 (2001); george k. yin, getting serious about corporate tax shelters: taking a lesson from history, 54 smu l .rev. 209, 222 (2001); daniel n. shaviro, economic substance, corporate tax shelters, and the compaq case, 88 tax notes 221 (2000); david a. weisbach, the failure of disclosure as an approach to shelters, 54 smu l. rev. 73, 79 (2001). 218. 254 f.3d 1014 (11th cir. 2001). transaction had a sufficient business purpose independent of tax considerations.214 therefore, in both ies215 and compaq216 the respective appellate courts found that the dividend stripping transaction had economic substance and a valid business purpose thereby supporting this type of tax shelter under future tax review standards on similar facts.217 d. offshore special purpose entities the case of ups v. commissioner218 illustrates how a business exigency can create a tax planning opportunity and, consequently, a tax shelter. this business exigency was clearly stated by the court: ups, whose main business is shipping packages, had a practice in the early 1980s of reimbursing customers for lost or damaged parcels up to $100 in declared value. above that level, ups would assume liability up to the parcel’s declared value if the customer paid 25¢ per additional $100 in declared value, the “excess-value charge.” if a parcel were lost or damaged, ups would process and pay the resulting claim. ups turned a large profit on excess-value charges because it never came close to paying as much in claims as it collected in charges, in part because of efforts it made to safeguard and track excess-value shipments. this profit was taxed; ups declared its revenue from excess-value charges as income on its 1983 return, and it 888 florida tax review [vol.5:10 219. id. at 1016. 220. salina p’ship lp, fpl group, inc. v. commissioner, 80 t.c. memo (cch) 686, t.c. memo (ria) ¶ 54122 (2000). 221. boca investerings p’ship v. united states, 137 f.supp.2d 298 (d.c. cir. 2001). 222. compaq computer corp. v. commissioner, 277 f.3d 778 (5th cir. 2001) 223. ies industries inc. v. united states, 253 f.3d 350 (8th cir. 2001). 224. it is the risk identification and risk inherent in the business transaction that each taxpayer in these cases attempted to mitigate. indeed this was the sine quo non of the business purpose that gave economic substance to the transaction – notwithstanding the favorable tax consequences. see, e.g., boca, 167 f.supp. at 351352. wherein the district court recited the credit, default, credit downgrade, liquidity and interest rate risks present in the contingent installment sale notes shelter. 225. ups v. commissioner, 254 f.3d 1014, 1016 (11th cir. 2001). 226. offshore tax havens, generally formed as special purpose entities, i.e., limited partnerships, international business corporations, etc. are used throughout the business community. for instance, the pritzker family, owners of the hyatt hotel chain, use multiple chains of offshore entities that afford the chain significant tax deferral mechanisms. among the chains are hyatt international pritzker (wilmington, del), baku hotel dev. lp (cayman is.), settlement investors, inc. (bahamas), baku hotel corp. (cayman is.), park hyatt baku (azerbaijan). see glenn r. simpson, island tax haven may aid pritzkers, wall st. j., may 13, 2002; see also reuven s. avi-yonah, u.s. international taxation 394-396. deducted as expenses the claims paid on damaged or lost excess-value parcels.219 like salina,220 boca,221 compaq,222 and ies,223 it was an independent third party that suggested an economic plan with a tax shelter dimension to reduce the risk of economic exposure.224 unlike the preceding cases, however, here the third party was the taxpayer’s insurance broker225 (not a securities firm). the broker proposed an offshore special purpose entity.226 ups could avoid paying taxes on the lucrative excess-value business if it restructured the program as insurance provided by an overseas affiliate. ups implemented this plan in 1983 by first forming and capitalizing a bermuda subsidiary, overseas partners, ltd. (opl), almost all of whose shares were distributed as a taxable dividend to ups shareholders (most of whom were employees; ups stock was not publicly traded). ups then purchased an insurance policy, for the benefit of ups customers, from national union fire insurance company. by 2002] watchdogs that failed to bark 889 227. ups, 254 f.3d at 1016-1017. 228. ups v. commissioner, 78 t.c. memo (cch) 262 (1999). 229. ups, 254 f.3d at 1017. this policy, national union assumed the risk of damage to or loss of excess-value shipments. the premiums for the policy were the excess-value charges that ups collected. ups, not national union, was responsible for administering claims brought under the policy. national union in turn entered a reinsurance treaty with opl. under the treaty, opl assumed risk commensurate with national union’s, in exchange for premiums that equal the excess-value payments national union got from ups, less commissions, fees, and excise taxes. under this plan, ups thus continued to collect 25¢ per $100 of excess value from its customers, process and pay claims, and take special measures to safeguard valuable packages. but ups now remitted monthly the excess-value payments, less claims paid, to national union as premiums on the policy. national union then collected its commission, excise taxes, and fees from the charges before sending the rest on to opl as payments under the reinsurance contract. ups reported neither revenue from excess-value charges nor claim expenses on its 1984 return, although it did deduct the fees and commissions that national union charged.227 the commissioner argued that the excess-value payment remitted ultimately to opl was, in reality, gross income to ups. a tax court memorandum opinion228 upheld the commissioner’s contention that the arrangement was a mere sham transaction, lacking in economic substance. the eleventh circuit noted the basis for the tax court’s holding: three core reasons support this result, according to the court: the plan had no defensible business purpose, as the business realities were identical before and after; the premiums paid for the national union policy were well above industry norms; and contemporary memoranda and documents show that ups’s sole motivation was tax avoidance. the revenue from the excessvalue program was thus properly deemed to be income to ups rather than to opl or national union. the court also imposed penalties.229 890 florida tax review [vol.5:10 230. id. 231. id. at 1018-1019. in reversing the tax court, the eleventh circuit responded to the issue of whether the excess-value plan had the kind of economic substance that removes it from “shamhood,” even if the business continued as it had before in the affirmative.230 the eleventh circuit initially addressed the question of whether the excess-value plan, with its offshore bermuda special purpose entity, opl, was a mere sham. focusing on the nature of the business risk and the degree of control over the offshore entity, the court found: the tax court dismissed these obligations because national union, given the reinsurance treaty, was no more than a “front” in what was a transfer of revenue from ups to opl. as we have said, that conclusion ignores the real risk that national union assumed. but even if we overlook the reality of the risk and treat national union as a conduit for transmission of the excess-value payments from ups to opl, there remains the fact that opl is an independently taxable entity that is not under ups’s control. ups really did lose the stream of income it had earlier reaped from excess-value charges. ups genuinely could not apply that money to any use other than paying a premium to national union; the money could not be used for other purposes, such as capital improvement, salaries, dividends, or investment. these circumstances distinguish ups’s case from the paradigmatic sham transfers of income, in which the taxpayer retains the benefits of the income it has ostensibly forgone. here that benefit ended up with opl. there were, therefore, real economic effects from this transaction on all of its parties.231 most enlightening is the court’s treatment of the business purpose – something which touches directly on the prospective tax planning aspects of the transaction: it may be true that there was little change over time in how the excess-value program appeared to customers. but the tax court’s narrow notion of “business purpose” – which is admittedly implied by the phrase’s plain language – stretches the economic-substance doctrine farther than it has been stretched. a “business purpose” does not mean a reason for a 2002] watchdogs that failed to bark 891 232. id. at 1019. 233. id. at 1020. transaction that is free of tax considerations. rather, a transaction has a “business purpose,” when we are talking about a going concern like ups, as long as it figures in a bona fide, profit-seeking business. see acm p’ship v. comm’r, 157 f.3d 231, 251 (3d cir. 1998). this concept of “business purpose” is a necessary corollary to the venerable axiom that tax-planning is permissible. the code treats lots of categories of economically similar behavior differently. for instance, two ways to infuse capital into a corporation, borrowing and sale of equity, have different tax consequences; interest is usually deductible and distributions to equityholders are not. there may be no tax-independent reason for a taxpayer to choose between these different ways of financing the business, but it does not mean that the taxpayer lacks a “business purpose.” to conclude otherwise would prohibit tax-planning.232 the transaction under challenge here simply altered the form of an existing, bona fide business, and this case therefore falls in with those that find an adequate business purpose to neutralize any tax-avoidance motive. true, ups’s restructuring was more sophisticated and complex than the usual tax-influenced formof-business election or a choice of debt over equity financing. but its sophistication does not change the fact that there was a real business that served the genuine need for customers to enjoy loss coverage and for ups to lower its liability exposure.233 e. pro-taxpayer synopsis a review of the recent pro-taxpayer corporate tax shelter cases demonstrates a common thread for the application of the realistic possibility and more likely than not standards. thus, when a prospective corporate tax shelter is proposed, the tax advisor, in order to satisfy the appropriate standard of review, should consider the following jurisprudential criteria: 892 florida tax review [vol.5:10 234. while this criterion was never specifically addressed as a determining factor, it did weave through all of the pro-taxpayer cases and clearly supported the lack of a pure tax avoidance nature. see salina p’ship lp, fpl groud, inc. v. commissioner, 80 t.c. memo (cch) 686, 688 (2000), t.c. memo (ria) ¶ 54122 (2000); boca investerings p’ship v. united states, 167 f.supp.2d 298, 309; (d.c. cir. 2001); compaq computer comp. v. commissioner, 277 f.3d 778, 779 (5th cir. 2001). 235. see ies industries, inc. v. united states, 253 f.3d 350, 352, 355 (8th cir. 2001). 236. see ups, 254 f.3d at 1019-1020. 237. see salina, 80 t.c. memo (cch) at 695; boca, 167 f.supp.2d at 373; compaq, 277 f.3d at 787. 238. see ups, 254 f.3d at 1019-1020. 239. 167 f.supp.2d 298. 240. 157 f.3d 231 (3d cir. 1998). 241. id. at 254-256. • proposal of the tax shelter arrangement should be by a third party, e.g., investment banker,234 insurance broker,235 etc.; • sound economic realities that result in risk transfer or risk reduction;236 • tax and financial leverage employed to facilitate a business purpose and not materially achieved solely to reduce the tax burden;237 and • a business purpose founded on a real, tangible business enterprise engaged in a profit-seeking activity.238 although the preceding criteria are not dispositive in every conceivable case, they do meet the “likelihood of success” of the tax shelter arrangement found in the standards and applied by the tax advisor. it follows, a fortiori, therefore that to disregard these criteria is at the tax advisor’s peril as the progovernment cases attest. 2. pro-government cases taxpayers have been unsuccessful in at least three notorious tax shelter cases of recent years. as with the pro-taxpayer cases, a jurisprudential nexus among these cases can be identified for application of the tax review standards. a. contingent installment sale notes like boca,239 the type of corporate tax shelter used in acm partnership v. commissioner,240 was a contingent installment sale note. however, unlike boca, the arrangement lacked a liability management purpose.241 2002] watchdogs that failed to bark 893 242. id. at 233. 243. id. at 239. 244. id. at 239-240. 245. id. at 240-244. 246. acm p’ship v. commissioner, 73 t.c. memo (cch) 2189, 2215, t.c. memo (ria) ¶ 97, 115 (1997). 247. acm, 157 f.3d at 262. 248. see steven m. surdell, acm partnership – a new test for corporate tax shelters?, 75 tax notes 1377 (june 9, 1997); jennifer d. avitabile, note, corporate tax shelter lacked economic substance: acm partnership v. commissioner, 51 tax law. 385 (1998). 249. compare acm, 157 f.3d 231 with boca investerings p’ship v. united states, 167 f.supp.2d. 298 (d.c. cir. 2001). 250. 117 t.c. 328 (2001). 251. id. at 330. to shelter its $105 million capital gain from the sale of a subsidiary, its investment banker suggested that taxpayer, colgate-palmolive co., form a partnership (acm) with a foreign (netherland antilles) bank.242 colgate would own 17% and the bank 82% with an approximate 1% ownership by the u.s. investment bank.243 the partnership purchased $205 million in corporate notes and three weeks later sold $175 million of the notes on an installment basis under section 453.244 like boca, acm realized its share of the basis loss ($111 million) on the installment note which was used to offset the entire $105 million in capital gain.245 the tax court found that the transaction was a mere sham and that taxpayer was not entitled to recognize a phantom loss wholly devoid of economic substance.246 the third circuit court agreed holding that the tax shelter transaction by a business that would not have occurred, in any form, but for tax avoidance reasons lacked a valid business purpose.247 apparently the distinguishing feature of this shelter, unlike its related cousin in boca, is that the sale transaction was deficient in a corporate liability management purpose and existed solely for tax avoidance goals.248 it was obviously designed for pure tax avoidance motives and not to shift liability risk as in boca.249 b. equipment leasing trusts in nicole rose corp. v. commissioner,250 a unique form of corporate tax shelter was devised largely to shelter an $11 million gain on the sale of taxpayer corporation’s assets.251 unfortunately for taxpayer, this case is a 894 florida tax review [vol.5:10 252. respondent’s expert testified that independent of the production of claimed tax deductions, there was no purpose to, and no substance for, the transfer of petitioner’s leasing trust interests. id. at 338. 253. id. at 335. 254. id. at 329. 255. id. 256. id. 257. atrium partnership was the sub lessor and assignee of an equipment lease from a dutch bank known as abn. it, in turn, was the seller and lessee of equipment from a separate brussels airport company that was financed by abn’s subsidiary, pierson, n.v. the atrium partnership was paid $25 million for the leaseback which it deposited in an equipment leasing trust fund that acted as security for the pierson loan (the latter being the trustee and beneficiary of the trust fund). id. at 332. 258. id. at 334. these latter residual value certificates obligated the dutch bank, abn, to pay the atrium partnership an unspecified amount equal to 200% of the fair market value of the leased equipment in excess of $5 and 2 million due on november 30, 1996 and november 30, 1998, respectively. id. at 333 but at the time of this restructuring in 1993 no appraisal of the equipment’s value was obtained. id. at 335. 259. id. at 335. blueprint for tax avoidance verging on tax evasion.252 it is also instructive to review this case and be amazed at how the complicated tax-oriented maneuvers ever approached a realistic possibility standard. in an effort to generate $22 million in ordinary business expense deductions (to offset a related $11 million gain) and to produce additional tax refunds of $1.8 million through the use of a claimed $9 million net operating loss carryback,253 taxpayer corporation’s controlling shareholder (wolf) devised the following tax-oriented arrangements. attorney wolf was the controlling shareholder in an equipment leasing firm, ipg.254 to facilitate the sale of assets of an unrelated corporation, ipg formed a (shell) corporate entity which purchased the stock of quintron corporation, which had pre-acquisition taxable income.255 it then merged the acquiring corporation and quintron, with the latter as the surviving entity.256 this surviving entity became petitioner-taxpayer corporation and it purchased the assets of loral corporation triggering an $11 million gain. to offset this gain and transform the preacquisition taxable income into tax refunds using net operating loss carrybacks, wolf had a uk partnership, known as atrium,257 transfer to petitioner a $400,000 equipment trust fund obligation, equipment leases and residual value certificates (rvcs).258 petitioner then simultaneously transferred these same items, except for the residual trust certificates, to another dutch bank, wildervank.259 2002] watchdogs that failed to bark 895 260. id. 261. id. on its fiscal year end tax return of january 1, 1994, petitioner-taxpayer claimed the following: • taxable income of $11 million from the sale of assets to loral corporation; • section 162 ordinary business deductions of $400,000 for the transfer to wildervank of the leasing obligation of future rent payments and $22 million for the transfer to wildervank representing the equipment leasebacks and trust fund; • capital loss of $2.1 million on a transfer to wildervank from ten shares of an unrelated corporation; and • net operating loss of $8.9 million.260 the commissioner denied all the section 162 deductions and the $8.9 million net operating loss, but allowed the capital loss.261 since the net operating loss was a result of the excess section 162 deductions, their transactional basis was the issue. petitioner contended, and respondent refuted, inter alia, that it is entitled to the $22 million claimed ordinary business expense deductions relating to its transfer to wildervank of its interest in the trust fund and the $400,000 in cash. petitioner’s apparent theory of deductibility is that the value of petitioner’s interest in the trust fund was equal to the $21.8 million balance in the trust fund and therefore that when petitioner transferred to wildervank its interest in the trust fund, plus the $400,000 in cash, the transfer should be treated as a “payment” by petitioner to wildervank of $22 million in exchange for the cancellation of petitioner’s obligation on an onerous lease. petitioner claims that the rvc it received and retained had significant value, that petitioner had the opportunity to realize significant profit from the rvc, and that this profit potential explains and supports petitioner’s participation in a legitimate for-profit transaction. respondent claims that the transfer to wildervank of petitioner’s interests in the brussels leaseback, in the trust fund, and in the $400,000 in cash, in exchange for wildervank’s assumption of petitioner’s obligations relating to the brussels 896 florida tax review [vol.5:10 262. id. at 337. 263. id. at 338. 264. see regs. § 1.6662-3(b)(3). leaseback and the trust fund lacked business purpose and economic substance and should be disregarded. we agree with respondent.262 in finding no economic substance and a lack of business purpose, the tax court noted: the record establishes that no credible business purpose and that no viable economic substance existed for the transfer to wildervank of petitioner’s interests in the brussels leaseback, in the trust fund, and in the $400,000 in cash. the complicated nature of these transactions fails to mask the lack of business purpose and economic substance in key aspects of the transactions and the tax avoidance objectives thereof. in september of 1993, when it participated in these transactions, petitioner never had any genuine obligation with respect to the brussels leaseback and the trust fund. even petitioner’s payment of the $400,000 in cash we regard as not supported by a valid business purpose and economic substance. that payment is tainted by petitioner’s sole tax motivation for participating in these transactions. petitioner’s only purpose for transferring to wildervank its interests in the brussels leaseback and in the trust fund was to create the claimed tax deductions. as respondent’s expert testified at trial, independent of the production of claimed tax deductions, there was no purpose to, and no substance for, the transfer to wildervank of petitioner’s interests in the brussels leaseback and in the trust fund.263 finally, it is quite clear from the tax court’s holding that participation of professional tax advisors in constructing such an obtuse, overly complicated, attempt at tax avoidance will result in the section 6662(a) accuracy related penalty since the reasonable basis standard of regulations section 1.6662-3(b)(3) is violated.264 the evidence is clear that petitioner had no valid business purpose for the transfer to wildervank of its interests in the 2002] watchdogs that failed to bark 897 265. nicole rose, 117 t.c. at 340-341. 266. 254 f.3d 1313 (11th cir. 2001), cert. denied 122 s. ct. 1537 (2002). trust fund and in the brussels leaseback and for the transfer to wildervank of the $400,000 in cash. other than claimed tax benefits, petitioner received nothing of value. the transactions lacked business purpose and economic substance, and the transactions are to be disregarded for federal income tax purposes. section 6662 imposes a penalty of 20% on underpayments of tax attributable to negligence or to disregard of rules or the regulations. for purposes of section 6662(a), negligence constitutes a failure to make a reasonable attempt to comply with the internal revenue code. sec. 6662(c). the accuracy-related penalty under section 6662(a) will not apply to any part of petitioner’s underpayments of tax if, with regard to that part of the underpayments, petitioner establishes reasonable cause and if petitioner acted in good faith. sec. 6664(c). the participation of highly paid professionals provides petitioner no protection, excuse, justification, or immunity from the penalties in issue. petitioner participated in a clear and obvious scheme to reap the benefits of claimed ordinary business expense deductions that had no business purpose and no economic substance. the facts and circumstances of this case reflect no reasonable cause and no good faith for petitioner’s participation in the transactions before us. petitioner is liable for the accuracy-related penalties under section 6662(a).265 this case illustrates how far a taxpayer will “push the envelope” to obtain illicit tax deductions by constructing obtuse tax shelter arrangements. more importantly, it highlights how a clear failure of such an arrangement violates the realistic possibility standard, i.e., the one in three likelihood of success. c. corporate owned life insurance yet another dismal attempt at generating tax deductions to offset taxable income is the case of winn-dixie stores, inc. v. commissioner.266 where a 898 florida tax review [vol.5:10 267. the term janitors insurance as a substitute for coli means that the employer takes out life insurance on its workers with itself as beneficiary and typically remains in force even when workers quit, retire or get fired. see, e.g., ellen e. schultz & theo francis, why are workers in dark? wall st. j., april 24, 2002, at c1. 268. winn-dixie, 254 f.3d at 1315. 269. id. at 1314-1315. 270. see 113 t.c. 254 (1999). 271. the life insurance contracts used in coli tax arbitrage shelters are known as whole life contracts, i.e., a form of life insurance coverage whereby premiums pay for term (pure life insurance) protection in the early years, with the balance paid into cash reserves (against which the owner can borrow) that rises in value over the life of the contract. in contrast, group term life insurance contracts cover a particular number of years with no cash surrender value and would be inappropriate for a coli program. see richard a. westin, wg&l tax dictionary at 789, 845 (warner, gorham & lamont 2000). burgeoning type of tax shelter known as company or corporate owned life insurance (coli) or “janitor’s insurance”267 was employed.268 this coli shelter was summarized by the eleventh circuit court as follows: in 1993, winn-dixie embarked on a broad-based companyowned life-insurance (coli) program whose sole purpose, as shown by contemporary memoranda, was to satisfy winndixie’s “appetite” for interest deductions. under the program, winn-dixie purchased whole life insurance policies on almost all of its full-time employees, who numbered in the tens of thousands. winn-dixie was the sole beneficiary of the policies. winn-dixie would borrow against those policies’ account value at an interest rate of over 11%. the high interest and the administrative fees that came with the program outweighed the net cash surrender value and benefits paid on the policies, with the result that in pre-tax terms winn-dixie lost money on the program. the deductibility of the interest and fees post-tax, however, yielded a benefit projected to reach into the billions of dollars over 60 years.269 the commissioner determined a deficiency attributable to taxpayer’s 1993 interest and fee deductions. the tax court rejected petitioner’s contention that the coli shelter had a valid business purpose.270 it found that these were mere sham loans and that any deductions were expressly disallowed. on appeal, petitioner argued that congress expressly authorized the deduction of interest and fees on borrowings against whole life271 insurance 2002] watchdogs that failed to bark 899 272. generally the benefits afforded life insurance contracts (defined at irc § 7702) are untaxed and the appreciation is tax deferred pursuant to irc §§ 101(a)(1),72(e), respectively. similarly, interest on policy loans is generally nondeductible under irc § 163(a) unless the exception of irc § 64(c)(1) is operative. 273. this is the 4-of-7 year exception set forth at irc § 264(c)(1). 274. winn-dixie, 254 f.3d at 1315. 275. id. 276. 364 u. s. 361, (1960). 277. in knetsch the contract was another form of insurance product known as an annuity contract which is materially similar to the coli product hereunder. id.at 362-363. 278. id. at 366. 279. id. at 367. policies’ cash value pursuant to code section 264(c)(1).272 therein, the deductibility of interest and fees on policy loans is allowable provided no part of the annual premium is financed by a policy loan in four of the first seven years.273 all of petitioner’s policy loans qualified for this exception.274 alternatively, petitioner contended that the tax court misinterpreted the economic substance and business purpose doctrines.275 in rejecting petitioner’s points, the eleventh circuit court relied on the u. s. supreme court case of knetsch v. united states.276 it applied the rule that where the contract277 is used as a tax shelter with no financial benefit other than its tax consequences any indebtedness was not bona fide and such interest therefrom nondeductible under section 163(a).278 knetsch can apply, therefore, to the deduction of interest under a sham transaction doctrine notwithstanding the application of the section 264 exception.279 in affirming the tax court, the eleventh circuit court noted the utter lack of any business purpose or economic substance – other than the production of tax benefits: the tax court found, without challenge here, that the program could never generate a pretax profit. that was what winn-dixie thought as it set up the program, and it is the most plausible explanation for winn-dixie’s withdrawal after the 1996 changes to the tax law threatened the tax benefits winn-dixie was receiving. no finding of the tax court suggests, furthermore, that the broad-based coli program answered any business need of winn-dixie, such as identifying it for loss of key employees. nor could it have been conceived as an employee benefit, because winn-dixie was the beneficiary of the policies. under kirchman, therefore, the broad-based coli program lacked sufficient economic substance to be respected 900 florida tax review [vol.5:10 280. winn-dixie, 254 f.3d at 1316-1317. 281. for interest paid or accrued after october 13, 1995, under coli policy loan plans, the interest deduction was repealed when the plan covered officers, employees, or financially interested individuals. however, there is a stated exception for debt on key person contracts up to a $50,000 debt cap. see 1996 tax legislation: law and explanation at para. 258 (commerce clearing house 1996). 282. see, e.g., winn-dixie, 254 f.3d at 1314-1315. 283. in winn-dixie the written memorandum, obtained upon discovery, belied any economic effects of the coli plan. id. 284. this was the fatal error in the colgate-palmolive co. shelter amid the contingent installment sale transaction. acm p’ship v. commissioner, 157 f.3d 231 (3d cir. 1998). 285. tax planning that is so patently complex fails to mark the lack of business purpose and economic substance. nicole rose corp. v. commissioner, 117 t.c. 328 (2001). 286. id. for tax purposes, and the tax court did not err in so concluding.280 while coli shelters are still used in various firms despite the 1996 tax law changes,281 it is an unchallenged fact that the realistic possibility standard of tax review would be voided for such shelters unless they are restructured. in this regard, winn-dixie is informative. thus, a coli shelter does exhibit economic substance and a business purpose where, for instance, the employer corporation uses the proceeds to fund employee fringe benefit plans.282 d. pro-government synopsis a review of the recent pro-government corporate tax shelter cases demonstrates a common thread for the application of the realistic possibility and more likely than not standards. thus, to run the gauntlet of irs scrutiny, the tax advisor should recognize the following traps in tax shelter review: • documentation underlying the transaction fails to recognize the economic effects and focuses solely on tax avoidance;283 • develop no profit-making incentive in the tax shelter;284 • ignore the law of parsimony in the tax shelter arrangement thereby emphasizing a transaction’s complexity;285 and • use as many offshore special purpose entities as possible ignoring their economic role in the transaction.286 2002] watchdogs that failed to bark 901 287. for a discussion of how the world community views the fairness and application of u. s. exclusion corporations under the new tax regime for foreign sales, see harold s. peckron, uniform rules of engagement: the new tax regime for foreign sales, 25 hastings int’l & comp. l. rev. 1 (2001). 288. see adam smith, an inquiry into the nature and causes of the wealth of nations 887-890. 289. id. once again, the preceding items do not guarantee an audit or failure to meet the requisite tax standard of review. nevertheless, one or more of them indicates that the tax shelter arrangement has a proclivity aimed at more tax avoidance (and in egregious cases tax evasion) than economic substance. but surely there must exist public policy and moral considerations that an ethical tax advisor should recognize in applying the relevant tax standard of review in addition to these jurisprudential guidelines. iv. public policy and moral considerations affecting standards review a tax advisor, in addition to legislative, regulatory, and judicial interpretations of tax review standards, needs to be aware of the public policy treatment of proposed legislation that will impact such standards. moreover, it would be myopic of the tax advisor to operate in an amoral environment in assessing a client’s proposed tax transaction; even when a review standard admits the efficacy of the transaction it may not be a moral choice. hence, both public policy and ethical dilemmas impinge upon tax review standards. good tax review standards should meet stated criteria that are universally accepted. while each nation or jurisdiction may have its own conception of a legitimate tax standard,287 it is noteworthy to identify the guiding principles of sound tax policy. similarly, in those multitudinous gray areas in tax transaction review where the 33% or more than 50% standards are difficult to assess, the tax advisor should be cognizant of his or her overriding moral or ethical call. like a clarion gently whispering in the wind of transaction complexity, the advisor should recognize when moral or ethical norms are in jeopardy. to these ends, therefore, the following concerns will impact the “black letter” standards of tax review. 1. public policy dimensions – it was adam smith in 1776 who first set forth the requisite of sound tax policy in the public environment.288 according to smith, a good tax should be equitable in form and substance, including its application, administratively convenient, and economical in collection.289 unfortunately in the 21st century smith’s pure standards have been adulterated 902 florida tax review [vol.5:10 290. see, e.g., sheldon d. pollack, the failure of u.s. tax policy: revenue and politics, 73 tax notes 341 (oct. 21, 1996). 291. aicpa, tax policy concept statement at 9 (aicpa, inc. new york, 2001). this principle addresses the concept of horizontal and vertical equity. horizontal equity is where taxpayers in similar circumstances are taxed in similar ways. vertical equity, on the other hand, is where taxpayers in different circumstances are taxed differently, e.g., higher income taxpayers would pay a higher tax based upon vertical equity. see j. s. newman, federal income taxation: cases, problems and materials 24-25 (1998). 292. aicpa, tax policy concept statement at 10 (aicpa inc., new york 2001). 293. id. 294. id. 295. id. 296. id. 297. id. 298. id. with political expediency.290 while congressional and special interests espouse mandates, however oblique, there are some guiding principles that establish sound tax policy. these “macro” public policy guidelines lay the groundwork for the “micro” tax review standards. thus, the tax advisor should have these macro guidelines ever in mind by recognizing his or her duty to participate in the tax policy debate. these tax principles are: • equity and fairness. similarly situated taxpayers should be taxed similarly.291 • certainty. the tax rules should clearly specify when the tax is to be paid, how it is to be paid, and how the amount to be paid is to be determined.292 • convenience of payment. a tax should be due at a time or in a manner that is most likely to be convenient for the taxpayer.293 • economy in collection. the costs to collect a tax should be kept to a minimum for both the government and taxpayers.294 • simplicity. the tax law should be simple so that taxpayers understand the rules and can comply with them correctly and in a cost efficient manner.295 • neutrality. the effect of the tax law on a taxpayer’s decisions as to how to carry out a particular transaction or whether to engage in a transaction should be kept to a minimum.296 • economic growth and efficiency. the tax system should not impede or reduce the productive capacity of the economy.297 • transparency and visibility. taxpayers should know that a tax exists and how and when it is imposed upon them and others.298 2002] watchdogs that failed to bark 903 299. id. 300. id. 301. notice 2001-51, 2001-34 i.r.b. 190, supra note 57. see also notice 2002-25, 2002-21 i.r.b. 992. 302. supra note 283 and accompanying text. 303. victor hugo, les miserables (charles e. wilborn trans., modern library 1992). 304. see frank magill, masterpieces of world literature 537 (harper collins 1989). 305. id. 306. hugo, supra note 303, at 1147. • minimum tax gap. a tax should be structured to minimize noncompliance.299 • appropriate government revenues. the tax system should enable the government to determine how much tax revenue will likely be collected and when.300 with these public policy principles in mind, and the recognition that not all ten can be achieved in any given tax proposal, the challenge to the tax advisor is to voice criticism of such proposals that will affect the micro tax planning review standards. for instance, the mandatory reporting of sixteen different tax shelter transactions301 supports the equity and minimum tax gap principles but militates against the economic growth and efficiency principle because disclosure invites irs audits and taxpayers will be disinclined to invite such scrutiny. as a tax advisor under the more likely than not tax shelter opinion standard, this disclosure edict raises the bar on certain shelters by either reinventing the shelter (as was the case with coli shelters after the 1996 tax law changes)302 or recommending their nonuse. public policy dimensions of tax proposals will continue unabated. their impact on existing tax review standards, e.g., the realistic possibility standard, can never be underestimated. it is the tax advisor’s duty to the client in evaluating a tax transaction that micro tax proposals be viewed in this larger context. 2. moral considerations inspector javert, the incorruptible policeman in hugo’s les miserables,303 endorsed a mindless, insane tenacity in his belief in moral duty.304 and it is not so much his morality as it was that of society’s of the time – an unquenchable thirst for dogmatic, kantian,black letter law.305 in the end, javert could no longer reconcile his intractable moral duty against the protagonist’s sense of justice so he succumbed to a self-inflicted death.306 904 florida tax review [vol.5:10 307. enron: a simple question of right and wrong, supra note 4. 308. id. see also martin luther king, jr., “letter from birmingham jail” in why we can’t wait 85 (harper & row 1963). this classic of literature has much to say about the current moral climate in business, where law is sometimes exalted over ethics, as in the enron case: just look at what enron, often with the blessing of andersen, managed to accomplish, apparently within the comfortable confines of today’s laws: • for nearly five years, enron inflated earnings by a total of almost $600 million. this “legal” practice forced investors to make decisions about the value of enron’s stock using bogus profit figures. • using off-the-books partnerships and maddeningly opaque accounting, with andersen’s approval, enron shielded about $500 million in debt. that helped keep enron’s credit rating high, but at the expense of misleading anyone foolish enough to trust the numbers coming from the company and the private credit-ratings agencies. to be sure, at least one high-level enron official tried to do the right thing. but since everything looked legal on paper, those asking pointed questions were ignored. even if the nation’s laws weren’t so permissive, enron very well may have met the same end. in a free-market economy, no business is guaranteed a successful future. had everyone involved used an ethical compass rather than a strictly legal one, investors would have been armed with accurate information about enron’s business and the risks it entailed when deciding whether or not to buy its stock.307 metaphorically, in the room of life, law is the floor and ethics is the ceiling. to do what is “legally correct” may be terribly deficient of any moral base. so how do moral considerations impact tax advisors in the application of legal tax review standards of proposed transactions? in several ways. first, an action can be illegal but morally right.308 for example, the assistance to jewish families to escape certain death at the hands of the nazis or 2002] watchdogs that failed to bark 905 309. king, supra note 308, at 8. 310. king, supra note 308, at 9. 311. report, supra note 10, at 178. 312. king, supra note 308, at 161. 313. king, supra note 308, at 162. while arthur andersen may or may not be criminally liable for its employee actions of shredding thousands of documents, under this moral responsibility theory, it is morally accountable as a firm for this immoral act. 314. king, supra note 308, at 295. the nonviolent protests of the 1960s in the south against segregation309 were moral actions albeit illegal. second, an action can be legal, but morally wrong.310 for instance, this was the enron case in its advisor approved legal use of special purpose entities. in the report, committee noted: overall, enron failed to disclose facts that were important for an understanding of the substance of the transactions. the company did disclose that there were large transactions with entities in which the cfo had an interest. enron did not, however, set forth the cfo’s actual or likely economic benefits from these transactions and, most importantly, never clearly disclosed the purposes behind these transactions or the complete financial statement effects of these complex arrangements. the disclosures also asserted without adequate foundation, in effect, that the arrangements were comparable to arm’s-length transactions. we believe that the responsibility for these inadequate disclosures is shared by enron management, the audit and compliance committee of the board, enron’s inhouse counsel, vinson & elkins, and andersen.311 third, persons must be morally responsible for their past actions. this means that an advisor should have the competency to make moral or rational decisions on one’s own.312 once again, this requires that even corporations, like enron, or partnerships like arthur andersen, can make rational and moral decisions on their own – if they are treated as moral agents – then such entities can demonstrate moral responsibilities to others, e.g. shareholders and employees.313 last, the question of self-interest is crucial to any moral decision. or, when does self-interest trump moral duty? in ethics this is known as prudential versus moral reason.314 every lawyer or accountant, at one time or another in their career, has had to consider prudential reasons (considerations of self906 florida tax review [vol.5:10 315. king, supra note 308, at 295. 316. king, supra note 308, at 294. 317. king, supra note 308, at 294. 318. the report noted that arthur andersen was paid $5.7 million for its assistance in designing controversial special purpose entities, viz., partnerships. report, supra note 10, at 5. 319. anita raghavan, accountable: how a bright star at andersen fell along with enron, wall st. j., may 15, 2002, at a1. interest) versus moral reasons (considerations of the interests of others) in making a decision.315 as a general rule, if prudential concerns outweigh moral ones, then the decision maker may do what is in their own best interest.316 on the other hand, if moral reasons override prudential ones, then the decision maker should honor their obligations to others.317 consider the case of enron once again. its payment of accounting and legal fees for advice was substantial.318 what type of pressure did the managing client partner of the accounting firm, david duncan, experience in “going along” with suspect tax shelter transactions and special purpose entity creations?319 the following is illuminating: in 1999 enron chief financial officer andrew fastow approached mr. duncan about a “special purpose vehicle” the cfo wanted to set up. it turned out to be ljm, a partnership that, it was revealed last fall, had brought mr. fastow millions of dollars in compensation and helped enron hide millions in debt off its balance sheet. mr. duncan consulted andersen’s professional standards group, the firm’s source of advice on tricky accounting issues. it balked. “setting aside the accounting, idea of a venture entity managed by cfo is terrible from a business point of view,” wrote benjamin neuhausen, a member of the standards group, in an email to mr. duncan on may 28, 1999. “conflicts of interests galore. why would any director in his or her right mind ever approve such a scheme?” he wrote. mr. neuhausen also told mr. duncan the standards group would be “very uncomfortable” with enron’s recording gains on sales of assets to the fastow-controlled entity or immediate gains on any transactions. 2002] watchdogs that failed to bark 907 320. id. 321. id. king, supra note 308, at 297. 322. id. king, supra note 308, at 297. 323. see, e.g., w. steve albrecht, ethical issues in the practice of accounting, xi (1992). 324. geisel, supra note 1. “i’m not saying i’m in love with this either,” mr. duncan replied in a june 1 email, referring to the recording of gains. “but i’ll need all the ammo i can get to take that issue on.” mr. duncan told the standards group member that “on your point 1, (i.e. the whole thing is a bad idea), i really couldn’t agree more.” but he made clear the issue was by no means dead. he said he had told mr. fastow that andersen would sign off on the transaction only if mr. fastow got chief executive and board approval at enron, among other things. enron ultimately approved setting up the partnership, with mr. fastow in charge. andersen’s total fees from enron for auditing, business consulting and tax work were $46.8 million that fiscal year ending august 31, 1999. the next year the fees leapt to $58 million. they were between $50 million and $55 million in fiscal 2001.320 this final ethical venue demands a balancing act. it is, in essence, a kind of character or personality audit, in that the decision maker must strive for a balance between prudential and moral interests.321 indeed, the very welfare of society is at issue.322 numerous cases, some blatant attempts at pure self-interest, litter the landscape of professional advice323 and pose a challenge for any tax advisor rendering advice to continue to keep these balancing concerns uppermost in his or her mind. armed with these legislative, regulatory, judicial, public policy and moral considerations, the post-enron impact on tax review and disclosure standards has begun to emerge. yet, it is “a place where the streets are not marked, some windows are lighted but mostly they’re darked.”324 908 florida tax review [vol.5:10 325. temp. regs. § 1.3011-4t(a). 326. sec chairman harvey l. pitt has recommended on january 17, 2002 a proposal for a new regulatory body to supervise the accounting industry. see <http://www.see.gov/news/speech/spch 535.htm> (last visited may 17, 2002). v. post-enron standards of tax review in light of the enron debacle, existing standards of tax review will be augmented by stronger disclosure325 and regulatory326 rules. all tax advisors, those who render legal opinions and those who furnish accounting information on proposed tax shelter transactions, will be subject to these new enhancements. a. enhanced regulatory review a harbinger of the nature of these enhancements, as suggested by the chairman of the securities and exchange commission, translates into greater regulation and supervision by existing and proposed government bodies. our disclosure and financial reporting system is still the best in the world, but it has long needed improvement. its inadequacies are more visible after enron’s failure, and the need for change cannot be ignored any longer. this is not a problem that arose overnight. investors here and abroad are entitled to rely upon our system as the finest in the world. we intend to fulfill that responsibility. we initially envision a new body dominated by public members, with two primary components – discipline and quality control. let me speak to those two elements: 1. discipline a. the system should be subject to a new body that is dominated by public membership. b. the sec should decide whether conduct should be pursued as violations of law (in which case the sec would handle it), or pursued as violations of ethical and/or competence standards (in which case they would be handled by the private sector regulatory body). c. the body should be empowered to perform investigations, bring disciplinary proceedings, publicize results, restrict individuals and firms from auditing public companies. 2002] watchdogs that failed to bark 909 327. id. 328. see 66 fr 3276 2001 wl 27422 (proposed jan. 12, 2001). 329. id. at 3294. 330. id at 3291-3295. 331. 31 c.f.r. § 10.33(a)(3) (2002). 332. id. 333. 31 c.f.r. § 10.33(a)(5)(iii). 334. 66 fed. reg. 3276, 3292 (proposed jan. 12, 2001). d. the disciplinary proceedings should proceed expeditiously. e. disciplinary actions should be subject to sec oversight. 2. quality control a. there should be a reform of the current peer review process that avoids firm-on-firm review. b. the new process should replace the current triennial firm-onfirm peer review with more frequent monitoring of audit quality and competence designed to produce better audits in the future. c. the staff should be deployed and overseen by the new publicly dominated body and its staff.327 b. enhanced due diligence while it was the lawyer’s responsibility to evaluate enron’s disclosures in reference to their compliance with the law, such review required due diligence as proposed by existing tax standards. under the new circular 230 standard of review328 every item in the tax shelter opinion must be addressed within the highest standard of review, i.e., a greater than 50% likelihood of the opinion being upheld.329 client inaccuracies will no longer be the sole responsibility of the client but shared with the tax lawyer who fails in his or her stricter standard of due diligence.330 tax shelter opinions rendered in the post-enron time must address all material federal tax issues.331 what is considered a “material” federal tax issue for circular 230 purposes? it would be any statutory, regulatory, or judicial doctrine that could impinge upon the tax shelter.332 thus, a careful review of recent (and perhaps not-so-recent) tax shelter cases is advisable. and legal conclusions can no longer be latent but must be prominently displayed on the initial page of the opinion.333 to the extent that tax lawyers rely upon another professional’s estimates of financial performance, they bear the burden to demonstrate that their reliance is based upon a reasonable belief.334 910 florida tax review [vol.5:10 335. see n. 129 supra. 336. this composite paradigm is based upon an actual series of articles dealing with major banks in the united states presently using bank owned life insurance (boli) or janitors insurance. see ellen e. schultz & theo francis, where to put dead peasants, wall st. j., april 19, 2002; theo francis & ellen e. schultz, why secret insurance on employees pays off, wall st. j., april 25, 2002; theo francis & ellen e. schultz, many banks boost earnings with janitors’ life insurance, wall st. j., april 26, 2002; theo francis & ellen e. schultz, big banks quietly pile up janitors’ insurance, wall st. j., may 2, 2002; ellen e. schultz & theo francis, the economy: senator to target tax boon to firms insuring workers, wall st. j., may 3, 2002. c. enhanced policy and ethical view furthermore, it is clear that all tax advisors should be held to public policy and ethical norms, as discussed in the preceding section of this article. the pre-enron legal threshold requirement will be, in all likelihood, woefully deficient in the post-enron world. for example, assuming arguendo that some of the enron special purpose entities that shifted debt off the balance sheet met the realistic possibility standard, still their ethical impact on third parties (e.g. shareholders, creditors, etc.) should have been considered. this does present the tax advisor with a unique set of random variables in the post-enron milieu. if a proposed tax shelter “fits” within the new circular 230 review, then should other variables be considered? for instance, is it ethically necessary to now consider the impact of the debt-shifting special purpose entity shelter on the publicly traded company’s stock price? and, if so, is that ethical obligation sated through the treasury’s recent sixteen disclosure “listed transactions”335 regulation? perhaps the days of the “black letter” code lawyer will meet the same fate as the green eyeshade accountant – dinosaurs that have become extinct through dramatic changes in their environment. the challenges in the post-enron world require the tax advisor to incorporate in his or her tax review standard new regulatory bodies, higher tax review and shelter disclosure standards and greater sensitivity to public policy and ethical dimensions, as the following paradigm demonstrates. d. paradigm: janitors insurance tax shelter336 1. factual background – first financial corporation (ffc), a publicly traded bank holding company, proposes a bank owned life insurance or boli program, modeled after the highly successful corporate owned life insurance program or coli. 2002] watchdogs that failed to bark 911 337. reg. § 1.6662-4(d)(1), (2). 338. id. 339. see supra note 129. 340. see, e.g., boca investerings p’ship v. united states, 167 f.supp.2d 298 (d.c. cir. 2001). 341. see supra note 281. 342. see supra note 272. the reason it seeks to establish the boli for its rank-and-file employees is two-fold. first, to receive significant tax free amounts. second is to increase its earnings using a newly developed smoothing technique. as ffc’s chief financial officer explains it, the build-up of cash value in the policies is tax free and the eventual payment of the death benefit to ffc, as sole beneficiary, is also tax free. also, with an earnings smoothing technique the boli will always reflect positive earnings on the income statement. projections from boli are expected to be 15% of ffc’s net income. no sec, comptroller of the currency, or other accounting rule require any disclosure, including no disclosure to the rank-and-file upon whose lives the boli is written. death benefits are to be used to fund some employee benefits programs but the lion’s share will be used for ffc’s capital acquisition program. moreover, ffc desires to write the life insurance policies on permanent, temporary, retired, and terminated employees. the chief financial officer asks what tax problems may arise in this area and whether, as the bank’s outside legal tax advisor, you can recommend this shelter. 2. tax advisor’s review – the initial concern is identification of the correct tax review standard. since this is an unambiguous example of a tax shelter and because it will be scrutinized by the irs, the more likely than not standard337 or greater than 50% likelihood of taxpayer’s position being upheld is appropriate.338 a review of the sixteen “listed transactions” in the regulations that mandate a disclosure standard indicate that disclosure of this particular shelter may not be required.339 judicial authorities are manifest in disallowing this shelter if it lacks economic substance or a valid business purpose.340 since no tax deductions are occurring to ffc’s benefit, expressly disallowed since the 1996 tax amendments,341 the tax free investment build-up and death benefit exclusions are allowable.342 however, while the technical code and regulations standards of tax review appear to allow this tax shelter arrangement, public policy and ethics may demand a further analysis before it is green-lighted. there is a definite ground swell of anti-coli/boli sentiment growing in congress, with several senators introducing bills to prevent all companies from obtaining janitors insurance 912 florida tax review [vol.5:10 343. see ellen e. schultz & theo francis, senator to target tax boom to firms insuring workers (may 3, 2002). 344. id. see also winn-dixie stores inc. v. commissioner,254 f.3d 1313 (11th cir. 2001). 345. raghavan, supra note 319. 346. see, e.g., compaq computer corp. v. commissioner, 277 f.3d 778 (5th cir. 2001). 347. south trust corp. with $935 million in boli assets and washington mutual inc. with $1.5 billion in boli assets both disclosed and obtained employee consents. see ellen e. schultz & theo francis, many banks boost earnings with janitors’ life insurance, wall st. j. april 26, 2002. simply to glean tax-free income.343 the irs, of course, has been fighting coli of all sorts since their virtual inception.344 so it appears that public policy may treat the boli shelter as a mere sham. whether the congressional bill becomes law and, if so, whether it will have retroactive effect (a rare occurrence in tax law for obvious reasons) needs to be carefully weighed. assuming arguendo that the present value of the tax benefits outweigh the tax cost attendant to public policy, there is still the moral question. what is disturbing in the majority of coli or boli cases is that employees (some of which are neither permanent nor current) are treated as means to an end, i.e., manipulated without their consent or, for that matter, their knowledge. this unethical result of the boli shelter places prudential reasoning (ffc’s selfinterest) above that of moral reasoning (employee’s interest).345 armed with this tax review standard and all its enhancements, what should the advisor recommend? 3. advisor’s recommendation – it is clear that the client, ffc, has legitimate business reasons for establishing the boli and the fact that favorable tax consequences result is not determinative of its ultimate success under the more likely than not standard.346 but since this tax shelter review is a la postenron, the enhancements must be considered. first, if a new public regulatory body reaches fruition will nondisclosure become mandated? second, what is the degree of confidence that the advisor vests in the client’s estimates, i.e., is it sufficient for enhanced due diligence? last, and most disturbing to the review, what of the public policy initiatives in congress and the irs alongside the ethical failure of the proposal? alas, unless the tax shelter proposal can be restructured it seems that the advisor should recommend against it. how to restructure? serious consideration should be given to disclosure. not only in footnote disclosure on the financial statements but, a fortiori, to the rank-and-file employees. indeed, it should be pointed out that ethical companies not only disclose but also obtain the employees’ consent.347 2002] watchdogs that failed to bark 913 348. francis bacon, the new organon 48 (fulton h. anderson ed., 1960). 349. see report, supra note 10. 350. see report, supra note 10, at appendix a. 351. see n.n. 22-27 supra. 352. id. 353. united states v. arthur andersen, llp, indictment. 354. aba opinion 85-352 and mrpc, supra note 54. 355. see circular 230, supra note 56. 356. temp. regs. § 1.6011-4t (2000); notice 2001-51, 2001-34 i.r.b. 190. 357. regs. §§ 6651, 6654, 6662, 6663, 6672, 6674, 6682, 6694, 6695, 6701, 6702. 358. see regs. §§ 1.6662-3(b)(3), 1.6662-4(1),(2); see also srtp, supra note 55. the recommendation should go further by requiring that the death benefits be used principally for funding employee benefit plans. this aids in both a stronger tax motive of economic substance and moral motive. with these modifications a “revised” boli tax shelter plan could be recommended – one that addresses the technical code and regulation tax shelter review standard and its enhancements. had such an approach been employed by the accounting and legal advisors to enron it is unlikely that the result would have been the same. vi. conclusion “[h]uman understanding is like a false mirror, which, receiving rays irregularly, distorts and discolors the nature of things by mingling its own nature with it, i.e., perceptions cloud reality.”348 it was the perceptions of greed that largely resulted in the demise of enron and its tax advisors. this article attempted to make sense of this tangled web of perceptions by tracing the enron imbroglio as seen through the eyes of the special investigative committee of the enron board of directors.349 as if the creation of special purpose entities350 which acted as tax shelters351 and off-balance sheet financing vehicles352 was not sufficient, enron’s accounting firm allegedly shred thousands of documents, some of which were pertinent to a pending sec investigation.353 it is this dramatic series of events that triggers the question of what impact such events will have on tax review standards. a summary of pre-enron standards of tax review discloses that various sources of standards exist: aba opinion 85-352 and mrpc,354 srtp and cpc circular 230,355 treasury regulations,356 and the internal revenue code.357 emerging from these sources are four discrete standards.358 the standards of tax 914 florida tax review [vol.5:10 359. regs. § 1.6662-3(b)(3). 360. regs. § 1.6662-4(d)(1),(2). 361. srtp, supra note 55. 362. regs. § 1.6662-4(d)(2). 363. circular 230, supra note 56, at § 10.34(d)(1). 364. 66 fed. reg. 3276, 3295 (proposed jan. 12, 2001). 365. see n. 353 supra. 366. generally supra n.n. 151-158. 367. see, e.g., ies industries, inc. v. united states, 253 f.3d 350 (8th cir. 2001). 368. see, e.g. acm p’ship v. commissioner, 157 f.3d 231, 253-255 (3d cir. 1998). 369. see, e.g., boca investerings p’ship v. united states, 167 f.supp.2d 298 (d.c. cir. 2001). review can be viewed along a continuum from the least stringent (reasonable basis)359 to the most strict (more likely than not).360 it is, however, two of these tax standards that demand greater recognition. those are the realistic possibility361 and the more likely than not362 standards. to place these in perspective, the former deals with tax review of proposed tax transactions where the tax advisor reasonably concludes that the tax position has approximately a 33% or greater likelihood of being sustained.363 on the other hand, the more likely than not standard applies primarily to tax shelter transactions and requires that the proposed tax shelter opinion rendered by the tax advisor has a greater than a 50% likelihood of the opinion being upheld.364 as to the latter standard, it is corporate tax shelters, as some of the enron special purpose entities were described by its special investigative committee of the board,365 whereby the irs has issued specific mandatory disclosure standards assuming that such tax shelter transactions fall within 16 “listed transactions.” thus, tax shelters have achieved a unique status in the tax review standards arena – mandated disclosure in many cases and stricter substantive review overall on a more likely than not basis. to view the tax standards in the context of recent tax shelter disputes, several tax court, district court and appellate court cases were examined.366 these cases were analyzed in relation to pro-taxpayer versus pro-government stances noting their respective tax shelter profiles. what emerged from some of these highly complex and intricate shelters is the added enhancement of the realistic possibility and the more likely than not standards. that is, regardless of the shelter’s construct it must exhibit economic substance367 and a valid business purpose.368 failure to adequately address these judicial tax doctrines guarantees failure of the standards and demise of the tax shelter.369 but the jurisprudential analysis of shelters is still “technical analysis” of the skeleton of a proposed tax shelter transaction. is such technical analysis 2002] watchdogs that failed to bark 915 370. 66 fed. reg. 3276 (proposed jane. 12, 2001). 371. notice 2001-51, 2001-34 i.r.b. 190, supra note 57; see also notice 2002-35, 2002-21 i.r.b. 992, supra note 302. 372. see, e.g., text accompanying n.n. 293-302. 373. king, supra note 308, at 8. 374. raghavan, supra note 319. 375. king, supra note 308, at 294. 376. raghavan, supra note 318. 377. king, supra note 308, at 294. 378. see ups v. commissioner, 254 f.3d 1014 (11th cir. 2001). 379. congress is considering tax legislation to block companies from incorporating in bermuda to lower their taxes. even before this provision becomes law pricewaterhouse coopers, an international accounting firm, has devised a means of navigating around this roadblock. see john d. mckinnon, pricewaterhouse’s spinoff discovers bermuda loophole, wall st. j., may 9, 2002, at a6. comprised of statutory, regulatory, and judicial sources sufficient in the postenron milieu? not in all likelihood will it carry the day for the tax advisor. no, in today’s volatile environment where new regulatory bodies are being proposed,370 new disclosure standards enacted,371 and new enhancements of tax review standards from public policy372 and ethical norms,373 the black-letter technical analysis is no longer the destination but merely the path to the ultimate advisor’s conclusion. and a gossamer path it is. public policy now more than ever demands that a tax advisor scrutinize proposals for curtailing or even eliminating specific tax shelter transactions.374 then the advisor must consider the prudential selfinterest of the corporate client who seeks to obtain improved financial results and concomitant tax benefits while balancing this against the moral third party interests.375 one conclusion arising from this post-enron tax review standards analysis is that emerging tax policy376 and ethical considerations377 will play an even greater role in augmenting the strict technical analysis of tax shelter transactions. of course, clients and tax advisors will forever develop new and creative ways to legally circumvent existing378 and proposed379 tax law. it was, after all, justice learned hand of the second circuit who best expressed the tax doctrine that there is nothing inherently illegal or immoral in the avoidance of 916 florida tax review [vol.5:10 380. see commissioner v. newman, 159 f.2d 848, 851 (2d cir. 1947). 381. in its broadest sense, a tax shelter is any transaction arrangement which has its primary objective the minimization of federal income tax. see generally daniel q. posin, tax shelters: how they work and the changes wrought by the 1976 act, 1 rev. tax. indiv. 195 (1977). 382. the pejorative connotation is fostered by “abusive” tax shelters that meet judicial and regulatory definitions. see id. see also reg. §§ 301.6111-2t(a)(3), (b)(1). 383. see, e.g., 66 fed. reg. 3276, 3295 (proposed jan. 12, 2001). taxation.380 and, in reality, even the term “tax shelter” is a denotative neutral term381 that, unfortunately, has acquired a pejorative connotation.382 so if in the post-enron planning world the typical tax advisor has become more circumspect and exercises greater due diligence383 in the review of proposed tax shelter transactions, can this be an entirely bad outcome? perhaps now tax lawyers and accountants will consider anew how much they can lose and how much they can win. page 1 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 page 16 page 17 page 18 page 19 page 20 page 21 page 22 page 23 page 24 page 25 page 26 page 27 page 28 page 29 page 30 page 31 page 32 page 33 page 34 page 35 page 36 page 37 page 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mike will prefer this over lengthy praises, which he greatly deserves. this issue includes three parts. all three include works exposing different perspectives on the universal struggle of nation states with the economic and market realities of the twentyfirst century when they come to form their tax policies. the first part focuses on the united states, whose international tax regime was dramatically reformed in 2017 with an unprecedented lack of guidance. the 2017 tax cut and jobs act (tcja) introduced a potpourri of reforms that struggle to reflect a single coherent set of policy goals. some of the changes represented dramatic policy volteface, while others implemented long acknowledged contingency plans that had been discussed and analyzed before. some seem to reflect international developments, conforming to what may be the new international consensus, while others clearly go against such trends. the first article, by christine ann davis, is a good example of the conflict between the desire to collect revenue and address other economic policy considerations with the desire to ensure the global competitiveness of u.s. multinational enterprises. davis demonstrates the 622 florida tax review [vol 22:3 gap between the declared purpose of the gilti rules introduced by the reform and their actual impact, proposing an alternative rule that would better balance the conflicting interests of the united states. the second work, an essay by melanie mccoskey & doron narotzki, demonstrates the undesirable impact of the tax reform on higher education in the united states, contrary to the reform’s declared purpose. the third work, an essay by shay menuchin, addresses a more general challenge that our tax system faces in the twentyfirst century: the abundance of data and our need and ability to utilize such data in the practice of tax law. the second part includes four works that address some of the hottest topics that the international tax regime (beyond the united states) faces today. the fourth work, an essay by debora de souza correa talutto, examines the ascent of profit splits in the world of transfer pricing, arguing that modern interpretation of the current norms of international taxation could provide a workable framework for the application of these rules even in the changing circumstances of the twentyfirst century. the fifth work, an article by aitor navarro, similarly discusses a contemporary challenge to the transfer pricing rules and responds to it with a constructive proposal for reform that permits the continuity of the regime based on its core arm’s length standard. the proposal is to introduce simplification of the transfer pricing rules through the enactment of rebuttable presumptions based on predetermined margins or methods in a manner that would be arm’s length compliant. the sixth work, an article by monica victor, more critically challenges the current oecdled international tax regime and contrasts its architecture with that of the trade regime embedded in the wto agreements, pointing to the fragility of the informal international tax regime. such fragility is demonstrated by the recent argentinapanama wto case, which exposed the weakness of the oecd’s harmful tax competition initiative and its inability to ensure efficient tax competition on the one hand and general fairness on the other. the seventh work, an essay by bertil wiman, provides a very contemporary example for a new challenge that the international tax regime faces, and that in its most homogeneous “corner”— the european union. professor wiman examines the impact of the socalled brexit on the direct tax rules in europe generally and sweden particularly, providing a concrete example of one narrative of the fragile state of the international tax regime in the beginning of the twentyfirst century. the third part of this issue is dedicated to latin america and its struggle to operate in an international regime that increasingly distances itself from the traditional values held by policymakers in the 2019] introduction: a tribute to michael k. friel 623 region. the eighth work, and essay by myself, exposes the long held opposition of latin american states to international tax arbitration, tracing it to the more general “calvo doctrine” that opposed any form of foreign intervention, and demonstrates that such a position may not be in the best interests of latin america at the present. the ninth work, an essay by luís eduardo schoueri and gustavo lian haddad, discusses the potential for a tax treaty between the united states and brazil, perhaps the most important trade relationship in the world not covered by a tax treaty and certainly the most important for these two states. their analysis and the history of the conflict among these two states demonstrates the policy distance between them (as a representative of the so called first and third worlds) that still leaves the international tax regime incomprehensive and fragile. the tenth work, an article by axel a. verstraeten, examines international tax policy making in argentina, another large latin american economy, and its struggle to adapt its laws to the international standards promoted by the oecd and the dominant western states. the eleventh work, an essay by hugo hurtado and jaime del valle, tells the story of chile, a smaller state but perhaps the most “western” among latin american states, establishing tax policies in support of its quest to become the region’s investment hub. the twelfth work, an essay by alvaro villegas aldazosa, provides an historical perspective of a less developed country, telling the story of the taxation of natural resources in bolivia. the thirteenth essay, by andrés báez moreno, discusses the growing provision of cross-border services, the taxation of which has proven tricky for the international tax regime, a regime based on the old economy. professor báez moreno analyzes the experience of two major latin american states attempting to tax such services, demonstrating the incongruity of the current rules with the economic reality they should be able to regulate. and, finally, the fourteenth work, an essay by andres bazó, tackles the conflict between the trend to intensify the exchange of taxpayer information in the modern tax world and the realization that such a trend may be harmful to taxpayers’ rights. this conflict enjoys much recent attention in tax scholarship, and this essay is the first to provide a comparative study of the issue from an american (north and south) perspective. the commitment of the university of florida’s graduate tax program, led by professor friel for over twenty years, to the study of tax law and policy in the americas, and to the education of students from latin america has been longstanding and wellknown. it is also unique. the compilation of this issue, supported by the iberoamerican 624 florida tax review [vol 22:3 observatory for international taxation (oiti), which includes the university of florida as its northernmost member, is an important demonstration of this commitment. our goal is to give voice to views beyond those of the traditional economic powers and to support tax policymaking with serious scholarship that is independent from such powers or any other interest groups. this is the legacy of professor friel, which, i hope, is well represented by this issue. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 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brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university– bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate student editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell kathleen duggan pfahlert executive assistant jessica e. joseph florida tax review volume 20 2017 number 9 iv information for contributors the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law. the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the florida tax review prefers electronic submissions sent via expresso (https://www.bepress.com/products /expresso/); articles may also be 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are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations promulgated under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 4 1998 number 1 winner-take-all markets: easing the case for progressive taxation martin j. mcmahon, jr.* alice g. abreu ** i. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 ii. the distribution of income and the distribution of taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 a. historical background.. . . . . . . . . . . . . . . . . . . . . . . . . . . 12 b. the distribution of changes during “the tax decade”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 c. distribution of income in the 90s. . . . . . . . . . . . . . . . . . . 21 d. legislative reaction to the tax cuts of the 80s.. . . . . . . . 26 e. the question of income mobility. . . . . . . . . . . . . . . . . . . 30 iii. equity, efficiency, and the diminishing marginal utility of money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 * professor of law, university of florida college of law. ** professor of law, temple university school of law. copyright © 1999 by martin j. mcmahon, jr. and alice g. abreu. we are grateful for comments we received from cliff fleming, bob frank, michael friel, david kairys, marjorie kornhauser, paul mcdaniel, david post, david richardson and dan simmons on previous drafts. participants in the university of kentucky college of law randall-park colloquium, the university of florida college of law faculty workshop and the tax and social policy forum held at the american bar association’s 1998 may meeting, also provided valuable commentary. john necci (temple law library), kay-frances brody, temple ‘98, emily moore, university of kentucky ‘96 and jesse rowe, university of kentucky ‘97, provided generous research assistance. shyam nair, temple ‘97, was instrumental in the development of the graphs that prove that a picture is indeed worth a thousand words. all errors, of course, are ours. 1 2 florida tax review [vol. 4:1 a. the diminishing marginal utility of money and equiproportional sacrifice. . . . . . . . . . . . . . . . . . . . . . . . 32 b. proof and imprecision. . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 c. the diminishing marginal utility of money and least aggregate sacrifice theory. . . . . . . . . . . . . . . . . . . 38 iv. a utility-based measure of efficiency. . . . . . . . . . . . . . . 39 a. the model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 b. productivity and tax rates. . . . . . . . . . . . . . . . . . . . . . . . 43 c. the importance of income distribution. . . . . . . . . . . . . . 46 d. progressive taxation and efficiency in the winner-take-all society. . . . . . . . . . . . . . . . . . . . . . . . . . 51 e. lessons from optimal tax theory. . . . . . . . . . . . . . . . . . 55 f. the failure of the rising tide. . . . . . . . . . . . . . . . . . . . . . 57 g. the elasticity of the labor supply. . . . . . . . . . . . . . . . . . 58 h. the responsiveness of the savings rate. . . . . . . . . . . . . . 60 i. might winners be specially responsive?. . . . . . . . . . . . . 63 v. the equities of progressive taxation. . . . . . . . . . . . . . . . 65 vi. designing the rate structure.. . . . . . . . . . . . . . . . . . . . . . . 71 a. evaluating the current rate structure. . . . . . . . . . . . . . . 71 b. suggestions for the design of the rate structure—forward to the past. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 1. the first four quintiles. . . . . . . . . . . . . . . . . . . . 73 2. the fifth quintile. . . . . . . . . . . . . . . . . . . . . . . . . 76 vi. conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 1998] winner-take-all markets 3 i. introduction everybody loves a winner, and the market often agrees, providing spectacular rewards for those who win. while the winners win big, everyone else is left behind, reaping rewards that bear little relationship to how close they were to winning or to the magnitude of the difference between their talents and those of the winners. the winner-take-all phenomenon, long the hallmark of the sports and entertainment markets, has spread throughout the u.s. economy over the last two decades. as more markets operate like the entertainment market, scholars1 have begun to analyze the ways in which such markets suggest a need to rethink established conclusions and policies. the recent work of two economists,2 1. see infra notes 7-16, 52-61 and accompanying text. see generally, edward n. wolff, top heavy: a study of the increasing inequality of wealth in america (1995). for an exhaustive compilation of scholarship showing the increasing gap in the distribution of income in the united states generally, see enrique r. carrasco, opposition, justice, structuralism, and particularity: intersections between latcrit theory and law and development studies, 28 u. miami inter-am. l. rev. 313, 314 n.4 (1997). 2. scholars interested in the operation of specific markets have already begun to explore the implications of winner-take-all markets. thus, david wilkins and mitu gulati have shown that the market for big firm lawyers operates in this way and explains the scarcity of minority lawyers in those firms. david b. wilkins & g. mitu gulati, why are there so few black lawyers in corporate law firms? an institutional analysis, 84 cal. l. rev. 493 (1996). wilkins and gulati argue that the market in which aspiring big firm lawyers compete functions in a way that fails to provide traditional safeguards against discriminatory action. see id. at 496. because the number of qualified applicants far exceeds the number of positions available, both at the entry level and at the partner level, firms can make racist decisions without the adverse market effects that would follow in a market that operated in the traditional, economically efficient way. see id. the market described by wilkins and gulati operates in the same way as that described by frank and cook. see robert h. frank & phillip j. cook, the winner-take-all society (1995); see also david charny & g. mitu gulati, efficiencywages, tournaments and discrimination: a theory of employment 4 florida tax review [vol. 4:1 robert h. frank and phillip j. cook, provides a good springboard for this analysis. in the winner-take-all society, frank and cook describe how an3 discrimination law for “high level” jobs, 33 harv. c.r.-c.l. l. rev. 57 (1998). more recently, douglas lichtman, noted that patent law perpetuates the winner-take-all phenomenon because relatively few individuals receive patents which allow them to reap enormous financial rewards while leaving those with unpatentable goods with little economic gain. douglas g. lichtman, the economics of innovation: protecting unpatentable goods, 81 minn. l. rev. 693 (1997); see also michael a. fitts, the paradox of power in the modern state: why a unitary, centralized presidency may not exhibit effective or legitimate leadership, 144 u. pa. l. rev. 827 (1996)(stating that a winner-take-all market exists in news media because the enormous payoff accruing to the news organization which breaks the big story causes the news media to focus a disproportionate amount of its resources on potential big stories such as the president). 3. frank & cook, supra note 2. although frank and cook were not the first to identify the winner-take-all phenomenon, their analysis of it is the broadest and has received considerable public and scholarly attention. over 15 years ago, university of chicago economist sherwin rosen identified what he described as “[t]he phenomenon of superstars, wherein relatively small numbers of people earn enormous amounts of money and dominate the activities in which they engage,” and began to relate the phenomenon to the distribution of income. sherwin rosen, the economics of superstars, 71 am. econ. rev. 845, 845 (1981); sherwin rosen, prizes and incentives in elimination tournaments, 76 am. econ. rev. 701 (1986). later, in planning a commencement address to harvard’s 1988 graduating class, derek bok, former president of harvard university, began to think about the disparities in compensation paid to workers in various sectors. his inquiry culminated in a thoughtful book that dissects the role of money in determining young people’s career choices, analyzes the impact of disproportionately high compensation on values, and laments the increasing lure of the private sector to the detriment of the public sector. derek bok, the cost of talent (1993). like frank and cook, bok looks to progressive taxation, among other things, to curb the lure of disproportionately high earnings. id. at 275-80. more recently, numerous scholars have applied the insights offered by 1998] winner-take-all markets 5 increasing number of labor markets now operate in ways that depart significantly from the classical economically efficient model. in these markets,4 a large number of individuals compete for a relatively small number of positions that offer the possibility for financial rewards far exceeding those that frank and cook to other areas. see davison m. douglas, the end of busing?, 95 mich. l. rev. 1715, 1730 n.63 (1997)(discussing the growing gap between education and opportunities available to rich and poor children); andrew j. gold, in the aftermath of sheff–considerations for a remedy, 29 conn. l. rev. 1043, 1058 n.54 (1997)(striving for improvement can produce non-useful societal results); consuelo l. kertz, executive compensation dilemmas in tax-exempt organizations: reasonableness, comparability, and disclosure, 71 tul. l. rev. 819, 847 n.99 (1996-1997)(comparing frank and cook’s work to bok’s); j.b. ruhl & harold j. ruhl, jr., the arrow of the law in modern administrative states: using complexity theory to reveal the diminishing returns and increasing risks the burgeoning of law poses to society, 30 u.c. davis l. rev. 403, 463 n.145 (1996)(unequal distribution of opportunities accounts for huge income disparities); c. edwin baker, giving the audience what it wants, 58 ohio st. l.j. 311, 338 n.50 (1997)(winner-take-all markets create heightened incentives to spend resources in manner which produces little to no value to society); kathleen e. keest, whither now? truth in lending in transition–again, 49 consumer fin. l. q. rep. 360, 366 n.40 (1995)(growing disparity in income and power in american society underscores a need for greater regulation of contract). 4. in frank and cook’s words, “[r]eward by relative performance is the single most important distinguishing characteristic of winner-takeall markets. in the markets that economists normally study, by contrast, reward depends only on absolute performance.” frank & cook, supra note 2, at 24. although we will focus on the effect of these markets on the labor performance of individuals, as do frank and cook, it is important to note that such markets exist for goods as well. in a telling example of the emphasis on relative quality in such markets, frank and cook note that to mark a special occasion “[w]e give two ounces of russian caviar, not forty pounds of frozen whitefish costing the same amount; one silk undergarment, not an equivalent dollar purchase of fruit of the loom cotton underpants.” id. at 42. 6 florida tax review [vol. 4:1 await less successful competitors. as in the entertainment industry, where the5 difference between the compensation received by the star and that received by her understudy is almost always far more than proportional to the differences in their talent, these steadily growing markets display what is essentially a winner-take-all paradigm.6 data on changes in the distribution of income confirm both the existence and the expansion of winner-take-all markets. in 1990, families in7 5. frank and cook’s thesis is that these markets are inefficient because their reward structure is so lucrative that it lures too many wanna-bes away from pursuits which would allow them to make a more meaningful contribution to society. frank & cook, supra note 2, at 8-11, 101-15. for example, the madonna wanna-be who neglects her studies and eschews college in her quest for stardom but ends up waiting tables, deprives society of the contributions she might have made as a scientist. she might also decrease the chances that any other person will win a coveted role, at least if one assumes that selection is, to a large extent, the product of chance, and that there are a limited number of starring roles available. id. frank and cook also posit that such markets are inefficient because they encourage wasteful competition, much like an arms-race. id. at 8-11, 125-38. the reward structure is so great that it encourages excessive investment in the competition, to the detriment of other uses to which those resources might have been put. id. while frank and cook’s work on the existence of such markets is central to the claims we make in this piece, agreement with their evaluation of the merits of such markets is not. thus, while our analysis posits the existence of such markets, our conclusions do not proceed from a desire either to foster such markets or to eliminate them. in frank and cook’s ideal world, such markets would be severely restricted or eliminated, and tax policy would be used to that end. id. at 212-19. in ours, they simply serve to justify graduated progressive taxation. 6. frank and cook acknowledge that most of the markets they analyze have more than one winner, so that it “would be more accurate to call them ‘those-near-the-top-get-a-disproportionate-share’ markets. but this is a mouthful, and hence our simpler, if somewhat less descriptive, label.” frank & cook, supra note 2, at 3. we agree and do likewise. 7. the data we present here appear, or are derived from, the distribution of income and tax burdens by household, which appears 1998] winner-take-all markets 7 the top 20% of the income scale received 51.4% of all income; families in the8 top 1% received nearly 13% of all income. that same year families in the9 bottom 40% also received 13% of all income. that a fifth of the families10 received over half of the income, with the top 1% receiving over 10% of the income, shows that we are indeed a winner-take-all society. that families in11 the top 1% had the same share of income as those in the bottom 40% is a testament to the size of the chasm between the winners and the wannabes. figures 1 and 2, below, paint the picture.12 as appendix k in the committee on ways and means, overview of entitlement programs, 103d cong., 1st sess. (comm. print 1993) [hereinafter 1993 greenbook]. these data were derived from what the greenbook described as a “forthcoming” study by the congressional budget office entitled, trends in federal tax progressivity: 1977-1994. however, the study has not been issued as a separate document. we will therefore refer to these data as the “greenbook data” throughout this article. 8. the definition of the top quintile varies with family size, but for the sake of consistency we will refer to the numbers that reflect the income for a family of four. for 1977, a family of four in the top quintile had income above $75,653. 1993 greenbook, supra note 7, at 1503 tbl. 14. for 1990, a family of four in the top quintile had income above $84,109. id. at 1502. however, the gap between most of those in the top quintile and those in the top 1% is substantial. a family of four had to have income of more than $400,000 (in 1996 dollars) to be counted in the top 1% in 1990, and the average income of families in this group was over $600,000. joel slemrod & jon bakija, taxing ourselves: a citizen’s guide to the great debate over tax reform 56 (1996)(slemrod and bakija also derive these numbers from the 1993 greenbook. id. at n.14.) 9. 1993 greenbook, supra note 7, at 1506 tbl. 17. 10. see id. 11. see id. 12. that the maximum income thresholds for the first four quintiles vary by $21,000, on average, but rise by over $256,000 between the fourth quintile and the first 19% of the fifth quintile—a factor of 12—underscores the size of the gulf. see 1993 greenbook, supra note 7, at 1502 tbl. 14. for a family of four, in 1990, the maximum income thresholds were: 8 florida tax review [vol. 4:1 figure 1 shares of pre-tax income for all families in 199013 lowest quintile: $ 20,274 second quintile: $ 37,241 third quintile: $ 55,659 fourth quintile: $ 84,109 fifth quintile: $340,174 (lowest 19% only) id. at 1501-02. 13. derived from 1993 greenbook, supra note 7, at 1506 tbl. 17. 1998] winner-take-all markets 9 figure 2 share of pre-tax income in 1990 for families in the top quintile14 the winner-take-all society is not only alive and well, but over the last two decades it has given an increasing share of the stakes to the winners. between 1977 and 1990 families in the top 1% increased their share of total income by 45%, while just about everybody else saw their share of total income decline,15 and those in the bottom quintile saw their share of income decline precipitously—by 24.5%. the winners are not only winning bigger, they are16 14. id. 15. see id. declines occurred for all families except those in the top 4% of the income scale. see figure 3. to make comparisons between years meaningful, the greenbook data put family incomes in constant dollars by the cpi-x1 price index. 1993 greenbook, supra note 7, at 1484. 16. see 1993 greenbook, supra note 7, at 1506 tbl. 17. a family 10 florida tax review [vol. 4:1 leaving everybody else in the dust. when it comes to their share of federal taxes, the winners have also been winning, for the changes in their share of the federal tax burden are anything but proportional to the changes in their share of the income. as17 figure 3, below, demonstrates graphically, while changes in shares of income18 of four with income under $21,920 was in the bottom quintile in 1977, and a family of four with income under $20,274 was in the bottom quintile in 1990. id. at 1501-03 tbl. 14. 17. see 1993 greenbook, supra note 7, at 1499 chart 1. 18. the table below presents the raw data from which we derived the graph in figure 3, and illustrates the changes in the shares of beforetax income and all federal taxes, including social security taxes, by income group. shares of total federal taxes paid by all families compared to share of total pre-tax income, 1977 and 1990 quintile 1977 1990 taxes income taxes income lowest 2.0% 4.9% 1.4% 3.7% 2d 7.2% 10.6% 6.4% 9.2% 3d 13.4% 15.7% 12.5% 14.5% 4th 21.6% 22.5% 21.2% 21.7% 81 to 90% 16.7% 15.8% 16.6% 15.4% 91 to 95% 11.3% 10.2% 11.7% 10.4% 96 to 99% 14.1% 11.9% 14.9% 12.9% top 1% 13.6% 8.8% 14.9% 12.8% 1993 greenbook, supra note 7, at 1506 tbl. 17, 1515 tbl. 25. while these numbers confirm the widely touted claim that the individuals at the top of the income scale pay more than half of the taxes (according to the foregoing data, families in the top quintile paid more than 58% of the taxes in 1990), that assertion overlooks the relationship between their 1998] winner-take-all markets 11 and taxes have remained in rough proportion to one another for 99% of the population, the increase in share of income has outstripped the increase in share of taxes by a factor of almost 5 for those at the top 1% of the income scale—the real winners. the spike in the graph confirms both the expansion of winner-19 take-all markets and the growing disjuncture between the distribution of income and the distribution of the tax burden. share of income and their share of taxes. 19. while the share of income received by families in the top 1% has risen by 45%, their share of the tax burden has only risen by 9.5%. data derived from 1993 greenbook, supra note 7, at 1506 tbl. 17, 1515 tbl. 25. 12 florida tax review [vol. 4:1 figure 3 changes in shares of income and taxes 1977-1990 the dramatic effect revealed by figure 3 would be masked by grouping all of the families in the fifth quintile, because three quarters of the families in that quintile have seen their shares of income and taxes either rise very little or actually decline. indeed, looking at the winners separately is at the heart of the analysis we offer. the distributional data show that those in the top 1% are very different from others in the top quintile, and that when it comes to fluctuations in income, three-fourths of those in the top quintile have more in common with those in the second, third, and fourth quintiles than they do with those at the top of the quintile. tax policy should reflect this, but it has not.20 tax policy has failed to consider the ways in which the distribution of income within the top quintile should affect the distribution of the tax burden. congress, like most policy analysts, apparently has assumed that those within the top quintile are just slightly different from one another, or that they differ from one another only incrementally. but the data show that families in the top 20. a member of a group in which the average income is $600,000 and the minimum income is $400,000, slemrod & bakija, supra note 8, at 56, is more like the other members of that group than like members of a group in which the minimum income is $84,109, which is the starting point for the fifth quintile. 1998] winner-take-all markets 13 quintile but below the 95th percentile have a lot more in common with one another and with families in the third and fourth quintiles than with families in the top 5th percentile, and especially with families in the top 1%. families in the top 1% are truly in a class of their own. these data, and the winner-take-all distribution it reveals, have significant implications for tax policy and tax system design.21 acknowledging the existence, expansion and unique operation of winner-take-all markets can serve to illuminate various aspects of tax policy. for instance, if people play to win, then taxing the second half of the winnings more steeply than the first half should not decrease the incentive to play the game. put another way, the existence of winner-take-all markets presents a serious challenge to the classical argument that progressive taxation is inefficient because it distorts the decision to create additional income or to consume at the margin, and so entails trading efficiency for equity. in a22 winner-take-all market, progressive taxation may be not only efficient, it may be nearly optimal; it may raise revenue from people whose incentive to make more money is nearly unaffected by the existence of the tax.23 the absence of a linear relationship between effort, ability, and 21. unlike frank and cook, we do not aim to provide a comprehensive explanation for the growth of winner-take-all markets. our project is to show that the surge in such markets, whatever the multiplicity of reasons for their proliferation, has significant implications for tax policy and for tax system design. 22. see richard a. musgrave & peggy b. musgrave, public finance in theory and practice 88-104 (3d ed. 1980); arthur m. okun, equality and efficiency: the big tradeoff (1975); martin feldstein, on the theory of tax reform, 6 j. pub. econ. 77, 78 (1976), and sources cited in note 2 therein; see also walter j. blum & harry kalven, jr., the uneasy case for progressive taxation, 19 u. chi. l. rev. 417 (1952); walter j. blum, revisiting the uneasy case for progressive taxation, 60 taxes 16 (1982). that a uniform tax rate is more economically efficient often has been conceded by both economists and lawyers representing a broad spectrum of viewpoints with respect to desirable tax rates and structures, even when arguing for a rate or base structure that might not comport with efficiency maximization. see jane g. gravelle, the flat tax and other proposals: who will bear the tax burden?, 69 tax notes 1517 (dec. 19, 1995). 23. for a brief explanation of the theory of optimal taxation, see the discussion at note 198. 14 florida tax review [vol. 4:1 compensation in winner-take-all markets lends special force to arguments that24 rest on the diminishing marginal utility of money. even a model that makes25 conservative assumptions about the rate at which the marginal utility of money declines shows that in winner-take-all markets progressive taxation results in greater total private utility after taxes than proportional taxation. in a society26 dominated by winner-take-all markets, then, we do not need to trade equity for efficiency. progressive income taxation can provide both.27 28 24. see discussion infra part iv.d. 25. the theory of diminishing marginal utility postulates that as consumers obtain additional units of the same good, they receive less utility from each additional unit. campbell r. mcconnell, economics, 501-02 (7th ed. 1981). the theory “presupposes not only the measurability of utility but also the cardinal measurability of the thing that produces felicity,” and can be traced to the eighteenth century writing of jeremy bentham. encyclopedia of economics 935 (douglas greenwald ed., 1982); see also george j. stigler, essays in the history of economics 382 (1965)(discussing jeremy bentham’s an introduction to the principles of morals and legislation (1789)). for a more detailed discussion of the status of the theory in the economic literature, see discussion infra part iii. 26. see infra part iv. 27. see infra notes 114-16 and accompanying text. 28. we focus here on progressive income taxation for at least three reasons. first, it is progressive income taxation that has served as the lightening rod for the progressivity debate. while other systems may have the virtue of adding progressivity to the tax system overall, see michael j. graetz, to praise the estate tax, not to bury it, 93 yale l.j. 259 (1983), only the income tax has the potential for affecting large numbers of individuals in ways that can raise large amounts of revenue. second, because the equity/efficiency tradeoff is one that necessarily implicates the likely behavioral responses to a tax, it is logical to focus on the effect of the tax usually thought to induce the greatest behavioral responses—the income tax. behavioral responses to other progressive taxes, such as the estate tax, are currently indeterminate, given the uncertainty over the impact of the bequest motive on behavior. see joint comm. on taxation, 103d cong., 1st sess., methodology and issues in measuring changes in the distribution of tax burdens 68-69 (comm. print 1993) [hereinafter redbook]. third, this article serves as a 1998] winner-take-all markets 15 with this article we begin the process of exploring the ways in which winner-take-all markets can alter perceptions about the appropriate distribution of the tax burden. this is neither a soak-the-rich polemic nor a plea for rejection of the tools of traditional economic analysis. it is an attempt to apply29 economic analysis to markets that produce unique incentives and that have resulted in a dramatically skewed distribution of income. winner-take-all markets are probably here to stay, so it behooves us to study them and to consider their operation when crafting tax policy. in part ii of this article we analyze the ways in which changes in the distribution of income over the last two decades evidence the growth of winnertake-all markets. we show that the federal income tax system has failed to reflect that growth and has resulted in a system that imposes taxes at dramatic odds with the distribution of pre-tax income. because this polarity reflects the triumph of efficiency concerns, we turn to an analysis of those concerns in parts iii and iv, where we first consider the possible effects of the diminishing marginal utility of money and then present a quantitative model that shows how progressive taxation can be superior to proportional taxation in providing the greatest overall utility. we turn to the question of equity in part v, where we explain why we think that progressive taxation is more equitable than proportional taxation. we conclude in part vi with a proposal for a rate structure that more accurately reflects the relationship between the diminishing marginal utility of money and the skewed distribution of income wrought by the expansion of winner-take-all markets. ii. the distribution of income and the distribution of taxes a. historical background from both the political and theoretical perspectives, progressive income tax rates always have been controversial. they also took nearly 3030 theoretical exploration of the subject, not an exhaustive treatise; future pieces may discuss the application of theories and models we develop here to other taxes and even to combinations of taxes. 29. this does not mean that we are not sympathetic to critical examination of the assumptions and methodologies on which traditional economic analysis is based. actually, we are, and have engaged in such critical analysis ourselves—if we had to choose, we would choose equity over efficiency in a heartbeat. the point of this piece, however, is not to argue that we would be right in making the choice, but that we don't need to make the choice because both roads lead to rome. 30. see generally sheldon pollack, the failure of u.s. tax 16 florida tax review [vol. 4:1 years to become a distinguishing feature of our tax system. at its inception in31 1913, the income tax had a relatively flat structure with generous exemptions.32 it imposed a low, nearly flat, rate of tax on high incomes. the most significant33 factor in the creation of the steeply graduated rate schedule that characterized our income tax system between the 1950s and the 1980s and that many have come to regard as the prototype for progressive taxation was the need for policy: revenue and politics 46-53, 234-37 (1996); john f. witte, the politics and development of the federal income tax 67-154 (1985); marjorie e. kornhauser, the morality of money: american attitudes toward wealth and the income tax, 70 ind. l.j. 119 (1994); marc linder, eisenhower-era marxist-confiscatory taxation: requiem for the rhetoric of rate reduction for the rich, 70 tul. l. rev. 905 (1996). 31. traditionally, the phrase progressive taxation has referred to a tax system that has a rate structure featuring graduated progressive rates. in such a system, which generally is simply called a progressive rate system, taxpayers are subject to increasing marginal rates of tax; for example, 10% on the first $10,000 of taxable income, 15% on the second $10,000, 30% on the third $10,000, and so forth. the term progressive taxation sometimes has been applied to flat rate taxes that have a zero bracket exemption. as a result of the zero bracket exemption, such a flat rate tax produces an aggregate tax rate that is less than the marginal tax rate but consistently increases as income increases. see charles r. o’kelley, jr., tax policy for post-liberal society: a flat-tax-inspired redefinition of the purpose and ideal structure of a progressive income tax, 58 s. cal. l. rev. 727, 729 (1985); robert e. hall & alvin rabushka, the flat tax (2d ed. 1995). the latter usage of the term progressive taxation is largely confined to the advocates of flat rate taxes who like to clothe their proposals in the garb of progressive taxation. see marjorie e. kornhauser, the rise of rhetoric in tax reform debate: an example, 70 tul. l. rev. 2345 (1996); marjorie e. kornhauser, equality, liberty, and a fair income tax, 23 fordham urb. l.j. 607, 652 n.123 (1996). 32. see boris i. bittker, federal taxation of income, estates and gifts, at a-8 tbl. 5 (1981). an earlier income tax was held unconstitutional in pollock v. farmers’ loan & trust co., 158 u.s. 601 (1895). see also paul r. mcdaniel et al., federal income taxation 3-5 (3d ed. 1994)(discussing pollock). 33. see bittker, supra note 32. 1998] winner-take-all markets 17 revenues in world war ii. during world war ii, the maximum marginal rate was increased to over 90%, and it remained close to that level until 1964. in34 1965 the top rate was reduced to 70% as part of a general tax cut, and in 1969 the top rate on “earned income” was reduced to 50%. other income, however,35 was subject to tax at rates up to 70%, except capital gains, which were taxed at maximum rates that varied from 25% to 35% through the 1960s and 1970s.36 when the post-1964 rate schedules, which were not indexed for inflation, met the viet-nam war and the opec-induced high inflation of the late 1960s and the 1970s, which pushed increasing numbers of middle class taxpayers into marginal tax brackets in the high 20s and the low 30s, the effectively flat rate tax system for most of the population was history. the37 middle class taxpayers who were subjected to this graduated rate schedule didn't like the results. by 1981 the middle class was ready for tax relief.38 the 1981 tax act, which turned into a bidding war between the39 republicans and democrats to see who could provide the biggest tax cut, was40 34. see bittker, supra note 32. withholding of income taxes on wages was also introduced during world war ii, in 1943. see slemrod & bakija, supra note 8, at 23. in the early 1960s, roughly 90% of taxpayers faced the 20, 22, and 24% brackets, and not very many reached the 24% bracket. see c. eugene steuerle, the tax decade 23-25 (1992). in essence, the system was largely a flat tax with steeply progressive surtaxes on a relatively small percentage of the population. see slemrod & bakija, supra at 25. 35. bittker, supra note 32; paul r. mcdaniel et al., federal income taxation, cases and materials 9 (4th ed. 1998). the 1964 act was a tax reduction that revised the rate schedules to create lower rate brackets, down to 14%, increasing the number of taxpayers exposed to the stair-step graduated rates. 36. bittker, supra note 32. 37. bittker, supra note 32. 38. see steuerle, supra note 34, at 17-29. slemrod and bakija provide graphic evidence of the shift from “class tax” to “mass tax” after world war ii by showing that while personal income tax revenues as a percentage of gross domestic product (gdp) remained essentially level between 1940 and 1990, the top rate during that period fell precipitously. slemrod & bakija, supra note 8, at 24 fig. 2.2. 39. economic recovery tax act of 1981, pub. l. no. 97-34, 95 stat. 172 (1981). 40. see harry l. gutman, reforming federal wealth transfer 18 florida tax review [vol. 4:1 the first step in the statutory attack on progressivity. first, all brackets above 50%—which applied almost exclusively to current yield from capital—were eliminated; this had the important ancillary effect of reducing the maximum rate on long-term capital gains from 28% to 20%. second, through adjustments in the remaining rate brackets, taxpayers at almost all demographic income levels received approximately a 10% reduction.41 the tax reform act of 1986 continued to dismantle the graduated rate schedule by reducing the number of rate brackets from 14 to just two: 15% and 28%. this flattening of the rate structure was combined with a broadening of42 the tax base so as not to produce an overall tax cut, or to affect the43 progressivity of the system, as measured by broad demographic income groups, such as income quintiles. nevertheless, the combined effects of the 1981 and44 1986 acts produced changes in income tax burdens that turned out to be taxes after erta, 69 va. l. rev. 1183, 1198-1206 (1983). 41. the 10% across the board reduction was not surprising; but the top end reductions were. historically, except for disproportionate relief at the lower end, tax cuts have tended to be proportional across income classes. for example, the 1969 reduction of the top rate on earned income from 70% to 50% was coupled with other changes restricting deductions and creating the alternative minimum tax that resulted in no net tax relief for the income class benefitting from the nominal statutory rate reduction. but the 1981 reduction of the top rate from 70% to 50% didn’t follow this pattern. it was more akin to the andrew mellon led tax cuts of the 1920s. see witte, supra note 30, at 228-35. 42. tax reform act of 1986, pub. l. no. 99-514, 100 stat. 2085 (1986). there was, however, a disguised 33% rate bracket, on what might loosely be described as the upper middle class. see boris i. bittker & martin j. mcmahon, jr., federal income taxation of individuals ¶ 40.2 (1988); andrew b. lyon, individual marginal tax rates under the u.s. tax and transfer system, in distributional analysis of tax policy 214 (david f. bradford ed., 1995). 43. see staff of the joint comm. on taxation, general explanation of the tax reform act of 1986, 1354 tbl. a-1 (comm. print 1987)(5-year projected revenue impact of 1986 act was projected to be a tax cut of only $257 million). 44. see michael j. graetz, paint-by-numbers tax lawmaking, 95 colum. l. rev. 609, 618 (1995). 1998] winner-take-all markets 19 lopsidedly in favor of those at the very top of the economic ladder.45 b. the distribution of changes during “the tax decade”46 dividing the population into quintiles, as was generally done in analyses of the 1981 and 1986 acts, and comparing the changes in the average effective income tax rates for each quintile, leads to the conclusion that the effects of that legislation were generally proportional across income classes. from 1977 to 1990 income tax burdens changed as shown in table 1. table 1 change in average income tax rates: 1977-199047 quintile percent change lowest n/a (negative rates) 2d -7.6 3d -6.8 4th -8.3 5th -7.3 but all is not as it appears, particularly when the appearance is produced by a distributional table. breaking down the top quintile and48 isolating the top 1% reveals the disproportionate reduction in tax rates for taxpayers at the very top of the income scale. it not only isolates the winners, but also exposes the size of the disparity between the top 1% and everybody else. within the top quintile, the percentage reduction in income tax rates was as shown in table 2. 45. for a discussion of how changes made during the 1990s affected the distribution of the tax burden, see infra part ii.c. 46. steuerle, supra note 34. 47. 1993 greenbook, supra note 7, at 1516 tbl. 26. 48. see generally, graetz, supra note 44. for an excellent discussion of the subject of, and problems with, distributional analysis, see lyon, supra note 42. exactly which distributional tables one examines, and what economic assumptions are made in constructing the tables, can dramatically affect the conclusions that are reached. id. for example, the lowest income quintile can include students, who are only temporarily poor, as well as the elderly, some of whom may be living by dissaving substantial accumulated wealth. income mobility also may be an issue, individuals with short term or one time large amounts of income appearing in higher than usual brackets. see infra text accompanying notes 109-113. 20 florida tax review [vol. 4:1 table 2 change in average income tax rates for the top 20%: 1977-199049 81 to 90% -7.3 91 to 95% -7.4 96 to 99% -5.9 top 1% -18.9 the results reflected by the distribution in table 2 are what one would expect in a progressive system: the magnitude of the changes increases toward the top of the income scale. the problem, of course, is that those values reflect a reduction in taxes. that is, they are negative numbers which reflect a regressive change in the average income tax rate, where those at the very top enjoyed the greatest percentage decrease. that families in the top 1% enjoyed a reduction that was more than twice that bestowed on families in the remainder of the top quintile shows not only the absence of proportionality in the reductions within the top quintile, but also how analyzing the distribution within the fifth quintile more clearly reveals the effect of the rate reductions on progressivity. those in the top 1% won the rate reduction sweepstakes.50 49. 1993 greenbook, supra note 7, at 1516 tbl. 26. 50. we refer to “families” because that is the unit used by the greenbook data from which we have drawn much of our analysis. the 1993 greenbook defines a family to include “both families of two or more people and single individuals.” 1993 greenbook, supra note 7, at 1485. the 1993 greenbook data also measures family income: [o]n a cash receipt basis, a definition generally consistent with the measure of income used by the federal tax system. family income equals the sum of wages, salaries, self-employment income, personal rents, interest, dividends, government cash transfers, cash pension benefits and realized capital gains. family income excludes accrued but unrealized capital gains, employer contributions to pension funds, in-kind government transfer payments, and other noncash income. because income is measured before reductions for any federal taxes, employer contributions for federal social insurance and federal corporate profits taxes are added to family income. family incomes are put in constant dollars by the cpi-x1 price index. 1998] winner-take-all markets 21 opponents of progressive taxation often claim that flattening the rate schedule increased progressivity, citing data indicating that during the 1980s the share of aggregate income taxes paid by high income taxpayers increased.51 id. at 1484. income for these purposes is therefore likely to be higher than the amounts actually available for consumption by individuals, but may be comparatively higher for workers who earn amounts under the social security threshold than for others due to the addition of the employer’s share of payroll taxes. the differences between the disposable incomes of those in the top 1% and everyone else may therefore be understated as a result of this methodology. to control for the effect of what the 1993 greenbook refers to as “paper losses,” which are more likely to be present for those at the top of the income distribution, “rental losses and most partnership losses were not subtracted from family income.” id. some critics of certain distributional studies have claimed that measures of income that include amounts other than disposable income, (such as family economic income), overstate wealth and so serve to give the appearance that the benefits of particular tax legislation go disproportionately toward the wealthy. for a sampling of this controversy see saxton calls treasury’s tax analysis method “misleading,” tax notes today (tax analysts) june 20, 1997, 97 tnt 119-h, available in lexis, fedtax library, tnt file; treasury analysis of tax bills a sham, house gop leaders charge, tax notes today (tax analysts) july 17, 1997, 97 tnt 137-6, available in lexis, fedtax library, tnt file; rubin hails crs take on tax bills’ fairness, tax notes today (tax analysts) july 10, 1997, 97 tnt 132-2, available in lexis, fedtax library, tnt file; donald lambro, keeping an eye on total tax burdens, wash. times, june 26, 1997, at a15. whatever the merits of such claims generally, in this context, such additions probably serve to decrease the differences between those in the top 1% and everyone and thus mute the effect we seek to expose. for example, addition of the employer’s share of fica, employer contributions to pension plans and even the addition of the imputed value of owner-occupied housing would have a proportionately greater effect on those in the bottom quintiles than on those in the top quintile, more of whose income is likely to come from capital and thus be unaffected by those measures, unless unrealized gains were included in the measure. 51. see the national commission on economic growth and tax reform, unleashing america’s potential: a pro-growth, pro-family tax 22 florida tax review [vol. 4:1 and so it did. but increases in the share of taxes is only part of the picture that policymakers should examine. the other part of the picture, the part that opponents of progressivity ignore, is the relationship between the increase in the share of taxes and the increases in the share of household income. between 1977 and 1990 families in the top 1% of the income distribution saw their share of household income increase at a much faster clip than their share of taxes. according to analysis of cbo data by paul krugman, the increases in income were approximately as shown in table 3.52 table 3 increases in household income, 1977-1989 quintile percent change lowest -10% 2d -2% 3d +5% 4th +10% 81 to 90% +14% 91 to 95% +18% 96 to 99% +24% top 1% +104% indeed, krugman estimates that 70% of the aggregate increase in average family income in this period accrued to the top 1% of families. as table 353 reveals, families in the top 1% saw their income increase more than four times as much as those in the remainder of the top 5%, i.e. the 96th to 99th system for the twenty-first century 47 (1996) [hereinafter kemp commission report]. of course, flattening the rate schedule could result in an increase in the aggregate share of taxes paid by high income taxpayers if the base broadening provisions that apply to such taxpayers (such as the increasingly popular phaseouts) serve to add progressivity through the back door. even if the base broadening provisions have precisely that effect, our claim is that the effect—the share of the tax burden borne by such individuals—should not be examined in isolation. 52. paul krugman, the rich, the right, and the facts: deconstructing the income distribution debate, 11 am. prospect 19, 21 (1992). 53. id. at 23. as table 3 reveals, the income of the top 1% rose by 104%, and this increase represents 70% of the total increase in average family income. 1998] winner-take-all markets 23 percentiles, and more than 10 times as much as those within the 4th quintile.54 again, the winners won big. an examination of changes in the share of total income received by different groups confirms the magnitude of the winners’ victory. from 1977 to 1990, the share of total income received by the top 1% increased from 8.8% to 12.8%. professor joel slemrod, one of the nation's leading fiscal economists,55 described this leap as “an extraordinary increase by the standards of usually glacial demographic trends.”56 the turtle became a hare when viewed from still another angle. thus, not only did average income rise relative to the median income at an increasing rate, but wage earners at the very top of the distribution saw a dramatic57 increase in their share of total wages. those at the apex, the top 1% of58 individuals by gross income, increased their share of wages from 3.8% of the total in 1970 to 4.7% in 1977; 5.6% in 1982; and 8.8% in 1988. similarly, the59 share of wages received by the top one-quarter of 1% of wage earners grew from 2.5% in 1970, to 3.7% in 1980, to 4.4% in 1984, and to 6.2% in 1990.60 this trend matches the increasing share of total income realized by those at the very top of the top. evidence of the winner-take-all market abounds.61 54. id. at 21. 55. 1993 greenbook, supra note 7, at 1506 tbl. 17. 56. joel b. slemrod, on the high-income laffer curve, in tax progressivity and income inequality 177, 203 (joel b. slemrod ed., 1994). using data from a different source, slemrod shows the increase from 1977 to 1989 to be from 8.4% to 12.4%. id. at 203. 57. krugman, supra note 52, at 23. based on census data, krugman concluded that income mobility was not significant. id. at 2830. that the median income (the income in the middle of the distribution; for example, of the numbers 1, 2, 3, 4, 5, the number 3 is the median) rose at a slower rate than the average can only mean that the income of those at the top of the distribution was rising faster than everybody else’s. had the relative distribution remained the same, the median would have risen at the same rate as the average. 58. see slemrod, supra note 56. 59. id. at 192 tbl. 7, 193 tbl. 8, 194 tbl. 9, 195 tbl. 10. the portion of the income of the top 1% derived from wages rose from 30.5% in 1962 to 43.4% in 1988. id. at 191 tbl. 6, 195 tbl. 10. 60. id. at 205. 61. a wealth of data is available on income distributions, and it reveals very unequal distributions no matter what method is chosen. 24 florida tax review [vol. 4:1 another measure of income concentration commonly used for comparative purposes by economists is the gini index. see generally, graetz, supra note 44, at 622-24; daniel h. weinberg, bureau of the census, a brief look at postwar u.s. income inequality, current population reports p60-191 (1996). for criticism of the use of the gini index, see louis kaplow, a fundamental objection to tax equity norms: a call for utilitarianism, 48 nat’l tax j. 497, 510-11 n.21 (1995). on the gini index, a measure of zero is absolute equality and a measure of one is the maximum inequality. changes in the gini index resulting from changing economic conditions over a time period or as a result of a change in government policy that affects income indicate the direction and magnitude of changes in the distribution of incomes. the bureau of the census calculates and publishes detailed gini indices using a variety of definitions of income. the pre-tax index, which includes money income (including capital gains), other than government transfers, and health insurance benefits for the period 1979 to 1993 shows steadily increasing concentration on incomes. see bureau of the census, table rdi-5, index of income concentration (gini index), by definition of income: 1979-1997 (last modi f ied jan . 4 , 1999) <http://www.census.gov/hhes/income/histinc/rdi05.html>. gini index of income concentration for 1979 to 1993 year gini index year gini index 1993 .514 1985 .486 1992 .497 1984 .477 1991 .490 1983 .478 1990 .487 1982 .475 1989 .492 1981 .466 1988 .489 1980 .462 1987 .488 1979 .460 1986 .505 the 1986 gini index for incomes including capital gains reflects abnormally high capital gains realizations in 1986 before higher tax rates on capital gains under the tax reform act of 1986 became effective. the gini indices of money income excluding capital gains and government 1998] winner-take-all markets 25 as the graph in figure 3 revealed, and as the foregoing data have underscored, since 1977 the distribution of income has reflected the expansion of winner-take-all markets. collectively, we have also continued to pay lip service to the concept of progressivity, with the opponents of progressivity pointing to statistics that show that those at the top pay a large share of the taxes to support their claims that flattening tax rates increases progressivity.62 but careful analysis reveals the fallacy of their claims. it is axiomatic that if share of income goes up, share of taxes will go up as well, even if tax rates remain constant. when income and tax data are linked, however, the picture of progressivity changes. the numbers that, alone, are so often used to show the increased progressivity of the federal income tax, also show that the system is a lot less progressive than it used to be when they are paired with the corresponding numbers for changes in income. pairing the tax63 and income numbers reveals that the rate reductions of the 80’s reduced the progressivity of the income tax system relative to the distribution of income.64 transfers for 1985, 1986, and 1987 were as follows: 1985, .471: 1986, .476; 1987, .477. for the gini index for all money income, including government transfers, see weinberg, supra; see also lynn a. karoly, trends in income inequality: the impact of, and implications for, tax policy, in tax progressivity and income inequality (joel slemrod ed., 1994). the gini index is rather abstract for purposes of making static comparisons and is not particularly helpful in clearly identifying the particular demographic income levels at which vast disparities in income occur. among the other, perhaps more easily understood, methods for comparing income distributions are actual money incomes for different income classes, incomes for different groups with reference to an index number, for example, as a multiple of the poverty rate, and the percentage of national income received by different income classes. these are all valid measures of income inequality and changes in income inequality. see weinberg, supra. 62. see supra note 51 and accompanying text. 63. see supra figure 3. 64. that the figures used in figure 3 include all federal taxes, and thus reflect the effect of the social security payroll tax, which taxes a larger proportion of the income earned by those at the bottom of the income scale, does not detract from the conclusions we seek to draw from these data. first, income tax rates declined precipitously, as shown in tables 1 and 2. second, our point is that the share of taxes paid by the 26 florida tax review [vol. 4:1 looking at the distribution of after-tax income also exposes the failure of income tax rates to reflect the increasing importance of winner-take-all markets. while those in the lowest quintile saw their share of income decline by 25% between 1977 and 1990, those in the top 1%, the winners, saw their share increase by 67%. the result of this trend is that by 1990, families in the65 top quintile had over 50% of the income.66 the graph in figure 4, below, which compares 1977 to 1990 on an after-tax basis, shows that the top 10% gained while everyone else lost, and that the gains enjoyed by the top 1% far outstripped the gains for the remainder of the decile.67 winners has failed to keep pace with their share of income, as these data graphically reveal, and that the federal income tax, whose graduated structure is extant and familiar, should be used to bring the share of taxes paid by the winners more into line with the relative increases in their income. 65. derived from 1993 greenbook, supra note 7, at 1507 tbl. 18. 66. see supra figure 1. 67. the discrepancies revealed so graphically earlier in the text are not a function of aberrations for a few individuals at the top of each income segment. analysis of changes in average adjusted preand aftertax income shows the same kind of discrepancies. changes in average adjusted pre-tax income for all individuals quintile 1977 1990 percentage change lowest 0.96 0.84 -12.8% 2d 2.12 2.06 -2.8% 3d 3.20 3.31 +3.4% 4th 4.51 4.89 +8.5% 81 to 90% 6.13 6.94 +13.2% 91 to 95% 7.88 9.19 +16.5% 96 to 99% 11.37 14.23 +25.1% top 1% 32.80 57.07 +74.0% 1993 greenbook, supra note 7, at 1498 tbl. 12 (income is expressed as a multiple of the poverty threshold and quintiles are weighted by persons.). 1998] winner-take-all markets 27 figure 4 percentage change in shares of after-tax income 1977-199068 changes in average adjusted after-tax income for all individuals quintile 1977 1990 percentage change lowest 0.87 0.76 12.2% 2d 1.79 1.73 -3.2% 3d 2.57 2.66 +3.3% 4th 3.52 3.81 +8.1% 81 to 90% 4.67 5.26 +12.5% 91 to 95% 5.90 6.85 +16.2% 96 to 99% 8.29 10.52 +26.9% top 1% 21.21 42.08 +98.4% 1993 greenbook, supra note 7, at 1500 tbl. 13 (income is expressed as a multiple of the poverty threshold and quintiles are weighted by persons.). 68. derived from 1993 greenbook, supra note 7, at 1507 tbl. 18. the greenbook data from which figure 4 was generated is as follows: shares of after-tax income 1977-1990 quintile 1977 1990 percentage change lowest 5.7% 4.3% -25% 2d 11.6% 10.0% -14% 3d 16.3% 15.1% -7% 4th 22.8% 21.8% -4% 81 to 90% 15.6% 15.0% -4% 91 to 95% 9.8% 10.0% +2% 96 to 99% 11.2% 12.3% +10% top 1% 7.3% 12.2% +67% 28 florida tax review [vol. 4:1 despite the numerous odes to base broadening sung by its proponents, the ‘86 act failed to increase the base of those at the top of the income scale enough to make up for the rate reductions it granted. indeed, base broadening might69 have hit taxpayers in the middle quintiles more heavily than those at the top, enhancing the salutary effect of the rate cuts for the winners.70 69. as gene steuerle has chronicled, although “a drop of about one-third in the top rate required about a 50 percent expansion of the tax base for the group of taxpayers paying that rate of tax.” steuerle, supra note 34, at 113. it was difficult to expand the base by that much because a large portion of the income of individuals at the top income levels came from interest and dividends, which were already considered to be overtaxed because of the corporate tax on dividend income and the taxation of the inflationary component of interest and so were not likely targets for base broadening; full taxation of capital gains would not have sufficed and elimination of the deduction for state and local income taxes did not survive the political process. steuerle, supra note 34, at 112-14. elimination of tax shelters through the restrictions on passive activity losses (§ 469), one of the more salient accomplishments of the ‘86 act, did result in base broadening. see id. at 113. this probably accounts for at least some of the increase in the share of taxes paid by those subject to the top rate. see pollack, supra note 30, at 98-106; timothy j. conlan et al., taxing choices, the politics of tax reform 26-30 (1990). 70. this would occur if the impact of the back door base broadening provisions—the floor on miscellaneous itemized deductions (§ 67), the reduction in all but a few itemized deductions (§ 68), and the phaseout of dependency exemptions (§ 151)—hit taxpayers in the bottom half of the fifth quintile more heavily than those in the top half. this could occur because the loss of deductions is not infinite and the portion of the deduction that remains after application of the various limitations is worth proportionately more to a taxpayer facing the top bracket. moreover, the back door progressivity provisions inserted into the ‘86 act through surtaxes and evanescent bubbles only served to insure that those with more than a certain amount of taxable income paid tax at an effective rate of 28%; while that made the system more progressive than it would otherwise have been, it did not make the system more progressive than it was prior to the early ‘80's rate reductions. in addition to the brackets provided in §§ 1(a), (b), (c), (d) and (e), the ‘86 act phased out the 15% bracket and the personal exemptions at various 1998] winner-take-all markets 29 c. distribution of income in the 90s according to census bureau data, for 1994 the average household income was $43,133, but the median household income was only $32,264.71 the distribution of incomes, by quintiles, was as shown in table 4.72 table 4 household income by income group for 199473 upper limit for percent of aggregate quintile average income the quintile household income 1st $ 7,762 $13,426 3.6% income levels (§ 1(h) as in effect immediately after amendment by the ‘86 act), and provided for a marginal rate “bubble” designed to make the effective rate 28% at certain income levels. for a somewhat different view of the potential effect of floors, see louis kaplow, the standard deduction and floors in the income tax, 50 tax l. rev. 1 (1994)(with certain adjustments elsewhere in the system, floors and the standard deduction can operate in identical ways). 71. bureau of the census, table h-7, divisions--households (all races) by median and mean income: 1976 to 1997 (last modified nov. 8, 1998) <http://www.census.gov/hhes/income/histinc/h07.html>. 72. the census bureau used a variety of measures of income over the year, particularly varying whether to take into account taxes and both cash and noncash transfer payments. although taking taxes and transfer payments into account somewhat levels inequality, the alternative methods do not alter the trends. see weinberg, supra note 61. 73. bureau of the census, table h-1, income limits for each fifth and top 5 percent of households (all races): 1967 to 1997 (last m o d i f i e d n o v . 6 , 1 9 9 8 ) <http://www.census.gov/hhes/income/histinc/h01.html>; bureau of the census, table h-2, share of the aggregate income received by each fifth and top 5 percent of households (all races): 1967 to 1997 (last m o d i f i e d n o v . 6 , 1 9 9 8 ) <http://www.census.gov/hhes/income/histinc/h02.html>; bureau of the census, table h-3, mean income received by each fifth and top 5 percent of households (all races): 1967 to 1997 (last modified nov. 6, 1998) <http://www.census.gov/hhes/income/histinc/h03.html>. the data for these years are slightly different in weinberg, supra note 61, but the differences are not significant. 30 florida tax review [vol. 4:1 2d $ 19,224 $25,250 8.9% 3d $ 32,385 $40,100 15.0% 4th $ 50,395 $62,851 23.4% 5th $105,945 49.1% within the top quintile, incomes were markedly skewed toward the top 5%. the average income for the top 5% was $183,044, and the threshold for entry into the top 5% was $109,821. the top 5%'s share of aggregate household income74 was 21.2% of the total household income in the united states. however one75 looks at the data, the conclusion is inescapable: a disproportionately large share of the income is earned by a small percentage of the population.76 74. see table h-1, table h-3, supra note 73. 75. see table h-2, supra note 73. 76. this conclusion remains unchanged even when different measures of income distribution are used. thus, another way to look at the data is to compare income groups’ income when measured as a percentage of the poverty rate. this measure is illustrated in the following table, drawn from data published in, data on poverty, which appears as appendix h in the committee on ways and means, overview of entitlement programs, 103d cong., 2d sess. (comm. print 1994) [hereinafter 1994 greenbook], and reflects changes in incomes between 1979 and 1992 measured as a multiple of the poverty rate. average income as a multiple of poverty rate, 1979 and 1992 quintile 1979 1992 c h ange lowest .90 .77 -14.4% 2d 2.06 1.95 -5.4% 3d 3.27 3.10 -5.2% 4th 4.32 4.55 +5.3% 5th 7.39 8.36 +13.1% see id. at 1196 tbl. h-21. neither the 1994 ways and means data nor the census bureau data provide detailed information on subgroups within the top quintile, but data from the 1994 greenbook, which compare 1977 and 1990, do provide some more detailed information. income as a multiple of the poverty rate separately stated within the top 10% reveals vast disparities 1998] winner-take-all markets 31 the census bureau data do not make any further distinctions within the top quintile, but the greenbook provides such data for 1990 and selected earlier years. table 5 illustrates the average family income and percent of aggregate income, by income group, for 1990. the overall average household income in that year was $39,429.77 table 5 average family income in the top quintile—199078 percentile average percent of aggregate 81 to 90% $ 60,719 15.4% 91 to 95% $ 78,226 10.4% 96 to 99% $120,090 12.9% within the top quintile. according to the 1994 greenbook, the overall change from 1977 to 1990 was a 14% increase, and the top quintiles average adjusted income increased from 8.95 times the poverty rate in 1977 to 11.47 times the poverty rate in 1990, for an increase of 28.1%. these numbers are deceiving, however, because of the concentration of incomes in the top 5% and the even greater concentration within the top 1%, as illustrated below. average income as a multiple of poverty rate, top quintile details, 1977 and 1990 1977 1990 change 81 to 90% 6.13 6.94 +13.2% 91 to 95% 7.88 9.19 +16.6% 96 to 99% 11.37 14.23 +25.1% top 1% 32.80 57.07 +74.0% 1993 greenbook, supra note 7, at 1498 tbl. 12. the foregoing data demonstrate that incomes are very unequal and that the inequality has been increasing. 77. according to the census bureau data, the average household income for 1990 was only $37,403. bureau of the census, table h-12, earners–households (all races) by median and mean income: 1980 to 1 9 9 7 ( l a s t m o d i f i e d n o v . 6 , 1 9 9 8 ) <http://www.census.gov/hhes/income/histinc/h12.html>. 78. derived from 1993 greenbook, supra note 7, at 1486 tbl. 10, 1506 tbl. 17. 32 florida tax review [vol. 4:1 top 1% $507,185 12.8% over one-half of all income was concentrated in the top quintile, and more than one-half of that amount (one-quarter of all income) was concentrated in the top 5%. the greenbook data reveal further details regarding the significant disparities within the top quintile and the significant disparity between the top 1% and the remainder of the top 5%. average income for a family in the 91st to 95th percentiles was slightly less than twice the overall average income. average income for the 96th to 99th percentiles was slightly more than three times the overall average. average income for the top 1% was more than twelve times the overall average. the winners really are different from the rest of us.79 the greenbook data do not break down the top 1%, but data from the internal revenue service, statistics of income, provide some insight into the differences within that range. for 1992, the top 1% of income tax returns, ranked by positive income, consisted of returns with at least $250,000 of positive income. thus, the top 1% includes not only fortune 500 ceos,80 leading entertainers and athletes, wall street investment bankers and lawyers, but hundreds of thousands of successful professionals and business owners all across the country. within the top 1% of tax return filers, which is a smaller81 79. table 5 also illustrates that average income is a deceptive concept for measuring general well-being of the average citizen because it reveals nothing about distribution. the 1990 average income of $39,429 was nearly $10,000 more than the average income of the third quintile. average does not mean typical. average does not even approach typical. the average income of the fourth quintile was barely $4,000 above the average overall income. distribution is important in measuring the well-being of the citizenry as a whole. thus, average income is a facile but deceptive yardstick on which to base tax policy decisions. an increase in per capita income may mask welfare losses by the majority of the population. likewise, a decrease in average income might not result in a welfare loss for the majority of the population. 80. this group represented 1,183,989 out of 111,210,660 income tax returns, or 1.06%. statistics of income division, internal revenue service, pub. no. 1304, individual income tax returns 1992, at 20 (1995). 81. for a demographic description of the top 1%, see edward n. wolff, who are the rich? a demographic profile of high-income and high-wealth americans (presented at the conference, “does atlas 1998] winner-take-all markets 33 group than the top 1% of the population as a whole, the potential disparities are even more dramatic than suggested by the preceding data. the number of return filers for various positive income groups within that top 1% was as shown below in table 6. the data reveal that the disparities in income within the top and bottom of the fifth quintile are significantly greater than those between the top and bottom of the fourth quintile. table 6 distribution of top one percent by income range 1992 income range number $ 251,000 $ 499,999 824,083 $ 500,000 $ 999,999 250,233 $ 1,000,000 $1,999,999 73,453 $ 2,000,000 $4,999,999 27,312 $ 5,000,000 $9,999,999 5,839 $10,000,000 or more 3,066 thus, although the average income for the top 1% may be just a shade over $500,000, the median income looks to be well below that amount. a very few households at the very top of the top of the distribution have vastly disproportionate incomes even when measured against the bottom half of the top 1%. a recent study by james alm and sally wallace underscores the magnitude of the gap between individuals at the very top of the income distribution and others, even others within the rarefied atmosphere of the top 1%. based on individual tax model files obtained from the irs statistics of82 income division, alm and wallace estimated that in 1989 individuals in the top 1% had 14.39% of all income, but individuals in the top one-half of 1% had 10.96% of the income. this means that individuals in the top half of the top83 1% received over 75% of the income of that group. that pattern of concentration at the top of the top was repeated in 1994, when individuals in the top 1% claimed 13.73% of all income, but those in the top half of that group received 10.47% of the total.84 shrug? the economic consequences of taxing the rich,” october 2425, 1997, office of tax policy research, university of michigan business school [hereinafter atlas shrug conference], on file with the authors, to be published by the cambridge university press). 82. james alm & sally wallace, are the rich different? 29 tbl. 5, presented at atlas shrug conference, supra note 81. 83. id. 84. id. 34 florida tax review [vol. 4:1 the dramatic differences within the top quintile reveal both the need to analyze this quintile more closely when formulating tax policy and the flaw in treating everyone in the top quintile alike. moreover, the dramatic85 differences within the top 1% itself show that even treating everyone within this relatively small group alike is inapt. those in the 5th quintile may all be winners relative to the rest of the population, but the top 1% wins on a very different scale from the rest of us, and those at the top one tenth of 1% win on a very different scale from the rest of the top 1%.86 85. most studies of popular notions of progressivity examine perceived fairness of differing marginal tax rates at income levels below $100,000 and lump together all persons with income over $100,000. see steven m. sheffrin, perceptions of fairness in the crucible of tax policy, in tax progressivity and income inequality 309 (joel b. slemrod ed., 1994), peggy a. hite & michael l. roberts, an experimental investigation of taxpayer judgments on rate structure in the individual income tax system, 13 j. am. tax assoc. 47 (1991). 86. the differences are revealed both by examples from the traditional winner-take-all markets—sports and entertainment—as well as from the evolving winner-take-all market of the corporate world. thus, forbes reports that entertainers still tend to be at the very top of the heap and provides useful insight into the size of winnings. see robert la franco, the top 40, forbes 162 (sept. 22, 1997). the number one earner in the entertainment industry for the two year period 1996 and 1997, steven spielberg, made $283 million in 1997 and $30 million in 1996, for a two-year total of $313 million. the runner up, george lucas, made $189 million in 1997 and $52 million in 1996, for a two-year total of $241 million. number three, oprah winfrey, made $104 million in 1997 and $97 million in 1996, for a total of $201 million. by comparison, michael crichton, whose income was only half of oprah’s—$65 million in 1997 and $37 million in 1996, for a total of $102 million, seems almost penurious. jerry seinfeld, david copperfield, steven king, tom cruise, arnold schwartzenegger, and harrison ford all made more than $70 million over the two year period. tim allen, john grisham, john travolta, garth brooks, roseanne, michael jackson, tom clancy, and robin williams were among those earning $50 million or more. bill cosby, number 40 on the list, earned $36 million during 1996 and 1997. see id. 1998] winner-take-all markets 35 athletes do well too. in december, 1997, pedro martinez, a 26 year old pitcher, signed a six-year contract with the boston red sox for $75 million; the average annual value of the contract was $12.5 million. see murray chass, martinez’s $75 million for 6 years raises bar, n.y. times, dec. 11, 1997, at c1. that was the top baseball salary; second place went to greg maddux, who will receive an average of approximately $11.5 million per year for five years from the atlanta braves. the average salary for major league baseball players in 1997 was $1,336,609. see murray chass, sultans who swat: d.h.’s are well paid, n.y. times, dec. 3, 1997, at c7. over the next six years, the minnesota timberwolves of the national basketball association will pay 21-year old kevin garnett $126 million, an average annual salary of over $20 million a year deal, while the venerable michael jordan had the highest annual salary in basketball, $36 million, see dave anderson, 1997 in review: amid all the achievements, a year of lost years, n.y. times, dec. 28, 1997, § 8, at 1, while patrick ewing averages $17 million a year from the n.y. knicks. coaches get big money as well. rick pitino left the university of kentucky to run the boston celtics for $70 million over 10 years, and chuck daly is getting $15 million over three years to coach the orlando magic. in professional hockey, top star eric lindros will receive $16 million over two years. the listings could go on and on. hundreds of major league baseball and football players make more than $1 million dollars a year. see claire smith, on baseball: for football union, a cap is no big deal, n.y. times, sept. 1, 1994, at b18. athletes do well off the field or court as well as on. for 1996 michael jordan was estimated to have earned $40 million from advertising endorsements alone. other endorsements earnings leaders included tiger woods, $25 million, shaquille o’neal, $23 million, arnold palmer, $19.2 million, andre agassi, $17 million, jack nicklaus, $16 million, grant hill, $15.5 million, joe montana, $12 million, and ken griffey, jr. and deon sanders, $6 million each. corporate ceos, while generally not in the same class as entertainers and athletes, do better than the average joe or jane. the 25 highest paid ceos between 1992 and 1996 collectively received over $2.5 billion in salaries and bonuses in that five year period. eric s. hardy, the prize, forbes, may 19, 1997, at 166. that’s an average of over $20 36 florida tax review [vol. 4:1 d. legislative reaction to the tax cuts of the 80s the enormously disproportionate tax cuts accorded to the very highest income class in the 1980s helped fuel the income disparities described above and set the stage for the 1993 tax increases, in the form of the 36% bracket for taxable incomes between $140,000 and $250,000 (married, filing jointly), and the 39.6% bracket on taxable incomes over $250,000. despite claims of some87 million a year each. lawrence m. coss of green tree financial may have distorted the averages, however, by getting over $102 million for just that year. by comparison, notables like michael eisner of disney and jack welch of general electric received $8.65 million and $6.3 million respectively. eight of the top 25 ceos received more than $5 million for 1996 and ten received between $2 and $5 million. see id. notably, we have not mentioned bill gates, whom we believe to be in a class by himself. significant numbers of investment bankers are reported to have earnings comparable to the mid-level forbes top-40 entertainers, and some lawyers are reported to have incomes approaching those of the typical top-25 ceo. see kevin phillips, the politics of rich and poor: wealth and the american electorate in the reagan aftermath 173-76 (1990). the bull market that was still going strong until august, 1998, has been so good to wall streeters that they are redefining the term conspicuous consumption by spending well over a quarter of a million dollars on country club memberships or home sound systems, and over $2,000 for suits. see brian o’reilly, spoils of a pig market, fortune, sept. 7, 1998, at 116. it is also possible that numerous owners of closely held businesses, entrepreneurs whose incomes are not public record, may be within the select group. but then so might securities traders and arbitrageurs. in the end, the best that can be said is that we can obtain only random glimpses of the identities and activities, and thus the social contribution, of the big winners, and accordingly no single categorization or generalization is fair. 87. revenue reconciliation act of 1993, pub. l. no. 103-66, §§ 13201(a), 13202(a)(1), 105 stat. 312, 458, 461 (1993). as a result, the share of total federal taxes paid by the top 1% increased from 14.9% in 1990 to 15.8% in 1994, and the share of taxes paid by the remainder of 1998] winner-take-all markets 37 politicians and commentators that the 1993 rate increases had a broad impact, they affected less than 4% of taxpayers—those at the very top of the income distribution. nevertheless, such rate increases were unprecedented in88 peacetime. why, then, were they enacted? three factors appear to have89 converged to lead to these new higher rates. first, the budget deficit may have created the perception of an almost war-like financing crisis. second, taking into account both income and fica90 taxes, both of which reduce current after-tax income, and which individuals the top 5% increased from 14.9% to 15.2%; the share of all other groups decreased. 1993 greenbook, supra note 7, at 1515 tbl. 25. 88. see therese m. cruciano & michael strudler, individual income tax rates and tax shares, 1993, 16 stat. inc. bull. 7, 10 fig. c (1996). 89. see supra part ii.a. 90. professor sheldon pollack has observed that, “the enduring budget crisis continued to play a crucial role in orienting tax policy making in 1993.” pollack, supra note 30, at 132. during the 1992 presidential campaign, candidate clinton emphasized the need to address the deficit. see, e.g., clinton suggests deficit may cancel a tax cut, wall st. j., january 14, 1993, at a18. when he presented his economic program to congress in his first state of the union address in february, 1993, president clinton expressed his support for the so-called “millionaire’s surtax” championed by congressional democrats since the early 1990s and proposed the marginal rate increases that became law later that year. pollack, supra note 30, at 125-26. for a good analysis of the political forces that led to the 1993 rate increases, including an analysis of other 1993 proposals (like the btu or energy tax) that did not become law, see pollack, supra note 30, at 125-33. professor daniel shaviro, who more recently undertook a comprehensive study of deficits generally, also attributes the tax increases of the 1990s, as well as the rate increases of 1982, 1984, 1987, 1990 and 1993 to concern over the deficit. daniel shaviro, do deficits matter? 2526 (1997). (the large rate reductions to which we have referred occurred in 1981 and 1986.) indeed, professor shaviro has observed that “[t]he reagan deficits may have been designed in part to create pressure for spending reductions in domestic programs. in their aftermath, however, deficit reduction through tax increases became an occasional democratic party theme. . . .” id. at 26. 38 florida tax review [vol. 4:1 may perceive as commingled, the rate increases hit those who actually got the91 overall tax rate reductions that exacerbated the deficit. third, as willie sutton92 91. although middle income americans whose full salary is subject to payroll taxes pay more in payroll taxes than in income taxes, they probably view their federal burden as the difference between their gross and net pay, and attribute it all to the federal income tax. see chris r. edwards, typical american family pays 40 percent of income in taxes, 66 tax notes 735 (jan. 30, 1995). for a fuller discussion of the relationship between the burdens imposed by the payroll and income taxes, see alice g. abreu, taxes, power, and personal autonomy, 33 san diego l. rev. 1, 39-50 (1996). 92. the 1993 rate increases added two brackets, 36% and 39.6%, which apply to joint filers with taxable income above $140,000 and $250,000, respectively. pub. l. no. 103-66, §§ 13201(a), 13202(a)(1), 107 stat. 457-58, 61 (1993). thus, the rate increases apply to those individuals who received the benefit of the previous rate reductions. the following tables show the effect of the 80’s rate reductions. change in average overall tax rates: 1977-1990 quintile percent change lowest -3.8% 2d 1.9% 3d -0.3% 4th 1.0% 5th -6.3% 1993 greenbook, supra note 7, at 1513 tbl. 24. changes in federal effective tax rates holding income and demographics constant at 1989 levels and applying 1977 and 1989 tax laws quintile percent change lowest 8% 2d 17% 3d 12% 4th 9% 5th -5% 1998] winner-take-all markets 39 is reputed to have answered when asked why he robbed banks, “that’s where the money is.” as prominent political analyst kevin phillips has observed, the 1980s were “an era of tax deception . . . where the average american family was concerned.” as the tables and graphs we have included in this part93 demonstrate, phillips was right, for despite all of the rhetoric of tax reduction, families in the middle quintiles saw their share of the tax burden rise even as their share of income was declining. only families in the top 5% saw their94 share of income rise more steeply than their share of taxes, and only families in the top 1% saw that happen dramatically. that’s where the money went.95 the 1993 rate changes are so new, relatively speaking, that long term data on their effects does not yet exist. to be sure, the data indicate that the96 average income tax rates for the highest income earners have increased slightly since the 1993 rate changes took effect, but have remained relatively stable since then. table 7 illustrates the changes by agi income classes. table 7 average income tax rates by agi class approximate average income tax rate income range percentage of by agi returns 1992 1993 1994 199597 98 99 100 separately stated within the top 10% 81-90% 9% 91-95% 9% 95-99% 1% top 1% -26% 1993 greenbook, supra note 7, at 1539 tbl. 35. 93. kevin phillips, boiling point: democrats, republicans, and the decline of middle class prosperity 103 (1993)(emphasis in original). 94. see supra figure 3. 95. id. 96. as we go to press, in the fall, 1998, the latest statistics of income bulletin in print is spring, 1998, which contains 1994 and 1995 tax return data. 97. therese m. cruciano, individual income tax returns, preliminary data, 1993, 14 stat. inc. bull. 9, 10 fig. b (1995). 98. therese m. cruciano, individual income tax returns, 40 florida tax review [vol. 4:1 $100,000 $199,999 4.0 18.4 18.5 18.5 18.3 $200,000 $499,999 1.2 23.9 25.7 25.6 25.6 $500,000 $999,999 .2 26.1 30.3 30.2 30.2 $1,000,000 or more .1 27.2 31.7 31.2 31.5 these rate increases—which generally affect only those in agi classes above $200,000—are the result of the combined effects of the higher income tax rates enacted in 1993 and the operation of the alternative minimum tax; the exact101 source of the changes cannot easily be isolated. more importantly, the post1992 increases in the effective average tax rates for the top 1% are relatively modest compared to the tax cuts accorded this group during the 1980s, and102 do not begin to match the increased rate of growth in the income of this group.103 furthermore, whatever increase in effective rates the top 1% may have experienced as a result of the 1993 rate increases was probably only transitory. existing data necessarily fail to take account of the dramatic changes made to the tax law in 1997 and, again, in 1998. the 1997 legislation dramatically104 lowered the maximum rate of tax on capital gains, and the 1998 legislation enhanced that benefit by reducing the holding period necessary to obtain the lowest possible rate. since most capital gains are realized by high-income105 preliminary data, 1994, 15 stat. inc. bull. 6, 7 fig. b (1996). 99. therese j. cruciano, individual income tax rates and tax shares, 1995, 17 stat. inc. bull. 11, 13 fig. b (1998). 100. id. 101. revenue from the alternative minimum tax (“amt”) increased dramatically—by 51.3%—in 1993, and continued to increase in 1995. see cruciano, supra note 99, at 17. 102. see supra table 2. 103. see supra text accompanying notes 68-86. 104. see the taxpayer relief act of 1997, pub. l. no. 105-34, § 311, 111 stat. 788, 831 (1997) [hereinafter 1997 act]; internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, § 5001, 112 stat. 685, 787 (1998). 105. while we cannot attempt a comprehensive analysis of the effects of the 1997 act at this juncture, that piece of legislation so exemplifies the trends we have observed and decry, that we cannot resist a few observations. for example, by creating back-loaded individual retirement accounts, the act threatens to so divorce the tax burden from any measure of ability to pay that at least one noted economist has 1998] winner-take-all markets 41 taxpayers, it is not farfetched to surmise that most of the substantial benefits106 wrought by the 1997 and 1998 changes went to the million dollar winners.107 for them, the mid-1990s increased effective tax rates very likely were just a temporary blip that was fixed by a sympathetic congress shortly thereafter. and the congressional sympathy only keeps growing, as talk of further reductions in the capital gains rates runs rampant.108 likened it to replacing income and consumption taxes with a head tax. gene steuerle, back-loaded iras: head taxes replace income & consumption taxes, 77 tax notes 109 (oct. 6, 1997). similarly, by dramatically reducing the rate of tax on capital gains, but not on other types of income, the 1997 act further widens the gulf between increases in income and increases in income taxes. see 1997 act, supra note 104, at 831; jane g. gravelle, crs distributional estimates find wealthy would win under tax bill, 74 tax notes 281 (jul. 14, 1997)(reprinting a congressional research service distributional analysis of the 1997 act prepared by dr. jane g. gravelle). 106. in 1995, approximately 1.07% of returns reporting an agi of $200,000 or more reported 59.57% of all net long-term capital gains from the sale of assets. within that group, .22% of returns reporting agi in excess of $500,000 reported 43.71% of capital gains, and .07% of returns reporting income of $1,000,000 or more reported 34.77%. data derived from therese m. cruciano, individual income tax returns, 1995, 17 stat. inc. bull. 9, 24 tbl. 1 (1997). it is reasonable to believe that most of these gains are reported by taxpayers who consistently report capital gains, not by the apocryphal low or middle income farmer or small business owner who realizes a one-shot capital gain. for analysis of capital gains realizations over time, indicating that individuals realizing capital gains generally are not in the highest income group by reason of one-shot or occasional recognition of capital gain, but tend to realize capital gains regularly, see michael haliassos & andrew b. lyon, progressivity of capital gains taxation with optimal portfolio selection, in tax progressivity and income inequality 275 (joel slemrod ed., 1994). 107. see cruciano, supra note 99, at 16. 108. for example, during each week in the period from the beginning of august, 1998, through the day after labor day, 1998, there was at least one, and often many more than one, major story on a capital gains tax cut proposal, nothwithstanding that congress recesses in august, and much of the rest of the world is supposed to be on vacation. 42 florida tax review [vol. 4:1 e. the question of income mobility an individual’s income is rarely static. before embracing an analytical model grounded in the distribution of income we must therefore consider whether that distribution reflects only transitory fluctuations in income that average out over the course of a lifetime, or whether it reflects enduring differences in income over the long term. in populations where there is a great deal of income mobility, with individuals frequently moving across a wide range of income classes within short periods of time, the distribution of income provides a less compelling model for the design of the rate structure than in populations where the distribution of income remains fairly constant, within one or two categories. examination of available data leads us to conclude that the analytical model we propose is sound even after taking into account the possibility of income mobility. while americans experience “significant” income fluctuations from year to year, the data do not support the conclusion that109 many households oscillate between broadly defined income classes. indeed, it is fair to say that most income mobility appears to result from life-cycle variations in wages, not from wide fluctuations in income realized by individuals while within any particular age cohort.110 according to one leading study, only 13.8% of those who are in the bottom 30% for any given year are in the top 30% over their lifetime, and only 2.6% of those who are in the top 30% for any particular year are in the bottom see, e.g., heidi glenn & daniel tyson, congress’s homestretch will highlight popular tax cuts, 80 tax notes 1111 (sept. 7, 1998); ryan j. donmoyer, presidential hopeful unveils $ 4 trillion tax cut plan, 80 tax notes 992 (aug. 31, 1998); rep. william j. coyne, coyne bill would reform capital gains tax laws, 80 tax notes 934 (aug. 24, 1998); senator charles e. grassley, grassley bill would cut capital gains, aid farmers, 80 tax notes 823 (aug. 17, 1998); tax analysts, tax cut talk fills the summer air, 80 tax notes 637 (aug. 10, 1998); heidi glenn, lott and others introduce capital gains cut, farm tax breaks, 80 tax notes 533 (aug. 3, 1998). 109. wilfred t. masumura, bureau of the census, moving up and down the income ladder, current population reports p70-56 (1996). 110. see joseph bankman & barbara h. fried, winners and losers in the shift to a consumption tax, 86 georgetown l.j. 539, 55861 (1998). 1998] winner-take-all markets 43 30% over their lifetime. top to bottom mobility is therefore quite rare, as is111 its converse, notwithstanding the emotional appeal of the american dream. focusing on those at the top of the pyramid, 90% of those in the top decile for their age cohort at age 49 were in the top two deciles at age 79, and only 2% of individuals in the top decile for their age cohort at age 49 had fallen below the top three deciles by age 79. at the top, then, almost all of the mobility is up,112 not down. this finding is confirmed by “other studies [which] show income mobility within one or two deciles, but not much income mobility across more dispersed deciles,” within any particular age cohort. in sum, the data on113 income mobility do not impugn the case for progressive taxation. iii. equity, efficiency, and the diminishing marginal utility of money debates over progressive taxation have divided scholars into those who champion efficiency over equity and those who favor equity over efficiency.114 111. don fullerton & diane lim rogers, who bears the lifetime tax burden? 111 (1993). 112. id. at 109. 113. see bankman & fried, supra note 110, at 560. other data suggest that there is no reason to worry that widespread movement across income categories will impugn the integrity of an analytical model of the rate structure that is founded on the distribution of income. thus, from 1992 to 1993, for example, the census bureau data tell us that 39% of households saw their income decline by 5% or more, 39% of households saw their income grow by 5% or more, and 22% of households failed to experience any change as high as 5%, in either direction. similar patterns occurred from 1990 to 1991 and from 1991 to 1992. nevertheless, our focus is the relationship between the economic position of individuals whose annual incomes exceed half a million dollars, and that of individuals making $50,000, $75,000, or even $150,000 per year. fluctuations of 5%, or even 10 or 15%, per year are not significant enough to support treating those individuals as if they were similarly situated over their lifetimes. 114. over 20 years ago, arthur okun analogized the tradeoff to taking from the poor to give to the rich, but carrying the money in a leaky bucket; the amount of leakage was the loss in efficiency, and the policy question was how much leakage should be tolerated. okun, supra note 44 florida tax review [vol. 4:1 the scholarly literature on the equity/efficiency tradeoff is rich and varied.115 equity and efficiency generally have been viewed as mutually exclusive objectives between which policy makers must choose. during the 80s,116 concerns over efficiency carried the day, producing the inequitable distribution of income described in part ii. we aim to show that the equity/efficiency tradeoff is a mirage. an efficient tax system need not produce the lopsided distribution of income that now exists. we will now show that progressive taxation can be efficient. in part iv, we will show why we think it is also equitable. a. the diminishing marginal utility of money and equiproportional sacrifice the most persuasive arguments for the equity of progressive taxation rest on the concept of the diminishing marginal utility of money and the proposition that taxation ought to exact equiproportional sacrifice. if the117 marginal utility of money declines as the amount of money increases, then118 22, at 91. okun explained how some people—those motivated by rawls’ difference principle pursuant to which ‘all social values . . . are to be distributed equally unless an unequal distribution of any . . . is to everyone’s advantage’—would favor equality over efficiency whereas others, like milton friedman, would favor efficiency over everything else. okun, supra at 92 (quoting john rawls, a theory of justice 62 (1971)). favoring efficiency does not necessarily lead to favoring proportional taxation, however. optimal tax theorists, who would impose high rates of tax on inelastic transactions, show that efficiency and proportionality need not follow one from the other. see infra note 198. 115. see musgrave & musgrave, supra note 22, at 88-104; okun, supra note 22; feldstein, supra note 22, at 78 and sources cited in note 2 therein. 116. see musgrave & musgrave, supra note 22, at 88-104; okun, supra note 22; feldstein, supra note 22, at 78 and sources cited in note 2 therein. 117. equal sacrifice can mean equal absolute sacrifice, equiproportional sacrifice, or equal marginal sacrifice. equal absolute sacrifice does not necessarily warrant progression, but equal proportional sacrifice does warrant progression at some rate regardless of the rate at which the marginal utility of money decreases. equal marginal sacrifice calls for leveling of incomes from the top down, a proposition that finds little support. see musgrave & musgrave, supra note 22, at 250-55. 118. see generally mark s. stein, diminishing marginal utility 1998] winner-take-all markets 45 proportional sacrifice requires progressive rather than proportional tax rates.119 the proposition that money has diminishing marginal utility follows from the empirical observation that all of the goods and services that money purchases have diminishing marginal utility. nevertheless, some prominent120 scholars have argued that just because the things money can buy have diminishing marginal utility does not a priori establish that money itself has diminishing marginal utility and maintain that the diminishing marginal utility of money has not been successfully demonstrated on an empirical basis.121 these scholars therefore reject the notion that the diminishing marginal utility of money provides an equitable justification for progressive taxation.122 until the 1930s, neoclassical economics generally accepted the proposition that money had diminishing marginal utility. with the rise of the123 ordinalist economics movement in the 1930s, analysis based on the diminishing marginal utility of money fell out of favor, ostensibly because it was “unscientific” due to the inability precisely to measure utility and to make of income and progressive taxation: a critique of the uneasy case, 12 n. ill. l. rev. 373 (1992)(arguing that there is a diminishing marginal utility of income which means that there is a lesser sacrifice per dollar taxed for a high income taxpayer as opposed to a low income taxpayer); milton friedman & l.j. savage, the utility analysis of choices involving risk, 56 j. pol. econ. 279 passim (1948). 119. see donna m. byrne, progressive taxation revisited, 37 ariz. l. rev. 739, 765-69 (1995). 120. see id. at 767. 121. see blum & kalven, supra note 22, at 474; richard a. musgrave, the theory of public finance 102-03 (1959). some scholars also point to the development of modern welfare economics, which is based largely on absolute wealth maximization and treats all dollars as having equal utility. see david f. bradford, untangling the income tax 153-54 (1986); see also jules l. coleman, markets, morals and the law 98-100, 104-08 (1980); richard a. posner, the economics of justice 6088 (1981); john b. shoven & paul taubman, saving, capital income, and taxation, in the economics of taxation 202-04 (henry j. aaron & michael j. boskin eds., 1980); edward j. mccaffery, tax policy under a hybrid income-consumption tax, 70 tex. l. rev. 1145, 1155-57 (1992). 122. blum & kalven, supra note 22, at 457-60. 123. see herbert hovenkamp, the first great law & economics movement, 42 stan. l. rev. 993, 1031-38 (1990). 46 florida tax review [vol. 4:1 interpersonal utility comparisons. it has been suggested, however, that the124 ordinalist economists were actually concerned that some of the more prominent neoclassicists began to use marginal utility analysis generally as a basis for justifying wealth redistribution, a course that was politically unacceptable to most economists. and while modern welfare economics, an outgrowth of125 ordinalism, generally rejects the notion that money has diminishing marginal utility, many economists still accept the concept of the diminishing marginal126 utility of money. we do likewise for two principal reasons.127 first, we believe that to neglect the concept of the diminishing marginal utility of money is to ignore reality. the experiential case for the proposition128 124. in 1970, in his famous work, the cost of accidents, judge guido calabresi referred to the diminishing marginal utility of money as an “empirical generalization” that had fallen out of favor among economists because it could not be proven to be universally true and had been shown to be invalid in some cases. guido calabresi, the cost of accidents 39-40 (1970). thus, some studies showed that individuals might care more about a relatively small drop in amount of money that resulted in a drop in social status than about a relatively larger drop in amount of money that did not result in a loss of status. see friedman & savage, supra note 118. we do not dispute the conclusions reached by such studies (indeed, we acknowledge the importance of factors other than absolute wealth throughout this article), but we believe that the diminishing marginal utility of money is such an accurate generalization that it cannot be ignored in the formulation of tax policy. 125. see hovenkamp, supra note 123, at 1056-57. 126. see david f. bradford, untangling the income tax 153-54 (1986)(asserting that economics has rejected the concept of utility generally). 127. see joseph bankman & thomas griffith, social welfare and the progressive rate structure: a new look at progressive taxation, 75 cal. l. rev. 1905, 1947 (1987); feldstein, supra note 22, at 81 n.9. 128. the concept of the diminishing marginal utility of money serves as the foundation for positive law outside of the tax law. thus, in the law of torts, most states allow evidence of the defendant’s wealth to allow the jury to determine the size of an award for punitive damages. see dan b. dobbs, law of remedies, damages–equity–restitution 32830 (2d ed. 1993); douglas laycock, modern american remedies, cases and materials 673 (2d ed. 1994). as professor laycock has explained, “if 1998] winner-take-all markets 47 the jury is to figure out how large an award is necessary to punish and deter the defendant, it surely must know something of his wealth.” id. at 673. only a belief in the diminishing marginal utility of money can explain that statement and the positive law it reflects. indeed, professor dobbs has pointedly observed that evidence of the defendant’s wealth is generally admissible because [t]he trier must know something about the defendant’s financial condition in order to inflict a liability that will have an appropriate sting, and proof may show either a wealthy defendant or a poor one. punishment, in other words, is to fit the person, not the crime. some kinds of financial information about the defendant, if it is an enterprise, would also be highly relevant in determining the amount necessary to achieve a deterrence. dobbs, supra, at 329 (footnotes omitted); see also restatement (second) of torts § 908 cmt. e (1977) (wealth is relevant). although in recent years a debate over the propriety of what some commentators have labeled the “long-standing rule that the defendant’s wealth is relevant in determining punitive awards,” has ensued, the positive law has not changed and the very existence of the debate underscores both the tenacity and appeal of the concept of the diminishing marginal utility of money. see kenneth s. abraham & john c. jeffries, jr., punitive damages and the rule of law: the role of defendant’s wealth, 18 j. legal stud. 415, 415 (1989); jennifer h. arlen, should defendants’ wealth matter?, 21 j. legal stud. 413 (1992); thomas j. miceli & kathleen segerson, defining efficient care: the role of income distribution, 24 j. legal stud. 189 (1995); see also paul mogin, why judges, not juries, should set punitive damages, 65 u. chi. l. rev. 179, 209-10 (1998). indeed, the diminishing marginal utility of money has been used by judge guido calabresi to explain the theoretical foundation for loss spreading in the tort system. calabresi, supra note 124, at 39-42. scholars have also considered the role of a defendant’s wealth, and thus of the diminishing marginal utility of money, in the context of the criminal law. see, e.g., david d. friedman, reflections on optimal punishment, or: should the rich pay higher fines, 3 res. l. & econ. 185 (1981); a. mitchell polinsky & steven shavell, a note on optimal fines when wealth varies among individuals, 81 am. econ. rev. 618 48 florida tax review [vol. 4:1 that money has diminishing marginal utility is so strong that those who argue that it does not should be forced to bear the burden of proof. we believe that129 a dollar means more to a poor person than to a middle class person and that it means more to a middle class person that to a truly rich person. although the diminishing marginal utility of money is difficult to measure empirically, evidence does indeed support its existence. if we use objective criteria of the value of things purchased with money in addition to subjective preferences, evidence abounds. the purchase of casualty and130 liability insurance that costs more than the statistical value of an expected uninsured loss, is a common example of a transaction motivated by the diminishing marginal utility of money. a number of studies and experiments131 likewise support the concept of the diminishing marginal utility of money,132 and significant anecdotal evidence indicates that those with very high incomes attach very little value to tens of thousands, or even millions, of dollars. indeed, the spending habits of those who are extraordinarily wealthy are so out of sync with those of everybody else that they are even considered newsworthy.133 witness the $2 million birthday party that malcolm forbes threw for himself in morocco in 1989, or bill gates’ new $100 million mansion, or consider134 135 (1991). 129. see stein, supra note 118. 130. see herbert hovenkamp, marginal utility and the coase theorem, 75 cornell l. rev. 783, 810 (1990). 131. see id. at 798-99. 132. see id. at 799-801. 133. for example, on february 8, 1998, the new york times reported that michael jordan had chosen to skip some nba all-star activities (a press conference) to go play golf, even though doing so would result in the imposition of a $10,000 fine. steve popper, nba allstar weekend; illness lays jordan low, putting appearance in all-star game in jeopardy, n.y. times, feb. 8, 1998, § 8, at 1. 134. see it’s your party, the new republic 4 (sept. 11, 1989). 135. see richard folkers, xanadu 2.0, bill gates’s stately pleasure dome and futuristic home, u.s. news & world report, dec. 1, 1997, at 87. although the residence is described as “the $100 million gates mansion in medina, wash.,” costs had apparently not reached $100 million figure at press time, although they were expected to, given the mammoth scale on which the house is being built. id. the structures on the property have a total square footage of over 66,000 square feet, with the family wing occupying 11,500 square feet, and the formal dining 1998] winner-take-all markets 49 ross perot and steve forbes’s self-financed runs for the presidency. the message is clear: each additional dollar spent means very little, if anything at all, to the super-rich. second, we simply disagree with those who reject the proposition of the diminishing marginal utility of money because of the difficulty of measuring the rate at which utility declines or the existence of individual differences in utility. while each of those things contributes to making136 quantifiable, empirically provable assertions impossible, they do not render the theory a nullity. we know that many things that are neither quantifiable nor empirically provable both exist and affect general well-being. in formulating137 public policy the welfare of the citizenry should be the primary goal. while welfare may be measured in either dollars or utility, to measure wealth138 maximization without regard to distribution—that is, to measure wealth in aggregate dollars—is to abdicate important decisions about overall societal welfare. modern welfare economics may reject interpersonal utility comparisons as “unscientific,” but policy makers cannot conscionably ignore such comparisons. economists who refuse to make interpersonal utility comparisons forfeit the ability to provide useful advice regarding the course of action that ought to be taken by policy makers who must consider the distribution of wealth in america.139 opponents of progressive taxation have also argued that even acceptance of the diminishing marginal utility of money does not produce equiproportional sacrifice because it is possible to construct utility curves for room alone occupying 1,000 square feet. id. at 88-91. the property is reported to have a total assessed value of $53,392,200. id. at 91; see also, wendy goodman, a classicist in cyberspace, harper’s bazaar, dec. 1995, at 178. 136. see lionel robbins, the nature and significance of economic science, in philosophy of economics: an anthology, 130-32; avery w. katz, positivism and the separation of law & economics, 94 mich. l. rev. 2229, 2248 (1996). 137. consider love, or hate. 138. see coleman, supra note 121, at 100-03, 106-08. 139. see hovenkamp, supra note 123, at 1048; jeffrey l. harrison, piercing pareto superiority: real people and the obligations of legal theory, 39 ariz. l. rev. 1, 2 (1997)(“because economics must and does steer clear of interpersonal comparisons of utility, it really is of no help in determining when one distribution is better or worse than another.”). 50 florida tax review [vol. 4:1 which progression does not produce equal proportional sacrifice. this occurs140 if marginal utility does not decline more rapidly than average utility. such a141 utility schedule is in all likelihood unusual, and the possible existence of142 idiosyncratic utility preferences should not drive the formulation of tax policy. the theory of equiproportional sacrifice based on the diminishing marginal utility of money also requires use of the simplifying assumption that all individuals have the same income-utility curve. opponents of progressive143 taxation often argue that because not everyone has the same utility curve and interpersonal utility comparisons are impossible, a progressive tax based on interpersonal utility comparisons is unfair because it is based on unrealistic simplifying assumptions.144 even detractors of progressive taxation make interpersonal utility comparisons, however. the conclusion that all dollars have equal utility to all taxpayers, which justifies proportional, rather than progressive, taxation, itself reflects a particular interpersonal comparison. similarly, the argument that uncertainty about the degree of interpersonal utility differences requires treating all taxpayers alike, also reflects a particular interpersonal comparison145 and has the same effect as one based on the assumption that the marginal utility of money is equal for everyone. in short, interpersonal utility comparisons may be difficult to make generally and impossible to make precisely, but they are nevertheless essential to making a rational choice regarding the structure of the tax system.146 140. musgrave, supra note 121, at 100-02; jeffrey a. schoenblum, tax fairness or unfairness? a consideration of the philosophical bases for unequal taxation of individuals, 12 am. j. tax pol’y 221, 241-42 (1995). 141. see musgrave, supra note 121, at 98. 142. see blum & kalven, supra note 22. 143. see musgrave, supra note 121, at 99. 144. see, e.g., schoenblum, supra note 140, at 241-42; musgrave, supra note 140, at 108-10. for a more general discussion of the rejection of interpersonal utility comparisons, see gary lawson, efficiency and individualism, 42 duke l.j. 53, 63-71 (1992). 145. see bankman & griffith, supra note 127, at 1947. 146. see louis kaplow, a fundamental objection to tax equity norms: a call for utilitarianism, 48 nat’l tax j. 497, 506 (1995); see also feldstein, supra note 22, at 79. indeed, many real world judgments are made on the assumption that interpersonal utility comparisons are possible. see hovenkamp, supra note 130, at 810 n.73. 1998] winner-take-all markets 51 b. proof and imprecision if the case for progressive taxation cannot be established for lack of precise knowledge, neither can the case for proportional taxation. the decision boils down to deciding who needs to prove what to whom. for us, the strength of the u.s. economy over the last 50 years and the remarkable stability of its political system suggest that the assumptions upon which progressive federal income taxation is based are sound. logic, reasonable assumptions, and147 credible empirical evidence support them. we place the burden of proof on148 those who would have us move away from a progressive tax system. the question is: which system is more likely to be closer to the correct estimation of the utility curves of the greatest number of people? we believe that the answer is a system of progressive taxation. if the marginal utility of money declines at all, then a system with some progression probably comes closer to reflecting reality than one that assumes that the marginal utility of money remains constant. average americans, who may never have heard the diminishing marginal utility of money referred to as such, also seem to understand this. in a 1991 study, peggy hite and michael roberts asked a random sample of 593 americans what they thought the average rate of personal income tax should be at nine different levels of income. the average responses . . . show a strong degree of progressivity, with the average rate increasing uniformly with income. . . . [furthermore] [w]hen forced to choose among five alternative tax schedules, 34% of the respondents chose one that featured a flat rate of 20% on all income above $5,000 a year. but two-thirds preferred a more progressive graduated rate structure. twenty-eight percent chose graduated rates that were about as progressive as the current system, and 38% chose rates that were more progressive than the current system.149 147. for a discussion of the overall progressivity of the tax burden in the united states, see joseph a. pechman, federal tax policy 6 (5th ed. 1987). 148. see supra part iii.a. 149. slemrod & bakija, supra note 8, at 60-61 (emphasis added)(discussing hite & roberts, supra note 85). for a thorough study of the difficulties of drawing meaningful conclusions from survey data, see marjorie e. kornhauser, equality, liberty, and a fair income tax, 23 fordham urb. l.j. 607, 652 n.123 (1996). 52 florida tax review [vol. 4:1 the case for progressive taxation may be uneasy, but it is both popular and persistent. c. the diminishing marginal utility of money and least aggregate sacrifice theory the diminishing marginal utility of money has also provided another justification for progressive taxation. the equal marginal sacrifice theory, which is also, more properly, called the least aggregate sacrifice theory, posits that even if the rate at which utility declines is uncertain, as long as the marginal utility of money declines, aggregate private utility can always be maximized by imposing a confiscatory tax rate on all incomes above a certain level while exempting incomes below that level. this theory is not based on150 equity but rather on welfare economics.151 150. see musgrave, supra note 140, at 108-10; william vickrey, agenda for progressive taxation 373 (1947). but see joel slemrod et al., the optimal two-bracket linear income tax, 53 j. pub. econ. 269 (1994)(asserting that welfare can be maximized by using two brackets with the second bracket lower than the first bracket). 151. see musgrave, supra note 121, at 110-11. the operation of a tax system based on this theory can be illustrated by considering a very simplified model society with four individuals. if we assume that the marginal utility of money, measured in utils, is 11 utils for every dollar up to $100, 8 utils for every dollar above $100 but not above $200 utils, 6 utils for every dollar above $200 but not above $300, and 5 utils for every dollar above $300, the incomes and aggregate utility are as illustrated below: model society before-tax income person income utility a 100 1,100 b 200 1,900 c 300 2,500 d 400 3,000 1,000 8,500 if the society requires public goods of $200, the least aggregate sacrifice 1998] winner-take-all markets 53 the problem with a tax system based on the least aggregate sacrifice theory is that a completely confiscatory tax rate clearly would have significant adverse behavioral effects. it would destroy incentives and reduce output so severely that the overall effect might not be welfare maximization. nevertheless, the least aggregate sacrifice theory can be a starting point for designing a system that is intended to maximize utility, as it shows that progressivity can maximize utility.152 iv. a utility-based measure of efficiency the theory that the tax system should be designed to maximize kaldorhicks efficiency, as measured by the gross domestic product (gdp), rests153 154 results from a tax of $150 on d and $50 on c, with a and b being exempt from tax. such a rate structure has the effect of confiscating all income above $250, as it leaves both c and d with $250 after-taxes. the resulting after-tax income and utility of each member of society is illustrated below: model society with least aggregate sacrifice income tax before-tax after-tax after-tax person income tax income utility a 100 0 100 1,100 b 200 0 200 1,900 c 300 50 250 2,200 d 400 150 250 2,200 7,400 aggregate private material utility decreased from 8,700 utils to 7,400 utils. if c’s tax burden is reduced by $1 and b’s tax burden is increased by $1, c’s total utility increases to 2,206 utils, but b’s decreases to 1,892 utils. aggregate after-tax private utility decreases from 7,400 utils to 7,398. there is no reallocation of tax burdens that will result in greater aggregate after-tax private utility. 152. see vickrey, supra note 150. 153. for a concise definition of kaldor-hicks efficiency, see jules l. coleman, markets, morals, and the law 98 (1988). one state of affairs (e’) is kaldor hicks efficient to another (e) 54 florida tax review [vol. 4:1 on the judgment that aggregate wealth maximization is a desirable public policy. if all dollars were of equal utility, regardless of how distributed, and interpersonal comparisons of utility are eschewed, a tax structure that maximizes gdp is by definition kaldor-hicks efficient, and no other tax structure is kaldor-hicks efficient. from this point, it is argued that a tax155 if and only if those whose welfare increases in the move from e to e’ could fully compensate those whose welfare diminishes with a net gain in welfare. under kaldor-hicks, compensation to losers is not in fact paid. this definition of efficiency is illustrated in the following example. for situation 1, assume a society consists of four individuals, a, b, c, and d, each of whom has 25 units of benefit (e.g., dollars, utils, etc.; the exact measure does not matter). in the aggregate, the society has 100 units. now, for situation 2, assume an alternative society in which individuals a, b, and c, have 5 units and d has 105 units. in the aggregate, the society in situation 2 has 120 units, 20 more than the society in situation 1, and a move from the situation 1 to situation 2 is kaldor-hicks efficient, even though three-quarters of the members of the society are left worse off by it. after the move from situation 1 to situation 2, d could give each of a, b, and c 20 units, thereby restoring them to the amount they had in situation 1 (25 units) while retaining 45 units (105 (3x20)). nothing in the definition of kaldor-hicks efficiency, however, actually requires d to compensate a, b, and c. thus a move from equality to vast inequality can be kaldor-hicks efficient if the winners’ gains exceed the losers’ losses, even if the losers are moved below the poverty line while the winners simply add to vast amounts of pre-existing wealth. 154. gross domestic product is the measure of all production inside the united states regardless of the nationality of the owner of the enterprise engaging in the manufacturing or production. karl e. case & ray c. fair, principles of economics 1002 (1989). 155. see john b. shoven & paul taubman, saving, capital income, and taxation, in the economics of taxation 203, 204 (henry j. aaron & michael j. boskin eds., 1980). another measure of efficiency uses the pareto criteria. a system is pareto optimal when no pareto efficient change is possible; a change is pareto efficient if it can make one member of society better off, without making another member of the society worse off. case & fair, supra note 154, at 289. for a discussion 1998] winner-take-all markets 55 structure that results in any smaller gdp is inefficient, thus establishing the trade-off between equity and efficiency.156 kaldor-hicks efficiency theory arose from economists’ efforts to provide a methodology for analyzing public policy without making interpersonal comparisons of utility. its measure of efficiency is aggregate157 wealth maximization. thus, kaldor-hicks efficiency, by definition, treats all158 dollars as having equal utility regardless of whether those dollars are received and held by a prince or by a pauper.159 but if the marginal utility of money declines, which we believe is undeniable, and we assume that it declines at identical rates for everyone,160 which as a practical matter is the only workable assumption, the161 maximization of total private utility depends on the distribution of the income as well as the aggregate amount of income. since a marginal dollar may have162 of why kaldor-hicks efficiency is the touchstone for analysis rather than pareto criteria, see gary lawson, efficiency and individualism, 42 duke l.j. 53, 88-96 (1992). 156. see supra note 22 and authorities cited therein. 157. see lawson, supra note 144, at 89-90. 158. id. at 92-96. for a criticism of the view that kaldor-hicks efficiency is based on wealth maximization, see jules coleman, the normative basis of economic analysis: a critical review of richard posner’s the economics of justice, 34 stan. l. rev. 1105, 1112-17 (1982). 159. see robert cooter & peter rappaport, were the ordinalists wrong about welfare economics?, 22 j. econ. literature 507 (1984). 160. to assume that utility declines at the same rate for everyone is not to assume that utility declines at a linear rate. the rate of decline might be logarithmic, but our point is that the logarithm is identical for everyone. 161. assuming identical rates of decline is the only practical assumption because there is no reliable way of constructing a model of different rates of decline for different individuals. see edwin r. a. seligman, the income tax, 32-33 (2d ed. 1914)(government can “deal only with classes, that is, with average men”). 162. for a concise presentation of the late 19th century economics literature that discusses this proposition and describes its fall from favor in the 1930s in the face of criticisms of the ability to make interpersonal utility comparisons, see hovenkamp, supra note 123, at 1002-05. 56 florida tax review [vol. 4:1 far more utility to a poor person than to a wealthy person, diminishing the income of the wealthy person by $3 to increase the income of the poor person by only $1 may actually increase total utility. thus, a tax structure that results in a lower gdp than a competing tax structure may actually result in greater utility. in other words, equity and efficiency may be advanced163 simultaneously. there is no trade off. a. the model the foregoing thesis can be illustrated more concretely by assuming the existence of a model society with five individuals and a gdp of $1,000, before the introduction of taxes. assume that any person with less than $35 will die from starvation or exposure, but that the poverty level is $100. also assume that the marginal utility of money, measured in utils, is 11 utils for every dollar up to $35, 9 utils for every dollar above $35 but not above $100 utils, 8 utils for every dollar above $100 but not above $250, and 7 utils for every dollar above $250. the income and utility in this society are distributed as shown in table 8. table 8 model society before-tax income individual income utility a 50 520 b 100 970 c 150 1,370 d 200 1,770 e 500 3,920 totals: 1,000 8,550 now assume that the society requires public goods of 300. the 300 could be raised by a proportional tax of 30%. assuming that the proportional tax does not result in any diminution in the aggregate social product, the after tax income and after tax utility for each person is as shown in table 9 (which makes no effort to allocate the utility of the public goods). table 9 model society with proportional income tax of 30% before-tax after-tax after-tax 163. this argument is based on the equal marginal, or least aggregate, sacrifice theory of equal sacrifice. see musgrave, supra note 121, at 95-96, 110-11. 1998] winner-take-all markets 57 individual income tax income util ity a 50 15 35 385 b 100 30 70 700 c 150 45 105 1,010 d 200 60 140 1,290 e 500 150 350 2,870 totals: 1,000 300 700 6,255 under the proportional tax, total private income decreased from $1,000 to $700 and total private material utility decreased from 8,550 utils to 6,255 utils. since there was no reduction in output, the total product of the society remained $1,000, the sum of the public and private sectors. total utility is more164 difficult to determine because it would be dependent on the distribution of benefits from the $300 of public goods.165 alternatively, the society might levy a graduated progressive tax with the following rate schedule.166 income rate $0 $50 0% $51 $100 20% $101 $150 30% $151 $250 40% 164. the lack of reduction in output follows from the proportional nature of the tax. even those who regard the labor supply as elastic in response to higher tax rates agree that the substitution effect is minimized under a proportional tax, since the tax rate does not vary in response to amount of money earned. see infra notes 207-208, 213-214 and accompanying text. 165. any such measurement is so difficult that the benefits theory of distributing tax burdens is generally held in disrepute. see marjorie e. kornhauser, the rhetoric of the anti-progressive income tax movement: a typical male reaction, 86 mich. l. rev. 465, 491 (1987). 166. this rate schedule may impose far steeper progressivity than equity would support, and we offer it not because we necessarily feel such steep progression is desirable, but because the application of such a rate schedule illustrates that progressive rates, even steeply progressive rates, can be more efficient than a flat rate. 58 florida tax review [vol. 4:1 $251 or more 62% this rate schedule is more steeply progressive than justified under the equiproportional sacrifice theory for progressive taxation, but less progressive than a rate schedule based on the least aggregate sacrifice theory of progressive taxation. it represents a compromise between the two, and might be justified167 by concerns that completely confiscatory rates would almost certainly have disincentive effects, reducing before-tax output. assuming that this tax schedule results in no change in aggregate social product, however, the results of this tax system are as shown in table 10.168 table 10 model society with progressive income tax rates: 0/20/30/40/62 before-tax after-tax after-tax individual income tax income utility a 50 0 50 520 b 100 10 90 880 c 150 25 125 1,170 d 200 45 155 1,410 e 500 220 280 2,380 totals: 1,000 300 700 6,360 again, total private income decreased from $1,000 to $700. under the graduated progressive tax regime, however, total private material utility decreased from 8,550 utils to 6,360 utils. when compared to the proportional tax that left 6,255 utils in the private sector, the progressive tax leaves 105 more utils in the private sector. although e is left with fewer utils, a,b,c, and d have a greater number of utils after-tax under the progressive tax. total private material utility is increased by the relative redistribution. thus, in the model society the progressive tax system is more efficient than the flat tax if efficiency is measured with respect to aggregate utility. b. productivity and tax rates the progressive rate structure necessarily enhances total utility only if 167. see discussion at supra note 151. 168. for a discussion of the support for this assumption, see infra notes 207-208, 213-214 and accompanying text. 1998] winner-take-all markets 59 one assumes that progressive income tax rates do not depress total productivity, as the model assumes. not surprisingly, this is the linchpin or the equity/efficiency tradeoff and it is on this assumption that theorists differ quite passionately. our thesis that the tradeoff is illusory does not rest on a rejection of the proposition that productivity is responsive to tax rates, however. rather, our thesis is that even if productivity is responsive to tax rates, that does not necessarily prove that proportional taxation is more efficient than progressive taxation. if efficiency is determined with respect to aggregate private material utility, progressive taxation can yield greater aggregate utility. the choice of a rate structure based on efficiency concerns depends not on the existence of a connection between productivity and tax rates but on the magnitude of the response and the demographics of the distribution of the response. since the choice is between tax structures, not between a no-tax world and a tax structure, the relative effects on productivity are determinative. in our model, only e faces a higher average tax rate under the progressive tax structure than under the proportional rate structure. individuals a, b, c, and d all face lower average rates. individuals a and b face a lower marginal tax rate; c’s marginal rate is unchanged; both d and e face a higher marginal tax rate. the higher marginal rates faced by d and e raise concerns about decreases in their productivity. the effect on d is most difficult to predict, because although d’s marginal rate has increased, her average rate has decreased. thus, d could reduce her productivity as a result of an income effect; d could work marginally less and still be better off under the progressive tax structure. conversely, if productivity is more responsive to marginal rates than to average tax rates, on the ground that marginal rates are more visible and many people don’t even know their average tax rates, then d’s productivity might actually increase as a result of an income effect. of course, the increase in d’s marginal rate could also cause her productivity to decline as a result of a substitution effect. on balance, since d’s after tax income does not decline, and the increase is not of great magnitude (7.5%), the change in tax would not be likely to affect d’s behavior significantly. the productivity effects on e are more straightforward. if e’s productivity declines, the model assumes the decline is caused by a net substitution effect resulting from the higher marginal tax rate, a conservative assumption. although the change in after tax income could produce either an income effect or a substitution effect, the substitution effect is the only one that need concern us; an income effect would result in increased productivity, and that would make the case for progressivity on efficiency grounds alone.169 the substitution effect could operate as follows. assume that e’s 169. see infra notes 207-08, 213-14 and accompanying text. 60 florida tax review [vol. 4:1 productivity decreases by $10 (a 2% response), total output falls to $990, and170 the highest marginal tax rate is increased to 64.58% to avoid a public deficit. in this case, e’s after-tax income drops from to $280 to $270. e’s after tax utility drops from 2,380 utils to 2,310 utils, and the society’s total utility drops from 6,360 to 6,290 utils. nevertheless, total utility is still 35 utils greater than under the model proportional tax system. if e’s productivity decreased by 3%, and e’s output dropped to $945, and if e’s tax rate were adjusted again to balance the budget, total societal utility would be the same as under the model proportional rate system. if e’s productivity in the model decreased by more than 3%, then total societal utility would be less under the progressive tax than under the proportional tax. for example, if e’s productivity decreased by 4%, total societal utility would be 35 utils less under the progressive tax than under the proportional tax. a significant problem with the foregoing assumption is its lack of symmetry: why would we assume that e reacts to the higher rate by decreasing productivity but not assume that a and b will react to the lower rate by increasing their productivity? if a and b increase the dollar value of their productivity, their increased production more than proportionately offsets e’s reduced productivity. this occurs because a marginal dollar provides greater utility to a and b than to e. for example, assume the following: if a increased productivity by 4%, from $50 to $52, and b increased productivity by 3%, from $100 to $103, an additional $.40 of tax will be collected from a and $.60 from b, leaving a with $51.60 and b with $92.40. a then has 14.4 additional utils, and b has 21.6 additional utils. furthermore, since a and b are paying $1 of increased taxes, the highest marginal tax rate, applicable to e, does not have to be increased to 64.58% to avoid a deficit. only $219, instead of $220, needs to be collected from e. as a result of the increased marginal rate being slightly less than a jump from 62% to 64.58%, e could be expected not to decrease productivity by the full 4%. assuming that e’s productivity decreased by almost 4%, from $500 to $481 (instead of $480), the distribution of after-tax income and utility is as shown in table 11. table 11 model society with progressive income tax and substitution effect throughout rates: 0/20/30/40/64.58 170. this is a reasonable assumption because empirical data show that responsiveness, if it exists at all, is not strong. see infra notes 189190, 195-96 and accompanying text. 1998] winner-take-all markets 61 before-tax after-tax after-tax individual income tax income utility a 52 0.4 51.6 534.4 b 103 10.6 92.4 901.6 c 150 25 125 1,170 d 200 45 155 1,410 e 481 219 262 2,254 totals: 985 300 685 6,270 with 6,270 after-tax utils distributed among the taxpayers, the progressive tax is still more efficient than the proportional tax, its perpetual foil, which results in 6,255 aggregate after-tax utils. the relationship between the rate structure and overall after-tax utility in the model society can be summarized as follows: figure 5 total after-tax utility in the winner-take-all society with various tax structures the comparison, of course, could be reversed if e’s productivity dropped even more, but then perhaps, the incentives to a and b also were understated in the example. likewise, whether any particular graduated progressive rate schedule is more or less efficient than a proportional rate schedule depends on the 62 florida tax review [vol. 4:1 number of utils assigned to dollars at different income levels. if the marginal utility of money declines more rapidly than in the examples, then the progressive rate structure continues to be more efficient than the proportional rate structure even though e decreases productivity somewhat more. conversely, if the marginal utility of money does not decline as rapidly as in the examples, then the proportional rate structure will be more efficient than the progressive tax structure at a lesser level of reduced productivity by e. the point of these examples is not that a graduated progressive rate structure always is more efficient than a proportional rate structure. the point is that if money has diminishing marginal utility and we measure efficiency in utility rather than in dollars, a graduated progressive rate structure easily might be more efficient than a proportional rate structure. which structure is more efficient depends on relative tax rates, the rate at which the marginal utility of money declines and the impact of income and substitution effects at various income levels. theory provides a framework for analysis, empirical evidence is helpful, but it is unlikely that any precise mathematical answer respecting efficiency maximization can be found. impossibility of precise quantification, however, does not imply that we should not make public policy judgments respecting the rate at which the marginal utility of money diminishes. the model only very roughly approximates the distribution of incomes across quintiles in the united states, and is not detailed enough to deal with the concentration of incomes in the top 5% or top 1%. in the model, the highest income was only ten times the lowest income. in the real world, the average income of the 91st through 95th percentiles is twelve times the average income of the lowest quintile; the average income of the 96th through 99th percentiles is 18.5 times the average of the lowest quintile; and the average income of the top 1% is 74 times that of the lowest quintile. the average income for the top 1% is twenty-nine times171 the average income of the second quintile. with disparities of this magnitude, there is some margin for error in deciding that the aggregate individual utility from money incomes will be maximized by graduated progressive taxation even though the productivity of the high income earners may fall. c. the importance of income distribution despite its limitations, our model provides important insight into the ways in which the proliferation of winner-take-all markets strongly supports the argument for progressive taxation. comparing the aggregate after-tax private utility produced by a progressive rate structure in winner-take-all market with the aggregate after-tax private utility produced by a progressive rate structure 171. see 1993 greenbook, supra note 7, at 1505 tbl. 15, 1506 tbl. 17. 1998] winner-take-all markets 63 in a market that distributes income more incrementally, reveals that progressivity, efficiency, and winner-take-all markets are curiously intertwined. in a more incrementalist income distribution, the relative efficiency advantages of progressive taxation over proportional taxation are less extreme than in a winner-take-all market. it is the winner-take-all market that dramatically eliminates the equity/efficiency tradeoff. in our model, a more incrementalist market would be one where income rises in increments of just $75. holding all other factors constant—the total output of the society ($1,000), the revenue to be raised ($300), the tax rate structure, and the rate at which the marginal utility of money declines—permits some important observations. the following table illustrates the effect of changing just the before-tax income distribution. table 12 incremental income distributions, progressive tax rates: 0/20/30/40/62 before-tax before-tax after-tax after-tax individual income utility tax income utility a 50 520 0 50 520 b 125 1,170 17 108 1,006 c 200 1,770 44.1 155.9 1,417.2 d 275 2,345 79.6 195.4 1,733.2 e 350 2,870 126.1 223.9 1,961.2 totals: 1,000 8,675 266.8 733.2 6,637.6 as the foregoing table reveals, using the progressive rate structure that raised $300 of revenue in the winner-take-all market in the incrementalist market fails to raise the requisite amount of revenue, because there is less income to tax at the top marginal rates. the shortfall, $33.20, is significant: over 10% of the society’s revenue needs. to raise the requisite amount of revenue in the incrementalist market, then, rates must be more steeply progressive than they would have to be in the winner-take-all market. the following rate structure, for example, would raise the requisite amount of revenue in an incrementalist market, but it’s top rate must be a full 10 percentage points higher for it to do so. income rate $0 $50 0% $51 $100 20% $101 $150 35% $151 $250 45% $251 or more 72% the following table illustrates the effect of applying such a rate 64 florida tax review [vol. 4:1 structure in a market in which income is distributed incrementally. table 13 incremental income distributions, progressive tax rates: 0/20/35/45/72 after-tax after-tax individual income utility tax income utility a 50 520 0 50 520 b 125 1,170 18.75 106.25 1,025 c 200 1,770 50 150 1,370 d 275 2,345 90.5 184.5 1,646 e 350 2,870 144.5 205.5 1,814 totals: 1,000 8,675 303.75 696.25 6,375 not surprisingly, such an incrementalist income distribution generates greater overall utility, 6,375 utils, than the winner-take-all distribution (which generated total utility of 6,360 utils with a progressive rate structure),172 because more of the after-tax income goes to individuals who value it more.173 nevertheless, it does so by taxing those at the highest end of the income distribution at a much higher rate than is necessary to raise the same amount of revenue in a winner-take-all market. applying the proportional rate (30%) to this more incremental income distribution also produces greater overall utility than applying that rate to the winner-take-all distribution. the following table illustrates the effect of applying the 30% proportional rate structure in a market where income is distributed more incrementally. table 14 incremental income distributions, proportional tax of 30% after-tax individual income utility tax income utility a 50 520 15 35 385 b 125 1,170 37.5 87.5 857.5 c 200 1,770 60 140 1,290 d 275 2,345 82.5 192.5 1,710 e 350 2,870 105 245 2,130 172. see supra table 9. 173. this increase in overall utility results from the shape of the income distribution, however, not from the rate structure. 1998] winner-take-all markets 65 totals: 1,000 8,675 300 700 6,372.5 the total utility remaining after taxes when the proportional rate is applied to the incrementally distributed market (6,372.5 utils) is greater than that produced by applying such a rate to a winner-take-all market (6,255 utils), again simply because the incrementalist distribution gives more of the income to the individuals who value it more. more importantly, however, even the steeply progressive rate structure did not reduce aggregate after-tax utility. the progressive rate structure generated 6,375 utils, while the proportional rate structure produced 6,372.5 utils. following is a graphic presentation of the relationship between the progressive and proportional tax rate structures, each designed to produce an identical amount of revenue, applied to the winner-take-all market and applied to the incrementalist market. figure 6 overall utility as affected by the relationship between income distribution and rate structure174 174. the data for this figure are derived from tables 8, 9, 12 and 13 presented earlier in the text. 66 florida tax review [vol. 4:1 the models presented in this part reveal several lessons. first, rates must rise more steeply in an incrementalist market than in a winner-take-all market in order to raise equivalent revenue. in the winner-take-all market, the top two rates in our model were 40% and 62%; in the incrementalist market, they were 45% and 72%. second, for a given income distribution, even steeply progressive rates result in greater aggregate private utility than does a proportional rate. this is important. it proves that reducing the top rates and increasing the other rates would not increase aggregate private utility in the incrementalist model. the steep progressivity necessary to produce adequate revenues also increased aggregate private utility relative to less steeply progressive alternatives. third, the efficiency advantages of progressive tax rates over proportional tax rates are greater in a winner-take-all market than in an incrementalist market. in the winner-take-all market the more mildly progressive rate structure yielded total after-tax utility of 6,360 utils, as compared to 6,255 utils for the proportional rate structure. by contrast, in a society where income is more incrementally distributed, the steeply progressive rate, which was needed to raise the same amount of revenue, left 6,375 utils 1998] winner-take-all markets 67 after taxes, compared with 6,372.5 utils for the proportional rate. although the progressive rate structure is more efficient than the proportional rate structure in this market as well, the significant point is that in the incrementalist175 market the progressive rate structure is just barely more efficient than the proportional one—a difference of 2.5 utils is nearly negligible. in the winnertake-all market the increase in overall utility produced by the progressive rate structure was 105 utils, or more than 40 times greater than the difference in utility produced by the progressive rate structure in the incremental market. as figure 7, below, demonstrates, in a winner-take-all income distribution, progressive taxation results in significantly greater overall utility than in an incrementalist distribution. 175. that progressive rates are more efficient than proportional rates follows directly from the diminishing marginal utility of money. a progressive rate structure takes more from those who value it less and so results in greater overall utility. 68 florida tax review [vol. 4:1 figure 7 difference in after-tax utility produced by a progressive rate structure as the income distribution in our society becomes more and more skewed in favor of the economic elite—as it has over the past two decades—increased progressivity should become relatively more, not less, important for maximizing aggregate private utility.176 d. progressive taxation and efficiency in the winner-take-all society frank and cook’s work provides yet another argument for the efficiency of progressive taxation. indeed, their argument makes increased marginal rates on winner-incomes a win/win proposition. frank and cook’s thesis is premised on the responsiveness of the labor supply, rather than on the responsiveness of the productivity of specific participants in the labor 176. that both proportional and progressive taxation result in greater overall after-tax utility in the incrementalist market than in the winner-take-all market follows from the diminishing marginal utility of money. because an incrementalist market has more people with higher levels of income than a winner-take-all market, it also has more people whose utility declines less as a result of any system of taxation. therefore, any form of taxation is likely to reduce overall utility more in a winner-take all market than in an incrementalist market. 1998] winner-take-all markets 69 market. they argue that the labor supply in winner-take-all markets is177 inefficient because it attracts more participants than the market can accommodate, causing the losers to squander talents that might have contributed to the general welfare. higher rates of taxation on the winners,178 they argue, would reduce the attraction of winning and might therefore reduce the inefficiency produced by excess market participation.179 it is easy to see why frank and cook’s thesis makes taxation that is steeply progressive at the very top of the income scale a win/win proposition. if they are right, we get greater overall efficiency in the marketplace because there will be less waste. if they are wrong, we get reduced disparities in aftertax income, increased aggregate utility, and we generate additional revenue without reducing productivity. efficiency becomes equity either way. frank and cook’s thesis is based on the similarities between winnertake-all markets and lotteries. they posit that high income labor markets present a winner-take-all payoff, somewhat like a lottery. the exceedingly180 high payoff for success in winner-take-all markets attracts an excessively high number of entrants, who abandon participation in labor markets in which the payoff bears a more direct relationship to absolute effort and success rather than relative effort and success. participants who abandon a lower payoff labor market for the winner-take-all market act in what they believe to be a rational manner, but their actions are inefficient because the losers in the winner-takeall market will be consigned to a labor market in which the maximum payoff is less than the payoff in the market that they abandoned. a simple example explains the problem. suppose an individual, b, has talents that would permit that individual to be either a professional baseball player or a civil engineer. b has a 100% probability of success as a civil engineer with a payoff of $40,000, but only one contestant in the baseball lottery will make the major leagues. all others will fail. no entrant in the contest has full knowledge of the probability of success of the other entrants. notwithstanding these odds, at age 18 b might elect to181 177. see frank & cook, supra note 2, at 8-11, 101-15. 178. see discussion at supra note 5. 179. see frank & cook, supra note 2, at 121. 180. indeed, frank and cook’s collaboration arose out of their realization that their separate research interests—the economics of status competition, for frank, and the economics of participation in lotteries, for cook—converged during the 1980s when “it became apparent that the competition for society’s top positions was becoming more and more like participation in a lottery.” frank & cook, supra note 2, at ix. 181. this sounds like it presents much the same quandaries as the 70 florida tax review [vol. 4:1 pursue a career in baseball instead of going to college, knowing that he has a 1% chance of a $6,000,000 payoff as a major league player and a 99% chance of a $10,000 payoff as a minor league player. although there would be room in the engineering labor market for b and the other contestants who fail to reach the major leagues if they had all chosen to enter the engineering market at age 18, that will not necessarily be the case when they become losers in the baseball lottery. often the point at which success or failure in baseball is determined is far removed from the initial point in time when baseball was chosen over engineering; consequently, the choice of the baseball option effectively forecloses the engineering option. nevertheless, given the reward structure just posited, it is rational for b to follow the baseball career because the statistical value of the baseball payoff exceeds the value of the engineering payoff.182 eventually, only one contestant will become a major league baseball star at a $6,000,000 payoff, and 99 baseball players each will earn $10,000. the total product will be $6,990,000. if, however, b had foregone the baseball career, b would have earned $40,000 as an engineer. the total product of b and the remaining 99 entrants in the baseball career lottery would then have gone up by $30,000 (b made $40,000 rather than $10,000), to $7,020,000. thus, b’s decision to pursue a baseball career, while individually rational, nevertheless reduced the total social product by $30,000. moreover, since the payoff to the winner of the baseball lottery is based only on that person’s productivity as a player, the diminution in the number of contestants does not reduce the winner’s payoff, so that b’s increased productivity as an engineer produces only an increase in overall productivity. if 50 of the 100 potential baseball183 classic prisoner’s dilemma, and the similarity is no accident. frank and cook draw on those similarities explicitly, noting that “the prisoner’s dilemma captures the essence of an important class of problems in which actions that seem compellingly attractive to individuals yield results that are unattractive to the group as a whole.” id. at 127. 182. the undiscounted statistical value of entering the baseball market is $69,900 (($6,000,000 x .01) + ($10,000 x .99)) compared to $40,000 in the engineering market. 183. since the payoffs in winner-take-all markets are based on relative performance, not on absolute performance, the results we describe would obtain even if our one entrant (b) otherwise would have been the winner in the baseball market, since other entrants would have been individually better off pursuing careers in engineering than in baseball and the total product of the participants in the labor market 1998] winner-take-all markets 71 players chose engineering, the total product of the 100 participants in the labor market would increase from $6,990,000 to $8,490,000. for frank and cook, progressive taxation of high income earners will increase economic efficiency because it will reduce the attraction of the high salaries. individuals like b would be more likely to choose engineering over184 baseball if the reward structure were less disparate. for frank and cook, a185 would have increased had they done so. 184. frank and cook made this point in an op-ed article in the washington post. see robert h. frank & phillip j. cook, the superstar economy: why a flat tax would make america less–not more–efficient, wash. post, nov. 12, 1995, at c2; see also frank & cook, supra note 2, at 101-46, 213. 185. frank and cook do not endorse the enactment of provisions like § 162(m), which prevents publicly held corporations from deducting executive compensation in excess of $1 million per year, unless the compensation is shown to be based on performance and meets specific criteria. frank and cook believe such provisions are ill-advised because they single out a particular type of winner, possibly distorting the incentives among markets. see frank & cook, supra note 2, at 218-19. we agree with frank and cook that restrictions on deductions for compensation are ill advised for still another reason: they attempt to address the problem from the wrong side and can result in tax burdens that are borne by individuals very different from those for whom they were intended. provisions like § 162(m) produce a situation in which executives who have the market power to demand and obtain compensation in excess of the proscribed amount still demand and obtain it. their employers spend additional sums seeking the legal advice that will allow them to behave in ways that avoid the limitation, thereby diverting funds either from the pockets of shareholders or workers to those of tax advisors, and deducting the resulting expense. the result is that the only losers are the owners of capital, who end up bearing the economic burden of the increased corporate tax. while there is much debate among economists on the question of who bears the economic burden of the corporate income tax, government economists, whose work is critical to enactment of tax legislation, assign the burden to the owners of capital. redbook, supra note 28, at 49; james r. nunns, distributional analysis at the office of tax analysis, in distributional analysis of tax policy 111, 112 (david f. bradford ed., 1995); thomas a. barthold, 72 florida tax review [vol. 4:1 proportional tax will have the converse effect, decreasing efficiency as well as increasing economic inequality because reducing the tax rates on the highest income earners “will exacerbate the glut of aspiring superstars.” frank and186 cook favor progressive over proportional taxation because proportional taxation cannot alter the relative statistical values of the career choices faced by b in the example in the preceding paragraphs. graduated progressive187 taxation, however, can reduce the expected payoff for the major league player position to the point that b's rational choice will be to pursue an engineering degree. the remaining contestants for the major league baseball position, who have an alternative payoff of less than the $40,000 available in the engineering market, say, $15,000 in the taxi-driver market, will not decrease productivity as a result of the higher marginal rates because of the danger of a rank reversal—falling from number one to number two—results in falling from a $6,000,000 payoff to a $10,000 payoff. thus, frank and cook maintain, taxation that is steeply progressive at the top can cure the inefficiencies of winner-take-all labor markets.188 distributional analysis at the joint committee on taxation, in distributional analysis of tax policy 128, 131 (david f. bradford ed., 1995); but cf. richard a. kasten & eric j. toder, distributional analysis at the congressional budget office, in distributional analysis of tax policy 120, 121 (david f. bradford ed., 1995) (noting that while some congressional budget office studies have assumed that half of the corporate income tax falls on income from capital and half falls on income from labor, the cbo assigned the burden of 1993 changes in the corporate income tax to families in proportion to their income from capital). while increasing the tax burden on capital may not necessarily be a bad thing, it is nevertheless not the thing that the provision was designed to accomplish. in the real world of imperfect markets and incomplete information, it is unlikely that the owners of capital would act to change the situation, particularly since it would be impossible to isolate the effect of this one provision. 186. frank & cook, the superstar economy, supra note 184, at c2. 187. graduated flat rate progressive taxation, such as that advocated by champions of the “flat tax,” progressive only through a standard deduction, will not alter the relative values of the choices because the progression is too gentle, as the marginal rate above what is essentially a zero bracket is the same. 188. like frank and cook, we believe that progressive taxation 1998] winner-take-all markets 73 examination of the distribution of income data in figure 3 and the tables in part ii.c., strongly supports frank and cook’s winner-take-all189 thesis with respect to distributions of incomes in the united states. their theory regarding the incentives that operate in such markets provides strong support for progressive taxation. most importantly, their theory has the virtue of costing nothing, since if frank and cook are wrong about the responsiveness of the labor supply, then much good results anyway because of decreased inequality and increased revenue that would result from adoption of the progressive rate structure they advocate.190 of course, one could rationally worry that the labor supply will be so elastic that an income tax that is steeply progressive at the top will cause all of the contestants in the baseball lottery to drop out. we just don’t think that is a realistic concern. not only do we believe that many winners respond to incentives other than the economic payoff, but neither we nor frank and191 cook are proposing a confiscatory tax. furthermore, outside of the world of theory, not everyone enjoys the same statistical payoff, even if most individuals overestimate their own payoff. individuals should consider not only the size of is a more effective and appropriate way to reduce the incentive for wasteful entry into winner-take-all markets than tax penalty provisions like § 162(m). for a discussion of tax penalties generally, see mcdaniel et al., federal income taxation 391-92 (3d ed., 1997) and eric m. zolt, deterrence via taxation: a critical analysis of tax penalty provisions, 37 ucla l. rev. 343 (1989). 189. see also the discussion of income distributions at note 61. 190. it merits repeating that we favor progressive taxation because of our view of the fairness of the resulting system, not because we aim to provide particular incentive or disincentive effects, as do frank and cook. for us, if a fair system offers such desirable collateral effects, that is great, but it is gravy. see infra part v. 191. while this may appear to contradict frank and cook’s thesis, we believe the question is one of degree, not of kind. we subscribe to a view of human motivation that is more nuanced than that posited by an economic theory that ascribes most human endeavor to a pursuit of economic gain. it is possible to believe both that a reduction in the payoff will affect the number of entrants into the market while believing that other factors—love of the game, desire for fame—will ensure a healthy number of entrants despite the reduction in the payoff, unless the payoff drops to close to zero. since neither we nor frank and cook are proposing confiscatory taxation, we need not worry about that. 74 florida tax review [vol. 4:1 the payoff but also, after assessing the abilities of others, the likelihood that their ability will give them a realistic chance to obtain it. while winner-take-192 all markets do not account for small differences in talent, neither are they unresponsive to vast differences in talent. e. lessons from optimal tax theory while we agree with frank and cook's analysis of the operation of winner-take-all markets and share their distress over the disparities in income that such markets produce, we do not advocate heightened levels of taxation for the winners as a cure for the expansion of winner-take-all markets. we193 simply do not believe that the labor supply as a whole is responsive to changes in tax rates, because we do not believe productivity is responsive to such changes in tax rates generally, nor do we believe that high income earners194 have a peculiar response to changes in tax rates. moreover, even if the labor195 supply is responsive to tax rates at the margin, there is nothing to suggest that the performance of those who actually become winners is affected by the level at which they are compensated, and much to suggest otherwise. thus, as196 192. for example, if there are 10 contestants for a $1 million payoff based at least in part on skill or some other individually variable attribute, they do not all have a 10% chance of winning a $100,000 payoff. instead, five of the contestants may have a 15% chance of winning, while the other five may have only a 5% chance of winning. statistically, then, the top five have a chance worth $150,000, while the bottom five have a chance worth $50,000. if taxes reduce the $1 million to $600,000, the statistical payoff for the top five will go down to $90,000 while that for the bottom five will go down to $25,000. in that case, if an alternative market would offer a 100% chance of a $30,000, after taxes, the top five contestants would remain in the game, but the bottom five would drop out in favor of the sure thing. 193. we thus differ from frank and cook in our reasons for advocating progressive taxation in the winner-take-all society. see frank & cook, supra note 2, at 213-14. 194. see infra notes 207-08, 213-14 and accompanying text. 195. see infra notes 236-243 and accompanying text. 196. see thomas h. sanders, effects of taxation on executives 17-32 (1951)(harvard business school study concluded that executive work effort was unaffected by tax rates at a time when maximum rates exceeded 90%); see also slemrod, supra note 56, at 203-09 (concluding 1998] winner-take-all markets 75 frank and cook point out, ceos of german and japanese companies “earn much lower salaries and face much higher tax rates than do their american counterparts . . . [a]nd yet the companies they manage have provided much of america’s stiffest competition in recent years.” factors other than taxes are197 at work. if frank and cook are right in their conclusion that winners will not work less if the rewards of winning shrink as a result of higher taxation, then taxing winners at proportionately higher rates is a no-lose proposition. optimal tax theory reinforces that conclusion. optimal tax theory holds that the best (“optimal”) tax is one imposed on an activity with relatively low elasticity, so that imposition of the tax will increase productivity (produce an income effect by causing people to work harder, if it affects their behavior at all), but will not have a substitution effect (causing people to substitute leisure for additional work because of the diminished after-tax value of the work). optimal tax198 that tax rates affect the form of compensation, but not its total amount). 197. frank & cook, supra note 2, at 217. of course, there are cultural differences between american and japanese executives, but economists don’t generally take those into account anyway. at any rate, frank and cook do not claim that incentive compensation is irrelevant, nor do they seek to abolish it. their claim is that “there is reasonably clear evidence that ceo performance does not strongly depend on the extent to which pay varies with profitability.” id. 198. optimal tax theory proceeds from utilitarianism. james mirrlees, a british economist, is generally credited with developing it through the publication of an article in 1971. j.a. mirrlees, an exploration in the theory of optimum income taxation, 38 rev. econ. stud. 175 (1971). bankman and griffith provided a blueprint for applying optimal tax theory in the formulation of american tax policy. bankman & griffith, supra note 127. in a recent book, ed mccaffery provides a clear, but not simplistic, explanation of optimal tax theory and uses it to argue for increased taxation of male labor. edward j. mccaffery, taxing women 163-84 (1997). in a recent article, nancy staudt discusses mirrlees’ work and uses optimal tax theory to argue for taxation of the poor, combined with demogrants designed to ensure the poor share the responsibilities of citizenship. nancy c. staudt, the hidden costs of the progressivity debate, 50 vand. l. rev. 919 (1997). an optimal tax then, would be imposed in inverse relation to the elasticity of the activity taxed. lawrence zelenak, marriage and the income tax, 67 s. cal. l. 76 florida tax review [vol. 4:1 theory suggests that imposing higher rates of taxation on winners will produce the greatest overall good by increasing revenue while not decreasing productivity. f. the failure of the rising tide proponents of proportional taxation likely will argue that the preceding analysis ignores their claim that the income level of higher income individuals affects the income level of everyone; “a rising tide lifts all boats.” the response is simple: look at the 1980s. the empirical data prove that a rising per capita income does not necessarily result in a proportionate increase in incomes across all income classes. a small percentage of the population can, and in the past two decades largely has, captured all of the benefits. from 1979 to 1992, average income in the united states, as a multiple of the poverty level, increased. but for the bottom three quintiles, 60% of the population, average199 income by this measure decreased. only the top two quintiles saw any200 significant increase, and even that increase was highly concentrated at the very rev. 339, 366 (1994). the modern theory of optimal tax was set out in mathematical detail in j.a. mirrlees, an exploration in the theory of optimal income taxation, supra, and while subsequent scholars have debated mirrlees’ quantitative formula, see bankman & griffith, supra at 1964, the theory has received substantial attention in recent years, has served to support arguments in favor of a tax structure that imposes comparatively lower taxes on groups whose labor supply is thought to be highly elastic, like married women, see edward j. mccaffery, taxation and the family: a fresh look at behavioral gender biases in the code, 40 ucla l. rev. 983, 1044-46 (1993), and immigrants, see howard f. chang, liberalized immigration as free trade: economic welfare and the optimal immigration policy, 145 u. pa. l. rev. 1147, 1169 (1997), and comparatively higher taxes on groups whose labor supply is thought to be largely inelastic, like married men, see mccaffery, taxing women, supra at 200-01. cf. zelenak, supra at 366; eric m. zolt, the uneasy case for uniform taxation, 16 va. tax rev. 39, 42 (1996). for a general overview of the early literature on optimal taxation, see agnar sandmo, optimal taxation: an introduction to the literature, 6 j. pub. econ. 37 (1976). 199. see discussion at supra note 76. 200. see discussion at supra note 76. 1998] winner-take-all markets 77 top few percentiles. for the bottom quintile, real income, measured in201 constant dollars, has only been as high as it was in 1979 once. likewise, the202 real income for the second quintile only exceeded the 1979 level in 1986 through 1990 and also in 1997, but even then only marginally, while the median real income for the third quintile has increased little since 1979, and was less than its 1979 level in ten of the seventeen years between 1980 and 1996, including the period from 1991 through 1994. in other words, a rising tide203 does not necessarily lift all boats; it swamps those boats with too short an204 anchor line. perhaps more importantly, cross-national data indicate a statistically significant negative correlation between the growth rate of the economy and inequality. inequality holds back the rising tide.205 g. the elasticity of the labor supply as the foregoing discussion has demonstrated, views about the desirability of progressive tax rates are affected by views on the behavioral effect of such rates. we have shown that in a winner-take-all society progressive taxation can produce greater overall after-tax efficiency than proportional taxation even assuming some negative behavioral response from those subjected to higher marginal rates. nevertheless, the most dramatic206 differences between progressive and proportional taxation in winner-take-all markets occur if progressive taxation does not produce significant adverse behavioral effects. the relationship between progressive taxation and decreased productivity therefore merits additional discussion. many economists conclude that the level of tax rates does affect the labor supply. they reach this conclusion from models based on the idea that207 201. see discussion at supra note 76. 202. see united states census bureau internet site, historical income tables-households, table h-3 (visited jan. 5, 1997) <http://www.census.gov/hhes/income/historic/h03.html>. 203. id. 204. see historical trends in poverty and family income: hearing before the subcomm. on human resources of the comm. on ways and means, 103d cong., 39 (1993)(statement of lynn a. karoly). 205. see robert h. frank, progressive taxation and the incentive problem 7-9, presented at atlas shrug conference, supra note 81. 206. see supra part iv.a. 207. see, e.g., jerry a. hausman, labor supply, in how taxes affect economic behavior 27-83 (henry j. aaron & joseph a. pechman 78 florida tax review [vol. 4:1 the substitution effect, substituting leisure for labor when the yield to labor decreases, predominates over the income effect, an increase in labor to maintain income levels when wages fall. indeed, some of these models lead to the208 conclusion that to maximize efficiency, rates ought to be regressive, that is, marginal rates ought to decrease as income increases. economic theory alone,209 however, does not explain which effect will predominate. the models that210 predict that work effort will increase if tax rates are decreased are based on assumptions regarding responsiveness of the labor supply to wages.211 however, empirical studies indicate that the labor supplied by primary wage earners does not respond significantly to after-tax pay changes; secondary212 wage earners, in contrast, generally have appeared to be responsive to changes in after-tax pay. recent work suggests that male labor supply is not very213 eds., 1981); andrew b. lyon, individual marginal tax rates under the u.s. tax and transfer system, in distributional analysis of tax policy 214, 224 (david f. bradford ed., 1995)(collecting references to such studies); replacing the federal income tax: hearings before the house comm. on ways & means (vol. ii), 104th cong, 2d sess. 123, 129 (1996)(statement of prof. alan j. auerbach); see also joel slemrod, professional opinions about tax policy: 1994 and 1934, 48 nat’l tax j. 121, 131 (1995)(71% of surveyed economics professors who were members of the nta-tia believed that lower marginal tax rates reduce leisure and increase work efforts). 208. see joseph j. minarik, making tax choices, 52-54 (1985); musgrave, supra note 121, at 241-46; robert k. triest, fundamental tax reform and labor supply, in economic effects of fundamental tax reform 247, 259-64 (henry j. aaron & william g. gale eds., 1996)(modeling the labor response to replacement of the corporate and individual income taxes by a 14.3% vat). 209. see lyon, supra note 207, at 225; slemrod et al., supra note 150. 210. see musgrave, supra note 121, at 241-46; james m. bickley, flat tax: an overview of the hall-rabushka proposal, 72 tax notes 97, 102-03 (july 1, 1996). 211. see supra notes 189-208 and accompanying text. 212. see eric engen & jonathan skinner, taxation and economic growth, 49 nat’l tax j. 617, 631 (1996). 213. benjamin m. friedman, day of reckoning, the consequences of american economic policy 242-43 (1988); jane g. 1998] winner-take-all markets 79 responsive to wage rates except at the lower wage levels, and may be negative; female responsiveness for females already in the work force might not be as great as previously estimated, and may resemble the responsiveness of males.214 historically, the long term trend in this country has been that increasing real wages have led to shorter work weeks, longer vacations, and earlier retirement. in other words, the income effect predominates over the215 substitution effect. the empirical evidence indicates that economists, and216 others, who predict that lower tax rates will increase work effort make a wildly erroneous assumption about human behavior. on balance, the most reasonable conclusion is that although there are theories that predict that the labor supply in general varies inversely with tax rates, these theories are unproven and, in all likelihood, erroneous. significantly, much tax policy analysis is grounded on the inelasticity of the labor supply—all three governmental agencies that conduct distributional analyses of changes in the tax system treat social security taxes as economically borne by workers because of the presumed inelasticity of the labor supply —and in the absence of evidence to the contrary, it seems217 sensible to craft rate policy on that basis as well. gravelle, behavioral responses to proposed high-income tax rate increases: an evaluation of the feldstein-feenberg study, 59 tax notes 1097 (may 24, 1993); triest, supra note 208, at 256-57; see also jane g. gravelle, behavioral feedback effects and the revenue-estimating process, 48 nat’l tax j. 463, 468-70 (1995). for a provocative application of this finding, see mccaffery, supra note 198 (using optimal tax theory to propose a higher tax on men than on women). 214. william c. randolph & diane lim rogers, the implications for tax policy of uncertainty about labor-supply and savings responses, 48 nat’l tax j. 429 (1995); nada eissa, tax and transfer policy and female labor supply, proceedings of the eightyeighth annual national tax association conference on taxation 160 (1996); minarik, supra note 208, at 52-54. but see mccaffery, supra note 198. 215. see robert eisner, the proposed sales and wages tax–fair, flat or foolish?, in fairness and efficiency in the flat tax 42, 79 (1996); randolph & rogers, supra note 214, at 435. 216. randolph & rogers, supra note 214. 217. redbook, supra note 28, at 41 (citing joseph a. pechman & benjamin a. okner, who bears the tax burden? 24-37 (1974)); nunns, supra note 185, at 111; kasten & toder, supra note 185, at 120. 80 florida tax review [vol. 4:1 h. the responsiveness of the savings rate while many winners gain entry into the winner's circle by dint of their labor, once there they increase the size of their winnings through investment. any discussion of the impact of higher marginal tax rates for winners must therefore consider the potential behavioral effects of such rates on both the supply of labor and the supply of capital. as with the responsiveness of the labor supply, theories on the responsiveness of the savings rate to changes in tax rates abound. many218 economists believe that income taxation discourages savings and investment.219 many politicians agree, and have called for the abandonment of income taxation and the adoption of consumption taxation instead. other economists220 believe that the increase in savings would be relatively small, or would221 218. for a clear and concise explanation of the relationship between the taxation of capital and the resulting economic behavioral response, see slemrod & bakija, supra note 8, at 110-17. 219. hall & rabushka, supra note 31, at 84-87; michael j. boskin, taxation, saving, and the rate of interest, 86 j. pol. econ. s3s27 (1978); see also slemrod, supra note 207, at 131 (67% of surveyed economics professors who were members of the nta-tia believed that lower tax rates on the return to savings increase private saving). 220. see, e.g., kemp commission report, supra note 51, at 67. a review of the “flat tax” movement that this belief has spawned and the considerable literature that it has generated is, of course, well beyond the scope of this article. for one analysis of the two most serious legislative proposals that have emerged from this movement, see alice g. abreu, untangling tax reform: simple taxes, complex choices, 33 san diego l. rev. 1355 (1996). 221. in the mid 1960s, when the maximum marginal income tax rate was 70%, richard goode, using a variety of statistical yardsticks, estimated that the effect on savings of shifting from a progressive income tax to a flat rate consumption tax would be “unimpressive.” richard a. goode, the individual income tax 67-68 (1964). more recently, diane lim rogers has estimated that the efficiency gains of shifting to a flat rate consumption tax would be less than 1% of lifetime income. diane lim rogers, sorting out the efficiency gains from a consumption tax, proceedings of the eighty-eighth annual national tax association conference on taxation 40 (1995). william gale has estimated that the long term efficiency gains of shifting to a consumption tax could be only 1998] winner-take-all markets 81 quickly dissipate when transition relief is provided. still others remain222 $200 per capita per year. william g. gale, building a better tax system: can a consumption tax deliver the goods?, 13 brookings rev. 18 (1995); see also roundtable discussion on tax reform and economic growth: hearing before the joint econ. comm., 104th cong., 134 (1996)(testimony of william g. gale). alan auerbach and lawrence kotlikoff have estimated the long run gains from shifting to a consumption tax to be only about $60 per capita per year. see speech of brookings institution’s gale at tax reform commission hearing, tax notes today (tax analysts) july 28, 1995, 95 tnt 147-65, available in lexis, fedtax library, tnt file. similarly, henry aaron has estimated that a 50% cut in taxation of all capital income would at most increase the national capital stock by .08% in five years. review of congressional budget cost estimating joint hearing before the house comm. on the budget and the senate comm. on the budget, 104th cong., 149 (1995)(testimony of henry j. aaron). while a model developed by eric engen, a federal reserve board economist, suggests that the savings rate would increase about 10% (from 5% to 5.5%), see william gale, building a better tax system, supra, this growth may be overstated because pension savings may decrease, see eric m. engen & william g. gale, comprehensive tax reform and the private pension system, 72 tax notes 345 (july 15, 1996). furthermore, much of this gain could be realized by reform to the income tax system, including a more comprehensive tax base. jane g. gravelle, the economic effects of taxing capital income 49-50, 245-52 (1994); louis lyons, hubbard: income tax reform offers same promise as consumption tax, 74 tax notes 560 (feb. 3, 1997)(reporting on comments by columbia university economist r. glenn hubbard, at an american enterprise institute conference, that integration of the corporate and individual income taxes could achieve substantially the same efficiency gains as replacing the income tax completely with a consumption tax). 222. some economists who predict shifting to a consumption tax could significantly increase output conclude that providing any transition relief to “old capital” and any progressivity, including a zero bracket on wages, would significantly reduce or eliminate completely the potential efficiency gains. see replacing the federal income tax: hearings before 82 florida tax review [vol. 4:1 unconvinced.223 the effect of the tax rate on the savings rate depends on whether the income or substitution effect predominates. under the substitution effect, if224 the yield to capital increases, future consumption, i.e., savings, becomes more attractive relative to present consumption. under the income effect, if the yield to capital increases, a target saver can reduce savings and still have the same “nest egg” in a future year. which of these two effects predominates depends on the motivation for saving. various economists, employing different225 models, reach different results. while some economists conclude that personal savings responds significantly to the interest rate, other economists conclude226 the house of representatives comm. on ways & means (vol. ii), 104th cong, 2d sess. 123, 129 (1996)(statement of prof. alan j. auerbach); alan j. auerbach, tax reform, capital allocation, efficiency, and growth, in economic effects of fundamental tax reform 29-73 (henry j. aaron & william g. gale eds., 1996). 223. see albert ando et al., the structure and reform of the u.s. tax system 67-71 (1985). furthermore, in the aggregate, income from capital already might be taxed at near an average zero rate due to combination of deduction of nominal interest, accelerated depreciation, and arbitrage. see joel slemrod’s testimony before bipartisan commission, hearing on entitlements and tax reform, tax notes today (tax analysts) oct. 7, 1994, 94 tnt 198-41, available in lexis, fedtax library, tnt file. recalling the 1980 presidential campaign, the economic recovery tax act of 1981, and the failure of supply-side economics to deliver the promised growth, larry summers, a respected economist and secretary of the treasury during president clinton’s second term, simply refers to the claimed economic efficiencies of the flat tax as “deja voodoo economics.” lee a. sheppard, flat tax and politics at nysba, 70 tax notes 488 (jan. 29, 1996). 224. see eisner, supra note 215, at 78. 225. in addition, some saving—much household saving—may be precautionary, the proverbial “saving for a rainy day.” such saving may not be affected one way or another by the yield to capital. see eric m. engen & william g. gale, the effects of fundamental tax reform on saving, in economic effects of fundamental tax reform 83, 93-94 (henry j. aaron & william g. gale eds., 1996). 226. see, e.g., boskin, supra note 219. 1998] winner-take-all markets 83 that there is little if any response. many econometric models predict that227 shifting to a consumption tax (which does not tax savings) would at best lead to only modest increases in the savings rate. as useful as it may be, however,228 economic theory cannot offer clear and certain predictions. empirical work229 must supply the answer. empirical evidence suggests that eliminating the taxation of capital would lead to efficiency effects that are small and ambiguous as to direction. some empirical evidence even suggests that the rate of saving decreases as the rate of return increases. other data corroborate this by showing that over the230 long term the united states personal savings rate has varied inversely with the yield to capital. the most recent experience with attempts to increase the231 227. see e. philip howrey & saul h. hymans, the measurement and determination of loanable-funds saving, in what should be taxed: income or expenditure? 1, 29-30 (joseph a. pechman ed., 1980). 228. see, e.g., don fullerton & diane lim rogers, lifetime effects of fundamental tax reform, in economic effects of fundamental tax reform 321-47 (henry j. aaron & william g. gale eds., 1996); alan j. auerbach, tax reform, capital allocation, efficiency, and growth, in economic effects of fundamental tax reform 29-73 (henry j. aaron & william g. gale eds., 1996). 229. alan j. auerbach, measuring the impact of tax reform, 49 nat’l tax j. 665, 666 (1996). 230. see gravelle, supra note 221, at ch. 2; benjamin m. friedman, day of reckoning: the consequences of american economic policy 252-55 (1989); slemrod & bakija, supra note 8, at 110-11 (figure 4.4, based on a study done by jane gravelle of the congressional research service, shows that “the saving rate fell when the incentive to save increased. in the period 1968 to 1980, the average return to saving was 3.5 percent, and the saving rate averaged 13 percent. from 1981 to 1993, the rate of return averaged 5.9 percent, but the saving rate averaged only 10 percent.” ). 231. see jonathan skinner & daniel feenberg, the impact of the 1986 tax reform on personal savings, in do taxes matter? the impact of the tax reform act of 1986, at 50, 58-63 (joel slemrod ed., 1990); see also joseph bankman, the structure of silicon valley start-ups, 41 ucla l. rev. 1737 (1994)(empirical analysis indicates that venture capitalists and entrepreneurs in silicon valley start-ups, surely high risk ventures, operate in almost complete oblivion of taxation issues); 84 florida tax review [vol. 4:1 savings rate in the united states by reducing tax rates indicates that the effort is counterproductive: during 1980s, when real interest rates increased and marginal tax rates, particularly the rates on the income from capital, decreased and produced a significant increase in after-tax yield, the savings rate fell.232 moreover, even if lower tax rates did influence saving behavior, increased savings might not result in greater gdp, because gdp would increase only if the savings were invested domestically. yet, there is no way to know that savings will be so invested. financial markets are international.233 thus, although united states wealth would increase, domestic labor productivity would not necessarily increase.234 i. might winners be specially responsive? much of the empirical work on responsiveness of labor supply and of savings to tax rates has excluded high-income taxpayers, and the suggestion often is made that high income taxpayers respond differently—that they are on the upper half of the famous laffer curve. but the suggestion has not gone235 slemrod & bakija, supra note 8, at 266-67 nn.26-27 (providing additional authority for and discussion of the empirical evidence of the inverse relationship between personal savings and yield to capital). 232. see gravelle, supra note 221, at 26; flat tax proposals: hearings before the senate comm. on finance, 104th cong., 21 (1995)(testimony of alan j. auerbach); roundtable discussion on tax reform and economic growth: hearing before the joint econ. comm., 104th cong., 134 (1996)(testimony of william g. gale); ando et al., supra note 223. 233. see states against markets (robert boyer & daniel drache eds., 1996); john h. friedland, the law and structure of the international financial system: regulation in the united states, eec, and japan (1994). see generally, charles l. schultze, memos to the president 107-19 (1992)(discussing the growing mobility of international capital and its consequences). for a discussion of the possibility that additional domestic savings might be invested abroad, see gravelle, supra note 221, at 14 and engen & gale, supra note 225, at 102. 234. see auerbach, supra note 228, at 63-65; minarik, supra note 208, at 63. 235. the laffer curve illustrates that the amount of revenue collected by the government is a function of the tax rate. this curve is represented by placing the tax rate on the vertical axis and tax revenue on 1998] winner-take-all markets 85 unchallenged. thus, although feenberg and poterba concluded that after the tax reform act of 1986, the top one-tenth of the top 1% of taxpayers (by agi class) significantly increased reported income in response to lower rates,236 slemrod concluded that this increase in reported income resulted from shifting the form of income, not from increased labor supply, and thus did not represent an increase in national income. notably, a very recent empirical study237 actually found that for high income earners there is a significant negative elasticity between lower income tax rates and hours worked—cutting taxes reduces the work effort of the rich. with respect to the importance of capital238 the horizontal axis. the graph assumes that there is a tax rate beyond which supply response is so great that tax revenues will fall. “it . . . shows that when tax rates are very high, any increase in the tax rate could actually cause tax revenues to fall.” case & fair, supra note 154, at 863 (explanation of figure 35.2). for a more thorough explanation of the laffer curve, see alfred l. malabre, jr., lost prophets 181-82 (1994). 236. feenberg & poterba, income inequality and the incomes of very high income taxpayers: evidence from the returns, tax notes today (tax analysts) nov. 25, 1992, 92 tnt 236-15, available in lexis, fedtax library, tnt file. 237. joel slemrod, income creation or income shifting? behavioral responses to the tax reform act of 1986, tax notes today (tax analysts) jan. 9, 1995, 95 tnt 5-74, available in lexis, fedtax library, tnt file; austan goolsbee, it’s not about the money: why natural experiments don’t work on the rich, presented at atlas shrug conference, supra note 81. there is, however, a revenue impact issue that must be considered if high income earners respond to higher tax rates by shifting compensation from a taxable form, i.e., current salary, to a tax preferred form, i.e., fringe benefits, stock options, etc. this is not a rate problem, however, so much as a base problem. a more comprehensive tax base, such as mark-to-market, see david j. shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. 1111 (1986), and elimination of capital gains preferences, would eliminate or reduce the revenue problem. 238. see robert a. moffitt & mark wilhelm, taxation and the labor supply decisions of the affluent, presented at atlas shrug conference, supra note 81; austan goolsbee, supra note 237. see also gerard brannon, taxes and progressivity, 77 tax notes 543 (nov. 3, 1997). that this finding could perhaps be explained by a shift from 86 florida tax review [vol. 4:1 income generally, as previously discussed, there is no convincing evidence (and little evidence at all) of a behavioral response to changes in the marginal rate.239 indeed, there is good reason to believe that for the very rich accumulation of wealth is an end in itself and not merely consumption deferred or bequests amassed; it is the accumulation of power and prestige. the proposition that240 a high income laffer curve actually exists lacks any empirical support.241 earned income to other forms of income, see slemrod & bakija, supra note 8, or by a realization that reduced taxes means that reduced work effort does not result in a decline in after-tax income, see eisner, supra note 215, does not detract from its significance, which is that the dreaded decline in productivity that theorists so often assert will attend an increase in marginal rates, just does not seem to occur in the real world 239. see supra part iii; see also andrew a. samwick, portfolio responses to taxation: evidence from the end of the rainbow, presented at the atlas shrug conference, supra note 81; brannon, supra note 238 (discussing atlas shrug conference papers). nevertheless, capital gains realizations are thought to be responsive to changes in rates, and recent tax legislation was enacted on that premise. see staff of the joint comm. on taxation, general explanation of tax legislation enacted in 1997, 516 app. (reduction in capital gains rates projected to produce revenue increases of $1,254 million in 1997, $6,371 million in 1998, and $171 million in 1999, followed by revenue losses totaling almost $29,000 million in 2000 through 2007). for a very good discussion of the impact of increased realizations, see gravelle, supra note 105, at 283 (discussing differences in distributional methodologies employed by the joint committee on taxation and the treasury department's office of tax analysis). 240. christopher d. carroll, why do the rich save so much?, presented at atlas shrug conference, supra note 81. 241. see slemrod, supra note 56, at ch. 6; triest, supra note 208, at 247, 257, 261, 269 (rate reductions in 1986 resulted, at best, in only a small increase in the labor supply of high income men; although an econometric model indicates that switching from an income tax to a flat rate consumption tax results in most significant hourly work increases for highest-income decile, empirical evidence supporting the theory of a high-income laffer curve is “scant”); see also samwick, supra note 239 (marginal tax rates provide a limited explanation for the actual portfolio changes of households at all points in the income distribution); eisner, 1998] winner-take-all markets 87 frank and cook would not be surprised. indeed, the absence of any effect on the performance of the winners follows from the operation of winnertake-all markets. winners know only too well that in the market they have242 conquered, the very high incomes they enjoy accrue to a limited number of competitors whose performance is rank-ordered at the top, above a cut-off point. in such a market, very small differences in performance at the margin can result in falling below the cut-off point and experiencing a decline in compensation that is disproportionately large when compared with the decline in performance. therefore, winners who want to remain in the winner's circle will not reduce their work effort in response to lower taxes; they will not risk falling out of the circle and experiencing a decrease in earnings that cannot be made up by any conceivable decrease in tax rates. moreover, there is evidence that the very individuals who become winners—the high-income lawyers, doctors, entertainers, major league athletes, investment bankers, and corporate ceos who receive the winners’ compensation—may respond more to nonpecuniary factors, such as personal gratification and prestige, than to changes in their after-tax compensation.243 for such individuals, the loss of personal gratification and prestige that would attend a fall from the ranks of the anointed would not be made up for by any decrease in taxes. supra note 215, at 79 (high income earners actually may reduce work effort in the face of lower tax rates because with lower taxes they can maintain or improve after-tax incomes notwithstanding lesser work effort). but see robert carroll et al., entrepreneurs, income taxes, and investment, presented at atlas shrug conference, supra note 81 (estimating that a 5% marginal tax increase would reduce sole proprietor entrepreneurial investment by 9%). 242. while frank and cook would use the tax system to diminish the attractiveness of winning and thus curb wasteful competition for the few winner’s slots, frank & cook, supra note 2, at 121-23, diminishing the attraction of entering is different from affecting performance by those who have won. 243. see richard a. musgrave & peggy b. musgrave, public finance in theory and practice 300 (5th ed. 1989); sanders, supra note 196, at 17-32 (harvard business school study concluding that executive work effort was unaffected by taxes; the maximum tax bracket at that time exceeded 80%); carroll, supra note 240. frank and cook acknowledge the importance of the status motive, as well as that of personal gratification. frank & cook, supra note 2, at 112-15. 88 florida tax review [vol. 4:1 v. the equities of progressive taxation equity is at the core of the concept of progressive income taxation.244 progressive income taxation can be regarded as equitable because it can require sacrifices proportional to the ability of people to make them. nevertheless,245 some critics of progressive income taxation have questioned the proportionality of the sacrifice required. others who might agree with its equitable goals246 have objected to the price of progressivity, arguing that progressive taxation impedes economic efficiency by distorting production decisions at the margin. the discussion in the preceding part attempted to show that247 progressive taxation can be efficient. we will now explain why we think it is also equitable, even if in implementation it results in the imposition of a more than proportionate burden on relatively higher income earners because of the 244. in his famous work, personal income taxation, henry simons summerized his argument for progressivity quite simply: “the case for drastic progression in taxation must be rested on the case against inequality—on the ethical or aesthetic judgment that the prevailing distribution of wealth and income reveals a degree (and/or kind) of inequality which is distinctly evil or unlovely.” henry simons, personal income taxation 18-19 (1938). although simons may have been somewhat flippant in his articulation of the justification for progressivity, egalitarian arguments for progressive taxation can rest on a solid philosophical basis, such as the philosophy of john rawls. see byrne, supra note 119, at 774-78. 245. see supra part iii.a. 246. see sources cited at supra note 144 and accompanying text. 247. see, e.g., byrne, supra note 119, at 749 (“in short, progressive rates are criticized because they create economic efficiency” and distort economic decision making.); bruce anderson, note, strategic choice taxation: a solution to the federal revenue crisis, 1995 colum. bus. l. rev. 281, 311 (1995)(asserting that “[i]nefficiency arises because individual economic decisions are increasingly distorted as a function of marginal tax rates and large scale investors are usually subject to the high-end of progressive rate structures”); martin j. mcmahon, jr., individual tax reform for fairness and simplicity: let economic growth fend for itself, 50 wash. & lee l. rev. 459, 463 (1993)(explaining that one of the main arguments against progressive taxation is the idea that progressivity stifles economic growth). 1998] winner-take-all markets 89 difficulty of measuring utility and making interpersonal utility comparisons.248 indeed, we believe that progressive taxation is a good idea even if it is inefficient. an efficient market may result in extreme poverty for many and extraordinary wealth for a few. thus, even if those who claim that249 progressive taxation reduces productivity are correct, a society very well may chose to provide for relatively more equality, at a lower level of aggregate output and utility. efficiency is an economic concept, and economics “is of no help in determining when one distribution is better or worse than another.”250 the long-term preservation of many of the values that our society holds dear very well may require a somewhat more proportional distribution of incomes (and wealth) than is produced in the winner-take-all market. if it were necessary, we would make that trade-off. the model we discussed in part iv, will help to illustrate why. consider what would happen if we assume that progressive taxation is inefficient and causes e, the winner, to decrease her productivity by $50 (so that e’s productivity drops to $450, instead of being $500), under a system in which the highest marginal rate is again adjusted to assure that e still pays $220 of tax. when these results are compared with the results under the proportional tax in table 12, it becomes apparent that the inefficient graduated progressive tax regime results in a $50 dollar diminution in the aggregate social product and a reduction in aggregate after tax utility of 235 utils. when distributional effects are considered, however, 80% of society is still better off after taxes. the operation of a market that functions as we just described is illustrated in table 15. 248. absent from our explanation will be any reliance on the notion that progressive taxation is redistributive. although some supporters of progressive taxation laud its redistributive potential, we are skeptical of that potential and believe that the attraction of progressive taxation lies in its ability to fund the cost of government, or of civilized society, as holmes put it, from the assets of those who will least miss them. the arguments we will make regarding the ability of progressive taxation to reduce large concentrations of wealth and political power are grounded in the merits of the reduction itself, not in the notion that the tax dollars collected from one person will be redistributed to another. 249. see amartya sen, on ethics and economics, 32-33 (1987). 250. harrison, supra note 139, at 2. 90 florida tax review [vol. 4:1 table 15 model society with progressive income tax and substitution effect that reduces total utility after-tax after-tax individual income tax income utility a 50 0 50 520 b 100 10 90 880 c 150 25 125 1,170 d 200 45 155 1,410 e 450 220 230 2,010 totals: 950 300 650 5,990 only e is worse off under the progressive tax system, but even this is only true if we assume that e reduced productivity without substituting anything in its place. to make this true, then, we have to assume that e reduced productivity but did not increase the utility received from leisure. the problem with such an assumption is that it defies reason: if e received no utility from leisure, e would not have any reason to substitute leisure for productivity. the patent irrationality of such an assumption should cause us to be skeptical of the claim that e enjoys less total utility, rather than simply less utility from material goods. difficulties in measuring the utility of leisure do not suggest its absence. our thesis, however, does not require agreement with the proposition that leisure has utility. assume that our only concern is utility from material goods, that e clearly receives less utility from material goods, and that the society in the aggregate thus receives less utility from material goods. might a society nevertheless rationally opt for such a system? our answer is: absolutely. if values other than maximization of aggregate material utility are important, the decision to impose such a tax system can make perfect sense. purely from a static economic welfare perspective, most individuals, particularly the worst off, are better off under the graduated progressive system than under the proportional tax even if we consider only material utility. individual e remains substantially better of than the remainder of society, although e's relative superiority has been reduced. there have been no rank reversals. if the social economic values of the society are based on a maximin welfarist theory of distributive justice, the society should reject the economically efficient proportional tax system in favor of the less efficient progressive tax system because the latter is fairer under the society's notions of 1998] winner-take-all markets 91 justice. this is really a philosophical argument, not an economic argument,251 252 and is based on the positions of philosophers like john rawls and ronald dworkin.253 furthermore, the society might find this after-tax distribution of income under the progressive structure better preserves the survival of a democratic form of government. in a democracy, the most important argument for egalitarianism might be reducing the concentrations of political power that could be derived from concentrations of wealth. to the extent that they254 prevent such concentrations of power and wealth, progressive rates preserve the liberty and freedom of the greatest number of the citizenry. in the end,255 maximizing economic efficiency is not necessarily a society's paramount desirable. it is but one element of the overall calculus, which must take into account other societal values. those values include the value of the goods256 provided by governments to all members of the society. concern for all members of a society is not grounded only in humanistic values but proceeds from a pragmatic, almost contractarian, 251. see bankman & griffith, supra note 127, at 1949-50. but see o’kelley, supra note 31. 252. in fact, all economic models implicitly accept social choices that have distributional effects. valuing efficiency as a factor influencing public policy choices in construction of legal rules, including the tax system, in and of itself inherently favors the wealthy. see bailey kuklin, the gaps between the fingers of the invisible hand, 58 brook. l. rev. 835, 871-72 (1992). 253. see john rawls, a theory of justice 278-79 (1971); ronald m. dworkin, is wealth a value?, 9 j. legal stud. 191 (1980). 254. see marjorie e. kornhauser, equality, liberty, and a fair income tax, 23 fordham urb. l. j. 607, 625 (1996); william vickrey, agenda for progressive taxation 375 (1947). this idea is hardly new, however. for a discussion of the belief that great extremes of wealth and poverty were incompatible with freedom in eighteenth century britain, and its influence on the founders, see lance banning, the sacred fire of liberty: james madison and the founding of the federal republic 40 (1995). 255. see rawls, supra note 253, at 277-79; kevin phillips, arrogant capital (1994). 256. see generally jane b. baron & jeffrey l. dunoff, against market rationality: moral critiques of economic analysis in legal theory, 17 cardozo l. rev. 431 (1996). 92 florida tax review [vol. 4:1 assessment of the relationship between the winners, the government, and the wanna-bes. in a modern democratic industrialized society, the market that produces and nurtures the winners is created by society collectively. while capital may be crucial for modern economic productivity and growth, the most important factors in significant increases in the rate of growth of the gdp historically have been increases in educational level and advances in technology. common goods provided by government, such as the highway257 system and public education, are an important factor of production. sam walton could not have implemented wal-mart’s inventory strategy, or, for that matter, had any shoppers in his stores or salesclerks who could count money, without public roads and public schools. oprah winfrey could not have her successful show without the regulation of the airwaves and the existence of a general standard of living that gives people the time to watch an hour of television in the afternoon or the resources to develop, sell, and eventually purchase, a vcr. laws protect private property and rights under contracts, the means of production. without the protection of the patent, trademark and copyright laws, multi-millionaires from michael jackson to bill gates could not have earned the incomes from which they amassed their fortunes, and martha stewart would not have become a household name. thus, in the model, e's earnings were not acquired in a vacuum, they were acquired in the market in transactions with a, b, c, and d.258 this analysis rejects, as abstractly unrealistic, the neoconservative philosophy, epitomized by robert nozick, that individuals are morally259 entitled to keep the fruits of their labor and have a claim superior to the societal claim. without a, b, c, and d, and the society, market, and government that260 they created along with e, e might not have had any productivity. there is no way of knowing what e would have produced as a hermit. it is not important to know what e might have produced under other circumstances, because e did not produce anything under any circumstances other than in the society together 257. see schultze, supra note 233, at 227-35, 290-306. 258. see james tobin, considerations regarding taxation and inequality, in income redistribution 127, 131-32 (colin d. campbell ed., 1977); see also bruce a. ackerman, social justice in the liberal state 53-59 (1980)(individuals have no natural right to keep the fruits of extraordinary beneficial endowments). 259. see robert nozick, anarchy, state, and utopia (1974). 260. see kornhauser, supra note 165, at 498-504 (explaining and criticizing nozick’s position); byrne, supra note 119, at 782-86 (demonstrating that nozick’s theory logically disallows all taxation, not merely progressive taxation). 1998] winner-take-all markets 93 with a, b, c, and d. indeed, in many cases there is substantial certainty that e’s income has been significantly enhanced by participation in societally created markets that are regulated through government in a manner that benefits high income earners like e. the monopoly rights conferred by the patent and copyright laws are prime examples of collective action that could have contributed significantly to e’s income. society at large owns the market, because it has created the market, including the legal infrastructure that facilitates e’s participation in that market. in levying taxes, society is, in effect, charging rent for the privilege of participating in the market—rent which will be plowed back into maintaining that market in the form of public goods. from this perspective, no individual has a right to any particular price, that is, tax rate, for the use of public goods, just like no individual has a right to buy an automobile at the lowest price at which the dealer has sold it to another individual. everybody must pay the price that the market will bear.261 thus there is no need to justify progressive taxation as redistributive. it is no more redistributive than the difference in price between a cadillac and a ford escort. the purchaser of a luxury car, who exercises a claim on a greater share of resources than does the purchaser of a modest car, must pay more—however much more the seller wants to charge. if the buyer doesn’t like the price of the cadillac, she can purchase the escort. a high income earner, like a low income earner, must pay more for the use of those public goods—however much more the seller, the citizenry acting through its government, wants to charge. if she262 doesn’t like the price, she can choose a lower income level. finally, egalitarian arguments for progressive taxation also can be 261. individuals do, of course, have the right to be free from discrimination on a variety of grounds, and our hypothesis assumes that price distinctions would not proceed from invidiously discriminatory animus. 262. as we noted earlier, in part ii.e., nothing provides reliable information to support an argument to the effect that the very highest income earners, taking into account income from all sources, capital as well as labor, are not at the apex for many years and that it is therefore appropriate to treat these individuals as winners. to the extent high income earners do ascend or slide down the income scales, as they might in the case of fluctuations in wage income, if the effects of progressive taxation warrant mitigation, that can be accomplished through an income averaging mechanism. 94 florida tax review [vol. 4:1 based on the fundamental american value of equal opportunity. this point263 is concisely captured by professor robert eisner in the following passage: an old joke runs, “i have been poor and i have been rich, and rich is better.” and it is better not merely because the rich can enjoy higher lifetime consumption than the poor. riches convey prestige and power and the ability to add to future income for oneself and one’s children.264 there is no doubt that many individuals’ wealth, power, and consequent income are derived from their, or their parents’, wealth and connections. vast concentrations of wealth inhibit equality of economic opportunity, and a265 progressive income tax can be a tool for mitigating the ability to accumulate vast fortunes. thus, a progressive income tax can help to preserve equality266 of opportunity for successive generations of americans. it can do so not by redistributing wealth—by taking from peter to pay paul—but by reducing the disparities in after-tax income that dampen opportunity and perhaps, as frank and cook claim, even inhibit large numbers of people from maximizing their potential by pursuing endeavors likely to produce the highest payoff in the long run.267 263. see kornhauser, supra note 254, at 635. 264. eisner, supra note 215, at 48. 265. see lester c. thurow, generating inequality: mechanisms of distribution in the u.s. economy 129, 142-54 (1975). 266. we believe that the distribution of income and wealth is so important to the social fabric of the nation that no practical debate over the most socially optimal tax base and rate structure can ignore the distribution of income and wealth in our society. see harold m. groves, toward a social theory of progressive taxation, 9 nat’l tax j. 27 (1956). 267. see frank & cook, the superstar economy, supra note 184, at c2. in the end, frank and cook do not advocate progressive income taxation because they worry about the impact of income taxation on the incentive to save. frank & cook, supra note 2, at 213. therefore, they conclude by advocating progressive consumption taxation. id. as they point out, “[a] progressive tax on consumption makes entry into winnertake-all tournaments less attractive for the same reasons that a progressive tax on income does. and by effectively reducing the prizes received by winners, a progressive consumption tax also reduces the 1998] winner-take-all markets 95 our analysis might be considered to proceed from a communitarian view of the appropriate balance between equity and efficiency in the design of the rate structure. we suggest a balancing of individual economic rights reflecting the obligations to the greater community of the winners in the winner-take-all market. we do not claim that communitarianism compels the268 conclusions reached by our analysis, but only that communitarian principles support those conclusions. what we present here might be termed a normative extension of socio-economic analytical principles, in opposition to a normative application of neo-classical economic principles. in the end, human behavior, and thus society, is governed by more than economic principles. societal values reflect a complex balancing of principles and interests. the current income269 tax is not really an income tax; it is a hybrid income/consumption tax. the270 tax base reflects a balancing of differing values. the rate structure should271 incentives to engage in positional arms races.” id. at 214. unlike frank and cook, we favor progressive income taxation over progressive consumption taxation, but further discussion of the choice of base must await another time. 268. see generally richard m. coughlin, whose morality? which community? what interests? socio-economic and communitarian perspectives, 25 j. socio-econ. 135, 143 (1996)(discussing how communitarianism balances individual rights and individual responsibilities). for a discussion on communitarianism generally, see amitai etzioni, the spirit of community: the reinvention of american society (1993). our analysis balances individual economic rights against the rights of the community because it rests on the insight that progressive taxation need not result in a decline in aggregate utility. we acknowledge that progressive taxation will require a greater proportionate sacrifice from some members of the society than others. see supra part iv. 269. see robert ashford, socio-economics: what is its place in law practice?, 3 wisc. l. rev. 611, 613-15 (1997)(summarizing principles of socio-economic analysis). 270. see david f. bradford, untangling the income tax 7 (1986); uneasy compromise: problems of a hybrid income-consumption tax 1-3 (henry j. aaron et al., eds., 1988); edward j. mccaffery, tax policy under a hybrid income-consumption tax, 70 tex. l. rev. 1145 (1992). 271. see boris i. bittker, a “comprehensive tax base” as a goal of income tax reform, 80 harv. l. rev. 925 (1967); edward a. 96 florida tax review [vol. 4:1 also reflect a balancing of multiple values.272 vi. designing the rate structure a. evaluating the current rate structure the current rate structure is progressive. indeed, many feel that it is273 too progressive and would like to make it less so. we don’t. while there are274 many things wrong with the current system, excessive progressivity is not275 one of them. the magnitude of the differences in incomes revealed by the data and the trend toward increasing income inequality suggest that changing the rate structure to make it less progressive is a move in the wrong direction. the principles of ability to pay, equal sacrifice, and mitigation of socio-economic inequality, all suggest that a winner-take-all society should have a tax system that is more progressive at the very top than for an incrementalist society. the rate schedule should parallel the distribution of income. the important question is not whether to have progressivity, but how progressive the rates should be. although the current rate schedule distinguishes the top quintile from the first four quintiles, the current rate structure fails adequately to account for the gap between the top 5% and the rest of the population as well as for the vast disparities of income within the top 1%. the approximate distribution of returns by marginal tax bracket for taxable returns for 1993 is shown in table 16. table 16 distribution of tax returns by marginal rate, 1993276 zelinsky, efficiency and income taxes: the rehabilitation of tax incentives, 64 tex. l. rev. 973 (1986). 272. see kornhauser, supra note 254. 273. indeed, the current system attempts to introduce progressivity not only through the front door of the rate structure in § 1, but also through the back door, with a variety of phaseouts and other limitations on tax benefits. see, e.g., irc §§ 67, 68, 151(d). 274. see, e.g., kemp commission report, supra note 51; o’kelley, supra note 31; hall & rabushka, supra note 31. 275. for an excellent and very entertaining discussion of the many ills that plague the current system, see michael j. graetz, the decline (and fall?) of the income tax (1997). 276. derived from statistics of income division, internal revenue service, pub. no. 1304, individual tax returns 1993, at 25 tbl. 1998] winner-take-all markets 97 marginal tax rate percent of returns quintile covered nontaxable 20.82% 1st (bottom) 15% 57.21% 2nd-4th (middle) 28% 18.80% 5th (top) 31% 1.89% 5th (top) 36% 0.66% 5th (top) 39.6% 0.40% 5th (top) since some households in the bottom quintile are neither required to file a return, nor file to obtain the earned income credit, the actual percentage of nontaxable returns understates the percentage of households with no tax liability. after taking into account households that do not file returns, the current rate structure thus basically exempts the first quintile and part of the second quintile, provides a flat rate for the remainder of the second quintile and the third and fourth quintiles, and begins to apply graduated progressive rates only in the top quintile, reserving all rates above the 28% bracket, the second positive rate, for the top 3% of households by income class.277 1.1, 99 tbl. 3.4 (1996). the percentages do not total 100% because 0.22% of returns were for minors subject to the “kiddie tax” in § 1(g) and were not classified by marginal tax rate. 277. the actual curve of progressivity is nowhere near as smooth as the statutory rates set forth in § 1 make it seem. due to numerous special rules, including phase-outs of itemized deductions and personal exemptions, rate “bubbles” are created and actual marginal rates at income levels beyond the bump may be lower than the stated marginal rates at the lower income levels within the bubble area. in addition, if total tax burden, including social security taxes (fica), is considered, the highest marginal tax rates are imposed at income levels significantly below the income level at which the highest marginal income tax rate applies. see elliot t. manning & laurence m. andress, the 1996 marginal federal income tax rates: the image and the reality, 73 tax notes 1585 (dec. 30, 1996); staff of the joint comm. on taxation, 105th cong., 2d sess., present law and analysis relating to individual effective marginal tax rates (comm. print 1998); see also, daniel shaviro, the minimum wage, the earned income tax credit, and optimal subsidy policy, 64 u. chi. l. rev. 405, 423 (1997)(observing that “phaseouts of social welfare programs often cause [the poor] to face the very highest marginal tax rates, sometimes at astonishing levels that approach or even exceed 100 percent”); supra note 67 (graphically 98 florida tax review [vol. 4:1 within the top half of the top 1%, however, the current rate structure fails to take into account the dramatic difference in income. under current law, the top half of the top 1%, by taxable income, includes everyone with more than $250,000 of taxable income. that group is subject to a marginal tax rate of 39.6%. the differences between those with taxable income of $250,000 and those with taxable income of $1,000,000 or more are so vast as to warrant differences in their marginal tax rates on the grounds of ability to pay, diminishing marginal utility of money, and mitigation of economic power. b. suggestions for the design of the rate structure—forward to the past the shape of the pre-1964 rate structure, if not the exact rates, provides some guidance for allocating the tax burden in a way that more closely reflects the disparities in income. the pre-’64 rate structure provided an essentially flat rate of tax for the overwhelming bulk of the population. in 1961, individuals in the bottom quintile faced a zero rate due to personal exemptions and the standard deduction. the first three positive rates, 20, 22, and 24%, applied to the next 70% of taxpayers, and the steeply graduated rates, which at that time went up to 90%, applied to 10% or fewer of individuals at the top of the income distribution. the marginal rates above 38% applied to less than 1% of all278 return filers, about 1.1% of taxable returns.279 1. the first four quintiles.—the distribution of incomes revealed by the data suggests that the income differences across the second, third, and fourth, quintiles are not so great as to warrant significantly different rate brackets.280 depicting changes in average adjusted pre-tax and after tax income). 278. see steuerle, supra note 34, at 23. 279. derived from statistics of income division, internal revenue service, pub. no. 79, individual income tax returns, 1962, at 110-13 tbl. 20 (1965). 280. see supra table 5. 1998] winner-take-all markets 99 figure 8 distribution of average income281 given this distribution, we believe that the first quintile should be excluded from the tax system by personal exemptions or a standard deduction, and probably a portion of the second quintile ought to be excluded as well. the282 remainder of the second quintile and the third and fourth quintiles easily could be subjected to a single flat rate or to two or three fairly similar stair-stepped rates. this is very close to the current rate structure. although the differences283 within any 20or 30-percentage point range within the first four quintiles might not seem too great, the income of individuals in the 30th percentile differs sufficiently from that of individuals in the 70th percentile to warrant different marginal rates between them. nevertheless, given the vicissitudes of income 281. the data for this figure are derived from table 5 presented earlier in the text. 282. for a recent proposal to impose a positive tax on individuals in the lowest quintile, combined with cash demogrants, as a way of allowing those individuals to feel like full, contributing and responsible members of society, see staudt, supra note 198. 283. we express no opinion on the appropriateness of any particular rate within the existing range, as we feel that the choice of specific rate from within that range will proceed from revenue and political constraints. as a matter of theory, there is no difference between a rate of, say, 15% and a rate of 16%. 100 florida tax review [vol. 4:1 measurement and reporting from year to year, the differences between the individuals in these quintiles are not significant enough to warrant more than two or three rate brackets more than a few percentage points apart. concluding that rates should not vary greatly over the middle of the income distribution invites questioning whether rates should vary at all for this segment of the population. there are at least three reasons for supporting a rate structure that provided a single rate for the great mass of people in the second, third and fourth quintiles. first, the economic differences between the people in these quintiles are not so great as to warrant mitigation of those differences. the delicate fine-tuning that would be required to have a rate structure that mirrors the differences between the individuals in these quintiles might not be either possible or desirable. second, the differences in income between284 individuals in the middle quintiles are not sufficient to provide the requisite certainty that the value of their marginal dollars has diminished enough to warrant a higher rate of tax. average income does not differ as greatly over the second through fourth quintiles as it does in the top quintile. third, it285 assuages public concerns—unwarranted but nevertheless real concerns—that progressivity is a cause of complexity for the average taxpayer. although all serious students of taxation recognize that complexity proceeds from base issues, not from the number of rates, the american people seem to have been convinced otherwise. the political attractiveness of flat tax schemes and the success of the bracket reduction rhetoric in ‘86 are testimony to that. providing for a single rate of tax for over 80% of taxpayers, might have the political appeal of the recently proposed “flat taxes” without the distributional mischief those taxes would wreak.286 284. attempts to fine tune aspects of the tax laws to specific personal and economic circumstances are responsible for much of the complexity in the current law. for a vivid illustration of this, see graetz, supra note 275, at 68-88. although the rate structure does not, of itself, add complexity, we feel that we should eschew attempts to fine tune whereever possible. we simply lack the tools to do it well and fine distinctions that must necessarily be imprecise are as likely to do harm as good. as a matter of policy, we shouldn't even try to make them. 285. see supra table 5 and figure 8. 286. for discussion of the distributional impact of recent “flattax” proposals, see william g. gale et al., distributional effects of fundamental tax reform, in economic effects of fundamental tax reform 281, 305 (henry j. aaron & william g. gale eds., 1996)(predicting a very substantial decrease in the tax burden of the top 1998] winner-take-all markets 101 nevertheless, while a structure that provided for a single rate for those below the fifth quintile has much to commend it and can be reconciled with our analysis, we believe that neither fairness nor administrability demand a single rate for this group. we agree with nobel laureate william vickrey, who observed that, “[t]o imply that simplicity requires a small number of brackets is essentially a ruse designed to inhibit progression at the top of the scale.”287 administrability is not really the issue. although we feel that the overwhelming majority should face an essentially flat rate structure, it is for reasons of fairness, not administrability. an essentially flat rate structure, however, need not be perfectly flat. if money really does have diminishing marginal utility, the difference between a $30,000 income and a $60,000 income is significant enough to warrant a somewhat higher marginal tax rate on the higher income. 2. the fifth quintile.—the fifth quintile is an entirely different matter. when we examine that top quintile, and particularly the top 5% and smaller subgroups within that top 5%, the case for more steeply graduated progressive rates begins to look significantly better and the attraction of a single flat tax rate quickly dims.288 figure 9 average income for families in the 5th quintile289 1%, increased tax burdens on the bottom 50%, and relatively little change for the 50%-99% group); office of tax analysis, united states department of the treasury, ‘new’ armey-shelby flat tax would still lose money, treasury finds, 70 tax notes 451 (jan. 22, 1996)(using a revenue neutral rate (20.8%) and the exemption levels proposed in the armey-shelby bill, only taxpayers in the highest quintile would receive a tax cut, everyone else would have an increased tax burden). 287. william vickrey, simplification, progression, and a level playing field, 73 tax notes 711, 713 (nov. 11, 1996). 288. see supra table 5. 289. the data for this graph are derived from table 5 presented earlier in the text. while we recognize the limitations inherent in our comparison of the data from tables 4 and 5, since the data within the fifth quintile (table 5) come from a different source, and a different year, than the overall data (table 4), we do not think that those limitations detract from the import of the picture the data paint given the wealth of greenbook data consistent with the distribution we derive. 102 florida tax review [vol. 4:1 for the bottom of the top quintile, the 81st to 95th percentile, average income is only between three and four times the average income of the second quintile. this difference is not so great as to compel a significantly higher290 rate on the grounds of ability to pay, i.e., the diminishing marginal utility of money, or mitigation of economic inequality. but it is sufficient to warrant a slightly higher rate on those grounds. moreover, if a single flat rate were imposed on all taxpayers (other than those in the zero bracket) below the fifth quintile, a higher rate for the bottom of the fifth quintile might provide enough revenue to help to keep the rate on the second through fourth quintiles low enough so as not to extract too much from those quintiles, which include households barely above the poverty level. families at the top of the fifth quintile, however, are truly different from the rest. if families in the 30th to 95th percentiles are apples, those in the last half of the top decile have metamorphosed into oranges. it is improper to treat them like apples. families in the group from the 96th to the 99th percentile have average incomes measured in six figures, which are more than double the average incomes of families in the ninth decile (81-90th percentile). a 290. see supra table 4. 1998] winner-take-all markets 103 somewhat higher graduated bracket may be warranted for this group. but it is in the top 1% where the greatest disparities lie. the bottom of the top 1% looks a lot more like the 96th through 99th percentile than it does the top of the top 1% but the differences in the top 1% as a whole are nevertheless striking. the same can be said for each income group as we move through subcategories within the top 1%. each group is closer to those below it than to those ahead of it, but the differences, not only in dollars but in multiples of income, are sufficient to warrant increasing steepness in the graduation of rates, whether graduated progressivity is based on the diminishing marginal utility of money or on the mitigation of economic power. at this juncture we want to stop short of prescribing the actual rates that should apply to this top group, for prescribing a given rate is really not our project. nevertheless, we are confident that for the really big winners,291 marginal rates in excess of the current 39.6% top rate are warranted, and again suggest that history can provide a useful model.292 in 1962, the top one-half of 1% of filers, by agi class, was subject to marginal tax rates of 50% or more; slightly less than four tenths of 1% of filers were in marginal tax brackets higher than 50%. even after the 1964 rate293 reduction, high income taxpayers continued to face marginal rates of up to 70%. in 1995 dollars, applying the 1964 rate schedule, a joint return reporting $1,000,000 of taxable income would be in the 70% marginal rate bracket; a joint return reporting $750,000 of income would be in the 66% marginal rate bracket; a joint return reporting $500,000 would be in the 62% marginal tax 291. neither is it our project to prescribe the mechanism for achieving the level of progressivity we advocate. thus, we have deliberately refrained from engaging in a discussion of whether the progressivity we advocate should be achieved through the front door of the positive rate schedule or through the back door of phaseouts and floors. for now, we feel compelled to leave that discussion to others, or to other articles. 292. although higher rates at the top would also raise revenue, that is not the reason we favor them. see mcmahon, supra note 247, at 465-67. the primary objective of our proposal is not to increase general revenues, but to reallocate the tax burden so as to relieve the burdens on those below the 95th percentile, and allocate more of the burden to those in the top 1% of the income distribution. 293. derived from statistics of income division, supra note 279, at 110-13 tbl. 20. 104 florida tax review [vol. 4:1 bracket; and a joint return reporting $250,000 would be in the 50% marginal tax bracket. the early 1960s rate schedules thus took into account the294 diminishing marginal utility of money at the top of the income scale more appropriately than any rate structure we’ve had since. the continued growth of winner-take-all markets has amplified the disparities in the income distribution and clearly supports a return to a rate structure that more closely matches tax rates to the marginal utility of money. raising marginal rates on the higher income earners within the top one-half of 1%, using the early 1960s rate schedules as a model, but perhaps using $500,000, $1,000,000, $5,000,000 and $10,000,000 as taxable income break points, would enhance the equity of the tax system, better taking into account the diminishing marginal utility of money. while we do not advocate a return295 to the specific rates of the early 60’s and recognize that other concerns might militate against the adoption of rates as high as those of the early 60’s, we nevertheless feel that the outline of the rate structure in effect during the early 60’s better fits the current distribution of income than any other. it would296 effect more than poetic justice for an economy with an income distribution like that of the arthurian camelot to have an income tax rate structure like that which existed during the time of the american camelot. 294. derived from irc § 1, as in effect for 1964, and bureau of the census, statistical abstract of the united states: 1996, 483 tbl. 745 (cpi-u, all items) (116th ed., 1996). 295. as one of us has argued elsewhere, tax systems can give, even as they are taking away, and what tax systems can give is power to control the size of the tax burden. abreu, supra note 91. a tax system designed like the current income tax gives those at the top of the income scale a degree of power over their ultimate tax liability that is simply not available to others further down. the ability to defer compensation, receive favorably taxed stock options rather than unfavorably taxed salary, relish the fruits of borrowed, and untaxed, money, while deducting the cost of obtaining that money, and to set the time of taxation by controlling realization, are reserved for those at the top. imposing a higher positive rate on the winners can be seen simply as compensating for the power the tax system gives to them but withholds from others. 296. see dan throop smith, high progressive tax rates: inequity and immorality? 20 fla. l. rev. 451 (1968). 1998] winner-take-all markets 105 vi. conclusion over 45 years ago, walter blum and harry kalven concluded their now-classic treatment of progressive taxation with the observation that, [i]n the end it is the implications about economic inequality which impart significance and permanence to the issue and institution of progression. ultimately a serious interest in progression stems from the fact that a progressive tax is perhaps the cardinal instance of the democratic community struggling with its hardest problem.297 those who were infants when blum and kalven made that observation are now staunchly middle-aged, and yet the struggle continues. the growth of winnertake-all markets over the last 45 years has served to make the struggle even harder, and that trend shows little indication of imminent abatement. as298 winner-take-all markets continue to expand, the differences between those at the top and those at the bottom of the income distribution are likely to become greater still. it is time for tax policy to confront head on the implications of the expansion of winner-take-all markets. it has long seemed axiomatic that to choose progressive taxation was to choose economic inefficiency. what we have tried to do in this article is show that the expansion of winner-take-all markets renders the choice 297. blum & kalven, supra note 22, at 520. 298. this is perhaps not surprising. arguably, the winner-take-all phenomenon in the economy identified by frank and cook is but one illustration of a penchant for winner-take-all systems that is manifested in other parts of our society. some political scientists, for example, have observed that our system of selecting government officials—our elections—also follows a winner-take-all paradigm. douglas j. amy, real choices/new voices 22 (1993). like the economic winner-take-all markets that frank and cook identified, the electoral winner-take-all system produces an environment in which the rewards of winning can eclipse the differences in talent between those who win and those who don’t. it is telling that we have maintained the winner-take-all model in something so fundamental as our electoral process, even though we stand with only a minority of industrialized nations in doing so. id. at 2-4. see also david kairys, why not democracy?, poverty & race (poverty and race research action council, washington, d.c.) may-june 1995, at 13. 106 florida tax review [vol. 4:1 unnecessary. when income is distributed in the manner typical of winner-takeall markets, even conservative assumptions about the rate at which the marginal utility of money declines make it simple to show that a system of progressive taxation can result in greater aggregate utility, and therefore greater efficiency, than a system of proportional taxation. in other words, the old equity/efficiency trade-off need not be made. we can have both. fundamentally, our claim is that efficiency should be measured by maximization of aggregate private utility rather than by the dollar amount of the gdp. for us, the determination of whether a progressive or proportional tax structure is more efficient depends on the distribution of after-tax incomes and on the rate at which the marginal utility of money declines. the problem with our claim is that while the after-tax distribution of incomes is empirically measurable, nobody has yet devised a mechanism for measuring the actual rate at which the marginal utility of money declines. we simply have to guess, so we can offer no empirical proof of our claim. nevertheless, we believe we have offered a valuable heuristic. we have offered a model based on very conservative assumptions about the rate at which the marginal utility of money declines. if the marginal utility of money declines more rapidly than we assume, the case for progressive taxation becomes even stronger. while we do not believe that tax rates have a significant effect on productivity, under our model the case for progressive taxation on efficiency grounds remains strong even if tax rates do cause productivity to decline. in narrative form, our claim is that when efficiency is measured by after-tax private utility, rather than by absolute dollars, a progressive rate structure can be more efficient than a proportional structure even if it reduces total productivity, measured in absolute dollars. the reason is that if a progressive rate structure reduces productivity, it will do so by reducing the productivity of those at the top of the income scale. yet, those are the very people for whom money has the least marginal utility. thus, the reduction in productivity would come at the cost of a minimal reduction in utility. if progressivity at the very top makes it more feasible to apply lower rates to those at the bottom of the income scale—those for whom money has the greatest marginal utility—it is easy to see how a progressive rate structure could result in no decline in aggregate private utility. the loss of productivity at the top reduces aggregate after-tax utility only a little, but the resulting low tax rates at the bottom increase aggregate after-tax utility a lot. a relatively smaller dollar value gdp that is more equally distributed therefore results in greater after-tax aggregate utility than a relatively larger dollar value gdp that is distributed in a highly skewed manner. winner-take-all markets produce highly skewed distributions of pre-tax income. given such distributions of income, a progressive rate structure can produce a result that is not only efficient, but that is equitable as well. such a rate structure takes more from those who not only have greater ability to pay 1998] winner-take-all markets 107 but who also derive less utility from each marginal dollar, while taking less from those who have less ability to pay and who derive greater utility from each marginal dollar. the rate structure we have proposed would produce precisely these effects. it would exempt those at the bottom and treat the remainder of those below the 95th percentile in substantially the same way, with only a few rate brackets, which would reflect the general similarity of their economic positions. such a rate structure would reflect our view that the families in the middle are essentially all apples; they may come in different sizes and varieties, but they are fundamentally similar and ought therefore to be treated in substantially the same way by the tax system. it is families in the top 5%, and especially those in the top 1%, the winners, who are the juicy oranges. they are really different from the rest of us, and the significantly higher graduated rates that we propose are saved for them.299 in its progressivity, the rate structure we propose simply mirrors the distribution of pre-tax income. the winner-take-all market that produces highly skewed distributions of pre-tax income prescribes the distribution of tax burdens that we propose. such a distribution of the tax burden is equitable, and, as we have shown, is also efficient. we don’t have to choose. if we did have to choose, what we would choose is clear. economic efficiency is not everything. other values count. progressive taxation shortens the economic distances that divide us. it comports with egalitarian values important to us. equality fosters social and political cohesion. progressive300 taxation may have endured at least in part because it reflects these values, just as other features of our tax system reflect fundamental values.301 a society can choose to be concerned about the distribution of income, or it can choose to ignore that distribution. but nothing in economics dictates whether or not the distribution of income is a valid societal concern or whether that concern should trump others. if there is a trade-off between equity and efficiency, equity should not be the loser. efficiency and justice are not the same thing. 299. f. scott fitzgerald was right when he had a character quip, “let me tell you about the very rich. they are different from you and me.” f. scott fitzgerald, the rich boy (1926), reprinted in the short stories of f. scott fitzgerald 318 (matthew j. bruccoli ed., 1989). 300. see michael keen, peculiar institutions: a british perspective on tax policy in the united states, 50 nat’l tax j. 779, 783 (1997). 301. kornhauser, supra note 30, at 121. for a discussion of the way in which our tax system reflects the value we place on personal autonomy, see abreu, supra note 91. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe 1. assistant professor of law, university of pittsburgh school of law. i would like to thank the university of pittsburgh school of law for providing financial support for the writing of this article. i would like to thank vivian curran and alan meisel for their helpful comments on previous drafts of this article and john marciano iii for his research assistance in the preparation of this article. i would also like to thank hien ma for his support while i was writing this article. 251 florida tax review volume 6 2003 number 3 the ethics of tax cloning anthony c. infanti1 i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 ii. description of activities of american advisors . . . . . 262 a. u.s. government agencies . . . . . . . . . . . . . . . . . . . . . . 263 b. private sector programs . . . . . . . . . . . . . . . . . . . . . . . . 266 c. academic endeavors . . . . . . . . . . . . . . . . . . . . . . . . . . . 270 d. international organizations . . . . . . . . . . . . . . . . . . . . . 274 1. the oecd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275 2. the imf . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278 iii. the terminological debate . . . . . . . . . . . . . . . . . . . . . . . 281 a. the extant terminological alternatives . . . . . . . . . . . . 283 b. a new alternative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288 iv. the normative basis of the ethical guidelines . . . . . 292 a. the bioethics debate . . . . . . . . . . . . . . . . . . . . . . . . . . . 293 1. arguments against human cloning . . . . . . . . . . . . . 294 a. secular arguments . . . . . . . . . . . . . . . . . . . . 295 b. religious arguments . . . . . . . . . . . . . . . . . . 299 2. arguments in favor of permitting cloning . . . . . . . . 301 3. the normative basis of the bioethics debate . . . . . . 305 b. legal ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311 1. the sources of legal ethical rules and their impact on the scope of the discussion . . . . . . . . . . . . . . . . . . . . . 311 2. the principle of nonmaleficence in legal ethics . . . 313 a. preventing harm to clients . . . . . . . . . . . . . 314 b. preventing harm to nonclients . . . . . . . . . . 315 252 florida tax review [vol. 6:3 v. providing content to the principle of nonmaleficence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 a. kahn-freund’s perspective on legal cloning . . . . . . . 320 b. watson’s perspective on legal cloning . . . . . . . . . . . . 324 c. common ground . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333 d. ethical guidelines for tax cloning . . . . . . . . . . . . . . . . 336 vi. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337 2003] the ethics of tax cloning 253 2. “the creation of new taxes requires the exercise of great caution.” e.f. kankrin, russian minister of finance (1774-1845) (translation by author). this quotation was found on a website maintained by the administration of the ministry of taxation of the russian federation for the nizhegoro d region , at http://www.umns.nnov.ru/comm/indexall.phtml?id=1354 (last visited sept. 12, 2003). please note that the transliteration from the russian cyrillic alphabet was made in accordance with the american library association-library of congress romanization tables, at http://www.loc.gov/catdir/cpso/roman.html (last visited sept. 12, 2003). 3. todd s. purdum, powell to press mideast peace: says we’ll expand role and pursue saudi peace plan, pittsburgh post-gazette, feb. 28, 2002, at a5. % jfh">@&:,>44 >@&zn >":@(@& >j0>" @r,>\ $@:\t"b @fh@d@0>@fh\. +.k. 7">8d4> <4>4fhd l4>">f@& c@ff44 (1774-1845)2 i. introduction one morning while i was reading the newspaper over breakfast, i was struck by the following sentence in an article that recounted the highlights of a wide-ranging interview with u.s. secretary of state colin powell: “in my judgment, any country right now that has a despotic leadership, that is unrepresentative of its people, that is not putting in place market economic systems, that is rife with corruption, a lack of transparency and no rule of law, that thinks it can achieve a position on the world stage through development of weapons of mass destruction that will turn out to be fool’s gold for them, is a loser,” he said.3 this sentence formed part of an attempt to explain president bush’s then-recent use of the phrase “axis of evil” to describe iran, iraq, and north korea. what struck me about this statement was that powell accorded the same level of stigmatization to the lack of market economic systems, transparency, and the rule of law as he did to despotism, corruption, and a form of blackmail. you might (quite correctly, i would add) be wondering why i simply did not move on to another story or just put the newspaper down and do something more productive, like walk my dog or prepare for the class that i had to teach in a scant few hours. but these three characteristics – market economic systems, transparency, and the rule of law – are the features of western political and 254 florida tax review [vol. 6:3 4. in other words, those of the united states, canada, and western europe. 5. see, e.g., maxwell o. chibundu, globalizing the rule of law: some thoughts at and on the periphery, 7 ind. j. global legal stud. 79, 79 (1999) (“in the wake of the unparalleled economic and political success of the west, rendered in stark relief by the fall of the berlin wall a decade ago, a triad of concepts has been deployed both to explain the west’s ascendancy, and as a prescription for the laggards of the emerging (or ‘transitional’) and underdeveloped countries of the former communist and third world societies. ‘democracy,’ the ‘free market,’ and the ‘rule of law’ are advanced as a trinity that underpin liberal capitalism, and without which developing and transitional societies will continue to languish in the shadows o f misery.” (footnote omitted)); john v. orth, exporting the rule of law, 24 n.c. j. int’l l. & com. reg. 71, 71 (1998) (“the achievement of the rule of law in western europe and north america came at a great cost, involving wars and revolutions, and took place over centuries and decades, not months and weeks.”); david m . trubek & m arc galanter, scholars in selfestrangement: some reflections on the crisis in law and development studies in the united states, 1974 w is. l. rev. 1062, 1085-86 (“legal development assistance began in a period when cold w ar rhetoric and cold w ar policy were ascendent. the american elite and policy makers saw the ‘rule of law’ as one of the major features that distinguished the united states from communist nations.”). 6. see james a. gardner, legal imperialism: american lawyers and foreign aid in latin america 12-15, 35-52 (1980); lawrence m. friedman, on legal development, 24 rutgers l. rev. 11, 11-12 (1969); john henry merryman, comparative law and social change: on the origins, style, decline & revival of the law and development movement, 25 am. j. comp. l. 457, 479-83 (1977); trubek & galanter, supra note 5, passim . 7. see gianmaria ajani, by chance and prestige: legal transplants in russia and eastern europe, 43 am. j. comp. l. 93, 103 (1995) (“during the current postsocialist phase, . . . the concealment [of western influence of socialist civil law] has changed in an open acceptance of foreign scholarly and statutory models . . . . the concealment disappeared because of pressure of various factors: the need to legislate in a short time and to fill the vacuum left by the previous experience; pressure from supranational organizations as well as of international financial institutions; and also the simple desire of the politicians, and jurists to provide one’s system with tools already in use elsewhere.”); jacques delisle, lex americana? united states legal assistance, american legal models, and legal change in the post-communist world and beyond, economic systems4 that have been used to explain the west’s success during the cold war period and the concomitant failure of the soviet union and its satellites.5 maybe i was reading too much into one sentence, but, at least to me, the subtext of powell’s statement appeared to be that any country that is not made in the western mold is a “loser” or “evil.” seen in this light, powell’s statement evinces what can only be described as missionary zeal – a zeal that has characterized american efforts to propagate western legal ideas in developing countries6 and, more recently, in the formerly socialist countries of central and eastern europe (“cee”) and the newly independent states of the former soviet union (“nis”).7 the effort 2003] the ethics of tax cloning 255 20 u. pa. j. int’l econ. l. 179, 180 (1999) (“these . . . episodes lie at the unhappy end of a spectrum of contemporary united states efforts to export legal models and provide legal assistance around the world. they represent only very small, and strikingly ineffective, parts of the extraordinarily ambitious and multifaceted drive undertaken or supported by u.s. organizations and individuals to transplant laws and legal ideas and to foster legal reform or development abroad.”); id. at 181 (“[t]he crumbling of state socialism has precipitated a worldwide wave of democratization. these transformations have produced a seemingly insatiable appetite for legal and constitutional reforms suited to the new political and economic orders. the opening of new areas (both geographic and substantive) to american influence, the removal of the principal rivals to u.s. power and american-supported ideologies, and the seemingly sweeping embrace of principles that official and unofficial u.s. actors have seen as congenial (o r even as proprietarily american) thus have provided the setting for countless u.s. legal export-promotion and advice-offering activities that have sought to respond to the demands and opportunities of the era.”). 8. gardner, supra note 6, at 13, 29. 9. see, e .g ., helmut k. anheier & lester m. salamon, volunteering in crossnational perspective: initial comparisons, 62 law & contemp. probs. 43, 57, 64 (1999); michael a. heller, the tragedy of the anticommons: property in the transition from marx to m arkets, 111 harv. l. rev. 621 passim (1998); victor thuronyi, international tax cooperation and a multilateral t reaty, 26 brooklyn j. int’l l. 1641, 1662-63 (2001). the fact that the formerly socialist countries of the cee/nis region are referred to as “transition” countries is itself indicative of the general attitude of western superiority. the term “transition” implies a change from a “bad” socialist state and command economy to a “good” market economy. see miranda stewart, global trajectories of tax reform: mapping tax reform in developing and transition countries, 44 harv. int’l l.j. 139, 173 (2003) (“tax reform discourse . . . participates in the conceptualization of developing and transition countries as ‘‘backward,’ ‘primitive,’ ‘feudal,’ ‘medieval,’ ‘developing country,’ and ‘pre-industrial,’’ hence representing them as deficient in relation to a ‘western’ (i.e., ‘developed,’ or ‘international’) norm.” (footnote omitted)). 10. see, e.g., the sources cited infra note 167. to convince these countries of the correctness and universality of our ideas may be perceived either as a benign attempt at sharing with them what has worked for us (fueled, of course, by a healthy dose of american hubris) or as a more malignant, thinly-veiled form of imperialism.8 whatever the impetus, my first reaction to powell’s statement was to question the utility of replicating western models in countries with markedly different social, political, and economic contexts. being a tax academic and recalling stories that had appeared in the tax press from time to time during the past decade, i particularly questioned the utility of replicating all or portions of western tax systems in the so-called “transition”9 countries of the cee/nis region.10 after further reflection, however, i began to look at the issue from a slightly different perspective. i began to focus on the relationship between the 256 florida tax review [vol. 6:3 11. while advice has also been proffered by foreign advisors, see, e.g., infra note 167 and accompanying text, a discussion of their activities is beyond the scope of this article. recognizing the fact that i am a product of the u.s. legal culture and that other legal cultures may view the issues discussed in this article differently, i have purposefully maintained a narrow focus on american advisors and american legal ethics. 12. while neither the international monetary fund nor the organization for economic co-operation and development is an american organization, i have included them in this discussion because of the perceived hegemonic influence of the united states over international economic organizations. see, e.g., paul b. stephan, american hegemony and international law: sheriff or prisoner? the united states and the w orld trade organization, 1 chi. j. int’l l. 49, 50 (2000) (“an essential component of these accounts is the perceived relationship between the united states and the international institutions that help shape the world economy. those who see the united states as a hegemonic power portray the international monetary fund . . . , the world bank, the wto, and similar bodies as instruments of u.s. policy. typical is the renowned historian eric hobsbawm, who speaks of the im f and the w orld bank as ‘de facto subordinated to us policy’ . . . .” (quoting eric hobsbawm, the age of extremes: a history of the w orld, 1914-1991, at 274-75 (1994)); miranda stewart, the “aha” experience: comparative income tax systems, 19 tax notes int’l 1323, 1329 (1999) (“this dramatically understates u.s. influence on the development of tax systems over the last half of the 20th century, both directly and through u.s. tax advisors who play a key role in international organizations, including the imf and oecd, that have pushed for structural tax reforms since the 1960s.”); e isuke suzuki, the fallacy of globalism and the protection of national economies, 26 yale j. int’l l. 319, 319 (2001) (“in addition to hold ing sway over the political economies of a large number of states, the united states also exerts considerable influence through international finance institutions . . . such as the international monetary fund . . . and the world bank . . . .”); paul lewis, conflict over post in o.e.c.d., n.y. times, nov. 2, 1981 , at d3 (“the smaller european nations, which are not invited to the annual meetings, value the o.e.c.d. as the only place where they have a chance to influence united states economic policy through direct contact with the american officials involved, and they say that for this reason, the organization should be run by someone appointed by themselves.”). american experts who are providing tax reform advice and the transition countries that are receiving that advice.11 for purposes of this article, i will divide these american tax experts into two general groups: the “stakeholders” and the “neutral” experts. the stakeholders include all of the advisors who have a direct stake in the outcome of the tax reform process in transition countries. this category includes, among others, the international monetary fund (because it loans large sums of money to transition countries) and the organization for economic cooperation and development (because transition countries may wish to accede to membership in the organization).12 the neutral experts constitute a residual 2003] the ethics of tax cloning 257 13. even though ostensibly fitting into the neutral category, some of these experts are more appropriately placed in the stakeho lder category because of a (sometimes, not so) hidden agenda. the description in the text below of the international tax and investment center may serve as an illustrative example. see infra notes 53-90 and accompanying text. this organization touts itself as “an independent nonprofit research and education foundation.” int’l tax & inv. ctr., b iennial report 2001, at 2 (2001), availab le at http://www.iticnet.org/publications/itic01ar.pdf (last visited sept. 12, 2003) [hereinafter biennial report]. nevertheless, the organization’s own description of its activities casts in serious doubt this claim of independence, because the description suggests a troubling level of influence by the organization’s corporate “sponsors,” which provide the vast majority of its funding. see infra notes 85-90 and accompanying text. 14. see infra notes 125 and 126 and accompanying text. see also stewart, supra note 9, at 184 (“[t]he increased focus on tax administration and enforcement is clearly the result of external pressures to increase collections and reduce government deficits, stemming from the deb t crisis of the 1980s. . . . [t]his kind of governance reform enables increased intervention of the international institutions into the bureaucratic workings of the borrower governments. it extends the scope of conditionality far beyond broad-brush policy recommendations, giving the institutions a role in the microconstruction of the developing or transition country government into one suited to a market-oriented state.”). 15. see infra notes 34 and 63 and accompanying text. category, and include all of the advisors who appear not to have a direct stake in the outcome of the tax reform process.13 dividing the experts along these lines serves to highlight the type of relationship between the expert and the transition country that, from an american perspective, would be deemed appropriate. on the one hand, it is understandable (if not expected) that stakeholders will attempt to influence the outcome of the tax reform process in transition countries – precisely because they have a stake in the outcome of that process and stand to benefit from achieving their desired result. this understanding (or expectation) arises from the quasi-adversarial, yet cooperative relationship between stakeholders and transition countries. transition countries should, therefore, be on notice that a stakeholder’s advice may be motivated by an interest in the outcome of the tax reform process and, to the extent practicable under the circumstances, they should adjust their acceptance of this advice accordingly. the neutral experts, on the other hand, simply do not have the same type of relationship with the transition countries. by definition, neutral experts lack a direct stake in the outcome of the tax reform process. they also lack the leverage that stakeholders sometimes have over transition countries – leverage that can be used to get desired tax reforms enacted.14 as a result, the neutral experts’ impact on the transition countries’ tax policies will depend both upon the neutral experts’ ability to foster confidence in their expertise15 – an expertise that these countries need, but which they themselves lack – and upon 258 florida tax review [vol. 6:3 16. see supra note 13. 17. see tamar frankel, fiduciary duties as default rules, 74 or. l. rev. 1209, 1212 (1995) (“in sum, fiduciary rules reflect a consensual arrangement covering special situations in which fiduciaries promise to perform services for entrustors and receive substantial power to effectuate the performance of the services, while entrustors cannot efficiently monitor the fiduciaries’ performance.”); d. gordon smith, the critical resource theory of fiduciary duty, 55 vand. l. rev. 1399, 1413-14 (2002) (“while courts use various formulations to describe informal fiduciary relationships, the common elements are quite simple: (1) ‘trust’ or ‘confidence’ reposed by one person in another; and (2) the resulting ‘domination,’ ‘superiority,’ or ‘undue influence’ of the other. trust alone is not enough, though courts often speak loosely in ways that suggest otherwise – nor is vulnerability. only in the aggregate do these factors give rise to a fiduciary relationship.”); cf. deborah a. demott, beyond m etaphor: an analysis of fiduciary obligation, 1988 duke l.j. 879, 915 (“one could justifiably conclude that the law of fiduciary obligation is in significant respects atomistic. . . . described instrumentally, the fiduciary obligation is a device that enables the law to respond to a range of situations in which, for a variety of reasons, one person’s discretion ought to be controlled because of characteristics of that person’s relationship with another.”). the neutral experts’ ability to foster confidence in their trustworthiness – because, lacking the expertise themselves, the transition countries will encounter difficulty in monitoring the experts’ performance and in detecting abuses of power.16 being based on trust and confidence and marked by a measure of vulnerability on the part of the transition countries, the relationship between the neutral experts and the transition countries can be characterized as fiduciary in nature.17 fiduciary relationships are normally accompanied by the imposition of ethical limits on the activities of the person in whom trust has been 2003] the ethics of tax cloning 259 18. in the oft-quoted words of justice cardozo: many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. a trustee is held to something stricter than the morals of the market place. not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. as to this there has developed a tradition that is unbending and inveterate. uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the “disintegrating erosion” of particular exceptions. only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. it will not consciously be lowered by any judgment of this court. meinhard v. salmon, 164 n.e. 545, 546 (n.y. 1928); see also frankel, supra note 17, at 1226; tamar frankel, fiduciary law, 71 cal. l. rev. 795, 829-32 (1983). 19. dem ott, supra note 17, at 879, 908-09; frankel, supra note 17 , at 1226; smith, supra note 17, at 1400, 1482-86. 20. see d emott, supra note 17, at 879, 891; frankel, supra note 18, at 797, 804-08 (arguing that this approach is flawed); smith, supra note 17, at 1430. 21. see victor thuronyi, introduction to 1 tax law design and drafting, at xxvii, xxix (victor thuronyi ed., 1996) [hereinafter tax law design]. 22. 1 restatement of the law governing lawyers § 16 cmt. b (2000) (“a lawyer is a fiduciary, that is, a person to whom another person’s affairs are entrusted in circumstances that often make it difficult or undesirable for that other person to supervise closely the performance of the fiduciary. assurances of the lawyer’s competence, diligence, and loyalty are therefore vital.”); see also comm’n on professionalism, am. bar ass’n, “. . . in the spirit of public service:” a blueprint for the rekindling of lawyer professionalism (1986), reprinted in 112 f.r.d. 243, 261 [hereinafter aba professionalism report]; howard s. becker, the nature of a profession, in 2 education for the professions: the sixty-first yearbook of the national society for the study of education 27, 37 (nelson b. henry ed., 1962); robert a . rothman, deprofessionalization: the case of law in america, 11 work & occupations 183, 188 (1984); fred c. zacharias, reconciling professionalism and client interests, 36 w m. & mary l. rev. 1303, 1308-09 (1995). reposed.18 the exact scope of these limits will vary depending upon the nature of the fiduciary relationship.19 in the united states, the limits on a fiduciary’s activities are usually developed by analogy, using existing fiduciary relationships as a guide.20 many of the american neutral experts advising transition countries are attorneys,21 and as such are fiduciaries whose activities are confined within prescribed ethical boundaries.22 in addition, the subject of the neutral experts’ advice – 260 florida tax review [vol. 6:3 23. delineating the precise boundaries of the “practice of law” has proved exceedingly difficult. see barlow f. christensen, the unauthorized practice of law: do good fences really make good neighbors – or even good sense?, 1980 am. b. found. res. j. 159 (1980); elizabeth michelman, guiding the invisible hand: the consumer protection function of unauthorized practice regulation, 12 pepp. l. rev. 1, 3-11 (1984); alan morrison, defining the unauthorized practice of law: some new ways of looking at an old question, 4 nova l.j. 363 (1980); john gibeaut, another try: aba task force takes a shot at defining the practice of law, 88 a.b.a. j. 18 (2002). one commentator has distinguished between the boundaries that should be set for purposes of applying codes of legal ethics and those that should be set for purposes of restricting the activities of non-lawyers. linda galler, new roles, new rules, but no definitions, 72 temp. l. rev. 1001 (1999). analyzing the issue from the perspective of multidisciplinary practice, this commentator has advocated adopting a broad construction of the practice of law for the former purpose, in order to ensure that lawyers working in non-traditional settings are subject to legal ethics rules. id. at 1004-06. as she points out, broadly construing the practice of law for this purpose is consonant with model rule 5 .7, which requires lawyers to comply with the model rules of professional conduct not only with respect to the legal services that they provide, but also with respect to “law-related” services that they provide. model rules of prof’l conduct r. 5.7 (2002); see galler, supra, at 1006. t he principal concern behind this rule is that the person for whom the law-related services are performed [may] fail[] to understand that the services may not carry with them the protections normally afforded as part of the client-lawyer relationship. the recipient of the law-related services may expect, for example, that the protection of client confidences, prohibitions against representation of persons with conflicting interests, and obligations of a lawyer to maintain professional independence apply to the provision of law-related services when that may not be the case. model rules of prof’l conduct r. 5.7 at cmt. at para. 1 (2002). similar concerns dictate a broad construction of what constitutes legal advice in the instant situation. whether they, as individuals, happen to be attorneys or not – is law reform. by rendering advice concerning the proper structure and content of a country’s tax laws, these experts are rendering what is arguably legal advice – broadly construed.23 in view of the nature of the advice being given and the fact that attorneys number among those rendering such advice, the attorney-client relationship will be employed in this article as the benchmark for setting ethical boundaries within which american neutral experts should confine their activities. the purpose of this article is to begin to explore these ethical boundaries. because the development of a complete ethical framework for the activities of american neutral experts is beyond the scope of this article, i have chosen, consistent with the impetus for writing this article, to focus on the ethical limits that should be imposed on american neutral experts when propagating western tax rules in transition countries. however, even within this 2003] the ethics of tax cloning 261 24. this group of american neutral experts includes not only attorneys, but also accountants, economists, and tax administrators. richard k. gordon & victor thuronyi, tax legislative process, in 1 tax law design, supra note 21, at 4-6. limited scope (and notwithstanding the use of the attorney-client relationship as a benchmark), this article is intended to cover the activities of all american neutral experts, whatever their respective professional calling or occupation,24 who are rendering tax reform advice to transition countries. as a result, the purpose of this article is not to point out that certain sections of the various state legal ethics codes may apply to attorneys who are advising transition countries; rather, it is to begin the process of elucidating and explicating the norms, derived from legal ethics, that should guide all american neutral experts when propagating western tax rules in transition countries. by drawing attention to the ethical dimension of their conduct, this article aims to prod american neutral experts to reflect both on the nature and quality of the advice that they have been rendering to transition countries and on the nature and quality of the advice, if any, that they will render in the future – taking into account the guidelines developed in this article as well as any and all other relevant legal ethical norms. part ii begins the exploration of this issue by providing a description of the activities of a cross-section of american tax experts. following this description, part iii revisits the debate over the appropriate terminology to be used when describing the propagation of western legal rules. in the comparative law literature, this phenomenon has generally been referred to as the “borrowing” or “transplantation” of legal rules. in part iii, it is argued that a timely and more accurate description of this phenomenon would be the “cloning” of a legal rule. because of the natural link with the ethical debate over human cloning, this suggested change in terminology would also carry with it the benefit of focusing attention on the ethical dimension of this phenomenon. with this background, the task of formulating ethical guidelines for the cloning of tax rules is then undertaken. first, in view of the aptness of the cloning analogy, part iv turns to the experience of bioethicists with the debate over human cloning for aid in identifying the norm(s) that should serve as the basis for these ethical guidelines. after analyzing the salient arguments in the debate over human cloning, it is concluded that the principle of nonmaleficence lies at the core of this debate. next, given that the relationship between the american neutral experts and the transition countries is analogous to the attorney-client relationship, part iv analyzes the ethical standards governing the professional conduct of lawyers to determine whether the principle of nonmaleficence also serves as part of the general framework for analyzing problems in legal ethics. concluding that it does, part v suffuses the principle of nonmaleficence – in its specific application to the context of tax cloning – 262 florida tax review [vol. 6:3 25. ward m. hussey & donald c. lubick, b asic world tax code and c o m m e n t a r y , a t v i i v i i i ( 1 9 9 6 ) , a v a i l a b l e a t http://www.taxanalysts.com/www/website .nsf/web/basicworldtaxcode?opendocu ment (last visited sept. 12, 2003) [hereinafter bwtc] (“no country has been beguiled into enacting our draft in toto , or has failed to receive ample advice (solicited and unsolicited) as to a myriad of alternatives”); kevin holmes, development of tax administrations in central and eastern europe and in developing countries: needs and opportunities for tax research, 42 eur. tax’n 18, 18 (2002) (“the early and mid-1990s were also periods of wholesale transformation of legislation in the former soviet countries, designed to implement the new tax policies. there was no shortage of experts from the west to advise these countries on tax policy and how the new legislation should be written.”); rick krever, parochialism and catholic advice, 7 tax notes int’l 193, 193 (1993) (“in a world of recession-induced constrictions and collapses, one industry has bucked the trends and embarked on a path of vigorous growth. that industry is the provision of tax design advice to the governments of developing countries and, since the collapse of socialism in eastern europe, to the governments of transforming cap italist economies.”). the provision of tax reform advice is not a new endeavor – transition countries are merely the most recent recipients of such advice. indeed, western experts have been proffering tax reform advice to developing countries for decades. u.n. technical assistance admin., taxes and fiscal policy in under-developed countries at 43-110, annex, u.n. doc. st/taa/m/8, u.n. sales no. 1955.ii.h.1 (1954); oliver oldman & stanley s. surrey, technical assistance in taxation in developing countries, in modern fiscal issues: essays in honor of carl s. shoup 278 , 278-83, 284-85 (richard m. bird & john g. head eds., 1972); see, e.g., nicholas kaldor, indian tax reform: report of a survey (1956); richard a. musgrave, fiscal reform in bolivia: final report of the bolivian mission on tax reform (1981); richard a. musgrave, fiscal reform for colombia: final report and staff papers of the colombian commission on tax reform (malcolm gillis ed., 1971); carl s. shoup et al., the fiscal system of venezuela: a report (1959). with content and meaning by describing the extant comparative law literature on issues related to legal cloning and synthesizing from it ethical guidelines that american neutral experts can employ when considering the propagation of western tax rules in transition countries. part vi consists of concluding remarks. ii. description of activities of american advisors since the break-up of the soviet union, there has been no shortage of western (and particularly american) experts willing to proffer tax reform advice to the transition countries in the cee/nis region.25 this advice has come from u.s. government agencies, private sector programs, universities, and international organizations. by way of background, a brief and non-exhaustive 2003] the ethics of tax cloning 263 26. for further description of the activities of external participants in the tax reform process in developing and transition countries, see stewart, supra note 9, at 14271. 27. u.s. dep’t of treasury, office of technical assistance overview, at http://www.treas.gov/offices/international-affairs/assistance/index.html (last visited sept. 12, 2003) [hereinafter ota overview]. 28. letter from g. edwin smith, iii, director, office of technical assistance, u.s. dep’t of treasury, to anthony c. infanti, assistant professor of law, university of pittsburgh school of law 1 (nov. 5, 2002) (on file with author) [hereinafter ota letter]. 29. id. 30. id. 31. id. at 2. 32. id. at 1, 2. 33. id. at 1. description of the activities of members of each of these groups, which include both neutral experts and stakeholders, follows immediately below.26 a. u.s. government agencies the u.s. treasury department, through its office of technical assistance (“ota”), provides tax reform advice to the transition countries in the cee/nis region. the office of technical assistance has provided advisors to governments in cee countries since 1990, and has provided advisors to governments in nis countries since 1992.27 advisors are assigned to a country only after the ota receives a written request for assistance from the country.28 a country is eligible to make such a request only if it is “committed to democracy, economic reform and to sound relations with . . . international financial institutions.”29 before the ota will honor a request for assistance, the treasury department and the requesting country must agree on the scope of the project, which is memorialized in a document referred to as the “terms of reference.”30 the terms of reference routinely include a confidentiality agreement in order to encourage the requesting country to “share confidential data [and] discuss policy options with treasury advisors.”31 ota operates through resident advisors, who are posted to the host country for no less than one year and whose assignments should ideally run “from 2-4 years to be maximally effective.”32 the resident advisors “almost always work inside host government agencies, so that advisors are regularly and conveniently close to their counterparts.”33 this arrangement allows the advisor “to engage in problem solving immediately when issues or policy decisions 264 florida tax review [vol. 6:3 34. id. 35. id. 36. id. 37. id. 38. ota overview, supra note 27. 39. id. 40. id. 41. id. 42. id. 43. id. 44. id. arise,” and helps to foster “relationships of trust and confidence” between the advisor and his host country counterpart.34 because of the government-to-government nature of ota’s activities, resident advisors “are assigned to work directly with officials of the counterpart government.”35 there can, however, be a wide range of potential counterparts in the host country government, “including officials in the ministries of finance, state tax authorities, or consolidated revenue authorities.”36 resident advisors may also meet with legislators and their staffs or with public interest groups if doing so is in furtherance of the project, but “ota does not provide assistance to non-governmental agencies.”37 resident advisors generally provide advice in three areas: (i) “tax policy (legal and economic advice in structuring tax legislation and regulation to eliminate complicating and inefficient tax preferences and reduce unreasonably tax high [sic] rates,”38 (ii) “forecasting and revenue estimation (the structuring of models and the generation of statistical data to feed such models),”39 and (iii) “tax administration (system organization and operation, taxpayer education and service, effective audit and collection functions, training, and creation of host country management and training capacities).”40 ota has provided tax policy advice to most cee/nis countries.41 as an example of such advice, ota cites “[a] major program in russia [that] resulted in formal tax reform proposals being submitted to the duma during the summer of 1996.”42 ota has provided advice on tax modeling to bosnia & herzegovina, bulgaria, estonia, latvia, poland, russia, slovakia, and ukraine.43 on the tax administration front, ota has undertaken “several pilot programs to demonstrate functional administration with centralized direction,” and has participated “in the development of a national tax administration training center in ukraine.”44 resident advisors serve under three types of employment agreements: “(1) personal service contracts, (2) reimbursable agreements with other u.s. government agencies, i.e. irs, the office of the comptroller of the currency, and others; (3) and inter-agency personnel agreements, under which ota 2003] the ethics of tax cloning 265 45. ota letter, supra note 28, at 2. 46. id. 47. id. at 3. 48. id. at 2. 49. id.; see also ota overview, supra note 27. 50. ota letter, supra note 28, at 2. 51. id. 52. id. secures the services of advisors from states and universities.”45 in each case, ota “directly manages the employee” while she serves as a resident advisor.46 individuals are hired to serve as a resident advisor based on the match between their professional skills and job experience with the project needs of the counterpart government agency. [ota] actively recruit[s] from both the government and the private sector to find the necessary skill sets to do [its] work. fluency in the local language or familiarity with the local culture can be a factor in ota’s hiring process, but the most important qualification is highlevel functional expertise. ota provides a budget for local language training for its advisors, although such training is optional. most advisors do take advantage of this training, and some have reached high degrees of fluency. ota regularly hires a local country national as an assistant to each resident advisor. the assistants often work as translators and are crucial in providing orientation on protocol, culture, and customs.47 although “ota prefers utilizing longer-term resident advisors to conduct technical assistance projects,” short-term advisors may be used under a variety of circumstances.48 for example, short-term advisors may be used (1) as a lead-in to a resident-based project, when sufficient funding is initially not available; (2) as a follow-up to a largely completed project to ensure that the work program stays on track; (3) when a project is very specialized and requires the use of functional experts for short periods of time; and (4) when a project needs to be operational and funding is only sufficient for intermittent work.49 short-term advisors may also “provide specialized expertise to existing resident-based projects.”50 a short-term advisor may, for example, provide expertise in tax forms design as part of a tax administration project.51 in fact, each of the resident advisor positions is accompanied by funding that is “budgeted for short-term specialists to conduct support missions.”52 266 florida tax review [vol. 6:3 53. these missions were organized by the tax foundation, which was the precursor to the international tax and investment center. int’l tax & inv. ctr., itic history, at http://www.iticnet.org/about/history.htm (last visited sept. 12, 2003); bill ahern, u.s. tax experts present russian officials with plan to improve investment climate, 5 tax notes int’l 187 (1992) (recounting advice of a delegation of tax experts supported by the tax foundation). 54. int’l tax & inv. ctr., about the international tax and investment center, at http://www.iticnet.org/about/default.htm (last visited sept. 12, 2003) [hereinafter about itic]; see also biennial report, supra note 13, at 2. 55. about itic, supra note 54; see also biennial report, supra note 13, at 2. 56. about itic, supra note 54; see also biennial report, supra note 13, at 2. 57. biennial report, supra note 13, at 5. “best international practice” appears to be a euphemism for w estern-style tax rules. 58. for a discussion of itic sponsors, see infra notes 85-90 and accompanying text. 59. biennial report, supra note 13, at 5. 60. id. at 12-16. 6 1 . i n t ’ l t a x & i n v . c t r . , i t i c p r o g r a m s , a t http://www.iticnet.org/programs/default.htm (last visited sept. 12, 2003). b. private sector programs following two missions to russia in 1991 and 1992,53 the international tax and investment center (“itic”) was organized in 1993 as “an independent nonprofit research and education foundation.”54 the mission of itic is “to serve as a clearinghouse for information and as a training center to transfer western taxation and investment know how to improve the investment climate of transition countries, thereby spurring formation and development of business and economic prosperity.”55 itic attempts to achieve this goal by (i) establishing relationships with officials in the governments of the transition countries, (ii) “maintain[ing] a reliable schedule of high-quality educational programs,” and (iii) consistently relaying the message in communications with government officials and in educational programs that there is a “need for tax and economic reforms that will achieve prosperity and financial stability.”56 itic describes its agenda as “spread[ing] ‘best international practice.’”57 there is a “division of labor” in spreading this information: relationships with government officials are cultivated by the itic staff, and substantive contributions to the educational programs are made by itic “sponsors,”58 who “draw[] on their particular international experience.”59 itic currently conducts its activities in russia, kazakhstan, azerbaijan, and ukraine.60 itic conducts several different types of programs “to facilitate dialogue and information sharing between private sector specialists and government policy makers.”61 these programs take place in the transition countries, the united states, and europe, and include: (i) monthly policy 2003] the ethics of tax cloning 267 62. id. 63. biennial report, supra note 13, at 12. 64. id. at 14. 65. id. 66. id. at 12-13. 67. id. at 12. 68. id. forums held in russia and kazakhstan that “provide government and parliament officials and company representatives an opportunity to work together to identify and solve specific tax and regulatory problems facing investors”; (ii) working groups and committees that allow private and public sector officials in transition countries to focus on “critical tax and investment issues”; and (iii) training workshops and seminars that are designed to expose “parliamentarians and finance and tax officials to western taxation and business practices.”62 itic has also provided assistance in the drafting of tax laws. itic recently served “as a trusted advisor in the drafting” of part ii of the russian tax code.63 in addition, itic worked with the government of kazakhstan to write and implement its tax code, a process that “continues today, as itic works closely with the important legislators assembled in the majilis’ budget and economics committee, where all tax and investment-related legislation is approved.”64 in conjunction with the recent redrafting of the kazakhstani tax code, itic served as an advisor to the expert council that advised the authors of the revisions, regularly organized conferences to bring investors together with the authors of the revisions, and “prepared numerous commentaries and memoranda on the draft tax code revisions.”65 itic has participated in several coalitions that are focused on making changes in specific tax policies. in russia, itic has helped to form the russian commercial taxation committee, the russian financial services taxation committee, the russian automotive investment center, and the petroleum tax reform project.66 in kazakhstan, itic has helped to form the caspian mineral taxation committee. the purposes and activities of each of these committees are briefly described below: russian commercial taxation committee. this committee was formed with ernst & young in 1998, and “is comprised of over 20 u.s. and european multinational manufacturing companies in russia.”67 the purpose of the committee is “to improve russia’s profits tax and [value-added tax] regimes, making them closer to international practice.”68 to achieve this goal, the committee provided assistance in legislative drafting to the department of tax reform of the russian ministry of finance and to the taxation subcommittee of the russian duma, and “improved the final language” of the russian tax code “with many proposals, including the elimination of the limit on 268 florida tax review [vol. 6:3 69. id. at 12-13. 70. id. at 13. 71. id. 72. id. 73. id. 74. id. 75. id. 76. id. 77. id. 78. id. 79. id. at 14. advertising expenses, travel expenses, [and] training and recruitment expenses.”69 russian financial services taxation committee. this committee was formed with pricewaterhousecoopers in 1998, and is comprised of banks and financial services companies.70 the committee has organized “an ongoing series of study tours and workshops in london” that “provide russian officials with hands-on exposure to the ways these complex financial and taxation issues are addressed in the west.”71 this educational program was launched with a grant from the u.k. department for international development.72 the committee has also worked on drafting and introducing legislation in the duma on the tax treatment of exchange gains and losses incurred in bank recapitalizations,73 and has reviewed and prepared amendments to the russian profits and value-added taxes as they relate to banks and financial institutions.74 russian automotive investment center. this coalition was formed with ernst & young in 2000 “to address the challenges of the russian automotive sector.”75 the center “has already succeeded in organizing foreign automakers and suppliers to address legislative and regulatory issues affecting the automotive sector in russia,” and has helped to secure changes in the russian tax code concerning “regional investment incentives for automotive investment.”76 petroleum tax reform project. this coalition was formed with the tax committee of the petroleum advisory forum in 2000, and has as its purpose “to rationalize the taxation of the petroleum industry, so that it can provide a reliable flow of energy to domestic and foreign markets, while also providing a steady flow of tax revenue.”77 the project has “organized a series of education programs for the state duma and ministry of finance tax code authors,” and has prepared “numerous draft amendments to the . . . draft tax code.”78 caspian mineral taxation committee. this committee is an industry group that is comprised of “22 multinational oil, gas, and mining companies.”79 the committee provides “input on tax policy and how to implement best international accounting and tax practices” in kazakhstan and other caspian 2003] the ethics of tax cloning 269 80. id. 81. id. at 15. 82. id. 83. id. 84. id. at 6. 85. int’l tax & inv. ctr., join itic, at http://www.iticnet.org/join/default.htm (last visited sept. 12, 2003) [hereinafter join itic]. 86. id. for a list of sponsors, see biennial report, supra note 13, at 17. 87. join itic, supra note 85. 88. about itic, supra note 54. 89. id. nations.80 the committee has organized conferences to discuss the revision of the portions of the kazakhstani tax code dealing with international taxation and natural resources taxation, and has prepared memoranda on draft revisions to the kazakhstani tax code and transfer pricing law.81 shifting from tax policy to tax administration, itic established its first “tax academy” in kazakhstan in 2000. the purpose of the kazakhstan mineral taxation academy is “to prevent promising legislative reforms from being rendered useless by poor implementation.”82 the academy is to achieve this goal by becoming “a place where civil servants in national and regional revenue offices, investors’ staff and foreign experts can interact in efforts to develop a balanced tax regime for the extractive industries.”83 to this end, the academy “employ[s] an interactive seminar format, requir[ing] host country faculty as well as western tax experts, and use[s] a jointly developed curriculum.”84 over 80% of itic’s funding is supplied by “the tax-deductible contributions of business with concerns in transition economy enterprise.”85 these sponsors “include a broad range of interests, including aviation, oil and gas, banking and securities, manufacturing, cosmetics and foodstuffs.”86 the sponsors “directly benefit from the talented advocacy of itic’s staff of experts . . . , and the pro-investment reforms itic has helped achieve contribute significantly to improving the . . . sponsors’ bottom lines.”87 in addition, the establishment of relationships with government officials in transition countries has “provided channels for private sector expertise to reach the government before, during, and after the official policymaking process. this combination, which is truly unique to itic, is the institution’s principal asset – it provides itic and its sponsors a seat at the policymaking table.”88 itic “briefs its sponsors constantly,” and, even though its “primary mission is transferring western know-how to cis officials, [it] also reports back to its supporters with advance information on tax and investment laws, decrees, and regulations so that itic investors are involved in the policy process on the ‘front end.’”89 in fact, itic maintains a “sponsors only” web 270 florida tax review [vol. 6:3 90. int’l tax & inv. ctr., welcome to iticnet.org, at http://www.iticnet.org/ (last visited sept. 12, 2003). for a list of information posted to the “sponsors only” web page, see, e.g., new postings on sponsors only itic web p a g e , i t i c b u l l e t i n , f e b r u a r y 2 0 0 2 , a t 5 , a v a i l a b l e a t http://www.iticnet.org/publications/itic%20bulletin%20feb02.pdf (last visited sept. 12, 2003); new postings on sponsors only itic web page, itic bulletin, december 2 0 0 1 , a t 5 http://www.iticnet.org/publications/itic%20bulletin%20december%202001.pdf (last visited sept. 12, 2003); new postings on sponsors only itic w eb page, itic bulletin, j u l y 2 0 0 1 , a t 6 , a v a i l a b l e a t http://www.iticnet.org/publications/bulletin-july%202001.pdf (last visited sept. 12, 2003); new postings on sponsors only itic web page, itic bulletin, june 2001, at 4, available at http://www.iticnet.org/publications/june_01_itic_%20bulletin.pdf (last visited sept. 12, 2003). 91. merryman, supra note 6, at 457 n.4. for a description of the program’s early activities, see oliver oldman & elisabeth a. owens, the harvard law school international program in taxation (harvard law school, occasional pamphlet no. five, 1961). this description was updated several years later in oliver oldman & elisabeth a. owens, the international tax program, 14 can. tax j. 444 (1966). 92. int’l tax program, h arvard law sch ., miss ion, a t http://www.law.harvard.edu/programs/itp/index.html (last visited sept. 12, 2003). 93. int’l tax program, harvard law sch., itp programs, at http://www.law.harvard.edu/programs/itp/programs.html (last visited sept. 12, 2003) [hereinafter itp programs]. 94. id. 95. id. page to which it posts information (e.g., draft tax legislation, commentaries on legislation, and regulations) that is accessible only with a password.90 c. academic endeavors the international tax program (“itp”) at harvard law school was founded in 1952.91 the mission of itp “is to provide future fiscal leaders and tax experts working in government, private practice and academics around the world with the finest available interdisciplinary graduate education in taxation.”92 a student’s course of study while enrolled in itp will depend, to a great extent, on whether she comes from the public sector or intends to work in the private sector or academia.93 public sector students are those tax professionals “who are involved in the formulation and implementation of tax policies, the drafting of tax legislation, the negotiation of tax treaties, and the management of tax administration.”94 public sector students are not required to be lawyers to be eligible for the itp program.95 public sector students enroll in the itp 2003] the ethics of tax cloning 271 96. id. 97. int’l tax program, harvard law sch., coursework, at http://www.law.harvard.edu/programs/itp/courses.html (last visited sept. 12, 2003). 98. id. 99. itp programs, supra note 93. 100. id. 101. id. 102. id. 103 . glenn p. jenkins, foreword to bwtc, supra note 25, at iii, iii. 104 . bw tc, supra note 25, at vii. 105. id. at viii. the published critiques of the preliminary edition of the bwtc include the following: brian j. arnold, international aspects of the basic world tax code, 7 tax notes int’l 260 (1993); tim edgar, the t ax treatment of interest under the basic world tax code, 7 tax notes int’l 347 (1993); richard goode, the basic world tax code and commentary, 7 tax notes int’l 189 (1993); richard k. gordon, some comments on the basic world tax code and commentary, 7 tax notes int’l 279 (1993); krever, supra note 25; leif muten, some comments on the basic world tax code, 7 tax notes int’l 179 (1993); frans vanistendael, the proof in making and eating the pudding: some comments on the basic world tax code, 7 tax notes int’l 463 (1993); and richard j. vann, some lessons from hussey and lubick, 7 tax notes int’l 268 (1993). 106 . jenkins, supra note 103, at iii. certificate program,96 and are required to take the following tax courses: u.s. federal income taxation, public finance economics of taxation, comparative tax policy and administration, and value-added tax.97 in addition to their required courses, students may take elective courses both within and without the law school.98 students with an academic background in law who intend to work in private practice, government, or academia are able to apply for admission to the itp/master of laws program.99 this program allows students to pursue ll.m. studies at the harvard law school with a concentration in tax.100 students in the itp/master of laws program are required to take u.s. federal income taxation, a tax seminar, and “an additional 8 credits in elective tax courses.”101 students may also take elective courses both within and without the law school.102 aside from its academic program in taxation, itp has sponsored ward hussey and donald lubick in their drafting of the basic world tax code and commentary (“bwtc”). hussey and lubick drafted the bwtc in response to “the demonstrated need by developing and transition countries for a legislative framework as they work to formulate modern tax policies and taxation laws.”103 a preliminary edition of the bwtc was published in 1992.104 shortly thereafter, tax notes international commissioned critiques of the preliminary edition, and it published those critiques in the summer of 1993.105 a revised edition of the bwtc was later published in 1996.106 while the policy decisions 272 florida tax review [vol. 6:3 107 . bw tc, supra note 25, at vii. 108. id. at 1. 109. id. 110. jenkins, supra note 103, at iv. 111. bwtc, supra note 25, at 2. 112. id. 113. id. that led to the 1992 preliminary edition “were heavily influenced by those developed over many years of technical assistance to developing countries in reform of their tax systems,”107 the 1996 revised edition was “slanted somewhat more to reflect [the authors’] experiences since the preliminary edition appeared, primarily in the formerly socialist countries of central and eastern europe and the former soviet union.”108 the bwtc consists of the text of a sample tax code (which is comprised of an income tax, a value added tax, excise taxes, property taxes, and provisions addressing tax administration) and commentary on that text.109 the purpose of the bwtc is described in the foreword to the 1996 edition as follows: the bwtc was initiated as a modest attempt to provide an example of the laws that are needed for an efficient and effective tax system. the objective was to provide the tax policy and legal experts in the reforming countries with a framework, or a checklist, of what is needed (or not needed) to have the foundation for a system . . . . the objective has never been, nor should be, to build a comprehensive tax code with all the details that might arise in each specific country. the goal has been to design a highly professional, but basic, tax code which could provide a solid legal foundation for a modern tax system.110 while acknowledging that a single tax code “will not exactly fit the economic, social, and political situations of each and every country,” hussey and lubick felt that there were sufficient common problems faced by developing and transition countries “to conclude that it is worthwhile to offer a single draft as a starting point.”111 in this regard, hussey and lubick explicitly contemplated that developing and transition countries would have to adjust the complexity of the bwtc’s provisions to suit their individual needs.112 they anticipated that the bwtc would prove too complex for some countries, even though it had been stripped of much of the complexity encountered in the tax laws of industrialized nations.113 at the same time, they anticipated that the bwtc would prove too basic for other countries, which would find it necessary to adopt some of the 2003] the ethics of tax cloning 273 114. id. 115. vann, supra note 120, at 274; see also arnold, supra note 120, at 261; edgar, supra note 120, at 347. notwithstanding the changes made in the 1996 edition, u.s. tax lawyers will still find themselves on very familiar ground when reading the income tax portion of the bwt c. see generally richard k. gordon, model codes and tax technical assistance: note on the revised edition of the basic w orld tax code and commentary, 12 tax notes int’l 927 (1996). 116. vann, supra note 120, at 274; see a lso goode, supra note 120 , at 192; gordon, supra note 120, at 282-84; krever, supra note 25, at 195 ; muten, supra note 120, at 179. 117. bwtc, supra note 25, at 6 (“any bwtc provision that is enacted will necessarily be translated into another tongue, we leave to the translator the choice of the appropriate local idiom”). 118. richard krever, drafting tax legislation: some lessons from the basic world tax code, 12 tax notes int’l 915, 919-20 (1996); see also vann, supra note 120, at 274-76. 119. jenkins, supra note 118, at iii; see also krever, supra note 24, at 211; muten, supra note 120, at 179; vanistendael, supra note 120, at 463. 120. see vann, supra note 105, at 276 (“in fact, every provision of a tax law involves a larger or smaller policy choice. for those who doubt this proposition, turn up a page or two of the bwtc and ask if the provisions found there could be done any differently in a policy sense.”); see also arnold, supra note 105, at 261; goode, supra more complex provisions encountered in the tax laws of industrialized nations.114 the bwtc has been criticized on several general grounds. with respect to its style, one commentator reviewing the 1992 preliminary edition stated that [t]he bwtc reads like a clone of the u.s. internal revenue code (albeit with some differences in policy). whether or not this is intended to suggest that the irc “style” is the epitome of legislative drafting, copying the style naturally leads to a thoroughgoing americanism about the bwtc that is much more pervasive than the authors probably realize.115 other commentators have echoed this criticism insofar as it concerns the use in the bwtc of “americanisms” (i.e., “u.s.-style jargon that has special meanings in u.s. tax terminology”).116 despite hussey and lubick’s dismissal of this criticism in the 1996 edition,117 one commentator has pointed out that employing americanisms will necessarily create difficulties in translation – the translator will need to be conversant not only in english, but also in the argot of american tax lawyers.118 although it has been asserted that a consensus has formed concerning the “design of effective and stable tax systems,”119 drafting a tax law naturally requires a number of policy choices to be made, and many of those choices are not the subject of universal agreement.120 in this regard, the bwtc has been 274 florida tax review [vol. 6:3 note 105 , at 189; krever, supra note 118, at 920-21; krever, supra note 25, at 211; vanistendael, supra note 105, at 464. 121. see g raham glenday, basic w orld tax code: does it fit the bill in subsaharan africa?, 12 tax notes int’l 1343, 1343-45 (1996); gordon, supra note 115, at 934-35; vann, supra note 105, at 276-78. 122. bwtc, supra note 25, at 3-4. 123. see gordon, supra note 115, at 934 (“a highly competent lawyer or group of lawyers (such as hussey and lubick) would never be fooled into adopting their own sample wholesale in an inappropriate setting. i am worried, however, about what might happen when others refer to their sample.”); vann, supra note 105, at 277 (“if the purpose is to provide both policy advice and drafting assistance, which seems to be the bw tc’s objective, the single draft approach is doubly difficult – . . . because the (presumably unintended) effect of its use will be to smuggle in a whole range of policy choices unbeknownst to the policymakers and administrators looking to the bwtc for help. the last point bears repetition. drafts rest upon various unstated assumptions about a whole range of topics, as we have seen in the analysis of the bwtc above. the lack of alternative drafts that allow for variation of the assumptions tends to disguise them.”) 124. gordon, supra note 105, at 279; vann, supra note 105, at 278. 125. susan himes & martine m illiet-einbinder, russia’s tax reform, oecd observer, jan. 1999, at 26 (“international lenders have made it clear that they will pull their money out and refuse to make new loans unless they see reforms throughout the economy. of particular importance is russia’s tax system and the imperative of improving collection.”); betsy mckay, yeltsin backs crackdown on taxes; russian parliament endorses overhaul, wall st. j., july 6 , 1998, at a12 (“the government is scrambling to implement long-promised reforms such as a tax overhaul because it wants criticized for its failure to present alternative policy choices in the text of the sample tax code.121 hussey and lubick rejected this approach as too cumbersome, choosing instead to present in each case only one of the possible alternatives in the text of the bwtc – the alternative that they preferred; however, they do, from time to time, supplement their preferred alternative with a brief mention of other alternatives in the commentary.122 some commentators have taken this criticism a step further and have questioned the approach of drafting a sample tax code at all, because such a code embraces policy choices that an uninformed advisor may unintentionally (and inappropriately) incorporate into local law.123 these commentators prefer a series of model income tax provisions, which would present various alternative choices and would be accompanied by commentary explaining their origin, the criteria for their selection, and the differences between them.124 d. international organizations the transition countries of the cee/nis region are also often given tax reform advice by the international monetary fund (“imf”), which holds the purse strings to sometimes sorely needed money,125 and by international 2003] the ethics of tax cloning 275 to qualify for $10 billion to $15 billion in funding from the international monetary fund and world bank that will help calm markets and prevent a potential financial collapse. the imf has imposed strict conditions for receipt of the aid; it regards passage of the tax code as one of the most important signs that reform is moving forward.”); john odling-smee, russia’s vicious circle of tax nonpayment, wall st. j., june 16, 1998, at a19 (“[the im f] strongly agree[s] that an orderly tax system with a reasonable tax burden is vital for output growth to resume. indeed, a key aim of the russian government and an element of the imf’s eff program is the passage of the tax code, which should go a long way toward reducing the burden on taxpayers by eliminating a number of taxes and exemptions and reducing compliance costs. these elements consistently have been a part of fund advice to the russian government since the medium-term program was launched in 1996.”); see also, e.g., letter of intent from victor youschenko, p rime m inister of ukraine, and volodymyr stelmakh, chairman, national bank of ukraine, to horst köhler, managing director, international monetary fund ¶¶ 7-11 (dec. 5, 2000) (outlining changes in tax policy that the country intends to implement in connection with its request for financial support from the imf), available at http://www.imf.org/external/np/loi/2000/ukr/01/index.htm (last visited sept. 12, 2003); memorandum of economic policies for july 1, 1998-june 30, 2001 from the government of ukraine and national bank of ukraine to the international monetary f u n d ¶ ¶ 6 , 2 5 2 6 (a u g . 1 1 , 1 9 9 8 ) ( s a m e ) , a v a i l a b l e a t http://www.imf.org/external/np/loi/081198 .htm (last visited sept. 12, 2003); statement of the government of the russian federation and central bank of russia on economic p o l i c i e s ¶ ¶ 1 3 2 2 ( j u l y 1 3 , 1 9 9 9 ) ( s a m e ) , a v a i l a b le a t http://www.imf.org/external/np/loi/1999/071399.htm (last visited sept. 12, 2003). 126. org. for econ. co-operation & dev., the oecd in the wider world, at http://www.oecd.org/document/21/0,2340,en_2649_33709_1915989_1_1_1_1,00.html (last visited sept. 12, 2003) (“compliance with oecd standards and best practices in the fiscal area is an important criterion when assessing a country’s request for accession.”) [hereinafter oecd in the wider world]. 127. id. 128. see, e.g., org. for econ. co-operation & dev., eurasia: regional baltic p r o g r a m m e : a b o u t , a t http://www.oecd.org/about/0,2337,en_2649_34679_1926375_1_1_1_1,00.html (last visited sep t. 12, 2003); org. for econ. co-operation & dev., eurasia: south eastern e u r o p e p r o g r a m m e : a b o u t , a t http://www.oecd.org/about/0,2337,en_2649_34683_1926291_1_1_1_1,00.html (last organizations of which they wish to become members (e.g., the organization for economic co-operation and development (“oecd”)).126 1. the oecd – the oecd provides assistance to transition countries in a number of different ways. the oecd cooperates with non-member countries through its global forum, “which stresses the strong mutual interest in a common agenda among member and non member countries.”127 the oecd has also established regional and country programs directed at transition countries.128 its country program with the russian federation is “the largest and 276 florida tax review [vol. 6:3 visited sept. 12, 2003); org. for econ. co-operation & dev., country programme on t a x a t i o n w i t h t h e r u s s i a n f e d e r a t i o n , a t http://www.oecd.org/document/49/0,2340,en_2649_34625_1909425_1_1_1_1,00.html (last visited sept. 12, 2003) [hereinafter oecd russia country program]. 129. oecd russia country program, supra note 128. 130. id. 131. id. 132. see infra notes 140-143 and accompanying text for a description of the oecd’s multilateral tax centers. 133. oecd russia country program, supra note 128. 134. centre for co-operation with non-members, org. for econ. co-operation & dev., oecd and the russian federation co-operation 1992-2000, at 8 (2002), availab le at http://www.oecd.org/dataoecd/14/57/2082432.pdf (last visited sept. 12, 2003) [hereinafter oecd russia co-operation]; see also oecd russia country program, supra note 128. 135. oecd russia co-operation, supra note 134, at 9; oecd russia country program, supra note 128. 136. oecd russia co-operation, supra note 134, at 9; oecd russia country program, supra note 128. most comprehensive” of these programs.129 at a general level, the russia program attempts to assist “the russian tax administration to implement reforms.”130 more specifically, the program “is designed to familiarise russian officials with western tax policies that promote domestic and foreign investment, improve the quality of international tax agreements, and protect taxpayer rights, including confidentiality.”131 the specific objectives of the russia program are achieved through the following means: first, the russian federation participates in seminars on international tax issues and in workshops hosted by the oecd’s multilateral tax centers.132 the russian federation also participates as an observer in the activities of the oecd committee on fiscal affairs.133 this observership, which commenced in 1998, has been credited with the adoption of a transfer pricing provision in the new russian tax code that is based on the oecd transfer pricing guidelines, the conclusion of tax treaties that follow the oecd model income tax convention, the improvement of both the quality and timeliness of exchanges of information, and the increasing adoption “of international best practices in tax administration.”134 second, the oecd participates in the moscow international tax centre, which is a joint venture of the russian state tax service, the european union, and the oecd.135 the center has hosted more than 100 activities since its establishment in 1993, “ranging from two-day workshops for senior officials on strategic management to two-week seminars on income tax and vat audits for inspectors.”136 2003] the ethics of tax cloning 277 137. oecd russia country program, supra note 128. 138. id. 139. id. 140. oecd in the wider world, supra note 126; see also jorg-dietrich kramer, bulgaria’s vat: the introduction of western t ax law into eastern european countries is sometimes a dubious gift, 8 tax notes int’l 14, 15 (1994); oecd offers to coordinate western efforts to build better tax system in russia, 17 tax notes int’l 880 (1998) (“so far the oecd, the u.s. treasury, and the international monetary fund have submitted plans for solving russia’s tax system woes. [the secretary-general of the oecd] said each of the p lans should be mulled over carefully and that the oecd is well-positioned to assist in that endeavor.”); central, east european countries should reform tax systems, oecd official says, daily tax rep. (bn a), at g-4 (jan. 25, 1991); oecd to train tax officials in central, eastern europe, daily tax rep. (bna), at g-1 (feb. 28, 1992); russian restructuring, economic investment depends on stable tax system, oecd says, daily tax rep. (bna), at d-13 (nov. 5, 1997). 141. org. for econ. co-operation & dev., the o ecd multilateral tax centres, at http://www.oecd.org/document/9/0,2340,en_2649_34677_1909385_1_1_1_1,00.html (last visited sept. 12, 2003). 142. id. finally, the oecd has directly assisted the russian federation in its tax reform efforts. oecd officials have met with members of the budget committee of the russian duma in an effort to engage the russian legislature in policy dialogue and to help “parliamentarians to better understand how tax proposals currently under discussion in russia relate to policies in [oecd] member countries.”137 the oecd has also commented on “the development of the international aspects of the russian tax code,”138 and has assisted the russian federation both in fighting international tax evasion and avoidance and in assessing whether it has “appropriate policies for developing innovative financial instruments and sound, transparent financial institutions and markets.”139 in addition to the foregoing methods, the oecd cooperates with and assists transition countries by (i) hosting regional programs to improve the efficiency of tax systems, (ii) hosting multilateral workshops on specific issues relevant to tax reform, and (iii) facilitating policy dialogue at its multilateral tax centers and in the context of in-country assistance.140 the oecd currently has four multilateral tax centers, which have hosted activities that “have ranged from two-day workshops on income tax policy to three-week seminars on international taxation and tax treaties.”141 the programs at the multilateral tax centers are designed to “facilitate[] experience-sharing between transition countries and oecd member countries in the areas of international taxation, tax policy, tax administration and tax training.”142 these programs also facilitate “the development and adoption of global tax standards in the area of international taxation,” and “promote[] these standards and assist[] non-member 278 florida tax review [vol. 6:3 143. id.; see a lso stewart, supra note 9, at 170 (“since 1990, the ‘remarkable consensus’ in tax reform advice also has affected reform in transition countries, largely through the work of the oecd and imf. . . . i suggest that the key factor is the development of an international consensus, or ‘norm,’ of tax reform and policy driven largely by the international institutions, and propounded by non-government tax experts.”). 144. see jorge martinez-vasquez et al., imf conditionality and objections: the russian case (int’l studies program, ga. state univ., working paper no. 00-3, 2000), available at http://isp-aysps.gsu.edu/papers/ispwp0003.pdf (last visited sept. 12, 2003); see also sources cited supra note 125. 145. int’l monetary fund, technical assistance: a factsheet, at http://www.imf.org/external/np/exr/facts/tech.htm (last visited sept. 12, 2003) [hereinafter technical assistance factsheet]; see also liam ebrill & oleh havrylyshyn et al., tax reform in the baltics, russia, and other countries of the former soviet union, at v (int’l monetary fund, occasional paper no. 182, 1999); staff of tax policy div., fiscal affairs dep’t, int’l monetary fund, technical assistance on tax policy: a review 8-14 (int’l monetary fund, working paper no. 93/65, 1993). 146 . technical assistance factsheet, supra note 145. (emphasis omitted.) 147 . id. (emphasis omitted.) 148. tax law design, supra note 21. 149 . françois gianviti, preface to 1 id. at xxiii. 150 . thuronyi, supra note 21, at xxvii. countries to apply them in a correct and efficient way.”143 three of these multilateral tax centers focus their activities on the transition countries in the cee/nis region. 2. the imf – the imf also provides tax reform advice to transition countries in the cee/nis region. this advice can come in the form of conditions imposed on imf loans to the transition country,144 or it can come in the form of technical assistance to the transition country in matters relating to fiscal policy.145 imf technical assistance “is provided through staff missions of limited duration, and the placement of experts for periods ranging from a few weeks to a few years.”146 technical assistance may also be provided “in the form of technical and diagnostic reports, training courses, seminars, workshops, and on-line advice and support from [imf] headquarters in washington, d.c.”147 to provide general guidance to developing and transition countries that wish to reform their tax systems, the imf has published a two-volume set entitled tax law design and drafting.148 this set is a collaborative effort by a number of authors, most of whom have served either as staff members of or as consultants to the legal department of the imf.149 the set is based on the experiences of the authors “in drafting laws and advising on tax legislation for over two dozen” developing and transition countries.150 2003] the ethics of tax cloning 279 151. id. 152 . id. at xxviii. 153. richard k. gordon & victor thuronyi, tax legislative process, in tax law design, supra note 21, at 11-14. 154. id. at 11-12. 155. id. at 13. 156. id. 157. id. the expressed purpose of tax law design and drafting is to present the tax laws of developed countries, which “are barely understandable to tax practitioners in the country concerned and are even more impenetrable to outsiders,” in a way that is “relevant and accessible” to officials in developing and transition countries who would look to those laws for guidance.151 the authors of tax law design and drafting intend the set to be a useful source for general background, options, and guidelines and examples, which should be supplemented by the study of much more specific material before the task of drafting the tax laws of a particular developing or transition country is undertaken.152 the first volume of tax law design and drafting discusses general issues, such as the legal framework for taxation, the tax legislative process, and the manner in which tax legislation should be drafted. of particular interest to this article, the chapter on the tax legislative process contains the following advice concerning the issues that should be considered when choosing and employing foreign legal advisors:153 ! first, foreign legal advisors should be familiar with the local language, and, at a minimum, should be able to read it so that drafting can occur in that language.154 ! second, foreign legal advisors should “have a knowledge of comparative tax law.”155 they should be experts in the tax laws of any country from which legal rules are to be borrowed, and “should not be a person who seeks to impose the law of [her] own country on that of another country, or who, regardless of intentions, is equipped only to do so.”156 ! third, foreign legal advisors should not only be experts in tax law, but should also “have substantial experience or skills in drafting tax legislation. drafting is a subspecialty that most practicing tax lawyers or academics do not normally cultivate, often because it is reserved for specialists in their home countries.”157 280 florida tax review [vol. 6:3 158. id. 159. id. at 13-14. 160. id. at 14. 161. id. 162. id. 163. id. at 11. ! fourth, foreign legal advisors should consult local lawyers to ensure that the draft tax legislation “is fully suited to the country’s circumstances,” and, more particularly, that it is consistent with the rest of the country’s legal system.158 ! fifth, foreign legal advisors should fully explain draft tax legislation to local officials, and should prepare an explanatory memorandum that explains both how the draft legislation functions and how it differs from existing law.159 ! finally, the exact role to be played by foreign legal advisors should be clarified.160 it is suggested that the local officials keep the foreign legal advisors involved in each step of the legislative process.161 in addition, although foreign legal advisors should not have the power to make changes in draft legislation prepared by local officials, they “should have an opportunity to raise and explain problems that [they] perceive[].”162 by being aware of these issues from the outset, local officials will increase the chance that the foreign legal advisors’ participation in the drafting process will prove helpful.163 the remainder of the first volume of tax law design and drafting is devoted primarily to a discussion of the major taxes other than the income tax (e.g., value-added tax, excise taxes, wealth taxes, and social security tax). the entirety of the second volume is devoted to a discussion of the income tax, with chapters on the individual income tax, the pay-as-you-earn tax on wages, the taxation of income from business and investment, the taxation of enterprises and their owners, the taxation of corporate reorganizations, and the international aspects of the income tax, among others. the first volume also contains two chapters with relevance to the income tax – one concerning presumptive taxation and the other concerning the adjustment of taxes for inflation. in contrast to the bwtc, tax law design and drafting does not take the form of a sample tax code embodying the preferences of the authors, which may simply be adopted in whole or in part by developing and transition 2003] the ethics of tax cloning 281 164 . thuronyi, supra note 21, at xxvii. 165. id. 166. victor thuronyi, introduction to 2 tax law design, supra note 21, at xxi, xxxi (“the baltic countries, georgia, kazakhstan, the kyrgyz republic, and to some extent uzbekistan and moldova have adopted systems heavily influenced by international models. russia and ukraine have been slower to make fundamental changes, but have nevertheless enacted a substantial volume of tax reform legislation in the income tax area, as with other taxes.”). countries. rather, the authors of tax law design and drafting have adopted as their framework “a comparative discussion of the tax laws of developed countries,” without any particular focus on the problems of developing and transition countries.164 the impetus for writing this set and for the differences between it and the bwtc are underscored by the following passage: the project responds to the suggestion of richard vann, who spent a year at the imf legal department in 1990, that there was a need in developing and transition countries for nonprescriptive drafting materials that covered the major choices to be made in constructing a tax system. it represents an effort to distill from our collective experience, and from the tax laws of many other countries of the world, practical guidelines for drafting tax legislation that can be used by officials of developing and transition countries and by their foreign advisors.165 iii. the terminological debate due at least in part to the efforts of this myriad of experts, transition countries have enacted tax legislation during the past decade that incorporates, or has been influenced by, western legal rules, concepts, and structures. naturally, the degree of western influence on the tax system of any given transition country has varied, with some having felt the impact more strongly than others.166 the following passage, which primarily describes western influence on the recently-enacted russian tax code, is particularly instructive: over the course of the preparation of the [russian] tax code, shatalov and other drafters of the tax code had numerous discussions with a wide range of tax experts. these experts included foreign advisors, primarily from the usaid-funded tax technical assistance program and the international monetary fund, but also from the oecd, the german ministry of finance, and the british know-how fund. the discussions with these foreign advisors no doubt influenced certain 282 florida tax review [vol. 6:3 167. joel m. mcdonald, the rise and fall of the russian government’s draft tax code, 16 tax notes int’l 121, 127 (1998) (note that, from 1994-97, the author advised the russian government on tax reform issues as part of the u.s. treasury department’s tax advisory program and the harvard institute for international development’s russian tax reform project); see also charles e. mclure, jr., tax policy lessons for ldcs and eastern europe 5-7 (int’l ctr. for econ. growth, occasional paper no. 28 , 1992); himes & milliet-einb inder, supra note 125, at 26 (“the oecd is working closely with russia–which has observer status in the organisation’s committee on fiscal affairs–to ensure that the code being enacted brings russia closer to international standards, while equipping administrators with new tools for collecting taxes in a non-discriminatory and fair manner.”); kramer, supra note 140, at 14 (“western tax law, more or less modified and adapted, is being adopted almost everywhere in eastern europe. tax experts from the western world should be glad that the laws with which they are more or less familiar are considered so attractive in the developing eastern european democracies. unfortunately, the happy response to this event cannot be unfettered when the conditions under which western tax law is adopted are taken into critical consideration.”); stewart, supra note 12, at 1329 (“radical income tax reform since 1992 in many of these [transition] countries has been heavily influenced by international models, one of which is the basic world tax code produced by ward hussey and donald lubick. reform in transition countries has also been driven by structural adjustment packages of the imf, with reliance on imf technical assistance.” (footnote omitted)); stewart, supra note 9, at 142-43 (“this mapping will allow us to understand the role of external influence in tax reform projects. w hereas tax reform in developed countries falls within the domain of domestic government policy, many tax reform projects in developing and transition countries are largely a product of external influence. in transition countries, this influence performs a crucial role in conversion of the fiscal system from that suitable to a socialist state with a planned economy to a state organized for a market economy.” (footnotes omitted)); see generally holmes, supra note 25, at 18-19 (indicating that “[t]his transition [from a centrally-planned to a market provisions in the draft tax code, but not to the extent of foreign influence on the new tax codes of kazakhstan, ukraine, and georgia, substantial portions of which were drafted by foreigners. both the russian government and the foreign advisors have been sensitive to the xenophobia of some russian parliamentarians and have avoided publicity of the foreign advisors’ role. . . . oddly enough, the western tax advisory community in moscow has actively discussed, and sometimes criticized, the role of foreign technical assistance providers in the development of the tax code. a few have even called attention to the american influence in particular by referring to the tax code as ‘cut and pasted’ from the u.s. internal revenue code. a close examination of the tax code, however, reveals that the drafters have borrowed from many different tax systems around the world.167 2003] the ethics of tax cloning 283 economy] entailed an examination of western-style tax systems with the ideal objective of transposing the best features of them into the newly emerging economic systems of the former soviet states, after making appropriate adjustments that took into account the particular characteristics of each state,” but then emphasizing “the need for (particularly western) advisors to tax policymakers to take cognizance of cultural differences between them and the recipient of advice”). 168. see generally jack a. hiller & bernhard grossfeld, comparative legal semiotics and the divided brain: are we producing half-brained lawyers?, 50 am. j. comp. l. 175 (2002). 169. otto kahn-freund does cast his discussion of the importability of legal rules in terms of the situations in which law reformers may appropriately use – or inappropriately misuse – comparative law. see infra notes 358-382 and accompanying text. 170. see, e.g., alan watson, legal transplants: an approach to comparative law 30 (2d ed. 1993) [hereinafter watson, legal transplants ii]; ajani, supra note 7, at 93 n.1; wolfgang wiegand, the reception of american law in europe, 39 am. j. comp. l. 229, 236 n.14 (1991). labeling a phenomenon such as the propagation of tax rules recounted in this passage requires logical and analytical skill. confined within a finite vocabulary, one must choose the label that most accurately describes the phenomenon being observed. but, in choosing a label, one must not stop there – while logical and analytical skills are important, one cannot overlook the creative aspect of this endeavor.168 choosing the most appropriate label also requires something akin to literary skill in selecting the term that best evokes the impressions, feelings, and emotions that one would like the term to conjure in the mind of the listener when she hears it or in the mind of the reader when she reads it. as this part details, the current terminology for describing the propagation of tax rules in transition countries falls short on all of these counts. in its place, this part suggests alternative terminology that would both more accurately describe the process of propagating tax (and other legal) rules and evoke the generally neglected169 ethical dimension of this phenomenon. hopefully, by employing terminology that is redolent of an ethical conundrum to describe their activities, we can give american neutral experts reason to pause and reflect before advocating the propagation of western tax rules in transition countries. a. the extant terminological alternatives comparatists have suggested a panoply of different terms to serve in the role of metaphorical shorthand for the propagation of legal rules.170 some of these terms do no more than limn the overall phenomenon. for example, the term “penetration” describes the phenomenon from the point of view of the 284 florida tax review [vol. 6:3 171. see guido tedeschi, on reception and on the legislative policy of israel, 16 scripta hierosolymitana 11-12, 14 (1966). for the sake of simplicity, i will hereinafter refer to the overall phenomenon as penetration or importation, as the context requires. 172. see id. at 12 (“to characterize the importation of law as a reception it is not enough to show that the provisions in question were imported from a given foreign system; it is also necessary to show how they were imported.”); see also kálmán kulcsár, forced adaptation and law-making: a functional aspect of comparative law, in law in east and w est: on the occasion of the 30th anniversary of the institute of comparative law, w aseda university, 243 , 244 (1988) (“the basis of this typification [i.e., as ‘reception’ or ‘acculturation’] is formed by the historical circumstances and conditions that ‘motivate’ the adoption of law and which are the components of the social and historical situation in which the reception takes place”). 173. tedeschi, supra note 171, at 14-15; see also max rheinstein, types of reception, in 6 annales de la faculté de droit d’istanbul 33, 35-36 (1956). 174. tedeschi, supra note 171, at 12; see also kulcsár, supra note 172, at 24344 (describing “true” reception in terms of “legal acculturation,” which, although it “embraces the fact of reception,” is “broader than the usual interpretation of this term. it also embraces the psychological, sociological and cultural spheres of law, that is, not only change in the law but also change in legal culture”); id. at 254-56 (describing “cultural reception” as “the introduction of a broader context of which the law forms a part and precisely because of the longer period of time involved in the reception and its acculturation nature, the receiving environment is favourable for the law”). 175. tedeschi, supra note 171, at 16. 176. id. at 12; see also kulcsár, supra note 172, at 244, 249-54 (referring to “imposed” receptions as “forced adaptations”). 177. tedeschi, supra note 171, at 12; see also rheinstein, supra note 173, at 34, 35-36. home legal environment, while the terms “absorption” and “importation” describe it from the point of view of the recipient legal environment.171 other terms are intended to categorize the variety of circumstances under which penetration or importation can occur:172 ! “reception” is the voluntary and conscious importation of a legal rule.173 there are three categories of receptions: “true” receptions (when the reception is not due to any outside pressure),174 “crypto-receptions” (when the reception is surreptitious or concealed),175 and “imposed” receptions (when the reception, albeit voluntary and conscious, is induced by outside pressure).176 ! “imposition” is contrasted with reception, and occurs “where the law is not received from within a society by its people or legislator but is imposed from without.”177 there are two 2003] the ethics of tax cloning 285 178. tedeschi, supra note 171 , at 14 (“it must be admitted that in palestine as in other british dependencies the ‘natives’ themselves often asked for the introduction of english law; that is, certain sections of the local population desired it. but even in these cases one cannot speak of a real reception, if only because a choice between english law and other law simply did no t exist in the circumstances . . . . at best one can describe the process as an intermediate state between a reception and an imposition, parallel to, but the reverse of, the phenomenon discussed by professor rheinstein: instead of an ‘imposed reception’ there was here a ‘solicited imposition.’”). 179. id. at 15. 180. id. at 16 (quoting r.w . lee, roman law in the british empire, particularly in the union of south africa, in 2 atti del congresso internazionale di diritto romano 251 (1934-35)). see id. at 16-20 for an argument that the metaphor of an “immunizing inoculation” is inapposite. 181. id. 182. edward m. wise, the transplant of legal patterns, 38 am. j. comp. l. 1, 1 (supp. 1990). 183. watson, legal transplants ii, supra note 170 , at 21. rheinstein had earlier employed the term “transplantation” in a narrower sense. he used the term to describe two different situations: first, where, under a system of personal law, a group migrates from one p lace to another, taking its law with it, and second, where, under a system of categories of impositions: “true” impositions and “solicited” impositions (when the imposition is made at the request of the recipient).178 ! “infiltration” is the importation of a legal rule that “is not regarded as a rule peculiar to one system or another (although it is in fact no more than that) but is regarded rather as a rule which every legal system demands” or that is merely regarded as “‘the law.’”179 ! “inoculation” is the importation of a limited amount of legal rules from another system in order “‘to give strength and coherence to its native fibre, and to enable it to resist successfully any general reception at a later date.’”180 ! “coincidental or parallel development” is the importation of a legal rule “in ignorance of the fact that it already exists or existed in some other country.”181 comparatists have generally come to refer to the process through which penetration or importation occurs as “transplantation,” after the style of alan watson, who has been, by far, the most prolific writer on this subject.182 watson defines legal transplantation as “the moving of a rule or a system of law from one country to another, or from one people to another.”183 286 florida tax review [vol. 6:3 territorial law, a group migrates from “an old, settled country in to what may be called empty or virgin soil” (or its equivalent). rheinstein, supra note 173, at 34-35. w ith respect to this point, consider the following passage from w atson, legal transplants ii, supra note 170, at 29-30: voluntary major transplants – that is, when either an entire legal system or a large portion of it is moved to a new sphere – fall into three main categories. first when a people moves into a different territory where there is no comparable civilisation, and takes its law with it. secondly, when a people moves into a different territory where there is a comparable civilisation, and takes its law with it. thirdly, when a people voluntarily accepts a large part of the system of another people or peoples. 184. see, e.g., wiegand, supra note 170, at 236 n.14 (expressing general dissatisfaction with the existing terminology used to “describe or explain the effective procedure of reception”); wise, supra note 182 , at 12 (“it seems less apt to talk in terms of ‘transplants’; that makes a process almost as natural as breathing sound like major surgery.”). 185. pierre legrand, the impossibility of ‘legal transplants,’ 4 maastricht j. eur. & comp. l. 111, 111 (1997). 186. webster’s new world dictionary of the american language 1512 (2d college ed. 1984). notwithstanding the pervasive use of this term, some commentators have expressed their discomfort with describing the process of effectuating penetration or importation as “legal transplantation.”184 upon reflection, it quickly becomes clear that the term “transplantation” does not accurately describe the process through which penetration or importation is effectuated. as pierre legrand has pointed out, the word “‘[t]ransplant’ . . . implies displacement.”185 webster’s new world dictionary of the american language defines the verb “transplant” as 1. to dig up (a growing plant) from one place and plant in another 2. to remove (people) from one place and resettle in another 3. surgery to transfer (tissue or an organ) from one individual or part of the body to another; graft.186 what each of these definitions has in common is the notion that something (a plant, a person, tissue, or an organ) has been removed from one location and has been deliberately placed in another. these definitions each contemplate the existence, at all times, of only one such thing; in other words, at any given time, the plant, person, tissue, or organ either exists in the home environment, in the recipient environment, or in transit between the two – the item being transplanted never exists in more than one of these three locations at the same time. when a legal rule is imported into a recipient environment, however, the rule does not cease to exist in the 2003] the ethics of tax cloning 287 187. watson appears to use the term “borrowing” interchangeably with the term “transplantation.” see, e.g., alan watson, the evolution of western private law 193-217 (2001) [hereinafter watson, evolution]; watson, legal transplants ii, supra note 170, at 107-18; alan watson, aspects of reception of law, 44 am. j. comp. l. 335 (1996) [hereinafter watson, reception]; alan watson, legal change: sources of law and legal culture, 131 u. pa. l. rev. 1121 (1983) [hereinafter watson, legal change]. this term, which in its etymological sense suggests that the recipient environment will at some point return the “borrowed” rule to the home environment, would seem to be equally inapposite. see w ebster’s new world dictionary of the american language 164 (2d college ed. 1984) (“borrow . . . 1. to take or receive (something) with the understanding that one will return it or an equivalent”); id. at xii (indicating that the senses of an entry in the dictionary are generally “arranged in semantic order from the etymology to the most recent sense”). 188. wise, supra note 182, at 1. 189. id. 190. id. at 12. 191. shen zongling, legal transplant and comparative law, revue internationale de droit comparé 853, 857 (1999). home environment; indeed, following penetration or importation, the rule exists in both the home and recipient environments simultaneously. for this reason, the term “transplantation” is an inapposite metaphor for the process of effectuating penetration or importation.187 commentators have proposed alternatives to the term “legal transplant.” for example, edward wise has suggested that the term “circulation” be used in place of “legal transplant.”188 wise describes circulation as “the movement, the continual flow of legal paradigms and ideas across national frontiers.”189 referring to the frequency with which one u.s. state imports law from another, wise indicates that “[i]t may not be inapt to think of such pervasive borrowing as involving the circulation or diffusion or transmission of ideas.”190 but, as defined by wise, the term “circulation” does not appear to describe the nature of the process of effectuating penetration or importation; rather, it appears to describe the frequency with which that process occurs. shen zongling has argued that there is “no substantial difference between the phrase legal transplant and drawing on or assimilating,” which is the terminology used in china to describe this phenomenon.191 once again, neither the phrase “drawing on” nor the term “assimilating” appears to describe the process of effectuating penetration or importation. instead, the phrase “drawing on” should be included in the list of terms intended to categorize the circumstances under which importation can occur. the phrase implies that the importation is being accomplished by, and at the instance of, the recipient legal system, and connotes both a voluntariness and consciousness of the actions being taken. accordingly, the phrase “drawing on” would more appropriately be characterized as a synonym of the term “reception” than as a synonym of the 288 florida tax review [vol. 6:3 192. stuart h. orkin, animal cloning and related embryo research: implications for medicine, in 2 nat’l bioethics advisory comm’n, cloning human beings: report and recommendations of the national bioethics advisory commission: commissioned papers at a-1, a-4 (1997) [hereinafter nbac commissioned papers]. 193. arlene judith klotzko, voices from roslin: the creators of dolly discuss cloning science, ethics, and social responsibility, in the cloning sourcebook 3, 10 (arlene judith klotzko ed., 2001) [hereinafter sourcebook]. 194. craig m. klugman & thomas h. murray, cloning, historical ethics, and nbac, in human cloning 3, 6-7 (james m. humber & robert f. almeder eds., 1998); see also glenn mcg ee, a pragmatic approach to human cloning, in sourcebook, supra note 193, at 173, 175; potter wickware, history and technique of cloning, in the human cloning debate 17, 20-21 (glenn mcgee ed., 1998) [hereinafter debate]. 195. gregory e. pence, introduction to flesh of my flesh: the ethics of cloning humans: a reader, at ix (gregory e. pence ed., 1998); see also wickware, supra note 194, at 27-32. term “transplantation.” as for the term “assimilating,” it is a synonym of absorption and, therefore, should be considered as describing the overall phenomenon rather than as describing the nature of the process of effectuating penetration or importation. b. a new alternative a timely and more accurate description of the process of effectuating penetration or importation would be the cloning of a legal rule, followed by its implantation in a recipient environment. in its strictest sense,192 the term “cloning” refers to the production of an exact copy;193 however, in its modern usage, cloning is more loosely defined as “asexual reproduction of any kind,” and includes within its ambit such commonplace occurrences as when a plant is grown from cuttings or when a bacterium procreates by splitting itself in two.194 the term “cloning” also includes within its ambit “molecular cloning, cellular cloning, embryo twinning, [and] somatic cell nuclear transfer”:195 in molecular cloning, strings of dna containing genes are duplicated in a host bacterium. in cellular cloning, copies of a cell are made, resulting in what is called a “cell line,” a very repeatable procedure where identical copies of the original cell can be grown indefinitely. in embryo twinning, an embryo that has already been formed by sexual reproduction is split into two identical halves. theoretically, this process could continue indefinitely, but in practice, only a limited number of embryos can be twinned and retwinned. somatic cell nuclear transfer is the process of taking the nucleus of an adult cell and 2003] the ethics of tax cloning 289 196. pence, supra note 195 , at ix. 197 . see infra note 210 and accompanying text. 198. orkin, supra note 192, at a-4 (“[i]t has been assumed that the ‘cloned animal’ [i.e., dolly] has a single parental origin, that of the adult somatic cell from which the donor nucleus was taken. this is largely, but not entirely, correct, as the egg’s cytoplasm contributes intracellular organelles, including mitochondria and accompanying mitochondrial dna, to the future ‘clone.’ mitochondria contribute very little dna to the cell. nonetheless, some human diseases are attributable to mutations in mitochondrial dna. the genetic composition of a ‘clone’ created by nuclear transfer may, therefore, not be precisely identical to that of the donor cell, although its nuclear genome is presumed to be. this seemingly minor detail is not meant to diminish the near genetic identity of the cloned animal and the parental cell, but merely to illustrate that perfect duplication of an individual animal by nuclear transfer may not be attained by the procedures described thus far. hence, if cloning humans were ever to take place, the individuals produced would, by definition, be non-identical (unless the somatic cell and the recipient egg were from the same woman).”); see also klotzko, supra note 193, at 10-11; pence, supra note 195, at xi-xii. 199 . see supra notes 185-187 and accompanying text. 200 . see supra note 195 and accompanying text. 201 . see supra note 198 and accompanying text. implanting it in an egg cell where the nucleus has been removed; this process could be used to originate a human child.196 technically, somatic cell nuclear transfer, which is the technique that was used to produce the lamb dolly,197 does not result in the production of an exact copy of the original. consequently, somatic cell nuclear transfer, which is what many people actually have in mind when they talk about human cloning, does not constitute cloning in the strict sense of that term, but will constitute cloning in the looser, modern sense.198 employing the term in this looser, modern sense, cloning is an apt metaphor for the process of effectuating penetration or importation. as described above, the primary difficulty with referring to this process as “transplantation” is the implication that the transplanted legal rule ceases to exist in its home environment once the penetration or importation has occurred.199 the term “cloning” avoids this problem by positing a reproduction or replication of the legal rule prior to its implantation in the recipient environment. cloning also embraces a wide variety of copying, from copying at the molecular or cellular level to copying an entire animal or human being.200 thus, the term can appropriately be used to refer to the penetration or importation of all or part of a single legal rule, a set of legal rules, or an entire legal system. in addition, by employing the term in its looser sense, it is not necessary that the copy be an exact reproduction of the original.201 as a result, 290 florida tax review [vol. 6:3 202. legrand, supra note 185, at 114. 203. see inmaculada de melo-martín, on cloning human beings, 16 bioethics 246, 249-50 (2002); raanan gillon, human reproductive cloning: a look at the arguments against it and a rejection of most of them, in sourcebook, supra note 193, at 184, 190; arlene judith klotzko, animal cloning: the pet paradigm, in sourcebook, supra note 193, at 169, 170; richard lewontin, the confusion over cloning, in debate, supra note 194, at 125, 129; orkin, supra note 192, at a-4 to a-5; peter singer, cloning humans and cloning animals, in sourcebook, supra note 193, at 160, 162, 163; wickware, supra note 194, at 39-40. but cf. james q. wilson, the paradox of cloning, the term “cloning” could also include within its ambit those legal rules that are altered or modified prior to penetration or importation. the cloning metaphor is particularly apposite if one believes that a rule is more than just a mere formulation of words, and that it is only suffused with meaning when it is the subject of interpretation: no form of words purporting to be a ‘rule’ can be completely devoid of semantic content, for no rule can be without meaning. the meaning of the rule is an essential component of the rule; it partakes in the ruleness of the rule. the meaning of a rule, however, is not entirely supplied by the rule itself; a rule is never completely self-explanatory. to be sure, meaning emerges from the rule so that it must be assumed to exist, if virtually, within the rule itself even before the interpreter’s interpretive apparatus is engaged. to this extent, the meaning of a rule is acontextual. but, meaning is also – and perhaps mostly – a function of the application of the rule by its interpreter, of the concretization or instantiation in the events the rule is meant to govern. this ascription of meaning is predisposed by the way the interpreter understands the context within which the rule arises and by the manner in which she frames her questions, this process being largely determined by who and where the interpreter is and, therefore, to an extent at least, by what she, in advance, wants and expects (unwittingly?) the answers to be. the meaning of the rule is, accordingly, a function of the interpreter’s epistemological assumptions which are themselves historically and culturally conditioned.202 based on experience with identical twins (who are naturally occurring clones), it has similarly been argued that a clone of a human being will be more than just a mere composite of genetic material.203 few would doubt that the personal 2003] the ethics of tax cloning 291 in leon r. kass & james q. wilson, the ethics of human cloning 61, 67 (1998) (arguing that claims “that the environment will have a powerful effect on a cloned child . . . [have been] exaggerated”). 204. watson, legal transplants ii, supra note 170, at 30 (“actually, receptions and transplants come in all shapes and sizes. one might think also of an imposed reception, solicited imposition, penetration, infiltration, crypto-reception, inoculation and so on, and it would be perfectly possible to distinguish these and classify them systematically . . . . there is, i suggest, no point in elaborating a detailed classification of borrowing until individual instances have been examined to see what they reveal. it is up to those (if any) who would wish to elaborate types of transp lantation to show what new light the classification would cast on the data.” (footnote omitted)). although watson’s challenge appears to concern only further classification beyond his meta-level labeling of the process as “legal transplantation” (either because he assumed that this term was correct or because, even if incorrect, any error would be harmless), his challenge would presumably also apply to any suggestion that this label be replaced with another. 205. despite his challenge, watson apparently agrees with me on this point. in fact, he dedicates an entire chapter of legal transplants to the importation of roman systematics in scotland and to discussing the importance of systematization (and classification). watson, legal transplants ii, supra note 170, at 36-43 (see especially pages 41-43 and note 13); see also w atson, evolution, supra note 187, at 258 (indicating that civil law countries’ acceptance of the corpus juris civilis had “profound consequences” for their legal systems, including the placement of an “academic and systematic” emphasis on law and the use of the corpus juris civilis as a model for the codification of local law). identity or individuality of a human clone would be different from that of its parent if the clone were raised in a different environment (e.g., a different time period or a different place). in the end, the parent and the clone might look alike, but they would be entirely different individuals with different personalities. thus, even though the term “cloning” – as applied to the process of effectuating penetration or importation – would imply the duplication of the structure of the legal rule, it would countenance divergences in later development by dint of implantation in a foreign legal environment. in his book legal transplants, alan watson abstained from entering into this terminological debate, and he challenged others who would to demonstrate that terminology can have an impact on the substantive debate concerning the penetration and importation of legal rules.204 i disagree with watson on this point, because i believe that there is an independent utility to classification and categorization.205 if one has decided to undertake the task of choosing a descriptive label for a phenomenon, then one should make every effort to choose the label that most accurately describes that phenomenon. an incorrect label has the potential to mislead others about the phenomenon’s true nature and fundamentally (and, most likely, unconsciously) to misshape their thinking about it. accordingly, i would argue that the term “cloning” should 292 florida tax review [vol. 6:3 206. see supra note 169. 207. klugman & murray, supra note 194, at 3, 9, 10, 26. 208. see gregory e. pence, who’s afraid of human cloning 49 (1998) (“‘clone’ connotes sub-human, zombie-like, insect-like behavior. it is associated with phrases such as ‘an army of clones’ and “slave clones of caldor.’ it is really in the same class as dozens of other nasty terms that slur the racial, ethnic, and sexual origins of a person.”); david k. chan, book review: who’s afraid of human cloning, 13 bioethics 440, 441 (1999) (“pence proposes the neutral phrase ‘nuclear somatic transfer’ (nst) in place of the emotionally-charged word ‘cloning’.”); gillon, supra note 203, at 194-95 (“it is in the context of the social and personal harms of human reproductive cloning that brave new world (and also the ira levin book of 1976, boys from brazil, in which clones of hitler are bred in an attempt to rekindle the nazi enterprise) has done so much to turn us against cloning, even succeeding in rendering the term pejorative.”); mcgee, supra note 194, at 175 (“to avoid the pejorative overtone about clones and cloning, pence suggests a new term: ‘somatic cell nuclear transfer.’”). replace “legal transplants” even in the absence of an impact on the substantive debate concerning the penetration and importation of legal rules. nevertheless, i would argue that watson’s challenge has been met, because terminology can have an impact on the substantive debate concerning the penetration and importation of legal rules. given its link with the ethical debate over human cloning, the term “cloning,” if applied to the process of effectuating penetration or importation, would clearly and immediately evoke the (for the most part, neglected)206 ethical dimension of this phenomenon in a way that “legal transplants” and other less accurate terms have not. use of the term “cloning” would also cause discussions of this phenomenon to become freighted with the baggage that naturally accompanies that term. in the popular imagination, the word “cloning” is associated with books such as aldous huxley’s brave new world and ira levin’s the boys from brazil and with motion pictures such as jurassic park.207 these and other associations have given the word a decidedly negative connotation,208 and its use should naturally cause one to question the ethical propriety of engaging in any process that it labels. as a result, by referring to the process of effectuating penetration or importation as “cloning,” not only will the label more accurately reflect the underlying activity it is meant to describe, but it will also add a needed dose of caution to discussions of, and attempts at, penetration or importation. iv. the normative basis of the ethical guidelines armed with terminology that now punctuates thoughts of propagating tax rules with an ethical question mark, we can turn to the task of developing guidelines that may help american neutral experts to resolve these newly-raised issues. the first step in this process will be to ascertain the relevant norm or set 2003] the ethics of tax cloning 293 209. for a historical overview of the ethical debate over cloning, see klugman & murray, supra note 194. 210. see gina kolata, w ith the cloning of a sheep, the ethical ground shifts, n.y. times, feb. 24, 1997, at a1. it was recently reported that dolly had been “put to death after developing a lung infection.” gina kolata, first mammal clone dies; dolly made science history, n.y. times, feb. 15, 2003, at a4. at the time of her death, dolly was six years old. id. 211. kolata, supra note 210. 212. arlene judith klotzko, a report from america: the debate about dolly, in sourcebook, supra note 193, at 121, 121; klotzko, supra note 193, at 13 (comments of keith campbell); orkin, supra note 192, at a-3; pence, supra note 195, a t x; lee m. silver, thinking twice, or thrice, about cloning, in sourcebook, supra note 193, at 61, 63. of norms that will guide our thinking about the ethical aspects of tax cloning. given the role of the attorney-client relationship as the benchmark for setting the ethical boundaries within which american neutral experts should confine their activities, legal ethics would be the natural source of the relevant norm(s). nevertheless, before having recourse to legal ethics, i propose continuing our sojourn in the world of bioethics a bit longer. in light of the similarity that we have encountered between cloning and the process for effectuating the penetration or importation of legal rules, the experience of bioethicists with the debate over human cloning may prove useful in developing ethical guidelines for tax cloning. to tap into this experience, this part will begin by exploring the bioethics debate over human cloning. the arguments for and against cloning will first be discussed with an eye toward ascertaining the norm or set of norms around which the debate is framed. once we have identified the relevant norm or set of norms that underpin the debate over human cloning, this part will consider whether an analogous legal norm or set of norms exists that may be used to develop ethical guidelines for tax cloning. the process of developing ethical guidelines for tax cloning will then be completed in part v, when the relevant legal norm or set of norms identified in this part will be suffused with specific content and meaning as they relate to tax cloning. a. the bioethics debate the latest phase in the ethical debate over human cloning209 was triggered by the announcement in february 1997 of the birth of a lamb named dolly.210 dolly had been cloned from the mammary cells of a six-year old adult sheep by dr. ian wilmut and his colleagues at the roslin institute near edinburgh, scotland.211 the birth of dolly was considered a breakthrough because, contrary to the then-prevailing scientific consensus,212 dr. wilmut and 294 florida tax review [vol. 6:3 213. orkin, supra note 192, at a-3. a somatic cell (as opposed to a germ cell) is one that has differentiated. see clarissa long & christopher demuth, introduction to kass & w ilson, supra note 203, at vii, xi. keith campbell, one of the scientists on the roslin institute team, has described differentiation as “the specialization of cells to perform particular functions. although all cells contain a complete copy of the genome [all the genes and other dna], the specific genes that are turned on in a cell are those required for it to fulfill its particular function.” klotzko, supra note 193, at 11. 214. orkin, supra note 192, at a-3. 215. singer, supra note 203, at 165. 216 . see pence, supra note 208, at 1 (“on february 24, 1997, every paper in the world carried a front-page story about a lamb named ‘dolly’ that had been cloned near edinburgh, scotland by ian wilmut. it was immediately apparent that wilmut’s cloning techniques might be applied to humans. never in the history of modern science had the world seen such an instant, overwhelming condemnation of the application to humanity of a scientific breakthrough.”); orkin, supra note 192, at a-3 (“while it extends the envelope of animal cloning, the wilmut experiment has raised immediate concern regarding the implications of this technology, if developed further, for humans”); silver, supra note 212, at 63 (“of course, it wasn’t the cloning of a sheep that stirred the imaginations of hundreds of millions of people. it was the idea that humans could now be cloned as well, and many people were terrified by the prospect.”); hans o. tiefel, human cloning in ethical perspectives, in human cloning, supra note 194, at 179, 179 (“the news of the scientific feat of cloning a sheep did not evoke popular press prophecies of flocks of identical sheep . . . , but of armies of cloned soldiers marching to the orders of a dictator, of cadres of replicated scientific geniuses controlling our future world.”). 217. because the purpose of this part is to ascertain the normative basis of the arguments made in the debate over human cloning, consideration of the merits of these arguments is not germane to the instant discussion and, therefore, will not be undertaken. suffice it to say that the existence and/or scope of the rights, harms, and benefits described in the text below is often the subject of dispute among the participants engaged in this debate. his colleagues demonstrated that it is possible to clone a mammal from an adult somatic cell.213 prior to dolly’s birth, “this feat had been accomplished only with cells of early embryos and only in selected non-primates.”214 although the product of this cloning was a lamb, dolly’s birth did not generate a debate about animal cloning.215 instead, what ensued was a vigorous debate over the propriety of human cloning and the related question whether a temporary or permanent ban on such activity should be enacted.216 in the course of this debate, a number of arguments have been marshaled both for and against human cloning. these arguments will first be summarized and then an attempt will be made to ascertain whether they share a common normative basis that can be seen as providing a framework for this debate.217 1. arguments against human cloning – both secular and religious arguments have been marshaled against human cloning. opponents of human 2003] the ethics of tax cloning 295 218. dan w . brock, cloning human beings: an assessment of the ethical issues pro and con, in nbac commissioned papers, supra note 192, at e-1, e-11 to e14; see also gillon, supra note 203, at 191; michael tooley, the moral status of the cloning of humans, in human cloning, supra note 194, at 67, 77-85. 219. de melo-martín, supra note 203, at 248; silver, supra note 212, at 65. 220. see pence, supra note 208, at 131-34; r. alta charo, cloning: ethics and public policy, 27 hofstra l. rev. 503, 506-07 (1999); george j. annas, the prospect of human cloning: an opportunity for national and international cooperation in bioethics, in human cloning, supra note 194, at 53, 60; leon r. kass, the wisdom of repugnance, in kass & w ilson, supra note 203, at 3, 31-32; ina roy, philosophical perspectives, in debate, supra note 194, at 41, 46-47; silver, supra note 212, at 65-66; tooley, supra note 218, at 74-77. 221. brock, supra note 218, at e-16; de melo-martín, supra note 203, at 248. 222. gillon, supra note 203, at 195; see also arthur l. caplan, does ethics make a difference? the debate over human cloning, in sourcebook, supra note 193, at 158. cloning have made these arguments either in support of a total ban on human cloning or in support of a ban on human cloning for the near future. the secular and religious arguments against human cloning will be summarized separately below. a. secular arguments – the secular arguments against human cloning are cast either in terms of the “rights” that are implicated by cloning or in terms of the effects that cloning may have on individuals or on society as a whole. the rights that may be implicated by cloning include “the right to have a unique identity and [the] right to ignorance about one’s future or to an ‘open future.’”218 it is argued that each of these rights would be infringed if cloning were to be permitted. the arguments concerning the effects that cloning may have on individuals or on society as a whole can generally be categorized under one of three rubrics: (i) risk of physical harm to those participating in the cloning process, (ii) risk of psychological harm to those participating in the cloning process, and (iii) risk of harm to society as a whole.219 the following is a description of the arguments made under each of these three rubrics: risk of physical harm. it has been argued that, at present, insufficient knowledge exists concerning the safety of somatic cell nuclear transfer to warrant its application to humans.220 commentators making this argument point to the fact that, in the case of dolly, it took 277 attempts to obtain one live birth from cloning.221 they also point to reports of animal experiments that “have produced many abnormal embryos and fetuses, many spontaneous abortions, and many abnormal births.”222 concerns have also been raised that clones 296 florida tax review [vol. 6:3 223. gillon, supra note 203, at 195; caplan, supra note 222, at 158. for a summary of research concerning the rate of aging of clones, see klotzko, supra note 193, at 17. 224. caplan, supra note 222, at 158; see also pence, supra note 208, at 135-40; alta charo, supra note 220, at 506; gillon, supra note 203, at 195-96; kass, supra note 220, at 33-34; klotzko, supra note 203, at 171; silver, supra note 212, at 66-67; carson strong, cloning and infertility, 7 cambridge q. healthcare ethics 279, 282-86 (1998); tooley, supra note 218, at 93-94. 225. genetic essentialism, which is also referred to as genetic determinism, is defined as “the idea that genes determine psychology and personality.” soren holm, a life in the shadow: one reason w e should not clone humans, in sourcebook, supra note 193, at 203, 204; see also brock, supra note 218, at e-12. 226. holm, supra note 225, at 205-06; see also brock, supra note 218, at e-14 to e-15; de melo-martín, supra note 203, at 250; gillon, supra note 203, at 190-94. produced from adult somatic cells may be prone to diseases associated with premature aging.223 risk of psychological harm. it has been argued that cloning may impose an intolerable psychological burden on the clone: if clones feel burdened by having a very close resemblance to one parent, if they feel that their future is not their own because they were made to conform to someone else’s expectations and dreams . . . , if they feel overwhelmed by the burden of knowing too much about their biological destiny because it is written in the body and appearance of the parent from which they came, if they elicit inappropriate or hostile reactions from parents and others, then it may prove to be too burdensome to ask someone to go through his or her life as a clone.224 in the same vein, it has been argued that, because of the prevalence of genetic essentialism225 in common thought, cloning violates the autonomy and human dignity of the clone by denying her the ability to live her life as she determines rather than in the shadow of her parent.226 in addition, the parents of a clone may do it psychological harm if they have expectations (as opposed to hopes) for their cloned child: still, if most parents have hopes for their children, cloning parents will have expectations. in cloning, such overbearing parents take at the start a decisive step that contradicts the entire meaning of the open and forward-looking nature of parent-child relations. the child is given a genotype that has already lived, with full expectation that the blueprint of a past 2003] the ethics of tax cloning 297 227. kass, supra note 220, at 41-42. 228. gillon, supra note 203, at 195. 229. see silver, supra note 212, at 67. 230. pence, supra note 208, at 141-42, 143-44; alta charo, supra note 220, at 504, 506; brock, supra note 218, at e-20; gillon, supra note 203, at 196; rosamond rhodes, clones, harms, and rights, in sourcebook, supra note 193, at 208 , 209; roy, supra note 220, at 47-53; strong, supra note 224, at 287-88; tooley, supra note 218, at 91-92; wilson, supra note 203, at 65. 231. de m elo-m artín, supra note 203, at 252-53; see also annas, supra note 220, at 59; brock, supra note 218, at e-18; kass, supra note 220, at 27; strong, supra note 224, at 286-87; tooley, supra note 218, at 95-96. 232. brock, supra note 218, at e-19; see also alta charo, supra note 220, at 506; kass, supra note 220, at 39-40. life ought to be controlling of the life that is to come. cloning is inherently despotic, for it seeks to make one’s children (or someone else’s children) after one’s own image (or an image of one’s choosing) and their future according to one’s will. in some cases the despotism may be mild and benevolent. in other cases it will be mischievous and downright tyrannical. but despotism – the control of another through one’s will – it inevitably will be.227 moreover, the potential for psychological harm to the women donating the eggs and carrying the clones has been raised in light of the fact that dolly was the one successful birth out of 277 attempts.228 risk of harm to society. it has been argued that cloning could result in a number of different harms to society:229 ! eugenics. cloning opens the door to eugenics, which could be used to racist ends or for exploitative purposes or could lead to a division in society between the “superior” clones and the “inferior” others.230 ! reducing respect for human life. cloning reduces respect for human life by making human beings seem “replaceable” or “made to order.”231 similarly, cloning would reduce respect for human life if commercial interests were able to sell “genetically certified and guaranteed embryos for sale, perhaps offering a catalogue of different embryos cloned from individuals with a variety of talents, capacities, and other desirable properties.”232 298 florida tax review [vol. 6:3 233. de m elo-m artín, supra note 203, at 251; see a lso alta charo, supra note 220, at 504; kass, supra note 220, at 33, 36; strong, supra note 224, at 288; wilson, supra note 203, at 72. 234. kass, supra note 220, at 31; see also pence, supra note 208, at 73-82; alta charo, supra note 220, at 504. 235. gillon, supra note 203, at 196; see also pence, supra note 208, at 129-31; brock, supra note 218, at e-20; wilson, supra note 203, at 68-69. 236. gillon, supra note 203, at 196. 237. brock, supra note 218, at e-19; roy, supra note 220, at 54. 238. roy, supra note 220, at 54. 239. pence, supra note 208, at 142-43. 240. id. at 142. ! threatening stability of family. cloning threatens the stability of the nuclear family by allowing a child “to be born from a single parent or to have up to seven parents” and by creating “confusion about who is the mother, the father, the grandparents, or the siblings.”233 ! dehumanizing. cloning “is inherently dehumanizing” because it severs “procreation from sex, love, and intimacy.”234 ! threat to evolution. cloning represents a threat to human evolution because it reduces “the genetic variability of the human race.”235 ! replication of mistakes. cloning raises the specter of a “geometric increase through germline inheritance of any mistakes that are created.”236 ! limited public resources. because it appears at present that cloning “uniquely meet[s] important human needs” in only a limited number of cases, using public funds to support cloning would divert those resources from more pressing needs.237 in addition, if infants with birth defects were to result from cloning, society would be burdened with the costs of supporting those children.238 ! sexism. cloning could foster sexism, because it could be used as a tool by men to control women.239 the fear here is that “women would become stepford wives and would choose assisted reproduction only because they were coerced by men in their lives or by the male values of the larger society.”240 if the child were cloned from the man, “[t]he wife would . . . 2003] the ethics of tax cloning 299 241. id. 242. mcgee, supra note 194, at 175. 243. silver, supra note 212, at 65; see also pence, supra note 208, at 122, 12627; james rachels, the principle of agency, 12 bioethics 150, 160-61 (1998). 244. jan c. heller, religiously based objections to human cloning: are they sustainable?, in human cloning, supra note 194, at 155, 158. 245. id. at 162; see also leon r. kass, family needs its natural roots, in kass & wilson, supra note 203, at 77, 79. 246. heller, supra note 244, at 168; see also campbell, supra note 254, at d-35. 247. gilbert meilander, cloning violates the dignity of children, in debate, supra note 194, at 189, 191. appear to some to be just the ‘handmaid’ of the husband and male son, to be discarded once the new male is produced.”241 b. religious arguments – lee silver, who cannot be counted among the opponents of human cloning,242 has argued that people who voice any one or more of these concerns are – either consciously or subconsciously – hiding the real reason they oppose cloning. they have latched on to arguments about safety, psychology, and society because they are simply unable to come up with an ethical argument that is not based on the religious notion that by cloning human beings, man will be playing god, and it is wrong to play god.243 in light of silver’s views, a brief exposition of the religious objections to human cloning should aid in elucidating the normative basis of this ethical debate. from a christian perspective, several different categories of objections or concerns about cloning have been raised. these categories have been labeled “responsible dominion over nature,” “human dignity,” and “procreation and the importance of the family”:244 responsible dominion over nature. the rubric “responsible dominion over human nature” embraces concerns arising out of the need to demarcate the boundary between scientific inquiry that is “an appropriate expression of the image of god” and scientific inquiry that is “an inappropriate expression of human hubris or pride, that is, human usurpation of a role that is properly reserved to god.”245 human dignity. objections have been raised against cloning on the ground that it violates human dignity, because it would compromise the uniqueness of the clone and of its parent.246 procreation and the importance of the family. cloning is considered to depart from the “normative view”247 of procreation that is set forth in the bible, which contemplates that procreation should take place between a man 300 florida tax review [vol. 6:3 248. see id .; john haas, catholic perspectives on human cloning, in debate, supra note 194, at 205; stephen g. post, the judeo-christian case against cloning, in debate, supra note 194, at 197; see also pence, supra note 208, at 79-81; kass, supra note 245, at 79;wilson, supra note 203, at 63. 249. see haas, supra note 248, at 208; heller, supra note 244, at 170; meilander, supra note 247, at 192. 250. see h aas, supra note 248, at 211-12; heller, supra note 244, at 170; meilander, supra note 247, at 193-96. 251. meilander, supra note 247, at 194-95. 252. haas, supra note 248, at 208. 253. id; see also meilander, supra note 247, at 192-93; post, supra note 248, at 202. 254. courtney s. campbell, cloning human beings: religious perspectives on human cloning, in nbac commissioned papers, supra note 192, at d-1, d-29. 255. id. 256. id. at d-29 to d-30. 257. id. at d-30. 258. id. 259. id. and a woman in the context of a marital union.248 by departing from the biblical prescription for procreation, cloning violates the dignity of conjugal relations.249 cloning also violates the human dignity of the child because the child is “made” rather than “begotten”250 – we view that which we beget to be of equal dignity with ourselves, while we view that which we have made as being subject to our will and our desires.251 in addition, cloning harms the child by depriving it “of the normal, nurturing relationship with engendering parents.”252 the biblical view of procreation is considered in itself to be good because “[o]nly in and through the personal act of marital intercourse is the new life engendered best served. the child will be better nurtured if the parents are committed to one another and to their common social task, the raising of a family.”253 judaism is committed to “an ethic of responsibility or duty, rather than an ethic of rights.”254 the overriding duty that is derived from the torah and rabbinic commentary is “the preservation of human life.”255 the existence of this duty could make it “possible to support cloning when it is presented as a therapeutic remedy for a genetic disease or condition, such as infertility, that besets an individual or couple.”256 but balanced against this is one of the exceptions to the duty to preserve human life: the prohibition of idolatry.257 furthermore, “[t]he ethic of responsibility is . . . expressed in jewish norms of parenthood and the responsibilities of lineage.”258 reservations and objections would increase to the extent that the processes of becoming a parent were “separated from the actual creation of life.”259 cloning would diminish the ethic of responsibility by changing roles and relationships, thereby making it 2003] the ethics of tax cloning 301 260. id. 261. abdulaziz sachedina, an islamic view, in debate, supra note 194, at 231, 237. 262. id. at 237, 238. 263. id. at 238; see also campbell, supra note 254, at d-28 to d-29. 264. sachedina, supra note 261, at 238. 265. id. at 238-39, 241; campbell, supra note 254, at d-28. 266. see campbell, supra note 254, at d-23 to d-24, d-26 to d-27; ravi ravindra et al., buddhists on cloning, in debate, supra note 194, at 227, 227-30. 267. campbell, supra note 254, at d-25 (emphasis omitted); see also ravindra, supra note 266, at 227-28 (comments of william lafleur). 268. campbell, supra note 254, at d-26. “unclear who has responsibilities to whom between and among the generations.”260 the primary issue in the islamic debate over cloning “is the question of the ways in which cloning might affect familial relationships and responsibilities.”261 in islam, interpersonal relationships are considered to be “fundamental to human religious life,” the family is “the fundamental institution to further these relationships,” and “the spousal relationship in marriage [is] the cornerstone of the prime social institution of the family for the creation of a divinely ordained order.”262 accordingly, “muslims [should] have little problem with endorsing this technology,” but only to the extent that it is limited to therapeutic uses in aiding infertile married couples within the boundaries of the spousal relationship (i.e., there can be no third-party assistance through egg or sperm donation).263 an additional issue in the islamic ethical debate over cloning “is the problem of determining the moral status of the technology itself.”264 due to concerns of spiritual equality, the preservation of human dignity, and distributive justice, muslims are troubled by the potential use of cloning for eugenics, the potential for cloning to result in the commodification of persons, and the need to address more immediately pressing, basic needs before pursuing costly research related to cloning.265 both buddhist and hindu teachings may be interpreted as not being opposed to cloning per se, because each of these religions contains stories of creation that may be analogized to cloning.266 nevertheless, the scientific research necessary for the development of cloning technology would be circumscribed in buddhism by the “[p]art of the ‘noble eightfold path’ promulgated by the buddha [that] prohibits infliction of violence or harm on sentient beings”267and in hinduism by “ahimsa, or the non-injury of sentient beings.”268 2. arguments in favor of permitting cloning – in form, the proponents’ arguments are cast in the same terms as the secular arguments of the opponents of human cloning; in other words, they are cast either in terms of the rights that 302 florida tax review [vol. 6:3 269. rhodes, supra note 230, at 209; see also jean e. chambers, equal access to cloning, 11 cambridge q. healthcare ethics 169, 179 (2002). 270. brock, supra note 218, at e-4 to e-5; see also pence, supra note 208, at 100-01; alta charo, supra note 220, at 505-06; gillon, supra note 203, at 194; kass, supra note 220, at 42; timothy f. murphy, entitlement to cloning, 8 cambridge q. healthcare ethics 364 (1999); john robertson, cloning as a reproductive right, in debate, supra note 194, at 67; strong, supra note 224, at 280-82; tiefel, supra note 216, at 182-83. 271. brock, supra note 218, at e-7; see also kass, supra note 220, at 42. 272. see pence, supra note 208, at 99-148; rhodes, supra note 230, at 208-12. 273. pence, supra note 208, at 106-08; alta charo, supra note 220, at 503-04; brock, supra note 218, at e-7; de melo-martín, supra note 203, at 254; kevin t. fitzgerald, human cloning: analysis and evaluation, 7 cambridge q. healthcare ethics 218, 220 (1998); kass, supra note 220, at 16; rhodes, supra note 230, at 211; robertson, supra note 270, at 68; roy, supra note 220, at 53; tooley, supra note 218, at 90. are implicated by cloning or in terms of the effects that cloning may have on individuals or on society as a whole. in content, however, the arguments in favor of permitting cloning appear like a photographic negative of the arguments against cloning. with respect to the rights that may be implicated by human cloning, proponents focus on the possibility that a ban on human cloning would infringe the rights of those who might wish to engage in cloning. it has been argued that, given the centrality of the right to liberty in our society, cloning should be permitted “unless it can be shown to cause harm to others in the enjoyment of their rights.”269 more specifically, it has been argued that this right to liberty takes the form of “a right to reproductive freedom or procreative liberty,” which “includes not only the familiar right to choose not to reproduce, for example by means of contraception or abortion, but also the right to reproduce.”270 in addition, it has been argued that a separate moral right may be implicated in the ethical debate over cloning: “the right to freedom of scientific inquiry and research in the acquisition of knowledge,” which may be considered part of the more general right to freedom of expression.271 with respect to the arguments concerning the effects that human cloning may have on individuals or on society as a whole, proponents have attempted to minimize the specter of harm raised by the opponents of human cloning, and they have countered with a list of cloning’s potential benefits.272 included in this list of benefits are: ! treating infertility. cloning can aid infertile couples in having children who are genetically related to them, and thereby alleviate the psychological burdens and difficulties that may accompany the inability to have children.273 2003] the ethics of tax cloning 303 274. de melo-martín, supra note 203, at 259; see also pence, supra note 208, at 101-06; brock, supra note 218, at e-7 to e-8; fitzgerald, supra note 273, at 219-20; kass, supra note 220, at 16; robertson, supra note 270, at 68. 275. de melo-martín, supra note 203, at 261-62; see also b rock, supra note 218, at e-9; fitzgerald, supra note 273, at 221; kass, supra note 220, at 16; robertson, supra note 270, at 72. 276. brock, supra note 218, at e-8; see also alta charo, supra note 220, at 504; fitzgerald, supra note 273, at 220-21; kass, supra note 220, at 16; robertson, supra note 270, at 68, 72, 73; singer, supra note 203, at 164; tooley, supra note 218, at 91. 277. brock, supra note 218, at e-9 to e-10; see also kass, supra note 220, at 16; tooley, supra note 218, at 86-88. 278. brock, supra note 218, at e-10 to e-11. 279. tooley, supra note 218, at 86. ! combating genetic diseases. cloning can be used to fight genetic diseases by allowing “couples at high risk of having offspring with a genetic disease . . . [to] decide to originate a child by cloning in order to avoid the risks of transmitting the genetic disease.”274 ! bringing back the dead. cloning could be used to replace loved ones who had passed away – either to have “a baby who would share with the dead one some specific trait . . . [or] to accept the loss and move on with their lives.”275 ! creating a matching donor. cloning could be used to obtain a donor who is a perfect match for an existing child who is suffering from an illness that requires as part of its treatment either organ or bone marrow transplantation.276 ! duplicating extraordinary individuals. cloning could benefit society by re-creating individuals with “great talent, genius, character, or other exemplary qualities.”277 ! opening the way to further scientific advances. engaging in human cloning or in human cloning research could lead to “important potential advances in scientific or medical knowledge.”278 in particular, it has been argued that cloning could aid psychologists in resolving the nature versus nurture debate.279 this particular knowledge is said to be of not only theoretical, but also practical, interest, because it would “enable one to develop approaches to childrearing that will increase the likelihood that one can raise people with desirable 304 florida tax review [vol. 6:3 280. id. 281. id. at 88. 282. id. 283. id. at 88-89. 284. id. at 89-90. 285. pence, supra note 208, at 108-12. traits, people who will have a better chance of realizing their potentials, and of leading happy and satisfying lives.”280 ! creating happier and healthier people. cloning could “make it possible to increase the likelihood that the person that one is bringing into existence will enjoy a healthy and happy life.”281 a person who is cloned from someone who has lived a long life free of mental and physical disease will be assured of an increased chance at a happy and healthy life, at least to the extent that health and character are determined by genetics.282 ! making a more satisfying childrearing experience. to the extent that parents can obtain children with traits that they desire through cloning, their childrearing experience will be more satisfying for them.283 where the child is cloned from one of the parents, the childrearing experience could also be rendered more satisfying by attempting to rectify the mistakes that the parent deems to have been made during her own childhood and adolescence.284 ! enhancing the genetic connection between parent and child. to the extent that a genetic connection between parent and child is considered valuable, cloning would enhance this connection. during the period immediately after birth, women tend to be more connected with babies than men by dint of their having engaged in child-bearing and breast-feeding. men tend to bond with children equally with women only after these activities have been completed. by cloning the child from the father, however, both parents would have a strong connection with the child from the outset.285 ! facilitating child-rearing by gay and lesbian couples. cloning could also expand the options available to gay and lesbian couples that wish to have children. in the case of lesbian couples, cloning would also allow the child to have a genetic connection to both members of the couple (rather than 2003] the ethics of tax cloning 305 286. see id. at 114-15; murphy, supra note 270; tooley, supra note 218, at 9091. 287. jean e. chambers, may a woman clone herself?, 10 cambridge q. healthcare ethics 194, 194 (2001). 288. klotzko, supra note 212, at 123-24; see also tom l. beauchamp & james f. childress, principles of biomedical ethics 114 (5th ed. 2001) (“many types of ethical theory, including both utilitarian and nonutilitarian theories, recognize a principle of nonmaleficence.”); id. at 166 (“beneficence and benevolence have played central roles in some ethical theories. utilitarianism, for example, is systematically arranged on a principle of beneficence (the principle of utility) . . . .”); id. at 348 (“although we have characterized utilitarianism as primarily a consequence-based theory, it is also beneficence-based. that is, the theory sees morality primarily in terms of the goal of promoting welfare.”). beauchamp and childress describe consequentialism as follows: consequentialism is a label affixed to theories holding that actions are right or wrong according to the balance of their good and bad consequences. the right act in any circumstances is the one that produces the best overall result, as determined from an impersonal perspective that gives equal weight to the interest of each affected party. the most prominent consequence-based theory, utilitarianism, accepts one and only one basic principle of ethics: the principle of utility. this princip le asserts that we ought always to produce the maximal balance of positive value over disvalue (or the least possible disvalue, if only undesirable results can be achieved). id. at 340-41; see also edward j. eberle, three foundations of legal ethics: autonomy, community, and morality, 7 geo. j. legal ethics 89, 115 (1993); roy, supra note 220, just one, as would be the case with in vitro fertilization) by having one member donate the egg and the other donate the nucleus.286 ! empowering single women. by allowing women to reproduce without the need for the participation of a man, cloning could “empower women to make autonomous choices about whether, with whom, and how they want to reproduce.”287 3. the normative basis of the bioethics debate – having summarized the arguments both in opposition to and in favor of permitting human cloning, these arguments can now be examined with an eye toward ascertaining whether they share some common normative basis that may also serve as the basis for developing ethical guidelines for tax cloning. notwithstanding the “pronounced deontological flavor” of the debate over human cloning, an examination of these arguments reveals an underlying norm that is consistent with the generally consequentialist cast of american bioethics.288 whether implicitly or explicitly, 306 florida tax review [vol. 6:3 at 42. in contrast, beauchamp and childress describe the deontological (or kantian) view of morality as “a theory that some features of actions other than or in addition to consequences make actions right or wrong.” beauchamp & childress, supra, at 348-49; see also eberle, supra , at 115; roy, supra note 220, at 43. under this view, moral judgments should rest “on reasons that also apply to others who are similarly situated” (the “categorical imperative”). beauchamp & childress, supra, at 349, 350; see also eberle, supra, at 117-18. a formulation of the categorical imperative that is particularly relevant to the debate over human cloning is the notion that human beings should be treated as ends in themselves and not merely as a means to an end. see, e.g., john harris, cloning and human d ignity, 7 cambridge q. h ealthcare ethics 163 (1998); john harris, is cloning an attack on human dignity?, 387 nature 754 (1997); axel kahn, clone m ammals . . . clone man?, 386 nature 119 (1997); see also beauchamp & childress, supra, at 350-51 (generally describing this formulation of the categorical imperative); roy, supra note 220, at 43 (same). 289. see generally klugman & murray, supra note 194, at 32, 39 (indicating that harm has been a major concern throughout the debate over human cloning). 290. roger b. dworkin, emerging paradigms in bioethics: introduction, 69 ind. l.j. 945, 946 (1994); see also susan m. wolf, shifting paradigms in bioethics and health law: the rise of a new pragmatism, 20 am. j.l. & med. 395, 399 (1994) (indicating that principles of biomedical ethics has had a “pervasive influence” in modern bioethics). 291. beauchamp & childress, supra note 288. wolf states that, although beauchamp and childress did not originate these four princip les, their book did, however, “[give] them great currency.” wolf, supra note 290, at 400. 292. beauchamp & childress, supra note 288, at 12. beauchamp and childress indicate that, historically, nonmaleficence and beneficence have played a central role in medical ethics, “whereas respect for autonomy and justice were neglected in traditional medical ethics but came into prominence because of recent developments.” id .; see also nancy s. jecker, introduction to the m ethods of bioethics, in nancy s. jecker et al., bioethics: an introduction to the history, methods, and practice 113, 114 (1997). 293. beauchamp & childress, supra note 288, at 3, 12-13 (emphasis omitted). the common normative denominator of all of the arguments described above is the principle of nonmaleficence.289 nonmaleficence is one of the four basic moral principles identified by beauchamp and childress in their seminal290 work, principles of biomedical ethics.291 the other three principles identified by them are beneficence, respect for autonomy, and justice.292 beauchamp and childress derived all four of these principles from the common morality (i.e., those norms that “bind all persons in all places”), and identified them after examination of “considered moral judgments and the way moral beliefs cohere.”293 beauchamp and childress contend that, together, these four principles provide a framework for analyzing 2003] the ethics of tax cloning 307 294. beauchamp & childress, supra note 288, at 12. beauchamp and childress’ approach to reasoning about ethical problems has been labeled “principlism.” wolf, supra note 290, at 399. over time, beauchamp and childress have come to reject a purely deductivist approach to principlism in favor of a dialectical approach in which principles provide normative guidance and individual cases help to shape the boundaries of those principles. see john d. arras, principles and particularity: the roles of cases in bioethics, 69 ind. l.j. 983, 986-87 (1994); wolf, supra note 290 , at 396 . the paradigm of principlism has dominated the field of bioethics “[f]or the bulk of its short history.” wolf, supra note 290, at 399; see also arras, supra, at 986; sandra h. johnson, the changing nature of the bioethics movement, 53 md. l. rev. 1051, 1051, 1060 (1994); franklin g. miller et al., clinical pragmatism: john dewey and clinical ethics, 13 j. contemp. health l. & pol’y 27, 27 (1996). principlism’s historic dominance of the field has, however, been called into question. for example, wolf has argued that bioethics is undergoing a paradigm shift, as “a plethora of alternative methods has recently been put forth, a new empiricism has challenged the content of previously accepted principles, and burgeoning feminist and race-attentive work has rendered suspect any bioethical approach geared to the generic ‘patient.’” wolf, supra note 290, at 398. for a critique of principlism, see k. danner clouser & bernard gert, a critique of principlism, 15 j. med. & phil. 219 (1990). see also arras, supra, at 991-1006, and w olf, supra note 290, at 403-08, for a discussion of some of the shortcomings of principlism as well as a description of some of the alternative methods that have been developed. see beauchamp & childress, supra note 288, at 384-97, for a response to these critiques. wolf argues that, when this shift is viewed as “part of larger trends,” what appears to be occurring is a move toward pragmatism. wolf, supra note 290, at 398. for an attempt at articulating the paradigm of pragmatism, see miller et al., supra, and for a pragmatic view of the ethical debate over human cloning, see mcgee, supra note 194. 295. wolf, supra note 290, at 400; see also jecker, supra note 292, at 117-18. 296. beauchamp & childress, supra note 288, at 113. 297. id. at 166 (emphasis omitted). 298. id. at 115. some commentators do not recognize the principle of beneficence. they reject the idea of an “obligation” to act beneficently, and recognize beneficence only as a moral ideal. id. at 115, 388. other commentators combine nonmaleficence and beneficence into a single principle. id. at 114. beauchamp and childress reject both of these positions. id. at 114, 390. they recognize both the principle of nonmaleficence and the principle of beneficence, and they treat each of problems in biomedical ethics.294 as such, these four principles “have become the most familiar litany recited in bioethics.”295 beauchamp and childress define the principle of nonmaleficence as the “obligation not to inflict harm on others.”296 for purposes of this discussion, the principle of nonmaleficence can best be understood by juxtaposing it with the closely related principle of beneficence. beauchamp and childress define the principle of beneficence as the “obligation to act for the benefit of others,”297 and they further divide this principle into three distinct norms: (i) “one ought to prevent evil or harm,” (ii) “one ought to remove evil or harm,” and (iii) “one ought to do or promote good.”298 308 florida tax review [vol. 6:3 them separately on the ground that to combine them together would “obscure[] relevant distinctions.” id. at 114-15. 299. id. at 165; see also id. at 168. 300. see robert araujo, the virtuous lawyer: paradigm and possibility, 50 smu l. rev. 433, 449 (1997). 301. see b rock, supra note 218, at e-14 to e-15. see beauchamp & childress, supra note 288, at 116-17, for an elaboration of the distinction between “wronging” and “harming” another person. beauchamp and childress describe the relationship between nonmaleficence and beneficence as follows: “no sharp breaks exist on the continuum from not inflicting harm to providing benefit, but principles of beneficence potentially demand more than the principle of nonmaleficence because agents must take positive steps to help others, not merely refrain from harmful acts.”299 by juxtaposing these two principles, the differing impact that each has on the actions of individuals comes into focus – nonmaleficence imposes an obligation not to take action, while beneficence imposes an obligation to take action.300 accordingly, the principle of nonmaleficence can be considered as undergirding the arguments made in the debate over human cloning only if two separate conditions exist: first, the obligation at issue must be one not to take action, and second, the obligation not to take action must stem from the potential harm that would be caused if action were to be taken. with respect to the arguments made by opponents of human cloning, both of these conditions are satisfied. first, all of the opponents’ arguments are aimed at convincing others that either a temporary or permanent ban on human cloning should be put in place. a ban on cloning would impose an obligation to refrain from engaging in that activity – which is the essence of the first condition described above. second, the impetus for the arguments in favor of a ban on human cloning is the harm that cloning could potentially cause – which is the essence of the second condition described above. some opponents argue that permitting human cloning would infringe an individual’s right to a unique identity and/or her right to an open future. infringing these rights would not only constitute a wrong, but could also produce psychological harm to the person whose rights have been infringed.301 with regard to the effects that cloning may have on individuals and on society as a whole, opponents put forth a number of reasons why they believe that cloning will risk (i) physical harm to those involved in the cloning process, (ii) psychological harm to those involved in the cloning process, and (iii) harm to society as a whole. in each case, these arguments are explicitly framed in terms of the harm that cloning may cause. avoiding the infliction of harm is also the rationale for the religious objections to human cloning: from the perspective of christianity, the objections to human cloning are based on (i) the harm caused by human hubris in attempting to usurp the 2003] the ethics of tax cloning 309 role of god; (ii) the harm caused when human dignity is violated by compromising the uniqueness of individuals; (iii) the harm caused by violating the dignity of conjugal relations; and (iv) the harm to the clone caused by violating its human dignity and depriving it of the normal, nurturing relationship that results from procreation in the context of a marital union. from the perspective of judaism, the objections to human cloning are based on the harm caused by violating the prohibition of idolatry and by diminishing the ethic of responsibility. from the perspective of islam, human cloning raises issues about its possible negative impact on familial relations as well as some of the same issues about its potential harms (e.g., commodification and the proper distribution of resources) identified by secular opponents of cloning. from the perspective of buddhism and hinduism, even though cloning may be permissible, the development of the technology to perfect the cloning process could run afoul of restrictions on the infliction of harm on sentient beings. thus, the secular and religious arguments of opponents of human cloning satisfy both of the conditions described above. in each case, opponents are arguing that an obligation not to take action should be imposed, and the arguments for imposing that obligation stem from the harm that would be caused if action were to be taken. because they have satisfied both of the conditions described above, it can be concluded that these arguments are based on an application of the principle of nonmaleficence to the specific context of human cloning. with respect to the arguments made by proponents of human cloning, both of the conditions described above are also satisfied. first, the proponents of human cloning argue against interference with the development of the technique of cloning and with the implementation of that technique. an obligation to refrain from interfering with the development and use of cloning technology can be conceptualized as an obligation not to take action – which, once again, is the essence of the first condition described above. second, proponents of human cloning posit the existence of countervailing rights that would be implicated if human cloning were to be banned (either temporarily or permanently), and these rights serve as the moral basis for this obligation to refrain from interference. according to the proponents, the rights implicated by a ban on human cloning are the right to reproductive freedom and the right to the freedom of scientific inquiry and research in the pursuit of knowledge. the proponents argue that to ban human cloning would infringe these rights. the infringement of these rights would not only constitute a wrong, but could also produce psychological harm to the person whose rights have been infringed (and, in the case of the right to freedom of scientific inquiry, other types of harm could easily be imagined) – the potential for such harm is, once again, the essence of the second condition 310 florida tax review [vol. 6:3 302. see strong, supra note 224, at 280-82. 303. at first blush, one might think that the principle of beneficence undergirds the list of benefits compiled by the proponents of human cloning; however, it should be borne in mind that the proponents of human cloning would probably not argue that the existence of these benefits gives rise to an obligation to clone in order that they might be produced. just as the existence of an obligation not to take action was a prerequisite to finding that the principle of nonmaleficence undergirds these arguments, the existence of an obligation to take action is a prerequisite to finding that the principle of beneficence undergirds them. because no such obligation would be argued to exist here, the princip le of beneficence should not be considered as undergirding the arguments concerning the potential benefits of human cloning. described above.302 thus, with respect to the arguments concerning the rights implicated by a ban on human cloning, both of the conditions described above have been satisfied, and it can be concluded that these arguments are based on an application of the principle of nonmaleficence to the specific context of human cloning. the proponents of human cloning also attempt to undercut the opponents’ arguments by minimizing the existence and/or scope of the harms identified by them and by countering with a list of the potential benefits of human cloning. the list of potential benefits of human cloning serves the additional purpose of bolstering the proponents’ rights-based arguments discussed in the previous paragraph. as has already been established, the principle of nonmaleficence undergirds both the opponents’ arguments that are being undercut and the proponents’ arguments that are being bolstered. thus, the arguments minimizing the harms identified by the opponents of human cloning and the list of potential benefits assembled by the proponents of human cloning should be considered as derivatively satisfying the second condition described above, and should, therefore, also be considered to be based on an application of the principle of nonmaleficence to the specific context of human cloning.303 to summarize, all of the arguments made by both the opponents and proponents of human cloning constitute an application of the principle of nonmaleficence to the specific context of human cloning. in other words, the obligation to refrain from causing harm either explicitly or implicitly serves as the basis of all of these arguments. having established that the arguments in the debate over human cloning do, in fact, have a common normative basis, it must next be determined whether this norm also serves as part of the general framework for analyzing problems in legal ethics, such that it might be used as a guide in establishing ethical guidelines for tax cloning. 2003] the ethics of tax cloning 311 304. see, e.g., model rules of prof’l conduct, pmbl. at paras. 1-13 (2002); anthony t. kronman, legal professionalism, 27 fla. st. u. l. rev. 1, 1 (1999); robert b. mckay, law, lawyers, and the public interest, 55 u. cin. l. rev. 351, 353 (1986); carrie menkel-meadow, ethics and professionalism in non-adversarial lawyering, 27 fla. st. u. l. rev. 153, 154 (1999); richard a. posner, professionalisms, 40 ariz. l. rev. 1, 1 (1998); deborah l. rhode, the professionalism problem, 39 w m. & mary l. rev. 283, 313 (1998); ronald d. rotunda, professionalism, legal advertising, and free speech in the wake of florida bar v. went for it, inc., 49 ark. l. rev. 703, 703 (1997); harold l. wilensky, the professionalization of everyone?, 70 am. j. soc. 137, 141 (1964). 305. see stephen f. barker, what is a profession?, 1 prof. ethics 73, 74 (1992); becker, supra note 22, at 27. 306. herbert m. kritzer, the professions are dead, long live the professions: legal practice in a postprofessional world, 33 law & soc’y rev. 713, 716-17 (1999). for a brief discussion of the different uses and meanings of the term “profession,” see anthony c. infanti, eyes wide shut: surveying erosion in the professionalism of the tax bar, 22 va. tax rev. 589, 598-602 (2003). 307. see nancy j. moore, professionalism reconsidered, 1987 am. b. found. res. j. 773, 778 (1987); rothman, supra note 22, at 183. 308. becker, supra note 22, at 35. 309. some may be ill at ease with the use of the word “altruism” to describe this trait. “altruism” suggests that professionals (including lawyers) selflessly pursue the welfare and interests of others and “stand above ‘the sordid considerations’ of acquisition and economics, ‘devoting their lives to ‘service’ of their fellow men.’” moore, supra note 307, at 783 (quoting talcott parsons, the professions and social structure, in essays in sociological theory 34, 43 (rev. ed. 1954)). some commentators, including talcott parsons, have proposed using the term “disinterestedness” in place of b. legal ethics 1. the sources of legal ethical rules and their impact on the scope of the discussion – law is commonly understood to be a profession, and lawyers, therefore, are commonly referred to as professionals.304 although the term “profession” is susceptible of a number of different uses and meanings,305 when it is used to refer to the practice of law, the term is being used in its sociological sense.306 notwithstanding a lack of consensus concerning the traits that are essential to classification of an occupation as a profession in the sociological sense,307 several traits do seem to recur in discussions of the sociological definition of a profession. these discussions posit an occupation that: (i) requires the mastery of “some esoteric and difficult body of knowledge”308 (with mastery of such knowledge normally being acquired through lengthy specialized education and training); (ii) is marked by altruistic motivations (i.e., the individual professional’s commitment to clients and public service surpasses her self-interest in making money from engaging in the activity);309 and (iii) is self-regulating (meaning that it determines and controls 312 florida tax review [vol. 6:3 “altruism.” see id.; russell g. pearce, the professionalism paradigm shift: why discarding professional ideology will improve the conduct and reputation of the bar, 70 n.y.u. l. rev. 1229, 1239 n.43 (1995). 310. see beauchamp & childress, supra note 288, at 6; aba professionalism report, supra note 22, at 261-62 (definition formulated by eliot freidson); barker, supra note 305, at 86-87, 92-93; becker, supra note 22, at 35-37; kritzer, supra note 306, at 717-18; john kultgen, evaluating codes of professional ethics, in profits and professions: essays in business and professional ethics 225, 236 (wade l. robison et al. eds., 1983) [hereinafter profits and professions]; lisa h . newton, professionalization: the intractable plurality of values, in profits and professions, supra, at 23, 23-24; pearce, supra note 309, at 1237-40; posner, supra note 304, at 2; rotunda, supra note 304, at 706-13; wilensky, supra note 304, at 138, 140-41, 146; zacharias, supra note 22, at 1307-14. 311. beauchamp & childress, supra note 288, at 5. 312. id. at 6. 313. model code of prof’l responsibility (1980). 314. model rules of prof’l conduct (2002). 315. geoffrey c. hazard, jr. & w. william hodes, 1 the law of lawyering § 1.11 at 1-19 , § 1.15 at 1-26, app. b (3d ed. 2002). for a succinct history of the codification of legal ethical norms, see geoffrey c. hazard, jr., the future of legal ethics, 100 yale l.j. 1239, 1249-60 (1991). for a history of the enforcement of these entry into the profession and enforces a specialized code of ethics that applies to those admitted to the practice of the profession).310 as a profession in the sociological sense, the law contains “a professional morality with standards of conduct that are generally acknowledged by those in the profession who are serious about their moral responsibilities.”311 these moral responsibilities take the form of special obligations that are imposed on lawyers because of the role that they play, obligations that are intended “to ensure that persons who enter into relationships with [lawyers] will find them competent and trustworthy.”312 to clarify these professional obligations, the legal profession has codified them in the model code of professional responsibility (“model code”)313 and the model rules of professional conduct (“model rules”),314 which were promulgated by the american bar association and have served as the basis for nearly all of the various state codes of legal ethics.315 more recently, the 2003] the ethics of tax cloning 313 norms, see mary m. devlin, the development of lawyer disciplinary procedures in the united states, 7 geo. j. legal ethics 911 (1994). 316. geoffrey c. hazard, jr., foreword to 1 restatement of the law governing lawyers, at xxi, xxi-xxii (2000); 1 hazard & hodes, supra note 315, § 1.19 at 1-36. 317. see supra part i. 318. even if it were, determining which country’s code of professional conduct applies, as well as how it applies in the context of the cross-border practice of law, remains open to debate. see, e.g., ronald a. brand, uni-state lawyers and multinational practice: dealing with international, transnational, and foreign law, 34 vand. j. transnat’l l. 1135 (2001); robert e. lutz, ethics and international practice: a guide to the professional responsibilities of practitioners, 16 fordham int’l l.j. 53 (1992); detlev f. vagts, professional responsibility in transborder practice: conflict and resolution, 13 geo. j. legal ethics 677 (2000). 319. see supra note 23 for a summary of the concerns that militate in favor of a broad application of the legal ethics rules in this situation. american law institute has published a restatement of the law governing lawyers (“restatement”), which goes beyond the model code and model rules by addressing (i) areas of law that lie beyond their scope and (ii) areas of law that lie within their scope, but which, in practice, have been the subject of variations made either by courts in decisional law or by the states when enacting the model code or model rules into law.316 while the model code, model rules, and restatement are useful tools for plumbing the norms that underlie the generally-acknowledged standards of conduct that apply to lawyers, the reader should not be misled into believing that this discussion is intended to pertain only to the conduct of american attorneys. as indicated earlier,317 the purpose of this discussion is not to provide a list of the sections of the various state legal ethics codes that may apply to attorneys who are advising transition countries.318 that approach would unduly narrow the scope of the discussion. instead, the discussion is meant to be of broad application, including within its ambit all of the american neutral experts, whatever their respective professional calling or occupation, who render tax reform advice to transition countries.319 the attorney-client relationship and the ethical standards implicit in that relationship are employed here as no more than a benchmark for developing the ethical boundaries that circumscribe the activities of american neutral experts when advocating the cloning of western tax rules in transition countries. 2. the principle of nonmaleficence in legal ethics – many of the ethical rules that govern the conduct of lawyers embody the principle of nonmaleficence. in keeping with this principle, there are ethical rules that prohibit not only actions that may harm clients, but also actions that may harm the legal system, the opposing party, the legal profession, or third parties. the obligations not to harm each of these groups will be discussed separately below. 314 florida tax review [vol. 6:3 320. 1 restatement of the law governing lawyers § 16 cmt. e (“the responsibilities entailed in promoting the objectives of the client may be broadly classified as duties of loyalty . . . . in general, they prohibit the lawyer from harming the client.”). 321. see id.; l. ray patterson, the fundamentals of professionalism, 45 s.c. l. rev. 707, 711 (1994). 322. 1 restatement of the law g overning lawyers § 16 cmt. d (2000); see also model rules of prof’l conduct r. 1.1 (2002); model code of prof’l responsibility dr 6-101(a)(1)-(2) (1980). 323. 1 hazard & hodes, supra note 315, § 3.2 at 3-5. 324. 1 restatement of the law governing lawyers § 60(1) (2000); see also model rules of prof’l conduct r. 1.6 (2002); model code of prof’l responsibility dr 4-101 (1980). 325. 2 restatement of the law governing lawyers § 121 (2000); see also model rules of prof’l conduct r. 1.7-.9 (2002); model code of prof’l responsibility dr 5-101 to 5-107 (1980). 326. 2 restatement of the law governing lawyers 243-44 (2000). 327. model rules of prof’l conduct r. 3.7 (2002); see also model code of prof’l responsibility dr 5-101(b), -102 (1980); 2 restatement of the law governing lawyers § 108 (2000). a. preventing harm to clients – the principle of nonmaleficence can be detected in the specific duties that comprise the lawyer’s more general duty of loyalty to her client;320 these specific duties include competence, confidentiality, and avoiding conflicts of interest.321 the duty of competence effectively prohibits a lawyer from undertaking matters on behalf of a client unless she has “the appropriate knowledge, skills, time, and professional qualifications.”322 the primary purpose of this prohibition is to protect the public from harm and thereby maintain its confidence in the profession.323 the duty of confidentiality generally prohibits a lawyer from using or disclosing confidential client information “if there is a reasonable prospect that doing so will adversely affect a material interest of the client or if the client has instructed the lawyer not to use or disclose such information.”324 the duty to avoid conflicts of interest generally prohibits a lawyer from representing a client “if there is a substantial risk that the lawyer’s representation of the client would be materially and adversely affected by the lawyer’s own interests or by the lawyer’s duties to another current client, a former client, or a third person.”325 this prohibition requires lawyers “to avoid divided loyalties that would harm their principals, their clients.”326 the obligation not to take action that will harm a client can also be seen in other ethical rules. a lawyer is generally prohibited from representing a client at the trial of a matter in which the lawyer is expected to testify for the client.327 it has been said that [c]ombining the roles of advocate and witness creates several risks. the lawyer’s role as witness may hinder effective 2003] the ethics of tax cloning 315 328. 2 restatement of the law governing lawyers § 108 cmt. b (2000). some commentators find the rationale for this rule to be weak. see 2 hazard & hodes, supra note 315, § 33.4. 329. model rules of prof’l conduct r. 1 .5(d) (2002); model code of prof’l responsibility dr 5-101 to 5-107 (1980); 1 restatement of the law governing lawyers § 35(1) (2000). 330. 1 hazard & hodes, supra note 315, § 8.14 at 8-34 to -35. 331. 2 restatement of the law g overning lawyers § 94(2); see also model rules of prof’l conduct r. 1.2(d) (2002); model code of prof’l responsibility dr 7102(a)(7) (1980). advocacy on behalf of the client. the combined roles risk confusion on the part of the factfinder and the introduction of both impermissible advocacy from the witness stand and impermissible testimony from counsel table. concomitantly, an advocate may not interfere with an opposing counsel’s function as advocate by calling him or her to the witness stand, except for compelling reasons. when a lawyer will give testimony adverse to the lawyer’s client, a conflict of interest is presented that must either be avoided by withdrawal of the lawyer and the lawyer’s firm or, where permitted consented to by the client . . . .328 in addition, a lawyer is prohibited from entering into a contingent fee arrangement with a client in either a criminal or domestic relations matter.329 such arrangements have the potential to harm a client because (i) in a criminal case, a lawyer who will obtain a fee only if the client is totally exonerated “might improperly counsel against a proffered plea bargain or might ignore opportunities to argue for mitigation or conviction of a lesser offense,” and (ii) in a domestic relations case, a lawyer who will obtain a fee only upon securing a divorce for the client might “have a disincentive to urge the client to consider counseling or mediation or other interventions that might preserve the marriage.”330 b. preventing harm to nonclients – with respect to nonclients generally, a lawyer is prohibited from counseling or assisting “a client in conduct that the lawyer knows to be criminal or fraudulent or in violation of a court order with the intent of facilitating or encouraging the conduct.”331 such conduct may entail harm to one or more of the following: opposing parties, third parties, the legal system, and the public in general. other ethical rules are intended to prevent harm from being inflicted on a discrete subset of nonclients. several ethical rules impose an obligation on lawyers not to take action that may inflict harm on the legal system or opposing parties. first, a lawyer is prohibited from making “a statement that the lawyer knows to be false or with reckless disregard as to its truth or falsity concerning 316 florida tax review [vol. 6:3 332. model rules of prof’l conduct r. 8.2(a) (2002); see also model code of prof’l responsibility dr 8-102 (1980). 333. model rules of prof’l conduct r. 8.2 cmt. at para. 1 (2002). 334. id. at r. 3.1; see also model code of prof’l responsibility dr 7102(a)(1)-(2) (1980); 2 restatement of the law governing lawyers § 110 (2000). 335. 2 restatement of the law governing lawyers § 110 cmt. b (2000). 336. model rules of prof’l conduct r. 3.3(a)(1), (3) (2002); see also model code of prof’l responsibility dr 7-102(a)(4), (5) (1980); 2 restatement of the law governing lawyers §§ 111, 120 (2000). 337. 2 hazard & hodes, supra note 315, § 29.2 at 29-3. 338. model rules of prof’l conduct r. 3.5 (2002); model code of prof’l responsibility dr 7-106(c)(6), -108, -110 (1980); 2 restatement of the law governing lawyers §§ 113, 115 (2000). 339. 2 restatement of the law governing lawyers § 113 cmts. b, f (2000). 340. model rules of prof’l conduct r. 3.6(a) (2002); see also model code of prof’l responsibility dr 7-107 (1980); 2 restatement of the law governing lawyers § 109 (2000). 341. 2 hazard & hodes, supra note 315, § 32.2 at 32-4. the qualifications or integrity of a judge, adjudicatory officer or public legal officer, or of a candidate for election or appointment to judicial or legal office.”332 false statements made by a lawyer with respect to holders of, or candidates for, judicial or public office “unfairly undermine public confidence in the administration of justice.”333 second, a lawyer is prohibited from “bring[ing] or defend[ing] a proceeding, or assert[ing] or controvert[ing] an issue therein, unless there is a basis in law and fact for doing so that is not frivolous.”334 a lawyer who brings frivolous claims causes harm by “inflict[ing] distress, wast[ing] time, and caus[ing] increased expense to the tribunal and adversaries.”335 third, a lawyer is prohibited from making false statements to a tribunal and from offering false evidence to a tribunal.336 a lawyer who violates this duty of candor to the tribunal harms “the ability of courts to function as courts” by undermining “the integrity of the decisionmaking process.”337 fourth, a lawyer is prohibited from engaging in conduct that taints the impartiality of or that disrupts the tribunal.338 if a lawyer engages in such conduct, he may harm the opposing party by violating her right to a fair hearing, and he may also undermine judicial authority and public confidence in judicial rulings, both of which require “the reality and the perception of impartiality on the part of judicial officers.”339 finally, within certain bounds, a lawyer who is participating, or has participated, in the investigation or litigation of a matter is prohibited from making “an extrajudicial statement that the lawyer knows or reasonably should know will be disseminated by means of public communication and will have a substantial likelihood of materially prejudicing an adjudicative proceeding in the matter.”340 this rule protects the integrity of the system, which “requires that extraneous influences upon the course of litigation be eliminated or rigidly controlled.”341 2003] the ethics of tax cloning 317 342. model rules of prof’l conduct r. 3.4(a), (b), (d) (2002); see also model code of prof’l responsibility dr 7-102(a)(6), -109 (1980); 2 restatement of the law governing lawyers §§ 106, 110(3), 116(2)-(3), 117, 118 (2000). 343. 2 hazard & hodes, supra note 315, § 30.2 at 30-4; see also model rules of prof’l conduct r. 3.4 cmt. (2002). 344. model rules of prof’l conduct r. 8.1 (2002); see also model code of prof’l responsibility dr 1-101, -102(a)(5) (1980). 345. model rules of prof’l conduct r. 8.4 cmt. at para. 2 (2002); see also model code of prof’l responsibility dr 1-102(a), 9-101(c) (1980). 346. model rules of prof’l conduct r. 7.6 (2002). 347. id. at cmt. at para. 1. a lawyer is further prohibited from engaging in actions that unfairly tip the scales against the opposing party; for example, a lawyer is prohibited from unlawfully obstructing the other party’s access to evidence; from unlawfully altering, destroying, or concealing evidence; from falsifying evidence or counseling or assisting a witness to testify falsely; and from making frivolous discovery requests.342 such tactics may harm the opposing party by burdening her, may allow the client to achieve unjust results, and also may “undermine the integrity of the litigation process itself.”343 several ethical rules impose an obligation on lawyers not to inflict harm on the legal profession (i.e., on all other persons who engage in the practice of law). lawyers (including aspiring lawyers) are prohibited from making false statements of material fact in connection with their own or others’ bar admission applications or disciplinary matters, and are prohibited from knowingly failing to respond to lawful demands for information from bar admissions or disciplinary authorities.344 they are also prohibited from engaging in a whole host of conduct that may indicate lack of those characteristics relevant to law practice. offenses involving violence, dishonesty, breach of trust, or serious interference with the administration of justice are in that category. a pattern of repeated offenses, even ones of minor significance when considered separately, can indicate indifference to legal obligation.345 recently, a specific rule has been adopted that prohibits lawyers from making or soliciting political contributions to a judge or other public official for the purpose of obtaining “a government legal engagement or appointment by a judge.”346 when lawyers engage in such conduct, “the public may legitimately question whether the lawyers engaged to perform the work are selected on the basis of competence and merit. in such a circumstance, the integrity of the profession is undermined.”347 several rules circumscribe the conduct of lawyers with respect to third parties. a lawyer is prohibited from making false statements to third parties, from generally communicating directly with persons who are known to be 318 florida tax review [vol. 6:3 348. id. at r. 4.1-.4; see also model code of prof’l responsibility dr 7102(a)(1), -102(a)(5), -104, -106(c)(2), -108(d)-(e) (1980); 2 restatement of the law governing lawyers §§ 98-103 (2000). 349. 2 restatement of the law governing lawyers § 98 cmt. b (2000). 350. 2 id. at 69, § 99 cmt. b. 351. model rules of prof’l conduct r. 7.1-.5 (2002); see also model code of prof’l responsibility dr 2-101 to -105 (1980). 352. 2 hazard & hodes, supra note 315, at §§ 55.2, 57.3, 58.3. 353. that this is the case should not be surprising, as the principle of nonmaleficence is counted among a handful of basic moral duties. paul g. h askell , teaching moral analysis in law school, 66 notre dame l. rev. 1025 , 1030-35 (1991); see supra note 293 and accompanying text; see generally araujo, supra note 300, at 447; eberle, supra note 288, at 116. represented by counsel, from stating or implying that she is disinterested when communicating with persons who are not represented by counsel, and from using “means that have no substantial purpose other than to embarrass, delay, or burden a third person, or us[ing] methods of obtaining evidence that violate the legal rights of such a person.”348 the prohibition against false statements “meets social expectations of honesty and fair dealing and facilitates negotiation and adjudication, which are important professional functions of lawyers.”349 the limits on direct communications with third parties are designed to prevent the harm that may be caused by overreaching and deception by the lawyer as well as “intrusion into confidential information of the nonclient, and undermining the nonclient’s client-lawyer relationship” in the case of a third party who is known to be represented by counsel.350 in addition, in disseminating information to the public (in its capacity as a mass of prospective clients), lawyers are prohibited from (i) making false or misleading communications; (ii) generally paying others to recommend them; (iii) generally soliciting clients through in-person, live telephone, or realtime electronic contact; (iv) indicating that they are certified as specialists, unless they are certified by an approved organization or they practice admiralty or patent law; and (v) using the name of a lawyer who holds public office in the name of a law firm, or in communications on its behalf, “during any substantial period in which the lawyer is not actively and regularly practicing with the firm.”351 although lawyers have a right to communicate truthful information about their services to the public, these restrictions are designed to protect the public against false and misleading communications. in particular, direct solicitation is circumscribed because it “is fraught with special dangers: the client may be vulnerable to overreaching, the lawyer can more readily mix misleading speech with factual statements, and the contact is in private so that public scrutiny is more difficult.”352 as this discussion indicates, the principle of nonmaleficence pervades the ethical rules governing the professional conduct of lawyers.353 the 2003] the ethics of tax cloning 319 354. william ewald, comparative jurisprudence (ii): the logic of legal transplants, 43 am. j. comp. l. 489, 492-96 (1995); see, e.g., alfred l. brophy, “ingenium est fateria per quos; profeceris”: francis daniel pastorious’ young country clerk’s collection and anglo-american literature, 1682-1716, 3 u. chi. l. sch. roundtable 637, 641-42 (1996) (“legal historians constantly debate the role of social forces in shaping law. the most popular belief, exemplified by the works of such people as willard hurst and lawrence friedman, is that law is largely a creation of the surrounding social conditions.”); p. john kozyris, comparative law for the twentyfirst century: new horizons and new technologies, 69 t ul. l. rev. 165, 168-69 (1994) (“[y]ou cannot truly pursue the comparative method through the study of formal legal texts alone. it is necessary to get to know what is behind the texts and also, even more important, how they function. this requires understanding the legal culture that produced the laws, and more broadly, the social and economic structures and the ethical and political values that support them. laws cannot be grasped in an idealized form outside the context of the society that created them.”); john henry merryman, comparative law and scientific explanation, in law in the united states of america in social and technological revolution: reports from the united states of america on topics of major concern as established for the ix congress of the international academy of comparative law 81, 92 (john n . hazard & wenceslas j. w agner eds., 1974) (“if a given social system changes appreciably over time, one can expect some correlative change to take place in its legal system. most, if not all, social systems do obligation not to take action that may inflict harm appears to be at the core of many of the rules governing a lawyer’s conduct vis-à-vis her client, which should be expected given the fiduciary nature of that relationship. nonetheless, the rules also evince the importance attached to lawyers’ refraining from actions that would inflict harm on nonclients – even when refraining from action would not be in a client’s unalloyed best interest. v. providing content to the principle of nonmaleficence having established that the principle of nonmaleficence, which is the common normative denominator of the ethical debate over human cloning, also pervades the ethical norms governing the professional conduct of lawyers, we can now construct ethical guidelines for tax cloning using this principle as a foundation. to construct these guidelines, it will be necessary to build on the principle of nonmaleficence by suffusing it with specific content and meaning as it relates to tax cloning. the source of this content will be the rich comparative law literature concerning legal cloning. the viability of legal cloning has been hotly debated in the comparative law literature. the source of this debate is a divergence of views concerning the relationship between law and society. on the one hand, the mainstream view of comparatists (and legal historians) is that “[n]othing in law is autonomous; rather, law is a mirror of society, and every aspect of the law is molded by economy and society.”354 on the other hand, the validity of the mainstream 320 florida tax review [vol. 6:3 change appreciably over time. accordingly, it should not be surprising if the legal systems of nations a and b (or of a given nation at times x and y) are found to differ. on the contrary, it would be astonishing if they did not.”); christopher osakwe, recent development: an introduction to comparative law, 62 tul. l. rev. 1507, 1508 (1988) (“modern comparative law is aware of the relationship among law, history, and culture. accordingly, any serious exercise in the comparison of laws proceeds on the premise that each national law is a tapestry woven from a rich background of historical and cultural threads. comparative law operates on the assumption that every legal system is deeply rooted in the spirit of the people and is an outgrowth of the national character of the society in which it operates.”); see also alan watson, society and legal change 1-4 (1977) [hereinafter w atson, society & legal change]; ugo m attei, efficiency in legal transplants: an essay in comparative law and economics, 14 int’l rev. l. & econ. 3, 4 (1994); p.g. monateri, “everybody’s talking”: the future of comparative law, 21 hastings int’l & comp. l. rev. 825, 825-26, 839 (1998); catherine a. rogers, gulliver’s troubled travels, or the conundrum of comparative law, 67 geo. wash. l. rev. 149, 181 n.166 (1998). 355. watson, legal change, supra note 187, at 1151. 356. see otto kahn-freund, on uses and misuses of comparative law, 37 mod. l. rev. 1 (1974); alan w atson, legal transplants: an approach to comparative law (1974) [hereinafter watson, legal transplants i]; alan watson, legal transplants and law reform, 92 l.q. rev. 79 (1976) [hereinafter watson, law reform] (replying to kahn-freund’s article); see also eric stein, uses, misuses – and nonuses of comparative law, 72 nw. u. l. rev. 198, 198 (1977). 357. see ewald, supra note 354, at 492. view has been assailed by those who perceive legal rules as being “dysfunctional, that is, out of step with the needs and desires both of society at large and of its ruling elite.”355 this debate is exemplified by an exchange between otto kahn-freund and alan watson on the question of legal cloning (or what they refer to as the “transferring” or “transplanting” of legal rules from one society to another).356 their exchange (along with watson’s other work) will be used here to supply the principle of nonmaleficence with necessary content and meaning. first, for those unfamiliar with their work, kahn-freund’s and watson’s views concerning the viability of legal cloning will be separately recounted. then, it will be established that (i) despite their generally divergent views, kahn-freund and watson do share some common ground, and (ii) ethical guidelines for tax cloning can be constructed using the principle of nonmaleficence as a foundation and this common ground as the building blocks. a. kahn-freund’s perspective on legal cloning advancing a nuanced version of the mainstream “mirror” theory of the relationship between law and society,357 kahn-freund argues that there are 2003] the ethics of tax cloning 321 358. kahn-freund, supra note 356, at 6. 359. id. 360. id. 361. id. at 5-6. 362. id. at 5. 363. id. at 5-6. 364. see id. at 12; stein, supra note 356, at 199. 365. kahn-freund, supra note 356, at 6. 366. for example, climate, fertility of the soil, and geography. id. at 7. 367. for example, the wealth of the people, their population density, and trade. id. 368. for example, religion, customs, and manners. id. 369. for example, the degree of liberty that the constitution will tolerate. id. 370. id. at 8. “degrees of transferability,”358 and posits the existence of a continuum of transferability.359 at one end of the continuum, he places those legal rules that can be mechanically removed from one system and inserted into another.360 he likens this process to the removal of a carburetor from one automobile and its insertion into another – no one would wonder that the new car might “reject” the transplanted carburetor.361 at the other end of the continuum, kahn-freund places those legal rules that can only be removed from one system and inserted into another through a “complicated and sometimes hazardous surgical operation[]” that may require adjustments to, and entail a risk of rejection by, the recipient.362 he likens this process to the removal of a kidney from one human being and its transplantation into another.363 the location of a given legal rule on this continuum of transplantability depends on how closely it is tied to its home environment.364 kahn-freund derives the factors that determine how closely a legal rule is tied to its home environment from montesquieu, who is often cited for his “opinion that it was only in the most exceptional cases that the institutions of one country could serve those of another at all.”365 montesquieu enumerated environmental,366 social and economic,367 cultural,368 and political factors369 in support of his opinion. the central thesis of kahn-freund’s article is that, while montesquieu’s list of factors remains relevant, the environmental, social, economic, and cultural factors “have greatly lost, but . . . the political factors have equally greatly gained in importance.”370 kahn-freund summed up his central thesis as follows: [t]he degree to which any rule, say on accident liability or on the protection of the accused in criminal proceedings, or any institution, say a type of matrimonial property or of commercial corporation or of local government, can be transplanted, its distance from the organic and from the 322 florida tax review [vol. 6:3 371. id. at 12-13. 372. id. at 13. 373. id. at 14-15. 374. id. at 15-16. 375. id. at 17; see a lso j.w .f. allison, a continental distinction in the common law: a historical and comparative perspective on english public law 13 (1996) (referring to this passage in kahn-freund’s article and stating that “[w]hat we would consider public-law rules [kahn-freund] considers as the least transplantable”). 376. kahn-freund, supra note 356, at 17-19. mechanical end of the continuum still depends to some extent on the geographical and sociological factors mentioned by montesquieu, but especially in the developed and industrialised world to a very greatly diminished extent. the question is in many cases no longer how deeply it is embedded, how deep are its roots in the soil of its country, but who has planted the roots and who cultivates the garden. or in non-metaphorical language: how closely it is linked with the foreign power structure, whether that be expressed in the distribution of formal constitutional functions or in the influence of those social groups which in each democratic country play a decisive role in the law-making and the decision-making process and which are in fact part and parcel of its constitutional and administrative law.371 in support of his thesis, kahn-freund cited experience in family law, which is an area where one “would expect the risk of rejection and the difficulties of adjustment to be . . . at their maximum.”372 to support his view that the importance of environmental, social, economic, and cultural factors has decreased, kahn-freund pointed to a number of situations in which rules of divorce law and the property relations between spouses have been transplanted from one country to another.373 to support his view that the importance of political factors has increased, kahn-freund pointed to “the staggering contrast between the english and irish attitudes” toward divorce, which can only be explained “in terms of the political power of the catholic hierarchy” in ireland.374 in further support of this view, kahn-freund discussed failed attempts at the transplantation of public law rules (i.e., rules that organize “constitutional, legislative, administrative, or judicial institutions and procedures”375), including the attempt “made in the nineteenth century to export the english jury system to the continent,” which failed because it departed from the “accustomed distribution of power between bar and bench” and was therefore opposed by the legal profession.376 kahn-freund considered public law rules to be “the ones most resistant to transplantation” because they “are 2003] the ethics of tax cloning 323 377. id. at 17. 378. id. at 20-27. 379. id. at 26-27. kahn-freund was proved correct when the industrial relations act of 1971 was “repealed in 1974 after the labor party’s election victory.” stein, supra note 356, at 201. 380. kahn-freund, supra note 356, at 27. 381. id. 382. id. closest to the ‘organic’ end of our continuum.”377 kahn-freund also discussed the provisions of the british industrial relations act of 1971 concerning collective agreements and strikes, which were strongly influenced by u.s. law.378 he stated that “[i]t would indeed be an almost unbelievable ‘hazard,’ an unexpected coincidence if substantive rules wrenched out of their american constitutional, political and industrial context could successfully be made to fit the needs of a country with institutions and traditions so different from those of the united states.”379 kahn-freund closed his article by stressing that “we cannot take for granted that rules or institutions are transplantable.”380 any attempt at transplanting a legal rule from its home environment into a recipient environment entails the risk of rejection,381 with the level of risk being determined by where the rule is situated along the continuum described above: the closer the rule is to the mechanical end of the continuum, the lower its risk of rejection by the recipient; conversely, the closer the rule is to the organic end of the continuum, the higher its risk of rejection by the recipient. an individual rule’s placement along the continuum is determined by how closely tied the rule is to its home environment. despite these warnings about the risk that transplanted legal rules might be rejected by the recipient environment, kahn-freund hoped that the existence of this risk would not deter legislators in this or any other country from using the comparative method. all i have wanted to suggest is that its use requires a knowledge not only of the foreign law, but also of its social, and above all its political, context. the use of comparative law for practical purposes becomes an abuse only if it is informed by a legalistic spirit which ignores this context of the law.382 324 florida tax review [vol. 6:3 383. watson, legal transplants i, supra note 356; watson, law reform, supra note 356 , at 79 (indicating the relative timing of kahn-freund’s and w atson’s publications). 384. wise, supra note 182 , at 1 (footnote omitted). for a cataloguing of many of watson’s articles that are relevant to this subject, see ewald, supra note 354, at 489 n.1. since the time that ewald compiled this list, watson has continued to pub lish on the subject of legal transplants. see, e.g., watson, evolution, supra note 187; w atson, reception, supra note 187; alan watson, legal transplants and european private law, 4.4 electronic j. comp. l. (2000), at http://www.ejcl.org/44/art44-2.html (last visited sept. 12, 2003) [hereinafter watson, european private law]. for criticism of watson’s theory of legal change, see, e.g., allison, supra note 375, at 12-16; richard l. abel, law as lag: inertia as a social theory of law, 80 mich. l. rev. 785 (1982); bruce w . frier, why law changes, 86 colum. l. rev. 888 (1986); legrand, supra note 185; and pierre legrand, john henry merryman and comparative legal studies: a dialogue, 47 am. j. comp. l. 3, 49-50 (1999) (indicating m erryman’s concurrence in legrand’s criticism of watson). 385. watson, legal transplants ii, supra note 170, at 95; see also id. at 7, 118; watson, evolution, supra note 187, at 193 (“with a significance that is hard to grasp, borrowing has been the most important factor in the evolution of western law in most states at most times.”); watson, aspects of reception of law, supra note 384, a t 335 (“in most places at most times borrowing is the most fruitful source of legal change.”); watson, european private law, supra note 384 (“i believe i have indicated, though by example rather than by express statement, that borrowing is usually the major factor in legal change.”); watson, legal change, supra note 187, at 1125 (“borrowing from another system is the most common form of legal change.”). 386. watson, legal transplants ii, supra note 170, at 77. 387. see id . at 8 (quoting s.f.c. milsom for the proposition that “‘[s]ocieties largely invent their constitutions, their political and administrative systems, even in these days their economies; but their private law is nearly always taken from others.’”); id. at 111 (“in keeping with my interests, the stress in legal transplants is on western law, b. watson’s perspective on legal cloning a few months following the publication of kahn-freund’s article, alan watson published the first edition of his book, legal transplants: an approach to comparative law.383 since that time, watson “has produced a torrent of books and articles on the relationship between law and society and the factors that account for legal change; nearly all emphasize the importance of borrowing from others in the development of law.”384 indeed, watson has repeatedly stated his belief that “transplanting is . . . the most fertile source of [legal] development. most changes in most systems are the result of borrowing.”385 watson has, nevertheless, acknowledged the possibility that “a powerful legal system [can] be developed by native talent without the help of transplants.”386 despite the rather far-reaching nature of some of his statements, watson has generally confined his studies, and the theory of legal change that they have produced, to the development of private law in western countries.387 2003] the ethics of tax cloning 325 especially private law.”); watson, evolution, supra note 187, at xi (sam e); w atson, society & legal change, supra note 354, at 6, 126-27 (same); watson, legal change, supra note 187, passim (same); see also ewald, supra note 354, at 503 (w atson’s “theories are based principally on his investigations of roman law, and specifically of roman private law. he is therefore no t entitled to claim that law in other, non-western cultures obeys the insulation thesis: this may well be true, but it is a conclusion that requires further argument. nor, indeed, by the same token can he claim that european public law is insulated from political, economic, and social forces. that conclusion is most likely false, and when watson is being precise he is careful to state his conclusions as conclusions about private law only.” (footnotes omitted)); cf. watson, evolution, supra note 187, at 138-92 (intermittently discussing the public-law dimension of water rights because it served to illuminate his discussion of the private law of water rights). 388. watson, european private law, supra note 384; see also watson, evolution, supra note 187, at 265-66 (“i am concerned with the development of the legal rules themselves, not with how the legal rules operate in society.”); alan watson, comparative law and legal change, 37 cambridge l.j. 313, 315 (1978) [hereinafter, watson, comparative law] (“what is borrowed . . . is very often the idea.”); watson, law reform, supra note 356, at 79 (“what, in my opinion, the law reformer should be after in looking at foreign systems was an idea which could be transformed into part of the law of his country.”). 389. watson, legal transplants ii, supra note 170, at 97; see also id. at 20 (“when a legal rule is transplanted from germany to japan it will interest us whether it can be moved unaltered , or whether, and to what extent, it undergoes changes in its formulation.”); id. at 116 (“transplanting frequently, perhaps always, involves legal transformation.”). 390. watson, european private law, supra note 384; see also watson, evolution, supra note 187, at 14-18 (describing the difficulties attendant to the t urkish reception of the swiss civil code and swiss law of obligations) ; watson, legal transplants ii, supra note 170, at 20 (“it cannot be doubted either that a rule transplanted from one country to another, from germany to japan, may equally operate to different effect in the two societies, even though it is expressed in apparently similar terms in the two countries.”); id. at 27 (“a successful legal transplant – like that of a watson is careful to note that what he views as being borrowed “is rules – not just statutory rules – institutions, legal concepts, and structures . . . , not the ‘spirit’ of a legal system.”388 watson does not contemplate that these rules will be borrowed without alteration or modification; rather, he indicates that voluntary transplants would almost always – always in the case of a major transplant – involve[] a change in the law, which can be due to any number of factors, such as climate, economic conditions, religious outlook . . . or even chance largely unconnected either with particular factors operating within the society as a whole or with the general historical trend.389 neither does watson expect that a rule, once transplanted, will “operate in exactly the way it did in its other home.”390 326 florida tax review [vol. 6:3 human organ – will grow in its new body, and become part of that body just as the rule or institution would have continued to develop in its parent system.”); id. at 116 (“even when the transplanted rule remains unchanged, its impact in a new social setting may be different. the insertion of an alien rule into ano ther complex system may cause it to operate in a fresh way.” (footnote omitted)). 391. watson, legal transplants ii, supra note 170, at 113; see also w atson, evolution, supra note 187, at 159. 392. watson, legal transplants ii, supra note 170, at 113; see also watson, evolution, supra note 187, at 159. 393. watson, legal transplants ii, supra note 170, at 92; watson, reception, supra note 187, at 339-41. 394. watson, legal transplants ii, supra note 170, at 57-60, 88-94. 395 . id. at 17 (“what [the law reformer] is looking for in his investigation of foreign systems is an idea which can be transformed into part of the law of scotland and will there work well. a rule of swedish law which is successful at home might be a disaster in the different circumstances existing in scotland; a rule of french law which there works badly might provide an ideal rule for scotland.”); watson, law reform, supra note 356, at 79 (“successful borrowing could be achieved even when nothing was known of the political, social or economic context of the foreign law.”); id. at 82 (“now, should an attempt be made to introduce english-style divorce law into ireland , it would be enough on my view to look at the irish power structure to know that the attempt would fail. for that success or failure in ireland, the power structure in england and any knowledge or appreciation of it is quite irrelevant.”); see also watson, evolution, supra note 187 , at 132-34 (addressing the notion that “legal rules, when available in an accessible form, can readily be borrowed often without an inquiry into their effectiveness”). compare the discussion of kahn-freund’s views in the text accompanying notes 357-371. watson has identified a number of factors that affect which rules will be borrowed, including: (i) accessibility (i.e., is the rule in writing, in a form that is easily found and understood, and readily available),391 (ii) habit (i.e., “[o]nce a system becomes used as a quarry, it will . . . be borrowed from again, and the more it is borrowed from, the more the right thing to do is to borrow from that system, even when the rule that is taken is not necessarily appropriate”),392 (iii) chance (e.g., “a particular book may be present in a particular library at a particular time,” or lawyers from one country may train in, and become familiar with the law of, another country),393 and (iv) the need for authority and the prestige of the legal system from which rules are borrowed.394 in contrast to kahn-freund, watson believes that, in the context of law reform, systematic knowledge of the home environment is not necessary; all that is necessary is knowledge of the recipient environment.395 responding directly to kahn-freund’s arguments, watson draws attention to the fact that it can often be difficult to determine how closely a rule is tied to the home country’s political power structure – “[b]ut on the other hand, when a legal 2003] the ethics of tax cloning 327 396. watson, law reform, supra note 356, at 82. watson also disputes kahnfreund’s assertion “that environmental factors are now less important, political factors more important, in determining the difficulties for a legal transplant.” id. at 83. watson simply believes that montesquieu “overestimated the extent to which environmental factors hindered legal borrowing.” id. 397. id. at 79; see also w atson, legal transplants ii, supra note 170, at 9 (a knowledge of foreign legal systems can be valuable to the law reformer), 17 n.4 (“nothing here is meant to deny that a law reformer with a systematic knowledge of foreign law or of comparative law will operate more efficiently.”). 398. watson, legal transplants ii, supra note 170, at 16. 399. see supra notes 396, 397; see also watson, legal transplants ii, supra note 170, at 99 (“reception is possible and still easy when the receiving society is much less advanced materially and culturally, though changes leading to simplification, even barbarisation, will be great”); watson, law reform, supra note 356, at 81 (“of course, where a rule of roman law was inimical to the political, social, economic or social circumstances of a later state, its chances of being borrowed by that later state would be greatly diminished . . . . without hesitation one can accept the proposition that a foreign legal rule will not easily be borrowed successfully if it does not fit into the domestic political context. the word ‘political’ is used . . . with a rather wide meaning, with reference not only to the structure of government and governmental institutions but also to powerful organised groups . . . .”). 400. ewald, supra note 354, at 490 (“watson’s theory flies in the face of some of the most treasured preconceptions of modern legal thought.”). change is suggested for a particular country it is not so difficult to spot the factors which would favour, or militate against, the success of the reform.”396 watson does, however, admit that a law reformer who possesses a systematic knowledge of the home environment “would be more efficient.”397 in enumerating the benefits of comparative law (which he distinguishes from a knowledge of foreign law), watson asserts that [i]t can enable those actively concerned with law reform to understand their historical rôle and their task better. they should see more clearly whether and how far it is reasonable to borrow from other systems and from which systems, and whether it is possible to accept foreign solutions with modifications or without modifications.398 as the foregoing discussion illustrates, watson’s writings are peppered with statements that evince a need for sensitivity to extra-legal concerns in order to ensure the success of a legal transplant.399 the basis for watson’s heterodox views400 can be found in the following passage, which restates the paradox that caused him to take issue with the mainstream view of the transplantability of legal rules: a perennial question is “do legal rules reflect a society’s desires, needs and aspirations?” the answer which is 328 florida tax review [vol. 6:3 401. watson, comparative law, supra note 388, at 313 (footnotes omitted); see also watson, evolution, supra note 187, at 113; watson, legal transplants ii, supra note 170, at 21. 402. w atson, evolution, supra note 187, at x. 403. watson, comparative law, supra note 388, at 313-14; watson, legal change, supra note 187, at 1125; watson, law reform, supra note 356, at 80; see also watson, evolution, supra note 187, at 218-30 (discussing other instances of “massive” transplantation, including the borrowing of the medieval libri feudorum, which concerns feudal law, and the french code civil). 404. watson, legal transplants ii, supra note 170, at 95. 405. id. 406. id.; see, e.g., watson, evolution, supra note 187, at 113-37. 407. watson, legal transplants ii, supra note 170, at 95. 408. id. at 96. see mattei, supra note 354, for an exposition of the manner in which law and economics “can add to the theory of legal transplants by discussing the role of efficiency in their occurrence.” ugo mattei, comparative law and economics 98 (1997). 409. watson, law reform, supra note 356, at 81 n.12; see also watson, society & legal change, supra note 354, at 43. ordinarily given or is just assumed is positive though minor qualifications are usually urged. and yet, the two most startling, and at the same time most obvious characteristics of legal rules are the apparent ease with which they can be transplanted from one system or society to another, and their capacity for long life. with transmission or the passing of time modifications may well occur, but frequently the alterations in the rules have only limited significance.401 as this passage implies, watson’s theory of legal change is based on his historical observations,402 primarily of the reception of roman law in civil law countries and the spread of english common law throughout its former colonies.403 these observations led watson to make a number of general reflections at the conclusion of his book, legal transplants, including the following four: (i) “the transplanting of individual rules or of a large part of a legal system is extremely common”;404 (ii) “transplanting is, in fact, the most fertile source of development”;405 (iii) “to a truly astounding degree law is rooted in the past”;406 and (iv) “the transplanting of legal rules is socially easy.”407 on the basis of these four reflections, watson concluded that “usually legal rules are not peculiarly devised for the particular society in which they now operate and also that this is not a matter for great concern.”408 watson later wrote that this disconnect between the rules of private law and a particular society “was the main point [he] was trying to make in transplants.”409 this point was further developed in society and legal change, where watson explored the frequently-observed disconnect between a society 2003] the ethics of tax cloning 329 410. watson, society & legal change, supra note 354, at 5; see also id. at 34, 58, 72; w atson, legal change, supra note 187, at 1134-46; alan watson, society’s choice and legal change, 9 hofstra l. rev. 1473, 1474-76 (1981) [hereinafter watson, society’s choice]. 411. watson, comparative law, supra note 388, at 321; see also watson, society & legal change, supra note 354, at 4-5, 125; watson, society’s choice, supra note 410, at 1473. 412. watson, comparative law, supra note 388, at 321-22. and its legal rules – a disconnect that persists despite the ruling elite’s awareness of it and despite the ruling elite’s ability to close the gap between its needs (or the needs of the society as a whole) and the legal rules in force: it is the thesis to be maintained in this book that, though there is a historical reason for every legal development, yet to a considerable extent law in most places at most times does not progress in a rational or responsible way, and that the divergence between law and the needs or wishes of the people involved or the will of the leaders of the people is marked. there is a divergence in the sense in which i am using the term when the legal rule, principle or institution is inefficient for its purpose in satisfying the needs of the people or the will of its leaders and when a better rule could be devised, and where both the inefficiency and the possibility of marked improvement are known to the persons concerned.410 in an article published a few years after legal transplants and shortly after society and legal change, watson stated that, notwithstanding the fact “that a considerable disharmony tends to exist between the ‘best’ rule that the society envisages for itself and the rule that it has,” there must be “some degree of correlation . . . between law and society.”411 in that article, watson delineated the factors that he considers relevant to legal change and that “control the relationship between legal rules and the society in which they operate.”412 these factors include: ! the nature of the predominant source(s) of law; ! pressure force, which consists of the organized groups that believe that they would benefit from a change in the law; ! opposition force, which is the converse of pressure force and consists of the organized groups that believe that harm will result from a change in the law; 330 florida tax review [vol. 6:3 413. note that, at the time of this article, watson did not consider law-shaping lawyers to constitute a truly separate factor because their role in legal change was covered by the source of law and transplant bias factors. id. at 328. nevertheless, watson discussed law-shaping lawyers separately and included them parenthetically in the equation in the text below because they “give law such a particular flavour that their role deserves to be stressed.” id. law-shaping lawyers later came to play a much more central role in watson’s views of legal change. see infra text accompanying notes 416428. 414. watson, comparative law, supra note 388, at 322-32. 415. id. at 333. ! transplant bias, which is watson’s theory that legal change primarily occurs through borrowing, with rules often being borrowed again and again from the same foreign legal system; ! law-shaping lawyers, who are the legal elite that shapes the law and whose knowledge, imagination, training, and experience strongly influence the end product of any change in the law;413 ! discretion factor, which is the implicit or explicit discretion that exists either to enforce (or not to enforce) the law or press (or not to press) one’s legal rights; ! generality factor, which is the extent to which legal rules regulate more than one recognizable group of people or more than one transaction or situation, thereby making it difficult to find a rule that precisely fits the situation of each group, transaction, or situation being regulated; ! inertia, which is “the general absence of a sustained interest on the part of society and its ruling élite to struggle for the most ‘satisfactory’ rule”; and ! felt needs, which are the purposes that the legal rule will fulfill, which are known to, and thought appropriate by, the pressure force.414 watson posited that the relationship between a society and its legal rules could be roughly expressed as a mathematical equation: legal change will occur only when (i) the force of felt needs, weakened by the discretion factor, activate the pressure force, as affected by the generality factor, to work on a source of law – all as modified by the transplant bias (and law-shaping lawyers) – is greater than (ii) the force of inertia plus the opposition force.415 2003] the ethics of tax cloning 331 416. the four books are: alan w atson, legal transplants: an approach to comparative law (1974); alan watson, society and legal change (1977); alan watson, the m aking of the civil law (1981); and alan watson, sources of law, legal change, and ambiguity (1984). 417. watson, legal change, supra note 187, at 1154; see also rodolfo sacco, legal formants: a dynamic approach to comparative law (pt. 1), 39 am. j. comp. l. 1 (1991); rodolfo sacco, legal formants: a dynamic approach to comparative law (pt. 2), 39 am. j. comp. l. 343 (1991); alan watson, from legal transplants to legal formants, 43 am. j. comp. l. 469 (1995). for an application of law and economics to sacco’s theory of legal formants, see mattei, supra note 408, at 101-21. 418. see supra note 413. 419. see supra text accompanying note 415. 420. see w atson, evolution, supra note 187, at 264 (“legal change comes about through the culture of the legal elite, the lawmakers, and it is above all determined by that culture.”). for a re-examination of the factors affecting legal change “from the angle of their involvement with the legal tradition,” see watson, society’s choice, supra note 410, at 1477-81. 421. watson, evolution, supra note 187, at 264; see also id. at 136, 262-63. 422. id. at 263. 423. id. 424. id. in a later article that reflects on, and attempts to synthesize the points made in, four of his books,416 watson revisited his enumeration of the factors that affect legal change and indicated that “what has emerged from these four books is [his] appreciation of the enormous power of the legal culture in determining the timing, the extent, and the nature of legal change.”417 thus, over time, watson’s formulation of the factors that affect legal change has itself evolved. originally, “law-shaping lawyers” did not merit enumeration as a separate factor418 and appeared only parenthetically in the mathematical equation that he formulated;419 at present, however, watson places primary emphasis on the role of legal culture in shaping legal change.420 watson now argues that, while society as a whole may have some input on the content of its laws, the actual laws that are produced are shaped by the legal tradition: “law is largely autonomous and not shaped by societal needs; though legal institutions will not exist without corresponding social institutions, law evolves from the legal tradition.”421 lawyers tend to seek authority for the positions that they take, which results in the “enormous extent [to which] law develops by borrowing from another place and even from another time.”422 while lawyers may sometimes search for the “best” rule, watson contends that lawyers more typically choose one legal system as “the prime quarry” and borrow rules from that system without fully investigating their appropriateness.423 normally, lawyers will be satisfied with a foreign rule from the prime quarry if it “is not obviously and seriously inappropriate.”424 332 florida tax review [vol. 6:3 425. id. at 263-64. 426. id. at 264. 427. id. at 263. 428. watson, legal change, supra note 187, at 1157. 429. ewald, supra note 354, at 491-92, 503-04 (differentiating between “strong” watson and “weak” watson, or, more precisely, “categorical” watson and “nuanced” watson). evidence of watson’s irreverence is found in a number of the points that have been made in the course of this discussion. in particular, see notes 401, 408, 410, 421, 424, 427, 428 and accompanying text. i would like to take this opportunity to acknowledge a debt of gratitude to my colleague, vivian curran, for the adjective “irreverent” in the text above. 430. watson, legal change, supra note 187, at 1136. 431. watson, legal transplants ii, supra note 170, at 108. 432. ewald, supra note 354, at 503. social, economic, and political factors affect the shape of the law that is produced only to the extent that they are present in the consciousness of lawmakers (i.e., the subgroup of lawyers who control the “mechanisms of legal change”).425 the lawmakers’ consciousness of these factors may be heightened by pressure from other parts of society, but, even then, watson asserts that “the lawmakers’ response [will be] conditioned by the legal tradition: by their learning, expertise, and knowledge of law, domestic and foreign.”426 for example, societal pressure may bring about a change in the law, but “the resulting law will usually be borrowed, from a system known to the legal elite, often with modifications, to be sure, but not always those deemed appropriate after full consideration of local conditions. the input of the society often bears little relation to the output of the legal elite.”427 watson has hypothesized that the similarity between the legal rules of very different societies can be explained by the general similarity of legal culture from one western country to another.428 despite some rather categorical statements about the lack of a relationship between law and society (as well as a generally irreverent attitude toward the relationship between law and society),429 watson has not contended that law and society completely lack any connection.430 rather, watson has argued that there is no “simple correlation” between law and society.431 william ewald has summarized watson’s argument against the strong versions of the mirror theory of the relationship between law and society as follows: “history shows that, because of the nature of the legal profession, legal change in european private law has taken place largely by transplantation of legal rules; therefore, law is, at least sometimes, insulated from social and economic change.”432 ewald describes this interpretation of watson’s argument as open[ing] the door to a view of law that is subtler and more nuanced than any of the theories that have hitherto prevailed. watson has shown that law does not reduce to economics (or 2003] the ethics of tax cloning 333 433. id. at 509. 434. in at least one instance, the rejec tion of tax reform advice proffered by western experts to a developing country has been attributed to the failure of those experts to take the legal, political, social, and economic context of that country into account. vicki l. beyer, the legacy of the shoup mission: taxation inequities and tax reform in japan, 10 ucla pac. basin l.j. 388, 396-99 (1992); m. bronfenbrenner & kiichiro kogiku, the aftermath of the shoup tax reforms: part i, 10 nat’l tax j. 236 (1957); m. bronfenbrenner & kiichiro kogiku, the aftermath of the shoup tax reforms: part ii, 10 nat’l tax j. 345 (1957); barry m . freiman, the japanese consumption tax: value-added model or administrative nightmare?, 40 am. u. l. rev. 1265, 1275-77 (1991); see supra note 25. politics or philosophy or society); but, as we saw, he need not claim that law is entirely unrelated to these subjects, and this means that he need not abandon altogether the insights of the great legal thinkers of the past. something can be salvaged from the work of marx and savigny, of montesquieu and jhering. but the point is that their ideas must now be coupled with a cautious awareness of the complexity of the relationship between law and society, and must be grounded in a deep investigation of the history of law.433 c. common ground although kahn-freund and watson differ on many points, they do share some common ground that proves particularly relevant to the instant inquiry. at a basic level, kahn-freund and watson differ on the ease with which legal rules can be cloned and implanted in a new legal environment. they also differ on the need for knowledge of the home legal environment of a rule that is to be cloned and implanted – while kahn-freund believes that knowledge of the social and political context of a rule is necessary to determine its transplantability, watson generally believes that such knowledge, although helpful, is unnecessary. they both, however, agree that knowledge of the recipient legal environment is indispensable to the successful cloning and implantation of a legal rule. knowledge of the recipient legal environment is necessary because the cloned rule must be examined to determine whether any adjustments or alterations must be made in order to tailor the rule to the recipient environment and thereby minimize the risk of its rejection by that environment. thus, both kahn-freund and watson would seem to agree that american neutral experts should advocate legal cloning as a part of the tax reform process in a transition country only if they have a thorough knowledge of its legal, political, social, and economic context and have tailored the rule to that context.434 334 florida tax review [vol. 6:3 435 . see supra note 154 and accompanying text. 436. see, e .g., michael beaupré, la traduction juridique: introduction, 28 les cahiers de droit 735 (1987); g. leroy certoma, problems of juridical translations in legal science, in org. comm. of the 12th int’l cong. of comparative law, int’l acad. of comparative law, law and australian legal thinking in the 1980s: a collection of the australian contributions to the 12th international congress of comparative law 67 (1986); vivian grosswald curran, cultural immersion, difference and categories in u.s. comparative law, 46 am. j. comp. l. 43, 54-59 (1998) [hereinafter curran, cultural immersion]; vivian curran, on the shoulders of schlesinger: the trento common core of european private law project, 2 global jurist frontiers (2002), at http://www.bepress.com/gj/frontiers/vol2/iss2/art2/ (last visited sept. 12, 2003) ; g.-r. de groot, la traduction juridique: the point of view of a comparative lawyer, 28 les cahiers de droit 793 (1987); jan engberg, legal meaning assumptions – what are the consequences for legal interpretation and legal translation?, 15 int’l j. semiotics l. 375 (2002); sofie m .f. geeroms, comparative law and legal t ranslation: why the terms cassation, revision and appeal should not be translated . . . , 50 am j. comp. l. 201 (2002); rodolfo sacco, la traduction juridique: un point de vue italien, 28 les cahiers de droit 845 (1987). 437. de groot, supra note 436, at 797; see also certoma, supra note 436, at 69; curran, cultural immersion, supra note 436, at 54-59; engberg, supra note 436, at 376, 385-88; sacco, supra note 436, at 849. 438. de groot, supra note 436, at 798-800; see also certoma, supra note 436, at 69-70. 439. beaupré, supra note 436, at 740-43; certoma, supra note 436, at 70-72; see also bernhard grossfeld & edward j. eberle, patterns of order in comparative law: discovering and decoding invisible powers, 38 tex. int’l l.j. 291, 310-11 (2003). a necessary adjunct to knowledge of the recipient environment is knowledge of its language(s).435 although not specifically discussed above, the importance of language proficiency is underscored by the comparative law literature on legal translation.436 it has been said that effective legal translation requires more than just linguistic skills – it also requires training in comparative law: “the translator must possess the skill to compare the legal content of terms in one language (one legal system) with the legal content of terms in another legal language (the other legal system).”437 this is especially true when the legal systems and languages involved are not closely related,438 which is the case here. a translator who lacks sufficient familiarity with both legal systems may not choose appropriate equivalent terms for the ideas being communicated, but will, nevertheless, wield a great deal of discretion in how the translation is performed.439 as a result, an american neutral expert who is unfamiliar with the local language(s) and relies on translation both to become familiar with the recipient environment and to draft legislation (or otherwise communicate legal ideas) places herself at the mercy of the translator, risking misunderstanding and miscommunication. 2003] the ethics of tax cloning 335 440. restatement (third) of foreign relations law of the united states § 483 reporter’s note 2 (1987); hans w. baade, the o peration of foreign public law, 30 tex. int’l l.j. 429, 447 (1995); william s. dodge, breaking the public law taboo, 43 harv. int’l l.j. 161, 161 (2002); philip j. mcconnaughay, reviving the “public law taboo” in international conflict of laws, 35 stan. j. int’l l. 255, 303 n.227 (1999). 441 . see supra note 387 and accompanying text. 442. mirjan damaška, the uncertain fate of evidentiary transplants: angloamerican and continental experiments, 45 am. j. comp. l. 839, 839 (1997); see john h. beckstrom, transplantation of legal systems: an early report on the reception of western laws in ethiopia, 21 am. j. comp. l. 557, 582 (1973) (“the limited empirical evidence available suggests only that it [i.e., the transplanted legal system] is not yet working. that evidence shows a country hardly aware of the new codes and a judiciary still struggling to comprehend them in basic particulars – even in the major urban areas.”); m.r. belgesay, social, economic and technical difficulties experienced as a result of the reception of foreign law, 9 int’l soc. sci. bull. 49 (1957) (highlighting instances where cloned rules implanted in the turkish legal system did not work because they were at variance with turkish cultural norms); elisabetta grande, italian criminal justice: borrowing and resistance, 48 am. j. comp. l. 227, 232 (2000) (describing the recent italian importation of the american adversary model of criminal procedure and indicating that the result was “that the transplant ended up being little more than an acoustic imitation, in which the mixture of the new ‘adversarial’ elements with the old non-adversarial ones produced effects diametrically opposed to those expected: the defendant in the italian legal system is today less protected against abuses of power than he was prior to the introduction of common law adversarial elements” (footnote omitted)); i.e. postacioglu, the technique of reception of a foreign code of law, 9 int’l soc. sci. bull. 54, 55-56 (1957) (making observations similar to those of belgesay, and noting that (i) it took twenty-five years before the imported rules began to be interpreted in the same manner that they were interpreted in their home environment and (ii) “[i]t must indeed be admitted that with the completion of the reception everything did not go smoothly all at once. against its undoubted advantages, reception unquestionably had its drawbacks, some of them resulting from the extraordinary rapidity of the whole operation, others more difficult to obviate, still require most delicate handling if the remedy is not to be worse than the disease.”); see supra note 381 and accompanying text. less obviously, the writings of kahn-freund and watson should give american neutral experts reason to be chary of advocating tax cloning when advising transition countries – even when they do possess both a thorough knowledge of the recipient environment and the requisite language skills. tax rules are rules of public (as opposed to private) law.440 on kahn-freund’s continuum of transferability, public law rules are considered to be closest to the organic end of the spectrum, and, therefore, to be the most resistant to transplantation. moreover, watson has expressly limited his views concerning the ease of transferability to rules of private law.441 the risks generally entailed in legal cloning include outright rejection of the cloned rule as well as unintended consequences that “can turn out to be a pleasant surprise . . . [or] very disappointing.”442 when tax rules are being cloned, these risks are magnified. if an incipient tax system is peppered with rules that are rejected in practice or do not function as anticipated, the stability 336 florida tax review [vol. 6:3 443. an established tax system, like that of the united states, should more easily be able to withstand the rejection of cloned rules as well as the consequences of cloned rules that do not function as anticipated. n evertheless, care should be taken in choosing the rules to be cloned and in tailoring those rules to the recipient environment. see generally anthony c. infanti, spontaneous tax coordination: on adopting a comparative approach to reforming the u .s. international tax regime, 35 vand. j. transnat’l l. 1105, 1142, 1226-31 (2002). 444. gordon & thuronyi, supra note 24, at 3. 445. see supra part i. 446. as discussed above, see supra part iv.b .2.a, this general duty of loyalty represents an application of the principle of nonmaleficence to the attorney-client relationship; the purpose of imposing this duty is to prevent the attorney from harming her client. and integrity of that system may be undermined.443 frequent amendments to the tax laws to correct these problems may “upset the expectations of investors and make it difficult for taxpayers to understand and comply with the laws,”444 which, in turn, may negatively impact government revenues. given the indeterminate nature of the transferability of public law rules, american neutral experts should not rule out the use of tax cloning when advising transition countries, but should take the risks attendant to tax cloning into account and proceed with the requisite level of caution. d. ethical guidelines for tax cloning using the principle of nonmaleficence as a foundation and this common ground as the building blocks, we can now begin to construct ethical guidelines for tax cloning. the principle of nonmaleficence imposes an obligation to refrain from harmful action. in the context of providing advice to transition countries, the harm that may be caused by tax cloning is relatively serious – if cloned rules are rejected or unexpectedly operate in a detrimental manner, the stability and integrity of an incipient tax system may be undermined and, as a result, the transition country’s ability to collect revenue and fund its activities may be threatened. it is with this potential harm in mind that the ethical boundaries that circumscribe the activities of american neutral experts should be drawn. to set these ethical boundaries, we will turn once again to our chosen benchmark for guidance.445 given that the relationship between american neutral experts and transition countries is analogous to the relationship between attorneys and clients, we may be able to minimize the potential harm that tax cloning can cause to transition countries by imposing on american neutral experts something akin to the lawyer’s general duty of loyalty.446 as part of this duty of loyalty, an american neutral expert would owe both a duty of competence and a duty to avoid conflicts of interest to any transition country 2003] the ethics of tax cloning 337 447. see supra part iii. 448 . see supra note 47 and accompanying text. that she advises. the content and meaning of these duties would be supplied by the common ground shared by kahn-freund and watson on the question of legal cloning. accordingly, the duty of competence would require an american neutral expert to refrain from advocating tax cloning unless she not only possessed the requisite technical tax expertise, but also (i) possessed a thorough knowledge of the legal, political, social, and economic context of the transition country, (ii) was proficient in the language(s) of that country, and (iii) had tailored the cloned tax rules to the specific context of that country. the duty to avoid conflicts of interest would work in tandem with the duty of competence by requiring that the cloned tax rules not only be tailored to, but also for the benefit of, the transition country. even armed with the requisite technical expertise and language and cultural skills, the general duty of loyalty would nonetheless require an american neutral expert to proceed with caution when advocating tax cloning, because the public law nature of tax rules may render their successful cloning and implantation both difficult and risky. it is worth recalling at this juncture that the simple change in terminology from legal “transplants” to legal “cloning,” which was advocated earlier in this article,447 should go far in helping to remind neutral experts of the need to pause and reflect before advocating tax cloning, because the debate over human cloning has given that term a decidedly negative connotation. vi. conclusion with these ethical guidelines in mind, american neutral experts should revisit the advice that they render to transition countries. they should reflect on whether they have complied with the duty of competence and the duty to avoid conflicts of interest when they have rendered advice to transition countries in the past. they should also take this opportunity to consider how they can go about complying with these duties when (if?) they render advice to transition countries in the future. the need for such reflection is underscored by the fact that each of the neutral experts described in part ii of this article has, in some respect, fallen short in complying with the general duty of loyalty. although the u.s. treasury department does demonstrate some sensitivity to the need for its tax experts to have language and cultural skills, it does not require such skills as a prerequisite for, or as a condition of, hiring.448 these skills are not required of office of technical assistance resident advisors even though they are expected to remain in a host country for no less than one year – and optimally should remain there from two to four years. ota appears to focus more heavily on technical tax expertise when hiring and to hope that 338 florida tax review [vol. 6:3 449 . see supra note 54 and accompanying text. 450. about itic, supra note 54. 451 . see supra notes 85-90 and accompanying text. 452 . see supra notes 115-124 and accompanying text. 453. vann, supra note 105, at 274. it can compensate for a lack of language and cultural skills by hiring local assistants who can serve as translators and provide advice on navigating the culture and customs of the host country. while the hiring of local assistants may, to some extent, mitigate the failure to require resident advisors to possess relevant language and cultural skills, the discussion above of the comparative law literature on legal translation indicates that this approach entails a serious risk of miscommunication and misunderstanding, because legal translation requires legal as well as linguistic skills. ota does offer resident advisors support for optional local language training; however, it would seem that the duty of competence would militate in favor of (i) making such training mandatory and (ii) requiring resident advisors to undergo such training prior to placement in the host country. the international tax and investment center describes its agenda as spreading “best international practices”449 (a euphemism for western-style tax rules). this agenda bespeaks a lack of restraint in advocating tax cloning as well as a failure to take into account the legal, political, social, and economic context of the transition countries that itic advises. more troubling, however, is the fact that itic’s description of its own activities raises the specter of a conflict of interest in providing advice to transition countries. despite styling itself as “an independent nonprofit research and education foundation” that is “a neutral forum for discussion and resolution of legislative, regulatory, and administrative problems in tax and investment policy,”450 itic seems to be overly solicitous of the needs and desires of its corporate sponsors. on its website, itic describes how its sponsors benefit from the advocacy of itic staff, how itic’s efforts help to improve its sponsors’ bottom lines, and how itic provides its sponsors with advance information on tax developments in the transition countries where it operates.451 this description of the myriad of ways in which itic can benefit its sponsors raises the question whether spreading best international practices in fact helps transition countries, or whether it actually helps itic sponsors by providing them with a familiar (and favorable) tax framework within which to conduct business. the basic world tax code and commentary suffers from the same lack of restraint in advocating tax cloning and failure to take into account the legal, political, social, and economic context of the transition countries that it aims to help.452 the bwtc has been criticized as too american in its flavor and content, and has even been called a “clone of the u.s. internal revenue code.”453 the bwtc also generally fails to present alternative provisions that 2003] the ethics of tax cloning 339 454. gordon & thuronyi, supra note 24, at 11-13. see supra text accompanying notes 153-163 for a more detailed account of this advice. 455. the martindale-hubbell lawyer locator is an online search engine that can be found at http://www.martindale.com. this search was performed on november 8, 2002, and , therefore, reflects only lawyers listed in the database as of that time. neither the postings of government nor of academic lawyers were included in this search because the search tabs for government and academic lawyers do not provide a field for narrowing the search by reference to language skills. embody policy choices different from those preferred by its authors. while hussey and lubick contemplate that the bwtc will have to be adapted to the needs of each individual transition country, their failure to discuss alternative provisions makes such adaptation more difficult and creates the possibility that an uninformed advisor who turns to the bwtc for guidance may unintentionally (and inappropriately) incorporate a whole host of policy choices into the transition country’s tax laws. interestingly, it is the two-volume set entitled tax law design and drafting – which was published by the international monetary fund, an entity that was classified as a stakeholder and not as a neutral expert for purposes of this article – that demonstrates the most sensitivity to the ethical guidelines formulated above. the chapter on the tax legislative process in the first volume of that set contains advice concerning the issues that should be considered when choosing and employing foreign legal advisors. in that chapter, transition countries are counseled to employ foreign advisors who (i) are familiar with the local language; (ii) are experts in the tax laws of any country from which legal rules are to be borrowed; (iii) are not seeking to impose the law of their own country on the transition country, or who, regardless of intentions, are only equipped to do so; and (iv) will consult local lawyers to ensure that the draft tax legislation “is fully suited to the country’s circumstances,” and, more particularly, that it is consistent with the rest of the country’s legal system.454 transition countries would be well-advised to take these admonitions to heart, because they incorporate much of the substance of the duty of competence described above. it must readily be acknowledged, however, that, in practice, it may prove quite difficult to locate individuals who combine technical tax expertise with the language and cultural skills required by the duty of competence. a search on the martindale-hubbell lawyer locator found that, of those lawyers in private practice who listed taxation as one of their practice areas, only fifty speak russian, seven speak ukrainian, three speak czech, three speak polish, and just one speaks latvian.455 the difficulty of finding lawyers with the requisite language and cultural skills is underscored by the small number of 340 florida tax review [vol. 6:3 456. during 1999-2000, only 371 people were graduated with a bachelor’s degree in east european languages and literatures, only 83 people were graduated with a master’s degree in east european languages and literatures, and only 40 people were graduated with a doctor’s degree in east european languages and literatures. thomas d. snyder & charlene m . hoffman, u .s. dep’t of educ., digest of education statistics 2001, at 307 tbl. 258 (2002). individuals graduating from american universities with bachelor’s, master’s, and doctor’s degrees in east european languages and literatures.456 the brief description in part ii of the activities of american tax experts who are advising transition countries evidences a level of activity that far surpasses the capacity of the small pool of candidates with the requisite combination of technical, language, and cultural skills. nevertheless, a dearth of fully qualified experts is not a license to disregard ethical proscriptions and to foist inappropriate – and potentially harmful – advice on unsuspecting recipients. by drawing attention to the ethical dimension of this activity, this article hopes to spur american neutral experts to reflect on the nature and quality of the advice that they have already rendered to transition countries and, more importantly, on the nature and quality of the advice – if any – that they will render to these countries in the future. page 1 page 2 page 3 page 4 page 5 page 6 page 7 page 8 page 9 page 10 page 11 page 12 page 13 page 14 page 15 page 16 page 17 page 18 page 19 page 20 page 21 page 22 page 23 page 24 page 25 page 26 page 27 page 28 page 29 page 30 page 31 page 32 page 33 page 34 page 35 page 36 page 37 page 38 page 39 page 40 page 41 page 42 page 43 page 44 page 45 page 46 page 47 page 48 page 49 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ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe volume 18 2016 number 8 florida tax review article big data and tax haven secrecy arthur j. cockfield florida tax review volume 18 2016 number 8 i article big data and tax haven secrecy arthur j. cockfield 483 florida tax review volume 18 2016 number 8 ii the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states, plus sales tax where applicable and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117634, 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of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manual. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 18 2016 number 8 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review selected issues in the taxation of swaps, structured finance and other financial products lewis r. steinberg* i. introduction h. swaps a. basic swap mechanics b. the use of interest rate swaps to create synthetic tax-advantaged assets c. equity swaps 1. basic mechanics 2. deemed disposition of the underlying stocks 3. deductibility of swap payments: creation of synthetic tax-advantaged assets using equity swaps 4. dividend capture and equity swaps 5. equity swaps and withholding taxes d. section 382 and swaps i. structured finance a. basic structure and goals b. dividing up cash flows to better meet investor objectives c. tax transparency d. optimization of the drd 267 267 268 281 281 282 284 285 287 293 296 296 297 298 302 iv. conclusion *partner, cravath, swaine & moore, new york. ny. this article is based on a paper presented by the author to the tax review of new york city on november 16, 1992. the author would like to thank mary f. cliff for her invaluable assistance in researching and editing this article, and michael l. schier for his helpful comments on an earlier draft. volume i number 5 florida tax review i. introduction the last decade has seen an explosive growth in the use of swaps and other derivative products' as part of the asset and liability management strategies of corporations and other institutional investors. beginning with interest rate and currency swaps, the menu of swap products has expanded to include commodity swaps, equity index swaps, equity swaps, total return swaps, basis swaps, and interest rate caps, floors and collars. according to industry sources, the market for interest rate swaps has grown in notional principal amount from an estimated $3 billion in 19822 to over $3.065 trillion by the end of 1991 (the most recent figures available). 3 similarly, the outstanding aggregate notional principal amount of currency swaps has grown from $182 billion in 1987 to $807 billion by the end of 1991.' at the same time as the swap market has been expanding, the structured finance market,5 including mortgage and asset securitization,6 has seen similar growth. beginning in the 1970s, u.s. government-backed enterprises such as the government national mortgage association ("ginnie mae") and the federal home loan mortgage corporation ("freddie mac") sponsored transactions in which pools of residential first mortgages were bundled into pass-through certificates that were then sold to thrifts, banks and other institutional investors. in 1983, freddie mac introduced collateralized mortgage obligations ("cmos"). cmos, which divided up the cashflows from 1. a derivative product is a financial instrument that, while not itself constituting a share of stock, debt obligation or commodity, has a value derived from the values, prices or returns of or on such "underlying" assets. examples of derivative products include swaps, options of either the cash-settled or physical-settled variety, futures contracts, forward contracts, caps, floors and collars. see generally saul hansell, is the world ready for synthetic equity?, institutional investor, aug. 1990, at 54 (discussing the types and economic uses of swaps and other derivative products); steven d. felgran, interest rate swaps: use, risk, and prices, new england econ. rev., nov.-dec. 1987, at 22. 2. why bank regulators need a contingency plan, the economist, dec. 1, 1984, at 93, 94. 3. international swap dealers association, market survey highlights year end 1991 7 (1992). 4. id. because the international swap dealers association counts only the firms that participate in its survey, it may understate the true size of the market. true size of swap market approaches $6 trillion, with replacement cost of $275bn, swaps monitor, oct. 19, 1992, at 1. it has been estimated that the true aggregate amount of currency and interest rate swaps outstanding at the end of 1991 was $5.7 trillion (notional principal amount). id. 5. "structured finance is a financing technique in which financial assets ... are pooled and converted into capital market instruments." div. of inv. management, u.s. sec. and exch. comm'n, protecting investors: a half century of investment company regulation i (may 1992). 6. securitization is the transformation of illiquid debt into standardized, marketable securities. 1 tamar frankel, securitization 3 (1991). [vol 1:5 selected issues in the taxation of swaps an underlying pool of mortgages into separate debt securities having different maturity, interest rate and credit characteristics, dramatically broadened the market for mortgage-backed securities. with the enactment of the "real estate mortgage investment conduit" ("remic") provisions7 as part of the 1986 tax reform act, the taxation of mortgage pass-through and pay-through securities became subject to a new, self-contained set of rules. moreover, since the mid-1980s, structured finance techniques originally employed in securitizing mortgages have been applied to a broad range of other financial assets, including stocks, credit card receivables, auto loans, lease receivables, home equity loans, commercial and industrial loans and trade receivables.' the development of swaps and structured finance products has given rise to a number of tax issues. even today, many aspects of the taxation of these products remain confused and in doubt. this article explores some of those confusing and contentious issues, as well as some issues on which there is, one hopes, more universal agreement. this article is divided into two broad parts. part h describes and analyzes certain tax issues involving swaps. after describing the basic mechanics of swap transactions, part h shows how swaps can be utilized to create synthetic tax-advantaged assets, to enable an investor to alter the mix of its investment assets without triggering gain recognition, and, in the case of foreign investors, to avoid withholding taxes. the emphasis in part ii is on interest rate and equity swaps, but the analysis contained therein applies more broadly to all kinds of swap products. also discussed in part h is whether equity swaps can be used as part of dividend capture strategies to avoid the strictures of section 246 and how swaps should be treated for purposes of the built-in gain and loss rules of section 382(h). part iii explores a number of issues in structured finance. this part uses an equity-based product recently developed by merrill lynch as a case study for analyzing structured finance techniques. as is typical of most structured finance transactions, the merrill lynch product maximizes economic value by achieving three goals involving both tax and non-tax considerations: (i) the dividing up of pre-tax cashflows from an underlying financial asset or assets in order to create new securities that better match the investment needs of discrete investor groups; (ii) the structuring of the investment vehicle, in this case, a state law trust, in order to avoid an entitylevel tax; and (iii) the structuring of the transaction to preserve, and flow through to the investors, the tax-advantaged character of the income from the underlying asset or assets. 7. irc §§ 860a-860g. 8. see generally christine pavel, securitization, econ. persp., july-aug. 1986. at 16. 19931 florida tax review in one sense, this article does not have a single unifying theme. rather, it represents an outgrowth of my professional practice advising investment banking and other clients about derivative products and asset securitization, and is intended to introduce generalist tax practitioners to some of the new financial products that have been developed in the swaps and structured finance areas over the last few years, and to some of the tax issues that have arisen with respect to those new products. in another sense, however, the theme linking many of the topics discussed in this article is that of "tax arbitrage." by tax arbitrage i mean a taxpayer's simultaneously holding "long" and "short" positions in the same or similar asset(s), but where the tax treatment of one position differs from the tax treatment of the other, resulting in an after-tax return from the overall transaction that is greater than its pre-tax return.9 many of the transactions explored in this article raise questions about the proper scope and content of a general, unifying theory of tax arbitrage. in particular, tax arbitrage strategies, at least in their "purest" forms, are generally viewed as abusive. nevertheless, in discussing many of the transactions analyzed in this article with my professional colleagues, i have discovered that, in the tax world, as in so much else, one person's poison is another person's meat. transactions that strike me as clearly troublesome appear perfectly legitimate to some of my peers and vice versa. the reason for these disagreements is not that some persons are more or less tolerant of tax arbitrage than others. rather, the disagreements stem from differing conceptions of what makes tax arbitrage abusive and, accordingly, what particular transactions should be considered examples of tax arbitrage in the first place. some of my colleagues believe that a sine qua non of tax arbitrage is the presence of debt financing. others believe that tax arbitrage only requires the holding of offsetting "long" and "short" economic positions. some tax lawyers seem to require a "direct" link between the "long" and "short" positions before a transaction can be considered an example of tax arbitrage. others view this as merely a rule of administrative convenience, rather than a theoretical requirement. my purpose in writing this article is far more modest than crafting a general, unifying theory of tax arbitrage. i do believe, however, that many of the transactions described in this article must be accounted for in developing such a theory. thus, only when one is able to articulate clearly and cogently why the strategy involving a market discount bond and an interest rate swap discussed in part ii either is, or is not, abusive, will the analysis be complete. 9. see generally myron s. scholes & mark a. wolfson, taxes and business strategy: a planning approach 104-27 (1992); c. eugene steuerle, taxes, loans and inflation: how the nation's wealth becomes misallocated (1985). [vol 1:5 selected issues in the taxation of swaps ii. swaps a. basic swap mechanics a swap, or more technically a "notional principal contract," is defined in proposed regulations section 1.446-3(c)(1), 56 fed. reg. 31,350 (1991), as "a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts." for example, suppose a and b10 enter into an interest rate swap pursuant to which a is obligated to pay b $100, or 10% of $1,000, on december 31st of each year, and b is required to pay a at the end of each calendar quarter an amount equal to the product of $1,000 and the prevailing london interbank offered rate ("libor") for 90-day deposits for the period, as determined at the beginning of the calendar quarter." here, the notional principal amount is $1,000, the specified index for a is a fixed 10% interest rate, and the specified index for b is a floating 90-day libor interest rate. a and b might enter into this swap in order to allow a to convert its libor-based floating interest rate debt obligations into fixed interest rate obligations and b to convert its fixed interest rate debt obligations into floating interest rate obligations.' 2 this is an example of a liability-based swap strategy. alternatively, a may own a fixed interest rate asset, a general motors debenture for example, and b may own a floating interest rate asset, a libor-based bank deposit note for example, and each may wish, by entering into the swap, to convert its "real" asset into a "synthetic" floating rate asset, in the case of a, or "synthetic" fixed rate asset, in the case of b. this would be an example of an asset-based swap strategy. 10. a and b are assumed to be accrual basis taxpayers throughout this article. 11. in practice, in order to limit b's exposure to a's credit risk, both the fixed and floating payments would generally be made on a quarterly basis and would be netted (i.e., depending on the relationship of current libor rates to the 10% fixed rate under the swap, either a or b, but not both, would make a payment each quarter). the examples in the text provide for only one fixed swap payment each year in order to make the analyses somewhat easier to follow. 12. because of market imperfections, for example, a may be unable to borrow on a fixed rate basis in the public or private debt markets, or may be able to borrow in those markets only at a rate substantially in excess of 10%. similarly, imperfections in the debt markets may prevent b from borrowing at 90-day libor rates. the use of swaps can allow both parties to borrow, on a net basis, at more attractive interest rates, thereby increasing the overall efficiency of the markets for borrowed funds. 19931 florida tax review b. the use of interest rate swaps to create synthetic tax-advantaged assets as described in part ii(a) supra, swaps can be used to create "synthetic" assets. for example, suppose a owns a $1,000 principal amount u.s. treasury bond that pays 10% interest per year and matures in two years. a likes the credit characteristics of this bond but, because a believes interest rates will rise over the next two years, wishes to convert the fixed rate return on the bond into a libor-based floating rate return. accordingly, a enters into the asset-based interest rate swap described in part ii(a) supra. economically, a has created a synthetic two-year bond that pays interest quarterly based on current 90-day libor interest rates and that provides for a bullet $1,000 payment of principal, "guaranteed" by the u.s. government, at the end of two years. thus, if the libor-based payments made by b in a given year equal $110 (i.e., 11% of the swap's notional principal amount of $1,000), a's net economic income from the swap will equal $10 (i.e., $110 received from b minus $100 of fixed payments made by a). this net economic income coupled with the $100 (i.e., 10% of the bond's principal amount of $1,000) of interest received on the bond that year results in a's receiving a total of $110, equal to the amount of the liborbased payments received from b. conversely, if the libor-based payments in any given year equal $90 (i.e., 9% of the swap's notional principal amount of $1,000), a's net economic income from the swap will equal a loss of $10 (i.e., $90 received from b minus $100 of fixed payments made by a). again, this net economic loss coupled with the $100 of interest received by a on the bond results in a's economic income being $100 minus the loss of $10, or $90, the amount of the libor-based payments. 3 for income tax purposes, however, the interest on the u.s. treasury bond and the net income or loss from the interest rate swap are accounted for separately. 4 thus, each year a (i) includes the interest income on the bond in taxable income and (ii) includes, or deducts, as the case may be, the net 13. the reason for these results is that a's $100 per year liability to b under the swap is exactly offset, as an economic matter, by a's right to receive $100 of interest each year on the bond, leaving a with annual net income equal to the amount of the libor-based payments received from b that year under the swap. 14. compare regs. § 1.988-5(a) (allowing a taxpayer to integrate a nonfunctional currency debt instrument or obligation and certain types of hedges to create a synthetic asset or liability, which is then taxed as if it were a real asset or liability) with preamble to prop. regs. § 1.446-3, 56 fed. reg. 31,350 (1991) (stating that the internal revenue service "is considering whether to permit taxpayers to account for a notional principal contract and the asset or liability that the notional principal contract hedges on an integrated basis"). [vol 1:5 selected issues in the taxation of swaps swap payments in, or from, taxable income.' the combination each year of the bond interest income plus (or minus) the net swap income (or deduction) will equal the amount of the libor-based payments to be made by b for such year.'6 thus, a's economic income and taxable income will be the same each year, and will be the same as would have been the case if a had purchased a libor-based bond having the same payment terms as the synthetic bond created through the combination of the bond and the interest rate swap. now assume that, rather than purchasing a u.s. treasury bond, a purchases a municipal bond, the interest on which is excludable from a's income pursuant to section 103.' 7 in that case, a's economic income each year will still equal the libor-based payments received from b that year. but now, the combination of the tax-free interest income on the bond and the net income/deduction from the swap results in a's taxable income being $100 less than its economic income each year. for example, if the libor-based payments in a given year equal $110, the net swap income for the year will still equal $10. the combination of this net swap income with the $100 of tax-free interest received on the bond results in taxable income to a of only $10, which is $100 less than a's economic income for that year. similarly, if the libor-based payments equal $90, the net swap deduction for the year will equal $10; this, plus the $100 of tax-free interest received on the bond, results in a's recognizing a net taxable loss of $10 for the year, which is $100 less than a's economic income.' 8 thus, even though the pre-tax pay15. prop. regs. § 1.446-3(e)(1), 56 fed. reg. 31,350 (1991). the swap will give rise to net income in any year in which the libor-based payments received from b exceed the fixed payments made by a; conversely, the swap will give rise to a net deduction in any year in which the libor-based payments are less than the fixed payments. 16. for example, if the libor-based payments made by b equal si 10. a's net taxable income from the swap will equal $i0 (i.e.. si10 received from b minus si00 of fixed payments made by a under the swap). coupled with the s100 of bond interest received by a results in a's net taxable income being $110, the amount of the libor-based payments under the swap. if, alternatively, the libor-based payments equalled only s90. a would have a net deduction of $10 with respect to the swap (i.e., $90 received minus $100 paid), which, coupled with the $100 of bond interest income, results in net taxable income of s90, again, the amount of the libor-based payments. 17. also assume that a is a corporation so that net swap payments are deductible under section 162, not section 212, and section 265(a)(1) will therefore not apply. 18. as discussed in note 13 supra, as an economic matter, a's obligation under the swap to make a $100 fixed payment to b each year is exactly offset by a's right to receive $100 of coupon interest on the tax-exempt bond, resulting in a's economic income being equal to the amount of the libor-based payments received from b. for tax purposes, however, the $100 fixed payment under the swap is deductible against the libor-based payments received from b (or, if b's payments are less than a's payment, from other income), which, coupled with the $100 of excludable interest on the bond, results in a's taxable income always being 1993] florida tax review ment stream of the synthetic asset in this second example is the same as that in the first, the tax treatment of the two synthetic assets is very different. in essence, by using a tax-exempt bond as one leg of the transaction, a has been able to create a synthetic libor-based bond the income from which is taxexempt to the extent of the 10% interest earned on the tax exempt bond.' 9 the same strategy could be employed using other tax-advantaged assets as one part of the bond/swap strategy. for example, under the market discount rules of sections 1276-1278, an investor is not required to include market discount on a bond2 in income until the bond is retired or otherwise disposed of, or until the investor receives principal payments on the bond.2 the universe of outstanding market discount bonds at any given time is limited and an investor, although aware of the tax advantages of owning such a bond,22 may be unable to find a bond that matches its investment profile. by buying a market discount bond and simultaneously entering into a swap, however, an investor can create a synthetic market discount bond, one that retains the tax advantages of the original but has non-tax characteristics more to the investor's liking. for example, assume that on january 1 of year 1 a purchases on the open market a u.s. treasury obligation having a remaining term to maturity of two years, and that the treasury obligation bears coupon interest of 5% at a time when prevailing treasury interest rates are 10%. thus, in general, the treasury bond will sell at a market discount designed to give the holder a 10% pre-tax yield to maturity.23 assuming a remaining term to maturity of $ 100 less than its economic income. as discussed infra, since payments under the swap would not constitute interest for tax purposes, section 265(a)(2) would not apply to disallow a deduction for such payments. 19. note that under the integration approach of regulations section 1.988-5(a), a synthetic asset is taxed as if it were a real asset, without regard to the tax treatment of its constituent parts. if this approach were applied to the examples in the text, the taxable bond/swap and tax-exempt bond/swap transactions would be taxed identically (i.e., a would not benefit from the tax exemption with respect to the bond interest and would be taxed on the full amount of the payments received from b each year). 20. subject to a de minimis rule, section 1278(a)(2) defines market discount as the excess, if any, of a bond's stated redemption price at maturity over a taxpayer's tax basis in the bond immediately after its acquisition. 21. irc § 1276(a). this assumes, of course, that the investor does not elect under section 1278(b) to include market discount in income on a current basis. 22. this ignores the fact that the bond may bear "implicit taxes," that is, that the bond may be priced at a lower pre-tax yield than comparable, newly-issued bonds to account for the benefit of being able to defer the inclusion of market discount in taxable income. see generally scholes & wolfson, supra note 9. 23. again, this ignores the fact that the ability to defer market discount income may be capitalized into the price of the treasury obligation, resulting in a less-than-10% pre-tax yield to maturity. [vol. 1:5 selected issues in the taxation of swaps two years, a $1,000 principal amount bond yielding coupon interest of 5% per annum (i.e., $50.00 per year) would sell for approximately $913.22, resulting in market discount of $86.78. at the same time, suppose a and b enter into a two-year, $913.22 notional principal amount interest rate swap pursuant to which (i) a is obligated to pay b $50.00 on december 31st of year 1 and $136.78 on december 31st of year 2, and (ii) b is obligated to pay a an amount on march 31st, june 30th, september 30th and december 31st, respectively, of each year equal to the product of $913.22 and the 90day libor interest rate for the period, as calculated on the first day of the second preceding month. 4 the following table compares a's economic and taxable incomes each year from entering into the transaction: a. economic income: year 1 (1) coupon interest: s50.00 (2) market discount: 41.323 (3) net swap income: aggregate amount of b's payments minus $91.3226 total aggregate amount of b's payments 24. a is effectively obligated to pay b under this "deferred coupon" swap at an overall 10% (compounded) fixed rate. only a portion of the first year's return, equal to 5.475% of the original notional principal amount of $913.22. however. is required to be paid in the first year, the rest accrues and, in essence, increases the notional principal amount to which the 10% rate is applied in the second year. thus, in the first year, a's liability to b is $91.32 (10% of $913.22), $50.00 (5.475% of $913.22) of which is paid currently and the rest of which ($41.32) accrues, effectively increasing the notional principal amount for purposes of calculating a's liability to b in the second year, but not b's liabilities to a. from $913.22 to $954.54. at the end of year 2, then, a is required to pay b s136.77, equal to the sum of (i) $95.45 (10% of $954.54), and (ii) $41.32, the accrued but unpaid amount from year 1. the slight difference between s136.77 and $136.78. the number in the text. is due to rounding error. under proposed regulations sections 1.446-3(e)(3)hii)(a) and (elt3itiiltdh, 56 fed. reg. 31,350 (1991), a would generally be entitled to deduct $91.32 in year i (i.e.. the amount that economically accrued in year i with respect to a's obligations to b under the swap), and $95.45 in year 2 (i.e., again, the amount that economically accrued in year 2 w ith resplzet to a's obligations to b) with respect to its obligations to pay b, and would include in income each year the amounts receivable from b in that year. technically. under proposed regulations section 1.446-3(e)(1), these items would be netted to determine a's net income or deduction from the swap each year. 25. i.e., 10% (the pre-tax yield) of s913.22 (the purchase price for the treasury obligation), or $91.32, minus coupon interest of s50.00. 26. this takes into account the amount that accrues each year with respect to a's obligations to b under the swap. see supra note 24. 19931 florida tax review year 2 (1) coupon interest: (2) market discount: (3) net swap income: total aggregate amount payments minus aggregate amount payments $50.00 45.4527 of b's $95.4528 of b's total over two-year period: aggregate amount of b's payments over twoyear term of swap. b. taxable income: year 1 (1) coupon interest: (2) market discount: (3) net swap income: total year 2 (1) coupon interest: (2) market discount: (3) net swap income: total $50.00 0 aggregate amount of b's payments minus $91.3229 aggregate amount of b's payments minus $41.32 aggregate amount payments minus aggregate amount payments plus $50.00 86.78 of b's $95.4530 of b's $41.3331 total over two-year period: aggregate amount of b's payments over twoyear term of swap. thus, compared to a's economic income, a's taxable income is understated by $41.32 in year 1 and overstated by the same amount in year 2. this $41.32 is, of course, the amount of market discount that accrued on the u.s. 27. i.e., 10% (the pre-tax yield) of $954.54 ($913.22 purchase price for the treasury obligation plus $41.32 of accrued but unpaid market discount from year 1), or $95.45, minus coupon interest of $50.00. 28. see supra note 24. 29. see supra note 24. 30. see supra note 24. 31. again, the difference between $41.32 and $41.33 is due to rounding error. [vol 1:5 selected issues in the taxation of swaps treasury obligation in year i but was not required to be included in a's taxable income until year 2. as in the tax-exempt bond example, the combination of the market discount bond and the swap results in the creation of a synthetic taxadvantaged asset, one that has the non-tax characteristics of a non-market discount libor-based floating rate debt instrument but that preserves the favorable tax characteristics of the market discount bond. a's obligation to make fixed payments to b under the swap is fully offset as an economic matter by a's right to receive the coupon interest and market discount component of the principal payment on the bond. nevertheless, the combination of a current deduction for the fixed swap payments and the deferred treatment of the market discount on the bond results in a's essentially being able to convert other income into tax-deferred market discount?2 the combination of deferring taxable income with respect to an asset, while taking a current deduction with respect to an offsetting liability, resulting in a conversion of non-tax advantaged income into tax-advantaged income, is a hallmark of tax arbitrage strategies.33 it might be argued that there is nothing abusive about this transaction since it simply "substitutes" a synthetic market discount obligation for a real one without increasing the aggregate amount of market discount in the universe. 4 nevertheless, there is something troubling about all this. in 32. in particular, to the extent the libor-based payments received from b on the swap are at least $41.32 in year i, a will be able to convert $41.32 of those payments into tax-deferred market discount. if, because of the prevailing level of the libor, payments from b in year 1 are less than $41.32, a will be able to defer other (non-swap related) income. because the term of the swap and the remaining term of the treasury obligation are only two years, the example in the text provides for only a one-year deferral. by using longer term swaps and market discount obligations, of course, synthetic assets could be created that provide for greater periods of deferral. indeed, because changes in interest rates cause larger changes in the prices of longer-term bonds relative to shorter-term bonds, thereby maximizing the amount of resulting market discount, the strategy may be "optimized" by using longer-term swaps and market discount bonds. 33. unlike classic tax arbitrage strategies, of course, the swaplbond examples discussed in the text require a to enter into a second long position (i.e., the right to receive libor-based payments from b under the swap), which arguably makes such transactions nonabusive or, at least, far less abusive than classic tax arbitrage strategies. 34. this statement, of course, is not strictly true. more precisely, the potential supply of market discount bonds is limited at any given time by the level of prevailing interest rates and the payment terms of existing bonds held by investors. however, because a bond is considered a market discount bond, within the meaning of section 1278, only if the holder's tax basis in the bond is less than the bond's stated redemption price at maturity, the quantity of actual market discount bonds extant will be increased if "high basis" investors can be induced to sell their depreciated bonds to new "low basis" investors. such sales will also, of course, generate deductible losses for the "high basis" sellers. allowing investors to customize their investments through the simultaneous holding of a market discount bond and an interest 19931 florida tax review particular, inasmuch as the original decision by congress not to require market discount to be included in income on a current basis was based on concerns about administrative convenience,35 it seems somewhat anomalous that such concerns should prevail here where the parties are obviously economically sophisticated and the swap tax accounting rules themselves, as provided in proposed regulations section 1.446-3, 56 fed. reg. 31,350 (1991), seem to be animated more by a desire to measure income accurately than by concerns about simplicity.3 6 nevertheless, it is hard to identify any particular provision of the code or the regulations that would be violated by rate swap should enhance the efficiency of the market discount bond "market" and result in the creation of more market discount bonds. a similar analysis would apply to the tax-exempt bond market. 35. see h.r. rep. no. 432, 98th cong., 2d sess., pt. 2, at 1170 (1984). 36. see, e.g., prop. regs. § 1.446-3(e)(3)(ii)(b) and (e)(3)(ii)(c), 56 fed. reg. 31,350 (1991) (requiring, in certain circumstances, that "nonperiodic payments" with respect to a swap, cap or floor be spread over the life of the contract "in accordance with the values of a series of cash-settled forward contracts [or, in the case of caps and floors, option contracts] that reflect the specified index and the notional principal amount"). while it is true that the proposed regulations do provide for certain optional methods for amortizing swap, cap and floor premiums in the interest of "simplicity," see, e.g., prop. regs. § 1.446-3(e)(3)(ii)(d), this type of "simplicity" is clearly different than the kind envisioned by congress when it allowed investors to defer the inclusion of market discount in income. two other points might also be made with respect to the examples in the text. first, one might argue that, under general principles, the right to claim the section 103 exclusion with respect to the interest on the tax-exempt bond inures to a as the (tax) owner of that bond. by entering into the swap a has not divested itself of such ownership, see part ii(c)(2) infra; taxing a on its net economic income from the overall tax-exempt bond/swap transaction, however, would effectively deny a the benefit of the section 103 exclusion. a similar argument might be made with respect to a's right to continue deferring market discount in the market discount bond/swap example. this, however, proves too much. for example, even if the owner of a tax-exempt bond borrows on a fully recourse basis, so that it is unquestionable that the investor retains ownership of the bond, section 265(a)(2) operates to prevent the owner from combining (taxable) interest deductions with tax-exempt interest inclusions to convert unrelated taxable income into tax-exempt interest income. second, one might analogize the combination of a bond and a swap to an interest coupon stripping transaction under section 1286. thus, by entering into the swap, a has effectively transferred the economic benefit of the interest coupons (and, in the market discount bond example, the market discount) on the bond to b. (this is not to say, however, that the bond/swap transactions are tantamount to a stripping transaction. they are not, since in a stripping transaction, unlike a swap transaction, a would have transferred tax ownership of a portion of the bond to b. cf. part it(c)(2) infra.) in that case, however, section 1286(d) would require that the section 103 exclusion be split between the holder of the stripped coupons, b, and the holder of the stripped principal, a. in the example in the text, however, a has been able to retain 100% of the tax exemption. similarly, the stripping of a market discount bond converts market discount into original issue discount and therefore eliminates the deferral possibilities. see irc § 1286(a) (treating stripped bond as newly issued on purchase date for purposes of the original issue discount rules). [vol 1:5 selected issues in the taxation of swaps the transactions described above.3 for example, section 1277 defers all or a portion of a taxpayer's interest deduction with respect to indebtedness incurred or continued to acquire or carry a market discount bond. the purpose of this rule is to prevent taxpayers from converting unrelated income into tax-deferred market discount income, in other words, to prevent tax arbitrage. " interest expense for this purpose includes not only interest incurred on borrowings, but also expenses attributable to short sales.39 nevertheless, except in certain unusual circumstances,' expense from an interest rate swap is not generally considered to be interest for purposes of the code.4 thus, it appears that 37. in general, any such transaction would have real non-tax significance. thus, it is hard to see how the internal revenue service (the "sen'ice") could challenge these transactions on "substance over form," "sham transaction" or "step transaction" grounds, or on the basis that they lacked bona fide business purposes or a profit-making potential. 38. h.r. rep. no. 432, supra note 35. 39. irc § 1277(c). 40. see, e.g., prop. regs. § 1.446-3(e)(4)(iii), 56 fed. reg. 31.350 (1991) (dealing with swaps having "significant nonperiodic payments" that are treated as having "embedded loans"); cf. regs. § 1.861-9t(b) (dealing with interest equivalents for purposes of calculating domestic and foreign source interest expense). 41. for example, the preamble to proposed regulations section 1.446-3. 56 fed. reg. 31,350 (1991), states that "[blecause the notional principal amount is not exchanged by the parties, the payments due under a typical interest rate swap, cap. or floor are not compensation for the use or forbearance of money and therefore are not 'interest'." it is possible, however, that $4.13 of a's year 2 payments (10% of the $41.32 obligation accrued in year 1 but not paid until year 2) could be recharacterized as interest. see prop. regs. § 1.446-3(e)(4)(iii). furthermore, the longer the term of the deferred coupon swap and therefore the greater the amount that is deferred and the period of deferral, the greater the amount that could be recharacterized as interest. nevertheless, depending on the circumstances, any such recharacterization might not have a material effect on the overall transaction. section 1277 only defers a deduction with respect to the "net direct interest expense" with respect to a market discount bond. the net direct interest expense is the excess, if any, of (i) the amount of interest paid or accrued during a taxable year on indebtedness incurred or continued to purchase or carry the bond over (ii) the aggregate amount of interest. including original issue discount, includable in gross income for the taxable year with respect to the bond. irc § 1277(c). only the portion of the swap payments recharacterized as interest would be taken into account for purposes of clause (i), while the full amount of coupon interest and original issue discount on the bond would be taken into account for purposes of clause (ii). for example, assuming a market discount bond paying interest of $50 per year, swap expense recharacterized as interest would be limited only to the extent it exceeded $50 in any given year. however, assuming deferred amounts under the swap compound at a 10% (pre-tax) yield, this would only occur if and to the extent the aggregate of the amounts deferred under the swap in earlier years exceeded $500. second. particularly given the separate (nonintegrated) treatment of the swap and the bond for tax purposes. it is far from clear that swap expense recharacterized as interest would be considered attributable to indebtedness incurred or continued to purchase or carry the market discount bond. rather, one might view these amounts as attributable to loans by b to a with respect to the swap. 19931 florida tax review section 1277 does not apply to defer a's deduction for the fixed payments under the interest rate swap in the example. alternatively, perhaps the straddle rules of section 1092 apply. the straddle rules were enacted in 1981 in order to stop certain tax-motivated straddle transactions. these transactions generally involved the manipulation of the "realization" requirement. thus, an investor might enter into offsetting long and short future contracts with different delivery dates on gold or some other commodity. subsequent changes in the market price for the underlying commodity would create a built-in gain or loss in the long position, and an (almost exactly) offsetting loss or gain in the short position. thus the overall net loss or gain in the taxpayer's economic position was likely to be minimal. nevertheless, by disposing of the loss leg of the straddle, while retaining the gain leg, the investor could create a taxable loss that could be used to shelter unrelated income, generally, short-term capital gains.42 in this way, the taxpayer was able to defer such unrelated income and frequently convert it from short-term into preferentially-taxed long-term capital gain.43 under section 1092(a), [a]ny loss with respect to 1 or more [straddle] positions shall be taken into account for any taxable year only to the extent that the amount of such loss exceeds the unrecognized gain (if any) with respect to 1 or more [other] positions which were offsetting positions with respect to [the] 1 or more positions from which the loss arose. any loss disallowed under this provision is carried forward and treated as a loss arising in the next succeeding taxable year, when it will again be subject to the rules of section 1092(a). section 1092(d)(2) defines a "position" as "an interest (including a futures or forward contract or option) in personal property." section 1092(d)(1) defines "personal property" to mean "any personal property of a type which is actively traded." finally, section 1092(c)(2) provides that [a] taxpayer holds offsetting positions with respect to personal property if there is a substantial diminution of the taxpayer's risk of loss from holding any position with respect to personal property by reason of his holding 1 or more other 42. cf. supra text accompanying note 32. 43. moreover, by entering into a new (long or short) leg to replace the (long or short) leg of the straddle that had been disposed of, the taxpayer would be able to reestablish its hedged economic position, which results from concurrently holding offsetting long and short positions. [val 1:5 selected issues in the taxation of swaps positions with respect to personal property (whether or not of the same kind). application of section 1092 to the transactions described above thus involves a series of technical and definitional questions. the first question is whether an interest rate swap can be a "position" for purposes of section 1092. this question, which was in some doubt prior to the issuance of proposed regulations section 1.1092(d)-l(c), 56 fed. reg. 31,350 (1991), was addressed in that provision of the proposed regulations. it states that a notional principal contract "constitutes personal property of a type that is actively traded if similar contracts are actively traded" in an interdealer market or other financial market and that "the rights and obligations of a party to a notional principal contract constitute an interest in personal property." proposed regulations section 1.1092(d)-l(b)(6) states that "[ain interdealer market is characterized by a system of general circulation which regularly disseminates price quotations or pricing information by identified dealers, brokers, or traders." the proposed regulations do not define a dealer, broker or trader, but proposed regulations section 1.446-4(b), 56 fed. reg. 31,350 (1991), issued at the same time as proposed regulations section 1.1092(d)-l(b)(6), states that a dealer or trader in derivative financial instruments (such as swaps) includes a person that "[m]akes a market in derivative financial instruments by regularly and actively offering to enter into, offset, assign, or otherwise terminate positions in those instruments with customers in the ordinary course of its trade or business."m because most swap transactions are, in fact, intermediated by investment and commercial banks that regularly quote rates for entering into swaps and act as middlemen between the ultimate counterparties to the swap, 5 it is likely that, if this 44. technically, the definition contained in proposed regulations section 1.446-4 applies only for purposes of that section. 45. generally, the investment or commercial bank in the middle will act in a principal capacity with respect to each counterparty. thus, the bank will be taking each party's credit risk and will be required to perform its obligations under the swap regardless of a default or delinquency by the counterparty on the other side of the transaction. for obvious commercial reasons, a bank acting in a principal capacity will not generally reveal to either counterparty the terms of, or the identity of the counterparty with respect to, the other leg of the transaction. the swap market is described as follows in the preamble to the proposed regulations sections 446 and 1092, 56 fed. reg. 31,350 (1991): a notional principal contract may be entered into directly with another principal end-user. more commonly, however, the counterparty to the contract is a commercial or investment bank that acts as a "dealer" in such contracts. the dealer typically creates a portfolio of notional principal contracts and seeks to maintain a balanced market position. notional principal contract dealers provide liquidity for the market by standing 19931 florida tax review definition of dealer or trader were to apply for purposes of section 1092, most swaps would constitute property "of a type" that is actively traded in an interdealer market. indeed, perhaps based on this type of analysis, the preamble to the proposed section 1092 regulations concludes that "notional principal contracts are generally actively traded personal property" for purposes of section 1092. the next question is whether the swap and the bond are offsetting positions? certainly, the swap and the bond are, in fact, economically offsetting positions. this follows ineluctably from the fact that a is required to pay to b under the swap amounts equal to the coupon interest and the market discount component of the principal payment on the bond. thus, if interest rates fall (rise), the value of the bond will increase (decrease), while a's obligation to pay b fixed amounts under the swap will increase (decrease) on a present value basis by an offsetting amount. since the bond is an asset, while a's obligation to make payments to b under the swap is a liability, an increase in the former is offset by an increase in the latter. 6 the final question, however, is whether the net deductions generated with respect to the interest rate swap constitute "losses" for section 1092(a) purposes. it is difficult to consider those net deductions as losses for tax purposes. the regulations under section 1092 refer to "dispositions" of loss positions and define a disposition as including the "sale, exchange, cancellation, lapse, expiration, or other termination of a right or obligation with respect to personal property.... payments under a swap would not seem to be dispositions unless each payment is treated as a discrete obligation. in that case, however, unless the payor were a dealer in swaps (or in the rare case where the swap did not constitute personal property under section 1092), payments under the swap would give rise to capital loss deductions pursuant to section 1234a(l), which would certainly be a surprising result. more importantly, section 1092 defines losses by reference to section 165(a), the general section governing deductions for losses; payments under a swap are presumably deductible pursuant to section 162, not section 165(a). moreover, proposed regulations section 1.446-3, 56 fed. reg. 31,350 (1991), itself seems to distinguish between net income or deduction from a swap for each taxable year and the gain or loss recognized on a sale, termination, assignment or other disposition of the swap. for example, ready to enter into these contracts with any qualified party at any time. 46. the changes in the present values of the bond and swap resulting from changes in interest rates will not be exactly offsetting, of course, since a is entitled to receive all the interest and principal on the bond, while a is only obligated to pay over amounts under the swap equal to interest and the market discount component of the principal payment on the bond. 47. temp. regs. § 1.1092(b)-5t(a). [vol. 1:5 selected issues in the taration of siwaps proposed regulations section 1.446-3(e)(1), 56 fed. reg. 31,350 (1991), states that the "net income or deduction from a notional principal contract for a taxable year is included in or deducted from gross income for that taxable year." throughout the proposed regulations, the phrase "net income or deduction" is used to refer to those taxable items arising from payments received or made according to the terms of the notional principal contract itself. in the examples dealing with the treatment of "termination payments" (i.e., payments made to extinguish or assign a notional principal contract), however, the proposed regulations speak uniformly of the parties recognizing gain or loss for tax purposes on the termination of the notional principal contracl4 this is also consistent with other areas of the tax law. for example, rental expense incurred by a lessee would generally not be considered to be a loss with respect to the lessee's leasehold interest. rather, the lessee would generally be considered to recognize gain or loss on a disposition of its leasehold interest. thus, it appears to be a "stretch" to treat the net deductions from a swap as losses for purposes of section 1092.49 finally, perhaps proposed regulations section 1.446-3(e)(4)(ii) applies to disallow all or a portion of the deductions with respect to a's obligations to make fixed payments under the interest rate swap. that regulation provides that "the commissioner may require that amounts paid to or received by the taxpayer under ... [a] notional principal contract" that is hedged by the taxpayer's "purchasing, selling or otherwise entering into other notional principal contracts, futures, forwards or other financial instruments be treated in a manner that is consistent with the economic substance of the transaction as a whole."' 0 perhaps, the service could exercise its authority under this 48. prop. regs. § 1.446-3(e)(6)(vi) ex. 1-3. 56 fed. reg. 31,350 (1991). it is perhaps significant that the only reference to section 1092 in proposed regulations section 1.446-3 is in the context of terminations of notional principal contracts. 49. section 1092 would, of course, still potentially apply to defer losses arising on the termination of a swap. arguably, the language of the preamble to the proposed section 1092 regulations, 56 fed. reg. 31,350 (1991), suggests the service intended that section 1092 cover cases other than those arising on a termination of a notional principal contract. the preamble states: thus, under the proposed regulations, a loss realized with respect to a notional principal contract would not be recognized under section 1092(a) to the extent the taxpayer has an unrecognized gain in one or more offsetting positions. further, the gain or loss realized through the termination (through extinguishment or assignment) of a taxpayer's rights and obligations under a notional principal contract would generally be treated as gain or loss from the sale of a capital asset under section 1234a. query whether the reference to gain or loss "realized through termination.found in the second sentence but not the first, is intended to imply that there are gains or losses that arise other than through terminations of notional principal contracts. 50. prop. regs. § 1.446-3(e)(4)(ii), 56 fed. reg. 31.350 (1991) (emphasis added). 19931 florida tax review regulation by requiring that a integrate the market discount (or tax-exempt) bond and the swap to create a (fully taxable) libor-based synthetic debt obligation. nevertheless, it is doubtful that proposed regulations section 1.4463(e)(4)(ii) should be applied in this fashion. few endusers of interest rate swaps ever enter into unhedged, naked swap positions: interest rate swaps are almost always used as part of a liability or asset-based strategy and are therefore hedged by some other (long or short) position held by the taxpayer.5 thus, unless proposed regulations section 1.446-3(e)(4)(ii) was designed to swallow up the more detailed tax accounting rules set forth in the other provisions of proposed regulations section 1.446-3, it is unlikely that the regulation was intended to apply to integrate swaps and the assets or liabilities that they hedge for purposes of determining the taxpayer's taxable income.52 this interpretation of the purpose of the provision is supported by the language of the regulation itself, as well as the examples in proposed regulations section 1.446-3(e)(4)(v) illustrating its application. the regulation speaks of treating the "amounts paid to or received by the taxpayer under the notional principal contract" in accordance with their economic substance. the implication is that certain payments that are purportedly made pursuant to a notional principal contract may be recharacterized as something else if, given the overall transaction, they are more properly characterized as such.53 for example, example 4 of proposed 51. see preamble to prop. regs. § 1.446-3, 56 fed. reg. 31,350 (1991) ("the service is aware of the fact that many notional principal contracts are used to hedge assets or liabilities, and it is considering whether to permit taxpayers to account for a notional principal contract and the asset or liability that the notional principal contract hedges on an integrated basis"). 52. on the other hand, the regulation is permissive, not mandatory (i.e., the commissioner "may," but is not required to, treat the transaction according to its economic substance). 53. proposed regulations section 1.446-3(e)(4)(ii), 56 fed. reg. 31,350 (1991), also prohibits a taxpayer from using certain methods for amortizing "nonperiodic payments made or received with respect to the hedged notional principal contract." once again, given the fact that substantially all interest rate swaps hedge some other financial asset or liability, it is hard to believe that this provision was intended to apply to the example in the text. (note that this rule, unlike the "economic substance" rule of proposed regulations section 1.446-3(e)(4)(ii), is mandatory.) however, if this provision were to apply to the interest rate swap/market discount bond example discussed in the text, it is at least possible that a would be prevented from deducting in year i more than $50.00, the amount actually payable by a to b in that year. nevertheless, if this were a problem, the fundamental economics and desired tax treatment of the transaction could be preserved by having a and b enter into (i) a "current coupon" swap, pursuant to which a would pay b each year $91.32 and b would pay a libor-based payments quarterly (based on a $913.22 notional principal amount) and (ii) a separate loan agreement, whereby b would loan a $41.32 at the end of year 1, repayable with 10% interest at the end of year 2. a similar approach could be used in the case of longcr-tern [vol 1:5 selected issues in the taxation of siaps regulations section 1.446-3(e)(4)(v) applies this "economic substance" rule in a situation where a taxpayer simultaneously enters into two offmarket, swaps with different counterparties and receives an upfront payment from each counterparty. by viewing the two swaps together, example 4 concludes that the overall transaction is equivalent to a fixed rate borrowing by the taxpayer and recharacterizes the upfront payments as loan proceeds.5 c. equity swaps 1. basic meclumics.-interest rate and currency swaps were the original types of notional principal contracts. in recent years, more sophisticated types of swap products have been developed. many of these are equitybased. for example, assume that a and b enter into an equity swap based on the all-in return (dividend yield and net price change) in the dow jones industrial average ("djia"). at the end of each month, a is required to pay b (i) an amount equal to the net increase, if any, in the djia over the course of that month (determined by comparing the value of the djia at the close of the last trading day of the month (the "closing value") with the value of the djia at the close of the last trading day of the preceding month (the "beginning value") and (ii) an amount equal to the aggregate amount of dividends declared and paid during that month on the underlying stocks making up the djia. similarly, each month b is required to pay a (i) an amount equal to the net decrease, if any, in the djia over the course of the month (determined by comparing the closing value and the beginning value) and (ii) an amount equal to the product of the 30-day libor interest rate for the period (determined at the beginning of the month) and the beginning value. what if a were to enter into this swap at the same time it owned the basket of stocks making up the djia, 6 such stocks having a current aggregate fair market value of $1,000x? by entering into the equity swap,5 market discount bond/swap transactions. 54. an offmarket swap is one where the present values of each counterparty's required payments under the swap are not equal, generally as a result of one counterparty's payments being based on an interest rate index that differs from current market interest rates. in order to equalize the two legs of the swap, the counterparty entitled to receive the stream of swap payments having a greater present value is required to make an upfront payment to the other counterparty. 55. see also prop. regs. § 1.446-3(0 (a general anti-abuse rule allowing the service to account for a transaction in a manner necessary to clearly reflect a taxpayer's income where the "taxpayer enters into a transaction that is not a customary commercial transaction"). i suggest that the transaction discussed in the text would constitute a "customary commercial transaction." 56. more precisely, a would own one share of each stock included in the djia. 57. technically, this would be an equity index swap since it is based on a 1993] florida tax review a would have been able to insulate itself from all (positive or negative) movements in the djia, and would have converted the return on its $1,000x investment in the underlying stocks from an equity-based return into a debtlike return based on libor: thus, a would, in effect, have created a synthetic fixed income (debt) position. b, on the other hand, now holds a position that mimics the performance of the underlying stocks. this raises at least three issues concerning the tax consequences to a. first, by entering into the swap, will a be considered to have disposed of the underlying stocks for tax purposes? second, will a be entitled to deduct payments made to b with respect to positive movements in the djia? if it can, a may be able, once again, to create a synthetic tax-advantaged asset. third, if a is a corporation, will a be entitled to claim the dividends-received deduction (the "drd") under section 243 with respect to dividends received on the underlying stocks, while at the same time deducting the swap payments made to b with respect to such dividends? if so, all sorts of tax arbitrage possibilities will have been created. the next three subparts will discuss each of these issues in turn. then the issue of withholding taxes and equity swaps will be discussed. 2. deemed disposition of the underlying stocks.-many investment bankers tout equity swaps as a convenient means for investors to alter the composition of their investment portfolios without incurring the transaction costs and taxes incident to an actual sale of the underlying stocks and the reinvestment of the proceeds in fixed income securities. this, assumes, of course, that entering into the equity swap will not constitute a disposition of the underlying stocks for tax purposes. is this a correct view? on the one hand, by entering into the swap, a has effectively insulated itself from the future price and dividend performance of the underlying stocks, and converted the return on its investment from an equitybased return into a debt-based return, and b has acquired a financial asset whose return (positive or negative) matches the performance of the underlying stocks. perhaps, then, a should be treated as having sold the stocks to b in exchange for b's libor-based payments. on the other hand, applying the traditional tests for determining who is the owner of assets for tax purposes and absent special circumstances," it is hard to see how b could be treated recognized stock index, rather than on the performance of one or more discrete stocks. 58. for example, this assumes that (i) a has not granted b a voting proxy, or any type of call option or forward or futures contract, with respect to the underlying stocks, (ii) a is a creditworthy party and that a's obligations under the swap are fully recourse to a and its assets, and a is not required to deposit in escrow, grant b a pledge or other security interest in, or give b possession of, the stocks in order to secure its performance under the swap, (iii) a is not required to continue to own all or any portion of the existing stock portfolio, b has [vol 1:5 selected issues in the taxation of swaps as the owner of the stocks for tax purposes, or a could be treated as having ceased to be the owner of those securities. for corporate law purposes, only a, and not b, is recognized as a shareholder of the issuers of the underlying stocks. thus, it is a, and not b, that has the right to vote those shares, to receive dividends and to participate in liquidating distributions; all b has is a creditor's claim, unsecured or secured by assets other than the stocks, to receive payments from a based on the economic performance of those stocks. a is under no obligation to continue to hold all or any portion of the existing stock portfolio, and b has no right to obtain any or all of those shares from a; thus, there is no necessary relationship between the payments to be made by a to b under the swap and particular (or, for that matter, any) shares of physical stock."' moreover, unlike a (non-cash settled) option or futures or forward contract, b's interest under the swap will never ripen into physical ownership of shares. a remains free to alter the basket's composition by buying new stock or selling stocks contained in the underlying portfolio and is not required to pay over any of those proceeds to b; thus, the actual return in any month on the underlying portfolio may differ dramatically from the amount a is required to pay b under the swap, and, depending on a's willingness to assume speculative risk, it can continue to benefit from favorable price movements, and may suffer the detriment of adverse price movements, with respect to the underlying stocks.' finally, a retains a $1,000x investment no power to direct a to dispose of all or a portion of the existing stock portfolio or acquire new or additional stocks, a is not required to account to b with respect to the proceeds of any such dispositions, and, regardless of any such dispositions or acquisitions, the swap continues to be based on the djia, rather than on any particular portfolio of stocks held by a from time to time, (iv) all payments under the swap are to be made in cash or property other than the underlying stocks, and (v) where the underlying stocks have a limited life (e.g., preferred stock having a fixed redemption date or common stock of a corporation that is in the process of liquidating or, like a fixed pool equity real estate investment trust, has a limited expected life), the term of the equity swap is not substantially coterminous with the anticipated life of the stocks. these assumptions are consistent with current market practice. 59. cf. aiken indus., inc. v. commissioner, 56 t.c. 925 (1971), acq. 1972-1 c.b. 1 and rev. rul. 84-153, 1984-2 c.b. 383, modified and clarified. rev. rul. 89-110. 19892 c.b. 275 (stating that where a u.s. corporation makes interest payments to a foreign corporation that is obligated to make corresponding interest payments to another person, that person and not the original payee shall be treated as the recipient of the u.s. corporation's payments for withholding tax purposes); rev. rul 77-137, 1977-1 c.b. 178 (holding that an assignee of the interest of a limited partner shall be treated as a substituted limited partner for federal income tax purposes). 60. this results from the fact that the swap is based on the djia. rather than on any particular stock portfolio owned by a, and on price changes as determined using month-end closing prices, rather than on the results of particular sale or purchase transactions. of course, unless a is willing to bear unhedged exposure with respect to its liabilities under the swap or is able to offset that exposure using hedges other than ownership of physical stocks, it is likely 19931 florida tax review in the portfolio; thus, unlike the situation where a sells the portfolio to b in exchange for a note bearing a libor interest rate, a has not liquidated or monetized its investment in the underlying stocks.6' under these circumstances, it is difficult to see how a could be treated as having disposed of the stock portfolio.62 3. deductibility of swap payments: creation of synthetic taxadvantaged assets using equity swaps.-as described above, a is obligated to pay b each month under the equity swap the positive change, if any, in the value of the djia over the course of the month. if a is allowed to deduct those payments currently, while, at the same time, being able to apply general tax principles to defer recognizing the offsetting gain in its long position in the stocks making up the djia, a would have effectively been able to convert unrelated income, including all or a portion of the libor-based payments received from b under the swap, into unrealized gain on the stocks.63 once again, a would have been able to create a synthetic taxthat a will continue to hold the underlying stock portfolio throughout the term of the swap. 61. this, of course, simply reflects the fact that b's payments under the swap are based on a notional, rather than an actual, principal amount. 62. query, however, whether the arrangement between a and b could be construed as a constructive partnership, the assets of which are the stocks making up the djia, and in which a owns a preferred equity interest (having a liquidation price of $1,000x) and b holds the common interest. in such case, a would probably be treated as having initially contributed the underlying stocks to the partnership in exchange for all the preferred and common equity interests therein and then as having sold the common interest to b in exchange for the right to receive the fixed payments from b under the swap. query also whether, if the entering into the equity swap should be treated as if a sold the underlying stocks to b, should the swap's termination be treated as a sale of the stocks by b back to a? obviously, both of these analyses seem strained. 63. of course, by entering into the swap, a may suffer adverse tax consequences if the stocks making up the djia decrease in value. in such case, a will receive payments from b under the swap in an amount equal to such decrease, which will generally be currently taxable to a as ordinary income. while as an economic matter such payments will be offset by the unrealized loss on the stock portfolio, the latter will not give rise to a tax benefit until a disposes of the depreciated shares in a taxable transaction not subject to the wash sale rules of section 1091, at which time the resulting loss will generally be recognized as capital loss which may be unusable by a. thus, if, at the outset, it was anticipated that the underlying shares were as likely to decrease in value as to increase in value, a might be expected to suffer from a net tax detriment, or, at the very least, not receive a net tax benefit, as a result of receiving and making payments under the swap. any such net detriment, of course, would have to be compared to the other non-tax and tax benefits from entering into the transaction to see whether, overall, entering into the swap was more beneficial to a than alternative transactions. this analysis might suggest that, at least under current law, securities dealers are the most likely candidates to be a. first, dealers that use the lower-of-cost-or-market-value method of accounting for their inventories are essentially able to deduct losses with respect to those [vol 1:5 selected issues in the taation of swaps advantaged asset and, once again, the question is whether the service can avoid this result by applying section 1092 or proposed regulations section 1.446-3(e). and here, even more so than is the case with the bond/interest rate swap transactions discussed above, the answer seems to be no. in particular, section 1092(d)(3)(a) states that, except as otherwise provided in section 1092(d)(3)(b), the term personal property for purposes of section 1092 does not include stock. section 1092(d)(3)(b) contains exceptions for (i) stock held as part of a straddle in which at least one of the offsetting positions is an option or, "under regulations, a position with respect to substantially similar or related property (other than stock),"6' or (ii) "any stock of a corporation formed or availed of to take positions in personal property which offset positions taken by any shareholder." it would appear that the equity swap in our example is not part of a straddle since, while it is a position with respect to personal property for section 1092 purposes, it neither offsets, nor is offset by, another position in personal property. accordingly, under current law, a should be able to deduct currently its payments under the equity swap. 4. dividend capture and equi., swaps.-what are the tax consequences to a of its obligation to make payments to b under the equity swap with respect to dividends declared and paid on the underlying stocks? in particular, if a is a corporation, will a be allowed to claim the drd with respect to dividends received on its long position in the underlying stocks, while at the same time deducting the offsetting payments to be made to b under the equity swap? if it can, a net deduction to a will result,6 which stocks without actually disposing of them, but are not required to recognize gains with respect to those inventories until they actual sell the underlying stocks. but see h.r. 11, 102d cong., 2d sess. § 3001 (1992) (requiring mark-to-market accounting for securities dealers' inventories), vetoed last year by president bush, and prop. regs. § 1.446-4, 56 fed. reg. 31,350 (1991) (providing an optional mark-to-market election for dealers and traders in derivative financial instruments, conditioned on neither the taxpayer nor any related party using the lower-of-cost-or-market-value method with respect to dealer or trading accounts in securities or commodities). the clinton administration has also proposed requiring securities dealers to mark their inventories of marketable securities to market value at each year-end. see dept. of the treasury, summary of the administration's revenue proposals 46-47 (feb. 1993), tax notes microfiche database doc. 93-2657 (mar. 1, 1993). second, section 1091 does not apply to sales made in the ordinary course of business by dealers in stock or securities. 64. no such regulations have been issued to date. the legislative history to section 1092 states that congress intended that any such regulations should only apply prospectively (i.e., to transactions entered into after the date such regulations are issued), except in the case of certain specified transactions (none of which involve equity swaps). h.r. rep. no. 861, 98th cong., 2d sess. 908 (1984). 65. for example, if a were entitled to the 70% drd with respect to dividends received on the underlying stocks while being allowed to deduct the offsetting payments made 19931 florida tax review a can then use to shelter other income, effectively converting that income into tax-advantaged dividend income. this, of course, is like an old-fashioned dividend capture strategy, a classic form of tax arbitrage, and the service seems to be on firm ground in disallowing a deduction for the dividend-based payments on the equity swap.' thus, section 246(c)(1)(b) disallows the drd "in respect of any dividend on any share of stock ... to the extent that the taxpayer is under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property." it does not seem too difficult to conclude that the equity swap should be considered a position in substantially similar or related property (indeed, the same property) for this purpose or that the dividend-based payments under the swap should be considered to be related payments for purposes of section 246(c)(1)(b). but what if a, perhaps counselled by a clever tax lawyer, alters the overall transaction a bit. for example, suppose that the equity swap is not based on values of the djia, but on a selected basket of particular publiclytraded stocks ("basket 1"). suppose further that, instead of being required to make payments to b under the swap based on the actual dividends declared and paid each month on the stocks making up basket 1, a is required to pay b an amount, fixed at the outset of the swap, which just happens to equal 1/12th of the average aggregate amount of dividends paid yearly on the basket 1 stocks over the three-year period prior to the date on which the parties entered into the swap. also assume that the aggregate dividend yield on the basket 1 stocks has been relatively constant, year-to-year, over the past ten years and that it is believed that this will continue to be the case over the course of the life of the swap.67 finally, suppose that a in fact owns none of the stocks comprising basket 1, but instead owns only particular publicly-traded shares making up a second basket ("basket 2"), and that the overall price performance/dividend yield of the basket 2 stocks is expected to be highly, but not perfectly, correlated with that of basket 1. here, application of section 246(c)(1)(b) to dividends received on the basket 2 stocks is more difficult and raises two issues. the first is whether the stocks making up basket 1 should be considered substantially similar or related to those comprising basket 2 for purposes of section 246(c)(1)(b). to b under the equity swap with respect to such dividends, a net deduction equal to 70% of the amount of dividends received (i.e., equal to the drd) would have been created. 66. the perceived abuses of dividend capture strategies led to the enactment of section 246(c). see h.r. rep. no. 775, 85th cong., 1st sess. 14 (1957); h.r. rep. no. 432, supra note 35, at 1180. 67. for example, suppose the stocks making up basket 1 are predominantly preferred stocks having fixed dividends terms. [vol. 1:5 selected issues in the taration of swaps the second is whether the fixed payments to be made by a to b under the swap should be considered related payments for purposes of that section. the service's position with respect to the first issue is suggested by i.r.s. technical advice memorandum 9128050 (apr. 4, 1991). in that memorandum, the service applied section 246(c)(1)(b) to a "preferred stock rollover" program. the taxpayer in the memorandum had purchased multiple baskets of dividend-paying preferred stock, and, at the same time, had sold short baskets of other dividend-paying preferred stock. the taxpayer was required to make dividend-equivalent payments with respect to the stocks comprising the short baskets. there was no overlap between the stocks making up the long baskets and the short baskets; nevertheless, the stocks making up the long and short baskets had been selected so that the all-in return (price change and dividend yield) of the long and short baskets were expected to be highly (inversely) correlated over the life of the program, thereby reducing, to the greatest extent possible, the taxpayer's economic risk from entering into the transaction. the service, on these facts, concluded that, given the high correlation between the expected economic performance of the long and short baskets and the purpose of section 246(c)(1)(b) to prevent tax arbitrage schemes involving use of the drd, the stocks in the short baskets should be considered substantially similar or related to the stocks comprising the long baskets, with the result under section 246(c)(1)(b) that no drd was allowed with respect to dividends received on the stocks making up the long basket. while some might criticize the reasoning of the memorandum as representing an overly expansive interpretation of the statute, the result is not unreasonable. and it is not difficult to see how the reasoning of the memorandum could be applied to the facts of our equity swap transaction. the second issue is whether the fixed payments on the equity swap constitute related payments with respect to dividends received on the basket 2 stocks. in particular, does the fact that they are based on the historic, rather than the actual, dividend yield on the basket 1 stocks insulate them from being related payments? probably not. given the expected correlation between the fixed payments on the equity swap and the dividends actually paid on the basket 1 stocks, which, in turn, are anticipated to mimic the dividend payments on the basket 2 stocks, and the fact that the statute merely requires that the fixed payments be related (not identical) to dividends on the basket 1 stocks, it is likely that the service could successfully contend that the fixed payments are indeed related payments. 5. equity swaps and withholding taxes.-equity swaps can be used to achieve a variety of economic goals. thus, an institutional investor can employ an equity swap to diversify its portfolio, effectively shifting from fixed income securities into stocks, from stocks into fixed income securities, 19931 florida tax review or from one basket of stocks into another, without incurring the transaction costs and capital gains taxes that would otherwise be incurred in actually selling and buying physical securities. additionally, equity swaps can be used, like over-the-counter options and forward contracts, to provide a customized hedge for an existing position in stocks. however, equity swaps can also be used for another purpose, one that is far more troubling to the service. for example, as scholes and wolfson point out, equity swaps are (potentially) a convenient way for foreign investors to avoid withholding taxes on dividends.68 in particular, if dividends paid on (physical) stock are subject to withholding tax, while dividend-based payments on equity swaps are not, the after-tax returns to foreign investors will be enhanced by substituting equity swaps for positions in (physical) stocks with little, if any, change in the non-tax characteristics and performance of those investors' portfolios.69 two questions thus arise: (1) are dividend-based payments on equity swaps subject to u.s. withholding taxes under current law? and (2) regardless of the result under current law, should withholding taxes be imposed on such payments as a matter of u.s. tax policy? the answer to the first question appears to be no. under regulations section 1.863-7, income attributable to a notional principal contract is generally sourced according to the tax residence of the taxpayer. thus, a nonu.s. counterparty receiving payments with respect to a notional principal contract from a u.s. counterparty will generally be considered as receiving foreign source income7° not subject to u.s. withholding tax.7' like proposed regulations section 1.446-3, regulations section 1.863-7 defines a notional principal contract as "a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated 68. scholes & wolfson, supra note 9, at 419-425. 69. the most significant non-tax differences between entering into an equity swap and acquiring physical stocks are that, in the former case, (i) the foreign investor is taking the credit risk of the swap counterparty, which, depending on the circumstances, may or may not be material, and (ii) the foreign investor has no voting rights vis-a-vis the issuers of the underlying stocks, which may have ramifications with respect to corporate control issues. this is not to say, however, that entering into an equity swap is tantamount to acquiring physical stock. see discussion supra part ii(c)(2). 70. an exception applies, however, to notional principal contract income that, under principles similar to those set forth in regulations section 1.864-4(c), is considered to arise from the conduct of a u.s. trade or business by the non-u.s. person. such income is considered to be effectively connected u.s. source income. regs. § 1.863-7(b)(3). nevertheless, such income would still not be subject to u.s. withholding tax. irc §§ 1441(c)(1), 1442(a). 71. sections 1441(a) and 1442(a) apply only to u.s. source fixed or determinable annual or periodic income that is not effectively connected with a u.s. trade or business. see also irc §§ 871(a), 881(a). [vol 1:5 selected issues in the taxation of swaps by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts." while regulations section 1.863-7 does not explicitly state that an equity swap constitutes a notional principal contract, both the plain language of this definition and the examples given in proposed regulations section 1.4463(c)(1)(ii) strongly suggest that income with respect to equity swaps is sourced according to the rules set forth in regulations section 1.863-7. accordingly, all payments made to non-u.s. counterparties under equity swaps, including those based on dividends declared and paid on the underlying portfolio of stocks, should generally be free and clear of u.s. withholding under current law.72 nevertheless, the service is clearly concerned by this conclusion. in the preambles to both proposed regulations section 1.446-3 and the proposed "securities lending" regulations,73 the service warned that it was currently studying wvhether or not payments on equity (and equity index) swaps "should be treated in the same manner as interest rate and commodity swaps for sourcing and withholding tax purposes." what is the right answer to the question of whether dividend-based payments on equity swaps should be subject to u.s. withholding taxes? as discussed above with respect to the question of whether entering into an equity swap should be treated as a disposition of the underlying stock, an equity swap, while similar to and derivative of the underlying stock, is not the same as the underlying stock, at least under general tax principles.' in particular, the non-u.s. investor has only a contractual right to receive certain amounts from the counterparty, who may or may not own any of the underlying stocks. under general principles such a contractual claim would not be considered equivalent to actual ownership of the underlying stocks. 72. any portion of a swap payment recharacterized as interest pursuant to proposed regulations sections 1.446-3 (e)(4)(iii) (swap with significant nonperiodic payments treated as containing embedded loan), 1.446-3(e)(4)(ii) (hedged swaps recharacterized according to their economic substance) or 1.446-3(0 (the general anti-abuse rule) will, of course, be subject to the general rules dealing with withholding on interest payments. see generally irc §§ 871(a)(1)(a), (a)(1)(c), (g), (h); 881(a)(1), (a)(3), (c); 1441(a), (c)(8). (c)(9); 1442(a). 73. prop. regs. §§ 1.861-2(a)(7), 1.861-3(a)(6). 1.871-7(b)(2). 1.881-2(b)(2). 1.8941(c), 1.1441-2(a)(1), 57 fed. reg. 860 (1992). 74. i am assuming that the counterparty on the swap is not an issuer with respect to the underlying stock (i.e., we are not talking about ford. for example, entering into an equity swap with respect to its own stock). such a situation would probably result in a different conclusion, since it would open up all sorts of possibilities for creating "homemade corporation integration." query, however, whether two different corporations, both having similar economic prospects (i.e., similar business opportunities. similar financial and operational leverage, similar dividend payout ratios, etc.), should be able to enter into equity swaps with third parties on each other's stock and deduct the payments. 1993] florida tax review nevertheless, one might argue that this is an overly formalistic view of the issue. after all, if, since equity swaps and physical stocks are (not quite perfect) economic substitutes for each other,75 and the receipt of dividend-based payments on equity swaps substitute for the receipt of dividends on the underlying stocks, perhaps dividend-based swap payments and actual dividends should be taxed in the same manner. this approach finds some support in other areas of the code. for example, in the regulations under section 1504(a)(5)(a), a broad range of financial instruments, including cash settlement options, are treated, under certain circumstances, as if they were stock for purposes of determining whether the stock affiliation rules of section 1504(a) are satisfied, even though, in general, such instruments would not be treated as stock for tax purposes. 6 similarly, the option attribution rules of sections 382(l)(3) and 382(k)(6)(b), and the regulations promulgated thereunder, in essence, treat certain equity-flavored financial instruments as if they constituted stock for purposes of the section 382 ownership rules under certain circumstances.77 finally, the proposed securities lending regulations themselves apply "look through treatment" for withholding tax purposes to payments in lieu of interest and dividends received by non-u.s. persons in securities lending transactions. on the other hand, this approach is more the exception than the rule in the tax law. thus, even a relatively deeply-in-the-money option on a growth stock (i.e., one with respect to which the investor's return is anticipated to come in the form of price appreciation, rather than dividend payments) is generally not treated as equivalent to the underlying stock for tax purposes, even though, for all practical purposes, the option may be an economically perfect substitute for the physical stock. similarly, absent special circumstances, a note issued by the buyer to the seller with respect to a sale of a business is not generally considered to be a continuing equity interest in that business, and payments on the note are treated as interest, even though such payments may be based on profits earned by the business. the same might be said of money market preferred stock: even though payments thereon may be based on prevailing money market interest rates, such stock is generally considered to be equity and payments thereon are 75. see supra note 69. 76. regs. § 1.1504-4. these regulations, of course, were promulgated pursuant to an explicit statutory grant of authority to "treat warrants, obligations convertible into stock, and other similar interests as stock." irc § 1504(a)(5)(a). it is also perhaps significant that options issued between persons that are unrelated to the affiliated group of which the issuing corporation is a member are not generally subject to these rules. see regs. § 1.1504-4(c)(4)(ii)(b)(2). 77. again, these rules are based on specific statutory provisions, and not merely on general tax principles or policies. [vol 1:5 selected issues in the taxation of swaps generally considered to be dividends for tax purposes. indeed, the service's treatment of income from swaps other than equity swaps supports this point. thus, as discussed above, the service does not treat interest rate swap income and expense as interest, even though it is based on prevailing interest rates, and the service clearly intends to continue to apply the rules of regulations section 1.863-7, rather than the sourcing rules for interest contained in sections 861(a)(1) and 862(a)(1), to interest rate swap payments. 78 nevertheless, the potential use of equity swaps to avoid u.s. withholding taxes may still trouble some readers. perhaps concern should be greatest when the equity swap is with respect to only a single underlying stock, or a small group of stocks-in that case, the putative non-tax purposes for entering into an equity swap (e.g., portfolio diversification and avoidance of transaction costs) are least likely to be at issue, and the swap was likely entered into primarily to avoid u.s. withholding taxes.79 furthermore, as noted above, the policy judgment to treat dividend-based payments the same as "real" dividends for withholding tax purposes has already been made in the securities lending context, and it might be thought anomalous to have a different rule for equity swaps. there are no definitive answers to these questions, but a few observations can be made. first, any attempt to distinguish "large basket" equity swaps from single equity or "small basket" swaps will be inevitably arbitrary. even accepting for purposes of argument that single equity or small basket equity swaps present the greatest potential for tax abuse with the least likely presence of countervailing business purposes, how can the line be drawn in a principled manner? if one stock is too little, how about two stocks, or three? does it matter if the price movements of all the stocks in the basket are expected to be highly correlated, thus arguably undercutting the portfolio diversification argument, even if there are a large number of stocks in the basket? and diversification is generally thought to be a function of the 78. it is true, of course, that the drafters of regulations section 1.863-7 did not lose much, if any, potential revenue for the fisc by treating interest rate swap payments as foreign source income, since most interest payments on real debt are not subject to withholding tax because of the portfolio interest rules of sections 871(h) and 881(c). nevertheless, there are certain cases where interest remains subject to withholding tax (e.g., interest received by a 10% shareholder, a related controlled foreign corporation, or by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of the bank's trade or business) and yet the regulations do not attempt to recharacterize interest rate swap payments as interest for purposes of applying these exceptions. 79. of course, while the lack of a bona fide business purpose may suggest that payments on a given type of equity swap should be subject to withholding taxes, the presence of a bona fide business purpose should not necessarily insulate swap payments from tax. the acquisition of stock may be made for the most compelling of business purposes and yet dividends on the stock are subject to withholding taxes. 19931 florida tax review taxpayer's overall portfolio, rather than simply of the stocks in the particular basket underlying the equity swap. nevertheless, if withholding taxes are to be collected by withholding agents, and if not all equity swaps are to be treated the same, some clear and objective lines must be drawn, based on the four comers of the swap contract and not on facts that may be known only to the non-u.s. swap counterparty or on the application of portfolio theory to particular facts. second, while the securities lending regulations do apply lookthrough treatment to (and therefore impose withholding tax on) dividend equivalent payments, securities lending transactions are distinguishable from equity swaps in an important way: the non-u.s. lender in a securities lending transaction actually owned physical stock prior to entering into the transaction, and will own physical stock again at the conclusion of the transaction.80 this important link between the non-u.s. lender and the ownership of physical stock makes a more compelling case for imposing withholding taxes in securities lending transactions as compared to equity swaps. finally, perhaps it is significant that equity swaps do not have to involve physical stocks, directly or indirectly. there is no requirement that the counterparty making the equity-based payments on the swap actually hold stock.8 thus, there is at least the potential that the aggregate amount of dividend-based payments on equity swaps may exceed the aggregate amount of dividends actually paid on the underlying stock, thereby multiplying (perhaps dramatically) the amount of dividend-related income subject to u.s. tax.82 80. indeed, in a securities lending transaction subject to section 1058, the agreement must provide that the lender may terminate the loan, and thus reacquire the physical securities, on no more than five business day's notice. see prop. regs. § 1.1058-1(b)(3), 48 fed. reg. 33,912 (1983). 81. it is probably the case, of course, that many, perhaps most, counterparties will hedge their obligations to make equity-based payments under the swap by holding physical stocks. 82. this would not be the case, however, if the u.s. counterparty hedged its exposure on the swap by holding physical securities. in such case, while receipt of the dividend would be includable in the u.s. counterparty's gross income, the u.s. counterparty would be entitled to an offsetting deduction for the related payment made to the non-u.s. counterparty under the swap. thus, unless the swap payment were subject to withholding tax, the dividend would have escaped u.s. tax. while this might suggest that a distinction should be drawn between a case where the u.s. counterparty hedges its exposure using physical stock, and one where it does not, it would certainly be strange if the non-u.s. counterparty's tax treatment turned on how the u.s. counterparty hedged its exposure under the swap. given the look-through treatment mandated by the proposed securities lending regulations, the potential for multiple u.s. taxation discussed in the text would also exist in any case where a stock lending arrangement involves a u.s. borrower and a non-u.s. lender and the borrower sells the borrowed stock short to a third party (i.e., goes unhedged). query [vol 1:5 selected issues in the taation of swaps d. section 382 and swaps this subpart explores an issue that, while not directly involving the taxation of swaps, has increasing relevance to end users of swaps. as swaps have become an increasingly important tool for corporate america for purposes of managing asset and liability exposures, they have begun to appear more frequently on the balance sheets of "loss corporations" undergoing ownership changes for purposes of section 382. the question thus arises as to how swaps are to be treated for purposes of the "built-in gain and loss" rules of section 382(h). a swap is a somewhat strange animal. like the lessee's interest in a leasehold, it is a combination of an asset (namely, the right to receive payments from the swap counterparty) and a liability (namely, the obligation to make payments to the swap counterparty). thus, at any given time, in relation to any given counterparty, a swap may have either a positive or a negative value, depending on the relationship between the present value of the asset leg of the swap and the present value of the liability leg.' take, for example, the interest rate swap described earlier. depending on the relative changes in interest rates since the inception of the swap, this swap at any time will have either a positive or a negative value to one of the counterparties, for example, a, and a negative or a positive value of an equal amount to the other counterparty, for example, b.' this is equivalent to saying that, where the swap has a negative value of $10 to a, a would have to pay b or a third party $10 to terminate or assign the swap; similarly, where the swap has a positive value of $10 to a, b or a third party would have to pay a $10 to induce a to terminate or assign the swap. how are swaps then to be treated for purposes of section 382(h)? section 382(h) provides that, for any year during the five-year period after an ownership change (the "recognition period"), the loss corporation's whether equity swaps or stock loan transactions are more likely to involve liabilities unhedged by ownership of physical stocks. see also tax section, new york state bar association. report no. 275: report on proposed regulations on certain payments made pursuant to securities lending transactions 12-16 (1992) (discussing the policy objectives underlying the proposed securities lending regulations' treatment of substitute dividend and interest payments as dividend and interest). 83. alternatively, a swap might be viewed as a (net) asset when it has a positive value, and a (net) liability when it has a negative value. cf. preamble to prop. regs. § 1.1092(d)-1, 56 fed. reg. 31,350 (1991) ("there has been some question whether a financial product such as an interest rate swap, which may be either an asset or a liability depending on the movement of interest rates, constitutes an interest in personal property that is subject to section 1092 and section 1234a"). 84. that is, if the swap has a $10 positive value to a at a given time, it will have a $10 negative value to b at that time, and vice versa. 19931 florida tax review annual limitation for section 382(a) purposes (i.e., the amount of taxable income for such year that can be offset by pre-ownership change losses) is increased by the amount of "recognized built-in gain" for that year. conversely, any "recognized built-in loss" recognized by the loss corporation during the recognition period is treated as a pre-ownership change loss subject to the limitations of section 382(a). these rules only apply if the loss corporation had a "net unrealized built-in gain" or a "net unrealized built-in loss," as the case may be, at the time of the ownership change. for this purpose, a recognized built-in gain means any gain recognized by the loss corporation during the recognition period on the disposition of an asset to the extent the loss corporation establishes that the asset was held by it immediately prior to the ownership change and the amount of the recognized gain does not exceed the gain inherent in the asset at that time. subject to a de minimis and other special rules, the net unrealized built-in gain at the time of any ownership change equals the excess of the aggregate fair market value of the loss corporation's assets immediately prior to the ownership change over the loss corporation's aggregate tax basis in those assets at that time. recognized built-in loss and net unrealized built-in loss are defined in an analogous manner.8 5 the aggregate amount of recognized built-in gain or loss over the five-year recognition period cannot exceed the net unrealized built-in gain or loss, as the case may, at the time of the ownership change. how should swaps be treated for purposes of the section 382(h) calculation of net unrealized built-in gain or loss? for example, if a swap has a positive value at the time of an ownership change, should the amount of net unrealized built-in gain be increased by an equal amount (or, conversely, should the amount of net unrealized built-in loss be decreased by such amount)? similarly, what happens if the swap has a negative value at the time of the ownership change. should this decrease (increase) the amount of net unrealized built-in gain (loss) for section 382(h) purposes? alternatively, given the definitions of net unrealized built-in gain and loss (looking, as they do, to the value of the corporation's assets immediately before the ownership change), should the "asset leg" (i.e., the right to receive payments from the counterparty) of the swap be valued separately from the "liability leg" (i.e., the obligation to make payments to the counterparty) and only the former taken into account for section 382(h) purposes.86 the answer to these questions is not completely clear, in great part 85. recognized built-in loss also includes any depreciation, amortization, or depletion deductions recognized during the recognition period to the extent such deductions reflect a loss inherent in an asset at the time of the ownership change. 86. alternatively, should swaps be taken into account only when they have positive values and thus constitute net "assets," but not when they have negative values and thus constitute net "liabilities"? [vol 1:5 selected issues in the taration of swaps because the treatment of liabilities, in general, is not clear under section 382(h). thus, low coupon debt (or, alternatively, high coupon debt) may constitute a potential economic benefit (or detriment) to the loss corporation at the time of the ownership change. more importantly, such debt represents a future source of taxable income (or deductions) that, absent the ownership change, could have been offset by the loss corporation's net operating losses in future periods (or, in the case of high coupon debt, would have increased those losses in future periods).87 thus, if, as appears likely, the purpose of the section 382(h) rules is to determine the maximum amount of taxable income or loss that the loss corporation would have generated if it had sold all its assets and paid off all its liabilities immediately prior to the ownership change, the inherent gain or loss with respect to the loss corporation's liabilities, as well as the inherent gain or loss in its assets, should be taken into account in determining net unrealized built-in gain or loss. while the statutory language, speaking as it does of the value of the loss corporation's assets immediately prior to the ownership change, seems to preclude this result with respect to "garden variety" liabilities, i believe that no damage to the statutory language will result if swaps are treated as a single instrument (i.e., the asset leg is not separated from the liability leg) capable of having either a positive or a negative value for section 382(h) purposes." under what circumstances should the inherent gain or loss in the swap be treated as having been recognized for purposes of increasing recognized built-in gain or loss? as noted above, the definition of recognized builtin gain or loss refers generally only to gain or loss recognized on a disposition of an asset. section 382(h)(6) expands this definition to include income or deductions recognized during the recognition period but attributable to preownership change periods. while it seems clear that gain or loss recognized on the termination or assignment of a swap may constitute recognized built-in gain or loss, what if the swap is held until maturity and the gain or loss is recognized over the term of the swap as increased net income or deduction? will this constitute recognized built-in gain or loss pursuant to section 382(h)(6)? here, particularly given the fact that the amount of net income or deduction recognized with respect to the swap in any future period depends on the future movements of the index or indices (e.g., libor) that determine each party's obligations under the swap, it seems hard to believe that this income or deduction could be viewed as attributable to pre-ownership change periods, any more than the coupon interest received in post-ownership change 87. see, e.g., priv. let rul. 9226026 (mar. 26. 1992) & priv. let. rul. 9124053 (mar. 20, 1991) (dealing with cancellation of indebtedness income and treating it as built-in income under section 382(h)(6)). 88. as noted above, similar issues arise under section 382(h) with respect to the lessee's interest in a leasehold, and similar mixed asset-liability contractual undertakings. 1993] florida tax review periods on a high coupon debt instrument held by the loss corporation as an asset at the time of the ownership change could be so viewed. im. structured finance a. basic structure and goals last year, corporate financing week reported that merrill lynch had developed and was marketing a product that allowed investors to take maximum advantage of the drd.89 according to that report, the product involved creating a state law trust (the "trust") that would acquire dividendpaying stock of u.s. issuers.9" the trust would raise the cash to buy the stock by issuing two classes of trust certificates. holders of the first class of certificates (the "preferred certificates") were entitled to receive (i) a fixed amount upon liquidation of the trust (equal to approximately fifty percent of the purchase price for the underlying stocks) and (ii) a current return based on prevailing money market interest rates. holders of the second class of certificates (the "common certificates"; the preferred certificates and the common certificates, collectively, the "certificates") were entitled to receive, both currently and upon liquidation, any cash flow of the trust remaining after payment of the amounts to which the preferred certificate holders were entitled.9" thus, the common certificates were effectively subordinated to the preferred certificates.' because these transactions were done as private placements, their 89. merrill splits percs in two, corp. financing wk., aug. 3, 1992, at 1. 90. in particular, the trust would acquire "preferred equity redeemable cumulative securities" ("percs"), which are preferred stocks having a relatively high dividend yield and are mandatorily convertible into the issuer's common stock after a fixed period of time. 91. thus, if the trust receives $10 of dividends on the underlying stock during a given period and is required to pay $4 with respect to the preferred certificates, the common certificates will be entitled to $6. because the current return on the preferred certificates is based on prevailing money market interest rates, the current return on the common certificates is inversely correlated to changes in money market interest rates. the common certificateholders' position is thus akin to an "inverse floater" class in a real estate mortgage investment conduit. similarly, since the common certificates are entitled to all the liquidation proceeds from the trust after payment of the preferred certificate's priority fixed liquidation amount, the common certificate holders enjoy 100% of the upside, and the first loss position on the downside, with respect to the underlying stocks. 92. the structure of the trust resembles the americus trust prime and score transactions that were done in the early 1980s. see, e.g., americus trust for american home products shares, dec. 1, 1986 prospectus. while existing americus trusts were treated as grantor trusts for tax purposes pursuant to a series of private rulings from the service, similar trusts established today cannot qualify as grantor trusts. regs. § 301.7701-4(c), ex. 3. [vol. 1:5 selected issues in the taxation of swaps operative documents are not generally available. nevertheless, it is not too difficult to "reverse engineer" these transactions from an economic and tax perspective. in particular, these transactions probably achieved three goals that are common to many, if not most, structured finance transactions today: (i) dividing up, and in some cases restructuring, the cash flows from the underlying trust assets into multiple classes of certificates in order to better meet the economic risk and reward profiles of different investors,93 (ii) making the trust "tax transparent" so that income from the trust assets is subject to only a single layer of tax at the certificate holder level (and not a second layer of tax at the trust level), and (iii) passing through to the corporate certificate holders the tax-advantaged character (here, the drd) of the trust income to the greatest extent possible. 4 by achieving all these goals, the sponsor of the transaction, merrill lynch in our case, can maximize the value of the underlying assets, thereby increasing the proceeds to the original owner(s) of those assets (who will generally be selling them to the trust or other issuing vehicle) and, hopefully, earn a big fee for itself. b. dividing up cash flows to better meet investor objectives how the merrill lynch product satisfies the first goal set forth above is relatively straightforward. the two classes of certificates have different 93. in part because of tax considerations (i.e., the need to ensure that the trust or other issuing vehicle is not subject to an entity-level tax), some structured finance transactions, particularly those involving auto loans or other non-equity receivables, do not appear to achieve this first goal. instead, such transactions are structured as "pass-throughs," in which all the cash flow from the underlying assets is passed through currently to the investors on a pro rata basis. even in those cases, however, the seller or servicer of the assets commonly retains a subordinated interest in the assets in the form of a right to receive "'excess servicing" (i.e., a right to receive amounts for servicing the assets in excess of reasonable compensation for services rendered) or of an "interest strip" which entitles the seller/servicer to all the interest on the underlying assets in excess of amounts necessary to pay pass-through interest on the investor certificates and trust expenses. thus, even these transactions divide up the cash flows from the underlying assets to better meet the risk/reward profiles of particular investing groups. 94. sometimes, the tax benefits attributable to the underlying assets will be more valuable to one type of investor than to another. for example, the 50% interst exclusion for employee stock ownership plan ("esop") loans under section 133 is available only to banks, insurance companies, regulated investment companies, and corporations actively engaged in the business of lending money. accordingly, structured finance transactions involving esop loans sometimes involve two classes of investor interests, one of which (structured in the form of equity certificates) is entitled to the section 133 exclusion and is sold to the types of qualifying financial institutions set forth in section 133, and the other of which (structured as debt obligations) is not entitled to such benefits and is sold to non-qualifying investors. this, of course, is a combination of goals (i) and (iii) described in the text, and these transactions have an obvious kinship to real estate syndications and leveraged lease transactions. 19931 florida tax review risk and reward profiles and would therefore generally appeal to different types of investors. for example, the common certificates, by virtue of their subordination to the preferred certificates, the fact that their current return is inversely correlated to changes in interest rates, and the fact that they are entitled to 100% of the upside on the underlying portfolio, bear substantially more risk and have a greater potential for reward than the preferred certificates; 95 accordingly, the common certificate holders should earn a greater return, on average, over the life of the transaction than the preferred certificate holders. in general, then, the preferred certificates should appeal more to risk-averse investors and the common certificates should appeal more to risk-taking investors. by issuing two classes of certificates, rather than a single class of "straight up," pro rata pass-through certificates, merrill lynch is able to offer a "pure play" to each class of investor; each investor is therefore able to buy the type of certificate that best meets its particular economic needs and desires, and is willing to "pay up" for that opportunity. c. tax transparency the second goal is that of tax transparency of the trust. obviously, to the extent that cash flows from the underlying stocks are subject to two layers of tax, the after-tax returns to the certificate holders, and the amount they are willing to pay for the certificates, will be reduced. the analysis of whether the trust will be subject to an entity-level tax begins with regulations section 301.7701-4(c) (the "trust classification regulations"). generally speaking, a state law trust used in a structured finance transaction can be taxable in one of three ways: (i) as a fixed investment trust, taxable as a grantor trust under subpart e of subchapter j of chapter 1 of the code (sections 671, et seq.),96 (ii) as a partnership, or (iii) as an association taxable as a corporation.' the first two vehicles, fixed 95. in essence, the common certificates represent a leveraged investment in the underlying stocks. alternatively, the preferred certificate holders could be viewed as "owning" the underlying stock and as having sold a call to, and bought a put from (the call and put having different strike prices), the common certificate holders. in such case, it is unclear how the common certificate holders' right to receive dividends from the stocks should be characterized. for example, should they be treated as constructive option premiums? nevertheless, this seems a bit of substance-over-form analysis gone amok. 96. grantor trusts are transparent entities for federal income tax purposes. thus, each certificate holder in a grantor trust is treated as if it owned directly its pro rata share of the trust's assets and earned, or incurred, directly its pro rata share of the trust's income and expenses. 97. this tripartite classification scheme, of course, is something of a simplification. in particular, it overlooks such important structured finance vehicles as "real estate mortgage [vol 1:5 selected issues in the taxtion of swaps investment trusts taxable as grantor trusts and partnerships, are tax transparent. the latter vehicle, an association, is not, and tax lawyers therefore generally attempt to structure transactions to avoid association status. under regulations section 301.7701-4(c),98 a fixed investment trust is a trust (i) in which "there is no power under the trust agreement to vary the investment of the certificate holders" 99 and (ii) which only has a single class of certificates. notwithstanding (ii), multiple classes of trust certificates are permitted where "the trust is formed to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership interests is incidental to that purpose." thus, example 2 of the trust classification regulations applies the "incidental to the direct investment purpose" exception to a case where the trust, which holds a pool of residential mortgages, issues two classes of certificates. one of the classes of certificates is subordinated to the other in the case of defaults on the underlying mortgages, but each class is otherwise entitled to a straight up, pro rata share of the trust's cash flow."°n similarly, example 4 of the trust classification regulations applies investment conduits" ("remics") taxable under sections 860a-860g, "real estate investment trusts" ("reits") taxable under sections 856-859, "regulated investment companies" ("rics-) taxable under sections 851-855, "publicly traded partnerships" taxable as corporations under section 7704, and "taxable mortgage pools" taxable as corporations under section 7701(i). in most cases, of course, tax lawyers avoid having an issuing vehicle taxed as a publicly traded partnership or taxable mortgage pool, since both of these vehicles are subject to an entity-level tax. 98. the trust classification regulations are commonly referred to as the "sears regulations" since they were issued in the wake of a proposed trust offering by sears mortgage securities corporation in 1983 in which there were multiple classes of ownership certificates, with different classes being entitled to receive principal payments in sequential order (i.e., 100% of the principal payments received on the underlying mortgages was paid to the earliest maturing class of certificates until they were fully retired, then 100% of the principal received was paid to the second earliest maturing class of certificates until they were fully retired, and so on). tax counsel to sears had opined that the trust would qualify as a fixed investment trust taxable as a grantor trust. the service disagreed with this analysis, as set forth in the trust classification regulations. the trust classification regulations seem to be animated by a concern that, given that the trust tax accounting rules lack the refinement, flexibility, and anti-abuse protections of section 704(b)-(c) (dealing with partnership allocations), taxable income generated by the trust assets will go untaxed at the certificate holder level (or, alternatively, will be taxed to the "wrong" certificate holders) unless fixed investment trust status is limited to relatively simple transactions. see preamble to regs. § 301.7701-4. t.d. 8080, 1986-1 c.b. 371. 99. tax lawyers generally view this restriction as a prohibition on the reinvestment of cash flows from the underlying trust assets. nevertheless, certain incidental reinvestment activity is allowed. see, e.g., rev. rul. 75-192, 1975-1 c.b. 384 (allowing short term reinvestment of cash flows from trust assets pending distribution of the same to certificate holders on next regularly scheduled distribution date). 100. the example reaches the conclusion that the "incidental to the direct investment purpose" exception applies by analogizing the transaction to one in which the 19931 florida tax review the exception to a case where the trust's assets consist of a portfolio of bonds, and the trust issues multiple classes of certificates to the public each of which "represents the right to receive a particular payment with respect to a specific bond." here, the example concludes that since section 1286 treats a stripped coupon or bond as a separate, newly-issued debt obligation for federal income tax purposes and "the multiple classes simply provide each certificate holder with a direct interest in what is treated under section 1286 as a separate bond," and "[g]iven the similarity of the interests acquired by the certificate holders to the interests that could be acquired by direct investment, the multiple classes of trust interests merely facilitate direct investment in the assets held by the trust." the trust in the merrill lynch transaction has multiple classes of certificates (i.e., the preferred certificates and the common certificates). like the trust interests at issue in example 2 of the trust classification regulations, the common certificates are subordinated to the preferred certificates. because the bond stripping rules of section 1286 apply only to debt obligations, however, the rationale of example 4 of those regulations does not apply to the trust. rather, the interests held by each class of certificate holder do, indeed, seem to differ from a direct investment in the underlying stocks, and as discussed above, are intended to so differ. in fact, the trust seems much closer to the transaction described in example 3 of the trust classification regulations. example 3 involves a trust holding publicly-traded stock. there are two classes of trust certificates, one of which represents "the right to dividends and the value of the underlying stock up to a specified amount; the other certificate represents the right to appreciation in the stock's value above the specified amount."'' on these facts, the example concludes that, since the two classes of certificates enable senior and junior certificate holders each purchased a pari passu, undivided interest in the mortgages, and the junior certificate holders then issued a limited recourse guaranty to the senior certificate holders secured solely by the junior certificate holders' interest in, and right to receive distributions with respect to, the mortgage pool. see also rev. rul. 92-32, 1992-1 c.b. 434 (sponsor creating an investment trust by transferring a pool of debt securities to a trustee in exchange for senior and subordinated certificates, both of which were sold to investors, qualified the investment trust as a trust for income tax purposes). whether this analogy to a limited recourse guaranty running from the junior certificate holders to the senior certificate holders should apply more generally for purposes of determining the taxation of senior and junior certificate holders in senior/subordinated grantor trust transactions has recently become a topic of some interest. see irs branch chief thomas j. lyden, remarks to financial transactions committee of the a.b.a. tax section (aug. 7, 1992); prospectus for nissan auto receivables 1992-b grantor trust (dated oct. 1, 1992). 101. as noted supra note 92, this example seems to be based on the americus trust prime and score transactions. [vol 1:5 selected issues in the taxtion of swaps investors "to fulfill their varying investment objectives of seeking primarily either dividend income or capital appreciation from the stock held by the trust" by owning certificates of one class rather than the other, "the trust is not formed to facilitate direct investment in the assets of the trust" and will accordingly not be classified as a fixed investment trust. the trust in the merrill lynch transaction is not identical to that at issue in example 3: for example, the common certificates share in the dividends on the underlying stock, and the preferred certificates do not participate in the upside on the underlying stock. nevertheless, the similarities far outweigh the differences. thus, it is highly likely that the service would claim that the trust does not qualify as a fixed investment trust taxable as a grantor trust. given this result, it is logical to suspect that tax counsel for the merrill lynch transaction attempted to achieve tax transparency by qualifying the trust as a partnership for tax purposes."r under regulations section 301.7701-2 as applied to the facts of the merrill lynch transaction, the trust will be taxable as a partnership 0 3 if at least two of the four following conditions are satisfied: (i) there is at least one certificate holder that is personally liable for the debts of, and claims against, the trust, t04 and such certificate holder either has substantial assets (other than its certificates) or is not merely a "dummy" acting as an agent for the other certificate holders, (ii) there is at least one certificate holder whose bankruptcy will cause the trust assets to be sold and the trust to liquidate unless at least a majority of the other certificate holders affirmatively vote to continue the transaction,105 (iii) each of the certificate holders, either alone or in combination 102. for a recent, thorough discussion of the issues involved in characterizing an entity as a partnership for federal income tax purposes. see william b. brannan. lingering partnership classification issues (just when you thought it was safe to go back into the water), 1 fla. tax rev. 197 (1993). 103. again, this assumes that the publicly traded partnership rules of section 7704 do not apply to the trust, either because the trust certificates are not publicly traded, which is apparently the case, or because at least 90% of the trust's income consists of "qualifying income" within the meaning of section 7704(c), which is also likely the case. but see irc § 7704(c)(3) (90% qualifying income exception from publicly traded partnership status does not apply if partnership could qualify as a ric if it were a domestic corporation). 104. the analogy here is to the general partner of a limited partnership. in the real world, of course, it is extremely unlikely that there would be any debts of or claims against the trust. 105. the power of a majority of the other certificate holders to override a liquidation event is based on proposed amendments to regulations section 301.770 l-2(b)( 1). 57 fed. reg. 32,472 (1992). the current version of regulations section 301.7701-2(b)(1) would require all the remaining certificate holders to vote to override a liquidation event, although this rule of unanimity clearly does not reflect current service practice (at least in the limited partnership area). see, e.g., rev. proc. 89-12, 1989-1 c.b. 798, amplified, rev. proc. 91-13, 1991-1 c.b. 477, and supplemented, rev. proc. 92-33, 1992-1 c.b. 782, and modified. rev. proc. 92-87, 19931 florida tax review with the other certificate holders, has the authority to manage the affairs of the trust or, if such is not the case, those persons having such authority consist of certificate holders owning more than an insubstantial amount of the certificates,'1 6 or (iv) more than an insubstantial portion of the certificates cannot be transferred without the consent of at least one of the certificate holders.'0 7 in the context of the trust, for example, tax counsel might have qualified the trust as a partnership by having merrill lynch create a special purpose "bankruptcy remote"' subsidiary to purchase one percent of each class of certificates.' 9 assuming that (a) the merrill lynch subsidiary is capitalized with a demand note from a creditworthy merrill lynch entity or with other substantial assets, (b) the subsidiary undertakes personal liability under the trust constituent documents for any debts of, or claims against, the trust, and (c), under those constituent documents and absent a vote of the majority of the other certificate holders, a bankruptcy of the subsidiary will cause the trust to sell the underlying stocks and liquidate, conditions (i) and (ii) above should be satisfied, thereby qualifying the trust as a partnership for federal income tax purposes. d. optimization of the drd the final goal that structured finance transactions seek to achieve is the preservation of the tax-advantaged character, if any, of the underlying 1992-42 i.r.b. 38 and rev. proc. 92-88, 1992-42 i.r.b. 39. 106. based on the service's ruling guidelines with respect to limited partnerships, this condition should be satisfied if the "managing" certificate holders own at least 20% of the certificates (based on value). rev. proc. 89-12, supra note 105. 107. rev. proc. 92-33, 1992-1 c.b. 782. based on the service's ruling guidelines with respect to limited partnerships, this condition should be satisfied if at least 20% of the certificates (based on value) are nontransferable without consent. even then, certificates will not be considered transferable without consent if only the right to share in the trust's profits and cash flow, but not the right to participate in the management of the trust's affairs, can be assigned without consent. see regs. § 301.7701-2(e)(1). nevertheless, given the likely limited participation rights afforded to certificate holders, it is not clear that this exception could apply. 108. bankruptcy remoteness means that the subsidiary's activities are generally strictly limited solely to owning the certificates so as to minimize the risk that the subsidiary will ever, voluntarily or involuntarily, enter bankruptcy proceedings. as noted in the text, the trust will be required, absent a contrary vote of a majority of the other certificate holders, to sell the underlying stocks and liquidate if the subsidiary goes into bankruptcy. the use of a bankruptcy remote entity is to minimize the risk of this occurring. 109. the reason for the 1% is to ensure that the merrill lynch subsidiary owns, at all times, at least 1% of the certificates, based on value, regardless of changes in the relative values of the preferred and common certificates, and therefore qualifies as a bona fide "partner" for purposes of applying the regulations section 301.7704-2 tests. [vol 1:5 selected issues in the taxation of swaps trust income and the "flowing through" of the resultant tax benefits to the investors. in the case of the merrill lynch product, that goal means that the full amount of the drd available to a corporation that owned the underlying stocks and received dividends thereon directly should be available to the certificate holders collectively, without diminution by virtue of the trust structure. under section 704(b) and the regulations thereunder, this seems to be the case. thus, dividend income on the underlying stocks would be allocated between and among the preferred certificate holders and the common certificate holders, based on each holder's entitlement to the cash attributable to such income. because these allocations would correlate with real entitlements to cash income, they should have "substantial economic effect" under section 704(b). under section 702(b), the "dividend" character of this allocated income would flow through to the certificate holders and be preserved, and each certificate holder would be able to claim a drd with respect to its allocable share of the dividend income to the same extent as if it had realized such income directly, rather than through the intermediation of the trustthus, without regard to any particular certificate holder's tax position, the aggregate drd available to the certificate holders would be the same as if a single corporate investor held the underlying stock directly. there are two potential challenges to this conclusion. first, based on the subordination of the common certificates to the preferred certificates, the service might attempt to recharacterize the preferred certificates as debt for tax purposes. in such case, (i) the return on the preferred certificates would constitute interest and therefore not be eligible for the drd and (ii) the "debt-financed portfolio stock" rules of section 246a"' would apply, thereby potentially disallowing a portion of the drd to which the common certificate holders would otherwise be entitled."' alternatively, the service 110. section 246a is another anti-abuse provision--this one dealing with the leveraged acquisition of dividend-paying stock. section 246a is designed to eliminate the tax arbitrage that would otherwise exist through the conjunction of the receipt of dividend income eligible for the drd and the deduction against ordinary income of offsetting interest expense. 111. under this analysis, the common certificate holders would be required to include 100% of the dividend income on the underlying stocks in taxable income, would be entitled to a deduction for "interest" payable on the preferred certificates, and would be entitled to a drd only to the extent provided in section 246a. until regulations are issued under section 246a(e), the common certificate holder's drd would be a function of the relative values of the preferred and common certificates at the inception of the trust, and not the relative amounts of dividend income allocated to each class of certificate holder in any given period. see irc § 246a(a), (d). for example, if the preferred certificates constituted 60% of the aggregate value of the certificates at the beginning of the transaction, 60% of the dividend income on the underlying stocks would be ineligible for the drd. thus, if $10 of dividend income were earned on the underlying stocks, $4 of which were allocable to the preferred certificate holders and $6 of which were allocable to the common certificate holders, the common 19931 florida tax review might adduce the subordination of the common certificate holders to the preferred certificate holders to support the disallowance of the drd with respect to the preferred certificate holders pursuant to section 246(c)(4)(c). under section 246(c)(4)(c), a taxpayer's holding period for purposes of satisfying the 46-day holding period requirement of section 246(c)(1)(a) is tolled "for any period ... in which, under regulations prescribed by the secretary, a taxpayer has diminished his risk of loss by holding 1 or more other positions with respect to substantially similar or related property." if section 246(c)(1)(a) were to apply to the preferred certificate holders, their holding period would be tolled at the outset and they would therefore not be able to satisfy the 46-day rule. there are a number of responses to any such possible challenge by the service. first, while there are a number of cases holding that obligations written as debt should be treated as equity for tax purposes, there are only two cases that have held the opposite." 2 while the economic differences between debt and preferred equity may be slight, or even nonexistent in certain cases, such as that of an unleveraged, purely passive investment vehicle such as the trust, the absence of a fixed maturity date and creditor's rights in bankruptcy should be sufficient to prevent the preferred certificates from being transmuted into debt. here, form and substance are consistent. certificate holders would have net taxable income of $6 (the same as would be the case if the preferred certificate holders were considered "partners," rather than lenders), but only 40% (i.e., 100% minus 60%) of the $10 of dividend income, or $4, would be eligible for the drd (versus $6 if the preferred certificates were not so recharacterized). thus, assuming a 70% drd, the common certificate holders would be entitled to $2.80 of deductions (i.e., 70% of $4.00), rather than the anticipated $4.20 of deductions (i.e., 70% of $6.00). obviously, in cases where, because of the level of prevailing money market interest rates, the preferred certificate holders were entitled to more than 60% of the dividend income in any period, recharacterization of the preferred certificates as debt might actually benefit the common certificate holders. pursuant to section 246a(e), under regulations, none of which have been issued to date, the reduction in the drd under section 246a cannot exceed the amount of the interest deductions allocable to the dividend. since the reduction in the example (which should be determined assuming that the common certificate holders would otherwise be entitled to a drd with respect to all $10 of dividend income) is $7.00 (i.e., 70% of $10) minus $2.80, or $4.20, if such regulations were to be issued the reduction in the drd would be limited to $4.00 (i.e., the amount of the allocable "interest" expense), resulting in a drd for the common certificate holders of $3.00. this is still less than the $4.20 of deductions that the common certificate holders would be entitled to if the form of the transaction were respected. query whether section 246a(e) is misdrafted and should limit the reduction in the amount of the dividend eligible for the drd (i.e., 60% in our case), rather than the reduction in the amount of the allowable drd, to the amount of the allocable interest expense. 112. see helvering v. richmond, fredericksburg & potomac r.r. co., 90 f.2d 971 (1937); bolinger-franklin lumber co. v. commissioner, 7 b.t.a. 402 (1927), acq. vii-1 c.b. 4 1928. [vol. 1:5 selected issues in the taxation of swaps second, section 246(c)(4)(c) is not self-executing; it requires the issuance of regulations and no such regulations have been issued to date. furthermore, the legislative history to section 246(c)(4)(c) states that congress anticipated that, except in very limited circumstances not applicable to our facts, any such regulations would generally have prospective effect only (i.e., most existing transactions would be grandfathered)." t3 most fundamentally, however, the transaction at issue here is simply not abusive. sections 246(c) and 246a were designed to stop tax arbitrage schemes in which a corporate taxpayer was able to convert non-dividend income into dividend income eligible for the drd by purchasing dividendpaying stock, including 100% of the dividends received therein in income (and taking the drd against such income), and then deducting an offsetting loss on the sale of such stock, or an interest deduction with respect to borrowings incurred or continued to acquire or carry such stock, against nondividend income.1 4 in the case of the trust, however, no such tax arbitrage potential exists. through the section 704(b) allocation rules, neither the preferred nor the common certificate holders are entitled to include all the underlying dividend income in their own incomes and claim a "deduction" (against unrelated income) for the portion of that income attributable to the other class of certificate holders. rather, each is only able to recognize its allocable share of the dividend income, and no tax arbitrage potential exists." 5 iv. conclusion swaps and structured finance techniques are powerful tools of modem corporate finance. the products analyzed in this article are just a small part of the types of products that are currently being used by corporate treasurers, fund managers, tax-exempt investors, and other institutional investors and liability managers. nevertheless, as the discussion herein hopefully suggests, 113. h.r. conf. rep no. 861, 98th cong.. 2d sess. 818 (1984). of course, the service might attempt to apply section 246(c)(4)(a) or (c)(4)(b), both of which are selfexecuting, rather than section 246(c)(4)(c), on the ground (as discussed supra note 95) that the preferred certificate holders should be treated as the owners of the underlying stock, and as having purchased from the common certificate holders an option to sell the stock and as having granted to the common certificate holders an option to buy the stock. as noted above, however, such an analysis seems strained. 114. see h.r. rep. no. 775, supra note 66; h.r. rep. no. 432. supra note 35. 115. another way to view this is that each certificate holder includes 100%7c of the dividend income on the underlying stocks in its own income, but then is allowed a deduction against that dividend income for the portion of the dividends paid out to the other certificate holders. because this deduction is against dividend income, and not against unrelated nondividend income, no tax arbitrage potential exists. 1993j florida tax review while many aspects of the taxation of these instruments are well-settled under current law, many difficult questions remain. the most notable of these are normative in nature. should one be able to deduct payments on an interest rate swap while still deferring market discount on an associated market discount bond? should one be treated as the owner of stock if she has traded away the bulk of the economics of that stock by entering into an equity swap? should non-u.s. investors be able to avoid u.s. withholding taxes by entering into equity swaps in lieu of holding dividend-paying stocks of u.s. issuers? and so on. the answers to these questions ultimately turn on some of the most fundamental aspects of the tax law, on questions about the proper scope of the realization requirement, on what constitutes tax arbitrage, on what are the contours of the principles of ownership of assets for tax purposes, and on how one should draw a principled distinction between debt and equity in an unintegrated corporate tax system. and therein lies perhaps the most surprising and interesting aspect of derivatives and structured finance legal practice: in a part of the world full of esoteric transactions designed to further basic economic goals of main street and wall street america, the tax lawyer is continually required to confront some of the most basic structural issues of the tax law. [vol. 1:5 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 1 lingering partnership classification issues (just when you thought it was safe to go back into the water) william b. brannan* i. introduction h. overview of partnership classification principles m. limited liability a. background b. issues 1. minimal equity partnerships 2. large equity partnerships 3. use of demand notes 4. multiple partnership interests 5. absence of "dunminess" 6. general partners with tiny interests 7. individuals as general partners 8. capital account restoration obligations iv. free transferability of interests a. background b. issues reasonable v. sole discretion limited transfer rights assignments without substitution multiple mild limitations free transferability for some but not all partners affiliated general and limited partners general partners with tin)' interests consent shopping number 4 1. 2. 3. 4. 5. 6. 7. 8. . partner, cravath, swaine & moore, new york, ny. this article is based on a paper presented by the author to the tax club of new york city on november 11, 1992. the author gratefully acknowledges the helpful assistance of his associate eli r. shahmoon in the preparation of this article. florida tax review v. continuity of life a. background b. issues 1. reliance on the presumption alone 2. number of dissolution events 3. weak dissolution events 4. reconstitution provisions 5. affiliated general and limited partners 6. general partners with tiny interests vi. centralized management a. background b. issues 1. "substantially all" issue 2. capital versus profits interests 3. removal rights 4. affiliated general and limited partners 5. "exclusive authority" issue 6. managing general partners vii. exotic partnerships a. limited liability companies b. one-partner partnerships c. business trusts and common law trusts viii. conclusion [vol 1:4 lingering partnership classification issues i. introduction this article discusses the federal income tax law relating to the classification of entities as partnerships for federal income tax purposes, with a focus on the practical problems that lawyers often encounter in distinguishing partnerships from associations under the four factor test set forth in regulations section 301.7701-2. partnership classification issues arise with respect to both general and limited partnerships formed under state partnership statutes and certain partnership-like foreign entities. moreover, the recent proliferation of other types of entities seeking partnership classification, such as "master limited partnerships," limited liability companies, business trusts, common law trusts and grantor trusts with partnership "fallback" positions, has focused renewed attention on those issues and raised still more classification issues.' the internal revenue service's recent published rulings have addressed some of these issues, but a number of issues remain. i. overview of partnership classification principles the question of whether an entity is a partnership for federal income tax purposes does not depend upon whether the entity is organized as a partnership under a state partnership statute.nor does it depend upon whether there is a written partnership agreement (or its equivalent) among the parties.3 to add further confusion, there is no comprehensive definition of the term "partnership" in the code. section 7701(a)(2) provides a starting point in stating that: "the term 'partnership' includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not ... a trust or estate or a corporation."4 thus, an unincorporated 1. this article deals only with partnership classification issues that arise where a partnership or other juridical entity has been formed under local law. it does not deal with the more metaphysical issue of whether co-ownership of property, "participating" loans. "kicker" leases, and other types of relationships not involving a separate legal entity should be characterized as partnerships for federal income tax purposes or the special rules for "publicly traded partnerships" in section 7704. any reference herein to a "partnership" means an entity organized as a separate legal entity under applicable state law, without regard to its characterization for federal income tax purposes, except as otherwise indicated. 2. see, e.g., nichols v. commissioner, 32 t.c. 1322, 1330 (1959), acq., 1960-2 c.b. 6; rev. rul. 58-243, 1958-1 c.b. 255; regs. §§ 301.7701-1(c), -3(a). 3. see, e.g., seattle renton lumber co. v. united states, 135 f.2d 989, 991 (9th cir. 1943); barron v. commissioner, t.c. memo 1992-598. 1034, 1037 (cch) (1992); nichols, 32 t.c. at 1329; beck chem. equip. corp. v. commissioner, 27 t.c. 840, 849 (1957), acq., 1957-2 c.b. 3. 4. see also irc § 761(a) and regs. § 301.7701-3(a) (containing virtually identical definitions of the term "partnership"). 19931 florida tax review organization 5 that carries on a business or financial operation will be characterized as a partnership only if it is not characterized as "a trust or estate or a corporation." normally it is clear that an unincorporated organization that carries on a business or financial operation is not a trust or estate. however, because "corporation" as used in the code includes not only entities formed as corporations under state laws but also unincorporated "associations,"6 the critical issue in characterizing an unincorporated organization normally is whether it is an "association." if it is an association, it will be treated as a corporation. if it is not an association, it will be characterized as a partnership. the term "association" is not defined in the code, but it is defined in the regulations. regulations section 301.7701-2(a)(1) states generally that an unincorporated entity will be treated as an association rather than a partnership if "the organization more nearly resembles a corporation than a partnership...." a more analytical framework is provided in regulations section 301.7701-2(a)(3), which indicates that an unincorporated organization generally will not be classified as an association unless it has "more corporate characteristics than noncorporate characteristics," determined without regard to the characteristics that corporations have in common with the alternative type of characterization being considered. regulations section 301.77012(a)(1) states that the "major characteristics ordinarily found in a pure corporation" that may distinguish it from other types of organizations are (i) associates, (ii) an objective to carry on a business and divide the gains therefrom, (iii) continuity of life, (iv) centralization of management, (v) liability for corporate debts limited to corporate property and (vi) free transferability of interests.7 regulations section 301.7701-2(a)(2) provides that associates and an objective to carry on business are common to corporations and partnerships and, therefore, that the determination as to whether an unincorporated organization is a partnership or an association turns on whether there is continuity of life, centralized management, limited liability and free transferability of interests, each of which is discussed separately below. the determination as to whether any such characteristic exists requires an analysis of the rights and obligations of the parties based upon applicable state law and the terms of any agreement among the parties. under the literal language of regulations section 301.7701-2, the four corporate characteristics that distinguish partnerships from associations are of 5. see infra text accompanying notes 24-27 (discussing the definition of the term "unincorporated association"). 6. irc § 7701(a)(3); regs. § 301.7701-1(c). 7. these factors were derived from the supreme court's opinion in morrissey v. commissioner, 296 u.s. 344 (1935), which dealt with the distinction between a trust and an association and is still cited with reverence in partnership classification cases. [vol 1:4 lingering partnership classification issues equal importance, and the courts have consistently rejected any attempt to weight the factors.8 also, with the exception of free transferability, the four relevant corporate characteristics have been approached in all-or-nothing terms, rather than as matters of degree. therefore, whether an entity is an association generally depends upon the purely mechanical test of whether the entity has more than two (i.e., at least three) of the four relevant corporate characteristics. it should be noted that regulations section 301.7701 -2(a)( 1) expressly states that "other factors" may be relevant in distinguishing partnerships from associations. however, only four cases have discussed the possible relevance of such "other factors" in any detail.9 in both bush and outlaw, the courts stated that such other factors were relevant to the classification issue, but in neither case did the court seem to regard them as being particularly significant. in larson, the tax court held that the "other factors" raised by the service were not relevant, except to the extent that they inhered in the four standard corporate characteristics.' in zcknan, the court of claims dismissed the other factors raised by the service as irrelevant, since the entity in question was so clearly a partnership based on the absence of all four standard corporate characteristics. most cases and published rulings only pay lip service to the possible relevance of "other factors," and not all of the published rulings recently issued by the service even do that." thus, this potentially nettlesome issue apparently will remain dormant for the foreseeable future. the evolution of the current association classification regulations has been a turbulent process that has been discussed at length by several 8. see, e.g., richlands medical association v. commissioner, 60 t.c.m. (cch) 1572, 1579 (1990), affd, 953 f.2d 639 (4th cir. 1992); foster v. commissioner, 80 t.c. 34. 186 (1983), affd in part and vacated in part, 756 f.2d 1430 (9th cir. 1985). ccrt. denied, 474 u.s. 1055 (1986); larson v. commissioner, 66 t.c. 159, 185-86 (1976). acq., 1979-1 c.b. 1. however, the larson majority did muse that it would weight the factors in favor of -practical continuity" and limited liability if it were writing the rules. 9. larson, 66 t.c. at 184; zuckman v. united states, 524 f.2d 729. 744 (ct. cl. 1975); outlaw v. united states, 494 f.2d 1376, 1385 (ct. cl.), cert. denied. 419 u.s. 844 (1974); bush #1 c/o stonestreet lands co. v. commissioner, 48 t.c. 218. 234 (1967), acq., 1968-2 c.b. 2. 10. shortly thereafter, the service issued a published ruling listing seven "other factors" that it would not consider as having relevance independent of their impact on the six major corporate characteristics, which factors reflected the other factors it unsuccessfully raised in larson. rev. rul. 79-106, 1979-1 c.b. 448. 11. recent partnership classification rulings that do not even mention the possible relevance of other factors include: rev. rul. 93-6. 1993-3 i.r.b. 8 (jan. 19). rev. rul. 93-5. 1993-3 i.r.b. 6 (jan. 19); rev. rul 93-4. 1993-3 i.r.b. 5 (jan. 19): rev. rul. 88-79, 1988-2 c.b. 361; rev. rul. 88-8, 1988-1 c.b. 403. revenue ruling 88-76. 1988-2 c.b. 360. does mention "other factors," though only in passing. 19931 florida tax review commentators. 12 however, three historical points regarding the evolution of the association classification regulations are worth mentioning at this juncture. the first point is that the current regulations reflect a bias that the service once had to make it difficult for unincorporated entities to achieve corporate status. that bias arose because at one time many professional service businesses operated in partnership, trust or association form, but claimed that they were taxable as corporations in order to become entitled to the favorable tax benefits that were available for corporate pension and profitsharing plans. 3 after losing a number of cases where it asserted that such businesses should be treated as partnerships, 4 the service promulgated regulations section 301.7701-2 in 1960 to make it easier to achieve partnership status. 5 that bias towards partnership classification has been the subject of discussion by commentators, 6 and it has even been acknowledged by the courts on several occasions. 7 the service's ruling guidelines also have been liberalized considerably over the years, thereby increasing the bias in favor of partnership characterization in the ruling arena. the current ruling 12. see, e.g., i william s. mckee, et al., federal taxation of partnerships and partners 3.06(1) (2d ed. 1990); richard a. fisher, classification under section 7701-the past, present, and prospects for the future, 30 tax law. 627 (1977); h, lawrence fox, the maximum scope of the association concept, 25 tax. l. rev. 311 (1970); stephen b. scallen, federal income taxation of professional associations and corporations, 49 minn. l. rev. 603 (1965). 13. the taxpayers presumably believed that treatment of the entity as a corporation would not involve an onerous double tax burden based on their expectation that the taxable income of the entity could be minimized through salary payments and by the availability at the time of the tax-free liquidation provisions for corporations. 14. see, e.g., united states v. kintner, 216 f.2d 418 (9th cir. 1954); gait v. united states, 175 f. supp. 360 (n.d. tex. 1959). 15. t.d. 6503, 1960-2 c.b. 409. in 1965, the service amended the original 1960 regulations by adding a special provision applicable only to unincorporated professional service businesses that would have made it virtually impossible for such professional service businesses to be treated as corporations. t.d. 6797, 1965-1 c.b. 553. that amendment was promptly held to be invalid. kurzner v. united states, 413 f.2d 97 (5th cir. 1969); o'neill v. united states, 410 f.2d 888 (6th cir. 1969); united states v. empey, 406 f.2d 157 (10th cir. 1969); holder v. united states, 289 f. supp. 160 (n.d. ga. 1968), aff'd per curiam, 412 f.2d 1189 (5th cir. 1969). the 1965 amendments were withdrawn in 1977. t.d. 7515, 1977-2 c.b. 482. additional amendments relating to limited liability were proposed in 1980, but they also were withdrawn. see discussion infra in part ii(a). one additional amendment was made in 1983. t.d. 7889, 1983-1 c.b. 362. the service has recently proposed an amendment to the continuity of life provisions of the regulations. notice ps-7-92, 1992-32 i.r.b. 29 (aug. 10). 16. see, e.g., fisher, supra note 12, at 630. 17. see, e.g., kurzner, 413 f.2d at 105; empey, 406 f.2d at 169; foster v. commissioner, 80 t.c. 34, 186 (1983), affd in part and vacated in part, 756 f.2d 1430 (9th cir. 1985), cert. denied, 474 u.s. 1055 (1986); larson, 66 t.c. at 186-88 (dawson, c.j., concurring); zuckman, 524 f.2d at 733, n.5. [vol. 1:4 lingering partnership classification issues guidelines" reflect at least six significant changes from the prior guidelines dating from 1972.'9 given that legal environment, it should come as no surprise that the service has lost most of the classification cases since 1960 where it was attempting to characterize as an association an entity that the taxpayer had been treating as a partnership.20 the second point is that there are surprisingly few cases and published rulings on a number of basic issues that frequently arise under the association classification rules contained in regulations section 301.7701-2, as the discussion below indicates. 2' indeed, the association classification law 18. the service's current ruling guidelines are contained in: rev. proc. 93-3. 1993-1 i.r.b. 71 (jan. 4); rev. proc. 92-88, 1992-42 i.r.b. 39 (ocl 19); rev. proc. 92-87. 1992-42 i.r.b. 38 (oct. 19); rev. proc. 92-35, 1992-1 c.b. 790; rev. proc. 92-33, 1992-1 c.b. 561; rev. proc. 89-12, 1989-1 c.b. 798, modified, rev. proc. 93-3, 1993-1 i.r.b. 71 (jan. 4). see also rev. proc. 91-13, 1991-1 c.b. 477 (providing the partnership classification ruling request checklist). 19. the prior ruling guidelines were contained in revenue procedure 72-13, 1972-1 c.b 735, as modified and supplemented by revenue procedure 74-17, 1974-1 c.b. 438. the significant liberalizing changes that were made by the current ruling guidelines include: (i) the minimum interest of the general partner need not be one percent in all cases (with as little as 0.2% now sufficing in certain cases), rev. proc. 89-12 at § 4.01; (ii) the minimum interest of the general partner may be subject to temporary reductions due to the requirements of sections 704(b) and 704(c) or more permanent reductions in certain years (provided that in the latter case there is a substantial interest in other years), rev. proc. 89-12 at § 4.01; (iii) there is no per se rule preventing the limited partners from owning more than 20% of the general partner or having an option or obligation to acquire securities issued by the general partner in the future, see rev. proc. 72-13 at §§ 2.01, 2.05; (iv) the general partner does not need to have a net worth equal to 10% of the capital contributions to the partnership in all cases (which was previously required even where the partnership is not relying on the absence of limited liability), see rev. proc. 72-13 at § 2.02; (v) the general partner's net worth for limited liability purposes may include the value of its interests in other limited partnerships, see rev. proc. 72-13 at § 2.03; and (vi) the partnership may generate losses in excess of the equity capital of the partners during the first two years of operations, see rev. proc. 74-17 at § 3.02. the only significant tightening of the ruling guidelines was the addition of the new requirement that the general partner either (x) maintain a capital account balance equal to the lesser of one percent of the aggregate positive capital accounts of all the partners or s500,000. or (y) represent that it will provide "substantial services" and agree to a limited negative capital account restoration obligation at liquidation. rev. proc. 89-12 at § 4.03. 20. the service's losses occurred in: mca, inc. v. united states. 685 f.2d 1099 (9th cir. 1982); larson, 66 t.c. 159; zuclknan, 524 f.2d 729; bush #1 c/o stonestreet lands co. v. commissioner, 48 t.c. 218 (1967), acq., 1968-2 c.b. 2. the only service victories were in richlands medical ass'n v. commissioner. 60 t.c.m. (cch) 1572 (1990). aff'd. 953 f.2d 639 (4th cir. 1992), and outlaw v. united states, 494 f.2d 1376 (ct. cl. 1974). 21. the key cases on distinguishing partnerships from associations under the current regulations are: mca, 685 f.2d 1099; kurzner, 413 f.2d 97; foster, 80 t.c. 34: larson, 66 t.c. 159; zuckman, 524 f.2d 729; outlaw, 494 f.2d 1376; bush #1 do sionestreet lands co., 48 t.c. 218; richlands medical ass'n, 60 t.c.m. (cch) 1572. the key published rulings are the revenue procedures referred to in note 18, supra, and: rev. rul. 93-6, 1993-3 i.r.b. 8 (jan. 19931 florida tax review has not been the subject of a supreme court decision since 1935,22 which was long before the current regulations were promulgated. the leading case is the tax court decision in larson, but even that case may be of questionable reliability.23 given that dearth of authority, the service's ruling guidelines and its private letter rulings in this area have become very important sources of guidance. only the bravest of practitioners knowingly go beyond the ruling guidelines to test the limits of the substantive law. the third point is that the issue of whether an entity is "incorporated" has not received much attention. the issue of whether an entity might be classified as a partnership under regulations section 301.7701-2 is academic if one concludes that the entity is "incorporated," since a partnership by definition is not an "incorporated" organization. presumably the drafters of section 7701(a)(2) intended the term "unincorporated organization" to mean an entity organized under a law other than an ordinary state corporate statute.2 ' the service has taken the position in a few private rulings that the term "incorporated" should be defined more broadly (and less precisely) based upon the common law concept of a corporation as described in the seminal dartmouth college case.25 in o'neill v. united states, one of the few cases to confront this issue directly, the sixth circuit court of appeals also looked to the definition of the term "corporation" in the dartmouth 26 isucollege case. this issue has the potential to spawn a second major line of authority relating to partnership classification, which could be a real problem for limited liability companies, business trusts and certain other types of 19); rev. rul. 93-5, 1993-3 i.r.b. 6 (jan. 19); rev. rul. 93-4, 1993-3 i.r.b. 5 (jan. 19); rev. rul. 88-79, 1988-2 c.b. 361; rev. rul. 88-76, 1988-2 c.b. 360; rev. rul. 88-8, 1988-1 c.b. 403; rev. rul. 79-106, 1979-1 c.b. 448; rev. rul. 77-214, 1977-1 c.b. 408. 22. morrissey v. commissioner, 296 u.s. 344 (1935). 23. the procedural history of larson was unusual, because the tax court originally held against the taxpayer, but later reversed itself after the taxpayer made a motion for reconsideration. the final decision was a 7-6 split decision that spawned no less than eight separate opinions. as indicated in note 8, supra, the service has acquiesced in larson, 1979-1 c.b. 1, but that acquiescence was subsequently reconsidered and then allowed to stand, 1979-2 c.b. 2. 24. see united states v. empey, 406 f.2d 157, 170 (6th cir. 1969); cf. o'neill v. united states, 410 f.2d 888, 895-98 (6th cir. 1969) (discussing the definition of "corporation" under section 7701(a)(3)); boris i. bittker, professional associations and federal income taxation: some questions and comments, 19 tax l. rev. 1, 25-27 (1961) (discussing definition of "corporation" under section 7701(a)(3)). 25. see priv. let. rul. 7921084 (feb. 27, 1979) (arizona "close corporation" does not need to be tested under regulations section 301.7701-2 because it is an "incorporated" organization within the meaning of the common law, citing trustees of dartmouth college v. woodward, 17 u.s. (4 wheat.) 518 (1819)); priv. let. rul. 8426031 (mar. 26, 1984) (same for a foreign "unlimited liability company"); g.c.m. 37127 (may 18, 1977) (same for a texas "close corporation"); see also g.c.m. 37953 (may 14, 1979); g.c.m. 38281 (feb. 15, 1980). 26. o'neill, 410 f.2d at 895-98. [vol 1:4 lingering partnership classification issues entities that bear certain similarities to ordinary corporations but are not organized under an ordinary state corporation statute. however, the service apparently does not intend to press this issue. in fact, the service now takes the position that foreign entities must be classified based upon an application of regulations section 301.7701-2 as if they were unincorporated organizations, regardless of how closely they resemble an ordinary corporation.' m. limited liability a. background regulations section 301.7701-2(d)(l) sets forth the basic rule that "an organization has the corporate characteristic of limited liability if under local law there is no member who is personally liable for the debts or claims against the partnership." under that rule, all partnerships organized under a state partnership statute would, of course, not have the corporate characteristic of limited liability, since all such partnerships would have at least one general partner that is personally liable for partnership liabilities. in the case of a general partnership, where all the partners have personal liability, the issue is that simple and no further inquiry is required under the regulations. however, in the case of a limited partnership, the limited partners do not have personal liability and, therefore, the entity seems more like a corporation. in recognition of that fact, the regulations qualify the general rule for limited partnerships with a corporate general partner by providing that the entity will be deemed to have limited liability if (1) the general partner has "no substantial assets" (other than its interest in the partnership) that could be reached by creditors of the partnership and (2) the general partner "is merely a 'dummy' acting as the agent of the limited partners."' there are three important points that should be noted with respect to the limited liability factor. first, historically the limited liability factor was regarded by many practitioners as being more important than any of the other three corporate factors in distinguishing partnerships from associations, even though it is coequal with the other three corporate factors under the literal language of regulations section 301.7701-2 and no case or published ruling has ever held that the limited liability factor should be given special weight.29 that concern was based in part on the notion that the personal liability of a general partner represents the most meaningful difference 27. rev. rul. 88-8, 1988-1 c.b. 403. but see rev. proc. 93-3. 1993-1 i.r.b. 71 (jan. 4), at § 4.01(47) (the service will ordinarily not rule as to whether "what is generally known as a foreign corporation" is a partnership for federal income tax purposes). 28. regs. § 301.7701-2(d)(2). 29. see supra note 8 and accompanying text. 19931 florida tax review between a partnership and a corporation and in part on the service's prior ruling policy, as codified in revenue procedure 72-13, that the corporate general partner of a limited partnership always should have a certain amount of net worth, even if the partnership were not relying on the absence of limited liability to support its partnership status.30 that concern reached its apogee in 1980, when the service proposed a regulation that would have automatically treated an entity as an association if no member was personally liable for the liabilities of the entity.' the proposed regulation was withdrawn in 1982 without any real explanation by the service.32 however, the withdrawal of the proposed regulation did not dispel the concern that limited liability might be a "superfactor," since the service's statement indicated that it planned to conduct a study of the association classification rules with a "special focus on the significance of the characteristic of limited liability" 33 and the service subsequently announced that it would not rule on the status of limited liability companies pending completion of that study.' the concern was finally eliminated in 1988 when the service announced that it would not insist on the absence of limited liability in all cases either as a matter of substantive law or as a ruling policy (with the result that limited liability was left coequal with the other three corporate characteristics) 35 and its publication of revenue ruling 88-76,36 indicating that wyoming limited liability companies may be treated as partnerships, without any member having personal liability, on the basis of the absence of at least two other corporate factors. the second point regarding the limited liability factor is that there is virtually no authority on what it means for a general partner to have "substantial assets." the only gloss that regulations section 301.7701-2(d)(2) provides is a statement to the effect that a general partner may be regarded as having substantial assets even if its assets would be "insufficient to satisfy any substantial portion of the obligations of the organization," indicating that the substantiality of the general partner's assets need not necessarily be judged by reference to the entity's liabilities. fortunately, the service has provided some bright-line guidance in the form of its ruling guidelines, which indicates that the service generally will rule that a limited partnership with a corporate general partner lacks the characteristic of limited liability if the 30. see rev. proc. 72-13, 1972-1 c.b. 735 at § 2.02. 31. prop. regs. §§ 301.7701-2(a), -2(g), 45 fed. reg. 75,709 (1980). 32. i.r.s. news rel. 145 (dec. 16, 1982), 82 cch '1 6851, 83 p-h 54,703. 33. id. 34. see rev. proc. 83-22, §§ 2.01, 5.26, 1983-1 c.b. 680, and successor ruling guidelines. 35. announcement 88-118, 1988-38 i.r.b. 26 (sept. 2); see also rev. proc. 88-44, 1988-2 c.b. 634 (abandoning service's no-ruling policy regarding limited liability companies). 36. 1988-2 c.b. 360. [vol 1:4 lingering partnership classification issues net worth of the general partner (exclusive of the value of its interest in the partnership) equals at least ten percent of the total capital contributions to the partnership.37 the guidelines go on to provide that the service may rule that a partnership lacks limited liability if the general partner has a lesser amount of net worth, although "close scrutiny" will be applied in such cases. the third point regarding the characteristic of limited liability is that the fact that a partnership has debt that is nonrecourse to the partners is not relevant. for a partnership that finances its operations solely with nonrecourse debt, the personal liability of the general partner may be relevant only for any trade creditors or tort claimants. b. issues the foregoing rules raise the following special problems. 1. minimal equity partnerships.-one issue that frequently arises under the ten percent net worth safe harbor for unlimited liability under revenue procedure 89-12 is whether it really means what it says when it is applied to situations where the capital contributions to the entity are minimal. in theory, one could organize a partnership or other entity with no equity capital (other than whatever de minimis amount of capital, if any, is required as a matter of state law) and rely solely on loans to fund the partnership's operations. this is most likely to occur when the partnership will be conducting a service business where capital is not a material income-producing factor or will be a "securitization" vehicle that does not need significant equity. in such situations, the safe harbor would require that the general partner have net worth equal to ten percent of a de minimis amount, which obviously seems too good to be true, since there is no substance to personal liability in that situation. the drafters of revenue procedure 89-12 may have been concerned about that case, since revenue procedure 89-12 includes the caveat that an entity "generally" (but apparently not always) will be deemed to lack limited liability if the general partner satisfies the ten percent safe harbor. in such situations, it would be advisable for the general partner to have a greater level of net worth such that its net worth would seem significant, perhaps by reference to the amount of debt capitalization of the entity (even though regulations section 301.7701-2(d)(2) suggests that is not relevant) or perhaps by reference to the amount of expenses expected to be incurred by the entity on an annual basis. given the dearth of authority on this issue, practitioners ultimately must be guided by the "smell test," with net worth amounts in the range of $10,000 often seeming to be the lower limit even for small partnerships. however, the net worth that is recommend37. rev. proc. 89-12, 1989-1 c.b. 798, at § 4.07. 1993] florida tax review ed for minimal equity partnerships is likely to vary inversely with the level of comfort that one has on the "dumminess" issue discussed below."8 2. large equity partnerships.-the opposite of the case posed in paragraph (1) above is the situation where the partnership has a huge amount of equity capitalization, such that the ten percent safe harbor net worth amount itself would be enormous. in such situations, it would seem that the net worth of the general partner could be regarded as "substantial" as a matter of general principles even if it fails to satisfy the ten percent safe harbor. historically, there was no exception to the ten percent safe harbor for partnerships with large amounts of equity capitalization.39 however, revenue procedure 89-12 itself expressly contemplates that a favorable ruling could be granted in situations where the ten percent safe harbor is not satisfied, provided that the partnership satisfies the "close scrutiny" test that applies in such cases."n it goes on to provide that limited liability will be found lacking if either the general partner has "substantial assets" or the general partner "will act independently of the limited partners." the former test, of course, reflects the service's new view that even for advance ruling purposes a net worth equal to ten percent of the capital contributions to the partnership may not be required. that having been said, one is still in uncharted waters when trying to determine how far below the ten percent safe harbor one can go in the case of a large equity partnership. thus, this issue also tends to be governed by rules of thumb, with practitioners often getting comfortable with net worth amounts that are as low as five percent of the capital contributions to the partnership (and sometimes less) where that amount would be at least five to ten million dollars on the theory that a judge would have difficulty concluding that such net worth was not substantial. again, one's willingness to take a risk on this issue is often directly related to his comfort on the "dumminess" issue. 3. use of demand notes.-assuming that one can determine the requisite amount of net worth that the general partner should have to insure that the partnership will lack limited liability, the next issue becomes how that net worth should be supplied. in many, if not most, cases the general 38. see discussion infra part iii(b)(5). 39. rev. proc. 72-13, 1972-1 c.b. 735 at § 2.02, modified, rev. proc. 74-17, 19741 c.b. 438. as indicated in note 19, the 10% net worth requirement in the old ruling guidelines applied to all partnerships, even where the partnership did not need to lack limited liability to be treated as a partnership as a matter of substantive law. in addition, the old ruling guidelines did not contemplate the possibility that a favorable ruling on limited liability could be given based on the absence of dumminess. 40. rev. proc. 89-12, 1989-1 c.b. 798, at § 4.07. [vol 1:4 lingering partnership classification issues partner is a special purpose entity or otherwise does not have sufficient net worth to satisfy the requirement. in such cases, the usual practice is for the shareholder of the general partner to issue a demand note to the general partner with a principal amount equal to the shortfall in net worth. the demand note provides that on demand by the general partner, the shareholder will immediately pay the principal amount to the general partner. the theory behind the use of a demand note is that such a note represents an asset of the general partner with fair market value equal to its face amount. while such a demand note normally would not be readily marketable, the creditors of the partnership could tap the value inherent in the note by obtaining a judgment against the general partner, levying on the demand note and then either making demand on the general partner's shareholder or selling the note to a third party. thus, the only issue should be whether the general partner's shareholder has the financial wherewithal to satisfy the demand note. the service attempted to impose certain limitations regarding the use of demand notes in a recent general counsel memorandum regarding advance rulings on partnership status in situations where the general partner is capitalized with a demand note." among other things, the memorandum requires that the note be negotiable within the meaning of the applicable state version of the uniform commercial code, that it be payable immediately upon demand and that it accrue interest (which compounds if not paid when due) at a "reasonable market rate. 4 in the abstract, these may be reasonable requirements so that the service will have some assurance that the note is worth its face amount for purposes of advance rulings. however, as a substantive matter, such requirements do not seem to be absolutely necessary, provided that such factors are taken into account in valuing the note. for instance, it is arguable that negotiability should be irrelevant, since negotiability only affects the liquidity of the note, which would not seem to be a particularly material factor in valuing a note payable on demand. in the case of the interest requirement, it is unclear whether the service wants the note to bear interest from the date of issuance or the date of demand. 3 if the former reading was 41. g.c.m. 39798 (oct. 24, 1989). 42. id. see also i.r.s. technical advice memorandum 9217007 (jan. 3, 1992). holding that a non-interest bearing demand note did not constitute good equity capital for a netherlands antilles finance subsidiary. although the demand note was essentially the same in substance as the demand notes used to capitalize corporate general partners, the service concluded that the note was a "nullity," relying in part on the failure of the note to bear interest. 43. unfortunately, the service's private letter rulings do not seem to resolve that ambiguity. see, e.g., priv. let. rul. 8942085 (july 27, 1989)priv. let. rul. 9021009 (feb. 20, 1990). the author has been advised informally by service officials that the service's position is that interest should run from the date of issuance. 19931 florida tax review intended, the service's position would not be reasonable, since it would be tantamount to either (i) requiring an increasing amount of net worth due to the mere passage of time (where the interest accrues but is not paid currently), which is not required where the general partner is capitalized with other types of assets, or (ii) requiring circular flows of cash (where the note pays interest on a current basis, in which event the cash presumably would be dividended back to the shareholder), which would not add any substance to the general partner. 4. multiple partnership interests.-another issue that frequently arises is whether the net worth of a general partner for "substantial assets" purposes may be measured taking into account the value of its interests in other partnerships in which it is a general partner. regulations section 301.7701-2(d)(1) expressly provides that the net worth of the general partner should be determined without regard to the value of the general partner's interest in the partnership whose status is in question. that rule is perfectly sensible, since that interest presumably would be worthless in any situation where the creditors of the partnership were seeking to collect from the general partner.44 however, the regulations do not answer the question of whether general partner interests in other partnerships may be taken into account. it is difficult to see why general partner interests in other partnerships should be disregarded for this purpose. general partner interests in other partnerships represent assets that normally could be valued and, subject to the likely absence of liquidity, may be used to satisfy the claims of creditors of the partnership. while such interests may seem pregnant with liabilities, particularly where the entity is the sole general partner, such liabilities could be taken into account in the valuation process. certainly it is difficult in principle to distinguish the situation where the entity owns a general partner interest in another partnership that conducts an operating business from the situation where it owns the operating business directly, in which case the fair market value of the business clearly should be taken into account. in either case, the entity would have personal liability for the liabilities of the business, the only difference being that in the direct ownership case the creditors with respect to the business generally would not have to exhaust the assets used in the business before going after the entity's other assets. 44. creditors of a partnership normally may not seek payment from a general partner in respect of a partnership liability until they have first attempted to collect from the partnership and exhausted all the partnership's assets. however, once the partnership's assets have been exhausted, the general partner's interest could not have any positive value (and it actually would represent a liability). [vol 1:4 lingering partnership classification issues historically, the service looked askance at a general partner taking the value of its interests in other partnerships into account. the service's long-standing ruling policy, as reflected in revenue procedure 72-13, was to exclude the value of such interests in determining whether the general partner satisfied the ten percent net worth test. 5 perhaps the service was concerned about the possibility that a general partner with interests in multiple partnerships would purport to have artificial net worth that would evaporate if all the partnerships went bankrupt. in any event, the service seemed to relent on this point in revenue procedure 89-12, since the ten percent net worth test contained therein does not expressly require that the net worth be determined by excluding the value of the general partner's interests in other limited partnerships.' however, revenue procedure 89-12 was quickly followed by general counsel memorandum 39798,' 7 which imposes limitations on counting interests in other limited partnerships in satisfying the ten percent net worth requirement for advance ruling purposes. general counsel memorandum 39798 imposes a twofold net worth requirement in such situations: (i) the "overall" requirement that the net worth of the general partner, taking into account the value of all its partnership interests, be equal to at least ten percent of the aggregate amount of capital contributions to all the limited partnerships and (ii) the "entity-by-entity" requirement that for each of the related limited partnerships, the general partner's net worth, exclusive of the value of its interest in that partnership but taking into account its interests in all other partnerships, be equal to at least ten percent of the aggregate amount of capital contributions to that partnership. under that test, the general partner's net worth requirement for numerous limited partnerships may be satisfied with a single valuable interest in another partnership, provided that the general partner has sufficient net worth based on the value of its other partnership interests or its other assets to satisfy the entity-by-entity ten percent net worth requirement with respect to the partnership that issued the valuable partnership interest.4 45. rev. proc. 72-13, 1972-1 c.b. 735, at § 2.03, modified, rev. proc. 74-17. 19741 c.b. 438. in fact, revenue procedure 72-13 literally seemed to require that such interests be disregarded, even where they represented a net liability. 46. rev. proc. 89-12, 1989-1 c.b. 798, at § 4.07. however, it should be noted that the service's partnership classification ruling checklist still asks for "a description of all other partnerships in which any of the general partners has an interest." rev. proc. 91-13. 1991-1 c.b. 477, appendix a, question 21. 47. g.c.m. 39798 (oct. 24, 1989). 48. as an illustration, suppose that a corporation ("gp co.") is a general partner in limited partnerships a, b, c, d, and e. suppose further that: (i) the aggregate amount of capital contributions to each of the limited partnerships was s 1,000; (ii) the value of gp co.'s interest in each of limited partnerships a, b, c, and d is $10; (iii) the value of gp co.'s 19931 florida tax review 5. absence of "dumminess. "-as indicated above, regulations section 301.7701-2(d)(2) provides that limited liability does not exist for a limited partnership with a corporate general partner unless (1) the general partner has no substantial assets and (2) the general partner is acting as the "dummy" of the limited partners. in other words, limited liability will not exist even where the general partner has absolutely no outside assets as long as it is not acting as the dummy of the limited partners. in larson, the service attempted to ignore the conjunctive language of the regulations and argue that the absence of substantial assets alone resulted in limited liability, but that reading of the regulations was rejected by the court.49 unfortunately, it is unclear what it means for a general partner to be acting as the "dummy" of the limited partners. the use of the term "dummy" apparently originated in the glensder textile case."0 intuitively, one might think that it simply means acting at the direction and control of the limited partners, which they could exert either through ownership of the general partner or through a right to remove the general partner. however, the language of regulations section 301.7701-2(d)(2), which speaks of the general partner being "merely a 'dummy' acting as the agent of the limited partners," would suggest that it means something different if ordinary principles of statutory construction are to be given effect in this context. a possible alternative interpretation is that the term "dummy" refers to a situation where the general partner has only a nominal economic interest and is participating in the transaction solely to satisfy the requirement that there be a general partner so that none of the limited partners will have to have personal liability, regardless of whether the limited partners actually control the general partner. the only authority on what it means to be a "dummy" of the limited partners within the meaning of the regulations is larson.5' in larson, a limited partner who was an individual with a 1.9% limited partner interest owned 23.1% of the stock of the corporate general partner. in determining that the general partner was not the dummy of the limited partners, the court interest in limited partnership e is $500; and (iv) gp co. has $60 of cash in a bank account. gp co. would satisfy the net worth requirement of revenue procedure 89-12, as interpreted by general counsel memorandum 39798, even though it only has $60 of "outside" net worth. the overall requirement would be satisfied, since the value of all of gp co.'s assets ($600) exceeds 10% of the aggregate amount of capital contributed to all the partnerships ($500). the entity-by-entity requirement would easily be satisfied for limited partnerships a, b, c, and d based on the value of gp co.'s interest in limited partnership e alone, while the entity-byentity requirement for limited partnership e would be satisfied based upon the combined value of gp co.'s interests in limited partnerships a, b, c, and d and its cash. 49. larson v. commissioner, 66 t.c. 159, 179-80 (1976); see also rev. proc. 89-12, at § 4.07 (adopting the conjunctive reading for advance ruling purposes). 50. glensder textile co. v. commissioner, 46 b.t.a. 176, 183 (1942), acq., 1942-1 c.b. 8. 51. larson, 66 t.c. at 179-82. [vol 1:4 lingering partnership classification issues noted that "a mere 'dummy' would be totally under the control of the limited partners. ' 5 2 the court concluded that "the limited partners did not use [the general partner] as a screen to conceal their own active involvement in the conduct of the business. ' 3 thus, the court seemed to regard a dummy as someone acting at the direction and control of, if not the alter ego of, the limited partners. that interpretation seems to be reflected in revenue procedure 89-12, which provides that the service generally will rule that a partnership lacks limited liability where its general partner does not have substantial assets if the general partner "will act independently of the limited partners." 54 if control by the limited partners is the key to dumminess, then dumminess would seem to be a fairly rare phenomenon. thus, one might ask why corporate general partners of limited partnerships are so frequently capitalized with substantial assets at the direction of tax lawyers. the answer probably lies in the fact that there is just not yet enough authority on the meaning of the term "dummy" to warrant reliance on the absence of dumminess, except in the cleanest of cases. it should be noted (primarily for comic relief) that zuckmnan55 stands for the proposition that there is a truism that makes the subtleties of the definition of the term "dummy" irrelevant. in zuckman, the service argued that a limited partnership with a sole corporate general partner had limited liability on the theory that the general partner had no substantial assets and was acting at the direction and control of a limited partner. 6 the taxpayer argued that limited liability was lacking on the ground that the limited partner's control of the general partner made the limited partner personally liable for partnership liabilities under applicable state law, a premise that the service contested.' the court did not resolve the state law question as to whether the limited partner had personal liability. instead, it concluded that the literal language of regulations section 301.7701-2(d) creates a truism: either the general partner is not acting as the dummy of the limited partners, in which case limited liability does not exist under the first sentence of regulations section 301.7701-2(d)(2) based upon the mere fact that the general partner has personal liability (without regard to the substantiality of 52. id. at 181. 53. id. 54. rev. proc. 89-12, at § 4.07. it is interesting to note that revenue procedure 7213, 1972-1 c.b. 735, which contains the prior ruling guidelines, does not include that rule but does require that in all cases the limited partners may not own more than 20,% of the stock of the general partner or its affiliates (taking into account the section 318 constructive ownership rules). 55. zuckman v. united states, 524 f.2d 729 (ct. cl. 1975). 56. id. at 740. 57. id. 19931 florida tax review its assets), or the general partner is acting as the dummy of the limited partners, in which case limited liability does not exist based upon the fact that the limited partners would be deemed to have personal liability under the second sentence of regulations section 301.7701-2(d)(2) due to their control of the general partner.58 however, it would be surprising if the zuckman analysis is ever followed by any other court, since it is tantamount to saying that all limited partnerships automatically lack limited liability without delving into the substance of the transaction. 6. general partners with tiny interests.-another issue in this area is whether a limited partnership should be regarded as lacking the characteristic of limited liability if the interest of the general partner is extremely small on the ground that the general partner should not be regarded as a partner for federal income tax purposes and, therefore, that no "member" has personal liability. there is ample authority in other tax contexts that de minimis things may be ignored.59 in addition, it could be argued, based upon the cases indicating that intent is the most important factor in determining whether a person is a partner,60 that a general partner with a tiny interest could not really intend to be a partner in the fullest sense, since it does not have a meaningful share of partnership profits and losses. on the other hand, a general partner with a tiny interest is a partner in form, would be regarded as a partner for state law purposes (with the consequence that it would be personally liable for partnership liabilities and have the other substantive rights and obligations of a general partner)61 and may actually intend to be a partner. 58. id. at 741. the second sentence of regulations section 301.7701-2(d)(2) reads as follows: "notwithstanding the formation of the organization as a limited partnership, when the limited partners act as the principals of such general partner, personal liability will exist with respect to such limited partners." it is unclear whether that statement was intended to be a purely tax rule or a summary of state partnership law. 59. e.g., mills v. commissioner, 331 f.2d 321 (5th cir. 1964), rev'g 39 t.c. 393 (1962) (cash payment in lieu of fractional shares of stock does not disqualify corporate reorganization from nontaxable status under section 368(a)(1)(b)); international artists, ltd. v. commissioner, 55 t.c. 94, 104-05 (1970) (incidental personal use of business property does not preclude section 167 deductions). 60. see, e.g., commissioner v. culbertson, 337 u.s. 733 (1949); estate of smith v. commissioner, 313 f.2d 724 (8th cir. 1963); luna v. commissioner, 42 t.c. 1067 (1964). 61. although the mere fact that the general partner is a partner for state law purposes would not be determinative, the fact that the general partner holds itself out as a partner for state law purposes may be evidence of intent and it does confer on such person all the substantive rights and obligations of a general partner, including personal liability for partnership liabilities (other than those that are expressly nonrecourse), the exclusive right to manage the business of the partnership (subject to any limited partner approval rights) and a fiduciary obligation to manage the partnership based upon the best interests of the partners. [vol 1:4 lingering partnership classification issues there seems to be no useful authority on this issue. the only case to expressly consider the issue was larson, which parenthetically discussed the question of whether a general partner that had only a fifteen percent interest in partnership profits (with no interest in partnership capital) should not be regarded as a partner for continuity of life purposes because of the relative insubstantiality of that interest.62 not surprisingly, the court decided that the general partner should be regarded as a partner. what is surprising, however, is the basis for that decision. the court's decision was not based upon the factual point that the general partner actually had a fairly significant interest; rather, it was based upon the court's rejection of the service's legal argument that a general partner could have a sufficiently small interest to be disregarded for continuity of life purposes (and presumably limited liability purposes as well). the court found that argument to be "structurally incompatible with the regulations, which consider the substantiality of a partner's interest in the partnership only in connection with the centralization of management and transferability of interests." 63 however, that conclusion is of dubious reliability, since the court was not confronted with a truly de minimis case where general tax principles might be brought to bear and in any event its discussion of the issue seems to be dictum. the de minimis interest issue was also considered in private letter ruling 8139048.6' in that ruling, a corporation and an employee of an affiliate of the corporation formed a limited partnership, with the corporation as the limited partner with a 99.999% interest and the employee as the general partner with a 0.00 1% interest. the service ruled that the partnership was not a partnership for federal income tax purposes on the theory that the employee did not intend to become a partner. however, that ruling also is of limited usefulness, because the factors relied upon by the service included not only the employee's "minuscule interest," but also the fact that the individual funded his share of the capital with a nonrecourse loan from his employer, the fact that he was fully indemnified against expense or loss by his employer and the fact that he was required to sell his interest at cost to the designee of his employer upon the termination of his employment. given the absence of authority, the only useful guidance is the service's ruling guideline relating to the minimum interest that a general partner must have in order to receive a favorable ruling, even though that guideline is not by its terms tied to the limited liability factor (or any other specific provision of the substantive law for that matter). historically, the service's ruling guideline was that the general partner had to have at least a one 62. larson, 66 t.c. at 175 n. 11. 63. id. 64. priv. let. rul. 8139048 (june 30, 1981). 19931 florida tax review percent interest in all cases.65 however, the service's new ruling guideline, while adhering to the one percent standard for most partnerships, allows the general partner to have a smaller interest where the total capital contributions of the partnership exceed fifty million dollars.66 the minimum permissible interest scales down to as little as a 0.2% interest, which applies where the total capital contributions are at least $250 million. 67 since that ruling guideline effectively provides a bright-line safe harbor as to the minimum percentage interest a general partner must have to be regarded as a partner, it tends to be faithfully observed in practice, as was its predecessor ruling guideline. assuming that the ruling guideline standard for the minimum percentage interest of a general partner is the de facto law of the land, the only remaining issue is how it applies where there are multiple general partners, i.e., whether each general partner must have that minimum interest individually or whether it is sufficient for the general partners collectively to have that minimum interest. the ruling guideline (which, as noted earlier, is not expressly tied to the limited liability factor) is clear that it applies to the aggregate interest of the general partners.68 that does not quite finish the story, since there may be cases in which the net worth supporting the absence of limited liability resides in only one of the general partners. until recently, the only prudent course of action in that case would seem to have been to make sure that that general partner's interest individually satisfied the minimum interest requirement of the ruling guidelines. however, revenue procedure 92-88, the service's new statement on partnership "comfort" rulings, seems to indicate that the net worth requirement may be satisfied by any one general partner, even if its interest standing alone does not satisfy the minimum interest requirement.69 7. individuals as general partners.-the foregoing discussion of the characteristic of limited liability has focused upon corporate general partners. however, another issue that frequently arises is whether an individual that serves as the general partner of a limited partnership must have a minimum 65. see rev. proc. 74-17, 1974-1 c.b. 438. 66. rev. proc. 89-12, 1989-1 c.b. 798. 67. assuming that the general partner would be making a pro rata capital contribution for its interest, the effect of the ruling guideline is to require that the general partner contribute one percent of the total amount of capital contributed by all the partners where such contributions are less than $50,000,000, $500,000 where the total capital contributions are $50,000,000 to $250,000,000 and 0.2% of the total amount of capital contributed by all the partners where such contributions exceed $250,000,000. 68. rev. proc. 89-12, 1989-1 c.b. 798 at § 4.01. note also that the general partners may count any interests in the partnership that they hold as limited partners in satisfying the minimum interest test. 69. rev. proc. 92-88, 1992-42 i.r.b. 39 (oct. 19), at § 4.03. [vol. 1:4 lingering partnership classification issues net worth for the partnership to be deemed to lack the characteristic of limited liability. as indicated earlier, the basic rule on limited liability is that all partnerships lack the characteristic of limited liability, because all partnerships have at least one general partner that is personally liable for partnership liabilities. 70 the only qualification to that rule applies in the case of a limited partnership with a corporate general partner (in which case the corporate general partner must either have substantial assets or not be acting as the dummy of the limited partners). thus, where the general partner is an individual, the regulations by their terms do not require any minimum net worth, even though the individual general partner case could involve fewer assets being at risk than the corporate general partner case.7 ' nonetheless, practitioners typically have tended to make some modest inquiry to make sure that individual general partners in partnerships relying on the absence of limited liability have assets of some significance, even if that inquiry consisted of simply confirming that the individual had a reasonably august title where he was employed. however, revenue procedure 92-8872 establishes a new bright-line benchmark for the net worth of individual general partners and is likely to prompt a more formal inquiry by practitioners into whether that benchmark is satisfied. revenue procedure 9288 provides that the service will not issue a "comfort" ruling on whether a partnership that has an individual as its sole general partner lacks limited liability if the individual has net worth, exclusive of the value of his interest in the partnership, equal to the lesser of (i) ten percent of the total capital contributions to the partnership or (ii) one million dollars.' 8. capital accowt restoration obligations.-a final issue that is tangentially related to the limited liability factor is whether a corporate general partner should have a certain minimum net worth even where the partnership is not relying on the absence of limited liability to support its partnership status. it is possible, of course, that purely business reasons would dictate that the general partner have substance. however, there also are two legal reasons why the net worth of the general partner might be a concern. the first reason, which is beyond the scope of this article, is the non-tax concern that the corporation may be more vulnerable to "veil-piercing" if it does not have any substance aside from its partnership interest. 70. see discussion supra part il(a). 71. notwithstanding the regulations, revenue procedure 91-13. 1991-1 c.b. 477 (providing the partnership status ruling checklist) requires that partnership status ruling requests indicate whether individual general partners have "'substantial assets." 72. 1992-42 i.r.b. 39 (oct. 19). 73. id. at § 4.03(2). 19931 florida tax review the second reason is that the general partner otherwise might not have sufficient financial wherewithal to satisfy its tax-related capital contribution obligations. as indicated earlier, revenue procedure 89-12 requires for advance ruling purposes that the general partner either (i) maintain a capital account balance equal to the lesser of one percent of the aggregate positive capital accounts of all the partners, if any, or $500,000 or (ii) represent that it will provide "substantial services" and agree to contribute on dissolution of the partnership an amount equal to the lesser of (a) the deficit balance, if any, in its capital account at that time or (b) the excess of 1.01% of the total amount of capital contributions by the limited partners over the amount of capital previously contributed by the general partner.74 the purpose of that ruling guideline, of course, is to insure that the general partner has a minimum capital interest in the partnership, which the service presumably felt was necessary for it to be comfortable that the general partner was a partner in substance. however, that ruling guideline is clearly more stringent than the substantive law, since a general partner need not have a capital interest to be regarded as a partner for tax purposes as a matter of substantive law, assuming that it has a significant profits interest.75 nevertheless, partnerships tend to comply with the ruling guideline to avoid any question on the issue, although often in reliance on the part applicable to general partners that provide "substantial services."76 whichever part of the ruling guideline is to be satisfied, it would not seem sufficient for the applicable partnership agreement simply to recite the required capital contribution obligation if the general partner does not have enough financial substance to satisfy that obligation. iv. free transferability of interests a. background regulations section 301.7701-2(e)(1) provides that an entity has the 74. rev. proc. 89-12, 1989-1 c.b. 798. curiously, the one percent figure in clause (i) and the 1.01% figure in clause (ii) are not subject to reduction where the capital contributions to the partnership exceed $50 million, even though the general partner need not have a one percent interest in profits and losses in such case under section 4.02 of revenue procedure 89-12. the clause (ii) amount also apparently is not reduced by any distributions to the partners that represent a return of capital. 75. see, e.g., beck chem. equip. corp. v. commissioner, 27 t.c. 840, 850-51 (1957). 76. it is unclear why the service felt that the general partner had to be providing "substantial services" to avoid a positive capital account maintenance obligation. one cynical explanation is that the service was looking for confessions by service partners of possible vulnerability to taxation upon receipt of their partnership interests under diamond v. commissioner, 492 f.2d 286 (7th cir. 1974). [vol 1:4 lingering partnership classification issues corporate characteristic of free transferability of interests if "those members owning substantially all of the interests in the organization have the power, without the consent of other members, to substitute for themselves in the same organization a person who is not a member of the organization." the regulation goes on to provide that the key is whether a member can assign "his rights to participate in the management of the organization." consequently, the ability of members to freely assign the economic attributes of their interests (without the transferee becoming a partner of record) is not relevant for this purpose, regardless of what additional significance there may be to becoming a partner of record. in addition, the ability of members to transfer to other members is not relevant, since the regulation looks to whether a transfer may be made to a nonmember. under regulations section 301.7701-2(e)(2), if the members are subject to a transfer limitation created by the existence of a right of first offer on the part of the other members,' then "a modified form of free transferability" is deemed to exist. the concept of partially limited transferability stands in contrast to the all-or-nothing approach taken with the other three corporate characteristics, even though those characteristics also could easily be viewed as matters of degree. in any event, it has long been recognized that the concept of partially limited transferability is largely academic, since the existence of partially limited transferability produces the same result as the existence of completely free transferability.7" under regulations section 301.7701-2(e)(1), a partnership is deemed to lack the characteristic of free transferability if a transfer of an interest would cause the entity to dissolve under local law (regardless of whether it is immediately reconstituted), even if the interests are otherwise freely transferable. as a result of that rule, general partnerships virtually always lack the characteristic of free transferability of interests. 77. the regulation describes the limitation as a situation where a member may transfer his interest "only after having offered such interest to the other members at its fair market value." 78. if the entity has only one other corporate characteristic (say, limited liability), the entity will be classified as a partnership if it has either partially limited transferability or completely free transferability, since in either case the entity will not have more than two of the four corporate characteristics. on the other hand, if the entity has two other corporate characteristics (say, limited liability and centralized management), it will be classified as an association if it has either partially limited transferability or completely free transferability, since in either case it will have more than two of the four corporate characteristics. see regs. § 301.7701-2(a)(3) (concerning requirement of more than two corporate characteristics to be classified as an association). 19931 florida tax review b. issues the foregoing rules raise the following special problems. 1. reasonable v. sole discretion.-one issue that arises is whether a partnership should be viewed as having the corporate characteristic of free transferability of interests if the limited partners must obtain the consent of the general partner to transfer their interests, but that consent may not be unreasonably withheld. the issue of what would be a reasonable basis for withholding consent must be decided on a case-by-case basis. at one extreme would be closely held partnerships where the limited partners have substantial financial obligations and participate in management, in which case the general partner presumably could reasonably be very selective in granting consent. at the other extreme would be widely held partnerships where the limited partners have no financial obligations and do not participate in management (master limited partnerships being the classic example), in which case the general partner probably could not reasonably withhold consent with respect to any proposed transferee except perhaps the mafia. the larson case holds that if the general partner's consent to a proposed transfer may not be unreasonably withheld, the entity will be treated as having free transferability. 79 that conclusion is questionable for a number of reasons. first, the larson holding seems to give no effect to the term "freely" in the regulation, since the term "freely" would seem to indicate that there are not any limitations. second, the requirement that a partner must go to another member and obtain consent before transferring provides a meaningful distinction from the truly free transferability typically associated with corporate stock, even if the consent may be withheld only for a good reason. third, there is authority in the real estate investment trust ("reit"') area that suggests that the larson holding may not be correct. under section 856(a)(2), a reit's shares must be "transferable," which obviously sounds like a weaker standard than the "freely transferable" standard. the reit requirement has been interpreted to mean the absence of any limitation on share transfers, other than any limitations that are necessary to avoid violating securities laws or to prevent a loss of reit status because of an increase in the concentration of share ownership."0 thus, a reasonable consent requirement would, a fortiori, seem to preclude the existence of free transferability. nevertheless, larson is the only authority on the issue in the partnership 79. larson v. commissioner, 66 t.c. 159, 183 (1976). 80. see regs. § 1.856-1(d)(2); priv. let. rul. 8921067 (feb. 28, 1989); priv. let. rul. 7311230330a (nov. 23, 1973). the reit authority on the meaning of the term "transferable" is favorable to the service in the reit context, but would be unfavorable to the service as it relates to the partnership issue. [vol. 1:4 lingering partnership classification issues context, and, therefore, it tends to be followed. that gloss having been established, the one remaining issue in this area is what the result is if the partnership agreement simply provides that the general partner must consent, without specifying whether such consent may be granted or denied in its sole discretion. that, in turn, leads to the nontax issue of whether there is an implied duty of reasonability under applicable state law. since the law varies from jurisdiction to jurisdiction and reasonable people may differ as to what the law in a particular jurisdiction actually is, the only prudent course of action where the absence of free transferability is being relied upon is to specify in the partnership agreement that the general partner's consent may be granted or denied in its sole discretion. 2. limited transfer rights.-another issue is whether free transferability will be deemed to exist where the partners have the right to freely transfer their interests in certain limited circumstances, but in all other circumstances transfers are subject to the general partner's consent. one type of transfer provision of this nature is a provision authorizing transfers occurring as a result of certain extraordinary events, such as a provision authorizing transfers to the estate of an individual partner upon his death, a provision authorizing transfers to the bankruptcy estate of a partner upon his bankruptcy or a provision authorizing a transfer to a lender that holds a loan secured by a partnership interest upon the occurrence of a default on the loan. this issue is more pervasive than one might imagine, because applicable law often requires such transfers, regardless of whether there is any transfer restriction in the partnership agreement.8' given the fact that such transfers are authorized only on a one-time basis upon the occurrence of an extraordinary (and typically unforeseen) event for the transferor partner, the fact that the transfer essentially is involuntary and the fact that the transfer would be made to an identified transferee that is the successor in interest to all the transferor partner's assets (not just his partnership interests), such provisions generally should not be regarded as making the interests "freely transferable." the service has issued at least three private letter rulings to that effect.8 the only close question 81. see, e.g., § 541(c) of the bankruptcy reform act of 1978, as amended (providing that a debtor's bankruptcy estate generally succeeds to the debtor's property, without regard to any transfer restrictions in any agreement): del. code ann. tit. 6. § 17-705 (supp. 1992) (providing for automatic transfers of interests in delaware limited partnerships to the estates of deceased individual partners or the successors to liquidated corporate partners). 82. priv. let. rul. 9253013 (sept. 30, 1992) (ruling that partnership lacks free transferability despite the lack of a consent requirement for transfers to specified persons by will or under the laws of descent and distribution); priv. let. rul. 9243018 (july 22, 1992) (ruling that foreign entity lacks free transferability despite the fact that the prohibition on transfers of shares did not apply with respect to transfers upon the death, dissolution. 19931 florida tax review in that regard involves provisions authorizing a transfer by a corporate partner to its successor in connection with a merger or liquidation transaction, since such a transfer generally is more volitional in nature than the other types of transfers described above. even that type of provision should not cause the partnership to be viewed as having the characteristic of free transferability, however, assuming that most of the partners in the partnership are not special purpose corporations created to circumvent a general transfer limitation.83 another common transfer provision is a provision authorizing transfers at any time to related transferees, such as family members or controlled affiliates, without the consent of any partner. it seems arguable that such provisions should not cause the partnership to be deemed to have freely transferable interests, assuming that the specified class of transferees is reasonably circumscribed. the argument would be that the partners must have a right of transfer that is unfettered in all respects for the interests to be regarded as being "freely" transferable, a conclusion that is supported by the reit authority mentioned earlier.' 4 however, the term "freely" may have been intended to refer only to the freedom to transfer at any time without any consent requirement. even if the class of potential transferees is limited, the partner does have the right to make a transferee of his choosing within that class a partner. one case to consider this issue was o'neill v. united states,85 which involved an ohio professional association the shares in which under ohio law could only be transferred to a person that was licensed to practice the profession and under the articles of association could only be transferred to a person who would become an employee of the association. without much discussion, the court ruled that the association had freely transferable interests. given the lack of clear authority on this issue, most practitioners tend to take the conservative view that such affiliate transfer rights create the corporate characteristic of free transferability. 3. assignments without substitution.-as indicated above, regulations section 301.7701-2(e)(1) provides that the key consideration for free liquidation, bankruptcy or insolvency of a member); priv. let. rul. 9210019 (dec. 6, 1991) (ruling that texas limited liability company lacks free transferability despite the lack of a consent requirement for transfers to specified persons incident to death, dissolution, divorce, liquidation, merger or termination). 83. see priv. let. rul. 9243018 (july 22, 1992) and priv. let. rul. 9210019 (dec. 6, 1991), supra note 82. but see g.c.m. 38012 (july 13, 1979) (trust has a modified form of free transferability where corporate beneficiaries could transfer their interests in connection with a merger or consolidation with another corporation). query also what effect the availability of a section 338 election for purchasers of the stock of the corporate partners should have on the free transferability issue. 84. see supra text accompanying note 80. 85. 410 f.2d 888 (6th cir. 1969). [vol 1:4 lingering partnership classification issues transferability purposes is whether a member can assign "his rights to participate in the management of the organization." consequently, the ability of members to freely assign the economic attributes of their interests, with the transferee becoming entitled to cash distributions but not becoming a partner of record, is not relevant for this purpose. that reading of the regulations has been confirmed in a number of published rulings.86 the irrelevance of free assignability is rather surprising as a policy matter. the assignee of a partnership interest has all the economic benefits and burdens of ownership. the only substantive indicia of ownership that the assignee lacks are that the assignee may not receive cash distributions directly from the partnership if the partnership agreement expressly provides that distributions will not be made to assignees and the assignee does not have the right to participate directly in partnership governance. however, the distribution point is not significant, since many partnership agreements authorize distributions directly to assignees and, even if the partnership agreement does not so provide, the assignor normally would function as the assignee's agent for those purposes, remitting distributions to the assignee upon receipt from the partnership. likewise, the partnership governance point is not significant, since limited partners usually have very limited rights to participate in management and again the assignor could presumably function as the assignee's agent by sending partnership communications to the assignee, voting as directed by the assignee, etc., if the partnership continued to allow the assignor to participate in management! 7 consequently, whether a limited partnership lacks the characteristic of free transferability is a largely formalistic question. on the basis of the foregoing considerations, the service has ruled that an assignee of a partnership interest that acquires substantially all dominion and control over the partnership interest should be treated as the 86. see, e.g., rev. rul. 88-76, 1988-2 c.b. 360 (classifying a wyoming limited liability company as a partnership based in part on the absence of free transferability of interests where substitutions were restricted but assignments were not); rev. rul. 88-79, 1988-2 c.3. 361 (classifying a missouri royalty trust as a partnership based on the same analysis); rev. rul. 93-5, 1993-3 i.r.b. 6 (jan. 19) (classifying a virginia limited liability company as a partnership based on the same analysis); rev. rul. 93-6, 1993-3 i.r.b. 8 (jan. 19) (classifying a colorado limited liability company as a partnership based on the same analysis). 87. as a general rule, under most state partnership statutes, the assignor would cease to have the right to participate in partnership governance after the assignment, unless the partnership agreement provided otherwise. see, e.g., del. code ann. tit. 6, § 17-702(a)(4) (supp. 1992). of course, if the partnership agreement contemplated that cash distributions would be made directly to assignees and it permitted assignees to participate in partnership management, there would not be any substantive distinction whatsoever between an assignee and a partner of record and, therefore, the partnership should be treated as having free transferability of interests if the interests therein were freely assignable. 19931 florida tax review partner for federal income tax purposes."8 thus, not only does the assignee have the substantive benefits and burdens of being a partner, but he also enjoys the tax attributes as well. that leads to the seemingly anomalous result that a partnership may be treated as lacking free transferability even though both economic and tax ownership is freely transferable by assignment. however, it is interesting to note that most tax practitioners have regarded that conclusion as being simply too good to be true when applied to "master limited partnerships" where what trades are assignee interests (or depository units representing assignee interests) that do not result in the automatic substitution of the transferee as a partner of record. 9 one argument that can be made as to why free assignability should not matter for purposes of determining whether a partnership has freely transferable interests is that it may be impossible for a partnership to prevent assignments of interests. the reason is that the law in many states is (or may be) that restrictions on the transfer of partnership interests that are contained in a partnership agreement, regardless of how absolute, are unenforceable as between a transferor and a transferee of a partnership interest.9" hence, even though the partnership would not recognize the transfer, the transferor could still confer the substantive benefits and burdens of ownership on the transferee in essentially the same manner as where assignments are specifically authorized under the partnership agreement. thus, if the ability to assign were the key to free transferability, partnerships in such states might have a real problem where partnership status depended upon the absence of free transferability. 4. multiple mild limitations.-as indicated above, a transfer limitation is not sufficient to cause an entity to be treated as not having the corporate characteristic of free transferability of interests if all it does is require the general partner's reasonable consent to a proposed transfer, restrict 88. see rev. rul. 77-137, 1977-1 c.b. 178; g.c.m. 36960 (dec. 20, 1976) (discussing rev. rul. 77-137); priv. let. rul. 8743083 (july 30, 1987); priv. let. rul. 8642050 (july 18, 1986); priv. let. rul. 8636019 (june 3, 1986); priv. let. rul. 8602062 (oct. 17, 1985); priv. let. rul. 8524070 (mar. 20, 1985); priv. let. rul. 8520105 (feb. 21, 1985); priv. let. rul. 8440081 (july 6, 1984); priv. let. rul. 8434047 (may 21, 1984); priv. let. rul. 8427073 (apr. 3, 1984); priv. let. rul. 8350033 (sept. 9, 1983); and priv. let. rul. 8229034 (apr. 20, 1982); cf. evans v. commissioner, 447 f.2d 547 (7th cir. 1971) (holding a transferor of his entire interest in partnership to no longer be a partner for federal income tax purposes). 89. see, e.g., the prospectuses for: de laurentiis film partners l.p. (dated feb. 27, 1987); eqk green acres, l.p. (dated aug. 20, 1986); falcon cable systems company (dated dec. 23, 1986). the tax opinions for these master limited partnerships did not seem to rely on the absence of free transferability. 90. see, e.g., trubowitch v. riverbank canning co., 182 p.2d 182 (cal. 1947) and rosenthal v. landau, 202 p.2d 810 (cal. dist. ct. app. 1949) for california authority limiting the enforceability of restrictions on assignments of contract rights. nvot 1:4 lingering partnership classification issues the class of eligible transferees or impose a right of first offer.9 that leads to the obvious question of whether the imposition of more than one such mild transfer limitation would cause the entity to be treated as not having the corporate characteristic of free transferability of interests. surprisingly, there is virtually no authority or even commentary on this issue. the larson case involved two mild limitations-a reasonable consent requirement and a very limited right of first offer-but the former only applied to transfers of profits interests and the latter only applied to transfers of capital interests.92 thus, the court easily concluded that the partnership had the characteristic of free transferability of interests. this issue also was addressed in a recent private letter ruling.93 the ruling involved a german gesellschaft mit beschrantker haftung ("gmbh") whose shares could not be transferred without the transferor first offering them for sale to the other members and, if they chose not to purchase the shares, obtaining their consent to the transfer (which could not be unreasonably withheld). the service ruled that the gmbh lacked free transferability of interests because of that double limitation, even though neither limitation individually would have been sufficient. finally, the reit authority discussed earlier' would seem instructive, as it would suggest that any mild transfer limitation and, a fortiori, a combination of mild transfer limitations would cause the interests to not be regarded as "transferable," much less "freely transferable." 5. free transferability for some but not all partners.-as noted earlier, free transferability of interests exists if persons holding "substantially all" the interests in the entity may freely transfer their interests. hence, an entity will not be deemed to have the corporate characteristic of free transferability of interests as long as the interests of persons subject to transfer limitations are sufficiently significant that the interests of the other persons are not regarded as "substantially all" the interests. unfortunately, there is virtually no authority as to what the standard of significance is for this purpose. the only directly relevant authority is the service's recent ruling guideline set forth in revenue procedure 92-33,9 which states that the question of whether "substantially all" the interests are freely transferable depends upon all the relevant facts and circumstances, with no particular percentage being controlling. however, it goes on to provide a 91. see supra text accompanying note 77 (regarding treatment of imposition of right of first offer requirement as creating modified form of free transferability). 92. larson v. commissioner, 66 t.c. 159, 182-83 (1976). 93. priv. let. rul. 9010028 (dec. 7, 1989). 94. see supra text accompanying note 80. 95. 1992-1 c.b. 782. 19931 florida tax review safe harbor by indicating that the service generally will rule that a partnership lacks the characteristic of free transferability of interests if the partnership agreement restricts the transferability of partnership interests that represent "more than 20% of all interests in partnership capital, income, gain, loss, deduction, and credit." there are two interesting aspects of this ruling guideline. first, revenue procedure 92-33 states that the service "generally" (but apparently not always) will rule favorably if the twenty percent test is satisfied. although there is no indication as to why that qualification was included, it probably reflects the service's concern regarding whether transfer limitations should be respected where the general and limited partners are affiliated, as discussed in part iv(b)(6) below. second, the twenty percent test apparently must be satisfied separately with respect to the interests in each of partnership capital, income, gain, loss, deduction and credit. that raises the issue of how the twenty percent test applies where the partners' interests in capital, income, gain, loss, deduction or credit vary over time. the ruling guideline could be interpreted as referring either to partnership interests that always represent at least twenty percent of partnership capital, income, gain, loss, deduction and credit or to partnership interests that are expected to receive twenty percent of such items on a present value basis. for instance, in a typical real estate or venture capital partnership, the limited partners put up all the equity capital and cash profits are distributed first to the limited partners to pay a preferred return on their capital and then, say, fifty percent to the limited partners and fifty percent to the general partner. under the former reading of the ruling guideline, forty percent of the limited partners' interests would have to be restricted, whereas under the latter reading something substantially less than forty percent should suffice. the "all interests" language in the ruling guideline suggests that the former reading was intended, as does a recent private letter ruling.96 one final observation on this issue is that it may be possible for a partnership that restricts the transferability of some but not all of its interests to provide all its partners with effective free transferability. the reason is that, as noted earlier, the free transferability factor turns on whether the members may substitute for themselves someone that is not a member, which means that it is not necessary to restrict transfers to other members. suppose, for example, that a partnership agreement provided that twenty-five percent of the interests in the partnership could be transferred to third parties only with the consent of the general partner (but could be freely transferred to existing partners without consent) and that the remaining seventy-five percent 96. see priv. let. rul. 9306008 (nov. 10, 1992) (describing the partnership interests not subject to transfer limitations as representing less than 80% of partnership capital, income, gain, loss, dedication and credit "throughout the life" of the partnership). [vol 1:4 lingering partnership classification issues of the interests could be freely transferred to anyone. the partnership would seem to lack free transferability based on the ruling guideline in revenue procedure 92-33. however, the holders of the restricted interests could transfer their interests to third parties without consent by first arranging for the transferee to acquire a small unrestricted interest, which would make the transferee a partner and thereby vitiate the consent requirement for the transfer of the restricted interest. because this potential to "unlock" restricted interests is inherent in the free transferability rules, it does not seem too disturbing, except possibly in the case where all the partners regard the transfer limitation as a subterfuge and partners routinely transfer restricted interests through this two-step process. 6. affiliated general and linited partners.-in some partnerships, the general partner is closely affiliated with some or all of the limited partners. in such situations, the issue arises as to whether the entity could be deemed to have freely transferable interests, even if transfers are subject to the general partner's consent, on the theory that the general partner would never refuse to grant its consent to a proposed transfer by its affiliate. the first hint of this issue as a real concern came in revenue ruling 75-19, 97 in which the service ruled that a general partnership formed under a uniform act statute by four corporate subsidiaries of the same corporation was a partnership for federal income tax purposes. the ruling held that the entity should be classified as a partnership on the basis of the absence of limited liability, continuity of life and centralized management, but there was an ominous silence as to whether the entity had free transferability of interests." the issue then surfaced in zuclanan,99 where the service argued that the interest of the largest limited partner in a partnership, which could not be transferred without the general partner's consent, was effectively freely transferable because that limited partner indirectly owned the general partner. the court seemed to accept that argument, although it went on to conclude that free transferability was lacking because the general partner's own sixty-two percent interest could not be transferred without the consent of all the limited partners. this issue gained much more prominence two years later when the service promulgated revenue ruling 7 7-2 14 ."o revenue ruling 77-214 97. 1975-1 c.b. 382. 98. id.; see also rev. rul. 83-156. 1983-2 c.b. 66 (assuming, in a section 721 ruling involving a general partnership formed between a first-ticr and second-tier subsidiary of the same corporation, that the partnership was a partnership for federal income tax purposes). 99. 524 f.2d at 742-44. 100. 1977-1 c.b. 408. it probably is not a coincidence that revenue ruling 77-214 was promulgated the same year as revenue ruling 77-316, 1977-2 c.b. 53. which disallowed 19931 florida tax review involved a german gmbh owned by two wholly owned u.s. subsidiaries of a u.s. corporation. since under german law a gmbh has the corporate characteristics of limited liability and centralized management, the classification issue depended upon whether the gmbh lacked free transferability of interests and continuity of life. although the "memorandum of association" for the gmbh provided that neither member could transfer its interest without the other's consent and that the gmbh would be dissolved upon the death, insanity or bankruptcy of either member, the service nevertheless ruled that the gmbh had freely transferable interests and continuity of life and, therefore, that the entity was an association for federal income tax purposes. on the free transferability of interests issue, the service simply stated that "it is apparent that the controlling parent could make all the transfer decisions for its wholly owned subsidiaries."'' in other words, any time one of the members desired to transfer its interest, it would be acting at the direction of, or at least with the approval of, the common parent, which would not then turn around and direct the other member to withhold its consent to the transfer. revenue ruling 77-214 was immediately criticized by commentators.'12 the issue resurfaced shortly thereafter in mca, inc. v. united states. 3 that case involved a number of different foreign entities, each of which was owned ninety-five percent by a dutch corporation (which, in turn, was owned forty-nine percent by mca, forty-nine percent by paramount pictures and two percent by an employee trust created for the benefit of the dutch corporation's key employees) and five percent by the employee deductions for insurance premium payments by a corporation to its "captive" insurance company on the theory that there could be no risk shifting because they were in the same "economic family." 101. rev. rul. 77-214, 1977-1 c.b. 408, 409. on the continuity of life issue, the service first stated that the gmbh would not dissolve upon the occurrence of a dissolution event as to one member unless the other member affirmatively acted to force dissolution (since dissolution was not automatic under german law) and then concluded that there were no "separate interests" that would compel dissolution should a dissolution event occur. the lack of "separate interests" rubric used in analyzing the continuity of interest issue is really just an alternative way of stating the service's concern with respect to the free transferability issue. for more discussion of the continuity of life aspect of revenue ruling 77-214, see part v(b)(5) below. 102. see, e.g., tax section, new york state bar ass'n, report on foreign entity characterization for federal income tax purposes, reprinted in 35 tax. l. rev. 169, 206-15 (1980). the main criticism of the single economic interest theory is that: if followed through to its logical conclusion, it would apply to three out of the four characteristics which the regulations specify as distinguishing partnerships from corporations.... it would be impossible for a corporate group to operate a foreign partnership if its full ownership is channelled through a single corporate parent at any point in its structure. id. at 206. 103. 685 f.2d 1099 (9th cir. 1982). [vol. 1:4 lingering partnership classification issues trust-t 4 the parties stipulated that the foreign entities had limited liability and centralized management, 0 5 so that, as in revenue ruling 77-214, the classification issue turned on whether the entities had freely transferable interests and continuity of life. although transfers of interests required the consent of the other member and the entities would dissolve upon the bankruptcy of a member or the occurrence of certain other events," t the service argued that the entities had freely transferable interests and continuity of life because the dutch corporation and the employee trust were under common control' 07 and constituted a "single economic interest" such that they could not act independently.10 8 the court held that the entities should be classified as partnerships, rejecting the service's position on the theory that the owners were different persons that potentially could have conflicting interests, despite the general commonality of their business interests.109 although the court acknowledged that there was common control of the members, it dismissed that concern based upon the fact that the board of trustees of the employee trust had a fiduciary duty to exercise its authority in good faith based upon the best interests of the beneficiaries."' revenue ruling 77-214 was recently reconsidered by the service in revenue ruling 93-4.11' while, as discussed below, the service purported to eliminate revenue ruling 77-214 as a problem for continuity of interest purposes,'1 2 the service essentially reaffirmed it for free transferability purposes. however, the service did add certain refinements. first, the service expressly stated the question in terms of whether "the possibility of an impediment to transfer" exists, which sounds like the narrow approach taken by the court in mca. second, the service made the surprising statement that if the "memorandum of association" for the gmbh had either prohibited transfers of interests or provided for an automatic dissolution of the gmbh upon the occurrence of a transfer, then the gmbh would have been viewed 104. id. at 1100. 105. id. at 1102. 106. the opinion states that dissolution occurred "because the organizational documents and local laws provide for dissolution." id. 107. the same persons controlled the board of directors of the dutch corporation and the board of trustees of the employee trust. id. at 1100-01. 108. id. at 1102. 109. the court concluded that, although the dutch corporation and the employee trust "are likely, as a practical matter, always to act in concert in their management of the [entities], we cannot conclude as a matter of law that their interests will never diverge." id. at 1104. 110. id. 111. 1993-3 i.r.b. 5 (jan. 19). 112. see discussion infra part v(b)(5). 19931 florida tax review as lacking free transferability of interests."' before turning to the free transferability issues raised by the service's "single economic interest" theory, it is instructive to note two points. first, despite the potentially sweeping nature of the service's argument, the authority for its position is actually quite narrow. the only favorable authorities, zuckman l 4 and revenue ruling 77-214, involved the extreme cases of a partnership principally owned by an individual and his wholly owned second tier subsidiary and a partnership between sister subsidiaries, respectively. moreover, both the mca opinion, which was sympathetic to the service's legal argument but rejected it as applied to the facts of the case, and revenue ruling 93-4 stated the legal issue in terms of whether there was any possibility that the members could have divergent interests that could result in the transfer limitation having substance, which is a relatively easy test to satisfy." 5 second, the service apparently has never asserted the "single economic interest" theory in the context of classifying an entity organized under domestic law. 1 16 in fact, the service has not even consistently applied the theory in the foreign context." 17 however, there is no reason in principle why the theory should not apply in the domestic context for free transferability purposes, and a service official recently stated publicly that the theory could be applied in the domestic context."18 113. that aspect of revenue ruling 93-4 was foreshadowed by private letter ruling 9243018 (july 22, 1992) and private letter ruling 9253029 (oct. 2, 1992), in which foreign entities owned by sister companies that prohibited transfers of interests were held to lack free transferability. 114. 524 f.2d 729 (ct. cl. 1975). 115. mca, 685 f.2d at 1104. 116. for an example of a recent private letter ruling that presents this issue in the domestic context, see private letter ruling 9248021 (aug. 31, 1992) (classifying partnership between s corporations with a common owner as a partnership based upon the lack of free transferability and continuity of life without mentioning revenue ruling 77-214). 117. see, e.g., priv. let. rul. 7934096 (may 24, 1979) (classifying french soci~t6 en nom collectif between sister companies as a partnership based on the absence of limited liability, free transferability of interests, continuity of life, and centralized management without mentioning revenue ruling 77-214); priv. let. rul. 8439037 (june 26, 1984) (classifying foreign partnership owned by parent and subsidiary as a partnership based upon the absence of limited liability and free transferability of interests without mentioning revenue ruling 77214); priv. let. rul. 9253029 (jan. 1, 1993) (same ruling for unspecified foreign entity owned by sister companies). see also the continuity of life rulings, infra note 128, although those rulings may have been given in each case because local law seemed to provide for an automatic dissolution if certain dissolution events occurred. 118. see nysba tax section copes with regulatory lull, reprinted in tax notes today (jan. 29, 1993) (lexis, fedtax library, tnt file, elec. cit. 93 tnt 21-11). see also letter to the editor from susan pace hamill, attorney advisor in the office of assistant chief counsel (passthroughs and special industries), tax notes (mar. 8, 1993) at 1385. [vol 1:4 lingering partnership classification issues the "single economic interest" issue, which is often overlooked, frequently arises in three contexts. the first is the context of partnerships between members of the same corporate group. that fact pattern presents the issue in its starkest form, since there are no adverse interests involved in a corporate group where there is 100% common ownership. revenue rulings 77-214 and 93-4 obviously reflect the service's view on that fact pattern." 9 it is difficult to quarrel with that view. thus, the only interesting issue is what amount of divergent ownership is required to create sufficiently separate economic interests for a consent requirement for transfers of interests to be considered meaningful. needless to say, there is not yet any authority on that issue. the second context in which this issue frequently arises involves tiered partnership structures where an upper-tier limited partnership owns, say, ninety-nine percent of a lower-tier limited partnership and the two limited partnerships have a common general partner owning a one percent interest in each. in those situations, a transfer of the upper-tier partnership's interest in the lower-tier partnership would be initiated by the general partner of the upper-tier limited partnership, which would then have to consent to the transfer in its capacity as the general partner of the lower-tier partnership. that structure is often employed by master limited partnerships' or partnerships seeking to insulate their assets from the liabilities relating to a particular part of their business.' 2 ' the "single economic interest" theory of revenue ruling 77-214 should also apply to this situation, subject to the question of what degree of divergent ownership at either level would produce sufficiently separate economic interests (and, therefore, potentially conflicting fiduciary duties of the general partner) for the transfer restrictions to be respected. 119. rev. rul. 93-4, 1993-3 i.r.b. 5 (jan. 19); rev. rul. 77-214. 1977-1 c.b. 408. for subsequent private letter rulings expressly applying the revenue ruling 77-214 theory in that context, see: priv. let. rul. 8401001 (june 16. 1983); priv. let. rul. 8114095 (jan. 12, 1981); priv. let. rul. 8023029 (mar. 11, 1980); priv. let. rul. 7936050 (june 8. 1979): priv. let. rul. 7841008 (june 20, 1978); priv. let. rul. 7831021 (may 3, 1978). but see the rulings. supra note 117. 120. for examples of this structure, see the prospectuses for apache petroleum company (dated aug. 22, 1985); burger king investors master l.p. (dated feb. 20. 1986); ep timberlands, ltd. (dated mar. 7, 1985). the tax opinions as to the status of the lower-tier partnership in these transactions did not seem to rely on the absence of free transferability. 121. for example, a real estate partnership might form one or more special purpose limited partnerships to hold individual properties. the parent partnership would be a 99% limited partner in the special purpose partnerships and its general partner would be a one percent general partner in the special purpose partnerships. thus, if one of the special purpose partnerships incurs a liability in an amount in excess of the value of its assets, the creditor may not reach any of the other assets of the parent partnership (although the creditor could go after the general partner). 19931 florida tax review the third context in which this issue frequently arises is the family partnership area, where the general partner is a family member or is a corporation that is owned by one or more family members and the limited partners are family members. one simple case would be a partnership between a husband and a wife where neither could transfer without the other's consent. the service recently ruled that a partnership with a corporation owned by the husband as general partner and the husband and wife as limited partners lacked free transferability of interests. 2 since differences obviously can arise among any family members, it seems highly unlikely that the revenue ruling 77-214 theory could be successfully applied in any family partnership context. 23 in any of the above situations where the affiliations among the partners mean that a consent requirement may be disregarded, there is still the possibility based on revenue ruling 93-4 that free transferability of interests may be defeated by simply prohibiting transfers of interests or providing for an automatic dissolution of the partnership upon the occurrence of a transfer. as noted above, revenue ruling 93-4 indicates that free transferability would be found lacking in any such situation. however, that seems a little too good to be true, since a partner that desired to transfer its interest could arrange to do so by causing the partnership agreement to be amended prior to the proposed transfer to permit that particular transfer. 24 7. general partners with tiny interests.-if a general partner has a tiny interest, a variation on the limited liability issue discussed in part iii(b)(6) above may arise, i.e., whether the general partner's interest is so small that the general partner should not be regarded as a partner for tax purposes. if the general partner's interest is so small that it would be disregarded, any general partner consent requirement for transfers of interests would not seem to be relevant for free transferability purposes, since regulations section 301.7701-2(e) looks to whether the consent of another member is required. accordingly, for the reasons discussed in part iii(b)(6), 122. priv. let. rul. 9239014 (june 25, 1992). 123. compare david metzger trust v. commissioner, 76 t.c. 42 (1981), aff'd, 693 f.2d 459 (5th cir. 1982), cert. denied, 463 u.s. 1207 (1983), and the cases cited therein on the issue of when family hostility can break attribution of ownership among family members under section 318. see also revenue ruling 93-12, 1993-7 i.r.b. 13 (jan. 26), on the issue of valuing the stock of a corporation owned by family members. 124. such an amendment, in and of itself, should not cause the partnership to have freely transferable interests, since it would only authorize a transfer of a specific interest to a specific person on a specific date and it may not involve "substantially all" the interests. however, if the partners had an agreement from the outset that transfers could be effected in that manner upon request or they routinely did transfer their interests in that manner, the service obviously could take the position that the transfer limitation was illusory. [vol 1:4 lingering partnership classification issues it would be prudent for the general partner's interest to satisfy the service's ruling guideline regarding the minimum size of a general partner's interest. 8. consent shopping.-a final free transferability issue arises where the partnership agreement provides that a transferee partner will not be admitted as a substitute limited partner without consent, but the consent need not be the consent of any particular partner. that issue can arise where the partnership has multiple general partners and any one general partner may give the consent, and it can arise where the consent of a particular percentage (say, twenty-five percent) of all the non-transferring partners is required. although regulations section 301.7701-2(e) literally would be satisfied (since the consent of a member is required for the transferee to be admitted), many tax practitioners tend to have a visceral feeling that this type of transfer limitation generally is not sufficient to avoid the corporate characteristic of free transferability. the only provision of this nature that has been held to defeat free transferability is a provision requiring a majority of all the members to consent to a proposed transfer.2' v. continuity of life a. background if the limited liability factor could be regarded as the most meaningful corporate characteristic, continuity of life is surely the most ephemeral. regulations section 301.7701-2(b)(1) sets forth the general rule that "an organization has continuity of life if the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member will not cause a dissolution of the organization." the term "dissolution" means a dissolution under applicable state law, 26 rather than a termination in the section 708(b)(1)(a) sense of ceasing to be engaged in business. whether the entity will automatically dissolve on a date certain or will dissolve on the occurrence of an event other than the six specified dissolutions events is irrelevant for that purpose. the partner whose death, bankruptcy, etc. would cause a dissolution of the partnership does not have to be the partner that has personal liability where the partnership is relying on the lack of limited liability or the partner whose consent is required for a transfer where the partnership is relying on the absence of free transferability.'' the regulations add two special rules. the first special rule is set forth in regulations section 301.7701-2(b)(3), which states that general 125. see rev. rul. 88-79, 1988-2 c.b. 360. 126. regs. § 301.7701-2(b)(2). 127. see regs. § 301.7701-2(b)(1). 19931 florida tax review partnerships organized under a statute "corresponding" to the uniform partnership act and limited partnerships organized under a statute "corresponding" to the uniform limited partnership act lack continuity of life. while it is not clear what it means for a statute to "correspond" to a uniform act, the service recently issued a ruling indicating that the limited partnership statutes of thirty-two states "correspond" to the uniform limited partnership act.128 as discussed below, the regulation flatly and without qualification states the conclusion that a partnership formed under a statute that corresponds to a uniform act lacks continuity of life, but that statement arguably should be regarded more as a favorable presumption because of certain continuity issues that may arise even for uniform act partnerships. second, the regulation, in attempting to state the converse of the basic rule stated above, adds a caveat regarding the possible continuation of the entity after the occurrence of a dissolution event: "if the retirement, death, or insanity of a general partner of a limited partnership causes a dissolution of the partnership, unless the remaining general partners agree to continue the partnership or unless all remaining members agree to continue the partnership, continuity of life does not exist."'129 as discussed below, that provision opens the door to the possibility that reconstitution mechanisms could cause an entity to be deemed to have continuity of life even if the governing 128. those states are: alabama, arizona, arkansas, california, colorado, connecticut, delaware, florida, georgia, idaho, illinois, iowa, kansas, maryland, massachusetts, michigan, minnesota, mississippi, missouri, montana, nebraska, new jersey, ohio, oklahoma, tennessee, texas, utah, virginia, washington, west virginia, wisconsin and wyoming. see revenue ruling 93-2, 1993-1 i.r.b. 8 (jan. 4), which provides a consolidated listing of all the state limited partnership statutes that have been determined to correspond to the uniform limited partnership act in prior revenue rulings (which rulings are superseded by revenue ruling 93-2). thus, eighteen states currently lack comfort on this issue, which states are: alaska, hawaii, indiana, kentucky, louisiana, maine, nevada, new hampshire, new mexico, new york, north carolina, north dakota, oregon, pennsylvania, rhode island, south carolina, south dakota and vermont. it should be cautioned that the approval of revenue ruling 93-2 is expressly based upon the partnership law of the applicable state as in effect on the date specified in the revenue ruling, which means that any subsequent changes in such law potentially could render the approval inapplicable. for example, the approval of the new jersey statute as in effect on january 1, 1985, may be obsolete because that statute was extensively amended in 1988. see n.j. stat. ann. § 42:2a (west supp. 1992); priv. let. rul. 9046037 (aug. 21, 1990) (noting that the new jersey statute, as amended, does not materially correspond to the uniform limited partnership act for purposes of classification criteria set forth in regulations section 301.7701-2). 129. regs. § 301.7701-2(b)(1) (emphasis added). it is curious that this part of the regulation refers to only three of the six relevant dissolution events. one possible explanation is that it was intended to be only an illustration of the converse of the general rule. in any event, the service's recently issued proposed amendment to regulations section 301.7701-2(b) would clarify that the reconstitution rule applies in the case of a dissolution triggered by any of the six events. see infra text accompanying note 151. [vol. 1:4 lingering partnership classification issues agreement provides that there is a dissolution for state law purposes on the occurrence of one or more of the six dissolution events. b. issues the foregoing rules raise the following special problems. 1. reliance on the presumption alone.-a threshold issue that arises with respect to any partnership organized under a statute "corresponding" to the uniform act is whether the partnership may rely on the statement in regulations section 301.7701-2(b)(3) that partnerships organized under such statutes lack continuity of life, regardless of what the partnership agreement specifically provides regarding dissolution. at first blush, it would seem that the unqualified nature of the statement means that it may be relied upon without further inquiry. in fact, the service has recently issued two revenue procedures indicating that it generally will not issue rulings on continuity of life if the partnership is organized under a uniform act statute on the ground that such rulings constitute "comfort" rulings.'"0 nevertheless, there are some grounds for concern on this issue. specifically, when the statement regarding uniform act partnerships is read in context, one cannot help but notice that it is preceded by a lengthy discussion of the substantive aspects of continuity of life.' 3' as will be seen below, there could be a serious question as to whether a uniform act partnership lacks continuity of life in substance because of the inclusion of certain reconstitution provisions, 32 affiliations between the general and limited partners 33 or other reasons. in addition, the service's ruling guidelines provide that it will not rule favorably on the continuity of life of a uniform act limited partnership if less than a majority of the limited partners can continue the partnership after the removal of the general partner.3' thus, it may be more prudent to treat the statement on uniform act partnerships as being more in the nature of a favorable presumption that would control in what might otherwise be a close case on continuity of life.' 130. rev. proc. 92-88, 1992-42 i.r.b. 39 (oct. 19), at §§ 3.03 and 4.02; rev. proc. 92-87, 1992-42 i.r.b. 38 (oct. 19). 131. regs. § 301.7701-2(b). 132. see discussion infra part v(b)(4). 133. see discussion infra part v(b)(5). 134. rev. proc. 89-12, 1989-1 c.b. 798, at § 4.05. 135. the leading partnership commentators seem to agree with that conclusion. see 1 john r. bonn, taxation of partnerships 13:46 (1987) (a uniform act partnership "ordinarily lacks" continuity of life); mckee, supra note 12, at 3-60 (a uniform act partnership is "probably immune" from continuity of life attacks based on substance). but see i arthur b. willis, et al., partnership taxation t 34.05 (4th ed. 1989) (no hedging language in describing 19931 florida tax review the only case to consider this issue has held that the rule on uniform act partnerships is absolute, even if there are provisions in the relevant partnership agreement that would raise questions as to whether the partnership lacked continuity of life in substance. in zuckman,'36 the service took the position that a partnership formed under a state limited partnership statute that admittedly corresponded to the uniform act had continuity of life on the grounds that (i) it had a special purpose corporate general partner, (ii) the partnership agreement provided that the partnership would not voluntarily be dissolved and (iii) the general partner agreed not to file for bankruptcy. the court held that it was "inescapable" that continuity of life would have to be found lacking under a literal reading of the statement in the regulations regarding uniform act partnerships. 37 however, the court did go on to analyze the continuity of life issue as if the statement did not apply and concluded that continuity of life was lacking in substance. 3 2. number of dissolution events.-the literal language of regulations section 301.7701-2(b)(l)-which refers to "the death, insanity, bankruptcy, retirement, resignation, or expulsion" as causing a dissolution-raises the grammatical issue of whether it means that all of those six events (rather than any one such event) must be capable of causing a dissolution for an entity to lack continuity of life, since that language could be read either way. however, the remaining portion of regulations section 301.7701-2(b), particularly the language relating to the reconstitution of a partnership after the occurrence of a dissolution event, makes reasonably clear that it is sufficient that any one such event causes a dissolution.'39 certainly that is the way the regulation is universally applied in practice by both the service and by taxpayers. as an illustration, the partnership at issue in larson was determined to lack continuity of life even though the only pertinent dissolution event was the bankruptcy of the general partner. 40 the issue of whether all six dissolution events were required was not even raised by the service. 4 ' the lack of continuity of life of uniform act partnerships). 136. zuckman v. united states, 524 f.2d 729 (ct. cl. 1975). 137. id. at 734. 138. id. at 734-37. see also foster v. commissioner, 80 t.c. 34, 187-88 (1983), aff'd in part and vacated in part, 756 f.2d 1430 (9th cir. 1985), cert. denied 474 u.s. 1055 (1986) (general partnership determined to lack continuity of life based on an analysis of the substance after noting that it was formed under a uniform act statute). 139. see also regs. § 301.7701-3(b)(2) (examples of partnerships that apparently lack continuity of life on the basis of only three dissolution events). it also may be instructive to note that the seminal pre-regulation case on continuity of life-glensder textile co. v. commissioner, 46 b.t.a. 176 (1942), acq. 1942-1 c.b. 8-held that a partnership lacked continuity of life where the only dissolution events were death, retirement, and insanity. 140. larson v. commissioner, 66 t.c. 159, 173-76 (1976). 141. id. [vol. 1:4 lingering partnership classificaion issues 3. weak dissolution events.-assuming that continuity of life may generally be avoided by providing that any one of the six stated dissolution events will cause a dissolution of the partnership, the next issue is whether the dissolution event that is specified may be one that is highly unlikely to occur. likelihood for this purpose is, of course, a relative concept, as the likelihood that any of the six dissolution events would occur for the typical partnership is very low. presumably it would be going too far to rely on death, insanity or retirement as the dissolution event where the general partner is a corporation for which those concepts have no relevance, except due to the possibility that it might later transfer its partnership interest to an individual. a closer question is whether a partnership may rely on expulsion as the dissolution event where the general partner may not be expelled unless it commits a wrongful act and/or a supermajority vote of the limited partners is required. another issue is whether a partnership may rely on bankruptcy as the dissolution event where the general partner covenants not to voluntarily file a bankruptcy petition, with the result that bankruptcy would occur only if the general partner's creditors file an involuntary petition or the general partner breaches its covenant. a similar issue is whether a partnership may rely on withdrawal as the dissolution event where the general partner covenants not to withdraw. in all those situations, the provision that would be relied upon to break continuity of life would not have much substance given the remote possibility that the applicable dissolution event would occur. two of the foregoing situations were addressed in zuckmnan,' 42 which, as noted earlier, 143 considered whether a partnership lacked continuity of life where the partnership agreement provided that the general partner would not voluntarily dissolve the partnership and the general partner separately agreed not to file for bankruptcy. the court held that such agreements would not cause the partnership to have continuity of life on the ground that the regulations look solely to whether the general partner has the power to cause a dissolution, not whether the general partner has agreed not to do so or whether the general partner would be liable for damages if it did so.'" that theory would suggest that continuity of life would also be found lacking in the expulsion case where the general partner could be expelled without cause, but presumably not where cause is required, since the existence of the power to dissolve the partnership would be contingent on the occurrence of wrongful behavior by the general partner. 142. zuckman, 524 f.2d at 734-37. 143. see supra text accompanying notes 136-38. 144. zucknan, 524 f.2d at 734-37. 19931 florida tax review 4. reconstitution provisions.-another issue is whether a so-called reconstitution provision in a partnership agreement may cause the partnership to be treated as having continuity of life. under such a provision, if a stated dissolution event occurs, a technical dissolution may occur under state law, but the partnership will be reconstituted and continued by the remaining members if a specified proportion of the members agree to so reconstitute the partnership.'45 for example, it is common for the partnership agreement of a limited partnership with multiple general partners to provide that, upon the occurrence of a dissolution event with respect to any one general partner, the remaining general partners may elect to reconstitute and continue the partnership. such reconstitution provisions can test the boundaries of the continuity of life factor, because they can cause the consequences of the occurrence of a dissolution event to be formalistic at best. indeed, as a federal income tax matter, the partnership would not even be viewed as terminating, since the business of the partnership would be continued.'46 as noted above, 47 regulations section 301.7701-2(b)(1) indicates that a partnership that otherwise would be treated as lacking continuity of life will nevertheless be treated as having continuity of life if the partnership may be continued, upon the occurrence of a dissolution event, by less than all the remaining members of the partnership. the language of the regulation indicates that unanimous consent must be required for reconstitution if continuity of life is to be found lacking, and the only case on point involved a unanimous consent provision.'48 unanimous consent obviously would be extremely difficult to obtain where the partnership is widely held. fortunately, the service's 1989 ruling guidelines indicated that a partnership agreement providing for reconstitution based on a simple majority vote of the remaining members after the removal of the general partner would not result in continuity of life,'49 but left unaddressed the issue of whether such a majority vote was allowable after the occurrence of any other type of dissolution event. a further advance was made in 1992 in revenue procedure 92-35,"0 in which the service announced that it would not take the position that a partnership has continuity of life if at least fifty percent of the members 145. under revised uniform limited partnership act statutes, the partnership is not even dissolved as a matter of state law if the vote to continue the partnership occurs within 90 days of the date on which the dissolution event occurs. see, e.g., del. code ann. tit. 6, § 17-801(3) (supp. 1992). 146. see irc § 708(b)(1)(a); regs. § 1.708-i(b)(1)(i). 147. see supra text accompanying note 129. 148. larson v. commissioner, 66 t.c. 159, 165; see also priv. let. rul. 9010027 (dec. 7, 1989) (limited liability company determined to have continuity of life because of a majority vote reconstitution provision). 149. rev. proc. 89-12, 1989-1 c.b. 798 at § 4.05. 150. 1992-1 c.b. 790. [vol 1:4 lingering partnership classification issues must vote to reconstitute the partnership upon the bankruptcy or removal of the general partner, but that still left the issue as to whether a majority vote was allowable after the occurrence of any of the four other dissolution events. this issue would finally be put to bed by the service's recently issued proposed amendment to regulations section 301.7701-2(b),' which would make clear as a matter of substantive law that a partnership will not be deemed to have continuity of life as a result of a provision in its partnership agreement that allows the partnership to be reconstituted based on a majority vote after the occurrence of any dissolution event. the most extreme example of a reconstitution provision would be one which provides that upon the occurrence of a dissolution event, the partnership would automatically be reconstituted and continued. at frst glance, that would seem to insure the entity had continuity of life. however, even that result is not perfectly clear. first, the occurrence of a dissolution event may have non-tax significance under the partnership statutes in certain states, since the dissolution event may cause a technical dissolution of the partnership as a matter of state law, with the consequence that the reconstituted partnership would be regarded as a new partnership for state law purposes.' " second, it is arguable that the requirement that all the partners agree to reconstitute has been satisfied, based either on the theory that all the partners effectively agreed in advance to reconstitute upon the occurrence of a dissolution event by becoming parties to a partnership agreement providing for such reconstitution or on the theory that all the partners agreed to agree to reconstitute the partnership in that event. third, if the partnership was formed under a uniform act statute, the statement in regulations section 301.7701-2(b)(3) that uniform act partnerships do not have continuity of life would seem to insure that continuity of life would be found lacking.5 3 notwithstanding such arguments, it would not seem wise to include an automatic reconstitution provision in a partnership agreement where partnership status depends upon lack of continuity of life (even if the partnership is organized under a uniform act statute), since such a provision would make the consequences of the occurrence of a dissolution event merely formalistic. 151. notice ps-7-92, 1992-32 i.r.b. 27 (aug. 10). it is interesting to note that notice ps-7-92 was issued only three months after revenue procedure 92-35. the proposed amendment also would clarify that a partnership may be reconstituted by the remaining general partner(s), without a limited partner vote, where a partnership has more than one general partner and a dissolution event occurs with respect to one of them. 152. this would not be true under most state statutes, since most states have adopted some version of the revised uniform limited partnership act. see supra note 145. 153. in fact, as noted earlier, the applicability of regulations section 301.77012(b)(3) would prevent the taxpayer from being able to obtain a "'comfort" ruling on that issue. see supra text accompanying note 130. 19931 florida tax review 5. affiliated general and limited partners.-in situations where the general partner is closely affiliated with some or all of the limited partners, a continuity of life issue analogous to that discussed earlier with respect to free transferability may arise." 4 specifically, the service might take the position, as it did in revenue ruling 77-214115 and mca, 156 that the entity has continuity of life even if the partnership agreement provides that the entity will dissolve upon the occurrence of one or more dissolution events on the theory that there are no "separate interests" that would seek to enforce the dissolution provision or, alternatively, that there are no "separate interests" that might prevent the reconstitution of the partnership. 57 while the considerations discussed earlier in the context of free transferability apply in this context, there is an important additional consideration that may change the result for continuity of life purposes. that consideration is the fact that the state statute under which the entity is organized may provide that the entity must dissolve upon the occurrence of one or more dissolution events (subject to the possibility of it reconstituting and continuing). thus, dissolution may occur automatically as a matter of law, rather than as a result of the enforcement of a contractual provision by the members. that consideration, of course, explains why regulations section 301.7701-2(b)(3) contains a flat statement that partnerships organized under a uniform act statute lack continuity of life. thus, historically it has been reasonably safe to rely on the absence of continuity of life where the entity has closely affiliated members but is organized under a uniform act statute. there was less certainty for entities organized under other types of statutes providing for automatic dissolution. however, there was only a glimmer of hope in the service's seemingly aberrational rulings in the foreign context that certain foreign entities owned by members of a single corporate group lack continuity of life, which could only be explained on the basis that local law provided for automatic dissolution.'58 154. see supra part iv(b)(6). 155. 1977-1 c.b. 408. 156. mca, inc. v. united states, 685 f.2d 1099 (9th cir. 1982). 157. but see i.r.s. t.a.m. 8533003 (may 7, 1985) (single beneficiary trust held to lack continuity of life because the beneficiary could revoke the trust). 158. see, e.g., priv. let. rul. 9237021 (june 12, 1992) (socidt6 en nom collectif between sister companies classified as a partnership based on the absence of continuity of life and limited liability without mentioning revenue ruling 77-214 or discussing free transferability); priv. let. rul. 9131057 (may 8, 1991) (same for a soci6t6 en nom collectif between sister companies); priv. let. rul. 9122074 (mar. 6, 1991) (same for a socidt6 en nom collectif between sister companies organized in an undisclosed country); priv. let. rul. 9103033 (oct. 23, 1990) (same for a soci6t6 en nom collectif between parent and subsidiary organized in undisclosed country); priv. let. rul. 8512024 (dec. 21, 1984) (foreign partnership organized in undisclosed country treated as a partnership based on the absence of continuity of life and limited liability without mentioning revenue ruling 77-214 or discussing free [vol 1:4 lingering partnership classification issues in revenue ruling 93-4,'59 the service purported to eliminate the lack of "separate interests" concern with respect to continuity of life. as noted earlier, 160 revenue ruling 93-4 reconsidered the service's treatment of the gmbh at issue in revenue ruling 77-214. without any explanation, it proclaims that "the presence of separate interests is not relevant to the determination of whether an entity possesses continuity of life."'' it then concludes that the gmbh at issue should have been treated as a partnership, since the memorandum of understanding provided for dissolution upon the bankruptcy of either member (which would occur automatically under german law without any further action by the members). although the sweeping language in revenue ruling 93-4 would seem to put this continuity of life issue to bed, two concerns still remain. the fu-st concern is whether revenue ruling 93-4's rejection of the relevance of separate interests applies in situations where the dissolution of the entity would not happen automatically under local law, but, rather, would require the affirmative action of one or more of the members. that could be the case, for example, with a partnership organized under a non-uniform act statute that did not provide for the automatic dissolution or with an entity such as a trust where the dissolution is required purely as a contractual matter 6"2 in such cases, the occurrence of a dissolution event would have absolutely no consequence at the entity level, unless a member enforced the dissolution provision. since the affiliated partners presumably would choose not to enforce the dissolution provision upon the occurrence of a dissolution event, the dissolution provision would have no substance."' hence, in the face of the service's reaffirmation of the lack of separate interests theory for free transferability); priv. let. rul. 8243193 (july 29, 1982) (german offence handelsgeselilschaft between sister companies classified as a partnership based on the absence of limited liability, continuity of life and centralized management without mentioning revenue ruling 77-214 or discussing free transferability); priv. let. rul. 8222012 (feb. 25. 1982) (foreign partnership organized in undisclosed country classified as a partnership based on the absence of continuity of life and limited liability without mentioning revenue ruling 77-214 or discussing free transferability); priv. let. rul. 7934096 (may 24, 1979) (same for a french societe en nom collectif between sister companies). 159. 1993-3 i.r.b. 5 (jan. 19). 160. see supra text accompanying notes 111-13. 161. rev. rul. 93-4, 1993-3 i.r.b. 5 (jan. 19). as indicated, supra text accompanying notes 111-13, revenue ruling 93-4 preserves the lack of "separate interests" theory for free transferability purposes. 162. the trust case is discussed in more detail infra at part vii(c). 163. this was the service's reasoning on the continuity of life issue in revenue ruling 77-214, 1977-1 c.b. 408. revenue ruling 934, 1993-3 i.r.b. 5 (jan 19). simply recognizes that "separate interests" were not necessary for the dissolution provision to have significance under the facts of that ruling, because the gmbh would dissolve automatically under german law upon the occurrence of a dissolution event. 19931 florida tax review transferability of interests purposes, it would not seem prudent to rely on the absence of continuity of life where the dissolution provision is purely a contractual matter or otherwise requires the affirmative action of the members. the second concern is whether a partnership with affiliated partners could be deemed to have continuity of life where there is automatic dissolution under local law but the partnership agreement contains a reconstitution provision that would permit continuation of the partnership upon the occurrence of a dissolution event. since the partners presumably would always vote to reconstitute, the dissolution provision would not really have any substance, other than the nuisance of forcing an affirmative vote to continue the entity. in the case of a uniform act partnership, the partnership normally would not even dissolve as a matter of state law after the occurrence of a dissolution event. 64 nevertheless, the unequivocal declaration in revenue ruling 93-465 that the separate interests theory is not relevant for continuity of life purposes, when coupled with the favorable presumption in the regulations on uniform act partnerships 66 and the zuckman case, 67 should result in uniform act partnerships among affiliated partners being treated as lacking continuity of life. 6s for other types of entities with affiliated members, there actually may be a dissolution of the entity under local law that the entity could rely on to prove that the dissolution provision had some significance. in any event, revenue ruling 93-4 and, by analogy, the treatment of uniform act partnerships, would seem to insure that such other types of entities also should be treated as lacking continuity of life. 6. general partners with tiny interests.-if a general partner has a tiny interest, a continuity of life issue, analogous to the limited liability issue discussed in part li(b)(6) above may arise, i.e., whether the general partner's interest is so small that the general partner should not be regarded as a member for federal income tax purposes. if so, the effect of a general partner's bankruptcy, death, withdrawal, etc. would not seem to be relevant for continuity of life purposes, since regulations section 301.7701-2(b) looks to whether the bankruptcy, death, withdrawal, etc., of a member would cause a dissolution. thus, for the reasons discussed in part ili(b)(6), it would seem prudent for the general partner's interest to satisfy the service's ruling 164. see supra note 145. the entity would dissolve, however, if the partners failed to vote to reconstitute the partnership within the statutory period (usually 90 days) for reconstitution without dissolution. 165. 1993-3 i.r.b. 5 (jan. 19). see also rev. rul. 75-19, 1975-1 c.b. 382. 166. regs. § 301.7701-2(b)(3). 167. zuckman v. united states, 524 f.2d 729 (ct.ci. 1975), which is discussed supra text accompanying notes 136-38. 168. that conclusion is also supported by the complete absence of any authority holding that uniform act partnerships among affiliated partners lack continuity of life. [vol. 1:4 lingering partnership classification issues guideline regarding the minimum size of a general partner's interest. however, even if the ruling guideline were not satisfied, there would still be the issue discussed in part v(b)(1) above as to whether the continuity of life rule for entities formed under a uniform act statute is really absolute. vi. centralized management a. background regulations section 301.7701-2(c)(1) states the general rule that an entity has the characteristic of centralized management "if any person (or any group of persons which does not include all the members) has continuing exclusive authority to make the management decisions necessary to the conduct of the business for which the organization was formed." the fact that a third party is appointed to run the day-to-day operations of the entity is not relevant, since the regulations look to the management responsibilities undertaken by the owners. the regulations expressly provide that a general partnership formed under a statute corresponding to the uniform partnership act always lacks centralized management because of the "mutual agency relationship" that exists among all the partners, meaning the authority of each partner to bind the partnership vis-a-vis third parties.' 69 one might be tempted to conclude that all limited partnerships have centralized management, given the concentration of management authority in the general partner. however, regulations section 301.7701 -2(c)(4) states that limited partnerships organized under a statute "corresponding" to the uniform limited partnership act "generally do not have centralized management, but centralized management ordinarily does exist in such a limited partnership if substantially all the interests in the partnership are owned by the limited partners." the theory apparently is that centralized management should not be deemed to exist where the general partner has a sufficiently large economic interest that it would be acting for its own account in managing the business of the partnership, rather than acting in a representative capacity like the board of directors of a corporation.' of course, that theory only goes so far, since a general partner has a fiduciary duty under state law to manage the partnership based upon the best interests of the limited partners, no matter 169. regs. § 301.7701-2(c)(4). 170. this theory is based on glensder textile co. v. commissioner, 46 b.t.a. 176 (1942), acq. 1942-1 c.b. 8, which held that a limited partnership where the general partners owned 42% of the interests lacked centralized management because "[t]hey were acting in their own interest as hitherto ... and not merely in a representative capacity for a body of persons having a limited investment and a limited liability." id. at 185. 1993] florida tax review what the size of its interest."' in addition, the general partner may be further constrained by limited partner consent rights. regulations section 301.7701-2(c)(4) goes on to state that if all or any group of the limited partners may remove the general partner, then "all the facts and circumstances must be taken into account in determining whether the partnership possesses centralized management." the theory apparently is that if the general partner may easily be removed by the limited partners, then the general partner's interest may not be sufficiently vested to motivate it to act for its own account in managing the partnership, thereby relegating it to acting in a representative capacity. b. issues the foregoing rules raise the following special problems. 1. "substantially all" issue.-the most obvious centralized management question is how substantial an interest the general partner must have for the entity to be deemed to lack centralized management. as indicated above, the specific legal issue under regulations section 301.7701-2(c)(4) is whether "substantially all" the interests in the partnership are owned by the limited partners.7 2 until 1989, there was no useful authority on what the term "substantially all" means for this purpose, other than an example in the regulations indicating that centralized management would exist where the general partner holds only a 5.7% interest. 73 in 1989, the service promulgated a ruling guideline indicating that it would not rule that a partnership lacks centralized management unless the general partners own at least twenty percent of the "total interests" in the partnership (including any interests held as a limited partner)., that ruling guideline, which codified what apparently had previously been an informal ruling policy, is likely to occupy the field until there is more definitive authority. 2. capital versus profits interests.-another issue is whether a partnership would be deemed to have centralized management if the general partner contributes little or no capital to the partnership but has a sizable 171. for delaware authority see, e.g., del. code ann. tit. 6, § 17-403 (supp. 1992); in re usa cafes, l.p. litigation, 600 a.2d 43 (del. ch. 1991). 172. the larson court rephrased the issue in terms of whether the general partners have "a meaningful proprietary interest." larson v. commissioner, 66 t.c. 159, 177 (1976) (citation omitted). 173. regs. § 301.7701-3(b)(2) (example 1). 174. rev. proc. 89-12, 1989-1 c.b. 798 at § 4.06. [vol. 1:4 lingering partnership classification issues interest in partnership profits. that situation apparently would fail to satisfy the ruling guidelines, since the ruling guideline test is whether the general partner has twenty percent or more of the "total interests" in the partnership. the only case to consider that issue is larson, 7 1 which involved a limited partnership where the general partner had a twenty percent interest in partnership profits after a return of the limited partner's capital." 6 the court did not seem to regard that subordination of the general partner's interest as being per se fatal on the centralized management issue. however, the court did hold that centralized management existed, since the court regarded the general partner's interest as being very speculative on the facts and it was concerned about the right of the limited partners to remove the general partner at any time with a sixty percent vote.'" it would seem that at some point a general partner's interest in partnership profits could be sufficiently large that it would be managing the partnership more as a principal than in a representative capacity, even if it had little or no interest in partnership capital. thus, the theory underlying the centralized management regulations would dictate that the partnership should not be regarded as being centrally managed. in addition, authorities on the meaning of the term "substantially all" for other tax purposes would support that result 78 to venture a guess, it would seem that an interest in partnership profits in the thirty to forty percent range should be sufficient to preclude centralized management, assuming that such interest is not subordinated to a return on the capital invested by the other partners. a higher percentage might be necessary, depending on the facts, if the general partner's interest were subordinated to a return on capital. 3. removal rights.-as indicated above, under regulations section 301.7701-2(c)(4), centralized management may be deemed to exist if the limited partners have the power to remove the general partner." the presence of a removal right throws the centralized management question into a facts and circumstances test with no further guidance from the regulations. the obvious issue in this regard is when centralized management will be deemed to exist under the facts and circumstances test where the general 175. 66 t.c. 159 (1976). 176. the amount of capital to which the general partner's interest was subordinated was actually only half the amount of cash actually contributed by the limited partners, and the limited partners were deemed to receive a return of their capital through both cash distributions and tax benefits. 177. larson, 66 t.c. at 176-79. 178. see, e.g., rev. proc. 77-37, 1977-2 c.b. 568 ("substantially all" the assets of a party to a triangular merger means 90% of its net assets and 70% of its gross assets). 179. see discussion supra part vi(a). this aspect of the regulations was added in 1983 by treasury decision 7889, 1983-1 c.b. 362. 19931 florida tax review partner has a substantial interest but is subject to a removal right. unfortunately, there is absolutely no authority on this issue. while it may seem like an issue of only academic significance, it is in fact of real practical significance. the reason is that many partnership agreements have express removal rights that apply where the general partner has acted wrongfully, and state law may supply such a removal right where the partnership agreement does not. there are two aspects of removal provisions that seem most relevant to the facts and circumstances inquiry. the first is when the removal right can be exercised. if the removal right can be exercised only when the general partner commits a wrongful act, it is difficult to see why the general partner should be treated as acting in a representative capacity, since the general partner should regard its interest as sufficiently vested to be motivated to act for its own account. in addition, it would be absurd as a policy matter for the partnership tax law to encourage limited partners to give up legitimate remedies against general partners that have acted wrongfully in order to avoid centralized management. in recognition of those considerations, regulations section 301.7701-2(c)(4) quite sensibly provides that: "[a] substantially restricted right of the limited partners to remove the general partner (e.g., in the event of the general partner's gross negligence, self-dealing, or embezzlement) will not itself cause the partnership to possess centralized management." that having been said, there is still the lingering issue of whether removal rights tied to a simple negligence standard or the failure of the general partner to satisfy a financial performance test (without regard to fault) would be deemed to be a "substantially restricted right." presumably such removal rights would be regarded as substantially restricted, except in the case of removal rights based on a financial performance test if the parties expected that the test would not be satisfied. the second aspect of a removal provision that should be relevant is what consideration, if any, the general partner would be entitled to receive as a result of a removal. if the general partner would be entitled to a payment equal to the fair market value of its interest or its interest would be converted into a limited partner interest with the same economic attributes as before, it is arguable that the general partner should not be regarded as acting in a representative capacity despite the presence of the removal right, since the general partner would always have the economic incentive to manage the partnership as it saw fit to maximize the value of its interest. there is some support for that position in larson, which involved a removal right pursuant to which the general partner would receive a cash payment equal to the fair market value of its interest if it were removed. the court indicated that such payment requirement created "a vested proprietary interest to protect," although it ultimately concluded that centralized management existed because [vol. 1:4 lingering partnership classification issues the interest had only speculative value. 18 4. affiliated general and limited partners.-where the general and limited partners of a partnership are affiliated, special centralized management concerns may come into play. the most important concern applies where the limited partners actually control the general partner, namely, whether centralized management could be deemed to exist, even if the general partner has a substantial interest in the partnership, on the theory that the general partner would always be directed to represent the interests of the limited partners. revenue procedure 89-12181 contains a warning in this regard, stating that "the service will consider all the facts and circumstances, including limited partner control of the general partners (whether direct or indirect), in determining whether the partnership lacks centralized management."" unfortunately, there is no definitive authority as to what degree of control by the limited partners will result in centralized management. on the one hand, the fact that a single limited partner with a small interest in a partnership with many partners has a minority interest in the general partner obviously should not be a problem. on the other hand, a limited partner's complete control of a general partner in a two-partner partnership would raise a serious centralized management problem. it should be noted that there is a paradox with respect to the centralized management concern raised by limited partners controlling the general partner. the paradox arises because the centralized management concern becomes more acute as the degree of control by the limited partners increases, yet, if the limited partners actually served as the general partners, there clearly would be no centralized management. a related issue is whether the service could extend its lack of "separate interests" theory, which it historically has applied only for free transferability1 3 and continuity of life purposes,'" to this area. the argument would be that a general partner that is closely affiliated with (but not controlled by) the limited partners naturally would protect the interests of the limited partners and presumably would be beholden to the same ultimate owners, thereby creating a sort of functional centralized management. fortunately, there is no evidence that the service has ever made that argument. 5. "exclusive authority" issue.-another centralization of management issue is whether a limited partnership that has a general partner with a 180. larson, 66 t.c. at 178. 181. 1989-1 c.b. 798. 182. id. at § 4.06. 183. see discussion supra part iv(b)(6). 184. see discussion supra part v(b)(5). 19931 florida tax review small economic interest could be determined to lack centralized management because of management rights granted to the limited partners. as noted earlier, regulations section 301.7701-2(c)(1) provides that centralized management exists where "continuing exclusive authority to make the management decisions necessary to the conduct of the business" (emphasis added) resides with members having a small interest. the partnership agreement for the typical limited partnership provides that the limited partners must consent to certain extraordinary transactions, such as selling substantially all the partnership's assets or admitting new partners. such approval rights often are quite extensive, particularly for limited partnerships formed under revised uniform limited partnership act statutes because of the freedom those statutes give to limited partners to participate in management without losing their limited liability. 5 in some cases, the limited partners may be represented by a management or advisory committee that actively monitors the partnership's business and routinely passes on general partner actions. thus, in the real world, general partners have varying degrees of control over partnership businesses, but they seldom have truly "exclusive" control. arguably such limited partner rights could cause a partnership to lack the characteristic of centralized management. 6. managing general partners.-one final centralized management issue arises for limited partnerships that have multiple general partners, one of whom is delegated the exclusive responsibility for managing day-to-day business of the partnership (and is usually referred to as the "managing general partner"). the question is whether the centralized management issue should be judged solely by reference to the size of the interest held by the managing general partner on the theory that the managing general partner has the "exclusive authority" to manage the partnership. it is doubtful that the service would prevail if it were to take that position. first, even though the managing general partner of a partnership actually runs the partnership on a day-to-day basis, all the general partners would at least have the authority to bind the partnership vis-a-vis third parties, which is all that seems to be relevant under regulations section 301.7701-2(c). 86 second, that position would require disregarding the language of regulations section 301.7701-2(c) and the service's 1989 ruling guideline on centralized management, both of which divide the world into the two generic categories of general partners and limited partners. this issue conceivably could be reopened, however, in light of the service's publication of revenue ruling 93-6.' revenue ruling 93-6 185. see, e.g., del. code ann. tit. 6, § 17-303 (supp. 1992). 186. see mckee, supra note 12 at 3.06[4][b]. 187. 1993-3 i.r.b. 8 (jan. 19). that ruling is discussed in more detail infra part [vol 1:4 lingering partnership classification issues involved a colorado limited liability company with five members, each of whom was designated as a "manager" to run the business. the ruling held that the limited liability company had centralized management, because the members were managing in a representative capacity (i.e., as "managers") rather than in their capacity as members. it would not be a huge leap for the service to attempt to apply that rationale to limited partnerships with managing general partners and claim that the status of managing general partner is a representative position. nevertheless, the service should not prevail even with revenue ruling 93-6 under its belt, since the fact that all the general partners of a partnership have the authority to bind the partnership in their capacities as partners still provides a critical distinction between the limited partnership case and the situation in revenue ruling 93-6 where none of the members had any authority to bind the limited liability company in their capacities as members. vii. exotic partnerships the following discussion analyzes some of the peculiar partnership classification issues raised by certain types of entities (other than ordinary partnerships) that may qualify as partnerships for federal income tax purposes. a. limited liability companies since the issuance of revenue ruling 88-76,'m a growing interest has developed in the use of limited liability companies as vehicles that can offer the enviable combination of limited liability and partnership tax treatment. i8 9 there has been a flurry of legislative activity on limited liability companies at the state level, often led by accounting firms and other professional service businesses seeking to obtain some type of liability protection for their owners. currently, eighteen states (including delaware) have enacted limited liability company statutes,'" and at least fourteen vii(a). 188. 1988-2 c.b. 360. the first favorable private letter ruling concerning a limited liability company actually was issued in 1980. priv. let. rul. 8106082. (nov. 18, 1980) (classifying a limited liability company as a partnership based on the absence of free transferability of interests and continuity of life). 189. it normally would be possible, of course, to replicate those attributes using (i) a limited partnership with a special purpose corporate general partner, (ii) a foreign corporation (which would have to be organized in a tax haven jurisdiction to avoid foreign tax) or (iii) a trust (as discussed infra part vii(c)) assuming in such case that the steps necessary to achieve partnership status were taken. 190. those states (and the year their respective statutes were enacted) are: arizona (1992); colorado (1990); delaware (1992); florida (1982); illinois (1992); iowa (1992); 1993] florida tax review others are actively considering their own legislation. 9' while tax lawyers can scarcely contain their enthusiasm for this new creature, 92 the actual use of limited liability companies has been fairly limited to date. that limited use is due in large part to concerns as to whether limited liability companies really offer limited liability both within and outside their state of organization. 193 it is also due to concerns as to how limited liability companies will be taxed in the states (such as new york) that have not yet spoken on the issue or the unfavorable treatment of limited liability companies relative to partnerships in certain states that have spoken on the issue.194 kansas (1990); louisiana (1992); maryland (1992); minnesota (1992); nevada (1991); oklahoma (1992); rhode island (1992); texas (1991); utah (1991); virginia (1991); west virginia (1992) and wyoming (1977). 191. those states include: california; georgia; hawaii; indiana; michigan; mississippi; missouri; nebraska; new hampshire; new jersey; new york; ohio; pennsylvania and south carolina. in addition, the conference of commissioners for uniform state laws is drafting a uniform limited liability company act. 192. see, e.g., alan g. lederman, miami device: the florida limited liability company, 67 taxes 339 (1989); edward j. roche, jr., et al., limited liability companies offer pass-through benefits without s corp. restrictions, 74 j. tax'n 248 (1991); francis j. wirtz & kenneth l. harris, the emerging use of the limited liability company, 70 taxes 377 (1992); curley, limited liability companies: emerging classification rules and issues (jan. 25, 1993) (unpublished paper delivered at the tax club in new york city). limited liability companies definitely are one of the major topics on the tax lecture circuit. congress has taken note of all the limited liability company hoopla, as reflected by the fact that the limited liability companies are on the 1993 agenda for the house ways and means subcommittee on select revenue measures. see ways and means select revenues subcommittee, report on referred tax issues, reprinted in tax notes today (feb. 3, 1993) (lexis, fedtax library, tnt file, elec. cit. 93 tnt 25-22). 193. the primary concern is that it is unclear what choice of law principle will apply where a limited liability company formed in one state does business and incurs liabilities in another state. see robert r. keatinge, et al., the limited liability company: a study of the emerging entity, 47 bus. law. 375, 447-56 (1992). if the second state does not look to the first state's law to determine the characteristics of the limited liability company (due to comity considerations or otherwise), it would apply its own law, which may result in the limited liability company being treated like a partnership for liability purposes in the second state. id. a secondary concern, which would arise even if the limited liability company did business only in the state where it was organized or it could assume that the other states where it did business would look to its home state's law on liability questions, is whether and to what extent judicial exceptions to the statutory limitation on liability will be created, perhaps by analogy to established "veil piercing" exceptions in the corporate area. id. at 442-46. 194. for commentary on new york's struggle with the taxation issue, see lee a. sheppard, new york contemplates the cost of limited liability companies, news analysis, 57 tax notes 1481 (dec. 14, 1992); lee a. sheppard, the dark side of limited liability companies, news analysis, 55 tax notes 1441, 1443-44 (june 15, 1992). new york state bar association tax section task force on new york tax treatment of limited liability companies, outline of issues and alternatives (jan. 26, 1993) (report submitted to governor cuomo) (lexis, fedtax library, tnt file, elec. cit. 93 tnt 56-24). [vol 1:4 lingering partnership classification issues the classification of limited liability companies as partnerships is based upon a fairly straightforward application of regulations section 301.7701-2. however, since a limited liability company purports to offer limited liability, partnership classification must be based on the absence of at least two of the other three corporate characteristics. 95 and it obviously must achieve that result without relying on the favorable presumptions in regulations section 301.7701-2 for uniform act partnerships or the key ruling guidelines set forth in revenue procedure 89-12.196 set forth below is a brief summary of how regulations section 301.7701-2 generally applies to limited liability companies, with a focus on the special issues that may arise because of the unique characteristics of limited liability companies. limited liability company statutes typically provide that a limited liability company will dissolve on the bankruptcy, death, expulsion, dissolution or retirement of a member, subject to any reconstitution provision in the governing instrument. 97 such statutes also typically provide that the governing instrument may provide for the automatic continuation of the limited liability company if one or more of those events occur.' thus, a limited liability company generally should lack continuity of life, unless the governing instrument provides for automatic continuance in the event that a dissolution event occurs or the governing instrument provides for an impermissible reconstitution provision. limited liability companies face a problem with respect to reconstitution provisions, since they may not rely on the favorable presumption in regulations section 301.7701-2(b)(3) for uniform act partnerships and, as noted earlier, regulations section 301.7701-2(b)(1) 195. in theory, of course, a limited liability company could lack limited liability on the basis of a member's contractual assumption of the limited liability company's liabilities. however, if lack of limited liability were necessary to achieve partnership tax treatment, there presumably would be no reason not to organize the entity as a plain vanilla limited partnership (and during this initial period of uncertainty regarding the legal and tax aspects of limited liability companies, that would be the preferred approach). 196. although the introductory part of revenue procedure 89-12. 1989-1 c.b. 798 states that it applies generally to all types of entities seeking partnership classification, a careful reading reveals that section 4, which contains the key ruling guidelines, applies only to limited partnerships. it should be noted that the service's proposed 1993 business plan includes issuing a revenue procedure to provide ruling guidelines for limited liability companies. see treasury department, treasury, irs release proposed 1993 business plan, reprinted in tax notes today, (jan. 19, 1993) (lexis, fedtax library, tnt file, elec. cit. 93 tnt 12-20). if the current interest in limited liability companies continues to build, the service sooner or later will be asked to consider amending regulations section 301.7701-2 to provide favorable presumptions for limited liability companies analogous to those for uniform act partnerships. 197. see, e.g., del. code ann. tit. 6, § 18-801(4) (supp. 1992); see also rev. rul. 88-76, 1988-2 c.b. 360 (applying a similar provision of the wyoming limited liability company act); rev. rul. 93-5, 1993-3 i.r.b. 6 (jan. 19) (virginia limited liability company); rev. rul. 93-6, 1993-1 i.r.b. 8 (jan. 19) (colorado limited liability company). 198. see, e.g., del. code ann. tit. 6, § 18-801(4) (supp. 1992). 19931 florida tax review seems to require that a reconstitution provision require unanimous partner approval.' thus, unless and until proposed regulations section 301.77012(b) is adopted in final form, limited liability companies will tend to require unanimous member consent to reconstitute after the occurrence of a dissolution event. 20° limited liability company statutes also typically provide that interests are freely assignable, subject to whatever restrictions are contained in the governing instrument. however, unless all the members consent to the transfer or the governing instrument provides otherwise,20' the assignee stands in essentially the same position as the unadmitted assignee of a partnership interest, with the right to receive distributions from the limited liability company but no right to participate in management. thus, as in the case of an ordinary partnership, a limited liability company generally should lack free transferability, unless there is no consent requirement (or only a reasonable consent requirement) for the admission of assignees. since the paradigm case involves free assignability, the distinction between assignments and substitutions in regulations section 301.7701-2(e)(2)2" is critical for limited liability companies. however, the service has respected that distinction in its three published rulings on limited liability companies.0 3 limited liability company statutes vary somewhat as they relate to centralized management. the prevailing pattern seems to be to provide that the members of a limited liability company may either delegate management responsibilities to one or more "managers" (which may be members) that would function like the general partners of a limited partnership or they may retain management responsibilities for themselves, similar to the general partners in a general partnership ("discretionary delegation statutes"). 204 199. see supra part v(b)(4) (discussing reconstitution provisions). 200. note that the reconstitution provisions for the limited liability companies at issue in each of the three published rulings referred to in note 197, supra, all required unanimous member approval. see also priv. ltr. rul. 9010027 (dec. 7, 1989) (limited liability company determined to have continuity of life because of a majority vote reconstitution provision). however, the wave of the future may be represented by a very recent private letter ruling holding that a limited liability company lacked continuity of life where the entity could be reconstituted by a majority vote of its "managing directors" and a majority in interest and number of the remaining members. priv. ltr. rul. 9308027 (nov. 27, 1992). 201. see, e.g., del. code ann. tit. 6, § 18-702 (supp. 1992); see also rev. rul. 8876 (applying a similar provision of the wyoming limited liability company act). 202. see supra part iv(b)(3). 203. see rev. rul. 88-76, 1988-2 c.b. 360 (wyoming limited liability company with freely assignable interests held to lack free transferability because assignees were not admitted without unanimous member approval); rev. rul. 93-6, 1993-3 i.r.b. 8 (jan. 19) (same result for a colorado limited liability company); rev. rul. 93-5, 1993-3 i.r.b. 6 (jan. 19) (same result for a virginia limited liability company). 204. see, e.g., del. code ann. tit. 6, § 18-402 (supp. 1992); rev. rul. 88-76, 1988[vol, 1:4 lingering partnership classification issues certain other statutes, however, contemplate management solely by designated managers, which may be members ("mandatory delegation statutes"). -o at first blush, one might be tempted to conclude by analogy to the result under regulations section 301.7701-2(c) in the plain vanilla partnership context2° that the centralized management issue for a limited liability company organized under either type of statute would turn on whether the persons that manage the business have a meaningful proprietary interest, regardless of whether they manage in the capacity as designated managers or in the capacity as members. however, the service has made two important distinctions in analyzing the centralized management issue in the limited liability company context in two recent published rulings. t . first, in revenue ruling 93-62s the service expressly indicated that centralized management always will be present with a limited liability company unless the limited liability company is organized under a discretionary delegation statute aui the articles of organization for the limited liability company do not delegate management authority to managers (even if such managers are members). revenue ruling 93-6 involved a colorado limited liability company with five members. the colorado statute is a mandatory delegation statute,2 and the limited liability company at issue chose all five of its members to be its managers. although the managers obviously had a meaningful proprietary interest in the limited liability company, the service held that the limited liability company had centralized management because the members did not have any authority under the statute to manage in their capacities as members and, therefore, they were managing in their capacities as managers, which the service presumably viewed as a representative capacity akin to a board of directors. thus, the service's position seems to be that limited liability companies organized under mandatory delegation statutes like the colorado statute have statutory centralized management and, presumably, that limited liability companies organized under discretionary delegation statutes will be deemed to have centralized management if the 2 c.b. 360 (management of a limited liability company by three of twenty-five members resulted in centralized management). 205. see, e.g., colo. rev. stat. § 7-80-401(1) (1992), which was the statute at issue in revenue ruling 93-6, 1993-3 i.r.b. 8 (jan. 19), as discussed in the following paragraphs in the text. 206. see discussion supra part vi. 207. curiously, the service's private letter rulings regarding limited liability companies generally do not analyze the centralized management issue. the one exception is private letter ruling 9010027 (dec. 7, 1989), in which a limited liability company organized under a discretionary delegation statute that was managed by all its members in their capacity as such was held to lack centralized management, although the distinctions described in the text below were not discussed. 208. 1993-3 i.r.b. 8 (jan. 19). 209. see supra note 205 and accompanying text. 19931 florida tax review delegation option is chosen, even if all the members are designated as managers. 2 10 a second centralized management distinction for limited liability companies that seems to have been drawn by the service is that limited liability companies must be managed by all their members to be deemed to lack centralized management. that point seems to have been made in revenue rulings 93-5 and 88-76,211 both of which involved a limited liability company organized under a discretionary delegation statute that had twenty-five members, three of whom were elected as managers. the service summarily concluded in each case that the limited liability company at issue had centralized management without providing any real explanation for its conclusion. while the result in these rulings can be explained based upon the above-described rationale set forth in revenue ruling 93-6, that theory was not referred to in revenue rulings 93-5 and 88-76. it also is possible that the result in those rulings could be explained based upon the relatively small percentage interest of the managers, assuming that they had a relatively small percentage interest, but the rulings do not specify their percentage interests.212 the only express basis for the result in those rulings was the service's reference in each to regulations section 301.7701-2(c)(1), which states the general rule that centralized management is present "if any person (or any group of persons which does not include all the members) has continuing exclusive authority to make the management decisions." hence, the service apparently does not intend to approach the centralized management issue in the limited liability context by analogy to the treatment of limited partnerships, which analogy would suggest that if members holding a meaningful proprietary interest managed in their capacities as members the limited liability company would lack centralized management." 3 given the 210. see the letter to the editor from susan pace hammill, attorney advisor in the office of assistant chief counsel (passthroughs and special industries), 58 tax notes 1266, 1385 (mar. 8, 1993). this position could be the death knell for mandatory delegation statutes, since they do not afford limited liability companies organized under them the option of defeating centralized management, thereby forcing such limited liability companies to achieve partnership status by defeating free transferability of interests and continuity of life. 211. rev. rul. 93-5, 1993-3 i.r.b. 6 (jan. 19); rev. rul. 88-76, 1988-2 c.b. 360. 212. assuming that all members held a pro rata interest, the members that were managers would have held 12% of the interests in the limited liability company, which obviously would not satisfy the 20% safe harbor. 213. one possible rationale for that position would be that a limited liability company does not have any member that is analogous to a general partner with personal liability for entity liabilities and whose bankruptcy, death, etc. alone may cause a dissolution of the entity. in revenue ruling 88-79, 1988-2 c.b. 361, a missouri business trust managed by beneficiaries who held ten percent of the interests and who had personal liability for trust liabilities was determined to have centralized management. the service referred to both the general rule on centralized management and the limited partnership rule, perhaps because the trust was [vol 1:4 lingering partnership classification issues first distinction described above, this second distinction is academic, of course, unless the limited liability company is organized under a discretionary delegation statute.24 notwithstanding the current hoopla regarding limited liability companies, the above-described steps that a limited liability company must take to achieve partnership status will, as a practical matter, tend to confine the use of limited liability companies to the closely held and personal service business contexts. a limited liability company must arrange to lack at least two out of the three corporate characteristics that they can avoid, i.e., free transferability of interests, continuity of life and centralized management. lacking free transferability of interests obviously requires tying up the transferability of the members' interests, which often is not practical, particularly for a widely held entity. lacking continuity of life requires living with the possibility of a dissolution, which is particularly troubling given that there can be no assurance of reconstitution because of the unanimous consent requirement under current law. finally, lacking centralized management requires that the members manage in their capacities as such, which generally would not be practical for a widely-held entity, except possibly in the personal service business context (e.g., a law firm). thus, even over the longer term as the personal liability and state and local tax concerns regarding limited liability companies are sorted out, it seems doubtful that limited liability companies will cause the disincorporation of america. b. one-partner partnerships another type of entity that poses unique partnership classification issues is the one-partner partnership. that situation is rather unusual in the plain vanilla partnership context, since under state partnership law a partnership normally must have at least two partners.2t 5 however, two different situations can arise where a partnership has two partners in the eyes of state partnership law but only one partner in the eyes of federal income tax more analogous to a limited partnership in light of the personal liability of the managers. id. 214. the delaware limited liability company act (delaware llca) apparently would permit a delaware limited liability company to be managed by some but not all of its members in their capacities as such, since section 18-402 of the delaware llca states that "unless otherwise provided in a limited liability company agreement." the limited liability company will be managed by all the members in their capacities as such or by designated managers. del. code ann. tit. 6, § 18-402 (supp. 1992). however, there may be a negative implication in section 18-404 of the delaware llca. which sets forth various options for how management may be carried out by designated managers but does not mention management by members. 215. see, e.g., del. code ann. tit. 6. § 17-101(7) (supp. 1992) (defining limited partnership); id. at § 1506(4) (defining general partnership). 19931 florida tax review law. the first is where one of the partners has such a de minimis interest that it might not be regarded as being a partner for federal income tax purposes. the second is where the partners are a reit and its "qualified reit subsidiary" within the meaning of section 856(i), which is not treated as a separate entity for federal income tax purposes. moreover, one-member entity classification issues obviously can arise where the entity is a trust, limited liability company or other type of organization that does not need to have more than one member under applicable state law. as a threshold matter, one could question whether any such entity could be a partnership for federal income tax purposes. the essence of a partnership is two or more persons joining together to carry on some business activity, and there is language in a number of cases supporting that conclusion.216 the service endorsed that position in two technical advice memoranda issued in 1985 dealing with the issue of whether one-member entities may be partnerships for federal income tax purposes.217 in technical advice memorandum 8533003, for example, the service ruled that a single beneficiary trust that was formed to make various investments was the agent of its beneficiary for federal income tax purposes, rather than a trust, partnership or association. the service first concluded that the trust was not a trust for federal income tax purposes, because the trust was engaged in a business for profit and the trust had associates, relying on the authorities holding that an entity with one owner can be deemed to have associates if the owner participates in the entity's creation and management.21 8 the service next concluded that the entity was not a partnership, using the following rationale: "despite the fact that under hynes a single member organization can be treated as having associates for purposes of determining if it is an association, no single member organization possesses associates in the partnership sense and an organization with only a single member cannot be a partnership." '219 the service then stated that the trust should be classified as either an association or as an agency arrangement, depending upon whether it had more than two out of four of the corporate characteristics that are relevant in distinguishing associations from partnerships under regulations section 301.7701-2. on the facts, the service concluded that the trust represented an agency arrangement on the theory that it lacked limited 216. see, e.g., beck chem. equip. corp. v. commissioner, 27 t.c. 840, 848-49 (1957), acq. 1957-2 c.b. 3. 217. i.r.s. t.a.m. 8552010 (sept. 25, 1985); i.r.s. t.a.m. 8533003 (may 7, 1985); see g.c.m. 39395 (aug. 5, 1985) (discussing i.r.s. t.a.m. 8533003); priv. let. rul. 8139048 (june 30, 1981). 218. i.r.s. t.a.m. 8533003 (aug. 5, 1985) (citing hynes v. commissioner, 74 t.c. 1266 (1980)). 219. id. [vol 1:4 lingering partnership classification issues liability and continuity of life.' the service's reasoning in these rulings is more tortured than is necessary. the cases holding that an association may have only one member do not really conclude that the term "associates" may refer to the singular, but, rather, they conclude that the presence of associates is not necessary for a single-member association based upon the parenthetical language in regulations section 301.7701-2(a)(2). 2 that language does not indicate that it is not necessary to have associates in the partnership context. thus, the service could simply have relied on the literal language of the regulations regarding associates, rather than the bald assertion that a one-member entity has associates for association and trust classification purposes but not for partnership classification purposes. in any event, the result seems sound. it should be noted that the "single economic interest" theory would apply in this context, presumably making it impossible for a one-member entity to lack free transferability of interests, except, possibly, if the governing instrument prohibited transfers of interests or provided that the entity would dissolve upon the occurrence of an attempted transfer. 22 thus, the issue of whether the entity constitutes an association versus an agency would turn on whether the entity lacks at least two of the remaining three corporate characteristics, i.e., limited liability, continuity of life and centralized management. however, because one normally thinks of an agency situation as involving personal liability, it would seem prudent always to arrange for the absence of limited liability.' it should be noted that the service has under active consideration the issue of whether one-member limited liability companies may qualify as partnerships for federal income tax purposes.2 4 220. id.; see also i.r.s. t.a.m. 8552010 (sept. 25. 1985) (concluding that a trust was an association, relying on the presence of centralized management, continuity of life and limited liability); cf. rev. rul. 92-105, 1992-49 i.r.b. 4 (dec. 7) (illinois land trust owned by one individual, who apparently was personally liable for trust liabilities, treated as an agency); priv. let. rul. 8139048 (june 30, 1981) (apparently treating what the service regarded as a one-member entity as an agency without any discussion of regulations section 301.7701-2). 221. regulations section 301.7701-2(a)(2) states that "associates and an objective to carry on business for joint profit are essential characteristics of all organizations engaged in business for profit (other than the so-called one-man corporation and the sole proprietorship)" (emphasis added). 222. see supra part iv(b)(6) (discussing free transferability issues raised by the "single economic interest" theory). 223. it presumably is not a coincidence that all four rulings referred to supra note 220 involved personal liability. 224. see treatment of single-member llcs under debate at irs. hamill says. reprinted in tax notes today (feb. 2, 1993) (lexis, fedtax library. tnt file, clec. cit. 93 tnt 25-22). apparently this currently is an issue only for texas limited liability companies, since all other state limited liability company statutes require at least two members. 19931 florida tax review c. business trusts and common law trusts in recent years, there has been a growing interest in the use of business trusts and common law trusts as vehicles for business transactions. that interest is due in large part to the potential that trusts, like limited liability companies, offer to provide limited liability and flow-through tax treatment, which interest was piqued by the issuance of revenue ruling 8879.22 in addition, trusts often are preferred for "securitization" transactions where the primary tax position may be that the entity is a grantor trust, but the parties want to be able to argue that the entity is a partnership as a "fallback" position if grantor trust status is challenged.226 as with limited liability companies, the status of a business trust or common law trust as a partnership for federal income tax purposes depends upon an application of regulations section 301.7701-2, without the benefit of the favorable presumptions in regulations section 301.7701-2 for uniform act partnerships or the ruling guidelines for limited partnerships. however, unlike the case with limited liability companies, which are formed under statutes designed to insure partnership classification, a trust normally is formed under a statute or body of common law that affirmatively provides for the four relevant corporate characteristics. 227 thus, the only way to achieve partnership status is to override at least two of those characteristics by contract. specifically, the characteristic of limited liability may be overridden through a contractual assumption of liabilities by a beneficiary, although that would be unusual outside the securitization area (where the expected liabilities of the entity are all nonrecourse), since one of the principal reasons to use a trust is to limit the liability of all the beneficiaries. 228 however, it 225. 1988-2 c.b. 361 (classifying a missouri common law royalty trust as a partnership for federal income tax purposes). 226. in securitization transactions using grantor trusts, there may be a risk that the trust would be viewed as failing the "sears" regulations regarding multiple classes of interests or that it would be viewed as engaging in an impermissible reinvestment or other business activity. see regs. § 301.7701-4(b), -4(c). in either case, the trust would be classified either as an association or as a partnership based on regulations section 301.7701-2. see generally james m. peaslee & david z. nirenberg, federal income taxation of mortgage backed securities, 31-58 (1989). 227. under many state trust laws, particularly non-statutory trust laws, there may be questions as to whether the trust really provides limited liability for any of the beneficiaries or, alternatively, it may be clear that any beneficiaries that actively participate in management do have personal liability. see, e.g., rev. rul. 88-79, 1988-2 c.b. 361 (noting that "manager" beneficiaries had personal liability for trust liabilities under agreement interpreted under missouri law); rev. rul. 64-220, 1964-2 c.b. 335 (noting that beneficiaries who manage and control trust property incur personal liability under illinois law). 228. for an example of a trust determined to lack limited liability due to a [vol 1:4 lingering partnership classification issues should be noted that under a number of trust laws, beneficiaries that participate in management (by directing the actions of the trustee, managing as a designated "manager" or otherwise) may have personal liability for trust liabilities. in those cases, the trust may lack limited liability without a contractual assumption of liability.? 9 the continuity of life of a trust may be broken by providing in the declaration of trust or other governing instrument that the trust shall dissolve on the bankruptcy, death, etc. of one or more designated beneficiaries." however, the point made earlier,"' that it generally would not seem prudent to rely on the absence of continuity of life of an entity where its members are closely affiliated and the dissolution provision is purely a contractual matter, would apply in the trust case. nevertheless, a trust is somewhat different from other types of entities where the dissolution provision is a contractual matter, inasmuch as the dissolution provision normally would be enforceable not only by the beneficiaries but also by the trustee, who may feel compelled to effect a dissolution upon the occurrence of a dissolution event. consequently, it may be possible for a trust with closely affiliated beneficiaries to avoid continuity of life, provided that the trustee is not a beneficiary (or a close affiliate of a beneficiary). ' likewise, free transferability of interests may be defeated by requiring the consent of one or more designated beneficiaries to any transfer of an interest by a beneficiary. 3 however, it does not appear sufficient for transfers of interests to be subject to the consent of the trustee (at least where the trustee is not also a beneficiary), since the free transferability issue turns on whether the consent of a member is required. the only difficult corporate characteristic is centralized management, since a certain amount of centralized management usually is unavoidable by virtue of the fact that a trust usually is managed by trustees for the benefit of the beneficiaries. in view of the service's recent published rulings analyzing contractual assumption of trust liabilities, see private letter ruling 9247009 (aug. 20. 1992). 229. see revenue ruling 64-220, 1964-2 c.b. 335 and revenue ruling 88-79, 1988-2 c.b. 361, for examples of trusts held to lack limited liability because of the personal liability of beneficiaries that participated in management. 230. see rev. rul. 88-79 (relying in part on such a provision to support the partnership status of a missouri royalty trust). 231. see supra text accompanying notes 154-58. 232. if the trustee could easily be removed by the beneficiaries (and replaced with a friendly trustee) after the occurrence of a dissolution event to preempt a dissolution by the trustee, the result would be less certain. since a dissolution presumably would occur unless the beneficiaries took that action, there would still be some substance to the dissolution provision. 233. see rev. rul. 88-79, 1988-2 c.b. 361 (relying in part on such a provision to support the partnership status of a missouri royalty trust). 19931 florida tax review the centralized management factor in the context of limited liability companies," it seems that a trust generally would be determined to have centralized management, since the trustee of a trust acts in a representative capacity. that would be true even if the trust were organized under a state statute or common law that permitted the beneficiaries to act as trustees and the beneficiaries did so. however, it might be possible to defeat centralized management if the trust were organized under a statute or common law that permitted the beneficiaries to manage the business as "managers" with personal liability for trust liabilities.235 in that event, it could be argued that the centralized management rules for limited partnerships236 should apply by analogy and, therefore, that the trust would lack centralized management if the managers held at least twenty percent of the interests.237 in addition, it should be possible to defeat centralized management by providing in the declaration of trust or other governing instrument that the trustee may take only ministerial actions without the consent of the beneficiaries, that the trustee will take whatever actions are directed by the beneficiaries, and that the trustee may be removed at any time by the beneficiaries. in that event, the trustee would effectively be functioning as the agent of the beneficiaries and would not have "exclusive authority" to manage the business of the trust, which should result in a lack of centralized management under regulations section 301.7701-2(c)(3). that conclusion is supported by a number of published rulings involving trusts. 238 234. see supra text accompanying note 187. 235. those were the facts in revenue ruling 88-79, 1988-2 c.b. 361. 236. see supra notes 170-71 and accompanying text. 237. in revenue ruling 88-79, the service indicated that the centralized management rules for limited partnerships should apply by analogy, but it determined on the facts that the 10% interest held by the managers was not sufficient to defeat centralized management. at first blush, that position seems inconsistent with the service's position on analyzing the centralized management issue in the context of limited liability companies (as discussed supra text accompanying notes 207-14), but it may be justified on the ground that a trust manager has personal liability for trust liabilities, which makes the trust manager seem much more analogous to a general partner of a limited partnership than the person that manages a limited liability company. 238. see rev. rul. 64-220, 1964-2 c.b. 335 (trust lacked centralized management because the trustee was required to manage the trust as directed by beneficiaries); cf. rev. rul. 57-607, 1957-2 c.b. 887 (trust lacked centralized management because the trustee's duties were "strictly ministerial"); rev. rul. 88-79, 1988-2 c.b. 361 (missouri trust, which had a trustee that performed ministerial acts only and was substantively managed by "managers," determined to have centralized management due to the small size of the managers' interests, not due to the presence of the trustee). nvot 1:4 lingering partnership classification issues vi. conclusion as the foregoing discussion indicates, the recent history of the partnership classification law demonstrates a trend towards minimizing the substantive barriers to achieving partnership status. the most recent example is the promulgation of revenue ruling 93-4,29 which purported to eliminate the continuity of life concern that arises for partnerships that have closely affiliated partners. the law that has emerged is an essentially mechanical test as to whether the entity lacks two out of the four standard corporate characteristics set forth in regulations section 301.7701-2, with those factors often being formalistic, with no real practical significance for the typical partnership. however, there still are a number of technical issues that can arise under the four factor test, creating uncertainty for the diligent and traps for the unwary. one might be tempted to conclude that we are effectively moving towards an elective, "check the box" type of entity classification scheme. however, to a large extent the current state of the partnership classification law is simply a product of the literal language of the four factor test set forth in regulations section 301.7701-2, which we have been living with since 1960. thus, while the service's announcement in 1988, that it would not insist on the absence of limited liability in all cases,2' might be regarded as a major milestone in breaking down the barriers to partnership classification, the service really was just reaffirming the mechanical nature of the four factor test in regulations section 301.7701-2 under which limited liability is coequal with the other three standard corporate characteristics. as illustrated by the larson case, limited liability may be found lacking on the basis of absence of dumminess even where the general partner has no assets. all that has really happened to the substantive law since 1960 is that the meaning of the four factor test has been fleshed out in a little more detail. when one steps back from the fray, it becomes apparent that the real liberalization that has occurred since 1960 has been the quiet failure of the service and the courts to take into account the more subjective elements of regulations section 301.7701-2, such as whether an entity should be regarded as being "incorporated," which would obviate the need to apply the four factor test, or whether the entity has attributes other than the four standard corporate characteristics that might be relevant to its classification. it is not clear whether that state of affairs reflects a conscious, studied decision on the service's part, or merely the cumulative effect of numerous ad hoc decisions on partnership classification matters over the years. in any event, the de-emphasis of the subjective elements of regulations section 301.7701-2 239. 1993-3 i.r.b. 5 (jan. 19). 240. see supra text accompanying note 37. 19931 262 florida tax review [vol. 1:4 does have the virtue of bringing a fair amount of certainty to the partnership classification law, which obviously is highly desirable given the tax consequences at stake. the relative ease with which limited partnerships, limited liability companies and other unincorporated entities may achieve partnership classification for federal income tax purposes undoubtedly will come under scrutiny by the service and congress in the near future. unincorporated entities that are treated as partnerships have already started to move into the spotlight as part of the simmering debate over corporate integration, since such entities provide a mechanism to achieve "do-it-yourself' integration. moreover, the current hoopla over limited liability companies has focused renewed attention on the partnership classification rules. and if corporate tax rates increase as proposed by the clinton administration, there may be increasing pressure to conduct business in unincorporated form and, therefore, additional revenue concerns raised by the partnership classification rules. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review florida tax review volume 19 2016 number 8 article accelerating depreciation in recession rebecca n. morrow 465 florida tax review volume 19 2016 number 8 the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. the subscription rate, payable in advance, is $125.00 in the united states and $145.00 elsewhere for the current volume. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352) 273-0658 or email ftr@law.ufl.edu. copyright © 2016 by the university of florida florida tax review volume 19 2016 number 8 editor-in-chief charlene luke professor of law university 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review. florida tax review volume 19 2016 number 8 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo 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with other countries: should tax compliance or privacy claims prevail? cynthia blum* i. the rationale for the regulation. . . . . . . . . . . . . . . . . . . . . . . 584 a. the irs explanation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584 1. detecting u.s. taxpayers posing as foreigners.. . . . 584 2. facilitating information exchange with other countries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 587 b. why the irs wants to achieve broader information sharing with other countries.. . . . . . . . . . . . . . . . . . . . . . . . . 590 1. the prevalence of tax evasion through offshore arrangements. . . . . . . . . . . . . . . . . . . . . . . . 590 2. how offshore arrangements facilitate tax evasion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593 3. efforts to break down the barriers of secrecy surrounding tax havens and how the proposed regulation fits together with these efforts. . . . . . . . 596 ii. the countervailing concern for preserving financial privacy. . . . . . . . . . . . . . . . . . . . . . . 602 a. why we want our financial information to be private. . . . . 603 b. how financial institutions serve as necessary stewards of financial information. . . . . . . . . . . . . . . . . . . . . . 606 c. how congress has also made the irs a custodian of our financial information. . . . . . . . . . . . . . . . . . . . . . . . . . . . 609 iii. the international context. . . . . . . . . . . . . . . . . . . . . . . . . . . . 623 a. the privacy claims of nonresident aliens with u.s. bank accounts.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623 b. the privacy claims of u.s. citizens or residents who have offshore accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632 *professor of law & robert e. knowlton scholar, rutgers law school newark. the author gratefully acknowledges the very helpful comments of charles i. kingson, charles davenport, and vera bergelson. 579 580 florida tax review [vol.6:6 c. the claims of tax havens to be entitled to provide privacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 633 d. the argument that fighting non-tax crime and international terrorism should take priority. . . . . . . . . 644 iv. questioning our current tax system. . . . . . . . . . . . . . . . . . . 645 v. conclusion.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648 580 2004] sharing bank deposit information with other countries 648 sharing bank deposit information with other countries: should tax compliance or privacy claims prevail? by cynthia blum a proposed regulation issued as one of the final acts of the clinton administration would have required u.s. banks to routinely file with the irs1 reports identifying nonresident alien individuals receiving payments of interest and the amount of such interest. u.s. bank deposit interest paid to nonresident aliens is exempt from u.s. tax, and previously only payments to canadians2 were required to be reported to the irs. intense opposition to this regulation3 4 was expressed by bankers and other organizations, such as the center for5 1. reg-126100-00, rin 1545-ay62, notice of proposed rulemaking, january 17, 2001. 2. irc § 871(i)(2)(a). “deposits” for this purpose include deposits with persons carrying on the banking business, certain deposits with savings and loan associations, as well as amounts held by an insurance company under an agreement to pay interest thereon. irc § 871(i)(3). in order to qualify for the exemption the interest must not be effectively connected with a u.s. trade or business. section 871(i)(2)(a). withholding by the payor under § 1441 is not required. section 1441(c)(10). a corresponding exemption from § 881 tax and § 1442 withholding applies to deposit interest paid to a foreign corporation. section 881(d) (exempting any amount described in § 871(i)(2)); § 1442(a) (incorporating the rules of § 1441 and providing that “the references in § 1441(c)(10) to § 871(i)(2) shall be treated as referring to § 871(d)”). 3. generally, a person required to withhold a tax pursuant to § 1441 or 1442 on an amount paid to a nonresident alien individual or a foreign corporation is required to report that payment to the irs on form 1042-s. see treas. reg. § 1.1461-1(c)(1)(i). bank deposit interest exempted from tax by § 871(i)(2)(a) or 881(d) is exempted from the information reporting on form 1042-s. treas. reg. §1.1461-1(c)(2)(ii)(a). however, an exception is made for interest paid to an individual who resides in canada with respect to a deposit maintained at an office within the u.s. treas. reg. §1.60498(a). see treas. reg. § 1.6049-4(b)(5) (form 1042-s to be transmitted in the manner prescribed by § 1461 and the regulations thereunder); §1.6049-6(e)(4) (copy of 1042-s to be furnished to payee). the general requirement that a payor of interest report the interest to the irs on form 1099 is also inapplicable to bank deposit interest paid to a nonresident alien. see infra note 13. 4. see john e. hembera, jr., witnesses criticize proposed regs on reporting requirements for deposit interest paid to nonresident aliens, 2001 tnt 121-4; unofficial transcript of irs hearing [june 21, 2001] on proposed regs on reporting requirements for deposit interest paid to nonresident aliens, 2001 tnt 128-18. present as witnesses were representatives of the freedom and prosperity foundation, the heritage foundation, the credit union national association, institute of international bankers, florida bankers association, bank of america, banco santander central hispano, the south florida area first union bank and a community bank in miami. 5. see, e.g., comment letter of patrick m. frawley, senior vice president, bank of america, feb. 26, 2001, reprinted at 2001 tnt 162-25; letter of christopher l. williston, president, independent bankers association of texas, to paul o’neill, 582 florida tax review [vol.6:6 freedom and prosperity, as well as by governor jeb bush of florida (where6 bank deposits are held by many residents of latin america). this opposition7 led the bush administration to withdraw the proposed regulation but to replace it with a similar proposed regulation applicable only to residents of 16 countries (12 member countries of the european union, as well as canada, australia, new zealand, and norway). while the new proposed regulation has also8 august 2, 2001, reprinted at 2001 tnt 159-30; letter of ken guenther, president, independent community bankers of america, to paul o’neill, july 30, 2001, reprinted at 2001 tnt 154-27 (negative impact particularly in california, florida and texas); comment letter of steve bartlett, president, the financial services roundable, july 1, 2001, reprinted in 2001 tnt 138-35; letter of daniel a. mica, president, credit union national association, inc., to paul o’neill, july 3, 2001, reprinted at 2001 tnt 134-36; comment letter of mary mitchell dunn, associate general counsel, credit union national association, inc., may 31, 2001, reprinted in 2001 tnt 126-26; comment letter of robert i. gulledge, chairman, independent community bankers of america, washington, d.c., may 15, 2001, reprinted in 2001 tnt 106-23; comment letter of mark r. baran, american bankers association, washington, d.c., feb. 27, 2001, reprinted at 2001 tnt 60-22; letter of lawrence r. uhlick, executive director, institute of international bankers, n.y., may 8, 2001, to mark a. weinberger, assistant sec’y of the treasury for tax policy, reprinted in 2001 tnt 105-26 (regulation of concern to international banks that operate in the u.s. through branches) 6. press release of center for freedom and prosperity, nov. 6, 2001, reprinted at 2001 tnt 217-31 (39 groups including heritage foundation, cato institute, and discovery institute, oppose regulation). see robert goulder, “cfp condemns new u.s. interest reporting regs for nonresident aliens,” 2001 tnt 50-6. see also dan r. mastromarco and lawrence a. hunter, “the ‘u.s. anti-savings directive,’” tax notes int’l magazine, jan. 13, 2003, p. 159 (also available in 2002 tnt 247-28), detailing arguments against adoption of the regulation; richard w. rahn & veronique de rugy, “threats to financial privacy and tax competition,” cato institute policy analysis no. 491, oct. 2, 2003, reprinted in 2003 tnt 197-28. 7. letter of governor jeb bush to paul o’neill, june 7, 2001, reprinted in 2001 tnt 120-22. see letter of rep. dave weldon, r-fla., dan miller, r-fla, et al, to paul o’neill, feb. 27, 2001, reprinted in 2001 tnt 51-46 (letter signed by 15 members of house of representatives from florida); letter of miriam lopez to paul o’neill, oct. 1, 2001, on behalf of florida international bankers association and florida bankers association, reprinted in 2001 tnt 198-36 (florida “could lose between $18 and $34 billion of nra deposits”). the irs also received negative comments on the regulation from a large number of individual banks in florida. see, e.g., comment letter of manuel lucena, general manager, banco comercial portugues, miami, feb. 26, 2001, reprinted in 2001 tnt 162-27; comment letter of joseph b. shearouse, iii, senior vice president, fidelity federal, west palm beach, may 30, 2001, reprinted in 2001 tnt 130-20; comment letter of thomas h. dargan, president, peninsula bank, daytona beach, may 25, 2001, reprinted in 2001 tnt 130-21. 8. reg-133254-02, rin 1545-ba86, august 2, 2002. the eu countries are denmark, finland, france, germany, greece, ireland, italy, the netherlands, portugal, spain, sweden, and the united kingdom. as discussed below, three of the current members of the eu were not listed in the regulation: austria, belgium, and luxembourg. the eu will be adding ten new members, i.e., 8 eastern european countries and cyprus and malta, in 2004. 2004] sharing bank deposit information with other countries 648 attracted fierce opposition, the bush administration has continued to defend9 it (but has not yet finalized it).10 9. see chuck gnaedinger & sarah kirkell, “witnesses criticize new proposed regulations on reporting nonresident aliens’ interest,” 2002 tnt 235-1; unofficial transcript of irs hearing [dec. 5, 2002] on proposed regs on reporting nonresident aliens’ interest, 2002 tnt 241-60 (critical testimony by representatives of office of advocacy at the small business administration, conference of state bank supervisors, small business survival committee, empower america, americans for tax reform, institute for international bankers, center for freedom and prosperity, citizens for a sound economy foundation, institute for research on the economics of taxation, southeastern legal foundation, and national small business united). in addition, the irs and treasury received critical comments on the revised proposed regulation from, inter alia, rep. philip m. crane, r-ill., see 2002 tnt 191-12, rep. mark foley, r-fla., see 2002 tnt 193-23, coalition for tax competition, see 2002 tnt 220-18, rep. ron paul, r-texas, see 2002 tnt 232-27, rep. jack kingston, r-ga., see 2002 tnt 23228, rep. pete sessions, r-texas, see 2002 tnt 232-26, mark r. baran, american bankers association, see 2002 tnt 232-24, mary mitchell dunn, senior vice president, credit union national association, see 2002 tnt 232-23, daniel j. mitchell, heritage foundation, see 2002 tnt 237-29, solveig singleton, competitive enterprise institute, see 2002 tnt 240-27, robert r. davis, managing director, america’s community bankers, see 2002 tnt 245-10, bruce chapman, president, discovery institute, see 2002 tnt 245-8, sen. robert bennett, r-utah, see 2002 tnt 246-55, rep. don a. manzullo, r-ill., see 2002 tnt 246-56, donald g. ogilvie, president, american bankers association, 2002 tntt 2-6, rep. robert ney, r-ohio, and sixteen other congressmen, see 2003 tnt 6-38, alejandro m. sanchez, florida bankers association, see 2003 tnt 39-180, rep. spencer bachus, r-ala., see 2003 tnt 43-34, sen. mike crapo, r-idaho, see 2003 tnt 43-33, sen. sam brownback, r-kansas, see 2003 tnt 43-32, sen. john ensign, r-nev, see 2003 tnt 46-59, 9 members of senate banking committee, see 2003 tnt 49-51, sen. james m. inhofe, r-okla., see 2003 tnt 50-42, phil gramm, vice chairman ubs ag, see 2003 tnt 50-41, sen. conrad burns, r-mont., see 2003 tnt 50-39, governor george pataki, new york, see 2003 tnt 65-66, sen. george allen, r. va., see 2003 tnt 65-65, robert l. livingston, livingston-solomon group llc, see 2003 tnt 99-36, rep. jeb hensarling, r-texas, and 14 other reps, 2003 tnt 99-35, 24 house members, see 2003 tnt 100-32. see also letter by 29 u.s. congressmen to president george bush, 2003 tnt 12-31; letter of center for freedom and prosperity et al. to secretary of the treasury, john snow, dated january 26, 2004, available at http://www.freedomandprosperity.org/ltr/ctc6/ ctc6.shtml. 10. see letter of pamela f. olson, assistant secretary (tax policy), dept. of treasury, to senator robert f. bennett, dated december 22, 2003, reprinted in 2004 tnt 1-34, stating that “[t]his proposed regulation is just one element of our multifaceted effort to protect the interests of honest taxpayers.” see also amy hamilton, “u.s. treasury official defends nonresident alien interest reporting regs,” tax notes international, may 12, 2003, p. 541; statement of pamela f. olson, assistant secretary for tax policy, treasury department, before house committee on small business, may 2, 2003, reprinted in 2003 tnt 85-20. but see letter of fred l. smith jr., president, competitive enterprise institute, to treasury secretary john w. snow, sept. 26, 2003, reprinted in 2003 tnt 194-23, in which mr. smith thanks secretary snow for “our meeting in your offices,” and states: “i understand that this proposal is opposed by treasury and the irs.” 584 florida tax review [vol.6:6 this article will explore some aspects of the controversy that continues to surround this proposed regulation. first, the article will discuss the chief justification for the regulation, i.e., to enhance and broaden efforts to exchange tax information with treaty partners. this part will explain that greater information sharing is needed as a means to counter the use of offshore bank accounts to facilitate tax evasion. in the next part, the article will assess the concern of many critics that the regulation will lead to unwarranted invasion of financial privacy. the article describes how congress has already had to limit americans’ financial privacy in order to provide the irs with adequate tools for verifying the accuracy of income tax returns. the article then argues that, assuming appropriate safeguards are in place, broader information exchange with our treaty partners will not significantly diminish the existing degree of privacy. the final part of the article suggests that some criticism of the proposed regulation may have the objective of replacing the income tax with another tax system that would afford greater financial privacy. the article will not address the effects of the proposed regulation on the well-being of u.s. banks or on the u.s. economy nor will it address arguments that the treasury may lack the authority to issue the regulation under current law. i. the rationale for the regulation a. the irs explanation 1. detecting u.s. taxpayers posing as foreigners when the clinton administration issued the proposed regulation in 2001, it offered two justifications. the first was “to ensure voluntary compliance by u.s. taxpayers by minimizing the possibility of avoidance of the u.s. information reporting system (such as through false claims of foreign status).”11 a bank located in the u.s. that pays interest on deposits is generally required to report the amount paid and the recipient to the irs on form 1099.12 however, under current law, no reporting is required if the bank has appropriate documentation that the recipient is a foreign payee (other than a canadian resident). therefore, a u.s. citizen or resident can avoid a u.s. bank’s filing13 11. reg-126100-00, supra note 1, ¶ 19. 12. see irc § 6049(a); treas. reg. § 1.6049-4. 13. section 6049(b) provides that form 1099 reporting is not required for an amount subject to withholding under § 1441 or 1442 or any amount that would be subject to such withholding but for the fact that such amount is described in § 871(i)(2). 2004] sharing bank deposit information with other countries 648 a form 1099 regarding interest paid to him if he falsely files with the bank a statement of his foreign status (on irs form w-8). there is no mechanism under current law that would block this type of perjurious action. the bank paying the interest is entitled to rely on a valid form w-8 (if it does not know or have reason to know of the inaccuracy).14 section 6049(b)(2)(c), (b)(5)(a),(b)(iv). see fsa 1998-381, august 24, 1992, available in 98 tnt 220-85. the regulations interpret this provision as making an exception from form 1099 reporting for “payments that a payor can, prior to payment, reliably associate with documentation upon which it may rely to treat the payment as made to a foreign beneficial owner in accordance with § 1.1441-1(e)(1)(ii).” treas. reg. § 1.6049-5(b)(12). this exception to the filing requirement is not available, however, for interest on a deposit that is not effectively connected to a u.s. trade or business and is paid to a canadian nonresident alien individual if the deposit is maintained at an office within the u.s. treas. reg. §1.6049-5(b)(12); §1.6049-8(a). see discussion in supra note 3. 14. under treas. reg. § 1.1441-1(e)(1)(ii), a “withholding agent may treat a payment as made to a foreign person that is a beneficial owner if . . . the withholding agent can reliably associate the payment with a beneficial owner certificate. . . furnished by the person whose name is on the certificate.” this certificate is “a statement by which the beneficial owner of the payment represents that it is a foreign person,” and it is provided on irs form w-8. reg. § 1.1441-1(e)(2)(i),(ii). according to the regulations, a “form w-8 is valid only if its validity period has not expired, it is signed under penalties of perjury by the beneficial owner, and it contains all of the information required on the form.” treas. reg. § 1.1441-1(e)(2)(ii). in addition, “the withholding agent. . . must not have been notified by the irs that any of the information on the withholding certificate. . . is incorrect or unreliable.” treas. reg. § 1.14411(e)(1)(ii)(b). according to treas. reg. § 1.1441-1(e)(4), a “withholding agent may rely on the information and certifications stated on withholding certificates or other documents without having to inquire into the truthfulness of this information. . . unless it has actual knowledge or reason to know that the same is untrue.” the form w-8ben (rev. december 2000) includes a space for the beneficial owner’s “permanent residence address” and states in bold “do not use a p.o. box or in-care-of address.” see also instructions for form w-8 ben (rev. january 2003), p. 4. however, the irs publication relating to withholding of tax on nonresident aliens states: “until further notice, you can rely upon forms w-8 that contain a p.o. box as a permanent residence address provided you do not know, or have reason to know, that the person providing the form is a u.s. person and that a street address is available.” irs publication 515 (rev. november 2002), p. 7. see generally stephen e. shay, j. clifton fleming, jr., and robert j. peroni, “‘what’s source got to do with it?’ source rules and u.s. international taxationn,” 56 tax law review 81 (2002), at 125, stating that “to avoid administrative burdens and excess withholding. . . , the final withholding regulations contain at least three important concessions that limit the identification of beneficial owners and the reach of disclosure.” 586 florida tax review [vol.6:6 however, under the original version of the proposed regulation, the bank relying on a form w-8 to avoid form 1099 reporting would nevertheless have to report the amount of interest and the name of the recipient to the irs on form 1042-s as deposit interest paid to a nonresident alien. whether this15 would serve as a greater deterrent to dishonesty by the u.s. taxpayer or would assist the irs in detecting the deception by the u.s. taxpayer is not entirely clear.16 in any event, under the revised version of the regulation, form 1042-s reporting of the interest would occur only if the recipient is a resident of one of 16 countries. thus, any u.s. taxpayer who under current law would falsely17 pose as a foreigner could easily avoid the impact of the new regulation by claiming residence in a country other than one of the sixteen listed in the regulation.18 moreover, even if the proposed regulation were to be extended to all nonresident aliens (as under the original proposal), it does not require information reporting for payments made to foreign corporations. thus, a u.s.19 citizen bent on avoiding any reporting to the irs could contribute the funds to 15. under the proposed regulation, the payor was permitted to “rely upon a valid form w-8 to determine whether the payment is made to a nonresident alien individual.” if the payor did not have “either a valid form w-8 or valid w-9, the payor [was required to] report the payment as made to a u.s. non-exempt recipient if it must so treat the payee under the presumption rules of § 1.6049-5(d)(2) and § 1.14411(b)(3)(iii).” proposed regulation § 1.6049-8(a). 16. see mastromarco & hunter, supra note 6, at 168 (questioning whether “the filing of the form 1042-s [would] really have any effect on compliance”). 17. see supra note 8. 18. under the revised proposed regulation, the payor “may rely upon an applicable withholding certificate described in § 1.1441-1(c)(16) (form w-8) that is valid to determine whether the payment is made to a nonresident alien individual who is a resident of one of the countries for which reporting is required.” proposed regulation § 1.6049-8(a). but if there is not a valid form w-8 or w-9, the payor “must report the payment as made to a u.s. nonexempt recipient if it must so treat the payee under the presumption rules of §§ 1.6049-5(d)(2) and 1.1441-1(b)(3)(iii).” id. 19. see treas. reg. § 1.1441-1(c)(6), stating that “the beneficial owner means the person who is the owner of the income for tax purposes and who beneficially owns the income.” see shay, fleming & peroni, supra note 14, at 125-26, explaining that “the regulations treat a foreign corporation as the beneficial owner of its income, irrespective of whether it is located in a tax haven, and its owner(s) need not be identified.” they state that “[t]his was a significant decision by the service to limit the extent to which the withholding tax rules would be used as a means to catch u.s. tax evaders.” id. at 126. 2004] sharing bank deposit information with other countries 648 be deposited to a wholly-owned foreign corporation and have the foreign corporation make the deposit in the u.s. bank. 20 2. facilitating information exchange with other countries the second justification offered for the regulation by the irs was that “several countries that have. . . agreements that provide for the exchange of tax information with the united states have requested information concerning bank deposits of individual residents of their countries. because of the importance that the united states attaches to exchanging tax information as a way of encouraging voluntary compliance and furthering transparency. . . ., treasury and the irs believe that it is important for the united states to facilitate, wherever possible, the effective exchange of all relevant tax information with our treaty partners.”21 bilateral treaties entered into by the u.s. typically contain an article similar to article 26 of the u.s. model income tax convention providing for “exchange of information and administrative assistance.” these agreements22 20. see shay, fleming & peroni, supra note 14, at n. 171, noting that “a u.s. tax evader resident in the united states might arrange with a fiduciary in a country with confidentiality protections to organize a corporation to hold investment assets.” 21. when the irs replaced the proposed regulation with the new, more limited version, it explained: “the irs and treasury believe that limiting reporting to residents of these countries will facilitate the goals of improving compliance with u.s. tax laws and permitting appropriate information exchange without imposing an undue administrative burden on u.s. banks.” reg-133254-02, supra note 8, at ¶ 25. 22. 1996 u.s. model income and capital tax convention, sept. 20, 1996, available at 96 tni 186-16. see richard gordon, “tax havens and their use by united states taxpayers an overview,” irs publication 1150, rev. 4-81, reprinted in 93 tnt 119-22 [hereinafter “gordon report”] at page 129, stating in 1981 that “united states treaties in force contain an article obligating this country and its treaty partner to exchange information on matters related to tax administration.” for further discussion of information exchange under treaties, see michael i. saltzman and jean-claude m. wolff, “the growing role of information exchange in u.s. tax treaties,” 32 tax notes int’l magazine 943 (2003). saltzman & wolff note that the “irs has five special programs for information exchange.” id. at 944, citing internal revenue manual 4.60.1. one program is responding to specific requests of treaty partners for information, including “property ownership, financial records such as bank account information, verification of income tax return filing and filing status, and the types and amounts of income and expense reported.” id. a second program includes “routine exchanges of 588 florida tax review [vol.6:6 would permit (but not require) routine or automatic exchange of information or a spontaneous sending of information without any request; they also mandate provision of information in response to a request regarding a specific taxpayer by the treaty partner. if the revised regulation were put into effect, the u.s.23 would be in a position to make an automatic exchange of information24 regarding bank deposit interest with the sixteen countries listed in the regulation. this would allow these countries to learn about interest paid by banks in the u.s. to their individual residents, thereby permitting these countries to impose their tax on such interest. similarly, the u.s. would learn about interest paid by banks in those countries to u.s. taxpayers and could verify that the interest is reported on form 1040.25 in addition, treasury’s adherence to the proposed regulation (as revised in august 2002) may be interpreted as an indication of willingness to participate in, and at least tacitly support, the recently adopted european union savings directive. under this directive, interest paid within the eu to an eu resident would automatically be reported to the residence country. the twelve eu countries that have agreed to this routine sharing of information are all listed in the treasury’s proposed regulation, whereas the three eu countries that have not agreed to routine information sharing (belgium, luxembourg and information, such as dividend, interest, rents, and royalties, records of which are computerized and capable of being communicated without difficulty.” id. at 944-45. 23. see gordon report, supra note 22, at page 130; see david e. spencer, oecd model agreement is a major advance in information exchange (part 2), 13 j. int’l tax’n 10, at text accompanying n. 8. 24. although the irs would be in a position to make an automatic exchange, the u.s. would not be required to do this under its existing treaties or informationexchange agreements. the irs would merely be required to provide specific information when a request is made pursuant to such an agreement. thus, it seems incorrect for the cato institute to say that “the proposed new regulation would be the equivalent of an automatic information-sharing agreement with other nations.” see rahn & de rugy, supra note 6, at ¶ 33. 25. an alternative to obtaining information regarding an american taxpayer from a foreign country is for the irs to obtain such information directly from an foreign financial institution in which the american has an account and which has signed up to be a “qualified intermediary.” see marnin j. michaels & thomas a. o’donnell, “the death of information-exchange agreements,” 13 j. int’l tax’n 8 (august 2002), noting that “foreign financial institutions have signed up en masse for the services’s new qualified intermediary. . . program.” the authors note however that under these agreements “the u.s. is allowing non-u.s. tax cheats to use the u.s. without obtaining information that it could exchange with the tax evader’s home country.” id. at text accompanying n. 11. see discussion in shay, fleming & peroni, supra note 14, at 12425; michael j. graetz, foundations of international income taxation 395-99 (2003). 2004] sharing bank deposit information with other countries 648 austria) are not listed in the regulation. although implementation of the eu26 directive in 2005 has been made explicitly contingent on adoption of equivalent measures by certain other countries, the eu has already acknowledged that the u.s. cooperation has been adequate, perhaps in part because of the proposed27 regulation.28 more generally, the treasury’s justification of the regulation suggests its desire to follow through with recent efforts to achieve greater information exchange with so-called tax havens. the efforts include the recent signing by the u.s. of bilateral information-sharing agreements with certain tax havens and the oecd initiative to compel tax havens to achieve greater transparency, both discussed below. by stating its own willingness to collect information about interest received by residents of other countries, the treasury may seek to reassure tax havens that they will not be required to be more forthcoming in sharing information than the u.s. is willing to be. in conclusion, the proposed regulation should be seen as part of a larger movement by the u.s. and its major trading partners toward greater sharing of 26. ten new countries are entering the eu in 2004. see supra note 8. these are not listed in the regulation. 27. in december 2002, the eu commission concluded that while the u.s. “is not prepared at this stage to give a formal statement in relation to the [proposed eu] savings directive,” the “treasury remains clearly focused on a full and effective administration of taxes based on information exchange on a bilateral basis.” commission of the european communities, communication from the commission to the council, report concerning negotiations with third countries on taxation of savings income, dec. 3, 2002, http://europa.eu.int/comm/taxation_customs/taxation/ information_notes/taxation_package/taxpack_4.htm, last visited 10/20/03, at ¶¶ 20-26. however, in november 2002, two members of the bush administration, larry lindsey, director of the national economic council, and r. glenn hubbard, head of the u.s. council of economic advisers, both apparently indicated that the administration did not support the european savings tax directive. see cordia scott, “white house signals lack of support for eu savings tax directive,” tax notes international magazine, nov. 4, 2002, at 421-422; see also edward alden, francesco guerrera and amity shlaes, “u.s. opposes sharing information on savings taxation white house advisers come out against european request for data on foreign-held accounts,” financial times, sept. 26, 2002, page 4. when the june 2003 agreement came out, its 2005 implementation was not conditioned on any further u.s. action. see infra notes 7275 and accompanying text. for continuing uncertainty regarding the u.s. position, see cordia scott, “oecd targets additional financial centers in expanded tax haven crackdown,” 2004 wtd 109-1. 28. see david r.burton, “financial privacy and individual liberty,” discussion draft/working paper, austrian scholars conference, march 14, 2003, available online at http://www.mises.org/asc/2003/asc9burton.pdf, stating that “the proposed regulation is almost certainly the reason why the eu regards the u.s. as being in compliance with the eu savings tax directive.” id. at 24 & n. 77. 590 florida tax review [vol.6:6 information between countries as a means of improving tax compliance. this certainly appears to be a concern for many critics of the proposal. in fact, some critics have argued that this regulation will lead inevitably to a world tax clearinghouse for information. because the regulation is part of a larger movement toward information sharing, it seems appropriate to consider, as a general matter, whether broader information sharing is really necessary and whether it brings too great a risk to the privacy of individuals. b. why the irs wants to achieve broader information sharing with other countries 1. the prevalence of tax evasion through offshore arrangements in responding to criticism of the proposed regulation, the treasury has recently made clear the reason that it considers broader information-sharing to be necessary: “the offshore sector is an increasing problem in the enforcement of u.s. tax laws. . . . addressing the potential for tax evasion through use of offshore accounts or entities is critical to maintaining the confidence of all americans in the fairness of the u.s. tax system.”29 the potential for tax avoidance or evasion through use of offshore entities or accounts has long been apparent. for example, in 1937, when congress held hearings on the subject of “tax evasion and avoidance,” there was testimony regarding “the device of evading taxes by setting up foreign personal holding corporations in the bahamas, panama, newfoundland and other places where taxes are low and corporation laws lax.” in 1970, a30 congressional report accompanying the passage of the bank secrecy act of 1970 stated: “these days when the citizens of this country are crying out for tax reform and relief, it is grossly unfair to leave the secret foreign bank account open as a convenient avenue of tax evasion.”31 more recently, in 1981, richard gordon, special counsel for international taxation at the treasury department, wrote an extensive report 29. treasury thanks lawmakers for letter on nra interest-reporting rules, 2003 tnt 124-61 (letter sent by pamela f. olson, assistant secretary of the treasury for tax policy, to 24 members of the house of representatives). 30. tax evasion and avoidance, hearings before the joint committee on tax evasion and avoidance, 75th cong., june 17, 18, 22, 23, and 24, 1937, page 2, quoting from a letter to the president from sec’y of the treasury henry morgenthau, jr., dated may 29, 1937. see charles i. kingson, international taxationn 459-60 (1998). 31. h.r. rep. no. 91-975, 91st cong., 2nd sess. (march 28, 1970), 1970 u.s.c.c.a.n. 4394, 1970 wl 5667 (leg.hist.). 2004] sharing bank deposit information with other countries 648 entitled “tax havens and their use by united states taxpayers – an overview.” “tax havens” were defined for this purpose as “countries having32 (1) low rates of tax when compared with the united states, and (2) a high level of bank or commercial secrecy that the country refuses to breach even under an international agreement.” in 1984, an updated report by the treasury, entitled33 “tax havens in the caribbean basin,” stated that “it seems reasonable to assume that a great deal of activities designed to violate the tax and other laws of the united states takes place in the caribbean basin tax havens.” a senate34 report, entitled “crime and secrecy: the use of offshore banks and companies,” was issued in 1985, and warned that “the effect has been to. . . thwart the collection of massive amounts of tax revenues.”35 in the 1990’s, the revelations by john mathewson, the indicted former chairman of a cayman island bank, of how he helped numerous american tax evaders set up undisclosed offshore accounts and access their funds through credit cards, made it clear that the problem was continuing. advertisements36 in airline magazines, numerous websites, and self-help books, by authors such as jerome schneider and terry neal, offered u.s. taxpayers the “offshore advantage.” books such as “the cheating of america,” and “the great37 american tax dodge” gave detailed examples of instances of offshore tax evasion. the fact that offshore accounts and entities can now be set up in the38 32. gordon report, supra note 22. 33. id. at i., overview of findings and options. 34. treasury dept., tax havens in the caribbean basin, january 6, 1984, quoted in ex parte motion by government to search offshore credit card records, u.s. district court for southern district of florida, oct. 25, 2000, declaration of joseph c. west, revenue agent, ¶¶ 15-16, available at 2000 tnt 209-24 [hereinafter “ex parte motion”]. 35. permanent subcommittee on investigations, senate committee on u.s. government affairs, “crime and secrecy: the use of offshore banks and companies,” august 28, 1985, quoted in ex parte motion, supra note 34, at ¶¶ 18-19. 36. u.s. department of justice press release, former chairman of cayman island bank sentenced for nationwide, multi-million dollar offshore banking scheme, august 2, 1999, available in 1999 wtd 174-28; letter of faith s. hochberg, united states attorney, to judge alfred j. lechner, jr., district judge, july 29, 1999, in u. s. v. john m. mathewson, crim. no. 96-353 (ajl), available in 1999 tnt 173-26; barton massey, “convicted bank chairman is key to dozens of tax haven cases,” 1999 wtd 172-2. see also testimony of jack a. blum, esq. before the senate finance committee on tax schemes, scams and cons, april 22, 2002, reprinted in 2002 tnt 71-34. 37. jerome schneider is the author of “the complete guide to money havens: how to make millions, protect your privacy and legally avoid taxes,” currently in a “revised and updated 4th edition” published in 2001. terry l. neal is the author of the offshore solution (2001) and of the offshore advantage (1999). see amazon.com, last visited on 07/09/03. 38. charles lewis, bill allison, & the center for public integrity, the cheating of america – how tax avoidance and evasion by the super rich are costing the country billions – and what you can do about it (ny 2002); donald l. bartlett & 592 florida tax review [vol.6:6 privacy of one’s home, through visiting websites on the internet, raises further concern that this problem could become more widespread. beginning in 2000, the government publicly set forth its case that taxpayers who held credit cards issued by offshore banks might well be engaged in tax evasion. on this basis, it convinced several federal district courts to permit it to serve summons on credit card companies and then on merchants to learn the identities of such holders. after gathering this information, the irs39 in 2003 offered taxpayers who had used offshore arrangements to improperly reduce taxes an opportunity to avoid the civil fraud penalty and criminal prosecution by coming forward voluntarily. in july 2003, the irs announced40 that 1,299 taxpayers had applied for the program, that it obtained information about 400 offshore promoters and that it had thus far collected $75 million in taxes. in this same period, the government obtained indictments against two41 leading promoters of offshore planning (who were also popular authors of selfhelp guides), jerome schneider and terry l. neal.42 43 james b. steele, the great american tax dodge – how spiraling fraud and avoidance are killing fairness, destroying the income tax, and costing you (berkley 2000). see also janet novack, forbes magazine, “are you a chump?” p. 122 (march 5, 2001). 39. internal revenue service, irs chronology on credit cards and john doe summons, january 4, 2003, available at 2003 tnt 10-12. see ex parte motion, supra note 34 (request before u.s. district court for southern district of florida). as of july 30, 2003, the irs said there were 2,800 cardholders under audit or for which audit had been completed, $3 million in taxes assessed, and “dozens of cases” referred to criminal investigation. internal revenue service, offshore compliance program shows strong results, july 30, 2003, available at 2003 tnt 147-12. see also david cay johnston, “irs says offshore tax evasion is widespread,” the new york times, march 26, 2002, at a1; lavonne kuykendall, “what’s behind offshore data tug-of-war,” the american banker, p. 1, april 1, 2002, available on lexis. see also “motion to quash summons based on irs offshore credit card project denied,” 2004 tnt 33-5 (district court granted government’s motion to enforce summons for bank records.) 40. revenue procedure 2003-11, available at 2003 tnt 10-7; irs, irs unveils offshore voluntary compliance initiative; chance for ‘credit-card abusers’ to clear up their tax liabilities, ir-2003-5, jan. 14, 2003; irs revises voluntary disclosure practice, ir-2002-135, dec. 11, 2002. see also irs, offshore voluntary compliance initiative has month to go; people need to apply directly to receive penalty relief, ir-2003-35, march 17, 2003. see also heather bennett, “irs offshore compliance initiative collects $170 million so far, official says,” 2004 tnt 22-13. 41. irs, offshore compliance program shows strong results, supra note 39. in october 2003, an irs official predicted that the program would bring in about $150 million. robert goulder, “irs official reviews offshore compliance initiative progress,” 2003 tnt 210-5. 42. u.s. attorney, northern district of california, press release of dec. 19, 2002, available at www.usdoj.gov/tax/usaopress/2002/2002_12_19_schneider.html. the indictment of schneider and eric j. witmeyer was for “one count each of conspiracy to 2004] sharing bank deposit information with other countries 648 2. how offshore arrangements facilitate tax evasion although a taxpayer is expected to voluntarily report all his income to the irs on form 1040, the irs has other means at its disposal for obtaining at least some of this information, at least when transactions are conducted within the u.s. for example, many types of payments, most notably, wages, dividends, interest, unemployment compensation, and gross proceeds of security sales, must be reported by a u.s. payor or broker to the irs as well as to the taxpayer. if the taxpayer recipient has not provided his taxpayer identification44 number to the payor or broker, then backup withholding of tax is required.45 46 in addition, the irs has authority to examine books or records which may be relevant to determining a taxpayer’s liability, and to summon the taxpayer or other persons to produce such books or records, or to give testimony under oath relevant to such determination. the u.s. district court is authorized to47 defraud the irs,” and additional counts of wire and mail fraud. the charges were “in connection with their alleged marketing and sales to u.s. taxpayer investors of offshore international banks or corporations and causing those entities to be ‘decontrolled’ which is a process used by the defendants to attempt to conceal the u.s. taxpayer investor’s ownership in the offshore bank or corporation.” 43. department of justice press release, alleged promoters of offshore credit card schemes indicted for conspiracy to defraud the irs, april 23, 2003. 44. see, e.g., irc § 6042 (dividends), § 6045 (returns of brokers), § 6049 (interest), § 6050b (unemployment compensation), § 6050n (royalties), § 6051 (wages). for provisions limiting reporting obligations to u.s. payors and middlemen, in the case of foreign-source income, see irc § 6042(b)(2)(a)(i); treas. reg. § 1.6042-3(b)(iv) (dividends); treas. reg. § 1.6045-1(a)(1) (broker); irc § 6049(b)(1)(d); treas. reg. § 1.6049-5(b)(6) (interest). 45. a u.s. citizen or resident opening a domestic bank account must provide his name, address and tin on a form signed under penalty of perjury; a foreign person must provide his name, and address in his country of permanent residence on a form signed under penalties of perjury. oecd, improving access to bank information for tax purposes (2000) [hereinafter “oecd bank report”], appendix i, ¶ 1.5.5.3.1. nonresidents must provide a tin in some cases. id. at ¶ 1.5.5.3.3. the same rules apply to foreign branches and subsidiaries of u.s. financial institutions, except foreign persons may provide documentary evidence of foreign status rather than use the irs form. id., ¶ 1.5.5.3.1. in opening a bank account in the u.s., documentary evidence must be provided if a currency transaction report is required. id., at ¶ 1.5.3.3.2. 46. irc § 3406(a). 47. irc § 7602. see generally william m. sharp, sr. & hale e. sheppard, “privilege, work-product doctrine, and other discovery defenses in u.s. irs’s international tax enforcement,” 32 tax notes int’l magazine 377 (2003). for the historical background of the summons power under § 7602, see bryan t. camp, “tax 594 florida tax review [vol.6:6 compel compliance with the summons and to use the contempt power toward this end. for example, the irs can use a summons to a bank to obtain the48 complete banking records of an individual suspected of underreporting income. finally, u.s. banks are required to file suspicious activity reports49 to report suspicious banking transactions, and currency transaction reports with respect to currency transactions in amounts exceeding $10,000. banks50 are subject to audit and may incur civil or criminal penalties for noncompliance. these reports are available to the irs. the purpose is to protect against moneylaundering as well as tax evasion. 51 administration as inquisitorial process and the partial paradigm shift in the irs restructuring and reform act of 1998,” 56 fla. l. rev. 1, 31-52 (2004). 48. irc § 7604. see § 7609, imposing special procedures, including notice, for a third-party summons. 49. banks are required to keep certain records regarding their customers’ accounts. see discussion in matthew n. kleiman, comment: the right to financial privacy versus computerized law enforcement: a new fight in an old battle, 86 nw. u.l.rev. 1169 (1992), at 1186. the right to financial privacy act establishes certain standards for bank secrecy but “an exception is made, pursuant to 12 u.s.c. § 3413(c), for financial records sought in accordance with the procedures set forth in title 26 of the code (i.e., the irc)”, including the administrative summons provided for in irc § 7609. oecd bank report, supra note 45, appendix i, at ¶ 1.3. disclosure to the irs of names and addresses of accountholders for purposes of withholding of tax on nonresident aliens is permitted by § 3413(k). id. other exceptions, e.g., §§ 3402, 3403(c)-(d), 3413 or 3414, involving “use of administrative or judicial subpoenas and search warrants,” may also be available to the irs. id. at ¶ 1.3. 50. oecd bank report, supra note 45, appendix i, ¶ 1.4, citing reg. § 103.21-22. the suspicious activity report (sar) is on form td f 90-22.47, and the currency transaction report (ctr) is on form 4789. in addition, the bank secrecy act requires filing of a form 4790 by a person transporting currency or certain other monetary instruments in excess of $10,000 out of or into the u.s. see generally treasury department, a report to congress in accordance with § 357 of the usa patriot act, april 26, 2002, available in 2002 tnt 84-19. see e.g., joseph j. darby, confidentiality and the law of taxation, 46 am. j. comp. l. 577 (1998), stating that “secrecy in banking is not protected in the united states. au contraire, the federal banking secrecy act authorizes the treasury department to require financial institutions in the united states to keep certain records of financial transactions and to report certain domestic and foreign currency transactions directly to the secretary of the treasury.” he notes that the statute’s constitutionality was upheld in california bankers association v. schultz, 416 u.s. 21 (1974). 51. oecd bank report, supra note 45, appendix i, ¶ 1.6, citing 31 u.s.c. §§ 5331 and 5332. for a general survey on the practices of oecd member countries with respect to tax authorities’ access to bank information, see oecd bank report, supra note 45, and oecd, access for tax authorities to information gathered by anti-money l a u n d e r i n g a u t h o r i t i e s – c o u n t r y p r a c t i c e s , a v a i l a b l e o n l in e 2004] sharing bank deposit information with other countries 648 by contrast, irs information-reporting generally does not extend to foreign payors or brokers. moreover, some foreign countries, such as52 liechtenstein, switzerland, and the cayman islands, have held themselves out as places where investors and depositors can be sure that their identity and holdings are secret, places where confidentiality is assured. in some cases, the53 government simply will not seek to collect information from banks; in other cases, the government may itself impose penalties on bank employees who breach secrecy. in any case, requests to the executive or judiciary of such a country for information related to taxes or to creditors’ claims to collect debts will not be entertained. apart from switzerland, these are countries that do not have income tax treaties with the united states. a u.s. citizen or resident who has an offshore account with a value exceeding $10,000 is legally required to acknowledge this on schedule b of http://www.oecd.org/finddocument/0,2350,en_2649_33751_1_1_119663_1_1_3742 7,00.htm (results of survey as of february 2002). the criminal investigation division of the irs has on-line access to fincen’s database of sars. the examination division may “receive particular suspicious activity reports in connection with particular examinations following a name-specific request for such information to fincen.” oecd, access for tax authorities, supra. in the u.s., currency transaction reports filed by financial institutions, and reports required of persons entering the u.s. and transporting at least $10,000 in currency “[g]enerally. . . [are] available to federal tax authorities and [are] maintained on-line by both the internal revenue and customs services.” id. “the bank secrecy act prevents the use of sars for civil tax compliance.” id. 52. see supra note 44. as a result, compliance suffers. see reuven s. aviyonah, “globalization, tax competition and the fiscal crisis of the welfare state,” 113 harv. l. rev. 1573, 1584-85 (2000), excerpted in graetz, supra note 25, at 375-76, noting that when neither “withholding at the source or information reporting. . . is available. . . as in the case of foreign source income, compliance rates drop dramatically;” michael j. graetz, “taxing international income: inadequate principles, outdated concepts, and unsatisfactory policies,” 26 brook. j. int’l law 1357, 1414 (2001), excerpted in graetz, supra note 25, at 374-75, noting very significant underreporting of interest, dividends and capital gains on outbound portfolio investments. 53. see lars p. feld, “swiss bank secrecy and international taxation,” tax notes international magazine, sept. 2, 2002, p. 1179; robert goulder, “liechtenstein defends low taxes and fiscal privacy,” 2000 wtd 246-2 (dec. 20, 2000). see also oecd report, improving access to bank information for tax purposes: the 2003 progress report (2003), at 13-14, noting that switzerland “had little or no access to [banking] information for civil tax purposes.” . see generally oecd bank report, supra note 45, at 20-31, discussing the adverse consequences of bank secrecy. 596 florida tax review [vol.6:6 form 1040 and, separately, to file a report of the account with the treasury54 department. however, the treasury department has, at least in the past, made55 little effort to enforce this requirement.56 bank accounts in bank secrecy jurisdictions are ideal for concealment of illegally earned funds, funds to be used for terrorism or that are the product of political corruption, or funds that represent unreported income in the residence country. even if the source of funds is completely legitimate, future earnings can be concealed from the home country’s taxes. finally, it may be impossible for the irs or other creditors to collect debts against these assets. 3. efforts to break down the barriers of secrecy surrounding tax havens and how the proposed regulation fits together with these efforts as noted, the u.s. has not generally entered into tax treaties with tax havens, and thus has not had an mechanism for exchange of information with tax authorities in those countries. in 1984, when congress passed the caribbean basin initiative, caribbean countries were offered the inducement of being able to host tax-deductible business conventions if they entered into agreements for the exchange of information. section 274(h)(6) described the necessary 54. a taxpayer filing schedule b to form 1040 is asked to indicate whether he has a financial interest in a foreign account and, if the answer is yes, is referred to the filing requirements for form td f 90-22.1. 2002 form 1040, schedule b, part iii, line 7a. see treasury department, a report to congress in accordance with § 361(b) of the usa patriot act, april 26, 2002, available at 2002 tnt 84-18. the 2002 instructions for schedule b explain that the “no” box is to be checked if the combined value of the foreign accounts is $10,000 or less during the whole year. however, the instructions also state that the relevant accounts include foreign bank accounts owned by any corporation in which the taxpayer owns more than 50 percent of the stock. 55. the report is on form td f 90-22.1, entitled report of foreign bank and financial accounts. section 5314 of the bank secrecy act (31 u.s.c. 5314) authorizes the treasury to issue regulations requiring these reports. this provision was enacted in 1970. see pub.l.91-508, 84 stat. 1114, § 241, enacting 31 u.s.c. 1121; pub. l. 97-258, 96 stat. 997, revising 31:1121(a) as 31 u.s.c. 5314(a). the regulation is at 31 cfr 103.24. under the bank secrecy act, civil or criminal penalties may be imposed for failure to file. 31 u.s.c. 5321(5), 5322. a constitutional challenge to this filing requirement was rejected in california bankers assn. v. shultz, 416 u.s. 21 (1974), at 56-63, 70-74. 56. in calendar year 2001, about 175,000 forms were filed. however, the irs suggests that as many as 1 million taxpayers might have been required to file the report. treasury department, a report to congress in accordance with § 361(b) of the usa patriot act, april 26, 2002, reprinted in 2002 tnt 84-18, at ¶ 8. 2004] sharing bank deposit information with other countries 648 agreements, and a draft agreement was developed. the u.s. entered into such agreements with certain countries.57 in 1998, the oecd launched a new assault on the secrecy of tax havens when it published a report entitled “harmful tax competition – an emerging global issue,” addressing “harmful tax practices” in both member and nonmember countries. a follow-up report in june, 2000, listed 35 jurisdictions58 that were considered to be tax havens and that would have to make commitments to eliminate “harmful tax practices” to avoid being labeled “uncooperative tax havens.” the incoming bush administration was heavily59 lobbied to reject this initiative (as well as the proposed regulation on bank deposits), and on may 10, 2001, secretary of the treasury paul o’neill60 57. see rev. rul. 2003-109, 2003 tnt 190-18, for an updated list of these countries. 58. oecd, harmful tax competition – an emerging global issue (1998) [hereinafter “1998 oecd report”]. see “tax evaders beware: rich countries prepare for crackdown on havens,” wall st. j., may 21, 1998, page a12. for a thorough discussion of the report, see david e. spencer, “oecd report cracks down on harmful tax competition,” 9 journal of int’l tax’n 26 (1998). 59. oecd, progress in identifying and eliminating harmful tax practices (oecd 2000). see discussion in david e. spencer, stepping up the pressure on tax havens: an update (part 1), 12 j. int’l tax’n 26 (2001). the 1998 report said that “[t]he necessary starting point to identify a tax haven is to ask (a) whether a jurisdiction imposes no or only nominal taxes. . . and offers itself. . . as a place to be used by nonresidents to escape tax in their country of residence.” 1998 oecd report, supra note 58, at ¶ 52. it then goes on to list other “key factors,” i.e., “(b) laws or administrative practices which prevent the effective exchange of relevant information with other governments on taxpayers benefitting from the low or no tax jurisdiction (c) lack of transparency and (d) the absence of a requirement that the activity be substantial, since it would suggest that a jurisdiction may be attempting to attract investment or transactions that are purely tax driven.” id. see also id. at ¶ 49, noting that “[t]ax havens serve three main purposes: they provide a location for holding passive investments (“money boxes”); they provide a location where “paper” profits may be booked; and they enable the affairs of taxpayers, particularly their bank accounts, to be effectively shielded from scrutiny by tax authorities of other countries.” 60. the lobbying efforts were coordinated by daniel mitchell of the heritage foundation, and andrew quinlan, president of the center for freedom and prosperity (“cfp”). see anand giriharadas, “the treasury coddles tax cheats – sacred havens,” the new republic online, posted august 21, 2001 (describing various closed-door meetings of cfp lobbyists with administration officials); exhibits 11-15 to hearings before permanent subcommittee on investigations of the senate committee on governmental affairs, july 18, 2001, reprinted in 2001 tnt 139-3 [hereinafter “hearings”] (memorandum from the prosperity institute, and special alert, strategic memos and press statements of the cfp); “avenue of the americas: oecd meets the xfl,” financial times, feb. 14, 2001 (describing lobbying against oecd initiative by 598 florida tax review [vol.6:6 publicly expressed disagreement with any effort “to harmonize world tax systems.” as a result, the oecd initiative underwent modifications in june61 2001 so that cooperation by tax havens required only that they commit to62 andrew quinlan “former amateur football player and inside-the-beltway veteran” and “his more scholarly sidekick, dan mitchell”) . the cfp also engaged in “an aggressive grassroots campaign, including “internet advocacy” which “generated about 10,000 emails to members of congress or the treasury secretary” and “a direct-mail crusade” in which it contracted for “100,000 pieces of mail to targeted citizens.” see exhibit 13 to hearings, supra, memorandum of dan mitchell to leaders of low-tax jurisdictions and supporters of tax competition, financial privacy, and fiscal sovereignty, dated june 16, 2001. girihandas mentions in particular meetings of cfp lobbyists with mark weinberger, assistant secretary of the treasury for tax policy, and an april meeting of secretary o’neill with ed feulner, president of the heritage foundation. see also lee a. sheppard, news analysis – it’s the bank secrecy, stupid, 91 tax notes 385 (april 16, 2001); robert s. mcintyre, “the taxonomist – tax cheaters’ lobby,” the american prospect, june 4, 2001, p. 12, available on lexis, describing the mission of cfp as “to protect the god-given right of the rich and powerful to evade taxes.” 61. secretary of treasury, paul h. o’neill, department of treasury news release, may 10, 2001, available as exhibit 2 to hearings, supra note 60. he also stated that “the work of this particular oecd initiative. . . must be refocused on the core element that is our common goal: the need for countries to be able to obtain specific information from other countries upon request in order to prevent the illegal evasion of their taxes by the dishonest few. in its current form, the project is too broad and it is not in line with this administration’s tax and economic priorities.” id. secretary o’neill’s concern was then conveyed in a letter to the g-7 finance ministers, dated june 7, 2001. see exhibit 1 to hearings, supra note 60. see discussion in david e. spencer, “oecd project on tax havens and harmful tax practices: an update (part 1),” 13 j. int’l tax’n 8 (2002); a retreat on tax havens, n.y. times editorial, may 26, 2001, page a-12. the administration’s position was the subject of a july 18, 2001 hearing, entitled “what is the u.s. position on offshore tax havens?” led by senator carl levin, dmichigan, chair of the permanent subcommittee on investigations, committee on governmental affairs. see amy hamilton, “o’neill says white house is pleased with oecd tax haven sanctions delay,” 2001 tnt 139-3; statement of paul h. o’neill before the senate committee on governmental affairs permanent subcommittee on investigations, july 18, 2001, reprinted in 2001 wtd 139-20; statement of donald c. alexander before senate committee on governmental affairs permanent subcommittee on investigations, july 18, 2001, reprinted in 2001 tnt 139-54; opening statement of carl levin, before senate committee on governmental affairs permanent subcommittee on investigations, july 18, 2001, reprinted in 2001 wtd 140-35, 2001 tnt 139-3. the hearings are described in spencer, supra. 62. see “accord is reached by u.s. and allies on tax havens, ” wall st. j., june 28, 2001, page a4; statement of paul o’neill, supra note 61, ¶¶ 24-34. these modifications were incorporated in “the oecd’s project on harmful tax practices: the 2001 progress report,” nov. 14, 2001, reprinted in 2001 wtd 221-14. the 2001 report confirmed that the “lack of substantial activities” criterion, described in the 1998 2004] sharing bank deposit information with other countries 648 transparency and effective information exchange. in april 2002, the oecd63 released its model agreement on exchange of information in tax matters, to reflect “the standard of effective exchange of information” for its tax haven initiative. thirty-two cooperating countries have agreed to engage in such64 exchange of information with respect to criminal tax matters, beginning january 1, 2004, and with respect to civil tax matters, beginning in 2006.65 at the same time that the oecd was pursuing this initiative, other complementary efforts were proceeding. in june 2000, the financial action task force on money laundering (fatf), established by the g-7, published its own list of 15 “uncooperative” countries. the u.s. in turn, through66 fincen (the u.s. financial crimes enforcement network) issued advisories about these jurisdictions.67 the september 11 attacks focused new concern on the issue of moneylaundering and inadequate supervision of bank accounts, onshore or offshore, because of their potential use by terrorists. in october 2001, congress enacted report, would not be used “to determine whether or not a tax haven is uncooperative.” in addition, the oecd would seek commitments “only with respect to transparency and effective exchange of information criteria.” 2001 report, ¶¶ 27-28. 63. in april 2002, the oecd cited seven “uncooperative tax havens:” andorra, liechtenstein, liberia, monaco, the marshall islands, nauru, and vanuatu. oecd, the oecd list of unco-operative tax havens, april 18, 2002, reprinted in 2002 tnt 7661. vanuatu and nauru were removed from the list in 2003. see letter of minister of finance and economic management, the republic of vanuatu, to oecd secretary general, may 7, 2003, online at www.oecd.org.; oecd, “nauru is removed from oecd list of uncooperative tax havens,” available in 2003 wtd 240-22. 64. oecd, agreement on exchange of information on tax matters, ¶ 3, available at www.oecd.org, last visited 07-03-03. see discussion in david e. spencer, “oecd model agreement is a major advance in information exchange,” 13 j.int’l tax’n 32 (2002) & (part 2), 13 j. int’l tax’n 10 (2002); graetz, supra note 25, at 38991. 65. see oecd report, improving access to bank information for tax purposes: the 2003 progress report (2003), at 18. 66. these were bahamas, cayman islands, cook islands, dominica, israel, lebanon, liechtenstein, marshall islands, nauru, niue, panama, philippines, russia, st. kitts and nevis, and st. vincent and the grenadines. david e. spencer, “stepping up the pressure on tax havens: an update (part 2),” 12 j. int’l tax’n 36 (2001), at n. 15. see also jacqueline b. manasterli, “offshore financial centers and harmful tax regimes trigger flurry of international developments,” tax notes international magazine, dec. 4, 2000, p. 2541. 67. spencer, supra note 66, at n.16. during these same years, the u.s. was also cooperating in multilateral efforts to combat money-laundering in offshore accounts. see william f. weschler, “follow the money,” foreign affairs, july-august 2001. mr. weschler was special adviser to the secretary of the treasury from 1999 to 2001. 600 florida tax review [vol.6:6 enhancements of the anti-money-laundering rules. in addition, during 200168 and 2002, the bush administration negotiated exchange of information agreements with tax haven countries, such as the netherlands antilles, the british virgin islands, bahamas, antigua and barbuda, and the cayman islands.69 in 2003, both the eu and the u.s. took further steps toward greater information exchange. in january, the u.s. entered into an agreement with70 switzerland designed to enhance tax information exchange under their existing 68. the international money laundering abatement and anti-terrorist financing act of 2001, title iii, of the usa patriot act, public law no. 107-56, signed on oct. 26, 2001. see marnin j. michaels and thomas a. o’donnell, “the death of information-exchange agreements?,” 13 j. int’l tax’n 8, at n.8 (2002). see also margaret r. blake & carrie j. di santo, “guidance on anti-money laundering compliance programs under usa patriot act,” 13 journal of int’l tax’n 35 (2002). section 311 of the usa patriot act authorizes the treasury to designate a foreign jurisdiction or financial institution as being “of primary money laundering concern” and to impose certain “special measures.” the treasury has exercised this authority with respect to ukraine and nauru. treasury dept., press release, december 20, 2002, available in 2002 tnt 247-20. in the case of nauru, “u.s. financial institutions” are prohibited “from opening or maintaining correspondent accounts with nauru-licensed financial institutions.” id. at ¶ 11. see hudson morgan, “treasury’s kid gloves,” new republic, p. 16, april 14, 2003, questioning treasury’s failure to use this authority with respect to saudi arabia. 69. during 2001 and 2002, the u.s. signed exchange of information agreements with the following countries: columbia (03-30-01), cayman islands (11-2701), antigua & barbuda (12-06-01), bahamas (01-25-02), british virgin islands (04-0302), netherlands antilles (04-17-02), guernsey (09-12-02), isle of man (10-04-02), jersey (11-04-02). in november 2003, the u.s. signed an exchange of information agreement with aruba. see kevin a. bell, “u.s., aruba sign tax information exchange agreement,” 2003 tnt 226-5. in the 1980’s and early 1990’s, the u.s. put into effect exchange of information agreements with the following countries: barbados (1984), jamaica (1986), grenada (1987), bermuda (1988), dominica (1988), dominican republic (1989), mexico (1990), trinidad & tobago (1990), st. lucia (1991), honduras (1991), marshall islands (1991), costa rica (1991), guyana (1992), peru (1993). all the latter agreements, except for those with mexico, peru and the marshall islands, qualify for the caribbean basin initiative. john venuti, manal s. corwin, steven r. lainoff, and paul m. schmidt, “current status of u.s. tax treaties and international tax agreements,” 32 tax management international journal 320, 325 (2003). see marnin j. michaels and thomas a. o’donnell, “the death of informationexchange agreements?,” 13 j. int’l tax’n 8, at n. 1 (2002). 70. earlier, in 1997, the council of the oecd adopted recommendations for use of tax identification numbers in an international context and for a standard magnetic format for automatic exchange of information. c(97)29; c(97)30. see detailed discussion in david e. spencer, “oecd information exchange recommendations are a significant first step in resolving tax evasion,” 8 journal of int’l tax’n 353 (1997). 2004] sharing bank deposit information with other countries 648 tax treaty. in june 2003, the eu adopted its savings directive, providing71 generally for automatic information exchange on interest paid within the eu to a eu resident, but permitting austria, belgium and luxembourg to impose a withholding tax (as a substitute for automatic information exchange). in 2004,72 the eu fixed july 1, 2005 as the starting date for the directive, after reaching agreement with the non-eu countries of switzerland, liechtenstein, san marino, monaco and andorra, as well as with the dependent or associated73 71. u.s. treasury press release, kd-3795, january 24, 2003, attaching mutual agreement of january 23, 2003, regarding the administration of article 26 (exchange of information) of the swiss-u.s. income tax convention of october 2, 1996, with appendix. the treaty provides for the exchange of information “for the prevention of tax fraud or the like.” the mutual agreement, inter alia, provides some elaboration of the term “tax fraud or the like.” see infra note 195. 72. eu council directive 2003/48/ec of june 3, 2003, on taxation of savings income in the form of interest payments, released june 26, 2003, available at 2003 wtd 126-12 [“eu savings directive”], art. 8, 9, 10, 11. the rate of withholding would be 15% for the first three years, 20% for the next three years and 35% thereafter. seventy-five percent of the revenue is to be transferred to the country of residence. id., art. 11.1, 12.1. see european commission, ip/03/787, taxation: commission welcomes adoption of package to curb harmful tax competition, june 3, 2003, available at 2003 wtd 108-16; see also european commission, results of council of economics and finance ministers, brussels, 21st january 2003 – taxation, memo /03/13, reprinted in 2003 wtd 15-12. for earlier steps in this process, see commission of the european communities, proposal for a council directive to ensure effective taxation of savings income in the form of interest payments within the community, brussels, 18.7.2001, com(2001) 400 final, 2001/0164(cns), at 3-4 , available at eu website, last visited july 7, 2003 (describing the november 2000 agreement). see discussion in david e. spencer, “eu agrees at last on taxation of savings,” 14 j. int’l tax’n 4 (2003); david e. spencer, “stepping up the pressure on tax havens: an update (part 1),” 12 j. int’l tax’n 26 (2001); graetz, supra note 25, at 387-89. 73. see european commission release ip/04/958, savings taxation: commission welcomes council agreement on 1 july 2005 application date, july 19, 2004. the application of the directive had been conditioned on reaching agreement with these non-eu countries. see eu savings directive, supra note 72, art. 17.2. for the initialing of the agreement with switzerland, see eu release ip/04/803, euswitzerland: nine agreements to be initialed today, june 25, 2004. see also chuck gnaedinger, “eu delays start for savings tax directive,” 2004 wtd 122-1. for the prior history, see european commission, ip/03/787, taxation: commission welcomes adoption of package to curb harmful tax competition, june 3, 2003, available at 2003 wtd 108-16, at ¶ 13. in that release, the eu commission described a draft agreement with switzerland for withholding of tax at the same rate, and under the same revenue sharing terms, as for belgium, austria and luxembourg. the current swiss withholding tax applies only to swiss source income, but the agreement would apply the withholding to non swiss source income. in addition, for “income covered by the draft agreement, switzerland [would] grant exchange of information on request for all criminal or civil 602 florida tax review [vol.6:6 territories of the netherlands and the u.k., for them to apply the same or74 “equivalent measures” (such as the withholding tax adopted by austria, belgium and luxembourg) for interest paid to eu residents. in this way, the eu seeks to avoid its directive merely resulting in capital shifting to other non-eu locations. austria, belgium and luxembourg are required to institute automatic exchange of information only if and when switzerland and the other non-eu countries listed above agree to an exchange of information regarding all interest, on request, in accordance with the oecd standard, and the u.s. is also committed to such exchange.75 ii. the countervailing concern for preserving financial privacy the argument that the treasury’s proposed regulation (as well the oecd anti-tax haven initiative and the european union savings directive) represent too great a invasion of financial privacy has been forcefully presented by the report of a task force on information exchange and financial privacy, chaired by former senator mack f. mattingly. in order to evaluate this claim,76 cases of fraud or similar misbehavior on the part of taxpayers.” on february 10, 2004, the european commission published the text of a proposed agreement with switzerland. see “eu publishes text of savings tax agreement with switzerland,” 2004 wtd 30-8. on may 19, 2004, switzerland confirmed “acceptance of [a] 13 may compromise on protecting bank secrecy in luxembourg and switzerland in exchange for swiss participation in the eu savings tax directive.” chuck gnaedinger, “eu, switzerland endorse bilateral ii framework,” 2004 wtd 98-1. 74. for the condition that these territories apply the same or equivalent measures, see eu savings directive, supra note 72, art. 17.2. see treasurey department, isle of man government, taxation strategy – exchange of information, response to the eu tax package, june 10, 2003, reprinted in 2003 wtd 113-15 (isle of man will adopt a withholding tax on the same terms as austria, belgium and luxembourg for interest paid to eu resident individuals, assuming all relevant dependent or associated territories and switzerland and other specified third countries adopt the same or equivalent measures); john burton & andrew parker, “ultimatum to caymans on eu tax directive: caribbean territory urged to comply in crackdown on evasion,” financial times, dec. 1, 2003, p.1; chuck gnaedinger, “cayman islands commits to eu savings plan,” 2004 wtd 33-1. 75. eu savings directive, supra note 72, at art. 10.2. 76. task force on information exchange and financial privacy, report on financial privacy, law enforcement and terrorism, march 25, 2002, available at 2002 tnt 65-54; see also burton, supra note 28. jack kemp and former attorney general edwin meese, iii, were senior advisors to the task force. david r. burton of the prosperity institute and the argus group was the excecutive director. the members of the task force were dr. veronique de rugy of the cato institute, stephen j. entin, of 2004] sharing bank deposit information with other countries 648 this part will begin by seeking to identify more specifically what is meant by the term “financial privacy” and why it is valuable. a. why we want our financial information to be private privacy has been defined by one observer as “a limitation of others’77 access to an individual.” under this approach, “[a] loss of privacy occurs as others obtain information about an individual, pay attention to him or gain access to him.” financial privacy has been described as “about the ability, and78 what many consider the right, to keep confidential the facts concerning one’s income, expenditures, investments and wealth.”79 most people, particularly americans, do not feel comfortable speaking openly about these financial facts about themselves. for example, they do not generally talk about the dollar amount of their salaries or their net worth with friends, acquaintances, co-workers, household help, or their children. even80 the institute for research on the economics of taxation, james w. harper of policycounsel.com and privacella.org, dr. lawrence a. hunter of empower america, j. bradley jansen of the free congress foundation, dan mastromarco, of the prosperity institute and argus group, dr. daniel mitchell of the heritage foundation, andrew quinlan of the center for freedom and prosperity, dr. richard w. rahn of the discovery institute, solveig singleton of the competitive enterprise institute, mark a. a. warner, of hughes, hubbard & reed llp, and john yoder of burch and cronauer. see also rahn & de rugy, supra note 6, at ¶¶ 63-68, supporting the task force proposals. 77. for an extensive discussion of the ways in which privacy has been conceptualized, see daniel j. solove, “conceptualizing privacy,” 90 calif. l. rev. 1087 (2002) at 1099-1125. 78. ruth gavison, privacy and the limits of the law, in philosophical dimensions of privacy, ed. by ferdinand david schoeman (cambridge 1984), at 35051. she goes on to say that “[t]hese three elements of secrecy, anonymity, and solitude are distinct and independent, but interrelated.” id. at 351. see discussion in solove, supra note 77, at 1104-06, arguing that this definition is too narrow in excluding “invasions into one’s private life by harassment and nuisance and the government’s involvement in decisions regarding one’s body, health, sexual conduct and family life.” he further contends that it may not cover some concerns about computer databases, i.e., “subjecting personal information to the bureaucratic process with little intelligent control or limitation, resulting in a lack of meaningful participation in decisions about our information.” id. at 1105 & n.83. 79. richard w. rahn, the future of money and financial privacy, in the future of financial privacy-private choices versus political rules, the competitive enterprise institute, ed. (2000), at 126, 132. 80. see abby ellin, “want to stop the conversation? just mention your finances,” the new york times, july 20, 2003, at business section, page 9, noting that her friends renting a beach house together never discuss “salary, savings, or how much 604 florida tax review [vol.6:6 these bare numbers (particularly in light of other information that the listener may already possess) may reveal a great deal about an individual’s activities, social status, preferences and personality; and an individual’s financial condition, may, justifiably or not, influence others’ assessment of his “worth.”81 some people may avoid revealing facts about their financial condition out of a desire to avoid blatant comparisons (favorable or unfavorable) with others. some people may do so to avoid interference with, or scrutiny of, their82 decisions so as to protect creativity and autonomy (although one commentator83 has questioned whether such a privacy claim is legitimate as it concerns financial information). some may fear that political or other enemies will84 make public revelation of their financial information in a manner designed to humiliate or embarrass. in addition, some are concerned that their wealth85 is owed on the visa card.” she comments, however, that “[p]eople i know in parts of europe and latin america say it is common for friends to ask one another about their economic status.” she quotes pamela york klainer, a workplace consultant, as saying that “americans, over all, are far too secretive about money topics.” id. 81. marc linder, “tax glasnost for millionaires: peeking behind the veil of ignorance along the publicity-privacy continuum,” 18 n.y.u. rev. l. & soc. change 951, 971 (1990/1991). he states that “in the united states a person’s income level plays a crucial part in determining ‘worth,’ that is, others’ estimation of her economic, social and moral value as a human being and in turn shapes her self-worth and self-image.” id. he explains that his article “challenges the underlying reality and desirability of this set of interlocking assumptions.” id. 82. ellin, supra note 80. ms. ellin quotes a silicon valley worker as saying, “showing off one’s fancy car, p.d.a. with integrated mp3 player, summer house, or throwing an elaborate party, is a classier way of communicating monetary status.” id. 83. see julie e. cohen, “examined lives: information privacy and the subject as object,” 52 stanford l. rev. 1373 (2000), at 1424-25, arguing that “autonomy in a contingent world requires a zone of relative insulation from outside scrutiny and interference – a field of operation within which to engage in the conscious construction of self.” she explains that “[t]he opportunity to experiment with preferences is a vital part of the process of learning, and learning to choose, that every individual must undergo.” 84. see linder, supra note 81, at 973-74, arguing that: “if the ethical, cognitive and moral developmental underpinnings of personhood are made the focus of a right to privacy, then it becomes very difficult to apply a protective shield to such mundane material matters as income.” he further notes “[t]he incongruity inherent in assimilating the annual results of the most successful individual encounters with mammon with the more ethereal aspects of personhood qua sanctuary.” id. at 974. 85. see solove, supra note 77, at 1145, arguing that “there is no overarching value of privacy,” but that “we must focus specifically on the value of privacy within particular practices.” he notes that “one of the most important reasons for protecting privacy is to prevent stifling exercises of power employed to destroy or injure individuals.” id. at 1149. solove gives as an example general motors’ “campaign of harassment, surveillance, and investigation” of ralph nader. see id. at 1149-51. 2004] sharing bank deposit information with other countries 648 makes them susceptible to requests for donations, or gifts to friends or family, or raises for employees. many may seek to avoid commercial solicitations, e.g., by purveyors of luxury goods or investment management. there may also be86 a fear that information about the amount of their wealth may make the wealthy a target of thieves, scam artists, or other criminals, including kidnappers seeking a ransom. disclosure of financial information may facilitate identity87 theft, or may allow advantage to business competitors. finally, information88 about an individual’s assets allow creditors to enforce monetary obligations, such as contractual debts, tax liability, obligations of support, tort liability or criminal fines.89 detailed information about an individual’s receipts or expenditures (i.e., the amount, timing, name of payee or payor) may reveal considerable additional information about a person’s activities, material possessions, spending or saving habits, obligations, occupation, abilities, associations, beliefs, interests, and personality. for example, a record of expenditures could include payments to a political party or charity, payments for a particular brand of clothing or auto, payments of child support or alimony or of a gift, payment of a mortgage, or payment for an airline ticket or for a hotel in a particular location. justice douglas, dissenting in california bankers ass’n v. schultz,90 86. for example, lottery winners, whose accession to wealth is publicly announced, often face these concerns. see, e.g., peggy y. lee, “lotto pots hold joys, trials for big winners,” los angeles times, jan. 25, 1993, at b1; roy bragg, winning & losing; scam artists, jealous neighbors and lousy investments – what’s so great about hitting the lottery, anyway?” san antonio express-news, august 9, 2003, p. 10h; tina moore, “experts tell lottery winners to protect their privacy first,” pittsburg postgazette, dec. 29, 2002, pg. c-3. 87. see e.g., r.posner, the economics of justice 234-35 (1983), suggesting that people “conceal an unexpectedly high income to avoid the attention of tax collectors, kidnappers, and thieves; [and] fend off solicitations from charities and family members,” cited by linder, supra note 81, at 970-71. 88. see joint committee on taxation, study of present-law taxpayer confidentiality and disclosure provisions as required by § 3802 of the irs restructuring and reform act of 1998, jcs-1-00, volume 1, reprinted in 2000 tnt 218, at ¶ 362 [hereinafter 2000 jct report]. see also peter p. swire, financial privacy and the theory of high-tech government surveillance, 77 wash. u. l. q. 461, 470 (1999), noting that making financial transactions “highly traceable” increases the risk of “identity theft.” 89. for discussion of the use of offshore asset protection trusts to prevent creditors from reaching assets, see stewart e. sterk, “asset protection trusts: trust law’s race to the bottom?” 85 cornell l. rev. 1035 (2000). 90. thus, one might be able to determine to what “groups and associations. . . the individual belongs. . . the social causes the individual supports. . . books and publications an individual buys. . . and the material items an individual purchases.” 606 florida tax review [vol.6:6 416 u.s. 21 (1974), stated that “the banking transactions of an individual give a fairly accurate account of his religion, ideology, opinions and interests.”91 b. how financial institutions serve as necessary stewards of financial information financial privacy can never be absolute because institutions, such as banks, credit card companies, and brokerage firms that assist individuals in the conduct of their financial transactions necessarily have access to financial information about their customers. most individuals (particularly those with greater income) utilize such institutions as intermediaries to conduct financial transactions despite the loss of privacy entailed. they do so because of the practical benefits that these institutions offer. 92 in addition, the loss of privacy may seem relatively tolerable because of limitations on the “degree of accessibility” of the financial information.93 knowledge on the part of the employees of a financial institution seems relatively unobtrusive because of the fact that one’s contact with the employees is purely on a business level, and for a particular purpose, and may take place over the phone, by mail or internet (rather than in person). one does not expect to see or deal with these employees in any other role or context, and although they know your name, they have no particular interest in knowing any details about your life. entertainers, politicians, athletes and other who are publicly kleiman, supra note 49, at 1176, citing david f. linowes, privacy in america: is your private life in the public eye? (1989) at 103. 91. california bankers ass’n v. schultz, 416 u.s. 21, 85 (dissenting opinion). some financial records might allow “interested observers to recreate a financial ‘snapshot’ of the individual [by reference to stocks and bonds, insurance, real estate, retirement funds, cars, homes, personal property, mortgage loans, alimony, and child support.” kleiman, supra note 49, at 1176, citing david f. linowes, privacy in america: is your private life in the public eye? (1989) at 103. in addition, through credit cards, one “can trace individuals in their every physical movement – to different countries, states, or cities, and even to restaurants, to stores, to airline travel, and to hotels.” id. 92. see generally, michael s. barr, banking the poor, 21 yale j. on regulation 121 (2004), at 135-42 (disadvantages of being unbanked). 93. “perfect privacy” in the sense of complete “secrecy [or] anonymity” is not attainable. see gavison, supra note 78, at 351. therefore, issues of privacy involve the appropriate “degree of accessibility of information.” solove, supra note 77, at 1152. as explained by professor anita allen, “[i]nformational privacy obtains where information actually exists in a state of inaccessibility.” the idea that privacy consists of control over one’s own personal information does not take into account that some people exercise that control by “making themselves informationally and physically more accessible to others.” anita l. allen, commentary: privacy-as-data control: conceptual, practical and moral limits of the paradigm, 32 conn. l. rev. 861, 868-69 (2000). 2004] sharing bank deposit information with other countries 648 known obviously cannot rely on anonymity to shield them from scrutiny. they may perhaps prefer to rely on private banking arrangements that include extra safeguards for their privacy. secondly, one may assume that the bank will not share the information with others. in order to make the use of a bank palatable to potential94 customers, bankers generally have a tradition or practice of maintaining the confidentiality of customer information. some courts have recognized an95 implied contract of confidentiality, though subject to exceptions, including96 one for “legitimate law enforcement inquiry.” in other countries, such as97 switzerland, this tradition has been even stronger. as we have seen, in the98 u.s. information in financial accounts is directly accessible to the federal government, particularly the irs, by a number of methods.99 94. thus, it has been noted that “our financial records are commonly understood as private matters even though third-parties may have access to (or even possess) that information.” solove, supra note 77, at 1152. he goes on to say: “we expect privacy because we do not expect unauthorized persons to delve through this information. indeed, we often share information in various relationships, such as those between attorney and client. . . in contrast to the notion of privacy as secrecy, privacy can be understood as an expectation in a certain degree of accessibility. this is not the only way to conceptualize privacy, but it is more appropriate as an account of modern practices, where cumulatively, we disclose a tremendous amount of data in various settings and transactions.” id. 95. see aclu feature, defending financial privacy, available at http://archive.aclu.org/issues/privacy/financial_privacy_feature.html. the aclu webpage states that “[f]or centuries, bankers used to pride themselves on being discreet and confidential about their customers’ business. but today that tradition. . . is breaking down. . . .” id. 96. see robert s. pasley, privacy rights v. anti-money laundering enforcement, 6 n.c. banking institute 147, 174-90 (2002) (discussing the case law). in tournier v. national provincial and union bank of england, 1 k.b. 461 (1934), an english court found that nondisclosure was “an implied term of the contract,” but with various exceptions. see pasley, supra, at 174. an idaho court found an agency relationship resulting in a “duty to the customer not to use or communicate information confidentially given him by the customer.” peterson v. idaho first nat’l bank, 367 p. 2d 284, 289-90 (idaho 1961), described in pasley, supra, at 175-76. 97. indiana national bank v. chapman, 482 n.e. 2d 474, 482 (ind. ct. app. 1985), quoted in pasley, supra note 91, at 181. 98. see erich i. peter, “reasonable limits of transparency in global taxation: lessons from the swiss experience,” tax notes int’l magazine, nov. 11, 2002, 591, at 615-16. 99. see supra notes 44-52 and accompanying text. in u.s. v. miller, 425 u.s. 435 (1976), the u.s. supreme court held that a bank depositor “takes the risk, in revealing his affairs to another, that the information will be conveyed by that person to the government,” and that the obtaining of those records by the u.s. attorney’s office 608 florida tax review [vol.6:6 recently, many have expressed concern that banks and other financial institutions in which they have accounts have been selling their personal information to others and that legislation adopted by congress in 1999 that addressed this privacy issue was not sufficiently protective. concerns that100 have been raised about this type of information sharing are that it “leads to annoying telemarketing calls, e-mail spam, and other unwanted marketing. . . increases the power and leverage of insurance companies and other big corporations over individuals. . . makes it easy for companies called data aggregators to compile huge dossiers of detailed information about american citizens. . . and allows personal information to be gathered by the government.”101 by a grand jury subpoena was not an “intrusion upon the depositors’ fourth amendment rights.” in reaction to that decision, congress enacted the right to financial privacy act of 1978. 12 u.s.c. 3401-22. see discussion in kleiman, supra note 49, at 1187-90. however, the limitations contained in this statute do not apply to an irs summons. see u.s. v. mackay, 608 f. 2d 830, 834 (10th cir. 1979). see supra note 49. 100. see aclu feature, defending financial privacy, available at http://archive.aclu.org/issues/privacy/financial_privacy_feature.html. the aclu webpage states that the “tradition” of bankers’ maintaining confidentiality “is breaking down. . . . the problem lies not just with banks, but also insurance companies and many other corporations who gather details about the financial lives of americans, and increasingly see those details as a valuable resource to be mined for profit.” id. the gramm-leach bliley act, enacted in 1999, provided in title v for certain privacy protections for the customers of financial institutions. these protections largely take the form of requiring the financial institution to provide notice of its information-sharing practices and offering an opportunity to opt-out of sharing of information with nonaffiliates. see statement of mr. edmund mierzwinski, consumer program director, u.s. public interest research group, sept. 19, 2002, before senate banking, housing and urban affairs committee, available in lexis, federal document clearing house congressional testimony. the legislation, however, allowed states to adopt stronger privacy requirements. alaska, connecticut, illinois, maryland, vermont, and north dakota have stricter rules. in june 2002, more than 70% of voters on a ballot measure in north dakota in effect reinstated stricter state protections requiring that consumers “opt-in” before certain information is shared. id. see aclu congratulates people of north dakota for defending their privacy, june 12, 2002, press release, available on aclu website. see also statement of professor h. cate, indiana university school of law, sept. 19, 2002, before senate banking, housing and urban affairs committee, available in lexis, federal document clearing house congressional testimony, noting that “[t]he available published information indicates that fewer than 5 percent of consumers responded to the deluge of notices [required by july 1, 2001, under the gramm-leach legislation] by opting out of having their financial information shared with third parties.” id. 101. aclu feature, defending financial privacy, available at http://archive.aclu.org/issues/privacy/financial_privacy_feature.html. 2004] sharing bank deposit information with other countries 648 c. how congress has also made the irs a custodian of our financial information despite their desire for financial privacy, americans not only choose to utilize financial institutions (which thus obtain access to financial information) but also tolerate massive collection of financial information by the irs. this information includes not only the source and amount of an102 individual’s income but also information about expenditures that may form the basis for various deductions and credits. for example, one’s form 1040 may show the amount of interest paid on a home mortgage, the amount of alimony paid, the amount one has given to particular charities, the dependents living in one’s household, gambling winnings and losses, the amount of loans to friends or relatives that have become worthless, amounts spent for childcare, tuition, business entertainment, or medical expenses. this information obviously may reveal a great deal about the taxpayer’s activities and personality. 103 collection of such information by the irs is presumably accepted because it is necessary to the enforcement of the tax system that congress has enacted. since the adoption of the 16th amendment in 1913, the congress has consistently imposed on u.s. citizens and residents an obligation to pay income taxes annually. congress has defined “gross income” in section 61 of the internal revenue code as including “all income from whatever source derived, including . . . compensation for services. . . gross income derived from business . . . gains derived from dealings in property. . . interest. . . rents. . .royalties. . . 102. dan mitchell, ph.d, tax reform: the key to preserving privacy and competition in a global economy, policy report 171, feb. 2002, ipi (institute for policy innovation), available online at http://www.ipi.org. mitchell states that “the personal income tax requires individuals to either disclose or make available upon demand almost every shred of their personal financial data to the internal revenue service. . . individuals have to reveal their personal savings, their financial assets, their personal wealth, their profits and losses, and other intimate details of their existence.” id. at 1. he further notes that “divulging private data to the government. . . is a compulsory activity that will result in the loss of income and/or assets.” id. see 2000 jct, supra note 88, at ¶¶ 35-42, 357-59, at ¶ 357, stating that “through the filing of tax returns, information received from third parties, and its own audits and investigations, the irs has ‘a data source of unparalleled detail and completeness.’” 103. see privacilla.org, assessing threats to privacy: the government sector – greatest menace to privacy by far (september 2000) [hereinafter “privacilla report,”] at 7, stating that “when americans file tax returns with the [irs], they must reveal a great deal of personal information, much of which is private or at least sensitive. . . . [including] name, address, phone number, social security number, income, occupation, marital status, parental status, investment transactions, home ownership, medical expenses, foreign assets, charitable gifts. . . . if anyone ever needed to compile a dossier on our behavior, the irs would be a good place to start.” 610 florida tax review [vol.6:6 dividends . . .alimony. . . annuities. . .pensions. . . income from discharge of indebtedness.” in addition, congress has determined that a variety of “personal” deductions (e.g., for charitable contributions or medical expenses) should be permitted. 104 given such an income tax system, it seems to be a necessary corollary that the irs should have access to financial information regarding each potential taxpayer. denying the irs such access would mean that taxpayers would essentially be on the “honor system.” a taxpayer would, in the privacy of his or her home, determine his sources of income and his deductions and credits, apply the rules of the code, compute the tax, and send to the irs merely a check for the amount of his self-computed tax liability; the only job of the irs would be to deposit the check and perhaps offer the taxpayers a reminder of when the check is due. there would be no way for the irs to verify the accuracy of the amount computed as tax liability of the taxpayer. obviously, this would not be a practical way for congress to raise revenues. there would be no motive other than a sense of patriotism for a taxpayer to compute his own tax accurately; even a patriotic citizen might well hesitate to pay the correct amount of tax when he knew that many other taxpayers would not do the same. therefore, it seems inevitable that congress would establish a method by which the correct amount of a taxpayer’s tax liability would be verified and, if necessary, collected by the irs. apart from administering a lie detector test to each taxpayer to determine if his computation of tax was at least intended to be accurate, the irs can verify the accuracy of the tax liability only by obtaining information about all the taxpayer’s items of income and all his expenditures eligible for deduction or credit. to this end, congress has required that each taxpayer file a tax return annually, which lists his income by source and also lists his allowable deductions and credits. congress has sought to insure that the taxpayer105 provides information that is accurate and complete by imposing civil or criminal penalties for a taxpayer’s failure to do so. but if a taxpayer’s failure106 to provide accurate information is to be detected, the irs must have some other 104. see id., stating that “the list [of personal information provided to the irs] is very, very long because politicians are addicted to social engineering through tax policy.” 105. irc § 6012. 106. if the taxpayer willfully makes statements on the return that she does not believe to be true and correct as to every material matter, she is guilty of a felony (and subject to a fine of not more than $100,000 and/or imprisonment of not more than 3 years). irc § 7206(1). this assumes that the return contains a written declaration that it is made under penalties of perjury, which the current form 1040 does. the code also provides civil penalties for inaccuracy. irc §§ 6662 and 6663. 2004] sharing bank deposit information with other countries 648 source of the relevant information for comparison with the information provided by the taxpayer. a very important source of information for the irs is the requirement, imposed by congress, that many types of payments, most notably, wages, dividends, interest, unemployment compensation, and gross proceeds of security sales, be reported by the payor or broker to the irs (as well as to the taxpayer). this allows the irs to run a very efficient check of these items for107 many or all taxpayers, without making any prior determination that a particular taxpayer is suspected of having filed inaccurately. the taxpayer, knowing that the irs has a ready source of information for checking his tax return (and having also received the same information from the payor), has very little incentive to provide other than accurate information on his return. thus, the gao has estimated that for 1992 taxpayers reported on their returns 99.1% of their true net income from wages, 97.7% of their true net income from interest, 92.2% for dividends and 92.8% for capital gains.108 congress has given the irs a further means of verifying information provided by a taxpayer about whose return the irs has suspicions. even though the irs does not have probable cause to believe that a wrongdoing has occurred, the irs has authority to examine books or records which may be relevant to determining a taxpayer’s liability and to serve a summons on the taxpayer or other persons to produce such books or records, or to give testimony under oath relevant to such determination. the u.s. district court is authorized to compel compliance with the summons and to use the contempt power toward this end.109 107. see supra note 44. 108. joel slemrod & jon bakija, taxing ourselves: a citizen’s guide to the great debate over tax reform (2d ed. mit press 2000), table 5.1, id., at 154, showing gao compliance estimates for certain types of personal income in 1992. by contrast, the percentages are 18.6% for “informal suppliers” and 67.7% for other sole proprietors. slemrod & bakija note that “[f]or types of income subject to information reporting, and especially for those with tax withholding at the source of payment, evasion is much less prevalent.” id. at 160-61. they also note that “[e]ach year, the irs receives one billion information reports, most of them on magnetic tape or transmitted electronically.” see id. at 157 & n. 50, citing irs data book, 1997, table 19. 109. irc §§ 7602 and 7604. see supra notes 48 and 99. the u.s. supreme court discussed the standard that must be met by the irs for enforcement of a summons in united states v. powell, 379 u.s. 48 (1964). it explained that the commissioner “need not meet any standard of probable cause to obtain enforcement of his summons . . . . he must show that that investigation will be conducted pursuant to a legitimate purpose, that the inquiry may be relevant to the purpose, that the information sought is not already within the commissioner’s possession, and that the administrative steps required by the code have been followed.” id. at 57-58. “the powell standards have been liberally construed by u.s. courts and as a result banks routinely comply with irs 612 florida tax review [vol.6:6 in sum, congress in imposing an income tax, recognized that its enforcement required that the irs have detailed knowledge of a taxpayer’s financial affairs, and congress provided the irs with the tools to obtain that information. thus, it seems fair to say that our current tax system simply does not contemplate that an individual should be able to exclude the irs from knowledge about his financial affairs. the irs’s access to financial110 information of individuals is essential not only to enforcement of the income tax, but also to the citizenry’s efforts to monitor and debate the government’s tax policy. knowledgeable debate of the income tax requires knowing the summons without requiring judicial enforcement.” oecd bank report, supra note 45, appendix i, ¶ 3.2. for further discussion of the powell decision, see camp, supra note 47, at 53-59. in reviewing the supreme court’s interpretations of § 7602, camp concludes that “the supreme court has consistently interpreted the service’s summons power expansively, using inquisitorial logic. . . [meaning that] the court based its decision on one or more of the following rationales: (a) an expansive interpretation was necessary to preserve the service’s role as decision-maker or evidence-gatherer; (b) truth trumped autonomy as the value promoted by the statute; and (c) potential abuse should be or was actually limited through internal bureaucratic controls.” id. at 53. 110. for example, professor anita allen explained: “[i]t might seem innocuous to make the assertion that people should be able to control personal financial data, until one realizes that our political obligations to our country and fellow citizens make that impossible. as james rule and lawrence hunter have observed, ‘if governments are expected to tax income or commerce. . . citizens can hardly expect control over information about their personal finances.’” anita allen, supra note 93, at pp. 7-9, n. 46, citing james rule & lawrence hunter, towards property rights in personal data, in visions of privacy: policy choices for the digital age, at 168, 16970 (colin j. bennett & rebecca grant eds., 1966). see also swire, supra note 88, at 485, noting that “[t]he government has a strong interest in receiving data relevant to its financial affairs, such as collection of taxes and distribution of benefits. . . . for the government, when collecting taxes, access to financial records helps correct for the sometimes overwhelming human temptation not to pay all of the taxes due by law. . . . the[se] arguments do not give a reason, however, for the irs. . . to share information with agencies that do not need the information to assist in the government’s financial affairs.” id. at 486. another reason for rejecting a citizen’s claim to conceal sources of income from his own government is that the government through its “massive. . . economic-protective intervention in the form of infrastructure, government contracts, regulation, licensing, and insurance,” is already “involved” in one’s financial affairs. linder, supra note 81, at 974-75. see also camp, supra note 47, at 16, arguing that “in order to maintain a voluntary tax reporting system, the government must have access to enough information about the taxpayer’s transactions to monitor, verify, and enforce the law.” 2004] sharing bank deposit information with other countries 648 extent to which the income tax is, in fact, paid by those that the code purports to tax.111 concern for open public debate and government accountability has led some to conclude that not only the government, but even one’s fellow citizens should have access to the information on one’s tax return. for example, in the112 1920’s and 1930’s, the progressives sought to institute public inspection of tax returns. however, the view that tax returns should be made public has not113 prevailed (although tax return information does become public when a taxpayer challenges the irs determination of his tax liability in the tax court).114 congress has recognized that taxpayers have an important interest in the privacy of the financial information about them collected by the irs even115 111. see julie roin, “competition and evasion: another perspective on international competition,” 80 geo l. j. 543 (2001), at 599-600, discussing the importance of “transparency” and how “self-help methods of tax reduction made available through the use of tax havens” are an obstacle to making “[p]ublic officials. . . properly accountable for their actions.” see further discussion at infra notes 201-02 and accompanying text. 112. see linder, supra note 81, recommending that the tax returns of millionaires be made public to foster public debate about income disparities and redistribution. he argues that this “would vindicate the principle that in a highly interdependent economy and a democratic state ‘there should be no secrecy in the transactions between any citizen and his government.’” id. at 976 & n.157, quoting 67 cong. rec. 892 (1925) (statement of rep. griffin). for a recent proposal for disclosure of corporate returns, see theodore s. sims, “corporate tax returns: beyond disclosure,” 96 tax notes 735 (july 29, 2002). he suggests that such disclosure “could pave the way for bringing non-governmental energies to bear on the effort to police corporate tax shelters, through a system of rewards to private auditors who brought such schemes to light and to heel.” id. 113. see linder, supra note 81, at 962-65. he notes that “for two decades after 1913, progressives in congress used the enactment of every revenue act to debate the issue of publicity of income tax returns.” id. at 963. for further discussion of this history, see marjorie e. kornhauser, “more historical perspective on publication of corporate returns,” 96 tax notes 745 (july 29, 2002) (describing debates of 1934-35). 114. see generally, diane m. ring, “on the frontier of procedural innovation: advance pricing agreements and the struggle to allocate income for cross border taxation,” 21 mich. j. int’l l. 143 (winter 2000), at 208, noting that “[i]n litigation,. . . most taxpayer information may be released in the form of court opinions and other litigation documents.” she explains that one reason for this is “a powerful vision about the importance of a public judicial process, as well as the likelihood that taxpayer data revealed in a case will usually be at least several years out of date.” 115. by contrast, linder argues that, at least as far as the tax returns of millionaires are concerned, “no legitimate privacy interest exists that would require accommodation.” linder, supra note 81, at 969. his article begins with the following quotation: “as far as taxation is concerned, there ought to be nothing ‘private’ about the 614 florida tax review [vol.6:6 though that interest must yield when it conflicts with the government’s need to accurately determine and collect the income tax. thus, congress has adopted a compromise position. the irs may have access to financial information required to enforce the tax; however, since 1976, congress has declared in irc section 6103 that tax return116 117 information “shall be confidential” and may not be disclosed by the irs except in certain situations expressly defined in the statute. confidentiality is viewed118 not only as a taxpayer’s entitlement in light of the compulsory nature of the amount of any man’s income, or the aggregate of all forms of his property, inasmuch as every man has a right to know, that all his neighbors are contributing pro rata with himself to support that government, which is common to him and them. . . . [l]east of all should there be anything private in the matter of public taxes, since in bearing up the burdens of government all the citizens are like copartners, and. . . for this purpose each has a right to demand a look into the books of all the others.” a. perry, principles of political economy 552 (1890), quoted in linder, supra note 81, at 951. 116. prior to 1976, tax returns were formally classified as “public records,” subject to disclosure by the order of the president or pursuant to regulations approved by him. see 2000 jct report, supra note 88, at ¶¶ 754-776, discussing the history from 1862 through 1975. the degree of actual disclosure varied. the revenue act of 1924 called for public lists with the taxpayer’s name, post office address, and the amount of tax paid. id. at ¶ 766. but the revenue act of 1926 eliminated the listing of the amount of tax paid. id. at 768. the revenue act of 1934 called for a taxpayer’s gross income, total deductions, net income and tax payable (shown on a so-called “pink slip”) to be open for public inspection but “congress repealed the provision before it took effect.” id. at ¶ 770. the requirement of public lists was repealed in 1966. immediately prior to 1976, “the regulations provided access to returns and return information for persons with material interest. . . the heads of departments for official business upon written request detailing why inspection was necessary, and use in legal proceedings where united states was a party to the proceedings.” id. at 774. for further discussion of this history, see linder, supra note 81, at 961-66; kornhauser, supra note 113; joe thorndike, “historical perspective: promoting honesty by releasing corporate tax returns,” tax notes, july 15, 2002, p. 324; richard d. pomp, “the disclosure of state corporate income tax data: turning the clock back to the future,” 22 capital u. l. rev. 374 (1993). 117. for a detailed discussion of irc § 6103, its background, and subsequent amendments, see 2000 jct report, supra note 88, at ¶¶ 754-844. for a similar view that the government should act as “confidante and not broadcaster,” see allen, supra note 93, at 874, referring to the court’s interpretation of the freedom of information act in wine hobby usa, inc. v. united states, 502 f.2d 133 (2d cir. 1974). 118. for a thorough description of these authorized disclosures, see 2000 jct report, supra note 88, at ¶¶ 38-153. one authorized disclosure is for statistical use of information in anonymous form. see i r c § 6103(j). 2004] sharing bank deposit information with other countries 648 disclosure on the tax return, but also as a necessary precondition if the119 taxpayer is to feel comfortable making full disclosure on his return.120 congress apparently believed that citizens would generally feel secure in providing financial information to the irs if the information would be held in confidence and used for the sole purpose of collecting taxes. the taxpayer121 would find assurance in the fact that the employees in the irs having access to the information are strangers, anonymous bureaucrats in unfamiliar places, such 119. “taxpayers have a justifiable expectation of privacy in the extensive information they furnish to the irs under penalty of fine or imprisonment.” 2000 jct report, supra note 88, at ¶ 359. see joint committee on taxation, general explanation of the tax reform act of 1976 (december 29, 1976), at 314-315, explaining that: “questions were raised and substantial controversy created as to whether the extent of actual and potential disclosure. . . to other federal and state agencies for non-tax purposes [under prior law] breached a reasonable expectation of privacy on the the part of the american citizen with respect to such information. this, in turn, raised the question of whether the public’s reaction to this possible abuse of privacy would seriously impair the effectiveness of our country’s very successful voluntary assessment system, which is the mainstay of the federal tax system. . . . . with respect to each of the [areas in which disclosure was permitted], the congress strove to balance the particular office or agency’s need for the information involved with the citizen’s right to privacy and the related impact of the disclosure upon the continuation of compliance with our country’s voluntary tax assessment system.” see also nina e. olson, “sugarman lecture: the relationship between the taxpayer and her government,” available in 2003 tnt 202-34, at ¶ 16, stating that “taxpayers have a right to expect that information related to their tax affairs is confidential and used for tax administration purposes only.” 120. see 2000 jct report, supra note 88., at ¶¶ 359-361, citing statement of senator haskell, 122 cong. rec. s 12589 (july 27, 1976). see supra note 119. the jct report notes that “one study showed an increase in nonfiling by those taxpayers whose refunds had been offset for child support the year before.” id. at ¶ 361. but it notes that a 1991 gao study concluded that “these results may have been overstated.” id. at n. 542. for the view that publicity of corporate tax returns could lead to more complete enforcement, see sims, supra note 112. 121. in part, this may because the taxpayer sees a practical benefit in revealing information that will permit claiming a deduction or credit. but in general, the disclosure of information to the irs on a tax return is not only compulsory (with little room for bargaining) but also without direct benefit to the taxpayer. see letter by james w. harper, editor, privacilla.org, to subcommittee on commercial and administrative law, house judiciary committee, may 24, 2002, available online at privacilla.org, at 2, noting that “[b]usinesses may lose customers if they ask for too much information . . . . governments, on the other hand, can demand information on tax forms,. . . without losing ‘customers’ if they collect too much.” he also explains that “[u]nlike businesses, governments do not lose the value of information they hold if they abuse it. . . . so, where a business must make tactful and intelligent use of scarce information, a government has few similar incentives.” id. at 2. see also privacilla report, supra note 103, at 10. 616 florida tax review [vol.6:6 as holtsville, ny, whom the taxpayers do not expect to see or deal with in any other role or context. although an irs employee handling a taxpayer’s return may know the taxpayer’s name, the taxpayer would expect that the irs employee has no particular interest in knowing any of the details of the taxpayer’s life (except to carry out the employee’s duties). by contrast, a taxpayer would likely be outraged if his own financial information were disclosed publicly or used by irs employees, or their friends or superiors, to satisfy curiosity, to achieve financial or political advantage, or to oppress122 disfavored groups. the danger that tax return information will be misused has been magnified by the advent of the computer. in the 1990’s, congress received123 much evidence that irs employees were perusing tax records of friends,124 122. see swire, supra note 88, at 493-94, discussing how government officials with a database of financial information might use such information for “financial gain.” first, the information “might reveal confidential business information or otherwise give officials an advantage in choosing their own investments.” second, “officials might get money from people who do not want their financial transactions revealed.” this could take the form of their being bribed or their practicing extortion. third, they “might benefit financially by sharing the data with outside parties,” with whom they might make a joint investment. 123. see generally kleiman, supra note 49, at 1177, stating that “modern advances in computer technology and use have escalated the potential for abuse [by governmental prying] in exponential degrees.” 124. in 1993, an internal irs report, showing that 350 employees had improperly accessed tax accounts through the irs’s integrated data retrieval system led to a hearing before the senate governmental affairs committee, chaired by john glenn, d-ohio. see rita l. zeidner, “lawmakers blast service for confidentiality breaches,” 93 tnt 163-48; stephen barr, “probe finds irs workers were ‘browsing’ in files; computer security review points to fraud,” washington post, august 3, 1993, page a1; stephen barr, “glenn calls irs lax on ‘browsing;’ senator says agency was aware of risk,” washington post, august 4, 1993, page a4; stephen barr, “accused of failing to protect data, irs says it will buttress safeguards, washington post, august 5, 1993, page a6; editorial, “snoops (and crooks) at the i.r.s.,” new york times, august 5, 1993. a follow-up hearing in july 1994 showed that in the previous 10 months more than 500 such cases were investigated by the irs. the irs installed an electronic audit research log, in an effort to monitor employees. stephen barr, “1,300 irs workers accused of snooping at tax returns; employees used computers to peek at friends’ files,” washington post, july 19, 1994, page a1; see also robert d. hershey jr., “i.r.s. staff is cited in snoopings,” new york times, july 19, 1994, page d1; stephen barr, “irs vows ‘zero tolerance’ for snooping in tax records; budget cut could delay computer safeguards,” washington post, july 20, 1994, page a4. nevertheless, in 1997, the gao concluded that the “irs is not effectively addressing electronic browsing.” see gao testimony before the subcommittee on treasury and general government, committee on appropriations, united states senate, statement 2004] sharing bank deposit information with other countries 648 enemies, acquaintances, relatives or celebrities. congress responded by125 enacting the taxpayer browsing protection act of 1997. this legislation makes unauthorized inspection of a tax return by an irs employee a criminal offense, if willful, and also authorizes a suit for civil damages. this has apparently not126 of dr. rona b. stillman, chief scientist, computers and telecommunications accounting and information management division, april 15, 1997, reprinted in 97 tnt 73-42. see robert d. hershey jr., “snooping by i.r.s. employees has not stopped, report finds,” n.y. times, april 9, 1997, page 16a; john godfrey, “irs finds more cases of browsing, falls short on sanctions,” 97 tnt 68-2; editorial, “tax snoops,” the washington post, april 10, 1997. see also statement of laurence summers, deputy treasury secretary, before the subcommittee on treasury, general government, civil service, committee on appropriations, u.s. senate, april 15, 1997, 97 tnt 73-39, acknowledging that the irs policy against browsing “was not effectively designed or implemented and penalties are neither sufficiently consistent nor severe to put an end to unauthorized access.” see also discussion of irs browsing in swire, supra note 88, at 495. 125. in a statement before the senate finance committee, an unidentified gs 12 revenue officer stated that he had personally witnessed browsing “to check on prospective boyfriends,” browsing to see if ex-husbands had increased income available to pay child support, browsing with respect to taxpayers “with whom irs employees were having some kind of personal disagreement,” browsing of records of “locally prominent or newsworthy individuals, public figures – even team coaches,” browsing “out of simple curiosity about a friend, a relative or an employee’s neighbor” or accessing information on “individuals who are perceived as critical of the irs.” in addition, the witness said that he had seen cases of institutional abuse, such as accessing tax records of potential witnesses or jurors in tax cases. unofficial transcript of finance hearing on irs abuses, september 25, 1997, 97 tnt 191-52, witness #3, at ¶¶ 191203. 126. public law 105-35, signed into law on august 5, 1997. the act added new irc § 7213a imposing a criminal penalty of a fine not to exceed $1,000 or imprisonment of not more than one year, or both. the act also added new irc § 7431 providing civil damages; in addition, this provision requires the irs to notify a taxpayer if an employee is criminally charged with unauthorized inspection of the taxpayer’s return. section 7431(e). see h. r. rep. no. 105-51, april 14, 1997, reprinted in 97 tnt 74-16; herman ayayo, “president signs anti-browsing bill,” 97 tnt 153-2. 618 florida tax review [vol.6:6 put an end to such browsing, and congress continues to debate further127 measures to combat it.128 most cases of unauthorized browsing by irs employees that have been investigated have apparently not involved fraud. however, the potential for129 malicious attacks on the irs computer systems by outside hackers, including attacks designed to perpetrate identity theft, does exist. accordingly to a report recently submitted to congress, the irs has made considerable progress in improving the security of its computer systems, but serious vulnerability is still present.130 the possibility that the white house might conspire to misuse information held by the irs, e.g., to harm political enemies, was a focus of131 127. in the two years following the statute’s enactment, the treasury substantiated 198 cases of unauthorized browsing. 2000 jct report, supra note 88, at n. 778 and accompanying text. the reports states that these cases involved the following kinds of employees: “auditors and tax examiners (77), collection (48), taxpayer service (31), clerical (19), criminal investigation division (3), management (6), professional/technical (2) and other (12).” id. 128. in 2003, the house of representative’s passed a bill that would classify unauthorized inspection of returns as being a serious form of irs employee misconduct requiring discipline, and would call for annual irs reporting regarding investigations and prosecutions of unauthorized browsing; in addition a taxpayer would have to be notified whenever the treasury inspector general for tax administration substantiates that his return has been unlawfully accessed. taxpayer protection and irs accountability act of 2003, h.r. 1528, § 331(a), amending irc § 7804a, and § 347(a),(b), reprinted in house passes bill revising ‘10 deadly sins,’ 2003 tnt 127-80. the offenses described in §7804a, disciplinary actions for misconduct, are referred to colloquially as the “10 deadly sins.” the irs acknowledges that in the short-term its computer system is not capable of modification to prevent and immediately detect unauthorized browsing. 2000 jct report, supra note 88, ¶¶ 512-13. 129. id. at ¶¶ 501-506. but cf. kleiman, supra note 49, at n. 47, describing a 1991 fbi arrest of “16 government ‘insiders’ on charges of stealing confidential personal information from government computer databases and brokering the information to customers. . . in the private sector.” 130. gao, report to the subcommittee on technology, information policy, intergovernmental relations, and the census, committee on government reform, house of representatives, may 2003, information security: progress made, but weaknesses at the internal revenue service continue to pose risks, reprinted in 2003 tnt 106-12, at ¶¶ 6-7. see generally swire, supra note 88, at 497, noting that “the defense department reports hundreds of thousands of successful intrusions into military computers per year. . . . the possibility of intrusions. . . is a powerful argument against allowing unlimited government access to sensitive personal information of any kind.” id. 131. see swire, supra note 88, at 494-95, for a discussion of how government officials with access to a government databases might “misuse [the data] for political gain.” first, “the data may be an inexpensive and effective form of opposition research.” in addition, “officials might use the inside information to extract concessions from targets of surveillance,” as j. edgar hoover is alleged to have done, and finally 2004] sharing bank deposit information with other countries 648 congressional concern in the 1970’s. the articles of impeachment against president nixon, voted by the judiciary committee in 1974, alleged that the president “endeavored to obtain from the [irs]. . . confidential information contained in income tax returns for purposes not authorized by law, and to cause. . . income tax audits. . . to be initiated. . . in a discriminatory manner.”132 to protect against further abuse by the white house, congress in 1976 required that requests by the white house for taxpayer information be signed by the president personally and that the president make a quarterly report to the joint committee on taxation regarding any tax returns that he requested to see and the reasons therefor.133 while congress appears to have focused its concern on curbing such specific abuses of power, some commentators appear to have a more generalized concern about the huge amount of financial information that comes into the hands of the irs and its effect on liberty. they suggest that when134 “political officials might benefit from sharing the data with friendly outside parties.” id. at 494. 132. articles of impeachment adopted by the committee on the judiciary, july 27, 1974, available at http://watergate.info/impeachment/impeachment-articles. president nixon allegedly asked his aide john dean to request that the irs commissioner audit taxpayers on his “enemies list.” see george lardner jr., “nixon sought ‘ruthless’ chief to ‘do what he’s told’ at irs; tape includes mention of pursuing enemies,” washington post, january 3, 1997, page a01. according to the article, commissioner johnnie walters, with the backing of treasury secretary george p. shultz, refused this request transmitted by dean. id. nixon, in turn, complained that there had been a probing audit of his own tax return in 1963, initiated by the kennedy administration. id. president kennedy is said to have shared tax return information regarding j. paul getty and h.l. hunt with ben bradlee of the washington post. see john berlau, “jfk used audits to silence his critics,” insight on the news, p. 21, sept. 29, 2003, available on lexis. see also senate comm. on the judiciary, s.rep. no. 1227, 93rd cong., 2d sess. 23 (oct. 4, 1974), stating that the irs had a “secret political intelligence unit known as the special service staff which was responsible for compiling political intelligence data on at least 11,000 individuals and organizations deemed to be ‘activist. . . ideological, militant, subversive or radical.’” in august 1973, the unit was disbanded. id. this episode is referred to in kleiman, supra note 49, at n. 46. for further discussion of the “ssi,” see david m. alpern with anthony marro and evert clark, “at sea with the irs,” newsweek, p. 32 (oct. 13, 1975) (subjects of files included mayor john v. lindsay and linus pauling); prepared statement of shelly l. davis before the senate finance committee-oversight hearing on the internal revenue service, federal news service, sept. 24, 1997, available on lexis. 133. see irc § 6103(g)(1),(5), added by p.law 94-455, sec. 1202. such reports need not include requests for returns of an official in the executive branch of the federal government. section 6103(g)(5). separate rules are also established for information regarding presidential appointees. see 6103(g)(2). 134. see privacilla report, supra note 103, at 7, stating that “[g]overnment databases and collections of information are a threat to privacy in and of themselves because governments can change or ignore the privacy laws that apply to them. even the united states government, one of the most solicitous of privacy and the rule of law in 620 florida tax review [vol.6:6 government obtains so much information about citizens, serious abuse is inevitable. they further argue that for government even to possess such information gives it a power that runs counter to our founders’ vision of limited government. government monitoring of citizens, in this view, inevitably135 moves our society in the direction of totalitarianism, such as is described in136 george orwell’s book entitled “1984.”137 the world, has done this.” see also swire, supra note 88, at 507, suggesting that: “in our most pessimistic moments, we might even contemplate how tracking of all financial transactions. . . might contribute to an increased risk of tyranny in a society. . . if a society repeatedly opts for surveillance rather than privacy, then the nature of that society may change over time.” see also privacilla report, supra note 103, noting that census information was used to identify americans of japanese ancestry and carry out their internment during world war ii. the report explains: “census bureau employees opened their files and drew up detailed maps that showed where japanese americans were located and how many were living in given areas.” he states: “nearly 112,000 people were captured and sent to internment camps with the help of the census.” see also letter of james w. harper, supra note 121, at 3. 135. recently, concern about excessive government spying against americans caused congress to block a proposed defense department anti-terrorist initiative called total information awareness, that would have used sophisticated data-mining and profiling technologies on an integrated database, created from existing government databases combined with financial, education, travel and medical records. see adam clymer, “congress agrees to bar pentagon from terror watch of americans,” n.y. times, p. a1, feb. 12, 2003; adam clymer, “senate rejects pentagon plan to mine citizens’ personal data for clues to terrorism,” n.y.times, p. a12, january 24, 2003; john schwartz, “planned databank on citizens spurs opposition in congress,” n.y.times, p. a16, jan. 16, 2003; jeffrey rosen, “the year in ideas; total information awareness,” n.y. times magazine, p. 128; william safire, n.y. times, editorial desk, p. a41, feb. 13, 2003. 136. see burton, supra note 28, at 15, explaining that: “free people are not required to report their whereabouts or their actions to their governments. governments in free societies do not monitor law-abiding citizens unless they are suspected of criminal acts and then can do so only under strict safeguards because all citizens are presumed innocent until the state has proven otherwise in a court of law. invading private spaces requires authority from an independent judiciary that enforces legal restrictions on police action.” he further states that: “[i]n contrast, totalitarian governments constantly monitor their citizens. . . . virtually all aspects on one’s life is known and controlled by the state. . . financial transactions must be conducted through state financial institutions. . . .systems are established to systematically collect, analyze and act on information about individuals. the information collected enhances the power of the state to control the lives of those living under its control. . . . the very fact that u.s. citizens are being required to report so much information to the federal government, whether for tax, regulatory or simply monitoring purposes would, the author believes, shock the founding generation. . . even relatively responsible governments, such as our own, can be expected to misuse and abuse information collected from time to time.” id. at 15-16. 137. george orwell, 1984 (1949). see kleiman, supra note 49, at 1176, referring to “orwell’s chilling vision of a nation where the ‘powers that be’ can monitor the who, what, where and how of every individual’s life.” in that book, the party 2004] sharing bank deposit information with other countries 648 congress, however, has not endorsed this view. not only has congress allowed the irs to collect the massive amount of information required to enforce the income tax, it has also sanctioned disclosure by the irs of such information to a variety of other agencies of the federal and state governments for purposes other than federal tax administration. pursuant to section 6103,138 the irs may make disclosure, for example, to state tax officials for purposes of state tax administration, to congressional committees and the gao in certain139 “criminalizes thoughts which are not in accord with the party line. . . [and] enforces this law by constant surveillance of the individual.” kleiman, supra note 49, at n. 45. but c.f. alan ehrenhalt, “the misguided zeal of the privacy lobby,” governing magazine, may 1999, p. 7, stating that “[o]f all the dangers that this society faces. . . one of the most remote is the risk that america will become an orwellian police state, watching everything citizens do and taking down every word that they say. . . . those of us who lay awake at night in america in 1999 worrying about the government’s desire to snoop on them are mostly (1) paranoid or (2) guilty of something.” he further claims: “in america in the 1990’s, the obsession with privacy. . . is a reflection of the hyper individualism to which the political system has succumbed in the past generation or so.” id. see also amitai etzioni, the limits of privacy, basic books 1999, at p. 127, arguing, in connection with a proposal for a mandatory national id card, that “libertarian concerns about totalitarianism confuse cause with consequence. . . totalitarian governments do not creep up on the tails of measures such as id cards. they arise in response to breakdowns in the social order when basic human needs, such as public safety and work opportunities, are grossly neglected;” michael lind, “solving the privacy puzzle; thinking aloud, “ the new leader, vol. 85, p. 15, jan. 1, 2002, suggesting that “[t]he fear that the convergence of high technology with law enforcement and business practices is about to rob us of our privacy has the hallmark of a classic, irrational moral panic.” he argues that “the new privacy crusaders” consist mainly of “elite men.” for an argument in favor of “transparency,” in contrast to privacy, see david brin, the transparent society (1998). but see “no hiding place,” the economist, january 25, 2003, arguing that brin’s solution of “mutually assured surveillance” is “one that most people would be unwilling to live with.” 138. in addition, congress has authorized disclosure to private contractors for purposes of federal tax administration. section 6103(n). for an argument that disclosure of tax return data to other agencies is unwise, see swire, supra note 88, at 498, arguing that such disclosure involves the dangers of “mission creep. . . [i.e.,] the risk that initial and justifiable government actions, such as collecting tax information or having a limited mission in south vietnam, can evolve into unjustified and potentially tragic actions. if mission creep continues unchecked, tax returns might become essentially public documents.” he notes that “[i]f the government. . . already has fifteen uses for a category of data, it may be impossible politically to stop the sixteenth or seventeenth uses, even where those additional uses would never have been approved at the time the data collection system was first instituted.” id. at 499. see also linder, supra note 81, at 966, noting that under the 1976 act, “the exceptions [to confidentiality] remain quite extensive, especially the massive use of individually identifiable returns by the bureau of the census.” 139. section 6103(d)(1). 622 florida tax review [vol.6:6 cases, to a federal, state or local agency administering various welfare or140 government assistance programs, to the u.s. customs service, to federal,141 142 state and local child support enforcement agencies, and to certain federal143 officials for the nontax criminal investigations. once the irs has collected144 its vast stores of information, use of this information by other government agencies has the advantage of efficiency. of course, just as congress has145 sought to prevent abuse of taxpayer information by the irs, it has also established a system of safeguards surrounding irs disclosures to other government agencies. 146 in summary, congress’s actions show its willingness for the irs to obtain extensive financial information about citizens to enforce the federal income tax and even to share this information with other government agencies for certain specified purposes. this suggests that congress is relatively sanguine that misuse of taxpayer financial information can be held in check and 140. section 6103(f),(i)(8). 141. section 6103(l)(7). the information is to be used for purposes of determining eligibility and the correct amount of benefits. id. for a proposal to amend § 6103(l)(13) to permit disclosure of taxpayer information to the department of education to permit income verification in determining eligibility for student financial aid, see dept. of treasury, office of tax policy, report to the congress on scope and use of taxpayer confidentiality and disclosure provisions (oct. 2, 2000), available at 2000-tnt 192-7, at ¶¶ 344-50; michael brostek, general accounting office, report to the senate finance committee, taxpayer information, increased sharing and verifying of information could improve education’s award decisions, available at 2003 tnt 160-17. 142. section 6103(l)(14). 143. section 6103(l)(6)(a). 144. section 6103(i)(1),(2),(3),(5),(7). 145. see swire, supra note 88, at 497, explaining that: “once the costs of the database and infrastructure are already incurred for initial purposes, then additional uses may be cost-justified that would not otherwise have been. . . . an efficiency argument can. . . be made that additional uses of [tax return] data, such as protecting against welfare fraud, should be authorized where the costs of gathering and organizing the comprehensive tax data would not have been justified solely to protect against welfare fraud.” id. at 497-98. 146. see § 6103(p)(4),(5),(6) (relating to disclosures to federal, state and local agencies). see also reg. § 301.6103(n)-1(d), relating to disclosures under § 6103(n). however, thus far it is not clear that these safeguards have been adequately implemented. see, e.g., deputy inspector general for audit, treasury inspector general for tax administration, final audit report, dated dec. 19, 2002, improvements are needed to prevent the potential disclosure of confidential taxpayer information, reprinted in 2003 tnt 12-22. 2004] sharing bank deposit information with other countries 648 that congress does not believe that extensive government knowledge about its citizens is incompatible with a free society.147 iii. the international context accepting the basic structure of the federal income tax precludes the argument that the internal revenue service has no right to know the details of one’s financial information. and the congressional scheme for automatic reporting of dividends, interest, and sale proceeds of u.s. taxpayers to the irs cannot be reconciled with the view that bank reporting of interest to tax authorities should be limited to cases of suspected wrongdoing. 148 why then is it controversial for the treasury to seek to develop a system of routinely exchanging information about interest paid on bank accounts with other countries? this scheme obviously involves some new elements: some of the reporting will be done by foreign banks, some information will be conveyed to, and transmitted by, foreign countries, and some of the reporting will be of interest paid to nonresident aliens, who are not subject to u.s. tax thereon. should the introduction of these new elements raise concerns to a new level? a. the privacy claims of nonresident aliens with u.s. bank accounts unless and until the proposed irs regulation is issued, nonresident aliens (other than canadians) are able to open u.s. bank accounts in the knowledge that will be no routine reporting of interest paid on the account to the irs or their home country’s tax authorities. under the regulation’s original version, the irs was to receive information annually about interest paid to all nonresident alien depositors; under the revised version, the irs is to receive information only about interest paid to residents of 16 countries. particularly under the original version of the regulation, there was concern that nonresident aliens would no longer wish to have deposits in u.s. banks. one potential concern of a nonresident could be that the irs itself would have routine access to information about her bank account. this might seem objectionable in that the irs has no need for the information in order to impose its own tax. on the other hand, the irs’s role in collecting information from u.s. banks is indispensable to the ultimate objective of conveying that information to the tax authorities of the depositor’s residence country. a u.s. 147. for arguments supporting this belief, see supra notes 110 and 137. 148. see roin, supra note 111, at n. 193, asking whether richard armey, who criticized the oecd tax competition initiative as destructive of privacy, “holds a similar view of employer-based wage reporting.” 624 florida tax review [vol.6:6 bank cannot be expected to convey information directly to each residence country of its depositors. moreover, as previously discussed, it is fairly unlikely that information held by the irs will be abused by it or disclosed without149 statutory authorization. (the likelihood is sufficiently low that congress is150 willing to subject u.s. citizens, as well, to this risk.) and the political stability of the u.s. government may be one of the reasons that the depositor has chosen a u.s. bank account in the first place. the more significant concern of a nonresident depositor is that the irs will convey the information to the tax authorities of her residence country, pursuant to the authorization in irc section 6103(k)(4) for disclosure pursuant to a treaty or information exchange agreement. this could lead to dire151 consequences if the residence country’s government is oppressive, corrupt, unstable, or otherwise irresponsible. the government might use this financial information about its resident to carry out illegitimate acts such as expropriation 149. irs considers giving data to law enforcement agencies, the boston globe, sept. 26, 2003, stating that irs officials have recently “approached the [ways & means] committee for discussions of how certain confidentiality laws could be reinterpreted to expedite the sharing of taxpayer records with the justice department, the fbi, ins and the securities and exchange commission.” irs apparently wants to share “information compiled under its individual taxpayer identification number program, which requires foreigners with earned income in the united states and awaiting citizenship to comply with us tax laws.” id. see also thomas f. field, “taxpayer privacy: an appeal to the commissioner,” 2003 tnt 218-48, requesting that the irs clarify its position. 150. it might be possible to argue that because the nonresident alien individual is not subject to u.s. tax with respect to the bank deposit interest (and may not have any other item that is taxable by the u.s.), he or she is not a “taxpayer” for purposes of § 6103(b)(2). in that case, the information about the nonresident alien’s interest may not be “return information” and thus may not be protected by the confidentiality rule of § 6103(a). section 6103(b)(2) defines “return information” as “a taxpayer’s identity, the nature, source, or amount of his income, payments, receipts. . . whether the taxpayer’s return was, is being, or will be examined. . . or any other data, received by. . . or collected by the secretary with respect to a return or with respect to the determination of the existence, or possible existence, of liability. . . of any person under this title for any tax, penalty. . . or offense.” although this interpretation is possible, it is not likely that the irs would press this interpretation. 151. section 6103(k)(4) provides that: “a return or return information may be disclosed to a competent authority of a foreign government which has an income tax or gift and estate tax convention or other convention or bilateral agreement relating to the exchange of tax information with the united states but only to the extent provided in, and subject to the terms and conditions of, such convention or bilateral agreement.” for a discussion of this statutory provision and of provisions of bilateral agreements providing for such exchange of information, see 2000 jct report, supra note 88, at ¶¶ 162-198. 2004] sharing bank deposit information with other countries 648 or persecution; or they could deliberately or through corruption or insufficient safeguards, let the information fall into the hands of criminals, who might152 then rob, or kidnap for ransom, the innocent bank depositor. (on the other153 hand, in the case of corrupt governments, it may be even more common for the leaders and their friends and relatives to secrete funds in offshore accounts to 152. opponents of the tax return publicity bill passed by congress in 1934, see supra note 116, argued that “kidnappers and other criminals would use returns to pick their next (wealthy) victims. in light of the lindbergh baby kidnapping two years before, this alleged consequence of publicity received an enormous amount of attention.” kornhauser, supra note 113. senator norris noted that this argument was “made on the floor of the senate by a number of senators. . . [and] it has had a great influence” in the statute’s repeal. 79 cong. rec. 54427 (april 11, 1935), quoted in kornhauser, supra. she notes that “norris was justly cynical” about these arguments in that context. kornhauser, supra. 153. see task force, supra note 76, at ¶ 122, recommending that informationexchange be limited to “governments that: 1. are democratic; 2. respect free markets, private property, and the rule of law; 3. can be expected to always use the information in a manner consistent with u.s. national security interest; [and] 4. have in place (in law and in practice) adequate safeguards to prevent the information from being obtained by hostile parties or used for inappropriate commercial, political or other purposes.” see mitchell, supra note 102, at 15, stating that “privacy. . . makes it harder for criminals to select victims.” he states that “[m]any citizens, particularly those from the developing world, want confidentiality so they are less likely to be targeted for kidnaping and other violent crimes.” id., citing testimony of amy elliot before the permanent subcommittee on investigations of the committee on governmental affairs, u.s. senate, nov. 9, 1999. he further states that the “ability to have private offshore accounts also enables people to protect themselves from financial instability and expropriation.” id., citing testimony of antonio giraldi before the permanent subcommittee on investigations of the committee on governmental affairs, u.s. senate, nov. 10, 1999. see also swire, supra note 88, at 471-72, expressing concern about “how an authoritarian or totalitarian government might use and abuse information about citizens’ financial transactions.” he notes that some “countries lack the democratic history and judicial oversight that exist in the united states.” id. he suggests that “united states deployment of [surveillance] technologies can embolden authoritarian regimes to deploy the same technologies and weaken u.s. complaints against authoritarianism.” id. at 503. he notes for example that, “other countries often do not offer the legal protection to individuals that match those within the united states . . . [such as] a warrant requirement and other judicial oversight of investigations and prosecutions. many countries give their officials greater access to data than is permitted in the united states. in some countries, there is a greater likelihood of corrupt officials.” id. at 504. see also swire, supra note 88, at 473, stating that “the harms from surveillance of all financial transactions are even easier to imagine in a police state. in the absence of effective checks on official powers, those in control might use the information for their economic or political advantage. political opponents, disfavored minorities, and powerless people generally could be targeted for exploitation by government officials.” id. 626 florida tax review [vol.6:6 hide them from the populace.) the bank depositor’s human rights are surely154 violated by a government that misuses the information in this way or allows the information to be misused by criminals. many of the governments that might meet this description, e.g., those of nigeria or bulgaria, have neither an income tax treaty nor an exchange of155 tax information agreement with the u.s., so disclosure of taxpayer156 information to tax authorities of such countries would be barred by section 6103. on the other hand, there may also be treaty or information-exchange partners of the u.s. that would not handle tax information responsibly; examples might include china, egypt, pakistan, morocco, russia, tunisia and 154. see roin, supra note 111, at 598, arguing that “secrecy laws abet the discriminatory application of facially neutral tax rules” in that “[t]he politically favored may be given advance warning of changes in tax rules, and allowed the opportunity to hide their money.” in addition, “bank secrecy laws and tax haven entities encourage corrupt administration and corrupt administrators.” id. at 598-99. 155. see burton, supra note 28, at 27, stating that “bulgaria, colombia and nigeria have major corruption problems.” the u.s. signed an exchange of information agreement with colombia on march 30, 2001, but there has not yet been an exchange of notes so that it is not yet in force. john venuti, manal s. corwin, steven r. lainoff, and paul m. schmidt, “current status of u.s. international tax treaties and international tax agreements,” 32 tax management international journal 375, 380 (july 11, 2003). see also task force, supra note 76, at ¶ 122 stating that “[c]ertain nato allies, most notably greece and turkey, do not currently provide adequate safeguards with respect to information and also have inordinate difficulties with corruption and protecting civil rights.” see generally burton, supra note 28, at 16, stating: “the idea of sharing banking, credit card and tax information relating to u.s. citizens or benign foreigners with most governments on the planet should cause most americans to shudder. most governments are corrupt. most governments are not interested in preserving freedom. most governments are more than willing to use such information to oppress their political opponents or disfavored ethnic or religious minorities. most governments are more than willing to confiscate the property of their opponents. few governments have meaningful controls on information, so unscrupulous government employees can misuse information even if its not a matter of state policy. for example, banking information has routinely been used in columbia to identify potentially profitable kidnap victims.” he also asserts that “french intelligence services are known to spy for commercial purposes” and that “the greek and turkish governments have intelligence services that used such information for domestic political oppression.” id. at 17 n. 60. see also mitchell, supra note 102, at 15, stating that “[f]inancial privacy historically has been viewed as ‘an essential safeguard of the citizen against the power of dictatorship.’” mitchell cites christopher adams, “nowhere to hide,” the financial times, june 26, 2000. 156. see venuti, corwin, lainoff, & schmidt, supra note 155, at 375-76, 380. 2004] sharing bank deposit information with other countries 648 turkey. treaty provisions providing for exchange of information typically157 provide that information received is to be disclosed only to person involved in tax administration and is to be used solely for such purposes. however, this158 restriction may be difficult to enforce after the information has already been conveyed. a nonresident alien depositing funds in a u.s. bank account deserves assurance that information about the account will not be transmitted to an irresponsible government that may misuse the information (or allow it to be used) in a way violating the alien’s human rights. this suggests that an amendment of irc section 6103(k)(4) is needed so that irs transmittal of tax information is restricted to countries that can provide assurance that the159 157. for a survey of the extent of political rights and civil liberties (from 1 as “best” and 7 as “worst”) in the various countries of the world, see freedom house, the world’s most repressive regimes 2003, a special report to the 59th session of the united nations committee on human rights, geneva, 2003, appendix a, available online, at www.freedomhouse.org/research/mrr2003.pdf, last visited oct. 18, 2003. the sixteen countries listed in the proposed regulation, see supra note 8, all have the highest score of 1 or political rights and 1 for civil liberties, except for greece, which has a score of 1 for political rights and 2 for civil liberties. other countries or territories with scores of 1 in each criterion are: andorra, austria, the bahamas, bermuda, barbados, belgium, british virgin islands, cayman islands, cyprus, dominica, iceland, isle of man, kirbati, liechtenstein, luxembourg, malta, marshall islands, san marino, slovenia, switzerland, tuvalu, and uruguay. the u.s. has tax treaties with the following countries that lack the highest (1,1) rating: armenia (4,4), azerbaijan (6,5), belarus (6,6), china (7,6), czech republic (1,2), egypt (6,6), estonia (1,2), georgia (4,4), hungary (1,2), india (2,3), indonesia (3,4), israel (1, 3), jamaica (2,3), japan (1,2), kazakhstan (6,5), korea (2,2), kyrgyzstan (6,5), latvia (1,2), lithuania (1,2), mexico (2,2), moldova (3,4), morocco (5,5), pakistan (6,5), the philippines (2,3), poland (1,2), romania (2,2), russia (5,5), slovakia (1,2), south africa (1,2), tajikistan (6,5), thailand (2,3), trinidad & tobago (3,3), tunisia (6,5), turkey (3,4), turkmenistan (7,7), ukraine (4,4), and uzbekistan (7,6), venezuela (3,4). the u.s. has an exchange of information agreement with the following countries or territories that lack the highest rating: colombia (4,4), antigua & barbuda (4,2), netherlands antilles (1,2), jamaica (2,3), grenada (1,2), dominican republic (2,2), mexico (2,2), trinidad & tobago (3,3), st. lucia (1,2), honduras (3,3), costa rica (1,2), guyana (2,2), peru (2,3). (the “freedom” ratings for territories are for the year 1999-00 and are found at http://www.freedomhouse.org/ratings/related.htm#top.) 158. see, e.g., u.s. model income tax convention of sept. 20, 1996, article 26.1; 2000 jct report, supra note 88, at ¶¶ 179-202, describing provisions in treaties with germany, canada, japan, and the u.k. 159. in fact, the irs may well have been sensitive to these issues in formulating its revised version of the proposed regulation for reporting of bank deposit interest of nonresident aliens. the 16 residence countries listed in the regulation are stable democracies, whose safeguards of the confidentiality of government information may 628 florida tax review [vol.6:6 information will be safeguarded and will be used only for the purposes intended. on the other hand, a foreign government that demonstrates its160 actual adherence to appropriate standards for handling and using tax information should not be denied such information merely because it does not meet western standards for political democracy; in some cases, securing a161 stable revenue source may be a necessary step in progress toward greater political rights and rule of law. many nonresident alien depositors in u.s. bank accounts may have a different concern about the proposed information-sharing. rather than fearing that the information will be put to unintended purposes, they might fear that the information will be used by the residence government, as intended, to enforce the residence country’s tax laws against the depositor. the depositor may sincerely believe that the tax which his residence country seeks to impose is grossly unfair to him. does the depositor have the right to be assured that when he secretes his funds in another country, that country will not report the deposits to the tax authorities in his home country? for example, one commentator has recently presented such an argument: “in a number of european countries, governments are elected from time to time on a platform of explicit class warfare. . . . when there is a significant chance of a [such a] government being elected. . . government is no longer the neutral body that law-abiding citizens should obey at all times[,] it is an instrument of depredation and plunder. in order to protect themselves against such looting, it is right and proper that the professional classes should have access to an offshore bank well equal or exceed those in the u.s. see, e.g., kleiman, supra note 49, at 1215-19, discussing the “independent privacy watchdog” used to insure protection of personal privacy in sweden, west germany and france, as potential models for the u.s. the one possible exception in this list is greece. see supra notes 155, 157. 160. the code already provides that in cases where information is shared with federal or state agencies or independent contractors pursuant to § 6103 the recipients must maintain certain procedures to safeguard the confidentiality of the information and that these are subject to audit by the general accounting office. irc § 6103(p). 161. by contrast, under the draft convention proposed by the task force on information exchange and financial privacy, see supra note 153, information would be exchanged only with “governments that: 1. are democratic; 2. respect free markets, private property, and the rule of law; 3. can be expected to always use the information in a manner consistent with u.s. national security interest; [and] 4. have in place (in law and in practice) adequate safeguards to prevent the information from being obtained by hostile parties or used for inappropriate commercial, political or other purposes.” task force, supra note 76, at ¶ 122. under this draft convention, however, information would be exchanged only for national security purposes, or to combat terrorism, or serious ordinary law crimes (defined so as not to include tax evasion). see infra note 197. 2004] sharing bank deposit information with other countries 648 account system, with banking secrecy that cannot be broken by agents of the looter government. without such access, there is no security of property, and we are reduced to the law of the jungle.” 162 in general, each country is considered to have the right to make its own decisions (through its own political system) about taxing its residents; these163 decisions require reaching a consensus about what level of government services should be provided and how the burden thereof should be distributed, and views on these matters often vary between (as well as within) countries. any164 scrutiny of such decisions by the international community would be quite limited; there is no international consensus regarding the appropriate level or distribution of taxes; only in extreme cases (usually involving discrimination on the basis of race, sex, ethnicity, religion or political views), would substantive rules of taxation be considered to involve a violation of human165 rights. if the residence country’s tax system does not have flaws of such an166 162. see, e.g., martin hutchinson, upi business and economics editor, bank secrecy – key civil liberty, united press international, oct. 4, 2001, available on lexis. 163. see roin, supra note 111, at 597, noting that “[w]hether rational or not, most countries consider the design of tax systems to be a national prerogative, and foreign influences thereon to be an intolerable intrusion.” 164. see roin, supra note 111, at 552, noting that “[i]n a simple world consisting of a single jurisdiction, that jurisdiction would choose its tax system and its tax levels based on its residents’ (or leaders’) evaluation of the social needs and desires of the populace;” id. at 557, noting that “residents of different countries may have different preferences regarding the mix between publicly and privately supplied services that affect the level (and thus the cost) of maintaining their public sectors;” id., at 581, arguing that “the whole point of the political process is to aggregate [the variety of] views to reach a collective ‘consensus’ according to which the society can function.” 165. see roin, supra note 111, at n. 180, noting that “[i]ndividuals’ definitions of ‘oppressive and confiscatory’ may differ.” 166. recently, philip baker has written an analysis of 240 cases involving taxation that were decided by the european commission on human rights and the european court of human rights during period 1959-2000. philip baker, taxation and the european convention on human rights, british tax review, 211-377 (2000). these decisions interpret the european convention on human rights, including protocols. see convention for the protection of human rights and fundamental freedoms, signed at rome on november 4, 1950 (ets no. 5), and protocol no. 1, march 20, 1952 (ets no. 9). there are 44 parties to the convention. see http://www.coe.fr. article 1 of protocol no. 1 is entitled the protection of property. it provides: “every natural. . . person is entitled to the peaceful enjoyment of his possessions. no one shall be deprived of his possessions except in the public interest and subject to the conditions provided for by law and by the general principles of international law. the preceding provisions shall not, however, in any way impair the right of a state to enforce such laws as it 630 florida tax review [vol.6:6 extreme nature, then the depositor is not entitled to assurance that information about his deposit will be kept from the tax authorities of his residence country. 167 critics of the treasury’s proposed regulation suggest that this initiative will inevitably lead to indiscriminate sharing of tax information with all countries (necessarily resulting in some misuse of information). they note that the treasury left open the possibility of adding to the list of 16 countries in the future, and they view the proposed regulation, the eu savings directive, and168 the oecd information-exchange initiative as leading to widespread, automatic information sharing, epitomized by the so-called “international tax169 deems necessary to control the use of property in accordance with the general interest or to secure the payment of taxes or other contributions or penalties.” baker explains that “all taxation must satisfy the principles underlying the convention: it must be imposed according to law, it must serve a valid purpose in the public or general interest, and the provisions adopted must be a reasonable and proportionate means to achieve that end.” id. at 220. he notes that of the 65 cases seeking relief under this article, only two have been successful, both involving tax enforcement measures. id. at 220 and 22628. a much larger number of successful taxation cases were raised under article 6 of the convention, dealing with the right to a fair trial. id. at 228. there were six successful taxation cases brought under article 14, prohibition of discrimination; five involved discrimination on the basis of sex and one “involved unjustified discrimination on grounds of residence.” id. at 249. two successful taxation cases were brought under article 8, right to respect for private and family life; both involved “informationseeking by revenue authorities where there were inadequate judicial safeguards.” id. at 253. in one case a search of premises was made by french customs officers; in the other, the taxpayer’s phone was tapped by the french government. id. at 254-55. finally, six successful cases were brought under article 5, right to liberty and security. id. at 26061. 167. in the case of countries party to the european human rights convention, discussed supra note 166, one could further argue that in light of the opportunity for redress before the european court of human rights, protective action by a third country, such as the u.s., should be viewed as an unnecessary intrusion. 168. burton, supra note 28, at p. 13: “as a prelude of things to come, the treasury presages it may expand upon this list of countries. the service intends to collect this information in a central repository, so that it can be made available to unspecified authorities in the enumerated foreign nations.” see cfp, “key lawmaker condemns irs regulation: florida banks are ultimate target,” oct. 3, 2002, reprinted in 2002 tnt 193-24, arguing that, if the regulation is not withdrawn, “it will be just a matter of a few short years before the irs imposes a reporting requirement for depositors from all nations.” 169. see burton, supra note 28, at 21, arguing that “the logic of the oecd proposal is the total abolition of financial privacy and a world where all governments can access the financial information . . . of any individual living anywhere in the world;” id., at 25: “the larger concern is that u.s. legal protections guaranteeing taxpayer 2004] sharing bank deposit information with other countries 648 organization” proposed in a 2000 u.n. report. these critics are correct to170 stress the dangers of indiscriminate sharing of tax information. but they seem to be unduly pessimistic in predicting the irs cannot maintain limitations on information-sharing in order to protect depositors against irresponsible governments. the u.s. and other countries seeking to stem offshore tax evasion by their respective residents can so do without agreeing to provide information to irresponsible governments that would abuse such information. for one thing, these countries are generally not countries in which americans or other tax evaders would seek to establish offshore accounts and thus there may be no need to negotiate for information exchange with those countries. second, even if the u.s. did need information about u.s. bank accounts in one of those countries, it could negotiate a bilateral agreement to receive information from that country without agreeing, as part of the bargain, to provide information about u.s. bank accounts to that country. an example of a one-way tax sharing agreement is the u.s.– bahamas tax information agreement, signed on january 25, 2002. of course, such one-sided agreements require that the u.s.171 confidentiality would be undermined by the automatic information exchange that is the eu’s ultimate goal. the united states is in a position to derail the entire eu savings tax directive process if it withdraws the proposed bank deposit interest regulation.” see also task force, supra note 76, at ¶ 138, stating that the oecd initiative on harmful competition “represents a major step toward the unrestricted disclosure of private financial and tax information, including from the u.s. and other oecd countries, to a wide array of countries that can be expected to misuse the information for commercial, political or intelligence purposes.” 170. see burton, supra note 28, at 6-7, citing report of the high level panel on financing for development to the general assembly, pp. 27-28, 64-66. the report proposed a “mechanism for multilateral sharing of tax information, like that already in place with oecd, so as to curb the scope for evasion of taxes on investment income earned abroad.” burton, at 6, quoting u.n. report, at 28; see also task force, supra note 76, at ¶¶ 56-59. see also cordia scott, “u.n.’s annan presses to create global tax commission,” 2003 wtd 211-1, stating that, on october 29, 2003, the secretary general “suggested that the current 25-member u.n. ad hoc group of experts on international tax policy should be transformed into an intergovernmental body.” 171. see william m. sharp sr., william t. harrison iii, rachel a. lunsford, and scott a. harty, “the u.s. tax information exchange agreements: a comparative analysis,” 2002 tnt 219-45, at n.4 and accompanying text. they note that the agreement “does not require the united states to tender any requested information to the bahamas,” whereas the u.s. could be required to provide information under the agreements with the cayman islands and british virgin islands, signed in 2001 and 2002, respectively. however “it seems unlikely that the cayman islands or the bvi will request this information.” id. at n. 4. 632 florida tax review [vol.6:6 offer the other party some incentive to enter the agreement other than reciprocity of information exchange.172 this section has focused on whether a nonresident alien depositor in a u.s. bank has the right to assurance that his deposit information will be kept secret from his home government. my conclusion is that the nonresident alien’s claim to secrecy is convincing only if the home government is likely to misuse (or allow misuse of) the information, and not if the home country can insure that the information is used solely to enforce the tax obligation of the depositor to his home country. this does not answer the question of whether the country where the deposit is made (e.g., the u.s.) has any reason, or obligation, to help the home country enforce its taxes (which may be too high in the view of the u.s.). i will turn to this question in part c. below.173 b. the privacy claims of u.s. citizens or residents who have offshore accounts if one accepts that a u.s. person banking with a u.s. bank will have his receipt of interest payments reported to the irs on a form 1099 (and that this does not pose an intolerable risk that the information will be misused), is there any basis to argue that a u.s. person banking with an offshore bank has a right to avoid such reporting to the irs? it could be argued generally that a u.s. citizen should be able to avoid the reach of the u.s. government when his actions occur wholly outside the u.s. but in this context this argument would be in direct conflict with decisions made by congress. congress has determined that the gross income of u.s. citizens or residents should generally include income from foreign as well as u.s. sources, and the permissibility of this rule has been confirmed by the174 172. one of the incentives for the bahamas to sign the agreement may be the provision in article 5 confirming that the limitations on deductions for expenses of attending a convention outside the north american area under § 274(h)(1) will not apply to a convention in the bahamas in light of § 274(h)(6) (bahamas is a beneficiary country under the caribbean basin economic recovery act that has in effect a bilateral agreement with the u.s. for exchange of information). see id. at text accompanying notes 131-36. 173. mastromarco & hunter, supra note 6, at 167 suggesting that, the eu and oecd efforts to expand information-reporting “would enable governments to impose high extraterritorial taxes with impunity – taxes that have driven the funds the eu is chasing offshore in the first place.” 174. sections 1; 61. section 911 provides an exclusion, however, for a certain amount of foreign earned income. for this purpose “earned income” is defined as “wages, salaries, or professional fees, and other amounts received as compensation for personal services.” section 911(d)(2). 2004] sharing bank deposit information with other countries 648 u.s. supreme court in cook v. tait. congress has not only made plain that175 interest paid by a foreign bank is taxable to a u.s. citizen or resident, but has also authorized the treasury to require a u.s. citizen or resident to file a report of any offshore financial accounts that he owns or controls. and, it has176 authorized the irs to obtain the records of a taxpayer’s domestic bank accounts without any showing of probable cause that any criminal or civil wrong has occurred. thus, congress’s failure to require reporting of the interest by the177 foreign bank to the irs can be assumed to be based not on concern for the privacy of the depositor but on a lack of jurisdiction to impose this reporting requirement on the foreign bank.178 the exchange of information meant to be facilitated by the proposed regulation would involve transmittal of information about an offshore bank account of a u.s. citizen first to the government of the country where the bank is located and then by that government to the irs. this might be considered a more serious invasion of privacy than the transmittal of information directly from a bank to the irs (as in the case of a u.s. bank account). however, the american depositor himself chooses the foreign country in which to make the deposit, and therefore presumably should be able to insure that the foreign government can be relied upon to keep the information confidential (except for conveying it to the irs). c. the claims of tax havens to be entitled to provide privacy thus far, i have sought to establish that a taxpayer secreting funds in a bank account outside his residence country has no entitlement to have the host 175. 265 u.s. 47 (1924). 176. 31 u.s.c. 5314. see supra note 55. 177. see supra note 109 and accompanying text. thus, there would seem to be no reason why the irs should be required to show “probable cause” in seeking information regarding a foreign bank account. but see burton, supra note 28, at 20-21, stating that: “the oecd mou provides for the total abolition of financial privacy in the 41 targeted countries as it relates to the 30 oecd member countries. the targeted countries would be under an obligation to routinely share banking, tax, and other financial information with oecd member countries. . . . there would be no requirement for the recipient country to show probable cause for belief that a crime had been committed in either country. . . [or even] a requirement to show that some civil wrong had been committed or was even suspected. the information would simply be routinely sent to any oecd country that asked for it. there are absolutely no restrictions on the use to which the information may be put.” 178. on the other hand, the irs has taken advantage of the willingness of foreign financial institutions to provide certain information by voluntary agreement under the “qualified intermediary” program. see supra note 25. 634 florida tax review [vol.6:6 country refrain from providing that information to his residence country (unless the residence country is expected to misuse or allow misuse of the information). in this part, i will address the claim that a host country should be permitted to choose the role of the tax haven (i.e., to provide privacy to nonresident investors seeking to evade taxes in their home countries) and that, because it is a sovereign nation, the host country’s choice should be respected by residence countries. tax havens defend this claim with a number of arguments: first, there is no affirmative obligation of one country to help another enforce its own tax law. providing such assistance has an administrative cost to the host country, and, more importantly, may damage or destroy the tax haven’s financial services industry (which may be its only profitable industry). maintaining bank secrecy not only serves a tax haven’s economic179 self-interest, but , in some cases, is an expression of the tax haven’s culture and political values (such as, protection of an individual’s privacy and freedom from government interference). thus, for residence countries to seek to force a tax haven to give up bank secrecy is a violation of the tax haven’s sovereignty. in this view, coordinated efforts by rich and powerful, developed countries to eradicate bank secrecy in poor, weak, undeveloped countries is a reprehensible form of bullying, particularly when developed countries have not fully renounced bank secrecy themselves. one commentator has likened the oecd to “twenty-first century pirates” who have “robbed fourteen caricom countries of their tax and economic policy sovereignty.”180 it is true that international law has not as yet recognized any universal obligation of host countries to assist in enforcement of tax imposed by residence countries. currently such an affirmative obligation only comes into being by agreement of the host country. this, however, does not establish that it is inappropriate for a residence country to seek to convince a host country to take on such an obligation. 179. it may well be that giving up bank secrecy will have dire effects on the economies of a number of caribbean counries. see vaughn e. james, “twenty-first century pirates of the caribbean: how the organization for economic cooperation and development robbed fourteen caricom countries of their tax and economic policy sovereignty,” 34 u. miami inter-am. l. rev. 1, 33-39, concluding that “[a]ll the blacklisted countries have been severely affected by their inclusion on the oecd list of tax havens.” see also roin, supra note 111, noting that some tax haven countries argue that “their economies will collapse if they cannot provide investors with secrecyleveraged tax advantages.” professor roin notes that this argument was made by the netherlands antilles in an effort to ward off repeal by the u.s. of the withholding tax on interest. she suggests that “[s]ympathy for european countries such as switzerland, luxembourg, and monaco may be even greater.” 180. james, supra note 179, at 33-39. 2004] sharing bank deposit information with other countries 648 in addition, the lack of a generalized obligation for a host country to assist a residence country in enforcing its tax law probably rests on the assumption that the host country has not participated in creating any obstacles to such enforcement, i.e., it is merely an innocent bystander. however, a tax haven adopts bank secrecy rules with the deliberate intent to attract banking transactions of nonresidents seeking to evade their home country’s taxes; the tax haven’s role is to facilitate such tax evasion. thus, the tax haven can be viewed as an accomplice in thwarting another country’s legitimate efforts to tax its own residents. the harm to the residence country is significant; it includes not only the taxes evaded by by those with offshore accounts, but also the resulting loss of confidence in its tax system and likely decline in voluntary compliance or even in respect for government. in the view of the residence181 country, the tax haven is not being asked for assistance but merely to refrain from interfering in the residence country’s affairs. in many cases where this conflict occurs, the tax haven is a poor, undeveloped country that is highly dependent on its financial services industry and the residence country is a rich, developed country. many would recognize an obligation of the richer country to provide economic aid to the smaller country. allowing the tax haven to profit by facilitating tax evasion on the part of residents of the richer country may be viewed as an indirect form of economic aid. however, even if rich countries should accept an obligation to help poorer countries, they have no obligation to offer assistance in this form. as professor julie roin has pointed out, more efficient means for providing financial assistance to poor countries can be devised.182 181. see roin, supra note 111, at 597, stating that arguments about infringement of sovereignty “lack much force in [the] contexts” of “bank secrecy and proposals for the exchange of tax information,” by comparison to the context of “[m]andated tax uniformity.” she explains: “[i]t is one thing to argue that a country should be able to use the tools at its disposal – tools that impose costs on the local population – to attract investment and tax revenues. it is another to attract investment (or launder the profits generated by investment elsewhere) by using tools that impose costs only on outsiders (including outside governments).” id. 182. see roin, supra note 111, at n. 196, commenting that a “simple transfer of money from the treasuries of the residence countries to those of the haven countries would be cheaper if the only goal is to provide foreign aid. the recipient country could use this money to encourage activity more productive than training people how to launder money.” id. she concludes: “surely more productive, and less open-ended methods of foreign aid can be designed.” id at 602. she also notes that “[a]s it stands, the residence countries have very little control over the amount of foreign aid being transferred to tax haven countries.” id. at n. 197. moreover, this form of aid is inefficient in that not all the benefits are captured by the tax havens; they must be shared with their customers, the tax evaders. 636 florida tax review [vol.6:6 in some cases, the residence country whose tax enforcement efforts are thwarted is not a wealthy, developed country. as discussed in a recent oxfam report, it may be a relatively poor developing country (even a tax haven)183 184 which is struggling to establish a working tax system. a country such as brazil should not be viewed as having an obligation to forego revenues by185 183. oxfam gb policy paper, tax havens: releasing the hidden billions for poverty eradication. the report asks “if revenue authorities in britain and germany feel threatened by offshore activity, how much more severe are the problems facing countries with weak systems of tax administration?” id. at 2. see also id. at 7, stating: “tax authorities, particularly in developing countries, rarely have an effective means of knowing about the income their residents earn from abroad. . . in some developing countries, the tax regime permits or even encourages the non-payment of tax on foreign income. even where this is not the case and tax treaties do contain adequate exchange of information agreements, the option of tax havens ensures that savers always have a way of escaping detection.” the report seeks to quantify the revenue loss, as follows: “by 1990, the stock of capital flight from developing countries was estimated at around u.s. $700 billion. . . . supposing a rate of return of 10 per cent and a tax rate of 22 per cent, tax on interest income from the u.s. $700 billion in capital flight could be contributing to developing country tax revenues to the tune of around u.s. $15.4 billion each year.” id. at 10. 184. see bruce zagaris, “tax compliance initiative in antigua and barbuda illustrates new approach to an old problem,” tax notes international magazine, feb. 3, 2003, 521, pointing out that the 2002 budget statement of the prime minister “focused on the culture of tax avoidance and evasion that has limited his government’s ability and capacity to deliver vital services to citizens.” id. at 521. zagaris notes that “[a]nother mechanism that antigua and barbuda will soon have to assist in its tax initiative is the proposed tax information exchange agreement” with the u.s. he explains that “tieas can help developing countries combat the ease with which taxpayers may use globalization to manipulate their financial affairs for the purpose of evading taxes.” id. at 524-5. 185. see david roberto r. soares da silva, “brazil considers tax amnesty for undeclared investments abroad,” 2003 wtd 23-2, noting that “the [brazilian] government estimates that more than u.s. $30 billion in undeclared, legally earned funds have been deposited abroad by brazilian taxpayers;” moises naim, the fourth annual grotius lecture: five wars of globalization, 18 am. u. int. l. rev. 1 (2002), describing the five wars of globalization as including the “war against money laundering.” he states that “developing countries lose about $50 billion a year in taxes through” tax evasion. he notes that “in 1998, $74 billion were transferred from russian banks to overseas accounts. of that amount, $70 billion went to accounts to banks in the small island-state of nauru.” id. at 11-12. see jennifer l. franklin, other international issues: tax avoidance by citizens of the russian federation: will the draft tax code provide a solution, 8 duke j. comp. & int’l l. 135 (1997), at 153 fn. 117, noting that one method of tax avoidance in the russian federation has been “sending money abroad,” citing vincent boland, russian maifa has $10 billion in swiss bank, financial times, feb. 14, 1997, at 3. see also iurie lugu, “russia to negotiate information 2004] sharing bank deposit information with other countries 648 allowing a caribbean tax haven to use bank secrecy to attract tax evaders from brazil. moreover, the country offering its services as a tax haven is not always a poor country with few alternatives for lifting its economy. for example, the united states and switzerland do not fit this description. critics of the186 proposed regulation appear to argue that the united states has a greater selfinterest as a tax haven country that attracts foreign capital by offering anonymity, than it does as a residence country seeking to prevent tax evasion by americans using offshore accounts. a quantitative comparison of these187 two competing interests of the united states is difficult because it is hard to quantify the damage to voluntary compliance that results from the widespread use of tax havens. in any event, neither the u.s. nor switzerland could be expected to suffer an economic collapse if bank deposits in their banks were made subject to information reporting to the home country. exchange agreements,” 2003 wtd 146-5, noting that russian tax authorities planned to enter into information exchange agreements with six additional countries and believed that exchange of information was “one of the principal factors in determining how effective [they are] are in preventing tax offenses and crimes.” see also cristian e. rosso alba, argentine revenue service empowered to exchange tax information, 2003 wtd 195-6, (this authorization is “part of an antifraud package the administration proposed to uncover argentine tax residents’ accounts and offshore corporations in tax havens and foreign jurisdictions”); michael casey, “argentina is taxing on tax dodgers,” wall street journal, june 25, 2003, at b5c, noting that “[t]here is. . . a broad consensus in argentine society that the enormous tax-evasion problem needs to be fixed. revenue lost to tax dodgers is estimated at 33 billion pesos (about $12 billion) each year, about half the federal government’s budget;” “u.s. colombia to sign pact to share tax information,” 2001 wtd 63-7 (colombian official stated that the new agreement “would encourage colombian taxpayers to take advantage of an amnesty that lets funds sent. . . overseas, without the knowledge of the tax authorities,. . . come back into the country”). 186. the per capita gdp of the u.s. is $37,600, the second in the world after first-place luxembourg, which has a per capita gdp of $44,000. bermuda and the cayman islands are respectively third and fourth, while switzerland is seventh, with per capita gdp of $31,700. liechtenstein is number fifteenth, with per capita gdp of $25,000. at the bottom (number 231) is east timor, with per capita gdp of $500. see the w orld factbook, rank order gdp per capita, available at http://www.odci.gov/cia/publications/factbook/rankorder/2004rank.htm, last visited on oct. 8, 2003. 187. see task force on information exchange, supra note 76, at 142, recommending that the u.s. reject the eu savings tax directive because: “the united states is a capital-inflow country. it is not in america’s interest to facilitate foreign taxation of u.s.– source income.” for an attempt to quantify this comparison, see mastromarco & hunter, supra note 6, at 171-72, citing testimony of stephen j. entin. 638 florida tax review [vol.6:6 of course, if small, poor countries with undiversified economies are expected to give up bank secrecy on the grounds that it is harmful to residence countries, it will be viewed by them as hypocritical and unfair for residence countries making that request, e.g., the united states, to themselves serve as tax havens in order to attract capital. but the fact that the u.s. currently is a tax188 haven is not a good reason for the u.s. to continue to thwart the tax enforcement efforts of other countries. it is circular to argue that the u.s. (in its role as tax haven) should maintain bank secrecy (i.e., should not adopt the proposed regulation) because the u.s. (in its role as residence country) has no right to criticize caribbean bank secrecy because the u.s. (in its role as tax haven) maintains bank secrecy itself. further, it has been argued that the oecd has acted to “impose [its] own cultur[e] on others.” some tax havens defend bank secrecy as a form of189 human rights protection. for example, switzerland claims to provide a haven for individuals who are persecuted by their own governments on the basis of190 188. see task force, supra note 76, at ¶ 99, stating that “[i]t is wrong for the u.s. to be demanding that the small targeted countries [labelled as tax havens by the oecd] live by tax and financial privacy rules by which the u.s. itself is not willing to abide.” see also burton, supra note 28, at 20 stating that the u.s., u.k. and switzerland “could also be on the oecd blacklist except the oecd members were excluded.” see also marshall j. langer, “harmful tax competition: who are the real tax havens?” 2001 tnt 19-66, stating that “it is obvious that the united states, britain, and many of the other oecd member states are significant tax havens.” id. at ¶ 42. to demonstrate that the u.s. meets the definition of a tax haven in the so-called gordon report, supra note 22, he points out: “the united states, the united kingdom, and many other oecd countries have local laws and practices that deny information to other countries and that are at least as abusive as those of the so-called tax havens. . . . the united states still does not tax interest on bank deposits of foreigners, nor does it generally require any reporting of these deposits except those paid to canadian residents. therefore it cannot and does not give information concerning such deposits to any country other than canada. the united states now also exempts portfolio interest and capital gains. . . other than real estate gains.” id. at ¶ 3. for discussion of the 1984 enactment of the portfolio interest exemption, see graetz, supra note 25, at 376-80. 189. langer, supra note 188, at ¶ 42 and n. 246, describing speech by neville nicholls, president of the caribbean development bank, at a consultation between the oecd and caricom in barbados in january 2001. 190. see roin, supra note 111, at 597-98, noting that “[b]ank secrecy laws and laws forbidding cooperation with foreign tax authorities traditionally have been justified as a necessary protection against the ability of oppressive governments to strip members of political, racial or religious minorities of their assets under the guise of taxation or other laws.” id at 597 & n. 178, citing allaire urban karzon, international tax evasion: spawned in the united states and nurtured by secrecy havens, 16 vand. j. transnat’l. l. 757, 781 (1983); jeffrey i. horowitz, comment, piercing offshore bank secrecy laws used to launder illegal narcotics profits: the cayman islands example, 20 tex. 2004] sharing bank deposit information with other countries 648 their religion, politics or race and who may be unfairly deprived of their assets. ironically, the bank secrecy laws of switzerland proved to be a barrier191 to efforts by holocaust survivors or their heirs to reclaim amounts deposited in swiss banks while the nazis were in power. in any event, as discussed above,192 int’l l.j. 133, 134-35 (1985); feld, supra note 53, at 1182 ( stating that “[h]istorically swiss bank secrecy was created by private bankers in geneva when french protestants had hidden their remarkable wealth from the access of catholic french kings in the banks of their brothers in faith in geneva”). professor roin notes that “switzerland’s protection of the assets of european jews during the hitler era was routinely cited as the paradigmatic example of the beneficent quality of such behavior.” id. at 598, citing senate comm. on gov’tal affairs, crime and secrecy: the use of offshore banks and companies, s. rep. no. 130, at 33 (1985); karzon, supra, at 781. but she notes that “that particular canard has been laid to rest.” roin, supra, at 598. 191. see jennifer a. mencken, note: supervising secrecy: preventing abuses within bank secrecy and financial privacy systems, 21 b.c. int’l & comp. law rev. 461, 467-68 (1998) explaining that: “after coming to power in 1933, the nazi government enacted a regulation requiring all german nationals to declare assets held outside of germany, with non-compliance punishable by death. when three germans were executed the following year, the swiss government codified the secrecy customs of swiss bankers.” germany was concerned with capital flight resulting from “hyperinflation and exchange controls caused by world war i.” id. at 467. she notes that: “prior to the creation of numbered accounts by swiss bankers, the gestapo would routinely target low level swiss bank employees for asset information concerning certain individuals.” id. at 471. 192. see mencken, supra note 191, at 461, providing as an example the case of jacob friedman. friedman at age 16 smuggled his father’s funds from romania to a numbered swiss bank account, but his father and the rest of his family died at auschwitz; in the 1970’s friedman sought to retrieve the funds from the swiss bank was turned away because he did not have the secret account number. this story is recounted in sean maccarthaigh, swiss held to account, irish times, march 8, 1997, available in lexis. in december 1999, a commission sponsored by the swiss bankers’ association and the world jewish congress and chaired by paul volcker, which conducted a three-year investigation, identified 53,000 swiss bank accounts that might have belonged to holocaust victims. the report stated that: “the handling of these funds was too often grossly insensitive to the special conditions of the holocaust and sometimes misleading in intent and unfair in result.” david e. sanger, 54,000 swiss accounts tied to nazis’ war victims, new york times, dec. 7, 1999, at a15. see also elizabeth olson, swiss holocaust accounts reportedly have $250 million, near york times, dec. 3, 1999, page a5; elizabeth olson, swiss embrace report; banks are tarnished, new york times, dec. 7, 1999, at a15. class action suits brought in federal court in brooklyn resulted in a 1998 settlement of $1.25 billion against a group of swiss banks, for which final court approval was given in 2000. alan feuer, final approval on swiss holocaust claims, new york times, july 27, 2000, at a8; see david barstow, plan for swiss to pay nazi victims, new york times, sept. 13, 2000, at a3; elizabeth olson, swiss to list bank accounts unclaimed since holocaust, new york times, nov. 26, 2000, § 1, p. 28; elizabeth olson, swiss banks find $10 million from 640 florida tax review [vol.6:6 protection from government persecution does not seem an adequate justification for a blanket rule of bank secrecy. rather, it would seem to justify special measures on the part of the country in which a bank is located to insure that information about residents is provided only to countries that will hold it in confidence and will put it to appropriate uses.193 some tax haven countries, such as switzerland, are said to have a different view than most developed countries about issues of government, privacy and taxes. for example, some countries do not view tax evasion as194 holocaust, new york times, oct. 12, 2001, at a9. in march 2002, a commission of historians, led by swiss historian, jean-francois bergier, completed a five-year investigation of switzerland’s wartime activities and concluded that swiss “authorities cooperated unduly with the nazis and failed to return assets to their rightful owners when the war ended.” the panel “criticized the banks’ failure to return jewish assets after 1945, but said it resulted from poor judgment and a desire to safeguard swiss banking secrecy rather than pure profiteering.” elizabeth olson, commission concludes that swiss policies aided the nazis, new york times, march 23, 2002, at a4; see also elizabeth olson, swiss were part of nazi economic lifeline, historians find, new york times, dec. 2, 2001, at § 1a, p. 24; nostra culpa, the economist, march 30, 2002, available on lexis, noting the commission’s conclusions that “after the war, banks and art galleries were negligent about restoring property. decades of pressure from hitler’s victims or their heirs seeking to recover the assets bore real fruit only in the late 1990’s, with the help of jewish groups, lawyers and the american government.” see also judith mandelbaum schmid, “bankers don’t tell: the swiss government and banks say they have no plans to alter the secrecy code. but given recent damage to the banks’ reputation and a changing financial landscape, they may have no choice,” swiss news, may 1, 2002, at p. 10, available on lexis, stating of the swiss bankers actions after the war: “the problem was not that they breached rules – it was that they followed the rules blindly (and in their own financial interests) without considering moral issues . . . they took cover under their own, perfectly legal rules of bank secrecy and did nothing, under the pretext that they were protecting their clients’ confidentiality.” id. for more recent developments, see william glaberson, “holocaust fund official says many people may not get paid – swiss banks are withholding information, a report says,” n. y. times, p. b1, oct. 8, 2003. 193. see roin, supra note 111, at 598, stating that “the time has come to distinguish between secrecy that serves. . . meritorious ends and secrecy that instead contributes to various forms of tax and nontax related illegal and abusive behavior by governments, bankers and their clients.” 194. see feld, supra note 53, at 1182, stating that “switzerland perceives itself as protecting free individuals from government access. . . the swiss government and the swiss people obviously believe that bank customer secrecy reflects their liberal values to a very strong extent.” professor feld is a professor of public finance at the philippsuniversity of marburg. he notes that a recent poll showed that “77 percent of swiss citizens support the existence of swiss bank secrecy laws.” id. at 1184. see erich i. peter, “reasonable limits of transparency in global taxation: lessons from the swiss 2004] sharing bank deposit information with other countries 648 a serious crime if it merely involves secrecy and not the use of false documentation. they may view tax evasion as a citizen’s natural response to195 experience,” tax notes international magazine, nov. 11, 2002, at 591, 614, stating that bank customer secrecy in switzerland “is not only rooted in long legal tradition but also [is] a part of the self-conception of the swiss people;” judith mandelbaum schmid, “bankers don’t tell: the swiss government and banks say they have no plans to alter the secrecy code. but given recent damage to the banks’ reputation and a changing financial landscape, they may have no choice,” swiss news, may 1, 2002, at p. 10, available on lexis, stating that “the tradition of bank secrecy [in switzerland] is inseparable from two national prerogatives: the inviolability of the individual’s right to making personal decisions about paying taxes and the right to privacy.” she notes that “the confederation of swiss cantons was formed in 1291 primarily as a means to avoid paying the exorbitant taxes demanded by the habsburg emperor [and that s]ince then the swiss have always voted on all taxes.” she quotes hans geiger, professor of economics at the university of zurich, who says that “tax evasion is not a crime in switzerland. it is only a minor offence.” id. although cantonal tax authorities cannot demand bank information about a suspected tax evader, this may not be necessary because banks levy a 35% withholding on interest (except from retirement funds). id. she notes that “switzerland has the lowest rate of tax evasion in europe.” id. see also rahn & de rugy, supra note 6, at ¶¶ 10-12. 195. see feld, supra note 53, at 1183, noting that that switzerland distinguishes between “tax evasion” which is not a crime and “is treated as contravention of regulations and punished in an ordinary civil administrative process like parking violations,” and “tax fraud,” which is a crime. he explains that “[t]ax fraud exists if false documents are used to cheat the tax authority,” e.g., a forgery, “while tax reporting forms are no document in this sense.” id. in his view, “[t]axes in switzerland are perceived and constructed as prices for public services,” and there is a “partnership between the state and its citizens. . . . less severe cases of tax evasion are. . . accepted as mistakes that might occur in such a partnership. nobody’s perfect and cheating a little bit does not undermine the basis of the state.” by contrast “[t]ax fraud. . . is actively breaching the tax contract with the government.” id. see also erich i. peter, “reasonable limits of transparency in global taxation: lessons from the swiss experience,” tax notes international magazine, nov. 11, 2002, at 591, 601-02, describing the distinction between tax evasion and tax fraud under swiss law. in january 2003, the u.s. and switzerland agreed that certain hypothetical conduct would constitute “tax fraud or the like” within the meaning of article 26.1 of the swiss-u.s. income tax convention of oct. 2, 1996, and thus require exchange of information. see mutual agreement of january 23, 2000, regarding the administration of article 26 (exchange of information of the swiss-u.s. income tax convention of oct. 2, 1996. one of the examples was of an individual who maintained a bank account in the other country into which he deposits income taxable in his residence country. the taxpayer does not file an income tax return. he uses a credit card issued in the name of a corporation to withdraw substantial amounts form the account to pay his living expenses. tax officials in the first country determine that a credit card tied to the bank account was used to purchase numerous personal items delivered to the taxpayer. “when these officials ask the individual 642 florida tax review [vol.6:6 a country’s imposition of excessively high taxes. thus, such countries may consider that automatic information sharing is an excessive invasion of privacy when used to identify “mere” tax evasion. such a country might find it196 distasteful to engage in automatic information sharing regarding american or european taxpayers with the respective home government and may argue that it is under no obligation to do so.197 in some cases, one might question whether a particular tax haven country sincerely holds this view or whether this is merely a convenient justification for actions taken out of economic self-interest. in any event, the tax haven does not have a convincing reason for refusing to exchange information routinely with a residence country with a democratic political system and a constitution that limits government powers and is interpreted by an independent judiciary, such as the united states. reasonable people may differ as to whether the u.s. government should subordinate the privacy rights of its taxpayers to the needs of tax enforcement by requiring routine reporting of their bank deposit interest. but whether he owns or controls the bank account, the individual does not acknowledge any interest in the corporation or the bank account, and provides no explanation regarding the source of the funds in the bank account.” id., hypothetical 12. see robert goulder, “former treasury official notes problems with swiss information exchange,” tax notes international magazine, may 19, 2003, 663, pointing out that the new agreement “does not provide for swiss cooperation in civil tax matters, and fails to cover all criminal tax matters.” 196. see peter, supra note 194, at 635, arguing that “there should be no exchange of information in a case of mere tax evasion since this offense does not represent a crime under swiss law.” see also task force, supra note 76, at ¶ 129, stating that: “the dual criminality principle should be honored. . . countries that honor requests for information about criminals and terrorists should not be harassed or sanctioned because they honor financial privacy in civil controversies or matters that are not a crime in their jurisdictions (e.g., tax evasion).” see also burton, supra note 28, at 18, 27. 197. the convention of privacy and information exchange proposed by the task force on information exchange and financial privacy, see supra note 76, would provide that information obtained under the convention be used by a member government for no purpose other than “national security,” defense against terrorism or “to detect, prevent or defend against serious ordinary law crimes and to apprehend persons who have committed serious ordinary law crimes.” article iii, ¶ (1). the convention defines a serious ordinary crime as “conduct that (a) constitutes an offence in all member states and (b) is punishable by a maximum deprivation of liberty of four years or more in all member states.” art. 4, ¶ 6. the penalty under irc § 7206(1) for willfully making statements on a tax return that the taxpayer does not believe to be true is a fine of not more than $100,000 and/or imprisonment of not more than 3 years. however, “a person who willfully attempts in any manner to evade or defeat. . . tax. . . or the payment thereof,” is subject to a penalty of not more than $100,000 and/or imprisonment of not more than 5 years or both. section 7201. 2004] sharing bank deposit information with other countries 648 there surely is no international consensus that the u.s. approach is a violation of human rights, which would justify outside intervention. moreover, aggrieved u.s. individuals have opportunities to debate and challenge the u.s. government’s approach through the american political or legal system. instead, tax havens offer the u.s. depositor with a means to bypass the irs information system silently and with impunity. in this light, the tax haven’s refusal to198 exchange information represents an unwarranted interference in the relationship between the u.s. government and its citizens or residents. a similar argument should preclude tax havens from arguing that bank secrecy is a salutary means to prevent western european countries from imposing confiscatory rates of tax on high income individuals. the argument that “political sovereignty” justifies the tax havens claim to impose low rates of tax also justifies the western european country’s claim to impose high rates of tax. the high-tax countries in western europe are recognized as having199 democratic governments, and there is thus no reason not to view such a country’s decisions about its own tax system as legitimate. moreover, these countries have subscribed to the european convention on human rights, and thus have provided a means for taxpayers to seek redress for oppressive or discriminatory taxation in a forum outside the taxing country.200 professor roin has suggested that in some cases a residence country may be content to have its residents (or a favored groups of its residents) use tax havens to avoid high taxes imposed by the residence country. in that case, the tax haven is assisting the residence country’s government to obscure its true tax policy and avoid accountability under its own political system. moreover,201 an unscrupulous government might utilize this means to subject unfavored 198. see roin, supra note 111, at 600, arguing: “if open tax reductions cannot be sustained politically, then the hidden version of such reductions, effected through the use of tax havens should not be allowed either. eliminating the secrecy surrounding such transactions would be a step in the direction of putting such policies to the necessary political test.” 199. see roin, supra note 111, at n.181, discussed at supra notes 163-65. 200. since 1959, at least 240 cases challenging improper substantive or procedural aspects of european tax systems have been brought before the european commission on human rights or the european court of human rights. see supra note 166. switzerland is one of the countries that has ratified the european convention on human rights (including protocols 6 & 7), although it has not ratified protocols 1 & 4. see http://www.echr.coe.int/eng/edocs/datesofratification.htm. currently, m. luzius wildhaber of switzerland is the president of the court. 201. see roin, supra note 111, at 597-601. roin argues that when countries “fail to provide openly for. . . rate reductions through domestic legislation. . .[and] rely instead on. . . informal, uneven, and unpoliced self-help methods of tax reduction. . . [this] suggests a disconnect between those parties effectively making tax policy and those that are supposed to determine that policy.” 644 florida tax review [vol.6:6 groups to discriminatory or harsh treatment, while alerting more favored groups (such as family and friends of the leaders) to the need to secrete funds. thus,202 the tax haven’s justification for withholding tax information from the residence country may not be as strong as it first appears even when the residence country is relatively undemocratic. if bank secrecy allows the governments’ tax treatment of its own citizens to be hidden, there is little opportunity for the government’s tax policy to be subject to democratic control. d. the argument that fighting non-tax crime and international terrorism should take priority among the arguments raised by the task force on information exchange to counter proposals for broader tax information exchange is that priority should be given to investigation of international terrorism or “serious ordinary law offenses.” thus, the task force asserts:203 “countries that honor requests for information about criminals and terrorists should not be harassed or sanctioned because they honor financial privacy in civil controversies or matters that are not a crime in their jurisdictions (e.g., tax evasion). misguided efforts like the oecd initiative against harmful tax competition should not be allowed to impede efforts to obtain information about terrorists.”204 this argument is in part a restatement of the arguments addressed in part c. above. but, in addition, the task force is contending that u.s. efforts to obtain tax information from tax havens jeopardizes its efforts to obtain information about terrorism and other serious crimes from such havens and that the need for the latter information is much greater. 202. id. 203. the convention of privacy and information exchange proposed by the task force on information exchange and financial privacy, see supra note 76, would provide that information obtained under the convention be used by a member government for no purpose other than “national security,” defense against terrorism or “to detect, prevent or defend against serious ordinary law crimes and to apprehend persons who have committed serious ordinary law crimes.” article iii, ¶ (1). see supra note 197 for the definition of serious ordinary law crimes. 204. burton, supra note 28, at 27; task force, supra note 76, at ¶ 129. see also rahn & de rugy, supra note 6, at ¶ 22, arguing that “[a] more constructive approach to fighting terrorism would be to move away from all-embracing information-gathering towards much more narrowly focused money-laundering laws.” 2004] sharing bank deposit information with other countries 648 assuming, for sake of argument, that fighting terrorism and serious non-tax crimes is much more important than enforcing the tax law, there is still a question as to whether pressuring tax havens with respect to tax information will in fact jeopardize tax havens’ cooperation with respect to terrorism and other serious crimes. a tax haven’s refusal to cooperate in the latter enterprise is likely to cost it dearly in terms of its standing in the international community. thus, it is by no means clear that fighting terrorism or other crime is a good reason for the irs to abandon its efforts to obtain tax information from tax havens. iv. questioning our current tax system the above defense of the treasury’s efforts to institute automatic information sharing regarding bank deposit interest accepted certain features of our current tax system as a given: under the current internal revenue code, u.s. citizens or residents on taxed on their income from worldwide sources and are allowed certain deductions or credits. the taxpayer is expected to compute his own tax liability. at the same time, the irs is to have various sources of financial information regarding taxpayers in order to verify that the tax is accurately determined. thus, the taxpayer is required to file a complete and accurate tax return, as well as a return detailing any foreign accounts that he owns or controls. u.s. payors of various types of income, e.g., wages, dividends, interest, and royalties, are required to report these payments to the taxpayer and the irs as a means to insure compliance. in addition, the irs may issue a summons for bank records of a taxpayer in order to verify the accuracy of his tax return without establishing probable cause to believe that the return is false. given these features of our current tax system, treasury’s effort to expand automatic information sharing to cross-border payments of bank deposit interest seems not to represent much of an additional invasion of privacy and seems clearly warranted by the needs of the system. thus, it seems plausible that much of the criticism of the proposed regulation is actually directed at the larger goal of replacing the federal income tax with a new tax system. the criticism may be designed to serve two alternative purposes: if the criticism succeeds in derailing the proposed regulation and the treasury’s efforts to broaden information exchange, then income tax compliance and taxpayer morale may decline further and the need for a replacement of the tax system will become apparent. if the proposed regulation is finalized despite the criticism, the criticism will at least have highlighted the degree to which privacy is necessarily sacrificed under the income tax and may help to convince citizens of the need for a less invasive alternative. for example, dr. daniel j. mitchell of the heritage foundation, who is one of the members of the task force on information exchange and 646 florida tax review [vol.6:6 financial privacy, has written: “the reduction of government prying is sufficient reason to scrap the internal revenue code.” he points out that205 under the “flat tax,” the only income that individuals (in contrast to businesses) would be required to report would be wages; dividends and interest would not be reported on an individual’s return. employers, as under the current system,206 would be responsible for reporting and withholding tax from an individual’s wages, so compliance would be fairly well assured. assuming also that deductions, such as medical expenses and mortgage interest, are not allowed, the irs would appear to have no need to obtain extensive financial information about individuals (apart from their ownership of businesses).207 on the other hand, a number of other federal programs require financial information about individuals, such as the social security disability program, college loan assistance, medicare benefits and food stamps. in addition, state208 205. see mitchell, supra note 102 , at 2. he notes that “[d]uring america’s early years. . . tax collectors were not even allowed to enter homes.” id., citing charles adams, for good and evil: the impact of taxes on the course of civilization (new york: madison books: 1993). see also rahn & de rugy, supra note 6, at ¶ 13, noting that “[u]ntil 1913 [when the sixteenth amendment was ratified,] the government did not have constitutional authority to invade financial privacy.” 206. see mitchell, tax reform, supra note 102, at 9-11; see john o. fox, if america really understood the income tax (westview press 2001), at pp. 260, 263, showing tax forms required under the flat tax. 207. see discussion in gao/ggd-98-37, u.s. general accounting office, potential impact of alternative taxes on taxpayers and administrators, january 14, 1998, appendix vii, reprinted in 98 tnt 11-10 & 11-11. similarly, it has been suggested that a national retail sales tax would avoid the need for information about an individual’s finances to be provided to the irs. see mitchell, supra note 102, at 11-12, stating that the irs would have no need to track wages or individual savings, stockholdings or bondholdings of individuals. further, although the government would have to keep track of sales, “the compliance burden would fall on sellers rather than buyers.” however, he notes that “[p]urchases of goods made overseas would be taxable, so consumers would have to divulge those purchases when returning to the united states.” id. at 12. by contrast, a cash-flow tax may not offer greater privacy because of the need to track amounts added to savings and amounts withdrawn from savings. id. at 13. 208. see e.g., mitchell, supra note 102, at 12 & n. 9, noting that although a national sales tax would not entail any tracking of individuals’ salaries by the irs, “[t]here may be other reasons for the government to obtain this data, including: 1. calculation of social security taxes and/or benefits, and 2. determination of eligibility for various government programs.” id. at n. 9; see privacilla report, supra note 103, at 7-8, noting that the ssa keeps records of “individuals’ earning histories over their entire lives.” this report further notes that the census bureau questionnaire asks for “a detailed breakdown of income, how people get to work. . . how many toilets families have, and how much they pay annually for electricity, gas water, sewers, oil, coal, 2004] sharing bank deposit information with other countries 648 and local governments require such information for their own income taxes and other programs. moreover, there is the question of whether a new federal program would be instituted to replace the earned income credit. if the209 current irs information-reporting system for income other than wages were dismantled, the same information might nevertheless be sought by government agencies, but the information actually collected might prove to be less accurate. thus, there is need for considerably more analysis before one could conclude that enhancing the privacy of americans would be sufficient justification to replace the federal income tax system with a flat tax.210 kerosene and wood.” id. at 8. the bureau “is a repository of massive amounts of sensitive personal information about americans.” he notes that “in the modern welfare state, governments use copious amounts of information to serve up various entitlements and benefits as well. any program that doles money out to citizens based on their condition or status must know that condition or status is, often in comparison to the condition or status of the population at large. a program to provide medical care, as an example, requires the government to collect the beneficiary’s name, address, telephone number, sex, age, income level, medical condition, medical history, providers’ names, and much more.” id. at 9. in addition “the government sector makes [use] of personal information. . . to investigate crime and enforce laws and regulations. governments’ ability to do these things correlates directly to the amount of information they can collect about where people go, what they do, what they say, to whom they say it, what they own, what they think, and so on. we rely on government to investigate wrongdoing by examining information that is often regarded as private in the hands of the innocent.” id. at 9. see also allen, supra note 93, at 7-9, explaining: “a sense of moral responsibility for one’s conduct and a desire for morally responsive public policies might lead to abandonment of enhancing individual data control as the central objective of privacy policy. . . it would seem unwise to prohibit the constitutionally mandated decennial census-takers from collecting personal information about household income. welfare, social security, disaster relief, student loans – all of these public benefits should be available, but surely require moral accountability in the form of personal financial disclosures.” 209. see david a. weisbach, ironing out the flat tax, 52 tax l. rev. 599 (2000), explaining that if the income tax were replaced with a flat tax and the earned income credit was to be retained, then there would be an issue as to whether to retain the partial phase-out based on overall income (as contrasted with wages). to eliminate this phase-out would allow the eic to be claimed by “those living off investments with low wages,” but to retain the phase-out would be putting “those who claim the eic, at least in part, back in an income tax system.” id. at 658-59. he notes that “[m]oving the eic out of the tax system to the welfare system does not change the analysis at all.” in addition, he points out that “[o]ne in five families now collects the eic.” id. at 658. 210. this topic will be explored further in a future article. 2004] sharing bank deposit information with other countries 648 v. conclusion this article has examined the treasury’s recent efforts to expand exchange of bank deposit information with other countries and, in particular, the criticism that these efforts involve a serious erosion of privacy. privacy, especially from scrutiny by the government, is an important value, but one that congress has balanced with other important objectives in fashioning the current tax system. under the current system, the treasury’s efforts to broaden information-sharing by the u.s. with other countries is critical to the goal of achieving an acceptable level of tax compliance (and of being sure of what level of compliance is actually being achieved). critics of the treasury’s information-sharing initiative are right to call for strong safeguards to insure that tax information is not transmitted to governments that will misuse it (or permit misuse by others). but, with such safeguards in place, it will be time for some of treasury’s critics to acknowledge that their arguments are directed not at improving the income tax, but at undermining and replacing it. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to 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publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe microsoft word simmon 1st 5 pages.doc florida tax review volume 9 2009 number 6 599 built-in gain and built-in loss property on formation of a partnership: an exploration of the grand elegance of partnership capital accounts by daniel l. simmons i. introduction ..................................................................................... 601 ii. formation of partnerships − general principles ............... 603 a. basic economic principles as reflected in capital accounts ............................................................................ 603 b. basic allocations−income items ............................................. 606 c basic allocations−loss items ................................................. 608 d. basic tax principles − contribution of property ................... 610 e. character and holding period ............................................... 611 iii. contribution of built-in gain property ................................ 613 a. allocation of recognized built-in gain .................................. 613 b. allocation methodologies ....................................................... 615 1. traditional method with the ceiling rule ........................ 615 2. traditional method with curative allocations ................. 616 3. remedial allocations ........................................................ 618 c. allocation of depreciation deductions attributable to contributed built-in gain property .............................................. 619 1. the ceiling limitation ..................................................... 621 2. curative allocations .......................................................... 623 3. remedial allocations ........................................................ 624 d. comparison of the three methods .......................................... 626 e. sale of depreciable property .................................................. 627 f. distribution of built-in gain property to a non-contributing partner ............................................................. 629 1. distributions to other partners while the contributing partner remains a partner .............................................. 629 2. distribution of property to the contributing partner ....... 634 3. extending the distribution rule clock with a partnership merger ................................................................ 636 600 florida tax review [vol. 9:6 iv. contribution of encumbered property and debt in general ..................................................................................... 656 a. some basic rules regarding partnership debt ...................... 656 b. recourse liabilities ................................................................ 657 c. nonrecourse liabilities ........................................................... 659 v. built-in loss property .................................................................. 661 a. general rules ......................................................................... 661 b. allocations of built-in loss ..................................................... 662 c. allocations of depreciation deductions with respect to built-in loss property ................................................................... 667 d. liquidation of the contributing partner ................................. 668 e. required basis adjustments with respect to built-in losses .. 670 1. distributions ....................................................................... 670 2. transfer of a partnership interest ...................................... 671 f. the trouble with post-contribution appreciation of built-in loss property and a transfer of the contributor’s interest .......... 677 g. post-contribution depreciation of built-in loss property and a transfer of the contributor’s interest ................................ 682 h. back to basis: post-contribution appreciation of built-in loss property and a transfer of the contributor’s interest .......... 684 vi. admission of a new partner to the partnership with built-in gain or loss property − reverse allocations ........... 686 a. admission of a partner to a partnership with built-in gain property ......................................................................................... 686 b. depreciation and capital recovery provisions ...................... 689 c. admission of a partner to a partnership with contributed built-in loss property ................................................................... 690 d. admission of a partner to a partnership with contributed built-in loss property and liquidation of the contributing partner ........................................................................................... 693 vii. conclusion ..................................................................................... 695 2009] built-in gain and built-in loss 601 built-in gain and built-in loss property on formation of a partnership: an exploration of the grand elegance of partnership capital accounts by daniel l. simmons∗ © 2009 i. introduction partnerships frequently are formed with an in-kind contribution of property by one or more of the initial partners. invariably, contributed property will have a value that differs from the contributing partner’s adjusted basis representing built-in gain or loss. the partnership sections of the internal revenue code (the “code”1) contain numerous provisions designed to restrict partners from shifting the tax consequence of the built-in tax gain or tax-loss that is inherent in contributed property. in addition, a partner may be admitted to an existing partnership that has property with a basis that differs from the value of the property on the partnership books, which may in turn differ from the fair market value of the property as determined for calculating the price of admission for the new partner. this circumstance also may shift accrued gains or losses from existing partners to the entering partner. the presence of built-in gains and losses raise wonderfully complex issues regarding the structure of partnerships that challenge even the most sophisticated partnership tax lawyer. this article is a primer on the issues faced by partners in dealing with the consequences of contributed built-in gain or loss property. the article explores the tax consequences of almost every aspect of the partnership treatment of built-in gain and loss property. while this article refers to partnerships throughout, the ubiquitous limited liability company, ∗ professor of law, university of california, davis. this article is based on a presentation by the author at the university of north carolina, 2007 j. nelson young tax institute. portions of the text and the facts of many of the examples are from paul mcdaniel, martin mcmahon, and daniel simmons, taxation of business organizations (foundation press 4th ed. 2006). i gratefully acknowledge the permission of foundation press to use this material. examples and discussion from federal income taxation of business organizations are indicated by footnote reference but are not placed within quotation marks. 1. internal revenue code of 1986, title 26 united states code, hereinafter cited as “irc.” 602 florida tax review [vol. 9:6 which is the favored form for many business activities, is treated as a partnership for federal income tax purposes.2 thus, the problems of built-in gain and loss property of a partnership are the same for a limited liability company. subchapter k of the internal revenue code is much maligned because of its complexity and the fact that its provisions are often used as the basis for transferring losses or avoiding gains in abusive tax shelter transactions.3 however, the statutory and regulatory structure has evolved in a most elegant fashion. subchapter k works if its basic principles are adhered to. these principles can be properly understood through close examination of the allocation of partnership gains and losses with an analysis of partnership capital accounts. as this article attempts to demonstrate, the solution to most issues under subchapter k can be found by seeking harmony between the capital accounts and tax accounts of the partnership and the partners. the statutory provisions of subchapter k should be interpreted within the overall context of subchapter k’s attempt to maintain a tax regime that accounts for economic allocations of partnership items.4 the article examines issues raised by the contribution of built-in gain and loss property at the formation of a partnership, largely through examples. the examples demonstrate that analysis of properly maintained capital accounts can be relied upon to determine the correct allocation of partnership tax items. part ii of the article discusses basic principles of partnership taxation that provide for the formation of partnerships and allocation of partnership book and tax items. a thorough understanding of these fundamental principles is a prerequisite to discussing the problems of built-in gain and loss property. part iii considers the problems raised by contributions of built-in gain property. the analysis demonstrates that recent proposed treasury regulations regarding contributed built-in gain or loss property and partnership mergers in some circumstances create mischief by 2. treas. reg. § 1.7701-3. 3. see e.g. tifd iii-e, inc. v. united states, 459 f.3d 220(2d cir. 2006). lawrence lokken, taxation of private business firms: imagining a future without subchapter k, 4 fla. tax rev. 249, 254 (1999), states, “in this writer’s opinion, because subchapter k’s flexibility and susceptibility to abuse derive from the same source, the balances struck in the statutory scheme are inherently unstable. uses of the partnership rules that the treasury finds to be abusive will continue to push the law further into complexity, and this complexity will makes [sic] less and less feasible for more and more partnerships.” 4. i recognize, of course, that the capital account provisions of the regulations can result in temporal mismatch of gains and losses and that commentators have recommended alternate approaches to avoid such results. see e.g. darryll k. jones, towards equity and efficiency in partnership allocations, 25 va. tax rev. 1047 (2006); simon friedman, some thoughts on partners’ interests in partnerships, 115 tax notes 925 (6/4/2007). 2009] built-in gain and built-in loss 603 failing to fully address deferred recognition. part iv looks at the complexity that is added by the existence of debt in the partnership. part v addresses special problems created by built-in loss property, including the issues raised by section 704(c)(1)(c) enacted in 2004. the analysis in this part demonstrates the need for analyzing partnership capital accounts in order to apply the basis limitation of section 704(c)(1)(c)(ii) in the context of its statutory purpose and suggests an interpretation of section 704(c)(1)(c)(ii) in conjunction with optional basis adjustments that produces proper allocations of loss. part vi considers partnership allocations that occur on the admission of a new partner to a partnership with built-in gain and built-in loss property. ii. formation of partnerships − general principles a. basic economic principles as reflected in capital accounts capital accounts are the starting point for establishing the relationship of the partners in a partnership.5 aside from their role in determining appropriate allocations of tax consequence, properly maintained capital accounts define the economic relationship of the partners. although the treasury regulations describing capital accounts can be daunting, the basic principles of properly maintained capital accounts are fairly straightforward. at the most basic level, capital accounts simply reflect money (or value) in and money (or value) out. on formation of a partnership, proper capital accounts are in reality an inventory of the assets contributed by each partner and a statement of each partner’s interest in the partnership measured by the value of contributed property. the initial partnership capital accounts thereby demonstrate the economic arrangement among the partners, including any implicit or explicit agreements regarding the valuation of contributed property or services. when applied correctly, the capital account rules of treasury regulations section 1.704-1(b)(2)(iv) define both the economic and tax relationship of partners. for tax purposes, the core of federal taxation of partners and partnerships is found in the proper maintenance of partnership capital accounts, which are dispositive of allocation issues among partners. indeed, the goal of the substantial economic effect test of the code6 is to insure that tax consequences to partners follow real economic consequences.7 5. detailed rules for maintaining capital accounts are in treas. reg. § 1.704-1(b)(2)(iv). see mark p. gergen, the end of the revolution in partnership tax?, 56 smu l.rev. 343 (2003), for a discussion of the evolution of capital account analysis as the basis for economic effect in partnership allocations. 6. irc § 704(b). 7. lokken, supra note 3, 255, asserts that “despite their unworkable complexity” the economic effects regulations are not successful in eliminating 604 florida tax review [vol. 9:6 at the end of the life of a partnership, the net financial history of the partnership reflected in properly maintained capital accounts provides the partners with guidance as to the liquidation interests of each partner. many practitioners will ignore partnership capital accounts in the allocation of tax items and make corresponding adjustments to capital accounts to match the partners’ expectations.8 this practice is workable if the partners can agree on their distribution rights, and, as long as capital account adjustments match the tax allocations with the economics of the partners’ capital accounts, the tax allocations are sustainable. however, in the event of a dispute among the partners, which is not an uncommon occurrence, failure to maintain proper capital accounts may result in disagreement among the partners regarding their interests in partnership assets, sometimes requiring substantial fees for experts to reconstruct capital accounts. a partner’s initial capital account is the sum of the amount of any money contributed to the partnership by the partner, plus the fair market value of any property contributed by the partner.9 a partner’s capital account is increased for any subsequent contributions by the partner to the partnership and by the amount of partnership income allocated to the partner that has not been distributed.10 these additions reflect the value of assets included in a partner’s ownership interest in the partnership capital. on the debit side, a partner’s capital account is decreased by the amount of any money distributed to the partner and by the partner’ share of partnership allocations that distort partners’ income, citing the ability to create transitory allocations over long periods or that distort timing principles. i agree that the complexity is substantial, but as i attempt to show in this paper, properly understood in the context of capital accounts neither the statute nor the regulations are unworkable. professor lokken is correct, however, that the partnership rules permit combinations of investment in a partnership that will change the nature of the taxation of the investment relative to single ownership. 8. see b. j. o’conner and s. schneider, capital-account-based liquidations: gone with the wind or here to stay? 102 jo. taxation 21 (2005). the authors describe liquidation arrangements based on schedules or formulae that allocate cash distributions (a so-called “waterfall”) rather than relying on capital accounts. id. at 22. distributions of cash and property are used to determine allocations of income and loss. these arrangements are based in part on the notion that “many clients simply do not understand capital accounts or the significance of income and loss allocations.” id. ironically, throughout the article the authors refer to an analysis of capital accounts in order to demonstrate how alternate liquidation schemes that incorporate priority distributions work. see also friedman, supra note 4, at p. 930, who suggests allocations on the basis of an adjusted cash flow system. 9. treas. reg. § 1.704-1(b)(2)(iv)(b). 10. id. 2009] built-in gain and built-in loss 605 losses.11 if property is distributed to a partner, the partner’s capital account must be reduced by the fair market value of the distributed property.12 for capital accounts to be economically meaningful (economic effect), the partners must agree that liquidation distributions to a partner will be based on the partner’s positive capital account balance, and that a partner with a deficit capital account will be required to restore the deficit in order to fund distributions of positive capital account balances to the other partners.13 capital accounts are meaningful only if they reflect what a partner ultimately may take out of the partnership. as a corollary, the interest of any one partner in any item is affected by the interests of the other partners. capital accounts are not merely an accounting device designed to satisfy the regulation’s substantial economic effect test. properly maintained capital accounts designate the interest of each partner in the assets of a partnership at any point in time. capital accounts provide a picture of the partners’ interests only if the partnership has assets available for liquidation distributions to partners with positive capital account balances.14 the book value of assets on the partnership side of the balance sheet must equal the sum of the partners’ capital accounts. nonetheless, a partner may withdraw money or property from a partnership in excess of the partner’s capital account, or a partner may be allocated losses in excess of the partner’s capital account. these situations create a negative, or deficit, capital account for a partner. a negative capital account indicates that a partner has received assets or has been allocated losses that are attributable to the capital of other partners, or to borrowed capital. properly maintained capital accounts should demonstrate to those other partners that the partner for whom a deficit capital account exists is receiving assets from the economic interests of non-deficit partners. in general, if a partner has no obligation to restore a capital account deficit, allocations of tax items to the partner that create a deficit are not permitted as they lack economic effect – the distributions or loss items are coming from the capital of other partners. the big exception to this general principle occurs in the presence of nonrecourse debt. 11. id. 12. treas. reg. § 1.704-1(b)(2)(iv)(e). this process requires revaluation of distributed property to fair market value on the date of the distribution and an allocation of the book gains and losses resulting from revaluation to the partners in accord with their share of gains and losses attributable to the distributed property. 13. treas. reg. § 1.704-1(b)(2)(ii)((b)(3). 14. the result in the seminal case orrisch v. commissioner, 55 t.c. 395, aff’d per curium, 31 a.f.t.r. 2d 1069 (9th cir. 1973), disregarding allocations of depreciation, turned on the partners’ failure to provide for distributions of partnership assets in accord with the partners’ capital accounts. 606 florida tax review [vol. 9:6 the utility of proper capital accounts can be illustrated with a simple example.15 example 1. a, b, and c form a partnership to which a contributes $100,000 in cash, b contributes whiteacre with an adjusted basis of $40,000, and c contributes blackacre with an adjusted basis of $60,000. b and c have paid differing amounts to acquire the properties, but a, b and c agree that the fair market value of whiteacre and blackacre is $100,000 each, and each partner will be treated as contributing $100,000 to the partnership. this agreement is reflected in capital accounts. under properly maintained capital accounts, the partnership’s “cost” or book value of blackacre and whiteacre will be $100,000, their fair market values.16 the partners’ agreement as to the value of the contributed properties is objectively reflected in the capital account at book values, which, immediately after the formation of the abc partnership, is as follows: assets partners’ capital accounts book value book value cash $100,000 a $100,000 whiteacre $100,000 b $100,000 blackacre $100,000 c $100,000 $300,000 $300,000 absent recognition of any realized gains or losses on disposition of the partnership assets, each partner is entitled to receive $100,000 on liquidation. b. basic allocations−income items the flexibility to freely allocate partnership income and expense items among the partners is one of the principal features of the partnership tax regime and is one of the principal benefits of the partnership form of doing business. for tax purposes, partners are allowed to allocate partnership items as they may agree as long as the allocation has “substantial economic effect,”17 which means that in the event there is an economic benefit or 15. the example is from paul mcdaniel, martin mcmahon, daniel simmons, federal income taxation of business organizations, 35 (foundation press, 4th ed. 2006). 16. treas. reg. § 1.704-1(b)(2)(iv)(b). 17. irc § 704(a) and (b). section 704(a) provides for allocation of partnership items as determined by the partnership agreement. section 761(c) provides that the partnership agreement includes any modifications up to the due date for filing the partnership tax return. these provisions permit the partners to adjust allocations of partnership items up to the date for filing the partnership return. 2009] built-in gain and built-in loss 607 economic burden that corresponds to a tax allocation, the partner to whom the tax allocation is made must receive such economic benefit or bear such economic burden.18 the scope of this flexibility can be examined through analysis of capital accounts. example 2 suppose in example 1, b’s basis and the partnership’s basis in whiteacre is $100,00019 and the partnership sold whiteacre for $130,000. the partnership has book and tax gain of $30,000. the partners can agree to share the $30,000 gain in any portion they choose as long as the book gain and tax gain are allocated the same way.20 thus, if the partners agree that the gain is shared equally, one-third each, each partner is allocated $10,000 of book gain to the partner’s capital account, and each partner is allocated $10,000 of tax gain. the partnership capital accounts will be adjusted accordingly. assets partners’ capital accounts book value book value cash $230,000 a $110,000 blackacre $100,000 b $110,000 c $110,000 $330,000 $330,000 these capital accounts demonstrate that each partner has received $10,000 of gain because each of the partners will receive a $110,000 distribution on liquidation of the partnership. alternatively, the partners might agree to allocate all $30,000 of the book gain to a, in which case the partnership capital accounts are as follows: 18. treas. reg. § 1.704-1(b)(2)(ii). the substantial economic effect test encompasses two distinct parts; (1) an allocation must have economic effect, and (2) the economic effect must be substantial in the sense that it affects the dollar amount that a partner will receive independent of tax consequences. treas. reg. §1.7041(b)(2)(iii)(a). since this paper focuses on the details of formation rather than allocations, i am omitting a discussion of the substantiality requirement. 19. basis equal to fair market value at contribution avoids application of irc § 704(c), discussed infra in the text beginning at note 40. 20. any allocation of gain to partners with positive capital account balances will satisfy the substantial economic effect test of treas. reg. § 1.704-1(b)(2), or, if the formalities of that test are not met, will be treated as in accord with the partners’ interests under treas. reg. § 1.704-1(b)(3). 608 florida tax review [vol. 9:6 assets partners’ capital accounts book value book value cash $230,000 a $130,000 blackacre $100,000 b $100,000 c $100,000 $330,000 $330,000 this latter allocation has economic effect because a will receive the $30,000 of gain on liquidation of the partnership in accord with the partnership capital accounts. partnership taxation deviates here from normal tax principles in the sense that the partnership mechanism permits partners to agree to assign items of income and deduction by agreement. the assignment of partnership items is respected as long as there is a corresponding economic consequence to the assignment. the partnership capital accounts reflect the partners’ economic arrangement as long as the capital accounts control the amount that a partner can ultimately withdraw from the partnership.21 thus, the assignment of $30,000 gain to one of the partners has an economic impact if the gain is recoverable by the partner through liquidation of the partner’s interest or earlier in a non-liquidating distribution. accordingly, the regulations provide that in order for allocations to be treated as having economic effect for tax purposes, allocations must be reflected in properly maintained capital accounts in a partnership that provides for liquidation distributions to the partners in accord with positive account balances in their capital accounts.22 c. basic allocations−loss items in general, the allocation of loss follows the same pattern as allocations of gain. loss may be allocated to partners for tax purposes as long as the allocation reflects an allocation of the economic burden of the loss. the regime of loss allocations is more complex, however, because of the use of partnerships as vehicles in tax shelter transactions for creating tax loss deductions that are divorced from economic losses. the detailed complexity of the section 704(b) regulations is beyond the scope of this paper. nonetheless, the fundamental principles are reasonably accessible. there are basically three guiding principles under the regulations. 21. these rules have been criticized because the flexibility inherent in the partnership scheme does permit partners to reallocate income in ways that do not necessarily reflect overall economic income. lokken, supra note 3, 259. 22. treas. reg. § 1.714-1(b)(2)(ii)(b)(2). 2009] built-in gain and built-in loss 609 1. you can always allocate loss items to the positive balance in a partner’s capital account. as long as no partner has a deficit capital account balance, and reductions in a partner’s capital account reflect a reduction in the amount ultimately distributable to a partner, the partner whose capital account is reduced by a loss allocation bears the economic burden of the loss.23 2. losses can be allocated against capital that a partner is committed to contribute to the partnership in the future, including a deficit restoration obligation or partner recourse debt. to the extent that a partner is liable to restore a negative capital account, thereby making the other partners whole for positive capital account balances, the partner with an obligation to restore a deficit capital account will bear the economic burden of any loss allocation.24 3. no allocation of deductions financed by nonrecourse debt25 can have economic effect. loss items which no partner is ultimately obligated to restore may be allocated to the partners in proportion to each partner’s allocation of the income or gain that will be recognized on payment of partnership liabilities that gave rise to the item (a minimum gain chargeback), e.g. nonrecourse debt funded items are allocable by profit share.26 23. this principle is derived from the rules of treas. reg. § 1.7041(b)(2)(ii) (substantial economic effect), (b)(2)(ii)(d) (the alternative economic effects test), and (b)(2)(ii)(i) (economic effect equivalence). while an allocated loss produces an immediate tax deduction, the ultimate economic burden of the loss is postponed to liquidation of the partnership. however, as the loss is immediately reflected in a devaluation of a partner’s capital account, in effect the economic impact of the loss is immediately realized in a devaluation of the value of the partner’s interest relative to the interests of other partners. 24. this principle is part of the economic effect test itself. treas. reg. § 1.704-1(b)(2)(ii)(c). this principle permits an immediate deduction for a loss that is funded by debt, a promise to repay in the future, but that is the case with any debtfunded expenditure whether incurred inside or outside of a partnership. 25. nonrecourse debt is debt for which no partner is personally liable. treas. reg. § 1.752-1(a)(2). allocations of items attributable to nonrecourse debt may be made in conformity with the safe-harbor described in treas. reg. § 1.704-2. 26. this is the minimum gain concept of treas. reg. § 1.704-2(d), which is consistent with the normal tax treatment of nonrecourse debt funded expenditures by a single taxpayer. 610 florida tax review [vol. 9:6 d. basic tax principles − contribution of property in general, gain or loss is recognized on an exchange of property for a different asset,27 which could include the contribution of property in exchange for an interest in a partnership. however, subchapter k provides a nonrecognition regime that results in tax-deferral for transfers of property by a partner to a partnership. recognition of gain or loss is deferred through statutory provisions that exchange the tax basis of contributed property for the contributor’s basis in the received partnership interest, and transfer the contributor’s basis in contributed property to the partnership. thus, section 721 provides that no gain or loss will be recognized by a partner or a partnership in the contribution of property in exchange for a partnership interest.28 section 722 provides that a partner’s basis in the partner’s partnership interest shall be the amount of money plus the basis of property contributed to the partnership. section 723 provides that the partnership’s basis in contributed property shall be the same as the basis of the contributing partner. under this regime, built-in gains and losses are preserved both in the differential between the value and basis of the contributing partner’s partnership interest and the differential between value and basis of assets within the partnership. as discussed below,29 section 704(c) operates to insure that a contributing partner ultimately recognizes pre-contribution gains and losses by allocating the tax effect of built-in gains or losses to the contributing partner. otherwise, the partnership tax regime ultimately avoids double inclusion of gains or double deduction of losses with offsetting gains or losses recognized on the termination of a partner’s partnership interest, although in particular circumstances tax gain or loss may be accelerated into a current taxable year to be offset in a later year. example 3 applying these tax rules to the abc partnership in example 1, b does not recognize the $60,000 gain realized on the exchange of whiteacre for a partnership interest worth $100,000, and c does not recognize the $40,000 gain realized on the exchange of blackacre for the partnership interest. nor does the partnership recognize gain on the receipt of whiteacre and blackacre. instead, the gains are preserved through the exchange basis rules; b’s basis in b’s partnership interest is $40,000, c’s basis in c’s partnership interest is $60,000. the abc partnership’s basis in whiteacre is $40,000, and its basis in blackacre is $60,000. the basis numbers are reflected in the partnership capital account as follows: 27. irc § 1001(c). 28. section 721 applies only to contributions of property. receipt of a partnership interest in capital in exchange for services is a taxable event. see treas. reg. § 1.721-1(b)(1). 29. infra, text at note 39. 2009] built-in gain and built-in loss 611 assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 whiteacre $100,000 $ 40,000 b $100,000 $ 40,000 blackacre $100,000 $ 60,000 c $100,000 $ 60,000 $300,000 $200,000 $300,000 $200,000 in this case, just as the values of the partnership assets are equal to the partners’ capital, the sum of the inside bases of partnership assets is equal to the sum of the outside bases of the partners’ partnership interests. this equality of inside and outside bases does not always occur.30 e. character and holding period consistent with the nonrecognition and exchange basis nature of the tax treatment of contributions of built-in gain and loss property, the tax regime contains rules for maintaining the tax character of the property. in general, a gain or loss on the sale or exchange of a partnership interest is treated as capital gain or loss to the selling partner, even though the partnership interest may have been acquired in exchange for assets that would produce ordinary income upon sale, such as inventory.31 in addition, if the contributed property was a section 1231 asset or a capital asset, a partner’s holding period for his partnership interest includes the period for which he held the contributed property.32 similarly, the partnership’s holding period will include the period that the contributing partner held the 30. the purchase and sale of partnership interests and some distributions may cause a disparity between inside and outside bases. in general, the disparity can be corrected with an election under § 754, which triggers adjustments under §§ 734(b) (distributions) and 743(b) (sales of a partnership interest). 31. irc § 741. however, if a partnership's property consists of inventory or unrealized accounts receivable, § 751(a) will require the recognition of ordinary income on a sale of the partnership interest to the extent of the selling partner’s interest in unrealized receivables and inventory, notwithstanding classification of a partnership interest as a capital asset. treas. reg. § 1.751-1(a)(2) provides that the amount treated as ordinary income is the amount of gain that would be allocated to the selling partner if the partnership sold unrealized receivables and inventory for fair market value. the remaining amount of gain treated as capital gain is determined by subtracting the amount of ordinary gain from the selling partner’s overall amount of gain or loss realized. in some situations, this subtraction can produce a capital loss in addition to ordinary income. 32. irc § 1223(1). 612 florida tax review [vol. 9:6 property.33 if the contributed property was an ordinary income asset in the hands of the contributing partner, however, the holding period of the partnership interest commences when the interest is received. if the contributing partner contributes assets consisting both of capital gain property and ordinary income property, the application of the holding period rules is not specifically spelled out. although a partnership interest is generally viewed as a unitary asset, fragmentation of the partnership interest into pieces with different holding periods seems to be the most logical answer to this problem.34 once the partnership interest itself is held for more than one year, disposition of the interest will produce longterm gains or losses. with respect to the partnership, contributed property is characterized as a capital asset, section 1231 asset, or ordinary income asset based on the purpose for which the partnership holds the property.35 there are some significant exceptions: 1. unrealized receivables contributed by a partner, such as a cash method service provider’s accounts receivable, retain their ordinary income character permanently.36 2. inventory items contributed by a partner retain their ordinary character for five years, even if the property is not held as inventory by the partnership.37 3. property with a built-in capital loss at the time of the contribution retains its character as a capital asset, to the extent of the built-in loss, for five years even though the partnership holds the asset as an ordinary income asset.38 these rules, in tandem with section 704(c), insure that a person contributing built-in ordinary gain property will ultimately recognize the property’s precontribution gain as ordinary or pre-contribution capital loss as a capital loss. 33. irc § 1223(2). 34. mcdaniel, et. al. supra note 15, 41 35. under irc § 702(b), partnership items are characterized at the partnership level and retain their character when passed-through and reported by the partner. 36. irc § 724(a). 37. irc § 724(b). 38. irc § 724(c). 2009] built-in gain and built-in loss 613 iii. contribution of built-in gain property39 a. allocation of recognized built-in gain section 704(c)(1)(a) provides that, “income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution . . .” in other words, pre-contribution built-in gain or loss is recognized by the contributing partner as an allocation from the partnership when recognized by the partnership. this rule prevents shifting of pre-contribution gain or loss from the contributing partner to other partners.40 example 4 assume that the abc partnership agreement in example 1 provides for an equal one-third division of all partnership profit and loss. the partnership balance sheet immediately following contributions by a, b, and c is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 whiteacre $100,000 $ 40,000 b $100,000 $ 40,000 blackacre $100,000 $ 60,000 c $100,000 $ 60,000 $300,000 $200,000 $300,000 $200,000 if whiteacre were sold for $100,000, the partnership has no gain for book purposes, but there is $60,000 of recognized tax gain. allocating the $60,000 tax gain in proportion to 1/3 interests of each partner would shift b’s precontribution built-in gain to partners a and c. a look at the resulting capital accounts demonstrates that this is the wrong result: 39. built-in gain or loss property is contributed property with a difference in the book value and tax basis at the time of contribution. treas. reg. § 1.7043(a)(3)(ii). 40. section 704(c)(1)(a) is applied on a property by property basis. the contributing partner is not permitted to aggregate the bases and value of contributed property to offset built-in gain on one asset with a built-in loss on another. treas. reg. § 1.704-3(a)(2). 614 florida tax review [vol. 9:6 assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $120,000 whiteacre/cash $100,000 $100,000 b $100,000 $ 60,000 blackacre $100,000 $ 60,000 c $100,000 $ 80,000 $300,000 $260,000 $300,000 $260,000 the allocation creates a disparity in the cash partner a’s book and tax accounts by the amount of the gain. recognition of the $20,000 of tax gain allocated to a on sale of whiteacre is translated into a $20,000 tax loss that is deferred until the date a disposes of or liquidates a’s partnership interest.41 b recognizes only $20,000 of b’s $60,000 pre-contribution built-in gain. the remaining $40,000 of b’s gain, which has been shifted to a and c, is deferred until a disposition or liquidation of b’s partnership interest. to prevent the shifting of b’s built-in gain to the other partners, section 704(c) requires that the partnership’s $60,000 tax gain be allocated to the contributing partner, b. thus, assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 whiteacre/cash $100,000 $100,000 b $100,000 $100,000 blackacre $100,000 $ 60,000 c $100,000 $ 60,000 $300,000 $260,000 $300,000 $260,000 the allocation required by section 704(c)(1)(a) has the effect of eliminating the book/tax disparity in b’s capital account. although the allocation rules of the regulations42 applying section 704(c) are complex, the guiding principle is that allocations related to differences in fair market value and basis at the time of contribution of property to a partnership are to be made in a manner that reduces the disparity between partners’ book and tax accounts. thus, properly maintained capital accounts are the guide to section 704(c) allocations. this can be seen in the following example: example 5 assume in example 4 that whiteacre is sold for $130,000, producing $30,000 of book gain ($130,000 $100,000) and $90,000 of tax gain ($130,000 $40,000). the book gain is allocated equally 41. liquidation of the partner’s interest for a cash payment that is less than basis results in a recognized loss to the partner. irc § 731(a)(2). 42. treas. reg. § 1.704-3. 2009] built-in gain and built-in loss 615 among the partners, 1/3 each. $10,000 of tax gain is allocated to each partner to match the allocation of book gain, so a and c are each allocated $10,000 of tax gain. b also is allocated $10,000 of tax gain to match b’s share of the book gain. in this respect, the tax consequences of the $30,000 of recognized book gain follow the economic allocation of this gain. the remaining $60,000 of tax gain ($90,000 $30,000), b’s pre-contribution built-in gain, is allocated to b. b’s total tax gain is $70,000. the result is reflected in partnership capital accounts as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $110,000 $110,000 whiteacre/cash $130,000 $130,000 b $110,000 $110,000 blackacre $100,000 $ 60,000 c $110,000 $ 70,000 $330,000 $290,000 $330,000 $290,000 a’s and b’s book and tax accounts are the same. c’s tax account is $40,000 less than book reflecting c’s pre-contribution built-in gain for blackacre. b. allocation methodologies complications arise when tax items attributable to built-in gain and loss property are not sufficient to match book gains and losses. example assume in example 4 that whiteacre is sold for $70,000. in this case the partnership realizes a $30,000 book loss ($70,000 $100,000) that is shared equally by the partners, $10,000 each. there is recognized tax gain of $30,000 ($70,000 – adjusted basis of $40,000). 1. traditional method with the ceiling rule under the traditional method of treasury regulations section 1.7043(b), on the disposition of contributed property the partnership must allocate to the contributing partner the built-in gain or loss inherent in the property at the time it was contributed to the partnership. there is no provision for matching the economic gains or losses of the partners as reflected in their capital accounts with tax items. indeed, the traditional regulation specifically limits allocations of tax items with a so-called “ceiling rule.”43 thus, in 43.treas. reg. § 1.704-3(b)(1) provides that, “the total income, gain, loss, or deduction allocated to the partners for a taxable year with respect to a property cannot exceed the total partnership income, gain, loss, or deduction with respect to that property for the taxable year (the ceiling rule).” for a discussion of the ceiling rule and other allocation methods under the regulations see laura cunningham, use 616 florida tax review [vol. 9:6 example 6, the $30,000 tax gain is allocated entirely to b. partners a and c each have a $10,000 book loss but no accompanying tax loss. the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $ 90,000 $100,000 whiteacre/cash $ 70,000 $ 70,000 b $ 90,000 $ 70,000 blackacre $100,000 $ 60,000 c $ 90,000 $ 60,000 $270,000 $230,000 $270,000 $230,000 the allocation of a book loss to a with no corresponding tax loss creates a disparity in a’s book and tax accounts. a’s partnership basis is $10,000 higher than a’s capital account. this excess basis reflects a’s share of economic loss, but not tax loss, on the sale of blackacre. a’s recognition of this economic loss is deferred for tax purposes until a realizes a $10,000 loss on disposition of a’s partnership interest. likewise, c’s book loss will be reflected as a $10,000 reduction of gain realized on disposition of c’s partnership interest. b’s realization of b’s remaining $20,000 precontribution gain ($60,000 $10,000-$30,000) is also deferred. as a result, deferral of b’s built-in gain causes a timing shift with the creation of deferred recognition of economic loss to a and c. 2. traditional method with curative allocations reasonable curative allocations permit a partnership to eliminate the timing distortions caused by the ceiling rule with curative allocations of other partnership income or deduction items of the same character as the tax items affected by the ceiling rule.44 these curative allocations of other partnership tax items of income, gain, loss, or deduction may be used to “cure” disparities caused by the ceiling rule by equalizing the overall allocations of economic and tax items to non-contributing partners, but only to the extent the curative allocation offsets the effect of the ceiling rule.45 curative allocations of tax deviate from the book allocations of the same items. thus, except as they are expressly permitted by treasury regulations section 1.704–3(c), curative allocations generally would not be valid under the substantial economic effect tests of treasury regulations section 1.704– 1(b). example 6a assume that the partnership in example 6 had $20,000 and abuse of section 704(c), 3 fla. tax rev. 93 (1996). 44. treas. reg. § 1.704-3(c). see mcdaniel et. al., supra note 15, 157. 45. treas. reg. § 1.704-3(c)(3). 2009] built-in gain and built-in loss 617 of expense and $20,000 of income from sources that matched the character of the partnership’s $30,000 tax gain from the sale of whiteacre. the partnership thus breaks even apart from its gain on the sale of whiteacre. the partnership’s only book item is its $30,000 book loss realized on the sale of whiteacre. although there are no allocations of book income and loss attributable to the partnership’s offsetting income and loss, in order to match the $20,000 of book loss that is divided between a and c on the sale of whiteacre with a tax loss, the partnership’s $20,000 of tax deductible expenses may be allocated to a and c, and none to b. this allocation cures the absence of allocable tax loss and matches the book loss from the sale of whiteacre. thus, a and c may each be allocated $10,000 of net tax loss. although there is no book income to match the operating income, the full $20,000 of taxable operating income is allocable to b to balance the $20,000 of expense allocated to a and c. b also is allocated the $30,000 of tax gain from disposition of whiteacre.46 the allocation of the partnership’s tax items is as follows: total a b c gain from whiteacre $30,000 $30,000 income $20,000 $20,000 deductible expense ($20,000) ($10,000) ($10,000) total tax affect $30,000 ($10,000) $50,000 ($10,000) these allocations reduce or eliminate disparities in the partners’ book and tax accounts by matching each partner’s tax allocation with the partner’s book loss. 47 the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $ 90,000 $ 90,000 whiteacre/cash $ 70,000 $ 70,000 b $ 90,000 $ 90,000 blackacre $100,000 $ 60,000 c $ 90,000 $ 50,000 $270,000 $230,000 $270,000 $230,000 46. irc § 704(c)(1)(a). 47. the book/tax disparity in c’s capital account is attributable to the difference in basis and value of c’s initial contribution of built-in gain property that remains preserved in the difference between the value of c’s partnership interest and outside basis. 618 florida tax review [vol. 9:6 3. remedial allocations rather than curative allocations of existing partnership items, the remedial allocation method of treasury regulations section 1.704-3(d) eliminates distortions of the ceiling rule with tax allocations of notional partnership gain or income that are offset by tax allocations of notional partnership deduction or loss.48 the creation of notional items of income or loss that do not reflect economic income or loss creates tax items without any recognition event.49 however, remedial allocations result in each partner recognizing total partnership income, gains, deductions, or loss for the year equal to the partner’s share of book gain or loss. remedial allocations are in addition to allocations under the ceiling rule. thus, the partnership makes a remedial allocation of notional income, gain, deduction, or loss (without affecting allocations of actual partnership income, gain, deduction, or loss) to the non-contributing partner equal to the difference in book and tax allocations caused by the ceiling limitation, and a simultaneous offsetting notional allocation of income, gain, deduction, or loss to the contributing partner. example 6 in example 6, where the partnership has a book loss of $30,000 and a tax gain of $30,000 on sale of the property contributed by b, and no other items of income or loss, the partnership may make remedial allocations to give each partner tax items equivalent to the partner’s book items. thus – a b c tax book tax book tax book gain (loss) from whiteacre ($10,000) $30,000 ($10,000) ($10,000) remedial allocation ($10,000) $20,000 ($10,000) ($10,000) ($10,000) $50,000 ($10,000) ($10,000) ($10,000) the partnership capital account is the same as in example 6a. a’s and c’s remedial deductions, and b’s corresponding notional income item, must be of the same character as the income item from the property that was sold.50 if the property is a capital asset, the remedial allocations must be capital gain and loss; if the property is an ordinary income asset, the remedial allocations must be ordinary gain and loss. if, as 48. see mcdaniel et. al., supra note, 15, 158. 49. treas. reg. § 1.704-3(d)(5)(i). 50. treas. reg. § 1.704-3(d)(3). 2009] built-in gain and built-in loss 619 is often likely, the property is a section 1231 asset, the remedial allocations must be section 1231 gain and loss, even though in some cases a character mismatch may occur after taking into account each partners other items of section 1231 gain and loss.51 remedial allocations must also be treated as arising from the same activity as the underlying section 704(c) item for purposes of applying the passive activity loss rules of section 469.52 even though remedial allocations involve purely notional tax items, remedial allocations of income, gain, deduction, and loss are treated as real tax items that are taken into account in adjusting partners’ bases in their partnership interests under section 705 in the same manner as distributive shares of partnership taxable income.53 remedial allocations, however, do not affect either partnership taxable income under section 703 or the partnership’s adjusted basis in any of its property.54 example 7to demonstrate that we are on the right track here, assume that in either example 6a or 6b the partnership sells blackacre for $100,000, realizing no book gain or loss and a $40,000 tax gain. the tax gain must be allocated to c (the contributing partner) under section 704(c)(1)(a). the partnership capital accounts are now – assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $ 90,000 $ 90,000 whiteacre/cash $ 70,000 $ 70,000 b $ 90,000 $ 90,000 blackacre/cash $100,000 $100,000 c $ 90,000 $ 90,000 $270,000 $270,000 $270,000 $270,000 the partnership has eliminated all of its inside built-in gain and loss and there are no built-in gains or losses in the partners’ interests. the various 704(c) allocations, along with either the curative or remedial allocations of treas. reg. section 1.704-3(c) or (d) eliminate the partners’ book/tax differences with the result that each partner recognizes tax gains and losses appropriate to the partner’s share of economic gain or loss. c. allocation of depreciation deductions attributable to contributed built-in gain property contribution to a partnership of depreciable property with a value different than adjusted basis raises the same sort of allocation issues with 51. mcdaniel et al., supra note 15, 159. 52. id. 53. treas. reg. § 1.704-3(d)(4)(ii). 54. treas. reg. § 1.704-3(d)(4)(i). 620 florida tax review [vol. 9:6 respect to the allocation of depreciation deductions among the partners as allocations of recognized pre-contribution gain. under section 704(c)(1)(a), allocations of depreciation and of gain or loss on depreciable property must reflect the difference between the contributing partner’s basis in the property and the book value of the property included in the contributing partner’s capital account. tax depreciation and book depreciation generally must be computed at the same rate in order to maintain capital accounts in the required manner. thus, book depreciation is the same proportion of book basis as tax depreciation bears to adjusted basis so that book and tax depreciation is accounted for at the same rate.55 the principles of section 704(c) apply to allocations of depreciation deductions attributable to contributed property with built-in gain or loss in the same fashion as allocations of built-in gain. the overriding principal is that allocations of tax depreciation to a non-contributing partner should match the partner’s share of book depreciation. any remaining tax depreciation is allocated to the contributing partner. section 704(c) principles thereby assure that depreciation deductions allocated to the partners for tax purposes reflect the economic deductions allocated to the partners’ capital accounts. again, properly maintained capital accounts provide the guide to consistent allocations under section 704(c). correct allocations will reduce the disparity between the partners’ book and tax accounts. example 8 d and e form a partnership to which d contributes $100,000 cash and e contributes depreciable property with a book value of $100,000 and a basis of $60,000.56 each partner has a 50% interest in partnership capital and profits. the initial partnership capital account is as follows: assets partners’ capital accounts book basis book basis cash $100,000 $100,000 d $100,000 $100,000 depreciable property $100,000 $ 60,000 e $100,000 $ 60,000 $200,000 $160,000 $200,000 $160,000 55. treas. reg. § 1.704-1(b)(2)(iv)(g)(3). in the case of capital recovery deductions, the rules for book income and expense depart from economic reality. by allowing capital recovery methods for book depreciation that mirror the accelerated tax depreciation methods of irc § 168, the capital account rules require capital recovery for book purposes that does not necessarily represent the actual annualized cost of depreciable assets. 56. this example is derived, with changes, from mcdaniel et. al., supra note 15, 160. 2009] built-in gain and built-in loss 621 assume, for simplicity, that under section 168 the property has a ten-year cost recovery period with five years remaining and its cost is recoverable using the straight line method. also assume that the de partnership breaks even for both tax and book purposes apart from the annual depreciation deductions. under the traditional method, book depreciation is computed using the property’s remaining tax cost recovery period for the entire book value.57 thus, the annual tax depreciation is $12,000 per year (starting basis of $120,000/10 years) and book depreciation for each of the remaining five years is $20,000 ($100,000/5 years). d and e’s annual share of book depreciation is $10,000 each. in effect, d has purchased a 50% interest in the property for $50,000 and should, therefore, be entitled to $10,000 of depreciation in each of the remaining five years of the asset recovery period. to match the non-contributing partner’s share of book depreciation, d must be allocated $10,000 of tax depreciation. the remaining $2,000 of tax depreciation is allocated to e.58 over five years, the disparity between book and tax accounts is reduced, then eliminated, as follows: d e book tax book tax initial capital account $100,000 $100,000 $100,000 $60,000 year 1 depreciation ($ 10,000) ($ 10,000) ($ 10,000) ($ 2,000) end of year 1 capital account $ 90,000 $ 90,000 $ 90,000 $58,000 year 2 depreciation ($ 10,000) ($ 10,000) ($ 10,000) ($ 2,000) end of year 2 capital account $ 80,000 $ 80,000 $ 80,000 $56,000 year 3 depreciation ($ 10,000) ($ 10,000) ($ 10,000) ($ 2,000) end of year 3 capital account $ 70,000 $ 70,000 $ 70,000 $54,000 year 4 depreciation ($ 10,000) ($ 10,000) ($ 10,000) ($ 2,000) end of year 4 capital account $ 60,000 $ 60,000 $ 60,000 $52,000 year 5 depreciation ($ 10,000) ($ 10,000) ($ 10,000) ($ 2,000) end of year 5 capital account $ 50,000 $ 50,000 $ 50,000 $50,000 1. the ceiling limitation the ceiling limitation on the traditional method will create timing distortions when the remaining tax depreciation on contributed property is 57. treas. reg. § 1.704-3(b)(2), ex. (2). 58. this is the traditional method of treas. reg. § 1.704-3(b). 622 florida tax review [vol. 9:6 less than the book depreciation allocable to the non-contributing partner. under the ceiling limitation, allocations of tax items cannot exceed the total partnership income, gain, loss, or deduction attributable to the contributed property.59 thus, in the absence of sufficient basis at the time of contribution, tax depreciation available for allocation to non-contributing partners will be less than the non-contributing partner’s allocation of book depreciation. example 9a assume in example 8 that e’s adjusted basis in the contributed depreciable property is only $40,000. in this case there is again $20,000 of annual book depreciation, but only $8,000 of annual tax depreciation (starting basis of $80,000/10 years). the full $8,000 of tax depreciation must be allocated to d, which is insufficient to match d’s $10,000 share of book depreciation. d e book tax book tax initial capital account $100,000 $100,000 $100,000 $40,000 year 1 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 end of year 1 capital account $ 90,000 $ 92,000 $ 90,000 $40,000 year 2 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 end of year 2 capital account $ 80,000 $ 84,000 $ 80,000 $40,000 year 3 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 end of year 3 capital account $ 70,000 $ 76,000 $ 70,000 $40,000 year 4 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 end of year 4 capital account $ 60,000 $ 68,000 $ 60,000 $40,000 year 5 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 end of year 5 capital account $ 50,000 $ 60,000 $ 50,000 $40,000 while d has paid $50,000 for a 50% interest in the depreciable property, d is allowed only $40,000 of tax depreciation over the remaining useful life of the property, leaving $10,000 of unrecovered cost in d’s outside partnership basis. d will recover that cost on final disposition of d’s partnership interest as a $10,000 loss, thereby deferring cost recovery beyond what is allowed under the depreciation method. 59. treas. reg. § 1.704-3(b) 2009] built-in gain and built-in loss 623 2. curative allocations the distortions created by the ceiling rule can be cured with reasonable curative allocations.60 the curative method permits a curative allocation of a deductible item for current expenses to the non-contributing partner (without a matching reduction in book income) or a curative allocation of ordinary income to the contributing partner (again without a matching allocation of book income). example 9b if the de partnership in example 9a also had $4,000 of gross income each year, or $4,000 of additional deductions, these items could be allocated differently from the partners’ share of the items for book purposes in order to cure the disparity between the book and tax accounts. assume that each year the partnership has an additional $4,000 of ordinary income that is allocated $2,000 to each partner for book purposes. in order to cure d’s $2,000 shortfall in tax depreciation, the full $4,000 of tax includible gross income may be allocated to e, even though e’s share of the income for book purposes is only $2,000. as a result, each year d receives $2,000 of book income without a corresponding allocation of taxable gross income to offset the $2,000 shortfall in allocated depreciation. e pays the tax on the $2,000 of book income allocated to d. the allocations of income and depreciation to the partners are as follows – d e book tax book tax initial capital account $100,000 $100,000 $100,000 $40,000 year 1 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 year 1 income $ 2,000 0 $ 2,000 $ 4,000 end of year 1 capital account $ 92,000 $ 92,000 $ 92,000 $44,000 year 2 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 year 2 income $ 2,000 0 $ 2,000 $ 4,000 end of year 2 capital account $ 84,000 $ 84,000 $ 84,000 $48,000 year 3 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 year 3 income $ 2,000 0 $ 2,000 $ 4,000 end of year 3 capital account $ 76,000 $ 76,000 $ 76,000 $52,000 year 4 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 60. treas. reg. § 1.704-3(c). 624 florida tax review [vol. 9:6 year 4 income $ 2,000 0 $ 2,000 $ 4,000 end of year 4 capital account $ 68,000 $ 68,000 $ 68,000 $56,000 year 5 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 year 5 income $ 2,000 0 $ 2,000 $ 4,000 end of year 5 capital account $ 60,000 $ 60,000 $ 60,000 $60,000 over the recovery period of the depreciable property, the allocation of an extra $10,000 of taxable income to e (which lacks economic effect because the economic allocation of income between the partners does not match the allocation of tax consequence), and the allocation of $10,000 of book income without an allocation of tax income, cures d’s loss of $10,000 of depreciation deductions attributable to d’s cost in book terms of d’s interest in the depreciable property. the same result could be accomplished if the partnership had a current expense deduction of $4,000. while the book allocation of the expense would be $2,000 to each partner, the full $4,000 tax deduction could be allocated to d as a curative allocation, representing d’s $2,000 book share of the item and an additional $2,000 deduction representing the cure for d’s depreciation shortfall. 3. remedial allocations the remedial allocation method is available to cure the timing distortions of the ceiling rule if a partnership with depreciable built-in gain property lacks sufficient income or expense items to cure the distortion.61 however, application of remedial allocations requires a two part process that has the effect, when compared to curative allocations, of delaying capital recovery for the non-contributing partner. under the regulations,62 a portion of the partnership’s book basis in property equal to its tax basis is recovered in the same manner as the tax basis. the remainder of the partnership’s book basis over adjusted tax basis is recovered under the recovery method available to the partnership for newly purchased property as of the date of the contribution. in this second step, the excess of book basis over tax basis is recovered as if the property were placed in service in the year of the contribution. example 9c assume in example 9a that the partnership has no ordinary income items or expenses other than its depreciation deductions. to determine the remedial allocations, first an amount of the book value of the asset equal to its tax basis is recovered for book purposes over the remaining 61. treas. reg. § 1.704-3(d). 62. treas. reg. § 1.704-3(d)(2). 2009] built-in gain and built-in loss 625 tax cost recovery period of the contributed asset. in the de partnership this amount is $8,000 per year ($40,000 adjusted basis recovered over 5 years). the $60,000 difference between the book value of the depreciable property ($100,000) and its adjusted basis ($40,000) is treated as depreciable property placed in service in the year of the contribution. this second item generates $6,000 of annual book depreciation deductions over ten years (on a straight line basis). the two depreciation items are combined during the remaining tax recovery period of the contributed asset. thus, total book depreciation in each of the first five years is $14,000 ($8,000 plus $6,000), which is allocated equally to each partner. in years 6 – 10 there is $6,000 of book depreciation, allocable $3,000 to each partner. in years 1 – 5, the $8,000 of tax depreciation is available to allocate $7,000 to d (the non-contributing partner) to match d’s share of the book depreciation in those years, leaving $1,000 of tax depreciation for allocation to e. in years 5 – 10, d’s share of the book depreciation is $3,000 but there is zero tax depreciation. during this second period, d is allocated a notional tax depreciation deduction equivalent to d’s $3,000 share of book depreciation. a remedial amount of notional taxable income of $3,000 must be allocated to e. the partnership allocations in each of the ten years of the useful life of the depreciable property are as follows: d e book tax book tax initial capital account $100,000 $100,000 $100,000 $40,000 year 1 depreciation ($ 7,000) ($ 7,000) ($ 7,000) ($ 1,000) year 2 depreciation ($ 7,000) ($ 7,000) ($ 7,000) ($ 1,000) year 3 depreciation ($ 7,000) ($ 7,000) ($ 7,000) ($ 1,000) year 4 depreciation ($ 7,000) ($ 7,000) ($ 7,000) ($ 1,000) year 5 depreciation ($ 7,000) ($ 7,000) ($ 7,000) ($ 1,000) year 6 depreciation ($ 3,000) ($ 3,000) ($ 3,000) 0 notional income $ 3,000 year 7 depreciation ($ 3,000) ($ 3,000) ($ 3,000) 0 notional income $ 3,000 year 8 depreciation ($ 3,000) ($ 3,000) ($ 3,000) 0 notional income $ 3,000 year 9 depreciation ($ 3,000) ($ 3,000) ($ 3,000) 0 notional income $ 3,000 year 10 depreciation ($ 3,000) ($ 3,000) ($ 3,000) 0 income $ 3,000 end of year 10 capital account $50,000 $50,000 $50,000 $50,000 626 florida tax review [vol. 9:6 over the ten year period, d receives capital recovery deductions representing d’s full cost for the depreciable property. e’s pre-contribution gain is recovered through reduced depreciation deductions and nominal allocations of ordinary income. d. comparison of the three methods over the life of a partnership investment, including liquidation or disposition of a partner’s interest, the total income and loss realized for tax purposes is the same for each partner under each of the three methods: the traditional method with the ceiling rule, curative allocations, or remedial allocations. however, the timing of the tax consequences varies with each method. one partner’s timing advantage is the other partner’s timing disadvantage. comparing the alternative allocations in example 9 reveals that the curative allocation is most beneficial to d, allowing d to recover the additional $10,000 of depreciation deductions more rapidly than either of the other methods, while the traditional method is the least beneficial to d because d’s deductions for depreciation are less than d’s book loss and d’s full recovery is deferred to disposition of d’s partnership interest. conversely, the traditional method is the most beneficial to e, allowing e to avoid recognition of a portion of e’s pre-contribution built-in gain until disposition of e’s partnership interest, while the curative allocation method is the least beneficial to e because it requires recognition of additional taxable income earlier than under the remedial method. the treasury is not affected by these choices unless the partners are in different tax rate brackets or one of the partners is a tax exempt entity. at any given discount rate, the net present value of the aggregate net income or loss of the partners over the cost recovery period of the asset is identical.63 this is the reason that partners are given the flexibility to choose among the different methods. however, if an allocation is made with a view to shifting tax consequences among partners in a manner that substantially reduces the present value of the aggregate tax liability, the anti-abuse rule of the regulations will cause the allocation to be disregarded as unreasonable.64 63. mcdaniel, et. al, supra note 15, 167. 64. treas. reg. § 1.704-3(a)(10) provides: “an allocation method (or combination of methods) is not reasonable if the contribution of property (or event that results in reverse § 704(c) allocations) and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability.” prop. reg. § 1.704-3(a)(10) (2008) would require that in testing for a shift in tax consequences, the tax consequences of both indirect and direct partners be taken into account. indirect partners include the participants in an entity that is a partner in the partnership that has § 704(c) items. the proposed regulation would apply to a 2009] built-in gain and built-in loss 627 given the shift of income, actual or notional, to a contributing partner, the contributor of low basis high value depreciable property is not going to have a strong interest in agreeing to either curative or remedial allocations in a partnership agreement, or at least without some form of compensation for the acceleration of income. nonetheless, competent representation of a non-contributing partner in this situation would seem to require raising the issue in negotiating contributions of built-in gain property to account for the present value of the loss of the depreciation deductions.65 e. sale of depreciable property allocations of depreciation with respect to contributed built-in gain or loss property affect the allocation of gain or loss on the partnership’s disposition of the property. again, section 704(c) operates to allocate tax gain and loss to the non-contributing partner(s) to match the non-contributing partner’s book gains and losses, subject to the ceiling rule.66 taxable gain or loss in excess of book gain is allocated to the contributing partner. example 10 suppose the de partnership in example 8 sold the depreciable property at the end of year 2 for $70,000. immediately before the sale, after two years of depreciation deductions, the partnership capital account is as follows: assets partners’ capital accounts book basis book basis cash $100,000 $100,000 d $ 80,000 $ 80,000 depreciable property $ 60,000 $ 36,000 e $ 80,000 $ 56,000 $160,000 $136,000 $160,000 $136,000 partnership, subchapter s corporation, estate, trust, or a controlled foreign corporation that is a 10 percent partner. indirect partners also include members of a consolidated group of corporations where a member of the group is a partner in the partnership. prop. reg. § 1.704-3(a)(1) would provide that the allocation methods of treas. reg. § 1.704-3 would apply only to contributions to a partnership that “are otherwise respected.” the proposed regulations would add that even though an allocation complies with the literal language of treas. reg. § 1.704-3(b), (c), or (d), “the commissioner can recast the contribution as appropriate to avoid tax results inconsistent with the intent of subchapter k.” the proposed changes would be effective on publication of final regulations in the federal register. 65. for an analysis of the impact of depreciation on the after-tax return from depreciable property see paul mcdaniel, martin mcmahon, daniel simmons, and gregg polsky, federal income taxation, 1193 et. seq. (foundation press 6th ed. 2008). 66. treas. reg. § 1.704-3(b)(1). see discussion supra, text at note 43. see also treas. reg. § 1.704–3(b)(2), ex. (1)(ii). 628 florida tax review [vol. 9:6 under the partnership agreement, the partnership’s book gain of $10,000 ($70,000 $60,000) is allocated equally between d and e, $5,000 each. under § 704(c), the partnership’s tax gain, $34,000 ($70,000 $36,000), is allocated $5,000 to d to match d’s book gain, and $29,000 to e, the contributing partner. as a result, the partnership capital account is as follows: assets partners’ capital accounts book basis book basis cash $100,000 $100,000 d $ 85,000 $ 85,000 depreciable property/cash $ 70,000 $ 70,000 e $ 85,000 $ 85,000 $170,000 $170,000 $170,000 $170,000 for purposes of determining the amount of any tax gain recognized by a partner that is treated as ordinary income under the section 1245 recapture rules,67 each partner will recapture the partner’s share of depreciation allocated to the partner while the property was held by the partnership.68 curative and remedial allocations to a non-contributing partner as a substitute for depreciation deductions are included in the partner’s share of section 1245 recapture.69 also, curative allocations of income to the contributing partner increase the non-contributing partner’s share of section 1245 recapture.70 curative and remedial allocations of ordinary income items to the contributing partner reduce the contributing partner’s share of section 1245 recapture, which has already been recovered as ordinary income recognized by the contributing partner.71 curative allocations of deduction items to non-contributing partners reduce the contributing partner’s share of section 1245 recapture.72 thus, additional ordinary income allocated to the contributing partner is treated as a recapture of the contributing partner’s 67. irc § 1245(a) requires that on any disposition of depreciable personal property, the transferor will recognize as ordinary gain the lesser of the amount realized (or fair market value of the property) over its adjusted basis, or the amount of basis recomputed by adding back all adjustments such as depreciation over adjusted basis. in other words, § 1245 recaptures as ordinary income the lesser of gain recognized or past depreciation deductions. 68. treas. reg. § 1.1245-1(e)(2)(ii)(a). 69. treas. reg. § 1.1245-1(e)(2)(ii)(c)(2) and (3). 70. treas. reg. § 1.1245-1(e)(2)(ii)(c)(2). 71. treas. reg. § 1.1245-1(e)(2)(ii)(c). 72. id. recall that the non-contributing partner’s share of tax depreciation can be enhanced either by curative allocations of income items to the contributing partner or curative items of deduction to the non-contributing partner. see supra, text at note 60. 2009] built-in gain and built-in loss 629 depreciation deductions, but not in an amount in excess of the depreciation claimed by the contributing partner.73 f. distribution of built-in gain property to a non-contributing partner the allocation of recognized built-in gain or loss to the contributing partner under section 704(c)(1)(a) is not possible if the contributing partner leaves the partnership before the gain is recognized, or if the property is distributed to another partner without partnership level recognition of the pre-contribution gain. sections 704(c)(1)(b) and 737 restrict these potential routes of escape from the built-in gain or loss of contributed property by requiring the contributing partner to recognize the built-in gain or loss. 1. distributions to other partners while the contributing partner remains a partner section 704(c)(1)(b) requires the contributing partner to recognize gain or loss on the distribution of contributed property subject to section 704(c)(1)(a) to a partner other than the contributing partner within seven years of the date of contribution. the contributing partner’s gain or loss is the amount that would have been allocated to the contributing partner if the partnership had sold the property to the distributee partner for its fair market value. the amount of pre-contribution built-in gain or loss remaining in the contributed property on the date of its distribution will depend on allocations of income and deductions, such as depreciation, during the period that the property is held by the partnership. thus, the amount of gain or loss recognized will depend on the particular allocation method adopted by the partnership, e.g., traditional method with the ceiling rule versus curative or remedial allocations.74 the character of the contributing partner’s gain or loss is the same as it would have been if the property had been sold by the partnership to the distributee partner.75 example 11in example 9b, using curative allocations, after three years of depreciation the partnership capital account is as follows: assets partners’ capital accounts book basis book basis cash $112,000 $112,000 d $ 76,000 $ 76,000 depreciable property $ 40,000 $ 16,000 e $ 76,000 $ 52,000 $152,000 $128,000 $152,000 $128,000 73. treas. reg. § 1.1245-1(e)(2)(ii)(c)(2) and (3) each provide for a reduction in the recapture amount but not below zero. 74. see treas. reg. § 1.704-4(a)(5), ex. (1) – (3). 75 treas. reg. § 1.704-4(b). 630 florida tax review [vol. 9:6 assume that the property is distributed to d in a partial reduction of d’s partnership interest when fair market value of the depreciable property is the same as its book value, $40,000. if the partnership had sold the depreciable property for $40,000, the partnership’s $24,000 of tax gain ($40,000 $16,000) would have been allocated to e (there is no book gain).76 thus, e must recognize $24,000 of tax gain on the distribution to d.77 e’s basis in e’s partnership interest is adjusted for the gain recognized by e.78 likewise, the partnership’s basis in the property is adjusted to reflect gain or loss recognized by the contributing partner.79 analysis of the tax consequence of the distribution to d, the noncontributing partner, requires an examination of the basic rules applicable to partnership distributions. first, the partnership capital accounts are adjusted by revaluing the distributed property to its fair market value, as generally will be agreed to by the partners in approving the distribution, and allocating any book gain or loss among the partners in accord with the partnership agreement.80 as a practical matter, on any distribution of property (other than cash), including the liquidation of a partner’s interest, or admission of a new partner,81 capital accounts should be revalued as permitted by the regulations in order to properly reflect the partners’ interests in the partnership immediately following the transaction.82 d’s capital account is reduced by $40,000 to reflect the fair market value of the distributed property.83 76. any additional gain, creating book gain, would require an allocation of the additional tax gain to d and e in the amount of the allocation of book gain. thus, if the property had been sold for $42,000, creating $2,000 of book gain and $26,000 of tax gain, d would be allocated $1,000 of the tax gain to match d’s book gain, and e would be allocated $25,000 of tax gain ($1,000 + $24,000). 77. see e.g. treas. reg. § 1.704-4(a)(5), ex. (3). 78. irc § 704(c)(1)(b)(iii); treas. reg. § 1.704-4(e)(1) and (2). 79. id. 80. treas. reg. § 1.704-1(b)(2)(iv)(f). 81. see infra, text at note 124. 82. howard e. abrams, the section 734(b) basis adjustment needs repair, 57 tax law., 347-348 (2004), who states, “although current aw does not require the restatement, most advisors recommend it, [fn omitted] and the regulations are clear that if a restatement is not made, the partnership will be closely scrutinized to determine if the failure to restate capital accounts represents an inappropriate sifting of value between related parties.” see also, gergen, supra note 5, 347, 352 et. seq., who indicates that professionally drafted partnership agreements routinely require adjustments on shifts of partner interests and advocates that mandatory revaluation of assets on a distribution that changes partners’ sharing ratios. 83. treas. reg. § 1.704-1(b)(2)(iv)(e). since the example assumes that the property’s fair market value is the same as its book value, there are no adjustments to the partnership’s book accounts to reflect revaluation. 2009] built-in gain and built-in loss 631 distribution of the property out of the partnership reduces the partnership’s capital account to reflect the value of property leaving the partnership.84 section 731(a) provides that no gain or loss is recognized on the distribution of money or property to a partner, except to the extent that a distribution of money exceeds the partner’s basis in the partner’s partnership interest. d does not recognize gain or loss on the non-liquidating distribution of partnership property. as a corollary to this nonrecognition provision, the basis of the distributed property is unchanged; the partnership’s basis (as adjusted to reflect the gain allocated to contributing partner by section 704(c)(1)(b)) is transferred to d.85 the distributee partner’s basis in the partnership interest is reduced by the basis transferred to the distributed property,86 which reflects the transfer of a portion of the distributee’s aftertax investment in the partnership to the distributed property. thus’ d’s basis in the distributed property is $40,000; the partnership’s $16,000 adjusted basis increased by the $24,000 gain recognized by e. d’s basis in d’s partnership interest is reduced by the amount of d’s basis in the distributed property, $40,000, to $36,000. while d and e may generally continue as 50% partners with respect to operating income of the partnership, the distribution of $40,000 of property to d changes the financial relationship of each partner to the partnership. the changed relationship and the impact of the distribution can be demonstrated by following the transaction through properly maintained capital accounts. in addition, the fact that the analysis of this transaction is correct is confirmed by the partnership capital accounts after the distribution, which are adjusted as follows – 84. treas. reg. § 1.704-2(b)(iv)(b). 85. irc § 732(a). the transferred basis is limited to the distributee partner’s basis in the distributee’s partnership interest. irc § 732(a)(2). 86. irc § 733(2). 632 florida tax review [vol. 9:6 d e book tax book tax initial capital account $100,000 $100,000 $100,000 $40,000 year 1 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 year 1 income $ 2,000 0 $ 2,000 $ 4,000 year 2 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 year 2 income $ 2,000 0 $ 2,000 $ 4,000 year 3 depreciation ($ 10,000) ($ 8,000) ($ 10,000) 0 year 3 income $ 2,000 0 $ 2,000 $ 4,000 end of year 3 capital account $ 76,000 $ 76,000 $76,000 $52,000 distribution ($ 40,000) ($ 40,000) recognized built-in gain $24,000 final capital account $ 36,000 $ 36,000 $ 76,000 $76,000 and the partnership capital account is – partnership assets partners’ capital accounts book basis book basis cash $112,000 $112,000 d $ 36,000 $ 36,000 e $ 76,000 $ 76,000 $112,000 $112,000 $112,000 $112,000 there is no built-in gain or loss inside the partnership. the harmony between the partners’ capital and tax accounts indicates that all of the pre-contribution built-in gain and loss issues have been reflected in allocations to the partners. in addition, properly reflecting the various allocations to the partners, along with the distribution to d in the capital accounts indicates clearly to both d and e their rights to partnership assets. a. exceptions to the application of section 704(c)(1)(b). the distribution scheme of subchapter k is designed to permit distributions of property to partners without recognition of gain as long as built-in gain or loss inherent in the distributed property is preserved to be recovered by the distributee partner on the ultimate disposition of distributed property. section 704(c)(1)(b) is a necessary exception to this principle to prevent the shifting of pre-contribution built-in gain or loss from the contributing partner to another partner under the nonrecognition element of 2009] built-in gain and built-in loss 633 the distribution rules. the code and regulations recognize some situations in which the contributing partner’s pre-contribution built-in gain or loss is preserved following distributions of contributed built-in gain or loss property to a non-contributing partner. section 704(c)(2) incorporates the principles of deferral in like-kind exchanges by providing that gain or loss required to be recognized under section 704(c)(1)(b) is reduced by the amount of built-in gain or loss attributable to property that is like-kind to the property distributed to another partner under section 1031 that is distributed to the contributing partner not later than the 180th day after the distribution to the non-contributing partner or, if earlier, the due date (with extensions) of the tax return of the contributing partner for the taxable year in which the distribution to the noncontributing partner occurs.87 in essence, the like-kind property distributed to the contributing partner is treated as received in exchange for the contributed property that is distributed to another partner. under the language of section 704(c)(2), to the extent of the fair market value of the like-kind property, section 704(c)(1)(b) is to be applied as if the contributing partner had contributed the like-kind property at the outset. thus, there is no distribution of contributed property to another partner. the contributing partner’s basis in the distributed like-kind property will be the same as the partnership’s basis.88 the contributing partner’s basis in the distributed like-kind property is determined without regard to any gain recognized by the contributing partner under section 704(c)(1)(b), e.g. the partnership’s basis in the distributed like-kind property will transfer to the contributing partner.89 the treasury regulations provide additional, non-statutory, exceptions to the application of section 704(c)(1)(b). the contributing partner is not required to recognize gain under section 704(c)(1)(b) on distribution of an interest in contributed property to another partner in complete liquidation of the partnership if the contributing partner also receives an interest in the contributed property that has a built-in gain or loss in an amount that is at least equal to the amount of gain that would be 87. irc § 704(c)(2)(b); treas. reg. § 1.704-4(d)(3). these deadlines mirror the rules for deferred like-kind exchanges in § 1031(a)(3)(b), which requires that a deferred exchange be completed within 180 days, or the due date for the exchanging taxpayer’s tax return, whichever is earlier. 88. treas. reg. § 1.704-4(d)(3). the regulation states, “the contributing partner’s basis in the distributed like-kind property is determined as if the likekind property were distributed in an unrelated distribution prior to the distribution of any other property distributed as part of the same distribution and is determined without regard to the increase in the contributing partner’s adjusted tax basis in the partnership interest under section 704(c)(1)(b) and this section.” see irc § 732(a). 89. id. the regulations warn, however, that the distribution of the like-kind property to the contributing partner may in some circumstances be treated as a sale under the disguised sale rules of treas. reg. § 1.707-3. 634 florida tax review [vol. 9:6 recognized by the contributing partner under section 704(c)(1)(a) on a sale of the contributed property for its fair market value.90 in this case, the exchange basis in the distributed property on liquidation of the partnership will preserve the contributing partner’s remaining built-in gain or loss.91 section 704(c)(1)(b) does not require recognition of gain by the contributing partner in the event of a deemed distribution and reformation of a partnership under the partnership termination rule of section 708(b)(1)(b) (termination of a partnership in a 50% ownership change).92 in this case, the built-in gain or loss of the contributing partner is preserved by treating the property in the hands of the re-formed partnership as section 704(c) property.93 similarly, section 704(c)(1)(b) gain is not recognized on the transfer of built-in gain or loss assets to a new partnership followed by a distribution of interests in the new partnership in liquidation of the original partnership – an assets over partnership reorganization.94 again built-in gain or loss is preserved by treating the assets as section 704(c) assets of the new partnership.95 the regulations also provide that section 704(c)(1)(b) does not require recognition of gain on incorporation of a partnership,96 or on a distribution of an undivided interest in partnership property to the extent that the interest received by the contributing partner does not exceed the undivided interest in the property contributed by the distributee.97 2. distribution of property to the contributing partner section 704(c)(1)(b) allocates built-in gain or loss to the contributing partner, as a partner, on distribution of partnership property to a non-contributing partner. section 704(c)(1)(b) can not allocate precontribution gain or loss if the contributing partner is no longer a member of the partnership at the time the contributed property is distributed. section 737 fills this gap by requiring that the contributing partner recognize precontribution built-in gain on the distribution of any other property to the contributing partner, notwithstanding the fact that a distribution would otherwise be without recognition. 90. treas. reg. § 1.704-4(c)(2). 91. irc § 732(b). see treas. reg. § 1.704-4(c)(7), ex. (1). 92. treas. reg. § 1.704(c)(3). 93. id. 94. treas. reg. § 1.704-4(c)(4). partnership mergers are discussed infra, text beginning at note 110. 95. id. 96. treas. reg. § 1.704-4(c)(5). 97. treas. reg. § 1.704-4(c)(6). 2009] built-in gain and built-in loss 635 normally a distribution of money or property to a partner does not require the recognition of gain, except to the extent that a distribution of money exceeds the distributee partner’s basis in the partnership interest.98 section 737, however, requires recognition of gain on a distribution to the extent of the lesser of the fair market value of any property (other than money) distributed to the partner over the adjusted basis of the partner’s partnership interest, or the amount of any pre-contribution gain of the partner, meaning the amount of gain that would be recognized by the partner under section 704(c)(1)(b) if contributed property were distributed to another partner. there is no provision for recognition of pre-contribution loss. gain recognized under section 737 increases the partner’s basis in the partnership interest immediately before the distribution.99 in addition, the partnership’s basis in property contributed by the distributee partner is also adjusted to reflect gain recognized by the contributing partner.100 example 12 suppose, that d contributed delta stock, with a fair market value of $1,000 and a basis of $200 to the abcd partnership in year 1; in year 3, when the fair market value of delta stock is $800, the partnership distributed omega stock to d in complete liquidation of d’s partnership interest; and in year 5 the partnership distributed the delta stock to a.101 section 704(c)(1)(b) does not apply to the distribution of the delta stock to a because at the time of the distribution d is no longer partner. however, section 737 taxes d on the receipt of the omega stock in year 3 in an amount equal to the gain that would have been recognized if the delta stock had been distributed to another partner at the time of the distribution to d in year 3, $600 ($800 $200).102 d’s basis in d’s partnership interest is increased to $800 ($200 + $600) immediately before the distribution, and d, therefore, takes the omega stock with an $800 exchange basis. the partnership’s basis in the delta stock is increased to $800. 98. irc § 731(a). 99. irc § 737(c)(1). the impact of this basis increase depends upon the nature of the distribution. in the case of a distribution of property in complete liquidation of the distributee’s partnership interest, the basis increase would be reflected in the exchange basis of the distributed property. see irc § 732(b). 100. irc § 737(c)(2). this adjustment is tantamount to a mandatory § 734(b) adjustment, but which is clearly beneficial to the partnership, and in the case of a current distribution, also benefits the contributing partner by reducing or eliminating future § 704(c) gain. 101. with some clarifying revisions, the example is from mcdaniel, et. al., supra note 15, 394-395. 102. without § 737, the year 3 distribution of capital asset #2 to d would not require recognition of gain by d (irc § 731(a)) who would take asset #2 with a basis equal to d’s basis in his partnership interest, $200. 636 florida tax review [vol. 9:6 a. exceptions to section 737 as is the case with respect to section 704(c)(1)(b),103 exceptions to the application of section 737 mitigate the reach of the provision in cases where the contributing partner’s built-in contribution gain is preserved. section 737(d) provides that if a distribution consists of property contributed by the distributee, such property will not be taken into account in computing gain recognized under section 737(a) or in computing the distributee’s precontribution gain.104 regulations provide additional exceptions for partnership terminations under section 708(b)(1) where assets are treated as transferred to a new partnership,105 partnership asset-over mergers, partnership divisions,106 incorporation of a partnership,107 and nonrecognition transactions where the property received is thereafter treated as the contributed property for section 704(c) purposes.108 3. extending the distribution rule clock with a partnership merger in an “assets-over” partnership merger, the merged partnership is treated as transferring its assets to the continuing partnership in exchange for a partnership interest in the continuing partnership.109 invariably, the value of the transferred assets will differ from their bases resulting in built-in gain or loss property. the merged partnership is then liquidated with a distribution of a partnership interest in the continuing partnership to the partners of the 103. see text supra, beginning with note 87. 104. see also treas. reg. §1.737-2(d). section 737(d) also provides that if the distribution consists of an interest in an entity, the exception from § 737 recognition only applies to the extent of the interest of the entity in the contributed property. section 737(d)(2) adds that § 737 is not applicable to the extent that § 751 (recognition of gain on distributions that change a partner’s interest in unrealized receivables and appreciated inventory) applies. 105. treas. reg. §1.737-2(a). 106. treas. reg. §1.737-2(b). 107. treas. reg. §1.737-2(c). 108. treas. reg. §1.737-2(d)(3). 109. treas. reg. § 1.708-1(c)(3)(i). an assets-up merger involves a transfer of partnership assets to the partners in liquidation of the merged partnership, followed by a contribution of assets to the continuing partnership. treas. reg. § 1.708-1(c)(3)(ii). the partners must be treated as the owners of the distributed assets. the former partners of the merged partnership then contribute the assets to the continuing partnership. a merger that is not an assets-over form, or an assets-up form, e.g. a merger in which the partners transfer partnership interests to the continuing partnership, an interests-over form, is treated as an assets-over form of merger. treas. reg. § 1.708-1(c)(3)(i), -1(c)(5), ex. (4). (for a discussion of partnership mergers and divisions, see mcdaniel, et. al., supra note15, 399-409. 2009] built-in gain and built-in loss 637 merged partnership, who become partners in the continuing partnership.110 the partnership that is treated as continuing is the partnership whose original partners hold more than 50% of the partnership interests in the resulting partnership.111 the merged partnership is terminated.112 the transfer of assets to the continuing partnership by the merged partnership in exchange for a partnership interest in the continuing partnership is a nonrecognition transaction under section 721. the liquidation distribution to the partners of the merged partnership of an interest in the continuing partnership is shielded from recognition by section 731(a).113 treasury regulations section 1.704-4(c)(4) provides that section 704(c)(1)(b) does not apply in an assets-over merger to require recognition of gain or loss by the merged partnership or its partners on distribution of contributed built-in gain or loss property to the continuing partnership. the regulation adds, however, that a subsequent distribution of built-in gain or loss property that remains subject to section 704(c)(1)(b) will require recognition of gain or loss by the original contributing partner to the same extent that a distribution by the merged partnership would have required recognition. in other words, the original contributing partner is required to recognize built-in gain or loss on a distribution by the continuing partnership of built-in gain or loss property that was contributed to the merged partnership within seven years preceding the distribution. likewise, treasury regulation section 1.737-2(b)(1) provides that section 737 does not apply to require recognition of gain on a distribution of interests in the merged partnership in an assets-over merger.114 the regulations further state, however, that a distribution of property to a partner who was formerly a member of the merged partnership who contributed built-in gain property will be subject to section 737 to the same extent that a distribution from the merged partnership would have triggered gain under section 737. in rev. rul. 2004-43115 the irs attempted to extend the seven year limitation of sections 704(c)(1)(b) and 737 by restarting the clock on built-in 110. treas. reg. § 1.708-1(c)(3)(i). any form of merger that is not an assets-up form will be treated as an assets-over merger. id. 111. treas. reg. § 1.708-1(c)(1). 112. id. 113. changes in liabilities for purposes of § 752(a) and (b) are netted for each partner. treas. reg. § 1.752-1(f). the basis of the former partners of the merged partnership in their interests in the continuing partnership is the same as their basis in the merged partnership, adjusted for liabilities and distributions of money. irc § 732(b). 114. the preamble to these regulations when proposed expressly stated that §§ 704(c)(1)(b) and 737 were not applicable in an assets-over partnership merger. notice of proposed rulemaking, partnership mergers and divisions, reg-11111999, 2001-1 c.b. 455, 456. 115. 2004-1 c.b. 842. 638 florida tax review [vol. 9:6 gain or loss existing at the time of the transfer of property from the merged partnership to the continuing partnership. the irs ruled that the seven year period during which built-in gain property is subject to recognition under sections 704(c)(1)(b) would re-commence on the date of the assets-over merger with respect to the amount of built-in gain or loss existing at the time of the merger that is attributable to property contributed to the continuing partnership, reduced by the built-in gain or loss present at the time of the initial contribution to the merged partnership. the net figure is referred to as new built-in gain. with respect to the amount of built-in gain existing at the time of the initial contribution of property to the merged partnership (old built-in gain), however, the seven year period would commence on the date of the original contribution.116 in response to comments that the approach of rev. rul. 2004-43 was inconsistent with the existing regulations,117 the irs revoked the ruling118 and announced that it would promulgate regulations implementing the principles of rev. rul. 2004-43 effective for distributions after january 19, 2005.119 proposed regulations were issued on august 21, 2007.120 the examples in the proposed regulations can be examined through the lens of partnership capital accounts.121 these examples were first explained in rev. rul. 2004-43.122 example 13a.123 on january 1, 2005, a and b form the prs1 partnership. a contributes asset #1 with a fair market value of $300 and a basis of $200. b contributes $300 cash. the partnership capital accounts are thus – prs1 partnership assets partners’ capital accounts book basis book basis asset #1 $300 $200 a $300 $200 cash $300 $300 b $300 $300 $600 $500 $600 $500 116. the status of built-in gain or loss property in the continuing partnership is unchanged. 117. district of columbia bar taxation section, comments on assets-over partnership merger guidance, 2004 tax notes today 135-28 (7/7/2004). 118. rev. rul. 2005-10, 2005-1 c.b. 492. 119. notice 2005-15, 2005-1 c.b. 527. 120. reg-143397-05, 72 fed. regis. 46932. 121. prop. reg. § 1.704-4(c)(4)(ii)(f) (2007). 122. 2004-1 c.b. 842. 123. prop. reg. § 1.704-4(c)(4)(ii)(f), ex. (1) (2007). 2009] built-in gain and built-in loss 639 also on january 1, 2005, c and d form partnership prs2. c contributes asset #2 with a fair market value of $200 and a basis of $100. d contributes $200 cash. the prs2 partnership capital accounts are thus – prs2 partnership assets partners’ capital accounts book basis book basis asset #2 $200 $100 c $200 $100 cash $200 $200 d $200 $200 $400 $300 $400 $300 on january 1, 2008, the prs1 and prs2 partnerships undertake an assets-over merger with prs1 as the surviving partnership. at the time of the merger asset #1 has appreciated to $900 and asset $2 has appreciated to $600. revaluing partnership assets as permitted by the regulations124 in the case of distributions and admissions of new partners is necessary in order to ascertain the relative interests of the partners in partnership property following the merger. the revalued capital account of prs1 partnership is as follows:125 prs1 partnership assets partners’ capital accounts book basis book basis asset #1 $ 900 $200 a $ 600 $200 cash $ 300 $300 b $ 600 $300 $1,200 $500 $1,200 $500 the differences in the partners’ book and basis accounts demonstrate the presence of built-in gain and instructs as to its allocation. if asset #1 were disposed of for $900, the $700 of tax gain would be allocated to $400 to a to account both for a’s pre-contribution section 704(c) gain of $100 and a’s reverse section 704(c) gain of $300 resulting from the revaluation, and $300 to b to account for b’s $300 of reverse section 704(c) gain.126 the revalued capital account of partnership prs2 is as follows: prs2 partnership assets partners’ capital accounts book basis book basis asset #2 $600 $100 c $400 $100 cash $200 $200 d $400 $200 $800 $300 $800 $300 124. treas. reg. § 1.704-1(b)(2)(iv)(f). 125. the partnership book gain of $600 is allocated equally to a and b. 126. irc § 704(c)(1)(a); treas. reg. § 1.704-1(b)(iv)(i). 640 florida tax review [vol. 9:6 the capital account demonstrates that on a sale of asset #2 for $600, $300 of gain is allocable to c to account for c’s pre-contribution built-in section 704(c) gain of $100 and c’s $200 share of reverse section 704(c) gain, and $200 of gain is allocable to d to account for d’s $200 of reverse section 704(c) gain.127 in the assets-over merger, prs2 is treated as contributing its assets to the continuing prs1 partnership in exchange for an interest in the prs1 partnership,128 which is then distributed to c and d in liquidation of the prs2 partnership.129 c and d thus become partners in prs1 partnership.130 the capital account of the continuing partnership is as follows: prs1 partnership assets partners’ capital accounts book basis book basis asset #1 $ 900 $200 a $ 600 $200 asset #2 $ 600 $100 b $ 600 $300 cash $ 500 $500 c $ 400 $100 d $ 400 $200 $2,000 $800 $2,000 $800 again, the differences in the partners’ book accounts and basis demonstrate that the $1,200 of gain that would be recognized on sale of assets 1 and 2 is allocable among the partners in a manner that would account for both precontribution and reverse section 704(c) gains.131 the amount of built-in gain allocable to each partner is evident from the book and tax difference in each partner’s capital account. in general, under the approach of the proposed regulations, the reverse section 704(c) gain in the assets of the merged prs2 partnership becomes regular section 704(c) gain in the continuing prs1 partnership as a result of the contribution of the prs2 assets in the merger. 127. id. 128. the transfer of cd assets is a contribution in exchange for a partnership interest under § 721. the cd partnership’s basis in its interest in prs1 partnership is the same as its basis in the transferred assets, $300. irc § 722. cd partnership’s $100 basis in asset #2 transfers to prs1 partnership. irc § 723. 129. treas. reg. § 1.708-1(c)(3)(i). 130. c and d do not recognize gain on the liquidation distribution of partnership interests in prs1 partnership. irc § 731(a)(1). c’s and d’s bases in their prs1 partnership interests are the same as their respective bases in the cd partnership, $100 and $200. irc § 732(b). 131. the allocations would be the same as described supra, text at notes 126 and 127, $400 to a, $300 to b, $300 to c, and $200 to d. gain on the sale of asset #1 would be allocated to a and b, gain on the sale of asset #2 would be allocated to c and d. 2009] built-in gain and built-in loss 641 the example of the proposed regulations132 describes the consequence of a distribution on january 1, 2013 of asset #2 to a in complete liquidation of a’s partnership interest. the distribution is eight years after c’s initial contribution and five years after the merger. at the time of the distribution the values of the partnership assets remain at $900 and $600. under the existing treasury regulation section 1.704-4(c)(4), which applies section 704(c)(1)(b) to require recognition of built-in gain only to the extent that a distribution from the merged partnership (prs2) would have triggered recognition, c avoids recognition of c’s original builtin gain because the distribution is more than seven years after c’s contribution.133 likewise, section 737 does not require a to recognize gain attributable to a’s pre-contribution built-in gain with respect to asset #1, which was contributed to the prs1 partnership more than seven years prior to the distribution.134 a will not recognize gain or loss on the liquidation distribution.135 a’s $200 basis in a’s prs1 partnership interest is exchanged to become a’s basis in asset #2. at this point in the analysis, the prs1 partnership capital account is as follows: prs1 partnership assets partners’ capital accounts book basis book basis asset #1 $ 900 $200 b $ 600 $300 cash $ 500 $500 c $ 400 $100 d $ 400 $200 $1,400 $700 $1,400 $600 the $100 disparity between the partnership’s inside basis in assets and the sum of the partners’ outside bases is attributable to the increase in the basis of asset #2 from $100 inside the partnership to $200 in a’s hands as a result of the liquidation distribution. a’s $400 of gain built into a’s partnership interest (consisting of a’s $100 precontribution gain and $300 revaluation gain) is now reflected as $400 of gain built-in to asset #2. thus, recognition of a’s pre-contribution and partnership gain is deferred to disposition by a of asset #2. the partnership provisions have allowed a to exchange an 132. prop. reg. § 1.704-4(c)(4)(f), ex. (1) (2007). the same analysis is in rev. rul. 2004-43, 2004-1 c.b. 842, revoked, rev. rul. 2005-10, 2005-1 c.b. 492. 133. irc § 704(c)(1)(b) only applies to a distribution within seven years of the date of the contribution. 134. prop. reg. § 1.737-2(b)(1)(ii)(f), ex. (1) (2007). irc § 737(b)(1) limits recognition under § 737 to pre-contribution gain on assets contributed within seven years of a distribution of other property to the contributing partner. 135. irc § 731(a). 642 florida tax review [vol. 9:6 interest in asset #1 for an interest in asset #2 without recognition of gain or loss, albeit after a seven year waiting period. in addition, the prs1 partnership’s $500 of built-in gain in asset #2 has been transformed into $400 of gain on asset #2 in a’s hands. also, while the partnership has $700 of built-in gain in asset #1, the sum the builtin gain in of the partners’ interests is $800. this situation permits the partners to defer recognition of $100 of pre-contribution and/or reverse section 704(c) gain on sale of asset #1 until a liquidation of the partnership. thus, if asset #1 were sold for $900, the partnership would have zero book gain and $700 of tax gain. the partnership’s $700 tax gain is allocated $300 to b136 and $200 each to c and d. the partnership would now have the following capital account: prs1 partnership assets partners’ capital accounts book basis book basis asset #1/cash $ 900 $ 900 b $ 600 $ 600 cash $ 500 $ 500 c $ 400 $ 300 d $ 400 $ 400 $1,400 $1,400 $1,400 $1,300 although the partnership itself has no unrealized gains or losses, the $100 disparity between the partnership inside asset basis and the sum of the partners’ outside bases represents $100 of deferred tax gain that will be recognized by c on a disposition of c’s partnership interest.137 a section 734(b) adjustment under a section 754 election, would resolve the disparity with respect to the partnership by decreasing the basis of asset #1 by $100 to account for the $100 increase in the basis of asset #1. the prs1 partnership capital account after application of a section 743(b) adjustment would be as follows: prs1 partnership assets partners’ capital accounts book basis book basis asset #1 $ 900 $100 b $ 600 $300 cash $ 500 $500 c $ 400 $100 d $ 400 $200 $1,400 $600 $1,400 $600 136. this allocation represents b’s share of reverse § 704(c) gain resulting from revaluation of prs1 assets at the time of the merger. treas. reg. § 1.7041(b)(2)(iv)(f) and (g). 137. c’s deferred gain relates back to the built-in gain inherent in asset #2 at the time of c’s initial contribution. see text and capital account supra following note 123. 2009] built-in gain and built-in loss 643 the capital accounts demonstrate the appropriate allocations of both the section 704(c) gains and revaluations gains. on sale of asset #1, the $800 tax gain is allocable $300 to b, $300 to c, and $200 to d. the capital accounts provide ready guidance to the appropriate cash flows and tax accounting throughout this transaction. unlike the current regulations, the proposed regulations would require recognition of gain by the partners of the merged partnership on the distribution of built-in gain property to a. following the approach of rev. rul. 2004-43, the proposed regulations treat the assets-over merger of prs2 into prs1 as a contribution of built-in gain property by prs2 to prs1 at the time of the merger, but only to the extent that the built-in gain attributable to the property exceeds the built-in gain present at the time of the original contribution.138 rev. rul. 2004-43 indicated that while existing treasury regulation section 1.704-4(c)(4) requires that the seven year period with respect to pre-contribution built-in gain in asset #2 commence on the date of its initial contribution to the prs2 partnership,139 the irs asserted that there is nothing in section 1.704-4(c)(4) to prevent the creation of new section 704(c) gain or loss when the assets are contributed by one partnership to another. the proposed regulations confirm this position by treating the difference between fair market value and basis at the time of an assets-over merger as section 704(c) gain. the $100 difference in the fair market value and adjusted basis of asset #2 at the time of c’s contribution to prs 2, the merged partnership, is treated as original section 704(c) gain or loss (old built-in gain) for which the seven year clock began to run on the date of the initial contribution.140 the remaining section 704(c) gain (the revaluation gain) is treated as new section 704(c) gain for which the seven year clock began to run on the date of the partnership merger.141 as a consequence, the $400 revaluation gain identified on the transfer of asset #2 from the prs2 partnership to the prs1 partnership, within seven years of the distribution to a, triggers recognition of the new pre-contribution built-in gain to c and d who step into the shoes of the prs2 partnership as partners in the prs1 partnership and who are thus treated as the contributors of the built-in gain property.142 the proposed regulations thus conclude that c and d, as the 138. prop. reg. § 1.704-4(c)(4)(ii)(b) (2007). the proposed regulations do not explicitly define new built in gain. however, the limitation on new built-in gain is implicit in prop. reg. § 1.704-4(c)(4)(ii)(b) (2007), which states that the seven year period with respect to old built-in gain, built-in gain existing at the time of contribution to the transferor partnership, will not restart on the assets-over merger. 139. under this application of treas. reg. § 1.704-4(c)(4), gain is recognized under § 704(c)(1)(b) only to the extent gain would be recognized on a distribution by prs2, here zero. 140. prop. reg. § 1.704-4(c)(4)(ii)(a) (2007). 141. prop. reg. § 1.704-4(c)(4)(ii)(b) (2007). 142. treas. reg. § 1.704-4(d)(2) treats the transferee of a partnership 644 florida tax review [vol. 9:6 contributors of asset #2, must each recognize $200 of gain on the distribution to a.143 recognition of this $400 of gain would increase the partnership basis in asset #2,144 but that basis adjustment is lost on the distribution to a, whose basis in asset #2 remains as $200.145 under this analysis, the resulting partnership capital account is as follows: prs1 partnership assets partners’ capital accounts book basis book basis asset #1 $ 900 $200 b $ 600 $ 300 cash $ 500 $500 c $ 400 $ 300 d $ 400 $ 400 $1,400 $700 $1,400 $1,000 the $500 basis in asset # 2, as adjusted to reflect the recognized gain under section 704(c)(1)(b),146 is decreased to $200 to a in the liquidation distribution.147 the loss of this basis in asset #2 creates a $300 disparity between the partnership’s inside basis in assets and the sum of the partners’ outside bases. the presence of this increased disparity in inside and outside bases demonstrates that the proposed regulations accelerate partners’ recognition of built-in gain in advance of a partnership level recognition.148 recognition of $700 of tax gain on a sale of asset #1 by the partnership would require the partners to recognize more tax gain than is reflected in the built-in gain in their partnership interests, and defers recovery of this excess gain until recognized as loss (or a reduction of gain) on disposition of the partnership interests.149 the potential doubling of tax on a partnership sale of asset# 1 can be avoided with a section 734(b) adjustment under a section 754 election which would resolve the inside/outside basis disparity by increasing the basis interest as the contributing partner with respect to built-in gains an losses subject to irc § 704(c)(1)(b). 143. prop. reg. § 1.704-4(c)(4)(ii)(f), ex. (1)(ii) (2007). irc § 737 does not apply to require a to recognize gain attributable to a’s contribution of asset #1 because that property was contributed to the prs1 partnership more than seven years preceding the distribution. prop. reg. § 1.737-2(b)(1)(ii)(f), ex. (1)(ii). 144. irc § 704(c)(1)(b)(iii). 145. irc § 732(b). 146. irc § 704(c)(1)(b)(iii). 147. irc§ 732(b). note again that a ultimately exchanges in interest in appreciated asset #1 for an interest in asset #2 without recognition of gain. 148. this recognition may also be described as recognition of built-in gain deferred from the date of the partnership merger. 149. the partnership tax gain would be allocated $300 to b, and perhaps $200 each to c and d, 2009] built-in gain and built-in loss 645 of asset #1 to $500.150 as adjusted, the partnership capital account would be as follows: prs1partnership assets partners’ capital accounts book basis book basis asset #1 $ 900 $ 500 b $ 600 $ 300 cash $ 500 $ 500 c $ 400 $ 300 d $ 400 $ 400 $1,400 $1,000 $1,400 $1,000 as a consequence of these adjustments, d’s book and basis accounts no longer reflect a disparity. b has $300 of built-in gain that reflects b’s share of revaluation gain at the time of the merger, and c’s $100 of built-in gain is attributable to c’s precontribution gain with respect to asset #2. the capital account disparities demonstrate that on a sale of asset #1 for $900, the $400 of tax gain is appropriately allocable $300 to b and $100 to c. 150. abrams, supra note 82, 344, notes that when inside and outside basis are not equal, taxpayers can exploit the difference. in this situation, where the partner’s outside basis is greater than the partnership’s inside basis, a sale of partnership interests reduces aggregate gain relative to a sale of partnership assets. id. see also william d. andrews, colloquium on partnership taxation: inside basis adjustments and hot asset exchanges in partnership distributions, 47 tax law rev. 3, 10 (1991), “inside and outside basis should be the same because they are essentially the same thing, just divided up or allocated differently.” professor abrams recommends that § 743(b) adjustments be allocable only to the partner to whom distributions trigger the adjustment, as is the case with § 743(b) adjustments that are made in the case of a sale or exchange of a partnership interest, in order to avoid shifting the benefits or burdens of the adjustment to other partners. abrams, supra note 82, 344, 351. in the case of non-pro rata current distributions, professor abrams recommends remedial allocations of gain to the non-distributee partner and loss to the distributee partner (which has the disadvantage of creating negative basis). professor karen burke suggests that the same result can be achieved with a deemed sale approach under which the non-distributee partner is treated as selling the partner’s interest in distributed property (an aggregate approach) in a taxable transaction. karen c. burke, repairing inside basis adjustments, 58 tax law. 639, 645-646 (2007). citing andrews, supra at 66, professor burke also points out that a partial liquidation approach, treating a non-pro rata distribution to a continuing partner as a partial liquidation of the partner’s interest, coupled with a mandatory § 734(b) adjustment would reach the correct allocation of built-in gains or losses. id. at 657. both of these recommendations have the obvious disadvantage of triggering recognition of gain on distributions, which does not occur under the current statutory scheme except in the case of a distribution of money (or release of debt) in excess of the distributee’s basis. see also leigh osofsky, solving section 734(b), 60 tax law. 473 (2007). 646 florida tax review [vol. 9:6 rather than limiting the amount of built-in gain subject to sections 704(c)(1)(b) and 737 to revaluation gain created at the time of an assets-over merger, the proposed regulations might have restarted the seven year period with respect to the full amount of built-in gain or loss as of the date of the merger. indeed, section 704(c)(1) refers to property contributed to a partnership by a partner.151 if property received by the continuing partnership from the transferring partnership or partners is treated as contributed to the partnership, then the express language of section 704(c)(1)(b) would seem to apply to all of the built-in gain inherent in the property at the time of contribution, not just gain attributable to the period the property is held by the transferring partnership. thus, in the example above, under this approach c would be required to recognize c’s $100 of pre-contribution gain with respect to asset #2 in addition to c’s share of the $400 revaluation gain arising prior to the merger. such an approach would capture all of c’s builtin gain within c’s partnership interest, which may be appropriate as c exchanges an interest in asset #2 for an interest in asset #1. d would be required to recognize d’s revaluation gain identified at the time of the merger. the resulting partnership capital account would be as follows: prs1partnership assets partners’ capital accounts book basis book basis asset #1 $ 900 $200 b $ 600 $ 300 cash $ 500 $500 c $ 400 $ 400 d $ 400 $ 400 $1,400 $700 $1,400 $1,100 with a section 754 election and a section 734(b) increase in the basis of asset #1, the partnership capital account would be as follows: prs1partnership assets partners’ capital accounts book basis book basis asset #1 $ 900 $ 600 b $ 600 $ 300 cash $ 500 $ 500 c $ 400 $ 400 d $ 400 $ 400 $1,400 $1,100 $1,400 $1,100 151. section 704(c)(1)(a) provides, “income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution,” and subdivision (b) applies “if any property so contributed is distributed (directly or indirectly) by the partnership (other than to the contributing partner) within 7 years of being contributed – . . .” 2009] built-in gain and built-in loss 647 with or without the section 754 election, requiring c to recognize the full amount of c’s share of built-in gain eliminates any disparity in c’s book and basis accounts. however, this approach may go too far. in enacting section 704(c)(1)(b) congress indicated that a seven year break between the contribution of property and distribution of the property to another is sufficient to permit continuation of the deferral normally available on the transfer of built-in gain or loss property to a partnership. indeed, since the contributed property has been in a partnership longer than the seven year period of section 704(c)(1)(b), it may not be appropriate to accelerate recognition of built-in gain because of the intervening assets-over merger. the distinction drawn by the proposed regulations between pre-contribution built-in gain or loss and the revaluation gain or loss inherent in property at the time of a partnership merger appears is purely a policy choice to accelerate recognition that may not be supportable under the language of the statute. there is nothing in sections 707(c)(1)(b) or 737 that justifies a differentiation between the total built-in gain or loss present at the time of contribution of assets to the continuing partnership. also, while technically required by the language of both sections 704(c)(1)(b) and 737,152 the proposed regulations restart the seven year clock with respect to only one of the partnership parties to the merger. there is no sound policy justification for restarting the seven year clock with respect to some, but not all, built-in gain or loss property in the resulting partnership. from a planning perspective, there would be an advantage to arranging the partnership merger so that the partnership with the least built-in gain survives as the continuing partnership. example 13b examples in the proposed regulations also address revaluation gains and losses resulting from the entry of a new partner into the merged partnership prior to the merger. unrealized gains and losses accruing to partnership assets that are reflected in restated capital accounts on the entry of partner with a contribution to the partnership are allocated among the partners in the case of a distribution subject to section 704(c)(1)(b) in manner that reflects the allocation of book gains and losses to the entering partner under section 704(c)(1)(a) principles.153 the examples in the proposed regulations address both revaluation losses and revaluation gains restated to capital accounts on the entry of a new partner into the transferor partnership. discussion of the revaluation loss example will illustrate the approach of both. assume the prs2 partnership in example 13a admits e as a new partner in 2005 when the fair market value of asset #2 has depreciated from 152. there is no contribution of built-in gain or loss property to the continuing partnership. 153. prop. reg. §1.704-4(f), ex.’s (2) and (3) (2007). 648 florida tax review [vol. 9:6 its contribution value of $200 to $150.154 twenty-five dollars of book loss is allocated to c and d. e contributes $175 cash for a one-third interest in prs2. the restated prs2 capital account is as follows: prs2 partnership assets partners’ capital accounts book basis book basis asset #2 $150 $100 c $175 $100 cash $375 $375 d $175 $200 e $175 $175 $525 $475 $525 $475 psr2 merges into psr1 on january 1, 2008, when the value of asset #1 has appreciated to $900 and asset #2 has appreciated to $600. the $600 increase in the value of asset #1 is allocated equally to a and b, increasing their capital accounts to $600 each. the $450 increase in the value of asset #2 increases c, d, and e’s capital accounts by $150 each. the resulting restated capital account of the continuing prs1 partnership is as follows: prs1 partnership assets partners’ capital accounts book basis book basis asset #1 $ 900 $200 a $ 600 $200 asset #2 $ 600 $100 b $ 600 $300 cash $ 675 $675 c $ 325 $100 d $ 325 $200 e $ 325 $175 $2,175 $975 $2,175 $975 the partnership distributes asset #2, worth $600, to a in liquidation of a’s partnership interest on january 1, 2013, more than seven years after c’s contribution of asset #2 to prs2, but within seven years of the contribution of asset #2 to prs1 in the assets-over merger. under the analysis in the proposed regulations,155 there is $500 of section 704(c) gain in asset #2. the unrealized loss that was reflected in the restated capital accounts on e’s admission to the partnership reduces the old section 704(c) gain to $50. the new section 704(c) gain that originates with the merger156 is $450, which is the difference between the total section 704(c) gain ($500) and the old section 704(c) gain ($50). the new section 704(c) gain matches the premerger appreciation in asset #2 realized after e’s admission into the prs2 154. prop. reg. §1.704-4(f), ex. (3) (2007). 155. prop. reg. §1.704-4(f), ex. (3)(ii) (2007). 156. prop. reg. §1.704-4(c)(4)(ii)(b) (2007). 2009] built-in gain and built-in loss 649 partnership. on distribution of asset #2 to a, the new section 704(c) gain is recognized by c, d, and e ($150 each) under section 704(c)(1)(b). asset # 2 is treated as having been contributed to the continuing partnership by c, e, and d within seven years of the distribution to a.157 the remaining $50 of built-in gain in asset #2 at the time of the merger, the old section 704(c) gain, resulted from c’s contribution to prs2 more than seven years prior to the distribution to a, and is, therefore, not subject to recognition under 704(c)(1)(b). example 13c for purposes of identifying gain recognized under section 737, the proposed regulations apply the same distinctions between built-in gain existing at the time of the original contribution of property to a partnership and new built-in gain that is identified from the revaluation of partnership assets at the time of an assets-over merger.158 the first example of the proposed section 737 regulations159 is situation 2 of rev. rul. 200443.160 assume that on january 1, 2012, the fair market value of asset #1 in the prs1 partnership of example 13a is $275. asset #1 is distributed to c in liquidation of c’s interest in the prs1 partnership. revaluing the partnership assets to allocate the $625 book loss161 on asset #1 is useful (if not necessary) to determine c’s capital account for purposes of determining the liquidation distribution required to liquidate c’s interest.162 the revalued capital account is as follows: prs1 partnership assets partners’ capital accounts book basis book basis asset #1 $ 275 $200 a $ 412.50 $200 asset #2 $ 600 $100 b $ 412.50 $300 cash $ 500 $500 c $ 275.00 $100 d $ 275.00 $200 $1,375 $800 $1,375.00 $800 rev. rul. 2004-43 holds that the distribution of asset #1 to c does not trigger recognition of a’s precontribution gain on asset #1 under section 157. id. 158. prop. reg. § 1.737-2(b)(1)(ii)(a) and (b) (2007). 159. prop. reg. § 1.737-2(b)(1)(ii)(f), ex. (1) (2007). 160. supra note 115, 2004-1 c.b. 842, 843. 161. $900 $275 = $625. 30% of the loss, $187.50 is allocated each to a and b, 20% of the loss, $125.00, is allocated each to c and d. 162. revaluation of asset #1 and allocation of the book loss among the partners is required by treas. reg. § 1.704-1(b)(2)(iv)(e), which provides that distributed property must be revalued to fair market value, book gains and losses allocated to the partners’ capital accounts, then the distributee partner’s capital account is reduced by the fair market value of distributed property. 650 florida tax review [vol. 9:6 704(c)(1)(b) because a contributed asset #1 to the partnership more than seven years preceding the distribution.163 the ruling also states that section 704(c)(1)(b) is not applicable to reverse section 704(c) gain, so the revaluation of asset #1 on the merger of prs2 partnership into prs1 (which continued to hold asset #1) does not trigger section 704(c) gain that would be recognized by a or b on distribution of asset #1 to c.164 however, the ruling asserts that the contribution of asset #2 to prs1 in the merger of prs2 within seven years of the date of the distribution to c creates precontribution section 704(c) gain that is subject to recognition under section 737. as described above,165 section 737 requires a distributee partner who contributed built-in gain property to a partnership within seven years preceding the distribution to recognize gain on a distribution of property to the extent of the contributor’s built-in gain. the prs2 partnership, in which c was a partner, contributed asset #2 with $500 of built-in gain to prs1; $100 that was attributable to c’s precontribution gain and $400 attributable to appreciation while the property was held by the prs2 partnership. under section 737, c is required to recognize the lesser of c’s gain on the distribution, $175, or c’s share of the prs2 partnership built-in gain, $200. thus, c recognizes $175 of gain on the distribution of asset #1. under section 737(c), c’s basis in c’s partnership interest is increased by the $175 of recognized gain to $275, and prs1 partnership’s basis in asset #2 is increased to reflect c’s recognized gain with respect to asset #2.166 c’s exchange basis in the distributed asset #1 is $275.167 the resulting partnership capital account is as follows: 163. a’s precontribution gain would be $75, the amount of gain that the partnership would recognize on a taxable disposition of asset #1 for its fair market value. irc § 704(c)(1)(b)(i). also see treas. reg. § 1.704-4(c)(7); § 704(c)(1)(b) does not apply to reverse § 704(c) gain. 164. the text of the ruling indicates that while treas. reg. § 1.7043(a)(6)(i) provides that the allocation rules of treas. reg. § 1.704-3 apply to reverse § 704(c) items, there are no corresponding regulations under §§ 704(c)(1)(b) and 737 requiring recognition of gain attributable to reverse § 704(c) allocations. rev. rul. 2004-43, supra note 115, 2004-1 c.b. 842, 844. this position is incorporated in prop. reg. § 1.704-4(f), ex. (4) (2007), and prop. reg. § 1.737-2(b)(1)(f), ex. (4) (2007). 165. supra text at note 98. 166. see treas. reg. § 1.737-3(c). 167. irc § 732(b). 2009] built-in gain and built-in loss 651 prs1 partnership assets partners’ capital accounts book basis book basis asset #2 $ 600 $275 a $ 412.50 $200 cash $ 500 $500 b $ 412.50 $300 d $ 275.00 $200 $1,100 $775 $1,100.00 $700 the $75 difference between the partnership’s inside property basis and the sum of the partners outside bases is attributable to the increased basis of asset #1 from the partnership basis of $200 to its $275 basis to c. a section 754 election and section 734(b)(2)(b) adjustment would require a decrease in the basis of asset #2 of $75, to $200. if the approach of the proposed regulations and rev. rul. 2004-43 is not applied in this example, and asset #2 contributed initially by c outside of the seven year period of section 704(c)(1)(b) so that 737(b)(1)168 is not applicable, c would not recognize gain on the distribution of asset #1169 and c’s exchange basis in asset #1 would be $100. the resulting prs1 partnership capital account would be as follows: prs1 partnership assets partners’ capital accounts book basis book basis asset #2 $ 600 $100 a $ 412.50 $200 cash $ 500 $500 b $ 412.50 $300 d $ 275.00 $200 $1,100 $600 $1,100.00 $700 here the $100 difference between the partnership’s inside property basis and the sum of the partners outside bases is attributable to the decreased basis of asset #1 from the partnership basis of $200 to its $100 basis to c. a section 754 election and section 734(b)(1)(b) adjustment would increase the basis of asset #2 to $200. 168. irc § 737 operates by requiring recognition of the lesser of gain on the distribution or the distributee partner’s net precontribution gain, which is defined in § 737(b) as the gain that would be recognized by the distributee partner under § 704(b)(1)(c) if built-in gain property contributed within seven years of the distribution had been distributed to another partner. in the example, c’s net precontribution gain would be limited to $100, the difference between book value and basis at the time of c’s original contribution to the cd partnership. 169. irc § 731(a). 652 florida tax review [vol. 9:6 after applying section 734(b) adjustments, whether or not the distributee is required to recognize section 737 gain on appreciation existing at the time of the assets-over merger, the partnership capital account is as follows: prs1 partnership assets partners’ capital accounts book basis book basis asset #2 $ 600 $200 a $ 412.50 $200 cash $ 500 $500 b $ 412.50 $300 d $ 275.00 $200 $1,100 $700 $1,100.00 $700 this capital account comparison demonstrates that the amount of deferred built-in gain remaining in the partnership is the same, whether or not the seven year period of sections 704(c)(1)(b) and 737 is restarted by the assetsover merger. the approach of the proposed regulations affects only the distributee by forcing recognition of gain that would otherwise be deferred in the basis of property distributed in complete liquidation of the partner’s interest. the proposed regulations accelerate recognition of $175 gain to c, with a $175 basis increase in the distributed property, contrasted with the existing approach that would defer c’s recognition of the pre-merger revaluation gain to c’s disposition of asset #1.170 the impact of this analysis is confirmed by looking at what happens on sale of asset #2 for its $600 book value. the $400 tax gain is allocated under section 704(c) principals to eliminate book/tax disparities in the partners’ capital accounts caused by contribution and reverse section 704(c) gains, $75 to d (the contributor of asset #2), $112.50 to b, and $212.50 to a, which accounts for revaluation gains and losses attributable to their interests. the resulting partnership capital account is as follows: prs1 partnership assets partners’ capital accounts book basis book basis a $ 412.50 $ 412.50 cash $1,100 $1,100 b $ 412.50 $ 412.50 d $ 275.00 $ 275.00 $1,100 $1,100 $1,100.00 $1,100.00 170. of course c could avoid recognition by dying, at least before dec .31, 2009, or perhaps after december 31, 2010, by operation of irc § 1014. 2009] built-in gain and built-in loss 653 this is as it should be. in the absence of a section 734(b) adjustment, the section 737 gain recognized by c on the distribution does affect the continuing partners by reducing the deferred built-in gain allocable to other partners. in the example, after application of section 737, c’s $175 of recognized gain permits a deferral of $75 gain by a, b, and d on a sale of asset # 1 through the $75 basis increase to asset #1. this is demonstrated by the higher inside asset bases in the partnership relative to the sum of the partners’ outside bases. if c is not required to recognize section 737 gain, c’s deferral of $175 gain into the distributed asset #1 accelerates recognition of $100 of gain to b, c, and d on a disposition of asset #1 by the partnership. again this is demonstrated by the capital accounts where the partnership inside bases exceed the sum of the outside bases of the partners. in addition, in either scenario, the allocations of gain on disposition of asset #1 by the partnership present difficulties. assume that c recognizes c’s section 737 gain and shortly thereafter the prs1 partnership sells asset #1 for $600, recognizing zero book gain and $325 tax gain ($600 $275). d, as the surviving contributor of asset #2 to prs1 in the assets-over merger, should be allocated the first $75 of the gain to reflect d’s contribution gain remaining after d’s book loss on revaluation. the remaining $250 of tax gain should be allocated to a and b in a fashion that proportionately reduces the disparity between their capital accounts and basis. the section 704(c) regulations do not mandate, or perhaps even permit, this result because a and b are not contributors of asset #2, and a’s and b’s revaluation gains and losses are attributable to asset #1, which is no longer in the partnership.171 nonetheless, it seems that the only reasonable method for allocating this tax gain is in a fashion that reduces the disparity between the partners’ book and tax accounts.172 thus, $112.50 of the tax gain should be allocated to b; the gain is allocated to the extent of the difference between b’s book and tax accounts. the remaining $137.50 of tax gain is allocated to a, who thus continues to be able to defer a portion of a’s pre-contribution gain. the resulting partnership capital account would be as follows: 171. see treas. reg. §1.704-3(a)(2), § 704(c) allocation methods are applied on a property-by-property basis. 172.treas. reg. § 1.704-3(a)(1). this deferred gain results from a’s $100 precontribution built-in gain on contribution with respect to asset #1, which is reduced in this example by devaluation of asset #1 to $275. 654 florida tax review [vol. 9:6 prs1 partnership assets partners’ capital accounts book basis book basis a $ 412.50 $ 437.50 cash $1,100 $1,100 b $ 412.50 $ 412.50 d $ 275.00 $ 275.00 $1,100 $1,100 $1,100.00 $1,025.00 the $75 difference between the partnership inside basis and the sum of the partners’ outside bases reflects a’s deferred gain that would be recognized on a liquidation distribution of the partnership cash.173 the end result demonstrated by these capital accounts is deferral of gain at the partner level even though all of the partnership gains and losses have been recognized. deferral for both the partnership and distributee partner remains a problem if section 737 is not applied to require c to recognize a portion of the built-in gain that existed on the date of the assets-over merger. in the absence of section 737, c will receive the liquidation distribution of asset #2 without recognition of gain or loss and will exchange c’s $100 basis in c’s partnership interest for a $100 basis in asset #2. c thus has $175 of deferred gain in asset #2. in this case, the remaining partner’s share a deferred loss represented by the fact that the partners’ outside bases is $100 greater than the partnership inside asset basis.174 now on sale of asset #2 for its book value, $600, the partnership recognizes $500 of tax gain. again, $75 of the gain must be allocated to d to account for the disparity in d’s book and tax accounts as a result of the section 704(c) gain attributable to d from contribution of asset #2 in the assets-over merger. beyond that, there is no sensible way to allocate the remaining $425 of gain that would eliminate book/tax disparities.175 a and b both have gain built into their partnership interests attributable to precontribution and revaluation gains in asset #1. allocating one-half of the remaining gain attributable to asset #2 to each partner, $212.50, produces the following capital account: 173. irc §731(a). allocating the $250 gain equally between a and b causes an overstatement of b’s basis, which would be $425, creating immediate recognition of gain and a deferred loss, and allows a to defer additional loss. 174. see the partnership capital account in the text supra, following note 169. 175. allocating more than $75 of gain to d may be unreasonable under the regulations, see treas. reg. §1.704-3(a)(2) because such an allocation would create deferred loss for c and increase deferred gain to a and b, contrary to the purpose of § 704(c). 2009] built-in gain and built-in loss 655 prs1 partnership assets partners’ capital accounts book basis book basis a $ 412.50 $ 412.50 cash $1,100 $1,100 b $ 412.50 $ 512.50 d $ 275.00 $ 275.00 $1,100 $1,100 $1,100.00 $1,200.00 while this allocation is appropriate as to a, b ends up recognizing accelerated gains at the price of a deferred loss. alternatively, the $425 of tax gain may be allocated between a and b in proportion to the difference between the book and tax amounts in their respective tax accounts; $278 to a,176 and $147 to b.177 the resulting partnership capital account is as follows: prs1 partnership assets partners’ capital accounts book basis book basis a $ 412.50 $ 478 cash $1,100 $1,100 b $ 412.50 $ 447 d $ 275.00 $ 275 $1,100 $1,100 $1,100.00 $1,200 in either scenario, although the partnership itself has recognized all of its gains and losses, one or two of the partners is overtaxed on gain with an accompanying deferral of loss, perhaps good for the fisc, but not the appropriate end result for application of subchapter k. this analysis demonstrates that the correct solution to deferred gains and losses lies in the section 754 election and the application of section 734(b) adjustments. while partners and partnerships in varying situations can determine whether to tolerate or take advantage of temporal deferral of gains and losses with the availability of the election, to the extent that congress is concerned with eliminating deferrals, a required section 734(b) adjustment in the case of section 704(c)(1)(b) and section 737 recognition of gains, is the best potential solution.178 176. ($212.50/$325) x $425 = $277.88. 177. ($112.50/$325) x $425 = $147.12. 178. see andrews, supra note 150 656 florida tax review [vol. 9:6 iv. contribution of encumbered property and debt in general a. some basic rules regarding partnership debt money makes the world go around, and in the partnership context much of the money comes from borrowed funds. property contributed to a partnership often is encumbered with liabilities that shift among the partners. the impact of partnership debt on allocations of income and expense items is one of the most complicated parts of partnership taxation. the rules affect contributions of property subject to liabilities because the contributing partner’s liabilities may be shifted to other partners. the presence of partnership debt facilitates the pass-through of losses and is the foundation of partnership tax shelters. section 752(a) provides that any increase in a partner’s share of partnership liabilities, or an increase in a partner’s share of individual liabilities by virtue of an assumption of partnership liabilities will be treated as a contribution of cash. the deemed cash contribution increases the partner’s basis in the partnership interest.179 thus, a partner may use the partner’s share of partnership liabilities to support the deduction of partnership losses and avoid the restriction of section 704(d), which limits a partner’s deduction of losses to the partner’s basis in the partnership interest. section 752(b) provides that any decrease of a partner’s share of partnership liabilities, or a decrease in a partner’s individual liabilities by reason of an assumption by the partnership of individual liabilities, shall be treated as a distribution of cash from the partnership. under section 731 cash distributions are received without tax except to the extent that the distribution exceeds the partner’s basis in the partnership interest. under section 733(1), cash distributions reduce the partner’s basis in the partnership interest. this is the offset provision. to the extent that a partner relies on partnership liabilities to create basis and support loss deductions, reduction or elimination of the liabilities comes back to the partner as recognized gain. in any particular situation, whether a partner’s share of liabilities is increased or decreased depends upon the rules for identifying the partner’s share of partnership liabilities. application of those rules varies by whether one or more partners have personal liability for a debt, or whether the liability is without recourse to any partner. 179. irc § 722. 2009] built-in gain and built-in loss 657 b. recourse liabilities a recourse liability is any liability for which any partner bears the economic risk of loss.180 in general, a partner bears the economic risk of loss with respect to a partnership liability (even if the liability is nonrecourse as to the partnership) if upon a hypothetical liquidation of the partnership in which all of its assets are treated as worthless, the partner (or a related person) “would be obligated to make a payment to any person (or a contribution to the partnership) * * * and the partner or related person would not be entitled to reimbursement from another partner [or person related to that partner].”181 in simpler terms, if the partnership comes unglued, and everybody goes after everybody else for all they can get, the partner who is ultimately liable for a partnership debt is the partner who bears the economic risk of loss. this determination requires an examination of all obligations of the partners to outside parties, such as guarantees, and obligations among the partners to make contributions to the partnership or to make-up any deficit capital accounts.182 a partner’s obligation is reduced to the extent that a partner has a right of reimbursement from other partners.183 applying this approach, a partner’s share of partnership liability is the amount of the liability for which the partner bears the ultimate economic risk of loss.184 a partner contributing encumbered property with built-in gain faces the possibility of recognized gain if the reduction in the contributing partner’s share of recourse liability exceeds the contributing partner’s basis in the contributed property. example 14a partner f contributes greenacre to the newly formed fgh partnership with a fair market value of $200,000 and a basis of $100,000. greenacre is subject to a mortgage of $180,000 for which f is personally liable. the partnership assumes f’s liability for the mortgage. g and h each contribute $20,000 of cash. partnership gains and losses are shared equally by the three partners. as a starting point, f does not recognize gain on the contribution of property to the partnership185 and f’s starting basis for his partnership interest is the basis of the contributed property, $100,000.186 however, as a result of the contribution and assumption of liabilities by the partnership, f’s share of partnership liability is reduced from $180,000 to $60,000, while g and h each pick up a one-third share of the liabilities. f is treated under 180. treas. reg. § 1.752-1(a)(1). 181. treas. reg. § 1.752-2(b). 182. treas. reg. § 1.752-2(b)(3). 183. treas. reg. § 1.752-2(b)(5). 184. treas. reg. § 1.752-2(a). 185. irc § 721. 186. irc § 722 658 florida tax review [vol. 9:6 section 752(b) as receiving a cash distribution of $120,000, which exceeds f’s partnership basis by $20,000 and results in $20,000 of gain recognized by f.187 f’s basis in the partnership interest is reduced to zero.188 f’s capital account contribution is measured by the net value of the property, e.g. the fair market value reduced by the amount of the mortgage, and is thus $20,000.189 g and h, as general partners with liability for partnership debt, each increase their share of partnership liabilities by $60,000.190 thus, g and h are each treated as making a $60,000 cash contribution to the partnership that increases their respective bases to $80,000.191 immediately after formation, the partnership capital account is as follows: assets partners’ capital accounts book basis book basis greenacre $200,000 $100,000 liability $180,000 cash $ 40,000 $ 40,000 f $ 20,000 $ 0 g $ 20,000 $ 80,000 h $ 20,000 $ 80,000 $240,000 $140,000 $240,000 $160,000 there is a $20,000 difference between the partnership’s inside property basis and the partners’ outside basis that is attributable to the fact that f was required to recognize $20,000 of gain under section 731(a). a section 754 election and the adjustment under section 734(b)(1) would allow the partners to increase the basis of greenacre by $20,000. example 14b if in example 14a, f were to remain personally liable for the mortgage on greenacre, without any rights of indemnification from g or h (a limited partnership or llc whereby only f is liable for the debt), then f’s share of the debt would remain $180,000. f would not recognize gain, f’s basis in f’s partnership interest would remain $100,000 (f’s liability is neither increased nor decreased) and g and h would not 187. irc § 731(a). 188. f’s $100,000 starting basis for f’s partnership interest is reduced, but not below zero, by the amount of the § 752(b) deemed distribution of cash. irc § 733. 189. treas. reg. § 1.704-1(b)(2)(iv)(b). 190. irc § 752(a). this result assumes that each partner is responsible for one-third of the partnership liabilities. if the partnership property were to be worthless and the partnership liquidated, creditors would have the right to recover the liability from each of the partners, and each partner would then have a right of reimbursement against the other partners for their share of the debt. see treas. reg. § 1.752-2(b)(1) and (5).treas. reg. § 1.752-1(a)(2). 191. irc §§ 752(a), 722. 2009] built-in gain and built-in loss 659 include any of the liability in their bases. the partnership capital accounts would be – assets partners’ capital accounts book basis book basis greenacre $200,000 $100,000 liability $180,000 cash $ 40,000 $ 40,000 f $ 20,000 $100,000 g $ 20,000 $ 20,000 h $ 20,000 $ 20,000 $240,000 $140,000 $240,000 $140,000 c. nonrecourse liabilities if no partner is ultimately liable for partnership debt, the debt is a “nonrecourse” liability.192 an allocation of a tax deduction or tax loss that is funded by of nonrecourse debt, meaning an item that is not funded with equity capital contributed by a partner or by debt for which partners will be required to make a contribution, cannot have economic effect.193 where expenses are incurred with money for which a lender is ultimately liable, no partner bears the economic risk of loss with respect to the expenditure.194 the regulations allow deductions of items funded by nonrecourse debt only where the partnership agreement contains provisions to insure that allocations of nonrecourse deductions will be matched with a corresponding future allocation of gain as debt is eliminated – partnership minimum gain.195 the rules that determine a partner’s share of nonrecourse liability reflect the absence of economic responsibility for the debt and the gain chargeback requirement. a partner’s share of nonrecourse liability is the sum of three components – (1) the partner’s share of partnership minimum gain under treas. reg. § 1.704-2(g)(1), which broadly is the partner’s share of gain that would be recognized by the partnership on a disposition of property encumbered by nonrecourse liability that exceeds the basis of the property; (2) the partner’s share of partnership gain that would be allocated to the partner under section 704(c) if all of the partnership’s property subject to 192. treas. reg. § 1.752-1(a)(2). 193. treas. reg. § 1.704-2(b)(1). 194. id. 195. see treas. reg. § 1.704-2(b)(2) and (d). these provisions of the allocation rules treat allocations of deductions attributable to nonrecourse debt as being in accord with a partner’s interest in the partnership. note that this result mirrors the tax treatment of nonrecourse debt incurred by a single individual. the nonrecourse debt is included in basis of acquired property, supports depreciation deductions, and is taken into account as amount realized on disposition of the property causing gain recognition to the extent that the debt exceeds the adjusted basis of the property. see crane, 331 u.s. 1 (1947); tufts, 461 u.s. 300 (1983). 660 florida tax review [vol. 9:6 nonrecourse mortgages were disposed of in satisfaction of the mortgages and for no additional consideration; and (3) remaining partnership nonrecourse liabilities are allocated in accord with the partner’s share of partnership profits.196 the second of the three nonrecourse debt allocation rules ensures that a partner contributing property encumbered with nonrecourse debt that has a basis less than the amount of the liability will not be required to recognize gain under section 731(a) on the deemed cash distribution triggered by section 752(b).197 example 14c in example 14a, if the mortgage encumbering greenacre were a nonrecourse debt, under the second component of the allocation rules, f’s share of the partnership nonrecourse liability includes the gain that would be allocated to f under section 704(c) if greenacre were sold for the amount of the nonrecourse liability, $80,000 ($180,000 debt $100,000 basis). the remaining $100,000 of the nonrecourse liability is allocated to the partners in accord with their profit share, one-third each. thus, f’s share of the liability is reduced from $180,000 to $113,333 ($80,000 + 33,333). the $66,667 reduction in f’s liability is treated as a cash distribution that reduces f’s basis in his partnership interest to $33,333. g and h are allocated $33,333 of the liability, which is treated as a cash contribution and added to their respective partnership bases.198 the partnership capital account is as follows: 196. treas. reg. § 1.752-3(a). the first of these provisions assures that a partner recognizes gain to the extent that the partner has been allocated expense or loss items in excess of positive capital contributions (or a deficit make-up), e.g allocations of nonrecourse debt funded deductions. with respect to the third item, treas. reg. §1.752-3(a)(3) permits the partnership agreement to specify a partner’s share of partnership profits for the purpose of allocating residual partnership nonrecourse debt. the specified shares will be respected as long as they are reasonably consistent with some other significant item of partnership income or gain that has substantial economic effect under the § 704(b) regulations. alternatively, treas. reg. § 1.752-3(a)(3) permits the partnership agreement to specify that excess nonrecourse indebtedness will be allocated with respect to the proportion in which partners reasonably can be expected to be allocated nonrecourse deductions. such a provision is important in any partnership that has nonrecourse debt, and in any llc because all debt of an llc that is not guaranteed by a member is nonrecourse debt. 197. this provision also applies to situations where the partnership capital accounts have been revalued under treas. reg. § 1.704-1(b)(2)(ii)(f) which requires using § 704(c) principles to address book/tax differences. 198. irc § 722. 2009] built-in gain and built-in loss 661 assets partners’ capital accounts book basis book basis greenacre $200,000 $100,000 liability $180,000 cash $ 40,000 $ 40,000 f $ 20,000 $ 33,333 g $ 20,000 $ 53,333 h $ 20,000 $ 53,334 $240,000 $140,000 $240,000 $140,000 v. built-in loss property a. general rules as described above,199 section 704(c)(1)(a) requires that all allocations with respect to built-in gain or loss property take into account the difference between adjusted basis and fair market value at the time of contribution. with respect to built-in loss property, this requires that precontribution losses be allocated to the contributing partner. section 704(c)(1)(c), added by the 2004 act,200 contains additional rules with respect to built-in loss property that do not change the basic principles of section 704(c)(1)(a), but which contain their own set of complexities. section 704(c)(1)(c) contains two separate rules. first, “if any property so contributed has a built-in loss – (i) such built-in loss shall be taken into account only in determining the amount of items allocated to the contributing partner.”201 this provision appears to be a restrictive subset of section 704(c)(1)(a) intended to insure that a built-in loss can be taken into account only by the contributing partner. section 704(c)(1)(c)(ii) adds an additional rule that provides, “except as provided in regulations, in determining the amount of items allocated to other partners, the basis of the contributed property in the hands of the partnership shall be treated as being equal to its fair market value at the time of contribution.” this provision buttresses the rule that only the contributing partner may take into account a precontribution built-in loss, but has additional implications. section 704(c)(1)(c) is clear in its limitation of built-in loss to the partner who contributed built-in loss property. this rule is consistent with section 704(c)(1)(a) and does not appear to change the allocation rules of 199. part iii, supra, beginning at note 39. 200. american jobs creation act of 2004, pub.l. no. 108-357, § 833(c), 118 stat. 1589 (2004). section 704(c)(1)(c) is applicable to contributions after oct. 22, 2004. 201. for purposes of subparagraph (c), the term “built-in loss” means the excess of the adjusted basis of the property (determined without regard to subparagraph (c)(ii) ) over its fair market value at the time of contribution. irc § 704(c)(1)(c), flush language. 662 florida tax review [vol. 9:6 that section. the second part of the limitation, the provision limiting basis of the non-contributing partners to fair market value at the time of the contribution, raises some questions that may ultimately be resolved by the exercise of the regulatory authority provided by its terms. while the contributing partner remains a member of the partnership, application of section 704(c)(1)(c)(i) prevents the transfer of built-in loss or excess depreciation to other partners, as does section 704(c)(1)(a). indeed, in the hierarchy of the code, section 704(c)(1)(a) should be controlling with respect to allocations attributable to either built-in gain or built-in loss property. however, as is discussed below in the context of the examples, even while the contributing partner remains in the partnership, independent application of section 704(c)(1)(c)(ii) may create realized gain by the noncontributing partners on the disposition of built-in loss property. this does not appear to be an intended result. section 704(c)(1)(c)(ii) should be read to require all allocations of loss attributable to contributed built-in loss property be made to the contributing partner as long as the partner remains in the partnership. section 704(c)(1)(c)(ii) should come into play to adjust the basis of contributed built-in loss property with respect to other partners only if allocations to the contributing partner are not possible because the partner has left the partnership. these propositions are not clear from the face of the statute, however. b. allocations of built-in loss in general, under both section 704(c)(1)(a) and (c), allocations of recognized built-in loss attributable to contributed property are the same as allocations of built-in gain. example 15a assume that a, b, and c form a partnership to which a contributes $100,000 in cash, b contributes gainacre, for which b paid only $40,000 but which is worth $100,000, and c contributes lossacre, for which c paid $130,000 but which is worth only $100,000. the partnership agreement provides that the partners will share all gains and losses one-third each. immediately after the formation of the abc partnership, the partnership capital account is follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre $100,000 $130,000 c $100,000 $130,000 $300,000 $270,000 $300,000 $270,000 if the partnership sells lossacre for $100,000, its book value, the $30,000 2009] built-in gain and built-in loss 663 partnership tax loss must be allocated entirely to c under § 704(c)(1)(a) and (c)(i). the resulting partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre/cash $100,000 $100,000 c $100,000 $100,000 $300,000 $240,000 $300,000 $240,000 the equality between c’s capital account and basis indicates that c’s precontribution loss has been eliminated with c’s recognition of the loss. example 15b if the partnership in example 15a were to sell lossacre for $85,000, the partnership would have $15,000 of book loss, which is allocated equally among the partners, $5,000 each. a portion of the partnership’s tax loss ($45,000) is allocated equally to each partner in accord with each partner’s share of the book loss. the remaining $30,000 of tax loss is allocated to c under § 704(c)(1)(a). this allocation is consistent with § 704(c)(1)(c)(i) in that the full $30,000 pre-contribution loss is allocated to the contributing partner. in addition, under section 704(c)(1)(c)(ii), the tax loss allocated to each of a and b is consistent with treating each of them as having a basis in lossacre equal to its fair market value at the time of c’s contribution. the resulting partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $ 95,000 $ 95,000 gainacre $100,000 $ 40,000 b $ 95,000 $ 35,000 lossacre/cash $ 85,000 $ 85,000 c $ 95,000 $ 95,000 $285,000 $225,000 $285,000 $225,000 again, the allocation eliminates the disparity in c’s book and tax accounts. section 704(c)(1)(c)(ii) begins to cause trouble where a partnership has both book gain and tax loss with respect to contributed built-in loss property. example 15c if the partnership in example 15a were to sell lossacre for $115,000, the partnership has $15,000 of book gain and a $15,000 tax loss. the book gain is allocated $5,000 to each partner. section 704(c)(1)(a), standing alone, would require that the full partnership tax loss 664 florida tax review [vol. 9:6 be allocated to c. the resulting partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $105,000 $100,000 gainacre $100,000 $ 40,000 b $105,000 $ 40,000 lossacre/cash $115,000 $115,000 c $105,000 $115,000 $315,000 $255,000 $315,000 $255,000 the remaining unrecognized pre-contribution built-in loss with respect to lossacre will be recovered by c on a disposition of c’s partnership interest; c’s outside basis exceeds c’s capital interest in an amount equal to the unrecovered built-in loss. a, the cash partner, will recognize a’s book gains on disposition of the partnership interest. b’s book gain on sale of lossacre is also reflected in an additional $5,000 difference between b’s capital account and tax basis. the allocations in this example permit the non-contributing partners to take advantage of c’s pre-contribution loss to defer recognition of realized book gains. $15,000 of c’s $30,000 pre-contribution loss offsets postcontribution appreciation of lossacre. section 704(c)(1)(c) might be applied to prevent this result by requiring recognition of gain by the non-contributing partners. section 704(c)(1)(c)(i) provides that pre-contribution loss “shall be taken into account only in determining the amount of items allocated to the contributing partner.” in this example, c’s pre-contribution loss is taken into account to avoid an allocation of tax gain to match book and economic gain to a and b. section 704(c)(1)(c)(i) could be interpreted to mean that only c may take advantage of the basis in lossacre in excess of $100,000 in order to avoid recognition of gain attributable to lossacre’s post contribution appreciation. c’s $5,000 share of the $15,000 of this book gain is offset by c’s section pre-contribution loss. eliminating c’s pre-contribution built-in loss from consideration, there is no basis to be used by a and b to offset their combined $10,000 of book gain, thereby requiring recognition of $5,000 of tax gain by a and b each.202 this analysis of section 202. tracing basis suggests that of the $130,000 basis, only c may take advantage of the $30,000 basis in excess of the fair market value of blackacre at the time of contribution. of this $30,000 c claims $15,000 of tax loss as permitted by § 704(c)(1)(a) and the traditional allocation with the ceiling rule of treas. reg. § 1.704-3(b)(1). another $5,000 of c’s excess pre-contribution basis absorbs c’s share of the post-contribution appreciation, leaving $10,000 of pre-contribution basis that may or may not offset a’s and b’s share of post-contribution appreciation. 2009] built-in gain and built-in loss 665 704(c)(1)(c)(i) is consistent with a literal application of section 704(c)(1)(c)(ii), which provides that, for purposes of determining the amount allocated to the non-contributing partners, a’s and b’s basis in lossacre is limited to $100,000, its fair market value at the time of c’s contribution. thus, also under section 704(c)(1)(c)(ii) a and b each must recognize taxable gain on the disposition of lossacre.203 sale of lossacre for $115,000 with a $100,000 basis would result in $5,000 of tax gain allocable to a and b each, a tax gain equivalent to their respective book gains. the resulting partnership capital account would be as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $105,000 $105,000 gainacre $100,000 $ 40,000 b $105,000 $ 45,000 lossacre/cash $115,000 $115,000 c $105,000 $115,000 $315,000 $255,000 $315,000 $265,000 the inside/outside basis disparity created by this analysis suggests that the result is not correct.204 the $10,000 of excess outside basis is the result of $10,000 of gain recognized by the partners outside of the partnership that is not attributable to a recognized partnership tax gain.205 this interpretation of section 704(c)(1)(c) creates a notional partnership tax item that produces partner tax gain. section 704 applies to the allocation of partnership tax items.206 section 704 does not allocate book gains and losses, nor create tax items to match book items.207 the opposite is the case; generally the tax allocation rules of section 704(b) are designed to insure that 203. see l. rachuba, new issues with partnership built-in loss property, 111 tax notes 1569 (2005). 204. note also that since the transaction is neither a distribution of property nor a sale of a partnership interest, this inside/outside basis disparity cannot be corrected by a § 754 election. 205. importantly, while §§ 734(b) and 743(b) are intended to eliminate book/tax disparities caused by the application of structural provisions of subchapter k, these provisions to not provide an adjustment to eliminate book/tax disparities created by the gain recognized here. 206. by its terms, § 704(a) applies to determine a “partner’s distributive share of income, gain, loss, deduction or credit.” section 704(c)(1)(a) begins by referring to “income, gain, loss, and deduction with respect to property contributed to the partnership . . .” section 704(c)(1)(c)(i) refers to taking into account built-in loss “in determining the amount of items allocated to the contributing partner.” 207. the exception to this statement is the provision in the treas. reg. § 1.704-3(d) for remedial allocations that creates notional items of offsetting tax 666 florida tax review [vol. 9:6 tax items are allocated to follow economic allocations. section 704 does not create tax items. in addition, section 704(c)(1)(c)(ii), by its terms, provides only that in determining allocations of partnership items, the basis of contributed built-in loss property is limited. the language does not create partnership taxable gain; it merely addresses the allocation of recognized partnership items. the allocation of $5,000 of recognized tax gain to a and b in this example inappropriately creates a tax item that does not exist in the partnership. if section 704(c)(1)(c)(ii) is to be read to require recognition of notional gain, reaching the correct capital account balance would require a remedial allocation of a notional $10,000 tax loss to c (to offset the $10,000 notional tax gain allocated to a and b), in which case the partnership capital account would be – assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $105,000 $105,000 gainacre $100,000 $ 40,000 b $105,000 $ 45,000 lossacre/cash $115,000 $115,000 c $105,000 $105,000 $315,000 $255,000 $315,000 $255,000 the balanced capital account suggests this result may be correct, or at least appealing. the result is good for c who is able to recover c’s full precontribution loss offset with c’s share of the post-contribution economic gain, but not so good for a and b who are required to accelerate recognition of their book gain. as suggested above,208 as a matter of statutory construction, § 704(c)(1)(a) should be read to operate first to allocate built-in loss to the contributing partner, as long as the contributing partner remains a partner. in addition, the legislative history of § 704(c)(1)(c) indicates that the statutory purpose is to prevent a transfer of tax loss from the contributing partner to others.209 although a and b in example 15c might be able to take advantage 208. text supra at note 201. 209. rachuba, supra note 203, also states that § 704(c)(1)(c) is designed to prevent duplicate loss and gives the following example, “assume a contributes property to partnership ab with fmv of $50 and basis of $100 and b contributes $50 cash. assume all allocations are made 50-50. assume that a then sells its interest for $50 to c. because a’s outside basis was $100, a recognizes a $50 loss on the sale. suppose the partnership thereafter sells the property for $50 and recognizes the $50 loss. under pre-section 704(c)(1)(c) treas. reg. § 1.704-3(a)(7), the ‘built-in loss’ is allocated to the transferee partner ‘as it would have been allocated to the transferor partner,’ that is, the transferee steps into the shoes of the transferor. thus, c now recognizes a $50 loss that, of course, a had already 2009] built-in gain and built-in loss 667 of the contributing partner’s pre-contribution loss in order to defer recognition of book gain, ultimately none of c’s pre-contribution loss is transferred to a and b. nor is the loss duplicated in the form of recognition by other than the contributing partner. the deferral of gain recognition does not require acceleration of unrealized tax gains by non-contributing partners on disposition of built-in loss property. the basis provision of section 704(c)(1)(c)(ii) is not necessary as long as pre-contribution loss can be allocated to the contributing partner. presumably, regulations ultimately will clarify this ambiguity. on the other hand, if the partners agree to permit the contributing partner to take advantage of the partner’s pre-contribution loss at the time of sale, the curative and remedial allocation provision of treas. reg. section 1.704-3(c) and (d) appear to be available to achieve that result. c. allocations of depreciation deductions with respect to built-in loss property allocations of depreciation attributable to built-in loss property do not create the same type of book/tax disparity as allocations with respect to built-in gain property because in the former case the tax allocations exceed book allocations. there will be sufficient tax basis to match tax allocations of depreciation and other capital recovery deductions with the book allocations to non-contributing partners. the full amount of the tax allocation in excess of book depreciation can be made to the contributing partner. in addition, section 704(c)(1)(c) should bar the allocation of depreciation to noncontributing partners that is calculated on an adjusted basis in excess of the fair market value of contributed built-in loss property as of the date of the contribution. example 16 assume that in example 15a c contributes depreciable property with a fair market value of $100,000 and an adjusted basis of $130,000. also assume for the sake of simplicity that the property has a remaining recovery period of 10 years and is subject to straight line depreciation. the partnership’s annual book depreciation is $10,000 and tax depreciation is $13,000. a, b, and c are each allocated $3,333 of book depreciation. a and b are also allocated $3,333 of tax depreciation (which is consistent with a $100,000 basis in accord with § 704(c)(1)(c)(ii)), leaving the remaining $6,334 of tax depreciation for allocation to c (c’s share of recognized. of course, c has to reduce its basis in its partnership interest to $0 and, were the partnership to immediately liquidate, c would recognize an offsetting capital gain of $50 because its liquidating distribution would equal $50. however, as long as the partnership continues in existence, the gain is deferred and a loss has been accelerated, or, to put it differently, two partners have ‘benefited’ from the same loss – one of them, c, in exchange for the obligation to recognize gain at a later date.” 668 florida tax review [vol. 9:6 book depreciation of $3,333 plus the $5,000 excess tax depreciation over book depreciation attributable to c’s pre-contribution built-in loss). at the end of the depreciable property’s ten year recovery period, a and b each recover their $33,333 “cost” for the depreciable property,210 and c recovers c’s pre-contribution basis in the depreciable property. the partnership capital account is as follows – assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $ 66,667 $ 66,667 gainacre $100,000 $ 40,000 b211 $ 66,667 $ 6,667 depreciable property 0 0 c $ 66,666 $ 66,666 $200,000 $140,000 $200,000 $140,000 d. liquidation of the contributing partner when the partnership interest of a partner who contributed built-in loss property is completely liquidated, allocations of tax items reflecting precontribution loss are no longer possible. the rule of section 704(c)(1)(c)(ii) limits the basis of “other partners” to the fair market value of contributed property at the time of contribution after the contributing partner’s interest is liquidated. as a result, the pre-contribution built-in loss is available only to the contributing partner. example 17 assume that the partnership in example 15a distributed $100,000 cash to c in complete liquidation of c’s interest in the partnership when the fair market value of the property contributed by c remained $100,000. c recognizes a $30,000 loss ($100,000 $130,000) on the receipt of cash in liquidation of c’s partnership interest.212 under the limitation of § 704(c)(1)(c)(ii), the continuing partners’ basis in lossacre is now limited to $100,000. the partnership capital account is thus − 210. rounded off. book depreciation is $3333.33/$3333.34 per year. 211 the disparity in b’s book and tax accounts is attributable to the $60,000 of pre-contribution gain in whiteacre at the time of its contribution to the partnership. 212. irc § 731(a)(2). loss is recognized on a distribution in complete liquidation of a partner’s interest where the distributee receives only cash and/or inventory and unrealized receivables (the basis of which is limited to the partnership basis) and the amount of the cash or the basis of the inventory and unrealized receivables is less than the partner’s basis in the partnership interest. 2009] built-in gain and built-in loss 669 assets partners’ capital accounts book value basis book value basis cash 0 0 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre $100,000 $100,000 $200,000 $140,000 $200,000 $140,000 c recognizes c’s pre-contribution loss on the liquidation distribution, thus c’s loss is preserved. section 704(c)(1)(c)(ii) prevents duplication of c’s pre-contribution loss with the basis reduction that prevents a and b from again taking advantage of the pre-contribution built-in loss.213 the same result would occur if the partnership had a section 754 election in effect. section 734(b)(2)(a) requires a reduction in the basis of partnership property in the amount of loss recognized by a partner under section 731(a)(2). thus, on the distribution to c, the partnership would have been required to reduce the basis of partnership property by the amount of c’s recognized loss.214 the basis reduction would have been allocated to lossacre as depreciated section 1231 property or capital gain or loss property under the rules of section 755.215 indeed, as a companion to section 704(c)(1)(c)(ii), congress required mandatory basis adjustments on distributions and transfers of a partner’s interest with substantial built-in losses.216 213. absent § 704(c)(1)(c)(ii), a and b could have sold blackacre after c’s departure from the partnership and recognized the built-in $30,000 loss. the loss would have decreased a’s and b’s bases in their partnership interest and thereby increased gain (or decreased loss) on the ultimate disposition of their partnership interest by either a or b. 214. irc § 734(b)(2)(a). 215. irc § 755(b) requires that increases or decreases in partnership basis required under the rules of either §§ 734(b) or 743(b) (applicable to partnership distributions and transfers of a partnership interest, respectively) attributable to (1) capital assets or § 1231 property, or (2) any other property, shall be allocated to property of like character. section 755(a) requires that any increase or decrease in the basis of partnership property will be applied first to reduce the difference between the fair market value and basis of property, then as provided in regulations. treas. reg. § 1.755-1 contains extensive rules for these allocations. if the partnership possessed several depreciated assets, a § 734(b)(2) basis reduction would not necessarily be allocated to contributed built-in loss property. 216. pub. law no. 108-357, § 833, 118 stat. 1589 (2004), amending irc §§ 734 and 743. notice 2005-32, 2005-1 c.b. 895, requires a partnership subject to a basis reduction to file a statement with the partnership return for the year of the adjustment under treas. reg. §§ 1.735-1(d) or 1.743-1(k) as if a § 754 election were in effect. 670 florida tax review [vol. 9:6 e. required basis adjustments with respect to built-in losses 1. distributions as amended in 2004,217 section 734 requires an adjustment to partnership asset bases on a distribution to a partner if there is a “substantial basis reduction.” a substantial basis reduction occurs if the reductions to partnership bases described by section 734(b)(2) exceed $250,000.218 section 734(b)(2) provides for a decrease in the bases of partnership assets on a distribution to a partner in complete liquidation of the partner’s interest if (a) the distributee partner recognizes a loss under section 731(a)(2),219 or (b), the basis of property other than money, inventory, or unrealized receivables is increased in the hands of the distributee partner over the basis of the property to the partnership.220 example 18 add one zero to each number in examples 15a and 17. the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $1,000,000 $1,000,000 a $1,000,000 $1,000,000 gainacre $1,000,000 $ 400,000 b $1,000,000 $ 400,000 lossacre $1,000,000 $1,300,000 c $1,000,000 $1,300,000 $3,000,000 $2,700,000 $3,000,000 $2,700,000 on distribution of $1,000,000 cash in complete liquidation of c’s interest, c will recognize a $300,000 loss.221 section 734(b)(2)(a) requires a reduction in the basis of partnership property of $300,000, which is a substantial basis 217. pub. law no. 108-357 (2004), § 833(c), 118 stat. 1591. 218. irc § 734(d). 219. loss is recognized only on a distribution in complete liquidation of a partner’s interest where the amount of money and the basis to the distributee of distributed inventory or unrealized receivables (the basis of which is limited to the partnership’s basis) is less than the distributee partner’s basis in the partnership interest. irc § 731(a)(2). 220. irc § 732(b) provides that the basis of property other than money distributed to a partner in liquidation of the partner’s interest shall be an amount equal to the distributee’s basis in the partnership interest. the partner’s basis is first allocated to unrealized receivables and inventory in an amount equal to the partnership’s basis in such assets. the remaining basis is allocated to other properties. if the distributee partner’s remaining basis is greater than the partnership basis in these assets, the increase is allocated first to properties with unrealized appreciation (in proportion to the unrealized appreciation in the assets), then to all properties in proportion to fair market value. irc § 732(c). 221. irc § 731(a)(2). 2009] built-in gain and built-in loss 671 reduction. the reduction will be allocated under section 755 principles to reduce the basis of lossacre by $300,000.222 the resulting partnership balance sheet is − assets partners’ capital accounts book value basis book value basis gainacre $1,000,000 $ 400,000 a $1,000,000 $1,000,000 lossacre $1,000,000 $1,000,000 b $1,000,000 $ 400,000 $2,000,000 $1,400,000 $2,000,000 $1,400,000 if § 704(c)(1))(c)(ii) were to be applied, the basis of lossacre as to the noncontributing partners also would be reduced to $1,000,000. note, however, that the mandatory basis adjustment of section 734 is not limited to losses generated by contributed built-in loss property. the mandatory basis adjustment of section 734(b)(2) and the basis limitation of section 704(c)(1)(c)(ii) prevent the continuing partners from duplicating losses on a subsequent disposition of partnership built-in loss property. as is the case with respect to allocations under section 704(c)(1)(c)(i), the liquidated partner’s share of built-in loss, as reflected in an excess of the partner’s partnership basis over the value of the partner’s capital account, is preserved with a loss deduction on distribution of cash, or in the difference in the fair market value and basis of distributed property.223 2. transfer of a partnership interest in general, on the sale or exchange of a partnership interest, the selling partner recognizes gain or loss treated as gain or loss from the sale or exchange of a capital asset.224 however, if the partnership has unrealized receivables or inventory,225 a portion of the amount realized by the selling partner is treated as realized for the partner’s interest in the unrealized receivables and inventory.226 the selling partner recognizes ordinary gain or loss based on the selling partner’s share of the partnership basis in the 222. see supra, note 215. 223. under irc § 732(b), the basis of property received in liquidation of a partner’s interest is the basis of the partner’s partnership interest reduced by the amount of money received. 224. irc § 741. 225. broadly, unrealized receivables and inventory include any property which, if sold by the partnership, would produce ordinary gain or loss. irc § 751(c) and (d). 226. irc § 751(a). 672 florida tax review [vol. 9:6 unrealized receivables and inventory.227 section 743(a) provides that the basis of partnership property will not be changed as a result of a transfer of a partnership interest. however, section 743(b) provides for adjustments in the bases of partnership assets to reflect the difference between a transferee partner’s basis for the acquired partnership interest and the transferee partner’s share of the partnership asset bases. normally section 743(b) is optional,228 but, under the 2004 changes, section 743(b) adjustments are mandatory if the partnership has a substantial built-in loss immediately after the transfer.229 traditionally, the transferee partner steps into the shoes of the transferor with respect to built-in gains and losses.230 however, section 704(c)(1)(c) changes this pattern with respect to pre-contribution built-in losses of the transferor partner. under section 704(c)(1)(c)(i), built-in loss with respect to contributed property is taken into account only in allocations to the partner who contributed built-in loss property. under section 704(c)(1)(c)(ii), for purposes of determining allocations to “other partners,” the basis of contributed built-in loss property is limited to its fair market value at the time of contribution. this basis limitation raises some difficult questions when the value of contributed built-in loss property has increased between the date of contribution and the date of a transfer of the contributing partner’s partnership interest. as the examples below will demonstrate, the correct approach is to apply section 704(c)(1)(c)(ii) to limit the basis of the transferee in contributed built-in loss property to fair market value at the time of contribution and rely on section 743(b) adjustments to properly reflect the transferee’s outside basis. a. mandatory basis adjustments on the transfer of a partnership interest section 743, as amended in 2004, requires basis adjustments on the sale or exchange of a partnership interest if immediately after the transfer if the partnership has a “substantial built-in loss.”231 a partnership has a substantial built-in loss if the partnership’s basis in partnership property 227. treas. reg. § 1.751-1(a)(2) provides that the selling partner recognizes as ordinary gain or loss the amount of gain or loss that would be allocated to the partner under the principles of § 704 if the partnership had sold its unrealized receivables and inventory for fair market value. 228. section 734(b) and 743(b) adjustments are triggered with an irrevocable partnership election under irc § 754. 229. see infra, text at note 231. 230. treas. reg. § 1.704-3(a)(7). 231. pub. law no. 108-357, § 833(d), 118 stat. 1591 (2004). the required basis adjustment of § 743 is effective with respect to transfers of partnership interests after oct. 22, 2004. 2009] built-in gain and built-in loss 673 exceeds the fair market value of its property by $250,000.232 where a purchasing partner acquires a partnership interest with built-in loss, the purchaser’s cost basis will be less than the purchaser’s share of the inside partnership’s total basis in assets. in this case, section 743(b)(2) provides for a decrease in the adjusted basis of partnership property in the amount that the transferee’s proportionate share of the adjusted basis of partnership property exceeds the transferee’s basis in the acquired partnership interest.233 the mandatory basis reduction prevents the partner acquiring an interest in a partnership with a substantial built-in loss from taking advantage of that loss on disposition of depreciated partnership property.234 the provision is intended to avoid a duplication of loss, which presumably has been accounted for by the selling partner on the disposition of the partnership interest. the adjustment under section 743(b) is the difference between the transferee partner’s basis in the transferee’s partnership interest and the transferee’s “proportionate share of the adjusted basis of partnership property.” regulations provide that the transferee’s share of the adjusted basis of partnership property is the sum of (1) the transferee partner’s interest as a partner in the partnership’s “previously taxed capital,” plus (2) the transferee partner’s share of partnership liabilities.235 the transferee partner’s interest in previously taxed capital is the amount of cash the partner would receive on a liquidation of the partnership after a hypothetical sale of all partnership assets for fair market value increased by the amount of tax loss, or decreased by the amount of tax gain, that would have been allocated to the transferee partner (including gains and losses allocable under section 704(c)236) as a result of the hypothetical sale.237 this methodology identifies the new partner’s share of asset bases while accounting for any gain or loss that would be allocated to the partners because of allocations of built-in gain or loss to the 232. irc § 743(d)(1). 233. irc § 743(b)(2). section 743(b)(1) provides for an increase in the basis of partnership assets to the extent that a transferee partner’s basis in the acquired partnership interest exceeds the transferee partner’s proportionate share of the a partnership’s basis in partnership assets. 234. the basis adjustment under § 743(b) is with respect only to the transferee partner and does not affect gain or loss allocated to other partners. irc § 743(b), flush language. 235. treas. reg. § 1.743-1(d). 236. the hypothetical allocations of gain and loss take into account any § 704(c) amount that would have been allocated to the transferee partner as a result of stepping into the shoes of the transferor partner, as well as any remedial allocations to the transferor partner. 237. treas. reg. § 1.743-1(d)(1). 674 florida tax review [vol. 9:6 partner under section 704(c) and the corresponding reverse allocation rules of the regulations.238 although there are similarities between the mandatory basis adjustments required under section 734(b) in the case of distributions where there is a substantial basis reduction239 and the adjustment under section 743(b) in the case of a transfer of an interest in a partnership with substantial built-in loss, the two provisions are not symmetrical. a partnership from which a distribution in liquidation of a partner will trigger a mandatory section 734(b) adjustment does necessarily require a mandatory adjustment on a transfer by the same partner. example 19a assume in the abc partnership described in example 18, that c sold c’s partnership interest to d for $1,000,000. c recognizes a $300,000 loss on the sale. d’s basis in the acquired partnership interest is $1,000,000. c’s recognized loss is attributable to c’s pre-contribution built-in loss in lossacre. however, for purposes of determining whether the partnership has a substantial built-in loss, the pre-contribution built-in gain attributable to gainacre offsets the built-in loss of lossacre. the mandatory adjustment rule of section 743 is not applicable.240 nonetheless, if section 704(c)(1)(c)(ii) is applicable to the abd partnership to limit “other” partners’ basis in contributed property to fair market value on the date of contribution, the basis of lossacre with respect to a, b, and d is limited to $1,000,000. the partnership balance sheet would be as follows: assets partners’ capital accounts book value basis book value basis cash $1,000,000 $1,000,000 a $1,000,000 $1,000,000 gainacre $1,000,000 $ 400,000 b $1,000,000 $ 400,000 lossacre $1,000,000 $1,000,000 d $1,000,000 $1,000,000 $3,000,000 $2,400,000 $3,000,000 $2,400,000 this is the same result that would occur if section 743(b) adjustments were required.241 238. see infra, text at note 262. 239. see supra, text at note 217. 240. compare the application of the mandatory adjustment rule of § 734(b) in the case of a cash distribution to c upon which c recognized a $300,000 loss, supra, text at note 222. 241. section 743(b) would apply if a § 754 election were in effect for the partnership. d’s share of the partnership asset basis is $1,000,000 that would be distributed on a liquidation following a hypothetical sale of assets increased by $300,000 of loss that would be allocated to d who steps into c’s shoes with respect to the required § 704(c)(1)(a) of pre-contribution loss attributable to blackacre. the 2009] built-in gain and built-in loss 675 example 19b assume in the abc partnership described in example 18, that b had contributed cash instead of gainacre. the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $2,000,000 $2,000,000 a $1,000,000 $1,000,000 lossacre $1,000,000 $1,300,000 b $1,000,000 $1,000,000 c $1,000,000 $1,300,000 $3,000,000 $2,300,000 $3,000,000 $2,300,000 now suppose that c sells c’s partnership interest to d for $1,000,000. the partnership has a substantial built-in loss. the mandatory application of section 743(b) requires a $300,000 reduction of the basis of partnership assets, which is only allocable to lossacre. thus − assets partners’ capital accounts book value basis book value basis cash $2,000,000 $2,000,000 a $1,000,000 $1,000,000 lossacre $1,000,000 $1,000,000 b $1,000,000 $1,000,000 d $1,000,000 $1,000,000 $3,000,000 $2,000,000 $3,000,000 $2,000,000 section 704(c)(1)(c)(ii) would also limit lossacre’s basis to $1,000,000 with respect to a, b, and d. f. the trouble with post-contribution appreciation of built-in loss property and a transfer of the contributor’s interest on disposition of contributed built-in loss property that has appreciated above its fair market value on the date of the contribution, precontribution built-in loss may be used by continuing partners to shelter book excess of d’s share of partnership basis over d’s $1,000,000 basis in the transferred interest produces a $300,000 basis reduction in blackacre to $1,000,000, attributable only to d, thereby eliminating the loss allocable to blackacre. as discussed infra, text accompanying note 250, applying § 704(c)(1)(c)(ii) to this determination, and otherwise limiting the basis of blackacre to $1,000,000, eliminates any § 743(b) adjustment and again eliminates potential loss allocable to d on disposition of blackacre. 676 florida tax review [vol. 9:6 gains from immediate recognition.242 the problem is compounded when the partner who contributed built-in loss property transfers the partnership interest to a new partner. a strict application of section 704(c)(1)(c)(ii), limiting the new partner’s basis in the contributed built-in loss property to its value as of the date of the original contribution, produces the correct result under subchapter k principles. indeed, the application of section 704(c)(1)(c)(ii) eliminates an anomaly in book and tax accounts that would exist in the absence of the basis limitation . under traditional applications of section 704(c)(1)(a), the purchaser of a partnership interest steps into the shoes of the seller with respect to the seller’s share of any allocations required by section 704(c)(1).243 if section 704(c)(1)(c)(i) is applied in the same fashion, allocations of tax items attributable to built-in loss property contributed by the selling partner are allocable to the purchasing partner. without more, however, this produces a duplicated tax loss attributable to the contributed built-in loss property, one loss recognized by the contributing partner on disposition of the partnership interest, and a second loss at the partnership level on disposition of the contributed property. section 704(c)(1)(c)(ii) eliminates the partnership level loss by limiting for allocation purposes the basis of the built-in loss property to its fair market value at the time of the contribution. however, applying this rule to a partner who purchases an interest in the partnership after the contributed built-in loss property has appreciated by an amount not in excess of its basis creates a built-in gain for the purchasing partner. a section 754 election and section 743(b) provide an appropriate mechanism to eliminate this gain. example 20 return to the abc partnership of example 15a. assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre $100,000 $130,000 c $100,000 $130,000 $300,000 $270,000 $300,000 $270,000 now suppose that when lossacre has appreciated to $115,000 c sells c’s partnership interest to d for $105,000. c recognizes a $25,000 loss244 and 242. this issue was considered in example 15c, supra, text preceding note 202. 243. treas. reg. § 1.704-3(a)(7). 244. irc § 741. 2009] built-in gain and built-in loss 677 d’s basis in the partnership interest is $105,000.245 the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre $100,000 $130,000 d $100,000 $105,000 $300,000 $270,000 $300,000 $245,000 the $25,000 disparity between the partnership’s asset bases and the partners’ bases in their partnership interest occurs because c’s recognized $25,000 loss is not reflected in adjustments to the basis of partnership assets.246 in the absence of section 704(c)(1)(c), under section 704(c)(1)(a), d, the transferee partner, would step into c’s shoes and would be allocated the first $30,000 of loss on the sale of lossacre.247 if lossacre were sold for $115,000, the partnership would recognize $15,000 of book gain, allocated equally to a, b, and d, and $15,000 tax loss allocable to d. the partnership capital account would then be – assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $105,000 $100,000 gainacre $100,000 $ 40,000 b $105,000 $ 40,000 lossacre/cash $115,000 $115,000 d $105,000 $ 90,000 $315,000 $250,000 $315,000 $235,000 the loss attributable to the pre-contribution built-in loss in lossacre is duplicated; $25,000 is recognized by c on disposition of the partnership interest and $15,000 is recognized on disposition of lossacre by the partnership. d’s recognized loss would be recovered on a disposition or liquidation of d’s interest with $15,000 of built-in gain. in addition, these allocations have the effect of worsening disparities in the partners’ book and tax accounts. again, ignoring the potential application of section 704(c)(1)(c)(ii), the partnership can eliminate its section 704(c) issues and the remaining built-in loss attributable to lossacre with a section 754 election. the 245. irc § 742. 246. irc § 743(a). 247. treas. reg. § 1.704-3(a)(7). 678 florida tax review [vol. 9:6 accompanying § 743(b) adjustment would reduce the basis of lossacre to $115,000, which is its fair market value at the time of d’s purchase of the partnership interest.248 only d is affected by this basis reduction. the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre $100,000 $115,000 d $100,000 $105,000 $300,000 $255,000 $300,000 $245,000 now, if lossacre is sold for $115,000, its fair market value, the partnership recognizes $15,000 of book gain allocated equally among the partners, and no tax gain or loss. the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $105,000 $100,000 gainacre $100,000 $ 40,000 b $105,000 $ 40,000 lossacre/cash $115,000 $115,000 d $105,000 $105,000 $315,000 $255,000 $315,000 $245,000 even with the section 754 election, there remains a $10,000 disparity between inside and outside bases that is attributable to the $10,000 of book gain on lossacre that is allocable to a and b, but which does not produce tax gain. a’s and b’s book appreciation is offset by $10,000 of the contributing partner’s pre-contribution loss.249 recognition of this gain will be deferred until a and b dispose of their partnership interests. the application of section 704(c)(1)(c) to this situation is not crystal clear. one could assert that a’s and b’s use of c’s pre-contribution loss to offset an allocation of gain is contrary to section 704(c)(1)(c)(i), which 248. the excess of d’s share of partnership inside basis over d’s outside basis is $15,000. d’s share of partnership inside basis is d’s share of previously taxed capital, which is the $105,000 that would be distributed to d on sale of partnership assets and complete liquidation, increased to $120,000 by the $15,000 loss that would be realized by the partnership on sale of blackacre and allocated to d under § 704(c)(1)(a) principles. treas. reg. § 1.743-1. 249. c’s share of the book appreciation is already reflected in c’s cost basis for the partnership interest. 2009] built-in gain and built-in loss 679 should, therefore, require recognition of tax gain by a and b to match their book gain. under a literal application of section 704(c)(1)(c)(ii), a, b, and d, as other partners, would be treated as having a basis in lossacre that is limited to its fair market value on contribution. under this approach, a, b, and d must each recognize $5,000 of gain on the disposition of lossacre. this interpretation of section 704(c)(1)(c)(ii) is creating a notional tax gain for the partners where there is no recognized gain in the partnership. the partnership capital accounts would be as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $105,000 $105,000 gainacre $100,000 $ 40,000 b $105,000 $ 40,000 lossacre/cash $115,000 $115,000 d $105,000 $110,000 $315,000 $255,000 $315,000 $255,000 here d has purchased an interest in lossacre for one-third of its current value and selling price but is forced to recognize a tax gain in the absence of a corresponding economic gain. d is required to recognize a tax gain that is not matched by an economic gain, which shows up in the difference between d’s capital account and basis. in essence d’s current tax gain will be translated into a later recognized loss (or reduction of gain) on final disposition of d’s interest in the partnership. this recognition of gain today with loss tomorrow is an inappropriate acceleration of tax liability to d. however, the acceleration of recognized tax gain or loss is a common feature of subchapter k when a purchaser acquires a partnership interest with a basis that varies from the acquiring partner’s share of inside partnership basis. the answer in subchapter k to this anomaly is to make a section 754 election. in the example, limiting the basis in lossacre as to each partner to $100,000, and making the adjustment under section 743(b) to account for d’s purchase price, increases the basis of lossacre with respect to d by $5,000.250 here, section 704(c)(1)(c)(ii) is applied to give all partners a date of contribution basis in contributed built-in loss property for purposes of making section 250. d’s share of previously taxed partnership capital is $105,000 less $5,000 of gain that would be allocated to d (without regard to the § 743(b) adjustment) on disposition of blackacre for fair market value after applying § 704(c)(1)(c)(ii) to limit the basis of blackacre to its date of contribution value. d’s basis in d’s partnership interest, $105,000 exceeds d’s share of partnership capital by $5,000, which results in a $5,000 increase in the basis of partnership assets. irc § 743(b)(1); treas. reg. § 1.743-1. 680 florida tax review [vol. 9:6 743(b) adjustments as well as for allocating gains and losses. in this case the sale of lossacre for $115,000 produces $10,000 of partnership gain ($115,000 $105,000) which is allocated equally to a and b. the resulting partnership capital account demonstrates that this is the correct result. assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $105,000 $105,000 gainacre $100,000 $ 40,000 b $105,000 $ 45,000 lossacre/cash $115,000 $115,000 d $105,000 $105,000 $315,000 $255,000 $315,000 $255,000 there is no disparity between the partnership’s inside basis and the sum of the partners’ bases in their partnership interest. also, there is no book/tax disparity between a’s and d’s capital and tax accounts. the $60,000 difference between the partnership’s capital account and basis, and between the sums of the partners’ capital accounts and bases, is attributable to b’s pre-contribution gain on gainacre and will be eliminated on disposition of gainacre. there are alternate ways to apply section 704(c)(1)(c)(ii) to mitigate the result to d. first, as one commentator has suggested, section 704(c)(1)(c)(ii) might be broadly interpreted to apply the fair market value limitation to basis to a transferee partner as of the date of the transferee’s acquisition of the partnership interest.251 in this case, as to d, the basis of lossacre would be treated as $115,000, its fair market value on the date of d’s acquisition from c, the contributing partner. a’s and b’s bases in lossacre would be treated as $100,000, the value of lossacre on the date of its contribution. this interpretation would result in recognition of no gain by d on sale of lossacre for $115,000, and recognition of $5,000 of gain by a and b.252 the resulting partnership capital account would be as follows: 251. rachuba, supra note 203, at 1573 252. sale for $115,000 of the property with a $100,000 basis results in $15,000 of gain. a’s and b’s one-third share is $5,000 each. d’s share of this gain is ignored because d is treated as having a $115,000 basis in blackacre, which results in no recognized gain. 2009] built-in gain and built-in loss 681 assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $105,000 $105,000 gainacre $100,000 $ 40,000 b $105,000 $ 45,000 lossacre/cash $115,000 $115,000 d $105,000 $105,000 $315,000 $255,000 $315,000 $255,000 this approach is no different than a section 754 election that increases the partnership’s basis in lossacre on behalf of d. it avoids the inconvenience and complexities of an irrevocable section 754 election that might produce adverse results in other contexts. the approach balances the partnership capital accounts and requires the continuing partners to recognize their realized gains. on the negative side, this approach creates notional partnership tax gains where none are recognized within the partnership. the approach also requires an application of the statute in a manner that is outside the statutory language. the regulatory authorization in section 704(c)(1)(c)(ii), however, would allow treasury to promulgate regulations to mandate this approach. an alternative approach would recognize that, by its terms, section 704(c)(1)(c)(ii) applies to determine items allocated to other partners by treating the basis of contributed built-in loss property as fair market value on the date of contribution, but does not operate to create notional tax gain.253 section 704(c)(1)(c)(ii) thus may be applied as a limitation on the allocation of partnership tax items. in other words, section 704(c)(1)(c)(ii) could be applied with a ceiling rule. under this approach, when the abd partnership sells lossacre for $115,000 and recognizes a $15,000 tax loss, if a, b, and d, as other partners, are treated for purposes of allocating the loss as having a basis of only $100,000 in lossacre, no loss is allocable to any of them. the loss, which is not allocable to any partner, disappears. under this approach, the abd partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $105,000 $100,000 gainacre $100,000 $ 40,000 b $105,000 $ 40,000 lossacre/cash $115,000 $115,000 d $105,000 $105,000 $315,000 $255,000 $315,000 $245,000 253. this interpretation is consistent with the assertion in the text supra, surrounding note 202, that § 704(c)(1)(c) should not be interpreted as creating nominal tax gain where none is recognized by the partnership. 682 florida tax review [vol. 9:6 the disparity between the inside partnership basis and the sum of the partners’ outside bases is attributable to the $10,000 book gain realized by a and b, but not recognized. the gain will be reflected in taxable income on a disposition of a’s and b’s partnership interests. the best interpretation is the strict application of section 704(c)(1)(c)(ii) to all partners, limiting the basis of contributed property to fair market value at the date of contribution, with the adjustments allowed under section 743(b) with a section 754 election to avoid recognition by a transferee partner. since book/tax differences can be eliminated through a section 754 election (as properly applied by taking into account section 704(c)(1)(c)(ii)), there is no reason to develop a convoluted application of section 704(c)(1)(c)(ii) in order to avoid the mis-match between book and tax losses. g. post-contribution depreciation of built-in loss property and a transfer of the contributor’s interest literal application of section 704(c)(1)(c)(ii) and relying on section 743(b) adjustments as determined by taking section 704(c)(1)(c)(ii) into account also works when contributed built-in gain loss has declined in value after the date of the contribution. example 21 again go back to the partnership in example 15a. assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre $100,000 $130,000 c $100,000 $130,000 $300,000 $270,000 $300,000 $270,000 now suppose that the value of lossacre has declined to $85,000, and c sells c’s partnership interest to d for $95,000. c recognizes a loss of $35,000.254 absent a section 754 election, the partnership’s asset bases are not changed.255 the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre $100,000 $130,000 d $100,000 $ 95,000 $300,000 $270,000 $300,000 $235,000 254. irc § 741. 255. irc § 743(a). 2009] built-in gain and built-in loss 683 the $35,000 difference between the partnership’s inside asset basis and the sum of the partner’s outside bases reflects c’s $35,000 loss recognized outside of the partnership. applying section 704(c)(1)(c)(ii), to limit a’s, b’s, and d’s basis in lossacre to $100,000, a sale of the property results in a $15,000 book loss and a $15,000 tax loss. the losses are allocated equally to a, b, and d. the resulting partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $ 95,000 $ 95,000 gainacre $100,000 $ 40,000 b $ 95,000 $ 35,000 lossacre/cash $ 85,000 $ 85,000 d $ 95,000 $ 90,000 $285,000 $225,000 $285,000 $220,000 as was the case with gain in example 20, this approach permits the transferee partner to recognize a tax loss when the partner suffered no economic loss. again, the solution to this anomaly is provided in subchapter k by section 743(b) adjustments. taking section 704(c)(1)(c)(ii) into account, a section 743(b) adjustment would require the partnership to decrease the basis of lossacre by $5,000 with respect to d’s partnership interest.256 the resulting partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $ 95,000 $100,000 gainacre $100,000 $ 40,000 b $ 95,000 $ 40,000 lossacre $100,000 $ 95,000 d $ 95,000 $ 95,000 $300,000 $235,000 $285,000 $235,000 now, on sale of lossacre for $85,000, the partnership recognizes a 256. the excess of d’s share of partnership inside basis over d’s outside basis is $5,000. d’s share of partnership inside basis is d’s share of previously taxed capital, which is the $95,000 that would be distributed to d on sale of partnership assets and complete liquidation, increased to $100,000 by the $5,000 loss that would be realized by the partnership on sale of blackacre and allocated to d if the partnership basis in blackacre were limited to $100,000. treas. reg. § 1.743-1. the basis of partnership property is decreased by the excess of d’s share of partnership basis and d’s $95,000 outside basis. in this case, the decrease can only be allocated to blackacre, the only partnership depreciated property. 684 florida tax review [vol. 9:6 tax loss of $10,000. since the section 743(b) basis adjustment affects only d,257 the tax loss is allocated equally to a and b. the resulting capital account validates this approach. assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $ 95,000 $ 95,000 gainacre $100,000 $ 40,000 b $ 95,000 $ 35,000 lossacre/cash $ 85,000 $ 85,000 d $ 95,000 $ 95,000 $285,000 $225,000 $285,000 $225,000 a and b have recognized their shares of realized partnership loss. d’s book loss has already been reflected in the purchase price and basis of d’s partnership interest. book tax disparities have been eliminated for the partners.258 h. back to basis: post-contribution appreciation of built-in loss property and a transfer of the contributor’s interest a final validation of the application of section 704(c)(1)(c)(ii) limiting the basis of a transferee partner to the date of contribution value of contributed built-in loss property appears from consideration of the allocation of gains when the contributed built-in loss property has appreciated to equal or exceed the contributing partner’s adjusted basis. example 22 assume that lossacre in example 15a has appreciated to $130,000 so that its value now equals c’s adjusted basis at the time of contribution. c sells c’s partnership interest to d for $110,000. c recognizes a $20,000 loss,259 which reflects the fact that c’s pre-contribution loss has not been offset by recognized partnership gain on a sale of the contributed built-in loss property. the partnership capital account, including d’s purchased interest is as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre $100,000 $130,000 d $100,000 $110,000 $300,000 $270,000 $300,000 $250,000 257. irc § 743(b), flush language. 258. the $60,000 difference attributable to b’s contributed built-in remains to be accounted for on disposition of whiteacre. 259. irc § 741. 2009] built-in gain and built-in loss 685 the inside-outside basis disparity is attributable to c’s $20,000 loss recognized outside of the partnership. applying section 704(c)(1)(c)(ii) to limit the partners’ basis in lossacre to its contribution fair market value changes the inside-outside disparity as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $100,000 $100,000 gainacre $100,000 $ 40,000 b $100,000 $ 40,000 lossacre $100,000 $100,000 d $100,000 $110,000 $300,000 $240,000 $300,000 $250,000 now the partner’s outside bases are $10,000 greater than the partnership inside asset bases, which occurs because d’s purchase price reflects appreciation in lossacre over its book value and basis. sale of lossacre for $130,000 would result in $30,000 of book and tax gain, allocable equally to the partners. d will be required to recognize $10,000 of tax gain notwithstanding the fact that d has no economic gain. again, this issue can be resolved with a section 754 election that would increase the basis of lossacre by $10,000260 with respect to d and eliminate d’s recognition of gain. the resulting capital accounts after the sale and allocation of $10,000 of book gain to each partner and $10,000 of tax gain to a and b, are as follows: assets partners’ capital accounts book value basis book value basis cash $100,000 $100,000 a $110,000 $110,000 gainacre $100,000 $ 40,000 b $110,000 $ 50,000 lossacre/cash $130,000 $130,000 d $110,000 $110,000 $330,000 $270,000 $330,000 $270,000 260. the excess of d’s of partnership basis over d’s share of partnership inside basis is $10,000. d’s share of partnership inside basis is d’s share of previously taxed capital, which is the $110,000 that would be distributed to d on sale of partnership assets and complete liquidation, decreased to $100,000 by the $10,000 gain that would be realized by the partnership on sale of blackacre and allocated to d if the partnership basis in blackacre were limited to $100,000. treas. reg. § 1.743-1. the basis of partnership property is increased by the excess of d’s outside basis over d’s $100,000 share of partnership inside basis. 686 florida tax review [vol. 9:6 here again, literal application of section 704(c)(1)(c)(ii) to limit the basis of all partners to the fair market value of contributed built-in loss property reaches the correct result under the overall pattern of subchapter k. vi. admission of a new partner to the partnership with built-in gain or loss property − reverse allocations section 704(c), by its terms, applies to control allocations only in the case of a contribution of built-in gain or loss property to a partnership by a partner. nonetheless, similar allocation issues arise when a new partner contributes cash for an interest in a partnership that holds built-in gain or loss property. in addition, a new partner entering a partnership that has contributed built-in loss property will be subject to the basis limitation of section 704(c)(1)(c)(ii), which raises interesting questions regarding the impact on the new partner on disposition of the built-in loss property. a. admission of a partner to a partnership with built-in gain property admission of a new partner by contribution does not require adjustments to the partnership capital accounts. however, the regulations permit a partnership to revalue its assets to fair market value for capital account purposes upon admission of a new partner by contribution.261 although voluntary, as a practical matter revaluation of partnership assets on admission of a partner is important, and probably necessary, to allow the partnership to properly reflect the partners’ interests in partnership capital. as partnership assets are revalued, book gains and losses are allocated to the partner’s capital account in the manner that gains and losses are shared under the terms of the partnership agreement. revaluation affects only the partnership book accounts. no tax gain or loss is triggered by the revaluation. accounting for book gains and losses without corresponding tax items thus creates a disparity in the partnership book and tax accounts. after revaluation, the regulations apply section 704(c) principles to allocate tax items to reduce book/tax disparities in the same manner as allocations attributable to contributed property.262 these “reverse allocations” insure that built-in gain or loss attributable to periods before a new partner is admitted is allocated to the old partners. curative and remedial allocations263 are available to offset distortions caused by the ceiling rule when there are insufficient tax items to match the partners’ share of book items. 261. treas. reg. § 1.704-1(b)(2)(iv)(f). 262. treas. regs. §§ 1.704–1(b)(2)(iv)(f), –1(b)(4)(i), and 1.704–3(a)(6)(i). 263. treas. reg. § 1.704-3(c) and (d). see text supra, at note 44. 2009] built-in gain and built-in loss 687 example 23a.264 i and j form the ij partnership with cash contributions of $90,000. the partnership purchases property for $180,000. the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis property $180,000 $180,000 i $ 90,000 $ 90,000 j $ 90,000 $ 90,000 $180,000 $180,000 $180,000 $180,000 when the partnership property has appreciated to $300,000, k is admitted to the partnership as a one-third partner with a cash contribution of $150,000. without a revaluation, the partnership capital accounts are as follows: assets partners’ capital accounts book value basis book value basis property $180,000 $180,000 i $ 90,000 $ 90,000 cash $150,000 $150,000 j $ 90,000 $ 90,000 k $150,000 $150,000 $230,000 $230,000 $230,000 $230,000 these capital accounts do not reflect the economic relationship of the partners. k is admitted as a one-third partner on the basis of valuations of partnership property, while the capital accounts show k as a 62% owner of partnership capital. ultimately reconciliation of the capital accounts with the economics of the partnership requires a special allocation of partnership gain on sale of the property to reflect the economic division of appreciation between i and j before k became a partner. rather than relying on capital accounts, the post-hoc allocation requires an amendment to the partnership agreement to provide for the appropriate allocation of book and tax items. thus, a partnership provision may be incorporated to allocate the first $120,000 of gain on the sale of the property to i and j, with any gain in excess of $120,000 to be divided equally. the tax gain would follow.265 revaluing the capital accounts to reflect fair market value at the time of k’s admission has the same economic and tax result, but has the additional 264. the example is from mcdaniel et. al. supra note15, 169. 265. this allocation has economic effect under the economic effects test of treas. reg. § 1.704-1(b)(2)(ii) or the alternative test of treas. reg. § 1.7041(b)(2)(ii)(d), depending on whether the partners have an obligation to restore a capital account deficit. 688 florida tax review [vol. 9:6 advantage of accurately reflecting the partners’ economic relationship without special allocations.266 revaluing the partnership asset to fair market value results in a partnership book gain of $120,000, which is allocated equally to i and j causing a $60,000 increase in each partner’s capital account.267 after admitting k to the partnership, the revalued partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis property $300,000 $180,000 i $150,000 $ 90,000 cash $150,000 $150,000 j $150,000 $ 90,000 k $150,000 $150,000 $450,000 $230,000 $450,000 $230,000 now suppose that the partnership sells the property for $330,000. the partnership realizes a book gain of $30,000, which is allocated $10,000 to each partner. the partnership recognizes $150,000 of tax gain. $10,000 of tax gain is allocated to each partner to match each partner’s book gain. the remaining $120,000 of tax gain is allocated equally to i and j to reflect their unrealized appreciation prior to k’s admission to the partnership. thus i and j each recognize $70,000 of gain. the resulting partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis property/cash $330,000 $330,000 i $160,000 $160,000 cash $150,000 $150,000 j $160,000 $160,000 k $160,000 $160,000 $480,000 $480,000 $480,000 $480,000 example 23b suppose the partnership in example 23a sells the partnership asset for $270,000. the partnership has a $30,000 book loss allocable to each of the partners, and a $90,000 tax gain. the partnership has no other income or loss. under the traditional method of treas. reg. section 1.704-3(b), the tax gain is allocable to i and j, $45,000 each. under the 266. this can be critically important in the event of a break-up of the partnership where the partners dispute their respective shares of partnership assets. the maintenance of accurate capital accounts throughout the life of a partnership facilitates the division of partnership assets in the event of a dispute. 267. treas. reg. § 1.704-1(b)(2)(iv)(g)(1). 2009] built-in gain and built-in loss 689 ceiling rule there is no tax loss to allocate to k to match k’s book loss. in addition, there are no additional items of income or expense with which to make curative allocations.268 however, the partnership could make a remedial allocation of a notional $10,000 tax loss to k coupled with a remedial allocation of $5,000 of taxable gain to i and j. using remedial allocations the partnership capital account is as follows: assets partners’ capital accounts book value basis book value basis property/cash $270,000 $270,000 i $140,000 $140,000 cash $150,000 $150,000 j $140,000 $140,000 k $140,000 $140,000 $420,000 $420,000 $420,000 $420,000 in the absence of a revaluation of partnership property, there is no way to adjust capital accounts to reflect k’s economic loss. on sale of the property for $270,000 the partnership has a book and tax gain of $90,000 ($270,000 $180,000). a special allocation might be crafted to allocate this gain equally to i and j, which avoids treating k as realizing an economic loss. the resulting partnership capital accounts, which now do not reflect one-third interests of the partners, would be as follows: assets partners’ capital accounts book value basis book value basis property/cash $270,000 $270,000 i $135,000 $135,000 cash $150,000 $150,000 j $135,000 $135,000 k $150,000 $150,000 $420,000 $420,000 $420,000 $420,000 this result may end in confusion amongst the partners who may expect a one-third division of partnership assets, which is contrary to the result shown by the capital accounts. b. depreciation and capital recovery provisions revaluation of partnership assets on admission of the new partner is also important to properly allocate depreciation and other capital recovery deductions among the partners to reflect the cost to the new partner of an interest in depreciable property. 268. treas. reg. § 1.704-3(c). 690 florida tax review [vol. 9:6 example 23c suppose the property purchased by i and j in example 23a is a section 197 intangible and that i and j have taken five years of capital recovery deductions ($12,000/year) reducing the basis of the asset to $120,000. at the end of five years, when the asset has appreciated to $300,000, k joins the partnership with a $150,000 capital contribution. at the time of k’s admission, the partnership assets are revalued. the partnership recognizes $180,000 of book gain which is allocated to i’s and j’s capital accounts, $90,000 each. the partnership breaks even other than the section 197 amortization deductions. on k’s admission to the partnership, the partnership capital accounts are as follows: assets partners’ capital accounts book value basis book value basis property $300,000 $120,000 i $150,000 $ 60,000 cash $150,000 $150,000 j $150,000 $ 60,000 k $150,000 $150,000 $450,000 $270,000 $450,000 $270,000 the year three § 197 amortization produces a $30,000 book expense and a tax deduction of $12,000. k’s allocation of the book loss is $10,000. thus, k must be allocated a tax deduction of $10,000 to match the book loss. the remaining $2,000 of the § 197 amortization is divided equally between i and j. at the end of ten years, each partner will have been allocated $100,000 of book expense. k will have been allocated $100,000 of tax loss, reducing k’s basis to $50,000. i and j each will have been allocated $10,000 of tax loss, reducing their respective bases to $50,000. the resulting capital account at the end of year ten will be as follows: assets partners’ capital accounts book value basis book value basis property 0 0 i $ 50,000 $ 50,000 cash $150,000 $150,000 j $ 50,000 $ 50,000 k $ 50,000 $ 50,000 $ 50,000 $150,000 $150,000 $150,000 c. admission of a partner to a partnership with contributed built-in loss property section 704(c)(1)(c) complicates the allocations of built-in loss to partners after admission of a new partner. fundamentally, section 704(c)(1)(c) should be read to apply subdivision (i) to allocate all recognized 2009] built-in gain and built-in loss 691 built-in loss to the contributing partner as long as the contributing partner remains a partner in the partnership. subdivision (ii) should be applied to eliminate partnership loss only after the contributing partner leaves the partnership by treating the basis of contributed built-in loss property as equal to fair market value on contribution as to the other partners. example 24 l and m form a partnership with a contribution of $90,000 cash by l and a contribution of property by m with a fair market value of $90,000 in which m’s basis is $135,000. when the property has appreciated to $120,000, n joins the partnership with a cash contribution of $105,000. the partnership agreement provides that the partners will share gains and losses equally. without restating the capital accounts, after n’s admission into the partnership, the partnership capital account would be as follows. assets partners’ capital accounts book value basis book value basis property $ 90,000 $135,000 l $ 90,000 $ 90,000 cash $ 90,000 $ 90,000 m $ 90,000 $135,000 cash from n $105,000 $105,000 n $105,000 $105,000 $285,000 $330,000 $285,000 $330,000 if the partnership were to sell the contributed property for $120,000, the partnership recognizes $30,000 of book gain, which should be specially allocated l and m to reflect the fact that the gain accrued before n became a partner, and a $15,000 tax loss. under both traditional section 704(c) principles, and following the mandate of section 704(c)(1)(c)(i), the $15,000 tax loss is allocated to m. the resulting capital account is as follows – assets partners’ capital accounts book value basis book value basis property/cash $120,000 $120,000 l $105,000 $ 90,000 cash $ 90,000 $ 90,000 m $105,000 $120,000 cash from n $105,000 $105,000 n $105,000 $105,000 $315,000 $315,000 $315,000 $315,000 restating the capital accounts under treasury regulation section 1.704– 1(b)(2)(iv)(f) demonstrates that this is the correct result. restating capital accounts on n’s admission to the partnership would require booking up the property value to $120,000 and allocating the book gain equally between l and m. the resulting capital accounts would reflect the true economic relationship of the partners as follows: 692 florida tax review [vol. 9:6 assets partners’ capital accounts book value basis book value basis property/cash $120,000 $135,000 l $105,000 $ 90,000 cash $ 90,000 $ 90,000 m $105,000 $135,000 cash from n $105,000 $105,000 n $105,000 $105,000 $315,000 $330,000 $315,000 $330,000 on sale of the property for $120,000 there is no partnership book gain because it has already been reflected in the partnership capital accounts. the tax loss of $15,000 is again allocated to m by virtue of both section 704(c)(1)(a) and (c)(1)(c)(i). assets partners’ capital accounts book value basis book value basis property/cash $120,000 $120,000 l $105,000 $ 90,000 cash $ 90,000 $ 90,000 m $105,000 $120,000 cash from n $105,000 $105,000 n $105,000 $105,000 $315,000 $315,000 $315,000 $315,000 applying the basis limitation rule of § 704(c)(1)(c)(ii) to this situation while the contributing partner remains in the partnership produces a distorted result. if the “other partners,” l and n are treated as having a basis of only $90,000 in the property, they would each be required to recognize their share of tax gain of $10,000 ([$120,000 $90,000]/3). the resulting capital account would be as follows: assets partners’ capital accounts book value basis book value basis property/cash $120,000 $120,000 l $105,000 $100,000 cash $ 90,000 $ 90,000 m $105,000 $120,000 cash from n $105,000 $105,000 n $105,000 $115,000 $315,000 $315,000 $315,000 $335,000 the allocation has created an inside/outside basis disparity by allocating $10,000 of tax gain to n in the absence of either book gain or economic gain (which are synonymous when capital accounts are restated). that does not appear to be the result intended by the enactment of section 704(c)(1)(c), which is to avoid duplicating and accelerating loss. in this case, section 704(c)(1)(c)(ii) should be applied to recognize that its basis limitation rule only applies to govern allocations of recognized tax items. on the context of 2009] built-in gain and built-in loss 693 its statutory purpose, section 704(c)(1)(c)(ii) should not be interpreted as creating notional tax items out of partnership book gains and losses.269 d. admission of a partner to a partnership with contributed built-in loss property and liquidation of the contributing partner where the contributing partner is no longer a member of the partnership, section 704(c)(1)(c)(ii) limits the other partners to the basis of contributed property at the time of contribution. example 25 suppose in example 24, after n is admitted to the partnership for a $105,000 cash contribution and the partnership capital accounts are revalued,270 m’s partnership interest is liquidated with a cash distribution of $105,000. m, who contributed the built-in loss property, recognizes a $30,000 loss on the liquidation distribution. irc section 731(a)(2). after the liquidation distribution, restated capital accounts are as follows: assets partners’ capital accounts book value basis book value basis property/cash $120,000 $135,000 l $105,000 $ 90,000 cash $ 90,000 $ 90,000 n $105,000 $105,000 $210,000 $210,000 $210,000 $195,000 under section 704(c)(1)(c)(ii), the basis of the contributed property as to l and n (the “other partners”) must be reduced to $90,000. using this basis, on sale of the property, the partnership now would recognize zero book gain and $30,000 tax gain. under the reverse § 704(c) allocation principles of treas. reg. section 1.704-1(b)(2)(iv)(g), the first $15,000 of tax gain is allocated to l. the remaining gain is split between the partners, $7,500 each. the resulting capital account is as follows: assets partners’ capital accounts book value basis book value basis property/cash $120,000 $120,000 l $105,000 $112,500 cash $ 90,000 $ 90,000 n $105,000 $112,500 $210,000 $210,000 $210,000 $225,000 269. see the discussion in the text, supra, note 204. 270. treas. reg. § 1.704-1(b)(2)(iv)(g)(1). $30,000 of book gain that results from the revaluation of the property from $90,000 to $120,000 is allocated equally to l and m, increasing their capital accounts to $105,000. on distribution of $105,000, m’s recognized loss is allowed under § 731(a)(2). 694 florida tax review [vol. 9:6 this analysis taxes the partners on $15,000 of excess gain, as demonstrated by the $15,000 inside/outside basis disparity. the problem can be avoided with a section 734(b)(2)(a) adjustment that would reduce the property basis on the liquidation distribution to m by $30,000. assets partners’ capital accounts book value basis book value basis property $120,000 $105,000 l $105,000 $ 90,000 cash $ 90,000 $ 90,000 n $105,000 $105,000 $210,000 $195,000 $210,000 $195,000 on sale of the property for $120,000, the $15,000 gain is allocable to l under treasury regulation section 1.704-1(b)(2)(iv)(g). assets partners’ capital accounts book value basis book value basis property/cash $120,000 $120,000 l $105,000 $105,000 cash $ 90,000 $ 90,000 n $105,000 $105,000 $210,000 $210,000 $210,000 $210,000 here the section 754 election and application of section 734(b) reach the correct result both economically and temporally.271 in effect, the partnership is treated as having a basis in the property of $90,000 as to l, which is consistent with the application of section 704(c)(1)(c)(ii) to l. however, with the section 734(b) adjustment, n is treated as having a basis of $105,000, the fair market value of the property at the time of n’s admission to the partnership. there are suggestions that section 704(c)(1)(c)(ii) be applied to limit the basis of a contributing partner to fair market value at the time of the contribution.272 however, with the strict application of section 704(c)(1)(a) and (c)(i) to allocate losses to the contributing partner while the contributing partner is still a partner, and the availability of section 271. the role of § 734(b) adjustments in eliminating the deferral of gains and losses provides a strong argument for making § 734(b) adjustments mandatory. see andrews, supra note 150, 23; noël b. cunningham, needed reform: tending the sick rose, 47 tax l. rev. 77, 81 (1991). professor andrews points out that mandatory § 734(b) adjustments would not involve the accounting complexity that would be associated with mandatory adjustments under § 743(b) because the former does not require separate accounting for the adjustments with respect to individual partners. but see also abrams, supra note 82, at 351, who recommends that § 734(b) adjustments attributable to non-liquidating distributions be allocated to the distributee partner’s continuing interest. 272. rachuba, supra, note 203. 2009] built-in gain and built-in loss 695 734(b) adjustments where the contributing partner’s interest has been completely liquidated, there is no need for stretched interpretations of section 704(c)(1)(c)(ii) that apply the provision differently in different contexts. section 704(c)(1)(c)(ii) should not be applied to overrule or revise application of the basis reduction calculated under section 734(b)(2). vii. conclusion if nothing else, this foray into the intricacies of changing partnership interests in built-in gain and loss property sustains the viability of capital account analysis as the key to understanding the correct application of the rules of subchapter k. analysis of disparities in the capital accounts and tax accounts (basis) provides key guidance to the allocation of both contributed built-in gains and losses and built-in gains and losses within a partnership on the entry of new partners. at the most basic level, realized pre-contribution built-in gain and loss is allocable to the contributing partner to the extent of the differences in the contributing partner’s capital account and basis. similarly, built-in gain and loss inherent in partnership assets at the time of entry of a new partner into a partnership is properly allocable to the continuing partners to the extent of the differences between the fair market value and adjusted basis of the continuing partners’ partnership interests. revaluation of partnership capital accounts on the entry of a new partner, or on distributions that change partners’ interests, presents a clear picture of the partners’ interests resulting from those events. analysis of partnership capital accounts and an examination of disparities between partners’ capital and the bases of partnership interests also provides guidance regarding the proper application of the separate subdivisions of section 704(c)(1)(c). the mismatch between the cumulative partnership inside asset bases and outside bases of the partners demonstrates that a strict application of section 704(c)(1)(c)(ii) to produce notional tax gain to non-contributing partners is the wrong result. likewise, a variable application of section 704(c)(1)(c)(ii) to apply different basis rules to a transferee of a partnership interest is not appropriate within the overall scheme of subchapter k. accelerations of gains and losses among the partners in the event of distributions by a partnership or transfers of partnership interests with built-in loss property are resolved by the elective adjustments provided by sections 734(b) and 743(b). although the capital account provisions of the treasury regulations were adopted to govern allocations of tax items, the principle of tax allocations that requires a match to economic consequences requires capital accounting that reflects partners’ interests. while practitioners advising partners and partnerships primarily grapple with the tax rules, advising partnerships to maintain consistent capital accounts will aid partnership 696 florida tax review [vol. 9:6 investors in understanding the nature of their interests. at the same time, capital accounts will provide a guide to the proper allocation of tax items. 607 florida tax review volume 4 2000 number 9 rethinking the risk of defined contribution plans regina t. jefferson* i. introduction ............................................................................. 609 a. plan classification ............................................................ 610 b. the shift from defined benefit plans to defined contribution plans ............................................................ 614 c. shortfalls in defined contribution plans.......................... 616 ii. the private pension program and the fiduciary law ............................................................................................... 620 a. fiduciary standards.......................................................... 620 b. fiduciary breach under erisa ....................................... 623 c. the fiduciary rules and participant directed plans ................................................................................. 627 1. investment practices and participant directed plans ..................................................... 628 2. the education and notification requirement in participant directed plans .................................................................... 630 3. section 404(c) plans ............................................ 632 d. pension policy and participant directed plans ............... 634 e. residual liability and a notification and education requirement ..................................................... 636 f. enforcement of a notification and education requirement ...................................................................... 639 iii. insurance protection against market fluctuations ............................................................................. 640 a. the gap in insurance protection ...................................... 640 b. reasons for shortfalls ....................................................... 641 c. insurance protection outside of erisa............................ 645 1. guaranteed investment contracts ....................... 645 * associate professor of law, catholic university of america, columbus school of law. b.s. howard university (1981); j.d. george washington university (1987); ll.m. georgetown university law center (1992). i wish to thank my mentor daniel i. halperin, professor of law at harvard university, for his very helpful comments and suggestions, and careful reading of this article. 608 florida tax review [vol. 4:9 2. banking investment contracts ............................. 647 3. retirement certificates of deposit (cds) ............. 648 d. defined contribution plan insurance ............................... 649 e. the hypothetical account proposalcan insurance model ................................................................................ 651 1. calculation of the guaranteed benefit ................ 654 2. the hypothetical account proposal and insurance premiums ............................................ 660 3. noncompliant investment allocations ................. 661 4. private insurers ................................................... 662 f. regulating defined contribution plan insurance ............ 663 1. the moral hazard problem ................................. 663 2. the impact of defined contribution plan insurance on the pbgc ....................................... 665 3. the problem of bailouts ...................................... 667 g. the floor-offset pension plan comparison .................... 669 iv. funding shortages in defined contribution plans ....... 671 a. funding under erisa ...................................................... 671 b. minimum funding standards and past service credits ............................................................................... 674 c. past service liabilities in defined contribution plans ................................................................................. 676 d. the funding rules and defined contribution plans ................................................................................. 680 v. conclusion ................................................................................. 681 i. introduction in response to pension funding failures and concern that abuses in the private pension system were denying benefits to many workers, congress passed the employee retirement income security act of 1974 (erisa).1 erisa has several specific objectives: to ensure that workers receive pension benefits after they satisfy certain minimum requirements, to ensure that sufficient funds are set aside to pay promised pension benefits, to ensure that 1. the employee retirement income security act, better known as erisa, is a massive piece of legislation. erisa, pub. l. no. 93-406, 88 stat. 829 (1974) (codified as amended in scattered sections of titles 26 and 29 u.s.c.). it originated as early as 1962 when president john f. kennedy commissioned a special cabinet-level task force to evaluate the impact of private retirement programs on the nation=s economy and public policy, as well as the investment policies of these programs and whether they were sufficient to provide promised benefits to the participants. see 120 cong. rec. s15,743 (1974) (statement of sen. javits). more than a decade later, on september 2, 1974, president ford signed erisa into law. erisa completely revised the legal framework of the qualified pension plan. enforcement of significant innovations of erisa were divided among the internal revenue service, department of labor, and the pension benefit guaranty corporation. 2000] rethinking the risk of defined contribution plans 609 workers receive adequate information about their employee benefit plans, and to set higher standards of conduct for those managing employee benefits and pension funds.2 erisa has been successful in accomplishing many of its goals.3 today employees vest earlier, more plans are adequately funded, and plan participants are more knowledgeable about their retirement benefits.4 moreover, since the passage of erisa, increased participation and contribution rates in private pension plans have caused the average income of retired individuals to be comparable to that of the rest of the population.5a. plan classification retirement plans are divided into two distinct categories: defined benefit plans and defined contribution plans.6 both types of plans can have 2. it is hereby declared to be the policy of this act [erisa] to protect . . . the interests of participants in employee benefit plans and their beneficiaries, by requiring the disclosure and reporting to participants and beneficiaries of financial and other information with respect thereto, by establishing standards of conduct, responsibility and obligation for fiduciaries of employee benefit plans, . . . by requiring them to vest the accrued benefits of employees with significant periods of service, to meet minimum standards of funding, and by requiring plan termination insurance. erisa ' 2(b), 29 u.s.c. ' 1001(b)-(c) (1999). 3. the growth of the pension system has resulted in an enormous accumulation of pension assets. private and public pension funds currently hold more than $4.5 trillion in assets. this staggering sum reveals that a very large percentage of personal savings and of aggregate capital formation in the united states occurs through the medium of pension plans. paul yakoboski et al., pbgc solvency: balancing social and casualty insurance perspectives, employee benefit research institute issue brief no. 126, 5-6 (may 1992) [hereinafter pbgc solvency]. 4. see generally john r. keville, note, retire at your own risk: erisa=s return on investment?, 68 st. john=s l. rev. 527, 528 (1994). 5. although much attention has been devoted to the widely known decrease in participation rates and pension sponsorship in the 1980s, relatively little attention has been focused on the reversal of these trends during the last several years. see paul yakoboski & celia silverman, baby boomers in retirement: what are their prospects? employee benefit research institute issue brief no. 151, 14-15 (july 1994); see also william f. may, future policies for employer-based pension plans, in search for a national retirement income policy 101, 103 (jack l. vanderhei ed., 1987). the bulk of retirement income increasingly comes from employer sponsored pension plans. id. at 14-15. as of 1983, one thousand of the largest nonfederal pension plans held assets of approximately $806 billion. id. at 102-04. a nation wide survey in may 1983 by the employee benefit research institute and the u.s. department of health and human services indicated that approximately 56% of the 88 million nonfarm workers in america were covered by a private pension plan. see john h. langbein & bruce a. wolk, pension and employee benefit law 25 (2d ed. 1995) (citation omitted). in 1993, participation increased so that private and public pension plans held more than $4.6 trillion in assets. see id. at 20, 736 (citation omitted). this figure represents more than a 300% increase from 1983. see id. 6. see erisa ' 3(34), 29 u.s.c. ' 1002(34) (1999) (defining adefined contribution plan@ as a apension plan which provides for an individual account for each participant and for 610 florida tax review [vol. 4:9 similar income replacement objectives and can be used equally effectively for retirement saving purposes.7 structurally, however, the two types of plans are very different; the distinguishing feature is risk allocation.8 a defined benefit plan pools the plan=s assets in an aggregate trust fund and promises a fixed amount to plan participants at retirement regardless of investment performance.9 in a defined benefit plan the sponsoring employer is liable for the payment of plan benefits and therefore bears the risk of accumulating insufficient assets. to protect defined benefit plan participants in the event that an employer becomes insolvent, the pension benefit guaranty corporation (pbgc) insures a limited accrued benefit, which is phased in over a five-year period.10 the maximum insurable benefit is approximately $35,000 per year for an individual who retires at age 65.11 to the extent that a participant=s benefits based solely upon the amount contributed to the participant's account, and any income . . . which may be allocated to such participant=s account@); id., erisa ' 3(35), 29 u.s.c. ' 1002(35) (1999) (defining adefined benefit plan@ as a apension plan . . . which is not an individual account plan and which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant@); see also keville, supra note 4, at 528; mary e. o=connell, on the fringe: rethinking the link between wages and benefits, 67 tul. l. rev. 1421, 1489 (1993). 7. in a defined contribution plan the expected benefit may not be received because of inadequate investment performance, or because plan participants may decline to make elective contributions. daniel i. halperin, retirement security and tax equity: an evaluation of erisa, 17 b.c. ind. & com. l. rev. 739, 775-76 (1976) (stating ait is necessary to decide whether defined contribution plans in fact do not promise a specific benefit. money purchase plans have a fixed contribution which under erisa must be made annually. while profit-sharing plans do not have a definite contribution, in many circumstances the employer fully intends to contribute the maximum permissible amount.@). 8. daniel i. halperin, tax policy and retirement income: a rational model for the 21st century, in search for a national retirement income policy 159, 184 (jack l. vanderhei ed., 1987). 9. see jon fitzpatrick, determining if a small company needs a retirement plan, and choosing the best plan, 14 tax=n for law. 76, 78 (1985) (discussing the two types of plans). 10. erisa, 29 u.s.c. '' 1301-1311 (1999). section 1302(a) details why congress created the pbgc. one of the purposes behind the creation of the pbgc was ato provide for the timely and uninterrupted payment of pension benefits to participants and beneficiaries under plans to which this subchapter applies.@ id. ' 1302(a)(2). 11. when a plan terminates with insufficient assets, the pbgc is required to pay accrued, vested benefits to plan participants up to a guaranteed amount. erisa limits the abasic guaranteed benefit@ payable by the pbgc to the lesser of the average monthly gross income, based on the highest compensation in any consecutive five-year period, or $750 per month, adjusted by the cost of living. see 29 c.f.r. ' 4022.22 (1999). basic benefits ainclude all retirement, death, and disability benefits of current retirees and, for vested current participants, the regular retirement benefit payable under the normal annuity form.@ alicia h. munnell, erisacthe first decade: was the legislation consistent with other national goals?, 19 u. mich. j.l. ref. 51, 54 (1985). abasic benefits do not include lump-sum and special supplementary benefits payable under some plans to encourage early retirement.@ id. erisa 2000] rethinking the risk of defined contribution plans 611 vested retirement benefit exceeds the maximum insurable limit, the participant bears the risk of insolvency. relatively few plan participants, however, have vested accrued benefits in excess of the insurable limit.12 in contrast to the defined benefit plan=s aggregate trust, a defined contribution plan assigns each participant an individual account.13 at retirement the participant receives the entire account balance. the relative success or failure of the plan depends on how well the assets have been invested.14 there is no pbgc protection because the retirement benefit is determined by the account balance, and not by a specific benefit.15 thus, in a defined contribution plan, the participant, rather than the employer and the pbgc, bears the risk of accumulating insufficient assets for retirement.16 also imposes a limit on the insured amounts. for example, in 1998, the pbgc insured up to a maximum monthly benefit of $2,880.68, $34,568.16 per year, payable in the form of a life annuity commencing at age 65 to a participant in a plan that terminated in 1998. see pension guarantees, <http://www.pbgc.gov/ygptabl.htm>, mar. 1999; 29 c.f.r. ' 4022.22(b) (1999). erisa initially provided that upon plan termination, employers were liable to the pbgc for any plan asset insufficiencies up to a maximum of 30% of the employer=s net worth, and the pbgc absorbed the excess liability. the 30% cap gave employers an incentive to terminate their plans when their unfunded insured liability exceeded 30% of the employer=s net worth. erisa was amended in 1986 to avoid this result. the single employer pension plan amendments act of 1986 (seppaa) limited the employer=s ability to terminate plans with unfunded vested accrued benefits. single employer pension plan amendments act of 1986, pub. l. no. 99-272, 100 stat. 237 (codified as amended in scattered sections of 29 u.s.c.). 12. langbein & wolk, supra note 5, at 831. thus, the guaranteed benefit can differ drastically from the benefit promised by the plan. 13. defined contribution plans provide individual accounts for each participant. benefits are based solely upon the amount contributed to the participant=s account, with adjustments for any income, expenses, gains, and losses. account balances also may be adjusted for forfeitures of the accounts of other participants. see 29 u.s.c. ' 1002(34) (1999). 14. douglas a. love, erisa: the law versus economics, 25 ga. l. rev. 135, 136 (1990). 15. the pbgc is to provide broad insurance coverage for pension plans, but with limits: aexcept as provided in subsection (b) of this section, this subchapter applies to any plan . . . .@ 29 u.s.c. ' 1321(a) (1999). the most important exception for defined contribution plans: athis section does not apply to any planc(1) which is an individual account plan [a defined contribution plan] . . . .@ id. ' 1321(b). thus, defined contribution plans are not insured by the pbgc. with no particular, identifiable benefit, there is no appropriate amount to insure. see s. conf. rep. no. 93-383 (1974), reprinted in 1974 u.s.c.c.a.n. 4890, 4911. the pbgc requires minimum funding standards to be met as a condition of protection, but the funding standards set out by the irc and erisa generally do not apply to defined contribution plans since by their nature the amount of funding is merely the individual account balance. see jay conison, employee benefit plans in a nutshell 413 (1993). 16. see deborah s. prutzman & edwin c. laurenson, impact of erisa on choice of mutual or collective investment funds as funding vehicles, 651 pli/comm 789, 805 (feb.-mar. 1993); yakoboski et al., pbgc solvency, supra note 3, at 4; see also infra part ii.c.1. 612 florida tax review [vol. 4:9 the most important objective of a retirement program is to provide a level of replacement income during retirement sufficient to provide a life style commensurate with that of an individual during her working life.17 in both defined benefit and defined contribution plans, the income replacement goal can be seriously threatened by fiduciary breach, poor investment, or inadequate funding.18 when one or all of these events occur, however, it is more likely that defined contribution plans ultimately will provide retirement benefits that fall short of their goals because such plans are neither pbgc insured nor adequately protected by the fiduciary and funding rules. when erisa was enacted, defined benefit was the predominant plan type.19 defined contribution plans typically were used as supplemental plans. since the passage of erisa, the composition of the private pension system has changed dramatically.20 in recent years, there has been a discernable 17. a large gap exists between what most people expect to receive during their retirement and what they actually will receive. a[a] secure retirement will depend on having a three-legged stool of income from social security, an employer-sponsored pension, and personal savings.@ susan mitchell, how boomers save, am. demog., sept. 1994, at 22. most have not saved enough to meet their demands. see steven brostoff, workers save more for retirement; still fall short, nat=l underwriter life & health fin. svcs. ed. dec. 23, 1996, at 6. the annual workplace pulse survey for 1996, sponsored by colonial life and accident and ecfc, stated that the average 30-year-old worker would have to save $662 more each year ato achieve an annual retirement income of $26,256 in 1996 dollars.@ id. the survey also stated that a[a] 60-year-old worker with $140,000 already saved for retirement would need to save an additional $2,325 a month to achieve an annual retirement income of $26,256.@ id. amarried-couple households headed by 35-to-44-year-olds with a total income of $40,000 to $60,000 a year need to save $200,000 by age 65 to maintain a similar standard of living after retirement, if they have a pension. those without a pension need to save $270,000.@ mitchell, infra, at 25. 18. see discussions infra part ii.b; part ii.c; and part iv.a. 19. between 1975, the year erisa became effective, and 1990, the total number of private defined benefit plans increased from 103,000 in 1975 to 175,000 in 1983, then fell to 113,000 in 1990. celia silverman et al., employee benefit research institute, ebri databook on employee benefits 139 (3rd ed. 1995) [hereinafter ebri databook]. meanwhile, the total number of private defined contribution plans increased from 208,000 in 1975 to 599,000 in 1990. id. 20. the composition of the workforce has changed as well. see ebri databook, supra note 19, at 7-10. the number of workers between the ages of 55 and 64 will increase from 11.3 million in 1970 to 17.4 million in 2005. see gerald cole & marjorie n. taylor, caught between demographics and the deficit: how can retirement plans meet the challenges ahead?, comp. & ben. review 32, 32 (jan.-feb. 1996). this increase in the number of older workers is predicted to result in a skills gap between generations. more jobs are predicted to be open, however they will be entry level positions. the older generation will create what is termed the agraybeard ceiling@ by staying in upper level positions, preventing advancement and training for the next generation. when the baby boomers finally retire, the next generation will be too under-skilled to move into their positions. see ron stodghill, ii, the coming job bottleneck, bus. wk., mar. 24, 1997, at 184. not only is the workforce aging rapidly, but it is becoming increasingly transient. aamerican workers born after world war ii will have at least 10 jobs over the course of their working lives. workers who do not remain at a single job for a 2000] rethinking the risk of defined contribution plans 613 movement toward using defined contribution plans as primary retirement saving vehicles.21 this trend has serious implications for the private pension system because it shifts the risk of accumulating insufficient retirement assets from the sponsoring employer to the employee. the use of defined contribution plans as primary savings vehicles also eliminates the significance of many of the protective measures introduced by erisa.22 consequently, unless congress amends the pension law as it applies to defined contribution plans, many future retirees may not receive the retirement benefits that they expect, or the level of protection envisioned by the drafters of erisa. the prospect of benefit shortfalls in defined contribution plans will become an increasingly serious societal problem as more and more participants depend on them for their retirement security. b. the shift from defined benefit plans to defined contribution plans long period are better served by defined contribution plans@ because they vest immediately and are easily rolled into a new employer=s plan or individual retirement account. keville, supra note 4, at 542 (footnotes omitted). but see yakoboski & silverman, supra note 5, at 21-27. yakoboski and silverman argue that boomers are, in fact, expected to have longer tenure figures (as of retirement) than previous generations, so they could not be more mobile. see id. at 23-24. boomers already had higher tenure levels than their predecessors when they hit age groups 25-34 and 35-44 in 1991, and tenure levels were higher in the 1980s and 90s for both men and women than in the 1950s, 60s, or 70s. see id. yakoboski and silverman also posit that the increase in the number of defined contribution plan participants is due mostly to small firms adding the plans, especially 401(k) plans, where they previously had none. see id at 21-23. 21. as a percentage of the total number of private pension plans, the number of defined benefit plans fell from 33% in 1975 to 16% in 1990. see yakoboski & silverman, supra note 5, at 21 (table 14). defined contribution plan have increased as a percentage of aggregate private pensions from 67% in 1975 to 84% in 1990. see id. as of the end of 1992, private defined benefit plans held $1.57 trillion in assets and private defined contribution plans held $911 billion. similar changes took place with regard to the number of participants in defined contribution and defined benefit plans between 1975 and 1990; however, the number of participants in defined benefit plans continues to exceed the number of participants in defined contribution plans. id.; see also keville, supra note 4, at 529. however, recent trends show an increase in the establishment of defined contribution plans so that in a few years defined contribution plans are likely to be the prevalent plan type, assuming no major changes in pension law. 22. the reallocation of risk has been manifested by not only an increase in the number of defined contribution plans but also a decrease in the number of defined benefit plans. see generally, advisory council: dol report will highlight ongoing shift in pension plans, 20 pens. & ben. rep. (bna) 2023 (sept. 27, 1993). the shift towards defined contribution plans can also be seen in the changing composition of private primary plans. see ebri databook, supra note 19, at 139-45. there was a decrease of 56,651 in the number of private primary defined benefit plans between 1985 and 1990. see id. at 140. meanwhile, between 1985 and 1990, the number of private primary defined contribution plans increased by 149,078. see id. however, most of this shift has taken place among small plans with two to nine participants. see id. 614 florida tax review [vol. 4:9 defined contribution plans are more attractive than defined benefit plans to employers for several reasons. first, there are fewer costs and administrative burdens associated with establishing and maintaining defined contribution plans than defined benefit plans. for example, in defined contribution plans there are no fees for actuarial services,23 and no pbgc premiums for pbgc insurance.24 thus, defined contribution plans are an attractive alternative for the cost-conscious employer. second, more onerous regulations are imposed on employers who sponsor defined benefit plans than those who sponsor defined contribution plans. over the last decade, changes to the laws governing private pensions have disproportionately affected defined benefit plans.25 as a result, defined benefit plan sponsors find it necessary to amend their plans frequently to comply with complex new laws and regulations.26 burdensome regulation is often given as the single most important reason underlying the recent shift to defined contribution plans.27 23. see langbein & wolk, supra note 5, at 274 (discussing actuarial fees and assumptions); see also generally halperin, supra note 8, at 186-88. 24. the pbgc premium must be paid by all employers who maintain defined benefit plans. see generally langbein & wolk, supra note 5, at 93-94, 830-31, 854-55. for a discussion of the impact of the pbgc premium on the pension system=s structure, see infra part iii.f.2. 25. see defined benefit plans: employers offer no replacements in more than one-third of terminations, benefits today, jul. 1992, at 223. 26. see vineeta anand, irs cuts some slack on retirement rules, pens. & inv., jan. 10, 1994, at 4; congress may ruin the party, bus. ins., sep. 7, 1992, at 8; see also keville, supra note 4, at 540. another reason not discussed in the text above that employers may prefer defined contribution plans is that the annual cost is not fixed in certain defined contribution plans, such as discretionary profit sharing plans or profit sharing plans with contribution formulas tied to profits. see langbein & wolk, supra note 5, at 42-43 (citing peter t. scott, a national retirement income policy, 44 tax notes 913, 919-20 (1989)). therefore, employers may have more flexibility in lowering their level of annual contribution during economic down-turns. in contrast, the annual contribution to a defined benefit plan is determined by the experience of the plan with respect to employee turnover, death, and investment returns in a given year. id. at 274. thus, from year to year the employer=s contribution to a defined benefit plan (which is generally not tied to profits) will fluctuate but cannot be decreased or increased at the employer's discretion. see regina t. jefferson, defined benefit plan funding: how much is too much?, 44 case w. res. l. rev. 1, 27 n.153 (1993). even with funding flexibility, however, most plans are subject to the minimum funding rules to protect against underfunding. see 29 u.s.c. '' 1081-86 (1999); irc ' 412; langbein & wolk, supra note 5, at 273. there are also caps under erisa on deductible contributions to prevent tax manipulation through overfunding. see irc '' 404(a)(1)(a)(iii), 412. 27. the american academy of actuaries conducted a survey of employers that found that terminations of defined benefit plans are occurring in part, because of excessive government regulation. see jerry geisel, weighty rules crush pension plans, bus. ins., mar. 22, 1993, at 3. for example, studies suggest that prolonged rulemaking by the irs on the nondiscrimination requirements for defined benefit plans created too much uncertainty, and therefore contributed to the termination of around 40,000 small defined benefit plans between 1986 and 1993. deirdre fretz, the irs redefines benefit plans, inst. investor, apr. 1993, at 2000] rethinking the risk of defined contribution plans 615 the reasons employees prefer defined contribution plans are different from those of the employer, and often relate to custom, flexibility, and participant involvement, rather than the inherent characteristics of the plan.28 for example, defined contribution plans typically have more liberal vesting schedules than defined benefit plans.29 also, some defined contribution plans allow pre-separation distributions; others give participants control over the investment of their plan assets.30 c. shortfalls in defined contribution plans notwithstanding erisa=s general success in improving the funding and delivery of retirement benefits, several areas of current pension law are particularly inadequate in preventing shortfalls in defined contribution plans. first, in defined contribution plans, the fiduciary rules do not provide the same level of protection as they do in defined benefit plans. historically, erisa=s fiduciary rules focused on employer mismanagement and the unauthorized use of plan assets.31 in defined contribution plans, however, it is often the employee rather than the employer who makes the allocation and investment decisions regarding plan assets. in such plans, the employers= liability for poor investment performance as a plan fiduciary is reduced; consequently, many of 149. 28. another significant reason that defined contribution plans are often selected by employees as the plan type of choice is because the defined contribution plan structure is more advantageous to the more mobile members of the workforce with respect to the way it measures vested benefits. for example, if an employee terminates employment at age 35 after 10 years of service and the retirement benefit provided by the plan is 1% per year of service times final compensation, the participant would have earned 10% at the time of termination. in contrast, in a defined benefit plan, the contribution level anticipates a certain level of benefits based on estimated final pay; thus, the percentage of contribution and the accumulation at any given point will be greater than if no increase in pay were anticipated. see halperin, supra note 8, at 185-86. 29. see irc ' 411 (providing minimum vesting standards for qualified plans); see also generally langbein & wolk, supra note 5, at 109-14. although not required by the minimum vesting standards, the vesting standards have historically been more generous in defined contribution plans. id. however, no rules prevent a defined benefit plan from being just as liberal in its vesting and distribution rules. 30. these plans are referred to as participant directed plans. see infra part ii.c.1; see also michael j. canan, qualified retirement and other employee benefit plans ' 16.3, at 787-88 (1996 student ed.); langbein & wolk, supra note 5, at 50-51, 347-48; john j. mcgrath, integration of benefits and allocation formula, 402 pli/tax 385, 414 (1997). 31. amost of [erisa=s] fiduciary standards represent a codification of the common law of trusts.@ elaine mcclatchey darroch, mertens v. hewitt associates: the supreme court=s dismantling of civil enforcement under erisa, 1994 det. c.l. rev. 1089, 1092. the fiduciary standards were included in erisa as a response by congress to the akickbacks, embezzlement, outrageous administrative costs, and excessive investments in the securities of plan sponsors/employers@ discovered through senate committee investigations in the 1950s. id. 616 florida tax review [vol. 4:9 the fiduciary rules are irrelevant for such plans.32 thus, participant involvement creates tension between individual choice and the retirement benefit protection provided by the fiduciary laws. on the one hand, participant involvement is desirable because it allows employees to be more active in the management of their retirement assets; on the other hand, when participants who lack financial expertise make investment decisions, their assets are often exposed to much greater risks. 32. in some instances, the fiduciary rules have been used to provide only limited relief for fiduciary breaches in defined contribution plans. aif a participant . . . exercises control over the assets in his account, the fiduciaries of the plan will not be liable for any loss or for any breach of fiduciary duty which is the result of the participant=s exercise of control.@ joseph r. simone & glenn e. butash, statutory framework, alanguage@ and fiduciary responsibility provisions of erisa, 385 pli/tax 7, 28 (1996) (footnotes omitted). 2000] rethinking the risk of defined contribution plans 617 a second reason defined contribution plan participants are more likely to experience shortfalls in their retirement benefits is because the insurance program for retirement plans has a gap in its insurance protection. as mentioned earlier, defined benefit plans are insured by the pbgc, whereas defined contribution plans are not. defined contribution plans are not insured because there is a reluctance on the part of policymakers to insure investment performance, as opposed to calculable retirement benefits.33 interestingly, the distinction between insuring investment performance and insuring calculable benefits is largely one of perception. although insuring a minimum return in a defined contribution plan may appear problematic and incompatible with the existing defined benefit plan insurance model, a guarantee of a minimum investment return can be exactly what occurs in a defined benefit plan under current law. the disparate treatment of investment performance in the two types of plans can be illustrated best by contrasting a traditional defined contribution plan, such as a profit sharing plan,34 with a non-traditional cash balance plan.35 the cash balance plan is a hybrid plan that has design features of a defined contribution plan, but in actuality is a defined benefit plan.36 the cash balance plan promises benefits in the form of a hypothetical account which increases with annual pay credits and annual interest credits.37 the pay credits are 33. see infra part iii.d. 34. a profit-sharing plan is a plan which provides for the participation in the employer=s profits by the employees. see canan, supra note 30, at ' 3.11, at 93. the plan must have a predetermined formula for distribution of contributions made to the plan among the participants at some fixed point in time, e.g., retirement or death. see id. 35. the cash balance plan operates very much like the profit sharing plan in terms of the contribution formula, but the retirement benefit itself is based on specific provisions of the plan document rather than the actual experience of each account. see plan administration: irs updating cobra regulations to provide new guidance, consultant says, 19 pens. & ben. rep. (bna) 592 (apr. 6, 1992) [hereinafter cobra]. in 1985, the cash balance plan was introduced by the bank of america. the bank concluded that a defined contribution-like plan would be more effective than the social security offset pension plan it maintained at the time in giving more mobile workers a reason to a. . . stay one more year.@ however, switching to a defined contribution plan would have lowered benefits for senior employees approaching retirement age. a defined contribution plan also would have transferred the investment risk to all employees. additionally, changing to a defined contribution plan would have required terminating the existing plan, and that could have had adverse tax consequences. thus, the cash balance plan was created to allow bank of america to achieve its goal without the problems that would result from switching to a defined contribution plan. vincent amoroso, cash balance plans, 15 pens. & ben. rep. (bna) 339 (feb. 22, 1988). 36. amoroso, supra note 35, at 339. as a defined benefit plan, the cash balance plan is subject to the funding rules of irc. see irc ' 412. see infra part iii.e. contribution levels are determined using actuarial assumptions for investment earnings, turnover, and death. see john fitzpatrick, supra note 9, at 78. 37. see cobra, supra note 35, at 592. 618 florida tax review [vol. 4:9 determined in the same manner as employer contributions are determined in a profit sharing plan.38 unlike the profit sharing plan, however, the cash balance plan guarantees an annual interest rate credit which is a proxy for investment earnings.39 in a cash balance plan, as with all other defined benefit plans, the employer, rather than the employee, assumes the primary investment risk. thus, for example, if the cash balance plan assumes an interest return of ten percent, and the actual investment return is five percent, the employer would be responsible for the difference between the assumed rate of return and the actual experience of the plan.40 if the employer were unable to make the additional contribution, the pbgc would be liable to the extent of the participants= vested accrued benefits.41 therefore, in reality the pbgc does insure against the failure to earn the expected rate of return in defined benefit plans. under similar circumstances, however, there would be no protection in a defined contribution plan. as a result, a defined contribution plan participant would experience a shortfall in her expected retirement benefit.42 because the shift from traditional defined benefit plans to more flexible savings arrangements is more commonly accomplished by means of conventional defined contribution plans, such as money purchase plans and profit sharing plans rather than cash balance plans, protection against unfavorable investment returns will be unavailable for increasing numbers of participants in defined contribution plans.43 as the use of hybrid plans such as cash balance plans expands, the continued reliance on plan classification to 38. the pay credits are not related to the plan asset levels. id. 39. the interest rate credit is generally related to a nonstatic indicator, such as the yield on treasury instruments. annuity benefits under a cash balance plan are determined by a formula that converts the account balance into a monthly benefit. alternatively, participants may elect to receive lump-sum distributions when they terminate employment. like defined contribution plans, cash balance plans provide greater benefits to employees who terminate employment before reaching retirement age. id. unlike the typical defined contribution plan, however, additional benefits in the event of disability, or death and ad hoc retirement increases can be made available in the cash balance plan. id. although the cash balance plan provides for optional form of payment as a lump sum, the pbgc does not guarantee the lump sum value of participants benefits; the pbgc guarantees only straight life annuity payments. 40. the cash balance plan falls within the broad coverage of erisa ' 4022 which provides that the pbgc shall guarantee the payment of all accrued benefits up to the limit under a single employer plan that terminates with insufficient assets. as a result, the cash balance plan is protected by the federal insurance program. 41. erisa provides in pertinent part that the pbgc aguarantee[s] . . . the payment of all nonforfeitable benefits . . . under a single-employer plan which terminates at a time when [erisa section 4021] applies to it.@ 29 u.s.c. ' 1322(a) (1999). 42. see discussion infra part iii.d. 43. see discussion infra part iii.d; see also 29 u.s.c. '1321(b)(1) (1999) (providing that protection is unavailable to individual account plans); keville, supra note 4, at 556 (discussing the lack of pbgc protection for defined contribution plans). 2000] rethinking the risk of defined contribution plans 619 determine insurance protection eligibility will become increasingly confusing, and create more and more anomalous results. this situation is particularly disturbing since the cash balance plan is functionally similar to a defined contribution plan. insufficient funding of the expected retirement benefit is the third reason defined contribution plan participants may not receive the retirement benefits they expect. when a plan is established, a participant's projected retirement benefit can be divided into two essential parts: (1) the portion attributable to the future; and (2) the portion attributable to the past. when newly established plans give credit for past service, the plans incur liabilities for prior years of service, although they have not accumulated any assets. plans typically fund their initial past service liabilities over thirty-year periods.44 thus, assuming that there are no benefit increases and the actual assumptions are correct, if the plan continues to operate for at least thirty years, there is no risk of a funding shortage. if the plan terminates before the funding period has run, however, there may be insufficient contributions to cover the portion of the benefit attributable to past service. although defined contribution plans generally do not provide explicitly for past service, many of them do provide for such benefits implicitly.45 however, because the pbgc fails to insure not only benefits attributable to future service in defined contribution plans, but also those attributable to past service, the past service benefit is not protected. thus, defined contribution plan participants are more likely to experience shortfalls in both the past and future portions of their expected retirement benefits. in defined contribution plans, just as in defined benefit plans, when shortfalls occur with respect to the past service benefit, it is because the employer fails to make sufficient contributions, not because unfavorable investment performance has occurred. accordingly, in both types of plans the portions of the expected retirement benefit attributable to past service are equally insurable and pre-fundable. therefore, even if one believes that there should be no protection in defined contribution plans of the portion of the expected retirement benefit attributable to future service because the benefit depends on future investment performance, one could view the portion of the retirement benefit based on past service credit very differently. 44. the serious underfunding of several large plans was caused by the 30-year funding period for past service credits. thus, the pension protection act of 1987, pub. l. no. 100-203, 101 stat. 1330-33 (1987) (codified in scattered sections of 29 u.s.c.), required more rapid funding of underfunded plans due to concerns about the solvency of the defined benefit plan system. for more information on minimum funding standards, see 29 u.s.c. ' 1082 (1999); irc ' 412(l). 45. see discussion infra part iv.c. 620 florida tax review [vol. 4:9 because current pension law provides defined contribution plans inadequate protection, the shift from traditional defined benefit plans to more flexible defined contribution plans as primary retirement saving vehicles compromises erisa's goal of guaranteeing the delivery of expected retirement benefits. this result is not inevitable, however. in order to provide the protection congress intended to confer upon private pension plan retirees when it enacted erisa, the fiduciary and funding laws should be amended. additionally, insurance protection should be extended to all, or some portion, of the defined contribution plan benefit, in order to prevent shortfalls in the expected retirement benefits of defined contribution plans. this article explores the feasibility of each of these suggestions, and separately analyzes the impact of the following in defined contribution plans: (1) inadequate fiduciary rules; (2) unfavorable investment performance; (3) lack of insurance protection; and (4) inadequate funding practices. this article concludes that the impact of these risks is extremely disparate between defined benefit plans and defined contribution plans. part ii shows that inadequate fiduciary rules threaten the success of erisa as the use of defined contribution plans as primary savings vehicles escalates. part iii demonstrates a need for insurance protection against unfavorable investment performance in defined contribution plans, and proposes an insurance model to resolve existing inequities among participants in the two types of plans. part iv determines that past service credits in defined benefit plans and defined contribution plans are indistinguishable; consequently, at a minimum, the portion of the expected retirement benefit attributable to past service warrants pre-funding, or some level of insurance protection. ii. the private pension program and the fiduciary law a. fiduciary standards one of the primary goals of erisa is to establish higher fiduciary standards in order to provide greater protection of retirement benefits.46 although erisa has been relatively successful in achieving this goal, recent developments in fiduciary law threaten its success, potentially placing plan participants in a more disadvantageous position than they were in prior to the passage of erisa. 46. see 120 cong. rec. s15,738, 15,741 (1974), reprinted in 1974 u.s.c.c.a.n. 4639, 5186-87 (statement of sen. williams). 2000] rethinking the risk of defined contribution plans 621 before erisa, the state common law of trusts and the internal revenue code governed a trustee=s conduct in the administration and investment of pension assets.47 common law doctrine required the trustee ato make such investments . . . as a prudent [person] would make of his own property.@48 the common law of trusts also imposed a duty of loyalty on the trustee and governed the remedies available to plan participants and their beneficiaries in the event of fiduciary breach.49 currently, erisa delegates to the federal government the duty of establishing all pension policy and law.50 while erisa preempts state law, including the state common law of trusts, erisa=s fiduciary standards are 47. until 1974, the internal revenue code=s exclusive benefit rule, still in effect today, prescribed the only federal guidelines applicable to plan fiduciaries. the exclusive benefit rule provided that a plan would not qualify for preferential tax treatment if it was not maintained for the exclusive benefit of plan participants and their beneficiaries. irc ' 401(a). historically, courts have not rigidly enforced the exclusive benefit rule, and the irs has had a practice of not penalizing investments whose primary purpose is for the benefit of plan participants and their beneficiaries, in spite of their contemporaneous generation of collateral benefits for others. see shelby u.s. distribs., inc. v. commissioner, 71 t.c. 874, 885 (1979); maria o=brien hylton, asocially responsible@ investing: doing good versus doing well in an inefficient market, 42 am. u.l. rev. 1, 38 (1992); see also irc ' 404 (a)(l)(a)(i), (c)(l). for further discussion of the exclusive benefit rule, see langbein & wolk, supra note 5, at 649. an employee benefit plan fiduciary=s behavior was also judicially reviewable under the taft-hartley act. see labor-management relations act (taft-hartley act), pub. l. no. 80-101, 61 stat. 136 (1947) (codified as amended at 29 u.s.c. '' 141-87 (1998)). the act provided that multi-employer plans must be in the form of a trust arrangement. 29 u.s.c. ' 186(c)(5) (1998). the act provides federal jurisdiction for claims seeking enforcement of a collective bargaining agreement requiring maintenance or funding of an employee benefit plan. id. at ' 185(c). the act was used to challenge fiduciary action under an arbitrary and capricious standard. this standard was incorporated into erisa common law, but was modified by the court. see terese m. connerton, suits by beneficiaries against plans or employers to recover benefits, sb68 a.l.i.-a.b.a. 569, 614-15 (1997) (discussing firestone tire & rubber co. v. bruch, 489 u.s. 101 (1989)). the act was a arelatively weak and incomplete effort[] to regulate employee benefit plans.@ catherine l. fisk, lochner redux: the renaissance of laissez-faire contract in the federal common law of employee benefits, 56 ohio st. l.j. 153, 162 (1995). 48. restatement (third) of trusts (prudent investor rule) '181 (1992). harvard college v. amory, 26 mass. (9 pick.) 446, first enunciated the traditional standard of the trust fiduciary, that the trustee act how amen of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.@ armory, 26 mass. (9 pick.) at 461. 49. see jeffrey a. brauch, the danger of ignoring plain meaning: individual relief for breach of fiduciary duty under erisa, 41 wayne l. rev.1233, 1248 (1995) (discussing justice brennan=s concurrence in mass mutual life ins. co. v. russell, 473 u.s. 134, 152-54 (1985), in which he argued that legislative history showed that congress intended to incorporate into erisa the fiduciary standards of the common law of trusts); see also hylton, supra note 47, at 39. 50. see erisa ' 514(a), 29 u.s.c. ' 1144(a) (1999). 622 florida tax review [vol. 4:9 rooted in state common law tradition and pre-erisa regulations. like the common law, erisa regulates fiduciary activities and protects pension assets from mismanagement, fraud, and bankruptcy. under erisa, a fiduciary=s conduct is governed by the aprudent [person] rule,@51 the general fiduciary standards of erisa section 404, and the prohibited transaction rules of erisa section 406.52 commentators are in general agreement that congress intended the prudent person rule to be applied more liberally under erisa than was customary at common law.53 nevertheless, plan fiduciaries must manage all activities with respect to the plan solely in a manner consistent with the best interests of plan participants and their beneficiaries.54 under erisa, plan fiduciaries are obligated to maximize investment returns. in doing so, they are permitted to take into consideration inherent risks associated with particular investments.55 thus, fiduciaries may accept lower investment returns in exchange for lower risks, or conversely, expose the assets to higher risks in exchange for the possibility of greater returns.56 however, an overriding rule of fiduciary law is that the investor must always 51. the prudent man rule is codified at erisa ' 404(a)(1)(b), 29 u.s.c. ' 1104(a)(1) (1999). this rule provides that a fiduciary shall act awith the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.@ 29 u.s.c. '1104(a)(1)(b) (1999). 52. erisa '' 404(a)(1), 406, 29 u.s.c. '' 1104(a)(1), 1106 (1999). 53. see e.g., donovan v. cunningham, 716 f.2d 1455, 1467 n.26 (5th cir. 1983) (holding that the flexible erisa prudent man rule takes a facts and circumstances approach and does not incorporate the rigorous aprudent expert@ standard of the common law); hylton, supra note 47, at 39. see also laurence b. wohl, federal duties under erisa: a tale of multiple loyalties, 20 u. dayton l. rev. 43, 53 nn.34-35 (1994); jay conison, the federal common law of erisa plan attorneys, 41 syracuse l. rev. 1049, 1135-36 (1990). 54. see 29 c.f.r. ' 2550.404a-1; see also dan m. mcgill & donald s. grubbs, jr., fundamentals of private pensions 115-16, 442-44 (6th ed. 1989); see also hylton, supra note 47 and accompanying text. 55. the department of labor takes the position that aeconomic considerations are the only ones which can be taken into account in determining which investments are consistent with erisa standards.@ ian d. lanoff, the social investment of private pension plan assets: may it be done lawfully under erisa?, 31 lab. l.j. 387, 392. in its evaluation of investment choices, the department of labor adopts an aggregate analyses which takes the entire investment portfolio into consideration rather than individual investments. see paul j. wessel, job creation for union members through pension fund investment, 35 buff. l. rev. 323, 340 (1986). 56. see deborah m. weiss & marc a. sgaraglino, prudent risks for anxious workers, 1996 wis. l. rev. 1175, 1198-1200. the department of labor has consistently rejected the common law approach to evaluating such investment choices with respect to a particular investment on the bases of using only the relative risk of the single investment. see joseph r. simone & glenn e. butash, statutory framework, alanguage@ and fiduciary responsibility provisions of erisa, 385 pli/tax 7, 27 (1996). 2000] rethinking the risk of defined contribution plans 623 adequately diversify the investment portfolio in order to reduce the risk of investment losses.57 historically, the fiduciary rules have been interpreted to provide greater protection to participants in defined benefit plans than in defined contribution plans.58 one explanation for the different interpretations in the two types of plans is the level of employer involvement. in a defined benefit plan the employer determines the level of retirement benefit, who participates, and the manner in which the plan's assets are invested.59 by contrast, in a defined contribution plan, it is often the employee who makes the decisions about participation, contribution, and asset management. furthermore, because defined benefit plans have calculable retirement benefits, plan participants readily can determine whether a failure to provide promised retirement benefits is attributable to fiduciary breach. in defined contribution plans, benefits are based upon the participants' individual account balances and therefore indeterminate in nature. thus, absent a showing of imprudent investment choices, a plan participant would have difficulty demonstrating fiduciary breach when account balances fall short of the expected retirement benefits.60 b. fiduciary breach under erisa erisa defines a afiduciary@ as one with discretionary authority or control over pension plan assets, or one who manages pension assets.61 accordingly, employers, plan trustees, fund managers, and all other 57. see hylton, supra note 47, at 15, 17-18. also see erisa ' 404(a)(1), 29 u.s.c. 1104(a)(1) (1994) (requiring that aa fiduciary shall discharge his duties . . . (c) by diversifying the investments of the plan so as to minimize the risk of large losses@); see also hylton, supra note 47, at 16 (noting that arisk and return are positively correlated@). diversification is a key method of reducing risk without reducing aggregate returns from a portfolio of assets. it exemplifies the old axiom: adon=t put all your eggs in one basket.@ essentially, diversification is spreading investment funds into areas which will react differently to the market, thereby eliminating risk. see richard j. teweles et al., the stock market 386-87 (6th ed. 1992). adiversification results from the interplay of three elements: (1) the number of different holdings; (2) the proportions in which different securities [or other assets] are held; and (3) the extent to which the securities [or other assets] held react in a dissimilar fashion to the same future contingencies.@ janet e. kerr, suitability standards: a new look at economic theory and current sec disclosure policy, 16 pac. l.j. 805, 817 (1985). a perfectly diversified portfolio will eliminate nonmarket risk, leaving the assets to fluctuate according to the market. see id. at 818. 58. see keville, supra note 4, at 547-48, 552. 59. subject to the minimum participation standards of irc ' 411. 60. see discussion infra part ii.b. 61. irc ' 4975(e)(3); erisa ' 3(21)(a), 29 u.s.c. ' 1002(21) (1999). 624 florida tax review [vol. 4:9 individuals who provide investment advice for profit are erisa fiduciaries.62 however, individuals who render professional services to a pension plan in a purely ministerial capacity are not considered fiduciaries.63 erisa does not expressly address or regulate the activity of those who are involved indirectly with the management of the plan=s assets.64 for example, investment managers are clearly erisa fiduciaries, but it is unclear whether investment consultants are considered fiduciaries.65 thus, it is sometimes difficult to determine whether a service provider is acting in a fiduciary or ministerial capacity.66 under erisa, a[f]iduciaries who breach their fiduciary duties are personally liable to the plan to make good any resulting losses to the plan.@67 erisa provides that equitable or remedial measures shall be awarded as a 62. see e.g., blatt v. marshall & lassman, 812 f.2d 810, 813 (2d cir. 1987). 63. for example, actuaries, attorneys, accountants, and plan administration companies all have been held to be nonfiduciary third parties. see painters of philadelphia district council no. 21 welfare fund v. price waterhouse, 879 f.2d 1146, 1149 (3rd cir. 1989) (holding that performance of a standard audit did not make the accounting firm erisa fiduciaries because the firm had no discretionary authority over management of the plan assets); pension plan of public service co. of new hampshire v. kpmg peat marwick, 815 f. supp. 52, 55 (d.n.h. 1993) (holding that an accounting firm that provides typical auditing services to an erisa plan was not an erisa fiduciary); see maria linda cattafesta, note, mertens v. hewitt associates: a narrow interpretation of erisa precluding nonfiduciary liability for money damages under erisa, 43 cath. u.l. rev.1165, 1170 n. 23 (1994); anoka orthopaedic assoc. v. lechner, 910 f.2d 514, 517 (8th cir. 1990) (holding that ministerial tasks performed for the purpose of collecting information was not a discretionary act and did not qualify the attorney as an erisa fiduciary); new york teamsters council health and hospital fund v. estate of de perno, 816 f. supp. 138, 148 (n.d.n.y. 1993); see cattafesta, supra, at 1170 n.22; pappas v. buck consultants, inc., 923 f.2d 531, 538 (7th cir. 1991) (holding that an actuary who performs usual actuarial services is not an erisa fiduciary); fechter v. connecticut general life ins. co., 798 f. supp. 1120, 1125 (e.d. pa. 1991) (same); see cattafesta, supra, at 1169-70 nn.20-21; pohl v. national benefits consultants, inc., 956 f.2d 126, 128-29 (7th cir. 1992) (holding that the performance of clerical, mechanical, and ministerial services did not confer discretionary authority over the plan administrator, and thus, the plan administrator was not an erisa fiduciary); baxter v. c.a. muer corp., 941 f.2d 451, 454-55 (6th cir. 1991) (holding that a plan administrator who performed claims processing services was not an erisa fiduciary); see cattafesta, supra, at 1170 n.23. but see bouton v. thompson, 764 f. supp. 20, 23 (d. conn. 1991) (holding that an attorney who exercises discretionary control over the management of plan assets is an erisa fiduciary). 64. see erisa ' 3(14)(a), 29 u.s.c. '' 1002(14)(a), 1101-1114 (1999). 65. see joel chernoff, hewitt decision challenged; metzenbaum, labor department fight high court ruling, pens. & inv., jun. 14, 1993, at 229. case law regarding other service providers gives the only guidance in this area. see custer v. sweeney, 89 f.3d 1156, 1161-63 (4th cir. 1996) (holding that plan=s attorney is not erisa fiduciary); united states v. coyle, 63 f.3d 1239, 1246-47 (3d cir. 1995) (aby providing medical services to the fund,@ amma is a fiduciary under erisa); see also andrew t. kusner, mertens v. hewitt associates, and the erisa liability of the professional service provider, 15 berkeley j. emp. & lab. l. 273, 304-05 (1994). 66. see mertens v. hewitt associates, 508 u.s. 248, 262-63 (1993). 67. michael j. canan & william d. mitchell, employee fringe and welfare benefit plans ' 16.5 (1994 ed.). 2000] rethinking the risk of defined contribution plans 625 court deems appropriate.68 historically, the beneficiary of a pension trust could maintain an equitable suit for damages against not only a fiduciary for breach of trust, but also against a participating non-fiduciary.69 thus, even though fiduciaries and participating non-fiduciaries were subject to different standards of care, there were remedies available against both, in the event of a breach of trust. however, in mertens v. hewitt, the supreme court interpreted section 502(a)(3) of erisa as precluding nonfiduciary liability in the event of breach.70 the court held that erisa does not provide monetary relief against participating nonfiduciary third parties, even when they knowingly participate in fiduciary breaches.71 the mertens court reasoned that because erisa mandates specific remedies and aallocates liability for plan-related misdeeds in reasonable proportion to [the] respective actors= power to control and prevent the misdeeds,@ the provision of monetary relief against service providers who performed services in the capacity of nonfiduciaries was unavailable.72 the court explained that professional service providers lacked the requisite fiduciary control, and became aliable for damages [only] when they cross the line from advisor to fiduciary.@73 the mertens court was concerned that exposing service providers to full liability for fiduciary breach would result in higher insurance costs for persons who regularly provide advisory services to erisa plans.74 to do so, they feared, ultimately would increase the costs for erisa plans. in other words, the court believed that money that otherwise would be used for retirement benefits would be used to pay for indemnification against potential litigation. thus, the mertens court preferred to limit the remedies against service providers to court injunctions, or restitution of fees, rather than to hold them liable for restoring losses resulting from their participation in fiduciary breaches.75 interestingly, the common law of trusts accords participants and their beneficiaries a cause of action for monetary damages against nonfiduciaries 68. see erisa ' 502(a)(3), 29 u.s.c. ' 1132(a)(3)(b) (1998); see roger c. siske et al., what=s new in employee benefits: a summary of current case and other developments, sb66 a.l.i.-a.b.a. 1, 13-36 (1997). 69. cattafesta, supra note 63, at 1191. the supreme court in mertens defined aequitable relief@ as ainjunction, mandamus, and restitution.@ mertens, 508 u.s. at 248. equitable relief is, in fact, remedies awarded that are not monetary. see black=s law dictionary 539 (6th ed. 1990). 70. see mertens, 508 u.s. at 254. 71. id. 72. id. at 262. 73. id. 74. id.; see also chernoff, supra note 65, at 3 (discussing the mertens opinion). 75. see mertens, 508 u.s. at 262. 626 florida tax review [vol. 4:9 who knowingly participated in fiduciary breaches.76 thus, under pre-erisa trust law, wealthy nonfiduciaries were discouraged from participating in fiduciary breaches fearing that they could be alternative financial resources to subsidize lost retirement benefits. for this reason, many commentators characterize the court's restrictive interpretation of erisa=s fiduciary law in the mertens decision as regressive.77 the court=s holding that nonfiduciary service providers are immune from fiduciary liability is potentially more devastating to defined contribution plan participants than to defined benefit plan participants. in defined benefit plans, if the remedies against third party non-fiduciaries are inadequate, the minimum retirement benefit is, nevertheless, guaranteed by the employer and the pbgc.78 participants, therefore, do not face the risk of insufficient asset accumulation as a result of third party involvement in fiduciary breaches. thus, diverting pension assets to provide a broader range of remedies against nonfiduciaries in defined benefit plans could be considered unnecessary or inefficient. consequently, the supreme court=s reluctance to have pension assets diverted for service provider indemnification can be understood in the defined benefit plan context. in contrast, however, because there is neither employer liability nor pbgc protection in defined contribution plans, defined contribution plan participants have no protection against shortfalls. therefore, if a defined contribution plan in which the fiduciary is unable to respond, terminates with 76. see kusner, supra note 65, at 280-81 (discussing how some circuits relied on pre-erisa trust law to reach an interpretation of erisa '502(a) different than the supreme court did in mertens). 77. see, e.g., kusner, supra note 65; dana m. muir, erisa remedies: chimera or congressional compromise?, 81 iowa l. rev. 1 (1995); gregory a. hewett, should non-fiduciaries who knowingly participate in a fiduciary breach be liable for damages under erisa?, 71 wash u. l.q. 773 (1993). the dissent in mertens argued that both equitable and legal remedies were available under the common law of trusts to ensure that beneficiaries received complete relief. see mertens, 508 u.s. at 264-66. moreover, the dissent concluded that the phrase aappropriate equitable relief@ used in erisa ' 502(a)(3) implicitly includes all remedies available under equity for breaches which include monetary damages against both fiduciaries and nonfiduciaries alike. id. at 266-67. the dissent=s interpretation would give plan participants and their beneficiaries the same protection under erisa that they would have had before the enactment of erisa. see id. mertens states in dicta that there is no cause of action against a nonfiduciary for knowingly participating in a fiduciary=s breach of duty under erisa. see remedies: seventh circuit finds no claim against nonfiduciary, cites mertens, 21 pens. & ben. rep. (bna) 1675, 1675 (aug. 29, 1994). chief judge posner and the seventh circuit followed this aconsidered dictum@ while holding that there is no cause of action against a nonfiduciary who knowingly participates in a fiduciary's breach of duty under erisa. reich v. continental casualty co., 33 f.3d 754, 757-58 (7th cir. 1994). the first circuit has also followed mertens=s lead in holding that equitable remedies are not available against nonfiduciaries who knowingly participate in a fiduciary=s breach of duty. see reich v. rowe, 20 f.3d 25 (1st cir. 1994). 78. see infra part iii.a. 2000] rethinking the risk of defined contribution plans 627 insufficient asset accumulation due to third party fiduciary breach, and the remedies against the third party are inadequate to fully restore the lost benefits, the plan participants will bear the brunt of the loss.79 defined contribution plan participants are, thus, exposed to much greater risks when service providers contribute to plan losses than defined benefit plan participants. accordingly, the use of retirement funds to indemnify service providers in connection with a broadening of the remedies against third parties, could be reasonably considered an efficient use of defined contribution plan assets, because plan participants otherwise have inadequate protection.80 thus, the mertens holding is less understandable in the defined contribution plan context, where participants are exposed to greater risks of loss when third parties make investment decisions, or are involved in the management of plan assets.81 c. the fiduciary rules and participant directed plans although employers who sponsor defined contribution plans are not required to allow participants to make individual participation and investment decisions, many employers recognize that giving flexibility enables employees to customize their retirement programs to accommodate specific saving objectives and risk tolerances.82 thus, growth in the defined contribution plan area has been driven largely by the establishment of 79. if a retirement plan is not covered by title i of erisa, the participant will have remedies available under state law, including money damages and injunctive relief. see canan, supra note 30, at ' 21.2, at 1024-25. 80. immediately after mertens was decided, the department of labor sought to persuade congress to amend erisa to assign fiduciary responsibility to anyone directly or indirectly involved in the management of pension assets. the senate labor committee drafted an amendment to erisa that explicitly made service providers liable for monetary damages if they aknowingly participate[d]@ in fiduciary breaches. chernoff, supra note 65, at 1. senator howard metzenbaum, with input from the department of labor, drafted the amendment to reverse the supreme court=s mertens decision. see chernoff, supra note 65, at 2. the amendment was later defeated. id. 81. see infra part ii.c. 82. employees often are asked to decide whether they will participate in the plan, how much to contribute to the plan from current compensation, how their funds should be invested within choices offered by the employer, and finally, whether to roll over lump sum distributions received from the plans on termination of employment. see keville, supra note 4, at 549-51. interestingly, the reason most employers allow participants to make these decisions is a general misconception about erisa. basically, employers who sponsor qualified plans are convinced that erisa ' 404(c) protects them from any potential liability arising out of the investment returns experienced in a participant=s account if they only transferred investment responsibility for the account to the participant. see jeffrey m. miller, employer-directed plans may be the answer, pension mgmt., nov. 1994, at 30. 628 florida tax review [vol. 4:9 participant directed plans.83 participant directed plans cover approximately 25 million employees, and represent the fastest growing component of the private sector retirement system.84 in participant directed plans, employees decide not only whether to participate, and the level of compensation to be contributed to the plan by the employer on their behalves, but also the manner in which their accounts are to be invested.85 in such plans, the individual decisions made by plan participants ultimately determine the adequacy of the retirement benefit. notwithstanding the significance of the investment decisions, however, erisa currently imposes no additional notification or education requirements on employers who sponsor participant directed plans. erisa=s general fiduciary standards govern the plan=s notification and investment practices. thus, participant directed plans raise an additional question about the adequacy of erisa=s fiduciary rules. is it appropriate to allow employers to shift the responsibility of making critical investment decisions to plan participants, who typically lack professional financial training?86 section 404(c) safe harbor plans (discussed below) raise even more concerns regarding the adequacy of erisa=s fiduciary rules because under such plans, the employer and other plan fiduciaries are almost completely insulated from fiduciary liability for the poor investment decisions made by plan participants. 1. investment practices and participant directed plans.cin employer directed plans, a plan administrator or an investment professional typically controls the plan investments.87 the investment manager is required to allocate investments in a manner that offers protection against inflation, market fluctuations, and unfavorable market performance.88 in participant directed plans, the same investment strategy is desirable, but generally not 83. participant directed plans are typically 401(k) plans; however, other defined contribution plans also may give participants the responsibility of choosing how the plan assets are to be invested. in addition to the self-directed feature, 401(k) plans often require participants to make numerous other decisions about their retirement security. 84. marlene givant star, participants in a quandry about plan options, pens. & inv., oct. 17, 1994, at 19. the number of participant directed 401(k) plans has grown rapidly. participation in such plans increased by approximately 45% from 1983 to 1993, attributable in large part to the creation of new retirement plans by small businesses. see canan, supra note 30, at '16.3, at 788. 85. the investment choice is made among the investment options offered by the employer. 86. see mary rowland, taking the power of the 401(k), and handing it to someone else, n.y. times, june 18, 1995, at f5 (stating that some plan participants have recognized their own inadequacies regarding investment management and have turned their retirement accounts over to outside stockbrokers). 87. see keville, supra note 4, at 543-44. 88. diversification is key to success of section 401(k) investments, aspa told, 17 pens. & ben. rep. (bna) 1243 (july 16, 1990) [hereinafter diversification]. 2000] rethinking the risk of defined contribution plans 629 utilized because employees often have not had sufficient investment training to achieve this result.89 89. insufficient financial training has been cited most frequently as the explanation for why participants use overly conservative investment strategies. id. at 1243. 630 florida tax review [vol. 4:9 the modern portfolio theory of investment explains that an adequately diversified portfolio should include an appropriate balance of stocks, bonds, and stable valued funds.90 however, inexperienced participants generally fail to adequately diversify their retirement accounts, investing disproportionately in stable value funds.91 because a balanced investment portfolio provides a better relationship between return and risk, the failure to adequately diversify investment portfolios adversely affects retirement income security. a high concentration of stable value, low-yield investments generally produces insufficient investment income over one=s working life to provide financial security for the retirement years.92 consequently, a participant who disproportionately invests in stable valued instruments would have to save greater amounts to be in the same position at retirement as a participant who sufficiently diversified their investment portfolio.93 not only are inexperienced investors likely to inadequately diversify their retirement portfolios, but they also are less likely to recognize the financial indicators on which investment professionals rely to know when to transfer funds from one investment to another.94 therefore, inexperienced investors may fail to make appropriate changes when such transactions are warranted. under other circumstances, inexperienced investors may act too hastily.95 for example, during market down-swings, undisciplined investors may abandon high-risk, high-return investments too quickly, notwithstanding conventional wisdom that these investments perform best over the long-run.96 if inexperienced participants do not, or cannot, make good investment decisions, they will have insufficient accumulation when they retire. younger employees are particularly vulnerable to less than optimal investment 90. see j. michael mcgowan, watching your basket: keys to nurturing a successful investment portfolio, 78 a.b.a. j. 97 (nov. 1992). 91. diversification, supra note 88, at 1243. 92. overly conservative investment strategy is problematic for two other reasons: first, inflation, although averaging only 4% over the last decade, is a potential threat to the purchasing power of retirement income. second, as life expectancies continue to increase, assets that participants have accumulated in their defined contribution plan accounts will need to stretch farther. alexander sussman, the investment horizon: how can employers assure adequate retiree benefits in the coming years?, comp. & ben. rev., jan. 1, 1996, at 73. 93. see regina t. jefferson, the american dream savings account: is it a dream or a nightmare?, taxing america 261 (karen b. brown & mary louise fellows eds., 1996). 94. see keville, supra note 4, at 545-46 (noting that athe majority of self-directed pension plan investors transferred funds to the stock market after it reached its high in 1987, and bailed out after the market crashed soon thereafter@). 95. participants in 401(k) plans are active traders, contrary to popular belief. these investors may panic during market fluctuations, selling too quickly, which ultimately could threaten their financial security. see vanessa o=connell, market bumps rattle nerves at 401(k)s, wall st. j., aug. 23, 1996, at c1. 96. see judy greenwald, investment education raises employer liability questions: when does information become advice?, bus. ins., oct. 31, 1994, at 2, 98. 2000] rethinking the risk of defined contribution plans 631 practices because the compounding of their returns will occur over longer periods of time. thus, the success or failure of participant-directed plans hinges on the proper education and notification of plan participants in areas of asset allocation, diversification, and risk return.97 2. the education and notification requirement in participant directed plans.cerisa=s mandate of afiduciary responsibility@ for plan trustees, investment managers, and other persons who control pension plans, makes all plan fiduciaries ultimately responsible for asset performance in retirement plans.98 thus, in participant directed plans, the employer remains liable as an erisa fiduciary, although the participant makes the investment choices.99 consequently, it is possible for the participant who loses money as a result of inadequate investment diversification to bring a cause of action against the employer, on the grounds that the availability of the transaction implied approval of the investment choice. alternatively, a participant could argue that the employer should have recognized a problem with the investment decision, and overruled the allocation. although a participant would have tremendous difficulty meeting the burden of proof for such allegations, the employer or plan fiduciaries, nevertheless, would be liable for the investment losses if the participant were successful.100 to minimize their potential liability for poor investment decisions made by plan participants, many employers have established education programs.101 providing investment education presents a catch twenty-two for 97. see james e. graham, does 404(c) provide more questions than answers?, pension world (july 1994) at p. 48. 98. see munnell, supra note 11, at 137; see also supra part ii.b. there is an exception for ' 404(c) plans in which the plan fiduciaries are not responsible for the investment decisions made by plan participants. see infra part ii.c.3. 99. this is true even in ' 404(c) plans in which the employer=s liability is significantly minimized. see infra part ii.c.3. 100. in participant directed defined contribution plans the fiduciary standards would most likely be applied less strictly than in other types of defined contribution plans. fiduciaries of such plans are apparently obligated to exercise only procedural prudence regarding investment decisions. therefore, successful participant claims regarding poor investment performance are essentially eliminated in participant directed accounts. to establish fiduciary breach or mismanagement in a participant directed plan, participants would be limited to showing either that they were not advised properly, that there were not broad enough investment choices, or that there were inappropriate investment alternatives. miller, supra note 82, at 30. for a discussion of participant directed plans, see supra, part ii.c.1. 101. see thomas r. hoecker & nancy k. campbell, participant directed investment planscproblems and solutions, q245 a.l.i.-a.b.a. 211 (1996); see also ebri releases report on participant education for improved retirement savings, 95 tax notes today 86-51 (may 3, 1995) [hereinafter ebri releases]. a survey by ebri and matthew greenwald and associates indicated that 73% of 401(k) participants received some type of educational material from their employer. id. among the 73% that received the material, 33% increased the amount of their contribution and 44% changed the allocation of their money. id. 632 florida tax review [vol. 4:9 the employer, however. on the one hand, employers can be held liable if they do not provide sufficient investment information to enable plan participants to make sound investment decisions. on the other, they can be held liable for losses as plan fiduciaries if the information is considered investment advice, and later proves to be incorrect.102 the department of labor regulations explain that ainvestment advice@ consists of recommendations pertaining to property value; ainvestment information@ consists of mere communication that is general in nature.103 accordingly, providing a list of investment vehicles and instructions about the investment selection process is likely to be considered mere communication. whereas, specific recommendations about particular investments are likely to constitute investment advice.104 until recently, employers were counseled that providing bad investment advice was a greater risk than providing insufficient investment information.105 in other words, employers were more exposed to litigation when they established education programs than when they allowed participants to make their investment decisions without the benefit of financial 102. see mary rowland, educate-or litigate: educating pension plan participants, inst. inv., march 1, 1995, at 87. if the information is considered investment advice, those providing the information, e.g., employers, plan sponsors, service providers, would be deemed fiduciaries, subject to liability under erisa. see frederick c. kneip, section 404(c): basic principles, 397 pli/tax 43 (1997); see also roger c. siske et al., what=s new in employee benefits: a summary of current cases and other developments, sb66 a.l.i.-a.b.a. 1, 78-79 (1997). 103. the department of labor has determined that a[a]n investment advisor who suggests investment alternatives for a pension plan has a definite fiduciary duty to select alternatives prudently.@ keville, supra note 4, at 551-52. keville also notes that aan investment advisor who is hired by an employer to provide investment instructions to employees is a fiduciary under the terms of erisa if the advisor is compensated for services rendered.@ id. 104. see keville, supra note 4, at 551-52. however, any individual giving investment information to plan participants may be considered a fiduciary if it reasonable for the participant to consider the information investment advice and if the participant acts accordingly to her detriment. jack w. murphy, associate director and chief counsel of the division of investment management at the sec stated that an employee sponsor providing information would not be considered to be giving advice unless it held itself out as providing advice or received additional compensation from employees or third parties for the advice. see division of investment management the year in review: regulation of investment companies, investment advisors and public utility holding companies in 1996, 979 pli/corp 7, 680 (feb.-mar. 1997). 105. see rowland, supra note 102, at 87. see also jeffrey m. miller, the difference between education and advice, pension mgmt., feb. 1995, at 34. if plan sponsors teach participants about investment performance in achieving long-term retirement goals, the sponsor will not be considered a fiduciary. id. however, if the sponsor creates programs which provide the basis for participants= investment decisions, plan sponsors may be regarded as fiduciaries which exposes them to potential liability. id. in this situation, sponsors will have crossed the line between providing investment information and advice. id. 2000] rethinking the risk of defined contribution plans 633 training.106 because employers are typically unwilling to assume a risk of greater exposure to potential liability, it is not surprising that many employers have not provided adequate investment education to their employees.107 as a result, employees participating in participant-directed plans are often left on their own to obtain the education and training necessary to successfully manage their retirement savings. the significance of the distinction between investment advice and investment information is another reason the mertens decisions is more troubling for certain defined contribution plan participants than for defined benefit plan participants. in participant-directed defined contribution plans, unsophisticated investors unable to distinguish between investment advice and investment information may suffer unfortunate consequences as a result of misunderstandings. if an investment broker aggressively markets alternative investments under the rubric of investment information, inexperienced plan participants could interpret the broker=s comments as specific recommendations, rather than general information. believing that they have received investment advice, participants may rely on the communication and make decisions that adversely affect the build-up of their accounts. under mertens, money damages would be unavailable to the plan participants in this situation, even if the broker had adequate assets to restore plan losses.108 thus, the participants ultimately would receive smaller retirement benefits than expected.109 3. section 404(c) plans.canother method of minimizing liability for poor investment performance is for the employer to adopt a section 404(c) plan.110 an employer's exposure to fiduciary liability is substantially reduced 106. see rowland, supra note 102, at 87; see also miller, supra note 105, at 30 (noting that in the 1980=s, employers thought they could avoid liability altogether by transferring the investment responsibility to plan participants). 107. see rowland, supra note 102, at 87. recent numbers suggest that there has been an increase in education programs offered by employers. however, many employers make such programs available because it is important for them to encourage low and middle income employees to participate in elective contribution plan. see ebri databook, supra note 19. however, with the introduction of the new safe harbor rules for nondiscrimination in 401(k) plans many employers may discontinue these programs. 108. see supra part ii.b. the only chance for the participant to receive money damages is for her to demonstrate that she reasonably interpreted the comments as investment advice. an investment advisor who directs participant investment selections for a pension plan has a fiduciary duty to select alternatives prudently. see keville, supra note 4, at 548-52. 109. a cause of action may be available under common law, however. see infra part iii.a. 110. erisa ' 404(c), 29 u.s.c. ' 1104(c) (1999). this section provides: (c)(1) in the case of a pension plan which provides for individual accounts and permits a participant or beneficiary to exercise control over assets in his account, if a participant or beneficiary exercises control over the assets in 634 florida tax review [vol. 4:9 if the plan complies with the rules and regulations of section 404(c), asafe harbor@ plans.111 these rules require the employer to give a broad range of investment options, and reasonable instructions regarding the significance of the options.112 unlike traditional participant directed plans in which plan fiduciaries retain some obligation to make sure that the plan assets are protected against losses, section 404(c)safe harbor plans essentially shield the employer and his account (as determined under regulations of the secretary) (a) such participant or beneficiary shall not be deemed to be a fiduciary by reason of such exercise, and (b) no person who is otherwise a fiduciary shall be liable under this part for any loss, or by reason of any breach, which results from such participant's or beneficiary=s exercise of control. id. section 404(c) of erisa is elective and applies only to defined contribution plans, such as 401(k) plans, where participants control the investment of their assets. id. 111. 29 c.f.r. ' 2550.404c-1 (2000). the ' 404(c) regulations were issued in october of 1992. 57 fed. reg. 46932 (1992). the regulations define an erisa ' 404(c) plan as, generally, a defined contribution plan that provides participants with the opportunity to aexercise control over assets@ in their accounts and provides the participant with aan opportunity to choose from a broad range of investment alternatives.@ 29 c.f.r. ' 2550.404c-1(b)(1)(i), (ii) (2000). see also canan, supra note 30, at '16.3, at 788-89. however, ' 404(c) relief is not available in transactions where a plan fiduciary has exercised improper influence or concealment of material nonpublic facts known by the fiduciary, or takes instructions from a participant that is known by the fiduciary to be legally incompetent. 29 c.f.r. ' 2550.404c-1(c)(2) (2000). 112. see canan supra note 30, at ' 16.3, at 791-93. a broad range of investment alternatives means: (i) a plan offers a broad range of investment alternatives only if the available investment alternatives are sufficient to provide the participant or beneficiary with a reasonable opportunity to: (a) materially affect the potential return on amounts in his individual account with respect to which he is permitted to exercise control and the degree of risk to which such amounts are subject; (b) choose from at least three investment alternatives: (1) each of which is diversified; (2) each of which has materially different risk and return characteristics; (3) which in the aggregate enables the participant or beneficiary by choosing among them to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant or beneficiary; and (4) each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant=s or beneficiary's portfolio; (c) diversify the investment of that portion of his individual account with respect to which he is permitted to exercise control so as to minimize the risk of large losses. . . . 29 c.f.r. ' 2550.404c-1(b)(3) (2000). 2000] rethinking the risk of defined contribution plans 635 other plan fiduciaries from any liability.113 regardless of how plan participants allocate their assets in such plans, plan fiduciaries are not liable for any losses that result from poor investment returns.114 these plans, therefore, place the entire risk of accumulating insufficient assets from poor investment decisions on the participants.115 as is the case in traditional participant directed plans, the employer who sponsors a section 404(c) safe harbor plan has no obligation to assist participants in making their investment decisions. furthermore, as discussed above, the employer is discouraged from doing so because such assistance could trigger fiduciary liability in plans that are otherwise in compliance with section 404(c).116 therefore, participants in safe harbor plans have little or no recourse against employers, administrators, or service providers for investment losses.117 they are barred from claiming that the employer either should have recognized a problem, or provided different investment options.118 in traditional participant directed plans, these allegations might be successful on the grounds that a failure to diversify the participant's account violates erisa=s prudence and diversification rule.119 d. pension policy and participant directed plans 113. see investments: pension plan participants need education on investments, group told, 21 pens. & ben. rep. (bna) 775 (apr. 18, 1994). however, ' 404(c)compliance does not shield the employer from all fiduciary liability. plan fiduciaries are still accountable for making certain that the investment options offered are sound and the investment managers selected are competent. see 29 c.f.r. ' 2550, 404c-1(a)(2) (2000). see also rowland, supra note 102, at 87-88; keville, supra note 4, at 549. 114. see frederick c. kneip, section 404(c): basic principles, 397 pli/tax 43, 46-48 (may 1997). 115. see canan, supra note 30, at ' 16.3, at 793; see also greenwald, supra note 96, at wl p. 2-3; 29 c.f.r. ' 2550.404c-1(b)(1), (2) (2000). 116. see also supra part ii.c.2; keville, supra note 4, at 551-52. 117. see erisa ' 404(c)(2), 29 u.s.c. ' 1104(c)(1)(b) (1999) (providing that a fiduciary is not liable for a loss resulting from the exercise of control by a participant or beneficiary); 29 c.f.r. ' 2550.404c-1(d)(2)(i) (2000) (providing that when independent control over the assets is exercised by a participant or beneficiary, the fiduciary is not responsible for any loss that is the direct and necessary result). however, there remains some liability for the employer. see kneip, supra note 114, at 69-70. 118. see hoecker & campbell, supra note 101, at 213; but see 29 c.f.r. ' 2550.404c-1(d)(2)(ii)(a)-(e) (2000) (providing that ' 404(c)=s limit on fiduciary liability will not be available if, for example, the participant's decision would violate provisions in the plan documents). 119. see weiss & sgaraglino, supra note 56, at 1213; patricia wick hatamyar, see no evil? the role of the directed trustee under erisa, 64 tenn l. rev. 1, 18-19 (1996); see also supra part ii.a. 636 florida tax review [vol. 4:9 employers prefer participant directed plans because they are more convenient and less costly to maintain than other plans, and some employers establish these plans in efforts to minimize their liability for investment decisions.120 employees typically prefer participant-directed plans because they believe that the plan=s flexibility can provide greater long term rewards, if they make wise investment decisions.121 however, it is not uncommon for plan participants to have inflated opinions about their investment expertise.122 thus, rather than increasing their retirement income security, participant directed plans, in reality, may decrease the retirement income security of those who are inexperienced in financial investment. this is particularly true as the emergence of new products and services makes investment decision making more difficult. for example, some plans allow participants to execute trades on a daily, rather than monthly basis.123 other plans provide broad ranges of options that include the entire universe of publicly traded stock.124 expansive measures such as these are increasingly offered, although the complexity of the limited investment options previously available to plan participants was well beyond the understanding of the average investor.125 the popularity of participant directed plans does not necessarily stem from the fact that they are the best way to maximize retirement income security, however. rather their popularity stems from the fact that they are what both employers and employees seemingly prefer.126 despite their overwhelming popularity, participant directed plans present a very difficult trade-off.127 employees are given greater flexibility and autonomy in making investment decisions, but they are also exposed to greater risks of investment losses. moreover, as employers increasingly establish participant directed 120. see supra part i.b. 121. see star, supra note 84, at 19. 122. two thirds of participants surveyed in a study conducted by buck consultants of new york and phoenix hecht of the research triangle in north carolina, preferred to manage their own assets. see star, supra note 84, at 19; jan m. rosen, self-directed retirement plans, n.y. times, dec. 1, 1990, at a1. 123. see brian e. schaefer, the trouble with daily switching for 401(k)s, pens. & inv., march 6, 1995, at 12; see also star, supra note 84, at 19. when plans allow fund switches on a daily basis, it may cause participants to play the market, producing inferior results in the long run. 124. see schaefer, supra note 123, at 12. 125. see star, supra note 84, at 19 (explaining that those who are significantly affected by the complexity are those under age 30, over age 55, and the poor). 126. see supra part i.b. 127. the combination of imprudent investment allocation and the elimination of the employer responsibility for the participant=s investment decisions is likely to result in benefits which fall short of the expected retirement income replacement goal for some participants. see donald faller, give 401(k) participants customized assistance, nat=l.underwriter life & health fin. serv. ed. 22 (may 15, 1995). see also supra part ii.c.1. 2000] rethinking the risk of defined contribution plans 637 plans, undoubtedly more of them will turn to safe harbor plans that provide even less protection for plan participants, in order to avoid unwanted exposure to fiduciary liability.128 notwithstanding the shortcomings of participant directed plans, it would nevertheless be difficult, and perhaps counter productive, to eliminate them as retirement savings options, because of their tremendous appeal to employees and employers alike. in the absence of participant directed plans, some employers may choose not to establish plans, and some employees may choose not to participate. even so, the self-help approach adopted by participant directed plans is inconsistent with erisa=s goal of increasing the retirement income security of plan participants. to provide the level of retirement income security envisioned by erisa as originally drafted, there should be some residual fiduciary responsibility imposed on employers who sponsor participant directed plans. an education and notification requirement should also be imposed on sponsors of such plans. these changes would ensure that plan participants are qualified to make prudent investment decisions with regard to their retirement savings, and can appreciate the significance of the risk of shortages when they do not.129 e. residual liability and a notification and education requirement the private retirement system is employment based.130 therefore, it is only through employment relationships that such benefits are made available. one of the rationales for the employment based characteristic of the private pension program is that there are comparative advantages from saving in employer sponsored plans as opposed to personal savings arrangements.131 first, saving for retirement requires financial investment expertise. because it is more likely that the employer is in a better position to retain financial experts than the employees, participants typically receive greater returns inside a plan than outside.132 second, an employer who invests large amounts can benefit from economies of scale. as a result, investment returns should be 128. the greenwich associates studies indicate that 29% of companies with defined contribution plans are planning to comply with the safe harbor rules of ' 404(c) in the near future. see supra part ii.c.3. the department of labor regulations on participant investments under ' 404(c) of erisa were issued in october 1992 and took effect january 1, 1994. see most firms comply with section 404(c) rules, 21 pens. & ben. rep. (bna) 1100 (june 6, 1994). 129. see supra part ii.c.2. 130. see langbein & wolk, supra note 5, at 32. 131. see munnell, supra note 11 at 54; see also langbein & wolk, supra note 5, at 32. 132. see langbein & wolk, supra note 5, at 32. 638 florida tax review [vol. 4:9 higher, and administrative costs should be lower, inside an employer sponsored plan.133 another characteristic of the private pension system is that it is voluntary. employers are encouraged to establish qualified plans with substantial tax benefits.134 the basic tax advantage is tax deferral. amounts contributed to qualified plans by employers are not taxed to the employee when they are made. also the earnings on the contributions accumulate tax-free, and the employee is not taxed on the amounts in the plan until they are distributed.135 in connection with the favorable tax treatment of pension plans, the treasury forgoes large amounts of tax revenue each year.136 because the preferential tax treatment of retirement benefits reduces the employee=s current taxable income, it is possible for the employer to deliver a dollar of retirement income at a lower cost than it could deliver a dollar of current wages to its employees.137 accordingly, an employer is able 133. see langbein & wolk, supra note 5, at 32-33. although not discussed in this article, wider participation is another reason the private pension system is employer based. in other words, another rationale for the tax favorable treatment of qualified plans is that retirement benefits for rank and file employees will exist only if congress provides tax incentives that will induce higher paid employees to support the establishment of employer sponsored retirement savings plans. id. at 200-03 (citing bruce wolk, discrimination rules for qualified retirement plans: good intentions confront economic reality, 70 va. l. rev. 419, 426-33) (1984). 134. aqualified plans provide the most tax effective way of delivering retirement income, because (i) the employer receives a current tax deduction for contributions to a trust, (ii) the trust pays no tax on its investment income, and (iii) the employee pays no tax until he receives a distribution from the trust.@ max j. schwartz & lora s. collins, securing the promise to pay: funding of non-qualified deferred compensation, 328 pli/tax 275, 279 (july-august, 1992); see also frank p. vanderploeg, role-playing under erisa: the company as aemployer@ and afiduciary,@ 9 depaul bus. l.j. 259, 272 n.43 (1997). 135. see langbein & wolk, supra note 5, at 156. 136. the cost to the treasury is in the form of forgone revenue. the annual cost of the private retirement program is an estimated $64 billion. see ebri databook, supra note 19, at 19-23, tbl. 2-5. the tax expenditure estimates for pensions are calculated on a cash flow basis. this method of calculation has the effect of placing no value on the pension promise itself, only on the advanced funding of the promise. see ebri, pension tax expenditures: art they worth the cost?, feb. 1993, #134. 137. see irc ' 402(a)(1). an employee may be willing to accept a lesser-valued plan contribution in exchange for current compensation, e.g., a $4,500 plan contribution in place of $5,000 in current compensation, because the $4,500 is tax free. see mary oppenheimer, from meldrum to indopco: should qualified plan professional fees be capitalized?, 40 wayne l. rev. 109, 131-132 (1993) (citing bruce wolk, discrimination rules for qualified retirement plans: good intentions confront economic reality, 70 va. l. rev. 419, 432 (1984)); langbein & wolk, supra note 5, at 149 (discussing the tax treatment of qualified plans). a related but different issue is the extent to which current wages are reduced in connection with expected retirement benefits, i.e., higher pensions lead to lower wages. while no one would deny that the retirement income contribution is a part of an employee=s wage package, the extent to which workers wages are effected by their expected retirement incomes is difficult to determine. see munnell, supra note 11, at 2. one view says the plan participants give 2000] rethinking the risk of defined contribution plans 639 to reduce current compensation by more than the actual amount of contributions made to the plan. arguably, the economic benefits enjoyed by employers are justifiable only if participants are in fact better off being covered by an employer sponsored arrangement than they otherwise would be. although sponsors of participant directed and employer directed plans enjoy equal tax benefits, participants of the plans are not accorded the same nontax advantages. in participant directed plans, participants, not the employer, make the investment decisions. thus, the participants do not benefit from the employer=s investment programs, or financial guidance. furthermore, any advantages derived from economies of scale are diminished, if the participants fail to make prudent investment decisions. therefore, another reason to impose residual liability on sponsors of participant directed plans is to justify the economic benefits they receive, as well as to justify the overall cost of the retirement savings program.138 the education requirement should also mandate a variety of educational mediums. there is substantial evidence showing that printed communication generally is ineffective in aiding the investment education of plan participants because employees either do not understand written materials, or disregard them.139 thus, the requirement should specifically include a complement of written materials, seminars, and financial planning software on retirement asset management. additionally, the education provided should be responsive to the investment needs of different groups of participants. for example, there should be age specific information.140 up wages equal to the value of the benefits that they accrue each year. see edward thomas veal & edward r. mackiewicz, pension plan terminations 204 (1989). another view is that of the aimplicit contract@ hypothesis. this view says that an employee=s wages are reduced equal to the level payment needed to fund the pension that is expected to be received if the plan continues indefinitely and the participant has a normal working life time with the employer. for example, if an employee expects to be employed for 30 years, and the anticipated normal retirement benefit under the plan is $300 per month, and the first year=s amortization of this benefit would be approximately $270. thus, the participant=s current wages would be reduced by that amount to fund the expected retirement benefit. id. at 204. 138. see glenn e. coven, corporate tax policy for the twenty-first century: integration and redeeming social value, 50 wash. & lee l. rev. 495, 512 (1993); see also jefferson, supra note 93, at 253 (stating that all taxpayers pay the subsidy by paying ahigher tax rates on the portions of their [retirement] incomes that do not enjoy special tax treatment@). 139. see generally ed peratta, 401(k) communication that works, pens. mgmt., dec. 1995, at 32; ebri releases report on participant education for improved retirement savings, 95 tax notes today 86-51 (may 3, 1995). 140. investment horizons will vary with age and will therefore affect investing strategies. because of this, employer-provided information will need to address different issues with various groups. see laurence b. wohl, fiduciary duties under erisa: a tale of multiple loyalties, 20 u. dayton l. rev.43, 92 (1994); keville, supra note 4, at 544. 640 florida tax review [vol. 4:9 finally, an education requirement should address the timing and frequency of retirement planning information. presently, some employers offer one-time retirement planning sessions to older employees who are approaching retirement, but do not provide similar sessions for younger workers.141 however, because the assets of younger workers are invested over longer periods of time, they are more likely to suffer from imprudent investment strategies than older employees.142 therefore, it would be important for the education requirement to require financial training for all workers throughout their working lives. the education requirement would not only enable participants to make better investment decisions, but also would eliminate the catch twenty-two that employers currently face regarding investment advice and investment information.143 the content, frequency, and medium of all communication regarding investment would be regulated. all participants would receive the same education. it would therefore no longer be necessary to use a cumbersome facts and circumstances analysis to classify communications between employers and employees as either advice or information. more importantly, however, plan participants would be better able to make prudent investment decisions and appreciate the future value of their expected retirement income in order to determine whether it is necessary for them to supplement their expected retirement benefits with increased personal savings.144 f. enforcement of a notification and education requirement under a properly implemented notification and education requirement, when an employer failed to comply, fiduciary liability for the resulting losses would be reinstated. although determining the actual loss in a defined contribution plan is not a straightforward calculation, the loss could be determined using any one of several approaches. for example, the actual loss could be determined by the excess of either the average rate of return for treasury bills, or the average rate of return for a specified portfolio mix, over the actual rate of return earned by the account.145 after determining the loss, an excise tax should be imposed on the employer. the excise tax could be a flat rate excise tax designed to recoup an 141. see keville, supra note 4, at 544. 142. id. poor returns compounded over the working life of a young employee result in greater gaps between expected and actual benefits than poor returns compounded only briefly as for older employees. id.; cf. fitzpatrick, supra note 9, at 79. 143. see supra notes 101-102 and accompanying text. 144. see dallas salisbury, erisa=s success and the vista for the future, pens. & inv., aug. 22, 1994, at 14. 145. see discussion infra part iii.e.1. 2000] rethinking the risk of defined contribution plans 641 account holder=s lost investment build-up. alternatively, like the section 4971 tax for underfunding, the flat rate excise tax could be imposed at a rate high enough to both recoup asset losses, and discourage noncompliance. another option is for the excise tax to be calculated on a case-by-case basis, using particular facts and circumstances to measure the loss, exactly.146 regardless of how the tax is determined or structured, however, under no circumstances should employers who completely insulate themselves from liability for imprudent investment decisions enjoy the same level of tax benefits as sponsors who retain liability when such losses occur. iii. insurance protection against market fluctuations a. the gap in insurance protection the goal of erisa was not only to protect participants from fiduciary misconduct and asset mismanagement, but also to protect plan participants from pension default.147 thus, in addition to establishing higher fiduciary standards for managers of employee benefits, as part of erisa congress also established a federal insurance program administered by the pbgc to protect participants from benefit loss due to plan failure.148 under the pension insurance program the pbgc provides substantial protection of defined benefit plan accruals, but not of defined contribution plans.149 section 3(34) of erisa specifically provides that pbgc protection is not available to individual account plans.150 this section defines individual account plans as plans in which the level of benefit for each employee fluctuates depending on the experience of the account. because the retirement benefit in defined contribution plans is dependent upon actual contributions made to an account and the investment performance of each separate account, all defined contribution plans are excluded from erisa=s insurance program.151 when erisa was established in 1974, congress could not have anticipated the recent shift from defined benefit plans to defined contribution plans.152 thus, the failure to provide insurance protection for defined 146. see jefferson, supra note 26, at 36. 147. see langbein & wolk, supra note 5, at 92-93. 148. see mcgill & grubbs, supra note 54, at 55. 149. see edward r. mackiewicz, pension plan terminations: procedures and liabilities, 444 pli/comm 51, 58 (1988); see also keville, supra note 4, at 553. 150. see 29 u.s.c. ' 1002(34) (1995) (defining a defined contribution plan as a plan providing an individual account for each participant). 151. erisa, 29 u.s.c. ' 1321(b). 152. see supra part i.a. 642 florida tax review [vol. 4:9 contribution plans may have been appropriate when the number of defined contribution plans was not expected to rise. however, because thousands of plan participants now rely upon defined contribution plans as their primary retirement savings vehicles, the financial security of many future retirees will depend on how successful defined contribution plans are in accumulating, and delivering their expected retirement benefits. therefore, notwithstanding the historical explanation for the absence of insurance protection for defined contribution plans, the gap in insurance protection is no longer appropriate or justifiable. insuring a minimum investment return in retirement savings plans is not only a feasible idea, but what actually occurs under the existing defined benefit plan insurance program in certain circumstances. b. reasons for shortfalls two of the most prevalent reasons for shortfalls in defined benefit plans are the failure of employers to contribute sufficient amounts for past service costs, and unfavorable investment returns.153 the funding of ongoing defined benefit plans is determined by the use of actuarial cost methods. actuarial cost methods estimate plan costs and assign the costs to appropriate years.154 the present value of pension benefits and liabilities depends on the actuarial assumptions selected for interest, early retirement, turnover, and salary increases.155 the funding rules require a plan sponsor to contribute annually an amount equal to the current plan year cost. this amount is referred to as the anormal cost@ of the plan.156 the normal cost allocates future plan costs over the life of the plan and can vary significantly depending on the actuarial assumptions and the funding method used by the plan. in addition to the plan's normal cost, the employer=s annual contribution must cover amounts attributable to supplemental costs. unlike 153. see canan, supra note 30, at 605, 609. 154. cost are assigned to appropriate years to prevent the employer=s deduction from being too large, as well as to create a systematic funding schedule. see jefferson, supra note 26, at 5; mcgill & grubbs, supra note 54, at 375; see irc ' 412. any of several actuarial cost methods may be selected if the actuary certifies that the method and assumptions are reasonable in the aggregate. mcgill & grubbs, supra note 54, at 393-94. erisa lists six acceptable actuarial cost methods, but it is possible that additional methods may be designated as acceptable by the internal revenue service. id. any change in the method used may be made only with the prior approval of the internal revenue service. id. 155. see jefferson, supra note 26, at 11 (citing langbein & wolk, supra note 5, at 228). 156. the normal cost will vary depending on the funding method selected. see jefferson, supra note 26, at 5. if a plan=s cost is determined on the basis of accrued benefits, the normal cost is the actuarial present value of the benefits accrued in a given year. id. if the cost is based on projected benefits, the normal cost is generally the level percentage of pay necessary per year to fund the projected benefits for all years of service. id. 2000] rethinking the risk of defined contribution plans 643 the normal cost, the supplemental costs may not be funded at once, but rather must be amortized over specified periods of time.157 supplemental costs include amounts derived from plan amendments, experience losses,158 inaccurate actuarial assumptions, and past service credits.159 liabilities for past service credits are the most common supplemental cost.160 past service liability occurs when an employer gives credit for service prior to the date on which the plan was established.161 thus, prospectively viewed the past service liability, also known as the accrued liability, is the amount that, together with future plan costs, is expected to cover all benefit costs incurred under the plan.162 the excess of the accrued liability over a plan=s assets is the aunfunded past service liability.@163 when plans terminate before there is time to make sufficient contributions to cover the past service liability, there will be insufficient funding, unless errors in the accompanying actuarial assumptions are offsetting.164 regardless of how carefully the actuarial assumptions are selected, advanced funding methods produce only cost estimates, not actual costs.165 thus, typically a plan will either have a funding surplus or a funding deficiency, since any deviation in the assumptions when compared with actual plan experience will produce a shortfall, or a windfall.166 157. see discussion infra part iv.c. 158. experience losses occur when actual plan costs exceed the actuarial estimates for a given plan year. for example, if the actuary assumes that the plan investments will earn 8% and the investment earned only 5%, the plan will have a deficiency, or an actuarial loss. see generally canan, supra note 30, at ' 12.3, at 607-11; langbein & wolk, supra note 5, at 285. 159. supplemental costs also include waived funding deficiencies, which occur when the secretary of the treasury, acting through the internal revenue service, waives part or all of a plan=s annual contribution upon a showing of substantial financial hardship such that making the plan contribution would adversely affect plan participants. see irc ' 412(d); see also langbein & wolk, supra note 5, at 290-91. 160. past service liability can arise in two ways: (1) it may accrue for service rendered before the plan was adopted, or (2) it may apply to service rendered by an employee after adoption of the plan but prior to a plan amendment which provides increased coverage for such service. see canan, supra note 30, at 593. 161. athe past service liability is also referred to as the >accrued liability.= despite its name, the accrued liability of a plan is not an accounting or legal liability.@ jefferson, supra note 26, at 5 n.21. 162. id., at 5. 163. irc ' 412(b)(2)(b). 164. if, for example, there were substantially higher turnovers among nonvested participants, there may be sufficient forfeitures to offset an incorrect interest rate assumption. see halperin, supra note 7, at 772-73. 165. see jefferson, supra note 26, at 11. 166. id., at 12. 644 florida tax review [vol. 4:9 when a defined benefit plan terminates with insufficient assets, the pbgc pays the plan=s vested accrued benefits at the time of termination.167 accordingly, the pbgc insures plan participants against shortfalls that arise from the differences in the estimated funding cost and the actual cost of a defined benefit plan.168 regardless of which actuarial assumption is inaccurate, all deficiencies are treated the same. if a plan experienced losses due to an erroneous turnover assumption and ultimately terminated, the pbgc would be liable for the unfunded vested accrued benefits. similarly, if the deficiency were attributable to an erroneous interest rate assumption, the pbgc would also be liable.169 in reality, the latter situation is more likely to occur.170 because the interest rate assumption typically reflects the long-term nature of the pension obligations, a change in the interest rate assumption affects the valuation results more than a change in any other actuarial assumption.171 although the impact of an inaccurate interest rate assumption depends upon the number of years involved, the age distribution of plan participants, and the weighting of plan liabilities,172 the rule of thumb to which actuaries generally adhere is that a 2% change in the interest rate results in a change in liabilities of 167. after five years of participation, the pbgc guarantees the participant=s vested accrued benefits. in order to fund the cost of the benefits, the pbgc uses the assets held by the underfunded plan and then makes up the shortfall with its own funds. daniel keating, pension insurance, bankruptcy and moral hazard, 1991 wis. l. rev. 65, 70 (1991). 168. the use of different funding methods could impact whether a plan has an actual funding deficiency or not. see jefferson, supra note 26, at 31-32; see generally norman p. stein, reversions from pension plans: history, policies, and prospects, 44 tax l. rev. 259, 265-67 (1989). 169. provided the assumptions are reasonable. 170. see jefferson, supra note 26, at 54. 171. id., at 54. a long term interest rate assumption is very difficult to project with certainty. the impact of the valuation interest rate on pension costs estimates depends upon the number of years involved in the interest discount, therefore, different parts of the evaluation are affected differently by a change in the valuation interest rate assumption. however, there is a rule of thumb to estimate the effect on liabilities of a change in the interests assumption. see id., at 34 n.181 (citing stuart g. schoenly, pension topics 10-11 (1991) (society of actuaries no. 460-24-91)). 172. the following comparisons illustrate the relationship between age and liability: age 7% factor as 8% factor as a % of 6% factor a % of 7% factor 25 deferred life annuity commencing at age 65 64.2% 64.7% 45 deferred life annuity commencing at age 65 77.5% 77.9% 65 life annuity 93.5% 93.8% schoenly, supra note 171, at 19. 2000] rethinking the risk of defined contribution plans 645 approximately 6% in a valuation period.173 thus, accuracy of the interest rate assumption is especially critical in preventing shortfalls. assuming all other assumptions are correct, when a plan experiences losses due to erroneous interest rate assumptions, a funding deficiency would result.174 in such cases, if the plan terminated, and the employer were unable to make an additional contribution, the pbgc would pay the unfunded vested accrued benefits.175 when the pbgc pays any portion of the retirement benefits in plans in which all actuarial assumptions other than the interest rate assumption are correct, the pbgc effectively insures a minimum investment return. therefore, participants in defined benefit plans are insured against poor investment performance. the pbgc=s guarantee of a minimum investment return in defined benefit plans can be demonstrated best by a numerical illustration. consider a defined benefit plan that assumes an 8% investment yield, uses an accurate mortality assumption and salary scale projection,176 has made no past service award, and uses an accrual formula of 2% times average compensation times years of service. assume employee x is age 50, 100% vested, was hired at age 45, and received $50,000 of compensation for each of the last five years. employee x, therefore, currently has an accrued benefit of $5,000 per year.177 further assume that over the last five years, the plan has experienced losses attributable to an actual 7% investment return, as compared to the 8% return assumed by the plan. all other assumptions are accurate. using the 2% to 6% rule of thumb, there would be a shortfall of approximately 12%. if the employer terminated the pension plan at this point, the shortfall in employee x=s retirement benefit would be provided by the pbgc.178 in other words, the pbgc would guarantee a retirement benefit based upon an expected investment return of 8%. interestingly, in a defined contribution plan there would be no insurance protection if the account balances of plan participants were less than expected as a result of unfavorable market conditions. opponents of federal insurance for defined contribution plans argue that losses in defined contribution plans resulting from market fluctuations are too difficult to measure.179 others argue that even if such losses are measurable, it is inappropriate for the federal government to insure them because title iv of erisa was established only to guarantee pension benefit 173. id. at 18. 174. this is true, unless there are offsetting errors in connection with the other accompanying assumptions. 175. see supra note 41 and accompanying text. 176. see jefferson, supra note 26, at 11. 177. 2% x $50,000 x 5 years = $5,000 178. see supra part i.a. 179. see keville, supra note 4, at 554. 646 florida tax review [vol. 4:9 promises, not minimum investment returns.180 as illustrated above, however, although it appears that the existing insurance program for underfunded terminated defined benefit plans insures something other than a minimum investment returns on the plan assets, this is exactly what occurs in certain instances. in fact, one of the most significant risks against which a terminated defined benefit plan is protected is market fluctuation.181 therefore, objections to insuring investment returns in defined contribution plans on the grounds that it is inconsistent with the underlying policy of erisa=s title iv insurance are invalid. furthermore, resistance to defined contribution insurance because the insurable risks in defined benefit and defined contribution plans are different is also unfounded. c. insurance protection outside of erisa although there is no pbgc protection for defined contribution plans under erisa, participants investing in certain relatively safe low-risk, low-yield instruments are nevertheless eligible for other insurance protection against market down-turn.182 stable-value investment contracts marketed by the banking industry are insured by the federal deposit insurance corporation (fdic). similar instruments marketed by insurance companies are covered by state-regulated insurance.183 thus, defined contribution plan participants investing in relatively safe, low-yield investments are covered by some type of governmental insurance.184 1. guaranteed investment contracts.chistorically, insurance companies and banking institutions only provided investment management services. in more recent years, however, both industries have expanded their roles to include offering stable-value investment contracts, in addition to providing managerial expertise.185 the guaranteed investment contract 180. see keville, supra note 4, at 554 (stating that defined contribution plan insurance might encourage aspeculative investing by employees who are not risk averse, and could result in multiple payouts if employees repeatedly lost principle@). 181. see sean s. hogle, the employee as investor: the case for universal application of the federal securities laws to employee stock ownership plans, 34 wm. & mary l. rev. 189, 240 n.96 (1992). 182. see discussion supra part iii.a, infra part iii.f, g. 183. see fdic, facts about bank investments (last modified jul. 27, 1999) <http://www.fdic.gov/deposit/investments/facts/index.html>. 184. as a result, some defined benefit plan participants have two levels of insurance protection. 185. pension assets are generally managed by a plan trustee. a trustee can be either an employee of the plan sponsor, a bank, a trust company, or an insurance company. when the assets are trusteed by an employee, bank, or trust company, the employer makes annual contributions directly to the plan. when the funds are trusteed by an insurance company, the employer pays the insurance company annual premiums in exchange for the insurance 2000] rethinking the risk of defined contribution plans 647 (gic) is the stable value instrument offered by insurance companies.186 they have flourished since their inception in the early 1970=s.187 the success of gics is attributed to the perception that they are extremely safe investments.188 while the term aguarantee@ may imply that the insurer provides afail safe@ protection for the return of the principal, the guarantee actually only applies to the interest rate and expense schedule.189 thus, the safety of the entire instrument depends on the solvency and credit worthiness of the issuing insurance company.190 although interest rates paid to gics have declined from their peak in the late 1980=s, gics nevertheless have remained very popular.191 gics are regulated under state insurance laws which vary from jurisdiction to jurisdiction. therefore, the level of protection and payment criteria vary.192 company=s promise to pay future plan benefits as they become due. see employee benefit research institute issue briefs 15 (june 1994). see also part ii.c. 186. the term gic is most often defined as a guaranteed investment contract; however, gic sometimes is referred to as a guaranteed income contract, guaranteed interest contract, or guaranteed insurance contract. all of these terms convey the same meaning which is a afail safe guarantee of principal and a predetermined rate of interest to be credited over the investment=s life.@ kenneth l. walker, what is a gic?, in guaranteed investment contracts: risk analysis and portfolio strategies 21 (kenneth l. walker ed., 1992). 187. william h. smith, a plan sponsor=s perspective, in guaranteed investment contracts: risk analysis and portfolio strategies 1 (kenneth l. walker ed., 1992). today=s gics have an outstanding balance of approximately $200 billion and are issued at the rate of approximately $40 billion annually. id. 188. keville, supra note 4, at 543-44. additionally, the nonvolativity of gics enable the employer to avoid having to report negative returns in the annual financial statements given to plan participants. defined benefit plans generally have not purchased investment contracts because of their low yield. 189. walker, supra note 186, at 22. 190. gic owners are considered the policyholder of the insurer. in most jurisdictions, the policyholder enjoys a senior lien over the general creditors of the insurer. thus, in the event of bankruptcy, the policy holder would generally rank ahead of the general creditors of the insurance company. walker, supra note 186, at 22. see also smith, supra note 187, at 1. 191. see frederick c. kneip, synthetic bics and gics, 381 pli/tax 273, 275 (1996). approximately 70% of all 401(k) assets are committed to gics or other similar stable valued options. see generally walker, supra note 186, at 32. 192. many amounts deposited by plans with an insurer are allocated to a separate account. these separate accounts are generally deemed by state insurance laws to be the property of the insurer. robert e. rice, synthetic bics & gics, 339 pli/pat 321, 330-31 (1993). consequently, if the insurer initiates insolvency or rehabilitation proceedings, the plan=s account may be frozen indefinitely, which could affect benefit liquidity or the interest rate earned on the gic. id. it has been suggested that to avoid this, physical custody of the assets could be placed in a third party. this would allow the plan uninterrupted access, and would also make the insurer a fiduciary of the plan. id. in addition, annuitants may have a claim in the state liquidation proceedings. james epstein, protecting pension annuities when insurance companies fail: the erisa fiduciary standards, 44 fla. l. rev.107, 110 (1992); see also 648 florida tax review [vol. 4:9 for example, under certain state insurance laws, gics are protected against insolvency by life insurance guaranty funds which typically limit the amount payable per claim.193 2. banking investment contracts.cthe bank investment contract (bic) is another type of stable-value instrument.194 bics are offered by banks rather than by insurance companies.195 bics are insured by the fdic, up to $100,000, per deposit, per account.196 peter a. fine, what to do if your insurer is insolvent, 439 pli/comm 139 (1987). also, insurance industry practice has been to protect annuitants hurt by the collapse of an annuities company through the state insurance regulations. retirees at risk: the executive life bankruptcy: hearing before the subcomm. on labor of the sen. comm. on labor and human resources, 102 cong. 23 (1991) (statement of david george ball, asst. secretary, pension and welfare benefits administration, u.s. dept. of labor). 193. however, any attempt to access a guaranty fund to satisfy gic claims against a large insolvent insurer would raise the following issue: most such funds are not apre-funded@; instead, an assessment is made by the fund against the remaining solvent insurance companies doing business in the state only after the need to honor claims has arisen. if the claims presented to the guaranty fund were very large, it might not be possible to make sufficient assessments without jeopardizing the financial health of the remaining insurance companies. rice, supra note 192, at 331. it is uncertain whether a gic purchased by a retirement plan would constitute a single claim, or whether the per-claim provisions would apass through,@ and apply to each beneficiary of the plan. whether the claim is viewed as a single claim or not determines the applicable level of insurance protection under state law. id. 194. the legal form of the bics differs from bank to bank. banks generally issue bics either in the form of time deposits or money market deposit accounts. the board of governors of the federal reserve, which regulates the banking industry, provides definitions for each form of deposit accounts in its regulations. david j. salvin, bank investment contracts, in guaranteed investment contracts: risk analysis and portfolio strategies 37 (kenneth l. walker ed., 1992). 195. although bics are similar to gics in many respects, the industry distinctions between banking and insurance account for differences such as credit-worthiness, plan language, government reporting, pricing, and most importantly, the availability of fdic insurance. walker, supra note 186, at 38. the relative success of bics stems from the desire for industry diversification. prior to the introduction of bics, a plan wishing to offer a stable value option was limited to gics and money market funds. sponsors were dependent upon the solvency of the insurance industry. id. at 38-39. bics allowed employers to spread their investments over two industries. however, simultaneously with the rise in bic popularity, many large banks saw their credit ratings drop, and experienced downgrades and negative press. the insurance industry, being the familiar option, did not experience similar consequences. id. at 39. 196. both the principal and the interest of a bic account are federally insured in domestic member banks. a domestic member bank is aa depository institution that is a member of the federal reserve.@ michael gordon hales, the language of banking 114 (1994). national banks are required to be members; state-chartered commercial banks and mutual savings banks may become members at their election. id. member banks are owners of stock in federal reserve banks and choose some of the reserve bank directors. id. 2000] rethinking the risk of defined contribution plans 649 until recently, when an employer sponsored a retirement plan invested in bics, a $100,000 cap applied to the plan as a whole. the cap did not pass through to individual participants. however, in 1991 congress passed the federal deposit insurance corporation improvement act of 1991 (fdicia), which established pass-through insurance for certain banks that brokered deposits to retirement plans.197 as a result, fdic insurance currently applies to individual plan participants as if they were individual depositors.198 3. retirement certificates of deposit (cds).cretirement certificates of deposit (cds) are a personal savings alternative available to taxpayers outside of the employer-sponsored regime.199 a retirement cd is an 197. under provisions set forth by the comprehensive deposit insurance reform and taxpayer protection act of 1991, deposits of trusts may not be insured on a pass-through basis a(a) if the trustee or an organizer of the trust solicits persons to transfer funds into the trust; (b) if interests in the trust are sold to beneficiaries; (c) if there are more than 10 settlors or grantors of the trust; or (d) in such other circumstances as the board of directors may prescribe.@ 137 cong. rec. s17910, s17923 (daily ed. nov. 23, 1991). additionally, banks must meet the requirements of irc '' 401(a) and 403(b)(9). pass-through fdic insurance protection generated considerable controversy. the american council of life insurance (acli) sought the repeal of pass-through insurance legislation. the acli was established in 1976 after a merger of several existing organizations. it currently represents 532 u.s. legal reserve life insurance companies, providing industry reports, consumer brochures on insurance, and unified lobbying efforts for life insurers at state and federal levels. see nina easton, financial industry lobbyists come from different perspectives, american banker, oct. 19, 1985, at 11; see also american council of life insurance, http://www.acli.com (as of march 1998). see investments: federal deposit insurance unnecessary due to existing protections, official says, 18 pens. rep. (bna) 781 (may 6, 1991) (maintaining that this result is dangerous as it tempts poorly capitalized banks to offer very high yields in order to attract deposits, thereby increasing the likelihood of bank failure). 198. in 1994, the federal deposit insurance corporation finalized regulations to incorporate the federal deposit insurance corporation improvement act of 1991 (fdicia) relating to deposits for employee benefit plans accepted on a apass-through@ basis. alson r. martin, recent developments affecting pcs and other closely held businesses, c884 a.l.i.-a.b.a. 1, 34 (feb. 10, 1994). the regulations explicitly provide that the $100,000 limitation applies to the aggregate interests of an employee=s deposits with the insured institution under all plans established by the same employer, or by the same employee organization. see id. at 35. for purposes of the $100,000 limitation, ira=s and participant directed individual account plans established by the individual investor are aggregated with employer sponsored amounts. see id. at 35. 199. a retirement cd is a special type of bic. it is therefore accurate to refer to retirement cds as bics. most bics are issued as fixed-rate instruments, typically issued as nonnegotiable, benefit responsive arrangements. they sometimes contain a window provision, and often have early-withdrawal provisions that allow withdrawals to be made before maturity for reasons other than benefit payments after the imposition of a market adjustment. when the benefit-responsiveness and window features are removed, what remains is a fixed-rate, nonnegotiable instrument that contains an early-withdrawal penalty. this instrument is known as a time deposit or nonnegotiable certificate of deposit, or a retirement cd. see mcgill & 650 florida tax review [vol. 4:9 insurance contract that is invested in cds. this arrangement offers tax deferral until retirement on the investment returns, and provides guaranteed interest rates for periods up to five years, on amounts payable as annuities.200 the retirement cd is a savings option which is particularly attractive to individuals close to retirement who are looking for safe places to store their personal savings.201 currently, rates for retirement cds are better than national cd averages; however, because funds cannot be transferred to other banks without paying taxes and penalties, it is expected that banks will establish rates below market levels during subsequent 5 year periods.202 presumably, heightened consumer interest in retirement cds is largely attributable to the fact that these savings arrangement are insured by the fdic up to $100,000, per account, per individual. d. defined contribution plan insurance fdic insurance encourages investment in bics and retirement cds over other noninsured forms of investment. however, an investment strategy that disproportionately selects low-risk, low-yield instruments such as bics, and retirement cds, contravenes the modern portfolio theory of investment which emphasizes diversification as a means of maximizing investment returns.203 therefore, the use of conservative investment strategy is not appropriate for long term investment goals, such as retirement savings. the fact that participants tend to under-diversify their investment portfolios by disproportionately investing in stable-value instruments suggests there is a need for congress to enact laws which encourage participants to invest their retirement savings more aggressively, rather than more conservatively.204 a properly designed federal insurance program for defined contribution plans could achieve this goal. a defined contribution insurance program which guaranteed an average rate of return over a participant=s working life would encourage participants to invest more aggressively because a portion of the risk of loss would shift from the participant to the grubbs, supra note 54, at 475-78. 200. these arrangements also rely on the favorable treatment of annuity contracts under irc ' 1275(a)(1)(b)(i). see stephen d. palmer, comment, what do you get when you cross a certificate of deposit with an annuity?: the retirement certificate of deposit struggles for survival, 45 emory l.j. 1429, 1432 (1996). 201. the high demand for retirement cds suggests that many savers are willing to forgo higher returns and immediate penalty-free access to their funds in exchange for federal insurance. see id. at 1459. 202. see duff mcdonald, retirement cds offer more than 7% plus headaches, money, may 1, 1995, at 57. 203. see supra part ii.c.1. 204. see supra part ii.c.2. 2000] rethinking the risk of defined contribution plans 651 insurer.205 this approach is consistent with erisa=s goal of increased retirement security, because a balanced investment portfolio increases retirement security by maximizing long-term returns.206 federal insurance for defined contribution plans also would eliminate the uncertainties and inconsistencies that result from the gap in insurance protection for defined contribution plans. under existing law, plan participants receive vastly different levels of insurance protection of their retirement benefits depending on the classification of their retirement plan, the type of investments selected, and the states in which they reside.207 federal insurance for defined contribution plans would eliminate these inequities by conferring upon all qualified plan participants some level of insurance protection. defined contribution plan insurance is a highly controversial concept. resistance to the idea includes both theoretical and practical concerns. there are, for example, concerns about identifying the goals and objectives of the program. there is also concern about defining an insurable accrued benefit in the context of individual account plans. furthermore, issues regarding the appropriate insurance levels and applicable limitations would have to be resolved before a defined contribution plan insurance scheme could be adopted. while all of these concerns are valid and should be addressed prior to the establishment of a defined contribution plan insurance program, they are 205. see discussion infra part iii.e.1. 206. the most conservative investments are not necessarily the most prudent ones since a>an investment can ordinarily be made which will yield a higher income and as to which there is no reason to anticipate a loss of principal.=@ weiss & sgaraglino, supra note 56, at 1185 n.23 (quoting restatement (second) of trusts ' 227(a)). 207. the executive life crisis of 1988 best illustrates the magnitude of the threat imposed by the gap in insurance. the executive life insurance company invested heavily in junk bonds. when the market crashed in the late 1980=s, executive life was unable to pay its contracts and ultimately filed bankruptcy. while all plan participants whose assets were invested in executive life were affected by the company=s collapse, the damages were more devastating for some participants than for others. employee-participants in defined benefit plans were accorded pbgc protection while those in defined contribution plans were not. because payments of defined contribution retirement benefits varied under state laws, some retirees received as much as 70% of their retirement benefits, while others received none. had investors selected bics instead of gics, the participants would have been insured up to $100,000 per account. from a pension policy perspective, it is difficult to justify this result. until the conservatorship of executive life, there had never been an instance when an insurance carrier had not been able to honor its investment contracts. therefore, the executive life crisis can be viewed as a milestone in pension history. policymakers should be aware of the level of devastation that defined contribution plans can experience when retirement funds disappear. moreover, the executive life crisis should serve as a reminder that as long as the gap in federal insurance protection exists for defined contribution plans, the promise of erisa will not be fulfilled for some plan participants. see gary m. ford, defined contribution plan gic litigation, annuities legislation, and pbgc legislation, c996 a.l.i.-a.b.a. 183, 187 (1995). 652 florida tax review [vol. 4:9 not unique to such a program. when the existing defined benefit plan insurance program was established, policymakers found it necessary to address many of the same issues, including the appropriate levels of benefits to insure, and the necessary limitations to impose.208 the pre-erisa committee placed limits on the maximum insurable amount in defined benefit plans because it believed it inappropriate to guarantee amounts in excess of a basic retirement benefit.209 the structure of these limits remains in effect today. thus, there are many lessons that can be learned from the existing defined benefit plan insurance program in connection with the implementation of a new insurance program for defined contribution plans. e. the hypothetical account proposalcan insurance model the defined contribution insurance model proposed in this section is a risk-based, voluntary program that uses a diversified hypothetical account to determine the level of insured benefit. this proposal provides insurance protection for defined contribution plans comparable in amount and objective to the insurance protection currently available for defined benefit plans. using this approach, participants of defined contribution plans would be insured against the risk of earning less than average investment returns, over their working lives. under the hypothetical account defined contribution plan insurance program, to the extent that a participant=s account complied with a prescribed diversification standard, she would receive a minimum benefit at retirement. the minimum retirement benefits would based on hypothetical annual rates of investment returns, and would be payable when the insured participant reached her social security retirement age.210 insured amounts would be payable in the form of a life annuity, rather than a lump sum, in order to spread the risk of payment over longer periods of time.211 208. see ford, supra note 207, at 186-87. 209. this figure has been amended since the establishment of erisa in 1974. initially, defined benefit plans were insured up to the vested accrued benefit, not to exceed $750 per month and not more than 50% of wages. the current insurable benefit in a defined benefit plan is the lesser of $30,000 per year, or 100% of compensation. 29 c.f.r. ' 4022.22; see supra note 12 and accompanying text. 210. athe social security retirement age is currently 65, but it will eventually increase to 66 for those born after 1938 and 67 for those born after 1954.@ langbein & wolk, supra note 5, at 268. distributions prior to a participant=s social security retirement age would be permitted in the event of death or disability. 211. in order to avoid a possibility of initial payments being made based on a number of years less than 5, under a defined contribution plan insurance program, only participants age 60 and below should be eligible to initially participate. this was a problem under the current pension insurance program. as a result, when it was first established the pbgc had to pay large sums that were attributed to years prior to the establishment of the insurance program. 2000] rethinking the risk of defined contribution plans 653 annual guaranteed rates of investment return would be determined by the performance of a hypothetical account assumed to be invested according to a prescribed diversification formula. for a given year, the guaranteed annual rate of return would be the average of the annual hypothetical investment returns for the five prior years. a five-year average is used instead of the performance of a single year to diffuse the impact of sudden market fluctuations, and further spread the risk of payment. the use of a five-year average to determine the annual guaranteed minimum rate of return would also protect participants against sudden downturns in the investment market.212 insurance protection would be determined by the extent to which an account complied with a prescribed allocation formula. in connection with the prescribed allocation formula, it would be necessary to develop an indexing system to evaluate all investment funds, so that the level of risk of a participant's investment allocation could be compared to the risk of the prescribed allocation.213 a ratings system similar to that supplied by the various rating services, such as standard and poors, could be utilized to facilitate the indexing process.214 alternatively, a totally independent rating system could be developed based on the historical investment performances, and long-term accumulation projections for retirement plan assets215. the hypothetical account proposal allows sponsoring employers and plan participants to insure some, or all, of an account balance, in exchange for the payment of an annual insurance premium. although the annual premium would be paid separately from the individual accounts, the payment of an annual premium would obviously impact a participant=s investment position, by decreasing the assets that remained available for her to contribute to the plan. even after taking the premium payment into account, however, in most circumstances insurance protection under this proposal should provide a return on aggregate employer contributions of an amount at least as great as the return on an account exclusively invested in low-risk, low-yield 212. however, if unfavorable market conditions existed over a sustained period of time, the guaranteed rate of return would eventually reflect such losses. 213. for this purpose the standard and poors rating system could be used, or alternatively, a new rating system could be developed. 214. aa standard & poor=s insurance claims-paying ability rating is an opinion of an operating insurance company=s financial capacity to meet the obligations of its insurance policies in accordance with their terms.@ claims paying ability ratings are divided into two broad classifications. rating categories from aaa to bbb are classified as asecure@ claims-paying ability ratings and are used to indicate insurers whose financial capacity to meet policyholder obligations is viewed on balance as sound. rating categories. allan g. richmond, quality-analyzing the life insurance industry, in guaranteed investment contracts: risk analysis & portfolio strategies 100 (kenneth l. walker ed., 1992). 215. the investment practices for pensions typically reflect longer term investments. 654 florida tax review [vol. 4:9 instruments, such as bics.216 thus, insurance protection under the hypothetical account insurance model should encourage risk averse individuals who are more likely to disproportionately invest in stable-value instruments, to invest more aggressively. unlike the existing mandatory insurance program for defined benefit plans, the hypothetical account insurance program would be voluntary. the voluntary characteristic of the proposal strikes a balance between individual choice and retirement income security. however, because of the voluntary characteristic of the program, it is unlikely that all defined contribution accounts would be covered. the hypothetical account insurance model hinges on a diversification formula, which defines an acceptable range of complementary allocations with respect to both investment categories, and risk classifications. the diversification formula would be designed to approximate an average rate of return for accounts invested in average risk investment instruments over a participant's working life.217 for example, the safe harbor diversification allocation could be selected consistently with the recommendations of financial planning experts218 who advise individuals to place 60% of their investment assets in the stock of companies with moderate volatility,219 25% in ainvestment-grade@ bonds,220 and 15% in stable-value instruments, for a moderate return. 216. if the insured rate is only slightly greater than the bic return insuring, the account balance generally would still be advantageous. however, it is plausible that the insured rate would be substantially higher than that of the bic because the safe harbor standard would require some portion of the account to be put in stocks and some portion to be put in bonds, which have rates that are generally higher than bic returns. these instruments are currently fdic insured. see discussion supra part iii.c. 217. the diversification formula would have to take into account the different recommendations for different age groups. therefore the prescribed diversification formula would account for the more aggressive investment strategies that are recommended at the front end of one=s working life as well as the more conservative strategy that is recommended at the back end of one=s working life. see weiss & sgaraglino, supra note 56, at 1206-08. 218. see strong funds, retirement planning: five model investment strategies (visited feb. 6, 2000) <http://www.strong-funds.com/strong/retirmenent98/ind/products/5pies.htm>. 219. beta is a measure of a stock=s risk in relation to the market. for example, if the market is up 10% over the last year, and a particular company=s stock price is also up 10% then the stock would have a beta of 1.0. the same principle applies when the market is down as when the market is up. <www.duke.edu/%7echarvey/classes/wpg/bfglosb.htm>. see campbell r. harvey, hypertextual finance glossary (visited feb. 6, 2000). 220. most corporate or municipal bonds are graded by standard & poor=s corporation, by moody=s investors service, inc., or both. the issuers must pay these agencies a fee to review and to rate their bonds. bonds are rated from the highest quality to the lowest on either the standard & poors scale aaa/aa/a/bbb/bb/b/ccc/cc/c/d, or the moody=s scale aaaa/aa/a/baa/ba/b/caa/ca/c/. any bond rated in the top four categories is considered an ainvestment grade@ bond. see 2000] rethinking the risk of defined contribution plans 655 the level of insurance protection and the cost of the insurance premium would depend on the degree to which the participant=s allocation complied with the diversification formula. using the established indexing system, a risk factor would be assigned to all allocations in order to compare their risk exposure to that of the prescribed diversification standard. in order for an account to be fully insurable at the regular premium rate, the participant=s account could not be exposed to an investment risk greater than that of the prescribed diversification formula. accounts having a risk factor greater than that of the prescribed diversification formula would not be in compliance with the diversification standard, and accordingly, not insurable at the regular premium rate. a very simple model of a diversification standard exists under current law for mutual funds. to qualify as adequately diversified, no more than five percent of a mutual fund=s assets may be invested in the securities of any one issuer.221 the hypothetical insurance model proposed in this section adopts a similar approach. in order for an account to be insurable at the regular premium rate, the hypothetical account proposal requires that the investment exposure of a participant=s portfolio be limited to the investment risk of the prescribed diversification standard. 1. calculation of the guaranteed benefit.cunder the hypothetical account proposal, an individual=s insurable principal would equal their annual employer contributions times the annual guaranteed rates of return, for each year of employment.222 each year=s guaranteed rate of investment return would be based on the annual performance of a hypothetical portfolio, assumed to be in compliance with the prescribed diversification formula. the annual performance of the hypothetical account would be determined by the weighted average of the annual investment returns for a hypothetical portfolio using the prescribed diversification formula. the annual guaranteed rate of return for a given year would equal the average of the annual rates of investment return for the hypothetical account, over the five prior years. an insured participant=s minimum retirement benefit would be determined by comparing her actual account balance at retirement age to the hypothetical account balance determined by the annual guaranteed rates of return for each year of employment, prior to retirement.223 if the participant's <http://www.strong-funds.com/strong/learningcenter98/concepts/glossary.htm#b>. 221. see weiss & sgaraglino, supra note 56, at 1208; citing former 15 u.s.c. ' 80a-5(b)(1) (1994). 222. the covered amount includes the elective contributions made by plan participants. 223. however, the minimum guaranteed amount applies only to the extent that the account had been invested according to the prescribed diversification standard. 656 florida tax review [vol. 4:9 actual account balance fell short of the hypothetical account balance determined by the annual guaranteed rates of return, the difference would be paid by the insurer. the hypothetical account insurance model is designed to protect the participant against the negative effects of severe market contractions over the participant's working life. thus, if the market took a sudden downturn immediately preceding a participant's retirement, the participant would be guaranteed at least an average return on her aggregate contributions over her working life, notwithstanding her actual account balance at retirement. under the hypothetical account model, to avoid sudden fluctuations in payment claims, insurance protection would not be available for early distributions. any distribution made from an account before a participant died, became disabled, or attained social security retirement age would constitute an early distribution.224 even if the plan provided for such distributions prior to normal retirement, such as for hardship, insurance protection would be unavailable. at an insured participant=s death, the insured benefit would be calculated using the nonparticipant spouses=s retirement age.225 under current law, similar treatment is given in connection with qualified preretirement survivor annuities (qpsas) which provide survivor benefits to non-participant spouses in the event that a participant dies before reaching retirement age.226 insurance protection also would be unavailable for contributions made after retirement age. if an individual worked beyond retirement age, the insured retirement benefit would be unaffected by post retirement contributions or post retirement market conditions.227 the following example numerically illustrates the proposed hypothetical account insurance model. assume that employee x participates in a profit sharing plan which annually contributes 10% of compensation. also, assume that employee x had compensation of $100,000 throughout her employment, began participating in the plan in 1986, and reached social security retirement age in 1995. additionally, assume that the prescribed diversification formula was to allocate 60% to stocks, 25% to bonds, and 15% 224. this approach is generally consistent with current pension law. aunder ' 72(t), a 10-percent additional tax is generally imposed on the taxable portion of any distribution made before the employee attains age 591/2, other than distributions made after the employee's death or by reason of disability. see langbein & wolk, supra note 5, at 349. 225. if the spouse were substantially older, there would be a sudden fluctuation. 226. the retirement equity act (react) of 1984 mandates that plans recognize the surviving non-employee spouse as a plan beneficiary. this benefit is referred to as a qualified preretirement survivor annuity (qpsa). see langbein and wolk, supra note 5, at 555-56. 227. because the insured benefit would be payable as an annuity, there could be some adjustment to the benefit for the delay in the annuity starting date. 2000] rethinking the risk of defined contribution plans 657 to stable-value instruments.228 further assume that employee x=s entire account was insured at all times.229 the annual rates of returns for 1981-1995 are illustrated in column 5 of table i.230 as described earlier, these numbers are assumed to be the composite annual investment returns of a hypothetical portfolio, assumed to be in compliance with the diversification standard.231 column 6 of table i illustrates the annual guaranteed rate of return, based upon an average of the hypothetical annual investment returns for the five prior years. the actual composite rates of return for 1986-1995 are listed in column 2 of table ii. these numbers have been selected randomly to represent the average actual rate of return for funds in a particular account, invested according to the prescribed diversification formula.232 the annual contributions made to the employee's account for years 1986 through 1995 are listed in column 2 of table iii. the actual account balances for the corresponding years are listed in columns (3)-(12) of table iii. the annual hypothetical account balances as determined by the annual guaranteed hypothetical return for years 1986-1995. these numbers are listed in columns (3)-(12) of table iv.233 table v shows the benefit employee x was entitled to receive at retirement in 1996. the guaranteed minimum retirement benefit is the greater of columns 1 and 2 in table v, in the participants retirement year. if employee x had died or become disabled prior to her retirement date, the guaranteed benefit would have been the greater of column 1 and 2 in the year in which the participant=s death or disability occurred. when the participant reached age 65 in 1995, the actual account balance was $190,325, and the hypothetical account balance was $203,824. because the insured account balance exceeds the actual account balance, the participant would be entitled to receive the difference from the insurer. employee x, therefore, would receive $203,824 at retirement, rather than $190,325, payable in the form of an annuity. while $190,325 would be paid 228. see supra notes 218-20 and accompanying text. 229. in other words, the account was in compliance each year with the prescribed diversification standard. 230. the selected rates are assumed to reflect a composite of 60% moderately volatile stock, 35% investment grade bonds, and 15% stable-value instruments. for purposes of this illustration, the numbers in columns 2, 3, and 4, of table i have been randomly selected. 231. the separate rates of return for stock, bonds, and stable-valued funds for 1981-1995 are illustrated in columns 2, 3, and 4 of table i, respectively. 232. the annual average hypothetical rate of return is a weighted average of 60% stock, 35% bond, and 15% stable-value funds. 233. these numbers are derived by multiplying the insured interest rate (table ii, column 2) by the actual contribution (table iii, column 2). 658 florida tax review [vol. 4:9 from the participant=s individual account, the additional $13,499 would be paid by insurance. the insured=s benefit in this example represents an increase of more than 7% in the participant=s retirement benefit. table i (1) (2) (3) (4) (5) (6) annual annual annual annual hypothetical average annual hypothetical hypothetical rate of return hypothetical guaranteed rate of return rate of return for stable rate of rate of year for stocks for bonds value funds return* return** 1981 14% 10% 6% 11.8% ------ 1982 15 11 7 12.9 ------ 1983 16 12 8 13.8 ------ 1984 17 13 9 14.9 ------ 1985 16 12 8 13.8 ------ 1986 15 11 7 12.9 13.4% 1987 12 10 6 10.6 13.7 1988 13 11 7 11.7 13.2 1989 14 12 8 12.6 12.8 1990 15 11 7 12.9 12.3 1991 16 10 6 13.0 12.1 1992 17 9 5 13.3 12.2 1993 16 8 4 12.2 12.7 1994 15 7 5 11.6 12.8 1995 14 8 6 11.3 12.6 *weighted average of 60% stock, 35% bonds, and 15% stable value funds. ** average of five prior years. table ii (1) (2) year actual rates of return* 2000] rethinking the risk of defined contribution plans 659 1986 15% 1987 14 1988 14 1989 13 1990 13 1991 12 1992 12 1993 10 1994 10 1995 9 * these numbers are selected randomly to represent the weighted average of actual returns for an account invested according to the prescribed diversification formula. 660 florida tax review [vol. 4:9 table iii actual annual account balances* composite rate of return from table ii. table iv hypothetical annual account balances* table v (1) (2) (3) (4) actual annual hypothetical annual date account balances* account balances** insurance payment 1/1/87 $ 11,500 $ 11,340 $ 0 1/1/88 24,510 24,264 0 1/1/89 39,341 38,786 0 1/1/90 55,756 55,031 0 1/1/91 74,304 73,029 0 1/1/92 94,420 93,076 0 1/1/93 116,950 115,652 0 1/1/94 139,646 141,610 1,964 1/1/95 164,611 171,015 6,404 1/1/96 190,325 203,824 13,499 *figures from table iii. ** figures from table iv. 2. the hypothetical account proposal and insurance premiums.calthough insurance protection would provide greater protection against shortfalls in the expected retirement benefit, the payment of annual premiums would necessarily lower the net investment return for insured plan participants. thus, in some instances the participants= actual investment return could be lower than the average return for uninsured accounts.234 for example, assume that the average composite rate of return for a diversified portfolio is 10% in a particular year, and the annual guaranteed hypothetical rate of return is 92%.235 further assume that the regular annual insurance premium is approximately 1% of the investment return. therefore, in that year, participants electing defined contribution plan insurance would receive a less 234. the after-premium rate of return. 235. the annual hypothetical rate of return is based on the average rate of return of the hypothetical account for the five prior years. 2000] rethinking the risk of defined contribution plans 661 than average net return on their investments.236 specifically, insured participants would receive a net annual rate of return of 9%, (a 10% actual return less 1% paid for the premium) instead of the 10% annual return that an uninsured participant would receive.237 similarly, if the market suddenly performed better than average, at 12% for example, an insured participant would receive a lower net rate of return. if the market suddenly performed substantially worse than average, however, the insured participant would receive a greater than average investment return. for example, assume that the annual composite investment return fell to 7% in the next year, and the annual hypothetical guaranteed rate of return was 92%. the insured participants in that year would receive a net investment return of 82%, which is 12% above the uninsured participant=s investment return. 3. noncompliant investment allocations.cfor the regular premium amount, insurance protection would be available to individuals who seek average returns by means of the diversification formula. an average rate of return would be guaranteed to individuals who take substantially lower than average risks, but only if they were charged an additional risk related premium. the additional premium would be economically derived to reflect the increased likelihood that such an account would earn significantly less than the minimum guaranteed rate of return. therefore, paying higher premiums for below-average risk allocations, could be viewed as functionally equivalent to a participant investing their funds more aggressively.238 as a result, in this situation, defined contribution plan insurance would not only guarantee some level of protection for accrued retirement benefits in defined contribution plans, but also would help to solve the problem of overly conservative investment practices.239 to illustrate, assume the same facts in the example above in which the annual guaranteed rate of return is 92%, and the average composite rate of return for a diversified portfolio is 10%. further assume that a conservative investment strategy yields 2% below the average market return, or 8% in this 236. this assumes that the annual guaranteed hypothetical rate of return is less than 10%. 237. the annual guaranteed hypothetical rate of return would be 10% minus 1% for the premium payment, or 9%. 238. for simplicity, it is assumed that the participant is 100% invested in stable-valued instruments; however, if a participant invested 100% in stable-value instruments, it would appear to be unnecessary to provide insurance protection as the assets would not be exposed to very much risk. thus, it would be more likely that the participant invested somewhere between 100% and the prescribed percentage for stable-valued instruments. 239. see supra part ii.c.1. 662 florida tax review [vol. 4:9 particular year. also assume that the additional insurance premium charged for conservatively invested portfolios is 2% of the average investment return. accordingly, under normal market conditions, a conservatively invested, insured participants would receive a net investment return of 72%, which is 22% less than an uninsured average return, and 2% less than she would have received had she not been insured and had invested conservatively.240 however, assuming the same 2% differential between average risk and below average risk portfolios used above, if the market performed substantially worse than average, at 7% for example, the under diversified uninsured portfolio would yield only a 5% rate of return. if it is assumed that the guaranteed annual rate of return is 92%, the insured participant would receive a net investment return of 72%, which is 22% more than the uninsured conservative investor, and 2% more than the uninsured average risk investor.241 thus, under the proposed defined contribution plan insurance model, there are incentives for both the average risk taker as well as the less than average risk taker to insure against the risk of market fluctuations. insurance protection for the regular premium amount would not be available to those who take greater than average risk with respect to either investment category or risk classification, unless they demonstrated that special circumstances warranted a deviation from the prescribed diversification standard. for example, again assuming that the safe harbor formula were 60% stocks, 35% bonds, and 15% stable-value instruments, a participant very close to retirement who invested 85% in stable-value instruments and 15% in bonds, could still be eligible for insurance protection at the regular rate, if it could be shown that the allocation was not overly conservative in light of the participant=s time horizon.242 under such a scenario, however, the participant would only be entitled to receive a level of insurance protection based upon a lower rate of return consistent with the asset mix for the regular premium amount. if, the noncompliant asset allocation neither comported with the prescribed diversification standards, nor satisfied a facts and circumstances test for the diversification requirement, insurance protection would be unavailable, unless an economically derived additional premium were charged. 240. that is, a guaranteed annual rate of return of 92%, minus a 2% premium for the use of conservative investment strategy. 241. the 82% return is based on the five prior year average of 92% minus 1% for the premium payment. 242. time horizon refers to the number of years left to save for retirement. this strategy would be used in order to provide protection against a down turn in the market with insufficient remaining time to offset such losses. a lower rate of return would be guaranteed consistent with the asset mix, however. 2000] rethinking the risk of defined contribution plans 663 4. private insurers.cthe hypothetical insurance account model for defined contribution plan insurance could just as easily be offered by a private insurance company as by a federal agency.243 private insurers could compete for a share of the defined contribution plan insurance market by offering comparable insurance protection at a lower premium. if the private sector became involved, there would have to be some means by which the financial viability of the insuring companies could be evaluated and monitored by the federal government. realistically, it is unlikely that the private sector could effectively compete because the premium charged by the federal government would more than likely always be less, since it could approach the insurance program as a revenue neutral activity. thus, the private insurer, who would have to charge a premium sufficiently high to provide a profit margin, would be at a competitive disadvantage. interestingly, the private industry has not sought in any meaningful way to offer insurance to defined benefit plans under the current insurance system.244 perhaps one explanation is that under erisa, pbgc insurance is mandatory for all employers who sponsor defined benefit plans.245 therefore, it is impractical for a private insurer to compete because an employer choosing private insurance would incur duplicate insurance costs.246 if employers were permitted to substitute private insurance for pbgc protection, the private industry would be more likely to compete in the retirement plan insurance market. nevertheless, the existing defined benefit plan structure would seem to provide greater incentives for private competition than a defined contribution plan insurance program, because there can be funding surpluses in defined benefit plans.247 the possibility of the insurer capturing a portion, or all, of a funding excess would appear to be sufficient to generate greater interest in insuring defined benefit plans. for example, an insurer of defined benefit plans could provide premium discounts in exchange for a pre-determined percentage of a plan surplus in the event of plan termination.248 there are no such possibilities in a defined contribution 243. subject to regulation by the government. 244. a participant can obtain insurance on their own to the extent that insurance companies will provide insurance protection on an individual basis, but there is no established program which would spread the risks among numerous plan participants. 245. see daniel keating, chapter 11=s new ten-ton monster: the pbgc and bankruptcy, 77 minn. l. rev. 803, 806-07 (1993); see also supra part i.a. 246. unless the pbgc elected to give way to private insurance. 247. an excess occurs in a defined benefit plan when the assumptions used by the plan are more conservative than the experience of the plan. a plan=s aexperience@ describes the actual cost of the plan. actuarial gain or loss is measured by the difference between the actual cost of the plan and the actuarial estimates for a plan year. 248. when a plan terminates with excess assets, the employer is permitted to capture 664 florida tax review [vol. 4:9 insurance arrangement because there are no funding excesses in individual account plans. therefore, the profits of an insurer of defined contribution plans would be limited to the difference in the insurance premiums charged and the payment of the minimum guaranteed rates of return. f. regulating defined contribution plan insurance 1. the moral hazard problem.cjust as a disparity in risk allocation distinguishes defined benefit and defined contribution plans structurally, a disparity in risk allocation also distinguishes the insurability of these plans. when a defined benefit plan terminates with insufficient funds, the sponsoring employer is primarily liable for the asset deficiencies. the pbgc is only secondarily liable.249 therefore, an employer who sponsors a defined benefit plan and does not anticipate insolvency is more likely to exercise caution to avoid exposing the plan assets to unreasonable investment risks.250 by contrast, when a defined contribution plan terminates with insufficient assets, there is no employer liability. thus, a provider of defined contribution plan insurance would be primarily liable for any deficiencies that a participant experienced. accordingly, the employer, or participant, making the investment decisions would have no incentive to avoid exposing the account to unreasonable investment risks.251 this concern expresses the moral hazard problem of insurance protection: those who are insured against certain risks have no incentive to use optimal care to avoid the insured risk.252 for example, an employer sponsoring an insured money purchase plan, who recognized that it had no liability for plan losses, may invest disproportionately in high-risk, high-yield instruments in order to reduce the amount of future employer contributions necessary to the excess. this is referred to as a reversion. the employer, however, must pay an excise tax on the reverted amount. interestingly, in some instances, plans considered underfunded under irc ' 412 standards can have excess assets at plan termination because the actuarial assumptions for ongoing plans differ from those used in connection with terminating plans. 249. employers will pay either by providing the benefits or by reimbursing the pbgc. see supra note 12 and accompanying text. 250. if the employer anticipates insolvency, however, the employer may nevertheless take unreasonable risks knowing that the promised benefits would be paid by the pbgc. 251. daniel keating, pension insurance, bankruptcy and moral hazard, 1991 wis. l. rev. 65, 66-67. 252. for purposes of defining moral hazard problems it is important to distinguish between two types of risks: reactive and fixed. a reactive risk is one over which the insured has some control. an example of this type of risk would be an automobile wreck due to controllable causes, such as speeding. a fixed risk is one for which the insured has no control, such as damage from floods and other acts of god. afor a moral hazard problem to exist, there must be some element of reactive risk involved.@ in other words, the insured must have some opportunity to exercise due care. id. at 68. 2000] rethinking the risk of defined contribution plans 665 reach a certain level of retirement benefit.253 alternatively, the employer may use the same strategy to increase plan benefits. however, a similarly motivated employer sponsoring a defined benefit plan would not choose to expose its plan assets to unreasonable risks because the employer would be liable for any asset deficiencies.254 prior to the passage of erisa, there was concern that the adoption of defined benefit plan insurance would also encourage abusive practices regarding risk exposure. legislative history reveals that some policymakers specifically feared that defined benefit plan insurance would enable employers to promise excessively generous pension benefits in efforts to satisfy increasing labor demands.255 there was also concern that an employer might establish or amend a plan to provide substantial past service benefits, realizing that if funding were inadequate to pay the benefits, the pbgc would subsidize the remaining deficiency.256 as a result, the pre-erisa committee determined that it was necessary to adopt safeguards against this type of abusive behavior. the committee initially imposed restrictions on an employer's ability to recover from the pbgc. it required employers to reimburse the pbgc for asset deficiencies of up to 30% of the employer=s net worth.257 subsequently, erisa was amended to require that employers reimburse the pbgc for the full amount of the plan=s funding deficiency.258 in connection with defined contribution plan insurance, it would be necessary to adopt similar protective measures to address the moral hazard problem. the prescribed diversification standard used in connection with the hypothetical account model discussed above accomplishes this goal by placing limitations on the level of risk to which an insured account may be exposed.259 2. the impact of defined contribution plan insurance on the pbgc.cskeptics of defined contribution plan insurance protection maintain that extending pbgc insurance protection to defined contribution plans would intensify the financial troubles of the pbgc.260 this particular concern is valid, however, only if the defined contribution plan insurance program 253. a money purchase plan is a defined contribution plan that has a definite contribution formula. in contrast, a profit sharing plan is a defined contribution plan that can have an indefinite contribution formula. 254. the employer would be liable to the pbgc. 255. see generally langbein & wolk, supra note 5, at 78-79. 256. see discussion infra part iv.b, c. 257. see supra note 11 and accompanying text. 258. the omnibus budget reconciliation act of 1987 eliminated the 30% cap on the plan sponsors= liability. 259. see discussion infra part iv.b, c. 260. see langbein & wolk, supra note 5, at 848-49. 666 florida tax review [vol. 4:9 replicated or expanded the existing insurance program for defined benefit plans. a newly established defined contribution plan insurance program should do neither. a defined contribution insurance program should be uniquely designed to reflect not only differences in plan type and plan structure, but also recent awareness of design deficiencies in the defined benefit plan insurance program.261 congress has conducted numerous studies to assess the strengths and weaknesses of the pbgc insurance program. these studies identify inherent problems with the pbgc insurance program, paying special attention to the mid 1980=s, when the pbgc=s liabilities began to increase.262 some studies have concluded that the pbgc=s financial problems primarily stem from the potential liability of underfunded ongoing pension plans terminating. other studies have concluded that the real crux of the pbgc=s funding crisis stems from the fact that the pbgc is not structured as a bona fide insurance company.263 two characteristics distinguish the pbgc insurance program from the bona fide insurance model used in the private sector. first, the pbgc premium is not fully risk based.264 as a result, healthy plans in thriving industries pay the same premiums as barely funded plans in troubled industries. second, the pbgc premium is only partially economically derived.265 consequently, extremely well funded plans pay the same premium as plans that are only adequately funded. although there are new increased variable rate premiums which require underfunded plans to pay higher premiums, there is still no corresponding adjustment to decrease the premiums of well funded plans.266 261. see generally keville, supra note 4, at 553-54. 262. richard a. ippolito, a study of the regulatory effect of the employee retirement income security act, 31 j.l. & econ. 85 (1988) [hereinafter ippolito, regulatory effect]. 263. see richard a. ippolito, pension security: has erisa had any effect?, in langbein & wolk, supra note 4, at 91, 93 [hereinafter ippolito, pension security]; ippolito, regulatory effect, supra note 262, at 109-10. 264. see ippolito, pension security, supra note 263, at 93; ippolito, regulatory effect, supra note 262, at 85. 265. see ippolito, pension security, supra note 263, at 93; ippolito, regulatory effect, supra note 262, at 109-110. studies show that the pbgc needs to impose a flat rate premium of at least $50 per participant to pay for its expected future liabilities. see ippolito, pension security, supra note 263, at 93. even though the removal of the cap on variable premiums in 1994 was estimated to raise approximately $650 million per year, the pbgc expected that their losses in future years will range between $12 and $20 billion. see leigh allyson wolfe, is your pension safe? a call for reform of the pension benefit guaranty corporation and protection of pension benefits, 24 sw.u.l. rev.145, 154-55 (1994). thus, even with its increased rates, the pbgc premiums still are not economically adequate. 266. athe flat-rate premium is $19 per participant, and the variable premium is $9 per $1,000 of unfunded vested benefits with a maximum variable rate charge of $53 per participant for a total maximum rate of $72 per participant.@ wolfe, supra note 265, at 154. 2000] rethinking the risk of defined contribution plans 667 the failure to calibrate pbgc insurance premiums to fully reflect risk and cost results in a cross-subsidization from the beneficiaries of well funded plans to less well funded plans.267 if a fully risk based insurance model were utilized for defined contribution plan insurance, employers or participants who invest in high-risk instruments would be required to pay more than those who invest at average risks.268 under such a model, the institution insuring the plan could be no better or worse off economically for having established the program.269 as a practical matter, any proposal to federally insure defined contribution plans should not duplicate the shortcomings of the existing insurance program. the defined contribution plan insurance program should be a new program with a risk-based premium. the hypothetical account model described in part iii.e is an example of such a program. 3. the problem of bailouts.csome commentators have expressed concern that a defined contribution plan insurance program would increase federal exposure, possibly leading to a bailout similar to that of the 1980=s saving and loan crisis. this is unlikely, however, because the need for the 1980 bailout developed out of circumstances unique to the savings and loan industry. the savings and loan crisis occurred when savings and loan institutions promised high investment returns in order to attract greater numbers of investors and remain competitive in the financial lending market.270 in efforts to generate sufficient income to pay the promised returns, the savings and loan institutions invested in short-term high-risk bonds. when 267. william h. simon, the prospects of pension fund socialism, 14 berkeley j. emp. & lab. l. 251, 256 (1993). a cross-subsidization of the beneficiaries as a class by the rest of the population can also occur if the insurance funds become insolvent and the federal government bails the companies out with general revenues. id. 268. see jefferson, supra note 26, at 40-41. 269. plans covering employees of troubled industries would be charged more because there exists a greater risk of plan failure. see generally ippolito, pension security, supra note 263, at 93-95 (contrasting the pbgc program with private insurance). 270. the savings and loan problem began in 1980 when interest rate legislation was passed which deregulated the liabilities (i.e., deposits), but not the assets of the savings and loans. soon after, federal tax incentives were introduced in 1981 and 1982 which encouraged real estate projects to be undertaken that were not economically viable. during the same time, the federal government tightened the money supply, which caused government bond interest rates to rise. this situation forced the savings and loans to seek higher short term rates through junk bonds. making matters worse, in 1986 oil plunged to $10 a barrel, and the income tax incentives were taken away with no grandfather provisions. also, one year later the stock market plummeted, and finally in 1989 the financial institution=s reform, recovery and enforcement act (firrea) imposed higher capital standards on the thrift industry, creating a situation in which more savings and loan institutions had to be seized by the government than had been anticipated. yakoboski, supra note 3, at 18. 668 florida tax review [vol. 4:9 the underlying businesses for the high-risk investments became insolvent, the savings and loans lost substantial sums of money. as a result, they were unable to meet their financial obligations as they became due. therefore, it became necessary for the federal government to bail out the industry. like the savings and loans, defined contribution plan sponsors and participants would have incentives to maximize returns by investing in high-risk, high-return instruments.271 however, the comparison between defined contribution plan insurance and the savings and loan crisis is nevertheless invalid. there were many factors in the savings and loan crisis which are inapplicable to the retirement system. first, there is an important distinction between the savings and loan industry and retirement plans with respect to cash flow. funds placed in savings and loan institutions are available to depositors upon request. therefore, when news that the savings and loans were experiencing financial difficulties reached the public, many depositors withdrew their funds from these institutions. this response made a bad situation worse. in contrast, in retirement savings arrangements early distributions are generally disallowed unless specific events occur, such as early retirement, disability, or death.272 even when other early distributions are permitted by the plan, a 10% excise tax ordinarily applies to discourage participants from withdrawing their funds prior to retirement age.273 furthermore, an insurance program for defined contribution plans could impose additional restrictions on payment. under the hypothetical account model for defined contribution plans proposed in part iii.e, insurance protection would be unavailable until a participant attained normal retirement age, became disabled, or died, notwithstanding the distributable events allowed by the plans.274 thus, the distribution rules of erisa, as well as additional restrictions imposed by the insurance program, would prevent a single event from increasing the volume of insured claims as it did in the savings and loan crisis.275 the second difference between the fslic's guarantee of savings and loan funds and a guaranteed benefit in a defined contribution plan program is industry diversification and its impact on the incident of failure. the funds guaranteed in the savings and loan crisis were exposed almost exclusively to the risk of a single industry, real estate. thus, the savings and loan funds were 271. sponsors and participants would do so to achieve returns in excess of guaranteed rates. 272. see regs. ' 1.401-1(b)(1)(i). 273. distributions before a participant reaches age 592 are normally considered early. exceptions to the 10% excise tax on early distributions are found in irc ' 72(t). 274. see discussion supra part iii.e.1. 275. limitations on the insured amounts, such as those discussed in connection with the hypothetical account insurance model, would also prevent a brief period of fluctuations in the financial market from triggering the level of insurance claims filed during the savings and loan crisis. see yakoboski, supra note 3, at 20. 2000] rethinking the risk of defined contribution plans 669 extremely vulnerable to fluctuations in a particular market. by contrast, retirement plan assets are ordinarily more diversified. specifically, defined contribution plan accounts in compliance with the diversification formula of the hypothetical account model described above, are required to be invested in multiple markets according to the prescribed portfolio mix.276 therefore, it is unlikely that defined contribution plans would fail as a result of the collapse of a single market. moreover, because the guaranteed minimum benefit under the hypothetical account model would be based on a five-year average rate of return instead of the performance of a single year, there would be an additional measure of protection for the insurer.277 as a result, any fluctuations in the market would be spread over a period of years. the third difference between the savings and loan crisis and the retirement system is the presence of fraud and mismanagement. the savings and loan crisis did not result merely from aggressive investment activity. fraud and mismanagement were present in approximately 60% of the savings and loan failures, and directly linked to the insolvency of at least 25% of the failed institutions, while evidence of fraud and mismanagement in pension plans is relatively low.278 this fact alone suggests that a defined contribution plan insurance program would not be exposed to the same risk of failure that the savings and loan industry was exposed to in the 1980=s.279 g. the floor-offset pension plan comparison while the hypothetical insurance model discussed above proposes a new method of guaranteeing a minimum benefit in defined contribution plans, a minimum benefit in connection with defined contribution plans is not a totally new concept. a type of minimum benefit protection similar to that provided by the hypothetical defined contribution model currently can be achieved if an employer adopts a floor-offset pension plan.280 thus, insuring 276. see supra part iii.e.1. 277. see supra part iii.e describing the hypothetical account proposal. 278. see yakoboski, supra note 3, at 20. 279. another difference not discussed in the text of this article is the significance of loan participation in the savings and loan crisis. as the savings and loans found themselves constrained by limits on the amount they could lend to a single borrower, they began to sell portions of loans to other institutions. many of the secondary lenders relied on the underwriting capacities of the originating savings and loans. thus, the savings and loans were extremely vulnerable. although a large proportion of defined benefit plan assets are placed in bank pooled funds and similar investments where investment results are shared, the investment strategy is fundamentally different. id. at 20. 280. the majority of firms with floor-offset plans have between 5,000 and 20,000 employees, according to a study conducted by robinson and small in 1993. typically, floor offset plans provide a floor benefit for a career employee of between 40 and 60% of 670 florida tax review [vol. 4:9 defined contribution plan retirement benefits is neither theoretically nor practically as different as one may initially believe. a floor-offset plan, also known as a feeder plan, is a hybrid arrangement. while most hybrid arrangements are single plans which combine characteristics of both defined benefit and defined contribution plans, the floor-offset plan consists of two separate plans: a defined benefit and a defined contribution plan. the defined benefit plan is the afloor@ plan. the floor plan uses a standard formula to establish a minimum benefit level that represent the employer=s income replacement goals. the formula may take into account age, service, and compensation. the defined contribution plan is the abase@ plan. the employer makes the annual contributions to the base plan.281 if the base plan provides a benefit at least equal to the minimum established under the floor plan, the participant receives the balance of the defined contribution account as her retirement benefit.282 in such cases, no benefit is paid from the floor plan. if, however, the defined contribution plan provides less than the minimum benefit established under the floor plan, as a result of investment performance or inflation, for example, payments will be made from the floor plan to offset the shortfall in the base plan benefit. the floor-offset plan is generally offered by employers who wish to maximize both the flexibility of defined contribution plans, and the retirement income security of defined benefit plans.283 in a floor-offset plan, the employer typically is responsible for the investment of assets in both the defined benefit and defined contribution plans. if the participants rather than employers controlled the investments of the funds in the defined contribution base plan, in cases where the floor-offset plan was set at a sufficient level the participants would have incentives to invest in high-risk, high-yield instruments, knowing that the minimum benefit under the defined benefit floor plan would be adequate for retirement.284 however, because the employer is the party making the investment decisions, and the one who bears the risk of a pre-retirement compensation. ebri, special report, hybrid retirement plans: the retirement income system continues to evolve 18 (1996) [hereinafter ebri]. 281. any defined contribution plan can be used as the base plan in a floor-offset plan; however, the standard profit sharing plan is most frequently used in such arrangements. 282. see ebri, supra note 280, at 17. 283. another situation for which a floor offset plan would be offered is a situation where the key employees are older and do not have sufficient time to accrue adequate retirement benefits under a traditional defined contribution plan. thus, by offering a floor offset plan, these employees could be assured of receiving the desired level of income replacement at retirement from the defined benefit floor plan. see ebri, supra note 280, at 18. as is the case with most hybrid retirement plans, there are many different plan designs. because of the presence of both a defined benefit and a defined contribution plan, the floor offset plan may incorporate design features that are typically limited to one plan type or the other. id. 284. see supra notes 251-61 and accompanying text. 2000] rethinking the risk of defined contribution plans 671 shortfall in the expected retirement benefit, the moral hazard problem is avoided.285 interestingly, when the minimum benefit level in a floor-offset plan roughly approximates an average investment return on employer contributions over a participant=s working life, the floor-offset arrangement provides a minimum retirement benefit guarantee very similar to the minimum benefit guarantee described under the hypothetical account proposal described in part ii.e. in both cases, participants are guaranteed receipt of a minimum benefit at retirement. the minimum benefit is calculated with reference to an expected return over the participant=s working life. the major difference between the two guarantees is the source of the guarantee. in a flooroffset arrangement, the expected retirement benefit in the defined contribution plan is guaranteed through the defined benefit floor plan. in the hypothetical account proposal, a governmental agency similar to the pbgc guarantees the benefit through a bona fide insurance program.286 in both cases the potential for the moral hazard problem of insurance protection is essentially eliminated. in the floor-offset plan, there is no moral hazard problem because the employer makes the investment decisions. in the hypothetical account insurance model, there is no moral hazard problem because the diversification standard restricts the use of overly aggressive investment strategies. the use of floor-offset plans is not prevalent.287 because the floor-offset plan involves both a defined benefit and a defined contribution plan, the administration of such plans is more complicated than that of either type plan. additionally, because the cost of the plan depends on the contributions made to the defined contribution offset plan and their investment build-up, a highly volatile portfolio in connection with the offset plan could result in losses and increase the funding of the defined benefit floor plan. consequently, the cost of the floor plan could be more expensive than maintaining either a traditional defined benefit plan or a traditional defined contribution plan.288 therefore, most employers would not choose to provide floor-offset plans because of the additional costs and administrative burdens associated with maintaining floor offset plans. 285. because the minimum benefit in a floor offset arrangement is provided by the defined benefit floor plan, the investment risk in a floor plan is substantially borne by the employer. see supra notes 252-54. 286. see supra part iii.e. 287. see cash balance pension plans and other hybrid retirement plans, <http://www.ebri.org/fundamentals/chpt10.html>; see also ebri, supra note 280. 288. although some employers who establish floor-offset plans view the defined contribution plan as the primary retirement saving vehicle, many others view the defined benefit plan as the primary vehicle. consequently, they recognize the defined benefit plan cost at all times. see ebri, supra note 280, at 18. 672 florida tax review [vol. 4:9 although the existence of the floor-offset plan demonstrates that the concept of defined contribution plan insurance is neither theoretically nor practically impossible, the limited use of such plans suggests that they have little impact on the retirement income security of the majority of defined contribution plan participants. therefore, to ensure that more than a nominal percentage of defined contribution plan participants receive adequate protection against retirement benefit shortfalls, a guarantee of a minimum benefit should be available to all defined contribution plan participants through a defined contribution insurance program. iv. funding shortages in defined contribution plans a. funding under erisa pre-erisa funding rules were not only inadequate in providing financial security for plan participants, but also created many problems related to underfunding.289 participants often did not receive the benefits they expected from plans that were in compliance with the existing funding rules.290 shortfalls in the expected retirement benefits are serious problems. shortfalls threaten the financial security of plan participants not only because the retirement benefit received from the plan is more likely to be insufficient for the participant=s retirement needs, but also because in reliance on their expected retirement benefits, participants are likely to have decreased personal savings. furthermore, when the participant becomes aware of the shortfall, there likely will be too few years of employment remaining to appreciably increase personal savings to offset the loss of benefit.291 as a result, when retirement plans are inadequately funded, participants may be worse off than they would have been in the total absence of a plan. 289. one such case was the studebaker case. this case made policymakers aware of the inadequacy of the existing funding requirements and consequently caused them to focus on plan funding and related matters. thus, athe closing of the studebaker automobile plant in south bend, indiana, in december of 1963 is regarded as a pivotal event@ leading to the enactment of erisa. see langbein & wolk, supra note 5, at 62. as a result of the plant closing, 5,000 workers were dismissed and 1,800 more eventually lost their jobs. id. when the plant closed, the company entered into an agreement with the united automobile workers (uaw) for the termination of its pension plan. id. at 63. athe termination agreement implemented the default priorities contained in the plan.@ id. it divided the plan participants into three groups and paid their benefits accordingly: (1) 3,600 retirees and active workers who had reached the plan's normal retirement age of 60 received their full benefits in the form of life annuities, (2) 4,000 employees age 40 to 59 who had at least 10 years of service with the employer received lump sum payments representing approximately 15% of the actuarial value of their accrued benefits, and (3) 2,900 workers had no vested rights and received nothing. id. 290. see also jefferson, supra note 26, at 8-9. 291. see id. at 18-29. 2000] rethinking the risk of defined contribution plans 673 therefore, in addition to strengthening the fiduciary rules and creating a federal insurance program, erisa established minimum funding standards to help prevent funding shortages in qualified retirement plans.292 the purpose of the funding standards is twofold. the funding standards not only provide greater retirement security to plan participants but also provide greater protection for the pbgc against underfunding in defined benefit plans.293 the minimum funding standards apply to all defined benefit plans, and some defined contribution plans.294 because they are required to have definite contribution formulas, money purchase plans and target benefit plans are two types of defined contribution plans which are subject to the minimum funding rules. profit sharing plans are not subject to the minimum funding rules because they are not required to have a definite contribution formula.295 in a defined contribution plan, if the required contributions are not made and the plan terminates, there is no pbgc protection, although there would most likely be shortfalls in the expected retirement benefits. in a defined benefit plan if the required contributions are not made and the plan terminates, the employer and the pbgc would be liable for the payment of the expected retirement benefits. thus, adequate funding is even more critical to 292. see irc ' 412 (1998). the funding rules of this section are enforced with severe penalties. any plan that fails to comply with the appropriate minimum funding standard must pay an excise tax equal to 10% of the underfunded amount, in addition to an interest charge. if, the plan fails to correct the deficiency after receiving notification from the irs that a deficiency exists, an excise tax of 100% of the deficiency is imposed. see canan supra note 30, at 652. plan costs are determined through actuarial valuations which estimate the cost of the plan and assign charges to the appropriate plan years as annual payments. in order to produce such estimates, the actuary must make assumptions about the future experience of the plan including the rate of investment return on plan assets, turnovers resulting in forfeitures of nonvested benefits, salary increases, the retirement age of plan participants, and the number of participants electing optional benefits offered by the plan. thus, the amount that an employer is required to contribute in a particular year to properly fund a plan can vary tremendously depending on the actuarial assumptions used for each of these incidents. 293. canan, supra note 30, at ' 12.1, at 605. the funding rules require that employers contribute annually at least the normal cost of the plan and the amount necessary to amortize any unfunded liabilities over a period ranging from 15 to 40 years. see jefferson, supra note 26, at 6; see also mcgill & grubbs, supra note 54, at 381-82. 294. canan, supra note 30, at ' 12.2, at 606. money purchase plans and target benefit plans are subject to the minimum funding standards. the minimum funding standard for money purchase pension plans require the plan to contribute an amount which does not depend upon the uncertainties of actuarial assumptions. the rules are similar for target benefit plans. however, the funding rules provide that all pension planscwhether defined contribution or defined benefitcare subject to the irc ' 4971 excise tax, if the required contributions are not made to the plan. id. the excise tax is 10% of the underfunded amount, and 100% of the underfunded amount if the underfunding is not timely corrected after notification by the irs. id. at 605. 295. profit sharing plans are permitted to make discretionary contributions. stock bonus plans, like profit sharing plans, are also excluded from the minimum funding standards. 674 florida tax review [vol. 4:9 the retirement income security of plan participants in defined contribution plans than in defined benefit plans, since neither the employer nor the pbgc is liable for the shortfalls. even though the funding rules do not require it, employers who sponsor defined contribution plans frequently fund toward erisa=s maximum permissible amount because of other considerations.296 when defined contribution plans are funded toward specific income replacement goals, funding shortages can occur if insufficient contributions are made. although the funding rules help to prevent deficiencies attributable to inadequate funding in defined benefit plans, they do little to prevent deficiencies attributable to inadequate funding in defined contribution plans.297 for defined contribution plans, the funding rules require only that plans annually contribute amounts specified by the plan=s contribution formula.298 thus, in addition to inadequate fiduciary rules and the absence of insurance protection, inadequate funding rules are another reason defined contribution plan participants may not receive their expected retirement benefits. b. minimum funding standards and past service credits as described in part iii, when a plan is established, a participant's expected retirement benefit consists of two parts: the portion attributable to future earnings and the portion attributable to past earnings.299 while it is the entire retirement benefit that the participant ultimately relies upon, the two portions of the retirement benefit describe conceptually distinct benefits. consequently, they are treated very differently for funding purposes. retirement benefits are deferred compensation. the benefits are earned during employment, but paid during retirement.300 when a plan is newly established, the portion of the expected retirement benefit attributable to future years presumably will be funded by a reduction in current wages. for example, if a retirement plan provides an annual contribution of 10% of compensation and a participant earns $50,000, the participant will receive a 296. irc '' 404. 297. however, most defined contribution plans are profit-sharing which are not subject to the minimum funding standards at all. see supra note 34, infra note 310 and accompanying text. 298. the funding rules have limited application to money purchase plans and target benefit plans. the rules have no applicability to profit sharing plans. see canan, supra note 30, at 606. 299. past service liability occurs when a retirement plan provides a benefit for service before the establishment of the plan or provides for retroactive benefit increases. see supra part iii.b. 300. this acommonly accepted modern account of pension obligations@ is referred to as the deferred wage theory. see langbein & wolk, supra note 5, at 16. 2000] rethinking the risk of defined contribution plans 675 plan contribution of $5,000.301 in that same year the employee=s wages would be reduced by a corresponding amount.302 if the plan were to terminate the next year, theoretically, the employee=s wages should increase.303 from the additional compensation, the employee would be able to increase personal savings to offset any reduction in the expected retirement benefit that resulted from the plan=s premature termination. therefore, because there is a corresponding increase in current wages which allows increased personal savings, participants could have no reasonable reliance on their expected benefits to the extent that they are attributable to future earnings. by contrast, however, if one believes that past service benefits are entirely related to past periods of service, theoretically, compensation from previous periods would have already been cut, in order to fund the benefit attributable to past service. consequently, if the plan terminates, to the extent that past service benefits have not been funded, a participant=s current wages would not increase.304 the participant, therefore, may be unable to increase personal savings to offset the reduction in the expected retirement benefit. this result suggests that it is reasonable for the participant to rely on the portion of the expected retirement benefit attributable to past service since there is neither a corresponding wage increase, nor sufficient time to offset a reduction in the expected retirement benefit.305 when a newly established plan gives credit for past service, the plan has an unfunded initial past service liability because the plan has liabilities for prior years of service, but no assets.306 these liabilities are generally funded over a period of thirty years.307 it is unlikely that such a plan will ever be fully funded, however, because ongoing plans typically fund not only the initial 301. interest is not accounted for. 302. there are numerous theories as to the benefits= impact on compensation. see veal & mackiewicz, supra note 137, at ' 12.1.1, at 205. 303. there is no adjustment for interest and the tax-free build-up. 304. for example, consider a 64 year old participant. it would obviously have to be some other participant's wages that were reduced to fund the past service portion of the 64 year old=s benefit. 305. see jefferson, supra note 26, at 48. 306. for a more detailed discussion see halperin, supra note 7, at 771. 307. allowing past service credits to be funded over 30 years has been responsible for underfunding in a large number of plans. because of concerns about funding inadequacies the pension protection act of 1987 mandated more rapid funding of underfunded plans with more than 100 participants. erisa ' 302(d); irc ' 412(l). afor such plans, the minimum required contribution is the greater of (1) the amount determined under the normal funding rule, or (2) the sum of (a) normal cost, (b) the normal charges and credits reflecting changes in actuarial assumptions and net experience gains or losses, (c) the >deficit reduction contribution,= plus (d) the >unpredictable contingent event amount.= @ see langbein & wolk, supra note 5, at 287. for plans in existence on january 1, 1974, the amortization period is forty years. see irc ' 412(b)(2)(b)(i). 676 florida tax review [vol. 4:9 unfunded liability over thirty years, but also subsequent past service liabilities over additional thirty year periods. if a plan with past service credits continues in operation, liabilities for past service generally will not cause a funding shortage.308 if the plan terminates before all of the funding periods have expired, however, the plan will have insufficient assets to cover the plan's accrued liabilities.309 thus, notwithstanding compliance with erisa=s minimum funding standards, a plan can be inadequately funded on plan termination. as a result there would be insufficient assets to pay the portion of the benefit attributable to the past service credits.310 in defined benefit plans, the entire vested accrued benefit is insured after five years by the pbgc, including the portion of the benefit attributable to the past service credit. in defined contribution plans, no portion of the retirement benefit is insured, including the portion of the retirement benefit attributable to past service. thus, if a defined contribution plan terminates prematurely, plan participants could experience shortfalls in both the past and future portions of their expected retirement benefits. this result is inappropriate if one accepts the theory that the portion of the expected retirement benefit attributable to past earnings in both types of plans is inherently different than the portion of the benefit attributable to future earnings. conceivably, the past service benefits in all plans could be insured by the time a participant reaches normal retirement age, even if the future service benefits are not. c. past service liabilities in defined contribution plans the rationale for requiring participants in defined contribution plans to assume the risk of adverse market conditions with respect to the accumulation of the future benefit does not adequately explain why they should be required to assume the risk with respect to the portion of their benefit attributable to previously earned amounts. most defined contribution 308. the initial unfunded accrued liability can be funded over periods as short as 10 years or over periods as long as 30 to 40 years, depending on the effective date of the plan. see mcgill & grubbs, supra note 54, at 399. if, however, no additional amendments were made to the plan, the plan would be fully funded in exactly 30 years from its establishment date. see halperin, supra note 7, at 771. 309. payments for certain plan liabilities are projected over periods ranging up to 30 years; thus, when a plan terminates prematurely and all of its accrued liabilities become due and payable, the plan would most likely be unable to pay the retirement benefits of plan participants. however, inadequate funding can occur for numerous other reasons. the use of erroneous actuarial assumptions in the projection of future plan costs can either overstate plan assets or understate plan liabilities, resulting in plan losses. the adoption of plan amendments, which provide more generous plan benefits, can also create funding deficiencies. 310. the past service liability would not present a problem as long as the plan continues to operate because contributions would generally exceed the benefits paid out. see halperin, supra note 7, at 771. 2000] rethinking the risk of defined contribution plans 677 plans do not expressly distinguish between the portions of the benefit attributable to future costs and those attributable to past costs. in defined contribution plans, annual contributions are usually based upon a certain percentage of compensation.311 for example, a plan may require the employer to annually contribute 10% of each participant=s compensation, and there generally would be no explicit recognition of a liability for past service. it would therefore appear that defined contribution plan sponsors ignore service prior to the establishment date of the plan for purposes of allocating annual contributions.312 however, this assumption is not necessarily correct. certain hybrid defined contribution plans explicitly award past service credits. the target benefit plan is an example of such a plan.313 the target benefit plan computes the retirement benefit in the same manner as a defined benefit plan.314 when a target benefit plan is established, a projected retirement benefit, or atarget@ benefit, is calculated for each participant.315 the 311. see canan, supra note 30, ' 3.52, at 174. 312. see wayne j. howe, education and demographics: how do they affect unemployment rates?, 111 lab. rev. 3 (1998). the method of contributing under profit sharing and stock bonus plans provides the employer greater flexibility. in such plans employers are permitted to make annual discretionary contributions subject to certain limitations. see canan, supra note 30, at 94. plans having cash or deferred provisions generally do not take into account past service. however, there are certain ways in which they might. for example, a plan could permit a higher deferral percentage for employees with a certain length of service. extreme care would have to be taken so as not to violate the antidiscrimination norms. id. at 174. 313. after the annual contributions are determined and allocated, the target benefit plan operates like any other defined contribution plan. at retirement, the individual=s account may be paid in a lump sum or used to purchase an annuity. however, the actual benefit could be more or less than the target benefit, depending on whether the actual investment earnings of the fund and the annuity purchase rates were more or less favorable than the actuarial assumptions used to calculate the contribution levels, or whether the plan did not terminate prematurely. see mcgill & grubbs, supra note 54, at 115. the target benefit plan is easier to administer than a traditional defined benefit plan. no actuarial valuations or reports are required. thus, although the target benefit resembles a defined benefit plan in many respects, its allocation of investment risk is very different. as a defined contribution plan, the participant, bears the risk of unfavorable investment returns rather than the employer. therefore, if the plan terminates early or if there is a substantial deviation in the experience of the plan as compared to the actuarial assumptions used by the plan, a participant=s retirement benefit could differ drastically from the targeted amounts. because the target benefit plan is an individual account plan, and the retirement benefit is based on the value of the participant=s individual accounts, the target benefit plan is excluded from pbgc coverage. therefore, there is no federal insurance protection for target benefit plan participants if the plan terminates with insufficient assets. see id. 314. see halperin, supra note 8, at 176. see employee=s right to convert policy not incident to ownership, irs says, vol. 11, no. 36, pens. & ben. rep. (bna) 1135 (sept. 3, 1984). 315. the targeted benefit assumes that each participant will work until normal retirement age. 678 florida tax review [vol. 4:9 employer's annual contribution level is the sum of the amounts that are needed to annually fund each participant's targeted benefit.316 the annual contribution is then allocated to the individual accounts according to the amount necessary to fund each participant=s targeted benefit.317 because the target benefit plan uses a benefit accrual formula to determine the retirement benefits,318 it is possible for the employer to account for service prior to the establishment of the plan, by expressly awarding past service credits. the use of past service credits in a target benefit plan is illustrated by the following example. assume an employee age 45 has 10 years of service at the time a target benefit plan is established, and the plan recognizes past service. if the plan provides 1% per year of service, the employee can expect a 30% benefit at age 65, assuming the plan=s investment performance is predicted accurately. the employee, accordingly, could assume a 10% benefit has already been earned when the plan is established. if level contributions are made over the next 20 years, there will be sufficient assets when the employee attains age 65 to pay the entire expected retirement benefit. if the plan were to terminate at any point before the participant reaches age 65, however, there would be insufficient funds to pay the past service benefit, and the participant would receive less at retirement than she expected.319 thus, the participant would have been misled by the past service credit award.320 the worst case scenario would occur at the end of year one. at this point the employee's account balance would fall significantly short of that required to provide an 11% benefit. while the target benefit plan is the only defined contribution plan which allows the employer to expressly award credit for prior service, past service credit can be given implicitly in other types of defined contribution plans. for example, in a money purchase plan an allocation of employer contributions can be based on years of service, or on compensation.321 in other types of defined contribution plans employers can take past service into 316. as is the case of all defined benefit plans, the target benefit plan provides higher contributions for older, more highly compensated employees. 317. see mcgill & grubbs, supra note 54, at 115. the contributions are determined by multiplying the target benefit by a factor in the plan that varies by age. id. 318. to the extent that the experience approximates the assumptions used to determine the projected benefit, the benefits will approximate those provided under a defined benefit plan with a benefit formula. the target benefit plan is even subject to the maximum limits on contributions which can limit the contributions that could otherwise be made to older participants. id. 319. see halperin, supra note 7, at 776-77. 320. but see id. at 772-78 (positing that we should treat past service in defined benefit plans like we treat it in defined contribution plans, which is to allow the same funding). 321. when this approach is used, care must be taken that such formulas are not discriminatory in favor of the highly compensated employees. see quality brands, inc. v. commissioner, 67 t.c. 167 (1976); see also canan, supra note 30, at 98; see also halperin, supra note 7, at 776; see also regs. ' 1.401-4(a)(2)(iii). 2000] rethinking the risk of defined contribution plans 679 account by permitting higher deferral percentages for employees with greater lengths of service.322 when an employer awards past service implicitly, it is more difficult to exactly determine the portion of the employer=s annual contribution attributable to past service. difficulty notwithstanding, it is nevertheless reasonable to assume that some portion of the annual contribution in defined contribution plans is made implicitly for prior service. employers who sponsor defined contribution plans presumably would want to reward prior service for the same reasons that employers who sponsor defined benefit plans would. therefore, even absent an explicit past service credit, a participant could reasonably consider her defined contribution plan as providing for past service when the plan is established.323 when credit for prior service is implicitly awarded, the portion of the annual contribution attributable to past service can be estimated, if the contribution level is known and certain assumptions are made. the annual accrual rate can be determined by dividing the expected retirement benefit by the participant=s projected years of service. the future accrual rate can be determined by dividing the expected retirement benefit by the total years of projected future service. taking the difference in these two results makes it possible to separate the portion of the projected benefit attributable to future earnings from the portion attributable to past earnings. to illustrate, assume an employee with 15 years of service is age 50 when a defined contribution plan is established. furthermore, the plan has a normal retirement age of 65, and the plan=s annual contribution formula, which was derived with a specific income replacement goal, is 20% of compensation. thus, the expected retirement benefit will accrue at a rate of 20% of the employee's annual compensation per year over the next 15 years.324 if the employee=s future compensation and investment earnings rate on future accruals are assumed, the expected retirement benefit can be calculated when the plan is adopted.325 for example, if annual compensation is expected to remain at $50,000 over the next 15 years, and an investment return on the future contributions of 10% is assumed, the expected retirement benefit would be $25,937.326 if the expected retirement benefit is divided by thirty, the total years of service, the portion of the retirement benefit attributed to each 322. for example 401(k) plans. see supra part i.a. 323. see canan, supra note 30, at 174. 324. plus an adjustment for interest. 325. if the contribution is known, the expected pension can be approximated by making assumptions about the period of service, the employee=s salary, and the earnings on the fund. for simplicity, there is no salary scale increase used in this problem. 326. $10,000 x 1.1010 = $25,937. 680 florida tax review [vol. 4:9 year of service can be determined. in this example each year=s accrual would be $865 per year.327 thus, when the plan is established, the participant has already earned 15 years of accruals, or a benefit of $12,975.328 as a result, the participant should reasonably expect to receive at retirement a $12,975 benefit for her prior years of service. this result occurs, however, only if some portion of each year=s annual contribution is attributable to the funding of the past service liability. if the plan continues to operate over the next 15 years, the participant would most likely be indifferent about whether any portion of the benefit was attributable to a past service credit, or not. this is because after 15 years the funding goal would be achieved, assuming the interest assumption were correct. however, if the plan were to terminate earlier, there would be insufficient contributions to cover the initial past service liability of $12,975. as a result, the uninsured defined contribution plan participant would not receive the full past service benefit that she expected, and perhaps had already earned. d. the funding rules and defined contribution plans in defined benefit plans, the distinction between past service and future service credits has substantial significance.329 in defined benefit plans, whether liabilities are attributable to the future or to the past determines their tax treatment,330 funding periods,331 and the level of insurance protection they received.332 although the distinction between past service and future service theoretically exist in defined contribution plans, under current law the distinction has no practical significance in such plans. this is even true for target benefit plans which expressly award past service credits. the inadequacies of the funding and insurance laws with respect to defined contribution plans is particularly evident in money purchase plans. money purchase plans are subject to the minimum funding standards.333 employers are subject to substantial penalties if the plans they sponsor fail to comply with these rules.334 although the applicability of the funding rules to money purchase plans and target benefit plans may appear to provide 327. $25,937/30 = $865. 328. $865 x 15 = $12,975. 329. for example, as discussed earlier, past service must be amortized over 10 to 30 years, while current liabilities are expensed. 330. generally, the maximum amount that an employer may deduct in a plan year is the sum of the normal cost and an amount sufficient to amortize the unfunded past service liability over ten years. 331. future plan costs may not be funded in advance. 332. future costs are not insured. 333. see irc ' 412. 334. see irc ' 4971. 2000] rethinking the risk of defined contribution plans 681 additional protection to plan participants against shortfalls, there is no such protection. if a money purchase plan terminates prematurely and there have been insufficient contributions made to fund the past service portion of the expected retirement benefit, the participants will receive less than they expect at retirement. this would be the same result in other defined contribution plans which are not subject to the funding rules. thus, the requirement that certain defined contribution plans comply with the funding rules is misleading. participants are given the false impression that their expected benefits are adequately funded since the plans are subject to erisa=s minimum funding standards. the opportunity for misimpression is particularly well illustrated by the target benefit plan. although the funding standards apply to target benefit plans, and the employer is allowed to expressly recognize prior service, there are nevertheless no additional funding requirements. thus, a participant=s retirement benefit could differ drastically from the targeted amount expressly stated in the plan. to avoid this result, congress should amend the funding rules to have greater impact in their applicability to defined contribution plans. similar to the treatment of defined benefit plans, employers sponsoring defined contribution plans subject to the funding rules should be required to annually contribute amounts necessary to fund the past service portion of the expected retirement benefit.335 admittedly, such a change is likely to have relatively little effect. as discussed above, very few defined contribution plans explicitly award past service credits.336 consequently, only the few employers who sponsor target benefit plans that award past service credits would be affected by the more stringent funding requirements. also, because the profit sharing plan, which is the most popular type of defined contribution plan, is not subject to the funding rules at all, such a remedy is not likely to have a meaningful impact on the majority of plan participants now covered by defined contribution plans.337 therefore, the inadequacies of the funding rules as they apply to defined contribution plans make the argument for defined contribution plan insurance more compelling. insurance protection is critically important for the retirement security of defined contribution plan participants because the funding rules do very little to protect them. at the very least, in defined contribution plans, the portion of the expected retirement benefit attributed to past service should be guaranteed. with slight modification, the hypothetical 335. for example, an employer sponsoring a target benefit plan that awarded a past service credit, would be required to make annual contributions in pre-determined amounts to cover the portion of the expected retirement benefit attributable to past service. 336. see supra part iv.b. 337. see supra part iv.c. 682 florida tax review [vol. 4:9 account insurance model discussed in part two of this article could very effectively be used for this purpose.338 v. conclusion participants who depend on defined contribution plans as their primary retirement savings vehicles are exposed to substantially greater risks of shortfalls in their expected retirement benefits than participants in defined benefit plans. those individuals who rely on participant directed plans are even more at risk. because the existing fiduciary and funding rules are inadequate as they apply to defined contribution plans, there is a critical need for congress to consider amending the pension laws to be more responsive to the risks of shortfalls in defined contribution plans. moreover, because the gap in insurance protection further exposes defined contribution plan participants to plan losses, a defined contribution plan insurance program should be established. insuring defined contribution plans does in fact present difficult trade-offs. however, many of the concerns regarding such a program are reactionary rather than substantive. as for the relatively few substantive concerns, the overwhelming need to amend erisa to be responsive to the current pension climate would appear to offset any difficulties that these concerns present. therefore, notwithstanding the complexity of implementing a defined contribution plan insurance program, policymakers should seriously consider establishing an insurance program for defined contribution plans to meet the needs of future retirees. frequent and significant post-erisa amendments that disproportionately affect defined benefit plans have led many to conclude that increased government regulation has been the impetus for the migration away from defined benefit plans to defined contribution plans.339 moreover, the regulations affecting defined benefit plans generally have been more burdensome than those affecting defined contribution plans.340 consequently, some skeptics of defined contribution plan reform may fear that increased regulation of defined contribution plans in connection with the fiduciary rules, insurance requirements, or the funding rules would adversely impact the establishment rate of defined contribution plans. although frequent amendments have undoubtedly contributed in some measure to the shift from defined benefit plans to defined contribution plans, the magnitude of the effect of governmental regulation is probably grossly overstated.341 338. see part iii.e. 339. see keville, supra note 4, at 534. this trend appears to apply to all work industries and all plan sizes. id. at 536. 340. id. at 535-37. 341. in some instances, new legislation affecting defined contribution plans has not 2000] rethinking the risk of defined contribution plans 683 an analysis of current establishment trends reveals that numerous other factors are responsible for the shift from defined benefit plans to defined contribution plans.342 business considerations unrelated to pension plans are also responsible for an increase in the number of defined contribution plans. the introduction of 401(k) plans, and greater portability of defined contribution plans have also adversely affected the establishment of defined benefit pension plans.343 even if government regulation affecting defined benefit plans has been more frequent than that affecting defined contribution plans, the number of changes does not necessarily indicate the significance of those changes. for example, while adjustments to the pbgc premium have been numerous, the premium, per employee, has remained relatively level over the past twenty years.344 a nominal premium increase per participant is probably too small to make a significant difference in the employer=s selection of a plan.345 similarly, it is unlikely that the introduction of a relatively low premium for defined contribution plans, or more stringent fiduciary rules in participant directed plans, would affect the establishment of these plans. this is true especially since other government regulations continue to place relatively smaller burdens on defined contribution plans than on defined benefit plans.346 a 1990 pbgc study supports the conclusion that the movement toward defined contribution plans is not solely in response to increased government regulation of defined benefit plans or additional plan costs.347 rather, the results of the study indicate that the primary cause of the recent decline in participation in defined benefit plans was a structural shift in the economy rather than conscious decisions made by plan sponsors and only been less burdensome but has even relaxed existing restrictions. id. for example, shortly after congress increased the pbgc premiums paid by defined benefit plan sponsors in 1977, the attractiveness of defined contribution plans increased by introducing 401(k) arrangements making employee contributions tax deductible for the first time. the premiums were raised again in 1986 and then again in 1990. id. 342. id. 343. because the net increase in defined contribution plans is far greater than the net decrease in defined benefit plans, it is reasonable to conclude that many workers, particularly those in small firms, who currently have defined contribution plans, previously would have had no plans at all rather than traditional defined benefit plans. paul yakoboski & celia silverman, baby boomers in retirement: what are their prospects?, in retirement in the 21st century: ready or not 13.33 (dallas l. salisbury & nora super jones eds., 1994). 344. the premium increase is relatively small if the amounts are adjusted for inflation. 345. see halperin, supra note 8, at 160-61. 346. see generally, pbgc study, consultants concur, plans will not vanish in future, vol. 17, no. 52 pens. & ben. rep. (bna) 2103 (dec. 24, 1990). 347. pbgc studies show that the shift of smaller plans toward defined contribution plans is offset by the slight shift of larger plans toward defined benefit plans. id. 684 florida tax review [vol. 4:9 employees.348 small businesses typically prefer defined contribution plans; while large, unionized, manufacturing companies traditionally favor defined benefit plans.349 since most of the recent growth in american industries has occurred in the service and high technology area, more defined contribution plans have been established.350 348. see id.; see also mark daniels, pensions in peril: single employer pension plan terminations in the context of corporate bankruptcies, 9 hofstra lab. l.j. 25, 27-29 (1991). 349. see canan, supra note 30, at 211-13. 350. see keville, supra note 4, at 541-42. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe *©2002 david a. brennen. **associate professor of law, mercer university school of law. b.b.a. florida atlantic university; j.d., ll.m., university of florida college of law. i would like to thank my colleagues at mercer and elsewhere who provided guidance to me on this paper, including alice abreu, alice baker, anthony baldwin, robert chapman, beverly moran, david oedel and virginia williams. i would also like to thank shelly all, denise gibson, wesley person and amber pride for valuable research assistance. thank you also to randall w. roth for his insights on the kamehameha schools. as always, thanks to my wife for her lasting support. earlier versions of this article were presented and discussed at the critical tax theory conference held at st. louis university school of law on april 21, 2001, and at the law, culture and humanities conference held at the university of pennsylvania school of law on march 8, 2002. research for this article was funded in part by a summer research grant awarded by mercer university school of law. florida tax review volume 5 2002 number 9 charities and the constitution: evaluating the role of constitutional principles in determining the scope of tax law�s public policy limitation for charities* david a. brennen** prologue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 781 i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 785 ii. tax law�s public policy limitation . . . . . . . . . . . . . . . . 788 a. the origins of the public policy limitation . . . . . . . . . 789 b. the consequences of violating the public policy limitation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 793 c. service statements that the constitution dictates when a public policy is sufficiently �established� . . . . . . . . . 796 1. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 796 2. the bishop estate schools . . . . . . . . . . . . . . . . 797 3. the service�s public policy findings with respect to the bishop estate schools . . . . . . . . . . . . . . . 799 iii. interpretational concerns with using constitutional law principles to define the scope of the public policy limitation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 803 a. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 803 b. equality: a sword against charitable status . . . . . . . . 805 1. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 805 780 florida tax review [vol5:9 2. equality principles concerning discrimination and minority preferences . . . . . . . . . . . . . . . . . . . . . 806 3. use of equality principles as a sword to invalidate affirmative action remedial efforts . . . . . . . . . . 808 4. problems with using constitutional equality principles as a sword against tax-exempt charities that engage in affirmative action . . . . . . . . . . . 809 a. differences between fourteenth amendment equality and fifteenth amendment equality . . . . . . . . . . . . . . . . . . . . . . . . 810 b. fourteenth amendment equality . . . . . 812 1) fluctuating standard of review 813 2) circuit spilt: race as a factor . 820 3) service lacks expertise on racial matters . . . . . . . . . . . . . . . . . . 822 4) conclusions . . . . . . . . . . . . . . 823 c. fifteenth amendment equality . . . . . . . 824 c. freedom of expressive association: a shield to protect charitable status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 830 1. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 830 2. freedom of expressive association . . . . . . . . . . 831 3. use of freedom of expressive association as a shield against violation of state anti-discrimination law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 832 4. problems with using freedom of expressive association as a shield to protect tax-exempt charities that discriminate . . . . . . . . . . . . . . . . 839 iv. theoretical concerns with using constitutional law principles to define the scope of the public policy limitation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 843 a. the public benefit subsidy theory . . . . . . . . . . . . . . . . 843 b. the inconsistency of reliance on constitutional principles with the public benefit subsidy theory . . . . . . . . . . . . . 845 v. conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 846 2002] charities and the constitution 781 1. see, e.g., johnson v. bd. of regents of univ. of ga., 263 f.3d 1234 (11th cir. 2001) (state of georgia could not use race as a factor in university admission decision); hopwood v. tex., 78 f.3d 932 (5th cir. 1996), cert. denied, 518 u.s. 1033 (1996) (state of texas cannot consider race as a factor when making law school admissions decisions); podberesky v. kirwan, 38 f.3d 147, 161-62 (4th cir. 1994), cert. denied, 514 u.s. 1128 (1995) (race-exclusive scholarship program offered by state university violates the equal protection clause). but see grutter v. bollinger, 2002 u.s. app. lexis 9126 (6th cir. 2002) (holding that the university of michigan school of law�s use of race as a factor in its admission decision does not violate the equal protection clause); smith v univ. of wash. law school, 233 f.3d 1188 (9th cir. 2000), cert denied, 532 u.s. 1051 (2001) (affirming district court conclusion that �race could be used as a factor in educational admissions decisions, even where that was not done for remedial purposes�). another example of this race-neutral application of the equal protection clause is a recent decision by a federal circuit court to expand application of strict scrutiny to government recruiting, not just hiring, of minorities. see broadcasters ass�n v. fed. communication comm�n, 236 f.3d 13 (d.c. cir. 2001). in broadcasters ass�n, the district of columbia circuit court invalidated an fcc rule that required outreach efforts in hiring by fcc licensees. this is in stark contrast to the prevailing view announced by the supreme court in regents of the univ. of cal. v. bakke, 438 u.s. 265 (1978), that race could be considered in such outreach efforts. when the supreme court invalidated the uc davis medical school�s affirmative action plan in 1978, it objected to the medical school�s use of race as a factor when making its admissions decisions. see discussion infra notes 123-27 and accompanying text. the court indicated that the medical school could achieve its goal of a diversified student body in a constitutionally permissible manner such as increasing efforts to attract minority applicants, so long as the actual admissions decision was not based on race. see bakke, 438 u.s. at 316 (discussing the acceptability of harvard college�s efforts to recruit �not only californians or louisianans but also blacks and chicanos and other minority students�). in fact, the supreme court has never invalidated government outreach efforts to attract minorities so long as the actual decision to grant the government benefit at issue (e.g., to admit a student or try to hire an employee.) was not based on race. however, in broadcasters ass�n, the district of columbia federal circuit signaled its intention to reverse this state of affairs when it invalidated an fcc rule that required outreach efforts prologue the judicial assault on constitutionally permissible social justice efforts including affirmative action for minorities and ending discrimination against homosexuals continues. through the rubric of �neutrality,� �equality� and �free expression,� courts today are using constitutional law principles to arrest efforts by state and federal governments either to (1) remedy present effects of historical discrimination or (2) end current discrimination. accordingly, various federal circuit courts have interpreted equal protection clause strict scrutiny as prohibiting government from considering race as a factor when making university admissions decisions or granting scholarships.1 thus, it is not 782 florida tax review [vol5:9 in hiring by fcc licensees. the rule violated the equal protection clause by putting pressure on fcc licensees to �focus recruiting efforts upon women and minorities in order to induce more applications from those groups.� see broadcasters ass�n, 236 f.3d at 19. this was held not narrowly tailored and violative of the equal protection clause. id. 2. in fact, the eleventh circuit in johnson recently refused to decide whether racial diversity is a �compelling� state interest. johnson, 263 f.3d at 1244. �we need not, and do not, resolve in this opinion whether student body diversity ever may be a compelling interest supporting a university�s consideration of race in its admissions process,� in part, because that court expects the united states supreme court to address this issue. id. at 1245 �[a] majority of the supreme court may eventually adopt justice powell�s opinion as binding precedent, and even now the opinion has persuasive value . . . .� id. however, the court in johnson did conclude that considering race in college admissions is not constitutionally �necessary.� id. at 1244-45. �even assuming that uga�s asserted interest in student body diversity is a compelling interest, uga�s 1999 freshman admissions policy is unconstitutional because uga has plainly failed to show that its policy is narrowly tailored to serve that interest.� id. 3. see, e.g., boy scouts of america v. dale, 530 u.s. 640 (2000). 4. private actors are not directly subject to the restrictions imposed by constitutional law provisions like the equal protection clause of the fourteenth amendment. see united states v. morrison, 529 u.s. 598, 620-27 (2000) (invalidating the violence against women act�s civil remedies holding that congress could not regulate private behavior pursuant to its fourteenth amendment section 5 enforcement powers); the civil rights cases, 109 u.s. 3 (1883) (invalidating civil rights act of inconceivable that the supreme court might soon rule that a state school�s consideration of race, in order to obtain a more diverse student body, violates equal protection clause strict scrutiny � either because racial diversity is not �compelling� or because considering race is not �necessary.�2 additionally, the supreme court invalidated, under the guise of free expression, state law attempts to lessen discrimination against homosexuals.3 though appealing on its face, this race-neutral and free expression trend in constitutional decision-making actually hinders efforts by government to achieve social justice through elimination of both current discrimination and lingering effects of past discrimination. for example, race-neutrality under the equal protection clause�s strict scrutiny test does not generally permit government to make proper distinctions between different types of racial preferences like invidious discrimination against racial minorities and benign affirmative action for such minorities. tax-exempt charities, because they generally are not government actors, are not ordinarily subject to the requirements of constitutional law principles like equal protection clause strict scrutiny. thus, even if the supreme court ultimately rules that the constitution prohibits state schools from considering race in their admissions decisions, private schools that have 501(c)(3) tax-exemption would not necessarily be prohibited from considering race in their admissions decisions.4 however, these 2002] charities and the constitution 783 1875 that provided for the full enjoyment of public accommodation because the fourteenth amendment only applied to state action and did not give congress the power to prohibited private behavior). but see katzenbach v. mcclung, 379 u.s. 294 (1964); heart of atlanta motel, inc. v. united states, 379 u.s. 241 (1964); united states v. lopez, 514 u.s. 549 (1995) (private discrimination that has a substantial effect on the economy can be regulated by congress through the commerce clause under art. 1, section 8, clause 2). however, private actors may be subject to any number of civil rights statutes that impose restrictions that are similar in many respects to those imposed by the constitution. 5. see, e.g., the civil rights cases, 109 u.s. 3, 11 (1883) (�it is state action of a particular character that is prohibited. individual invasion of individual rights is not the subject-matter of the [fourteenth] amendment.�); lugar v. edmondson oil co., inc., 457 u.s. 922, 937 (1982) (�our cases have accordingly insisted that the conduct allegedly causing that deprivation of a [constitutional] federal right be fairly attributable to the state.�); united states v. morrison, 529 u.s. 598, 621 (2000) (�[t]he fourteenth amendment, by its very terms, prohibits only state action.�). 6. see, e.g., evelyn brody, of sovereignty and subsidy: conceptualizing the charity tax exemption, 23 iowa j. corp. l. 585 (1998): the modern u.s. political economy is traditionally described in terms of three sectors: the public sector (government), the proprietary sector (business), and the nonprofit sector (private, but with public purposes). no one would argue that the nonprofit sector enjoys true co-sovereignty with the public sector, because the nonprofit sector lacks the compulsory powers that inhere in a sovereign. nevertheless, tax exemption carries with it a sense of leaving the nonprofit sector inviolate, and the very concept of sovereignty embodies the independent power to govern. indeed, a major trade association of charities takes a most sovereign-sounding name, calling itself �the independent sector.� id. at 588 (footnotes omitted). private schools, like all other charities, are subject to the public policy limitation which prohibits violations of �established public policy.� this article examines the question of how the service should rely on constitutional law principles when it applies the public policy limitation to particular taxexempt charities such as private schools. this article expands the discussion of whether tax-exempt charities, for constitutional law purposes, should be treated as government actors, as private actors or as something in between. while government actors are subject to constitutional law restrictions concerning discrimination and free speech, private non-government actors are not generally subject to these same restrictions.5 although tax-exempt charities are often thought of as sovereigns and, thus, government-like,6 the fact remains that charities are private entities 784 florida tax review [vol5:9 7. see bob jones univ. v. united states, 461 u.s. 574, 587-88 (1983). �[i]n enacting . . . § 501(c)(3), congress sought to provide tax benefits to charitable organizations, to encourage the development of private institutions that serve a useful public purpose or supplement or take the place of public institutions of the same kind.� id. 8. but see linda sugin, tax expenditure analysis and constitutional decisions, 50 hastings l.j. 407, 457-59 (1999) (outlining an approach under which the equal protection clause could be applied against the government for allowing tax deductions for contributions to charities that discriminate based on race). professor sugin suggests that the service�s knowing grant of tax-exempt charitable status to organizations that discriminate based on race, like bob jones university, might violate the equal protection clause. see id. at 452-53 (asserting that application of § 501(c)(3) �to authorize exemptions for racially discriminatory private schools, such as bob jones university, could potentially violate equal protection� because of the view that �the government actively approves of a private party�s discrimination by affirmatively granting a discriminating party an exemption and placing that organization on the official and public list of approved organizations�). 9. though private in a constitutional law sense, tax exempt charities have many public qualities. but see discussion supra note 8. for instance, a charity must, in accordance with irc § 501(c)(3), provide a benefit to the public and avoid providing either private benefits or private inurement to members, insiders and others. irc § 501(c)(3). additionally, a charity is required to make public much of its typically private corporate (or trust) information concerning officers, directors, finances and operations. see generally irc § 6104 (providing for public inspection of a variety of information relative to tax-exempt charities, such as applications for tax exemption including any papers submitted in support of such application and any letter or other document issued by the service with respect to such application and annual information returns). 10. see bob jones univ., 461 u.s. at 586. �such an examination reveals unmistakable evidence that, underlying all relevant parts of the code, is the intent that entitlement to tax exemption depends on meeting certain common-law standards of charity � namely, that an institution seeking tax-exempt status must serve a public purpose and not be contrary to established public policy.� id. created to serve public purposes.7 as private entities, charities � like all other private entities � are not necessarily bound by constitutional law principles.8 still, the many �public� aspects of charities seem to dictate allegiance to some higher principle than merely being permitted to do what every other private entity may do.9 hence, the supreme court ruled that charities may not violate a principle called �established public policy.�10 but what does this mean? surely it does not mean that charities, because of the public policy limitation, are somehow transformed into government actors limited by constitutional law 2002] charities and the constitution 785 11. indeed, while for-profit non-charitable entities may engage in any lawful purpose and not-for-profit non-charitable entities may engage in non-charitable activities, charities are uniquely restricted to engaging mostly charitable functions. see irc § 501(c)(3). 12. see rice v. cayetano, 528 u.s. 495 (2000). 13. see boy scouts of america v. dale, 530 u.s. 640 (2000). 14. see bob jones univ., 461 u.s. at 595-96. �racially discriminatory educational institutions cannot be viewed as conferring a public benefit within the �charitable� concept discussed earlier, or within the congressional intent underlying § 170 and § 501(c)(3).� id. 15. see david a. brennen, the power of the treasury: racial discrimination, public policy and �charity� in contemporary society, 33 u.c. davis l. rev. 389, 403 (2000) (noting that court in bob jones university based its conclusions about the existence of a national public policy against racial discrimination on �such notable events as brown v. bd. of education, congress�s passage of civil rights laws in the principles. nor does it mean that charities are completely �free� of societal responsibility in the same sense that other private entities are �free.�11 thus, charities exist in an undefined space somewhere between government and private in which constitutional law principles do not directly apply, but something constitutional-like (i.e., the public policy limitation) surely does apply. the question is: how is it applied? i. introduction recently the united states supreme court issued two opinions that concern the constitutionality of racial preferences and sexual orientation discrimination. in the first opinion, rice v. cayetano, the court held that the fifteenth amendment prevents hawaii from using racial preferences for native hawaiians to determine the right to vote for trustees of a state fund benefitting native hawaiians.12 in the second opinion, boy scouts of america v. dale, the court held that the first amendment permits the boy scouts to exclude homosexuals from adult membership in its charitable organization, even though a state statute prohibits such discrimination.13 ostensibly, these recent constitutional law cases have nothing to do with tax law; however, because of the court�s holding in bob jones university v. united states, these decisions may have everything to do with tax law as it relates to the public policy limitation. in bob jones university, the court, relying on the statutory-based concept of �established public policy,� upheld the service�s revocation of the tax-exempt status of a private school that discriminated against black people.14 in concluding that there was an �established public policy� against such discrimination, the court analyzed decisions by various federal authorities which concluded that discrimination against black people in public education is unconstitutional and against public policy.15 emboldened by the court�s 786 florida tax review [vol5:9 1960s and 1970s, and various executive orders issued between the 1940s and early 1980s�). 16. see national office technical advice memorandum from the irs to the kamehameha schools/bernice pauahi bishop estate (feb. 4, 1999) (on file with the florida tax review) [hereinafter �bishop estate tam�]. the service performed a similar action in a 1977 private letter ruling issued to a tax-exempt scholarship fund. see priv. ltr. rul. 7744007 (july 28, 1977) (relying on constitutional distinction between concepts of �inherently suspect� and �rationality,� service concludes that, although public policy requirement applied to foundation generally, requirement does not extend to gender-based exclusions). 17. see bishop estate tam, supra note. 18. see discussion infra notes 77-86 and accompanying text. 19. see bishop estate tam, supra note. 20. see, e.g., sugin, supra note, at 473. professor sugin writes: the anti-discrimination approach in equal protection analysis parallels the . . . approach in traditional tax policy. they are both analysis in bob jones university, the service recently intimated that it will rely significantly on constitutional law principles to ascertain �established public policy� on matters involving racial preferences by tax-exempt charities.16 in an administrative decision issued in 1999 to a tax-exempt charitable trust that operates a grade school in hawaii, the service approved the trust�s process of using racial preferences for native hawaiians when choosing beneficiaries.17 after referring to bob jones university and several cases concerning permissible racial preferences under constitutional law, the service concludes in the administrative decision that the trust�s preference for hawaiians does not violate any �established public policy.�18 however, the service also indicates that its decision about the trust should be re-examined after the supreme court�s ruling in rice v. cayetano, a then-pending constitutional law voting rights case concerning racial preferences for hawaiians.19 notably, the entity making the racial preference in rice was a governmental entity � the state of hawaii�s office of hawaiian affairs � and not a non-governmental tax-exempt charity. the apparent implication of the service�s re-examination statement in its administrative decision is that the service makes its public policy determinations about tax-exempt charities based on constitutional law principles that concern the permissible bounds of government action. should private charities and government actors be subject to the same legal restrictions in regard to preferences based on matters like race and sexual orientation? that is, should constitutional law principles that limit government action also necessarily limit, in the same way, the service�s ability to determine �established public policy� with respect to activities of non-governmental taxexempt charities?20 this article contends that constitutional law doctrine 2002] charities and the constitution 787 concerned with the government treating like-situated people alike, without inquiring into the historical, social and institutional questions that surround what it means to be alike. while formal justice in this sense may be all that the constitution requires for equal protection. . . , tax policy�s aspirations can be more expansive. tax policy can be about defining and achieving substantive equality, even if it is beyond what the constitution requires, and even though it requires explicitly linking tax policy to ideas that are outside its traditional borders. id. 21. see brennen, the power of the treasury, supra note , at 431-445 (arguing that public policy with respect to affirmative action, for example, should be based upon various legal sources, including non-constitutional sources at both state and federal levels). see also francis r. hill and barbara l. kirschten, federal and state taxation of exempt organizations, operational issues: public policy requirement, ¶2.03[6][c] (1998) (explaining that service�s reliance on constitutional law standards when making public policy decisions is �flaw[ed]�). cannot, and indeed should not, so limit or dictate the service�s regulatory activities with respect to private charities. true, no government agency can be in the business of holding itself to be above and beyond constitutional strictures and the court that interprets that constitution. however, the public policy doctrine is a statutory principle applicable to private charities, not a constitutional one. accordingly, it is inappropriate for the service to make its public policy determinations about tax-exempt charities based almost exclusively on constitutional law principles that concern limits on government actors.21 part ii briefly recounts the origins and effects of tax law�s public policy limitation, which requires that tax-exempt charities not violate �established public policy.� part ii also examines those statements by the service indicating its view that constitutional law decisions should dictate when a public policy is sufficiently �established� for purposes of the public policy limitation. part iii begins a discussion of constitutional law by providing an overview of the supreme court cases concerning constitutional equality as a general limitation on the government�s use of racial preferences. part iii also discusses the extent to which private groups may use the constitutional right of freedom of expressive association as a shield to escape government restrictions imposed by state anti-discrimination laws. finally, part iii demonstrates how these various constitutional law doctrines might impact the service�s ability to enforce the public policy limitation against tax-exempt charities. part iv argues that the service�s primary reliance on constitutional law principles when making its public policy determinations is inappropriate for theoretical reasons as well. reliance on constitutional law principles is inconsistent with the public benefit subsidy theory, which holds, in part, that tax-exempt charities are private actors intended to provide goods and services that government either 788 florida tax review [vol5:9 22. see brennen, the power of the treasury, supra note ; david a. brennen, tax expenditures, social justice and civil rights: expanding the scope of civil rights laws to apply to private charities, 2001 b.y.u. l. rev. 167 (2001), for background discussion of this issue. 23. see, e.g., calhoun academy v. commissioner, 94 t.c. 284, 305 (1990). after a comprehensive review of the administrative record, we find that petitioner has not carried its burden to show that it operates in good faith in accordance with a racially nondiscriminatory policy as to students. . . . [a]ccordingly, petitioner has not shown that [the service] was erroneous in denying petitioner tax-exempt status under § 501(c)(3). id. see also va. educ. fund v. commissioner, 85 t.c. 753 (1985) (discussing acceptable standards of proof for a charity to show that it has not violated nondiscrimination requirements). cannot or will not, often for constitutional or political reasons, provide. thus, subjecting charities to the same standards as government actors necessarily means that charities will be less likely to accomplish their intended tasks. this article concludes that the service should await guidance from congress on the issue of how constitutional law principles should affect tax law decisions about the charitable tax-exemption authorized by section 501(c)(3) of the internal revenue code. alternatively, the service could engage in a type of analysis that considers a variety of sources � constitutional, nonconstitutional, federal and non-federal � in deciding if a particular charity is in violation of �established public policy.� thus, this article examines the relationship between constitutional law and tax law in an effort to continue the discussion of how federal tax authorities should respond when a tax-exempt charity engages in activities that would be unconstitutional if done by a government actor.22 additionally, this article examines the matter of whether a private charity should be permitted to use the constitution as a shield in tax cases, like the boy scouts did in a non-tax case, to prevent revocation, on public policy grounds, of its 501(c)(3) tax exemption. ii. tax law�s public policy limitation in 1983, the united states supreme court announced in bob jones university v. united states that the service has authority to make certain tax law decisions on public policy grounds. for example, if the service determines that a charity is discriminating against black people it can terminate that charity�s tax-exempt status because the charity is violating an �established public policy� against invidious racial discrimination.23 this part demonstrates that the effect on a charity�s continued existence of the service�s power to make public policy decisions is real and, often, substantial. 2002] charities and the constitution 789 24. 461 u.s. 574 (1983). see generally brennen, the power of the treasury, supra note, at 400-410 (explaining origins of tax law�s public policy limitation). 25. see bob jones univ., 461 u.s. at 605. 26. see id. at 580-81. �to effectuate these views, negroes were completely excluded until 1971. from 1971 to may 1975, the university accepted no applications from unmarried negroes, but did accept applications from negroes married within their race.� id. 27. see id. at 591. �a corollary to the public benefit principle is the requirement, long recognized in the law of trusts, that the purpose of a charitable trust may not be illegal or violate established public policy.� id. 28. see id. at 593-95. �over the past quarter of a century, every pronouncement of this court and myriad acts of congress and executive orders attest a firm national policy to prohibit racial segregation and discrimination in public education.� id. 29. see bob jones univ., 461 u.s. at 592-93 (citing plessy v. ferguson, 163 u.s. 537 (1896)). 30. see, e.g., mccabe v. atchison, topeka & santa fe railway co., 235 u.s. 151, 161-162 (1914). �it is the individual who is entitled to the equal protection of the laws, and if he is denied by a common carrier, acting in the matter under the authority a. the origins of the public policy limitation the public policy limitation emanated from the court�s analysis in bob jones university v. united states.24 in bob jones university, the supreme court held that the service properly revoked the tax-exempt charitable status of a private university that discriminated against black people in its admissions process.25 bob jones university discriminated against black people by denying them admission to the university and, later, by denying them admission to the university if they were engaged in an interracial romantic relationship.26 in sustaining the service�s revocation of bob jones university�s tax-exempt status, the supreme court reasoned that it is inconsistent with charitable trust law principles for an entity that provides a �public benefit� to also engage in behavior that violates �established public policy.�27 in explaining the reasoning for its decision that the public policy denouncing discrimination against black people was �established,� the court in bob jones university referred to judicial, legislative and executive statements of anti-discrimination law.28 though some of these statements were constitutional in nature, some were not. regarding judicial statements of the public policy against invidious racial discrimination, the court notes that prior to 1954, public education was racially segregated under authority of the �separate but equal� constitutional principle of plessy v. ferguson.29 the �separate but equal� principle provided that racially segregated educational facilities are permissible under the constitution if the separate facilities are substantially equal to each other.30 the 790 florida tax review [vol5:9 of a state law, a facility or convenience in the course of his journey which under substantially the same circumstances is furnished to another traveler, he may properly complain that his constitutional privilege has been invaded.� 31. see bob jones univ., 461 u.s. at 592-93. �prior to 1954, public education in many places still was conducted under the pall of plessy v. ferguson, 163 u.s. 537 (1896) � this court�s decision in brown v. bd. of education, 347 u.s. 483 (1954), signaled an end to that era.� id. 32. 347 u.s. 483 (1954). 33. see bob jones univ., 461 u.s. at 593. 34. see, e.g., cooper v. aaron, 358 u.s. 1, 19 (1958). �the right of a student not to be segregated on racial grounds in schools . . . is indeed so fundamental and pervasive that it is embraced in the concept of due process of law.� id. 35. bob jones univ., 461 u.s. at 593-94 (quoting norwood v. harrison, 413 u.s. 455, 468-69 (1973)). 36. see, e.g., titles iv and vi of the civil rights act of 1964, 42 u.s.c. §§ 2000c, 2000c-6, 2000d (1994) (providing that members of class of persons similarly situated are entitled to equal protection of laws and may not be denied admission to or prohibited from continuing attendance at public college by reason of race, color, religion, sex or national origin; prohibition agains exclusion from participation in, denial of benefits of, and discrimination under federally assisted programs on ground of race, color, or national origin); voting rights act of 1965, 42 u.s.c. § 1971 (1994) (stating that race, color, or previous condition not permitted to affect right to vote); title viii of the civil rights act of 1968, 42 u.s.c. § 3601 (1994) (providing fair housing within constitutional limitations). court in bob jones university explains that, beginning in 1954, it began to eradicate the �separate but equal� doctrine from constitutional law.31 that year, the court declared in brown v. board of education32 that the �separate but equal� doctrine was an unconstitutional violation of the equal protection clause of the fourteenth amendment.33 later, in 1958, the court explained in cooper v. aaron that racial segregation laws also violate constitutional due process principles.34 the bob jones university court did not end its analysis with references to these constitutional judicial statements of the antidiscrimination public policy. indeed, the court remarks that the nondiscrimination policy was also reflected in laws applicable to private schools, noting that the �legitimate educational function [of private schools] cannot be isolated from [racially] discriminatory practices.�35 in its analysis of legislative statements about the public policy against racial discrimination, the court in bob jones university did not directly rely on any constitutional law principles. indeed, the bob jones university court highlights the civil rights act of 1964�s prohibition of racial discrimination in education, voting and housing as a premier legislative statement of the federal government�s anti-discrimination public policy.36 these civil rights statutes impose limitations on private non-governmental actors that often 2002] charities and the constitution 791 37. regents of the univ. of cal. v. bakke, 438 u.s. 265, 287 (1978). �in view of the clear legislative intent, title vi must be held to proscribe only those racial classifications that would violate the equal protection clause or the fifth amendment.� id. 38. rodney a. smolla, federal civil rights act, § 1.01[2] (3d ed., 2000). 39. see, e.g., the education of the handicapped act, 20 u.s.c. §§ 1401-20; the american with disabilities act of 1990, 42 u.s.c. §§ 12101-213; the age discrimination in employment act, 29 u.s.c. § 621. 40. smolla, supra note, at § 1.01[2]. 41. see, e.g., title vi of the civil rights act of 1964, 42 u.s.c. § 2000d (providing remedies for discrimination based on race on showing of discriminatory impact); guardians ass�n v. civil serv. comm�n, 463 u.s. 582, 584 (1983) (indicating that five justices of supreme court interpret title vi as not requiring proof of discriminatory intent, as is case with the equal protection clause); title vii of the civil rights act of 1964, 42 u.s.c. § 2000e (providing remedies for employment discrimination on a showing of disparate impact); compare griggs v. duke power co., 401 u.s. 424, 431 (1971) (concluding that title vii outlaws employment �practices that are fair in form, but discriminatory in operation�). with mccleskey v. kemp, 481 u.s. 279 (1987) (requiring proof of �discriminatory intent� for showing of equal protection violation by governmental actor); washington v. davis, 426 u.s. 229, 238-48 (1976) (the equal protection clause prohibits only intentional discrimination). the requirement of proof of discriminatory impact only, and not discriminatory intent, for civil rights statutory purposes is limited to situations in which the requested relief is declaratory or injunctive in nature, not compensatory. see smolla, supra note, at § 8.02[3]; guardians ass�n, 463 u.s. at 584, 597-606 (white, j.) (concluding that �unless discriminatory intent is shown, declaratory and limited injunctive relief should be the only available private remedies for title vi violations�). 42. see brennen, tax expenditures, supra note 22, at 181-182. professor brennen writes: parallel constitutional limitations imposed on government actors.37 however, civil rights statutory limits on private actors are not necessarily the same as constitutional limits on government. civil rights statutes may impose greater or lesser limits on private actors than the constitution imposes on government actors. for example, certain civil rights statutes extend constitutional-like protections to �forms of discrimination not covered in any meaningful way by the constitution,�38 such as discrimination based on age or disability.39 also, civil rights statutes may broaden the �substantive principles governing discrimination,�40 such as by allowing claims to be based upon disparate impact, rather than proof of discriminatory intent.41 finally, civil rights statutes permit private actors to be more proactive than government in advancing social justice objectives via methods like race based affirmative action.42 792 florida tax review [vol5:9 [p]rivate employers have long enjoyed greater freedom under title vii of the civil rights act of 1964, [sic] than government employers under the constitution to engage in aggressive voluntary affirmative action programs aimed at recruiting, hiring and promoting race and gender minorities. when properly structured, an employer�s voluntary affirmative action plan will not be invalidated under title vii so long as the plan is consistent with congress� goal of eliminating discrimination against traditional minorities. however, if a government employer were to implement a similar voluntary affirmative action plan (such as one based on race) and that plan were evaluated under the constitution, a court would more likely invalidate the plan as unconstitutional. id. (citations omitted). 43. see bob jones univ. v. united states, 461 u.s. 574, 594 (1983). �several years before this court�s decision in brown v. bd. of education, supra, president truman issued executive orders prohibiting racial discrimination in federal employment decisions, exec. order no. 9980, 3 cfr 720 (1943-1948 comp.), and in classifications for the selective service, exec. order no. 9988, 3 cfr 726, 729 (1943-1948 comp.)� id. 44. id. at 594-95 (quoting exec. order no. 11,063, 3 c.f.r. 652 (1959-1963)) (prohibiting racial discrimination in housing). 45. see, e.g., the civil rights cases, 109 u.s. 3, 11 (1883). �it is state action of a particular character that is prohibited. individual invasion of individual rights is not the subject-matter of the [fourteenth] amendment.� id. regarding executive statements of the government�s antidiscrimination public policy, the court in bob jones university referenced executive orders since president truman that prohibited racial discrimination in federal employment decisions and in classifications for the selective service.43 the court also highlighted president eisenhower�s use in 1957 of military force to ensure compliance with federal school desegregation requirements and president kennedy�s statement in 1962 that providing federal assistance for racially discriminatory housing facilities �is . . . inconsistent with . . . public policy.�44 these executive statements of anti-discrimination public policy reflect enforcement of the constitutional principle that governmental discrimination based on race is highly suspect, especially in areas such as education, housing and employment. however, while these statements are premised on constitutional law principles like those contained in the equal protection clause, they are not synonymous with these constitutional provisions which only apply to government actors.45 indeed, these statements were made as a result of the political will of various presidents and, even though constitutionally permitted, were not constitutionally required. in essence, the court�s analysis in bob jones university demonstrates that �established public policy� is not synonymous with that which is 2002] charities and the constitution 793 46. see discussion infra part iii. 47. reportedly, bob jones university is now trying to change its image as a �racist� institution. see �bob jones university seeks black students in bid to improve its image,� jet (march 4, 2002). �in trying to eradicate its racist image, bob jones university, the fundamentalist christian college in greenville, sc, that banned interracial dating until two years ago, recently began to recruit minorities.� id. 48. irc § 501(a). 49. irc § 170. 50. see irc §§ 511-514 (discussing income tax imposed on unrelated business taxable income of organizations otherwise exempt from federal income tax by § 501(a)). 51. irc § 501(a) provides: �an organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.� constitutional. thus, while constitutional law principles may be relevant in making determinations about when a particular public policy is clearly established, such principles alone do not dictate public policy. further analysis of constitutional law doctrine will show how inappropriate it is for the service to rely almost exclusively on constitutional law principles when making specific public policy determinations.46 but first, the remaining sections of this part explain the effect on tax-exempt charities of losing that exemption and the nature of the service�s statements that a public policy violation is virtually synonymous with a constitutional law violation. b. the consequences of violating the public policy limitation as the bob jones university case demonstrates, the necessary consequence of a finding that a tax-exempt charity violates �established public policy� is that the charity loses its 501(c)(3) tax-exemption. while the service�s revocation of bob jones university�s tax-exempt status did not result in the end of that school,47 the denial or revocation of tax-exempt charitable status may be, and often is, devastating to the affected organization. tax-exempt charitable status often opens the door for many organizations to thrive at doing whatever it is they are purposed to do. thus, when this prized status is lost or denied, the affected organization may be forced to cease its public benefit activities. among the many advantages of tax-exempt charitable status that are lost upon revocation is entitlement to a variety of federal tax benefits. the most visible of these federal tax benefits are the federal income tax exemption48 and the right to receive tax-deductible contributions from the public.49 the advantage of the federal income tax exemption is readily apparent: with certain exceptions not relevant here,50 tax-exempt charities do not pay federal income taxes on income earned during the year.51 the advantage gained by being able to receive tax-deductible contributions is not as direct as the federal income tax exemption, but may be just as vital, if not more vital. because contributors are 794 florida tax review [vol5:9 52. see irc § 170 (authorizing an income tax deduction for charitable contributions). even though congress authorizes a charitable deduction in § 170, not all such deductions are in fact deductible. in order to actually receive the full benefit of the charitable contribution deduction, one must itemize deductions and not be adversely impacted by the § 68 overall limitation on itemized deductions. see irc §§ 63 (defining itemized deductions); 68 (imposing overall limitation on itemized deductions). 53. actually, the cost to the contributor of a one dollar contribution to a tax-exempt charity is one dollar minus the amount of the the tax deduction available to that contributor. thus, if the contributor has a marginal tax rate of 30%, the cost of a one dollar contribution to a tax-exempt charity is $0.70, computed as follows: $1.00 contribution ($1.00 x 0.30) = $1.00$0.30 = $0.70. 54. there are a number of other federal tax benefits associated with tax-exempt charitable status. for example, qualifying charities are exempt from the requirement to pay federal unemployment taxes. irc § 3306(c)(8). under the present system, charities only have to pay the equivalent of the former employee�s unemployment compensation. bazil facchina, evan a. showell & jan e. stone, privileges & exemptions enjoyed by nonprofit organizations, 28 u.s.f. l. rev. 85, 102 (1993). also, tax-exempt charities have access to tax-exempt government bonds as provided for under § 145(a)(1), which allows state and local governments to issue bonds paying interest, exempt from federal income tax, to organizations described in§ 501(c)(3). irc § 145(a)(1). however, 95 percent of the net proceeds from these bonds must be used by the charity and all property purchased with the bond proceeds has to be owned exclusively by the charity. irc § 145. in addition to the many federal tax benefits that are lost as a result of a charity losing its tax-exempt status, one very important non-tax federal benefit vanishes along with the tax-exemption: preferred postal rates. the current postal regulations give religious, educational, scientific, philanthropic, agricultural, labor, veterans�, and fraternal organizations second and third class nonprofit rates. facchina, supra, at 112. the only requirement is that the nonprofit mailers must be organized and operated for the primary purpose of the organization. id. at 113. permitted to take a deduction for federal income tax or estate tax purposes for contributions made to charities during the year, individuals and corporations are arguably more willing to contribute money to a tax-exempt charity than to an organization that is not a recognized charity.52 eligibility to receive these taxdeductible contributions clearly gives charities an advantage over non-charities when it comes to fund-raising because it costs contributors less than one dollar to give one dollar to charity.53 thus, in terms of maximizing financial profit and in terms of raising funds through charitable contributions, charities clearly have an advantage over non-charities.54 in addition to the many federal benefits of tax-exempt charitable status, state and local governments also offer benefits to charities that often hinge on the charity maintaining its tax-exempt charitable status at the federal level. for example, many states exempt tax-exempt charities from the requirement to pay 2002] charities and the constitution 795 55. for example, under the georgia code a 501(c)(3) organization is exempt from state income taxes �in the same manner and to the same extent as for federal purposes.� ga. code ann. § 48-7-25 (2001).. 56. see, e.g., fla. stat. ann. § 212.08(7)(p) (2001). section 212.08(7)(p) provides: (p) section 501(c)(3) organizations.�also exempt from the tax imposed by this chapter are sales or leases to organizations determined by the internal revenue service to be currently exempt from federal income tax pursuant to s. 501(c)(3) of the internal revenue code of 1986, as amended, when such leases or purchases are used in carrying on their customary nonprofit activities. id. 57. facchina, et al., supra note 54, at 103-04. 58. see, e.g., tex. tax code § 11.18 (1992). section 11.18 provides: (a) an organization that qualifies as a charitable organization as provided by this section is entitled to an exemption from taxation of: (1) the buildings and tangible personal property that: (a) are owned by the charitable organization; and (b) except as permitted by subsection (b), are used exclusively by qualified charitable organizations; and (2) the real property owned by the charitable organization consisting of: (a) an incomplete improvement that: (i) is under active construction or other physical preparation; and (ii) is designed and intended to be used exclusively by qualified charitable organizations; and (b) the land on which the incomplete improvement is located that will be reasonably necessary for the use of the improvement by qualified charitable organizations. id. state and local income taxes.55 a number of states also exempt charities from both collecting and paying sales or use taxes on goods and services.56 sales and use tax exemptions for charities are usually limited to transactions related to the charity�s exempt purposes.57 finally, many states exempt charities from the requirement to pay real property taxes.58 this brief listing of benefits of tax-exempt charitable status provides a rather clear picture of the enormity of the financial impact of a charity losing its tax exemption. thus, while some charities, like bob jones university, may continue to operate after loss of exemption, many other charities would likely have to cease operations altogether without these benefits. therefore, any mechanism, like the service�s authority to revoke a charity�s tax-exempt status 796 florida tax review [vol5:9 59. see bishop estate tam, supra note 16. 60. see, e.g., bishop estate tam, supra note 16 (service relying �upon several supreme court opinions addressing the constitutional challenges to governmental actions under the equal protection clauses�); calhoun academy v. commissioner, 94 t.c. 284 (1990) (service relying on a supreme court position that private schools which discriminate on the basis of race violate public policy). 61. for a discussion of various issues, both tax and non-tax, concerning the bishop estate, see generally symposium issue on the bishop estate controversy, 21 u. haw. l. rev. 353 (1999). see also john tehranian, a new segregation? race, rice v. cayetano, and the constitutionality of hawaiian-only education and the kemehameha schools, 23 u. haw. l. rev. 109 (2000); judge robert mahealani m. seto and lynn marie kohm, of princesses, charities, trustees, and fairytales: a lesson of the simple wishes of princess bernice pauahi bishop, 21 u. haw. l. rev. 393 (1999); evelyn brody, a taxing time for the bishop estate: what is the i.r.s. role in charity governance?, 21 u. haw. l. rev. 537 (1999). 62. see bishop estate tam, supra note 16. if it violates �established public policy,� that enables the service to effectively end a charity�s operations is certainly worth close examination. c. service statements that the constitution dictates when a public policy is sufficiently �established� 1. introduction the service has issued various decisions concerning the public policy limitation and its applicability in particular contexts. for example, the service has held that tax-exempt charities that favor indians over non-indians do not violate �established public policy� because of the history of special treatment of native americans by the federal government.59 however, in many of these situations involving the service�s determinations about particular public policies, the service has relied almost exclusively on the supreme court�s positionregarding certain constitutional issues that relate directly to the public policy at issue.60 a recent example of this strong reliance by the service on the court�sconstitutional jurisprudence to determine �established public policy� involves the service�s administrative decisions concerning the bishop estate.61 the service issued at least two technical advice memorandums �tam�s� to the bishop estate on the issue of that trust�s denial of admission of non-hawaiians to the trust�s grade school. the first tam, issued in 1975, concluded that bishop estate�s policy of restricting admissions to children of hawaiian ancestry was �consistent with federal policy� and, therefore, charitable.62 the second tam, issued 24 years later in 1999, similarly concluded that �the estate�s admission policy is consistent with the requirements for recognition of exemption as an organization described in 2002] charities and the constitution 797 63. see id. 64. see id. 65. see will of bernice pauahi bishop, thirteenth article, at http://www.ksbe.edu/endowment/bpbishop/will/will.html (jan. 15, 2002). 66. id. the entire residuary clause of the will provided: i give, devise and bequeath all the rest, residue and remainder of my estate real and personal, wherever situated unto the trustees below named, their heirs and assigns forever, to hold upon the following trusts, namely: to erect and maintain in the hawaiian islands two schools, each for boarding and day scholars, one for boys and one for girls, to be known as, and called the kamehameha schools. i direct my trustees to expend such amount as they may deem best, not to exceed however one-half of the funds which may come into their hands, in the purchase of suitable premises, the erection of school buildings and in furnishing the same with necessary and appropriate fixtures, furniture and apparatus. id. 67. in 1883, a seal was affixed to bernice bishop�s will, which formally established the bishop estate to carry out bernice bishop�s desire to build a school for boys and a school for girls. the school for boys opened in 1887 and the school for girls opened in 1894. see id. 68. see bishop estate tam, supra note 16. 69. http://www.ksbe.edu/campus/campus.html (feb. 29, 2000). section 501(c)(3) of the code.�63 however, in this second tam the service suggested that the supreme court�s decision in a then-pending constitutional law case, rice v. cayetano, might cause the service to re-think its position on the acceptability of the bishop estate�s admission practice.64 2. the bishop estate schools the bishop estate is a tax-exempt charitable trust created by the will of bernice pauahi bishop, last direct descendant of ali`i nui kamehameha i.65 the purpose of the trust is �to erect and maintain in the hawaiian islands two schools, each for boarding and day scholars, one for boys and one for girls, to be known as, and called the kamehameha schools.�66 the single-sex schools referenced in the will were formally created in 1883,67 have been continuously maintained since that time and are now combined into one co-educational school enrolling both boys and girls.68 the trustees of the bishop estate believe that bernice bishop created the schools out of her deep concern for �the decline of the hawaiian people following western contact.�69 the trustees assert that bernice bishop �believed that a sound, formal education was the key to 798 florida tax review [vol5:9 70. id. 71. bishop estate tam, supra note 16. 72. see id. �the schools process between 5,000 and 6,000 applications per year. because there are more applicants than available seats at the school, competition for entrance is keen . . . .� id. 73. see id. �the selection process includes a �first screening� based on development skills and an �observation phase.�� id. 74. see id. �for the 1997/98 school year 78.3 percent of the students were of caucasian ancestry, 73.7 percent chinese ancestry, 30.9 percent filipino ancestry, 27.7 percent japanese ancestry, and 23.4 percent were of other ancestries . . . [including] african american . . . .� id. 75. see id. �hawaiian children who are orphaned and/or living in indigent circumstances are given special consideration for kindergarten.� id. 76. it is not at all clear whether the bishop estate�s hawaiian lineage requirement is the same type of racial preference that was contemplated by the supreme court when it concluded that discrimination against black people violates established public policy. see bob jones univ. v. united states, 461 u.s. 574, 595 (1983). �whatever may be the rationale for such private schools� policies, and however sincere the rationale may be, racial discrimination in education is contrary to public policy.� id. first, hawaiian people are not black people and do not share a unique characteristic of black people in that they do not have a history of being taken away from their homeland and forced into slavery in a foreign land. second, ancestry is not necessarily the same as race. thus, the bishop estate�s requirement that one have hawaiian ancestry in order to be admitted to the kamehameha schools, could be something other than a preference based on race such as a political classification. see robert j. deichert, note: rice v. cayetano: the fifteenth amendment at a crossroads, 32 conn. l. rev. 1075, 1098 survival [of the hawaiian people].�70 accordingly, the school operated by the bishop estate requires that all admitted students have �at least one hawaiian ancestor.�71 the hawaiian lineage requirement is only one of many factors considered by the bishop estate when making admissions decisions for the kamehameha schools. indeed, the admissions process is quite competitive. because each school receives more applications per year from potential students than it can accommodate, it has to turn away many persons who are interested in attending.72 in order to decide who is admitted and who is not, each school has special admissions screening criteria.73 even with these special criteria, however, the admitted students have a variety of racial and ethnic backgrounds.74 further, despite the competition for admission into the kamehameha schools, the schools are able to reserve space for orphans and indigent children.75 however, the orphans and indigents, like all other students, must have at least one hawaiian ancestor. this aspect of the kamehameha schools (i.e., limiting admission to students with some hawaiian lineage) prompted the service to consider whether the bishop estate�s admissions policy violated an established public policy against racial discrimination.76 2002] charities and the constitution 799 (2000). �this relationship, and the special treatment afforded native hawaiians, is similar to that between the united states government and native americans and therefore should be looked upon as a political rather than racial classification, or at least be given a greater level of deference.� id. finally, even if the preference for persons with hawaiian lineage is a racial classification for some purposes, it may not necessarily be a racial classification for all purposes. for example, the hawaiian lineage requirement might be a racial classification for fifteenth amendment purposes, but might not be a racial classification for fourteenth amendment purposes. also, the hawaiian lineage requirement might be a racial classification for constitutional law purposes, but not for purposes of the public policy doctrine. thus, the service�s conclusion in the bishop estate tam that the bishop estate�s preference for persons having hawaiian lineage is a racial preference, is not necessarily a valid one. nonetheless, this article assumes that such a conclusion is valid, but only for purposes of demonstrating the inappropriateness of the service�s reliance on constitutional law doctrine to determine when an �established public policy� is violated. 77. see discussion infra notes 123-66 and accompanying text. 78. see bishop estate tam, supra note 16. 79. id. 80. see rice v. cayetano, 146 f.3d 1075 (9th cir. 1998), cert. granted, 526 u.s. 1016 (1999). 81. see rice v. cayetano, 528 u.s. 495 (2000). it remains to be seen whether the bishop estate will, pursuant to the service�s advice, request a private letter ruling in light of the supreme court�s decision in rice. see id. see also milton cerny, federal public policy: the irs historic challenge to racially discriminatory private schools, american bar association section of taxation, 2000 midyear meeting materials, january 21, 2000, available in lexis, aba library, aba tax file (stating that �[i]n 3. the service�s public policy findings with respect to the bishop estate schools the service issued the bishop estate tam in 1999, shortly after the supreme court decided a series of cases concerning the constitutional permissibility of race-based affirmative action.77 in the bishop estate tam, the service advised the bishop estate that its policy of only admitting children with hawaiian ancestry to the trust�s schools is consistent with established public policy.78 accordingly, the service concluded that in denying admission to nonhawaiians, the bishop estate, a private tax-exempt charity, does not violate tax law�s public policy limitation. the service continued, however, that the bishop estate �should consider requesting a private letter ruling on whether the [thenpending supreme court�s] decision [in rice v. cayetano] has any effect on the [service�s] analysis.�79 rice v. cayetano concerns the constitutionality of hawaii�s practice of denying non-native hawaiians the fundamental right to vote for trustees of the office of hawaiian affairs.80 one year later, the united states supreme court held in rice v. cayetano that hawaii�s denial of voting rights to non-hawaiians is unconstitutional.81 800 florida tax review [vol5:9 light of this [tam] and the united states supreme court review of rice v. cayetano, it would be well to revisit the application of the public policy doctrine as it applies to the exemption of organizations described in section 501(c)(3))� (citations omitted). 82. see bishop estate tam, supra note 16 (citing green v. connally, 330 f. supp. 1150 (d.d.c. 1971), aff�d sub nom., coit v. green, 404 u.s. 997 (1971); norwood v. harrison, 382 f. supp. 921 (n.d. ms. 1974), on remand from the supreme court, 413 u.s. 455 (1973); brumfield v. dodd, 425 f. supp. 528 (e.d. la. 1976); prince edward school foundation v. united states, 478 f. supp. 107 (d.d.c. 1979), aff�d (d.c. cir. 6/30/80), cert. denied, 450 u.s. 944 (1981); bob jones university v. united states, 461 u.s. 574 (1983); calhoun academy v. commissioner, 94 t.c. 284 (1990). 83. see bob jones univ., 461 u.s. at 592. "[a] declaration that a given institution is not �charitable' should be made only where there can be no doubt that the activity involved is contrary to a fundamental public policy." id. the bishop estate tam clearly demonstrates the service's abject reliance on constitutional law standards as its means of determining whether the bishop estate�s preference for native hawaiians violates an established public policy against racial discrimination. the rationale section of the bishop estate tam begins by reciting a brief history of how the public policy limitation came into being � that is, how the service arrived at the conclusion that tax-exempt charities could not violate established public policy. this historical discussion highlights various situations in which private tax-exempt educational institutions discriminated against black people. indeed, each of the service's �specific and prominent [case law] examples� of the public policy against discrimination involves invidious racial discrimination against black people82. granted, there is nothing in the bob jones university opinion that necessarily limits the public policy limitation to situations involving discrimination against black people. in fact, the supreme court so much as indicated an expansive view of the universe of possible public policy arenas when it announced a broad rule prohibiting violation of any clear established public policy83. the point here, though, is that these �specific and prominent [case law] examples� highlighted by the service do not, by themselves, make the case that a preference for native hawaiians violates any public policy with respect to racial discrimination. thus, the service had to extend the bob jones university public policy rationale so that it could apply, not only to invidious discrimination against non-blacks, but also to benign preferences in favor of non-blacks. by far, the most telling indication that the service relied almost exclusively on constitutional law as its basis for deciding if the public policy rationale could be extended to apply to the bishop estate situation is its explicit statement concerning the cases upon which it relies. these cases include �several supreme court opinions addressing the constitutional challenges to governmental actions under the equal protection clauses of the fourteenth 2002] charities and the constitution 801 84. bishop estate tam, supra note 16 (emphasis supplied). 85. in regard to regents of the university of california v. bakke and adarand constructors, inc. v. pena, the service states that "the court in both cases, however, recognized that there would be situations in which benefits to ethnic minorities would be appropriate to further compelling governmental interests." see bishop estate tam, supra note 16. amendment and the fifth amendment.�84 based on this statement, one can easily � and quite reasonably � conclude that the service accepts as a given that the constitutional law standards for equality and, arguably, due process, define that which is consistent (or inconsistent) with public policy. indeed, the service explains in the bishop estate tam that remedial affirmative action for racial and ethnic minorities may at times further compelling government interests and, thus, be constitutionally permissible85. because such remedial efforts are constitutionally permitted to be done by government, then such efforts are, according to the service, also consistent with established public policy. as a result of this implicit (if not explicit) assumption about the equivalency of constitutional standards with public policy standards, the service evaluated the bishop estate's remedial activity with respect to native hawaiians in light of constitutional law principles concerning remedial activity by government concerning racial minorities. consistent with this constitutional equivalency approach, the service looked to how the supreme court would likely determine the constitutional permissibility of hawaiian preference rules imposed by government, as opposed to those imposed by non-governmental entities such as charities. relying on the court of appeal�s decision in rice v. cayetano that hawaiian preferences by government are political (rather than racial) classifications subject to mere rational constitutional scrutiny for equal protection clause purposes, the service concluded that the bishop estate�s preference for native hawaiians is likewise not the type of preference that requires close scrutiny. as such, according to the service, because the native hawaiian preference would not be unconstitutional if performed by government, it is not contrary to established public policy. recognizing that the rice v. cayetano case was to be appealed to the supreme court, the service advised the bishop estate that its conclusion that hawaiian preference policies do not violate public policy might change after the supreme court's decision in the case. this hesitancy to rely on an intermediate court decision as support for its �political classification� conclusion was a good idea given the procedural posture of the rice v. cayetano case. however, this hesitancy also supports this article�s claim that the service relies quite heavily on the direction of constitutional jurisprudence when making its decisions about the parameters of �established� public policy. presumably, the reason for the hesitancy was the service�s assumption that if 802 florida tax review [vol5:9 86. newspapers recently reported that the bishop estate schools �recently admitted a student not of hawaiian ancestry,� allegedly as a means of avoided additional government scrutiny. see generally �school set aside for hawaiians ends exclusion to cries of protest,� new york times (july 27, 2002); �decision viewed as peasement to irs,� honoluluadvertiser.com (july 16, 2002); �hawaiians� concerns go beyond school issues,� honoluluadvertiser.com (july 21, 2002). the supreme court reversed the court of appeal and concluded that hawaiian preferences are unconstitutional (which it did), then the service would likewise have to �reverse� its position and conclude that such preferences are inconsistent with established public policy. though the service has yet to revisit this matter since the supreme court�s ruling in rice v. cayetano, the bishop estate tam has given every indication that it is indeed well aware of this eventuality.86 implicit in the service�s analysis in the bishop estate tam is that, to the extent the constitution permits government to engage in a particular activity, the activity is consistent with established public policy. as a corollary, the service�s analysis also means that if an act would violate the constitution if performed by government, then that act is necessarily inconsistent with established public policy. thus, the service has essentially equated public policy standards with constitutional standards. indeed, the service has given no indication of when, if ever, it would deviate from constitutional law standards when making public policy decisions. this article�s view is that such strong reliance on constitutional law standards to determine public policy in any particular context is, quite simply, too extreme. this is not to say that the service should ignore constitutional law principles when it makes its public policy determinations. for if the service were to turn a blind eye to constitutional principles that would be too extreme in the other direction. instead, the service should use constitutional law standards only as a starting point for determining whether or not a tax-exempt charity�s particular activity is consistent or inconsistent with established public policy. parts iii and iv of this article explain in greater detail how inappropriate it is for the service to rely so much on constitutional law standards when determining public policy. 2002] charities and the constitution 803 87. see bob jones univ., 461 u.s. at 574. 88. see brennen, the power of the treasury, supra note 15, at 403 (describing analysis used by united states supreme court to conclude that treasury has authority to determine the public purpose of a charity). 89. see bob jones univ., 461 u.s. at 591. the treasury has indicated that other matters besides discrimination against blacks are areas contemplated by the public policy power. see 1994 service exempt organization cpe technical instruction program textbook, chapter l: illegality and public policy considerations: section 4.b., 94 tnt 71-47 [hereinafter irs exempt organization textbook]. �just as the service responded to public outrage over racial discrimination in education in bob jones and to possible kickbacks in gcm 39862, the service can be expected to re-evaluate positions in other areas as the public policy considerations become more clearly focused because of congressional action, decisions of the executive branch, or court actions.� id. 90. although the service indicates a willingness, under the current the constitutional law climate, to permit affirmative action by charities, it does not view absence of affirmative action policies as proof of discrimination by a charitable entity. see, e.g., calhoun academy v. commissioner, 94 tc 284 (1990): iii. interpretational concerns with using constitutional law principles to define the scope of the public policy limitation a. introduction the scope of the public policy limitation, as announced by the court in bob jones university v. united states, is unclear.87 this lack of clarity stems in large part from the court�s failure clearly to delineate how the service might use various sources of public policy to determine �established public policy� on particular matters.88 in other words, the court did not address the limits of the service�s authority to determine when or if a public policy is sufficiently �established� in any context other than an historically advantaged group discriminating against members of an historically disadvantaged group. for example, the court did not discuss whether affirmative action programs aimed at attracting racial minorities, which might require denying benefits to nonminorities, are consistent or inconsistent with �established public policy.�89 is it not conceivable that a service official might view these programs as contrary to �established public policy� because they involve racial preferences, albeit for minorities instead of against them? to its credit, the service has not interpreted the bob jones university case as prohibiting all racial preferences by charities. accordingly, the service permits charities to have some race-based policies, like affirmative action, even though such policies may involve racial preferences.90 however, this 804 florida tax review [vol5:9 granted, the facts before the supreme court [in bob jones university] did not raise an affirmative action issue because both subject schools discriminated within the rev. rul. 71-447 definition. the supreme court emphasized, however, that an institution should be deemed not charitable under its analysis only when there can be �no doubt� that the activity involved is contrary to a fundamental public policy. declining to take affirmative steps to seek out black students and teachers does not fall within this standard. id. at 304 (citations omitted). 91. see discussion supra part ii. 92. see, e.g., johnson v. bd. of regents of univ. of ga., 263 f.3d 1234, 1245 (11th cir. 2001) (�[a] majority of the supreme court may eventually adopt justice powell�s opinion as binding precedent, and even now the opinion has persuasive value . . . .�); corinne e. anderson, a current perspective: the erosion of affirmative action in university admission, 32 akron l. rev 181, 228 (1999) (noting that, even though the supreme court has not explicitly acted to outlaw the use of race to achieve diversity, universities should begin to implement race neutral programs because of the many appellate decisions that invalidated programs that use race to achieve diversity). see also robert westley, many billions gone: is it time to reconsider the case for black reparations?, 40 b.c. l. rev. 429 (1998). professor westley notes: affirmative action for black americans as a form of remediation for perpetuation of past injustice is almost dead. due to a string of supreme court decisions beginning with bakke and leading up to adarand, the future possibility of using affirmative action to redress the perpetuation of past wrongs against blacks is now in serious doubt. whereas some believe that the arguments supporting affirmative action as a remedy or even a tool of social policy are still sound, affirmative action programs continue to encounter strong political headwinds and judicial disapprobation. id. at 429 (footnotes omitted). willingness only seems to exist when the affirmative action at issue would be constitutional if done by the government, as is the case when the affirmative action policy is not inconsistent with the equal protection clause of the fourteenth amendment.91 but courts and commentators predict that the supreme court may soon decide that race-based affirmative action is never consistent with the equal protection clause, and therefore, never constitutional.92 if this prediction comes true, and if the service continues to rely on constitutional law principles to determine public policy, the service would likely no longer consider affirmative action by private charities to be consistent with �established public policy.� this strong reliance by the service on constitutional law principles in its public policy decision-making only exists because of the lack of specific guidance on how to determine public policy in particular contexts. thus, the court�s failure in bob jones university to clarify 2002] charities and the constitution 805 93. without such guidance, the court�s failure also means that tax advisors to charities cannot state with any degree of certainty whether a policy on any subject, other than white people discriminating against black people, is violated or not. see hill & kirschten, supra note 21, at ¶2.03[6][c]. �in the absence of specific guidance. . . it is neither possible nor prudent to state with certainty what �clear public policies� other than racial discrimination might lead to nonrecognition or revocation of exempt status.� id. 94. see gerald gunther, forward: in search of evolving doctrine on a changing court: a model for a newer equal protection, 86 harv. l. rev. 1 (1971) (explaining how the standard of review often determines whether a particular classification is constitutional or not). the scope of the public policy limitation requires the service to both determine and enforce law in this area without appropriate statutory or judicial guidance.93 this part focuses more specifically on the role constitutional law principles might play in the service�s task of delineating the scope of the public policy limitation. as primary examples, this part considers legal doctrine regarding constitutionally permissible preferences based on race and sexual orientation by examining two constitutional law principles: equality and freedom of expressive association. close examination of these constitutional law principles reveals various interpretational concerns the service faces if it chooses to continue to rely significantly on constitutional jurisprudence as its guide-star for defining public policy. b. equality: a sword against charitable status 1. introduction the linchpin of equality under the constitution is the standard of review (or level of scrutiny) with which a court will evaluate whether an admitted case of unequal treatment by government is fair or unfair.94 this section focuses on the appropriate standard of review for racial preferences by government under two constitutional equality provisions: the fourteenth amendment�s equal protection clause and section one of the fifteenth amendment. the purpose of this two-fold examination is to evaluate the appropriateness of the service�s use of equal protection clause strict scrutiny standards, as it seems to do in the bishop estate tam, to determine if a charity�s racial preference violates �established public policy.� this article�s use of fourteenth amendment equal protection analysis in order to demonstrate principles of equality under the constitution is made in light of a similar analysis applicable for purposes of the equal protection component of the due process clause of the fifth amendment. technically, the fourteenth amendment�s equal protection clause only applies to states and the equal protection component of the due process clause of the fifth amendment 806 florida tax review [vol5:9 95. see bolling v. sharpe, 347 u.s. 497 (1954). 96. in bolling, 347 u.s. at 497, the supreme court held that the equal protection standards announced in brown v. bd. of education, would apply to the district of columbia public schools: the fifth amendment, which is applicable in the district of columbia, does not contain an equal protection clause as does the fourteenth amendment which applies only to the states. but the concepts of equal protection and due process, both stemming from our american ideal of fairness, are not mutually exclusive. the �equal protection of the laws� is a more explicit safeguard of prohibited unfairness than �due process of law,� and, therefore, we do not imply that the two are always interchangeable phrases. but, as this court has recognized, discrimination may be so unjustifiable as to be violative of due process. id. at 499. 97. adarand constructors, inc. v. pena, 515 u.s. 200, 217 (1995). 98. see, e.g., rice v. cayetano, 528 u.s. 495, 512 (2000). �enacted in the wake of the civil war, the immediate concern of the [fifteenth] amendment was to guarantee to the emancipated slaves the right to vote, lest they be denied the civil and political capacity to protect their new freedom.� id. 99. the equal protection clause of the fourteenth amendment provides that �[n]o state shall . . . deny to any person within its jurisdiction the equal protection of the only applies to the federal government.95 nevertheless, despite the fact that the fifth amendment was adopted almost one hundred years before the fourteenth amendment and the fifth amendment has no equal protection clause,96 the supreme court recognizes that �equal protection analysis in the fifth amendment area is the same as that under the fourteenth amendment.�97 thus, except as otherwise indicated, analysis throughout this article of the equal protection clause of the fourteenth amendment applies equally as well to the equal protection component of the due process clause of the fifth amendment. 2. equality principles concerning discrimination and minority preferences equality, for constitutional law purposes, is significantly defined by the equal protection clause of the fourteenth amendment and section one of the fifteenth amendment. these constitutional amendments were adopted around the same time in american history to alleviate state-sanctioned discrimination against former slaves and other people of color.98 the fourteenth amendment prohibits discrimination generally, no matter the basis or the subject.99 2002] charities and the constitution 807 laws.� u.s. const. amend. xiv. see also, the slaughterhouse cases, 83 u.s. 36 (first case to analyze the fourteenth amendment). 100. section 1 of the fifteenth amendment provides that �[t]he right of citizens of the united states to vote shall not be denied or abridged by the united states or by any state on account of race, color, or previous condition of servitude.� u.s. const. amend. xv, § 1. 101. see rice, 528 u.s. at 495. �the fifteenth amendment has independent meaning and force.� id. 102. see discussion infra notes 178-95 and accompanying text. 103. see discussion infra notes 123-66 and notes 178-200, and accompanying text. 104. see discussion infra notes 123-66 and accompanying text. while, in form, the equal protection clause applies to any type of unequal treatment, the standard of review often dictates whether such application will have a substantive effect. thus, even though the equal protection clause applies to discrimination based on sexual orientation, because sexual orientation is not a suspect class, it does not receive strict scrutiny. the result is that statutes that discriminate based on sexual orientation are rarely stricken as an unconstitutional violation of the equal protection clause. 105. see discussion infra notes 178-200 and accompanying text. however, the fifteenth amendment only prohibits discrimination based on race or color in voting.100 thus, while both amendments are intended to guarantee a certain level of equal treatment by government, the fifteenth amendment has a quite different (and much narrower) scope of applicability than the fourteenth amendment.101 as a result of this difference, certain discriminatory acts that violate the equal protection clause do not necessarily violate the fifteenth amendment. further, and more importantly for purposes of this article, certain discriminatory acts that violate the fifteenth amendment do not necessarily violate the equal protection clause. thus, the service�s reliance on rice v. cayetano, a case potentially implicating both the equal protection clause and the fifteenth amendment,102 is at best confusing and at worst inappropriate.103 the fourteenth and fifteenth amendments are directed at preventing unequal treatment by government that is constitutionally �unfair.� fairness for these purposes is principally determined by two factors: (1) the subject about which the government discriminates and (2) the basis upon which the government discriminates. the fourteenth amendment concerns unequal treatment by government on any basis (e.g., race, gender, sexual orientation, etc.) no matter what the subject (e.g., voting, college admissions, awarding of government contracts, etc.).104 the fifteenth amendment, on the other hand, concerns unequal treatment by government that is based on race and concerns the subject of voting.105 historically, these constitutional equality provisions have been used as legal tools to thwart discrimination by government against traditionally disadvantaged groups like black people and other persons of 808 florida tax review [vol5:9 106. see rice, 528 u.s. at 512. �enacted in the wake of the civil war, the immediate concern of the [fifteenth] amendment was to guarantee to the emancipated slaves the right to vote, lest they be denied the civil and political capacity to protect their new freedom.� id. 107. see id. at 512. �the [fifteenth] amendment grants protection to all persons, not just members of a particular race.� id. 108. see discussion infra notes 123-66 and notes 178-200 and accompanying text. 109. see miller v. johnson, 515 u.s. 900, 904 (1995) (citation omitted) (�[t]he basic principle is straightforward: �racial and ethnic distinctions of any sort are inherently suspect and thus call for the most exacting judicial examination.��); city of richmond v. j.a. croson constr. co., 488 u.s. 469 (1989) (the court used strict scrutiny analysis to invalidate a race preference program that benefitted underrepresented minority contractors, the program was challenged by a non-minority color.106 however, the supreme court has repeatedly stated that the protections available under the fourteenth and fifteenth amendments are not available only to traditionally disadvantaged groups. instead, these equality protections are available to all people without regard to their societal status as disadvantaged or not.107 3. use of equality principles as a sword to invalidate affirmative action remedial efforts simply asserting that members of both disadvantaged and advantaged groups are entitled to equal treatment by government does not necessarily mean that equality for members of each group is judged by the same standard. for instance, one might claim that a particular type of unequal treatment by government that advantages members of an historically disadvantaged group is beneficial to society overall. in fact, it might be so beneficial, the claim might go, that the government�s unequal treatment need not be judged as critically as it would be if the unequal treatment disadvantaged (instead of advantaged) members of that historically disadvantaged group. on the other hand, one might also claim that all unequal treatment that disadvantages any person, whether that person is a member of an historically disadvantaged group or not, should be judged by the same standard. in essence, one�s membership in a particular group, the claim might go, should not dictate the level of scrutiny applied to the government�s unequal treatment of that person. constitutional jurisprudence with respect to racial equality has clearly addressed this matter in a series of fourteenth and fifteenth amendment cases.108 the standard of review under the fourteenth and fifteenth amendments for determining whether government distinctions based on race are �fair� is generally rather high. under current law, the high standard applies whether or not the claimant is a member of a disadvantaged race.109 thus, 2002] charities and the constitution 809 contractor); wygant v. jackson bd. of educ., 476 u.s. 267 (1986) (white teacher challenged the school board�s policy of extending preferential protection against layoffs to some employees because of their race; the court, using strict scrutiny analysis, held that the policy violated the fourteenth amendment.) 110. see, e.g., smith v. univ. of wash., 233 f.3d 1188 (9th cir. 2000) (involving claims by white law school applicants that they were discriminated against when they were denied admission to law school, but some black applicants were not.) 111. see rice, 528 u.s. at 513. 112. for example, the federal circuits are currently split on the issue of whether preferences for racial minorities that stem from affirmative action efforts are constitutionally �fair� under the fourteenth amendment. see, e.g., smith, 233 f.3d at 1188 (concluding that, in the ninth circuit, bakke permits government to consider race as one of many factors when making decisions about public law school admissions). but see hopwood v. tex., 78 f.3d 932 (5th cir. 1996), cert. denied, 518 u.s. 1033 (1996) (concluding that, in the fifth circuit, government can never use race as a factor when making decisions about public law school admissions). 113. see discussion infra notes 123-27 and accompanying text. claims of discrimination by members of a traditionally advantaged race are ordinarily judged by the same high standard as claims by members of a traditionally disadvantaged race. indeed, white people have successfully claimed that they are unconstitutionally discriminated against when they are denied a government benefit, like admission to a state school, because of government affirmative action efforts to attract racial minorities.110 similar claims of discrimination with respect to voting have been raised under the fifteenth amendment.111 as a result of these atypical claims of racial discrimination, the constitutional �fairness� of affirmative action by government has been challenged, often resulting in the constitutional invalidity of the government�s affirmative action efforts.112 for example, the uc davis medical school�s affirmative action plan, which considered the race of applicants in its aim to increase diversity in the student body, was invalidated because it impermissibly discriminated against white applicants.113 it is in this way that constitutional equality principles are used by some as a sword to invalidate government affirmative action efforts aimed principally at repairing harm caused by past government discrimination. 4. problems with using constitutional equality principles as a sword against tax-exempt charities that engage in affirmative action the service has indicated its inclination to rely on constitutional law principles when fulfilling its legal obligation to determine in the �first 810 florida tax review [vol5:9 114. see bob jones univ. v. united states, 461 u.s. 574, 597-98 (1983). �[t]he irs has the responsibility, in the first instance, to determine whether a particular entity is charitable for purposes of . . . § 501(c)(3). . . we emphasize, however, that these sensitive determinations should be made only where there is no doubt that the organization�s activities violate fundamental public policy.� id. 115. see discussion supra notes 59-81 and accompanying text. 116. see adarand constructors, inc. v. pena, 515 u.s. 200 (1995) (holding that all racial classifications will be subject to strict scrutiny). instance�114 whether a particular public policy is sufficiently �established� for purposes of the public policy limitation.115 this subpart outlines several aspects of the constitutional principle of equality as espoused through the fourteenth amendment�s equal protection clause and section one of the fifteenth amendment. as a method of demonstrating how the service might rely on constitutional equality principles when making its public policy decisions, it is useful to re-visit the matter of the appropriateness of the bishop estate trust�s native hawaiian preference policies. for example, what if the service were to re-examine, in light of the supreme court�s interpretation of constitutional equality in rice v. cayetano, the trust�s policy of admitting only hawaiian children to the trust�s school. such re-examination would necessarily require the service to answer two related, yet very different, questions. first, if denying non-native hawaiians admission to the trust�s school would violate the equal protection clause if the school were a state actor, does this necessarily mean that the school�s racial preference is contrary to �established public policy?� second, does the supreme court�s conclusion in rice that denying nonhawaiians the right to vote for trustees of the oha violates fifteenth amendment equality principles necessarily mean that denying non-hawaiians admission to the trust�s school violates �established public policy?� the following analysis demonstrates how problematic it would be for the service to rely significantly on either of these constitutional equality provisions to make its public policy determinations about tax-exempt charities. a. differences between fourteenth amendment equality and fifteenth amendment equality the parameters of what constitutes a violation of �established public policy� are much different if viewed through the lens of the fourteenth amendment�s equal protection clause rather than section one of the fifteenth amendment. under current equal protection clause standards, racial distinctions by government are subject to strict scrutiny review.116 this means that unequal treatment based on race violates the equal protection clause unless the unequal treatment is necessary to accomplish a compelling 2002] charities and the constitution 811 117. see id. at 235. �[r]acial classifications . . . must serve a compelling governmental interest, and must be narrowly tailored to further that interest.� id. (quoting fullilove v. klutznick, 448 u.s. 448, 496 (1980)). 118. this assumption that strict scrutiny analysis would apply assumes that preferences based on hawaiian lineage are a type of racial classification for equal protection clause purposes. 119. see rice v. cayetano, 528 u.s. 495, 512 (2000). �fundamental in purpose and effect and self-executing in operation, the [fifteenth] amendment prohibits all provisions denying or abridging the voting franchise of any citizen or class of citizens on the basis of race.� id. 120. see generally deichert, supra note 76, at 1078, arguing that the fifteenth amendment is broad in its reach and �mandates that racial discrimination in voting is not permissible under any circumstances.� governmental interest.117 the service, using this equal protection clause standard for equality, would likely focus on whether the trust�s denial of admission to non-hawaiians passes equal protection clause strict scrutiny.118 service analysis would thus center on the issues of whether the trust has a �compelling� interest to exclude non-hawaiians and, if so, whether exclusion of non-hawaiians from the school is �necessary� to accomplishing that compelling interest. if the service were to rely on fifteenth amendment standards, the parameters of what constitutes a violation of �established public policy� would involve no discussion of compelling interests or the necessity of a racial distinction to accomplishing those interests. instead, because racial distinctions in voting are absolutely prohibited under the fifteenth amendment,119 the necessary result under a fifteenth amendment analysis is that exclusion of nonhawaiians, for whatever reason, violates �established public policy.�120 thus, the first major problem with the service relying on constitutional standards of equality to decide if a particular charity is violating �established public policy� is that no guidance exists as to which constitutional equality standards apply � those of the equal protection clause or those of the fifteenth amendment. that is, is it enough that the service determines that a charity makes racial distinctions; or should the service also determine that the racial distinction is not �necessary� to accomplish a �compelling� governmental interest? the absence of either legislative or judicial guidance on this issue of which equality standard applies might have devastating consequences. for example, assume that the service took a fifteenth amendment type approach to racial discrimination. pursuant to such an approach, the service might conclude that a particular instance of racial preference that might be appropriate for equal protection clause purposes is inappropriate for fifteenth amendment purposes and, thus, violates �established public policy.� the particular instance of racial preference might be appropriate under the equal protection clause because the purpose of the racial preference is to remedy 812 florida tax review [vol5:9 121. although the service appears to look to equal protection clause jurisprudence to determine �establish public policies� on race, the service�s reference in the bishop estate tam to a case potentially implicating both the fourteenth amendment and the fifteenth amendment indicates that the service might also look to fifteenth amendment standards. 122. see, e.g., see grutter v. bollinger, 288 f.3d 732 (6th cir. 2002) (holding that student diversity may be a compelling rationale for use of race as a factor in admission decisions). �specific acts of prior discrimination� (a compelling interest) and the preference might be the �only practical� way of instituting a remedy for the prior discriminatory acts. if the service had, instead, taken an equal protection clause-type view of equality, its conclusion would be that the particular racial preference is appropriate and, thus, does not violate �established public policy.� in the end, the service�s determination about which type of constitutional equality standard to apply would have a definite impact on its conclusions about whether affirmative action like racial preferences are consistent or inconsistent with �established public policy.�121 aside from the concern over the essential differences between equal protection clause equality and fifteenth amendment equality, additional concerns exist with respect to using either equality standard. the next section discusses these concerns. b. fourteenth amendment equality should the service necessarily equate a violation of the equal protection clause by a charity, if that charity were a government actor, with a violation of tax law�s public policy limitation? the following analysis suggests not. although the type of invidious discrimination at issue in bob jones university is necessarily unconstitutional, benign affirmative action policies may not be unconstitutional because courts sometimes recognize that affirmative action is necessary to achieve compelling interests.122 several aspects of fourteenth amendment jurisprudence relating to affirmative action make it problematic for the service to rely on fourteenth amendment equal protection clause principles to determine �established public policy.� first, because it has changed several times in the past 20 years, the supreme court�s standard of review for determining whether race-based affirmative action violates the equal protection clause is anything but �clear[ly] established.� second, because the court in bakke failed to reach a majority consensus on the proper role race should play in government affirmative action, circuit courts are split on the issue of whether race can ever be considered by government. finally, the service, by its very nature, is not a government agency with sufficient expertise to make proper determinations about racial discrimination. these three aspects of fourteenth amendment 2002] charities and the constitution 813 123. 438 u.s. 265 (1978). 124. bakke involved the court�s review of a state medical school�s special admissions program that considered the applicant�s economic background and race. see id. at 272-75. under the regular admissions program applicants with undergraduate grade point averages below 2.5 on a scale of 4.0 were automatically rejected. several of the non-rejected applicants were evaluated for admissions purposes based on various criteria, none of which included race of the applicant. the criteria included interview performance, overall grade point average, science grades, medical school admissions test scores, letters of recommendation, extracurricular activities, and other biographical data. under the special admissions program, applicants did not have to meet the 2.5 grade point cutoff and were not ranked against candidates in the regular admissions process. among the factors used to determine an applicant�s eligibility for the special admissions program was the applicant�s disadvantaged economic status and the applicant�s membership in one of several racial minority groups. see id. under this special admission program, the school did not admit any white and economically disadvantaged applicants. see id. at 276. a rejected white male applicant sued the school alleging that the special admissions program operated to exclude him on the basis of his race in violation of federal and state constitutional provisions and federal civil rights laws. see id. at 276-78. bakke, the plaintiff, alleged that the �special admissions program operated to exclude him from the school on the basis of his race, in violation of his rights under the equal protection clause of the fourteenth amendment, art. i, § jurisprudence demonstrate the inappropriateness of service�s primary reliance on equal protection clause principles to determine if race based affirmative action by charities violates �established public policy.� 1) fluctuating standard of review though currently stabilized at strict scrutiny, the standard of review under the fourteenth amendment for government-sponsored race-based affirmative action has been in flux in recent years. between 1978 (in bakke) and 1995 (in adarand), the supreme court has outlined various frameworks within which it will evaluate whether government affirmative action plans comply with the equal protection clause. in each framework the consensus of the court has fluctuated between various standards of review for benign racial preferences. these standards have included intermediate level scrutiny and differing types of strict scrutiny. though the current stance is that strict scrutiny applies to even benign racial preferences, it is far from �clear[ly] established� that this standard either applies in the same manner for all circumstances or will continue to apply in the future. in the first of the modern era cases to address the issue of what standard of review applies, the supreme court, in regents of the university of california v. bakke,123 held that government affirmative action programs are subject to strict scrutiny review.124 in a plurality opinion, justice powell emphasized that 814 florida tax review [vol5:9 21, of the california constitution, and § 601 of title vi of the civil rights act of 1964, 78 stat. 252, 42 u.s.c. § 2000d.� id. at 277-78. the california supreme court held that the special admissions program violated the equal protection clause and ordered the medical school to admit the white applicant. see regents of the univ. of cal. v. bakke, 553 p.2d 1152, 1166 (1976) (holding that equal protection clause required that �no applicant may be rejected because of his race, in favor of another who is less qualified, as measured by standards applied without regard to race�). the supreme court, agreeing with california�s highest court, held that the medical school�s special admissions program impermissibly discriminated against the white applicant in violation the equal protection clause. see bakke, 438 u.s. at 320. nevertheless, the court concluded that race could be taken into account in future admissions. see id. (concluding that so much of the california court�s judgment as enjoins petitioner from any consideration of the race of any applicant must be reversed.) 125. id. at 289-90. 126. see id. at 290. 127. id. at 291. 128. 448 u.s. 448 (1980). 129. id. at 472. at issue in fullilove was the constitutionality of a minority business enterprise (mbe) provision of federal law which generally required that at least 10% of federal funds granted for public works projects be used to obtain services the appropriate standard of review under the equal protection clause for governmental preferences for racial minorities is the same as it is for invidious discrimination against such minorities: strict scrutiny. though both parties in bakke agreed that all racial preferences by government are subject to the equality restrictions of the equal protection clause, the parties disagreed on the level of scrutiny to be applied by a reviewing court. the medical school argued that intermediate scrutiny was appropriate because strict scrutiny should be applied only to classifications that disadvantage �discrete and insular minorities.� the rejected white applicant argued that strict scrutiny is appropriate because rights protected under the equal protection clause are personal rights and, thus, are not contingent upon the race of the person claiming protection. justice powell agreed with the white applicant, concluding that �[t]he guarantee of equal protection cannot mean one thing when applied to one individual and something else when applied to a person of another color.�125 powell rejected the �discrete and insular minorities� rationale because the court had never before required that rationale as a �prerequisite to subjecting racial . . . distinctions to strict scrutiny.�126 powell further noted that �[t]his perception of racial . . . distinctions is rooted in our nation�s constitutional and demographic history.�127 two years after bakke, in 1980, the court in fullilove v. klutznick128 applied a different type of strict scrutiny when it upheld a federal minority setaside statute, reasoning that a court must give �appropriate deference to congress� when assessing the constitutionality of a federal statute.129 although 2002] charities and the constitution 815 or supplies from minority-owned businesses. several private construction contractors and others claimed that the mbe provision, both on its face and as applied, violated the equal protection clause. the district court and the court of appeals upheld the validity mbe program, and the supreme court affirmed. 130. see id. at 492. (this opinion does not adopt, either expressly or implicitly, the formulas of analysis articulated in such cases as bakke.) 131. id. at 472. �a program that employs racial or ethnic criteria, even in a remedial context, calls for close examination; yet we are bound to approach our task with appropriate deference to the congress, a co-equal branch charged by the constitution with the power to �provide for the . . . general welfare of the united states� and �to enforce, by appropriate legislation,� the equal protection guarantees of the fourteenth amendment.� id. (citations omitted). 132. see id. at 480. the court in fullilove found that congress had done extensive research into how past discrimination had hurt the development of minority business and how companies involved in public works projects continued to act in discriminatory fashions. id. at 465. 133. see id. at 473. �here, we pass, not on a choice made by a single judge or a school board, but on a considered decision of the congress and the president.� id. 134. city of richmond v. j.a.croson co., 488 u.s. 469 (1989). the city of richmond passed a minority business utilization plan (the plan). the plan called for prime contractors working on city funded building project to subcontract at least 30% with one or more minority business enterprises (mbe). the city council stated that the ordinance was passed a responds to the barriers mbe faced due to past and present racial discrimination. the plan allowed contractor to use subcontractor within the local communities and outside of the local communities as long those subcontractor was with the definition of mbe. an mbe was defined as an enterprise which is controlled and owned by a member of a minority group. a member of a minority group was defined as a �citizens of the united states who are black, spanish-speaking , orientals, indians, eskimos or aleuts.� a contractor could receive a waiver where it was shown that the contractor was unable to find suitable mbe for the job. the program was challenged by j.a croson company (croson), a mechanical plumbing and heating contractor. croson the court in fullilove recognized that racial preferences by government �must necessarily receive a most searching examination,� it refused to adopt the bakke approach to strict scrutiny when analyzing benign racial preferences articulated by congress.130 instead, the court in fullilove applied traditional strict scrutiny analysis, but gave �appropriate deference to the congress�131 in its exercise of legislative authority to craft a statute that was narrowly tailored to remedy present effects of past discrimination.132 the court in fullilove emphasized that this �appropriate deference� strict scrutiny standard applies only to congress in its creation of statutes. the special deference standard does not apply to either judicial decrees or to judicial reviews of application of remedial statutes.133 in 1989, nine years after fullilove, the court, in richmond v. j. a. croson co.,134 concluded that, under the equal protection clause, state and 816 florida tax review [vol5:9 had been awarded a contract to install plumbing fixture for the city jail. croson attempted to subcontract with a mbe to supply the fixture need for the job. croson was only able to find one mbe that expressed interest in participating in the project but after receiving it bid that would increase the price of the project by 7% the company determined that the mbe was not suitable. croson�s request for a waiver was denied and the city informed the company that the project was to be rebid. croson filed suit in the federal district court for the eastern district of virginia, maintaining that the program was unconstitutional. the district court upheld the plan. the fourth circuit court of appeals affirmed the district court, hold that under the supreme court�s fullilove opinion the plan was constitutional. the supreme court vacated the decision and remanded the case back to the court of appeals for further consideration in like of the court opinion in wygant v jackson bd. of educ., 476 u.s. 267 (1986). after further review the court of appeals held that the plan violated the fourteenth amendment equal protection clause. the supreme court affirmed. 135. fullilove, 448 u.s. at 448. 136. see croson, 488 u.s. at 476. justice o�connor delivered the opinion with respect to parts i, iii-b and iv. with respect to part ii, justice o�connor was joined by chief justice renquist, justice white, and on parts iii-a and v she was joined by the chief justice, justices white and justice kennedy. 137. wygant, 476 u.s. at 267. in wygant, the court had to determine if the school board had violated the equal protection clause when it fired a white teacher so that it could keep a black teacher in order to provide a �role model� for black students. the court held that schools could not use �societal discrimination� as a compelling interest in order to justify the use of race as a determining factor. the court held that only by showing evidence that the school board was engaged in discrimination could the school board action be a constitutional use of race. 138. see croson, 488 u.s. at 491. �thus, our treatment of an exercise of congressional power in fullilove cannot be dispositive here.� id. local government race-based set-aside programs were subject to strict scrutiny, notwithstanding the program�s remedial or benign purpose. in croson, the court reviewed a remedial racial program enacted by the city of richmond that was similar to the program reviewed by the court in fullilove.135 the court held that that the city of richmond�s affirmative action program for minorities violated the equal protection clause of the fourteenth amendment. writing the opinion for the plurality,136 justice o�connor stated that the court would not follow the fullilove opinion, but would instead follow the court�s opinion in wygant.137 justice o�connor reasoned that standards used in fullilove were not applicable here because there the question was whether a congressionally enacted program violated equal protection of the fifth amendment due process clause.138 according to justice o�connor, while states are limited in how they can deal with race, the federal government is 2002] charities and the constitution 817 139. see id. at 490. �congress, unlike any state or political subdivision, has a specific constitutional mandate to enforce the dictates of the fourteenth amendment.� id. 140. see id. at 492. 141. see id. at 493. �indeed the purpose of strict scrutiny is to �smoke out� illegitimate use of race by assuring that the legislative body is pursuing a goal important enough to warrant use of a highly suspect tool. the test also ensures that the means chosen �fit� this compelling goal so closely that there is little or no possibility that the motive for the classification was illegitimate racial prejudice or stereotype.� id. 142. id. 143. id. at 494. 144. see id. at 495. 145. see id. at 505. �[n]one of the evidence presented by the city points to any identified discrimination in the richmond construction industry.� id. 146. id. at 498. 147. see id. at 505. �we, therefore, hold that the city failed to demonstrate a compelling interest . . . .� 148. see id. at 506. �the gross overinclusiveness of richmond�s racial preference strongly impugns the city claim of remedial motivation.� id. given much broader power to combat racial problems.139 states could enact programs that were designed to remedy discrimination but those programs had to be within the �constraints of section one of the fourteenth amendment�.140 that meant that any remedial racial program promulgated by a state would be subject to strict scrutiny to ensure that race was not used improperly.141 the plan could be held constitutional only if it served a compelling government interest and was narrowly tailored to achieve that interest.142 justice o�connor rejected justice marshal�s position which called for a lesser standard when reviewing programs that seek to benefit racial minorities. justice o�connor maintained that it �bears little resemblance to the close examination of legislative purpose we have engaged in when reviewing classification based on race or gender�.143 only by employing a heightened judicial standard will the court fulfill its role to protect minorities from discrimination.144 justice o�connor found that the city had not produced any evidence of discrimination in the local construction business to justify a remedial program.145 under wygant, the city could not depend on showing a pattern of past discrimination because it �provides no guidance for a legislative body to determine the precise scope of the injury it seeks to remedy.�146 absent any proof of discrimination, justice o�connor held that the plan failed to meet the compelling interest prong of the test.147 the court also found that the plan was �overinclusive� because it provided relief to racial minorities that were not present in the city and had not suffered past discrimination.148 under croson, the court ruled that states must show evidence of discriminatory practice before they can enact remedial racial programs. the 818 florida tax review [vol5:9 149. metro broad. v. fed. communication comm�n, 497 u.s. 547 (1990). at issue in metro was a program instituted to improve the number of minority owned media outlet. the program give minority applicant enhancements when awarding new licenses and set up a �distress sale� program that were limited transfer of existing television and radio station to minorities . the program was challenged by shurberg broadcasting claiming that the awarding enhancement and the distress sale program violated the equal protection component of the fifth amendment due process clause. the court of appeals for the district of columbia affirmed the award enhancement but held that the distress sale violated the equal protection right of non-minorities. the supreme court reversed, holding that the program did not violate the equal protection component of the fifth amendment. 150. see id. at 552. �the issue in these cases . . . is whether certain minority preference policies of the federal communication commission violate the equal protection component of the fifth amendment.� id. 151. id. at 565. 152. id. at 565. quoting justice o�connor in croson, the court stated, �congress may identify and redress the effect of society-wide discrimination.� id. (quoting croson, 488 u.s. at 490). 153. see id. at 565-66. citing justice scalia�s concurring opinion in croson, the court discussed the difference between state remedial programs and those passed by congress. id. (citing croson, 488 u.s. at 522-23). 154. id. at 566. court held that only a showing of present discrimination will satisfy the compelling interest requirement under the strict scrutiny test. this standard appears to only apply to states because the court stated that congress possessed powers that were excluded from the state. however, as later supreme court cases would demonstrate, even congress� power under the fourteenth amendment is not plenary. in 1990, one year after croson, the court returned to its pre-croson stance when it held in metro broadcasting,149 that a minority preference policy instituted by the federal communication commission (fcc) did not violate the equal protection clause.150 the court employed the same reasoning in metro broadcasting that it used in fullilove in holding that congressional programs should be given deference.151 the court even held that croson had �reaffirmed the lesson of fullilove� that remedial programs created by congress to address racial discrimination are subject to a different level of scrutiny than those passed by state and local governments.152 the court held that because congress is unlikely to be controlled by a racial or minority group there was no need to use strict scrutiny which had been employed in croson.153 the court held that because the �struggle� for racial justice has been a fight between �individual states� and �the national society,� the threat which strict scrutiny desired to eliminate was not present.154 the court used an intermediate level of scrutiny and held that the program was permissible if it met an �important objective� 2002] charities and the constitution 819 155. id. �we hold that the fcc minority ownership policies pass muster under the test we announce today. first, we find that they serve the important governmental objective of broadcast diversity. second, we conclude that they are substantially related to the achievement of that objective.� id. 156. id. at 569. the court in metro found that the fcc was merely effectuating the wishes of congress when it promulgated the minority ownership program. the court held that congress had determined that minority ownership benefitted the public by creating more diversity over the public air ways. the court also found that congress had hearings and passed numerous pieces of legislation to increase minority ownership. id. at 572-579. 157. 515 u.s. 200 (1995). 158. id. adarand involved an equal protection challenge to �subcontractor compensation clauses� in federal agency contracts, which provided that general contractors would receive additional compensation for hiring minority subcontractors. id. at 205. a white contractor challenged the use of compensation clauses under the equal protection clause, claiming that the government improperly used race as a factor in selecting a contractor. id. at 210. relying on fullilove and metro broadcasting, the federal district court granted the government�s motion for summary judgment and the tenth circuit affirmed. adarand constructors, inc. v. skinner, 790 f. supp. 240 (d. colo. 1992), aff�d by, adarand constructors, inc. v. pena, 16 f.3d 1537, 1547 (10th cir.). on appeal, the supreme court vacated the tenth circuit�s judgment and remanded the case for further proceedings. adarand, 515 u.s. at 239. 159. adarand, 515 u.s. at 235. 160. id. at 227, 232-34. �by refusing to follow metro broadcasting, then, we do not depart from the fabric of the law; we restore it.� id. at 234 (emphasis added). 161. id. at 227. �[s]uch classifications are constitutional only if they are narrowly tailored measures that further compelling governmental interests. to the extent that metro broadcasting is inconsistent with that holding, it is overruled.� id. and was �substantially related to achievement of those goals.�155 in metro broadcasting, the court again stated that deference should be given to �the factfinding of congress� when determining whether a program is related to an important governmental interest.156 finally, in 1995, five years after croson, the court, in adarand constructors, inc. v. pena,157 returned to strict scrutiny review of government affirmative action programs.158 in adarand, the court held that all government racial classifications, even remedial classifications, must be analyzed under a strict scrutiny standard, requiring their invalidation unless they are necessary to further compelling government interests.159 the court thus overruled metro broadcasting to the extent that it was inconsistent with this strict scrutiny requirement.160 writing the opinion for the court, justice o�connor rejected the standard used in metro broadcasting, holding that any use of race as a determining factor will receive the highest level of scrutiny.161 justice o�connor also made it clear that the court had departed from the standard used 820 florida tax review [vol5:9 162. id. at 235. �[i]t follows that to the extent (if any) that fullilove held federal racial classifications to be subject to a less rigorous standard, it is no longer controlling.� id. 163. id. at 215-18. justice o�connor cited bolling v. sharpe, 347 u.s. 497 (1954), holding for the first time that the fifth amendment due process clause contains a equal protection component that prohibits federally segregated schools. 164. adarand, 515 u.s. at 226. 165. id. �indeed, the purpose strict scrutiny is to �smoke out� illegitimate uses of race by assuring that the legislative body is pursuing a goal important enough to warrant us of a highly suspect tool.� id. 166. id. at 227. in fullilove that subjected federal programs to a more deferential standard.162 justice o�connor reasoned that the constitution held the federal government to the same standard as the states.163 thus, by subjecting federal programs to a lesser standard there was no way of determining whether the programs were �motivated by illegitimate notions of racial inferiority or simple racial politics.�164 the use of a strict scrutiny test would guard against any �illegitimate� use of race in any government program.165 justice o�connor stated that the standard used in metro broadcasting, threatens to �undermine� the protection offered by the constitution to protect individuals and not �groups.�166 in the final analysis, the court in adarand made it clear that any program that used racial classifications would be subject to strict scrutiny. the court�s various positions on the correct standard of review for government affirmative action illustrate how dangerous it is for the service to rely primarily on equal protection clause standards in making its own �established public policy� determinations about affirmative action by charities. for one thing, the standard for determining if benign racial preferences by government violate the equal protection clause has changed repeatedly over the years. if a public policy upon which the service acts must be �clear[ly] established,� it is not clear at all whether the court�s current strict scrutiny standard will apply to benign racial preferences in the not-to-distant future. second, the court�s various discussions about why a particular review standard is chosen center around the governmental nature of the preference decisions (e.g., state decisions versus federal decisions). since charities are not governmental bodies, nor are they generally subject to governmental restrictions, it seems inappropriate to apply a standard that emanates from discussions of governmental qualities. 2) circuit spilt: race as a factor in addition to the fluctuating nature of the standard of review, the current split in the federal circuits courts about whether race can ever be a 2002] charities and the constitution 821 167. 78 f.3d 932, 934 (5th cir. 1996), cert. denied, 518 u.s. 1033 (1996). 168. 2002 u.s. app. lexis 9126 (6th cir. 2002). 169. 233 f.3d 1188 (9th cir. 2000), cert denied, 532 u.s. 1051 (2001). 170. 263 f.3d 1234 (11th cir. 2001). 171. hopwood, 78 f.3d at 962. similarly, the fourth circuit, in podberesky v. kirwan, 38 f.3d 147, 161-62 (4th cir. 1994), cert. denied, 514 u.s. 1128 (1995), held that a race-exclusive scholarship program offered by a state university violated the equal protection clause of fourteenth amendment. 172. smith, 233 f.3d at 1201. factor in government affirmative action is also problematic for the service. the circuits in which this split is most apparent are the fifth circuit, in hopwood v. texas,167 and in the sixth, ninth and eleventh circuits in grutter v. bollinger,168 smith v. university of washington law school169 and johnson v. board of regents of the university of georgia.170 in hopwood, the fifth circuit held that it was a violation of the equal protection clause for a state to use race as a factor when making decisions about public law school admissions.171 however, in bollinger, smith and johnson, the sixth, ninth and eleventh circuits held that race may be used as a factor by a state when making university admissions decisions. the ninth circuit majority in smith described the fifth circuit�s opinion in hopwood as �flawed� to the extent that it held otherwise.172 this circuit split demonstrates that, while it is clear that government discrimination against black people always violates the equal protection clause, it is unclear whether race-based affirmative action is necessarily unconstitutional. circuit courts uniformly interpret bakke to hold that strict scrutiny applies to both invidious discrimination and benign affirmative action for racial minorities. accordingly, both types of racial preferences will be upheld if the government can show that the preference is necessary to accomplish a compelling interest. this standard effectively means that any racial preference by government in favor of members of a racial majority that disadvantage members of a racial minority necessarily violates the equal protection clause. indeed, no modern day federal court has ever concluded that it was necessary to discriminate against racial minorities in order to accomplish a compelling government interest. on the other hand, equal protection clause strict scrutiny does not mean that racial preferences in favor of racial minorities that disadvantage racial majorities necessarily violate the equal protection clause. the fifth circuit�s view is that it is never necessary to favor a racial minority over a racial majority in order to accomplish a compelling government interest. the sixth, ninth and eleventh circuits� views are that it may be necessary to make such racial preferences in order to accomplish compelling government interests. this aspect of equal protection clause strict scrutiny is the central ever be a factor in government affirmative action efforts. 822 florida tax review [vol5:9 173. 438 u.s. 265 (1978). 174. see id. at 309. see also brian k. landsberg, balanced scholarship and racial balance, 30 wake forest l. rev. 819, 822 (1995) (discussing justice powell�s opinion in bakke). 175. see, e.g., brennen, the power of the treasury, supra note 54, at 424-25. professor brennen writes: in a plurality opinion, justice powell emphasized that the medical school established its special admissions program to remedy specific acts of prior discrimination, not general societal discrimination. while recognizing the importance of the state�s interest in �ameliorating . . . the disabling effects of identified discrimination,� justice powell noted that �remedying of the effects of �societal discrimination� [is] an amorphous concept of injury that may be ageless in its reach into the past.� thus, a governmental entity seeking to justify �a classification that aids persons perceived as members of relatively victimized groups at the expense of other innocent individuals� must make �judicial, legislative, or administrative findings of constitutional or statutory violations.� absent such findings, it cannot be said that �the government has any greater interest in helping one individual than in refraining from harming another.� id. 3) service lacks expertise on racial matters the service, by its very nature, is not a government agency with sufficient expertise to make proper constitutional law determinations about racial discrimination. this lack of expertise means that the service is not an appropriate governmental body to decide if a particular racial preference by a tax-exempt charity is consistent or inconsistent with equal protection clause strict scrutiny and, hence, �established public policy.� the supreme court has emphasized this aspect of equal protection clause decision-making authority in regents of the university of california v. bakke.173 in bakke, justice powell refused to consider the board of regents� asserted justification for its affirmative action plan for the medical school, in part, because that governmental entity lacked sufficient authority and expertise to make appropriate racial findings.174 after emphasizing that constitutional affirmative action plans are designed to remedy specific acts of prior discrimination (as opposed to general societal discrimination),175 justice powell refused to even consider the board of regent�s asserted findings of such discrimination because of the board�s lack of expertise on racial matters: 2002] charities and the constitution 823 176. bakke, 438 u.s. at 309-10 (footnote omitted) (citations omitted). petitioner does not purport to have made, and is in no position to make, such findings. its broad mission is education, not the formulation of any legislative policy or the adjudication of particular claims of illegality. . . . [i]solated segments of our vast governmental structures are not competent to make those decisions, at least in the absence of legislative mandates and legislatively determined criteria. before relying upon these sorts of findings in establishing a racial classification, a governmental body must have the authority and capability to establish, in the record, that the classification is responsive to identified discrimination. lacking this capability, petitioner has not carried its burden of justification on this issue.176 powell�s opinion in bakke demonstrates that agencies that are not authorized to make racial findings cannot properly decide if an asserted compelling interest for discrimination is sufficiently �compelling� to satisfy equal protection clause strict scrutiny. thus, absent proper judicial or legislative guidance, an administrative agency like the service, whose expertise is in taxation, cannot decide if a specific act of discrimination by a tax-exempt charity would be permitted or prohibited by the equal protection clause if the charity were a state actor. it stands to reason that it would likewise be inappropriate for the service to use that same constitutional standard as a proxy for �established public policy.� 4) conclusions the standard of review regarding government affirmative action and the circuit split regarding whether race may be used as a factor demonstrates the danger of the service relying on equal protection clause standards to determine �established public policy.� equal protection clause principles do not indicate whether race based affirmative action is necessarily unconstitutional. while the state of texas may not prefer racial minorities when deciding on university admissions, the state of washington may prefer racial minorities when making such decisions. neither state, however, may discriminate against racial minorities in making admission decisions. relying on this aspect of equal protection clause jurisprudence, one can draw two 824 florida tax review [vol5:9 177. see bob jones univ. v. united states, 461 u.s. 574, 592 (1983). �[a] declaration that a given institution is not �charitable� should be made only where there can be no doubt that the activity involved is contrary to a fundamental public policy.� id. 178. miller v. johnson, 515 u.s. 900, 915 (1996). conclusions regarding the service�s enforcement of the public policy limitation. first, it would be appropriate for the service to determine that a charity�s invidious discrimination against racial minorities violates �established public policy� because the supreme court has never held that this type of racial preference is necessary to accomplish a compelling interest. second, it would not be appropriate for the service to determine that a charity�s preference of racial minorities over racial majorities necessarily violates �established public policy� because the supreme court has held that this type of racial preference may, at times, be necessary to accomplish a compelling interest. further, the service has no authority or special capacity to determine when a particular interest of a charity is compelling or not. thus, it would be inappropriate for the service to look solely to equal protection clause standards to determine if a tax-exempt charity that engages in race-based affirmative action violates �established public policy� regarding racial preferences. c. fifteenth amendment equality should the service equate violation of the fifteenth amendment by a charity, if that charity were a state actor and if the suspect charitable act concerned voting in a state election, with a violation of the public policy limitation? as with the fourteenth amendment, the following analysis suggests not. indeed, the bob jones university principle that charities cannot violate established public policy is only implicated when the public policy violation is �clear.�177 the court in bob jones university surely contemplated that the service would make some evaluation of the societal acceptability of the charity�s challenged action. the fifteenth amendment does not permit such evaluation. thus, a hypothetical fifteenth amendment violation should not be used as the sole determinant of whether a private charity has violated �established public policy.� while the fourteenth amendment (at least under current law) permits the government to make racial preferences that satisfy strict scrutiny, the fifteenth amendment does not employ the same strict scrutiny standard.178 equal protection clause strict scrutiny under the fourteenth amendment requires a reviewing court to initially determine whether the state has used race as a basis for treating otherwise similarly situated people differently. if it finds that the state has made such a racial classification, the fourteenth amendment 2002] charities and the constitution 825 179. 528 u.s. 495 (2000). rice represents the first time since reconstruction that the court relied exclusively on the fifteenth amendment, not the fourteenth amendment, to invalidate a voting scheme. this was also the first time the court used the fifteenth amendment to invalidate a voting scheme that denied historically advantaged groups, instead of historically disadvantaged groups, the right to vote. see deichert, supra note 76, at 1084 n.59. �rice was the first case decided under the fifteenth amendment dealing with the outright denial of the franchise to a non-minority racial group on the basis of race.� id. thus, rice is an important case on many levels. 180. rice, 528 u.s. at 524. the controversy in rice began when harold rice, a white citizen of hawaii, sued the governor of hawaii to invalidate hawaii�s law that granted only certain long-time native hawaiians the right to vote for trustees of the office of hawaiian affairs (oha). oha, a state agency created by a 1978 amendment to the hawaiian constitution, is charged with effectuating �the betterment of conditions of native hawaiians . . . [and] hawaiians.� oha accomplishes its betterment goal by representing descendants of hawaiians and native hawaiians on issues concerning government control of valuable land stolen from hawaiians and native hawaiians by westerners. although mr. rice could trace his hawaiian genealogy back to the mid1800's, he was not considered to be either hawaiian or native hawaiian under the law because he could not trace his ancestry back to 1778 the year westerners invaded the hawaiian islands. rice alleged that this voting rights limitation was in fact a proxy for race. accordingly, rice asserted that the hawaiian only limitation is a classification based on race that is subject to strict scrutiny review under the fourteenth and fifteenth amendments. rice further claimed that the limitation of the class of eligible voters to certain long-time hawaiians and native hawaiians does not satisfy the strict scrutiny standard. both rice and the state of hawaii moved for summary judgment. the federal district court in hawaii granted summary judgment for the state of hawaii. the district court concluded that congress and hawaii recognize a guardian-ward relationship with permits the reviewing court to uphold the admitted racial distinction if the classification is necessary to accomplish a compelling government interest. this aspect of fourteenth amendment equal protection clause strict scrutiny differs drastically from the standard of review of racial preferences by government in voting under the fifteenth amendment. even though the fourteenth amendment permits states to make racial distinctions in some circumstances, the fifteenth amendment absolutely bars racial preferences no matter what justification is proffered by the state. thus, even if a state denies the right to vote to an historically advantaged race as a type of recompense to an historically disadvantaged race (i.e., an affirmative action-like denial), the state�s denial of the right to vote always violates the fifteenth amendment. the supreme court recently made this point clear in rice v. cayetano.179 in rice v. cayetano, the supreme court held that hawaii�s denial to non-native hawaiians of the right to vote in a statewide election violated the fifteenth amendment�s prohibition against discrimination based on race.180afterreciting a detailed history of hawaiian civilization and the 826 florida tax review [vol5:9 native hawaiians which is analogous to the relationship between the united states and indian tribes. thus, the voting restriction, according to the district court, was not subject to strict scrutiny review; rather it was subject to rational basis review. accordingly, the district court held the voting restriction did not violate either the fourteenth or the fifteenth amendment because the restriction was rationally related to hawaii�s �responsibility under [the law]� to provide �for the betterment of native hawaiians.� rice v. cayetano 963 f. supp. 1547, (haw. 1997). the court of appeals for the ninth circuit affirmed. the court of appeals for the ninth circuit noted that rice only challenged the voting limitation and not the underlying programs of oha or oha itself. thus, that court concluded that it was �bound to �accept the trusts and their administrative structure as [it found] them, and assume that both are lawful.�� even though the laws containing the hawaiian-only limitations �contain racial classifications on their face,� the court of appeals held that hawaii �may rationally conclude that hawaiians, being the group to whom trust obligations run and to whom oha trustees owe a duty of loyalty, should be the group to decide who the trustees ought to be.� rice then sought review by the united states supreme court, which granted certiorari in rice v. cayetano and reversed the ninth circuit, holding that hawaii�s denial of rice�s right to vote was �a clear violation of the fifteenth amendment.� rice, 528 u.s. at 521. 181. because it was able to resolve the case based solely on fifteenth amendment grounds, the court never reached the fourteenth amendment issues. id. at 524. 182. id. at 512. �fundamental in purpose and effect and self-executing in operation, the amendment prohibits all provisions denying or abridging the voting franchise of any citizen or class of citizens on the basis of race.� id. 183. in examining how to determine if a particular state law makes a racial distinction � even if that law does not explicitly mention race, the court noted that sometimes circumstantial evidence concerning the intent of the lawmakers may show that a particular law makes a racial classification. id. for example, in guinn v. united states, 238 u.s. 347 (1915), the court concluded that oklahoma�s vote restriction scheme � which was similar to hawaii�s in that it did not mention race but instead used ancestry to exclude at least one race from voting � violated the fifteenth amendment. in 1910, oklahoma enacted a literacy requirement for voting eligibility. however, �lineal descendants� of persons previously �entitled to vote� were exempted from the literacy requirement. id. at 357. the court invalidated the oklahoma scheme because it was a transparent racial exclusion that tended to perpetuate laws that excluded black people from the voting franchise. id. at 364-65. the majority in rice concluded that hawaii�s distinction based on ancestry clearly demonstrated an intent by hawaii to make a racial distinction. in essence, according to the court, hawaii�s use of ancestry as a proxy for race is the same as if the statute explicitly mentioned race. rice, 528 u.s. at challenged hawaiian voting law, the court�s analysis focused on the principles underlying the fifteenth amendment.181 the court concluded that the fifteenth amendment applies to all denials or abridgments, based on race, of the right to vote no matter the race of the complaining individual.182 after the court determined that hawaii�s voting law indeed made a distinction based on race,183 2002] charities and the constitution 827 514. �ancestry can be a proxy for race. it is that proxy here.� id. many commentators have criticized this aspect of rice. see discussion supra note 77. the commentators argue that distinctions based on hawaiian lineage are not racial distinctions because hawaiian ancestry is not race. 184. id. at 518. 185. id. at 518-19. the indian tribe analogy involved hawaii�s comparison of the quasi-sovereign legal status of various indian tribes to that of hawaiians and native hawaiians. the court noted that judicial decisions interpreting the effect of federal legislation and federal treaties have held that indian tribes often retain elements of socalled �quasi-sovereign authority� relating to self-governance after united states invasion or take-over. id. thus, the court, beginning primarily with morton v. mancari, 417 u.s. 535, 553-55 (1974), has sustained federal enactments that give employment preferences to members of these tribes giving employment preferences to persons of tribal ancestry. since the oha trustees are charged with protecting the interests of native hawaiians, as indian tribes are charged with protecting the interests of native americans, the state in rice relied on this analogy to justify its preferences to persons of hawaiian ansestry. the court rejected the state�s tribal analogy because the court was unwilling to conclude that congress has made the determination that native hawaiians have a status like that of native americans in organized indian tribes. further, the court was unwilling to conclude that this congressional determination has delegated to the state of hawaii plenary authority to protect that status. 186. rice, 528 u.s. at 520-21. �even were we to take the substantial step of finding authority in congress, delegated to the state, to treat hawaiians or native hawaiians as tribes, congress may not authorize a state to create a voting scheme of this sort.� id. 187. see, e.g., united states v. antelope, 430 u.s. 641 (1977); delaware tribal bus. comm. v. weeks, 430 u.s. 73 (1977). 188. rice, 528 u.s. at 521. �although the [indian] classification had a racial component, . . . the preference was �not directed towards a racial group consisting of indians,� but rather �only to members of federally recognized tribes.�� id. the court went on to show that no justification proffered by the state could justify the racial distinction. the first justification offered by the state to justify the racial classification was that �exclusion of non-hawaiians from voting is permitted under our cases allowing the differential treatment of certain members of indian tribes.�184 after rejecting the validity of the state�s indian tribe analogy,185 the court noted that even if the analogy applied hawaii�s law would still violate the fifteenth amendment because of the racial classification for voting.186 the indian tribe cases involve congress� special treatment of indians who are members of federally recognized tribes.187 those cases do not involve, as does the instant case, denial of the right to vote based solely on race.188 the second justification offered by the state was that �the limited voting franchise is sustainable under a series of cases holding that the rule of one person, one vote does not pertain to certain special purpose districts such as water or irrigation 828 florida tax review [vol5:9 189. id. at 522. 190. id. 191. id. at 523. 192. id. 193. id. 194. id. 195. id. districts.�189 the court rejected this justification for two reasons. first, unlike special purpose district elections which are excepted from the one person one vote requirement, the oha trustee elections are statewide elections. thus, the court would have to justify extending the one person one vote exception to statewide elections � something that the court was unwilling to do.190 second, even if the court were to extend the one person one vote exception to apply to the oha statewide election, hawaii�s argument still fails, according to the court, because that exception applies for fourteenth amendment purposes only. the concern with the oha election eligibility rule is whether it violates the race-neutrality command of the fifteenth amendment. because the fifteenth amendment has �independent meaning and force,� the court was not convinced that �compliance with the one-person. . . one-vote rule of the fourteenth amendment somehow excuses compliance with the fifteenth amendment.�191 thus, the court refused to find any exception to the raceneutrality command of the fifteenth amendment. the third justification proffered by the state for its racial classification was that �the voting restriction does no more than ensure an alignment of interests between the fiduciaries and the beneficiaries of a trust.�192 the court rejected this justification for two reasons. first, the fiduciary and beneficiary interests are not in fact aligned under the challenged scheme. indeed, while the benefits of the trust are intended primarily for �native hawaiians,� the state permits �native hawaiians� and �hawaiians� to vote for trustees. thus, instead of creating an alignment of interests, the challenged scheme actually �creates a differential alignment� between trustees and beneficiaries.193 second, even if the interests were aligned, the court concluded that the state�s argument still fails because the essence of the alignment is to allow race to �qualify some and disqualify others from full participation in our democracy.�194 this race qualification requirement, according to the court, is inconsistent with the principle of race-neutrality, which underlies the fifteenth amendment.195 this analysis of the rice decision demonstrates that it would be inappropriate for the service to rely significantly on fifteenth amendment jurisprudence when making its public policy decisions about tax-exempt charities. the sole purpose of the fifteenth amendment is to eradicate racial preferences by government with respect to voting in governmental elections. thus, in order for the service to properly rely on fifteenth amendment 2002] charities and the constitution 829 196. see u.s. const. amend. xv. 197. id. 198. rice, 528 u.s. at 512. �the design of the amendment is to reaffirm the equality of races at the most basic level of the democratic process, the exercise of the voting franchise.� id. 199. see discussion supra notes 77-86 and accompanying text. 200. another conclusion the service might have to make in order to apply fifteenth amendment standards to tax-exempt charities is that the standards apply to citizens and non-citizens alike. on its face, the fifteenth amendment only applies to rights of �citizens of the united states.� it is not clear whether or not those denied admission to the kamehemeha schools were united states citizens. however, given the standards, it would have to make at least two preliminary conclusions regarding the relationship of fifteenth amendment equality standards to the public policy limitation. the first conclusion the service would have to make is that fifteenth amendment equality applies even to circumstances in which neither the �united states� nor �any state� has acted.196 this conclusion is necessary because, by its very terms, the fifteenth amendment only applies to denials or abridgments of voting rights by one of these governmental units. no court has extended application of this constitutional prohibition to any non-governmental actor. with some exceptions not relevant here, tax-exempt charities are not government actors. thus, the service must conclude that, for some reason yet unexplained by the judiciary, the fifteenth amendment applies to both government actors and to non-government actors. such a conclusion would be baseless. another conclusion the service would have to make in order to apply fifteenth amendment standards to tax-exempt charities is that the standards were intended to apply, not just to �the right . . . to vote,� but also to rights other than voting, such as the right to attend school.197 again, by its very terms, the fifteenth amendment only applies in the context of voting. no court has ever found otherwise. indeed, the supreme court, in rice v. cayetano, specifically noted that the only concern of the fifteenth amendment is denials or abridgements of the right to vote.198 the service intimated in the bishop estate tam that it would apply these fifteenth amendment equality-in-voting standards to a tax-exempt trust that denied those lacking sufficient hawaiian lineage admission to the trust�s schools.199 the service made no mention in the bishop estate tam of �the right . . . to vote� ever being an issue. thus, once again, in order for the service to rely almost exclusively on holdings in cases like rice v. cayetano to define the parameters of the public policy limitation, it must conclude that the fifteenth amendment applies to circumstances that do not involve issues of voting. reaching such a conclusion would be inconsistent with constitutional jurisprudence concerning the fifteenth amendment.200 830 florida tax review [vol5:9 hawaii is a popular destination for foreign visitors, it is not entirely improbable that at least some who were denied admission to the school were non-united states citizens. 201. see, e.g., roberts v. united states jaycees, 468 u.s. 609 (1984): our decisions have referred to constitutionally protected �freedom of association� in two distinct senses. in one line of decisions, the court has concluded that choices to enter into and maintain certain intimate human relationships must be secured against undue intrusion by the state because of the role of such relationships in safeguarding the individual freedom that is central to our constitutional scheme. in this the service�s reliance on constitutional law equality standards to determine when and if a particular tax-exempt charity has violated �established public policy� is inappropriate. equality principles concerning racial preferences, for example, are not readily applicable in non-constitutional settings. two of the most significant constitutional equality provisions � the equal protection clauses of the fourteenth amendment and the fifteenth amendment � have various characteristics that make direct application of these provisions to tax-exempt charities problematic. although both equality standards apply in situations involving racial preferences, one standard requires judgment by an arbiter as to the acceptability of the racial preferences (fourteenth amendment) whereas the other standard is not concerned at all with acceptability just with whether a racial preference exists (fifteenth amendment). who�s to say which of these standards applies for �established public policy� purposes? additionally, concerns exist regarding level of scrutiny, the capacity of the service to make appropriate determinations about race and the appropriateness of extending constitutional provisions to non-constitutional settings without judicial guidance. thus, the service�s apparent reliance on equality aspects of the constitution as the guide-star to determine equality for purposes of the public policy limitation is inappropriate; that is, the service cannot use the constitution as a proverbial sword to revoke the tax-exempt status of a charity. but what about the other way around? that is, might a tax-exempt charity use the constitution as a shield to prevent the service from revoking the charity�s tax-exemption? c. freedom of expressive association: a shield to protect charitable status 1. introduction the united states constitution protects two types of associational freedoms: freedom of intimate association and freedom of expressive association.201 this subpart will focus exclusively on the constitutional right to 2002] charities and the constitution 831 respect, freedom of association receives protection as a fundamental element of personal liberty. in another set of decisions, the court has recognized a right to associate for the purpose of engaging in those activities protected by the first amendment -speech, assembly, petition for the redress of grievances, and the exercise of religion. the constitution guarantees freedom of association of this kind as an indispensable means of preserving other individual liberties. id. at 617-618. see also evelyn brody, entrance, voice, and exit: the constitutional bounds of the right of association, 35 u.c. davis l. rev. 821, 829-30 (2002), explaining the origins of freedom of association in the 1950's. 202. see u.s. const. amend. i. 203. roberts, 468 u.s. at 622. 204. id. at 623. 205. id. freedom of expressive association and its use by private groups as a shield against anti-discrimination laws aimed at preventing discrimination against homosexuals. the purpose of this examination is to evaluate whether a private charity that discriminates against homosexuals in violation of state law may use freedom of expressive association as a shield to protect it from the service�s attempts to revoke its tax-exempt status on public policy grounds. more broadly, the ultimate issue is whether and how the service should consider a charity�s constitutional defenses, such as a claim of freedom of expressive association, in ascertaining whether the charity violates �established public policy.� 2. freedom of expressive association subject to certain constraints, the first amendment guarantees citizens the right to free speech.202 the supreme court has recognized that �implicit in [this right]� is �a corresponding right to associate with others in pursuit of a wide variety of political, social, economic, educational, religious, and cultural ends.�203 the right to associate in this way is critical when it comes to preventing the tyranny of the views of the majority over those of the minority. thus, protecting a group�s right to freedom of expressive association aids in preserving political and cultural diversity in society and in shielding unpopular expression from repression by the majority. among the many government actions that might violate a group�s freedom of expressive association is �intrusion into the internal structure or affairs� of the group.204 one type of intrusion might be a regulation or other law that �forces the group to accept members it does not desire.�205 such force might significantly impair the group�s ability to express its often unpopular 832 florida tax review [vol5:9 206. see boy scouts of america v. dale, 530 u.s. 640 (2000). 207. id. at 648. 208. new york state club ass�n, inc. v. city of new york, 487 u.s. 1, 13 (1988). 209. roberts, 468 u.s. at 623. �infringements on [the right to freedom of expressive association] may be justified by regulations adopted to serve compelling state interests, unrelated to the suppression of ideas, that cannot be achieved through means significantly less restrictive of associational freedoms.� id. 210. the service defines a �membership organization� (or membership charity) as �an organization that is composed of individuals or organizations who (1) share in the common goal for which the organization was created; (2) actively participate in achieving the organization�s purposes; and (3) pay dues.� see irs form 990 (instructions for part ii, line 11). views.206 accordingly, freedom of expressive association �plainly presupposes a freedom not to associate.�207 the standard utilized by the court to determine if forced inclusion of a person in a group infringes that group�s freedom of expressive association is to determine whether the person�s presence significantly impairs the group�s ability to advocate its viewpoints.208 like many constitutionally protected rights, however, freedom of expressive association is not an absolute freedom. the freedom must yield if a particular law or regulation is adopted to serve a compelling governmental interest that is unrelated to the suppression of ideas and cannot be achieved in a significantly less intrusive manner.209 thus, a private group�s constitutional right to freedom of expressive association may yield to a state�s often compelling interest in eliminating many types of discrimination in society, including discrimination based on race, gender and age. 3. use of freedom of expressive association as a shield against violation of state anti-discrimination law the supreme court recently decided a freedom of expressive association case, boy scouts of america v. dale, that implicitly raises questions about the extent to which the service may use �established public policy� to revoke (or deny) tax-exempt charitable status. boy scouts of america does not actually involve a denial of tax-exempt status; instead, the case involves the first amendment right of one of the country�s largest membership charities,210 the boy scouts of america (the boy scouts), to violate state law by excluding a person from its organization based on the person�s sexual orientation. though not explicitly recognized in federal civil rights laws, many people would argue that it is nearly universally accepted in society that discrimination based on sexual orientation is wrong. indeed, this is one of the many arguments raised by justice stevens in his dissent in boy scouts of america when he explains that old negative opinions about homosexuality have been replaced by more 2002] charities and the constitution 833 211. see boy scouts of america, 530 u.s. at 669 (stevens dissent). �over the years, however, interaction with real people, rather than mere adherence to traditional ways of thinking about members of unfamiliar classes, have modified those [negative] opinions.� id. 212. thirteen states currently have statutory laws that explicitly prohibit discrimination based on sexual orientation. see cal. gov�t. code § 12940 (west supp. 2001); conn. gen. stat. ann. §§ 46(a)-81(c) (west supp. 2001); d.c. code ann. § 21402.11 (2001); haw. rev. stat. §§ 368-1, 378-2 (supp. 2000); md. ann. code art. 49b, §§ 5, 16, 14, 8 (supp. 2001); mass. ann. laws ch. 151, §§ b1, b3, b4 (law. co-op. supp. 2001); minn. stat. ann. §§ 363.03, 363.12 (west supp. 2001); nev. rev. stat. ann. §§ 610.020, 613.340 (michie 2000); n.h. rev. stat. ann. §§ 354-a:7, :8 (supp. 2001); n.j. stat. ann. §§ 10:2-1, :5-4, :5-12 (west supp. 2001); r.i. gen. laws §§ 28-5-2, 28-5-7 (supp. 2001); vt. stat. ann. tit. 21, § 495 (supp. 2001-2002); wis. stat. ann. § 111.36 (west supp. 2001). also, there are 42 out of 3,097 u.s. counties that to some extent prohibit discrimination based on sexual orientation. see lambda l e g a l d e f e n s e a n d e d u c a t i o n f u n d , a t www.lambdalegal.org/cgi-bin/iowa/states/antidiscrimi-map (jan. 7, 2002). see also brody, entrance, voice and exit, fns 70-72 and accompanying text �while federal law bars discrimination on the basis of race, color, religion, or national origin in �places of public accommodation,� many states and municipalities have gone further, both in their enumeration of protected classifications, and in their definition of �public accommodation.� the u.s. constitution, however, provides an outer limit to the reach of these statutes and ordinances.� (footnotes omitted). 213. boy scouts of america, 530 u.s. at 647-48. 214. one author has noted that �boy scouts of america v. dale represents the first defeat for the application of a state anti-discrimination law; time will tell howbroadly it will apply.� see brody, entrance, voice, and exit, supra note 201. 215. boy scouts of america, 530 u.s. at 640. 216. the opinion simply describes the boy scouts as a �private, not-for-profit organization engaged in instilling its system of values in young people�. see id. at 643. however, the service identifies the boy scouts as an organization exempt from taxation by section 501(c)(3) of the code and entitled to receive tax deductible contributions from the public. enlightened and informed views.211 additionally, an overwhelming majority of states now have statutory laws that explicitly prohibit discrimination based on sexual orientation.212 nevertheless, the court�s conclusion in boy scouts of america is that freedom of expressive association permits private nongovernmental organizations, like the boy scouts, to exclude homosexuals if forced inclusion would significantly impair the organization�s message.213 in essence, boy scouts of america stands for the proposition that private nongovernmental groups may use freedom of expressive association as a shield against forced compliance with state anti-discrimination laws.214 in boy scouts of america v. dale,215 james dale an openly gay former eagle scout sued the boy scouts, a private membership charity,216 after that organization revoked dale�s adult membership based solely on his sexual 834 florida tax review [vol5:9 217. dale applied for and was granted adult membership in the boy scouts in 1989. shortly thereafter, dale, for the first time, acknowledged to himself and to others that he is gay. dale then became president of his college lesbian/gay organization. a newspaper later published an article about dale and his advocacy of gay issues, including the need for youths to have gay role models. the article included a picture of dale with a caption identifying him as president of his college lesbian/gay organization. during that same month, in 1990, dale received a letter from his local boy scouts council revoking his membership because the boy scouts �specifically forbid[s] membership to homosexuals.� see boy scouts of america, 530 u.s. at 665. 218. see boy scouts of america, 530 u.s. at 661-662 (citing n. j. stat. ann. § § 10:5-4 and 10:5-5 (west supp. 2000)). new jersey�s anti-discrimination law provides: all persons shall have the opportunity to obtain employment, and to obtain all the accommodations, advantages, facilities, and privileges of any place of public accommodation . . . without discrimination because of race, creed, color, national origin, ancestry, age, marital status, affectional or sexual orientation, familial status, or sex, subject only to conditions and limitations applicable alike to all persons. n. j. stat. ann. § 10:5-4 (west supp. 2000). new jersey�s anti-discrimination law defines �place of public accommodation� as including: any tavern, roadhouse, hotel, motel, trailer camp, summer camp, day camp, or resort camp, whether for entertainment of transient guests or accommodation of those seeking health, recreation or rest; any producer, manufacturer, wholesaler, distributor, retail shop, store, establishment, or concession dealing with goods or services of any kind; any restaurant, eating house, or place where food is sold for consumption on the premises; any place maintained for the sale of ice cream, ice and fruit preparations or their derivatives, soda water or confections, or where any beverages of any kind are retailed for consumption on the premises; any garage, any public conveyance operated on land or water, or in the air, any stations and terminals thereof; any bathhouse, boardwalk, or seashore accommodation; any auditorium, meeting place, or hall; any theatre, motion-picture house, music hall, roof garden, skating rink, swimming pool, amusement and recreation park, fair, bowling alley, gymnasium, shooting gallery, billiard and pool parlor, or other place of amusement; any comfort station; any dispensary, clinic or hospital; any public library; any kindergarten, primary and secondary school, trade or business school, orientation.217 dale�s primary claim against the boy scouts was that his exclusion violated a new jersey law that prohibits discrimination based on sexual orientation by places of public accommodation.218 the boy scouts 2002] charities and the constitution 835 high school, academy, college and university, or any educational institution under the supervision of the state board of education, or the commissioner of education of the state of new jersey. nothing herein contained shall be construed to include or to apply to any institution, bona fide club, or place of accommodation, which is in its nature distinctly private; nor shall anything herein contained apply to any educational facility operated or maintained by a bona fide religious or sectarian institution, and the right of a natural parent or one in loco parentis to direct the education and upbringing of a child under his control is hereby affirmed; nor shall anything herein contained be construed to bar any private secondary or post secondary school from using in good faith criteria other than race, creed, color, national origin, ancestry or affectional or sexual orientation in the admission of students. n. j. stat. ann. § 10:5-5 (west supp. 2000). 219. see boy scouts of america, 530 u.s. at 651-52 (the boy scouts asserts that homosexual conduct is inconsistent with the values embodied in the scout oath and law, particularly with the values represented by the terms �morally straight� and �clean.�). 220. see id. at 645. the new jersey superior court�s chancery division held that new jersey�s anti-discrimination law does not apply because the boy scouts is �not a place of public accommodation� and, further, is exempt from coverage under the law because the boy scouts is a private group. the court also held that the first amendment right to freedom of expressive association prevented new jersey from forcing the boy scouts to accept dale as a member. 221. see id. at 646. the new jersey superior court�s appellate division affirmed reversed and remanded for further proceedings, holding that the antidiscrimination law applied to the boy scouts, that the boy scouts violated that law and that the boy scouts was not entitled to insulation from liability by the first amendment right of freedom of expressive association. dale v. boy scouts of america, 706 a.2d 270 (1998). the new jersey supreme court affirmed the judgment of the appellate division. dale v. boy scouts of america, 734 a.2d 1196 (1999). responded that the anti-discrimination law is unconstitutionalas applied to its exclusion of dale because of the boy scouts� first amendment right not to associate with homosexuals, which the boy scouts considers inconsistent with its core values.219 a new jersey trial court rejected dale�s discrimination claim and granted summary judgment to the boy scouts.220 however, the state appellate and supreme courts sided with dale.221 the new jersey supreme court held that the boy scouts is a place of public accommodation covered by the state�s anti-discrimination law; it violated this law by revoking dale�s membership based solely on his sexual orientation; and it is not shielded from 836 florida tax review [vol5:9 222. see boy scouts of america, 530 u.s. at 646-47. the new jersey supreme court �agree[d] that [the boy scouts] expresses a belief in moral values and uses its activities to encourage the moral development of its members.� dale v. boy scouts of america, 734 a.2d at 1223. however, the court noted that it was �not persuaded . . . that a shared goal of boy scout members is to associate in order to preserve the view that homosexuality is immoral.� dale v. boy scouts of america, 734 a.2d at 1224 (internal quotation marks omitted). further, the court determined that the state has a compelling interest to eliminate �the destructive consequences of discrimination from our society,� and that this anti-discrimination law infringes no more speech than is necessary to accomplish this purpose. dale v. boy scouts of america, 734 a.2d at 1227-28. the boy scouts also claimed that new jersey�s law violated its right to intimate association. see boy scouts of america, 530 u.s. at 646-47. however, the new jersey supreme court concluded that the boy scouts� �large size, nonselectivity, inclusive rather than exclusive purpose, and practice of inviting or allowing nonmembers to attend meetings, establish that the organization is not �sufficiently personal or private to warrant constitutional protection� under the freedom of intimate association.� dale v. boy scouts of america, 734 a.2d at 1221 (quoting duarte, supra at 546). 223. see boy scouts of america, 530 u.s. at 649-56. 224. see id. at 650-56. 225. see id. at 648. 226. see id. at 649-50. 227. see id. at 650. coverage of this law by the first amendment right to freedom of expressive association.222 on appeal, the united states supreme court reversed the new jersey supreme court, concluding that new jersey�s interpretation of its antidiscrimination law violated the boy scouts� freedom of expressive association by forcing the organization to grant adult membership to dale.223 in reaching this conclusion, the supreme court determined that the boy scouts is engaged in expressive activity, that the nature of that expression is that homosexuality is immoral, and that the forced inclusion of dale would significantly impair the boy scouts� ability to advocate its views against homosexuality.224 in determining that the boy scouts engages in protected first amendment expression, the court reviewed the boy scouts� mission, which includes �helping to instill values in young people.�225 adult scout leaders, as dale once was, are charged with instructing young members in various outdoor activities while also inculcating the young boys with the boy scouts values. the communication of such values, per the court, is clearly a type of expression.226 after determining that the boy scouts engaged in expressive activity, the court evaluated the nature of that expression and the impact on that expression of forcing the boy scouts to keep dale as a member.227 the court notes that the boy scouts� core values include those contained in the scout oath and law, especially those represented by the terms �morally straight� and 2002] charities and the constitution 837 228. see id. at 648-50. 229. see id. at 652-53. 230. as an example, the court states that �some people may believe that engaging in homosexual conduct is not at odds with being �morally straight� and �clean.� and others may believe that engaging in homosexual conduct is contrary to being �morally straight� and �clean.�� id. at 651. 231. in fact, the court flatly refused to adopt the new jersey supreme court�s analysis of the boy scouts� beliefs that the �exclusion of members solely on the basis of their sexual orientation is inconsistent with [the boy scouts�] commitment to a diverse and �representative� membership . . . [and] contradicts [the boy scouts�] overarching objective to reach �all eligible youth.�� id. at 651 (quoting dale v. boy scouts of america, 734 a.2d at 1226). the supreme court notes that �it is not the role of the courts to reject a group�s expressed values because they disagree with those values or find them internally inconsistent.� see id. at 686. see also democratic party of united states v. wis. ex rel. la follette, 450 u.s. 107, 124 (1981) (�[a]s is true of all expressions of first amendment freedoms, the courts may not interfere on the ground that they view a particular expression as unwise or irrational.�); thomas v. review bd. of ind. employment sec. div., 450 u.s. 707, 714 (1981) (�religious beliefs need not be acceptable, logical, consistent, or comprehensible to others to merit first amendment protection.�). 232. see boy scouts of america, 530 u.s. at 655-56. �as we give deference to an association�s assertions regarding the nature of its expression, we must also give deference to an association�s view of what would impair its expression.� (citations omitted). see also la follette, 450 u.s. at 123-24 (considering whether wisconsin law burdened the national party�s associational rights and stating that �a state, or a court, may not constitutionally substitute its own judgment for that of the party�). however, the court cautions that an expressive association may not shield against antidiscrimination laws by nakedly asserting that mere acceptance of a particular member will impair its message. apparently, something more is required. 233. boy scouts of america, 536 u.s. at 659. it is unclear from the majority opinion whether the court would have reached the same conclusion about significant impairment had dale not been a �leader� in his community and �open and honest� about his sexual orientation. that is, the court�s explanation does not indicate whether the boy scouts� refusal to admit dale would have been upheld as freedom of expressive �clean.�228 the boy scouts asserted that homosexual behavior is inconsistent with these core values.229 though the court recognized that these terms may be subject to multiple interpretations,230 it gave great weight to the boy scouts� statement of its view that engaging in homosexual conduct is contrary to being �morally straight� and �clean.�231 the court also gave great weight to the boy scouts� view that dale�s continued adult membership as assistant scoutmaster would significantly impair the boy scouts� expression.232 according to the court, because dale was a �leader[ ]� in his community and �open and honest� about his sexual orientation, his mere presence forces the boy scouts �to send a message . . . that [it] accepts homosexual conduct as a legitimate form of behavior.�233 the supreme court concluded that this intrusion upon the boy 838 florida tax review [vol5:9 association if dale was either not a �leader� or not �open and honest.� this issue is made even more relevant by the court�s discussion of its earlier decision in hurley v. irish-american gay, lesbian and bisexual group of boston, inc., 515 u.s. 557 (1995). see boy scouts of america, 530 u.s. at 653-54. in hurley, the court considered whether a massachusetts law interpreted as requiring private organizers of a st. patrick�s day parade to include an irish-american gay, lesbian and bisexual group violated the organizers� freedom of expressive association. in concluding that the exclusion was protected by the first amendment, the court in hurley noted that the private parade organizers did not exclude the gay, lesbian and bisexual group because of the members� sexual orientation. rather, the group was excluded because they wanted to march behind a banner announcing its members� sexual orientation. the court in hurley concluded that the private parade organizers have the right to choose not to propound the view that homosexuality is socially acceptable by having members of a gay, lesbian and bisexual organization marching behind a banner. see hurley, 515 u.s. at 574-75. 234. boy scouts of america, 530 u.s. at 658. originally, state public accommodation laws were adopted to prevent discrimination in traditional places of public accommodation, such as inns and trains. see, e.g., hurley, 515 u.s. at 571-72 (explaining the history of massachusetts� public accommodations law); romer v. evans, 517 u.s. 620, 627-29 (1996) (describing the evolution of public accommodations laws). today, however, public accommodation laws have expanded to cover places not usually thought of as places of public accommodation, like summer camps and roof gardens. see, e.g., boy scouts of america, 530 u.s. at 658 (citing n. j. stat. ann. § 10:5-5(l) (west supp. 2000)) (noting that new jersey�s definition of place of public accommodation is so broad as to include a list of over 50 types of places). new jersey is the only state that has gone so far as to interpret its public accommodation statute as not requiring that a place of public accommodation be a physical location, thus encompassing membership organizations like the boy scouts. compare welsh v. boy scouts of america, 993 f.2d 1267 (7th cir. 1993); cert. denied, 510 u.s. 1012 (1993); curran v. mount diablo council of the boy scouts of america, 952 p.2d 218 (1998); seabourn v. coronado area council, boy scouts of america, 891 p.2d 385 (1995); quinnipiac council, boy scouts of america, inc. v. comm�n on human rights & opportunities, 528 a.2d 352 (1987); schwenk v. boy scouts of america, 551 p.2d 465 (1976). scouts� first amendment right is not outweighed by new jersey�s interest in preventing discrimination against homosexuals by places of public accommodation.234 the thrust of the court�s opinion in boy scouts of america v. dale is that private groups may use freedom of expressive association as a shield against a state�s enforcement of its anti-discrimination laws. it is ironic, however, that a state�s attempt to curb the tyranny of the majority by enacting laws to protect the minority may be thwarted by a constitutional law provision also aimed at preventing the tyranny of the majority. this conflict, between government attempts to lessen discrimination and private claims of a constitutional right to free expression, presents a paradox that is not insignificant. indeed, the juxtaposition of these two societal goals � lessening 2002] charities and the constitution 839 235. see boy scouts of america, 530 u.s. at 661. see also discussion supra notes 210-34 and accompanying text. discrimination against allowing free expression � implicates fundamental aspects of true democracy. thus, good or bad, the court in boy scouts of america resolves the anti-discrimination / free expression conflict in favor of free expression, at least where the anti-discrimination law protects homosexuals and the free expression violates anti-discrimination law by denouncing homosexuality. query: what does this decision mean with respect to service enforcement of the public policy limitation? must a public policy prohibiting discrimination against homosexuals, like an anti-discrimination law prohibiting such discrimination, also yield to an appropriate private claim of a constitutional right to free expression? 4. problems with using freedom of expressive association as a shield to protect tax-exempt charities that discriminate in deciding whether a particular charity violates �established public policy,� the service could confront a constitutional law claim that, for lack of a better term, justifies the charity�s clearly discriminatory action or policy. how should the service consider such a claim? should constitutional law claims such as freedom of expressive association be considered proverbial shields that prevent the service from revoking the charity�s tax-exempt status? what should be the relevance of the fact that the charity, though acting within its federal first amendment rights, violates a state law that might embody �established public policy� regarding discrimination? this article is not focused on the issue of whether a state may enforce its sexual orientation anti-discrimination laws against a private charity that has a valid freedom of expressive association basis for its discrimination. clearly, the court in boy scouts of america v. dale concludes that such state laws are unconstitutional and, therefore, unenforceable.235 but what about the federal tax laws that attempt to accomplish a goal similar to that strived for by state anti-discrimination laws? is the service, like states, also barred by valid freedom of expressive association claims from enforcing its version of federal anti-discrimination law for charities (i.e., the public policy doctrine) against private charities that discriminate? in order to demonstrate how a possible freedom of expressive association shield claim might be raised to fend off service enforcement of the public policy limitation, consider the following hypothetical: 840 florida tax review [vol5:9 236. just as the prior �prediction� about the future of constitutional law, this prediction about the future of anti-discrimination law is mere speculation, based somewhat on current trends in law. 237. see boy scouts of america, 530 u.s. at 640. 238. see bob jones univ. v. united states, 461 u.s. 574, 586 (1983). the public is outraged over the discovery that the male scouts of america (male scouts) excludes homosexuals from membership. while state law prohibits such exclusion by places of public accommodation like male scouts, a competent court determines that forcing the male scouts to comply with the state law would violate the male scouts� freedom of expressive association. in the wake of discovering that the male scouts is a tax-exempt charity, the service audits the male scouts for compliance with section 501(c)(3). pursuant to its audit, the service properly determines that discrimination against homosexuals like discrimination against black people violates �clear established public policy.� accordingly, the service issues appropriate notice to the male scouts that the service intends to revoke the male scouts� tax-exempt status because of this public policy violation. the male scouts then responds to the service that it cannot revoke its tax-exemption on this ground because a competent court previously determined that the �no homosexuals� policy is protected expression. how should the service respond? the primary focus of this hypothetical is not the service�s determination that discrimination against homosexuals violates �established public policy.�indeed, for purposes of the hypothetical, this determination is assumed to be correct.236 rather, the primary focus of the hypothetical is the issue of how the service should contend with an alleged constitutional law justification for this clear violation of public policy. stated differently, the concern is whether the first amendment�s prohibition against government infringing on a private group�s freedom of expressive association would be violated if the service revoked the male scouts� tax-exempt status. the service could respond to the male scouts� justification for its discrimination by arguing that no first amendment right is violated because revoking their tax exempt status does not prevent the male scouts from associating to express anti-homosexual views. unlike new jersey�s law in boy scouts of america v. dale, which outright prohibited discrimination by organizations like the male scouts,237 the public policy limitation only prohibits violations of �established public policy� while the organization maintains taxexempt status pursuant to section 501(c)(3).238 thus, whereas the boy scouts 2002] charities and the constitution 841 239. see discussion supra notes 46-58 and accompanying text. 240. boy scouts of america, 530 u.s. at 650. 241. see id. would not be able to operate at all if the state�s anti-discrimination violation finding were upheld, the male scouts could continue to operate (albeit in a taxable, as opposed to tax-exempt, form) even if the service�s public policy violation finding is upheld. the service�s public policy violation claim against the hypothetical male scouts under this scenario is arguably a stronger case than new jersey�s anti-discrimination claim against the boy scouts. while the boy scouts must cease operations as a result of a successful anti-discrimination claim, the male scouts can continue to operate both with and without its 501(c)(3) taxexemption. this analysis, of course, ignores the reality that many entities actually fail without the 501(c)(3) tax-exemption.239 nevertheless, the pivotal question is: what is the relevance of the nature of the punishment here (loss of exemption instead of loss of existence) to resolving the constitutional law issue of whether the boy scouts� right to freedom of expressive association is implicated by the service�s revocation action? the supreme court�s opinion in boy scouts of america is, at least, partially instructive on the issue of the proper focus of a court in deciding a freedom of expressive association case. in its analysis of whether new jersey�s law unconstitutionally infringed the boy scouts� freedom of expressive association, the court had to �determine whether the forced inclusion of dale . . . would significantly affect the boy scouts� ability to advocate public or private viewpoints.�240 thus, the court�s focus was on the nature of the boy scouts� expression and the effect on that expression of keeping dale as a member.241 similarly, the focus with regard to the service�s proposed action against the male scouts would likely be the nature of the male scouts� expression. however, even assuming that the nature of the male scouts� expression is the same as the boy scouts� and, assuming further, that keeping a homosexual as a member might significantly impair the male scouts� expression, the male scouts hypothetical raises another issue that was not addressed in boy scouts of america. that non-addressed issue is: what significance is attached to the distinction between necessarily preventing a private group from operating at all if it excludes homosexuals (boy scouts of america) versus preventing the group from operating with the special tax status afforded by section 501(c)(3) if it excludes homosexuals (male scouts hypothetical)? on this point, boy scouts of america is not very helpful. the supreme court has never addressed the specific issue of whether it is constitutional to require an organization to forego its constitutionally protected freedom of expressive association in order for the organization to obtain or maintain a 501(c)(3) tax-exemption. however, the court has 842 florida tax review [vol5:9 242. see regan v. taxation with representation, 461 u.s. 540 (1983). 243. see id. the court explains: twr is certainly correct when it states that we have held that the government may not deny a benefit to a person because he exercises a constitutional right. but twr is just as certainly incorrect when it claims that this case fits the speiser-perry model. the code does not deny twr the right to receive deductible contributions to support its nonlobbying activity, nor does it deny twr any independent benefit on account of its intention to lobby. congress has merely refused to pay for the lobbying out of public moneys. this court has never held that congress must grant a benefit such as twr claims here to a person who wishes to exercise a constitutional right. id. at 545. 244. see id. at 546. �congress has not infringed any first amendment rights or regulated any first amendment activity. congress has simply chosen not to pay for twr�s lobbying. we again reject the �notion that first amendment rights are somehow not fully realized unless they are subsidized by the state.�� id. 245. see, e.g., connick v. meyers, 461 u.s. 138 (1983). in connick, the court recognizes the authority of governmental employers to discharge employees because of inappropriate speech when it writes: addressed the closely related issue of whether it is constitutional to force a charity to give up certain first amendment rights (lobbying congress for example) in order to obtain or maintain 501(c)(3) tax-exempt status.242 in regan v. taxation with representation, the supreme court held that congress� requirement that charities agree not to lobby congress in order to satisfy requirements for 501(c)(3) tax-exempt status is not a violation of the first amendment because congress is not required to effectively fund lobbying by way of a tax-exemption.243 although lobbying congress is a first amendment free speech right, the court in taxation with representation held that the right is not violated by the government�s withdrawal of 501(c)(3) tax exemption pursuant to statutory law.244 similarly, even if the male scouts� exclusion of homosexuals is made in furtherance of its right to freedom of expressive association, that right is not necessarily violated by denying or revoking 501(c)(3) tax-exemption. this conclusion that the males scouts could not successfully claim, on public policy grounds, that freedom of expressive association would shield it against the service�s revocation of tax-exemption is also in line with other aspects of federal law. for example, in the labor law area, federal employees are often required to give up certain first amendment rights in order to keep their federal jobs.245 again, as in taxation with representation, the federal 2002] charities and the constitution 843 we hold only that when a public employee speaks not as a citizen upon matters of public concern, but instead as an employee upon matters only of personal interest, absent the most unusual circumstances, a federal court is not the appropriate forum in which to review the wisdom of a personnel decision taken by a public agency allegedly in reaction to the employee�s behavior. id. at 147. see also 5uscs § 7324(a) (2002) �the hatch act� (generally prohibiting federal employees from taking an active part inpolitical campaigns). 246. the charitable tax-exemption has been described as more �intuitive� than anything else. presumably, this means that congress just felt it �right� to exempt entities such as schools, churches and the like from the income tax. 247. some other theories that espouse an explanation for the existence of taxexempt charities include: 1) the income measurement theory; 2) the capital subsidy theory and 3) the donative theory. government is not required to fund a private actor�s free speech right. thus, the service�s public policy power, as currently conceived and even in the face of a proper freedom of expressive association claim, could be applied to revoke or deny the tax-exempt status of the hypothetical male scouts of america. iv. theoretical concerns with using constitutional law principles to define the scope of the public policy limitation a. the public benefit subsidy theory part ii showed how the service is guided by constitutional law decisions in developing its tax policy with respect to the tax-exempt status of private charities. part iii highlighted the many interpretation problems associated with the service relying significantly on constitutional law principles when making its public policy determinations. in part iv, this article argues that, for theoretical reasons, the service�s significant reliance on constitutional law decisions is inappropriate. reliance on constitutional law norms is inconsistent with the theory that tax-exempt charities are private actors who provide goods and services that government either cannot or will not provide. legislative history concerning �the reason for being� of tax-exempt charities is non-existent. it is as though congress was more concerned, historically at least, with the constitutionality of imposition of an income tax, than with rationales for exemptions from that tax.246 thus, courts and commentators have had to take it upon themselves to explain the basis for the charitable tax-exemption. although many such theories have been developed over the years,247 the most widely-accepted is the public benefit or traditional 844 florida tax review [vol5:9 248. see generally, rob atkinson, altruism in nonprofit organizations, 31 b.c. l. rev. 501, 606 n.292 (1990); brody, of sovereignty and subsidy, supra note 6. 249. james j. fishman et al., nonprofit organizations: cases and materials, 316 (1995) (citing chauncey belknap, the federal income tax exemption of charitable organizations: its history and underlying policy, iv research papers sponsored by the [filer] commission on private philanthropy and public needs, 2025, 2039 (1977)). 250. may l. heen, reinventing tax expenditure reform: improving program oversight under the government performance and results act, 35 wake forest l. rev. 751, 759 (2000). �[t]he funding of tax expenditures by foregone revenues tends to be less publicly visible than the funding of discretionary spending programs. tax expenditures, like entitlements, are not subject to the appropriations process.� id. 251. see national law journal, july 31, 1995. 252. see discussion supra notes 48-58 and accompanying text. subsidy theory.248 the public benefit subsidy theory holds that charities are exempt from taxation because they serve public purposes that are governmentlike, but government either cannot (or will not) satisfy the public need in the particular area. concisely put, the theory states that the tax-exemption is a government subsidy provided to organizations so as to encourage activities that are �recognized as inherently meritorious and conducive to the general welfare.�249 in essence, the charitable tax-exemption, per the public benefit subsidy theory, is a subsidy for certain activities favored by significant segments of the society, whether government supports the activity or not. congress� grant of the subsidy indirectly by way of a tax-exemption, instead of having the government provide direct subsidies to deserving entities and meritorious activities, supports the notion that the charitable tax-exemption is intended to support activities that do not necessarily have governmental or majority appeal. an indirect subsidy by way of a tax-exemption lessens the involvement of government in the affairs of charities. indeed, since a taxexemption is by its very nature �automatic,� its grant is not readily subject to the annual whims of government concerning budget balancing matters and the like.250 take the example of congress� attempt in the mid-nineteen nineties to lessen government financial support for death penalty relief organizations by threatening decreased direct funding of said organizations unless the organizations agreed to curtail activities with respect to certain types of cases.251 the death penalty groups refused and, accordingly, congress reduced their funding. despite this unfortunate circumstance, these death penalty groups, because of their tax-exempt status, were able to continue to operate even without direct government subsidies because of their tax-exempt charitable status. the tax-exemption enabled these private organizations to operate without the burden of income tax payment obligations and the taxdeduction enabled the organizations to raise funds in the form of increased charitable contributions.252 2002] charities and the constitution 845 253. the preamble to the elizabethan statute of charitable uses outlines some of the various types of charitable purposes that were recognized at that time in the seventeenth century. however, these purposes were only indicators, or typical, of the various charitable purposes that would be recognized by the crown. they were not exclusive. the preamble provides: whereas lands. . . have been heretofore given . . . by the queen . . . her most noble progenitors [and] other well [intentioned] persons, some for the relief of [the] aged, . . . some for maintenance of [the] sick, . . . [some for schools, bridges, and highways and some for the benefit of the poor]. . . see statute of charitable uses (preamble) (1601). the two major goals of the statue of uses were to 1) establish commissions throughout england so that misapplication of charitable trusts could be investigated and 2) define �charitable purposes� so that the various commissions would know what trusts to investigate and protect. these common law beginnings of organized philanthropy have had a tremendous influence on our modern day charitable framework, especially concerning tax-exempt charities. 254. see, e.g., treas. reg. § 1.501(c)(3)-1(d)(2) (1990). section 1.501(c)(3)1(d)(2) provides in part that: [charity] includes: relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of government; and promotion of social welfare. . . id. 255. see, e.g., bob jones univ. v. united states, 461 u.s. 574 (1983). b. the inconsistency of reliance on constitutional principles with the public benefit subsidy theory of all theories that attempt to justify the tax-exemption for charities, the public benefit subsidy theory seems to be the most intuitive and widelyaccepted. the public benefit subsidy theory is supported by historical notions of charity dating back to the statute of charitable uses in 1601.253 an aspect of this theory, that charities lessen the burdens of government, has been enshrined in the regulations pertaining to 501(c)(3) tax-exemption.254 additionally, the supreme court has espoused a version of this theory in its decisions concerning the propriety of the service�s regulatory activities respecting charities.255 for example, in bob jones university v. united states, the court notes that: �[i]n enacting . . . § 501(c)(3), congress sought to provide 846 florida tax review [vol5:9 256. id. at 587-88. tax benefits to charitable organizations, to encourage the development of private institutions that serve a useful public purpose or supplement or take the place of public institutions of the same kind.�256 given that the public benefit subsidy theory espouses a separate-fromgovernment role for tax-exempt charities, it would be highly inconsistent with this theory to suggest that charities are subject to constitutional law restrictions that constrain government activity. if we ever reach the day when the supreme court invalidates race-based affirmative action by government, this might inevitably mean that state colleges and universities could not use the race of an applicant as a factor when making its admissions decisions. while this might mean the end to one type of social justice action by government (race-based affirmative action that is), it should not mean the end to that type of action by tax-exempt charities, at least not if the public benefit subsidy theory is an accurate reflection of charitable existence. indeed, pursuant to the public benefit subsidy theory, the fact that government is constitutionally prohibited from doing that which many in society see as remedying the lingering effects of slavery is a more than adequate justification for tax-exempt charities to act. thus, the service�s efforts in using constitutional law principles to decide issues of �established public policy� is inconsistent with the entire underpinnings for why tax-exempt charities exist. v. conclusion when the supreme court decided in bob jones university that charities cannot violate established public policy, it failed to provide the service with sufficient guidance on how to use various sources of public policy to determine �established public policy� on particular matters. as a result, the service has taken upon itself to define public policy by looking almost exclusively to constitutional law principles. the bishop estate tam is a prime example of this strong reliance by the service on constitutional law principles. in evaluating whether the bishop estate�s exclusion of persons having no hawaiian ancestry was consistent with �established public policy,� the service relied on a line of fourteenth amendment cases. these cases hold that state actors cannot make distinctions based on race unless those distinctions are �necessary� to accomplish �compelling� government interests. none of these cases involve scrutiny of actions by private actors, only state actors. to make matters worse, the service apparently relied on a fifteenth amendment case, rice v. cayetano, in deciding whether the bishop estate�s �no non-hawaiian� policy is consistent with fourteenth amendment principles and, hence, with established public policy. 2002] charities and the constitution 847 it is entirely inappropriate for the service to look almost exclusively to constitutional law principles to decide when a charity violates established public policy. the public policy doctrine is a statutory principle, not a constitutional one, emanating from section 501(c)(3) of the internal revenue code. as such, the public policy doctrine defines acceptable conduct for those entities subject to the statute charities. while some charities may be state actors and, thus also subject to separate restrictions imposed by constitutional law, most charities are not state actors. the supreme court has been very clear to point out that, absent special statutory enactments like the 1964 civil rights act, private actors such as charities are not directly subject to constitutional law provisions like the equal protection clause of the fourteenth amendment. the service�s significant reliance on equal protection clause principles to decide whether a charity violates established public policy presents some interpretational concerns in regards to race-based affirmative action that are not insignificant. for one, it is not at all clear what standard of review the service should use to determine if a particular charity�s race policies violate public policy. over the years, the supreme court has fluctuated between strict scrutiny and intermediate level scrutiny for benign, as opposed to invidious, racial preferences. what standard should the service use for benign affirmative action policies by charities? even if the service chooses the correct standard, how should it use a standard that requires consideration of compelling government interests in circumstances where the actor is not governmental? a second concern with applying equal protection clause standards to charities relates to the current circuit split on the issue of whether race can ever constitutionally be used as a factor in making government decisions. if some circuits say considering race is acceptable, some circuits say considering race is not acceptable, and the supreme court has not addressed the issue, how is the service to decide which circuit to follow? a third concern relates to the nature of the service as a tax agency � it lacks the necessary expertise to decide either whether a particular use of race is necessary or whether the reason for its use is compelling. the service should await guidance from congress on the issue of how constitutional law principles should affect tax law decisions about the tax-exemption for charities authorized by section 501(c)(3) of the internal revenue code. alternatively, the service could engage in a type of analysis that considers a variety of sources constitutional, non-constitutional, federal and non-federal � in deciding if a particular charity is in violation of �established public policy.� thus, this article examines the relationship between constitutional law and tax law in an effort to continue discussion of how federal tax authorities should respond when a tax-exempt charity engages in activities that would be unconstitutional if done by a government actor. additionally, this article examines the matter of whether a private charity should be permitted to use the constitution as a shield in tax cases, like the boy 848 florida tax review [vol5:9 scouts did in a non-tax case, to prevent revocation, on public policy grounds, of its 501(c)(3) tax exemption. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 2 1994 number 3 rethinking section 2702 grayson m. p. mccouch" i. introduction in 1990, congress added chapter 14 to the code' to address several gift and estate tax avoidance techniques that flourished under prior law.2 in general, those avoidance techniques involved fragmenting beneficial ownership into separate interests to facilitate transferring the underlying property in several stages. a donor utilizing one of these techniques initially transferred one interest while retaining another interest in the same property. eventually, the interest retained in the initial transfer lapsed or was disposed of in a subsequent transfer. especially where the underlying property was held in a closely-held business entity or family trust, the respective interests could be tailored to shift value from donor to donee in ways that proved extremely difficult to detect or measure. chapter 14 responds by adopting special valuation rules for certain types of transactions to ensure that such value shifts are included in the transfer tax base.' * associate professor of law, university of miami school of law. a.b., harvard university; j.d., stanford law school; ll.m. (taxation), boston university school of law. 1. omnibus budget reconciliation act of 1990, pub. l. no. 101-508. § 11602, 104 stat 1388, 1388-491 (codified at irc §§ 2701-2704). 2. in enacting chapter 14, congress retroactively repealed its earlier, ill-fated attempt to deal with the same techniques under former § 2036(c). omnibus budget reconciliation act of 1990, supra note 1, § 11601, 104 stat. at 1388490. section 2036(c) was enacted by the omnibus budget reconciliation act of 1987, pub. l. no. 100-203, § 10402, 101 stat. 1330. 1330-430, and amended by the technical and miscellaneous revenue act of 1988, pub. l. no. 100-647, § 3031, 102 stat. 3342, 3634. 3. for overviews of estate freezing techniques under prior law, see staff of joint comm. on taxation, 101st cong., 2d sess.. present law and proposals relating to federal transfer tax consequences of estate freezes (comm. print 1990); george cooper, a voluntary tax? new perspectives on sophisticated estate tax avoidance, 77 colum. l. rev. 161 (1977); symposium, the estate freezing rage: a practical look at planning opportunities and potential problems, 15 real prop., prob. & tr. j. 21 (1980); see also byrle 1m. abbin, the value-capping cafeteria-selecting the appropriate freeze technique, 15 inst. on est. plan. ch. 20 (1981). 4. see irc §§ 2701 (gift of subordinate equity interest in corporation or partnership), 2702 (gift of split interest in property), 2703 (restrictions on use or disposition of florida tax review section 2702 of the code applies to split-interest arrangements involving successive beneficial interests representing present and future rights to possess or enjoy the underlying property. when a donor transfers one interest to a family member while retaining another interest, the special valuation rules of section 2702 assign a value of zero to the retained interest unless it meets various statutory requirements. since the value of the transferred interest is determined by subtracting the value of the retained interest from the value of the underlying property, section 2702 produces a correspondingly high value for the transferred interest, which is reflected in the donor's gift tax base. for example, a parent who gratuitously transfers a remainder to a child while retaining an income interest for a limited term makes a completed gift of only the remainder. if the special valuation rules assign a zero value to the income interest, the donor makes a taxable gift of the full value of the underlying property. if the parent subsequently disposes of the retained interest in a transfer that attracts a gift or estate tax, a problem of double taxation may arise. the section 2702 regulations address this problem by providing a corrective adjustment at the time of the subsequent transfer. this article examines the structure and operation of section 2702 in the context of the existing gift and estate tax system. part ii explains the abuses under prior law that led to the enactment of section 2702. part iii analyzes the impact of section 2702 in valuing the transferred and retained interests in the initial transfer, and critically examines the operation of the corrective adjustment under the regulations. part iv argues that the approach of section 2702 is fundamentally misguided because it adds unnecessary complexity and exacerbates existing structural problems in the gift and estate tax system. those problems, as well as the abuses targeted by section 2702, could be addressed more effectively by a uniform transfer tax base coupled with uniform rules for the completion and valuation of all lifetime and deathtime transfers. ii. valuation under general principles section 2702 is aimed primarily at a few tax-driven techniques involving transfers with retained interests. a classic example is the so-called grantor retained income trust (a "grit"'), by which the donor makes a gift property), 2704 (lapsing rights or restrictions). the split-interest transfers addressed by § 2702 differ materially in form, function, and tax treatment from the other estate freezing techniques addressed by §§ 2701, 2703, and 2704; the latter transactions fall outside the scope of this article. for an overview of chapter 14, see 5 boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts ch. 136 (2d ed. 1993). [vol 2:3 rethinking section 2702 of property subject to a retained income interest for a limited termi during the 1980s when interest rates were high and property values appreciated rapidly (in nominal dollars), grits and similar techniques offered donors attractive opportunities to take advantage of annual increases in the unified credit.6 the following overview of these techniques lays a foundation for understanding the scope and operation of section 2702 and for evaluating its effectiveness. moreover, the techniques discussed below remain viable in situations where section 2702 does not apply.' a. timing and amount of hiclusion under well-established gift tax principles, a donor carving beneficial ownership of property into separate interests may make a completed gift of some interests while retaining others, and no gift is made of a retained interest.8 even with respect to a transferred interest, the gift generally remains incomplete if the donor retains control over its beneficial enjoyment by others.9 however, the possibility that beneficial enjoyment may return to the donor in the discretion of another person generally does not prevent 5. see staff of joint comm. on taxation. supra note 3. at 12-13. 15-16 (describing grits and similar techniques); u.s. trust, practical drafting 397-430 (1984) (comprehensive analysis by richard b. covey). on the viability of split-interest arrangements after the enactment of § 2702, see howard m. zaritsky & ronald d. aucutt. structuring estate freezes under chapter 14 chs. 10-13 (1993); mitchell m. gans, grit's. grat's and grut's: planning and policy, i1 va. tax rev. 761 (1992); u.s. trust, practical drafting 3325-457 (1993). 6. between 1981 and 1987, the unified credit rose from $47.000 to s192,800. economic recovery tax act of 1981, pub. l. no. 97-34. § 401(b). 95 stat. 172, 299 (amending irc § 2505). as a result, the amount of cumulative taxable transfers sheltered from gift and estate taxes by the unified credit rose from $175,625 to s600.000. 7. for example, a grit remains viable if the donee is not a member of the transferor's family, see irc §§ 2702(a)(1), (e), 2704(c)(2), or if the underlying property is to be used as a personal residence by the holder of the term interest, see irc § 2702(a)(31(a)(ii). 8. regs. § 25.2511-1(e); smith v. shaughnessy, 318 u.s. 176 (1943). the gift tax applies only to transfers of beneficial interests in property (i.e., the right to possess or enjoy the property or its income); for gift tax purposes, a transfer of bare legal title to a trustee is not a gift. regs. § 25.2511-1(g)(1). 9. estate of sanford v. commissioner, 308 u.s. 39, 44 (1939). a retained power which permits the donor to regain beneficial enjoyment or to change the beneficial enjoyment of others generally prevents completion. regs. § 25.2511-2(b), (c). a retained power does not prevent completion, however, if it affects only "'the manner or time of enjoyment." regs. § 25.2511-2(d), is exercisable only in conjunction with a person having a substantial adverse interest, regs. § 25.2511-2(e), or is exercisable in a fiduciary capacity and limited by a fixed or ascertainable standard, regs. § 25.251 1-2(g). 19941 florida tax review completion.' the donor thus enjoys considerable flexibility both in defining separate interests in the underlying property and in determining the time of completion of a gift of a particular interest. the amount of a gift is its value at the time of completion." property generally is valued at "fair market value"-the price at which it would change hands in a hypothetical ann's-length transaction.1 2 when beneficial enjoyment of property is split into a term interest 3 and a remainder, 4 the property's value is apportioned among the interests. since the combined interests represent complete ownership of the property, the value of each interest generally is derived by subtracting the value of the other interests from the value of the entire property. 5 thus, the values of the respective interests are interdependent, and any uncertainty or inaccuracy in the valuation of one interest indirectly affects the valuation of the other. if the limitations and conditions affecting possession or enjoyment of the underlying property can be estimated reasonably, 6 the gift tax value of a term interest or remainder is determined by discounting the future payments to present value under treasury tables based on prescribed discount rates and mortality assumptions. 7 the tables greatly simplify the valuation of split 10. regs. § 25.2511-2(g); shaughnessy, 318 u.s. at 181. to the extent that the donor's creditors can reach the property under state law, however, the donor is treated as retaining the power to regain beneficial enjoyment. outwin v. commissioner, 76 t.c. 153, 186 (1981), acq. 1981-2 c.b. 2. 11. irc § 2512(a). the value of any consideration in money or money's worth received by the donor reduces the amount of the gift. irc § 2512(b). moreover, the first $10,000 of present-interest transfers made by a donor to any donee in any calendar year is excluded from the donor's gifts for that calendar year. irc § 2503(b). 12. the fair market value of property generally is "the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts." regs. § 25.2512-1. 13. for convenience, this article adopts the terminology of § 2702, which uses the phrase "term interest" to mean any present or future interest that confers a right to possess or enjoy property, or to receive income or annuity payments, for a definite period of time, such as the life of one or more individuals or a term of years. irc § 2702(c)(3). 14. for convenience, this article uses the term "remainder" to mean any future interest that confers a right to possess or enjoy property at the expiration of a term interest, including an interest that would be classified as a reversionary interest or executory interest under state property law. 15. see regs. § 25.2512-5. 16. special problems arise if the duration of a term interest or the time for possession or enjoyment of a remainder depends on conditions that cannot be measured actuarially. see prop. regs. § 25.7520-3(b); infra notes 53-60 and accompanying text. 17. irc § 7520 (valuation of annuities, interests for life or a term of years, remainders, and reversions); regs. §§ 1.664-4, 25.2512-5; prop. regs. § 25.7520-1. the treasury tables appear in i.r.s. publication 1457, actuarial values-alpha volume (1989) [vol. 2:3 rethinking section 2702 interests by sidestepping the need to resort to case-by-case investigations of factors affecting expected rates of return and life expectancies. a simple grit illustrates the impact of the tables on the gift tax value of split interests. assume that a, age 70, transfers property worth $100,000 in trust to pay income to herself for a term of 15 years with remainder at the end of the term to her nephew b or b's estate.'" if the applicable discount rate is 10%, the value under the tables of a's retained interest is $76,061 (the present value of 15 annual payments of $10,000 each), and a has made a gift of $23,939, the value of the trust property less the value of a's retained income interest.' 9 a can reduce further the amount of the gift by retaining the right to receive the trust property at the end of the 15-year term in the event she is not then living.20 under the tables, the present value of this additional retained interest is $14,131, and the amount of the gift is only $9,808.21 in the example, the respective values of the interests in trust income and corpus are not necessarily unrealistic. if, in accordance with the assumptions built into the tables, the trust property actually has a constant value of $100,000 and generates income at an annual rate of 10%, a's retained income interest is properly valued by discounting a 15-year stream of $10,000 annual payments at an annual rate of 10%.' moreover, if a retains the right to receive the trust corpus at the end of the 15-year term in the event she is not then living and if the mortality tables accurately reflect a's life expectancy, the value of b's remainder is discounted properly to reflect the probability that a will die within 15 years. ' [hereinafter actuarial values (alpha)] and i.r.s publication 1458, actuarial values-beta volume (1989). 18. the special valuation rules of § 2702 do not apply because b is not a "member of [a]'s family" within the meaning of that section. irc § 2702(a)ll). see infra note 76. 19. see actuarial values (alpha), supra note 17. at table b. 20. a might retain this additional interest because the trust corpus will be included in her gross estate for estate tax purposes in the event she dies before her retained income interest expires. retention of the conditional interest in trust corpus therefore reduces the gift tax without significantly increasing the potential estate tax. see infra note 45. 21. b's remainder will become possessory only if a survives the 15-year term. accordingly, the present value of the interest transferred to b is the present value of the right to receive $100,000 in 15 years ($23,939) multiplied by the probability that a will survive the 15-year term (27,960/68,248), or $9,808. similarly, the present value of a's additional retained interest is the present value of the right to receive s 100,000 in 15 years (s23,939) multiplied by the probability that a will not survive the 15-year term 0 (27,960168,248)), or s 14,131. see actuarial values (alpha), supra note 17, at tables b. h, 80cnsmt. 22. in other words, the income distributed to a will replace the declining value of her interest in future trust income, leaving a's net worth unchanged. 23. a may appear to be undertaxed if she survives the 15-year term because her retained interest in trust corpus will terminate without triggering any further inclusion in her 19941 florida tax review however, the values of the interests in trust income and corpus are only as accurate as the assumptions built into the tables. three of those assumptions raise special concerns in the context of a's grit. first, the tables assume that the trust corpus remains constant in value and that the trust's entire investment return takes the form of current income. any assumption concerning the allocation of investment return to income or corpus is unreliable because that allocation normally depends on subsequent actions of the trustee in administering the trust.24 for example, assume that the trustee of a's grit properly invests the trust corpus of $100,000 in stock that generates $9,000 of capital appreciation and $1,000 of dividends annually? 5 although a actually receives annual income of only $1,000, the tables value her retained income interest as a stream of $10,000 annual payments and produce a corresponding undervaluation of the remainder transferred to b. a second, analytically distinct problem concerns the assumed discount rate (rate of return). in determining the present value of a split interest, 26 the tables apply a uniform discount rate indexed to the prevailing rate of return on federal obligations. since the expected return on an investment reflects the type and degree of risk of the investment,28 the discount rate assumed transfer tax base. conversely, she may appear to be overtaxed if she dies during the term because the entire trust property will revert to her and be included in her gross estate. without the benefit of hindsight, the tables apportion the value of the trust corpus at the end of the 15year term between a and b based on the actuarial probability of a's survival or death during the term. the accuracy of that apportionment depends on how closely the mortality tables reflect a's actual life expectancy. 24. section 2702 addresses this problem by valuing the retained interest at zero unless the trust is structured in a way that makes the trust accounting distinction between income and corpus largely irrelevant. see infra notes 82-94 and accompanying text. 25. in theory, the trustee may be constrained in its investment and allocation decisions by a duty of impartiality. as a practical matter, however, the shift of investment return from a to b may escape inclusion in a's transfer tax base. see infra note 51 and accompanying text. 26. for a general introduction to risk, return, and present value, see william a. klein & john c. coffee, jr., business organization and finance 225-35, 303-24 (5th ed. 1993). 27. the discount rate is 120% of the federal midterm rate (determined monthly under § 1274(d)(1)), rounded to the nearest 0.2% and compounded annually. irc § 7520(a)(2). the discount rate approximates a riskless rate plus a modest premium to compensate for volatility risk. 28. the expected return on an investment represents the arithmetic mean of probable outcomes and reflects the risk of loss (default risk). the variance or dispersion of probable outcomes (volatility risk), to the extent that it cannot be eliminated by diversification, commands a market risk premium. the market risk premium is reflected in a lower present value, and a correspondingly higher discount rate, for the investment. in theory, it is possible to adjust the expected return to eliminate volatility risk and discount the resulting certainty [vol. 2:3 rethiddng section 2702 by the tables is almost certainly unrealistic in any particular case.' for example, if the discount rate is unrealistically low, the tables distort the relative present values of split interests." in the case of a's grit, this distortion might benefit the government, since an understated discount rate produces an artificially low value for a's retained income interest and thus overvalues the remainder transferred to b. the distortion would benefit a, however, if she retained a right to fixed payments rather than an income interest.3 finally, the tables assume that each individual has a life expectancy consistent with the national mortality experience.' -" this assumption is unrealistic because it takes only age into account, and disregards other factors that indicate a longer or shorter life expectancy for a particular individual. as a result, the tables may produce distorted values for split interests conditioned on survival or nonsurvival. 3 for example, in the case of a's grit, if a enjoys unusually robust health and expects to live longer than the average 70year-old, the tables may produce an unrealistically high value for her retained interest in corpus (conditioned on her death within 15 years) and a correspondingly low value for the remainder transferred to b.-" in sum, the tables reflect assumptions about income and corpus allocations, rates of return, and mortality risks that diverge from actual equivalent at a riskless rate in calculating present value. see richard a. brealey & stewart c. myers, principles of corporate finance 201-04 (4th ed. 1991): klein & coffee, supra note 26, at 226-35, 323-24. 29. it might be argued that the probability of a low return should offset the probability of a high return and that all investments should have the same expected return. this argument ignores the fact that an increase in nondiversifiable volatility risk drives up the expected return if the present value of the investment is held constant. see klein & coffee, supra note 26, at 231-35. 30. in effect, the tables apportion the value of the underlying property among the respective split interests. if the value of the underlying property is understated, however, all of the interests will be undervalued. section 2702 does not address the separate (and more serious) problem of ensuring accurate valuation of the underlying property. see joseph isenbergh, simplifying retained life interests, revocable transfers, and the marital deduction, 51 u. chi. l. rev. 1, 16 (1984) (noting the "ubiquitous and largely irreducible problem of valuation"). 31. this problem, unlike the problem of allocating return to income or corpus, is not addressed by § 2702. as a result, opportunities for valuation abuse persist with respect to qualified interests under § 2702. see infra notes 93-98 and accompanying text. 32. the national mortality statistics are revised at least every 10 years. irc § 7520(c)(3). 33. this problem is not addressed by § 2702. as a result, opportunities for valuation abuse persist with respect to qualified interests under § 2702. see infra notes 99-101 and accompanying text. 34. under the tables, a has an actuarial life expectancy of 13.32 years. see actuarial values (alpha), supra note 17. at table 80cnsmt. 1994] florida tax review outcomes in particular cases. this does not raise serious concerns as long as valuation risks are allocated fairly between taxpayers and the government.35 the opportunity for abuse arises when valuation risks are skewed systematically in favor of taxpayers. inevitably, the tables reflect crude and rigid assumptions that bear little or no relation to the facts and circumstances of particular cases. since the tables are almost always conclusive in valuing split interests,36 taxpayers (who usually have superior information concerning the factors affecting value in particular cases) tend to structure transactions to exploit the tables and reduce the gift tax value of transferred interests.37 whether a grit simply defers or permanently avoids transfer tax depends on what becomes of the donor's retained interests after the initial transfer. in the case of a's grit, if a subsequently makes a completed gift of her retained interest in trust income or corpus, the gift will be valued under the tables in the same manner as the initial transfer. if she instead retains both interests, any trust income or corpus distributed to a will ultimately be reflected in the pool of assets constituting her transfer tax base. 38 if a survives the 15-year term, however, the trust property will 35. in making an immediate gift of a future interest in the grit property (rather than waiting to transfer the property outright at the end of the 15-year term), a in effect engages in a wager with the government concerning the future value of the property. an analogous allocation of risk occurs in a short sale where a seller, s, agrees to deliver property (not presently owned by s) to a 15 years in the future. if the property appreciates, a benefits and s loses; if the property declines in value, s benefits and a loses. if the sale price accurately reflects the present value of the right to receive the property in 15 years, the allocation of risk is fair. 36. section 7520 prescribes mandatory tables for valuing split interests where the valuation date occurs after april 30, 1989. proposed regulations authorize departures from the tables where the terms of an income interest or remainder failed to provide substantially the same degree of beneficial enjoyment as general trust law principles, or where an individual who is a measuring life is terminally ill at the time of the gift. prop. regs. § 25.7520-3(b)(2), (3); cf. o'reilly v. commissioner, 973 f.2d 1403 (8th cir. 1992) (permitting departure under prior law where grit was funded with low-dividend growth stock of closely-held corporation); estate of mclendon v. commissioner, t.c. memo 1993-459 (cch) (1993) (permitting departure under prior law where donor's actual life expectancy was less than one year); rev. rul. 80-80, 1980-1 c.b. 194 (permitting departure under prior law where death was "clearly imminent" or reasonably certain to occur within one year). 37. see s. rep. no. 1001, 101st cong., 2d sess. 59-60 (1990), reprinted at 136 cong. rec. s15629, s15681 (oct. 18, 1990) [hereinafter 1990 senate report] (noting problem of "adverse selection"); staff of joint comm. on taxation, supra note 3, at 18; see also gans, supra note 5, at 766-76 (discussing disparities between assumed discount rate and expected rate of return). 38. with the lapse of time, a's interest in trust income is gradually reduced to possession as each year's income is distributed to her. any income distributed to a ultimately will be reflected in her transfer tax base unless consumed or dissipated by her during life. to the extent that a consumes her income distributions rather than other assets, the income [vol 2:3 rethinking section 2702 escape subsequent inclusion in her transfer tax base. neither the termination of a's retained interests in trust income and corpus at the end of the term, nor the simultaneous vesting in possession of b's remainder, constitutes a transfer for gift or estate tax purposes. if a dies during the 15-year term, the entire trust property is included in her gross estate at its deathtime value. this result makes good sense where a retains a reversion in trust corpus that becomes possessory at death, since property owned by a decedent forms the core of the gross estate.3 the inclusion of the entire trust corpus in a's gross estate may at first appear excessive, since the value of b's remainder was previously included in a's taxable gifts. however, the amount included in the gross estate is attributable solely to a's reversion and not to b's previously-taxed remainder. the apparent overtaxation where a dies during the 15-year term is the converse of the apparent undertaxation where a survives the term. even if a retains only the right to receive trust income and dies during the 15-year term, the entire trust property is included in her gross estate under the so-called "string" provisions.' the string provisions raise a problem of potential double taxation to the extent that they include in the gross estate property which already has been subjected in whole or in part to gift tax during the decedent's life." to mitigate this problem, section 2001(b) of the code excludes any previously-taxed interest from adjusted taxable gifts while allowing the previously-paid gift tax as an offset against the tentative estate tax.42 as a result, the string provisions and section distributions indirectly enhance the value of the other assets. any corpus distributable to a's personal representative at death is included in her gross estate. 39. irc § 2033. 40. irc § 2036(a)(1). the same result occurs if a releases the income interest within three years of her death. irc § 2035(a), (d). the term "string provisions" generally refers to the estate tax provisions that, in various circumstances, include property transferred during life in the gross estate. irc §§ 2035-38. 41. where applicable, the string provisions include property transferred during life in the gross estate based on the transferor's retained ownership or control with respect to an interest in the property, regardless of whether the lifetime transfer was a completed gift. double taxation also may occur with respect to contractual survivorship arrangements, irc § 2039(a), joint tenancies with survivorship rights, irc § 2040(a). property subject to a general power of appointment, irc § 2041(a), and life insurance on the decedent's life transferred within three years of death, irc §§ 2035(a), (d). 2042. 42. very generally, the gift and estate taxes are integrated by computing the estate tax as (1) a tentative tax on the sum of the taxable estate and "adjusted taxable gifts" (generally, all taxable gifts made after 1976), less (2) a hypothetical gift tax on all post-1976 taxable gifts, computed under the rate schedule in effect at the decedent's death. irc § 2001(b). however, if property transferred by taxable gift is included in the gross estate, the gift is omitted from adjusted taxable gifts, but is included in computing the hypothetical gift tax. irc § 2012 (providing estate tax credit for gift tax on pre-1977 gifts included in gross estatel. 19941 florida tax review 2001(b) generally ensure that reincluded property ultimately enters the transfer tax base only once, at its deathtime value, and treat any gift tax on a lifetime transfer of the same property as a prepayment of the resulting estate tax.43 a's grit produces the greatest transfer tax savings if the string provisions do not apply. the entire trust property is included in a's gross estate if she dies during the 15-year term, due to her retained interest in trust income.44 by retaining the additional interest in trust corpus conditioned on her death within the 15-year term, a achieves an immediate reduction in gift tax while avoiding any substantial increase in estate tax.45 moreover, if a survives the 15-year term, the expiration of her additional interest in trust corpus does not attract a subsequent transfer tax. accordingly, if the 15-year term exceeds a's actuarial life expectancy 46 but in fact ends before her death, a grit with a retained reversion permits a to transfer the underlying property at substantially less transfer tax cost than a single outright transfer made during life or at death. if a's actual life expectancy is less than her actuarial life expectancy, she may still be able to exploit the tables using either of two arrangements involving a simple life income interest with no reversion.47 as in the case of a grit, the most dramatic opportunities for transfer tax avoidance occur where the underlying property is expected to appreciate substantially during a's life while producing little current income. the first of these arrangements is a sale of a remainder. assume that a, age 70, transfers property in trust to pay income to herself for life with 43. although the net amount included in the transfer tax base may be the same as if the decedent simply had retained the underlying property until death, the tax cost of a splitinterest transfer subject to the string provisions may be heavier or lighter than that of a single deathtime transfer of property owned at death. on one hand, the donor loses the return on amounts used to pay gift tax on the initial transfer. on the other hand, the amount of the gift tax paid is removed from the gross estate if the initial transfer occurs more than three years before death. see infra notes 163-66 and accompanying text. 44. if a retains an income interest for her life, the trust property is included in the gross estate no matter how long she lives, unless she disposes of the income interest more than three years before death. irc §§ 2035(a), (d), 2036(a)(1). 45. the retained interest in trust corpus reduces a's taxable gift by $14,131 (leaving a taxable gift of $9,808), and potentially increases her estate tax by the amount of the gift tax on the gift, which will not be allowed if the trust property is included in her gross estate under § 2033 rather than § 2036(a)(1). see supra note 21 and accompanying text. the reduced gift tax represents an immediate benefit to a that may well outweigh the discounted present value of the potential additional estate tax cost. 46. under the tables, a has an actuarial life expectancy of 13.32 years. see actuarial values (alpha), supra note 17, at table 80cnsmt. 47. the tables may be inapplicable if a is terminally ill at the time of the gift. see supra note 36. [vol 2:3 rethinking section 2702 remainder at her death to b or b's estate. in exchange, a receives money'sworth consideration from b. if the consideration is equal to the value of b's remainder, there is no taxable gift.4 moreover, the same consideration may be sufficient to remove the arrangement from the reach of the string provisions, notwithstanding a's retained life income interest. "9 if the consideration is adequate for gift and estate tax purposes, a's transfer tax base will reflect the consideration received by a as well as any income actually distributed to her, but these amounts may be substantially less than the value of the trust property that they replace.5" conversely, any appreciation in the value of the trust property after the initial transfer may increase the value of b's remainder while escaping inclusion in a's transfer tax base.' alternatively, the arrangement might take the form of a joint purchase. assume that a purchases a life income interest and b simultaneously purchases a remainder in the underlying property from a third party. if each purchaser furnishes money's-worth consideration equal to the value of the interest received, there is no taxable gift. moreover, the string provisions should be inapplicable because a made no lifetime transfer; indeed, she never owned more than a life income interest in the underlying property. if the 48. for gift tax purposes, the consideration must at least equal the value of b's remainder determined under the tables. irc §§ 2512(b), 7520(a). if a is 70 years old, the trust property is worth $100,000, and the applicable discount rate is 10%. the values of a's life income interest and b's remainder under the tables are $64,093 and $35,907, respectively. see actuarial values (alpha), supra note 17, at table s. as in the original grit example, the special valuation rules of § 2702 do not apply because b (a's nephew) is not a "member of [a]'s family" within the meaning of that section. irc § 2702(a)(i). see infra note 76. 49. see irc § 2036(a)(1) (providing exception for "bona fide sale for an adequate and full consideration in money or money's worth"). however, by analogy to the similar exception in § 2035(b)(1), one court has held that for estate tax purposes the adequacy of consideration must be measured by the value of the underlying trust property, which otherwise would be included in the gross estate, rather than by the value of the transferred interest. gradow v. united states, i1 cl. ct. 808 (1987). aff d, 897 f.2d 516 (fed. cir. 1990). see charles l.b. lowndes, consideration and the federal estate and gift taxes: transfers for partial consideration, relinquishment of marital rights, family annuities, the widow's election, and reciprocal trusts, 35 geo. wash. l. rev. 50, 81-82 (1966). 50. if the money's-worth consideration received by a is not adequate for estate tax purposes, the deathtime value of the trust property, reduced only by the amount of the consideration, is included in her gross estate. irc §§ 2036(a)(1), 2043(a). 51. in theory, the trustee may be liable to a for making investment or allocation decisions that improperly favor b at a's expense. restatement (second) of trusts § 232 (1959) (duty of impartiality). furthermore, if a consents to such investments or fails to pursue her remedies against the trustee, she may be treated as making an indirect gift to b. see dickman v. commissioner, 465 u.s. 330 (1984); estate of lang v. commissioner. 613 f.2d 770 (9th cir. 1980). as a practical matter, however, such a gift may be difficult to detect or measure. see snyder v. commissioner, 93 t.c. 529 (1989). 19941 florida tax review form of the transaction is respected,52 a's transfer tax base will reflect any income actually received by her, which may be substantially less than the compounded value of the consideration that she paid for her income interest. as in the previous example involving a sale of a remainder, substantial value may be shifted from a to b without entering a's transfer tax base. b. retained interests lacking an ascertainable value in apportioning value among term interests and remainders, the assumptions built into the tables concerning income and corpus allocations, discount rates, and mortality risks are normally conclusive. in some cases, the probability of an uncertain event, such as marriage or birth of issue, may be estimated based on actuarial or other evidence.53 in other cases, however, no evidentiary basis exists for ascertaining the values of the various interests. in those cases, a donor bears the burden of proving the value of any retained interest in arriving at the value of a transferred interest. assume that, in the case of a's grit, a retains the right to receive the trust property at the end of the 15-year term if neither b nor any of b's issue is then living. in robinette v. helvering,54 the supreme court refused to allow any reduction in the amount of a gift for a similarly conditioned retained interest because the donor failed to offer "any recognized method by which it would be possible to determine the value" of the interest.55 whether 52. to the extent that consideration furnished by b is traceable to a, the government may be able to recast the transaction as a purchase of the underlying property by a followed by a gift of a remainder to b. in that case, a corresponding portion of the underlying property is included in a's gross estate under the string provisions. see estate of shafer v. commissioner, 749 f.2d 1216 (6th cir. 1984) (estate tax); gordon v. commissioner, 85 t.c. 309 (1985) (income tax); priv. let. rul. 9206006 (oct. 24, 1991) (estate tax). 53. see commissioner v. maresi, 156 f.2d 929 (2d cir. 1946) (affirming tax court's reliance on remarriage statistics in determining estate tax value of claim for payments to divorced spouse until death or remarriage); rev. rul. 76-472, 1976-2 c.b. 264 (noting that decedent's vested remainder subject to open should be valued with "due regard" for probability that 53-year-old woman might bear or adopt additional children); rev. rul. 71-67, 1971-1 c.b. 271 (valuing claim for payments to surviving spouse until death or remarriage); rev. rul. 6188, 1961-1 c.b. 417 (noting that decedent's remainder conditioned on death without issue of a childless 44-year-old married woman should be valued with regard to "all known circumstances relative to the particular life tenant, rather than to women aged 44 in general"). 54. 318 u.s. 184 (1943). 55. id. at 188. in robinette, a 30-year-old woman created a trust, in contemplation of marriage, to pay income to herself for life, then to her parents for their lives, with remainder to her issue upon reaching age 21 or in the absence of issue to the appointees of the last surviving income beneficiary. clearly, the settlor's taxable gift excluded the value of her retained income interest but included the value of her parents' secondary income interests. the dispute concerned the value of the settlor's reversionary interest, which was conditioned ['vol. 2:3 retzinking section 2702 viewed as announcing an evidentiary standard or a rule of valuation, robinette imposes an outer limit on the technique of tailoring retained interests to reduce the gift tax value of transferred interests.6 the holding of robinette is limited to cases where a donor retains one or more interests that have no ascertainable value while making a gift of other interests in the same underlying property." whether a retained interest has an ascertainable value is a question of fact. 58 if the retained interest has an ascertainable value,59 or if the transferred interest represents the donor's entire interest in the underlying property,60 there is no need to deviate from general valuation principles in valuing the transferred interest. although the impact of robinette on the apportionment of value in the initial transfer is well settled, the subsequent treatment of a retained interest having no ascertainable value remains unclear. specifically, a problem of double taxation arises if the value of the retained interest, having already been subjected to gift tax in the initial transfer, enters the transfer tax base not only on her surviving both parents but also on her dying without issue. id. at 185-86. 56. see regs. § 25.251 1-1(e) (noting that if a donor retains a reversion conditioned on a 25-year-old beneficiary's death without issue, gift tax "normally" applies to the entire value of the property because the reversion is "not susceptible of measurement on the basis of generally accepted valuation principles"). 57. under robinette, the value of a retained interest is taken into account only to the extent established by the taxpayer. 318 u.s. at 188-89. thus, a retained interest with no ascertainable value is valued at zero; if the donor establishes some minimum value, only that value is taken into account. see, e.g., rev. rul. 72-571, 1972-2 c.b. 533 (noting that settlor who released control over reversion in stock worth si,500x. while retaining reversion in $100x, made completed gift of discounted value of reversion in s1,400x; possibility that settlor might receive stock at termination had no ascertainable value); rev. rul. 77-99, 1977-1 c.b. 295 (noting that allocation of future capital gains to income and capital losses to corpus deprives retained reversionary interest of any ascertainable value). 58. see mchugh v. united states. 142 f. supp. 927 (ct. cl. 1956) (denying summary judgment, and permitting taxpayer to introduce evidence concerning value of income beneficiary's limited power to invade corpus). moreover, whether value is ascertainable may depend on whether a relevant condition (e.g., marriage or birth of issue) is within the control of an interested person. assume that a creates a trust to pay income to b (who currently has no issue) for life, with remainder at b's death to b's issue or reversion to a if no issue of b are then living. a's reversion may have no ascertainable value, whether or not the probability of death without issue is statistically unascertainable, if b has motive and opportunity to skew the outcome in b's favor. see estate of cardeza v. united states. 261 f.2d 423, 426-27 (3d cir. 1958); cf. commissioner v. estate of sternberger, 348 u.s. 187, 197-98 (1955) (noting potential abuse where charitable interest was conditioned on event within private beneficiary's control). 59. see, e.g., smith v. shaughnessy, 318 u.s. 176 (1943) (holding amount of gift reduced by value of reversion where property was transferred in trust to pay income to settlor's wife for life, then reversion to settlor if living, otherwise remainder to wife's heirs). 60. see regs. § 25.251 i-i(0); cf. rev. rul. 76-472. 1976-2 c.b. 264: rev. rul. 6188, 1961-1 c.b. 417. 19941 florida tax review again during life or at death. if the donor makes a subsequent lifetime gift of the retained interest, what little authority exists indicates that the subsequent gift should simply be disregarded, regardless of the value of the interest at that time.6' this approach can be defended on grounds of consistency; since the interest retained in the initial transfer was valued at zero under robinette, it is also valued at zero in the subsequent transfer. disregarding the subsequent transfer preserves symmetry in valuing the retained interest and prevents double taxation.62 at the same time, this approach wreaks havoc with the general principle that a gift of an interest should be valued and included in the gift tax base when the gift becomes complete.63 the disjunction between the time the gift tax is imposed on the retained interest (in the initial transfer) and the time the donor makes a completed gift of that interest (in the subsequent transfer) has its roots in the holding of robinette. by imposing a gift tax on the combined value of the retained and transferred interests in the initial transfer, robinette in effect telescopes the initial and subsequent transfers into a single taxable event. though conceptually inelegant, this pragmatic approach sidesteps the problem of valuing an interest that has no ascertainable value. moreover, once the retained interest has attracted a gift tax in the initial transfer, the same interest should not be subject to a second gift tax in the subsequent transfer. the rationale for disregarding a subsequent transfer of the retained interest might appear equally persuasive where that transfer occurs at death rather than during life. however, if the donor still owns the retained interest at death, the interest generally is included in the gross estate. 6' indeed, the 61. see estate of kolb v. commissioner, 5 t.c. 588 (1945) (holding that settlor who created trust with fixed equal shares for existing grandchildren, retaining power to add afterbom grandchildren, made gift of entire value of trust property, and that no additional gift occurred when settlor subsequently released retained power); rev. rul. 79-421, 1979-2 c.b. 347 (holding that gift included retained rights to extent value not ascertainable, where initial trustee relinquished general power of appointment, retaining rights conditioned on co-trustees dying or ceasing to act during his life; on subsequent release of remaining rights, gift excluded value of previously-taxed rights). 62. see burnet v. guggenheim, 288 u.s. 280, 285 (1933) (noting that gift tax requires "consistent choice" of rule governing time of completion). 63. see irc §§ 2501(a)(1) (imposing gift tax on transfer of property by gift), 2511 (a) (defining scope of transfer), 2512(a) (valuing gift of property at date of gift). although the government occasionally has flirted with the notion of holding a completed gift "open" until valuation difficulties are resolved, see, e.g., rev. rul. 81-31, 1981-1 c.b. 475, it appears to have conceded that the issue of completion logically precedes the separate issue of valuation. see rev. rul. 92-68, 1992-2 c.b. 257 (revoking rev. rul. 81-31); see also estate of dimarco v. commissioner, 87 t.c. 653 (1986), acq. in result 1990-2 c.b. 1. 64. irc § 2033. an owned interest that expires at death is not transmissible and therefore has no includable value. however, a reversionary interest that expires at death may trigger inclusion of the underlying property under the string provisions. irc § 2037(a) [vol 2:3 rethinking section 2702 controlling statute expressly requires that property owned at death be included in the gross estate at its deathtime fair market value." since the initial transfer, the retained interest may have changed substantially in value, and may have become more susceptible of valuation. if the interest is included in the gross estate at its fair market value, double taxation can be avoided only by making an adjustment to neutralize the initial inclusion in the gift tax base. section 2001(b) provides such an adjustment when a lifetime gift is included in the gross estate, ensuring that the gift ultimately enters the cumulative transfer tax base only once, at its deathtime value. technically, this is accomplished by excluding the reincluded gift from the decedent's adjusted taxable gifts,6 while reducing the estate tax by the amount of gift tax payable with respect to the lifetime transfer.67 the section 2001(b) adjustment normally applies when the interest retained in the initial transfer is not directly included in the gross estate but is sufficient to trigger inclusion of a previously-taxed interest in the underlying property under the string provisions. 6s technical and practical problems arise in applying the section 200 1(b) adjustment to a retained interest that was valued at zero in the initial transfer. when the retained interest is a reversion that becomes possessory at or before death, the underlying property is included in the gross estate without reference to the string provisions. 69 even if such a reversion is valued at zero in (providing that property transferred during life, with retained reversionary interest worth more than 5% of underlying property immediately before death, is includable in gross estate if possession or enjoyment of property can be obtained only by surviving the decedent). 65. fair market value generally is determined at death, unless the alternate valuation date is elected. irc §§ 2031, 2032; regs. § 20.20311(b). the value assigned to a reversionary interest for purposes of the 5% test under § 2037(a) is relevant to the question of includability, regs. § 20.2037-1(c)(3), but not to the amount included in the gross estate, regs. § 20.20371(e)(4). cf. cardeza, 261 f.2d at 424-25 (valuing reversionary interest at zero for purposes of 5% test under prior law). 66. irc § 2001(b). see supra note 42. 67. if the lifetime gift occurred before 1977, the adjustment takes the form of a credit against the estate tax in the amount of the gift tax. irc § 2012. 68. for example, if a creates a trust to pay income to herself for life with remainder at her death to b or b's estate, the retained life income interest itself is not included in a's gross estate, but it may trigger inclusion of the remainder. irc § 2036(a)t 1). similarly, if a creates a trust to pay income to b for life with reversion at b's death to a if living or to c or c's estate if a is not living, and a dies before b. the retained reversion itself is not included in a's gross estate, but it may trigger inclusion of the remainder. irc § 2037(a). 69. assume that a creates a trust to pay income to b (currently age 25, unmarried, and without issue) for life, with reversion at b's death to a if a is then living and no issue of b are then living, otherwise remainder to c or c's estate. if a's reversion has no ascertainable value, the entire value of the trust property is subjected to gift tax under robinette. if b dies 19941 florida tax review the initial transfer under robinette, it is difficult to see how a completed gift can be made of a retained interest.7" if no completed gift occurred with respect to the retained interest, the section 2001(b) adjustment may be unavailable because it applies only to "taxable gifts" that are included in the gross estate. even if the section 2001(b) adjustment technically applies, it may prove unworkable. the adjustment consists of an exclusion from adjusted taxable gifts of the value of the taxable gift that is included in the gross estate, but this value could not be ascertained at the time of the gift. if the retained interest had no ascertainable value for gift tax purposes in the initial transfer, it similarly should generate no section 2001(b) adjustment for estate tax purposes.7' as a practical matter, the problem of double taxation resulting from the lack of a section 2001(b) adjustment seldom arose before the enactment of section 2702. transfers in trust normally can be structured to avoid subjecting the same beneficial interest both to a gift tax in the initial transfer and to an estate tax at death. where the string provisions draw a previouslytaxed gift into the gross estate, section 2001(b) generally mitigates the risk of double taxation.7 2 an acute problem of double taxation normally arises only where a donor subsequently transfers a retained interest that was valued at zero in the initial transfer. this troublesome situation is likely to become increasingly common as a result of section 2702. im. valuation under section 2702 in response to valuation abuses involving split-interest transfers, congress, in 1990, enacted section 2702, which provides special rules for apportioning the value of trust property between retained and transferred interests. a few defined types of retained interests continue to be valued under the tables. the special rules value most other retained interests at zero, thereby indirectly increasing the gift tax value of interests transferred in the without issue and a is still living, a's reversion becomes possessory and is included in a's gross estate under § 2033, presumably with no § 2001(b) adjustment. 70. the gift tax result of valuing a retained interest at zero is equivalent to finding a completed gift of that interest, but a completed gift is inconsistent with inclusion of the interest in the gross estate as property owned at death. 71. the value of the retained interest has probably changed, and may have become easier to measure, between the initial transfer and the donor's death. however, the deathtime value of that interest is irrelevant in calculating the § 2001(b) adjustment, which depends on the value of the retained interest at the time of the initial transfer. 72. in robinette, for example, the donor retained a life income interest in addition to her reversion in the trust corpus. a life income interest, if retained until death, triggers inclusion of the entire trust property in the donor's gross estate under § 2036(a)(1), with a § 2001(b) adjustment for the value of the interests subjected to gift tax in the initial transfer. [vol 2:3 rethinking seciion 2702 initial transfer. section 2702 thus may be viewed as an expanded application of the principle of robinette. from this perspective, the following discussion focuses first on the effect of the special valuation rules in the initial transfer and then on related problems in the subsequent treatment of specially-valued retained interests. a. initial transfer the scope of section 2702 is defined by reference to three interrelated elements: a trust, a transfer, and a retained interest. 3 for purposes of section 2702, a trust includes any arrangement that splits beneficial ownership of property into successive interests, i.e. a term interest and remainder. 4 the statute applies when a living donor transfers a beneficial interest in trust property75 to or for the benefit of a member of the donor's family.76 the special rules apply for gift tax purposes in valuing interests retained by the donor (or an "applicable family member"n ) in the underlying property? 8 73. in determining the existence and amount of a gift resulting from a "transfer of an interest in trust to (or for the benefit of) a member of the transferor's family," § 2702 provides special rules governing the valuation of "any interest in such trust retained by the transferor or any applicable family member." irc § 2702(a)(1 ). the regulations enumerate certain transfers that are not subject to § 2702. regs. § 25.2702-1(c). 74. for purposes of § 2702, a term interest is a present or future interest that confers a right to possess or enjoy property, or to receive income or annuity payments, for a definite period of time, such as the life of one or more individuals, or a term of years. irc § 2702(c)(3). a remainder is a future interest that confers a right to possess or enjoy property at the expiration of a term interest. see supra notes 13-14. property is held in trust if there is at least one term interest (and, by implication, a remainder) with respect to the property. irc § 2702(c)(1) (defining "transfer in trust"). thus, the concept of a trust depends on the division of beneficial ownership of property into successive (as distinguished from concurrent) interests. see regs. § 25.2702-4(a). 75. a transfer in trust includes a transfer of property to a new or existing trust, as well as a transfer of an interest in an existing trust. a transfer does not include a qualified disclaimer or an exercise, release, or lapse of a power of appointment that is not treated as a transfer for gift tax purposes. regs. § 25.2702-2(a)(2). 76. "member of the family" includes the donor's spouse, ancestors and lineal descendants of the donor or the donor's spouse. the donor's siblings, and spouses of the foregoing. irc §§ 2702(e), 2704(c)(2). if the beneficiaries of a transfer in trust include family members and others, § 2702 presumably applies to the entire trust, excluding only any specified portion in which no family member has an actual or potential interest. cf. irc § 2702(d) (stating that in the case of a transfer of an income or remainder interest with respect to a "specified portion" of trust property, § 2702 applies only to such portion). 77. "applicable family member" includes the donor's spouse, ancestors of the donor or the donor's spouse, and spouses of those ancestors. irc §§ 2702(a)(1). 2701(e)(2). 78. an interest is "retained" if it is held by the same individual both before and after the transfer in trust. regs. § 25.2702-2(a)(3). an individual who retains a power affecting beneficial enjoyment of property is treated as retaining an interest in the property to the extent 19941 florida tax review accordingly, the special rules do not apply if the transfer in trust constitutes a completed gift of all interests in the property,79 or if the donor's retained interests and powers ensure that no portion of the transfer is a completed gift.80 in general, section 2702 reaches most types of grits and similar split-interest arrangements that exploited the valuation tables under prior law.8 section 2702 serves a limited function of apportioning value for gift tax purposes between interests that are retained and transferred in the initial transfer.8 2 based on the notion that the aggregate value of all beneficial interests in the trust equals the value of the trust property, the regulations derive the value of transferred interests by subtracting the value of retained interests from the value of the trust property. 3 thus, in focusing on the valuation of retained interests, the special rules indirectly control the valuation of transferred interests for gift tax purposes. by limiting the value of retained interests, the special rules set a floor on the amount of the gift in the initial transfer. the special rules have no effect, however, on general principles governing the timing or extent of gift completion. under section 2702, a "qualified" retained interest is valued under the tables, and any other retained interest is generally valued at zero." a term interest is qualified only if it confers a right to receive payments in fixed amounts (an annuity interest) 5 or payments equal to a fixed percentage of that the retained power would prevent a transfer of the property from being a completed gift. regs. § 25.2702-2(a)(4). thus, a donor cannot avoid § 2702 simply by retaining a power to revoke or change beneficial interests rather than retaining beneficial ownership of the interests. 79. regs. § 25.2702-2(d)(1) ex. 3. however, if a beneficiary of an existing trust transfers the beneficiary's entire interest to a family member, § 2702 applies if an applicable family member of the beneficiary owns an interest in the trust both before and after the transfer. 80. regs. §§ 25.2702-1(c)(1), 25.2702-2(d)(1) ex. 4. 81. personal residence trusts represent a glaring gap in the coverage of § 2702. see regs. §§ 25.2702-1(c)(2), 25.2702-5. as the drafters of the regulations acknowledge, such trusts perpetuate precisely the valuation abuses that § 2702 is intended to curb. t.d. 8395, 1992-1 c.b. 316, 319. 82. accordingly, § 2702 has no effect on valuation for income, estate, or generationskipping-transfer tax purposes. i.r.s. notice ps-92-90, 1991-1 c.b. 998, 999; t.d. 8395, 1992-1 c.b. 316, 318. 83. regs. § 25.2702-1(b). 84. irc § 2702(a)(2)(a), (b); regs. § 25.2702-2(b)(1), (2). an exception applies where the nonexercise of rights under a retained term interest in tangible property has no substantial effect on the value of the remainder. irc § 2702(c)(4); regs. § 25.2702-2(c). in this case, the retained term interest is valued under an arm's-length standard that normally produces a value for the term interest that is lower than its value determined under the tables. this exception permits limited tax benefits from a grit with respect to tangible, nondepreciable property such as antiques, art works, jewelry, or unimproved land. 85. irc § 2702(b)(1); regs. § 25.2702-3(b). [vol 2:3 rethinking section 2702 the annually-determined value of the trust property (a unitrust interest); ' in either case, the amounts must be payable at least annually, for a term equal to the holder's life, a specified term of years, or the shorter (but not the longer) of those periods. 87 a remainder is qualified only if it confers an unconditional right to receive property in which all other interests are qualified interests. 88 the requirements are intended to ensure that the holder of a qualified interest will actually receive distributions that can be valued realistically under the tables.' 9 conversely, denying value to nonqualified interests reduces opportunities for manipulating the tables. to illustrate the impact of the special rules, assume that a transfers property worth $100,000 in trust to pay income to herself for a term of 15 years with remainder to her child c or c's estate.90 under section 2702, the amount of a's gift is $100,000; her retained income interest is valued at zero because it is not a qualified interest. the result is the same if a also retains a reversion conditioned on her death within the 15-year term. in view of the possibility that a might survive the 15-year term and never receive any distributions of income or corpus, the special rules treat her retained interests as having no ascertainable value in the initial transfer. the special rules also curtail the gift tax advantages of a sale of a remainder or a joint purchase. assume that a, age 70, transfers property worth $100,000 in trust to pay income to herself for life with remainder at her death to her child c or c's estate, and in exchange c pays a the value of the remainder determined under the tables. under section 2702, the amount 86. irc § 2702(b)(2); regs. § 25.2702-3(c). 87. regs. § 25.2702-3(d)(3). the § 2702 regulations impose no restrictions on the type of property that may be used to make the required payments. nevertheless. § 2701 may apply if a donor creates a trust of subordinate equity interests in a corporation or partnership while retaining senior equity interests in the same entity. regs. § 25.2701-31bl(4)fiii) (incorporating § 2702 principles in valuation under § 2701). under § 2701, payment in the form of an equity interest in the entity is not a qualified payment. regs. § 25.2701-4(c1(5). 88. irc § 2702(b)(3); regs. § 25.2702-3(f). 89. reflecting the same concern, the regulations prohibit any distribution to a person other than the holder during the term as well as any prepayment of the holder's interest. t.d. 8395, 1992-1 c.b. 316, 319; regs. § 25.2702-3(d)(2), (4). if the holder does not receive the required payments, the interest apparently ceases to be qualified. see regs. § 25.2702-3(d1 1), (f)(1)(ii) (noting that definitional and functional requirements apply from creation). the definition of qualified interests under § 2702 is derived from the rules limiting charitable deductions for gifts of split interests, which reflect similar valuation concerns. see i.r.s. notice ps-92-90, 1991-1 c.b. 998, 1001; cf. irc § 2522(c)(2)(b); regs. § 25.2522(c)3(c). indeed, certain transfers qualifying for a gift tax charitable deduction are exempt from § 2702. regs. § 25.2702-1(c)(3)-(5). 90. this example is identical to the grit described in text accompanying note 18. supra, except that the remainder beneficiary is a member of a's family and, as a result. § 2702 applies. see supra note 76. 19941 florida tax review of a's gift is the difference between the value of the underlying property and the consideration furnished by c.9 alternatively, assume that a purchases a life income interest and c simultaneously purchases a remainder in the underlying property from an unrelated third party, each furnishing consideration in proportion to the value (determined under the tables) of the interest received. section 2702 recasts the joint purchase as if a purchased the underlying property and then sold the remainder to c for the consideration actually furnished by c.92 in both cases, section 2702 denies a the tax benefit of valuing her life income interest under the tables. section 2702 substantially reduces the gift tax advantages of retaining nonqualified interests in transfers subject to the special rules. split-interest transfers remain viable as transfer tax avoidance techniques, however, where the special rules do not apply.93 even under section 2702, the mandatory use of the tables to value qualified interests offers substantial planning opportunities to the extent that the tables reflect unrealistic assumptions concerning actual rates of return and life expectancies. assume that a, age 70, transfers property worth $100,000 in trust to pay a qualified annuity of $10,000 to herself for 15 years or until her prior death, with remainder to her child c or c's estate. if the applicable discount rate is 10%, a's retained annuity is valued at $60,307 and the amount of a's gift to c is $39,693.' 4 the amount of the gift accurately reflects the present value of c's remainder if the underlying assumptions of the tables coincide with realistic expectations concerning the rate of return on the trust's investments and a's actual mortality risk. to the extent that those assumptions are unrealistic, however, the tables may distort the value of c's remainder.95 for example, the tables reflect an assumption that the trust property will produce a 10% annual return that will match precisely the $10,000 annuity payments to a, 91. assuming a discount rate of 10%, the values of a's life income interest and c's remainder determined under the tables are $64,093 and $35,907, respectively. see actuarial values (alpha), supra note 17, at table s. accordingly, the amount of a's gift is $64,093. see regs. § 25.2702-4(d) ex. 2. 92. irc § 2702(c)(2); regs. § 25.2702-4(c). thus, if a pays $64,093 and c pays $35,907, in proportion to the values of their respective interests under the tables, the amount of a's gift is $64,093 ($100,000 $35,907). see regs. § 25.2702-4(d) ex. 1. the amount of a's gift, however, cannot exceed the amount of consideration furnished by a. thus, if a pays only $20,000 and c pays $35,907, the amount of a's gift is limited to $20,000. see regs. § 25.27024(d) ex. 4. the bargain sale to a may trigger a separate gift by the third-party seller. 93. for example, the special rules do not apply if the donee is not a member of the donor's family, see supra note 76, or to certain transfers of property to be used as a personal residence. irc § 2702(a)(3)(a)(ii); regs. § 25.2702-5. 94. see actuarial values (alpha), supra note 17, at table h. 95. an even more serious distortion may arise if the trust property itself is undervalued. see supra note 30 and accompanying text. [vol 2:3 rethinking section 2702 leaving property worth $100,000 for c at the end of the term. if the property actually produces a 12% annual return and a survives the 15-year term, c will receive property worth $174,559 rather than $100,000 at the end of the trust term. if the interests were valued using the actual rate of return of 12%, rather than the 10% assumed return, a's retained annuity would be valued at $54,791, and the gift to c would be $45,209, not $39,693.' the tables thus produce a substantial undervaluation of a's gift, and this undervaluation increases in proportion to the length of the term. the effect is even more accentuated if the annuity payments increase in amount over the term.' if the rate of return on trust investments is lower than the assumed rate, a donor can manipulate the special rules by retaining a qualified reversion. assume that a transfers property worth $100,000 in trust to pay a qualified annuity of $10,000 to c for 15 years with reversion to a or a's estate. if the applicable discount rate is 10%, a's retained reversion is valued at $23,939 and the amount of a's gift to c is $76,061. 9if the property actually produces an annual return of only 5%, the annuity payments will exhaust the trust during the 15th year, leaving a with a worthless interest at the end of the term. thus, a substantial portion of the value of the underlying property may escape inclusion in a's transfer tax base. a similar distortion may arise if a has an unusually short life expectancy, even if the underlying property actually produces precisely the assumed rate of return.99 assume that a, age 70, transfers property worth $100,000 in trust to pay a qualified annuity of $12,000 to herself for 15 years or until her prior death, with remainder to c or c's estate. at a discount rate of 10%, the value of c's remainder under the tables is $27,632 at the time of the initial transfer.tu since the $12,000 annuity exceeds the assumed annual income of $10,000, the tables reflect an assumption that the annuity payments will gradually consume the value of the underlying property. if the 96. see actuarial values (alpha), supra note 17, at table h. 97. backloading a's annuity payments increases the risk and potential return for b by increasing the portion of the trust property locked into the trust's rate of return during the early years of the term. the § 2702 regulations permit noncumulative annual increases of up to 20% in the payments under a qualified term interest. regs. § 25.2702-3(b)( )(ii). (cjli)(ii). the extent of permitted backloading thus increases in proportion to the length of the term. the holder of a qualified term interest may also have a right to receive any trust income in excess of the payments under the qualified interest, but the excess income is disregarded in valuing the qualified interest. regs. § 25.2702-3(b)(1)(iii), (c)(1)(iii). 98. see actuarial values (alpha), supra note 17, at table b. 99. if a is terminally ill at the time of the initial transfer, the tables may be inapplicable in valuing her retained interest. see supra note 36. 100. under the tables, a has a life expectancy of 13.32 years, and the present value of her retained annuity is $72,368. see actuarial values (alpha). supra note 17, at tables 80cnsmt, h. 1994] florida tax review property generates annual income of 10%, and a dies two years after the initial transfer, the trust property will be worth $95,800 at a's death.'' thus, in overestimating a's life expectancy, the tables may substantially undervalue c's remainder in the initial transfer. in theory, it is possible to fix the amount of a retained qualified annuity high enough to eliminate gift tax in the initial transfer. such a "zeroout" arrangement, if permitted, would permit a donor to make a tax-free transfer of any return on the property in excess of the assumed rate without suffering any tax cost if the actual return fell below the assumed rate.t ° the section 2702 regulations prevent this result, however, by discounting the present value of each annuity payment by the probability of the holder's death. thus, although a donor may retain a qualified annuity for a fixed term, the special rules in effect accord value only to annuity payments for the shorter of the fixed term or the donor's life. 3 since there is always a possibility that the donor may die before receiving a particular payment, the gift tax value of the retained interest is always less than the value of the underlying property.1°4 thus, despite their apparent harshness, the special rules leave room for planners to exploit the tables in apportioning value between retained and transferred interests in the initial transfer. to measure the impact of section 101. the string provisions may include all or a portion of the trust property in a's gross estate if a actually dies during the 15-year term. see irc § 2036(a)(1); rev. rul. 82105, 1982-1 c.b. 133 (retained annuity interest); rev. rul. 76-273, 1976-2 c.b. 268 (retained unitrust interest); priv. let. rul. 9345035 (aug. 13, 1993) (including entire trust property under § 2039). 102. assume that a creates a trust to pay a qualified annuity to herself for a fixed term of years with remainder to her child c or c's estate. if the present value of a's retained annuity is exactly equal to the value of the underlying property at the time of the initial transfer, there is no taxable gift. moreover, if a survives the 15-year term, there will be no further transfer tax consequences. if the property generates a return above the rate assumed under the tables, c will receive the excess value at the end of the term free of transfer tax; if the property generates less than the assumed rate, both a and c will be in the same position as if the transaction had never occurred. 103. regs. §§ 25.2702-3(d)(3) (permitting fixed-term qualified interest), 25.27023(e) exs. 1, 5 (valuing fixed-term qualified interest as if for shorter of fixed term or holder's life). 104. this result cannot be circumvented by increasing the annuity amount, since annuity payments are taken into account only to the extent supported by the value of the underlying property. see prop. regs. § 25.7520-3(b)(2)(i), (v) ex. 5; rev. rul. 77-454, 1977-2 c.b. 351; see also gans, supra note 5, at 833-37 (arguing that a donor who retains an annuity interest "confers a valuable right on the remainderman even where the annuity amount is set at a level that zeroes out the taxable gift"); u.s. trust, practical drafting 3546-51 (1994) (tables assume underlying property sufficient to support annuity payments); but cf. estate of shapiro v. commissioner, t.c. memo 1993-483 (cch) (1993) (disregarding possibility that annuity payments might exhaust underlying property). [val 2:3 rethinking section 2702 2702 on split-interest transfers in trust, however, it is important to examine the subsequent treatment of retained interests after the initial transfer. b. subsequent treatment of retained interests after the initial transfer, the value of a retained interest is no longer determined under the special rules; in a subsequent transfer, the interest is valued under general principles. in the case of a retained qualified interest, the shift from one valuation method to another is innocuous because both methods value a qualified interest under the tables. in the case of a retained nonqualified interest, however, the two valuation methods raise a problem of potential double taxation. the special rules generally increase the amount of the gift in the initial transfer by disregarding the value of a retained nonqualified interest. in effect, the value of the retained interest is subject to gift tax in the initial transfer. if the same interest subsequently enters the transfer tax base at a value determined under general principles, an adjustment may be necessary to avoid double taxation. as in robinette, the problem stems from applying inconsistent valuation methods to the same interest at different times. one possible approach would be to eliminate the inconsistency by applying the special rules in the subsequent transfer. if a retained interest was valued at zero in the initial transfer, this would produce the same effect as simply excluding the interest from the transfer tax base in the subsequent transfer. although this approach may achieve a pragmatic result in particular cases,105 it exacerbates the inconsistency between the special rules and general principles concerning the timing and valuation of transfers, and offers no viable general solution to the problem of double taxation. the section 2702 regulations provide a special adjustment to mitigate the problem of double taxation106 the adjustment takes the form of a reduction in the donor's cumulative taxable gifts 7 upon a subsequent transfer of a nonqualified interest that was valued under the special rules in the initial transfer (a "section 2702 interest").es in general, the adjustment 105. cf. rev. rul. 79-421, 1979-2 c.b. 347; see supra note 61. 106. regs. § 25.2702-6. in contrast to § 2701, the statutory language of § 2702 does not expressly provide for an adjustment. cf. irc § 2701(e)(6). thus, in providing the adjustment, the treasury has exercised its general regulatory authority. see i.r.s. notice ps30-91, 1991-2 c.b. 1118, 1120. 107. for convenience, this article uses the term "cumulative taxable gifts" to mean the aggregate sum of taxable gifts under § 2502(a) or the amount of adjusted taxable gifts under § 2001(b), as appropriate. 108. regs. § 25.2702-6(a)(1), (2). the regulations properly provide no adjustment upon a subsequent transfer of a retained qualified interest. since a qualified interest is valued under the tables in the initial transfer even under § 2702. the special rules create no risk of 19941 florida tax review is available only with respect to a section 2702 interest that was held by the donor at the time of the initial transfer."° moreover, the adjustment becomes available only when the donor makes a subsequent transfer of the section 2702 interest during life or at death; if the donor simply retains the interest until it expires, the adjustment is lost."' the regulations limit the amount of the adjustment to ensure that the amount ultimately included in the transfer tax base on account of the section 2702 interest is at least equal to the value of that interest (determined under general principles) at the time of the initial transfer."' predictably, the adjustment raises several technical and policy issues. 1. amount of adjustment.-the regulations limit the adjustment to the lesser of (1) the increase in taxable gifts resulting from applying the special rules to value the section 2702 interest in the initial transfer (the "first limitation") or (2) the increase in taxable gifts or gross estate resulting from the subsequent transfer of the section 2702 interest (the "second limitation").1 12 the first limitation is the difference, at the time of the initial transfer, between the value of the section 2702 interest determined without regard to the special rules and the value of the same interest under the special rules. 13 typically, the section 2702 interest was valued at zero in the initial transfer, and the first limitation is accordingly equal to the value of the section 2702 interest at the time of the initial transfer determined without regard to the special rules." 4 assume that a transfers property worth $100,000 in trust to pay income to herself for 15 years with remainder to her child c or c's estate. under the tables, assuming a 10% discount rate, the value of a's retained income interest is $76,061,"' but its value under the double taxation, and there is no need for a corrective adjustment. for similar reasons, the regulations provide no adjustment with respect to retained interests that were not valued under the special rules in the initial transfer. 109. on the unavailability of the adjustment with respect to interests held by applicable family members, see infra notes 138-44 and accompanying text. 110. see regs. § 25.2702-6(a)(1), (2). 111. for a discussion of the amount of the adjustment, see infra notes 112-28 and accompanying text. 112. see regs. § 25.2702-6(b)(1). 113. under the subtraction method adopted by the § 2702 regulations, any value denied to the § 2702 interest by the special rules automatically increases the amount of the donor's gift. 114. the only situation in which the special rules accord positive value to a § 2702 interest involves certain tangible, nondepreciable property. see supra note 84. a conversion of the property during the term may trigger a deemed gift of the unexpired term interest and give rise to an adjustment under the § 2702 regulations. regs. § 25.2702-2(c)(4). 115. see actuarial values (alpha), supra note 17, at table b. [vol 2:3 rethinking section 2702 special rules is zero. any adjustment allowed in a subsequent transfer cannot exceed $76,061. in effect, the first limitation ensures that any appreciation in the section 2702 interest subsequent to the initial transfer is included in the transfer tax base. the second limitation, which is normally equal to the value of the section 2702 interest at the time of the subsequent transfer, ensures that any decline in the value of the interest subsequent to the initial transfer does not reduce the amount included in the donor's gift tax base in the initial transfer. thus, in the preceding example, if a makes a gift of her retained income interest two years after the initial transfer when the value of the interest (determined under the tables) is $71,034,16 the adjustment is limited to $71,034. however, in the case of a lifetime transfer that is not fully includable in taxable gifts, the adjustment may be less than the value of the interest at the time of the subsequent transfer. this occurs, for example, if the subsequent transfer qualifies for a marital deduction" 7 or (in some cases) an annual exclusion.' s the adjustment may also be reduced in the case of a sale or exchange of the section 2702 interest for money's-worth consideration, since the consideration reduces the amount of the taxable gift."" thus, if a sells her income interest two years after the initial transfer for its value (determined under the tables) of $71,034, no adjustment is allowed. to the extent that the second limitation actually reduces the amount of the adjustment below the value of the section 2702 interest, the adjustment is wasted. the second limitation also raises a more subtle problem if the section 2702 interest is a term interest. the value of a term interest tends to decrease with the passage of time, producing a corresponding decrease in the amount 116. see actuarial values (alpha), supra note 17, at table b (value of right to receive $100,000 in 13 years, assuming 10% discount rate). 117. a § 2702 interest that qualifies for a gift tax marital deduction upon a subsequent transfer by the donor escapes inclusion in the donor's taxable gifts but is ultimately reflected in the spouse's transfer tax base. there is no apparent reason why the spouse should not be entitled to an adjustment upon a subsequent transfer of the interest. cf. regs. § 25.2702-6(a)(3) (adjustment assignable in connection with split gift of § 2702 interest to third party); but cf. t.d. 8536, 1994-21 i.r.b. 7 (rejecting assignability of analogous adjustment under § 2701 on grounds of "administrative complexity"). 118. if the donor makes gifts of a § 2702 interest and of other property to the same donee in the same calendar year, and if both gifts qualify for the annual exclusion, a question arises concerning the amount of "taxable gifts" attributable to the § 2702 interest. for purposes of the second limitation, the regulations allocate the annual exclusion first to property other than the § 2702 interest. see regs. § 25.2702-6(b)(2). this rule preserves the adjustment even if the gift of the § 2702 interest is excluded from taxable gifts under § 2503(b). 119. there is no apparent reason why the adjustment should not be preserved and allowed as a reduction in subsequent cumulative taxable gifts. cf. regs. § 25.2701-5(c)(3) (analogous adjustment under § 2701). 1994] florida tax review of the adjustment. 2 ° assume that a transfers property worth $100,000 in trust to pay income to herself for 15 years with remainder to her child c or c's estate. in the initial transfer, a's retained income interest is valued at zero, producing a taxable gift of $100,000. if a subsequently makes a taxable gift of her remaining income interest, the income interest is valued under the tables, and the regulations allow an offsetting adjustment. assuming a constant discount rate of 10% and a constant value of the trust property, the amount of the gift and the adjustment is $61,446 after 5 years, $37,908 after 10 years, and zero after 15 years.' if a retains the term interest for the full 15-year term, no adjustment is allowed. 22 although the adjustment matches the value of a's remaining income interest, the gradual erosion of the adjustment over the 15-year term produces harsh results if a actually receives income distributions after the initial transfer. whether or not a subsequently transfers the income interest, those distributions ultimately are reflected in her transfer tax base 2 3 and are not offset by any adjustment. arguably, an adjustment should be allowed in connection with subsequent transfers of amounts traceable to income distributions received by a. however, the administrative problems of tracing distributions and discounting their value back to the time of the initial transfer'24 probably outweigh the increased accuracy that such an adjustment would 120. some commentators argue that the decrease in the value of a term interest resulting from the passage of time should be ignored for purposes of the second limitation, whether or not the holder actually receives any distributions. american bar association, section of real property, probate, and trust law and section of taxation, comments on second installment of chapter 14 proposed regulations, specific comment b.3 (oct. 16, 1991), 91 tnt 219-48 (lexis, fedtax lib., tnt file). the § 2702 regulations properly reject this approach, which would threaten to revive the very abuses at which § 2702 is aimed. cf. t.d. 8536, 1994-21 i.r.b. 7 (rejecting "purge" approach under § 2701). 121. see regs. § 25.2702-6(b)(1)(ii) (second limitation); actuarial values (alpha), supra note 17, at table b. 122. the expiration of the income interest at the end of the 15-year term is not a transfer for gift tax purposes; even if it were, the amount of the adjustment would be limited to zero, the amount of a's taxable gift in the subsequent transfer. 123. see supra note 38 and accompanying text. 124. in the preceding example in text, assume that a receives no income for the first 14 years and then in the 15th year receives an income distribution of $30,000, of which she immediately makes a taxable gift. even if the subsequent transfer were valued at $30,000 for purposes of the second limitation, the $30,000 income distribution would in theory have to be discounted back to the time of the initial transfer for purposes of the first limitation. the present value of $30,000 payable in 15 years (assuming a 10% discount rate) is $7,182 ($30,000 x 0.239392). see actuarial values (alpha), supra note 17, at table b. therefore, if an adjustment were allowed, the first limitation would presumably limit it to this amount. [vol 2:3 rethinking section 2702 provide. 125 accordingly, the regulations permit the adjustment only if a assigns or releases her income interest during the term.'26 the regulations draw a formalistic distinction between a transfer of an existing trust interest and a transfer of amounts received as distributions with respect to the trust interest. in the preceding example, assume that the income is payable to c for the 15-year term, subject to a's retained power to revoke the income interest. in the initial transfer, a's retained power is treated as a retained interest and valued at zero, producing a gift equal to the entire value of the trust property. each year, as a allows her retained power to lapse with respect to current income, she is treated as making a completed gift of the income to c. nevertheless, the regulations allow no adjustment because a's annual gifts relate to amounts distributed as income rather than to the income interest itself. 27 by contrast, the adjustment would be available if a completely released her retained power (or exercised it in favor of another person) during the 15-year tenr '2 2. interaction with string provisions.-if the section 2702 interest is included in the donor's gross estate, the regulations generally allow a reduction in the donor's adjusted taxable gifts. if an interest transferred in the initial transfer is also included in the donor's gross estate under the string provisions, however, section 2001 (b) provides an independent reduction in the donor's adjusted taxable gifts. 29 the section 2702 regulations resolve the potential overlap by giving precedence to the section 2001(b) adjustment.' the section 2001(b) adjustment often applies in conjunction with section 2036(a) when the donor makes a lifetime transfer of a remainder 125. in some cases, however, the regulations do provide adjustments based on compounded or discounted values to reflect subsequent events inconsistent with assumptions made in the initial transfer. see, e.g., regs. §§ 25.2701-4 (compounding rule for untimely qualified payments), 25.2702-2(c)(4) (valuing retained term interest in certain tangible property on conversion). 126. see t.d. 8395, 1992-1 c.b. 316, 320 (stating adjustment is available -only if the retained interest itself is taxed in a transfer subsequent to the [initial transfer)-). 127. see regs. § 25.2702-6(c) ex. 6. 128. see regs. § 25.2702-6(c) ex. 7. presumably, if a releases her retained power over a fractional or percentage portion of the entire income interest, a corresponding portion of the adjustment should be allowed. a partial adjustment may be allowed even if a releases her retained power over the income interest for specified future years. the regulations, however, do not address the problem of partial transfers. see infra notes 145-51 and accompanying text. 129. for a discussion of the string provisions, see supra notes 40-43 and accompanying text. 130. regs. § 25.2702-6(b)(3) (denying reduction "to the extent section 2101 would apply to reduce the amount of an individual's adjusted taxable gifts with respect to the same [retained] interest"). 19941 florida tax review while retaining an income interest for a period that does not end before death. in this situation, the underlying property is included in the gross estate, the gift tax value of the remainder is excluded from adjusted taxable gifts, and an offset is allowed against the estate tax for the gift tax payable with respect to the initial transfer.' 3' the interaction of sections 2036(a) and 2001(b) produces approximately the same nominal amount of transfer taxes regardless of whether the special rules applied to the initial transfer.'32 if the special rules applied to the initial transfer and the section 2702 interest is a term interest, the adjustment under section 2702 is generally superfluous unless for some reason the string provisions do not trigger inclusion of the transferred interest in the gross estate. accordingly, if the section 2702 interest is a term interest, the regulations allow a deathtime adjustment only in the unusual case where the string provisions do not apply.133 131. irc §§ 2036(a)(1), 2001(b). 132. for example, assume that a transfers $100,000 in trust to pay income to herself for 15 years, and dies during the trust term. section 2702 applies to the initial transfer only if the remainder is transferred to a member of a's family. based on the simplifying assumptions of a 10% discount rate, a constant value of the trust property, and a flat transfer tax rate of 50% with no exclusions, deductions or credits, the following calculation shows that the total amount of transfer taxes is the same regardless of whether § 2702 applies to the initial transfer: general principles section 2702 initial transfer: taxable gift $ 23,939 $100,000 gift tax 11,970 50,000 subsequent transfer: gross estate $100,000 $100,000 adjusted taxable gifts (§ 2001(b)) 0 0 tentative estate tax 50,000 50,000 gift-tax offset 11,970 50,000 estate tax 38,030 0 total transfer taxes $ 50,000 $ 50,000 the total amount of transfer taxes in each case is the same. the economic cost is not identical, however, due to disparities in the transfer tax base and the completion rules of existing law. see infra notes 156-76 and accompanying text. 133. the § 2702 adjustment is available only if the retained term interest is included in the gross estate "solely by reason of section 2033." regs. § 25.2702-6(a)(2)(i). for example, assume that a purchases a 15-year income interest in property and her child c simultaneously purchases the remainder in the same property, and that a dies during the 15-year term owning the unexpired income interest. in this case, the special rules apply to the joint purchase, irc § 2702(c)(2), but the string provisions do not trigger inclusion of the underlying property in a's gross estate as long as a is not treated as having made a lifetime "transfer" subject to a retained income interest. irc § 2036(a). under the §2702 regulations, a's adjusted taxable gifts should be reduced by the lesser of the increase in her taxable gifts resulting from the application of the special rules in the initial transfer or the value of the term interest included in her gross estate under § 2033. see regs. § 25.2702-6(c) ex. 8. this represents a liberaliza[vol 2:3 rethinking section 2702 if the only section 2702 interest is a reversion that is included in the donor's gross estate, the section 2702 adjustment is available unless the string provisions trigger a section 2001(b) adjustment.'the section 2001(b) adjustment displaces the section 2702 adjustment where the string provisions trigger inclusion in the gross estate of a remainder that was transferred during life. 35 often, however, a retained reversion does not trigger inclusion of any transferred interest under the string provisions, leaving the section 2702 adjustment intact. 36 if the special rules valued the retained reversion at zero in the initial transfer, the section 2702 adjustment is equal to the lesser of the value of the section 2702 interest at the time of the initial transfer or at death, determined in both cases under general principles.7 if the retained reversion would have been valued at zero in the initial transfer under robinette, even without regard to the special rules, the first limitation apparently produces a section 2702 adjustment of zero. in this case, section 2702 produces the same result as robinette in the initial transfer, and offers no tion of the original proposed regulation, which allowed no adjustment in connection with a retained term interest. prop. regs. § 25.2702-6(a)(2), reprinted at 1991-2 c.b. 1118, 1122. 134. regs. § 25.2702-6(a)(2)(ii). 135. for example, assume that r (age 40) creates a trust of s100,000 to pay income to r's spouse s (age 42) for life with corpus at s's death to r if living or if r is not then living to their child t. assuming a constant discount rate of 10, a constant value of the trust property, and no marital deduction under § 2523(f), if r dies 10 years later, survived by s. the deathtime value of y's remainder ($14,780) is included in r's gross estate. irc § 2037(a); regs. § 20.2037-1(e) ex. 3. the § 2001(b) adjustment is the value of t's remainder (determined under the tables) at the creation of the trust (s3.681). this displaces the § 2702 adjustment, which is limited to the lesser of the value of r's reversion determined under the tables at the time of the initial transfer ($4,360) or the value of r's reversion included in r's gross estate ($0). see actuarial values (alpha), supra note 17, at tables s. 80cnsmt. 136. if the only retained interest is a reversion, a donor normally can avoid the string provisions quite easily. section 2037 does not apply if possession or enjoyment of the transferred interest might be obtained during the donor's life. assume that r (age 40) creates a trust of $100,000 to pay income to r's spouse s (age 42) for life with corpus at s's death to their child t (age 20) if living or if t is not then living to r. if r dies 10 years later, survived by s, only the value of r's reversion is included in r's gross estate. irc § 2033. neither s's income interest nor 7's remainder is included. irc § 2037(a)1 ): regs. § 20.2037l(e) ex. 1. 137. in the example in note 136. supra. assuming a constant discount rate of 10%, a constant value of the trust property, and no marital deduction, the first limitation is s1.1 34the value of a remainder on the death of a 42-year-old (s8.04 1) multiplied by the probability that a 20-year-old will fail to survive a 42-year-old (.14105); the second limitation is $2,008--the value of a remainder on the death of a 52-year-old (s14.780) multiplied by the probability that a 30-year-old will fail to survive a 52-year-old (.13589). under the first limitation, the amount of the § 2702 adjustment is $1,134. see actuarial values (alpha), supra note 17, at tables s, 80cnsmt. 19941 florida tax review better solution to the intractable problem of double taxation in the subsequent deathtime transfer. 3. special problems.-the regulations fail to address the availability and operation of the section 2702 adjustment in several special situations. one problem arises where the section 2702 interest was held by an applicable family member at the time of the initial transfer. technically, the adjustment is potentially available, upon a subsequent transfer of a section 2702 interest, to the individual who held that interest at the time of the initial transfer.'38 in operation, however, the amount of the adjustment may not exceed the increase in the holder's taxable gifts resulting from applying the special rules to value the section 2702 interest in the initial transfer.'39 as a practical matter, in the usual case where the donor is the only individual who made a taxable gift in the initial transfer, the adjustment is unavailable with respect to any section 2702 interest that was held by an applicable family member 40 at the time of the initial transfer.' thus, the donor's transfer tax base may include the value of an interest that the donor never actually owned or transferred. the regulations provide some flexibility where the donor and the donor's spouse elect gift-splitting treatment with respect to a subsequent lifetime transfer of the section 2702 interest. under the regulations, the donor, who would otherwise be entitled to the entire adjustment, may assign half of the adjustment to the consenting spouse. 142 where the spouses elected giftsplitting in the initial transfer, however, half of the adjustment is apparently lost unless half of the retained interest is treated as "held" by the consenting spouse at the time of the initial transfer. 4 the regulations might easily be 138. regs. § 25.2702-6(a)(1), (2). by definition, the individual who held a § 2702 interest at the time of the initial transfer is either the donor or an applicable family member. irc § 2702(a)(1). 139. regs. § 25.2702-6(b)(1)(i). 140. the adjustment may be available with respect to a § 2702 interest held by the donor's spouse as a result of a gift-splitting election. see infra notes 142-44 and accompanying text. 141. by contrast, the analogous adjustment under § 2701 is allowed as a reduction in the donor's cumulative taxable gifts, even where the holder is an applicable family member. regs. § 25.2701-5(a)-(c). there is no apparent reason for a more restrictive rule under § 2702. 142. regs. § 25.2702-6(a)(3). if the gift-splitting election produces a second annual exclusion, the second limitation may produce a correspondingly smaller adjustment. see regs. § 25.2702-6(c) ex. 4. 143. if the entire retained interest is treated as "held" by the donor at the time of the initial transfer, only the donor's half of the split gift is taken into account in calculating the § 2702 adjustment. regs. § 25.2702-6(b)(l)(i) (first limitation). moreover, if half of the retained interest is treated as held by each spouse at the time of the initial transfer, half of the adjustment may still be lost unless the spouses elect gift-splitting treatment with respect to the [vol 2:3 rethinking section 2702 clarified to allocate the adjustment equally between the spouses or permit the donor to assign half of the adjustment to the consenting spouse.'" a different problem arises where multiple initial transfers occur with respect to the same section 2702 interest. for example, assume that a, age 40, transfers property worth $100,000 in trust to pay income to herself for life, with remainder at her death to her child c, age 10. under section 2702, the amount of a's gift in this first initial transfer is $100,000. three years later, a (now age 43) carves her life income interest into a 10-year term interest and a remainder, retaining the term interest and transferring the remainder to c. under section 2702, the amount of a's gift in this second initial transfer is apparently equal to the value (determined under the tables) of an income interest for a's life.141 apparently, no section 2702 adjustment is allowed as long as a retains any portion of her income interest.'" 6 assume, however, that five years later a (now age 48) transfers the balance of her income interest to c. at that time, a becomes entitled to an adjustment, 4 ' arguably in a comsubsequent transfer. regs. § 25.2702-6(b)(1)(ii) (second limitation). the need for a § 2702 adjustment may be obviated, however, if the transferred interest is subsequently included in the donor's gross estate under the string provisions. see supra notes 129-37 and accompanying text. in that case, § 2001(b) attributes the entire gift to the donor for purposes of the reduction in adjusted taxable gifts and the gift-tax offset. irc § 2001(b), (d). moreover, if the gift is included in the donor's gross estate under § 2035, half the value of the gift is removed from the spouse's adjusted taxable gifts, and the spouse's gift-tax offset is reduced by the amount shifted to the donor under § 200 1(d). irc § 200 1(e). thus, the gift may be removed from the adjusted taxable gifts of both spouses. see regs. § 25.2702-6(c) ex. 5. 144. the original proposed § 2702 regulations allocated the adjustment equally between the spouses if they elected gift-splitting in the initial transfer, and permitted them to assign the adjustment to each other. prop. regs. § 25.2702-6(a)(3)(i). reprinted at 1991-2 c.b. 1118, 1122. the final regulations contain no such provision concerning gift-splitting in the initial transfer. see regs. § 25.2702-6(a). 145. assuming a discount rate of 10% and a constant value of the underlying property, a's income interest is worth $91,424. see actuarial values (alpha). supra note 17, at table s. the amount of a's gift is calculated by subtracting the value of the retained term interest (determined as zero under the special rules) from "the value of the transferred property." regs. § 25.2702-1(b). presumably, the value of the transferred property does not include the value of the remainder retained by c. since c is not an applicable family member, the value of cs retained remainder should be determined under the tables (rather than under the special rules). accordingly, the value of the transferred property should be the difference between the value of the trust property ($100,000) and the value of c's retained remainder ($8,576), or $91,424. 146. cf. regs. § 25.2702-6(c) ex. 6 (allowing no reduction on partial lapse of retained power). 147. cf. regs. § 25.2702-6(c) ex. 7 (allowing reduction on complete exercise of retained power). 19941 florida tax review bined amount based on the two initial transfers. 4 on the other hand, if a dies owning the carved-out term interest, the entire value of the underlying property is included in her gross estate and the combined amount of a's taxable gifts in the two initial transfers is excluded from her adjusted taxable gifts. 49 the section 2001(b) adjustment more than compensates for the lack of a section 2702 adjustment. 50 if the first initial transfer took the form of a joint purchase rather than a gift of a remainder, however, the absence of a section 2702 adjustment might raise a serious problem of double taxation.' a final problem may arise when a donor transfers a section 2702 interest at death in a manner qualifying for the estate tax marital deduction. if the section 2702 interest was valued at zero in the initial transfer, the donor's adjusted taxable gifts are reduced by the lesser of the value of that interest at the time of the initial transfer (determined under general principles) or its value in the donor's gross estate, unreduced by the amount of the marital deduction. 52 if the donor's taxable estate is sufficient to offset the full amount of the reduction in adjusted taxable gifts, the adjustment is fully effective. on the other hand, the adjustment is wasted to the extent that the taxable estate is less than the amount of the reduction. this could occur, for example, if the donor leaves a marital bequest determined under a formula that fails to take account of the adjustment. the problem could be avoided if the regulations provided a mandatory or elective mechanism for shifting the adjustment from the donor to the surviving spouse in connection with a 148. although the § 2702 regulations are silent on the matter, the analogous adjustment under § 2701 is equal to the sum of the separate adjustments for each initial transfer. regs. § 25.2701-5(c)(3)(vi). based on an assumed constant discount rate of 10% and a constant value of the underlying property, the combined amount of the adjustment is $74,866 ($37,433 + $37,433). with respect to the life income interest retained in the first initial transfer, the first limitation is $92,945 (the value of an income interest for the life of a 40year-old), and the second limitation is $37,433 (the value of an income interest for five years or until the prior death of a 48-year-old). with respect to the carved-out term interest retained in the second initial transfer, the first limitation is $91,424 (the value of an income interest for the life of a 43-year-old), and the second limitation is again $37,433. see actuarial values (alpha), supra note 17, at tables s, h, 80cnsmt. 149. irc §§ 2001(b), 2036(a)(1). 150. see regs. § 25.2702-6(a)(2), (b)(3). 151. in that case, the expiration of a's purchased income interest at death arguably would trigger no inclusion in her gross estate. see supra note 133. accordingly, both the § 2702 adjustment and the § 2001(b) adjustment would be unavailable, and the value of a's income interest, valued separately in both initial transfers, would be included twice in her transfer tax base. 152. regs. § 25.2702-6(b)(1)(ii). [vol 2:3 rethinking section 2702 subsequent transfer of the section 2702 interest that qualifies for the estate tax marital deduction. 53 in sum, the section 2702 adjustment attempts to compensate for the unfavorable valuation assumptions introduced by the special rules in the initial transfer. in determining the amount ultimately included in the transfer tax base with respect to the section 2702 interest, the adjustment raises several problems. the amount of the adjustment does not reflect distributions actually received by the donor, even though such distributions may replace all or part of the section 2702 interest in the transfer tax base. moreover, the adjustment does not purport to compensate the donor for the lost return on any increase in gift tax caused by the special rules between the time of the initial transfer and the subsequent transfer.' z at a more general level, the section 2702 adjustment introduces considerable complexity and uncertainty while failing to provide an adequate remedy for the distortions caused by the special rules in the initial transfer. thus, section 2702 falls far short of its goals of simplicity, accuracy and fairness.' 5 iv. rethinking section 2702 conceptually, section 2702 carries the principle of robinette to its logical extreme. in the initial transfer, the special rules in effect reapportion the value of the underlying property between nonqualified retained interests and transferred interests. the section 2702 adjustment, where it applies, offers limited relief from this unfavorable valuation approach. in addition to its internal shortcomings, section 2702 exacerbates tensions within the existing gift and estate tax system. the following discussion reexamines some proposals originally developed in the broader context of gift and estate tax reform that offer a simpler, more effective solution to the problems raised by split-interest transfers. 153. the proposed regulations provided an automatic shift between spouses with respect to the analogous adjustment under § 2701. prop. regs. § 25.2701-5(a)(2). reprinted at 1992-1 c.b. 1239, 1241. however, this provision was eliminated in the final regulations. t.d. 8536, 1994-21 i.r.b. 7, 9. 154. indeed, the timing effect is magnified where the increase in taxable gifts caused by the special rules pushes other taxable gifts made by the donor between the initial transfer and the subsequent transfer into higher brackets. even if the amount of taxable gifts is subsequently adjusted, § 2702 may indirectly increase gift taxes payable with respect to interim gifts that are completely unrelated to the initial transfer. 155. the legislative history indicates that chapter 14 is intended "to assure more accurate gift tax valuation of the initial transfer" and to deter abuse through "'a well defined and administrable set of rules," without hindering nonabusive "standard intrafamily transactions." 1990 senate report, supra note 37, at s15680-81. 19941 florida tax review a. section 2702 in context although section 2702 curbs many abusive valuation techniques involving split-interest transfers, it does nothing to resolve some basic structural weaknesses of the existing gift and estate tax system. indeed, section 2702 superimposes new distortions that make reform of the existing system even more urgent. the interaction of the gift and estate taxes produces anomalous results in the case of a split-interest transfer. if the donor retains sufficient ownership or control so that no completed gift occurs with respect to any interest during life, the string provisions pull the full deathtime value of the underlying property into the gross estate.'56 the transfer tax result is virtually the same as if the donor retained complete ownership of the underlying property until death. on the other hand, if the donor retains ownership or control of an interest in income or corpus while making a completed gift of a remainder interest, the string provisions often draw the full deathtime value of the underlying property-including the previously-taxed remainder-into the gross estate. 57 for example, if a transfers property in trust to pay income to herself for life with corpus at her death to b or b's estate, a makes a completed gift of the remainder.'58 if a retains the income interest until death, the deathtime value of the trust property is included in her gross estate. 59 alternatively, if a transfers property in trust to pay income to b for life with corpus at b's death to a if living or if a is not living to c or c's estate, a makes completed gifts to b of an income interest and to c of a remainder."w if a dies before b and the value of her reversion (determined under the tables immediately before death) exceeds five percent of the deathtime value of the trust property, the deathtime value of c's remainder is included in a's gross estate.' 61 indeed, a may make a completed gift of 156. a transmissible beneficial interest retained in the initial transfer and owned at death is included in the gross estate. irc § 2033. moreover, any retained control that prevents a completed gift from occurring during life with respect to an interest should trigger inclusion of the interest in the gross estate. see irc § 2038 (estate tax); regs. § 25.2511-2 (gift tax). 157. although especially acute in the case of the string provisions, the same problem can arise under other provisions that include property in the gross estate. see irc §§ 2039, 2040(a), 2041, 2042. 158. regs. § 25.2511-1(e). 159. irc § 2036(a)(1). 160. regs. § 25.2511-1(e). 161. irc § 2037. [vol 2:3 rethinking section 2702 the entire property while retaining certain powers which, if held at death, suffice to bring the entire property into the gross estate.16 when a taxable gift is included in the gross estate, section 2001(b) prevents the gift from being double-counted in the cumulative transfer tax base, and at the same time preserves an offset for any gift tax payable with respect to the gift. in conjunction with the string provisions, the section 2001(b) adjustment generally ensures that the total amount ultimately included in the transfer tax base with respect to a reincluded interest is the deathtime value of that interest. in effect, any gift tax imposed on the initial transfer counts as a prepayment of the estate tax imposed at death.16 3 the prepayment of tax represents an economic cost, since the donor loses the return that would otherwise have been earned on the amount used to pay the gift tax on the initial transfer. this cost is offset, at least in part, by the fact that the lost return is not included in the donor's gross estate. accordingly, the cost of making a split-interest transfer subject to the string provisions, as compared to making a single deathtime transfer, depends in part on the rate of return on investments and the length of time between the initial transfer and death. assume that a transfers property worth $100,000 in trust to pay income to a for 15 years with remainder to her nephew b or b's estate. to simplify the calculation, assume a flat transfer tax rate of 30%, a 10% discount rate under the tables, and a 10% annual rate of return (entirely in the form of capital appreciation) on all property. in the initial transfer, a makes a taxable gift of $23,939' 6' and incurs a gift tax of s7,182 (30% x $23,939), which she pays from non-trust assets. if a dies holding the income interest during the 15-year term, the deathtime value of the trust property is included in her gross estate. for example, if a's death occurs after four years, the includable value of the trust property is $146,410, generating an estate tax 162. for example, a may make a completed gift by a transfer of property in trust. even if the transfer is subject to a retained power that affects only the time or manner of enjoyment of the property, or that is exercisable only in conjunction with a person having a substantial adverse interest in the property. regs. § 25.2511-2(d), (e). the same retained power that did not prevent a completed lifetime gift of the property may trigger inclusion of the property in a's gross estate. irc § 2038; regs. § 20.2038-1(a). 163. to take account of any change in the rate schedule between the time of the initial transfer and the donor's death, the gift-tax offset is calculated using the rates in effect at the time of death, and thus may not equal the gift taxes actually paid. irc § 2001(b)12). 164. the tables apportion 23.9392% of the value of the underlying property to the remainder. see actuarial values (alpha), supra note 17, at table b. section 2702 does not apply because a's nephew b is not a "member of [al's family" within the meaning of that section. see supra note 76. 1994] florida tar review of $36,741 and leaving $109,669 after transfer taxes.'65 the after-tax value of the trust is less than if a made no completed gift in the initial transfer (for example, by retaining a power to revoke b's remainder) and added the $7,182 gift tax savings to the trust in the initial transfer. in that case, the trust property would appreciate to $156,925 at a's death, generating an estate tax of $47,078 and leaving $109,847 after transfer taxes.'66 by avoiding a completed lifetime gift of the remainder, a is able to increase the deathtime value of her trust by $10,515 before transfer taxes ($156,925, rather than $146,410), but the estate tax increases by $10,337, leaving an increase of only $178 in the after-tax value of the trust.' 67 this result highlights a further anomaly in the gift and estate tax system: the "taxinclusive" estate tax base includes the amount of estate tax as well as the value of property transferred to successors, but the "tax-exclusive" gift tax base includes only the value of property transferred to donees.168 accord165. at a 10% annual rate of return in the form of capital appreciation, the trust property is worth $146,410 (1.14 x $100,000) at a's death. that amount is included in her gross estate, generating a tentative estate tax of $43,923 (30% x $146,410) and, after a gift-tax offset of $7,182, an estate tax of $36,741. if the estate tax is paid from the trust property, the after-tax value of the trust property is $109,669 ($146,410 $36,741). 166. at a 10% annual rate of return in the form of capital appreciation, the trust property is worth $156,925 (1.14 x $107,182) at a's death. that amount is included in her gross estate, generating an estate tax of $47,078 (30% x $156,925); since a made no completed gift in the initial transfer, there is no gift-tax offset. the after-tax value of the trust is $109,847 ($156,925 $47,078). a longer period between the initial transfer and a's death would magnify the difference in the value of the trust after transfer taxes. for example, if a dies after 14 years, the after-tax value of the trust is as follows, depending on whether the initial transfer is a completed gift: completed gift no completed gift initial transfer: pre-tax (and after-tax) value $100,000 $107,182 taxable gift 23,939 0 gift tax 7,182 0 at death: gross estate $379,750 $407,023 tentative estate tax 113,925 122,107 gift-tax offset 7,182 0 estate tax 106,743 122,107 after-tax value 273,007 284,916 167. the $10,337 increase in the estate tax results from a $3,155 increase in the tentative estate tax (30% x $10,515) combined with the elimination of a $7,182 gift-tax offset. 168. see generally stanley s. surrey et al., federal wealth transfer taxation 27174 (1987). in the case of gifts made by a decedent (or the decedent's spouse) within three years of death, § 2035(c) eliminates most of the benefits of the tax-exclusive gift tax base by including in the gross estate any gift tax paid by the decedent (or the estate) with respect to [vol 2:3 rethinking section 2702 ingly, a prepayment of transfer tax in the initial transfer produces a tax benefit that offsets the tax cost of reinclusion, wholly or partially depending on the transfer tax rate, the rate of return on investments, and the length of time between the initial transfer and the date of death. with a flat transfer tax rate of 40% and a 10% rate of return, this benefit outweighs the cost of prepaying the transfer tax if a dies after four years'6' but not if she survives for 14 years. 70 the disparity between the gift and estate tax bases thus injects an element of arbitrariness into the interaction of the string provisions and section 2001(b). far from ameliorating the arbitrary effects of the reinclusion provisions, section 2702 aggravates them. if the special rules apply in the initial transfer and the string provisions include the underlying property in the gross estate, the after-tax value of the property still depends on the transfer tax rate, the rate of return on investments, and the length of time between the initial transfer and death. by increasing the amount of the taxable gift in the initial transfer, section 2702 accentuates both the tax cost of the lost return on the such gifts. 169. if a dies after four years, the after-tax value of the trust is as follows, depending on whether the initial transfer is a completed gift: completed gift no completed gift initial transfer: pre-tax (and after-tax) value s 97,815 s107,182 taxable gift 23,416 0 gift tax 9,367 0 at death: gross estate s143,21 1 s156,925 tentative estate tax 57.285 62,770 gift-tax offset 9,367 0 estate tax 47.918 62,770 after-tax value 95,293 94,155 170. if a dies after 14 years, the after-tax value of the trust is as follows: completed gift no completed gift initial transfer. pre-tax (and after-tax) value $ 97.815 s107,182 taxable gift 23,416 0 gift tax 9.367 0 at death: gross estate $371.453 s407.023 tentative estate tax 148,581 162.809 gift-tax offset 9,367 0 estate tax 139.214 162,809 after-tax value 232.239 244.214 19941 florida tax review amount used to pay gift tax and the tax benefit of using pre-tax dollars to pay gift tax. assume that a transfers property worth $82,448 in trust to pay income to a for 15 years with remainder to her child c or c's estate.17' a makes a taxable gift of $82,448 in the initial transfer, and with a flat transfer tax rate of 30%, the gift tax is $24,734, which a pays from non-trust assets. if a dies holding the income interest during the 15-year term, the deathtime value of the trust property is included in her gross estate. if the trust property appreciates at a 10% annual rate and a dies after four years, the includable value of the trust in the gross estate is $120,711, generating an estate tax of $11,479 and leaving $109,232 after transfer taxes. 7 ' if a retained a power to revoke c's remainder and added the $24,734 gift tax savings to the trust in the initial transfer, the includable value of the trust property in the gross estate would be $156,925, generating an estate tax of $47,078 and leaving $109,847 after transfer taxes. 173 the increase in the after-tax value of the trust would be magnified if a survived for a longer period. 7 4 assuming a flat transfer tax rate of 40%, section 2702 accentuates the tax benefit of the 171. in the present example, as in the preceding examples, a begins with $107,182. section 2702 produces a larger gift tax in the initial transfer and a correspondingly smaller initial trust corpus than if the transfer were valued under general principles. 172. at a 10% annual rate of return in the form of capital appreciation, the trust property is worth $120,711 (1.14 x $82,448) at a's death. that amount is included in her gross estate, generating a tentative estate tax of $36,213 (30% x $120,711) and, after a gift-tax offset of $24,734, an estate tax of $11,479. if the estate tax is paid from the trust property, the aftertax value of the trust property is $109,232 ($120,711 $11,479). 173. see supra note 166. 174. for example, if a dies after 14 years, the after-tax value of the trust is as follows, depending on whether the initial transfer is a completed gift: completed gift no completed gift initial transfer: pre-tax (and after-tax) value $ 82,448 $107,182 taxable 82,448 0 gift tax 24,734 0 at death: gross estate $313,094 $407,023 tentative estate tax 93,928 122,107 gift-tax offset 24,734 0 estate tax 69,194 122,107 after-tax value 243,900 284,916 [val 2:3 rethinking section 2702 reinclusion provisions if a dies after four years1 75 as well as their tax cost if she dies after 14 years. 76 ultimately, section 2702 serves a limited anti-abuse purpose at the cost of unwarranted complexity and inconsistency.'7 by adopting the gift tax valuation approach of robinette, section 2702 accelerates gift tax and builds in the need for a subsequent adjustment to compensate for the distortion in valuing the retained and transferred interests in the initial transfer. the section 2702 adjustment in effect establishes a minimum value for the retained interest that eventually is included in the transfer tax base, but 175. if a dies after four years, the after-tax value of the trust is as follows. depending on whether the initial transfer is a completed gift: completed gift no completed gift initial transfer. pre-tax (and after-tax) value $ 76,558 s107,182 taxable gift 76,558 0 gift tax 30,623 0 at death: gross estate $112.089 s 156.925 tentative estate tax 44,835 62,770 gift-tax offset 30,623 0 estate tax 14.212 62.770 after-tax value 97,877 94.155 176. if a dies after 14 years, the after-tax value of the trust is as follows: completed gift no completed gift initial transfer. pre-tax (and after-tax) value s 76,558 s107.182 taxable gift 76,558 0 gift tax 30,623 0 at death: gross estate s290,730 5407,023 tentative estate tax 116.292 162,809 gift-tax offset 30,623 0 estate tax 85,669 162,809 after-tax value 205,061 244.214 177. section 2702 affects the valuation of the retained and transferred interests only for gift tax purposes in the initial transfer. thus, the value of the transferred interest must be determined independently under general principles for other purposes. for example. the special rules do not affect the donee's income tax basis in the transferred interest, see t.d. 8395, 1992-1 c.b. 316, 318, or the amount of a direct skip for generation-skipping transfer tax purposes. see i.r.s. notice ps-92-90, 1991-1 c.b. 998, 999. moreover, money's-worth consideration received by the donor may be sufficient to bring the initial transfer within an exception to the string provisions even though it does not produce a taxable gift of zero under the special rules. 1994] florida tax review does not purport to neutralize fully the distortions in the amount and timing of gift tax produced by the special rules. if section 2702 simply discouraged abusive transactions by imposing uniformly unfavorable valuation assumptions on all retained nonqualified interests, its complexity might seem relatively harmless. after all, donors can readily avoid problems under section 2702 by retaining only qualified interests (or by transferring all interests in the underlying property at one time). 78 however, section 2702 does not apply uniformly to all splitinterest transfers; instead, it redirects old valuation abuses into new channels involving certain types of retained interests, underlying property, and beneficiaries. 179 the problems of complexity, inconsistency, and continued transfer tax avoidance under section 2702 indicate a need for a simpler, more neutral solution. b. eliminating the need for section 2702 for many years, proponents of tax reform have recommended integrating the gift and estate taxes.180 these proposals, while differing in 178. in other words, as long as donors can use nonabusive techniques, they should not complain that grits and similar techniques produce harsh tax consequences under § 2702. 179. the special rules permit retained qualified interests to be valued under the tables, irc § 2702(a)(2)(b), and permit nonqualified retained interests in certain tangible property to be valued under an arm's-length standard. irc § 2702(c)(4). section 2702 may be entirely inapplicable if the underlying property is to be used as a personal residence by the holder of the term interest, § 2702(a)(3)(a)(ii), or if the beneficiary of the initial transfer is not a member of the donor's family. irc § 2702(a)(1). 180. the literature on integration is extensive. see house comm. on ways and means and senate comm. on finance, 91st cong., 1st sess., tax reform studies and proposals: u.s. treasury department 351-87 (comm. print 1969) [hereinafter 1969 treasury proposals]; carl s. shoup, federal estate and gift taxes (greenwood press 1980); 2 dep't of the treasury, tax reform for fairness, simplicity and economic growth 374-83 (1984) [hereinafter 1984 treasury proposals]; u.s. dep't of the treasury, federal estate and gift taxes: a proposal for integration and for correlation with the income tax (1947); american bar association, section on taxation, task force on transfer tax restructuring, report on transfer tax restructuring, 41 tax law. 395 (1988) [hereinafter aba report]; a. james casner, american law institute, federal estate and gift taxation (1969) [hereinafter all proposals]; a. james casner, american law institute federal estate and gift tax project, 22 tax l. rev. 515 (1967); adrian w. dewind, the approaching crisis in federal estate and gift taxation, 38 cal. l. rev. 79 (1950); joseph m. dodge, redoing the estate and gift taxes along easy-to-value lines, 43 tax l. rev. 241 (1988); john t. gaubatz, the unfinished task of estate and gift tax reform, 63 iowa l. rev. 85 (1977); erwin n. griswold, a plan for the coordination of the income, estate and gift tax provisions with respect to trusts and other transfers, 56 harv. l. rev. 337 (1942); harry l. gutman, a comment on the aba tax section task force report on transfer tax restructuring, 41 tax law. 653 (1988) [hereinafter gutman, comment]; harry l. gutman, reforming federal wealth transfer taxes after [vol 2:3 rethimking section 2702 technical details, generally agree that economically equivalent wealth transfers should be taxed similarly. in an integrated system, the transfer tax consequences of a split-interest transfer should be essentially the same as those of an outright transfer of similar property during life or at death. if the after-tax value of a split-interest transfer were economically equivalent to that of an outright transfer of the same underlying property, the transfer tax incentives to carve beneficial ownership of property into separate interests would disappear. to the extent that integration would minimize disparities between split-interest transfers and outright transfers, it represents an attractive alternative to section 2702. as a first step toward integrating the gift and estate taxes, the disparity between the tax-exclusive gift tax base and the tax-inclusive estate tax base should be eliminated. systematically excluding gift tax from the gift tax base while including estate tax in the estate tax base in effect produces gift tax rates that are lower than the estate tax rates, notwithstanding the unified rate schedule.' the difference in effective rates generally provides an unwarranted incentive to structure transfers in a manner that attracts a gift tax rather than an estate tax. 82 in the case of a split-interest transfer, even erta, 69 va. l. rev. 1183 (1983) [hereinafter gutman, transfer tax reform]. jerome kurtz & stanley s. surrey, reform of death and gift taxes: the 1969 treasury proposals, the criticisms, and a rebuttal, 70 colum. l. rev. 1365 (1970); stanley s. surrey. an introduction to revision of the federal estate and gift taxes, 38 cal. l. rev. 1 t 1950). 181. for example, with a flat 25% transfer tax rate, both a taxable gift of sio and a taxable estate of $100 trigger a $25 transfer tax. however, since the amount used to pay the gift tax is not itself taxed, the lifetime donor transfers an after-tax benefit of sico at a total cost of $125, while the decedent transfers an after-tax benefit of s75 at a total cost of s100. in tax-inclusive terms, the effective gift tax rate is 20% (25/125), while the effective estate tax rate is 25% (25/100). more generally, a tax-exclusive rate r, can be expressed as an equivalent tax-inclusive rate r,, under a simple algebraic formula: r,, = rj( i + r,). michael j. graetz, implementing a progressive consumption tax, 92 harv. l. rev. 1575, 1583 n.25 (1979). 182. the standard arguments in favor of lower effective gift tax rates are not persuasive. there is no reason to believe that property given away during life is more productive than property transferred at death or that tax incentives favoring lifetime transfers enhance general welfare. the argument that a lower gift tax rate compensates for the donee's carryover income tax basis in the property misses the mark because the burden or benefit of a carryover basis depends on the donor's cost basis in the property, which plays no role in determining transfer taxes; moreover, this argument merely raises the question of why the income tax treatment of property acquired by gift differs so markedly from the treatment of property acquired from a decedent. finally, a lower gift tax rate cannot be justified as a discount for early payment of an estate tax, since in theory the timing of a transfer tax payment does not affect its economic cost if the tax rate and base are constant and the rate of return on all investments is the same. see gutman, comment, supra note 180, at 656-57; see also aba report, supra note 180, at 403-05; ronald d. aucutt, further observations on transfer tax restructuring: a practitioner's perspective, 42 tax law. 343, 34548 (1989); paul b. stephan iii, a comment on transfer tax reform, 72 va. l. rev. 1471, 1480-90 (1986). 19941 florida tax review if the string provisions include the underlying property in the gross estate, the gift-tax offset under section 2001(b) generally preserves the benefit of the tax-exclusive base with respect to the amount taxed in the initial transfer. if section 2702 applies, it accentuates the same tax benefit to the extent that it increases the amount of the taxable gift in the initial transfer. these distortions could be avoided by including the amount of gift tax in the gift tax base, producing a tax-inclusive base consistent with the existing estate tax base.183 although conceptually simple, increasing the gift tax base requires an algebraic solution where the increase causes the total amount of the gift to span more than one rate bracket.' 84 to avoid solving for interdependent variables (i.e., the tax-inclusive equivalent amount and the amount of gift tax), the same result could be achieved by applying nominally higher gift tax rates to a tax-exclusive base. 5 a uniform tax-inclusive base would remove a longstanding discontinuity between the gift and estate taxes and pave the way for further simplification.8 6 even under a uniform tax-inclusive base, a progressive rate schedule provides an incentive to make lifetime gifts of property with substantial potential future appreciation because a gift completed before the property 183. recent reform proposals generally favor this "gross-up" approach. see 1969 treasury proposals, supra note 180, at 355, 369; "discussion draft" relating to estate valuation freezes: hearings on serial 101-102 before the comm. on ways and means, 101st cong., 2d sess. 36, 39, 41 n.4 (apr. 24, 1990) (statement of kenneth w. gideon, assistant secretary (tax policy), dep't of the treasury); 1984 treasury proposals, supra note 180, at 377-78; dodge, supra note 180, at 340; gutman, comment, supra note 180, at 656-57; theodore s. sims, timing under a unified wealth transfer tax, 51 u. chi. l. rev. 34, 59-69 (1984). a similar approach produces a tax-inclusive base for certain generation-skipping transfers. irc § 2621(b) (taxable distribution). a uniform base could also be achieved by adopting a tax-exclusive estate tax, though rate increases might be necessary to compensate for the resulting revenue loss. see gaubatz, supra note 180, at 87. 184. for example, under the existing unified rate schedule, a tax-exclusive transfer of $90,000 cannot be converted to a tax-inclusive equivalent simply by adding $21,000 (the tax on a tax-inclusive transfer of $90,000), because the marginal rate rises from 28% to 30% for cumulative transfers over $100,000. irc § 2001(c)(1). instead, the tax-exclusive amount must be bifurcated into two parts: the first $76,200 of the transfer generates a $23,800 tax, producing the equivalent of a $100,000 tax-inclusive transfer; the remaining $13,800 of the transfer is taxed at 30%, producing the equivalent of a tax-inclusive transfer of $19,714 ($13,800/(1 .3)). thus, the tax-exclusive transfer of $90,000 is equivalent to a tax-inclusive transfer of $119,714 ($76,200 + $23,800 + $19,714), including tax of $29,714. 185. sims, supra note 183, at 70-74, 89-90 (deriving tax-exclusive rate equivalents). 186. a uniform tax-inclusive base would permit repeal of§ 2035(c), which presently includes in the gross estate any gift tax paid by a decedent (or the decedent's estate) with respect to gifts made by the decedent (or the decedent's spouse) within three years of death. but cf. isenbergh, supra note 30, at 14-15 (proposing expansion of § 2035(c) to include all gift taxes, instead of adopting tax-inclusive gift tax base); joseph isenbergh, further notes on transfer tax rates, 51 u. chi. l. rev. 91, 91-96 (1984) (same). [vol. 2:3 rethinking section 2702 appreciates often falls within lower rate brackets, whereas a later transfer of the same property at an appreciated value would often fall within higher rate brackets. although this bracket effect presumably could be eliminated without compromising the progressivity of the rate schedule, the complexity of the solution probably outweighs its usefulness. 8 ' under the existing gift and estate tax system, however, the timing of taxable transfers produces more serious distortions that can and should be addressed. 88 several problems arise from the overlap between the gift and estate taxes when the gross estate includes an interest that was previously transferred in a completed gift during life. such an overlap often occurs, for example, in a split-interest transfer when a donor transfers a remainder while retaining ownership or control sufficient to trigger inclusion of the underlying property at death under the string provisions.' s9 although the string provisions include the deathtime value of the underlying property in the gross estate, the section 2001(b) adjustment removes the amount of the previouslytaxed gift from adjusted taxable gifts, ensuring that the reincluded interest is counted only once in the estate tax base. in effect, only the appreciation in the property between the initial transfer and death increases the cumulative transfer tax base at death. quite apart from the amount included in the gross estate, the payment of gift tax in the initial transfer increases the economic cost of reinclusion. the amount of the gift-tax offset under section 2001(b) depends on the gifttax value of the transferred remainder, which is fixed in the initial transfer. section 2702, if applicable, may substantially increase the amount of gift tax payable with respect to the initial transfer. whether or not section 2702 applies, the lost return on the gift tax payment represents an economic cost which increases in proportion to the length of time between the initial transfer and death."tg the distortion caused by the early gift tax payment could be 187. sims, supra note 183, at 75. under existing law, the benefit of the low rate brackets cannot exceed $552,000 (i.e., the sum of the $192,800 unified credit and the $359,200 difference between the maximum 55% rate and the lower rates applied to the first s3,000,000 of cumulative transfers). see irc §§ 2001(c)(1), 2010(a), 2505(a), isenbrgh. supra note 30. at 13 n.50. one commentator has proposed imposing transfer tax at a flat rate and allowing an exemption at death against transfers in reverse chronological order. dodge. supra note 180, at 340-43. 188. for critical analyses of existing law, see dodge, supra note 180. at 264-309; isenbergh, supra note 30, at 2-16; sims, supra note 183, at 39-52. 189. a similar overlap may arise in an outright transfer or a joint tenancy. see, e.g., irc §§ 2035(a), (d), 2042 (transfer of life insurance policy on decedent's life within three years of death), 2040(a) (nonqualified joint tenancy to extent decedent furnished consideration). 190. see supra notes 164-66 and accompanying text. disregarding the effects of credits, deductions, and progressive rate brackets, the economic cost of reinclusion may be 19941 florida tax review ameliorated by compounding the amount of the payment forward to the time of death at an appropriate rate of return.' 9 ' using a consistent deathtime value for both the gift tax payment and the includable value of the property would significantly reduce the distorting effect of the reinclusion provisions. at a more fundamental level, however, the question arises why any transfer should ever enter the transfer tax base more than once. in a completely integrated gift and estate tax system, each transfer would be taxed only once, either during life or at death. under a uniform completion rule, a completed gift of property would occur if the donor relinquished sufficient ownership and control during life; if the donor retained ownership or control sufficient to prevent a completed gift of the property from occurring during life, the property would be included in the gross estate.192 such a uniform rule would not only eliminate the overlap between the gift and estate taxes but also, if properly framed, minimize tax incentives to manipulate the timing of transfers. in theory, the timing of a taxable transfer should not affect the economic cost of transfer tax, assuming a constant flat transfer tax rate and a uniform rate of return on all investments.'93 assume that a donor intends to transfer property either during life or at death. the property is presently worth $100, and transfer tax is imposed at a flat rate of 40% on a taxinclusive base. if the donor makes an immediate lifetime transfer, the amount of the transfer is $100, triggering a tax of $40 and leaving an after-tax value of $60. if instead the property is taxed at death when it has appreciated by 50%, the amount of the transfer is $150, triggering a tax of $60 and leaving an after-tax value of $90. the economic cost of the transfer tax is the same in both cases if all property generates the same 50% return during the time between the two transfers. more generally, the amount of transfer tax and the after-tax value of the property bear a fixed ratio to each other and to the preexpressed as ta((l t)(1 + r)y 1), where t is the nominal gift tax rate, a is the amount of the gift in the initial transfer, r is the after-tax rate of return, and y is the number of compounding periods. karen c. burke, valuation freezes after the 1988 act: the impact of section 2036(c) on closely held businesses, 31 wm. & mary l. rev. 67, 139 n.347 (1989). 191. for example, an appropriate rate might be defined by reference to the rate on federal obligations, approximating a riskless rate of return. cf. irc § 1274(d) (defining discount rate used in calculating issue price of certain debt instruments). 192. technical details of various uniform completion proposals are discussed extensively in the integration literature. see 1969 treasury proposals, supra note 180, at 36465, 384-87; 1984 treasury proposals, supra note 180, at 378-80; aba report, supra note 180, at 404-10; all proposals, supra note 180, at 41-47; dodge, supra note 180, at 267-79, 286-88, 300-04, 308-09, 313-16; gaubatz, supra note 180, at 92-101; gutman, comment, supra note 180, at 674-81. 193. alvin c. warren, jr., the timing of taxes, 39 nat'l tax j. 499, 500-01 (1986). [vol 2:3 rethinking section 2702 tax value of the property, regardless of the rate of return." stated differently, the lost return on an early tax payment exactly offsets the exclusion of subsequent appreciation from the transfer tax base."' a uniform completion rule, if practicable, would eliminate the cumbersome mechanics and arbitrary effects of the existing reinclusion provisions. under an "easy-to-complete" rule, a donor may make a completed gift while retaining a substantial degree of control over the transferred property. by contrast, a "hard-to-complete" rule prevents a completed gift from occurring until the donor relinquishes substantially all control over the transferred property. the existing gift tax rules represent a hybrid approach which offers a donor considerable flexibility in determining the time of completion with respect to separate interests in the underlying property.6 those rules, however, operate without regard to ease or difficulty of valuation.197 indeed, most of the abuses at which section 2702 is aimed involve exploiting the tables to apportion value unrealistically between transferred and retained interests in the initial transfer. any choice between an easy-tocomplete rule and a hard-to-complete rule should reflect the need for a consistent, accurate, and administrable valuation method. in general, a uniform hard-to-complete rule would minimize uncertainty in valuing separate interests in the underlying property.' indeed, 194. assuming a uniform tax-inclusive base, a flat 40% tax rate, and a constant rate of return on all investments, the following table illustrates the fixed ratio between the pre-tax value of property, the amount of transfer tax, and the after-tax value of the property: rate of return none 20% 50% 100% ratio pre-tax value $100 $120 $150 5200 100% amount of tax 40 48 60 80 40% after-tax value 60 72 90 120 60% 195. as a practical matter, the rate of return is not the same for all investments. to the extent that the rate of return on donated property exceeds the rate of return on the property used to pay transfer tax, the donor has an incentive to pay the tax sooner rather than later. 196. for example, a donor generally can prevent gift completion with respect to an interest simply by retaining a power affecting beneficial enjoyment of the interest. regs. § 25.2511-2(b), (c). on the other hand, a retained power affecting beneficial enjoyment does not prevent completion if the power is limited by an "ascertainable standard" and is held by the donor in a fiduciary capacity. regs. § 25.2511-2(c). (g). 197. the government appears to have rejected an "open" transaction approach in the gift tax context. see supra note 63. 198. by contrast, an easy-to-complete rule tends to require valuation of separate transferred interests at a time when the degree of beneficial enjoyment they represent remains speculative. on the implications of easy-to-complete and hard-to-complete rules, see 1969 treasury proposals, supra note 180, at 361-68, 372-73, 384-87; 1984 treasury proposals. supra note 180, at 378-83; aba report, supra note 180. at 404-10; all proposals, supra note 180. at 41-47; dodge, supra note 180, at 281-304; gaubatz, supra note 180, at 92-101: gutman. comment, supra note 180, at 674-81; gutman, transfer tax reform, supra note 180. at 125659. 1994] florida tax review under a strong version of a hard-to-complete rule, a split-interest transfer would trigger no completed gift as long as the donor retained any interest (or control of any interest) in the underlying property. upon the expiration or disposition of the retained interest during life or at death, the entire property could be valued under general principles without apportioning value between retained and transferred interests. thus, for example, if a donor transferred property in trust retaining only an income interest for a fixed term of years, a completed transfer of the underlying property would occur at the expiration of the term or at the donor's prior death. in effect, a hard-to-complete rule would hold split-interest transfers "open" until the retained interest ceased to have any significance for valuation purposes.'99 as a result, the need for special valuation rules and subsequent adjustments would disappear. one possible objection to a hard-to-complete rule is that some interests may be valued and included in the transfer tax base long after the donor relinquished ownership and control of them. in the case of a grit, for example, the remainder transferred in the initial transfer may appreciate substantially in value by the time all retained interests expire.2 there is no reason, however, why common-law property concepts should determine the timing or extent of a transfer for federal tax purposes.2"' in effect, a hard-to-complete rule ignores the fragmentation of beneficial ownership in the initial transfer and treats the donor as making a completed transfer of the entire property upon the termination of all retained ownership and control. this represents a systematic extension of existing rules concerning the time of completion in the context of retained powers over a particular transferred interest.2"2 a more serious problem with the strong version of a hard-to-complete rule stems from the treatment of retained future interests. if a donor transfers a term interest while retaining a reversion, any distributions with respect to the transferred interest would trigger completed gifts.2" 3 although periodic 199. cf. irc §§ 2612(a), 2622 (timing and amount of taxable termination for generation-skipping transfer tax purposes); irc § 2642(f) (timing and amount of direct skip determined at expiration of "estate tax inclusion period"). 200. presumably, most donors who create grits expect that the underlying property will appreciate and structure the transaction to maximize the probability that future appreciation will escape gift and estate tax. 201. the same term often refers to fundamentally different concepts, depending on whether it appears in a federal gift tax context or a common-law property context. see, e.g., dickman v. commissioner, 465 u.s. 330, 333-38 (1984) ("gift"); jewett v. commissioner, 455 u.s. 305 (1982) ("disclaimer"); commissioner v. disston, 325 u.s. 442, 446 (1945) ("future interest"). 202. see regs. § 25.2511-2(b), (f). 203. regs. § 25.2511-2(f); cf. irc §§ 2612(b), 2621 (timing and amount of taxable distribution for generation-skipping transfer tax purposes). [vol 2:3 rethinking section 2702 gifts present no conceptual difficulty, they raise administrative concerns, especially if the only retained interest represents a remote possibility that possession or enjoyment of the underlying property might return to the donor.2°4 in such a case, a more practical solution would be to modify the hard-to-complete rule to disregard remote interests.' 5 obviously, some bright-line rules would be necessary to define remote interests and to determine when the donor would be treated as retaining powers actually held by other persons.206 furthermore, an adjustment to mitigate double taxation might be necessary if the remote interest became possessory or if the donor transferred the interest.2 7 with such modifications, a hard-to-complete rule would represent a substantial improvement over the provisions of existing law concerning timing and valuation. a hard-to-complete rule, coupled with a uniform tax-inclusive base, would remove the most troublesome transfer tax disparities between a splitinterest transfer and a single deferred outright transfer. under such a rule, by contrast with existing law, the transfer tax base would include the full value of the underlying property at the time of completion, obviating the need to apportion value between transferred and retained interests in the initial transfer." moreover, a hard-to-complete rule would eliminate the vexing overlap between the gift tax and the estate tax rules concerning the timing and extent of completion.' the special attraction of a hard-to-complete 204. donors might welcome the prospect of periodic distributions, despite the burden of filing frequent gift tax returns, if the distributions qualified for one or more annual exclusions. a strong argument can be made for curtailing the annual exclusion with respect to transfers in trust and trust distributions. see gutman, comment. supra note 180. at 657-60: gutman, transfer tax reform, supra note 180. at 1244-49; see also robert b. smith. should we give away the annual exclusion?, i fla. tax rev. 361, 431-33 (1993). 205. see gutman, comment, supra note 180. at 676-79. 206. for specific proposals of such rules, see 1969 treasury proposals, supra note 180, at 365, 386-87; 1984 treasury proposals, supra note 180, at 379; aba report. supra note 180, at 405-07; ali proposals, supra note 180, at 41-43, 46; gaubatz, supra note 180, at 98101; gutman, comment, supra note 180, at 680-81. 207. the same problem arises under existing law where a donor retains an interest having no ascertainable value in the initial transfer and subsequently transfers the same interest see supra notes 61-71 and accompanying text. 208. a strong easy-to-complete rule represents a mirror image of the hard-tocomplete rule discussed in text. including the underlying value of the entire property in the transfer tax base at the time of the initial transfer similarly would avoid the problem of unrealistic assumptions in valuing split interests; any retained interests could simply be disregarded in a subsequent transfer. this approach. combined with a uniform tax-inclusive base, would remove most of the transfer tax incentives for making split-interest transfers rather than outright transfers. 209. a hard-to-complete approach would leave the string provisions essentially intact, while limiting the range of transfers treated as completed gifts under existing law. alternatively, under an easy-to-complete approach, most of the string provisions could be 19941 florida tax review rule-in addition to improving the general structure of the gift and estate tax system-stems from its role as a viable substitute for section 2702.210 v. conclusion the need for structural reform of the gift and estate tax system remains just as urgent after the enactment of section 2702 as before. under prior law, disparities between the gift and estate taxes created strong incentives for structuring transfers to attract a single gift tax while avoiding the estate tax. to be sure, split-interest trusts represented a special variety of available techniques for reducing transfer taxes by carving beneficial ownership of property into separate interests. in contrast to techniques addressed by other provisions of chapter 14,211 the split-interest trusts at which section 2702 is aimed combined the advantages of a single completed lifetime transfer with the unrealistically favorable valuation assumptions of the tables. as a result, grits and similar techniques permitted donors to transfer property at unrealistically low gift tax values. section 2702 responds to those abuses by sharply limiting the availability of the tables and imposing an unfavorable zero-value assumption on many retained interests. this approach, however, is flawed in concept and implementation. on one hand, the zero-value assumption builds in fresh valuation distortions which often remain uncorrected, notwithstanding the elaborate compensating adjustments provided in the regulations. on the other hand, the continued use of the tables in valuing qualified retained interests, personal residence trusts and gifts to nonfamily members leaves considerable room for sophisticated transfer tax avoidance. thus, section 2702 has redirected many of the old abuses into new channels. eliminated. see isenbergh, supra note 30, at 12, 14, 16-19. 210. the major obstacle to enacting a hard-to-complete approach is rooted in politics rather than policy. the experience with former § 2036(c), which extended the reinclusion provisions to a broad range of estate freezing techniques for a brief period before 1990, offers a sobering lesson. in 1990, congress responded to sustained opposition from "small business" interests and their lawyers by retroactively repealing § 2036(c) simultaneously with the enactment of chapter 14. see supra note 2. for discussions of the politics of transfer tax reform, see michael j. graetz, to praise the estate tax, not to bury it, 93 yale l.j. 259, 259-73 (1983); gutman, transfer tax reform, supra note 180, at 1197-1207; see also byrle m. abbin, the politics of transfer taxation or watching sausage being made-is anyone in charge?, 25 inst. on est. plan. ch. 4 (1991). 211. see irc §§ 2701 (gift of subordinate equity interest in corporation or partnership), 2703 (restrictions on use or disposition of property), 2704 (lapsing rights or restrictions); see also estate of bright v. united states, 658 f.2d 999, 1001-02 (5th cir. 1981) (deathtime transfer of interest in community property); rev. rul. 93-12, 1993-1 c.b. 202 (simultaneous gifts of separate minority blocks of closely-held stock to different family members). [vol 2:3 rethinking section 2702 at a more fundamental level, section 2702 injects complexity and inconsistency into a gift and estate tax system already badly in need of reform. by focusing narrowly on valuation in the initial transfer, section 2702 exacerbates preexisting disparities between the gift and estate taxes. the use of split-interest trusts to avoid transfer taxes could be curbed far more effectively by moving toward an integrated gift and estate tax system. specifically, a uniform tax-inclusive base and consistent rules governing completion and valuation would eliminate most of the differences in transfer tax cost between split-interest transfers and outright transfers made during life or at death. although these reforms would represent only a first step toward full integration,2t2 they would render section 2702 obsolete while making the gift and estate tax system simpler, fairer, and more neutral. 212. integrating the gift and estate taxes represents an especially easy solution to the problem of valuation abuses in the context of split-interest transfers. provisions addressing other techniques might require further refinement even in a completely integrated system. see john t. gaubatz, a generation-shifting transfer tax. 12 va. tax rev. 1 (1992) (proposing integration of gift, estate, and generation-skipping transfer taxes). 19941 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 18 2015 number 2 i article many unhappy returns: the need for increased tax penalties for identity theft-based refund fraud pippa browde 53 florida tax review volume 18 2015 number 2 ii the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117634, gainesville, florida 32611-7627. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352)273-0904 or email ftr@law.ufl.edu. copyright © 2015 by the university of florida florida tax review volume 18 2015 number 2 iii editor-in-chief martin j. mcmahon, jr. james j. freeland eminent scholar in taxation university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar in taxation dennis a. calfee professor of law michael k. friel professor of law david m. hudson professor of law emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar in taxation charlene luke professor of law grayson mccouch professor of law adam smith visiting assistant professor samuel c. ullman adjunct professor of law board of advisors hugh j. ault boston college bradley t. borden brooklyn law school j. martin burke university of montana charlotte crane northwestern university jasper l. cummings, jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina kerry a. ryan st. louis university graduate editors alisa french paul hankin john hodnette laura michael hughes m. blair james young hei jo michael schwartz mark westenberger executive assistant keyosha r. monroe florida tax review volume 18 2015 number 2 iv information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: “articles,” “commentaries,” and “book reviews.” the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manual. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 18 2015 number 2 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe volume 18 2016 number 10 florida tax review article a hitchhiker’s guide to the oecd’s international vat/gst guidelines walter hellerstein florida tax review volume 18 2016 number 10 i article a hitchhiker’s guide to the oecd’s international vat/gst guidelines walter hellerstein 589 florida tax review volume 18 2016 number 10 ii the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states, plus sales tax where applicable and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117634, gainesville, florida 32611-7627. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352)273-0904 or email ftr@law.ufl.edu. copyright © 2016 by the university of florida florida tax review volume 18 2016 number 10 iii editor-in-chief martin j. mcmahon, jr. james j. freeland eminent scholar in taxation university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar in taxation dennis a. calfee professor of law michael k. friel professor of law david m. hudson professor of law emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar in taxation charlene luke professor of law grayson mccouch professor of law adam smith visiting assistant professor samuel c. ullman adjunct professor of law board of advisors hugh j. ault boston college bradley t. borden brooklyn law school j. martin burke university of montana charlotte crane northwestern university jasper l. cummings, jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina kerry a. ryan st. louis university graduate editors alisa french paul hankin john hodnette laura michael hughes m. blair james young hei jo michael schwartz mark westenberger executive assistant keyosha r. monroe florida tax review volume 18 2016 number 10 iv information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: “articles,” “commentaries,” and “book reviews.” the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manual. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 18 2016 number 10 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 2 1994 number 4 tax aspects of remic residual interests kirk van brunt* i. introduction ............................... 152 h. what is a remic residual interest? . . . . . . . . . . .. . 153 m. the creation and issuance of residual interests . 158 a. definition of a remic residual interest ......... 158 b. a single class of residual interests ............ 161 c. the existence of "reasonable arrangements" .. ..... 162 1. transfer prohibitions ................ 162 2. information requirements .............. 165 iv. taxing the holder of a residual interest ........ 166 a. computing the taxable income of the remic ..... 167 1. gross income of the remic ........... 167 2. calculating remic net income or loss .... 168 b. taking into account remic taxable income or net loss ................................... 171 1. in general ........................ 171 2. character of remic income and losses ... 172 a. remic losses ................ 173 b. remic taxable income .......... 175 3. determining a residual interest holder's basis ............................ 177 c. treatment of up-front payments .............. 184 1. existence, timing and manner of income recognition ....................... 186 a. receipt of income? ............. 186 b. treatment of up-front payments as income ..................... 188 c. tax policy issues .............. 191 * associate, cleary, gottlieb, steen & hamilton, washington, d.c. j.d. 1985, harvard law school. the author gratefully acknowledges the many helpful comments on an earlier draft of this article from mitchell s. dupler. florida tax review 2. up-front payments and basis ........... 195 a. what is cost? ................ 195 b. a negative basis approach ....... 196 c. an alternative basis approach .... 198 3. up-front payments and the sponsorltransferor ................... 198 d. treatment of the sponsor on retained interests .... 200 e. transfers and terminations of residual interests ... 202 1. status as property ................... 203 2. presence of a sale or exchange ......... 205 a. up-front payments as gain/loss on a sale or exchange ............. 205 b. loss upon remic termination ... 209 3. wash sale rules .................... 209 v. excess inclusions ............................ 210 a. "phantom income": a closer look ............ 211 1. in general ........................ 211 2. phantom income and losses in securitizations ..................... 214 b. the excess inclusion rules ................... 215 1. measuring excess inclusions ........... 215 2. taxability of excess inclusions .......... 217 3. special rule for thrifts ................ 218 a. in general ................... 218 b. the significant value requirement . 219 4. special rules for reits and rics ........ 222 c. excess inclusions and the alternative minimum tax ................................... 225 vi. tax treatment of special holders .............. 227 a. foreign residual interest holders ............. 227 1. applicability of u.s. withholding taxes .... 227 a. the portfolio interest exemption ... 229 b. tax treaty relief .............. 233 2. time and manner of withholding ......... 238 b. securities dealers ......................... 240 1. remic residual interests as securities .... 240 a. in general .................... 240 b. section 1236(c) ............... 241 c. section 475 .................. 242 [vol. 2:4 tax aspects of remic residual interests 2. selected rules applicable to securities dealers .......................... 249 a. applying the current mark to market rules ................. 249 b. inventor, accounting ............ 251 c. section 1236(c) ............... 254 d. sales or exchanges of residual interests .................... 254 e. wash sales .................. 255 3. who are dealers in residual interests? .... 255 c. thrift institutions and reits ................. 258 1. thrift institutions ................... 258 2. reits ........................... 262 vii. regulating transfers of residual interests ...... 263 a. in general .............................. 263 b. prolegomenon: what is a transfer? ............ 263 c. noneconomic residual interests ............... 264 1. the definition of a noneconomic residual interest ........................... 265 2. transferor due diligence .............. 268 3. failed transfers .................... 269 d. special rules on transfers to foreign holders .... 270 1. transfers to foreign holders ........... 270 2. exception for residual interests generating eci ............................. 273 3. transfers by foreign persons to u.s. persons .......................... 274 e. penalty tax on transfers to disqualified organizations ........................... 274 1. in general ........................ 274 2. calculation of the penalty tax .......... 276 3. special rules for pass-through entities ... 277 viii. postscript: residual interests-paradigm for the future? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278 19941 florida tax review i. introduction with the creation in 1986 of the "real estate mortgage investment conduit" (remic),' there came into existence a new type of financial instrument, the remic residual interest, the economics and tax treatment of which are quite unlike those of any other financial instrument. the remic residual interest is a unique creature of the tax laws and exists only because the tax laws say it must, and not because there is a particular demand for such instruments in the marketplace. moreover, residual interests are intensely regulated by arcane and complicated tax rules that are designed principally to maximize a holder's tax liability. yet, remic residual interests are a staple of the mortgage-backed securities marketplace today-a marketplace that has become gargantuan in recent years.2 the raw number of residual interests and their prevalence in the portfolios of sophisticated investors and securities dealers can only increase steadily as more and more mortgages are pooled into remics. accordingly, it is appropriate to examine the complex tax rules associated with residual interests, particularly since these rules are relevant not only to the holder of a residual interest, but also to the remic itself, and therefore indirectly to the holders of regular interests in the remic. 1. remics are governed principally by the tax rules in §§ 860a through 860g and the regulations thereunder (collectively, the "remic rules"). the remic code provisions were enacted by the tax reform act of 1986, pub. l. no. 99-514, § 671, 100 stat. 2085, 2309-18, and later amended by the technical corrections and miscellaneous revenue act of 1988, pub. l. no. 100-647, § 1006(t), 102 stat. 3342, 3419-27 [hereinafter tamraj. regulations were adopted in 1992. t.d. 8458, 1993-1 c.b. 147. in general, a remic is a self-liquidating entity that holds a pool of mortgage loans and issues interests in those mortgages to investors. more technically, a remic is defined as an arrangement of which substantially all the assets are qualified mortgages and permitted investments, and all of the interests are either regular interests or part of a single class of residual interests. irc § 860d(a). in addition, to qualify as a remic, the arrangement must make a timely election and have reasonable arrangements in place with respect to the ownership of residual interests in the remic by disqualified organizations. id. with the exception of the rules relating to disqualified organizations, which are discussed further in part ih.c., infra, this article does not elaborate on the requirements for qualifying as a remic. 2. as of the end of the first quarter of 1994, the total principal amount of mortgagebacked securities outstanding had reached $1.6 trillion, up from $917 billion at the end of 1989. 80 fed. res. bull. a38 (no. 9, sept. 1994). some $710 billion of outstanding mortgage backed securities consist of freddie mac and fannie mae remic securities. tom albertson, a tale of two remic markets, secondary mortgage markets: mortgage market review 1994, at 26 (a publication of freddie mac). it has been estimated that historically about 24.75% of mortgage originations will end up in remics. joseph hu & chip stem, observations: prospects of derivative mortgage securities, mortgage backed securities letter, sept. 5, 1994, at 6. [vol 2:4 tax aspects of remic residual interests this article provides a comprehensive analysis of the tax issues associated with creating, issuing, holding and trading remic residual interests. this far ranging inquiry is necessary because remic residual interests are a novelty and do not fit within, nor are they readily analogized to, normal tax concepts and rules that apply to other financial instruments. for example, the tax laws have spent many decades working out the appropriate treatment of debt and equity, and how to distinguish between the two. and in recent years the tax laws have become increasingly adept at untangling the tax treatment of various derivative financial instruments, such as notional principal contracts. yet, the remic residual interest is neither debt, equity, option nor notional principal contract-although it has points of similarity to each of these-and consequently it has the fortune or misfortune of entering the marketplace with no applicable tax common law to help establish the appropriate tax treatment. as a result, although a handful of specific provisions in the remic rules resolve a great many issues, the tax treatment of residual interests is unsettled in a number of important respects. this article seeks to catalogue the tax aspects of residual interests and, in doing so, to identify the open issues, address the relevant tax policy considerations, and suggest possible solutions. hi. what is a remic residual interesr? in an asset securitization, relatively illiquid receivables are pooled and interests in the cash flows thereon are sold to investors. although the concept is simple enough, the legal forms of securitization transactions can differ significantly.3 one of the simplest and earliest forms of securitization is the venerable mortgage pass-through trust, in which mortgage loans are pooled in a trust and investors purchase trust certificates representing undivided ownership interests in the pool.4 taxation of the holders of a pass-through arrangement is relatively straightforward: the holders of trust certificates are the owners of trust assets and they are taxed on their pro rata shares of the 3. for a general overview of securitization, see thomas r. boemio & gerald a. edwards, jr., asset securitization: a supervisory perspective, 75 fed. rcs. bull. 659 (no. 10. oct. 1989); 1 tamar frankel, securitization: structured financing, financial asset pools. and asset-backed securities (1991). 4. rev. rul. 70-545, 1970-2 c.b. 7, modified by rev. rul. 74-169, 1974-1 c.b. 147; rev. rul. 70-544, 1970-2 c.b. 6, modified by rev. rul. 74-169, 1974-1 c.b. 147. for a brief review of the evolution of the tax treatment of mortgage pass-through arrangements, see subcommittee on asset securitization, a.b.a. sec. tax'n, legislative proposal to expand the remic provisions of the code to include nonmortgage assets, 46 tax l rev. 299. 30204 (1991) [hereinafter american bar association legislative proposal]. pass-through trust arrangements are commonly used today to securitize nonmortgage assets, such as credit card or automobile receivables, for which no remic-like vehicle is available. 1994] florida tax review net income on the assets. since the certificateholders are the equity holders, there is no residual interest in this type of securitization;5 all cash flows simply pass through to the equity holders.6 the trust entity itself is structured as an "investment trust"7 and as such is not subject to entity level taxation. a different form of securitization is the so-called "pay-through" arrangement,' in which investors acquire separate debt obligations of an issuer that are funded by the underlying assets being securitized. payments on the issuer's obligations are structured to match, in large part, the payments received on the assets, but investors do not actually own the assets; they are only secured creditors. beneficial ownership of the assets rests with a separate class of equity holders. an "owner trust"9 is an example of a pay-through arrangement, as is the remic.'0 pay-through arrangements are similar to pass-through arrangements in that the economic substance of both types of securitizations is the sale of cash flows from assets to investors. however, since a pay-through arrangement involves separate debt obligations of an issuer, the cash flows from assets can be carved up in much more sophisticat5. this statement is true as a legal matter, although as an economic matter some certificate holders may bear all or a disproportionate share of the losses and, in this respect, resemble residual interest holders. 6. equity characterization, however, is not absolute. for certain purposes in applying the so-called portfolio interest rules in §§ 871(h) and 881(c), a pass-through certificate is treated as a separate debt instrument issued by the trust. temp. regs. § 35a.9999-5(c). moreover, it is possible that the service will impose similar treatment in other areas, such as the market discount rules in §§ 1276-78. see david c. garlock, federal income taxation of debt instruments 346-47 (supp. 1993). 7. regs. § 301.7701-4(c). this regulation does not define an investment trust per se, but states that in order for an investment trust to qualify as a trust for tax purposes, (1) there must be no "power under the trust agreement to vary the investment of certificate holders," and (2) subject to certain exceptions, the trust generally must not possess multiple classes of ownership interests. id. 8. the term pay-through arrangement is borrowed from james m. peaslee & david z. nirenberg, federal income taxation of mortgage-backed securities 13 (rev. ed. 1994); see also i frankel, supra note 3, at § 2.5.4.3. 9. the term owner trust is used to refer to a grantor trust entity that is the issuer of debt obligations. it is used to distinguish the grantor trust issuer from the trust created under the bond indenture in connection with the debt issuance. the debt obligations of an owner trust are typically referred to in the mortgage-backed security industry as collateralized mortgage obligations (cmos). 10. the issuer in a pay-through securitization may also be a corporation, in which case pass-through treatment is accomplished by virtue of the interest deduction that is available to the corporation to offset income on its assets. on other legal structures for securitizing assets, see generally kenneth g. lore, mortgage-backed securities: developments and trends in the secondary mortgage market § 6.01 (1990-91 ed.). [vol 2:4 tax aspects of remic residual interests ed and creative ways. in a pass-through trust arrangement, investors must generally share the cash flows pro rata." a pay-through arrangement thus involves structuring a series of debt obligations to match the aggregate cash flows on the assets being securitized. the match, however, generally will not be perfect and some of the cash flow on assets will not be paid out to the debt holders. this mismatch means that residual amounts of cash flow will be left over and these scraps are taxable to the equity holder, who thus holds what is referred to as a residual interest in the securitized assets. since it is generally more efficient to channel as much of the cash flow as possible to the debt holders, there is pressure in structuring a securitization to make the remainders available for the equity holder as small as possible. 2 outside the remic context, tax concerns arise about the substantiality of the residual interest in the assets of a debt issuer, since the characterization of the investors' interests as debt is potentially jeopardized if the value of the residual interest becomes too insubstantial or ephemeral. 3 thus, the "residual interest" in a non-remic pay-through arrangement generally will possess a real entitlement to a portion of the cash from the assets. however, in the case of a remic, as discussed below, traditional debt-equity analysis is not applicable and the amount of residual equity can be effectively eliminated, if desired. in addition to being taxable on the remainders, the equity holder in a pay-through arrangement also bears the tax burden of timing mismatches. as the owner of the assets the equity holder is taxable on the income on the assets, but is entitled to an offsetting deduction for income paid to the debt holders. because of timing differences, the income items in some periods may exceed the deduction items and the equity holder may have taxable income, although the timing mismatch generally will reverse in later periods and generate offsetting losses to the equity holder. timing differences can arise for a number of reasons, but the principal cause, discussed in greater detail 11. with only limited exceptions, an entity will not qualify as a trust if it possesses more than one class of ownership interests, defined as different rights or priorities with respect to trust income. rather, such an entity will constitute a partnership or a corporation. this greatly limits flexibility in dividing up cash flows. see generally reid a. mandel. investment yields: tax consequences of bifurcations, layering, tiering and differentiation: a study in income and principal gene-splicing, 65 taxes 965 (1987) (discussing the major alternatives to remics for those interested in division of income streams among investors with differing goals). 12. see infra note 30 (discussing the analogy to limited partnerships). 13. in addition, the lack of residual equity creates a concern that the issuer has, in reality, sold the securitized assets to the debt holders and that such assets are being held in trust for the holders, which trust itself would risk corporate characterization if there were multiple classes of debt holders. see john p. simon. selected federal income tax aspects of securitizing debt obligations, 66 taxes 897, 903 (1988). 19941 florida tax review below, is the so-called "tranching" of the debt obligations and the term structure of interest rates. 4 income and deductions created by timing differences will ultimately offset each other and net to zero. however, timing is everything and the pain of a substantial tax liability on phantom income in one year is only partially eased by the prospect of offsetting phantom losses in a later year. remic residual interests are a special type of residual equity interest in a pay-through arrangement. like the equity holder in a non-remic paythrough arrangement, the remic residual interest holder is taxable on the remainders and bears burden of timing differences. frequently the residual interest is viewed as a cost or inefficiency in a remic securitization; the sponsor of the remic generally could realize a better return from the securitization if no residual interest were created. as a result, there is pressure to minimize the amount of cash to which a residual interest is entitled, so that today many residual interests are entitled to minimal or even zero cash flow from the remic. for example, assume a remic is formed by contributing to it mortgages with an aggregate principal amount of $100, each of which pays interest at a fixed rate of 7%. the remic in turn issues two regular interests, class a and class b, which are entitled, respectively, to principal of $75 and interest at the rate of 7% and principal of $25 and interest at the rate of 7%. clearly, there are no remainders for the residual interest; all of the cash flow from the mortgages has been dedicated to the class a and class b regular interests. as a result, the residual interest will be issued with a zero cash flow entitlement. 5 in this case, as we will see later, the residual interest is effectively reduced to no more than an agreement by the holder to assume the remic's tax liability in exchange for an up-front payment. on occasion, however, structuring considerations will necessitate that a residual interest possess material economic terms. for example, in one type of remic that has recently begun to appear, an "interest only" or 10 instrument and a "principal only" or po instrument are contributed to a remic."6 assume that the 10 pays interest at the rate of 8% on a reference 14. see infra part v.a. 15. although a residual interest is issued with zero cash flow entitlement, the holder is nevertheless the equity stakeholder in the remic and is entitled to any cash that is not needed to pay the class a and class b regular interests. possibly, stray cash amounts will appear from time to time, which the residual interest will get. for example, if a remic sells a mortgage at a premium (probably an unlikely occurrence), the premium typically would go to the residual holder. generally, disclosure in the offering documents for such residual interests will state that it is not expected that there will be material amounts of such stray cash. 16. the 10 is an instrument that represents the right to receive some or all of the interest payments on a mortgage security (e.g., an agency pass-through certificate). the rights to the principal of the mortgage security (and any other remaining interest amounts) are then transferred separately to other holders. the po, conversely, represents the right to receive only [vol. 2:4 tax aspects of remic residual interests principal balance of $100 and the po pays principal of $100. the remic issues a single regular interest, class a, with a principal balance of $100 that pays interest equal to libor, with interest on the 10 in excess of libor used to pay down the class a principal balance. based on a broad band of prepayment assumptions and historical data regarding libor, it can be expected that sufficient funds will always exist ultimately to pay the class a its principal and interest entitlement. any cash not needed to retire the class a then goes to the residual interest. depending on how closely the libor and prepayment assumptions are borne out, the residual interest may receive very little cash or the holder may literally strike it rich.' 7 although residual interests are a permanent fixture of today's mortgage-backed securities market, the actual market for residual interests is small, consisting of only relatively few sophisticated investors and securities dealers. yet, it is an active market in that hundreds of remics are formed each year, each necessarily involving the creation and typically the sale of a residual interest. in order to appreciate fully the market for residual interests it is important to realize that although a residual interest may be structured to provide the holder with an insignificant cash flow, this does not mean that the acquisition of a residual interest is a "noneconomic" event. on contrary, it is as economic an event as the acquisition of any other derivative financial instrument. even if a residual interest provides the holder with no cash flow entitlements from the remic, the holder will be paid an up-front amount, by the transferor of the residual interest (the remic sponsor), to accept the tax burdens and benefits that result from ownership. the holder is thus making a sophisticated financial bet, the same bet, if not quite on the same scale, as the holder of the residual interest in the io/po remic described above. if events turn out in its favor (e.g., the mortgages enjoy favorable prepayment experience), the residual interest holder may realize a significant yield, whereas if events are less favorable, the holder may lose money. the term "noneconomic" residual interest is commonly used, and the term has a technical meaning as discussed below, yet it is something of a misnomer to the extent that it connotes that a holder cannot recognize any profit from ownership of a residual interest. principal payments on a mortgage security. 17. for example, in the most extreme (and unrealistic) case, if the po prepays tomorrow and the 10 never experiences any prepayment (the underlying mortgage security from which it derives is never prepaid), then the class a will be retired when the po pays off, and the entire interest stream from the 10 will go the residual interest for the life of the 10-a total return likely to be many hundreds of times greater than the price paid for the residual interest. 19941 florida tax review ii. the creation and issuance of residual interests one condition to qualification as a remic is that there be a single class of residual interests in the remic."8 an improperly created residual interest, or the absence of a "single class" of residual interests, will jeopardize remic status. 9 although the consequences of creating a "bad" residual interest are thus ominous, the remic rules relating to the creation and issuance of residual interests were not intended to lay down treacherous and deceptive rules to trip up unwary taxpayers; the rules are neither complex nor subject to significant uncertainties in meaning. rather, the rules are largely procedural and impose only minimal restrictions on the substantive economic characteristics of residual interests. the emphasis is primarily on designating an appropriate person to take responsibility for the remic's taxable income. nevertheless, since the consequences of an improper residual interest include the failure to qualify as a remic, it is important to review the modest rules that do exist. a. definition of a remic residual interest the code defines a remic residual interest in laconic fashion as a "an interest in a remic which is issued on the startup day, which is not a regular interest, and which is designated as a residual interest."20 the statutory definition thus consists of three elements: an interest (i) other than a regular interest, (ii) issued on the startup day, and (iii) designated as a residual interest. since a regular interest is defined, in part, as any interest in a remic that is designated as such,2' the act of not designating a residual interest as a regular interest is sufficient in and of itself to meet the "not a regular interest" requirement. prior to tamra, however, there was no designation requirement for regular interests and thus an issue existed whether a residual interest must actually differ economically from regular interests in order to meet the "not a regular interest" requirement. 22 since 1988, however, it is clear that the "not a regular interest" requirement is not intended to restrict the economic characteristics of a residual interest. concerning the "issued on the startup day" requirement, the term "startup day" is defined as the day when residual and regular interests are 18. irc § 860d(a)(3). 19. irc § 860d(b)(2). 20. irc § 860g(a)(2). 21. irc § 860g(a)(1). 22. james m. peaslee & david z. nirenberg, federal income taxation of mortgagebacked securities 73-74 n.39 (1989). [vol. 2:4 tax aspects of remic residual interests issued by the remic, 2' which creates a certain circularity. meeting this requirement generally raises few issues, however, although in theory a concern could arise if the terms of a residual interest were modified after the startup day, which could be construed as the issuance of a new residual interest after the startup day in exchange for an old one. an additional concern that could arise, again in theory, relates to a pre-existing entity for which a remic election is sought. for example, assume a corporation is formed, stock is issued and six months later the corporation issues mortgagebacked securities and seeks to make a remic election. possibly it could be argued that the residual interest (the stock) was issued before the startup day.24 as a practical matter, the issue never seems to arise, since it is easily bypassed by simply designating the relevant assets of the entity (rather than the entity itself) as a remic. turning finally to the designation requirement, the regulations provide that a residual interest is designated as such by attaching to the remic's first tax return information concerning the terms and conditions of the residual interest (or by attaching a copy of the offering circular or prospectus containing such information).' the requirement is thus largely a procedural one and is easily satisfied. the organizational documents of a remic generally will carefully designate the residual interest and amply describe its terms. conceivably a problem could arise if a remic chose to effect a designation by merely attaching a public offering document to its return, which the regulations permit. this approach, however, places an additional premium on ensuring that the disclosure is correct, since a misstatement of the residual interest terms in an offering document not only can give securities law concerns, but could also affect the status of the residual interest (and hence the remic). but apart from the risk of erroneous disclosure, the residual interest is frequently not included in the securities being publicly offered under a prospectus and its terms may not be adequately described therein. attaching such an offering document to the tax return can thus give rise to questions about whether a proper designation has been timely made. 6 23. irc § 860g(a)(9). the regulations provide that a remic sponsor "may contribute property to a remic in exchange for regular and residual interests over any period of 10 consecutive days and the remic may designate any one of those 10 days as its startup day." regs. § 1.860g-2(k). the day so designated is treated as the day the regular and residual interest were issued. id. 24. peaslee & nirenberg, supra note 8. at 107-08. since a residual interest is a creature of the remic election, it is strange to speak of one existing before an election is made. 25. regs. §§ 1.860d-1(d)(2)(ii), 1.860g-1(c). 26. these concerns apply equally to regular interests, which, as noted above, are also subject to a designation requirement. irc § 860g(a)(l): regs. § 1.860g-l(a)(l). often classes of regular interests are not publicly offered (they are privately placed or retained by 19941 florida tax review although the likelihood of such a mistake may seem remote, it must be borne in mind that the person actually charged with making the remic election and filing tax returns may possess little sophistication and knowledge of the requirements.27 presumably the internal revenue service (the "service") would be lenient in granting relief in such situations.2" in addition to elaborating on the designation requirement, the regulations also confirm what is implicit in the statutory scheme: a residual interest need not entitle a holder to any distributions from the remic.29 prior to the issuance of the regulations, some questioned whether a residual interest could be issued that entitled the holder to nothing and, out of caution, typically tax counsel required that a residual interest have some minimum principal amount ($10,000 was a common figure). this concern was based in part on the fact that it seemed counterintuitive to speak of a residual interest, with no entitlement to any cash flow, as being an "interest" in the remic,3" and in part on the question of how one effects a "transfer" of the remic sponsor) and are described, if at all, only in an extremely cursory fashion in the public offering document covering the other classes. 27. this is evident from the number of requests for relief under regs. § 301.91001(a) by remics whose tax return preparers forgot to file tax returns for the remic and make a timely remic election (or in one case failed to have the return signed by the right person). see priv. let. rul. 9411022 (dec. 16, 1993); priv. let. rul. 9309043 (dec. 9, 1992); priv. let. rul. 9239010 (june 24, 1992); priv. let. rul. 9239007 (june 24, 1992); priv. let. rul. 9144014 (july 30, 1991); priv. let. rul. 9144013 (july 30, 1991); priv. let. rul. 9144012 (july 30, 1991); priv. let. rul. 9139007 (june 26, 1991); priv. let. rul. 9111057 (dec. 19, 1990); priv. let. rul. 9108008 (nov. 19, 1990); priv. let. rul. 9006009 (nov. 2, 1989). often these failures apparently are due to misunderstandings about who is responsible to do what, which underlines the need for tax counsel to be very specific in the remic's organizational documents about who is to file tax returns. 28. the service may, upon a showing of good cause, grant a reasonable extension of time for making an election. regs. § 301.9100-1(a); rev. proc. 92-85, 1992-2 c.b. 490, modified by rev. proc. 93-28, 1993-2 c.b. 334. 29. regs. § 1.860g-i(c); staff of the joint comm. on tax'n, 99th cong., 2d sess., general explanation of the tax reform act of 1986, 416 (comm. print 1987) [hereinafter 1986 act bluebook]. 30. a distant analogy to the concerns over zero entitlement residual interests arises with respect to certain limited partnerships (particularly those used as a securitization vehicle), where there is often pressure in structuring them to make the general partner's partnership interest as small as possible. if the general partner's interest in partnership capital or profits is too small or trivial, a concern exists that the general partner is not a partner at all (i.e., it has no real interest in the venture). see william b. brannan, lingering partnership classification issues (just when you thought it was safe to go back into the water), i fla. tax rev. 197, 214-16 (1993). in this regard, the service requires for ruling purposes that the general partner maintain a minimum 1% interest in the partnership, although this phases down to as little as .2% for partnerships with capital contributions of $250 million or more. see rev. proc. 92-88, 1992-2 c.b. 496, § 4.01(1). significantly, the service chose not to impose any such economic standards on residual interests. [vol 2:4 tax aspects of remic residual interests something that has no positive cash flow entitlements and that may in fact represent a net liability to the holder. as noted above, it is relatively common now for a residual interest to be issued with zero distribution rights. so much for the statutory definition of a residual interest. as the foregoing shows, the formal requirements are few and relatively minor. as described in the following subsections, however, a number of collateral requirements exist that a remic must meet in issuing a remic residual interest. b. a single class of residual interests section 860d(a)(3) provides that a remic must have one, and only one, class of residual interests and all distributions to such interests, if any, must be pro rata.3 1 this prohibition is straightforward and generally presents few structuring issues.32 one issue that occasionally arises is whether some person holds a "disguised" equity interest in the remic. the remic regulations resolve this in many common situations by providing that a number of common rights vis-a-vis the remic are not considered "interests" therein (and thus do not give rise to an impermissible second class of residual interests).33 in addition, prior to the remic regulations, concerns occasionally were expressed about this requirement in the case of two-tier or double remic structures. if the separate existence of the remics were ignored and the two collapsed and treated as a single remic, one might be troubled by the existence of two different classes of residual interests. however, the threat of two-tier remic structures being collapsed is now a remote one, if indeed it was not always so. the remic regulations allow for tiered remic 31. although the statutory scheme is clear that a renic must issue a residual interest, the remic need not issue any regular interests. this was not entirely certain before the remic regulations were issued. peaslee & nirenberg, supra note 8. at 99 & n.9. see also h.r. conf. rep. no. 841, 99th cong., 2d sess. 11-228 (1986). reprinted in 1986 u.s.c.c.a.n. 4075, 4313 (suggesting that a remic must issue both regular and residual interests). the preamble to the final remic regulations, however, plainly states that a remic need not issue regular interes. 57 fed. reg. 61,295 (1992) ("the remic must issue one, and only one, class of residual interests. a remic may issue one or more classes of regular interests.") (emphasis added). 32. the fact that one residual interest holder may be singled out to be the tax matters person should not affect the single class requirement. such a designation is specifically recognized and permitted in the regulations. regs. § 1.860f-4(d). 33. regs. § 1.860d-l(b)(2). under this regulation an interest in a remic does not include rights to receive payment for services, stripped bonds or coupons not held by a remic (such as excess servicing compensation), rights to reimbursements under credit enhancement contracts, and certain rights to acquire remic assets (e.g., pursuant to a clean-up call). see generally peaslee & nirenberg, supra note 8, at 100-05 (discussing what is an interest in a remic). 19941 florida tax review arrangements to be created in a single document, even if for state law purposes only a single entity is created. 4 c. the existence of "reasonable arrangements" as discussed in detail below in part vii, the remic rules are seemingly tireless in their quest to police who holds a remic residual interest. one cornerstone in this war on inappropriate holders is the requirement that a remic must possess "reasonable arrangements" that are designed to ensure that (i) residual interests in the remic are not held by "disqualified organizations" and (ii) information necessary for the application of the penalty tax in section 860e(e)35 will be made available by the entity. these requirements are intended, in essence, to "deputize" the remic and force it to take steps to restrict who comes into possession of its residual interests. as originally enacted, remic provisions did not restrict ownership of residual interests by disqualified organizations, and thus did not contain any "reasonable arrangements" requirement. in 1988, tamra added these elements, effective generally for any remic with a startup day after march 31, 1988,36 when it became apparent that taxation on remic income could be easily avoided by transferring the residual interests to entities that are not subject to u.s. taxation. there are, however, a multitude of older remics that do not have, and need not have, any "reasonable arrangements." 37 1. transfer prohibitions.-the first prong of the reasonable arrangements requirement is that arrangements exist to ensure that residual interests are not held by disqualified organizations. a disqualified organization is defined in section 860e(e)(5) as: 34. regs. § 1.860f-2(a)(2)(i), 35. the § 860e(e) penalty tax is described in greater detail below in part vile. 36. the tamra amendments do not apply to a remic with a startup day after march 31, 1988, if it was formed pursuant to a binding written contract in effect on that date. tamra, supra note 1, § 1006(t)(16)(d)(i), 102 stat. at 3425. the startup day for purposes of the effective date of the tamra amendments is the startup day as that term was defined prior to the enactment of tamra (which changed the definition of startup day). under the pre-tamra definition, the startup day was any day chosen by the remic that was on or before the day its regular and residual interests were issued. 37. although an older remic need not have reasonable arrangements in place, any transfer of a residual interest in such a remic after march 31, 1988 to a disqualified organization is nevertheless subject to the § 860e(e) penalty tax enacted by tamra for such transfers (as described more fully below in part vile.). tamra, supra note 1, § 1006(t)(16)(d)(ii), 102 stat. at 3342; regs. § 1.860a-l(b)(3). on the development of the tamra legislation relating to disqualified organizations and reasonable arrangements, see generally thomas a. humphreys & robert m. kreitman, mortgage-backed securities: including remics and other investment vehicles 308 (1994). [vol. 2:4 tax aspects of remic residual interests (a) the united states, any state or political subdivision thereof, any foreign government, any international organization, or any agency or instrumentality of any of the foregoing, 03) any organization (other than a cooperative described in section 521) which is exempt from tax imposed by this chapter unless such organization is subject to the tax imposed by section 511, and (c) any organization described in section 1381(a)(2)(c). this list is an exclusive one and is intended to encompass those entities that by law are exempt from u.s. taxation. other tax-exempt entities, such as section 501(c) organizations, are not included in the list, since they are taxable on unrelated business taxable income. a special provision provides that so-called "excess inclusion" income on a residual interest will be treated as unrelated business taxable income.3" as for what measures constitute reasonable arrangements, the legislative history states that they include "restrictions in the governing instruments of the entity prohibiting disqualified organizations from owning a residual interest in the remic and notice to residual interest holders of the existence of such restrictions., 39 the legislative history further provides that the reasonable arrangements requirement will not be met if it is contemplated when the remic is formed (apparently by the remic sponsor) that disqualified organizations will own residual interests in it.' the legislative history thus seems to envision a system such as the so-called tefra d rules that apply to bearer debt instruments." however, the tefra d rules provide a reasonably clear safe harbor for taxpayers to achieve certainty, whereas prior to the regulations described below, remics were left to the whims and vagaries of "reasonableness," which often prompted tax counsel to impose some fairly stringent safeguards against transfers of residual interests to disqualified organizations. 38. irc § 860e(b). 39. s. rep. no. 445, 100th cong., 2d sess. 86 (1988). reprinted in 1988 u.s.c.c.a.n. 4515, 4604-05. 40. id. at 4605. 41. see regs. § 1.163-5(c)(1) (requiring that reasonable arrangements exist to prevent a bearer debt instrument from being sold to a u.s. person and that notice to this effect be provided to holders by way of a legend). see generally peter j. connors & peter f. hiltz, final regs. ease rules for portfolio bearer debt offerings, 73 j. tax'n 166 (1990). 19941 florida tax review fortunately, the regulations now provide a bright-line definition of reasonable arrangements, stating that a remic will be considered to have adopted such arrangements if: (a) the residual interest is in registered form (as defined in [treas. regs.] § 5f.103-1(c)); and (b) the qualified entity's organizational documents clearly and expressly prohibit a disqualified organization from acquiring beneficial ownership of a residual interest, and notice of the prohibition is provided through a legend on the document that evidences ownership of the residual interest or through a conspicuous statement in a prospectus or private offering document used to offer the residual interest for sale.42 the registration requirement is the same as the one that applies generally to registration-required debt instruments under section 163(f). in general, a residual interest is in registered form if it is registered as to both principal and interest (if any) with the remic, and the residual interest can be transferred only through a book entry system or by surrendering the residual interest instrument to the remic and having a new instrument issued in the name of the new holder (or through both methods).43 with respect to the second part of the definition, the organizational documents (generally the pooling and servicing agreement, trust indenture or similar document) must prohibit transfers of residual interests to disqualified organizations. it should be noted that the prohibition refers to beneficial ownership and drafters of the remic documents must be careful to couch the transfer prohibition language in such terms. one common provision that many remic documents contain is a statement that any transfer in violation of the prohibition shall be null and void and the transfer shall be disregarded. prior to the regulations, such a provision was a reasonable response to the uncertainty about what constituted reasonable arrangements. now, it is clear that this type of statement is not necessary under the regulations and can impose needless administrative burdens on the remic. 44 all that is required 42. regs. § 1.860d-l(b)(5). 43. temp. regs. § 5f.103-1(c). 44. revesting ownership of the residual interest with the transferor may amount to punishing the transferor for the transferee's sins (e.g., the transferor may have paid the transferee to accept ownership of the residual and may now be saddled with a substantial remic tax liability). this makes no sense, and the likely effect will be merely to provoke lawsuits where the transferor is the innocent victim of the transferee's misrepresentations. see infra note 463. [vol 2:4 tax aspects of remic residual interests is a clear prohibition; the remic need not impose sanctions for violations. in fact, as discussed immediately below, the remic statute provides rules for those occasions when, despite reasonable arrangements, a residual interest falls into the hands of a disqualified organization, further indicating that the remic need only prohibit, not punish, violative transfers. in addition to prohibitions in the organizational documents, a prohibition must be placed in a legend on the document evidencing ownership of the residual interest or in the public or private offering document. generally, a remic will meet both of these standards, setting forth a legend and inserting notice of the prohibition in the offering documents. two final notes on the reasonable arrangements requirement are in order. first, curiously the regulations do not implement the point in the legislative history that the reasonable arrangements requirement will not be met if it is contemplated (probably by the sponsor) at the time the remic is formed that a disqualified organization will acquire a residual interest (other than for a transitory period). nevertheless, this actual knowledge restriction still exists as the expressed intent of congress and it is not vitiated by the service's decision not to address the issue in the regulations. second, related to the foregoing, remic documents often prohibit transfers of residual interests to a person that holds the interest as a so-called "bookentry" nominee. by having such a restriction, obviously a remic reduces materially the chances that beneficial ownership of a residual interest could fall into the hands of a disqualified organization, which is generally a desirable goal even if remic qualification is not at issue. however, strictly speaking, such a restriction on book entry nominees, while desirable, is not required under the definition of "reasonable arrangements." 2. information requirements.-the second prong of the reasonable arrangements requirement is that there be arrangements to ensure that the remic makes available the necessary information for the application of the section 860e(e) penalty tax. section 860e(e) is discussed below in part vii.e, but, in brief, it imposes a penalty tax, generally on the transferor, for transfers of residual interests to disqualified organization. the penalty tax is equal to the product of the highest tax rate specified in section i l(b)(1) (currently 35%) and the present value of total anticipated excess inclusions for future periods after the transfer. the regulations provide that a remic must provide to the service and to the person liable for the penalty tax a computation showing the present value of anticipated excess inclusions for future periods.45 45. regs. § 1.860d-1(b)(5)(ii). 19941 florida tax review the regulations provide that a remic meets this information requirement if its organizational documents require it to provide the foregoing information to the irs and to persons liable for the tax. however, a remic's obligation to provide this information is triggered only by a request for it. a remic is under no obligation to determine if its residual interests have been transferred to a disqualified organization.46 if a request is made, the remic must provide the information within 60 days and may charge a reasonable fee without the income constituting income derived from a prohibited transaction.47 iv. taxing the holder of a residual interest a remic must compute its separate taxable income and in this respect the remic is recognized as an entity for tax purposes. however, the holder of the residual interest, and not the remic, is taxable on remic taxable income and in this respect the remic is a pass-through entity akin to a partnership.4" the partnership analogy, however, is a rough one at best. for example, unlike a partnership, the income and deduction items of the remic generally do not pass through and retain their character in the hands of the residual interest holder.49 instead, taxable income is computed at the remic level and only the resulting, bottom-line taxable income or net loss is passed through and taken into account by the holder as an ordinary income or loss amount.5 ° the discussion below begins with how a remic computes its taxable income. the next section addresses how this income is taken into account by a holder, starting first with a discussion of how a holder computes its basis in a residual interest. a topic touched on only briefly in this section is the treatment of excess inclusion income, which is addressed more thoroughly in part v. finally, the discussion considers certain special topics, such as the 46. regs. § 1.860e-2(a)(5). 47. id. 48. in fact, for procedural purposes under the code, a remic is treated as a partnership. irc § 860f(e); regs. § 1.860f-4(a). 49. one exception to this is that the investment expenses of a remic for the calendar quarter pass through and retain their character as such in the hands of pass-through interest holders. temp. regs. § 1.67-3(a)(1). for a further discussion of the character of remic income and losses, see infra part iv.b.2. 50. irc § 860c(e)(1). perhaps the closest analogy to the way residual holders are taxed on remic income is anti-deferral rules that require u.s. shareholders to take into account currently a deemed dividend amount based on a foreign corporation's earnings and profits. irc § 551(a), (b) (pertaining to foreign personal holding companies); irc § 951(a) (pertaining to controlled foreign corporations). [not. 2:4 tax aspects of remic residual interests treatment of so-called "up-front" payments to residual interest holders and the treatment of transfers of residual interests. a. computing the taxable income of the remic 1. gross income of the remic.-since a remic is limited in the kind of assets it may hold and in the kind of activities it may undertake, the gross income items of a remic typically will consist of only a limited array of different types of income. the first and most obvious type of income item will be coupon interest on the remic's qualified mortgages. if the qualified mortgages are actual mortgage loans or mortgage-backed pass-through certificates, the remic may also be required to accrue market discount to the extent that it purchased such assets at a price below their adjusted issue price." on the other hand, if the remic holds other remic regular interests, then it is quite possible that the remic will have original issue discount accruals (and possibly market discount accruals as well). because the amount of market discount or original issue discount, if any, will depend in the first instance on the remic's basis in the qualified mortgages, it is necessary consider briefly the applicable basis rules. in general, a remic receives a basis in the assets, including qualified mortgages that are contributed to it on the startup day, equal to the aggregate issue prices of the remic's residual and regular interests.52 this rule is a sensible one, but curious results arise when the residual interest is issued with negative fair market value (i.e., when the sponsor makes an up-front payment to a holder to accept ownership). as described below, the service requires the residual interest to be taken into account as if its fair market value were zero, the result of which is manifestly to overallocate basis to the remic's qualified mortgages.5 3 this has the collateral effect of reducing remic accruals of discount, but it also then reduces the remic's accrual of interest expense too. in short, a certain symmetry should result. apart from interest and discount income on qualified mortgages, a remic will also realize investment income on the reinvestment of proceeds 51. in unusual circumstances a remic may be required to accrue original issue discount on such mortgages, but typically whole mortgage loans will not be issued with original issue discount. 52. regs. § 1.860f-2(c). "issue price" is defined by reference to the definition in the original issue discount regulations. irc § 860g(a)(10); regs. §§ 1.860g-l(d)(l). 1.1273-2. 53. for example, if a remic issues class a and class b regular interests, each with an issue price of $50 and issues a residual interest, class r, for which the sponsor pays the holder $2 to accept ownership, it is clear that the sponsor's net proceeds from this transaction are $98 ($50 + $50 $2). yet, by ignoring the negative issue price of the residual interest, the basis rules will require the remic to take a basis in its assets equal to $100. 19941 florida tax review from its assets pending distribution. 54 similarly, a remic may realize income on qualified reserve fund assets." reserve fund assets may take any form (stock, bonds, deposits, et al.), so long as they are held for investment (i.e., not as part of an active business, such as securities trading) and are in a reasonably required amount. 6 thus, a remic may derive a variety of possible types of income from its qualified reserve fund, but as a practical matter such income is likely to comprise only a minimal part of a remic's total gross income. in addition to the foregoing, a remic is subject to the same rules as other taxpayers. in particular, a remic can realize cancellation of indebtedness income to the extent that it is relieved of liability under its indebtedness (i.e., the regular interests). this can arise when regular interests are written down due to credit losses on qualified mortgages. frequently, however, the remic will have a corresponding write-off with respect to its qualified mortgages, which will thus offset the cod income, but this may not always be the case. 2. calculating remic net income or loss once the gross income of the remic has been identified, the rules for computing remic taxable income or net loss are simply stated: a remic's taxable income must be determined under an accrual method of accounting and, with certain enumerated modifications, in the same manner as for an individual.57 the first such modification is that regular interests in the remic shall be treated as indebtedness of the remic 8 this is one of the important advances made by the remic legislation-to remove the vexing debt vs. equity issue. in this context, the principal effect of this statutory pronouncement is to ensure that relevant payments to regular interest holders constitute interest and thus are deductible in computing remic taxable income or net loss. today, however, having identified an expense item as interest is only half the job; one must then run the gauntlet of restrictions that can apply to the deductibility of interest. in this respect, the regulations set out two 54. a remic is permitted to hold cash flow investments, which are defined in general terms as investments of payments related to qualified mortgages, for a temporary period pending distribution to remic interest holders. regs. § 1.860g-2(g)(1)(i). the return on such investments must be in the nature of interest. id. 55. see regs. § 1.860g-2(g)(2) (defining "qualified reserve fund"). 56. regs. § 1.860g-2(g)(3). 57. irc § 860c(b)(1). 58. irc § 860c(b)(1)(a). an identical rule in § 860b(a) provides that in computing the taxable income of a holder, a remic regular interest is treated as debt. i[vol. 2:4 tax aspects of remic residual interests additional modifications that are relevant. first, they sensibly provide that, contrary to the normal rule applicable to individuals, a remic is allowed an interest expense deduction without regard to the investment interest limitations under section 163(d)." second, they provide that in applying section 265 (denying a deduction for amounts related to tax-exempt income), a remic is treated as a financial institution.60 as a result, if the remic holds assets that produce tax exempt interest, an amount of the remic's interest expense deduction is disallowed based on a ratio of the remic's tax exempt obligations to its total assets. 6' a second modification provided by the statute relates to market discount on a mortgage or other debt obligation held by the remic. generally, a holder of a debt obligation acquired with more than a de minimis amount of market discount must accrue market discount on either a ratable or a constant yield basis, and recognize the accrued market discount as the debt instrument is repaid, or upon its disposition to the extent of any gain.62 alternatively, a holder can elect to recognize market discount currently.63 in case of a reic, however, the choice is fixed: market discount must be accrued on a constant yield basis and recognized as it accrues.6s a third statutory modification is that a remic is not allowed any of the deductions listed in section 703(a)(2).65 section 703(a)(2) sets out certain deductions that are not allowed in the case of partnerships: personal exemptions, foreign or possessions taxes, charitable contributions, net operating loss carryovers or carrybacks, and depletion. none of these prohibited deductions is particularly surprising. denial of a net operating loss carryover or carryback deduction is common to all pass-through entities, since the entity's losses pass through to the investors and are carried over or back by the investors according to their own particular facts. some have questioned the wisdom of disallowing a remic any kind of deduction for foreign or possessions taxes, since those taxes do not otherwise pass through as a credit or deduction for the residual interest holders, and thus are, in effect, lost.6 likely the drafters got carried away in following the partnership rules and simply overlooked this glitch. 59. regs. § 1.860c-2(b)(2). 60. see regs. § 1.860c-2(b)(5). 61. irc § 265(b)(2). for this purpose, however, the special exception in § 265(b)(3), relating to qualified tax-exempt obligations, does not apply. regs. § 1.860c2(b)(5). thus, such obligations are included in the numerator of the ratio described in the text. 62. irc §§ 1276-78. 63. irc § 1278(b). 64. irc § 860c(b)(1)(b). 65. irc § 860c(b)(1)(d). 66. peaslee & nirenberg, supra note 8, at 280 n.26. 19941 florida tax review the last two statutory modifications pertain to transactions that give rise to penalty taxes on the remic. first, in the case of a "prohibited transaction," the remic does not take into account any item of income, gain, loss or deduction in computing its taxable income or net loss.67 instead, a prohibited transaction is, in effect, segregated from other remic activities and placed in a separate basket; all income and deduction items related to the transaction are netted and the resulting net gain, if any, is subject to a 100% tax (any net loss disappears and is not otherwise taken into account). 68 second, the amount of any net income from foreclosure property is reduced by the amount of tax imposed by section 860g(c).69 intended to deter a remic from entering into a business activity via a foreclosure, a single level of tax (currently at 35%) is imposed on the net income from foreclosure property. a full, second level of tax at the residual holder level was not considered appropriate and to prevent this result the residual holder, in effect, gets a deduction (but not a credit) for the taxes paid by the remic. however, if there is a loss from foreclosure property (e.g., the property is sold at a loss), the remic would take that loss into account in computing its taxable income or net loss. 70 the regulations add two other modifications. first, they provide that in computing remic taxable income or net loss, any gain or loss from the sale of any asset of the remic is treated as deriving from the sale or exchange of property that is not a capital asset.7' this implements the instructions in the legislative history of tamra that the irs issue regulations allowing remics to deduct capital losses without limitation.72 second, the regulations provide that any debt owed the remic is not treated as a "nonbusiness debt" under section 166 and thus the remic is allowed an ordinary deduction when the debt becomes wholly or partially worthless.73 this too implements instructions in tamra legislative history to this effect.74 it is interesting to note that the regulations do not implement other instructions in the tamra legislative history. in particular, the legislative 67. irc § 860c(b)(1)(c). 68. irc § 860f(a). this is unlike the treatment of prohibited transactions under the reit rules, which permit net losses from such transactions to be deducted in computing real estate investment trust taxable income. see irc § 857(b)(2)(f); 1986 act bluebook, supra note 29, at 397 n.36, 398-99. it is not clear why the remic prohibited transaction rules, which are otherwise closely modeled on the reit prohibited transaction rules, differ in this respect. 69. irc § 860c(b)(1)(e). 70. this is consistent with the treatment of net losses on foreclosure property in the reit context. regs. § 1.857-3(c). 71. regs. § 1.860c-2(a). 72. s. rep. no. 445, supra note 39, at 88, reprinted in 1988 u.s.c.c.a.n. at 4607. 73. regs. § 1.860c-2(b)(3). 74. s. rep. no. 445, supra note 39, at 88, reprinted in 1988 u.s.c.c.a.n. at 4607. [vol 2:4 tax aspects of remic residual interests history specified that in connection with allowing a remic to treat its bad debts as other than "nonbusiness debt" and to deduct capital losses without limitation, regulations should prevent individuals from using the remic election to circumvent the limitations that would otherwise apply to them with respect to these items.75 perhaps the irs decided it had enough general tax avoidance weapons in its arsenal to attack the truly abusive cases that it declined the offer to issue specific regulations. individual taxpayers, however, can take some comfort that the irs is not likely to challenge a transaction that has as a collateral effect the avoidance of the foregoing limitations, assuming the transaction otherwise has independent economic significance.76 b. taking into account remic taxable income or net loss 1. in general.-once remic taxable income or net loss for a taxable year has been determined, it is taken into account by a remic residual interest holder based on the number of days in the remic taxable year that it held the residual interest.77 the remic is required to allocate its taxable income or net loss after each calendar quarter and to provide notice to each residual interest holder of such holder's share of that income or loss.78 mechanically, the total income or loss for the calendar quarter is allocated ratably to each day of the quarter and the amount allocated to each day is then allocated proportionately among the residual holders. 9 as in the case of a partnership, the residual interest holder takes into account its share of remic income or loss in computing its tax liability, regardless of whether any actual distributions are received. the amount taken 75. id. 76. the legislative history also specified that a remic should not be allowed a dividends received deduction, but this is not reflected in the regulations. s. rep. no. 445, supra note 39, at 88, reprinted in 1988 u.s.c.c.a.n. at 4607. the service, however, may have realized that the legislative history's concern is misplaced. a reic is required to compute its income as if it were an individual and a dividends received deduction is only available for corporate shareholders. see irc § 860a(a) (stating that a remic is not treated as a corporation for federal income tax purposes). 77. irc § 860c(a)(1). 78. regs. § 1.860f-4(e)(l)(i). notice is provided on schedule q of form 1066, which must be delivered to each residual interest holder no later than the last day of the month following the close of the calendar quarter. id. the remic is permitted to use any reasonable counting convention in allocating income or loss, such as 30 days per month, or 90 days per quarter, or 360 days per year. regs. § 1.860c-1(c). 79. irc § 860c(a)(2). the statute thus expressly prohibits any special allocation of income or losses among residual holders, although, even absent this language, a special allocation would likely give rise to an impermissible second class of residual interests. 19941 florida tax review into account is treated as ordinary income (or loss)." when actual distributions are received, they generally are not included in taxable income, but rather reduce the holder's basis in the residual interest.8 however, as in the case of a partnership, if distributions do exceed basis, the excess is treated as gain from the sale or exchange of the residual interest and such gain generally would be capital gain. 2 special rules apply to net losses allocated to a residual interest holder. similar to a partnership, a holder may not take into account its share of net losses for the quarter to the extent that the losses exceed the holder's adjusted basis in its residual interest as of the close of that quarter.83 any loss disallowed because of insufficient basis may be carried forward indefinitely by the holder to succeeding quarters.' as noted above, losses cannot be carried over by the remic and used to offset its income in future periods. any disallowed losses that remain at the time a residual interest is disposed of or retired disappear unused. one problem with the foregoing scheme is the uncertain relationship of distributions on a residual interest to a holder's basis in a residual interest. in particular, distributions can occur at any time during a taxable year, but basis adjustments (based as they are on net income or loss) can be triggered no earlier than the end of calendar quarters. logically, the determination of whether a distribution triggers gain recognition should be suspended pending the end of the calendar during which the distribution, but the answer is not entirely clear. this point is addressed in detail in part iv.b.3, which discusses the holder's basis in a residual interest. 2. character of remic income and losses.-as noted above, the statute provides that a residual interest holder's share of remic taxable income or net loss shall be treated as an item of ordinary income or loss. although that designation is helpful in distinguishing such items from capital gains or losses, for many purposes under the code one must further determine whether an item of ordinary income or loss is of a specific type or not. 80. irc § 860c(e)(1). the loss is taken into account as an ordinary deduction. foreign taxpayers that are not taxable on net income would therefore receive no benefit from this deduction. see regs. §§ 1.871-7(a)(3), 1.881-2(a)(3). 81. irc § 860c(c), (d)(2); regs. § 1.860c-1(b)(2)(i). 82. irc § 860c(c)(2). for a discussion on the status of a residual interest as property, see infra part iv.e.1. gain or loss would not be capital if the residual interest was held by a taxpayer in its capacity as a dealer. for a discussion of special considerations regarding dealers in residual interests, see infra part vi.b.2. 83. see irc § 860c(e)(2)(a). cf. irc § 704(d) (providing that a partner's share of partnership losses are allowed only to the extent of the partner's adjusted basis in the partnership interest). 84. irc § 860c(e)(2)(b). [vol 2:4 tax aspects of remic residual interests for example, a panoply of tax rules may apply based on whether an item of ordinary income is passive investment income such as interest, dividends, etc. in some cases, the code and regulations specifically state how remic residual income should be treated, but in many other instances there is no clear answer. a. remic losses in general.--a remic will incur a number of deductible expenses, principally for interest, and if such deductions exceed gross income the remic will experience a net loss. except in the case of certain "pass-through interest holders," remic deductions do not pass through to the residual interest holders. rather, they are deductible by the remic in computing its taxable income. in this manner, the residual interest holder can, in effect, receive the benefit of a deduction for items that it might not itself be able deduct, such as capital losses or, in the case of noncorporate holders, partial write-offs of bad debts.' however, except in the abusive case where the residual interest holder is using the remic intentionally to avoid these limits, congress apparently did not intend to prevent this result.8 if a remic's deductions exceed its gross income and a net loss thereby arises, this loss generally passes through to residual interest holders as a simple ordinary loss. however, it may be necessary in some instances to obtain greater precision about the nature of the ordinary loss. for example, for purposes of section 469, a residual interest holder's share of a remic's ordinary loss should be treated as an expense clearly and directly allocable to portfolio income producing propertyy similarly, the loss should also be taken into account as an item of "investment expense" in determining net investment income for purposes of section 163(d).8 pass-through interest holders.-notwithstanding the general rule that remic deductions do not pass through, in the case of a so-called "passthrough interest holder" ("ptih'), 89 such holder's share of the amount of 85. see supra text accompanying notes 71-76. 86. id. cf. temp. regs. § 1.67-3(a)(2)(ii)(b)(2)(ii) (concerning a remic that is substantially similar to an investment trust and that is structured for the principal purpose of avoiding the investment expense limits). 87. see temp. regs. § 1.469-2(d)(4). as described below, a holder's share of remic income is treated in the regulations as portfolio income for purposes of the passive loss rules. see infra text accompanying note 103. 88. by referencing the portfolio interest rules, § 163(d)(5)(a)(i) causes a remic residual interest to be treated as property held for investment. 89. a ptih is defined in general as a residual interest holder (or in the case of a single tier remic, a residual or regular interest holder) that is: 19941 florida tax review remic deductions attributable to investment expenses' is broken out and separately reported to him. the ptih then accounts for such investment expenses according to its own facts (i.e., subject to the 2% floor under section 67). in this manner, individuals are prevented from avoiding the 2% floor on miscellaneous itemized deductions through investing in pass-through entities and only reporting their share of the entity's income net of such expenses. mechanically, the ptih is treated as having received income in the amount of his allocable share of investment expenses and as having directly paid such expenses.9' this can have the obvious effect of increasing a holder's share of remic income or reducing its share of the remic's net loss, based on whether the holder is able to deduct such expenses in full. yet, such expenses do not increase or decrease the holder's basis in the residual interest.92 one situation in which the reporting of investment expenses to ptihs is complicated is the so-called double remic structure, in which all of the regular interests of a lower-tier remic are held by an upper-tier remic that issues its regular interests to investors.93 in such arrangements, there will be (1) an individual (other than a nonresident alien whose income with respect to this or her interest in the remic is not effectively connected with the conduct of a trade or business within the united states), (2) a person, including a trust or estate, that computes its taxable income in the same manner as in the case of an individual, or (3) a pass-through entity.., if one or more of its partners, shareholders, beneficiaries, participants, or other interest holders is (i) a pass-through entity or (ii) a person described in paragraph ... (1) or (2) [above]. temp. regs. §§ 1.67-3(a)(2)(i)(a), (ii)(a). a pass-through entity, in turn, is defined as including, in principal part, a trust, partnership, s corporation, common trust fund described in § 584, a nonpublicly offered regulated investment company, and a remic. temp. regs. § 1.67-3(a)(3)(i). 90. investment expenses are defined as expenses paid or accrued by the remic for which a deduction is allowable under § 212 in determining the taxable income of the remic. temp. regs. § 1.67-3(a)(4). typical investment expenses of a remic would include servicing fees, trustee fees, and other administration fees, but they would not include interest expense. of course, it may not always be obvious whether an item of income paid to a servicer is in fact fee income or, alternatively, a retained ownership interest in the remic mortgages (e.g., a stripped coupon). see, e.g., rev. rul. 9146, 1991-2 c.b. 358 (characterizing excess servicing fees as a stripped coupon). 91. temp. regs. § 1.67-3(b)(1). 92. temp. regs. § 1.67-3(b)(5). on the rules applicable to ptihs, see generally ann m. hannaford & james c. engel, final remic regulations on allocation of investment expense: round one, 6 j. bank tax'n 20 (1993). 93. the double remic is frequently used to enable the creation of types of regular interests that could not be created directly in a single remic. see generally peaslee & nirenberg, supra note 8, at 217-20 (providing copious examples of the technique). both remics are typically created in a single document and the two remics are separate purely [vol 2:4 tax aspects of remic residual interests two residual interests (a lower-tier and an upper-tier residual interest) and the question arises as to how to allocate investment expenses between the two residual interests. this is an issue because, except for tax purposes, there is in substance only a single economic entity and a single set of expense items and no easy basis may exist for dividing up such expense items between the upper and lower tier remics.9' the issue is more acute if the upperand lower-tier residuals are held by separate ptihs. absent further guidance, the two remics should be free to divide up the expenses between themselves in any reasonable way. b. remic taxable incone.-remic residual holders take into account their shares of remic taxable income as items of ordinary income. although special rules apply to that portion of remic taxable income that constitutes an excess inclusion (generally limiting the extent to which such excess inclusion income may be offset by deductions), the character of remic taxable income is not otherwise specified by the remic provisions.95 the first question that arises in considering the character of remic taxable income is whether such income should be viewed, in whole or in part, as interest income. clearly a residual interest is not a debt instrument, but one could plausibly argue that since the items of gross income of a remic predominantly, although not necessarily exclusively, consist of interest income, one should "look through" in some sense and treat at least a portion of the taxable income of the remic passed through to the residual interest holders as having the character of interest. yet, there is no authority that supports that characterization, other than in the case of actual remic distributions to foreign holders.96 in fact, the code and regulations seemingly are careful to avoid this characterization. 97 one limited exception to this as a formal matter. the regulations expressly sanction such double remic structures. see supra text accompanying note 34. the prevalence of double remic structures and the fact that they serve little purpose other than to accomplish indirectly what cannot be accomplished directly under the remic rules suggests that the definition of a regular interest in the remic regulations probably should be broadened or revamped to reflect the reality of the marketplace. 94. regs. § 1.860f-2(a)(2)(i) sanctions the creation of tiered remics in a single document and requires that the organizational documents clearly and expressly identify the assets of, and interests in, each remic. it does not require clear identification of each remic's expenses. 95. for a detailed discussion of excess inclusions, see infra part v. 96. see h.r. conf. rep. no. 841, supra note 31, at 11-238, reprinted in 1986 u.s.c.c.a.n. at 4326. for a further discussion, see part vi.a. i. 97. see, e.g., temp. regs. § 1.67-3(b)(4) (providing that investment expenses allocated to a regular, but not residual, interest holder constitute additional interest income): 19941 florida tax review relates to reits holding residual interests, for which income on a residual interest is treated as interest on a "qualifying real property loan" to the extent that the income of the remic would qualify as such.98 absent interest characterization, no other pigeonhole seems even remotely viable, yet that answer complicates the application of certain other provisions of the code, such as the domestic personal holding company ("phc") and foreign personal holding company ("fphci") rules. in applying those rules, phci and fphci income includes dividends, interest, royalties, rents, and other specified types of passive income." a residual interest holder's share of remic taxable income (whether or not such amounts represent excess inclusions) does not fit into any one of the listed items in section 543 or section 553, although it is indeed a strange result that such income is not includible/°° a more practical issue arises with respect to tax exempt organizations that hold residual interests. although excess inclusions are expressly treated as unrelated business taxable income ("ubti"), it is not immediately obvious why nonexcess inclusion amounts are not also treated as ubti.' °' the structure of the ubti rules is to include all gross income from any unrelated trade or business regularly carried on by an institution, exclusive of certain passive types of income, such as interest, dividends, royalties, etc. given the large investment activities of many tax exempt organizations, it is generally important to ensure that income falls within one of the excluded categories of passive income. in this regard, residual interest income is not interest or dividends nor seemingly any other type of income listed in section 513(b). 0 2 yet, the fact that the statute expressly provides that excess inclusions are ubti must mean that they otherwise would not be, although it temp. regs. § 1.469-2(c)(3)(i)(a) (providing that portfolio income includes interest, dividends, and income from a remic). 98. for a detailed discussion of this rule, see infra part vi.c. 99. irc §§ 543(a), 553(a). 100. the answer is less clear with respect to the definition of fphi in § 954(c). a comparison of § 954(c)(l)(b)(i) and (ii) may suggest that a remic residual interest does not give rise to interest, which, as noted, is consistent with the treatment elsewhere in the code. 101. one issue that has been raised is whether such amounts could be treated as debt financed income in light of the fact that the remic is leveraged by virtue of the regular interests. debt financed income treatment is unlikely, and certainly unjustified, for the reasons stated in peaslee & nirenberg, supra note 8, at 284-85 n.47. 102. regs. § 1.512(b)-i(a)(1) provides that, in addition to excluding dividends and interest, ubti does not include "other substantially similar income from ordinary and routine investments to the extent determined by the commissioner." regs. § 1.512(b)i (a)(1). to date, no such determination has been made with respect to nonexcess inclusion income under a residual interest. [vol 2:4 tax aspects of remic residual interests would not be the first time the code made redundant and nonsensical statements. in another context, the regulations expressly provide that income from remics (apparently including income under both regular and residual interests) will be treated as portfolio income (although not as interest) for purposes of the passive loss rules." 3 further, since a residual interest is treated as property held for investment by virtue of the fact that it produces portfolio income,'0 4 gross income from the residual interest is treated as investment income for purposes of section 163(d). thus, income under a residual interest increases the individual taxpayer's allowable interest expense deduction. in something of a perverse twist, the mandate that excess inclusions cannot be offset by other deductions' 05 can be neutralized through the investment interest expense rules. example: investor x at the end of 1994, has net investment income of $400 from certain securities and investment interest expense of $500. investor x also holds a remic residual interest under which x has income for 1994 of $100, all of which is an excess inclusion. investor x has net investment income for 1994 of $500 ($400 + $100) and therefore is allowed to deduct the full $500 of investment interest expense. thus, even though investor has the misfortune of incurring $100 of excess inclusion, which cannot be offset by deductions, this adversity is neutralized by the additional investment interest deduction that investor x enjoys. in light of the recent amendments to section 163(d) to eliminate long term capital gains from investment income, ' 6 one may question the tax policy basis for including income on remic residual interests in investment income for purposes of section 163(d). 3. determining a residual interest holder's basis.-as the foregoing indicates, an important element in determining the tax treatment of the residual interest holder is its basis in the residual interest. in general, basis calculations are similar to those that apply in determining a partner's basis in 103. temp. regs. § 1.469-2(c)(3)(i)(a). in tamra, congress stated its intent that portfolio income treatment would apply. s. rep. no. 445, supra note 39, at 88 n.46. reprinted in 1988 u.s.c.c.a.n. at 4607. 104. irc § 163(d)(5)(a)(i). 105. see infra part v.b.2. 106. see omnibus budget reconciliation act of 1993. pub. l no. 103-66, § 13206(a), 107 stat 463, 463 [hereinafter obra 1993). 19941 florida tax review its partnership interest. however, the basis rules are not necessarily intuitive and can produce curious results. the starting point in understanding the basis rules is to recognize the distinction between the basis of a residual interest issued to a remic sponsor upon formation of the remic and the basis of a residual interest acquired from the sponsor or from a secondary transferee. this distinction is analogous to the distinction between section 722 and section 743 in the partnership context. the regulations ordain that all formations of remics, however effected, will be treated for tax purposes as a contribution of assets to a remic by a "sponsor' '" 7 in exchange for the regular and residual interests in the remic.108 the statute characterizes this contribution transaction as one in which the sponsor does not recognize gain or loss." any gain or loss is recognized when the sponsor sells regular or residual interests, or, in the case of retained interests, such gain or loss is accrued over the weighted average life of the remic." ° the remic, however, takes a basis in the contributed assets equal to fair market value."' the formation, thus, is somewhat analogous to a deferred inter-company transaction within a consolidated group (the transferee takes a fair market value basis; gain/loss recognition is deferred). in the contribution transaction, the sponsor will have an aggregate basis in the regular and residual interests that it is considered to receive equal to aggregate of the adjusted bases of the property it transfers to the remic, increased by the amount of "organizational expenses" incurred."2 this aggregate basis is allocated among regular and residual interests 107. a sponsor is defined as "a person who directly or indirectly exchanges qualified mortgages and related assets for regular and residual interests in a remic." regs. § 1.860f-2(b)(1). 108. regs. § 1.860f-2(a)(1). thus, if the form of the transaction is that the sponsor forms the remic, the remic sells regular/residual interests to investors and forwards the proceeds to the sponsor, the transaction is treated as if the sponsor received back the interests and sold them directly to the investors. 109. irc § 860f(b)(1)(a). 110. see irc § 860f(b)(1)(c) & (d). for a further discussion of accrual of gain or loss on retained residual interests, see infra part iv.d. 111. irc § 860f(b)(2). fair market value for this purpose equals the aggregate of the issue prices of the regular and residual interests. regs. § 1.860f-2(c). the definition of "issue price" is discussed infra note 211. 112. regs. § 1.860f-2(b)(3)(i). this follows the rule for partnerships. see, e.g., rev. rul. 87-111, 1987-2 c.b. 160. organizational expenses are defined in regs. § 1.860f2(b)(3)(ii)(a) as expenses "directly related to the creation of the remic" and include, for example, legal fees related to creation of the remic, accounting fees, and other administrative costs. cf. regs. § 1.709-2(a)(1) (defining organizational expenses for partnership purposes as expenses "incident to the creation of the partnership"). organizational expenses do not include syndication expenses under either definition. [vol 2:4 tax aspects of remic residual interests in proportion to their fair market values on the pricing date (or, if none, the startup day). 1 13 in the case of a secondary transferee of a residual interest, basis is determined under normal concepts and generally should equal cost." 4 although "cost" is typically not a difficult concept to apply in most asset acquisitions, the concept is a hard one in the case of a transfer of property that has negative value, such as a residual interest that requires the seller to make an up-front payment to the buyer. how basis should be calculated in such cases in discussed in greater detail below in part iv.c.2. outside of transfers of residual interests involving up-front payments, determining a holder's cost basis in a residual interest should present few unique issues. one interesting wrinkle regarding a secondary transferee is the fact that the transferee's basis in the acquired residual interest does not give rise to any adjustment in the remic's basis in its assets. unlike a partnership, there is nothing analogous to a section 754 election and section 743(b) basis adjustment. the result is that the secondary residual holder is overor undertaxed to the extent remic assets have increased or decreased in value. in theory, one would think the residual holder should either amortize the "acquisition" premium or accrue "acquisition" discount, but such is not the case under the current scheme. the legislative history recognized the problem: the congress understood that the taxable income allocated to holders of residual interests in a remic who purchased such interests from a prior holder after a significant change in value of the interest, could be substantially accelerated or deferred on account of any premium or discount in the price paid by such purchaser." 5 yet, having recognized the issue, congress opted for the service to craft an appropriate solution in regulations. the regulations contain no special rule and apparently none is contemplated." 6 thus, until and unless a special rule is issued, secondary transferees are stuck with the burden or benefit of this lack of an adjustment to a remic's asset bases. 113. the allocation is made by multiplying the aggregate bases of remic property by a fraction, the numerator of which is the fair market value of an interest and the denominator of which is the aggregate fair market values of all the remic regular and residual interests. 114. see irc § 1012. 115. 1986 act bluebook, supra note 29, at 421 n.81. see also h.r. conf. rep. no. 841, supra note 31, at 11-233 n.15, reprinted in 1986 u.s.c.c.a.n. at 4321 n.15. 116. this issue was not listed in the preamble to the final remic regulations as an issue that is under consideration by the service. see 57 fed. reg. 61,297-98 (1992). 19941 florida tax review once a residual interest holder's basis is established, periodic adjustments are made as in the case of a partnership. first, basis is increased by the daily portions of remic taxable income taken into account by the holder and by the amount of any contribution to the remic described in section 860g(d)(2)." i7 contributions other than those described in section 860g(d)(2) are subject to a 100% penalty tax (i.e., the contribution is paid over to the fisc);" 8 thus, no basis adjustment is appropriate. basis is decreased, in turn, by the amount of cash or the fair market value of property distributed to the holder by the remic with respect to the residual interest, and by the daily portions of remic net losses taken into account by the holder." 9 unlike a partnership, however, the remic rules do not provide for a basis adjustment for the receipt of tax-exempt income by a remic, although the possibility of a remic receiving such income is acknowledged in the regulations, which provide a special rule for the application of section 265.120 this appears to be a conceptual flaw in the basis adjustment scheme.'2 ' similarly, unlike a partnership, the residual holder's basis is not decreased by the amount of nondeductible expenditures, such as interest incurred to purchase or carry tax exempt obligations. once again, this appears flawed. 2 2 the proper approach should be to provide both a positive basis adjustment for tax-exempt income and a negative basis adjustment for nondeductible expenditures. however, since it is unlikely that a remic would derive substantial tax exempt income, these flaws may be largely academic. 117. irc § 860c(d)(1); regs. § 1.860c-1(b)(1). a contribution described in § 860g(d)(2) is one made after the remic startup day that is either (i) to facilitate a clean-up call or qualified liquidation, (ii) a payment in the nature of guarantee, (iii) a contribution made within three months of the startup date, (iv) any contribution to a qualified reserve fund, or (v) any other contribution permitted in the remic regulations. 118. irc § 860g(d)(1). 119. irc § 860c(d)(2); regs. § 1.860c-1(b)(2). 120. see regs. § 1.860c-2(b)(5). 121. for example, if a remic held a single asset which generated $1,000 of taxexempt income (for simplicity, assume the remic has a basis of $0 in the asset prior to receipt of the income) and incurred $500 of interest expense with respect to its regular interest holders, the remic would not be entitled to a deduction for the $500 interest expense under section 265 and the residual holders would not receive a basis adjustment for such income. thus, a subsequent sale of the residual interest for $500 would trigger gain and effectively result in taxation of $500 of tax-exempt income. see also infra note 122. 122. for example, if a remic held a single asset which generated $500 of taxexempt income (once again, with a basis of $0) and incurred $1,000 of interest expense with respect to its regular interest holders, the remic would not be entitled to a deduction for the $1,000 interest expense and the residual holder would not experience a negative basis adjustment for such expenditure. thus, a subsequent sale of the residual interest at a loss of $500 would trigger a loss and effectively result in a $500 deduction of disallowed interest expense. [vol. 2:4 tax aspects of remic residual interests a far more practical problem exists with respect to the relationship between the basis adjustment system and distributions on residual interests. as noted above, a distribution on a residual interest in excess of a holder's adjusted basis therein is treated as gain from the sale or exchange of such interest. however, while distributions may occur at any time, with one exception, basis adjustments occur no more frequently than the end of calendar quarters. 23 the one exception to this, which seemingly proves the rule, is that if a holder disposes of a residual interest, appropriate basis adjustments are deemed to occur immediately before the disposition."4 conversely, absent a disposition, basis adjustments prior to the end of a quarter are apparently not authorized. this situation gives rise to some uncertainty about the correct relationship between basis adjustments and distributions, as the following example illustrates. a remic has net income or loss for the calendar quarters of a taxable year of -$1,000, $1,500, $500, -$1,000, respectively."z its net taxable income for the year thus is $0. at the beginning of the taxable year, the sole residual interest holder has an adjusted basis in such interest of $1,000. on may 15 (the middle of the second calendar quarter), the remic makes a distribution (the first distribution of the taxable year) to the residual interest holder of $1,000. several possible ways to account for the distribution exist: 1. taxable year look-back. the distribution could be considered to result in gain at the time of the distribution to the extent it exceeds a holder's adjusted basis as of the beginning of the taxable year. under this approach, the holder realizes no gain on the distribution since it exactly equals his adjusted basis of $1,000 at the beginning of the taxable year. 123. section 860c(d) merely provides that basis is increased or decreased by the amount of income or loss taken into account under § 860c(a). the amount of income or loss taken into account under § 860c(a) in turn equals the sum of a holder's daily portions for the taxable year, determined by allocating quarterly income or loss among the days of each quarter. it is not entirely clear when such income or loss is considered to be taken into account for purposes of basis adjustments. arguably, these items could be considered taken into account only at the end of a taxable year when a holder's total share of remic net income or loss under § 860c(a) can be determined. alternatively, and more likely, they could be considered taken into account at the end of each calendar quarter, the smallest accounting unit of the remic. 124. regs. § 1.860c-1(b)(3). 125. for purposes of this simple example, no excess inclusion amounts are assumed. 1994] florida tax review 2. calendar quarter look-back. the distribution could be considered to result in gain at the time of distribution to the extent it exceeds the holder's adjusted basis as of the beginning of the last calendar quarter. under this approach, the holder's basis of $1,000 is reduced to $0 at the end of the first calendar quarter by the remic's $1,000 loss for that quarter. thus, the holder would recognize gain of $1,000 upon receipt of the distribution on may 15. 3. pro rata. the distribution could be considered to result in gain at the time of distribution to the extent it exceeds the holder's adjusted basis as of may 15. under this approach, the holder's basis of $1,000 is reduced to $0 at the end of the first calendar quarter by the remic's $1,000, but it is then increased by $750, the pro rata share of the second quarter net income of $1,500 (45 days/90 days x $1,500). thus, the holder would recognize gain of $250 upon receipt of the distribution on may 15. 4. calendar quarter delay. determination of the tax treatment of the distribution could be deferred until the end of the calendar quarter in which it occurs and then tested by reference to the holder's adjusted basis at such quarter end. under this approach, the holder's adjusted basis of $1,000 at the beginning of the year is decreased to $0 by the first quarter loss and then increased to $1,500 by the second quarter net income. the distribution of $1,000 is then measured against this $1,500 adjusted basis and thus would be nontaxable to the holder. 5. taxable year delay. determination of the tax treatment of the distribution could be deferred until the end of the taxable year in which it occurs and then tested by reference to the holder's adjusted basis at such year end. under this approach, the holder's adjusted basis of $1,000 at the beginning of the year remains unchanged since the remic's net income for the taxable year is $0. the distribution of $1,000 is then measured against this $1,000 adjusted basis and thus would be nontaxable to the holder. although perhaps a hyper-technical reading of the statute and regulations could support alternative 1 or 2, those approaches are hard to defend since they can yield patently arbitrary and potentially ridiculous results. the [vol 2:4 tax aspects of remic residual interests prospectivity approach of alternatives 4 and 5 is reasonable, both from the standpoint of equity and administrability, but precedent in other areas of the code suggests that a clear statutory or regulatory mandate may be necessary to achieve this result.'26 having had to resolve this solomonic puzzle in actual practice, the author chose to follow alternative 3. the reasoning was that this reading was not necessarily inconsistent with the statutory language and was a fair attempt to bridge the gaps in the statutory scheme.' the foregoing basis calculus should raise few eyebrows; those versed in partnership taxation are well accustomed to this type of articulation. one interesting footnote to the discussion concerns the basis of residual interests that have a negative fair market value-i.e., the sponsor has to make a payment to someone to induce them to accept ownership of it. the issue of negative basis is related to the treatment generally of up-front or inducement payments and is addressed in that context in the next section. 126. for example, a similar issue arises with respect to distributions from partnerships. see irc § 731(a)(1). however, by regulation the service has effectively provided that the determination of whether a distribution exceeds basis is to be made at year-end. regs. §§ 1.705-1(a)(1), 1.731-1(a)(1)(ii). this year-end rule was created to avoid the administrative burdens of computing basis at the time of every distribution. see g.c.m. 36919 (nov. 12, 1976). this concern arose from the language of the § 73 1(a)(1) which, unlike § 860c(c)(2). states that gain is triggered to the extent that a distribution of cash exceeds adjusted basis "immediately before the distribution." irc § 73 l(a)(l). an express regulatory scheme similar to that in subchapter k applies in the case of distributions from a subchapter s corporation. see regs. §§ 1.1367-1(d), 1.1368-1(e)(1), -3 ex. 1. an additional analogy can be found regarding the determination of whether distributions from a subchapter c corporation are considered a dividend of earnings and profits or a return of capital. however, in this context. the statute expressly provides a timing rule. irc § 316(a)(2) (providing that earnings and profits are to be computed as of the end of the taxable year). in sum, it is interesting to note that when congress and the service have recognized the problem, a calendar year delay approach is adopted to resolve it. such a rule would seem appropriate under § 860c(c)(2) as well, but in the absence of an explicit rule, it would take a bold leap of faith to follow that approach. 127. it is true that the regulations state that the pro rata method must be used in the event of a disposition of a residual interest, suggesting perhaps that it is not otherwise authorized. however, in determining whether a distribution produces gain, one is in effect measuring whether there has been a disposition of the residual interest and, if so. what the amount of gain realized is. thus, one might argue that it is perfectly consistent to use the pro rata method in determining the treatment of distributions. also, it is not clear that the legislative history and the regulations meant that the pro rata approach should apply only in the case of actual dispositions; they do not necessarily preclude its use where reasonable in other contexts. 19941 florida tax review c. treatment of up-front payments as previously described, a residual interest may entitle the holder to minimal or zero cash distributions from the remic-i.e., all of the remic's cash flow is dedicated to the regular interests. yet, the residual interest holder still will be taxable on "phantom" income of the remic. although phantom income should ultimately be offset by phantom losses, which may provide tax benefits for the holder, a net liability arises from the timing difference; phantom income today, but no offsetting deduction for phantom losses until tomorrow. 28 as a result, by its terms the residual interest may not have any net economic value and in fact may represent a net liability for the holder. no one would willingly acquire a security that amounts to no more than a net liability. thus, the sponsor must make a payment to a holder in connection with the transfer in order the make the transaction profitable for the holder. the calculation of the amount of the up-front payment can be a complex affair, although the basic pricing elements can be described in general terms. 2 9 the foundation for pricing a noneconomic residual interest is a model or projection, based on an assumption about prepayment rates (among other variables), of the remic's taxable income and net losses, given the issue prices of the regular interests. based on that model, it is possible to project the associated tax liabilities and tax losses in holding the residual interest. in theory, the excess of the present value of future tax liabilities over the present value of expected tax benefits' 30 should represent the amount of an up-front payment that purchaser could accept. the discount rate used in computing the present values would reflect a risk premium to cover uncertainties. the following example illustrates the pricing calculation using simplified numbers. the table assumes a residual interest that entitles the holder to zero cash distributions, produces phantom income (excess inclusions) and losses as set out below and has anticipated life of nine years. 128. in general terms, phantom income or loss means income or losses that a taxpayer must recognize for tax purpose without any associated cash receipt or outlay. a number of causes can give rise to phantom income or loss, but the principle one at issue in the case of remic residual interest arises as a result of so-called "tranching." for a discussion of phantom income, see infra part v.a. 129. in reality, the market for noneconomic residual interests is not an entirely perfect one. in the case of publicly underwritten remics, the underwriter-sponsor may put a noneconomic residual up for bid and place it with the lowest bidder. sophisticated purchasers will do their own modelling and formulate their own bid. other purchasers may rely on the sponsor's modelling and make a bid based on that. 130. the calculus would also factor in an assumption regarding the tax liability of the purchaser on the up-front payment. [vol 2:4 tax aspects of remic residual interests up-front payment calculation year residual interest tax (liability) incomel(loss) /benefit 1 $100.00 $(35.00) 2 75.00 (26.25) 3 50.00 (17.50) 4 25.00 (8.75) 5 0 0 6 (25.00) 8.75 7 (50.00) 17.50 8 (75.00) 26.25 9 (100.00) 35.00 total 0 0 1. present value* of tax liabilities $78.01 2. present value* of tax benefits 54.99 3. difference in present values 23.01 */ assuming a discount rate of 6%. based on the assumed discount rates, the prospective purchaser of the residual interest in this example requires an up-front payment of at least $23.01.' since neither projected tax liabilities nor the value of the tax losses is certain (e.g., the losses may not be fully usable at the time they arise), the purchaser would also require some premium to cover these risks. for example, the purchaser might choose to discount future tax benefits by a higher figure (e.g., 10%) than is used to discount future tax liabilities. although the purpose and pricing of an up-front payment is readily grasped, the appropriate tax treatment of an up-front payment remains elusive. the irs has indicated that it is studying this issue and may issue regulations in the future. 32 in general, only three broad options are available: immediate recognition of the full payment, delayed recognition (amortization), or some form of adjustment to the basis of the residual interest. in weighing these alternatives, refinement of what constitutes an "up-front payment" is also necessary. these points are addressed below. 131. this assumes that the purchaser would be able to shelter the s23.01 with losses. if the payment would instead attract tax liability, to that extent the purchaser would seek a gross-up. for example, assuming the payment were taxable in full in year i at a marginal rate of 35%, the purchaser would seek to have the payment grossed up to s35ao. 132. 57 fed. reg. 61,298 (1992). 19941 florida tax review 1. existence, timing and manner of income recognition. 133when a sponsor makes an up-front payment to a holder to accept ownership of a remic residual interest, the sponsor is in essence making the holder whole for its agreement to assume the tax liabilities associated with ownership of the residual interest. from the holder's perspective, the up-front payment is simply part of its overall return on the residual interest. in determining the tax treatment of up-front payments, the threshold issue is whether such payments are income at all. if they are, the follow-up question is when should the transferee recognize such income-in full at the time of receipt or spread over some period of time? a. receipt of income ?.-it may seem curious to even raise an issue whether an up-front payment constitutes income; the bald receipt of cash would seem to be the epitome of income, absent an offsetting liability to repay the cash (such as in a loan transaction)."3 yet, it is not entirely clear that an up-front payment should be considered income. the transfer of a residual interest accompanied by an up-front payment could be viewed as simply the purchase of property by the transferee and any cash it receives would be merely an adjustment to the purchase price, which should be reflected solely in the basis of the acquired property. 35 in short, the transferee is acquiring property in exchange for consideration and such a purchase transaction should not be the occasion for income recognition to the buyer.'36 133. for a discussion of character issues relating to up-front payments, see infra part iv.e.2.a. 134. see infra note 143. 135. in essence, the transferee has bought property subject to a liability. just as a buyer increases basis in purchased assets by the amount it pays to satisfy liabilities it assumes in the purchase transaction (see, e.g., david r. webb co., inc. v. commissioner, 77 t.c. 1134, 1137 (1981), aff'd, 708 f.2d 1254 (7th cir. 1983)), so too the buyer should decrease its basis in purchased assets by the net amount it receives in such a transaction as consideration for assuming such liabilities. as one commentator has noted, "it is counter-intuitive to suggest that the buyer has income in a purchase transaction." kevin m. keyes, the treatment of liabilities in taxable asset acquisitions, 50 inst. on fed. tax'n §§ 21.02, 21.04[2][iii] (1992). the problems with viewing the acquisition of a residual interest as an acquisition of property subject to a liability are discussed below in part iv.c.2.a. 136. an up-front payment made to the transferee of a residual interest has some similarities to the assumption by a buyer of assets of contingent liabilities of the seller. in any such asset sale, one can bifurcate the transaction and view some portion of the property transferred to the buyer as an up-front payment for the buyer's agreement to assume the liabilities. cf. michael l. schler, sales of assets after tax reform: section 1060, section 338(h)(10), and more, 43 tax l. rev. 605, 672-73 (1988) (making a similar point). however, the state of the law on the assumption of contingent liabilities is itself confused and chaotic, and provides no firm star to steer by. see generally alfred d. youngwood, the tax treatment of contingent liabilities in taxable asset acquisitions, 44 tax law. 765 (1991) (describing [vol 2:4 tax aspects of remic residual interests an instructive example of this analysis is the case of commissioner v. oxford paper co.,137 in which a lessee in ailing financial condition assigned its lease to the taxpayer. the taxpayer assumed the lessee's rent obligations under the lease. as consideration for this assumption, the lessee paid the taxpayer $100,000 in cash, some stock, and a plant worth $350,000. the court held that the transaction was in reality a purchase of property by the taxpayer (the plant and the stock) in exchange for the taxpayer's agreement to assume the lessee's liabilities. neither the cash nor any of the property received was includible in the taxpayer's income, but rather the court held that the taxpayer should take a cost basis in the property received equal to the value of liabilities assumed less the cash received." this approach was also taken in revenue ruling 55-675,"39 in which the service clarified that cost should not include assumed liabilities that are so contingent and indefinite in nature that they are not susceptible to present valuation. the analogy to oxford paper and revenue ruling 55-675, however, is not a perfect one. in those cases, the taxpayer acquired items of property in addition to receiving a payment of cash, and separate from such items were certain liabilities of the seller that the buyer agreed to assume. the case is different with respect to residual interests. while it probably requires no great leap of faith to conclude that the residual interest is property,"o there are no direct liabilities of the transferor that the transferee is assuming as the cost of the residual interest. rather, the liabilities at issue are tax liabilities of the transferee that arise after the sale as a result of phantom income that is generated by the residual interest after the sale. in short, it is as if the transaction in oxford paper consisted simply of the lessee giving the plant plus the cash to the taxpayer, and by virtue of being the owner of the plant, the taxpayer thereby became subject to future tax assessments that exceed the value of the plant. one can still argue that such a transaction is an asset acquisition and the up-front payment is not income to the purchaser, but admittedly that is a different transaction than that at issue in oxford paper the relevant authorities and addressing the tax issues involved); new york state bar ass'n, comm. on alternative minimum tax, report on the federal income tax treatment of contingent liabilities in taxable asset acquisition transactions, 49 tax notes 883 (nov. 19. 1990) (same). 137. 194 f.2d 190 (2d cir. 1952). 138. a fuller discussion of oxford paper and related authorities can be found in william b. landis, liabilities and purchase price, 27 tax law. 67, 72-74 (1973). 139. 1955-2 c.b. 567. 140. for a discussion of the status of residual interest as property, see infra part iv.e.1. 19941 florida tax review and revenue ruling 55-675.4' how a basis adjustment approach like that in oxford paper could apply is considered further in part iv.c.2.c., below. in sum, an up-front payment could be viewed as an adjustment to basis rather than as income. although such an approach would be consistent with the economic reality of transactions involving such residual interests and would produce reasonable tax results, as discussed below in part iv.c.i.c. such an approach could give rise to manipulation and allow taxpayers some measure of electivity regarding the tax treatment of up-front payments. however, before considering these points further, the alternative treatment of an up-front payment as an item of income must be considered. b. treatment of up-front payments as income.-under normal realization principles, the receipt of a lump sum of cash in a closed transaction, over which the recipient has full dominion and control, would be income to the recipient.'42 if that view is accepted, then the issue of timing arises-should the up-front payment be recognized in full in the year received or should recognition occur periodically over some longer period? under normal realization principles, one would expect the receipt of a lump sum of cash to be subject to immediate inclusion in gross income. immediate recognition is also supported by the prepaid income for services cases, which require that the taxpayer include such amounts in income unless they are clearly related to services that are required to be provided in the future according to a fixed schedule. 3 although the noneconomic residual 141. support for an adjustment to basis approach, however, may also be found in authorities involving short sales, which may present a closer analogy. in i.t. 3721, 1945 c.b. 164, supplemented by i.t. 3858, 1947-2 c.b. 71, modified by rev. rul. 57-29, 1957-1 c.b. 519, an example is provided in which a taxpayer assigns an out-of-the money, when issued, sell contract to a third party and makes a payment to the third party as consideration for the latter's assumption of the liabilities thereunder. the service held that the third party did not recognize income on the receipt of the assignment payment; rather this amount was to be taken into account in determining the gain or loss by the third party on closing out the contract. i.t. 3721, 1945 c.b. 164, 172. 142. commissioner v. glenshaw glass co., 348 u.s. 426, 431 (1955); north american oil consolidated v. burnet, 286 u.s. 417, 424 (1932). but query whether the transferee really has enjoyed an accession to wealth. even if the transferee has not, strictly speaking, acquired property subject to liabilities, still it can be questioned whether the transferee has truly experienced a net accretion to net worth equal to the full amount of the up-front payment. see new york state bar ass'n, comm. on alternative minimum tax, supra note 136, at 897-98. 143. in three famous cases, the supreme court addressed whether prepayments for services were immediately includible in income by accrual method taxpayers. schlude v. commissioner, 372 u.s. 128 (1963) (involving prepaid dance lessons); american auto. ass'n v. united states, 367 u.s. 687 (1961) (involving advance payments of annual dues); automobile club of mich. v. commissioner, 353 u.s. 180 (1957) (same); see generally laurie mvl 2:4 tax aspects of remic residual interests holder is certain that it will have to perform the service of paying the remic's tax liability each year, the precise services and the time for providing them (i.e., the amount of the remic's tax liability and the years in which such a liability will exist) are uncertain and contingent. thus, seemingly the schlude line of cases also calls for immediate inclusion. on the other hand, in contrast with normal realization principles, is the rule applicable to notional principal contracts. notional principal contracts provide a close analogy to residual interests in certain respects. '" in particular, an up-front payment on a remic residual interest, from the recipient's perspective, is not unlike an assignment of an "out-of-the-money" swap position, in connection with which the assigning swap party makes an upfront payment to the assignee. in the case of a swap, the recently promulgated regulations require the assignee-third party to amortize into income the "upfront" payment it receives over the remaining term of the swap. 4 s although this swap rule presents a potentially helpful analogy, unfortunately the rule is sui generis; the principles of the swap regulations are bereft of supporting rationale and seemingly sprang, figuratively speaking, from zeus' head in full armor. it is difficult therefore to extend them to other similar situations.14 some authority independent of the notional principal regulations may also suggest that amortization is appropriate. for example, in a 1988 private letter ruling, 47 the service considered the case of a taxpayer (the lessee) that sold certain facilities to an unrelated corporation (the lessor) and then leased them back in the form of an arrangement that qualified as a safe harbor lease. under the arrangement, the lessor gave installment notes to the lessee for the purchase of the facilities, the lessee held a purchase option at l. malman, treatment of prepaid income--clear reflection of income or muddied waters, 37 tax l. rev. 103 (1981) (reviewing the case law). in those eases, the court held that prepaid income could not be deferred, reasoning in part that it was not certain that the services for which the payments were made would ever be performed or, if they were performed, whether they would be performed in the period to which income would be deferred. subsequent to schlude, cases have allowed deferral where there is relative certainty as to performance and the timing of the services. see artnell co. v. commissioner, 400 f.2d 981 (7th cir. 1968); see also boise cascade corp. v. united states, 530 f.2d 1367 (ct. cl.), cert. denied, 429 u.s. 867 (1976); collegiate cap & gown v. commissioner. 37 t.c. memo (cch) 960, t.c. memo (p-h) 78,226 (1978). 144. the new york bar association recommends that up-front payments be amortized based on the analogy to notional principal contracts. new york state bar ass'n tax section, comm. on pass-through entities, report on the proposed real estate mortgage investment conduit regulations, 92 tnt 100-58 (mar. 19, 1992) (lexis, fedtax library, tnt file) [hereinafter report on proposed remic regulations]. 145. regs. § 1.446-3(h)(3), (5) ex. 2(c). 146. see also bruce kayle, the taxpayer's intentional attempt to accelerate taxable income, 46 tax law. 89, 109 (1992) (making this point). 147. priv. let. rul. 8807065 (nov. 24, 1987). 19941 florida tax review lease end for a nominal sum, and the lessee was obligated to pay the lessor rent amounts. subsequently, the lessee sold all of its interest in the facilities and the lessor's installment notes to a third party (the assignee). the assignee paid the lessee a sum of money for the items it received, but the sum was less than the remaining balance of the installment notes. the service ruled that the difference between the balance of the installment notes and the payment from the assignee was in reality a payment to the assignee from the lessor in consideration for assuming the lessee's lease obligations (principally, the payment of rent). the service held that the payment to the assignee for the assumption of the lessee's obligations should be includible in the assignee's income ratably over the remaining term of the lease-"in effect, as an offset to [the assignee's] future rental deductions," according to the service. like the notional principal regulations, private letter ruling 8807065 contains no supporting rationale nor does it cite any authority for its conclusion. beyond the foregoing situations, little other direct authority exists on the treatment of receipt of up-front payments. falling back on more distant analogies, one line of authorities that may superficially seem relevant relates to payments to purchasers of newspapers or magazines in consideration of their assumption of the business' prepaid subscription liabilities. in this situation, the service has required the purchaser to include the payment in income,'48 but has not expressly addressed the timing of the inclusion in income. rather, the irs has indicated simply that it is subject to the taxpayer's normal accounting method and the requirement that it clearly reflect income under section 446. thus, these authorities do little to advance the analysis. a second analogy concerns so-called "structured settlements" and other settlement funds-arrangements under which a person makes lump sum payment to an assignee in consideration of the latter assuming the former's liabilities with respect to a plaintiff (e.g., tort damages). if an assignment of the liability qualifies under section 130, the assignee need not include the payment in gross income,' 49 whereas, according to the legislative history, if the assignment does not so qualify then the full payment would be included 148. rev. rul. 71-450, 1971-2 c.b. 78; priv. let. rul. 8749076 (sept. 11, 1987); priv. let. rul. 8612050 (dec. 23, 1985); cf. james m. pierce corp. v. commissioner, 326 f.2d 67 (8th cir. 1964) (dealing with tax treatment of assignor/seller). see generally alan s. lederman, special tax benefits of magazine publishing enhance its usefulness as a tax shelter, 55 j. tax'n 26, 28-29 (1981) (discussing the treatment of the assignee/buyer on receipt of payment to assume subscription liabilities). 149. irc § 130(a). [vol 2:4 tax aspects of remic residual interests in gross income. 50 the legislative history stops short of specifically addressing the timing of the inclusion, although it appears to have envisioned that the payment would be includible in full in the year the assignment is made. in sum, the law authorizing or requiring amortization, such as it is, is murky. amortization authorities, such as private letter ruling 8807065 and the notional principal contract regulations, at best represent what the law could be (and perhaps should be), and indicate that the service can, when it wants to, authorize amortization under its general authority to require that an accounting method clearly reflect income. however, amortization of up-front payments for remic residual interests cannot be said to be required under current law. if one concludes that an up-front payment is income, then until and unless the service issues further guidance normal realization principles should be determinative, and under such principles the up-front payment should be included in gross income in full in the taxable year it is received or accrued under the taxpayer's accounting method. c. tax policy issues.-since, however, the service is currently considering addressing the tax treatment of up-front payments, it is appropriate to step back and ask what should the law be? what position should the service take on this point? in general, it must be acknowledged that the issue is not an easy one, but several tax policy issues, of varying significance, can be identified. marketplace distortion.-one policy consideration that might be advanced in favor of either not treating an up-front payment as income or requiring amortization is that such treatment is necessary in order to prevent market distortions. if up-front payments are taxable in full immediately, normal economic forces will push noneconomic residual interests into the hands of those who would pay the least: holders with net operating losses. taxable holders would have to factor in associated federal income taxes in negotiating the up-front fee, whereas "tax-exempt" holders (those with nols) would not. thus, a tax driven distortion in the marketplace would be created. however, this distortion, if one chooses to label it as such, has nothing peculiar to do with residual interests, but relates to allowance of a deduction for losses. loss taxpayers will always place a higher, after tax value on current income than nonloss taxpayers; this loss "distortion" already pervades the marketplace generally and there is no reason to single out remic residual interests as the beachhead for battling this perceived problem.' 5' 150. h.r. rep. no. 426, 99th cong., 1st sess. 659 (1985) ("[tihe full amount of the consideration received is included in gross income."). 151. moreover, it is unclear whether amortization solves the perceived distortion in any event. even under an amortization regime, loss taxpayers presumably would still value a 19941 florida tax review perhaps a more fundamental objection to the validity of this policy is one's uneasiness with the notion of the service through regulations attempting to redress perceived market distortions. the regulatory process is a blunt instrument indeed, and the service is neither well qualified to nor efficient in using the tax system to fine-tune market forces. instead, the service should identify and implement other, more appropriate tax policy goals at issue and let the chips fall where they may in the marketplace. conflict with loss limitation policies.-one tax policy issue that requires careful consideration is whether immediate recognition of an up-front payment is appropriate where noneconomic residual interests are acquired by taxpayers with expiring losses, including losses that are about "expire" as a result of a pending section 382 ownership change. these taxpayers could acquire residual interests and use the up-front payment to soak up losses that might not otherwise be usable.152 it would seem that this policy issue ultimately turns on the resolution of the fundamental question of whether the up-front payment is properly viewed as income attributable to the current period or income that relates to future periods. if it is concluded that the income is properly attributable to future periods, then indeed it would transgress the policy of section 382 and section 172 to permit the taxpayer to accelerate that income into the current taxable year. 53 if, however, the residual interest differently than nonloss taxpayers-i.e., the premium placed on such an investment by loss taxpayers would be reduced, but not necessarily eliminated. only by treating the up-front payment as a nonincome item would the perceived distortion be neutralized. 152. an analogous issue concerns the status under § 382 of a loss recognized by a transferor as a result of making an up-front payment incident to the transfer of a residual interest. if the residual interest was held by the transferor prior to a § 382 ownership change and later sold within five years after the ownership change, is the loss a built-in loss? similarly, if the transferor retains the residual interest, are future remic losses realized within the five year period built-in losses? the former probably should be. the answer is less clear in the latter case. cf. lewis r. steinberg, selected issues in the taxation of swaps, structured finance and other financial products, 1 fla. tax rev. 263, 293-96 (1993) (addressing similar § 382 questions with respect to out-of-the-money swaps). 153. an alternative analysis of an up-front payment would be to view it as a loan to the buyer of the residual interest coupled with an agreement of the buyer to repay the loan by paying the tax liability associated with the residual interest. cf. regs. § 1.446-3(g)(4), (6) ex. 3 (recasting a swap with significant nonperiodic payments as a swap plus a loan); mapco, inc. v. united states, 556 f.2d 1107 (ct.ci. 1977) (recasting purported sale of future pipeline revenue in exchange for $4 million as a nonrecourse loan); hydrometals, inc. v. commissioner, 31 t.c. memo (cch) 1260, t.c. memo (p-h) 72,254 (1972) (recasting purported sale of future manufacturing income for $2.3 million as a loan), aff'd, 485 f.2d 1236 (5th cir. 1973), cert. denied, 416 u.s. 938 (1974). but cf. estate of stranahan v. commissioner, 472 f.2d 867 (6th cir. 1973) (upholding sale treatment of future dividend payment virtually certain to be made). see generally kayle, supra note 146, at 105-08; jeffrey p. cantrell, et al, notice 89-21 crashes the interest rate swap party, 45 tax notes 337, 338-40 (oct. 16, 1989). however, the authorities adopting the loan analysis all involve a relatively fixed stream of [vol. 2:4 tax aspects of remic residual interests up-front payment is not viewed as necessarily relating to future periods, then neither section 382 nor section 172 would independently dictate amortization. taxpayers are largely free to acquire current income when and as they please without violating any policy of section 172 or section 382. does the up-front payment relate to future periods? indeed it does. the up-front payment is meant to compensate the holder, on a present value basis, for the fact that future burdens associated with ownership will exceed future benefits. in this respect, the up-front payment certainly does represent an acceleration of income. the concern this raises can be more clearly seen if the acquiror of a target corporation with nols that will be subject to section 382 after the acquisition transfers residual interests it owns to the target in contemplation of the acquisition and makes up-front payments to the target. effectively, the acquiror can sop up target nols. accordingly, one must be troubled by the existence of loss limitations and the ability of taxpayers to manipulate or avoid those limitations by entering into income acceleration transactions-such as, arguably, the acquisition of an up-front payment residual interest. however, as described below, requiring amortization of the up-front payment or adopting an adjustment to basis approach raises other, potentially equally troubling tax policy issues. administrability and taxpayer electivii..-one problem with requiring amortization of up-front payments or with adopting an adjustment to basis approach, which in the end may doom such approaches, is simply the difficulty of defining what is an "up-front payment" for purposes of such a rule. in structuring a remic residual interest, the sponsor may have significant flexibility as to whether an up-front payment is used. for example, instead of a sponsor making an up-front payment to a holder to accept ownership, it can simply assign a principal balance to the residual interest. the holder would then pay little or nothing for the residual interest and look to the economics of the residual interest by its terms to furnish the compensation. in the most extreme case, the sponsor could simply divert the up-front payment that it would have made to the holder to the remic and have the reic pay the funds out within the first three months." in less extreme future income that is reduced to its present value by, in effect, borrowing against it. no such fixed stream of future income exists with respect to the buyer of the residual interest. (moreover, the stream of future liabilities associated with a residual interest is contingent, not fixed.) it would therefore seem to be something of a stretch to apply the disguised loan cases to the transfer of a residual interest. 154. in general, a remic is allowed to hold assets other than qualified mortgages and permitted assets for an initial period ending at the close of the third month beginning after the startup day. irc § 860d(a)(4). thus, so long as the cash representing the up-front payment is distributed by the remic during this period, remic qualification is unaffected, although the remic would be subject to prohibited transaction taxes on any earnings on the payment prior to distribution. irc § 860f(a)(2)(b). 1994] florida tax review cases, the sponsor could structure the remic so that the residual interest principal was paid down from cash flow on the mortgages over a longer period of time, such as six months or a year. returning to the example above, the sponsor could make an up front payment of $23.01 to the holder, or choose among any number of alternatives that are identical in present value terms. for example, instead of issuing the residual interest with zero principal and interest entitlement, the sponsor could issue the residual interest with a principal balance of $23.01 and an interest rate of 6% (the discount rate assumed in the above example). the remic would be structured to pay down the principal balance within some brief period of time-for example, six months. the sponsor would not make an upfront payment to the holder and the holder would pay $0 for the residual interest, thus taking a basis of $0 in the residual interest. the net result is that when distributions of $23.01 (with interest) are made, they will be fully includible in income unless, of course, the payment is characterized as an upfront payment and a special amortization or basis adjustment rule is appropriate.'55 a special rule that requires amortization or basis adjustments will thus create competing regimes for taxing residual interests based on the formal distinction between how compensating payments to the holder are made. such a rule would effectively grant taxpayers the option to select the most appropriate tax regime and structure the residual interest accordingly. that situation obviously would be unacceptable to the service and suggests that perhaps the best course of action may be simply to retain the default rule of having up-front payments taxable immediately in full. of course, an alternative possibility is to attempt to craft a substantive definition of an up-front payment that is not bound purely by the form and thus easily manipulable. yet, it is not clear what the substance of an up-front payment is and how it could be defined with precision. distinguishing between "distributions" and "up-front payments" would involve a subtle and complex line drawing exercise, one that would surely produce arbitrary results. however, to pursue the analysis further, perhaps one could craft a set of rules similar to the disguised sale rules for partnerships'56 and provide that if, under a given prepayment assumption, a residual interest holder will receive substantially all (defined perhaps as a specified percentage) of the cash it is entitled to receive within some initial period after the issue date 155. distributions in excess of basis (here, $0) are includible in income as gain from the sale of the residual interest. however, depending on when the distributions are made, basis likely will be above $0 on account of remic taxable income that will have accrued. also, the interrelationship of basis adjustments and distributions would affect the answer. see discussion supra part iv.b.3. 156. irc § 707(a)(2)(b). [vol 2:4 tax aspects of remic residual interests (e.g., by the end of the taxable year), then the anticipated distributions will be treated not as distributions, but as up-front payments.'" 2. up-front payments and basis.-resolving the proper treatment of an up-front payment will also affect the calculation of a holder's basis in a residual interest. as noted above, under general tax principles the basis of a holder (other than the remic sponsor) in a residual interest should equal "cost," although applying that concept to negative value property, such as an up-front payment residual interest, can be confusing. a. what is cost?-at first blush, one may conclude that the transferee of a residual interest accompanied by an up-front payment has no positive cost investment in the asset; rather, the transferee has a negative investment equal to the up-front payment it receives. yet, the reason the property has negative value must be on account of a liability or other encumbrance on the property that the transferee assumes. indeed, at previous points in the discussion it has been suggested that the acquisition of a residual interest can be analogized to the acquisition of property subject to a liability! 5 under traditional tax principles, subject to a number of special rules and exceptions, a transferee's basis in property should reflect assumed liabilities.159 accordingly, viewed in the abstract, one might take the position that the transferee of a residual interest should compute its basis by adding in the liabilities it has assumed and then reducing that figure by the amount of the up-front payment ali oxford paper and rev. rul. 55-675.' the latter approach may have some appeal at a theoretical level, but it has a conceptual drawback. from a tax perspective, the holder has not truly purchased property subject to a liability; the holder has purchased property that is expected to generate income. it is true that the income may be largely, if not entirely, phantom income and the residual interest will therefore represent a net liability on account of taxes. yet, that should be irrelevant from the perspective of the tax laws-income is income. in other words, the 157. in order to prevent easy avoidance of such a rule, anticipated credit losses would have to be taken into account-a point that is discussed in greater detail below in connection with significant value residuals issued to thrift institutions. see infra part v.b.3. taking credit losses into account not only would compound the complexity of the rule, but also would compound the arbitrariness of the results. 158. see supra note 135. 159. see, e.g., u.s. v. hendler, 303 u.s. 564 (1938); crane v. commissioner. 331 u.s1 (1947); consolidated coke co. v. commissioner, 70 f.2d 446 (3d cir. 1934). 160. the effect would be to produce a basis of zero in the hands of the transferee. since the up-front payment would probably be taken as the best evidence of the value of the net liability assumed by the transferee. application of a basis adjustment approach is discussed further infra part iv.c.2.c. 19941 florida tax review residual interest is not directly saddled with any liabilities per se; liability for taxes on future income generated by property is in reality a personal liability of the transferee, not a liability burdening the property.' 6' accordingly, cost should not include such future tax burdens. 62 therefore, although the net economic effect of acquiring a residual interest may be that of assuming a liability, it is questionable whether existing tax authorities could accommodate treating such liability as a part of cost, especially since the liability does not directly burden the property per se. accordingly, it would seem that under normal tax principles, the basis of a transferee in a residual interest accompanied by an up-front payment should not reflect the economic liability being assumed. but how then should the transferee's basis be computed? b. a negative basis approach.-if an up-front payment received by the transferee is not includible in full in the gross income of the transferee upon receipt, clearly the transferee has made a negative investment in the property and correspondingly should take a negative basis. it would be a strange result indeed to give a holder a basis of zero in a residual interest, but defer recognition of the up-front payment. that amounts to giving the holder a free step-up in basis without the associated gain recognition. ultimately, of course, the gain will be recognized, but prematurely granting 161. the issue of liability for future taxes as a cost includible in basis was considered in joell co. v. commissioner, 41 b.t.a. 825, 827 (1940), acq. 1942-i c.b. 1. in joell, the court held that the amount of such liability, although expressly assumed by the purchaser of a building, was not a "cost" includible in the purchaser's basis. rather, only the amount of taxes that had accrued prior to the purchase could be capitalized in basis. the court, however, reasoned in part that the seller could not have reasonably factored such taxes into the sales price-a rationale which would not apply in the case of a seller of a residual interest. 162. even if one were to adopt a view that the purchase of a residual interest accompanied by an up-front payment should be treated for tax purposes as, in some sense, the acquisition of property burdened by a liability, it is unclear whether under the existing authorities the liability at issue could be taken into account for basis purposes. it can be argued that the liability at issue is a contingent one, and that the buyer should capitalize such a liability only as and when it becomes fixed. see, e.g., temp. regs. § 1.338(b)-3(c)(1); david r. webb co. v. commissioner, 77 t.c. 1134, 1137 (1981); rev. rul. 55-675, 1955-2 c.b. 567; keyes, supra note 135, at § 21.04[2][b][i]. this latter point, however, is not entirely persuasive, since the existence of the up-front payment in some sense demonstrates that the amount of the net liability being assumed is capable of present valuation and therefore should not be viewed as an excluded contingent liability. this is further bolstered by the existence of the excise tax imposed on a transferor for a transfer of a residual interest to a disqualified organization. that tax is imposed on future excess inclusion amounts and thus evidences a conclusion that such liabilities can be presently valued for tax purposes. irc § 860e(e)(2); regs. § 1.860e-2(b)(3), (4); see also the discussion infra part vii.e.2. recent caselaw has also evidenced a broadened view of when contingent liabilities may be includible in basis. see transamerica corp. v. u.s., 999 f.2d 1362 (9th cir. 1993). [vol. 2:4 tax aspects of remic residual interests basis affects the economics of the residual interest, since this "extra" basis will affect the amount of remic losses that the holder may take into account (as well as the amount of gain, if any, the holder would recognize upon distributions from the remic), not to the mention the gain or loss the holder would recognize if it sells the residual interest.'63 implementing a negative basis approach, however, is complicated by the fact that the code and the service have an aversion to the notion of negative basis. section 860c(d)(2) provides that a holder's basis in a residual interest may not be decreased below zero, suggesting that a holder cannot take a cost basis in a residual interest that is less than zero. and this is in fact the view of the service, as expressed in the preamble to the 1991 proposed remic regulations, in which the service states that existing tax rules do not accommodate residual interests with a negative basis and a negative issue price.164 yet, while it is true that the code does prohibit negative basis in many contexts,165 negative basis exists in other contexts, such as in the case of stock of consolidated group members (i.e., excess loss accounts).166 thus, the question is really which "existing tax concepts" are most appropriate in the remic context. the need to confront the negative basis issue is avoided, of course, if an up-front payment is treated as includible in gross in full upon receipt. in this case, the basis of the residual interest should appropriately equal zero. for example, if x acquires a noneconomic residual interest and receives an up-front payment of $1,000, which it recognized immediately, basic tax concepts would hold that x computes its basis as the amount paid (-$1,000) 163. this point is recognized by the new york bar association tax section, supra note 136, at 12-14. the bar suggests that in the name of rough justice perhaps the service may want to ignore the issue. but why not just get the answer right. it is not that difficult an issue and the necessary rules for implementing a negative basis system would not have to be that complex. 164. see 56 fed. reg. 49,531 (sept. 30, 1991). this statement is lacking in the preamble to the final regulations, but so are many other items. thus, it should not be taken to mean that the service necessarily has abandoned its position. 165. the paradigm example of the prohibition on negative basis is section 357(c), which denies a transferor a negative basis in stock received in exchange for property transferred to a controlled corporation if liabilities are assumed in excess of the transferor's adjusted basis in the property. instead, the transferor recognizes gain to the extent of the excess liabilities and takes a basis of zero in the stock received. this result has been questioned. see george cooper, negative basis, 75 harv. l. rev. 1352 (1962); see also lee a. sheppard, reading section 357(c) out of the code, 47 tax notes 1556 (jun. 25, 1990). other, analogous restrictions on negative basis apply with respect to partnerships and subchapter s corporations. see §§ 705(a)(2), 1367(a)(2). 166. see, e.g., 57 fed. reg. 53,643 (nov. 12, 1992) (preamble to prop. regs. § 1.1502-19) ("in general, an ela is treated as negative basis for computational purposes ...."). 19941 florida tax review plus the amount of gain recognized (+$1,000), or in other words $0.167 since losses are not allowed to the extent that they exceed the adjusted basis of a residual interest and gain is recognized to the extent of any distributions in excess of adjusted basis, there should never be an occasion for the basis of a residual interest to dip below zero. thus, if the up-front payment is recognized immediately, the computation of basis is straightforward and there should be no occasion to deal with the negative basis conundrum. in sum, the service's reluctance to accommodate a negative basis system for negative value residual interests is curious, but the issue should be academic if up-front payments remain immediately taxable in full when received. if, however, the service should require amortization of such payments, or conclude that such amounts are not income, a negative basis system may be necessary to avoid distortions. c. an alternative basis approach.-if it is concluded that the up-front payment should not be taxable in full upon receipt and a full-blown negative basis system is not desirable, an alternative approach would be to apply the amount of the up-front payment as an adjustment to the future costs that the holder is expected to incur as a result of holding the residual interest. the total future costs that the holder will incur, economically, is the excess of value of the tax burden on account of phantom income over any cash or tax benefits the holder will enjoy. this excess amount represents the holder's cost or net investment in the residual interest. it would seem theoretically justifiable to spread the up-front payment among or across the expected excess inclusions of the remic (which is what generates the tax burden) and use the portion of the payment so allocated to reduce the increase in basis that would otherwise result from such excess inclusions. of course, upon a sale or other disposition of the residual interest (or upon a distribution of cash from the remic), any remaining portion of the up-front payment that has not been taken into account would trigger gain or loss (much in the same way an excess loss account gives rise to income upon a trigger event). this approach is not necessarily more administrable than a negative basis approach, but it may avoid any theological misgivings that the service and the code have with that concept. 3. up-front payments and the sponsor/transferor.-if a holder of a remic residual interest makes an up-front payment to a transferee, one remaining issue concerns the treatment of the up-front payment by the transferor, which typically will be the remic sponsor. we have seen that the contribution of mortgages to a remic and the receipt of regular and residual 167. see, e.g., regs. § 1.358-3(b), example (2). [vol 2:4 tax aspects of remic residual interests interests in exchange therefor is not a taxable event. rather, the sponsor carries over its basis in the mortgages (and in any other assets contributed to the remic) and allocates it among the remic interests based on fair market value, realizing any built-in gain or loss generally upon disposition of the remic interests.'" the amount of built-in gain or loss is directly affected by the way one chooses to treat up-front payments. once again, it is interesting to contrast the treatment of the sponsor under the service's approach of not permitting the residual interest to have a negative fair market value with an approach that would permit it. assume a sponsor holds mortgages in which it has an aggregate bases of $90, which it then contributes to a remic and receives back two classes of regular interests, class a and class b, and single residual interest class, class r. assume that class a and class b each has a fair market value of $50 and that the sponsor would have to make an up-front payment of $2 to a transferee to induce it to accept ownership of class r. all would agree that at the bottom line the sponsor has parlayed its mortgages into a net gain of $8-the net amount received of $98 ($50 + $50 $2) less basis of $90. but what is the basis of the regular interests in the hands of the sponsor? since we are directed to ignore negative basis or negative fair market value concepts, the basis computations result in underallocating basis to the regular interests (and overstating the built-in gain therein). in particular, the residual interest is assigned a fair market value and basis of zero, and each regular interest takes a basis of $45, calculated by multiplying the aggregate bases of remic property ($90) by the "basis" fraction ($501$100) for each regular interest. the sponsor then realizes $5 of gain on the sale of each regular interest, for a total gain of $10. the total gain of $10 is manifestly inappropriate, since all would agree that the sponsor has realized true economic gain of only $8. however, if the sponsor is permitted an immediate deduction of $2 for the up-front payment, then in the end the right result prevails and the sponsor will realize a net gain of only $8. however, it is important in this respect that the $2 deduction be of the same character as the gain on the sale of the regular interests. the foregoing basis calculus should be contrasted with what would be the case if the service were to permit negative basis. in that event, the numbers in the above example would change, but the ultimate result would remain the same. first, the basis of each regular interest would be determined once again by multiplying the aggregate bases of the property ($90) by the 168. the sponsor will recognize built-in gains on retained remic interests ratably over the interests' estimated lives. irc § 860f(b)(i)(c). see discussion infra part iv.d. 19941 florida tax review basis fraction ($50/$98),169 with each regular interest receiving a basis of $45.92 and the residual interest assigned a negative basis of -$1.84 ($90 x $2/$98). if the sponsor promptly sold all of the remic interests, it would have total gain on the sale of the regular interests of $8.16 ($50 $45.92 x 2) and a loss on the sale of the residual interest of -$.16 (-$2 + $1.84), or in other words a net gain of $8.00-which is the right result. this equivalence of results, however, depends on the up-front payment of $2 by the sponsor being deductible in full when paid as a capital loss (assuming gain on the sale of the regular interests is capital). the character issue is explored further below in part iv.e.2.a. deductibility in general should not be controversial, even if the service should ultimately conclude that the transferee must amortize the up-front payment. this is, for example, clearly the rule with respect to up-front payments by a transferor of an out-ofthe-money swap: the transferee amortizes the payment, but the transferor immediately recognizes the loss. 7 ' moreover, with certain limited exceptions such as section 267, the internal revenue code does not generally seek to establish symmetrical treatment between the two sides of a transaction.' d. treatment of the sponsor on retained interests as noted above, a remic sponsor recognizes no gain or loss upon the transfer of property to a remic, but takes an aggregate bases in the residual and regular interests received in exchange for the transferred property that is equal to the basis of the transferred property. the aggregate bases of the residual and regular interests is then allocated among the separate interests in proportion to their respective fair market values.'72 the sponsor thus will recognize any gain or loss on the residual and regular interests when it sells them. however, in the event the sponsor retains remic interests, the statute denies the sponsor indefinite deferral of built-in gain or loss recognition. rather, the sponsor is required to accrue such gain or loss over time. 73 169. the $98 figure equals the fair market value of the regular interests ($100) plus the fair market value of the residual interest (-$2). 170. see regs. § 1.446-3(h)(2), (5) ex. 2(b). 171. see generally reed h. shuldiner, consistency and the taxation of financial products, 70 taxes 781, 786-87 (1992) (discussing role of symmetry in the code). 172. irc § 860f(b)(1)(b); regs. § 1.860f-2(b)(3). 173. irc § 860f(b)(i)(c), (d). it is not entirely clear what "retained" means. the term should be interpreted with an eye to regs. § 1.860g-l(d)(1), which defines issue price for retained and publicly offered regular interests. thus, if a regular interest is part of an issue that is publicly offered, it should not be viewed as retained, unless perhaps the sponsor is unsuccessful in selling the interests within some reasonable period of time. the author is aware of some sectors of the industry that take the view that any regular interests that remain unsold on the startup day are to be viewed as retained. such a view is motivated less by a reasoned [vol. 2:4 tax aspects of remic residual interests under the statute, a regular or residual interest has built-in gain or loss equal to the difference between the sponsor's basis in the interest and its issue price. 74 in the case of residual interests, the sponsor must accrue built-in gain or loss ratably over the anticipated weighted average life of the remic.175 the regulations provide that built-in gain recognized by the sponsor increases its basis in the residual interest, whereas recognized built-in loss decreases it.'76 however, in the case of losses, it is unlikely that the service intended that a sponsor's basis in a residual interest be reduced below zero, although technically the regulations can produce that result.'" 7 an unfortunate distortion produced by these rules arises in the case of negative value residual interests, where the sponsor retains both the residual and regular interests (an uncommon, but not unprecedented situation). because the service objects to a negative issue price, a negative value residual interest will not have a built-in loss to offset built-in gain on regular interests. for example, if a sponsor contributes property with a basis of $90 to a remic and takes back two regular interests each with a fair market value of $50 and a residual interest with a negative value of -$2, it is clear that the sponsor has net built-in gain of $8. yet, the sponsor will be forced to accrue built-in gain of $10 ($50 x 2 $90) and will have no offsetting accrual of built-in loss on the residual interest. the result is plainly anomalous, but likely to arise only on rare occasions. one issue raised by the built-in gain and loss rules relates to the character of the income or loss. since the statute does not expressly provide for capital treatment, such gains and losses are ordinary in character (there clearly is no sale or exchange of property), which is a mildly curious result since the actual realization of built-in gain or loss by way of a sale of residual or regular interest may well be capital (if the interests are not held interpretation of the remic rules than by administrative expediency. for example, under the remic rules all remic formations are treated as if the regular interests were issued to the sponsor on the startup day and then sold, which would mean that all regular interests are always retained under the foregoing interpretation. regs. § 1.860f-2(a). 174. in this context, issue price means the fair market value of an interest. see regs. § 1.860g-l(d)(1). 175. see regs. § 1.860f-2(b)(4)(iii), (iv). the use of weighted average life is a slight gloss on the statute (but an entirely reasonable one). which provides that built-in gain or loss is accrued over "the anticipated period during which the remic will be in existence." irc § 860f(b)(1)(c)(ii). the weighted average life of a remic is defined for this purpose in regs. § 1.860e-l(a)(3)(iv). see regs. § 1.860f-4(b)(4)(iii). 176. regs. § 1.860f-2(b)(5). 177. section 860c(d)(2), of course, provides that basis in a residual interest may not be reduced below zero, but by its terms that section only precludes negative basis as a result of distributions to the holder or allocations of remic losses under § 860c(a). the recognition of built-in losses falls under neither of the foregoing categories and thus literally the statute does not preclude a negative basis in this context. 19941 florida tax review by the sponsor in its capacity as a dealer). finally, it is worth noting that nothing in the statute or regulations limits the recognition of built-in gains or losses; thus, a sponsor is free to offset built-in gains, even on residual interests, with net operating losses or other deductions and is free to use builtin losses to offset other income. this is something of an oddity in the statutory scheme, since the accrual of built-in losses can effectively offset excess inclusions to a certain extent. yet, it is clear that the statute and regulations impose no restrictions on the use of accrued built-in losses. unrestricted use of built-in losses can give rise to some planning opportunities in certain circumstances. for example, assume a taxpayer holds a pool of mortgages in which it has a basis of $100 and the fair market value of such pool is $90. the taxpayer contributes mortgages to a remic in exchange for a residual interest entitled to 99% of the cash flows on the mortgages (a super economic residual interest) and a regular interest entitled to 1%. thus the taxpayer has a built-in loss of $10 in the residual and regular interests. what if the remic by its terms is scheduled to liquidate in one year (or perhaps less) and the taxpayer retains the residual and regular interests? 78 apparently, the taxpayer accrues a built-in loss of $9.90179 and then upon liquidation of the remic the taxpayer reclaims its mortgages. when all the dust has settled, the taxpayer has largely realized the built-in loss on its mortgages without having actually disposed of them. 80 although literally nothing in the remic rules appears to prevent this result, one must be wary that in egregious cases the service could utilize substance over form or "sham" transaction precedents to attempt to disallow the loss. e. transfers and terminations of residual interests an issue that remains to be considered concerning the taxation of the residual interest holder is the treatment of gain or loss realized by the holder upon the transfer of a residual interest or the termination of the remic. depending on the cash flow entitlements of the residual interest, either the transferor or the transferee may realize income. in general, if the transfer or termination event is not considered a sale or exchange of property, then any gain or loss recognized by a party in connection with the transfer or termination will be ordinary in character. alternatively, if a sale or exchange is 178. if the taxpayer sells the residual and regular interests, then the taxpayer obviously is entitled to a loss deduction to that extent, but it cannot reclaim mortgages allocable to such regular interests upon liquidation. 179. since the remic is scheduled to liquidate by its terms in one year, the built-in loss attributable to the residual interest (99% of $10) is accrued based on that one year period. 180. in effect, the taxpayer has engaged in a type of wash sale transaction, but one that should be beyond the grasp of § 1091. [vol. 2:4 tax aspects of remic residual interests considered to occur, then any gain or loss may or may not be ordinary depending on whether any of the exceptions under section 1221 apply. finally, if a sale or other disposition of a residual interest results in a loss, the wash sale rules may apply if substantially similar securities are acquired within six months before or after the date of disposition. the discussion below first addresses the extent to which a residual interest is property. assuming residual interests are property, the discussion then addresses the extent to which a transfer or termination event should be considered a sale or exchange. if a residual interest is not found to constitute property, or if no sale or exchange is found to occur, then any gains or losses will be ordinary in character. the third issue is relates the application of the wash sale rules. 1. status as property.-at first blush, it would seem beyond question that a residual interest is "property" for tax purposes. for example, the statute plainly states that a holder has a basis in a residual interest and that distributions in excess of such basis are treated as gain on the sale or exchange of the residual interest.'' in fact, the very use of the term "interest" indicates that a residual interest is some type of property or asset. and in the case of residual interests that entitle the holder to a significant share of the cash flow from the remic's assets, the status of such interests as property is not an issue. however, the answer is not as obvious in the case of residual interests that provide the holder with little or no cash flow entitlements, and under which the liabilities for future taxes may outweigh any future tax benefits. in such cases, the residual interest by its terms may lack positive economic value and, it could be argued, may represent a net liability of the holder. traditional notions of property may not readily accommodate pure liabilities. yet, the residual interest is not a pure liability. although the future tax liabilities burdening a residual interest at a given time may exceed the future benefits, the residual interest nevertheless has some elements of positive value-if nothing else, the value of future tax losses. as discussed in the next paragraph, it seems clear that an asset does not lose its status as property by virtue of being encumbered by obligations that for certain periods exceed the value of its positive attributes. of course, one might ask whether the right to future tax losses is a cognizable property interest, but in an economic sense one must answer most certainly yes, just as net operating losses economically represent assets of a taxpayer.8' and it appears that the 181. irc § 860c(c), (d). 182. cf. in re prudential lines, inc., 928 f.2d 565 (2d cir.). (holding that nol carryforward was property of the debtor's estate under § 541 of the bankruptcy code) cert. denied, 112 s.ct. 82 (1991); in re russell, 927 f.2d 413 (8th cir. 1991) (irrevocable election 19941 florida tax review service agrees. in the recently issued regulations under section 475, which are discussed in greater detail below,"8 3 the service defines a positive value residual interest by reference to the present value of future distributions and future tax savings, thus acknowledging that expected tax savings are an economic attribute of the residual interest that should be taken into account in valuing it for tax purposes.' 4 even if it be accepted that an interest in future tax benefits is a type of property interest, nevertheless where a residual interest entitles the holder to minimal interest in the remic's cash flow and the value of future tax liabilities exceeds the value of future tax benefits, the residual interest will represent a net liability (although this will turn around in later periods as the remic begins to generate losses). is the concept of property flexible enough to encompass an instrument that may have positive or negative value during a given period? it should first be noted that the question is not novel to residual interests, but has arisen with respect to other financial instruments, such as notional principal contracts. 5 however, it appears that the weight of authority today is to treat derivative financial instruments as property, notwithstanding the fact that they may become liabilities during some period to forego carryback of nols may constitute an avoidable transfer of property under the bankruptcy code). see generally gordon d. henderson & stuart j. goldring, failing and failed businesses ii, 1002.04 (1993) (discussing the treatment of nols as property under bankruptcy laws). it is true that nols are different from future tax losses on residual interests in that the latter have not actually occurred, are not fixed in amount, and are subject to contingencies affecting timing and amount. but these same points can also be made regarding the future tax liabilities of the remic. in short, one must either ignore both future tax benefits and burdens or take both into account. if both are ignored, then the residual interest will never have negative value; it will always have some positive administrative rights (e.g., right to vote, right to liquidate the remic at some point) and those rights standing alone should justify property treatment. 183. see infra part vi.b.l.c. 184. temp. regs. § 1.475(c)-2(b). 185. see, e.g., the preamble to the proposed regulations under § 1092, which were finalized in t.d. 8491, 1993-2 c.b. 215: "there has been some question whether a financial product such as an interest rate swap, which may be either an asset or a liability depending upon the movement of interest rates, constitutes an interest in personal property that is subject to section 1092 and section 1234a." 56 fed. reg. 31,350 (1991). as finalized, the regulations under § 1092 provide that a notional principal contract is personal property for purposes of that section. regs. § 1.1092(d)-1(c). see also edward d. kleinbard & suzanne f. greenberg, business hedges after arkansas best, 43 tax l. rev. 393, 438 n.139 (1988) ("an intriguing alternative analysis would be to view a swap position as a hybrid instrument that takes on the characteristics of a property interest when it has positive value and the characteristics of a liability when its value turns negative.") the service, however, does not seem inclined to take kleinbard's "intriguing" gambit. [vol. 2:4 tax aspects of remic residual interests of their life.'86 by the same reasoning, residual interests should be viewed as property as well, regardless of whether they may represent a net liability to the holder at a given period of time. 2. presence of a sale or exchange.-any gain or loss on an outright sale of a residual interest for cash or an exchange of it for property would clearly be gain or loss on the sale or exchange of property. but for the possible application of the wash sale rules, such gain or loss would be recognized and would be capital or ordinary based on whether any of the exceptions under section 1221 apply. the existence of a sale or exchange, however, is less clear in two situations: (i) the transferor makes an up-front payment to the transferee to accept ownership of a residual interest, and (ii) the remic terminates at a time when a residual interest holder has a remaining basis in its residual interest. do the up-front payment and the loss on termination constitute amounts realized upon a sale or exchange? a. up-front payments as gain/loss on a sale or exchange.-the treatment by the transferor of the up-front payment is wrapped up in the fog of uncertainty that hangs heavily over the treatment of up-front payments generally. it is true that a bona fide transfer of the ownership of property occurs, and it would be an entirely sensible result that any gain or loss recognized in connection with such transfer should be treated as derived from a sale or exchange. yet, absent a specific rule to such effect, a transfer involving an up-front payment by the transferor is not easily squared with normal concepts of a sale or exchange. the transferor is paying someone to take a piece of property that has no value or negative value. a similar issue arose with respect to assignment payments with respect to notional principal contracts, and the character question long remained unresolved in that context as well.8 7 with respect to notional principal contracts, it has been argued that an assignment payment is not a loss from the sale or 186. see irc § 475(c)(2) (treating all manner of derivatives as securities that may be marked to market); temp. regs. 1.954-2(a)(4)(iii), (iv) (providing that all manner of derivatives may be dealer property for purposes of computing foreign-based company income); regs. § 1.1092(d)-l(c); priv. let. rul. 8714023 (dec. 31, 1986) (short sale contracts treated as assets for purpose of allocating basis thereto pursuant to a § 754 election)see also edward 0. kleinbard, equity derivative products: financial innovation's newest challenge to the tax system, 69 tex. l. rev. 1319, 1338 n.61 (1991) (reviewing case law on treatment of derivative instruments as property). 187. the recently finalized notional principal contract regulations define termination payment as including a payment made to assign a contract, indicating that the payment is capital in character by virtue of § 1234a. regs. § 1.446-3(h)(1). that would appear to reflect a conclusion by the service that, but for the application of § 1234a. such payments cannot otherwise be viewed as capital. 19941 florida tax review exchange of property (and thus a capital loss for nondealers), but rather it is an ordinary loss, based on the authorities treating payments to be relieved of a burdensome contract as ordinary in character.'88 those authorities, however, may be distinguishable since in each instance the property at issue disappears, whereas in the case of a transfer of a residual interest (or an assignment of a notional principal contracts) ownership of the property is transferred to a third party. however, from the perspective of the transferor, regardless of whether the property continues in existence, the up-front payment has the same effect-to terminate the transferor's responsibilities thereunder. notwithstanding the foregoing, treatment of an up-front payment as a loss on the sale or exchange of property may be better justified by analogy to authorities on short sales. if a taxpayer enters into a short sale and the securities that are the subject of the sale subsequently rise in value, the taxpayer would suffer a loss in closing out the contract. however, prior to closing out the contract, the taxpayer could pay a third party to accept an assignment of the short sale contract. the assignment payment in this circumstance would resemble closely the up-front payment made on a transfer of a residual interest. in stavisky v. commissioner,'89 this precise issue arose, where the taxpayer entered into "when issued" buy contracts and "when issued" sell contracts for the stock to be issued in a corporate reorganization then under consideration. when the price of the when issued stock had risen significantly, the taxpayer faced a potential loss on its when issued sell contracts, and agreed to assign a portion of them to a third party. taxpayer paid the third party $31,150 as consideration for the third party assuming its obligations under a portion of the when issued sell contracts. the court held that the assignment payment was a capital loss realized on the sale or exchange of property (the when issued sell contracts), rejecting the taxpayer's argument that the payment was merely one made for his release from an obligation. petitioner was a party to a bilateral contract with mutual rights and obligations, not a mere obligor. had the market price of mo-pac shares "when issued" declined instead of risen, his rights under his contract would have outweighed his liabilities ... and he would have been the payee rather 188. see, e.g., new york state bar ass'n, tax section, comm. on financial instruments, report on proposed regulations on methods of accounting for notional principal contracts (jan. 6, 1992), reprinted in 24 highlights & documents 633, 656 n.84 (jan. 16, 1992); kleinbard & greenberg, supra note 185, at 438 n.139; olympia harbor lumber co. v. commissioner, 30 b.t.a. 114 (1934); rev. rul, 69-511, 1969-2 c.b. 24. 189. 34 t.c. 140 (1960), aff'd, 291 f.2d 48 (2d cir. 1961). [vol. 2:4 tax aspects of remic residual interests than the payor as the result of the transaction of december 1951.... we think it clear that in such case he would have been in the position of having sold a portion of his rights under the contract... and are not prepared to hold that a given transaction is or is not an exchange from day to day depending on the vagaries of the securities market. ... itihe transaction of december 1951 was in form and substance a transfer to sutro of petitioner's rights and liabilities under the contract, not a mere cancellation or release from liability.' the holding in stavisky reiterates the earlier conclusion of the service in i.t. 3721, ' which also held that an assignment payment made by a taxpayer to a third party in consideration for the latter assuming the former's liability under a when issued sell contract was a loss realized on the sale or exchange of property.' 92 whether the stavisky analysis would be applied by the service in the context of up-front payments on residual interests is unclear; to date stavisky has not been applied outside of the when issued contracts context. 93 however, the case involves a situation that is closely analogous and may well represent the position the service will ultimately assert. as a policy matter, in the case of the remic sponsor the up-front payment should take the same character as gain or loss on the sale of the regular interests. otherwise the minor differences in the structure of the residual interest can give rise to character shifts. for example, assume a sponsor (who is not a dealer) holds mortgages with a basis of $90 and contributes them to a remic. the remic issues two regular interests and a residual interest. one option available to the sponsor is to provide enough cash flow to the residual interest so that it has a value of zero and therefore may be transferred with no (or a minimal) payment to the transferee. assume that under this first option the regular interests have an issue price of $49 each (for a total price of $98), and the residual interest has an issue price of $0. a second option equally available to the sponsor is to reallocate all of the cash flows that would go to the residual interest under option one to the 190. 34 t.c. at 142-43; see also g.c.m. 35475 (sept. 11, 1973) (the mere fact that the obligations outweighed the rights thereunder in terms of comparative values does not prevent the transaction from constituting a sale or exchange.") (citing stavisky). 191. 1945 c.b. 164, supplemented by i.t. 3858, 1947-2 c.b. 71, modified by rev. rul. 57-29, 1957-1 c.b. 519. 192. see also g.c.m. 37332 (nov. 25, 1977) (affirming the conclusion of i.t. 3721). 193. this point is made by the new york state bar association, supra note 188, 24 highlights & documents, at 656 n.84 (jan. 16, 1992). 19941 florida tax review regular interests. assume that under this option the regular interests now have an issue price of $50 each ($100 total) and the sponsor must make an upfront payment of $2 to the transferee to accept ownership of the residual interest. under option two, the sponsor would have a $10 capital gain and, under the no-sale-or-exchange view, a $2 ordinary loss, whereas under option one the sponsor simply has an $8 capital gain (in effect the $2 loss on the residual interest is a capital loss). so much for the transferor. what is the treatment of the transferee upon receipt of the up-front payment? whether, and if so when, the transferee should recognize income with respect to an up-front payment has already been discussed.94 if it is concluded that the up-front payment is properly treated as an item of gross income, what is its character? if the transferor is viewed under the stavisky line of analysis as realizing a capital loss, should the transferee have a capital gain? the answer should be yes; both parties to the transaction should be taxed consistently. to conclude otherwise would effectively grant taxpayers a degree of electivity. in the illustration in the preceding paragraph, for example, by structuring the $2 as an up-front payment the transferee would have ordinary income, whereas if the $2 is structured as an early distribution from the remic the transferee would have gain from the sale or exchange of the interest to the extent such gain exceeded basis. 195 this suggests that both parties to the up-front payment should be treated as deriving a gain or loss from a sale or exchange. one possible drawback to capital gain treatment, however, could be that such treatment would tend to cause up-front payment residual interests to be acquired by taxpayers with excess capital losses. in short, capital treatment could amount to a potentially significant leak in the capital loss limitation rules of sections 1211 and 1212. in sum, probably the better view is to follow the stavisky line of analysis and view the transferor as incurring a loss on the sale or exchange of property when it makes an up-front payment to a transferee. however, arguments that the payment should be ordinary based on authorities involving payments to get out of burdensome contracts are not without force. in the case of the transferee, the up-front payment should be viewed as capital, although that raises other conflicting tax policy concerns. 194. supra part iv.c.i.b. 195. the ability to cast the $2 amount as a distribution from the remic in excess of basis would be affected by one's conclusion as to how distributions and basis adjustments were interrelated. if a distribution is tested against basis at the beginning of a calendar quarter, then structuring the $2 payment as capital should be relatively easy. see discussion of the interrelationship of distributions and basis supra part iv.b.3. [vol 2:4 tax aspects of remic residual interests b. loss upon remic termination.-a second situation in which the presence of a sale or exchange is uncertain arises in the event that a remic terminates (e.g., upon a liquidation or when the regular interests are entirely paid off) and a holder has a remaining basis in his residual interest. in general, it seems beyond question that the holder recognizes a loss under section 165(a). 9 6 however, it is unclear whether the loss would be a capital loss, since there may be no sale or exchange.'" unlike the case where an actual transfer occurs, this involves a situation in which the property disappears and, absent a special rule to the contrary, there is little basis for concluding that the loss arises from a sale or exchange. unfortunately, if there is no sale or exchange, then an individual holder cannot claim an "above the line" deduction for such losses, unless the residual interest was held in connection with a trade or business.' 3. wash sale rules.-the wash sale rules in section 1091 provide that a loss otherwise allowable under section 165 on the "sale or other 196. the loss would be evidenced by a closed and completed transaction that is fixed by an identifiable event, as required in the regulations. rcgs. § 1.165-1(b); cf. birckhead v. commissioner, 33 b.t.a. 466 (1935) (taxpayer suffered a loss upon dissolution of syndicate stock pool). the loss would not be deductible under § 165(g) as a loss upon the worthlessness of a security, since a reic residual interest does not fit within the definition of a security in § 165(g)(2) (applying only to securities of corporate issuers). as a result, the loss would not be subject to the rule in § 16 5(g)(1) treating a worthless stock loss as resulting from the sale or exchange of a capital asset. 197. if the termination of the residual interest is analogized to the discharge of a debt instrument or the termination of contract rights, no sale or exchange occurs for purposes of § 1221. see, e.g., fairbanks v. united states, 306 u.s. 436 (1939) (holding that the redemption of a corporate bond is not a sale or exchange; superseded in part by § 1271(a)); riddell v. scales, 406 f.2d 210 (9th cir. 1969) (same); rev. rul. 75-527, 1975-2 c.b. 30 (holding that the cancellation or release of a contract right does not result in a sale or exchange). see generally kleinbard & greenberg, supra note 185, at 393. 436-37 (discussing the so-called extinguishment doctrine). the termination should not be subject to § 1234a, since it is difficult to view a residual interest as a "right or obligation with respect to personal property." the remic termination alternatively may be analogized to a corporate liquidation. but the absence of any provision in the remic rules corresponding to § 331(a) (treating property received upon a corporate liquidation as full payment in exchange for stock) would suggest that no sale or exchange occurs. further, if, as will often be likely, the residual holder receives no cash or property from the remic upon termination, then the corporate liquidation analogy would in fact support the conclusion that there is no sale or exchange. see, e.g.. commissioner v. johnson, 131 f.2d 709 (6th cir. 1942) (a pre-§ 165(g)(1) case holding that no sale or exchange occurs when shareholders received nothing). rather, the stockholder has a loss deductible under § 165. 198. see irc § 62(a)(3); temp. regs. § 1.62-1(c)(1). (4) (allowing an above-theline deduction only for losses on sales or exchanges of property). taxpayers, of course, can still claim an itemized deduction for such losses. 1994] florida tax review disposition" of a stock or security will not be deductible if the taxpayer acquires substantially similar stock or securities within a period beginning 30 days before and ending 30 days after the date of disposition. in applying section 1091 in the case of residual interests, section 860f(d) provides three special rules. first, a residual interest is treated as a security. second, the prohibited period is extended to a period beginning six months before and ending six months after the date of disposition. third, any residual interest in any remic and any interest in a "taxable mortgage pool"'" is treated as a substantially similar stock or security, except as provided in regulations. to date, no regulations have been issued under section 860f(d). in general, the application of the wash sale rules is relatively clearcut, but also harsh. several points can be made. first, the wash sale rules are triggered by losses on sales or "other dispositions," a term that should be viewed as broader than a sale or exchange and likely would include the termination of a remic residual interest. °0 second, the regulations under section 1091 clarify that a taxpayer is considered to "acquire" substantially similar stock or securities only where the stock or securities are acquired by purchase or by an exchange upon which the entire amount of gain or loss was recognized by law.20' thus, the receipt of a residual interest by a remic sponsor upon the formation of a remic would not be viewed as an "acquisition" triggering the wash sale rules.2 2 third and finally, the wash sales are inapplicable to taxpayers that are dealers if the loss is incurred in transaction undertaken in the ordinary course of such business. v. excess inclusions perhaps the most complicated aspect of the remic tax rules is the 199. a taxable mortgage pool is defined in § 7701(i)(2)(a) as any non-remic entity if (i) substantially all of the assets of which are debt obligations and more than 50% of such debt obligations are mortgages, (ii) such entity is the obligor under debt obligations with two or more maturities, and (iii) the payments on such debt obligations bear a relationship to payments on the underlying debt obligations held by such entity. the purpose of the taxable mortgage pool provisions is to force multiple class securitizations of mortgages to utilize the remic provisions. to this end, any entity that becomes a taxable mortgage pool is subject to adverse tax treatment. 200. cf. temp. regs. § 1.1092(b)-5(a) ('the term 'disposing,' 'disposes,' or 'disposed' includes the sale, exchange, cancellation, lapse, expiration, or other termination of a right or obligation with respect to personal property."). 201. regs. § 1.1091-1(f). 202. the statute and regulations are explicit that the sponsor does not recognize gain or loss upon the exchange. irc § 860f(b)(1)(a); regs. § 1.860f-2(b)(2). it is true that the sponsor may have to accrue built-in gain or loss on a retained residual interest. irc § 860f2(b)(l)(c), (d). this does not change the fact that the sponsor does not recognize gain or loss on the exchange itself. [vol 2:4 tax aspects of remic residual interests so-called "excess inclusion" rules. this is because some knowledge of basic financial analysis is essential to understanding the origin and purpose of the rules. until now, we have been content to refer offhandedly to the matter as one involving "phantom income," a useful and evocative term, but one with little analytical content. it is time to look more carefully at the notion of phantom income and the response to the problem that the remic rules adopt. a. "phantom income": a closer look 1. in general.-the essence of a securitization is the segregation of debt assets and the sale of interests in the future income stream from those assets to investors. as illustrated below, however, the tax treatment of a debt instrument as whole can differ in significant respects from the treatment of the separate pieces of which it is comprised. that difference in treatment can result in phantom income or phantom loss in a given period, which may be defined, in a mechanical sense, as simply the excess of the interest income accrued on the debt assets in a given period over the interest expense accrued on the investor's interests for that period. but a mismatch between income and deductions can arise for a number of mundane, and for our purposes irrelevant, reasons. 3 the nub of the phantom income (or loss) issue in securitization is the mismatch that occurs as a result of the so-called "term structure" of interest rates.2d4 the term structure of interest rates, or more succinctly the yield curve, refers to the relationship between the yield on a series of different bonds that differ only with respect to the length of time until maturity. the market will likely require a different yield on a one-year zero coupon bond than on a ten-year zero coupon bond. graphically, the array of different yields associated with different maturities may slope upward (long-term rates exceed short-term rates), downward (vice versa) or be largely flat. the relevance of the yield curve to a bond providing for cashflows prior to its 203. for example, if the remic has a qualified reserve fund, earnings thereon that are retained for future use will give rise to income for the residual interest without a corresponding deduction. similarly, on rare occasions there may be a write-down of regular interests that occurs prior to the time that underlying mortgages are written down, which can give rise to cancellation of indebtedness income to the residual interest without an offsetting deduction. 204. a discussion of the term structure of interest rates can be found in most basic finance texts. see, e.g., frank j. fabozzi, bond markets, analysis and strategies 187-213 (2d ed. 1993). for a legal discussion of the phenomenon and the tax issues it raises, see joseph bankman & william a. klein, accurate taxation of long-term debt: taking into account the term structure of interest, 44 tax l. rev. 335 (1989); theodore s. sims. long-term debt, the term structure of interest and the case for accrual taxation, 47 tax. l rev. 313 (1992). 19941 florida tax review maturity (e.g., a coupon paying bond) is that such a bond can be analyzed as an assemblage of zero coupon bonds. that is, another way to view a bond is as an aggregation of a series of promises to pay specified amounts at specified times. the weighted average of the yields for the several cashflows should equal the overall yield to maturity of the bond as a whole, yet the timing of interest accruals for tax purposes can differ significantly. in general, interest on a bond accrues for tax purposes based on the single, overall yield to maturity for the bond; the tax laws do not require the bond to be broken up into its component cashflows. yet, if the holder chooses to sell the separate cashflows due under the bond to different investors, the tax laws treat (and must treat) the separate cashflows as individual bonds. the most elementary example of breaking up a bond into its pieces is stripping off the coupons and selling them. 5 simple coupon stripping transactions, however, do not give rise strictly speaking to phantom income or loss, although they do generate a mismatch between the issuer's interest expense accruals and a holder's interest income accruals.2t 6 true phantom income or loss arises when the division of bond cashflows is effected through an intermediary entity, which is what happens in a "pay through" form of securitization. a simple illustration of phantom income or loss can be constructed by assuming a corporation holds a single debt asset. the asset is issued to the corporation on january 1, 1993 for a price of $1,000 and under the terms of the bond the issuer promises to make the following series of payments: debt asset year (12/31) interest principal 1993 $ 80 1994 80 1995 80 1996 80 1997 80 $1,000 total $400 $1,000 given the issue price of $1,000, the yield on this bond (assuming annual compounding) is 8% and the corporation would have interest income each year in the amount of $80. assume the corporation securitizes the debt asset 205. on coupon stripping, see generally joseph p. mcgrath, coupon stripping under section 1286: trees, fruits, and felines, 38 tax law. 267 (1985). see also george c. howell iii & cameron n. cosby, exotic coupon stripping: a voyage to the frontier between debt and option, 12 va. tax rev. 531 (1993). 206. see bruce kayle, where has all the income gone? the mysterious relocation of interest and principal in coupon stripping and related transactions, 7 va. tax rev. 303 (1987). [vol. 2:4 tax aspects of remic residual interests by pledging it to secure a series of debt instruments issued to five investors (investors a through d). each debt instrument entitles the holder to an amount equal to one of the cash flows due under the debt asset. for example, investor a would be entitled to receive $80 at the end of 1993, investor b would be entitled to $80 at the end of 1994, and so on. assuming the yield curve listed below, each investor's debt instrument would have the following issue prices: year yield (12/31) curve 1993 5.50% 1994 6.03 1995 6.40 1996 7.45 1997 8.25 issue prices investors a b $80.00 80.00 $75.83 $71.16 80.00 80.00 1080.00 $66.41 $60.12 $ 726.58 based on the foregoing issue prices and yields, the holders will accrue interest income on the debt instruments in each period as set forth below: a b 1993 $4.17 $4.29 1994 4.55 1995 1996 1997 total interest interest accruals c d $4.25 $4.47 4.52 4.80 4.81 5.16 5.55 the total interest accruals for the holders, however, interest accruals for the corporation on the underlying difference representing phantom income or loss: total accruals (investors) $ 77.12 78.76 80.21 81.59 82.31 $400.00 total accruals (corporation) $ 80.00 80.00 80.00 80.00 80.00 $400.00 will not match the debt asset, with the phantom income or (loss) $2.88 1.24 (0.21) (1.59) (2.31) $0.00 thus, in this example, the corporation will have phantom income in 1993 and 1994 of $2.88 and $1.24, meaning that the interest that the corporae $59.94 64.89 70.24 76.04 82.31 totals $77.12 78.76 80.21 81.59 82.31 $400.00 1993 1994 1995 1996 1997 totals 19941 florida tax review tion accrues on the bond will exceed the interest expense it accrues on the investors' debt instruments by these amounts. of course, the phenomenon turns around beginning in 1995 and the corporation begins to recognize phantom losses. in the aggregate, the phantom income and losses of the corporation sum to zero, showing that in the aggregate the total amount of interest accrued by the investors will equal the total interest accrued by the corporation on the underlying bond. the only difference is one of timing. in general, given an upward sloping yield curve, the holder-investors will accrue less interest income in the early periods and more in the later periods. 2. phantom income and losses in securitizations.-the preceding subsection described in general terms the phantom income and loss phenomenon. what remains to be considered before describing the remic excess inclusion rules is why special rules dealing with phantom income or loss were considered necessary in the case of remics. the starting point for the discussion is the distinction between coupon stripping transactions and paythrough securitizations. both are conceptually alike-the substance of each is to carve up cash flows on debt assets and sell interests in them to investors. in a stripping transaction, however, investors directly acquire interests in the debt asset and the curious, janus-faced situation arises of investors being taxed as if they held separate bonds and the issuer being taxed as if it had issued a single, unified debt instrument. thus, the issuer deducts interest based on a single rate, but the holders report interest income based on their different respective yields. a stripping transaction thus involves the same yield curve v. single rate distortion described above, but it does not give rise to phantom income and loss for tax purposes. on the contrary, phantom income or loss escapes from the tax system altogether. in the example described above, if it is assumed that the transaction involved a coupon strip instead of a pay-through securitization, the result is that instead of issuing debt backed by the cash flows on the bond, the corporation sells the actual cashflows and thus the corporation is no longer a "holder" of the rights to those cashflows. since the corporation no longer holds the debt asset, there are no longer interest income accruals matching the issuer's interest deductions. accordingly, for tax purposes, the issuer of the debt asset deducts interest at 8% per year ($80), but the new holders report interest income, in aggregate, of less than $80 per year in the first two years and more than $80 per year in the remaining three years. thus, the phantom income or loss drops out of the tax system entirely. this feature of coupon stripping may help explain restrictions that currently exist on the ability of a holder to engage in coupon stripping transactions. in general, the tax laws permit a straightforward strip of a fixed portion of cashflows due on a bond, notwithstanding the resulting asymmetry of tax treatment between the debt issuer and the "stripees." however, the tax [vol 2:4 tax aspects of remic residual interests laws treat more complicated or sophisticated divisions of cash flows ("synthetic coupon stripping") as necessarily giving rise to a separate taxable entity, thus requiring that phantom income and loss be picked up by some intermediary entity that resides between the issuer and the ultimate investors that have bought the cashflows.27 this goal of ensuring that phantom income and loss is swept into the tax system for more complex stripping transactions is defeated, however, if the income of the securitization entity is not subject to tax.' this is where the excess inclusion rules enter in. b. the excess inclusion rules given the foregoing background, the thrust of the excess inclusion rules is manifest. these rules are designed to identify an amount of income of a remic that approximates, albeit in a rough and imperfect way, the phantom income of a remic (the "excess inclusion") and ensure that such income is subject to tax. the rules ensure taxation of excess inclusion amounts by prohibiting transfers of residual interests to entities that are not subject to any u.s. taxation (this aspect is discussed below) and imposing a blanket rule that in the hands of taxable holders excess inclusion amounts are subject to tax in all events, i.e., such amounts cannot be offset by losses or deductions. each aspect is discussed below. 1. measuring excess inclusions.-an excess inclusion amount is measured as of a calendar quarter and is defined, with respect to each residual interest holder, as the excess of the holder's share of the taxable income of the reivic for that quarter over the sum of the "daily accruals" for such residual interest based on the number of days during that quarter that the interest was held by the holder.2° daily accruals are calculated by multiplying the "adjusted issue price" of the residual interest at the beginning of a calendar quarter by 120% of the long term federal rate,2" and allocating the 207. synthetic coupon stripping cannot be done on a pass-through basis by use of a grantor trust because such transactions will give rise to an impermissible second class of ownership interests in the trust. in the case of mortgage loans, synthetic coupon stripping generally must be done in a remic or in a separate taxable entity: this is the effect of the taxable mortgage pool rules. for nonmortgage debt, synthetic coupon stripping, in a broad sense of the term, could be done on a pass-through basis with a partnership. however, this approach carries a certain amount of baggage with it. see generally howell & cosby. supra note 205, at 550-60 (discussing different structures to accomplish coupon stripping, broadly construed). 208. see kayle, supra note 206, at 345. 349-50. 209. irc § 860e(c)(1). 210. the long term federal rate means the federal long-term rate, determined on the basis of quarterly compounding, which would have applied to the residual interest under 19941 florida tax review result ratably among the days of the quarter. the adjusted issue price of a residual interest is its initial issue price (adjusted for any contributions after the start-up date), increased by the amount of daily accruals for prior quarters and decreased (but not below zero) by any distributions before the beginning of the quarter.211 the daily accrual mechanism is intended to impute to a residual interest a minimum return on a holder's investment (i.e., 120% of the long term federal rate) and treat the excess of remic taxable income over that minimum return as a proxy for phantom income. the proxy, however, is a rough one at best. for example, the calculation is a one way street; excess inclusions are taken into account, but there is no concept of an "excess" or phantom loss that is deductible in all events. in theory, the failure of a remic to realize taxable income at least equal to daily accruals would represent such phantom losses, but such is not permitted in practice.1 ' 2 a second criticism along these same lines relates to the fact that excess inclusion amounts are taxable in all events. although this is intended to ensure that phantom income is subject to tax and not lost from the system through transfers to entities with tax losses, it is a problematic solution to that concern. this is because the phantom income/loss problem is one of timing; by definition the phantom income will be matched by offsetting losses. since the issue is one of timing, recognition of income in all events should be matched with rules permitting recognition of some form of excess losses in all events as well-at least as a carryback or carryforward against prior or future excess inclusions. the statute also grants to the service regulatory authority to provide that all of a remic's taxable income allocable to a residual interest holder will be treated as excess inclusion amounts if the residual interest lacks significant value. the service has not exercised this authority and it is § 1274(d) (without regard to § 1274(d)(2)) if it were a debt instrument. irc § 860e(c)(2)(c). the legislative history provides that the applicable rate is determined at the time the residual interest is issued. h.r. rep. no. 841, supra note 31, at 11-235, reprinted in 1986 u.s.c.c.a.n. at 4323. in practice, the service releases the applicable federal rates for a given month on or about the 20th day of the preceding month. 211. "issue price" for this purpose is defined in regs. § 1.860g-l(d)(l), which provides that, if the interest is publicly offered, the issue price equals the initial offering price to the public at which a substantial amount of the class is sold. if the interest is not publicly offered, the issue price is the first price paid by the first buyer, and if the interest is retained by the sponsor the issue price is the fair market value on the pricing date. id. as we have seen, a negative issue price is not permitted. supra text accompanying note 164-65. 212. the roughness is further evident from the fact that the residual interest in a lower-tier remic that is part of a double remic structure can experience excess inclusions, even though no tranching occurs. see regs. § 1.1275-2(c)(4) ex. 2 (treating regular interests of such a lower-tier remic as a single debt instrument). in theory, that result is indefensible. [vol 2:4 tax aspects of remic residual interests unlikely that it will, since the rule makes little sense. if a residual interest lacks significant value, the interest will likely have small or zero issue price and thus the amount of the daily accruals will be minimal. in sum, the computation formula described above already has the effect of treating an increasing portion of a residual holder's allocable share of remic taxable income as excess inclusion amounts.1 3 2. taxability of excess inclusions.-having identified the amount of excess inclusions with respect to a residual interest, the true core of the excess inclusion rules is reached: "the taxable income of any holder of a residual interest in a remic for any taxable year shall in no event be less than the excess inclusion for such taxable year."214 in the case of an affiliated group of corporations that file a consolidated return, consolidated taxable income of the group may not be less than the sum of the excess inclusions of the members.2 5 in the case of tax-exempt organizations, excess inclusion amounts are treated as unrelated business taxable income for purposes of section 51 1.216 requiring taxation in all events reflects a concern that absent such a rule residual interests would be issued in all cases to tax-exempt entities, with the net result being that phantom income again escapes the system. the effect of the foregoing rule is that otherwise available deductions may not offset excess inclusion amounts. moreover, as touched on above, excess inclusion amounts are computed on a quarterly basis and may not be offset by losses of the remic in other quarters, even if for the taxable year the residual holder recognizes a net loss from the remic."1 deductions that cannot be used because of the existence of excess inclusion amounts are treated as being in excess of gross income and give rise to a net operating loss under section 172.218 the rule, however, simply requires taxable income to be no less than excess inclusion amounts; the rule does not limit a taxpayer's ability to zero out its tax liability through available tax credits. thus, excess inclusion amounts cannot be offset by deductions, but the resulting tax liability can be offset by credits. the logic of the rule in distinguishing between credits and 213. see peaslee & nirenberg, supra note 8, at 184. 214. irc § 860e(a)(1). 215. irc § 860e(a)(3); regs. § 1.860e-1(a)(2). 216. irc § 860e(b). 217. for example, if a remic residual holder realized $1,000 of taxable income from a remic in the first quarter, $800 of which was an excess inclusion amount, and in the next three quarters realized net losses totalling $1,000, the holder would have to report minimum taxable income of $800, even though for the year the remic broke even. 218. see irc § 860e(a)(5). 19941 florida tax review deductions is indeed elusive; the allowance of the use of credits may have been an oversight. in any event, there may not be many taxpayers with excess credits that desire or are able to invest in residual interests. thus, the significance of the issue may be minimal." 9 special excess inclusion rules for certain residual interest holders are discussed below. 3. special rule for thrifts a. in general.-an exception to the general rule that excess inclusion amounts may not be offset by deductions applies with respect to thrift institutions." ° thus, a thrift institution holding a residual interest may use its losses to offset excess inclusion amounts.2"' the stated reason for the thrift exception is "the difficulties currently being experienced by such industry."22 and so, the thrift exception joins the long parade of special tax expenditures bestowed by congress in the 1980s on the ailing thrift industry. logically, one would think that this advantageous rule would drive most residual interests into the hands of thrifts. however, two factors (among others) have conspired to render the special thrift exception of limited utility. first, thrift regulators have adopted rules that, as practical matter, make it very difficult for thrifts to hold residual interests. 223 second, prompted by 219. one case where the issue could take on some magnitude would be the case of residual interests in foreign remics. depending on which basket foreign-source excess inclusion amounts would be placed in, they could generate income to soak up excess foreign tax credits. although the passive income basket would seem the most likely candidate, technical deficiencies in the definition make it uncertain whether excess inclusion amounts would necessarily fit thereunder. however, since foreign remics are a relatively uncommon phenomenon, the issue may be left for another day. 220. irc § 860e(a)(2). specifically, the exception applies in the case of a corporation to which § 593 applies, which encompasses any domestic building and loan association (as defined in § 7701 (a)(19)), any mutual savings bank, or any "cooperative bank," provided in each case the 60% asset test of § 7701(a)(19)(c) is met. irc § 860e(a)(4). a § 593 corporation is lumped together with each qualified subsidiary and treated as a single § 593 corporation. id. a qualified subsidiary is a corporation "(i) all the stock of which, and substantially all of the debt of which, is held directly by the corporation to which § 593 applies, and (ii) which is organized and operated exclusively in connection with the organization and operation of one or more remic's." irc § 860e(a)(4)(b). 221. a thrift may not be able to entirely zero out its tax liability, since under the alternative minimum tax, among other adjustments, a corporation is entitled to offset only 90% of its alternative minimum taxable income with a deduction for net operating loss carryovers. irc § 56(d)(1). 222. see 1986 act bluebook, supra note 29, at 422. 223. under risk-based capital requirements, thrift institutions must maintain a minimum amount of capital against their assets, depending on the risk weight attributed to them. remic residuals are among the riskiest class of assets and receive a 100% risk [vol. 2:4 tax aspects of remic residual interests the legislative history the service issued regulations restricting the application of the thrift exception to residual interests that have "significant value."" 4 the net result is that today only a small proportion of residual interests finds its way into the hands of thrifts. nevertheless, some discussion of the contours of the thrift exception is appropriate. b. the significant value requirement.-unless a residual interest has significant value, a thrift is not entitled to use deductions to offset excess inclusion amounts. the regulations define in some detail what significant value means, providing computation rules that allow a high level of certainty about whether a residual interest has significant value. in general, a residual interest possesses significant value if (i) the aggregate of the "issue prices" of the residual interests in the remic is at least 2% of the aggregate of the "issue prices" of all residual and regular interests in the remic (the "2% test"), and (ii) the anticipated weighted average life of the residual interests is at least 20% of the anticipated weighted average life of the remic (the "20% test").22s weighting. in short, many thrifts simply find investment in rem1ic residual interests an unattractive use of scarce capital. 224. section 860e(a)(2) provides regulatory authority for the significant value rule: 'the secretary may by regulations provide that the preceding sentence shall not apply where necessary or appropriate to prevent avoidance of tax imposed by this chapter." the legislative history indicates that in case of a residual lacking "significant value," the thrift exception should not apply. h.r. rep. no. 841, supra note 31, at 11-235, reprinted in 1986 u.s.c.c.a.n. at 4323; 1986 act bluebook, supra note 29, at 423 n.83. as to the meaning of significant value, the legislative history states that a residual should be considered to have significant value where its value equals at least 2% of the combined value of the remic's regular and residual interests. id. before regulations were proposed, in order to meet the significant value requirement foreshadowed in the legislative history, some would structure remic residual interests to have the minimum 2% percent value, but only for a short period. thus, for a time it was not uncommon to see residual interests that provided for a relatively large amount of distributions to be paid out within the first month or two of the remic. these were referred to in some quarters as short-term amortization residuals ("stars") and amounted to no more than the residual holder momentarily passing a large amount of cash through the remic in order to convert the residual interest into a significant value residual. that the significant value requirement could be so facilely skirted seemed too good to be true. stars died when the proposed regulations were issued containing the 20% requirement discussed below. it is interesting that legislative history specifically envisioned that the service would apply the significant value requirement retroactively, yet the service chose not to do so in the case of stars. this helped set a trend for prospectivity in the regulations and served to reward some quite aggressive tax stratagems. 225. regs. § 1.860e-1(a)(3)(iii). as originally proposed, the regulations required that the weighted average life of a significant value residual equal at least 20% of the "anticipated life" of the remic, which would generally be some 15 or 30 years (depending on the 19941 florida tax review the 2% test measures the relative value of the remic residual interest and is essentially mechanical in operation. the operative element is the issue price of the remic's residual and regular interests, which is defined in the regulations generally as, in the case of publicly offered interests, the initial offering price to the public at which a substantial amount of the class is sold.226 unfortunately, this definition is imprecise in some respects and somewhat out of touch with the reality of the marketplace. in a public offering, the underwriter initially may not sell any, or may sell only minimal portions, of one or more classes of regular interests in a remic. absent actual prices on substantial sales of these classes the status of the residual interest may not be determinable with precision at the time it is sold. at least for purposes of applying the significant value rule, the regulations should have adopted a safe harbor based on reasonable belief, under which parties could rely on an underwriter's reasonable estimate of the initial price at which a substantial amount of remic interests of a class will be sold in treating a residual interest as meeting the 2% test. what the 2% test lacks in exactitude is made up for by the preciseness of the 20% test. in general, the first step in applying the 20% test is to determine the anticipated weighted average life of the residual interests and each class of regular interests. for regular interests that have specified principal amounts and do not provide for disproportionately high interest, 7 the calculation is based on the dates on which it is anticipated that payments of specified principal amounts will be made.22 ' for residual interests and regular interests that do not have a specified principal amount (i.e., an 10) or that provide for disproportionately high interest, all anticipated payments are taken into account in the calculation, regardless of whether they are denominated as principal or interest.229 weighted average maturities of the underlying mortgages). 56 fed. reg. 49537 (1991) (proposed sept. 30, 1991). that made little sense, and, as finalized, the regulations refer to the remic's weighted average life-a considerably shorter period of time. 226. regs. § 1.860g-l(d)(1). thus, in the case of regular interest classes, each class has a single issue price. however, by referring to the "aggregate of the issue prices of the residual interests," the regulations appear to contemplate adding all of the separate prices at which the residual interests have been sold, rather than simply using the first price at which a substantial portion was sold. regs. § 1.860e-l(a)(3)(iii). 227. a regular interest is considered to provide for disproportionately high interest if its issue price exceeds 125% of the specified principal amount. regs. § 1.860gi (b)(5). 228. regs. § 1.860e-1(a)(3)(iv)(b). 229. regs. § 1.860e-1(a)(3)(iv)(c). as originally proposed, the regulations stated that the weighted average life of a residual that provided for a specified principal amount is always determined by taking into account only payments of such amounts. 56 fed. reg. 49537 (1991) (proposed sept. 30, 1991). this provided for easy manipulation of the 20% test; one need simply structure a residual to pay a large proportion of specified principal late in the life of the remic to produce a high weighted average life. this curiosity was pointed out by [vol. 2:4 tax aspects of remic residual interests the key to determining weighted average lives, once the proper payments have been identified, is the meaning of the term "anticipated." fortunately, the regulations are quite specific: anticipated payments are determined based on the prepayment and reinvestment assumption adopted under section 1272(a)(6), and any required or permitted clean up calls or any required qualified liquidation provided for in the remic's organizational documents.230 absent from this formulation is any reference to anticipated delinquencies or nonpayments on the remic mortgages, which can give rise to interesting planning possibilities. for example, assume a remic holds residential mortgages. statistically, it is certain that there will be defaults on some of the mortgages. consequently certificate holders (regular and residual interest holders) may not receive the full value to which they are entitled, absent some form of credit support. if one structures a residual interest with a significant specified principal balance, payable at the end of the remic after all regular interests have been retired, the result would be to increase greatly the weighted average life of the residual interest, but at the economic cost of "wasting" cash flow on the residual interest class-typically not the most efficient use of such cash flow. however, if one specified that this principal balance was subordinate to all other interestholders and absorbed all losses of the remic first before any other credit support or subordination was utilized, then (depending on the size of the principal balance), the likelihood that the residual interestholder will ever actually receive its promised principal balance may well be zero. in essence, one has assigned to the residual interest a deeply subordinate (i.e., empty) right to cash, but this right nevertheless is taken into account testing for significant value since the likelihood of defaults plays no role in the test." commentators and corrected in the final regulations. 230. regs. § 1.860e-l(a)(3)(iv)(d). 231. the author is aware of the possible argument that the determination of anticipated payments is based on a prepayment assumption and that anticipated defaults could be construed as a type of prepayment that one must take into account as part of this assumption. although the service is, of course, free to adopt any definition of a prepayment assumption that it wants under § 1272(a)(6), until such time taxpayers are expressly permitted to adopt an accepted industry prepayment assumption. see h.r. rep. no. 841, supra note 31. at 11-239, reprinted in 1986 u.s.c.c.a.n. at 4327 ("the conferees intend that unless otherwise provided by regulations, the use of a prepayment assumption based on a recognized industry standard would be permitted."). in this regard, under no accepted industry prepayment assumption are defaults taken into account. on the broader point of whether the service should adopt a definition of a prepayment assumption under § 1272(a)(6), it should be noted that doing so would have collateral consequences that far outstrip the discrete issue of how a significant value residual interest is defined. for example. remic regular interest holders (and holders of other prepayable instruments) would be able to accrue old based on assumed defaults and delinquencies-a rather startling notion. cf. prop. regs. § 1.1275-4(b) (stating that a payment under a debt instrument is not contingent merely because of the risk of 19941 florida tax review once the anticipated weighted average lives of the regular and residual interests have been calculated, the second step is to compute the weighted average life of the remic. this is determined by reference to all payments taken into account in computing the weighted average lives of the regular and residual interests, which are treated as principal payments on a single regular interest. the final step in applying the 20% test is to compare the weighted average life of the residual interest, as computed above, to the weighted average life of the remic. the anticipated weighted average life of the residual must equal at least 20% of the anticipated weighted average life of the remic. although the significant value requirement was not wholly unanticipated,232 the service decided that it should apply only on a prospective basis. thus, only residual interests acquired by a thrift on or after september 27, 1991 (the date the proposed regulations were released) are subject to the significant value rule; residual interests acquired before that date qualify for the thrift exception regardless of whether they have significant value.2 33 4. special rules for reits and rics.-reits and rics are corporations that are subject to corporate tax on their income, but such entities are able to achieve pass-through treatment by virtue of being allowed a dividends-paid deduction.2 34 consistent with the intent that these entities function as conduits, however, congress has imposed minimum distribution requirements on them, forcing them to disgorge virtually all of their income to their shareholders each year.235 yet, a ric or a reit can retain some income and, to the extent that it does so, it will be subject to tax at the normal corporate tax rates. 6 given this rudimentary background, how should a ric or reit be taxed with respect to excess inclusions? it could be argued that the minimum taxable income of a ric or reit cannot be less than the excess inclusion income that it accrues, i.e., it is effectively denied a dividends paid deduction for excess inclusions. that insolvency or default). on the tax policy implications of the failure of current law to take into account default risk, particularly in the case of the issuer of a debt instrument, see the provocative discussion in robert scarborough, risk diversification and the design of loss limitations under a realization-based income tax, 48 tax l. rev. 677, 686-90 (1994). 232. see supra note 224. 233. regs. § 1.860a-l(b)(2)(iii). further, a special transition rule exempts residual interests acquired by a thrift as a sponsor at the formation of a remic if more than 50% of the interests in the remic (determined by reference to issue price) were sold to unrelated investors before november 21, 1991. this exception, however, applies only for so long as the thrift-sponsor owns the residual interest. 234. see generally subchapter m of subtitle a. 235. id. 236. id. [vol. 2:4 tax aspects of remic residual interests result makes little sense; there is no policy reason why the conduit function of the ric or reit should be curtailed on account of excess inclusions. rics and reits should be able to pass through such amounts to their shareholders, provided that the character of excess inclusion amounts is preserved. this is, in fact, the general approach outlined in section 860e(d), which provides: (d) treatment of residual interests held by real estate investment trusts.-if a residual interest in a remic is held by a real estate investment trust, under regulations prescribed by the secretary(1) any excess of(a) the aggregate excess inclusions determined with respect to such interests, over (b) the real estate investment trust taxable income (within the meaning of section 857(b)(2), excluding any net capital gain), shall be allocated among the shareholders of such trust in proportion to the dividends received by such shareholders from trust, and (2) any amount allocated to a shareholder under paragraph (a) shall be treated as an excess inclusion with respect to a residual interest held by such shareholder. rules similar to the rules of the preceding sentence shall apply also in the case of regulated investment companies, common trust funds, and organizations to which part i of subchapter t applies. there are several elements at work in section 860e(d). first, the reit must identify its excess inclusion amounts. this should be a straightforward matter of examining the schedule q that the reit will receive from the remic for each quarter. however, just like any other corporate taxpayer, a reit's taxable income may not be less than its excess inclusion, i.e., a reit may not offset such amounts with other deductions. second, the reit must identify the amount of what may be termed its "distributed" excess inclusions. this determination involves subtracting the reit's taxable income (excluding capital gain) from the amount of excess inclusions. the reit's taxable income, it will be recalled, is the amount of its income that the reit chooses to retain for the taxable year. thus, the effect of the section 860e(d) calculus is to treat the reit's retained income 1994] florida tax review as being attributable to excess inclusions; only to the extent that excess inclusions exceed retained income are they treated as distributed to shareholders." the exclusion of capital gains from reit taxable income is sensible, since such amounts are already required to be segregated and separately accounted for by the reit, and are passed through to shareholders as capital gains dividends.238 third, once the amount of distributed excess inclusions is identified, the reit must allocate them among its shareholders based on their relative share of the dividends of the reit that they receive. dividends for this purpose should include ordinary dividends as well as capital gain dividends. finally, an excess inclusion amount allocated to a shareholder by a reit is to be treated as an excess inclusion amount accrued on a residual interest held by the shareholder. thus, the reit effectively passes on to its shareholders such amounts for them to account for on their own tax returns. it should be emphasized that, at least in the absence of regulations, section 860e(d)(2) does not deem the reit shareholder to be a residual interest holder except for the limited purpose of forcing the shareholder to account for its share of excess inclusions in accordance with the remic rules. in particular, the reit shareholder is not treated as a residual interest holder for purposes of the transfer restrictions described in greater detail below. thus, a reit shareholder is generally free to sell its reit shares without concern that in doing so it might be treated as selling a proportionate interest in the residual interests held by the reit.239 the foregoing rules were enacted in 1986 solely with an eye to reits, but in 1988 congress amended section 860e(d) to provide that similar rules should apply to registered investment companies and other conduit entities. to date, no regulations have been issued implementing section 860e(d) and is unclear what the law is in the interim. although a literal reading of the statute might suggest that until regulations are issued no rules apply to reits and rics with respect to preserving the character of excess inclusion amounts in the hands of its shareholders, that reading is probably 237. regulations, when issued, will no doubt add more flesh to the bones of § 860e(d). for example, to the extent that excess inclusions are not treated as distributed in a given year, such amounts should carry over and be added to the excess inclusions that accrue in the subsequent year, although nothing in the § 860e(d) calculation mandates such a carryover. 238. irc § 857(b)(3). 239. a limited exception, discussed further in part vii.e.3. on penalty taxes, applies in the case of an acquisition of reit shares by a disqualified organization, which is treated effectively as a transfer to such holder of a portion of a residual interest held by the reit. this rule, however, should serve to underline the fact that an acquiror of an interest in a passthrough entity is not otherwise treated as becoming a holder of a residual interest that the entity holds among its assets. [vol, 2:4 tax aspects of remic residual interests incorrect; in other contexts involving similar language the statute has been viewed as self-executing. 24° moreover, the latter reading would lead to excess inclusions escaping tax altogether (although regulations, if and when issued, could apply retroactively). in short, the prudent course is for rics and reits to take reasonable steps to attempt to apply section 860e(d). stepping back from the details of section 860e(d), it is difficult to gauge as a practical matter to what extent reits and rics actually will choose to invest significantly in residual interests. this is because these entities are subject to minimum distribution rules that require them to distribute in dividends the greater part of their taxable income each year. excess inclusions, of course, are items of taxable income for which little or no cash is received. thus, in order to meet the minimum distribution requirements, a reit or ric holding residual interests may have to distribute capital to its shareholders. this detriment, however, may be balanced by the benefit of having phantom losses in later years from a residual interest that offset taxable income and thereby lower the minimum distribution requirements."' c. excess inclusions and the alternative mininun tar under current law, no special provisions exist with respect to the calculation of the alternative minimum tax ("amt") and excess inclusions from remic residual interests. excess inclusions are simply part of a taxpayer's taxable income and, as such, they are part of the starting point for applying the amt.242 although at first blush it is not apparent why this situation is at all problematic, as a policy matter a question exists whether this amt calculus is appropriate. take a simple, but extreme example: x holds a residual interest and derives excess inclusions for 1994 in the amount of $1,000. in 1994, x also realizes deductions of $2,000, $1,000 of which would be added back into income under the amt rules. x has no other income or deductions. for regular tax purposes, x has regular taxable income of $1,000. for amt purposes, x must adjust its regular taxable income by adding back the $1,000 of deduc240. see robert 1. crnkovich & kenneth h. heller, "to the extent" provisions: when do they operate without regulations?, 76 j. tax'n 176 (1992). 241. some discussion of tax considerations for rics investing in remic residual interests can be found in steven d. conlon & suzanne m. russell, tax considerations for mutual funds investing in asset-backed and derivative securities. 71 taxes 12 (1993). 242. under § 55(b)(2), alternative minimum taxable income is defined as the taxable income for the year (which would include excess inclusion amounts) subject to certain adjustments and add-backs of certain tax preferences. 19941 florida tax review tions, thus producing amti of $2,000. is it appropriate for x to be subject to additional tax under the amt in this case? interestingly, in an unusual display of solicitude toward holders of residual interests, congress is considering (and probably will pass someday) legislation aimed at changing the above result. specifically, proposed legislation would add a new section 860e(a)(6), which would provide for rules coordinating the amt with the excess inclusion rules.243 the first aspect of the legislation would be to provide that, for purposes of applying the amt, taxpayers may compute taxable income by offsetting excess inclusions with deductions, including net operating loss carryovers.244 thus, in the above example, the taxpayer would compute its taxable income by subtracting the deductions of $2,000 from its income of $1,000, producing a loss of $1,000. under the amt, $1,000 of deductions are added back, thereby producing amti of $0 and no amt liability for x. the proposed legislation, however, would provide a second, independent rule that the amti of a taxpayer may not be less than its excess inclusion for the taxable year.245 the stated effect of this rule is that even if a taxpayer has been able to utilize nonrefundable tax credits to eliminate its tax liability for regular tax purposes,246 it will not be able to do so for amt purposes and will therefore always be liable at the amt rate on its excess inclusions. it is hard to quibble too much with this provision from a policy perspective, since it is difficult to reconcile the allowance of credits against excess inclusion liability for regular tax purposes with the objective of ensuring such amounts were taxable in all events. a third and final rule that proposed legislation would create would be that in computing the alternative tax net operating loss deduction, excess inclusions are ignored. according to the accompanying description of the rule, "[t]his provision insures that net operating losses will not reduce any income attributable to any excess inclusions."247 it is not entirely clear whether this rule is necessary to achieve that purpose, given the second rule described above (amti may not be less than the excess inclusion for the taxable year). however, it would have the collateral effect of ensuring that not only does the taxpayer pay tax on its excess inclusion, but that the taxpayer pays some tax on its non-excess inclusion income. 243. tax simplification and technical corrections act of 1993, h.r. 3419, 103d cong., 1st sess. (1993) (proposing § 860e(a)(6) in § 1003(i)(1)). 244. id. 245. id. (section 1003(i)(1) adds proposed § 860e(a)(6)(b)). 246. see supra part v.b.2. 247. h.r. rep. no. 353, 103d cong., 1st sess. 225 (1993). [vol 2:4 tax aspects of remic residual interests as currently drafted, the legislation would carry a retroactive effective date and apply to taxable years beginning on or after december 31, 1986 (the general effective date of the original remic provisions), but taxpayers would be permitted to elect to apply the provision only to taxable years beginning after the date of enactment.248 the entire discussion above rests, of course, on the enactment of new section 860e(a)(6), an event that is inherently uncertain and unpredictable. vi. tax treatment of special holders a. foreign residual interest holders as described below, certain restrictions apply to the transfer of a residual interest to a foreign person, the result of which is to constrain significantly those instances in which a foreign person can ever hold a residual interest. yet, the transfer restrictions are not absolute; with appropriate structuring a residual interest can be transferred to a foreign person." 9 further, the transfer restrictions seemingly do not apply to a foreign sponsor that retains a residual interest. however, it must be acknowledged that, absent a change in law, the incidence of foreign-owned residual interests is likely to be quite small. thus, it may seem something of an academic exercise to discuss the rules applicable to foreign holders of residual interests, but since some foreign holders do exist and likely always will, it is nevertheless appropriate to consider the tax rules that apply to them. in discussing the taxation of the foreign residual interest holder, the focus is on the application of u.s. withholding taxes. in general, three issues are presented. first, to what extent is income on a residual interest subject to withholding. second, when does withholding apply. third, how does withholding apply. 1. applicability of u.s. withholding taxes.-in general, u.s. withholding taxes apply at a 30% rate (except as reduced by treaty) to u.s. source "fixed or determinable annual or periodic" ("fdap") income of a foreign person that is not effectively connected with the conduct of a u.s. trade or business."5 one would have to acknowledge that the precise character of income under a residual interest is not at all obvious, although certainly it has every indicia of fdap income. however, merely classifying 248h.r. rep. no. 3419, supra note 243, at 225. 249. one possibility is for a foreign person to hold a residual interest through a u.s. pass-through entity, such as a partnership. see infra part vii.d.i. 250. on the definition of a foreign holder, see infra note 440. 251. see §§ 871(a), 1441. 19941 florida tax review income as fdap is not enough; various exemptions and special rules apply based on the type of fdap income at issue. for example, interest income is generally treated favorably and frequently enjoys the benefit of withholding tax exemptions or rate reductions, whereas dividend income generally is less favorably treated. in this respect, were one writing on a clean slate, one might be inclined to characterize residual income as analogous to dividends, since such income represents the profits of the entity. congress, however, has not left the slate clean. in the legislative history of the remic provisions, it is specifically stated that "amounts paid to foreign persons with respect to residual interests should be considered to be interest for purposes of applying the withholding rules." 2 while income on residual interests may bear little resemblance to interest income, this treatment is consistent with the treatment of residual interests as debt instruments for purposes of section 582(c).z" thus, once it is determined that an amount received by a foreign person is received "with respect to a residual interest," the character of such amount is settled.254 however, once again the issue arises of how to treat up-front payments. in economic substance, such amounts are part of a holder's investment return on a residual interest and, as noted above, any distinction between such payment and actual distributions would be highly artificial. more importantly, the legislative history, whether deliberately or not, uses the phrase "amounts paid ... with respect to residual interests" and it does no violence to that language to construe it as encompassing up-front payments. 5 accordingly, it is probably a fair reading of the legislative history to construe up-front payments as amounts that are to be characterized as interest. however, until and unless the service issues further guidance, the matter must be considered somewhat uncertain. 252. h.r. conf. rep. no. 841, supra note 31, at 11-238, reprinted in 1986 u.s.c.c.a.n. at 4326; cf. regs. § 1.856-3(b)(2) (providing that amounts includible in gross income on a remic residual interests are treated as "interest on obligations secured by mortgages on real property."). under the principle expressio unius est exclusio alterius (mention of one thing is the exclusion of another), one may be tempted to argue that residual interest payments are not interest for purposes other than withholding taxes. however, without more, it is probably reading too much into the legislative history to attribute such an intent to congress. 253. h.r. conf. rep. no. 841, supra note 31, at 11-233, reprinted in 1986 u.s.c.c.a.n. at 4321. 254. the legislative history addresses the character of amounts paid by the remic, raising the question whether a different analysis applies to taxable income on residual interest which accrues but is not paid. the language of the legislative history, however, merely reflects the fact that withholding generally does not attach before an amount is treated as paid to a foreign person. thus, the issue of character prior to payment is essentially irrelevant. 255. h.r. conf. rep. no. 841, supra note 31, at 11-238, reprinted in 1986 u.s.c.c.a.n. at 4326 (emphasis added). [vol 2:4 tax aspects of remic residual interests given that amounts paid on residual interests (including, one can argue, up-front payments) are to be treated as interest for withholding tax purposes, such amounts may therefore qualify for the withholding tax relief that is available for interest payments. the first such relief provision that may apply is the so-called "portfolio interest" exemption. the second general form of relief is by tax treaty. each is addressed in turn below. a. the portfolio interest exeniption.--concerning the portfolio interest exemption, one confronts a confusing, and perhaps contradictory, array of statutory provisions and statements in the legislative history. beginning first with what is known with certainty, "interest" paid to a residual interest holder is treated for portfolio interest purposes as paid on or with respect to the obligations held by the remic, and not on or with respect to the residual interest itself. 6 this statement indicates that payments under a residual interest can qualify for the portfolio interest exemption, but only to the extent that the interest on the underlying mortgages held by the remic would so qualify had the foreign person held them directly. this "look-through" approach has two significant consequences. first, portfolio interest treatment is available only to the extent the remic mortgages were issued after july 18, 1984 (the general effective date of the portfolio interest rules). second, the mortgages must be in registered formr-a requirement that typically will not be met in the case of traditional residential mortgages. as an aside, the look-through approach may make sense from a tax policy perspective insofar as it limits the portfolio exemption to mortgages issued after the july 18, 1984 effective date. and such look-through treatment is in fact the approach taken with respect to pass-through certificates for purposes of the july 18, 1984 effective date. s however, the rationale for following a look-through approach with respect to the registration requirement is suspect. first, the residual interest itself is, and must be, in registered form, 9 making it difficult to perceive the tax policy goal at stake in looking through to the mortgages. second, the burden of meeting the registration requirement imposed under the look-through approach is readily skirted by establishing a double remic structure (the remic regular interests are in 256. regs. § 35a.9999-5(e), a-21(ii). the regulation does not substantively define when payments under a residual interest are treated as interest; rather, it merely declares that any payments that do constitute interest are eligible for portfolio interest treatment as described in the text. however, as noted above, the-legislative history fills in this gap by stating that all payments on a residual interest constitute interest. see supra notes 252-53 and accompanying text. 257. irc § 871(h)(2) (requiring debt to be in registered form unless it meets the socalled "tefra d" rules). on the definition of registered, see regs. § 5f.103-1(c)(l). 258. regs. § 35a.9999-5(e) a-21(i). 259. regs. § 1.860d-1(b)(5)(i)(a). 19941 florida tax review registered form and are treated as newly issued debt instruments). it is certainly a grand exaltation of form over substance that would distinguish between a single remic and double remic structure in applying the registration requirement. 26' third, and related to the second point, the lookthrough approach in this context would have the effect of distinguishing between remic collateral in the form of residential mortgages and collateral in the form of pass-though certificates based on those same residential mortgages-indeed a subtle and ethereal distinction.261' fourth and finally, the regulations expressly reject a look-through approach with respect to the registration requirement in the case of pass-through certificates.262 assuming, however, that a residual interest is able to satisfy the effective date and registration requirements for portfolio interest treatment, a host of other definitional elements must also be met. in general, however, with two potential exceptions, these other elements should not pose a problem.263 the first such definitional element that warrants further attention is the rule that portfolio interest does not include any interest received 260. of course, the double remic structure can also be used to skirt the lookthrough approach to the july 18, 1984 effective date. 261. this point is made in a.b.a. sec. tax'n, comments on proposed regulations governing real estate mortgage investment conduits (june 16, 1992), reprinted in 26 highlights & documents 1325, 1330 (july 24, 1992) [hereinafter american bar association comments on proposed regulation]. 262. pass-through certificates are treated as separate debt instruments for purposes of the registration requirement and thus they, and not the underlying obligations to which they relate, must be in registered form. the regulations take this approach because pass-through certificates would not otherwise be treated as debt instruments subject to the registration requirement and would present potential compliance problems. see staff of the joint comm. on taxation, 98th cong., general explanation of the revenue provisions of the deficit reduction act of 1984, 396 n.19 (joint comm. print 1984). remic residual interests present no such compliance problems since, by virtue of regs. § 1.860d-l(b)(5)(i)(a), they are registration-required obligations. it is something of a perverse twist of logic that the regulations ignore the mortgages and apply the registration requirement at the level of the pass-through certificate, but in the case of a residual interest, which is a registration-required obligation, they ignore the actual security held by investors and look through to the underlying mortgages. 263. were a foreign bank to acquire a remic residual interest, one additional hurdle, which is not addressed in the text, is the potential treatment of payments on such interest as received by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business. see irc § 881(c)(3)(a). in effect, by purchasing the residual interest, one might argue that the bank owns the remic assets subject to the liability represented by the regular interests, and, as the owner of the assets, the bank could be viewed as the lender under the remic mortgages. although the scope of the bank exception is unclear, it is difficult to argue for its application in such circumstances (e.g., the residual interest holder does not receive basis for the liabilities represqnted by regular interests). [vol. 2:4 tax aspects of remic residual interests by a "10% shareholder" of the payor entity.2 ' a 10% shareholder is specifically defined as a person that owns 10% or more of the total combined voting power of all classes of stock of a payor-corporation, or, in the case of a partnership, a person that owns 10% or more of the capital or profits interest in such partnership.s although a residual interest holder is certainly an equity holder in the remic, it is clear that the remic is not viewed as a corporation or a partnership (or a trust) for purposes of the subtitle of the code that includes the withholding tax provisions. '6 this fact, perhaps together with the full-fledged look-through approach that is adopted elsewhere with respect to residual interests, indicates that even the sole residual interest holder in a remic should not run afoul of the 10% rule, 7 unless perhaps the holder is a 10% shareholder with respect to one or more of the obligors under the mortgages held by the remic.' a second exception concerns the newly enacted section 871(h)(4), which excludes from portfolio interest treatment certain contingent interest obligations. in general, subject to the application of certain exceptions, amounts paid on a residual interest would literally constitute interest that is determined by reference to "income or profits of the debtor"' and therefore would be contingent interest for this purpose. however, such interest may escape contingent interest treatment by virtue of the exception for "interest all or substantially all of which is determined by reference to any other interest not described in subparagraph (a) (or by reference to the principal amount of indebtedness on which such other interest is paid). '' 0 the amounts paid on a residual interest will be determined in large part by the timing and amount of payments of interest and principal on regular interests and to this extent payments on a residual interest may fall within the 264. irc §§ 871(h)(3), 881(c)(3)(b). 265. irc § 871(h)(3)(b). 266. see irc § 860a(a). the subtitle of the code for purposes of which the classification rule applies is subtitle a, which encompasses §§ 1-1563. 267. a collateral issue concerns the application of the 10% shareholder rule to interest paid on a remic regular interest that is held by a person who also holds a 10% or greater interest of the residual interests in the remic. 268. in addition to the 10% rule, a similar question could be raised regarding the exclusion of interest received by a controlled foreign corporation ("cfc") from a related person (as defined in § 864(d)(4)). once again, read literally, a residual interest holder that constituted a controlled foreign corporation does not fall within the categories of a related person vis-a-vis the remic, as set forth in § 267(b). absent further guidance, the best interpretation may be to apply the cfc rule on a look-through approach and focus on the relationship of the obligors under the remic mortgages and the residual interest holder. 269. irc § 871(h)(4)(a)(i)(ii). 270. irc § 871(h)(4)(c)(iii). 1994] florida tax review foregoing exception." certainly it would be sensible-and consistent with the look-through approach described above-to look through to the remic assets and take the position that, to the extent that such assets earned a return that was not contingent within the meaning of section 871(h)(4), payments on the residual interest would be viewed as noncontingent. this approach has the virtue of protecting the fisc against use of a residual interest, in effect, to pass through contingent interest (e.g., mortgagor profits), but it is unclear whether this interpretation would prevail under section 871(h)(4).2 a final issue raised by the portfolio interest rules concerns the treatment of excess inclusions. as described above, such amounts are intended to be taxed in all events and section 860g(b)(2) provides that "no exemption from the taxes imposed by [sections 871(a), 881, 1441, and 1442] (and no reduction in the rates of such taxes) shall apply to any excess inclusion." 273 it is thus clear that excess inclusions are not intended to be eligible for portfolio interest treatment. were withholding taxes applied at the time that income accrued under a residual interest, applying this rule would be straightforward; to the extent that the current accruals were excess inclusion amounts no exemption would apply. however, as discussed in greater detail below, withholding taxes do not apply at the time of accrual, but rather at the time an actual payment is made on a residual interest. there is no provision in the statute or regulations for, tracing a payment or distribution under a remic to specific income accruals. thus, no rule exists for identifying payments as payments of excess inclusion amounts or other amounts (a curious void in the statute and regulations). the nub of the problem, therefore, is the lack of an accounting rule (lifo, fifo, et al.) to determine to what extent distributions on a residual interest are considered distributions of excess inclusions. on the one hand, it could be forcefully argued that to the extent that excess inclusions truly are phantom income accruals, then by definition there never will be any cash attributable to them for the remic to distribute.274 271. payments on a residual interest can be influenced by other factors that do not fit within the exception, such as profitable dispositions of foreclosure property and equity kickers or other contingent payment provision of a mortgage. typically, however, such features play only a small role, if any, in the amount of income on a residual interest. 272. cf. regs. § 1.856-3(b)(2)(iii) (providing that the look-through approach applies if the residual interest is held for the primary purpose of passing through mortgagor net profits or shared appreciation). 273. the legislative history echoes this, providing that excess inclusions are "not eligible for any reduction in the rate of withholding tax (by treaty or otherwise) in the case of a nonresident alien holder." h.r. conf. rep. no. 841, supra note 31, at 11-234, reprinted in 1986 u.s.c.c.a.n. at 4322. 274. this point is recognized in american bar association comments on proposed regulations, supra note 261, 26 highlights & documents at 1329 (july 24, 1992). [vol 2:4 tax aspects of remic residual interests cash distributions in this sense will always be attributable to nonexcess inclusion amounts. however, as we have seen, excess inclusions only imperfectly capture the phantom income phenomenon and it would be an overstatement to conclude that remic distributions can never consist of excess inclusion amounts. certainly congress thought that some portion of remic payments would be excess inclusions; otherwise, its statement that withholding exemptions would not apply to such amounts is meaningless. what should the accounting rule be? the harshest rule would be to assert that all distributions are first treated as excess inclusions, to the extent such amounts have accrued, and only amounts distributed in excess thereof are eligible for withholding exemptions. nothing in the statute or regulations or in tax policy can be said to compel that rule, other than a visceral desire to further punish residual interests. 275 the opposite rule would be to treat a distribution as consisting of excess inclusion amounts only to the extent that the amount of the distribution exceeds the amount of nonexcess inclusion amounts that have accrued. that approach also lacks any support, although it can be viewed as consistent with the point made above that generally there will be no cash attributable to phantom income to distribute. perhaps the more neutral answer would be to craft some form of pro rata rule under which only a portion of remic distributions is allocated to excess inclusion amounts. b. tax treaty relief.-apart from the possible application of the portfolio interest exemption, payments on a residual interest may be subject to withholding tax relief under tax treaties. a full discussion of tax treaties as they might apply to a foreign holder of a residual interest is beyond the scope of this article, although in many respects residual interests present the same treaty issues and concerns that any financial instrument presents. two particular treaty aspects, however, warrant further discussion. first, what is the character of residual interest payments under tax treaties? second, how do treaty relief provisions interact with the special rules in the code regarding excess inclusions? it was observed above that for u.s. withholding tax purposes, payments on a residual interest are considered "interest," but it remains to be investigated whether this characterization applies for treaty purposes as well. in general, u.s. tax treaties deal with the threshold issue of what is interest in different respects. the u.s. model treaty, for example, provides a specific definition of "interest" as follows:276 275. this is, however, the recommendation of the american bar association. id. 276. u.s. department of the treasury, proposed model convention between the united states of america and for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital. june 16. 1981, art. 11, para. 19941 florida tax review [i]ncome from debt claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities, and income from bonds or debentures, including premiums or prizes attaching to such securities, bonds, or debentures. penalty charges for late payment shall not be regarded as interest for the purposes of this convention. although resort may be had to u.s. tax laws in interpreting such terms as "debt claims" or "bonds or debentures," 277 no firm basis can be found in such laws for treating a remic residual interest as a debt instrument, except for certain specifically defined purposes.278 thus, notwithstanding the intention of the legislative history that payments on residual interests constitute interest for withholding tax purposes, there is reason to doubt whether the u.s. model treaty and tax treaties with similar definitions of "interest" in fact would so treat residual interest payments. 79 example of a treaties that present this potential problem are the treaties with india and hungary.28° although the scope of the definition of "interest" in the u.s. model treaty is uncertain regarding payments on residual interests, many recent treaties contain a broader definition.28" ' for example, in the recent treaty 3 [hereinafter u.s. model treaty]. the u.s. model treaty definition is identical to the definition of interest in the organization for economic co-operation and development (oecd) model double taxation convention on income and capital (1977), art. 11, para. (3). 277. u.s. model treaty, supra note 276, art. 3, para. 2 (allowing undefined terms to be interpreted by a contracting state in accordance with the law of that state concerning the taxes to which the treaty applies). 278. see supra note 253 and accompanying text (stating that residual interests are treated as a debt obligation for purposes of § 582(c)); see also infra note 383 and accompanying text (stating that residual interests are treated as qualifying real property loans for thrifts). 279. disparate definitions of interest would not represent a conflict between treaty and statute, such that one must trump the other. rather, it would merely be a case where the united states and the other contracting party have decided to extend treaty benefits to a class of interest receipts that is narrower than the u.s. definition of interest. 280. convention between the government of the united states of america and the government of the republic of india for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, sept. 12, 1989, u.s.-india, art. 1i, para. 4, s. treaty doc. no. 101-5; convention between the government of the united states of america and the government of the hungarian people's republic for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, feb. 12, 1979, u.s.-hung., art. 10, para. 2, 30 u.s.t. 6357. 281. some treaties contain no definition of interest, in which case, in applying u.s. withholding taxes to the interest receipts of a treaty country resident, the u.s. domestic definition applies (i.e., payments on residual interests constitute interest). see, e.g., convention between the united states of america and new zealand for the avoidance of double [vol, 2:4 tax aspects of remic residual interests with germany, interest is defined as including "all other income that is treated as income from money lent by the taxation law of the contracting state in which the income arises."' the latter type of definition clearly is intended to make the treaty definition of interest co-extensive with the u.s. domestic definition of interest (subject to any specific exceptions noted in the treaty). thus, to the extent that, under general u.s. tax principles, payments on a residual interest are treated as interest, they are to be so treated in applying the treaty." of course, even where the treaty definition of "interest" does not clearly encompass residual interest payments, it may be that such payments are covered by the "other income" article of the treaty. in many cases, other income is treated as favorably as interest and entitled to exemption from the imposition withholding taxes by the source country.' residual interest payments may also fall within the treaty definition of "dividends," and therefore be entitled to different, less favorable treaty benefits. 2m taxation and the prevention of fiscal evasion with respect to taxes on income, july 23, 1982, u.s.-n.z., art. 11, t.i.a.s. 10772. 282. convention between the united states of america and the federal republic of germany for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital and to certain other taxes, august 29, 1989, u.s.g.d.r., art. 11, para. 2, s. treaty doec. no. 101-10; see also convention between the united states and mexico for avoidance of double taxation and prevention of fiscal evasion with respect to income taxes, including protocol, sept. 18, 1992, u.s.-mex., art. 11, para. 5, s. treaty doc. no. 103-7; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, dec. 18, 1992, u.s.-neth., art. 12 para. 2, s. treaty doec. no. 103-6. some older treaties contain a slightly different wording: "all other income assimilated to income from money lent by the taxation laws of the contracting state." see, e.g., convention between the united states of america and canada with respect to taxes on income and on capital, sept. 26, 1980, u.s.-can., art. 11, para. 4, t.i.a.s. 11087; convention between the united states of america and japan for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, mar. 8. 1971, u.s.-jap., art. 13, para. 7, 23 u.s.t. 967. it does not appear that the "assimilated' vs. "treated" distinction leads to any material difference in interpretation. 283. the interest treatment, in fact, is confirmed in certain recent treaties, which contain provisions in the article on interest that expressly withdraw treaty benefits for excess inclusions on remic residual interests. see, e.g., u.s.-mex. treaty, supra note 282, protocol 10(a), s. treaty, doec. no. 103-7; u.s.-neth treaty, supra note 282 art. 11, para. 7. s. treaty doec. no. 103-6. the existence of such provisions serves to confirm that payments on residual interests otherwise constitute interest under the broader definition of interest in most recent treaties. 284. see, e.g., u.s.-hung. treaty, supra note 280, art. 19, 30 u.s.t. 6357. 285. for example, the definition of dividends in art. 10, para. 3, of the treaty with india could be interpreted broadly to encompass payments on a remic residual interest. u.s.india treaty, supra note 280, s. treaty doec. no. 101-50. 19941 florida tax review if a non-u.s. person that is a resident of a treaty country receives residual interest payments and such payments are safely viewed as interest under the applicable treaty, a further issue that arises is whether the treaty benefits that are otherwise available to interest will apply. the principal concern in this regard is the treatment of excess inclusion amounts. section 860g(b)(2) proclaims that "no exemption from the taxes imposed by [sections 871(a), 881, 1441, and 1442] (and no reduction in the rates of such taxes) shall apply to any excess inclusion." although the statute makes no specific reference to tax treaties, the legislative history clarifies that section 860g(b)(2) is intended to trump "any reduction in rate of withholding (by treaty or otherwise) in the case of a nonresident alien holder." 286 assuming for the moment that one can identify the portion of residual interest payments that represent excess inclusion amounts," 7 the intent of section 860g(b) is clearly to override contrary treaty provisions that would otherwise provide an exemption or reduced withholding rate for such income. and at least with respect to treaties in force at the time of the 1986 act, section 860g(b) is doubtlessly effective in overriding contrary treaty provisions. 8 however, for treaties that entered into force after the 1986 act, the answer must be that section 860g(b) is not effective, absent express treaty language indicating that no override of section 860g(b) is intended. under the "later in time" rule, subsequent treaty provisions, to the extent in conflict with section 860g(b)(2), are controlling.289 although this may not be the 286. h.r. conf. rep. no. 841, supra note 31, at 11-234, reprinted in 1986 u.s.c.c.a.n. at 4322. 287. see supra text accompanying notes 273-75 (discussing when a payment is attributable to excess inclusion accruals). 288. that subsequently enacted legislation can override prior contradictory treaty provisions is well established. reid v. covert, 354 u.s. 1, 18 (1956). additionally, § 7852(d)(1) states that neither a treaty or law is to be preferred. in order for subsequent legislation to effect an override, it has been held that congress must clearly express such intent. cook v. united states, 288 u.s. 102, 120 (1933). but see s. rep. no. 445, 100th cong., 2d sess. (1988), reprinted in 1988 u.s.c.c.a.n. at 4885-88 (questioning the need for congress to advert to contrary treaty provisions). the validity of this treaty override doctrine has been questioned. see, e.g., david sachs, is the 19th century doctrine of treaty override good law for modem day tax treaties?, 47 tax law. 867 (1994) (criticizing the doctrine of treaty override). the legislative history of § 860g(b) probably represents a clear expression of congressional intent to override inconsistent treaty provisions, although in 1988 when congress attempted to list provisions of the 1986 act that contradicted treaty provisions it overlooked § 860g(b). see technical and miscellaneous revenue act of 1988, pub. l. no. 100-647, § 1012(aa)(2), (3), 102 stat. 3342, 3531. 289. the "later in time" rule provides that a subsequent statute overrides a conflicting treaty provisions, but, conversely, a subsequent treaty provision overrides a conflicting prior statute. the legislative history of § 7852(d) expressly states that congress intended to codify this rule in the 1988 amendments to this section. s. rep. no. 445, supra note 39, at 318, reprinted in 1988 u.s.c.c.a.n. at 4829-30. [vol 2:4 tax aspects of remic residual interests result the drafters intended, it can hardly be considered surprising; the treasury department clearly retains the power to bargain away section 860g(b)(2) if it so desires in future tax treaties. of course, it may be argued that in enacting section 860g(b), congress intended not only to override existing treaties, but also any future treaties as well. two responses may be made to that argument. first, the existence of such intent is questionable, since no express statement to this effect was made.' second, even if such intent were evidenced, it is doubtful whether it would have any effect." the issue is somewhat academic, since the treasury department now recognizes that the interest article in recent treaties, absent special provision, will operate to override section 860g(b) and has taken steps to prevent that result. for example, in the recent tax treaty between the united states and the netherlands it is expressly stated that the united states retains its right to impose full withholding on excess inclusions under remic residual interests. 2 a similar provision exists in the treaty with mexico.' yet, the treasury department was slow to realize the relationship of the remic provisions to its treaty program and, as a result, a few recent treaties entered into force without any restriction on the availability of treaty benefits for reivic excess inclusion amounts. such treaties would include those with the federal republic of germany, finland, spain and tunisia. in sum, for treaties that entered into force after the effective date of the 1986 act, payments on residual interests are entitled to the full benefits under the treaty, notwithstanding section 860g(b), unless the treaty specifically excludes them. although recently the treasury department has negotiated treaties that do specifically exclude excess inclusions, a few post-1986 treaties apparently slipped through. thus, for example, it appears that under the u.s.federal republic of germany treaty, which entered into force on august 21, 1991, all payments on residual interests (including excess inclusions) should 290. this is in contrast to other instances where congress expressly stated that a code provision is to override any future inconsistent treaty provisions. see tax reform act of 1986, pub. l. no. 99-514, § 1810(a)(4). 100 stal 2085, 2821 (relating to irc § 904(g)). 291. in the first place, it would be contrary to the established "later in time" principle. second, the attempt of congress to tie the hands of the executive branch and the senate in future treaty negotiations might well be unconstitutional. the american law institute, proposals on united states income tax treaties, federal income tax project 71 (1991). 292. u.s.-neth. treaty, supra note 283, art. 12, para. 7. s. treaty doc. no. 103-6; protocol, dec. 30, 1993, s. treaty doc. no. 103-19. similar provisions are contained in other recently ratified treaties, including treaties with france, s. treaty doc. no. 103-32; russia. s. treaty doc. no. 102-39; israel, s. treaty doc. no. 103-16; czechoslovakia, s. treaty doc. no. 103-17; the slovak republic, s. treaty doec. no. 103-18; and the protocol to the treaty with barbados, s. treaty doc. no. 102-41. 293. see supra note 282. 19941 florida tax review be fully exempt from u.s. withholding taxes under article 11(1), to the extent the recipient otherwise qualifies for the benefits of that article.294 2. time and manner of withholding.-section 860g(b)(1) provides that amounts includible in the gross income of a nonresident alien holder are to be taken into account for u.s. withholding tax purposes when such amounts are paid or distributed (or when the interest is disposed of).295 thus, a foreign holder is subject to withholding taxes on remic income only when, and to the extent that, amounts are actually paid or distributed by the remic (or upon disposition).296 thus, if the remic never distributes any cash, then there is nothing to which withholding taxes can attach. alternatively, if cash distributions are delayed, for example, until the end of the life of the remic, substantial deferral can be obtained.297 by tying the application of withholding taxes to actual distributions, congress was not adopting a novel approach, but was merely applying the general rule that withholding taxes do not apply until amounts are actually paid to the foreign person.298 moreover, this treatment comports specifically with the treatment of debt instruments issued with original issue discount, a closely analogous situation. notwithstanding the general timing rule of section 860g(b)(1), the legislative history provides that a different rule may be appropriate in certain tax avoidance situations: the conference agreement also provides that under regulations, the amounts includible may be taken into account earlier than otherwise provided where necessary to prevent avoidance of tax. the conferees intend that this regulatory 294. id. 295. irc § 860g(b)(1). 296. id. 297. as discussed infra part vii.d., however, transfer restrictions substantially eliminate these strategies now. 298. see irc §§ 871(a), 881(a), (withholding tax equals "30 percent of the amount received ') (emphasis added); regs. § 1.1441-1 (withholding taxes apply "when such income is paid to a nonresident"). see generally harvey p. dale, withholding tax on payments to foreign persons, 36 tax l. rev. 49, 73-74 (1980) (noting that withholding generally applies on a cash basis). a statutory exception to this cash basis approach is provided for partnerships, under which withholding applies to a foreign partner's distributive share, whether or not actually distributed. irc § 1441(b); regs. § 1.1441-3(f). significantly, congress opted not to adopt such a rule for remics. [vol 2:4 tax aspects of remic residual interests authority may be exercised where the residual interest in the remic does not have significant value.' the service to date has chosen not to exercise this authority. instead, it has chosen to attempt to combat tax avoidance transfers to foreign persons through substantive restrictions on the type of residual interest that may be transferred to a foreign person."° although the legislative history quoted above is not clear about how much earlier one could take amounts into account, one approach that could be taken is to impose withholding at the time of "distributions" (as expansively defined), but impose it on the present value of anticipated excess inclusion amounts."' thus, for example, if negative value residual interest is transferred by a sponsor on the startup day to a foreign person along with an up-front payment, under the foregoing rule withholding could attach to the up-front payment in an amount equal to 30% of the anticipated excess inclusions. apart from the time at which withholding attaches, a related question is the manner in which withholding is accomplished. on this score, neither the statute nor the legislative history provides specific guidance. probably the most reasonable approach is to follow the rules that apply in the case of debt instruments with oid.3 2 in this regard, the code specifies that when payments are made on a bond, tax is withheld therefrom in an amount equal to the lesser of (i) 30% (or such lesser treaty rate) of the old accruals to date for the period that the foreign person has held the bond, and (ii) the amount of such payment as reduced by any withholding on such payment. 3 in the case of a sale or exchange of a residual interest, an amount of the proceeds of such sale equal to the income on the residual interest accruing while the foreign person held it is subject to withholding taxes, even if such amount is in excess of the gain realized on the disposition.' of course, if the foreign holder has no proceeds from the sale, then there is nothing to 299. h.r. conf. rep. no. 841, supra note 31, at 11-236. reprinted in 1986 u.s.c.c.a.n. at 4324. 300. see infra part vii.d. 301. the rule thus would be analogous to the tax in § 860e(e) on transfers of residual interests to disqualified persons. 302. the legislative history specifically provides that in the case of a disposition of a residual interest, the withholding rules are to apply in the same manner they apply upon the disposition of an instrument with oid. see h.r. conf. rep. no. 841, supra note 31, at 11-236 n.18, reprinted in 1986 u.s.c.c.a.n. at 4324. it would be reading too much into this statement to conclude that the withholding rules applicable to old instruments prior to disposition are not to apply, although it is a bit puzzling that congress focused on the need for rules for dispositions of residual interests, but overlooked the need for rules in all other cases. 303. irc §§ 1441(a), (b); 871(a)(1)(c). 304. irc § 871(a)(1)(c)(i). 19941 florida tax review which withholding can apply. it is unclear what rule should apply if a foreign holder makes a payment to a person to take ownership of the residual interest. b. securities dealers one type of residual interest holder that warrants special attention is securities dealers. the recent enactment of section 475305 has broadened the concept of a securities dealer and sharpened the consequences of that status, but it has also complicated and confused the analysis. although a comprehensive discussion of the tax rules relevant to securities dealers is beyond the scope of this article, several selected issues warrant special attention. one principal issue that arises is whether remic residual interests actually are "securities" in the first place. in general, there seems to be no question that residual interests may be securities at least in some instances, but the service currently is unwilling to treat what it terms "negative value" residual interests as securities for some purposes. however, even if one assumes that residual interests are securities in some instances, a second issue that arises relates to how the rules applicable to securities dealers should apply in the case of residual interests. finally, apart from the status of residual interests as securities and the rules applicable thereto, an issue arises regarding when a person should be considered a dealer with respect to residual interests. 1. remic residual interests as securities a. in general.-the code and regulations do not contain a comprehensive definition of a "security," but rather provide several discrete definitions tailored to specific code provisions. 306 the remic rules give 305. section 475 was enacted as part of the omnibus budget reconciliation act of 1993, pub. l. no. 103-66, § 13223, 107 stat. 312, 481. in general terms, § 475 provides that a dealer in securities must include all securities carried in inventory at their fair market value or, in the case of securities not included in inventory, mark such securities to market unless (among other exceptions) it has specifically identified the securities as held for investment. section 475 has received an unusual amount of attention by the service since its enactment. shortly after enactment of § 475, the service issued i.r.s. notice 93-45, 1993-2 c.b. 334, extending the effective date for the identification. the service subsequently issued rev. rul. 93-76, 1993-2 c.b. 235, providing limited guidance on certain issues under § 475. then on december 28, 1993, in an unusual display of alacrity, the service released temporary and proposed regulations under § 475. temp. regs. §§ 475(b), (c), 1994-4 i.r.b. 4 (dec. 28, 1993), and immediately thereafter issued rev. rul. 94-7, 1994-3 i.r.b. 6, amending rev. rul. 93-76 in light of the regulations. 306. see, e.g., irc § 165(g)(2) (defining security for purposes of a deduction upon worthlessness); irc § 475(c)(2) (defining a security for purposes of the mark-to-market [vol 2:4 tax aspects of remic residual interests only minimal guidance on when residual interests are to be treated as securities under code. for example, section 860f(d)(1) provides that all residual interests are to be treated as securities for purposes of the wash sale rules. °7 similarly, section 582(c) provides that residual interests are to be treated as evidences of indebtedness for purposes of the rule applicable to banks and thrifts treating gain or loss from the sale or exchange of evidences of indebtedness as ordinary in character.m beyond that, the remic provisions are silent as to the status of residual interests as securities for other purposes under the code. two distinct definitions of a security that are of particular importance for securities dealers are those contained in section 475 and section 1236. the status of a residual interest under each is discussed below. b. section 1236(c).-section 1236 provides that gain by a dealer on the sale or exchange of any security will not be treated as capital gain unless the dealer has timely identified the security as held for investment and the security was not at any time held primarily for sale to customers in the ordinary course of business.3' similarly, no loss will be treated as ordinary if at any time it was identified as held for investment."' however, mere failure to identify does not mean securities are automatically treated as inventory;3" rather, in such case, gains will be ordinary (because of the failure to identify), but losses will be capital if the facts indicate that the security was in fact held for investment. section 1236(c) broadly defines a "security" for this purpose as: requirement); irc § 852(b)(3) (adopting the lengthy definition of a security in the investment advisors act of 1940); irc § 1091(c) (defining a security for wash sale purposes); irc § 1236(c) (defining a security for purposes of the identification requirement for securities held for investment by securities dealers); regs. § 1.864-2(c)(2) (defining a security for purposes of the securities trading exemption in § 864(b)(2)); regs. § 1.864-4(c)(5)(v) (defining security for purposes of determining the effectively connected income of foreign banks). 307. see irc §§ 860f(d)(1), 1091. 308. irc § 582(a). see also § 593(d)(4) (treating both residual and regular interests as qualifying real property loans in computing the bad debt reserve deduction for thrift institutions); see infra part vi.c.i. (discussing § 593(d)(4)). 309. irc § 1236(a). the temporary regulations provide that a timely identification for purposes of § 1236, that was in effect as of the close of the last taxable year ending before december 31, 1993, is treated as a timely identification for purposes of § 475. temp. regs. § 1.475(b)-2(a)(1). 310. irc § 1236(b). an exception to this rle exists for losses on evidences of indebtedness held by a bank or thrift, which are always ordinary (as are gains). irc § 582(c). a remic residual interest is an evidence of indebtedness for this purpose. id. 311. stephens, inc. v. united states, 464 f.2d 53, 61 (8th cir. 1972). cert. denied, 409 u.s. 1118 (1973). 19941 florida tax review [a]ny share of stock in any corporation, certificate of stock or interest in any corporation, note, bond, debenture, or evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing."' that mortgages are securities for purposes of the foregoing definition is settled.3 13 that a residual interest is an "evidence of an interest in" the mortgages held by the remic seems equally clear. accordingly, based on the literal language, residual interests would appear unquestionably to be securities for purposes of section 1236. further, nothing in the language of section 1236 indicates that only residual interests that meet some minimum economic threshold are to be so treated. even residual interests that entitle the holder to zero cash seemingly qualify as securities. one might argue that in the case of the latter type of residual interest, the holder has effectively surrendered any interest in the mortgages (i.e., all of the cash flows have been sold to the regular interest holders). yet, it would be something of a stretch to assert that the residual holder has no evidence of any interest in the mortgages. if nothing else, the holder often may have the right to instruct the trustee to liquidate the remic at some point and may have the right to purchase the remaining mortgages. further, the income and losses of the holder (albeit largely phantom income and losses) directly flow from the underlying mortgages and in this sense the holder certainly does have a type of interest in the mortgages. in sum, a straightforward reading of section 1236(c) indicates that all residual interests, regardless of their economic attributes, should be viewed as securities for purposes of that section. c. section 475 in general.-newly enacted section 475 provides, in general, that securities held by a dealer in securities must (i) if they constitute inventory, be included in inventory at fair market value, or (ii) if they are not inventory, be "marked to market" at year-end.314 an exception is provided for securities held for investment, provided they are timely identified as such by the dealer.3 5 a "security" for this purpose is broadly defined to include any: 312. irc § 1236(c). 313. see rev. rul. 72-523, 1972-2 c.b. 242. 314. irc § 475(a)(1), (2). section 475 was enacted as part of the omnibus budget reconciliation act of 1993, supra note 305, at § 13223, 107 stat. at 481. 315. irc § 475(b)(1)(a). other exceptions apply to securities that are a hedge with respect to investment securities or to nonsecurities, and securities that are acquired or originated in the ordinary course of the taxpayer's trade or business and which are not held [vol 2:4 tax aspects of remic residual interests (a) share of stock in a corporation; (b) partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; (c) note, bond, debenture, or other evidence of indebtedness; (d) interest rate, currency, or equity notional principal contract; (e) evidence of an interest in, or a derivative financial instrument in, any security described in (a), (b), (c), or (d), or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency; and (f) position which is(i) not a security described in (a), (b), (c), (d), or (e), (ii) is a hedge with respect to such a security, and (iii) is clearly identified in the dealer's records as being described in this subparagraph before the close of the day on which it was acquired or entered into (or such other time as the secretary may by regulations prescribe). 6 notwithstanding this sweeping definition of a security, in recently issued temporary regulations317 the service has acted to rein in the broad statutory definition in certain respects. in particular, the temporary regulations provide that the term "security" in section 475(c)(2) does not include remic residual interests that have "negative value," ' effective for taxable years for sale. irc § 475(b)(1)(b), (c). 316. irc § 475(c)(2). an instrument that would otherwise be a security under (e) is not so treated if it is a contract to which § 1256 applies. id. 317. temp. regs. § 1.475(c)-i, -2, 58 fed. reg. 68,747. 68,750 (1993). 318. temp. regs. § 1.475(c)-2(a)(3). in addition to negative value residual interests, the regulations exclude from the definition of a security (i) stock (including treasury stock) of the taxpayer and any option to buy or sell its stock (including treasury stock), or (ii) a liability of the taxpayer. id. 1994] florida tax review ending on or after december 31, 1993. 3 9 a negative value residual interest is defined as any residual interest if, on the date the taxpayer acquires the residual interest, the present value of the anticipated tax liabilities associated with holding the interest exceeds the sum of (i) the present value of the expected future distributions on the interest, and (ii) the present value of the anticipated tax savings associated with holding the interest as the remic generates losses.320 for this purpose, anticipated tax liabilities, expected future distributions, and anticipated tax savings are determined under the rules in regulations section 1.860e-2(a)(3) (and without regard to the operation of section 475),321 and present values are determined under the rules in regulations section 1.860e-2(a)(4).32 2 moreover, if a person acquires a residual interest in a "carryover" basis transaction, then such person is considered to have acquired it when the transferor acquired the residual interest (or is deemed to have acquired it under this rule).323 in addition to negative value residual interests as defined above, the regulations state that the term "security" will not include "an interest or arrangement that is determined by the commissioner to have substantially the same economic effect [as a negative value residual interest]. 324 the preamble to the regulations provides some elaboration on this, giving as an example--"a widely held partnership that holds noneconomic remic residual 319. the effective date has retroactive effect since taxpayers having purchased residual interests prior to the issuance of regulations with view to marking them to market will not be permitted to do so. this is harsh; some taxpayers bought residual interests at a price calculated by reference to the applicability of mark to market treatment in reasonable reliance on the broad definition of a security in the statute. such taxpayers had no notice that negative value residuals would be excluded from the definition of security. 320. temp. regs. § 1.475(c)-2(b), (c). 321. temp. regs. § 1.475(c)-2(c)(2). that is, one computes these anticipated or expected items "based on (i) [e]vents that have occurred up to the time of the transfer; (ii) [tihe prepayment and reinvestment assumptions adopted under section 1272(a)(6) or that would have been adopted if the remic's regular interests had been issued with original issue discount and (iii) [any required or permitted clean up calls, or required qualified liquidation provided for in the remic's organizational documents." regs. § 1.860e-2(a)(3). in computing anticipated tax savings, apparently one would refer to the particular tax rate applicable to a holder and any peculiar facts that relate to a holder's ability to utilize tax losses from the residual interest. 322. temp. regs. § 1.475(c)-2(c)(3). under these rules, future tax savings and future distributions are discounted by the applicable federal rate (as specified in § 1274(d)(1)) that would apply to a debt instrument issued on the day the dealer acquired the residual interest and whose term ended presumably when the residual interest is expected to be retired. regs. § 1.860e-2(a)(4). the discounting of future tax savings probably is done from the end of each calendar quarter, but the discounting of future distributions should be from the time such distributions are expected to occur. 323. temp. regs. § 1.475(c)-2(c)(1). 324. temp. regs. § 1.475(c)-2(a)(3). [vol 2:4 tax aspects of remic residual interests interests."'3" this evidences a concern that one could get around the negative value residual rule by "wrapping" the negative value residual within some other type of security (i.e., a widely held partnership interest), although it is unclear how much of a threat such a ruse would otherwise be. the preamble, moreover, goes on to solicit comments on whether additional rules are needed for taxpayers that hold economic residual interests or interests in other pass through entities (including subchapter s corporations or widely held partnerships).326 in short, the service does not necessarily believe that it has solved the perceived problem by simply banishing negative value residual interests from section 475. thus, the service is making ominous rumblings about excluding from section 475 other residual interests that can have substantially the same economic effect, whatever that may be. this has created a fair amount of confusion and uncertainty in the marketplace regarding marking residual interests to market and no doubt this in terrorem effect was intended. one issue that arises in surveying the impact of the temporary regulations under section 475 is the existence of regulatory authority for excluding negative value residuals. the statutory definition of a "security" clearly encompasses remic residual interests (they are "an evidence of an interest in" debt instruments)327 and the regulatory authority granted to the service under section 475 does not specifically contemplate adjusting the definition of a security.32 however, the grant of regulatory authority does generally instruct the service to issue "such regulations as may be necessary or appropriate to carry out the purposes of the section,"" which is potentially broad enough to justify regulations restricting the definition of a security. in any event, according to the preamble, the basis for excluding negative value residuals is not only to carry out the purposes of section 475, but also to carry out the purposes of section 860e,33 although it is interesting to note that the service was not specifically granted regulatory authority under the remic rules to prevent avoidance of the excess inclusion rules in section 860e. 331 rethinking the concept of a "negative value" residual interest.-the regulations under section 475 single out the so-called "negative value" 325. 58 fed. reg. 68,747, 68,749 (1993). 326. id. in the case of arrangements involving partnerships. it appears the service has given itself a potent weapon in the new anti-abuse rule in prop. regs. § 1.701-2. see infra note 448 and accompanying text. 327. irc § 475(c)(2). 328. irc § 475(e). 329. irc § 7805(a). 330. 58 fed. reg. 68,747, 68,749 (1993). 331. see irc § 860g(e) (setting forth the service's regulatory authority). 19941 florida tax review residual interest and exclude it from the definition of a security for purpose of section 475.332 on closer analysis, the notion of a residual interest being treated as having negative value is rather arbitrary and detached from the reality of the marketplace. the regulations seem to recognize this fact in that they provide that a residual interest that is outside the definition of a negative value residual nevertheless may be recharacterized as a negative value residual interest if the service judges it to have substantially the same economic effect.333 this open-ended statement is something of a shot across the bow of securities dealers, warning them to move cautiously in marking "positive value" residual interests to market under section 475. it also, however, betrays the service's uncertainty about what should be the correct target and its uneasiness about its own definition of a negative value residual interest. the service's apparent anxiety is well justified; its attempt to define a class of residual interests that are somehow distinguishable from other residual interests by possessing negative value is doomed to fail. as noted above in the discussion of up-front payments, residual interests that provide for up-front payments are easily restructured as residual interests that provide for distributions, with little or no effect on the true economics of a transaction.334 similarly, a negative value residual interest often can be painlessly transformed into an positive value residual through minor tinkering with the structure. for example, the up-front payment that would always accompany a transfer of a negative value residual interest often can be built into the terms of the residual interest and paid out as cash distributions thereon during the first three months, or the first six months, or perhaps even the first year. by doing so, the negative value residual interest often can be metamorphosized into a positive value residual interest with little or no inconvenience. in short, negative value status is virtually elective. surely that cannot be acceptable to the service. the service seems to recognize this situation and has included broad, deterrent language in the regulations.335 yet, it seems equally clear that the service is not entirely certain of what the abuse is that it should be aiming at. at the root of the problem is the failure of the service to come to grips with up-front payments. perhaps a different perspective is in order. it has become pass6 to observe that residual interests may have zero or negative value and that they may in effect represent no more than a net liability for the holder. if one simply focusses on the cash entitlements under a residual interest and the anticipated future tax burdens, then indeed residual 332. temp. regs. § 1.475(c)-2(a)(3), -2(b). 333. see temp. regs. § 1.475(c)-2(a)(3). 334. see supra text accompanying note 154. 335. see temp. regs. § 1.475(c)-2(a)(3). [vol 2:4 tax aspects of remic residual interests interests frequently, if not most of the time, will lack positive value. yet, this is only half of the story. in assessing the economic character of a residual interest it is necessary not only to take into account the cash entitlements and the future tax burdens, but also the future tax benefits and the amount of any the up-front payment. all of these elements are integral parts of the issuance or transfer of a residual interest.336 the correct approach in analyzing the economics of a residual interest is to add the amount of any up-front payment to the present value of anticipated future tax benefits and cash distributions and subtract the present value of anticipated future tax burdens. this approach recognizes that the upfront payment is incident to the issuance or transfer of a residual interest and that it should offset the amount of the future tax burdens. the approach, hardly a novel one, amounts to treating the up-front payment, in essence, like a payment incident to a lending transaction (e.g., points) in the context of the issuance of a debt instrument.337 viewed in this manner, of course, no residual interest can be said to have been issued or transferred with negative value; by taking the up-front payment into account a residual interest will always have economic value in the eyes of the parties, since no rationale holder dealing on an arm's length basis would enter into a transaction in which it only stood to lose money. the bottom line is that there is no true dividing line between socalled negative value and positive value residual interests; generally, all residual interests are issued or transferred in transactions in the holder anticipates earning some minimum, positive return on its investment. some residuals are designed to provide the holder with a greater portion of its overall return in cash, whereas many others are designed to provide most or all of the return in kind through tax benefits. there would not appear to be any stopping point along the spectrum of residual interests that could serve to distinguish some residual interests from others based on the positiveness or negativeness of their economics. how then should the service decide which residual interests should and which should not be subject to mark to market treatment under section 475? one approach would be to abandon attempts to identify residual interests as having negative or positive value and focus on the real issue at 336. the regulations under § 475 recognize the need to weigh future tax burdens against future tax benefits when assessing the economics of a residual interest, but nowhere does the up-front payment figure into the calculation. see temp. regs. § i.475(c)-2(b) (defining negative value residual interest). 337. analogous treatment is provided in the original issue discount regulations for payments incident to a lending transaction. see regs. § 1.1273-2(g)(2) (providing that payments by the borrower to the lender reduce the issue price of a debt instrument): see also supra part iv.c.1.a. 19941 florida tax review stake. in general, the service's principal concern is that marking residual interests to market will give rise to deductions that will effectively offset excess inclusions. and in fact, the service's concern is correct. 33 ' however, 338. a simple illustration, one which builds on our earlier example, indicates the problem. consider a hypothetical remic residual interest, which carries zero principal and interest entitlement and which generates the income and losses indicated below. given these income and losses, the tax benefits/burdens, year-end values, and the holder's bases are readily determinable as set forth below: hypothetical residual interest (issued january 1 of year i) year residual interest tax (liability) value* basis income/(loss) /benefit** issuance -$(23.01) 0 1 $100.00 $(35.00) 10.61 100 2 75.00 (26.25) 37.69 175 3 50.00 (17.50) 57.71 225 4 25.00 (8.75) 69.43 250 5 0 0 73.59 250 6 (25.00) 8.75 69.26 225 7 (50.00) 17.50 55.91 175 8 (75.00) 26.25 31.15 100 9 (100.00) 35.00 0 0 */value = present value of future tax benefits less future tax liabilities. **/assuming 35% tax rate. if this hypothetical residual interest were subject to the mark to market rules of § 475, it would be treated as if it were sold at year-end for its fair market value. however, its fair market value will equal the present value of the future tax benefits less the present value of future tax burdens, and the value of the future tax benefits in turn will be affected by the availability of mark to market. this is because marking to market will have the effect of using up the holder's basis, which will then limit the holder's ability to use remic losses. after a series of iterative calculations, the result is that the holder can expect to receive no tax benefits from the losses. when all is said and done, the holder ends up with the following array of gains and losses on holding the hypothetical residual interest: year residual tax (liab.)/ value basis m-to-m inc./deds benefits gain issuance -$(78.01) $ 0 -1 $100.00 $(35.00) (47.69) 100.00 $(147.69) 2 75.00 (26.35) (24.30) 27.31 (51.61) 3 50.00 (17.50) (8.25) 25.70 (33.96) 4 25.00 (8.75) 0 16.75 (16.75) 5 0 0 0 0 0 6 0 0 0 0 0 7 0 0 0 0 0 8 0 0 0 0 0 9 0 0 0 0 0 totals $250.00 0 0 0 $(250.00) [vol. 2:4 tax aspects of remic residual interests the only way that marking a residual interest to market will not have this effect, to some degree, is to permit a residual interest to be marked to market only if the value of future benefits under the remic (tax benefits and cash distributions) at the end of each year when the mark would occur equals or exceeds the increase in the basis of the residual interest on account of excess inclusions. 339 such a test should ensure that losses from marking to market are exclusive of excess inclusions. although the test may appear complicated, in reality the technology largely already exists in the remic rules. taxpayers are currently required to project the stream of anticipated excess inclusions for purposes of the definition of a noneconomic residual interest. further, the regulations under section 475 now require the taxpayers to project the present value of future tax benefits.' ° it would not be that significant an increase in administrative burdens to require the taxpayer to compute the present value of future benefits (cash distributions and tax benefits) at the end of each future taxable year and require that such present values equal or exceed the basis of the residual interest at the beginning of year, as increased by the amount of excess inclusions that accrue for the year."' under such a test, unless the residual interest had an adequate stream of future benefits, based on an assumed prepayment rate, it would not be permitted to be marked to market by securities dealers. 2. selected rules applicable to securities dealers a. applying the current mark to market rules.-as described above, the current mark to market rules provide that mark to market accounting does not apply to a negative value residual interest. this means that "positive value" residual interests must be treated as securities for purposes of section 475 and must be marked to market if held by a dealer in its capacity as such. further, taxpayers that are dealers with respect to some type of security, but which do not hold residual interests in their dealer capacity, must identify positive value residual interests as held for investthe net result is that the holder of the hypothetical residual interest is able to offset almost completely the phantom income from the remic as it accrues. 339. the reason marking residual interests to market produces a lax loss to offset excess inclusion income is that basis is increased by such excess inclusions, and such basis increase is not commensurate with any real increase in the residual interest's value. 340. temp. regs. § 1.475(c)-2(b). 341. no special provision would be needed for up-front payments. because they would be reflected in the basis of the remic residual interest. 19941 florida tax review ment.342 the taxpayer has no option to not apply the mark to market rules to positive value residuals. as noted above, however, the service has indicated that other residual interests (i.e., those that have positive value) in the future may be excluded from the definition of a security for purposes of section 475, if the service determines that they have substantially the same economic effect as a negative value residual. in essence, the taxpayer is required to apply the mark to market rules to positive value residual interests, but the taxpayer is put on notice that the service may determine that section 475 is not to apply, and any such determination may have retroactive effect. this is particularly problematic since it is anyone's guess what "substantially the same economic effect" means. as discussed in the preceding section, the service is concerned primarily about taxpayer's being able to offset excess inclusions by mark to market losses. but how much of an offset is necessary in order to have substantially the same economic effect? given the vagueness of the standard, hopefully if the service chooses to exercise its discretion to broaden the definition of a negative value residual interest, it will do so on a prospective basis or will limit retroactivity to those cases that truly are abusive.-3 how then should taxpayers proceed in the interim while the service mulls over its next step? in particular, how should issuers structure positive value residual interests in order to reduce the potential for having that status overturned by future service guidance? on the one hand, the definition of a negative value residual interest is purely a function of mathematical computations of anticipated distributions, tax liabilities, and tax savings. as such, the definition is easily manipulated. for example, as discussed above in connection with significant value residual interests, a positive value residual can be created relatively painlessly by simply granting to the residual interest deeply subordinate rights to cash flow that are effectively worthless since they absorb the first losses on the mortgage pool.' similarly, a positive value residual interest can be created by converting the up-front payment that would otherwise be paid in connection with a negative value residual into a cash distribution from the remic during the first year. other variations on the foregoing are no doubt possible, but in each such case the possible threat of retroactive guidance by the service overturn342. if the taxpayer does not so identify, and the residual interest is not otherwise exempt from the mark to market rules, then the residual interest must be marked to market. see temp. regs. § 1.475(b)-i. any gain or loss, however, will be capital. see temp. regs. § 1.475(d)-i. 343. for example, retroactive application may be appropriate where a residual interest provided for a sizable cash entitlement and qualified as a positive value residual, but the cash was scheduled to be paid out within three months. 344. see supra text accompanying notes 230-3 . [vol 2:4 tax aspects of remic residual interests ing positive value status looms large. the existence of this threat makes it difficult to rely on structuring techniques to produce positive value residuals that are not significantly different, by some economic standard, from negative value residuals. accordingly, it is probably desirable in structuring a positive value residual interest to place some meaningful distance between it and the negative value residual interest. for example, the cash entitlement of a residual interest should not be front-loaded (i.e., it should not pay out quickly). to take a very conservative position, the cash should pay out pro rata with principal payments on the regular interests or it should pay out only after a significant portion of the principal balance of the regular interests has been paid down. the most troublesome case, of course, is where substantially all of the cash pays out within one year. those cases must be considered extremely vulnerable to recharacterization. b. inventory accounting.-as noted above, the regulations under section 475 provide that negative value residual interests are not considered securities for purposes of that section and, hence, they may not be marked to market under that section. this leaves unanswered, however, the issue of whether residual interests, including negative value residual interests, are securities that are subject to inventory accounting. the issue is potentially a significant one since securities includible in inventory may be carried in inventory at cost, at the lower of cost or market, or at market.3" this is unlike other types of property which generally are never permitted to be carried at market.' obviously, by carrying securities in inventory at market, one is effectively marking them to market. neither section 471 nor the regulations contain a definition of "securities" for this purpose, but the long-standing position of the service has been that the definition of a security for purposes of section 1236(c) applies as well for purposes of section 471.47 as described above, residual interests-both positive and negative value-are securities under section 1236(c), prima facie indicating that they are capable of inventory accounting. a couple of considerations indicate caution in embracing that conclusion. first, presumably the service in.some manner will clarify eventually that the exclusions from the definition of a security in regulations under section 475 will also apply for purposes of section 47 1. otherwise, as noted above, such excluded securities could be simply inventoried at market value under section 471 and a dealer could thus achieve the precise mark to market 345. regs. § 1.471-5; rev. rul. 74-227, 1974-1 c.b. 120. 346. see regs. § 1.471-2(c). 347. see, e.g., rev. rul. 72-523, 1972-2 c.b. 242. modifying rev. rul. 65-95, 1965-1 c.b. 208; g.c.m. 34965 (july 28, 1972) (relating to rev. rul. 72-523); priv. let. rul. 8141035 (june 30, 1981); priv. let. rul. 6308205670a (aug. 20, 1963). 19941 florida tax review effect that the regulations under section 475 were trying to stop. that would be an absurd result. since the regulations under section 475 were issued with retroactive effect as to negative value residual interests, it would take an intrepid soul to attempt to exploit this apparent glitch in the system. second, inventory accounting is permitted, indeed required, "in every case in which the production, purchase, or sale of merchandise is an income producing factor." 8 this language reflects an important point. inventory accounting is appropriate for "merchandise" or property, and many types of derivative financial instruments have not been considered inventoriable. for example, apparently neither futures nor forward contracts are considered inventoriable, nor short sale contracts, 9 although options are.3 10 like residual interests, each of the foregoing may at a given time have a zero or negative value and may become a liability to the holder. in the case of notional principal contracts, for example, commentators have speculated whether inventory accounting is permissible in view of the potential for them to become negative in value.35" ' yet, the reason such derivative instruments are not inventoriable appears to have nothing to do with their potential for negative value, but rather it seemingly is based on the rigid transfer of title requirements 352 or on the notion that the holder cannot truly be a dealer in such instruments. nevertheless, it is probably true that inventory accounting never envisioned the possibility of negative market values, although ultimately the matter must be considered uncertain. 3 348. regs. § 1.471-1. 349. see i cch internal revenue manual, audit § 4232.5, 314(4) (dec. 14, 1976); mark rachleff & herman m. schneider, security and commodity dealers 206 (1992). 350. priv. let. rul. 8141035 (june 30, 1981). 351. see, e.g., 2 andrea s. kramer, financial products: taxation, regulation, and design, § 60.2(b)(2)(ii), at 1437-38 (1991). 352. see regs. § 1.471-1 ("merchandise should be included in the inventory only if title thereto is vested in the taxpayer .... a purchaser... should not include in goods ordered for future delivery, transfer of title to which has not yet been effected."). 353. one area under the current inventory accounting rules where negative values are possible with respect to merchandise relates to "subnormal" goods. in general, a taxpayer is entitled to value subnormal goods at their bona fide selling price minus direct disposition costs. regs. § 1.471-2(c). if disposition costs equal or exceed the selling price, a zero or negative value would result. there appears to be no direct authority on this issue, although one commentator has recognized the issue: presumably, the offset for the costs of disposition enables a taxpayer to reduce inventory carrying values to a zero cost in some cases. it would not seem appropriate to permit a taxpayer to create a negative scrap value and deduct currently the excess disposition costs not yet incurred as an inventory writedown. 1 leslie j. schneider, federal income taxation of inventories, 6.03[3], at 6-15 (1994). [vol 2:4 tax aspects of remic residual interests a third consideration is that, even if one accepts that residual interests are securities capable in theory of being inventoried, generally only property the sales of which are expected to generate a profit are properly inventoriable." 4 in the case of securities dealer that acquires residual interests from remic sponsors or other third parties for the purpose of then marketing them at a mark-up to customers, this point is not an issue."' manifestly, such a dealer is seeking to turn a profit and inventory treatment in such a case would seem entirely appropriate. however, a less clear case concerns the remic sponsor that "originates" residual interests and is considered a dealer therein by virtue of the fact that it regularly creates and sells them." in this case, if the residual interests are not being sold at a gain (e.g., the sponsor must make an up-front payment to the transferor), then the sponsor will not earn, and will have no expectation of earning, any profit on the transfer of the residual interest itself. it is true that overall the sponsor may expect to earn a net profit on the creation and sale of both the residual and regular interests, and it could be argued the loss on the transfer of the residual interest is part of earning that overall profit. yet, inventory accounting authorities suggest that the residual interest in and of itself must be held with the requisite profit expectation."7 an alternative way in which residual interests that will not be sold at a profit may be accounted for, at least theoretically, is by integrating the loss on the transfer of them with the gain on the sale of the regular interests. that is, to the extent that the regular interests in the remic are held in inventory, a portion of the loss on the residual interest transfer is an adjustment to the inventory of such regular interests. in essence, the loss is capitalized into the cost or basis the regular interests.35s although this type 354. see, e.g., united states v. ingredient technology corp., 698 f.2d 88, 94-95 (2d cir. 1983). 355. query: how many taxpayers actually act as this type of dealer? 356. on the treatment of originators of securities as dealers therein, see infra text accompanying note 371. 357. for example, an analogous situation concerns promotional goods, where a merchant will take a loss on certain giveaways or below cost sales in order to realize an overall profit on a tie-in product (e.g., get a free refrigerator on the purchase of a new car). it appears settled that promotional goods that are being sold at a loss may not be inventoried, although the issue is less clear if they are themselves the subject of profitable sales (e.g.. buy one refrigerator, get a second one at half price). see, e.g., francisco sugar co. v. commissioner, 47 f.2d 555 (2d cir. 1935); see generally i schneider, supra note 353, 1 1.0316], at 1-62 to 1-65 (discussing the authorities). 358. the principle is similar to the uniform capitalization rules in § 263a, which technically would not appear to apply to the creation of remic regular interests. see irc § 263a(b)(l) (providing that uniform capitalization rules only apply to real or tangible property produced by the taxpayer); cf. regs. § 1.263a-i(b)(13) (stating that the origination of loans is not considered the acquisition of intangible property for resale). 19941 florida tax review of integration has been recognized for hedging gains or losses,"' there appears to be no authority outside that context for such integration. c. section 1236(c).-since all residual interests, regardless of their economic attributes, should be viewed as securities for purposes of section 1236(c), this means that a securities dealer must identify such securities as held for investment in order to obtain capital gain treatment. failure to so identify would cause the dealer to recognize ordinary income, yet any loss would be capital if, in fact, the residual interest is held for investment. 360 d. sales or exchanges of residual interests.-even if remic residual interests are not securities or are not otherwise inventoriable, the issue arises whether gain or loss recognized by a dealer on the transfer of residual interests will be ordinary in character. in general, section 1221(1 )361 provides that a loss on the sale or exchange of property will not be a capital loss if the property constitutes: stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxpayer year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. it is clear that gain or loss on property may be ordinary under section 1221(1) even if such property is not, or cannot be, held in inventory.362 moreover, the taxpayer need not actually be a dealer with respect to the property at issue, so long as the property is nevertheless held primarily for sale to customers in the ordinary course of the taxpayer's trade or business. 363 359. see, e.g., prop. regs. § 1.446-4(e)(2); monfort of colorado, inc. v. united states, 561 f.2d 190, 196 (10th cir. 1977). 360. stephens, inc. v. united states, 464 f.2d 53, 60-61 (8th cir. 1972). 361. irc § 1221(1). apart from the application of § 1221(1), there would appear to be no basis to treat gain or loss on a sale or exchange of a remic residual interest as ordinary in character. section 1221(4) would not apply because it does not appear possible to stretch the term "notes or accounts receivable" far enough to encompass a residual interest. 362. see rev. rul. 60-346, 1960-2 c.b. 217; g.c.m. 34965 (july 28, 1972) (relating to rev. rul. 72-523, 1972-2 c.b. 242). real estate, for example, is a common type of § 1221(1) property even though it is not inventoriable. see, e.g., keeney v. commissioner, 17 b.t.a. 560, 566 (1929). 363. see, e.g., katz v. commissioner, 19 t.c. memo (cch) 200, t.c. memo (p-h) 60,200 (1960); girard trust corn exchange bank v. commissioner, 22 t.c. 1343, 1360-61 (1954). [vol 2:4 tax aspects of remic residual interests accordingly, a sale or exchange of residual interest may produce ordinary gain or loss under section 1221(1), based on whether it is held "primarily for sale to customers." several points can be made regarding this standard. first, the supreme court has held that in this context "primarily" means "of first importance" or "principally."' 64 further, the "to customers" requirement is satisfied even if the taxpayer only has one customer.' this can be important in the context of residual interests, since the number of buyers is relatively small and a remic sponsor may well sell all of its residual interests to a single buyer. finally, property can be considered held primarily for sale even if the taxpayer has no expectation of making a profit on the sales.3" this is also potentially important in the remic context since frequently residual interests are sold at a loss by the remic sponsor. the application of section 1221(1) is not an issue for banks and thrift institutions, since section 582(c) already provides that sales or exchanges of residual interests produce ordinary gain or loss. however, for other holders, the application of section 1221(l) can be critical. e. wash sales.-in general, securities dealers are not subject to deferral of losses on dispositions of securities where identical securities are considered acquired within 30 days before or after the date of disposition, provided that the dealer incurs such losses in sales made in the ordinary course of its business. 367 a "dealer" for purposes of the wash sale rules is defined by reference to the definition under section 471.3 as discussed below,369 however, it is highly uncertain whether a remic sponsor can be a dealer with respect to residual interests that by their terms have negative value. in such cases, taxpayers that are not otherwise securities dealers may have reason to be concerned about the possible application of the wash sale rules. 3. who are dealers in residual interests?-assuming that residual interests are indeed a type of security, at least for some purposes under the 364. malat v. riddell, 383 u.s. 569, 572 (1966). 365. see, e.g., belcher v. commissioner, 24 t.c. memo (cch) 1, t.c. memo (ph) 65,001 (1965); see also sykes v. commissioner, 57 t.c. 618 (1972) (holding seller of leafcutter bee larvae to have sold in the ordinary course of business where half of total sales were to one customer). 366. see girard trust, 22 t.c. at 1360-61; see also i.t. 3648. 1944 c.b. 268. 367. irc § 1091(a). in addition, securities dealers are not subject to the modified wash sales rules for losses on sales of securities that are part of a straddle. see irc § 1092(b)(1); temp. regs. § 1.1092(b)-l(d)(2). 368. donander co. v. commissioner, 29 b.t.a. 312, 314 (1933) (involving the predecessors of § 1091 and regs. § 1.471-5). 369. see infra part vi.b.3. 19941 florida tax review code, it remains to be considered in what circumstances a taxpayer can qualify as a dealer in residual interests. the primary definition of a securities dealer in this regard is found in the regulations under section 471: [a] dealer in securities is a merchant of securities, whether an individual, partnership, or corporation, with an established place of business, regularly engaged in the purchase of securities and their resale to customers; that is, one who as a merchant buys securities and sells them to customers with a view to the gains and profits that may be derived therefrom. 3 70 like the foregoing definition, authorities defining a dealer tend to invoke the quaint image of the dealer as a merchant or middleman who stands by with a warehouse or inventory of goods ready to make a profit by marking up his merchandise and selling it retail to customers.371 the dealer-merchant is to be distinguished from the mere trader or speculator in securities, who strives to profit from hoped for increases in the market value of a security. 72 in the context of residual interests that by their terms have positive economic value, the determination of dealer status should be no different than with respect to other types of securities. however, unlike other types of stocks or bonds, it should be noted that a taxpayer may be a dealer not only where it purchases and resells remic residual (or regular) interests, but also 370. regs. § 1.471-5. 371. see, e.g., kemon v. commissioner, 16 t.c. 1026, 1032-33 (1951), in which the court stated: those who sell "to customers" are comparable to a merchant in that they purchase their stock in trade, in this case securities, with the expectation of reselling at a profit, not because of a rise in value during the interval of time between purchase and resale, but merely because they have or hope to find a market of buyers who will purchase from them at a price in excess of their cost. this excess or mark-up represents remuneration for their labors as a middle man bringing together buyer and seller, and performing the usual services of retailer or wholesaler of goods. see also stokes v. rothensies, 61 f. supp. 444, 448 (e.d. pa. 1945), aff'd, 154 f.2d 1022 (3d cir. 1946) ("there must be an offering of wares to customers with a primary view to a distributing profit which may be derived from a middleman operation in securities."). 372. this is not to say that a dealer may not also seek to maximize its profit by holding securities with an eye to cashing in on increases in market value. see, e.g., stokes, 61 f. supp. at 450; rev. rul. 72-523, 1972-2 c.b. 242 (holding a taxpayer is a dealer in mortgages even though it expects to profit not only from sales, but also from future servicing fees with respect to the sold mortgages). however, such market returns cannot be the sole basis on which the purported dealer hopes to profit. see, e.g., brown v. united states, 426 f.2d 355, 364 (ct. cl. 1970); priv. let. rul. 9345003 (july 15, 1993). [vol. 2:4 tax aspects of remic residual interests where the taxpayer originates remic interests (i.e., the sponsor). for example, a bank that regularly packages its mortgages and contributes them to remics and sells the resulting residual and regular interests certainly should be viewed as a dealer in such remic interests.' the matter is less clear with respect to residual interests that by their terms do not have positive value. if a sponsor contributes mortgages to a remic in exchange for regular interests and a negative value residual interest, can the sponsor be a dealer in the residual interest? the sponsor may regularly create and sell remic interests, but focussing solely on the residual interest it is clear that the sponsor will derive no profit (and has no expectation of deriving a profit) from sales thereof. in fact, it will have to pay someone to accept ownership, thus taking a loss on the transaction. from a tax policy vantage point, it would seem untenable to permit the sponsor to be a dealer with respect to the regular interests, but not with respect to the residual interests. yet the caselaw does not clearly support dealer status for negative value or loss property. in general, the authorities indicate that the taxpayer must have a specific profit expectation with respect to sales of property in order to be a dealer in that property."' it is true that overall the sponsor may anticipate a net profit on the combined sales of both the regular interests and the residual interests, but that does not appear to be a sufficient basis under the caselaw for being a dealer with respect to property that is inherently loss property. 375 373. some commentators suggest that securitization of receivables and the sale of the resulting interests therein to investors should not be viewed as dealer transactions. see, e.g., nysba analyzes mark-to-market rules, 32 highlights & documents 3920 (mar. 4. 1994). no authorities or analysis for that puzzling conclusion are provided. under longstanding law, a bank that in the ordinary course of its business regularly originates receivables and sells them is a dealer therein. rev. rul. 81-200, 1981-2 c.b. 81; rev. rul. 72-523, 1972-2 c.b. 242; cf. rev. rul. 60-346, 1960-2 c.b. 217 (involving § 1221(1)). why would the conclusion be different merely because a bank chooses to securitize these receivables first and then sell separate interests in the underlying receivables? if anything, this further enhances the merchandising function that the bank is performing, i.e., it is taking raw receivables and tailoring them for retail sale to customers. see andrew h. braiterman, temporary mark-to-market regulations: a small step in the right direction, 63 tax notes 467, 469 (apr. 25, 1994). braiterman appears to agree with this conclusion, although he states that "good arguments can be made" that such securitization transactions by banks are not dealer transactions. id. though arguments to this end can be made, they are probably not either good or persuasive. 374. brown, 426 f.2d at 364 (holding taxpayer not to be a dealer where "[tlhere was no hope or expectation of selling the securities at a profit. instead, the obligations were purchased in anticipation of selling them at a loss."); girard trust con exchange bank v. commissioner, 22 t.c. 1343, 1361 (1954) (stating definition of dealer includes the requirement of buying as well as selling for purposes of profit). 375. see, e.g., stephens, inc. v. united states, 464 f.2d 53, 59-60 (8th cir. 1972). compare the discussion of the inventoriability of negative value residuals supra part vi.b.2.b. 19941 florida tax review c. thrift institutions and reits 1. thrift institutions.-thrift institutions are required to meet certain asset tests under the code and regulations in order to qualify for special tax treatment.376 in particular, if a thrift institution meets the so-called "60%" asset test, it may deduct a reasonable addition to bad debt reserves, which deductions other taxpayers generally are not permitted.377 moreover, in computing the deductible addition to its bad debt reserves, a more generous methodology applies with respect to loan assets that constitute "qualifying real property loans. ' 3 78 how are remic residual interests treated for purposes of these tests? under the 60% test of section 7701(a)(19)(c), at the close of the taxable year at least 60% of the institution's total assets must consist of specified assets (e.g., cash, residential real property loans, property used in the institution's trade or business, et al.) ("qualifying assets"). 379 for purposes of the 60% test, the statute treats remic regular and residual interests as qualifying assets, but only in the proportion which the assets of the remic consist of such qualifying assets. 3s0 however, if 95% or more of the remic's assets consist of qualifying assets, then the entire residual or regular interest at issue is considered a qualifying asset.38' moreover, if a remic holds a regular interest in another remic, such other interest is treated as qualifying asset, once again based on the proportion of the remic's assets that are qualifying assets. if, however, the two remics are part of a "tiered structure," both are treated as one remic for purposes of the 60% test.382 376. a thrift institution, in general, is any domestic building and loan association, mutual savings bank, or cooperative bank without capital stock organized and operated for mutual purpose and without profit. irc § 593(a). 377. irc § 593(a)(2). 378. see irc § 593(b)(l)(b). 379. regs. § 301.7701-13a(d), (e). 380. irc § 7701(a)(19)(c)(xi); regs. § 301.7701-13a(e)(12). 381. id. the remic is required to report to the residual interest holders on the quarterly schedule q the extent to which its assets are qualifying assets under § 7701(a)(19). regs. § 1.860f-4(e)(1)(ii)(a)(2). the 95% computation is based on adjusted tax basis. regs. § 1.860f-4(e)(1)(iii). as noted above, § 7701(a)(19)(c) only requires that the test be met as of the close of the taxable year, although the regulations thereunder permit the taxpayer to use the monthly, quarterly or semiannual average and permit the taxpayer to change the basis of its averaging from year to year. regs. § 301.7701-13a(d). accordingly, the taxpayer has flexibility at the end of the year to determine whether year-end or some average of schedule q data is most appropriate. 382. irc § 7701(a)(19)(c). according to the legislative history, a tiered remic structure exists if it was contemplated (apparently by the sponsor) when both remics were formed that some or all of the regular interests in one remic would be held by the other. s. [vol 2:4 tax aspects of remic residual interests in addition to the 60% asset test, in computing bad debt reserves it is important to determine whether the more favorable rules applicable to "qualifying real property loans" apply. on this point, once again the statute provides that any remic regular or residual interest is treated as a qualifying real property loan in the same proportion that the assets of the remic so qualify, provided that if 95% of the remic assets are qualified real property loans, then the entire regular or residual interests are so treated.mss in applying the 60% qualifying asset test and in testing for qualifying real property loan status, it is thus necessary for the remic to categorize its assets. generally, the definition of a "qualified mortgage" is such that all of the remic's assets that consist of qualified mortgages typically will be both qualifying assets and qualified real property loans. for example, with respect to the 60% test, a remic's qualified mortgages would typically constitute loans secured by an interest in real property for purposes of section 7701(a)(19)(c), although the match is not an entirely perfect one.? with respect to qualifying real property loan status, few issues should arise with respect to remic qualified mortgages,3 s except possibly with respect to the explicit requirement in the statute that a mortgage must constitute debt within the meaning of section 166.386 rep. no. 445, supra note 39, at 91-92, reprinted in 1988 u.s.c.c.a.n. at 4609-10. the computations where a tiered structure is involved can become quite complicated if. for example, the remic owns a medley of other remic regular interests. 383. irc § 593(d)(4); regs. § 1.593-11 (e). 384. irc § 7701(a)(19)(c). for example, a remic may hold mortgages secured by commercial real estate or agricultural property, but these are not qualified assets under the 60% test. irc § 7701(a)(19)(c)(v) (requiring that loans primarily be secured by residential real property, with certain exceptions). mortgages secured by shares in a cooperative are a qualified mortgage for remic purposes, but the statute and regulations are unclear regarding the 60% test. however, the service has ruled that such mortgages constitute a qualifying asset under the 60% test and are a qualifying real property loan. rev. rul. 89-59, 1989-1 c.b. 317. 385. one minor interpretive issue concerns loans secured by manufactured housing. in general, under the literal instructions in the regulations, when testing whether a remic's assets are qualifying real property loans for purposes of the 95% test, qualified mortgages held by a remic that are secured by manufactured housing are treated as qualified real property loans if the manufactured housing constitutes a single family residence under § 25(e)(10). regs. § 1.593-1 l(e)(2)(i) (stating § 25(e)(10) manufactured houses are "qualified real property" for purposes of the 95% test). yet, the actual definition of a qualifying real property loan in regs. § 1.593-1 1(b) also independently defines when a mortgage secured by a "mobile unit" (which largely overlaps manufactured housing) qualifies, and it imposes a more elaborate and stringent set of requirements than § 25(e)(i0). it appears, however, that the service intends that § 25(e)(10), where different, controls with respect to the remic 95% test. 386. irc § 593(d)(3). this should rarely, if ever, be an issue for a residential mortgage. in the case of a commercial mortgage with an equity kicker or other contingent feature, it is possible that the loan would be bifurcated into a part-debt. part-equity instrument or, less likely, recast as equity in its entirety. 1994] florida tax review even if a remic's qualified mortgage qualifies as a valid type of mortgage under the foregoing tests, a further issue arises regarding the extent to which it may qualify. a mortgage is a qualified mortgage for remic purposes if, either at the time of origination or at the time of contribution to the remic, the value of the real property interest securing a mortgage is at least 80% of the mortgage's adjusted issue price.387 the test is an all or nothing one; if the 80% threshold is met, then the entire mortgage is treated as a qualified mortgage for remic purposes, otherwise the entire mortgage is disqualified for remic purposes.388 for purposes of the 60% test, section 7701(a)(19)(c) and the current regulations thereunder are silent regarding the extent to which a loan must be secured by a qualifying real property interest, although prior regulations contained elaborate rules for measuring this.389 in general, under the former regulations a loan was treated as a loan secured by an interest in real property only to the extent the loan did not exceed the "loan value" of the real property interest.390 however, if the loan value of the real property interest exceeded 85% of the loan amount, then the loan was treated in its entirety as secured by a real property interest.391 the former regulations are not controlling and it is probably reasonable to simply follow the all or nothing approach of the remic rules absent further guidance. the issue in any event is not an acute one, since even if the principles of the former regulations were followed, a remic's qualified mortgages will generally constitute qualified assets in their entirety for purposes of the 60% test. the case is slightly different with respect to the definition of a qualifying real property loan, which specifically directs that the principles of section 7701(a)(19) be applied to determine the portion of a loan that constitutes a qualified real property loan.3 92 as noted, there are no such principles under section 7701(a)(19); the reference in the section 593 regulations is an obsolete one that was meant to incorporate the former regulations under section 7701 (a)(19)(c). notwithstanding this confusion, one probably should simply follow the approach of the former regulations.393 387. regs. § 1.860g-2(a)(1)(i). 388. id. 389. regs. § 301.7701-13(k) (t.d. 6766, oct. 31, 1964) (applicable for pre-1970 taxable years). 390. regs. § 301.7701-13(k)(1)(i). loan value for these purposes is the maximum amount that an institution is permitted to lend on such property under applicable law, but not in excess of its fair market value. regs. § 301.7701-13(k)(4). generally, the determination is made at origination. regs. § 301.7701-13(k)(3). 391. regs. § 301.7701-13(k)(1)(i). 392. regs. § 1.593-1 l(d)(2). 393. see 1 peat, marwick, main, taxation of financial institutions § 16.01 [l[ie] (1993) ("presumably, the pre-1970 regulations still have precedential value."). [vol. 2:4 tax aspects of remic residual interests as described above, the loan is treated as a qualifying real property loan up to the value of the real property security, except that if the value of the real property equals 85% of the amount of loan, then the entire loan is treated as secured by such property.39 once again, it is unlikely that this would prove problematic with respect to a remic's qualified mortgages. in sum, it is altogether possible that some of the qualified mortgages of a remic may be secured by collateral other than real property; the definition of a remic qualified mortgage affords significant flexibility in this respect. nonreal property collateral can arise, for example, in the case of remic mortgages secured by hotel or motel property, or remic mortgages that have a buy-down fund where, as is typical, the buy-down fund is viewed as additional collateral for the loan. nevertheless, unless the real property collateral for the loan slips below 85% generally no issue should arise. apart from the status of a remic's qualified mortgages, a remic may hold certain types of nonmortgage assets, such as cash flow investments, foreclosure property, or a qualified reserve fund.3 " with certain exceptions, nonmortgage assets can count against the remic in applying the foregoing 95% test. an exception, however, is provided for remic cash flow investments, which are defined as investments of payments received on qualified mortgages for a temporary period pending distribution to interest holders, so long as such investments are passive investments earning a return in the nature of interest. 396 the regulations under section 593, but curiously not under section 7701(a)(19)(c), expressly provide that cash flow investments are treated as qualifying real property loans.'97 further, foreclosure property is treated by statute as a qualifying asset for purposes of the 60% asset test,398 although not surprisingly such property is not a qualifying real property loan under section 593. in sum, remics must identify the nature of their qualified mortgages and determine on a quarterly basis the breakdown of their assets in order to report to residual interest holders to what extent their assets are qualifying 394. regs. § 301.7701-13(k)(i)(i). 395. irc § 860g(a)(5). 396. regs. § 1.860g-2(g)(l)(i). 397. regs. § 1.593-11 (e)(2)(ii). it is unclear why such a rule was not included in regs. § 301.7701-13a(e). it is true that § 7701(a)(19)(c) already includes, as qualifying assets for purposes of applying the 60% test, items such as cash and time or demand deposits, but these cash-like items fall short of covering the spectrum of cash flow investments permitted for a remic. for example, the list of permitted investments for a remic typically includes federal funds and bankers acceptances, which would not be qualified assets under § 7701(a)(19)(c). rev. rul. 66-318, 1966-2 c.b. 522 (stating that bankers acceptances are not cash items); cf. g.c.m. 39531 (july 16, 1986) (concluding that federal funds are not cash items for purposes of § 851(b)(4)). 398. irc § 7701(a)(19)(c)(viii). 19941 florida tax review assets under the foregoing tests. as the discussion above indicates, the determination is not necessarily an easy one and one wonders how precise of a job remic administrators do, given the welter of different standards and rules. 2. reits.-like thrift institutions, reits are also subject to rules relating to the composition of their assets, and in addition they must meet certain gross income tests. in particular, as of the close of each quarter of the taxable year, at least 75% of the total assets of a reit must be represented by "real estate assets," cash and cash items (including receivables, and government securities),399 and at least 75% of the gross income of a reit must be derived from real estate assets. gross income derived from real estate assets includes interest on obligations secured by mortgages on real property ("real estate mortgages").4 ' ° for this purpose, the statute provides that remic residual and regular interests are treated as a real estate asset in their entirety, and any income thereon is treated in its entirety as interest on a real estate mortgage, if at least 95% of the assets of the remic qualify as real estate assets.4°1 however, if the remic assets do not meet this 95% test, then a reit residual interest holder is treated as holding directly its proportionate share of the remic's assets and income.4' the rule thus is virtually identical to the rule described above with respect to thrifts.4 °3 as in the case of thrift institutions, special rules provide that manufactured housing and cash flow investments are treated as real estate assets.4" in addition, as in the case of thrifts a special rule applies to treat tiered remics as one remic. °5 once again, the status of remic residual and regular interests ultimately requires an analysis of the assets (and in this context, income as well) of the remic. in general, it appears that all remic qualified mortgages will constitute real estate assets for purposes of section 856(c)(6)(b). 406 399. irc § 856(c)(5)(a). 400. irc § 856(c)(3). 401. irc § 856(c)(6)(e). the 95% test focuses solely on the proportion of the remic's assets which constitute real estate assets; there is no additional requirement that 95% of the remic's gross income constitute interest income on real estate mortgages. 402. id. 403. unlike § 593(d)(4) and § 7701(a)(19)(c), § 856(c)(6)(e) provides that the reit is treated as holding directly and receiving directly its proportionate share of the assets and income of the remic if less than 95% of the remic's assets constitute real estate assets. this is necessary since at issue is not only the type of asset that the remic interests represent, but also the type of income. 404. regs. § 1.856-3(b)(2)(ii). 405. irc § 856(c)(6)(e). 406. stock in a cooperative, for example, has been held to be an interest in real property which are "real estate assets" under § 856(c)(6)(b). priv. let. rul. 8628038 (apr. 14, [vol 2:4 tax aspects of remic residual interests foreclosure property generally will also be a real estate asset, although nonreal property items that may be swept up in the foreclosure (such as furniture or other nonfixtures) would not be. a final issue with respect to reits concerns the definition of a real estate mortgage for purpose of the 75% income test in section 856(c)(3). in general, a reit is limited in its ability to receive contingent interest amounts under mortgages (e.g., interest based on mortgagor profits),4 whereas a qualified mortgage for remic purposes can include mortgages that provide for such contingent interest. to prevent reits from avoiding the limitations on contingent interest, the regulations provide that even if a remic satisfies the 95% test (95% or more of its assets are real estate assets and 95% or more of its gross income is interest on real estate mortgages), nevertheless in abusive cases the reit will be treated as holding directly and receiving directly its share of the remic assets and income.' o' vii. regulating transfers of residual interests a. in general given the desire to ensure that excess inclusion amounts be currently taxable in all events, it is not enough to provide simply that holders may not utilize losses or other deductions. some holders are exempt altogether from u.s. income taxation and others are de facto taxable only on a cash basis (i.e., taxable only to the extent of actual receipts). thus, the goal of ensuring current taxation of excess inclusion amounts would be thwarted if no provision were made for special taxpayers that are in some sense outside the normal u.s. tax system. this is where the special rules regarding transfers of residual interests come into play. in essence, as described below, these rules disregard or penalize transfers of residual interests in circumstances where avoidance of current tax on excess inclusion amounts can arise. b. prolegomenon: what is a transfer? all of the various rules restricting transfers of residual interests that are described below utilize the operative term "transfer," which is no where defined. since adverse consequences flow from violative transfers, it is 1986). the service also has ruled that interest on debt secured by cooperative stock is treated as interest on an obligation secured by a mortgage on real property. rcv. rul. 76-101, 1976-1 c.b. 186. 407. irc § 856(0, (g). 408. regs. § 1.860g-2(a)(7). 409. regs. § 1.856-3(b)(2)(iii). 19941 florida tax review necessary to obtain as much precision as possible about what is and is not a transfer. the universe of events that could lead to a new person or legal entity becoming, in some sense, a new owner of a residual interest is indeed a large one. a residual interest could be obtained, for example, by gift, bequest, tax-free contribution, merger, liquidation, reincorporation, distribution, foreclosure, not to mention the paradigmatic type of transfer-by sale or exchange. all of these events apparently would be transfers for purposes of the remic rules, although that approach seems needlessly formalistic. the potentially broad concept of a transfer should prove less troublesome in the case of transfers of noneconomic residual interests than in the case of transfers involving foreign persons. in the former case, as discussed in greater detail below, the transfer will be respected unless the transferor had "improper knowledge," a subjective enough standard that taxpayers should always have some room to argue. the matter is less promising for transfers involving foreign persons, where any event involving a foreign persons that should cross the threshold of being a "transfer" in most cases will automatically result in a violation. as a tax policy matter, changes in ownership that are in some sense involuntary should not be transfers. for example, transfers of ownership incident to bankruptcy or foreclosure hardly seem appropriate candidates for triggering transfer penalties. similarly, formal transfers of ownership that occur incident to transactions that do not effect any real change in beneficial ownership are also inappropriate targets. for example, to take the clearest case, a transfer incident to a reincorporation (i.e., an "f' reorganization) should not be a "transfer." in addition, transfers within a consolidated group of corporations, where each corporation remains jointly and severally liable for the taxes of the entire group,410 should be ignored. finally, a transfer that occurs as a part of a deemed distribution and recontribution of partnership assets upon a section 708(b) termination also should not be a transfer. yet, in the absence of further guidance, which guidance is unlikely to be forthcoming, one must be concerned that all of the foregoing events could be transfers for purposes of the remic rules. c. noneconomic residual interests as we have seen, residual interests frequently may be structured with minimal or negative value. thus, although the holder may receive an up-front payment, he may receive little, or no other cash under the residual interest to cover the future tax liability. when the tax liability arises, a naive holder or a deadbeat holder may no longer have assets to cover the liability, having 410. regs. § 1.1502-6(a). [vol 2:4 tax aspects of remic residual interests long since spent the up-front payment, and thus may decide to walk away from the liability or seek shelter in bankruptcy. although the tax collector may seize the residual interest, such interest may have no real value. further, the backup withholding regime is of no help, since there will be little or no distributions of cash by the remic on the residual interest. in short, de facto avoidance of current tax can arise. in order to prevent this situation, the service decided to place a burden of due diligence on the transferor of so-called a "noneconomic" residual interest.4 ' in essence, the transferor must take steps to ascertain that the transferee will likely pay the tax liability associated with the residual interest as it becomes due. if the transferor fails to do this, then the transfer is disregarded for federal income tax purposes, thus causing the transferor to remain the owner.412 these due diligence rules regarding transfers of noneconomic residual interests only apply to transfers to domestic persons." 3 separate rules (discussed below) apply in the case of transfers of certain types of residual interests to foreign holders." 4 there are three aspects to the rules regarding transfers of noneconomic residual interests: (i) the definition of a noneconomic residual, (ii) the scope of the transferor's required due diligence, and (iii) the consequences of failing to meet the requirements. each aspect is discussed in turn below. 1. the definition of a noneconomic residual interest.-the status of a residual interest as a noneconomic residual interest is tested as of the time of a transfer.4t 5 in general, a residual interest is a considered noneconomic residual if it fails either of the following tests.416 first, at the time of a transfer the present value of expected future distributions on the residual 411. a noneconomic residual interest and its counterpart, an economic residual interest, are unrelated to a significant value residual interest and its counterpart, an insignificant value residual interest. in theory, for example, a residual interest that has significant value under regs. § 1.860e-1(a)(3)(iii) could well be noneconomic; e.g., insufficient remic distributions are expected to occur after excess inclusion tax liabilities attach. 412. presumably the transfer of a noneconomic residual interest to a holder other than the sponsor is treated as a transfer by the sponsor. see regs. § 1.860f-2(a)(1) (providing all remic formations are treated as a transfer of mortgages by the sponsor to the rfmic in exchange for the regular and residual interests). thus, the remic is never a transferor, the sponsor is responsible for due diligence in this circumstance and liable in the event the transfer is disregarded. this is explicitly stated in regs. § 1.860g-3(a)(1) regarding transfers of residual interests to foreign persons. 413. regs. § 1.860e-l(d). transfers of residual interests by foreign holders to domestic persons are also potentially subject to the rules regarding noneconomic residual interests because no reference to regs. § 1.860g-3(a)(4) is present in regs. § 1.860e-1(d). 414. regs. § 1.860g-3. 415. regs. § 1.860e-l(c)(2). 416. id. 19941 florida tax review interest must at least equal the product of the present value of the anticipated excess inclusions and the highest corporate marginal tax rate (currently 35%) for the year in which the transfer occurs.417 second, the transferor must reasonably expect that, for each anticipated excess inclusion, the transferee will receive distributions from the remic at or after the time at which the taxes accrue on the anticipated excess inclusion in an amount sufficient to satisfy the accrued taxes.418 as to the first test, the determination is purely a mathematical one. upon a transfer, one discounts back to the transfer date the amount of "anticipated" excess inclusions from the end of each remaining calendar quarter to the date of the transfer and multiplies the sum of the present values by the applicable tax rate.4" 9 next, one discounts back expected distributions from the remic, presumably from the date each distribution is expected to occur (e.g., at the end of a each month) and not as of the end of each calendar quarter.420 finally, the two figures so computed are compared and the present value of expected distributions must equal or exceed the present value of the future taxes.42' the determination of anticipated excess inclusions and distributions is based (i) events that have occurred up to the time of the transfer, (ii) the prepayment and reinvestment assumptions adopted under section 1272(a)(6), and (iii) any required or permitted clean up calls, or required qualified liquidation provided for in the remic organizational documents.4 2 the second test relates to the timing of distributions from the remic.4 13 even if a residual interest has sufficient expected distributions to cover the future tax liability on excess inclusions, this is not enough.424 the transferor must reasonably expect that the holder will receive sufficient cash from the remic to pay the excess inclusion tax liability at or after it accrues. 425 it is interesting that this second test is not a strictly quantitative one; one could imagine an objective rule that requires that the stream of taxes due on anticipated excess inclusions at no point in time exceed the sum of 417. regs. § 1.860e-i(c)(2)(i). 418. regs. § 1.860e-1(c)(2)(ii). 419. regs. § 1.860e-i(c)(3),-2(a)(4). 420. the procedure set forth in regs. § 1.860e-2(a)(4) refers to discounting on the basis of calendar quarters. it would seem distortionary to use that method for expected distributions, but compare the discussion supra part iv.b.3. on the timing of distributions and basis calculations. 421. in performing the discounting, the regulations require use of the applicable federal rate as specified in § 1274(d)(1). regs. § 1.860e-2(a)(4). 422. regs. § 1.860e-2(a)(3). 423. see regs. § 1.860e-2(c)(2)(ii). 424. id. 425. id. [vol 2:4 tax aspects of remic residual interests expected future distributions (as calculated in the first test). yet, the test does not purport to be a strictly mathematical one, but rather one that turns on the subjective concept of a transferor's reasonable expectations.42 6 although, all things being equal, one would prefer generally that a residual interest not be noneconomic, it does not appear that a great deal of pressure to avoid this status exists in the structuring of remic residuals. this is no doubt largely because, as discussed below, the status of a residual interest as noneconomic has little bearing on the remic itself or the remic regular interest holders and the transfer restrictions that accompany noneconomic status are not all that onerous. however, for those instances where noneconomic status is a sensitive structuring point, it is worthwhile exploring how to cope with the definition of a noneconomic residual. regarding the first test, the same point that was made with respect to significant value residual interests can be made here. to wit, the expected future distributions encompass all future cash to which the remic residual holder is entitled, regardless of the credit quality of that entitlement. thus, by assigning to the residual interest deeply subordinate rights to cash, ' 7 one can bump up the present value of expected future distributions to meet the first test. with respect to the second test, future distributions are required to come on or after the accrual of tax liabilities, but there is no requirement that the distributions match up in any way with such tax liabilities.42 thus, by scheduling a sufficient distribution at or near the end of the remic, one can satisfy the timing test. however, since the transferor must "reasonably expect" that the transferee will actually receive sufficient distributions from the remic, merely assigning deeply subordinate rights to cash would not seem to pass muster. a final point to note regarding the definition of a noneconomic residual interest is that noneconomic status is tested at the time of transfer.429 thus, noneconomic status at issuance is not necessarily relevant in the case of later, secondary transfers of a residual interest. for example, if a residual interest is noneconomic at issuance, but subsequently the remic begins experiencing losses and such losses are projected to continue, then even a residual interest that provides for no distributions will not be a noneconomic residual interest. the result is entirely sensible; since the purpose of the noneconomic test is to prevent tax avoidance, there is no need for such a rule if there is no tax to avoid. 426. id. 427. see supra part v.b.3.b. 428. see regs. § 1.860e-1(c)(2)(ii). this is in contrast with rule for transfers of certain residual interests to foreign persons. see infra part vii.d.i. 429. regs. § 1.860e-i(c)(2). 1994] florida tax review 2. transferor due diligence.-the regulations provide that a transfer of a noneconomic residual interest is disregarded if a significant purpose of the transfer was to impede the assessment or collection of tax.430 as originally proposed, this was all that the regulations stated, and a number of comments were made requesting further elaboration on this subjective and vague mens rea standard. for example, it was unclear whether the "purpose" at issue was that of the transferor in transferring the residual interest, that of the transferee in acquiring it, or both. thus, it was common to have both the transferor and the transferee certify that they had no illicit motive in the transaction. as finalized, the regulations expound further on the standard and, more importantly, provide a safe harbor rule. under the regulations significant purpose exists if, at the time of the transfer, the transferor either knew or should have known that the transferee would be unwilling or unable to pay taxes due on its share of the taxable income of the remic. 431' the existence of such knowledge is referred to in the regulations as "improper knowledge. '' 432 thus, the focus is on what the transferor knows or should have known about the transferee; secret purposes of, or suspicious facts regarding the transferee are irrelevant if the transferor is ignorant of them and such ignorance is reasonable. although this refinement of the meaning of a "significant purpose" is helpful, it is still fraught with uncertainty. fortunately, however, the regulations go on to provide a safe harbor that, as a practical matter, transferors of noneconomic residuals generally will always seek to satisfy. under the safe harbor rule, a transferor will not be considered to have improper knowledge if the transferor conducts a credit investigation of the transferor and obtains certain representations.433 specifically, the regulations provide that the transferor must conduct, at the time of transfer, a reasonable investigation of the financial condition of the transferee and, as a result of the investigation, find that the transferee has historically paid its debts as they came due and find no significant evidence to indicate that the transferee will not continue to pay its debts as they come due in the future.43 in addition, the transferor must obtain from the transferee a representation that it understands that, as a holder of a noneconomic residual interest, it may incur tax liabilities in excess of any cash flows generated by the interest and that it 430. regs. § 1.860e-1(c)(1). 431. id. 432. id.; cf. regs. § 1.856-6(a)(3) (setting out an "improper knowledge" test for foreclosure property). 433. regs. § 1.860e-1(c)(4)(i). 434. id. [vol 2:4 tax aspects of remic residual interests intends to pay taxes associated with holding the residual interest as they become due. 435 as noted above, in most instances the transferor of a noneconomic residual interest will seek to come within the safe harbor rule. as a practical matter, complying with the safe harbor rule has not proved exceedingly onerous, since many remic sponsors had been undertaking comparable due diligence anyway before the safe harbor rule was issued in december 1992. although the precise extent of the requisite credit investigation is not certain, transferors should not be too cursory in their investigation and should take particular care in documenting it. inevitably, the day will come when a transferee will fail to pay the remic's taxes and just as certain, when that day arrives the service, armed with hindsight, will look to the transferor and attempt to assert that it should have known this was going to occur. obviously, the more thorough and documented the credit investigation, the better able will the transferor be to prevail. 3. failed transfers.-if a noneconomic residual interest is transferred with a "significant purpose" of enabling the transferor to impede the collection or assessment of tax, the resulting penalty is that the transfer is disregarded for all federal income tax purposes.4 in short, the transferor is still considered to own the residual interest and remains liable for the income thereon (and is entitled to claim the associated deductions). disregarding a transfer can have obvious and severe consequences to the transferor, but it is also an event that is easier said than done. trying to unwind a transfer that may have occurred years before would be a complicated undertaking. however, the purpose of the regulations doubtlessly is that the mere threat of this will have sufficient in terrorem effect so as to obviate any need for the service to actually implement the penalty on a regular basis. in addition, disregarding the transfer is an option available to the service, but not the taxpayer. thus, a transferee should be stuck with the form of the transaction and should not be able in retrospect to disregard the transfer, perhaps arguing that the transferor should have known that it, the transferee, had no intention of paying the tax. finally, while perhaps obvious, it is worth stressing that the rules regarding transfers of noneconomic residual interests are the concern of the transferor and the transferee. there are no direct remic level tax consequences that flow from "failed" transfers of noneconomic residual interests; the remic is never considered a transferor.437 thus, no express penalty 435. regs. § 1.860e-1(c)(4)(ii). 436. regs. § 1.860e-i(c)(1). 437. see supra note 412. 19941 florida tax review taxes apply to the remic in these circumstances nor is remic qualification at all affected by such transfers. in short, the remic has no duty to monitor transfers of its noneconomic residual interests.438 however, though not expressly required, the remic probably is under an obligation to provide, upon request, the necessary information to determine whether at the time of a proposed transfer a residual interest is a noneconomic residual or not.439 d. special rules on transfers to foreign holders 1. transfers to foreign holders.-rules roughly analogous to those relating to noneconomic residual interests are provided with respect to transfers of residual interests to holders that are "foreign persons."" these rules apply to transfers of residual interests that have "significant tax avoidance potential" and, once again, the penalty for failed transfers is that they are disregarded for all federal tax purposes." although similar to the noneconomic residual rules, the foreign transferee restrictions are distinct and have a different focus. in general, foreign persons that are not engaged in a u.s. trade or business are taxable in the united states only through withholding on payments from united states sources. if no actual cash is paid out to the foreign holder, then no tax is collected." 2 thus, excess inclusion amounts effectively escape current taxation-becoming taxable only when and if cash is paid out-and thereby result in de facto avoidance of current tax. for example, if a residual interest paid out cash in the first two years and thereafter all distributions ceased, the service would never collect tax on excess inclusion amounts after the residual interest ceased to pay out cash-a loophole of potentially gargantuan proportions. 438. cf. regs. § 1.860e-2(a)(5). of course, if the remic had actual knowledge that a transfer of a noneconomic residual interest was invalid, a concern might arise. although it is not clear how the remic would acquire such knowledge. 439. regs. § 1.860e-i(c)(3) (describing how noneconomic status is calculated) probably should be viewed as incorporating § 1.860e-2(a)(5) (obligating a remic to provide information upon request in order to compute tax due on transfers to disqualified organizations). 440. see regs. § 1.860g-3. a "foreign person" is indirectly defined by the code as any nonresident alien individual, foreign partnership, foreign corporation, or foreign estate or trust. irc §§ 7701(a)(1), (a)(30). a foreign corporation or partnership generally is one that is organized under the laws of a foreign country. see irc § 7701(a)(5). a foreign trust or estate is one that is not taxable in the united states on a net basis on its worldwide income. see irc § 7701(a)(31). 441. regs. § 1.860g-3(a)(l). 442. see discussion of withholding supra part vi.a.2. [vol. 2:4 tax aspects of remic residual interests the service's eventual solution to this concern is to prohibit transfers to foreign persons unless the residual interest is structured in such a way that the associated tax liability can be satisfied through withholding as it becomes due. in general, a residual interest may be transferred to a foreign person if, at the time of transfer, the transferor "reasonably expects" that for each excess inclusion, (i) the remic will distribute to the foreign transferee an amount that will equal at least 30% of the excess inclusion, and (ii) each such amount will be distributed at or after the time at which the excess inclusions accrues and no later than the close of the calendar year following the calendar year of accrual." 3 as originally proposed, the regulations did not specify when the requisite cash amounts needed to be distributed, other than that they be distributed at some point in time after the excess inclusion tax liability accrued. while this approach would ensure that tax on excess inclusion amounts would be collected someday, it granted generous deferral. remics soon began to issue residual interests that paid out sufficient cash distributions, but paid it out late in the life of the remic-for example, a bullet payment of cash in year thirty. true, the foreign holder would pay tax, but only after many years of deferral. it was somewhat surprising that the service initially failed to anticipate this situation; the marketplace, however, seized on it. in very short order, a large proportion of remic residual interests began to flow offshore into the hands of foreign holders. with some prompting from jealous domestic residual buyers (as rumor has it), the service reacted by amending the proposed regulations, as described above, to provide that the requisite cash distributions must be made by the end of the calendar year following the calendar year in which the tax liability for excess inclusion amounts accrued. although the intent of the service was not to impose an outright prohibition on transfers to foreign persons, in actuality its restrictions on the type of residual interests that can be so transferred has largely had that effect. the author is aware of few situations where the parties were willing to go through the inconvenience of structuring a residual interest that could be held by foreign persons. for those that are inclined to structure such residual interests, however, the thrust of the regulations is on what characteristics the transferor reasonably expects a residual interest to have. although not specifically stated, to be reasonable an expectation probably must be one that is based on the assumed prepayment and reinvestment assumptions, events that have occurred up to the time of the transfer, and any required or 443. regs. § 1.860g-3(a)(2)(i). 19941 florida tax review permitted clean up calls or any required qualified liquidation.4" under a special safe harbor, a transferor will be considered to have a reasonable expectation if the residual interest would have the requisite characteristics were the remic's qualified mortgages to prepay at each rate within a range of rates from 50% to 200% of the assumed prepayment speed.445 some interesting or odd features of the rules relating to foreign transfers are worth noting. first, the rules literally apply to any transfer of a residual interest to a foreign person, and they apply even if the transferor is itself a foreign person.4' thus, if a residual interest was transferred to a foreign person prior to the effective date of the regulations, that grandfathering is lost upon a subsequent transfer to another foreign person. more significantly, the rule is automatic and therefore is a double-edged sword. if a foreign person obtains a residual interest, then apparently the service is not able to pursue or assert any unpaid remic taxes directly against the foreign person," 7 since for tax purposes no transfer occurred. that seems to be a silly result. second, the rules only apply to direct transfers of ownership interests. a foreign person that holds an interest in a domestic pass through entity (such as a partnership, ric or reit) the assets of which include a residual interest is not deemed to acquire or transfer a residual interest merely by acquiring or transferring an interest in the pass-through entity. since each of these entities clearly are u.s. persons, the rules for transfers to foreign persons would not apply. a partnership would appear to be a particularly attractive vehicle for foreign persons to hold residual interests, since the character of the partnership's income items would flow through to the holder.448 a foreign holder would be subject to withholding at the partner444. cf. regs. § 1.860e-1(a)(3)(iv)(d) (providing method for determining value of anticipated payments); regs. § 1.860e-2(a)(3) (providing method for calculating anticipated excess inclusions). 445. regs. § 1.860g-3(a)(2)(ii). 446. regs. § 1.860g-3(a)(1), (4). 447. the foreign person may be subject to transferee liability, but that would seem to be a rather slender reed. 448. the recently proposed anti-abuse rule under § 701 should be considered in this context. see prop. regs. § 1.701-2. the heart of the anti-abuse rule is that "if a partnership is formed or availed of in connection with a transaction or series of related transactions ... with a principal purpose of substantially reducing the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter k, ... the commissioner can recast the transaction for federal tax purposes as appropriate." prop. regs. § 1.701-2(b). one way a partnership transaction may be recast is to treat the partners as owning their respective shares of partnership assets directly, a penalty that if applied would preclude ownership of a residual interest by a foreign person through a partnership. prop. regs. § 1.701-2(b)(3). the author does not believe that use of a u.s. partnership to hold residual interests in this context is in any sense abusive; the concern underlying the foreign [vol 2:4 tax aspects of remic residual interests ship level, regardless of distributions, although the importance of this issue may be diminished or eliminated if the foreign holder is a qualified resident of a treaty country. as noted above,' 9 certain treaties would exempt all income under a residual interest-excess inclusion and nonexcess inclusions income-from u.s. withholding taxes. to date, however, it does not appear that many foreign persons have chosen to hold residual interests through partnerships. 2. exception for residual interests generating ecl.-the foregoing restrictions on transfers to foreign persons do not apply if the income from the residual interest in the hands of the foreign holder would be treated as effectively connected with the conduct of a u.s. trade or business ("ecr') 5 ° although not specifically stated, in the case of foreign holders eligible to claim treaty benefits, this eci exception should apply where the income would be attributable to a u.s. permanent establishment of the holder. as a practical matter, it would seem an unusual case where a foreign person that is not bank would be able to demonstrate that a income on a residual interest is effectively connected with a u.s. trade or business.45' for foreign banks, the matter may be different; income from a residual interest is treated as eci if the u.s. office of the foreign actively and materially participated in the acquisition of the residual interest" 5-a test that allows more planning flexibility.43 it is unclear, however, to what holder transfer restrictions was that generous deferral or tax avoidance could be obtained due to the fact that withholding taxes would not apply until actual distributions under a residual interest occurred (not as income thereunder accrued). but these concerns do not exist in the case of a u.s. partnership; all income under a residual interest is reported by a u.s. entity and any amounts attributable to foreign partners are subject to withholding on a current basis regardless of partnership distributions. see regs. § 1.1441-3(0. it is true that foreign partners may be able to claim treaty benefits for excess inclusions, but that can scarcely be characterized as abusive; the treaty represents a decision by the treasury to bargain away the tax on excess inclusions and taking advantage of that bargain is hardly abusive. nevertheless, out of caution, practitioners may want to ensure that in addition to residual interests the partnership holds some cognizable business assets which can independently justify the partnership's existence. 449. see discussion supra part vi.a.i. 450. regs. § 1.860g-3(a)(3). however, the rules regarding noneconomic residual interests would apply. 451. in general, interest income on a security is effectively connected with the conduct of a trade or business in the united states based on the application of either an assetuse test or a business-activities test. regs. § 1.864-4(c)(1)(i). 452. see regs. § 1.864-4(c)(5)(ii), (iii). see generally yaron z. reich. u.s. federal income taxation of u.s. branches of foreign banks: selected issues and perspectives, 2 fla. tax rev. 1, 6-15 (1994) (discussing the eci rules for interest income of foreign banks). 453. in the hands of a foreign bank, a residual interest would qualify as a "security" 19941 florida tax review extent (if at all) u.s. branches of foreign banks actually participate in the residual interest marketplace. 3. transfers by foreign persons to u.s. persons.-a special rule is prescribed in the case of transfers of residual interests by a foreign person to a u.s. person (or to a foreign person in whose hands income from the residual interest would be eci).4 4 in such cases, if the transfer has the effect of allowing the transferor to avoid tax on accrued excess inclusions, then the transfer is disregarded and the transferor continues to be treated as the owner of the residual interest for u.s. withholding tax purposes.455 for example, if a foreign holder of a residual interest (viz., a residual interest that did not have tax avoidance potential) had accrued income tax liability for excess inclusion amounts and had not yet received cash distributions from the remic on which withholding could attach, a transfer of the residual interest to a u.s. person would mean that withholding taxes may never be collected.456 to prevent this result, the regulations provide that the transfer is disregarded and the foreign transferor remains liable.457 thus, when cash is distributed, withholding taxes attach, even though the residual interest is now "held" by a u.s. person. unfortunately, the regulations are somewhat vague in establishing a standard of whether the transfer will have the effect of avoiding tax on excess inclusions; seemingly they envision a strict liability type standard under which intent is irrelevant. e. penalty tax on transfers to disqualified organizations 1. in general.-in tamra, congress amended provisions to restrict the ownership of residual interests by disqualified organizations. 458 to accomplish this goal, it required a remic to have in place "reasonable arrangements" to prevent such ownership.459 however, in recognition of the within the meaning of regs. § 1.864-4(c)(5)(v) (it is an "evidence of an interest in" evidences of indebtedness) and as an "other security" within the meaning of regs. § 1.8644(c)(5)(ii)(b)(3). because residual interests involving up-front payments by definition do not have positive value, they would have a book value of no more than zero (query whether they could have a negative book value) for purposes of regs. § 1.864-4(c)(5)(ii). thus, acquiring such residual interests could produce eci, but without affecting the "other security" ratio in regs. § 1.864-4(c)(5)(ii)(b)(3). 454. see regs. § 1.860g-3(a)(4). 455. id. 456. typically gain on the sale of the residual will not be subject to u.s. withholding tax because the gain will not be from u.s. sources. see irc §§ 865(a)(2), 87 1(a), 1441(a). 457. regs. § 1.860g-3(a)(4). 458. see supra part iii.c.1. 459. see irc § 860d(a)(6); regs. §§ 1.860d-i(a)(4), (5). [vol 2:4 tax aspects of remic residual interests practical limitations that necessarily exist on the ability of a remic to police ownership of its residual interests, congress also enacted a special penalty to apply in the event that, notwithstanding the remic's best efforts, a residual interest does come into the hands of a disqualified organization. " 46 in general, the penalty is a one time tax that applies at the time of a transfer to the transferor or, if the transfer is effected through an agent of a disqualified organization, to such agent.46' the amount of the penalty is described below. in general, the transferor (or agent) can escape liability for the tax if it obtains from the transferee an affidavit that the transferee is not a disqualified organization, provided the transferor has no actual knowledge that the affidavit is false. 2 in short, if a disqualified organization acquires a residual interest through chicanery or ineptitude, the penalty tax is waived as to the transferor or agent, and apparently the disqualified organization can continue to own the interest without further tax consequence.4 ' an affidavit for this purpose is defined in the regulations as either the furnishing of a social security number and a statement under penalties of perjury that the number is that of the transferee, or a statement under penalties of perjury by the transferee that it is not a disqualified organization.' if a transferor or agent fails to get an acceptable affidavit (or has actual knowledge that an affidavit is false) and it turns out the transferee is a disqualified organization, the code does provide a waiver provision whereby the transferor can obtain some relief from the penalty described above. 5 under the waiver procedure, if within a reasonable period of time 460. see irc § 860e(e). the regulations provide a special exccption for transitory ownership situations, under which ownership of a residual interest by a disqualified organization is ignored if it arises incident to the formation of the remic. the disqualified organization has a binding contract to sell the interest, and the sale occurs within seven days of the startup day. regs. § 1.860e-2(a)(2). 461. irc § 860e(e)(3). an agent for this purpose is defined in the regulations as including a broker (as defined under § 6045(c) and regs. § 1.6045-1 (a)(1)), nominee or other middleman. regs. § 1.860e-2(a)(6). 462. irc § 860e(e)(4). 463. frequently, however, the remic organizational documents will provide that any transfer of a residual interest to a disqualified organization is null and void and ownership revests with the transferor. this approach, however, simply invites a lawsuit from the transferor, who may want nothing more to do with the residual interest and may be an innocent dupe of the transferee. in short, what sense does it make to punish the transferor for the transferee's transgressions? a better approach would be for remic organizational documents to prohibit ownership by disqualified organizations and leave it at that, with no provision for nullifying the transfer. 464. regs. § 1.860e-2(a)(7)(i). thus, it is not necessary, and something of an inconvenience, to require a notarized affidavit as is all too frequently required in remic organizational documents. 465. see irc § 860e(e)(7). 19941 florida tax review after discovery of the situation steps are taken so that the disqualified organization no longer holds the residual interest and if the transferor agrees to pay an amount prescribed by the service, the penalty tax will be waived. 466 if the waiver is granted, the regulations provide that the transferee will only have to pay a penalty tax based on the actual excess inclusions that accrued while the disqualified organization held the residual interest.4 67 of course, the transferor no longer owns the residual interest, so it is not entirely clear what steps the statute envisions the transferor taking to divest the transferee of ownership. unless the transferor can coax the transferee to sell its newly acquired residual interest, the rational transferor will not choose to reveal the error to the service. however, if the transferor succeeds in inducing the transferee to sell the residual interest, then transferor's risk of being assessed a penalty drops precipitously and the wily transferor may well choose to let sleeping dogs lie at this point. in short, the waiver provision seems ill designed to accomplish its goal of encouraging taxpayers to come clean. 2. calculation of the penalty tax.-the amount of the penalty tax equals the product of the highest rate of tax imposed under section 11 (b)(1) (currently 35%) and the present value of the total anticipated excess inclusions with respect to such interest for periods after the transfer.468 for this purpose, anticipated excess inclusions are those that are expected to accrue at each future quarter-end, discounted back to the date of transfer by the applicable federal rate.469 the computation of anticipated excess inclusions, which has been described previously, must be based on events that have occurred up to the time of the transfer, the prepayment and reinvestment assumptions adopted under section 1272(a)(6) (or that would have been adopted if the regular interests were issued with oid), and any required or permitted clean up call or any qualified liquidation provided for in the remic organizational documents. 470 the amount of penalty tax reflects an assumption that the residual interest will be held by a disqualified organization from the date of transfer until maturity. if the penalty tax is asserted on audit against a transferor and the disqualified organization has previously disposed of the residual interest, the unfortunate transferor must still pay the full penalty tax.47' 466. id. 467. regs. § 1.860e-2(a)(7)(ii). 468. irc § 860e(e)(2). this penalty tax is to be distinguished from the § 860e(e)(7)(b) waiver tax previously discussed. 469. regs. § 1.860e-2(a)(3). 470. id. for a discussion of the computation, see supra part vii.c. 1. 471. see irc § 860e(e). [vol 2:4 tax aspects of remic residual interests application of the penalty tax depends on calculation of the anticipated excess inclusions amounts and in order to ensure that such information is available to the transferor, the code requires that the remic has reasonable arrangements in place to ensure that this information will be provided.47, 3. special rules for pass-through entities.-the penalty tax on transfers to disqualified organizations could be easily avoided by simply having the disqualified entity hold an interest in a residual interest through a "pass through entity." for example, two disqualified organizations could enter into a partnership and have the partnership acquire residual interests. the partnership would not itself be a disqualified entity, and upon passing its income through to the partners no tax would be collected since the partners would not be subject to tax. congress had the foresight to anticipate this possibility and it provided that in this event a penalty tax would be imposed on the pass through entity itself.473 the penalty tax on pass through entities applies if during any taxable year of the entity a disqualified organization is the record holder of an interest in such entity.474 a pass through entity for this purpose is defined as a ric, reit, partnership, trust, estate, or subchapter t cooperative." in addition, if any person holds an interest in a pass through entity as a nominee for another person, such holder will be treated as itself a pass through entity with respect to the interest it holds in the pass through entity.476 in effect, the pass through entity becomes a withholding agent and is used as a tool for exacting the tax on excess inclusions that would otherwise escape. a pass through entity can avoid the penalty tax for any period if it obtains an affidavit from the record owner of an interest that such holder is not a disqualified organization, provided that during such period the 472. see irc § 860d(a)(6)(b). see also supra part iii.c. 473. see irc § 860e(e)(6). 474. irc § 860e(e)(6)(a). proposed legislation would modify the application of the penalty tax on pass-through entities in the case of so-called "large" partnerships. see tax simplification and technical corrections act of 1993, supra note 243 (proposing new §§ 771777). in general, a large partnership would be defined as one with 250 or more partners (or one with 100 or more partners that affirmatively elects large partnership status). see proposed § 775(a). under the proposed legislation, if a large partnership holds a residual interest, it would be taxed as if all of its partners were disqualified organizations (the net result being that tax on excess inclusions is collected at the partnership level at the highest corporate tax rate). see proposed § 774(e). the amount of excess inclusions subject to the penalty tax, however, would be excluded from partnership gross income (thus avoiding a second tax at the partner level). by all accounts, few large partnerships exist that hold residual interests. 475. irc § 860e(e)(6)(b). 476. id. 1994] florida tax review pass-through entity does not have actual knowledge that the affidavit is false.477 the affidavit is the same as that described above for transferors to avoid liability for a penalty tax on a direct transfer of a residual interest to a disqualified organization.478 one final aspect of the penalty tax on pass through entities concerns the effect of payment of the penalty on the entity. in this regard, the statute provides that the amount of the penalty is deductible by a pass-through entity in computing its taxable income.479 this is important for corporate entities, such as the reit or ric, which formally are taxable on their net income. by allowing a deduction, the statute is recognizing that the entity is being forced to pay the tax of its shareholder and some credit for the payment of that tax should be provided. the allowance of a deduction, however, is not entirely satisfactory to other holders of interests in a ric or reit, since the effect of collecting the tax from the entity is to reduce their respective shares of the net profits of the entity that they would otherwise receive. in effect, each is asked to shoulder the burden of paying the tax due from one or more of the interest holders that are disqualified entities. this injustice is soothed in the regulations, which permit a ric or reit to specially allocate the penalty tax to the income payable on interests held by disqualified organizations. 40 viii. postscript: residual interestsparadigm for the future? as this article shows, the tax treatment of remic residual interests is a complicated topic involving an impressive array of rules that permit, prohibit, or require all manner of acts. since the residual interest is a pure creature of statute, it carries with it no common law baggage that inevitably accompanies other financial instruments that build off the venerable tax foundations of debt, equity, option, etc. this can be a blessing in one sense; the government has fairly tight control over how the residual interest will be taxed. but it is a curse in another sense; the government must painstakingly integrate the tax rules applicable to residual interests into the general tax rules in the code. as we have seen, much work remains to be done on the latter score. too many questions remain unanswered about how general tax provisions in the code relate to residual interests. yet, stepping back from the fray for a moment, it seems clear that the remic statute as whole has been 477. irc § 860e(e)(6)(d). 478. the necessary affidavit is described in regs. § 1.860e-2(b)(2). 479. irc § 860e(e)(6)(c); regs. § 1.860e-2(b)(3). 480. see regs. § 1.860e-2(b)(4). absent this special rule, a concern could arise as to whether this special allocation violates the general prohibition against rics and reits paying preferential dividends. [vol 2:4 tax aspects of remic residual interests a huge success and there is little likelihood in the near term that remic transactions will fall out of favor. in short, the residual interest is here to stay. the success of the remic legislation has led to calls for similar securitization vehicles for other types of receivables.48' recently, independent sectors of the financial community have developed proposals for two different types of new securitization vehicles. the first such vehicle is the "financial asset securitization trust" or "fasit," which is designed for the securitization of any type of debt asselt. 2 the second is the "tax exempt municipal investment conduit" or "temic," which is designed specifically for the securitization of tax exempt debt instruments."' although it is too early too predict whether either or both proposals will be enacted in some form, it is clear that asset securitization in general has been growing exponentially in recent years. as more and more financial receivables are drawn into securitization vehicles, the prospects seem good that eventually a remic analogue or analogues will be developed for nonmortgage receivables. if so, any new securitization vehicle will likely draw heavily on the remic provisions in general (as indeed both the fasit and temic proposals do) and the remic residual interest in particular. it is therefore appropriate to examine and attempt to distill what lessons our experience with the remic residual interest can have for such new securitization vehicles. resolving the treatment of up-front payments. as we have seen, one aspect of the taxation of residual interests that has continued to plague the remic community with uncertainty after almost eight years is the treatment of up-front payments. it is likely that any future securitization vehicle, like the remic, will be permitted to have an equity interest that has little or no cash entitlement. if so, then such other vehicles will also have to grapple with the up-front payment phenomenon. thus, it is imperative that the service come to grips with the admittedly complicated tax issues that negative value property or equity present and devise a reasoned approach to taxing them. taxing phantom income and loss. much of the complexity in the tax treatment of residual interests can be traced to the stubborn resolve on the part of the government to ensure that it exacts at least one layer of tax on phantom income. the goal is laudable, to be sure, and were it possible with reasonable administrative effort to identify accurately phantom income, then perhaps the elaborate rules aimed at taxing it would be more justifiable. 481. one of the first such proposals was by the american bar association. see american bar association, legislative proposal, supra note 4. 482. a draft of the fasit rules was introduced in congress last year. see h.r. conf. rep. 2065, 103d cong., 1st sess. (1993). however, the legislation has undergone numerous changes since its introduction and likely will be introduced in a revised form. 483. the temic proposal has not been introduced in congress. although a draft of the temic legislative proposal is currently circulating among interested parties. 19941 florida tax review however, the excess inclusion rules are admittedly an inaccurate, rough justice solution that has neither the benefit of administrative ease nor the virtue of accuracy." in other words, if it be decided that accuracy is to be sacrificed or that it be unattainable, then surely some more straightforward tollcharge or other surcharge would be preferable than the excess inclusion apparatus and collateral rules. in short, the excess inclusion rules represent a theory in search of a practical application. hopefully, future securitization legislation will find a simpler compromise that will meet the government's concerns for obtaining one layer of tax and the financial community's concerns of reducing mindless transaction costs and inefficiencies. regulating transfers. growing out of the government's fixation on phantom income and its desire to ensure that such income is taxed, are a panoply of rules regulating who may own remic residual interests. in essence, the government exacts its desired tax by forcing the residual interest to be held by taxable entities and by limiting the extent to which income may be reduced by deductions. thus, the transfer rules are in reality an ad hoc set of rules patched together when and as the government perceived loopholes in its excess inclusion scheme. the problem with erecting transfer restrictions is that they are hard to enforce or audit and they amount to interposing the service into the financial marketplace. one alternative to transfer restrictions is for the government to exact some form of minimal entity level tax as the price of admission. such entity level taxes, however, tend to scare off investors and rating agencies. yet, there is much to be said for simply imposing a one time tax on the startup date to be paid by the sponsor out of the proceeds of the sale of the interests in the securitization vehicle and abandoning any effort to regulate who may own an interest in the vehicle. in conclusion, it does not augur well for the goal of simplifying the tax system that it should take an article of this length to review the tax aspects of a single financial instrument. yet, complexity-where it advances accuracy and equity in taxation-is an acceptable, if not welcome outcome. it is questionable, however, whether the rules regarding residual interests achieve an appropriate trade-off between complexity and these goals. certainly there is much room for simplification at little cost to the government, and it is to be hoped that in considering future securitization legislation 484. only irc § 809 comes to mind as a provision that surpasses the remic excess inclusion rules in terms of having a worse ratio of complexity to accuracy. section 809 sets forth an elaborate formula for limiting the deductibility of policyholder dividends by mutual life insurance companies. [vol 2:4 1994] tax aspects of remic residual interests 281 decisionmakers take away this lesson, if no other, from the tax treatment of remic residual interests. florida tax review volume 1 number 5 tax amnesty: an old debate as viewed from current public choices gerald p. moran" i. introduction the clinton administration arrived with specific, well-advertised goals: job creation, a comprehensive national health care program, economic recovery and a commitment to reduce the constantly increasing federal deficit.' there is no question that president clinton has established these policy objectives as the primary criteria upon which he desires his forthcoming leadership efforts to be judged by the electorate. success on these domestic issues would enhance his position for re-election in 1996, and would merit well-deserved respect for leadership and judgment. whether all of these separate but related goals can be achieved within both the short and long term, without being counter-productive to each other, presents one of the more intriguing enigmas faced by the administration. job creation and a comprehensive national health care program will necessarily consume more revenue in the short term. consequently, the federal deficit will increase unless new resources are found to pay the costs of these programs and unless acquisition of such resources does not significantly impair the economic recovery in progress. indeed, the current economic recovery can, on its own, deliver significant dividends. nevertheless, the search for resources will be one of the more consuming and politically sensitive issues facing president clinton. the new resources may be generated by any of the following items: (i) a cut in government expenditures, including mandatory programs; (2) an economic dividend generated *professor of law, university of toledo; university of scranton, b.s. 1960. catholic university of america, j.d. 1963, george washington university, ll.m. 1966. 1 would like to express my appreciation for the exceptional research assistance provided by mark j. dinsmore, j.d. 1994, and the generous administrative support provided by ms. peggye cummings. 1. see president william j. clinton, inaugural address (jan. 20, 1993). in 29 wkly. compilation of presidential documents, 75-77 (jan. 25, 1993). florida tax review through restructuring of the health delivery system;2 and (3) an increase in tax revenues. notwithstanding the anticipated economic dividend to be generated from the restructuring of a health delivery system, it is likely that only cuts in federal expenditures coupled with increased tax revenues will provide the funds necessary to attain and sustain president clinton's goals as laid out in his state of the union address. the normal political jousting conducted during the presidential campaign-i.e., do the numbers add up--is now irrelevant to the more pressing search for new resources in light of the recently revised report of the office of management and budget (the "omb") that the deficits for fiscal year 1994 and the out years are greater than the original estimates of the bush administration.4 apart from the debate as to whether the increase in the 2. president william j. clinton, remarks on health care reform and an exchange with reporters (jan. 25, 1993), in 29 wkly. compilation of presidential documents, 96-98 (feb. 1, 1993). president clinton has consistently expressed the view that universal health insurance can be provided without incurring increased costs. in responding to a question of whether universal health coverage will increase deficits, president clinton stated, in part, the following: so the answer to your question is, in my judgment, if we do this right over the next 8 years, you're going to see huge savings in tax dollars and even bigger savings, more than twice the savings, in private dollars that will free up hundreds of billions of dollars literally between now and the end of the decade to reinvest in economic growth and opportunity. in the short run, our tough call will be how do you take savings and phase in universal coverage. or should there be some other way to pay for that? we've got some short-term calls to make. but there's no question that in the median term, 5 to 8 years, you're looking at massive savings with universal coverage in both tax dollars and private sector dollars if we do it right. id. at 97-98. obviously, president clinton is aware that, during the short term, universal health care will impose very substantial increases in costs if such health protection is provided. a memorandum on health care costs, written by white house advisor ira magaziner to health care task force leader hillary rodham clinton, estimated that the annual additional cost for universal health care coverage might run between $30 billion and $90 billion a year by 1997. see priscilla painton, the next dose of medicine, time, mar. 1, 1993, at 28. this highly confidential memorandum was leaked to the wall street journal. id. 3. see president william j. clinton, state of the union address (feb. 17, 1993), in n.y. times, feb. 18, 1993, at a20; see also discussion infra text accompanying notes 8-9. recently, president clinton personally acknowledged that universal health care coverage would generate the need for more revenues and discussed the possibility of increased federal taxes on tobacco as a means of meeting some of these revenue demands. see michael k. frisby, clinton signals new tax on cigarettes, other items to finance health program, wall st. j., feb. 26, 1993, at a3. thus, the basic choice is between cutting federal expenditures or raising taxes; as between those options, raising taxes may be the easier political choice. 4. office of management and budget, budget baselines, historical data, and alternatives for the future 32-37 (january, 1993). see also office of management and budget, [vol 1:5 tax anmestv: an old debate estimate of deficits was a true "surprise," 5 the expectation of greatly increased deficits approaching $50 billion a year, over and above the previously projected figures for the out years, has been accepted as reasonably accurate for present planning purposes by both the administration and congress. thus, federal deficits, both accumulated and recently revised, have greatly reduced the administration's discretionary choices with respect to the design of programs necessary to attain its policy objectives. this is particularly true as rhetoric gave way to the birth of specific clinton prescriptions, set forth in his state of the union address, and their anticipated enactment, with or without congressional modifications. because of the opportunity for budget of the united states government, fiscal year 1994 2 (1993) [hereinafter 1994 budget]. there is a complicated political struggle behind the increased deficits projected in the recent budget of the bush administration. the original budget projections for fiscal years ending 1993 through 1997, inclusive, reflected projected deficits for the respective fiscal years (independent of a national health care) of $351 billion (1993), $211.4 billion (1994). s192.1 billion (1995), $180 billion (1996) and $181.8 billion (1997). the final report of the bush administration, as prepared by the office of management and budget ("omb"), dated january 6. 1993. revealed projected deficits for 1994 and the out years significantly greater than original estimates made on january 29, 1992. id. prior estimates made by the congressional budget office ("cbot). released during august of 1992, projected deficits for the years 1993 through 1997 of $331 billion (1993), $268 billion (1994), $244 billion (1995), $254 billion (1996) and s290 billion (1997). congressional budget office, the economic and budget outlook: an update xii (aug. 1992) [hereinafter budget outlook]. these estimated losses were substantially greater than the original projections of the omb and are confirmed in the budget of the united states for fy 1994. 1994 budget, supra. the cbo explained in its budget outlook that the 1990 budget agreement failed to reach its goal of control over the deficits because: "a stubbornly sluggish economy, a shortfall in tax revenues, and unexpectedly rapid growth in federal benefit programs-primarily medicare and medicaid-have left the federal deficit stuck near s300 billion for the next few years and heading upward in the second half of the decade." budget outlook. supra. because of the significant increases in the deficit projections by the cbo, senator pete v. domenici (r-n.m.) expressed the view that the clinton administration was somewhat disingenuous in its claimed "shock" regarding notice of the revised deficit projections of the omb released on january 6, 1993. pete v. domenici, the gop's offer, wash. post, feb. 21. 1993. at c7. yet, president clinton's team said "our legs were taken out from under us when the new omb numbers came out." dan balz & ann devroy, how clinton navigated politics, economics on plan, wash. post, feb 21, 1993, at a1, a16. the normally confrontational richard darman, former director of the omb, went out of his way not only to point out that candidate clinton's economic blueprint "creates a circle that cannot be squared..." but also assumed that discretionary spending will be frozen for the years 1996, 1997 and 1998, after the caps established under the 1990 budget summit expire. george hager, time bombs for clinton seen in bush's final budget, 51 cong. q. 68, 71 (jan. 9, 1993). the completely unrealistic assumption of a freeze in discretionary spending for the out years after fiscal year 1995, and the resulting increase in the projected deficits, broke the back of the promised middle class tax relief. 5. balz & devroy, supra note 4, at a16. 19931 florida tax review political manipulation of omb projections, president clinton's goal of a $140 billion cut in the projected deficits for 1997 will now be based upon the perhaps less politically sensitive budget projections of the congressional budget office.6 the american electorate likely will support the president when he effects a significant change in his political policy-for example, by recommending increases in taxes without providing tax relief to the middle class-if the facts necessitating such change are candidly set forth. president clinton's inaugural address highlighted the need for equal sharing of the sacrifice. the state of the union address filled in some painful details which illustrate the meaning of commitment to shared sacrifice. the president said that all americans must share the burdens of government if more of us are to realize the promises of a right to liberty in its full empirical reality: a place to live, a quality education, a job, comprehensive health care and the full opportunity to realize our individual potential. the initial public response suggests that the body politic is willing to support the president's comprehensive economic and tax program. president clinton has selected experienced policy advisers who will effectively represent his position as the comprehensive program moves through congress. secretary of the treasury lloyd bentsen and omb director leon panetta, among others, provide an exceptional combination of experience, 8 legislative expertise, and judgment to defend president clinton's recommendations with respect to cuts in government expenditures and increases in taxes. to fund his comprehensive economic plan, president clinton recommended that congress immediately enact a tax package containing the following elements: 1. an energy tax based on british thermal unit or heat content as well as a continuation of a federal gasoline tax. 2. an increase in the highest marginal rate to thirty-six percent on incomes in excess of $140,000 for people filing a joint return and a surtax on taxable income in excess of $250,000. 3. disallowance of business expense deductions by corporations for compensation of a corporate officer or director in excess of $1 million dollars, except where compensation is based upon productivity. 6. clinton, supra note 3. 7. nancy gibbs, working the crowd, time, mar. 1, 1993, at 26. the initial public response to the economic and tax proposals was quite positive. the polls reflected very favorable support for the president's plan. id. 8. see balz & devroy, supra note 4, at a16. [vol 1:5 tax anmesty: an old debate 4. an increase in tax collected on the incomes of foreign businesses through enhanced enforcement of section 482 of the internal revenue code or the enactment of amendments which may be necessary to tax foreign corporations on profits made in the united states. 5. an increase in the tax rate to thirty-six percent for corporations the taxable income of which exceeds $10 million. 6. an increase in the percentage of social security benefits which are subject to the income tax from fifty percent to eighty-five percent for a single person whose income is in excess of $25,000 and for couples whose income is in excess of $32,000. 7. a reduction in the amount of deductible entertainment expenses from eighty percent to fifty percent and the elimination of any deduction for club dues. 8. an expansion of the earned income tax credit to cover more low income taxpayers. 9. the enactment of an investment tax credit (permanent for small business and temporary for large corporations). 10. the enactment of enterprise zones, under which numerous tax benefits would be available to businesses operating in such zones.9 it is the purpose of this article to suggest that there be incorporated in the tax package a comprehensive federal tax amnesty program to secure additional tax revenues which will not othenvise be recovered by the government. although a federal tax amnesty program has often been discussed,"0 9. summary of administration's revenue proposals. released by treasury department feb. 25, 1993, daily tax rep., special supplement (bna) (feb. 26, 1993). 10. see testimony before the subcomm. on commerce, consumer and monetary affairs of the house comm. on government operations, 101st cong.. 2d sem. (1990) (testimony of sen. alan j. dixon) (available in tax notes. microfiche database doec. 90-5335 (july 30, 1990)); james p. angelini, federal tax amnesty: some policy considerations, 36 tax notes 907 (aug. 31, 1987); robert m. melia, is the pen mightier than the audit?, 34 tax notes 1309 (mar. 30, 1987) (discussing a state amnesty program); carol douglas, is a federal tax amnesty the answer to our deficit problems?, 30 tax notes 711 (feb. 24. 1986); richard e. harris, revenue sans taxes: congress shifts attention to federal tax amnesty, 30 tax notes 916 (mar. 10, 1986); leo p. martinez, federal tax amnesty: crime and punishment revisited, 10 va. tax rev. 535 (1991): bonnie g. ross. federal tax amnesty: reflecting on the states' experiences, 40 tax law. 145. 149 n.24 (1986) (listing tax amnesty bills introduced in the 99th congress); u.s. budget: talk of tax amnesty sweeps congress as senate panel starts work on fy 1987 budget plan, daily tax report. (bna) ll2 (mar. 5, 1986); federal tax amnesty: has its time come?, u.s. news & world rep. 16 (1986). 19931 florida tax review the internal revenue service has consistently opposed the adoption of such a program. in light of the pressing need for more revenue and anticipated significant increases in federal expenditures to fund a comprehensive health program," the matter of a tax amnesty program deserves a full review. if we are to reinvent the government as the president has proposed, we must be able to review prior policy conclusions to see whether they remain appropriate from the perspective of current conditions.' 2 the sections set forth below discuss (1) the "tax gap"; (2) the recently announced nonfiling program of the internal revenue service; (3) the administrative enforcement options available to the internal revenue service; (4) an overview of a comprehensive tax amnesty program; (5) the traditional response of the internal revenue service to a proposed amnesty program; and (6) a proposed model for a comprehensive tax amnesty program. ii. the tax gap and taxpayer rationalization the loss of revenue from noncompliance presents one of the more vexing and frustrating matters faced by tax administrators. the most recent internal revenue service estimate of income tax revenue loss due to noncompliance has grown to between $110 and $127 billion a year, 13 an amount there have been a number of bills introduced on the topic. see douglas, supra (listing bills introduced concerning a federal tax amnesty program); see also, e.g., testimony before the subcomm. on commerce, consumer and monetary affairs of the house comm. on government operations, 101st cong., 2d sess. (1990) (testimony of michael j. graetz) (available in tax notes, microfiche database doc. 90-5337 (july 30, 1990)); testimony before the subcomm. on commerce, consumer and monetary affairs of the house comm. on government operations, 101st cong., 2d sess. (1990) (testimony of fred t. goldberg, jr.) (available in tax notes, microfiche database doc. 90-5336 (july 30, 1990)); proposals to simplify and streamline the payment of employment taxes for domestic workers: joint hearing before the subcomm. on social security & subcomm. on human resources of the house comm. on ways and means, 103d cong., ist sess. (1993) (containing a discussion of tax amnesty for the limited purpose of employment tax liability of household consumers in connection with employment of domestic servants). 11. see clinton, supra note 2 at 97 (containing president clinton's remarks regarding the tough choices necessary to control health care costs and provide health care for everyone). 12. see clinton, supra note 3. 13. testimony before the subcomm. on treasury, postal service and general government of the house comm. on appropriations, 103d cong., 1st sess. (1993) (testimony of michael p. dolan) (available in lexis, fedtax library, tnt file, elect. cite 93 tnt 2649). the tax gap estimates are based on service studies conducted in 1988 and 1990. id. see gibbs, infra note 16. former commissioner fred t. goldberg candidly stated that" 'we don't really know, folks,' about the size of the tax gap. 'it might be $80 billion [a year], it might be $200 billion. we do know its a very large number.' sean ford & marianne evans, irs [vol 1:5 tax anmesty: an old debate almost equal to president clinton's goal of cutting the deficit in 1997 by $140 billion. 14 the revenue loss due to noncompliance is referred to as the "tax gap.' the tax gap does not include losses due to noncompliance with respect to employment taxes, excise taxes, or illegal sources of income. 6 consequently, the actual revenue loss due to noncompliance each year certainly exceeds the president's deficit reduction goal. 17 a consumption type of system or a national sales tax may reduce the effects of noncompliance, but would present many other problems.'8 for the short term, the issue of tax compliance under the existing income tax system, as it relates to nonfilers, tax avoiders and evaders, is a matter of national urgency. the tax gap and the consequent annual loss of billions of dollars has been reviewed by the internal revenue service and congress, as well as independent experts. the most important question is not the amount of the revenue lost, or whether the percentage of compliance is decreasing, improving or remaining the same,' 9 but rather how can the amount of the revenue loss be reduced. admittedly has long way to go on administration, simplification, 49 tax notes 1272, 1273 (dec. 17, 1990). 14. clinton, supra note 3. 15. united states general accounting office, bricfing report to the chairman, subcomm. on oversight, house comm. on ways and means. tax administration: irs' tax gap studies 4 (mar. 1988) (available in tax notes, microfiche database dec. 88-3368 (apr. 4, 1988)). the tax gap according to the definition of the gao is "the difference between the amount of income taxes voluntarily paid by individuals and businesses and the amount of income taxes that are owed." id. the methodology used in determining such estimates relies largely on data derived from in-depth audit examinations referred to as the taxpayer compliance measurement program ("tcmp"). see dolan. supra note 13. 16. see testimony before the senate budget comm., 100th cong., 2d sess. (1988) (testimony of lawrence b. gibbs) (available in tax notes, microfiche database doe. 88-3367 (apr. 11, 1988)). the tax gap does not include taxes not paid on income derived from illegal activities. id. the service was expected to issue similar tax gap reports concerning noncompliance in the tax areas of employment tax, excise tax, and illegal sources of income. staff of the house comm. on ways and means, 101st. cong., 2d sess., overview of the federal tax system 195 (comm. print 1990) [hereinafter overview]. this, as yet, has not occurred. 17. clinton, supra note 3. 18. among the major problems attendant to the adoption of a vat would be that, like a national sales tax, the vat would be a regressive tax and present numerous collection problems. see shift to consumption taxation is desirable, says former cea member, daily tax report, (bna) g-2 (jan. 26, 1993). 19. see f.r. nagle, irs takes aim at practitioners amid news that some are nonfilers, 58 tax notes 833, 834 (feb. 15, 1993). acting commissioner dolan indicated the rate of compliance remains stable at 83%. id. see also susan b. long & david burnham. the numbers game: changes in tax compliance during the last 25 years?, 46 tax notes 1177 (mar. 5, 1990); ross, supra note 10, at 146 (indicating the rate of compliance in 1965 was 94%). 19931 florida tax review a separate but important part of the milieu in which nonfilers, tax avoiders and evaders often interact is the broad social structure of the "underground economy." the underground economy is actively supported by many of our citizens sub silentio. unfortunately, they frequently view the issue of noncompliance with a certain degree of "gleeful joy" that one of them is escaping payment of taxes, rather than recognizing such conduct as it truly is, theft from every taxpayer who pays his or her fair share. this phenomenon is analogous to the public's support for the continuing illegal escapades of john dillinger in the 1930's. ideally, of course, the obligation to pay taxes should be viewed as a compact among all citizens to pay for the variety of services produced by the government such as insuring our savings accounts, guaranteeing minimum social security benefits, providing for health care and economic assistance in the event of a disaster, as well as providing police and armed forces protection for our basic security. the extent to which people voluntarily enter into this compact can be affected by their perceptions of how well the government fulfills its purpose. some believe that the government too often assumes a life of its own, independent of its purpose. it sometimes adopts policies which may violate common sense standards, for example, "he had to destroy the village to save it;" 20 and it attempts, consciously or not, to accumulate more power while providing less service and attempting to avoid accountability. the basic institutional attitudes of some careerist members of the government are directed toward increasing their own job security at the cost of delivering services. for this reason, it is enormously difficult for an agency of the government to present a vision of renewal which necessarily divests some of its careerist members of their secured positions of power. this situation also occurs in private industry. indeed, everyone exists in interacting economic and social structures, and adopts strategies for his or her own survival. careerist members of the government and independent entrepreneurs are simply operating in different primary regimes within which they both seek security and economic freedom. our natural antagonism toward government and its inability to deliver common sense services, when combined with a sociopathic insensitivity in the administration of the law, particularly tax laws, enrages us! still, the inherent and institutional limitations of the government do not provide justification for failing to pay one's fair share,2' nor should 20. mike causey, is the bureaucracy political football?, the wash. post, apr. 20, 1979, c2. 21. noncompliant taxpayers resort to a wide range of rationalizations to avoid paying their taxes, including perceived improbability of detection, negative attitudes about the government and the belief that other taxpayers are not paying their taxes. see steven m. sheffrin & robert k. triest, can brute deterrence backfire?: perceptions and attitudes in tax compliance (dec. 7-8, 1990) (available in tax notes, microfiche database doc. 90-8544 (dec. [not. 1:5 tax anmesry: an old debate we smile when a citizen escapes the tax snare. li. the new internal revenue service policy with respect to nonfilers-voluntary disclosure the internal revenue service has reported that the number of filed income tax returns increased from i 10 million in 1988 to 114 million in 1990 and, unfortunately, that the number of nonfilers also rose.2the report concluded that approximately ten million individuals and businesses do not file income tax returns.' during 1991, the inventory of nonfilers rose by thirty percent.24 in response to this problem the internal revenue service has recently reassigned 2000 examining agents the task of locating and contacting nonfilers. 5 this allocation of almost ten percent of the audit staff should both reduce the existing inventory of nonfiler cases and identify additional nonfilers. thus, the existing inventory as of 1991 should decrease, but new nonfiler cases will likely exceed closings. the income tax gap attributable to nonfilers for 1992 was approximately $7 billion according to an announcement of the internal revenue service on september 30, 1992.26 since the estimate of the income tax gap for nonfilers in 1987 was over $7 billion, -7 one senses that either the 1987 figure was inflated or the current projection of the tax gap due to nonfilers is seriously understated. indeed, acting commissioner dolan recently testified that the tax gap for nonfilers in fiscal year 1992 was over $10 billionl the internal revenue service has, for many years, encouraged nonfilers to get into the system through a voluntary disclosure program. between 1934 and 1952, it was the policy of the internal revenue service not to recommend criminal prosecution when the taxpayer came forward, made a true voluntary disclosure, and filed an accurate tax return.this policy was 17, 1990)); j. andrew hoerner, why comply? michigan conference focuses on why taxpayers do not, 49 tax notes 1294, 1295 (dec. 17, 1990). 22. i.r.s. news rel. 92-5 (jan. 17, 1992). 1992 cch '1 46.164. 23. id. 24. id. 25. i.r.s. news rel. 92-94 (sept. 30, 1992). 1992 cch 1 46,553. 26. id. 27. internal revenue service, u.s. dep't of the treasury, pub. no. 7285. income tax compliance research: gross tax gap estimates and projections for 1973-1992 3 (mar. 1988) (available in tax notes, microfiche database doe. 88-27 18 (mar. 28, 1988)). 28. dolan, supra note 13. 29. see harry g. balter, tax fraud and evasion 1 4.01 (5th ed. 1983 & supp. i 1993); theron l. caudle, how the department of justice operates in income tax fraud cases, 87 j. acct. 206 (1949). caudle points out that the voluntary disclosure policy began in 1934 and was publicly discussed in 1945 by then secretary of the treasury frederick m. 19931 florida tax review vinson. id. at 213-14. see also denzil y. causey, jr., the tax practitioner 7-5 to 7-6 (1984) (discussing legal strategy under current internal revenue service policy); united states v. hebel, 668 f.2d 995 (8th cir.), cert. denied, 456 u.s. 946 (1982) (affirming convictions of taxpayers who voluntarily disclosed filing false returns). the most comprehensive review of the voluntary disclosure policy of the service can be found in congressional hearings. in 1952, representative cecil r. king, as chairman of the subcommittee on administration of internal revenue laws of the house committee on ways and means, conducted an intensive and extensive inquiry into the internal practices of the service with respect to how voluntary disclosure, health conditions of the taxpayer, and other relevant matters impact on the decision of the service to recommend criminal tax prosecution. see proposals for strengthening tax administration: hearings on administration of the internal revenue laws before the subcommittee on administration of the internal revenue laws of the house committee on ways and means, 82d cong., 2d sess. (1952) [hereinafter proposals]. richard c. schwartz, the then assistant head, penal division, bureau of internal revenue, provided specific testimony concerning the long and ambiguous policy of the service with respect to voluntary disclosure. id. at 103-66. the internal policy was first formally adopted on august 22, 1919, although there was a prior negative policy on the compromise of criminal prosecutions dating back before september 12, 1912. id. at 138-39. the 1919 policy as stated was: in cases where voluntary disclosure is made of deficiencies through intentional evasions which, if discovered by internal revenue officers, would be made the basis of criminal prosecution, it will be the policy of the bureau to impose maximum civil penalties and accept offers in compromise of the criminal liability, instead of instituting prosecution and insisting on jail sentence. id. at 139. a similar statement of internal policy was announced on july 2, 1934, in a confidential written statement from commissioner guy t. helvering, which was approved by secretary of the treasury h. morganthau, jr. id. at 139-142. the policy was not made public until 1945 when it was included in various announcements by service and treasury officials. id. at 139-50. the policy was formally withdrawn on january 10, 1952. id. at 151. the entire text of the policy reversal is as follows: secretary snyder announced today that the treasury department has abandoned the policy under which criminal prosecution has not been recommended in cases where taxpayers made voluntary disclosures of intentional violation of the internal revenue laws prior to the initiation of the investigation by the bureau of internal revenue. this action was recommended by commissioner dunlap. in connection with this change of policy, the secretary issued the following statement: while it has been the long-established policy of the treasury department to refrain from recommending criminal prosecution where taxpayers make voluntary disclosure of intentional tax evasion prior to the initiation of an investigation by the bureau of internal revenue, it has been concluded that such policy will no longer be followed. litigation in the courts in recent years has illustrated the controversial nature of the question as to what constitutes a true voluntary disclosure in fact. in the administration of the policy it has been difficult and at times impossible to ascertain whether the disclosure was made because the taxpayer realized he was under investigation or whether the disclosure was in fact voluntary and in [vol. 1:5 tax amnesty: an old debate formally abandoned on january 10, 1952." thereafter, voluntary disclosure was considered merely as one of the factors in deciding whether to file criminal charges. 3' termination of the policy in 1952 was based, in part, on the fact that it created an opportunity for taxpayers, no matter what the facts were, to claim that they had voluntarily disclosed and therefore could not be criminally prosecuted. 2 in light of the resulting litigation, it was natural for the service to modify the policy from guaranteeing no criminal prosecution to merely considering voluntary reporting as one factor in deciding whether to prosecute. there was also some concern about possible corruption by government officials arising from the discretion inherent in the original policy.33 after the 1952 change in policy, a taxpayer could no longer argue that voluntary disclosure insulated the taxpayer from a subsequent criminal prosecution. nevertheless, a "common law" expectation has long continued, derived in part from the past practices of the service that voluntary disclosure generally would avoid a criminal prosecution, particularly for nonfilers.' the conclusion which can be derived from this history is that the internal revenue service does not have a formal policy of immunity from prosecution by reason of voluntary disclosure, but may decline criminal prosecution after considering the evidence, including the taxpayer's voluntary disclosure. notwithstanding the "common law" expectation, a tax adviser could never assure a taxpayer that there will not be criminal prosecution. clearly, counsel's advice regarding voluntary disclosure presents not only a difficult question because of the potential for criminal prosecution of the reliance on the immunity held out by the policy. the intensified enforcement activities of the bureau's special tax fraud drive and racket squads throughout the country are ferreting out the willful tax evaders, and resulting in recovery of the additional taxes and penalties due the government. it is the policy of the treasury department to recommend criminal prosecution in every case where the facts and circumstances warrant that action. id. at 151-52. the purpose behind the public announcement of the voluntary disclosure policy in 1945 was primarily to produce revenue collections from sources which could not otherwise be discovered. id. at 152-53. the extent to which the policy did generate increased tax revenues, and the extent to which its withdrawal caused a decrease in revenue are unknown. id. at 152-52, 161-62. the most complex difficulty in administering the voluntary disclosure program was fixing the date on which the investigation began. id. at 160-63. this date was critical for a taxpayer to obtain criminal tax immunity. id. 30. proposals, supra note 29, at 151-52. see also harry g. balter, caplin restates voluntary disclosure policy as rumors of irs change circulate, 16 j. tax'n 104 (1962). 31. baiter, supra note 29, 9h 4.02-4.04. 32. see proposals, supra note 29, at 162-63. 33. see, e.g., connelly v. united states, 249 f.2d 576 (8th cir. 1957). 34. balter, supra note 29, %91 4.02-4.04. 19931 florida tax review client, but also because of the potential criminal and ethical exposure of the tax adviser in certain instances where voluntary compliance is not recommended.35 on september 30, 1992, the internal revenue service issued a notice announcing the adoption of a special program to provide comprehensive support for the ten million nonfilers. 6 the core of this new program was the realization that many taxpayers who failed to file for one year became frightened about filing a tax return the next year. thus, there was a "psychological freeze" about facing the issue in successive tax years.37 as part of the program, the service noted that those who would voluntarily come forward should not fear criminal prosecution. commissioner shirley peterson explained that the internal revenue service would not recommend criminal prosecution of any taxpayer for wrongdoing if such action occurred prior to the initiation of an investigation by the service. 38 this is identical to the terminated voluntary disclosure program, except that it does not provide unconditional "absolute" amnesty from criminal prosecution and it is limited to nonfilers. tax advisers and taxpayers welcomed the adoption of this policy. unfortunately, despite the best intentions of the internal revenue service, the recent policy is still couched in conditional language. thus, a tax adviser cannot guarantee that voluntary filing will never result in criminal prosecutions. even commissioner peterson's position on the nonfiler policy does not resolve all ambiguities on the issue of criminal prosecution. in an appearance before the tennessee tax institute, she stated that: "the nonfiler program is a long-term effort to improve tax compliance and the whole purpose is to get people back in the system, not to prosecute ordinary people who made a mistake (emphasis added)."39 obviously, this suggests that an "extraordinary person," for example, a drug dealer, may still be subject to criminal prosecution. thus, although the service's new policy has been characterized as "a virtual amnesty, 40 that characterization is not synonymous with a formalized tax amnesty.4' 35. united states v. baskes, 442 f. supp. 322 (1977), aff'd, 649 f.2d 471 (7th cir., 1980). 36. i.r.s. news rel. 92-94 (sept. 30, 1992), 1992 cch 46,553. 37. id. 38. see id. 39. i.r.s. news rel. 92-114 (dec. 7, 1992), 1992 cch 46,669. 40. nagle, supra note 19, at 833 (noting a statement of steven harris, a miami tax practitioner, indicating that the nonfiling program of the internal revenue service is "virtual amnesty" from prosecution). acting commissioner dolan and acting assistant attorney general, tax division, james a. bruton disagreed with the view of harris that the term amnesty was an accurate description of the nonfiler program. id. 41. irs official says taxpayers should not expect announcement of full tax [vol 1:5 tax annest.: an old debate some authorities have been troubled by the degree to which a taxpayer could rely on the internal practice of the internal revenue service with regard to voluntary disclosure as a bar to prosecution. the new policy, as now formalized, applies only to nonfilers of income tax returns and remains subject to certain conditions which remain entirely within the discretion of the service. the voluntary policy would not apply to a drug dealer or anyone else whose source of income is an illegal activity or to a situation which presents an "egregious" failure to file. nor does this new policy apply to tax evaders who have filed fraudulent income tax returns. in addition, tax practitioners who failed to file an income tax return might face disbarment from practice before the service unless certain provisions of internal revenue service circular 230 are revised.4" unfortunately, because of the limitations on the policy with respect to nonfilers, a tax adviser cannot guarantee that voluntary filing will preclude criminal prosecution. thus, even though the american bar association tax section has fully cooperated with the internal revenue service in assisting taxpayers in filing income tax returns,43 there is no absolute assurance that those taxpayers will not be prosecuted. it is probably true that earners of modest amounts of income who have not previously filed for a limited number of taxable periods do not have to fear criminal prosecutions, however other earners of income still face a degree of anxiety and some, such as drug dealers, face a high probability of criminal prosecution. while one may applaud the service with respect to its policy amnesty, daily tax rep., (bna) (jan. 7, 1993). acting commissioner dolan stated, on january 6, 1993, before the bentley college center for tax studies 15th annual institute on federal taxation, that, while the principal thrust of the nonfiling program is not one of criminal prosecution, the "irs has stopped short of promising amnesty to all nonfilers because some cases are so egregious and so significant that the irs will introduce criminal prosecution." id. frank wolpe, director of the center for tax studies at bentley college expressed the concern that some career members of the criminal investigations division might attempt to end run the program by making early contact with nonfilers before they come in voluntarily. id. notwithstanding, acting assistant attorney general james a. bruton has said that the service has not recommended criminal prosecution in any case where the taxpayer participated in the nonfiler program. nagle, supra note 19, at 833. 42. see nagle, supra note 19, at 833. at the mid-year meeting of the american bar association tax section, internal revenue service director of practice leslie s. shapiro expressed the view that internal revenue service circular 230 would be amended so that tax professionals who had failed to file an income tax return, but had then come forward and voluntarily filed a return, would receive a letter of reprimand rather than face possible disbarment. former commissioner shirley peterson stated that the tax section had been informed that there are a shocking number of tax practitioners, including attorneys and certified public accountants, who have not filed. id. 43. id. more than 300 american bar association members have assisted the service in the nonfiler program through telephone assistance and on-site tax clinics. id. 19931 florida tax review regarding nonfilers, the policy should be revised so that all conditions limiting its application are "formally" withdrawn. a simple and unconditional tax amnesty for nonfilers of income tax returns is appropriate. in addition, the program should not be limited to income tax returns, but should apply to all types of returns, for example, information, excise, employment or other similar returns which are required to be filed." since the government needs revenue, and participation by more taxpayers necessarily increases tax revenue, the burden of taxation will be reallocated so that each taxpayer's share of the pain will, at some point, be reduced.45 a revised nonfiler policy of this nature allows for correction of the collective and intentional failures of those taxpayers who have, for one reason or another, failed to file a return and pay taxes. the cost will be acceptable to many so long as such policy generates substantial increases in tax revenue. in addition to the elimination of criminal prosecution, a number of the civil tax penalties should also be waived. under the existing policy of the service, certain civil penalties may be waived if the taxpayer establishes reasonable cause for his or her failure to file. it does not make sense to impose the full range of civil penalties where the amount of such penalties is in excess of the amount the nonfiling taxpayer reasonably can pay in light of his or her economic circumstances. obviously, an increase in the number of installment agreements or offers-in-compromise due to inability of the nonfiler to pay such penalties frustrates one of the primary purposes of the program-payment of past taxes. but the imposition of penalties may limit the effectiveness of the new policy in getting taxpayers on the rolls for future tax "contributions." indeed, it may be that fear of civil penalties is one of the reasons some taxpayers cannot come out of the cold; they cannot afford to pay. the program should be designed to reach the primary objectivevoluntary compliance! iv. enforcement options of the internal revenue service the reason behind a policy of no absolute amnesty from criminal prosecution for nonfilers arises, presumably, from an internal debate between 44. irs looking to expand the non-filer program to employment and other taxes, daily tax rep., (bna) (feb. 19, 1993). because some nonfilers have failed to file other tax returns, they are reluctant to make a voluntary disclosure about their failure to file an income tax return. internal revenue service chief operations officer dave blattner and internal revenue service compliance 2000 executive marshall washburn have informally indicated that the service is considering expanding its nonfiler program to other returns such as excise and employment tax returns. id. 45. this assumes the government will not increase expenditures as new revenues are generated. [vol. 1:5 tax anuzesty: an old debate different elements of the service. one group, composed of computer-oriented managers, recognizes that fear of prosecution and/or civil audits as the principal mechanism for voluntary tax compliance is no longer sufficient if the service is successfully to meet its onerous administrative responsibilities into the next century. the other group believes, based largely on past practices, that the primary method of maintaining or increasing tax compliance is through increased audits and criminal enforcement. according to acting internal revenue service commissioner dolan, data indicates that the degree of compliance is relatively stable.47 this begs the question as to whether new approaches, such as the nonfiler program, should be tried and expanded. one senses that behind the service's new nonfiler program and its recently adopted administrative approach known as compliance 2000,4 46. see jeffrey a. dubin, et al., penny-wise and pound-foolish: new estimates of the impact of audits on revenue, 35 tax notes 787 (may 25, 1987). graetz is also of the view that audits are a principal force for deterrence and should be restored to the central place of enforcement. see j. andrew hoerner, think incremental tax changes, graetz tells compliance conference, 49 tax notes 1271, 1272 (dec. 17, 1990). 47. nagle, supra note 19, at 834. 48. the internal revenue service, through the leadership of, among others, former commissioner shirley peterson and former assistant to the secretary of the treasury for tax policy fred t. goldberg, adopted a new approach with respect to administration of the tax laws under the policy known as compliance 2000. [see testimony before the subcomm. on treasury, postal service and general government of the house comm. on appropriations, 103d cong., ist sess. (1993) (testimony of michael p. dolan).] the focus of this program is to increase voluntary compliance, reduce taxpayer burdens, and improve productivity and customer service. a main feature of this program is to treat the taxpayer as a customer or client of the internal revenue service. regional commissioner leon moore, in discussing elements of the recently announced nonfiling program of the internal revenue service, stated this change in policy was part of a new policy to make the internal revenue service more "user-friendly." [internal revenue service regional commissioner leon moore, address at the central region internal revenue service and bar association liaison meeting (nov. 13, 1992); see also, internal revenue service regional counsel clarence e. barnes, jr.. address at the central region internal revenue service and bar association liaison meeting (nov. 13, 1992) (expressing similar concerns that compliance achieved solely through fear was becoming outdated). see kent w. smith & loretta j. stalans, encouraging tax compliance with positive incentives: a conceptual framework and research directions, 13 law & pol'y 35 (1991) (suggesting that positive incentives, rather than threats, punishment and incapacitation, can increase compliance with the tax laws and that additional research is needed on this approach). the smith and stalans article includes an excellent bibliography. id. at 50-53.) the taxpayer is now recognized as an important resource who should not live in fear and suspicion of the internal revenue service, but rather should look to the internal revenue service for competent and caring assistance in meeting the complex responsibilities created by the existing tax system. see irs expects continued oversight by appropriations subcommittee, daily tax rep., (bna) g-1, g-2 (feb. 9, 1993). acting commissioner dolan stated that the "irs is using a more 'differentiated' approach to the taxpayer community." he explained that taxpayers are broken down into three groups: (1) those in compliance; (2) those who want to be 19931 florida tax review there are many careerist members within the service who are willing, with certain restrictions, to innovate and accept responsibility for the possibility that such new programs might not succeed. there is a realization that these new programs might, indeed, provide a catalyst to increase voluntary compliance. the initial report on the nonfiler programs is that over 140,000 taxpayers have made voluntary filings of income tax returns. 49 given the modest effort in publicizing the nonfiler program, these results are very promising. the ongoing conflict concerning the future enforcement policy options of the service presents a question of intense concern within the service, and the resolution of that conflict will necessarily have an immense impact upon taxpayer compliance. the service is facing the choice between either seeking a tremendous increase in its enforcement staff or adopting a new, innovative management approach for the administration of tax laws and effecting an enormous enhancement of its computer resources. there are inherent and serious limitations on maintaining or increasing voluntary compliance through the threat of enforcement. in truth, and apart from the debate over administrative policy, the service has not been able to sustain the percentage of returns it audits. over the last ten years there has been a steady decline in the rate from 1.6% of the returns filed in 1983 to less than one percent of the returns filed in 1992.' 0 this significant decrease in the percentage of audits is understandable in view of the budget constraints imposed on the service, the difficulty of training and maintaining competent agents, and the great increase in the number of returns. furthermore, information returns and computer matching have most certainly had a positive effect on compliance. nevertheless, the steady decline in the percentage of returns audited leads to the conclusion that primary dependency on audits by in compliance but fail to do so because of the burden; and (3) those who are intentionally out of compliance. for the first two groups, dolan indicated that the service will be less confrontational and more innovative, but for those intentionally out of compliance, the service will use its arsenal of enforcement procedures. id. see also dolan, supra note 13. too often, the typical antagonism between the agency as enforcer and the taxpayer or tax adviser as advocate, are counter-productive, particularly when there exist many ways in which all of the participants can cooperate. the dynamics of an enormous increase in the number of returns filed, the limited audit resources of the internal revenue service, the complexity of the tax system, and the synergistic interaction between all of these factors demands that we seek new ways of designing tax laws to achieve efficient administration and an increase in voluntary compliance. 49. see dolan, supra note 13. 50. id. the percentage of audits has declined from 6.5% of all returns in the midsixties to less than 1% today. hoerner, supra note 46, at 1272. indeed, the long-term increase in the staffing of the service, when considered with an enhanced budget authority and reduced productivity, places the service in an awkward position. see f.r. nagle, irs productivity dropped alarmingly during the '80s, magazine finds, 49 tax notes 1274 (dec. 17, 1990). [vol 1:5 tax anmiesiy: an old debate the service is no longer viable for the long term. for that reason and others, the service will be forced to rely on modernization of computer resources3' and more innovative approaches to maintain and improve taxpayer compliance under the user-friendly approach associated with its commitment to compliance 2000.52 51. see dolan, supra note 13, at 10-11. what is envisioned is that modernized computers will perform automated audits. forms w2 and 1099, as well as other relevant information concerning one's income tax return, will be cross-referenced with the information set forth in the return itself and the computer will be programmed to request certain additional information when it identifies inconsistencies or irregularities. if this data supplies all the needed information to resolve the audit, the computer will either accept the return as filed or send out a 30-day letter proposing adjustments. if the information does not adequately answer the questions raised, the computer will refer the return to an agent for further discussions with the taxpayer. id. the american bar association has made comprehensive recommendations regarding implementation of certain changes which would improve taxpayer compliance. see american bar association commission on taxpayer compliance, report and recommendations on taxpayer compliance, 41 tax law. 329 (1988). with regard to designing tax forms or laws to increase efficiency, the author believes that structural modifications in tax forms, like the relatively recent requirement that all dependents' social security numbers be stated on the return, should be developed. this one structural change caused an amazing decrease in claimed dependents of over 7 million. id. finally, changes should be made in the structural design of the tax law to decrease the need to verify deductions. see daniel feenberg & jonathan skinner, raising revenue without raising tax rates, 58 tax notes 969 (feb 15, 1993) (discussing, for example, what the increase in standard deduction might do in reducing the number of taxpayers who itemize and how changes of this nature could also increase revenue): see also charles e. mclure, jr., the budget process and tax simplification/complication, 46 tax l rev. 25 (1989); paul r. mcdaniel, federal income tax simplification: the political process, in federal income tax simplification 507 (c. gustafson ed.) (1979); deborah h. schenk. simplification for individual taxpayers: problems and proposals, 45 tax l. rev. 121 (1989). 52. house comm. on government operations, tax systems modernization: some early observations on its progress, h.r. rep. no. 388, 102d cong., 1st sess. ( 1991) (available in tax notes, microfiche database doc. 91-10225 (dec. 9. 1991)). while the modernization of computer resources presents a principal mechanism by which the service can keep modest pace with the exponential increase in the number of income tax returns and other informational reports, the service's road to successfully effecting modernization of its computer systems has been uncertain and frustrating. according to this report, the service is in the third phase of attempting to modernize its antiquated computer systems under a program entitled tax systems modernization ("tsm"). there is a serious question whether the service possesses the management controls in the areas of procurement and systems development to successfully achieve its modernization objectives. id. at 5. the report concluded with the view that tsm is a critical long-term program, which is not only massive and challenging, but also fraught with risk. id. at 8. with the anticipated 30% annual increase in the number of returns filed through the year 2008, failure to bring this highly complex and advanced computer system online could have a disastrous impact on future administration of the tax laws. id. at 18 n. 1. see dolan, supra note 13, at 101l (providing a current report on tsm); ford & evans, supra note 13, at 1272, 1273. 19931 florida tax review v. a comprehensive tax amnesty program the current nonfiler program represents only a slight modification of the original administrative approach of the service to secure voluntary compliance. the service's recent expansion of its offer-in-compromise program is another change in policy designed with renewed concern for efficient collection of back taxes.53 the nonfiler and the expanded offer-in-compromise programs, along with other similar developments, are moderately daring from the perspective of the historically draconian attitude of the service. the early returns from these programs are somewhat promising in terms of securing additional tax revenue.54 this fact, along with the desperate need for more tax revenue, raises the broader question of whether a comprehensive tax amnesty program ought to be considered by the clinton administration and congress. quite frankly, if innovation and flexibility are the mechanism for private industry to meet the challenges of the next century, then tax amnesty at the federal level may be the mechanism for the government to 53. in the instructions to its form 656, the service has stated its policy regarding offers-in-compromise. department of the treasury, internal revenue service, offer in compromise, instructions to irs form 656 (rev. feb. 1992). the service policy as stated in the instructions is as follows: the service will accept an offer in compromise when it is unlikely that the tax liability can be collected in full and the amount offered reasonably reflects collection potential. an offer in compromise is a legitimate alternative to declaring a case as currently not collectible or to a protracted installment agreement. the goal is to achieve collection of what is potentially collectible at the earliest possible time and at the least cost to the government. in cases where an offer in compromise appears to be a viable solution to a tax delinquency, the service employee assigned the case will discuss the compromise alternative with the taxpayer and, when necessary, assist in preparing the required forms. the taxpayer will be responsible for initiating the first specific proposal for compromise. the success of the compromise program will be assured only if taxpayers make adequate compromise proposal [sic] consistent with their ability to pay and the service makes prompt and reasonable decisions. taxpayers are expected to provide reasonable documentation to verify their ability to pay. the ultimate goal is a compromise which is in the best interest of both the taxpayer and the service. acceptance of an adequate offer will also result in creating for the taxpayer an expectation of and a fresh start towards compliance with all future filing and payment requirements. 54. see rita l. zeidner, a year later, irs reports gains from offers in compromise program, 58 tax notes 540 (feb. 1, 1993) (comparing offer-in-compromise statistics for 1992 with those for 1991). the new offer-in-compromise policy is not only imminently practical but it also benefits both the taxpayer and the government in that it accelerates collection of outstanding taxes while giving the taxpayer a fresh start. [vol 1:5 tax anmesty.: an old debate address the increasingly serious problem of noncompliance. vi. the traditional response concerning tax amnesty: internal revenue service since the future is frequently a product of past practices, it is doubtful whether the service can, or, for that matter, should, ever recommend the adoption of a full-scale tax amnesty program. the service's traditional mission has been one of enforcement, and thus its organization has been functionally designed to secure compliance through the fear of civil penalties and criminal prosecution. this is not to suggest that there has not been a significant allocation of resources by the service to develop simplified tax forms, carefully provide instructions, and provide individual taxpayer assistance;55 nor is it to suggest that there is not a positive relationship between increasing the percentage of audits and increasing federal revenue.' a policy change to a user-friendly system is simply contrary to the primary mission of the service as understood over the last 70 years. a policy of tax amnesty, despite the recent changes in the agency discussed above, remains antithetical to the purpose for which the service was created and the interests of its careerist members who have a vital stake in the continuation of past practices. for example, it was probably not surprising that the central intelligence agency (the "cia") was totally unable to foresee the collapse of the former soviet union and other communist states. the cia was created to report on the threat that such countries presented to us. it simply was not able to predict the rather startling decomposition of the communist states. similarly, the service is not able to be sufficiently objective about a truly radical revision of its approach to the collection of taxes, although it is obvious that harsh realities forced the creation of compliance 2000." this is not a criticism of the service, but rather a description of the obvious nature of the limitations that preclude the service from recommending such a policy. more importantly, the question of whether to adopt a comprehensive tax amnesty program presents a purely political issue which must be resolved by president clinton and congress. thus, it would be inappropriate for the service, on its own, to recommend such a program. 55. overview, supra note 16, at 199-200. the service has had difficulty securing competent employees to provide taxpayer assistance. in a recent year. 36.3% of all answers provided by the service to taxpayers were incorrect the service attributes this high error rate to inadequate training and high employee turnover. id. (setting forth a brief discussion regarding efforts by the service). 56. see dubin, et al., supra note 46. 57. see dolan, supra note 13. 19931 florida tax review this is not to suggest that a federal tax amnesty program would solve the deficit problem, and therefore should be instantly adopted. there are many serious and difficult matters to consider. in 1990, testifying before the house subcommittee on commerce, consumer and monetary affairs, committee on government operations, fred t. goldberg, former commissioner, and michael j. graetz, former deputy assistant secretary of the treasury, outlined a series of significant concerns that support the rejection of a federal tax amnesty program.5" their individual and collective views constitute a compelling case justifying rejection of a federal tax amnesty program. the following were among their major concerns. 1. that the states may have had successful tax amnesty programs does not necessarily mean that a federal tax amnesty program would be successful. 2. taxpayers who have fully complied with their federal income tax obligations understandably might object to allowing noncompliant taxpayers to be relieved of criminal prosecutions, and perhaps civil tax penalties. 3. the tax amnesty program would not result in a net increase in revenue since there would be offsetting transactional costs. 4. there is no agreement as to how much additional revenue would be collected solely by reason of the tax amnesty program. 5. it is not clear that the service has sufficient enforcement resources to provide the "stick," after the period of tax amnesty expires, to insure a full harvest of taxpayers who would chose voluntary disclosure.59 58. see graetz, supra note 10; goldberg, supra note 10. see also feasibility and revenue impact of a federal tax amnesty program, hearings before the subcomm. on commerce, consumer and monetary affairs of the house comm. on government operations, 101st cong., 2d sess. (1990). but see martinez, supra note 10, at 563-66 (making a strong statement against the adoption of a federal tax amnesty program from the perspective of fairness, impact on future compliance, and deterrence, among other important concerns). 59. graetz, supra note 10; goldberg, supra note 10. increased enforcement after the period of tax amnesty is one of the main ingredients to insure success, a comprehensive review of eight state and three european countries' tax amnesty programs revealed the following four conditions for a successful outcome: (1) the program must be long enough to allow taxpayers to respond and should not coincide with the regular tax filing season; (2) the amnesty program should be accompanied by the enactment of laws for stiffer fines and prison terms for tax evaders; (3) audit coverage should be expanded; and (4) the amnesty program should be well-publicized. state, european tax amnesties surveyed, 23 tax notes 350 (apr. 23, 1984) (summarizing a recent report by the congressional research service). [vol. 1:5 tax anwesty: an old debate it would be impossible to answer these and other questions without (1) analyzing recent data regarding taxpayer compliance; (2) making an effort to realistically determine the amount of net tax revenue that would be generated; (3) assessing the impact on the attitude of compliant taxpayers; (4) assessing the impact on existing civil audit and criminal tax investigations; (5) anticipating the impact on long-term compliance; and (6) determining the ability of the service, under its current budget constraints, to successfully administer an amnesty program. in short, an intensive analysis must be conducted before these and other issues can be resolved. it may not be possible to objectively determine whether, all things considered, it makes sense to adopt a comprehensive tax amnesty program. if one were to attempt to design a mathematical approach to answering this question, a number of factors would have to be considered. one would have to determine the present value of short-term and long-term benefits, the associated investment costs, the discounted value of the loss of future revenue, direct and indirect, from a reduction in audit and criminal enforcement activities during the amnesty period, and revenue loss from future noncompliance by present complying taxpayers (who might view such a program as unfair). any such mathematical formulation would also take into consideration the economic value of fairness to the extent that tax amnesty would create a loss of future revenue from presently compliant taxpayers. it would not address the question of fairness, or of comparable values, from a moral point of view. that is not to suggest that the moral aspects of tax amnesty are irrelevant, but rather that such matters should be considered separately. a specific determination of the net financial increase, if any, to the government under such a comprehensive analysis would inherently be subject to uncertainty. the present investment costs to be incurred in the implementation of a tax amnesty program may be predictable. such costs would include not only the direct cost of management training, and advertising, but also the loss of revenue incurred by a reallocation of manpower from audit and criminal investigations to the tax amnesty program. it may be that the present value of the long-term benefits will be the most crucial element to ascertain. if there is a significant increase in new long-term contributing taxpayers, the additional tax revenues realized from them may be the most important issue to focus upon in deciding whether a federal tax amnesty program is worth the considerable risks. presently complying taxpayers may be opposed to a tax escape hatch at the federal level, but such taxpayers' institutional habit of compliance-i.e., servitude to following the existing tax norms-probably would not be significantly broken. one may anticipate an initial negative response by the public and some political leaders. however, with appropriate and accurate information, the disclosure of anticipated net economic benefits should be 1993] florida tax review sufficient to mitigate any serious concerns. an equally difficult question is what agency or institution should be assigned to conduct the study. it would not be unreasonable for the government accounting office, along with the joint committee on taxation, the treasury department, the congressional budget office and the internal revenue service to gather their respective resources to conduct the study and make appropriate recommendations. the tax section of the american bar association should also be an active participant in such research. secretary bentsen and director panetta should co-chair the study. vii. a proposed model for a comprehensive tax amnesty program implementation of a comprehensive tax amnesty program would be a task even more complex than the study itself. the following is a list of suggested minimum conditions necessary to provide a realistic opportunity for a federal tax amnesty program to reach its goals. i. the study should be conducted in secrecy to the extent allowed under existing law. 2. the president must be a participant in announcing the program and a consistent supporter during the period of tax amnesty. 3. there must be a substantial national media effort constantly reinforcing the merits of the program and the consequences of being caught after it closes. 4. the program must be ready for full implementation on the date of the announcement. 5. the duration of the program should be one year; announced on april 16 and available through april 15 of the following year. 6. there should be no conditions concerning the program's applicability during the amnesty period. 7. tax amnesty should apply to all criminal tax prosecutions and special consideration should be given to the possible waiver of certain civil penalties. past amnesty programs were limited to only criminal prosecutions. 8. strict enforcement of criminal and civil tax penalties should apply for the period following the tax amnesty.6 60. but cf. nagle, supra note 19, at 834 (during the existing nonfiler program the service is continuing to regularly refer nonfiler criminal cases to the department of justice for [vol. 1:5 tax anmesty: an old debate 9. the enactment of the program should include a prohibition against enactment of a similar program for the next twentyfive years.6' 10. any taxpayer who benefits under the program, and who is convicted in a criminal tax prosecution for a later taxable period, would lose all tax benefits of the prior relief and would receive at least a minimum jail sentence. 11. persons engaged in illegal activities may report the income from such illegal activities and information contained in such tax returns may not be used in other federal criminal prosecutions.62 12. maximum contemporaneous state participation in the program should also be obtained.63 13. a specific procedure to clarify the date on which the taxpayer made the disclosure should be established; perhaps, a certified filing at a particular office of the service should be required. the benefits of such a tax amnesty program are not simply the additional federal revenue generated during the amnesty period, but also the entry of more taxpayers into the system, so that the revenue benefits will accelerated prosecution during the tax filing season). see james aim. et al.. amazing grace: tax amnesties and compliance, 43 nat'l tax j. 23, 24 (1990). although tax compliance might normally decrease after tax amnesty, if post-amnesty enforcement efforts are increased, aggregate compliance will actually increase. id. but while amnesty programs may be appropriate as a transition to enhance enforcement and generate immediate revenue, such programs may not be effective in identifying tax evaders, resulting most likely in only modest long-term gains. see ronald c. fisher, et al., participation in tax amnesties: the individual income tax, 42 nat'l tax j. 15 (1989). 61. cf. angelini, supra note 10, at 908. 62. perhaps it is a misallocation of service resources to use the tax laws as a primary weapon against organized crime because it hinders one of the fundamental objectives of the service, that is, collecting revenue. participants in illegal activities are certain that the information contained in accurate income tax returns will be used against them for purposes of other federal criminal prosecutions. accordingly, many either fail to file or file a fraudulent income tax return. if the information contained in a return were protected from use in a subsequent criminal prosecution, other than a prosecution involving tax violations, it may be possible to induce some of the many persons engaged in illegal activities to file accurate income tax returns. nevertheless, because of past governmental practices with regard to the use of such information, one would be extremely naive to believe that the announcement of such a change in policy would have an immediate and positive impact on the receipt of tax revenues. 63. cf. tax compliance: irs to give circular 230 leniency to non-filing tax practitioners, daily tax rep., (bna) g3, g4 (feb. 9. 1993) (noting that the tax section of the american bar association working with the service has attempted to persuade individual states to use compliance 2000 guidelines for nonfilers of state tax returns). 19931 florida tax review extend, on an annual basis, well into the next century.' clearly, the most pressing question is the amount of new federal revenue generated. an accurate estimate of the tax recovery and net revenue benefit which would be generated by the adoption of a comprehensive tax amnesty program will be far more difficult to predict than our national deficits. notwithstanding the uncertainty as to the amount of tax recovery and net revenue benefit, one senses that this is the time in our nation for innovation and experimentation in federal tax administration.65 the clinton administration possesses the capacity and energy to face basic realities of health care, federal deficits, increased taxes, domestic investment in the infrastructure, economic expansion, and federal budget cuts-why not the question of a broad-based tax amnesty program? the time for a comprehensive study of a federal tax amnesty program is now. viii. conclusion the historic approach used to improve tax compliance has been premised on audits and criminal prosecution. in more recent years, congress 64. although, in 1986, one authority expressed the view that the net revenue from federal tax amnesty would only be approximately $1 billion, he still was of the view that federal tax amnesty may be appropriate. if there are no prospects of significant revenue from a federal tax amnesty, should use of an amnesty be opposed? the answer is "not necessarily." there are reasons for tax amnesties apart from revenue. an amnesty may be an equitable way of allowing people to turn over a new leaf and become compliant. more importantly, an amnesty may be perceived as a useful, equitable, and necessary tool when major changes are made in a tax system or when a major effort to increase compliance is undertaken.... thus, the arguments for and against amnesty must be based on equity and on long-run compliance effects. would an amnesty be equitable both to those who have abused the tax system in the past and to those who have paid all of their tax obligations? to a large extent, the answer to this question involves political judgment. but that judgment might be based on whether an amnesty would improve long-run compliance, thereby helping to reduce the tax burdens of those who have been compliant. if an amnesty does permanently return people to the tax system and does raise revenue for an extended period of time, the equity argument could tilt in favor of amnesty. thus, the wisdom of tax amnesties cannot be determined until more is known about their long-run compliance effects. allen h. lerman, tax amnesty: the federal perspective, 39 nat'l tax j. 325, 331 (1986). 65. but see martinez, supra note 10, at 538. martinez is of the view that the present adoption of federal tax amnesty would constitute an uncontrolled experiment in a national laboratory where actual results would, under current information, be no better than a guess. id. [vol 1:5 tax amnesty: an old debate has enacted a series of new civil penalties to increase the cost of playing the audit lottery. the current change in the administrative policy to make the service more "user-friendly" and to treat taxpayers as "customers" raises the risk of an increase in noncompliance. nevertheless, there are other factors, such as the volume of tax returns, the inherent complexity of the tax law, and the decrease in the percentage of returns audited, forcing dissolution of the ancient regime of fear. in the next century, the service may be forced to adopt a "user-friendly" policy because the time and cost of an enforcement regime is no longer effective. indeed, the consistent decrease in the percentage of returns audited alone suggests that this is occurring well before a formal readjustment of administrative policy is fully developed by the service. it is doubtful that a specific resolution of administrative choices will occur in the near future. rather, an amalgamation of the two primary techniques will take place, with increased emphasis on one or the other for the reasons expressed herein. hopefully, the "user-friendly" approach, as expanded through modernized computer resources, and the enactment of tax laws with administrative efficiency as a main concern, will become the primary means of achieving future tax compliance. with respect to the principal and more specific issues discussed in this comment regarding adoption of a comprehensive tax amnesty, the case for re-examination exists and the opportunity for a broad-based review awaits the decision of the clinton administration. a federal tax amnesty program is not a panacea, but rather a very complex and uncertain opportunity.' 66. the first reading assignment for any task force assigned to review the issue of tax amnesty would be the king report. see proposals, supra note 29. this report is as current with respect to the important legal issues concerning the administration of tax amnesty as any existing report. one senses that it should have been fully reviewed by the service before it began its "mini-amnesty" program for nonfilers. 19931 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 8 2008 number 8 tax my ride: taxing commuters in our national economy by morgan l. holcomb i. intro d uctio n .................................................................................... 886 part i. state taxation of income from experimental to inevitable ........................................................................................ 887 a. taxation of individual income ................................................. 887 b. apportionment: taxation of business income ........................ 893 c. what's good enough for business income ought to be good enough for individual income ..................................................... 895 part ii. constitutional norms in the beginning ...................... 897 a. dormant commerce clause doctrine and taxation ............ 897 1. the founder's intent: the historic purpose of the commerce clause ........................................................... 897 2. the dormant commerce clause and state taxation: complete auto transit test ............................................. 900 3. application of the complete auto transit test ........... 902 b. the privileges and immunities of taxation ............................. 903 1. the privileges and immunities clause ofarticle iv ... 903 2. the privileges of immunities clause of the 14th am endm ent .............................................................. 907 part iii. constitutional norms as complimentary ................... 911 a. the perils of double taxation ................................................ 911 b. constitutional norms and commuting .................................... 919 1. the interstate market for employees .......................... 919 2. historic purposes and modern commuters ................ 920 3. constitutional overlap ................................................ 926 ii. c onclusio n ....................................................................................... 929 florida tax review tax my ride: taxing commuters in our national economy by morgan l. holcomb* i. introduction located on the scenic st. croix river, hudson, wisconsin is just a half-hour drive from the major metropolitan area of minneapolis and st. paul "the twin cities" of minnesota. hudson is, therefore, a popular "bedroom" community for twin cities' workers. those commuters, the wisconsin residents who work in minnesota, face taxation by two sovereign states:' they are taxed by the state of wisconsin on the basis of their residency in wisconsin, and they face taxation by minnesota on the income that was "sourced" or earned, in minnesota.2 it is well-settled that both states are entitled to tax at least some portion of our wisconsin commuters' incomes. what is less settled is the * visiting assistant professor, hamline university school of law. this article was written while the author was a visiting assistant professor at the university of minnesota school of law. this article benefited from valuable feedback from mary patricia byrn, mary louise fellows, walter hellerstein, kristin hickman, joel michael, roy spurbeck, and edward a. zelinsky, as well as comments from a university of minnesota faculty workshop. university of minnesota students in the author's fall 2007 tax policy class provided excellent commentary and challenging questions which improved the article. university of minnesota school of law co-deans guy charles and fred morrison provided funding for outstanding research assistant caroline rummel. special thanks to roy, ella, and ruby. 1. a third sovereign to which wisconsin residents must pay tax is the federal government. this article is concerned with horizontal federalism; this article is not concerned with the propriety of taxation by the federal government and an individual state. 2. this example is illustrative because minnesota and wisconsin have a reciprocity agreement under which the states have agreed to refrain from asserting source-based taxation against residents of the other state working within their borders. see minn. stat. § 290.081 (2006). the minnesota-wisconsin agreement is unusual, and the problem suggested by the hypothetical is not theoretical. in particular, new york, a city with a huge number of teleworkers and commuters, is notorious for its aggressive collection practices. see infra note 169, and accompanying text. [vol 8:8 tax my ride constitutional limit of the "double" taxation that can occur when two states claim to be the source of income, a situation that is happening with increasing frequency in our increasingly mobile, and telecommuting, population. if, for example, a wisconsin resident worked for a minnesota employer, but occasionally worked from home, both wisconsin and minnesota could claim to be the source of the income. if both states claim to be the source of the income, the commuter will be taxed twice on that portion of her income, a result that doubtless seems markedly unfair to our commuter. the question this article explores is becoming increasingly pressing. demographic and work place trends, along with increasingly aggressive state revenue collection practices, 3 combine to predict that the question of fair apportionment of individual taxation will only grow in importance.4 the article begins with a comparison of state taxation of individual and business income. part ii proceeds to explore the relevant constitutional norms: the dormant commerce clause and the privileges and immunities clauses of both article iv and the 14th amendment. part iii synthesizes these constitutional norms and their application to commuters. part iv concludes with a discussion of the growing importance of this question and the avenues for possible resolution. part i state taxation of income from experimental to inevitable an understanding of the problem faced by interstate commuters begins with an assessment of how state taxation of individual income has developed. those practices can then be compared to the collection practices of business income. part i provides that assessment. a. taxation of individual income the personal income tax now seems as american as mickey mouse,5 and as certain as death,6 but this was not always the case. though several 3. gerald b. silverman, institute report says state tax revenues increased by 4.8% in first quarter, 120 daily tax rep. (bna) h-2 (jun. 22, 2007). 4. this same predicament faces commuters who travel to major work force centers from neighboring states, including, for example, new york city, washington d.c., and chicago. 5. marjorie e. kornhauser, robert stanley, dimensions of law in the service of order: origins of the federal income tax, 1861-1913, 44 j. legal educ. 288, 288 (1994) (book review) (noting that despite the fact that other countries use the income tax, it "seems characteristically american"). 6. cf. gary martin, the phrase finder, http://www.phrases.org.uk/meanings/death-and-taxes.html (last visited aug. 6, 2008] florida tax review states experimented with income taxes in 19th century,7 it was not until the early part of the 20th century that states imposed income taxes with any regularity.8 by the 20th century, however, almost every state imposed personal income taxes.9 the personal income tax is now a behemoth revenue generator, accounting for about a third of the revenues generated by the states.' ° the federal income tax grew up roughly parallel with the state income taxation regime." the federal government collected an income tax during the civil war, and then again enacted an income tax statute in 1894.12 although the 1894 statute was struck down as a violation of the prohibition on "direct" taxes in article i, section 9, clause 4,13 the 16th amendment permitted congress in 1913 to enact the precursor to our modern income tax regime.' 4 initially very few citizens were obliged to pay the income tax, which was imposed only on the extraordinarily wealthy.' 5 it was not until 2007), attributing the quote to various sources. martin notes that benjamin franklin used the familiar form of the phrase, "in this world nothing can be said to be certain, except death and taxes," in a letter to jean-baptiste leroy in 1789. id. 7. jerome r. hellerstein & walter hellerstein, cases and materials 928 (8th ed. 2005). 8. hellerstein & hellerstein, supra note 7, at 928-29; see also susan pace hamill, an argument for tax reform based on judeo-christian ethics, 54 ala. l. rev. 1, 112 n. 10 (2002) (citing 2 jerome r. hellerstein & walter hellerstein, state taxation 1 20.01 (1st ed. 1992)). 9. hellerstein & hellerstein, supra note 7, at 928. 10. hellerstein & hellerstein, supra note 7, at 929 (noting that in the period ending june 2004, state governments collected $193.2 billion, or 33.2% of the total state tax collections). 11. john k. mcnulty, flat tax, consumption tax, consumption-type income tax proposals in the united states: a tax policy discussion of fundamental tax reforms, 88 cal. l. rev. 2095, 2098 (2000) (noting that "the federal income tax has served this country well for most of the twentieth century, continuously since 1913 (since 1909 for corporate taxpayers), and with roots even earlier than that.") 12. william a. klein, joseph bankman & daniel n. shaviro, federal income taxation 4-6 (14th ed. 2006); see also marjorie e. kornhauser, the origins of capital gains taxation: what's law got to do with it?, 39 sw. l.j. 869, 871-72 (1985) (providing a brief discussion of the history of the federal income tax and noting that "the entire federal income tax system, in fact, was largely experimental."). 13. pollock v. farmers' loan & trust co., 157 u.s. 429, aff'd on reh'g, 158 u.s. 506 (1895). 14. klein, bankman, & shaviro, supra note 12, at 4-6; mcnulty, supra note 12, at 2098. 15. see klein, bankman & shaviro, supra note 12, at 4-6 (noting that the exemption of up to $4,000 for married couples made the early income tax a tax on the "well-to-do"); komhauser, supra note 12, at 873 n. 18 (noting that in 1920, only approximately 13% of the labor force paid income taxes). [vol 8:8 tax my ride world war ii and its aftermath that the federal income tax became, as it is today, "a mass tax"1 6 or perhaps more aptly, a tax on the masses. most of us, the masses, must file income tax returns to the united states each year. 17 most of us also file income tax returns to our home state, that is, our state of residence or domicile. 18 at least some of us, and an increasing number of us, must also file an additional income tax return, that is to the state or states in which we earn income, if that state is not our state of residence.' 9 a state of residence can tax its residents on income those residents earn, regardless of where the income is earned.20 residence-based taxation is premised on the idea that residents of a state have a special relationship to their home state. 2' as the court put it, "[e]njoyment of the 16. klein, bankman & shaviro, supra note 12, at 5. 17. in 2005, just over 52 million returns were jointly filed by married couples, accounting for about 104 million people. internal revenue service, soi tax stats, available at www.irs.gov/pub/irs-soi/05inl2ms.xls. approximately 2.4 million married people filed separately. id. almost 20 million people filed as head of household, about 71,000 filed as surviving spouses, and just over 59 million people filed as single. id. thus a total of approximately 185.5 million people filed tax returns for tax year 2005. id. in 2005, 56.4 million people in the u.s. were age 13 or younger, and thus most likely too young to work and have a filing requirement. press release, u.s. census bureau, nation's population one-third minority (may 10, 2006), available at http://www.census.gov/pressrelease/www/releases/archives/population/006808.html. assuming that the vast majority of the 185.5 million filers in 2005 were over age 13, it is possible to estimate that approximately 76% of people over age 13 filed a 2005 tax. 18. hellerstein & hellerstein, supra note 7, at 929 (noting that "41 states and the district of columbia levy broad-based personal income taxes.") 19. ferdinand p. schoettle, state and local taxation: the law and policy of multi-jurisdictional taxation 521 (2003) (noting that states have "begun developing apportionment rules that apply to a broader base of nonresident individuals" and that states have "increased efforts to collect taxes from nonresident individuals"). 20. oklahoma tax comm'n v. chickasaw nation, 515 u.s. 450, 462-63 (1995) (noting that it is well established that "a jurisdiction, such as oklahoma, may tax all the income of its residents, even income earned outside the taxing jurisdiction."); shaffer v. carter, 252 u.s. 37, 57 (1920). although the focus of this article is on state taxation, it is worth noting that the united states taxes the worldwide income of its citizens, a practice that renders the united states "an outlier in the international community." michael s. kirsch, taxing citizens in a global economy, 82 n.y.u. l. rev. 443,445 (2007). 21. it seems intuitively correct that one can be a citizen of only one state at a time. e.g., sanford levinson, suffrage & community, 41 fla. l. rev. 545, 554 (1989) ("we do not recognize [] dual status; thus, a citizen of massachusetts cannot legally also be a citizen of rhode island (any more than, in the united states, the spouse of a can also be the legal spouse of b."). that intuition, however, has failed to convince the court that there is any due process violation when two states claim 20081 florida tax review privileges of residence in the state and the attendant right to invoke the protection of its laws are inseparable from responsibility for sharing the costs of government., 22 if the special relationship between a resident and her home state justifies the taxation of a resident's income, some other rationale must justify the taxation of nonresidents. indeed, nonresident taxpayers long challenged the ability of "source states" to tax any nonresident's income. the court finally laid the question to rest in the seminal case of shaffer v. carter23 in which the court firmly rejected the notion that states lacked taxing authority over nonresidents, calling it a "radical contention" that could be "easily answered by reference to fundamental principles. 24 one such principle is our special brand of federalism, and the concomitant autonomy and sovereignty of the several states that gives them "complete dominion over all persons, property, and business transactions within their borders., 25 the court went on to emphasize that states have a duty to preserve and protect all persons, property and business within their borders, and the people, property and businesses within the states' borders have a corresponding duty to remit taxes for those protections.26 the court concluded with strident language, "that the state, from whose laws property and business and industry derive the protection and security without which production and gainful occupation would be impossible, is debarred from exacting a share of those gains in the authority to tax a decedent's estate as if the decedent were a resident. in guaranty trust co. v. virginia, new york and virginia both assessed estate taxes on identical income. the court rejected a due process challenge to the assessment, holding that "here, the thing taxed was receipt of income within virginia by a citizen residing there. the mere fact that another state lawfully taxed funds from which the payments were made did not necessarily destroy virginia's right to tax something done within her borders." 305 u.s. 19, 23 (1938). see also douglas laycock, equal citizens of equal and territorial states: the constitutional foundations of choice of law, 92 colum. l. rev. 249, 316-17 (1992) ("an american state is not like a nomadic tribe, with membership based on kinship .... the state ... is defined by its territory, and 'its people' are defined by the territory in which they live."); lemmon v. people, 20 n.y. 562, 609 (1860) ("the position that a citizen carries with him, into every state which he may go, the legal institutions of the one in which he was born, cannot be supported."). this question of the persuasiveness of the court's reasoning in guaranty trust will be reserved for another article. 22. new york ex rel. cohn v. graves, 300 u.s. 308, 313 (1937). see generally walter hellerstein, some reflections on the state taxation of a nonresident's personal income, 72 mich. l. rev. 1309 (1974) [hereinafter hellerstein, some reflections] (discussing the basis on which states may permissibly tax both residents and non-residents). 23. shafer, 252 u.s. at 57. 24. id. at 50. 25. id. 26. id. [vol 8:8 tax my ride form of income taxes for the support of the government, is a proposition so wholly inconsistent with fundamental principles as to be refuted by its mere statement., 27 despite the court's firm rejection of the argument that a nonresident source state cannot tax nonresident income, there is no doubt that the nonresident state enjoys a more limited taxing authority than a resident state enjoys over its domiciliaries. source states may tax only the income that is earned in the source state. 28 the schaffer court noted that a state's jurisdiction to tax nonresidents "extends only to their property owned within the state and their business, trade, or profession carried on therein, and the tax is only on such income as is derived from those sources., 29 taxpayers have "a more narrowly defined relationship 30 with states in which they are not residents, and there is a correspondingly more circumscribed ability of those states to tax. unlike states of domicile or residence, states in which taxpayers enter for a limited time do not provide the same benefits and protections to taxpayers. 3' the jurisdiction to tax, therefore, bears some rough relationship to the benefits provided to taxpayers.3 2 that two states are authorized to tax individual income has led to persistent taxpayer indignation about the resulting double-taxation. historically, this concern has been mitigated by the residency state offering credits for taxes collected by the source state.33 to illustrate, assume that a wisconsin commuters earns the 90% of her income in minnesota. minnesota will tax that income because minnesota is the source state.34 double taxation 27. id. 28. id. at 57. "source" based taxation is an international norm. kirsch, supra note 20, at 448-49 (noting that "all countries recognize (and most countries, including the united states, exercise) the right of a country to tax income of a foreign person that arises within the country's borders"). 29. shafer, 252 u.s. at 57. 30. hellerstein, some reflections, supra note 22, at 1318. 31. id. at 1319. 32. id. 33. see, e.g., wis. stat. § 71.07(7) (2006); wisconsin department of revenue schedule os, credit for net tax paid to another state, available at http://www.dor.state.wi.us/forms/2006/06i-023.pdf (explaining that wisconsin residents who paid tax on the same income to another state in the same tax year qualify to claim the credit). this same practice of residence state deferring to source state is also the norm in international taxation. kirsch, supra note 21, at 456 ("the foreign tax credit reflects an acknowledgment that the country in which income arises has the first claim on taxing that income, and that a country exercising residence-based (or citizenship-based) taxation will only collect tax on that foreign income to the extent the source country does not."). 34. minnesota department of revenue, part-year residents and nonresidents, available at http://www.taxes.state.mn.us/individ/residencyand filing _status/part_year nonresident/partyearresidentsnon.shtml (last visited aug. 23, 2008] florida tax review is avoided by wisconsin's decision to give her a credit for the taxes paid in minnesota.35 in other words, wisconsin will not tax that portion of her income that was already taxed by minnesota. the remaining 10% of her income, perhaps income from interest or dividend income, will be taxed by wisconsin, but not minnesota. this solution, however, is imperfect. most states grant credits only to "source" income taxes paid, and the states have differing definitions of what constitutes source income. 36 that is, new york taxes an individual on income that new york considers sourced in new york, but connecticut taxes that same income, contending that the income was in fact sourced in connecticut. 37 more fundamentally, the solution is flawed because the credit granted, usually by the state of residence, is seen not as an imperative in a constitutional or some other sense, but is understood as granted by the grace of the state.38 in other words, the credit-granting state at any moment could change its collective mind, and repeal the credit provision. 2007) ("part-year residents and nonresidents pay tax only on their minnesota sources of income .... "). 35. wis. stat. § 71.07(7) (2006); wisconsin department of revenue schedule os, credit for net tax paid to another state, available at http://www.dor.state.wi.us/forms/2006/06i-023.pdf, minn. stat. § 290.081 (2006). minnesota residents are required to complete form micr when filing their state income tax returns in order to claim the credit for taxes paid to other states. the minnesota department of revenue web site provides instructions to filers: the state of minnesota taxes all of the income of a minnesota resident, regardless of where it was earned. occasionally, other states or canadian provinces may tax this same income if a minnesota resident temporarily worked ... in the other state. to prevent double taxation of this income, a resident may file schedule ml cr... to receive credit for the taxes paid. minnesota department of revenue, credit for taxes paid to another state, available at http://www.taxes.state.mn.us/individ/other-supporting-content/taxes-paid%20_to _anotherstate.shtml (last visited aug. 23, 2007). 36. e.g., hellerstein & hellerstein, supra note 7 (noting that it is generally the credit granting state that "determines the sourcing rules that are used to determine whether the state that is purporting to tax on a source basis is taxing income that has its source in that country for tax credit purposes" which can "result in double taxation"). 37. indeed, this was the exact situation facing law professor edward zelinsky when new york and connecticut both taxed the income he earned as a law professor for benjamin n. cardozo school of law. the factual scenario is detailed in the new york court of appeals decision reported at zelinsky v. tax appeals tribunal, 801 n.e.2d 840 (n.y. 2003) cert. denied 541 u.s. 1009 (2004). for a discussion of the zelinsky case, see infra notes 204, 210 and corresponding text. 38. "it is well established . . . that the due process clause imposes no restraints on such double taxation (state power to tax based on both residence and source)." hellerstein & hellerstein, supra note 7, at 942. "to deal with the problem [vol 8:8 tax my ride returning to the example set out in the introduction: let us now assume that our commuter and her employer decide that they should capitalize on the ease and benefits of telecommuting, and the employer directs our commuter to work at least two days a week, or 40% of the time, from home. they hope that this arrangement will serve them both allowing the employee to avoid commuting stress and be more productive, and enabling the employer to reap the benefits of the increased productivity, retain a valued employee and save on overhead.39 both states now have a legitimate claim to consider the income that the commuter earns while working from home to be sourced to their state. if minnesota continues to lay claim to the income tax revenues, and wisconsin does as well, so that so that the commuter pays income tax on approximately 126%41 of her income, is there any constitutional redress? b. apportionment: taxation of business income now assume our commuter is not a commuter, but instead, a business headquartered in wisconsin doing business nationally. if our commuter were such a multistate business, the constitution would indeed provide protection from multiple taxation.41 in particular, the due process of double taxation resulting from the overlapping claims of power to tax on the basis of residence and source, all states with broad-based personal income taxes provide a credit for taxes paid by their residents to other states." id. this same problem of potential "double" taxation arises in the international context. in international tax "the residence country generally eliminates double taxation by either exempting the item of income from its tax base or by giving a credit against the domestic tax liability for the foreign tax." hugh j. ault & brian j. arnold, comparative income taxation: a structural analysis 357 (2d ed. 2004). 39. e.g., nick paumgarten, there and back again, new yorker, apr.16, 2007, at 58, 64, available at http://www.newyorker.com/reporting/2007/04/16/07041 6fa-fact paumgarten (reporting that many studies have shown that "[c]ommuting makes people unhappy ..... ). according to harvard political scientist robert putnam, "every ten minutes of commuting results in 10% fewer social connections" id. commuting can also take a physical toll on people. "researchers have found that hours spent behind the wheel raise blood pressure and cause workers to get sick and stay home more often. commuters have lower thresholds for frustration at work, suffer more headaches and chest pains, and more often display negative moods at home in the evenings." eric m. weiss, your car + your commute = a visit to your doctor, wash. post, apr. 9, 2007, at b01. 40. recall that our commuter earns only 90% of her income from her minnesota job; if minnesota continues to tax 90%, and wisconsin now taxes 40%, she will be taxed on approximately 126% of her income. 41. hellerstein & hellerstein, supra note 8, at 192-325, 351-426 (discussing, respectively, commerce clause and due process clause restrictions). 20081 florida tax review clause42 requires that a state not tax income earned beyond its borders, and the commerce clause limits taxes to income that is "fairly apportioned" to the taxing state.43 the constitutional requirement of apportionment will be discussed at length in part ii, but to illustrate, assume the business earns 40% of its income in wisconsin and the remaining 60% in minnesota. both states can tax some of the business income, but neither state can tax 100% of the income.44 in fact, the states have developed relatively sophisticated apportionment formulas and schemes to tax only the income that can be "reasonably attributed" to that state.45 when a company operates in multiple states, it can be quite difficult to decide where income is "earned" and consequently it can be difficult to determine to which state the income can be reasonably attributed. for example, if a minnesota company manufactures widgets in minnesota and then sells the widgets nationally, how will the company and the state revenue departments determine the amount of income attributable to each state? assume the company makes $100 profit on the sale of a widget and the sale 42. the due process clause also applies to taxation of individual income. an individual must have a nexus with the taxing state for the state to exert its taxing authority. so long as an employee spends a minimal amount of time in the state, due process standards are satisfied. see, e.g., zelinsky v. tax appeals tribunal, 801 n.e.2d 840, 849 (n.y. 2003), cert. denied, 541 u.s. 1009 (2004) ("[a] state ... may not tax value earned outside its borders") (citing allied-signal, inc. v. director, div. of taxation, 504 u.s. 768, 777, (1992)). 43. quill corp. v. north dakota, 504 u.s. 298, 306 (1992) ("the due process clause 'requires some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax."' (quoting miller bros. co. v. maryland, 347 u.s. 340, 344-45 (1954)); complete auto transit inc. v. brady, 430 u.s. 274, 279 (1977) (setting forth a four-prong test that state taxes must pass to be constitutional per the commerce clause; the prongs include (1) the taxing state must have a substantial nexus to the tax, (2) the tax must be fairly apportioned to services provided by the taxing state; (3) the tax must not discriminate; and (4) the tax must be fairly related to the services provided by the state). 44. northwestern states portland cement co. v. minnesota, 358 u.s. 450 (1959) (holding that both minnesota and iowa could tax the income earned by a corporation because, although the corporation was headquartered in iowa, it made sales in minnesota as well as iowa); complete auto transit, 430 u.s. at 279 (the tax must be fairly apportioned to services provided by the taxing state); moorman mfg. co. v. bair, 437 u.s. 267, 273 (1978) (a state is not required to apportion by identifying geographical source of the corporations profits as long as it's apportionment method provides a "rough approximation of a corporation's income that is reasonably related to the activities conducted within the taxing state."). 45. to be sure, the states are at times aggressive in reconfiguring their apportionment schemes so as to apportion to themselves as much income as possible. see underwood typewriter co. v. chamberlain, 254 u.s. 113 (1920); hans rees' sons, inc. v. north carolina ex rel. maxwell, 283 u.s. 123 (1931); butler bros. v. mccolgan, 315 u.s. 501 (1942). [vol 8:8 tax my ride occurs in iowa. the near impossible administrative task of determining how much of the profit should be attributed to (and therefore taxable by) iowa and how much of the profit should be attributable to (and therefore taxable by) minnesota has led states to settle on apportionment. almost all states that impose a corporate income tax use some variation of a three-factor apportionment formula in an attempt to approximate the amount of income attributable to a taxing state. 4 the factors almost universally include sales, property, and payroll, and the goal is to make a satisfactory, albeit rough, estimate of how income should be divvied up amongst the states. these three factors were chosen because each factor represents an asset commonly understood to contribute to the ability to generate income.47 several states have tinkered with the weight given to each factor, a common maneuver is to double-weight the sales factor,48 but in broad strokes, there is consensus on how to apportion the income of multistate businesses. importantly, there is no dispute that apportionment is required. c. what's good enough for business income ought to be good enough for individual income the states have apportioned corporate income for years, but fail to apply those well-settled apportionment rules apply to taxation of individual income. 49 the resistance to application of the apportionment schemes probably has several bases, but a prime suspect is that because relatively few individuals earn their income in a state that is not their home state, the states have not had to address apportionment.50 even when an individual does cross 46. hellerstein & hellerstein, supra note 7, at 440 (noting that the threefactor test is the most widely used formula). 47. see, e.g., arthur d. lynn, jr., the uniform division of income for tax purposes act re-examined, 46 va. l. rev. 1257, 1261-62 (1960) ("on the basis of a trial and error process, the so-called massachusetts formula evolved as the most common general apportionment method. the three factors of sales, payroll, and property were selected as representative income producing elements."). 48. approximately half of the states imposing a corporate income tax put additional weight on the sales factor, usually double. hellerstein & hellerstein, supra note 7, at 440. 49. see zelinsky v. tax appeals tribunal, 801 n.e.2d 840, 847 (n.y. 2003), cert. denied, 541 u.s. 1009 (2004) (arguing that "the taxpayer's crossing of state lines to do his work at home simply does not impact upon any interstate market in which residents and nonresidents compete so as to implicate the commerce clause," but nonetheless applying the complete auto transit test and finding that even if it did apply to zelinsky's situation, it would not be violated by new york's convenience of the employer test for allocation of income). 50. more than 73% (94 million) of all commuters in america work and live in the same county. alan e. pisarski, commuting in america iii xv (transp. 2008] florida tax review state lines to work, it historically has been easier to "locate" income earned by an individual than income earned by a multi-state company. if a factory worker commutes from michigan to ohio each day to work in the ford plant, for example, there's not much question that the worker's income is earned in ohio and is therefore taxable by ohio. so long as the employee does his or her work in the "source" state, there is relatively little dispute about which state gets to tax the income. the rise of telecommuting, 5' and the continuing shift in our economy from a goods to a service economy5 2 changes that dynamic. an increasing number of workers structure their employment much like our hypothetical commuter outlined in the introduction working for an employer in one state from a home in another. in those situations, determining which state, or states, properly lay claim to the income tax revenue becomes a difficult question. should the state in which the employer is located tax all of the income? should the employee's state of research bd. of the nat'l acad. 2006), at http://onlinepubs.trb.org/onlinepubs/nchrp/ciaiii.pdf. this is changing, however, as 51% of all new workers in the 1990s worked outside of their counties of residence. id. see also john leland, off to resorts, and carrying their careers, n.y. times, aug. 13, 2007, at al (reporting that 'location-neutral' migrants" make up a growing percentage of the population of resort towns such as steamboat springs, colorado and nantucket, among others, and that "[flrom 2000 to 2006, population in the 297 counties rated highest in natural amenities by the united states department of agriculture grew by 7.1%, 10 times the rate for the 1,090 rural counties with below-average amenities"). 51. elizabeth olson, executive life: at home (of course) with a telecommuter, n.y. times, aug. 24, 2003, at 11 ("telecommuting has become more popular over the years, and interest spiked after the terrorist attacks of sept. 11, 2001. according to an estimate from the international telework association and council, which tracks telecommuting, the number of wage earners who work exclusively from home has increased to roughly 17 million from 5.5 million a decade ago."). furthermore, the trend is poised to continue. in a 2003 survey by spherion corporation, a fort lauderdale-based staffing and recruiting company, 96% of respondents agreed that an employer was more attractive when it helped them meet family obligations through options like flextime, telecommuting, or job sharing. inst. of mgmt. and admin., inc., is your firm ready for the impending war for talent? your employees are!, 06-3 law off. mgmt. & admin. rep. 2 (mar. 2006). 52. william j. holstein, and now a syllabus for the service economy, n.y. times, dec. 3, 2006, at 10 (noting that the u.s. economy is about 75% services and stating that universities must prepare students to succeed in a services-based economy). 53. cf. robert j. peroni, back to the future: a path to progressive reform of the u.s. international income tax rules, 51 u. miami l. rev. 975, 984 (1997) (arguing that international tax policy should move away from source-based taxation given the difficulty of "associating items of income and expense with a particular geographic location"). [vol. 8:8 tax my ride residence tax it all? or should the states do in individual taxation what they do in the corporate income tax realm determine some rough way to apportion the income to the state in which it was more properly considered earned? part ii constitutional norms in the beginning two constitutional norms help in the inquiry set out above. the first is the dormant commerce clause, and the second is the privileges and immunities clause. this part will explore the historic purpose of each of these clauses, tracing commonalities among the dormant commerce clause and the privileges and immunities clauses. those commonalities, and their import for telecommuting taxpayers, are then explored in depth in part iii. a. dormant commerce clause doctrine and taxation 1. the founder's intent: the historic purpose of the commerce clause the dormant commerce clause is the notion that even in the absence of congressional action, the states may not discriminate against or burden the flow of interstate commerce.54 economic protectionism by the states during the time of the articles of confederation 5 was a key concern of the drafters of the constitution. 56 54. see kathleen m. sullivan & gerald gunther, constitutional law 245 (15th ed. 2004). 55. see, e.g., brannon p. denning, confederation-era discrimination against interstate commerce and the legitimacy of the dormant commerce clause doctrine, 94 ky. l. j. 37, 49 (quoting cathy matson, the revolution, the constitution, and the new nation, in 1 the cambridge economic history of the united states: the colonial era 363, 373 (stanley l. eugerman & robert e. gellman, eds., 1996) ("[t]he centrifugal, contentious economic interests rising among the states" at the time "dampened ... postwar enthusiasm and reoriented public and private views toward the nationalists," who warned that "discrimination against the commerce of neighboring states weakened the economies of all states.")). 56. see h.p. hood & sons, inc. v. du mond, 336 u.s. 525, 534 (1949) ("the necessity of centralized regulation of commerce among the states was so obvious and so fully recognized that the few words of the commerce clause were little illuminated by debate."). see also denning, supra note 55, at 49. the inability of the continental congress to harmonize the commercial policies of the several states, and its failure to convince states to part with that much of their sovereignty as would permit congress to regulate commerce and raise revenue of its own, convinced many fence-sitters that the problem lay with the articles of confederation and encouraged moderate 2008] florida tax review state policies, including "[d]ifferent state taxation policies" were of especial concern as those policies "weakened the economies of all states."57 for example, new york and massachusetts, states with major ports, "took advantage of their superior position in international commerce and in regional markets to pass discriminatory duties against neighboring states' traffic at their ports, while weaker states tried to divert trade to themselves by abolishing duties altogether, thus setting parameters for intense interstate rivalries by mid-1785. 58 alexander hamilton and james madison addressed the economic protectionism problem in the federalist papers. in federalist no. 7, discussing possible conflicts between the states, hamilton noted that, the competitions of commerce would be another fruitful source of contention. the states less favorably circumstanced would be desirous of escaping from the disadvantages of local situation, and of sharing in the advantages of their more fortunate neighbors. each state, or separate confederacy, would pursue a system of commercial policy peculiar to itself.59 hamilton also foresaw the troubles that would arise in areas where people of neighboring states participated in multi-state markets. for example, new york relied on revenue from laying duties on imports arriving through its ports. new york's practice resulted in residents of new jersey and connecticut also paying higher prices for goods, but without the benefit of the duty revenue accumulating in their states' coffers. 60 hamilton thus asked, "would connecticut and new jersey long submit to be taxed by new york for her exclusive benefit? ' 61 james madison also referenced the detrimental effect of economic competition between the states on the stability of the union. "we may be assured by past experience, that such a practice [states imposing duties on imports and exports through their nationalists, like james madison, that the survival of the union necessitated substantial changes in the constitutional regime. 57. cathy matson, the revolution, the constitution, and the new nation, in 1 cambridge economic history of the united states: the colonial era 363, 377 (stanley l. eugerman & robert e. gellman, eds., 1996). "merchants in providence, rhode island, believed that they were virtually barred from trade by 1785 because of the high state duties at massachusetts and new york ports." id. at 381. 58. id. at 380. 59. the federalist no. 7 (alexander hamilton). 60. id. 61. id. [vol. 8:8 tax my ride borders] would be introduced by future contrivances; and both by that and a common knowledge of human affairs, that it would nourish unceasing animosities, and not improbably terminate in serious interruptions of the public tranquility. 62 he was concerned not only about the harm to national unity that this would cause, but also the inefficiency of such a practice, noting that "the desire of the commercial states to collect, in any form, an indirect revenue from their uncommercial neighbors, must appear not less impolitic than it is unfair; since it would stimulate the injured party, by resentment as well as interest, to resort to less convenient channels for their foreign trade. 63 the economic conflict among the states was so alarming to many that it has been cited as "the immediate cause that led to the forming of a [constitutional] convention." 64 granting the commerce power to congress in the constitution was a means of providing the national government with the power to prevent the states from harming national unity and the national economy through economic protectionism. 65 the commerce clause "embodied a grant of authority to congress that created the conditions for the free movement of people, transport of products and capital, and uniform institutions that, together, proved crucial to establishing a national market., 66 in the absence of congressional legislation regarding an area of commerce, the supreme court enforces the anti-economic protectionism purpose behind the commerce clause by striking down state discrimination against interstate commerce through the dormant commerce clause doctrine. 67 when analyzing state action that impacts interstate commerce, avoiding "economic balkanization" has become one of the "central purposes of [the supreme court's] negative commerce clause jurisprudence. 68 62. the federalist no. 42 (james madison). 63. id. 64. camps newfound/owatonna, inc. v. town of harrison, 520 u.s. 564, 571 (quoting gibbons v. ogden, 22 u.s. 1, 77 (9 wheat. 1) (1824) (johnson, j., concurring in judgment)). 65. see sullivan & gunther, supra note 55, at 245 ("the framers of the constitution centralized the power to regulate interstate commerce in the congress because they viewed destructive trade wars among the states as a major problem under the articles of confederation."). 66. matson, supra note 57, at 385. 67. see sullivan & gunther, supra note 54, at 245. 68. camps newfound/owatonna, 520 u.s. at 577. 2008] florida tax review 2. the dormant commerce clause and state taxation: complete auto transit test when a business engages in economic activity in more than one state, each of those states will be interested in taxing the business's income. naturally, the business will want to avoid taxation in the new state if possible, and the home state will want to maintain its tax base. "conflict between the states' interest in exercising their essential taxing power and the nation's interest in fostering economic unity has been an enduring feature of our federal system., 69 the supreme court noted in northwestern states portland cement co. v. minnesota that the issue of state taxation of interstate commerce was so contentious that by 1959 the court had issued over 300 opinions addressing commerce clause challenges to state taxes.7 ° over time the supreme court developed a test to determine whether a state tax violates the dormant commerce clause. when a state tax is challenged as violating interstate commerce, the court applies the four-part complete auto transit test to determine whether the tax rises to an unconstitutional level.7 ' complete auto transit was decided in 1977, wrapping up the court's journey from holding interstate commerce to be wholly immune to state taxation to allowing interstate commerce to be taxed by any levy that can pass the four-part test.72 69. hellerstein & hellerstein, supra note 8, at 192. 70. see id. at 193. 71. readers familiar with dormant commerce clause challenges to non-tax regulatory laws are doubtless familiar with the "pike balancing test." the supreme court does not appear to apply pike to challenges to state taxes. though the supreme court has not articulated why the pike balancing test is not applied in state tax discrimination cases, others have noted that the language in pike refers only to "regulatory" measures (robert z. kelley, over the long haul: state court decisions on flat truck taxes, 42 state tax notes 103 (oct. 9, 2006)., quoting pike v. bruce church, 397 u.s. 137 (1970)). the washington supreme court reasoned that regulatory fees fall under the pike balancing test because fees do not have to be apportioned and do not have to satisfy the internal consistency test. see franks & sons, inc. v. state, 966 p.2d 1232, 1234-35 (1998), cited in 42 state tax notes 103. as taxes do have to meet both of those qualifications (fair apportionment and internal consistency), they must pass the more complex complete auto transit test the pike balancing test does not do a sufficient analysis to determine the constitutionality of a taxing measure. see id. see also walter hellerstein, is "internal consistency" foolish?: reflections on an emerging commerce clause restraint on state taxation, 87 mich. l. rev. 138 (1988) ("because the distinction between a 'regulatory fee' subject to the pike balancing test and a tax subject to the complete auto four prong analysis is fuzzy at best, states will likely continue to defend questionable taxes under both theories."). 72. see hellerstein & hellerstein, supra note 7, at 193-205 (summarizing the supreme court's changing analysis of state taxation of interstate commerce). [vol. 8:8 tax my ride before setting forth the 4-part test, it is useful to outline the court's journey to that point. initially, the court reasoned that any tax on interstate commerce constituted a regulation on that commerce, and such regulations were entirely barred due to congress's power to regulate the privilege of doing interstate business.7 3 this was the "wholly immune" era of the 1870s. 74 by the 1930s, the court had progressed to holding that interstate commerce can be made to "pay its way," but would still strike down any tax which had even a possibility of imposing a multiple tax burden on the taxpayer. 75 after allowing states to begin taxing the income of interstate businesses, the court had trouble reaching a clear standard to determine whether states were requiring businesses to do more than just pay their way. the court's reasoning reached a point where it elevated form over substance, disallowing taxes that were directly imposed on interstate business, but not on indirectly imposed taxes.76 after three decades of cases in which the outcome often turned on the label the state gave the tax,77 the court articulated its four-factor test in complete auto transit to determine whether a state's tax on corporate income imposes an impermissible burden on interstate commerce.78 the four factors considered are (1) nexus: the tax must be applied to an activity that has a substantial nexus with the state; (2) apportionment: the tax must be fairly apportioned to activities carried on by the taxpayer in the state; (3) discrimination: the tax must not discriminate against interstate commerce; and (4) fairly related: the tax must be fairly related to services provided by the state.79 73. see the case of the state freight tax, 82 u.s. (15 wall.) 232 (1872); hellerstein & hellerstein, supra note 7, at 193-98. 74. see the case of the state freight tax, 82 u.s. (15 wall.) 232 (1872); hellerstein & hellerstein, supra note 7, at 193-98. 75. see western live stock v. bureau of revenue, 303 u.s. 250, 254 (1938); hellerstein & hellerstein, supra note 7, at 198-201. 76. see spector motor service, inc. v. o'connor, 340 u.s. 602 (1951); hellerstein & hellerstein, supra note 7, at 201. 77. after the spector motor service decision in 1951, many states changed the name of their corporate income taxes from "franchise taxes on the privilege of doing business" to "direct net income taxes." hellerstein & hellerstein, supra note 8, at 202. this practice did not end until 1977 when the complete auto transit decision overruled spector and "explicitly rejected the formalistic commerce clause doctrine that provided the foundation for the spector rule." id. at 204. 78. complete auto transit, inc. v. brady, 430 u.s. 274, 279 (1977). 79. id. at 279. 2008] florida tax review each state in which the taxpayer does business has an interest in taxing some of the taxpayer's income, but only to the extent that the taxpayer receives benefits from the state.80 the court's test recognizes that when a taxpayer does business in more than one state, a perfect outcome would be for the taxing states to apportion the income such that the taxpayer would be subject to tax on 100% of its income, no more and no less. this way interstate business taxpayers are treated the same way as businesses operating in only one state they are both taxable on all of their income, but no more than that. 3. application of the complete auto transit test a state seeking to impose an income tax on a business engaged in interstate commerce may tax only an apportioned amount of the business's income; the apportionment scheme must be intended to reflect the business activity conducted in the state.8 ' this apportionment requirement is a critical prong of the complete auto transit test. when apportioning corporate income, the most commonly used method is the so-called "massachusetts formula," which includes the three factors of property, payroll, and sales. 82 states can and do choose other methods of apportionment, such as the singlefactor sales test and a three-factor test with a double-weighted sales factor.83 when analyzing a state apportionment formula, the court considers whether the formula shows "internal consistency." 84 internal consistency is preserved when the imposition of a tax identical to the one in question by every other state 80. see quill corp. v. north dakota, 504 u.s. 298, 306 (1992), quoting moorman mfg. co. v. bair, 437 u.s. 267 (1978) (noting that due process requires that the income the state seeks to tax have a rational relation to "values connected with the taxing state" and that such a relation could be established by a showing that the state provides protection and services to the taxpayer's local activities). 81. see hans rees' sons v. north carolina ex rel. maxwell, 283 u.s. 123, 133 (1931). 82. see, e.g., lynn, supra note 47, at 1261-62 ("on the basis of a trial and error process, the so-called massachusetts formula evolved as the most common general apportionment method. the three factors of sales, payroll, and property were selected as representative income producing elements."). 83. institute on taxation and economic policy, corporate apportionment and the "single sales factor," policy brief #11 (2005), available at http://www.itepnet.org/pb iissf.pdf. 84. see armco, inc. v. hardesty, 467 u.s. 638 (1984); tyler pipe indus., 483 u.s. 232 (1987); am. trucking ass'ns, 483 u.s. 266 (1987); okla. tax comm'n v. jefferson lines, 514 u.s. 175, 184 (1995) (noting that the "principle of fair share is the lineal descendant of [the] prohibition on multiple taxation."). [vol 8:8 tax my ride would add no burden to interstate commerce that intrastate commerce would not also bear. . . . a failure of internal consistency shows as a matter of law that a state is attempting to take more than its fair share of taxes from the interstate transaction. it is possible for two states to have apportionment formulas which conflict, resulting in double taxation, but which are both internally consistent. the court also asks whether a tax is "externally consistent." that is, the tax must be "fairly attributable to economic activity within the taxing state."86 unlike the tidy thought experiment required by the internal consistency test, external consistency looks to "the economic justification for the state's claim upon the value taxed" with the goal of discovering "whether a state's tax reaches beyond that portion of value that is fairly attributable to economic activity within the taxing state." 87 the external consistency test is therefore a practical check on taxes that could pass the internal consistency test, but would nonetheless impermissibly burden commerce. b. the privileges and immunities of taxation 1. the privileges and immunities clause ofarticle iv like the dormant commerce clause, the privileges and immunities clause of article iv of the constitution 88 prohibits states from discriminating against non-residents. 89 and like the goal of national unity underlying the 85. jefferson lines, 514 u.s. at 185. see also gen. motors corp. v. tracy, 519 u.s. 278, 299 n.12 (1997) ("the requirement of apportionment... assur[es] that interstate activities are not unjustly burdened by multistate taxation") 86. jefferson lines, 514 u.s. at 185 (citing goldberg v. sweet, 488 u.s. 252, 262 (1989)). 87. id. 88. the article four privileges and immunities clause is referred to as the "interstate" privileges and immunities clause. it provides that "[t]he citizens of each state shall be entitled to all privileges and immunities of citizens in the several states." u.s. const., art. iv, § 2. 89. lunding v. n.y. tax appeals tribunal, 522 u.s. 287, 290-91 (1998) (concluding that "because new york has not adequately justified the discriminatory treatment of nonresidents . . . the challenged [tax] provision violates the privileges and immunities clause."). although the privileges and immunities clause speaks of discrimination against "citizens" the court held that "a general taxing scheme ... if it discriminates against all non-residents has the necessary effect of including in the discrimination those who are citizens of other states." travis v. yale & towne mfg. co., 252 u.s. 60, 79 (1920). see also susan m. cordaro note, a high water mark: the article iv, section 2, privileges and immunities clause and nonresident beach 2008] florida tax review commerce clause, a goal motivating this additional anti-discrimination provision was "to help fuse into one nation a collection of independent, sovereign states."90 although the clause arguably has multiple purposes, it is "first and foremost a national unity provision, eliminating a source of interstate divisiveness.' 91 as expressed by chief justice taney, the clause seeks to ensure the avoidance of "discord and mutual irritation" among the states. 92 taxes especially taxes one state attempts to export to another state's residents historically have been, and continue to be, a prime area for states to provoke each other to such discord and irritation.93 this practice of filling the state access restrictions, 71 fordham l. rev. 2525, 2563 n. 21 (2003) ("the supreme court has come to view 'citizen' and 'resident' as terms that are 'essentially interchangeable' as part of article iv, § 2, privileges and immunities analysis.") (quoting hicklin v. orbeck, 437 u.s. 518, 524 n.8 (1978) (quoting austin v. new hampshire, 420 u.s. 656, 662 n.8 (1975))). 90. toomer v. witsell, 334 u.s. 385, 395 (1948). see also hicklin v. orbeck, 437 u.s. at 523 (noting that the privileges and immunities clause "establishes a norm of comity that is to prevail among the states with respect to their treatment of each other's residents.") (citation omitted); laycock, supra note 22, at 270 ("the specific concerns that underlie the privileges and immunities clause inform the more general right of equality in the equal protection clause and the equality component of the commerce clause."). 91. laycock, supra note 21, at 263 (further citing alexander hamilton's statement that the clause was "the basis of the union.") (citing the federalist no. 80, at 478 (alexander hamilton) (clinton rossiter ed., 1961)). 92. smith v. turner (passenger cases), 48 u.s. (7 how.) 283, (1849) (taney, c.j., dissenting) (" [a] tax imposed by a state for entering its territories or harbours is inconsistent with the rights which belong to the citizens of other states as members of the union, and with the objects which that union was intended to attain. such a power in the states could produce nothing but discord and mutual irritation, and they very clearly do not possess it.") 93. the federalist no. 7 (alexander hamilton); austin v. new hampshire, 420 u.s. 656, 662 (1975); see also the capital-journal editorial board, border dispute a tax war, topeka cjonline, at www.cjonline.com/stories/082507op 1_ 194425567.shtml, (last visited oct. 2, 2007) (reporting that kansas and missouri are involved in "another border skirmish" over tax treatment of nonresident commuters and foreshadowing a "never-ending battle between state legislatures"); rick vanderknyff, msn money, could you be hit by the "jock tax"?, available at http://moneycentral.msn.com/content/taxes/p 112872.asp (last visited oct. 2, 2007) (noting that the source-based income taxes states impose on professional athletes arose when california retaliated for the chicago bulls' defeat of the l.a. lakers in the 1991 nba finals; other states quickly followed suit in imposing their own 'jock taxes"). [vol 8:8 tax my ride fisc by imposing taxes on outsiders is known as tax exporting. 94 in an early case, the court addressed states' attempts to ease the tax burden on their own residents by imposing entry taxes on non-residents. 95 the majority struck down the tax as violating the commerce clause.96 chief justice taney, in dissent, set forth his opinion that no state may impose a tax for entering its "territories or harbours" because such a tax "is inconsistent with the rights which belong to the citizens of other states as members of the union, and with the objects which that union was intended to attain., 97 in other words, such a tax violates the privileges and immunities clause as well as the commerce clause. although the chief justice was in dissent, his opinion "set the groundwork for a right to travel. 9 8 as the court more recently put it, the privileges and immunities clause "places citizens of each state upon same footing with citizens of other states, so far as the advantages resulting from citizenship in those states are concerned." 99 one such advantage of citizenship is "the right of a citizen of any state to remove to and carry on business in another [state] without being subjected in property or person to taxes more onerous than the citizens of the later state are subjected to." 100 the court recognizes that taxing authority is fundamental to state sovereignty and as such the court has noted that its "review of tax classifications has generally been concomitantly narrow." 10 1 however, when state tax authority pushes up against "an activity granted special constitutional recognition" that deference to state taxing authority yields so that the court may "protect the competing constitutional value. 1 °2 94. daniel shaviro, an economic & political look at federalism in taxation, 90 mich. l. rev. 895, 908 (1992) (defining tax exportation as occurring "when governments succeed in placing tax burdens on outsiders."); see also hellerstein, some reflections, supra note 22, at 1333 (striving to find the "constitutional line [that] must be drawn in a manner that allows the state to exercise its taxing power freely but not so freely that it is allowed to care for its own at the expense of others.") 95. the passenger cases, 48 u.s. (7 how.) 283 (1849). 96. id. at 409-410, see also michelle l. himes, note, constitutional law you can't take it with you: the constitutionality of workers' compensation rules based on residency, 27 w. new eng. l. rev. 261, 277-78 (2005). 97. the passenger cases, 48 u.s. (7 how.) 283, 492 (taney, c.j., dissenting). 98. patrick m. garry, the constitutional lynchpin of liberty in an age of new federalism replacing substantive due process with the right to travel, 45 brand. l. j. 469, 494 n. 91 (2007). 99. lunding v. n.y. tax appeals tribunal, 522 u.s. 287, 296 (1998) (quoting paul v. virginia, 75 u.s. 168, (8 wall), 168, 180 (1869)). 100. id. 101. austin v. new hampshire, 420 u.s. 656, 662 (1975). 102. id. 2008] florida tax review despite its anti-discrimination promise, the article iv privileges and immunities clause does not bar all disparate treatment of citizens and noncitizens." 3 in particular, the privileges and immunities clause does not bar all disparate taxation treatment of citizens and non-citizens. °4 "[i]nequalities that result not from hostile discrimination, but occasionally and incidentally in the application of a [tax] system that is not arbitrary in its classification, are not sufficient to defeat the law."' 5 if a non-resident demonstrates a taxing scheme results in something less than "substantial equality of treatment"'0 6 for resident and nonresident taxpayers, it is up to the state to articulate a "reasonable ground" for the difference.'0 7 states may defend challenged actions by demonstrating a substantial reason for the difference, and showing that the discrimination bears a substantial relationship to the state's objective.'"° with relative frequency, the high court has held that a state has not sufficiently articulated a reasonable ground for the different treatment of non-residents, and has held a particular tax or fee violates the article iv privileges and immunities clause. 10 9 in a paradigmatic case, toomer v. 103. see lunding, 522 u.s. at 298 ("the privileges and immunities clause bars 'discrimination against citizens of other states where there is no substantial reason for the discrimination beyond the mere fact that they are citizens of other states. but it does not preclude disparity of treatment in the many situations where there are perfectly valid independent reasons for it."') (quoting toomer v. witsell, 334 u.s. 385, 396)). note that in this way, the clause differs from the dormant commerce clause; under current supreme court doctrine, any tax that discriminates against interstate commerce is per se invalid. but see laycock, supra note 22, at 259 (arguing that the "court should be reluctant to imply exceptions to any of these [the privileges and immunities clause, the equal protection clause, and the commerce clause] protections.") 104. lunding, 522 u.s. at 297 ("the privileges and immunities clause affords no assurance of precise equality in taxation between residents and nonresidents of a particular state."). 105. id. at 297 (quoting maxwell v. bugbee, 250 u.s. 525, 543 (1919)). (alteration in original). 106. id. at 297 (quoting austin v. new hampshire, 420 u.s. 656, 665 (1975)). 107. id. at 298 (quoting travis v. yale & towne mfg. co., 252 u.s. 60, 79 (1920)). 108. id. for a succinct and accessible description of modem doctrine, brannon p. denning, why the privileges & immunities clause of article iv cannot replace the dormant commerce clause doctrine, 88 minn. l. rev. 384, 388-93 (2003). 109. see walter hellerstein, state taxation: third edition, part iv, 20.06[1] "discrimination against non-residents under privileges and immunities clause" (1998) (discussing toomer v. witsell, 334 u.s. 385 (1948)); hellerstein & hellerstein, supra note 7, at 86-89 (discussing toomer, 334 u.s. 385, mullaney v. [vol. 8:8 tax my ride witsell,"10 the court invalidated south carolina's shrimping license fee that charged non-residents one-hundred times more than south carolina residents for the privilege of shrimping in south carolina's coastal waters."' the license fee cases demonstrate clear examples of prohibited state action. they also illustrate, however, a critical limitation on the scope of the interstate privileges and immunities clause. that limit is that only certain "fundamental" rights those rights "bearing upon the vitality of the nation as a single entity" are protected.12 the court has consistently held that pursuit of a common calling is a fundamental right." 3 2. the privileges or immunities clause of the 14th amendment while the court has discussed the interstate, or article iv, privileges and immunities clause in numerous tax cases, the privileges or immunities clause of the 14th amendment has not figured prominently in tax cases. 114 anderson, 342 u.s. 415 (1952), lunding v. new york tax appeals tribunal, 522 u.s. 287 (1998), austin v. new hampshire, 420 u.s. 656 (1975)). 110. 334 u.s. 385. see also ward v. maryland, 79 u.s. (12 wall.) 418, 430 (1871) (striking down a state law that, among other things, charged nonresidents a higher license fee than those in-state residents who were required to secure licenses). 111. toomer, 334 u.s. at 385 (the statute charged resident-owned boats $25 for a license to shrimp, while charging non-resident owned boats $2,500). 112. baldwin v. fish & game comm'n of montana, 436 u.s. 371, 383 (1978). the understanding of what rights are "fundamental" is undeveloped, at best, as is discussed infra. 113. e.g., united bldg. & constr. trades council v. camden, 465 u.s. 208, 219 (1984) ("certainly, the pursuit of a common calling is one of the most fundamental of those privileges protected by the clause."). while shrimping for a livelihood qualifies as a "fundamental" privilege or immunity, hunting big game for sport does not. the high court made this latter point express when it upheld montana's licensing scheme that charged resident elk-hunters significantly lower fees than non-resident elk-hunters. baldwin v. montana fish & game comm'n, 436 u.s. 371 (1978). see gillian e. metzger, congress, article iv, and interstate relations, 120 harv. l. rev. 1468, 1504 (2007) (questioning why national unity is less threatened by discrimination surrounding recreation than commercial activities; noting that the distinction between the shrimp and elk cases "reveals the commercial flavor of the court's view of the privileges and immunities clause, it leaves unexplained why resentment and retaliation outside the commercial context is less threatening to the nation's well-being."). 114. indeed, the 14th amendment privileges or immunities clause has not figured prominently in any subject of the court's jurisprudence. william j. rich, taking "privileges or immunities" seriously: a call to expand the constitutional canon, 87 minn. l. rev. 153, 207 (2002) (lamenting that "the current generation of lawyers and judges has been trained to ignore the privileges or immunities clause."). 2008] florida tax review this later privileges or immunities clause instructs that "no state shall make or enforce any law which shall abridge the privileges or immunities of citizens of the united states.""' 5 for over 100 years, the privileges or immunities clause of the 14th amendment was "all but read ... out of the constitution" by the slaughter-house cases. 1 6 in 1999, however, the court reinvigorated the clause, holding that the clause protects the right to travel." 7 in particular, the court held that the 14th amendment prohibits states from impeding "the free interstate passage of citizens"'" 8 and held that california's cap on welfare benefits for newly arrived residents violated the privileges and immunities of the state's new residents."19 like the interstate privileges and immunities clause of article iv, the 14th amendment privileges or immunities clause, as the saenz court noted, protects only "fundamental" rights. 20 though the precise definition of what constitutes a fundamental right is unclear, 12 1 it seems certain that two 115. u.s. const. amend. xiv. although the amendment refers to "citizens" the amendment protects residents as well. rich, supra note 115, at 195 (quoting d.o. mcgovney, privileges or immunities clause, 14th amendment, 4 iowa l. bull. 219, 240-41 (1918) ("privileges or immunities of a united states citizen include rights conferred upon him by national law, whether it is conferred upon him because he is a citizen, or because he is a human being. .. [i]t is none the less a privilege of citizens of the united states' that others have the same privilege.") 116. saenz v. roe, 526 u.s. 489, 521 (1999) (thomas, j. dissenting) (noting that "unlike the equal protection and due process clauses ... the court all but read the privileges or immunities clause out of the constitution in the slaughterhouse cases."). the court has not completely ignored the clause, however. e.g., colgate v. harvey, 296 u.s. 404, 431, 433 (1935) ("one purpose and effect of the privileges and immunities clause of the 14th amendment ... was to bridge the gap left by [article iv, section 2] so as also to safeguard citizens of the united states against any legislation of their own states having the effect of denying equality of treatment in respect of the exercise of their privileges of national citizenship in other states .... when [a citizen] trades, buys, or sells, contracts or negotiates across the state line, when he loans money or takes out insurance in new hampshire, whether in doing so he remains in vermont or not, he exercises rights of national citizenship which the law of neither state can abridge .... ") 117. according to then chief justice rehnquist, the saenz case "breathe[d] new life into the previously dormant privileges and immunities clause of the 14th amendment." saenz, 526 u.s. at 511 (rehnquist, c.j., dissenting). the court's revitalization reinvigorated academic interest. see scott dodson, vectoral federalism, 20 ga. st. u. l. rev. 393, 457 (2003) (noting that "the privileges or immunities clause is experiencing academic revival"). 118. saenz, 526 u.s. at 511-12 (1999) (rehnquist, j. dissenting). 119. id. 120. id. 121. metzger, supra note 113, at 1504 (stating "the court's efforts to render this standard [the 'fundamental' right standard] operational again have not been models of consistency."). [vol. 8:8 tax my ride such rights relevant here include the right to commute; or as it was phrased in the early 19th century in a discussion of the iv amendment, the "right of a citizen of one state to pass through, or to reside in any other state, for purposes of trade, agriculture, professional pursuits, or otherwise...,,122 and the right to be free of discriminatory taxation, or, again, as phrased in the landmark 123 corfield opinion, "an exemption from higher taxes or impositions than are paid by the other citizens of the state.... . combined, these rights have been explicitly recognized by the court at least twice: first, in ward v. maryland,' 5 and then again in hicklin v. orbeck.126 the hicklin court summarized the protection afforded by the clause: "a resident of one state is constitutionally entitled to travel to another state for purposes of employment free from discriminatory restrictions in favor of state residents imposed by the other state.' ' 127 this right to work in another state is the second of three components of the right to travel that the saenz court articulated. 28 the shared goal of national unity that underpins both the commerce clause and the article iv privileges and immunities clause is also an aim 122. corfield v. coryell, 6 f. cas. 546 (c.c.e.d. pa. 1823) (no. 3230). similarly, the saenz majority defined as "fundamental" the right to travel. reference to corfield to define the privileges and immunities to which the 14th amendment applies is sound: "the meaning of the terms 'privileges' and 'immunities' did not change when they were repeated in the 14th amendment." rich, supra note 115, at 215. see also michael p. o'connor, time out of mind: our collective amnesia about the history of the privileges or immunities clause, 93 ky. l. j. 659, 701-02 (2005) (noting that the most obvious place to begin understanding the meaning of "privileges or immunities" in the 14th amendment is by reference to the "nineteenth-century understanding of the original privileges and immunities clause") (citing corfield v. coryell, 6 f. cas. 546 (c.c.e.d. pa. 1823) (no. 3,230)). 123. saenz, 526 u.s. at 524 (thomas, j. dissenting) (referring to corfield v. coryell as "justice bushron washington's landmark opinion.") 124. corfield v. coryell, 6 f. cas. 546, 552 (c.c.e.d. pa. 1823) (no. 3230). see also tracy a. kaye, tax discrimination: a comparative analysis of u.s. & eu approaches, 7 fla. tax rev. 47, 82 (2005) (noting that "the freedom from discriminatory taxation had previously been named as a fundamental right.") (citing gary j. simson, discrimination against non-residents and the privileges and immunities clause of article iv, 128 u. pa. l. rev. 379 (1979) (citing corfield v. coryell, 6 f. cas. 546, 551 (c.c.e.d. pa. 1823) (no. 3230))). 125. 79 u.s. 418 (12 wall.) (1870). 126. 437 u.s. 518 (1978). 127. hicklin, 437 u.s. at 525 (citing ward v. maryland 79 u.s. 418 (12 well.) (1870)). 128. saenz, 526 u.s. at 500, the first component is the right of a citizen of one state to enter and leave another, and the final component is the right to be treated like other citizens once one elects to become a resident of that state. id. 2008] florida tax review animating the 14th amendment privileges or immunities clause. 2 9 indeed, recent scholarly effort addressing and valuing the 14th amendment privileges or immunities clause emphasizes the critical national building component of the clause.' 3 0 william j. rich, for example, undertakes a careful examination of the historic context of the 14th amendment, and persuasively concludes that the 14th amendment changed [the] federal balance and "strengthened the values of nationhood, equality, and democracy.' 131 professor rich emphasizes the "central importance of national citizenship and democratic control" to the amendment. 132 rich notes the majority opinion for the slaughterhouse cases identified four sources of federal privileges or immunities: negative constraints in the text of the constitution; rights derived from the "national character" of the government; 133 "federal privileges or immunities incorporated [into] the 'right to peaceably assemble and petition for redress of grievances;""' 134 and finally, the "right to use the navigable waters of the united states."' 135 as rich points out, this last category is "fundamental" and reflects that the "right to use navigable waters referred to the commerce clause."' 36 this constitutional overlap that rich identifies the right to use navigable waters that is present in both the understanding of federal privileges or immunities and explicitly in the commerce clause illustrates the critical role this interest plays in our union. 129. jide nzelibe, free movement: a federalist reinterpretation, 49 am. u. l. rev. 433, 435 (1999) (attempting "to dispel the notion that the limitation on a state's power to restrict interstate travel and migration is based upon a notion of a personal right to travel" . . . and instead positing that "this limitation, like the dormant commerce clause, is traceable to an idea of conserving the political and economic union against provincial state interests.") (citation omitted). 130. e.g., rich, supra note 114; james w. fox, jr., democratic citizenship & congressional reconstruction: defining & implementing the privileges & immunities of citizenship, 13 temp. pol. & civ. rts. l. rev. 453 (2004) (considering the "implementation of the 14th amendment during reconstruction through the lens of democratic citizenship"); thurgood marshall, reflections on the bicentennial of the united states constitution, 101 harv. l. rev. 1, 4 (1987) ("while the union survived the civil war, the constitution did not. in its place arose a new, more promising basis for justice and equality, the 14th amendment.") 131. rich, supra note 114, at 158. 132. id. 133. id. (citing the slaughter-house cases, 83 u.s. 36, 79 (1873)). 134. id. at 181-82 (quoting slaughter-house cases, 83 u.s. 36, 79 (1873)). 135. id. at 181-82, (quoting slaughter-house cases, 83 u.s. 36, 79 (1873)). 136. id. at 182. [vol. 8:8 tax my ride part hi constitutional norms as complementary part iii begins with an exploration of the perils of double taxation, and proceeds to demonstrate that the dormant commerce clause, which is said to protect "markets and market participants, not taxpayers as such"'137 does in fact protect the "market" for employees, and therefore should provide solace to interstate commuters and teleworkers. this part also synthesizes the goals of the privileges and immunities clause with those of the dormant commerce clause, and demonstrates that the privileges and immunities clause does not occupy the field to the exclusion of the dormant commerce clause. even if the dormant commerce clause did not apply to interstate commuters, both the 14th amendment privileges and immunities clause and the dormant commerce clause were, and continue to be, concerned with national unity and true national citizenship. retaliatory and protectionist taxing regimes undermine the interest in national unity, and therefore are constitutionally prohibited. a. the perils of double taxation double taxation doubtless seems unfair to an individual taxpayer, but its impact on the overall economy is even more pernicious. fairness in itself is a basic building block of a good taxing system. 38 fairness is admittedly a hazy concept, but for the purposes of this article, a straightforward characterization borrowed from scholar linda beale will suffice: a fair tax system is one in which "taxpayers ... believe that they will not be required to pay too much tax in comparison to other taxpayers.' 39 fairness is important for its own sake, but fairness and the perception of fairness are also critical when tax systems rely significantly on voluntary 137. general motors corp. v. tracy, 519 u.s. 278, 300 (1997). 138. e.g., linda m. beale, book-tax conformity & the corporate tax shelter debate: assessing the proposed section 475 mark-to-market safe harbor, 24 va. tax rev. 301, 359 (2004) (stating that "as any introductory tax text makes clear, the three concerns traditionally considered determinative of tax policy are fairness, efficiency, and simplicity.") 139. id. at 371. see also stephen j. dubner & steven d. levitt, filling in the tax gap, n.y. times magazine, apr. 2, 2006, at 26 (setting forth evidence that the average (federal income) taxpayer underpays by about one-fifth, and arguing that "unless you are personally cheating by one-fifth or more, you should be mad at the i.r.s. not because it's too vigilant, but because it's not nearly vigilant enough. why should you pay your fair share when the agency lets a few hundred billion dollars of other people's money go uncollected every year?"). 2008] florida tax review compliance, as ours do.140 compliance is more likely when taxpayers believe that the system is fair. 141 to the extent that a taxing system requires interstate commuters to pay more than similarly situated intra-state commuters, the double-taxation is perceived to be, and is, unfair. this perception of unfairness chips away at the taxpaying public's faith in the tax system. this is a serious critique given the current "tax gap."' 142 the fairness problem is illustrated by analogy to the taxation faced by professional athletes. after the chicago bulls defeated the l.a. lakers in the 1991 nba finals, california got even by enacting the first "jock tax."'143 when a professional athlete plays an away game, the city and/or state where the game is played will tax the athlete's income earned that day, claiming it is sourced in that jurisdiction.144 the tax is most commonly calculated using a ratio of "duty days," where the number of days the athlete is required to be in the taxing city/state for team duties is divided by the total number of days in the year the athlete is required to perform team duties. 14 while many of these taxes apply to all people entering a state to work and earn income, professional athletes and entertainers are the most common targets of this tax because their schedules are public and announced in advance, giving tax administrators easy access to the information they need to assess the tax. 46 the targeting of athletes based on their high salaries 140. e.g., id. (noting that "most people aren't cheating" on their federal income taxes, and reporting that experts estimate "that the u.s. is easily within the upper tier of worldwide compliance rates"). 141. beale, supra note 138, at 371. 142. e.g., dubner & levitt, supra note 139, at 26 (discussing in general terms the federal income tax "tax gap"). the "tax gap" is not a uniquely american problem. see eric j. lyman, vatican officials say papal encyclical will condemn tax evasion, tax havens, bna daily tax report, no. 158, aug. 16, 2007 at i-1 (reporting that pope benedict xvi has equated tax evasion to stealing and will release "an encyclical that will condemn tax evasion as 'socially unjust;' and further reporting that "statements from the vatican... can have an impact on the behavior of individuals or companies and on policy in poor and predominantly catholic countries in latin american, africa, and parts of asia."). 143. rick vanderknyff, could you be hit by the jock tax?, msn money, http://moneycentral.msn.com/content/taxes/p112872.asp (last visited aug. 7, 2007). as of 2006, 20 states had enacted a jock tax. mike baker, state lawmaker proposes "retaliation" tax on athletes, seattle post-intelligencer, feb. 6, 2006, available at http://seattlepi.nwsource.com/local/258384__gjocko6.html. 144. see thomas heath and albert b. crenshaw, in professional sports, states often claim players; 'jock tax' follows athletes to their places of work, wash. post., feb. 24, 2003, at doi. 145. id. 146. see schoettle, supra note 19, at 521 ("the state can calculate the time an athlete spends in the state without an expensive audit, can identify the employer, [vol. 8:8 tax my ride and public work schedules strikes some as unfair, especially considering that other highly paid individuals have an easier time flying under the radar.' 47 in addition, it is not just the highly paid athletes who bear the burden of this tax it is also assessed against trainers, coaches, and lower-paid athletes who all travel with the team as well. 148 athletes end up paying large sums of money to accountants to help file all of their additional state income tax returns. 49 even those who are opposed to the ever-increasing salaries paid to athletes could agree that imposing taxes on people merely because they are easy to track is not fair. in addition, using the tax system as a tool in this way merely serves to drive the targets of the tax to find more ways to insulate themselves from state taxation. 150 the taxation of professional athletes has attracted a fair amount of scholarly attention, but commuters with less exciting jobs are similarly impacted. the question of the fairness of taxing, or over-taxing commuters, has been brought into stark relief in two recent cases in which new york's highest court held against two non-resident taxpayers one, a law professor, and the other an information technology professional.' 5' in the first case, law professor edward zelinsky challenged new york's ability to tax as "source" income monies he earned while working at his home in connecticut. cardozo law school the institution for which zelinsky taught is located in new york.152 zelinsky performed many of his duties, however, at his home in connecticut. 53 zelinsky commuted three days each week during the semester, and when school was not in session and and in general can enforce tax laws against this population with far more ease than other professionals who earn salaries from activities carried on in nonresident states."). 147. see heath and crenshaw, supra note 144 (quoting david k. hoffmann, an economist with the tax foundation, as saying "'it's not fair [that] just because this particular occupation is so easy [to track] and no one feels bad fore [sic] the rich players that they have to pay these taxes."). but see vanderknyff, supra note 143 (noting that states are becoming more aggressive in trying to tax ceos and -lawyers by auditing company travel records). an aggressive state revenue department could easily target trial lawyers, whose appearances in court are matters of public record. although perhaps not as lucrative as taxing professional athletes, a trial team in a month-long, complex civil trial could easily bill in excess of a quarter of a million dollars. 148. id. 149. id. 150. id. 151. zelinsky v. tax appeals tribunal of the state of new york, 801 n.e.2d 840 (n.y. 2003), cert. denied, 541 u.s. 1009 (2004); huckaby v. tax appeals tribunal of the state of new york, 829 n.e.2d 276 (n.y.), cert. denied, 126 s. ct. 546 (2005). 152. id. 153. id. 20081 florida tax review during his sabbatical leave in the fall semester of 1995, he worked exclusively at home. 54 zelinsky argued that new york should be permitted to tax as source income only the percentage of income he earned while he was physically in new york.'" similarly, thomas huckaby, a resident of tennessee, worked primarily from his tennessee home for a new york employer. 156 mr. huckaby presents perhaps a more compelling case, because his time in new york was even more limited than that of professor zelinsky mr. huckaby spent only 59 days in new york in the first tax year at issue, and only 62 days in new york in the second tax year at issue. 157 another factor making huckaby arguably more sympathetic is that a daily commute for huckaby would not have been just inconvenient it simply would not have been possible. when zelinsky prepared his tax returns, he "apportioned to new york the percentage of his total salary that reflected the number of days he commuted to the law school."' 58 similarly, when huckaby filed his returns, he "allocated his income between new york and tennessee based on the number of days he worked in each state relative to the total number of days he worked in each tax year."' 59 the new york state department of taxation and finance disagreed with both zelinsky's and huckaby's returns, and assessed deficiencies upon audit.160 in separate cases, both teleworkers challenged the deficiencies. zelinsky raised commerce and due process clause challenges to the assessment;'16 huckaby did not raise the commerce clause argument, but challenged the assessments on due process grounds. 162 the new york court rejected both appeals, and upheld the assessments. 163 the propriety of the court's decision will be discussed below,' 64 what is remarkable here, however, is the criticism these decisions received in both academic and 154. id. at 833-34. by my calculations, professor zelinsky spent no more than 90 days working in new york during the tax year in which he did not take a sabbatical. 155. id. 156. huckaby, 829 n.e.2d at 277-78. 157. id. at 278. 158. zelinsky, 801 n.e.2d at 843-44. 159. huckaby, 829 n.e.2d at 278. 160. id. at 278; zelinsky, 801 n.e.2d at 844. 161. zelinsky, 801 n.e.2d at 844. 162. huckaby, 829 n.e.2d at 281. mr. huckaby also raised a statutory interpretation argument, not relevant here, that was rejected by the court. id. at 279281. 163. huckaby, 829 n.e.2d at 285; zelinsky, 801 n.e.2d at 849. 164. see infra notes 204210 and accompanying text. [vol. 8.'8 tax my ride popular press. 165 one academic commentator noted that new york's practice of aggressively taxing non-residents such as zelinsky and huckaby violates "the due process clause, commerce clause, and privileges and immunities clause... principles." 166 in a short opinion piece published in the new york times, the cases were criticized as unfair, and the author concluded, "the country needs telework to help address the health, energy, transportation and homeland security challenges before us, and new york's thirst for nonresident revenue simply can't take priority.'0 67 in addition to the fairness problem, discriminatory taxation of commuters has the potential to impact the flow of capital, impair commerce, and alter or impair individual travel and work habits. although all taxes have some effects on individual behavior, 168 discriminatory taxes can create deadweight social losses. as daniel shaviro explains, "when [taxes] cause a taxpayer to substitute an activity for the one she would otherwise prefer in order to reduce her tax liability, they create a deadweight social loss in the amount of the reduced pretax benefit to the taxpayer by reason of the substitution."' 169 in other words, if a connecticut resident would prefer to live in connecticut and work in new york city, but because of double taxation she either foregoes the new york job, or moves to new york, a deadweight social loss is created. this inefficiency and corresponding deadweight losses 165. see, e.g., molly mcdonough, telecommuter tax case is closely watched, 4 a.b.a. journal report 2 (jan. 14, 2005) (calling the case "closely watched" and noting that "upwards of $100 million in tax revenue" was at stake). 166. william v. vetter, a critique of the empire state's "new" convenience of the employer rule, j. of multistate taxation & incentives 14, 23 (feb. 2007). see also meredith a. bentley, huckaby v. new york state division of tax appeals: in upholding the current tax treatment of telecommuters, the court of appeals demonstrates the need for legislative action, 80 st. john's l. rev. 1147, 1166 (2006) (criticizing the decisions in huckaby and zelinsky, and concluding that "the onus is on the legislature to put an end to the unfair tax treatment of telecommuters"). 167. nicole belson goluboff, taxing telecommuters, n.y. times, aug. 6, 2006, at § 14cn, at 13. 168. shaviro, federalism in taxation, supra note 94, at 900 ("taxes inevitably have income effects by reducing the taxpayer's wealth, they affect her behavior"). 169. id. see also president's advisory panel on federal tax reform, simple, fair, and pro-growth: proposals to fix american's tax system 36 (2005) [hereinafter president's advisory panel], available at http://www.taxreformpanel.gov /final-report/taxreformch3.pdf (explaining efficiency costs as follows: "when taxpayers change their behavior to minimize their tax liability, they often make inefficient choices that they would not make in the absence of tax considerations. these tax-motivated behaviors divert resources from their most productive use and reduce the productive capacity of our economy."). 2008] florida tax review "waste economic resources, reduce productivity, and, ultimately lower living standards for all. 17° despite all the drags that double-taxation puts on our national economy, states remain sorely tempted to export taxes and generate revenues from non-residents. states often give in to that temptation, after all, the demands on states' fiscs continue to grow, and non-residents who earn substantial revenue in the state present what must appear to legislators and revenue authorities as a bull's eye target as they drive across the state line to come to work.' 7' this problem of tax exportation promises to continually become worse as our economy becomes ever more integrated. 172 non-residents, of course, are also non-voters, and as such, have a much more difficult time finding relief in the state legislature. 73 nonresidents historically have also faced a difficult time finding relief in the congress. 174 although a recent bill, the telecommuting tax fairness act, has been introduced in both the house and senate, 175 congressional intervention in state and local tax matters has been nearly nil over the two 170. president's advisory panel, supra note 167, at 36. a telling example of such deadweight social losses was recently reported by the new york times. cbs c.e.o. leslie moonves amended his contract with cbs so that cbs will pay any state or local taxes moonves might incur by living in california but occasionally working in new york. patrick mcgeehan, getting too big for his own taxes?, n.y. times, aug. 26, 2007 at b2. these legal costs and related expenses would be unnecessary if mr. moonves could rely on consistent tax treatment. 171. new york's revenue department is notorious for its aggressive collection practices. see, e.g., nicole belson goluboff, new york makes it official: double taxing of telecommuters will continue, 40 st. tax notes 877, 877-79 (2006) (urging congress to "remind new york that the state's hunger for nonresident revenue does not trump the nation's need to prepare for emergencies" such as pandemic flu and energy crises). 172. shaviro, federalism in taxation, supra note 94, at 902 ("today's more integrated national economy presents far greater opportunities than existed in 1787 for states in effect to reach across their borders and tax nonconsenting nonbeneficiaries.") 173. e.g., metzger, supra note 113, at 1484 (noting "it seems fair to expect that states will downplay harms to out-of-state interests for in-state gain, at least when out-of-state interests lack effective in-state surrogates."). 174. see shaviro, federalism in taxation, supra note 94, at 897. but see kaye, supra note 124, at 54, 66-67 (noting a "historic reluctance of congress to intervene in state taxation" but also noting that "in the last decade, there has been an increase in interference with state tax systems"). 175. telecommuter tax fairness act of 2007, h.r. 1360, 110th cong. (2007); s. 785, 110th cong. (2007). both bills were introduced by connecticut politicians: representative chris shays and senator chris dodd. [vol. 8:8 tax my ride hundred years of union.'7 6 commentators dispute whether congress would adequately protect state interests in this realm. tracy a. kaye, for example, argues that "congress is causing more harm than good in the name of avoiding tax discrimination and should exercise the legislative restraint it historically had shown to the taxing powers of the states. 177 another respected scholar, edward zelinsky argues, on the other hand, that it is time to restore politics to the dormant commerce clause and "scrap the dormant commerce clause prohibition on discriminatory taxation."' 178 zelinsky suggests that taxpayers with complaints about discriminatory taxation take those complaints to "congress or to the legislature imposing those taxes. 179 regardless of whether congress would adequately protect states' interests, or the interests of individual commuters, nonresidents challenging state taxes have had little success in congress. similarly, nonresident taxpayers have had relatively little success in their complaints to state courts or in the united states supreme court. nonresidents face potentially hostile state courts courts with at least some incentive to protect the treasury on which their paychecks are drawn. nonresident taxpayers might avoid the risk of parochial state courts by bringing suit in federal court, however, litigants must clear several hurdles to successfully maintain a suit in federal court. this is no easy task. first, the taxpayer must surmount the tax injunction act, 180 the federal statute prohibiting federal courts from enjoining the collection of state taxes unless there is no adequate state court remedy. the tax injunction act has been interpreted "liberally to impose a strict bar on federal court jurisdiction to entertain challenges to state taxes, except in the rare situation where the plaintiff can demonstrate that it has no adequate 176. see shaviro, federalism in taxation, supra note 94, at 897 (noting that "for two hundred years congress has almost never used these [commerce clause] powers to constrain state and local discretion in the tax area"). 177. kaye, supra note 124, at 70-71. kaye marshals the legislation that congress has been willing to pass, including the state taxation of pension income act of 1995 (preventing states from taxing certain retirement income of former residents) and the intemet tax freedom act (itfa) (preventing certain sales taxes on internet access and on some internet purchases) to conclude that "congress does not represent the states and there is increasing temptation to enact legislation that benefits a select constituency at a revenue cost to the states." id. at 70. 178. edward a. zelinsky, restoring politics to the commerce clause: the case for abandoning the dormant commerce clause prohibition on discriminatory taxation, 29 ohio n.u.l. rev. 29, 29 (2002) [hereinafter restoring politics]. see also edward a. zelinsky & brannon denning, the future of the dormant commerce clause: abolishing the prohibition on discriminatory taxation, 155 u. pa. l. rev. pennumbra 196 (2007).. 179. id. at supra note 176, at 30. 180. 128 u.s.c. § 1341. 2008] florida tax review remedy in the state courts." 18' even if the taxpayer meets the strictures of the tax injunction act, the challenger must also satisfy federal prudential and constitutional standing requirements, and the court has been parsimonious in permitting taxpayer standing.182 even if a taxpayer has standing, another challenge taxpayer litigants face is the perception, if not the reality, that the supreme court is more deferential to states when states are exercising their taxing authority than in other instances of challenges to state power.183 one explanation for that deference is that the supreme court "regards the power to tax as at the heart of a government's sovereignty.' ' 18 4 indeed, a sovereign's "authority to impose taxes is one of its most pervasive and fundamental powers."' 85 even if the taxpayer finds a friendly state court, or can maintain an action in federal court, yet another intensely practical hurdle exists money. the costs of bringing litigation to challenge a tax collection will frequently outweigh the potential reward for an individual taxpayer. 8 6 181. hellerstein & hellerstein, supra note 7, at 1114 (citing california v. grace brethren church, 457 u.s. 393, 411 (1982) ("[b]ecause congress' intent in enacting the tax injunction act was to prevent federal-court interference with the assessment and collection of state taxes, we hold the act prohibits declaratory as well as injunctive relief'). see also kaye, supra note 124, at 55 (noting that "in the u.s. judicial system, taxpayers normally have to challenge a state tax in state court."). 182. e.g., daimlerchrysler corp. v. cuno, 126 s. ct. 1854 (2006) (dismissing for lack of standing where state taxpayers' claims that a particular tax incentive violated the commerce clause); kristin hickman, how did we get here anyway? considering the standing question in daimlerchrysler v. cuno, 4 geo. j.l. & pub. pol'y 47 (2006). see also hein v. freedom from religion foundation, inc., 127 s. ct. 2553, 2559 (2007) (discussing the limitations of taxpayer standing). 183. see shaviro, federalism in taxation, supra note 94, at 942 (discussing this perception). 184. id. shaviro continues, "another explanation is that the court simply lacks confidence in its ability to understand tax cases and resolve them intelligently, and thus prefers to let most challenged tax cases stand." id. this second explanation is less persuasive. although the supreme court might lack confidence to tackle highly technical federal income taxation questions, it is unlikely that the court lacks confidence in its ability to discern questions of constitutional law, and it is questions of constitutional law that many state and local tax disputes raise. the authors of the leading textbook on state and local taxation, hellerstein & hellerstein, dedicate the majority of the book to constitutional questions. 185. stephen w. mazza & tracy a. kaye,. restricting the legislative power to tax in the united states, 54 am. j. comp. l. 641, 641 (2006) (citing the federalist no. 33 (alexander hamilton) (describing the power to tax as the most important of the legislative powers)). 186. e.g., javor v. state bd. of equalization, 527 p.2d 1153 (cal. 1974) (permitting a class action challenging a state sales tax because "[t]he amount due each member of the class is relatively small and when compared with the costs of [vol. 8:8 tax my ride b. constitutional norms and commuting with the perils of double-taxation fir-mly in mind, the article now turns to a more specific exploration of how the constitution protects our national economy from double-taxation. this part explains why the commerce clause 8 7 applies to this question, and then turns to the constitutional overlap of the commerce and privileges and immunities clauses. 1. the interstate market for employees it is somewhat awkward to consider commuters people as articles of commerce. nonetheless, it is "settled beyond question" that individuals are indeed articles of commerce, at least for dormant commerce clause analysis.1 88 perhaps it is less unseemly to think about the commerce clause as protecting the market in which states compete for residents£ or the market in which employers compete for employees. the dormant commerce clause trigger is flipped regardless of whether we consider the teleworkers articles of commerce themselves or we consider the market for those workers the triggering event. in any case, given the clear impact on interstate commerce, there is no persuasive reason that the complete auto transit test should not apply to individual personal income taxation just as it applies to taxation of business income. the historic purpose of the clause dictates that it applies to suit, would discourage individual legal actions."). note, too, that "in the absence of a waiver of immunity, the taxpayer cannot ordinarily recover interest on an unconstitutional levy." hellerstein & hellerstein, supra note 7, at 1096. 187. see generally walter hellerstein, reconsidering the constitutionality of the "convenience of the employer" doctrine, 2003 state tax today 235-16 (may 12, 2003) (suggesting that the due process clause prevents states from taxing individual income on an unapportioned basis when that income is earned in another state which also has power to tax a portion of the income). 188. edwards v. california, 314 u.s. 160, 172 (1941); mary sarah bilder, the struggle over immigration: indentured servants, slaves, and articles of commerce, 61 mo. l. rev. 743, 745 (1996) (asserting that "people are articles of commerce, or so the united states supreme court held in 1941, emphasizing that the issue was 'settled beyond question."' (quoting edwards, 314 u.s. at 172)). bilder notes the uneasiness that comes with considering individuals to be items of commerce, she cites justice jackson's discomfort with the theory that "the migrations of a human being .. . are commerce." id. (citing edwards, 314 u.s. at 182 (1941) (jackson, j., concurring)). bilder's article demonstrates good reason for that discomfort; she argues that "the court's nineteenth-century opinions on immigration under the commerce clause reveal the shadows of slaves and indentured servants." id. at 749. 20081 florida tax review interstate commuters' plight. 89 that the dormant commerce clause doctrine applies is even clearer after consideration of recent case law, including the court's opinion in camps newfound/owatonna v. town of harrison.190 rather than pre-empting application of the dormant commerce clause to our commuter's complaint, the privileges and immunities clauses of both article iv and the 14th amendment complement, and provides an independent constitutional means for relief for our commuter. 2. historic purposes and modern commuters over 200 years after alexander hamilton and james madison expressed their concerns about economic competition between the states, the national economy has not (yet) been destroyed by state rivalries. 91 as states fund increasingly expensive and expansive services, however, they must turn more and more to increasing taxes to generate revenue. 192 as the pressure to raise revenue grows, states compete with each other to try to attract more business and more high-income-earning residents. 193 this competition not only implicates hamilton and madison's concerns about harm to national unity, but also can leave interstate commercial actors, including teleworkers, fending off attempts by states to tax more than a fair share of their income. by its terms, the complete auto transit test applies to cases involving taxation of businesses engaged in interstate commerce. the court has not used the complete auto transit test to analyze an individual person's interstate commercial activity, at the same time, the court has not expressly held that the four-part test does not apply to the taxation of individual 189. but c.f., bernard e. jacob, an extended presence, interstate style: first notes on a theme from saenz, 30 hofstra l. rev. 1133, 1237 (2002) (arguing that the commerce clause doesn't need to cover this situation, because "at least as high a standard of protection is or ought to be available under the 14th amendment."). 190. 520 u.s. 564, 572 (1997). 191. c.f., peter d. enrich, saving the states from themselves: commerce clause constraints on state tax incentives for business, 110 harv. l. rev. 377 (1996) (suggesting that the national economy has in fact been damaged by such rivalries). 192. hellerstein & hellerstein, supra note 7, at v (noting that since 1952 tax revenues collected by state and local governments have increased almost fifty-fold; an "astronomical tax increase[]" that "reflect[s] comparable increases in state and local government expenditures" attributable in part to inflation but also in substantial part to "the broadening of the nature and scope of state and local government services"). 193. e.g., enrich, supra note 191, at 377 (discussing the "vicious cycle" of state and local incentives and its pernicious effect on interstate relations and on the states themselves). [vol 8:8 tax my ride income. 194 at least one state court to address the question, however, insists that the dormant commerce clause does not apply to the taxation of individual income. 195 the new york court of appeals continues to maintain that "[t]he taxpayer's crossing of state lines to do his work at home simply does not impact upon any interstate market in which residents and nonresidents compete so as to implicate the commerce clause." 196 this conclusion does not withstand scrutiny. though the supreme court has not expressly held that commuting trips the dormant commerce clause test, the court has noted that the crossing of state lines by individuals constitutes interstate commerce. 197 the court has also long recognized that individual activity can affect interstate commerce when looked at in the aggregate.1 98 it does not matter that the imposition on commuters impacts only a portion of the stream of interstate commerce: "the imposition of a differential burden on any part of the stream of commerce from wholesaler to retailer to consumer is invalid, because a burden placed at any point will result in a disadvantage to the out-of-state producer.1 199 the supreme court's recent opinion in camps newfound/owatonna v. town of harrison supports the application of the dormant commerce clause to the taxation of commuters' income. in camps newfound, the 194. the question was raised in the appeal from zelinsky, but the court denied certiorari. the petition for certiorari posed the question as follows: "1) on days when new york's "convenience of the employer" rule risks double taxation of nonresident telecommuters for working at their out-of-state homes, does that rule, and the risk of double taxation the rule causes, violate the commerce clause? 2) on days when new york's "convenience of the employer" rule risks double taxation of nonresident telecommuters for working at their out-of-state homes, does that rule, and the risk of double taxation the rule causes, violate the due process clause?" petition for certiorari at i, zelinsky, 541 u.s. 1009, 2004 wl 322430. 195. zelinsky v. tax appeals tribunal of the state of new york, 801 n.e.2d 840, 847 (n.y. 2003), cert. denied 541 u.s. 1009 (2004). 196. zelinsky, 801 n.e.2d at 847. the court's position in zelinsky is even more confounding considering the court's previous holding in city of new york v. state of new york, 94 n.y.2d 577,597 (2000) that transportation of persons is interstate commerce. 197. camps newfound/owatonna, inc. v. town of harrison, 520 u.s. 564, 572 (1997) (disagreeing with the town's argument that campers are not articles of commerce). the court has addressed so-called "commuter taxes." a commuter tax is essentially an entry tax on out-of-state workers. in austin v. new hampshire the court struck down these blatantly discriminatory taxes. 420 u.s. 656 (1975). 198. see wickard v. filburn, 317 u.s. 111 (1942). see also camps newfound/owatonna, 520 u.s. at 586 ("the interstate commercial activities of nonprofit entities as a class are unquestionably significant."). 199. camps newfound/owatonna, 520 u.s. at 580 (quoting west lynn creamery v. healy, 512 u.s. 186, 202 (1994)). 2008] florida tax review court held that a maine property tax exemption for charitable organizations which excluded charities operated principally for the benefit of non-residents violated the dormant commerce clause. 2 00 the court rejected the town's argument that campers were not "articles of commerce," and invoked the dormant commerce clause, noting that campers' travel to attend the camps "necessarily generates the transportation of persons across state lines that has long been recognized as a form of 'commerce."' 20' rejecting the notion that economic protectionism includes only state attempts to provide advantages to in-state merchants, the court noted that it also may include attempts to provide advantages to in-state consumers.2 °2 the court reiterated that "a state may not tax a transaction or incident more heavily when it crosses state lines than when it occurs entirely within the state. '203 finding the maine property tax exemption to be facially discriminatory,2°4 the court strictly scrutinized, and subsequently struck down, the exemption statute.20 ' a few campers choosing to camp in one state or another might appear trivial, and not a threat to the national economy. but the court reminds us that the facts must be considered in the aggregate, and in the aggregate, there is no doubt that summer campers impact commerce.20 6 camps newfound illustrates how the zelinsky court erred.20 7 the zelinsky court supports its conclusion by suggesting that because it is a personal decision to live in connecticut, and work in new york, the commerce clause is not implicated.2 8 this conclusion misses the point. just as the camper's choice, most likely for personal reasons, to cross state lines in camps newfound triggered dormant commerce clause scrutiny of a tax, 200. id. 201. id. 202. id. 203. id. 204. id. 205. id. at 583 n. 16. 206. id. 207. the plaintiffs urged the new york court to consider the supreme court's opinion in camps newfound. see reply brief of the appellants edward a. and doris zelinsky at 2, 4, zelinsky v. tax appeals tribunal for the state of new york, 801 n.e.2d 840, 847 (n.y. 2003), cert. denied 541 u.s. 1009 (2004). inexplicably, the zelinsky court did not cite or discuss camps newfound. walter hellerstein provided an earlier critique of the intermediate court's decision in the zelinsky case. see walter hellerstein, reconsidering the constitutionality of the "convenience of the employer" doctrine, 2003 state tax today 235-16 (may 12, 2003). 208. zelinsky v. tax appeals tribunal of the state of new york, 801 n.e.2d 840, 847 (n.y. 2003), cert. denied 541 u.s. 1009 (2004). the zelinsky court distinguished austin v. new hampshire, 420 u.s. 656, 665-68 (1975), in which the court held that state imposition of higher tax rate for nonresidents violates the privileges and immunities clause. [vol. 8.'8 tax my ride so too does the crossing of state lines by commuters like zelinsky. the impact of commuters on the national economy cannot be denied. as one leading federal income tax text puts it, "[t]he mobility of labor is an important and necessary part of the nation's economy, since it reduces unemployment and increases productive capacity. 2 °9 the zelinsky court referred to commuting as a "personal choice" of the taxpayer. 2 10 no doubt personal preference plays a role in where to live and to some extent where to work. indeed, the federal tax code considers commuting to be a "personal" expense, and does not allow deductions for commuting. 211 at first blush, the federal treatment of commuting expenses as personal might provide fodder for the conclusion that interstate commuting does not trigger the commerce clause. the lack of a federal deduction for commuting expenses, however, has been criticized as disingenuous. as one casebook puts it, "if it is a 'personal' decision to decide where to live, it is equally a 'business' decision to decide where to work., 212 in fact, the goal of neatly separating expenses into business (and therefore deductible) and personal (and therefore not deductible) is subject to cogent criticism. 213 furthermore, the decision to deny a personal income tax deduction for commuting expenses is efficient: whether a person chooses a long commute or a short commute, her tax liability will not change as a result of her decision, and thus tax considerations should not impact her choice. double 209. klein, bankman, & shaviro, supra note 12, at 445 (citing a 1970 congressional report). 210. zelinsky, 801 n.e.2d at 847 (noting that zelinsky's "voluntary choice to bring auxiliary work home to connecticut cannot transform him into an interstate actor"). 211. treas. reg. §§ 1.162-2(e), 1.262-1(b)(5) (2007); klein, bankman, & shaviro, supra note 12, at 445. the federal government does, however, allow taxpayers to elect to use up to $215 a month in pre-tax wages to pay for their parking at work. william neuman, mixed signals: driving to work as a tax break, n.y. times, aug. 16, 2007, at al. at the same time, as the neuman article points out, the federal government has recently made it a priority to discourage people from driving. the tax-break for parking, coupled with the new department of transportation grants to discourage driving is described as a "perverse" example of government policies working at cross-purposes. id. 212. klein, bankman, & shaviro, supra note 12, at 445. 213. e.g., mary louise fellows, rocking the tax code: a case study of employment-related child-care expenditures, 10 yale j.l. & feminism 307, 38893 (1998) (arguing that the "business/personal distinction does not produce predictable and widely accepted results" and further observing that "the difficulty of distinguishing business and personal expenditures is far more complex than merely a problem of determining taxpayer intent. the problem with the distinction is that it marks business expenses as productive, and personal expenses as unproductive in a way that misapprehends productivity in the home and nonproductivity in the marketplace."). 2008] florida tax review taxation of nonresident commuters, however, is inefficient. if a person faces double taxation as a result of his decision to live in one state and work in another, his tax liability will be affected by his choice, and tax considerations almost certainly will impact his decision of whether to maintain this arrangement. rather than making his choices of where to live and work free of tax considerations, his decision will now be impacted by the knowledge that he could avoid double taxation by moving to the state of employment or finding a new job in the state of residence. taxpaying commuters challenging discriminatory taxation could find an unlikely ally in justice scalia, elsewhere a vehement opponent of the court's dormant commerce clause doctrine. scalia's dissent in camps newfound makes clear that he is willing to apply the doctrine to overrule state taxes that facially discriminate against interstate commerce.214 particularly, scalia quoted justice jackson's statement in h.p. hood & sons, inc. v. du mond that the "vision of the founders" was "that every farmer and every craftsman shall be encouraged to produce by the certainty that he will have free access to every market in the nation .... 25 while scalia argued against the applicability of the dormant commerce clause doctrine to the maine tax in camps newfound, the tax in the case was not truly an economic protectionist measure in the way that aggressive taxation of interstate commuters is protectionist, and thus his opposition to the use of the dormant commerce clause doctrine in that situation is unlikely to carry over to a commuter tax apportionment situation. scalia thought that the maine statute was best viewed as "a narrow exemption for organizations that provided services the state might otherwise provide., 216 he did not think that providing a tax break to an organization that relieved the state of providing 217social services was something that implicates interstate commerce. the concept that the commerce clause protects the right of every farmer and craftsman to have free access to every market in the nation is not just an anachronism; the concept is commonplace in judicial decisions today. the eighth circuit decided jones v. gale in 2006, holding that a nebraska constitutional amendment prohibiting corporations or syndicates from acquiring interests in nebraska real estate used for farming or ranching (with certain exceptions) violated the dormant commerce clause by favoring nebraska residents and people who were in close enough proximity to nebraska farms and ranches to make a daily commute.21 8 the court 214. see hellerstein & hellerstein, supra note 7, at 206. 215. camps newfound/owatonna, 520 u.s. at 595 (scalia, j., dissenting). 216. karin j. kysilka, recent development: a jurisdictional vacuum in the wake of camps newfound/owatonna?, 21 harv. j. l. & pub. pol'y 288, 294 (1997). 217. id. at 294. 218. jones v. gale, 470, f.3d 1261, 1264-65 (8th cir. 2006). [vol 8:8 tax my ride particularly noted the advertisements that had run during the ballot initiative to adopt the constitutional provision, which encouraged people to vote for it in order to "send a message to those rich out-of-state corporations., 219 the court did not find any of the state's proffered non-discriminatory reasons for adopting the provision to outweigh the harm done by denying non-residents access to the nebraska farm market.220 the jones v. gale decision explicitly applies the commerce clause to interstate commuters. as commuting across state lines becomes a more common work arrangement, states are unsurprisingly able to take advantage of the situation to reap more than may be fair from non-resident employees. the world of work has changed since the time of the drafting of the constitution.221 people are able to live in one state and work in a place much farther away than would have been possible years ago.222 as cities and states compete to attract workers to strengthen their economies,223 they also face the increasing ability of workers to separate the choice of where to live from the choice of where to work.224 by placing a greater tax burden on people who work in their state but not live there, states with many commuter employees are able to provide themselves with some protection in the market for residents, as well as the market for workers,225 in contravention of the principles behind the commerce clause.226 219. see id. at 1270. 220. id. at 1267-69. the jones v. gale decision is open to criticism on a number of counts-including the court's questionable assessment that the anticorporate farming provision purposefully discriminated against interstate commerce. the case is cited here not because it is necessarily a persuasive example of dormant commerce clause jurisprudence, but simply to illustrate how courts are analyzing the issue. 221. see generally hellerstein & hellerstein, supra note 8, at 192 ("with the rapid growth of large-scale industry and the foreshortening of distances through modem transportation and communication, state lines lost much of their economic importance. at the same time the increasing demands upon the states for schools, roads, relief, and other social services forced them to seek out every available source of revenue.") 222. see, e.g., david schultz, 16 touro l. rev. 435, 435 (2000) ("the nature of work and employment in america has changed dramatically in the last twenty to thirty years.... people often choose or are required to work in certain places that are located in a different jurisdiction, county, or state from where they live."). 223. see, e.g., shaila dewan, cities compete in hipness battle to attract young, n.y. times, nov. 25, 2006, at al; karen brune mathis, to keep young workers, keep attention on downtown, fla. times-union (jacksonville), feb. 24, 2006, at d1. 224. see schultz, supra note 222. 225. see dewan, supra note 223; mathis, supra note 223. cf. christina gostomski, more local income taxes may go unpaid, moming call (allentown, 2008] florida tax review 3. constitutional overlap although the commerce clause "provides the strongest constitutional bulwark against hostile state regulation and taxation of the national economy"227 it is not the only constitutional norm implicated by the situation of our double-taxed commuting taxpayer. indeed, academic commentators, and the court itself have found a "mutually reinforcing relationship between the privileges and immunities clause of article iv, section 2, and the commerce clause a relationship that stems from the common origin in the fourth article of the articles of confederation and their shared vision of federalism., 228 as one scholar recently phrased it, "[w]here economic activity of nonresident individuals is involved, the demands of the dormant commerce clause and article iv largely overlap. 229 that interstate commuting taxpayers may appeal to the commerce clause to challenge discriminatory taxation does not mean that the privileges and immunities clause has no place in the double-taxed commuter's arsenal. the article iv privileges and immunities clause is in fact the more typical pa.), may 6, 2007, at al (discussing the high amount of unpaid pennsylvania local income taxes and noting that a major source of the problem is the increase of nonresident employees from neighboring states). 226. see paul j. hartman, state taxation of corporate income from a multistate business, 13 vand. l. rev. 21, 21-22 (1960), quoted in hellerstein & hellerstein, supra note 7, at 193: if one state in order to supply her fiscal needs or promote the commercial and economic well-being of her citizens may shield them from competition from sister states by the taxing process, we have opened a pandora's box of troubles in the nature of reprisals and trade wars that were meant to be averted by subjecting commerce among the states to the power of the federal government. 227. jim chen, a vision softly creeping: congressional acquiescence and the dormant commerce clause, 88 minn. l. rev. 1764, 1764 (2004). but see hicklin v. orbeck, 437 u.s. 518, 524 (1978) (referring to the privileges and immunities clause: "it has been justly said that no provision in the constitution has tended so strongly to constitute the citizens of the united states one people as this."). 228. hicklin, 437 u.s. at 531-32. see also laycock, supra note 21, at 259, 270 (noting that "much of the constitution addresses the task of creating one nation out of separate states, and of doing so without abolishing those states." further noting that "the same constitutional principles of national unity and interstate equality are at work in all three [commerce, privileges and immunities, and equal protection] clauses."). 229. metzger, supra note 113, at 1507. [vol. 8:8 tax my ride clause trotted out when a state seeks to prohibit or restrict nonresidents from working within the state's borders. 230 the privileges and immunities clause expressly protects the rights of nonresidents.23' because the privileges and immunities clause speaks quite directly to the treatment of interstate commuters, it has been argued that the dormant commerce clause cannot also apply.232 such an argument rests on cannons of statutory construction, and particularly on the notions that implied language cannot trump express language in the same legal document and that implied repeals are strongly disfavored.233 it is unclear, however, that the "regular" rules of statutory construction apply with equal force to 234interpretation of the constitution.234 our constitution is, after all, a unique document.235 scholars have wondered whether "special canons of construction, not applicable to any ordinary legal documents, [can] be derived from the constitution's unique context and purpose?, 236 even if the generic rules of construction apply, however, the better reading is that the commerce clause and privileges and immunities clauses should be read in concert, rather than in tension. it is not the case that the protections afforded by the commerce clause repealed those provided by the privileges and immunities clause. it is the combination of these clauses read together in both historic context and as the clauses have developed along with our national economy, that i wish to emphasize. read together, these clauses provide a sound argument for our weary and overtaxed commuter. as one scholar put it, "[t]he non-discrimination component of right to travel case law introduces an element of affinity with the dormant commerce clause doctrine and the privileges and immunities clause." 237 the interaction of these constitutional 230. see infra notes 89 to 114 and accompanying text discussing the history of the privileges and immunities clause. see also robert j. firestone, does a commuter's choice of where to reside implicate the dormant commerce clause?, 49 n.y.l. sch. l. rev. 943 (2004-2005) (suggesting that because the privileges and immunities clause applies, the dormant commerce clause should not apply to protect the interests of interstate commuters). 231. see infra. 232. firestone, supra note 227, at 943. 233. id. at 950-51. 234. e.g., caleb nelson, originalism & interpretive conventions, 70 u. chi. l. rev. 519, 555 -556 (2003) (noting the radical nature of our written constitution and asking, "did such a document trigger the rules of interpretation applicable to an ordinary statute? to a treaty? to a contract?"). 235. id. at 556. 236. id. (further asking "if so, what were those canons?") 237. francesca strumia, citizenship and free movement: european and american features of a judicial formula for increased comity, 12 colum. j. eur. l. 713, 715 (2006). 2008] florida tax review principles in case law results in a doctrine of unconstrained travel that is largely indebted to ideas of non-discrimination and equal citizenship." 238 just as the word "travel" is not found in the constitution, neither is the word "commute."'2 39 nonetheless, just as the right to travel is a "virtually unconditional personal right, guaranteed by the constitution to us all"'240 so too is the right to pursue a common calling, unencumbered by protectionism or discrimination of sister states. as the court explained, "every farmer and every craftsman shall be encouraged to produce by the certainty that he will have free access to every market in the nation, that no home embargoes will withhold his exports, and no foreign state will by customs duties or regulations exclude them.'241 this system benefits our national residents as both producers and consumers, as the court continued, "every consumer may look to the free competition from every producing area in the nation to protect him from exploitation by any. such was the vision of the founders; such has been the doctrine of this court which has given it reality."242 the dormant commerce clause doctrine, and the privilege and immunities clauses share a common origin and a common goal of federalism, but the privileges and immunities clause arguably has even more lofty ambitions than the commerce clause. while the commerce clause is concerned primarily with markets and economics, the privileges and immunities clause ("commercial flavor''243 though it may have) has as its goal "social, economic, and political unity and national identity. '"244 the protection from double taxation is "not based on the interstate commerce clause after saenz, but on national citizenship, the right to travel and national privileges or immunities clause of the 14th amendment."2 45 238. id. 239. saenz v. roe, 526 u.s. 489, 498 (noting that the word "travel" is not in the constitution). 240. id. 241. h.p. hood & sons, inc. v. du mond, 336 u.s. 525, 539 (1949). 242. id. 243. metzger, supra note 113, at 1503. 244. francis j. conte, sink or swim together: citizenship, sovereignty, and free movement in the european union and the united states, 61 u. miami l. rev. 331, 354 (2007) (arguing that "the american free movement is more robust than that currently enjoyed within the european union, and its animating purpose social, economic, and political unity and national identity is much broader than the european union's 'economic integration' purpose.") 245. jacob, supra note 189, at 1237. jacob continues: "the bite of the state 'double taxation' that is inconsistent with national citizenship is that it becomes due solely by reason of the several states' indifference to the taxpayer's reasons for assigning residential and work places in different states." id. [vol. 8:8 tax my ride ii. conclusion if, as this article argues, the constitution limits multiple taxation of commuters' income, what solution is there for states? states must be permitted to exercise their taxing power, and if a state chooses to do so, it should be permitted to exercise that authority up to the constitutional limit. one solution would be to require states to apportion source income that is, when two or more states have a legitimate claim to consider income "sourced" to their state, those states could be required to apportion only a percentage of that income to themselves. states are familiar with apportionment of business taxation, and could apply that regime to the taxation of individual income.245 congress could solve the problem expeditiously by using its commerce clause powers to put an end to discriminatory taxation. 46 congress could require states to apportion source income, or perhaps a more drastic, but more administratively feasible solution would be for congress to 245. this apportionment argument is not unique to taxation, and in fact has been applied to voting: sanford v. levinson "proposed that commuters and others who have contacts with more than one state be allowed to vote in more than one place, perhaps apportioning one vote over several jurisdictions." douglas laycock, equal citizens of equal & territorial states: the constitutional foundations of choice of law, 92 colum. l. rev. 249, 337 n.142 (1992) (citing sanford v. levinson, suffrage and community: who should vote?, 41 fla. l. rev. 545, 55154 (1989)). laycock agrees in principle to allowing commuters "to apportion a single vote among more than one jurisdiction" but would "object only on grounds of workability." id. 246. this article does not attempt to address the question of whether congress could do the opposite-authorize discriminatory taxation of interstate commuters' income. if the freedom from discriminatory taxation rests on the privileges and immunities clauses, it is unlikely that the congress could authorize states to discriminate. compare michael p. o'connor, time out of mind: our collective amnesia about the history of the privileges or immunities clause, 93 ky. l. j. 659, 719 (2005) ("saenz v. roe makes clear that congressional power is limited by the privileges or immunities clause.") and jim chen, a vision softly creeping: congressional acquiescence and the dormant commerce clause, 88 minn. l. rev. 1764, 1773-77 (2004) (arguing that congress lacks authority to authorize article iv privileges and immunities violations) with gillian e. metzger, congress, article iv, and interstate relations, 120 harv. l. rev. 1468 (2007) (exploring whether congress has the power to authorize states to engage in conduct that otherwise would violate article iv and concluding that in some circumstances, congress does have such power). if the only constitutional norm implicated is the commerce clause, then it is more likely that congress can authorize discrimination. but see norman r. williams, why congress may not "overrule" the dormant commerce clause, 53 ucla l. rev. 153, 159 (2005) ("in short, the dormant commerce clause may not be overridden by congress."). 2008] florida tax review prohibit states from taxing the compensation of a nonresident when the nonresident is not physically present in the state as the proposed telecommuter tax fairness act of 2007 would do.247 absent action from congress, it is almost certain that courts will continue to be called upon to resolve taxpayer challenges to discriminatory taxation. our changing economy and the lure of teleworking face off against the increasing revenue needs of states, and the corresponding increase in aggressive collection of taxes from outsiders. "it is critical to the union," douglas laycock recently urged, "that we continue to think of ourselves as a single people, and it is important that we not knowingly create legitimate interstate grievances. 248 discriminatory, or double, taxation of interstate commuters creates genuine grievances, and by allowing those discriminatory taxes to run rampart over interstate commuters, we undermine not only the economy, but also the union. the constitution teaches that when state taxing power runs up against preservation of the union, the union trumps every time. 247. telecommuter tax fairness act of 2007, h.r. 1360, 1 10th cong. (2007); s. 785, 11 oth cong. (2007). 248. laycock, supra note 22, at 264. [vol. 8:8 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 1 1994 number 12 the taxation of interest swaps and the financial service charge: toward a consistent approach yishai beer' i. introduction the supreme court has defined interest as "compensation for the use or forbearance of money."' this definition, and its subsequent interpretation by the courts, requires a direct link between the payment of "compensation" and the "use of money." this link has created a distortion in the current u.s. tax treatment of the administrative cost component of interest and its "financial service charge" substitute, and ambiguity with regard to the taxation of interest swaps. economically, interest consists, in part, of compensation given to a saver-lender for forgoing current consumption in favor of an ability to consume more in the future ("time preference") and compensation for forgoing a typical preference for liquidity.2 interest also reflects compensation for the risks of default and inflation, and reimbursement of the lender's administrative costs. the u.s. tax system has adopted a consistent approach by treating all the interest components alike, and generally, by not bifurcating a fixed amount of interest into its different economic components. this approach can be demonstrated, for example, with regard to the taxation of the inflation component. an exception to this approach however, is the tax * law faculty, hebrew university of jerusalem. this article was written while the author was a visiting scholar at the harvard law school. the author thanks professor alvin c. warren, jr. and richard gordon for comments on a previous draft. the views expressed are the author's alone. this research was supported by the israel science foundation administrated by the israel academy of science and humanities. 1. deputy v. du pont, 308 u.s. 488. 498 (1940). the english courts have reached a similar definition. see yishai beer, the credit price: income or capital. 1986 brit. tax rev. 271, 273 (citing bennett v. ogston, 15 t.c. 374, 379 (1930) (u.k.) (defining interest as "payment by time for the use of money")). 2. see infra notes 21-22 and accompanying text. 3. the current u.s. income tax system does not make adjustments for the effects of inflation. for example, in hellermann v. commissioner. 77 t.c. 1361 (1981). the taxpayer argued that the basis of an investment should be adjusted to include the inflation component when calculating capital gains. the court rejected this argument, pointing to the traditional florida tax review treatment of an "abnormal" risk of default under the "junk-bond" provision4 of the code.' this article deals with the inconsistent approach adopted by the u.s. tax system with regard to the administrative cost component of interest and its typical substitute "service charge." the combined effect of the general policy of nonbifurcation of the interest components with the formal requirements by which "interest" is recognized has distorted the tax system. the amount of the administrative cost component of a given interest rate is determined by the actual administrative cost incurred in extending the underlying loan. there is a difference between a loan made and repaid in one lump sum, and a loan made and repaid in installments; the latter, assuming that all relevant factors for credit price determination (i.e., duration and risk) are equal in both loans, costs the lender more to administer. an extreme example of the cost of the administrative component is a pawn transaction. the high amount of interest typically charged in such a transaction can be explained by, inter alia, the high administrative expenses of a pawnbroker, loyalty of u.s. courts to the nominalistic principle according to which a dollar always equals a dollar, disregarding any international or domestic changes in its value. see, e.g., the legal tender cases, 79 u.s. (12 wall.) 457 (1870). the supreme court followed this principle in validating the departure from the gold standard. see, e.g., perry v. united states, 294 u.s. 330 (1935). compare the united kingdom indexation provision which exempts "inflation gains" from capital gains tax. see butterworths uk tax guide 1993-1994, 624-28 (john tiley ed., 12th ed. 1993). for an example of the full neutralization of the inflation component in both assets and liabilities of a taxpayer under the israeli adjustment for inflation system, see yishai beer, taxation under conditions of inflation: the israeli experience, 5 tax notes int'l 299 (aug. 10, 1992). 4. under irc § 163(e)(5)(i), an "applicable high yield discount obligation" is divided into two components: (1) a deferred-deduction interest portion as to which the issuer deduction is deferred until the interest is actually paid, but which is nevertheless reported by the holder as income as it accrues under the regular oid rules; and (2) for a debenture whose yield exceeds the applicable federal rate plus six percentage points, a permanently nondeductible portion of the interest rate above that threshold, which is never deductible by the issuer but is nevertheless reported by the holder as income as it accrues (under the regular oid rules), and may qualify in its full amount for the "dividend received deduction" if the holder is a corporation. see martin d. ginsburg & jack s. levin, mergers, acquisitions and leveraged buyouts iv i 1303a (1989). for a criticism of this section, see yishai beer, the taxation of the risk component in a loan: an option analysis, special report, 57 tax notes 525 (oct. 26, 1992). 5. by comparison, in lomax v. peter dixon & son, ltd., 25 t.c. 353, 367 (1943) (u.k.), it was held in the united kingdom that in some circumstances, a discount (or a premium) can be recognized as a risk premium which is not considered interest, but rather capital income or expense. for a criticism of the english tax law approach, see beer, supra note 1. cf. old colony r.r. v. commissioner, 284 u.s. 552 (1932), discussed infra text accompanying notes 38-39. [vol. 1:12 19941 the taxation of interest swaps and the financial senice charge 731 including the costs of appraisal, storage, and insurance, and sale expenses (in case the item pawned is not redeemed).6 under current rules, if the administrative cost component of interest is priced as an integral part of the interest charged, for example, when the overhead costs of a lender are reflected in the interest rate it charges (say, for a mortgage), the administrative cost component constitutes interest for tax purposes. however, if this component is charged separately, it may or may not be treated as interest depending on the facts. this article calls for a similar treatment in both cases; furthermore, it argues that any direct costs borne by a borrower, incurred for the purpose of reducing the effective cost of interest or paid for the mere providing of credit (or its availability), should be considered interest for tax purposes. in many cases, a similar result would be achieved under an approach that integrates related cost with the underlying debt. the approach suggested in this article is broader. it applies in cases in which the integration approach, which requires that there be an actual underlying debt and that the related payment be paid to the lender, does not apply. it calls for a debt related cost to be treated as interest even in cases in which no debt has actually been incurred (e.g., in the case of "commitment fee") and suggests that amounts paid by a borrower to third parties as a prerequisite to a loan (e.g., payment for legal, accounting, or appraisal costs) be treated as interest, even though the payees are not lenders. the following discussion deals with three applications of the suggested approach: reimbursement of a lender's expenses (part ii); commitment fees (part im); and interest swaps (part iv). part iv does not deal with other interest notional contracts aimed at either reducing the borrowing cost of the parties or hedging (e.g., caps, floors, and collars). nevertheless, this discussion may be relevant, subject to some modifications, to the tax analysis of such interest notional contracts. ie. reimbursement of a lender's expense the amount of a lender's loan related expenses reimbursed by a borrower should be considered an integral part of interest charged, even if the amount charged is not determined by reference to the amount of the loan. furthermore, such reimbursement, whatever its label, should be treated as interest whether it is paid to a lender directly or to a third party. current law, however, has adopted a hybrid approach. the prevailing rule is that if the administrative cost is not represented separately from the other economic components of interest, it constitutes interest for tax purposes. in contrast, an "extra" loan-related expense is considered interest only if it is computed by 6. see, e.g., irving fisher, the theory of interest 213-14 (1930). florida tax review reference to the risk, amount and life of the loan.7 in such a case, the charge is considered payment "for the use of money."' however, if the expense incurred was for examining the credit of a prospective borrower, appraising assets or preparing loan documents, it would be considered a "service charge" rather than interest. under the service's approach, "a service charge is a fixed charge having no relationship to the amount borrowed or the time given to pay whereas interest is based on the amount deferred and the time of deferral."9 thus, amounts that are computed by reference to the risk, duration, and the amount of the loan (e.g., "points") are treated as interest."0 a service charge, even though not considered interest, might still be considered a business expense of the borrower. if the amount borrowed is used for business purposes, the service charge can be deducted ratably over the period of the loan under the general rule of section 162.11 the distinction between interest and service charge was crucial in the pre-1986 code with regard to the deductibility of a debt related expense incurred in connection with personal debt. only if the expense was considered interest was it deductible. 12 in the 1986 code, the distinction between interest and service charge, though less significant, still applies in certain circumstances. first, it applies with regard to mortgages for personal residence related expenses. only expenses characterized as interest are deductible. 3 second, even if an expense is deductible, different timing rules apply 7. see, e.g., pacific first fed. sav. & loan ass'n v. commissioner, 79 t.c. 512 (1982) (holding "loan originating fee" is interest, not compensation for services, because it bore no relation to actual cost incurred; rather, it was computed as a percentage of the amount of the loan and derived from the credit risk involved). 8. for the definition of interest, see supra note i and accompanying text. 9. rev. rul. 72-315, 1972-1 c.b. 49, 50; cf. rev. rul. 69-189, 1969-1 c.b. 55. 10. rev. rul. 69-188, 1969-1 c.b. 54, amplified by rev. rul. 69-582, 1969-2 c.b. 29. 11. see, e.g., goodwin v. commissioner, 75 t.c. 424 (1980), aff'd mem., 691 f.2d 490 (3d cir. 1982); wilkerson v. commissioner, 70 t.c. 240 (1978), rev'd on other grounds and remanded, 655 f.2d 980 (9th cir. 1981). similarly, if the funds are used for investment purposes, the "service charge" can be deducted ratably over the period of the loan under the general rule of § 212; 2 boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts 31.1.3, at 31-11 (2d ed. 1990). 12. if a debt related expense was not characterized as interest, it could not even be added to the basis of property purchased with the borrowed funds because it was not part of the cost of the property. rev. rul. 67-297, 1967-2 c.b. 87. 13. irc § 163(h)(2)(d), (h)(3). [vol 1:12 1994] the taxation of interest swaps and the financial service charge 733 to expenses characterized as interest, as opposed to a "regular" business expense. 4 the different tax rules which apply to the administrative cost component when calculated independently do not make any economic sense. nor is the special status granted to this component, in comparison to the other components of interest (e.g., inflation and default risks which are always considered an integral part of interest"), acceptable as a matter of policy. these distinctions reflect a preference for the form of the transaction over its substance, and thus contradict the tendency of the tax system to treat transactions for tax purposes in accordance with their commercial reality. in the past, this distinction might have been justified as far as usury law was concerned. usury laws determine the price of a commodity (money) which otherwise would have been determined by market forces. the interference in the normal operations of financial markets by means of usury laws led to negative economic consequences. facing a reality in which the maximum rate of interest was determined by legislation, the only tool available to the courts to reduce the economic distortion caused by such a legal restriction was to limit the scope of the usury law. one of the alternatives which was exercised by the courts was to distinguish between interest and the administrative cost of lending ("service charge"). lenders were allowed to collect a service charge in addition to the maximum interest rate imposed by law.' 6 thus, even though this distinction has no economic validity, it might be justified as a tool against the distortion caused by the legal restriction of market forces. from this perspective, every effort should be made to reduce the economic damage caused by usury laws, and that includes, so the argument goes, the legitimizing of the use of the artificial distinction between interest and service charge. whatever one thinks of the validity of this argument in the usury law context, it has no relevance with regard to taxation. the cosmetic questions of how to present an administrative cost of lending and whether it should be paid directly to a lender or to a third party, should not have any substantial effects upon the taxation of such costs. unfortunately, this is not the perspective of the current rule. 14. for example, while interest may be subject to the old regime, which requires that pre-paid interest be amortized by a constant interest method, a pre-paid business expense may be amortized on a pro-rata basis. see bittker & lokken. supra note 11. at 31-10 n.51. 15. see supra notes 3-5 and accompanying text. 16. the traditional exclusion of service charge in determining whether interest rates are usurious "probably reflects a recognition by the courts that financing sources for risky personal loans might dry up if charges for credit investigations, appraisals, and similar activities were taken into account in computing the interest rate." bittker & lokken. supra note 11, at 31-11. florida tax review i. commitment fee under the traditional approach, a charge which relates to the mere availability of a lender's funds to a borrower, without regard to their actual use (a "commitment" or "standby" fee) is not considered interest. the service's approach is that "the commitment fee is a charge for agreeing to make funds available to b [the borrower] rather than for the use or forbearance of money and, therefore, is not interest."' 7 from this perspective, a commitment fee is the price paid for the option to exercise the potential funds by actual borrowing. 8 if this option is intended for business or profit purposes and expires unexercised, the fee is then deductible as a loss, subject to the limitation section 165 of the code. if the option is exercised and a business loan is taken, the commitment fee is a "service charge"-type cost of the loan that can be deducted ratably over the term of the loan. 9 under the approach suggested in this article, there should be no difference between making funds available to a potential borrower and their actual use. assume that a businessman who travels abroad for business purposes rents a car (whose rental deductibility is taken as a given), but does not actually use it. the deductibility of the cost should not be dependent upon the ex-post actual use of the car. furthermore, assume that a taxpayer is willing to pay a yearly premium to a rental corporation for its mere willingness to rent trucks to the payor on short notice and under preferred conditions. assuming that both parties are profit-seeking and acting at arm's length, the payor would be willing to pay the premium since she ex-ante thinks that any alternative which would guarantee her availability of trucks on short notice (e.g., purchase or "spot" rental under market conditions) would cost her more. the premium of the "commitment fee" in the above examples should be treated, for tax purposes, as an integral part of the rental cost of the payor. should there be any difference between the premium in the truck rental example and a premium paid for a lender to guarantee supply of funds, 17. rev. rul. 70-540, 1970-2 c.b. 101, 102 (citing rev. rul. 56-136, 1956-1 c.b. 92). similarly, in the united kingdom "[sluch a payment compensates the lender for standing ready to make a loan, but cannot be said to be interest since it is a payment in respect of a sum not lent rather than in respect of a sum lent." e.c.d. norfolk, taxation treatment of interest 9 (2d ed. 1992). 18. rev. rul. 81-160, 1981-1 c.b. 312, 313. 19. see, e.g., francis v. commissioner, t.c. memo 1977-170 (cch) 1977. see generally lyndell e. lay, note, the deductibility of commitment fees, financing fees, and "points," 31 tax law. 888 (1978). [vol 1:12 1994] the taxation of interest swaps and the financial service charge 735 on short notice, and under agreed conditions? 0this article argues that, both practically and theoretically, there should not be any difference. economically, interest consists, in part, of compensation given to a saver-lender for postponing her current consumption in favor of an ability to consume more in the future ("time preference"),2' and compensation due to her typical preference for liquidity. the same rationale of time and liquidity preferences which explains why a premium is charged in actual lending explains why such a premium is required by lenders for making funds available to potential borrowers. thus, the potential lender charges a "commitment fee" premium because of her liquidity preference (and the liquidity risk involved in lending), and for the same reason, the potential borrower is 20. the definition of interest, see supra note i and accompanying text, does not include compensation paid for the use of borrowed property. such compensation is usually called "rent" in the case of tangible property (e.g., land) or "royalties" in the case of intangible (e.g., a patent). 21. many saver-lenders have a preference for current consumption and their willingness to defer current consumption depends upon the rate of compensation ("interest' they receive. fisher prefers to call this typical "one way" preference "impatience," rather than using the more traditional term "time preference." fisher, supra note 6 at 66. the term "pure interest" ("pure rate" or "net rate") often refers in economic literature to this component of interest. it excludes the other components which also determine the credit price: the administrative cost, the risk of default, and inflation and liquidity risks. alternatively, alfred marshall used the terms "net interest" to refer to "pure interest" and "gross interest" to refer to the credit price determined by all components of the cost of credit. alfred marshall. principles of economics §§ 4-5, at 588-91 (8th ed. 1949). 22. see, e.g., john maynard keynes, the general theory of employment interest and money ch. 15 (1960). keynes categorizes liquidity preferences as follows: (i) the transactions-motive, i.e., the need of cash for the current transaction of personal and business exchanges; (ii) the precautionary-motive, i.e., the desire for security as to the future cash equivalent of a certain proportion of total resources; and (iii) the speculative-motive, i.e., the object of securing profit from knowing better than the market what the future will bring forth. id. at 170. the liquidity preference theory explains why investors require compensation for the underlying liquidity risk. an investor is not exposed to the risk of interest rate fluctuation if she buys a bond that matures exactly when she needs the money. in any other case, she is subject to this risk and consequently charges a liquidity premium. this theory explains the traditional phenomenon in financial markets according to which long term bonds pay higher interest than short term bonds. most investors have relatively short horizons and have to be offered an inducement to hold long bonds. furthermore, due to the risk of fluctuation of interest rates, the safest strategy for an investor is to continue investing in short term bonds; thus, investors have to be offered an inducement to accept the additional risk of long term bonds. see richard a. brealey & stewart c. myers, principles of corporate finance 558 (3d ed. 1988). florida tax review willing to pay it.23 thus, from the time preference and liquidity perspectives, there should be a similar tax rule for the premium charged for actual and potential lending. the same risk is involved in both cases; the only difference is its measure, and thus this difference should only be reflected in the amounts of their respective premiums. practically speaking, there is no justification for treating a commitment fee as distinguishable from interest. the current law, which distinguishes between the cost of actual lending ("interest") and the cost related to securing a credit line, creates a distortion. it may force a potential borrower to create her own "home made" (rather than third party's) business credit line, for example, by borrowing money even though she does not need it currently and lending it, for short periods (as long as she does not need it). in this case, the margin between the interest she pays, and the typically lower rate of interest she charges would be considered an interest expense, while the commitment fee (which creates the same economic results without actual borrowing) would not. the end result of such an activity is to damage efficiency; transaction costs are increased due to the necessity of actual borrowing in order to decrease the tax burden. iv. interest swaps a. the function of the swap an interest swap involves a "notional principal contract' 24 in which, in its simple form, one party to the contract agrees to make periodic fixed interest-type payments to the counterparty. in exchange, the counterparty promises to make periodic payments that vary in accordance with an agreedupon financial market interest rate (e.g., "prime," libor).25 in practice, the 23. in this way, the payor of the commitment fee succeeds in neutralizing part of the risks related to the determination of the amount of her required credit while maintaining flexibility with regard to the actual credit she uses. 24. a "notional principal contract" is a financial instrument under which one party to the contract, in exchange for consideration from the other party, makes payment, determined by a specific agreed upon index and based upon notional principal amount, to the other party at designated intervals. examples of notional principal contracts are interest rate swaps, interest rate caps and floors, currency swaps, commodity swaps, and equity swaps. see generally lewis r. steinberg, selected issues in the taxation of swaps, structured finance and other financial products, i fla. tax rev. 263 (1993); alvin c. warren, jr., financial contract innovation and income tax policy, 107 har. l. rev. 460 (1993); note, tax treatment of notional principal contracts, 103 har. l. rev. 1951 (1990). 25. see henry t.c. hu, swaps, the modem process of financial innovation and the vulnerability of a regulatory paradigm, 138 u. pa. l. rev. 333, 347 (1989). in general, the prime rate represents interest charged by a bank for loans to creditworthy customers. id. n.39. [vol 1:12 19941 the taxation of interest swaps and the financial service charge 737 parties usually net the total payments due, and the losing party (who is not "in the money") pays the net amount to the counterparty. interest swap transactions have three major functions.26 first, they serve to reduce the user's effective cost of borrowing. whatever one thinks of the efficiency of the capital markets, in many cases, the interest rate differential between borrowers with high credit ratings and those with low credit ratings in the fixed-rate market is relatively large when compared with the interest rate differential between high-rated and low-rated borrowers in the floating-rate market.27 the swap transaction-in an arbitrage-type mechanism-reduces both parties' borrowing costs; the low-rated borrower effectively obtains lower rates in the fixed-rate market, and the high-rated borrower receives lower rates in the floating-rate market.' the second function that an interest rate swap serves is to allow parties to match between their assets and liabilities and to neutralize (or reduce) the risk of interest rate fluctuation. without a matching, a firm whose assets are fixed while its liabilities bear a floating rate of interestfor example, a savings and loans association whose mortgages are at a fixed rate but whose depositors are paid a floating rate-is subject to the risk of libor represents the london interbank offered rate which is the rate major international banks charge each other for large loans outside of the united states. id. 26. see christopher d. olander & cynthia l. spell, interest rate swaps: status under federal tax and securities laws, 45 md. l. rev. 21. 23 (1986): sec also note. tax exempt entities, notional principal contracts, and the unrelated business income tax, 105 harv. l. rev. 1265, 1267-68 (1992). 27. see olander & spell, supra note 26, at 27. 28. for example, assume that for a given loan, a high-rated firm (aaa) can borrow in the floating market at the "prime" rate, or at the fixed-rate of 10%, and that a relatively low-rated firm (bbb) can borrow either at prime+l %, or at the fixed rate of 12%. the swap allows both parties to reduce their borrowing cost by dividing between themselves the 1% difference of the extra risk premium that bbb is required to pay in the different markets (1% in the floating rate versus 2% in the fixed rate). thus. bbb borrows at prime+l%. and aaa borrows at the fixed rate of 10%. in a swap, aaa agrees to pay bbb the prime rate, and bbb agrees to pay aaa the fixed rate of 10.5%. in this example, the 1% margin is equally divided. aaa's effective borrowing cost is 9.5% (prime minus 0.5%). the 0.51% reduction is due to the difference between the 10% "original" rate paid to a lender and the 10.5% aaa charged bbb. in fact, aaa notionally sells her fixed rate loan to bbb at a gain of 0.5%, and notionally borrows from bbb at the prime rate. similarly, the borrowing cost of bbb is a fixed rate of 11.5% instead of 12%. bbb notionally assigned her 111% floating rate to aaa at the price of 10%, and "lost" 1% in this assignment. she, however, manages to borrow notionally from aaa at the fixed rate of 10.5% which, with the 1% cost of the assignment transaction, makes her effective fixed rate 11.5%. similarly, the swaps can serve as a tool for managing existing assets and liabilities. thus, for a given loan borrowed at a floating rate. the borrower can take advantage of declining fixed rates and swap its original floating liability for a fixed one. the alternative of repaying the old debt and taking a new one gives the same results, but in many cases costs much more. florida tax review fluctuation of interest rates. in order to hedge against the effects of this risk, the firm has to match floating-rate assets to its floating liabilities, and fixedrate assets to fixed-rate liabilities. the swap allows the parties to create their own hedging. the third function allows parties to use the swap in order to speculate upon the interest rate movement. while the former functions allow a firm either to reduce its actual borrowing costs or to neutralize interest rate fluctuation, speculation allows the parties to gamble upon market rates. the discussion in this article assumes, generally speaking, the existence of a "real" underlying debe9 and thus is relevant mainly to costs incurred with regard to the first two functions (reduction of borrowing costs, and hedging). b. the characterization of interest swap for tax purposes because the current code does not deal specifically with swap transactions, their treatment for federal income tax purposes must be determined under the existing rules. commentators have suggested different approaches. most of them, however, seem to agree that swap receipts do not represent interest income. one view is that swaps should be considered to generate financial service income or expense.3" a different approach suggests treating the swap as an insurance transaction ("hedging"), resulting in either insurance premium payments or receipts.3' another approach draws 29. section 163(a) allows a deduction for "interest paid or accrued within the taxable year on indebtedness." there are situations in which the meaning of "indebtedness" is disputed. for example, due to a lack of indebtedness, a guarantor's payment of interest before default is not considered payment of interest for tax purposes. see bittker & lokken, supra note 16, 1 31.1.4. 30. "of the several possible characterizations, service income offers the greatest promise." note, supra note 24, at 1958. under this characterization, the financial service income should be treated, in many cases, as ordinary income or expense. 31. see olander & spell, supra note 26, at 49. the characterization of the swap as a hedging transaction does not necessarily resolve its tax treatment, in arkansas best, the supreme court interpreted the corn products decision as "involving an application of § 122 i's inventory exception" rather than creating "a general exemption from capital-asset status for assets acquired for business purposes." arkansas best corp. v. commissioner, 485 u.s. 212, 220-21 (1988) (interpretating corn prods. ref. co. v. commissioner, 350 u.s. 46 (1955)). a relatively narrow interpretation of arkansas best was adopted recently in federal national mortgage ass'n, where the tax court held that the transactions undertaken by the federal national mortgage association to reduce its interest-rate risk with respect to the issuance of debentures and mortgage commitments were hedges. federal nat'l mortgage ass'n v. commissioner, 100 t.c. no. 36 (cch) 49,102, at 4191. the disposition of the hedges resulted in ordinary gain or loss since the association's portfolio of mortgages bore a close enough connection to the § 1221(4) statutory exception to capital-asset treatment. id. at 4196. [vol 1:12 19941 the taxation of interest swaps and the financial service charge 739 an analogy with forward contracts, and treats the swap as a capital asset,32 unless it has a hedging purpose.33 under this approach, periodic payments under the swap contract create its basis, while periodic receipts represent a return of capital to the extent of the purchase price; any excess of receipts over payments is to be considered as capital gain (or loss). 4 the "consensus" of most commentators-who, while not agreeing upon the character of the swap receipts, do agree that they do not represent interest income-was recently described as follows: interest represents compensation for the use of borrowed money. in an interest rate swap, the contracting parties never exchange any part of the notional principal amount; it serves only as a reference on which payments are based. because no party has borrowed funds from a counterparty, there can be no compensation for the use of borrowed funds-and thus no "interest" in the traditional sense of that term." indeed, it is this "traditional sense" of the term "interest," as adopted by the courts, which is the subject of this article. under the suggested approach, "interest" should be determined, normatively speaking, by its effective rate, and not by its nominal rate. the effective rate of interest is 32. for a discussion of the problem of an apparent lack of "'sale or exchange,see olander & spell, supra note 26, at 45-47. 33. id. at 49. 34. id. at 48. in proposed regulations the service adopted a programmatic approach. for example, under a straddle-type analysis, any realized loss in a swap transaction would not be recognized to the extent, if any, of an unrealized gain in an "'offsetting position.gain or loss arising at the termination of the contract would be considered capital. see prop. regs. §§ 1.446-3, -4. 35. note, supra note 26, at 1275. the american bar association task force of the interest rate agreement subcommittee has reached a similar conclusion with regard to character of payments made pursuant to caps and floors. since, on its face, a cap or floor agreement does not call for a loan of money (the principal amount specified in the agreement is merely "notional" and there is no obligation to repay the premium received). payments made pursuant to the agreement would not appear to qualify as compensation for the use or forbearance of money. a.b.a. sec. of tax'n, comm. on fin. transactions, task force of the interest rate agreement subcommittee, report on selected aspects of interest rate caps, floors. and collars, 44 tax law. 1075, 1093 (1991) [hereinafter a.b.a. task force report). similarly, the preamble to prop. regs. § 1.446-3, 56 fed. reg. 31,350 (1991). states that "[because the notional principal amount is not exchanged by the parties, the payments due under a typical interest rate swap, cap, or floor are not compensation for the use or forebearance of money and therefore are not 'interest'." see also steinberg, supra note 24, at 275. florida tax review determined by inter alia including any direct cost of credit whether incurred to reduce the overall expense of borrowing or to hedge against the risk of interest rate fluctuation.36 any other treatment (including the "service charge" approach), so the argument goes, distorts the tax system as long as the "service-swap-charge" is not treated for tax purposes exactly like interest. it allows a taxpayer to reach her specific economic end result with regard to a given credit transaction, by choosing either the "interest" way, or an alternative way which, though economically similar, has different tax implications. the concept of "effective rate" is not foreign to the u.s. tax system. indeed, a similar discussion has taken place with regard to the taxation of market and original issue discount transactions. the existence of a market discount upon a given debt reflects changes which have occurred in the financial markets since its issuance. it can happen either due to interest rate fluctuation or because of the financial weakness of the borrower, or a combination of the two. given the substantial equality between market discount and interest, one would expect to find that the same tax rules apply to each of them. yet, it has taken thirty-three years for the united states supreme court to reverse a prior judgment and to recognize the substantial equality between interest, discount and premium. 37 in old colony, the court refused to consider the "effective rate" of interest as consisting of both interest and premium charged or paid.38 the notion that the effective rate of interest consists of any payment actually paid for the use of money, whether it is called interest, premium, or discount, was considered by the court to be an "esoteric concept derived from subtle and theoretic analysis. '39 according to this view, only interest which was stipulated by both parties to the financial transaction should be recognized as such for income tax purposes. only in midland-ross did the court recognize "the economic function of discount as interest,,40 and decide that original issue discount represents ordinary-interest income rather than capital gain.4 36. this approach, therefore, calls for "capitalization" of debt-related expenses in the cost of interest. cf. irc § 263a. 37. by comparison, english tax law, to some extent, still distinguishes between discount and interest. see supra note 5. under current u.s. tax law, a discount can create a capital gain if it is a market discount, to the extent that the gain realized is greater than the "accrued market discount." see infra note 41. 38. old colony r.r. v. commissioner, 284 u.s. 552, 560-61 (1932). 39. id. at 561. 40. united states v. midland-ross corp., 381 u.s. 54, 66 (1965). 41. id. at 67. even then, the symmetry between discount and interest was restricted to oid. the anomaly which had allowed taxpayers to enjoy capital gain treatment on realization of any gain attributable to market discount prevailed until the enactment of the deficit reduction act of 1984 which added § 1276 to the code. deficit reduction act of [vol 1:12 1994] the taxation of interest swaps and the financial service charge 741 according to the approach suggested in this article, the relevant criterion in determining an "effective rate" of interest is the real cost of a given credit transaction. any direct expense of a credit price, even if determined or paid "independently," should represent interest cost for tax purposes. the commercial reality which, for example, looks at the end result of a "two step" transaction, should prevail over the form of a given credit transaction.42 whenever a swap transaction's function is to reduce the parties' cost of borrowing, or to serve as a hedging, its cost should represent interest. failure to recognize this leads to different tax treatment regarding swap transactions and other traditional, economically similar, but in most cases less efficient transactions.43 to put it differently, financial reality and the development of financial tools which triggered the court in midland-ross to extend the scope of the "legal" interest beyond the simplistic approach of old colony, justify reform in the treatment of interest swaps. however, at this stage, it seems that this reform should be made by legislation. in this connection, many commentators favor the integration approach-under which a swap agreement would be combined with any related debt instrument and the two instruments would be treated as one integrated instrument for all tax purposes.' this approach, when applicable, is consistent with economic reality, but its scope seems to be too limited. it applies smoothly, for example, to cases in which the interest rate agreement actually 1984, pub. l. no. 98-369, § 41(a), 1984 u.s.c.c.a.n. (98 stat.) 543 (codified at 26 u.s.c. § 1276). this section provides that the imputed interest component of the gain derived from disposition of a debt instrument bought at market discount produces ordinary income. irc § 1276(a). thus, if a buyer sells it before its maturity date, she realizes ordinary interest gain which is determined on a pro-rata (linear) daily basis. irc § 1276(b)(1). the taxpayer has the option to choose to calculate the interest under the more accurate oid rules which determine the imputed interest component according to its yield to maturity. irc § 1276(b)(2). 42. the tax rules regarding credit-sale transactions, which have generally adopted the "two transactions approach," distinguish between the sale and credit transactions. this is the premise of §§ 483 and 1274, which deal with imputed interest on deferred payment sales. by the same token, § 7872 presupposes that a "subsidized" loan between related parties contains another "disguised" commercial transaction, the tax effects of which should be determined according to its substance. 43. see note, supra note 24. while the note accepts the function of a swap as an adjustor for the effective interest rate the parties bear on their respective underlying debts, it argues that "the swap itself is a risk-bearing agreement whose payments are therefore not properly categorized as interest." id. at 1960. a "regular" debt instrument is arguably a riskbearing agreement as well. see supra notes 2-5. 21-23 and accompanying text (discussing the risks associated with any loan). 44. see, e.g., note, supra note 24, at 1959; new york state bar ass'n tax sec. comm. on fin. instruments, report on proposed regulations on methods of accounting for notional principal contracts, 54 tax notes 1127, 1151 (mar. 2, 1992) [hereinafter new york state bar report]. florida tax review hedges a single asset or liability. it does not easily address cases in which the swap agreement hedges a pool of assets or liabilities. the scope of the approach suggested in this article is broader, and can encompass both hedges of single assets and of a pool of assets.45 furthermore, the characterization of interest suggested here allows for much more simplicity in the tax system with regard to interest swap transactions in comparison with prevailing or other suggested rules.46 v. concluding remarks the definition of interest for tax purposes as "compensation for the use or forbearance of money" and its narrow interpretation by the courts,47 have triggered, in certain cases, the recognition of an alternative to interest-"financial service charge"-which is taxed differently than interest. despite the narrow interpretation, in some cases courts have been willing to expand the definition of "interest." the mere fact that there was no actual use of borrowed funds did not prevent the tax court from treating payments on overdue taxes and judgments as interest.48 the underlying rationale in these cases is probably that payment related to a debt--even though not derived from actual use of money-should be considered interest. in effect, the economic reality prevailed. furthermore, the extension of the term "debt" for tax purposes to include involuntary debts, was followed by an extension by the court of the term "interest" to include the "effective rate of interest" whenever the credit price is calculated, either in whole or in part, as discount or premium. this article-based upon the same "effective rate" rationale-argues for further extension of the term interest for tax purposes. similar treatment should apply for reimbursement of a lender's actual administrative cost, whatever the label of the payment, and whoever the payee. the duality between this component of interest and the "financial service charge" should be rejected. similarly, a "commitment fee" should not be viewed as a service45. neither approach addresses speculative investments. 46. see, e.g., new york state bar report, supra note 44 (discussing amortization of nonperiodic payments, assignment of notional principal contracts, and the character of termination payments); a.b.a. task force report, supra note 35 (discussing interest rate agreements). similarly, an interest characterization of income received in swap transactions, with regard to hedging and reducing the credit price functions of swap, may resolve the taxation of swap transactions made by nonprofit organizations. under current rules, income derived from swaps should be considered "unrelated" business income. see generally note, supra note 26. 47. see supra note 1 and accompanying text. 48. see, e.g., koppers co. v. commissioner, 11 t.c. 894 (1948); appeal of bettendorf, 3 b.t.a. 378 (1926). [vol. 1:12 19941 the taxation of interest swaps and the financial sen'ice charge 743 type charge; rather, it should be considered an integral part of the cost of borrowing. by the same token, whenever a swap transaction's function is to reduce the parties' cost of borrowing, or to serve as a hedging tool, its cost should be considered interest. alternate treatment, as in the prevailing rules in all those cases, leads to an unacceptable situation in which the taxpayer may choose which tax result she desires for her debt related costs. florida tax review volume 20 2016 number 1 article can audits encourage tax evasion?: an experimental assessment emily satterthwaite untitled-4 1 1/31/17 1:11 pm florida tax review volume 20 2016 number 1 information for subscribers the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. for volume 20, the subscription rate is $125.00 in the united states and $145.00 elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. for volume 20, subscriptions and changes of address should be sent to florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. beginning with volume 21, the florida tax review will be published by the university of florida press on behalf of the graduate tax program of the university of florida levin college of law. for subscription information and queries relating to volume 21 and subsequent volumes, please contact the johns hopkins university press, p.o. box 19966, baltimore, md 21211; phone 1-800-548-1784; jrnlcirc@press.jhu.edu. all correspondence of a business nature, including advertising, should be addressed to the university of florida press, 15 nw 15th st., gainesville, fl 32603; phone 352-392-1351; http://upress.ufl.edu. untitled-4 2 1/31/17 1:11 pm florida tax review volume 20 2016 number 1 editor-in-chief charlene luke professor of law university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar dennis a. calfee professor of law patricia e. dilley professor emeritus michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law martin j. mcmahon, jr. james j. freeland eminent scholar adam smith visiting assistant professor lee-ford tritt professor of law samuel c. ullman adjunct professor of law steven j. willis professor of law board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university– bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate student editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell katheleen duggan pfahlert untitled-4 3 1/31/17 1:11 pm florida tax review volume 20 2016 number 1 information for subscribers the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. for volume 20, the subscription rate is $125.00 in the united states and $145.00 elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. for volume 20, subscriptions and changes of address should be sent to florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. beginning with volume 21, the florida tax review will be published by the university of florida press on behalf of the graduate tax program of the university of florida levin college of law. for subscription information and queries relating to volume 21 and subsequent volumes, please contact the johns hopkins university press, p.o. box 19966, baltimore, md 21211; phone 1-800-548-1784; jrnlcirc@press.jhu.edu. all correspondence of a business nature, including advertising, should be addressed to the university of florida press, 15 nw 15th st., gainesville, fl 32603; phone 352-392-1351; http://upress.ufl.edu. untitled-4 2 florida tax review volume 20 2016 number 1 editor-in-chief charlene luke professor of law university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar dennis a. calfee professor of law patricia e. dilley professor emeritus michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law martin j. mcmahon, jr. james j. freeland eminent scholar adam smith visiting assistant professor lee-ford tritt professor of law samuel c. ullman adjunct professor of law steven j. willis professor of law board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university– bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate student editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell katheleen duggan pfahlert florida tax review volume 20 2016 number 1 information for contributors the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law. the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the florida tax review prefers electronic submissions sent via expresso (law.bepress.com/expresso); articles may also be e-mailed to ftr@law.ufl.edu as a microsoft word document. if a hard copy submission is necessary, please mail your article to editor-in-chief, florida tax review, university of florida levin college of law, 309 village drive, gainesville, fl 32611. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. all citations should follow the bluebook uniform system of citation (20th ed.); some modifications will, however, be made by our editors to conform to the florida tax review style manual (available to contributors on request). all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the articles in the florida tax review. florida tax review volume 20 2016 number 1 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations promulgated under the internal revenue code of 1986, as amended, unless otherwise indicated. 1/31/17 1:11 pm florida tax review volume 20 2016 number 1 information for contributors the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law. the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the florida tax review prefers electronic submissions sent via expresso (law.bepress.com/expresso); articles may also be e-mailed to ftr@law.ufl.edu as a microsoft word document. if a hard copy submission is necessary, please mail your article to editor-in-chief, florida tax review, university of florida levin college of law, 309 village drive, gainesville, fl 32611. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. all citations should follow the bluebook uniform system of citation (20th ed.); some modifications will, however, be made by our editors to conform to the florida tax review style manual (available to contributors on request). all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the articles in the florida tax review. untitled-4 4 florida tax review volume 20 2016 number 1 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations promulgated under the internal revenue code of 1986, as amended, unless otherwise indicated. untitled-4 6 florida tax review volume 20 2016 number 1 can audits encourage tax evasion?: an experimental assessment by emily satterthwaite* abstract governments and tax administrators around the world rely on the premise that audits will deter tax evasion. this article presents experimental evidence that this premise may be, at least in part, misguided. counterintuitively, i find that audits presented as random may induce taxpayers to cheat more. where audits were described as being conducted at random, participants increased their levels of evasion in the tax periods immediately following the audit. this effect, however, did not plague nonrandom audits. when a separate group of participants faced audits that were presented as being nonrandom—participants were told that detected evasion would “flag” a participant for one or more future audits— participants cheated less in the periods immediately following the audit. overall, average compliance in the nonrandom audit condition systematically and significantly dominated average compliance in the random audit condition. by revealing, under experimental conditions, strong behavioral responses to the way tax audits are presented, this article highlights the potential enforcement benefits of being more transparent with taxpayers about the nature of audit selection. * assistant professor, university of toronto faculty of law. for helpful comments, thank you to benjamin alarie, james alm, lisa austin, joseph bankman, wei cui, yasmin dawood, angela fernandez, brian galle, andrew hayashi, erich kirchler, jack manhire, susan morse, shuyi oei, jason oh, leigh osofsky, mariana mota prado, diane ring, ted seto, daniel shaviro, stephen shay, michael trebilcock, albert yoon, and workshop participants at the 2015 law & society association annual meeting, the 2015 junior tax scholars’ workshop, the 2015 canadian law & economics association meetings, the national tax association 108th annual conference, and the tulane tax roundtable. special thanks to leandra lederman for feedback and questions. the author is grateful for generous support from the university of toronto’s 2015–16 connaught new researcher award. dennis (zhenyu) luo provided outstanding research assistance. all errors and omissions are mine. 1/31/17 1:11 pm florida tax review volume 4 1999 number 5 book review perspectives on social security reform framing the social security debate: values, politics, and economics (r. douglas arnold, michael j. graetz & alicia h. munnell eds., 1998) prospects for social security reform (olivia s. mitchell, robert j. myers & howard young eds., 1999). reviewed by karen c. burke* and grayson m.p. mccouch.*" these two volumes offer an interdisciplinary perspective on major issues which lie at the heart of the current debate over social security reform. each volume contains a series of papers from a broad range of contributors, including economists, actuaries, investment managers, political scientists, and policymakers. in analyzing various specific proposals and conceptual models for reform, the contributors identify some areas of emerging consensus as well as numerous conflicts, tensions, and tradeoffs which ultimately must be resolved through the political process. the result is a valuable survey of proposals and trends which will determine the direction of future reform. options for refonln projected long-term shortfalls in social security financing have prompted all sorts of proposals for modifying or restructuring the existing system. many of these proposals involve two basic reforms which hold special interest for economists: (1) moving away from a pay-asyou-go system in the direction of advance funding; and (2) adopting a more diversified investment strategy for funds accumulated in the social security system. economists generally agree that advance funding and investment diversification might bring substantial benefits but would also pose significant risks and costs. thus, they emphasize that the focus of debate should be on identifying and comparing the tradeoffs required by various approaches rather than on whether there is a "free lunch."' * professor of law, university of minnesota law school. ** professor of law, university of miami school of law. 1. see john geanakoplos, olivia mitchell & stephen p. zeldes, would a privatized social security system really pay a higher rate of return?, in framing the social security debate: values, politics, and economics 137, 150 (r. douglas arnold, michael j. graetz & alicia h. munnell eds., 1998) [hereinafter framing the social security debate]. florida tax review some proposals would go further and introduce a system of private accounts owned and controlled by individual participants. in effect, these proposals would privatize social security by shifting from a defined-benefit system in the direction of a defined-contribution system. although the concepts of advance funding, diversification, and privatization are often linked together, they are analytically distinct: in theory, it is possible to introduce any one of them independently of the others.2 all three issues are central to the social security debate, but the implications of privatization remain far more controversial than those of advance funding or investment diversification. thus, in analyzing and comparing different reform proposals, economists treat the three concepts separately. in particular, they point out that advance funding and investment diversification could be implemented either under a collective defined-benefit system or under a privatized definedcontribution system. advance funding and transition costs. in the abstract, advance funding is attractive because it would potentially increase national savings and economic growth (to the extent that increased social security fund accumulations would not be offset by dissaving in other sectors of the economy). the resulting higher return on the accumulated funds might ultimately make it easier to provide a given level of benefits without increasing payroll taxes. under the existing pay-as-you-go system, almost all of the revenue collected each year in payroll taxes is used to pay current benefits. (the social security trust funds are presently accumulating modest annual surpluses, but these accumulations are expected to be exhausted by 2032.) in effect, the burden of financing benefits for each generation of retirees falls on succeeding generations of workers. by contrast, under a system with full advance funding, payroll taxes would be set aside and used, with accumulated earnings, to pay benefits for current workers in retirement. in effect, advance funding would place on each generation of workers the burden of financing their own retirement. economists point out, however, that the transition to advance funding would not be costless. even if it were possible to replace the existing system prospectively with full advance funding, it would still be necessary to pay future benefits that have been promised to current retirees and workers under the existing system based on their previously credited earnings. by one estimate, this "unfunded liability" already stands at around $9 trillion.3 given the magnitude of this transition cost, any proposal to implement advance 2. see id. at 138-41. 3. see stephen c. goss, measuring solvency in the social security system, in prospects for social security reform 16, 34 (olivia s. mitchell, robert j. myers & howard young eds., 1999) [hereinafter prospects for social security reform). [vol 4:5 perspectives on social security reform funding should specify how the cost is to be financed (e.g., from additional government debt, increased taxes, or revenue diverted from other uses). obviously, the choice of financing method would determine how the transition costs would be spread among current and future generations. furthermore, it might be imperative as a political matter to impose costs as gradually and imperceptibly as possible, especially in the absence of immediate and obvious benefits.' proponents of privatization sometimes argue that the projected surpluses in the unified budget should be used to finance a "painless" transition to an advance-funded system of private accounts. the projected surpluses, attributable primarily to the temporary accumulation of social security funds, may seem to offer a ready source of funds to defray transition costs. however, diverting the projected surpluses to fund private accounts would merely exacerbate the unfunded liability of the existing system. this approach, described by one commentator as "stealth privatization," appears to be a political tactic designed to jump-start the process of privatization and preempt full consideration of the direction of future reform.5 the current budgetary skirmishing highlights the need to devise a mechanism to ensure that accumulated social security funds cannot be raided to finance other government expenditures. investment returns. the prospect of accumulating substantial funds through partial or full advance funding raises the issue of how those funds should be invested to achieve optimal returns. many of the current reform proposals would abandon the practice of investing funds exclusively in government bonds and permit investment in a more diversified portfolio of stocks and bonds. there seems to be little reason, on purely economic grounds, to deny access to higher returns from private capital markets; indeed, modem financial theory treats diversification as an important aspect of prudent investment. at the same time, it is important to understand the risks and limitations associated with a more flexible investment strategy. proponents of privatization often complain that the existing system produces unreasonably low returns, and argue that all current and future workers would be better off under a privatized system that allowed individual workers to invest funds directly in private capital markets. careful economic analysis reveals two major flaws in this standard "moneys-worth" claim. first, the claim ignores the massive transition costs associated with the shift to advance funding. if those costs were taken into account (e.g., by converting 4. see rl douglas arnold, the political feasibility of social security reform, in framing the social security debate, supra note 1, at 389, 397-408. 5. see id. at 414. 19991 florida tax review the existing unfunded liability into explicit debt financed with new taxes along a similar time path), the return on private accounts invested in government bonds would be no higher than the low projected return on current contributions under the existing system. second, the money's-worth claim fails to make a proper adjustment for risk. investors who already hold properly diversified portfolios will not necessarily choose to invest their marginal dollars entirely in stocks rather than in government bonds, even though the stocks have higher expected returns. indeed, these investors may rationally choose to offset any change in social security investments by making a countervailing change in the rest of their portfolios. the real beneficiaries of diversifying social security investments would be "constrained" investors who would otherwise lack access to private capital markets. after taking account of transition costs and risk, the improvement in investment returns would be neither as dramatic nor as widespread as they might appear at first glance.6 of course, higher investment returns could be also be achieved in a centralized system without private accounts. here again, the correlation between risk and return is relevant in determining how the accumulated funds should be invested. moving social security funds from government bonds into private capital markets would imply a corresponding shift of other funds in the opposite direction, leaving a larger portion of non-social security funds invested in government bonds. such an "asset swap" might well result in higher investment returns for the social security funds, which would offer the political advantages of improving the financial condition of social security and reducing the need for payroll tax increases (or benefit cuts). at the same time, higher returns would be accompanied by increased risk and would presumably trigger countervailing adjustments in the rates of risk and return for non-social security funds. control of investments. the prospect of investing accumulated funds in private capital markets also raises the issue of control over investment strategy. if the funds are held by the government in a centralized system, there are grounds for concern that government control might lead to "social investing" or to unwarranted interference in corporate decision-making.7 one response to these concerns would be to introduce institutional safeguards to insulate investment strategy from political pressure. the leading example of this approach is the federal thrift savings plan (tsp), which has adopted a combination of safeguards: the investment function is delegated to an inde6. see geanakoplos et al., supra note 1, at 148-57. 7. see theodore j. angelis, investing public money in private markets: what are the right questions?, in framing the social security debate, supra note 1, at 287, 290-93, 304-10. [vol 4:5 perspectives on social security reform pendent board, funds are invested exclusively in broad index funds, and stock voting rights are exercised by an independent investment manager.' it is not clear whether this approach would prove as effective for the social security system as it has for the tsp; the sheer size of the funds involved in an advance-funded social security system might pose special risks of government interference. furthermore, even the most effective safeguards would remain subject to the political risk of revision or repeal by subsequent legislation. proponents of privatization often argue that putting funds directly into private accounts under the control of individual workers would be a more effective approach to prevent unwarranted government interference in private capital markets. a decentralized system of private accounts, however, would give rise to a fresh range of problems: high administrative costs; excessively risky investment decisions; fraud; and breaches of fiduciary obligations. to protect individual workers and preserve the integrity of the system, the government would almost certainly be called on to regulate financial service providers and perhaps to restrict individual investment choices as well.9 furthermore, it would be necessary to specify whether the responsibility for establishing and maintaining private accounts should fall on individual workers or on their employers in the first instance. a worker-based system (along the lines of individual retirement accounts) would raise special concerns about administrative costs, funding errors, and imprudent investment choices, while an employer-based system (along the lines of 401(k) plans) would rely heavily on employers who in many cases might be ill-equipped to meet their new obligations.'0 these increased regulatory and administrative burdens should be taken into account in evaluating any proposal to move toward a decentralized system of private accounts. retirement security. the debate over privatizing social security reflects a fundamental tension between competing goals of "social adequacy" and "individual equity." in general, reformers who place a high value on social adequacy support retaining the existing collective defined-benefit system with various modifications, while those who emphasize individual equity recommend moving toward a defined-contribution system with private accounts. even staunch proponents of privatization, however, usually acknowledge the need to maintain some minimally adequate level of retirement benefits. 8. see id. at 293-303; francis x. cavanaugh, discussant, in framing the social security debate, supra note i, at 319, 319-23. 9. see howell e. jackson, discussant, in framing the social security debate, supra note 1, at 329, 335-45. 10. see janice m. gregory, possible employer responses to social security reform, in prospects for social security reform, supra note 3, at 313, 321-23. 19991 florida tax review a defined-contribution system with private accounts automatically serves the goal of individual equity by linking the level of retirement benefits directly to the accumulated value of the participant's prior contributions. a major concern under such a system is that retirement benefits may prove inadequate due to premature account withdrawals, market fluctuations, or low lifetime earnings. to guard against these risks, the system might include one or more of the following: (1) restrictions on the time and form of account withdrawals; (2) guarantees to ensure a minimum account balance or investment return; and (3) government matching contributions for low earners. a separate issue is whether such measures, even if adopted, would prove politically sustainable over time. in the absence of any restrictions on account withdrawals, there is an obvious risk that participants might spend down their entire account balances promptly upon retirement, leaving inadequate resources for later years. (indeed, the experience with private pension funds suggests that there might be substantial political pressure to allow withdrawals in certain cases even before retirement.) to prevent premature exhaustion of private accounts, participants might be required to use all or part of their account balances at retirement to purchase annuities. full mandatory annuitization would provide valuable protection for long-lived participants (albeit at the expense of shortlived participants), and would mitigate the effects of adverse selection on annuity prices. even partial annuitization would provide some of the same protection while allowing individual participants to spend down part of their account balances. just as some form of mandatory savings is considered necessary to ensure an adequate level of resources at retirement, some level of mandatory annuitization may be desirable to ensure an adequate level of income throughout the retirement period. restrictions on the time and form of account withdrawals also have important consequences for surviving spouses. elderly widows run a disproportionately high risk of poverty, despite the mandatory survivor benefits provided by the existing social security system." under a system of private accounts, special safeguards would be necessary to prevent an even higher poverty rate among elderly widows. assuming some level of mandatory annuitization, one approach would be to require that benefits be paid out in the form of joint-and-survivor annuities, by analogy to the existing treatment of private pension plans.'2 in the absence of mandatory survivor benefits, it would be necessary to consider whether some form of "earnings sharing" should be required for private accounts. a pure earnings11. see karen c. holden, women as widows under a reformed social security system, in prospects for social security reform, supra note 3, at 356, 358-61. 12. see id. at 361-67. [vol 4:5 perspectives on social security reform sharing approach would allocate to each spouse an equal one-half share of the couple's combined earnings during marriage, resulting in a corresponding allocation of balances in their private accounts. in comparison to the existing system of spousal benefits, a system of private accounts with earnings sharing might be viewed as considerably more equitable for many kinds of families. it remains unclear, however, whether earnings sharing would prove any more politically feasible under a privatized system than under the existing system. another concern raised by private accounts relates to the issue of market risk. to the extent that individual participants had a wide range of investment choices, many of them would likely end up with inadequate balances in their private accounts at retirement, due to poor investment decisions or simple bad luck. it seems likely, therefore, that the government would be called on to guarantee some minimum account balance or rate of return on investments.' 3 to control the cost of such guarantees and address the related problem of moral hazard, the government would presumably insist on restricting the range of investment choices open to individual participants. for example, participants might be allowed to allocate the funds in their private accounts among a limited number of index funds classified according to type and level of investment risk. even under a closely regulated system of private accounts, the volatility of private capital markets would probably intensify problems of equity among different groups of participants. those who happened to retire at a moment when the market had soared to unprecedented heights (or dived to unexpected depths) would find themselves locked into abnormally high (or low) levels of retirement income during retirement. 14 finally, a system of private accounts raises the issue of providing adequate retirement benefits for participants with low lifetime earnings. the existing social security system includes a significant redistributive component, due to a progressive benefit formula which produces disproportionately high benefit levels for low earners. even in a system of private accounts, it is possible to preserve some degree of progressivity. to the extent that only a portion of the existing system is privatized, the remaining defined-benefit portion could continue to provide higher benefits for low earners. alternatively, a two-tier system could provide a flat minimum benefit for all participants as well as a supplementary tier of private accounts. if private accounts represent most or all of the overall system, it might be necessary to provide some sort of matching contributions for low earners. it is also 13. see stephen g. kellison & marilyn moon, new opportunities for the social security system, in prospects for social security reform, supra note 3, at 60, 72-74. 14. see lawrence h. thompson, individual uncertainty in retirement income planning under different public pension regimes, in framing the social security debate, supra note 1, at 113, 121-29. 1999] florida tax review important to consider the allocation of administrative costs among private accounts. since charges based on a flat amount per account would disproportionately erode the value of small accounts, it might be fairer to allocate charges based on accumulated account balances. private pension plans. any fundamental reform of the existing social security system will inevitably affect the structure of private employersponsored pension plans. employer-sponsored plans have expanded in a context of targeted federal tax incentives and complex nondiscrimination rules designed to ensure access for nonhighly compensated employees. since plan benefit formulas typically take social security benefits into account, any changes in the level of social security benefits or in the payroll tax base will have an immediate impact on the administration and design of "integrated" employer-sponsored plans. in the long run, employer-sponsored plans will respond to altered employee expectations, business needs, and regulatory requirements. 5 introducing mandatory private accounts into the social security system might induce workers to reduce other savings. for example, nonhighly compensated employees might choose to reduce voluntary contributions to employer-sponsored 401(k) plans, thereby threatening the ability of some employer-sponsored plans to comply with the nondiscrimination rules. furthermore, allowing individual workers to make additional, voluntary contributions to their private social security accounts might make employersponsored plans less attractive for highly-compensated employees. some observers fear that proposed social security reforms could accelerate a trend toward a "two-tier" system in which employers would offer unfunded, nonqualified plans for highly-compensated employees and funded plans that would be "adequate for the lower-paid and inadequate for employees in the middle."' 16 from the broader perspective of retirement income policy, social security and employer-sponsored pension plans, along with private savings, have long been viewed as essential complementary components of a "threelegged stool." taken together, social security and employer-sponsored plans in their existing forms combine defined-benefit and defined-contribution approaches in a "mixed" system of retirement savings. within the context of employer-sponsored plans, voluntary defined-contribution arrangements such as 401(k) plans have substantially encroached on more traditional definedbenefit arrangements, with the result that individual workers bear an 15. see gregory, supra note 10, at 318-30. 16. see christopher bone, an actuarial perspective on how social security reform could influence employer-sponsored pensions, in prospects for social security reform, supra note 3, at 333, 346. [vol 4:5 perspectives on social security reform increasing share of investment risks compared to employers. introducing a system of private social security accounts would shift the balance in the combined public and private systems even more decisively toward a definedcontribution approach. such a shift might raise questions both about the desirability of creating a new type of savings vehicle (in addition to existing 401(k) plans and iras) and about the long-term stability of employersponsored plans. political risk. all retirement programs are subject to political risks in the sense that their original design, operation, and purposes may prove unstable or become unsustainable over time due to evolving political conditions. for example, if the social security system is bifurcated into a defined-contribution component and a defined-benefit component, the main political risk is that the goal of social adequacy will ultimately be undermined. initially, the proposed reform might retain some version of the existing defined-benefit system with a progressive benefit formula, coupled with a supplementary tier of private accounts. such a bifurcated system would concentrate the redistributive function in the defined-benefit component, which would be more isolated and vulnerable than under the existing system. indeed, the reformed system itself might generate a new political dynamic in which middleand high-income participants sought to expand the definedcontribution component at the expense of the defined-benefit component. although long-term predictions are hazardous, there is little reason to expect that introducing private accounts would ultimately strengthen the collective retirement security system or mitigate existing disparities of income among retired workers. 17 by contrast, the main political risk for the existing system is that the public will be unwilling to accept the tax increases (or benefit reductions) necessary to restore actuarial balance. with this risk in mind, many commentators assert that promised benefits cannot be paid without raising payroll taxes to politically unacceptable levels and conclude that social security in its existing form is unsustainable.' despite repeated predictions that the existing system will inevitably lose political support, the situation appears to be far more complex. careful analysis of polling data confims low public confidence in the existing system but also indicates strong and 17. see hugh heclo, a political science perspective on social security reform. in framing the social security debate, supra note 1, at 65, 83-89. 18. see gordon p. goodfellow & sylvester j. schieber, simulating benefit levels under alternative social security reforms, in prospects for social security reform, supra note 3, at 152, 180-81. 19991 florida tax review sustained public support for social security. 9 moreover, in analyzing attitudes toward reform proposals, there appear to be significant differences along income and gender lines but, somewhat surprisingly, age does not appear to be an especially salient factor.2" value judgments as well as economic factors may play an important role in shaping public opinion about the existing system and proposals for its reform. polling data also give grounds for concern about the level of public understanding of basic issues in the social security debate. many people express general support for social security yet oppose raising taxes (or cutting benefits) because they do not believe such measures are needed to preserve the existing system. furthermore, people who appear worried about their own retirement security nevertheless tend to underestimate the need for increased individual saving. these gaps and inconsistencies suggest that political leaders, policy analysts, and the news media all have important roles to play in framing the debate and shaping public opinion. developing a political consensus will not be easy. nevertheless, delay will only increase the cost of implementing reform. at present, the changes needed to restore actuarial balance to the existing system are still relatively modest, but the required tax increases (or benefit cuts) will rise steeply with the passage of time. proponents of privatization also cannot afford delay, since the costs of maintaining promised benefits under the existing system while setting aside additional funds for a new system of private accounts will eventually become prohibitive. even in the absence of an immediate liquidity "crisis," there is general agreement that social security reform should be undertaken sooner rather than later. conclusion. these volumes provide insightful and balanced analysis of a broad range of issues in the social security debate. despite the diverse approaches taken by the contributors, there appears to be remarkable agreement about the economic tradeoffs inherent in various reform proposals. indeed, according to one of the editors, "the economics, while interesting, complicated, and often misreported, is not controversial."'" at the same time, the various reform proposals elicit differing assessments which inevitably reflect highly controversial judgments about values and politics. this is hardly surprising, for values and politics lie at the heart of the social 19. see lawrence r. jacobs & robert y. shapiro, myths and misunderstandings about public opinion toward social security, in framing the social security debate, supra note 1, at 355, 364-76. 20. see john rother & william e. wright, americans' views of social security and social security reforms, in prospects for social security reform, supra note 3, at 380, 392-93. 21. alicia h. munnell, introduction, in framing the social security debate, supra note 1, at 1, 28. [vol 4:5 19991 perspectives on social security reform 427 security debate. it would be unrealistic to expect unanimous agreement on the criteria for evaluating competing reform proposals, much less on their substantive merits. for all of the differences in their premises and viewpoints, the contributors bring a welcome note of clarity and candor to the debate. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe volume 18 2015 number 3 florida tax review article the historical origins of the debt-equity distinctions camden hutchison florida tax review volume 18 2015 number 3 i article the historical origins of the debt-equity distinction camden hutchison 95 florida tax review volume 18 2015 number 3 ii the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117634, gainesville, florida 32611-7627. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352)273-0904 or email ftr@law.ufl.edu. copyright © 2015 by the university of florida florida tax review volume 18 2015 number 3 iii editor-in-chief martin j. mcmahon, jr. james j. freeland eminent scholar in taxation university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar in taxation dennis a. calfee professor of law michael k. friel professor of law david m. hudson professor of law emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar in taxation charlene luke professor of law grayson mccouch professor of law adam smith visiting assistant professor samuel c. ullman adjunct professor of law board of advisors hugh j. ault boston college bradley t. borden brooklyn law school j. martin burke university of montana charlotte crane northwestern university jasper l. cummings, jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina kerry a. ryan st. louis university graduate editors alisa french paul hankin john hodnette laura michael hughes m. blair james young hei jo michael schwartz mark westenberger executive assistant keyosha r. monroe florida tax review volume 18 2015 number 3 iv information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: “articles,” “commentaries,” and “book reviews.” the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manual. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 18 2015 number 3 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 1 1993 number 10 horizontal and vertical equity: the musgrave/kaplow exchange paul r. mcdaniel" and james r. repetf'" over the past several years, professors richard musgrave and louis kaplow have engaged in an exchange over the question whether the concept of horizontal equity has any independent significance apart from vertical equity.' kaplow answers that question in the negative, musgrave in the affirmative. the purposes of this comment are (1) to sort out the issues raised in the musgrave-kaplow exchange, and (2) to set forth a somewhat different perspective from which to view those issues. i. conceptual issues a. the definitions kaplow and musgrave define horizontal equity (he) as the requirement that equals be treated alike. both define vertical equity (ve) as requiring an "appropriate" pattern of differentiation among unequals.2 b. synopsis of the argunents the starting point was a statement by musgrave in 1959 that the requirements of horizontal and vertical equity are but different sides of the same coin. musgrave asked rhetorically "[i]f there is no specified reason for discriminating among unequals, how can there be a reason for avoiding * professor of law, new york university school of law. ** associate professor of law, boston college law school. the authors thank emily powers, a second year law student at boston college law school, for helpful research assistance. 1. louis kaplow, horizontal equity: measures in search of a principle. 42 nat'l tax j. 139 (1989) [hereinafter kaplow i]; richard a. musgrave, horizontal equity, once more, 43 nat'l tax j. 113 (1990) [hereinafter musgrave i]; louis kaplow, a note on horizontal equity, i fla. tax rev. 191 (1992) [hereinafter kaplow ii]; richard a. musgrave, horizontal equity: a further note, 1 fla. tax rev. 354 (1993) [hereinafter musgrave il. 2. kaplow i, supra note 1, at 140-41; musgrave i. supra note 1, at 113. florida tax review discrimination among equals."3 his rhetorical question can be rephrased as a statement: if we cannot explain why we discriminate among unequals, then we cannot explain why we fail to discriminate among equals. thus, in 1959, musgrave viewed he and ve as inextricably linked. he explained: without a scheme of vertical equity, the requirement of horizontal equity at best becomes a safeguard against capricious discrimination-a safeguard which might be provided equally well by a requirement that taxes be distributed at random. to mean more than this, the principle of horizontal equity must be seen against the backdrop of an explicit view of vertical equity (emphasis added).' musgrave also felt in 1959 that he and ve, by themselves, were inadequate for formulating tax policy because they are dependent upon the determination of some measure for distinguishing equals and unequals. he stated: "an objective index of equality or inequality is needed to translate either principle into a specific tax system."5 subsequently, in 1989, kaplow examined the current use of he in tax policy analysis.6 he concluded, like musgrave in 1959, that he is not a useful tool because it has no normative content and has no significance apart from ve.7 compliance with ve will always assure compliance with he, kaplow stated, "because whatever reasons motivate a particular treatment of one individual will require the same treatment of another individual who is equal in all relevant respects."8 in response to kaplow's critique of he, musgrave reexamined his own 1959 critique of he.9 he surveyed various formulations of distributive justice and concluded that he has a normative basis of its own that is more firmly planted than ve. 0 he stated: the requirement of he remains essentially unchanged under the various formulations of distributive justice, ranging from lockean entitlement over utilitarianism and fairness solutions. that of ve, on the contrary, undergoes drastic change 3. richard a. musgrave, the theory of public finance 160 (1959). 4. id. 5. id. at 161. 6. kaplow i, supra note 1, at 139-40. 7. id. 8. id. at 143. 9. musgrave i, supra note 1. 10. id. at 117. [vol 1:10 horizontal and vertical equity under the various approaches. while he is met by the various ve outcomes, this does not mean that he is derived from ve. if anything, it suggests that he is a stronger primary rule." as discussed below, musgrave argued that it is necessary to compare proposed tax changes that differ in their ve and he outcomes. where ve results are similar, then the change that produces better he results is to be preferred.' 2 but kaplow then responded: "musgrave does not attempt to offer an example involving he violation that any relevant distributive theory would count as decisive against an otherwise desirable policy.' 3 as an example of the insignificance of he, kaplow stated: [a]ssume that the only administratively feasible way to redistribute wealth from the rich to the poor involves omitting some of the rich from the tax base or excluding some of the poor from receiving transfers (perhaps because some individuals live in remote areas). clearly, neither a maximum welfare perspective nor a rawlsian approach (derived from a veil construct) would oppose such redistribution because it violated he. (they would indicate that the distributive objective is satisfied incompletely.) 4 in a subsequent response, musgrave agreed with kaplow that in an ideal world, arrangements which satisfy ve also satisfy he.'" moreover, in the real world, musgrave stated that it is unreasonable "to limit considerations of departure from he to individuals with identical incomes only, while disregarding the relative treatment of individuals with more or less similar incomes. ' ' 6 musgrave argued, however, that this did not mean that he is a useless concept since he and ve concerns must be traded off in assessing proposed tax changes in the less than ideal world in which those changes must be considered.' 7 11. id. at 116-17. 12. musgrave ii, supra note i, at 356-58. 13. kaplow ii, supra note 1, at 192. 14. id. (footnote omitted). 15. musgrave it, supra note 1, at 355. 16. id. at 358. 17 idat 359. 19931 florida tax review c. analysis of the exchange in analyzing the above exchange, it is necessary to return to the he and ve definitions employed both by musgrave and kaplow. recall that he is the requirement that equals be treated alike. one might think that ve, then, simply is a requirement that unequals be treated differently. stated in this way, it is clear that neither concept has any normative content. the response to each definition is "why"? neither definition, in itself, provides any answer. thus, both kaplow and musgrave use a definition of ve which is different from the above, i.e., for both it is a requirement that there be an "appropriate" pattern or system of differentiating among unequals. the word "appropriate" is not self-defining, so where do the two go to provide it with content? theoretically, ve could apply to a tax system that is progressive, proportional or regressive. which of these designs is chosen depends upon one's underlying theory of justice and decisions about some key economic assumptions. for example, one can be a thoroughgoing utilitarian and reach any of the three tax equity designs noted above. the reason for this is that the utilitarian must make a decision about the slope of the marginal utility of income. if she thinks that the slope declines, the tax paid will rise with income. however, whether the rate schedule should be regressive, proportional or progressive will depend on the rate of decline of the slope (i.e., the elasticity of the marginal utility of income with respect to income). 8 perhaps somewhat surprisingly, the same conclusion about possible tax system designs (i.e., progressive, proportional or regressive) is true for a believer in distributive justice as articulated by rawls. for rawls, the demands of justice are met by a society that provides maximum liberty for everyone and in which the advantages of the more fortunate promote the well-being of the least fortunate.' 9 in the context of taxation, rawls concluded that the best tax system for his theory of justice may be a flat tax rate on consumption.2 ° by design, a tax on consumption only exempts capital income from tax and capital income is concentrated in the upper income levels. economists commonly argue that, under certain assumptions, 18. the tax design will be progressive, proportional, or regressive depending on whether the elasticity of the marginal utility of income with respect to income is, respectively, greater than, equal to, or less than one. richard a. musgrave & peggy b. musgrave, public finance i, theory and practice, 200 (1973). although most economists agree that the slope of the marginal utility of income declines, there is far less agreement about its rate of decline (its elasticity). 19. see john rawls, a theory of justice 60-61, 83 (1971). 20. id. at 278-79. [vol 1:i0 horizontal and vertical equity such a tax is the equivalent of a tax on wage income only.2' given the facts that lower income earners have mostly wage income and that they consume a higher percentage of total income then do upper income individuals, the optimal tax design favored by rawls is regressive to income (although not to consumption). with this background, what is the ve to which kaplow refers? kaplow infuses ve with content by adopting a progressive income tax system as the "appropriate" differentiation in the tax treatment of unequals. for example, in his analysis of various he indexes, he suggests that ve favors moving individuals closer together.2similarly, he subsequently states that "ve objects to inequality and favors equality."z3 and that "gains from moving individuals closer together are already encompassed in ve."' kaplow's appeal to progressivity in defining ve is entirely understandable. ve lacks normative content and is derivative, because in order to determine what the "appropriate" differential among unequals should be, one has to refer to economic assumptions and some theory of distributive justice.25 for example, if one believes that the marginal utility of income declines in such a manner as to permit the use of a progressive tax rate in order to impose equal burdens on taxpayers, then a tax provision based on the belief that marginal utility increases is "bad." it is not "bad" because it failed to make a distinction among unequals. it is "bad" because one disagrees as to whether it is an "appropriate" distinction. in order to determine what is "appropriate," one has to refer to additional concepts. thus, the concept of ve, as defined, is itself entirely derivative. 21. musgrave, supra note 3, at 262, 266-67. rawls would use progressive rates to prevent excessive accumulations of wealth that could impair the liberty of others. rawls, supra note 19, at 279. for some, this concession might consume the rule for the reasons described in the text. to make sure that no one would think he was making use of any of the tools of utilitarianism (which he rejects totally), rawls added: it is evident also that the design of the [system of taxation] does not presuppose the utilitarian's standard assumptions about individual utilities... . the aim of [tax] is not, of course, to maximize the net balance of satisfaction but to establish just background institutions. doubts about the shape of utility functions are irrelevant. id. at 280. 22. kaplow i, supra note i, at 143. he states: "hence, the central defining characteristic of he-and its central force in policy applications-is that it also condemns moving individuals closer together in the income distribution ... directly contrary to ve." see also id. at 144 (stating that the impact of moving two individuals closer together in income distribution as a result of a tax reform is measured under ve). 23. kaplow i, supra note 1, at 147. 24. id. at 148. 25. joseph bankman & thomas griffith, social welfare and the rate structure: a new look at progressive taxation, 75 cal. l. rev. 1905, 1910 (1987). 19931 florida tax review with respect to he, given the economic and justice judgments which kaplow appears to make, he clearly is correct that he will always merge into ve and will not survive as an independent normative criterion. a system which seeks to impose equal burdens on all taxpayers should, by definition treat equally the subset of taxpayers that have equal income. similarly, a system that seeks to equalize the income of all taxpayers will, of course, treat taxpayers with equal income equally.26 thus, kaplow correctly asserts that he never will prevail to prevent enactment of a provision that would otherwise be appropriate on grounds of administrative efficiency or ve. as kaplow has noted, musgrave has not provided any such example and indeed he cannot. the reason musgrave cannot, however, has nothing to do with his defense of he. the reason is that musgrave has accepted kaplow's definition of ve and, in that definition, he is subsumed into ve. thus, neither musgrave nor anyone else can respond to kaplow's challenge on his terms. musgrave properly, in our view, subsequently pointed this out by observing that kaplow is correct only "if the relevant norm is defined in [prescribed] ve terms.' 'z even where the "appropriate" form of differentiation among unequals for ve purposes does not involve a progressive rate structure, he will lack normative content.2" in order to determine whether equals are treated equally, the measure of equality has to be defined, i.e., in tax terms the tax base must be determined. once that definition is properly articulated, it necessarily follows they will be treated alike. in a different, but relevant, area of the law, professor westen stated: the formula "people who are alike should be treated alike" involves two components: (i) (sic) a determination that two people are alike; and (2) a moral judgment that they ought to be treated alike. the determinative component is the first. once one determines that two people are alike for purposes of the equality principle, one knows how they ought to be treated. 29 26. musgrave ii, supra note 1, at 358. 27. id. at 356. 28. there has been a debate over whether equality has any normative content in the context of the administration of justice. that discussion is relevant to our analysis. see, e.g., peter westen, the empty idea of equality, 95 harv. l. rev. 537 (1982); erwin chemerinsky, in defense of equality: a reply to professor westen, 81 mich. l. rev. 575 (1983); anthony d'amato, comment: is equality a totally empty idea, 81 mich. l. rev. 600 (1983); kenneth l. karst, why equality matters, 17 ga. l. rev. 245 (1983); kenneth w. simons, equality as a comparative right, 65 b.u.l. rev. 387 (1985). 29. westen, supra note 28, at 543. [vol 1:10 horizontal and vertical equity the first component is satisfied in the context of taxation by a selection and definition of a tax base. thus, with respect to he, once one has decided on the tax base (say, income), then all that is required is a definition of income.30 however, once income is defined, those with equal amounts of income will, by definition, be taxed equally. if a particular item which constitutes "income" is not taxed or a consumption cost is allowed to be deducted, we know that the provision is "bad" and applying he adds nothing to that analysis. musgrave resorts to external resources to support his assertion of the independence of he. for example, he refers to the fact that it reflects "a basic premise of social mores"31 and is "almost universally accepted." 32 and, in his assertion that it is necessary to conceive of a "meta principle" by which trade-offs between ve and he may be weighed in assessing a particular tax revision, he relies on "the public's sense of equity."33 we do not imply that musgrave is inappropriately calling on these principles to justify he. we only point out that in this process, he is doing exactly what both he and kaplow do in asserting a normative content for ve. in summary, we believe that musgravelkaplow exchange reveals the following: (1) musgrave in 1959 demonstrated that there is no independent content to ve and resort must be had to economic assumptions and a theory of justice to provide that content; (2) we read kaplow as agreeing with that view and he, in fact, does infuse ve with just such content; and (3) given kaplow's now content-infused ve, he has demonstrated (and musgrave agrees in an ideal world) that he is subsumed within it and has no independent normative content for us, however, both he and ve at best become surrogates to describe consistency with or departures from the underlying decisions about the tax base and rate structure. the question is whether they are useful surrogates or whether they confuse or obscure the real issues that should be addressed in assessing proposed or actual changes in tax structure. we address those issues in iii, below. but fi-st we turn to the indexes of he discussed by kaplow and musgrave. 30. musgrave, supra note 3, at 161. 31. musgrave 11, supra note 1, at 355. 32. id. at 356. 33. id. at 358. 19931 florida tax review ii. measurement issues a. the kaplow/musgrave exchange if one agrees with our conceptual analysis, it follows that any attempt to develop an index to measure the extent to which a tax change violates he or ve is futile. however, economists, including musgrave, 4 have sought to develop such indexes. kaplow asserts that the inadequacies of he as an independent normative concept become apparent when one seeks to measure it. he states that two major problems exist. first, unless he is viewed as an absolute constraint, it is necessary to assign some measure of the degree to which it is violated.35 second, since by definition he applies only to equals, it does not address individuals whose positions initially differ.36 thus, kaplow observes, that "even an infinitesimal difference in treatment beyond whatever range is deemed 'equal treatment' counts as a violation, while further deviations, no matter how significant, are ignored."37 kaplow analyzes the efforts of investigators who have sought to deal with these problems by measuring changes in he. he states that several economists have sought to measure the he impact of a tax law change by comparing the pre-change ranking of taxpayers to the post-change ranking of taxpayers. 38 if the rankings change, he is said to be violated. 39 for example, assume that prior to a tax law change the ranking of individual4" taxpayers a, b, and c, based on after-tax income is: 34. see musgrave i, supra note 1, at 117-20; musgrave ii, supra note 1, at 357-58. 35. kaplow i, supra note 1, at 140. 36. id. 37. id. at 140-41. 38. the rankings are based on measures of economic well-being. see, e.g., robert plotnick, a comparison of measures of horizontal equity, in horizontal equity, uncertainty, and economic well-being 239, 246-47 (martin h. david & smeeding timoth eds., 1985). economists have suggested or actually employed various definitions of income or utility in ranking the economic well-being of taxpayers. see, e.g., a.b. atkinson, horizontal equity and the distribution of the tax burden, in the economics of taxation 3-19 (henry j. aaron & michael j. boskin eds., 1980); martin feldstein, on the theory of tax reform, 6 j. pub. econ. 77 (1976); mervyn a. king, an index of inequality: with applications to horizontal equity and social mobility, 51 econometrica 99 (1983); harvey s. rosen, an approach to the study of income, utility, and horizontal equity, 92 q. j. econ. 307 (1978). 39. see kaplow i, supra note 1, at 141, 146-48. see also king, supra note 38 at 99115; robert plotnick, the concept and measurement of horizontal equity, 17 j. pub. econ. 373, 373-91 (1982). 40. usually, individual taxpayers are not ranked but rather groups of similar taxpayers are ranked. this example uses individuals for illustrative purposes. [vol 1:10 19931 while after the tax change the ranking of taxpayers based on income is: ranking 1 2 3 taxpayer b a c their after-tax income 99 98 50 he is deemed violated by the change because b and a have changed ranks. kaplow argues that the ranking studies suffer from essentially the same defects as the concept of he itself because a small change in income (a's income dropped only by 2 in the above example) as a result of a tax law change may result in a rank change while a large change in income might result in no rank change." this is illustrated by the following example. consider again taxpayers who have the following after-tax income and rankings prior to a tax law change: ranking 1 2 3 taxpayer a b c income 100 99 50 as discussed above, if a's after-tax income were to decrease by 2 to 98 as the result of a tax law change, while the income of b and c remain the same, the ranking studies would show a violation of he because a and b have switched ranks. contrast this result with the consequences where the tax change causes a's income to increase to 147, b's income to decrease from 99 to 51, and c's income stays at 50. ranking 1 2 3 taxpayer a income 147 41. kaplow i, supra note 1, at 141. horizontal and vertical equity taxpayer a b c income 100 99 50 florida tax review note that the rankings have not changed and, therefore, that no change in he would be registered by the ranking analysis although the disparity between a's and b's income has increased markedly. also note that kaplow correctly states that the indexes are not measuring the treatment of equals (he), but really are measuring the treatment of unequals (ve) since the ranking process begins with individuals (or groups) with different incomes.42 lastly, kaplow asks why the ranking of taxpayers prior to the tax law change is the starting point for this form of he analysis.43 the use of changes in the ranking of taxpayers to measure the impact of a tax law change on he must in effect assume that the pre-change ranking achieved he. yet, kaplow observes, the pre-change ranking is itself the result of several prior tax law changes that may or may not have achieved he.' musgrave also proposes an index that seeks to measure he. rather than using a ranking system such as that described above, musgrave devised an index with two parts. the first part, the he component, would measure the difference between the welfare cost of the tax system if equals were treated equally and the welfare cost of the system when equals are not treated equally.45 the second component, the ve component, would measure the difference between the welfare costs of the tax system assuming that ve had been achieved and the welfare costs of the tax system where ve is not achieved.46 musgrave uses the term welfare costs to represent the burden imposed on all taxpayers by the tax system. in his examples, he calculates welfare cost by assuming that the marginal utility of income declines as income increases.47 he argues that his system of employing two components to isolate the welfare costs arising from the failure to achieve he or ve is superior to ranking studies because his system measures changes in the allocation of tax burdens that might be considered significant but that might not result in a rank shift.48 42. id. 43. id. at 146-47. 44. id. kaplow notes that some authors have attempted to deal with this problem by determining what the distribution of income would be if the ideal tax system were in effect and then comparing the effect of the tax reform on the distribution of income to the ideal distribution. id. at 147-48. however, kaplow argues that the distribution analysis is really focusing on ve since it is analyzing the impact on unequals. 45. musgrave i, supra note 1, at 117-18; musgrave ii, supra note 1, at 357-58. 46. musgrave i, supra note 1, at 117-18; for this purpose, musgrave assumes that ve has been achieved with a tax distribution that minimizes aggregate welfare costs. 47. musgrave assumes a social welfare function that assigns a value of 10 to the first dollar of income, of 9.1 to the second dollar of income, of 8.19 to the third dollar of income, etc., with the social welfare of each successive dollar of income declining by 10%. musgrave i, supra note 1, at 119. 48. id. at 118. [vol 1:10 horizontal and vertical equity a simple version of musgrave's index will illustrate musgrave's thesis. consider four individuals l1, l2, hi, and h2. li and l2 have low incomes, each receiving $5, and are grouped together in the low rank category l. hi and h2 have high incomes, each receiving $10, and are grouped together in the high rank category h. two proposals to implement an income tax for the first time ever are being considered. the impact of the two proposals on the after-tax income and rankings of the individuals is illustrated below. first tax proposal net group tax income rank 4 6 1 4 6 1 0 5 2 0 5 2 second tax proposal net group tax income rank 2.5 7.5 1 3.8 6.2 1 .4 4.6 2 1.3 3.7 2 note that although the two tax proposals have a disparate impact on the members of the two groups, l and h, the reforms do not register a rank change so long as only two ranking groups are used because h i and h2 still have after-tax incomes that place them in the highest ranking group and li and l2 still have incomes that place them in the lowest group. thus, using the ranking analysis, each proposal is consistent with he although after-tax incomes differ markedly depending upon which proposal is adopted. musgrave's index attempts to capture the he movement which the ranking studies miss. in addition, musgrave's index attempts to measure ve differences. thus, under musgrave's approach, the two systems would register different welfare impacts, as illustrated below.49 first tax proposal net second tax proposal net initial income tax income tax income h1 10 4 6 2.5 7.5 h-2 10 4 6 3.8 6.2 li 5 0 5 .4 4.6 l2 5 0 5 1.3 3.7 ve welfare costs as result of not achieving ve 0 6.4 49. this example is obtained from musgrave h, supra note 1, at 357. initial income h1 10 h2 10 li 5 l2 5 initial group rank 1 1 2 2 19931 florida tax review he welfare costs as result of not achieving he 0 2.3 note that the first tax proposal has no excess welfare cost under musgrave's approach,5" but the second tax reform registers both excess he and ve costs.5 thus, the first tax proposal would be preferable. kaplow criticizes musgrave's two-component index because it devotes one entire component (the he component) to the few persons who just happen to be equal while all other persons are lumped together in the ve component. in terms of the above example, if li and l2 had not started with identical incomes of 5 but had instead had initial incomes of 5 and 4.9, and hi and h2 had not started with initial incomes of 10 each, but had initial incomes of 10 and 9.9, no he measure would be applied to the treatment of hi, h2, li, and l2. instead, the treatment of hi, h2, li, and l2 would be measured solely by the ve index. kaplow asks why a separate index, the he index, should be devoted solely to the measurement of the impact of individuals who start out as equals when all other taxpayers are lumped into the ve index.52 moreover, kaplow asks what weight should be assigned to ve and he costs. for example, if one proposed tax law change results in an excess ve cost of 6 and he cost of 0 while the other result in an excess ve cost of 3 and he cost of 3, both will have the same aggregate welfare cost of 6. kaplow queries which tax proposal should be selected. he asserts that since both he and ve derive from the same normative base,53 it is difficult to see why they should have a different normative import. in a subsequent article, musgrave admits that in a complex world it is unrealistic "to limit considerations of departure from he to individuals with identical incomes only, while disregarding the relative treatment of individuals with more or less similar incomes.'"" but he maintains that this does not mean that he is a useless independent concept. b. analysis in our view, kaplow's analysis of the defects of ranking studies to analyze he is correct. as noted above, to the extent that ranking studies use 50. that is, equals are treated equally, and there is an "appropriate" differentiation between h and l. 51. that is, equals are not treated equally, and there is not an "appropriate" distinction in the treatment of unequals. 52. kaplow ii, supra note 1, at 195. 53. see supra text accompanying notes 3-7. 54. musgrave ii, supra note 1, at 358. [vol 1:10 horizontal and vertical equity, the distribution of income existing prior to a tax law change as a base to measure the he impact of the change, the studies are in effect assuming that the pre-change distribution achieved he, an assumption that appears to be extremely weak. moreover, because in the real world the ranking studies compare the impact of the change on taxpayers or groups of taxpayers who start with different incomes, kaplow is correct in asserting that ranking studies really involve a ve analysis. we also believe that musgrave's effort to defend the vitality of his indexes for measuring he and ve ultimately must fail. we believe that his concession quoted above that the he component cannot be limited to taxpayers with identical incomes is in fact a reversion to his 1959 assertion that he folds into ve once a system that makes appropriate distinctions among unequals is adopted. moreover, the ve component gives no information in addition to the economic assumption made by musgrave that the marginal utility of income declines. finally, it follows that the index will not assist in identifying relevant trade-offs in assessing proposed tax changes because ve and he both are derivative concepts. because he and ve derive their normative base from economic judgments, values based on some theory of justice and efficiency concerns, the relevant trade-off is between or among those potentially conflicting fundamental judgments and values. if it is agreed that objective indexes of he and ve are not likely to be developed, the question remains as to whether he and ve concepts may have some utility in the real world. mt. he and ve as surrogates for basic economic and justice decisions a. kaplow's suggestions although kaplow rejects both the proposition that he contains any normative content and the validity of indexes of measures of he, he nonetheless concludes his 1989 article by suggesting some practical, if limited, uses for which he may be employed. two of those uses are: (1) he analysis may reveal provisions (or the absence thereof) that are the source of inefficiencies or which need adjustment in order that ve norms may be applied properly. 55 55. kaplow i, supra note 1, at 149. 19931 florida tax review (2) repeated violations of he could have adverse effects on (presumably labor and investment) incentives and undesirably impose the element of risk.56 b. analysis kaplow concludes that none of these uses demonstrates any normative content to he (and, we would add, the same is true for ve). instead, according to kaplow, they serve as signals that something is amiss that needs investigation. the question is whether attention to he in the above situations (and others he describes) adds anything to the analytical process. to take kaplow's first example, would application of he analysis have added anything to the analysis of the need for the time value of money rules enacted in 1984? indeed, the more troubling question is whether a focus on he concerns would have masked the source of the problems and hence the need for the changes. that is, were not principles of income definition and allocation of income and expenses to proper accounting periods sufficient to indicate the need for changes?57 after applying the principles, what further could he analysis have provided that would have led to any different conclusions about the appropriate legislative responses? in the case of kaplow's second example, if legislative changes impose undesirable elements of risk, it is the identification of the undesirable risk effects (undesirability measured in terms of risk, not he) that will be determinative. he adds nothing to the analysis and waiting for he analysis to reveal the risk effects may postpone identification of problems that would have been revealed if risk analysis were used to begin with. similar lines of analysis lead to the conclusion that kaplow's other suggested uses of he are better served by an examination of the fundamental concerns that underlie each problem. because musgrave sees a broader role for he than the practical uses suggested by kaplow, he presumably does not object to these lesser suggestions. we suggest, however, that the questions raised as to the more limited uses require further exploration. in the end, we believe, any use of he is going to be driven by more fundamental concerns. the question for advocates of even limited use of he is why should analysis not begin and end in terms of those more fundamental concerns. the risk is that relying on he or ve analysis might lead policymakers and the public astray if those 56. id. 57. in 1959, musgrave observed that once the appropriate income definition is agreed upon, most of the he concerns have been resolved. musgrave, supra note 3, at 161. [vol 1:10 horizontal and vertical equity concepts in fact do not accurately or adequately reflect underlying principles in a given situation." c. the effect of tax expenditure analysis on he and ve even if one believes that he and ve analyses do or should have a role to play, it is important to keep in mind the kind of provision being assessed. if the provision is a tax expenditure, he and ve notions should not play a role in assessing a change. as mcdaniel demonstrated in an earlier article,59 the introduction or removal of a tax expenditure has no impact on tax equity, whether he or ve. this counter-intuitive result flows from the tax expenditure construct itself: a taxpayer is deemed to pay tax based on economic income and is then given a treasury check in an amount equal to the subsidies run through the tax system for which he or she qualifies. obviously, in the real world two checks are not exchanged. instead, the taxpayer nets his or her "economic tax check" amount with the "tax subsidy" check amount and remits the difference (or gets a refund). but focusing on the economic tax check portion of the analysis reveals that a tax expenditure is not the object of traditional tax he or ve concerns. indeed, if those concerns are applied to tax expenditures (as frequently they are), policymakers can be led astray (e.g., "no new taxes" as a call to oppose repeal of a tax expenditure). of course, there are equity concerns to address in assessing tax expenditures. but those concerns are those that are involved in assessing the outlay side of the budget (which may or may not be identical to tax notions of he and ve). use of tax expenditure analysis also is consistent with our criticisms of he and ve. that is, tax expenditure analysis avoids he and ve altogether and focuses directly on the issues of why, for example, an item of income is untaxed and what the economic and distributional effects of that omission are. iv. conclusion the kaplow/musgrave exchange has raised issues of considerable theoretical and practical interest. our analysis of this exchange leads us to the following conclusions: (1) neither he nor ve has any independent normative content, and that content must be supplied by reference to economic assumptions and a theory of justice; (2) kaplow has demonstrated convincingly the inadequacies of efforts to develop indexes that will measure 58. see westen, supra note 28 (making a similar point in his broader analysis of equality). 59. paul r. mcdaniel, identification of the "tax" in "'effective tax rates," "tax reform" and "tax equity," 38 nat'l tax j. 273. 277 (1985). 19931 622 florida tax review [vol. 1:10 movements in he as a result of tax law changes; and (3) it is not likely that he and ve add anything to the need to analyze tax changes in terms of basic tax policy objectives and indeed may conceal problems or lead policymakers astray as particular tax changes are considered. login | florida tax review main navigation main content 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32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review florida tax review volume 19 2016 number 7 article joint winners, separate losers: proposals to ease the sting for married taxpayers filing separately michelle lyon drumbl 399 florida tax review volume 19 2016 number 7 the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. the subscription rate, payable in advance, is $125.00 in the united states and $145.00 elsewhere for the current volume. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352) 273-0658 or email ftr@law.ufl.edu. copyright © 2016 by the university of florida florida tax review volume 19 2016 number 7 editor-in-chief charlene luke professor of law university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar dennis a. calfee professor of law patricia e. dilley professor emeritus michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law adam smith visiting assistant professor lee-ford tritt professor of law samuel c. ullman adjunct professor of law steven j. willis professor of law martin j. mcmahon, jr. james j. freeland eminent scholar board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university – bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell katheleen duggan pfahlert florida tax review volume 19 2016 number 7 information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: “articles,” “commentaries,” and “book reviews.” the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word sent via expresso (law.bepress.com/expresso). articles may be emailed to ftr@law.ufl.edu. if 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university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the florida tax review. florida tax review volume 19 2016 number 7 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines 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navigation home search current archives subscribe florida tax review volume i november 1992 number 2 treaty-based nondiscrimination: now you see it now you don't sanford h. goldberg and peter a. glicklich" i. introduction a broad nondiscrimination provision appears in every income tax treaty that the united states has entered into in the last quarter century. the nondiscrimination article of these treaties purports to prohibit discriminatory taxes levied against foreign nationals or their businesses. however, some distinctions have always been permitted, based on the fact that domestic and foreign taxpayers are not similarly situated because different taxing jurisdictions are concerned. the problem is that it is difficult to articulate a consistent and rational standard to apply to determine when proscribed discrimination is present. the language used in a typical u.s. nondiscrimination provision, such as article 24 of the 1981 u.s. model income tax treaty (the "1981 u.s. model"), can be traced to the 1963 draft model convention published by the organization for economic cooperation and development committee on fiscal affairs, draft double taxation convention on income and on capital (the "1963 oecd model").' the 1977 draft of the organization for * sanford h. goldberg and peter a. glicklich are partners of roberts & holland, new york city and washington, d.c., a law firm concentrating its practice in tax matters. 1. although all of the recent u.s. income tax treaties contain a nondiscrimination provision, this provision has not always been present. for example, the following income tax treaties contain no such provision: convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, may 14, 1953. u.s.-austl.. 4 u.s.t. 2274; convention on rates of income tax on nonresident individuals and corporations, dec. 30, 1936, u.s.-can., 50 stat. 1399; convention on double taxation, apr. 27, 1932, u.s.-fr., 49 stat. 3145; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, mar. 30. 1955. u.s.-italy, 7 u.s.t. 2999; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, apr. 16, 1954. u.s.-japan. 6 u.s.t. 149; convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, june 13, 1949, u.s.-nor., 2 u.s.t. 2323: convention for the florida tax review economic cooperation and development model double taxation convention on income and on capital (the "1977 oecd model") includes a similar provision as its article 24. both the 1963 oecd model and the 1977 oecd model have been instrumental in guiding development of the language of bilateral income tax treaties. copies of article 24 of the 1981 u.s. model and of article 24 of the 1977 oecd model are attached as appendix a and appendix b. although treating similarly situated taxpayers the same is a laudable goal, there appears to be a great distance between acceptability of the nondiscrimination concept in general and the ease or exactness of its application. a former international tax counsel and director of the office of international tax affairs at the u.s. treasury department, who was involved in negotiating several u.s. income tax treaties, has observed that, "as admirable as the 'nondiscrimination' concept sounds, the ramifications of ... [the nondiscrimination article] are probably more uncertain than those of any other article."' similarly, interpretation of the nondiscrimination article of u.s. income tax treaties has been described as "a most confusing area of the tax law."3 based in part on particular policy concerns and in part on interpretative difficulties discussed below, some countries either refuse to include nondiscrimination provisions in their treaties, or significantly limit the application of such provisions. thus, in addition to being difficult to interpret, the typical model nondiscrimination article is not necessarily acceptable to other nations. more disturbing is the increasing tendency of congress to articulate a standard, apply it to proposed legislation, and state that, while congress does not consider the legislation discriminatory under that standard, if a court disagrees then the nondiscrimination provision is intended to be overridden anyway. such behavior is one of the reasons for the title of this article. another reason is the evanescent character of discrimination as seen through the eye of the beholder. this article analyzes the nondiscrimination concept, evaluates its general acceptance worldwide, explores its rather inconsistent application in the united states, and considers whether it makes sense to continue including a nondiscrimination article in future u.s. income tax treaties. avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, dec. 22, 1966, u.s.-trin. & tobago, 18 u.s.t. 3091. 2. robert j. patrick, jr., a comparison of the united states and oecd model income tax conventions, 10 law & pol'y int'l bus. 613, 705 (1978); see discussion of australian position on nondiscrimination infra pp. 55-57. 3. james g. o'brien, the nondiscrimination article in tax treaties, 10 law & pol'y int'l bus. 545, 612 (1978). [vol 1:2 treaty-based nondiscrimnination a. concept of nondiscrimination the principle of nondiscrimination against foreign nationals and their enterprises has been applied in international fiscal relations since well before the appearance, at the end of the nineteenth century, of the classic bilateral double taxation convention.4 the nondiscrimination principle was often incorporated in consular or establishment conventions and in treaties of friendship, commerce, and navigation; the parties to those agreements often attempted to obtain "most favored nation" protection for the businesses conducted abroad by their nationals. the existence of nondiscrimination provisions in treaties has been justified as being consistent with the concept that taxes should not be an impediment to the free-flow of international trade, investment, or the movement of individuals.5 according to the american law institute (the "all"), it is accepted practice to include generalized assurances that a country will not employ excessive or burdensome taxation as a protectionist or exclusionary device, "which means that nationals (or residents) of both treaty counties will be on a level [tax] playing field."6 rather than leveling the playing field by extending domestic investment incentives to foreign investments made by their own nationals, the level playing field concept has been implemented by having source countries agree to avoid placing extra burdens upon foreign persons and their businesses conducted in the source countries. thus, in practice, a treaty nondiscrimination provision represents a commitment that a source-country will not tax nationals7 or residents of its treaty partner more heavily than it taxes its own nationals or residents. in addition to committing to tax foreign nationals no more heavily than source-country nationals, some source countries, including the united states, implement the level playing field concept by retaliating against foreign nationals of a country that imposes discriminatory taxes against sourcecountry nationals. for example, sections 891 and 896 of the internal revenue 4. see committee on fiscal affairs. organization for economic co-operation and development model double taxation convention on income and on capital, art. 24 (1977) [hereinafter "1977 oecd model"] (appendix b hereto); 1963 and 1977 oecd model income tax treaties and commentaries art. 24, para. 1(2) (kluwer 1987) [hereinafter "1977 oecd commentaries"]. the concept also appears in the league of nations mexico model convention (1943) and the london model convention (1946). 5. see american law institute, federal income tax project, international aspects of united states income taxation h, proposals on united states income tax treaties [hereinafter "a.l.i. treaty project"], 253 (1992). 6. id. 7. the term "nationals" is used in the 1977 oecd model and in the 1981 u.s. model income tax treaty. 1977 oecd model, supra note 4. art. 24, para. 1-2: u.s. model income tax treaty, art. 24, para. 1-2 (1981) [hereinafter "1981 u.s. model"] (appendix a hereto). see infra at text accompanying notes 142-64. 19921 florida tax review code (the "code") allow the united states to increase taxes applicable to nationals, residents and corporations of another nation that subjects u.s. citizens or domestic corporations to discriminatory or extra-territorial taxes.8 b. typical nondiscrimination provisions in order to evaluate the concept of nondiscrimination in the context of the actual nondiscrimination provisions found in a typical u.s. treaty, reference must be made to the specific restrictions that the treaty incorporates. article 24 of the 1981 u.s. model, which is discussed in detail throughout the balance of this article, includes four basic rules. 1. nationals of one country may not be subjected in the second country to any taxation or requirement connected therewith that is "other or more burdensome" than is applicable to nationals of the second country who are "in the same circumstances." 9 2. taxes may not be "less favorably levied" by a country on foreign owned permanent establishments located in the country than are levied by the country on enterprises of the country carrying on "the same activities."'" 3. enterprises of one country, the capital of which is owned or controlled wholly or partly, directly or indirectly, by one or more residents of the second country, may not be subjected in the first country to any taxation or requirement connected therewith that is "other or more burdensome" than that applicable to "similar enterprises" of the first country." 4. interest, royalties, and other disbursements paid by a resident of one country to a resident of the second country, shall, for purposes of determining taxable profits of the resident of the first country, be deductible under the same conditions as if they had been paid to a resident of the first country. 2 8. although critical to their implementation, neither section 891 nor section 896 of the code defines discrimination. 9. 1981 u.s. model, supra note 7, art. 24, para. 1. 10. 1981 u.s. model, supra note 7, art. 24, para. 3. 11. 1981 u.s. model, supra note 7, art. 24, para. 5. 12. 1981 u.s. model, supra note 7, art. 24, para. 4. [vol 1:2 treaty-based nondiscrimination c. covered taxes while u.s. income tax treaties are normally limited to federal income taxes,13 their nondiscrimination articles may be much broader. for example, in the 1981 u.s. model, the nondiscrimination rules apply to "taxes of every kind and description" imposed by one of the treaty countries or by any political subdivision or local authority of such countries. 4 thus, the provision would apply to federal estate, gift, and generation-skipping taxes, as well as to all state and local taxes.' 5 d. concenzs of other nations the approaches of other nations indicate that the 1981 u.s. model nondiscrimination article is not universally accepted. these approaches also help raise the question of whether the united states should continue to seek nondiscriminatory treatment for its nationals and grant such treatment to nationals of its treaty partners. by way of illustration, canada, australia, and new zealand generally have not adopted a nondiscrimination provision similar to that of the 1981 u.s. model.' 6 also, japan reserves the right not to extend domestic benefits to the permanent establishments of nonresidents.'7 article 23 of the u.s.-australia income tax treaty of 1982" adds the following three limiting paragraphs to the 1981 u.s. model: (2) nothing in this article relates to any provision of the taxation laws of a contracting state: (a) in force on the date of signature of this convention; (b) adopted after the date of signature of this convention but which is substantially similar in general purpose or intent to a provision covered by subparagraph (a); or (c) reasonably designed to prevent the avoidance or evasion of taxes; provided that, with respect to provisions covered by 13. 1981 u.s. model, supra note 7. art. 2, par. 1. 14. 1981 u.s. model, supra note 7. art. 24, para. 1. 15. see convention with respect to taxes on income and on capital. sept. 26. 1980, u.s.-can. art. xxv, para. 10, t.i.a.s. no. i 1.087, at 24, [hereinafter -u.s.-can. treaty-l. 16. 1977 oecd commentaries. supra note 4. art. 24, par. 61. 17. 1977 oecd commentaries, supra note 4, art. 24, para. 65. 18. convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, august 6. 1982. u.s.-austl., art. 23, par. 2-4. t.i.a.s. no. 10,773, at 50-52 [hereinafter "u.s.-austl. treaty"]. 19921 florida tax review subparagraphs (b) or (c), such provisions (other than provisions in international agreements) do not discriminate between citizens or residents of the other contracting state and those of any third state. (3) without limiting by implication the interpretation of this article, it is hereby declared that, except to the extent expressly so provided, nothing in the article prevents a contracting state from distinguishing in its taxation laws between residents and nonresidents solely on the ground of their residence. (4) where one of the contracting states considers that the taxation measures of the other contracting state infringe the principles set forth in this article the contracting states shall consult together in an endeavor to resolve the matter. paragraph 2 of this additional language permits australia to continue enforcing all of its tax provisions that were in effect in 1982, or that are adopted after 1982 and have a substantially similar purpose or intent as a pre1983 provision, regardless of whether they discriminate against u.s. taxpayers. as to post 1982 provisions, the treaty does not protect against discrimination against u.s. taxpayers as compared with australian residents or nationals, but only as compared with third country nationals. paragraph 3 of the additional language allows a contracting state to distinguish in its tax laws between residents and nonresidents solely on the basis of their residence. a similar provision appears in the u.s.-new zealand income tax treaty of 1982.19 paragraph 4 of the additional language provides for competent authority consultation where one of the parties believes discrimination has occurred. although the treaty does not state that this is the sole remedy, the competent authority provision may have been intended to preclude individual taxpayer private actions.2" if paragraph 4 is intended to limit enforcement 19. convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, july 23, 1982, u.s.-n.z., art. 23, t.i.a.s. no. 10,772 [hereinafter "u.s.-n.z. treaty"]. new zealand also entered a reservation to the oecd model nondiscrimination provision. no other new zealand treaty contains a nondiscrimination article. 20. the u.s. treasury department's technical explanation of the u.s.-austl. treaty speaks only of a taxpayer's right to enlist his government's aid in determining whether discrimination has occurred. treasury dept. technical explanation of u.s.-austl. treaty, fed. tax treaties i (p-h) i 15,062 at 15,069. [vol 1:2 treaty-based nondiscrintination to official competent authority negotiations, it may be ineffectual, since paragraph 4 only requires consultation, not agreement.2' nor is it clear that a u.s. taxpayer can compel the internal revenue service to participate in negotiations under the competent authority procedure." it seems that australia's reason for negotiating double taxation agreements is simply to agree upon a division of taxing rights between itself and other countries in a way that relieves double taxation and prevents fiscal evasion. under this view, a nondiscrimination article, like article 24 of the 1981 u.s. model, is not necessary. australia is apparently of the view that certain serious disadvantages may arise from including a broad nondiscrimination provision in its treaties. such a provision would conflict with what australia considers a proper division of taxing rights between the parties to the tax treaties. for example, it would restrict australia's right to impose a branch profits tax, could limit australia's ability to reallocate profits under an arm's-length pricing provision, and could prevent australia from applying "thin capitalization" rules to foreign-owned companies. australia is also concerned that such an article would preclude it from adopting some tax measures intended principally for economic regulation, rather than revenue raising. apparently australia is concerned that particular economic problems may arise only in relation to foreign-owned companies, and believes that its ability to deal with such problems through measures affecting only those companies should not be impaired. apart from policy considerations, australia also apparently considers the language of article 24 of the 1981 u.s. model too imprecise. some countries may also find a nondiscrimination provision unnecessary to resolve some problems. the ali's suggested manner of dealing with a situation in which a nondiscrimination claim conflicts with a specific substantive rule of a treaty is to apply the specific substantive rule despite the nondiscrimination provision, because the treaty implicitly reflects its own resolution of the conflict.24 in other words, since the nondiscrimination language is more general, the ali suggests that the more specific provision should govern. similarly, the ali suggests that if treaty negotiators can 21. a similar problem exists with the competent authority or mutual agreement provision. see sanford h. goldberg, how and does the competent authority work? a multinational analysis, 39 the tax executive 5 (1986); sanford h. goldberg, usa: competent authority, 40 bull. for int'l fiscal documentation 431 (1986). 22. see yamaha motor corp. v. united states, 779 f.supp. 610 (d.d.c. 1992); see generally sanford h. goldberg and seth b. goldstein, "u.s. district court lacks jurisdiction to compel irs to consider request for competent authority assistance," 40 can. tax j. (forthcoming 1992) (manuscript on file with author). 23. however, the u.s.-can. treaty, supra note 15, includes a typical "associated enterprise" article. 24. see generally a.l.i. treaty project. supra note 5. 19921 florida tax review reasonably be said to have accepted an existing domestic law or treatment in effect at the time the treaty was negotiated, such law or treatment should not be attacked on nondiscrimination grounds. such interpretative refinements might be considered by other nations as a means of reconciling some of their disagreements with the united states without resort to a nondiscrimination provision. canada also has reservations about the 1981 u.s. model nondiscrimination article, perhaps because canada recognizes that it discriminates against foreign taxpayers in a number of ways and wants to be able to continue to do so.' like australia, canada has agreed to treat all foreign taxpayers similarly, but not necessarily the same as it treats its own residents. thus, article xxv(2) of the u.s.-canada treaty26 compares nationals of the other treaty country to "citizens of any third state in the same circumstances (including state of residence)...." similarly, article xxv(5) of the u.s.-canada treaty, dealing with foreign-owned domestic corporations, compares u.s.owned companies to companies "owned or controlled, directly or indirectly, by one or more residents of a third state," rather than to companies owned by canadian residents." finally, like the australia 2s and new zealand29 treaties, article xxv(8) of the u.s.-canada treaty provides: the provisions of paragraph 7 shall not affect the operation of any provision of the taxation laws of a contracting state: (a) relating to the deductibility of interest and which is in force on the date of signature of this convention (including any subsequent modification of such provisions that does not change the general nature thereof); or (b) adopted after such date ... and which is designed to ensure that a person who is not a resident of that state does not enjoy, under the laws of that state, a tax treatment that is more favorable than that enjoyed by residents of that state.30 25. under questioning in the canadian house of commons concerning the disallowance of deductions for advertising placed in foreign magazines, international trade minister john crosbie acknowledged that the provision was discriminatory. "i expect the americans to accept with resignation and disfavor and disappointment and frustration and irritation and anger our position with regard to cultural industries. i don't blame them. if i was them, i'd take the same position." bna daily tax report (mar. 20, 1991) at g-6. 26. u.s.-can. treaty, supra note 15, at art. xxv, para. 2, t.i.a.s. no. 11,087, at 23. 27. u.s.-can. treaty, supra note 15, art. xxv, para. 5. 28. see supra note 18. 29. see supra note 19. 30. u.s.-can. treaty, supra note 15, art. xxv(8). [vol 1:2 treaty-based nondiscrimination differences in the views of other nations as to the appropriate scope of a nondiscrimination provision raises the fundamental question: what conduct by a state constitutes discrimination? e. recent withdrawal of u.s. model treaties in its notice withdrawing both the 1977 and 1981 u.s. models, the u.s. treasury department recently noted that the model treaties, which have served as a starting point for u.s. treaty negotiations with other nations, are "significantly" outdated.31 the notice invited comments from the private sector on the nondiscrimination article and nine other parts of the model treaties. thus, it is now appropriate to reconsider what function, if any, the nondis-crimination article of a u.s. income tax treaty should serve. ii. what is discrimination? just as the courts have difficulty in evaluating claims under the due process and equal protection provisions of the u.s. constitution (the "'constitution"), so it appears that claims of discriminatory taxes prove difficult to evaluate. one problem is determining what sort of unequal treatment rises to the level of prohibited discrimination. another problem is determining who is to be compared to whom in deciding whether unequal treatment exists. finally, although perhaps a problem of different magnitude, if discrimination is found, what is the appropriate remedy. a. equal protection clause few u.s. courts have considered issues arising under nondiscrimination provisions of treaties. yet, there is a rather large body of law interpreting the equal protection clause in the fourteenth amendment of the constitution that one might think would provide some guidance. the equal protection clause provides that: "[n]o state shall ... deny to any person within its jurisdiction the equal protection of the laws." since this clause assures that persons similarly situated will be treated alike under the laws of a state, it seems to share the general goal of nondiscrimination articles of income tax treaties. courts that have interpreted the equal protection clause have not 31. t.d. news rel. n.b.1900 (july 17. 1992). 92-13 cch 146.416. the oecd has recently released its latest, 1992 model treaty: this article does not comment on the 1992 model. 32. u.s. const. amend. xiv. § 1. a similar provision is "read into" u.s. const. amend. v. 19921 florida tax review required identical treatment. in the absence of a "suspect" classification, in fact, the courts seem to accept virtually any non-arbitrary distinction among different persons.33 the applicable standard, referred to as the "rational basis test," is often phrased in three parts: (1) the classification must rest on real rather than superficial differences, (2) the distinction must have some relevance to the purpose for which the classification is made, and (3) the different treatment must not be so disparate relative to the difference in classification as to be "wholly arbitrary. ' despite the apparent similarity between constitutional equal protection and treaty nondiscrimination, different standards may be acceptable in interpreting them given the differences in their origins and purposes. the equal protection clause was designed to prevent the various states within the united states from drawing invidious and arbitrary distinctions among those persons within their borders, while preserving to the extent possible the rights of states to govern themselves.35 this restriction on the states was thus intended to permit great latitude to state legislatures. however, the same deference need not be given in the international arena. as the supreme court recently stated in davis v. michigan dept. of the treasury, "'our decisions in [the equal protection] field are not necessarily controlling where problems of intergovernmental tax immunity are involved,' because 'the government's interests must be weighed in the balance.' , 36 "instead, the relevant inquiry is whether the inconsistent tax treatment is directly related to, and justified by, 'significant differences between the two classes.' , the davis court stated that "[t]he state's interest in adopting the discriminatory tax, no matter how substantial, is simply irrelevant. ... ,38 thus, discrimination for treaty purposes may be present even though, applying equal protection standards, discrimination would not be found. b. permitted distinctions in interpreting "taxation or any requirement connected therewith which is other or more burdensome," the commentaries to the 1977 oecd model state that when a tax is imposed on nationals and foreigners in the same circumstances, (1) it must be in the same form as regards both the basis 33. see railway express agency, inc. v. new york, 336 u.s. 106 (1949) (setting forth the rational basis test). 34. see dandridge v. williams, 397 u.s. 471 (1970). 35. see generally ronald d. rotunda & john e. nowak, constitutional law ch. 14 (4th ed. 1991). 36. davis v. michigan dept. of the treasury, 489 u.s. 803, 816 (1989); see also kraft gen. foods, inc. v. iowa dept. of revenue, 112 s.ct. 2365 (1992). 37. davis, 489 u.s. at 816. 38. id. [vol 1:2 treaty-based nondiscrimination of the charge and the method of assessment, (2) its rate must be the same, and (3) the "formalities" connected with the taxation (returns, payment, prescribed times, etc.) must not be more onerous for foreigners than for nationals.39 in practice, however, differences in collection mechanisms and return requirements have been accepted because of the different circumstances in which treaty country residents not resident in the united states find themselves compared to u.s. residents. 40 the oecd commentaries to the 1977 oecd model acknowledge another permitted distinction. the nondiscrimination provision is not to be construed as obliging a state that accords special taxation privileges to its own public bodies or services to extend the same privileges to public bodies or services of another state.4' this is considered justified "because such bodies and services are integral parts of the state and at no time can their circumstances be comparable to those of the public bodies and services of the other state."42 similarly, the oecd commentaries state that the nondiscrimination provision is not to be construed as obliging a state which accords special taxation privileges to not-for-profit private institutions whose activities are performed for purposes of public benefit, which are specific to that state, to extend the same privileges to similar institutions whose activities are not for that state's benefit. it is perhaps for this reason that the all considers it inappropriate to compare foreign nationals to domestic tax exempt entities.43 such limitations on the scope of nondiscrimination with respect to private not-for-profit institutions permit the united states to limit the exemption under section 501 of the code in some instances to domestically organized entities, although the major exemptions under section 50 1(c) do not require domestic organization. for u.s. income tax purposes, a charitable deduction is allowed only for contributions made to domestically organized or created entities.44 moreover, a charitable contribution by a corporation is deductible only if it is to be used within the united states." since the 39. 1977 oecd commentaries, supra note 4, art. 24, para. 4. 40. in the 1977 oecd model, supra note 4, art. 24. para. i & 3 and in oecd committee on fiscal affairs, draft double taxation convention on income and capital 151. para. 1(2) (1963), "in the same circumstances" may mean "in substantially similar circumstances both in law and fact." see also discussion infra pt. iv.d. 41. 1977 oecd commentaries, supra note 4. art. 24. 42. 1977 oecd commentaries, supra note 4, art. 24, para. i at 7. the oecd commentary states, however, that this reservation is not intended to apply to state corporations carrying on gainful undertakings. 43. a.l.i. treaty project, supra note 5, at 258-59. 44. irc § 170(c). the 1977 oecd commentaries do not expressly discuss the deductibility of contributions made to such domestic exempt organizations. 45. id. 19921 florida tax review income tax deduction provision applies to both foreign and domestic taxpayers, it does not appear to be discriminatory. however, the u.s. gift and estate tax charitable deduction provisions are different for resident and nonresident taxpayers. resident taxpayers and u.s. citizens are permitted charitable deductions for gift and estate tax purposes for transfers to both domestic and foreign charities, whereas nonresident taxpayers who are not u.s. citizens are permitted charitable deductions for gift and estate tax purposes only for transfers to domestic charities.46 since foreign charities are generally not subject to u.s. income tax,47 it would be difficult for them to claim that their inability to receive deductible contributions is a more burdensome tax or requirement. in addition, under the oecd commentaries, this distinction is permissible if the ability to receive deductible contributions is a "special taxation privilege. 48 consistent with this view, the internal revenue service has refused to extend article 24 to foreign pension trusts. in a technical advice memorandum, the service denied income tax exemption to a dutch pension fund that satisfied the requirements of section 401(a) of the code and related provisions except for the fact that it was created in the netherlands.49 in reaching that result, the service had to determine whether, in spite of the nondiscrimination provision in the treaty, exemption could be denied on the grounds of u.s. national social purpose.5" the technical advice memorandum states that the purpose behind the section 501(a) exemption granted to u.s. pension funds is to encourage the development and use of private pension funds by u.s. employers so that their u.s. employees will not have to rely on public welfare after retirement for their support.5' in the case under consideration, in contrast, the pension fund's beneficiaries were primarily employees other than u.s. nationals or residents. because the social purposes served by domestic pension plans-to benefit u.s. workers-did not apply to a foreign pension fund benefiting primarily non-u.s. workers, the 46. compare irc § 2522(a) with irc § 2522(b) (relating to charitable gifts) and irc § 2055 with irc § 2106(a)(2) (relating to charitable bequests). 47. irc § 501(c)(3). a foreign charity may be subject to u.s. tax, however, on any unrelated business taxable income of the organization. see irc §§ 51 l(a), 512(a)(2). 48. 1977 oecd commentaries, supra note 4, art. 24. the coverage of cross-border charitable contributions in the u.s.-can. treaty may also indicate that the u.s. and its treaty partners acknowledge that the limitation on charitable donees is not violative of article 24. see u.s.-can. treaty, supra note 15, art. xxi(5). 49. i.r.s. t.a.m. 8030005 (mar. 28, 1980). 50. id. another issue was whether the permanent establishment nondiscrimination provision of article 24(3), which uses the term "same activities" could be broadened to include the "same circumstances" as in article 24(t). the service concluded, without analysis, that "same activities" means the same thing as "same circumstances." id. 51. id. [vol 1:2 treaty-based nondiscrimination dutch pension fund was held taxable.52 the ali has suggested that a taxing country should not be considered to be engaged in prohibited discrimination if its treatment of foreign treaty beneficiaries, or entities owned by them, is "reasonably comparable" to the treatment extended to resident taxpayers or entities owned by them. 53 similarly, the ali states that the fact that foreign taxpayers are subject to limited tax jurisdiction in the source country, and frequently have few (if any) assets located there, may justify differences in enforcement and collection mechanisms without introducing prohibited discrimination. nevertheless, the all suggests that no remedy should inhere under a nondiscrimination article unless the effect of the violation puts the person or entity at a substantively significant disadvantage in relation to domestic or domestically owned taxpayers. such differences are sometimes rationalized and referred to as "procedural" rather than "substantive" differences. "' but the use of a label, while convenient, does not necessarily provide insight into which distinctions in treatment are or should be permitted. c. which country comparison the internal revenue service has not always taken a consistent approach in determining what comparison is required under the nondiscrimination provision. article 24(1) of the 1981 u.s. model, for example, is susceptible of two interpretations. first, it can be interpreted as prohibiting the united states from imposing taxes on foreign citizens who reside in the united states which taxes are more burdensome than those imposed by the foreign country on u.s. citizens who reside in the foreign country. such a comparison might be referred to as a "foreign-tax jurisdiction" or "reciprocal" comparison. second, the 1981 u.s. model can be interpreted as prohibiting the united states from imposing more burdensome taxes on foreign citizens who reside in the united states than are imposed on resident u.s. citizens. such a comparison might be referred to as a "source-jurisdiction" comparison. in a ruling under the former (1941) u.s.-canada treaty, the internal revenue service determined that the source-jurisdiction comparison is the correct one and denied canadian citizens who were part-year united states residents the benefit of electing head-of-household or joint-filing tax 52. id. 53. see a.li. treaty project, supra note 5. at 255. 54. a.l.i. treaty project, supra note 5. at 256. 55. a.l.i. treaty project, supra note 5. at 256. 56. see e.g., a.l.i. treaty project, supra note 5. at 256 tidlespite the fact that substantive tax discrimination is to be determined by comparing [non-resident taxpayers with resident taxpayers], it is unavoidable that procedural differences ... %% ill be encountered."). 19921 florida tax review treatment.57 in the general counsel's memorandum associated with that ruling,58 the service relied on the technical memorandum of the treasury department on the u.s.-u.k. treaty (effective july 25, 1946) and the literal language of the canadian treaty." the general counsel memorandum stated that this interpretation is "consistent with the interpretation attributed to the nondiscrimination clauses incorporated into the 1943 mexican draft, the 1945 london draft, the o.e.e.c. drafts, and the [1963] o.e.c.d. draft of the model tax convention, '6° and noted that the united states "participated in the drafting of all of the above documents either on an official or unofficial basis.' also consistent with this view is article 24(1) of the 1981 u.s. model, which provides that a u.s. national who is not a resident of the united states is not in the same circumstances as a foreign national who is not a resident of the united states. similarly, the assistant treasury secretary for tax policy assumed that a source-jurisdiction comparison was relevant in responding to a recent protest by the confederation of british industry.62 apparently, the protest claimed discrimination in the application of the lookthrough rules of section 904(d)(3) of the code, dealing with the foreign tax credit (the "frc"). those rules permit look-through treatment for ftc purposes of certain amounts received (or deemed received) by a u.s. shareholder from a controlled foreign corporation. the code does not expressly permit such a look-through for payments received by a domestic subsidiary from its foreign parent corporation. the assistant secretary concluded that there was no discrimination against u.k.-owned u.s. corporations, since the concerns leading congress to adopt the look-through rules do not exist in the case of a foreign parent payor. according to the staff of the joint committee on taxation, as reflected in the general explanation to the tax reform act of 1986, there were four such concerns: (1) the availability of information from the payor necessary to enforce the rule; (2) the economic equivalence of the payor to a branch of the payee; (3) the economic equivalence of the payment to a dividend; and (4) the incentive to "strip earnings" out of the payor's jurisdiction by converting dividends to deductible payments. 63 however, the internal revenue service has not always taken the view that the source-jurisdiction comparison applies. in general counsel's 57. rev. rul. 74-239, 1974-1 c.b. 372. 58. westlaw, ftx-gcm database, elec. cit. g.c.m. 35518 (oct. 11, 1973). 59. id. at 2. 60. id. at 3. 61. id. 62. letter from fred t. goldberg, jr. to g.d. swaine (may 20, 1992), in 92 tax notes, highlights & documents 116-52 (june 4, 1992). 63. see staff of the joint comm. tax'n, general explanation of the tax reform act of 1986, 866-67, 888-91 (1987). [vol. 1:2 treaty-based nondiscrimtination memorandum 35444,6 interpreting the nondiscrimination provision of the u.s.-japan treaty on friendship, commerce and navigation, the issue was the application of section 367 of the code to the merger of two public japanese companies with branches operating in the united states. the taxpayer argued that the correct comparison was a merger of two u.s. corporations with japanese branches and the consequences of such a merger under u.s. income tax law-one sort of source-jurisdiction comparison. the service did not agree.6 1 it relied instead on a foreign tax-jurisdiction comparison, noting that there was no discrimination because if two u.s. corporations, each with a branch operating in japan, were to consummate a corporate merger, the transaction might well give rise to the imposition of a japanese tax.' thus, instead of comparing the treatment of u.s. and japanese entities under u.s. tax law, the service compared japanese taxpayers engaging in trade or business in the united states under u.s. law and u.s. taxpayers engaging in trade or business in japan under japanese law.67 so far, the federal courts have also adopted a source-country comparison. for example, the tax court recently rejected a claim of discrimination by a non-resident alien, resident of switzerland, who was married to a non-resident alien and who was required to pay u.s. income tax based upon his status as a married individual filing separately.' section 6013(a)(i) of the code denies joint returns to any individual whose spouse is a nonresident alien. the court reasoned that the swiss individual was not discriminated against because (1) he was treated the same as any other nonresident alien individual, and (2) even if he were a u.s. citizen he would be subject to the same filing status restriction if he were married to a nonresident alien.' d. generic vs. individual conparison another question is whether a required comparison is generic or specific? a generic comparison ignores the specific facts involved and looks instead to a hypothetical taxpayer and his or her potentially applicable facts and circumstances. although it is not clear, it seems that the internal revenue service applies the nondiscrimination provision on a generic basis. in 64. g.c.m. 35444 (aug. 17, 1973). 65. id, 66. id. 67. see id. in addition, the service argued that section 367 did not give rise to discriminatory tax treatment against japanese corporations because section 367 does not single out japanese corporations for more burdensome tax treatment than that applicable to taxpayers of any other (third) nation. 68. hofstetter v. comm'r, 98 t.c. no. 48 at 4981 (cch) (june 29, 19921. see irc § 6013(a)(1). 69. id. at 4984-85. 19921 florida tax review revenue ruling 74-239,7" the question was whether the nondiscrimination clause of a protocol to the 1941 u.s.-canada treaty prevented the united states from denying a canadian citizen, who was a dual-status taxpayer, the benefits of using the head of household tax rate tables, optional tax tables, standard deduction or joint return for federal income tax purposes. none of these provisions is applicable to a person who is a nonresident alien at any time during the year. the ruling concluded that a dual-status canadian citizen is not in similar circumstances to a u.s. citizen because "not all of his worldwide income is necessarily subjected to federal income tax."'" there was no discussion of whether the dual status taxpayer actually had income that was not subject to u.s. tax and the comparison was therefore generic. moreover, while any existing discrimination could have been solved by allowing the taxpayer to elect to include his worldwide income and be taxed as a resident, there was no discussion of that possibility.72 in watson v. hoey,73 the issue was whether, under a nondiscrimination treaty with ireland, the estate of a nonresident alien decedent was entitled to the same exemption granted both resident and nonresident citizens under the u.s. estate tax law. the exemption, if allowed, would have been sufficient to eliminate any u.s. estate tax liability. the court ruled against the estate, saying: in the present case, because of its size and the proportionate location of its assets here and abroad, the estate of the nonresident not a citizen pays a small tax, although a similar estate of a nonresident citizen would pay none. but taking it by and large, the 1934 revenue act did not unfairly discriminate against the nonresident not a citizen.74 thus, the comparison was generic and not specific. it would have been more in keeping with the intent of the treaty countries to have permitted an allocation of the exemption in accordance with the proportionate amount of assets situated in the united states as compared to the worldwide assets. this is the way that the unified credit, administrative expenses and deductions are now treated.75 70. rev. rul. 74-239, 1974-1 c.b. 372. 71. id. 72. the discrimination is now partially eliminated by article xxv of the current u.s.-can. treaty and is ameliorated by changes in the code. see u.s.-can. treaty, supra note 15, art. xxv; irc § 6013(g), (h). 73. 59 f. supp. 197 (s.d.n.y. 1943). 74. id. at 200 (emphasis added). 75. irc §§ 2102(c)(3)(a), 2106(a)(1); cf. u.s.-can. treaty, supra note 15, art. 24, para. 4. [vol 1:2 treaty-based nondiscrimination although these authorities generally take the generic approach, the wording of the nondiscrimination provision of article 24(1) of the 1981 u.s. model seems more appropriately to invoke an individual or specific analysis. moreover, requiring a taxpayer to prove the consequences to a class might impose much more substantial evidentiary and practical burdens on foreign taxpayers. such a burden may be insurmountable if the courts also adopt a standard of proof requiring the taxpayer to show that there is no possible set of facts under which the alleged discrimination would not reach "substantive" proportion. e. which nation's taxes? recently the code was amended to limit the interest deduction for "earnings-stripping" payments to related tax-exempt parties.7" the code provides that certain interest paid or accrued by a corporation to a related taxexempt party is not deductible. 7 the deduction is denied to the extent that the excess, if any, of the payor corporation's total interest expense over total interest income is greater than fifty percent of the corporation's adjusted taxable income.7' the interest is only disallowed where the payor corporation has a ratio of debt to equity as of the close of the taxable year exceeding one and one-half to one.79 a taxpayer is treated as tax exempt with respect to interest received if no tax is imposed by the united states with respect to such interest-go if a treaty between the united states and any foreign country reduces the u.s. tax rate imposed on interest that the taxpayer pays to a related person, the related person is treated as tax exempt, and the interest is treated as nondeductible, to the extent of the same proportion of such interest paid or accrued as the treaty's rate reduction from the thirty percent normal statutory rate bears to the thirty percent rate." subsequent to the introduction of the proposal in the house, a number of taxpayers' representatives contended that the provision violated the nondiscrimination provision of u.s. treaties82" the conference report answered that contention by stating: finally, some have argued that ... the house bill provision would violate treaties. the conferees believe that the conference agreement 76. irc § 163(j). 77. irc § 163(j)(1)(a). 78. irc § 163(j)(2)(b)(i). 79. irc § 163(j)(2)(a)(ii). 80. irc § 163(j)(3)(a). 81. irc § 163(j)(5)(b). 82. see h.r. conf. rep. no. 386, 101st cong.. ist ses. 568 (1989). 19921 florida tax review does not violate treaties. this belief is based on several factors. first, the conferees believe that because the provision treats similarly situated persons similarly, there is no discrimination under treaties. for this purpose the conferees believe that the determination of which persons are similarly situated is properly made by reference to the u.s. tax those persons do or do not bear on interest income from u.s. corporations." this is consistent with the view that payments leaving u.s. taxing jurisdictions may in appropriate circumstances, consistent with treaties, be subjected by the united states to tax that would not be imposed on a payment to a u.s. person. 4 the conferees' analysis is clearly correct in ignoring foreign taxes. under article 24 of the 1981 u.s. model, in determining whether an alien has been subject to more burdensome taxation by the united states, only u.s. taxes are considered. paragraph 1 of article 24 provides that a national of one state shall not be subjected to other or more burdensome taxation or connected requirements in the "other contracting state." paragraph 3 provides that the taxation on a permanent establishment of an enterprise of one state shall not be less favorably levied in that "other contracting state." paragraph 5 applies to foreign-controlled enterprises which shall not be subjected to discriminatory taxation in the state in which the enterprise is located. on the other hand, the interest restrictions in the earnings-stripping provision still seem to violate basic nondiscrimination principles, including the views expressed in the oecd commentaries and in the ali's recommendations that foreign taxpayers appropriately not be compared to domestic taxexempts. 85 f. interpretative guidance the 1981 u.s. model is not accompanied by commentaries. however there were commentaries for the 1977 oecd model on which the 1981 u.s. model is based. therefore, in the absence of any helpful language in the "legislative history" of the treaty under consideration, reference is commonly made to the oecd commentaries in interpreting language in u.s. treaties. however, as an initial matter, it is not clear whether it is appropriate to apply the oecd commentaries to u.s. treaties. while generally beyond the scope 83. reference to such views appears in the conference report. h.r. conf. rep. no. 386, 101st cong., 1st sess. 568 (1989). 84. id. the conference report further stated in a footnote as follows: "thus the provision makes no distinction between foreign lenders on the basis of whether or not their interest income is subject to tax in their residence country." id. at 568 n.4. 85. see supra text accompanying notes 41-48. [vol 1:2 trea v-based nondiscrimination of this article, many intriguing issues are raised by the question of the relevance of the oecd commentaries. assuming that the commentaries are relevant, one issue is whether there are limitations on the circumstances under which reference can be made to them-for example, must the treaty language be ambiguous? a second issue is whether it matters that the commentaries were written before, rather than after, the treaties being interpreted were agreed upon. 6 in united states v. a. l burbank & co.,s7 a rare u.s. case in which reference was made to the oecd commentaries, the second circuit relied on the commentaries from a later model convention to reinforce its decision on the exchange of information article of the earlier u.s.-canada treaty. a third issue is the weight to be given to the commentaries. perhaps the most useful reference in this difficult interpretative area is the vienna convention on the law of treaties,' which came into force on january 27, 1980, and which by its terms is applicable only to treaties concluded after that date. many countries, including the united states, have not adopted the vienna convention. nevertheless, its provisions dealing with the interpretation of treaties have been generally accepted by tax administrations, including that of the united states, and various courts, as a codification of customary international law. interpretation is dealt with in article 31 of the vienna convention, which sets forth the general rule, and article 32, which deals with supplementary means of interpretation.' article 31 provides as follows. general rule of interpretation 1. a treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in light of its object and purpose. 2. the context for the purpose of the interpretation of a treaty shall comprise, in addition to the text, including its preamble and annexes: (a) any agreement relating to the treaty which was made between all the parties in connection with the con86. see sidney i. roberts & peter a. glicklich, u.s. interprets netherlands-u.s. treaty by reference to later treaties with other nations, 34 can. tax j. 228 (1986). 87. 525 f.2d 9 (2d cir. 1975), cert. denied, 426 u.s. 934 (1976). the irs has also used the oecd commentaries in interpreting treaties on several occasions. see e.g.. rev. rul. 91-32, 1991-1 c.b. 107; rev. rul. 86-145, 1986-2 c.b. 297. 88. vienna convention on the law of treaties. may 23, 1969, 1155 u.n.t.s. 331 (entered into force jan. 27, 1980). 89. id. at arts. 31, 32. 19921 florida tax review clusion of the treaty; (b) any instrument which was made by one or more parties in connection with the conclusion of the treaty and accepted by the other parties as an instrument related to the treaty. 3. there shall be taken into account together with the context: (a) any subsequent agreement between the parties regarding the interpretation of the treaty or the application of its provisions; (b) any subsequent practice in the application of the treaty which establishes the agreement of the parties regarding its interpretation; (c) any relevant rules of international law applicable in the relations between the parties. 4. a special meaning shall be given to a term if it is established that the parties so intended. article 32 of the vienna convention provides: supplementary means of interpretation recourse may be had to supplementary means of interpretation, including the preparatory work of the treaty and the circumstances of its conclusion, in order to confirm the meaning resulting from the application of article 31, or to determine the meaning when the interpretation according to article 31: (a) leaves the meaning ambiguous or obscure; or (b) leads to a result which is manifestly absurd or unreasonable. as might be expected, paragraph 1 of article 31 emphasizes that the starting point in interpretation is the text of the treaty. the other items set forth in article 31 are considered to express the intention of the parties. the application of "supplementary means of interpretation" to determine meaning has a secondary role in the process of interpretation. a crucial issue, then, in determining the deference that should be given to oecd commentaries by the tax administrations or the courts in interpreting a bilateral tax treaty is whether the commentaries fall under article 31 or 32 of the vienna convention. [vol 1:2 treaty-based nondiscrimination it has been contended that the oecd commentaries fall under article 31(2)(b) of the vienna convention on the ground that they constitute an instrument made in connection with the conclusion of the treaty that was the result of joint discussions between member countries who were free to make observations and reservations." however, this position appears to be contrary to certain statements made in the 1977 oecd report, that the commentaries are not designed to be annexed in any manner to the conventions.9 these statements appear to deny that the oecd commentaries should be taken into account on the level of the "agreements" that are referred to in paragraphs 2, 3 and 4 of article 31 of the vienna convention.92 nor is there any indication that the national legislatures delegated to their oecd representatives the power to conclude a treaty that is on the same level as such other agreements. moreover, article 31(2)(b) of the vienna convention refers to an instrument made "in connection with the conclusion of the treaty," which appears to refer to a treaty made by the legislatures of the two countries that are parties to the bilateral tax treaty under consideration, not a model treaty. finally, the elevation of the oecd commentaries to article 31 of the vienna convention status would make them superior to the bilateral preparatory work in connection with a particular treaty, if any, since the latter is expressly included only under article 32. prior doctrine has generally fit the oecd commentaries under article 32;93 such doctrine cites judicial precedents that have relied upon the oecd commentaries but without clearly expressing a conclusion on the issue of whether they are applied under article 31 or article 32 of the vienna convention. 94 the vienna convention suggests the following issues in respect of the oecd commentaries: (1) do the oecd commentaries fall under article 31 (3)(a) (subsequent practice) or article 31(4) (special meaning)? 90. cornelius van raad, interpretation of tax conventions: interpretatie van belastingverdragen, m.b.b. 1978 no. 2/3, 49 (in translation). 91. oecd model double taxation convention on income and on capital, report of the oecd committee on fiscal affairs 14 (1977). 92. see also john f. avery jones et al., the interpretation of tax treaties with particular reference to article 3(2) of the oecd model (pts. i & i1). 1984 brit. tax rev. 1454 and 90-108, at 92-93 (1984). 93. id. at 100. 94. see sun life assurance co. of canada v. pearson, 1986 simon's tax cases 335 (ct. app. 1986), stating that "it is common ground that we are entitled to consider the commentary in determining the constitution of the treaty." id. at 347. see burbank. supra note 87. 19921 florida tax review (2) are they within article 32 ("preparatory work") but not article 31?9' (3) under what circumstances should the oecd commentaries be considered by a court, i.e., only under the conditions stated in article 32, or in any case to determine the "object and purpose" of the treaty under article 3 1(1)? (4) if the oecd commentaries may properly be considered by the courts under article 32 but not under article 31, are they entitled to lesser weight than if they were included under article 31? the ali similarly recommends that greater importance be given in interpreting treaties to bilateral materials, such as simultaneous or agreed upon technical memoranda, on the grounds that these documents will better reflect the understanding of both parties to the negotiations, while unilateral materials, such as statements by the treasury department or the internal revenue service, may reflect only one party's position. in addition, the ali contends that little or no weight should be given to oral or written statements made by individual treaty negotiators,7 or to post-ratification unilateral declarations, including interpretative rulings published in connection with pending disputes. even where prior to ratification one of the countries agrees with material published by the other country interpreting the treaty,98 the ali states that such material should not control where it is contrary to the express language of the treaty. 99 since the oecd commentaries have not been determined to be in the nature of legislative history in the united states, the use of the oecd commentaries to change the meaning of the otherwise plain language of a treaty is probably improper. however, the internal revenue service and treasury department have at least adopted certain views consistent with the oecd commentaries-the service believes, for example, that legal rather than factual similarity is required (for example, being taxed under the same regime). that interpretation leaves little room, as a practical matter, for article 24(1) to apply in the united states except to resident aliens. 95. cf. david a. ward, principles to be applied in interpreting tax treaties, xxv can. tax j. 263, 268 (1977). 96. a.l.i. treaty project, supra note 5, ii.b. 97. but see o'connor v. united states, 761 f.2d 688, 690-91 (fed. cir. 1985) (testimony of one negotiator seven years later), affd, 479 u.s. 27 (1986). 98. cf. treas. tech. expl. of can. treaty, art. i, 1987-2 c.b. 298 (example of interpretative material published by the united states). 99. a.l.i. treaty project, supra note 5, ii.b. [vol. 1:2 treaty-based nondiscrimination the foreign decisions interpreting tax treaties have reached mixed results on this issue. in a case in new zealand, a jurisdiction where nondiscrimination provisions are not favored, it was held that if the parties being compared are not taxed under the same regime, comparison cannot be made." ° a belgian case adopted the same view.'0 ' the french cour de cassation, however, adopted an opposite result'0 the case involved the annual three percent tax on french real estate owned by a corporation whose residence was outside of france. the provision was held to violate article 24(1) of the france-switzerland treaty. m. attitude of the u.s. to nondiscrimination concept as indicated above, the reaction of congress, the courts and the treasury department to an alleged violation of the nondiscrimination article of a u.s. treaty has been inconsistent. indeed, they often determine that allegations of nondiscrimination are unfounded. even if a claim is well founded, congress has been increasingly willing to mandate that new legislation apply, notwithstanding the treaty's general proscription of discrimination. such overrides have become a matter of contention with many of our treaty partners. section 7852(d) of the code was amended by the technical and miscellaneous revenue act of 198803 (the -1988 act") to provide that "[f]or purposes of determining the relationship between a provision of a treaty and any law of the united states affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law." the conference report accompanying the 1988 act states that this provision adds no operative rules but rather restates the constitutional principle that the "ordinary rules of interpreting the interactions of statutes and treaties" apply."° the statute could be read to continue the generally accepted interpretation that treaties are not overridden unless congress expressly indicates its intention to do so. thus, if a treaty obligation has not been expressly 100. commissioner of inland revenue v. united dominions trust ltd., 1 n.z.t.c. 61,028 (1973). 101. cour de cassation (june 30, 1988). revue generale de la fiscalite 1989 no. 2 p. 42. 102. cour de cassation (no. 328p, 392d, 330) (feb. 28, 1989). the case is discussed in 29 european taxation at 285 (1989). an attempted legislative reversal of the decision was rejected by the court. cour de cassation (no. 922p) (dec. 21, 1990). see 31 european taxation at 315 (1991). 103. technical and miscellaneous revenue act of 1988, pub. l. no. 100-647. § 1012(aa)(1)(a), 102 stat. 3342, 3531. 104. h.r. conf. rep. no. 1104, 100th cong., 2d sess. 12-13 (1988). 19921 florida tax review "superseded" for internal u.s. law purposes, under section 7852(d)(1) taxpayers and the service can continue to look beyond the code to determine the proper tax treatment of an item.'0 5 despite this legislative language, the tax court recently suggested, in dictum, that section 7852(d)(1) codified a later-in-time rule. the tax court's decision was dictum because the issue in dispute, application of the ninety-percent foreign tax credit limitation in the alternative minimum tax, was specifically addressed by congress in 1988. congress enacted a "technical" provision stating that the ninety-percent limitation would apply notwithstanding an existing treaty. therefore, the tax court did not specifically address the nondiscrimination argument invoked by a u.s. citizen living and working in switzerland.1" a. testing the limits of "procedural" discrimination 1. denial of deductions.-consider the treasury department's regulations pursuant to sections 882(c)(2)'17 and 874(a)'0 8 of the code. these provisions allow deductions and credits to foreign corporations and nonresident alien individuals only if they file u.s. tax returns.0 9 the regulations vastly expand this limitation by denying deductions and credits altogether if u.s. returns are not filed "timely."" 0 according to the preamble to the regulations, this timely filing requirement is justified by the different administrative and compliance concerns relating solely to foreign corporations and non-resident alien individuals."' however, article vii(3) of the u.s.-canada treaty, which is typical of u.s. treaties in this respect, provides that, "[in determining the business profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment...." in addition, article xxv(6) of the u.s.-canada treaty, like the 1981 u.s. model, provides that "the taxation on a permanent establishment which a resident of a contracting state has in the other contracting state shall not be less favorably levied in the other state than the taxation levied on residents of the other state carrying on the same activities." several writers have suggested that the regulations, as applicable to canadian taxpayers, violate the 105. id. 106. lindsey v. commissioner, 98 t.c. no. 46 (1992). 107. treas. reg. § 1.882-4(a)(2) and (3). 108. treas. reg. § 1.874-1(a), (b)(1)-(4). 109. treas. reg. § 1.882-4(a)(2); treas. reg. § 1.874-1(a). 110. the regulations set forth a novel concept of timely filing, which in no case is the actual deadline for filing returns without penalty for late filing. see t.d. 8322, 1990-2 c.b. 172. 111. id. [val. 1:2 treaty-based nondiscrinzation u.s.-canada treaty. 112 however, one writer has stated: the ... claim for treaty relief is under the nondiscrimination provisions of article xxv(6) of the canada-u.s. treaty. the longstanding position of the us government (and, i believe, all other governments) is that some differences in the procedural rules applicable to domestic and foreign taxpayers are consistent with the nondiscrimination clause of treaties. those differences must be justified, however, by the differences in the circumstances of the domestic and foreign taxpayers. the position of the us tax authorities is that assessing and collecting taxes from foreign taxpayers present special problems that justify special procedural rules. i think it highly likely that an american court would hold that those special problems justify the timely filing rule of the regulations under code sections 874(a) and 882(c)(2). any other interpretation would call into question the validity of denying deductions to foreigners under any circumstances." that writer also speculated about the motives of the u.s. tax authorities: [t]he new regulations are a logical complement to the us strategy of forcing foreign taxpayers engaged in economic activities within the united states to either make a formal claim of treaty protection under the new provisions of code section 6114 or to file a tax return. by filing a tax return, a foreign person provides the irs with information that should be helpful to it in determining whether an audit is likely to result in a revenue gain for the government. foreign taxpayers who fail to file become very attractive audit targets-the irs can be pretty sure that it will be able to recoup the costs of an audit in most cases by denying the foreign person otherwise allowable deductions."4 the regulations under section 882(c) of the code test the limits of the 112. comments on proposed regulations under code sections 874(a) and 882(cj(2) regarding the untimely filing of income tax returns by nonresident alien individuals and foreign corporation, a.b.a. tax sec. (may 25, 1990); iunda ng, u.s. treasury denies canadian late filers their deductions and credits. 39 can. tax j. 429 (1991). 113. michael j. mcintyre, correspondence, 39 can. tax j. 1129-30 (1991). 114. id. at 1130. 19921 florida tax review commonly accepted distinction between procedural (permitted) discrimination and substantive (prohibited) discrimination. by denying foreign filers their deductions and credits when they fail to file timely returns, the regulations effectively prescribe a new and more onerous method of computing their taxable income. thus, it appears, the regulations discriminate not only "procedurally," but also substantively. this conclusion is supported by the oecd commentaries, as well. permanent establishments must be accorded the same right as resident enterprises to deduct the trading expenses that are, in general, authorized by the taxation law to be deducted from taxable profits.... such deductions should be allowed without any restrictions other than those also imposed upon resident enterprises." 5 what if the united states merely imposed a higher rate of interest on the tax deficiency of all foreign corporations with u.s. permanent establishments? article 24(3) of the 1981 u.s. model states that "[t]he taxation on a permanent establishment which an enterprise of a contracting state has in the other contracting state shall not be less favorably levied in that other state than the taxation levied on enterprises of that other state carrying on the same activities." '" 6 in addition, article 24(1) of the 1981 u.s. model provides that "[n]ationals of a contracting state shall not be subjected in the other contracting state to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which nationals of that other state in the same circumstances are or may be subjected."'" 7 would these provisions prevent the united states from adopting a provision that increased the interest rate on any deficiency of a foreign corporation to twice that applicable to a u.s. taxpayer? such a rule might be justified on the basis that it is more difficult and timeconsuming for the internal revenue service to audit the tax returns of a permanent establishment of a foreign enterprise in the united states than it is to audit the returns of a u.s. corporation. arguably, the interest charge is not taxation "less favorable," nor the imposition of any requirement which is "other or more burdensome" than those applicable to a u.s. taxpayer, given the different audit circumstances. similar questions arise under the penalty provisions applicable to information reporting under sections 6038a and 6038c of the code. both 115. 1977 oecd commentaries, supra note 4, art. 24, para. 26(a) (emphasis added). 116. see 1981 u.s. model, supra note 7, art. 24, para. 3 (emphasis added). 117. see id. at para. 1 (emphasis added). [vol 1:2 treaty-based nondiscriminaion sections require information reporting, one from twenty-five percent foreignowned domestic corporations and the other from foreign corporations engaged in a u.s. trade or business." 8 if the taxpayer fails to supply adequate information at the audit stage to support its treatment of intercompany transactions, the proper treatment is determined by the internal revenue service in its sole discretion." 9 the legislative history of the provisions emphasizes that a court is not to overturn the service's decision except in rare circumstances.12° while the treasury department contends that these rules are similar to those applicable to u.s. taxpayers, 2 ' it seems clear that they are not similar. in an intercompany pricing case, for example, all taxpayers have the burden of proving that the service acted arbitrarily in asserting a deficiency,"2 yet taxpayers to whom sections 6038a and 6038c apply appear to have fewer rights, since the service's determination is apparently given greater weight. these sections, although arguably justifiable on the grounds of "procedural" needs of enforcement, clearly impose more burdens on foreignowned u.s. corporations and on foreign corporations engaged in a u.s. trade of business. as such, they appear to violate one or more of the typical treaty nondiscrimination provisions. perhaps all taxpayers should be forced to supply information at the audit stage or be prevented from introducing it into court. the problem is not unique to foreign taxpayers. without admitting any nondiscrimination problems, the service provided in the section 6038a final regulations that it will first seek to obtain information under treaty information exchange provisions before invoking penalties under section 6038a.'22. additional record keeping and information reporting.-is it discriminatory to require more information reporting or different record keeping requirements for foreign taxpayers or foreign-controlled domestic enterprises? article 24(5) of the 1981 u.s. model prohibits, with respect to foreign owned or controlled u.s. enterprises, "taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which" a domestic corporation controlled by domestic taxpayers is or may be subjected. 118. irc §§ 6038a(a), 6038c(a). 119. irc §§ 6038a(e)(3), 6038c(d)(3). 120. see h.r. conf. rep. no. 386, 101st cong.. 1st sess. 594-95 (1989). reprinted in 1989 u.s.c.c.a.n. 3197-98. 121. t.d. 8353, 1991-2 c.b. 402, 404. 122. see g.d. searle & co. v. commissioner, 88 t.c. 252. 358 (1987). foster v. commissioner, 80 t.c. 34, 143 (1983), modified on other grounds. 756 f.2d 1430 (1985). cert. denied, 474 u.s. 1055 (1986). 123. treas. reg. § 1.6038a-6(b) (1991): see preamble to regs. § 6038a. 1991-2 c.b. 402, 405. 19921 florida tax review section 6038a of the code generally requires reporting corporations to report transactions with foreign related parties. since u.s. corporations with u.s. owners do not report their intercompany dealings on separate information returns, or by separate lines of business, as section 6038a requires, this provision arguably is discriminatory. in the preamble to the final regulations under section 6038a, the treasury department stated that in view of the possible application of the nondiscrimination articles in many treaties, it was amending the proposed regulations to make them no more burdensome than the reporting requirements imposed on u.s. owners of foreign corporations.124 the comparison may be justifiable but it is not technically the comparison called for by article 24(5) of the 1981 u.s. model. nor is it clear that the claim of no more burden is factually correct. congress apparently did not believe that the reporting requirements of section 6038a were discriminatory because the purpose of the provision was to impose "equivalent reporting obligations on u.s. corporations irrespective of capital ownership, while recognizing the unique tax administration problems" presented by the foreign ownership of such corporations.'25 in any event, the congressional reports state that if the new requirements do conflict with any nondiscrimination provisions, the statute overrides the treaty. 1 26 state reporting and record keeping requirements have also recently provoked claims under the nondiscrimination provision of treaties. one such claim arose under new york law. new york state, like many other states, imposes its corporate tax on an allocable portion of the worldwide income of the corporation. the allocation method is based upon a typical three-factor formula: property, net sales and payroll. in reuters, ltd. v. tax appeals tribunal,27 reuters, operating as a branch of a u.k. corporation, recently claimed that the state of new york had violated the nondiscrimination provision of the u.s.-u.k. treaty, as well as the foreign commerce clause of the constitution, by adopting reporting and record keeping requirements that were more burdensome for a foreign taxpayer than for a domestic taxpayer. in part, the taxpayer noted that currency fluctuation made its cost of compliance much greater. indeed, although unsuccessful, reuters argued that the cost of compliance for an alien taxpayer outweighed the advantages to new york of 124. see chief counsel directive manual transmittal (42)910 (sept. 12, 1991), reprinted in bna daily tax report (nov. 19, 1991) at l-l; irs official says section 6038a procedures to ensure uniform, judicious application, bna daily tax report (dec. 9, 1991) at g11; treasury and irs said to be aware of concerns over new recordkeeping rules, bna daily tax report (sept. 19, 1990) at g-4. 125. see h.r. conf. rep. no. 247, 101st cong., 1st sess. 1301-02 (1989). 126. id. 127. reuters ltd. v. tax appeals tribunal, 584 n.y.s. 2d 932 (a.d. 3 dept. 1992). [vol 1:2 treaty-based nondiscrinination complying.y 3. statute of linitations.-the difficulty of auditing foreign transactions led to a 1990 legislative proposal that would have permitted the internal revenue service to extend the normal three-year statute of limitations to six years for foreign corporations or domestic corporations with twenty-five percent foreign shareholders, where the service determined that the taxpayer prevented a timely audit of its transactions by delay or other actions.', the proposal was criticized as violating the nondiscrimination article in typical u.s. income tax treaties. 13 article 24(5) of the 1981 u.s. model protects foreign-owned u.s. corporations from "any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements" to which other similar enterprises of the united states are or may be subjected,' 31 and article 24(3) mandates no less favorable levies on a permanent establishment of an enterprise of the treaty country than those on a domestic enterprise carrying on the same activities. since a statute of limitations does not itself impose a tax, the issue is whether it is a "requirement" or "connected requirement" that is more burdensome under article 24(5) or results in a less favorable levy under article 24(3). one commentator believes it is not more burdensome under article 24(5).132 the authors believe that such a provision could be discriminatory in certain cases, depending on how the provision is implemented. 128. reuters estimated its additional accounting at si.000,000 a year. it is not clear whether reuters introduced evidence of the compliance costs forced by domestic corporations with similar worldwide corporations. of interest, the new york court stated that the relevant comparison under the treaty's nondiscrimination provision dealing with permanent establishments is between a united kingdom corporation and a domestic corporation each conducting the same worldwide business through branches, rather than (as reuters had argued) a new york branch of the united kingdom corporation and a new york corporation conducting only the branch's activities. the court also stated that, like a domestic corporation, a united kingdom corporation could have elected to operate in new york through a separate subsidiary rather than a branch. approximately one week after the new york court's decision. however, the u.s. supreme court, in kraft general foods inc.. 112 s.ct. 2365, overturned on foreign commerce clause grounds iowa's denial of a dividends received deduction for dividends received from a foreign subsidiary. 129. h.r. 4308, 101st cong., 2d sess. (1990). 130. see task force of a.b.a. comm. on u.s. activities of foreigners and tax treaties, aba comments on the foreign tax equity act of 1990 (h.r. 4308 & s. 2410). 19 tax mgml int'l j. 503, 504 (1990); note verbale from the delegation of the commission of european communities and the embassy of ireland to the u.s. department of state, in highlights and documents, aug. 14, 1990, at 1757-58. 131. 1981 u.s. model, supra note 7. art. 24. para. 5. 132. see michael j. mcintyre, happiness deferred-extending the statute of limitations for taxpayers with complex returns, tax notes lnt'l 1019, 1020 (october 1990). 19921 florida tax review 4. advance rulings.-an interesting general counsel's memorandum, 133 which is discussed above, 34 considers whether an early version of section 367 was discriminatory as applied to foreign corporations engaged in a u.s. trade or business. at the time of the transaction in question, in determining the extent to which gain was required to be recognized in a corporate reorganization, section 367 provided that a foreign corporation would not be considered a corporation unless prior to the transaction it was established to the satisfaction of the internal revenue service that the transaction was not pursuant to a plan having as one of its principal purposes the avoidance of u.s. income tax. the transaction involved the merger of two japanese corporations, each with a branch in the united states. the treaty involved was the treaty of friendship, commerce, and navigation between the united states and japan, effective october 30, 1953.135 the general counsel's memorandum concluded that the nondiscrimination provision was inapplicable. it said that the internal revenue service was not aware of any situation in which the application of an administrative provision, adopted for the purpose of administrating a country's revenue acts, was viewed as in conflict with a treaty nondiscrimination clause. 36 if discrimination existed solely for administrative reasons, the general counsel's memorandum considered it acceptable. moreover, the general counsel did not consider this the type of provision encompassed by the phrase "requirements with respect to levy and collection" in the friendship, commerce, and navigation treaty. that phrase, the general counsel's memorandum concluded, was intended to cover such matters as statutory restrictions on the assessment and collection of tax, the issuance of statutory notices of deficiency, the payment of interest on overpayments, the right to sue for refunds of tax and the right to petition the tax court. the general counsel's memorandum also stated: "there is no indication that the respective parties to the treaty had any intention to contractually modify the application of a longstanding provision so essential to the administration of the revenue laws of the united states as code section 367 (or its counterpart in prior revenue acts)." 1 37 yet, both the ali's138 and ordinary methods of treaty interpreta133. g.c.m. 35444 (aug. 21, 1973). 134. see supra text accompanying notes 64-67. 135. the income tax convention with japan was signed two years later, in 1955, and did not include a nondiscrimination provision. in gcm 35444 the service initially considered whether the income tax convention had implicitly repealed the nondiscrimination provision in the treaty of friendship, commerce, and navigation. g.c.m. 35444, supra note 133. although there was apparently some internal disagreement within the service, the chief counsel ultimately concluded that the nondiscrimination provision survived. g.c.m. 35444, supra note 133. 136. g.c.m. 35444, supra note 133. 137. g.c.m. 35444, supra note 133. [vol 1:2 treaty-based nondiscrimination tion would suggest that modification of the application of section 367 could well be required by a later-enacted treaty. b. withholding taxes generally, a withholding tax on a gross basis has been accepted as a surrogate for a tax computed on a net income basis where the taxpayer is not engaged in business or has no permanent establishment in the source country or if the income is not effectively connected or attributable to that trade or business or permanent establishment. this approach generally applied in the united states during years in which the tax rate on net income was much higher than it is today; but tax rates on net income for individuals are now generally below thirty percent and there seems little or no rationale for retaining the withholding rate at thirty percent. however, treaties reduce most withholding rates to at least fifteen percent, and such a reduced rate may still be justified as a surrogate for taxation on a net basis, except perhaps in lowmargin industries like financial institutions. in order to be nondiscriminatory, the premise must be that the income being withheld upon has a high content of net income because any related expenses are not significant.' where this is not true, then, a withholding on gross income could well be discriminatory. for example, it is recognized that normally rental income does not contain a high degree of net income. older treaties compensated for this by permitting a foreign taxpayer to elect to be taxed on a net basis. similarly, royalty income from intangibles is permitted an offset for basis adjustments when treated as a sale for contingent payments. otherwise, deductions attributable to royalty income from intangibles, such as royalties paid, are ignored. interest is a much more troublesome area. it is not unusual for the recipient of interest to have offsetting interest payments on borrowings that are not taken into account for withholding purposes. a potential solution to this problem would be to permit foreign taxpayers to elect to be taxed on a net basis if they file worldwide income returns and prove their deductions. prior to 1936, foreign taxpayers were permitted to elect to be taxed on a net income basis in the united states."' the problems with this alternative include enforcement concerns and similar administrative matters. enforcement may not really be a problem, however, since withholding on gross income would always be available as a "backup" enforcement mechanism. administrative matters, like auditing foreign deductions, could also be a problem. 138. see supra note 24 and accompanying text. 139. but see rev. rul. 89-91, 1989-2 c.b. 129. modifying rev. rul. 80-222, 1982-2 c.b. 211. 140. see revenue act of 1934, § 214(a). 19921 florida tax review such matters presumably could be resolved since the united states can obtain information from the taxpayer's treaty country under the treaty and such countries generally impose tax at comparable rates. the ali apparently believes that there is no discrimination in cases of withholding taxes since the more narrow withholding issue has been specifically dealt with by parties to the treaty in establishing withholding rates.14' in general, this conclusion may be correct, but changes in u.s. domestic rates make the argument seem weaker. in addition, if discrimination is tested using a specific-taxpayer's facts, the conclusion may be questioned in many cases. finally, since the discrimination here is based on residence and not nationality, there may be no discrimination under article 24(1). a more detailed analysis of that provision and the other provisions of the nondiscrimination article of the 1981 u.s. model follows. iv. the nationality provision article 24(1) of the 1981 u.s. model provides: nationals of a contracting state shall not be subjected in the other contracting state to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which nationals of that other state in the same circumstances are or may be subjected. this provision shall apply to persons who are not residents of one or both of the contracting states. however, for the purposes of united states tax, a united states national who is not a resident of the united states and a ... national who is not a resident of the united states are not in the same circumstances. 142 a. personal scope article 24(1) of the 1981 u.s. model provides nondiscrimination protection to "nationals of a contracting state." from the united states' perspective, "nationals" means citizens whether or not they are resident in the contracting state in which they have citizenship.'43 although the 1981 u.s. model would limit this provision to individuals, 144 the 1977 oecd model and most of the actual u.s. treaties extend this provision to "all legal persons, 141. a.l.i. treaty project, supra note 5, i.a.3 and iii, at 257, 263. 142. 1981 u.s. model, supra note 7, art. 24, para. 1. 143. id. cf. u.s.-can. treaty, supra note 15 (utilizing a most favored nation comparison for nonresident citizens). 144. 1981 u.s. model, supra note 7, art. 24, para. 2(b). [vol. 1:2 treatv-based nondiscrinmination partnerships and associations deriving their status as such from the laws in force in a contracting state."'45 the failure to define "partnership" or to limit the definition raises the issue whether a partnership, some or all of whose partners are not residents of the united states for tax purposes, or a trust or estate, some or all of whose beneficiaries are not subject to u.s. tax, is covered by this provision. normally, the question would be answered by article 4 of the 1981 u.s. model, which states: in the case of income derived or paid by a partnership, estate, or trust, this term ["resident"] applies only to the extent that the income derived by such partnership, estate, or trust is subject to tax in that state as the income of a resident, either in its hands or in the hands of its partners or beneficiaries. 46 however, the term employed in the nondiscrimination provision of the 1981 u.s. model is "national" not "resident." under civil law a partnership is generally considered a legal person and would presumably be considered a national; but under common law it is not considered a legal person. although the united states is a common law jurisdiction, the treatment of partnerships in the united states is not presently clear. early drafts of the uniform partnership act treated a partnership as a legal person: "a partnership is a legal person formed by the association of two or more individuals for the purpose of carrying on a business with a view to profit."' 47 however, after the death of the chief draftsman of the uniform partnership act, his successors eliminated the reference to a legal person and left the law unclear." s in unger v. conunissioner,"' involving whether a canadian limited partner in a u.s. partnership had a permanent establishment in the united states, the tax court responded as follows to the canadian taxpayer's argument that the "modem theory" of a partnership was to treat it as a legal entity: the interpretation of the law of partnership which petitioner alleges is more 'modem' is not a recently evolved 145. 1977 oecd model, supra note 4, art. 24, para. 2(b). 146. 1981 u.s. model, supra note 7, art. 4, para. i(b). 147. cf. unif. partnership act § 1(i) (2d tent. draft 1909). 148. see generally i alan r. bromberg & larry e. ribstein, bromberg and ribstein on partnership § 1.03 (1991). 149. 58 t.c.m. (cch) 1157, 1160, t.c.m. (p-h) 1 90.015 (1990). 19921 florida tax review interpretation. rather it is merely a competing view which places more emphasis on the entity theory of partnership than on the aggregate theory of partnership. the entity theory holds the nature of a partnership to be such that the partnership is a distinct legal entity separate from its partners. the aggregate theory on the other hand considers the partners of a partnership as not forming a collective whole. rather the partnership is viewed as merely an aggregate of the individual partners of which it is comprised. a resolution of the dispute concerning whether the entity theory or aggregate theory of partnership should be applied for all purposes has not been reached. the character attributed to a partnership varies from case to case, sometimes even within jurisdictions, often depending on the issue to be decided. 5 ' even if a u.s. partnership composed of all nonresident alien partners was a "national" of the united states, since a partnership is not subject to tax, the application of the nondiscrimination provision to it would be limited to the "connected requirements." nevertheless, the u.s. taxation of a treatycountry national who is a partner may still be subject to nondiscrimination protection under a treaty corresponding to the 1981 u.s. model if the aggregate theory of partnerships is applied for this purpose. it would seem that a trust created under u.s. law will not qualify as a national, since, even though it derives its status as such from the law in force in the united states, it is not a "legal person." both scott'' and the second restatement of the law of trusts 52 state that a trust is a legal "relationship." article 2 of the hague convention on the law applicable to trusts and on their recognition'53 also defines a trust as a legal relationship but attributes to it the following characteristics: a. the assets constitute a separate fund and are not a part of the trustee's own estate; b. title to the trust assets stands in the name of the trustee; and c. the trustee has the power and the duty, in respect of 150. id. 151. 1 austin w. scott & william f. fratcher, the law of trusts § 2.4 (4th ed. 1987). 152. restatement (second) of the law of trusts § 2 (1957). 153. convention on the law applicable to trusts and on their recognition, oct. 20, 1984, art. 2, 23 i.l.m. 1388, 1389. [vol. 1:2 treaty-based nondiscrimination which he is accountable, to manage, employ or dispose of the assets in accordance with the terms of the trust and the special duties imposed upon him by iaw. 154 article 11 of the hague convention on trusts states that "[such recognition shall imply, as a minimum, that the trust property constitutes a separate fund, that the trustee may sue and be sued in his capacity as trustee, and that he may appear or act in this capacity before a notary or any person acting in an official capacity."'55 thus, it is not clear that a trust will be treated as a "national" under any u.s. treaty. b. application of the savings provision every u.s. income tax treaty reserves to the united states, in a "savings" provision, the power to tax its citizens and residents as if the treaty had not come into effect. if the same reservation were applied to the nondiscrimination article, however, there would be very little room, if any, for the nationality provision to apply to a non-united states national, resident in the united states, since by its terms the savings provision is to be applied to such persons. section 911 of the internal revenue code of 1954 granted an exemption from u.s. tax for personal service income earned outside the united states by a citizen of the united states. aliens, although resident in the united states, were not eligible for the foreign earned income exclusion. after concluding that the savings article was not applicable, the internal revenue service has determined that resident aliens were in similar circumstances to u.s. citizens, since they were both taxed on their worldwide income, and that section 911 resulted in more burdensome taxation on resident aliens than on u.s. citizens.'56 section 911 has subsequently been modified to cover both resident aliens and u.s. citizens. significantly, however, this appears to be one of the only instances in which the internal revenue service (as distinguished from the treasury department) has determined that a statute adopted by congress violated the nondiscrimination article. 1 57 154. id. 155. id. art. 11, 23 i.l.m. at 1390 (emphasis added). 156. rev. rul. 72-330, 1972-2 c.b. 444, amplified by rev. rul. 72-598, 1972-2 c.b. 451, declared obsolete, rev. rul. 91-58, 1991-2 c.b. 340. 157. see the discussion of treasury department regulations under the branch profits tax at text accompanying notes 192-215 infra. the ali also considered certain private rulings under the foreign insurance company excise tax to illustrate the irs's recognition of potentially discriminatory treatment. a.li.. 19921 florida tax review c. derivation of status under the laws of a number of foreign countries, a corporation is treated as domiciled in the country in which its management is located. a corporation could be incorporated in country x and managed and controlled in country y. it is not clear whether a treaty which contains the 1977 oecd model "all legal persons" language will treat such a corporation as a national of the country in which it is incorporated, the country in which it is managed and controlled, or both. the latter interpretation could prove quite interesting, as it results in multiple comparisons for purposes of determining discrimination. d. "in the same circumstances" a more important and more often disputed question is the meaning of the phrase "in the same circumstances" in article 24(1) of the 1981 u.s. model and of similar language in the 1977 oecd model.'58 little guidance is given in the treaties or in the u.s. treasury department's technical explanations accompanying them. in fact, the only interpretative assistance in article 24(1) of the 1981 u.s. model relates to the meaning of "national." in this case, since the united states taxes its citizens on their worldwide income irrespective of their residence while other countries do not, the united states added to the 1977 oecd model the following language: "a united states national who is not a resident of the united states and a ... national who is not a resident of the united states are not in the same circumstances."'5 9 this limits the comparison under the 1981 u.s. model to one between resident citizens and resident aliens and eliminates the comparison of nonresident citizens with nonresident aliens. the phrase "in the same circumstances" would appear to mean the same factual circumstances, since the question being addressed is whether the situations are treated the same under the law. thus, "in the same circumstances" should be thought of as referring to situations in which all of the facts are identical except for the difference that is being tested, for example, resident versus nonresident, permanent establishment versus domestic corporation. the oecd commentaries state that "it]he expression 'in the same circumstances' refers to taxpayers (individuals, legal persons, partnerships and associations) placed, from the point of view of the application of the ordinary taxation laws and regulations, in substantially similar circumstances both in treaty project, supra note 5, at 255. 158. see 1981 u.s. model, supra note 7, art. 24, para. 1; 1977 oecd model, supra note 4, art. 24, para. 1. 159. 1981 u.s. model, supra note 7, art. 24, para. 1. [vol 1:2 treaty-based nondiscrinination law and in fac"' 160 it is not clear what was intended by the language "substantially similar circumstances both in law and in fact." webster's third new international dictionary defines "similar" as "having characteristics in common: very much alike: ... alike in substance or essentials."' 6' similar circumstances in fact would appear to mean that slight differences in fact, for example, married versus unmarried taxpayers, should be ignored. similar circumstances in law is a more difficult concept. if the factor that is being contested is the basis for alleged discrimination, then that factor alone should not be determinative, yet some questions that seem factual, such as residence, may really be mixed questions of fact and law. perhaps that is what the oecd commentaries mean here. in the other paragraphs of article 24 of the 1981 u.s. model, the language appears less susceptible to interpretative difficulty. in paragraph 3 of article 24 (paragraph 4 of article 24 of the 1977 oecd model), for example, the phrase used is "same activities" of a permanent establishment. paragraph 5 of the 1981 u.s. model (paragraph 6 of the 1977 oecd model) uses the phrase "similar enterprises" which is widely read to mean ownership of a domestic subsidiary. similarly, paragraph 4 of the 1981 u.s. model (paragraph 5 of the 1977 oecd model) uses the phrase "same conditions" when referring to deductions permitted to an enterprise of the other state. o'brien 62 and van raad' 6would adopt a strict interpretation, giving meaning to use of the term "same circumstances" in the treaty provision. it is possible that the united states may have taken this view when it did not agree that a u.s. citizen who is taxable on his or her worldwide income is the same as a nonresident non-u.s. citizen who is taxable in the united states only on his effectively connected income and certain gross income from u.s. sources." on the other hand, the united states could have accepted a more liberal view of "in the same circumstances" and still have reached that conclusion. indeed, as discussed further below, the internal revenue service appears to treat "in the same circumstances," in article 160. 1977 oecd commentaries, supra note 4, art. 24, para. i at 3 (emphasis added). 161. webster's third new international dictionary 2120 (1986) (unabridged). 162. see generally o'brien, supra note 3. 163. see generally van raad, nondiscrimination and international tax law (1986). 164. 1981 u.s. model, supra note 7, art. 24, para. 1. perhaps the following, even broader, language of the australian and new zealand treaties should be adopted by the united states. without limiting by implication the interpretation of this article, it is hereby declared that, except to the extent expressly so provided, nothing in the article prevents a contracting state from distinguishing in its taxation laws between residents and nonresidents solely on the ground of their residence. u.s.-austl. treaty, art. 23, para. 3. see also u.s.-n.z. treaty, art. 23, para. 6. 1992] florida tax review 24(1) and carrying on "the same activities" in article 24(3) of the 1981 u.s. model as having the same meaning. v. taxation of a permanent establishment paragraph 3 of article 24 of the 1981 u.s. model (paragraph 4 of the 1977 oecd model) protects domestic permanent establishments of foreign enterprises as follows: the taxation on a permanent establishment which an enterprise of a contracting state has in the other contracting state shall not be less favorably levied in that other state than the taxation levied on enterprises of that other state carrying on the same activities. this provision shall not be construed as obliging a contracting state to grant to residents of the other contracting state any personal allowances, relief, and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents.'65 as explained above, paragraphs 1 and 2 of article 24 of the 1977 oecd model, and of those u.s. treaties that adopt the 1977 oecd model, pertaining to nondiscrimination with respect to "nationals" of a contracting state apply to both individuals and legal persons. to the extent that these nationals have a permanent establishment in the united states, it would appear that there is an overlap: both the provision applicable to individuals and legal persons and the provision protecting permanent establishments may apply simultaneously. even in the case of the 1981 u.s. model, where a "national" can only be an individual, both the "national" and "permanent establishment" provisions can apply simultaneously to individuals. the interpretative issues that arise in other cases under the permanent establishment provision are more serious and they generally involve greater amounts of tax. a. "enterprise" the term "permanent establishment" is defined under article 5 of both the 1981 u.s. model and 1977 oecd model. the term "enterprise," although contained in all of the u.s. treaties for many years, is not defined. in the absence of a treaty definition of the term "enterprise," the meaning 165. 1981 u.s. model, supra note 7, art. 24, para. 3; 1977 oecd model, supra note 4, art. 24, para. 4. [vol 1:2 treaty-based nondiscrimination would normally be determined under domestic law," 6 but it is not a term frequently used in the united states. recently, the united states sought to give the term content in its treaties. for example, in explaining article 3 of the u.s.-china treaty, which defines an enterprise of a country as an enterprise carried on by a resident of that country, the senate report added, "[a]lthough the treaty does not define the term 'enterprise,' it will have the same meaning that it has in other u.s. tax treaties-the trade or business activities undertaken by an individual, company, partnership, or other entity."167 in contrast, however, the technical explanation of the u.s.-spain treaty states that it is understood that most activities carried on by individuals will be covered by the independent and dependent personal service provisions and will not be considered an "enterprise" except where the trade or business involves the risk of capital. b. personal allowance both the 1981 u.s. model and the 1977 oecd model provide that the contracting states are not required to grant the personal allowances or credits that they grant to their own residents to reflect differing family responsibilities. this provision is applicable to those situations where an individual is maintaining a permanent establishment, such as a sole proprietorship utilizing capital. c. carrying on the same activities paragraph 4 of article 24 of the 1977 oecd model and paragraph 3 of article 24 of the 1981 u.s. model determine discrimination by comparing the taxation of a permanent establishment in a contracting state with the taxation levied on an enterprise of that state, such as a domestic corporation, carrying on the same activities.'" s the comparison is a source-jurisdiction comparison: comparing a permanent establishment in the united states of a foreign enterprise with a u.s. corporation carrying on the same activities also in the united states. 69 but is it meant to compare, for purposes of the "carrying on the same activities" test, only the permanent establishment and its u.s. counterpart or the entire foreign corporation and its u.s. counterpart? is the test a factual one or a legal one? do only identical activities satisfy the test of the "same activity"? how far from identical can the business be? 166. see e.g., 1977 oecd model. supra note 4. art. 3, para. 2. 167. report of the senate committee on foreign relations, exec. rep. no. 7. 99th cong., 1st sess. 19 (1985). 168. 1977 oecd model, supra note 4, art. 24, para. 4. 169. 1977 oecd commentaries, supra note 4. art. 24. para. 4 at 23. 1992] florida tax review the internal revenue service apparently does not believe it is sufficient to have factual congruity; there must be legal congruity as well. the problem can be illustrated by the special treatment of dividends received by a permanent establishment. the oecd commentaries recognize that there is a problem and recommends that treaty countries make their position clear in a protocol. 170 the united states has often done so. for example, article xxv(6)(b) of the u.s.-canada treaty states that the nondiscrimination article shall not be construed as obliging a contracting state "[t]o grant to a company which is a resident of the other contracting state the same tax relief that it provides to a company which is a resident of the first-mentioned state with respect to dividends received by it from a company.'' the technical explanation to the u.s.-canada treaty states that this provision is merely clarifying in nature, since neither the united states nor canada would interpret the language as providing the same relief anyway.'72 however, a claim for the one hundred percent dividends received deduction on dividends received by a permanent establishment in the united states appears to have been settled in favor of at least one taxpayer in an unreported case.'73 thus, if the stock of the distributing company is owned by the permanent establishment, and the dividend is effectively connected with the permanent establishment so that it is not eligible for the lower treaty withholding rate, it is difficult to justify any disallowance of the dividends received deduction. 17 one explanation might be that the distribution by the foreign parent corporation of a dividend out of the earnings of its u.s. permanent establishment would not be subject to a withholding tax, while a similar distribution (to the extent made to foreign shareholders) from a u.s. corporation would be. this argument has been seriously weakened, if not eliminated, however, by adoption of the u.s. branch profits tax, which is considered below.175 a second possible explanation is that the comparison should be made between a u.s. corporation and the entire foreign enterprise, for instance the "foreign parent" of the u.s. permanent establishment, rather than only the permanent establishment. in that case, it would be the position of the service that the "same activity" be interpreted in the same manner as 170. 1977 oecd commentaries, supra note 4, art. 24, para. 31-37, 171. u.s.-can. treaty, supra note 15, art. xxv, para. 6(b). 172. treas. tech. expl. of can. treaty, supra note 98, art. xxv (providing that the nondiscrimination provisions applies with respect to a fixed base as well as a permanent establishment). 173. schlumberger limited v. united states, 195-75 (ct. cl. petition filed june 27, 1975); see also a.l.i. treaty project, supra note 5, at 269-72. 174. france now permits the deduction as a result of a french supreme administrative court decision under the nondiscrimination article of the french-italian income tax treaty. judgment of nov. 18, 1985, conseil d'etat (fr.), discussed in 26 european tax'n 157 (1986). 175. see infra text accompanying notes 192-215. [vol. 1:2 treaty-based nondiscrimination "in the same circumstances" under article 24(1). the service does in fact appear to take the view that the "same circumstances" test includes the payment of a u.s. tax and is not satisfied where the foreign taxpayer, unlike a u.s. citizen, is not subject to u.s. tax on its worldwide income. 76 in irs technical advice memorandum 8030005, the service explicitly extended the "similar circumstances" concept of article 24(1) to permanent establishments under article 24(4) of treaties corresponding to the 1977 oecd model.' 7 a comparison to the whole foreign corporation, however, rather than merely to its u.s. permanent establishment, clearly seems incorrect. since that part of the foreign corporation's income that is not effectively connected with the u.s. permanent establishment is not subject to any u.s. tax, 78 the foreign corporation could only be comparable to a u.s. corporation if all of its income were effectively connected with its u.s. trades or businesses. even in that situation, if the test were generic (rather than specific), a permanent establishment could never be protected under article 24(4), because another hypothetical corporation may have income not subjected to tax in the united states. it appears that the treasury department's interpretation could effectively eliminate paragraph 4 from its treaties altogether, since a permanent establishment is generically never in the same u.s. tax circumstances as a u.s. corporation.179 a similar rationale would also justify the denial of the right to file a consolidated return between a permanent establishment and its domestic subsidiaries. it would also justify section 906 of the code, which restricts the foreign tax credit to foreign income taxes paid "with respect to income effectively connected with the conduct of a trade or business within the united states,"180 while denying it to foreign taxes that are imposed on other income from sources within the united states which is not effectively connected.'81 in contrast, no such limitations apply to a domestic corporation that is managed and controlled in a foreign jurisdiction. d. "taxation ... not ... less favorably levied" the language of the nondiscrimination provision applicable to permanent establishments is different than that of the nondiscrimination provision applicable to foreign nationals. the provision applicable to foreign nationals 176. see e.g., i.r.s. t.a.m. 8030005 (mar. 28, 1980). 177. id.; see also rev. rul. 74-239, 1974-1 c.b. 372. 178. this is true as long as the other income is not from a u.s. source. see irc §§ 881(a), 882(a). 179. see william c. gifford, permanent establishments under the nondiscrimination clause in income tax treaties, i1 cornell int'l lj. 51. 63 (1978). 180. irc § 906(a). 181. irc § 906(b)(i). 19921 florida tax review prevents taxation and connected requirements that are "other or more burdensome" than those applicable to nationals.'82 the provision applicable to permanent establishments only requires that taxation "not be less favorably levied" on permanent establishments than on residents. 83 thus, the permanent establishment provision seems to be limited to the quantum of the tax. if the provision is limited to the quantum of the tax, then it would clearly not prevent discrimination in relation to certain administrative matters, such as information requirements, limitation periods, interest and penalties."84 as previously noted, even under the foreign nationals provision the tax imposed on foreign taxpayers generally need not be identical to that imposed on nationals of the taxing state. 85 yet, article 24(4) of the 1977 oecd model, applicable to permanent establishments, does not even include the limiting term "other." if a different (other) method of taxation applies to a permanent establishment but it produces no greater tax, article 24(4) is not violated-it is the effective tax rate alone that counts. 86 nevertheless, it appears incongruous for the united states to import the meaning of "same circumstances" in article 24(1) to the interpretation of "same activities" in article 24(4) but not import the meaning of "other or more burdensome" in article 24(1) to "taxation ... not be less favorably levied" in article 24(4). e. firpta when the foreign investment in real property tax act of 1980 (firpta) was enacted, 87 congress adopted rules to tax indirect dispositions of u.s. real property by foreign persons. for example, a nonresident alien or foreign corporation is subject to tax under firpta upon a sale of shares of certain u.s. corporations that are considered u.s. real property holding corporations.'88 gain from the sale is treated as effectively connect182. 1981 u.s. model, supra note 7, art. 24, para. 1. 183. 1981 u.s. model, supra note 7, art. 24, para. 3. in fact, a number of u.s. treaties adopt the same expression, in both nationality and permanent establishment paragraphs; in those cases the term adopted is usually "more burdensome." 184. cf. 1977 oecd commentaries, supra note 4, art. 24, para. i at 10 ("[tlhe formalities connected with the taxation (returns, payment, prescribed times, etc.) must not be more onerous for foreigners than for nationals."). 185. see supra text accompanying notes 39-56. 186. see 1977 oecd commentaries, supra note 4, art. 24, para. 4 at 22; cf. g.c.m. 35066 (oct. 2, 1972) modified on other grounds, g.c.m. 38052 (aug. 20, 1979) (considering whether double taxation violates an anti-discrimination clause in insurance excise and income tax context). 187. pub. l. no. 96-499 §§ 1121-1125, 94 stat. 2682 (codified in scattered sections of 26 u.s.c.). 188. id. §§ 1122, 1124 (codified as amended at irc §§ 897(c), 861(a)(5)). [vol 1:2 treaty-based nondiscrindnation ed income. dispositions of shares of foreign corporations are not taxed directly under firpta,' 9 but rules were adopted to override certain nonrecognition provisions that otherwise would have applied to foreign corporations having interests in u.s. real property, such as the transfer of u.s. real property by a nonresident alien individual or foreign corporation to a newly created foreign corporation in a section 351 exchange.9' congress also decided to override any existing treaties that would have prevented imposition of the firpta tax, but phased in such overrides.' 9 ' in addition, because congress acknowledged that the rules overriding nonrecognition provisions could in fact result in discriminatory taxation of foreign taxpayers, it adopted a novel approach-it included section 897(i) in the code. that section allows a foreign corporation that has a permanent establishment in the united states and to which a nondiscrimination article of the treaty applies to elect to be treated as a domestic corporation for purposes of firpta. a condition of the election, however, is waiver of any treaty benefits that might otherwise apply including benefits under the nondiscrimination provision. f. branch profits tax in 1986, the united states adopted a branch profits tax which actually consists of three taxes-the branch profits tax, the branch-level interest tax, and the excess interest tax.192 1. branch profits tax.-the branch profits tax is a tax levied in addition to the general corporate tax on the u.s. earnings of a foreign corporation. it is imposed on the earnings that are available for distribution as a dividend by any foreign corporation that is doing business in the united states. such available earnings, in the terms of the code, are called the "dividend equivalent amount."' 93 the dividend equivalent amount is equal to current net earnings of the branch less any reinvestment in the united states, with certain modifications that are not relevant for this analysis."9 a domestic corporation is not subject to such a tax, but its non-u.s. shareholders may be subject to u.s. tax on the u.s. source dividend paid by such a corporation, and such tax is only imposed if a dividend is actually paid. as 189. see id. but see firpta § 1122(i), 94 stat. 2682 (codified as amended at irc § 897(i)). 190. see irc §§ 897(d) and (e). see also temp. treas. reg. § 1.897-6t(bj. 191. firpta § 1125, 94 stat. 2690. 192. pub. l. no. 99-514, § 1241(a), 100 stat. 2085. 2576 (1986) (codified as amended at irc § 884). 193. irc § 884(b). 194. id. 19921 florida tax review described further below, prior to the enactment of the branch profits tax, dividends paid by certain foreign corporations with substantial u.s. income were also considered u.s. source dividends which were subject to tax in the hands of non-u.s. shareholders. the branch profits tax can be viewed as an anticipatory withholding tax on future dividends. since no domestic corporation bears a branch profits tax, however, the tax violates the permanent establishment nondiscrimination provision. in 1986 the joint committee staff was of the view that it was uncertain whether the new branch profits tax violated the treaty nondiscrimination articles. 195 in deference to the treasury department's view that the branch profits tax was discriminatory under article 24(3) of the 1981 u.s. model, however, the conferees took pains to give assurance that treaty protection would be available in the absence of treaty shopping. the conferees also do not intend that the branch tax be imposed on income not attributable to a permanent establishment (even though the income is effectively connected with a u.s. trade or business under code rules) if the treaty in question in fact precludes the united states from imposing its regular corporate income tax on income not attributable to a permanent establishment, so long as the shareholders of a foreign corporation are not treaty shopping.196 the treaty protection was to be limited to income tax treaties only and was to be applicable only if the foreign corporation that had a permanent establishment in the united states was a "qualified resident of such foreign country."' 197 in addition, the branch profits tax was not necessarily eliminated, but rather was in some cases only reduced to the tax rate applicable to dividends paid by a domestic corporation to a corporation resident in the treaty country if it wholly owned such domestic corporation.'9" the branch profits tax was thus adopted based upon the treasury department's contention that the proper comparison is between a domestic branch of a foreign corporation and a domestic corporation wholly owned by the foreign corporation. this approach does not seem to comport with the comparison required under article 24(5) of the 1981 u.s. model (the foreign ownership provision), even if there is some novel justification for this approach under article 195. see staff of the joint committee on taxation, general explanation of the tax reform act of 1986 1038 (1987). 196. 2 h.r. conf. rep. no. 841, 99th cong. 2d sess. 650 (1986). cf. article 24(5) u.s.-germany treaty excepting branch profits tax from nondiscrimination. 197. irc § 884(e)(1). 198. irc § 884(e)(2)(a)(ii). [vol 1:2 treaty-based nondiscrimination 24(3) (the permanent establishment provision). imposition of the anti-treaty shopping provision as a condition to nondiscrimination treatment may itself discriminate in some sense against foreign enterprises, because no similar limitation applies under the code to foreign-owned u.s. corporations.'" 2. branch-level interest mr.-the branch-level interest tax is a withholding tax imposed on interest considered paid by the u.s. permanent establishment of a foreign corporation to a foreign lender. ' the mechanism adopted to implement this tax is to characterize such interest payments as being from a u.s. source."0° previously, interest payments made by a foreign corporation, and similar payments of dividends, were considered u.s. source payments and were subjected to u.s. withholding tax only if more than fifty percent of the foreign corporation's earnings for the preceding three-year period were effectively connected with a u.s. trade or business. if fifty percent or more of the earnings were effectively connected with a u.s. trade or business during that period, then a proportionate amount of the payment was subjected to u.s. withholding tax unless a code or treaty provision exempted the payment 20 this tax was difficult to enforce.203 a branch-level interest tax is now imposed upon any interest considered paid by the u.s. permanent establishment. : " the statute does not define the method of determining the amount of interest paid by the u.s. permanent establishment. given the problems of fungibility inherent in the payment of interest, such a system can work only if some sort of identification is possible. the regulations permit a timely identification of such liabilities by a taxpayer.' °5 since the interest is actually paid, and since a domestic corporation would be required to withhold on such interest, this provision as a whole does not appear to violate the nondiscrimination article. in a specific case, however, it is possible for different tax results to be achieved by a u.s. corporation and a foreign corporation with a u.s. permanent establishment. 199. it is also interesting that the anti-treaty shopping rule may apply in a way that a corporation owned by nationals of a third country (1) may not be subject to regular u.s. tax on their u.s. business income that is not attributable to a permanent establishment. but (2) would be subject to the branch profits tax attributable to the same income. 200. irc §§ 861(a)(1), 881(a)(l). 884(f)(i)(a), 1442(a). temp. treas. reg. § 1.8844t(a). 201. irc § 884(f). 202. irc § 861(a)(1)(d), (2)(b) (1954). 203. see staff of the joint committee on taxation, supra note 195, at 1036. 204. irc §§ 861(a)(1), 881(a)(1). 884(f)(1)(a). 205. treas. reg. § 1.884-4(b)(1). 19921 florida tax review 3. excess interest tax.-the united states also imposes a tax on the "excess interest" of a u.s. branch of a foreign corporation. 6 excess interest is generally the excess of (1) the amount of interest that is allocated to and deducted by the u.s. branch in computing its taxable income over (2) the amount treated as u.s. source interest under the branch-level interest tax.2 7 under the u.s. tax system applicable to a branch of a foreign corporation, the branch is able to deduct a portion of the interest paid by the entire foreign corporation. the deductible portion is determined under a formula that generally allocates the entire interest paid by the corporation among all of its branches and its home office in accordance with the assets of each.20 8 if the amount apportioned to the u.s. branch and, therefore deductible by it, exceeds the interest actually paid by the branch, then this excess is treated as interest paid by the u.s. branch to the home office. it is also subjected to a surrogate withholding tax at the rate that would have been applicable under the code or under a treaty if the excess interest had actually been paid by a u.s. corporation to the foreign corporation.2" congress recognized that this provision could be in conflict with nondiscrimination provisions of treaties, but left that determination for later consideration. neither the code nor the temporary regulations addressed the nondiscrimination issue under the excess interest tax. the service first explained that the matter is "under consideration in connection with the treasury [d]epartment study of the tax treaty program. 210 in notice 89-80, however, the internal revenue service announced: "[t]he treasury department has concluded that the tax on excess interest is not prohibited by the nondiscrimination provision or any other provision in any income tax treaty to which the united states is a party., 21' this is also the position reflected in the final regulations. according to notice 89-80, the nondiscrimination provisions do not require "structural or mechanical identity" between the tax computations for foreign and domestic corporations "so long as the net result of such method is approximately the same, i.e., the tax burden imposed on a foreign corporation in respect of its united states permanent establishment approximates the tax burden that is imposed on an enterprise of the united states engaged in the same activities. 2 2 the notice also states that "[t]his treatment recognizes that excess interest with respect to a branch is the functional equivalent of interest paid on parent debt funding with respect to a 206. irc §§ 861(a)(1), 881(a)(1), 884(f)(1)(b). 207. irc §§ 861(a)(1), 882(c)(1), 884(f)(1)(b). 208. treas. reg. § 1.882-5. see also prop. treas. reg. § 1.882-5. 209. irc § 884(f)(1)(b); treas. reg. § 1.884-4t(a)(2). 210. preamble to treas. reg. § 1.884-4, t.d. 8223, 1988-2 c.b. 182, 186. 211. i.r.s. notice 89-80, 1989-2 c.b. 394, 397. 212. id. [vol 1:2 treaty-based nondiscrinination subsidiary. 21 3 in the view of the service then, there is no discrimination since the overall tax treatment is similar to the payment of interest by a u.s. subsidiary to its foreign parent. this conclusion seems to be based on the wrong comparison. the better comparison seems to be interest paid by a u.s. subsidiary to a u.s. parent, rather than to a foreign parent. this is the comparison required under article 24(4) of the 1981 u.s. model (the deduction provision), where the interest and other disbursements paid by a resident of the united states to a resident of the other treaty country are compared to interest and other disbursement paid to a resident of the united states. 4 in any case, it appears that the service has persuaded the full treasury department that its view is correcl 2 15 g. minimum taxable income proposal a controversial provision in recently proposed legislation2 " would deem certain corporations to have minimum taxable income. these corporations would include twenty-five percent foreign-owned u.s. corporations and foreign corporations that are subject to tax on a net basis in the united states which, in either case, also have transactions with related foreign persons equal to at least two million dollars or ten percent of the corporation's gross income.2 17 the minimum taxable income of such a corporation for any category of business activities would be equal to seventy-five percent of the amount determined by applying the average profit-level indicator for the industry, apparently applying book rather than tax profit-level indicators. the proposed legislation would favor covered corporations that apply for a private ruling by providing an exception to the minimum taxable income rule once a ruling has been obtained. the joint committee staff's explanation of the bill indicates a belief that the bill does not violate treaties, at least in light of certain other provisions of the bill which would eliminate 213. id. 214. 1981 u.s. model, supra note 7. art. 24, para. 4. but the technical incidence of the tax is on the foreign corporation, rather than on the recipient of the payment. 215. see preamble to treas. reg. § 1.884-4. t.d. 8432. 1992-2 c.b. .; see also a.l.i. treaty project supra note 5, at 265-72. 216. h.r. 5270, 102d cong., 2d sess. § 304 (1992) (foreign income tax rationalization and simplification act of 1992). 217. id. the explanation of the joint committee staff indicates that amounts not taken into account in determining taxable income, such as contributions to capital or the principal amount of the loan, are disregarded for purposes of determining whether this transactional threshold is met. staff of the joint committee on taxation. 102d cong., 2d sess., explanation of h.r. 5270, 52 (1992). 1992] florida tax review deferral for u.s.-controlled foreign corporations." 8 similarly, the joint committee staff indicated that the minimum taxable income requirement is generally consistent with the business profits and associated enterprises articles of u.s. treaties."1 9 turning taxpayer difficulties on their head, the joint committee staff also indicates that the minimum profit rule is "prima facie" reasonable because of the difficulties of proof otherwise applicable to taxpayers.2 in any event, the staff believes there is no discrimination because a covered corporation would be free to get a private ruling, presumably at some substantial cost.22 ' finally, the joint committee indicates that if this proposal were considered to violate a treaty obligation in the united states, it was intended that the provisions apply nonetheless.2 2 vi. the ownership provision paragraph 5 of article 24 of the 1981 u.s. model provides: enterprises of a contracting state, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other contracting state, shall not be subjected in the first-mentioned state to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned state are or may be subjected.223 paragraph 5 protects business enterprises located in the united states and owned by residents of the other contracting state from discriminatory treatment. the provision is commonly interpreted as an ownership provision comparing, for example, a u.s. corporation owned by treaty-country residents to u.s. corporations owned by u.s. residents. the language would appear to cover other entities and businesses as well as corporations. 24 the wording of the provision closely parallels that of paragraph 1 of article 24 which deals with nationals.225 however, paragraph 5 uses a different basis of com218. id. at 54. 219. see id. at 55. 220. id. 221. see id. 222. id. 223. 1981 u.s. model, supra note 7, art. 24, para. 5. 224. 1977 oecd commentaries, supra note 4, art. 24, para. 5 (focusing directly on the tax treatment of u.s. enterprises, not on the indirect tax treatment of the capital invested in such enterprises). 225. 1981 u.s. model, supra note 7, art. 24, para. 1. [vol. 1:2 treaty-based nondiscrimnation parison: paragraph 1 refers to nationals in the "same circumstances," while paragraph 5 refers to "similar enterprises." 6 as suggested above, it is to be hoped that paragraph 5 also applies a factual comparison. a. consolidated returns where two or more domestic corporations are commonly owned by another domestic corporation, they are generally permitted to file a consolidated u.s. income tax return.? the same benefit is not permitted under the code, however, for two or more commonly owned domestic corporations where the parent corporation is foreign. 228 apart from such a difference, the two sets of domestic corporations appear to be similar enterprises. the treasury department is of the view that the two groups of corporations are not similar enterprises, because the foreign parent corporation is not necessarily subject to u.s. tax on a worldwide basis. while it is clearly justifiable not to permit domestic corporations to distribute funds to their foreign shareholders without having paid a u.s. tax, it is not as clear why the united states should not permit the offsetting of profits and losses among affiliated domestic corporations, notwithstanding that their common parent is not a domestic corporation. however, other jurisdictions have reached the same result as the united states on this issue.29 the ali states that while the legislative history is obscure, limiting the privilege of filing consolidated returns to situations involving a domestic parent and domestic subsidiaries "seems to be premised on the idea that only when dividends to the common shareholder are free of tax can transactions among sister companies in the group be allowed to proceed on a tax-deferred basis without concern that these might involve shifts of value amounting in substance to constructive dividends to the shareholder(s)." a compromise might be to permit the offsetting consolidation of gains and losses of sister domestic corporations owned by a foreign parent company without permitting the deferred intercompany transaction rules, but this idea has not gained currency. 226. 1981 u.s. model, supra note 7, art. 24, para. 5. the permanent establishment provision (paragraph 3) uses a third comparison: enterprises carrying on the same activities. 1981 u.s. model, supra note 7, art. 24, para. 3. 227. irc § 1501. 228. irc §§ 1501, 1504(b)(3). 229. see e.g., decision of the tax court cologne, 13 v 300/90 (may 30, 1990). in the u.k., something similar to the benefits of consolidation are available to u.k. parent-u.k. subsidiary companies and to a u.k. company owned by a qualifying consortium (members of which own at least five percent of the first company). see generally t.m. portfolio 68-8th. at a-29 to a-30. 230. a.l.i. treaty project, supra note 5, pt. 4. v.c. 19921 florida tax review b. integrated tax systems one of the more controversial issues in international taxation is the economic discriminatory effect of integrated tax systems that limit credits or refunds to resident shareholders of domestic corporations. an integrated tax system or, as it is frequently called, an imputation system, is one in which the corporate and shareholder taxes are dependent and integrated. in contrast, under the classic corporate tax system, the corporation's and the shareholder's taxes do not depend on each other. in a pure integrated or "split-rate" system, the corporation pays no tax or a lower rate of tax on the earnings it distributes as dividends. a variation is the allowance of a deduction from earnings for dividends distributed. in these instances, the shareholder pays a full rate of tax on the dividend received. an alternate means to the same end is to permit the recipient shareholder to gross up the amount he receives by the tax paid by the corporation in determining his taxable income and permit him a credit against his individual tax for the corporate tax paid, such as in the french "avoir fiscal" and the united kingdom's act. most, if not all, integrated tax systems deny their benefits for distributions to nonresident shareholders. where the system is a pure integrated or split-rate system, it clearly violates articles 24(6) (the ownership provision) and 24(5) (the deduction provision) of the 1977 oecd model. limitations on shareholder credits seem less likely to violate the nondiscrimination provisions of treaties. it may be argued that the split-rate system of germany is not discriminatory because it is dependent on dividend distributions and the discrimination against nonresident shareholders is therefore only indirect. however, the argument itself admits that discrimination exists. neither the split-rate nor the shareholder credit system would violate article 24(1) of the 1977 oecd model. the discrimination is not because of nationality; it is because of nonresidence. were the foreign country to grant its national nonresidents a credit, or the corporate deduction for distributions to them, the provision would violate article 24(1) of the 1981 u.s. model. a more difficult question is whether the shareholder credit system amounts to a reduction of the tax at the corporate level and therefore results in a more burdensome tax to a corporation having foreign shareholders. although the credit for the tax paid by the corporation results economically in a lower overall burden on corporate earnings, the credit or reduction is not given to the corporation, and it therefore does not appear to violate articles 24(6) and 24(5) of the 1977 oecd model, which apply only to the enterprise. [vol. 1:2 treaty-based nondiscrnination c. corporate liquidations section 337 of the code provides that no gain or loss shall be recognized to the liquidating corporation on the distribution to an eighty percent corporate distributee of any property in a complete liquidation qualifying under section 332 of the code. section 332 requires that the distributee own the stock of the liquidating corporation from the date of the adoption of the plan of liquidation until the property is received. in addition, the distribution must be in complete cancellation or redemption of the corporation's stock and the transfer of the property must occur within a single taxable year or be part of a series of distributions completed within three years.2' section 367(e)(2) of the code denies the benefit of these tax-free provisions where the eighty percent distributee is a foreign corporation, unless regulations are adopted by the treasury department that provide otherwise. initially, the internal revenue service stated in notice 87-5,2' that regulations would provide that section 367(e)(2) will be inapplicable to the liquidation of domestic subsidiaries where a treaty nondiscrimination provision was available, because such an application would violate the ownership provision (similar to article 24(5) of the 1981 u.s. model.) shortly thereafter, in notice 87-66," ' the internal revenue service withdrew that portion of the notice applicable to future distributions, claiming that a domestic enterprise owned by a u.s. corporation is not a similar enterprise to a domestic corporation owned by a foreign corporation. the service said in notice 87-66: the capital ownership nondiscrimination provision requires that a foreign-owned corporation be treated no worse than a similar domestically-owned corporation. this rule, like all nondiscrimination provisions, does not prohibit differing treatment of entities that are in differing circumstances. rather, a protected enterprise is only required to be treated in the same manner as other enterprises that, from the point of view of the application of the tax law, are in substantially similar circumstances both in law and in fact. accordingly, section 367(e)(2)'s denial of section 337 nonrecognition treatment constitutes prohibited capital ownership discrimination only if a u.s. corporation owned by a foreign corporation is, in the context of a liquidation, 231. irc §§ 332(b)(2), (3). 232. i.r.s. notice 87-5, 1987-1 c.b. 416. 417. 233. i.r.s. notice 87-66, 1987-1 c.b. 376. 19921 florida tax review similar to a u.s. corporation owned by another u.s. corporation. it is clear that such enterprises are not similar, since a liquidating distribution by the foreign-owned corporation may remove u.s. corporate assets from u.s. corporate-level taxing jurisdiction, while in the liquidation of the u.s.-owned corporation the assets will remain in u.s. corporate solution, assuring u.s. corporate-level taxation.2 4 the conclusion reached by the internal revenue service is rational, but cannot be easily justified under the wording of article 24(5) of the 1981 u.s. model. the comparison in that provision is between "similar enterprises. ,2 35 the service's analysis in notice 87-66 concludes that similar enterprises are not similar if they are owned by differing shareholders. yet, that is the exact situation to which paragraph 5 is supposed to apply! the entities involved are taxed the same way. that a later transaction by a shareholder would not be subject to tax should not be relevant. under article 24(5), the tax on the u.s. corporation should be the same whether the similar enterprise is owned by foreign or domestic shareholders. indeed, since section 367(e)(2) provides the same sort of "compensatory" tax as that imposed under certain provisions of firpta and the branch profits tax, and since the congress and treasury departments agree that nondiscrimination provisions apply in the latter cases, they should apply to section 367(e)(2) as well. the ali contends that the imposition of one "layer" of tax on appreciated assets passing in the jurisdiction should not be considered discriminatory.236 using the same analysis, the ali concludes that gain should not be recognized by a u.s. corporation on a spin-off or a split-off of a u.s. subsidiary to foreign shareholders since the gain remains subject to u.s. tax in the future, except for gain which accrued on the stock of the distributed corporation while held by the distributing corporation. if the ali suggests these results as a policy matter, it is hard to disagree with that conclusion. however, treaties should be modified by the parties or by an appropriate agreement of the competent authorities; they should not be modified by a tortured analysis, no matter how apparently justified.237 d. treaty gain on stock as a dividend during the last few years, congress has considered treating the gain 234. id. 235. 1981 u.s. model, supra note 7, art. 24, para. 5. 236. a.l.i. treaty project, supra note 5, v.b. 237. note that the temporary regulations defer the tax on assets that remain used in a business in the united states. see temp. treas. reg. § 1.367(e)-2t(b)(2). [val 1:2 treaty-based nondiscrimzination or loss from the disposition of stock of a domestic corporation by a ten percent foreign shareholder as income effectively connected with a trade or business and attributable to a permanent establishment in the united states. 8 since many of the u.s. treaties prevent imposition of a u.s. tax on the sale of stock, this proposed legislation has included provisions that would treat liquidating distributions and redemptions as dividends in those situations. in response to claims of discrimination, the explanation accompanying one of these bills stated: it is further understood that application of the bill's dividend definition rule only to liquidating and redemption gains realized by certain foreign persons does not violate a typical treaty nondiscrimination provision. among other things, it is believed that a u.s. shareholder and a foreign shareholder are not similarly situated for this purpose. a liquidating distribution or redemption distribution by a foreign-owned corporation may permanently remove u.s. corporate earnings from u.s. shareholder-level taxing jurisdiction (which all u.s. treaties retain to some extent), while in the liquidation of (or redemption of shares in) the u.s.-owned corporation the earnings will remain in u.s. taxing jurisdiction, assuring u.s. shareholder-level taxation. -9 this is the same justification given for section 367(e)(2) and it suffers from the same infirmities. however, these proposals seem more odious coming from congress and adopting so transparent a mechanism of overriding treaties. e. partnership withholding as noted above, article 24(5) of the 1981 u.s. model is not limited to corporations, since it covers "enterprises." 2 a partnership conducting a business is such an enterprise. since a partnership is not generally a taxable entity in the united states,it is rare that this provision will be applicable in the united states. on the other hand, a nonresident alien individual or foreign corporation is considered as being engaged in a trade or business in 238. see e.g., h.r. 5270, 102d cong., 2d sess. § 301 (1992); h.r. 4308, 101st cong., 2d sess. § 201 (1990). 239. technical description accompanying h.r. 4308, 101st cong.. 2d sess. (1990), tax notes microfiche database, doc. 90-2228, fiche 462. 240. see supra text accompanying note 224. 241. irc § 701. 19921 florida tax review the united states if the partnership of which such individual or corporation is a member is so engaged.242 thus, it would appear that the ownership provision is applicable to the individual partners in the partnership. section 1446 of the code requires a partnership that includes nonresident alien partners to withhold tax on those partners' shares of partnership income where the partnership has income effectively connected, or treated as effectively connected, with the conduct of a trade or business in the united states. each foreign partner of the partnership is allowed a credit for such partner's share of the withholding tax paid by the partnership.243 article 24(5) of the 1981 u.s. model provides that the foreign-owned domestic enterprise shall not be subjected to any taxation or any requirement connected therewith that is other or more burdensome than the taxation and connected requirements to which a similar enterprise of the united states is subjected. a partnership owned by u.s. taxpayers is not required to withhold on payments to its partners. it could be argued, however, that the withholding tax is only a necessary procedural and collection device; since the foreign partner may claim a credit for the tax withheld. in other words, some would say this is just another example of permitted "procedural" discrimination. this has not always been the view of congress, however. in 1966, the house ways and means committee, while discussing the reasons for changes proposed in the withholding provisions applicable to foreign taxpayers, stated: "[a]lthough an alien may obtain a refund of the excess withholding when he files his return at the end of the year, overwithholding in these circumstances can create a substantial hardship for the alien."2"4 the internal revenue service, during the course of a lengthy discussion of the history of the withholding provisions from 1913 through 1979, stated that congress has recognized the hardship that may result from overwithholding even when a refund can be obtained at the end of the tax year.24' nevertheless, withholding does not violate the nationality, permanent establishment, or ownership provisions, since it is not based on citizenship and is not a burden on the enterprise. f. subchapter s a domestic corporation that qualifies and elects to be taxed under subchapter s is generally not subject to corporate tax;246 its income is taxed 242. irc § 875(1). 243. irc § 1446(d)(1). 244. h.r. conf. rep. no. 1450, 89th cong., 2d sess. (1966), 1966-2 c.b. 965, 983. 245. g.c.m. 38052 (aug. 20, 1979). cf. treas. regs. §§ 1.445-3(g), -6(g) ("quick" refund procedures for overwithheld firpta taxes). 246. irc § 1363(a). [vol 1:2 treaty-based nondiscrimination to its shareholders.247 a corporation cannot qualify to make the election if any of its shareholders are nonresident aliens.2s since an s corporation bears no tax and a regular corporation does, an enterprise denied s corporation status is subject to taxation that is other or more burdensome solely because it has nonresident alien shareholders. the election can be made with nonresident shareholders who are citizens, and it can be made with aliens who are residents. thus, it might be argued that the discrimination is not because of residency or nationality. that argument seems to be weak, however. the technical explanation to the new u.s.-germany treaty states that the reason for the exclusion of nonresident aliens is that they are not net-basis taxpayers, rather than because they are nonresidents.2-4 that may sound rational, but it does not seem reconcilable with the language of article 24(5) of the 1981 u.s. model. in order to avoid violating article 24(5), the statute should probably permit nonresident alien shareholders for s corporations, if those shareholders consent to be taxed on a net basis, as is required for nonresident alien individuals and foreign corporate shareholders of domestic international sales corporations and under firpta. vii. the deduction provision paragraph 4 of article 24 of the 1981 u.s. model provides: except where the provisions of paragraph i of article 9 (associated enterprises), paragraph 5 of article 11 (interest), or paragraph 4 of article 12 (royalties) apply, interest, royalties, and other disbursements paid by a resident of a contracting state to a resident of the other contracting state shall, for the purposes of determining the taxable profits of the first-mentioned resident, be deductible under the same conditions as if they had been paid to a resident of the firstmentioned state. similarly, any debts of a resident of a contracting state to a resident of the other contracting state shall, for the purposes of determining the taxable capital of the first-mentioned resident, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned state.2' 247. irc § 1366. 248. irc §§ 1361(b)(1)(c), 1362(a)(1). 249. treasury dept. technical explanation of u.s.-germany treaty, art. 24, fed. tax treaties ii (p-h) 39,066 at 39,060-2.9. 250. see irc §§ 871(b), 882(a), 897, 996(g). 251. 1981 u.s. model, supra note 7. art. 24, para. 4. 19921 florida tax review this provision appears to be merely an elaboration of the more general "not less favorably levied" language of paragraph 3; the disallowance of any of these deductions would result in a greater taxable income and, accordingly, a greater tax burden on the permanent establishment. moreover, it appears to overlap article 24(5) of the 1981 u.s. model, which prevents taxation that is other or more burdensome on an enterprise the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other contracting state. the united states income tax law contains a number of limitations on the deductibility of interest peculiar to foreign taxpayers. in general, interest is deductible on an accrual basis for taxpayers not using the cash method of accounting. similarly, original issue discount on a loan is generally deductible on an accrual basis. however, original issue discount is not deductible on an accrual basis if the holder is a related nonresident; it is only deductible at the time of payment.2"2 in addition, under the broad power granted under section 267(a)(3) of the code, the service has deferred the deduction for interest accrued to a related foreign person until paid.253 the deferral of the deduction would appear to be discriminatory. however, the wording of article 24(4) of the 1981 u.s. model is limited to amounts "paid" and thus the article may not be applicable. moreover, a similar limitation is imposed upon related domestic taxpayers. section 267(a)(2) of the code limits the deduction of interest paid by a related party if the person to whom the payment is to be made is not required to include the amount in its gross income by reason of the taxpayer's method of accounting. for u.s. tax purposes, with one exception, foreign taxpayers are taxable on a cash rather than an accrual basis. methods of accounting other than the cash method are available with respect to income of a business that is effectively connected with a united states trade or business. where there is no u.s. tax on the foreign recipient of the interest, the argument that the domestic recipient's rule of section 267 provides justification for the deduction limitation may lack validity, although the regulations will provide otherwise.254 vih. estate tax as noted above, the nondiscrimination article applies to taxes of every kind and description imposed by a treaty nation or a political subdi252. irc § 163(e)(3). see generally supra text accompanying notes 76-85. 253. prop. treas. reg. § 1.267(a)-3, 56 fed. reg. 11532 (1991); see also i.r.s. notice 89-84, 1989-2 c.b. 402. 254. see prop. treas. reg. § 1.267(a)-3, 56 fed. reg. 11532 (1991); see also i.r.s. notice 89-94, 1989-2 c.b. 402. [vol 1:2 treaty-based nondiscrimination vision or local authority thereof." thus, it applies to the federal estate tax. the nondiscrimination article has not always been as broad. for example, the former canadian estate tax treaty was not terminated even after canada abandoned its federal estate and gift tax. the effect of maintaining the estate tax treaty was to preserve the nondiscrimination article which was important because the nondiscrimination article of the income tax treaty then in effect was limited to income taxes. the estate tax treaty was abandoned only after a new income tax treaty, with its own, broader nondiscrimination article was adopted. a few years ago, revenue canada expressed the view that u.s. tax law violates the broader nondiscrimination clause in the current u.s.-canada income tax treaty because u.s. residents are entitled to an exemption in respect of at least $600,000 of their estate, while nonresidents were entitled to a smaller exemption. paragraph 10 of article xxv of the u.s.-canada treaty extends the nondiscrimination article to "all taxes imposed under the internal revenue code."" the only provision of article 24 of the 1981 u.s. model that relates to non-business income is the nationality provision which is generally found in paragraph 1 .' the canadian treaty is identical to the 1981 u.s. model except that citizens of a contracting state who are not residents of the other contracting state are compared with citizens of a third state in the same circumstances. " the nondiscrimination provision of the canadian income tax treaty was negotiated in the context of the income tax." the problem raised by the application of an income tax treaty to an estate tax situation is not simple. the treaty protects a citizen of canada who is a resident of the united states."-' the term "resident" is a defined term under article iv(l) and means any person who, under the laws of that state, is liable for tax therein by reason of his domicile. 6 ' thus, the question is whether the term "resident" means resident in terms of the u.s. income tax law or in terms of the u.s. estate tax law. under u.s. law, for income tax purposes, a resident is generally defined as an individual who either has a "green card" or is a resident because of the number of days spent in the united states.262 for purposes of the estate tax, however, residence means domicile. 63 if the canadian taxpayer is a resident of the united states 255. see supra text accompanying notes 13-15. 256. u.s.-can. treaty, supra note 15, art. xxv, para. 10. 257. 1981 u.s. model, supra note 7, art. 24, para. 1. 258. u.s.-can. treaty, supra note 15, art. xxv, para. 2. 259. u.s.-can. treaty, supra note 15, art. xxv, para. 10. 260. u.s.-can. treaty, supra note 15. art. xxv, para. 1. 261. u.s.-can. treaty, supra note 15, art. iv, para. 1. 262. irc § 7701(b). 263. treas. reg. § 20.0-1(b)(1). 19921 florida tax review because he is domiciled in the united states, then all of his worldwide assets will be subject to u.s. estate tax and he will be entitled to the full estate tax credit, equivalent to a $600,000 exemption.2 "4 if, on the other hand, the taxpayer is a resident only within the meaning of the income tax provision, then he or she is not taxable on worldwide assets and is not entitled even to the benefit of a proportionate share of the $600,000 exemption.265 in such cases, there may be some merit in some circumstances to the nondiscrimination contention. if a canadian citizen resides outside of the united states, then under article xxv(2) the contention would be unsuccessful since the united states applies the same rule with respect to nonresident aliens of all countries, regardless of their citizenship: discrimination no longer exists. it should be noted, however, that in 1990 the code was amended to grant the proportionate credit to the extent required under a treaty obligation.266 another recent controversy involving claimed discrimination arose under an amendment to the u.s. estate tax that disallowed the full marital deduction where the surviving spouse is not a u.s. citizen.2 67 as disturbing as this provision may be to couples where one or both of the spouses are not u.s. citizens, it is difficult to see how this change violates a nondiscrimination provision, since the estate tax is not technically imposed on the surviving spouse, but rather affects estates of decedents who were u.s. citizens as well as those who were not u.s. citizens.268 thus, it is neither "other" or "more burdensome" to the taxpayer. however, germany held up ratification of its new income tax treaty because it viewed the estate tax provision as giving rise to discriminatory treatment of german spouses as compared to u.s spouses.269 ix. conclusions neither the treasury department nor congress seems to have a strong commitment to nondiscrimination despite the existence of a nondiscrimination provision in all modem u.s. tax treaties. in addition, while those provisions include rather sweeping terms, they appear to be read narrowly. even congress cannot be viewed as respecting nondiscrimination as a serious u.s. obligation, since it has recently, rather indiscriminately, overridden u.s. treaties in the process of expanding the level of u.s. taxation of foreign 264. see irc §§ 2001(a); 2010(a). 265. see irc §§ 2001(a); 2010(a); treas. reg. § 20.0-1(b)(1). 266. see irc § 2102(c)(3)(a). 267. see irc § 2056(d)(1)(a). 268. see h.r. conf. rep. no. 795, 100th cong., 2d sess. 592, 593 (1988). 269. see e.g., mary gael timberlake, u.s. treasury department says germany is delaying income tax treaty for estate tax deal, germany blames u.s., 3 tax notes int'l 375, 376 (april 1991). [vol 1:2 treamy-based nondiscrimhinaion taxpayers and their u.s. subsidiaries. finally, in view of the recent suspension of the 1981 u.s. model, it appears timely to suggest two approaches that may be more palatable to congress and the treasury department. under the first approach, u.s. treaties would begin to incorporate the "most-favored nation" approach described above and now found in most of the treaties of canada, australia, and new zealand. the most-favored nation approach would afford nationals (or enterprises) of any treaty country only treatment as favorable as the treatment afforded nationals of any other country. the second approach would be to tailor the language of the nondiscrimination provisions more closely to the allowances that the u.s. should be ready to make. under this approach, at a minimum, the language would permit different treatment reflecting reasonably different tax regimes applicable to foreign and foreign-owned taxpayers on the one hand and u.s. and u.s.-owned taxpayers on the other hand, to account for the fact that foreigners are not subject in the u.s. to worldwide taxation. in addition, this approach would require that the nondiscrimination provision set forth the types of comparison to apply, such as a source-jurisdiction comparison, and include a mechanism for the competent authorities to agree on interpretative guidelines to be applied under the nondiscrimination provision in both jurisdictions. if possible, that mechanism would apply to resolve disputes between competent authorities, if a treaty party asserts that the united states has overstepped its bounds in enacting new legislation. the authors believe that it is time for the united states to decide which, if any, nondiscrimination principle it is willing to follow. they also believe that either approach suggested above would represent an improvement over the present "now-you-see-it-now-you-don't" situation. 1992] florida tax review appendix a 1981 u.s. model income tax treaty article 24 non-discrimination 1. nationals of a contracting state shall not be subjected in the other contracting state to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which nationals of that other state in the same circumstances are or may be subjected. this provision shall apply to persons who are not residents of one or both of the contracting states. however, for the purposes of united states tax, a united states national who is not a resident of the united states and a ... national who is not a resident of the united states are not in the same circumstances. 2. for the purposes of this convention, the term "nationals" means a) in relation to ... ; and b) in relation to the united states, united states citizens. 3. the taxation on a permanent establishment which an enterprise of a contracting state has in the other contracting state shall not be less favorably levied in that other state than the taxation levied on enterprises of that other state carrying on the same activities. this provision shall not be construed as obliging a contracting state to grant to residents of the other contracting state any personal allowances, reliefs, and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents. 4. except where the provisions of paragraph 1 of article 9 (associated enterprises), paragraph 5 of article 11 (interest), or paragraph 4 of article 12 (royalties) apply, interest, royalties, and other disbursements paid by a resident of a contracting state to a resident of the other contracting state shall, for the purposes of determining the taxable profits of the firstmentioned resident, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned state. similarly, any debts of a resident of a contracting state to a resident of the other contracting state shall, for the purposes of determining the taxable capital of the firstmentioned resident, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned state. [vol 1:2 19921 treaty-based nondiscrimination 111 5. enterprises of a contracting state, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other contracting state, shall not be subjected in the first-mentioned state to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned state are or may be subjected. 6. the provisions of this article shall, notwithstanding the provisions of article 2 (taxes covered), apply to taxes of every kind and description imposed by a contracting state or a political subdivision or local authority thereof. florida tax review appendix b 1977 oecd model article 24 non-discrimination 1. nationals of a contracting state shall not be subjected in the other contracting state to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of that other state in the same circumstances are or may be subjected. this provision shall, notwithstanding the provisions of article 1, also apply to persons who are not residents of one or both of the contracting states. 2. the term "nationals" means: a) all individuals possessing the nationality of a contracting state; b) all legal persons, partnerships and associations deriving their status as such from the laws in force in a contracting state. 3. stateless persons who are residents of a contracting state shall not be subjected in either contracting state to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of the state concerned in the same circumstances are or may be subjected. 4. the taxation on a permanent establishment which an enterprise of a contracting state has in the other contracting state shall not be less favorably levied in that other state than the taxation levied on enterprises of that other state carrying on the same activities. this provision shall not be construed as obliging a contracting state to grant to residents of the other contracting state any personal allowances, reliefs and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents. 5. except where the provisions of paragraph 1 of article 9, paragraph 6 of article 11, or paragraph 4 of article 12, apply, interest, royalties and other disbursements paid by an enterprise of a contracting state to a resident of the other contracting state shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned state. similarly, any [vol 1:2 19921 treaty-based nondiscrimination 113 debts of an enterprise of a contracting state to a resident of the other contracting state shall, for the purpose of determining the taxable capital of such enterprise, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned state. 6. enterprises of a contracting state, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other contracting state, shall not be subjected in the first-mentioned state to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned state are or may be subjected. 7. the provisions of this article shall, notwithstanding the provisions of article 2, apply to taxes of every kind and description. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 1 1994 number 12 reassessing sales and liquidations of partnership interests after the omnibus budget reconciliation act of 1993 james e. tierney" i. introduction subchapter k of the internal revenue code has historically afforded considerable flexibility in determining the federal income tax consequences of the retirement or withdrawal of a partner from a partnership. in general, the departure of a partner can be structured either as a purchase of the retiring partner's interest by the remaining partners or as a liquidation of the partner's interest by the partnership. although these two transactions are essentially similar in economic consequences, they have been governed by two separate sets of provisions in subchapter k, often resulting in significantly different tax consequences. the sale of a partner's interest is governed primarily by sections 741 and 751(a), whereas the liquidation of a partner's interest by the partnership is governed primarily by section 736. under sections 741 and 751(a), the sale of a partnership interest generates capital gain or loss to the selling partner, except to the extent that he or she is being compensated for an interest in certain ordinary income items of the partnership-namely, its unrealized receivables and substantially appreciated inventory. the purchasing partners receive few, if any, immediate tax benefits. under section 736, by contrast, the liquidation of a partner's interest by a partnership could result in significant immediate tax benefits to the remaining partners. specifically, under section 736(a), certain payments for a retiring partner's share of the partnership's good will and unrealized receivables would give rise to an immediate deduction or its equivalent for the remaining partners and usually result in ordinary income to the retiring partner. payments for the partner's share of other partnership property would * associate professor of law, the university of toledo college of law. b.a. 1978, rutgers college; j.d. 1981, ll.m. (in taxation) 1984, new york university school of law. the author wishes to thank mark j. dinsmore of the university of toledo college of law, class of 1994, for his perceptive and diligent research assistance. the author also gratefully acknowledges research support from the university of toledo college of law summer research grant program. florida tax review be treated under section 736(b) as a distribution from the partnership to the partner, resulting in no deduction for the remaining partners and, for the most part, generating capital gain or loss for the retiring partner. in enacting the omnibus budget reconciliation act of 1993 (hereinafter "obra 1993") congress made a number of amendments to the internal revenue code affecting the withdrawal or retirement of a partner. outside the specific context of subchapter k, it increased the maximum individual tax rates on ordinary income to 39.6% but left the maximum capital gains rate at 28%, thus making it even more desirable for individuals to obtain capital gain treatment. it also added new section 197, providing for the amortization of certain intangible assets, including good will. within subchapter k, it amended various provisions in an effort to address areas of potential abuse that it perceived as existing under prior law. part ii of this article analyzes congress's amendments in this area and compares their effects on services-oriented and capital-oriented partnerships. it observes that congress virtually has repealed section 736(a) insofar as capital-oriented partnerships are concerned, and contends that congress's reforms in this area were in some respects too broad and in others too narrow. they unfairly preclude capital-oriented partnerships from currently deducting payments for a departing partner's share of traditional "unrealized receivables," for which the opportunity for abuse was minimal. by the same token, they leave open to services-oriented partnerships a significant opportunity for abuse that existed under prior law, namely, the ability currently to deduct payments representing a retiring partner's share of unstated partnership good will. by thus creating two separate sets of rules under section 736-one for partnerships in which capital is a material income-producing factor and another for partnerships in which it is not-congress has not achieved its intended goal of reducing confusion in this area. finally, the article explores the changes effected by obra 1993 and illustrates that notwithstanding congress's amendments, different tax consequences will still follow, depending upon whether a partner's interest is sold or liquidated. part ii of this article describes the tax treatment resulting from the sale and the liquidation of a partnership interest prior to the enactment of obra 1993. readers already familiar with this area may wish to proceed directly to part iii, which analyzes the specific amendments made to prior law. part iv concludes by summarizing and commenting upon these amendments and their effects on partners and partnerships. ih. the sale or liquidation of a partner's interest prior to tie enactment of obra 1993 a. introduction this part first describes the tax treatment of the sale of a partnership [vol. 1:12 reassessing sales and liquidations of partnership interests interest for both the selling and purchasing partners under section 741 and related provisions that, relatively speaking, was only slightly affected by obra 1993. then, it outlines the tax consequences of the liquidation of a partner's interest by a partnership under section 736 and related provisions as in effect before the enactment of obra 1993. although obra 1993 did significantly affect these provisions, this discussion is of more than historical interest for three reasons. first, it provides a frame of reference for analyzing the obra 1993 amendments. second, as discussed in part iii, the rules of section 736 as in effect under prior law will continue to apply in modified form to the liquidation of the interest of a general partner in a partnership for which capital is not a material income-producing factor. third, although the amendments to section 736 made by obra 1993 generally apply to partners retiring or dying on or after january 5, 1993, they are inapplicable if a written contract to purchase such partner's interest was binding on january 4, 1993, and at all times thereafter before such purchase.' in such cases, the preobra 1993 rules will apply. it is convenient to demonstrate the application of the law through the use of an example. for simplicity, the article uses for this purpose a general example involving the abc partnership consisting of ms. a and messrs. b and c, each of whom has a one-third interest in capital and profits. the partnership's balance sheet is as follows. abc partnership asset basis fmv gain cash 6000 6000 inventory 270 300 30 machine* 0 150 150 accounts receivable 0 150 150 capital asset 30 300 270 good will 0 300 300 total 6300 7200 900 partners' equity a 2100 2400 300 b 2100 2400 300 c 2100 2400 300 total 6300 7200 900 *the machine is section 1245 property that originally cost $200 and has been fully depreciated under section 168. 1. omnibus budget reconciliation act of 1993, pub. l. no. 103-66, § 13262(a), (c)(2), 107 stat. 312, 541 [hereinafter obra 19931. 19941 florida tax review if the abc partnership were to sell its assets for cash equal to their fair market value, the amount and character of the gain and loss realized on each asset would pass through to the partners.2 since the partnership would recognize $330 of ordinary income from its inventory, machine, and accounts receivable and $570 of capital gain from its capital asset and good will, each partner would be allocated income of $300, consisting of $110 of ordinary income and $190 of capital gain.3 the basis of each partner's interest in the partnership would increase by $300, to $2,400.' a liquidating distribution of $2,400 in cash to each partner would result in recognition of no further gain or loss. 5 under an ideal system of flow-through taxation, the same results should follow if the partners, either together or separately, disposed of their partnership interests; each would be taxed on ordinary income of $110 and capital gain of $190. accordingly, in the following discussion, recognition by each partner of $110 of ordinary income and $190 of capital gain is referred to as the "theoretically correct result." b. the sale of a retiring partner's interest to remaining partners under section 741 and related provisions prior to amendments by obra 1993 assume that b and c will each purchase one-half of a's interest in the partnership using $1,200 of their individual funds. the aggregate $2,400 2. irc § 702(a), (b). 3. the example assumes that the good will has been generated by the abc partnership's operations. such good will historically has given rise to capital gain when transferred in connection with the sale of a business. see, e.g., cox v. commissioner, 17 t.c. 1287 (1952); schilbach v. commissioner, t.c. memo 1991-556 (cch) 1991. cf. danielson v. commissioner, 378 f.2d 771 (3d cir. 1967) (holding that although good will gives rise to capital gain on sale of business, amounts attributable to a covenant by the seller not to compete give rise to ordinary income and are amortizable by the purchaser of a business), cert. denied, 389 u.s. 858. under § 197, as added by obra 1993, taxpayers may amortize the basis of certain intangibles, including certain "acquired" good will. if such acquired good will subsequently is disposed of at a gain, prior amortization deductions are recaptured as ordinary income. see irc § 197(f)(7). see also infra text accompanying notes 98-121. 4. under § 705, the adjusted basis of a partner's interest in the partnership is increased by the partner's distributive share of taxable income of the partnership and decreased for distributions and losses of the partnership. a partner's basis in her interest in the partnership, referred to as a partner's "outside basis," is thus distinct from the partnership's own basis in its assets, referred to as "inside basis." 5. "in the case of a distribution by a partnership to a partner, gain shall not be recognized to such partner, except to the extent that any money distributed exceeds the adjusted basis of such partner's interest in the partnership immediately before the distribution .... " irc § 731(a)(1). [vol. 1:12 reassessing sales and liquidations of partnership interests purchase price represents a's share of the fair market value of the partnership's assets, including good will. 1. tax consequences to selling partner a. in general: oveniew of sections 741 and 751(a).sections 741 and 751(a) prescribe the tax consequences for the seller of an interest in a partnership. the selling partner will realize and recognize gain to the extent that her amount realized exceeds the adjusted basis of her partnership interest, or loss to the extent that the adjusted basis of her partnership interest exceeds the amount realized on the sale.' such gain or loss will be treated as capital gain or loss, except as otherwise provided by section 751 (a).7 b. operation of section 751(a): unrealized receivables and substantially appreciated inventory.-if the partnership has "unrealized receivables" and "inventory items that have appreciated substantially in value" (collectively referred to herein as "section 751 property"), the partner who sells a partnership interest will be treated under section 75 1(a) as if she directly sold her interest in these items, resulting in ordinary income treatment.8 for purposes of section 75 1, the term "unrealized receivables" is defined by section 751(c) as including, to the extent not previously includible in the partnership's income, any rights to payment for goods delivered or to be delivered or services rendered or to be rendered. 9 thus, a cash-method 6. irc §§ 741, 1001. 7. irc § 741. 8. thus, even a partner who sells her interest at an overall loss may have ordinary income under § 751(a) and a capital loss under § 741. 9. as amended by obra 1993, § 751(c) provides as follows. (c) unrealized receivables.-for purposes of this subehapter. the term "unrealized receivables" includes, to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for(1) goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or (2) services rendered, or to be rendered. for purposes of this section and sections 731 and 741 (but not for purposes of section 736), such term also includes mining property (as defined in section 617(f)(2)), stock in a disc (as described in section 992(a)), section 1245 property (as defined in section 1245(a)(3)), stock in certain foreign corporations (as described in section 1248), section 1250 property (as defined in section 1250(c)), farm land (as defined in section 1252(a)). 1994] florida tax review partnership's outstanding accounts receivable constitute unrealized receivables. the term also includes other "ordinary income" items, such as unrealized depreciation recapture inherent in the partnership's property.'" because the distinction is significant after the enactment of obra 1993, this article will refer to the first type of unrealized receivables (i.e., rights to payment for services rendered or goods sold) as "traditional" unrealized receivables and to the second type (i.e., depreciation recapture) as "nontraditional" unrealized receivables." the term "substantially appreciated inventory" is defined by section 751(d). before its amendment by obra 1993, that section provided that the partnership's inventory items had appreciated substantially in value if their fair market value exceeded both 120% of their adjusted basis to the partnership and 10% of the value of all partnership property, other than money. 2 franchises, trademarks, or trade names (referred to in section 1253(a)), and an oil, gas, or geothermal property (described in section 1254) but only to the extent of the amount which would be treated as gain to which section 617(d)(1), 995(c), 1245(a), 1248(a), 1250(a), 1252(a), 1253(a) or 1254(a) would apply if (at the time of the transaction described in this section or section 731, 736, or 741, as the case may be) such property had been sold by the partnership at its fair market value. for purposes of this section and, sections 731 and 741 (but not for purposes of section 736), such term also includes any market discount bond (as defined in section 1278) and any short-term obligation (as defined in section 1283) but only to the extent of the amount which would be treated as ordinary income if (at the time of the transaction described in this section or section 731 or 741, as the case may be) such property had been sold by the partnership. irc § 751(c), amended by obra 1993, supra note 1, § 13262(b)(1)(a)-(b), 107 stat. at 541. obra 1993 added the parenthetical references indicating that the items referred to in the flush language constitute unrealized receivables for purposes of §§ 751, 731, and 741, but not for purposes of § 736. 10. irc § 751(c) (flush language). for example, assume that a partnership owns a depreciable machine having a basis of $75 and an original cost (recomputed basis under § 1245) of $100. if the machine has a fair market value of $80, all $5 of gain that would be realized on a sale of the asset at its fair market value would be considered ordinary income under § 1245. hence, the machine would constitute an "unrealized receivable" to the extent of $5. by contrast, if the machine were worth $120, a sale for its fair market value would generate gain of $45, of which only $25 would be ordinary income under § 1245, and $20 would be gain from the sale of property used in the trade or business under § 1231. in that case, the machine would be an "unrealized receivable" only to the extent of $25. 11. after the enactment of obra 1993, "traditional" unrealized receivables are considered unrealized receivables for purposes of § 736, but "nontraditional" unrealized receivables are not. see supra note 9 and infra text accompanying notes 83-88. 12. as amended by obra 1993, § 751(d) provides as follows. (d) inventory items which have appreciated substantially in value.(1) substantial appreciation.[vol. 1:12 reassessing sales and liquidations of partnership interests for this purpose, inventory items include not only property held for sale to customers in the ordinary course of business, but also any other property of the partnership which, if sold or exchanged by the partnership, would give rise to ordinary income or loss. therefore, because a partnership's traditional and nontraditional unrealized receivables would give rise to ordinary income if sold, they are treated as "inventory" (along with any actual inventory held by the partnership) in applying the substantial appreciation test. for the abc partnership, the $150 of depreciation recapture inherent in the machine and the $150 worth of accounts receivable constitute unrealized receivables under section 751(c). these unrealized receivables have, in the aggregate, a basis of zero and a value of $300. 3 the partnership's actual inventory has a basis of $270 and a value of $300. because the value of the partnership's section 751(d) "inventory" (actual inventory plus unrealized receivables) is thus $600, which exceeds both 120% of its $270 basis and 10% of the $1,200 value of the partnership's noncash property, it is "sub(a) in general.-inventory items of the partnership shall be considered to have appreciated substantially in value if their fair market value exceeds 120 percent of the adjusted basis to the partnership of such property. (b) certain property excluded.-for purposes of subparagraph (a), there shall be excluded any inventory property if a principal purpose for acquiring such property was to avoid the provisions of this section relating to inventory items. (2) inventory items.-for purposes of this subchapter the term "inventory items" means(a) property of the partnership of the kind described in section 1221(1), (b) any other property of the partnership which, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in section 1231. (c) any other property of the partnership which, if sold or exchanged by the partnership, would result in a gain taxable under subsection (a) of section 1246 (relating to gain on foreign investment company stock), and (d) any other property held by the partnership which. if held by the selling or distributee partner, would be considered property of the type described in subparagraph (a), (b), or (c). irc § 751(d), amended by obra 1993, supra note 1, § 13206(e)(1), 107 stat. at 467. before the enactment of obra 1993, inventory was substantially appreciated under this section if its fair market value exceeded both 120% of the adjusted basis to the partnership of such property, and 10% of the fair market value of all partnership property, other than money. obra 1993 eliminated the latter requirement for sales, exchanges, and distributions occurring after april 30, 1993. obra 1993, supra note i, § 13206(e)(2), 107 stat. at 467. see infra text accompanying notes 76-82. 13. depreciation recapture is treated as an asset having a basis of zero. see regs. § 1.751-1(c)(5). 19941 florida tax review stantially appreciated." therefore, under section 751 (a), a is treated as selling her $100 share of the partnership's actual inventory and her $100 share of its unrealized receivables. 4 the remaining $2,200 received by her is used to compute her capital gain or loss under section 741. to determine the amount treated as ordinary income, the selling partner must allocate a portion of the basis of her partnership interest to the section 751 property treated as sold by her under section 751 (a). this is done by determining the basis that she would have had in such section 751 property if she had received it from the partnership in a current distribution."5 in a current distribution, a partner succeeds to the partnership's basis in the property immediately before the distribution and must reduce the basis of her partnership interest by that amount. 16 however, the partner's basis in the distributed property may not exceed the basis of her partnership interest immediately before the distribution, reduced by any money distributed in the same transaction.' 7 in a current distribution of her one-third share of the partnership's section 751 property, a would have succeeded to a zero basis in the machine and the accounts receivable (each having a value of $100) and a $90 basis in the inventory (having a value of $100). this aggregate basis of $90 is used in determining the amount of a's ordinary income under section 751 (a), and the remaining basis of her partnership interest ($2,010) is used in determining the amount of a's capital gain or loss under section 741. c. final determination of selling partner's gain.-the portion of a selling partner's amount realized and the basis of her partnership interest not dealt with under section 75 1(a) yields a capital gain or loss under section 741. here, a realizes $110 of ordinary income and $190 of capital gain on the sale of her partnership interest, corresponding to the theoretically correct result, and calculated as follows: 14. although the partnership's unrealized receivables (as defined in § 751(c)) are within the definition of inventory under § 751(d), they are not subjected to tax twice. however, because such unrealized receivables will typically have a low or zero basis, their inclusion makes it more likely that traditional inventory of the partnership, which might not be considered substantially appreciated when viewed alone, will be considered substantially appreciated when considered together with the partnership's unrealized receivables. 15. regs. § 1.751-1(a)(2). for this purpose, a current distribution is one other than in liquidation of a partner's interest. 16. irc §§ 732(a)(1), 733. 17. irc § 732(a)(2). [vol 1:12 reassessing sales and liquidations of partnership interests total sec. 751(a) sec. 741 amount realized 2400 200 2200 adjusted basis 2100 90 2010 gain (loss) 300 110 190 2. tax consequences to purchasing partners a. effect on basis in partnership interest.-the basis of an interest in a partnership acquired other than by contribution is determined by the code's general basis rules.' 8 thus, the basis of a purchased interest is its cost.' 9 because a partnership interest is a unitary asset, a partner who purchases an additional interest in a partnership will increase the basis of his existing interest by the amount paid.' therefore, by purchasing one-half of a's interest for $1,200 cash, b and c increase their respective interests in the partnership from one-third to one-half and will increase the basis in their partnership interests by $1,200, to a total of $3,300 each. b. adjustments to basis of partnership propertr.-the basis of partnership property is not adjusted on the transfer of an interest in a partnership by sale or exchange unless the partnership has made an election under section 754.21 (1) tax consequences if section 754 election not in effect.-the purchasing partners can be affected adversely by the failure to make a section 754 election where the partnership's assets have appreciated in value.22 to illustrate, assume that immediately after b and c purchase a's interest, the partnership sells its assets for $7,200 in cash and distributes $3,600 to each partner in liquidation. the partnership's assets and the amount and character of its gain on the sale are as follows: 18. irc § 742. 19. regs. § 1.742-1. see irc § 1012 (providing that basis of property is cost). 20. see rev. rul. 84-53, 1984-1 c.b. 159 (holding that a partnership interest is a unitary asset having a single basis, even if portions of such interest have been acquired at different times). 21. irc § 743(a). 22. however, where the partnership's basis exceeds the value of such assets, the purchasing partners may prefer that a § 754 election not be in effect, so that they may use the higher inside basis of the partnership's property. if, in such circumstances, an election is already in effect at the time of the purchase, the pertinent regulations indicate that an application to revoke the election would not be approved when the purpose of the revocation is primarily to avoid a reduction in the basis of partnership assets upon a transfer or distribution. regs. § 1.754-1(c). 19941 florida tax review asset basis fmv gain character cash 6000 6000 0 -inventory 270 300 30 ordinary machine 0 150 150 ordinary accounts receivable 0 150 150 ordinary capital asset 30 300 270 capital good will 0 300 300 capital total 6300 7200 900 the partnership will realize $900 of gain on the sale of its assets, of which $330 is ordinary income and $570 is capital gain. but because a has left the partnership, b and c as the remaining partners will each be allocated one-half, rather than one-third, of these amounts. accordingly, b and c each will be allocated $450 of gain, of which $165 is ordinary income and $285 is capital gain, and each will increase the basis of his partnership interest by $450, to $3,750. on receiving $3,600 in liquidation, each will recognize a capital loss of $150. 23 thus, although the theoretically correct result ($110 of ordinary income and $190 of capital gain) has been achieved as to a, partners b and c each have $165 of ordinary income and $135 of overall capital gain (capital gain of $285 and a capital loss of $150), or $55 too much ordinary income and $55 too little capital gain. this occurs because the basis of the partnership's property was unchanged after a's sale of her partnership interest, even though b and c have paid fair market value for a's one-third interest in the partnership's property and even though a has been taxed on one-third of the inherent but unrealized gain on such property.24 indeed, the additional aggregate $110 of ordinary income allocated to b and c represents the ordinary income previously taxed to a.25 accordingly, b and c should 23. under § 731 (a)(2), loss is recognized only on distributions in liquidation where no property other than money, unrealized receivables, and inventory are distributed. such loss is measured by the excess of the partner's adjusted basis in her partnership interest over the sum of money distributed and the basis to the distributee under § 732 of any unrealized receivables and inventory. 24. that is, the partnership only realized the gain inherent in its assets after a sold her interest therein. 25. because b and c are each taxed on an excess $55 of ordinary income (representing a's one-third share thereof), they acquire an additional $55 of basis in their partnership interests. this increases their capital loss on liquidation of the partnership by $55 and reduces pro tanto their capital gain. but this loss is a capital loss that can be recognized only upon complete liquidation of the partnership or sale of their interests. thus, when characterization and time value of money considerations are taken into account, this loss will not fully compensate b and c for the extra ordinary income they have been allocated. [vol 1:12 reassessing sales and liquidations of partnership interests consider causing the partnership to make a section 754 election, the consequences of which are described immediately below.6 (2) tax consequences if section 754 election in effect (a) overview of section 754.-if a partnership makes a section 754 election, it will adjust the basis of its property under section 734(b) in connection with partnership distributions and under section 743(b) in connection with transfers of partnership interests.' these adjustments are allocated to specific partnership assets in accordance with the rules set forth in section 755 and the regulations thereunder?(b) basis adjustments under section 743(b) upon transfer of a partnership interest.-if a partnership interest is transferred while a section 754 election is in effect, the partnership must either increase the basis of its property by the excess of the transferee's basis in his partnership interest over his proportionate share of the basis of the partnership's property, or decrease the basis of its property by the excess of the transferee's proportionate share of the basis of partnership property over the basis of his partnership interest. 29 the adjustment applies with respect to the transferee partner only, which partner will have a special basis for those partnership properties which are adjusted, consisting of his share of the common partnership basis, plus or minus his special basis adjustments.3' basis adjustments resulting from a partnership's section 754 election are allocated to specific partnership assets under section 755 and the regulations thereunder, which provide two guiding principles. " first, adjustments ordinarily must be allocated in a manner that reduces the difference between 26. see irc §§ 734, 743, 754. 27. once made, the election applies to all distributions of property and all transfers of interests in the partnership during the taxable year with respect to which the election is made and for all subsequent taxable years. irc § 754. if a § 754 election is made, the adjustments prescribed under §§ 734 and 743 are mandatory; a partnership cannot elect to make adjustments only under one or the other of the sections. regs. § 1.754-1(a). an election may be revoked in accordance with limitations contained in the pertinent regulations. irc § 754. the procedure for revoking an election and the grounds on which an application for revocation may be granted are set forth in regs. § 1.754-1(c). 28. irc §§ 734(c), 743(c); regs. §§ 1.734-1(c), 1.743-1(c). 29. irc § 743(b). a partner's proportionate share of the partnership's basis in its property is the "sum of his interest as a partner in partnership capital and surplus, plus his share of partnership liabilities." regs. § 1.743-1 (b)(i). if. for example. a partner holds a onethird interest in partnership capital and profits, his share of the adjusted basis of partnership property generally will be one-third of the partnership's basis. id. 30. irc § 743(b); regs. § 1.743-1(b)(i)(ii). 31. irc §§ 734(c), 743(c); regs. §§ 1.734-1(c), 1.743-1(c). 1994] florida tax review the fair market value and adjusted basis of such properties.32 thus, an adjustment that increases basis usually must be allocated only to assets whose fair market values exceed their bases, while one that decreases basis must be allocated only to assets whose bases exceed their fair market values. 33 second, in allocating basis adjustments, the partnership's property is divided into two classes: one, capital assets and property described in section 1231 (b) 32. irc § 755(a)(1). 33. regs. § 1.755-i(a)(l)(i), (ii). thus, an upward adjustment can only reduce gain, and not increase loss inherent in partnership property, and a downward adjustment can only reduce loss and not increase gain. therefore, such adjustments will not always conform a transferee partner's share of the basis of the partnership's property to his share of the fair market value of such property. for example, assume that the balance sheet of the wxy partnership, which has a § 754 election in effect, is as follows: basis fmv gain (or loss) asset 1 0 300 300 asset 2 90 60 (30) total 90 360 270 partners' equity w 30 120 90 x 30 120 90 y 30 120 90 total 90 360 270 if z purchases w's one-third capital and profits interest for $120, w will recognize gain of $90. by paying the equivalent of his share of the fair market value of the partnership's assets, z should be entitled to an overall basis of $100 in asset i and $20 in asset 2 (onethird of each asset's fair market value). if so, he would be allocated no gain or loss if the partnership sold either asset for its fair market value. but that result does not occur under the general provisions of the regulations. the $90 upward special basis adjustment to which z is entitled under § 743(b) must be allocated entirely to asset 1, whose value exceeds its adjusted basis, giving z a special basis therein of $90. thus, z would be allocated $10 of gain from the sale of asset 1 and $10 of loss from the sale of asset 2 representing, for asset 1, the difference between $100 (z's one-third share of the asset's $300 fair market value) and $90 (z's special basis in asset 1) and for asset 2, the difference between $30 (z's one-third share of the partnership's basis in the asset) and $20 (z's one-third share of the asset's $60 fair market value). z could avoid allocation of such gain or loss if he obtained a net $90 of basis adjustments linked to each asset's fair market value-that is, a $100 upward special basis adjustment with respect to asset i and a $10 downward special basis adjustment with respect to asset 2. his special basis would then be equal to one-third of each asset's fair market value. partnerships may apply for authority to make special basis adjustments in the manner just described, in lieu of that initially prescribed by the regulations; such an application must be made no later than 30 days after the close of the partnership's taxable year in which the proposed adjustment is to be made. regs. § 1.755-1(a)(2). [vol. 1:12 reassessing sales and liquidations of partnership interests (hereinafter "capital and 1231(b) assets") and two, all other property.' a positive basis adjustment is allocated first, between the two classes of property according to the relative net appreciation of assets in the two groups and then, to specific assets within each class on the basis of relative net appreciation when compared with other assets within that class." a negative basis adjustment would similarly be made on the basis of relative net depreciation in assets. these considerations can be illustrated with reference to the abc partnership, which had the following assets when b and c purchased a's interest: asset basis fmv gain and character cash 6000 6000 0 inventory 270 300 30 other machine 0 150 150 other unrealized receivables 0 150 150 other capital asset 30 300 270 capital/1231(b) good will 0 300 300 capital/123l(b) total 6300 7200 900 after the purchase, b and c each have a basis in their respective partnership interests of $3,300 and a $3,150 proportionate share of the basis of the partnership's property, so that each of them is entitled to an upward special basis adjustment of $150. the partnership has net appreciation of $570 in its capital and section 1231(b) assets,36 and $330 in its "other" property, or total appreciation of 34. regs. § 1.755-1(b). the pertinent regulations provide that to the extent that an amount paid by the purchaser of a partnership interest is attributable to the partnership's capital and § 1231(b) assets, any difference between the amount so attributable and the transferee partner's share of the partnership's basis of such property shall constitute a special basis adjustment with respect to such capital and § 1231(b) assets. regs. § 1.755-1(b)(2). similarly, any such difference attributable to other property of the partnership shall constitute a special basis adjustment with respect to such other property. id. 35. see regs. § 1.755-1(c) ex. 2. for this purpose, net appreciation is the excess of aggregate fair market value over aggregate basis of the properties being considered. thus, if a partnership's capital assets and § 1231(b) property had appreciated by $400, while its other property had not appreciated, an upward § 743(b) adjustment must be allocated entirely to the partnership's capital assets and § 123 1(b) property. if, instead, the capital assets and § 123 1(b) property had appreciated by $200 and its other property by s100. then two-thirds (2001300) of the adjustment is allocated to the partnership's capital assets and § 1231(b) property, and one-third (100/300) is allocated to its other property. 36. it is unnecessary to classify cash as either capital and § 1231(b) assets or "other" property, since its basis and fair market value always will be equal. 19941 florida tax review $900.3 7 therefore, of each partner's $150 special basis adjustment, 570/900 ($95) is allocable to the partnership's capital and section 1231(b) assets and 330/900 ($55) to its other property. the total adjustment to each class of property is allocated among specific assets within that class, again based on relative net appreciation. of the total $570 of net appreciation in the first class, having total appreciation of $570, $270 was attributable to the capital asset and $300 to the good will. therefore, of each partner's allocable $95 special basis adjustment, 270/570 ($45) is allocable to the capital asset and 300/570 ($50) to the good will. similarly, the partnership's other property had total net appreciation of $330, of which $150 was attributable to the accounts receivable, $150 to the machine, and $30 to the inventory. therefore, of each partner's allocable $55 special basis adjustment, 150/330 ($25) is allocable to the accounts receivable, 150/330 ($25) to the machine, and 30/330 ($5) to the inventory. with these special basis adjustments, the partnership's balance sheet would be as follows: special total asset basis basis adi.38 basis fmv cash 6000 0 6000 6000 inventory 270 10 280 300 machine 0 50 50 150 accounts receivable 0 50 50 150 capital asset 30 90 120 300 good will 0 100 100 300 total 6300 300 6600 7200 partners' equity b 3300 3300 3600 c 3300 3300 3600 total 6600 6600 7200 now, if the partnership sold its assets for $7,200 and distributed $3,600 of cash to b and c in liquidation, it would recognize ordinary income of $220 ($20 from the inventory, $100 from the machine and $100 from the 37. although the machine is described in § 1231(b), it should not be placed in the § 1231(b) category for this purpose since the entire gain from its sale at fair market value would be characterized as ordinary income under § 1245. 38. for convenience, the table aggregates the special basis adjustments for b and c. technically speaking, however, the partnership must make separate special basis adjustments for each partner entitled thereto. see irc § 743(b); regs. § 1.743-1(b). [vol. 1:12 reassessing sales and liquidations of partnership interests accounts receivable) and capital gain of $380 ($180 from the capital asset and $200 from the good will). b and c would each be allocated $i10 of ordinary income and $190 of capital gain, and would recognize no further gain or loss on liquidation.39 in this example, the theoretically correct result has been obtained as to b and c because of the basis adjustments resulting from the section 754 election. 3. summary of results to selling and purchasing partners.sections 741 and 751(a) can tax a selling partner on the theoretically correct amounts of capital gain and ordinary income, almost as if she sold her proportionate interest in the partnership's underlying assets."m the selling partner, therefore, will usually be neither overtaxed nor undertaxed.4 by contrast, if the partnership does not make a section 754 election and holds appreciated assets, the purchasing partners may be overtaxed. where a section 754 election is in effect, however, the purchasing partners obtain an adjustment to the basis of partnership property that reflects both their payment of the value of the selling partner's interest in the partnership's property and the taxation of the selling partner on the sale of her interest. that basis adjustment can shield them from being taxed on the selling partner's share of the inherent gain on such property when the partnership subsequently disposes 39. b and c will each increase the basis of his partnership interest by $300. from $3,300 to $3,600. if the partnership then were liquidated, each partner would receive cash ($3,600) equal to the basis of his interest in the partnership and would recognize no further gain or loss. 40. since § 751(a) provides ordinary income treatment to the selling partner only with regard to her share of unrealized receivables and substantially appreciated inventory, she will not always be taxed in the same manner as if she directly sold her interest in the partnership's assets. for example, if a partner directly sold an appreciated inventory item. ordinary income invariably would result. under § 751(a), ordinary income treatment follows on the sale of a partnership interest only if the inventory held by the partnership is "substantially appreciated." 41. this conclusion assumes that, as was true for a on the facts of the example, the selling partner's proportionate share of basis of the partnership's property corresponds to her proportionate share of the value of such assets. such a correspondence may be lacking where, for example, the selling partner purchased an interest in an existing partnership that holds appreciated assets and that has not made an election under § 754. as an example. consider again the facts illustrated above. if, after purchasing one-half of a's interest. c sold his interest in the partnership to d for $3,600, he would have realized ordinary income of s 165 and capital gain of $135 if the partnership had not made a § 754 election. 19941 florida tax review of the property.42 the partnership's section 754 election will not alter or adversely affect the tax consequences to the selling partner.43 c. liquidation of a partner's interest under section 736 and related provisions prior to amendments by obra 1993 as an alternative to the purchase of a partner's interest by her fellow partners, the partnership itself could liquidate a partner's interest. the tax consequences of this form of transaction are governed by section 736 and related code provisions. the amendments made to these provisions by obra 1993 are discussed in detail in part i, below, while this part describes such provisions as in effect immediately prior to the enactment of obra 1993. 1. overview of section 736: subsections (a) and (b).-since its addition to the internal revenue code in 1954, section 736 has divided partnership payments to retiring partners into two categories. payments for the partner's interest in partnership property are treated under section 736(b)(1) as a liquidating distribution. section 736 does not itself prescribe the tax consequences of such a distribution, but leaves that task to other provisions of subchapter k dealing with distributions, in particular, section 731. thereunder, except as otherwise provided by section 751 (b), gain or loss on the distribution of money in liquidation of a partner's interest results in capital gain or loss." the remaining partners may not deduct these payments since they represent either a distribution or a purchase of the withdrawing partner's capital interest by the partnership (composed of the remaining partners).45 payments for the retiring partner's share of unrealized receivables and "unstated good will" of the partnership are not treated as payments for a partner's interest in partnership property within the meaning of section 736(b).46 instead, such payments fall within section 736(a), where they are 42. if upward special basis adjustments resulting under § 743(b) are allocated to depreciable or amortizable property, the partners obtaining such special basis adjustments are entitled to claim deductions for depreciation or amortization with respect thereto. see infra text accompanying notes 111-12. 43. in closing this discussion of § 741, it should be noted that the same consequences, albeit with slightly different numbers, would have resulted if b and c caused the partnership to distribute $1,200 to each of them and used such funds to purchase a's interest in the partnership. 44. irc § 73 1. 45. regs. § 1.736-1(a)(2). 46. irc § 736(b)(2). a payment for good will is not considered to be made in exchange for an interest in partnership property and is thus outside the scope of § 736(b) "except to the extent that the partnership agreement provides for a payment with respect to [vol 1:12 reassessing sales and liquidations of partnership interests considered either a distributive share of the partnership's income (if the amount thereof is determined with regard to the partnership's income) or a guaranteed payment (if the amount thereof is determined without regard to the partnership's income). section 736(a) payments usually constitute ordinary income to the retiring partner and result in a deduction or its equivalent to the partnership (consisting of the remaining partners). 7 the tax consequences of a liquidation under section 736 under preobra 1993 law can be illustrated by again considering the abc partnership, whose balance sheet is reproduced here for convenience: asset cash inventory machine accounts receivable capital asset good will total partners' equity a b c total abc partnership basis fmv 6000 6000 270 300 0 150 0 30 0 6300 2100 2100 2100 6300 150 300 300 7200 2400 2400 2400 7200 the partnership will liquidate a's interest for $2,400 in cash. although $100 of this payment represents her share of the partnership's good will, it is assumed that the partnership agreement does not "provide" for a payment with respect to good will, so that payment therefore is considered a section 736(a) paymentgood will." irc § 736(b)(2)(b). thus, a payment for unstated good will is a § 736(a) payment. and a payment for good will that is provided for in the partnership agreement is a § 736(b) payment. 47. a guaranteed payment is considered a payment made to a nonpartner and results in ordinary income to the recipient partner. see irc § 707(a), (c). if a payment is considered a distributive share of income to a partner, it reduces the distributive shares of income allocable to the other partners, affording them the equivalent of a deduction. see regs. § 1.736-1(a)(4). gain 30 150 150 270 300 900 300 300 300 900 19941 florida tax review 2. tax consequences to retiring partner a. section 736(a) payments.-under section 736(a), the $200 paid for a's interest in the partnership's unrealized receivables 48 and unstated good will is treated as a guaranteed payment and results in ordinary income to a.49 b. section 736(b) payments.-the remaining $2,200 of the partnership's payment is treated under section 736(b) as a distribution in liquidation of a's interest. under section 731(a), a will recognize a capital gain or loss from these payments, except as provided by section 751(b).50 c. effect of section 751(b) (1) in general.-section 751(b) seeks to prevent partners from shifting the partnership's ordinary income and capital gain items among themselves through current or liquidating distributions that alter their respective interests in such items. it divides property of the partnership into two groups: one, unrealized receivables and substantially appreciated inventory (section 751 property) 5' and two, all other property, including money (non-section 751 property). it asks whether, after any distribution, each partner has retained a proportionate share of each group of property or has instead relinquished an interest in one group of property in exchange for a larger interest in the other group. if a partner receives in a distribution either section 751 property in exchange for all or part of her interest in nonsection 751 property or non-section 751 property in exchange for all or part of her interest in section 751 property, the distribution is, to this extent, considered a sale or exchange of such properties between the distributee partner and the partnership as constituted after the distribution. 2 therefore, 48. before the amendment of § 75 1(c) by obra 1993, unrealized receivables meant for this purpose both traditional and nontraditional unrealized receivables. see infra text accompanying notes 83-88. 49. see irc § 707(c). 50. irc § 731(a)(1), (c). a will have a gain to the extent that the money distributed exceeds the adjusted basis of her partnership interest immediately before the distribution, or a loss to the extent that the basis of her partnership interest exceeds the amount of money distributed to her in liquidation. 51. these terms are defined, respectively, in §§ 751 (c) and (d). for § 751 purposes, both before and after enactment of obra 1993, the term "unrealized receivables" means both traditional and nontraditional unrealized receivables. 52. irc § 751(b). because § 751(b) operates by reference to the overall value of, rather than appreciation or depreciation in, the partnership's § 751 property, it does not always succeed in preventing disproportionate shifting of gains and losses among partners. for [vol 1:12 reassessing sales and liquidations of partnership interests section 751(b) can apply whenever a partner receives money, which is nonsection 751 property, in exchange for her interest in section 751 property. (2) application of section 751(b) to section 736 payments.-section 751 (b) is inapplicable to payments under section 736(a), but it does apply to payments under section 736(b).53 if a retiring partner receives section 736(b) payments for her interest in the partnership's section 751 property, section 751(b) treats her as if she received her proportionate share of such section 751 property in a current distribution and resold it to the partnership.-4 only the 736(b) payments in excess of this amount are treated as a distribution in liquidation of the retiring partner's interest." when a received a $2,400 payment in liquidation of her interest, the abc partnership's balance sheet was as follows. a's share of asset basis fmv fmv cash 6000 6000 2000 inventory 270 300 100 machine 0 150 50 accounts receivable 0 150 50 capital asset 30 300 100 good will 0 300 100 total 6300 7200 2400 example, assume that a partnership having two equal partners owns, among other assets, inventory items 1 and 2. each item has a value of s100, but item i has a basis of s30 and item 2 has a basis of $80. section 751(b) will not apply to the distribution of item i to one partner and item 2 to the other, because each partner is receiving in the distribution a pro rata $100 share of § 751 property. this is the case even though the distribution shifts disproportionate amounts of gain and loss among the partners (i.e.. the partner receiving item 1 has property containing $70 of built-in ordinary income and the partner receiving item 2 has property containing $20 of built-in ordinary income). 53. irc § 751(b)(2)(b). because § 736(a) generally treats payments for a partner's share of unrealized receivables (which are § 751 property) as ordinary income, it is unnecessary to apply § 75 1(b) to characterize such payments. under obra 1993's amendment of irc § 751(c), only certain payments for a retiring partner's share of traditional unrealized receivables qualify as § 736(a) payments. see infra text accompanying notes 83-88. 54. see regs. § 1.751-1(b), (g) ex. 2. 55. see regs. § 1.751-1(b)(4), which provides that if there is an exchange of substantially appreciated inventory items for other property. § 736(b) payments must be divided between the payments treated as a sale or exchange under § 751(b) and payments treated as a distribution under §§ 731 through 736. 19941 florida tax review because section 751(b) does not apply to the section 736(a) payments of $200 for a's interest in the accounts receivable, the machine, and the unstated good will, only the section 736(b) payment of $2,200 for her interest in the cash, inventory, and capital asset need be considered. regarding these assets, a initially had a proportionate interest of $2,100 in non-section 751 property (the money and the capital asset) and $100 in section 751 property (the substantially appreciated inventory), but she received non-section 751 property of $2,200 (money) and no section 751 property (inventory). section 751(b) treats this $100 disparity as if a actually received her proportionate $100 share of inventory in a current distribution and sold it to the partnership for the excess non-section 751 property received by her (the $100 of money). at the time of the deemed distribution, a's basis for her partnership interest was $2,100 and the partnership's $300 worth of inventory had a basis of $270, so that $100 worth of inventory deemed distributed to a under section 751(b) would have had a basis of $90. that deemed distribution would result in nonrecognition of gain or loss,56 with a taking a $90 basis in the distributed inventory57 and reducing the basis of her partnership interest from $2,100 to $2,010.58 on the deemed sale of this inventory to the partnership for $100, a realizes $10 of ordinary income. 9 the remainder of the section 736(b) payment, in the amount of $2,100, is treated as a liquidating distribution that results in gain to the extent that a receives money in excess of the basis of her interest in the partnership.6" since the deemed distribution of inventory under section 751(b) reduced the basis of her partnership interest to $2,010, a will recognize a capital gain of $90.61 in summary, a's total gain was $300. of this amount, $200 was treated as a guaranteed payment taxable as ordinary income under section 736(a), $10 was treated as ordinary income under section 751(b), and $90 was treated as capital gain under sections 736(b) and 731. therefore, a had $210 of ordinary income and $90 of capital gain which, when compared with the theoretically correct result ($110 of ordinary income and $190 of capital gain) is $100 too much ordinary income and $100 too little capital gain. this 56. irc § 731(a), (b). 57. irc § 732(a). 58. irc § 733(2). 59. this deemed sale transaction under § 751(b) generates ordinary income even if the property would not otherwise be considered inventory when held by the selling partner. see irc § 735(a)(2) (treating gain or loss on the sale or exchange by a distributee partner of inventory items within five years of distribution as ordinary income or ordinary loss, as the case may be). 60. irc § 731(a)(1). 61. irc § 731(a). it is appropriate that this $90 of gain be taxed as capital gain because it represents a's share of appreciation in the partnership's capital asset. [vol 1:12 reassessing sales and liquidazions of partnership interests disparity results because the payment for unstated good will is treated as an ordinary income item under section 736(a). had the partnership agreement "provided for" a payment for good will, that amount would have been a section 736(b) payment, yielding the theoretically correct amounts of $110 of ordinary income and $190 of capital gain. 3. tax consequences to remaining partners a. in general.-upon retiring a's interest, the partnership deducts $200 under section 736(a) for its payment for a's share of unrealized receivables and unstated good will. this deduction passes through to b and c equally and reduces the bases of their respective partnership interests. because it is deemed under section 751(b) to have distributed and repurchased $100 worth of inventory, the partnership obtains a $10 increase in the basis of its inventory. 2 no further adjustments would be made to the basis of its property unless a section 754 election is in effect. 6if such an election is in effect, the partnership must increase the bases of its assets under section 734(b) by the $90 of gain recognized to a on the section 736(b) distribution.64 because such gain represented a's share of the appreciation in the capital asset and was taxed to her as capital gain, the basis of the partnership's capital asset is increased by this amount. 6 this adjustment is made at the partnership level and is not specific to a particular partner.' 62. immediately before a's retirement, the partnership's inventory had a value of $300 and a basis of $270. the deemed distribution of sloo worth of inventory to a (representing her proportionate share thereof) under § 751(b) left the partnership holding $200 worth of inventory with a basis therein of $180. the deemed repurchase of sl00 worth of inventory from a under § 751(b) for cash of $100 increased the total value of the partnership's inventory back to $300 and increased its total basis therein to $280. 63. irc § 734(a). 64. irc § 734(b)(1)(a). 65. where a distribution results in an adjustment under § 734(b)(i)(a) or (b)(2j(al (because capital gain or loss has resulted to the partner on the distribution). "such adjustment must be allocated only to capital assets or § 1231(b) property." regs. § 1.755-1(bj(l)(ii). although the partnership's good will is arguably a capital asset or § 1231(b) property, it seems inappropriate to give the partnership any basis whatsoever in the good will on these facts because the partnership (consisting of b and c) effectively has deducted its si00 cost of purchasing a's share of the partnership's good will under § 736(a). otherwise, if a's share of good will were considered an amortizable intangible asset under new § 197, the partnership might obtain double tax benefits (immediate deduction and amortization deductions) for the same economic outlay. thus, the partnership should emerge from the transaction with a zero basis in the good will. see generally infra text accompanying notes 98-121. 66. irc § 734(b)(1). 1994] florida tax review b. illustration of tax consequences.-it is useful to consider the result if, after acquiring a's interest, the partnership sold all its assets and liquidated. with no section 754 election in effect, its balance sheet would be as follows: bc partnership asset basis fmv gain cash 3600 3600 -inventory 28067 300 20 machine 0 150 150 accounts receivable 0 150 150 capital asset 30 300 270 good will 0 300 300 total 3910 4800 890 partners' equity b 200068 2400 400 c 2000 2400 400 total 4000 4800 800 the sale of the partnership's assets would result in $890 of gain, of which $320 is ordinary income and $570 is capital gain. of the ordinary income, $20 is attributable to the sale of the inventory, and corresponds to the amount that would have been allocable to b and c if the partnership had sold its inventory before a's retirement. the remaining $300 is attributable to its "unrealized receivables" (the accounts receivable and the machine). if a had not retired, b and c would have been allocated only $200 of income from the sale of the partnership's unrealized receivables, so it initially seems that a $100 increment of gain with respect to these items is taxed twice, once to a and again to b and c. however, b and c have already obtained a $100 deduction from ordinary income under section 736(a) with respect to these unrealized receivables that effectively offsets the additional income later attributed to them. moreover, depending upon the length of time between the making of the section 736(a) payment and the realization of gain on the unrealized receivables by the partnership, b and c have obtained the benefit of an immediate deduction coupled with deferral of income. 67. see supra note 62 and accompanying text. 68. b and c each had a basis of $2,100 in his partnership interest before a's retirement. because the $200 § 736(a) payment to a was a guaranteed payment that resulted in a partnership level deduction that passed through to them in the amount of $100 each, b and c must each reduce the basis of his partnership interest by $100. irc § 705(a)(2). [vol 1:12 reassessing sales and liquidations of partnership interests of the partnership's capital gain of $570, $300 is attributable to the good will and $270 to the capital asset. if the partnership had sold these assets before a's retirement, b and c would have been allocated only $200 of gain from the good will and $180 of gain from the capital asset, so they initially appear to be overtaxed on these items. but at least as to the good will, b and c have obtained a $100 deduction from ordinary income under section 736(a) that will offset this additional income later attributed to them.69 it is true that, as to the sale of the capital asset, b and c will be taxed on $90 of excess capital gain ($45 per partner), which will be adjusted for by an aggregate $90 capital loss ($45 per partner) upon liquidation of the partnership or sale of the partner's interest.70 if a section 754 election had been in effect, the partnership would have had $90 less capital gain on the disposition of its assets and there would have been no further gain or loss to b or c on liquidation of the partnership.7' 4. sumnary of results to retiring and remaining partners.-where the partnership liquidated a's interest and in doing so made a payment for unstated good will, a was taxed on $210 of ordinary income and $90 of capital gain. thus, she has been overtaxed as compared with the theoretically correct result ($110 of ordinary income and $190 of capital gain). by contrast, b and c have fared better than under the theoretically correct result. each of them has been taxed on $60 of ordinary income and $240 of capital gain, or $50 less ordinary income and $50 more capital gain than under the 69. indeed, even ignoring the time value of money considerations. b and c have obtained deductions against ordinary income for the $100 good will payment to a. at a cost of having $100 more of capital gain upon the disposition of the good will. 70. the partnership's $890 gain will be allocated equally to b and c, increasing the basis of each partner's interest in the partnership by s445, to $2,445. on liquidation, each partner will receive cash of only $2,400. the $45 excess of each partner's basis in his partnership interest over the amount of money received constitutes a capital loss: this aggregate loss of $90 ($45 per partner) corrects for the $90 of capital gain that was taxed once to a under §,736(b) and later recognized by the partnership because no § 754 election was in effect. 71. if a § 754 election were in effect, the partnership would increase the basis of its capital asset under § 734(b)(l)(a) by the $90 gain recognized by a under §§ 736(b) and 731. see regs. § 1.755-1(b)(i)(ii). see also supra note 65. therefore, the partnership would have a basis of $120 in its capital asset (its original basis of s30 plus the s90 basis adjustment under § 734(b)(l)(a)). with that basis, the partnership would recognize only $180 of gain on the sale of the capital asset at its $300 fair market value. this amount (590 per partner) corresponds exactly to the amount that would have been taxable to b and c if the partnership had sold the capital asset immediately before a's retirement. on this scenario, the partnership's total gain on the sale of its assets is $800. b and c would increase the bases of their partnership interests by $400 each. since each partner would have a basis of s2,400 in his partnership interest, no further gain or loss would be recognized on the distribution of $2,400 to each partner in liquidation. 19941 florida tax review theoretically correct result.72 because the payment for a's share of the partnership's unstated good will was within section 736(a), $100 of ordinary income shifted to a and away from b and c. in the process, b and c's aggregate capital gain was increased by $100 and a's was decreased by that amount. b and c have also benefitted from time value of money considerations by obtaining immediate deductions for the partnership's section 736(a) payments, even though income from its unrealized receivables and good will may not be realized until some point in the future. lastly, because the transaction was structured as a liquidation of a's interest under section 736, section 751(b) applied and resulted in an automatic adjustment to the basis of the partnership's substantially appreciated inventory, even where a section 754 election was not in effect. where b and c purchased a's interest, the theoretically correct result was reached as to a under sections 741 and 751(a) but not as to b and c unless a section 754 election was made. by causing the partnership to make such an election, however, b and c would be made better off and a would be no worse off. thus, the tax treatment of a will not adversely affect, or be adversely affected by, the tax treatment to b and c. but where the partnership liquidates a's interest, a different regime operates. by allowing the payments for good will to be designated as either section 736(a) or section 736(b) payments, the code encourages a zero-sum game among the partners. if the payments for good will are designated as section 736(b) payments, the theoretically correct result will be reached as to a. that result will also be reached to b and c if a section 754 election is in effect and their making such an election will not adversely affect a. but where the payments for a's share of good will were unstated and hence within section 736(a), a had more, and consequently b and c had less, ordinary income than the theoretically correct result would prescribe. this is the case even though good will has historically been treated as a nondeductible capital expenditure that gives rise to capital gain on its disposition.73 because of these disparate results, an evident tension existed in the positions that the various parties might take when a partner left a partnership, at least where capital gains were taxed more favorably than ordinary income. 72. the partnership has ordinary income of $320 ($300 from the disposition of the accounts receivable and the machine and $20 from the disposition of its inventory) and $200 of deductions from ordinary income for the § 736(a) payments to a. this results in net ordinary income of $120 to the partnership, or $60 per partner. it had capital gains of $300 from the disposition of its good will and $180 with regard to the capital asset, or a total of $480 of capital gain, or $240 per partner. 73. see regs. § 1.263(a)-2(h) (providing that "[tihe cost of good will in connection with the acquisition of the assets of a going concern is a capital expenditure"). see also supra note 3. [vol. 1:12 reassessing sales and liquidations qf partnership interests typically, the departing partner would seek to maximize capital gain treatment by asserting that her interest had been sold or, instead, liquidated by the partnership, with most of the consideration constituting section 736(b) payments. the remaining partners, on the other hand, would be likely to assert that the partnership had liquidated the partner's interest, with most of the consideration constituting section 736(a) payments, including payments for unstated good will.74 for the treasury, the worst situation was that in which the retiring and remaining partners treated and reported the transaction inconsistently. indeed, the issue of whether a particular transaction constituted a sale or instead a retirement of a partner's interest has been the focus of numerous litigated cases.75 partly in response to these disparate results under sections 741 and 736, congress effected a number of changes to this regime in obra 1993. im. amendments under obra 1993 affecting sales and liquidations of a partnership interest a. description of amendments the following section discusses five specific changes made by obra 1993 that affect the foregoing statutory scheme. as will be seen, congress's specific amendments to subchapter k were targeted more at liquidations under section 736 than at sales of partnership interests under section 741. 1. increased ordinary income-capital gain rate differential.-first, obra 1993 increased the maximum individual tax rate on ordinary income from 31% to 39.6%, but left the maximum individual tax rate on capital gains at 28%. accordingly, most individuals, including partners in partnerships, will prefer to maximize capital gains and minimize ordinary income. 74. of course, where capital gain and ordinary income are taxed at the same rates (as they were from 1986 through 1990), retiring partners may be indifferent as to whether they are allocated "excess" ordinary income. since they are generally taxed the same whether good will is treated as a § 736(a) or a § 736(b) payment, they may be more willing to allow their partners to obtain current deductions for payments by characterizing them as § 736(a) payments. 75. see, e.g., estate of quirk v. commissioner, 928 f.2d 751 (6th cir. 1991). aff'g in part, t.c. memo 1988-286 (cch) 1988; cooney v. commissioner, 65 t.c. 101 (1975): foxman v. commissioner, 41 t.c. 535 (1964); tolmach v. commissioner, t.c. memo 199 1538 (cch) 1991. for a discussion of the various factors applied by courts in determining how to characterize a transaction as a sale or liquidation of a partner's interest, and a proposal for the repeal of § 736, see john a. lynch, jr., taxation of the disposition of partnership interests: time to repeal irc § 736, 65 neb. l. rev. 450 (1986). 19941 florida tax review 2. section 751(d): substantially appreciated inventory.-obra 1993 amended the definition of "substantially appreciated inventory" under section 751(d)(1). under prior law, inventory items were substantially appreciated if their fair market value exceeded both 120% of the partnership's basis in such property and 10% of the fair market value of all partnership property, other than money. obra 1993 eliminated the latter requirement. for sales, exchanges, and distributions occurring after april 30, 1993, inventory items are substantially appreciated if their fair market value exceeds 120% of their adjusted basis to the partnership. 76 in making this determination, inventory items acquired by the partnership with a principal purpose of avoiding the provisions of section 751 are to be disregarded. 77 this definition of substantially appreciated inventory will apply both to sales of partnership interests implicating section 751(a) and to liquidations of partnership interests implicating section 751(b). given the increased rate differential created by obra 1993 between ordinary income and capital gain, congress sought to strengthen existing provisions designed to prevent the conversion of ordinary income into capital gain, and amended section 751(d) with this goal in mind.78 congress was concerned that taxpayers could avoid the 10%-of-assets test of prior law, and hence avoid ordinary income treatment, by manipulating the partnership's gross assets.79 prior law's threshold requirement that the inventory's value had to exceed 10% of the value of the partnership's noncash property created a de minimis safe harbor under which partnerships having inventory of relatively minimal value generally could ignore provisions such as sections 751 (a) and (b), which deal with substantially appreciated inventory. as a practical matter, however, the expansive definition of the term "inventory," which includes all ordinary income items of the partnership, made this safe harbor more illusory than real for many partnerships. in any event, the amendment of section 751(d) will broaden the reach of code sections dealing with substantially appreciated inventory, since partnerships holding any inventory items must now inquire whether that property's value exceeds 120% of its basis to the 76. irc § 75 1(d). see supra note 12 for the text of § 75 1(d) as amended by obra 1993. 77. irc § 751(d)(1)(b). 78. section 75 1(d) was amended by § 13206 of obra 1993, which also amended other code sections designed to prevent the conversion of ordinary income into capital gain. obra 1993, supra note 1, § 13206, 107 stat. at 462-67 (codified in scattered sections of 26 u.s.c.). 79. staff of senate comm. on the budget, 103d cong., 1st sess., reconciliation submissions of the instructed committees pursuant to the concurrent resolution on the budget 240 (comm. print 1993); h.r. rep. no. 111, 103d cong., 1st sess. 642 (1993), reprinted in 1993 u.s.c.c.a.n. 378, 873. [vol. 1:12 reassessing sales and liquidations of partnership interests partnership. if so, these items will be considered substantially appreciated, even if of minimal value when compared with the total assets of the partnership. under section 751(d) as amended, assets acquired with a principal purpose of reducing appreciation to less than 120% in order to avoid ordinary income treatment will be disregarded.80 the purpose of this rule was the same as the purpose for eliminating the 10%-of-total-assets test of prior law, to prevent circumvention of the rule through the manipulation of partnership assets.81 such a provision seems appropriate to prevent abuse, but unfortunately reduces the predictability inherent in an otherwise bright-line, mathematical test by creating uncertainty as to whether particular inventory items will be disregarded in making the calculation required by section 751(d). administrative guidance concerning this new aspect of section 751(d) will be welcome. 82 3. section 751(c): unrealized receivables.-before the enactment of obra 1993, the term "unrealized receivables" meant, for all purposes, both traditional unrealized receivables, such as accounts receivable, and nontraditional unrealized receivables, such as depreciation recapture. thus, liquidating payments by a partnership for a retiring partner's share of both traditional and nontraditional unrealized receivables were treated as payments for "unrealized receivables" and, therefore, were invariably within section 736(a). obra 1993 amended section 751 (c) to exclude nontraditional unrealized receivables from the definition of "unrealized receivables" for section 736 purposes only, so that under section 736, the term "unrealized receivables" now means only traditional unrealized receivables. thus, payments for 80. irc § 751(d)(1)(b). 81. staff of senate comm. on the budget, supra note 79, at 240; h.r. rep. no. i l1, supra note 79, at 642, reprinted in 1993 u.s.c.c.a.n. at 873. 82. in providing such guidance, the service might consider using, by analogy, the anti-manipulation rules under § 336 with respect to corporate liquidations. section 336 precludes liquidating corporations from deducting built-in losses on previously contributed property if such property was contributed as part of a plan a principal purpose of which was to recognize loss on liquidation. irc § 336(d)(2)(b)(i)(ll). the statute presumes that property contributed within two years of the date of adoption of a plan of liquidation is part of such a plan, except as provided in the regulations. irc § 336(d)(2)(b)tii). such regulations are to provide that the presumed prohibited purpose will be disregarded. however, unless there is no clear and substantial relationship between the contributed property and the conduct of the corporation's current or future business enterprises. joint committee on taxation. general explanation of the tax reform act of 1986 343-44 (prentice hall 1987). a similar rule would be helpful in determining circumstances in which property acquired by a partnership will be disregarded in making the determination of substantial appreciation. 19941 florida tax review items such as a retiring partner's share of partnership depreciation recapture are no longer within the scope of section 736(a); rather, such payments will be section 736(b) payments considered made in exchange for the partner's interest in partnership property. for purposes of other code sections, such as sections 731, 741 and 751, however, these nontraditional unrealized receivables remain within the definition of the term "unrealized receivables."83 in thus amending section 751(c), congress sought to prevent the timing advantages gained under section 736 by the nonretiring partners, who could immediately deduct payments for the retiring partner's share of nontraditional unrealized receivables, while deferring the recognition of income from such items. the legislative history notes that payments for unrealized receivables generally constitute nondeductible capital expenditures, and that when section 736 was enacted, the term "unrealized receivables" generally meant only traditional unrealized receivables; as to these items, the tax deferral resulting from immediate deduction was relatively short because payment is usually received in the near future.84 however, the opportunity for deferral had increased given the expansion of the definition of unrealized receivables to include nontraditional items such as depreciation recapture and market discount.85 obra 1993 thus creates two classes of unrealized receivables for section 736 purposes: one, traditional unrealized receivables, payment for which will, as discussed below, be governed for eligible partnerships by section 736(a),86 and two, nontraditional unrealized receivables, such as depreciation recapture, payment for which will be governed in all cases by section 736(b). thus, payments for a retiring partner's share of nontraditional unrealized receivables are now on a par with payments for the partner's share of the partnership's substantially appreciated inventory, which were already within section 736(b).87 for purposes of section 751, these nontraditional unrealized receivables still constitute "unrealized receivables." thus, section 736(b) payments for a retiring partner's share of both nontraditional unrealized receivables and substantially appreciated inventory must henceforth be analyzed under section 751(b), which will cause the retiring partner to have ordinary income and afford the partnership a partial cost basis with respect 83. irc § 75 1(c). see supra note 9 for the text of § 75 1(c) as amended by obra 1993. 84. staff of senate comm. on the budget, supra note 79, at 426; h.r. rep. no. il1, supra note 79, at 782, reprinted in 1993 u.s.c.c.a.n at 1013. 85. staff of senate comm. on the budget, supra note 79, at 426; h.r. rep. no. i 11, supra note 79, at 782, reprinted in 1993 u.s.c.c.a.n. at 1013. 86. as discussed infra text accompanying notes 90-97, under obra 1993's amendments to § 736, only services-oriented partnerships may treat payments for a retiring partner's share of traditional unrealized receivables as § 736(a) payments. 87. see supra notes 53-54 and accompanying text. [vol 1:12 reassessing sales and liquidations of partnership interests to these items.88 the remainder of the retiring partner's section 736(b) payments will be treated as a distribution under section 731. 4. amendment of section 736(b).-at the heart of the changes affecting the liquidation of a partner's interest under section 736 was congress's amendment of section 736(b). as under prior law, section 736(b)(1) treats payments for a partner's share of partnership property as a distribution to the retiring partner, while section 736(b)(2) excludes from this treatment payments for a retiring partner's share of unstated good will and unrealized receivables (now meaning only traditional unrealized receivables) 89 and places them into section 736(a), where they are characterized as a distributive share of partnership income or a guaranteed payment. obra 1993 added a new paragraph (3) to subsection 736(b), which provides that section 736(b)(2) will apply only if the retiring or deceased partner was a general partner in a partnership for which capital is not a material incomeproducing factor.90 the determination of whether capital is a material 88. the partnership will obtain an increased basis in the retiring partner's share of these nontraditional unrealized receivables and substantially appreciated inventory by being deemed to have purchased these items from the retiring partner under § 75 1(b). see supra note 62 and accompanying text. 89. under the obra 1993 amendments to § 751(c). the term "unrealized receivables" means, for § 736 purposes, only traditional unrealized receivables. irc § 751 (c). see supra text accompanying notes 83-86 for a discussion of this change. 90. as amended by obra 1993, § 736 provides as follows: (a) payments considered as distributive share or guaranteed paymenl-payments made in liquidation of the interest of a retiring partner or a deceased partner shall, except as provided in subsection (b). be considered(1) as a distributive share to the recipient of partnership income if the amount thereof is determined with regard to the income of the partnership, or (2) as a guaranteed payment described in section 707(c) if the amount thereof is determined without regard to the income of the partnership. (b) payments for interest in partnership.(1) general rule.-payments made in liquidation of the interest of a retiring partner or a deceased partner shall, to the extent such payments (other than payments described in paragraph (2)) are determined, under regulations prescribed by the secretary, to be made in exchange for the interest of such partner in partnership property, be considered as a distribution by the partnership and not as a distributive share or guaranteed payment under subsection (a). (2) special rules.-for purposes of this subsection, payments in exchange for an interest in partnership property shall not include amounts paid for19941 florida tax review income-producing factor is to be made under principles of present and prior law.9 (a) unrealized receivables of the partnership (as defined in section 75 1(c)), or (b) good will of the partnership, except to the extent that the partnership agreement provides for a payment with respect to good will. (3) limitation on application of paragraph (2).-paragraph (2) shall apply only if(a) capital is not a material income-producing factor for the partnership, and (b) the retiring or deceased partner was a general partner in the partnership. irc § 736, amended by obra 1993, supra note 1, § 13262(a), 107 stat. at 541. 91. for purposes of § 736 as thus amended, capital is not a material income-producing factor where substantially all the gross income of the business consists of fees, commissions, or other compensation for personal services performed by an individual. the practice of his or her profession by a doctor, dentist, lawyer, architect, or accountant will not, as such, be treated as a trade or business in which capital is a material income-producing factor even though the practitioner may have a substantial capital investment in professional equipment or in the physical plant constituting the office from which such individual conducts his or her practice so long as such capital investment is merely incidental to such professional practice. h.r. conf. rep. no. 213, 103d cong., 1st sess. 697-98 (1993), reprinted in 1993 u.s.c.c.a.n. 1088, 1386-87; staff of senate comm. on the budget, supra note 79, at 426-27; h.r. rep. no. 111, supra note 79, at 782-83, reprinted in 1993 u.s.c.c.a.n. at 1013-14. the pertinent legislative history cites § 401(c)(2) (relating to self-employed individuals), § 911(d) (excluding foreign earned income from gross income), and former § 1348(b)(1)(a) (defining personal service income) as relevant in determining whether capital is a material income-producing factor. h.r. conf. rep. no. 213, supra, at 697 n.36, reprinted in 1993 u.s.c.c.a.n. at 1386 n.36; staff of senate comm. on the budget, supra note 79, at 426 n.35; h.r. rep. no. 111, supra note 79, at 783 n.158, reprinted in 1993 u.s.c.c.a.n. at 1014 n.158. the above-cited example regarding professional services is taken nearly verbatim from the regulations under former § 1348. see regs. § 1.1348-3(a)(3). thereunder, capital is a material income-producing factor if a substantial portion of the gross income of the business is attributable to the employment of capital in the business as reflected, for example, by a substantial investment in inventories, plant, machinery, or other equipment. id. under these cited provisions, the determination of whether capital is a material income-producing factor of a business is generally a facts and circumstances based determination. see, e.g., id. with respect to former § 1348, see rev. rul. 78-306, 1978-2 c.b. 218, 21920 (holding under former § 1348 that capital need not directly produce income to be a material income-producing factor and was a material income-producing factor for an investment banking firm); rev. rul. 74-597, 1974-2 c.b. 272, 272-73 (holding capital was a material income-producing factor where individual engaged in fanning activity, leased farmland, and owned several items of farm equipment); i.r.s. t.a.m. 7914016 (dec. 28, 1978) (holding capital was material income-producing factor for naval architect who designed, constructed, [vol 1:12 reassessing sales and liquidations of partnership interests by thus restricting the application of section 736(b)(2), section 736(b)(3) precludes partnerships for which capital is a material incomeproducing factor from treating payments for both unstated good will and traditional unrealized receivables as section 736(a) payments.9 " as to such partnerships, therefore, section 736(b)(3) effectively repeals section 736(a) with respect to payments for a retiring partner's share of partnership property.93 by contrast, partnerships for which capital is not a material incomeproducing factor must continue to treat payments for nontraditional unrealized receivables as section 736(a) payments, and may also treat payments for unstated good will as section 736(a) payments. in thus amending section 736, congress was primarily concerned with the ability of partnerships under prior law to use section 736(b)(2) to deduct immediately payments for good will, which ordinarily would constitute a nondeductible capital expenditure.' it feared that such treatment could erode the rules requiring capitalization of such payments generally, and operated to mismeasure partnership income.95 finally, it noted that while the special treatment of good will under section 736 was predicated on the assumption that the partners' respective adverse interests would lead to a stated price equal to the true value of the good will, experience had proved that assumpand sold hulls for ships); i.r.s. t.a.m. 7838007 (june 19, 1978) (holding facts and circumstances indicated that capital was a material income-producing factor for taxpayer's aerial crop spraying service, despite importance of taxpayer's skills to the business). with respect to § 911, see rousku v. commissioner 56 t.c. 548, 550-52 (1971) (indicating that the determination is "fundamentally factual in nature" and holding that capital was a material income-producing factor in the taxpayer's automobile body repair business). 92. as noted earlier, § 751(c), as amended by obra 1993, precludes all partnerships from treating payments for a retiring partner's share of nontraditional unrealized receivables as § 736(a) payments. see supra text accompanying notes 83-88. 93. certain payments to a retiring partner in a capital-oriented partnership still will be outside the scope of § 736(b) and hence deductible by the partnership. for example, payments to compensate a retiring partner for services rendered to the partnership are not payments for that partner's interest in partnership property and are not § 736(b) payments. see h.r. conf. rep. no. 213, supra note 91, at 698, reprinted in 1993 u.s.c.c.a.n. at 1387 (indicating that obra 1993 "does not affect the deductibility of compensation paid to a retiring partner for past services"); staff of senate comm. on the budget. supra note 79, at 427; h.ri rep. no. 111, supra note 79, at 783, reprinted in 1993 u.s.c.c.a.n. at 1014. 94. it noted that under prior law, acquisition transactions could be structured to permit the current deduction of good will by having the acquiror form a partnership with the seller and liquidating the seller's interest therein under § 736. see staff of senate comm. on the budget, supra note 79, at 425; h.r. rep. no. 11l, supra note 79, at 782, reprinted in 1993 u.s.c.c.a.n. at 1013. 95. see staff of senate comm. on the budget, supra note 79, at 425; h.r. rep. no. 111, supra note 79, at 782, reprinted in 1993 u.s.c.c.a.n. at 1013. 1994] florida tax review tion false.96 for these reasons, congress sought to alter the treatment of good will payments by generally relegating them to section 736(b). however, it continued prior law's treatment of payments for unstated good will to general partners in partnerships for which capital is not a material incomeproducing factor because it believed that "general partners in service partnerships do not ordinarily value good will in liquidating partners. ' 5. enactment of new code section 197 concerning amortization of intangibles.-finally, although it is a provision of broader application than the sale or liquidation of a partnership interest, it is appropriate to consider in this context the impact of section 197, added by obra 1993, which allows the amortization of certain intangibles. a. purpose.-under prior law, taxpayers could amortize the basis of certain intangible assets acquired for use in a trade or business or income-producing activity if such property had a useful life that could be ascertained with reasonable accuracy. 98 in practice, this scheme led to considerable controversy between taxpayers and the service in three particular areas: (1) whether an intangible asset existed; (2) in the case of the acquisition of a business, the portion of the purchase price allocable to an amortizable intangible asset, and (3) the proper method and period for recovering the cost of an amortizable intangible asset.99 to alleviate such controversies, congress enacted section 197 which provides a single method and period for recovering the cost of most acquired intangible assets and which treats acquired good will and going concern value as amortizable intangible assets.'0 in doing so, however, congress did not seek to change the tax treatment of self-created intangible assets, such as good will created through advertising and other similar expenditures.' the following discussion very 96. congress noted that in many cases, the stated value of the good will and the total retirement payments could be set so as to maximize the combined tax savings for both retiring and continuing partners. see staff of senate comm. on the budget, supra note 79, at 425-26; h.r. rep. no. 111, supra note 79, at 782, reprinted in 1993 u.s.c.c.a.n. at 1013. 97. staff of senate comm. on the budget, supra note 79, at 426; h.r. rep. no. 111, supra note 79, at 782, reprinted in 1993 u.s.c.c.a.n. at 1013. 98. regs. § 1.167(a)-3. see h.r. conf. rep. no. 213, supra note 91, at 672, reprinted in 1993 u.s.c.c.a.n. at 1361; staff of senate comm. on the budget, supra note 79, at 397; h.r. rep. no. 111, supra note 79, at 760, reprinted in 1993 u.s.c.c.a.n. at 991. 99. see staff of senate comm. on the budget, supra note 79, at 397; h.r. rep. no. 111, supra note 79, at 760, reprinted in 1993 u.s.c.c.a.n. at 991. 100. see staff of senate comm. on the budget, supra note 79, at 397; h.r. rep. no. 111, supra note 79, at 760, reprinted in 1993 u.s.c.c.a.n. at 991. 101. see staff of senate comm. on the budget, supra note 79, at 397; h.r. rep. no. 111, supra note 79, at 760, reprinted in 1993 u.s.c.c.a.n. at 991. [vol. 1:12 reassessing sales and liquidations of partnership interests generally describes the operation of this new provision and examines its potential application in connection with the sale or liquidation of a partner's interest. b. brief overview of section 197.-section 197(a) allows the adjusted basis of any amortizable section 197 intangible to be amortized ratably over a fifteen-year period beginning with the month in which the intangible was acquired. 02 it provides the exclusive cost recovery method with regard to section 197 intangibles. 0 3 the term "amortizable section 197 intangibles" means section 197 intangibles acquired after the enactment of section 197 and used in connection with a trade or business or incomeproducing activity, but does not generally include intangibles created by the taxpayer other than in connection with a transaction (or series of transactions) involving the acquisition of assets constituting a trade or business or a substantial portion thereof.' °4 the term "section 197 intangible" includes, among other items, good will, 10 5 going concern value,' °6 workforce in place, business books, records, and other information bases, patents, know-how, governmental licenses and permits, covenants not to compete, and certain franchises, trademarks, and tradenames.1 0 7 the term does not, however, include financial interests, including interests in corporations, partnerships, trusts, or estates."c where intangibles are transferred in certain nonrecognition transactions, to the extent that the transferee's adjusted basis in the intangible does not exceed the transferor's adjusted basis therein, the transferee succeeds to any amortization 102. irc § 197(a). 103. irc § 197(b). 104. irc § 197(c). 105. irc § 197(d)(1)(a). for this purpose, good will means "the value of a trade or business that is attributable to the expectancy of continued customer patronage, whether due to the name of a trade or business, the reputation of a trade or business, or any other factor." h.r. conf. rep. no. 213, supra note 91, at 674, reprinted in 1993 u.s.c.c.a.n. at 1363; staff of senate comm. on the budget, supra note 79. at 400; h.r. rep. no. 11l, supra note 79, at 762, reprinted in 1993 u.s.c.c.a.n. at 993. 106. irc § 197(d)(l)(b). for this purpose, "going concern value is the additional element of value of a trade or business that attaches to property by reason of its existence as an integral part of a going concern," and it includes value "attributable to the ability of a trade or business to continue to function and generate income without interruption notwithstanding a change in ownership." h.r. conf. rep. no. 213, supra note 91, at 674, reprinted in 1993 u.s.c.c.a.n. at 1363; staff of senate comm. on the budget, supra note 79. at 400; h.r. rep. no. 11, supra note 79, at 762, reprinted in 1993 u.s.c.c.a.n. at 993. 107. irc § 197(d)(i)(c)-(f). 108. irc § 197(e)(l)(a). 1994] florida tax review deductions to which the transferor was entitled.' 9 any amortizable section 197 intangible is treated as property which is of a character subject to the allowance for depreciation provided in section 167.110 c. application to sale or liquidation of a partnership interest (1) in general.-the foregoing provisions make it clear that the cost of a partnership interest may not be amortized under section 197. a question arises, however, as to whether a person acquiring an interest in a partnership may amortize the basis of any section 197 intangibles owned by the partnership. of course, the acquiring partner will succeed to the transferor partner's share of any amortization deductions already being claimed by the partnership. beyond this, however, the acquisition of an interest in an intangible held by a partnership will be treated as an acquisition to which section 197 applies only if, and to the extent that, the acquiring taxpayer obtains, as a result of the transaction, an increased basis for the intangible. such an increased basis will ordinarily come about only where the partnership has made a section 754 election. a taxpayer who acquires an interest in a partnership which has made a section 754 election and does obtain an increased basis in a section 197 intangible is treated as owning an interest in two intangible assets. the first asset consists of the selling partner' s share of the basis of the intangible; as to this, the acquiring taxpayer succeeds to the transferor's share of any allowable amortization deductions. the second asset consists of the basis increase obtained by the acquiring taxpayer; this amount is treated as a newly acquired item which is amortizable over a fifteen-year period."' similarly, when a partnership owning an 109. irc § 197(f)(2)(a). the transfers to which this rule applies are those described in §§ 332, 351, 721, 731, 1031, and 1033, as well as transfers between members of an affiliated group of corporations during any taxable year for which a consolidated return is made. irc § 197(f)(2)(b)(ii). 110. irc § 197(f)(7). thus, an amortizable § 197 intangible is not a capital asset, but is § 1231 property if held for more than one year. irc § 1231(b). similarly, such property constitutes § 1245 property (giving rise to depreciation recapture) and § 1239 applies to characterize as ordinary income any gain on the sale or exchange of any amortizable § 197 intangible between related persons. see h.r. conf. rep. no. 213, supra note 91, at 688, reprinted in 1993 u.s.c.c.a.n. at 1377; staff of senate comm. on the budget, supra note 79, at 418; h.r. rep. no. 111, supra note 79, at 775, reprinted in 1993 u.s.c.c.a.n. at 1006. 111. the legislative history provides the following example: a, b, and c each contribute $700 to the p partnership, which acquires a § 197 intangible for $2,100. when the partnership's sole asset is the intangible having a basis of $1,500 and each partner's partnership interest has a basis of $500, a sells her interest to d, an unrelated individual for $800. if no § 754 election is in effect, d will simply succeed to a's $500 basis in the intangible, which will be amortizable over the amortization period remaining for the partnership. if, on the other hand, a § 754 election is in effect, d will have an $800 basis in [vol 1:12 reassessing sales and liquidations of partnership interests amortizable section 197 intangible liquidates the interest of a partner and has a section 754 election in effect, it can generally amortize any resulting increase in the basis of section 197 intangibles over a fifteen-year period." 2 this fact provides an additional incentive for partnerships to make a section 754 election where the partnership holds depreciable or amortizable property that has appreciated in value. (2) partnership good will as a section 197 intangible (a) in general.-before the enactment of section 197, a taxpayer acquiring a basis in good will derived little benefit therefrom since it was not amortizable and thus could only reduce gain or increase loss realized upon the disposition thereof. thus, the immediate deductibility of payments for unstated good will under section 736(a) was particularly attractive to partners in partnerships. after the enactment of obra 1993, however, only such payments by services-oriented partnerships to general partners remain deductible under section 736(a). in all other cases, therefore, it will be important to know whether any basis obtained for a retiring partner's share of partnership good will will be amortizable under new section 197. subject to a number of qualifications, it appears that such basis will be so treated. the examples in the legislative history deal only with situations in which a partnership purchases an amortizable section 197 intangible from a third party, and therefore do not explicitly address the question of partnership good will. one might view such good will as an asset created by the partnership itself, so that where a partnership liquidates a partner's interest and in doing so makes a payment for the partner's share of good will, it acquires a the intangible. of this, $500 is his share of the partnership's s1.500 basis and $300 is his special basis adjustment. d is treated as owning an interest in two intangibles. as to the first. he will obtain amortization deductions of $500 over the amortization period remaining for the partnership. as to the second, he will be entitled to claim amortization deductions of $300 over a 15-year period beginning on the date of acquisition of his partnership interest. h.r. conf. rep. no. 213, supra note 91, at 686-87, reprinted in 1993 u.s.c.c.a.n. at 1375-76; staff of senate comm. on the budget, supra note 79, at 416. h.r. rep. no. 111. supra note 79, at 774, reprinted in 1993 u.s.c.c.a.n. at 1005. 112. if, instead, the partnership described in the preceeding footnote liquidates a's interest for $800 and has made a § 754 election, it will be treated as owning two amortizable § 197 intangibles: one with a basis of $1,500 that is amortizable over its remaining amortization period and the other with a basis of $300 that is amortizable over a 15-year period from the month that the partnership retires a's interest. see h.r. conf. rep. no. 213. supra note 91, at 687, reprinted in 1993 u.s.c.c.a.n. at 1376; staff of senate comm. on the budget. supra note 79, at 417; h.r. rep. no. i11, supra note 79, at 775, reprinted in 1993 u.s.c.c.a.n. at 1006. 19941 florida tax review "self-created" intangible that is not amortizable under section 197. however, the legislative history suggests that a partner's share of partnership good will is generally amortizable under section 197, by providing as follows: as discussed more fully below, the bill also changes the treatment of payments made in liquidation of the interest of a deceased or retired partner in exchange for goodwill. except in the case of payments made on the retirement or death of a general partner of a partnership for which capital is not a material income-producing factor, such payments will not be treated as a distribution of partnership income. under the bill, however, if the partnership makes an election under section 754, section 734 will generally provide the partnership the benefit of a stepped-up basis for the retiring or deceased partner's share of partnership goodwill and an amortization deduction for the increase in basis under section 197. 113 the foregoing language from the legislative history strongly suggests that payments for a partner's share of partnership good will ordinarily will be amortizable where the payment results in a basis increase in such good will. therefore, payments for a retiring partner's share of good will that are not immediately deductible under the restrictive provisions of section 736(a) may qualify for amortization deductions under newly-added section 197. any deductions claimed with respect to such good will may be recaptured as ordinary income." 4 (b) anti-churning rules for existing intangibles.-unfortunately, at least in the case of good will in existence on the date of enactment of obra 1993, the situation is somewhat more complex than the foregoing discussion suggests. this is so because congress generally intended that section 197 apply only to intangibles acquired after the enactment of obra 1993. it was concerned that taxpayers could avoid this prospective aspect of section 197 by transferring previously-existing intangibles (for which no amortization deduction was allowable) to related taxpayers, 113. h.r. conf. rep. no. 213, supra note 91, at 687, reprinted in 1993 u.s.c.c.a.n. at 1376; staff of senate comm. on the budget, supra note 79, at 417; h.r. rep. no. i 11, supra note 79, at 774-75, reprinted in 1993 u.s.c.c.a.n. at 1005-06. 114. section 197(f)(7) states that a § 197 intangible "shall be treated as property which is of a character subject to the allowance for depreciation provided in section 167." this means that a § 197 intangible is § 1245 property, irc § 1245(a)(3), and therefore subject to § 1245's recapture rules. irc § 1245(a)(1). [vol 1:12 reassessing sales and liquidations of partnership interests who would then seek to amortize them under section 197. to prevent such avoidance, it enacted several rather complex "anti-churning" rules."' generally, these rules preclude amortization of certain intangibles (including good will) in existence before, but acquired from a related person after, the date of enactment of obra 1993.16 persons are related for this purpose if they bear a relationship specified in section 267(b) or 707(b)(1), with the modification that the usual 50% threshold ownership level required under those sections is reduced to 20%, thus expanding the potential universe of related persons." 7 with respect to any increase in the basis of partnership property under section 732, 734, or 743, determinations under the antichurning rules are to be made at the partner level and each partner is to be treated as having owned and used such partner's proportionate share of the partnership assets. 18 therefore, even if a partner's share of partnership good will is an amortizable section 197 intangible, the anti-churning rules will affect the ability of partners to claim amortization where such good will was in existence before the enactment of obra 1993. for example, since a partnership and a partner owning an interest greater than 20% therein are considered related persons," 9 the partnership's payment for that partner's share of pre-obra 1993 good will appears not to qualify for amortization under section 197, even if it obtains a basis therefor under section 734(b). similarly, a person who purchases a partnership interest from a related person will be unable to obtain an amortization deduction for pre-obra 1993 good will, even if the purchaser obtains a special basis adjustment therefor under section 743(b)."2 115. see irc § 197(c)(3), (0(9). 116. irc § 197(f)(9)(a). obra 1993 was signed into law on august 10. 1993. 117. irc § 197(f)(9)(c). 118. irc § 197(f)(9)(e). the legislative history indicates that as a result of this provision, the anti-churning rules will not apply to any increase in the basis of partnership property that occurs upon the acquisition of partnership property if the person acquiring the partnership interest is not related to the person selling the partnership interest. see h.r. conf. rep. no. 213, supra note 91, at 692, reprinted in 1993 u.s.c.c.a.n. at 1381; staff of senate comm. on the budget, supra note 79, at 423; h.r. rep. no. il1. supra note 79, at 779-80. reprinted in 1993 u.s.c.c.a.n. at 1010-11. under the foregoing provision, therefore, the purchaser of an interest in a partnership will not be precluded from claiming amortization with respect to any basis thereby acquired in partnership good will, so long as the purchaser and seller are not otherwise related. 119. see irc §§ 197(f)(9)(c)(i)(i), 707(b)(1)(a). 120. see irc §§ 197(f)(9)(c)(i)(i), 267(b)(1), (c)(4). for example, if a mother sells her partnership interest to her daughter, these rules apparently preclude amortization of any basis increase for the benefit of the purchasing partner in the partnership's good will. compare this example with the result between nonrelated parties. see supra note 118. 19941 florida tax review congress provided an exception to the anti-churning rules where the parties are related only because of the last sentence of section 197(f)(9)(c), which reduces to 20% the otherwise applicable 50% threshold ownership levels under sections 267(b) and 707(b). in such cases, the persons acquiring amortizable basis may claim deductions to the extent that the seller recognizes gain on the transaction with respect to such intangible and agrees to pay tax on such gain at the highest applicable ordinary income tax rate. 12' this exception thus allows certain deductions for amortization that would otherwise be precluded by the anti-churning rules, but exacts a high tax toll from the person who transfers the interest in the intangible. b. summary of amendments several general observations can be made concerning the foregoing amendments effected by obra 1993. first, the increased tax rate differential between ordinary income and capital gains after obra 1993 provides an incentive for partners to take steps to maximize capital gains and minimize ordinary income. for example, where a partnership holds appreciated ordinary income items, partners who purchase a retiring partner's interest will generally prefer that the partnership make a section 754 election, since they may otherwise be overtaxed when the partnership realizes gain from these ordinary income items. 2 2 second, a uniform definition of substantially appreciated inventory will apply to sales and liquidations of interests in all partnerships, irrespective of the nature of their business. all partnerships must determine whether the value of their inventory items exceeds 120% of the partnership's basis in such items; the relative value of the inventory items as compared with the gross assets of the partnership is no longer a relevant factor in determining substantial appreciation. third, liquidation payments by all partnerships for a retiring partner's share of nontraditional unrealized receivables (e.g., depreciation recapture, market discount, etc.) will be section 736(b) payments because, under section 751 (c), such items are not "unrealized receivables" for section 736 purposes. such items do remain "unrealized receivables" for section 751 purposes, so that henceforth, liquidating payments for a partner's share of these nontraditional unrealized receivables, together with any payments for the partner's share of substantially appreciated inventory, must be analyzed under section 751(b). 121. irc § 197(f)(9)(b). 122. see supra text accompanying notes 22-26. [vol. 1:12 reassessing sales and liquidations of partnership interests beyond the foregoing rules, which are common to all partnerships, congress has created a distinction between services-oriented partnerships and capital-oriented partnerships with respect to payments for a retiring partner's share of unstated good will and traditional unrealized receivables. such payments will, as under prior law, continue to be deductible section 736(a) payments when made by services-oriented partnerships, but will be nondeductible section 736(b) payments when made by capital-oriented partnerships. virtually all liquidation payments by capital-oriented partnerships will be considered section 736(b) payments and, to the extent they represent the retiring partner's share of traditional and nontraditional unrealized receivables and substantially appreciated inventory, will be analyzed under section 751(b). finally, the effect of new code section 197 must be considered where the partnership owns intangible assets, including good will. where a section 754 election is in effect, increased deductions for amortization with respect to intangibles owned by the partnership may be available. in addition, in cases where a payment for a withdrawing partner's share of partnership good will is not immediately deductible, that section may at least provide amortization deductions with respect to such payment. c. illustrative example this section illustrates the effect of these revisions upon the analysis of the sale and liquidation of a's interest in the abc partnership, which has the following balance sheet. abc partnership asset basis fmv gain cash 6000 6000 inventory 270 300 30 machine 0 150 150 accounts receivable 0 150 150 capital asset 30 300 270 good will 0 300 300 total 6300 7200 900 partners' equity a 2100 2400 300 b 2100 2400 300 c 2100 2400 300 total 6300 7200 900 19941 florida tax review 1. sale of a's partnership interest.-the tax consequences of the sale to b and c of a's interest would be only slightly different under the amendments made by obra 1993. the partnership's inventory was substantially appreciated even under the two-pronged test of prior law and remains so under the single 120%-of-basis test prescribed by obra 1993. as under prior law, a would still have $110 of ordinary income under section 75 1(a) and $190 of capital gain under section 741.123 the basis of the partnership's property would not change unless a section 754 election were in effect. as under prior law, the failure to make a section 754 election can result in b and c being overtaxed. 24 if such an election were in effect, the partnership would increase the basis of its assets under section 743(b), as under prior law.125 in such a case, b and c may now be able to amortize their increased basis in a's share of the partnership's good will under section 197 as added by obra 1993, subject to the limitations discussed above. 26 this fact provides an additional incentive for the partnership to make a section 754 election. as under prior law, such an election will not affect the taxation of the selling partner. 2. liquidation of a's partnership interest a. effects if capital is not a material income-producing factor.-if capital is not a material income-producing factor for the abc partnership, payments for a's $100 share of unstated good will and $50 share of the traditional unrealized receivables (the accounts receivable) continue as under prior law to be section 736(a) payments, resulting in ordinary income to a and providing a deduction for b and c. however, the $50 payment for a's share of nontraditional unrealized receivables (the depreciation recapture inherent in the machine) is now a section 736(b) payment, making the total amount of such payments $2,250. under section 751 (b), a is considered to have received $100 for her share of the partnership's substantially appreciated inventory, and $50 for her share of the machine, generating $60 of ordinary income under section 751 (b). she will also realize a capital gain of $90 under sections 736(b) and 731, for a total of $210 of ordinary income and $90 of capital gain. 127 for a, therefore, these results are the same as under prior 123. see supra text accompanying notes 6-17. 124. see supra text accompanying notes 22-26. 125. see supra text accompanying notes 27-39. 126. see supra text accompanying notes 98-121. 127. under § 751(b), a is deemed to have received from the partnership inventory having a value of $100 and basis of $90 and a share of the machine having a value of $50 and a basis of zero and to have sold these items back to the partnership for $150 in cash, resulting in $60 of ordinary income. the deemed distribution reduces the basis of her partnership [vol 1:12 reassessing sales and liquidations of partnership interests law; she has $100 excess ordinary income and $100 too little capital gain when compared with the theoretically correct result. for b and c, however, there is a difference in result when compared with pre-obra 1993 law. they can still immediately deduct $150 under section 736(a), representing a's share of unstated good will and traditional unrealized receivables (the accounts receivable), but not the $50 payment for a's share of the machine. because the partnership is deemed under section 751(b) to have purchased a's share of the machine at its s50 fair market value, it will obtain a $50 basis increase therein. b and c will ultimately have ordinary income of $60 and capital gain of $240 each. as under prior law, they each have $50 less ordinary income and $50 more capital gain than the theoretically correct result would prescribe.'2 as to b and c, therefore, post-obra 1993 law is less generous in terms of timing, but not in terms of overall characterization of gain and loss. by continuing prior law's treatment of payments for a's share of unstated good will under section 736(a), present law still permits b and c to shift $100 of ordinary income to a and away from themselves. b. effects if capital is a material income-producing factor.-if capital is a material income-producing factor for the abc partnership, all payments for a's share of partnership property, including unstated good will and traditional unrealized receivables, are section 736(b) payments. of these payments, a total of $200 (representing a's $100 share of traditional and nontraditional unrealized receivables and her $ 100 share of substantially appreciated inventory) is subject to section 751(b), resulting in ordinary income to a of $110. the remaining $2,200 is treated as a liquidating interest from $2,100 to $2,010, so that the remaining $2,100 of § 736tb) payments will generate $90 of capital gain under § 731. 128. as noted above, the partnership has obtained deductions from ordinary income of $150 under § 736(a). on the sale of its assets, the partnership would realize ordinary income of $270 ($100 from the machine, $150 from the accounts receivable, and $20 from the inventory), leaving net partnership ordinary income of 5120, or s60 per partner. each partner's basis in his partnership interest would increase by $60, to $2,160. if no § 754 election were in effect, the partnership would realize a capital gain of $570 ($300 from the good will and $270 from the capital asset), or $285 per partner, increasing each partner's basis in his partnership interest to $2,445. in liquidation, each partner would receive cash of s2.400 and would thus realize a capital loss of $45. in total, each partner will have $60 of ordinary income and a net $240 of capital gain (consisting of a $285 capital gain and a $45 capital loss). if a § 754 election were in effect, the partnership would have recognized $90 less capital gain on the sale of its assets ($240 per partner) and the partners would have recognized no further gain or loss on the liquidating distribution. as indicated supra note 65. since the partnership has effectively deducted the cost of a's share of good will, it should not be entitled to obtain any basis in the partnership's good will. administrative or legislative clarification of this point may be necessary. 19941 florida tax review distribution, giving rise to capital gain of $190. thus, as in the case where she sold her partnership interest, a is taxed on the theoretically correct amounts of gain where the partnership liquidates her interest.'29 because the entire $2,400 payment to a is within section 736(b), no deduction is available to the remaining partners. thus, similar results obtain for b and c as if they had directly purchased a's interest, but with one significant difference. where b and c purchased a's interest, the basis of the partnership's assets did not change at all in the absence of a section 754 election. 3 here, where a's interest is liquidated under section 736, the partnership is treated under section 751(b) as purchasing a's $200 share of the partnership's inventory, machine, and accounts receivable and will therefore adjust the basis of these assets even if it has not made a section 754 election. such adjustments are especially favorable for the remaining partners because they increase the basis of the partnership's ordinary income assets, thus relieving them of excess ordinary income.' thus, if a capital-oriented partnership will not make a section 754 election, the partners may prefer to structure the transaction as a liquidation of the partner's interest by the partnership, rather than as a purchase of the partner's interest by the other partners. doing so will not affect the tax treatment of the retiring partner, but may place the remaining partners in a better position than if they had purchased the interest of the retiring partner.'32 129. under § 751(b), a is deemed to receive $i00 of inventory having a basis of $90, $50 of accounts receivable having a basis of zero, and $50 of the machine also having a basis of zero. she thus has a basis of $90 in the properties deemed distributed and reduces the basis of her interest in the partnership from $2,100 to $2,010. a has $110 of ordinary income on the deemed sale by her of these § 751 properties to the partnership for $200 of cash, and the partnership will increase its basis in such properties by a net amount of $110 ($10 for the inventory, $50 each for the accounts receivable and the machine). the remaining $2,200 amount of the § 736(b) payments to a will give rise to capital gain of $190 under §§ 736(b) and 731 ($2,200 cash distributed minus $2,010 basis in a's partnership interest). 130. see supra text accompanying notes 21-22. 131. see infra note 132. 132. if the abc partnership were a capital-oriented partnership and did not make a § 754 election its balance sheet before and after the liquidation of a's interest would be as follows. pre-liquidation post-liquidation asset basis fmv basis fmv cash 6000 6000 3600 3600 inventory 270 300 280 300 machine 0 150 50 150 accounts receivable 0 150 50 150 capital asset 30 300 30 300 goodwill 0 300 0 300 total 6300 7200 4010 4800 [vol. 1:12 reassessing sales and liquidations of partnership interests if the partnership has made a section 754 election, it will increase the basis of its capital asset and its good will by a total of $190 to reflect the capital gain recognized by a under sections 736(b) and 731. the resulting increase in the basis of the partnership's good will may be amortizable under section 197 as added by obra 1993, subject to the limitations discussed above. 133 iv. comments and conclusion the sale of a partner's interest will not have radically different consequences after the enactment of obra 1993 when contrasted with prior law. with respect to such transactions, particular attention must be paid to the newly-expanded definition of substantially appreciated inventory under section 751(d) and to the possibility that purchasing partners may be able to obtain amortization deductions under newly-enacted section 197 for the seller's share of the partnership's good will and other intangible assets where a section 754 election has been made. pre-liquidation post-liquidation partners' equity basis fmv basis rmv a 2100 2400 0 0 b 2100 2400 2100 2400 c 2100 2400 2100 2400 total 6300 7200 4200 4800 as the table illustrates, the partnership will increase the basis of its inventory, machirie, and accounts receivable by a total of s i 10 as a result of § 75 1(b). thus, even if no § 754 election is in effect, the partnership will only recognize ordinary income of s220 if it sold its inventory, machine, and accounts receivable, which corresponds to the theoretically correct result of $110 per partner. without a § 754 election b and c will still be taxed on $570 ($285 per partner) of the capital gain inherent in the partnership's good will and capital asset, which includes $190 of capital gain ($95 per partner) already taxed to a under §§ 736(b) and 731. accordingly, each partner will increase the basis of his partnership interest by $395, to $2,495. on the receipt of s2,400 in a liquidating distribution, each will claim a capital loss of $95. for b and c, therefore, this yields s 110 of ordinary income and a net s190 of capital gain (capital gain of $285 and capital loss of $95 on liquidation of the parnership). this does pose timing problems for them, but eliminates the characterization problems resulting where they purchased a's interest and the partnership did not make a § 754 election; there, each had a total of $165 of ordinary income and $135 of capital gain. see supra text accompanying notes 22-26. if the partnership made a § 754 election, it also would increase the basis of its capital asset and good will by an aggregate amount of $190. to reflect the capital gain recognized to a under §§ 736(b) and 731. in that case, each partner would recognize si 10 of ordinary income and $190 of capital gain on the sale of the partnership's assets with no further gain or loss on liquidation of the partnership. 133. see supra text accompanying notes 101-21. 19941 florida tax review with regard to liquidations of a partner's interest, however, the rules have changed much more substantially. under the amendments made by obra 1993, section 736 now contains two distinct sets of rules, one for partnerships for which capital is not a material income-producing factor, and one for partnerships for which it is such a factor. partnerships for which capital is not a material income-producing factor (i.e., services-oriented partnerships) will be affected by the obra amendments. such partnerships must be aware of the expanded definition of substantially appreciated inventory under section 751(d). however, with regard to payments in liquidation of a partner's interest, such partnerships can rely upon the rules of prior law in modified form. specifically, they can continue to treat payments for a retiring general partner's share of unstated good will and traditional unrealized receivables as section 736(a) payments, generally resulting in ordinary income to the retiring partner and an immediate deduction or its equivalent for the remaining partners. in contrast with prior law, payments for a retiring partner's share of nontraditional unrealized receivables, such as depreciation recapture, will now be section 736(b) payments, causing the retiring partner to realize ordinary income under section 751 (b), but depriving the partnership of an immediate deduction with respect to such payments. whether or not it has made a section 754 election, the partnership will adjust the basis of its nontraditional unrealized receivables to reflect the amount paid to the retiring partner.' 34 however, the obra 1993 amendments will have their greatest effect upon partnerships for which capital is a material income-producing factor. like their services-oriented counterparts, these partnerships are subject to the newly-expanded definition of substantially appreciated inventory and must also treat payments for a retiring partner's share of nontraditional unrealized receivables as section 736(b) payments. however, the changes wrought by obra 1993 upon capital-oriented partnerships are even more far-reaching. indeed, with regard to such partnerships, this legislation effectively repeals section 736(a). for such partnerships, all liquidating payments for a retiring partner's share of partnership property including unstated good will, traditional and nontraditional unrealized receivables, will be analyzed under sections 736(b) and 751(b). under this regime, the retiring partner will be taxed on the liquidation of her interest just as if she had sold her interest to her fellow partners. for the remaining partners, the consequences of such a liquidation are less favorable than under prior law, since they can no longer immediately deduct 134. this assumes that the retiring partner is a general partner. see irc § 736(b)(3)(b), enacted by obra 1993, supra note 1, § 13262(a), 107 stat. at 541. all payments to retiring limited partners, even if made by a services-oriented partnership, are governed by the rules applicable to capital-oriented partnerships, discussed below. [vol 1:12 reassessing sales and liquidations of partnership interests payments under section 736(a) or shift additional ordinary income to the retiring partner via payments for unstated good will. even so, however, it may still be better for partners in capital-oriented partnerships to have the partnership liquidate the retiring partner's interest than to purchase such interest themselves. this is so because the section 736 liquidation route implicates section 751(b), under which the partnership will automatically increase the basis for its unrealized receivables and substantially appreciated inventory to reflect its payment for the retiring partner's interest in such assets, even when no section 754 election is in effect. by contrast, if the retiring partner's interest were purchased by her fellow partners, no adjustments would be made to the basis of any partnership property in the absence of such an election. in enacting the amendments described above, congress was concerned, in part, with the mismeasurement of income that could result from the immediate deduction of items under section 736(a), even though income therefrom might not be realized until well into the future. in this respect, its amendment of section 751(c) to preclude all partnerships from immediately deducting payments for nontraditional unrealized receivables seems appropriate. a correlative exception to this rule, under which partnerships may continue to deduct payments for traditional unrealized receivables under section 736(a), also seems justified, since the opportunity for deferral with respect to such items is limited.'35 what is surprising however, is that congress also amended section 736 to allow this correlative exception to apply only to services-oriented partnerships. thus, unlike their servicesoriented counterparts, capital-oriented partnerships can no longer deduct payments for a retiring partner's share of traditional unrealized receivables. since congress apparently believed that traditional unrealized receivables did not pose the same potential for deferral as nontraditional unrealized receivables, it is difficult to understand why it singled out capital-oriented partnerships in this respect, at least in the absence of evidence that such partnerships have greater opportunities for deferral or mismeasurement of income with respect to such items. yet the legislative history cites no such evidence and offers no stated basis for treating services-oriented partnerships less favorably than capital-oriented partnerships. indeed, one wonders from the legislative history whether congress realized that it was creating this specific distinction between the two types of partnerships. in this respect, congress's amendments are overly broad because they unjustifiably preclude capital-oriented partnerships from deducting payments for a retiring partner's traditional 135. in general, a current deduction is permitted for items that do not have a useful life substantially beyond the taxable year. see zaninovich v. commissioner, 616 f.2d 429, 431-32 (9th cir. 1980), rev'g 69 t.c. 605 (1978); rcgs. § 1.263(a)-2(a) (stating that property having a useful life substantially beyond the taxable year is a capital expenditure). 1994] florida tax review unrealized receivables, even though the opportunity for abuse in such cases is minimal. by contrast, congress clearly was aware that it was creating a distinction between capital-oriented partnerships and services-oriented partnerships with regard to payments for a retiring partner's share of good will. in addressing this issue as part of the amendments to section 736, congress echoed the criticisms of commentators concerning the potentially abusive treatment of good will under prior law.'36 given its concern with the issue of deferral and the possibility of manipulation, however, the question is not why congress altered the treatment of good will with respect to capital-oriented partnerships, but rather, why it did not also do so with respect to services-oriented partnerships. by thus creating an exception for services-oriented partnerships, congress has left open to such partnerships the possibility of manipulation that existed under prior law. its stated justification for doing so-that "general partners in service partnerships do not ordinarily value good will in liquidating partners" 37 -is unpersuasive. if such partnerships indeed do not ordinarily value good will in liquidating partners, then it is unnecessary to provide them with a special rule on the subject. nothing inherent in the nature of services-oriented partnerships precludes them from engaging in the sorts of abuses with which congress was concerned.,38 the elective treatment of good will is at odds with the extensive efforts under other portions of subchapter k to prevent partners from allocating items to 136. see, e.g., lynch, supra note 75, at 473-75 (noting, for example, that partners could, under prior law, structure payments for good will so as to take advantage of differences in tax rates and the partners' respective tax situations in order to maximize tax savings for all partners). staff of senate comm. on the budget, supra note 79, at 425-26; h.r. rep. no. i11, supra note 79, at 782, reprinted in 1993 u.s.c.c.a.n. at 1013; see also supra text accompanying notes 94-97. 137. staff of senate comm. on the budget, supra note 79, at 426; h.r. rep. no. 111, supra note 79, at 782, reprinted in 1993 u.s.c.c.a.n. at 1013. 138. several cases involving the proper characterization of payments for good will to a departing partner have involved services-oriented partnerships. see, e.g., tolmach v. commissioner, t.c. memo 1991-538 (cch) 1991, where in connection with the expulsion of a partner from a law firm, a referee found the value of the partnership to be over $11,000,000 of which $8,750,000 was attributable to good will, and therefore the payment to the partner was held to be within § 736(a) because the partnership agreement did not provide for a payment with respect to good will. cf. schilbach v. commissioner, t.c. memo 1991-556 (cch) 1991 (holding that seller of medical practice received payment for practice good will which was taxable as capital gain); rev. rul. 70-45, 1970-1 c.b. 17 (holding that a taxpayer who admits partners to his professional practice may be considered to have transferred a portion of his share of the practice's good will, entitling him to capital gain treatment). [vol 1:12 reassessing sales and liquidations of partnership interests maximize tax benefits among themselves and is thus difficult to justify from a policy perspective.' 39 finally, congress's action is puzzling in light of its concurrent enactment in obra 1993 of new section 197 of the code, under which good will is not currently deductible, but is treated as an intangible asset that is amortizable ratably over a fifteen-year period. in the absence of more compelling justifications, congress should have abrogated prior law's treatment of payments representing a partner's share of good will for services-oriented partnerships as well as capital-oriented partnerships. doing so would have better harmonized the rules applying to all partnerships. congress believed that its amendments would reduce the confusion of prior law concerning whether a transaction is a sale or a liquidation of the partner's interest "by eliminating a primary difference between sales and liquidations."'" as this article has demonstrated, however, the legislation does not entirely eliminate differences between these transaction forms. it is true that under these amendments, the retiring partner in a capital-oriented partnership will now be taxed in the same way whether her interest is sold or liquidated by the partnership. however, the remaining partners in such a case may still be better off by structuring the transaction as a liquidation of the retiring partner's interest. thus, one can imagine future cases in which such partners contend, as they had an incentive to do under prior law, that a transaction seemingly structured as a purchase by them of a departing partner's interest was actually a retirement of that partner's interest by the partnership.' these considerations are even more pronounced in the case of services-oriented partnerships. as to them, congress allowed the rules of prior law to continue to apply with regard to payments for a retiring partner's share of unstated good will and traditional unrealized receivables, leaving intact the significant tax differences that depend upon the characterization of a transaction as a sale or instead as a liquidation of a partner's interest. accordingly, for services-oriented partnerships, the new legislation does little to minimize the respective stakes that existed under prior law. 139. see, e.g., irc § 704(b) (requiring that allocations of partnership items have economic effect in order to be given tax effect); irc § 751(b) (precluding shifting of ordinary income and capital gain among partners through disproportionate distributions). see generally lynch, supra note 75, at 473-83. 140. staff of senate comm. on the budget. supra note 79, at 425; h.r. rep. no. 111, supra note 79, at 782, reprinted in 1993 u.s.c.c.a.n. at 1013. 141. similarly, the service may in certain cases assert that a transaction reported as a liquidation of a partner's interest was in fact a purchase of the partner's interest by her fellow partners, thus denying the partnership the benefits of the automatic basis adjustments resulting from the application of § 751(b). 19941 florida tax review in addition to thus perpetuating certain differences that resulted under prior law between sales and liquidations of partnership interests, congress added to the statutory scheme elements of uncertainty and complexity that did not previously exist. for example, in amending section 751 (d)(1), defining substantially appreciated inventory, it added a facts-and-circumstances oriented, tax-avoidance "purpose" test that reduces the certainty of the more mechanical test of prior law. even more significantly, because section 736 now prescribes different rules for capital-oriented partnerships and for services-oriented partnerships, it is now necessary to determine whether capital is or is not a material income-producing factor for a partnership. that inquiry was previously irrelevant, and hence unnecessary, under section 736. given the greater flexibility available under section 736 to partnerships in which capital is not a material income-producing factor, one can expect many partnerships to characterize themselves as services oriented, rather than capital oriented. moreover, the application of section 197 in connection with sales and liquidations of partnership interests, and particularly the scope of the antichurning rules, will need administrative clarification. thus, it is not evident that congress's actions have significantly reduced confusion or complexity in this area. congress could have created more harmony within the statutory scheme and curbed a significant area of potential abuse by allowing all partnerships to continue to treat payments for a retiring partner's share of traditional receivables as section 736(a) payments, while at the same time requiring all partnerships to treat payments for the partner's share of unstated good will and nontraditional unrealized receivables as a section 736(b) payments. instead, obra 1993 precludes capital oriented partnerships from deducting payments for a partner's share of traditional unrealized receivables, where the possibility for abuse seems minimal. at the same time, by continuing the treatment of prior law for good will payments in the context of services-oriented partnerships, the legislation fails to address the more potentially abusive area that existed under prior law. it has been contended that a single rule should govern the withdrawal of a partner from a partnership, whether by sale or liquidation of that partner's interest. 4 ' given its stated intentions as reflected in the relevant legislative history, congress may have had as its ultimate goal the elimination of all differences in tax consequences between sales and liquidation of a partner's interest. nevertheless, the amendments effected by obra 1993 do not in fact equalize the tax consequences of sales and liquidations of partnerships. rather, they perpetuate an area of potential abuse that existed under prior law and create additional and unjustifiable uncertainties. 142. see lynch, supra note 75, at 483-85. 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publishes several types of manuscripts: “articles,” “commentaries,” and “book reviews.” the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word sent via expresso (law.bepress.com/expresso). articles may be emailed to ftr@law.ufl.edu. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow the bluebook: a uniform system 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contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 9 2011 number 11 discretion and deterrence in tax sentencing after rita, gall and kimbrough opportunities for alternative sentences and potential abuses by marla schwaller carew* i. introduction .................................................................................... 921 ii. the foundations of rita, gall and kimbrough and the history of tax sentencing .......................................................... 924 a. prehistory and creation of the federal sentencing g uideline .................................................................................. 924 b. sociological roots of "white collar" crime and the guidelines's focus on offense, rather than offender ........... 928 c. seeds of uncertainty: koon, apprendi/blakely and booker .... 930 d. sea change or free for all? booker's aftermath in rita, gall, and kimbrough ...................................................... 932 m. cases and trends: sentencing tax crimes and debates over deterrence ............................................................................ 938 a. severity in tax sentencing with gall and kimbrough in the wings united states v tomko, or was booker's restoration of limited judicial discretion just a dream? ......................... 938 b. lenience in tax sentencing after booker, rita, gall and k im brough ............................................................................... 944 1. united states v. taylor ........................................................ 945 2. united states v. coughlin .................................................... 946 3. united states v. levinson ..................................................... 947 4. united states v. gardellini .................................................. 949 5. united states v. weisberg .................................................... 951 6. united states v. sm ith .......................................................... 951 *attorney, varnum llp; adjunct professor, thomas m. cooley law school; university of michigan, b.a. 1990; m.a. 1994; j.d. 2000; wayne state university law school, llm 2009. the author gratefully acknowledges professor peter henning, wayne state university law school, eric m. nemeth, tax attorney, varnum llp, and professor marjorie gell, thomas m. cooley law school. 920 florida tax review [vol. 9:11 iv. the future and a modest proposal .......................................... 952 a. troubling trends ..................................................................... 952 b. opportunities ........................................................................... 954 c. a modest proposal one guideline doesn ft fit all ............... 958 v. conclusion ........................................................................................ 959 discretion and deterrence in tax sentencing i. introduction in 2007, the 3rd circuit, on appeal, vacated and remanded the nonincarceration sentence of criminal tax defendant william tomko jr. in an opinion notable for its outrage and disgust at the sentencing court's order of probation and home confinement (in a luxurious home built with the proceeds of tomko's criminal tax evasion).' in 2008, the district of columbia circuit, on appeal, affirmed a non-incarceration sentence for criminal tax defendant gus gardellini, in an opinion that permitted gardellini to serve his term of probation at his then-current home in belgium, and noted that he had already "suffered substantially" due to his prosecution.2 the tomko court was convinced that deterrence of similar tax crimes required incarceration 3 and the gardellini court noted with approval the sentencing court's belief that publicity was a sufficient deterrent to potential criminal tax offenders, and maintained that a focus on deterrence above all other sentencing factors was a mistake. aside from the individual characteristics of the offenders and judges, and the passage of one year, what accounted for the dramatic turn-about in federal appellate sentencing review (and the growing number of sentencing, and sentencing appeal, opinions in 2008 sharing gardellini's flexibility)? the answer resides in the supreme court's 2007 and 2008 sentencing guidance that enhanced judicial discretion and allowed for this dramatic change in sentences upheld on appeal. in 1984, congress gave the nation the sentencing reform act and united states sentencing commission, and in 1987 the commission gave the legal community the federal sentencing guidelines, directions for sentencing criminal defendants with uniformity, justification and an eye towards deterrence of other crimes and criminal intents. the guidelines took much discretion away from judges in the name of uniformity in all sentencing and increased punishment, and deterrence, of white collar crime. in 2006 the supreme court, in united states v. booker,5 began to restore discretion to sentencing judges by making the guidelines advisory, and the floodgates opened wider in 2007 and 2008 with supreme court opinions in rita,6 gall7 and kimbrough,8 each of which permitted increasing degrees of 1. united states v. tomko, 498 f.3d 157 (3rd cir. 2007), affd en banc 562 f.3d 558 (3rd cir. 2009). 2. united states v. gardellini, 545 f.3d 1089 (dc cir. 2008). 3. tomko, 498 f.3d at 166-167. 4. gardellini, 545 f.3d at 1091, 1095. 5. 543 u.s. 220 (2006). 6. 127 s. ct. 2456 (2007). 7. 128 s. ct. 586 (2007). 8. 128 s. ct. 558 (2007). 2011] florida tax review judicial discretion and use of lessor non-incarceration sentences to punish criminal defendants. these grants of increasing judicial discretion, like possession of human free will in any circumstance, were not without drama and dissent. by 2007 the tax community found itself faced with a sentencing landscape purporting to embrace discretion and departure in the absence of mandatory guidelines, but proceeding in cases like the sentencing of william tomko jr., on pre-booker, guidelines-adherent grounds. this battle between sentencing discretion, often favoring hefty fees, restitution and alternative sentences such as probation and home confinement, and traditional guidelines sentences reliant on prison time for all (with a double helping for the white collar offender), continues to unfold in the federal tax community. as this much of this article was being written, tax practitioners awaited the opinion of the 3rd circuit tomko en banc rehearing with a growing body of individualized, below-guidelines federal criminal tax sentences at their disposal. as the oral arguments in the tomko en banc rehearing were reminiscent of gardellini and other, flexible or downward-departing sentences from 2008, an equally flexible (or alternative) rehearing opinion was expected (and duly delivered). as the commission, in a 2009 paper, has turned from its 1980s calls for increased incarceration of white collar criminals to requests for alternative sentences for non-violent offenders (to remedy prison overcrowding and cost escalation), a look back to where we have been and where we are going in federal criminal tax sentencing is a worthy endeavor. it is also an endeavor marked by the increased role, need, and respect for sentence alternatives in carrying out the commission's and guidelines' goals of criminal deterrence. much has been written about the effects of booker and its progeny, rita, gall and kimbrough, on the current and future direction of criminal sentencing under the united states sentencing guidelines and the availability of flexible and alternative sentences, such as probation, home confinement and restitution. many publications have viewed these cases and predicted trends with regard to white collar criminal sentencing. however, little to none of the plentiful academic and practitioner studies of the ussg after booker, rita, gall and kimbrough have focused on the impact of these changes in law on sentencing of tax crimes. review of united states sentencing commission publications on trends after booker make few or any references to treatment of tax defendants 9 and some otherwise 9. see u.s. sentencing commission, post-kimbroughlgall data report, fiscal year 2008 which has only scanty mention of tax and so few statistics on tax cases that meaningful analysis is difficult. [vol. 9:11 discretion and deterrence in tax sentencing comprehensive publications by the commission fail to break tax crimes out of the category of "other white collar" at all.' 0 the internal revenue service, passionate though it may be in pursuit of tax scofflaws" and closure of the "tax gap" recently estimated to total $345 billion,12 participates in sentencing of tax criminals only as an interested party 3 and focuses its efforts on tax compliance and enforcement 14 rather than tracking criminal sentencing trends or advocating for changes in sentencing law. its publications do not address the opportunities and concerns for adequate deterrence under rita, gall and kimbrough, and the department of justice is charged with too many other, non-tax litigation duties to focus solely on tax sentencing matters. tax controversy defense 10. see the united states sentencing commission, overview of federal criminal cases fiscal year 2007 (glenn r. schmitt, director, officer of research and data), which does not discuss tax or specifically mention whether it is discussed in the category of "fraud." similarly, the united states sentencing commission, alternative sentencing in the federal criminal justice system (january 2009) tracks white collar crime by only two categories, "fraud" and "other white collar." 11. see examples of general tax fraud investigations fiscal year 2009, at http://www.irs.gov/compliance/enforcement/article/0,,id=187277,00.html. see also internal revenue service fiscal year 2008 enforcement results, available at http://www.irs.gov/pub/irs-news/2008_enforcement.pdf, showing upward trend of collections and enforcement revenues from 1999-2008; u.s. government sues jackson hewitt tax preparation franchises in four states, alleging pervasive fraud, apr. 30, 2007 at http://www.irs.gov/newsroom/article/0,,id=169251,00.html and fraudulent telephone tax refunds, abusive roth iras top off 2007 "dirty dozen" tax scams notice ir-2007-37, feb. 20, 2007. 12. irs updates tax gap analysis, notice ir-2006-28, feb. 14, 2006. "as with" prior estimates, the updated estimate of the tax gap shows that the largest component of this gap, more than 80%, comes from underreported taxes. underreported income tax is the largest component of this (see attached tax gap map for tax year 2001). nonfiling and underpayment of tax comprise the rest of the tax gap." 13. as set forth in 28 cfr 0.70, the department of justice, tax division, under the direction of an assistant attorney general appointed specifically to that division, conducts civil and criminal litigation arising under the internal revenue code. detailed information on the specific functions and subgroups within the tax division is available at http://www.usdoj.gov/tax/index.html. an example of tax division prosecution of criminal tax offenders first investigated by the irs criminal investigation division, which established the foundation of the case prior to the tax division's involvement, may be found at department of justice press release dated jan. 29, 2009, former nfl player, ex-casino owner and nevada businessman indicted in massive tax fraud scheme. 14. see irs publications describing the role of its law enforcement arm, criminal investigations, such as criminal investigation (ci) at-a-glance, http://www.irs.gov/irs/article/0,,id--98398,00.html and internal revenue manual part 9, criminal investigation. 2011] florida tax review counsel, a group of stakeholders nearly as vitally concerned in criminal tax sentencing trends as their clients, appear to be consumed with other practice matters and most are not publishing on this topic beyond speculations that gall and kimbrough could offer certain white collar defendants the possibility of more lenient or otherwise "alternative" sentences.1 5 in part ii of this article i will describe the prehistory and creation of the united states sentencing commission and federal sentencing guidelines, the roots of the concept of "white collar" crime and its treatment under the guidelines, and the goals specific to white collar criminal sentencing that motivated congress, in part, to take these steps to formalize criminal sentencing. i will briefly revisit the supreme court's first holdings regarding the limits of the guidelines and the sixth amendment in koon v. united states,16 apprendi v. new jersey,7 blakely v. washington18 and united states v. booker,19 which made the guidelines effectively advisory, and the supreme court's subsequent rulings in rita, gall and kimbrough, all of which collectively set the stage for the current opportunities for departure in criminal tax sentencing. in part ei of this article, i will discuss the current state of flexibility and availability of alternative sentences in criminal tax sentencing after rita, gall and kimbrough. finally, in part iv, i will present public outrage against high profile criminal tax violators, troubling trends, and a modest proposal for future tax sentencing flexibility that could balance salient legal and public policy concerns. part v is a brief conclusion. 11. the foundations of rita, gall and kimbrough and the history of tax sentencing a. prehistory and creation of the federal sentencing guidelines prior to the creation of the federal sentencing guidelines, federal judges had broad discretion to sentence defendants within the ranges created by statutory minimums and maximums, and so long as a sentence was within these statutory limits it was nearly unreviewable by a court of appeals.2° in 1975, senator ted kennedy introduced s. 2966, 94th cong., 2nd sess., a 15. see, e.g., the promise of booker: probationary tax sentences, new york law journal, vol. 240 no. 99, nov. 20, 2008. 16. 518 u.s. 81 (1996). 17. 530 u.s. 466 (2000). 18. 542 u.s. 296 (2004). 19. 543 u.s. 220 (2006). 20. id. see also koon v. u.s., 518 u.s. 81, 96 (1996). [vol. 9:11 discretion and deterrence in tax sentencing sentencing reform measure created by liberal reformers to serve as an antiimprisonment and anti-discrimination bill.21 "sentencing reform i" in 1978 and 1980, s.1437, 95th cong., 2nd sess., introduced by senators kennedy and mcclellan, featured strong encouragement of alternative, non-imprisonment sentences and judicial discretion to depart from guidelines and flexibly meet the challenge of defendants' aggravating and mitigating personal characteristics.22 the alternatives to imprisonment encouraged by these bills featured a presumption against imprisonment for rehabilitative purposes, the goal of not exceeding the capacities of the nation's federal prisons, and the desire to reduce society's reliance on imprisonment as "the archetypical criminal punishment."2 3 in addition to the senate judiciary committee additions to these bills, senator gary hart sponsored an amendment to limit sentences under the new legislation and allay fears that "the results could be longer terms of incarceration than we have under current law.', 24 another provision provided that a newly created sentencing commission would be guided by actual and current sentences, and another directed the commission to draft guidelines reflecting "the general appropriateness of imposing a sentence other than imprisonment" for a first time offender not convicted of a violent or otherwise serious offense (by contrast, habitual offenders and those engaged in racketeering were to be sentenced more harshly).25 by "sentencing reform ii" in 1982 and 1984, all of the prior intent to create non-incarceration, more liberal guidelines that would deal with rehabilitation of the nonviolent, first time offender by alternative means were gone. 26 this legislation was pro-incarceration and not clearly concerned with retention of discretion to sentencing judges. after years of discussion, debate, haggling and changes of priority beginning in the mid-1970s, 27 chapter ii of the comprehensive crime control act of 1984, the sentencing reform act of 1984 (popularly referred to as the "sra"), established the united states sentencing commission, which was charged with promulgating sentencing guidelines.28 the sra directed the commission to provide certainty and fairness in meeting the 21. kate stith and steve y. koh, the politics of sentencing reform: the legislative history of the federal sentencing guidelines, 28 wake forest l. rev. 223, 224 (1993). 22. id. at 237-238. 23. ld. at 242. 24. id 25. ld. at 243. 26. id. at 266-268. 27. ld. at 237-238. 28. the comprehensive crime control act of 1984, pub. l. no. 98-473, § 217(a), 98 stat. 1837, 2017-34 (codified as amended at 28 u.s.c. §§ 991-998 (supp. iv 1986)). 2011] florida tax review purposes of sentencing, avoid unwarranted sentencing disparities while maintaining sufficient flexibility to permit individualized sentences and develop means of measuring the degree to which the sentencing, penal, and correctional practices are effective in meeting the purposes of sentencing as set forth in section 3553(a)(2) of title 18, united states code. 29 this subsection (a)(2) contained, in relevant part for this discussion, direction that a court consider the need for the sentence imposed to reflect the seriousness of the offense, promote respect for the law, provide just punishment for the offense 30 and afford adequate deterrence to criminal conduct. subsections (b) and (c) of section 3553 directed courts to impose sentences "of the kind, and within the range" established by the sentencing commission for the applicable offense unless the court found that an aggravating or mitigating circumstance existed that was not adequately taken into consideration by the sentencing commission and that should result in a sentence different from that described.32 the sentencing court was required to state in open court the reasons for its imposition of the sentence and specific reasons for any departure from the sentence required in subsection (b).33 by november 1987, the commission created and congress approved the federal sentencing guidelines, 34 which embodied congress' primary purposes of promoting honesty in sentencing (e.g., ending the practice of a judge sentencing a defendant to 12 years in prison, only to have the parole commission release the prisoner after 4 years)35 and reducing sentencing disparities.36 it is interesting to note that while congress used statistical studies to analyze sentencing disparity trends and prove the existence on 29.28 u.s.c. § 991(b). 30. 18 u.s.c. § 3553(a)(2)(a) as enacted by pub. l. no. 98-473, § 227, 98 stat 1987, 1989-1990. 31. 18 u.s.c. § 3553(a)(2)(b) as enacted by pub. l. no. 98-473, § 227, 98 stat 1987, 1989-1990. 32. 18 u.s.c. § 3553(b) as enacted by pub. l. no. 98-473, § 227, 98 stat 1987, 1989-1990. 33. 18 u.s.c. § 3553(c) as enacted by pub. l. no. 98-473, § 227, 98 stat 1987, 1989-1990. 34. while these guidelines were promulgated as the "federal sentencing guidelines," the commission currently requests that they be called "united states sentencing guidelines" for standard legal citations, so that an individual guideline, such as the one regarding tax evasion, is cited as ussg § 2t1.1. 35. stephen breyer, the federal sentencing guidelines and the key compromises upon which they rest, 17 hofstra l. rev. 1, 4-5 (fall 1988) 36. id. [vol. 9:11 discretion and deterrence in tax sentencing unpalatable variances,"7 the newly created commission used analysis of 10,000 prior cases to attempt to follow "typical past practice, 38 as it created categories of offenses and set lengths of sentences. the past sentencing patterns of unconstrained judges thus proved simultaneously too wideranging and individualized for lawmakers' tastes but also served as the building blocks of the new rules designed to rein in judges. the commission's depth of empirical and statistical analysis brought significant discrepancies in pre-guidelines sentences of white collar criminals to its attention,39 and the commission decided to remedy this apparent inequity by requiring "short but certain terms of confinement" for many of the kinds of white collar offenders, specifically tax, antitrust and insider trading offenders, who would previously have likely received a sentence of probation.40 once the sentencing guidelines were in place, district court judges were directed to follow a set procedure when sentencing defendants, consisting of determining the applicable offense guideline section, base offense level and specific offence characteristics, making certain adjustments and referring to policy statements or commentary that might warrant consideration in imposing a sentence.41 they were also to consider the purposes of sentencing set forth in 18 u.s.c. section 3553(a)(2),42 namely the competing goals of imposing a sentence "sufficient, but not greater than necessary" that "reflects the seriousness of the offense, to promote respect for the law" and "afford[ing] adequate deterrence. 'a3 37. id. for example, 2nd circuit sentences ranging from three to 20 years of imprisonment for identical crimes. 38.id at 7-8. 39. commission statistics indicated that courts granted probation to white collar offenders more frequently than to other types of offenders, and if a prison term was ordered, the terms were less severe than for other types of offenders. id. at 20. 40. id. at 20-21. see also paul j. hofer and mark h. allbaugh, perspectives on the federal sentencing guidelines and mandatory sentencing: article: the reason behind the rules: finding and using the philosophy of the federal sentencing guidelines, 40 am. crim. l. rev. 19, 29; see also frank 0. bowman, iii, symposium: panel four: the institutional concerns inherent in sentencing regimes: the failure of the federal sentencing guidelines: a structural analysis, 105 colum. l. rev. 1315, 1321-1323 (may 2005); frank 0. bowman, iii, pour encourager les autres? the curious history and distressing implications of the criminal provisions of the sarbanes-oxley act and the sentencing guidelines amendments that followed, i ohio st. j. crim. l. 373 (spring 2004). 41. ussg § 1bi.1. 42 ussg § 1bi.10 comment (backg'd). 43. 18 u.s.c. § 3553(a), (a)(2)(a) and (b). included in the 2008 version of § 3553(a), though not in its original sra incarnation, is a new subsection (7), requiring courts to consider the need to provide restitution to victims. 2011.] florida tax review the 2008 version of ussg section 2t1.1 clearly retains the marks of this goal, with the base offense level for tax loss of $2,000 or less set to 6 (06 months of imprisonment for a class i criminal history defendant, 2-8 years for a class ii defendant, etc.) and rapidly climbing to offense levels of 16 and 18 for tax loss over $80,000 or $200,000, respectively (both numbers that are possible and realistic amounts of tax loss for seemingly "ordinary" offenders accused of underreporting income from a small business for a limited number of years).44 for a class i defendant, these offense levels of 16 and 18 equate on the 2008 sentencing table to 21-27 or 27-33 months imprisonment, respectively. these are hefty terms of imprisonment for white collar offenders who might be able to make restitution and pay fines to the irs from their earnings or small business cash flow, but unable to make the united states treasury whole if imprisoned for a year or more. b. sociological roots of "white collar" crime and the guidelines' focus on offense, rather than offender the term "white collar" crime was first used in 1939 in a speech b sociologist edwin sutherland to the american sociological society. sutherland used the term in the course of discussing crime committed by individuals in positions of power, and in the course of his larger work of disproving that crime was due to "poverty and its related pathologies."' 6 he defined white collar crime as "crime committed by a person of respectability and high social status in the course of his occupation. '47 sutherland intended to end the treatment of such offenses as civil wrongs and obtain criminal prosecution of them, and ultimately succeeded. while sutherland's early studies of white collar crime focused on the "high social status" and other characteristics of the offender, the guidelines and other federal criminal statutes focus instead on the offense committed. 8 while this focus on offense rather than offender (at least until chapter 5, part h specific offender characteristics, of the guidelines comes into play for potential sentencing departures) would seem to reduce the kind of disparity that congress and the commission found offensive when it produced 44. ussg § 2t4.1. 45. ellen s. podgor, criminal law: the challenge of white collar sentencing, 97 j. crim. l. & criminology 731, 734-735 (spring 2007). 46. id. at 734-735 (quoting edward h. sutherland, white collar crime 9 (1949)). 47. id. (quoting edward h. sutherland, white collar crime 9, 10 (1949). 48. e.g., 28 u.s.c. 7201 makes criminal evasion of federal taxes. see id. at 736-737 for podgor's discussion of crimes generally treated as "white collar," involving "deception and absence of physical force" and ranging from racketeering based on mail and wire fraud to antitrust and, in certain jurisdictions, environmental offenses and food and drug administration offenses. [vol. 9:11 discretion and deterrence in tax sentencing lenience in pre-guidelines white collar sentencing, this focus actually ignores the greater media scrutiny, shame and difficulty reintegrating into society after incarceration experienced by white collar defendants. 49 the offense-focus also masks one very real offender-focus under the guidelines, the sentence enhancements under 3b 1.1 and 3b 1.3 for defendants in a leader or management role, or those acting in a position of trust or using a special skill (defined as skills not possessed by the general public and usually requiring substantial education, training or licensing, e.g., skills possessed by lawyers, pilots, doctors, and accountants). the 3b1.1 and 3b1.3 sentence enhancements most commonly applied to white collar criminals, on top of the heightened guidelines applicable to defendants sentenced under 2b1.1 (larceny, embezzlement, fraud, etc.) and 2t1.1 (tax offenses), can produce sentences for white collar first-time offenders substantially more severe than those received for violent "street crimes" such as murder and rape.50 while, as we will see in section ili.b. of this article, there appears to be greater flexibility in granting lowincarceration and otherwise "alternative" sentences to criminal tax offenders after the supreme court's 2008 opinions in gall and kimbrough, as recently as 2007 sentencing data indicated that, after the supreme court's 2005 opinion in booker, the majority of federal criminal sentences imposed remained in conformity with the guidelines51 and did not address issues such as the disproportionate harshness of some white collar sentences. 49. podgor supra note 45 at 740, discussing the long-lasting postsentencing life disruptions of disbarment for lawyers, exclusion from federal medical programs for doctors, "bad boy" restrictions in federal securities work for stockbrokers and contra the street cred found by some non-white collar defendants in "catching a case" the shaming and social ostracism of white collar defendants and their families. see also dan m. kahan and eric a. posner, shaming white collar criminals: a proposal for reform of the federal sentencing guidelines, 42 j. law & econ. 365 (april 1999). 50. podgor supra note 45 at 732-733, quoting in n 10 united states v. ebbers, 458 f.3d 110, 129 (2nd cir. 2006) and the 2nd circuit's statement that "twenty-five years is a long sentence for a white collar crime, longer than the sentences routinely imposed by many states for violent crimes, including murder, or other serious crimes such as serial child molestation." 51. u.s. sentencing comm'n, final report on the impact of united states v. booker on federal sentencing, at vi (2006). see also ellen s. podgor, throwing away the key, 116 yale l.j. pocket part 279, 280 (2007), http://thepocketpart.org/2007/02/21/podgor.html. 2011.] florida tax review c. seeds of uncertainty: koon, apprendi/blakely and booker once the guidelines were in place and held to be constitutional5 2 district sentencing courts applied them with strictly constrained discretion 53 until united states v. koon in 1996, 54 when the supreme court ruled that the decision of a district court to grant a departure from the guidelines would be due, in most cases, "substantial deference" upon review by a court of appeals, because the district court's decision "embodies the traditional exercise of discretion by a sentencing court." 55 much of this discretion was due to the fact that the koon court saw district courts in the position of being best able to make a "refined assessment" of the facts bearing on a sentence outcome and whether the sentence should fall within or without the "heartland" of cases in the guidelines.56 as the district courts had "an institutional advantage over appellate courts in making these sorts of determinations" deference was owed to the "judicial actor . . . better positioned than another to decide the issue in question., 51 "it has been uniform and constant in the federal judicial tradition for the sentencing judge to consider every convicted person as an individual and every case as a unique study in the human failings that sometimes mitigate, sometimes magnify, the crime and the punishment to ensue. 58 this restoration of at least limited discretion to sentencing judges did not last long, though. in 2001 the commission promulgated more stringent guidelines for tax criminals, which increased the chances of time in prison for offenders, and in 2003, the protect act59 reversed the portion of koon 52. see, united states v. mistretta, 488 u.s. 361 (1989) holding the sra constitutional because it provides an "intelligible principle" to guide the commission's work, id. at 372, and that the principle of separation of powers was not violated in allowing judges on the commission or locating the commission in the judicial branch, id. at 390-392. 53. see, 18 u.s.c. § 3553(b). see also koon v. united states, 519 u.s. at 92, "before the act [sra], sentencing judges enjoyed broad discretion in determining whether and how long an offender should be incarcerated .... a district judge now must impose on a defendant a sentence falling within the range of the applicable guideline, if the case is an ordinary one." 54. koon v. united states, 519 u.s. 81 (1996). 55. id. at 98. 56. id. at 98. 57. id. at 98-99. 58. id. at 113. 59. prosecutorial remedies and tools against exploitation of children today act of 2003, pub. l. no. 108-21. 117 stat. 650. [vol. 9:11 discretion and deterrence in tax sentencing that directed appellate courts to give due deference to sentencing judges' decisions.60 the supreme court opinions in apprendi and blakely sowed the seeds of booker by, in cases regarding the interplay of the 6th amendment with state sentencing guidelines, overruling guidelines-compliant sentences that allowed judges to usurp the constitutional role of the jury in finding facts necessary to support increased criminal sentences.61 apprendi and blakely taken together appeared to curtail judicial discretion by limiting the sentences that a judge may impose based on judicially found facts, but these opinions also (as the supreme court was about to elucidate in booker) struck at the viability of sentencing guidelines in general.62 by the time the supreme court was presented with review of freddie booker's and duncan fanfan's sentences on cocaine charges, the implications of blakely's reservation of rights to juries and away from guidelines had caused chaos in the federal criminal justice system and raised issues regarding proper ongoing administration of justice.63 booker presented a case of two defendants convicted of cocaine offenses, for whom trial judges had made additional factual findings.64 the booker court held that apprendi and blakely applied to the federal sentencing guidelines, 65 that any fact necessary to support a guidelines sentence exceeding the maximum authorized by jury-found facts must be admitted by the defendant or proved to a jury beyond a reasonable doubt,66 that the guidelines (in the so-called "remedy opinion") offer the possibility of imposing sentences beyond those supported by jury-found facts and thus are no longer constitutional but instead "effectively advisory. ' 6 7 finally, the booker court held that courts must now "consider" the advisory 60. steven toscher, sentencing discretion in criminal tax cases where we have been and where we are, cch journal of tax practice and procedure, december 2007-january 2008, vol. 9, no 6. 61. 530 u.s. at 490 ("other than the fact of a prior conviction, any fact that increases the penalty for a crime beyond the prescribed statutory maximum must be submitted to a jury, and proved beyond a reasonable doubt."); 542 u.s. at 313 ("as apprendi held, every defendant has the right to insist that the prosecutor prove to a jury all facts legally essential to the punishment."). 62. 542 u.s. at 305-306. "our commitment to apprendi in this context reflects not just respect for longstanding precedent, but the need to give intelligible content to the right of jury trial. that right is no mere procedural formality, but a fundamental reservation of power in our constitutional structure." 63. steven toscher, sentencing discretion in criminal tax cases where we have been and where we are, cch journal of tax practice and procedure, december 2007-january 2008, vol 9, no 6. 64. 543 u.s. at 227-228. 65. id. at 235. 66. id. at 244. 67. id. at 245. 2011.] florida tax review guideline ranges and also tailor sentences in light of other concerns set forth in 18 u.s.c. section 3553(a).68 the booker "remedy" court adopted this approach to maintain a "strong connection between the sentence imposed and the offender's real conduct a connection important to the increased uniformity of sentencing that congress intended. ..,,69 the "remedy" court also directed appellate courts to review sentences for reasonability.70 booker spawned numerous law review and practitioner articles as well as marked uncertainty over the future of federal sentencing would life with "effectively advisory" guidelines be a sentencing free-for-all or more of the same? 71 d. sea change or free for all? booker's aftermath in rita, gall, and kimbrough any excitement generated by booker's de-fanging of the guidelines had barely abated when the supreme court took on its next groundbreaking federal sentencing case, rita v. united states.72 the defendant in rita appealed post-booker, using the booker remedy court's holding that district court sentences should be reviewed for reasonability to argue that his withinguidelines sentence was improperly subjected to the presumption of reasonability on appellate review.73 the court held that a court of appeals may apply a presumption of reasonableness to a within-guidelines sentence 74 because the presumption is not binding and also reflects the fact that by the time a within-guidelines sentence has reached an appellate court for review, both the sentencing judge and commission will have reached the same conclusion as to the proper sentence for the defendant.75 the court also revisited the basic sentencing objectives set forth in 18 u.s.c. section 3553(a) and noted the guidelines' commentary statement that congress's aims of seeking uniformity (narrowing the disparity of sentences imposed by different courts for similar conduct) and proportionality (imposing appropriately different sentences for criminal conduct of different severity) of sentencing often conflict.76 the court acknowledged that difficulty in conceding that a presumption of 68. id. at 245-246 and 264. 69. id. at 246. 70. id. at 261. 71. lee d. heckman, note: the benefits of departure obsolescence: achieving the purposes of sentencing in the post-booker world, 69 ohio st. l. j. 149, 171 (2008). 72. 127 s. ct. 2456 (2007). 73. 127 s. ct. at 2462. 74. id. 75. id. at 2463. 76. id. at 2464. [vol 9:11 discretion and deterrence in tax sentencing reasonability could encourage sentencing judges to impose within-guidelines sentences.7 the subsequent cases of gall and kimbrough, each of which raised tantalizing issues for the future of federal criminal tax sentencing and lay the groundwork for the last part of this article, were heard and decided on the same days in late 2007. gall followed rita's discussion of within-guideline sentences by addressing the case of a defendant charged for his past participation in a drug ring, who after substantial rehabilitation and cooperation with law enforcement, received a sentence far below the applicable guideline."8 while defendant gall's presentence report recommended a term of incarceration of 30 to 37 months, the district court sentenced gall to 36 months' probation, stating that probation reflected the seriousness of his offence and imprisonment was unnecessary because of gall's voluntary withdrawal from the criminal activity years before his charge and the upstanding character of his post-offense conduct. 79 the 8th circuit reversed and remanded for sentencing8° and the supreme court took the case to address the reasonability of gall's sentence and the 8th circuit's practice of requiring proportionality (or "extraordinary" circumstances) to justify a substantial departure from a guidelines range. it held that gall's dramatically lowered sentence was reasonable, for reasons set forth below. 81 the supreme court first addressed the applicable standard of review. gall addressed a downward departure so substantial that it was sentence wholly outside of the applicable guidelines.82 the court briefly revisited its holdings in booker,83 directed sentencing judges to give serious consideration to any departure from the guidelines and explain their conclusions that unusually lenient or harsh departure sentences were appropriate and sufficiently justified 4 the court left sentencing courts with sufficient discretion to vary from the guidelines without requiring rules that demand "extraordinary" circumstances to justify substantial departures outside of guidelines ranges.85 the gall court, in the context of upholding the district court's nonincarceration sentence, dispelled any suggestion that a sentence of probation with no incarceration was overly lenient. this language subsequently played 77. id. at 2467. 78. 128 s. ct. 586 (2007). 79. id. at 600-601. 80. id. at 594. 81. id. at 591. 82. id. at 594 (the court of appeals characterized the sentence as "a 100% downward variation"). 83. id. at 594. 84.id. 85. id. 2011] florida tax review a starring role in opinions and oral arguments granting, or advocating, for non-incarceration sentences for white collar offenders. the court stated: we recognize that custodial sentences are qualitatively more severe than probationary sentences of equivalent terms. offenders on probation are nonetheless subject to several standard conditions that substantially restrict their liberty. [citations omitted] probationers may not leave the judicial district, move, or change jobs without notifying, and in some cases receiving permission from, their probation officer or the court. they must report regularly to their probation officer, permit unannounced visits to their homes, refrain from associating with any person convicted of a felony, and refrain from excessive drinking.86 furthermore, the conditions of a sentence of probation "can have a significant impact on both that person and society .... often these conditions comprehensively regulate significant facets of their day-to-day lives .... they may become subject to frequent searches by government officials, as well as to mandatory counseling sessions with a caseworker or psychotherapist. ',87 the court then introduced two concepts that have produced much of the opportunity for increased judicial discretion and use of alternative sentences discussed in section iii.b of this article. these concepts of procedural and substantive reasonableness may be explained as follows. first, at the district court level, a sentencing court should begin all sentencing proceedings by correctly calculating the guidelines range applicable to the defendant and offense, and then consider all of the section 3 553(a) factors to see whether they support the sentences advocated by the parties.88 in this review of section 3553(a) against potential sentences, the sentencing must make "an individualized assessment based on the facts presented." 89 as a penultimate step, the sentencing court must consider the extent of deviation from the guidelines, if it believes that an outside-guidelines sentence is warranted, and weigh the justification to ensure that it is "sufficiently 86. id. at 595-596. 87. id. at 595, fl 4, quoting 1 n. cohen, the law of probation and parole 7:9 (2d ed. 1999). 88. id. at 597, also fin 6 "§ 3553(a) lists seven factors that a sentencing court must consider .... the fact that § 3553(a) explicitly directs sentencing courts to consider the guidelines supports the premise that district courts must begin their analyses with the guidelines and remain cognizant of them throughout the sentencing process." 89. 596-597. [vol 9: 11 discretion and deterrence in tax sentencing compelling to support the degree of variance"9 finally, the sentencing judge must "adequately explain" the sentence to promote the perception of fair sentencing and allow for meaningful appellate review.91 procedural error may occur when a sentencing court treats the guidelines as mandatory, fails to consider section 3553(a) factors or fails to explain a sentence. 92 substantive error may occur if, taking into account the totality of the circumstances, the sentence imposed is substantively unreasonable (a nebulous standard at best).93 the gall court directed appellate courts to review for both levels of reasonableness under the "familiar" abuse of discretion standard.94 once a sentencing court's actions successfully pass both procedural and substantive review, the appellate court may apply a presumption of reasonableness to a within-guidelines sentence, but may not apply a presumption of unreasonableness to an outsideguidelines sentence.95 it must instead consider the extent of the deviation and give "due deference" to the sentencing court's decision that "the section 3553(a) factors, on the whole, justify the extent of the variance. the fact that the appellate court might have ruled otherwise is insufficient to reverse the district court's sentence. 97 the gall court supported this explication of procedural and substantive reasonableness review by acknowledging that sentencing judges are in superior positions to find facts with full knowledge of the facts and insights not on the record, and reiterated rita's and koon's 90. id. at 597, though note that "sufficiently compelling" falls short of the mathematical proportionality and "exceptional" circumstances embraced by the 8th circuit and rejected by the supreme court, though all of the terms of "sufficiently compelling," "proportional" and "exceptional" are sufficiently amorphous and susceptible to construction and manipulation, and the stevens opinion does not define, parse and differentiate these terms in a meaningful way. 91. id. see also united states v. peters, 512 f.3d 787 ((6th cir. 2008) for an example of a failure of procedural reasonableness, when the sentencing court failed to adequately address defendant's non-frivolous (time served) reasons for imposing a different sentence or adequately explain his reasons for rejecting the arguments); united states v. funk, 534 f.3d 522 ((6th cir. 2008) "procedural error, then, is abuse of discretion per se, inasmuch as the court applied the law improperly. but substantive error is far more ambiguous it is an error so serious that the decision is not entitled to deference, just as if the court had relied on a clearly erroneous finding of fact, clearly misapplied the law, or applied the wrong law." internal citation omitted). 92. id. at 597. 93. id. 94. id. 95. id. 96. id. 97. id. 2011] florida tax review statements that the sentencing judge has greatest access to and familiarity with the individual defendant and case.98 the court's opinion in kimbrough, issued on the same day, takes gall's focus on the role of section 3553(a) in a procedurally reasonable sentence even further to make section 3553(a) the foundation of judicial freedom to vary from the guidelines based on policy disagreements. defendant derrick kimbrough pled guilty to four crack cocaine offenses, which under statutory sentencing minimum carry dramatically higher applicable guidelines ranges (i.e., kimbrough's crack offenses led to a range of 19-22.5 years of incarceration, versus 97 to 106 months for similar powder cocaine charges).99 while the court stated that it granted certiorari to determine whether the crack/powder guidelines disparity had been rendered advisory by booker, 00 its subsequent discussion of the district court's belowguidelines sentence focused on the fundamental role of the 18 u.s.c. section 3553(a) goals of sentencing and a sentencing court's responsibility to consider those varying, often contradictory goals (e.g., sufficient but not greater than necessary versus sufficient to afford deterrence).' 0 ' after a discussion of the policy reasons for the 100:1 crack/powder sentence ratio,102 the court revisited is holding in booker and the new status of the guidelines as advisory.103 it characterized the post-booker guidelines as containing an overarching provision, codified in 18 u.s.c. section 3553(a), instructing district sentencing courts to impose sentences "sufficient, but not greater than necessary" to accomplish sentencing goals, including reflecting "the seriousness of the offense," promoting respect for law, providing just punishment and affording "adequate deterrence to criminal conduct."' 0 4 in short, "booker permits the court to tailor the sentence" in light of statutory concerns other than the guidelines.0 5 the court reviewed the district court's dramatically belowguidelines sentence and statements that a within-guidelines sentence would have been "greater than necessary" to accomplish the purposes set forth in 18 u.s.c. section 3553(a), especially in light of the "disproportionate and unjust effect" of the 100:1 sentence disparity'06 and upheld the district court's sentence, because the district court properly fulfilled its procedural 98. id. at 597-598, quoting rita, 551 u.s. at 2463 and koon, 518 u.s. at 98 "district courts have an institutional advantage over appellate courts in making these sorts of determinations, especially as they see so many more guidelines sentence than appellate courts do." 99. 128 s. ct. at 565-566. 100. id. at 565-566. 101. id. at 570. 102. id. at 568-569. 103. id. at 570. 104. id. 105. id. 106. id. at 565. [vol. 9:11 discretion and deterrence in tax sentencing prerequisites (calculating a guidelines range, addressing 18 u.s.c. section 3553(a) factors, considering the nature and circumstances of the offense and history and characteristics of the defendant, and explaining its sentence and its disagreement with the "unwarranted disparity" caused by the crack/powder sentences). 10 7 finally, the district court "appropriately," in the view of the court, framed its final sentence determination in terms of the overarching instruction of 18 u.s.c. section 3553(a) to "impose a sentence sufficient, but not greater than necessary" to accomplish the sentencing goals of 18 u.s.c. section 3553(a)(2).'0 8 the district court sentence met the second test, that of substantive reasonableness, as well by weighing the goals of 18 u.s.c. section 3553(a) with the "particular circumstances" of the defendant's case and the policy argument that a 100:1 sentence disparity was at odds with section 3553(a) and the goal of preventing unwarranted sentence disparities.1°9 the kimbrough court looked back to gall and rita to acknowledge the sentencing court's superior position for fact finding and section 3553(a) evaluation °10 and the need for closer review when the sentencing court varies "based solely on the judge's view that the guidelines range 'fails properly to reflect section 3553(a) conditions.""" subsequent commenters have raised the possibility that the kimbrough holding properly affects only crack cocaine sentences, 12 though the supreme court's january 2009 per curiam opinion in spears v. united states 3 suggests that a new door for judicial discretion based on policy disagreements opened with justice ginsburg's opinion in this case. 114 107. id. at 575. 108. id. at 575-576. 109. id. at 576. 110. id. at 574. 111. id. 575, quoting rita, 551 u.s. at 2563. 112. lynn adelman & jon deitrich, gall, kimbrough and crack retroactivity: positive but incomplete steps in the evolution of federal sentencing, osjcl amici: views from the field (january 2008), at http://osjcl.blogspot.com, stating that the kimbrough justices refused "to fully accept the government's concession that district courts may disagree with other policies embedded in the guidelines." 113. 129 s. ct. 840 (2009). 114. id. at 843-844. "kimbrough thus holds that with respect to the crack cocaine guidelines, a categorical disagreement with and variance form the guidelines is not suspect." while this immediately appears to apply only to crack sentences, the court goes on to state that its permission of policy disagreementbased variances follows in the tradition of booker's permission of individualized determinations of guideline applicability to particular cases. id. ("and not simply based on an individualized determination that they yield an excessive sentence in a particular case. the latter proposition was already established pre-kimbrough, see united states v. booker. . . ."). this language, and the absence of any statement by 2011] florida tax review i. cases and trends: sentencing tax crimes and debates over deterrence white collar criminal scholars 15 and defense practitioners 11 6 eagerly wondered at the wider impact of kimbrough on sentences for which section 3553(a) arguments for leniency might be made. they did not have to wait long for a series of cases addressing combinations of rita, gall and kimbrough, notably with regard to varying amounts of judicial severity and leniency on appellate review of downward departures in criminal tax sentences. the first illustrative tax case issued after rita, and in expectancy of the supreme court's yet-undelivered opinions in gall and kimbrough, was the 3rd circuit's 2007 opinion in tomko v. united states. 17 a. severity in tax sentencing with gall and kimbrough in the wings united states v. tomko, or was booker's restoration of limited judicial discretion just a dream? tomko featured the case of a contractor who pled guilty to tax evasion, pursuant 26 u.s.c. section 7201, after causing numerous subcontractors to falsify invoices and create the appearance that work done on his luxurious new home was actually done for his company." 8 the estimated tax loss was more than $225,000.119 he was sentenced by the district court to community service, probation and a fine, rather than the applicable guidelines sentence of 12-18 months of incarceration, after extensive district court explication of tomko's charitable generosity, the court in spears that its permission of policy disagreements in crack cocaine cases is inapplicable to any non-crack cocaine case, leaves the white collar criminal bar with the appearance of retained flexibility and hope for future policy-motivated judicial discretion. 115. nancy gertner, gall, kimbrough and me, osjcl amici: views from the field (january 2008), at http://osjcl.blogspot.com. 116. see, steven toscher, sentencing discretion in criminal tax cases where we have been and where we are, cch journal of tax practice and procedure, december 2007-january 2008, vol 9, no 6; the promise of booker: probationary tax sentence, new york law journal, vol. 240 no. 99, november 20, 2008. 117. united states v. tomko, 498 f.3d 157 (3rd cir. 2007), affd en banc 562 f.3d 558 (3rd cir. 2009). 118. 498 f.3d at 159. 119. id. at 159. [vol. 9:11 discretion and deterrence in tax sentencing acceptance of responsibility and the effect that his incarceration would have on his 300 innocent employees. 120 following guidance provided in rita, the 3rd circuit court of appeals reviewed the sentence for reasonableness under a deferential abuse of discretion standard, and to make sure that the sentencing court gave meaningful consideration to the 18 u.s.c. section 3553(a) factors and applied them to the circumstances of the case. 2 ' the court noted that "review for reasonableness, though deferential [does] not equate to a rubber 122 ,12stamp" and there is a "difference between deference and abdication. these disclaimers should rob the eventual result that the court found tomko's non-incarceration sentence lacking of no suspense.' 24 the 3rd circuit began its review of tomko's probationary sentence by acknowledging that reasonability review must begin with procedural review of the district court's weighing and balancing of the 18 u.s.c. section 3553(a) factors, and substantive review of the sentence itself, to ferret out sentences illogical and inconsistent with 18 u.s.c. section 3553(a).125 such sentences are substantively unreasonable, stated the court in a notably vague piece of guidance, when illogical and inconsistent with the section 3553(a) factors (even if procedurally reasonable). in a notably vague piece of guidance, the tomko court went on to explain identification of illogical and inconsistent sentences by conceding that there is a "recipe for reasonableness," though appellate courts may not complain of overly bitter or sweet results, but if key ingredients are missing they must draw attention to sentences for which "there is no proof in the pudding., ' 126 this statement leaves one wondering how an appellate court is to find proof, or lack thereof, in a recipe that may be acceptable when either bitter or sweet. the 3rd circuit went on to find no proof in tomko's pudding on the grounds that the guidelines: were drafted by a respected public body with access to the best studies of penology (and thus sentences that departed from the guidelines to impose no imprisonment required "careful, impartial" weighing of sentencing factors127); contained policy statements emphasizing the seriousness of tax evasion; 128 and underscored in policy statements the 120. id. at 161. 121. id. at 163. 122. id. at 164, quoting united states v. rattoballi, 452 f.3d 127, 132 (2nd cir. 2006). 123. id., quoting united states v. crisp, 454 f.3d 1285, 1290 (1 1th cir. 2006). 124. id. at 172. 125. id. at 165, fi 7. 126. id. 127. id. at 165. 128. id. at 165-166, quoting ussg manual ch 1, pt a, intro cmt 4(d) re the commission's goal to replace pre-guidelines probationary sentences for economic criminals with "at least a short period of imprisonment." 2011] florida tax review need for tax prosecutions to provide just punishment, promote respect for the law and provide for deterrence. 29 specifically, the guidelines state that "criminal tax prosecutions serve to punish the violator and promote respect for the tax laws,' 30 that deterrence from violating the tax laws is a primary consideration in light of the low proportion of tax violations actually prosecuted, and that sentences for tax crimes should be "commensurate with the gravity of the offense" to act as successful deterrents.13 1 the tomko appellate court found his probationary sentence lacking in deterrent value due to the component of home confinement in a "gilded cage" bought through tax evasion, 132 and stated that the luxury and comfort of tomko's 8,000 square-foot house (complete with home theatre, pool, sauna and bar) did not reflect the seriousness of his offence or provide adequate deterrence pursuant to 18 u.s.c. section 3553(a)(2)(a) and (b). in light of its belief that 18 u.s.c. section 3553(a) requires a sentence "minimally sufficient" to satisfy concerns of general and specific deterrence,3 and discussion of the greater value of jail time as a general deterrent (citing the guideline's statement that willful tax evaders go undetected so often that those who are caught must be given some term of imprisonment), 134 the court agreed with the government's argument that "real deterrence is jail"'135 and concluded that tomko's probationary sentence was inconsistent with the deterrence goals of 18 u.s.c. section 3553(a)(2)(a)-(b).1 36 ultimately, when faced with booker's goals of increasing deference to sentencing courts, the tomko court elected instead to closely and conservatively hew to the 20 year old "basic statutory goals" congress embraced when it created the commission and charged it with diminishing unwarranted sentence disparity. 137 as the taxpayer's counsel relied on arguments supporting tomko's bid for downward departure based on charitable works and negligible prior criminal history, the chance to engage 129. id. at 166, citing 18 u.s.c. § 3553(a)(2)(a) and (b). 130. id., quoting ussg manual ch. 2, pt. t, intro. cmt. (1997). 131. id. 132. id. 133. id. note 9 at 166. 134. id. at 167. 135. id. at 166-167. 136. id. at 167. 137. id. at 169. [vol 9:11 discretion and deterrence in tax sentencing in any meaningful debate regarding alternative sentences (such as home confinement and other probation) as paths to deterrence was lost.' 38 in its own brief dismissal of alternative sentences as inadequate to provide deterrence, the tomko court summarizes its rejection of the sentencing court's departure based on good works and employment history, noting the sentencing court's alleged errors with the brief statements "a sentence of mere probation ... is unreasonable"'3 9 and "we disagree with the dissent that the hefty fine imposed on tomko mitigates the unreasonableness of the sentence in this case."' 140 the court found the fine imposed on tomko a "justification for leniency" that would reinforce the perception that "wealthy defendants can buy their way out of a prison sentence" contra congress's clear intent as shown in the sra and section 3553(a), and condemned restitution imposed in "lenient" sentences as encouraging disparate sentencing, which is violative of the guidelines and possibly unconstitutional. 141 the tomko dissent acknowledged the opportunity for greater judicial discretion, and looked forward to the supreme court's pending ruling in gall, with its exploration of whether a deviation required exceptional circumstances 142 and prohibition of applying the presumption of unreasonableness of outside-guidelines sentences.1 43 the tomko dissent found that the sentencing court gave ample and meaningful consideration to section 3553(a) factors.' the district court did, in fact, examine subsections (a)(1) [nature and circumstances of the offense and defendant characteristics], (a)(2)(a)-(d) [the need to reflect the seriousness of the offense, promote respect for the law and provide just punishment, to afford adequate deterrence, and to protect the public from further crimes of the defendant], (a)(3) [kinds of sentences available], (a)(4) [sentences and guidelines range for the offense] and (a)(6) [the need to avoid unwarranted sentence disparities] of section 3553 and discuss its considerations at length. 14 in summary, it explained its sentence departure for tomko through its recognition of the need for consistent sentencing, but given tomko's specific characteristics, its finding that a sentence mitigated by section 3553(a) factors was more appropriate. it also increased tomko's fee above that in the applicable guidelines range (to $250,000, over eight times more than the upper end of the applicable guideline range at the 138. id. at 169-172. 139. id. at 172. 140. id. at 173. 141. id. at 173. 142. ld. at 174. 143. id. at 175. 144. id. at 176. 145. id. 2011] florida tax review time146) and ordered restitution as permitted under section 3553(a)(7), stating that, for a wealthy defendant, the within-guidelines fee was insufficient, but the combination of probation, a substantial fine and payment to the irs of tomko's tax obligation "will address the sentencing goals of punishment, deterrence and rehabilitation. 147 the dissent opined that both it and the appellate court majority would have applied the section 3553(a) factors differently had they been the sentencing court, but conceded that the district court's evaluation of section 3553(a) factors was thorough, supported by the record, logical and consistent with the factors and thus ultimately deserved to be upheld under a deferential reasonableness standard. 148 finally, the dissent addressed its disagreement with the tomko majority's emphasis on guidelines policy statements and the majority's view that the sentencing court improperly ignored the pertinent policy statements. 149 the dissent countered with criticism that the tomko majority was impermissibly reviewing the sentencing court's judgment on a de novo standard, and most crucially, justifying its reversal of the district court's sentence based on overreliance on one section 3553(a) factor ((a)(5) direction to look to guidelines policy statements) and devaluation of all other section 3553(a) factors. 50 the tomko dissent is correct that the majority's skewed application of section 3553(a) factors is not supported elsewhere in case law. however, the dissent could have, and did not, use the discussion as an opportunity to revisit the purely advisory nature of the guidelines (and their policy statements) per booker as well as gall direction that a reasonable sentence upheld on review need not be the same sentence that the appellate court would have issued itself, had it been in the position of the sentencing court.' 5 ' 146. id. at 181. 147. id. at 176-177. 148. id. at 177-179. see also gall, 128 s. ct. at 597 regarding the fact that the appellate court may not reverse a district court solely because it would have imposed a different sentence. 149. ussg manual ch 2, pt t introductory cmt. [stating that because of the limited number of criminal tax prosecutions relative to incidence of such violations, deterrence is a primary consideration of the part t tax guidelines] and section 2t1.1, cmt. background [discussing the pre-guidelines history of more probationary sentences for white collar offenders, the commission's belief that increased costs of incarceration are inconsequential in relation to potential revenue from tax compliance and the commission's intent that guideline 2tl.1 will reduce sentence disparity and "somewhat increase average sentence length"]. 150. id. at 181. 151. gall, 128 s. ct at 597 "the fact that the appellate court might reasonably have concluded that a different sentence was appropriate is insufficient to justify reversal of the district court." [vol. 9:11 discretion and deterrence in tax sentencing taken together, the tomko majority and dissent present an interesting discussion of the politics and policy of probationary sentences and deterrence of criminal tax defendants. the majority focused on the need for deterrence (one factor among many) and its perceived inadequacy of arguments for departure based on tomko's charitable works, employment record and ability to pay restitution 52 in response, the dissent noted that the policy statement in ussg section 2t.1.1 used in the majority opinion as a weapon against non-incarceration sentences actually stated that its intention of disparity reduction will result in a "reduced," not "eliminated," number of purely probationary sentences.'53 the dissent saw the plain language of the background comment to 2t1.1 mirroring section 3553(a)(6) to acknowledge the need to avoid unwarranted sentence disparities, though neither mandates elimination of non-incarceration sentences, and also noted that overreliance on section 3553(a)(6) encourages automatic application of the guidelines and violation of the supreme court's holding in booker.154 on this topic, and with its fuller acknowledgment of the messy and often contradictory goals of the guidelines and section 3553(a) post booker, the tomko dissent appears to have the superior recipe for pudding (leaving the tomko majority with no "proof' in the same). the tomko majority and dissent also plumbed the depths of the thenrecent rita opinion for supreme court direction on procedural and substantive reasonableness. the majority, as discussed above, focused on a mythical "recipe for reasonableness" and tomko's probationary sentence substantively having "no proof in [its] pudding." the dissent saw the majority's review and application of rita as improperly drawing a hard line between procedural and substantive review that the rita court, with its emphasis on the interconnectedness of procedure and substance, did not intend.'55 the dissent argued convincingly that the majority impermissibly focused on pure substance, ignoring the sentencing court's thorough procedural review, in its "repeated references to the need for tomko to spend time in jail"'156 and makes the prescient statement that "[i]n order for the guidelines regime to be truly advisory, a district court must be able to 152. tomko498 f.3d at 166, 170-73. 153. id. at 182. 154. id. 155. see id. at 183. (stating that the tomko dissent correctly noted that in rita, justice stevens' attempt to separate procedural and substantive review in the story of a district judge acting unreasonably, despite perfect procedural rulings, in giving yankees fans harsh sentences and red sox fans lenient ones, 127 s. ct at 2473, (stevens j., concurring), is ultimately unhelpful as a guide to bifurcating these processes and that justice scalia's statement that substance and procedure are chameleon-like terms, 127 s. ct at 2483 (scalia, j., concurring in part and concurring in the judgment), though no more practically helpful, is more accurate in acknowledging the slippery ground underfoot.). 156. id. at 183-84. 201lu florida tax review potentially, when the proper situation arises, sentence a defendant outside of the guidelines range but within the statutory range. any other conclusion would alter the statutory sentencing scheme as passed by congress and interpreted by booker."'157 the tomko dissent's call for proper departure under booker was answered within months by the supreme court's holdings in gall and kimbrough. 158 b. lenience in tax sentencing after booker, rita, gall and kimbrough in contrast to the "business as usual" approach of the 3rd circuit in tomko, 159 a growing number of tax cases decided after gall and kimbrough embrace the opportunity for more flexible sentencing. for example, the 3rd circuit tax sentencing appeal levinson is more welcoming of the opportunities for alternative sentencing presented in gall and kimbrough, though the district court in question undermined its attempt at authorizing a probationary sentence by entirely failing to explain the grounds for its 157. id. at 184. 158. gall and kimbrough were released shortly after the 3rd circuit's tomko opinion, reversing and remanding a non-incarceration sentence on grounds of providing inadequate deterrence and (although said, it was strongly implied) offending the sensibilities of the court by allowing tomko to serve out his home confinement sentence in a luxurious home complete with a home theatre, pool and bar. see id. at 172. the effect of gall, kimbrough and the increased discussion of deterrence an overarching goal or merely one of many § 3553(a) factors can be seen in the nov. 19, 2008 oral argument transcript of the 3rd circuit's en banc rehearing. transcript of oral argument, united states v. tomko, 498 f.3d 151 (no. 05-4997) (3rd cir. argued nov. 19, 2008). the oral argument is lively reading, with the court hazing assistant attorney general, tax division, nathan hochman over his unwavering interest in deterrence as "the" § 3553(a) goal to be met, and its goodnatured teasing of tomko's defense counsel (who doubts that he will argue before the panel again). given the tone of the court's insistence with hochman that deterrence is only one of many § 3553(a) factors, and that his laser-like focus on it, and only it, is unduly narrow, it was no surprise to find that the en banc court upheld tomko's sentence in an opinion filed on apr. 17, 2009. the majority opinion upheld the tomko non-incarceration sentence as procedurally and substantively reasonable, though it admitted that many of its judges would not have imposed the same sentences had they been in the district court but that is not the test of a sound and reasonable sentence. 159. explaining that may courts have yet to see a guidelines sentence they do not like or a variance they can support, see, nancy gertner, gall, kimbrough and me, osjcl amici: views from the field (jan. 2008), at http://osjcl.blogspot.com. [vol. 9:11 discretion and deterrence in tax sentencing variation.1 60 this embrace of downward departures is seen outside of tax in "other" white collar criminal sentencing as well.' 6' 1. united states v. taylor talmus taylor was convicted of aiding and assisting in the preparation of false tax returns, in violation of 26 u.s.c. section 7206(2), and sentenced to one year in a halfway house and a fine.1 62 the guidelines sentence for his offence would have been 30 to 37 months in prison, a supervised release, and a fine.163 after an appeal by the government, the 1st circuit vacated the sentence as substantively unreasonable and remanded the case. the case returned to the 1st circuit again after the supreme court remanded it for further consideration in light of gall and kimbrough, which were released after taylor's initial sentencing. 164 the 1st circuit acknowledged that rita, gall and kimbrough made clear that "in the postbooker world, district judges are empowered with considerable discretion in sentencing, as long as the sentence is generally reasonable and the court has followed the proper procedures," and that it would, per gall, review taylor's sentence under a deferential abuse of discretion standard, requiring procedural and substantive inquiries. 165 while the 1 st circuit, in its first 2007 review of taylor's sentence, 66 found the sentence substantively unreasonable on grounds that the district court failed to take all section 3553(a) factors into account, failed to adequately explain its justifications for a probationary sentence, 167 and ultimately issued a sentence that did not afford adequate deterrence. 68 this appellate opinion is very much like the 3rd circuit's opinion in tomko, both 160. united states v. levinson, 543 f.3d 190, 194 (3rd cir. 2008). 161. see, e.g., united states v. adelson, nos. 06-2738-cr(l), 2008 u.s. app. lexis 24864, at 3 (2d cir. dec. 9, 2008) (affirming a below-guidelines sentence, coupled with substantial restitution, on the grounds that the sentencing court properly considered the § 3553(a) factors, and did not fail to recognize the guidelines or give proper weight to them.). 162. united states v. taylor, 532 f.3d 68, 69 (1st cir. 2008). 163. united states v. taylor, 499 f.3d 94, 96 (1st cir. 2007), vacated, 532 f.3d (2008). 164. taylor, 532 f.3d at 71. 165. see id. at 69-70, (noting that in the 1st circuit, after procedural and substantive review, "[r]eversal will result if and only if the sentencing court's ultimate determination falls outside the expansive boundaries of that universe [of reasonableness]." 166. taylor, 499 f.3d at 95. 167. see id. at 102 (finding the statement that a non-incarceration sentence was appropriate because of the "fantastic contribution he [taylor] has made to the community" was insufficient). 168. id. at 103-4. 2011] florida tax review in disagreement with the sentencing court's weight given to charitable work and the ultimate holdings that probationary sentences lacked deterrence, though it tempers the appellate tomko court's harshness with the openminded approach of requesting adequate explanation of the sentence on remand and leaving open the possibility that the non-incarceration sentence might be upheld so long as it is procedurally sound and adequately explained per gall.1 6p 2. united states v. coughlin like taylor, this case presents a pre-gall/kimbrough sentence remanded for resentence after gall's holding. thomas coughlin, a prominent corporate executive, pled guilty to five counts of wire fraud and one count of filing a false tax return in violation of section 7206(1).170 his applicable guidelines sentence would have been 27 to 33 months, but the district court sentenced him to no imprisonment, five years of probation, a $50,000 fine and $411,218 in restitution due to coughlin's poor health,'7 ' family circumstances, and charitable works. 172 tantalizingly, the district court mentioned coughlin's "fall from grace" in its reasoning for a nonincarceration sentence. 173 was this a poorly articulated opinion on the punitive and deterrent effect of probation, fines and restitution or merely an off-hand acknowledgment of the shame suffered by any criminal offender? a more thorough statement could have been useful, given gall's acknowledgement of the loss of liberty and real effect of non-incarceration sentences. the 8th circuit reversed and remanded this sentence on the grounds that the district court did not appropriately weigh the section 3553(a) factors and state with specificity the reasons for its below-guidelines sentence. 1 74 on remand, 175 the district court restored its sentence of no incarceration and five years of probation, including 27 months of home detention with electronic monitoring (and credit given for time served), with a memorandum explaining its reasoning at length. 176 not surprisingly, the district court in this february 2008 resentencing first addressed the impact of gall, released after the initial sentence and before the remand hearing, and the procedure gall established for calculating guidelines, reviewing section 169. taylor, 532 f.3d at 69. 170. united states v. coughlin, 500 f.3d 813, 815 (8th cir. 2007). 171. id. at 816-17. 172. id. at 819. 173. id. at 819. 174. id. 175. united states v. coughlin, no. 06-20005, 2008 u.s. dist. lexis 11263, at 3 (w.d. ark. feb. 1, 2008). 176. id. at 2-3. [vol 9:11 discretion and deterrence in tax sentencing 3553(a) factors and adequately explaining the given sentence.177 the district court then revisited its below-guidelines sentence in light of section 3553(a) to impose a sentence "sufficient, but not greater than necessary" to achieve the diverse statutory sentencing goals. 178 among the section 3553(a) factors discussed at length is the factor of greatest interest for the purposes of this article, the need for deterrence. the district court defended its non-incarceration sentence for coughlin on the grounds that his offense was "gravely serious," arguing that probation and home detention accomplished the goals of punishment and deterrence "more effectively than imprisonment. not all defendants must be sentenced to be duly punished."' 179 stating that probation can accomplish the goals of punishment, the court revisited gall's discussion of the substantial restriction of liberty inherent in non-incarceration punishment, 80 concluding that coughlin's sentence "is far from an act of leniency, and its characterization as such deprives sentencing courts of a valuable and effective form of punishment." ' 81 the district court, in addition, revisited portions of the sra, enacted in part to address prison overcrowding, and congress' statutory direction to the commission "to minimize the likelihood that the federal prison population will exceed the capacity of federal prisons."'8 2 the court concluded with the observation that, after the fines, restitution and loss of liberty "coughlin has suffered greatly, for he had it all and squandered his success. for that he is paying the price and will be punished for the rest of his life."'8 3 3. united states v. levinson levinson pled guilty to counts of wire fraud and filing a false tax return under 26 u.s.c. section 7206(l).l8 the district court found that the tax loss from levinson's actions exceeded $44,000, and thus the applicable guidelines sentence would be 24 to 30 months.' 85 the district court instead imposed a sentence of two concurrent 24 months of probation' 86 and 177. id. at 9-10. 178. id. at 17-18. 179. id. at 20-21. 180. gall v. united states, 552 u.s. 38, 48 (2007). 181. coughlin, 2008 u.s. dist lexis 11263 at 26. 182. id. at 32-33. 183. id. at 38. in light of gall, the united states filed a motion to dismiss appeal with the 8th circuit on mar. 28, 2008 (entered as a mandate of that court on mar. 31, 2008), dismissing its own appeal of the sentencing court's 2008 sentence on remand. 184. united states v. levinson, 543 f.3d 190, 191 (3rd cir. 2008). 185. id. at 192. 186. id. at 194 2011] florida tax review restitution 87 on the grounds that levinson did not harm the public through his conduct (considering harm to a privately held company already compensated through a civil suit to be a purely private harm).'8 8 the 3rd circuit found that the delaware sentencing court failed to offer sufficient explanation for its downward departure to a wholly non-incarceration sentence, and failed to adequately explain its policy disagreement with the guidelines. 89 levinson's sentence was reversed and remanded, and any subsequent opinion has not yet been released. while it might appear from this brief summary that the levinson court was acting as the tomko court did in hewing closely to the guidelines, closer reading of the case shows the profound effect of gall and kimbrough (and the passage of 10 months from the date of filing the tomko opinion) on the 3rd circuit. the levinson court acknowledged that the sentencing court properly determined the applicable guidelines sentence and reviewed the section 3553(a) factors' 90 before it made its controversial determination that levinson was unlike other white collar tax offenders because his harm to a privately held company was a private harm.' 9' the district court sentenced levinson to probation and restitution after a few short statements regarding its view that after it reviewed the costs of incarcerating levinson, a nonviolent offender "whose crimes had little impact beyond his business partners and family," it concluded that "i just can't see that it makes much sense. i just do not."'192 the 3rd circuit did not agree with the government that the sentencing court committed procedural and substantive error in imposing levinson's sentence, but did take the view, reasonable in the circumstances, that the district court must "provide us with enough analysis on the record to permit meaningful appellate review, which it so far has not.', 193 it also looked to gall for the proposition that a failure to adequately explain a sentence deviation may be addressed "by giving the sentencing judge an opportunity to better explain the reasoning behind the decision" 194 and to kimbrough for the proposition that district courts have institutional advantages in access to and consideration of evidence, and appellate courts would be foolish to try to second guess them.' 95 the levinson court further stated that in the postbooker era of advisory guidelines, per gall it did not need "extraordinary 187. id. 188. id. 189. id. at 199. 190. id. at 192-193, also 197-198. 191. id. at 194. 192. id. at 194. 193. id. 194. id. at 195. 195. id. at 196. [vol 9:11 discretion and deterrence in tax sentencing circumstances" to justify a downward departure.' 96 it took issue only with the district court's sparse explanation of its analysis for downward departure 97 and the spectre of an unexplained policy disagreement with the guidelines raised by that court's comments on public and private harm and the cost of incarcerating criminal tax violators. 198 "policy considerations are not offlimits in sentencing, see kimbrough" though they require care in forming the basis of a wholly probationary sentence.199 the levinson court concluded with its acknowledgment that, given the sentencing possibilities offered by gall and kimbrough, "we do not say that a sentence of probation would be, on the record, plainly outside of the boundaries of permissible discretion. we only hold that the justifications given for the sentence are inadequate for us to recognize them as reflecting a proper exercise of discretion." 200 compare this acceptance of the possibility of departures to probationary sentences, departures based on policy disagreements, and sentences deemed procedurally and substantively reasonable though they might not be to the tastes of all jurists with the tomko court's disregard of procedural reasonableness and apparent obsession with the cost of tomko's residence.20 1 this shift from wholesale dismissal of non-incarceration sentences, on the grounds of failure to afford adequate deterrence, to open acknowledgment that a below-guidelines sentence (one that would not be the appellate court's first choice) may still be lawful and appropriate continues in subsequent criminal tax sentence precedent. 4. united states v. gardellini gus gardellini pled guilty to filing a false income tax return in violation of 26 u.s.c. section 7206(1), an offense that, given gardellini's offender characteristics, resulted in a guidelines sentence of 10 to 16 months of imprisonment.20 2 the district court took into account gardellini's payment of restitution and section 3553(a) factors, principally his cooperation, minimal risk of recidivism and that he had "suffered substantially" due to his 203prosecution. 2°3 the district court concluded with a statement that "what 196. id. at 199. 197. id. at 199. 198. id. at 200. 199. id. 200. id. at 202. 201. 498 f.3d at 159. 202. united states v. gardellini, 545 f.3d 1089, 1090 (dc app 2008). 203. id. at 1091. 2011.] florida tax review really deters" potential tax evaders is "the efforts of prosecutors . .. in vigorously enforcing the laws." 2°4 in consideration of its review of the section 3553(a) factors and the preceding considerations, the district court found a sentence of probation and a fine to be adequate. 0 5 the government appealed gardellini's probationary sentence as substantively unreasonable under booker and gall. the court of appeals for the dc circuit reviewed the district court's sentence in light of rita, gall and kimbrough, using a deferential abuse of discretion standard, reviewing for procedural and substantive reasonableness, looking for policy disagreements with the guidelines or commission, and mindful that gall does not require "extraordinary circumstances" to support a below-guideline sentence.20 6 the gardellini court next raised an interesting point when an appellate court, in substantive reasonableness inquiry, asks whether a sentence is unreasonably high or low, "analytical difficulty" arises because this question begs the response "compared to what?" 20 7 the guidelines are advisory, the section 3553(a) factors are "vague, open-ended, and conflicting" and each sentence decision involves a unique combination of offender and offense characteristics. 2°8 when the foregoing are combined with the deferential abuse-of-discretion standard of review, "it will be an unusual case when an appeals court can plausibly say that a sentence is so unreasonably high or low as to constitute an abuse of discretion by the district court."209 the dc circuit upheld gardellini's non-incarceration sentence as procedurally and substantially reasonable, noting that the government's objection to it held one section 3553(a) factor deterrence above all others210 and in light of the discretion given to sentencing courts by the supreme court's holdings in booker, rita, gall and kimbrough, "only a fool would think that he or she necessarily would receive the same sentence as gardellini for a similar tax offense., 211 to the extent that booker and its progeny causes the federal sentencing system to become "unwise or inequitable," congress and the president are empowered to produce new legislation and should address sentencing concerns. 212 204. id. 205. id. the opinion notes that gardellini would spend his probation in belgium, where he lived with his family (his wife's job took them to an overseas post), but did not state that gardellini's residence was a factor in his sentencing. 206. id. at 1092-1093. 207. id. at 1093. 208. id. 209. id. 210. id. at 1095. 211. id. 212. id. at 1096. [vol 9:11 discretion and deterrence in tax sentencing the gardellini dissent disagreed, finding gardellini's sentence too low and inadequate to afford deterrence, in a thorough opinion supported by statistics on the low percentage of filed returns audited by the irs and the interplay of courtroom publicity and deterrence. t 3 in so doing, however, the dissent arguably fell into the government's trap of placing excessive weight on only one section 3553(a) factor deterrence and denying reasonability to all other inquiries and considerations. 5. united states v. weisberg this brief and unpublished 6th circuit case offers an additional view of the increased discretion and liberalization in sentencing post gall and kimbrough. joseph weisberg pled guilty to felony tax evasion in violation of 26 u.s. 7201, which would carry a guidelines sentence of 33 to 41 months, after enhancement in light of weisberg's "special skills" gained in his practice of law and tax loss of $321,654.14 the district court sentenced weisberg to five months imprisonment, five months home confinement, and a three-year term of supervised release after finding no "special skill" required to evade taxes and mitigating offender characteristics (age, health, no prior convictions, punishment in the loss of his law license).2 15 on appeal, the 6th circuit reviewed weisberg's sentence for procedural and substantive reasonableness and upheld the sentence, noting that post rita and gall, the government failed to appreciate the amount of deference due an appellate court to the sentencing court, and, given the superior position of a sentencing judge in having access to and familiarity with the individual case before him, finding that the district court adequately explained its reasons for imposing a below-guidelines sentence.216 6. united states v. smith a northern district of ohio sentencing case provides an additional look at below-guidelines sentences in the wake of rita, gall and kimbrough. joseph smith pled guilty to conspiracy to defraud the irs in violation of 18 u.s.c. 371, making false tax returns in violation of 26 u.s.c. section 7206(1) and corruptly endeavoring to obstruct and impede in violation of 26 u.s. section 7212(a). 7 smith's guidelines sentence was 27 to 33 months, though the district court sentenced him to imprisonment of 12 months and 1 day on one count, 3 months on the other counts (to be served 213. 1d. at 1098-1099. 214. united states v. weisberg, 2008 u.s. app. lexis 22095 (6th cir. 2008). 215. id. at 6-7. 216. id. at 14-15. 217. united states v. smith, 2009 u.s. dist lexis 7462 (n.d. oh. 2009). 2011.] florida tax review concurrently with the year-and-day sentence), 2 years of supervised release, community service, and restitution of $39,154 to the irs.21 1 the sentencing judge approached her below-guidelines sentence by noting that the duty of every sentencing judge is to evaluate each person as a unique individual who may not fit within a formulaic sentencing table. the importance of this duty has only been enhanced by koon, booker, gall and the like.219 after consideration of section 3553(a) factors and the difficulty of reconciling the goals of specific and general deterrence 220 the court explained smith's below-guidelines sentence as adequate because of its success in specific deterrence (the stress, shame and financial burden on smith since he was charged made it "most unlikely" that he will re-offend) and the punitive and deterrent effects of the hefty restitution smith must make to the irs.221 the sentencing judge further dispelled any concerns of unwarranted sentence disparity by showing that smith's year-and-a-day term of incarceration was the median sentence given for such offenses in the 6th circuit, and only 3 months shorter than the median national sentence for such offenses.222 in an example of the kind of adequate disclosure and explanation of a belowguidelines sentence not seen in taylor and levinson, supra, the sentencing judge concluded with a summary of matters considered, each party's briefs, the guidelines range and section 3553(a) factors, in arriving at a sentence "sufficient, but not greater than necessary, to comply with the purposes of section 3553(a). 223 iv. tie future and a modest proposal a. troubling trends at the time that this article was written, high profile white collar and tax criminals such as ponzi scheme promoters bernard madoff and r. alan stanford224 and offshore tax shelter promoter ubs225 dominate the business and financial news with stories of multimillion and multibillion dollar thefts 218. id. at 2-3. 219. id. 220. id. at 10-11 "yet specific and general deterrence are inherently in conflict with one another, as the former requires the focus on the individual and the latter requires the focus on the larger societal good." 221. id. at 10-11. 222. id. at 13. 223. id. at 16-17. 224. fraud is the "in" crime mar. 1, 2009, white collar crime prof blog, http://lawprofessors.typepad.com/whitecollarcrime_blog/2009/03/fraud-is-thein.html ("the message is loud and clear the doj has a growing number of alleged fraud cases dropping in its lap."). 225. lynnley browning, us extends its inquiry of offshore tax fraud, nytimes.com mar. 18, 2009. [viol. 9:11 discretion and deterrence in tax sentencing from clients and illegal sheltering of taxes from united states law. this author believes it reasonable to assume that these cases will further sour public sentiment against white collar offenders, especially those accused or convicted of high profile offenses with large dollar figures of loss. such an understandable hardening of public opinion brings with it the danger of courts turning away from the judicial discretion to impose non-incarceration sentences embodied gall and kimbrough and revisiting sentencing prebooker to impose automatic within-guidelines sentences (in other words, to follow the lead of the tomko appellate court in 2007). federal judge nancy gertner of the district of massachusetts raises a similar specter of conservative conformity in her study of discretion in gall and kimbrough, noting that booker "did not unleash judges and herald a return to indeterminate sentencing" and that the vast majority of judges "in the vast majority of cases did essentially nothing new., 226 judge gertner speculates that this is due in part to the fear of some judges that after nearly twenty years of guidelines they were no longer competent to make sentencing judgments, and in part to those judges who "never saw a guideline sentence they didn't like" despite the disrespect for law promoted by harsh punishments that fail to take into account individual facts and circumstances. 227 judge gertner's concerns are well founded, as shown in her acknowledgement that koon's pro discretion language did not spur a revolution in sentencing (so much for "it has been uniform and constant in the federal judicial tradition for the sentencing judge to consider every convicted person as an individual and every case as a unique study in the human failings that sometimes mitigate, sometimes magnify, the crime and the punishment to ensue."228), nor did booker's (see the tomko 2007 majority appellate decision), and dicta in spears notwithstanding, 229 226. nancy gertner, gall, kimbrough and me, osjcl amici: views from the field (jan. 2008), at http:osjcl.blogspot.com. 227. id. p 4. 228. 519 u.s. at 113. 229. 129 s. ct at 843-844. "kimbrough thus holds that with respect to the crack cocaine guidelines, a categorical disagreement with and variance form the guidelines is not suspect." while this immediately appears to apply only to crack sentences, the court goes on to state that its permission of policy disagreementbased variances follows in the tradition of booker's permission of individualized determinations of guideline applicability to particular cases. id. ("and not simply based on an individualized determination that they yield an excessive sentence in a particular case. the latter proposition was already established pre-kimbrough, see united states v. booker...."). this language, and the absence of any statement by the court in spears that its permission of policy disagreements in crack cocaine cases is inapplicable to any non-crack cocaine case, leaves the white collar criminal bar with the appearance of retained flexibility and hope for future policy-motivated judicial discretion. 2011] florida tax review kimbrough may only be applied to crack offenses2 30 or may be limited to policy disagreements closer in magnitude to the 100:1 crack-powder dichotomy (while at lower loss levels tax crimes are dealt with somewhat more harshly than non-tax economic crimes, the disparity quickly evens out and is nowhere near 100:1 in magnitude).23' also, in a caution and concern raised by federal judge lynn adelman of the eastern district of wisconsin and professor jon deitrich, the defendant in gall was "an extremely sympathetic figure" who withdrew from crime and began self-rehabilitation before he was contacted by the police.2 32 criminal tax defendants are rarely sympathetic figures (william tomko, jr., convicted of instructing subcontractors to falsify invoices and appear to be doing work for schools when they were building his new home instead,233 was certainly not treated with sympathy, respect or affection upon his 3rd circuit appeal) in the manner of defendant gall, and in the wake of stanford, madoff, wesley snipes et al, actors with any stain of willfulness or defiance are very likely to be pilloried in the press and, eventually, in court. 2 34 b. opportunities however, troubling trends and gloom aside, if gall, kimbrough and the dicta in spears bear out true restoration of judicial discretion in sentencing, and fulfillment of koon's promise of sentencing every defendant as an individual,235 the supreme court has created great opportunities for sentencing judges to deal most effectively with criminal tax defendants. the commission's and guidelines' competing goals of affording adequate discretion and imposing sentences sufficient, but no greater than necessary to 230. nancy gertner, gall, kimbrough and me, osjcl amici: views from the field (jan. 2008), at http://osjcl.blogspot.com. 231. in lynn adelman & jon deitrich, gall, kimbrough and crack retroactivity: positive but incomplete steps in the evolution of federal sentencing, osjcl amici: views from the field (jan. 2008), at http://osjcl.blogspot.com, page 4, judge adelman and professor deitrich also note that even after kimbrough addressed the 100:1 crack/powder ratio and the commission revised the guidelines, the disparity remains significant (between 25:1 and 80:1). 232. id. at 3. 233. 498 f.3d at 159. 234. as seen in contemporary coverage of sentencing on professor douglas berman's sentencing law and policy blog, pre-booker precedents still appear in sentencing and defense victories and downward departures continue to remain strangely suppressed in legal news http://sentencing.typepad.com/sentencingjaw_ and-policy/2009/3/the-persistene-f-prebooker-precedents-in-a-postboker-wrld .html, http://sentencing.typepad.com/sentencingjaw and_policy/2009/0 2/why-dodefense-wins-in-sentencing-appeals-often-go-unpublished.html. 235. 116 s. ct. at 2053. [vol 9:11 discretion and deterrence in tax sentencing punish, will remain, but increased judicial discretion will offer a larger toolkit for tackling these issues. the tensions between sufficient and deterrent sentences are frequently seen in most stark detail in white collar sentences, when the "piling on of points" for special skills, leadership roles, etc. can result in sentences for subordinate white collar offenders so severe that even the government may advocate for departures at sentencing. 236 the commission, in its own publications, has begun to advocate for alternative sentences to mitigate the high cost of incarceration a stunning change of position from its advocacy of more incarceration for more white collar offenders in the 1980s. with a cost to the nation of more than $49 billion to incarcerate one in every 100 adults in 2007-2008, the commission is now interested in uses of restitution and probation for nonviolent offenders.237 in a recent publication on the uses of alternative sentences in the federal criminal justice system, the commission stated "increasingly, criminal justice professionals have argued that dwindling prison space should be reserved for the most serious and dangerous offenders, necessitating a reconsideration of alternative sanctions for first-time and nonviolent offenders." 238 while the sra required the guidelines to reflect the general appropriateness of non-imprisonment sentences in certain cases for first-time or non-violent offenders, or those not convicted of an "otherwise serious offense, ' , 239 and tax crimes are considered serious offenses, 240 the commission concedes that in the current fiscal climate "aside from offense severity, financial offenses may be more suited to alternative sentences because of restitution... to the extent that these offenders are sentenced to prison alternatives, they may be better positioned to pay restitution. '241 reasoned and intelligent discussions of the legitimate uses, and genuine punitive, life-inconveniencing character, of alternative sentences 236. see, united states v. adelson, 441 f. supp. 2d 506, 510-511 (s.d.n.y. 2006), in which the court noted that with regard to a guidelines sentence of 85 years "even the government blinked at this barbarity." pressed repeatedly by the court as to whether he was asking for a guideline sentence (which, under the justice department's prevailing policy he was obligated to do), government counsel refused to answer the question directly. 237. united states sentencing commission, alternative sentencing in the federal criminal justice system (jan. 2009). 238. id. at 1. 239. 28 u.s.c. § 9940). 240. ussg § 2t1.1 comment (backg'd). 241. id. at 19. 2011] florida tax review such as probation and home confinement (i.e., drug tests, unannounced home visits, inability to move or change jobs freely) are found in gall242 and the tomko rehearing oral argument243 as well as professor ellen s. podgor's numerous and impassioned writing on the topic.244 a congressional policy preference for sentencing alternatives to strict incarceration is found, though often forgotten, in the 1970s and 1980s legislative histories of senate acts predating the sra, in which promotion of alternative sentences was, for a short time, a widely discussed and viable goal of uniform sentencing. 245 gall and kimbrough might also give criminal tax defendants room to argue about policy disagreements over differences in treatment of tax and other white collar offenders in section 2t1.1 and section 2b1.1 (though the disparities found here are minimal by crack/powder standards), high levels of incarceration available for use against white collar sentences in general, or the proportionately higher sentences meted out to first-time, non-violent white collar offenders than to certain violent criminal offenders. 46 242. 128 s. ct. at 595-596; 128 s. ct. at 595 l 4. 243. transcript of oral argument, united states v. tomko, no. 05-4997 (3rd cir. argued nov. 19, 2008), at 49 (tomko's counsel explains that one immediate penalty from tomko's indictment was the sudden loss of his line of credit at his long-time bank and subsequent rejection by 39 banks before he could find one to lend him the funds needed for restitution). 244. see, john r. lott, optimal penalties versus minimizing the level of crime: does it matter who is correct?, 17 b.u.l. rev. 439 (1991); ellen s. podgor, throwing away the key, 116 yale l.j. pocket part 279, 280 (2007), http://thepocketpart.org/2007/02/ 21/podgor.html. 245. kate stith and steve y. koh, the politics of sentencing reform: the legislative history of the federal sentencing guidelines, 28 wake forest l. rev. 223 (1993). professor stith and mr. koh note a subsequently discarded sentencing priority in a 1978 senate bill (s. 1437) that has regained urgency in the courts and commission in recent years strong encouragement of alternative, nonimprisonment sentences and judicial discretion to depart from guidelines and flexibly meet the challenge of aggravating and mitigating personal characteristics of defendants. id. at 237-238. 246. see, e.g., frank 0. bowman, iii, economic crimes: model sentencing guidelines 2b1, 18 fed. sent. r. 330 (2006) "the fact that the guidelines contemplate life imprisonment and then a bunch more for such crimes [white collar] reveals the degree to which emotion has overtaken logic in this area ... the overkill of the current economic crime guidelines is not limited to the most culpable offenders in the most exceptional cases." "the combination of political pressure and some failures of foresight on the part of those involved in revising the economic crimes guidelines in recent years ... has produced guidelines sentencing ranges for moderate-to-serious white collar offenders that simply cannot be rationally defended." see also ellen s. podgor, criminal law: the challenge of white collar sentencing, 97 crim. l. & criminology 731 (spring 2007) for a discussion of the sociological roots of white collar crime and the irrationality of subjecting nonviolent first time white collar offenders to sentences higher than those imposed for violent [vol 9:11 discretion and deterrence in tax sentencing kimbrough, with justice ginsburg's nod to the commission's development of the guidelines "using an empirical approach based on data about past sentencing practices, including 10,000 presentence investigation reports 247 and subsequent allowance of sentence deviation based on policy disagreements (due to the commission's formation of the crack cocaine guidelines without "tak[ing] account of 'empirical data and national experience ' '248) may also provide an avenue to policy disagreement and departure from the tax and other white collar guidelines due to their shared origin in the commission's stated desire to increase sentences over those commonly given in past practice and corresponding lack of basis in "empirical data and national experience." although, to concede the obvious at this point in history, these arguments are lacking the moral force and urgency of the racially and economically charged crack/powder disparity and would be offered to the public and courts at a time when high profile white collar and tax offenders are objects of little to no sympathy and continue to merit and receive stiff sentences. 249 while commenters like ellen podgor are surely correct in predicting that white collar criminals like bernie ebbers will not backslide into repeated acts of crime, most likely because post-conviction they will never again have access to the high positions that facilitated their misdeeds, 250 even professor podgor concedes elsewhere that the social harms from single courses of white collar criminal activities may be larger, and tied crimes such as murder or rape and failing in general to take the white collar offender's clean slate (lack of prior convictions) into account; and ellen s. podgor, throwing away the key, 116 yale l.j. pocket part 279, 284 (2007), http://thepocketpart.org/2007/02/21/podgor.html. 247. kimbrough, 128 s. ct at 567. 248. id. at 575. 249. e.g., little public sympathy will (or should) arise for adrian dicker, whose guilty plea is memorialized in mar. 17, 2009 department of justice press release 09-061 former accounting firm vice chairman and board member pleads guilty to tax fraud related to tax shelters claiming over one billion dollars of fraudulent tax losses, http://www.usdoj.gov/usao/nys/pressreleases/march09/ dickeradrianpleapr.pdf or mariuz debowski, co-conspirator in a fraudulent tax return scheme involving fraudulent check cashing, as described in mar. 25, 2009 department of justice press release 09-269 "connecticut resident pleads guilty to multi-million dollar tax fraud conspiracy," http://www.usdoj.gov/atr/pulic/ press releases/2009/244034.htm. justifiably harsh sentences are still given to white collar offenders post gall and kimbrough, as seen in mar. 27, 2009 department of justice press release 09-282 former national century financial enterprises ceo sentenced to 30 years in prison, co-owner sentenced to 25 years in prison for conspiracy, fraud and money laundering (defendants order to pay restitution of $2.3 billion and forfeit $1.7 billion). http://www.usdoj.gov/opa/pr/2009/march/09crm-282.html. 250. ellen s. podgor, throwing away the key, 116 yale l.j. pocket part 279,280 (2007), http://thepocketpart.org/2007/02/21/podgor.html at 284. 2011] florida tax review to enormous economic loss to victims.25 1 with loss of this magnitude, why would any defendant deserve a second bite at the apple? however, one must acknowledge the inherent tension in increasing non-incarceration sentencing for white collar offenders. on the one hand, some would argue that such a trend is motivated by preference of educated, white offenders. on the other hand, it will be a pyrrhic victory for the federal sentencing system when all offenders, violent and nonviolent, are sentenced to the maximum defensible terms of incarceration "in order to be fair" and also, unintentionally, overburden the federal prison system to the point of financial crisis, human rights violations and arbitrary shortening of sentences or early releases motivated only by getting bodies out of the system. c. a modest proposal one guideline doesn't fit all the few years between this article and the supreme court's opinion in booker have held almost more change in sentencing laws than the courts and scholars can absorb. from a known process that reduced judicial discretion to an "advisory" system and standards of procedural and substantive reasonableness of sentences on appeal that allow (or force, as the case may be) appellate courts to admit that they must uphold sentences that they would never have handed down themselves, were they in the district court sentencing judge's shoes (e.g., the 3rd circuit en banc panel in tomko), the landscape for judges and advocates has changed and left many disoriented. recent cases such as tomko and gardellini have shown retrenchment by the government in emphasizing deterrence above all other section 3553(a) factors to be considered in rendering a sentence, and courts such as those in tomko, coughlin and gardellini issuing and sometimes upholding on appeal sentences for large-dollar tax loss criminal tax defendants that feature little or no time in prison. on the one hand, such sentences may be seen as too lenient. on the other hand, commenters such as professor podgor and judge nancy gertner recognize that white collar defendants suffer other, substantial, punishments in the restrictions inherent in probation, social shaming, extreme difficulty in raising the funds required for restitution to the irs and loss of the ability to hold jobs in their customary line of work again. in fact, podgor suggests that non-incarceration sentences may be acceptable for white collar defendants because notorious offenders like bernie ebbers will never again have access to a position of trust that would allow the commission of white collar crime. these arguments could be stereotyped as the watchdog government versus wily defense counsel, if they did not occur in the context of a guidelines system that, over time, became increasingly driven by political 251. ellen s. podgor, criminal law: the challenge of white collar sentencing, 97 crim. l. & criminology 731, 738-739 (spring 2007). [vol 9: 11 discretion and deterrence in tax sentencing agendas (two obvious examples being the enhanced white collar sentences post sarbanes-oxley or the crack-cocaine disparity) and motivated more by number-crunching and departure horse-trading than the goal of reaching individualized sentences that were only "sufficient but no greater than necessary" to further the purposes of section 3553(a) (only one of which is deterrence). with the commission calling for flexibility in sentencing to hold down the ballooning price of the federal prison system, and the recognition post-gall that a sentence may be procedurally and substantively reasonable though unpopular with certain appellate judges, this seems to be a poor time to wish for a renewal of the guidelines through congressional action. instead, while occasionally unpopular and humanely flawed, district court sentencing judges, coupled with the availability of appellate review for reasonableness, appear post-rita and gall to be the federal criminal sentencing system's best hope at crafting individualized sentences that take into account all of offense, offender and state of the system. accordingly, this writer proposes renewed commitment to the development of federal criminal tax (as well as white collar) sentencing through case law, and looks forward to additional federal appellate application of gall and kimbrough to tax sentencing cases. one may bring order from chaos, just as the courts may bring enlightenment from the tomko en banc opinion and others of its kind. in addition, a commitment to judicial law making in this area should avoid the worst excesses of the bush-obama era of heightened partisan politics and suspicion. just as the legislative intent behind the sentencing reform act shows changes in priority and policy, so could congressional attempts to "fix" the guidelines post-booker result in unexpected and truly unpalatable results. legislators don't sentence every day, and may never have met a tax or white collar defendant (all joking aside about their close colleagues and primary donors). the sentencing judges are in the trenches with the guidelines every day, and thanks to the supreme court, with little but compasses and multi-purpose tools. at least they are in the trenches at all. v. conclusion in the aftermath of decades of congressionally-directed sentencing legislation, and the recent burst of discretion, departures, returns to convention and dissent, the state of federal sentencing of criminal tax defendants in 2009 is murky. the future is difficult to forecast, with the presumption, on one hand, that the democratic administration's recent supreme court appointments from the left maybe more amenable to flexible sentencing and rehabilitation) and the suspicion, on the other, that public outrage over notable white collar crimes during the worst economic recession in memory will affect the near-term course of sentencing (towards stiffer penalties and fewer opportunities for judicial discretion to free highliving tax offenders like william tomko, jr.). competing social and political 2011] florida tax review agendas of this kind could produce the kind of flip-flops in pre-guidelines sentencing policy seen in the 1970s and 1980s and discussed in section ii.a. above. however, this writer maintains that buried in the murk remains the goal of individualized sentencing appropriate to the offense and offender and driven by the sentencing judge's greater familiarity with the defendant. staying the course of post-booker, advisory guidelines sentencing, driven by supreme court holdings and influenced by the occasional federal circuit en banc opinion, will produce imperfect and occasionally unpalatably lenient sentences. but it will produce sentences that, in large part, honestly and accurately reflect all of the section 3553(a) factors not limited to deterrence and avoid the "barbarities" of the kind memorialized in adelson.252 a popular legal maxim, or clich6, says that bad facts make bad law, but no more so than hardened positions and refusal to look at the big picture. sentences under the guidelines were intended to be "sufficient, but not greater than necessary" to comply with the diverse purposes and goals of section 3553(a), and while humans are imperfect, our imperfect district court judges stand a better chance of producing the most reasoned and rounded sentences than party-bound legislators. to borrow a metaphor from a recent former president, federal sentencing should "stay the course" of case law development unless or until it becomes untenable. 252. united states v. adelson, 441 f. supp 2.d 506 at 510 (2006). "the [sentencing] commission has never explained the rationale underlying any of its identified specific offense characteristics ... or the weights it has chosen to assign.. .here, their combined effect an added 20 points under the guideline's approach ill-fits the situation of someone like adelson. it represents, instead, the kind of "piling-on" of points for which the guidelines have frequently been criticized. "even the government blinked at this barbarity," id. at 511. [vol 9:11 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 3 1996 number i another uneasy compromise: the treatment of hedging in a realization income tax deborah l. paut" i. introduction .................................. 3 ii. doctrinal background of the realization requirement ..................................... 8 a. benefits and burdens of ownership ............... 9 b. fungible assets ............................ 13 c. special statutor' realization rules .............. 14 ii. a closer examination of the distinction between holding and disposing ................... 17 a. voluntary action by the taxpayer ............... 20 b . risk .................................... 21 1. the concept of risk ................... 21 2. sales and risk ....................... 22 3. amount of risk ....................... 22 4. nature of risk ....................... 24 5. disposing of a portion of an asset ......... 25 iv. hedging as a substitute for a disposition ......... 26 a. hedges that strongly substitute for dispositions .... 27 b. purchase of a put or sale of a call ............. 29 1. reduces some risks, but introduces others . . 29 * cf. uneasy compromise: problems of a hybrid income-consumption tax (henry j. aaron et al eds., 1988). ** assistant professor, benjamin n. cardozo school of law. a.b.. 1986, j.d.. 1989, harvard university; ll.m. (tax), 1994, new york university. i would like to thank reuven avi-yonah, joseph bankman. kevin buehler, lawrence cunningham. nicholas gunther, arthur jacobson, michael knoll, liam murphy. anthony polito. leo schmolka, david shakow, nancy staudt, stewart sterk, alvin warren. edward zelinsky. eric zolt, and the faculty and student participants in the new york university school of law colloquium on tax policy and public finance, at which i presented this paper in february 1996. for their helpful comments. florida tax review 2. similar to disposition of share ........... 31 3. similar to disposition of embedded short put . 32 4. similar to disposition of fraction of share ... 32 c. risk-magnifying transactions .................. 34 d. factor hedges ............................ 35 e. portfolio diversification ...................... 36 f. dynamic hedging .......................... 37 v. efficiency and equity analysis of the economic substitute argument for treating hedging as a realization event ............................. 39 a. efficiency and equity under current realization requirement ...................... 40 b. would treating hedging as a realization event be an improvement? ........................ 41 c. the consumption tax perspective ............... 46 vi. the future of the realization requirement ....... 48 vii. conclusion ................................. [vol 3:1 .. 49 1996] another uneasy compromise 3 i. introduction tax law distinguishes between holding an asset and disposing of it. dispositions are "realization" events, occasions for taxing accrued appreciation, while holding is not. an owner of an asset who would like to dispose of it may instead hold the asset and hedge.' hedging, like disposing, changes a taxpayer's exposure to risk, but is, in many cases, not a realization event. a taxpayer may hedge an asset by obtaining a derivative financial instrument whose value varies inversely with the value of the asset.2 derivative financial instruments thus enable taxpayers to simulate a disposition without current tax. because hedging is often a close economic substitute for disposing, hedging should arguably be taxed like a disposition. if taxpayers are indifferent between two methods of accomplishing the same result, tax law 1. for example, a taxpayer owning a block of stock worth si million could enter into an "equity swap" agreement with a financial institution requiring the taxpayer to pay the counterparty over the term of the agreement any dividends on the stock and, at the end of the term, any increase in value of the stock above $ million. in exchange, the financial institution would agree to pay the taxpayer an interest-like return (such as 6% of si million each year) and, at the end of the term, any amount by which si million exceeds the value of the stock. for the term of the swap, the taxpayer would be indifferent to changes in the stock's value and to whether the issuer of the stock paid dividends because, under the swap. any increases in the stock value and any dividends inure to the benefit of the financial institution and the financial institution compensates the taxpayer for any decreases in value of the stock. the equity swap is a variation on traditional transactions that also enable a taxpayer to dispose of economic risk in an asset without selling the asset. in a "short sale against the box," a taxpayer owns securities (retained hypothetically in a "box") and sells for cash identical borrowed securities. after the transaction, the taxpayer's obligation to deliver securities to the securities lender offsets the taxpayer's ownership of the securities in the "box." if the value of the securities increases by $1, the taxpayer's delivery obligation does also. see edward d. kleinbard & erika w. nijenhuis, short sales and short sale principles in contemporary applications, 53 inst. on fed. tax'n § 17.01[2][b] (1995) (providing a detailed description of short sales against the box). in a "married put and call," a taxpayer owning stock purchases a put option granting the taxpayer the right to sell the stock for a fixed price, say, $100. on a designated exercise date and sells a call option granting the option holder the right to purchase the stock for the same fixed price on the same exercise date. on that date, either the stock will be worth s100 or, more likely, one of the options will be exercised, with the result that the taxpayer will then have $100 worth of cash or stock. 2. the value of a derivative depends on, or derives from. the value of something else, such as the value of a share of stock or a stock index. see nancy huckins & steve krull, equity and the traditional equity derivatives, in the handbook of equity derivatives 3, 3 (jack c. francis et al. eds., 1995) [hereinafter equity derivatives) (defining a derivative asset as a "conditional claim on another asset"); henry t.c. hu, hedging expectations: "derivative reality" and the law and finance of the corporate objective, 73 tex. l. rev. 985. 996 (1985) (defining a derivative as "a contract that either allows or obligates one of the parties to buy or sell an asset"). a classic example is a stock option. florida tax review can create social costs by taxing the two methods differently. indeed, on january 12, 1996, the treasury released a proposal that would treat an owner of an appreciated asset as having sold the asset if the person enters into a transaction that offsets exposure to risk in the appreciated asset.3 several authors also favor treating hedging as a realization event,4 while others believe that this would not be a helpful reform.' 3. under the proposal, a taxpayer would recognize gain (but not loss) upon entering into a "constructive sale" of a position in stock, debt, a partnership interest, or certain actively traded trust instruments. a constructive sale would occur if the taxpayer "substantially eliminate[s] both risk of loss and opportunity for gain" by entering into one or more positions with respect to "the same or substantially identical property." an appropriate adjustment would be made in the amount of subsequently realized gain or loss to reflect the constructive sale, and the appreciated position would begin a new holding period as if such position were acquired on the date of the constructive sale. title ix, revenue reconciliation act of 1996, from president clinton's fy 1997 budget bill submitted to congress march 19, 1996 § 9512, reprinted in daily tax rep. (bna) no. 55, at s-67 (supp. mar. 21, 1996) [hereinafter budget bill]; see dep't of treasury, news release, treasury comments on "short against the box" proposal (jan. 12, 1996); staff of joint comm. on tax'n, description of tax provisions included in a plan to achieve a balanced budget submitted to the congress by the president on january 6, 1996 (jcx-1-96) 37-39 (jan. 24, 1996). senator thomas daschle (d.-s.d.) crafted the proposal. see tom herman, white house moves to curb techniques to get around capital-gains taxes, wall st. j., jan. 15, 1996, at a2. the proposal was apparently prompted by a "short against the box" transaction undertaken by este6 lauder and her family in conjunction with their initial public offering of stock. see allan sloan, lauder family's stock maneuvers could make a tax accountant blush, wash. post, nov. 28, 1995, at d3; see also rob marvin, relief offered for financial instruments subject to some administration proposals, daily tax rep. (bna), dec. 12, 1995, at g-3, g-4. see supra note i for a description of a "short against the box transaction." see n.y. st. b. ass'n tax sec. comm. on "short-against-the-box" proposal (mar. 1, 1996), 96 tnt 46-35 (mar. 6, 1996) (supporting proposal but expressing concern about uncertainty in its scope) [hereinafter n.y. st. b. ass'n report]. the clinton administration recently proposed sweeping legislative changes designed to conform the taxation of financial instruments to economic substance. for example, the proposals would disallow interest deductions on certain long-term debt instruments, defer original issue discount deductions on convertible debt, require taxpayers to use an average basis for substantially identical securities, and repeal the "extinguishment doctrine." budget bill, supra, §§ 9511, 9514-16; see dep't of treasury, explanation of corporate subsidies, loophole closers, and other measures in president clinton's seven-year balanced budget proposal, reprinted in daily tax rep. (bna) no. 236, at l-28, l-33 to l-34 (dec. 8, 1995). 4. alan l. feld, when fungible portfolio assets meet: a problem of tax recognition, 44 tax law. 409, 442 (1991) (stating that if a taxpayer owns a positive (negative) position, acquisition of a negative (positive) position should be a disposition); deborah h. schenk, taxation of financial instruments: a partial integration proposal, tax l. rev. (forthcoming) (proposing that acquisition of short position be treated as realization event to the extent that new position eliminates risk of loss in long position). 5. daniel n. shaviro, risk-based rules and the taxation of capital income, tax l. rev. (forthcoming) (arguing that bright line rule and vague test are manipulable). [vol 3:1 another uneasy compromise this article explores the conceptual and practical foundations and limits of the economic substitute argument for taxing hedging like a disposition. within the context of an income tax, reformations of the realization requirement to apply to hedges might well accomplish little improvement in the efficiency and equity of the tax system because the realization requirement itself is a departure from an ideal income tax. although treating hedging as a realization event might reduce transaction costs associated with hedges, it would encourage taxpayers to engage in more complicated and expensive transactions to avoid the new realization rule and would increase the extent to which taxpayers are locked into investments that they would prefer to sell. as to equity, the current ability to hedge without tax undermines the tax on capital. but, so too does the ability to hold without tax, and this undermines the equity argument for taxing hedging. by exposing the inevitable formality of the realization requirement, this article supports examination of a broader reform that would apply accrual taxation to marketable securities.6 the concept of income used in this article is the haig-simons definition of income as the sum of consumption and changes in wealth.7 the 6. this article is part of a wider reappraisal of basic tax concepts prompted by derivatives. see david p. hariton, the taxation of complex financial instruments, 43 tax l. rev. 731 (1988); randall k.c. kau, carving up assets and liabilities-integration or bifurcation of financial products, 68 taxes 1003 (1990), bruce kayle. realization without taxation? the not-so-clear reflection of income from an option to acquire property. 48 tax l. rev. 233 (1993); edward d. kleinbard, risky and riskless positions in securities, 71 taxes 783 (1993); reed shuldiner, a general approach to the taxation of financial instruments, 71 tex. l. rev. 243 (1992); lewis r. steinberg, selected issues in the taxation of swaps, structured finance and other financial products, i fla. tax rev. 263 (1993); jeff stmad, taxing new financial products: a conceptual framework. 46 stan. l. rev. 569 (1994); alvin c. warren, jr., financial contract innovation and income tax policy, 107 harv. l. rev. 460 (1993). other commercial law areas are undergoing a similar reassessment. see, e.g.. hu, supra note 2, at 985 (finding that derivatives challenge legal conceptions of the corporation); symposium: regulation of financial derivatives, i stan. j.l.. bus. & fin. 191 (1995). financial accounting experts are also reconsidering the treatment of derivatives. steve burkholder, fasb to proceed with derivatives proposal; board's aim is issuing draft rules by june, daily tax rep. (bna) no. 66, at gg-i (apr. 5. 1996) (reporting that financial accounting standards board tentatively agreed to mark-to-market regime for derivatives). 7. specifically, henry simons defined personal income as "the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question." henry c. simons, personal income taxation: the definition of income as a problem of fiscal polic' 50 (1938). robert haig described economic income as "'the money value of the net accretion to one's economic power between two points of time." robert m. haig, the concept of income-economic and legal aspects, in readings in the economics of taxation 54 (1959) (lecture delivered at columbia university in december 1920). 19961 florida tax review contours of that definition are sometimes a matter of debate.8 but, unrealized appreciation falls squarely in the category of an increase in wealth. under haig-simons, unrealized and realized appreciation alike are economic income.9 as henry simons explained, "one may gain without realizing and realize without gaining."' commentators agree that unrealized appreciation would be taxed in an ideal income tax system." economic income is thus unrelated to the distinction between holding and disposing and unrelated to hedging. a taxpayer holding an asset with appreciation of $90 has as much economic income as a taxpayer that sells or hedges the asset. for valuation and liquidity reasons, the tax system postpones tax until realization. it would be difficult for taxpayers and administrators to value assets (and liabilities) every year in order to recognize unrealized appreciation, and some taxpayers would have difficulty paying tax in the absence of liquid proceeds of sale.' 2 those valuation and liquidity arguments are less persuasive in the context of publicly-traded assets for which valuation is generally straightforward and the market sufficiently liquid to accommodate sales needed to raise funds to pay tax. some authors have therefore advocated 8. william d. andrews, personal deductions in an ideal income tax, 86 harv. l. rev. 309 (1972) (arguing that medical expense and charitable contribution deductions are refinements of, not departures from, ideal personal income tax); marjorie e. komhauser, the constitutional meaning of income and the income taxation of gifts, 25 conn. l. rev. 1 (1992) (income includes gifts); victor thuronyi, the concept of income, 46 tax l. rev. 45 (1990) (income concept grounded on tax fairness). 9. obvious as it may seem today, the inclusion of unrealized appreciation was a controversial feature of the haig-simons concept when it was developed. see simons, supra note 7, at 80-88. 10. simons, supra note 7, at 84. 11. e.g., id. at 100, 207 ("strictly speaking, the calculation of income demands complete revaluation of all assets and obligations at the end of every period," but abandonment of realization requirement would be "utter folly" in view of administrative burden of annual valuations); haig, supra note 7, at 73 (tax appreciation when "susceptible of a definite evaluation"). an accrual or mark-to-market regime imposes tax on accrued income, regardless of whether the income is realized, by periodically (generally annually) treating assets as if they were sold for their then fair market value, requiring the taxpayer to recognize gain or loss equal to the difference between fair market value and basis. the taxpayer's basis is then adjusted to equal fair market value. liabilities can also be marked to market under an analogous approach. 12. 1 boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts 5.2, at 5-16 5-17 (2d ed. 1989) (taxing unrealized appreciation would require "cumbersome, abrasive, and unpredictable" annual valuations and forced sales); simons, supra note 7, at 100 (realization requirement is "practical expedient" responding to valuation problem). [vol 3:1 another uneasy compromise eliminating the realization requirement for such assets." indeed, because the realization requirement causes inefficiencies, inequities, and complexities,'" proposals for more dramatic curtailment of the requirement are periodically discussed,"5 and significant steps have already been taken to override the realization requirement.'6 the realization doctrine is conflicted. justified on grounds of administrative convenience, it creates categories-holding and disposingwith significance. part ii reviews the realization doctrine. under the "benefits and burdens" test, the concept of risk is used to determine whether a disposition has occurred, but the benefits and burdens test appears not to apply to publicly-traded assets. for them, whether a disposition has occurred is largely a matter of form. indeed, as shown in part iii, notwithstanding the benefits and burdens test, the distinction between simple dispositions and holdings is ultimately formal. changes in risk occur in the context of holding, and a disposition may or may not change the amount or nature of risk for the taxpayer. in a simple disposition, a taxpayer voluntarily disposes of risk in an asset. after the transaction, the taxpayer owns a different asset than the asset she owned 13. see david slawson, taxing as ordinary income the appreciation of publicly held stock, 76 yale lj. 623 (1967); note, realizing appreciation without sale: accrual taxation of capital gains on marketable securities, 34 stan. l. rev. 857 (1982). see also joseph bankman, a market-value based corporate income tax. 68 tax notes 1347. 1347 (sept. 11, 1995) (suggesting that a tax based on market value of publicly-traded entities should replace current corporate income tax). 14. william andrews has described the realization requirement as the "achilles heel" of the income tax. michael j. graetz & deborah h. schenk. federal income taxation: principles and policies 160 (3d ed. 1995) (citing william andrews, the achilles heel of income taxation, in taxation for the 1980's (charles walker ed., 1983)). 15. e.g., david j. shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. i 11, 1113-14 (1986) (arguing that comprehensive accrual taxation is feasible and simpler than current system); a proposal for revision of capital gains tax provisions of the federal internal revenue code and critique of treasury proposals in related areas: hearings on the subject of tax reform before the house committee on ways and means, 91st cong., 1st sess. 4275, 4281-82 (1969) (statement of martin david & roger miller) (proposing accrual taxation for publicly traded assets, shares in closely-held corporations, unincorporated business interests, and real property); see mary louise fellows, a comprehensive attack on tax deferral, 88 mich. l. rev. 722. 729 (1990) (recommending that a realization-based system should adjust tax liability to take account of time delay for payments); jeff strnad, periodicity and accretion taxation: norms and implementation. 99 yale l.j. 1817, 1819-20 (1990) (noting that under mark-to-market system, changes in value need not be recognized annually). 16. e.g., irc §§ 475, 1256 (requiring mark-to-market regime for securities dealers and certain exchange-traded contracts), § 1272 (requiring current inclusion of original issue discount on constant yield basis). see infra notes 40-46 and accompanying text for discussion of §§ 475 and 1256. 19961 florida tax review before. this change in the taxpayer's position is entirely independent of whether the taxpayer has accrued income in the haig-simons sense. indeed, identifying a disposition depends on formal notions differentiating one asset from another and identifying the types of transactions that give rise to realization. any reform of the realization requirement to apply to transactions that resemble dispositions will depend on formal distinctions because the distinction between holding and disposing is itself formal. part iv examines different kinds of hedging, showing the extent to which they resemble sales. certain hedges that eliminate a taxpayer's exposure to risk in an asset are likely to be close substitutes for sales, while other hedges that reduce risk or introduce new types of risk are less likely to be. part v examines the efficiency and equity arguments for taxing hedging, arguing that because realization is a second-best system, taxing hedges that resemble sales may not significantly improve efficiency and equity. part vi considers briefly the possibility of placing more types of property on an accrual basis. ii. doctrinal background of the realization requirement accrued gain is generally not taxed until it is realized. the realization doctrine originated with eisner v. macomber, which required something to be "severed" from a taxpayer's original investment for the taxpayer's "'separate use, benefit and disposal."'17 appreciation alone was not subject to tax. the severance concept eventually gave way in helvering v. bruun because it was inconsistent with taxing exchanges of property. 8 the value of property received in an exchange reflects unsevered, yet realized, gain in the property disposed of. realization under current law generally depends on 17. 252 u.s. 189, 207-208 (1920) (holding shareholders not taxable on receipt of stock dividends). the court's struggle with stock dividends in eisner v. macomber reflected the lack of consensus at the time of the decision on the meaning of economic income. the theme in that opinion that income existed only upon separation from capital was a counterpoint, reflected in the economics literature, to the haig-simons concept of income. see edwin r.a. seligman, are stock dividends income? 9 am. econ. rev. 517, 524 (sept. 1919) (uncut trees in forest not income because not separated), quoted in simons, supra note 7, at 87; see also richard l. bacon & harold l. adrion, taxable events: the aftermath of cottage savings (part i), 59 tax notes 1227, 1241 (may 31, 1993), and (part ii), 59 tax notes 1385 (june 7, 1993) (alleging that eisner v. macomber court confused distinction between whether income exists and when income is realized). 18. 309 u.s. 461 (1940) (taxing landlord at expiration of lease upon receipt of building constructed by tenant); see stanley s. surrey, the supreme court and the federal income tax: some implications of the recent decisions, 35 i11. l. rev. nw. u. 779, 783-84 (1941) (noting that bruun replaces the conceptual approach of eisner v. macomber with an administrative rule capable of "routine handling"). [vol 3:1 another uneasy compromise ownership, which in turn depends on benefits and burdens.' 9 a disposition of the benefits and burdens of ownership, including risk of profit and loss, is a realization event. the benefits and burdens test emphasizes risk of profit and loss, and reflects valuation concerns and formal legal concepts unrelated to risk. a. benefits and burdens of ownership a disposition of ownership of an asset is generally a realization event. ownership for this purpose is not simply a matter of having legal title.' instead, ownership depends on having the benefits and burdens of ownership.2' in determining whether a sale occurred in grodt & mckay realt, ic. v. commissioner, the tax court catalogued the relevant benefits and burdens: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity was acquired in the property; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the operation and sale of the property.19. there is virtually no statutory guidance and little regulatory guidance on the issue of what constitutes a realization event. see irc §§ 61 (a)(3), 1001. regulations § 1.100 11(a) states that an exchange of property for cash or other property "differing materially either in kind or in extent" is a realization event. regulations have been proposed that would treat "a significant modification of a debt instrument" as satisfying the material difference standard. prop. regs. § 1.1001-3. significant modifications include certain changes in the yield, term. or obligor of a debt instrument, but not a "ministerial change." prop. regs. § 1.1001-3(e). most gnidance on realization is found in case law. 20. helvering v. f. & r. lazarus & co.. 308 u.s. 252 (1939) (holding no sale notwithstanding transfer of title). 21. see, e.g., grodt & mckay realty. inc. v. commissioner, 77 t.c. 1221. 1237 (1981) (finding that the passage of benefits and burdens is "key" to sale) merrill v. commissioner, 40 t.c. 66, 76 (1963). affd. 336 f.2d 771 (9th cir. 1964) (deciding that seller's holding period ended prior to passage of bare legal title because buyers obtained "almost all the incidents, both beneficial and detrimental, of total ownership"). 22. 77 t.c. 1221, 1237-38 (1981) (citations omitted). the tax court and other courts have subsequently used those factors. see, e.g.. bailey v. commissioner. 912 f.2d 44, 47 (2d cir. 1990) (stating that "many different factors" determine tax ownership); benedict v. united states, 881 f. supp. 1532, 1542-50 (d.c. utah 1995) (analyzing each grodt & mckay factor). 1996] florida tax review as reflected in items (7) and (8), risk of profit and loss is a prominent theme. for example, in bradford v. united states, a taxpayer that acquired shares subject to an obligation to resell them at a specified time for a fixed price had a holding period in the shares of zero because the purchaser would enjoy appreciation or suffer depreciation in the shares arising after the taxpayer acquired them.23 in determining whether an estate sells assets to beneficiaries, risk of profit and loss is often critical. in the case of a specific bequest, where the will identifies particular property to be delivered to the beneficiary, the estate does not realize gain or loss on transferring the property to the beneficiary because the estate was never exposed to risk in the several extensive studies of tax ownership have been made. richard marsh argues that the multi-factor test described in grodt & mckay is one of at least six tests for a sale of real estate that courts have purported to apply. the others are whether title has passed, whether the parties intended a sale, whether the purchasers are unconditionally obligated to pay, whether sufficient benefits and burdens of ownership pass, and whether either title or benefits and burdens of ownership pass. marsh argues that with certain modifications, the benefits and burdens test best reconciles the cases. he advocates a three-pronged test for real estate sales: (1) whether the purchaser has acquired at least the overall potential for appreciation in the property, (2) whether the risks and rewards of operation of the property have shifted in some significant manner from the seller to the purchaser, and (3) whether the purchaser has the most "junior" stake in the property's residual, except for any nonrecourse lender or the equivalent. richard e. marsh, jr., tax ownership of real estate, 39 tax law. 563, 566-67 (1985). examining tax ownership in the context of leasing transactions, michael simonson also proposes a three-part test: (1) whether the lessor retained an asset of value at the end of the lease term, (2) whether the lessor made a significant equity investment in the leased property at some point during the lease term and, most significantly, (3) whether the lessor retained either "upside" potential or "downside" risk normally associated with the ownership position of a lessor. michael h. simonson, determining tax ownership of leased property, 38 tax law. 1, 3 (1984). simonson rejects as unhelpful distractions the economic profit requirement and subjective intent inquiry that courts often use. see peter l. faber, determining the owner of an asset for tax purposes, 61 taxes 795, 809 (1983) (arguing that the right to capital appreciation and depreciation are the most important "sticks in the bundle" of ownership). 23. 444 f.2d 1133 (ct. cl. 1971). see also rev. rul. 82-150, 1982-2 c.b. i10 (holding that owner of deep in-the-money option to purchase nontraded stock of foreign corporation is actual owner of stock for foreign personal holding company purposes). but see stanley v. united states, 436 f.supp. 581 (n.d. miss. 1977), aff'd, 599 f.2d 672 (5th cir. 1979) (per curiam) (holding that no sale occurred upon agreement to purchase interest-paying convertible debentures from family members at maturity because purchaser's only attribute of ownership prior to maturity was risk of profit and loss in issuer's common stock); morgan pacific corp. v. commissioner, 70 t.c. memo. (cch) 540, t.c. memo (ria) 95418 (1995) (finding that noteholder's agreement with shareholders of note issuer to swap debt return for equity return was consistent with debtor/creditor relationship). [vol. 3:1 another uneasy compromise property and therefore never owned it.24 on the other hand, if a bequest of a specific dollar amount is satisfied with property other than money, the estate realizes gain or loss as if the estate sold the property to a third party and delivered cash to the beneficiary.' item (4) in the grodt & mckay list-whether the contract creates present obligations on the part of the purchaser and seller-relates to the closed transaction doctrine, which reflects the concept of risk, formal notions of when a transaction is "closed", and administrative concerns about valuation. under that doctrine, a transaction that is subject to meaningful conditions to closing generally is not a realization event until closing because, prior to closing, there is a risk that the transaction might not in fact occur.26 an executory contract to sell is not itself a sale. but, prior to the closing date, there may be as a practical matter little risk that a transaction will fail to occur, and the closed transaction doctrine may nonetheless have the result of delaying the sale for tax purposes until a formal closing occurs. further, a transaction may be considered closed in advance of full performance by the parties, even though there is a risk that such performance may never occur. a purchaser may become unable to pay. either party may choose to 24. see rev. rul. 55-117, 1955-1 c.b. 233 (ruling that no sale or exchange occurs upon partial distribution of testamentary trust principal); priv. let. rul. 8447003 (june 8. 1984) (reaching same conclusion because beneficiary's right "fluctuated" until distribution date); see also regs. § 1.1014-4(a)(2) (requiring heir to take basis equal to fair market value on estate tax valuation date). 25. regs. § 1.661(a)-2(f) (no gain or loss is realized by trust or estate on in-kind distribution except in satisfaction of right to specific dollar amount or other specific property); see kenan v. commissioner, 114 f.2d 217 (2d cir. 1940) (holding that gain was realized because beneficiary "took none of the chances" that property would appreciate or depreciate); suisman v. eaton, 15 f.supp. 113 (d. conn. 1935), aff'd, 83 f.2d 1019 (2d cir. 1936) (per curiam), cert. denied 299 u.s. 573 (1936) (holding that transfer of securities in satisfaction of legacy of specified dollar amount was "sale or other disposition"); rev. rul. 83-75. 1983-1 c.b. 114 (ruling that distribution of trust corpus to pay fixed annuity to charity is sale or exchange); see also louis a. delcotto. sales and other dispositions of property under section 1001: the taxable event, amount realized and related problems of basis, 26 buff. l. rev. 219, 228-32 (1977). 26. lucas v. north texas lumber co., 281 u.s. 11. 13 (1930) (holding that notice of exercise of option is not a sale where purchaser was ready to close "as soon as the papers were prepared"); borrelli v. commissioner, 31 t.c. memo (cch) 876, 881, t.c. memo (p-h) 72,178, 72-919 (1972) (holding that option is not a sale because conditional): hoven v. commissioner, 56 t.c. 50, 56 (1971) (holding that executory contract is not a sale because purchaser not unconditionally obligated); dyke v. commissioner, 6 t.c. 1134, 1139.40 (1946) (holding that no sale of shares occurred until all conditions of escrow agreement were satisfied). remote contingencies are no impediment to a closed transaction. herbert j. investment corp. v. united states, 500 f.2d 44. 46 (7th cir. 1974). 1996] florida tax review breach.27 a seller may continue to be at risk with respect to property after it is sold because, for example, sales proceeds contingent on the performance of the property are yet to be paid or the seller remains responsible for liabilities related to the property.28 because sales that involve contingent proceeds raise valuation problems, such transactions are, under rare circumstances, held open until the proceeds are actually received. 9 prevailing tax law identifies a single owner of each item of property and views certain rights to acquire property as separate from ownership, even if such rights convey risk of profit or loss in the property. an owner of an option to purchase an asset enjoys the potential for profit in the asset because if the asset increases in value, so does the option. the supreme court held in helvering v. san joaquin fruit & investment co.,3" however, that an option is a property right separate from ownership and conveys no interest in the underlying asset until exercise. similarly, under this separate transactions approach, the second circuit in woodsam associates, inc. v. commissioner3' held that no disposition results from incurring a nonrecourse mortgage secured by an asset whose basis to the taxpayer is less than the amount of the mortgage. a creditor is not an owner even though the creditor bears risk of loss. finally, in cottage savings association v. commissioner,32 the 27. the cases have viewed the possibility of breach as irrelevant and, accordingly, have chosen a legally, rather than economically, oriented test. see fletcher v. united states, 303 f. supp. 583 (n.d. ind. 1967), aff'd, 436 f.2d 413, 415 (7th cir. 1971) (per curiam) (holding that contract obligation was not an option because breach unlawful); grodt & mckay realty, inc. v. commissioner, 77 t.c. 1221, 1242 (1981) (holding that risk of nonperformance is not normally associated with tax ownership). 28. commissioner v. brown, 380 u.s. 563, 574 (1965) (holding that risk shifting is not "an essential ingredient" of a sale). contingent payment sales may be eligible for installment method reporting. see regs. § 15a.453-i(c). 29. regs. § 15a.453-1(d)(2)(iii) (in "rare and extraordinary" case where fair market value of contingent payment obligation is not readily ascertainable, transaction may be held open). see also burnet v. logan, 283 u.s. 404, 413 (1930) (holding that seller was entitled to recover basis before recognizing gain in contingent payment sale since contingent payments might never be received and had no readily ascertainable value); philadelphia park amusement co. v. united states, 126 f.supp. 184 (ct. cl. 1954) (in arm's length transaction, if valuation of property received is difficult, such value may be presumed to equal the value of the property given in the exchange). 30. 297 u.s. 496, 498-99 (1935) (holding that lease and purchase option was not a transfer of land). 31. 198 f.2d 357, 359 (2d cir. 1952). 32. 499 u.s. 554 (1991). see bacon & adrion, supra note 17 (arguing that cottage savings affirms that exchange of property is realization event regardless of economic or financial similarity of properties exchanged); thomas l. evans, the realization doctrine after cottage savings, 70 taxes 897 (1992) (explaining that under cottage savings, realization doctrine operates based on legal form, not economic substance); loren d. prescott, jr., cottage [vol 3:1 another uneasy compromise supreme court interpreted the realization requirement in a manner that the court believed served the purpose of the realization requirement to avoid burdensome valuation. but, the connection between valuation and the court's test for realization-whether exchanged properties embody "legally distinct entitlements"--is tenuous. the taxpayer in that case, a savings and loan association, exchanged a pool of mortgage receivables that it owned for another pool of mortgage receivables with similar financial characteristics. the transaction was designed to trigger realization of losses in the taxpayer's original pool for tax purposes but not for financial accounting purposes. the court held that the exchange was a realization event because the exchanged properties consisted of different legal rights and obligations. the new mortgages were made by different obligors and secured by different properties than the old mortgages.33 it is unclear why the court believed that an exchange of properties with different legal rights and obligations makes valuation practical. the court's emphasis on legal rights and obligations was, in addition, a rejection of economic risk as a relevant criterion for realization. the court rejected as subjective, not administrable, and doctrinally irrelevant the commissioner's argument that no realization occurred because the new pool was an "economic substitute" for the old pool. b. fungible assets notwithstanding cottage savings, risk is an important theme under the benefits and burdens doctrine. hedging publicly-traded stock might therefore appear at first blush to constitute a disposition of the stock because the hedge changes, and in some cases eliminates, the taxpayer's exposure to risk in the stock.-3 edward kleinbard has argued, however, that different criteria for ownership apply in the context of fungible traded assets." the benefits and burdens doctrine developed primarily in the context of unique assets, such as real estate. unlike unique assets, fungible assets can be sold short because the short seller can acquire property in the market to close out 36 shrthe short position. since short sales of fungible securities are possible, savings association v. commissioner refining the concept of realization, 60 fordham l rev. 437 (1991). 33. however, the proposed regulations interpreting cottage savings do use economic tests. prop. regs. § 1.1001-3. see supra note 19. 34. see supra note i and accompanying text (describing equity swap, short sale against the box, and married put and call). 35. kleinbard, supra note 6, at 784. 36. the term "fungible" is slightly over broad to describe the type of assets that kleinbard argues are subject to a special realization rule. short sales are possible and common in the case of publicly-traded assets, but not all fungible assets are publicly-traded. shares in a closely-held corporation, for example, are fungible because the shares are interchangeable and identical, but short sales in such shares are impractical because a short seller could not be 19961 florida tax review many people can be exposed to risk (directly or inversely) in a particular security. but, for tax purposes, there is only one owner. according to kleinbard, the critical factor indicating ownership of a fungible asset is the "freedom to dispose" of both legal title and market risk in the asset.37 ownership of a fungible asset does not require exposure to risk, and hedging such an asset does not generally defeat ownership or trigger realization of accrued gain.38 c. special statutory realization rules the code provides several special realization rules applicable to certain to be able to acquire shares to cover the short sale. 37. kleinbard, supra note 6, at 793-94. see also kevin dolan & carolyn dupuy, equity derivatives: principles and practice, 15 va. tax rev. 161, 208 (1995) (arguing that transferring the economic benefits of ownership cannot transfer tax ownership). 38. as argued by kleinbard, this doctrine developed primarily in the context of short sales against die box and securities loans. in a short sale against the box, an owner of a security (the security in the "box") borrows an identical security and then sells the borrowed security. after the sale, the taxpayer is both long and short the security, and is therefore not at risk with respect to the security. see supra note 1. the tax law nonetheless treats the taxpayer as continuing to own the security. see griffin v. commissioner, 45 b.t.a. 588, 593 (1941), nonacq., 1942-1 c.b. 23 (holding that gain or loss on short sales is calculated separately from gain or loss on long positions); bingham v. commissioner, 27 b.t.a. 186, 189 (1932), acq., 1933-1 c.b. 2 (holding that no gain or loss is realized on short sale against the box until short position is closed out); rev. rul. 72-478, 1972-2 c.b. 487 (short sale against the box is valid short sale where long and short positions are reflected in separate accounts). in a securities loan, an owner transfers property in exchange for a contract right, but remains at risk with respect to the property. nonetheless, the tax law treats the securities lender as having disposed of the security. see irc § 1058 (nonrecognition of gain or loss for securities lender if requirements met); provost v. united states, 269 u.s. 443 (1926); rev. rul. 60-177, 1960-1 c.b. 9 (holding that dividend-equivalent payment to securities lender is not a dividend). see also priv. let. rul. 8818010 (feb. 4, 1988) (holding that legging into reverse currency swaps is not a realization event with respect to original currency swaps involving same counterparties because the taxpayer remains obligated under original currency swaps). the doctrine is at odds with itself. as argued by kleinbard, the doctrine creates a separate realization rule for fungible securities. however, that conclusion depends in part on the identification rule in regs. § 1.1012-1(c), which reflects a conception of shares as nonfungible. the identification rule entitles a taxpayer that sells some, but not all, of the shares in a pool of identical shares to identify which shares were sold for purposes of determining the taxpayer's basis and holding period. (the clinton administration has proposed repealing the identification rule. see supra note 3.) in the absence of identification, shares are treated as sold on a first-in, first-out basis. the identification rule is an essential piece of the tax treatment of short sales against the box. the taxpayer is entitled to specify that the shares delivered to the short sale purchaser were the borrowed shares, not the shares in the "box." kleinbard argues that because a short sale against the box leaves the taxpayer riskless with respect to the shares initially owned, but is not a disposition of those shares for tax purposes, ownership does not depend primarily on risk in the case of fungible assets. [vol 3:1 another uneasy compromise financial instruments: a loss deferral regime for straddles, mark-to-market regimes for "section 1256 contracts" and for securities dealers, and a matching regime for "hedging transactions." except in narrow circumstances, those rules do not cause a taxpayer to realize gain upon entering into a hedge of an appreciated asset. section 1092 defers a loss realized on one leg of a straddle until the gain on the other leg is recognized. 9 section 1256 requires that a taxpayer mark to market annually any "section 1256 contract," including futures contracts and certain exchange-traded options)° by enacting sections 1092 39. in its most generic sense, a straddle is a set of rights and obligations whose values offset one another. specifically, under § 1092(a)(1). any loss with respect to one or more "positions" is taken into account only to the extent it exceeds any "unrecognized gain" with respect to "offsetting positions," and any loss not so taken into account is carried forward. "position" means an interest in personal property. irc § 1092(d)(2). "personal property" means personal property of a type that is actively traded. irc § 1092(d)(1). a taxpayer holds "offsetting positions" if, by reason of holding one position. there is a "substantial diminution of the taxpayer's risk of loss" in the other. irc § 1092(c)(2)ta). although stock is, in general. not personal property under § 1092(d)(3)(a), stock can be personal property if accompanied by the appropriate offsetting position. specifically, stock is personal property if it is part of a straddle under which the offsetting position is "(1) an option with respect to such stock or substantially identical stock or securities or (2) under regulations, a position with respect to substantially similar or related property (other than stock)." irc § 1092dl13b). regs. § 1.1092(d)-2(a), which was promulgated on march 17, 1995, implements the latter prong. 40. specifically, "section 1256 contract" means any "regulated futures contract," "foreign currency contract," "nonequity option," or "dealer equity option." irc § 1256tb). a "nonequity option" is an exchange-traded option that is not an "equity option." irc § 1256(g)(3). an "equity option" is an option to buy or sell stock (or the value of which is determined by reference to any stock, group of stocks, or stock index), except that an option with respect to a group of stocks or stock index is a nonequity option if the commodities futures trading commission has designated a contract market in the option (or the treasury has determined that the option meets the legal requirements for such a designation). irc § 1256(g)(6). thus, some broad-based equity-based options are "nonequity options" and therefore marked to market under § 1256. a "dealer equity option" is an equity option held or issued by a dealer of a type that is listed on the exchange on which the dealer is registered and is purchased or granted by the dealer in the normal course of the dealer's activity of dealing in options. irc § 1256(g)(4). thus, options dealers are required to mark to market listed options on single stocks or groups of stocks, even in the absence of a contract market designation for such options. section 1256(d) provides an elective exception to the general mark-to-market rule of § 1256(a) in the case of mixed straddles. mixed straddles are straddles, as defined in § 1092, consisting of at least one § 1256 contract and at least one position that is not a § 1256 contract. each position must be clearly identified by the taxpayer as being part of such straddle. section 1256(e) exempts "hedging transactions" from the mark-to-market regime of § 1256(a). hedging transactions generally are transactions entered into in the normal course of the taxpayer's trade or business primarily to reduce risk with respect to ordinary incomeor loss-producing transactions and must be clearly identified by the taxpayer. cf. regs. 1996] florida tax review and 1256, congress responded to a long battle between the treasury and taxpayers over commodities straddles. before the enactment of those and related provisions in 1981, a taxpayer would enter into a forward contract to sell a commodity in one month and a hedge in the form of an approximately economically offsetting forward contract to purchase the commodity in another month. over time, one contract would inevitably increase in value, and the other would decrease in an approximately equal amount. the taxpayer would then close out the loss position, recognizing capital loss, and enter into a new forward contract to hedge the gain position. in a subsequent taxable year, the taxpayer would close out the gain position, as well as the new forward contract, recognizing capital gain. thus, with little or no economic investment, a taxpayer was able to manufacture a loss in one year and a gain in a later year.4 1 the treasury attacked the losses on the grounds that they were not incurred in transactions entered into for profit, leading to significant uncertainty and eventual litigation.42 sections 1092 and 1256 were thus originally aimed at situations in which the taxpayer's initial investment is zero and the taxpayer attempts to trigger loss in one year and gain in a later year. section 1092 accordingly defers losses, but does not generally trigger gain.43 section 1256 generally requires recognition of gain or loss as it accrues.44 §§ 1.1221-2 (treating income and loss from hedging transactions as ordinary); 1.446-4 (matching timing of income and loss from hedging transactions to timing of items from underlying transaction). 41. see staff of joint comm. on taxation, 97th cong., 1st sess., general explanation of the economic recovery tax act of 1981, 294-99 (comm. print 1981) [hereinafter staff of joint comm.]. 42. see 2 bittker & lokken, supra note 12, 45.1, 45.6. 43. an exception applies to a "section 1092(b)(2) identified mixed straddle." a "mixed straddle" is a straddle that consists of at least one § 1256 contract and one position that is not a § 1256 contract and meets various other conditions. temp. regs. § 1.1092(b)-5(e). a "section 1092(b)(2) identified mixed straddle" is a mixed straddle with respect to which an appropriate election has been made. if one of the positions comprising a § 1092(b)(2) identified mixed straddle was held before the straddle was established, the position is deemed sold for its fair market value as of the close of the last business day preceding the day on which the straddle is established. temp. regs. § 1.1092(b)-3(b)(6). see also temp. regs. § 1. 1092(b)-4(c)(5) (same for mixed straddle accounts). 44. unlike § 1092, § 1256 applies whether or not the § 1256 contract is held in combination with other positions resulting in a riskless or reduced risk position. section 1256 has been defended as an application of the constructive receipt doctrine, as well as a response to the commodity straddling activity discussed in the text. e.g., staff of joint comm., supra note 41, at 296; murphy v. united states, 992 f.2d 929 (9th cir. 1993). many § 1256 contracts are marked to market as a business matter under the rules of the exchange on which the contract is traded. see irc § 1256(g)(l)(a) (deposits and withdrawals with respect to regulated futures contract depend on mark-to-market system). [vol 3:1 another uneasy compromise section 475, enacted in 1993, generally requires securities dealers to mark to market securities (other than those that are held for investment and clearly identified as such).45 "security" for this purpose is broadly defined to include certain derivative financial instruments and hedges (clearly so identified by the taxpayer) of securities. 6 finally, section 1.446-4 of the regulations requires taxpayers to match the timing of items on a "hedging transaction" with the timing of items on the underlying hedged position. for those purposes, a hedging transaction generally includes hedges of ordinary incomeor loss-producing assets or liabilities. 1il. a closer examination of the distinction between holding and disposing many dispositions are undertaken voluntarily by a taxpayer in order to change the taxpayer's exposure to risk. the taxpayer disposes of one asset and acquires another because the taxpayer prefers exposure to the risk carried by the new asset. similarly, when a taxpayer hedges, the taxpayer voluntarily changes her exposure to risk. because hedges and dispositions are voluntary and often have a similar impact on a taxpayer's exposure to risk, one might conclude that hedges should receive the same tax treatment as dispositions. but, why should voluntariness, risk or both be relevant to the tax treatment in the unlikely event that a taxpayer holds a contract that becomes a § 1256 contract (because, for example, the cftc designates a market in such contracts). § 1256 apparently requires recognition of previously accrued gain or loss. 45. irc § 475(a), (b). 46. a "security" is a share of stock, a partnership interest, a beneficial ownership interest in a widely held or publicly traded partnership or trust, a note, certain notional principal contracts, an interest or derivative financial instrument in any of the foregoing, and any clearly identified hedge of any such security that is not itself otherwise a security. irc § 475(c)(2). section 475 resolved a dispute between taxpayers and the treasury over methods of accounting for securities dealers. section 1.471-5 of the regulations permitted three methods for such dealers' inventories: cost, market, and the lower of cost and market. to the objection of some dealers, proposed regulations would have required securities dealers to forgo accounting based on the lower of cost or market for securities and commodities inventories in order to elect mark-to-market accounting for notional principal contracts. prop. regs. § 1.446-4(a)(3). see letter from stephen l. gordon on behalf of international swap dealers association to karl t. walli, internal revenue service (sept. 27, 1991). available in 91 tnt 210-50 (linkage indefensible); letter from saul m. rosen, salomon brothers. inc.. to karl t. walli (dec. 6, 1991), available in 91 tnt 255-37 (same); letter from joanne ames. american bankers association to fred goldberg, former commissioner of the internal revenue service (sept 23, 1991), available in 91 tnt 203-34 (same). the internal revenue service withdrew the proposed regulations on october 8, 1993. in response to the enactment of § 475. fi-16-89, 1993-2 c.b. 611. 1996] florida tax review of hedges? and, what role do those concepts play in justifying and describing the distinction between holding and disposing? normatively, both voluntariness and risk appear to be irrelevant. they are unrelated to the haig-simons concept of income because a taxpayer's increase in wealth does not depend on whether the taxpayer has changed voluntarily the taxpayer's exposure to risk. voluntariness and risk are also unrelated to the administrative concerns relating to valuation and liquidity addressed by the realization requirement.47 the periodic valuation of assets and liabilities under an accrual taxation regime could be extremely burdensome. the realization requirement obviates the need for periodic valuation. if realization occurs by a cash sale, valuation is simple. if the taxpayer receives property, other than money, valuation may be difficult, but the realization requirement reduces valuation problems by requiring valuation only upon realization, rather than periodically over the taxpayer's holding period. as to liquidity, under accrual taxation, some taxpayers would be taxed on appreciation, but have inadequate cash with which to pay the tax, because they have not exchanged their assets for cash. they would have to sell assets in order to raise funds to pay the tax. the realization requirement reduces the need for such forced sales by deferring tax until disposition. if the taxpayer receives only cash in exchange for an asset, the taxpayer should have enough cash to pay the tax since the tax is less than the taxpayer's gain, which is in turn less than the amount of cash received. in a property-forproperty exchange, liquidity may be a problem. the taxpayer may need to sell some of the property received in the exchange in order to raise cash to pay tax. the realization requirement reduces liquidity problems, however, by making such forced sales necessary only upon realization, not periodically. although voluntariness and risk are unrelated to valuation and liquidity, voluntariness and risk might nonetheless be important, especially for publicly-traded assets. the valuation and liquidity justifications for the realization requirement are less compelling for publicly-traded assets, which are generally easy to value and liquid, than for other assets. indeed, some scholars have advocated repealing the realization requirement for publiclytraded assets.48 but, voluntariness and risk do not explain as a descriptive matter, much less normatively justify, the tax law's differential treatment of holding and disposing. voluntary action by the taxpayer is not necessary for realization since forced dispositions are realization events. further, voluntary 47. see supra notes 12-13 and accompanying text. 48. e.g., slawson, supra note 13; note, supra note 13. it may, however, be difficult to value a controlling, or even a large, block of shares of a publicly-traded corporation, even if the value of a single share is known. [vol 3:1 another uneasy compromise action is not sufficient since holding is voluntary but is not a realization event. a change in risk through a voluntary action (of holding) is not sufficient for realization either because changes in risk occur while a taxpayer holds, but do not trigger realization. there is no consistent relationship between risk and dispositions either. in a sale or exchange, the taxpayer disposes of an asset that the taxpayer held before the transaction. if a taxpayer exchanges her boat for someone else's car, perhaps it is obvious that she owns a new asset. in many cases, however, the determination that the asset that the taxpayer owns after the transaction is a different asset from the asset she owned before depends on formal notions of what constitute separate assets. the economic concept of risk could potentially define assets for purposes of realization with the result that a change in risk is necessary or sufficient or both for realization. but, the concept of risk tends to dissolve assets rather than define them. a change in the amount of risk to which the taxpayer is exposed is neither necessary nor sufficient for realization since such amount might not change if a taxpayer exchanges an asset but often does change while a taxpayer holds an asset. a change in the nature of risk could form the test for realization, but requires supplemental rules defining separate types of risk. further, even if it is clear that a taxpayer has disposed of something, identifying what asset has been disposed of can be a troublesome matter unresolved by the concept of risk. if a taxpayer disposes of a part of an asset, the taxpayer could equally be viewed as disposing of the part only or of the whole asset. examples in this part iii and part iv involve coin flip, a hypothetical asset that, unless otherwise stated, entitles its holder to be paid $100 in the event that a particular coin flip turns up heads and zero in the event that the flip turns up tails. there is a 50% probability of each occurrence.49 49. the examples deliberately do not specify the taxpayer's basis or holding period in coin flip in order to focus the analysis on realization. basis and holding period are relevant to the amount and character of gain or loss realized if there is a realization event, but are not relevant to whether there is a realization event. basis and holding period could, however, be relevant to the appropriate timing of gain or loss under a regime that imposes tax based on expected outcomes in advance of realization. for example, if coin flip was purchased for $20 one year before the coin flip, the taxpayer should arguably be required to accrue over the year s30-an amount equal to the expected value of coin flip of $50 (see infm note 52 and accompanying text), less the taxpayer's $20 basis in coin flip. see prop. regs. § 1.1275-4 (accrual based on payment schedule projected at issuance of contingent payment debt instrument); shuldiner. supra note 6, at 285 (financial instruments should accrue income based on expected future values). even under such a regime, however, realization is relevant because actual outcomes inevitably differ from expected outcomes and realization is likely the appropriate time to adjust for such differences. 19961 florida tax review a. voluntary action by the taxpayer sales and exchanges are usually voluntary, as is hedging. that similarity is important for the economic substitute argument because the argument centers on avoiding social costs generated by taxpayers choosing to engage in transactions for tax reasons. as demonstrated in part iii.b below, a change in risk does not alone trigger realization. changes in risk can occur as a taxpayer holds an asset. a taxpayer's exposure to risk fluctuates while the taxpayer holds one asset and, after an exchange, fluctuates while the taxpayer holds the second asset. the exchange does not demarcate a change in the taxpayer's overall exposure to risk. although riskiness exists on a continuum, realization is an on/off switch. a voluntary action could potentially demarcate a sale or exchange. but, voluntariness does not distinguish between holding and disposing because holding an asset is voluntary, as is disposing. a voluntary action by the taxpayer is not necessary for realization. for example, forced dispositions of property by virtue of government condemnation, foreclosure, or corporate merger are realization events, yet it would be strained to characterize them as resulting from voluntary taxpayer actions. however, nonrecognition provisions sometimes apply in these cases, perhaps reflecting a congressional determination that it is not appropriate to tax involuntary dispositions." a voluntary action is also not sufficient for realization since holding is voluntary. a taxpayer that holds effectively decides daily to hold rather than sell. holding could be viewed as a voluntary decision to expose oneself to the risks carried by the asset that the taxpayer holds. holding a share of stock is equivalent to selling it and then repurchasing." the observation that the realization requirement creates an incentive to hold rather than sell concedes that holding is voluntary. voluntary action coupled with a change in risk can be viewed as sufficient for realization only if the voluntariness of holding is disregarded. 50. see irc §§ 1033 (gain realized upon involuntary conversion recognized only to extent amount realized exceeds cost of replacement property); 354 (nonrecognition on exchange of stock for stock in corporate reorganization). section 108 excludes from gross income certain amounts that would otherwise constitute discharge of indebtedness income, and requires the taxpayer to reduce tax attributes by the amount so excluded. section 108 is thus a nonrealization provision, not a nonrecognition provision. 51. see irc § 1091 (disallowing deduction from disposition of stock or securities if taxpayer acquires substantially identical stock or securities within thirty days before or after sale). [vol. 3:1 another uneasy compromise b. risk any connection between dispositions and risk is largely a matter of definition, not substance. a change in risk is generally neither necessary nor sufficient for realization. potentially, a change in the nature of risk could be sufficient for realization, but that formulation depends on defining what constitutes such a change. 1. the concept of risk.-variance and standard deviation of outcomes anticipated ex ante are textbook measures of risk. each measures the extent to which actual outcomes are likely to differ from the expected, or average, outcome. 52 an asset with a high variance and standard deviation is likely to provide an actual outcome that differs significantly from its expected outcome, while the outcome of an asset with a low variance and standard deviation is likely to be close to the asset's expected outcome. for example, common stock that is expected to be worth $100 has a higher variance than a debt instrument of a creditworthy issuer that is also expected to be worth $100. the common stock could easily turn out to be worth much less or much more than $100, while the debt instrument is very likely to be worth an amount that is close to $100. the capital asset pricing model (capm) provides another approach to measuring risk of a capital asset.53 under capm, capital assets carry 52. mathematically, expected return = e(r) = pj, where p, is the probability of the jth return and r, is the jth possible return; variance = 0. = e p,(r3e(r))"; and standard deviation = a = see edwin j. elton & martin j. gruber, modem portfolio theory and investment analysis 4751 (5th ed. 1995); richard a. brealey & stewart c. myers. principles of corporate finance 131-34 (4th ed. 1991). for example, suppose that, in a game of chance, a player bets sioo and is entitled to receive $120, $110, or $90 with a probability of 50%, 40%. and 10%. respectively. the expected return is the weighted average of the possible returns. since the player has a 50% probability of a $20 return, a 40% probability of a sio return, and a 10% probability of losing $10, the expected return is (50% of $20) + (40% of $i0) + (10c of -$10). or s13. variance, which measures the extent to which the actual return is likely to differ from the expected return, is the weighted average of the squares of the differences between each possible return and the expected return. thus, variance is (50% of (20-13)2) + (40% of t 10-13)) + (10% of (-$10-13)2), or 81. standard deviation is the square root of variance, or 9. for simplicity, the examples in parts iii and iv calculate expected value assuming that the time value of money is zero. 53. see john lintner, the valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets, 47 rev. econ. & stat. 13 (1965); william f. sharpe, capital asset prices: a theory of market equilibrium under conditions of risk, 19 j. fin. 425 (1964). 19961 florida tax review systematic and unsystematic risk. systematic risk, measured by "beta," is the asset's sensitivity to market risk, and unsystematic risk is the additional risk.54 2. sales and risk.-a sale for cash, illustrated in example 1, is a paradigmatic realization event. example 1. taxpayer owns coin flip. taxpayer sells coin flip for $50 in cash. sales arguably eliminate risk in two senses. the first focuses on what the taxpayer owns after the transaction, while the second focuses on what the taxpayer does not own. first, after the transaction, the taxpayer owns dollars. measured by reference to nominal dollars, dollars are riskless. but, measured by reference to a more meaningful standard, the value of dollars changes over time. dollars are risky because their value depends on inflation and currency exchange rates. the second sense in which the sale eliminates risk is that after the sale, the taxpayer is not at risk with respect to coin flip. the taxpayer's fortunes no longer depend on whether the coin turns up heads or tails. the nature of the taxpayer's risk has changed from exposure to the flip of a coin to cash. 3. amount of risk-a change in the taxpayer's exposure to a particular amount of risk is not necessary or sufficient for a realization event.5 5 it is not necessary because a property-for-property exchange could involve two assets with the same, or approximately the same, amount of risk, as illustrated in the following example. example 2. taxpayer owns coin flip and exchanges it for another asset entitling taxpayer to $100 if a coin (different from the coin on which coin flip is based) turns up heads and zero if the coin turns up tails. the new asset has the same variance as coin flip. notwithstanding the identical riskiness of coin flip and the new asset, the exchange is probably a realization event. 6 54. brealey & myers, supra note 52, at 137-39, 143. beta is the ratio of the stock's covariance with the market divided by the variance of the market. id. at 145. covariance measures the extent to which two assets, a and b, are likely simultaneously to exceed or be less than their respective expected returns and is denoted by cr. thus, a., = y(rj-e(r.))(rbi e(rb)). elton & gruber, supra note 52, at 56. 55. for example, the taxpayer in cottage savings intentionally exchanged assets with similar financial characteristics. cottage savings ass'n v. commissioner, 499 u.s. 554, 557 (1991). 56. the exchange is probably a realization event if the obligor of coin flip is different from the obligor of the new asset. id. at 560-62. even if the coin flips have the same [vol 3:1 another uneasy compromise a change in the amount of risk to which the taxpayer is exposed is also not sufficient for a realization event because a taxpayer's exposure to risk in an asset fluctuates while the taxpayer holds the asset. variance and standard deviation (and beta) change if expectations about outcomes change while the taxpayer holds. example 3. a taxpayer owns coin flip. during the taxpayer's holding period, circumstances change so that coin flip will pay the taxpayer $75 if the coin turns up heads and $25 if the coin turns up tails. as illustrated in the chart below, that change in expectations means that the variance and standard deviation of coin flip have changed. probability and expected standard outcome value variance deviation initial 50% 100 50 2500 50 50% 0 subsequent 50% 75 50 625 25 50% 25 the new possible outcomes of $75 and $25 fall within a narrower range than the initial possible outcomes of $100 and zero. although the new outcomes do not change the $50 expected value, they reduce the variance of coin flip from 2500 to 625, and the standard deviation from 50 to 25. changes in the riskiness of capital assets are not unusual. in fact, they are the norm. for example, if a corporation sells one line of business and enters a new one, the riskiness of the corporation's stock thereafter reflects the risks of the new business. riskiness can also change in the absence of extraordinary transactions. any change in the corporation's businesses or the market factors affecting them can alter the riskiness of the corporation's stock if expectations about outcomes change. studies show that beta for a particular stock changes over time.57 changes in risk also occur with respect to other obligor, the exchange may be a realization event. an exchange of convertible preferred stock for convertible debt of the same issuer might involve no material change in the taxpayer's exposure to risk, but is nonetheless a realization event. 57. brealey & myers, supra note 52, at 183-86 (noting. however, that -true betasappear to be "reasonably stable"). one widely-used source for betas predicted that the beta of aetna life and casualty, america online. and american express changed from 0.96. 1.57, and 19961 florida tax review property. for example, if a machine has a faulty part that threatens to explode the machine, the riskiness of returns from the machine may be reduced by replacing the part. also, a debt instrument's exposure to interest rate risk generally decreases as the remaining term decreases. 4. nature of risk.-perhaps then a change in the nature of risk is necessary or sufficient or both for realization. if the taxpayer is exposed to one random variable, such as the value of one issuer's stock, and is then exposed to another random variable, such as the value of a different issuer's stock, realization occurs. this explains why an exchange of ibm stock for gm stock is a realization event and why the exchange of coin flip for cash in example 1 is a realization event. but, that formulation depends on rules defining separate risks. there is reason to believe that although ibm stock and gm stock may carry different amounts of risk, it is a matter of definition to view them as carrying risks of a different nature. under capm, a taxpayer with a diversified portfolio is exposed to one risk, market risk, regardless of which shares the taxpayer owns. using capm, a property-for-property exchange by a taxpayer with a diversified portfolio substitutes one exposure to market risk (measured by beta) for another. example 4 illustrates the idea of a property-for-property exchange as a change in the taxpayer's sensitivity to a single random variable. example 4. taxpayer owns coin flip and exchanges it for a new asset that pays $75 or $25, respectively, based on whether the coin used in coin flip turns up heads or tails. 1.25, respectively, in march 1995 to 0.98, 1.59, and 1.2 in may 1995. see barra u.s. equity beta book-company listing (may 1995); barra u.s. equity beta book-company listing (march 1995). see also marshall f. blume, on the assessment of risk, 26 j. fin. 1, 8 (1971) (concluding that estimates of beta tend to regress towards mean over time); robert a. levy, on the short-term stationarity of beta coefficients, fin. analysts j., nov.-dec. 1971, at 55, 62 (providing evidence that beta tends to be "stationary for large portfolios, less stationary for smaller portfolios and unpredictable for individual securities"); thomas m. tole, how to maximize stationarity of beta, j. portfolio mgmt., winter 1981, at 45, 47 (arguing that increasing number of securities in portfolio improves two conditions necessary for stationary portfolio beta). risk measurement involves speculative predictions about the future or extrapolations from the past. because probabilities of possible outcomes cannot be easily determined, most financial analysts use historical data to calculate variance. brealey & myers, supra note 52, at 135-36. portfolio managers and other investment professionals spend significant time and effort using sophisticated statistical procedures to estimate risk. "beta books" are published by various financial advisory services and brokerages providing betas for various stocks. see, e.g., barra, supra. such calculations are estimates, some more accurate than others. brealey & myers, supra note 52, at 185-89. [vol 3:1 another uneasy compromise probability and expected standard outcome value variance deviation coin flip 50% 100 50 2500 50 50% 0 new asset 50% 75 50 625 25 50% 25 before and after the exchange, the taxpayer owns an asset that is sensitive to the flip of a particular coin, but the degree of sensitivity of the initially-owned and subsequently-owned assets differs. similarly, if a taxpayer with a diversified portfolio exchanges stock in one corporation for stock in another corporation, the taxpayer is exposed to one kind of risk, market risk, before and after the transaction, but the sensitivity to market risk of the initiallyand subsequently-owned stock differs as reflected in their different betas. even apart from capm, the riskiness of a share of stock depends on the assets and liabilities of the issuer. the nature of the risk to which a taxpayer is exposed could therefore be defined by reference to those assets and liabilities, rather than the share of stock. as illustrated in example 5, whether a transaction is viewed as changing the nature of the risk to which a taxpayer is exposed depends on whether the nature of the taxpayer's risk is defined by reference to the entity's assets and liabilities or the stock that the taxpayer owns. example 5. taxpayer owns stock in a corporation that owns coin flip. the corporation exchanges coin flip for another asset, a bet on a roll of a pair of dice. the exchange is a realization event for the corporation, but not for the taxpayer/stockholder,58 because the taxpayer holds stock without exchanging anything. but, the nature of the taxpayer's risk has changed. the taxpayer was first exposed to the flip of a coin and then exposed to a roll of dice. 5. disposing of a portion of an asset.-even in the case of a sale or exchange that changes the amount or nature of risk, questions remain 58. the absence of realization with respect to the taxpayer is not a result of the separate tax on corporations, but rather is the result when any separate entity, including a passthrough entity, holds coin flip. if the entity were a partnership or s corporation rather than a c corporation, the taxpayer would include gain or loss from the entity's exchange of coin flip, but that is different from deeming the taxpayer to have sold the partnership interest or s corporation shares. 19961 florida tax review about what the taxpayer disposed of. if a taxpayer replaces the engine on her boat, she could be viewed as disposing of the old engine only or as disposing of her old boat for a new boat. similarly, risk does not help determine whether the disposition illustrated in example 6 is a disposition of coin flip or a subasset of coin flip. example 6. coin flip can be viewed as a combination of two assets, coin flip a, which pays $50 if the coin turns up heads and nothing if it turns up tails, and coin flip b, which pays $50 if the same coin turns up heads and nothing if it turns up tails. suppose the taxpayer sells coin flip a for $25 cash. that might be a realization event only with respect to coin flip a. alternatively, if coin flip is viewed as a single asset, then the transaction is a disposition of coin flip in exchange for $25 in cash plus coin flip b. determining whether an asset has been disposed of is especially difficult in the case of a disposition of a subasset for property, rather than cash, particularly if the property received depends on the same random variable as the subasset transferred. example 7. suppose, as in example 6, that coin flip is viewed as a combination of coin flip a and coin flip b. taxpayer, who owns coin flip, exchanges coin flip a for another asset, coin flip c, entitling the holder to payment depending on the results of the same coin flip as the flip involved in coin flip. this exchange might be a realization event only with respect to coin flip a. but, it could instead be viewed as an exchange of coin flip for a combination of coin flip b and coin flip c. changes in risk provide no apparent normative basis for treating holding and disposing differently. risk also does not describe or explain the distinction. dispositions may or may not change the amount or nature of the taxpayer's exposure to risk. dispositions cannot be distinguished from holding based on their effect on the taxpayer's exposure to risk, absent definitions about which types of risk matter. further, if a disposition has occurred, risk does not determine what has been sold or exchanged. the realization requirement is highly formal. not only is it unrelated to the normatively relevant economic concept of income and administrative concerns of valuation and liquidity, its relationship to risk is attenuated. iv. hedging as a substitute for a disposition it has long been recognized that within the haig-simons definition of income, unrealized appreciation and realized appreciation are identical. two principal justifications-valuation and liquidity-have been advanced for treating the two forms of appreciation differently. in addition, voluntariness [vol. 3:1 another uneasy compromise and risk present themselves as possible explanations for the differing tax treatment of simple cases of holding and disposing. i have so far argued that for publicly-traded assets, neither valuation, liquidity, voluntariness, nor risk furnishes a coherent justification or explanation for the different tax consequences of selling and holding. what implications does that conclusion have for hedging, which resembles selling in some ways, but not all? at a minimum, an argument in favor of taxing hedges must do more than point out that taxing hedging avoids problems of valuation and liquidity or that hedging involves voluntary changes in risk. on all those counts, dispositions, which precipitate taxation, are functionally equivalent to holding, which does not. the economic substitute argument in favor of taxing hedging is more sophisticated, however. it suggests that there may be social costs, especially in the form of transaction costs, when the tax regime treats economically similar transactions differently. even if there is no normative justification for distinguishing between holding and selling, the appropriate treatment of hedging can be analyzed based on whether taxpayers treat hedging as a substitute for selling, resulting in social costs. this part iv discusses the structure of some basic hedges in order to determine the extent to which taxpayers use them as substitutes for dispositions. some hedges, such as a short against the box transaction, do, from the taxpayer's point of view, strongly resemble dispositions and will therefore be used as substitutes so long as the tax treatment of hedging continues to be better than the tax treatment of disposing. other hedges, such as acquisition of a put option, bear a weaker resemblance to dispositions. arguably, a realization requirement that took account of differing amounts of risk, and therefore required measurement of risk, could measure the extent to which a hedge resembles a sale. but, except at a very gross level, risk measurement is not administrable. compliance with, and administration of, tax rules requiring measurement of fair market value is difficult enough. measuring risk is even harder. involving anount of risk in the test for realization cannot be done in a comprehensive and administrable way. since the realization requirement is itself a response to the practical problem of measuring value, it would be perverse to institute a rule that requires even more difficult measurements. a. hedges that strongly substitute for dispositions in the following example of a "married put and call," the taxpayer simulates a sale of coin flip for $50 cash.59 59. this strategy can be used to transform a share of common stock that does not pay dividends into a bond. for example, a taxpayer owning a share worth $10 could buy a 19961 florida tax review example 8. taxpayer owns coin flip. taxpayer sells a call for $25 entitling the holder to the excess of the payment under coin flip over $50. taxpayer also purchases a put for $25 entitling taxpayer to the excess of $50 over the payment under coin flip. taxpayer will have $50 at the end of the day, regardless of whether the coin flip turns up heads or tails. coin put call put call outcome flip premium premium payment payment heads 50 = 100+ (25)+ 25+ 0+ (50) tails 50 = 0+ (25)+ 25+ 50+ 0 because taxpayer is certain to have $50, the married put and call is similar to a sale of coin flip for $50 cash. as illustrated below, buying a put and selling a call results in a riskless position with zero variance and standard deviation: 6° probability expected standard and outcome value variance deviation coin flip 50% 100 50 2500 50 50% 0 coin flip 50% 50 50 0 0 and sell 50% 50 call and buy put cash-settled put option and sell a cash-settled call option with respect to the share, each with a one-year term and a strike price of $11. under the put, the taxpayer would be entitled in one year to receive any excess of $11 over the value of the share on that date. under the call, the taxpayer would be obligated to pay the owner of the call any excess of the value of the share one year from now over $11. if the stock value exceeds $11 on the exercise date, the call owner will exercise, and the put will lapse. if the stock value is less than $11 on such date, the taxpayer will exercise the put, and the call will lapse. if the stock value is exactly $11, neither option will be exercised. thus, regardless of the value of the stock, the taxpayer will have a total of $11 ($10 plus the equivalent of 10% interest), taking into account the value of the stock and the payments that the taxpayer makes or receives under the options. 60. taxpayer's position is riskless in the sense that the amount of cash that taxpayer will have is certain. the value of cash is, however, risky. see supra part iii.b.2. [vol. 3:1 another uneasy compromise "hedge and forget" strategies, such as a married put and call, short against the box, equity swap, or a forward contract approximate a disposition by making a taxpayer's returns largely independent of the price of the taxpayer's stock.6' some hedge and forget strategies leave the taxpayer slightly exposed to risk in the hedged asset, however, because of counterparty credit risk. for example, in the case of an equity swap, a married put and call, or a forward contract, the taxpayer remains exposed to the possibility that the counterparty may default, in which case the taxpayer's return would depend on price variations in the underlying asset.6 b. purchase of a put or sale of a call 1. reduces some risks, but introduces others.-the purchase of a put or sale of a call might be used by a taxpayer as a substitute for a sale because a taxpayer that owns an asset and buys a put or sells a call reduces exposure to risk in the asset. example 9 illustrates that buying a put reduces a taxpayer's exposure to risk in an asset. example 9. taxpayer, who owns coin flip, purchases a put for $25 entitling taxpayer to the excess of $50 over the payment under coin flip. thus, if the coin turns up heads, the put entitles taxpayer to nothing (the excess of $50 over the $100 payment under coin flip) and if the coin turns up tails, the put entities taxpayer to $50 (the excess of $50 over the payment of zero under coin flip). the following table shows taxpayer's net outcomes: i outcome= coin flip + put premium + put payment heads 75 = 100+ (25)+ 0 tails 25 = 0+ (25)+ 50 61. see supra note i. 62. a short against the box arguably does not involve credit risk. klcinbard, supra note 6, at 789 n.30. there is precedent for disregarding credit risk in the context of realization. for example, the original issue discount rules require a taxpayer to accrue income under a noncontingent bond, even though there is risk that the accrued amounts will not be received because the issuer of the bond defaults. see irc § 1272(a)(1) (including original issue discount in gross income); t.a.m. 9538007 (june 13, 1995) (finding no "doubtful collectibility" exception to original issue discount accrual). 19961 florida tax review owning only coin flip is riskier than owning coin flip and the put, because the variance of outcomes is higher in the first case than in the second: probability expected standard and outcome value variance deviation coin flip 50% 100 50 2500 50 50% 0 coin flip 50% 75 50 625 25 and put 50% 25 the financial concept of "delta" also illustrates that acquisition of a put or sale of a call reduces, but does not eliminate, a taxpayer's exposure to price variations in the underlying asset. delta is the rate of change in value of a derivative security with respect to the value of the underlying asset.63 if the price of the underlying asset changes, the price of an option on that asset changes less. for every incremental change in the value of the underlying asset, the option will change in value by some fraction of that increment. delta is that fraction. for example, if a taxpayer owns one share of stock and a put with respect to one share of stock with delta of, say, negative 0.75, then, if the value of the stock declines by a small amount, such as $1, the put increases in value by $0.75. if the stock value instead increases by $1, the put value decreases by $0.75. a change in stock value of $1 thus changes the taxpayer's overall position by only $0.25. the delta of an option depends on, among other variables, the value of the asset. for a deep in-the-money option, the absolute value of delta approaches one, meaning that the option changes in value approximately dollar-for-dollar with changes in the asset value. a deep in-the-money put is thus a very good hedge of the underlying stock because, for every incremental change in value of the underlying stock, the put changes by approximately the same amount in the other direction. at the other end of the spectrum, a deep out-of-the-money put changes in value very little for any change in value of the underlying stock and therefore does not significantly hedge the underlying stock. although buying a put or selling a call reduces the taxpayer's exposure to risk of price changes of an asset, it also exposes the taxpayer to 63. delta is the first partial derivative of the derivative security's value with respect to the underlying asset's value. see john hull, options, futures, and other derivative securities 298-307 (2d ed. 1993). i[vol 3:1 another uneasy compronise new risks, such as the volatility of the underlying stock. under the blackscholes option pricing technique, option prices depend on, among other variables, the volatility of the underlying stock. but, the value of stock does not depend on the volatility of the stock. as discussed in part iii.b. i., above, the total volatility of a share of stock consists of systematic risk and unsystematic risk. stock values depend on systematic risk only because diversification can offset exposure to unsystematic risk. thus, a stockholder who acquires a put is introduced to volatility risk in the underlying stock. if purchase of a put or sale of a call is treated as a disposition, it is unclear, however, what asset has been disposed of. as discussed in parts iv.b.2., 3., and 4., below, acquisition of a put or sale of a call by a taxpayer owning a share of stock could be viewed as a disposition of the share, a subposition of the share, or a fraction of the share. 2. similar to disposition of share.-under the "put-call parity" theorem, the combination of owning stock, buying a put on that stock, and selling a call on that stock with the same strike price and exercise date as the put is equivalent to owning a zero coupon bond that provides for a payment at maturity (the exercise date of the options) of an amount equal to the strike price of the options.64 on the exercise date of the options, either the stock will be worth exactly the strike price, or the put or call will be exercised. in all events, on that date, the taxpayer will have an amount of cash and stock equal to the strike price. algebraically, s + p c = z, where s represents owning the stock, p represents owning the put, c represents being short (being the grantor of) the call, and z represents owning the zero coupon bond. solving that equation for s, it is apparent that s = z p + c. owning stock can be disaggregated into owning a bond, selling a put, and owning a call. consider a taxpayer who owns stock and acquires a put. after acquiring the put, the taxpayer owns s + p, which is equivalent to owning z + c. the acquisition of the put might be a substitute for a disposition of the stock in exchange for a zero coupon bond and a call. indeed, a taxpayer might acquire a put in order to set a minimum on the taxpayer's return. by owning s and p together, the taxpayer is assured of having at least an amount equal to the strike price of the put on the expiration date, just as the taxpayer would be assured of receiving at least the stated redemption price at maturity on such date by owning z and c. therefore, if acquisition of the put is an appropriate time to tax previously accrued appreciation, the taxpayer's 64. john c. cox & mark rubinstein, options markets 41-42 (1985): hull. supra note 63, at 163-66. see also warren, supra note 6. at 465-67 (arguing that put-call parity poses conceptual challenge to code's realization regime for stock and options, and original issue discount accrual regime for debt). the text assumes that the stock does not pay dividends. 19961 florida tax review amount realized is the value of the bond and call, which equals the value of the stock and put. the taxpayer's basis is the basis in the stock plus the cost of the put. the value of the put drops out, with the result that the acquisition of the put would cause the taxpayer to recognize gain or loss equal to the difference between the value of the stock and the taxpayer's basis in the stock. that is the same amount of gain that the taxpayer would realize by selling the stock for its fair market value. 3. similar to disposition of embedded short put.-based on put-call parity, the purchase of the put could instead be viewed as a disposition of a subposition of the stock, rather than a disposition of the entire share. since s equals z p + c, a share of stock may be viewed as having embedded within it a short put, -p.65 acquisition of the put eliminates the taxpayer's risk in the subposition, -p, that is embedded in the stock. on that view, the taxpayer's amount realized is the amount that the taxpayer received upon selling the embedded put, and the taxpayer's basis is the cost of acquiring the new put. it is unclear, however, how much amount realized the taxpayer should be treated as having for the embedded put. although the taxpayer's basis in s is known, allocation of that basis among subpositions, including a short subposition, is unclear.66 4. similar to disposition of fraction of share.-acquisition of a put by a taxpayer that owns a share of stock could instead be viewed as a disposition of a fraction of the share. owning a share of stock and a put on that stock is similar economically to owning a fraction of a share of the stock, owning an appropriate amount of treasury obligations, and following a strategy under which, as the value of the stock increases, treasury obligations are sold and stock is purchased, and, as the value of the stock falls, stock is 65. in fact, a share of stock could be viewed as having an infinite number of short puts embedded within it, because the formula s = z p + c is true if the strike price of the options and the stated redemption price at maturity of the bond equal one another, and the exercise date of the options and maturity date of the bond are the same. that price could be any amount, however, and the date could be any date. 66. the treasury proposal appears to treat stock as a fundamental unitary asset. it does not apply to a taxpayer that owns stock and buys a put (unless the put is substantially certain to be exercised) because buying the put reduces, but does not substantially eliminate, risk of loss and opportunity for gain with respect to the stock. see budget bill, supra note 3, § 9512. but, as demonstrated in the text, if stock may be disaggregated, then, under the proposal, buying a put would trigger realization with respect to an embedded put. see n.y. st. b. ass'n report, supra note 3 (taxpayer's appreciated financial position should generally not be disaggregated). the proposal's assumption that stock is a fundamental asset that should not be broken down into constituent parts is administratively helpful, but enables taxpayers that own appreciated stock to avoid the proposal entirely by selling a call or purchasing a put. [vol 3:1 another uneasy compromise sold and treasury obligations are purchased.67 in fact, such a strategy is called a "synthetic put." suppose that a taxpayer owns one share of stock worth s100 and a put whose value, at that stock price, changes inversely by 50% of any change in the stock price."g if the value of a share of the stock decreases by $1, the put will increase in value by approximately $0.50, and if the value of a share of the stock increases by $1, the put will decrease in value by approximately $0.50. thus, a $1 decrease in value of the stock causes a $0.50 decline in the taxpayer's overall position. the same result would occur if, instead of owning one share of stock and a put, the taxpayer owned 0.5 shares of stock with a value of $50 and invested the remainder of the portfolio in treasury obligations. a $1 decline in value of a share of the stock would cause a $0.50 decline in value of the taxpayer's stock position and no change in the value of the treasury obligations. 69 thus, acquisition of the put resembles a 67. cox & rubinstein, supra note 64, at 47; elton & gruber. supra note 52, at 59394; hull, supra note 63, at 319. synthetic puts are sometimes referred to as "artificial" or "homemade" puts, and the strategy as "portfolio insurance." see generally portfolio insurance: a guide to dynamic hedging (donald l. luskin ed.. 1988). the combination of owning stock and selling a call can also be created by dividing the taxpayer's portfolio between stock and treasury obligations. in that case. however, as the stock price rises, the taxpayer sells stock and buys treasury obligations, and as the stock price falls, the taxpayer buys stock and sells treasury obligations. cox & rubinstein. supra. at 47. transaction costs make continuous rebalancing of the portfolio inefficient. see, e.g.. gerard gennotte & alan jung, commissions and asset allocation, j. portfolio mgmt.. fall 1992, at 12. but, creating synthetic puts and calls using futures contracts, rather than the underlying stocks themselves, can reduce transaction costs. elton & gruber. supra. at 594; hull, supra, at 320. 68. "delta" of the put is -0.5. see supra note 63 and accompanying text. 69. at a different stock price, the put value would vary with the stock value by a different percentage, requiring a different mix of stock and treasuries. for example, at a stock price of, say, $120, the put might change in value by only 25% of any change in the stock value, and a $1 decrease in value of a share of the stock would cause a so.75 decrease in the value of the taxpayer's stock and put position. the equivalent stock and bond portfolio would consist of 0.75 shares of the stock and the remainder in treasury obligations. the proportion of the portfolio that should be invested in stocks can be described in terms of the value of the stock, the strike price, the risk-free rate of interest, the dividend yield on the stock, the volatility of the stock, and the time remaining until expiration. hull. supra note 63. at 319. the fraction of the overall position invested in stock or treasury obligations must be adjusted as the time to expiration of the synthetic put decreases, even if the value of the stock does not change. if the synthetic put is out-of-the-money, the fraction invested in stock should be increased as the time to expiration decreases, so that in the absence of any change in stock value, the taxpayer owns one share of stock at maturity. if the synthetic put is in-themoney, the fraction invested in treasuries should increase over time, so that at expiration the taxpayer owns only treasuries with a value equal to the strike price. see cox & rubinstein. supra note 64, at 46. 19961 florida tax review disposition of 0.5 shares. c. risk-magnifying transactions if a taxpayer wants to increase exposure to risk in a share of stock that the taxpayer owns, the taxpayer could sell the stock and purchase a call on the stock. disposing of the stock would be a realization event. instead, the taxpayer could try to avoid realization by increasing risk using a separate transaction. a taxpayer can enter into a transaction that magnifies the taxpayer's exposure to risk of the same variable that the taxpayer was exposed to before the transaction. for example, a taxpayer owning a share of stock might agree to pay a counterparty the square of the value of the share. example 10 is a simplified version of such a contract, illustrating the taxpayer's increased exposure to coin flip after the transaction. example 10. taxpayer owns coin flip. taxpayer sells a contract for $5,000 entitling the holder to be paid the square of the payment under coin flip. thus, if the coin turns up heads, taxpayer will pay the holder of the contract $10,000. if the coin turns up tails, taxpayer will pay the holder nothing. taxpayer's net outcomes are as follows: outcome= coin flip + premium + payment heads (4,900) = 100 + 5,000 + (10,000) tails 5,000 = 0+ 5,000+ 0 the variance of the taxpayer's outcomes is dramatically increased by selling the contract, but the outcomes continue to depend only on the flip of the coin: a synthetic put can be created for a diversified portfolio, instead of a single stock, or for a fixed-income security, rather than equity. see erol hakanoglu et al., constant proportion portfolio insurance for fixed-income investment, j. portfolio mgmt., summer 1989, at 58. derivatives other than options can be created synthetically. for example, options can form the building blocks of synthetic futures contracts. see panagora to boost otc derivatives use, eyes emerging markets instruments, derivatives week, dec. 20, 1993, at i (synthetic futures positions in germany, spain, and the netherlands constructed by purchasing call option on an equity index and selling put with same strike price). [vol 3:1 another uneasy compromise probability expected standard and outcome value variance deviation coin flip 50% 100 50 2500 50 50% 0 coin flip 50% (4,900) 50 24,502,500 4,950 and sell contract 50% 5,000 d. factor hedges the price of a share of stock is not fundamental because it can be decomposed into other risky variables. factor hedges reduce or eliminate a taxpayer's exposure to a risk that influences the price of a share of stock. under arbitrage pricing theory (apt), a share of stock reflects several general economic variables, as well as the stock's unique risk.70 although there is debate about which variables matter, some authors have proposed that the appropriate variables are the level of industrial activity, the rate of inflation, the spread between shortand long-term interest rates, and the spread between the yields of lowand high-risk corporate bonds.7' under apt, stock price is a function of the stock's sensitivity to those random variables. just as betas can be estimated, so can the stock's sensitivity to those variables.72 a hedge can be constructed to eliminate exposure to some variables, while maintaining exposure to others. example 11. taxpayer owns asset u, which consists of coin flip r ($100 if coin is heads, nothing if tails), coin flip s ($200 if different coin is heads, nothing if tails), and coin flip t ($300 if third coin is heads, nothing if tails). taxpayer shorts coin flip r; that is, in exchange for $50, taxpayer agrees to pay someone $100 if the coin involved in coin flip r turns up heads, and nothing if such coin turns up tails. such a hedge could be viewed as a disposition of coin flip r only or of asset u. the example echoes the issues raised in examples 6 and 7, in which 70. see brealey & myers, supra note 52, at 169. 71. id. at 171; elton & gruber, supra note 52. at 383. see. e.g., claude b. erb et al., country risk and global equity selection, j. portfolio mgmt., winter 1995, at 74 (country credit ratings correlate with international equity returns); steven l heston & k. geert rouwenhorst, industry and country effects in international stock returns. j. portfolio mgmt., spring 1995, at 53 (country dominates industry as factor in international equity returns). 72. brealey & myers, supra note 52, at 170. 1996] florida tax review the taxpayer disposed of a subasset of coin flip. a disposition of a part could be viewed as a disposition of the part only or of the whole. perhaps if the value of coin flip r dominates the value of asset u, the hedge is a substitute for a sale of asset u. another type of hedging strategy based on apt consists of entering into a short position in one asset in order to hedge a long position in a different asset. if the two assets have similar sensitivities to the underlying variables, the short position offsets the long position. example 12. taxpayer, who owns asset u (described in example 11), shorts asset v, which also pays based on the r, s, and t coins, but in somewhat different amounts. this type of hedge could be a substitute for a disposition of asset u because the taxpayer's exposure to the variables underlying asset u has been reduced. but, determining what kinds of risk underlie any particular asset and the asset's sensitivity to those risks is an art, rather than a science.73 e. portfolio diversification portfolio diversification reduces a taxpayer's exposure to risk in a share of stock. under capm, capital assets produce returns based on the performance of the market and another random variable. sensitivity to the market is reflected in the asset's systematic risk, and the other random variable is unsystematic risk. portfolio diversification eliminates unsystematic, but not systematic, risk by including in the portfolio other assets with 73. arbitrage pricing theory is, in effect, already recognized in the tax law. section 1.246-5(b)(1) of the regulations defines "substantially similar or related property" for purposes of § 246(c)(4)(c) (dividends received deduction holding period tolled if taxpayer diminishes risk of loss) and § 1092(d)(3)(b)(i)(ii) (stock and offsetting position with respect to substantially similar or related property can be straddle). under the regulation, property is substantially similar or related to a stock if (1) the fair market values of the stock and the property primarily reflect the performance of a single firm or enterprise, the same industry or industries, or the same economic factor or factors, such as interest rates, commodity prices, or currency exchange rates, and 2) changes in the fair market value of the stock are reasonably expected to approximate, directly or inversely, changes in the fair market value of the property (or a fraction or multiple thereof). for example, although two automobile manufacturer stocks primarily reflect the value of the same industry, they are not substantially similar or related because individual management decisions and capital structures affect their respective values, which, accordingly, are not reasonably expected to approximate one another. regs. § 1.2465(d) ex. 1. on the other hand, the stocks of two corporations, each of which holds gold as its primary asset, are substantially similar or related because they reflect the performance of the same economic factor and, based on historically similar price movements, are reasonably expected to change in value together. regs. § 1.246-5(d) ex. 2. [vol 3:1 another uneasy compromise unsystematic risk. 4 the example below illustrates reduction in a taxpayer's exposure to unsystematic risk through portfolio diversification. example 13. taxpayer owns 1,000 assets, each of which pays $2 if a particular coin turns up heads and nothing if the coin turns up tails. heads and tails each have a 50% probability. taxpayer's expected value is $1,000 because taxpayer has a 50% probability of getting $2,000 and a 50% probability of getting nothing. suppose that taxpayer exchanges 999 of the assets for 999 new assets involving 999 different coins, each different from the coin involved in the retained coin flip. each new asset pays $2 if its respective coin turns up heads and nothing if tails. each coin has a 50% probability of turning up heads and a 50% probability of tails. taxpayer's expected value is still $1,000, but variance is much lower. overall, taxpayer is likely to receive an amount that is close to $1,000. taxpayer has moved from an undiversified portfolio to a diversified portfolio. although there is a realization event with respect to the 999 assets that were exchanged, there is no realization event with respect to the retained asset. although diversification is a form of hedging, it does not appear to be a substitute for a disposition of the retained asset.75 f. dynamic hedging a taxpayer may use a dynamic hedging strategy, involving frequent purchases and sales, to dispose of some risk in a share of stock instantaneously. under such a strategy, a taxpayer eliminates risk of small price changes in the underlying asset, becoming "delta neutral," but remains exposed to risk of large price changes in the underlying asset.76 for example, suppose that a taxpayer owns one share of stock worth $100 and hedges by selling ten calls, each with respect to one share of stock and each having a delta of 0.1.77 if the value of a share of stock increases 74. brealey & myers, supra note 52, at 137-38. 75. if portfolio diversification were treated as a disposition. basis in the risk disposed of would be zero. because unsystematic risk can be eliminated through portfolio diversification, no part of the return on an asset is attributable to the bearing of unsystematic risk and, similarly, no part of a taxpayer's purchase price, or basis, should be attributed to unsystematic risk. amount realized might also be zero, however, on the view that the value of the assets in a portfolio do not reflect unsystematic risk, regardless of whether the portfolio is diversified. 76. there are many kinds of dynamic hedging strategies, including synthetic puts. see supra notes 67-69 and accompanying text. the text discusses a dynamic hedging strategy designed to render the taxpayer neutral to small price changes in the underlying asset. 77. see supra note 63 and accompanying text. 19961 florida tax review by $1, the taxpayer's overall position is unchanged because the value of the stock that the taxpayer owns increases by $1, but the value of the taxpayer's obligations under each of the ten calls increases by $0.10. a taxpayer could dynamically hedge as a substitute for selling since the strategy aims to achieve a riskless overall position.7" but, dynamic hedging introduces the taxpayer to new types of risks. first, the value of the options in the example depends on other variables in addition to the stock value. under the black-scholes option pricing technique, in addition to depending on the value of the underlying stock, the price of an option depends on the price volatility of the underlying stock, the strike price of the option, the time remaining until maturity of the option, and the risk-free rate of interest.79 the black-scholes technique derives from an analysis of a riskless portfolio consisting of an option and an appropriate amount of the underlying asset.8° it posits that over a very short period of time, the return on the portfolio is the risk-free rate of interest because arbitrage opportunities would otherwise be available.8 using stochastic calculus, it establishes an equation for the return on the portfolio, sets that equal to the return on the portfolio at the risk-free rate, and solves for the value of the derivative security. 2 second, dynamic hedging requires frequent monitoring and trading because the delta of the options changes as the value of the stock changes. in order to remain delta neutral, the taxpayer must buy or sell shares of stock (or write or close out calls) as the stock price changes because delta is different at different stock prices. owning one share of stock and being the grantor of ten calls achieves a risk-free (or, more precisely, delta risk-free) position while the stock price is $100. when the stock price moves away from $100, a different number of calls would balance the stock. for example, if delta is 0.25 at a stock price of $120, the taxpayer would, at that price, 78. some taxpayers engaged in dynamic hedging are already required to mark to market under § 475 or § 1256. but, traders that use options to dynamically hedge single stocks are not subject to those provisions because § 475 applies only to securities dealers and § 1256 applies to certain options on a group of stocks or a stock index, but not to options on a single stock. if a taxpayer dynamically hedges and makes a mixed straddle election under § 1.1092(b)-3(d) of the regulations, gain accrued prior to the establishment of the straddle is recognized when the straddle is established. temp. regs. § 1.1092(b)-3(b)(6). 79. see fischer black & myron scholes, the pricing of options and corporate liabilities, 81 j. pol. econ. 637, 638-39 (1973). 80. robert c. merton, theory of rational option pricing, 4 bell j. econ. & mgmt. sci. 141, 160 (1973). 81. id. 82. black & scholes, supra note 79, at 637; hull, supra note 63, at 218-21; merton, supra note 80, at 141. [vol 3:1 another uneasy compromise need to be the grantor of only four calls to hedge the taxpayer's one share of stock. gamma is the rate of change of delta of a derivative security with respect to changes in the value of the underlying asset."delta hedging is imperfect because delta is not constant. gamma measures how frequently a delta neutral position must be rebalanced in order to maintain delta neutrality. 84 taxpayers might not view delta hedging as a good substitute for a sale because it introduces the taxpayer to new risks and requires ongoing monitoring and trading 85 and because transaction costs make inefficient some adjustments that would ideally be made under a dynamic hedging strategy. a taxpayer is generally not perfectly delta hedged. in the case of delta hedged portfolios with large gammas, the hedging strategy would leave the taxpayer highly exposed to price changes if the portfolio were not frequently rebalanced. treating dynamic hedging as a realization event would be administratively burdensome. for example, it would be difficult and impractical to draw lines between portfolios with low gammas and those with larger gammas. indeed, whether a taxpayer is following a dynamic hedging strategy, rather than a strategy designed to take a view on a stock or on the market, could be unclear, could change over time, and is a matter of degree. v. efficiency and equity analysis of the economhc substitute argument for treating hedging as a realization event the decision whether to treat hedging as a realization event should be based on efficiency and equity considerations relating to the ability of taxpayers to use hedges as economic substitutes for sales. as compared with current law, treating hedging as a realization event is not a clear winner. taxing hedging might eliminate some transaction costs associated with hedging because some taxpayers who would have hedged under current law will likely choose to sell. a reformed realization rule might apply too narrowly, however, inviting taxpayers to enter into more complicated hedges generating greater transaction costs than the current realization system. or, it might result in taxpayers holding their assets without hedging, exacerbating the lock in effect of current law. taxing hedging is appealing on equity grounds, but arguments in favor of taxing hedgers also apply to taxing holders. the desirability of reforming realization to apply to hedging depends on the particular terms of the regime under consideration. 83. gamma is the second partial derivative of the value of the derivative security with respect to the value of the underlying asset. see hull. supra note 63. at 310-14. 84. id. at 310. 85. a trading desk is required in order to monitor and trade with the required frequency. financial institutions are therefore well-positioned to engage in dynamic hedging. 19961 florida tax review a. efficiency and equity under current realization requirement realization proposals should be analyzed by comparison with the current realization regime, which produces certain social benefits and costs. the well-recognized benefits of the realization requirement relate to valuation and liquidity.86 the realization requirement makes unnecessary the annual valuation of assets that would be required under an ideal income tax. the realization requirement also helps prevent taxpayers from being required to sell assets in order to raise funds to pay tax. the realization requirement produces several social costs. first, the requirement discourages taxpayers from selling appreciated assets. a taxpayer who would otherwise sell an appreciated asset might decide to hold, rather than incur tax on the appreciation. the realization requirement creates a lock in effect by imposing tax on dispositions but not on holding.87 it thus undermines a taxpayer's ability to hold a portfolio that matches the taxpayer's risk and other preferences. second, the realization regime causes social costs in the nature of transaction costs by allowing taxpayers to avoid lock in through hedging. as discussed in part ii.b., above, hedging fungible assets generally does not trigger gain under current law. thus, entering into an equity swap, short sale against the box, or married put and call enables a taxpayer to eliminate exposure to risk in an appreciated asset without triggering tax. those transactions bear transaction costs, which vary depending on the type of hedge. short against the box transactions have low transaction costs because the short sale involves a publicly traded asset, but equity swaps involve significant social resources since they are over-the-counter products drafted specially for the parties. even short sales against the box involve some transaction costs. they are more expensive than the ultimate elective tax under which a taxpayer checks a box on the taxpayer's return. to the extent that taxpayers avoid lock in through hedging, the social costs of lock in are eliminated, but transaction costs are created. third, the realization requirement favors relatively affluent taxpayers because the deferral benefit of the realization requirement is only available to holders of appreciated capital.8 thus, assuming that fairness requires distribution of the tax burden in accordance with ability to pay, measured by 86. see supra notes 12-13 and 47-48 and accompanying text. 87. see, e.g., daniel n. shaviro, an efficiency analysis of realization and recognition rules under the federal income tax, 48 tax l. rev. 1, 5 (1992) (noting that lock in constitutes a reduction in a taxpayer's pretax welfare without any revenue gain to the government). 88. the step up in basis at death under § 1014 provides an additional benefit to holders of appreciated assets. [val 3:1 anoiher uneasy compromise economic income, the realization requirement forces persons who earn their income through labor to bear more than their fair share of the tax burden. fourth, the realization requirement creates a perceptual cost. the public may believe the system is unfair when taxpayers with large amounts of capital appreciation avoid paying tax. that perception of unfairness may be exacerbated when such taxpayers hedge their appreciated assets without paying tax.89 for a tax system based on voluntary compliance, the perception that the regime is fair is crucial. on the other hand, realization may be a sufficiently esoteric subject that public perception of the fairness of the realization rule in general and its application to hedging may be mixed or uncertain. b. would treating hedging as a realization event be an improvement? whether a reform of the realization requirement to apply to hedging would be an improvement over current law depends on the particular proposal because different proposals would have different effects. the valuation and liquidity benefits that underlie the realization requirement would be lost generally if entering into a hedge were treated as a realization event. but, those benefits are small in the context of publiclytraded assets where valuation is generally simple and the market is liquid.' valuation could be more difficult if a nonmarketable asset, or a large block of shares of a single issuer, needed to be valued.9' but, presumably, in order to arrange the hedge that triggered the realization event, the parties estimated the asset's fair market value. in any event, valuation and liquidity concerns are no greater in the context of hedging than they are in the context of property-for-property exchanges that are taxable under current law. as to lock in, treating hedging as a realization event would probably cause some taxpayers that would otherwise hedge to sell. the joint committee on taxation has estimated that the treasury proposal will generate 100 million in revenue for each year from 1996 through 2002,9" implying that some taxpayers that, under current law, would have utilized a short 89. i thank noel cunningham for emphasizing this point to me. 90. valuation could be difficult if hedging is treated as a realization event and the taxpayer is treated as realizing an amount other than the fair market value of the asset. 91. the treasury proposal could require valuation of a nonmarketable asset. the proposal generally applies to appreciated financial positions. whether or not they are marketable. however, a contract for sale of nonmarketable stock, debt. or partnership interests is excluded if the sale occurs within one year after the contract is made. budget bill, supra note 3, § 9512 (proposed § 1259(c)(3)). 92. joint comm. on tax'n, estimated revenue effects of "middle class bill of rights tax relief act of 1996" (jan. 6. 1996), reprinted in b.n.a. daily tax report (jan. 10. 1996), at l-9. 19961 florida tax review against the box or other hedge to neutralize their position without triggering tax would, under the proposal, sell their appreciated asset (or hedge in a way that is covered by the proposal). such a taxpayer's desire to dispose of the asset is sufficiently strong that the taxpayer would prefer to sell and recognize gain than to hold and defer tax. as to those taxpayers, there would not be lock in under current law (because the taxpayer would have hedged) and there will not be lock in under the proposal (because the taxpayer will sell or hedge). the transaction costs associated with avoiding lock in would be reduced under the proposal because taxpayers will generally sell, rather than hedge, and selling generally involves transaction costs that are less than or equal to the costs of hedging. the extent of that reduction in social costs may not be dramatic, however, since a short sale against the box, the standard hedging device for publicly traded assets under current law, does not involve significantly greater transaction costs than a sale. other taxpayers that want to overcome lock in will avoid triggering gain under a new realization rule by hedging in a way that is not covered, but such hedges might involve higher transaction costs. the treasury proposal, for example, would favor imperfect hedges over perfect hedges, encouraging people to buy puts or sell calls or enter into collars with respect to appreciated assets, rather than enter into a short sale against the box or total-return equity swap. over-the-counter puts, calls, and collars would likely involve higher transaction costs than a short sale against the box. a realization regime that covered puts and calls would encourage taxpayers to create synthetic puts or calls unless those were also taxed.93 for taxpayers who make such substitutions, the lock in effect of the realization requirement is reduced (to the extent the hedge overcomes lock in), but not eliminated, because the hedges permitted under the regime would not neutralize the taxpayer's position. 93. the tax incentive to use synthetic puts or calls might not be sufficient to overcome the transaction costs required to implement a synthetic option. but see ubs creates synthetic dax put option position, derivatives wk., nov. 22, 1993, at 4 (stating that for german tax reasons, a synthetic put option was created because exchange-traded puts were unavailable). from a market perspective, synthetic puts are destabilizing because the strategy involves buying as the stock value increases and selling as it decreases. see donald l. luskin, after the fall, in portfolio insurance, supra note 67, at 311, 313 (portfolio insurance is "trendfollowing" strategy). in fact, there is debate about the extent to which portfolio insurance exacerbated the october 1987 market crash. see report of the presidential task force on market mechanisms 36 (1988) (stating that three portfolio insurers made $2 billion of total $21 billion of new york stock exchange sales on monday, october 19); luskin, supra, at 313 (finding that portfolio insurance was not uniquely responsible); mark kritzman, portfolio insurance and related dynamic trading strategies, in financial options: from theory to practice 454, 482 (stephen figlewski et al. eds., 1990) (stating that although market conditions for success of portfolio insurance are more restrictive than originally expected, strategy remains "reasonably effective"). [vol 3:1 another uneasy' compromise further, the transaction costs of hedging would be increased because taxpayers would need to engage in especially sophisticated transactions in order to avoid triggering gain. taxpayers would need to be exceptionally well-advised, not just well-advised, to win. 4 those transaction costs include legal fees for determining whether the realization rule applies to particular hedges. for example, the treasury proposal appears narrow, applying to a taxpayer that enters into a position with respect to "the same or substantially identical property" and thereby "substantially eliminate[s] both risk of loss and opportunity for gain.' " in fact, the scope of the treasury proposal is uncertain in many respects.96 a more narrowly drawn rule, such as a rule that applied only to short against the box transactions, would reduce such interpretive costs. finally, some taxpayers that would have hedged under current law will, under a realization rule that applies to hedging, continue to hold their appreciated assets without hedging. 97 they suffer lock in, which they would not suffer under current law (because they would hedge), but they do not incur the transaction costs that they would have incurred under current law. 98 94. tom herman, white house moves to curb techniques to get around capitalgains taxes, wall st. j., jan. 15, 1996, at a2 (arguing that taxpayers will use more sophisticated strategies if administration's "substantial elimination" test is enacted). 95. budget bill, supra note 3, at § 9512 (proposed § 1259(c)(1)(a)). 96. n.y. st. b. ass'n report, supra note 3 (arguing that treasury proposal could lead to "costly and unnecessary market distortions and inefficiencies" unless prompt guidance is provided). 97. this group includes taxpayers that would have hedged under current law solely in order to avoid gain recognition on a sale and taxpayers that would have used imperfect hedges for nontax reasons to achieve a desired exposure to risk. 98. if many taxpayers choose neither to sell nor hedge, treating hedging as a realization event could reduce revenues relative to a realization regime not based on risk. suppose that a taxpayer holding a risky appreciated share of stock that pays no dividends wants to sell the stock and purchase treasury bonds. suppose further that the taxpayer will not sell because the taxpayer does not want to realize gain on the appreciation. under a realization regime that does not tax hedging, the taxpayer could hedge into a treasury bond return and, depending on the type of hedge, would generally pay tax currently on the treasury bond return that accrues after inception of the hedge. if the counterparty to the hedge is tax-exempt. there would be no offsetting deduction in the system with the result that more tax could be collected by virtue of the hedge than would be collected if the hedge did not occur. under a regime that treats hedging as realization, the taxpayer will not hedge because she does not want to realize gain on the appreciation. she will also not pay any tax on any subsequent return on her stock because the stock does not pay dividends. to the extent that such a regime discourages taxpayers owning appreciated assets without a currently taxable return from hedging into assets with a currently taxable return, the regime could suppress revenues as compared with current law. 19961 florida tax review as to distributional considerations, consider three taxpayers: holder, seller, and hedger. each holds an asset with $90 of unrealized appreciation. holder simply holds her asset. seller sells her asset for its fair market value. hedger hedges her asset.99 the three taxpayers have the same ability to pay, but the realization requirement treats holder better than seller. from a distributional standpoint, all three taxpayers should be taxed. because the realization requirement favors higher income taxpayers by allowing deferral that is generally not available to labor income, taxing hedger helps ameliorate that unfairness. individual investors who hedge are likely to be high bracket taxpayers. perhaps we should be unconcerned that the system fails to tax holder. on this view, one imperfection in the regime does not justify more imperfections." ° not all hedgers are individuals, however. anecdotal evidence indicates that corporations,'' individuals,"° and institutional investors"0 3 99. deborah schenk uses a similar example. see schenk, supra note 4. 100. indeed, in the example in the previous paragraph, if the amount of appreciation were $90 million, rather than $90, there might be no holder or seller under current law because persons with that amount of appreciation who wanted to dispose of their assets might find a way to avoid realization by hedging. 101. corporations utilize a wide variety of hedging strategies. see deborah l. paul, derivatives can be used to monetize portfolio stock investments, but tax issues remain, 1 derivatives 52 (1995). for example, in addition to short against the box, option, and equity swap transactions, see supra note 1, corporations hedge exposure to portfolio stock by issuing debt instruments that pay contingent returns based on the performance of such stock. e.g., debt exchangeable for common stock issued by allstate based on the pmi group, inc. common stock (may 1995), sprint corporation based on southern new england telecommunications corporation common stock (march 20, 1995), first chicago corporation based on nextel communications, inc., common stock (february 8, 1994), and american express company based on first data corporation common stock (october 7, 1993). id. at 54 n.9. see also saul hansell, lazard finds brawny ally for derivatives, n.y. times, mar. 22, 1994, at di (discussing equity swap strategy for corporate shareholders). the issuance of § 1.1092(d)-2(a) of the regulations on march 17, 1995, may have deterred some corporate and other taxpayers from entering into equity swaps because those regulations generally treat actively traded stock and an offsetting equity swap as a straddle. 102. individuals have fewer hedging alternatives than corporations. equity swaps are generally available to individuals only if they have a high net worth. see adam bryant, betting the farm on the company stock, n.y. times, apr. 16, 1995, § 3, at 1 (stating that executives may diversify portfolio with equity-for-equity swap); executive privilege, n.y. times, apr. 3. 1994, § 3, at 2 (pointing out that equity swaps are not available to small stockholders); floyd norris, for wall st., a new tax break, n.y. times, mar. 29, 1994, at di (reporting that chairman and ceo of autotote corporation entered into equity swap with bankers trust covering 500,000 autotote shares). other hedging devices, such as short sales against the box and exchange-traded options, are readily available to individuals. see peter brimelow & mark hulbert, constructing your own hedge fund, forbes, july 31, 1995, at 114 (recommending simultaneous long and short positions in different stocks); william baldwin, crash insurance, forbes, july 31, 1995, [vol 3:1 another uneasy compromise use derivatives to hedge investment assets. the distributional impact of imposing tax on corporations and other entities that hedge is uncertain. further, imposing tax on hedger creates a new distributional concern. not all capital investors are alike. because realization inevitably depends on form, whatever the particular proposal, there will likely be ways to hedge without triggering realization. under current law, the formality is obvious, and hedges, such as the short against the box, that do not trigger realization are available to relatively unsophisticated investors. under a realization regime that taxed short against the box transactions and other hedges that at 116 (index put options for individual with appreciated portfolio); ken brown, a way to hold on to those stock profits, n.y. times, july 9, 1995, § 3. at 7 (reporting on professor purchasing index puts as insurance); floyd norris, investing it; 4700 and coping with high anxiety, n.y. times, july 9, 1995, § 3, at 1; (discussing short sales against the box used "routinely" by large investors, such as family with huge profits in salomon stock). 103. see aim creates equity hedges for pension fund clients, derivatives wk., feb. 21, 1994, at 5 (put, "put spread," and "put butterfly" hedging strategies): burgundy hedges international portfolio with s&p 500 puts. derivatives wk, feb. 14, 1994, at 6; cristal hedges equity exposure, derivatives wk., july 31, 1995, at 5 (reporting that shortdated index put options were acquired to hedge french equity market exposure); jgb swap activity heats up, derivatives wk., june 26, 1995, at 2 (discussing funds entering swaps to hedge japanese government bonds); murphy capital hedges s&p 100 while remaining bullish, derivatives wk., sept. 5, 1994, at 7 (fund hedges with puts); paul o'keefe, derivatives come to the rescue of lloyd's of london trusts, derivatives wk., oct. 25, 1993, at i (fund to purchase index put); paul o'keefe, surge in equity swaps: j.p. morgan leads the way with giant deal, derivatives wk., may 3, 1993, at i (reporting s620 million swap of s&p 500 for floating interest-like return); u.s. hedge funds are sticking with derivatives, says study, derivatives wk., nov. 28, 1994, at 5 (stating 56% of u.s. hedge funds use derivatives). institutional investors include funds subject to the investment company act of 1940, hedge funds, and pension funds. the investment company act of 1940 imposes restrictions, including leveraging and hedging restrictions, on funds with more than 100 investors. the organizational documents or investment policies of the fund may impose additional limitations on hedging. among such investment companies are "mutual funds," which typically qualify as a "regulated investment company" under § 85 1, entitled generally to conduit treatment. see 3 bittker & lokken, supra note 12, t 95.7.1. alternatively, u.s. investors may invest in funds not subject to the investment company act of 1940. because of their relatively unregulated ability to hedge. some such funds are called "hedge funds." for tax purposes, these funds are generally organized to qualify for flow-through treatment. pension funds are also important hedgers. see, e.g., calpers chooses dynamic hedging strategies: names palomar, bea to manage fx exposure, fx week. march 13, 1992, at 1. investment income of pension funds is generally excluded from unrelated business taxable income under § 512(b). that exclusion covers income and deductions from notional principal contracts (including equity and equity index swaps), regs. §§ 1.512(b)-l(aj( l), 1.4463(c)(1)(i), and gain or loss recognized in connection with the pension fund's investment activities from the lapse or termination of options to buy or sell securities. irc § 512(bl(5); regs. § 1.512(b)-l(d)(2). 19961 florida tax review strongly substitute for sales, the system's formality may be less obvious and therefore require more sophisticated tax planning available only to more affluent investors. for example, under the treasury proposal, the short against the box transaction would trigger realization, but certain collars would not.' o° constructing a collar, and determining whether a particular collar was covered by the proposal, would require consultation of a tax expert and perhaps also an investment bank, expenses that a less affluent investor may not want to incur. further, to the extent that taxpayers choose not to sell (or choose to hedge in a manner that is not taxed), a reformed realization requirement will not raise revenue or improve the distribution of the tax burden. as to the perceptual concern, it is unclear what signal would be sent to the public by reforming the realization requirement to apply to hedging. on the one hand, perhaps the regime would be viewed as remedying an unfairness. on the other hand, if the rule is perceived as ineffective because some taxpayers are able to avoid paying tax through more sophisticated hedging, the public perception of unfairness in the system might not be counteracted. in sum, the lock in and transaction costs caused (or aggravated) by taxing hedger create second best'0 5 arguments that militate against that reform. distributional concerns favor taxing all appreciation, including appreciation accrued by hedger. the treasury proposal appears to strike a reasonable balance among those competing concerns. c. the consumption tax perspective the present tax system is a hybrid income-consumption tax. 1' 6 many of its departures from a pure income tax move the system structurally towards a consumption tax. indeed, the realization requirement is sometimes 104. a collar is a combination of options, or an equity swap, that leaves the taxpayer exposed to price variations in the underlying asset within a range, but protects the taxpayer outside that range. 105. the theory of the second best begins with the observation that our income tax regime retreats from an ideal income tax system in many ways. further, taxing haig-simons income is not itself the aim of the tax system. rather, the goal is efficiency and a fair distribution of the tax burden based on well-being. as a result, individual proposals, such as a proposal to treat hedging as a realization event, that move toward an accretion system are not necessarily steps in the right direction. particular proposals must be assessed in the context of whether they move the system as a whole closer to achieving the desired allocation of tax burden. a particular proposal that moves away from taxing economic income may be desirable if it offsets other departures from the ideal. boris i. bittker, a "comprehensive tax base" as a goal of income tax reform, 80 harv. l. rev. 925, 982-84 (1967). 106. william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113, 1117-18 (1974). i[vol 3:1 anotier uneasy' compromise viewed as a consumption tax feature of present law because, under that requirement, no tax is imposed if the taxpayer remains invested in the same asset."7 consumption tax proposals have been popular recently. and, the advantages and disadvantages of a consumption tax as compared with an income tax have been debated for many years."es a consumption tax ideally is neutral between current and future consumption, while an income tax favors current consumption." 9 but, a consumption tax could be regressive." an advocate of a consumption tax might believe that even absent wholesale adoption of a consumption tax, the more consumption tax treatment contained within the income tax system the better. since income equals consumption plus changes in wealth, reducing tax on changes in wealth is desirable because it shifts the system towards taxing consumption only. on that view, the realization requirement appropriately defers tax on savings and therefore offsets the income tax system's overall disincentives for savings. further, taxpayers' efforts to avoid realization through hedging should be encouraged because they advance a self-help consumption tax. under a more extreme version, achieving realization could be made more difficult by, for example, repealing the rule that property-for-property exchanges are realization events."' 107. see william d. andrews & david f. bradford, savings incentives in a hybrid income tax, in uneasy compromise: problems of a hybrid income-consumption tax 276 (henry j. aaron et al. eds., 1988) (stating that capital gain treatment may be closer to consumption tax model than accretion tax model). 108. see andrews, supra note 106: david f. bradford. the case for a personal consumption tax, in what should be taxed: income or expenditure? 75 (joseph a. pechman ed., 1980); barbara h. fried, fairness and the consumption tax, 44 stan. l. rev. 961 (1992) (traditional arguments for fairness of consumption tax not persuasive); richard goode, the superiority of the income tax, in what should be taxed?, supra. at 49: alan gunn, the case for an income tax, 46 u. chi. l. rev. 370 (1979) (claim that income tax imposes double tax on savings is dubious); alvin c. warren, jr., fairness and a consumption-type or cash flow personal income tax, 88 harv. l. rev. 931 (1975); william d. andrews. fairness and the personal income tax: a reply to professor warren. 88 harv. l. rev. 947 (1975). 109. see, e.g., andrews, supra note 106, at 1168. 110. see u.s. dep't of the treasury, blueprints for basic tax reform 136 (1977) (arguing that apparent regressivity of cash flow consumption tax is misleading); michael j. graetz, implementing a progressive consumption tax. 92 harv. l. rev. 1575 (1979) (describing serious implementation problems). 111. nonrecognition rules already provide that certain exchanges are not currently taxed. e.g., irc §§ 351 (nonrecognition on contribution of property to controlled corporation in exchange for stock); 354 (nonrecognition on exchange in pursuance of plan of reorganization of stock or securities solely for stock or securities of party to reorganization), 721 (nonrecognition on exchange of property for partnership interest). if property-for-property exchanges were generally tax-free, sales for cash should be 19961 florida tax review the argument that incremental steps towards a consumption tax are desirable is not clear, however, even assuming that a consumption tax would be better than an income tax. whatever the merits of a consumption tax, incremental shifts toward it in the context of an income tax might not be wise. steps toward a consumption tax could produce some of the possible regressivity of a consumption tax. arguments for inching toward a consumption tax should do more than point out the merits of a consumption tax."12 vi. the future of the realization requirement a reform of the realization requirement to apply to hedging would be formal because the realization requirement's distinction between holding and disposing is formal. such a reform aims to maintain the integrity of the categories, but the categories are themselves normatively irrelevant and conceptually unclear. the advantages of distinguishing between holding and disposing are undermined by the inefficiencies needed to maintain the distinction. consideration should be given to placing more assets (and liabilities)" 3 on an accrual system.' 4 tax-free if the funds are reinvested. cf. irc §§ 1034 (rollover of gain on sale of principal residence if new principal residence is purchased within two years of sale); 1042 (nonrecognition of gain on sale of securities to employee stock ownership plan if "qualified replacement property" purchased within specified period). 112. a potentially promising route is systematic construction of a better hybrid income-consumption tax. by distinguishing among savings for life cycle, precautionary, and bequest purposes, edward mccaffery, for example, has evaluated regimes that would provide different treatment for different kinds of savings. edward j. mccaffery, tax policy under a hybrid income-consumption tax, 70 tex. l. rev. 1145 (1992). michael knoll has evaluated three hybrids: a blended hybrid under which earnings are taxed at full marginal rates and savings at reduced marginal rates, a simple hybrid that would provide immediate expensing of a portion of basis and economic depreciation for the remainder, and a system that would provide a deduction for a fraction of the undepreciated portion of every asset at a statutorily defined cost of capital. michael s. knoll, designing a hybrid income-consumption tax, 41 ucla l. rev. 1791 (1994). those reforms tend to reduce the significance of the realization requirement by placing significant savings on a consumption tax model. hedging would therefore pose less of a problem for those regimes than for the current system. 113. although this article focuses on realization with respect to assets, realization is also a key issue for liabilities. a borrower can realize cancellation of indebtedness income or bond repurchase premium if the borrower is treated as extinguishing the liability for less or more, respectively, than the principal amount of the borrowing. 114. it has been argued that the law is heading in this direction. see thomas l. evans, the evolution of federal income tax accounting-a growing trend towards markto-market? 67 taxes 824 (1989) (stating that uniform capitalization rules, percentage of completion method for long-term contracts, limitations on availability of cash method of accounting, repeal of reserve method for bad debts, and curtailment of installment method in tax reform act of 1986 and revenue act of 1987 reflect trend toward mark-to-market). see also scott m. kolbrenner, derivatives, design and taxation, 15 va. tax rev. 211, 274-75 [vol 3:1 another uneasy compromise comprehensive accrual taxation is impractical, but limited mark-tomarket regimes may be workable. the valuation and liquidity concerns underlying the realization requirement are less problematic in the context of marketable securities, and, accordingly, such securities could be subject to a mark-to-market regime. on the other hand, a limited mark-to-market regime raises efficiency problems of its own by encouraging taxpayers to invest in assets not subject to the regime. in general, assets outside the mark-to-market regime would be favored from a tax point of view because marking to market eliminates the deferral benefit of the realization requirement. in addition, for individuals, marking to market eliminates the possibility of a basis step-up at death under section 1014. for example, if marketable securities were subject to an accrual regime and real estate were not, tax considerations would encourage investment in real estate or nonpublicly-traded stock."15 an additional difficulty for a limited mark-to-market regime would be valuing hedges. for example, if a taxpayer owns stock and purchases a put, valuing the stock may be simple, but valuing the put would not be simple if the put were not itself traded. substantial examination is required before significantly expanding mark-to-market treatment. the general parameters for such examination are that assets (and liabilities) subject to mark-to-market should be susceptible of valuation with relative ease and should be liquid, in order that the system be administrable and not unfair to taxpayers with limited cash resources. also, in view of the efficiency concern described in the previous paragraph, demand for such assets (and liabilities) must be relatively inelastic to tax results. "16 vii. conclusion derivative financial instruments enable taxpayers to dispose of risk in an asset without disposing of the asset itself. the resemblance of hedging to disposing raises the question whether hedging should be a realization (1995) (advocating mark-to-market regime for contingent payment debt instruments). 115. see shaviro, supra note 87, at 38 (arguing that taxing unrealized appreciation in publicly traded stock may cause taxpayers to invest in other stocks): edward a. zelinsky, for realization: income taxation, sectoral accretionism and the virtue of attainable virtues (forthcoming) (stating that limited mark-to-market regime would distort investment decisions). 116. see shaviro, supra note 87, at 30-35 (stating that it is generally best to tax taxinelastic events). limited accrual taxation would appear to enhance equity. the realization requirement presumably favors high-bracket taxpayers most and therefore reduces progressivity. although taxpayers with investment income exist in all brackets, limited accrual taxation would appear to enhance the overall system's allocation of tax burden according to ability to pay. 19961 50 florida tax review [vol. 3:1 event. but, on closer examination, the connection between dispositions and risk is tenuous and, at best, dependent upon many formal assumptions about which risks matter and what constitutes a single asset. conceptually, the resemblance between a hedge and a disposition is dependent upon such assumptions. because the distinction between holding and disposing is formal, whether hedging should be treated as a disposition can only be made based on second-best efficiency and equity arguments addressing the ability of taxpayers to substitute hedging for disposing. the treasury proposal strikes a reasonable compromise among competing concerns, but, in the end, a realization requirement that applies to hedging introduces marginal efficiency and equity advantages in exchange for significant complexity defending a meaningless distinction. a better approach to overcoming the difficulties posed by the realization requirement might be to limit its scope by imposing a broader mark-to-market regime than currently applies. florida tax review volume 3 1996 number 4 foreign law in u.s. international taxation: the search for standards philip r. west" i. introduction ................................ 148 ii. use of foreign law by the courts, the treasury, and the 1s .................................... 150 a. "legal liability" under section 901 ............ 153 1. biddle decision ..................... 153 2. the regulations ..................... 157 b. indirect credit ........................... 159 1. goodyear ......................... 159 2. vulcan materials .................... 162 c. definition of "income tax" .. .................. 164 d. intercompany transfer pricing ................ 167 m. cross-border tax arbitrage .................... 171 a. entity classification ....................... 174 1. foreign tax credit .................. 177 2. entity classification and treaties ......... 179 b. other cross-border tax arbitrage transactions .... 182 1. hybrid instruments ................... 182 2. double dip leases ................... 184 iv. conclusion .................................. 184 * acting deputy international tax counsel, dep't of treasury. this article was written while the author was with the law firm of steptoe & johnson llp. the opinions expressed in the article do not necessarily reflect the views of the treasury. the author is grateful for the review of, and comments on this article by reuven avi-yonah, charlie kingson, stan smilack, bob staffaroni and joni walser. the author is also grateful for the research and other assistance of andrew walker. all errors and omissions remain the author's. copyright © 1996 by philip r. west florida tax review i. introduction among u.s. tax professionals, references to international taxation commonly encompass two things: the u.s. tax rules that apply to the u.s. income of non-u.s. persons, and the u.s. tax rules that apply to the non-u.s. income of u.s. persons. in both cases, the focus is on u.s. rules. frequently, however, foreign law affects the application of these u.s. rules. this article examines the role of foreign law in u.s. international taxation.' in a variety of contexts, u.s. tax law either explicitly or implicitly requires an interpretation of foreign law or allows for an argument that foreign law is relevant to u.s. tax consequences. neither the courts nor the treasury has, however, articulated a standard for determining when foreign law should be taken into account and, where foreign law is taken into account, what its proper role should be in the interpretation of u.s. tax rules. as a result, taxpayers and the government continue to dispute the role of foreign law in interpreting u.s. tax rules. even different courts may take different views of the relevance of foreign law to what appears to be the same u.s. tax issue.2 part ii of this article seeks a principled basis for resolving these disputes and reconciling these authorities, and proposes a standard for determining when and how foreign law should be taken into account in determining u.s. tax consequences. in brief, part ii shows that, contrary to 1. some 15 years ago, charlie kingson wrote the most thoughtful piece yet published on how and to what extent the united states takes into account the foreign treatment of international income. see charles i. kingson, the coherence of international taxation, 81 colum. l. rev. 1151 (1981). he advanced the proposition, supported in exquisite detail, that u.s. tax legislative policy and treaty policy must be formulated in light of and with regard to (in coherence with) the tax policies of our trading partners. this article builds on kingson's thesis, primarily by proposing a standard for how tax statutes and treaties should be interpreted when the taxpayer or the government invokes foreign law as a factor affecting u.s. tax consequences, and secondarily by making specific tax policy recommendations with respect to u.s. law/foreign law interactions affecting cross-border tax arbitrage transactions. the role of foreign law in the interpretation of u.s. tax law was directly addressed by joseph isenbergh over a decade ago. see joseph isenbergh, the foreign tax credit: royalties, subsidies, and creditable taxes, 39 tax l. rev. 227 (1984). isenbergh traced the government's search for the contours of a creditable foreign tax. recognizing the definitional and practical difficulties of distinguishing creditable foreign taxes from other, noncreditable payments to foreign governments, he proposed that "in all but the most transparent cases," all foreign government levies should be creditable, whether or not they are taxes. id. at 229. as discussed in greater detail below, it is this author's view that the u.s. treasury need not give up by allowing u.s. tax credits for nontax payments to foreign governments by u.s. taxpayers and their subsidiaries. 2. compare united states v. goodyear tire & rubber co., 493 u.s. 132 (1989) with vulcan materials co. v. commissioner, 96 t.c. 410 (1991), aff'd per curiam, 959 f.2d 973 (1 1th cir. 1992), nonacq. 1995-1 c.b. 1. see part ii.b., infra. [vol 3:4 foreign law in u.s. international taration the implications of several irs positions regarding the irrelevance of foreign law in determining u.s. tax consequences, 3 the cases are consistent in allowing "factual" uses of foreign law and prohibiting "interpretive" uses of foreign law.4 foreign law is used factually when it is proven as an evidentiary fact tending to show that a u.s. legal standard was or was not satisfied. foreign law is used interpretively when it is used as a rule of decision, when the meaning to be given a term in a u.s. statute or other rule is determined by or with reference to the meaning of that term under foreign law. as a consequence, the issue of whether foreign law is relevant to u.s. tax consequences in a particular situation can be resolved on the basis of whether an interpretive or factual use of foreign law is being advocated. once it is determined that a factual use is being advocated, the foreign law cannot be dismissed as irrelevant based solely on the cases that have rejected particular uses of foreign law.5 as discussed below, the factual/interpretive distinction is useful for other purposes as well. for example, it provides a basis for rules that would ease the administrative burden on the irs regarding its use of foreign law, without ignoring relevant tax policy concerns. part ell examines the role of foreign law in transactions offering tax results that, at first blush, appear too good for taxpayers to be consistent with sound tax policy: cross-border tax arbitrage transactions. evaluating such transactions, which involve the favorable and inconsistent tax treatment of an item by two or more jurisdictions, requires a sequential resolution of several factual and tax policy questions. for example, is foreign law relevant in any way to the u.s. tax consequences? if it is, is favorable tax treatment in the united states predicated on consistent tax treatment abroad, or is foreign law relevant only in that it must be consulted in a factual sense to help determine u.s. tax consequences? if favorable u.s. tax treatment is thought to be conditioned on consistent tax treatment abroad, is this condition explicit or merely implicit? can an implicit condition of consistency be a legitimate basis for the irs to attack a transaction? in the analysis of cross-border tax arbitrage transactions, it is submitted that, except in the treaty context, an implicit condition of 3. see, e.g., exxon corp. v. commissioner, 66 t.c. memo (cch) 1707, 1737, t.c. memo (p-h) 93,616, 93-3261 (1993) (irs argument against applying foreign law); action on decision cc-1995-002 (feb. 13, 1995), available in lexis, fedtax library, rels file. 4. an exception is the unusual case in which the relevant statute or its legislative history expressly contemplates an interpretive use of foreign law. 5. collateral questions about whether a given foreign rule is a "law" or whether the taxpayer has colluded with the foreign government to achieve certain tax results must be addressed, but they go to the evidentiary weight to be accorded the foreign law, not to whether foreign law may be used to help determine u.s. tax results. 19961 florida tax review consistency is tantamount to an interpretive use of foreign law. absent an explicit requirement of consistency, inconsistent treatment of a transaction may therefore provide a reason for the united states to revise its rules, but it may not serve as the basis for an attack on the transaction as long as no rules of either jurisdiction are violated. moreover, if the standard for the use of foreign law were the irs' (overly) broad position that foreign law is per se irrelevant in determining u.s. tax consequences, such an attack would even more clearly be improper. ii. use of foreign law by the courts, the treasury, and the irs several cases, decided in various contexts, have looked to foreign law in determining u.s. tax consequences. the treasury has also expressed its view on this subject in the form of regulations and other guidance issued in discrete areas. in other contexts in which the issue arises, it has not been addressed by the courts or in other published authority. but even in contexts in which the issue has been addressed, neither the courts nor the executive branch has articulated a consistent guiding principle for the use of foreign law. it is thus frequently unclear whether and to what extent foreign law should be taken into account. foreign law has been examined to determine u.s. tax results in the following situations: + in 1938, the supreme court decided that u.s. and not foreign legal principles should govern whether a taxpayer is entitled to foreign tax credits under the predecessor to section 9016 the issue in that case, whether a taxpayer "paid" the tax for which it claimed credit, still stirs up controversy today.7 in separate cases, the supreme court and the tax court recently addressed the impact of foreign law on a u.s. multinational corporation's entitlement to credits under section 902 for foreign taxes imposed on a foreign subsidiary! the irs has also addressed this issue in recently proposed regulations.9 6. biddle v. commissioner, 302 u.s. 573 (1938). 7. see, e.g., norwest corp. v. commissioner, 69 f.3d 1404 (8th cir. 1995); continental ill. corp. v. commissioner, 998 f.2d 513 (7th cir. 1993), cert. denied, 114 s. ct. 685 (1994). 8. united states v. goodyear tire & rubber co., 493 u.s. 132 (1989); vulcan materials co. v. commissioner, 96 t.c. 410 (1991), affd per curiam, 959 f.2d 973 (11 th cir. 1992), nonacq. 1995-1 c.b. 1. 9. prop. regs. §§ 1.902-1(a)(9)(iv), -1(a)(10)(ii). [vol 3:4 foreign law in u.s. international taxation * although u.s. taxpayers are allowed credits for foreign income taxes, they may not claim credits for payments that are not taxes. the treasury issued no fewer than four sets of regulations"0 that attempted to provide a framework for evaluating foreign laws that nominally impose taxes but that also can be viewed as providing for royalty or other payments for mineral deposits or other goods or services provided by the foreign government." * several recent cases have addressed the extent to which restrictions of foreign law on payments between related persons should be taken into account in analyzing whether the prices charged and paid by them are the same as those that would have been charged and paid by unrelated persons acting at arm's length.' 2 the treasury has issued regulations reflecting its views on this issue as well.'" in other contexts, foreign law is relevant to u.s. tax consequences because inconsistent treatments of an item under the laws of different jurisdictions raise the tax policy question of whether a particular treatment of an item under foreign law should preclude an inconsistent treatment of that item under u.s. law: * in a ground breaking development, the irs recently proposed regulations that would allow most legal entities to determine whether they will be taxed as corporations or as partnerships simply by checking a box on a form.'4 the irs initially suggested that the extraordinary benefits of this proposal might be withheld from foreign entities, in part because of concerns about the consequences where u.s. and foreign law classifications of an entity are not 10. see regs. §§ 1.901-2, 1.901-2a, 1.903-1 (48 fed. reg. 46,272, 46,284,46.295 (1983)); prop. regs. §§ 1.901-2, 1.901-2a, 1.903-1 (48 fed. reg. 14,641, 14,643, 14,650, 14,658 (1983)); prop. regs. § 1.907-1 (45 fed. reg. 75,695 (1980)); prop. rcgs. §§ 1.902-2, 1.903-1 (44 fed. reg. 36,071, 36,072, 36,076 (1979). amendments to § 1.901-2(c)(3) were proposed on november 15, 1988 (53 fed. reg. 45,943 (1988)) and finalized on october 31, 1991 (56 fed. reg. 56,007 (1991)). 11. see generally isenbergh, supra note 1, at 260-80. 12. exxon corp. v. commissioner, 66 t.c. memo (cch) 1707, t.c. memo (p-h) 93,616 (1993); procter & gamble co. v. commissioner, 95 t.c. 323 (1990), aftd, 961 f.2d 1255 (6th cir. 1992). 13. see regs. § 1.482-1(h)(2); regs. § ia82-1(a)(3) (before amendment in 1994). 14. ps-43-95, 61 fed. reg. 21,989 (1996). the proposed regulations were preceded by an irs request for comments on the check-the-box idea. i.r.s. notice 95-14. 1995-1 c.b. 297. 19961 florida tax review consistent.' 5 the proposed regulations, however, allow the checkthe-box election to be made by many foreign entities. the issuer of a financial instrument may treat it as debt (to generate interest deductions), while the holder, residing in another country, treats it as equity under the laws of that country (e.g., to provide a dividends-received deduction). similarly, taxpayers may structure a lease so that the lessor resides in a jurisdiction that provides depreciation deductions to the legal title holder and the lessee resides in a jurisdiction that provides depreciation deductions to the holder of the economic benefits and burdens of ownership7 in all of these situations, and in many others,'" the issue is whether 15. see notice 95-14, supra note 14, at 298 ("a second consideration in the foreign area is the possibility of inconsistent, or hybrid, entity classification; that is, classification as a taxable entity in one country but as a flow-through entity.., under the tax laws of another country"). 16. prop. regs. § 301.7701-3(a). generally, the election would be available to a foreign entity unless it is organized under laws analogous to the corporation laws of the states of the united states. see prop. regs. § 301.7701-2(b)(8). that the application of the existing rules for classifying a foreign entity require "a thorough understanding of the controlling foreign law" is cited as a reason for allowing the election to foreign entities. ps-43-95, supra note 14. 17. see leo f. naughton, international leverage and facility leasing in the united states, 44 n.y.u. inst. ch. 47, § 47.04 (1986). 18. see, e.g., irc § 404a(d) (linking the treatment under u.s. and foreign tax law of certain payments and accruals under foreign deferred compensation plans); § 865(g)(2) (conditioning the treatment of certain u.s. persons as nonresidents on the imposition of foreign taxes on gains realized in property sales); § 891, 896 (permitting the president to increase tax rates on citizens and corporations of countries whose tax laws are found to discriminate against u.s. persons); § 954(b)(4) (excepting from subpart f certain income subject to high foreign taxes); § 999 (establishing an "international boycott factor," which may result in reduction of the available tax credit to taxpayers participating in a boycott of israel); § 1504(d) (permitting consolidation of certain subsidiaries formed in contiguous foreign countries solely for purposes of complying with those countries' laws as to title and operation of property); temp. regs. § 1.367(a)-4(f) (exempting a transfer of assets to a foreign corporation from gain recognition under § 367(a) if, among other things, the transfer is "legally required by [a] foreign government as a necessary condition of doing business in that country"); prop. regs. §§ 1.1441-1(c)(6)(ii)(b), -6(b)(4) (for purposes of claiming reduced rate of withholding tax under a treaty, looking to tax principles in effect in the country whose treaty is being revoked); § 1.1296-4(c) (linking qualification as an "active bank" for pfic purposes to foreign licensing rules); convention between the government of the united states of america and the government of the united mexican states for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, dec. 28, 1993 [hereinafter mexican treaty), art. 24, para. 3 (treating as foreign source income for u.s. foreign tax credit purposes, capital gains of a u.s. resident that are taxed by mexico in accordance with the treaty despite the contrary general rule of § 865(a)). [vol. 3:4 foreign law in u.s. international taxation foreign law should be taken into account and, if so, how. the following sections attempt to answer those questions. a. "legal liability" under section 901 1. biddle decision.-in 1938, the supreme court issued what is commonly viewed as the seminal opinion on the impact of foreign law in the foreign tax credit area, biddle v. commissioner.' 9 even outside this area, the biddle case is frequently the starting point for any discussion of the impact of foreign law in u.s. tax analysis. the issue in biddle was whether a shareholder was entitled to credit under the predecessor of section 901 for u.k. taxes on corporate earnings that were distributed to the shareholder.' ms. biddle received a dividend from a u.k. corporation, accompanied by a statement showing the amount of the dividend and the amount of tax "appropriate" thereto. somewhat simplified, the appropriate tax was the aggregate tax to be paid by the corporation and the shareholder under the u.k. integrated tax system. assuming distribution of all corporate earnings, the sum of the cash dividend and the tax appropriate to the dividend equaled the corporation's pretax earnings. for both u.s. and u.k. tax purposes, ms. biddle reported as income the cash dividend and the u.k. tax appropriate thereto and, for u.s. tax purposes, she claimed credit for the tax appropriate to the dividend. the characterization of a payment under foreign law has also been determinative, on occasion, of the source of income. for example, in karrer v. united states, 152 f. supp. 66 (ct. cl. 1957), the taxpayer was a nonresident alien who had made a contract with a foreign pharmaceutical manufacturer. the taxpayer granted the foreign manufacturer all rights in certain processes invented by the taxpayer in exchange for a fixed percentage of the manufacturer's future sales. under swiss law, the contract was treated as a services contract, rather than one involving royalties. the foreign manufacturer licensed the rights to a u.s. manufacturer, which agreed to pay the requisite percentage of sales proceeds to the taxpayer. the irs argued that the payments were in the nature of u.s. source royalties. the taxpayer argued that the payments were for services rendered outside the united states and as such were not u.s. source income subject to tax. the court of claims held that the nature of the payments was governed by the treatment under swiss law of the contract between the taxpayer and the foreign manufacturer. 19. 302 u.s. 573 (1938). 20. the u.s. tax system is a so-called "classical" system, subjecting income to a tax at both the corporate level and the shareholder level. by contrast, most other industrialized countries have adopted "integrated" systems, whose goal is to tax corporate income only once, even if distributed to the corporation's shareholders. this is generally achieved by providing tax credits to shareholders for taxes paid at the corporate level ("imputation" system). the treasury has studied the issues that would arise in integrating the u.s. tax system. see report of dep't of treasury, integration of the individual and corporate tax systems, taxing business income once (u.s. gov't printing office, jan. 1992). for a fascinating recent case involving the u.kimputation system, see xerox corp. v. united states. 41 f.3d 647 (fed. cir. 1994), cert. denied, 116 s. ct. 72 (1995). 19961 florida tax review the question in the case was whether the u.k. taxes were "paid" by the taxpayer/shareholder, as required by the applicable u.s. statute.2 in addressing this issue, the court analyzed the requirements of british law regarding payment of the tax by the stockholders and evaluated whether the actions so required of the stockholders were the substantial equivalent of payment of the taxes in the u.s. sense.22 under british law, the corporation, not the stockholder, was actually required to pay the tax. by the weight of british authority, the stockholder was not liable for the tax, even if the corporation defaulted in payment; the remedies for nonpayment ran against the corporation, not the stockholder. moreover, in the absence of dividends, the corporation was required to pay tax on its profits, and no tax was paid by the stockholder. all of these requirements of british law indicated that the corporation and not the stockholder "paid" the tax, as that term was used in the u.s. sense. conversely, the court noted that the stockholders bore the tax burden "in substance." moreover, if the stockholder's income were exempt from u.k. tax, the stockholder would get a refund of her proportionate share of any tax paid by the corporation. finally, any liability of the stockholder for surtax (another u.k. tax applicable to certain stockholders) was computed on the gross dividend (i.e., the dividend plus the tax appropriate to the dividend). the court quickly dismissed these countervailing considerations. with respect to the tax burden in substance being on the stockholders, the court asserted that all corporate income taxes are borne economically by the stockholders.23 the stockholders are not, however, viewed as having paid a corporate tax for foreign tax credit purposes. the court stated that the other countervailing considerations are logical concomitants of an integrated system, but the united states has no such system. therefore, they are not indicative of whether the tax is "paid" by the stockholders as that term is used in a u.s. sense. it is an oversimplification to read biddle as standing for the broad proposition that u.s. principles, not foreign principles, govern u.s. tax 21. the present statutes also limit the credit to taxes "paid or accrued." irc § 901(b)(1), (2), (3). the unstated statutory requirement is that the taxes be paid by the taxpayer claiming the credit. 22. according to the court, the phrase "income taxes paid" has "for most practical purposes a well understood meaning to be derived from an examination of the statutes which provide for the laying and collection of income taxes." biddle, 302 u.s. at 579. 23. more recently, economists have discussed whether corporate taxes are borne by the corporation's shareholders, its customers, its employees, or some combination of the foregoing. see, e.g., joseph a. pechman, federal tax policy, 141-48 (5th ed. 1987); arnold c. harberger, the incidence of the corporation income tax, 70 j. pol. econ. 215 (1962); merton h. miller & myron s. scholes, dividends and taxes: some empirical evidence, 90 j. pol. econ. 1182 (1982). [vol 3:4 foreign law in u.s. international taxation consequences.24 the court did not disregard british law. rather, it analyzed what the british law required of the stockholder and whether that was the substantial equivalent of payment of the tax as that term is used in the u.s. statute. although the court refused to define a term used in a u.s. statute by looking to the manner in which the term is defined under u.k. law,' it was perfectly willing to look to u.k. law to determine whether the facts of the case warranted a finding that the u.s. statute's terms had been met. biddle may be seen as applying a relatively narrow rule of statutory construction: when a statutory term is not defined in any relevant u.s. law, its legal meaning is derived from its plain meaning in the english language as used in the united states.2 however, once the word is defined to establish a standard, a court, in applying that standard, is required to determine what, as a matter of fact, the taxpayer in a particular case did and did not do. if what the taxpayer did and did not do is a function of what is required and prohibited under foreign law, an examination of the foreign law may be perfectly appropriate. the use of foreign law rejected by the biddle court may be referred to as an interpretive use of foreign law. under an interpretive use, foreign law supplies the definition of terms contained or implicit in a u.s. statute and is therefore used as a rule of decision. conversely, the use of foreign law accepted by the court may be referred to as a factual use of foreign law. 24. both the vulcan materials a.o.d. (action on decision cc-1995-002 (feb. 13, 1995), available in lexis, fedtax library, rels file) and the government's position in exxon corp. v. commissioner, 66 t.c. memo (cch) 1707, t.c. memo (p-h) 1 93,616, 933261 (1993), appear to be premised on a broad interpretation of biddle's progeny. although a detailed discussion of the relevant authorities is premature at this point, it is useful to note here that, in the vulcan materials a.o.d., vulcan materials is summarily found to conflict with goodyear, without any attempt to determine the outer limits of biddle and goodyear. similarly, in exxon, the logical conclusion to be drawn from the government's argument is the radical position that no use of foreign law is acceptable in determining u.s. tax consequences. see exxon, 66 t.c. memo (cch) at 1737 (describing irs argument that procter & gamble (holding that § 482 could not be applied to impute income payment forbidden by foreign law) was wrongly decided because foreign law is difficult to apply, foreign governments should not dictate u.s. tax policy, and the legislative history of § 482 does not support extension of first security bank to the foreign context). 25. the court stated that the statutory language "must be taken to conform to its own criteria unless the statute, by express language or necessary implication, makes the meaning ... and... operation of the statute... depend upon its characterization by the foreign statutes and by decisions under them." biddle, 302 u.s. at 578. finding no such language or implication in the u.s. foreign tax credit statute, the court held that u.k. law's treatment of the stockholder as the payor of the tax was at most a factor in determining whether the stockholder paid the tax within the meaning of the u.s. statute. id. at 579. 26. as a corollary, this meaning cannot be altered or illuminated by other meanings, including specialized american meanings (such as scientific meanings) and meanings ascribed by foreign statutory or judicial authorities. 19961 florida tax review under a factual use, foreign law is proved as an evidentiary fact. in biddle, foreign law was proven as a fact tending to show that the stockholder was not the person who "paid" the tax, as that term is used in the u.s. sense." in the author's view, biddle was correct in freely accepting a factual use of foreign law, but rejecting an interpretive use in the absence of a showing that the statute was intended to be interpreted in accordance with 27. courts have adopted the factual/interpretive distinction, at least implicitly, in analyzing the impact of state law on federal tax consequences. legal interests are created by state law, but federal income tax statutes determine the tax consequences of those interests. see united states v. irvine, 114 s. ct. 1473, 1481 (1994); morgan v. commissioner, 309 u.s. 78, 80-81 (1940); burnet v. harmel, 287 u.s. 103, 110 (1932). see also united states v. mitchell, 403 u.s. 190, 197 (1971). as one commentator has stated, "the substantive rule is federal, and state law merely establishes some of the facts to which the court applies federal law in order to reach its conclusions." note, the role of state law in federal tax determinations, 72 harv. l. rev. 1350, 1351 (1959) (emphasis added). the treasury has taken the same approach. for example, the classification of an entity as a partnership or association under state law is irrelevant to its status for federal income tax purposes. see regs. § 301.7701-1(c) (stating that the internal revenue code, not local law, establishes the standards applied in determining the classification of an entity). however, federal entity classification depends on the rights, duties, and relationships that are prescribed by state law. see regs. § 301.7701-1(c). see also rev. rul. 88-8, 1988-1 c.b. 403 (extending this approach to foreign entities); but cf. ps-43-95, 61 fed. reg. 21,989 (1996) (proposing "check-the-box" elective entity classification). as another example, the definition of a life insurance contract may include certain arrangements, whether or not they are treated as insurance contracts under state law. see irc § 77020)(1). ultimately, it is the intent of congress that determines the role of state law. for example, under § 2053(a), the estate tax deduction for "administration expenses" appears to turn upon whether the expenses are allowable under state law, but the treasury has attempted to impose an additional federal law requirement that such expenses be "necessary." see regs. § 20.2053-3. the federal courts are split on the validity of the additional requirement. compare estate of park v. commissioner, 475 f.2d 673 (6th cir. 1973) (statute looking solely to state law preempts broader regulations) with estate of love v. commissioner, 923 f.2d 335 (4th cir. 1991). however, this dispute is not so much over the proper role for state law generally, as the role that congress intended for state law in this particular context. see generally paul l. caron, the role of state court decisions in federal tax litigation: bosch, erie, and beyond, 71 or. l. rev. 781 (1992), reprinted in 93 tnt 112-36 (may 26, 1993). the factual/interpretive distinction is also discussed in the literature on the law of evidence. see, e.g., arthur r. miller, federal rule 44.1 and the "fact" approach to determining foreign law: death knell for a die-hard doctrine, 65 mich. l. rev. 613 (1967). more generally, it may be thought of as an elaboration, in a narrow context, of choice of law principles. there is an enormous body of literature on choice of law, and discussion of that literature is beyond the scope of this article. for discussion of these principles in the u.s. context, see, e.g., brainerd currie, selected essays on the conflict of laws (1963); russell j. weintraub, commentary on the conflict of laws (3d ed. 1986); walter w. cook, the logical and legal bases of the conflict of laws, 33 yale l.j. 457 (1924); arthur r. von mehren, special substantive rules for multistate problems: their role and significance in contemporary choice of law methodology, 88 harv. l. rev. 347 (1974). [vol 3:4 foreign law in u.s. international taration foreign law. this view would seem to be noncontroversial. indeed, there is scant criticism of the biddle holding or ratio decidendi in the literature. 28 as will be seen, however, biddle has been interpreted more broadly. 2. the regulations.-the regulations implementing the biddle decision state that a tax is considered paid for purposes of section 901 by the person on whom foreign law imposes legal liability for the tax. ' 9 thus, even if another party to a transaction with the taxpayer assumes liability for foreign taxes on income generated in the transaction, only the person legally liable for the tax, and not that other party, is entitled to a credit for such foreign taxes. the economic burden of the tax is also irrelevant. by making the credit's availability depend on formalistic legal liability," the treasury may cause section 901 to be applied both too broadly and too narrowly. too broadly because the credit may be available in circumstances that violate the tax policy principle that the tax consequences of a transaction should be based on its economic substance.3' too narrowly because, in certain cases, the legal liability standard makes the availability of the credit too uncertain, violating a second tax policy principle: to the extent possible, taxpayers should have certainty regarding the tax consequences of their transactions.32 the legal liability test can violate both principles when applied to net loans. in a net loan, the borrower is required to pay interest free and clear of 28. but see charles i. kingson, the foreign tax credit and its critics, 9 am. j. tax pol'y 1, n. 147 (1991) [hereinafter kingson, foreign tax credit]. one might also infer such criticism from the failure of the continental illinois court to cite biddle. see continental ill. corp. v. commissioner, 998 f.2d 513 (7th cir. 1993), cert. denied, 114 s. ct. 685 (1994). 29. regs. § 1.901-2(0(1). 30. this formalistic approach may be considered administratively desirable because, in many cases, it should be easier to determine legal liability than to make a factual determination of economic burden. for a similar reliance on a formalistic application of foreign law, see prop. regs. § 301.7701-3(b)(2) (classifying a foreign "eligible entity" that does not elect a particular classification, based in part on formalistic application of foreign law regarding liability for claims against the entity). 31. see frank lyon co. v. united states, 435 u.s. 561. 583-84 (1978): knetsch v. united states, 364 u.s. 361, 365-69 (1960); gregory v. helvering, 293 u.s. 465,470 (1935); goldstein v. commissioner, 364 f.2d 734, 740 (2d cir. 1966). cert. denied. 385 u.s. 1005 (1967). 32. formalistic dependence of the credit on legal liability can result in uncertainty because foreign law regarding legal liability is sometimes unclear. moreover, if the irs declines to apply the legal liability standard in cases where there is suspicion of taxpayer/foreign government collusion, it is uncertain whether even a clear foreign statute is dispositive. for a recent case well illustrating these difficulties in an analogous foreign tax credit context, see amoco v. commissioner, 71 t.c. memo (cch) 2613. 96.159 t.c. memo (ria) (1996). 19961 florida tax review any withholding tax. thus, if a net loan of $100 bears interest at 10%, the borrower will pay the lender $10 of interest each year and will, in addition, pay to the taxing authority any withholding tax on the interest.3 conversely, in a gross loan, the borrower deducts any withholding tax from the stated interest, pays the tax to the taxing jurisdiction, and pays the difference to the lender.34 from a policy perspective, it is at least arguable that the lender in a net loan pays no foreign tax and should therefore be entitled to no foreign tax credit. an analysis based on the economic burden of the tax could easily lead to this result. instead, however, the irs has struggled unsuccessfully to establish that foreign law imposes legal liability on the borrower, rather than the lender.35 in at least one case, the irs ruled that the lender in a net loan was legally liable for a foreign tax, only to later reexamine the foreign law 36and take a contrary position. this situation is unsatisfactory for both tax administrators and taxpayers. practitioners have found that the irs is sometimes reluctant to rule on the question of legal liability.37 this reluctance is ostensibly due to ambiguity in some foreign laws, but it may also be due, in part, to irs uneasiness with the formalistic legal liability standard.38 in light of this unsatisfactory state of affairs brought about by a restrictive set of regulations, the question arises whether the authors of the regulations might have based them on an unnecessarily broad interpretation of biddle. as indicated above, the regulations have implicitly interpreted biddle to preclude the application of the substance over form doctrine. nothing in the biddle opinion requires this result. application of the substance over form doctrine could easily have been harmonized with biddle. the regulations could have rejected an interpretive use of foreign law, as the 33. to calculate the withholding tax, simultaneous equations are required. see harvey p. dale, withholding tax on payments to foreign persons, 36 tax l. rev. 49, 90-91 (1980). 34. in a gross loan, the lender typically seeks additional interest from the borrower to compensate for the return on its investment that is lost to the taxing jurisdiction. thus, the after-tax cost to the borrower is likely to be the same. 35. norwest corp. v. commissioner, 69 f.3d 1404 (8th cir. 1995); continental i11. corp. v. commissioner, 998 f.2d 513 (7th cir. 1993), cert. denied, 114 s. ct. 685 (1994); nissho iwai american corp. v. commissioner, 89 t.c. 765 (1987). 36. see rev. rul. 78-258, 1978-1 c.b. 239, modified, rev. rul. 89-119 1989-2 c.b. 132. 37. although the irs is not required to issue rulings, its policy is to respond to inquiries regarding the tax effect of transactions prior to the filing of a tax return whenever this is in the interest of sound tax administration. see regs. § 601.201(a)(1). 38. this conclusion derives from the fact that the irs has been reluctant to rule, even with the customary caveats that the ruling is conditioned on the completeness and accuracy of the facts and translations of foreign law provided by the taxpayer. [vol 3:4 foreign law in u.s. international taxation court did in biddle, yet not required a formalistic application of the legal liability standard that can produce inappropriate results and create unnecessary uncertainty for taxpayers. b. indirect credit 1. goodyear.-a recent case, united states v. goodyear tire & rubber co.,39 provided the supreme court with an opportunity to revisit the propriety of interpretive uses of foreign law. in goodyear, the court construed section 902, which provides that taxes paid by a foreign corporation may be creditable by the corporation's u.s. shareholders when the earnings upon which those taxes were levied are distributed to the shareholders. this credit, commonly referred to as the indirect credit, is only allowed to a domestic corporation that owns at least 10% of a foreign corporation's voting stock and receives a dividend from the corporation. 0 it is intended to ensure that only one layer of u.s. tax is imposed on earnings of a domestic corporation that are earned through a foreign subsidiary." the indirect credit under section 902 equals the portion of foreign corporation's foreign income taxes that is ratably allocable to the earnings distributed to the domestic corporation as a dividend. during the years at issue in goodyear, the indirect credit was computed as the foreign income taxes for the year that the corporation realized the distributed earnings, multiplied by the following fraction: dividend after-tax accumulated profits for that year the issue in goodyear was whether the term "accumulated profits" should be construed to mean u.s. taxable income or taxable income under the applicable foreign (u.k.) law. as a result of an operating loss carryback, the u.k. tax liability of goodyear's u.k. subsidiary was reduced for the taxable year involved in the case. goodyear contended that since the carryback 39. 493 u.s. 132 (1989). 40. irc §§ 902(a). other rules allow the credit where earnings are taxed to such a shareholder without being distributed. irc §§ 960, 1291(g). 41. if a domestic corporation operates through a foreign branch, foreign taxes on branch income are creditable under § 901, the statute whose predecessor was at issue in biddle. section 902 provides roughly equivalent tax results to a domestic corporation operating through a foreign subsidiary. interestingly, had the taxpayer in biddle been a 10% corporate shareholder of the u.k. corporation involved in that case, rather than an individual, the predecessor of § 902 would have allowed the credits the court denied under the predecessor of § 901. see revenue act of 1918, § 240(c). 19961 florida tax review reduced the subsidiary's foreign taxes, it should also reduce the subsidiary's "accumulated profits."'42 the court resolved the issue by analyzing the purposes of section 902: to eliminate double taxation and to equate the taxation of foreign operations conducted through subsidiaries with the taxation of operations conducted through branches. double taxation can result if accumulated profits are computed solely with reference to u.s. principles. a3 this militates against a reading of section 902 that allows a foreign corporation's "accumulated profits" to differ from taxable earnings under foreign law. on the other hand, because the income of a foreign branch is computed under u.s. tax rules, foreign branch income and foreign subsidiary income would be taxed unequally if the accumulated profits of a foreign subsidiary were computed 42. the effects of the differing computations of accumulated profits is illustrated by the following chart. in scenario 1, accumulated profits are not reduced to reflect the reduction in foreign taxable income. in scenario 2, accumulated profits are so reduced. after-tax foreign taxes accumulated creditable paid dividend profits taxes scenario 1 $100 $900 $1,800 $50 scenario 2 $100 $900 $900 $100 43. under the pre-1987 rules involved in goodyear, a dividend is traced to the accumulated profits of a particular year, and the indirect tax credit is only allowed for taxes paid with respect to the accumulated profits for that year. see irc § 902(a) (before amendment in 1986); reg. § 1.902-1(f); rev. rul. 87-72, 1987-2 c.b. 170. in goodyear, the subsidiary's operating loss carryback under u.k. law reduced u.k. taxes for the taxable years to zero, but because accumulated profits, defined by u.s. law, were not affected by the carryback, the dividends continued to be traced to these years' earnings and thus carried no indirect credit. the result is not necessarily double taxation because the foreign corporation may distribute other dividends that are traced to years for which foreign income taxes are paid by the corporation and the u.s. shareholder might therefore ultimately be allowed credit for all taxes paid by the foreign corporation. the double taxation can be more obvious in the opposite situation. if accumulated profits for a particular year are zero under the u.s. rules, but the foreign corporation nevertheless pays foreign income taxes for the year (e.g., because accumulated profits are reduced under rules that do not apply under the foreign tax law), a dividend can never be traced to accumulated profits for that year, and it is thus impossible for the foreign income taxes to be creditable to the u.s. shareholder. if the income taxed by the foreign country for this year is recognized under u.s. principles for another year, the income may be taxed to the u.s. shareholder when dividends are distributed from accumulated profits for that other year, and the result may be double taxation. see kingson, foreign tax credit, supra note 28, at 36-37. these problems are lessened for post-1986 years because dividends are drawn from a pool of accumulated profits, rather than earnings of one year, thus minimizing such artificial disparities between tax years. see irc § 902(a). [vol 3:4 foreign law in u.s. international taration under foreign law. this militates against a reading of section 902 that requires a foreign corporation's "accumulated profits" to be computed in accordance with its taxable earnings under foreign law. the court found more compelling the policy that branches and subsidiaries should be taxed equally. although the reasoning is not particularly persuasive," the court undoubtedly reached the correct result. "accumulated profits" is one element of a fraction whose function is to determine the part of the foreign taxes that should be credited to a particular shareholder. since the fraction's numerator (dividends) is always computed with reference to u.s. tax principles,45 the denominator (after-tax accumulated profits) must also be computed under u.s. tax principles. for example, if all of a year's profits are paid to one shareholder, the numerator and the denominator should be equal, a condition that is possible only if both figures are computed under the same rules. from one perspective, goodyear presents an even stronger case for the rejection of foreign law than biddle. biddle presented two questions: what does the word "paid" mean? did the taxpayer satisfy this definition? the court declined to use foreign law in answering the first question (doing so would have been an interpretive use of foreign law), but it was willing to answer the second question with reference to foreign law (doing so was a factual use of foreign law). goodyear involved only one question, a pure question of law, requiring only an interpretive and not a factual use of foreign law. however, a distinction might be drawn between biddle and goodyear that would allow the goodyear issue to be addressed with greater flexibility in the use of foreign law than the biddle issue. the biddle court was asked 44. inconsistencies in the calculation of branch and subsidiary profits are not necessarily the type of inconsistency that offends the policy behind § 902. this policy would be offended if the tax liabilities incurred in operating through a foreign subsidiary were inconsistent with those that would result from carrying on the same operations through a foreign branch. the tax liabilities resulting from branch and subsidiary operating structures would not necessarily be inconsistent simply because profits are calculated differently. consistency of tax liabilities would depend on whether branch profits and subsidiary profits play the same role in determining the foreign tax credit of the u.s. corporate parent. as a general rule, they do not. in the case of subsidiary profits, the higher the profits the lower the amount of the foreign taxes paid that will be available as a credit under § 902. other things being equal. see supra note 42. in the case of a foreign branch, the amount of the branch's taxable profits is irrelevant to the amount of credits available to the u.s. corporation under § 901. although such profits are relevant to the calculation of the foreign tax credit limitation under § 904, the limitation applies to credits for foreign taxes of both branches and subsidiaries and therefore does not affect this analysis of the differences between the two. for a discussion of the sometimes troubling distinction between branch and subsidiary, see diane ring, treatment of risk shifting, common ownership and legal status in related party transactions (july 30, 1995) (unpublished draft on file with the florida tax review). 45. see irc § 316(a). 19961 florida tax review to define a term ("paid") by looking to the foreign law definition of the term. in goodyear, the court was not asked to apply a foreign law definition (the term "accumulated profits" was not defined in u.k. law), but to adopt a u.s. definition of a u.s. term that would depend on the way in which the foreign taxes were computed.46 biddle thus did not compel the result in goodyear, and the goodyear court's rejection of an interpretive use of foreign law was not as critical as biddle's. in sum, the goodyear issue, viewed from one perspective, calls for a rejection of the application of foreign law even more clearly than the biddle issue, but viewed from another perspective, the goodyear issue leaves greater room for the application of foreign law. if the former perspective is correct, it may be difficult to justify the decision in vulcan materials47 (discussed immediately below), another case that involved the goodyear issue (or a closely related issue), but reached the opposite result. conversely, if goodyear allows greater room for the application of foreign law than biddle, or if, as judge tannenwald believed, vulcan materials involved an issue distinct from that in goodyear, an issue that required only a factual use of foreign law, a result opposite to goodyear's may be justifiable. with these perspectives in mind, we turn to the vulcan materials case. 2. vulcan materials.-in vulcan materials, the taxpayer argued that, for purposes of the indirect credit, the accumulated profits of a saudi arabian corporation (tvcl) should be lower than that asserted by the irs because saudi arabian law imposed tax only on the profits attributable to vulcan's stock in tvcl and not on the profits attributable to the stock owned by tvcl's saudi arabian shareholders. in response to the irs' argument that the case was controlled by goodyear, judge tannenwald stated: there is no question that, under goodyear, the determination of tvcl's accumulated profits turns upon the application of u.s. tax rules, and petitioner does not contend otherwise. the question before us is not how tvcl's accumulated profits are to be determined but whether, pursuant to section 902, all or only a pro rata portion of such profits so determined are to be included in the denominator of the formula.4" 46. by failing to cite biddle until a brief reference at the end of the opinion, goodyear implicitly recognized that biddle only stood for a limited rule of statutory construction. united states v. goodyear tire & rubber co., 493 u.s. 132, 145 (1989). 47. vulcan materials co. v. commissioner, 96 t.c. 410 (1991), aff'd per curiam, 959 f.2d 973 (11th cir. 1992), nonacq. 1995-1 c.b. 1. 48. id. at 417. after dismissing the notion that the issue in the case was resolved by goodyear, judge tannenwald stated: [vol 3:4 foreign law in u.s. international taxation to the irs, this distinction is too subtle." but in none of its attacks on vulcan materials is a standard proposed for distinguishing legitimate uses of foreign law from illegitimate uses of foreign law. in explaining its nonacquiescence in the decision, the irs both oversimplifies and overstates the goodyear holding: "the tax court decision conflicts with the rule clearly articulated in goodyear that the determination of the section 902 fraction is ... computed in accordance with united states tax principles, and not on foreign taxable income."50 the vulcan materials opinion does not explicate a principled approach to the use of foreign law. therefore, to analyze whether vulcan materials violates the principles concerning the use of foreign law that can be gleaned from biddle and goodyear, we should ask: is there a principled basis for taking foreign law into account in interpreting the phrase "accumulated profits," and if so, was this basis appropriately used by the vulcan materials court? it is this author's view that such a principled basis does exist and was appropriately used by the vulcan materials court. however, the irs has legitimate concerns regarding the potential for abuse that led it to read goodyear as applying broadly, and because of those concerns, it is reasonable to promulgate regulations reversing the result in vulcan materials.5 in short, vulcan materials involved a factual use of saudi arabian law, although the point is more subtle in the context of this case than in the the long and the short of the matter is that "no definitional approach to 'accumulated profits' uniformly and unqualifiedly satisfies the dual purposes underlying the indirect credit." see united states v. goodyear tire & rubber co., 493 u.s. at [143]. such being the case, the question before us is which interpretation of that term as discussed by the parties herein "is more faithful to congressional intent." 493 u.s. at [1431. our view is that petitioner's interpretation of the phrase "accumulated profits," rather than that of respondent, best carries out that intent. we so hold. id. at 421. 49. see prop. regs. §§ 1.902-1(a)(9)(iv), l(a)(10)(ii) (proposing to reverse the decision in vulcan materials to the extent the issue remains relevant); action on decision cc1995-002 (feb. 13, 1995), available in lexis, fedtax library, rels file (explaining irs decision not to acquiesce in the vulcan materials decision). 50. action on decision cc-1995-002, supra note 49. 51. ironically, the dispute in vulcan materials might never have arisen if an economic substance approach to the credit had been adopted by the regulations. under such an approach, vulcan would have been able to argue that only its allocable share of tvcl's earnings economically bore the burden of the foreign tax and, therefore, only its allocable share of tvcl's accumulated profits should be considered under § 902. in effect, as described below, judge tannenwald accepted an economic substance approach, and perhaps vulcan materials can best be reconciled with goodyear on that basis. in both cases, the courts ensured that the taxpayers were able to claim appropriate credits for the foreign taxes imposed on the income they indirectly earned. 1996] florida tax review cases discussed above. viewed from judge tannenwald's perspective, foreign law was not being invoked to provide a rule of decision; goodyear would have precluded any such use. 2 rather, foreign law was, in effect, being used factually to support a sub silento substance over form approach to the case. 3 in essence, the court approached the case by determining, under u.s. tax principles, what the corporation's accumulated profits were, and then looking to foreign law for the factual determination of whether, in substance, the corporation had an obligation to make a payment (in this case, a pretax set-aside of a proportionate share of profits) to a third-party (in this case, the saudi shareholder) that would, like a royalty payment, reduce the corporation's accumulated profits even under u.s. tax principles. admittedly, this theory is not stated in the opinion. moreover, the approach may be viewed as tying the term "accumulated profits" more to the "foreign taxes paid" term of the § 902 equation than to the "dividend" term, in apparent violation of the underpinnings of goodyear. it is submitted, however, that the use to which foreign law is put in vulcan materials is more factual than the use of foreign law sought by the taxpayer in goodyear. as such, a basis may exist for reconciling the two cases. adoption of the vulcan materials result in all cases could, however, open the door to collusion between taxpayers and foreign governments to increase indirect foreign tax credits. the irs thus has a legitimate concern over the vulcan materials result. for this reason, and because reconciling vulcan materials and goodyear requires significant effort, it is fully appropriate for the irs to reverse the result in vulcan materials by finalizing its proposed regulations on this point.' c. definition of "income tax" under section 901, taxpayers may elect to claim a credit for foreign income taxes. under section 903, the credit also lies for foreign taxes imposed "in lieu of' income taxes. in both cases, the foreign levy must be a tax. foreign governments may deal with u.s. taxpayers as sovereigns, proprietors, or both.55 therefore, u.s. taxpayers may make payments to foreign governments that are taxes, contract payments, or both. since the credit lies only for taxes, the treasury must sort out which of these payments are taxes and which are not, often hindered, not helped, by the labels attached to the payments by the foreign government. 52. see vulcan materials, 96 t.c. at 417 ("there is no question that, under goodyear, the determination of tvcl's accumulated profits turns upon the application of u.s. tax rules ... "). 53. cf. vudcan materials, 96 t.c. at 419. 54. prop. regs. §§ 1.902-1(a)(9)(iv), 1(a)(10)(ii). 55. see isenbergh, supra note 1, at 228. [vol. 3:4 foreign law in u.s. international taration as was pointed out over 10 years ago: foreign precepts of ... tax administration, and notions of income differ notably from our own. how much a foreign tax system can differ from ours in its structure and practical effect and still give rise to creditable income taxes has been a matter of dispute virtually since the credit was introduced. 56 to address these concerns, the treasury issued, after numerous iterations, detailed regulations distinguishing taxes from noncreditable payments to foreign governments and distinguishing creditable foreign taxes on income from other types of taxes.? shortly after the regulations were issued in 1983, it was predicted that they would lead to enormous complexities of application and questionable results.58 therefore, it was suggested, the attempt to distinguish taxes from royalties paid to foreign governments should essentially be abandoned. 9 however, the regulations, although complex, are no more complex than many other regulations issued during and since 1 9 83 .v0 moreover, there do not appear to have been many disputes 56. id. at 227. 57. see regs. §§ 1.901-2, -2a, 1.903-1, 48 fed. reg. 46.272 (1983); prop. regs. §§ 1.901-2,-2a, 1.903-1,48 fed. reg. 14,641 (1983) (proposed apr. 5. 1983); temp. & prop. regs. §§ 1.901-2, 1.903-1, 45 fed. reg. 75,695 (1980); prop. regs. §§ 1.901-2. 1.903-1, 44 fed. reg. 36,071 (1979) (proposed june 22, 1979). amendments to § 1.901-2(e)(3) were proposed on november 15, 1988 and finalized on october 31. 1991. see 53 fed. reg. 45,942 (1988); 56 fed. reg. 56,007 (1991). 58. isenbergh, supra note 1, at 229. 59. id. it was suggested that this proposal be wedded to a repeal of the deferral privilege, which (subject to large exceptions in subpart f and other provisions) allows u.s. taxation of earnings of u.s.-owned foreign corporations to await the distribution of the earnings as dividends. the apparent basis for this marriage was that the revenue gain posited from the repeal of deferral could offset the revenue loss resulting from liberalization of the credit. recent analysis, however, suggests that a repeal of deferral might not raise significant tax revenues, and could even be a net revenue loser, because (1) most foreign earnings would carry foreign tax credits when included in u.s. shareholders' income and (2) u.s. taxable income would be reduced by the allowance of formerly deferred losses. see. e.g., treasury dep't study, international tax reform: an interim report 50 (jan. 15, 1993). in tax'n, budget & account. text (bna) no. 13, at l-1 (jan. 22, 1993). 60. for example, within the context of the foreign tax credit, the complexity of these regulations has been equaled, if not exceeded, by regulations under the separate limitation rules of § 904(d). see regs. §§ 1.904-4 to -7 (issued in 1988). in a closely related context. regulatory developments under subpart f continue to dazzle and amaze tax practitioners. see regs. §§ 1.954-1, -2 (issued in 1995). outside the area of international taxation, the examples of highly complex regulations issued over the last 10 years are almost too numerous to list. see, e.g., regs. §§ 1.469-1 to -11 (passive activity losses); 1.704-1 to -3 (partnership allocations); 1.1271-1 to -6 (original issue discount). 19961 florida tax review over the regulations' application.6' simplification of these regulations thus would not materially simplify the tax landscape. perhaps most importantly, there are significant tax policy reasons why the credit should only be allowed for foreign taxes and not for other payments to foreign governments.62 the purpose of the foreign tax credit is to prevent double taxation. to achieve this purpose, the law must identify the fiscal burdens that would create double taxation and provide relief from those burdens. if the relief is not restricted to tax burdens, nontax expenditures will be elevated from deductible payments to creditable payments without any substantive policy reason for doing so. moreover, the regulations, while looking to foreign law, require only a factual use of foreign law. they are quite detailed with respect to the standards to be used in determining whether a foreign levy is an income tax in the u.s. sense. foreign law is only considered to determine whether these standards of u.s. tax law have been satisfied. because there is a strong tax policy to restrict the credit to foreign taxes, because foreign law is used for these purposes in a principled manner under the standards advocated in this article, and because the ostensible objectives of simplification and the prevention of questionable results do not appear to be materially furthered by eliminating the distinction between foreign taxes and foreign nontax payments, we must ask what greater good would be served by eliminating this distinction. it appears that the argument comes down to this: the job of defining a "tax" is too difficult.63 it is this author's view that, with a good working definition of a "tax" such as the regulations provide, and a principled use of foreign law to inform that definition, the policy stakes are too high to justify a response of "it's too difficult."' 61. isenbergh does not identify the questionable results he predicts. if inappropriate results were identified, isenbergh would have a substantive basis for objecting to the rules, rather than an administrative basis, such as avoiding complexity. a substantive objection, unless overridden by countervailing substantive or administrative concerns, such as the desire to avoid even greater complexity, would have to be seriously considered. substantive objections may, however, still emerge because cases testing the regulations may not yet have reached the point of litigation. for example, a recently decided case on the creditability of a norwegian petroleum levy involved the tax years 1981 and 1982, which predate the present regulations. see phillips petroleum co. v. commissioner, 104 t.c. 256 (1995). 62. isenbergh acknowledges the importance of these concerns by his reservation that the tax/nontax distinction should be retained in "the most transparent cases." isenbergh, supra note 1, at 229. 63. see id. at 229 ("these proposals derive much of their force from the difficulties of setting the boundaries of creditable taxes under present law"). 64. this is not to say that the regulatory definition of a tax is perfect. the author understands that some foreign governments have made compelling cases that their taxes are excluded from u.s. creditability due to an overly narrow definition of what is a tax on income [vol 3:4 foreign law in u.s. international taration d. intercompany transfer pricing section 482 gives the irs authority to reallocate income among commonly controlled businesses if necessary to prevent tax evasion or to reflect clearly the income of such organizations. 65 a reallocation is appropriate if the terms of transactions among commonly controlled businesses differ from those that would have been agreed upon by unrelated persons dealing at arm's length.66 suppose a legal restriction makes it unlawful for a member of a controlled group of taxpayers to realize the income that the member would have had if it dealt at arm's length with an unrelated person and the legal restriction did not apply. can the irs nevertheless require under section 482 that the member recognize the arm's length amount of income? this question was first presented to the courts in the context of a domestic legal restriction. in the first security bank case, the supreme court barred the irs from allocating insurance premiums from an insurance agency to its bank affiliate because the bank was precluded under the national bank act from serving as an insurance agent.67 more recently, the courts have considered whether this principle applies in the context of a foreign legal restriction. in the procter & gamble case, the taxpayer had a spanish subsidiary that, under the laws of spain, was precluded from paying royalties or technical assistance fees.68 both the tax court and the sixth circuit rejected the government's argument that first or a tax in lieu of a tax on income. but when the policy reasons for restricting the credit to foreign taxes are so clear, and there are such meager principled objections to the present method of achieving this restriction, such problems should be solved by refining the definition, not by the curious expedient of throwing up our hands and abandoning the restriction altogether. 65. section 482 provides, in pertinent part: in any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the united states, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. 66. see regs. § 1a82-1(a)(1). 67. commissioner v. first security bank, 405 u.s. 394 (1972). see tower loan v. commissioner, 71 t.c. memo (cch) 2581, t.c. memo (ria) 1 96.152 (1996) (following first security in case involving credit life insurance premiums paid to insurance subsidiary of consumer loan company that was barred by state law from receiving such premiums). 68. procter & gamble co. v. commissioner, 95 t.c. 323. 325 (1990). aft'd, 961 f.2d 1255 (6th cir. 1992). 19961 florida tax review security could be distinguished because it involved a domestic, not a foreign statute. they reasoned that section 482 allows the irs to reallocate income where the taxpayer's income is distorted by virtue of the fact that it is a member of a controlled group. where the distortion arises from (or cannot be corrected because of) a governmental restriction, reallocation is inappropriate, whether the restriction is contained in foreign law or domestic law.69 in the tax court, the irs moved for reconsideration of the procter & gamble decision, citing goodyear for the proposition that "tax provisions should generally be read to incorporate domestic tax concepts absent a clear congressional expression that foreign concepts control."70 in ruling on the motion, the tax court, although not expressly relying on the interpretive/factual distinction advocated here, made precisely that distinction in substance, responding that its ruling was premised upon a u.s. tax concept (reallocation is inappropriate when receipt of the income at issue is prohibited by law) that made relevant the fact of the foreign legal restriction.7 the use of foreign law as a fact was perfectly acceptable to the court, as long as the court used a u.s. rule of decision. the irs mounted a strenuous attack on this line of authority in one of the largest cases ever to come before the tax court, the exxon case,72 which dealt with a saudi government-mandated reduction in crude oil prices paid by exxon, chevron, texaco, and mobil for saudi oil.73 in brief, these four american companies, through foreign affiliates (offtakers), acquired significant amounts of crude oil from saudi arabia at prices below the market prices charged by other oil producing nations.74 the saudi government wanted the benefit of these lower prices (the aramco advantage) to be passed on to consumers. it attempted to do so by requiring the offtakers to sell the crude to refineries at a low price reflecting the saudi discount. the 69. 95 t.c. at 339; 961 f.2d at 1259-60. 70. procter & gamble co. v. commissioner, 60 t.c. memo (cch) 1463, 1466, t.c. memo (p-h) 90,638, at 3114-90 (1990), aff'd, 961 f2d 1255 (6th cir. 1992). 71. id. 72. exxon corp. v. commissioner, 66 t.c. memo (cch) 1707, t.c. memo (ria) 93,616 (1993). these consolidated cases were believed to involve a deficiency exceeding $8 billion, the largest in the tax court's history. see karen matthews, progress slow as $8 billion 'aramco advantage' trial begins, 91 tni 15-4 (apr. 10, 1991) (lexis, fedtax library, taxtxt file). a companion case involving texaco, inc., is on appeal to the court of appeals for the fifth circuit. an appeal in the exxon case will lie in the second circuit. 73. aramco was a joint venture owned by these four companies. exxon corp., 66 t.c. memo (cch) at 1709, t.c. memo (ria) at 93-3230. 74. the discrepancy arose because, during the oil crisis of the late 1970s, saudi arabia did not raise prices as dramatically as did other members of the organization of petroleum exporting countries (opec). id. 66 t.c. memo (cch) at 1714-15, t.c. memo (ria) at 93-3236. [vol 3:4 foreign law in u.s. international taxation saudi government could not, however, ensure that the prices paid by purchasers from the refineries also reflected the aramco advantage. thus, the refineries buying from the offtakers bought at prices reflecting the aramco advantage and sold at the normal market prices, allowing them to capture the advantage. in many cases, the refineries and offtakers were controlled by the same oil companies. the irs took the position that, in these controlled sales from offtakers to refineries, section 482 authorized it to restate the sales prices at market, notwithstanding the requirement of saudi law that the offtakers sell at below-market prices.75 in support of this position, the irs made several arguments, including: (1) because foreign law is difficult to ascertain, the court erred when, in procter & gamble, it extended first security bank to foreign law situations, and (2) to allow foreign law to control the consequences in exxon would be to allow foreign law to dictate u.s. tax law and policy.76 regarding the first argument, the court agreed that a heightened scrutiny of the evidence might be required in the case of a foreign legal restriction, in part because the taxpayer might have had a role in the promulgation of the restriction. the court did not go so far as to hold, however, that the need for heightened scrutiny should preclude the application of the first security principle. although foreign law may be difficult to ascertain (mere translation of statutory language may fail to convey the full meaning of a statutory provision), the question is not whether foreign law is difficult to ascertain, but whether, in a particular circumstance, the tax law should devote the resources necessary to ascertain foreign law. as discussed above in part li.a.2, the necessity for ascertaining foreign law could have been avoided in many cases if the treasury had adopted an economic substance approach to determining who may claim the foreign tax credit. apparently convinced that, in those cases, the tax law must devote the resources necessary to ascertain foreign 75. exxon corp., 66 t.c. memo (cch) at 1733, t.c. memo (ria) at 93-3256. presumably, the effect of the irs' proposed adjustment was to shift revenue from the refineries, with substantial costs and deductions reducing taxable income, to the offtakers, with considerably fewer costs and deductions. this would increase the earnings and profits and subpart f income of the group, increasing its u.s. tax liability. see irc §§ 312, 952(c), 964(a). 76. exxon corp., 66 t.c. memo (cch) at 1737, t.c. memo (ria) at 93-3261. the irs' other arguments included: (1) procter & gamble is distinguishable because, in that case, the foreign law was embodied in a formal statutory provision whereas, in exxon, there was only a series of memoranda and letters from government officials, and (2) procter & gamble was incorrectly decided because the legislative history of § 482 does not refer to foreign law and, therefore, foreign law should not affect allocations under § 482. these arguments were dismissed by the court. id. 66 t.c. memo (cch) at 1736-37, t.c. memo (ria) at 93-3260. 19961 florida tax review law, it seems anomalous that the government argues against the relevance of foreign law under section 482. 77 arguably, the results should be reversed. where there is an alternative to relying on foreign law (e.g., reading biddle more narrowly to allow for the application of the substance over form doctrine in ascertaining the payor of a foreign tax, thus obviating the need to determine legal liability for the tax), arguably, the alternative should be pursued before the sometimes murky waters of foreign law are entered. where, however, the application of a statute may require that foreign law be established as a fact, such as is the case under section 482,78 foreign law arguably should be taken into account. regarding the irs' second argument-a taxpayer victory would allow foreign law to dictate u.s. tax consequences-the exxon court stated: while foreign law may be relevant for purposes of determining whether a legal prohibition exists and, ultimately, ... whether section 482 is applicable in a particular instance, such determinations are made in accordance with, and in furtherance of, the supreme court's decision in first security. consequently, we look to foreign law as a means of implementing u.s. law, not as a means of usurping it.79 it is thus evident that the exxon court, like the others discussed above, distinguished between interpretive and factual uses of foreign law. if the court were to have ceded a u.s. law determination to a foreign government, as the government said it would be doing if it ruled for the taxpayer, it would have made an interpretive use of foreign law. the court did not, however, do so. it did not interpret u.s. statutory language as that language is interpreted under the laws of a foreign jurisdiction. instead, the court put foreign law to a factual use, as did the courts in biddle, vulcan materials, and procter & gamble.8° 77. the government did not expressly argue in exxon that foreign law should never be taken into account under § 482, but this is the logical extension of its argument that foreign law should not be taken into account because it is inherently unreliable. 78. as noted above, before § 482 can apply, it must be established that a nonmarket price results from the fact that the taxpayers are under common control and not from other facts, such as bona fide foreign legal restrictions. see supra text accompanying note 69. 79. exxon corp., 66 t.c. memo (cch) at 1738, t.c. memo (ria) at 93-3261 (footnote omitted). 80. under the 1968 regulations, when payments between affiliates were prevented "because of currency or other restrictions imposed under the laws of any foreign country," adjustments under § 482 could be treated as deferrable income or deductions if this treatment was consistent with the taxpayer's accounting method. regs. § 1.482-1(d)(6) (before amendment in 1994). thus, the treasury applied a deferral approach to situations involving foreign restrictions on payments, rather than completely exempting restricted payments from [vol 3:4 foreign law in u.s. international taxation lu. cross-border tax arbitrage jurisdictions often differ in their tax treatments of particular transactions or items. the tax treatments are sometimes so different as to be inconsistent. where this inconsistent treatment produces tax benefits that would not be available if the transaction or item were treated consistently, it may be referred to as cross-border tax arbitrage. foreign law generally plays a different role in cross-border tax arbitrage transactions than it does in the situations discussed above. in tax arbitrage situations, foreign law generally has no direct impact on u.s. tax consequences, either as a prescriptive rule of decision or as a fact tending to satisfy a condition precedent to the application of a statutory rule.8' rather, foreign law is most often implicated solely because the inconsistent treatment, by creating tax benefits in two jurisdictions, each predicated on a view of the facts or a legal characterization fundamentally at odds with the other, raises tax policy concerns. under one view of this tax policy issue, u.s. tax officials can have no legitimate objection to this sort of tax arbitrage.s because neither jurisdiction's law is dependent on, or even relevant to the other, the concerns raised above regarding the use of foreign law are not implicated. that is, tax arbitrage situations are not a u.s. tax policy concern because there is no extraterritorial relevance to the law of either jurisdiction, only the fortuitous anomaly that the tax result in each jurisdiction is predicated upon a view of the application of § 482 under the principles of first security bank. see, e.g., rev. rul. 74-24, 1974-1 c.b. 124 (conditioning suspension of current adjustments on taxpayer's election of an accounting method that deferred recognition of income). this alternative to applying first security bank in the foreign context addressed a concern about collusion between taxpayers and foreign governments: to the extent a foreign government has an interest in restricting deductible payments and a taxpayer benefits from the resulting offshore accumulation of income, there is room for mutually beneficial ad hoc restrictions on the distribution of income. however, as discussed above, the irs' position regarding the foreign application of first security bank was rejected in the procter & gamble case. the present regulations acquiesce to some extent in the principles of the procter & gamble case while attempting to limit the risk of collusion. under the regulations, a foreign law restriction is only taken into account if it has been applied to other uncontrolled taxpayers in comparable situations or a three-part test is satisfied: (1) the foreign restriction is a law of general applicability that prevents payments outright rather than merely limiting associated deductions, (2) the law has not been circumvented or violated by the taxpayer, and (3) the taxpayer has exhausted its remedies under foreign law in seeking a waiver of the restriction. see reg. § 1.482-1(h)(2). 81. as discussed below, an exception, which allows for an analysis consistent with that employed in the cases described above, involves the use of treaties in cross-border tax arbitrage. see infra part ih.b. 82. see statement of u.s. council for international business on international application of check-the-box entity classification proposal of revenue notice 95-14, reprinted in 95 tnt 147-7 (july 28, 1995) (lexis, fedtax library, tnt file). 1996] florida tax review the facts or a legal characterization that is inconsistent with that in the other jurisdiction. as long as the united states is satisfied that its laws are being observed, what goes on outside its borders should be of no importance. this position is correct only if (1) the consequences in one jurisdiction do not depend to any extent on the consequences in the other jurisdiction and (2) the united states has no legitimate objection when taxpayers take inconsistent positions in two jurisdictions. conversely, the position is incorrect if either the consequences in one jurisdiction depend on the consequences in the other jurisdiction or the united states can articulate a legitimate tax policy objection to cross-border tax arbitrage. one objection might be that, even if a u.s. tax rule does not by its terms apply differently depending on the results under foreign law, the rule might implicitly be premised on a particular treatment under foreign law. under this view, the u.s. tax results properly may be altered if the foreign tax results are not as implicitly contemplated.83 ultimately, cross-border tax arbitrage might be the price of the absence of international consensus on tax matters.84 in the context of international trade regulation, the laws of many nations have been harmonized, and complex multilateral treaties have been concluded." in the tax area, only halting steps have been taken towards multijurisdictional harmonization.86 arguably, absent a global tax law, the united states can have no 83. see daniel i. halperin, are anti-abuse rules appropriate? 48 tax law. 807, 810 (1995). this objection might be stronger or weaker depending on whether the differing tax consequences in the two jurisdictions result from inconsistent laws or inconsistently applications of consistent laws. that is, we might distinguish a case in which the laws of the two jurisdictions prescribe inconsistent results under the same view of the facts, from a case in which the taxpayer urges inconsistent views of the facts in the two jurisdictions. arguably, in the latter case, the united states has a more legitimate objection. 84. for a forceful argument in favor of international consensus in the transfer pricing context, see reuven s. avi-yonah, the rise and fall of arms length: a study in the evolution of u.s. international taxation, 15 va. tax rev. 89 (1995). 85. see, e.g., general agreement on tariffs and trade (gatt), oct. 30, 1967, 61 stat. (5)-(6), 55 u.n.t.s. 194; general agreement on trade in services (gats), negotiated as part of the uruguay round of gatt negotiations (adopted in pub. l. no 103-465, 108 stat. 4809 (1994)). 86. the organisation for economic co-operation and development (oecd) is probably the best hope for those who endorse multijurisdictional tax harmonization. the oecd has developed a model bilateral tax treaty and a set of transfer pricing guidelines, portions of which have been accepted by substantially all industrialized countries. see oecd committee on fiscal affairs, model tax convention on income and capital (1992) [hereinafter oecd model treaty]; organisation for economic co-operation and development, transfer pricing guidelines for multinational enterprises and tax administrations (1995) [hereinafter oecd transfer pricing guidelines]. ironically, the most logical end-game of multilateral agreement on transfer pricing matters, worldwide formulary apportionment of multinational profits (see avi-yonah, supra [vol 3:4 foreign law in u.s. international taxation legitimate objection to cross-border tax arbitrage, at least where the tax consequences in one jurisdiction do not depend on the tax consequences in any other jurisdiction. the following questions are thus relevant to an analysis of crossborder arbitrage transactions: (1) are the results in one jurisdiction dependent to any extent on the results in the other jurisdiction? (2) is the u.s. tax rule that is being applied explicitly or implicitly premised on a particular tax treatment in the foreign jurisdiction? if the answers to both questions are negative, a strong argument exists that the cross-border tax arbitrage transaction is unobjectionable from a tax policy perspective.' if, however, note 84), has been soundly rejected by the oecd members, including the united states. see oecd transfer pricing guidelines, supra, ch. ili.c; regs. § ia82-1(b). the united states even balked when faced with the prospect that its accession to a multilateral trade agreement might affect tax matters, potentially moving the united states away from its policy of entering into only bilateral tax treaties. see, e.g., john turro, u.s. tax concerns threaten gatt talks, 7 tax notes int'l 1467 (1993). illustrative of the difficulty of multinational tax harmonization is the experience of the european union. the ec (and later the eu) has made sporadic attempts in the direction of harmonizing direct taxes. these efforts began as early as 1963 with the neumark committee report, which recommended a uniform split rate system of corporate taxation for the ec. only seven years later, the van den tempel committee report recommended a uniform classical system of corporate taxation. a 1975 draft directive proposing a partial integration system was never finalized and was withdrawn in 1990. see proposal for a council directive concerning the harmonization of systems of company taxation and of withholding taxes on dividends, 1975 o.j. (c253) 2 (withdrawn apr. 18, 1990). the only area of real progress before 1990 was in facilitating the exchange of information between taxing authorities of the member states. see, e.g., council directive 77fl99, 1977 o.j. (136) 15. a package of three directives, issued in 1990, generated some momentum in the direction of harmonization: (1) the parent-subsidiary tax directive, which is generally intended to eliminate multiple levels of corporate and withholding tax on intercorporate dividends (council directive 90/435, 1990 o.j. (l225) 6); (2) the mergers (tax) directive, which is generally intended to facilitate tax-free business reorganizations (see council directive 90/434, 1990 o.j. (l225) i); and (3) the arbitration convention, which prescribes procedures for member states to resolve transfer pricing issues (see council convention 901436, 1990 o.j. (l225) 11). however, the implementation of these directives has been less than complete. several countries sought and obtained exemptions from the parent-subsidiary directive, while the mergers (tax) directive was modified, at the insistence of germany, to allow a member state to deny the benefits of the directive to a merger that contravenes labor legislation. subsequently, a proposed directive on interest and royalty withholding taxes ran into significant political opposition from germany and belgium and was withdrawn. thus, while some progress has been made, the movement towards harmonization has been fraught with difficulty and is very far from being completed. see generally howard m. uebman & isret m. sinn, business operations in the european union, 999 tax mgmt. (bna) a-95 to a-104. 87. as discussed above, it may also be relevant whether, for the inconsistent treatment to prevail, the taxpayer would be required to argue inconsistent facts, including ultimate facts, or whether a consistent view of the facts can lead to different results under the laws of both jurisdictions. 19961 florida tax review the u.s. tax rule being applied is explicitly premised on a particular foreign tax treatment, and that premise is not met, a strong argument can be made that the tax consequences under foreign law are properly taken into account in evaluating a cross-border tax arbitrage and that it is proper for the irs or a court to deny the contemplated u.s. tax benefits. similarly, if the tax rule is implicitly premised on a particular foreign tax treatment, and that premise is not met, the transaction is objectionable if it is legitimate to look to such an implicit premise in the absence of a formal explicit global tax law. as discussed further below, it is legitimate to do so in the treaty context. it is submitted, however, that, in general, looking to such an implicit premise in the absence of a global tax law is tantamount to an impermissible interpretive use of foreign law. therefore, an arbitrage transaction outside the treaty context in which such premise is not met is, at least arguably, unobjectionable from a u.s. tax policy perspective.88 with this analytical framework in mind, we now turn to an evaluation of particular cross-border tax arbitrage transactions. a. entity classification the code taxes corporations, including "associations," but does not tax partnerships, whose income is instead taxed directly to the partners." whether a given entity is an association taxable as a corporation or a partnership depends on classification rules set forth in the regulations.9" although all entities organized under the corporation laws of any of the 50 states or the district of columbia are classified as corporations, the classification of foreign entities is determined under a six-part test set forth in the regulations, regardless of how similar the laws under which such entities are organized may be to domestic incorporation statutes.9' the consequences of entity classification in the foreign context differ from the consequences in the domestic context. entity classification in the foreign context involves both u.s. entities owned by foreign persons, and foreign entities that either are owned by u.s. persons, are engaged in a u.s. trade or business, or own u.s. assets. the most important consequence in the domestic context, whether the entity is subject to u.s. tax, is not of concern with respect to a foreign entity whose owners are foreign persons and whose businesses and investments are located outside the united states. whether such an entity is classified as a corporation or as a partnership, its business 88. in part ii above, doubt was cast on the legitimacy of interpretive uses of foreign law. in this part, doubt is cast on the legitimacy of taking into account inconsistent results under foreign law if foreign law is used interpretatively. 89. irc §§ 11, 701, 7701(a)(3). 90. regs. §§ 301.7701-1 to -4. 91. rev. rul. 88-8, 1988-1 c.b. 403. but see infra note 95 and accompanying text. [vol 3:4 foreign law in u.s. international taxation profits are not taxable by the united states unless it carries on a trade or business in the united states and, if the taxpayers reside in a country having an income tax treaty with the united states, has a permanent establishment in this country.92 nonbusiness income of such an entity is subject to u.s. tax only to the extent it is from u.s. sources.93 nevertheless, u.s. tax consequences can vary significantly depending on whether a foreign or a foreignowned entity is classified as a partnership or an association taxable as a corporation.9 92. see irc §§ 872(a), 882(b). under most tax treaties entered into by the united states, business income of a resident of one contracting state cannot be taxed by the other contracting state unless the person has a permanent establishment in the latter state and the income is attributable to the permanent establishment. see, e.g., convention between the united states of america and japan for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, mar. 8, 1971, art. 8. para.l. 23 u.s.t. 967 [hereinafter u.s.-japan treaty]. while the definition of "permanent establishment" varies from treaty to treaty, it is intended to describe a more extensive level of business activity than the minimum level that might justify taxation by the source country. a permanent establishment may take the form of a factory or office, a construction site in existence for a specified period of time, or a relationship with a dependent agent who exercises the requisite degree of discretionary authority on behalf of the foreign entity. see, e.g.. u.s.-japan treaty, supra, art. 9, paras. 1, 2. 93. irc §§ 871(a), 881(a). 94. if a foreign entity is engaged in a u.s. business (and, in a treaty situation, has a u.s. permanent establishment), the amount of tax can vary depending on whether it is a corporation or a partnership. if the entity is owned by individuals (or trusts or estates), the tax is at the individual rates if it is classified as a partnership or at the corporate rates if it is classified as a corporation. moreover, repatriated profits are subject to the branch profits tax of § 884 if the entity is a corporation, but not if it is a partnership and its owners are not corporations. other consequences can also vary. for example: * foreign income and loss flow through to the u.s. owners of a partnership, whereas u.s. taxation of earnings of a foreign corporation may be deferred until the earnings are distributed as dividends to u.s. shareholders. * section 902 allows an indirect credit for foreign taxes on the income of a foreign corporation that is distributed as dividends to a domestic corporation owning at least 10 percent of the foreign corporation's stock. no other shareholders of the foreign corporation may claim credit for taxes imposed on the corporation. credits for foreign income taxes on partnership profits are available to all u.s. partners under § 901 without regard to the owner's corporate status or ownership percentage. * although the indirect credit is allowed for foreign taxes on earnings of lower-tier subsidiaries distributed up the chain of ownership, it does not extend deeper than three tiers of foreign corporations. this limitation does not apply to tiered partnerships. * taxes paid and deemed paid with respect to dividends received by a domestic corporation eligible for the indirect credit are subject to the separate foreign tax credit limitation of § 904(d)(1)(e) if the distributing foreign corporation is not a controlled foreign corporation. partnership income is not subject to any such limitation. 19961 florida tax review because of the ease with which taxpayers can, under current law, achieve different classifications for entities that are virtually indistinguishable for nontax purposes, the treasury has proposed regulations allowing taxpayers to chose the classification of their entities by simply checking a box on a form filed with the irs.9" in considering whether to extend this proposal to foreign entities, the treasury initially expressed concern that it could exacerbate cross-border tax arbitrage through the use of "hybrid" entities, that is, entities that are classified as corporations in one jurisdiction and partnerships in another.9 6 although the treasury subsequently proposed to extend the check-the-box system to foreign as well as domestic entities, it * active income that flows through a partnership is not foreign personal holding company income (fphci) to a controlled foreign corporation (cfc). with certain exceptions, dividends from a foreign corporation to a cfc are fphci. * a foreign corporation's holding of less than 25% of the stock of another foreign corporation is a passive asset for purposes of the passive foreign investment company (pfic) asset test. with a similar investment in a foreign partnership, the foreign corporate partner apparently may look through to the partnership's assets and characterize its investment as active or passive with reference to the character of those assets. * the interest allocation rules that help determine the limitation on a u.s. person's foreign tax credits may operate more favorably if a foreign investment takes the form of a partnership interest, rather than stock of a foreign corporation. * foreign owners of a partnership engaged in a u.s. trade or business are themselves engaged in a u.s. trade or business and are therefore subject to u.s. tax on their distributive shares of income effectively connected with the trade or business. * transfers of more than 50% of the interests in a foreign partnership within 12 months result in a termination of the partnership and a recontribution to the partnership of the partnership's assets. any built-in gain in the assets recontributed by a u.s. person may be subject to a 35% excise tax. * unlike foreign partnerships, foreign corporations can engage in tax-deferred reorganizations under subchapter c. * all interest payments by a foreign partnership engaged in a u.s. trade or business are treated as u.s. source and potentially subject to withholding, whereas interest payments of a foreign corporation engaged in a u.s. trade or business may be only partially u.s. source. for a discussion of these differences in the context of elective entity classification, see new york st. bar ass'n, tax section, report on the "check the box" entity classification system proposed in notice 95-14, 95 tnt 173-64 (sept. 5, 1995) (lexis, fedtax library, tnt file) [hereinafter nysba report on notice 95-14]. for a discussion of international tax issues that arise once partnership classification is determined, see robert j. staffaroni, partnerships: aggregate vs. entity and u.s. international taxation, 49 tax law. 55 (1995). 95. ps-43-95, 61 fed. reg. 21,989 (1996) [hereinafter proposed check-the-box regulations]. the proposed regulations were preceded by an irs request for comments on the check-the-box idea. i.r.s. notice 95-14, 1995-1 c.b. 297. 96. notice 95-14, supra note 95. [vol 3:4 foreign law in u.s. international taralion may still have these concerns.97 the extent to which hybrid entities create a u.s. tax policy issue is explored below in two contexts: the foreign tax credit context and the treaty context.9 1. foreign tax credit.-in abbott laboratories," the u.s. owner of argentinean and columbian entities included the earnings of those entities in its gross income and claimed direct credits for foreign taxes on those earnings.' °° although the entities were classified as corporations for u.s. tax purposes, they were treated as partnerships for foreign tax purposes, and primary liability for the taxes under foreign law was thus imposed on the u.s. owner.01 because the u.s. owner was primarily liable for the taxes, the owner should seemingly have been entitled to the credit under biddle, which holds that whether taxes have been "paid" in the u.s. sense depends on what is required under the law of the foreign jurisdiction. the abbott laboratories court denied the credit, however, stating that whether the taxes were paid by the subsidiaries or paid by the parent does not turn solely on the legal incidence of the taxes under foreign law.1°2 the court appears to have been heavily influenced by the fact that, had the entities distributed their earnings, the u.s. owner would have been able to claim indirect credits for the foreign 97. see proposed check-the-box regulations preamble ("the treasury department and the irs will continue to monitor carefully the use of partnerships in the international context and will issue appropriate substantive guidance when partnerships are used to achieve results that are inconsistent with the policies and rules of particular code provisions or of u.s. tax treaties"). 98. examination of the extent to which elective entity classification would exacerbate any tax abuse associated with the use of hybrids is beyond the scope of this paper. for a fuller discussion of the issue, see american bar ass'n, tax section. comments on notice 95-14, proposed revisions to the entity classification rules, 95 tnt 145-25 (july 26, 1995) (lexis, fedtax library, tnt file); nysba report on notice 95-14. supra note 94; tax executives inst., comments on notice 95-14 relating to entity classification, 95 tnt 147-41 (july 28, 1995) (lexis, fedtax library, tnt file). 99. abbott lab. int'l co. v. united states, 160 f. supp. 321 (n.d. ill. 1958). aff'd per curiam, 267 f.2d 940 (7th cir. 1959). 100. as discussed above, direct credits are credits allowed under § 901 for taxes paid by the taxpayer claiming the credit, while indirect credits are credits allowed under § 902 for taxes paid by a foreign corporation in which the taxpayer owns at least a 10% voting interest. indirect credits are only available when the earnings on which the foreign taxes have been imposed are distributed or taxed to its u.s. owners without distribution (e.g., under subpart f). see irc §§ 902, 960. 101. however, the entities actually paid the taxes. 102. the court did state, however, that it was significant that the entities were secondarily liable for the tax. abbott lab., 160 f. supp. at 328-29. 19961 florida tax review taxes under the predecessor to section 902.1"3 the court did not, however, state that it would have ruled differently had the u.s. owner been ineligible for a section 902 credit.' °4 the court recognized that the code provides a choice to taxpayers: (1) do business through a foreign partnership, with the consequence that the taxpayer will immediately take the entity's foreign earnings into income and claim a credit for the foreign taxes on those earnings,' °' or (2) do business through a foreign corporate subsidiary, with the consequence that the taxpayer will defer both the income and the credits until the subsidiary's earnings are repatriated. obviously, it is abusive if taxpayers defer the income and claim the credits. however, as noted above, the taxpayer in abbott laboratories did not defer the income. it agreed to take the foreign entities' earnings into income if it could credit the foreign taxes on those earnings. that is, although the taxpayer sought the advantages of partnership classification, it was also willing to live with the disadvantages of partnership classification. the taxpayer in abbott laboratories was not so much seeking to exploit an inconsistency between u.s. and foreign law as to change the u.s. tax classification to conform to the foreign tax classification. thus, although the taxpayer was not engaging in that which is the arguably offensive aspect of cross-border tax arbitrage, it was attempting to use foreign law in an interpretive, as opposed to a factual manner. had the taxpayer's position prevailed in abbott laboratories, foreign law regarding entity classification would have been used as a prescriptive rule of decision to determine u.s. tax results. the united states has a legitimate tax policy objection to the result sought by the taxpayer-not an objection based on the illegitimacy of crossborder tax arbitrage, but an objection based purely on the illegitimacy of interpretive uses of foreign law. 103. id. at 329 ("it is no 'equalization' of tax treatment to provide that a select group of taxpayers shall have it within their power to postpone the time for the realization of foreign income indefinitely [by failing to distribute it] while at the same time using foreign taxes paid on such income, to lessen their tax burden in this country"). for further discussion of the role of § 902 in the decision, see elisabeth a. owens, the foreign tax credit 377-80 (1961). 104. the closest the court came to such a holding was the following: it may be that a stockholder who cannot qualify for treatment under [the predecessor to § 902] and who has no control over the distribution of the profits of a foreign corporation, should be given credit under [the predecessor to § 901] where it appears that the tax paid by the corporation has been levied against him, and where he stands to lose the credit if he were to wait for the distribution. abbott lab., 160 f. supp. at 330 (citation omitted). 105. partners are entitled to credit for their "proportionate share[s]" of the partnership's foreign income taxes. see irc § 901(b)(5). [vol 3:4 foreign law in u.s. international taxation 2. entity classification and treaties.lo---whether u.s. treaty benefits are available with respect to u.s. source income received by an entity depends in part on how that entity is classified for tax purposes." therefore, when u.s. and foreign law classify an entity differently, a central issue is whether u.s. or foreign law should determine the classification for treaty purposes."0 8 to decide this issue, it may be appropriate to modify the analysis heretofore employed in this article. in the treaty context, one state grants tax benefits based on certain assumptions about the treaty partner's tax system and on the concessions granted by that other state. therefore, a stronger basis arguably exists for using foreign law in an interpretive way where treaty issues are implicated." 9 the importance of this issue can be illustrated by the following example: assume that canadian persons own a cayman islands entity that 106. for a discussion of some issues that arise in connection with the treatment of partnerships under treaties, see richard 0. loengard, tax treaties, partnerships and partners: exploration of a relationship. 29 tax law. 31 (1975). see also comm. on tax'n of int'l transactions, ass'n of bar of city of new york, united states tax treatment of partnerships and partners under income tax treaties, 7 rec. 773 (1995). 107. generally, only treaty country "residents" are entitled to treaty benefits. under most of our treaties, a "company" is a resident of a treaty country only if it is liable to tax in that country. under some of our treaties, however, a partnership is also a resident to the extent that its income is subject to residence country tax in the hands of its partners. see, e.g., convention between the government of the united states of america and the government of the french republic for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital, aug. 31, 1994 [hereinafter french treaty], art. 4, para. 2(b)(iv). therefore, classification of an entity may be an implicit first step to application of the residence article of a treaty. similarly, certain treaty benefits are available only when a resident of the treaty country is the beneficial owner of the income for which benefits are claimed. see, e.g., convention between the united states of america and canada with respect to taxes on income and capital, aug. 16, 1984 [hereinafter canadian treatyl, art. x, para. 2. if income is received by an entity that one state views as a partnership but the other state views as a corporation, there may be disagreement on the identity of the beneficial owner. 108. proposed regulations under § 1441 articulate the government's position that, in certain cases involving foreign entities, foreign classification rules should govern. prop. regs. §§ 1.1441-1(c)(6)(ii)(b), -6(b)(4). 109. indeed, a provision found in many u.s. treaties provides express authority for interpretive uses of foreign law. see, e.g., canadian treaty, supra note 107, art. iii. para. 2 ("as regards the application of the convention by a contracting state any term not defined therein shall, unless the context othenvise requires . . ., have the meaning which it has under the law of that state concerning the taxes to which the convention applies") (emphasis added). some treaties are even more specific in deferring to foreign law. for example, the mexican treaty provides that, for u.s. foreign tax credit purposes, capital gains of a u.s. resident that are taxed by mexico shall be treated as foreign source income, despite the contrary general rule of § 865(a). mexican treaty, art. 24, para. 3. 19961 florida tax review invests in u.s. dividend-paying stocks; the entity is classified as a partnership for u.s. tax purposes but as a corporation under canadian tax laws. in the absence of a treaty, the u.s. would impose a 30% withholding tax on the dividends. under the canadian treaty, however, that rate is reduced if the dividend's beneficial owner is a canadian resident. if the u.s. withholding rate is determined for treaty purposes by treating the dividend recipient as a partnership and by treating the partnership as an aggregate, the dividends qualify for the reduced rate of withholding tax on dividends under the canadian treaty because, purely from the u.s. perspective, the owners of the cayman entity reside in canada. however, because the cayman entity is classified as a corporation for canadian tax purposes, the canadian owners will not currently pay any canadian income tax, directly or indirectly, on the dividend unless canada applies rules similar to our subpart f. moreover, the cayman islands has no income tax."' it is arguably abusive to exploit the divergent u.s. and canadian classifications to obtain a reduced u.s. withholding tax under the u.s.canada treaty, even though the dividend income may ultimately be taxed in canada. the argument is that the fundamental purpose of the treaty is to avoid double taxation of income and that the source country treaty benefit thus is at least implicitly conditioned on the income being taxed in the residence country. it is beyond doubt that the implicit premise of the reduced withholding tax rate is the imposition of a significant income tax in the country of residence.11 therefore, the only question is whether this premise is entitled to recognition in the absence of more explicit articulation in the treaty or otherwise under u.s. law." 2 on the one hand, since the united states does not expressly condition treaty benefits on significant income taxation by the foreign treaty partner, taxpayers appear to be within their rights in objecting to a denial of these benefits." 3 for example, if canada unilaterally reduced its income tax rate to 5%, the united states could not legitimately respond by denying treaty 110. see howard d. rosen, asset protection planning, 810 tax mgmt. (bna) a31. i 11. it is a longstanding policy of the treasury not to negotiate treaties with tax havens. moreover, in many treaties, a partnership is a "resident" of a country (i.e., a person entitled to treaty benefits) only if its income is taxed in that country on a residence basis, either in its hands or in the hands of its partners. see, e.g., convention between the government of the united states of america and the government of the french republic for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital, aug. 31, 1994, art. 4, para. 2(b)(iv). 112. the "beneficial ownership" concept in many u.s. treaties may constitute such an explicit articulation. 113. for a thoughtful discussion of the legitimacy of a court sustaining such a denial of treaty benefits, see robert smith, tax treaty interpretation by the judiciary: the claims of legitimacy (oct. 2, 1995) (unpublished manuscript on file with the florida tax review). [vol 3:4 foreign law in u.s. international taxation benefits to bona fide canadian residents. however, in the latter case, the united states might exercise its rights to renegotiate or terminate the treaty on the ground that there is no significant double taxation justifying a double tax treaty between the united states and canada, even though it could not address this issue by selectively denying treaty benefits.' as indicated above, some have suggested that a transaction like the "cayman sandwich" described above is not a matter of legitimate concern for the united states." 5 rather, they suggest, any abuse is of canadian law, which could, after all, require that the dividends be included in the income of the canadian owners of the cayman entity. although there is some force to this position, it is difficult to argue that the united states may not predicate treaty benefits on the imposition of a significant tax by its treaty partner. once that legitimacy is established, the position that the united states has no legitimate objection to this transaction loses its force. objections to this transaction could be addressed by requiring the u.s. entity classification to follow the foreign entity classification solely for determining whether treaty benefits are available with respect to u.s. source income. however, several issues would have to be addressed for this approach to be applied. for example, if the law of canada were applied to classify the entity as a corporation, no treaty benefits would be available because the income would not be considered beneficially owned by a canadian resident. however, if the entity were organized in one treaty jurisdiction that classified it as a corporation and its owners resided in another treaty jurisdiction that classified the entity as a partnership, it would be unclear which treaty would apply. moreover, difficult issues would arise concerning the interaction of these treaty withholding rules with the rules imposing substantive liability for u.s. tax on u.s. source fixed or determinable periodic income.! 6 would the u.s. classification rules continue to apply for purposes of determining substantive tax liability? if foreign law were used to classify an entity for u.s. tax purposes, it would be used as a prescriptive rule of decision. that is, the terms 114. for example, on november 16, 1995, the united states announced the termination of its treaty with malta. see john iekel, u.s.-malta tax treaty terminated: u.s., swiss officials to resume treaty talks, 11 tax notes int'l 1426 (nov. 27, 1995). also, the united states and the netherlands recently signed a protocol phasing out the remaining applicable provisions of the netherlands treaty as extended to the netherlands antilles. (the phase-out continues treaty benefits for eurobonds issued before october 15, 1984.) see protocol between the government of the united states of america and the government of the kingdom of the netherlands in respect of the netherlands antilles amending article viii of the 1948 convention with respect to taxes on income and certain other taxes as applicable to the netherlands antilles, oct. 10, 1995, art. 1. 115. see supra note 84 and accompanying text. 116. irc §§ 871, 881. 19961 florida tax review "partnership" and "corporation" would be defined for u.s. tax purposes with reference to foreign entity classification rules. as stated above, however, a compelling case could be made that the at least implicit condition of residence country taxation for treaty benefits justifies an interpretive use of foreign law in the treaty context. foreign law could, moreover, be used in another way in this context. if the united states negotiated treaties that more explicitly clarified that treaty benefits are tied to the imposition of tax in the residence country, foreign law would be used as fact, rather than interpretively. this recommendation could be incorporated in u.s. tax treaty policy with the following simple rule: foreign entities would be classified as corporations for treaty purposes only if they are subject to tax in the treaty jurisdiction. this use of foreign law recognizes the dependence of one country's laws on another's, the "coherence" of international taxation, yet simultaneously enhances the independence and sovereignty of all nations.' b. other cross-border tax arbitrage transactions the analysis described above also can be applied to other crossborder tax arbitrage situations. this section addresses two of them: (1) inconsistent treatment of a financial instrument as debt in the issuer's jurisdiction and equity in the holder's jurisdiction, and (2) inconsistent treatment of a lease as providing depreciation to the legal owner in the lessor's jurisdiction and to the beneficial owner in the lessee's jurisdiction. 1. hybrid instruments.-because of the interest deduction, issuing debt is generally a more tax-efficient way to raise capital than issuing equity. conversely, because of the dividends-received deduction, equity is generally a more tax-efficient investment for a corporation than holding debt." 8 with similar rules in other jurisdictions, issuers and holders can maximize tax benefits by treating an instrument as debt in the issuer's jurisdiction and equity in the holder's jurisdiction. such an instrument may be called a hybrid instrument. 19 117. see kingson, supra note 1. 118. for the dividends-received deduction, see irc §§ 243-246a. 119. in the domestic context, inconsistent treatment of hybrid instruments is severely limited by § 385(c), enacted in 1992 (pub. l. no. 102-486, § 1936(a), 106 stat. 2776, 3032), which provides that the issuer's characterization, at the time of issuance, of an instrument as stock or debt is binding on the issuer and on all holders except holders who disclose on their tax returns that they are treating the instrument in a manner inconsistent with the issuer's characterization. although § 385(c) generally mandates consistent treatment for u.s. income tax purposes, it has no effect on the treatment of an instrument under foreign law. consequently, it does not limit the inconsistent treatment of a hybrid instrument under the laws of the united states and a foreign jurisdiction. [vol. 3:4 foreign law in u.s. international taxation it is clear that under u.s. law, the interest deduction is not explicitly dependent on any particular treatment of the recipient's interest income under foreign law. neither does the dividends-received deduction explicitly depend on foreign law. it may be, however, that the rationale for the interest deduction is that the interest is subject to tax when received. 20 more clearly, the dividends-received deduction is justified as a measure to lessen the burden of multiple levels of tax on distributed corporate earnings," a burden that is absent if the distributed earnings were deducted from the payor's corporate tax base. moreover, if foreign law is examined to determine whether an interest payment is taxed on receipt or a dividend payment is being deducted as interest, foreign law is used in a factual, not an interpretive, sense. that is, foreign law is used not to provide a rule of decision but to provide facts to determine whether an implicit premise of u.s. law has been satisfied. the question that remains is whether it is legitimate to condition u.s. tax benefits on such an implicit premise. if one is of the view that taxpayers are entitled to rely on the literal language of a statute or regulation, even if that language provides a benefit at odds with the purposes of the statute or regulation, then one would not object to inconsistent treatment of payments under hybrid instruments.'2 " if, however, one believes that the government may disallow a tax benefit provided by the literal language of a rule if that benefit is inconsistent with the purposes of the rule, then one is more likely to view the implicit premises of the interest deduction and the dividendsreceived deduction as adequate support for denying inconsistent treatment of 120. such a rationale was used to support the limitation on interest deductions for so-called earnings-stripping payments. see irc § 163(j), enacted by pub. l. no. 101-239, § 7210(a), 103 stat. 2106, 2339 (1989); h.r. conf. rep. no. 386, 101st cong., 1st sess. 569 (1989), reprinted in 1989 u.s.c.c.a.n. 3018, 3172. see generally new york st. bar ass'n, tax section, report on section 163(j) of the internal revenue code, 47 tax notes 1495 (june 18, 1990). 121. for this reason, the u.s. dividends-received deduction is usually unavailable for dividends received from a foreign corporation. irc §§ 243(a), 245. from 1917 to 1935, corporations were not taxed on dividends received from other corporations, in order to prevent multiple levels of corporate tax. see 44 cong. rec. 4696 (1909) (remarks of rep. payne). the law was revised in 1935, however, to exempt only 85% of the dividends received in order to discourage the use of multiple entities for tax avoidance purposes and as part of a program intended to achieve simplification of corporate structures. see revenue act of 1935, ch. 829, § 102(h), 49 stat. 1014, 1016. this 85% threshold was lowered to 80% in 1986, and in 1987 was again lowered, in the case of "portfolio dividends," to 70%. see tax reform act of 1986, pub. l. no. 99-514, § 61 l(a)(1), 100 stat. 2085. 2249; revenue act of 1987, pub. l. no. 100-203, § 10221(a)(1), 101 stat. 1330, 1330-408. 122. as examples of literal applications of the language of statutes or regulations, see brown group, inc. v. commissioner, 77 f.3d 217 (8th cir. 1996); cs[ hydrostatic testers, inc. v. commissioner, 103 t.c. 398 (1994), aff'd, 62 f.3d 136 (5th cir. 1995) (per curiam); woods investment co. v. commissioner, 85 t.c. 274 (1985), acq. 1986-1 c.b. 1. 19961 florida tax review payments under hybrid instruments. 23 it is the author's view that, under a system such as ours that puts a high premium on the rule of law, a transaction complying with the literal terms of the law must be respected unless the result is so clearly at odds with the law's purposes that it is reasonably certain that the transaction would have been explicitly carved out from the -scope of the law had it been considered by the legislators. 24 under this standard, the interest deduction cannot be denied simply because the interest payment is not subject to tax in the hands of the recipient." 2. double dip leases.-a similar andlysis may be applied to double dip leases-lease transactions in which legal title to property is retained by a taxpayer in a jurisdiction that provides depreciation deductions based on legal ownership, and beneficial economic ownership is transferred to a lessee in another jurisdiction that provides depreciation based on economic ownership. 26 first, where the lessor is a foreign person and the lessee is a u.s. person, the central u.s. tax consequence of a double dip lease, the availability of depreciation deductions based on economic ownership, is in no sense dependent on foreign tax rules. second, it is not an explicit condition or implicit premise of the u.s. depreciation rules that the same property not be depreciated by another taxpayer under the laws of some other country.'27 therefore, the united states has no legitimate tax policy objection to a double dip lease based on the fact that foreign law allows depreciation deductions based on legal principles inconsistent with those of u.s. law. iv. conclusion notwithstanding pronouncements to the contrary, foreign law clearly has relevance to the determination of u.s. tax consequences in several contexts. this is particularly apparent in the context of the foreign tax credit, 123. see, e.g., halperin, supra note 83, at 809; g.c.m. 35984 (sept. 12, 1974). 124. the dual consolidated loss rules of § 1503(d) and the regulations thereunder perhaps represent the high water mark in explicit congressional disfavor of a tax benefit because of the relevant item's treatment under foreign law. 125. in the unusual cases where the dividends-received deduction is available for dividends paid by a foreign corporation, the payment would have to have been deducted against u.s. taxable income for the objection described above to be lodged. it is highly unlikely, however, that a corporate shareholder would claim a dividends-received deduction for a payment deducted against u.s. taxable income. 126. see naughton, supra note 17. 127. u.s. depreciation deductions are limited for property used predominantly outside the united states (irc § 168(g)(4)), but not for property used in the united states but simultaneously depreciated by different taxpayers in different jurisdictions. [vol. 3:4 foreign lav in u.s. international taxation for the simple reason that the credit is conceptually tied to the incidence of foreign income taxes. as discussed above, however, the application of foreign law is also important in other contexts, including transfer pricing and entity classification. blanket assertions of the irrelevance of foreign law are not supported by a careful reading of the case law, which demonstrates a reluctance of courts to disregard foreign law in appropriate contexts. drawing on these authorities, this article suggests a distinction between interpretive uses of foreign law, where foreign law supplies the rule of decision, and factual uses, where foreign legal consequences are examined as facts relevant to the application of u.s. law. u.s. courts have, with few exceptions, declined to make interpretive uses of foreign law. indeed, the basic learning of biddle may be that the interests of the united states in furthering the policies of its own tax law almost always outweigh the interests of the foreign jurisdiction. nevertheless, u.s. courts have not been willing to disregard foreign law altogether. for example, where the policy underlying u.s. rules is based on economic income, disregard of foreign laws that have an economic impact may result in a mismeasurement of income. the distinction between interpretive and factual uses of foreign law provides a framework for analysis of when and how foreign law should be used. this analysis is important not only for interpreting statutes and regulations, but also for determining the legitimacy of tax policy objections to transactions that may at first blush seem abusive. admittedly, this approach is not without its problems. the factual/interpretive distinction may break down in marginal cases, and foreign law is often difficult to ascertain. moreover, exceptions may be appropriate in particular classes of cases, such as those involving treaties. it is the author's view, however, that these difficulties do not outweigh the benefits of the factual/interpretive analytical framework. and it is the author's hope that future cases and administrative pronouncements will build on the distinction between factual and interpretive uses of foreign law to develop a more predictable and workable standard. 19961 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 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navigation home search current archives subscribe florida tax review volume 20 2017 number 8 i article poor support / rich support: (re)viewing the american social welfare state wendy a. bach uf law 2017 fl tax review 20-8 r2.pdf 1 6/11/17 2:20 pm florida tax review volume 20 2017 number 8 ii information for subscribers the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. for volume 20, the subscription rate is $125.00 in the united states and $145.00 elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. for volume 20, subscriptions and changes of address should be sent to florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review 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1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 1 1993 number 11 schneer v. commissioner: continuing confusion over the assignment of income doctrine and personal service income ronald h. jensen* i. introduction ii. development of the assignment of income doctrine and examination of its underlying rationale a. gratuitous assignments of personal service income b. gratuitous assignments of investment income c. rationale of the assignment of income doctrine d. nongratuitous assignments of income: a different case m1[. variations on a theme: the assignment of income in different contexts iv. the "similarity" and "agency" tests: failed solutions a. introduction b. the similarity test c. the agency test v. resolving the conflicts: a return to basics a. the overlooked distinction b. formal statement of approach c. issues involved in applying proposed approach d. the personal service corporation: a case of nonrecognition? e. the basketball player: a case of deferral f. a loose end: should schneer have been tared on tire fee that was fully earned at the time of the assignment? vi. conclusion * professor of law, pace university school of law. a.b., yale university: llb., harvard law school. i would like to express my appreciation to gregory holder for his insight into the "basketball player case," discussed infra part v.e., and to charles h. simmons, walter e. swearingen, and peter c. bruzzese for research assistance. florida tax review i. introduction more than sixty years have elapsed since justice holmes first enunciated in lucas v. earl' the principle that income from personal services "must be taxed to him who earns it"2 and that assignments of such income "however skilfully devised"3 will not be respected for tax purposes. the supreme court has described this principle-now known as the assignment of income doctrine-as the "first principle of income taxation."4 yet despite its venerable lineage and importance, the doctrine remains today beset by confusion and uncertainty. this was vividly demonstrated in schneer v. commissioner5 where the tax court agonized over the application of the doctrine to a simple, indeed pedestrian, set of facts. the twenty-page majority opinion brought forth a concurrence,6 based on an entirely different theory, and two vigorous dissents,7 one of which attacked the court's decision as "unprincipled."8 the decision has given rise to considerable comment, some of it heated. one commentator described the decision as not only wrong but "exquisitely wrong, so misguided at every turn, that it becomes a wayward sort of achievement,"9 while another described the first commentator's analysis as "wrong, although not exquisitely wrong."'" all commentators, however, have recognized the case's significance. the tax lawyer, the official publication of the american bar association section of taxation, designated the case as one of the important tax decisions of 1992," while 1. 281 u.s. 111 (1930). 2. commissioner v. culbertson, 337 u.s. 733, 739-40 (1949) (restating the holding in earl). 3. earl, 281 u.s. at 115. 4. culbertson, 337 u.s. at 739. the classic work on the assignment of income doctrine is charles s. lyon & james s. eustice, assignment of income: fruit and tree as irrigated by the p.g. lake case, 17 tax l. rev. 293 (1962), as supplemented by james s. eustice, contract rights, capital gain, and assighiment of income-the ferrer case, 20 tax l. rev. 1 (1964). 5. 97 t.c. 643 (1991). 6. id. at 663 (beghe, j., concurring). 7. id. at 664 (wells, j., dissenting); id. at 667 (halpern, j., dissenting). 8. id. at 669. 9. lee a. sheppard, partnership mysticism and the assignment-of-income doctrine, news analysis, 54 tax notes 8, 8 (jan. 6, 1992). 10. michael asimow, applying the assignment of income principle correctly, letter to the editor, 54 tax notes 607, 607 (feb. 3, 1992). 11. james p. holden, note, important tax decisions of 1992: forward, 46 tax law. 507, 510-11 (1993). see also gina l. bozajian, note, a case of mistaken identification: when income is earned and the classification of earnings as individual or partnership income in schneer v. commissioner, 46 tax law. 583 (1993). the tax lawyer was employing editorial license in describing schneer as one of the "important tax decisions of 1992"; the decision in [vol. 1:11 schneer v. conunissioner a publication of the section on taxation of the association of american law schools recommended its use in the classroom as the "practically perfect case" for teaching the assignment of income doctrine.'2 the schneer case therefore presents an opportune occasion to reexamine the assignment of income doctrine as applied to personal service income. the facts of schneer are as follows. stephen schneer, a law firm associate, had an agreement with his firm entitling him to a certain percentage of all fees collected from clients he brought to the firm. 3 schneer thereafter left the firm and became, on successive occasions, a partner in two other firms.14 schneer agreed, as a condition to becoming a partner in the latter two firms, that while serving with them as a partner he would turn over to them any fees he collected under his agreement with the first firm. 5 after leaving the first firm, schneer continued to render legal advice and consultation on those matters handled by the first firm in which he was entitled to share the fees. 6 the parties themselves were uncertain whether schneer would have been entitled to share in the fees had he refused to provide these consulting services. 7 schneer fully complied with his agreements and turned over to the second and third firms all fees he received from the first firm.'8 all of these fees, save one in the amount of $1,250, involved work performed after schneer left his first firm; the $1,250 fee was fully earned before his departure from that firm.' 9 the issue was whether the fees paid to schneer were taxable to him in full under the assignment of income doctrine, because he had earned them, or whether they constituted partnership income, in which case schneer would be taxable only on his distributive share of such fees. had the service been successful in applying the doctrine in this case, schneer apparently would have been taxed on more than 100% of such fees. he had already reported his distributive share of the fees as income, and the service did not offer to schneer was actually filed on december 12, 1991. schneer, 97 t.c. at 643. 12. boyd c dyer, new cases for teachers, newsl. (ass'n of am. law sch., section on taxation, wash., d.c.), apr. 1993, at 9. 13. schneer, 97 t.c. at 644. 14. id. at 645. 15. id. 16. id. 17. id. 18. id. at 646. 19. id. schneer received a total of $31,914 from the first firm, which he remitted to the second and third firms. with the exception of one fee in the amount of s1,250, all of these fees (representing more than 96% of the total amount of fees collected) were for work performed after schneer left the first firm. id. 1993j florida tax review adjust his distributive share or allow him a deduction for the amounts paid over to his new firms if the court applied the doctrine.20 the tax court held that the $1,250 fee which was fully earned before schneer left his first finn was taxable to him, because it had already accrued to him under the "all events" test.2' in the case of the fees earned after schneer's departure from the first firm, the court perceived a conflict between the assignment of income doctrine, which taxes income to the person who earns it, and the principles of partnership taxation, which tax partnership income to the partners in accordance with the terms of the partnership agreement regardless of whose personal efforts generated the income.22 relying on several revenue rulings and case authority, the tax court held that income in such cases should be treated as partnership, not personal, income provided the services performed by the partner in his individual capacity were "similar" to those performed by the partnership.3 the court held that since the consulting services performed by schneer were essentially of the same nature as those performed by the second and the third firms, the fees which he turned over to them should be treated as partnership income.24 schneer was therefore not taxable on such fees except to the extent of his distributive share of them. the court did not explain why the similarity between the taxpayer's activities which generated the fees and work normally performed by the firm should have any bearing on the application of the assignment of income doctrine,' and it is this aspect of the decision which caused the dissent and other critics to denounce it as "unprincipled. 26 20. see martin b. cowan, tax court leaves confusion in wake of decision on assignment of income to partnership, special report, 55 tax notes 1535, 1535 (june 15, 1992). 21. schneer, 97 t.c. at 649-52. although the tax court applied an accrual concept, that is, the "all events" test, in determining that schneer was taxable on the fee that was fully earned before he left the first firm, he was a cash-basis taxpayer. id. at 645. 22. id. at 657-58. 23. id. at 652-56. 24. id. at 656. 25. judge halpern commented that: [t]he majority fails to explain why the similarity of the work done by the partner to earn the fees to the work of the partnership is determinative. that failure not only casts doubt upon the correctness of this decision, but foreshadows the difficulty future courts will have in resolving the question: how similar is similar enough? without any inkling of why similarity has been deemed important, future courts will lack any effective guidelines for answering that question. id. at 669 n.3 (halpern, j., dissenting). 26. id. at 669 (halpern, j., dissenting). see cowan, supra note 20, at 1541. [vol 1:11 scmneer v. conmissioner i agree with the critics who have denounced the rationale of schneer as unprincipled, yet at the same time i believe the results in the case are substantially correct. however, both the court and its critics failed to grasp the true rationale for the assignment of income doctrine and were diverted into chasing will-o'-the-wisps such as the tests of "similarity" and "agency." the true nature of the assignment of income doctrine is simply this: it is a remedial doctrine designed to prevent high income taxpayers from fragmenting their taxable income among related and lower income taxpayers thereby undermining the graduated nature of the income tax system. the assignment of income doctrine implements this policy by refusing to give effect, for tax purposes, to gratuitous shifts of taxable income from one taxpayer to another. if this widely accepted rationale of the doctrine is respected, many puzzles encountered in applying the doctrine yield themselves to easy solution. this is true of schneer itself. schneer did not involve the gratuitous shifting of income from a high income family member to a low income family member, the classic case for applying the doctrine, but rather it involved a hard-headed negotiation conducted at arm's-length between unrelated parties. for every dollar of taxable income that schneer assigned to his new partnership, he received (or expected to receive) a dollar of taxable income in return. there is simply no reason to believe that taxable income was being shifted in scirneer from one taxpayer to another and thus no occasion to apply the assignment of income doctrine.27 somehow, the courts and the internal revenue service have lost sight of the crucial distinction between gratuitous assignments of income and assignments of income for value in personal service cases and as a result have produced a collection of irreconcilable and inexplicable cases and rulings. this article will analyze the proper application of the assignment of income doctrine to personal service income. part ii will trace the historical development of the assignment of income doctrine and will analyze the doctrine's underlying rationale. the importance of distinguishing between gratuitous and nongratuitous assignments of income will be developed in this part. part iii will present a number of hypothetical situations drawn from actual cases and rulings that involve the application of the doctrine to personal service income. this will both show the pervasiveness of the doctrine and lay the basis for further analysis. part iv will demonstrate that the tests currently used by the internal revenue service and the courts in these situations-the "similarity" test and the "agency" test-fail to provide either a rational or workable basis for solving these problems. instead, they have resulted in a welter of unintelligible and irreconcilable decisions. finally, part v will show how reference to the doctrine's underlying purpose, 27. see discussion infra part v.a. 19931 florida tax review and particularly to the basic distinction between gratuitous and nongratuitous assignments of income, solves many of the puzzles besetting the application of the doctrine. ii. development of the assignment of income doctrine and examination of its underlying rationale a. gratuitous assignments of personal service income in lucas v. earl28 a married couple entered into an agreement in 1901 which granted each spouse absolute ownership of one-half of any income earned by the other.29 on his 1920 and 1921 tax returns, the husband reported only half of his earnings for those years as taxable income contending that under the agreement the other half was owned by his wife and thus was taxable to her.3" justice holmes, in a unanimous opinion for the supreme court, held the husband taxable on all of his earnings: there is no doubt that the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skilfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. that seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.3 thus was born the assignment of income doctrine: one is taxable on all income earned through one's personal services, regardless of who actually receives that income. this principle is so deeply embedded in our tax jurisprudence it is difficult to consider it afresh. nevertheless, we need to do so to understand the basis for the doctrine. the holding in earl is not selfevident; indeed, the taxpayer's case was quite substantial. mr. earl argued that income should be taxed to the person beneficially entitled to receive it." the court took for granted that the agreement was legally enforce28. 281 u.s. 111 (1930). 29. id. at 113-14. 30. id. 31. id. at 114-15. 32. id. at 114. see alan gunn, tax avoidance, 76 mich. l. rev. 733, 762 (1978) (acknowledging that "[s]ome common definitions of income suggest the benefit approach"); michael j. mcintyre & oliver oldman, taxation of the family in a comprehensive and [vol 1:11 scimeer v. conunissioner able.33 thus, although the court held mr. earl taxable on all his earnings, he in fact had a legal right to only half of those earnings. although the practical effect of this agreement might be minimal in a harmonious marriage, it would have significant consequences if the marriage were dissolved or troubled, or the parties separated; and it might also have significant consequences if the husband became insolvent and creditors sought to levy upon his earnings. moreover, the agreement clearly had not been made to avoid tax, since it was entered into in 1901-twelve years before the adoption of the sixteenth amendment. given these considerations, the court's conclusion that income should be taxed to the person whose efforts generated the income, rather than to the person entitled to receive it, is hardly incontrovertible. nor does the court enlighten us as to why its conclusion should be so; it merely states that this result "seems to us [to be] the import of the statute." 34 the rationale of the court's holding must therefore be inferred. in retrospect it appears that what concerned the court was the effect a contrary holding would have had upon the tax system. had the court upheld mr. earl's claim, taxpayers could easily subvert the progressive tax rate structure by making multiple assignments of income among family members.3 if either the income earner dominated his family, or the family was a harmonious unit, such assignments would have little, if any, effect on the economic status of the assignor. of course, the court could have implemented this "policy" by limiting the earl doctrine to tax-motivated assignments, but such a limitation would have required lengthy, expensive, and uncertain findings as to the assignor's motives. moreover, such an approach would have laid bare that the court was making policy at a time when the prevailing jurisprudence held that courts should find, not make, law. accordingly, the court held that "no distinction can be taken according to the motives leading to the arrangement." 36 the result in earl might have been explained by the husband's continuing power to affect the flow of his earned income to his wife even simplified income tax, 90 harv. l. rev. 1573, 1582 (finding that assignment approach lacks "support in any normative model of the income tax"). 33. earl, 281 u.s. at 114. 34. id. at 115. as professor bittker has commented, "[the opinion in lucas v. earl is late-vintage holmes, magisterial in tone, studded with quotable phrases, and devoid of analysis." boris i. bittker, federal income taxation and the family, 27 stan. l rev. 1389, 1401 (1975) (footnote omiued). 35. ernest j. brown, the growing "common law" of taxation, 34 s. cal. l rev. 235, 243 (1961) ("the government, particularly in its petition for certiorari, less clearly in a short brief on the merits, presented mr. earl's claim as a threat to the statutory scheme of graduated rates."). 36. earl, 281 u.s. at 115. 19931 florida tax review after he had assigned such income to her. that is, mr. earl, even after the assignment, retained the ability to increase, decrease, or cut off altogether the flow of earned income to his wife simply by working more, working less or ceasing to work completely. this continuing ability to control the flow of the income might be thought to justify taxing the husband on such income. therefore, the result might be different where the assignor had already earned the income at the time of the assignment; in such a case, the assignor would lose all ability to affect the flow of that income to the assignee once he made the assignment. the supreme court rejected this distinction in helvering v. eubank.3 7 there the taxpayer assigned to a family trust his right to future insurance renewal commissions which he had earned through his sale of insurance policies in prior years.3s although mr. eubank forever lost his ability to affect the amount of assigned income flowing to the trust once he made the assignment, the court in a brief, cryptic opinion held mr. eubank fully taxable on all renewal commissions as they were paid to the trust. 9 in so holding, the court reinforced the rule that income is taxable to him who earns it, and further limited the ability of taxpayers to circumvent the graduated tax rate structure by making gratuitous assignments of income. b. gratuitous assignments of investment income in the meantime, the law relating to the gratuitous assignment of investment income (that is, income derived from property as opposed to income derived from personal services) developed along somewhat different lines. the supreme court held that income from property, in contrast to income from personal services, could be effectively assigned for tax purposes provided that the assignor assigned the income-producing property itself.4" thus, a parent who gives stock to a child will not be taxed on future dividends paid on the stock. by giving away the stock, the parent effectively transfers the incidence of taxation on future dividends to the child. on the other hand, if the taxpayer merely assigns income from the property while retaining the property itself (or, in terms of holmes's metaphor, merely assigns the "fruit" but retains the "tree"), the taxpayer will continue to be taxed on the assigned income as it is received by the assignee.4' moreover, 37. 311 u.s. 122 (1940). 38. id. at 124. 39. id. at 125. 40. blair v. commissioner, 300 u.s. 5, 12 (1937) (stating that "tax liability attaches to ownership"). 41. helvering v. horst, 311 u.s. 112 (1940). consequently, a parent who transfers interest coupons to a child while retaining the bond will be taxed on the interest when the coupons mature. id. [vol 1:11 scluzeer v conunissioner even where the taxpayer assigns the income-producing property he will be taxed on any income that had already accrued on the property at the time of the assignment. 4 2 c. rationale of the assignment of income doctrine in making these decisions, the supreme court spoke in broad conclusionary terms rather than in terms of the policies it was seeking to implement. as professor chirelstein has written: on the whole, the supreme court's opinions in this field are over-long and confusing .... the problem throughout, perhaps, was how the court could aid in developing a set of anti-tax avoidance rules-how it could act to give protection to the graduated rate structure-without directly admitting that it was engaged in judicial law-making. operating under a limited mandate, the court sought to safeguard the rates by manipulating the legal concepts of "income," "property," and "ownership" instead of making bald utterances about taxavoidance.43 of the seminal cases, only helvering v. clifford 4 alludes (and even then obliquely) to the court's underlying policy concern. in clifford, a husband had set up a five-year trust for the benefit of his wife but named himself trustee and in that capacity retained extensive administrative powers as well as the power to determine whether income would be paid currently to his wife or accumulated for her benefit.45 the court held that the totality of the factors-the short duration of the trust, the retention of income within the family group, and the husband's retained powers over the principal of the trust as trustee-irresistibly led to the conclusion that the husband had parted with no substantial control or benefit in the transferred property and hence remained taxable on its income. 6 in posing the problem, the court, through justice douglas, stated that "where the grantor is the trustee and the beneficiaries are members of his family group, special scrutiny of the arrangement 42. see generally boris i. bittker & martin 1. mcmahon. jr., federal income taxation of individuals 31.3, at 31-21 to 31-24 (1988). 43. marvin a. chirelstein, federal income taxation: a law student's guide to the leading cases and concepts 8.05, at 191-92 (6th ed. 1991). 44. 309 u.s. 331 (1940). 45. id. at 332-33. 46. id. at 335. 19931 florida tax review is necessary lest what is in reality but one economic unit be multiplied into two or more,"'47 and added: we have at best a temporary reallocation of income within an intimate family group. since the income remains in the family and since the husband retains control over the investment, he has rather complete assurance that the trust will not effect any substantial change in his economic position.... for where the head of the household has income in excess of normal needs, it may well make but little difference to him (except income-tax-wise) where portions of that income are routed-so long as its stays in the family group.4" here is the essence of the assignment of income doctrine: the concern that the progressive tax rate schedule not be subverted by permitting income to be artificially split among formally separate taxpayers who in fact constitute a single economic unit.49 in more recent years, the courts have become more candid in acknowledging this policy as the basis for the assignment of income doctrine. for example, the supreme court in 1973 extolled the doctrine as "a cornerstone of our graduated income tax system.' '50 today, this explanation is commonplace among both courts5' and commentators.5 2 47. id. 48. id. at 335-36. 49. this conclusion is reinforced by the court's citation of randolph e. paul, the background of the revenue act of 1937, 5 u. chi. l. rev. 41 (1937). clifford, 309 u.s. at 335 n.2. mr. paul emphasized that many of the tax "schemes" the 1937 revenue act was designed to curtail involved splitting a taxpayer's income among multiple related taxpayers comprising a single economic unit: one characteristic underlies several of these devices; the multiplication of the taxpayer's personality. a taxpayer, in almost all the cases mentioned, starts with single individuality and subdivides himself by various mechanisms into a group of people. he subdivides himself into several people, some of whom are incorporated, and others of whom are not. it is a common denominator of the several schemes that the income of a family economic unit shall be treated as if there were no such economic unit. paul, supra at 48-49 (footnotes omitted). 50. united states v. basye, 410 u.s. 441, 450 (1973) (emphasis added). 51. see, e.g., foglesong v. commissioner, 621 f.2d 865 (7th cir. 1980), wherein the court states: the impact of the graduated income tax is eroded when income is split artificially among several entities or over several tax years. the assignment of income doctrine under section 61 of the internal revenue code (as formulated in lucas v. earl) seeks to recognize "economic reality" by cumulating income diffused among several recipients through "artificial" [vol. 1:11 scimeer v. conmmissioner d. nongratuitous assignments of income: a different case all the cases above involved gratuitous assignments of income. what should the rule be when the right to future personal service income is assigned, or exchanged, for consideration? if, as is commonly agreed, the assignment of income doctrine is intended to preserve the integrity of the graduated tax rate schedule, the assignor should be taxed on the amount he receives for the assignment but no more, while any amount collected by the assignee over and above the amount paid for the assignment should be taxed to the assignee. this is in fact the approach adopted by the courts. the vice of a gratuitous assignment of income is that, if respected for tax purposes, it would enable the assignor to shift the incidence of tax on the assigned income to one or more other taxpayers. therefore, a taxpayer, by assigning income, could fragment his aggregate taxable income among multiple taxpayers and thereby avoid the higher rates prescribed by the progressive tax rate schedule. if, however, the assignor assigns his earned income for full and adequate consideration, that is, if he "sells" his right to the earned income for its full value, the incidence of taxation will not be shifted since the taxpayer will receive, and report as taxable income, one dollar for every dollar of income he assigns." since the vice which the doctrine seeks to prevent does not exist in this case, there is no reason to apply the doctrine. but what if the amount received by the assignor differs from the amount ultimately collected by the assignee? provided the transaction is at arm's-length, the assignor still should be taxed on the amount he receives for legal arrangements. id. at 868. 52. bittker & mcmahon, supra note 42, 1 31.1, at 31-3 ("[tihe courts recognized at the outset that transfers within the family, if honored by federal tax law, could seriously undermine the progressive rate schedule."); ralph s. rice, judicial trends in gratuitous assignments to avoid federal income taxes, 64 yale l.j. 991, 991 (1955) (tracing doctrine to the fact that "[t]axpayers in the higher income brackets often seek to redirect their income to objects of their bounty in order to minimize the progressive features of the tax"), lloyd g. soil, intra-family assignments: attribution and realization of income, 6 tax l. rev. 435,435 (1951) ("the problem of the gratuitous intra-family assignment is a creature of the progressive surtax."). but see gunn, supra note 32, at 760-65 (arguing that the assignment of income doctrine is not based on notions of tax avoidance but rather on notions of convenience and fairness). 53. where the assignor receives full consideration for his assignment of income, the assignment will generally not alter the total amount of income the assignor reports. the assignment may, however, affect when he reports the income. for example, the assignor may attempt to defer recognition of his income by assigning income which he is to receive over the next three years in exchange for a lifetime annuity. the applicability of the assignment of income doctrine to tax-motivated attempts to defer income is discussed infra part v.e. 1993] florida tax review the assignment-no more, no less. this is particularly clear where the assignor receives more from the assignee than the assignee collects. in such case, the assignor should be taxed on the full amount received because that is the amount which constitutes his accession to wealth.' there are two possible reasons why the amount received by the assignor may be less than the amount collected by the assignee: (1) the shortfall may be a discount for early payment of the income representing the time value of money; or (2) the shortfall may be the result of an improvident bargain by the assignor. if the shortfall merely represents a discount for the time value of money, the assignor clearly should be taxed only on the amount he receives, since that amount is the financial equivalent of the amount ultimately collected. the government will not lose under this approach, since sale of the income right accelerates the taxation of the earned income and thus the government collects its tax sooner.55 the crucial test of this approach comes where the assignor made an improvident bargain and sold his right to receive income for less than the amount ultimately collected by the assignee. if the dictum that "income must be taxed to him who earns it"" is taken as a metaphysical truth rather than a pragmatic device to prevent tax avoidance, then the assignor should be taxed on all amounts collected on account of his personal services even where that amount, after discount for the time value of money, exceeds what he received from transferring his right to such income. otherwise, not all of the income will "be taxed to him who earns it."57 if, however, the doctrine is recognized as a prophylactic against tax avoidance, the assignor should be taxed only on the amount he receives for his assignment. this is the proper approach and the one adopted by the courts. the effect of this approach on tax revenues should be neutral. where the price of the assignment has been negotiated in good faith on an arm'slength basis, there is no reason to suppose a priori that the amount paid for the assignment will be less or greater than the amount ultimately collected under the assignment. naturally, in some cases the amount received for the assignment will be less than the amount collected by the assignee, but among all the assignments negotiated in good faith at arm's-length there should be 54. see commissioner v. glenshaw glass co., 348 u.s. 426, 431 (1955) (treating "undeniable accessions to wealth" as gross income). 55. moreover, the assignee will have to report any amount he collects in excess of what he paid for the assignment as taxable income. wilkinson v. united states, 304 f.2d 469, 472 (ct. cl. 1962) ("[t]he assignee is taxed on any amount ultimately collected ... in excess of his cost."). 56. commissioner v. culbertson, 337 u.s. 733, 739-40 (1949). 57. id. at 740. [vol 1:11 schmeer v. commissioner an equal number of cases where the reverse is true. as the supreme court observed in a different context, "the united states is in business with enough different taxpayers so that the law of averages has ample opportunity to work."58 in many, probably most, gratuitous assignment of income cases the assignee will be in a lower marginal tax bracket than the assignor, thereby creating the loss of tax revenue. in contrast, there is no reason to suppose that this will be true where the assignment of income is in exchange for valuable consideration in an arm's-length transaction. moreover, taxing the assignor on income collected in excess of the amount he received for his rights would give rise to double taxation. in the case of gratuitous assignments of income, no problem of double taxation arises because the collection of the assigned income by the assignee is simply the realization of the "gift" from the assignor and is therefore excluded from the assignee's income by section 102 of the code. however, section 102 is unavailable to protect the assignee who collects more than what he paid for the assignment in an arm's-length transaction. unless the assignor's income is limited to the amount he receives, the excess amount collected by the assignee would be taxed to both the assignor and the assignee. finally, taxing the assignor on income he does not receive seems inequitable where he has transferred his right to that income in a bona fide arm's-length transaction. of course, the assignor is taxed on income he does not receive in gratuitous assignment of income cases, but the harshness of this result is mitigated since the assignee is an object of the assignor's bounty. this is not true where the assignment is made in an arm's-length transaction. one disadvantage of this approach is that the service and the courts will be required to monitor assignment-for-consideration cases to ensure that they are truly negotiated at arm's-length and are not merely a cover for transferring income to an intended beneficiary of the taxpayer for less than a full and adequate consideration. but this problem is common in our tax system and does not seem to have significantly hindered the effective administration of the tax laws.59 where the courts have recognized that a case involves a sale of an income right for bona fide consideration, they have uniformly taxed the assignor only on the amount he received from the sale, and no more. thus, insurance agents who sell their rights to renewal commissions are taxable only on the amounts for which they sold their rights and not on the amount 58. northeastern pa. nat'l bank & trust co. v. united states, 387 u.s. 213, 224 (1967) (quoting gelb v. commissioner, 298 f.2d 544. 552 (2d cir. 1962)). 59. one instance in which such a problem has arisen is in determining whether a payment to the sole shareholder of a corporation is to be characterized as deductible compensation or a nondeductible dividend. 19931 florida tax review collected by the buyers of such rights; 6° a construction contractor who sells his claim against the government for unpaid construction work is taxable only on the amount for which he sold his claim and not on the amount collected by the assignee;6' and one who sells his right to a contingent fee is taxed only on the amount received by him on the sale and not the fee ultimately collected.62 thus the courts have firmly established two rules in the case of assignments of personal service income: first, all amounts collected by an assignee under a gratuitous assignment of personal service income will be taxed to the assignor; second, a taxpayer who exchanges his right to such income for bona fide consideration will be taxed on the consideration he receives and no more.63 unfortunately, the courts and the service have 60. cotlow v. commissioner, 228 f.2d 186 (2d cir. 1955). the case involved the tax status of the purchaser of the renewal commissions, but in the course of its opinion the court stated: "where there is an arm's-length assignment of income rights for a valuable consideration, it is clear that the assignor realizes only the amount of the consideration received, and the assignee is taxable for receipts in excess of this amount." id. at 188 (emphasis added) (citation omitted). 61. jones v. commissioner, 306 f.2d 292 (5th cir. 1962). 62. in wilkinson v. united states, 304 f.2d 469,472 (ct. cl. 1962), captain bonnin had sold a partial interest in a contingent fee to wilkinson in 1938 for $12,092.17. wilkinson gave that interest to charities in september 1951; later that year the court awarded total legal fees of $2,794,616.43, of which wilkinson's share came to $191,363.28. id. the court held that wilkinson was taxable on the difference between the amount of the awarded fee ($191,363.28) and the amount he paid for the interest in the contingent fee ($12,092.17). id. at 474. this holding, together with the court's observation that "[i]n an arm's-length transaction the assignor of a personal services contract right is taxed on the consideration received, and the assignee is taxed on any amount ultimately collected under the assignment in excess of his cost," id. at 472, strongly suggests that the court would have taxed captain bonnin only on the consideration received from wilkinson and not on the amount of the fee ultimately awarded. 63. this rule is also applied where the taxpayer sells his right to future investment income. see, e.g., estate of stranahan v. commissioner, 472 f.2d 867 (6th cir. 1973) (holding seller of right to future dividends taxable on consideration received). a number of cases have held that a purported sale of future income failed to accelerate the recognition of income. see, e.g., mapco, inc. v. united states, 556 f.2d 1107 (ct. cl. 1977); hydrometals, inc. v. commissioner, 31 t.c. memo (cch) 1260, t.c. memo (p-h) 72,254 (1972), aff'd per curiam, 485 f.2d 1236 (5th cir. 1973), cert. denied, 416 u.s. 938 (1974); martin v. commissioner, 56 t.c. 1255 (1971), affd per curiam, 72-2 u.s. tax cas. (cch) 9637, 30 a.f.t.r.2d (p-h) 72-5396 (5th cir. 1972) (not officially reported). these cases do not reject the principle that a bona fide sale of future investment income will cause the seller to be taxed on the consideration received and no more; rather, they were decided on the ground that the particular transaction before the court was in the nature of a "loan" rather than a bona fide "sale." for example, the court in mapco stated: we ... recognize that a taxpayer may sell a property right to future income. if the bona fide sale occurs at arm's-length for adequate consider[vol. 1:11 sclmeer i conunissioner frequently failed to appreciate the relevance of this basic distinction between gratuitous and compensated assignments of personal service income and have instead been sidetracked by the chimera of the "similarity" and "agency" tests. u. variations on a theme: t-e assignment of income in different contexts set forth below are a number of hypotheticals that have been drawn from actual cases and revenue rulings; these represent the principal controversies that have arisen over the application of the assignment of income doctrine to personal service income. they provide an overview of the diverse but intriguing situations where assignment of income questions occur while at the same time laying the basis for further analysis in the following parts. 64 army reserve pay case: p is a partner in a law firm and under the partnership agreement is obligated to pay over to the firm all "outside" earned income. p is also a member of the united states army reserves and pursuant to the partnership agreement, he dutifully turns over all of his army reserve pay to the firm. is the army reserve pay reportable by p, under the assignment of income doctrine, or by the firm? 65 vow-of-poverty case: father john is a member of the franciscan order. one of the order's missions is serving the poor and the infirm. at the direction of the order, father john applies to become chaplain at a mental hospital run by the state. his application is accepted and he undertakes the duties of being a chaplain. one of his tasks is the celebration of the eucharist and the administration of the sacraments, which in the roman catholic church can only be performed by a priest. father john's religious superior visits him annually to ation, the seller is taxed in the year of sale on the amount of consideration he actually receives and the buyer is taxed on any excess of income received over his purchase price. mapco, 556 f.2d at 1110. 64. unless otherwise indicated, the taxpayers in the hypothetical cases described in this article employ the cash receipts and disbursements method of accounting. 65. this hypothetical was suggested by i.t. 3824, 1946-2 c.b. 37 (a partner's compensation for service in the armed forces does not constitute partnership income). 19931 florida tax review observe and monitor performance of his priestly duties. pursuant to father john's vow of poverty (which is legally enforceable), he remits all of his pay from the state, less a small allowance for his subsistence, to his order. is the amount father john remits taxable to him under the assignment of income doctrine? 66 law school clinic case: law school x operates a criminal law clinic which is supervised by a full-time faculty member f. from time to time, f is appointed by the federal district court under the criminal justice act to represent indigent defendants in criminal matters, and in those instances students in the clinic assist f in the defense of the defendants. the act authorizes the payment of compensation to the counsel of record-but not to the law school. however, f has agreed with the law school, as a condition of her participation in the program, to turn over to the law school any fees she may receive from the court. therefore, f endorses all checks received by her under the act to law school x. is f taxable on these fees under the assignment of income doctrine?67 personal service corporation case: 0 was a manufacturers' representative for producers of steel tubing. operating as a sole proprietor, 0 netted about $250,000 a year. no more than $5,000 of this amount represented a return on the few assets he used in the business (e.g., his word processor, photocopier, etc.); the balance ($245,000) was solely attributable to o's personal services. on the advice of his attorney, 0 at the beginning of 1970 formed newco, inc. in which he was the sole shareholder and employee. thereafter, he conducted his business of representing manufacturers through the corporation. o's salary from newco, inc. for 1970 was fixed at $100,000 leaving the corporation with a net profit of $150,000. was 0 taxable on $245,000 in 1970 under the assignment of income doctrine, since that was the amount of income his services produced?68 66. this hypothetical was suggested by kircher v. united states, 872 f.2d 1014 (fed. cir. 1989). 67. this hypothetical was suggested by rev. rul. 74-581, 1974-2 c.b. 25. 68. this hypothetical was suggested by foglesong v. commissioner, 35 t.c. memo (cch) 1309 (1976), rev'd and remanded, 621 f.2d 865 (7th cir. 1980), on remand, 77 t.c. [vol 1:11 schneer v. conmmissioner basketball player case: b, a basketball player, is acutely aware that the life of a professional athlete is short. he wishes to spread out the income he earns during his "good years" over his lifetime to reduce his overall tax burden. on the advice of his attorney, he enters into an agreement with an unrelated corporation, x corp., to provide all his services in professional sports to x corp. for six years in return for $18,000 a year for the rest of his life. b's attorney then attempts to negotiate an agreement between hawks, a professional basketball club, and x corp. under the terms of which x corp. would provide the hawks with b's services as a basketball player for the next three years for $100,000 a year. however, because of the hawks' adamant insistence that it will only deal directly with b, b enters into an agreement with the hawks to play basketball for it for the next three years for $100,000 a year, and then assigns his rights to this pay to x corp. is b taxable on $100,000 a year under the assignment of income doctrine, or only on the $18,000 a year he receives from x corp.? 69 a preliminary question is whether the earner of the income in these cases would be entitled to a deduction for the amounts he or she pays over to the assignee even if the assignment of income doctrine applies? the answer is that the payment over to the assignee generally qualifies as a deduction but frequently fails to provide a full offset. if the earner is an employee who turns over the earned income to her employer pursuant to her employment contract (as in the "law school clinic case") the amount turned over will qualify as an ordinary and necessary business deduction" but will be deductible only to the extent that it and other "miscellaneous deductions" exceed two percent of the employee's adjusted gross income.7' if the earner turns his earned income over to a religious organization (as in the "vow-ofpoverty case"), the amount turned over will qualify as a charitable deduction72 but will only be deductible to the extent of fifty percent of the 1102 (1981), rev'd, 691 f.2d 848 (7th cir. 1982). 69. this hypothetical was suggested by johnson v. united states, 698 f.2d 372 (9th cir. 1982), and johnson v. commissioner, 78 t.c. 882 (1982), aff'd, 734 f.2d 20 (9th cir.). cert. denied, 469 u.s. 857 (1984). 70. see, e.g., rev. rul. 66-377, 1966-2 c.b. 21 (permitting a deduction under irc § 162 for fees from private practice turned over to medical school by faculty members as required by their employment agreements). 71. irc § 67. 72. see, e.g., rev. rul. 76-323, 1976-2 c.b. 18 (holding compensation from outside 19931 florida tax review earner's adjusted gross income.73 since most members of religious orders have no other taxable income, their income almost invariably exceeds the amount deductible as a charitable contribution. if the earner is a partner who turns his outside income over to his partnership pursuant to the partnership agreement (as in the "army reserve pay case"), the answer is unclear. judge beghe, who concurred with the result in schneer, would allow a full deduction for the income turned over,74 but judge halpern in his dissent suggested that possibly no portion of the amount turned over would be deductible since it may constitute a nondeductible contribution to capital under section 721 of the code.75 in short, whether it is theoretically correct to apply the assignment of income doctrine in the above cases is of crucial practical significance. iv. the "similarity" and "agency" tests: failed solutions a. introduction this part will review and analyze the attempts of the courts and the service to resolve assignment of income problems by using the "similarity" and "agency" tests. this analysis will show that these tests are wholly inadequate to the task; they are neither rational nor workable, and they lead to irreconcilable results. the most noteworthy feature of the cases and rulings discussed below is failure of the courts and the service to discern the relevance of the basic distinction between gratuitous and nongratuitous assignments of income to the question at hand. not one of these cases or rulings even alludes to this basic distinction despite its relevance. part v will show that this distinction provides a rational basis for resolving these problems and for reconciling the cases and rulings. employment remitted by member of religious order to order deductible under irc § 170). 73. irc § 170(b)(1)(a)(i) (limiting charitable deduction to 50% of donor's contribution base); irc § 170(b)(1)(f) (defining "contribution base" as taxpayer's adjusted gross income computed without regard to any net operating loss carryback). 74. schneer, 97 t.c. at 663-64 (beghe, j., concurring). 75. id. at 669-70 (halpern, j., dissenting). martin b. cowan asserts that if the amount paid over to the firm is a nondeductible capital contribution under irc § 721, then that amount must be excluded from the firm's taxable income. he further argues that the reduction in the firm's taxable income must be allocated solely to the contributing partner's share of taxable income to satisfy the economic effect requirement of irc § 704(b). the result is that the contributing partner will not be taxed twice on the same income. cowan, supra note 20, at 1542-44. [vol 1:11 scimeer vt conmissioner b. the similarity test partnership agreements frequently require every partner to turn over to the partnership all income he earns regardless of whether he earns that income in his capacity as a partner or in his individual capacity. 6 thus, many law partnerships require their partners to turn over to the partnership all fees they earn for serving as executors or as corporate directors.' the purpose of this provision is to assure that no partner will be tempted to divert his time and attention from partnership matters to those matters in which he receives all the income.78 by requiring the partners to pool all their earned income from whatever source derived, the partnership ensures that the partners will maximize their efforts on behalf of the partnership as a whole. a series of rulings has considered whether income earned by a partner in his individual capacity which he pays over to the partnership pursuant to such an agreement is taxable to the partner under the assignment of income doctrine or reportable by the partnership. the service initially ruled that the income was taxable to the individual partner if the activity producing the income was one which the partnership could not, or did not, perform as an entity. thus, it held that compensation received by a partner for his active service in the military that he paid over to the partnership was taxable to him and not reportable by the partnership: obviously, a partnership can not [sic] exist for the purpose of serving in the armed forces, and it is clear that compensation and allowances received by an individual for military service can not [sic] be transmuted, in the manner here involved, into earnings and profits (as such) of a partnership of which he is a member. 9 76. cowan, supra note 20, at 1541; william l. raby, outside income of professionals who practice in firms, 54 tax notes 423, 423-24 (jan. 27, 1992) (listing types of income that partners are usually required to turn over to their partnerships). 77. see raby, supra note 76, at 423-24. 78. see cowan, supra note 20, at 1541. the author noted that: [a] firm cannot long exist if each partner can go off on his own whenever he determines his personal interest would be benefitted by doing so.... accordingly, it is common, if not close to universal, to insist that all partners ... bring all of their law and law-related activities into the firm and that any services they render in connection with such matters be on behalf of the firm. id. 79. i.t. 3824, 1946-2 c.b. 37, 38. 19931 florida tax review likewise, it ruled that the salary received by a partner for his service as an elected official which he turned over to the partnership was taxable to the partner individually since "[a] partnership cannot exist for the purpose of serving as an elected public official.""s the service retreated from this position in a 1964 ruling which held that fees turned over to a partnership by a partner for a service which the partnership did not, or could not, provide would nevertheless be reportable by the partnership so long as the service was "similar" to those performed by the partnership."' the service expanded on the "similarity" test in a 1980 ruling which held that executor's commissions turned over by a partner to his accounting firm pursuant to the partnership agreement were reportable by the partnership, and not the partner, even though state law prohibited a partnership from acting as executor.8 2 the ruling reasoned that although state law prohibited a partnership from serving as executor, such a "function was within the range of services undertaken by accountants," and added that "[i]t is not unusual in an accounting or legal practice that specific responsibilities must be assumed by an individual partner rather than by the partnership."" in each of the above rulings, the service made its pronouncements ex cathedra; it did not deign to explain why the similarity between the services performed by a partner in his individual capacity and the services performed by the partnership as an entity should have any bearing on the applicability or nonapplicability of the assignment of income doctrine. in schneer v. commissioner, the tax court also held in favor of the taxpayer on the basis of the similarity test: it found that the consulting services performed by schneer for the clients he had introduced to his old firm were "similar" to the legal services provided by his new firm. 84 but like the service, the court offered no convincing rationale or justification for the similarity test. it was 80. rev. rul. 54-167, 1954-1 c.b. 152, 152. cf. hamm v. commissioner, 40 t.c. memo (cch) 284, t.c. memo (p-h) 80,154 (1980) (holding that salary earned by partner in his capacity as a judge did not constitute partnership income), aff'd, 683 f.2d 1303 (10th cir. 1982). the rationale of the holding is unclear. the tax court stated that income earned by a partner for services "outside of the scope of his partnership duties" is taxable directly to the partner even if he assigns it to the partnership, and it found that taxpayer's duties as "a district court judge were not within the scope of any partnership duties." hamm, 40 t.c. memo (cch) at 285. however the court found that the salary was earned after the dissolution of the partnership. hamm, 40 t.c. memo (cch) at 285, t.c. memo (p-h) at 80-747. the court of appeals affirmed solely on the ground that the partnership had been dissolved. hamm, 683 f.2d at 1304. 81. rev. rul. 64-90, 1964-1 c.b. (part i) 226, 227. 82. rev. rul. 80-338, 1980-2 c.b. 30. 83. id. 84. schneer, 97 t.c. at 656 ("his referral fee income was clearly earned through activities 'within the ambit' of the business of his new partnerships."). [vol 1:11 schneer v. conmissioner this aspect of the decision which caused judge halpern, and has since caused others, to denounce the court's decision as "unprincipled."' the schneer court did find that an inherent tension existed between the assignment of income doctrine and the partnership provisions of subchapter k.86 in a partnership, different individuals may agree in advance on the division of partnership income. that agreement will be respected for tax purposes even if it turns out that the amounts payable under the agreement to some partners are disproportionately large or disproportionately small relative to the amount of partnership income their services generated. in effect, those partners whose efforts generated a disproportionately large amount of income relative to their distributive shares are making assignments of some of the income they earned to the other partners; yet those partners are taxed only on their distributive shares and not the amount of income their services produced. from this, the court concluded that congress intended for the partnership rules permitting the pooling of gains and losses to override, at least in part, the assignment of income doctrine.' the problem, in the court's mind, was to determine the extent to which the pooling permitted by subchapter k displaced the assignment of income doctrine. the court concluded that the similarity test gave the answer pooling would be permitted so long as the services performed by an individual partner are similar to the services performed by the partnership. the trouble with the court's opinion is its failure to provide any reason for its conclusion. if the pooling provisions of subchapter k override the assignment of income doctrine where the individual partner's services are similar to those offered by the partnership, why do they not also prevail where the individual's services are unrelated to those offered by the partnership? the court gave no answer to this question.8 commentators, however, have offered several possible explanations or justifications for the similarity test. one has suggested that the test provides a "rough and ready" basis to determine the bona fides of the 85. id. at 669 (halpern, j., dissenting); see supra note 20. 86. sclueer, 97 t.c. at 657-58. 87. id. 88. the court observed that "[i]f the partners perform services in the name of the partnership or individually they are, nonetheless, associated with the partnership as a partner.id. at 661-62 (emphasis added). it is unclear whether this statement was meant to justify the similarity test, but in any event the statement is equally true whether the services performed by the partner are similar or dissimilar to those performed by the partnership. consider the law firm partner who is also a united states senator and who turns his salary as senator over to the firm pursuant to the partnership agreement. service as a senator would probably not be considered similar to the services provided by his law firm. nonetheless, the notoriety of the senator's position and the possible perception that the senator's position gives the firm's clients access and influence (whether true or not) will inevitably increase the firm's business. 19931 florida tax review partnership. 89 for example, in mayes v. commissioner,9° the tax court refused to permit a son's income as an airplane engine mechanic to be pooled as partnership income with his father's accounting and real estate rental income. 9' although the court did not say so, perhaps it suspected that the purported partnership was merely a device for splitting income between two related parties to minimize their overall tax burden. the close family relationship between the parties and the dissimilarity in the types of income which they were attempting to pool may have fanned the court's skepticism. this may indeed "explain" why the courts have used the similarity test, but it does not "justify" its use. even as a warning device alerting the court to greater scrutiny, the similarity test has little utility where the parties are unrelated and are dealing with each other at arm's-length. and where the parties are related, the test's use should be limited to raising a cautionary "go slow" sign, not for automatically disregarding a bona fide partnership. some have suggested that "public policy" concerns may justify the use of the similarity test, at least in certain instances. 92 in other words, the courts and the service may have felt that it violated public policy to give effect to an arrangement under which a publicly elected official, or a member of the armed forces, shares his salary from these activities with his law partnership. however, neither the courts nor the service asserted public policy as the basis for the similarity test.93 moreover, it is difficult to discern any compelling public policy that is being violated in these cases. consider the case of a law firm partner who is also a justice of the peace. the code of judicial conduct strictly prohibits him from hearing any case involving any 89. cowan, supra note 20, at 1538. 90. 21 t.c. 286 (1953). 91. id. the court of appeals for the tenth circuit reached the same result in a proceeding involving the father's tax liability for other years. mayes v. united states, 207 f.2d 326 (10th cir. 1953). see also villere v. commissioner, 133 f.2d 905 (5th cir. 1943), in which the court refused to recognize a partnership between two brothers, who had purportedly agreed to split their aggregate income equally, where one brother earned a large salary and had dividend income while the other had only a small income. 92. cowan, supra note 20, at 1541-42. 93. see, e.g., rev. rul. 64-90, 1964-1 c.b. (part i) 226; rev. rul. 54-167, 1954-1 c.b. 152; i.t. 3824, 1946-2 c.b. 37. moreover, the relatively mild sanction that these rulings imposed upon a partner who did pool one of these types of income with partnership income suggests that public policy was not the basis for their holdings. in general, these rulings adopted an approach that, aside from matters of timing, produced the same taxable result as if such income had been permitted to be pooled. thus, if the amount of the income assigned by a partner exceeded his share of the pooled income under the partnership agreement, the rulings allowed him a deduction for the difference. for an illustration of this approach, see rev. rul. 64-90, 1964-1 c.b. (part i) 226, 226-27. schneer appears to be the first instance where the service did not adjust the partner's distributive share of partnership income when it applied the assignment of income doctrine. [vol 1:11 scluzeer v. conunissioner client of his firm, regardless of the nature of his financial arrangement with his firm. 4 since this rule largely, if not entirely, precludes conflicts of interest from arising between his role as judge and his role as a partner of the firm, it is difficult to see how public policy is violated if he pays his justice of the peace salary to his firm." it is even more difficult to see how public policy is violated when a member of the armed forces pays his salary into the firm. furthermore, the supreme court has stated that the normal rules of taxation should give way to public policy concerns only where the policy is "sharply defined 96 and publicly stated. diligent research has failed to unearth any statute, cannon of ethics, bar association ruling, or case holding that it is improper for a publicly elected official, a justice of the peace, or a member of the armed forces to pay his salary into a partnership. thus the 94. the code of judicial conduct permits a part-time judge, such as a justice of the peace, to continue to practice law. model code of judicial conduct, compliance with the code of judicial conduct a(1) (1972). but he may not participate "in a proceeding in which his impartiality might reasonably be questioned." model code of judicial conduct canon 3c( 1). this of course would preclude the justice of the peace from hearing any case in which his firm was involved. 95. cowan, supra note 20, at 1541-42 states: where a partner renders services as a corporate director or as a fiduciary, the loyalty and conflict of interest issues normally require a pooling, and there is no public policy that prohibits this. however. working as a judge, or as a soldier, does not require pooling, and the allocation of time, expenses, and other resources should be determined by considerations that may be utterly inconsistent with those dictated by firm loyalty and possible conflicts of interest. serving in the armed forces or as a judge requires sole loyalty to that employer, and a sharing of loyalty with a partnership of other individuals is completely contrary to public policy. i have two observations. first, the issue of whether a partnership needs pooling with respect to a given activity seems best resolved by the partners themselves. second, the possibility of significant conflicts of interest arising between a partnership and an outside party seems most likely where the partnership and the outside party have an ongoing relationship, as in the case of an estate or a corporation represented by the firm. thus, in the case of a partner who serves as an executor there will be obvious conflicts in selecting legal counsel for the estate, determining the amount of legal fees to be charged, and determining whether the partner should be permitted to receive both legal fees and executor's commissions. in contrast, the possibility of significant conflicts of interest arising between a partnership and the united states army where a partner serves in the army reserves seems highly remote. 96. commissioner v. heininger, 320 u.s. 467, 473 (1943) (stating that "ordinary and necessary" business deductions may be disallowed only if the allowance of such deductions would "frustrate sharply defined national or state policies"). 97. lilly v. commissioner, 343 u.s. 90, 96-97 (1952) (stating that "ordinary and necessary" business deductions may be disallowed only where their allowance would frustrate national or state policies which are "evidenced by some governmental declaration of them-). 19931 florida tax review minimum requirements for invoking public policy in a tax case have not been met. an obvious difficulty in applying the similarity test is determining whether one activity is similar to another. for example, in the district of columbia nonlawyers are permitted to be partners with lawyers.98 are the services performed by an economist or a lobbyist in such a firm similar to those performed by lawyers?" are services performed by a trust lawyer who is primarily engaged in drafting and tax analysis similar to those of a criminal lawyer who is constantly in court trying cases? what about services performed by an architect and an engineer? 1° since neither the service in its rulings nor the court in schneer explains the reason for the similarity test, there is no meaningful guidance on how to make this type of determination. 101 but the real deficiency of the similarity test is this: any test which purports to define the limits and contours of a doctrine like the assignment of income doctrine should be grounded in policies underlying that doctrine. that is, the test should limit application of the doctrine where the policies underlying the doctrine cease to be relevant. neither schneer nor the service's rulings justify the similarity test in terms of the policies underlying the assignment of income doctrine. part v below, shows how reference to the policies underlying the assignment of income doctrine leads to a proper resolution of the problem posed by schneer and similar cases. c. the agency test outside the partnership area, the most popular test for resolving assignment of income questions is the "agency" test. under this test, if the person who earned the income was acting on his own behalf, the income will be taxed to him; however, if he was acting as another's agent, the income will be taxed to his principal. this approach is illustrated by the "vow of poverty" cases where typically a member of a religious order takes "outside" employment at the order's direction and then, pursuant to her vow of poverty, turns over the earnings from that employment to the order. the service has consistently 98. see district of columbia rules of professional conduct rule 5.4(b), reprinted in d.c. r. civ. p. 5.4(b). 99. this question is posed in sheppard, supra note 9, at 9. 100. this question is posed in cowan, supra note 20, at 1541. 101. in his dissent in schneer, judge halpern observed that the failure of the majority to articulate an understandable rationale for the similarity test left the courts without "any effective guidelines" for resolving future cases. schneer, 97 t.c. at 669 n.3 (halpern, j., dissenting). see supra notes 25-26 and accompanying text. [vol. 1:11 schmeer v. conmnissioner ruled that a member's earnings are not taxable to her where she is acting as the order's agent in working for the employer, but are taxable to her if she is acting on her own behalf.0 2 both the service and the courts have recognized that vows of poverty are legally enforceable so that if the member fails to remit her earnings to the order, the order can legally collect them from her.0 3 early rulings involved situations where the work performed by the member was unrelated to the work or mission of the order, for example, where the member took a job in the plumbing or construction industry"1 or as an associate in a law firm. 05 in each of these rulings, the service found that the member was not acting as the order's agent but on her own behalf to benefit the order and therefore was taxable on the full amount of her earnings. none of these rulings explained the reasons for finding that the member was not acting as her order's agent. it might have been inferred from the facts that the crucial factor was the dissimilarity between the order's mission and the services performed by the members-in other words, that the service was importing the similarity test from the partnership rulings-but a 1979 ruling made it clear that similarity, even identity, would not suffice to make the member an agent of the order."° that ruling involved a military chaplain in the united states armed forces who turned over his pay to the order pursuant to his vow of poverty.0 7 here, the services performed by the chaplain were not only similar to the work or mission of the order, they were identical with that of the order. nevertheless, the ruling found that the chaplain was working on behalf of himself and not as an agent of the order. the ruling stated that "an agency relationship is established when it appears, based on all the facts and circumstances, that the payer of the income is looking directly to the order, rather than to the individual member, for the performance of the services."'8 since the chaplain was an employee of the armed services and subject to its rules and regulations, the ruling found that the armed services were looking to the chaplain, not his order, for the performance of his services, and hence he was not acting as agent of his order.'09 the agency test, as refined by the 1979 ruling, has become possibly the most popular test in resolving assignment of income issues. in practice it 102. see, e.g., rev. rul. 77-290, 1977-2 c.b. 26, 27. 103. see, e.g., id. and fogarty v. united states, 780 f.2d 1005, 1009 (fed. cir. 1986), each relying on order of st. benedict v. steinhauser, 234 u.s. 640 (1914). for the proposition that vows of poverty are legally enforceable. 104. rev. rul. 76-323, 1976-2 c.b. 18, 19. 105. rev. rul. 77-290, 1977-2 c.b. 26, 26-28. 106. rev. rul. 79-132, 1979-1 c.b. 62. 107. id. at 62. 108. id. at 63. 109. id. 19931 florida tax review works in a highly mechanistic manner: if a contract or agreement exists between the employer and a third party under which the third party provides the services of the employee to the employer, the employee will be treated as the third party's agent. in the absence of such a contract or agreement, the employee will be treated as acting on his own behalf and accordingly will be taxed on his earnings. the tax court adopted this approach, sometimes called the "agency triangle" theory, in schuster v. commissioner, i0 another vow of poverty case. sister francine schuster was a member of an order one of whose purposes was "the care and treatment of suffering humanity."''. members were allowed to obtain outside employment provided they received the prior approval of the order; approval depended on whether the proposed employment furthered the charitable objectives of the order." 2 members who received outside employment agreed they would obey any direction of the provincial superior concerning their employment including a direction to terminate that employment.'' l sister schuster obtained the permission of the order to serve as a midwife in an underserved area in a clinic aided by the national health services corps ("nhsc"), a federal agency."4 sister schuster was employed by and received her checks from the nhsc." 5 the order had attempted to enter into a contract directly with the nhsc but the nhsc did not respond to the order's request.6 sister schuster, pursuant to her vow of poverty, endorsed over to the order all checks she received from the nhsc and asserted on her income tax returns that she was not taxable on the salary she received from the nhsc since she was acting as the agent of the order. 1' 7 the tax court rejected this claim because the order was under no contractual liability to provide midwife services to the nhsc. [i]n the legal sense, one can perform services for a third party on someone's "behalf' only if some sort of obligation to perform the services rests initially with the person on whose behalf one wishes to act. if the "principal" is under no duty to perform the services itself, or to ensure that the services be performed, but merely approves of the 110. 84 t.c. 764 (1985), aff'd, 800 f.2d 672 (7th cir. 1986). 111. schuster, 800 f.2d at 673. 112. id. at 673-74. 113. id. at 674. 114. id. 115. id. at 675. 116. id. 117. id. [vol 1:11 schneer v. conunissioner performance as an irrelevant bystander, then, in the legal sense of the word, one cannot act on the other's behalf."' a variation of the "agency triangle" theory was utilized by the tax court in johnson v. commissioner" 9 which involved a so-called "loan out" corporation. 20 johnson was a basketball player with the san francisco warriors. 2 ' in 1974, he entered into an agreement with an unrelated panamanian corporation ("pmsa") under which he granted the corporation exclusive rights to his professional services in sports for the next six years in exchange for monthly payments of $1,500 for the rest of his life. johnson's attorney, who was negotiating the renewal of johnson's contract with the warriors at that time, attempted to have the warriors contract with pmsa for johnson's services.2' however, the warriors adamantly insisted that it would only sign a contract with johnson." consequently, johnson signed a contract directly with the warriors and assigned his salary under the contract to pmsa.2t the internal revenue service determined a deficiency based on the difference between the amount johnson received from pmsa and his salary under his contract with the warriors.' -6 the court held for the service. an examination of the case law from lucas v. earl hence reveals two necessary elements before the corporation, rather than its service-performer employee, may be considered the controller of the income. first, the service-performer employee must be just that-an employee of the corporation whom the corporation has the right to direct or control in some meaningful sense.... second, there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation's controlling position.'27 118. schuster, 84 t.c. at 774. 119. 78 t.c. 882 (1982), afftd, 734 f.2d 20 (9th cir.), ccrt. denied, 469 u.s. 857 (1984). 120. id. 121. id. at 883. 122. id. at 884. pmsa could terminate the s1,500 monthly payments if johnson failed to play for any professional athletic teams for any consecutive 24-month period. id. at 886-87. 123. id. at 884. 124. id. 125. id. at 884-85. in fact, johnson assigned his salary to pmsa's assignee. id. 126. id. at 889. 127. id. at 891 (footnote omitted) (citation omitted). 19931 florida tax review although the court assumed arguendo that the first requirement was met, it held against johnson since clearly the second requirement was not met. 2s some courts have rejected both the "agency triangle" theory and the johnson "two part test" as overly rigid and have opted instead for a supposedly more flexible approach. on the appeal of the schuster case from the tax court, the court of appeals for the seventh circuit expressly rejected both tests and chose instead to make its determination of whether an agency relationship existed on the basis of the six factors listed by the court of claims in fogarty v. united states: 29 1) the degree of control exercised by the order over the member; 2) ownership rights [to the compensation as] between the member and the order; 3) the purposes or mission of the order; 4) the type of work performed by the member vis-a-vis the purposes or mission; 5) the dealings between the member and the third-party employer, including the circumstances surrounding inquiries and interviews, and the control or supervision exercised by the employer; and 6) the dealings between the employer and the order. 30 while the schuster court acknowledged that the third and fourth factors "arguably" pointed toward the existence of an agency relationship, it nevertheless held that sister schuster was not acting as agent of her order.'3 ' the court emphasized that the order did not exercise "day-to-day control" over sister schuster in her activities as midwife in the clinic (the first factor), that the checks were issued to sister schuster rather than the order thereby giving her greater control over the compensation (the second factor), and that sister schuster, not her order, had been employed to act as midwife (the fifth and sixth factors). 132 although the fogarty "six-part" factor test purports to be more flexible than the "agency triangle" test or the johnson "two part test," 128. id. at 891-92. in sargent v. commissioner, 93 t.c. 572 (1989), rev'd, 929 f.2d 1252 (8th cir. 1991), the taxpayers, professional hockey players, formed professional service corporations, which in turn contracted with the owner of the minnesota north stars hockey team to furnish the services of the taxpayers. thus, the second part of the johnson test was satisfied. however, the tax court found the hockey team exerted such extensive "on-the-job" control over the taxpayers that it, rather than the professional service corporations, was the true employer of the taxpayers. sargent, 93 t.c. at 580. the eighth circuit reversed, holding that the contracts between the taxpayers and their respective professional service corporations established the requisite employer-employee relationships. sargent, 929 f.2d at 1261. 129. 780 f.2d 1005 (fed. cir. 1986). 130. schuster v. commissioner, 800 f.2d 672, 677 (7th cir. 1986). 131. id. at 678. 132. id. at 678-79. [vol 1:11 scimeer v. commissioner it almost invariably will produce the same result. if the employer's contract is with the member instead of the order, then the employer will normally exercise more day-to-day control over the member than the order does and the checks will be issued to the member instead of the order. there are many difficulties with the agency tests as applied by the service and the courts. first, they are irreconcilable with many of the service's own rulings. in revenue ruling 58-515,'-" a police officer in the performance of his official duties took a job in private industry "for the purpose of obtaining certain information for the [police] department without disclosure of his identity."' during this period of employment, the officer continued to receive his regular pay from the department, and in accordance with departmental regulations turned over his pay from the private employer to the police pension fund. 3 ' the ruling held that the police officer was not taxable on the pay from the private employer since he "was employed in private industry as an agent of the police department."'" obviously, the private employer here was looking to the officer and not the police department for the performance of his duties; it did not even know that its employee was a police officer. obviously, it was the private employer, rather than the department, that exercised greater control over the police officer in the performance of his day-to-day activities on the employer's job, and both his pay and the form w-2 were issued to the officer and not the department.'" although the inconsistency may not be as pointed, other rulings also diverge from the "agency triangle" theory and related tests. for instance, in revenue ruling 65-28218 attorneys accepted employment at a fixed salary with a legal aid society and agreed, as a condition of their employment, to turn over any court-awarded fees to the society.' 3 under the applicable state statute, the court appointed individual attorneys to represent indigent persons accused of crimes, and upon completion of their representation, the attorneys were paid by the county on order of the appointing court." the ruling held the attorneys who immediately paid over such fees to the society in accordance with their employment agreements were not taxable on the fees since "the attorneys are considered to be receiving the fees as agents for the legal aid society.' 4' the ruling found that the individual attorneys were 133. 1958-2 c.b. 28. 134. id. at 28 (emphasis added). 135. id. 136. id. 137. id. 138. 1965-2 c.b. 21. 139. id. at 21. 140. id. 141. id. 19931 florida tax review agents of the society even though (1) the court appointed the individual attorneys rather than the society to represent the indigent; (2) the court exercised disciplinary authority over the individual attorneys; (3) there was no contract between the court and the legal aid society for the society to provide the services of the attorneys; (4) the court awarded the fees to the attorney rather than the society; and (5) checks were issued to the attorney and not the society. the striking divergence in the service's treatment of seemingly similar cases is illustrated by a comparison of its holding in revenue ruling 74-581 142 with the service's successful litigating position in kircher v. united states. 43 revenue ruling 74-581 involved a law school's clinical program.' 44 from time to time, a federal district court or a state supreme court would assign a faculty member who was an attorney to represent an indigent defendant in a criminal matter pursuant to the criminal justice act of 1964.145 students in the clinical program would assist the attorneyfaculty member in the defense of the case. 146 the faculty members participating in the program had agreed, before entering the program, to endorse over to the law school any fees received under the criminal justice act. 47 in the ruling, the clerk of the court took the "generally acknowledged position" that fees under the act could not be paid to the law school but must be paid directly to the assigned attorney. 48 therefore, in practice, the attorney-faculty member would submit vouchers to the appropriate court in his or her name, and upon receipt of the check would endorse it to the law school. 149 the ruling held, without explanation, that the attorney-faculty member was not taxable on the fees. 50 in kircher v. united states, a mental hospital operated by the state of ohio had an organized pastoral service to meet the needs of its patients.' 5 ' the hospital required that before any candidate could be appointed as chaplain, he must first be appointed by the ecclesiastical body of which he is a member. 52 since only a priest can celebrate the eucharist and administer the sacraments in the roman catholic church, only ordained 142. 1974-2 c.b. 25. 143. 872 f.2d 1014 (fed. cir. 1989). 144. 1974-2 c.b. 25, 25. 145. id. 146. id. 147. id. 148. id. at 25-26. 149. id. at 26. 150. id. 151. 872 f.2d at 1016. 152. id. at 1016. [vol 1:11 schneer v. conunissioner priests could serve as catholic chaplains at the mental hospital.' in 1972, the franciscan order appointed father waldschmidt to serve as chaplain at the state mental hospital."5 however, before undertaking his duties as chaplain, father waldschmidt was required to submit his application for employment to the hospital and have it approved by the superintendent of the hospital; this was duly done.' the hospital did not interfere with father waldschmidt's performance of his priestly duties, except to the extent his duties "would violate the rules and regulations governing the care of the patient."'56 father waldschmidt had an annual visitation by his religious superior and various other visits by members of the franciscan order to monitor the manner in which he was performing his duties.' the state of ohio treated father waldschmidt as a full-time state employee and issued checks for his service payable to him which he then duly remitted to the franciscan order.158 the court sustained the service's contention that father waldschmidt was not the order's agent and that therefore the salary was taxable to him. 59 the results in revenue ruling 74-581 and kircher cannot be reconciled on the basis of any of the tests for determining agency. in both cases, the contract or appointment from the third-party "employer" (the hospital in kircher and the court in the ruling) ran directly to the purported agent rather than the purported principal; in neither case was there a contract by the purported principal to provide the services of its agent to the third party. in both cases, the checks were payable to the purported agent and not the purported principal. in both cases, there was a close nexus between the "principal's" mission and the services performed by its purported "agent." finally, nothing in the ruling suggests that the law school exercised any greater control over the faculty member-attorney in his or her representation of the indigent client than the franciscan order exercised over father waldschmidt's performance of his priestly duties. in short, there seems to be no principled basis for distinguishing the ruling and kircher on the basis of agency. either kircher is wrong or the ruling is wrong, or else the courts and the service have overlooked the basis on which they may be reconciled. 153. id. at 1016-17. 154. id. at 1017. 155. id. 156. id. 157. id. 158. id. 159. id. at 1019-20. 1993] florida tax review v. resolving the conflicts: a return to basics a. the overlooked distinction surprisingly none of the cases or rulings discussed above even alludes to the basic distinction between gratuitous assignments of income and assignments for consideration. invariably, each of them cites the classic gratuitous assignment of income cases-earl, horst, and eubank-without regard to the type of case under consideration. this is strange since some of these cases fall in one category while the remainder fall in the other, and thus are subject to dramatically different rules of taxation. schneer, for instance, is clearly an assignment-for-value case. in negotiating the terms of his admission as partner to the second and third firms, schneer was engaged in an arm's-length transaction with unrelated parties in an effort to maximize his economic position. schneer intended to get back a dollar for every dollar of income he assigned; and the law presumes that in an ann's-length transaction the amount transferred by one party equals what he receives in return.'6 although the opinion is silent on the point, the transcript shows that in return for schneer's agreement to share his fees from the first firm with the partners of the second firm, schneer was permitted to share in the fees the second firm collected for work it performed before he joined the firm.16 1 clearly, there was a quid pro quo for the release of his right to the fees from the first firm. there is simply no reason to believe that income was being gratuitously shifted in this case from one taxpayer to another. revenue ruling 74-58 1162 (the law school clinic ruling) and revenue ruling 65-282 163 (the legal aid society ruling) are also assignment-forconsideration cases. in revenue ruling 74-581, the full-time faculty member operating the criminal law clinic received consideration, her law school salary, for endorsing over her checks to the law school."64 her salary was intended to compensate her for all her duties as faculty member, including her duties in running the law school clinic.' 65 permitting her to retain both the court-awarded fees and her salary would have resulted in double compen160. united states v. davis, 370 u.s. 65, 72-73 (1962); philadelphia park amusement co. v. united states, 126 f. supp. 184, 189 (ct. cl. 1954). 161. record at 28-29, schneer (no. 31804-88) (testimony of robert sylvor). 162. 1974-2 c.b. 25. 163. 1965-2 c.b. 21. 164. 1974-2 c.b. 25, 25. 165. id. "[t]he time spent in supervising work of students on these cases and in the representation of the client is part of the faculty member's teaching duties for which the faculty member is compensated by a total annual salary .... id. [vol 1:11 schmeer v. conmmissioner sation for the same services. if her salary did not fully compensate her for her service to the law school, including her operation of the clinic, she presumably would have declined to participate in the clinical program or else would have bargained for an increase in her salary. on the other hand, if the law school had permitted the faculty member to retain the court-awarded fees, it undoubtedly would have reduced her law school salary by a corresponding amount.' 66 there is no reason to believe that income either was intended to be, or was in fact being, shifted from the faculty member to the law school. in revenue ruling 65-282, the attorneys in the legal aid society received for their services and their agreement to pay over to the society all court-awarded fees a fixed salary and presumably the use of office facilities and staff support. 167 if this package of benefits did not fully compensate the attorneys, they presumably would not have accepted employment from the society. again, there is no evidence that these attorneys intended to, or did in fact, shift any income from themselves to the society. in contrast, in the "vow-of-poverty" cases both the intent and effect of gratuitously shifting income from the member to the order were present. the member upon entering the order had vowed "never [to] claim or demand, directly or indirectly, any wages, compensation, remuneration, or reward... for the time or for the services or work i devote for or with [the order]" thereby evidencing his intent to benefit the order, t while the disparity between the amount earned by the member and the small allowances he was permitted to retain for his subsistence evidence the fact that income was being shifted. as shown above, in assignment for consideration cases, the earner is taxed only on the consideration he receives in exchange for his earned 166. in fact, many firms and businesses resolve the "'outside income" issue by permitting the partner or employee to keep the outside income and then crediting the amount of such outside income against the amount of income the employee or partner would otherwise be entitled to receive. for an example of such a provision in a partnership agreement and a description of how it operates, see raby, supra note 76, at 424-25. 167. 1965-2 c.b. 21. 168. schuster v. commissioner, 800 f.2d 672, 673 (7th cir. 1986) (alterations in original) (quoting vow which sister francine schuster took upon entering the order of the adorers of the blood of christ). the order's constitution provided that a member withdrawing from the order was entitled to no compensation for the work she had performed while a member of the order, since "like all the adorers of the blood of christ. she freely chose to serve the lord and his people in a life of poverty, without personal gain." schuster. 84 t.c. at 767 (quoting the order's constitution). see generally sharon l. holland. title 1: norms common to all institutes of consecrated life [cc. 573-6061, in the code of canon law: a text and commentary 453, 465-66 (james a. coriden et al. eds., 1985) (quoting and commenting on canon 600, which elaborates on requirement of poverty imposed on all members of roman catholic religious orders). 19931 florida tax review income.'69 this principle produces the following results. in schneer, the taxpayer would be taxed only on the consideration he received for surrendering his right to receive payments from the first fin, that is, on his distributive share in the firm's profits. 7° in the legal aid society ruling, the attorneys would be taxed only on the consideration they received for surrendering their right to court-awarded attorneys' fees, that is, on their fixed salaries. in the law school clinic ruling, the faculty member would be taxed only on the consideration she received for surrendering her right to court-awarded fees, that is, on the portion of her law school salary allocable to her running of the legal clinic program. in contrast, the vow-of-poverty cases involve gratuitous assignments of income, and, as discussed below, the member of the religious order should be taxed on the income his personal services generated, that is, on the compensation that the third-party employer paid for his services. these indicated results dovetail perfectly with the actual holdings in those cases. note, however, that these results were obtained under an approach having nothing to do with the "similarity" or "agency" rationales asserted in the those cases and rulings. as shown above, the "similarity" and "agency" tests provide no intelligible reason for applying or not applying the assignment of income doctrine.' moreover, they have been applied so inconsistently from one case to another as the courts and the service have strained to reach the "correct" result, that these tests afford no basis for predicting results or structuring transactions. 172 in contrast, the approach 169. see discussion supra part ii.d. 170. there has been an ongoing controversy as to whether a taxpayer's receipt of a profits interest in a partnership in exchange for services is a taxable event requiring the taxpayer to report immediately as income the present value of the profits interest, or whether the taxpayer need only report as income his distributive share of the partnership's profits when and as they are earned by the partnership. see generally i arthur b. willis et al., partnership taxation ch. 46 (4th ed. 1993). contrary to the hopes of the legal profession, the eighth circuit's decision in campbell v. commissioner, 943 f.2d 815 (8th cir. 1991), did not resolve the basic issue since it held in favor of the taxpayer on the ground that his particular profits interest lacked fair market value at the time of receipt and did not pass on the question of whether receipt of a profits interest is, as a matter of law, nontaxable. id. at 823. the internal revenue service recently issued rev. proc. 93-27, in which it stated that it would not treat receipt of a profits interest in a partnership as a taxable event; however, the revenue procedure does not apply where (i) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, (ii) the partner disposes of his profits interest within two years of receipt, or (iii) the profits interest is a limited partnership interest in a publicly traded partnership as defined in irc § 7704(b). 1993-24 i.r.b. 63, 64 (july 6) at § 4. in schneer, the service did not treat schneer's receipt of a profits interest in the second and third firms as taxable events. 171. see discussion supra part iv. 172. see discussion supra part iv. [vol 1:11 sciweer v. conwiissioner advocated here resolves these cases by reference to the basic purposes of the assignment of income doctrine and thereby avoids the practical and theoretical infirmities of the "similarity" and "agency" tests. note moreover that this approach resolves many of the inconsistencies created when the "similarity" or "agency" test is used. for example, it was shown in the preceding part that the results in revenue ruling 74-581 (the law school clinic ruling) and kircher v. united states (where father waldschmidt served as a chaplain in a state mental hospital) cannot be reconciled under the agency test approach.17 3 but when one focuses on the distinction between gratuitous and compensated assignments, the results become self-evident, and the apparent inconsistencies disappear. revenue ruling 74-581 is an assignment-for-value case (thus the doctrine does not apply), while kircher is a gratuitous assignment of income case (thus the doctrine does apply). operation of this approach may be further illustrated by the following example. sister joan, at direction of her order, teaches in a public school for which she receives a salary of $25,000. this salary is paid directly to sister joan, who, pursuant to her vow of poverty, endorses her pay checks over to the order. sister joan's duties require her to live away from the convent, and accordingly her order sends her a monthly stipend of $1,250, or $15,000 a year, for her subsistence (rent, food, utilities, clothing, etc.). analysis shows this case involves both a gratuitous assignment of income and an assignment for value. to the extent sister joan receives a stipend from the order in connection with her services, her assignment of income is for value; hence she should be taxed on the consideration received, or $15,000 a year. the balance of the amount she remits to the order, $10,000, is gratuitous, and hence she should also be taxed on this amount. sister joan should therefore be taxed on a total of $25,000: $15,000 under the assignment for value rule, and $10,000 under the gratuitous assignment of income rule."" this analy173. see supra notes 142-59 and accompanying text. 174. this bifurcated analysis is consistent with the holdings in priv. ltr. rul. 8105008 (sept. 29, 1980). this ruling concerned a member of a religious order who, at the order's direction, taught in the public school system. pursuant to her vow of poverty, she endorsed all her pay checks over to the order, and the order in turn paid her for her personal living expenses. using the conventional "agency" analysis (i.e., the school system looked to the member rather than the order for teaching services), the ruling held the member was taxable on her salary. however, the ruling used a more intricate analysis to determine whether the member was entitled to a charitable deduction on the amounts she endorsed over to the order. the ruling stated that a payment to a charitable organization could qualify as a charitable contribution only to the extent it was a gift. it found that the amounts that the member received for her personal living expenses were partial consideration for her assignment to the order of her public school teacher's salary. consequently, only "the excess of the amount 1993] florida tax review sis also demonstrates that the value of sister joan's charitable contribution is only $10,000, not $25,000.175 b. formal statement of approach perhaps a more formal statement of the approach proposed here would be helpful. first, of course, it must be determined that the taxpayer's services generated the income. then two questions must be answered. 1. at the time the income was earned, was the taxpayer entitled to receive and retain the income, or was he legally compelled by agreement to turn it over to another? if he could receive and keep the income, he must be taxed on it. if he was compelled to pay the income to another, he may or may not be taxable on the assigned income depending on the answer to question 2. 2. did the taxpayer receive consideration for agreeing to turn the income over to another person, or was his assignment of that income gratuitous? if the agreement was for consideration, the taxpayer will be taxed only on the consideration he received; any income collected by the assignee over and above the consideration paid will be taxed to the assignee. if the assignment was gratuitous, the taxpayer will be taxed on the full amount of income his personal services generated. question 1 makes it clear that a necessary, but not sufficient, condition for a taxpayer to avoid being taxed on the assigned income is that he be under a legal compulsion to turn it over to another. this requirement may be thought of as a replacement for the similarity and agency tests. under the similarity test, income earned by a partner in his individual capacity will be reportable by the partnership, rather than the partner, only if he has agreed to turn it over to the partnership and the services he performs are similar to those offered by the partnership as an entity. in contrast, the test proposed here requires only that the partner have agreed, prior to the time he rendered the services, to turn over the income to the partnership. this is the more logical approach. if income from the sale of sophisticated electronic equipment, the leasing of automobiles, and the sale of bread may be treated as income of a single corporate conglomerate, there is no reason why such taxpayer remits to the order over the amounts she receives from the order for her personal living expenses" was a gift and qualified as a charitable contribution. id. the ruling, in effect, bifurcated the member's assignment of her salary: (1) part of her salary was exchanged for consideration, and (2) the remainder was gratuitously transferred to the order. although the ruling used this analysis only to determine the amount of the member's charitable contribution, there is no reason why it should not also be used to determine the extent to which the member is taxable on her salary. 175. id. [vol 1:11 schneer v% conunissioner disparate types of income should not also be treated as the income of a single partnership. the requirement proposed here recognizes that the business of a partnership is whatever the partners agree to, and if they agree to pool income from a given activity, that income becomes, by virtue of such agreement, partnership income and the activity generating it part of the partnership's business.176 likewise, the proposed requirement obviates the need to find an agency relationship in the nonpartnership cases. all that is required is that the taxpayer have legally obligated himself to pay the income he earns over to another. the proposed requirement recognizes that where a taxpayer agrees to remit the income from a given activity to another, the taxpayer is acting on the other person's behalf when he performs that activity. it is absurd to say, as the tax court did in schuster, that sister schuster was not acting on the order's behalf in serving as midwife" when she was legally obligated to turn over all her earnings from that activity to the order. but being under a legal obligation to turn one's earnings over to another does not, by itself, make the assignment of income doctrine inapplicable. otherwise, the assignment of income doctrine would not apply to the vow-of-poverty cases. to make this determination, one must then answer question 2: was the assignment gratuitous or for consideration? applying these principles to the first three hypothetical cases in part ih produces the following results: the army reserve pay that p turns over to his law partnership is reportable by the partnership and not by p; the fees awarded by the court to f, the faculty member who operates the law school clinic, is income to the law school and not to f; and father john's salary as a chaplain in a state hospital is taxed to father john and not the order. 176. cf. cowan, supra note 20, at 1537-38: whether the partner is acting as an agent of the partnership with respect to a specific activity seems to depend almost exclusively on the terms of the partnership agreement.... for example, if a real estate partnership with 100 partners and 200 employees is engaged in operating shopping centers throughout the country, and one of the partners also acts as a broker in the leasing and selling of properties other than shopping centers, and all of the partners share in the profits and losses, and exposure to liability, from that activity, the partnership is per se also in the business of leasing and selling such other properties.... if there is a bona fide, mutual sharing of the economic venture, including in profits and losses, there is probably a partnership. (first emphasis added.) however, cowan would not recognize for tax purposes the pooling of a judge's salary or the salary of a member of the armed forces: "serving in the armed forces or as a judge requires sole loyalty to that employer, and a sharing of loyalty with a partnership of other individuals is completely contrary to public policy." id. at 1541-42. 177. schuster v. commissioner, 84 t.c. 764, 774 (1985). aff'd, 800 f.2d 672 (7th cir. 1986). 19931 florida tax review c. issues involved in applying proposed approach the idea that a person who assigns earned income for consideration is taxed only on the consideration received is premised on the notion that for every dollar of taxable income he assigns he will receive (or could expect to receive) a dollar of taxable income in return. thus, the tax treatment of the assignor, on average, is not changed or bettered by the assignment. in two cases, however, the assignor will benefit from the assignment of income. first, the assignor will benefit if the transaction can be structured so that amount received for the assignment of income avoids recognition. second, the assignor will benefit if the consideration is paid out over a longer period than the earned income was to have been paid. spreading out the income over a longer period of time may benefit a taxpayer in a progressive tax regime by causing more of the income to be taxed at lower rates than if it were "bunched up" in one or a few years. these issues will be addressed below: the nonrecognition issue in the discussion of the personal service corporation, and the deferral issue in the discussion of the basketball player hypothetical. d. the personal service corporation: a case of nonrecognition? although personal service corporations no longer offer the same opportunity for income tax savings as they did a couple of decades ago, they merit study because of the light they shed on the proper reach of the assignment of income doctrine. 178 at the height of their popularity in the 178. immediately before the recent enactment of the revenue reconciliation act of 1993, pub. l. no. 103-66, 107 stat. 312 [hereinafter 1993 rra], the personal service corporation ("psc") offered little opportunity for tax savings. this was primarily because the highest marginal rate for c corporations, such as a psc, was then higher than the highest marginal tax rates for individuals and unincorporated businesses (34% vs. 31%). irc §§ 1(a)(e), 11. in the 1970s, the situation was reversed. see infra notes 179-80 and accompanying text. other factors that made operating as a psc unattractive were: (1) substantial elimination of the preferential tax rates for capital gains: the substantial preference in tax rates for capital gains formerly in effect made it possible to sell the stock of a psc or to liquidate a psc at a very favorable tax rate. in 1970, for example, individuals were subject to a maximum tax rate of 70% on ordinary income, while the maximum tax rate on long-term capital gains was only 35%. irc §§ 1, 1202 (1970). however, immediately prior to the enactment of the 1993 rra, the highest individual tax rate on ordinary income (31%) exceeded the highest individual tax rate on long-term capital gains (28%) by only three percentage points. irc § 1(a)-(e), (h). (2) denial of tax benefits for "personal service corporations" formed to avoid income tax: section 269a authorizes the irs to disallow tax benefits in certain cases where a "personal service corporation" (as defined therein) was formed for the principal purpose of avoiding income tax. irc § 269a. [vol 1:11 sclweer v. commissioner 1970s, personal service corporations offered the prospect of substantial tax savings. for example, the highest marginal tax rate for individuals in 1970 was seventy percent, 79 while the highest marginal tax rate for corporations was forty-eight percent.'80 a high income taxpayer, by splitting off some of his earned income to his wholly-owned corporation, could take advantage of the lower corporate marginal rates and also a separate graduated tax schedule, all the while retaining complete control over the diverted income. if the individual died owning the stock of his personal service corporation, his estate would receive a stepped-up basis in the stock of the corporation equal to its date-of-death value;' ' this of course would reflect the value of the corporation's accumulated income. the estate could then sell the corpora(3) flat corporate tax rare of 34% for "qualified personal senice corporations": section 11(a), as in effect prior to enactment of the 1993 rra, taxed a "qualified personal service corporation" (as defined in § 448(d)(2)) at a flat rate of 34%---the highest marginal rate imposed on a corporation. irc §§ 11, 448(d)(2). this provision deprived a qualified personal service corporation of the benefit of the lower corporate tax rate brackets. (4) double tax regime of subchapter c: the double tax regime of subchapter c subjects corporate earnings to a double tax: first an income tax is imposed on the earnings when the corporation earns them, and then an income tax is imposed on the earnings when the corporation distributes them to the shareholders as dividends. irc §§ 1i, 61(a)(7). (5) repeal of the "general utilities" doctrine: prior to the tax reform act of 1986, the code made it possible for a corporation to sell its assets and distribute the sale proceeds without the gain being taxed at the corporate level. this mitigation of the double tax regime of subchapter c was eliminated by the tax reform act of 1986, pub. l. no. 99-514, § 631. 100 stat. 2085, 2269. the 1993 rra makes the following relevant changes: (1) it increases the maximum individual income tax rate from 31% to 39.6%; (2) it increases the maximum corporate tax rate to 35% but only for corporations whose taxable income exceeds si0,000,000; and (3) it imposes a flat rate of 35% on "qualified personal service corporations." 1993 rra. §§ 13201, 13202, 13221. as a result of the changes made by the 1993 rra. pscs may become attractive again for high-income individuals, since the maximum individual tax rate for individuals (39.6%) will now exceed the maximum tax rate for corporations (35%, but 34% for corporations having taxable income of less than $i,000,000). also, the preferential tax rate for capital gains is more significant (28% vs. a maximum tax rate of 39.6% on ordinary income). but pscs will not be as attractive as they were in the 1970s since taxpayers will now have to deal with § 269a (authorizing the service to deny tax benefits to personal service corporations formed primarily to avoid tax), § i 1(b) (imposing a flat tax rate of 35% on "qualified personal service corporations"), and the repeal of the general utilities doctrine. see generally leonard sloane, new tax law limits the draw of s corporations, n.y. times, aug. 12, 1993, at d5. 179. irc § 1 (1970). a special provision. irc § 1348 (1970), repealed by economic recovery tax act of 1981, pub. l. no. 97-34, § 101(c), 95 stat. 172, 183, limited the maximum tax rate on earned income to 50%. 180. irc § 11 (1970). 181. irc § 1014 (1970). 1993] florida tax review tion's stock at no taxable gain. if this scenario were followed, the income tax savings effected through the use of the personal service corporation would become permanent. even if the individual sold or liquidated the corporation before his death, his taxable gain (again reflecting the value of the corporation's accumulated income) would be taxed at preferential capital gain rates. 182 the personal service corporation thus represented in the seventies an almost perfect case for applying the assignment of income doctrine, as all the necessary elements were present. consider the following hypothetical case that was posed in part iii: personal service corporation case: 0 was a manufacturers' representative for producers of steel tubing. operating as a sole proprietor, 0 netted about $250,000 a year. no more than $5,000 of this amount represented a return on the few assets he used in the business (e.g., his word processor, photocopier, etc.); the balance ($245,000) was solely attributable to o's personal services. on the advice of his attorney, 0 at the beginning of 1970 formed newco, inc. in which he was the sole shareholder and employee. thereafter, he conducted his business of representing manufacturers through the corporation. o's salary from newco, inc. for 1970 was fixed at $100,000 leaving the corporation with a net profit of $150,000. was 0 taxable on $245,000 in 1970 under the assignment of income doctrine, since that was the amount of income his services produced? here, 0 is in effect shifting some of the income earned through his personal services, namely, $145,000 out of the $245,000 his services produced, to a related taxpayer, namely, his wholly-owned corporation newco, inc., to reduce his overall tax burden. strangely, the efforts of the internal revenue service to apply the doctrine in these cases met with little success. 183 182. the code provided individuals with a deduction equal to 50% of the amount by which an individual's net long-term capital gains exceeded his net short-term capital losses. irc § 1202 (1970), repealed by tax reform act of 1986, pub. l. no. 99-514, § 301(a), 100 stat. 2216. since the highest marginal tax rate on individuals was then 70%, irc § 1 (1970), this provision effectively capped the marginal tax rate on long-term capital gains at 35%. 183. foglesong v. commissioner, 621 f.2d 865(7th cir. 1980) (rejecting application of assignment of income doctrine, since its application conflicted with the policy of recognizing a corporation as a separate legal person and economic actor), on remand, 77 t.c. 1102 (1981), rev'd, 691 f.2d 848 (7th cir. 1982); rubin v. commissioner, 429 f.2d 650 (2d cir. 1970) (rejecting application of assignment of income doctrine to a personal service corporation [vol 1:11 schmeer v. conmmissioner professor manning has argued that the doctrine should not apply to an assignment of earned income to a wholly owned corporation.' 84 he argues as follows: the assignment of income doctrine can properly be applied only to a gratuitous assignment of income;"' an assignment to a whollyowned corporation is not gratuitous since the "value of the stock received or the increase in the value of stock already owned, of necessity, equals the value of the income transferred";'86 therefore, the doctrine cannot be applied to an assignment to a wholly-owned corporation. professor manning confuses the purpose of the assignment of income doctrine. it is true, as he points out, that the shareholder-employee suffers no diminution of wealth in these cases. but the assignment of income doctrine is not concerned about diminution of wealth but with tax avoidance. in the seventies, a person by utilizing a personal service corporation could achieve an unwarranted reduction in taxes in just the manner proscribed by the assignment of income doctrine: the splitting of earned income among related taxpayers thereby defeating the graduated tax system. that the taxpayer could accomplish this without experiencing a diminution in wealth strengthensrather than weakens-the case for applying the doctrine. recall in clifford the emphasis justice douglas placed on the fact that the purported transfer in that case left the husband's economic status unchanged: "since the income remains in the family and since the husband retains control over the investment, he has rather complete assurance that the trust will not effect any substantial change in his economic position."' 7 that the earner can still control and enjoy income that he has purportedly assigned strengthens the case for taxing him on that income. in clifford, justice douglas assumed the existence of a harmonious family unit in finding no change of economic position. how much stronger is the case for taxation when the absence of economic change is not based on the vagaries of inter-family relations but on unfettered legal control of a wholly-owned corporation. the question remains whether the proper result in these cases can be obtained within the framework of the approach outlined above, or whether that approach needs to be modified. no modification is necessary. if we accept professor manning's characterization of the transaction as an assignbecause such application tended to undermine policy of treating corporation as a taxable entity distinct from its shareholders, and because § 482 was available to deal with the problem). 184. elliott manning, the service corporation-who is taxable on its income: reconciling assignment of income principles, section 482, and section 351, 37 u. miami l rev. 657, 669 (1983). professor manning would, however, apply § 482 to a shareholderemployee who works exclusively for his wholly-owned corporation. id. at 676-80. 185. id. at 668. 186. id. at 669 (footnote omitted). 187. helvering v. clifford, 309 u.s. 331, 335-36 (1940). 19931 florida tax review ment for value, then under the established rules the shareholder-employee is taxable on the amount of consideration received. this amount, to use professor manning's words, is the "value of the stock received or the increase in the value of stock already owned, [which,] of necessity, equals the value of the income transferred."' 188 in the above hypothetical, o's rendering of services to newco, inc. for an inadequate consideration may be viewed as a transaction governed by section 351 of the code. 0, of course, did not receive any stock in return for selling his services to newco, inc. at a bargain price, and thus the transaction would not at first blush seem to be governed by section 351. but the courts have held that issuance of additional stock to a 100% shareholder is an "meaningless gesture," and that transactions involving a sole shareholder should be analyzed as though additional stock had been issued. 89 thus, 0 may, and should, be viewed as though he received stock from newco, inc. having a value equal to the difference between the fair market value of his services and the salary he actually received. however, even when the transaction is cast in this form, 0 does not qualify for the nonrecognition rule of section 35l.'90 0 is not contributing "property" to the corporation, but rather his "services" which do not qualify for nonrecognition under section 351.'9' in response, it might be argued-weakly i think-that 0 is not transferring services but the income which the services produce; that therefore he is transferring "property" which qualifies for nonrecognition under section 351.192 even acceptance of this dubious argument will not enable 0 to avoid taxation. both the courts and the service hold that assignment of income principles override the nonrecognition rule of section 351 where, as here, the assignment is tax motivated and results in an artificial fragmentation of income. 93 188. manning, supra note 184, at 669 (footnote omitted). 189. see, e.g., lessinger v. commissioner, 85 t.c. 824, 831-36 (1985), rev'd on another issue, 872 f.2d 519 (2d cir. 1989), and authorities cited therein. 190. irc § 351(a). 191. irc § 351(d). 192. the courts and the service have recognized that the transfer to a newly-formed corporation of accounts receivable arising from services performed for the predecessor business constitutes a transfer of "property" and not of "services." see hempt bros. v. united states, 490 f.2d 1172, 1175-76 (3d cir.), cert. denied, 419 u.s. 826 (1974); rev. rul. 80-198, 1980-2 c.b. 113. in these situations, the services were performed before the transfer to the corporation took place; hence, there were no "services" left to transfer but only a chose in action. moreover, the services were performed for a predecessor business, not for the new corporation. however, in the case posed in the text, the services are being performed for the corporation. clearly, the performance of services on behalf of a corporation for a less than fair market salary represents a contribution of "services" to the corporation. 193. brown v. commissioner, 40 b.t.a. 565 (1939), aff'd, 115 f.2d 337 (2d cir. 1940); rev. rul. 80-198, 1980-2 c.b. 113. [vol. 1:11 sclheer v. conunissioner other objections to applying the assignment of income doctrine to personal service corporations include: (1) applying the doctrine undermines the tax principle that a corporation is a separate and distinct taxpayer from its shareholders;194 (2) applying the doctrine is a crude, sledgehammer solution to a problem requiring a more delicate treatment;195 and (3) the presence of a specific code provision (section 482) dealing with the problem precludes resort to general judicial doctrines.19 the first two arguments are without merit while the third requires modification. the supreme court did not impugn the viability of mrs. earl as a separate taxpayer when it applied the assignment of income doctrine to her husband's salary. 197 likewise, applying the doctrine to a personal service corporation does not impugn the corporation's viability as a separate and distinct taxpayer. indeed, the assignment of income doctrine presupposes the existence of a separate viable taxpayer. a finding that all or a portion of the corporation's income should be taxed to the shareholder-employee does not mean that the corporation's existence is being disregarded; it simply means that the value of the shareholder-employee's services exceeds the salary he has elected to take, and that such excess constitutes earned income which the shareholder-employee has assigned to the corporation. if the corporation owns other assets, either tangible or intangible (including goodwill), which contribute to the profitability of the corporation, a reasonable portion of the corporation's profits should be attributed to those assets and not the shareholder-employee's services. application of the doctrine is thus completely compatible with the notion of a personal service corporation as a separate income-generating taxpayer. of course, if the corporation has no assets apart from its right to the personal services of its shareholder-employee, as sometimes occurs in the case of a personal service corporation, the corporation will have no taxable income after paying its shareholder-employee a fair price for his services. moreover, the assignment of income doctrine need not-and should not-be applied in a sledgehammer manner. statements to the effect that applying the assignment of income doctrine is like "crackling] walnuts with a sledgehammer" ' 98 or represents an "all-or-nothing approach""' suggest 194. foglesong, 621 f.2d at 868-69; rubin, 429 f.2d at 652-53. 195. foglesong, 621 f.2d at 872 (comparing application of assignment of income doctrine to "crack[ing] walnuts with a sledgehammer"); rubin, 429 f.2d at 653 (describing the assignment of income doctrine as an "all-or-nothing approach"). 196. rubin, 429 f.2d at 653 (stating common law doctrines like the assignment of income doctrine "have no place where, as here, there is a statutory provision [i.e.. § 482] adequate to deal with the problem presented"). 197. lucas v. earl, 281 u.s. 111 (1930). 198. foglesong, 621 f.2d at 872. 19931 florida tax review that application of the doctrine to a personal service corporation inevitably results in all of the corporation's income being taxed to the shareholderemployee. but as shown above, the only portion of a corporation's income properly taxable to the shareholder-employee under the assignment of income doctrine is the amount by which the fair value of his services exceed his salary: this is the amount that the shareholder-employee has assigned to the corporation. if the corporation, for example, uses its own physical assets in its business, a portion of the corporation's income represents a return on those assets and should properly be taxed to the corporation. application of the doctrine therefore requires a refined and delicate analysis of the portion of the firm's profits properly allocable to the services of the shareholderemployee and the portion properly allocable to its other assets.2 °° depending on the circumstances, a substantial portion of a corporation's profits properly could be taxed to it notwithstanding application of the assignment of income doctrine.20' the principle stated above that a shareholder-employee should be taxed on the fair value of his services to his corporation is subject to one limitation: the amount of compensation deemed paid to him should not exceed the income he would have recognized had he not incorporated. consider the case of an unsuccessful personal service corporation that earned $10,000 in revenues and paid $8,000 in secretarial salary before it ceased 199. rubin, 429 f.2d at 653. 200. requiring the parties to determine the fair value of a shareholder-employee's services to his personal service corporation does not seem unduly burdensome. taxpayers and the service already confront a similar task in applying § 162(a)(1) which limits a taxpayer's deduction to a "reasonable allowance" for compensation paid. moreover, taxpayers and the service must make similar determinations in applying the "arm's-length" standard under § 482. 201. it is unclear whether the courts realize the need to make the refined analysis called for in the text. the tax court, in sustaining the commissioner's allocation of 98% of the corporation's net commission income to mr. foglesong under § 482, stated: the touchstone for determining whether the financial relations between the petitioner and the corporation reflected those of unrelated parties dealing at arm's-length is the extent to which the total remuneration to the petitioner from the corporation for the services he performed ... was essentially equivalent to that which he would have received absent incorporation. foglesong v. commissioner, 77 t.c. 1102, 1105-06 (1981), rev'd, 691 f.2d 848 (7th cir. 1982). this test is too crude, since it fails to recognize that a sole proprietor's net taxable income from the conduct of his unincorporated business may reflect a return on his physical and intangible assets (including goodwill and going concern value) as well as remuneration for his personal services. the case, however, may simply reflect a failure of proof on the part of the taxpayer, since the decision makes no reference to any contention by the taxpayer that the commissioner's allocation failed to allow a reasonable return on the corporation's physical and intangible assets. [vol. 1:11 scluzeer v. conunissioner operations. assume that the fair value of the shareholder-employee's services during the corporation's existence was $20,000. if the $20,000 were deemed paid to the shareholder-employee, he would be taxed on $20,000 of compensation income, and the corporation would recognize a taxable loss of $18,000 [$10,000 of revenues $8,000 of secretarial salary $20,000 of salary deemed paid to shareholder-employee]. this result does not further the policy of the assignment of income doctrine. the purpose of the doctrine is to prevent a taxpayer from shifting taxable income from himself to related taxpayers thereby avoiding the higher rates prescribed by the progressive tax rate schedule. if the shareholder-employee had not incorporated, he would have recognized taxable income of $2,000 [$10,000 of revenues $8,000 of secretarial salary]. consequently, the shareholder-employee has shifted only $2,000 of income from himself by operating through a corporation; and this is the only amount he may properly be taxed on under the assignment of income doctrine. taxing him on this amount will cause the corporation to break even [$10,000 of revenues $8,000 of secretarial salary $2,000 of compensation paid to the shareholder-employee]. other doctrines or statutory provisions may cause the shareholder-employee to recognize more than $2,000 of compensation income; 2 but the assignment of income doctrine, being concerned solely with the amount of taxable income a taxpayer shifts to another party, should tax him only on this amount. where section 482 and the assignment of income doctrine produce the same result, it becomes something of a quibble whether that result is produced under the statutory provision, the judicial doctrine, or both. however, one court has held that section 482 does not apply to a shareholderemployee who works exclusively for his personal service corporation. -' 3 a 202. if § 482 applies to a shareholder-employee who works exclusively for his personal service corporation, see infra note 203 and accompanying text, the shareholderemployee will be taxed on the fair value of his services even if this causes the corporation to recognize a loss. regs. § 1.482-ia(d)(4) (as amended in 1993) (applicable to taxable years beginning on or before april 21, 1993); regs. § ia82-it(d)(1)(ii) (1993) (applicable to taxable years beginning after april 21, 1993). the validity of this rule has been sustained over the objection that § 482 authorizes only the allocation of income, not the "creation of income." fitzgerald motor co. v. commissioner, 508 f.2d 1096 (5th cir. 1975). kerry inv. co. v. commissioner, 500 f.2d 108 (9th cir. 1974); kahler corp. v. commissioner, 486 f.2d 1 (8th cir. 1973); b. forman co. v. commissioner, 453 f.2d 1144 (2d cir.). cert. denied. 407 u.s. 934 (1972); latham park manor, inc. v. commissioner, 69 t.c. 199 (1977) (overruling prior inconsistent tax court decisions). aff'd, 618 f.2d 100 (4th cir. 1980). 203. foglesong v. commissioner, 691 f.2d 848 (7th cir. 1982) (refusing to apply § 482 to a shareholder-employee who worked exclusively for his wholly owned corporation because the "two or more organizations, trades, or businesses" requirement was not met). the service announced in rev. rul. 88-38, 1988-1 c.b. 246, that it would not follow this holding in foglesong, and the tax court in post-foglesong cases has continued to apply § 482 in these situations. e.g., haag v. commissioner, 88 t.c. 604 (1987). 19931 florida tax review court following this ruling should have no hesitancy in applying the common law assignment of income doctrine. if anything, section 482 should encourage the courts to apply the doctrine to cases not falling within the section's literal language, since the section represents congressional endorsement of the general philosophy of the doctrine: income should be taxed to the party that earns it and not artificially split among related parties to produce tax benefit. 2°4 e. the basketball player: a case of deferral as mentioned above, a person who assigns his earned income for valuable consideration may still derive a tax benefit if the consideration is paid out over a longer period than the earned income was scheduled to have been paid. by stretching out the payments, instead of "bunching" them in one or a few years, more of the income will be taxed in lower brackets. this was the tax plan in the "basketball player" hypothetical posed in part iii: basketball player case: b, a basketball player, is acutely aware that the professional life of an athlete is short. he wishes to spread out the income he earns during his "good years" over his lifetime to reduce his overall tax burden. on the advice of his attorney, he enters into an agreement with an unrelated corporation, x corp., to provide all his services in professional sports to x corp. for six years in return for $18,000 a year for the rest of his life. b's attorney then attempts to negotiate an agreement between hawks, a professional basketball club, and x corp. under the terms of which x corp. would provide the hawks with b's services as a basketball player for the next three years for $100,000 a year. however, because of the hawks' adamant insistence that it will only deal directly with b, b enters into an agreement 204. in philipp bros. chems. v. commissioner, 435 f.2d 53 (2d cir. 1970), the court made the following observation regarding the policy of § 482: "the statute rests on the well-settled policy that income is taxable under section 61 of the 1954 code to the party who earns it and that it is economic reality rather than legal formality which determines who earns income." id. at 57. in keller v. commissioner, 77 t.c. 1014, 1034 (1981), aff'd, 723 f.2d 58 (10th cir. 1983), the court observed that "section 482, and the regulations pursuant thereto, provide a detailed mechanism to deal with the tax-avoidance problems which spur the assignment of income doctrine. section 482 and the assignment of income doctrine, therefore, should not lead to different results in this case." see also olla state bank v. united states, 77-1 u.s. tax cas. (cch) 9455, at 87,148-49, 40 a.f.t.r.2d (p-h) 5073, 5073-74 (w.d. la.) ("§ 482 only provides a method for making the determination allowed by § 61"). [vol 1:11 schmeer v. corunissioner with the hawks to play basketball for it for the next three years for $100,000 a year, and then assigns his rights to this pay to x corp. is b taxable on $100,000 a year under the assignment of income doctrine, or only on the $18,000 a year he receives from x corp.? note first what is not occurring here. b is not attempting to shift income to another party; he was dealing at arm's-length with an unrelated party to maximize his earnings; and he fully expected to receive back a dollar of income for each dollar of income he assigned to x corp. under the analysis employed above-that one who assigns his earned income for value should be taxed only on the consideration received-b would only be taxed on the payments received from x corp. but another element is present here: b is achieving a substantial tax saving by deferring his income. since the assignment of income doctrine is a remedial device to carry out basic tax policy, the question becomes whether there is a compelling public policy against achieving tax savings through deferral that justifies applying the doctrine in these cases. in fact, there seems to be no policy against it at all. persons selling property are free to structure the sale to qualify for the installment sale provisions in the internal revenue code and thereby spread out recognition of their gain.2"' employees and independent contractors desiring to stretch out or defer their compensation to reduce their tax burden may negotiate deferred compensation agreements.26 case law permits an employee who has already deferred his income once to defer it again, even if already earned, provided the agreement to further defer is made before the income was scheduled to be paid.207 the attitude of the law is that if a taxpayer is willing to accept delayed payment of his income he will be taxed accordingly. tax policy thus provides no warrant for using the assignment of income doctrine to prevent tax savings through deferral. not surprisingly then, courts have declined to invoke the assignment of income doctrine to prevent the deferral of income. this was demonstrated in rushing v. commissioner-'s where two corporations owned by the taxpayers adopted plans to liquidate within twelve months of the day the plans were adopted.2' the reason for adopting these 205. irc §§ 453, 453a, 453b. 206. rev. rul. 60-31, 1960-1 c.b. 174, modified by rev. rul. 64-279. 1964-2 c.b. 121 and rev. rul. 70-435, 1970-2 c.b. 100. 207. see veit v. commissioner, 8 t.c. memo (cch) 919 t.c. memo (p-h) 49,253 (1949). 208. 441 f.2d 593 (5th cir. 1971). 209. id. at 593-94. 1993] florida tax review plans was to qualify under old section 337 which permitted a corporation to avoid recognition of gain on the sale of its assets if it completely liquidated within twelve months of the adoption of a plan of liquidation.2 0 shortly after the adoption of these plans, the corporations sold all their assets.2", a few days before the deadline for liquidating, the taxpayers sold their stock in the corporations to two trusts they had established for their children in exchange for notes payable over a number of years.2"' the taxpayers elected to report the gains on the sales of their stock on the installment sales method.213 thereafter, the corporations were timely liquidated and the proceeds paid to the trusts.214 had the taxpayers retained their stock and received the liquidation proceeds, they would have had to recognize the entire gain on the liquidations in a single year, that is, the year in which the liquidation proceeds were distributed. the commissioner asserted that the taxpayers were taxable on the liquidation proceeds under the assignment of income doctrine and consequently were required to report their entire gains in the year of the liquidations.2 5 his argument was that the liquidations were foregone conclusions at the time of the stock sales; that the taxpayers in selling their stock were merely assigning to the trusts the gains that had already been earned on the liquidations; and that the taxpayers were thus taxable on the gains under the assignment of income doctrine.2"6 the court of appeals for the fifth circuit affirmed the tax court's holding in favor of the taxpayer.2 7 in an opinion by judge goldberg, the court first found the assignment of income doctrine inapplicable: at the outset we feel compelled to state what this case is not about .... [t]his is not a case where one taxpayer has attempted to shift the gain to a second taxable entity in 210. id. at 593 n.2 (quoting irc § 337 (1970), amended by tax reform act of 1986, pub. l. no. 99-514, § 631(a), 100 stat. 2269). 211. rushing, 441 f.2d at 593-94. 212. id. at 594. 213. id. at 595 n.4. 214. id. at 595. 215. rushing v. commissioner, 52 t.c. 888, 896-97 (1969), aff'd, 441 f.2d 593 (5th cir. 1971). 216. id. 217. rushing, 441 f.2d at 598. the tax court found for the taxpayers on the dubious ground that "the trusts [as sole shareholders] could have voted to rescind the resolutions of liquidation." rushing, 52 t.c. at 897. this is highly unrealistic. had the liquidations not been completed within the 12-month period specified in the plans because of the trustees' actions, the corporations would needlessly have incurred a huge tax on the gains they realized on the sale of their assets; this would have injured the trusts' beneficiaries and subjected the trustees to personal liability for their dereliction of duty. [vol. 1:11 schmeer v. conunissioner order to reap the benefits of the second entity's lower tax rate. the price the trusts paid the taxpayers for the stock was the full value of the stock, including the appreciation in value which would be realized upon liquidation. we therefore find the commissioner's reliance upon the anticipator, assignment of income theory entirely misplaced simply because no income was assigned.2 8 the only question was "whether they must pay taxes on the entire amount of the gain in the year the corporations were liquidated or ... over a period of years as the installment payments are received from the trusts."219 the answer to this question simply turned on whether the taxpayers had retained any direct or indirect control over the proceeds or any economic benefit therein.2' since "[a]n autonomous entity [i.e., trust] controlled the proceeds, and no right of recapture inured to the benefit of the taxpayers," and since the "taxpayers retained no effective benefit or control over the liquidation dividend," the taxpayers were not taxable on the liquidation proceeds and were permitted to recognize the gains on their stock sales under the installment sales method.2' significantly, many courts have applied the assignment of income doctrine in cases virtually identical to rushing except for the fact that taxpayers gave away rather than sold their stock. that is, the courts have found in cases where the taxpayers gave away their stock that the gain on the liquidation had already been earned at the time of the gift and thus was taxable to the assignor." but in rushing, where the stock was sold, the court refused to treat the gain as already earned at the time of the sale. these contrasting results demonstrate the basic premise of this article: the assignment of income is not a metaphysical truth but a pragmatic device to carry out basic tax policy. the courts will apply the doctrine when the taxpayer is 218. rushing, 441 f.2d at 597 (emphasis added). 219. id. 220. id. at 598. 221. id. 222. jones v. united states, 531 f.2d 1343 (6th cir. 1976); kinsey v. commissioner, 477 f.2d 1058 (2d cir. 1973); hudspeth v. united states. 471 f.2d 275 (8th cir. 1972); allen v. commissioner, 66 t.c. 340 (1976). in the earlier cases, the courts relied in part on the fact that the donees lacked the power to block unilaterally the scheduled liquidations. kinsey, 477 f.2d at 1063; hudspeth, 471 f.2d at 279. the later cases, however, held this factor was not decisive and found that under the "realities and substance" test the liquidations were virtually certain to occur in those cases even though the donees possessed sufficient stock to prevent the liquidations had they so desired. jones, 531 f.2d at 1345-46 (donees together with shareholders, other than donor, could stop liquidation); allen. 66 t.c. at 347-48 (donee received controlling stock interest). 19931 florida tax review attempting to shift income to a lower tax bracket taxpayer through a gratuitous assignment but decline to apply it where the taxpayer sells his stock for full value in an attempt to spread out recognition of his gain.223 although the courts have not articulated their reason for refusing to apply the doctrine in the latter case, it is undoubtedly due to their perception-perhaps unconscious-that no vital tax policy is at stake where the taxpayer merely attempts to achieve a tax savings through deferring the receipt of his income. the treasury succeeded in having the rushing result legislatively modified in the installment sales revision act of 1980.224 the treasury was not concerned that taxpayers could transform an immediately recognizable gain into a deferred gain, but that a group comprising a single economic unit (such as a family) could enjoy immediate receipt of the proceeds while recognizing the gain on a deferred basis.225 thus, the statute was amended to provide that where a taxpayer sold property on an installment sales basis to a "related person," and the "related person" resold the property within two years, the taxpayer would recognize his gain at the time the "related person" realized his gain (if that resulted in earlier recognition of the gain).226 "related person" was defined to include, among others, members of the same family and trusts for the benefit of family members.227 thus the result in rushing under the current law would be different: the taxpayers would have recognized gain at the time the trusts for the benefit of their children 223. in hudspeth, the court noted that the failure to apply the assignment of income doctrine in rushing only permitted the taxpayers to defer recognition of their gain and had "no effect on the character or total amount of gain eventually recognized" whereas a failure to apply the doctrine where the taxpayers gave the stock to charity would enable the taxpayers to avoid recognition of the gain on liquidation entirely. hudspeth, 471 f.2d at 278. 224. pub. l. no. 96-471, 94 stat. 2247 (codified as amended in scattered sections of 26 u.s.c.). 225. the installment method is currently abused by taxpayers who sell appreciated property to related persons (for example, a trust set up for the benefit of the seller's children), who immediately resell the property to a third party as a part of a prearranged transaction. the original seller defers recognition of gain. the related person receives the full sale proceeds tax free because the tax basis of the property in the hands of the related person is its purchase price. thus, the economic unit comprised of the two related persons has cash equal to the value of the property while deferring taxation of the gain which would have been immediately recognized had the initial sale been for cash. installment sales revision act of 1980 and minor bills: hearings on h.r. 6883, h.r. 5616, h.r. 5729, h.r. 6039, h.r. 6140, h.r. 6247, h.r. 6824, and h.r. 7009 before the subcomm. on select revenue measures of the house ways and means committee, 96th cong., 2d sess. 25, 27 (1980) (statement of harry l. gutman, deputy tax legislative counsel, treas. dep't). 226. irc § 453(e). 227. irc § 453(f)(1). [vol 1:11 scluzeer v. conunissioner recognized their gain, that is, at the time of the liquidations. note, however, that the statute applies only when the taxpayer sells to a "related person"; it has no application to a sale to an unrelated person. congress did not revise, nor did the treasury seek to revise, the rule dealing with sales to unrelated parties. thus, in sales to unrelated parties, the statute left intact the reasoning of rushing that the assignment of income doctrine has no application where a party sells his right to income for fair consideration on a deferred basis. some additional support for the proposition that the assignment of income doctrine should not be applied where the taxpayer merely seeks to defer receipt of his income may be found in keller v. commissioner.' there the taxpayer carried on his pathology practice as an employee of his wholly owned professional service corporation. ' the commissioner asserted that the taxpayer was taxable on all earnings arising from his practice under the assignment of income doctrine, and not merely his salary. 23' the tax court recognized that the doctrine would apply if his total compensation were less than what he would have received absent incorporation. " the court found, however, that his salary plus the amount the corporation contributed to the qualified retirement plan on his behalf plus the value of the corporation's medical reimbursement plan approximated what he would have received absent incorporation, and therefore the doctrine did not apply. during the years in question, the amount of income that could be deferred through a qualified plan was much greater in the case of an employee than in the case of a self-employed individual. dr. keller's arrangement thus resulted in a much greater deferral of income than would have been possible absent incorporation. the court's refusal to apply the assignment of income doctrine under these circumstances suggests that it did not view mere deferral of income as justifying application of the doctrine. 228. 77 t.c. 1014 (1981), aft'd, 723 f.2d 58 (10th cir. 1983). 229. id. at 1020-21. 230. id. at 1021, 1029. the commissioner relied on § 482 and the doctrines of lack of business purpose and substance over form as well as the assignment of income doctrine. id. 231. id. at 1025. the court, in making this observation, was explaining the application of § 482, rather than the assignment of income doctrine, to dr. keller and his wholly-owned corporation. however, the court later stated that the assignment of income doctrine produced the same result as § 482. id. at 1029, 1033-34. therefore, it seems fair to conclude that the court's observation with respect to § 482 was equally applicable to the manner in which the doctrine was to be applied. 232. id. at 1028. 233. see, e.g., i michie's federal tax handbook 1977 1j 537. at 211 (joseph e. gibson ed. 39th ed., 1977) (stating that "tax advantages obtainable by a sole proprietor or partner from a pension, profit-sharing or annuity plan are not so spectacular as those granted a regular employee, including the stockholder-officer of a corporation"). 19931 florida tax review return now to the "basketball player" hypothetical. it has been shown that neither policy nor precedent justifies applying the assignment of income doctrine where the taxpayer merely defers receipt (and therefore recognition) of his income. certainly no warrant would exist for applying the doctrine to b had the hawks contracted directly with x corp. rather than with b. should the result change merely because the hawks, in the hypothetical, contracted directly with b who then assigned his rights under that contract to x corp. pursuant to his pre-existing agreement with x corp.? reaching different results in these cases would exalt form above substance. all relevant factors are the same: in both cases, the payments made by the hawks end up in the hands of x corp.; in both cases, b will receive the same amount; and in both cases, b performs the same personal services. therefore, the same result should prevail and b should be taxed only on the amounts received from x corp.' a more difficult question would be presented if b had been under no obligation to assign his contract rights to x corp. when he contracted with the hawks. in that case, it could be asserted that b's right to income from the hawks vested in him when he signed with the team, and thereafter it was too late for him to disavow that income. suppose the sequence of events had 234. b's initial agreement with x corp. may be viewed as a sale or other disposition of the right to his services giving rise to a taxable event under § 1001. a question might arise as to whether b must immediately recognize a taxable gain equal to the difference between the present value of his right to receive $18,000 a year for life (say, $220,000) and b's basis in his services, zero. this is unlikely. if x corp.'s obligation to b is unfunded and unsecured, b will probably be taxed only when and as the $18,000 annual installments are paid to him. see rev. rul. 60-31, 1960-1 c.b. 174, examples (1) and (2). this is especially so, since b's right to the payments is contingent upon his performing his obligations under the contract. the subsequent transfer of the right to b's services to the hawks should not cause b any tax liability. first, the transfer should be treated as made by x corp. and not by b. x corp. owned the right to b's services, and only it could lawfully dispose of such right. second, b should not realize any gain on the transfer of his services to the hawks, since x corp. is entitled to receive all amounts realized on such transfer. the above analysis is premised on the assumption that the agreement with x corp. and the subsequent agreement with the hawks are separate and distinct events, and that x corp.'s $18,000-a-year obligation is fixed and independent of the agreement ultimately reached with the hawks. however, if the fact finder determines that both events are integral steps of the same transaction and that the hawks is the real employer of b, the result may be different. the service may argue that hawks by making payments (either directly or indirectly) to x corp. is, in effect, funding its obligation to b and protecting b against the claims of the hawks's creditors. when an employer funds its obligation to an employee in a way that immunizes the employee against the claims of the employer's creditors (for example, by funding an escrow account or buying an annuity in the employee's name), the cases hold that the employee receives an economic benefit which he must immediately recognize as income. united states v. drescher, 179 f.2d 863 (2d cir.), cert. denied, 340 u.s. 821 (1950); rev. rul. 60-31, 1960-1 c.b. 174, example (4). [vol 1:11 sclmeer v. conmmissioner been as follows: (1) b enters into a player's contract with the hawks under which he is entitled to annual salary of $100,000 for three years; and (2) b thereafter enters into an agreement with x corp. under which he assigns his rights under the contract to x corp. in return for its promise to pay him $18,000 a year for life. unlike the hypothetical above, b at the time of his contract with the hawks was free to receive and keep those payments himself. b's subsequent assignment of his rights under the hawks contract to x corp. clearly constitutes a "sale or other disposition" of his contractual rights triggering recognition of gain under section 1001. b (whose basis in his contractual rights is probably zero) would therefore be taxed immediately on the full present value of the right to receive $18,000 a year for life, unless he could either avail himself of the installment sales method or successfully argue that he should be taxed on the $18,000 payments only when and as he receives them since he is a cash basis taxpayer. it is unclear under present law whether b would prevail on either the cash basis argument or the installment sales approach.25 in view of the great freedom that employees 235. the cash method argunment: where there is a taxable sale or exchange, § 1001 requires that the seller recognize as the "amount realized" the cash received plus the fair market value of any other property received. irc § 1001(b). in the case of cash basis taxpayers, like b, the cases have varied greatly in deciding whether an unfunded promise to make future payments must be valued and taxed immediately under § 1001 or whether recognition of income may be delayed until actual receipt of the payments. some cases have held that such obligations need be valued and taxed immediately only if they possess the necessary element of negotiability while others have held they must be taxed immediately if they can be sold by the taxpayer at any price. 4 boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts [ 105.3.2 (2d ed. 1992). the service takes the position that congress in enacting the comprehensive revision of the installment sales provisions in 1980 intended to make the installment sales method the exclusive method of deferring gain where the amount of the payments is fixed. id. ti installment sales approach: in realty loan corp. v. commissioner, 54 t.c. 1083 (1970), aff'd, 478 f.2d 1049 (9th cir. 1973), both the tax court and the ninth circuit held that a contract to perform services constituted "property" and therefore a sale of such a contract could qualify for the installment sales method. this holding seems to cover b's sale of his contractual rights with the hawks to x corp. but see sorensen v. commissioner, 22 t.c. 321 (1954). however, the service can make a strong counterargument. a primary reason for enactment of the installment sales method was to relieve a taxpayer of the hardship of immediately paying the tax on the full gain when he had received cash in the year of the sale for only a small portion of the sales price. commissioner v. south tex. lumber co.. 333 u.s. 496 (1948). in this case, b was originally entitled to receive annual payments of sl00.000 over a three-year period; he thereafter converted this right into a right to receive annual payments of $18,000 over his lifetime. the hardship to b of paying a tax in a single year (or in three years) on income that he will receive over a lifetime is self-inflicted. the service might argue that the installment sales method was not meant to enable a taxpayer to defer recognition of income beyond the time when he would have received all of his cash payments under his original contract. this argument seems implicit in the holding in real. loan corp. where the tax court upheld use of the installment sales method where its use did not extend the period 19931 florida tax review and sellers of property have in deferring recognition of income, it is difficult to discern how tax policy would be subverted by either allowing b to use the installment sales method or allowing him to defer recognition of income until actual receipt of the annual payments. but whatever the answer to that question, there is no warrant for applying the assignment of income doctrine here. there is simply a deferral of income, and that is not a concern of the assignment of income doctrine. f. a loose end: should schneer have been taxed on the fee that was fully earned at the time of the assignment? all the judges in schneer agreed that schneer was taxable under the assignment of income doctrine on the one fee, amounting to $1,250, which had been fully earned before he left the first firm. 6 this conclusion is almost surely wrong. since this fee had been fully earned when schneer assigned it to the second firm, it was in effect an account receivable. 37 accounts receivable are "property'2 '38 and thus are subject to the partnership basis rule of section 723. pursuant to that rule, the second partnership took over schneer's basis in the account receivable, 239 that is, zero. section 704(c)(1), as in effect during the time in question, provided that in allocating gain or loss with respect to the contributed property, the property was to be treated "as if [it] had been purchased by the partnership." 4 ' the purpose and effect of this for recognizing gain beyond the time when the taxpayer would have received and recognized income under the original service contract. realty loan corp., 54 t.c. at 1097-98. the tax court distinguished sorensen, which had disallowed the use of installment sales, on the ground that its use in that case would have extended the time for recognizing gain beyond the time the taxpayer would have otherwise received and reported his gain. id. at 1097 (stating that the sale of contract rights "could not change ... the time at which the amount was includable in income"). 236. schneer, 97 t.c. at 651-52. 237. the opinion does not indicate whether the $1,250 was billed prior to schneer's departure from the first firm. however, the court found that it had accrued prior to his departure from the first firm and it recognized that income would only accrue when all events have occurred which fix the right to receive the income and the amount in question could be determined with reasonable accuracy. id. at 649-50. in any event, it is clear that schneer was at least contributing a chose in action, and a chose in action is "property" and not services. 238. hempt bros. v. united states, 490 f.2d 1172, 1175-76 (3d cir.), cert. denied, 419 u.s. 826 (1974); see also rev. rul. 80-198, 1980-2 c.b. 113. 239. irc § 723. 240. irc § 704(c)(1) (1982). section 704(c)(1) was amended by the deficit reduction act of 1984, pub. l. no. 98-369, § 71, 98 stat. 589, to provide that gain on property contributed to the partnership was to be shared among the partners, pursuant to regulations issued by the service, to take account of the difference between the basis of the [vol 1:11 schmeer v conmissioner language was to assure that the entire gain or loss realized with respect to the contributed property was reported by the partnership instead of by the contributing partner.24' the gain or loss would then be allocated among the partners in accordance with the ratios specified in the partnership agreement for sharing gains or losses.242 if they preferred, the partners could have agreed pursuant to section 704(c)(2), as then in effect, to share the gain from the collection of the receivable so as to take account of the difference between the partnership's basis in the receivable and the receivable's fair market value at the time of the contribution. 3 however, in schneer there was no such agreement. thus, under the statutory scheme then in effect, collection of the $1,250 fee by schneer's second firm was reportable by it (and not by schneer), and schneer should have been taxed on this fee only to the extent of his distributive share in it. the question is whether this statutorily mandated scheme was overridden by the assignment of income doctrine. in hempt bros. v. united states,2 ' the court was confronted with deciding whether section 351 and related provisions were overridden by the property to the partnership and its fair market value at the time of the contribution. this meant that the contributing partner would be required to recognize the "built-in gain" that existed on the contributed property at the time of the contribution (i.e.. the difference between the property's fair market value and its basis at the time of the contribution) when the partnership sold or otherwise realized gain upon the contributed property. thus, under the new rule, schneer would have been required to recognize all or a substantial part of the si,250 when his partnership collected this fee since schneer's "built-in gain" in the fee was its fair market value at the time of contribution less his basis in the fee (presumably zero). however, the new rule applies only to "property contributed to the partnership after march 31, 1984." id. § 7 1(c), 98 stat. at 589. although the published opinion of the tax court does not so state, a review of the record in the case shows that a check from the first firm to schneer for the fee in question was dated january 30, 1984 and was endorsed and deposited in the second firm's bank account on january 31, 1984. record at petitioners' exhibit 22, schneer (no. 31804-88) (ledger of first firm showing payment of $1,250 forwarding fee to schneer on january 30, 1984); id. at joint exhibit 5-e (front and back of check no. 2331, dated january 30, 1984, drawn by first firm and made payable to stephen schneer in the amount of $1,250); id. at joint exhibit 10-j (deposit slip of second firm showing deposit on january 31, 1984 of $1,250 received from first firm); id. at joint exhibit 12-l (second firm's bank statement showing deposit of $1,250 on january 31. 1984). thus, whether the date of the contribution is deemed to be the date on which schneer became a partner in the second firm. or the actual date on which the fee was paid over to the second firm, it is clear that the contribution occurred prior to april 1, 1984, and that the old rule applied. 241. 1 arthur b. willis et al., partnership taxation § 108.03 (4th ed. 1993). 242. irc § 704(a) (1982); willis et al., supra note 241, § 108.03. 243. irc § 704(c)(2) (1982). 244. hempt bros. v. united states, 490 f.2d 1172, 1175-76 (3d cir.), cert. denied. 419 u.s. 826 (1974). 19931 florida tax review assignment of income doctrine.245 in that case, a cash basis partnership had transferred its accounts receivable to a corporation upon its formation.246 under the statutory scheme, the corporation would be taxed on the accounts receivable when it collected them; however, the corporation argued this result was precluded by the assignment of income doctrine which taxes income to the person who earns it.247 the court rejected the corporation's claim, holding that judicially created assignment of income doctrine "must give way ... to the broad congressional interest in facilitating the incorporation of ongoing businesses" as evidenced by its enactment of section 35 1.248 similar considerations are present here. congress in enacting in section 704(c) expressly recognized and sanctioned the ability of a contributing partner to shift taxable gains and losses on the contributed property to the other partners.249 this scheme was consistent with the underlying objectives of congress in enacting subchapter k in 1954: simplicity, flexibility and equity as between the partners."0 the rule of section 704(c)(1), which allocates all gain or loss to the partnership, has the virtue of simplicity25' and is far simpler than the present rule which mandates that the gain or loss be allocated between the contributing partner and the other partners in a manner that takes account of the difference between the partnership's basis in the property and its fair market value at the time of contribution. 52 moreover, the rule of section 704(c) furthered the congressional purpose of flexibility since it permitted the partners to determine among themselves their respective tax burdens. 53 under section 704(c), as in effect during the period in question, the partners could either have followed the rule of section 245. id. at 1173. 246. id. at 1174. 247. id. at 1176. 248. id. at 1178. 249. willis et al., supra note 241, § 108.03. 250. h.r. rep. no. 1337, 83d cong., 2d sess. 65 (1954), reprinted in 1954 u.s.c.c.a.n. 4025,4091; s. rep. no. 1622, 83d cong., 2d sess. 89 (1954), reprinted in 1954 u.s.c.c.a.n. 4629, 4721. 251. willis et al., supra note 241, § 108.03, at 108-7 (stating that "§ 704(c)(1) had the attribute of simplicity"). 252. for an insight into the complexity of the present rule, see prop. regs. §§ 1.704-1(b)(1)(vi), 1.704-1(b)(2)(iv), 1.704-1(c), 1.704-3, 57 fed. reg. 61345 (1992). these proposed regulations set forth three alternative methods to make the adjustments mandated by irc § 704(c); the proposed regulations result from congressional concern that the regulations under the formerly elective method might be inflexible and overly burdensome for taxpayers in situations where there was little potential abuse. 253. see foxman v. commissioner, 41 t.c. 535, 551 (1964), aff'd, 352 f.2d 466 (3d cir. 1965) ("accordingly, one of the underlying philosophic objectives of the 1954 code was to permit the partners themselves to determine their tax burdens inter sese to a certain extent, and this is what the committee reports meant when they referred to 'flexibility.' "). [vol. 1:11 sclmeer v. conmmissioner 704(c)(1) of allocating all gain or loss to the partnership, or have agreed under section 704(c)(2) on an allocation that took into account the difference in the property's basis and its fair market value at the time of contribution. the objective of equity was also advanced since it gave the partners the opportunity to adopt the alternative approach of section 704(c)(2)-probably the more equitable approach2while allowing them to use the section 704(c)(1) approach if section 704(c)(2) proved too burdensome. here, as in hempt bros., the assignment of income doctrine must yield to the broad congressional purposes in enacting the statutory scheme. indeed, it was widely recognized by commentators that in non-abuse situations, section 704(c), as in effect during the time in question, overrode the assignment of income doctrine. -" this is shown by the following excerpt from a leading treatise on partnership taxation: problem a and b form an equal partnership to engage in the practice of accountancy. a contributes $10,000 in money and b contributes unrealized receivables which are valued at $10,000 arising out of b's previous accounting practice. assuming the partnership reports on the cash method of accounting, will the receipt of income from the collection of the $10,000 of unrealized receivables contributed by b be allocable for income tax purposes one-half to a and one-half to b? the famous case of lucas v. earl established at an early date that a taxpayer may not assign earned income to another taxpayer.... [however,] when the cash method ab partnership collects the unrealized receivables and thereby realizes taxable income, it is allocable 50% to a and 50% to b. thus, § 721(a) sanctions the assignment of income to a 254. see willis et al., supra note 241, § 108.03 for possible inequities resulting to partners under the § 704(c)(1) approach. 255. arthur b. willis et al., partnership taxation § 22.03 (3d ed. 19821; 1 william s. mckee et al., federal taxation of partnerships and partners 14.02[21 (ist ed. 1977) (stating that in non-abuse cases, "the nonrecognition policy of § 721 should generally prevail over assignment-of-income restrictions in order to facilitate the transfer of going businesses to partnerships" referring specifically to contribution by accountants of accounts receivable from their prior practices to new partnership); [1993] partnership tax plan. & prc. (cch) 1 1595 (june 1993) (stating that under old § 704(c) "irs rarely, if ever, asserted that the transfer of earned but uncollected income... by a partner to a partnership ... was an anticipatory assignment of income" even though the result under the statute was "an assignment of a portion of the income from the contributing partner to the other partners"). 19931 florida tax review partner where there is a transfer to the partnership of unrealized receivables as a part of a genuine business transaction.25 since the tax court found that schneer's agreement with his second firm was a genuine transaction with "no apparent attempt to avoid the incidence of tax by the formation or operation of the partnership,"" it should have taxed the account receivable to the partnership and not to schneer. vi. conclusion despite its venerable pedigree, the assignment of income doctrine as applied to personal service contracts is still beset by confusion and uncertainty. the key to resolving these questions is an understanding of the origin and purpose of the doctrine: it is a judicially created device designed to preserve the integrity of the graduated tax system by preventing taxpayers from splitting their income among lower income tax bracket taxpayers. this understanding in turn leads to further insights: (1) the doctrine does not apply where the income earner has assigned his right to income for consideration in an arm's-length transaction since this does not result in any shifting of income; (2) the doctrine does not apply where the taxpayer merely attempts to defer his income since there is no strong policy against reducing one's tax burden through the deferral of income; and (3) when applying the doctrine in connection with a nonrecognition section, one must determine whether the policies congress intended to implement by providing for nonrecognition outweigh the policy of the doctrine in the case under consideration. a constant recognition of the purpose of the doctrine and its resulting limitations as developed in this article will resolve many of the puzzles currently encountered in its application. 256. willis et al., supra note 255, § 22.03, at 22-3 to 22-4 (footnotes omitted). 257. schneer, 97 t.c. at 663. 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contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 5 2001 number 5 equity and the article i court: is the tax court’s exercise of equitable powers constitutional? leandra lederman* i. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359 ii. the role and powers of article i courts. . . . . . . . . . . . 362 a. the constitutional role of legislative courts. . . . . . . . 362 b. the tax court as an article i court. . . . . . . . . . . . . . . . 365 c. the powers of article i courts . . . . . . . . . . . . . . . . . . . . 368 iii. the origins of equity and its use in article i courts. 371 a. a history of equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371 1. the development of equity in england. . . . . . . 372 2. equity in the united states. . . . . . . . . . . . . . . . . 374 b. equity in article i courts.. . . . . . . . . . . . . . . . . . . . . . . . 375 1. in general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 2. equity in the tax court.. . . . . . . . . . . . . . . . . . . 378 a. the equitable recoupment saga. . . . . . 379 b. equitable estoppel.. . . . . . . . . . . . . . . . 388 c. equitable innocent spouse relief. . . . . 390 iv. the tax court: does it have equitable powers?. . . . . 393 a. the parallelism fallacy. . . . . . . . . . . . . . . . . . . . . . . . . 396 b. possible sources of power to apply equitable principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399 1. four categories of cases. . . . . . . . . . . . . . . . . . 399 2. the indebitatus assumpsit ancestry of tax refund claims. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 401 a. the tax refund action and the tax court overpayment claim. . . . . . . . . . . . . . . . 402 * associate professor, george mason university school of law. i am extremely grateful to terry chorvat, david hyman, matthew mirow, and david richardson for their helpful suggestions and comments on various aspects of this article, and to judge herbert chabot, stephen mazza and dan shaviro for their comments on prior drafts. i would also like to acknowledge the valuable insights of judge james halpern, marty mcmahon, and other participants in the tax section’s teaching tax committee program at the american bar association’s 2001 annual meeting, and of kent syverud and other participants in the southeastern association of american law schools’ 2000 annual meeting. i would also like to thank larry lederman and mark newton for helpful conversations about the topic of this article; c. drew hoster for his excellent research assistance; femi cadmus for her research support; and george mason university school of law and its law and economics center for financial support. 357 358 florida tax review [vol. 5:5 b. the quasi-equitable history of indebitatus assumpsit. . . . . . . . . . . . . . . . . . . . . . . 406 v. conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411 2001] equity and the article i court 359 “relieve the judges from the rigour of text law, and permit them, with pretorian discretion, to wander into it’s equity, and the whole legal system becomes incertain.”** “tax law is not based on equity and arguments of equity have little force.”*** i. introduction to most lawyers, the “federal courts” are the courts created under article iii of the united states constitution. however, the federal courts also1 include the united states tax court, the united states court of federal claims, the bankruptcy courts, and the territorial courts – all “legislative courts” created by congress under article i of the constitution. several of these article i courts have important jurisdiction and large dockets, and issue influential opinions with precedential value. yet, scholars typically have not paid much attention2 to legislative courts other than the bankruptcy courts, which are courts adjunct to the article iii district courts. since 1988, when professor richard fallon of harvard law school published his important article, “of legislative courts, administrative agencies, and article iii,” little has been published on the3 features and limitations of article i courts. ** letter from thomas jefferson to philip mazzei (nov. 28, 1785), in 9 the papers of thomas jefferson 71 (j. boyd ed. 1954) (original spelling retained). *** polos v. united states, 231 ct. cl. 929, 932 (1982) (citing commissioner v. kowalski, 434 u.s. 77, 95 (1977)). 1. see judith resnik, housekeeping: the nature and allocation of work in federal trial courts, 24 ga. l. rev. 909, 910 (1990) (“the words ‘the federal courts’ and ‘the federal judiciary’ are still commonly used to refer to that set of judges who have life tenure (‘article iii judges’), but the equation is imprecise. ‘the federal courts’ are also populated by other ‘federal judges’ – who work within the judicial branch but who are creatures of congressional legislation.”). 2. the united states tax court (tax court) is an example. the tax court is a national court that sits in numerous cities nationwide, and has a multi-billion dollar docket. in fiscal year 1999, for example, $32.8 billion were in dispute in pending tax court cases. by contrast, $2.7 billion were in dispute in tax cases in the court of federal claims, and $2.6 billion were in dispute in tax cases in the district courts. american bar association tax section court procedure committee, january 2001 report of office of chief counsel, internal revenue service, at 2 [hereinafter, report to aba]. tax court cases are often cited by article iii courts. see, e.g., ge v. commissioner, 245 f.3d 149 (2d cir. 2001) (citing, among other tax court cases, central pa. sav. ass’n v. commissioner, 104 t.c. 384, 392 (1995); sim-air, usa, ltd. v. commissioner, 98 t.c. 187, 192 (1992)); estate of o’neal v. united states, 81 f. supp. 2d 1205 (n.d. ala. 1999) (citing, among others, quirk v. commissioner, 15 t.c. 709 (1950), aff’d, 196 f.2d 1022 (5th cir. 1952); holmes v. commissioner, 47 t.c. 622, 627 (1967); estate of stein v. commissioner, 40 t.c. 275 (1963); estate of trompeter v. commissioner, 75 t.c. memo (cch) 1653 (1980)). 3. 101 harv. l. rev. 916 (1988). 360 florida tax review [vol. 5:5 perhaps legislative courts are overlooked because they have no clear place in the study of constitutional law; it is article iii of the constitution that4 grants the judicial power of the united states to the united states supreme court (supreme court) and inferior courts such as the united states courts of appeals and the district courts. yet article i courts perform the traditional5 judicial function of resolving controversies by applying the law to the facts and rendering an opinion. in fact, they resemble article iii courts in most respects, except that their judges lack the salary and tenure protections of article iii.6 despite the superficial resemblance to article iii courts, article i courts lack other features key to judicial power. for example, article iii expressly provides courts with jurisdiction in both law and equity; article i does not mention law or equity and does not even specifically grant congress the power to create any court. in 1938, the adoption of the federal rules of civil procedure eliminated the distinction between law and equity in article iii7 courts, but those rules do not apply in the united states tax court. does the8 tax court have equitable powers? should it? given the importance of the article i courts in adjudicating public rights, it is surprising how uncertain and9 4. cf. eric bruggink, a modest proposal, 28 pub. cont. l.j. 529, 542 (1999) (a “consequence of being an article i court is the lack of any clear location for the court in the government’s organizational chart”). 5. see u.s. const. art. iii. § 1 (“the judicial power of the united states, shall be vested in one supreme court, and in such inferior courts as the congress may from time to time ordain and establish . . . . ”). 6. see id. (“the judges, both of the supreme and inferior courts, shall hold their offices during good behavior, and shall, at stated times, receive for their services, a compensation, which shall not be diminished during their continuance in office.”). 7. see fed. r. civ. p. 2, 18; see also ross v. bernhard, 396 u.s. 531, 539 (1970); john r. kroger, supreme court equity, 1789-1835, and the history of american judging, 34 hous. l. rev. 1425, 1430 (1998). the court of federal claims has a rule similar to rule 2 of the federal rules of civil procedure. see ct. fed. cl. 2 (“there shall be one form of action to be known as a ‘civil action.’”). 8. “the united states tax court is the paradigm of an article i court and the quintessential specialty court.” richard b. hoffman & frank p. cihlar, judicial independence: can it be without article iii?, 46 mercer l. rev. 863, 869 (1995). 9. see ex parte bakelite corp., 279 u.s. 438, 451-52 (1929) (“legislative courts . . . may be created as special tribunals to examine and determine various matters, arising between the government and others, which from their nature do not require judicial determination and yet are susceptible of it. . . . conspicuous among such matters are claims against the united states. these may arise in many ways and may be for money, lands or other things.”). in fiscal year 1999, for example, the tax court had a docket of approximately 21,900 cases, which was lower than in prior years. see report to aba, supra note 2, at 3. for the same year, the district courts had approximately 1,200 docketed tax cases, and the court of federal claims had approximately 700. see report to aba, supra note 2, at 3. district court suits include cases over which the tax court does not have jurisdiction, such as certain types of excise tax cases. the district courts generally receive more tax filings than the court of federal claims. for example, during the years 1975 through 1984, the tax court received 95.58% of tax cases filed, the court of federal claims 0.076%, and the district courts 3.65%. see charles e. 2001] equity and the article i court 361 unclear the limits on their power are. the united states supreme court has held that the tax court’s predecessor court lacked equitable powers. that could end the inquiry. yet,10 the tax court increasingly has used equitable doctrines in deciding cases in ways contrary to the result indicated by a straightforward application of applicable statutes. public choice theory teaches that judges may seek to11 maximize their power by expanding the jurisdiction of their courts and through decisions that go beyond the governing statutes. the tax court’s application12 of equity reflects both of these tendencies. to elucidate the limits article i of the constitution places on legislative courts, this article considers the question of the extent, if any, of the equitable powers of the tax court under article i. part i of the article considers generally the role of article i courts in the federal system, and the constitutional limits on that role. next, part i traces the tax court’s evolution into an article i court. boynton iv & jack robison, choosing district court over tax court: some case characteristics, 36 tax notes 807, 808 table 1 (1987). in fiscal year 1999, approximately 20,400 of 20,799 federal tax cases (98.08%) were filed in tax court. see report to aba, supra note 2, at 8, 22. in general, the comparison of the number of tax court cases to refund court tax cases was starkest during the tax shelter era because of the particularly high volume of tax court case filings. see infra note 46. 10. see commissioner v. gooch milling & elevator co., 320 u.s. 418 (1943) (board of tax appeals, predecessor of the tax court, had no equity jurisdiction); see also commissioner v. mccoy, 484 u.s. 3, 7 (1987) (“[t]he tax court is a court of limited jurisdiction and lacks general equitable powers.”). there is an argument that “general equitable powers” differ from application of equitable principles. for a discussion of the distinction, see infra text accompanying note 131. 11. see, e.g., estate of mueller v. commissioner, 101 t.c. 551, 553 (1993) (applying equitable recoupment); orenstein v. commissioner, 79 t.c. memo (cch) 1971 (2000) (same); alderman v. commissioner, 55 t.c. memo (cch) 86, t.c. memo (ria) ¶ 88,049 (1988) (applying equitable estoppel); see also bachner v. commissioner, 109 t.c. 125, 131 n.7 (1997) (“in a tax court proceeding, either party is free to raise equity-based defenses to the assertions of the other party, and the court, insofar as it has jurisdiction over the main claim, is free to entertain those defenses.”). the internal revenue service (irs) has not stemmed the equity tide; in fact, in one recent instance the irs immediately reversed itself, acquiescing in an apparent reach for equitable power by the tax court. see infra notes 272-273 and accompanying text. 12. see edward l. rubin, beyond public choice: comprehensive rationality in the writing and reading of statutes, 66 n.y.u. l. rev. 1, 51 (1991) (“rather than trying to protect their power, judges might be trying to maximize it, another approach related to the public choice analysis of administrators. if one imagines this as an effort to expand judicial jurisdiction, one is left with effects that are as occasional and as marginal as the power-protection hypothesis. alternatively, judges could be trying to expand their power through their substantive rulings. under this theory, judges would ignore statutory language whenever possible or frame rules of construction that permitted them to ignore this language. there is some empirical support for this hypothesis.”) (footnote omitted); see also richard a. posner, what do judges and justices maximize? (the same thing everybody else does), 3 sup. ct. econ. rev. 1, 2 (1993); william landes & richard posner, the independent judiciary in an interest-group perspective, 18 j.l. & econ., 875, 885-87 (1975). 362 florida tax review [vol. 5:5 part ii considers the meaning and scope of the terms “equity” and “equitable powers,” providing both a brief history of the development of equity in england and america, and an analysis of the distinction between “law” and “equity.” this part also considers the use of equity in article i courts. in particular, it considers the tax court’s use of equity, focusing on the doctrines of equitable recoupment and estoppel, and statutory equitable relief from joint and several tax liability for an “innocent” spouse. part iii combines the analyses of article i courts and equity, focusing on the tax court. this part considers the argument made by some tax lawyers that because outcomes in the tax court should be the same as outcomes in similar cases in the article iii district courts, the tax court must have equitable powers. next, it examines possible sources of equitable power for the tax court, including applicable statutes and the possible equity-like ancestry of tax court overpayment claims. the article concludes that article i courts have limited sources of equitable power, and that even article i courts granted equitable powers by congress must be alert to possible derogation of the judicial power of article iii. given those constraints, the tax court’s tendency to apply equitable doctrines when necessary to avoid harsh outcomes dictated by statute lacks constitutional authority. for the tax court to apply equitable principles as it has been doing, congress will need to take appropriate action – within constitutional limits – to broaden or redefine the jurisdiction of the court. ii. the role and powers of article i courts a. the constitutional role of legislative courts the current federal court system consists of both article i and article iii courts. article iii of the united states constitution sets forth the general outline of federal judicial power: the judicial power of the united states, shall be vested in one supreme court, and in such inferior courts as the congress may from time to time ordain and establish. . . . the judicial power shall extend to all cases, in law and equity, arising under this constitution, the laws of the united states, and treaties made . . . under their authority; [and] . . . to controversies to which the united states shall be a party.”13 13. u.s. const. art. iii. §§ 1, 2, cl. 2. 2001] equity and the article i court 363 courts such as the federal district courts and the courts of appeals are established by congress under that power. other courts, including the tax14 court, are created using congress’ power under article i of the constitution.15 article i courts are created by congress under its powers enumerated in, and the “necessary and proper” clause of, article i. article i courts differ from15 article iii courts in that they are not subject to the restrictions of article iii. that is, article i judges need not have life tenure, and their pay may be16 diminished. article i courts are also not subject to the “case or controversy”17 limitation in article iii. thus, article i courts constitutionally may give18 advisory opinions to congress.19 the well-known constitutional doctrine of “separation of powers” separates and balances the roles of the article i legislature, article ii executive branch, and article iii judiciary. a branch of government violates separation of powers if it either assumes power of another branch or gives away too much of its own power. given the seemingly mandatory language of article iii,20 21 14. u.s. const. art. iii. § 1. 15. see, e.g., richard b. saphire & michael e. solimine, shoring up article iii: legislative court doctrine in the post cftc v. schor era, 68 b.u. l. rev. 85, 127 (1988) (“the court has viewed [the] power [to create non-article iii courts] as premised on congress’s power under article i’s ‘necessary and proper clause’ power to implement its enumerated powers.”) (footnote omitted); martin h. redish, legislative courts, administrative agencies, and the northern pipeline decision, 1983 duke l.j. 197, 198 (“congress will usually employ one of its enumerated powers in article i, in combination with the ‘necessary-and-proper’ clause of that same article.”). 16. see erwin chemerinsky, federal jurisdiction 181-82 (little brown & co. 1989); resnik, supra note 1, at 912 (“in short, ‘the federal courts’ include many ‘judges’ who lack life tenure.”). tax court judges, for example, serve fifteen-year terms. see irc § 7443(e). 17. see chemerinsky, supra note 16, at 181-82; resnik, supra note 1, at 910-911; cf. burns, stix friedman & co., inc. v. commissioner, 57 t.c. 392, 395 (1971), (“did the provisions of the tax reform act of 1969 so change the status and function of the tax court that it is now exercising the ‘judicial powers’ referred to in article iii and must be established as an article iii court with its judges having the tenure and compensation protection provided in section 1 of article iii? we think not.”). 18. see leandra lederman, precedent lost: why encourage settlement, and why allow non-party involvement in settlements?, 75 notre dame l. rev. 221, 248 (1999); u.s. const. art. iii. § 2, cl.1. 19. see donald d. haber, the declaratory powers of bankruptcy courts to determine the federal tax consequences of chapter 11 plans, 3 am. bankr. inst. l. rev. 407, 426 (1995). interestingly, the supreme court found that the court of claims was an article iii court although it had the power to render advisory opinions. see glidden v. zdanok, 370 u.s. 530, 586-87 (1962); (clark, j., concurring). the tax court, however, does not have statutory jurisdiction to give congress advisory opinions. 20. see glidden, at 605. 21. see u.s. const. art. iii. § 1 (“the judicial power of the united states, shall be vested in one supreme court, and in such inferior courts as the congress may from time to time ordain and establish”) (emphasis added). the “inferior courts” referred to in article iii are article iii courts created by congress under art. i § 8, cl. 9 (the “inferior tribunals” clause) not article i “legislative” courts. 364 florida tax review [vol. 5:5 article i courts are an odd creation. their very existence appears to be prima facie evidence of an infringement by the legislature on the judicial power expressly granted to article iii courts. nonetheless, despite the language of article iii, article i courts are so accepted today that commentators consider “a return to ‘article iii literalism’ virtually unthinkable.”22 the approval of article i courts by the supreme court may be traced back to the 1800s. in 1828, the supreme court upheld territorial courts created under article i and, even earlier, in marbury v. madison, recognized the right23 of william marbury to his commission for a five-year term as a justice of the peace in the district of columbia, thereby apparently allowing the exercise of judicial power without the lifetime tenure required by article iii. since then,24 the supreme court has upheld the constitutionality of article i courts such as the superior court and court of appeals for district of columbia; the25 predecessor of the current court of federal claims, the court of claims; the26 now-defunct court of customs appeals; the territorial courts; and, by27 28 implication, the predecessor to the tax court, the board of tax appeals.29 nonetheless, article i courts have not experienced entirely smooth sailing. in northern pipeline v. marathon pipe line co., the supreme court30 31 22. m. isabel medina, judicial review–a nice thing? article iii, separation of powers and the illegal immigration reform and immigrant responsibility act of 1996, 29 conn. l. rev. 1525, 1550 (1997) (footnotes omitted) (quoting fallon, supra note 3, at 938). 23. see american ins. co. v. canter, 26 u.s. 511 (1828); fallon, supra note 3, at 916. 24. see akhil reed amar, marbury, section 13, and the original jurisdiction of the supreme court, 56 u. chi. l. rev. 443, 451 (1989); marbury v. madison, 5 u.s. 137, 162 (1803). 25. see palmore v. united states, 411 u.s. 389 (1973). 26. see williams v. united states, 289 u.s. 553 (1933). 27. see ex parte bakelite corp., 279 u.s. 438 (1929). 28. see american ins. co. v. canter, 26 u.s. 511 (1828). historically, supreme court case law confined congress’ power to create article i courts to certain areas. article i courts that fall in the following four categories have been held constitutionally permissible: “(1) for united states possessions and territories, (2) for military matters, (3) for civil disputes between the united states and private citizens, and (4) for criminal matters or for disputes between private citizens where the legislative court serves as an adjunct to an article iii court that can review the legislative court’s decisions.” chemerinsky, supra note 16, at 184. 29. phillips v. commissioner, 283 u.s. 589, 599-601 (1931) (review by board of tax appeals is constitutionally adequate); cf. freytag v. commissioner, 501 u.s 868, 873 (1991) (upholding constitutionality of tax court’s use of special trial judges appointed by the chief judge of the tax court). lower courts have held the tax court constitutional. see, e.g., shenker v. commissioner, 804 f.2d 109, 114 n.6 (8th cir. 1986), cert. denied, 481 u.s. 1068 (1987); knoblauch v. commissioner, 749 f.2d 200, 202 (5th cir. 1984), cert. denied, 474 u.s. 830 (1985); sparrow v. commissioner, 748 f.2d 914, 915 (4th cir. 1984); redhouse v. commissioner, 728 f.2d 1249, 1253 n.2 (9th cir. 1984), cert. denied, 469 u.s. 1034 (1984). 30. see deborah a. geier, the tax court, article iii, and the proposal advanced by the federal courts study committee: a study in applied constitutional theory, 76 cornell l. rev. 985, 1002 (1991) (discussing northern pipeline decision). 31. 458 u.s. 50 (1982). 2001] equity and the article i court 365 held unconstitutional a prior incarnation of the bankruptcy courts. after32 northern pipeline, in determining the constitutionality of an article i court, the court has balanced the desirability of an article i court against the degree of encroachment on the article iii judiciary. “among the factors upon which we33 have focused are . . . the extent to which the non-article iii forum exercises the range of jurisdiction and powers normally vested only in article iii courts, the origins and importance of the right to be adjudicated, and the concerns that drove congress to depart from the requirements of article iii.”34 b. the tax court as an article i court the tax court became a legislative court under article i of the constitution as part of the tax reform act of 1969. prior to 1969, the tax35 36 court was an executive agency, originally named the board of tax appeals (board). the board was created in 1924. initially, there was no appeal from37 a board of tax appeals decision. however, the losing party could file a lawsuit “where the findings of the board would be taken as prima facie evidence of the facts.” in 1926, congress made decisions from the board directly appealable38 to the circuit courts of appeals.39 in 1942, congress changed the board’s name to the tax court of the united states, but it was not until 1969 that the tax court officially became40 a court. the process by which the tax court became an article i court was41 almost an accident of the periodic struggle of various parties between 1943 and 1969 to obtain judicial status, and particularly article iii status, for the board of tax appeals.42 as chances for achieving article iii status for the tax court became increasingly bleak, congressman mills submitted an alternative bill in 1969 providing for legislative court status 32. see northern pipeline, 458 u.s. 50 (1982). 33. see commodity futures trading commission v. schor, 478 u.s. 833 (1986); thomas v. union carbide agricultural products co., 473 u.s. 568 (1985); see also susan blocklieb, the costs of a non-article iii bankruptcy court system, 72 am. bankr. l.j. 529, 537-38 (1998) (citing chemerinsky, supra note 16 at § 4.5.4 (1994)). 34. schor, 478 u.s. at 851 (citations omitted). 35. see irc § 7441; freytag, 501 u.s. at 887 (in 1969, congress expressly made the tax court an article i court rather than an executive agency). 36. pub. l. no. 91-172, § 951, 83 stat. 487, 730. 37. revenue act of 1924, ch. 234, § 900, 43 stat. 253, 336. 38. geier, supra note 30, at 990 (citing revenue act of 1924, ch. 234, § 900(g), 43 stat. 337). 39. revenue act of 1926, ch. 27, §§ 1001(a), 1002, 44 stat. 9, 109-10. 40. revenue act of 1942, ch. 619, § 504(a), 56 stat. 798. 41. see supra note 36 and accompanying text. 42. see geier, supra note 30, at 991-993. 366 florida tax review [vol. 5:5 under article i. no public hearings were held on the subject, and the provisions of the bill “were quietly inserted into the tax reform act of 1969 by the senate finance committee in executive session,” becoming law on december 30, 1969.43 the tax court has remained an article i court ever since. the tax court’s primary function since its inception as the board of tax appeals has been to provide taxpayers an opportunity to litigate tax disputes with the irs without paying the disputed amount first. although the44 tax court has jurisdiction over a multitude of types of claims, the bulk of its45 43. id. at 993 (footnote omitted) (quoting harold dubroff, the united states tax court: an historical analysis 214 (commerce clearing house, inc. 1979)). 44. see appeal of everett knitting works, 1 b.t.a. 5, 6 (1924) (“the board was created to give the taxpayer a chance to have an open and neutral consideration of his liability for a deficiency before he is required to pay. the harsh rule of payment first and litigation afterwards was sought to be mitigated.”); hoffman & cihlar, supra note 8, at 869 (“the purpose of the board [of tax appeals] was to ensure that in most cases a taxpayer could obtain an independent review of a tax deficiency determination before the tax was assessed.”); leo p. martinez, the summons power and tax court discovery: a different perspective, 13 va. tax rev. 731, 742 (1994) (“the united states tax court was established to provide taxpayers with a forum for informal and inexpensive adjudication of purported tax payment deficiencies.”); cf. flora v. united states, 357 u.s. 63, 75 (1958) (“it is suggested that a part-payment remedy is necessary for the benefit of a taxpayer too poor to pay the full amount of the tax. such an individual is free to litigate in the tax court without any advance payment.”). 45. tax court jurisdiction extends to (1) tax deficiency cases; (2) overpayment claims incidental to its deficiency jurisdiction; (3) certain actions for attorney’s fees; (4) declaratory judgment actions in specific types of cases; (5) proceedings for determination of employment status; (6) certain actions for disclosure of irs written determinations; (7) innocent spouse claims; (8) collection due process claims; (9) adjustments of partnership items; and (10) irs denial of requests for abatement of interest. see irc §§ 6213(a) (“within 90 days, or 150 days if the notice is addressed to a person outside the united states, after the notice of deficiency authorized in section 6212 is mailed (not counting saturday, sunday, or a legal holiday in the district of columbia as the last day), the taxpayer may file a petition with the tax court for a redetermination of the deficiency.”), 6214(a) (“except as provided by section 7463, the tax court shall have jurisdiction to redetermine the correct amount of the deficiency even if the amount so redetermined is greater than the amount of the deficiency, notice of which has been mailed to the taxpayer, and to determine whether any additional amount, or any addition to the tax should be assessed, if claim therefor is asserted by the secretary at or before the hearing or a rehearing.”), 6512(b)(1) (“except as provided by paragraph (3) and by section 7463, if the tax court finds that there is no deficiency and further finds that the taxpayer has made an overpayment of . . . tax . . . in respect of which the secretary determined the deficiency, or finds that there is a deficiency but that the taxpayer has made an overpayment of such tax, the tax court shall have jurisdiction to determine the amount of such overpayment, and such amount shall, when the decision of the tax court has become final, be credited or refunded to the taxpayer.”), 7430 (awards of administrative and litigation costs and fees), 7428 (declaratory judgments relating to status and classification of organizations under § 501(c)(3), etc.), 7476 (declaratory judgments relating to qualification of certain retirement plans), 7477 (declaratory judgments relating to value of certain gifts, 7478 (declaratory judgments relating to status of certain governmental obligations, 7479 (declaratory judgments relating to eligibility of estate with respect to installment payments under § 6166), 2001] equity and the article i court 367 caseload consists of tax deficiency cases in which the irs has mailed the taxpayer a notice of deficiency (asserting an understatement of taxes) and the taxpayer has filed a timely responsive petition. for the tax court to have46 jurisdiction over the subject matter of a deficiency case, the irs must have mailed the taxpayer a notice of deficiency for a particular tax period, and the47 taxpayer must have filed a timely responsive petition. in general, the court’s48 jurisdiction extends only to the tax year(s) that are the subject of the notice of deficiency and the petition. the tax court also has pendent jurisdiction over49 the taxpayer’s overpayment claims with respect to those tax years. these50 deficiency cases could, alternatively, and at the option of the taxpayer, be litigated in the court of federal claims or the district courts (the so-called “refund fora”). however, the refund fora, unlike the tax court, require51 payment of the full amount in dispute before litigating.52 7436 (proceedings for determination of employment status), 6110(f) (resolution of disputes relating to disclosure), 6015(e) (innocent spouse claims), 6330(d)(1)(a) (hearing before levy on taxpayer property), 6226 (judicial review of final partnership administrative adjustments), and 6404(i) (review of irs denial of taxpayer request for abatement of interest). 46. for example, as of september 30, 2000, the tax court had a docket of 16,609 cases in which a total over $28 billion were at stake, and only 37 declaratory judgment cases. see report to aba, supra note 2, at 4. the tax court’s overall docket has shrunk as tax shelter cases have been resolved. in 1987, 42,623 cases were filed in tax court, while only 1,100 refund cases were filed in the district courts and court of federal claims combined. see united states tax court, 1994 fiscal year statistical information (1994); william f. nelson & james j. keightley, managing the tax court inventory, 7 va. tax rev. 451, 453 (1988). after a slight increase from 1985 to 1986 in the number of tax court cases filed (48,398 in fiscal year 1986), the number of cases filed hovered around 30,000 from 1988 through 1993, dropping to 23,524 in fiscal year 1994. see united states tax court, 1994 fiscal year statistical information (1994). the numbers continue to drop. in 1998, approximately 21,400 cases were filed, and in 1999, approximately 13,700 were filed. see report to aba, supra note 2, at 8. 47. see irc § 6212. 48. see irc § 6213. 49. see irc § 6214(b) (“the tax court in redetermining a deficiency of income tax for any taxable year or of gift tax for any calendar year or calendar quarter shall consider such facts with relation to the taxes for other years or calendar quarters as may be necessary correctly to redetermine the amount of such deficiency, but in so doing shall have no jurisdiction to determine whether or not the tax for any other year or calendar quarter has been overpaid or underpaid.”). the tax court’s application of equitable recoupment in spite of this section is discussed infra at part iii(b)(2)(a). 50. see irc § 6512(b). 51. a taxpayer who has received a notice of deficiency faces a choice of fora. he may petition the tax court, generally within 90 days of the date on the notice. see irc § 6213. he also has the option of paying the deficiency and following the refund procedures that will afford jurisdiction in the refund courts. leandra lederman & stephen w. mazza, tax controversies: practice and procedure 9 (matthew bender & co., inc. 2000). the refund procedures require that the taxpayer pay the tax and then claim a refund from the irs. see irc § 6511; lederman & mazza, supra, at 10-11. 52. see flora v. united states, 362 u.s. 145, 189 (1960). 368 florida tax review [vol. 5:5 the tax court undoubtedly is constitutional under the northern pipeline test. it does not exercise all of the judicial powers of the federal53 district courts, such as conducting jury trials and issuing writs of habeas corpus. in fact, the tax court exercises a narrower, more specialized54 jurisdiction that is permitted because congress has waived the federal55 government’s sovereign immunity with respect to the type of claims the court adjudicates. nonetheless, the tax court, like all article i courts, is subject to limits to avoid unconstitutional usurpation of article iii powers. the supreme court stated in commodity futures trading commission v. schor that in ruling on56 the constitutionality of an article i court, one of the factors it considers is “the extent to which the non-article iii forum exercises the range of jurisdiction and powers normally vested only in article iii courts . . . .” although this is only57 one factor, and although the court would be unlikely to find the tax court unconstitutional, it could find its use of equity unconstitutional. c. the powers of article i courts supreme court jurisprudence on article i courts reflects the court’s struggle to distinguish article i from article iii courts. in one case, the court stated, “we think it proper to state that we do not consider congress can . . . withdraw from judicial cognizance any matter which, from its nature, is the subject of a suit at the common law, or in equity, or admiralty. . . . at the same time there are matters, involving public rights, which may be presented in such form that the judicial power is capable of acting on them, and which are susceptible of judicial determination, but which congress may or may not bring within the cognizance of the courts of the united states, as it may deem proper.” another case distinguished “public rights” suits, which may be58 decided by article i courts, from those that are “inherently judicial.” in59 53. cf. freytag v. commissioner, 501 u.s. at 873 (upholding constitutionality of tax court’s use of special trial judges appointed by the chief judge of the tax court); shenker v. commissioner, 804 f.2d 109, 114 n.6 (8th cir. 1986) (upholding constitutionality of tax court), cert. denied, 481 u.s. 1068 (1987). 54. see schor, 478 u.s., at 852-53 (1986) (finding that commodity futures trading commission (cftc) does not exercise all powers of district courts, and citing as examples cftc’s inability to conduct jury trials or issue writs of habeas corpus). 55. see id. at 852 (approving the cftc as focusing on only a “particularized area of law”) (citing northern pipeline, 458 u.s. at 85); hoffman & cihlar, supra note 8, at 869 (“the united states tax court is the paradigm of an article i court and the quintessential specialty court.”). 56. 478 u.s. 833 (1986). 57. id. at 851 (citations omitted). 58. den, ex dem. murray v. hoboken land and improvement co., 59 u.s. 272, 284 (1855). 59. see northern pipeline constr. co. v. marathon pipe line co., 458 u.s. 50, 68 2001] equity and the article i court 369 general, public rights suits involve the government as a party. the case law60 also indicates that because article i courts are legislative courts subject to congress’ statutory control, they are more limited in their powers than article iii courts.61 there seems to be little dispute that article i courts can decide constitutional questions, even without express statutory authority. professor62 dubroff has pointed out that the tax court cannot determine the correctness of the irs’s assertion of a deficiency “by simply examining the tax statutes in a vacuum.” in effect, this allows the legislative branch to decide the63 constitutionality of its own statutes. this potentially broad power is constrained by the accepted practice of resolving issues, if at all possible, on nonconstitutional grounds.64 although it might seem that the power to decide constitutional questions would indicate the power to use equity (as a sort of lesser included power), in fact, these two powers are not related in this manner. the board of tax appeals, an executive agency, considered constitutional questions when it faced them. by contrast, in commissioner v. gooch milling & elevator65 co., the supreme court held that the board of tax appeals had no equity66 jurisdiction. the court reasoned that the jurisdiction of the board was expressly defined in the code, and congress had not granted the board equity (1982); see also william m. millard, note, eroding the separation of powers: congressional encroachment on federal judicial power: cftc v. schor, 53 brooklyn l. rev. 669 (1987). 60. see northern pipeline constr. co., 458 u.s., at 69 (1982) (citing ex parte bakelite corp., 279 u.s. 438, 451 (1929)); ellen e. sward & rodney f. page, the federal courts improvement act: a practitioner's perspective, 33 am. u. l. rev. 385, 409 (1984). 61. see, e.g., commissioner v. mccoy, 484 u.s. 3, 7 (1987) (per curiam) (“the tax court is a court of limited jurisdiction and lacks general equitable powers.”); chavez v. united states, 18 cl. ct. 540, 547 (1989) (“[t]his court is an article one court with very specific jurisdiction granted by the congress. this legislative grant of equitable jurisdiction is to be strictly construed.”); in re hessinger & assocs., 192 b.r. 211, 215 (bankr. n.d. ca. 1996) (“[b]ecause the bankruptcy courts are creatures of article i, they have no ‘inherent’ powers and their jurisdiction is limited to that expressly granted by congress.”). 62. see harold dubroff, the united states tax court: an historical analysis 214, 47980 (commerce clearing house, inc. 1979) (discussing tax court’s power to decide constitutional questions); see also boyce v. commissioner, 97-2 u.s. tax cas. (cch) ¶ 50,681 (9th cir. 1997) (“[t]he tax court has jurisdiction over constitutional questions even though it is not an article iii court.”); rager v. commissioner, 775 f.2d 1081, 1083 (9th cir. 1985) (“taxpayers argue that because the tax court is not an article iii court, it cannot have jurisdiction over constitutional questions. taxpayers’ argument is frivolous; we have often upheld tax court decisions which were based on a constitutional inquiry.”). 63. dubroff, supra note 62, at 482. 64. see brian c. murchison, interpretation and independence: how judges use the avoidance canon in separation of powers cases, 30 ga. l. rev. 85 (1995). 65. see dubroff, supra note 62, at 480 (describing the board of tax appeals’ consideration of constitutional questions, beginning as early as 1926). 66. 320 u.s. 418 (1943). 370 florida tax review [vol. 5:5 jurisdiction. in effect, the power to decide the constitutionality of statutes has67 been accepted as necessary to making decisions regarding those statutes. by68 contrast, a court need not have the power to do equity in order to make decisions about the application of statutes. eskridge and frickey have cogently argued that the supreme court draws on canons of statutory interpretation to advance constitutional values such as separation of powers. the court may use a variety of canons to avoid69 a separation of powers violation, including avoidance of unnecessary constitutional questions, a presumption against derogation of the judiciary’s70 inherent powers, a presumption against derogation of the president’s71 traditional executive powers, and the nondelegation doctrine that applies to72 the legislature.73 the presumption against derogation of the inherent power of the judiciary precludes another branch, such as the legislature, from infringing upon the “judicial power” granted to courts in article iii. for example, in link v. wabash r. co., the court held that federal rule of civil procedure 41(b),74 which allows a defendant to move for involuntary dismissal of an action or claim, did not limit a court’s power to dismiss for failure to prosecute to75 instances where a defendant moves for dismissal, but rather allowed a court to dismiss the case sua sponte. similarly, in roadway express, inc. v. piper, the76 court held that the courts have “inherent power” to discipline litigants, including the imposition of attorney’s fees, regardless of the particular terms of statutes that provide for recovery of costs.77 the essential attributes of the “judicial power” referenced in article iii arguably consist of jurisdiction in cases at common law, in equity, and in admiralty. certainly the “inherent power” of the judicial branch includes the power to do equity. use of that power by another branch of government78 67. see id. at 420. 68. see supra note 65 and accompanying text. 69. see william n. eskridge, jr. & philip p. frickey, quasi-constitutional law: clear statement rules as constitutional lawmaking, 45 vand. l. rev. 593 (1992). 70. see brian c. murchison, interpretation and independence: how judges use the avoidance canon in separation of powers cases, 30 ga. l. rev. 85 (1995). 71. eskridge & frickey, supra note 69, at 605. 72. id. at 606. 73. cass r. sunstein, nondelegation canons, 67 u. chi. l. rev. 315 (2000); eskridge & frickey, supra note 69, at 606. 74. 370 u.s. 626, 632 (1962). 75. fed. r. civ. p. 41(b). 76. 447 u.s. 752, 764-67 (1980). 77. this example appears in eskridge & frickey, supra note 69, at 605. 78. see, e.g., porter v. warner holding co., 328 u.s. 395, 397 (1946); brotherhood of locomotive engineers v. baltimore & o. r. co., 310 f.2d 513, 516 (7th cir. 1962). see also bell v. hood, 327 u.s. 678, 684 (1946) (inherent power of a federal court to enjoin threatened or actual violation of constitutional rights); robert lincoln, executive decisionmaking by local legislatures in florida: justice, judicial review and the need for legislative reform, 25 stetson 2001] equity and the article i court 371 therefore may infringe upon the power of the judicial branch. as with any separation of powers issue, assertion by the legislative branch of equitable powers raises the question of what the limits are before the assertion is an unconstitutional derogation of the powers of the judiciary. the use of canons of construction to advance constitutional values would suggest that the jurisdiction of article i courts should be narrowly construed. narrow construction of the jurisdiction of article i courts is consistent with avoidance of constitutional questions in that it avoids separation of powers problems. arguably, article i courts constitutionally may consider only statutory causes of action. this would suggest that, in the absence of statutory authorization of equitable powers, an article i court does not have such powers. of course, sometimes statutes expressly authorize equitable considerations or equitable causes of action, even in article i courts like the tax court. for example, the tax court has longstanding declaratory judgment jurisdiction, and must weigh the equities in awarding an innocent spouse relief from joint and several liability. are those unconstitutional derogations of the79 judicial power of article iii courts? the statutory grant of equitable power is necessary but not sufficient under the constitution. the statute could be unconstitutional on its face, or unconstitutional as applied in a particular case. iii. the origins of equity and its use in article i courts a. a history of equity “in a broad jurisprudential sense, equity means the power to do justice in a particular case by exercising discretion to mitigate the rigidity of strict legal rules.” however, the modern use of the term “equity” with respect to80 courts’ jurisdiction and power reflects the historical development, first in england and then in america, of two distinct judicial systems. a brief81 l. rev. 627, 655 (1996) (“[f]undamental judicial powers generally involve issues for which the right to a jury trial is protected, equitable powers, and the inherent judicial power to control proceedings.”). 79. see irc § 6015(b), (e). 80. kevin c. kennedy, equitable remedies and principled discretion: the michigan experience, 74 u. det. mercy l. rev. 609, 610 (1997) (“all writers on the subject of equity, regardless of their philosophical persuasion, agree that the terms ‘equity’ and ‘equitable’ are difficult to define.”). 81. prior to the distillation in two courts, the courts of law and the courts of equity, there were multiple, competing venues. the common law courts were the exchequer, common pleas, and king’s bench. see daniel j. meador, transformation of the american judiciary, 46 ala. l. rev. 763, 770 (1995). the ecclesiastic courts applied the canon law of the catholic church. jack moser, the secularization of equity: ancient religious origins, feudal christian influences, and medieval authoritarian impacts on the evolution of legal equitable remedies, 26 cap. u. l. rev. 483, 517 (1997). the english court of chancery drew upon the practices of 372 florida tax review [vol. 5:5 overview of the equity system is therefore in order. 1. the development of equity in england.—historically, litigation in england took place in a two-court system: “common law” or “law” courts, and “chancery” or “equity” courts.82 by the early sixteenth century it was apparent that the common law system was accompanied by a substantially different one called equity. equity was administered by the chancellor, as distinguished from the three central common law courts with their common law judges. . . . the main staples of chancery jurisdiction became the broader and deeper reality behind appearances, and the subtleties forbidden by the formalized writ, such as fraud, mistake, and fiduciary relationships.83 because common law courts awarded only after-the-fact money damages, which did not provide appropriate relief in all cases, the court of chancery made available both preventive injunctive relief and nonemontary relief such as specific performance. “that this court was attempting to do ‘equity,’ that84 is to accomplish justice, gave rise to the term ‘equity’ as the designation for the system of jurisprudence involved, and the court that dispensed it as a court of equity.”85 equity is probably noted most for its remedies. injunctions and specific performance are the classic equitable remedies. other equitable remedies86 include rescission and reformation of contracts, and imposition of constructive trusts. in fact, equity consisted of several additional elements that87 distinguished it from law: its pleading practice, including its causes of action88 89 the ecclesiastical courts. see moser, supra, at 485-486; timothy s. haskett, the medieval english court of chancery, 14 law & hist. rev. 245, 256-257 (1996). 82. stephen n. subrin, how equity conquered common law: the federal rules of civil procedure in historical perspective, 135 u. pa. l. rev. 909, 914 (1987). “lawyers well into the nineteenth century on both sides of the atlantic viewed the ‘common law’ procedural system as comprising the writ or form of action, the jury, and the technical pleading requirements that attempted to reduce cases to a single issue.” id. at 917. previously, there were multiple, competing courts. see supra note 81. 83. id. at 918 (footnotes omitted). 84. see kennedy, supra note 80, at 612. 85. id. 86. see kennedy, supra note 80, at 627 (“equitable remedies can be divided into two kinds: coercive and restitutionary. coercive, or injunctive, remedies are the most common.”). 87. see the honorable marcia s. krieger, “the bankruptcy court is a court of equity”: what does that mean?, 50 s.c. l. rev. 275, 281 (1999). 88. see kroger, supra note 7, at 1433. 89. moser, supra note 81, at 484 (footnote omitted). historically, certain causes of action, such as accountings and novel disseisin, were cognizable only in equity courts. see, e.g., natalie a. dejarlais, note, the consumer trust fund: a cy pres solution to undistributed 2001] equity and the article i court 373 and defenses, and its system of discovery. furthermore, actions in equity90 91 also generally were not triable by jury, and “certain forms of property, such92 as mortgages and trusts, were recognized only in equity courts.”93 equity developed maxims that limited its application to those cases in which it was thought justice could be done through equity. those maxims include, “equity does not suffer wrong to be without a remedy” and “he who94 seeks equity must do equity.” in addition, equitable relief was available only95 in equity courts, and only when there was no adequate remedy at law.96 97 furthermore, equitable defenses were appropriately raised in response to equitable claims, not claims at law. equitable defenses include laches,98 equitable recoupment, and equitable estoppel. laches is an equitable defense that refers to the staleness of a claim, serving a role similar to that of a statute99 of limitations, which generally did not exist in equity. for example, in tax100 funds in consumer class actions, 38 hastings l.j. 729, 732 (1987) (“the class action originated in the english courts of chancery with the ‘bill of peace.’ a creature of equity, the bill of peace allowed a representative of a group of similarly injured persons to bring suit on behalf of absent class members as well as herself.”). see also subrin, supra note 82, at 915 (“the writ of novel disseisin . . . was designed to provide for the rapid ejection of one who was wrongfully on the plaintiff’s land.”). 90. equitable defenses include laches, see kennedy, supra note 80, at 622 (“along with the unclean hands doctrine . . . laches is the chief defense to equitable claims brought by a plaintiff who has unreasonably delayed his claim.”); unclean hands, george keeton, an introduction to equity 112 (6th ed. 1965) (“he who comes into equity must come with clean hands.”); equitable estoppel, see john m. maguire & philip zimet, hobson’s choice and similar practices in federal taxation, 48 harv. l. rev. 1281, 1321 (1935); and equitable recoupment, see id. 91. see kroger, supra note 7, at 1433. 92. see subrin, supra note 82, at 920. 93. see kroger, supra note 7, at 1433. 94. keeton, supra note 90, at 89. 95. id. at 87-117. “this maxim . . . is designed to prevent the unjust enrichment of the plaintiff at the expense of the defendant . . . .” kennedy, supra note 80, at 618. 96. ellen e. sward, legislative courts, article iii, and the seventh amendment, 77 n.c. l. rev. 1037, 1041 n.15 (1999) (“courts of law, whose jurisdiction was limited to common law writs, could never hear and decide equitable matters.”) (citing s.f.c. milsom, historical foundations of the common law 33-36 (2d ed. 1981)). 97. krieger, supra note 87, at 279. this is no longer true in practice. see douglas laycock, the death of the irreparable injury rule, 103 harv. l. rev. 687 (1990). 98. see, e.g., county of oneida v. oneida indian nation, 470 u.s. 226, 244-45 n.16 (1985) (“[a]pplication of the equitable defense of laches in an action at law would be novel indeed.”); 1 dan b. dobbs, law of remedies 2.4(2), at 94 (2d ed. 1993) (“discretion to deny legal relief would mean that the judge might refuse to permit recovery of personal injury damages to a pedestrian struck down in a crosswalk on the ground that she was on her way to an illicit rendezvous and would not have been injured had she stayed home with her family.”); martin kasten, summons at 1600: clinton v. jones’ impact on the american presidency, 51 ark. l. rev. 551, 568 (1998) (“equitable defenses, such as laches, are not available in a case at law.”). 99. see southern pac. transp. co. v. commissioner, 75 t.c. 497, 840 (1980). 100. see ashraf ray ibrahim, note, the doctrine of laches in international law, 83 va. l. rev. 647, 647 (1997) (“unlike statutes of limitations, which are legislatively created and 374 florida tax review [vol. 5:5 cases, a taxpayer might assert the defense when the irs took unusually long in pursuing the case.101 2. equity in the united states.—the american colonies generally distinguished between law and equity. in the united states, the same court102 often sat in both law and equity, even before the merger of law and equity in 1938. when a federal court sat in law, juries were used, and in common law103 actions, federal courts applied state law. when a federal court sat in equity,104 a judge decided the case, applying the precedents of the english chancery court, except as modified by any equity rules promulgated by the supreme court.105 the language of article iii of the constitution reflects the then-existing separation of law and equity, stating, in part, “the judicial power shall extend to all cases, in law and equity, arising under this constitution . . . .”106 when the framers of the constitution began to design a system of national courts, they naturally used the english model. the federal courts were to be units of government that exercised “judicial power,” one of the component parts of sovereign authority. they could exercise that power in common law, equity, and admiralty/maritime. . . . although generally deferring to common law's interpretation of substantive rights, federal equity would, like its english predecessor, provide relief from the rigidity of common law by exercising discretion in procedure and remedies.107 the judiciary act of 1789 granted the federal circuit courts jurisdiction over “suits of a civil nature at common law or in equity” between citizens of different states but denied equity jurisdiction where there was a complete and108 adequate remedy at law. at the time the judiciary act was enacted, there was109 mechanically applied in courts of law, the doctrine of laches developed as an affirmative defense in courts of equity – historically outside the statute of limitations’ purview.”). 101. see, e.g., mecom v. commissioner, 101 t.c. 374, 391 (1993); tregre v. commissioner, 71 t.c. memo (cch) 3,098, t.c. memo (ria) ¶ 96,243 (1996). 102. kroger, supra note 7, at 1438. (“by the time of the constitutional convention in 1787, all thirteen states had, at one time or another, granted their courts or governors equity powers.”) id. 103. see krieger, supra note 87, at 280. 104. id. 105. id. 106. u.s. const. art. iii. § 2, cl. 1 (emphasis added). 107. john t. cross, the erie doctrine in equity, 60 la. l. rev. 173, 210-11 (1999). 108. 1 stat. 78 (1789) (quoted in naomi r. cahn, family law, federalism, and the federal courts, 79 iowa l. rev. 1073, 1087-88 (1994)). 109. 1 stat. 73, 82 (1789) (quoted in baker v. biddle, 2 f. cas. 439, 443 (e.d. pa. 2001] equity and the article i court 375 substantial disagreement as to whether equity focused on judicial discretion without reference to precedence (the traditional view) or instead was subject to specific procedures and stare decisis (the view of reformers). it was not110 until after the year 1800 that the supreme court, under chief justice marshall, began to depart from the traditional view of equity.111 over time, the supreme court began to “blur the lines between law and equity” by importing various legal doctrines, such as stare decisis, into equity. in 1938, law and equity were merged in the federal courts through the112 adoption of the federal rules of civil procedure. generally speaking, as a113 result of the merger, “in civil matters before the district court . . . the distinction between law and equity is now limited to the type of remedy imposed and the parties’ right to a jury trial.” in addition, the use of equitable defenses is no114 longer limited to equitable claims.115 b. equity in article i courts 1. in general.—article i courts are a heterogeneous group. the116 bankruptcy courts are commonly termed “courts of equity,” although the117 appellation is misleading. congress has expressly granted the court of118 federal claims certain equitable powers, and the tax court, though lacking119 at least “general equity jurisdiction,” routinely applies equitable principles. yet, despite their heterogeneity, all article i courts are creatures of statute. 1831)). this provision “prevent[ed] encroachment upon the common-law right to jury trial inasmuch as the seventh amendment had not been adopted at that time,” 2 j. moore, moore’s federal practice ¶ 2.05[1] (2d ed. 1989). this is not surprising because the seventh amendment was under consideration by congress at the time the judiciary act passed. charles warren, new light on the history of the federal judiciary act of 1789, 37 harv. l. rev. 49, 54 (1923). 110. kroger, supra note 7, at 1433. 111. id. at 1446. 112. kroger, supra note 7, at 1452-1453. 113. see ross v. bernhard, 396 u.s. 531, 539 (1970); fed. r. civ. p. 2. 114. krieger, supra note 87, at 281. 115. see edward yorio, a defense of equitable defenses, 51 ohio st. l.j. 1201, 1205 (1990). 116. such diverse courts as the territorial courts, military courts martial, and the courts for the district of columbia are all article i courts. see ron weiss, contempt power of the bankruptcy court, 6 bank. dev. j. 205, 239 (1989). 117. see krieger, supra note 87, at 276 n.1 (“in the author’s experience, the frequency of reference to the bankruptcy court as a court of equity is second only to introductions, ‘may it please the court’ or ‘good morning (afternoon), your honor.’”). 118. see id. at 292 (“neither bankruptcy law nor bankruptcy courts can claim roots in english courts of equity. bankruptcy remedies and insolvency rights have always been a product of legislative enactment rather than case-by-case determination in common law or equity courts.”); id. at 309 (“bankruptcy courts apply a statutory scheme rather than equitable maxims”). in the united states, bankruptcy is a statutory creation. bankruptcy courts are courts of “equity” in the fairness sense, rather than in the chancery sense. 119. see infra note 122 and accompanying text; see also ct. fed. cl. 2, 8(e)(2). 376 florida tax review [vol. 5:5 article iii courts have equitable power because it is specifically authorized by article iii itself and granted to these courts by congress.120 article i does not contain similar language. simply being a “court” should121 not confer equitable power because, constitutionally, there is a difference between constitutional courts that exercise power granted by article iii of the constitution and legislative courts that may only exercise power expressly conferred by congress. nonetheless, congress has authorized certain article i courts to apply equitable principles in certain situations. for example, since 1982, the court of federal claims, an article i court, has had the power to grant equitable relief in contract actions. similarly, the tax court has declaratory judgment power122 in a narrow set of cases. however, power to grant an equitable remedy, such123 as an injunction or a declaratory judgment, is still circumscribed by statute. in general, any equitable power an article i court exercises finds its source in a statute. the statute defining a court’s jurisdiction may specifically authorize the application of equitable relief as is true for the court of federal claims. specific statutory provisions that the court is charged with applying124 may also authorize the use of equity. for example, certain internal revenue code provisions expressly bring equitable principles into the analysis.125 in addition to true equitable power, article i courts may use equitable considerations where that is provided by statute. in such instances, the use of the term “equity” may be a definitional shorthand rather than a true grant of equitable power. in other words, congress may use the terms “equity” or “equitable” to refer to the types of fairness considerations that are part of the jurisprudence of equity, without actually conferring equitable powers by doing so. for example, as discussed below, general innocent spouse relief126 127 120. see u.s. const. art. iii. § 2, cl. 1(“the judicial power shall extend to all cases, in law and equity, arising under this constitution . . . .”). 121. see cross, supra note 107, at 201 (“congress cannot delegate authority it does not have. none of congress’s enumerated powers, even when augmented by the necessary and proper clause, are broad enough to cover the entire set of substantive rules that comprise the law of equity.”) (footnotes omitted); id. at 218 (“congress exercises the legislative power, not the judicial.”). 122. see 28 u.s.c. § 1491(b)(1) (2000); 28 u.s.c. § 1491(a)(3) (1996) (“to afford complete relief on any contract claim brought before the contract is awarded, the court shall have exclusive jurisdiction to grant declaratory judgments and such equitable and extraordinary relief as it deems proper, including but not limited to injunctive relief. in exercising this jurisdiction, the court shall give due regard to the interests of national defense and national security.”); administrative dispute resolution act of 1996, p.l. 104-320, § 12(a), 110 stat. 3875; the federal courts improvement act of 1982, pub. l. no. 97-164, § 133, 96 stat. 25, 41. 123. see supra note 45. 124. see 28 u.s.c. § 1491(b)(1) (2000); 28 u.s.c. § 1491(a)(3) (1996). 125. see, e.g., irc §§ 6015(b) (equity of awarding innocent spouse relief from joint and several liability), 6511(h) (equitable tolling of statute of limitations on refund claims). 126. see infra notes 262-64 and accompanying text. 127. the innocent spouse defense allows an exception in certain cases from the rule of 2001] equity and the article i court 377 includes a provision requiring that “taking into account all the facts and circumstances, it is inequitable to hold the other individual liable for the deficiency in tax for such taxable year attributable to such understatement . . . .” that use of the word “inequitable” likely refers to factors in128 determining the “fairness” of innocent spouse relief. this distinction does not affect the tax court’s statutory power to decide the innocent spouse claim, but it may affect the tax court’s power to consider equitable defenses.129 an analogous situation may occur with respect to claims with an equitable heritage. that is, congress’ grant to an article i court of jurisdiction over an equity-based cause of action probably carries with it the power to consider related equitable defenses. on the other hand, if an action has equitable aspects only in the sense that it has a fairness-based history, that need not bring with it the power to hear equity-based defenses. for example, tax refund claims are heard both by the federal district courts, which are article iii courts, and the court of federal claims, which is an article i court.130 numerous decisions by these courts state that the current refund suit derives from the action for indebitatus assumpsit for money had and received. as discussed below, that action is infused with equity-type fairness considerations. yet that may not mean that the court of federal claims can apply equitable recoupment or equitable estoppel in tax refund cases. similarly, in current legal practice, “general equitable powers,” such as the power “to take jurisdiction over a matter not provided for by statute” may be distinguishable from the power to apply “equitable principles” such as joint and several liability of spouses filing a joint tax return. see irc §§ 6013(d)(3) (“if a joint return is made, the tax shall be computed on the aggregate income and the liability with respect to the tax shall be joint and several.”), 6015 (providing for innocent spouse relief). 128. irc § 6015(b)(1)(d) (emphasis added). 129. see, e.g., friedman v. commissioner, 53 f.3d 523, 532 (2d cir. 1995) (with respect to equity element, “[r]elevant factors include significant benefits received as a result of the understatements of the spouse claiming relief, any participation in the wrongdoing on the part of the ‘innocent’ spouse, and the effect of a subsequent divorce or separation.”) (interpreting code section 6013(e)(1)(d)); pietromonaco v. commissioner, 3 f.3d 1342, 1347 (9th cir. 1993) (significant benefit in excess of normal support is a factor relevant to equity of granting innocent spouse relief); see also regs. § 1.6013-5(b) (“whether it is inequitable to hold a person liable for the deficiency in tax . . . is to be determined on the basis of all the facts and circumstances. in making such a determination a factor to be considered is whether the person seeking relief significantly benefitted, directly or indirectly, from the items omitted from gross income. however, normal support is not a significant ‘benefit’ for purposes of this determination.”). 130. the court of federal claims has an article iii history. its predecessor, the court of claims, was an article iii court, with trial and appellate jurisdiction, until 1982. stephen j. legatzke, note, the equitable recoupment doctrine in united states v. dalm: where’s the equity?, 10 va. tax rev. 861, 895 n.252 (1991). in 1982, congress created the trial-level claims court under article i. see federal courts improvement act of 1982, pub. l. no. 97-164, §§ 105, 133, 139, 96 stat., at 26-28, 39-41, 42-44. at that time, congress also renamed the court the united states claims court. see id. 378 florida tax review [vol. 5:5 equitable estoppel. for example, the supreme court has stated that “the131 court of claims has no power to grant equitable relief.” subsequently,132 congress provided the court with jurisdiction to afford equitable relief, including injunctive relief, in “any contract claim brought before the contract is awarded.” during the life of that provision, the supreme court ruled that133 the claims court had jurisdiction only to award damages, not specific equitable relief, in a case involving review of the department of health and human services’ administration of medicaid. the supreme court stated, “the134 claims court does not have the general equitable powers of a district court to grant prospective relief.” the court acknowledged both its prior statement135 that “the court of claims has no power to grant equitable relief” and congress’ subsequent grant of equitable powers with respect to a different type of action than the one before it.136 the distinction drawn by the supreme court with respect to the court of federal claims is quite helpful in understanding the limits on the equitable powers of article i courts. article i courts have no general equitable powers or generalized ability to grant equitable relief purely from their existence as courts of law. however, to the extent that congress affords to an article i court jurisdiction over equitable causes of action or jurisdiction to grant equitable relief, the court has those powers unless the grant unconstitutionally infringes on article iii courts. 2. equity in the tax court.—in general, the debate over the tax court’s equitable powers has taken place in specific contexts with respect to specific equitable doctrines, most notably equitable recoupment and equitable estoppel. in addition, and most recently, the tax court has asserted137 jurisdiction over equitable innocent spouse relief despite statutory language that does not seem to grant such jurisdiction.138 131. buchine v. commissioner, 20 f.3d 173, 176-77 (5th cir. 1994). 132. richardson v. morris, 409 u.s. 464, 465 (1973). 133. see 28 u.s.c. § 1491(a)(3) (1996); administrative dispute resolution act of 1996, pub. l. no. 104-320, § 12(a), 110 stat. 3875; the federal courts improvement act of 1982, pub. l. no. 97-164, § 133, 96 stat. 25, 41 (1982). that provision was deleted and replaced with a similar one in 1996. see 28 u.s.c. § 1491(b)(1) (2000); pub. l. no. 104-320, § 12(a), 110 stat. 3874 (oct. 19, 1996). 134. bowen v. massachusetts, 487 u.s. 879 (1988). 135. id. at 905; see also kanemoto v. reno, 41 f.3d 641, 644-45 (fed. cir. 1994) (“the court of federal claims is an article i trial court of limited jurisdiction. . . . the remedies available in that court extend only to those affording monetary relief; the court cannot entertain claims for injunctive relief or specific performance, except in narrowly defined, statutorily provided circumstances not here pertinent.”) (citation omitted). 136. bowen , 487 u.s., at 905 n.40 (1988). 137. see dubroff, supra note 62, at 483-84. 138. see infra notes 265-75 and accompanying text. 2001] equity and the article i court 379 a. the equitable recoupment saga.—“[e]quitable recoupment allows a party to use a tax related claim, barred by the statute of limitations, as a defense to another party’s timely tax-related claim, where the two claims arise out of the same transaction or taxable event.” it “is based upon the concept139 that ‘one taxable event should not be taxed twice, once on a correct theory and once on an incorrect theory . . . and that to avoid this happening the statute of limitations will be waived.’”140 the tax court’s power to consider equitable recoupment arguments has a long and winding history. historically, the irs took the position that it was not entitled to offset a barred deficiency against a timely refund claim.141 its analysis was primarily statutory. however, in lewis v. reynolds, the142 143 supreme court allowed the irs to avoid issuing a refund when it found a deficiency for the same tax year after the statute of limitations on assessment had run. shortly thereafter, in bull v. united states, a tax refund action, the144 supreme court recognized that although the taxpayer was the plaintiff, functionally he was defending a claim made by the government, and allowed145 him to use recoupment, thus modernizing the doctrine. yet, with respect to146 the board of tax appeals, the supreme court stated in 1943: the internal revenue code, not general equitable principles, is the mainspring of the board’s jurisdiction. until congress deems it advisable to allow the board to determine the overpayment or underpayment in any taxable year other than the one for which a deficiency has been assessed, the board 139. james e. tierney, equitable recoupment revisited: the scope of the doctrine in federal tax cases after united states v. dalm, 80 ky. l.j. 95, 101-02 (1991) (footnote omitted). equitable recoupment issues may result because the party seeking recoupment has not planned ahead to avoid the problem of a statute of limitations about to expire. see burgess j.w. raby & william l. raby, equitable recoupment – maybe not for tax court? 81 tax notes 87, 91 (1998) (“tax practitioners need to remember that the problem is caused by the statute of limitations. the best cure is usually the protective refund claim. this works much better than statute mitigation or equitable recoupment. file them early; file them often.”). 140. mann v. united states, 552 f. supp. 1132, 1135 (n.d. tex. 1982) (quoting minskoff v. united states, 490 f.2d 1283, 1285 (6th cir. 1974)). 141. see, e.g., l.o. 1095, i-1 c.b. 313 (1922). 142. id. at 314. 143. 284 u.s. 281 (1933). 144. 295 u.s. 247, 260 (1935) (“the usual procedure for the recovery of debts is reversed in the field of taxation.”). 145. see leandra lederman, “civil”izing tax procedure: applying general federal learning to statutory notices of deficiency, 30 u.c. davis l. rev. 183, 192-93 (1996). 146. john a. lynch, jr., income tax statute of limitations: sixty years of mitigation enough, already!!, 51 s.c. l. rev. 62, 113-15 (1996). 380 florida tax review [vol. 5:5 must remain impotent when the plea of equitable recoupment is based upon an overpayment or underpayment in such other year. 147 for years, tax court cases consistently expressed the view that the court lacked jurisdiction over equitable recoupment claims. in 1998,148 congress considered granting the tax court jurisdiction over a refund action either related by subject matter to a pending deficiency action, or where the result in either action would affect the amount in controversy in the other action. the provision included language providing that the tax court’s149 jurisdiction would “include any counterclaim, set-off, or equitable recoupment against (or for) the taxpayer.” that provision became part of the technical150 and miscellaneous revenue act of 1988, but was deleted at conference without explanation.151 [j]udicial application of equitable recoupment historically evinces a strong desire to keep the equity genie in the bottle because a genie who possesses equitable powers threatens values dear to the law of taxation and, indeed, the entire federal system. these threatened values include the annual accounting principle, limitation of actions, and its esteemed relative, sovereign immunity.152 one problem for the tax court is that, unlike with respect to equitable estoppel, discussed below, there was and is a specific statutory barrier to the board/tax court’s consideration of equitable recoupment. code section153 6214(b) provides that, in making an income tax or gift tax determination for a particular year or calendar quarter, the tax court has “no jurisdiction to determine whether or not the tax for any other year or calendar quarter has been overpaid or underpaid.” arguably, that precludes equitable recoupment154 147. commissioner v. gooch milling & elevator co., 320 u.s. 418, 422 (1943). 148. see e.g., estate of schneider v. commissioner, 93 t.c. 568, 570 (1989); phillips petroleum co. v. commissioner, 92 t.c. 885, 888-890 (1989); poinier v. commissioner, 86 t.c. 478, 490-491 (1986), aff’d, in part and rev’d, in part, 898 f.2d 917 (3d cir. 1988); estate of van winkle v. commissioner, 51 t.c. 994, 999-1000 (1969); vandenberge v. commissioner, 3 t.c. 321, 327-328 (1944), aff’d, 147 f.2d 167 (5th cir. 1945); cf. rev. rul. 71-56, 1971-1 c.b. 404, 405 (“the tax court lacks jurisdiction to consider a plea of equitable recoupment”). 149. see s.2238 § 785, 100th cong., 2d. sess., 134 cong. rec. s12344 (daily ed., sept. 12, 1988). 150. id. 151. h.r. conf. rep. no. 1104, 100th cong., 2d. sess., 233-34 (1988). 152. lynch, supra note 146, at 108 (footnote omitted). 153. see revenue act of 1926, ch. 27 § 274(g), 44 stat. 56; dubroff, supra note 62, at 485. 154. irc § 6214(b). 2001] equity and the article i court 381 involving income taxes and gift taxes. in 1999, congress considered adding155 a sentence to section 6214(b) that would grant the tax court equitable recoupment power. the provision was part of the taxpayer refund and relief act of 1999, which was vetoed by president clinton.156 in united states v. dalm, the supreme court stated that because dalm had not raised the issue in her tax court petition, the court had “no occasion to pass upon the question whether dalm could have raised a recoupment claim in the tax court.” in dissent, justice stevens echoed the majority’s view that157 it was possible that the tax court did have equitable recoupment jurisdiction.158 those statements provided an opening for the tax court to reconsider its power to apply equitable recoupment.159 in estate of mueller v. commissioner (mueller ii), the tax court160 considered only the question of whether the tax court had jurisdiction to apply equitable recoupment. in mueller ii, the taxpayer-estate raised “the partial affirmative defense of equitable recoupment” with respect to a time-barred overpayment of income tax by the estate’s residuary legatee, the bessie i. mueller trust (trust). both the time-barred income tax overpayment and the161 estate tax deficiency were based on the estate’s valuation of stock in the mueller company, which the irs had contested. the irs moved to dismiss162 the defense for lack of jurisdiction. the tax court held that it had163 jurisdiction to consider the affirmative defense of equitable recoupment when the defense is raised in a tax deficiency case over which it has jurisdiction.164 the court stated, “in deciding this case, we may take into account all facts that 155. the counter-argument is that § 6214(b) only precludes determination of prior years’ income taxes in income tax cases, and prior years’ gift taxes in gift tax cases, and that it does not apply if the two types of tax are different. this argument is based on the statute’s use of the phrase “the tax,” which seemingly refers to the same tax under consideration, and on its legislative history. for a discussion of the legislative history, see estate of bartels v. commissioner, 106 t.c. 430, 434 (1996). 156. h.r. 2448 § 1343, h.r. conf. rep. 106-289 at 194. 157. united states v. dalm, 494 u.s. 596, 611 n.8 (1990). 158. see id. at 615 n.3 (stevens, j., dissenting). 159. see estate of mueller v. commissioner, 101 t.c. 551, 553 (1993). 160. id. there was a prior decision in mueller that focused on valuation of mueller co. stock. see estate of mueller v. commissioner, 63 t.c. memo (cch) 3,027, t.c. memo (ria) ¶ 92,284 (1992). that opinion is referred to by the courts as mueller i. see estate of mueller v. commissioner, 107 t.c. 189, 191 (1996), aff’d, on other grounds,153 f.3d 302 (6th cir. 1998), cert. denied, 525 u.s. 1140 (1999); see also estate of mueller v. commissioner, 101 t.c. 551, 551 (1993). 161. estate of mueller, 101 t.c. at 551. 162. see estate of mueller, 107 t.c. at 190. in mueller i, the tax court held “that the date-of-death value of the mueller co. stock was $1,700 per share, as opposed to $1,505 per share as reported on petitioner’s estate tax return or $2,150 as determined by respondent in the notice of deficiency.” estate of mueller, 107 t.c. at 191. 163. estate of mueller, 101 t.c. at 551. 164. id. at 560. 382 florida tax review [vol. 5:5 bear on petitioner's deficiency and may apply equitable principles in so doing.” essentially, the court’s position was that it could consider any165 argument necessary to making a decision in the case. in its decision in mueller ii, the tax court found that the statute that precluded jurisdiction over other tax years did not bar the application of166 equitable recoupment. instead, the court focused on whether it had equity167 jurisdiction. it is not surprising that the court was reluctant to hold that it simply did not have the equitable power to consider the equitable recoupment argument. easing into its holding that the court had jurisdiction over an equitable recoupment claim, the tax court in mueller ii referred to equitable recoupment as having “developed concurrently at common law and in equity,” citing a commentator who has been noted for his singularity in168 disputing recoupment’s origins in equity. in fact, at common law, recoupment169 was narrowly applied to allow the defendant to reduce the amount owed to the plaintiff by prior payment or recovery with respect to the same claim. in170 addition, even then, “[t]he defense of recoupment was an innovation upon, or departure from, the strict rules of law, sanctioned by the courts for the purpose of doing equity between parties, where it could not be otherwise attained, or not without a circuitous and expensive process.”171 judge chabot dissented in mueller ii, stating: the majority do not reveal to us where in subtitle b, or anywhere else in the internal revenue code, is the element of petitioner's tax that might be affected by possible application of equitable recoupment. obviously, equitable recoupment does not affect the amount shown as the tax on the taxpayer’s tax return. it appears that the doctrine of equitable recoupment does not affect what we have already described as the “sole issue for decision” in the instant case, or any other element of the internal revenue code that is to be taken into account in determining the amount of any deficiency in the instant case. . . .172 165. id. at 556. 166. see irc § 6214. 167. estate of mueller, 101 t.c. at 561. 168. id. at 552 (citing mcconnell, the doctrine of recoupment in federal taxation, 28 va. l. rev. 577, 579-581 (1942)). 169. lynch, supra note 146, at 111 n.297 (“unlike others who define this doctrine, mr. mcconnell disputes that its nature is equitable.”). 170. thomas w. waterman, a treatise on the law of set-off, recoupment, and counter-claim, §§ 455-460, at 476-480 (baker, voorhis & co. 1872). 171. id. § 421, at 469. 172. estate of mueller, 101 t.c. at 566 (chabot, j., dissenting). 2001] equity and the article i court 383 thus, judge chabot made the valid point that the application of equitable recoupment would neither affect the amount of deficiency nor result in an overpayment for the tax year, the linchpins of the tax court's subject matter173 jurisdiction in a tax deficiency case.174 in mueller iii, the tax court considered the actual application of equitable recoupment principles to the case. the court held that because equitable recoupment may only be used as a defense, and because, based on its valuation of the shares of the mueller company, the estate was entitled to an175 overpayment of estate tax, the doctrine did not apply to the case. this holding176 rendered mueller ii irrelevant to the ultimate result.177 on appeal, the court of appeals for the sixth circuit held that the tax court lacked jurisdiction to apply equitable recoupment. the sixth circuit178 found that [a] deficiency redetermination sought in the tax court should not be confused with a refund suit filed in the district court. whereas the deficiency redetermination is nothing more than the judicial review of an assessment made by an administrative agency, a refund suit is an “action brought to recover a tax erroneously paid, [which,] although an action at law is equitable in its function. it is the lineal successor of the common count indebitatus assumpsit for money had and received.”179 however, as discussed below, that analysis does not consider the similarities of the refund suit to the overpayment suit in tax court.180 subsequent to the sixth circuit’s adverse holding in mueller, the tax court nonetheless applied equitable recoupment in three cases, estate of bartels v. commissioner, appealable to the seventh circuit, estate of181 branson v. commissioner, appealable to the ninth circuit, and estate of182 orenstein v. commissioner, appealable to the eleventh circuit. in two of183 173. see id. at 568 (chabot, j., dissenting). 174. see irc §§ 6213, 6214(b). 175. see estate of mueller, 63 t.c. memo (cch) 3,027, t.c. memo (ria) ¶ 92,284 (1992); supra note 162. 176. estate of mueller, 107 t.c. at 199. 177. prior to its decision in mueller ii, the tax court had already valued the mueller company stock at issue. see estate of mueller, 63 t.c. memo (cch) 3,027, t.c. memo (ria) ¶ 92,284 (1992). it was that valuation, coupled with the irs’s allowance in the notice of deficiency of a credit for tax on prior transfers, that eliminated any deficiency in estate tax, and in fact entitled the estate to an overpayment. see estate of mueller, 107 t.c. at 191-192. 178. estate of mueller v. commissioner, 153 f.3d 302 (6th cir. 1998). 179. id. at 304 (quoting stone v. white, 301 u.s. 532 (1937)). 180. see infra notes 354-60 and accompanying text. 181. 106 t.c. 430 (1996). 182. 113 t.c. 6 (1999). 183. 79 t.c. memo (cch) 1971 (2000). 384 florida tax review [vol. 5:5 these cases, the tax court had to address circuit court case law on the issue of equitable recoupment application in the tax court; golsen v. commissioner184 requires the tax court to apply circuit precedent “squarely in point.”185 in estate of bartels v. commissioner, mr. and mrs. bartels had filed joint income tax returns for their 1981 and 1982 tax years. in 1990, after the186 death of both of the bartels, the irs issued notices of deficiency for those years, and their estates timely petitioned the tax court. the estates later187 conceded those income tax liabilities. however, mr. bartels’ estate sought188 to recoup a time-barred estate tax overpayment against the income tax deficiency. mr. bartels’ estate had filed an estate tax return on february 21, 1990. it had reported a total estate tax liability of $3,582,245, which it paid189 on february 20 and 21, and which was assessed on april 9, 1990. on190 november 18, 1991, the irs assessed a deficiency in estate tax of $94,364, plus interest of $17,094.88. the estate paid both amounts on september 18,191 1991. on its return, the estate had not claimed any deduction for debts of the192 decedent to the irs for income tax liabilities for the 1981 and 1982 tax years.193 accordingly, on september 14, 1993, the estate filed an amended estate tax return, claiming additional deductions totaling $267,705.57, which resulted194 in an overpayment of estate tax of $108,689. because the estate had filed its195 amended return more than three years after its original return, the irs allowed the refund claim only to the extent of estate tax paid within two years before the amended estate tax return was filed ($94,364). the irs thus found that196 $14,325 of the estate tax overpayment was barred by the statute of limitations. the taxpayers asserted in tax court that the amount of the197 federal income tax deficiencies should be reduced by the time-barred overpayment of estate tax, under the doctrine of equitable recoupment. the198 tax court held that it had jurisdiction to consider the equitable recoupment 184. 54 t.c. 742 (1970), aff’d, on other grounds, 445 f.2d 985 (10th cir. 1971); cert. denied, 404 u.s. 940 (1971). 185. id. at 757. 186. estate of bartels, 106 t.c. at 431. 187. id. at 432. 188. id. 189. estate of bartels, 106 t.c. at 432. 190. id. 191. id. 192. id. 193. id. 194. id. 195. id. 196. see id. at 433; irc § 6511(a). 197. see estate of bartels, 106 t.c. at 433. 198. id. 2001] equity and the article i court 385 argument, and granted the taxpayers’ motion. in part, the court found that199 section 6214(b), which precludes tax court consideration of income or gift tax liability for any year not before the court, did not preclude the court from allowing equitable recoupment of the estate tax overpayment against the income tax deficiency.200 the facts of orenstein v. commissioner parallel those of estate of201 bartels. the irs issued notices of deficiency in income tax to the orensteins with respect to their 1981 and 1982 tax years. after mrs. orenstein’s death202 in 1983, mr. orenstein petitioned the tax court for a redetermination of the income tax deficiency. mr. orenstein died in 1993 and his estate filed a203 return that did not reflect a deduction for pending 1981 and 1982 income tax liabilities. in 1998, the taxpayers’ estates conceded the income tax204 deficiencies. because a refund of estate taxes based on the deduction of the income tax liability was time-barred, the estates sought equitable recoupment of the barred estate tax overpayment against the conceded income tax deficiency.205 in orenstein, the tax court considered continental equities, inc. v. commissioner, in which the court of appeals for the fifth circuit had stated,206 “the conclusion that the 1969 tax reform act [establishing the tax court as an article i court] did not grant the tax court equitable jurisdiction is inescapable. the courts that have addressed the issue are in agreement without [sic] conclusion that the tax court still does not possess jurisdiction over equitable claims.” nonetheless, the tax court did not feel bound by207 continental equities, inc. because of the lack of factual similarity of the two cases, the intervening passage of two decades during which the understanding of equitable recoupment had evolved, and the eleventh circuit’s decision in bokum v. commissioner that the tax court had jurisdiction to apply a208 different equitable doctrine, equitable estoppel. thus, in orenstein, as in209 bartels, the tax court allowed recoupment of the otherwise barred estate tax against the income tax deficiencies.210 199. id. at 436. 200. id. at 435. 201. 79 t.c. memo (cch) 1971 (2000). 202. id. 203. id. 204. id. 205. id. 206. 551 f.2d 74 (5th cir. 1977). cases decided by the court of appeals for the fifth circuit prior to october 1, 1981, are considered binding precedent within the eleventh circuit. see bonner v. city of prichard, 661 f.2d 1206, 1209 (11th cir. 1981). 207. continental equities, inc., 551 f.2d at 84. 208. 992 f.2d 1136 (11th cir. 1993), aff’g 58 t.c. memo (cch) 1183, t.c. memo (ria) ¶ 90,021 (1990). 209. orenstein v. commissioner, 79 t.c. memo (cch) 1971 (2000). 210. see id. 386 florida tax review [vol. 5:5 estate of branson presented facts similar to those involved in the mueller cases. in branson, the taxpayer-estate had reported certain date-ofdeath values of the stock in two companies, savings bank of mendocino county and bank of willits. the estate sold some of the shares in each211 company at a gain, and distributed the proceeds to the residuary legatee, who had assumed individual liability for the estate taxes. she also reported the212 gain on her federal income tax return and paid the income tax due. the irs213 determined a deficiency in estate tax liability based on higher valuations of the shares in each company. in a memorandum opinion, the tax court214 determined date-of-death fair market values that lay between the amounts asserted by the estate and the irs. that resulted in a deficiency in estate tax215 and an overpayment of income tax on the gains from sale. refund of the216 overpayment of income taxes was barred by the statute of limitations, so the estate asserted its entitlement to equitable recoupment, based on estate of mueller.217 in deciding estate of branson, the tax court considered mohawk petroleum co. v. commissioner, in which the ninth circuit had held that,218 under gooch milling & elevator co., the board of tax appeals lacked jurisdiction to consider equitable recoupment of income taxes. the tax court219 held that gooch milling, a case addressing the board of tax appeals (an executive agency), did not apply to the tax court (an article i court). accordingly, it found that the ninth circuit lacked precedent squarely on point. the tax court then followed its decision in mueller ii, allowing220 recoupment.221 the court of appeals for the ninth circuit recently affirmed estate of branson, holding that the tax court had the power to apply equitable recoupment, and that it properly applied it in the branson case. this decision222 has created a circuit split with the court of appeals for the sixth circuit. the223 ninth circuit’s reasoning in branson hinged on its view that it would be unfair to taxpayers not to have the option to raise an equitable recoupment claim in tax court, the sole forum not requiring advance payment of litigated taxes. the 211. estate of branson, 113 t.c. 6, 6 (1999), aff’d 264 f.3d 904 (9th cir. 2001). 212. id. at 7. 213. id. at 7-8. 214. id. at 9. 215. see estate of branson v. commissioner, 78 t.c. memo (cch) 78, t.c. memo (ria) ¶ 99,231 (1999). 216. estate of branson, 113 t.c. at 9. 217. id. 218. 148 f.2d 957, 959 (9th cir. 1945), aff’g 47 b.t.a. 952 (1942). 219. see id. at 959. 220. estate of branson, 113 t.c. at 13. 221. see id. at 36. 222. estate of branson v. commissioner, 264 f.3d 904 (9th cir. 2001). 223. see mueller v. commissioner, 153 f.3d 302 (6th cir. 1998). 2001] equity and the article i court 387 branson court accordingly found a “presumption” of equivalent authority of the tax court and the district courts, and held that “[t]o rebut this presumption . . . the commissioner must find specific support in the provisions of the tax code . . . .” because the ninth circuit did not find a bar to equitable224 recoupment in the code, it held that the tax court may apply equitable225 recoupment. this “parallelism fallacy” is debunked below.226 the ninth circuit discussed mueller in a footnote. it stated that its227 reading of section 6214(b) disagreed with that of the mueller court. it also seemed to distinguish mueller on the ground that the income tax and estate tax in mueller related to two different tax years, unlike in branson. apparently,228 the ninth circuit found significant the fact that in branson, the estate tax had been paid in 1992 (though the decedent died in 1991) and the income tax year229 in question was 1992 (though the income tax was paid in 1993). the court230 stated, “[w]e have no occasion to pass upon the question whether the tax court would have jurisdiction to consider an equitable recoupment claim where the tax sought to be recouped was from a previous tax year.” however, this231 analysis is flawed because the estate tax is not an annual tax, so it is not assessed for a particular “tax year.” it will be interesting to see whether the supreme court has an opportunity to consider this case. the opinions in these cases were not without dissenters. judge chabot expressed his belief that the tax court lacks equitable recoupment authority. in his dissent in estate of branson, he made the point that “nothing in the concepts of a ‘court’, or a ‘court of law’, makes equitable recoupment an essential characteristic of a court, or of a court of law.” he made a similar232 point in mueller i: 224. estate of branson, 113 t.c. at 14. 225. the branson court correctly stated that § 6214(b) did not apply because it does not refer to estate taxes. estate of branson, 264 f.3d at 913. 226. see infra notes 301-319 and accompanying text. 227. see estate of branson, 264 f.3d at 913 n.5. 228. id. (“we also note, however, that in mueller the taxpayer sought recoupment of an income tax overpayment that was made in a different tax year from the estate tax deficiency before the tax court.”); see also id. at 915 (“in this case, the taxpayer seeks to apply an income tax overpayment against an estate tax deficiency, both of which occurred in the same year.”). perhaps the strangest statement the court made in this regard is “[a]ppellee’s estate tax deficiency and consequent income tax overpayment were both paid in the same tax year.” id. at 912. in fact, the estate tax was paid in 1992, and the income tax with respect to 1992 was paid in 1993. see estate of branson v. commissioner, 113 t.c. 6, 8-9 (1999). the ninth circuit apparently had a fundamental misunderstanding of the different nature of income taxes and estate taxes. 229. see estate of branson v. commissioner, 113 t.c. at 6. 230. id. at 9. 231. estate of branson v. commissioner, 264 f.3d at 913 n.5. 232. estate of branson, 113 t.c. at 46 (chabot, j., dissenting). 388 florida tax review [vol. 5:5 in the context of considering whether the tax collector should refund to the taxpayer any specific amount of money that the taxpayer has paid to the tax collector, there has developed the concept of equitable recoupment as a doctrine that affects the “oughtness” of any such refund. thus, it may be more productive of understanding to say that equitable recoupment fits into the refund jurisdiction of certain fora, and not that those fora have equitable recoupment jurisdiction.233 however, this approach has not prevailed. b. equitable estoppel.—equitable estoppel is broader than equitable recoupment. the application of equitable estoppel prevents one party from obtaining an advantage over the other party through misleading conduct. “the application of the doctrine ordinarily involves a decision not234 to follow general principles of the tax law because of the equities in a particular case and therefore courts are cautious in its use.” equitable estoppel has four235 primary elements: (1) the first party, with knowledge of the facts, communicates something to a second party in a misleading way. (2) the second party reasonably relies on the communication. (3) the second party would be materially harmed if the first party is permitted to assert a claim inconsistent with his earlier communication. (4) the first party should have known that the second party would rely on the misleading communication.236 the tax court’s use of equitable estoppel reflects the court’s inconsistent approach to equitable doctrines in general. in some cases, the court applies equitable estoppel without analysis of its jurisdiction to do so. in237 other cases, the court asserts that it has jurisdiction to apply it, and in still238 other cases, the court has said that it lacks jurisdiction to apply it. thus, there239 is some dispute over whether the tax court may use equitable estoppel.240 equitable estoppel therefore provides a valuable springboard for consideration 233. estate of mueller, 101 t.c. at 567-68 (chabot, j., dissenting). 234. kennedy, supra note 80, at 624. 235. dubroff, supra note 62, at 488. 236. kennedy, supra note 80, at 624. 237. see, e.g., graff v. commissioner, 74 t.c. 743, 760-65 (1980), aff’d, 673 f.2d 784 (5th cir. 1982); bartel v. commissioner, 54 t.c. 25 (1970); hollman v. commissioner, 38 t.c. 251, 260 (1962). 238. see e.g., orenstein v. commissioner, 79 t.c. memo (cch) 1971 (2000); alderman v. commissioner, 55 t.c. memo (cch) 86, t.c. memo (ria) ¶ 88,049 (1988). 239. see, e.g., schwartz v. commissioner, 40 t.c. 191, 193-94 (1963) (construing claim as claim for “pseudo-estoppel”); lorain ave. clinic v. commissioner, 31 t.c. 141, 164 (1958); see also dubroff, supra note 62, at 491. 240. see dubroff, supra note 62, at 492-93. 2001] equity and the article i court 389 of the tax court’s equitable power in the absence of a statute specifically granting or denying that jurisdiction. in some tax court cases, the court has used equitable estoppel, particularly against the taxpayer. in many other cases, it has refused to apply241 the doctrine either because one or more of the necessary elements were not present, or on the ground that it lacks equity jurisdiction. the tax court242 243 has been somewhat reluctant to apply estoppel against the government, for244 reasons that have nothing to do with whether or not it has equitable power; most courts are hesitant to estop the federal government.245 some courts seem simply to have assumed without analysis that the tax court has the power to use equitable estoppel. by contrast, in flight246 attendants against ual offset v. commissioner, judge posner expressly held247 that the tax court has jurisdiction over equitable estoppel claims, noting that “[t]he argument that the tax court cannot apply the doctrines of equitable tolling and equitable estoppel because it is a court of limited jurisdiction is fatuous. all federal courts are courts of limited jurisdiction.”248 241. see, e.g., sangers home for chronic patients, inc. v. commissioner, 72 t.c. 105 (1979) (taxpayer estopped); herschler v. commissioner, 48 t.c. memo (cch) 1475, t.c. memo (ria) ¶ 84,569 (1984) (taxpayer estopped); cf. fredericks v. commissioner, 126 f.3d 433 (3d cir. 1997) (government estopped), rev’g 71 t.c. memo (cch) 2998. 242. see, e.g., hofstetter v. commissioner, 98 t.c. 695, 700 (1992); kronish v. commissioner, 90 t.c. 684 (1988); boulez v. commissioner, 76 t.c. 209, 214-15 (1981); graff v. commissioner, 74 t.c. 743, 761 (1980); schwotzer v. commissioner, 51 t.c. memo (cch) 902, t.c. memo (ria) ¶ 86,161 (1986). 243. see dubroff, supra note 62, at 488. 244. see, e.g., hofstetter v. commissioner, 98 t.c. 695, 700 (1992) (equitable estoppel is to be applied against the government only “with utmost caution and restraint.”) (quoting estate of emerson v. commissioner, 67 t.c. 612, 617 (1977)); boulez v. commissioner, 76 t.c. 209, 214-15 (1981) (similarly quoting emerson), aff’d, 810 f.2d 209 (d.c. cir. 1987), cert. denied, 484 u.s. 896 (1987); graff, 74 t.c. 743, 761 (1980) (“although the doctrine of equitable estoppel is not inapplicable to the federal government, it has been applied to such government with caution and only where justice and fair play require it.”), aff’d, 673 f.2d 784 (5th cir. 1982). 245. see, e.g., kennedy v. united states, 965 f.2d 413, 417 (1992) (“this court, along with several other circuits, allows a private party to assert equitable estoppel against the government in a very narrow category of cases–when the traditional elements of estoppel are shown and there is affirmative misconduct on the part of the government.”) (citing united states v. asmar, 827 f.2d 907, 911 n.4 (3rd cir. 1987)); estate of carberry v. commissioner, 933 f.2d 1124, 1127 (2d cir. 1991) (“the doctrine of estoppel ‘is applied against the government “with the utmost caution and restraint.”’”) (quoting boulez v. commissioner, 76 t.c. 209, 214-15 (1981)); see also heckler v. community health serv. inc., 467 u.s. 51, 60 (1984) (expressly leaving open the possibility of a flat rule barring any estoppel against the government). 246. see, e.g., boulez v. commissioner, 810 f.2d 209, 218 n.68 (d.c. cir. 1987), cert. denied, 484 u.s. 896 (1987), aff’g 76 t.c. 209, 214-17 (1981); graff v. commissioner, 673 f.2d 784, 785 (5th cir. 1982), aff’g 74 t.c. 743, 760-65 (1980); estate of emerson v. commissioner, 67 t.c. 612, 617-18 (1977). 247. flight attendants against ual offset (faauo) and united air lines, inc. v. commissioner, 165 f.3d 572, 578 (7th cir. 1999). 248. id. 390 florida tax review [vol. 5:5 other courts have also held that the tax court may apply equitable estoppel. the ninth circuit has held that the tax court had the “equitable249 power to reform the two irs forms 872-a that were the subject of the deficiency determination before it.” similarly, in mayfair minerals, inc. v.250 commissioner, the fifth circuit affirmed the tax court’s holding that when251 the irs allowed the statute of limitations on assessment to run because of the taxpayer's misleading returns, equitable estoppel prohibited the taxpayer from denying that the deductions were properly taken in the earlier years in which he had taken them. relying on the equitable estoppel line of authority, the sixth circuit held, in reynolds v. commissioner, that the tax court has judicial estoppel power. “the judicial estoppel doctrine protects the integrity of the judicial252 process by preventing a party from taking a position inconsistent with one successfully and unequivocally asserted by the same party in a prior proceeding.” it prevents litigant game-playing through repudiation in one253 lawsuit of a ground successfully maintained in another lawsuit. the reynolds254 holding is somewhat surprising, because, as discussed above, it was the sixth circuit in estate of mueller that reversed the tax court’s holding that it may255 apply equitable recoupment. however, mueller involved a statutory bar to256 equitable recoupment, as well as supreme court authority (with respect to the board of tax appeals); reynolds did not involve either of these barriers.257 258 c. equitable innocent spouse relief.—certain internal revenue code sections expressly authorize the tax court to consider equitable concerns. for example, after the supreme court refused to apply equitable259 tolling in a 1997 statute of limitations case, congress amended the statute of260 limitations on refund claims to allow equitable tolling of the statute in certain 249. see, e.g., bokum v. commissioner, 992 f.2d 1136, 1140-41 (11th cir. 1993) (dictum) (“if the tax court lacked authority to entertain a claim of equitable estoppel . . . taxpayers would essentially be denied the right to challenge deficiencies in the tax court if they wanted to assert an equitable estoppel claim. this would be an unfair choice to pose to taxpayers, and would undermine the purpose of the tax court.”). 250. kelley v. commissioner, 45 f.3d 348, 352 (9th cir. 1995). 251. 456 f.2d 622 (5th cir. 1972). 252. reynolds v. commissioner, 861 f.2d 469, 472 (6th cir. 1988). 253. id. 254. see, e.g., ogden martin systems v. whiting corp., 179 f.3d 523, 526 (7th cir. 1999); levinson v. united states, 969 f.2d 260, 264 (7th cir. 1992). 255. estate of mueller v. commissioner, 153 f.3d 302 (6th cir. 1998), cert. denied, 525 u.s. 1140 (1999). 256. id. 257. see id. at 305-306. 258. see generally reynolds v. commissioner, 861 f.2d 469 (6th cir. 1988). 259. see supra note 128 and accompanying text. 260. united states v. brockamp, 519 u.s. 347 (1997). 2001] equity and the article i court 391 situations. similarly, section 6015, and its predecessor, section 6013(e),261 affording an innocent spouse defense to joint and several liability for taxes,262 also have equitable elements. code section 6015(b) provides, in part: (1) in general. under procedures prescribed by the secretary, if— (a) a joint return has been made for a taxable year; (b) on such return there is an understatement of tax attributable to erroneous items of one individual filing the joint return; (c) the other individual filing the joint return establishes that in signing the return he or she did not know, and had no reason to know, that there was such understatement; (d) taking into account all the facts and circumstances, it is inequitable to hold the other individual liable for the deficiency in tax for such taxable year attributable to such understatement; and (e) the other individual elects (in such form as the secretary may prescribe) the benefits of this subsection not later than the date which is 2 years after the date the secretary has begun collection activities with respect to the individual making the election, then the other individual shall be relieved of liability for tax (including interest, penalties, and other amounts) for such taxable year to the extent such liability is attributable to such understatement.263 statutorily, the tax court has jurisdiction over such an innocent spouse claim, and therefore must consider the equities of the facts and264 circumstances. the content of subsection (b) of section 6015 contrasts with that of subsection (f), which provides for innocent spouse relief based on equity: (f) equitable relief. under procedures prescribed by the secretary, if— (1) taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion of either); and (2) relief is not available to such individual under subsection (b) or (c), the secretary may relieve such individual of such liability. 265 this section arguably reflects the individualized justice without explicit standards that is the hallmark of equity.266 261. see irc § 6511(h). 262. see irc § 6013(d)(3). 263. irc § 6015(b)(1) (emphasis added). 264. see irc § 6015(e)(1)(a) (emphasis added). 265. irc § 6015(f). 266. see supra note 80 and accompanying text. the irs quickly produced a list of the facts and circumstances it considered appropriate to consider. see rev. proc. 2000-15, 2000-5 i.r.b. 447. 392 florida tax review [vol. 5:5 if the code provides the tax court with jurisdiction to consider section 6015(f) claims, then the tax court may exercise the discretion provided. however, the subsection of section 6015 providing the tax court with jurisdiction over innocent spouse claims seemingly does not provide for review of a denial of section 6015(f) equitable relief: (e) petition for review by tax court. (1) in general. in the case of an individual who elects to have subsection (b) or (c) apply— (a) in general. the individual may petition the tax court (and the tax court shall have jurisdiction) to determine the appropriate relief available to the individual under this section . . . .267 commentators considering subsection (e) soon after its enactment generally concluded that the tax court did not have jurisdiction over denials of section 6015(f) relief in light of the language italicized above.268 nonetheless, in three recent cases the tax court asserted that it had such jurisdiction, so long as it was also exercising jurisdiction over a claim under section 6015(b) or (c). the tax court noted, “where a taxpayer elects to have269 either subsection (b) or (c) apply, the taxpayer ‘may petition the tax court (and the tax court shall have jurisdiction) to determine the appropriate relief available to the individual under this section’.” the court found that the270 phrase “this section” in section 6015(e)(1)(a) referred to all of section 6015.271 surprisingly, the irs quickly acquiesced in the tax court’s assertion of jurisdiction over section 6015(f) claims, reversing its prior position that272 the irs’s determination of whether to afford equitable innocent spouse relief was not subject to judicial review. in fact, it found that the tax court has273 jurisdiction over section 6015(f) claims regardless of whether the taxpayer has also claimed relief under subsections (b) or (c), a reading arguably274 inconsistent with the language of the statute.275 267. irc § 6015(e)(1)(a) (emphasis added). 268. see, e.g., leslie book, the new collection due process taxpayer rights, 86 tax notes 1127, 1143 (2000); toni robinson & mary ferrari, the new innocent spouse provision: “reason and law walking hand in hand?”, 80 tax notes 835, 849 n.88 (2000); see also field serv. adv. no. 199929019 (1999), 1999 f.s.a. lexis 110. 269. see charlton v. commissioner, 114 t.c. 333 (2000); fernandez v. commissioner, 114 t.c. 324 (2000), action on decision, 2000-06 (may 12, 2000); butler v. commissioner, 114 t.c. 276 (2000). 270. butler, 114 t.c. at 289-90. 271. id. 272. see irs notice n(35)000-338 (june 5, 2000), 87 tax notes 1612 (june 19, 2000). this notice was issued about five weeks after the tax court’s first section 6015(f) decision, butler v. commissioner, 114 t.c. 276 (2000). 273. see, e.g., field serv. adv. no. 199929019 (1999), 1999 f.s.a. lexis 110. 274. irs notice n(35)000-338 (june 5, 2000), 87 tax notes 1612 (june 19, 2000). 275. see irc § 6015(e)(1). 2001] equity and the article i court 393 iv. the tax court: does it have equitable powers? the tax court has expressly recognized that it “is a court of limited jurisdiction, and . . . may exercise . . . jurisdiction only to the extent authorized by congress.” accordingly, as congress has never specifically granted the276 tax court equitable powers, one would expect the tax court to lack such277 powers. and in fact, traditionally, the tax court had held that, as a court created by statute under article i of the constitution, it lacks “equity jurisdiction.” moreover, the united states supreme court has stated that “the278 tax court is a court of limited jurisdiction and lacks general equitable powers.”279 nonetheless, as the discussion above demonstrates, over time, the tax court began to make use of equitable doctrines. in fact, in a 1989 decision,280 woods v. commissioner, in support of its decision to apply equitable281 principles and reform a form 872-a, the tax court listed numerous doctrines that it had previously applied, and that it considered to be grounded in equity.282 276. see fernandez v. commissioner, 114 t.c. 324, 328 (2000); gati v. commissioner, 113 t.c. 132, 133 (1999); yuen v. commissioner, 112 t.c. 123, 124 (1999); bourekis v. commissioner, 110 t.c. 20, 24 (1998). 277. as one commentator has noted, “[o]ver six decades have passed since congress created the tax court, and, as yet, congress has not authorized equity jurisdiction.” legatzke, supra note 130, at 894. 278. see, e.g., estate of van winkle v. commissioner, 51 t.c. 994, 999-1000 (1969) (tax court does not have jurisdiction over equitable recoupment claim); vandenberge v. commissioner, 3 t.c. 321, 327-28 (1944) (same), aff’d, 147 f.2d 167 (5th cir. 1945); payson v. commissioner, 6 t.c. memo (cch) 590, t.c. memo (ria) ¶ 47,147 (1947) (“respondent points out that petitioner seeks to invoke the doctrine of equitable estoppel and that this court is without general equity jurisdiction.”); cf. phillips petroleum co. v. commissioner, 92 t.c. 885, 889 (1989) (“the court may not ‘exercise “general equitable principles” to take jurisdiction over a matter not provided for by statute.’”) (quoting woods v. commissioner, 92 t.c. 726, 787 (1989)); doner v. commissioner, 48 t.c. memo (cch) 1276, t.c. memo (ria) ¶ 84,528 (1984) (“we are satisfied that we should not . . . apply the general equitable principle asserted by petitioner that the federal government should not be permitted to profit from its mistakes.”). in general, “equity jurisdiction” is a court’s power to hear certain civil actions according to the procedures that were applied in courts of equity, and to resolve them under equitable rules. black’s law dictionary 856 (7th ed. 1999). 279. commissioner v. mccoy, 484 u.s. 3, 7 (1987). 280. see, e.g., estate of mueller v. commissioner, 101 t.c. 551, 553 (1993) (equitable recoupment); orenstein v. commissioner, 79 t.c. memo (cch) 1971 (2000) (equitable estoppel); alderman v. commissioner, 55 t.c. memo (cch) 86, t.c. memo (ria) ¶ 88,049 (1988) (same). 281. 92 t.c. 776 (1989). 282. see id. at 784 (“we have applied the equity-based principles of waiver, duty of consistency, estoppel, substantial compliance, abuse of discretion, laches, and the tax benefit rule.”) (footnotes omitted). 394 florida tax review [vol. 5:5 given the tax court’s evolution from an executive agency to an article i court with increasingly broad jurisdiction, it may not be surprising that the283 tax court has sought to take on as many of the powers of an article iii court as possible. of course, the judges of the tax court do not all think with one mind. recently, tax court cases have reflected express disagreement among the judges of the tax court over the extent of the court's equitable powers.284 yet, a majority of the tax court considers the tax court to have at least some equitable power despite the lack of statutory authorization. several tax court285 judges apparently believe that the tax court may exercise the full panoply of equitable powers. in a concurring opinion in which judges parr, foley, vasquez, thornton, and marvel joined, judge laro stated:286 the u.s. tax court is a court of law that, like the u.s. district courts, has the authority to apply equitable principles such as equitable recoupment. . . . i write separately to emphasize the fact that this court, although different from district courts in a few regards, the most obvious of which is that district courts were created under article iii of the u.s. constitution whereas this court was created under article i of the u.s. constitution, is a court of law that has the authority to apply all of the judicial powers of a district court.287 283. see supra notes 35-57 and accompanying text. 284. see, e.g., estate of branson v. commissioner, 113 t.c. 6 (1999) (equitable recoupment case with majority opinion, two concurrences and one dissent); see supra notes 276282 and accompanying text. 285. see supra notes 280-84; infra note 287 and accompanying text. since the famous case of marbury v. madison, 5 u.s. 137 (1803), courts have opined on their own jurisdiction over matters before them, and asserted jurisdiction over those matters. courts generally have been loath to relinquish jurisdiction over cases before them. see, e.g., laura s. fitzgerald, beyond marbury: jurisdictional self-dealing in seminole tribe, 52 vand. l. rev. 407, 408-409 (1999) (“the [supreme] court ruled in its own favor each time it decided an overt question about the federal ‘judicial power’ vested by article iii, consistently voting to fortify the court’s status within the constitution’s structure for the separation of powers, often at congress’ direct expense.”) (footnotes omitted). in that light, the tax court’s actions are unsurprising. 286. with the exception of judge parr, all of these judges have been appointed since 1993. judge parr, appointed in 1985, is the author of the dorchester concurrence expressing the view that the tax court has the power to refuse to enter a bilateral settlement agreement, in the interest of justice. see dorchester indus. v. commissioner, 108 t.c. 320, 343 (1997) (parr, j., concurring). 287. estate of branson v. commissioner, 113 t.c. 6, 41 (1999) (laro, j., concurring). 2001] equity and the article i court 395 it is undeniable that the tax court is a court of law. it became a court288 of law in 1969, when congress made it a legislative court under article i of the constitution. yet, not all courts of law are governed by article iii of the289 constitution. as an article i court, the tax court is subject to constitutional and statutory limitations not applicable to article iii courts. thus, finding290 that the tax court is a “court of law” does not resolve whether the tax court has the authority to apply equitable doctrines. judge hamblen has stated, somewhat more modestly, “[w]hile we cannot expand our jurisdiction through equitable principles, we can apply equitable principles in the disposition of cases that come within our jurisdiction.” this statement was quoted in judge beghe’s majority opinion291 in estate of mueller v. commissioner in which 13 judges joined, including292 judges parr and laro. judge hamblen’s statement that the tax court cannot293 expand its jurisdiction through the use of equity is uncontrovertable. yet, it does not determine the issue of what constitutional limits article i may place on the tax court’s use of equity in cases before it. a court does not acquire jurisdiction by simply asserting that it has jurisdiction. even if a court has applied equitable doctrines without reversal294 on appeal, that does not necessarily mean that the court acted constitutionally or within its jurisdiction. in addition, as discussed above, judges may try to maximize power through their decisions. accordingly, assertions in tax295 288. see freytag, 501 u.s. at 888-89 (tax court is a “court of law” within the meaning of the appointments clause of article ii of the constitution); cf. estate of branson, 113 t.c. at 41 (1999) (laro, j., concurring) (“the united states tax court is a court of law that, like the united states district courts, has the authority to apply equitable principles such as equitable recoupment.”); see also steven j. willis, sixth circuit decision on equitable recoupment criticized, 81 tax notes 361, 370 n.52 (1998) (“as an article i court, the tax court is a true court.”). surprisingly, before freytag was decided, the second circuit had held that the tax court was not a court of law but rather an executive agency, at least in part. samuels, kramer & co. v. commissioner, 930 f.2d 975 (2d cir. 1991). although the second circuit recognized “that congress intended to establish a ‘court’ pursuant to its article i authority,” it nonetheless stated that it did “not find the legislative history to indicate definitively where in our constitutional scheme congress intended to place this adjudicatory body.” id. at 991. 289. see tax reform act of 1969, pub. l. no. 91-172, § 951, 83 stat. 487, 730. 290. see estate of rosenberg v. commissioner, 73 t.c. 1014, 1017-18 (1980) (“the tax court has only such jurisdiction as is conferred upon it by statute. it has no jurisdiction to exercise the broad common law concept of judicial power invested in courts of general jurisdiction by article iii of the constitution.”). 291. berkery v. commissioner, 90 t.c. 259, 270 (1988) (hamblen, j., concurring). 292. estate of mueller v. commissioner, 101 t.c. 551, 557 (1993). 293. see id. at 561. 294. “a court cannot write its own jurisdictional ticket.” zerand-bernal group v. cox, 23 f.3d 159, 163 (7th cir. 1994); see also cox v. court of common pleas, 537 n.e. 2d 721, 725 (ohio ct. app. 1988) (“no matter how ‘just’ the cause, a court cannot confer jurisdiction upon itself to correct a perceived wrong.”). 295. see supra note 12 and accompanying text. 396 florida tax review [vol. 5:5 court cases that the tax court has equitable power must be considered skeptically because tax court judges may consider it to be in the court’s best interest both to actively expand the court’s jurisdiction and not to surrender jurisdiction over matters that come before the court. the tax court’s actions are consistent with this premise. for example, decided cases, including those settled after docketing, are entered by the court. in fact, unlike in district court, once a taxpayer properly commences296 a case in tax court, only the court can remove the case from its jurisdiction. thus, the tax court refuses to allow voluntary dismissal or “removal” to297 district court. although it rarely does so, the tax court may also refuse to298 enter as a decision a full concession by one party if that concession is rejected by the other party, who wants to litigate the case. four tax court judges have299 concurred in the view that the tax court may refuse to enter as a decision a bilateral settlement agreement if the interests of justice require that.300 a. the parallelism fallacy part of what may underlie the tax court’s assertion of equitable power is the recognition that the tax court shares jurisdiction with at least two courts, one of which clearly may apply equitable doctrines in tax cases. the united states district courts and court of federal claims may both hear federal tax cases. the district courts, having been formed under article iii, have equitable powers. from the perspective of a tax lawyer or a tax court judge, it may be301 difficult to see why forum choice may affect the outcome simply because some courts have equitable powers and others may not. even judge posner has302 used this approach to uphold tax court jurisdiction over equitable estoppel claims. in flight attendants against ual offset, he stated, “[w]e are given303 296. see leandra lederman, which cases go to trial?: an empirical study of predictors of failure to settle, 49 case w. res. l. rev. 315, 327 n.47 (1999). 297. see wellman v. commissioner, 49 t.c. memo (cch) 866, t.c. memo (ria) ¶ 85,097 (1985) (“this court has no procedure which authorizes or permits a party to unilaterally withdraw a petition once filed.”). 298. tuckett v. commissioner, 46 t.c. memo (cch) 1413, t.c. memo (ria) ¶ 86,575 (1983); dorl v. commissioner, 57 t.c. 720, 722 (1972), aff’d, 507 f.2d 406 (2d cir. 1974). 299. see, e.g., smith v. commissioner, 78 t.c. 350 (1982) (taxpayer’s attempted full concession reflected in case transcript), aff’d, 820 f.2d 1220 (4th cir. 1987) (unpublished op.); ltv corp. v. commissioner, 64 t.c. 589 (1975). for further discussion of this issue, see lederman, supra note 18. 300. see dorchester indus. v. commissioner, 108 t.c. 320, 343 (1997) (parr, j., concurring). judge parr was joined by judges chabot, jacobs, and laro. id. 301. see u.s. const. art. iii. the bankruptcy courts also decide tax issues. 302. cf. willis, supra note 288, at 368 (“the [sixth circuit in mueller] also did not deal with the patent unfairness of denying tax court equitable jurisdiction –and the silly games it prompts.”). 303. flight attendants against ual offset (faauo) and united air lines, inc. v. commissioner, 165 f.3d 572 (7th cir. 1999). 2001] equity and the article i court 397 no reason to suppose that statutes of limitations are intended to be administered differently in the tax court than in the federal district courts, which share jurisdiction in federal tax cases with the tax court.”304 yet tax court and refund court procedures and outcomes often differ – even with respect to statutes of limitations. that is, there are tax cases that305 are timely in one forum but not in another. the supreme court’s decision in commissioner v. lundy provides an example of this situation. lundy argued306 to the court that the court’s interpretation of section 6512 would result in a shorter statute of limitations applicable to his overpayment claim in tax court than in district court. the court responded to this argument as follows:307 we assume without deciding that lundy is correct, and that a different limitations period would apply in district court, but nonetheless find in this disparity no excuse to change the limitations scheme that congress has crafted. the rules governing litigation in tax court differ in many ways from the rules governing litigation in the district court and the court of federal claims. some of these differences might make the tax court a more favorable forum, while others may not.308 the court pointed out that the “full payment” rule of the refund fora does not309 apply in tax court, and that in tax court the taxpayer is deemed to have filed a refund claim stating the grounds on which he seeks an overpayment of tax;310 in the refund courts, undue “variance” from the grounds of the claim may result in dismissal.311 tax court and refund court procedures differ in other key ways, as well. one important example is that the burden of proof in tax court deficiency cases differs from the burden of proof in refund courts, at least in the absence of a burden shift under section 7491, as discussed below. in a tax312 court deficiency case, the taxpayer need not prove the dollar amount. an additional difference is that the specifics of the burden of proof in tax court 304. id. at 578 (citations omitted). 305. see infra notes 306-11 and accompanying text. 306. 516 u.s. 235 (1996). 307. see id. at 251. 308. id. at 252. 309. see supra note 52 and accompanying text. 310. id. 311. see, e.g., real estate-land title & trust co. v. united states, 309 u.s. 13, 17-18 (1940); mcdonnell v. united states, 180 f.3d 721, 722 (6th cir. 1999); charter co. v. united states, 971 f.2d 1576, 1579 (11th cir. 1992); see also regs. § 301.6402-2(b)(1) (requiring refund claim to state grounds for refund with specificity). 312. see irc § 7491 (allowing burden of proof to be shifted to the irs in tax litigation in any forum if the taxpayer meets several prerequisites). 398 florida tax review [vol. 5:5 cases emphasize the notice of deficiency. access to the tax court in a313 deficiency case requires issuance to the taxpayer of a notice of deficiency in income, estate, or gift tax. no notice of deficiency is required for access to314 a refund forum.315 in tax court cases in which section 7491 does not apply, the tax court’s burden of proof rule provides, in part: the burden of proof shall be upon the [taxpayer], except as otherwise provided by statute or determined by the court; and except that, in respect of any new matter, increases in deficiency, and affirmative defenses, pleaded in the answer, it shall be upon the [irs]. . . .316 new matters and increases in deficiency both refer to matters raised by the irs after the notice of deficiency was mailed. code section 6212 prohibits the317 irs from avoiding the effect of this rule by mailing a second notice of deficiency to a taxpayer for the same tax and tax year with respect to which he petitioned the tax court. because the notice of deficiency is largely318 irrelevant in refund litigation, the refund courts provide for no such burden shift. equal access to the tax court is not required by the constitution; numerous courts have held that there is no due process requirement of access to a pre-assessment forum. therefore, differences in outcome between319 similar cases in the tax court and the refund courts, even those resulting from different procedures in the two courts, are constitutionally permissible. the facts that different procedures are permissible in tax court and the federal district courts, and that the differences may result in a different outcome, suggest that it is constitutionally permissible for equity to be available in article iii courts and not in the tax court. accordingly, if the tax court is going to apply equitable principles, it must find a specific source of the power to do so. 313. see tax court rule 142(a). 314. see irc § 6213. 315. see lederman and mazza, supra note 51, at 350. 316. see tax court rule 142(a)(1). 317. see lederman, supra note 145, at 199, 227. 318. see irc § 6212(c). 319. see, e.g., lewin v. commissioner, 569 f.2d 444, 445 (7th cir. 1978); brown v. lethert, 360 f.2d 560, 562 (8th cir. 1966); cohen v. united states, 297 f.2d 760, 772 (9th cir. 1962); whittemore v. united states, 1992 u.s. dist. lexis 10243 (n.d. ohio 1992); see also fendler v. commissioner, 441 f.2d 1101, 1103 (9th cir. 1971) (“the taxpayer has an opportunity for review of his tax liability in the district court, after payment, in a refund proceeding. . . . there is no denial of due process.”). 2001] equity and the article i court 399 b. possible sources of power to apply equitable principles 1. four categories of cases.—cases involving the extent of the tax court’s equity jurisdiction may be divided into four categories. the first category reflects an uncontroversial absence of jurisdiction. the tax court itself recognizes that it cannot simply create such things as new deductions or exclusions from income through the use of equity. professor harold dubroff320 aptly terms such taxpayer requests as “pleas for remedial legislation.” such321 pleas must be directed to congress, not a court – not even an article iii court. courts have no power to enact statutes. the second category involves a jurisdictional grant by congress. as discussed above, in cases in which congress has expressly granted the tax court authority to do equity, the tax court presumptively may do so. that is, an express statutory grant of equitable power to an article i court is presumptively constitutional. the declaratory judgment action available in certain tax court cases falls in this category. considering the equities in322 providing innocent spouse relief and equitable tolling of the statute of limitations may be additional examples.323 the third category, a variation on the second, involves instances in which the governing statute requires interpretation to ascertain its intent. in section 6015(e), congress expressly gave the tax court jurisdiction over irs denials of relief under section 6015(b) and (c), but was silent as to whether the 320. see paxman v. commissioner, 50 t.c. 567, 576 (1968) (tax court could not authorize an equitable deduction for home improvements to offset gross income from a prize awarded based on the improvements). the court stated, [w]e do not regard it as necessary to discuss the question whether the allowance of deduction would or would not be equitable, it being our opinion that it is sufficient to say that not only is the tax court not a court of equity but that petitioners, in effect, are asking us to legislate changes in the statute as enacted by congress. the proper forum for a petition or plea of that kind is congress. the power to legislate is exclusively the power of congress and not of this court or any other court. id. at 576-77. 321. dubroff, supra note 62, at 483. 322. see, e.g., green v. mansour, 474 u.s. 64, 72 (1985) (“the propriety of issuing a declaratory judgment may depend upon equitable considerations”); abbott labs. v. gardner, 387 u.s. 136, 155 (1967) (“the declaratory judgment and injunctive remedies are equitable in nature, and other equitable defenses may be interposed.”); see also charles a. rees, preserved or pickled?: the right to trial by jury after the merger of law and equity in maryland, 26 u. balt. l. rev. 301, 451 (1997) (“before the merger of law and equity, the declaratory judgment was available at law as well as in equity. after merger, the declaratory judgment is difficult to characterize as being either legal or equitable.”) (footnotes omitted). 323. irc § 6511(h) does not itself mention the words “equity” or “equitable.” it is entitled, “[r]unning of periods of limitation suspended while taxpayer is unable to manage financial affairs due to disability,” and provides guidelines for such a suspension. see irc § 6511(h). it is the supreme court case that was overruled by § 6511(h) that used the term “equitable tolling.” see united states v. brockamp, 519 u.s. 347, 348 (1997). 400 florida tax review [vol. 5:5 court had such jurisdiction over denials of relief under the purely equitable provision, section 6015(f). the irs and commentators interpreted the statute324 to mean that the tax court did not have jurisdiction over section 6015(f) claims. however, once the tax court asserted that it did have such325 jurisdiction, the irs acquiesced. yet, the tax court does not have326 jurisdiction just because it says so. the question is whether congress in fact327 authorized the tax court to take jurisdiction over equitable innocent spouse relief. if it did, then, as with category two, the grant presumptively is constitutionally permissible. although the tax court’s interpretation of section 6015(e) was not the one reached by initial commentators, and may not have been congress’s intent, it is a valid reading of an ambiguous statute. however, in one case, the tax court went so far as to amend the taxpayer’s petition sua sponte to reassert a claim for innocent spouse relief under subsections (b) and (c), despite the taxpayer’s concession at trial that she was not eligible for relief under those subsections. this seems to go further than congress intended; it is unlikely328 it intended that the tax court consider section 6015(f) claims when neither section 6015(b) or (c) were in issue. nonetheless, congress hinged section 6015 jurisdiction on the taxpayer’s election of section 6015(b) or (c) relief, not the taxpayer’s maintenance of eligibility for that relief. thus, the tax court’s jurisdictional approach remains within the letter of the statute. there have not yet been appellate decisions on this issue, and considering the irs’s acquiescence, there are unlikely to be any anytime soon. in addition, the tax court does have a track record of following its own rule in spite of reversal by one court of appeals, in cases where appeal lies to another court of appeals.329 once again, reversal of the tax court may lie with congress. the tax court’s power to apply such doctrines as equitable estoppel and equitable recoupment falls in a fourth category. this category reflects different considerations because the doctrines in question lack governing code sections. it is the hardest group of doctrines for which to find authority to apply equity because the doctrines themselves are not statutory and the tax court’s jurisdiction-granting provisions do not expressly provide for equity jurisdiction. 324. see irc § 6015(e). 325. see supra note 268 and accompanying text. 326. see supra note 272 and accompanying text. 327. see supra note 276. 328. charlton v. commissioner, 114 t.c. 333, 339 n.2 (2000). 329. see, e.g., estate of branson v. commissioner, 113 t.c. 6, 11 (1999) (applying equitable recoupment after sixth circuit reversal of mueller); estate of bartels v. commissioner, 106 t.c. 430, 433 (1996) (same); estate of orenstein v. commissioner, 79 t.c. memo (cch) 1971, t.c. memo (ria) ¶ 2000-150 (same); golsen v. commissioner, 54 t.c. 742, 757 (1970) (“we shall remain able to foster uniformity by giving effect to our own views in cases appealable to courts whose views have not yet been expressed”), aff’d, on other grounds, 445 f.2d 985 (10th cir. 1971), cert. denied, 404 u.s. 940 (1971). 2001] equity and the article i court 401 the best argument might be the historical lineage of tax refund actions, which may be traced back to the action of indebitatus assumpsit, an action tinged with equity.330 2. the indebitatus assumpsit ancestry of tax refund claims.—in 1934, the supreme court stated, “the statutes providing for refunds and for suits on claims therefor proceed on the same equitable principles that underlie an action in assumpsit for money had and received.” in 1937, the court reiterated that331 statement, and further stated that a tax refund action, 332 although an action at law, is equitable in its function. it is the lineal successor of the common count in indebitatus assumpsit for money had and received. originally an action for the recovery of debt, favored because more convenient and flexible than the common law action of debt, it has been gradually expanded as a medium for recovery upon every form of quasi-contractual obligation in which the duty to pay money is imposed by law, independently of contract, express or implied in fact.333 although the supreme court is correct that the modern tax refund action developed out of the cause of action indebitatus assumpsit and has equitable aspects, the implication that assumpsit was an equitable cause of action (that is, cognizable by a court of equity) is misleading. in fact, as is discussed below, indebitatus assumpsit was actually a common law action with equitable aspects. according to the supreme court, because the tax refund334 action has an equitable pedigree, equity is relevant to disputes between taxpayers and the irs over the taxpayer’s correct tax liability.335 330. see infra text accompanying notes 397-402. 331. united states v. jefferson elec. mfg. co., 291 u.s. 386, 402 (1934). the common count of money had and received was one of several common counts in indebitatus assumpsit. see arthur allen leff, the leff dictionary of law: a fragment, 94 yale l.j. 1983, 2083 (1985) (“if one could not frame one’s pleading so as to allege a sum certain owing to the plaintiff, one had available the ‘common counts,’ the most important of which (along with the ‘debt’ form for money had and received) were ‘quantum meruit’ and ‘quantum velebant.’”). 332. stone v. white, 301 u.s. 532, 535 (1937). 333. id. at 534. in fact, indebitatus assumpsit was an action at law, not in equity. see infra notes 388-94 and accompanying text. 334. see infra notes 397-402 and accompanying text. cf. yung frank chiang, payment by mistake in english law, 11 fla. j. int’l l. 91, 97-98 (1996) (“in england, an action to recover payment for money had and received on the ground of mistake is within the jurisdiction of the court of law. chancery, the equity court, never dealt with such action unless the plaintiff based the action on the fraud on the part of the defendant or unless the plaintiff, in an insolvency case, requested the court to distribute assets among claimants.”). 335. stone, 301 u.s. 532, 534 (1937). 402 florida tax review [vol. 5:5 a. the tax refund action and the tax court overpayment claim.—historically, tax refund actions were suits brought against the tax collector because, until the court of claims was created in 1855, no suit of any kind against the united states government was permitted in any court. to336 allow recovery “without seeming to do violence to the sovereign’s immunity from suit,” in elliott v. swartwout, an 1836 case regarding customs duties,337 338 the supreme court sanctioned suits in assumpsit for money had and received against tax collectors for taxes collected illegally. “there money had been339 taken by the collector for duties which were not imposed. this money lawfully belonged to the plaintiff; it was the duty, therefore, of the collector to pay it back to him.”340 although this type of suit against the tax collector was soon superseded in some cases by a statute requiring the duties to be paid over to the treasury, and by the resulting administrative procedure, in 1866, the supreme court341 held that the right to sue the tax collector with respect to internal revenue taxes was implicit in various assessment and collection statutes. that case was also342 an action in assumpsit for money had and received.343 the supreme court recognized that the suit against the tax collector was merely a mechanism to afford a remedy against the government. once344 the court of claims was created, it afforded a forum for tax suits directly against the federal government. yet, as discussed below, congress and the courts seemed to deem important district court jurisdiction over tax refund actions. in 1887, congress passed the tucker act, which gave the district courts jurisdiction over all claims against the united states for damages up to $1,000 that were founded upon the constitution of the united states, any law of congress, or any contract with the united states government. in 1911, the345 limitation on the amount of damages under the tucker act was increased to $10,000. in 1915, the supreme court held that the tucker act included346 336. william t. plumb, jr., tax refund suits against collectors of internal revenue, 60 harv. l. rev. 685, 687 (1947). 337. id. at 688. 338. 35 u.s. 137 (1836). 339. plumb, supra note 336, at 687; see elliott, 35 u.s. 137 (1836). 340. cary v. curtis, 44 u.s. 236, 250 (1845). 341. see plumb, supra note 336, at 689; cary, 44 u.s. at 251. 342. see philadelphia v. the collector, 72 u.s. 720, 730 (1866); plumb, supra note 336, at 690. 343. philadelphia v. the collector, 72 u.s. at 727. 344. see plumb, supra note 336, at 691; see also george moore ice cream co. v. rose, 289 u.s. 373, 383 (1933) (referring to a suit against the tax collector as “merely a remedial expedient for bringing the government into court.”). 345. act of mar. 3, 1887, ch. 359, 24 stat. 505. 346. act of mar. 3, 1911, ch. 231, § 24, 36 stat. 1093. 2001] equity and the article i court 403 jurisdiction over suits for tax refunds. suits in district court against the tax347 collector remained available for cases involving more than the capped amount. in 1935-1938, for example, suits against the collector comprised about 40% of tax refund actions brought in district court.348 in 1921, the supreme court held that actions against a tax collector were personal in nature, and therefore not maintainable against his successor in office. thus, if the collector had died or retired, a taxpayer with a refund349 claim of more than $10,000 had no remedy in a district court. although the claims court option remained available, the revenue act of 1921 preserved the district court as a forum by allowing suits against the united states for tax refunds involving more than $10,000. in 1954, the $10,000 cap on tucker350 act claims was eliminated.351 district court jurisdiction in refund actions is now embodied in 28 u.s.c. § 1346(a)(1), which provides:352 the district courts shall have original jurisdiction, concurrent with the united states claims court [united states court of federal claims], of: (1) any civil action against the united states for the recovery of any internal-revenue tax alleged to have been erroneously or illegally assessed or collected, or any penalty claimed to have been collected without authority or any sum alleged to have been excessive or in any manner wrongfully collected under the internal-revenue laws.353 the modern-day action grew out of the historic action in indebitatus assumpsit against the tax collector. just as the origins of the modern-day suit directly against the sovereign for refund of overpaid taxes may be traced to the indebitatus assumpsit action against the tax collector based on a promise implied in law to refund taxes collected erroneously, the overpayment suit in tax court may be traced to the same great-grandparents. congress gave overpayment jurisdiction to the board of tax appeals in 1926 for two reasons: (1) so that the board would not lose354 jurisdiction over a case in which the taxpayer paid the deficiency prior to entry 347. united states v. emery, bird, thayer realty co., 237 u.s. 28 (1915). 348. roger j. traynor, administrative and judicial procedure for federal income, estate, and gift taxes– a criticism and a proposal, 38 colum. l. rev. 1393, 1404 n.21 (1938). 349. smietanka v. indiana steel co., 257 u.s. 1 (1921). 350. see revenue act of 1921, ch. 136, § 1310(c), 42 stat. 311. 351. see act of july 30, 1954, ch. 648, § 1, 68 stat. 589. 352. flora v. united states, 362 u.s. 145, 189 (1960). 353. 28 u.s.c. § 1346(a)(1). 354. revenue act of 1926, ch. 27, § 284(e), 44 stat. 67. the board of tax appeals did not become a court until 1969. see tax reform act of 1969, pub. l. no. 91-172, § 951, 83 stat. 487, 730. 404 florida tax review [vol. 5:5 of its decision, and (2) so that if the taxpayer not only contested the355 deficiency but also claimed an overpayment for the same type of tax for the tax year, litigation in two courts could be avoided. initially, the supreme court356 determined that the board’s overpayment jurisdiction did not allow it to order a refund after finding that the taxpayer had made an overpayment: when the determination of overpayment by the board becomes final, the statute provides that such amounts shall be refunded or credited, § 322 (d), and upon the commissioner's failure to comply with the statute, a plenary suit will lie in the district court or the court of claims, for the recovery of any refund to which he is entitled.357 the supreme court later found that, “the commissioner may secure a final adjudication of his right to withhold the overpayment determined by the board, on the ground that other taxes are due from the taxpayer, or that upon other grounds he is not equitably entitled to the refund.” code section358 6512(b)(2), which allows the tax court to order a refund, was enacted in359 1988, to avoid the necessity of duplicative litigation.360 if the court of federal claims has equitable powers over refund actions in that court, the next question is whether the tax court similarly has equitable powers over overpayment claims. like the refund courts’ jurisdiction over refund claims, the tax court’s overpayment jurisdiction is statutory.361 362 courts have distinguished the two types of courts’ jurisdiction, but their focus on comparing deficiency and refund cases may be misleading. for example, in estate of mueller v. commissioner, the sixth circuit stated: a deficiency redetermination sought in the tax court should not be confused with a refund suit filed in the district court. whereas the deficiency redetermination is nothing more than the judicial review of an assessment made by an administrative agency, a refund suit is an “action brought to recover a tax 355. see harold dubroff, the united states tax court: an historical analysis, 42 alb. l. rev. 353, 372 (1978). this issue is now specifically resolved by statute. see irc § 6213(b)(4) (“in any case where [an] amount is paid after the mailing of a notice of deficiency under section 6212, such payment shall not deprive the tax court of jurisdiction over [the] deficiency determined under section 6211 . . . .”). 356. see dubroff, supra note 355, at 373. 357. united states ex rel. girard trust co. v. helvering, 301 u.s. 540, 542 (1937). 358. id. 359. see irc § 6512(b)(2). 360. pub. l. no. 100-647 § 6244(a). 361. see 28 u.s.c. § 1346(a)(1). 362. see irc § 6512(b). 2001] equity and the article i court 405 erroneously paid, [which] although an action at law is equitable in its function. it is the lineal successor of the common count indebitatus assumpsit for money had and received.”363 this statement says nothing about the origins or nature of the overpayment suit in tax court. in fact, overpayment suits function just like refund suits. the difference is that the tax court only has jurisdiction over overpayment suits in cases in which the irs has alleged a deficiency. in other364 respects, overpayment suits and refund suits are virtually indistinguishable. in both cases, the taxpayer will have already paid the tax in question. the365 statutory periods of limitation will be the same, although, primarily as a366 result of the lack of necessity for a refund claim, the time periods will not367 always run at the same time.368 another apparent, but misleading, difference between the refund courts and the tax court lies in the burden of proof. as discussed above, in the369 absence of the application of a statutory burden of proof rule, the burdens of370 proof have been analyzed differently in the two types of courts. in refund371 courts, the taxpayer bears a two-part burden: proving the government wrong, and establishing the amount owed him. in a deficiency case in tax court, the372 taxpayer need not prove a dollar amount. the explanation for this distinction between the burden of proof in refund courts and in tax court rests on the indebitatus assumpsit origins of the refund suit. however, for this purpose,373 363. estate of mueller, 153 f.3d at 304 (emphasis added) (quoting stone v. white, 301 u.s. 532 (1937)). 364. see irc § 6512(b). in other words, if the taxpayer simply discovers that he overpaid his taxes, his only potentially available fora are the district courts and the court of federal claims. 365. in refund courts, flora v. united states, 362 u.s. 145 (1960), requires full payment as a condition of suit. in the tax court, an overpayment claim may only be made with respect to tax already paid. see irc § 6512. 366. see irc § 6511. 367. see irc § 6512(b)(3) (providing time periods that refer to § 6511 and generally correspond to time period that would be applicable in refund court suits). 368. see commissioner v. lundy, 516 u.s. 235 (1996). for analysis of the problems created by the complications of § 6512, particularly with respect to delinquent returns, see, e.g., leandra lederman, it’s time to fix the “traps for the unwary” in the refund statutes, 79 tax notes 1057 (1998); leandra lederman, applying the refund statutes to delinquent returns, 68 tax notes 1639 (1995). 369. see supra note 312 and accompanying text, supra notes 316-18 and accompanying text. 370. see irc §§ 7454 (burden of proving fraud is on the irs), 7491 (burden shifts to irs when taxpayer meets certain threshold requirements). 371. see supra notes 316-18 and accompanying text. 372. see, e.g., united states v. janis, 428 u.s. 433, 440 (1976); bar l ranch, inc. v. phinney, 426 f.2d 995, 999 (5th cir. 1970). 373. see, e.g., leo p. martinez, tax collection and populist rhetoric: shifting the 406 florida tax review [vol. 5:5 the burden in refund courts should be compared with the burden in overpayment cases, not the burden in deficiency cases. with respect to overpayments, the taxpayer does have to prove the amount he overpaid. thus, with respect to taxpayer claims of entitlement to a refund, the two types of fora would seem to have the same requirements. thus, overpayment jurisdiction and the ability to order refunds are statutorily created in the tax court, much like the refund actions justiciable in the district courts and the court of federal claims are created by statute. as the discussion above reflects, overpayment suits are modeled after refund suits. accordingly, like the refund suit, the overpayment suit may trace its origins back to the indebitatus assumpsit action. b. the quasi-equitable history of indebitatus assumpsit.—the term “indebitatus assumpsit” is latin for “being indebted, he promised,”374 reflecting the idea of an existing indebtedness followed by a promise by the debtor to the creditor to repay the debt. the assumpsit action developed because of the common law courts’ need for an action that did not suffer from the constraints of the actions for debt and for covenant. the action for debt required an exact sum due and quid pro quo. in addition, “wager of law,” in375 which the defendant brought to court “oath helpers” who affirmed that no debt was owed, allowing the defendant to prevail, was available as a defense to informal (unsealed) contracts. the action for covenant would lie for breach376 of promise, but only for promises under seal.377 because of the inflexibility of the actions of debt and covenant, the court of chancery began to countenance actions not allowed in the common law. in response, the common law courts began to expand the tort action of378 trespass, which alleged a wrong done against the peace of the king, into trespass on the case, in which the king had no special interest. over time, a379 trespass action became available to a plaintiff alleging that the defendant had not kept his covenant. “by the late fourteenth century, the undertaking,380 ‘assumpsit,’ had become the contractual basis for recovery.”381 burden of proof in tax cases, 39 hastings l.j. 239, 262 (1988); bar l ranch, inc. v. phinney, 426 f.2d 995, 999 (5th cir. 1970). 374. leff, supra note 331, at 2083. 375. james oldham, reinterpretations of 18th-century english contract theory: the view from lord mansfield’s trial notes, 76 geo. l.j. 1949, 1950, 1953 (1988). 376. see id. at 1950 n.24; leff, supra note 331, at 2083. 377. leff, supra note 331, at 2083. 378. oldham, supra note 375, at 1953. 379. id. at 1953-54. 380. id. at 1955 (quoting milsom, supra note 96, at 322). 381. id. 2001] equity and the article i court 407 in 1602, slade’s case extended the assumpsit action from failure to382 perform an action promised to failure to pay an amount promised. in effect,383 slade's case allowed a plaintiff to plead assumpsit “when what had really happened is that the defendant had received something which he ought to pay for, but had not in fact promised to do so, either at the time of the transaction or thereafter.” the term indebitatus assumpsit has been used to describe the384 action permitted in slade’s case although in fact the term was not used until 1657.385 in 1760, in moses v. macferlan, lord mansfield, the chief justice386 of the court of king's bench, allowed an action of indebitatus assumpsit for387 money had and received where no contract existed and the plaintiff alleged that he had made payment by mistake. this allowed the law to develop so that,388 although indebitatus assumpsit required that a promise be alleged, the389 promise did not need to be proven. in addition, though indebitatus assumpsit390 originally applied only to contracts implied-in-fact, it was later extended to contracts implied-in-law (or “quasi-contracts”), that is, obligations created by law, such as taxes. courts addressed the illogic of finding a subsequent391 promise in a contract only implied by law by finding that “the law implied a promise.” this allowed the extension of the indebitatus assumpsit doctrine392 to its eventual use to obtain a refund of taxes illegally or erroneously collected. the common counts in indebitatus assumpsit, which reflected the nature of the underlying obligation, arose out of standardization of pleading in the seventeenth century. the common counts in indebitatus assumpsit393 included money had and received, money paid, quantum meruit and quantum 382. 76 eng. rep. 1074 (1602). 383. oldham, supra note 375, at 1957 (quoting j.h. baker, an introduction to english legal history 282 (2d ed. 1979)). 384. leff, supra note 331, at 2083. 385. chiang, supra note 334, at 97 n.39. 386. 97 eng. rep. 676 (k.b. 1760). 387. oldham, supra note 375, at 1949. 388. chiang, supra note 334, at 97 n.39 (1996); cf. ramsay v. county of clifton, 92 ill. 225, 228-29 (1879) (refusing to grant bill in equity for mistake because “the action at law for money had and received is . . . a full and complete remedy”) (cited in val d. ricks, american mutual mistake: half-civilian mongrel, consideration reincarnate, 58 la. l. rev. 663, 731 n.361). 389. william a. keener, quasi-contract, its nature and scope, 57, 66 (1893); see also cary v. curtis, 44 u.s. 236, 250 (1845) (“this promise [to pay] is always charged in the declaration, and must be so charged in order to maintain the action.”). 390. see oldham, supra note 375, at 1957. 391. j. b ames, the history of assumpsit, 2 har. l. rev. 53, 63, 65 (1888), (citing city of london v. goree, 1 vent. 298). 392. keener, supra note 389, at 66. 393. see james oldham, reinterpretations of 18th-century english contract theory: the view from lord mansfield’s trial notes, 76 geo. l.j. 1949, 1957 (1988). 408 florida tax review [vol. 5:5 velebat. it is the common count of money had and received (essentially a debt394 action) that underlies the modern tax refund action.395 396 an erroneous link of indebitatus assumpsit to equity apparently arose from a misinterpretation of moses v. macferlan. in that case, lord mansfield397 found that the plaintiff had the equities on his side, referring to “ties of natural justice and equity to refund the money,” and allowed an indebitatus398 assumpsit action for money had and received to lie where no actual contract, express or implied, existed. the reference to equity may have caused an399 inference that indebitatus assumpsit was an action available in courts of equity, rather than courts at law. thus, american courts have made such statements400 as: according to the modern doctrine, there is no difference at law or in equity with respect to [the defendant’s] liability. the action for money had and received . . . is an equitable action, and is held to lie wherever money has been paid to the use of another, which, ex equo et bono, he ought to refund. the defence allowed to this action is equally liberal, every thing being permitted to be given in evidence . . . which may tend to destroy or diminish the equity of the plaintiff’s claim.401 however, as peter birks has persuasively argued, lord mansfield’s equity reference was to roman aequitas (fairness), not chancery.402 394. see supra note 331, at 2083; mitchell mcinnes, the canadian principle of unjust enrichment: comparative insights into the law of restitution, 37 alberta l. rev. 1, 18 (1999). 395. see leff, supra note 331, at 2083. 396. see supra note 179 and accompanying text; supra note 331 and accompanying text. 397. 97 eng. rep. 676 (k.b. 1760). 398. id. at 681. 399. see mark p. gergen, the jury’s role in deciding normative issues in the american common law, 68 fordham l. rev. 407, 485 n.308 (1999); ricks, supra note 388, at 731; chiang, supra note 334, at 103. 400. see ricks, supra note 388, at 732 n.369. 401. dupuy v. johnson, 4 ky. 562 (1809) (emphasis added); see also keyes v. first nat. bank, 25 f.2d 684, 688 (8th cir. 1928) (“the action of assumpsit for money had and received is equitable in its essential nature and purpose. it lies for money which ex aequo et bono the defendant ought to refund.”); ricks, supra note 388, at 732-33. “ex aequo et bono” means something like “in fairness and justice.” see, e.g., keyes, 25 f.2d at 694 n.142. courts tend to use this phrase in connection with determining the taxpayer’s equitable rights in an action in indebitatus assumpsit. see, e.g., herrmann v. gleason, 126 f.2d 936, 939 (6th cir. 1942) (“where one has in his hands money which, according to the rules of equity and good conscience, ought to be paid to another, assumpsit is the proper form of remedy; and if, at the time of commencement of action, a party holds money which, ex aequo et bono, he ought not to have retained from plaintiffs, they are entitled to recovery.”). 402. peter b.h. birks, english and roman learning in moses v. macferlan, 37 current legal problems 1, 21 (1984). 2001] equity and the article i court 409 the fairness-based “equitable” character of the assumpsit action is evident in statements in some american decisions. for example, the tax court has stated, “[a]n action in assumpsit for money had and received is equitable in character and lies, in general, whenever a defendant has received money that in equity and good conscience he ought to pay to plaintiff.” the court of403 federal claims stated, “[a]n action for refund of taxes is essentially governed by equitable principles . . . equity is woven into the warp and woof of a refund suit . . . .” that is, the refund action does have an equity-based flavor. this404 analysis arguably might allow equitable defenses such as equitable recoupment to apply absent a statutory prohibition – though the connection with true equity is weak. for example, if a taxpayer claimed an income tax overpayment in tax court (after receiving a notice of deficiency for that tax year) and the irs responded by raising the specter of a deficiency in gift tax for a barred year,405 the assumpsit line of reasoning might allow the irs to raise the defense of equitable recoupment. unfortunately, in each of the four recent cases in which the tax court applied equitable recoupment, the taxpayer had not made an overpayment claim. the cases were deficiency cases before the tax court; overpayments406 403. estate of mueller v. commissioner, 101 t.c. 551, 566 n.2 (1993) (citing black’s law dictionary 112 (5th ed. 1979)). because in an assumpsit action “the plaintiff must recover by virtue of a right measured by equitable standards, it follows that it is open to the defendant to show any state of facts which, according to those standards, would deny the right . . . .” stone, 301 u.s. at 535. 404. erickson v. united states, 309 f.2d 760, 763 (ct. cl. 1962). cf. steuerwald v. richter, 158 wis. 597, 604 (1914) (i would not speak of the right to money had and received as an equitable right, nor of the remedy to enforce it, as in its nature equitable, nor the form of the action as legal; but that the primary right is a creation of equity, the right to enforce it is a legal right the same as in case of any other legal obligation . . . .”). currently, the right to a trial by jury in tax refund suits in the district courts is provided by statute. see 28 u.s.c. §§ 1346(a)(1), 2402. the seventh amendment guarantees the right to a jury trial “in suits at common law.” see u.s. const. amend. vii. the common law referenced is that of england as of 1791. baltimore & carolina line, inc. v. redman, 295 u.s. 654, 657 (1935). there is some disagreement over whether the seventh amendment protects the right to trial by jury in a tax refund suit. compare beard v. commissioner, 99-2 u.s. tax cas. (cch) ¶ 50,677, 84 a.f.t.r. 2d 99-5058 (6th cir. 1999) (finding no such right because “no right of action at common law existed against a sovereign.”) with united states v. new mexico, 642 f.2d 397, 401 (10th cir. 1981) (reviewing legislative history of 28 u.s.c. § 2402 to find that “the 1954 congressional action is a reaffirmation of the common law recognition of the right to jury trial.”); cf. wickwire v. reineke, 275 u.s. 101, 105. however, in neither case did the courts contrast common law rights with rights in equity. 405. for example, if, in year 5, a taxpayer timely seeks a refund for year 2, the taxpayer’s equitable right “ex aequo et bono” to the refund should be lost if the taxpayer has a deficiency for year 1 that is barred by the statute of limitations on assessment. although the statute of limitations on assessment bars the government from pursuing the year 1 tax deficiency, the presence of that deficiency would render it inequitable for the taxpayer to collect a refund from the government. 406. see supra notes 160-233 and accompanying text, (discussing mueller, orenstein, bartels, and branson, all deficiency cases). 410 florida tax review [vol. 5:5 arose with respect to related transaction in a barred year only after the tax court had decided the deficiency issues. in each case, the taxpayers could not407 make an overpayment claim because of the bar of the statute of limitations on refund claims. although the tax court can consider tax years not before it408 in order to redetermine the tax deficiency for the tax year that is before it,409 that is not what the tax court did in these cases. the court did not need to consider other tax years or other taxes in order to compute the amount of the deficiency in the years before it. therefore, absent jurisdiction over the other410 taxes and tax years, it lacked the power to consider the equitable recoupment claim. the statute of limitations on refund claims is apparently a jurisdictional bar; section 6512(b)(1) provides: except as provided by paragraph (3) and by section 7463, if the tax court finds that there is no deficiency and further finds that the taxpayer has made an overpayment of income tax for the same taxable year, of gift tax for the same calendar year or calendar quarter, of estate tax in respect of the taxable estate of the same decedent, . . . the tax court shall have jurisdiction to determine the amount of such overpayment, and such amount shall, when the decision of the tax court has become final, be credited or refunded to the taxpayer.411 paragraph (3) of section 6512(b) provides limitations on the amount of credit or refund to be allowed, requiring timeliness in order for any amount to be refunded or credited. accordingly, the tax court did not have jurisdiction to412 407. see supra notes 160-233 and accompanying text. 408. see supra notes 160-233 and accompanying text; irc § 6512(b)(3). 409. see irc § 6214(a). 410. see estate of mueller, 101 t.c. at 566 (tannenwald, j., dissenting). 411. irc § 6512(b)(1) (emphasis added). 412. see irc § 6512(b)(3). it provides, in relevant part: (3) no such credit or refund shall be allowed or made of any portion of the tax unless the tax court determines as part of its decision that such portion was paid(a) after the mailing of the notice of deficiency, (b) within the period which would be applicable under section 6511(b)(2), (c), or (d), if on the date of the mailing of the notice of deficiency a claim had been filed (whether or not filed) stating the grounds upon which the tax court finds that there is an overpayment, or (c) within the period which would be applicable under section 6511(b)(2), (c), or (d), in respect of any claim for refund filed within the applicable period specified in section 6511 and before the date of the mailing of the notice of deficiency– (i) which had not been disallowed before that date, (ii) which had been disallowed before that date and in respect of which a timely suit for refund could have been commenced as of that date, or (iii) in respect of which a suit for refund had been 2001] equity and the article i court 411 consider the merits of the overpayment claim. without considering the merits, the tax court could not determine whether an overpayment in fact existed. this result is unfortunate in that (1) a federal district court would have the power to consider the taxpayer’s equitable recoupment arguments, and (2) arguably, given the equity-based origins of the overpayment claim, the tax court might have the authority to consider equitable recoupment arguments made by the government in overpayment cases. the tax court’s tendency to “do equity” in difficult cases is understandable, but “hard cases make bad law.” a solution lies with congress; it should amend the tax court’s413 jurisdiction-granting statutes to allow recoupment. absent such an amendment, tax court should not engage in jurisdictional “self help.”414 application of equitable estoppel or judicial estoppel is not limited by statute, unlike equitable recoupment, but its application also is not authorized by statute, as is equitable tolling, for example. in addition, equitable estoppel415 and judicial estoppel arguments may be raised in deficiency cases that do not involve an overpayment claim. therefore, routine application of these and similar doctrines depends on finding a source of equitable power outside both the jurisdictional statutes and the quasi-equitable pedigree of the overpayment suit. v. conclusion the powers of article i courts are necessarily more circumscribed than those of their cousin courts granted power under article iii. yet, article i courts play a critical role in determining public rights such as the application of federal tax laws. therefore, it is important to understand the extent of article i courts’ powers. the question of the role that equity plays or should play in article i courts has received little attention. article i courts such as the tax court were unaffected by the merger of law and equity in the federal rules of civil procedure, and congress did not grant the tax court general or specific equitable powers when it created the court. in fact, the supreme court has416 commenced before that date and within the period specified in section 6532. . . . id. 413. northern sec. co. v. united states, 193 u.s. 197, 400 (1904) (holmes, j., dissenting). 414. see donald black & m.p. baumgartner, on self-help in modern society, in the manners and customs of the police 193, 193 n.3 (donald black ed., 1980) (“defining ‘self-help’ as a response to offensive behavior in which offended party takes action on his or her own”) (cited in marc galanter & david luban, poetic justice: punitive damages and legal pluralism, 42 am. u. l. rev. 1393, 1399 n.15 (1993)). 415. see irc § 6511(h). 416. see irc §§ 6511, 6512; cf. supra notes 36-44 and accompanying text. 412 florida tax review [vol. 5:5 stated that the tax court lacks equitable power. it is true that the tax court has no general reservoir of equitable powers on which it may draw when it sees fit; article i of the constitution does not provide that, and congress did not supply it.417 nonetheless, the tax court has been applying equitable doctrines when necessary to avoid harsh statutory results. this article has shown that the tax court lacks the authority to apply many of these doctrines. public choice insight into judges’ maximization of their power may help explain the tax court’s application of equity in spite of the strictures of article i of the constitution. in addition, part of the tax court’s temptation to “do equity” may result from the specter of outcomes inconsistent with similar cases brought in district court. that is a genuine problem, particularly because the tax court418 hears about 95% of litigated federal tax cases. but the reality is that, when419 congress provided a pre-assessment tax forum, it did not give it jurisdiction coextensive with the jurisdiction of the district courts and the court of federal claims.420 as tempting as it is to view the three federal tax fora as functionally indistinguishable (except when forum shopping), that simply is not the case.421 in fact, courts have ruled over and over that due process does not require access to the tax court. due process does not require similar outcomes, either.422 423 it is simply considered the taxpayer’s choice whether to seek refuge in the tax court or instead to pursue refund litigation, despite the practical reality that many people cannot afford to pay the asserted deficiency in full up front.424 congress may enlarge the tax court’s equity arsenal simply by enacting appropriate statutes, subject to the limits on separation of powers. congress could also reconstitute the tax court as an article iii court.425 alternatively, congress could overrule flora’s full-payment rule to provide426 increased access to the federal district courts, which, under article iii, may 417. see u.s. const. art. i; irc §§ 6511, 6512. 418. see supra note 301 and accompanying text. 419. see lederman, supra note 145, at 185. 420. see irc §§ 6511, 6512. 421. see supra notes 305-18 and accompanying text. 422. see supra note 319 and accompanying text. 423. see supra notes 301-319 and accompanying text. 424. see flora, 357 u.s. at 75 (“it is suggested that a part-payment remedy is necessary for the benefit of a taxpayer too poor to pay the full amount of the tax. such an individual is free to litigate in the tax court without any advance payment. where . . . for some . . . reason a suit in the district court seems more desirable, the requirement of full payment may in some instances work a hardship.”). 425. see geier, supra note 30; cf. judicial conference of the united states, report of the federal courts study committee 69 (apr. 2, 1990) (suggesting that congress create an article iii appellate division of the tax court with exclusive jurisdiction over most federal tax appeals, and provide exclusive trial-level jurisdiction in such cases to an article i division of the court). 426. see flora v. united states, 362 u.s. 145, 189 (1960). 2001] equity and the article i court 413 exercise the full array of equitable powers. any of those options would427 resolve the constitutionally based problem facing the tax court when it uses equitable doctrines to achieve fair outcomes. however, they would not address the similar situations of other article i courts. it is time for congress to act so that courts such as the tax court will not exceed the constitutional limits on their powers. 427. see u.s. const. art. iii. § 2, cl. 1 (“the judicial power of the united states, shall be vested in one supreme court, and in such inferior courts as the congress may from time to time ordain and establish. . . .”). this last option would likely result in some shift of tax case filings from tax court to the district courts, an occurrence that might not be desired by either forum. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 4 1999 number 7 interpreting the interpreters: assessing forty-five years of tax literature daniel m. schneider' i. introduction .................................... 485 ii. methodology .................................... 486 a. sampling tax literature ........................ 486 b. interpreting the results ........................ 488 c. questions asked .............................. 489 m . the sample ...................................... 493 a. data about tax journals ....................... 493 b. literature and data about women ................ 495 1. observations about women, careers, and publishing ......................... 495 2. data about women in fields associated with tax ............................. 499 3. conclusions ........................... 505 c. literature and data about the professions of those who write tax articles ................. 506 1. observations about tax practice ........... 506 2. data about the professions of authors of tax articles ......................... 507 3. conclusions ........................... 511 d. literature and data about tax scholarship ......... 511 1. taxonomy of tax scholarship ............. 512 a. observations about the taxonomy ... 512 b. data about the taxonomy.......... 513 * professor of law, northern illinois university college of law. a.b. 1970, washington university; j.d. 1973, university of cincinnati; ll.m. 1976, new york university. i would like to thank peter abrams and charles cappell. colleagues at northern illinois university, for helping me to understand quantitative analysis tools necessary to assemble and interpret the data collected for this article. i would also like to thank marjorie e. kornhauser, beverly i. moran, alan j. samansky, and lorraine a. schmall for reading prior drafts of this article, as well as beverly, alan, boris i. bittker, and dale a. nance for their initial observations about characterizing information to be drawn from the sampled articles. finally, i would like to express my gratitude to the college's research librarian, susan boland, for her assistance in my research. 484 florida tax review [vol. 4:7 c. conclusions ..................... 517 2. the subject matter of the sampled articles ... 517 a. observations about specialities in tax ......................... 517 b. data about the subject matter of sampled articles ............... 519 c. conclusions ..................... 522 3. interplay in tax among congress, the internal revenue service, and courts ....... 523 a. observations about the interplay of these institutions .............. 523 b. data about the interplay ........... 524 c. conclusions ..................... 528 iv. conclusions ..................................... 528 appendix ............................................... 530 interpreting the interpreters i. introduction when i began practicing tax law in the 1970s, i kept current by reading journal of taxation, taxes, tax law review, and tar lawyer. i'm sure the genesis of my reading lies in advice from more senior attorneys with whom i worked. even as my interests have expanded and as topics of current interest in tax have shifted over the last two decades, i still read these journals. how has tax literature changed over time? why do these changes matter? to paraphrase a well-known book title, we are what we write.' what we write reflects what we hold important. were there no articles, for example, about business tax or the intersection of tax and race or tax and gender, the absence would suggest that these topics are not important or, if important, that they have been ignored. the steady production of business tax articles over the years and the more recent publication of articles about tax and race and tax and gender lets us deduce that business tax (to state the obvious) has always been important and that tax and race and tax and gender have been examined more recently.2 in an attempt to ascertain what tax literature can tell us about tax culture, this article samples articles from four tax journals-journal of taxation, taxes, tax law review, and tax lanyer-written during the fortyfiveyear periodbetween 1954 and 1998. over 1,500 articles, comprising roughly 20% of all articles published in these journals during this period, are classified for a number of different variables, such as gender and professional status of the author, and the subject matter and stylistic approach of the article. subject to the limitations of sampling itself, and a willingness to draw conclusions beyond the sampling, several benefits inure from this review. one benefit is to examine trends because a forty-five year review reveals whether women and men have published at comparable rates, for example, more readily than a one or five year review.3 another benefit of this longitudinal review is what the sample tells us about scholarship and tax practice. to draw on women again, others have written 1. see victor h. lindlahr, you are what you eat (1st ed. 1940). 2. for business tax, see text discussed below in part iild.2 (discussing subject matter of articles sampled). for tax and race, see generally beverly l moran & william whitford, a black critique of the internal revenue code, 1996 wis. l rev. 751 (black critique of internal revenue code). for the response it has generated and for other observations about critical tax theory, including tax and gender, see symposium, critical tax theory: criticism and response, 76 n.c. l rev. 1519 (1998). 3. for criticisms of other quantitative assessments of legal scholarship, see, e.g., william m. landes & richard a. posner, symposium on trends in legal citations and scholarship: heavily cited articles in law, 71 chi.-kent l rev. 825 (1996) (criticizes assessment of most cited law review articles, infra note 51); david h. kaye & ira mark ellman, the pitfalls of empirical research: studying faculty publication studies, 36 1. legal educ. 24 (1986) (criticizes study of declining rates of publications for more senior law faculty). 19991 florida tax review about women's presence in law and in publishing; this sampling casts light on how women have published in tax. part ii of this article explains the methodology of the article: what journals i chose, why i chose them, and how i drew information from them. part iii examines the data extracted from the sampling and places it in the context of what others have observed about the relevant areas. the data is grouped in three areas, (i) authors' gender, (ii) authors' professions, and (iii) other aspects of the scholarship, such as the type of scholarship the articles represent (e.g., normative, empirical), the subject matter of the articles, and the institution which authors would have remedy the problems addressed in their articles-congress, the internal revenue service, or the courts. part iv sets forth conclusions to this article. briefly stated, my conclusions about the sampled literature are: (i) women lawyers, including law professors, published at lesser rates among the sampled articles than their presence in the legal profession or in teaching would suggest, but the trend has been reversed among professors in the last several years; (ii) tax's movement away from law firms and towards accounting firms has not been reflected in authorship of the articles; (iii) doctrinal scholarship has remained an important part of tax scholarship, although normative scholarship has become more important, the subject matter of the articles has remained remarkably stable over time, and the development of more complex tax statutes and regulations has been reflected, albeit modestly, in the sampled articles. ii. methodology a. sampling tax literature part of the rationale for my sampling was personal; the four journals sampled were those i was encouraged to read when i began to practice tax and among those i assume other tax lawyers and accountants read.4 more formally, these have long been important tax journals. journal of taxation and tax lawyer, and even taxes, have relatively wide circulations, especially when compared with the number of subscribers typically associated with general law reviews, and so trends discerned from the sampled articles gave me a larger base.5 while the tax law review has a more modest subscription, its place in 4. see supra part l 5. for example, the circulation figures for the journals in 1992-93 were: journal of taxation, 16,621; taxes, 8,491; tax law review, 2,704; and tax lawyer, 31,500. for information about circulation of thesejournals dating from 1997-98 back to 1978-79, seetable ia in the appendix. [vol 4:7 interpreting the interpreters tax literature is secure, having been published by new york university's school of law graduate tax faculty since 1945. the dedication of these journals exclusively to tax made them a better field from which to reap information than general law reviews. significant tax articles might have appeared in the harvard law review or the yale law journal, for example, but the likelihood that these tax articles would appear in a sampling of articles published in general law reviews is less than that they would appear in a sampling of journals exclusively devoted to tax. in addition to tax law review's association with new york university, tax lawyer, the publication of the american bar association's section of taxation, also has a scholarly patina, if somewhat less and somewhat more recent than the tax law review, and academicians certainly have also published articles in the other two journals.6 thus, i chose these journals because of their focus on tax, their relatively wide circulations, and because, both at first glance and upon further inspection, they might offer a mix of scholarly and less scholarly articles. the articles published in these four journals were reviewed over a fortyfive year period, from 1954 to 1998, in order to increase the visibility of trends. 1954 signifies the enactment of a new internal revenue code, and 1998 brings the review to a close after forty-five years. other, equally meritorious tax journals, were excluded, largely because of their shorter lives. for example, university of florida's college of law also has a graduate tax program and a tax journal-florida tax revie--but its journal has been published only since 1992. the university of virginia school of law has a tax journal-virginia tax review-but the review has been published only since 198 1. tax notes also was a suitable candidate for review, but its shorter life-it has been published only since 1972-led to my not choosing to sample it either. the review of literature in this article is a sampling, not an exhaustive analysis.7 journal of taxation and taxes are published monthly, and the tax law review and tax lawyer, quarterly. i analyzed articles from two of the twelve monthly issues in the first two journals in each year of the forty-five year period, and one of the four quarterly issues published in each of these forty-five years in the other two journals. thus, i reviewed either 17% or 25% of all of the issues published in these four journals during the forty-five year period; presumably, i also analyzed roughly between 17% and 25% of all articles 6. see infra note 21 (tax lawyer merely reported activities of american bar association for a number of years). 7. for articles about tax literature, see michael a. livingston, reinventing tax scholarship: lawyers, economists, and the role of the legal academy, 83 cornell l rev. 365 (1998); paul l. caron, tax myopia, or mamas don't let your babies grow up to be tax lawyers, 13 va. tax rev. 517 (1994). while not directly on point, useful insights into publishing by tax professors after they gain tenure are set forth in philip f. pastleraite. life after tenure: where have all the articles gone?, 48 j. legal educ. 558 (1998). 19991 florida tax review published in these journals during this time. i reviewed the issues in a pattern designed to examine issues without bias, so that i would sample as many january issues of journal of taxation, for example, as may or september issues, in order to preclude the possibility that a more exclusive reliance on the issues of any particular month would somehow skew the sample.' i reviewed only signed articles. journal of taxation publishes more than just signed articles, but limiting myself to articles authored by an acknowledged person, persons, or committee, reflects my observation that signed articles have been the element most common to all the journals while student notes or unsigned, largely informational, articles, for example, have not.9 the sample might have been cast differently. i might have sampled articles from other journals, including the unread tax journals noted above or general law reviews. undoubtedly, some articles by female lawyers or law professors or normative articles were excluded because of the journals not read. nevertheless, the sample offers a good snapshot. i believe that some trends, such as how the percentages of authors who were women lawyers lagged, relative to the percentages of women lawyers in the general population, would occur, even in a reshaped sampling. other trends, such as the subject matter of the articles, might be more drastically affected by a different population of sampled articles. such speculations are the subjects of further research. b. interpreting the results i compiled the information by entering it into a database system and then by asking questions about the variables in my entries. 0 to some extent, the 8. fewer articles tended to be published in tax law review and tax lawyer than journal of taxation or taxes. see infra table 1. even though 25% of all issues of the first two journals were examined, the total number of articles published in all four journals ultimately sampled was probably closer to 17% than 25%, because more of the articles appeared in the other two journals, in which i reviewed only 17% of all issues. variances sometimes existed among a journal's issues. papers presented at the university of chicago's annual federal tax conference have usually been reprinted in taxes' december issue since 1949. as noted in the text, i ignored these variances by sampling the december issues no more nor less than the other eleven months' issues. see text accompanying note 8. 9. student notes appear only in tax lawyer. unsigned articles conveying information, such as the likely trend in the internal revenue service in a particular substantive area, appear in journal of taxation and taxes. i also took the information at face value so that a speech treated as an article was included in the sampling while a speech treated as a speech was not, nor was a signed piece in the nature of a column. see also infra note 16 (gender of some authors not identified because of inability to determine gender based upon names and immediately surrounding material). 10. for those even less familiar than i about databases, this sampling required entering the information into a database, for which i used paradox 8. sophisticated assessment of the data was made through spss 9.0. [vol 4:7 interpreting the interpreters variables i entered reflected the nature of the articles i reviewed. i was quickly struck, for example, by the absence of women authors, and so i backtracked and started almost immediately recording authors' gender. similarly, my assessment of the taxonomy of the scholarship-was it descriptive or did it tell a lawyer how to advise her client-reflects what i perceived as i read the articles as opposed, for example, to more traditional characterization of scholarship as doctrinal or normative." statistical information can reveal trends in the surveyed population, and the data collected in this article reveals trends among the four law journals since 1954.12 for example, one trend is that women did not seem to publish much. only around 5% of all sampled articles-actually, 72 of the 1,520 articles-were written by women, the first one appearing in 1959.3 possibly women chose to publish in issues i did not review or in unsigned articles. sampling does not guarantee that 5% of all articles published in these journals during this forty-five year period were published by women, but it can suggest that the proportion of articles published by women in the forty-five year population of articles probably was around 5%. c. questions asked statistical information can reveal trends in the population of surveyed material. what i learned, therefore, was a function of the data i derived from the articles. i derived information from the articles by cataloguing the following characteristics about each article. year-to state the obvious, by designating the year in which an article was published, i could more easily discern trends. subject natter-categories from which i used articles ranged from accounting to utilities. 4 the material dictated my choices. 11. see infra part iild.i. 12. the data underlying the sampling is on file with the author. 13. see infra table 2 (identity of authors by group and by percentage). 14. the categories are: accounting, capital assets, compensation. corporate, credits, crime, deductions, employment tax, estate planning, excise tax, exempt organizations, financial entities, financial products, foreign, gross income, individual, insurance, intellectual property, jurisprudence, leasing, mortgages, natural resources, partnerships, policy, procedure, rates, real estate, retirement, stamp tax, state tax, tax practice, tobacco tax, and utilities. i also used secondary categories when inputting the data, e.g.. for accounting, i added secondary categories for allocations, depreciation, inventory, and prepayment, and forcorporate, consolidated returns, distributions, s corporations, and transformations. i have not listed the secondary categories in this article because, ultimately, i did not use them when interpreting the data. 1999] florida tax review * authors-authors were classified by gender. 5 i characterized a few authors as having no gender, at least in my sampling, because gender was not apparent from the author's name or because the author was a committee and not an individual. more frequently, the name itself or a footnote identified the author's gender, and so gender identification was not problematic, with the few exceptions. 6 whenever there were multiple authors, i entered information only for the first author.17 authors were further categorized by whether they were academicians or practitioners and the nature of their profession. academicians were either identified as teaching at law schools, business schools, or elsewhere (most probably in an economics department in a college of arts and science). students at such schools or departments were also identified as academicians, but most of the academicians were teachers, not students. authors who appeared to have another, nonacademic, position, but had listed themselves in some diminished academic capacity, such as an instructor or lecturer, were not treated as academicians. because the author's rank, e.g., as a partner or associate or as an assistant, associate, or full professor, was not uniformly or readily available, i did not attempt to ascertain rank. practitioners also were categorized by profession. either they were lawyers, accountants, or something such as an employee of the treasury department, the internal revenue service, a corporation, or an institute. because i took the journal's description of the author at face value, i always tried to characterize an author by the predominant tenor of the description. for example, if he were both a lawyer and accountant, and listed as a lawyer first, i characterized him as a lawyer; if listed as an accountant first, i characterized him as an accountant. obeisance to the journal's description of the author also meant that the late professor stanley surrey could be characterized as a law school professor in one of his articles included in the sampling and as a government employee in another.' 8 15. i also entered names, but they did not prove helpful in assessment of the data, other than to ascertain gender. 16. most articles listed the author as, e.g., frank smith or mr. smith. photographs appended to an article helped identify an author's gender, but an author listed as f. smith did not. 17. my impression, however, is that many secondary authors were women. 18. compare stanley s. surrey, income tax problems of corporations and shareholders-american law institute project-american bar association committee study on legislative revision, 14 tax l. rev. 1 (1958) (professor) with stanley s. surrey, the united states tax system and international tax relationships, 43 taxes 6 (1965) (assistant treasury secretary). [vol 4:7 interpreting the interpreters timeliness-was the article written about some new development? if it was, did the author write about something triggered by an action taken by congress, such as a new law or a hearing, an action taken by the service, such as promulgation of a new ruling or proposal or publication of a regulation, or a decision by a court? 0 breadth of the article-what was the scope of the article? the scope could have ranged from the very technical, to the merely technical, to the very general. 0 taxonomy of the scholarship-was the article advisory, descriptive, prescriptive, interpretive, or empirical? working with the easiest category first, empirical research might result, for example, from a survey of a social science nature, but not from the more traditional, lawyer-like, survey of cases, for example, about unrelated trade or business income of an exempt organization. interpretive articles assembled material in a particular manner to promote some normative evaluation. all articles tended to interpret particular cases, rulings, facts, etc., but i judged interpretive articles to do this to a much higher degree. prescriptive articles tended to call for a certain course of action to be taken. i further categorized that call for action by the body that should take action-courts, congress, or the internal revenue service. descriptive articles merely described a particular problem, such as "this is what a tax practitioner should think about when one company acquires another." my research also suggested that some articles were advisory: "these are three things you should consider when your client's company acquires another company, and they are a, b, and c." as explainedbelow, i characterized the interpretive and prescriptive articles as normative, and the descriptive and advisory articles as doctrinal. 9 authors rarely wrote just a descriptive article or an empirical article. i tended to categorize articles as i saw them presenting themselves. i was struck by how almost any topic could be approached in a variety of ways, ranging from the mere presentation of information and thus as a descriptive article, to an advisory article, which told the reader what to do with the information, to an interpretive article, which put the same event into a broad stream of events over a period of time. thus, articles frequently fell into more than one category. 19. for taxonomy, see infra part iild. 1. examples of all four types of article are set forth at notes 73-78. some of the classifications were divided further, e.g.. prescriptive articles were characterized for the degree to which an institutional course of action was suggested, ranging from articles that emphasized the problem and offhandedly suggested that courts, for example, might do something, to articles that explicitly stated that a certain action should be taken and how the appropriate body should act. that line of research did not prove useful, and it has not been included in the article. 19991 florida tax review reading these articles led me to discover the breadth of thoughtful articles, many academic and many practical, that have been written, even though this is a judgment not within the systematic analysis of data contained in the sampling. the data have been presented in a variety of formats, each designed to display the information as sensibly and clearly as possible. most of the sampled articles were written by lawyers or accountants. but because i was more interested in data about lawyers, i frequently sorted for information only dealing with lawyers and not with a wider base, such as all women or all authors. sometimes, figures have been set forth annually. in these cases, such as the identity of the authors in table 2, i thought that an annual summary let a reader see that the first article published by a women author in the sampled articles was published in 1959. in other cases, setting forth data by decade, starting with 1954-1959, 1960-1969, and ending with 1990-1998, was appropriate, because tracking annual changes did not add substantially to a reader's understanding the material. the percentage of doctrinal articles in table 8 illustrates this approach.2" 20. another benefit of collapsing years into decades is that it better enabled me to test for "statistical significance," viz, whether the "pattern" i observed actually was a pattern or just chance fluctuations that i willed into becoming a pattern. for example, i believed that the proportion of normative articles increased in tax law review and tax lawyer over time, but not in journal of taxation and taxes, see infra table 9, a conclusion i base on the 1,520 articles i sampled during that period. had i read all of the articles in those journals published during that 45 year period (which probably number around 5,000), i could have made, or rejected, this conclusion with certainty. instead, this conclusion has been tested for and been found to possess statistical significance. in other words, a pattern exists in the sampled material, one that is likely to be repeated if other samples were taken of the same base. statistical significance is ascertained for the data assembled for this article through application of the x2 test. in turn, the x2 test is generated by cross tabulating data, such as the professions of authors and decades, in table 6, and creating a "table cell" for the intersection of each job for each decade that contains the count of articles that have both of those attributes. generally, statistical data is thought to be significant if there is a small likelihood of the results occurring by chance, generally no more than 5%. however, too many empty cells in the cross tabulations can weaken the assertion that the data is statistically significant. because i collapsed some data into decades, sometimes i was able to apply the x2 test and thus can state that the data in table 8 is statistically significant. since i frequently presented data in more detailed form, e.g., annually, too many cells were created, thereby impeding establishing statistical significance. the following tables possess statistical significance and few, if any, empty cells: tables 8, 9, 14. some other tables are statistically significant, but possess several empty cells. for example, the cross tabulation in table 2 of year and identity leads to many empty cells because there are many years, few women authors, and even fewer unknown and group authors. by collapsing data further, something commonly done in statistical analysis in order to minimize existence of empty cells, i was able to examine and establish the level of statistical significance for the following tables and under the following conditions: tables 2 (collapsing years into decades and gender identity into two categories-(i) male and (ii) female, group, and unknown); 3 (same); 6 (collapsing jobs into (i) lawyers and judges, (ii) accountants, and (iii) all others); [vol. 4:7 interpreting the interpreters as can be gleaned from table 1, more articles were published in journal of taxation and taxes than the other two journals. in order to avoid having the results skewed towards journal of taxation and tares, tabulations have also been made journal by journal, when appropriate. finally, i frequently used graphs to visually display information then immediately set forth in following tables. the information set forth in concomitant graphs and tables is identical; it has simply been presented in different forms. ilh. the sample a. data about tax journals table 1 sets forth the number of articles published, by journal and by year, in order to aid in an understanding of the scope of the sampling. as can be seen, the number of articles per year ranged from 20 to 47, and many more articles were sampled from the journals that published monthly-journal of taxation and taxes-than the other two, quarterly, journals. the tables in note 63 (by collapsing jobs as in table 6 in the first table and years into decades and jobs as just noted in the latter table); 7 (collapsing years into decades and jobs as in table 6); 13 (by collapsing areas into (i) congress, (ii) courts, (iii) internal revenue service, and (iv) all others); 2a (by collapsing identity as in table 2); 3a (by collapsing years into decades and gender identity as in table 2); and 4a (by collapsing years into decades and jobs as noted in table 6). by collapsing the data for table 4, i was able to establish the likelihood of the table resulting from chance fluctuations only to about 20%, and many empty cells still remained. table 5 was statistically significant, but i was unable to eliminate its several empty cells. the frequent presentation of detailed data, such as annual figures, the manipulation of data in the tables as noted, and even the inability to reduce the risk of randomness in table 4 does not invalidate the findings. i think that detailed presentation underscores much of the material, and thus have chosen to use it regardless of the effect it has on statistical significance. collapsing the data enables me to test for general patterns as best as possible by accepted statistical standards. and, while table 4 does not meet the usually accepted maximum 5% risk that randomness prevails and others may find the increased, 20%, risk unacceptable, i am willing to accept it, given the weight of the other data about women. similarly. i accept table 5, even though i was unable to avoid its several empty cells. 1999] florida tax review table 1. number of articles, by journal and year2' year 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 j. tax'n 1 9 11 19 19 19 16 21 16 20 7 19 16 14 17 16 16 20 15 17 16 15 17 15 15 16 19 15 18 15 14 21. tax lawyer was first published in 1947, but the blanks in its column through 1963 and in a few later years reflect the journal's failure to publish articles in the sampled issues. instead, the tax lawyer served as more of a house organ, setting forth material such as proceedings of the a.b.a. section of taxation. articles were published in the tax lawyer thereafter, so that subsequent blanks reveal a particular issue's devotion to the section's activities and the exclusion, in that issue, of more traditional articles. similarly, the blank in tax law review's column in 1998 indicates that it had not published an issue for 1998 at the time of this article's publication. taxes 16 14 14 13 13 13 10 13 21 11 9 12 12 11 18 10 11 10 10 12 16 9 15 13 16 19 19 16 13 14 16 tax l. rev. 3 5 3 4 5 4 3 4 3 6 4 4 3 4 3 1 3 1 4 1 2 2 2 4 2 3 3 4 2 2 3 tax law. total 20 28 28 36 37 36 29 38 40 37 1 21 1 36 5 36 29 2 40 5 32 3 33 5 36 29 6 36 3 37 6 32 34 4 36 7 40 8 46 6 47 6 41 3 36 4 35 4 37 [vol 4:7 interpreting the interpreters year j. tax'n taxes tax l. rev. tax. law. total 1985 15 17 3 4 39 1986 14 21 4 2 41 1987 11 15 3 3 32 1988 12 12 3 4 31 1989 13 12 4 3 32 1990 12 14 3 3 32 1991 12 9 2 4 27 1992 13 17 5 5 40 1993 15 8 3 5 31 1994 12 9 3 3 27 1995 14 8 3 2 27 1996 12 8 4 5 29 1997 13 8 5 5 31 1998 13 7 3 23 total 664 584 142 130 1520 the data is analyzed below for a variety of trends. b. literature and data about wonen 1. observations about w~onzen, careers, and publishing.-a substantial amount of literature documents the difficulty women have establishing themselves in the legal profession. women, and members of minority groups, did not appear in substantial numbers in law schools until the late 1960s. until then, most law students were white men. but others-white women and all minorities-began to make inroads.2-' similarly, at one point, few women were law school professors. one author documents the rise in the number of women law school professors from 14 women total in 1960, up to 2% of tenure track professors in 1967.3 women, whether student, professor, or lawyer, tended to be isolated, given their small numbers.' this older generation of women entering law were outsiders.' while women form larger percentages of students, faculty, and practicing lawyers than they used to,' they still fail to match their broader 22. see cynthia fuchs epstein, women in law chs. 3, 4 (2d ed. 1993). 23. deborah jones merritt, the status of women on law school faculties: recent trends in hiring, 1995 u. 11. l rev. 93 (1995). see also henna hill kay. the future of women law professors, 77 iowa l rev. 5 (1991) (recounting early days of women law school teachers). 24. see, e.g., epstein, supra note 22, at chs. 3, 4, 5 (especially pp. 61-70). 25. id. at 60-61. 26. see, e.g., a.b.a., official american bar association guide to approved law schools 1999 edition 455 (rick l morgan & kurt snyder eds. 1998) (in fall 1997, 43% of all 1999] florida tax review demographic presence. in teaching, they still tend to be marginalized by teaching at less prestigious schools, by entering teaching at lower ranks, and by teaching less attractive courses than men. 7 in practice, the importance of larger firms has increased over time; the greatest number of lawyers may still be sole practitioners, but that segment of practice is smaller than it used to be, and the percentage of lawyers engaged in a large firm practice has increased.28 furthermore, women in practice tend to be younger than their male counterparts29 and are less likely to be partners in these larger firms.3" many women avoid practice in firms; they tend to cluster, for example, in government work.3 additionally, women lawyers have lagged behind in assumption of positions of leadership in the bar. for example, women participated more than their percentages of membership in the american bar association would have suggested on the board of governors of the aba, one of three types of leadership positions in the aba, but less in the other two, the house delegates and the full-time law school students were women and 29% of all full-time law school teachers were women); merritt, supra note 23, at 95 (women comprised roughly 38% of law school teachers between 1986-1991, and were 38% of student population from 1981-1983); a.b.a., comm'n on women in the profession, goal ix report card 2 (1998) [hereinafter goal ix report card] (for preceding 5 years, women comprised about 25% of a.b.a. members); barbara a. curran & clara n. carson, the lawyer statistical report: the u.s. legal profession in the 1990s 1-6 (1994) (discussing gender composition of lawyers, with percentage of women lawyers expected to rise to 27% by 2000). 27. see merritt, supra note 23, at 100-01; barbara a. curran, a.b.a., comm'n on women in the profession, women in the law: a look at the numbers 13-16 (1995) (places women in a greater breadth of professional settings); linda r. hirschman, battle of sexes rages in law schools, 21 nat'l l.j. a20 (august 23, 1999) (current review of women's status at law schools). see merritt, supra note 23, at 99. constitutional law is an "attractive" course, while legal writing and trial advocacy are not. merritt has no position on the interest tax generates, but does characterize its cousin, trusts and estates, as another unattractive course. but see caron, supra note 7, at 524 n. 20 (high status accorded tax). see infra table 12 (major topics of articles by gender of author). 28. see a.b.a., comm'n on women, women in the law, supra note 27, at 14-15; curran & carson, supra note 26, at 15-26. 29. see a.b.a., comm'n on women, women in the law, supra note 27, at 11-12; curran & carson, supra note 26, at 4-6, 11-14. 30. see a.b.a., comm'n on women, women in the law, supra note 27, at 27,21-28; curran & carson, supra note 26, at 13; see also ann j. gellis, great expectations: women in the legal profession, a commentary on state studies, 66 ind. l.j. 941, 945 (1991). for an equally grim sociological assessment of law firms and women's marginalization in them, see generally john hagan & fiona kay, gender in practice: a study of lawyers' lives (1995). 31. see, e.g., epstein, supra note 22, at ch. 7 (discussing women lawyers in government practice). [vol 4:7 interpreting the interpreters nominating committees.32 (to compound matters, as of 1998, the section of taxation was one of the few remaining aba sections that had never had a woman chair.33 women, however, have assumed some other positions of leadership in the section, e.g., on the section council and its nominating committee.34) several reasons have been assigned for women's continued marginalization in practice. growth in the profession has been generated primarily through the numbers of women who have become lawyers. thus, the ascendance of large firms has been fueled by the increased numbers of women practicing law. 35 because women are less likely to have mentors than men, they frequently have less challenging assignments at their law firms and become even less likely to become rainmakers. a6 the school and social ties that have been important for advancing the careers of men are less important for women."' women are also more likely to leave a practice which, at a large firm, is likely to be from the less desirable employee status of associate, and not from the narrower group of partner-owners. 38 personal choices, such as childbearing and parenting, have an adverse impact upon professional advancement as well.39 in some ways, academia offers no greater solace for women. some recent studies indicate that university men outside law schools are more likely to publish articles than similarly situated women. another set of studies, while focusing more on publishing and less on academia, addresses law, and also indicates the preponderance of men in publishing.' the good news for women is that 32. see goal ix report card, supra note 26, at 2. epstein, supra note 22, at 250, suggests that women lawyers, unlike other women professionals, have joined bar associations in numbers proportionate to their professional presence. 33. see goal ix report card, supra note 26, at 8. but see karen hube, tax report, wall st. j., jan. 27, 1999, at al (first woman, pamela f. olson, nominated to head tax section in 2000). 34. see goal ix report card, supra note 26, at 8-15. 35. see hagan & kay, supra note 30, at 43-48 (discussing how the structure of the legal profession changed between 1977 and 1990); epstein, supra note 22, at ch. 11 (discussing women's entrance into prestigious law firms). 36. see generally cynthia l rold, women and law, 1995 u. ill. l rev. 105 (1995); elizabeth k. ziewacz, comment: can the glass ceiling be shattered?: the decline of women partners in large law firms, 57 ohio st. lj. 970 (1996). 37. see generally hagan & kay, supra note 30, at ch. 4 (discussing the factors that prevent women from attaining partnership status); epstein, supra note 22, at ch. ii (discussing women in prestigious law firms). 38. see hagan & kay, supra note 30. at 35-42; (discussing hierarchy in law firms). 39. see id. at 76-77, 91 ("having a family can be an asset for men and a liability for women"), 92-95, 104-12; ziewacz, supra note 36, at 986-89. 40. compare elizabeth g. creamer, assessing faculty publication productivity. issues of equity (1998) (broad study of publication productivity) and yu xie & kimberlee a. shauman, sex differences in research productivity. new evidence about an old puzzle, 63 1999] florida tax review statistics about women publishing are not as bad as they once were. the bad news, however, is that statistically women are still not as productive as men.4' one study about the scholarly productivity of scientists suggests that women scientists are less likely to be productive than their male counterparts.42 reexamining broad studies from the past, the authors, professors xie and shauman, concluded that the relative ratio of women's to men's production increased from 60-65% in 1969 to 75-80% in 1993.4' they do not believe that this gap can be explained by gender. some aspects of the gap may result from marriage, which is more likely to benefit men than women,' and "women's extra family responsibility associated with childbearing... reaffirms the importance of structural sources of gender inequality in science: women and men scientists are located in different academic structures with differential access to valuable resources." 45 in another, broader-based, study, professor creamer examines publishing productivity in a variety of academic disciplines.46 she also concludes that women are publishing more than they used to, but that they still publish less than men do; they have closed the gap when measured over a short term more than when measured of an entire career.47 like professors xie and shauman, she also amer. soc. rev. 847 (1998) (study of scientists) with symposium on trends in legal citations and scholarship, 71 chi.-kent l. rev. 743 (1996) (discussing trends in demographics in legal scholarship and publishing). 41. more good news for law school teachers is that they argue about the same things as other professors, such as how to measure scholarship. compare landes & posner, supra note 3, at 826 (discussing methods of studying legal scholarship), with xie & shauman, supra note 40, at 849 (scholarship of scientists) and creamer, supra note 40, at 5-7 (discussing the criteria used to study publishing productivity). 42. see xie & shauman, supra note 40, at 863. xie and shauman chose to measure this productivity on a short-term basis, not over a scientist's entire career, because they believed that women were more likely to withdraw from teaching on a short-term basis than men. by not examining production over an entire career, they believed they were better able to isolate variables that could account for scholarly production. see id. at 849-50. 43. see id. at 863. 44. see id. (making the observation that "[t]here is very little direct effect of sex on research productivity."); id. at 859-60 (discussing aspects of the gap). 45. id. at 864. as women entered the labor force and academic institutions in increasing numbers and the gender differences in teaching loads have diminished, women have become more prolific authors. the disadvantage with which women have worked at universities is echoed in law schools. for an account of the difficulty women have had in obtaining equal academic rank to men with respect to both entry-level and tenured faculty appointments as opposed to some lesser status such as "research assistant" or "research fellow," see epstein, supra note 22, at 224-29; kay, supra note 23, at 9-10. 46. some of the fields professor creamer examined include accounting, physical education, science, and social science. see creamer, supra note 40, at 5-8. 47. see id. at 8, 15. [vol. 4:7 interpreting the interpreters believes that productivity in publishing has less to do with individual qualities, such as the desire to write, and more to do with institutional or environmental factors, such as work assignments, funding for research, or the network necessary to publish scholarly articles, at least outside law. 8 she also describes the mixed authority about the effect of marriage and child rearing on women's publishing productivity, although she notes that family responsibilities never make publishing easier.49 she believes that other factors have a gender impact. for example, men tend to cite other men more in their research, and women tend to cite other women more; gatekeepers, who enable others to publish, tend to be men. 50 chicago-kent law school devoted a recent issue of its law review to a symposium about legal citations and scholarship. in the symposium, fred shapiro updated his earlier study of the most cited law review articles.5 he and others note that the dearth of women on the earlier list and their increased presence, as well as the increased presence of minority scholars on the list, means that these outsiders have become insiders. they disagree as to the meaning of the change in status,52 but some of the conclusions that can be drawn from the symposium articles echo the experience of women academicians teaching outside law school. they have improved their lot, but not necessarily in proportion to their numbers; they tend to teach at less prestigious schools, and thus might expect to be rewarded less for scholarship than those-men-who tend to teach at more prestigious schools.53 2. data about women in fields associated with tax.-what does the data about the sampled articles say about women writers in the sampling? the following table indicates the character of authors of all 1,520 articles by percentage annually-what percentage were women, men, groups or individuals 48. see id. at 47-61. but cf. j.m. balkin & sanford levinson. how to win cites and influence people, 71 chi.-kent l rev. 843 (1996). 49. see creamer, supra note 40, at 26-27, 67. 50. see creamer, supra note 40, at 40-41, 53-54. 51. fred r. shapiro, the most-cited law review articles revisited, 71 chi.-kent l. rev. 751 (1996). 52. see id. at 757-59 (outsiders have become insiders); frances olsen, affirmative action: necessary but not sufficient, 71 chi.-kent l rev. 937 (1996) (inside status notwithstanding, women still suffer at law schools); william n. eskridge, jr., outsider-insiders: the academy of the closet, 71 chi.-kent l rev. 977 (1996) (outsiders based on sexual orientation have yet to come inside). see also deborah j. merritt & melanie putnam. judges and scholars: do courts and scholarly journals cite the same law review articles?, 71 chi.-kent l rev. 871, 895-97 (1996) (authors contrast citations by articles and by courts, and note smaller percentage of women authors on their list of articles cited by courts). 53. see generally olsen, supra note 52. 19991 florida tax review whose gender could not be identified. thus, all authors whose articles were published in 1954 were men. table 2. identity of authors by year year 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 group unknown 4% 3% female male 100% 100% 96% 100% 97% 3% 97% 3% 93% 100% 98% 100% 95% 100% 3% 97% 100% 100% 97% 3% 91% 3% 97% 7% 93% 3% 92% 3% 93% 100% 100% 8% 86% 3% 93% 96% 94% 10% 88% 3% 94% 11% 89% 11% 89% 13% 87% 2% 95% 9% 88% 16% 84% 6% 94% 3% 97% [vol 4:7 interpreting the interpreters year female male group unknown 1991 19% 78% 4% 1992 5% 95% 1993 13% 84% 3% 1994 19% 82% 1995 4% 96% 1996 14% 86% 1997 16% 81% 3% 1998 13% 83% 4% total 5% 94% 1% 1% these statistics indicate that women in the sampled literature have tended to publish more over time, with the trend beginning in the 1970s. the climb, however, has not been a focused one. while highwater marks of 19% were reached in 1991 and 1994, 1991 was sandwiched between two years reminiscent of the 1970s, when only 3 and 5% of all authors sampled were women and 1994 was followed by a year in which 4% of all sampled authors were women. nor does the distribution of the gender of authorship by journal reveal a cluster of women authors in any one of the four journals. the greatest percentage of female authors published in any one journal was in taxes-7%---and the lowest percentage was in the journal of taxation-3%. but neither figure varies significantly from the overall percentage of women authors in all journals over all 45 years-5%., 4 this information becomes more meaningful when contrasted with the percentage of women in other, relevant, groups set forth in tables 3 and 4. table 3 sets forth two figures: (i) the percentage of women in the sampling who either were lawyers or judges and (ii) the percentage of women who were lawyers or judges in the population at large. the latter information did not come neatly packaged, and some information related more easily to the sampling than others.'5 the american bar foundation and the department of the census provide information, but not over each year of the year span of the sampling. consequently, the baseline i have used for comparison are figures provided by thedepartment of labor's bureau of labor statistics. the bureau's information is for employed lawyers and judges. figures about the percentage of employed "lawyers and judges" were first made available in 1962.' the percentage in the 54. see infra appendix table 2a. 55. the taxation section of the a.b.a. apparently has not published information about the gender of its members. if available, such information obviously would have been useful. 56. the statistics about women lawyers and judges in the general population have been compiled from published and unpublished data from the bureau, and the unpublished information is on file with the author. the bureau aggregated lavyers and judges in some years, 19991 florida tax review middle column represents that percentage of all lawyer or judge authors in the sampled literature who were women. thus, in 1996, only 25% of authors who were lawyers or judges were women, while 29% of all lawyers and judges counted by the bureau of labor statistics were women. table 3. women lawyer/judge authors in sample and women lawyer/judges in population at large, by year % women lawyer/judge authors 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 5% 0% 0% 0% 8% 4% 8% % women per bls 3% 2% 2% 4% 3% 3% 3% 3% 4% 4% 4% and not in others. while it seems reasonable to believe that the proportion of tax lawyers who are judges is less than the proportion of general lawyers who are judges, for consistency, i used the figures for lawyers andjudges for all 36 years for which figures were available because these figures were the only ones available for several years. one published source, however, is employment & earnings, a monthly publication of the department of labor, bureau of labor statistics, in which annual statistics are published for each year in the january issue of the following year. see, e.g., bureau of labor statistics, department of labor, no. 45 employment & earnings 174 (1998) (1997 figures); bureau of labor statistics, department of labor, no. 31 employment & earnings 178 (1984) (1983 figures). another is the bureau of labor statistics web site, which, when this article was published, set forth figures from 1995 on. see bureau of labor statistics home page (visited sept. 30, 1999) ftp://ftp.bls.gov/pub/special.requests/lf/). for comparison of the bureau of labor statistics, the census bureau, and foundation methods of counting lawyers, see barbara a. curran, comm'n on women in the profession, a.b.a., women in the law: a look at the numbers 1-2 (1995). year 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 [vol. 4:7 interpreting the interpreters year 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 % women lawyer/judge authors 0% 0% 0% 0% 7% 0% 0% 0% 12% 3% 13% 5% 11% 0% 5% 5% 5% 0% 18% 3% 10% 16% 0% 25% 17% 13% with a few exceptions, suchas 1966, 1970-1972, 1981, 1983, 1991, and 1996, the percentage of women lawyer/judge authors in the sample lagged behind, sometimes substantially, the percentage of lawyers who were women, according to the bureau of labor statistics.5 table 4 sets forth information about women law professors in the sampling and in the population at large. the middle column represents that portion of authors in the sampled articles who were law school professors and 57. thirty-nine of the authors in the sample were women lawyevrs or judges. the bureau grouped accountants and auditors in most )ears. see infra note 106. because the bureau figures indicate that the percentage of accountants and auditors who were women was even higher than the percentage who were lawyers and judges, the lag between women in the population at large who were accountants or auditors is even greater when compared to the percentage of authors in the sampled literature who were women accountants. for the figures regarding accountants and auditors, see appendix table 3a. % women per bls 6% 7% 7% 9% 10% 9% 12% 13% 14% 15% 16% 16% 18% 18% 20% 19% 22% 21% 19% 21% 23% 25% 26% 29% 27% 29% 19991 florida tax review also were women. therefore, for example, none of all articles written by law school professors in 1988 were written by women (and all were written by men). the third column consists of the percentage of women law professors according to the american bar association. again, the information was limited, here from 1987-1998, because of the shorter period of time for which the american bar association has kept records about women law professors than the information that is available from the bureau of labor statistics.58 table 4. women law professor authors in sample and women law professors at large, by year % women law professor authors in samplina 50% 0% 17% 0% 0% 0% 0% 25% 0% 67% 33% 33% % women law professors per aba 20% 23% 24% 25% 26% 27% 29% 26% 27% 28% 29% 29% there is no clear pattern. earlier on, women law school professor tended to publish at lower percentages than their presence in law schools generally would have suggested and, in the last four to five years, have published as much as or more than their presence generally would suggest. other statistics can be gleaned about women and men, if comparisons to populations at large for lawyers or judges and for law school professors are set aside. for example, 36% of all articles in the sampling written by female lawyers and judges were written by law school professors; in contrast, only 14% of all articles in the sampling written by male lawyers or judges were written by 58. this information was provided by the a.b.a., office of the consultant. because data was self-reported until 1994, one school may have counted women differently than men, and so the earlier information may not be uniform. nor was information was not available before 1987. eight women law professors were authors in the sample from 1987 through 1998, and six were women in all prior years of the sample. but cf. merritt, supra note 23, at 95 (larger percentage of women comprise law school professors than noted in table 4, but she used her own research, not a.b.a.'s). year 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 [vol. 4:7 interpreting the interpreters law school professors. women law school professors were also more likely to publish in the more academic journals than men law school professors. table 5 indicates what percentage of articles in the sampling in each of the four journals were written by women and men law professors. thus, 7% of all articles by women lawyers or judges published in journal of taxation were written by women law professors; the comparable percentage for men was only 6%. table 5. comparison of authors who were law school professors, by gender and journal59 of authors in journal who of authors in journal who werelaw school pofessors, were law school professors, journal % who were women % who were men j. tax'n 7% 6% taxes 29% 11% tax l. rev. 83% 44% tax law. 80% 22% in addition to publishing in greater percentages in the sampled literature than their percentages in the population of law school professors at large would suggest, women law professors also have published in greater percentages than men law professors and also seem to have published in greater percentages than in the two more scholarly journals, tax law review and tax laiter. 3. conclusions.-tables 2-4 sets forth the presence of women in a variety of settings-as a percentage presence in the practice of law, as a presence in law schools and, most importantly, as a presence in the sampling as the authors of articles by these two measures. although there are some years in which the percentages of lawyer or judge authors who were women equaled or exceeded the percentage of lawyers or judges in the population at large who were women and other years in which there was no significant difference between the two, once women entered the legal profession in the late 1970s in greater numbers, according to bureau of labor statistics figures, they usually did not publish in proportion to these numbers. thus, the trend has been that the percentage of women lawyers and judges who have published tax articles has been less, sometimes dramatically so, than the percentage of women who practice law or are judges. until the last few years, a similar statement could be made when contrasting the percentage of law professors who were women publishing in the sampled journals to the percentage of women law professors generally. in the last few years, the percentage of women law professors in the sample has been in proportion to, and even exceeded, the proportion of law professors 59. in the sample 14 women and 131 men were law school professors. 19991 florida tax review generally who were women. the sampling of tax articles written by lawyers is consistent with the literature and studies, but the recent trend in the sampled tax articles written by law school professors is not. furthermore, table 5 indicates that authors in the sampled literature who are women and either a lawyer or a judge were more likely to be law school professors than men authors who were a lawyer or a judge. female law school professors were also more likely to publish in the more scholarly journals in the sample than their male counterparts. further research might illuminate whether institutional and environmental factors that have led to women lawyers not rising as high as men in law or publishing have led to their publishing tax articles less than men, and why they have been more successful in publishing if they were women law professors. the importance attached to publishing frequently and publishing well might lead women authors to try to avoid the less scholarly journals included in this sample, even though one of these lesser journals, taxes, included a higher percentage of women among its authors than any of the otherjournals. arguably, they are more at risk than men, especially white men, who are more entrenched in law firms and law schools, and thus need to achieve more than men. but it seems hard to believe that such over achieving women should congregate in law schools and avoid practicing law. c. literature and data about the professions of those who write taxarticles 1. observations about tax practice.-the practice of tax has shifted from law to accounting firms in recent years. as said of one lawyer who departed from a law firm to a big six accounting firm, he was "yet another in the stream of lawyers leaving law firms for cpa firms for the familiar triad of reasons: more money, fewer chargeable hours required, and no material client development responsibilities." additional stimuli for the change include the statutory extension of privileged communications with clients to certified public accountants in 199861 and a growing amount of tax court litigation conducted by accounting firms. 62 60. sheryl stratton, top tax litigator leaves law firm for big six cpa firm, 79 tax notes 683 (may 11, 1998). see also ass'n of am. law schools, 1999 annual meeting program 89-90 (1999 aals tax section meeting examined consequences of growing influence of accounting firms practicing tax law); lisa brennan, baker & mckenzie taxed by brain drain, 21 nat'l l.j. at a13 (may 31, 1999) (describes firm's loss of "nine prominent tax partners" to big five accounting firms in six month period). 61. irc § 7525, enacted as part of internal revenue service restructuring and reform act of 1998, pub. l. no. 105-206, § 3411, 112 stat. 685,750 (1998). section 7525 applies to persons subject to 31 u.s.c. § 330. in turn, that section includes certified public accountants. see s. rep. no. 105-174, at 70 (1998). 62. see, e.g., sheryl stratton, more big five attorneys appearing in court than before mdp commission, 82 tax notes 779 (feb. 8, 1999). the push towards multidisciplinary practice affects much more than the practice of tax law. see, e.g., testimony of stefan f. [vol 4:7 interpreting the interpreters 2. data about the professions ofauthors of taxarticles.-the observations that tax practice is being handled more by accountants and less by lawyers was tested against data from the sampling. in order to avoid skewing the results towards lawyers, the data was drawn from the two journals more likely to favor accountants, jounzal of taxation and taxes. the other two journals, published respectively by a law school and the american bar association, arguably are primarily intended for an audience of lawyers. the trend of tax practice towards accountancy notwithstanding, authors in the sampling have tended to be lawyers or judges. graph i sets forth visually the percentage of articles in each decade written by lawyers or judges and by accountants in journal of taxation or taxes, whether they were engaged in practice or taught at law or business schools. table 6 does this in more detailed form. the percentages given are relative to all authors engaged in the same type of job so that, for example, from 1954-1959, only 18% of the authors sampled were something other than lawyers or judges, on the one hand, or accountants. members of this minority might have been others professors, such as an economics professor, or a student. graph 1. authors in sample in journal of taxation and taxes who were lawyers or accountants, by decade 70% 60%-{ . u u 50%lawyerfiudge o a 40%accountant 30%-20% i i i i i 1954-1959 1960-1969 1970-1979 1980-1989 1990-1998 decade tucker, chair, section of taxation, before the aba commission on multidisciplinary practice, los angeles, california, february 4, 1999, 52 tax law. 591 (1999). 19991 florida tax review table 6. authors in sample in journal of taxation and taxes who were lawyers or accountants, by decade63 decade lawyer/judge accountant 1954-1959 60% 22% 1960-1969 59% 25% 1970-1979 62% 27% 1980-1989 64% 33% 1990-1998 60% 33% on a more academic side, graph 2 visually sets forth comparisons in each decade between the percentage of sampled articles from all four journals which were written by academicians, comparing the percentage of those academicians in each year who either taught at a law school or at a business 63. 664 articles from the journal of taxation were included in the sampling, and 584 from taxes. of these, 763 authors were lawyers or judges, and 353 were accountants. nor do accountants fare better if articles by them and lawyer/judges are drawn from all four journals. then the statistics are as follows: decade lawyer/judge accountant 1954-1959 65% 19% 1960-1969 61% 22% 1970-1979 64% 23% 1980-1989 69% 27% 1990-1998 66% 27% again, these are percentages relative to all authors in the sampling. from 1954-1959, for example, 16% of the authors were neither lawyer/judges nor accountants. and, even if one examines recent journal of taxation and taxes annually, e.g., since 1989, accountants still do not fare as well as the literature suggests. they seem to have written about a third of sampled articles each year, sometimes more, sometimes less, and the proportion of published articles written by accountants contained in the sampling has not inevitably increased over the decade, as the following table suggests. year lawyer/judge accountant 1989 60% 36% 1990 69% 31% 1991 57% 38% 1992 77% 17% 1993 57% 39% 1994 67% 29% 1995 41% 50% 1996 50% 35% 1997 52% 38% 1998 60% 30% [vol. 4:7 interpreting the interpreters school. table 7 repeats this information in a more detailed fashion. thus, in years such as 1967, professors at law and business schools wrote all the articles and in years such as 1970, other academicians, perhaps an economics professor, possibly a student, wrote articles among the sampled literature as well. graph 2. academic authors who were law or business school teachers, by year 100% 90% 80% :; , ,i 50% % 40% " 30% , 20% :: 10% 0%w ;'; c) 0 o c14 cd nt 0(0o 00)0)0)0)0)0) year % law school teachers % business school teachers table 7. academic authors who were law or business school teachers, by year % law school teachers % business school teachers 0 0 0 0 75% 0 100% 0 60% 20% 75% 25% 0 0 80% 0 80% 0 50% 0 50% 50% 67% 0 year 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 19991 florida tax review year 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 avg. % % law school teachers 57% 80% 60% 67% 44% 50% 80% 0 33% 0 0 71% 58% 33% 50% 63% 40% 33% 21% 50% 46% 17% 27% 50% 33% 44% 78% 44% 44% 33% 33% 38% 55% 45% in contrast to lawyer and accountant contributions to these journals, law school teacher articles declined and business school teacher articles increased, with few exceptions, over time.' 64. 328 of the authors were academicians, of whom 146 taught at law schools and 154 taught at business schools. if the onlyjournals reviewed are journal of taxation and taxes, the % business school teachers 0 20% 40% 33% 44% 50% 20% 67% 67% 80% 82% 14% 33% 67% 50% 38% 60% 56% 79% 50% 46% 83% 73% 42% 58% 56% 22% 56% 44% 67% 56% 50% 36% 47% [vol 4:7 interpreting the interpreters 3. conclusions.-the increased practice of tax law by accountants notwithstanding, lawyers in the sampled articles wrote and continue to write more than accountants have. it seems unlikely that lawyers are more adept at generating business or more academically inclined than accountants, either of which could generate articles. one possible explanation is that the shift has been so recent and sudden that it has not registered in the literature. it seems equally arguable that the developments prompting the shift could not occur overnight. neither the accounting firms who entice them, nor the lawyers who have been seduced, suddenly realized, sometime after 1998, that better money, billable hours and client development could persuade the lawyers to work for accounting firms. another possibility is that law has been held in higher esteem than accounting by people interested in tax during the period of the sampling. although i cannot document my conclusion, many authors in the sample were both lawyers and accountants, but almost invariably the author's status as a lawyer preceded mention of his status as an accountant. my impression of the sampled articles is that only in later years of the sampling, and then only occasionally, did the reverse occur. this could account for lawyers having always been more productive authors than accountants in the sampling. in contrast, the percentage of law school teachers in the sampled articles declined over time-even more if the articles are drawn just from journal of taxation and taxes-even as the percentage of business school teachers increased. i believe that presumably rising standards of tenure at law schools accounts for the declining percentages of sampled articles written by law school teachers in these two journals.' an increased distance between law school tax teachers and tax lawyers may also account for this trend, as might a decreased distance between business school teachers and tax accountants. d. literature and data about tax scholarship the third area for inquiry encompasses other aspects of the tax scholarship revealed by the sampling. first, what is the taxonomy of the same question-what were the percentages of authors who were law school or business school teachers-shows an even more dramatic tilt towards the latter teachers. those results are set forth in the appendix, in graph ia and table 4a. 65. cf. richard a. posner, legal scholarship today, 45 stan. l rev. 1647 (1993) (widening gap between practitioners and law school teachers); harryt. edwards, the growing disjunction between legal education and the legal profession, 91 mich. l rev. 34 (1992) (same). but see livingston, supra note 7, at 375 (tax authors of whom he writes, able to make their scholarship accessible to practicing lawyers). i cannot begin to address personnel standards at business schools and, indeed, often have difficulty determining them at law schools, including my own. 1999] florida tax review scholarship: were the articles, e.g., doctrinal, normative, empirical? second, what were the subject matters of the articles? finally, were there any discernable trends in the institutions-be they congress, the internal revenue service, or courts-about which authors wrote? 1. taxonomy of tax scholarship a. observations about the taxonomy.-scholarship, including tax scholarship, can be characterized in many ways. it may be practical, for which any number of treatises are good and obvious examples. 6 and it may be less practical. for example, scholarship might promote a particular course of action to remedy a perceived infirmity in the law. both a practical and a prescriptive article could be interesting to a practicing lawyer, but she presumably would find a practical article more useful, because it would more easily enable her to advise a client than a merely prescriptive article. judge richard posner wrote about the three types of legal scholarship he perceived-doctrinal, positivist, and a new normativist scholarship.67 doctrinal scholarship might be understood to be analogous with what, and how, students learn in law school. "it involves the careful reading and comparison of appellate opinions with a view to identifying ambiguities, exposing inconsistencies among cases and lines of cases, developing distinctions, reconciling holdings, and otherwise exercising the characteristic skills of legal analysis."6 in turn, positivism entails a seemingly scientific, or more probably a social scientific method of analyzing law. it encompasses any number of "law and...," the best known of which is law and economics.69 normativism evaluates legal doctrine, and thus might analyze "discrimination, including reverse discrimination, the ethical basis of contract and tort law," and so on.7" solutions for the 66. see, e.g., boris l bittker & james s. eustice, federal income taxation of corporations and shareholders (6th ed. 1994); boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts (2d ed. 1989). 67. see generally richard a. posner, the present situation in legal scholarship, 90 yale l.j. 1113 (1981) (discusses three types of scholarship, while conceding "that my taxonomy is crude, the categories both incomplete and overlapping"). see also posner, supra note 65 (further discussion of scholarship, especially doctrinal scholarship); edwards, supra note 65, at 35 (" 'practical' scholarship, as i envision it, is not wholly doctrinal .... ideally, the 'practical' scholar always integrates theory with doctrine."). 68. posner, supra note 67, at 1113. 69. id., at 1119-25. see also william m. landes & richard a. posner, the influence of economics on law: a quantitative study, 36 j. l. & econ. 385 (1993). 70. see posner, supra note 67, at 1127 (footnotes omitted). see generally symposium, 139 u. pa. l. rev. 801 et. seq. (1991) (discusses normativism); pierre schlag, normative and nowhere to go, 43 stan. l. rev. 167 (1990) (same); livingston, supra note 7 (discusses current state of tax scholarship and ways in which to improve it). [vol 4:7 interpreting the interpreters deficiencies in these doctrines are promoted, e.g., through a proposed change in the law.71 b. data about the taxonony.-nomenclature for scholarship notwithstanding, the articles in the sampling were not self-labeling. instead, as already noted," patterns became apparent. one pattern was articles that described a concrete problem, possibly attempting to solve it, although the description of the present state of the law was invariably more important than the solution.73 another, often cruder, pattern was for the author to simply render advice to a practicing lawyer, e.g., "the five things you should remember when considering the tax consequences of the marital deduction are ... ." some of the descriptive articles rose to high levels, such as the chapters from their treatise, "federal income taxation of corporations and shareholders," that professors bittker and eustice first published in tar law review.' it is harder, however, to dress up the "five points" type of article as anything other than a bare conveyance of information to the reader. fit within the framework usually given to legal scholarship, these descriptive and advisory articles might be characterized as doctrinal scholarship. other articles suggested or prescribed a solution to a problem, either by action to be taken by courts, the internal revenue service or congress. the prescriptive articles ranged from the very crude, where a solution was tacked to a more descriptive article almost as an afterthought to much more sophisticated 71. see posner, supra note 67, at 1125-29. within tax, see generally livingston. supra note 7, at 375-80. 72. see supra part ilc. 73. see supra part ilc (describes author's sense ofdescriptive and advisory articles). for examples of descriptive articles in the sampling, see, e.g., a. finley schuldenfrei & arych guttenberg, acquisitions of s corporations, 63 taxes 802 (1985); john h. birkeland & philip f. postlewaite, the uncertain tax ramifications of a terminating disposition of a partnership interest-the constructive termination of a partnership, 30 tax law. 335 (1977); joseph p. giljum, federal tax problems encountered in advance tax payment transactions, 21 tax l rev. 495 (1966); frank k. greisinger, decisions to lease or buy equipment are made no easier by new revenue rulings, 4 j. tax'n 191 (1956). 74. for examples of advisory articles in the sampling, see, e.g., harry j.j. o'neill & david a. schenck, using discount stock options as executive compensation, 72 j. tax'n 348 (1990); richard s. mark, windfall profit tax-traps to avoid in the incremental tertiary maze, 60 taxes 571 (1982); john h. young, the role of motive in evaluating tax sheltered investments, 22 tax law. 275 (1969); harry yohlin, the short-term trust-a respectable tax-saving device, 14 tax l rev. 109 (1958). 75. one chapter included in an article in this sampling is boris l bittker & james s. eustice, collapsible corporations in a nutshell, 22 tax l rev. 127 (1967) [hereinafter, collapsible]. for another chapter not in the sampled material, see boris i. bittker & james s. eustice, complete liquidations and related problems, 26 tax l rev. 191 (1970). 1999] florida tax review solutions.76 finally, some articles were of a more interpretive nature. invariably, the interpretive articles were of a more sophisticated nature than prescriptive articles, especially the simpler prescriptive articles. however, both the prescriptive and the interpretive articles might be characterized as normative scholarship, in that they tended to hold some value to be important, and tried to enable that value.77 none of the articles sampled could be characterized as positivist. as noted above, there were a few empirical articles, but not on substantial topics. invariably, the empirical research was about tax preparation software.78 two graphs and two tables set forth below reveal the doctrinal and normative nature of the sampled articles. the percentage of sampled articles in each journal, annually, which were doctrinal are set forth in summary and visual form in graph 3 and then set forth in greater detail in table 8. these doctrinal articles were either advisory or descriptive, as i have just used the terms, and the normative articles were, in turn, either prescriptive or interpretive. 76. for examples of prescriptive articles in the sampling, see, e.g., michael asimow, public participation in the adoption of temporary tax regulations, 44 tax law. 343 (199 1) (more sophisticated prescription); james s. eustice, contract rights, capital gain, and assignment of income-the ferrer case, 20 tax l. rev. 1 (1964) (same); john s. ellett, ii & steven s. rubinstein, disallowed deductions: 1969 tax reformact changes to code sec. 162, 48 taxes 457 (1970) (simpler prescription); robert j. mcdonald, irs errs in denying that no-restricted options can be compensation at grant, 12 j. tax'n 331 (1960) (same). 77. for examples of interpretive articles in the sampling, see, e.g., daniel schaviro, perception, reality and strategy: the new alternative minimum tax, 66 taxes 91 (1988); kenneth f. joyce & louis a. del cotto, interest-free loans: the odessey of a misnomer, 35 tax l. rev. 459 (1980); daniel s. goldberg, open transaction treatment for deferred payment sales after the installment sales act of 1980, 34 tax law. 605 (1981); herman t. reiling, developing a law of income taxation, 32 taxes 546 (1954). 78. see, e.g., journal of taxation editorial staff, 32 software packages for preparing individual returns reviewed by practitioners, 79 j. tax'n 218 (1993); norman a. kanter, 1975 survey of computer tax return preparers; a report on services available this year, 43 j. tax'n 236 (1975). but see, e.g., robert g. bromley, a closer statistical look at tax court compromise, 57 taxes 325 (1979) (example of empirical research that was not about tax return software). as livingston suggests, tax scholars have not taken to empirical research. see livingston, supra note 7, at 385, n.71. [vol. 4:7 interpreting the interpreters graph 3. doctrinal articles in sample, by journal and decade 1000/0 a 600/6-taxes 0 0/0 • 40% 60. tax6lm 6.0. llo cd -i1' 0 ). 3) 0) m)0) cm 0) 0) 0) 0)0)d decade table 8. doctrinal articles in sample, by journal and decade decade j. tax'n taxes tax l. rev. tax law. 1954-1959 92% 93% 92% 1960-1969 98% 88% 80% 100% 1970-1979 99% 88% 96% 93% 1980-1989 99% 98% 77% 90% 1990-1998 98% 86% 43% 74% as can be seen, there was a high degree of doctrinal scholarship, especially in the journal of taxation and taxes, usually between 80% and 100%. while somewhat constant in both these journals, the percentage of doctrinal articles in journal of taxation increased modestly and held firm, while they diminished, then held constant, but for an increase in one later decade, in tares. there was a high degree of doctrinal scholarship in tar lain5yer and in tar law review, earlier on. but doctrinal scholarship dropped off in both journals in the two decades since 1980, especially in tax law review. the percentage of all sampled articles in each journal, by decade, which were normative are set forth in summary and visual form in graph 4 and then in greater detail in table 9. these normative articles were either prescriptive or interpretive, again as i have just used the terms. 19991 516 florida tax review [vol. 4:7 graph 4. normative articles in sample, by journal and decade 100% 90%80%70%-. j. tax'n z0/6 taxes d 50%i c m -. --.-40/ tax l. rev. 30/ 2°*/o=tax law. 10% 10% 1954-1959 1960-1969 1970-1979 1980-1989 1990.1998 decade table 9. normative articles in sample, by journal and decade decade j. tax'n taxes tax l. rev. tax law. 1954-1959 18% 17% 46% 1960-1969 6% 15% 43% 21% 1970-1979 2% 18% 58% 29% 1980-1989 5% 7% 68% 49% 1990-1998 6% 24% 89% 43% as graph 4 and table 9 indicate, relatively little sampled literature in the journal of taxation and taxes was normative, while a greater percentage of the sampled articles in the other two journals, especially tax law review, became normative as time passed. more specifically, normative scholarship in journal of taxation was and remained low, was fairly low and then increased modestly in taxes, continually increased in tax law review and continually increased, but for a modest decrease in the last decade, in tax lawyer. presumably, conveyance of information has been important to readers of the four sampled journals, and the continued presences of doctrinal articles in all four journals sustains that conclusion. in recent years, the two more academic journals, tax law review and tax lawyer,79 have had diminished percentages 79. see supra part ii.a. there were 1,403 doctrinal articles and 262 normative articles in all four journals. the sum of these two figures exceed the number of sampled articles because some of the articles were characterized as being both doctrinal and normative. see supra part ilc. interpreting the interpreters of doctrinal articles; this is especially true of tax law review. these two journals havehadgreater percentages of normative articles as well, more than the first two journals. change that have hit other areas of academic legal scholarship, including a decline of doctrinal scholarship,80 seems to have affected the academic tax scholarship that was included in the sampling. c. conclusions.-doctrinal scholarship has a secure basis in the sampled tax scholarship. normative scholarship has become more prevalent over time, and has been present in tax law review for some time. the earlier one looks in the sample, the stronger the doctrinal nature of the scholarship. this comports with the belief that doctrinal scholarship once was more prevalent than today.8' readers of these journals might have guessed that tax law review would be the most academic of the journals and, if it joined contemporary currents of legal scholarship, the one least likely to have remained doctrinal. in fact, tax law review's articles seem to have become less doctrinal in the last two decades, and have long been normative. even the articles in ta lawyer became less doctrinal in the last decade of the sampling. the doctrinal nature of the scholarship is not surprising. all of the journals are devoted to tax; whether or not viewed as an academic journal, all of them conveyed information, especially technical information, to the tax technicians that presumably comprised their audiences. doctrinal scholarship is more "practical" than normative scholarship,' and the absence of doctrinal scholarship from this base would be more striking than its presence, even if it has diminished in some journals over time. 2. the subject matter of the sampled articles a. observations about specialties in tax.-tax is a less attractive specialty in which to practice law than it once was. even as the tax reform act of 198683 killed tax shelters, it wounded tax practice. from a heady prediction in 1985 that tax would continue to be a good area in which to specialize-based upon the information that the size of the american bar association section of taxation had more than doubled from 1970 to 1980, to 28,000 members-the number of lawyers belonging to the section peaked at 27,483 in 1984-85 and has slowly declined since, to 19,741, in 1997-98, even as 80. see landes & posner, supra note 3, at 829-32 (lack of influence of perceived doctrinal scholarship elsewhere in law). 81. see, e.g., posner, supra note 65, at 1648-54 (doctrinal scholarship more prevalent when legal community was more cohesive). 82. see posner, supra note 67 (call for doctrinal scholarship): edwards, supra note 65 (call for practical scholarship). 83. tax reform act of 1986, pub. l no. 99-514, 100 stat. 2085 (1986). 1999] florida tax review aba membership has increased? 84 viewed from another perspective, the percentage of lawyers specializing in tax at the largest firms, as measured by the national law journal, diminished from 8.6% in 1979 to 4.8% in 1995.85 it is difficult to determine which tax specialties have become more and or less popular over the years. on the other hand, some articles have hinted at different directions the practice of tax has taken over time. for example, the tax lawyer engaged a number of lawyers to look back on their practices over the years.86 while several noted qualitative changes in the practice, e.g., the increased complexity of tax rules, the larger size of firms, 7 only one commented upon the areas in which he practiced. what were the issues that seemed most important in the fifties.... debt/equity questions; unreasonable compensation; accumulated earnings tax; personal holding company problems; doing business questions; multiple surtax questions; organizing base company operations for united states companies doing business abroad; section 482 questions galore; liquidation reincorporation problems; utilization of net operating losses; section 269 questions; constructive receipt.... in terms of the practice of tax law, the sixties and seventies were for me the most exciting, the most demanding and the most stimulating.... tax-free reorganizations were in vogue; imaginative equity interests hopefully known as stock were being created; new reorganization techniques in the form 84. see stephen koff, why specialize?-tax, 14 student law. 20 (nov. 1985) (prediction). during the same time period, a.b.a. general membership rose from 288,896, in 1984 to a peak of 362,104, in 1992, reached a nadir of 339,476, in 1995, and has since risen to 347,903 in 1998. information from a.b.a. market research department (on file with author). 85. mike france, ip's hot tax is not, in mid-90s practice; trends in specialization at large firms, 18 nat'l l.j. al (february 26, 1996). but cf. make work: headhunters survey, amer. law., jan./feb. 1999, at 30 (in survey of legal recruiters, tax viewed both as cold and hot area in which to practice). the practice of tax law by men may be compounded by female lawyers' aversion to dating them. see karen hall, the lunch bunch, amer. law., july, 1999, at 20 (article about president of dating service, one fourth of whose clients are lawyers, in which tax lawyers rated at the bottom of the list of male lawyers that female lawyers would like to date). 86. tax lawyering: a changing profession, 46 tax law. 665 (1993). 87. see, e.g., n. jerold cohen, it always looks better when you look back, 46 tax law. 683 (1993) ("the aspect of tax practice which has been the most aggravating in the past and which appears a sure bet to be the most aggravating in the future is this accelerating growth in the spider web of complex rules in the code and regulations"); theodore tannenwald, jr. & mary ann cohen, a dialogue between tax court judges, 46 tax law. 672 (1993) (judge tannenwald notes size of his firm when he left practice in 1965); paul j. sax, the more things change the more they stay the same, 46 tax law. 690 (1993) (growth of his firm). [vol. 4:7 interpreting the interpreters of subsidiary mergers were being utilized, as well as complicated earnout transactions; spin-offs were being combined with mergers. [other areas the author lists includes: "complicated abc transactions" in the mineral area; deducting antitrust damages, "new investment companies" being formed under code section 351; manufacturing companies selling assets and being acquired by mutual funds in c reorganizations; and a whole panoply of foreign tax issues].s and another recent article suggested that, among the members of a group of accountants it had interviewed, the five areas most often the subject of tax specialties were: estate planning, partnerships and s corporations, succession planning in closely held businesses, personal financial planning, and taxation of divorce.89 b. data about the subject matter of sampledarticles.-there is no direct evidence in the sampling about tax specialties, but classification of the subject matters of the articles enables us to determine what topics intrigued the authors of these articles. the topics on which articles have been written during the course of the sampling have been remarkably stable. table 10, which follows, sets forth areas which have been addressed over the years in declining order of frequency. certain areas have been combined in order to simplify the information. for example, corporate and partnership tax were combined into business tax, retirement, employment taxes and compensation articles were combined into compensation, and procedure and criminal tax issues were combined into litigation.9" the percentages are relative to all articles so that, of all the articles published during 1954-1959, 28% were written about business tax. 88. m. bernard aidinoff, reflections on my tax practice, 46 tax law. 665, 666-67 (1993) (footnote omitted). see also the changing practice of tax law for lawyers and accountants, 72 taxes 190 (1994), including the comments of herbert lerner, at 201 ("[in most large [accounting] firms we tend to think of two areas of specialty-industry and functional areas-whereas the law firms tend to think about specialization only in terms of functional areas, whether it's estate planning, employee benefits, international, m and a. etc."); robert mundheim, at 208-09 (notes increased importance of state tax). if one may deduce the change in practice over years from what has been written about particular individuals, other articles may be of interest. see, e.g., boris 1. bittker, federal income taxation-then and now, 74 tax notes 903 (1997) (first lecture in behalf of larry woodworth, along-time government employee, whose career began in 1944); michael j. graetz, edwin s. cohen's a lawyer's life deep in the heart of taxes, 65 tax notes 1045 (1994) (review of book written by edwin cohen, whose career began in the 1930s). 89. burgess j.w. raby & william l raby, tax 20 forum: tax-related niches or specialties, 76 tax notes 379 (july 21, 1997). 90. other areas in which significant percentages of articles were written include: accounting (7% of all articles sampled), tax practice (5%), deductions (5%), gross income (5%), and individuals (3%). 19991 florida tax review table 10. more common topics of articles in sample, by decade9 estate decade business compensation planning foreign litigation state tax 1954-1959 28% 6% 9% 7% 9% 9% 1960-1969 21% 7% 10% 11% 6% 3% 1970-1979 21% 10% 9% 11% 7% 2% 1980-1989 22% 11% 7% 7% 6% 1% 1990-1998 24% 8% 9% 9% 6% 3% avg. % 23% 9% 9% 9% 6% 3% there is some variance among the areas, but there is also a remarkable consistency among the areas as well. all, more or less, varied between 0% and 30% of the total of the number of articles published in each year during the sampling. much of the literature was devoted to business tax. only one of the combined areas-business tax-is worthy of further analysis. table 11 sets forth the component parts of this business tax specialty by breaking that information down into the relative percentages of all articles in the sampling which were about corporate tax and then about partnership tax, again on an annual basis, after 1969. table 11. business tax articles in sample-corporate tax and partnership tax articles, by year92 year corporate partnership 1970 21% 0% 1971 17% 6% 1972 14% 7% 1973 14% 6% 1974 24% 3% 1975 28% 6% 1976 21% 0% 1977 14% 6% 1978 15% 5% 1979 9% 0% 1980 13% 4% 1981 10% 0% 1982 8% 8% 91. the same information is set forth, by year, in the appendix, at table 5a. 92. before 1970, lesser percentages of articles were written about partnership tax. the percentage was 11% in 1957,5% in 1954 and 1958, less in six other years, and nonexistent in six other years. [vol. 4:7 interpreting the interpreters year corporate partnership 1983 20% 3% 1984 19% 8% 1985 18% 3% 1986 34% 12% 1987 13% 9% 1988 3% 13% 1989 9% 13% 1990 16% 13% 1991 7% 0% 1992 30% 5% 1993 10% 7% 1994 7% 7% 1995 26% 11% 1996 14% 17% 1997 7% 7% 1998 22% 13% avg. % 18% 5% the percentage of partnership tax articles in the sampling has increased, and the percentage of corporate tax articles has decreased. but these are not precipitous changes. the stability of topics addressed over the years suggests that, if authors are writing about their clients' needs, then these needs have not changed much. people still need advice about estate planning (richer people, to be sure, in 1993 than 1954) and they still need advice about business planning. only the contours of business planning have changed, as partnership tax has become more important than it once was.93 on a related topic, 95% of the articles sampled were written in a highly technical manner, one that presumably would not be readily comprehensible to someone who did not have a strong background in tax.' for example, while an article might have been written about the marital deduction for a general practitioner-the "five things you should know" type article-even this type of article inevitably was written on a more technical level, more for someone with a prior understanding of the area.9" given the devotion of these journals to tax practitioners, this result is not surprising. 93. see also raby & raby, supra note 89 (areas of importance to group of accountants). 94. 95% were highly technical, 4% were moderately technical (or moderately free of technical language, depending upon one's view) and 1% were not technical at all. 95. for example, compare bittker & eustice, supra note 75 (technical), with boris l bittker, dedication: charles stuart lyon, 37 tax l rev. 159 (1982) (less technical). 19991 florida tax review the articles also can be broken down by gender. among all sampled articles, percentages of the total number of articles by women and by men were devoted to the following, selected, topics, again combining certain topics (such as corporate and partnership tax to form business tax). table 12. identity of authors of sampled articles, by gender and more common topics by %, topic women men business tax 13% 23% compensation 15% 8% estate planning 11% 9% foreign 10% 9% litigation 7% 4% state tax 6% 3% thus, 13% of all articles sampled that were written by women were about business tax, as defined above, while 23% of the articles sampled were written by men were on the same topic. articles by male authors were more concentrated in business tax while articles by women authors were more concentrated in compensation. 96 c. conclusions.-the data also tends to suggest that authors whose articles were sampled have written fairly consistently about the same topics. business tax has always been important, to judge by the articles written about it, as have other areas such as foreign tax, compensation matters, estate planning, litigation and state tax. some of the literature indicates that areas such as foreign and state tax have become more important over time but, with the sole exception of partnership tax, this has not been reflected in the percentage of articles devoted to these areas. there does not seem to be much of a gender gap in areas about which men and women have written, although the greatest percentage of men's articles were about business tax and women, about compensation. the stability and the technicality of the sampled articles suggest one relatively simple truth to me, and also leaves me puzzled. taxpayers do business; taxpayers die. they have always needed to know the tax consequences of running a business and of dying, and the literature has followed clients' needs. as the underlying laws have changed and, for example, partnership tax blossomed, some of the subjects about which authors wrote have changed, but the underlying subject matter, the taxation of business, has not. i cannot explain, however, why areas such as foreign tax and state tax, presumably more important areas of 96. but cf. a.b.a., comm'n on women, women in the law, supra note 27 (citing areas in which women law professors are likely to teach). [vol. 4:7 interpreting the interpreters practice than they once were, have not reflected an increase in the percentage of articles written about them. possibly, they always have been important anchors in tax practice, and thus people have always written about them. 3. interplay in taxamong congress, the internal revenue service, and courts a. observations about the interplay ofthese institutions.-tax law is drawn from statutes enacted by congress. as tax students recognize all too painfully, the essential elements of tax law consist of sections of the internal revenue code and not what each of them thinks it is (either when examined socratically or at the end of the semester). of course, tax law is much more, and the meanings, for example, of a gift or of alimony under sections 102 or 71, are amplified by many other sources, including court decisions, government pronouncements, and legislative history.97 tax also is more complex than it used to be.98 a number of reasons have undoubtedly propelled this complexity, but it has, in part, occurred as statutes and regulations have proliferated." simple statutes have become more complex 97. the institutional inquiry is not exclusive to tax. one useful way in which to analyze the separation of powers is to engage in a comparative institutional analysis, in which one might ask which legal institution can best offer an answer to a particular problem. for example, trespass has traditionally been handled by courts, which is appropriate because of the highly factual nature of the inquiry of an individual incursion onto someone else's property. but another type of trespass, or trespass-type activity, such as air pollution, might be dealt with more effectively by another institution, such as a legislature. see neil k. komesar, imperfect alternatives: choosing institutions in law, economics, and public policy 14-28 (1994). see also neil k. komesar, back to the future-an institutional view of making and interpreting constitutions, 81 nw. u. l. rev. 191 (1987); neil k. komesar, taking institutions seriously:. introduction to a strategy for constitutional analysis, 51 u. chi. l. rev. 366 (1984); neil komesar, in search of a general approach to legal analysis: a comparative institutional alternative, 79 mich. l rev.1350 (1981). 98. one analysis of this complexity questions which branch of government is best suited for "making" tax law. compare john f. coverdale, text as limit: a plea for decent respect for the tax code, 71 tul. l. rev. 1501 (1997) (argues for respect for the statutes comprising the code and, thus, for the primacy of congress) with deborah a. geier, interpreting tax legislation: the role of purpose, 2 fla. tax rev. 492 (1995) (looks to structure of code and, thus, beyond mere textualism), michael livingston, practical reason, "purposivism."and the interpretation of tax statutes, 51 tax l rev. 677 (1996) (disagrees with geier, but still agrees with need to interpret statutes) and william d. popkin, the collaborative model of statutory interpretation, 61 s. cal. l rev. 541 (1988) (believes that courts must -collaborate" with legislatures in interpreting statutes). 99. for studies of increased complexities in specific areas, see james w. colliton, standards, rules and the decline of the courts in the law of taxation, 99 dick. l rev. 265 (1995) (grantor trusts); edward a. zelinsky, another look attax law simplicity, 47 tax notes 1225 (june 4, 1990) (erisa). for the need for detailed rules, such as the drive towards 19991 florida tax review and complex statutes have multiplied in number. congress has frequently delegated responsibility for devising rules to the treasury department, and regulations have become more complex as well.' 00 b. data about the interplay.-implicit in any article in which the author perceives a problem and then suggests how to solve it is his belief about the best institution to effect that solution. an author might suggest that a new law or regulation is all that is needed to correct the perceived ill, or that courts only need to decide cases in line with the author's proposals. each of these solutions would, in turn, chose a different institution to cope with the problem-congress, the internal revenue service, or the courts. for example, implicit in the unwillingness, or inability, of the treasury department in the 1980s to adopt regulations regarding discriminating between debt and equity in the corporate area is that it and, more specifically, the internal revenue service, were not the best institutions to deal with the difference between the two. instead, the highly factual nature of the difference made the courts a better institution for handling this problem.' on the other hand, congress' enactment of a statute certainty, see, e.g., colliton; john a. miller, indeterminancy, complexity, and fairness: justifying rule simplification in the law of taxation, 68 wash. l. rev. 1 (1993); deborah l. paul, the sources of tax complexity: how much simplicity can fundamental tax reform achieve?, 76 n. car. l. rev. 151 (1997). several authors have noted the accelerating rate of tax legislation. see, e.g., michael livingston, congress, the courts, and the code: legislative history and the interpretation of tax statutes, 69 tex. l. rev. 819, 827-28 (1991) (notes legislative action in 1980s); daniel shaviro, beyond public choice and public interest: a study of the legislative process as illustrated by tax legislation in the 1980s, 139 u. pa. l. rev. 1 (1990) (same); richard l. doernberg & fred s. mcchesney, on the accelerating rate and decreasing durability of tax reform, 71 minn. l. rev. 913 (1987) (same). 100. see generally asimow, supra note 76 (discussing regulations, especially temporary regulations). on the other hand, what is complicated is relative, and what may have once seemed to be difficult may have untangled, if only in comparison, as time passes. consider the board of tax appeals' view in gregory v. commissioner, 27 b.t.a. 223 (1932), rev'd, helvering v. gregory, 69 f.2d 809 (2d cir. 1934), affd, 293 u.s. 465 (1935) about the reorganization statute under examination almost 70 years ago. "a statute so meticulously drafted must be interpreted as a literal expression of the taxing policy, and leaves only the small interstices for judicial consideration." gregory, 27 b.t.a. at 225. or consider the § 305 regulations promulgated in 1969, and one commentator's weighty assessment of them. "one has the impression that the authors of the [new § 305] regulations regarded the new provisions as intended to have an in terrorem purpose." henry w. dekosmian, taxable stock dividends under new section 305, 28 tax. law. 57, 59 (1974). they certainly had that effect on me when i first learned about them in a corporate tax course, but they pale in comparison to other, even more intricate, subsequent regulatory schemes. 101. for a history ofthis inaction, see bittker & eustice, supra note 66, at 4.02. for a still-exhaustive summary of the cases distinguishing debt from equity, see william t. plumb, [vol 4:7 interpreting the interpreters creating a safe harbor for debt that is not treated as stock, thus easing an s corporation's burden of possessing only one class of stock, as well as regulations illuminating that safe harbor, tends to suggest that congress and the service were better institutions for solving a more discrete problem. " two aspects of the sampled data illustrate trends in institutional bias. first, some authors wrote about new developments-newly enacted statutes, newly issued regulations or rulings, or court decisions just rendered. presumably, a tendency towards the increasing complexity of statutes and regulations and concomitant frequency with which they would have been enacted or promulgated could have been reflected in tax literature. assuming that people wrote about what was currently happening and that complexity translates into proliferation of statutes and regulations, new developments should increasingly have been about the activities of congress and the internal revenue service and decreasingly about court decisions. second, authors wrote about problems they felt were open to a specific remedy (some more specifically and in greater detail than others). an author's solution, for example, to a complicated question about accounting just described in her article could lie only in the hands of congress, the service, or the courts. 3 although somewhat weaker in my view than the presumed relationship between complexity and the growth of new developments by congress and the service, i still think that the tendency towards complexity might translate into a greater percentage of articles about what congress or the service should do and less about what courts should do. faced with a simple statute largely interpreted by court decisions, an author seems likely to remedy whatever problem he perceives by more decisions, in a certain vein. but faced with an area governed by regulations or by statutes, he is more likely to encourage the service to change its regulations to reach the result he desires, or congress, its laws. graphs 5 and 6 and tables 12 and 13 respectively set forth these aspects of the sampling. in each graph and then, in greater detail, in each table, the percentage for each institution is contrasted against all of the institutions, not just against the other two institutions set forth in the tables. because authors sometimes proposed remedies from some other institutions, e.g., state legislatures, the totals sometimes do not add up to 100%. jr., the federal income tax significance of corporate debt: a critical analysis and a proposal. 26 tax l rev. 369 (1971). 102. see irc § 1361(b)(l)(d), (c)(5); regs. § 1.1361-1(1)(5). 103. see, e.g., marvin a. chireistein, some aspects of basis and the proposed regulations, 35 taxes 151 (1957) (congress should act, to correct proposed regulations); marvin j. garbis, improving the procedural system under which tax controversies are resolved, 33 j. tax'n 278 (1970) (service should act); elwood l thomas, brother-sister multiple corporations-thetax reform act of 1969 reformed by regulation, 28 tax l rev. 65 (1972) (courts should act). 19991 florida tax review graph 5. institutions examined in articles about new developments, by decade buy'/ 50%-440%cd 30%20%i1u/o i t i t t 1954-1959 1960-1969 1970-1979 1980-1989 1990-1998 decade -m courts congress irs table 13. institutions examined in articles about new developments, by decade'04 decade 1954-1959 1960-1969 1970-1979 1980-1989 1990-1998 courts 44% 38% 28% 22% 25% congress 34% 21% 37% 45% 19% irs 17% 39% 33% 32% 55% 104. only the articles in these three areas are included in this table. articles triggered by some new development, other than by one of these three institutions, totaled 1% of all 690 articles triggered by a new development. the other institutions included a government agency other than the service, such as a state agency, or a legislature other than congress, such as a state legislature. -'--' -~u u [vol. 4:7 interpreting tie interpreters graph 6. institutions authors would use to remedy problems, by decade 70 0 0 0 20%* 10%1954-1959 1960-1969 1970-1979 1980-1989 1990-19m3 decade -a courts u congress irs table 14. institutions authors would use to remedy problems, by decade'05 decade 1954-1959 1960-1969 1970-1979 1980-1989 1990-1998 courts 26% 25% 33% 31% 10% conaress 67% 61% 45% 56% 61% irs 8% 9% 22% 13% 29% the two sets of data do not readily correspond with one another. a smaller percentage of new development articles were triggered by court decisions in the 1990s than earlier, but seems to have risen modestly in the 1990s. a lesser percentage of authors proposed judicial remedies for perceived problems in the 1990s than in prior decades. while authors have not turned to courts recently as much as they did earlier, court decisions are still noted more in the 1990s as new 105. only the articles in these three areas are included in this table. articles in which another institution was prescribed as the remedy for the problem, totaled 1% of all 221 articles for which some remedy was prescribed. the other institution would be a legislature other than congress, such as a state legislature. n u u u u u-.--u 1999] 6w16o florida tax review developments (25%) than they are as authors' choices to remedy problems (10%). when viewed individually, the internal revenue service and congress do not bear much relationship in the two tables. a decreasing percentage of new development articles noted new laws in the 1990s, but congress remained a popular institution among authors who proposed remedies for problems they perceived. and the dramatic rise in the percentage of new developments written about internal revenue service activities resonated, faintly, in the institutional remedies authors proposed. the increasing complexity of the code should have suggested increased activity by congress or the internal revenue service. both measures, especially the new developments criterion, somewhat display such activity. beyond that, however, new developments articles appear to have been written more about activity by the service than by congress, while authors chose to remedy perceived problems more by congressional action than by the service. while authors can, of course, chose to write about new developments they favor and ignore the rest, that does not seem likely. thus, new developments articles tend to reflect increased activity, by congress and especially by the service, at the cost of judicial decisions, and thus may reflect an increased complexity in the tax laws. to judge by the articles in which authors prescribed a specific course of action, they do not seem to reject this complexity, only to give greater weight to congressional than service action. c. conclusions.-theoretical observations suggest that our tax statutes have become increasingly complex, and that more detailed statutes and regulations are the source of that complexity. it follows that courts would initially have been the remedial institution of choice, when there was less complexity, but not subsequently. the percentage of articles about courts, whether new decisions or the preferred institution to remedy a perceived problem, have somewhat diminished. while authors favored congress and the internal revenue service both as the source of new developments about which to write and to remedy perceived problems, new developments articles reveal greater activity by the service and the remedial articles, by congress. in either case, the articles seem to reflect an increased complexity in the tax law. iv. conclusions forty-five years of articles from four standard tax journals-journal of taxation, taxes, tax law review, and tax lawyer-were sampled and catalogued for a variety of variables. what does the sampling tell us about who has written articles, what they wrote, and what they held to be important? [vol 4:7 interpreting the interpreters recent studies indicate that women academicians publish more than they once did, but still lag behind their male colleagues. in tax, women in the sampled articles tended to publish at lesser percentages than their male colleagues, if they were practicing lawyers and even if they were law professors, although the trend for law professors has changed in the last several years. while literature suggests that accounting is taking over more of the practice of tax from lawyers, even in the two journals less directed towards lawyers-journal of taxation and taxes-the percentage of sampled articles written by lawyers still substantially exceeds the percentage written by accountants. the percentage of articles written by law school teachers in these two journals has declined, especially when compared to those written by business school professors, suggesting that these journals are less enticing to law school teachers than they once were. doctrinal scholarship is less ubiquitous than it once was, but still has a strong hold in tax, especially in journal of taxation and taxes. normative scholarship is more prevalent than it once was-certainly in tax law review and even, somewhat, in tax lawyer. within the sampling, there is scant evidence of empirical research. there also appears to be a remarkable stability in what people have written about over the years, topics such as business and estate planning, foreign tax, and compensation. among the sampled articles, partnership tax seems to have become a more compelling topic over time, but that cannot be said of other topics which would appear to have become a larger part of tax practice, such as foreign tax or state tax. the perceived tendency towards complexity, driven by more detailed statutory and regulatory schemes, has somewhat been reflected in the sampled articles. 19991 florida tax review appendix table 1a. issues printed per year, from 1978-97 journals are required to post the number of copies printed during the prior year. all fourjournals posted the "average number" of issues printed during the prior fiscal year. those numbers are set forth below. no information was available for the three years left blank for tax law review. year j. tax'n taxes tax l. rev. tax law. 1997-98 12,000 4,700 22,950 1996-97 12,633 5,200 2,100 25,100 1995-96 12,996 7,200 2,660 25,000 1994-95 14,667 7,517 26,500 1993-94 16,067 7,450 2,666 31,500 1992-93 16,621 8,491 2,704 31,500 1991-92 18,095 9,460 2,700 31,000 1990-91 19,745 11,010 3,548 33,000 1989-90 21,591 13,670 3,776 33,000 1988-89 22,583 14,255 4,520 33,000 1987-88 25,020 13,710 4,967 33,000 1986-87 27,879 13,490 5,238 31,810 1985-86 31,058 15,210 5,675 33,333 1984-85 31,517 15,560 5,975 31,814 1983-84 27,885 12,710 6,125 32,024 1982-83 25,333 11,920 28,625 1981-82 26,266 15,640 6,825 28,625 1980-81 24,167 13,830 6,775 27,000 1979-80 23,614 12,350 5,925 26,824 1978-79 20,500 9,600 5,250 26,619 table 2a. identity of authors by journal journal female male group unknown j. tax'n 3% 96% 1% 0% taxes 7% 92% 0% 1% tax l. rev. 5% 90% 3% 2% tax law. 4% 89% 5% 2% avg. % 5% 94% 1% 1% [vol. 4:7 interpreting the interpreters broken down more specifically by decade, the results for the last two decades are: 1980-1989 journal j. tax'n taxes tax l. rev. tax law. 1990-1998 journal j. tax'n taxes tax l. rev. tax law. female 4% 11% 13% 5% female 10% 16% 7% 6% male 95% 88% 84% 87% male 89% 82% 89% 94% group 1% 0% 0% 6% group 1% 0% 4% 0% unknown 0% i% 3% 3% unknown 0% 2% 0% 0% table 3a. women authors in sample and women accountant/auditors in population at large, by year't 6 % women accountant authors 0% 0% 0% 0% 0% 11% 0% 0% 0% 0% 0% 0% 0% % women accountant/auditors per bls 19% 18% 18% 19% 20% 106. for 1972-1982, information from the bureau of labor statistics was available only for accountants. for all other years, it includes both accountants and auditors. as in table 3, the percentage in the middle column reveals the percentage of accountants in the sampling who were women. for example, in 1993, 22% of all accountants were women (and 78% were men), while 49% of all accountants and auditors counted by the bureau of labor statistics were women. year 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1999] florida tax review year 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 % women accountant authors 0% 0% 0% 0% 0% 0% 8% 17% 0% 0% 25% 0% 0% 0% 0% 0% 13% 20% 17% 11% 20% 44% 11% 13% 13% 20% 22% 33% 9% 0% 11% 17% %women accountant/auditors per bls 19% 22% 22% 23% 20% 22% 22% 24% 25% 27% 28% 30% 33% 36% 39% 39% 39% 41% 44% 45% 46% 50% 49% 51% 52% 51% 49% 52% 52% 56% 57% 58% [vol 4:7 interpreting the interpreters graph ia. authors in journal of taxation and taxes who were law or or business school teachers, by year 100% 90% " ',i i i i i ii 80% $1 , ,-, ,, , 70% ,% . . ..%" 60% ' ..,,0% ::40% *s-" 30% 20% 10% 0% . ut) c0 0 r fo 0) 0) -% law school teachers ...... % business school teachers year the percentages are measured against all of the articles written by law and business school professors in either of these journals. the percentages will not total 100% in years in which other academics, e.g., arts and science professors or students, published articles. in these two journals, 238 articles were written by academicians. table 4a. authors in journal of taxation and taxes who were law or or business school teachers, by year % law school teachers 0% 0% 67% 100% 50% 67% 0% 80% 80% 33% 0% % business school teachers 0% 0% 0% 0% 25% 33% 0% 0% 0% 0% 100% year 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 19991 florida tax review year 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 avg. % % law school teachers 67% 40% 67% 0% 50% 38% 33% 50% 0% 33% 0% 0% 50% 50% 27% 29% 25% 33% 25% 0% 27% 14% 9% 11% 17% 13% 0% 50% 0% 0% 0% 0% 25% 50% 27% the percentages are measured against all of the articles written by law and business school professors in either of these journals. the percentages will not total 100% in years in which other academics, e.g., arts and science professors or students, published articles. % business school teachers 0% 0% 33% 100% 50% 50% 67% 50% 75% 67% 80% 82% 25% 40% 73% 71% 75% 67% 63% 100% 73% 71% 91% 89% 83% 88% 100% 50% 100% 80% 100% 100% 75% 40% 63% [vol 4:7 interpreting the interpreters in table 5a, some of the topics were combined, as described in the text accompanying note90 (e.g., corporate and partnership tax, to form business tax). table 5a. more common topics of articles, by year estate year business compensation planning foreia-n liti2ation state tax 1954 20% 10% 5% 0% 20% 5% 1955 32% 7% 4% 11% 11% 11% 1956 18% 7% 14% 7% 4% 11% 1957 28% 6% 6% 8% 8% 17% 1958 38% 5% 16% 5% 3% 5% 1959 28% 6% 8% 8% 11% 6% 1960 17% 7% 0% 10% 14% 0% 1961 21% 11% 5% 16% 8% 5% 1962 25% 5% 8% 5% 8% 0% 1963 11% 5% 8% 8% 5% 0% 1964 10% 10% 10% 14% 10% 14% 1965 25% 6% 14% 8% 0% 3% 1966 28% 6% 14% 17% 6% 6% 1967 24% 10% 10% 7% 0% 0% 1968 23% 8% 13% 13% 3% 0% 1969 19% 6% 19% 9% 6% 6% 1970 21% 6% 9% 21% 3% 9% 1971 22% 11% 8% 8% 11% 3% 1972 21% 3% 7% 10% 14% 0% 1973 20% 8% 3% 11% 3% 0% 1974 27% 14% 3% 14% 5% 0% 1975 34% 3% 13% 0% 6% 0% 1976 21% 12% 15% 6% 9% 0% 1977 20% 8% 6% 17% 8% 0% 1978 20% 15% 10% 10% 5% 3% 1979 9% 13% 13% 9% 4% 4% 1980 17% 11% 6% 11% 9% 0% 1981 10% 12% 5% 12% 5% 0% 1982 17% 17% 6% 0% 0% 3% 1983 23% 9% 14% 14% 0% 0% 1984 27% 11% 8% 3% 8% 3% 1985 21% 13% 10% 8% 8% 5% 1986 46% 5% 5% 2% 7% 2% 1987 22% 16% 9% 0% 6% 0% 1988 16% 10% 3% 10% 10% 0% 19991 536 florida tax review [vol. 4:7 estate year business compensation planning foreign litigation state tax 1989 22% 13% 3% 3% 6% 0% 1990 28% 6% 6% 6% 9% 3% 1991 7% 7% 11% 4% 7% 4% 1992 35% 5% 3% 20% 3% 0% 1993 16% 10% 0% 3% 7% 0% 1994 15% 15% 7% 15% 15% 4% 1995 37% 7% 11% 7% 4% 4% 1996 31% 7% 10% 10% 0% 0% 1997 13% 6% 19% 7% 3% 13% 1998 35% 9% 17% 9% 9% 0% avg. % 23% 9% 9% 9% 6% 3% login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar 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register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 4 1999 number 3 the future taxation of private business firms george k yin' i. introduction ................................ 144 ii. the need to reexamine current law ............ 144 u. taxation of private firms as conduits ............ 150 a. the basic case for conduit taxation ........... 151 b. the fundamental difficulty of conduit taxation and the case for entity taxation ............... 153 1. economic effect ..................... 156 2. substantiality ....................... 160 3. subjective purpose ................... 162 4. would some other test be effective? ..... 163 5. summary .......................... 164 c. which approach would be more administrable? ... 165 d. summary and conclusion .................... 171 iv. a smiplified version of conduit taxation ........ 172 a. introduction ............................. 172 b. eligibility for the simplified version: theory and definition ...................... 174 1. ownership limitations ................ 176 a. individuals as owners ........... 176 b. public subchapter c firms as owners ................... 182 c. other possible owners .......... 185 * harrison foundation research professor of law, university of virginia. copyright © 1998 by george k. yin. this article represents a continuation of work i have done as reporter to the american law institute's federal income tax project on the taxation of private business enterprises. portions of this article have been drawn from drafts and discussions undertaken in connection with that project as well as from a prior article, george k. yim, the taxation of private business enterprises: some policy questions stimulated by the "check-the-box" regulations, 51 smu law rev. 125 (1997). none of the views expressed here should be attributed to the all to my co-reporter, professor david shakow, or to any of the consultants to the project. i am greatly indebted to professor shakow for his close and continuing collaboration on the project and his assistance in preparing this article. all errors are mine alone. this article was prepared for presentation at a february 1998 symposium and research for it was completed in may 1998. a final ali reporters' study is scheduled to be published in june 1999. florida tax review d. summary .................... 190 2. only one class of residual ownership interests .......................... 190 3. other eligibility conditions not proposed .. 194 a. number of owners ............. 195 b. ownership of other entities ....... 196 c. nature of income .............. 196 d. size of enterprise (measured by assets, sales, income or some other measure) ........... 199 c. operating rule provisions of the simplified system ................................. 202 1. explicitly elective system .............. 202 2. passthrough scheme; allocations of tax items and debt of the firm ............. 203 a. in general ................... 203 b. preferred interests ............. 205 c. losses ...................... 206 d. spbf liabilities ............... 207 3. contributions and distributions .......... 211 a. contributions-present law ....... 211 b. distributions-present law ....... 213 c. additional partnership rules to prevent income shifting, income character changes, and timing distortions ................... 214 i. section 704(c)(1)(a) ....... 214 ii. reverse section 704(c) allocations ............. 216 iii. section 704(c)(1)(b) ....... 216 iv. section 737 ............. 216 v. section 707(a)(2)(b) ...... 217 vi. section 731(c) ........... 217 vii. sections 724, 735, and 751(b) ............. 217 viii. subjective purpose ........ 218 d. analysis of current law ......... 218 i. entity versus aggregate theory of the firm ....... 221 ii. tax policy considerations .. 223 e. summary and proposals ......... 226 i. contributions ........... 227 [vol 4:3 the future taxation of private business firms ii. no section 704(c)(1)(a) rule .................. 228 iii. distributions ............ 229 iv. other rules not included ... 233 v. relation to default conduit system .......... 234 4. treatment of ordinary income assets of an spbf .............................. 234 a. sections 751 and 341 not included in the spbf rules ..................... 234 b. character continuation rules ........... 238 5. inside basis adjustments .................... 238 a. in general ........................ 238 b. adjustments made on distributions of property .......................... 239 c. adjustments made on the sale of ownership interests .................. 240 6. conversions/reorganizations of firms from one system to another ..................... 242 a. private firm (either spbf or default system) to public firm (subchapter c) ..... 242 b. public firm (subchapter c) to private firm (either spbf or default system) ......... 244 c. changing tax systems of private firms (spbf to default system or vice-versa) .... 245 7. transitional considerations .................. 246 v. summary and conclusion ...................... 247 19991 florida tax review i. introduction recent federal and state law developments liberalizing the permissible forms of business organizations and the classification of such organizations for tax purposes have underscored the need to reexamine the current system of taxing the income of private businesses. this article, which undertakes that reexamination, makes two principal claims. first, current law ought to be replaced by a system whereby all private business firms, no matter what their form of organization and organizational characteristics, are taxed as conduits for income tax purposes. second, because conduit taxation is so complicated, the system should be implemented through a "two-track" approach in which a subset of private business firms would, at their election, be subject to a simplified set of tax rules. in general, the simplified version would be available to firms which have only individuals as owners and which have surrendered some flexibility in their economic dealings. part ii of this article briefly explains why current law merits reexamination and parts iii and iv correspond to the two main claims being made. a final part contains a brief summary and conclusion. ii. the need to reexamine current law thanks to a recent change adopted by the treasury department responding to important developments at the state level regarding the permissible forms of business organization, many private business firms, no matter what their organizational characteristics under state law, are provided with an explicit choice regarding how the income of the firm is taxed.' for firms engaged in general business activities, the choices under current law are generally the rules contained in subchapters c, k, and s of the internal revenue code. although incorporated firms are currently not provided with the same choice as unincorporated ones, an unincorporated business with precisely the same characteristics as an incorporated firm is given that choice. hence, it seems only a matter of time before all private firms, incorporated and unincorporated, will be afforded the same explicit choice of taxation schemes. 1. see regs. §§ 301.7701-1, -2, and -3. the new regulations, which were effective january 1, 1997, were stimulated by state law changes permitting partnerships and other unincorporated organizations to possess business characteristics traditionally associated with corporations. see notice 95-14, 1995-1 c.b. 297; rod garcia & nancy loube, llcs, or how the government got to check-the-box classification, 67 tax notes 1139 (1995). 2. public firms are not provided the same choice by reason of § 7704 of the code. see regs. § 301.7701-2(b)(7). the proper classification and taxation of public firms is beyond the scope of this article. [vol. 4:3 the future taxation of private business firms this state of affairs is a curious one, given the historical background and substantive rules of subchapters c, k, and s. the origin of subchapters c and k and, specifically, the separate entity taxation of corporations as opposed to the conduit taxation of partnerships, can be traced to some extent to a debate which raged during the last part of the 19th century and the early part of the 20th century concerning the nature of corporate and partnership personality.3 at that time, the "aggregate" versus "entity" controversy, familiar now in the partnership area, applied to both corporations and partnerships. gradually, the entity theory prevailed for corporations but not for partnerships: corporate characteristics of free transferability of interests, continuity of life, limited liability and centralized management... emphasized the distinction between the corporation and its shareholders. corporate liability was not shareholder liability. the life of the corporation was independent of that of its shareholders.... this was in contrast to a partner's relationship to a partnership. partners were generally actively involved in the partnership's business, as well as responsible for the partnership debts. additionally, the life of the partnership was contingent on the life of its members. these factors created a unity between the partner and the partnership. legal theory, following these basic differences between a corporation and a partnership, veered toward a natural entity theory in the corporate area, but resisted it, at least partially, in the partnership area. this theory of business organization personality influenced the income tax rules that developed for those organizations. the first income taxes in this country, imposed during the civil war period, were generally only taxes on individuals. although certain companies were required to pay tax on amounts paid out as dividends or interest, the same amounts were then deductible from the payee's tax base.' thus, the original structure could well be viewed as imposing a mere withholding tax on the companies and not a 3. see marjorie e. kornhauser, corporate regulation and the origins of the corporate income tax, 66 ind. u. 53, 57-62 (1990). much of the following discussion regarding the origins of the corporate income tax are based on professor kornhauser's article. 4. see id. at 61. 5. see act of july 1, 1862, cli 119, §§ 81-82, 90-91, 12 stat. 432,469-71,473-74 (1862). the taxes were also imposed based upon the specific industry or trade of the business and not its form of organization. 1999] florida tax review tax independent of the individual income tax.' for owners of other firms, both incorporated and unincorporated, a pure conduit approach was specified: in estimating the annual gains, profits, or income of any person,... the gains and profits of all companies, whether incorporated or partnership, other than the companies specified in this section, shall be included in estimating the annual gains, profits, or income of any person entitled to the same, whether divided or otherwise.7 thus, as of the time of the civil war period, there was no clear indication that corporations should be treated any different from partnerships for income tax purposes. this attitude changed in 1894 when the income tax was reintroduced.8 the 1894 law contained both a 2% tax on the income of individuals and a similar tax on the income of all "corporations, companies, or associations ... but not including partnerships."9 an individual, however, was entitled to exclude from his or her tax base any dividends received from a corporation which had already paid the 2% tax.'0 this feature, combined with the fact that both taxes were levied at the same rate, also suggested that the corporate tax might be viewed as a mere withholding tax. however, in at least one important respect, the corporate tax was more clearly a separate and independent tax: unlike individuals, who only had to pay tax on income in excess of $4,000, corporations were not provided with any exemption amount." thus, the corporate tax was not simply a convenient and administrable way to collect the individual income tax on corporate-source income. the significance of the separate, entity tax levied on corporations in 1894 was not lost on the legislators at the time. those who advocated a corporate exemption similar to the one available to individuals objected to the fact that corporate-source income would otherwise be taxed more harshly than the income of partnerships. they viewed the corporation as primarily an aggregate of individuals analogous to a partnership. in contrast, legislators 6. the supreme court was confused regarding the nature of the tax imposed on certain companies, first holding that it was a separate tax, barnes v. the railroads, 84 u.s. 294, 303 (1872), and then concluding that it was a mere withholding tax and therefore part of the individual income tax system, united states v. railroad co., 84 u.s. 322 (1872). 7. act of june 30, 1864, ch. 173, § 117, 13 stat. 223, 281-82 (1864). 8. see patrick e. hobbs, entity classification: the one hundred-year debate, 44 cath. u. l. rev. 437, 438 (1995) ("[the 1894 act ... marked the first time in this country's revenue history that the law distinguished corporations from other types of business organizations for tax purposes"). 9. act of aug. 27, 1894, ch. 349, §§ 27, 32, 28 stat. 509, 553, 556 (1894). 10. see id. § 28, at 554. 11. see id. §§ 27, 32, at 553, 556. [vol 4:3 the future taxation of private business firms who successfully opposed all attempts to adopt a corporate exemption, including some amendments limiting an exemption to small corporations, supported their position by articulating an entity theory for corporations.'2 consistent with the statute and legislative background, the regulations issued by the treasury under the 1894 act made clear that the corporate tax did not apply to partnerships. instead, partnership income would be taxed under a conduit system: partnerships, as such, are not liable to taxation of firm or partnership profits or income, but each individual member of the partnership shall include his share of the partnership profits, gains, or income, in his individual list, where he is required by law to make return of his income for taxation.'3 the 1894 income tax was later found to be unconstitutional in pollock v. farmers loan and trust co.'4 nevertheless, the divergent tax treatment of corporations and partnerships, based in part on the differing theories of their legal personality, was established. the corporate excise tax of 1909, the predecessor to the modem corporate income tax, imposed a 1% tax on net income in excess of $5,000." because of constitutional and other reasons, the tax was explicitly limited to corporations and associations; individuals and partnerships engaged in the same business were not subject to the tax. 6 once again, one of the justifications for this treatment was the "entity" nature of a corporation. 17 following passage of the sixteenth amendment, subsequent tax acts continued the pattern of taxing corporations but not partnerships as separate entities. the only difference was that with the reintroduction of an individual income tax in 1913, congress provided for various schemes to implement at least partial integration of the corporate and individual income taxes. integration efforts were eventually ended in 1936. 12. see kornhauser, supra note 3, at 87-90. there was also concern that corporations, but apparently not other forms of business organizations, were not paying their proper share of taxes. see hobbs, supra note 8, at 445-46. 13. regulations relative to the assessment, levy and collection of the tax on incomes under the provisions of the act of congress in effect august 28, 1894 (december 13, 1894), reproduced in roger foster & everett v. abbot, a treatise on the federal income tax under the act of 1894 484 (1895). 14. 157 u.s. 429 (1895), reh'g granted, 158 u.s. 601 (1895). 15. act of aug. 5, 1909, cl. 6, § 38, 36 stat. 11, 112 (1909). 16. see id. pollock had placed into question whether this pre-sixteenth amendment tax would be constitutional if applied to individuals. another reason for limiting the tax to corporations was a desire to regulate businesses organized in corporate form. see kornhauser. supra note 3, at 99. 17. see kornhauser, supra note 3, at 102-05. 19991 florida tax review in summary, the separate entity taxation scheme of subchapter c and the conduit taxation approach of subchapter k can be traced to some extent to theories relating to the legal personality of corporations and partnerships. corporations, as entities, were taxed independently from owners; partnerships, as aggregates, were not. and important in deciding whether a business organization constitutes an entity or an aggregate were the characteristics of the organization such as centralized management, continuous life, free transferability of ownership interest, and limited liability. other differences in the substantive rules of subchapters c and k bear out this entity/aggregate distinction. for example, contributions to and distributions from a corporation are more likely to be taxable than those to and from a partnership." these results naturally flow from a conception of a corporation, but not a partnership, as an entity separate and distinct from its owners. similarly, liabilities incurred by a partnership, but not a corporation, are passed through and taken into account in determining the tax consequences of the owners of the firm. 9 subchapter s, enacted in 1958 and substantially revised in 1982, constitutes a middle ground between subchapters c and k. it provides a conduit form of taxation for certain businesses organized in corporate form.2" nevertheless, perhaps because of its close relationship to subchapter c (a given business may move easily between the c world and the s world) and because it has been applicable only to corporations, subchapter s retains many "entity" tax characteristics. probably the most important is the refusal to permit corporate-level debt to pass through to the shareholders of an s corporation for income tax purposes.2' in addition, the contribution and distribution rules for s corporations follow the subchapter c provisions more closely than their subchapter k counterparts.22 furthermore, unlike the section 754 election in subchapter k, there is no mechanism in subchapter s for adjusting the inside basis of a firm's assets upon the death of an owner, a transfer of ownership interests, or a distribution from the firm. finally, s corporations, but not subchapter k firms, can participate in a tax-free reorganization with a c corporation.3 18. compare irc § 351 with § 721 and §§ 301, 302, 331, 311, and 336 with §§ 731, 704(c)(1)(b), and 737. 19. see irc § 752. 20. former subchapter r, enacted in 1954 and repealed in 1966, did the opposite of subchapter s. it allowed certain unincorporated businesses to elect to be taxed as entities under subchapter c. 21. see irc § 1366(d). 22. see irc §§ 351, 311, 336, 1368, 302, and 331. 23. see irc § 1371(a). [vol 4:3 the future taxation of private business firms thus, each set of rules-most clearly in the case of subchapters c and k and less obviously in the case of subchapter s-was designed to apply to a particular business organization form with specific characteristics. yet, adoption of the check-the-box regulations reflects a policy determination generally to disregard business organization form and characteristics for income tax purposes. given that, it is difficult to understand why firms are nevertheless allowed a choice regarding how they are taxed and why they are given the particular choices that they are. if the three sets of rules produced more or less the same tax consequences in most situations, the choice among them might not be especially significant. but that is not the case. in any given situation, subchapters c, k or s might provide an advantageous tax result for particular taxpayers. for example, subchapter c generally offers graduated tax rates for the business income of firms subject to those rules,24 and there are a host of special tax provisions limited to subchapter c firms.rn subchapter k offers the purest form of conduit taxation under which the firm is not taxed and business income and losses are passed through to the owners of the firm. finally, as just noted, subchapter s offers another form of conduit taxation which, nevertheless, incorporates certain significant entity tax characteristics. as a result, subchapter s is in many cases less advantageous than subchapter k but in certain cases, more advantageous.6 the elective tax treatment of private firms under current law undermines both equity and efficiency objectives for the income tax. although in theory, similarly situated businesses have the same opportunity to be treated in the same tax-advantageous manner under current law, the practical reality is probably to the contrary, due to disparities in the quality 24. see irc § 11(b). if the shareholder tax of a subchapter c firm is deferred or reduced sufficiently or eliminated altogether, the graduated rate structure can mean that business income is taxed more favorably under subchapter c than under either subchapters k or s. subchapter c may also be an attractive choice for those private firms which envision going public someday. cf. joseph bankman, the structure of silicon valley start-ups, 41 ucla l. rev. 1737, 1749-50 (1994). 25. see, e.g., irc §§ 465(a)(1)(b) and 469(a)(2)(b) (at risk and passive activity loss rules generally applicable only to certain closely held c corporations). on the other hand, these rules do apply to the individuals who are either partners or s corporation shareholders. see irc §§ 465(a)(1)(a) and 469(a)(2)(a). 26. in addition to the differences previously noted in the text, there are two other significant ways subchapters k and s depart from one another. subchapter k but not subchapter s firms may specially allocate their tax items among their owners. compare irc § 704(a) and (b) with irc § 1377(a). on the other hand, there exists in subchapter k a series of complicated rules designed to prevent tax advantages in selected situations. see, e.g., irc §§ 704(c), 707(a)(2) and (b), 724, 731(c), 735, 737, and 751. subchapter s corporations are not subject to those rules although they are subject to the collapsible corporation provisions of § 341. see irc § 1371(a). 19991 florida tax review of advice the businesses receive. by permitting such disparate choices without any apparent underlying conceptual foundation, current law has simply provided a tax benefit for the well-advised and a trap for the ill-advised. there is no particular policy reason why the taxation of private business fimis should result in the minimization of tax liabilities for only the welladvised.27 moreover, current law violates vertical equity norms. by giving business owners a range of tax liabilities to choose from, current law by definition cannot impose the "proper" level of tax on them based upon vertical equity principles. inefficiency arises because of the increased transactions costs necessitated by current law. to minimize tax burdens, businesses must be prepared to examine the consequences of three possible operating rule structures on their anticipated business activities and to comply with the rules selected. the irs must administer and give oversight to the three different structures. further, the planning, compliance, and administration costs are ongoing in that businesses may have the opportunity to change their choice of rule structure as their business activities evolve. moreover, aside from increasing transactions costs, current law's favorable tax treatment of private business firms distorts economic decisions for those businesses on the individual/firm and public firm/private firm boundaries, thereby potentially causing deadweight losses. finally, to the extent simplification is a tax policy goal independent of equity and efficiency concerns, it is certainly not enhanced by current law. in conclusion, the current system of taxing the income of private business firms has evolved into one which is inconsistent with its historical roots and violates important tax policy objectives. the balance of this article describes an alternative system for such taxation. iii. taxation of private firms as conduits a threshold question is whether a private firm should be treated as a "conduit" or an "entity" for tax purposes. under conduit taxation, the firm is not treated as a taxpayer separate and apart from its owners. rather, the firm is transparent for tax purposes; its various tax items pass through to the owners of the firm, the real (and only) taxpayers in interest. under current law, the purest form of conduit taxation is found in the partnership tax rules of subchapter k. 27. see william a. klein & eric m. zolt, business form, limited liability, and tax regimes: lurching toward a coherent outcome?, 66 u. colo. l. rev. 1001, 1012-13 (1995). [vol 4:3 the future taxation of private business finns in contrast, under entity taxation, the firm is treated as a taxable entity in its own right. although entity taxation is often associated with the "double tax" system of subchapter c, it need not have that consequence. for example, in 1992, the treasury department recommended exploration of an approach, termed the comprehensive business income tax (cbit), which would subject the income of all business entities (except for extremely small ones in terms of gross receipts), including sole proprietorships, partnerships, corporations, and firms organized in other business forms, to a single, comprehensive entity-level tax, with generally no further income tax consequences at the owner level.2 other, similar proposals have been advanced over the years.29 the treasury estimated that cbit would produce greater welfare gains than any other form of corporate integration, including treasury's version of partnership-style integration. 3 the following sections explore some of the pros and cons of conduit and entity taxation.' although the choice is a close one, the conclusion is that all private firms should be taxed in accordance with a conduit approach. a. the basic case for conduit taxation the most basic form of business is the sole proprietorship. sole proprietors have historically been taxed directly on their proprietorship income as it arises and been entitled to deduct currently any losses of the enterprise as they arise. the business itself has not been subject to a separate federal income tax. it would theoretically be possible to treat a proprietorship as a taxpayer separate from its proprietor, but such a system would be very problematic, depending upon the applicable tax rate structure. for example, if all proprietorships were treated as taxpayers subject to a flat 30% income tax rate, then individuals in marginal tax brackets higher than 30% might be encouraged to redesign their economic arrangements to generate proprietorship income for themselves rather than wages or other income. 2 meanwhile, 28. u.s. dep't of treasury, integration of the individual and corporate tax systems: taxing business income once (1992) [hereinafter treasury integration report]. 29. see mortimer m. caplin, income tax pressures on the form of business organization: is it time for a "doing business" tax?, 47 va. l. rev. 249, 261 (1961) (suggesting adoption of an entity-level tax on the profits of virtually all business enterprises, whether incorporated or not, combined with a lowering of dividend taxes to alleviate concerns of double taxation). 30. see treasury integration report, supra note 28, at 134 (table 13.8). 139-141. 31. a third option is a hybrid approach in which low-rate taxes at both the firm and owner levels equate to a single tax on business income. see george k. yin, corporate tax integration and the search for the pragmatic ideal, 47 tax l rev. 431, 480-501 (1992). 32. this discussion ignores the potentially significant effect of employment and state and local taxes on the choice of compensation arrangement. 19991 florida tax review proprietors in marginal tax brackets less than 30% might be encouraged to employ the opposite strategy. for instance, they might increase the level of deductible salary payments paid by their proprietorship to themselves. given the absence of arm's length dealing in a proprietorship, it would presumably be extremely difficult for the irs to monitor and prevent purely taxmotivated arrangements of this sort. taxing the proprietorship's income in a progressive manner would not improve matters because there still would not be any necessary correlation between the proprietorship's tax rate and the proprietor's ability to pay. the proprietor may well have income or losses from other sources. it is for this same reason that the graduated tax rate structure under which many corporations are taxed today does not carry out any vertical equity objective.33 assuming proprietors are to continue to be taxed directly on their business income and losses, then it follows that businesses with more than one owner should likewise be taxed as conduits. if the proprietorship is not treated as a separate taxpayer, it is difficult to see why, say, a two-person general partnership should be so treated. further analogies then might suggest that no business firm should be separately taxed. as an economic matter, if proprietors are taxed directly on their proprietorship income but partnerships (and not the partners) are taxed on the partnership income, then the tax system will have created an undesirable barrier against or inducement in favor of the pooling of resources via a partnership. true, the state law characteristics of a proprietorship may be different from those of many other business forms. unlike a proprietorship, other forms of business organization are treated for an increasing number of state law purposes as legal entities separate from their owners. for example, the recently revised uniform partnership act (rupa) generally endorses an entity theory of a partnership, and it therefore provides that the withdrawal of a partner from a partnership causes the dissolution of the partnership only in limited circumstances? 4 rupa also makes clearer that a partner is not 33. see irc § l(b). 34. see revised unif. partnership act § 801 (amended 1996), 6 u.l.a. 87 (supp. 1997) [hereinafter rupa]. see, generally, rupa, § 201 ("[a] partnership is an entity distinct from its partners"), comment to § 201 ("rupa embraces the entity theory of the partnership"). as of the end of 1995, seven states had adopted the rupa. although the uniform partnership act (upa) included certain entity-type characteristics for partnerships, particularly relating to the rights of the entity to own and convey property (see u.p.a., §§ 8, 10, 25, and 26), the act generally favored an aggregate interpretation of the partnership. examples of the upa's aggregate approach included its provisions relating to the joint and several liability of partners for partnership debts, the rights of all partners to manage and conduct the business of the partnership, and the dissolution of a partnership upon any partner's ceasing to be associated with the business, see u.p.a., §§ 15, 18(e), and 29. [vol 4:3 the future taxation of private business firms co-owner of the underlying property of the partnership; rather, the only transferable interest of a partner in the partnership is the right to share in profits and losses and to receive distributions.' other forms of doing business, such as limited partnerships, llcs, limited liability partnerships (llps), limited liability limited partnerships (lllps), and of course, corporations, justify an entity interpretation of the business because, among other things, they generally insulate the owners from the entity's liabilities. further, the check-the-box regulations may accelerate these state law trends, with future approval by the states of noncorporate business forms having more and more entity characteristics. but the clear message of the check-the-box regulations is that state law differences among private business entities should be ignored in deciding how they are taxed.36 thus, the decision of whether a private firm should be taxed like a conduit or an entity should seemingly be based on tax policy considerations such as equity, efficiency, and simplicity. as just discussed, the strongest tax policy argument in favor of the conduit approach is that people pay taxes, not entities, and that people should pay income taxes in accordance with their abilities to pay. the use of an entity to generate income should not interfere with that basic objective. hence, the entity should be disregarded for tax purposes and the income of the entity should be taxed directly to its owners. entity losses and other tax items should similarly be passed through directly to the owners, to be netted with the owners' items from other sources. another tax policy argument favoring the conduit approach is that it avoids distorting the choice of business form, given how proprietorships are taxed. but these arguments may only be valid for a theoretically ideal form of conduit taxation. for reasons detailed in the next section, if a conduit approach is considered in actual practice, it may be that the approach does not accomplish either tax policy objective very well while, at the same time, spawning significant transactions costs. b. the fundamental difficulty of conduit taxation and the case for entity taxation the same theoretical reasons in support of conduit taxation would lead one to conclude that entity taxation is unacceptable. for example, if we take as a given that people and not entities pay taxes, and that people should pay income taxes in accordance with their ability to pay, then it would seem 35. see rupa, supra note 34, §§ 501, 502. 36. cf. william a. klein, income taxation and legal entities, 20 ucla l rev. 13, 15 (1972) (argued that correlation between taxation method and relationship under state law of an entity to its owner has "relatively limited explanatory value"). 1999] florida tax review odd and inconsistent with those premises to impose a separate income tax on the business entity itself. if the owners of the firm indirectly bear the burden of the entity-level income tax, then the proper rate for the tax should presumably be tied to their ability to pay. but how should the entity tax rate be determined where the ability to pay of the owners is different from one another? the case for entity taxation, however, is essentially a negative one. specifically, if it is not possible to design a workable conduit tax system which is broadly applicable to most private business firms and is consistent with general income tax principles, then an entity tax approach may be worth a second look. to illustrate some of the difficulties in implementing conduit taxation, the balance of the discussion in this part ii of the article will focus mainly on the partnership tax rules-subchapter k-because they represent the most refined example of conduit taxation in existence. under conduit taxation, if a business firm earns $300 in taxable profits in a given year, a total of $300 of taxable income must be currently included in the tax base of the owners of the firm. but how much should be included in whose base? the difficulty in answering that question is the fundamental problem of any conduit system. the source of the difficulty is the fact that income and other items realized by many business entities are treated under state law as belonging to the entity and not to the owners. the receipt by the owners of the entity's income, for example, may arise only upon a distribution from the entity. yet consistent with basic income tax principles, tax reporting of the income cannot await a distribution. someone must include it in that person's tax base when the income arises. thus, if there is no distribution of the income by the entity, there must nevertheless be a current allocation of the income among the owners to permit them to report currently their share of it. how is the allocation of income and other items determined for tax purposes under current law? in general, current law permits the allocation of tax items to be made with great flexibility. indeed, the general rule for a partnership allows the determination to be made by the partners in their partnership agreement.37 hence, by private agreement, the partners might decide to allocate the income of the partnership equally among themselves, or to allocate all of the income to only one partner, or to provide for any other sharing arrangement. assuming the allocation has "substantial economic effect," a concept discussed below, the only limitation is that all of the partnership taxable income must be reported by some partner or partners for the year. the partners also may allocate to themselves different shares of each partnership tax item in any given year and may vary the allocation of each 37. see irc § 704(a). [vol 4:3 the future taxation of private business finns such item from year to year. the tax sharing rules are flexible to permit consistency with flexible economic sharing arrangements. indeed, the tax shares can even be determined with hindsight, that is, after the end of the year in question, to accommodate the often hindsight determinations of economic shares. but flexible tax sharing rules also may be used simply to minimize the collective tax liabilities of the partners, to the detriment of the treasury and all other taxpayers. by allocating items to the partner who is in a position to utilize them most favorably for tax purposes, the partners can put their respective tax advantages to best use and share in the resulting tax savings. as professor surrey and others stated with some concern when special allocations were first permitted in 1954: ... parties, perhaps for the first time in the history of the tax laws, will be permitted to agree on the incidence of tax; to agree as to which of several co-earners of income shall be entitled to specific items of income and of income tax deduction and credits. capital gains could be allocated on one basis, dividends on another, tax-free interest in accordance with still another ratio. by agreement, operating expenses, depletion or depreciation could all be allocated in differing proportions. the ability to contract with respect to specific items of income, and particularly with respect to specific items of deduction and credit, would give the ingenious businessman and his lawyers the utmost flexibility in devising a variety of novel and unique business arrangements.38 is there anything wrong with the partners minimizing their collective tax liabilities in that manner? the objection, often unstated, is the concern that the partnership vehicle permits the taxpayer to obtain a tax result more favorable than the one that would have arisen had the taxpayer simply owned a share of the business's assets directly.39 thus, assume a taxpayer would have had $100 of taxable income from a share of certain real estate assets had the taxpayer owned that share directly. assume that with $100 of income for the year from the asset, a portion of the taxpayer's net operating loss 38. see j. paul jackson, mark h. johnson, stanley s. surrey, carolyn k. tenen & william c. warren, the internal revenue code of 1954: partnerships, 54 colun. l rev. 1183, 1187-88 (1954). 39. cf. regs. § 1.701-2(c)(1) (potential applicability of partnership anti-abuse regulation if "[t]he present value of the partners' aggregate federal tax liability is substantially less than had the partners owned the partnership's assets and conducted the partnership's activities directly"). 19991 florida tax review carryover would have expired unused. to preserve the integrity of the taxable unit, the tax laws presumably should not permit the taxpayer to join up with two others, obtain a special $300 allocation of taxable income for the year (representing the taxpayer's share of income from the asset and the shares of the taxpayer's partners), offset it with a disproportionately small allocation of income in future years, and thereby make greater use of the carryover than would otherwise have been possible. a tax system allowing that result neither protects vertical equity objectives nor is neutral in the choice of business form, the two tax policy advantages initially identified for the conduit approach. can such tax advantages be prevented? the statutory standard is to require that an allocation have "substantial economic effect" in order to be respected. if substantial economic effect is absent, the statute authorizes a reallocation of all items in accordance with the partner's normative or economic share of the item in question.40 the regulations interpret "substantial economic effect" as encompassing two requirements: the allocation must have "economic effect" and must pass a "substantiality" test.4 as we will see, however, neither test is particularly effective at preventing purely taxmotivated allocation arrangements under a conduit method of taxation. 1. economic effect.-the basic principle of the "economic effect" test is that tax items may be allocated to partners only in the same manner in which they share the economic burdens and benefits relating to those items.42 in other words, a partner may be allocated a $100 share of the partnership's taxable income only if the partner is also allocated $100 of the partnership's economic benefit relating to the taxable income. the partner may be allocated a $100 tax loss by the partnership only if the partner must suffer the $100 economic detriment relating to that loss. as a technical matter, the regulations implement this principle by focusing on the book capital accounts of the individual partners, the accounts which describe the economic relationship of the partners between and among themselves and specify what their respective rights are upon a liquidation of 40. see irc § 704(b). 41. see regs. § 1.704-1(b)(2)(i). 42. see regs. § 1.704-1(b)(2)(ii)(a) (to be valid, a tax allocation "must be consistent with the underlying economic arrangement of the partners. this means that in the event there is an economic benefit or economic burden that corresponds to an allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden"); cf. regs. § 1.701-2(a)(3) ("... the tax consequences under subchapter k to each partner of partnership operations and of transactions between the partner and the partnership must accurately reflect the partners' economic agreement and clearly reflect the partner's income..."). [vol 4:3 the future taxation of private business firms the firm. to have economic effect, the capital accounts must be maintained in a certain way, be adjusted in the same manner as the tax allocation, and be respected by the partners in determining their economic interests in the partnership upon liquidation.43 the rules are lengthy and complex, and the burden on those taxpayers who attempt to comply with them is considerable,4 but the basic idea is simple: if tax allocations follow comparable adjustments to the partners' capital accounts, which are economic accounts, and if those adjustments affect account balances which ultimately have real economic significance to the partners, then the tax allocation will be consistent with the economic share. pairing tax consequences with their economic counterparts is a common method of trying to prevent tax avoidance because ordinarily, assuming a tax rate of less than 100%, the underlying economic consequence of an action outweighs the tax effect of that action. for example, one would not expect a taxpayer to make a cash outlay of $100 merely to obtain a tax deduction equal to that amount because the tax savings from the deduction will be less than the amount of the cash outlay. thus, if the availability of the tax deduction were conditioned on the taxpayer's actual incurrence of the $100 expense, one might have confidence that the deductions were all legitimate. in short, the concept of "economic effect" might be a promising method of monitoring and preventing purely tax-motivated allocations. unfortunately, the economic effect requirement fails to achieve its intended purpose and does not preclude purely tax-motivated allocations. one reason for this failure is that capital account balances only supply some indication of the economic rights and obligations of the partners upon a hypothetical liquidation in the current year of either the partner's interest in the partnership or the partnership itself. yet in the vast majority of cases, neither of those two events is specifically contemplated by the partners, so that a capital account adjustment resulting in a currently negative or positive account balance may not be particularly meaningful. rather, in most cases, the economic outlook of the partners goes far beyond such a hypothetical current liquidation to encompass events that may occur well in the future. in 43. see regs. §§ 1.704-1(b)(2)(ii)(b), -1(b)(2)(iv)(b). 44. see alan gunn, partnership income taxation 44 (2d ed. 1995) (the allocation rules are "so difficult that only a handful of partnership-tax specialists in large firms will be able to apply [them]"); stephen utz, federal income taxation of partners and partnerships 108 (3d ed. 1995) [hereinafter utz-federal] (describing regulations as "monstrously complex!); see also michael j. close & dan a. kusnetz, the final section 704(b) regulations: special allocations reach new heights of complexity, 40 tax law. 307, 336 (1987); lawrence lokken, partnership allocations, 41 tax l. rev. 547, 621 (1986) ("the ... regulations under section 704(b) are a creation of prodigious complexity .... the complexity ... makes the regulations essentially inpenetrable (sic) to all but those with the time, talent, and determination to become thoroughly prepared experts on the subject.') 1999] florida tax review short, capital accounts provide at best a mere static snapshot of the economic situation of the partners whereas their real situation may well be based on dynamic, multi-year expectations. 5 to illustrate, suppose general partnership ab makes a special allocation of a $200 tax loss in year 1 to partner a. in that situation, the economic effect test simply requires that the special allocation be accompanied by an allocation to a's capital account of a $200 economic burden in year 1. but the allocation of an economic burden to a has significance only if there is a liquidation of a's interest at the end of year 1, an event not likely to occur and not expected by the parties. the economic effect test does not require a to actually outlay a $200 investment in year 1 in order to obtain the $200 tax loss. indeed, the other partner, b, may have made all or most of the actual investment, yet a may be allocated the entire tax loss. nothing in the treasury's economic effect regulations prohibits that outcome.46 to be sure, if there were a liquidation immediately after year 1, then based on the capital account adjustment, a's economic share in the venture would be reduced by $200. again, however, liquidation is not contemplated by the parties so that possibility may not be of significance. in short, the economic effect requirement attempts to match the allocation and actual claiming of a tax item with the economic burden or benefit associated with that item, yet it completely ignores the proximity or remoteness of the burden or benefit and, therefore, whether it will in fact ever be realized.47 in that sense, the regulatory mandate constitutes a highly complex and extremely burdensome set of paper entries. the regulations basically concede the "paper entry" aspect of the economic effect requirement. under the "transitory" leg of the substantiality test, which (as described later) is an independent basis for invalidating an 45. cf. mark p. gergen, reforming subchapter k: special allocations, 46 tax l. rev. 1, 11-14 (1990); alan gunn, the character of a partner's distributive share under the "substantial economic effect" regulations, 40 tax law. 121, 124-25 (1986); william s. mckee, partnership allocations: the need for an entity approach, 66 va. l. rev. 1039, 1059 n.85 (1980); utz-federal, supra note 44, at 118; stephen g. utz, partnership taxation in transition: of form, substance, and economic risk, 43 tax law. 693, 700-01 (1990). 46. if a's only investment in the partnership were less than $200 and the partnership had no debt, then a's loss for the year would be limited to the amount of his or her investment. irc § 704(d). but if the loss were generated by partnership debt and enough of the debt were allocated to a, which would almost always be the case, there is nothing in the economic effect rules to prohibit a's claim of the $200 loss. 47. see utz-federal, supra note 44, at 117. what the parties may contemplate, and what in fact may transpire, is a prompt special allocation of income to a in year 2 to make up for the special loss allocation in year 1. the offsetting allocation immediately cancels out the hypothetical economic burden assumed by a as a result of the year i allocation. thus, in any year after year 2, a's economic burden would have vanished, with the allocation of such burden to a in year 1 having been a mere paper entry. [vol 4:3 the future taxation of private business firms allocation, neither a current nor future allocation will be respected if at the time they are agreed to, there is a strong likelihood that they will offset one another yet will reduce collective tax liabilities. 8 but if adjustments to capital accounts have real economic significance when they are made, then there is no particular reason why the treasury should be concerned about the possibility of there being offsetting future adjustments. the fact that the treasury is rightly concerned about that possibility is indicative of the inconsequential nature of the initial capital account adjustment and, therefore, the entire economic effect test. in addition, the economic effect test is completely ineffective at preventing the tax-motivated allocation of tax items which do not have any economic counterpart borne by any partner. initial examples of such tax items include certain tax credits, depreciation and other noneconomic deductions, and deductions attributable to nonrecourse indebtedness incurred by the partnership. if a $100 tax depreciation deduction of a partnership has no economic corollary (because there is no cash outlay of that amount and the property being depreciated has in fact retained its value), to whom should the deduction be allocated under the economic effect test? other even more pervasive examples of tax items without economic counterparts are tax deductions attributable to any form of entity debt if the owners, such as limited partners, llc members, corporate shareholders, or any partners of an llp or an lllp, are shielded from personal liability for repayment of the debt.49 in those circumstances, it may not be possible to award tax losses only to those bearing the economic risk of loss because no owner may bear that economic risk. lastly, certain tax items, such as capital gain or tax-exempt income, have an economic counterpart but also introduce matters of significance only for tax purposes. a dollar's worth of capital gain and ordinary income may look the same from the perspective of a capital account adjustment, but they may have very real differences from a tax standpoint. for all of these types of tax items, then, there may be no economic touchstone on which to determine the proper allocable share of the item belonging to the partner. the solution of matching tax allocation with economic consequence does not work if a tax item is without any corresponding economic effect or is important only because of some uniquely tax-related reason. 48. see regs. § 1.704-1(b)(2)(iii)(c). 49. see karen c. burke, the uncertain future of limited liability companies, 12 am. j. tax pol'y 13, 58 (1995) ("[t]he economic risk of loss concept is meaningless with respect to most llc liabilities, since no member is personally liable"). 1999] florida tax review 2. substantiality.-recognizing the inadequacy of the capital account approach and the economic effect test, the regulations impose a second, independent requirement for insulating a tax allocation from challenge. this requirement, termed "substantiality" in a curious use of a word, focuses on the tax minimization effect of the allocation.5" in other words, even if a tax allocation conforms to the capital account adjustments of the partners in the manner specified by the economic effect requirement, the allocation may still be invalid if its effect is to minimize tax liabilities. the substantiality requirement is manifested in several different ways in the regulations but the strongest version focuses on the after-tax economic consequences of the proposed allocation to the partners. under this version of the test, substantiality is flunked and an allocation is invalid for tax purposes if, after the tax effects of the allocation are taken into account, no partner is worse off and at least one partner is better off (both determined from a present value standpoint) than the results had no special allocation taken place." it is, in effect, a test of "tax efficiency," with a pareto improvement in this case being an arrangement indicative of tax avoidance and therefore impermissible. an obvious concern with such a test is the potential invalidation of an economically efficient allocation which just happens to coincide with the tax efficient one. but the regulations apparently set that concern aside as perhaps the price that must be paid to prevent tax avoidance. the substantiality test is sometimes difficult to apply in practice. for example, suppose special allocations span a number of years or encompass a number of different tax items in a given year, with all such allocations involving, perhaps, different sharing arrangements. which group of allocations should be taken into account in measuring the after-tax economic consequences mandated by the substantiality test? the substantiality test generally requires consideration of more than one allocation, yet it provides little indication regarding exactly which allocations must be considered.52 the after-tax economic consequences of allocations may also not be readily ascertainable. suppose, for example, a partnership claims certain tax depreciation deductions with respect to an investment in a building and 50. see regs. § 1.704-1(b)(2)(iii). 51. see regs. § 1.704-1(b)(2)(iii)(a). 52. for certain incarnations of the substantiality test, but apparently not for the strongest version of it, the regulations apply a five-year cut-off rule. see regs. § 1.704l(b)(2)(iii)(c) (flush language). hence, offsetting allocations occurring more than five years after the initial allocation under scrutiny need not be taken into account in determining whether substantiality is met. the arbitrary five-year rule applies even though the fact of the offsetting allocation is reasonably fixed and certain at the time of the initial allocation. see regs. § 1.704-1(b)(5), ex. (2). [vol. 4:3 the future taxation of private business firms disproportionately allocates the deductions to one partner. suppose the same partner is allocated any tax gains resulting from a disposition of the building up to the amount of depreciation allocated to such partner. under the strongest version of the substantiality test, it might be argued that the partner has obtained an after-tax economic benefit from the allocation if the building is reasonably expected to hold its value over the period of the allocations. in that case, the partner will likely receive an economic gain to offset the initial allocation of economic cost, and will obtain the tax advantage of the early deductions.53 but such a rule presumably would not be administrable-it would require a case-by-case analysis of property values to know whether a particular allocation should be respected or not. hence, the current regulations indulge in an assumption-surely false in many cases-that the value of the building declines each year by the amount of its book depreciation (the "value-equals-basis" rule). therefore, the partner in the example is deemed to have suffered an economic detriment greater than any tax savings as a result of the allocations, and the substantiality test is thus satisfied.' although the regulatory assumption may be the only feasible rule to use, it certainly highlights the artificiality and ineffectiveness of the substantiality requirement in this common circumstance. aside from these practical dilemmas, there is a more fundamental concern with the substantiality test. as noted, the strongest version of the test (as well as both of the weaker versions) requires a comparison: are the aftertax consequences of the partners from the allocation better or worse than from some other? but which other? surely, it cannot be any other allocation, for it must always be possible to hypothesize an allocation which is economically no different from the one under scrutiny, yet is not as favorable from a tax standpoint. in other words, presumably the objective of the law is not to force tax maximization upon the partners, i.e., the least "efficient" outcome from a tax standpoint. rather, the concept would seem to require identification of some normative method of allocating the particular item in question, and a comparison with the tax consequences of that normative method. yet in many cases, the proper normative method of allocating an 53. one assumes that normal arm's length bargaining will protect the other partners from suffering a net after-tax detriment from the special allocation. so long as the tax disadvantage to those partners due to their loss of the early deductions is less than the tax benefit to the partner who is allocated a disproportionately large share of those deductions, the parties can split the net tax savings with the only loser being the treasury and taxpayers generally. 54. see regs. §§ 1.704-1(b)(2)(iii)(c) (flush language), -l(b)(5), ex. (1)(xi). the assumed decline in value of the building means that there will be no offsetting gain belonging to the partner upon disposition of the property. 1999] florida tax review item-presumably the economic allocation-may not be known or knowable.5 in summary, substantiality seems like a promising test for preventing tax avoidance but it cannot work for much the same reason economic effect does not work. both tests require knowledge of the owners' economic shares of the various burdens and benefits of the entity. but where those burdens and benefits are retained by the entity and not distributed to or assumed by the owners directly, there may be no feasible method of ascertaining what the economic shares are. 3. subjective purpose.-in part in recognition of the inadequacy of both the economic effect and substantiality tests, the treasury recently promulgated a general "anti-abuse" regulation in the partnership area. the regulation expressly grants the commissioner authority to recast a partnership transaction if a principal purpose of the transaction is to reduce substantially the present value of the partners' aggregate federal income tax liability in a manner that is inconsistent with the intent of subchapter k.56 the recharacterization may take place "even though the transaction may fall within the literal words of a particular statutory or regulatory provision."57 thus, even if an allocation complies with the complex and extensive regulatory requirements for special allocations and passes both the economic effect and substantiality tests, it might still be invalidated under authority of the new treasury rule.5" despite the formidable tone of this new regulation, it likely will not prove to be an effective tool in preventing the tax advantages available from special allocations. for one thing, as ultimately promulgated, the regulation takes a liberal, "hands-off' attitude towards special allocations. for example, it explicitly blesses rules adopted for "administrative convenience," such as 55. see gunn, supra note 44, at 53-54; close & kusnetz, supra note 44, at 321. the regulations require comparison with a hypothetical situation in which the allocation under scrutiny is not included in the partnership agreement. see regs. § 1.704-1(b)(2)(iii)(a)(1) and (2), (b)(1) and (2), and (c)(1) and (2). obviously, that instruction provides little guidance regarding the proper normative share of the partners. 56. see regs. § 1.701-2(b). 57. see id. 58. see regs. §§ 1.701-2(c)(5) (allocations complying with the literal language of the regulations are nevertheless subject to scrutiny under the anti-abuse regulations if the results of the allocations are "inconsistent with the purpose of section 704(b) and those regulations"), -2(b)(4) (one weapon of commissioner in implementing anti-abuse regulations is to reallocate partnership items). [vol. 4:3 the future taxation of private business firns the value-equals-basis rule, which are key to insulating certain allocation arrangements from irs challenge.59 even if that explicit blessing were removed, however, the basic design of the anti-abuse regulation undermines its effectiveness. for example, by focusing on whether or not there has been a substantial reduction in the present value of aggregate tax liabilities, the regulation encounters the same difficulty facing the substantiality test: the "as compared to what" inquiry. indeed, the answer to that question provided by the new regulation is even less satisfactory than the one provided in the substantiality test. in substantiality, the comparison is with a result produced by a normative, economic sharing of the item in question, something, unfortunately, that may not be known in certain cases. in the new regulation, the answer is to compare with an outcome consistent with "the intent of subchapter k," an even less welldefined standard. further, the regulation is only operative if a subjective intent test is satisfied. "a principal purpose of the transaction" must be to reduce tax liabilities in the forbidden way. aside from the practical difficulty of knowing whose purpose must be determined and how it should be ascertained, this aspect of the regulation raises the normative question of why tax results should turn on one's state of mind in the first place.' if the partnership tax rules somehow permit tax outcomes that the treasury considers inappropriate, the solution should be to fix the rule rather than simply to prejudice those taxpayers who take advantage of the rule with the wrong mindset. 4. would some other test be effective?-as dismal as the current treasury regulations are in this area, the problem lies not with them. rather, the problem is that the regulations are trying to achieve something which cannot be done. as detailed above, the conduit model requires the existence of an economic baseline against which a tax allocation can be tested. yet so 59. see regs. § 1.701-2(a)(3), -2(d), ex. (6) (application of value-equals-basis rule respected by anti-abuse regulation), -2(d), ex. (5) (special allocation scrutinized by anti-abuse regulation but respected). 60. see american law institute, federal income tax project-subchapter k-proposals on the taxation of partners 245 (1984) [hereinafter ali 1984 subchapter k proposals] (arguing against subjective intent test in determining validity of tax allocation); walter j. blum, motive, intent and purpose in federal income taxation, 34 u. chi. l rev. 485, 515 (1967) ("if tax-reducing actions are to pass muster but tax avoidance actions are to be penalized, some way of distinguishing between the two must be located. the trouble is that. as a mental phenomenon, a desire to minimize taxes does not differ from a desire to avoid taxes"); edwin s. cohen, taxing the state of mind, tax executive, apr. 1960, at 200, 218 ("to [make tax consequences] depend upon selecting and weighing the motives or state of mind which prompted his action is a far more complex assignment, and one which i believe we should endeavor to avoid"). 1999] florida tax review long as there is state law separation between the entity and the owners-that is, the owners do not, in fact, own the assets directly but instead only own interests in the firm which owns the assets-the economic baseline against which the tax allocation needs to be compared is necessarily missing. for example, we simply don't know how the partners would have shared undistributed income earned by a firm had there, in fact, been a distribution of that income in the year it was earned. indeed, in many cases, the partners themselves don't even know how they would have shared the income, because their "deal" extends far beyond the economic outcome of the first year. but without that piece of information, it is not possible to fashion a workable rule that can ferret out purely tax-advantaged allocation arrangements under a conduit model of taxation." 5. summary.-to summarize the argument up to this point, this article has contended that as a theoretical matter, the conduit method of taxing the income of private business firms is appealing because it can protect vertical equity norms and minimize distortions in the choice of business form. the practical reality, however, is that the conduit model may not accomplish either objective very well while imposing extremely high transactions costs on both taxpayers and the irs. the central flaw of the conduit model is its inability to provide assurance that the proper amount of business income and loss for any given year is allocated and taxed to the proper owner. under the conduit model, allocations of the firm's tax items have no grounding in economic substance due to the absence of an economic baseline against which the allocation can be tested. in addition, the validity of allocations cannot even be tied to matters of legal form because it is the firm, and not the owners, that maintains legal ownership of the items in question. as a result, the conduit approach is unable to protect vertical equity norms; that objective may be thwarted, for example, by allocating to a high-bracket owner a disproportionately small share of the firm's income for a given year. further, the choice of business form is distorted by the existence of tax advantages available only to businesses with more than one owner which are taxed as conduits. although the law has certainly evolved well beyond its state in 1954, professor surrey's concerns at that time with the potential flexibility of special allocations still seem to be appropriate.62 61. see gergen, supra note 45, at 10-11 ("[qluite simply, there is no dependable way to distinguish tax motivated allocations from allocations with an economic basis"); cf. gunn, supra note 44, at 53-54. 62. see supra note 38 and accompanying text. [vol 4:3 the future taxation of private business firms c. which approach would be more administrable? the discussion thus far would seem to have exposed major flaws in both conduit and entity taxation. although the latter would tax the business income at the wrong rate, the former cannot provide assurance that the business tax base is taxed to the right taxpayer. so which approach is preferable? there is no easy answer to that question. concerns about the ease with which the irs can administer the rules and taxpayers can comply with them, however, should obviously play a role in deciding the preferred approach. otherwise, any rules which are developed risk being a mere facade, a nice theoretical way of imposing taxes on business income that is not matched by real world consequences to most taxpayers. administrability concerns are particularly significant given the applicability of the rules to taxpayers who are in diverse business arrangements and who may have widely differing levels of sophistication and tolerances for complexity. the conduit tax system epitomized by subchapter k is notoriously difficult to comprehend and apply. many analysts have suggested that there may be widespread disregard of one or more of the existing rules because of the inability of firms and their advisors to apply them correctly and of the irs to administer them. indeed, back in 1986-which might properly be described as a time when complexity in subchapter k was still in a state of infancy-one tax expert estimated a mere 2-1/2% compliance rate with one particular partnership provision.63 more recently, another distinguished tax 63. hearings before the subcommittee on select revenue measures of the u.s. house committee on ways & means on issues relating to passthrough entities, 99th cong., 2d sess. 56 (1986) [hereinafter hearings] (statement of joel rabinovitz) (§ 751(b) is probably overlooked in 90% of the cases in which it applies, is ignored in another 5% of the cases because the cost of compliance would be so high, and is misapplied by the irs in another 21/2% of the cases). see also sheldon i. banoff, the use and misuse of anti-abuse rules, 48 tax law. 827, 829 n.17 (1995) (describing how most taxpayers and their advisors "employ a 'common sense' approach to the tax law (i.e., it is cheaper to guess the right answer than to research it thoroughly; it is easier to take an aggressive reporting position than it is to plan prophylactically; it is simpler to make a 'reasonable' estimate than to compile detailed records of substantiation)"); curtis j. berger, w(h)ither partnership taxation?, 47 tax l rev. 105, 107-08 (1991) (subchapter k "has become one of the most inaccessible and burdensome features of the entire tax system"); burke, supra note 49, at 57 ("ilt is already widely perceived that many small (and even some large) partnerships fail to comply strictly with the detailed requirements of subchapter c'); pamela olson, some thoughts on anti-abuse rules, 48 tax law. 817, 824 (1995); joseph a. snoe, economic reality or regulatory game playing?: the too many fictions of the § 752 liability allocation regulations, 24 seton hall l. rev. 1887, 1888-90 (1994). in the allocation area, noncompliance might be broken down into at least three categories: failure to establish and utilize mandated procedures (for example, failure to 19991 florida tax review expert, a former chief counsel of the irs and chair of the aba section of taxation, has conceded the need to enlist expert assistance to give advice on core portions of the partnership tax law.' in addition, the general accounting office has reported on the ineffectual nature of the irs's strategy for insuring compliance among partnerships and their partners. 65 furthermore, as noted above, the partnership tax rules were made even more difficult by the recent adoption of a general "anti-abuse" regulation in subchapter k. although there continues to be some disagreement as to the meaning and scope of the regulation, as well as its wisdom and validity,66 the adoption of the regulation is certainly not a positive maintain book capital accounts in the required manner or failure to include certain boilerplate provisions in the partnership agreement), failure actually to follow through on provisions in the partnership agreement mandated by the tax authorities (for example, refusal by the partners to make liquidating distributions in accordance with their capital account balances despite statements in the agreement that they will do so), and failure to satisfy legal standards (for example, failure to meet the substantiality test). one suspects that many smaller partnerships that are not particularly well-advised never even encounter the second and third set of issues because of their failure to satisfy one or more of the first type of requirements. larger and better-advised partnerships may, in fact, clear the first hurdle by meeting the technical requirements of the first category of issues, but there is still doubt whether their actual behavior conforms to the specific provisions of their agreements. recall that in the classic case of orrisch v. commissioner, 55 t.c. 395 (1970), aff'd per curiam, 31 a.f.t.r.2d 73-1069 (9th cir. 1973), where the special allocation of the taxpayers was invalidated, the problem was not the taxpayers' failure to maintain capital accounts correctly but, instead, doubt on the part of the court that the taxpayers would actually respect the account balances when a liquidation took place. at a 1996 aba tax section meeting of the partnership committee, there was a similar discussion regarding whether clients really permit liquidating distributions to be made in accordance with their capital account balances when their agreement specifies that outcome. finally, because of the amorphous nature of the substantiality test, there is serious question whether those partnerships satisfying the first two hurdles in fact comply with the third. 64. see n. jerold cohen, it always looks better when you look back, 46 tax law. 683, 684 (1993). 65. see u.s. general accounting office, irs' partnership compliance activities could be improved, gao/ggd-95-151 (1995), reprinted in 95 tnt 118-21 (june 19, 1995) (lexis, fedtax library, tnt file). the irs is attempting to increase its audit coverage of partnership returns. see internal revenue service, examination program letter-fy 1997 (nov. 1996), p. 7, reprinted in 97 tnt 32-45 (feb. 18, 1997) (lexis, fedtax library, tnt file); phil brand, irs releases 1997 examination program letter, 28 tax adviser 242 (1997). 66. some commentary on the final version of the anti-abuse regulation includes sheldon i. banoff, anatomy of an antiabuse rule: what's really wrong with reg. section 1.701-2, 66 tax notes 1859 (mar. 20, 1995); banoff, supra note 63; frank v. battle, jr., the appropriateness of anti-abuse rules in the u.s. income tax system, 48 tax law. 801 (1995); michael j. grace, final anti-abuse regulation expanded and clarified, but uncertainties remain, 12 j. partnership tax'n 91 (1995); daniel halperin, are anti-abuse rules appropriate?, 48 tax law. 807 (1995); richard m. lipton, the partnership anti-abuse regs. revisited: is there calm after the storm?, 83 j. tax'n 68 (1995); and olson, supra note 63. [vol 4:3 the future taxation of private business firms indication of the general health of the subchapter k rules. indeed, some of the commentary published in response to the proposed version of the regulation illustrates examples of transactions meeting the literal terms of the statute and/or regulations yet reaching seemingly nonsensical results.67 finally, it is evident that if one were writing on a clean slate, one would not adopt a set of operating rules like subchapter k that first touts their flexibility,' then proceeds to restrict that flexibility with a series of highly complex mechanical and sometimes subjective tests,' and then overlays on top of those tests a relatively amorphous supertest authorizing the disregard of the consequences of earlier tests despite plain compliance with them. indeed, the general anti-abuse rule may apparently apply to negate a taxpayer's successful navigation of other anti-abuse rules adopted to monitor particular types of partnership-related transactions." ° something very fundamental must be awry in the basic structure of the rules for the law to have evolved into this unhappy state. in short, the arguments against adopting a conduit tax system like subchapter k for the taxation of private business firms are extremely powerful ones. yet it is not enough simply to decry the inadequacy of one particular approach; one must try to devise a workable alternative. although a complete development and analysis of an entity tax approach which attempts to impose only a single level of tax on business income is beyond the scope of this article, some earlier analyses suggest the difficulty of that endeavor.7 67. see, e.g., new york state bar association tax section, report on the proposed partnership antiabuse rule, 64 tax notes 233 (july 11, 1994) [hereinafter n.y.s.b.a. tax section report]. the recent case of acm partnership v. commissioner, 73 t.c.m. 2189 (1997) illustrates another large transaction which seemed to satisfy the literal provisions of the statute and regulations but reached an impermissible result. cf. regs. § 1.701-2(d), ex. 7. for recent commentary on the acm case, see steven m. surdell, acm partnership--a new test for corporate tax shelters?, 75 tax notes 1377 (1997). for additional discussion of some of the current problems of subchapter k, see staff of joint comm. on tax'n, review of selected entity classification and partnership tax issues 26 (comm. print 1997) [hereinafter 1997 jct partnership tax study]; william d. andrews, inside basis adjustments and hot asset exchanges in partnership distributions, 47 tax l. rev. 3 (1991); and william b. brannan. the subchapter k reform act of 1997, 75 tax notes 121 (1997). 68. h.r. rep. no. 1337, 83rd cong., 2d sess. 65 (1954). 69. see, e.g., regs. § 1.704-1, -2, and -3. 70. see regs. § 1.701-2(d), ex. (8)(iii) (general anti-abuse rule may recast transaction already subject to (and presumably satisfying the requirements of) anti-abuse disguised sale rule in § 707). 71. see michael l. schler, taxing corporate income once (or hopefully not at all): a practitioner's comparison of the treasury and all integration models, 47 tax l rev. 509 (1992) (describing implementation problems with treasury's dividend exclusion model of integration, a slimmed-down (and much simplified) version of cbit, and ali reporter's integration proposal); yin, supra note 31, at 436-68. 19991 florida tax review in addition, an entity tax system starts with the fundamental flaw of taxing business income and losses at the wrong rate and not permitting the netting of related tax items. finally, it also presents greater transitional concerns than adoption of a conduit system.72 to illustrate just one of the problems in implementing an entity tax approach, consider a scheme in which business income is taxed once at the entity level with distributions of already-taxed income then being tax-free to the owners of the firm. such an approach, termed the "dividend exclusion prototype," was recommended by the treasury department in 1992 because, among other reasons, it represents "the most straightforward and easily administered" method of integration considered by the department. 3 consider just the single issue of how capital gain or loss arising upon a transfer of the ownership interests of a firm should be taxed under such a system.74 in theory, any capital gain or loss might reflect some combination of (1) income accumulated by the firm which has already been subject to the entity-level tax, (2) accumulated preference income which has escaped the entity-level tax, and (3) unrealized gains and losses of the firm (including the value of the firm's projected profits and losses). neither the fully-taxed income nor the preference income should be taxed again upon the transfer of ownership interests, assuming there is a policy decision to pass through preferences. presumably, however, there should be a tax on the capital gain or loss representing the unrealized entity-level gain or loss. how should the rules be designed to tax this last element while not taxing the portion of the capital gain or loss representing accumulated, previously taxed income or preference income? one rough method of accomplishing that end, suggested by both the treasury department and the ali reporter in their integration proposals, is to provide outside basis adjustments equal to the fully-taxed and preference income (assuming passthrough of preference income) not distributed by the 72. requiring all private business firms to be taxed in the same way, either under a conduit or an entity tax approach, would present transitional problems because of the change from current law. a conduit approach, however, is already in effect for those firms currently subject to subchapters k or s. in contrast, an entity tax approach imposing only a single level of taxation on business income would represent a new system for all firms. 73. u.s. dep't of treasury, a reconmendation for integration of the individual and corporate tax systems, dec. 1992, letter from nicholas brady, secretary of the treasury, to dan rostenkowski, chairman, u.s. house comm. on ways and means, p.1. 74. any gain or loss on the sale of ownership interests need not, of course, constitute capital gain or loss. the reference in the text to capital gain or loss is simply shorthand for the gain or loss arising from the sale of ownership interests, no matter what the actual character of that gain or loss is. [vol 4:3 the future taxation of private business firms firm.' analytically, the procedure, termed a "dividend reinvestment plan'" or "drip" by the treasury, would allow firms to retain their earnings but to declare constructive distributions followed by constructive reinvestments of those amounts back to the firm. the distributions would be tax-free to the distributees, and the reinvestments would produce the desired increase in outside basis. at least in theory, if all retained earnings were made subject to a drip, then capital gain and loss would reflect only unrealized gains and losses at the firm level. if such gain and loss were taxed, an inside basis adjustment could be made to preclude the same gain or loss from being taxed again when realized by the firm. a drip, however, is nothing more than an allocation of undistributed income among the owners of the firm, the core requirement of existing subchapter k. although the ramifications of a drip under an entity-level tax would be less significant than under subchapter k because the income being allocated under the drip would already have been subject to tax, nevertheless the practical difficulties with the allocation would be the same. if a set of rules could be developed to specify the appropriate outside basis adjustments for private business firms with tiers of owners and preferential, contingent, and inchoate ownership interests, among other things, those same rules could be utilized to implement a conduit tax system. in addition, the necessary, accompanying inside basis adjustment might encounter the same problems as under the current law of subchapter k.76 both the treasury and the ali reporter suggested an elective drip to be fashioned by the taxpayer. but an elective drip would still face the same problems, the only difference being that there would be an initial, ad hoc development of taxpayer-favorable allocation schemes. also, in certain circumstances, firms might find it advantageous from a tax standpoint not to distribute constructively all of their retained earnings. no doubt, there would follow the inevitable congressional and treasury responses to those schemes-like a "substantial economic effect" test in order to validate a drip-with resulting considerable complication. in short, adoption of a drip may encounter many of the same daunting allocation problems now dealt with under subchapter k. another possible solution is to tax the capital gains, forgo a drip and any basis adjustments, and simply permit the liberal utilization of capital losses. the theory is that to the extent the capital gain ought not be taxed because it represents fully-taxed or preference income accumulated by the 75. see treasury integration report, supra note 28, at 87-88; american law institute, federal income tax project-integration of the individual and corporate income taxes-reporter's study of corporate tax integration 126-27 (1993) (proposal 5) [hereinafter ali reporter's integration study]. 76. see irc §§ 734, 743, and 755. 1999] florida tax review firm, there will subsequently be an offsetting capital loss to the purchaser of the ownership interest when the income is distributed out of the firm. thus, so long as the capital loss can be easily utilized, overall double taxation would be avoided. one problem with this approach, however, is that the offsetting capital loss may not arise until many years after the capital gain is incurred and the tax is paid. further, there is a potential rate arbitrage problem: the seller who incurs the capital gain may not be taxed at the same rate as the purchaser who obtains the capital loss. finally, full taxation of capital gains without a drip, even with liberal availability of capital losses, might place undue pressure on firms to distribute their earnings. the opposite approach, also suggested by the treasury department, would be to exempt the capital gain from taxation.77 as noted, the only element of the capital gain that ought to be taxed is the amount equal to the unrealized gains or losses at the firm level. but such gains or losses can be taxed when realized by the firm. thus, a capital gains exemption (and, of course, nonrecognition of capital losses) would still permit a single tax to be collected ultimately on all income earned by the firm. moreover, it would do so in a very simple fashion, without the need of a drip or inside basis adjustments. the principal problem with this idea is the deferral that would be permitted, and the resulting distortions potentially created. if an acquisition of the ownership interests of a firm were tax-free but the acquisition of the firm's assets were not, there would be a clear bias in favor of the former transaction. this bias might be similar to or even greater than the bias under current law of an acquisition of corporate stock (which ordinarily results in only one tax) over an acquisition of the corporation's assets (which may result in two taxes). to be sure, the magnitude of the bias is uncertain. it might be offset to some extent by an implicit tax imposed in the capital gains transaction if the price for the ownership interests takes into account the unrealized gains and future tax liability at the entity level. nevertheless, because taxation of those gains would continue to be deferred, the implicit tax would likely be much smaller than the explicit tax arising on an asset sale, so that some distortion would be caused. accelerating entity-level realization events would reduce the distortion because it would cause the implicit tax to be closer in amount to the explicit tax. for example, exemption of capital gains might be accompanied by a mandatory section 338-type rule triggering an entity-level realization event upon a sufficient change in ownership of a firm. but implementing a mandatory section 338 regime would be extraordinarily 77. see treasury integration report, supra note 28, at 83. [vol 4:3 the future taxation of private business firms difficult.78 it would in most cases force an undesirable result on the taxpayer, in contrast to existing section 338 which was originally designed to provide a taxpayer-favorable election. thus, the major thrust of the qualification rules in a mandatory section 338 environment would be to devise a net from which the taxpayer could not escape, much like the rules for section 382, surely no model for simplicity.79 in summary, achieving the proper tax treatment of capital gains in an entity tax system would present a formidable challenge and is illustrative of the difficulties to be encountered in devising such a system. there are the same age-old trade-offs between equity and simplicity, with the price of "getting it right" in an entity tax system being perhaps as high as doing so in a conduit system. d. summary and conclusion as difficult as it is to implement a conduit tax system, there does not seem to be any clear advantage to developing an entity tax approach for the taxation of private business firms. each system, as implemented, includes certain basic flaws in the taxation of business income. in addition, each system may encounter similar problems in facilitating taxpayer compliance and irs review. an entity tax approach has the additional disadvantage of presenting greater transitional concerns. but this rather pessimistic resolution of this issue would seem to create a dilemma for policymakers. if subchapter k, the most refined conduit system in existence, is already viewed as placing intolerable burdens on taxpayers and the irs alike, and further, necessary reforms would likely make it even more difficult to comply with and administer, then how can that subchapter be mandated as the uniform method of taxation for all private business firms? wouldn't such a recommendation simply lead to disregard of the law even more widespread than at the present time? this article suggests a way out of that dilemma. specifically, two versions of conduit taxation should be pursued. one version should reform subchapter k to prevent potential abuses of those rules even at the cost, if necessary, of some additional complication. subchapter k, as reformed, will sometimes be referred to as the "default version of conduit taxation" in this article. the other version should focus on providing an administrable set of conduit rules with some concession, if necessary, to not achieving the correct 78. see george k. yin, a carryover basis asset acquisition regime?: a few words of caution, 37 tax notes 415, 418-20 (oct. 12, 1987). 79. still another possible approach would be to tax the capital gains but to permit such gains to be excluded from income if the taxpayer agrees to accelerate the entity-level gains. cf. irc § 338(h)(10). 1999] florida tax review outcome in all cases. the next part of the article describes the theory behind, and the specific provisions of, the simplified version of conduit taxation." iv. a simplified version of conduit taxation a. introduction development of the simplified version of conduit taxation described in this article used subchapter k as its starting point. this point of departure might seem odd given the complex nature of that subchapter. on the other hand, subchapter k represents the purest version of conduit taxation in existence. as explained in greater detail in the next section, the theory was to begin with subchapter k and to try to strip off as many of the complicating features of the law as possible in order to develop a simple core of conduit principles and rules. the key was in fashioning eligibility rules which would enable one to discard the "extraneous" portions of subchapter k. subchapter s was not selected as the initial model because of its entity tax features which seemed inconsistent with a conduit tax objective. those features are a natural outgrowth of subchapter s's original application only to corporations and its close relationship with subchapter c. but they seemed to make subchapter s an unsound foundation on which to construct a simplified conduit version applicable to all forms of business organization." despite this initial step, the proposal has evolved into one which has a strong resemblance to subchapter s. in part, this result can be explained by the historical roots of that subchapter. subchapter s was enacted in 1958 to reduce the impact of tax consequences on the choice of business form and to remove the double tax burden on, and permit the passthrough of losses by, 80. consideration of possible subchapter k reforms for the default version of conduit taxation is beyond the scope of this article. one commentator has suggested a similar "two-track" approach except that he would develop an entity tax system to be mandatorily applicable to those firms not qualifying for his simple conduit approach. see jeffrey l. kwall, taxing private enterprise in the new millennium, 51 tax law. 229 (1998). 81. interestingly, one of the "entity" tax features of subchapter s-the requirement that a firm recognize gain upon a distribution of appreciated property-was included in subchapter s in 1982 prior to its inclusion in subchapter c. later amendments in 1984 and 1986 extended and expanded the rule in subchapter c, thereby making the s rule superfluous. see subchapter s revision act of 1982, pub. l. no. 97-354, § 2, 96 stat. 1669, reprinted in 1982-2 c.b. 702, 706 (enacting former irc § 1363(d)); deficit reduction act of 1984, pub. l. no. 98-369, § 54(a)(1), 98 stat. 494, 568 (amending former irc § 311(d)(1)); tax reform act of 1986, pub. l. no. 99-514, § 631(a), (c), 100 stat. 2085, 2269, 2272 (amending irc §§ 311, 336). [vol. 4:3 the future taxation of private business firms small businesses.' although the creation of an administrable set of provisions was not stated as a specific objective, it is evident that congress included consideration of that goal in crafting the rules.8 whether congress has achieved that goal is a matter of some disagreement,' but most observers surely would agree that subchapter s is simpler than subchapter k 5 thus, in trying to develop a simplified conduit approach to a particular tax issue, it was natural to consider the rule in subchapter s. indeed, for reasons explained below, the basic structure of subchapter s serves as a remarkably coherent version of a simplified conduit system. subchapter s provided another important advantage. one worry in trying to fashion a simpler set of rules is the possibility that they will not adequately protect the fisc. elimination of complicated subchapter k provisions intended to prevent inappropriate tax outcomes might result in such outcomes being resurrected within the simplified conduit system. subchapter s, however, offers an instructive 40-year track record of taxpayers and transactions subject to those rules. thus, if an inappropriate transaction has not arisen under that subehapter, it may be indicative of the experience one could expect under a new system modeled after one or more of its rules. a difficulty with relying too heavily on subchapter s, however, is its somewhat perverse relationship to subchapter k assuming that use of the simplified conduit version is a matter of explicit or transactional election by the taxpayer, then the substantive tax outcomes under that version must be compared to those under the default conduit version, i.e. some variation of subchapter k. unless the results under the simplified version are roughly equivalent to (or indeed, more taxpayer-favorable than) the results under the 82. see s. rep. no. 1983, 85th cong., 2d sess. 87 (1958), reprinted in 1958-3 c.b. 922, 1008. 83. for example, in explaining the reason for the one class of stock rule contained in an early proposal of what eventually became subchapter s, the senate report describes the "great complications" that would arise under a contrary rule. see s. rep. no. 1622, 83rd cong., 2d sess. 453-54 (1954) (serial set 11735). 84. see burgess j.w. raby & william l. raby, s corporation aaa and oaa-alphabet soup or taxpayer stew?, 78 tax notes 1013, 1013 (1998) (describing subchapter s as "remarkably complicated'); michael l. schler, initial thoughts on the proposed "check-the-box" regulations, 71 tax notes 1679, 1684 (1996) (subchapter s is "extraordinarily complex"). 85. see berger, supra note 63, at 110 (greater reliance upon the "relatively simple foundation of subchapter s, rather than upon the intricately ornate base of subchapter k (would permit] most of the arcane complexity from this sector of tax law [to disappear]"); martin d. ginsburg, maintaining subchapter s in an integrated tax world, 47 tax l rev. 665, 669 (1992) ("one thing that makes subchapter s look really good is subchapter k. the awesomely complex partnership tax provisions"); deborah h. schenk, commentary: complete integration in a partial integration world, 47 tax l. rev. 697, 712 (1992) ("one of the hallmarks of subchapter s is its ... simplicity [relative to subchapter k].'). 19991 florida tax review default system, use of the simplified version might well be discouraged. yet current subchapters k and s do not have that relationship. subchapter s is simpler than subchapter k but it also generally produces tax results less favorable to taxpayers. as a result, some commentators have predicted the demise of subchapter s and some have even urged its repeal.8 6 for reasons described in part ii, this article contends that it is important to preserve a simplified version of conduit taxation for as many private business firms as possible. to accomplish that end, it is necessary to reconfigure somewhat the tax consequences under subchapters s and k. far from being repealed, the former should generally be liberalized; in contrast, some of the vaunted flexibility of the latter should be curtailed. the challenge is achieving the right balance: liberalization of subchapter s should not result in any significant loss of simplicity, and modifying subchapter k should not cause it to produce significantly incorrect results. the next section describes the theoretical underpinning of the simplified version of conduit taxation. it explains why the availability of "simple" rules is necessarily tied to the characteristics of the firms and owners subject to those rules. accordingly, the proposal limits applicability of the simplified version to a subset of private business firms referred to in this article as "simple private business firms" (spbfs). section c then outlines the basic operating provisions of the simplified system, which generally consists of a liberalized version of subchapter s. b. eligibility for the simplified version: theory and definition over 40 years ago, the reporters and two consultants to the all project on partnership tax described the source of the difficulty in subchapter k in the following way: most of the problems encountered in the partnership area are concerned with the distribution of the burden of taxation among the members of the group. since the treasury from the standpoint of tax policy is not greatly concerned about this allocation, the issues are 86. see jerome kurtz, the limited liability company and the future of business taxation: a comment on professor berger's plan, 47 tax l. rev. 815, 831 (1992) (predicting demise); schler, supra note 84, at 1684-85 (urging repeal); walter d. schwidetzky, is it time to give the s corporation a proper burial?, 15 va. tax rev. 591, 593 (1996) (same); willard b. taylor, beyond check-the-box-neglected issues, 75 taxes 671, 674 (1997) (same); compare ginsburg, supra note 85, at 665 n.3 ("[w]hile in the past some have suggested replacing subchapter s with an extension of subchapter k to electing corporations, a proposition that commends itself mainly to those who find the level of complexity in federal tax law much too low .... ). [vol 4:3 9the future taxation of private business firms essentially not between treasury and taxpayer-partner but between partner and partner." the passage of time since publication of that statement has revealed that the authors were only partly correct. certainly, one of the principal difficulties of partnership tax has been the distribution or allocation of the tax burden of the business firm among the owners of the business. but in contrast to the second sentence of the quoted statement, which lay the groundwork for the authors' proposal of what is now section 704(a), it would appear that the treasury department is greatly concerned with the manner of allocation. for example, the regulations under section 704 evidence treasury's concern that the flexibility of the subchapter k rules will be used to shift tax items from one owner to another. this concern is not limited to the possibility that income will be shifted from high-taxed to low-taxed persons, while deductions flow from the low-taxed to the high-taxed. also included are possible shifts of particular categories of income-section 1231 gains and losses, foreign-source income and deductions, capital gains and losses, and so forth. moreover, the shift need not necessarily be within a particular time period. the shifting of income, losses, and other tax items recognized in different time periods may also be objectionable.' this section attempts to identify the characteristics of firms for which the second sentence of the ali reporters' statement would also be true, that is, firms whose tax issues would be essentially between owner and owner rather than between the treasury and the taxpayer. if the characteristics of such firms (termed "spbfs") offer only limited potential for the type of tax advantages that the treasury is worried about, then the firm can be provided with an operating rule structure consisting of a stripped-down version of subchapter k, one that eliminates many of the administrative and compliance requirements of those provisions. to be sure, the eligibility conditions of an spbf cannot be so precise as to preclude every possible instance of the firm being used to achieve an advantageous tax result. nevertheless, the objective of the spbf proposals is to balance a concern of protecting the fisc with a desire to provide an administrable set of tax operating rules for as many firms as possible. the spbf definition contains two basic eligibility conditions similar to those used in defining an s corporation. first, the owners of an spbf must generally all be individuals. in addition, an spbf may have only one class 87. j. paul jackson, mark h. johnson, stanley s. surrey & william c. warren. a proposed revision of the federal income tax treatment of partnerships and partners-american law institute draft, 9 tax l. rev. 109, 112 (1954). 88. cf. acm partnership v. commissioner, 73 t.c.m. 2189 (1997); regs. §§ 1.7012(d), ex. (7), 1.704-1(b)(2)(iii)(c) (transitory allocations invalid). 1999] florida tax review of residual ownership interests. the terms and rationale for these conditions are discussed in further detail below. a final section explains why other conditions are not proposed. 1. ownership limitations.-as noted, one of the principal reasons for the tremendous complexity in subchapter k is the desire to prevent the shifting of tax items from one owner to another. shifting strategies, however, are only advantageous if the parties participating in the shift are in different tax situations. thus, if all owners of a private business firm have and continue to have exactly the same tax profile, many of the protective rules of subchapter k could be eliminated. as a practical matter, of course there are far too many potential tax differences among taxpayers to ever insure, other than on a case-by-case basis, absolutely identical tax profiles among the owners of a private business firm. but if, for example, all owners of a subset of firms were in at least the 28% marginal income tax bracket, it might be unlikely that such firms would be utilized on a widespread basis to gain the potential tax advantages from certain shifting strategies. s9 an important goal of the ownership limitations described in the next sections is to try to insure that owners of an spbf will have more-or-less the same general tax profile. a. individuals as owners.-the following table 1 breaks down by agi class the number of individual income tax returns on which either partnership or subchapter s income or loss was reported in 1994, the latest year for which such data is available. an examination of the tax profile of individuals who have invested in partnerships and s corporations in the recent past offers some insight into the likely profile of the individuals who will be future spbf owners. 89. one might expect that the transaction costs of shifting would make it uneconomic if the shifting of income and losses or deductions occurred between taxpayers in the 28% bracket and those in the 36% or 39.6% bracket. this broad generalization ignores the potential advantage of shifting particular tax items, such as § 1231 gains and losses, capital gains and losses, and passive income and losses, the advantage from which is not necessarily a function of the marginal income tax bracket of the taxpayer. that concern is addressed later in connection with the rule limiting an spbf to one with a single class of residual ownership interests. [vol 4:3 the future taxation of private business firms table 1 number of individual income tax returns reporting partnership or s corporation income or loss, by agi class (1994) (numbers in 000s) (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) agi #rets. %of cum% #w/ %tot. cum% #w/ %tot cum% #w/ %toz cum% class filed total of col. k&s w/k&s of col. k&s wlk&s of col. k&s w/k&s of col (s00) rets. (3) inc. inc. (6) loss loss (9) ':'--' -'"-a (12) 0 953 0.8% 0.8% 44 1.3% 1.3% 153 7.3% 7.3% 197 3.5% 3.5% 1-5'0 14,632 12.6% 13.4% 88 2.5% 3.8% 59 2.8% 10.1% 147 2.6% 6.1% 5-10 14,235 12.3% 25.7% 122 3.5% 7.3% 77 3.7% 13.8% 199 3.6% 9.7% 10-15 13,465 11.6% 37.3% 161 4.6% 11.9% 106 5.0% 18.8% 267 4.8% 14.5% 15-20 11,411 9.8% 47.1% 185 5.3% 17.2% 89 4.2% 23.0% 274 4.9% 19.4% 20-25 9,663 8.3% 55.4% 162 4.6% 21.8% 85 4.0% 27.0% 247 4.4% 23.8% 25-30 8,121 7.0% 62-4% 147 4.2% 26.0% 105 5.0% 32.0% 252 4.5% 28.3% 30-40 12,014 10.4% 72.8% 315 9.0% 35.0% 196 9.3% 41.3% 511 9.1% 37.4% 40-50 9,024 7.8% 80.6% 267 7.6% 42.6% 198 9.4% 50.7% 465 8.3% 45.7% 50-75 13,127 11.3% 91.9% 542 15.5% 58.1% 385 18.3% 69.0% 927 16.6% 62.3% 75-100 4,784 4.1% 96.0% 365 10.5% 68.6% 202 9.6% 78.6% 567 10.1% 72.4% 100-200 3,405 2.9% 98.9% 627 18.0% 86.6% 265 12.6% 91.2% 892 16.0% 88.4% 200-500 890 0.8% 99.7% 342 9.8% 96.4% 138 6.6% 97.8% 480 8.6% 97.0% 500-1000 149 0.1% 99.8% 81 2.3% 98.7% 28 13% 99.1% 109 1.9% 98.9% 1000+ 70 0.1% 99.9% 44 1.3% 100.0% 14 0.7% 99.8% 58 1.0% 99.9% total 115,943 3,492 2,100 5,592 source: irs statistics of income, individual income tax returns 1994, publ. 1304 (1997), table 1.4, cols. (1), (73), and (75). numbers do not add to 100% due to rounding. the irs statistics underlying the data set forth in table 1 unfortunately do not provide any indication of the filing status of the taxpayer filing the return (single, joint, married filing separately, or head of household). it may, however, be reasonable to assume that on average, 1994 returns reporting adjusted gross income below about $40,000 represented taxpayers in the 15% or lower marginal income tax bracket.9' based on that assumption, 90. this category represents all returns with agi greater than zero but less than $5,000. 91. in 1994, married taxpayers with taxable income below $38,000 were in the 15% bracket; for heads of household, the figure was $30,500; for single individuals, $22,750; for married filing separate, $19,000. irc § 1(a)-(d), (f). to estimate the average agi cut-off point for the 15% tax bracket, we first increased the taxable income amount for each category of tax return filer by a personal exemption amount ($2,450 in 1994; two exemptions were assumed for joint filers and heads of household) and the 1994 standard deduction (s6,350 for joint filers, $5,600 for heads of household, $3,800 for singles, and s3,175 for married filing 1999] florida tax review table 1 indicates that roughly 37.4% of the returns reporting partnership or s corporation income or loss in 1994 were filed by taxpayers in the 15% or lower tax bracket, and roughly 62.6% were filed by taxpayers in the 28% or higher bracket. 92 in contrast, approximately 72.8% of all returns were filed by taxpayers in the 15% or lower tax bracket, and approximately 27.2% were filed by taxpayers in the 28% or higher bracket.93 other data reveals that about 13% of the returns reporting partnership or s corporation income or loss were "nontaxable returns" reporting no income tax liability, and therefore, the taxpayers filing them might be considered to have been in the 0% tax bracket.94 putting all of this information together, a rough profile of the individual taxpayers reporting partnership or s corporation income or loss in 1994 is as follows: marginal income % of all returns % of tax bracket filed by individuals all returns of tax return reporting k or s filed by filer income or loss individuals 0 percent 13% not avail. 15 percent 24.4% not avail. 0 or 15 percent 37.4% 72.8% 28 percent or higher 62.6% 27.2% separately). irc §§ 63(c), 151(d). we then averaged the estimated agi cut-off points in each category for the 15% tax bracket ($49,250 for joint filers, $41,000 for heads of household, $29,000 for singles, and $24,625 for married filing separately) based on the percentage of filers in each category in 1994 (joint 41.7%, head of household 13.0%, single 43.0%, and married filing separately 2.1%). see irs statistics of income, individual income tax returns 1994, publ. 1304 (1997) [hereinafter 1994 soi individual], table 1.3, cols. (1), (3), (5), (7), and (11), at 36-37. the result was an estimated, overall agi cut-off in 1994 for the 15% tax bracket of $38,854 ($49,250 x 41.7% + $41,000 x 13.0% + $29,000 x 43.0% + $24,625 x 2.1%). because the minimum number of exemptions and the standard deduction were both assumed, the actual figure would be higher than $38,854, hence the assumption of about $40,000 in the text. another recent study has estimated that in 1994, there were approximately 25,562,000 returns filed by taxpayers in the 28% or higher tax bracket. see therese m. cruciano, individual income tax rates and tax shares, 1994, 16 soi bulletin 7, 10 (spring 1997) (figure c). counting up from the bottom of column (2) of table 1 indicates that the break between the 15% and 28% tax brackets occurs somewhere between $40,000 and $50,000 of agi. 92. table 1, col. (13), line 8. 93. table 1, col. (4), line 8. 94. 1994 soi individual, supra note 91, table 1.4, cols. (73) and (75), at 44, and pp. 126-27. [vol 4:3 the future taxation of private business firms thus, as one might expect, individual participants in partnerships or subchapter s corporations in 1994 were, on average, in higher income tax brackets than tax return filers generally, with almost two-thirds of those reporting k or s items belonging in the 28% tax bracket or higher. nevertheless, there were a surprisingly high number of low-bracket k or s individual participants as well. this conclusion might suggest that there would be ample opportunity for income shifting between lowand high-bracket owners of a private business firm. for a number of reasons, however, the figures probably exaggerate the extent of that potential problem if the firm is limited to individual owners. for one thing, low-bracket taxpayers may pair up with one another to participate in a common private business firm. although pairing of that sort would increase their overall participation rate in such ventures, it would not create a significant concern of tax item shifting. second, the figures in table 1 indicate the likely tax bracket of partners and s corporation shareholders after their share of pass-through income or loss is taken into account. but to evaluate the potential availability of a shifting strategy from investment in a pass-through entity, the tax bracket of the participants should be known before taking into account their share of pass-through items. for example, two high-income partners might shelter most or all of their income through losses generated by their two-person partnership, thereby making them both appear to be low-bracket taxpayers after such losses are taken into account. yet that sheltering would not result from an inappropriate shifting of tax items between high and low-bracket taxpayers, nor would that outcome be possible under those facts. there is some evidence in the data to support this explanation as one reason for the surprisingly high level of participation shown by table 1 of low-bracket taxpayers in partnerships and s corporations.95 third, a small number of low-bracket taxpayers reporting partnership or s corporation income or loss in 1994 apparently were subject to the 95. of those taxpayers reporting k or s net income, only 1.3% were in the so agi class. in contrast, of those taxpayers reporting k or s net loss, 7.3% were in the $0 agi class. see table 1, cols. (6) and (9), line 1. in addition, the amount of k or s net losses claimed by taxpayers with $0 agi represented almost 40% of all such losses claimed, whereas the amount of k or s net income reported by taxpayers with $0 agi represented less than 1% of all such income reported. 1994 soi individual, supra note 91, table 1.4, cols. (74) and (76). at 44. these figures suggest that k and s losses helped to make some numbers of partners and s shareholders appear to be low-bracket taxpayers even though before such losses are taken into account, they may have been high-bracket taxpayers. 1999] florida tax review alternative minimum tax.96 thus, their marginal income tax bracket was either 26% or 28%, the minimum tax rates, rather than 15% or lower.97 fourth, the figures in table 1 only reflect participation in partnership and s corporation ventures by number of returns filed. if participation is measured by amount of net income reported, a different picture is revealed: table 2 amount of partnership or subchapter s net income reported on individual income tax returns, by agi class (1994) (1) agi class ($000) 0 1-598 5-10 10-15 15-20 20-25 25-30 30-40 40-50 50-75 75-100 100-200 200-500 500-1,000 1,000 + total (2) k or s net inc. reported ($ million) $ 1,136 205 507 995 1,096 1,078 1,233 3,297 2,718 7,300 7,270 24,054 34,536 19,658 49,193 $154,277 (3) % of tot. k or s net inc. reported 0.7% 0.1% 0.3% 0.6% 0.7% 0.7% 0.8% 2.1% 1.8% 4.7% 4.7% 15.6% 22.4% 12.7% 31.9% (4) cum % of col. (3) 0.7% 0.8% 1.1% 1.7% 2.4% 3.1% 3.9% 6.0% 7.8% 12.5% 17.2% 32.8% 55.2% 67.9% 99.8% source: irs statistics of income, individual income tax returns 1994, publ. 1304 (1997), table 1.4, col. (74). col. (4) does not add to 100% due to rounding. 96. about 93,000 tax returns, or roughly 1.7% of all returns reporting partnership or s corporation income or loss, had agi of under $10,000 yet were "taxable returns" and therefore reported income tax liability. see 1994 soi individual, supra note 91, table 1.4, cols. (73) and (75), at 44, and pp. 126-27. because a taxpayer with agi of less than $10,000 probably had no regular income tax liability, these returns were likely reporting minimum tax. 97. irc § 55(b)(1)(a). 98. see supra note 90. [vol 4:3 the future taxation of private business firns table 2 indicates that in 1994, only 6% of total partnership or subchapter s net income reported on individual income tax returns was reported on returns having agi of less than $40,000, which we have assumed to represent a rough proxy for taxpayers in the 15% or lower tax bracket." this figure indicates that if partnerships and s corporations were utilized previously to shift income from highto low-bracket individual taxpayers, only a relatively small amount of income was involved. of course, the proposals contained in this article might change that pattern in the future. nevertheless, the figures suggest that at least historically, such entities have not been widely employed to shift income between highand low-bracket individuals." ° finally and perhaps most importantly, regardless of how many lowbracket taxpayers have participated in partnerships and s corporations in the past and might be expected to participate in an spbf in the future, they are able to shelter only a limited amount of income before higher brackets would apply to them. the one exception would be a zero-bracket individual taxpayer with a large net operating loss carryover, but that apparently is a fairly uncommon situation.'' thus, the transaction costs to design a tax shelter involving lowand high-bracket individual taxpayers may be fairly high. many low-bracket taxpayers would have to be assembled before any significant amount of income of the high-bracket taxpayers could be sheltered. the transaction costs might be particularly high if one further assumes that low-bracket taxpayers who truly have low incomes may be 99. table 2, col. (4), line 8. 100. the same inference can be drawn from data appearing on table 1. for each agi category greater than $0 and less than $40,000, roughly the same percentage of taxpayers reported partnership or s corporation loss as reported partnership or s corporation income. see table 1, cols. (6) and (9), lines (2)-(8). if shifting strategies involving low-bracket individuals had been widely utilized, one would expect to see greater percentages of the low agi categories reporting pass-through income rather than pass-through losses. 101. for 1994, only 431,277 individual income tax returns out of a total of almost 116 million filed, or about 0.4% of all individual returns, claimed a net operating loss deduction for a loss arising in a prior taxable year. see 1994 soi individual, supra note 91, table 1.4, col. (97), at 46. (the term "net operating loss" used in the irs tables refers to net operating loss deductions claimed in 1994 for prior year losses, and not to net operating losses arising in 1994 which may be carried back or forward to other years. see id. at 118-19.) although the claiming of an nol deduction by an individual is therefore infrequent, the amount of deduction claimed may be sizable. in 1994, a total of $47.045 billion in nol deductions for losses from prior years were claimed by individuals, or an average nol deduction of $109,000 per claim. see id., table 1.4, col (98), at 46. one might speculate that nol deductions of individuals are naturally and quickly used up as the level of the individual's income and loss fluctuates from year to year because individuals could not be expected to suffer losses for an extended period of time. if this is true, then there may not be a large pool of nols belonging to individuals which would be available to offset income from a tax shelter investment. but we have as yet uncovered no data to support or refute this speculation. 19991 florida tax review fairly hard to identify due to their relative lack of sophistication in financial matters. 10 2 all of the foregoing reasons support the conclusion that an spbf with only individuals as owners does not present significant opportunities for income and loss shifting."0 3 accordingly, a more relaxed set of tax operating rules for an spbf is permissible in that situation. b. public subchapter c firms as owners.-the picture changes rather dramatically if public firms taxable under subchapter c are also permitted to be owners of an spbf. many c corporations have net operating losses, which means that they not only are in a zero marginal income tax bracket but also may be able to shelter a significant amount of income in a given year. for example, in 1993, the latest year for which such data is available, just slightly over one-half of the corporate income tax returns filed (other than returns of s corporations, rics and reits) reported net income." the c corporation returns without net income reported an aggregate loss of over $127 billion, an average loss of over $136,000 for each c corporation return without net income.105 moreover, over 39% of the c corporation returns with net income claimed a net operating loss deduction from a prior year loss, with a total of over $45 billion in such deductions claimed.0 6 the foregoing information relates to income tax returns filed by both public and closely-held c corporations. to estimate the likely nol situations of public c corporations, table 3 provides data regarding the amount of corporate nol deductions claimed in 1993, broken down by the asset size of the corporation whose return made the claim. 102. but see boris i. bittker, tax shelters for the poor?, 51 taxes 68 (1973) (tongue-in-cheek description of partnership venture operating coin-operated washing and vending machines in basement of low-income housing project, in which low-income tenantpartners with "excess" personal exemptions and standard deductions are allocated predepreciation income of venture and high-bracket investor-partners are allocated depreciation deductions). 103. again, this conclusion does not apply to possible shifts involving particular tax items of the firm, such as capital gains and losses. that concern is addressed below. 104. internal revenue service, 1993 statistics of income, corporation income tax returns, publ. 16 (1996) [hereinafter 1993 soi corporate], table 18, col. (1). we treat the category of corporate income tax returns other than s, ric, or reit returns as a proxy for c corporation returns. 105. 1993 soi corporate, table 18, cols. (1) and (2). 106. id. corporate net operating loss carrybacks to 1993 are not included in the irs statistics. see id. at 181. the fact that the c corporation losses reported in 1993 were almost three times the amount of the net operating loss carryforwards deducted in 1993 may suggest either a significant amount of nol carrybacks not reflected in these statistics or large amounts of unused nols. [vol 4:3 the future taxation of private business firms table 3 corporate nol deductions claimed, by asset size of corporation filing return (1993) (1) (2) (3) asset size # corp. # rets. rets. w/nol (o00s) ded. (000s) $0 239.3 20.93 $1-$100k 2,049.6 224.74 $100k-$250k 635.3 80.47 $250k-$500k 394.2 48.55 $50ok-$1m 269.3 28.91 $1m-$5m 279.1 27.54 $5m-$10m 40.1 3.97 $1om-$25m 25.9 3.14 $25m-$50m 11.4 1.50 $50m-$100m 8.0 1.06 $10om-$250m 6.6 .82 $250m + 6.8 1.12 total 3,964.6 442.74 (4) % rets. w/nol ded. (3)-(2) 8.7% 11.0% 12.7% 12.3% 10.7% 9.9% 9.9% 12.1% 13.2% 13.3% 12.4% 16.5% 11.2% (5) nol. ded. (sm) $ 1,773.4 2,085.5 1,470.0 1,305.7 1,496.4 3,420.6 1,294.9 2,075.4 1,771.0 2,276.0 2,629.4 23,560.7 $45,158.9 (6) % of tot. nol ded. 3.9% 4.6% 3.3% 2.9% 3.3% 7.6% 2.9% 4.6% 3.9% 5.0% 5.8% 52.2% (7) avg. nol ded. per claim (scos) (5)y(3) s 84.7 9.3 18.3 26.9 51.8 124.2 326.2 661.0 1,180.7 2,147.2 3,206.6 21,036.3 $ 102.0 source: michael g. seiders, corporation income tax returns, 1993, 16 sol bulletin 36, 51-54 (summer, 1996) (table 2). certain information was obtained from a telephone conversation between john comisky, economist at the statistics of income, and the author. the data only reflects net operating losses carried forward to, and deducted in, 1993. data concerning nols carried back to 1993 is not included. according to table 3, more than half of the corporate nol deductions in 1993 were claimed on returns for corporations with assets in excess of $250 million, the largest asset size category available from irs statistics, and about 63% of those deductions were claimed on returns for corporations with assets greater than $50 million.'07 except for the initial category of returns showing $0 assets, the average nol deduction per claim steadily increases with the size of the corporate claimant, with corporate returns in the largest asset size category claiming an average nol deduction of over $21 million.' moreover, these figures only reflect nol deductions 107. table 3, col. (6), lines 10-12. 108. table 3, col. (7). 19991 florida tax review carried forward to 1993 from a prior taxable year."°9 hence, the average nol carryforward and carryback deduction in 1993 was larger than these numbers. in 1993, there were 12,764 10-k forms filed with the sec, an indication of the number of domestic public corporations in existence in that year."' over 60% of those companies were listed on either the new york stock exchange, the american exchange, or the nasdaq."' data for companies listed on the american exchange in that year indicates a median asset size of $58.3 million and a mean asset size of $330.4 million." 2 nasdaq companies seem to have a similar profile, and new york stock exchange companies appear to be larger. ' 3 thus, as one might expect, it would seem that public c corporations fall disproportionately among the higher asset size categories listed in table 3, the companies with the largest average nol deductions. in light of the fact that net operating losses appear to be so prevalent among subchapter c corporations generally, and that public c corporations appear to have large pools of nol deductions, allowing public firms to be owners of an spbf will significantly increase the chances that these entities will be used to shift sizable amounts of income and loss around." 4 the pools of losses provide potential sources for very deep tax shelters with minimal transaction costs. accordingly, public firms taxed under subchapter c should be excluded from the ranks of owners of an spbf. 109. see michael g. seiders, corporation income tax returns, 1993, 16 sol bulletin 36, 42 (summer, 1996). 110. securities and exchange commission, directory of companies required to file annual reports with the securities and exchange commission under the securities exchange act of 1934 1 (sept. 30, 1993). 111. the breakdown was 4,611 companies for nasdaq, 2,362 for the new york stock exchange, and 869 for the american exchange, a total of 7,842 companies or about 61% of the 12,764 10-k forms filed. see nasdaq mkt data web page (visited july 15, 1997) <http://www.nasd.com/> [hereinafter nasdaq web page]. the statement assumes that the same company was not traded on more than one of the exchanges. 112. american stock exchange, 1994 fact book: equities and derivative securities covering the 1993 market 16 (1994). 113. for 1997, nasdaq reported that the average asset size of its companies was just under $500 million, almost exactly the same average reported by the american exchange for that year. see nasdaq web page, supra note 111; letter from scott slatin, equity research and development, american stock exchange, to peirce moser (aug. 6, 1997) (electronically transmitted) (on file with author). in 1994 and since 1988, to be listed on the new york stock exchange, a company had to have a minimum of $18 million in assets. new york stock exchange, fact book for the year 1994, p. 35 (1995). 114. cf. richard g. cohen & lori s. hoberman, partnership taxation: changes for the '90s, 71 taxes 882, 883 (1993). [vol 4:3 the future taxation of private business finns c. other possible owners.-in addition to corporations, the subchapter s rules prohibit most other entities from being owners.'" clearly, for reasons described above, a private business firm with a public firm owner should not be an eligible spbf owner. to maintain simplicity and to protect the one class of residual ownership interests rule (described below), most other entities should also be excluded as eligible owners. exceptions are provided for estates and certain trusts that qualify under current law as an eligible shareholder of an s corporation." 6 as under current law, however, a qualifying trust may not have as a beneficiary any person who is ineligible to be an owner of an spbf."' an spbf may also have another spbf as an owner. thus, for example, a professional partnership some of whose partners are single-member llcs would satisfy the ownership requirement for an spbf if the llc partners themselves qualify as spbfs. congress recently allowed tax-exempt qualified retirement plans under section 401(a) and charitable organizations under section 501(c)(3) to qualify as shareholders of an s corporation so long as the tax-exempt entity's share of s income is taxable as unrelated business income."' according to the senate report... the present-law prohibition of certain tax-exempt organizations being s corporation shareholders may inhibit employee ownership of closely-held businesses, frustrate estate planning, discourage charitable giving, and restrict sources of capital for closely-held businesses. the committee seeks to lift these barriers by allowing certain taxexempt organizations to be shareholders in s corporations. however, the provisions of subchapter s were enacted in 1958 and substantially modified in 1982 on the premise that all income of the s corporation (including all gains on the sale of the stock) would be subject to a shareholder-level income tax. this underlying premise allows the rules governing s corporations to be relatively simple (in contrast, for example, to the partnership rules of subchapter k) because of the lack of concern about "transferring" income to non-taxpaying persons. consistent with this underlying premise of subchapter s, the 115. irc § 1361(b)(1)(b). 116. irc § 1361(c)(2). 117. irc § 1361(e)(1)(a). 118. irc §§ 1361(c)(6) and 512(e), added by the small business job protection act of 1996. but see irc § 512(e)(3), added by the 1997 act, which repealed the application of the unrelated business income tax to esops that are s corporation shareholders. see martin d. ginsburg, the taxpayer relief act of 1997: worse than you think, 76 tax notes 1790 (1997) (demonstrating how § 512(e)(3) may operate to exempt from tax all of the income of an s corporation for an extended period of time). 19991 florida tax review provision treats all the income flowing through to a tax-exempt shareholder, and gains and losses from the disposition of the stock, as unrelated business taxable income."9 the senate report evidences a desire to increase the flexibility and utility of subchapter s while, at the same time, preserving its relatively simple operating rule structure. these are exactly the same two objectives for an spbf. however, in contrast to the congressional decision in 1996, this article concludes that on balance, it would be preferable to exclude such entities as owners, as was the case for subchapter s prior to 1996. first, allowing such entities to be owners of an spbf, and taxing them on their share of business income, increases the complexity of the rule structure. 2 although the flexibility of an spbf is increased slightly by permitting such owners, it comes with a high price. furthermore, there is a simple alternative to permitting exempt owners of an spbf. if it is truly critical for an exempt entity to participate in a common business venture organized as an spbf, the taxpayers could form a non-spbf partnership or other private enterprise taxable as a conduit, with the owners of such entity being the spbf and the exempt partner.'2 1 thus, the business necessity of allowing an exempt entity to be an spbf owner is far from clear. finally, taxing exempt entities on their share of spbf business income may not eliminate the shifting concerns so central to preserving the simple rule structure applicable to an spbf. table 4 provides data on the 119. s. rep. no. 281, 104th cong., 2d sess. 60-61 (1996), reprinted in 1996 u.s.c.c.a.n. 1474, 1534-35. 120. the peculiar complexities of subchapter k have already started to creep into subchapter s as a result of this 1996 change. section 170(e)(1) of the code, as amended by § 1316(b) of pub. l. no. 104-188, 110 stat. 1755 (1996), says that when stock of an s corporation is contributed to a charity, "rules similar to the rules of § 751 shall apply in determining whether gain on such stock would have been long-term capital gain if such stock were sold by the taxpayer." in other words, on the occasion of such a contribution, an analysis of the s corporation's assets will have to be made to determine what percentage of them are unrealized receivables and inventory. see generally testimony of martin d. ginsburg, professor of law, georgetown university law center, before the subcommittee on taxation of the senate finance committee on s. 758, the s corporation reform act of 1995, 95 tnt 119-19 (june 20, 1995) (lexis, fedtax library, tnt file) ("the proposal to allow as s corporation shareholders tax-exempt organizations and nonresident aliens is i think unwise. inevitably, it must add significant complexity to a tax regime a principal justification for which is its relative simplicity in operation"); small-business bill's subchapter s provisions will spawn more regs., 72 tax notes 965 (aug. 19, 1996) (rule allowing charities and esops to be eligible s corporation shareholders will cause lengthy irs regulations project). 121. see regs. § 1.701-2(d), ex. 2, which explicitly blesses this type of arrangement. [vol 4:3 the future taxation of private business firms unrelated business income and loss reported by section 501(c)(3), section 401(a), and all tax-exempt organizations in 1993, the latest year for which such data is available. table 5 then provides data on the net operating loss deductions claimed by such organizations in that year. table 4 unrelated business (ub) income and loss reported by section 501(c)(3), section 401(a), and all tax-exempt organizations (1993) (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) type of # rets. # w/ %w/ #w/ %w/ # w/ %w/ tot. avg. loss exempt w/ub pos. ub pos. ub $0 ub $0 ub ub ub loss per loss org. inc.loss inc. inc. inc. inc. loss loss (s ail) org. (3)-+(2) (5)+,(2) (7)-.(2) (9y+-(7) 501(c)(3) 9,246 3,191 34.5% 1,204 13.0% 4,851 52.5% 1,001.6 s206.473 401(a) 1,135 718 63.3% 163 14.4% 254 22.4% 19.4 76.378 all 32,638 15,067 46.2% 4,805 14.7% 12,766 39.1% 1,650.8 129,312 source: margaret riley, exempt organization business income tax returns: highlights and an analysis of exempt and nonexempt finances, 1993, 16 sol bulletin 75, 91-92 (spring 1997) (tables 1 and 3). certain information was obtained directly from ms. riley, a statistician in the special studies and publications branch, statistics of income. table 5 nol deductions claimed by section 501(c)(3), section 401(a), and all tax-exempt organizations reporting unrelated business (ub) income or loss (1993) (1) (2) (3) (4) (5) (6) type of # rets. # rets. % rets. nol avg. nol exempt wi ub w/nol w/nol ded. ded. per org. inc./loss ded. ded. (s m) claim (3)-(2) (5)-(3) 501(c)(3) 9,246 2,516 27.2% $ 783.3 $311,328 401(a) 1,135 313 27.6% 17.8 56,869 all 32,638 6,844 21.0% $1,342.8 $196,201 source: margaret riley, exempt organization business income tax returns: highlights and an analysis of exempt and nonexempt finances, 1993, 16 soi bulletin 75, 91, 97-98 (spring 1997) (tables 1 and 7). certain information was obtained directly from ms. riley. the data only reflects net operating losses carried forward to, and deducted in, 1993. data concerning nols caried back to 1993 is not included. 1999] florida tax review according to table 4, almost two-thirds of the section 501(c)(3) organizations reporting unrelated business income or loss in 1993 reported either zero income or a net loss for the year.'22 over half of them reported a net loss, with an average loss per section 501(c)(3) "loss" organization of over $200,000. 123 the total loss reported by such organizations was just over $1 billion. 24 table 5 indicates that more than one-fourth of all section 501(c)(3) organizations reporting unrelated business income or loss claimed a net operating loss deduction from a prior year loss in 1993, with an average nol deduction per claim of over $300,000."' 5 about $783 million in such nol deductions were claimed in that year. 126 these figures suggest that the tax profile of section 501(c)(3) organizations involved in unrelated business activities may not be markedly different from that of public c corporations. a substantial number of section 501(c)(3) organizations report either no income or losses for tax purposes from their unrelated activities, and although their average claimed nol deduction is small in comparison with the average nol deductions of the largest taxable corporations, the deductions are nevertheless significant in size. 27 like their corporate counterpart, those deductions could provide ample shelter opportunities in any given case. perhaps these conclusions should not be surprising; after all, if an exempt organization is taxed on its unrelated business activities in the same manner as a taxable corporation, then one might expect a similar resulting tax profile to those corporations. indeed, some have suggested that the tax rules for computing unrelated business taxable income are more favorable than for calculating taxable income generally because the former may allow the deduction against unrelated business income of expenses attributable to the exempt function of the organization. 2' obviously, the more favorable the 122. table 4, cols. (6) and (8), line 1. 123. table 4, cols. (8) and (10), line 1. 124. table 4, col. (9), line 1. 125. table 5, cols. (4) and (6), line 1. 126. table 5, col. (5), line 1. 127. compare table 3, col. (7), lines 10-12 with table 5, col. (6), line 1. in addition, just like the other data on nol deductions, the figures in table 5 do not include loss carrybacks to 1993. see margaret riley, exempt organization business income tax returns: highlights and an analysis of exempt and nonexempt finances, 1993, 16 soi bulletin 75, 84 (spring, 1997). thus, the actual nol deductions of exempt organizations are larger than the numbers shown in columns (5) and (6) of table 5. 128. see u.s. house ways and means oversight subcommittee ubit recommendations (draft), reprinted in 88 tnt 132-5 (jun. 24, 1988) (lexis, fedtax library, tnt file) ("there has been evidence of excessive, and in some cases possibly abusive, allocations to taxable uses of various expenses ... attributable to [facilities used for both exempt and nonexempt purposes]. in these cases, net income from taxable activities may be greatly reduced or completely eliminated simply through liberal expense allocations."). for additional [vol. 4:3 the future taxation of private business firms tax rules, the greater the possibility of generating losses for tax purposes. in any event, whatever the explanation, it would seem that for the same reasons that public c firms are excluded as owners of an spbf, section 501(c)(3) organizations should also be excluded.' 29 the case for excluding taxpayers qualifying under section 401(a) is less clear. as shown on tables 4 and 5, fewer of them than section 501(c)(3) organizations report losses, and the average amount of losses reported and net operating loss deductions claimed is much less.' on the other hand, the issue of permitting them to be an spbf owner may not be very significant, as only 1,135 section 401(a) organizations reported any unrelated business income or loss at all in 1993, 13 and just a fraction of them reported income from partnerships and therefore might be expected to be potential owners of an spbf in the future. 13 therefore, for the other reasons stated above, it seems preferable to exclude them as owners as well. in summary, exempt entities are treated like almost all other entities and are excluded from ownership of an spbf. much the same reasoning supports excluding nonresident aliens as owners of an spbf. ascribing the firm's activities to the nonresident alien, as in the case of a foreign partner in a partnership or a foreign beneficiary of a trust or estate engaged in a trade or business in the united states,'33 thereby creating a trade or business in the united states for the foreigner and serving as a basis for taxing the foreign person on the u.s. profits of the enterprise, would add complexity to the spbf structure. there would also be the administrative problem of collecting any resulting tax on undistributed income from the foreign person."l in addition, the business necessity of discussion of this issue, see john copeland & gabriel rudney, business income of nonprofits and competitive advantage, 33 tax notes 747, 752-53 (1986); thomas a. troyer, changing ubit: congress in the workshop, 41 tax notes 1221, 1224 (1988). 129. the charities reporting unrelated business income or loss are, of course, just a small fraction of the roughly 500,000 nonprofit charitable organizations recognized by the irs under § 501(c)(3). but the tax profile of that small subset of charities is very relevant to this analysis. the most likely charities to own an spbf in the future, if the rules allow it, are those that have previously served as partners in partnerships, and therefore have received and reported unrelated business income. 130. see table 4, cols. (8) and (10), compare lines 1 and 2; table 5, col. (6), compare lines 1 and 2. 131. see table 4, col. (2), line 2. 132. only 2,690 exempt organizations out of the 32,638 reporting any unrelated business activities in 1993, about 8%, reported income or loss from partnerships. see riley, supra note 127, at 95 (table 6, col (11)). 133. irc § 875(1) and (2). 134. section 1446(a) requires a partnership with effectively connected income and a foreign partner to pay a withholding tax on the portion of such income allocable to the foreign partner. the withholding tax obligation arises regardless of whether there is any 19991 florida tax review permitting foreigners to own an spbf is not clear, in view of the alternative means available to accomplish that investment objective.'35 finally, a foreigner who is in a low u.s. income tax bracket may nevertheless be a "high-bracket" taxpayer if worldwide income is considered, in which case assumptions regarding the lack of financial sophistication of such a taxpayer would be inapplicable. for these reasons, as is true for existing subchapter s, nonresident aliens are excluded as eligible owners of an spbf.'36 d. summary.-in summary, individuals other than nonresident aliens may be owners of an spbf. the only other permissible owners are estates, trusts that are allowed to be shareholders of an s corporation under current law, and other spbf firms. public firms taxed under subchapter c may not be owners of an spbf. 2. only one class of residual ownership interests.-although the ownership restrictions for an spbf are designed to insure that most owners have roughly the same tax profile and therefore cannot easily benefit from income and loss shifts between one another, such rules are not effective at precluding strategic shifts of categories of income and loss and other tax items. for example, two high-bracket owners would not ordinarily benefit from shifting ordinary income from one to the other. but if one owner had unused capital losses and the other did not, the two owners might both benefit from a shift of capital gains to the owner with the capital losses. the availability of strategic shifts involving particular categories of tax items is limited, however, if all ownership interests of an spbf have identical rights to income, loss, distributions, and liquidation proceeds of the firm and the allocation of all tax items has to be done in the same straight-up manner in accordance with the per-day, per-interest share of each owner."' in effect, such a rule eliminates the possibility of item allocations. all tax items would have to be allocated in the same way. thus, a one-class-ofownership-interest rule may be a useful complement to the ownership restrictions of an spbf to restrict the availability of shifting strategies within an spbf. another reason to include such a requirement is to reduce the complexity of the spbf operating rules. the one-class-of-stock rule in the distribution to the foreign partner and whether the partnership's income is reflected in cash. the provision, enacted in 1986, requires the tax to be paid in accordance with treasury regulations, which to date, have not been issued. 135. see supra note 121 and accompanying text. 136. a proposal to make them eligible was not included in the small business job protection act of 1996. 137. cf. regs. § 1.1361-1(0(1). [vot 4:3 the future taxation of private business firms subchapter s area has been explained as "prevent[ing] complexities in attributing the corporate distributions to the various shareholders."'33, those complexities certainly do exist in the rules applied to partnerships, trusts and consolidated groups, none of which imposes restrictions on ownership classes. as just one example, the partnership rules contain strict and extensive requirements regarding the maintenance of the capital accounts of the partners in order to validate the special allocations of the partners, whereas the s corporation rules have no comparable requirement. in the ideal, the spbf rules would not require owners of the firm to maintain capital accounts in any particular way. on the other hand, if the spbf eligibility conditions are too restrictive, they would be contrary to the objective of providing a simplified rule structure to as many private business firms as possible. thus, it is not clear that an spbf would have to have only a single class of ownership interests as that concept is interpreted under existing subchapter s. consider, for example, two taxpayers, a and b, who decide to contribute $5,000 each to a common business venture. a would like a relatively certain and safe return on his or her investment with the understanding that there will be little or no upside potential beyond that safe return. b is willing to go along with a's request and to assume the risk of all losses beyond the amounts contributed so long as b will garner all of the upside potential in excess of the return belonging to a. under current law, the two investors can utilize an s corporation only if a's investment is treated as debt rather than equity.139 if, for good business reasons such as the insistence of a third-party lender to the firm, a loan from a is not feasible, then an s corporation cannot accommodate them; they would have to form a partnership or other unincorporated entity and be taxed under subchapter k."o 138. barnes motor & parts co. v. united states, 309 f. supp. 298, 301 (ed. n.c. 1970); see also paige v. united states, 580 f.2d 960, 963-64 (9th cir. 1978). the barnes opinion suggests that all the restrictions in § 1361(b)(1) can be explained on this basis. that includes the number of shareholders, the prohibition of a shareholder who is not an individual, and the prohibition of a nonresident alien shareholder. see also supra note 83. 139. see irc § 1361(c)(5) (straight debt not considered second class of stock). 140. the granting of compensatory options to shareholder-employees of the s corporation is one way of achieving some flexibility within the constraints of the s corporation's one-class-of-stock rule. see james s. eustice & joel d. kuntz, federal income taxation of s corporations 6.04 (3d ed. 1993); berger, supra note 63, at 141. the regulations specifically bless certain forms of such options. see regs. § 1.13611(/(4)(ii)(b)(2). on the other hand, the regulations indicate that if the state corporation commissioner imposes a restriction on the distribution rights of certain shareholders, the restriction may constitute a second class of ownership and therefore prevent qualification as an s corporation. see regs. § 1.1361-1(/)(2)(v), ex. (1); paige v. united states, 580 f.2d 960 (9th cir. 1978). permitting the firm to issue a class of straight preferred ownership interests would overcome that obstacle. 19991 florida tax review one method of accommodating the foregoing business arrangement would be to allow the entity to issue the equivalent of plain vanilla preferred stock. 4 ' the proposal would permit a class of ownership interests to be issued with a clear priority over the only other class of interests, and return on the preferred class would be fixed and limited to the earnings of the entity. in the foregoing example, a might own all of the preferred interests and be allocated the first slice of entity income. b would own all of the remaining, residual interests, and be allocated any losses of the firm and all income beyond the initial slice belonging to a. could the existence of two classes of ownership interests, one with clear income priority over the other, be manipulated by the parties? one possible concern might be the "skimming" of income to part-year owners. consider a calendar year firm that issues a new class of preferred interests on december 31. if there is nothing to limit the amount of income that could be allocated to the one-day owner of the preferred interest, the newly-issued interest would allow manipulation of the firm's income for the year. in an extreme case, the preference could be such that all of the firm's income for the year would be allocated to the new owner and away from the holders of the residual interests. 42 but a similar problem arises under existing subchapter s and, as a result, section 1377 requires the firm to divide up its income pro rata among the days of the year. thus, one who acquires all of the stock in an s corporation under existing law on the last day of the year cannot be allocated all of the corporation's income for the year. as long as the preferred class of ownership interests is restricted in the same way, the possibility of manipulation from such a maneuver appears to be reduced or eliminated.4 3 141. such a proposal was included in the "s corporation reform act of 1995," s. 758, reproduced at 95 tnt 88-5 (may 5, 1995), § 121 (lexis, fedtax library, tnt file). however, it was not part of the subchapter s liberalizations contained in the small business job protection act of 1996, pub. l. no. 104-188, 110 stat. 1755 (1996). 142. the "s corporation reform act of 1995," s. 758, reproduced at 95 tnt 88-5 (may 5, 1995) (lexis, fedtax library, tnt file), as drafted, appears to have allowed for such manipulation. it would have added § 1361(c)(8) to the code, under which distributions on qualified preferred stock (stock described in § 1504(a)(4)) would have been treated as interest payments. there is no indication that the holder of the stock on the record date would not have been credited with the full amount of interest no matter how short a time period the stock had been held. in any event, this provision did not become part of the small business job protection act of 1996. 143. income of the entity would first be allocated to each day of the taxable year. hence, if an owner acquires all of the preferred interests on the last day of the year, that owner can get allocated at most all of the income of the entity allocated to that day. that result would occur no matter how great the preference of the ownership interest. at most, an interest with a large preference could be allocated all the firm's income earned for the year properly allocable to the period that the interest was outstanding. [vol 4:3 the future taxation of private business firms other concerns relate to the character of income allocated to the preference holder. for example, suppose a is provided a preferential interest equal to the first $1,000 of the firm's income, with any additional income and all losses to be shared equally by a and b. suppose during the year, the firm has only $1,200 of capital gain income, a fact reasonably known to the parties at the time the preferential interest was created. should a's preference then mean that a is allocated $1,100 and b $100 of the firm's capital gains for the year? if so, it is evident that the strategic utilization of preferential interests could easily permit the equivalent of special item allocations.'" to avoid such possibilities and to be consistent with the "debt-like" characterization of the preferred interest, any income allocated to the preference holder should be treated as ordinary income with the firm being provided with an ordinary deduction.' the preference should not in any other respect affect the amount or character of tax items allocated to the owners of the firm." thus, in the above example, a would be allocated $1,000 of ordinary income and would share equally with b in the $1,200 of capital gain and the $1,000 ordinary deduction of the firm. the tax result would be the same as if a had loaned funds to the firm and been entitled to a $1,000 interest payment that year. if the firm has enough income to support the preference but does not distribute the full preferred amount, one possible rule would be to defer the tax consequences of the unpaid amount until paymenl' 47 alternatively, the 144. moreover, if the firm had, say, $1,200 of capital gains and s800 of ordinary income for the year, what should be the character of a's income preference? 145. section 201 of s. 758, the "s corporation reform act of 1995," supra note 141, would have imposed this requirement with respect to its qualifying preferred stock interest. 146. id. at § 201(b)(2) (holders of preferred stock not allocated any of the s corporation's § 1366(a)(1) items). 147. this treatment would be consistent with an idea long advocated by professor eustice in connection with subchapter s. professor eustice would permit an s corporation to have a single class of common stock and any number of classes of preferred stock, including participating preferred (which he would treat as preferred stock, and not common, in his allocation scheme). dividends actually paid on the preferred stock would be taxable as ordinary income to the shareholders without regard to the corporation's earnings or profits or other indication of income, and the corporation would be allowed to deduct the amount of dividends actually paid. thus, he would place both shareholders and the corporation on the cash method of accounting with respect to dividends. the corporate dividends-paid deduction could not, however, create a loss; the excess of such a deduction over corporate income would have to be carried forward within the entity. other losses and any remaining income of the firm would be passed through to the common shareholders on a per-day, per-share basis. see james s. eustice, subchapter s corporations and partnerships: a search for the pass through paradigm (some preliminary proposals), 39 tax l. rev. 345, 366 (1984) (a single class of preferred stock); eustice & kuntz, supra note 140, at 1.0312][b][v] (multiple classes); see also berger, supra note 63, at 141 (endorses eustice and kuntz proposal); aba section of 1999] florida tax review allocation of ordinary income (with accompanying ordinary deduction for the firm) might take place in the current year, as would generally be true in the case of a deferred payment of interest. 48 in that case, if the preference is not satisfied by the time the holder terminates his or her investment in the firm, then the tax treatment would be the same as cancellation of a debt obligation-the preference holder would be entitled at that time to a bad debt deduction and the firm would have cancellation of indebtedness income. other possible manipulative uses of a preferred interest would be mitigated by the ownership restrictions of an spbf. suppose, for example, that preferred interests and residual interests of the same firm could be exchanged tax-free, either directly in a tax-free recapitalization or indirectly through a combination of contributions and distributions. the special allocation rules in the partnership area basically permit tax-free exchanges because allocations can be changed from one year to the next without tax consequences. ordinarily, if investors a and b could change their positions as preferred and residual interest holders from one year to the next without tax consequences, then important tax advantages might result. but the extent of the advantage would depend upon how different the investors' tax profiles are, something the ownership restrictions are designed to restrict. in summary, the proposal merely limits an spbf to having only one class of residual ownership interests. every outstanding interest in the residual class must confer identical rights with respect to income, loss, distributions, and liquidation proceeds of the firm. multiple classes of preferred interests are permissible provided that a clear order of priority for the different preferred interests is established. all preferences should constitute ordinary income to the preference holder and generate an ordinary deduction to the firm. any income of the firm not allocable to the preferred interests, and all losses of the firm, are allocable to the class of residual interest holders in a proportional manner based on their percentage interests and the number of days in the year they owned such interests. 3. other eligibility conditions not proposed.-several other possible eligibility conditions for an spbf were considered in addition to, or in some cases as substitutes for, the ones described above. this section briefly describes why they are not included in the proposal. taxation committee on s corporations, report on the comparison of s corporations and partnerships (part i), 44 tax law. 483, 494 (1991) (single class of stock requirement should be altered). 148. see irc § 1272(a). similarly, a guaranteed payment which is deducted or capitalized by a partnership must be included currently in the income of a cash-basis partner even though the amount is unpaid. see william s. mckee, william f. nelson & robert l. whitmire, federal taxation of partnerships and partners 13.03[2] (3d ed. 1997). [vol 4:3 the future taxation of private business firms a. number of owners.-there is no restriction on the number of permissible owners for a partnership, ric, reit, remic, fasit or cooperative. 49 in contrast, an s corporation may not have more than 75 shareholders.5 0 the irs has indicated that the purpose of the limitation on the number of shareholders of an s corporation is "administrative simplicity in the administration of the corporation's tax affairs."'' the service has nevertheless allowed a number of s corporations to join together in a partnership even though that arrangement could be viewed as a way to avoid the limitation on the number of shareholders in an s corporation (and, indeed, was so viewed by the irs at one time).152 a major source of complexity in subchapter k is the allocation rules which attempt to prevent the inappropriate shifting of tax items among owners of a firm. in contrast to the eligibility conditions for an spbf already identified, it does not appear that the availability of shifting strategies is affected by the number of participants in the enterprise. true, the greater the number of owners, the greater the potential that taxpayers with distinctly different tax profiles will participate together in a common venture. but important tax advantages may exist even though a firm has only two owners. and the fewer the number of owners, the greater the flexibility in devising an advantageous shifting strategy. moreover, as a practical matter, very few private businesses have a large number of owners. for example, in 1994, over 90% of all partnerships and almost 99% of all s corporations had 10 or fewer owners,' 3 and comparable figures seem likely for closely-held c corporations. thus, any reasonable limitation on number of owners would not likely have much impact on spbf eligibility."s 149. a fasit may have only one holder of its ownership interest but any number of holders of its regular interests. irc § 860l(a)(1)(b) and (c). 150. irc § 1361(b)(1)(a), as amended by the small business job protection act of 1996. 151. rev. rul. 94-43, 1994-2 c.b. 198. 152. id.; cf. regs. § 1.701-2(d), ex. (2) (blessing partnership between nonresident alien and s corporation to avoid restrictions of § 1361(b)(i)(c)). the service's prior contrary position was stated in rev. rul. 77-220, 1977-1 c.b. 263. 153. in 1994, about 68% of all partnerships and 90% of all s corporations had three or fewer owners. for the s corporation data, see susan m. wittman, s corporation returns, 1994, 16 soi bulletin 38,74 (spring 1997) (table 5). the information about partnerships was obtained in a telephone conversation between the author and mr. tim wheeler, a statistician in the corporation special projects section, statistics of income, internal revenue service. 154. congress's recent amendment of the subchapter s rule provides no guidance regarding what the proper limit on the number of owners should be, assuming one is imposed. congress tersely explained its reasons for increasing the allowable number of s shareholders from 35 to 75 in the following way: "the committee believes that increasing the maximum number of shareholders of an s corporation will facilitate corporate ownership by additional 19991 florida tax review in short, any limitation on the permissible number of owners of an spbf would seem to be an arbitrary and ineffectual restriction insufficiently linked to the availability of potential tax advantages of such a firm, and is therefore not proposed. b. ownership of other entities.-until recently, the s corporation rules prohibited an s corporation from being part of an affiliated group 55 since s corporations may not have corporate owners, the major effect of this rule was that s corporations could not own more than 80% of the stock of another corporation (unless it was an inactive corporation). on the other hand, s corporations were permitted to be partners in partnerships, to be members of cooperatives, and to own stock in rics and reits. the restrictions on stock ownership by s corporations have now been repealed, although s corporations are prohibited from filing consolidated returns.'56 s corporations are now also allowed to be 100% owners of other s corporations, which are then not treated as separate entities. 57 rics and reits are limited in the amount of their assets that can be invested in particular companies.15 the rules applicable to rics and reits, however, are not functions of the conduit nature of those entities. rather, they relate to their roles as investment vehicles for relatively small investors, and a securities law concern that such vehicles be sufficiently diversified so as not to be too risky for such investors.'59 consistent with congress's recent change regarding s corporations, there does not seem to be any reason to impose any restrictions on the particular type of entity an spbf may own. c. nature of income.-eligibility for certain pass-through entity regimes under current law is conditioned on the nature of the firm's income or business activities. but the significance of a firm's passive or family members, employees and capital investors." s. rep. no. 281, 104th cong., 2d sess. 45 (1996), reprinted in 1996 u.s.c.c.a.n. 1474, 1519. congress's reasoning may justify a number greater than 35, but doesn't explain the reason for stopping at 75. 155. see former irc § 1361(b)(2)(a), repealed by the small business job protection act of 1996, pub. l. no. 104-188, § 1308(a). 156. see irc § 1504(b)(8), added by the small business job protection act of 1996, pub. l. no. 104-188, § 1308(d)(2) (excepts s corporations from the definition of "includible corporation"). this change tracks a suggestion made by professor eustice. see eustice, supra note 147, at 360. 157. see irc § 1361(b)(3), added by the small business job protection act of 1996, pub. l. no. 104-188, § 1308(b). 158. see irc §§ 851(b)(4) and 856(c)(5)(b). 159. the relevant provisions are referred to as diversification of investment requirements. see regs. §§ 1.851-2(c) and 1.856-2(d). [vol 4:3 the future taxation of private business firms active income or business activity is not coherent across the different tax regimes. for a trust to be classified as such, it cannot be engaged in an active business. in the past, failure to qualify as a trust would probably have doomed the trust to be taxed as a corporation, but that is no longer true under the check-the-box classification regulations."6 on the other hand, s corporations with earnings and profits from their operations as c corporations are currently subject to tax if they have excessive passive income.161 most income of rics must come from investment sources,' 62 and the income of reits must come substantially from real estate investments that must be relatively passive in nature." remics are generally limited to holding mortgages and other passive investments,'(' and fasits are similarly limited to certain short-term debt instruments. 65 partnerships generally have no limitation on the type of income that they can earn, except that partnerships with publicly traded ownership interests escape corporate classification if 90% or more of their gross income consists of certain categories of "qualifying income."'" 160. although the former classification regulations provided that an entity that failed trust classification could be classified as either a partnership or an association, see former regs. § 301.7701-4(b), the four factor test usually resulted in entities formed as trusts being classified as corporations. trusts would generally have limited liability, free transferability of interests, and centralized management, and would be classified as associations with those three corporate characteristics. the check-the-box regulations treat failed trusts as "business entities." and therefore permit them to make an explicit entity classification election for tax purposes. see regs. § 301.7701-4(b). 161. see irc § 1375. 162. irc § 851(b)(2) provides that at least 90% of the gross income of a ric for any taxable year must be from dividends, interest, payments with respect to security loans, and gains from the sale of stocks, securities, foreign currency, or other investment income. since failure to satisfy this requirement would cause the ric to be disqualified, the management of a ric is likely to stay comfortably above the 90% line. rics are subject to additional restrictions, including those relating to the assets they hold, see irc § 851(b)(4), as well as restrictions imposed on them so that they can comply with the investment company act of 1940. 163. the income restrictions applicable to reits can be found in irc § 856(c)(2) and (3). key to the limitation on the reit income are the restrictions applicable to "rents from real property" that are found in irc § 856(d). excluded from "rents from real property" are rents that are based on a tenant's income or profits, and rents received when the reit (as opposed to an independent manager) provides services to the tenants or runs the property, see irc §§ 856(d)(2)(a), (c). 164. see irc §§ 860d(4) and 860g(a)(3) and (5). 165. see irc §§ 860l(a)(1)(d), (c)(1). 166. see irc § 7704(c)(1). "qualifying income" is generally passive-type income although it also includes certain potentially active income from businesses engaged in the extractive industries. see irc § 7704(d)(1). 19991 florida tax review as can be seen from the foregoing brief review, there are contradictory views of the importance of passive or active income or business activities in the context of pass-through entities. do the various conditions of current law provide any basis for imposing similar restrictions on the nature of an spbf's income or activities? perhaps the reason for the special rules in the trust area is a problem unique to that form of entity-the problem of taxing income to unknown beneficiaries, such as an unborn child. one author has suggested that, in such a situation, a withholding tax should be imposed on the entity at the highest individual tax rate, and that the law, through relatively mechanical rules, would then determine which potential beneficiary is the proper taxpayer.'67 that "taxpayer" can then take a credit (with the possibility of generating a refund) in respect of the trust's prior withholding tax payment. in other words, the trust would be subject to a temporary entity tax with a relief mechanism to avoid double taxation. the proposal helps to bring the taxation of trusts and estates closer to the taxation of other pass-through entities. the nature-of-income limitations for rics, reits, remics, fasits, and publicly traded partnerships may simply be part of the tax law's condition for permitting such publicly traded entities to obtain pass-through treatment. in addition, there may be securities law reasons for some of the limitations. if there were no such limits, the pass-through regime could become the norm for all businesses-for example, general motors could become a ric. because there is no consensus regarding why the income of public firms should be taxed twice, it is not surprising that the exact nature of these restrictions cannot be explained from first principles. instead, one might simply conclude that a limitation may be needed in order to maintain the integrity of the double tax system as applied to public firms, whether such a system can be justified or not. in the s corporation context, the rules of section 1375, which restrict the ability of s corporations to receive passive income, raise issues that are essentially transitional in nature. an s corporation with no c corporation history will not run afoul of this rule. in conclusion, there is no apparent reason to limit the nature of income or business activity of an spbf. existing restrictions applicable to other entities seem designed to either protect the double taxation of the income of public firms, protect transitional concerns when a double-taxed entity is converted into a single-taxed one, or respond to features peculiar to that entity. because these explanations are not applicable to an spbf, no such restrictions are included in the proposal. 167. sherwin kamin, a proposal for the income taxation of trusts and estates, their grantors, and their beneficiaries, 13 am. j. tax pol'y 215 (1996). [vol 4:3 the future taxation of private business firms d. size of enterprise (measured by assets, sales, income, or some other measure).-the tax statute is littered with past congressional efforts to provide special treatment for "small businesses." these provisions are in addition to the many special rules applicable only to subchapter s corporations. most of the provisions define small businesses in terms of gross receipts, but assets and other tests have been employed as well.' 68 in addition to its other eligibility conditions, should an spbf be limited by size? from the treasury's perspective, smaller enterprises generally present tax issues of only limited significance. thus, if a more relaxed set of operating rules eliminating some of the protective features of subchapter k is to be provided to a subset of firms, it might make sense to limit the availability of those rules to small businesses. from the taxpayer's vantage point, small businesses are likely to have less sophisticated owners and advisors than larger businesses. therefore, small businesses would particularly benefit from a simplified tax rule structure. although larger businesses would also benefit from simplification, they might have alternative means not available to smaller businesses of coping with tax law complexity. 168. see, e.g., irc §§ 44(b) (business with gross receipts not exceeding s1 million or one having no more than 30 full-time employees), 55(e)(1) (corporation with average annual gross receipts for three preceding years not exceeding $5 million (or $7.5 million after 1997)), 447(d) (gross receipts not exceeding $i million or, in certain cases, $25 million), 448(c) (average annual gross receipts for three preceding years not exceeding $5 million), 474(c) (same), 6721(d)(2)(a) (same), 263a(b)(2)(b) (average annual gross receipts for three preceding years not exceeding $10 million), 460(e)(1)(b) (same), 613a(d)(2) (certain gross receipts may not exceed $5 million), 508(c)(1)(b) (gross receipts normally not more than $5,000), 6033(a)(2)(a)(ii) (same), 6113(b)(2)(a) (gross receipts normally not more than $100,000), 1044(c)(3) (any partnership or corporation licensed by the sba under § 301(d) of the small business investment act of 1958), 1202(d)(1) (gross assets not exceeding s50 million), 1244(c)(3) (shareholder contribution, including paid-in surplus, not exceeding si million), 243(a)(2) (must be small business investment company operating under the small business investment act of 1958), 246a(b)(2) (same), 582(c)(2)(a)(iii) (same), 1242 (same), 1243 (same), 542(c)(8) (same, except that firm must be actively engaged in business of providing funds to small business concerns), 220(c)(4) (average of 50 or fewer employees during either of two preceding calendar years), 4980d(d)(2) (average of at least two but not more than 50 employees during preceding calendar year), 6053(c)(4) (10 or fewer employees during preceding calendar year). certain other provisions are designed to be limited to small businesses through a phase-out or other mechanism. see, e.g., irc §§ 1 l(b) (phase-out of low brackets for corporations with higher income), 179(b)(2) (phase out of § 179 expensing benefit where amount of § 179 property placed in service begins to exceed $200,000), 195 (special rule limited to "start-up expenditures"). similar rules have been included in recent proposals. see, e.g., treasury integration report, supra note 28, at 42 (businesses with gross receipts less than $100,000 not subject to cbit); berger, supra note 63, at 165 (distinguishes one-tier from two-tier entities based on their total revenues, with the dividing line between so million and $50 million). 1999] florida tax review one problem with a "small business" condition is developing a proper definition for that term. a dollar-size rule establishes a bright line, but it is unclear whether a dollar-size limit should apply to assets, receipts, taxable income, some combination of the foregoing, or something else. "receipts" seem to draw too arbitrary a line between capital-intensive and service-based firms; such a distinction appears unrelated to either the tax advantage potential of the firm or its need for a simple operating rule structure. "taxable income" is probably too inaccurate a proxy for "small business." in addition, "taxable income" presents the greatest boundary problems, given how common it is for business income to fluctuate from year to year. 69 an asset-based test is reasonably stable and somewhat representative of "small business," yet it entails the potential disadvantage of requiring periodic valuations. 70 it also may arbitrarily distinguish service businesses from others. 17 1 in short, any test for small business seems either too arbitrary or unworkable, and prior efforts to define small business for tax purposes do not appear helpful. another problem with a rule providing preferential treatment to small businesses is the need to prevent division of a single enterprise into parts small enough to qualify for that treatment. a number of existing provisions undertake to accomplish this task, but none seems consistent with a goal of keeping the system simple. 72 a further concern of any dollar-size rule is the boundary problem created: how should firms be treated when they flipflop onto different sides of the applicable dollar threshold? a more fundamental concern is that any dollar size rule would exclude too many firms. some larger firms, used to the relative simplicity of subchapter s, would be forced to be taxed under more complex conduit rules such as subchapter k. although a larger firm willing to engage in a less 169. see berger, supra note 63, at 162-63. 170. the proper treatment of debt is also problematic under an asset-based test. see berger, supra note 63, at 163. one possible way of reducing the valuation burden is to value a firnm as of the last noncash contribution to or distribution from the entity, when some value for the firm was presumably agreed to by the parties, adjusted by the book value of any net accumulations since that time. but such a rule seems to ignore substantial value, such as the value of any asset appreciation of the firm since the time of the last noncash contribution or distribution. in addition, the rule appears to permit the firn to transact a very large economic deal and still qualify under the applicable dollar test so long as there is a contemporaneous distribution of the proceeds of the deal to the owners of the firm. that outcome does not seem consistent with a small business limitation to the spbf rules. 171. see timothy d. wheeler, partnership returns, 1994, 16 soi bulletin 76, 78 (fall 1996) (figure d) (setting forth net income, total receipts, and total assets of partnerships by industry). 172. see, e.g., irc §§ 44(d)(2) and (3), 220(c)(4)(d), 474(d)(1), 1202(d)(3); cf. irc § 1561. [vol 4.3 the future taxation of private business firms flexible business arrangement can always obtain a fairly simple tax regime within the confines of regular subchapter k, it is much easier for taxpayers to proceed under a prepackaged set of simple tax operating rules than to tailor their own set to accommodate their individual business needs. if the theory of the other eligibility conditions of an spbf is sound, then the size of the enterprise should not matter. in that regard, the subchapter s rules have never included a size-of-enterprise limitation. some thought was also given to using a dollar size test as the exclusive eligibility condition for firms entitled to a simpler set of tax operating rules. the theory is that firms under a certain economic size do not likely comply with a more rigorous set of rules anyway; the irs is not likely to discover whether they do or do not comply; and their small size makes any resulting tax advantage to the owners a relatively modest concern to the treasury. hence, a highly simplified operating rule structure could be provided to such firms without much effect on the fisc. such an approach would, of course, place considerable pressure on the definition of "small business" in order to prevent large firms or economic deals from obtaining the greater tax advantages presumably available under the simple version of subchapter k. moreover, even a foolproof definition would apparently not preclude wealthy and sophisticated taxpayers from engaging in small economic deals through such small business firms, thereby obtaining certain tax advantages not otherwise available. thus, a market of spbf tax shelters might develop for the middle and upper income taxpayer. this concern might be alleviated if the dollar size limitation is low enough to make purely tax-motivated transactions uneconomic, but of course, an excessively low threshold would then exclude a number of deserving firms. finally, a nagging concern about such an approach is whether it would ultimately result in any practical benefit to anyone, including particularly the small economic firms to which the rules would be targeted. given the complexity of subchapter k, the lack of significant irs auditing of firms subject to those rules, and the general feeling that large parts of subchapter k are misapplied even by very knowledgeable practitioners, it may well be that many small firms (as well as some not so small ones) already utilize a watered-down, intuitive version of subchapter k. this "intuitive k," which is surely different things to different people, may well continue to govern the world of small firms (and some large ones), regardless of what this article might propose and what the congress might someday enact. if so, then a simplified operating rule structure limited to small economic firms may ultimately be nothing more than an attractive nuisance for which some sophisticated practitioners may find improper uses. for all of the foregoing reasons, the proposal does not contain any test based on the size of the enterprise. 19991 florida tax review c. operating rule provisions of the simplified system this section sketches out the principal operating rule provisions for the spbf system. 1. explicitly elective system.-the spbf operating rules to be described should be explicitly elective to qualifying taxpayers. because the rules are intended to be more administrable than subchapter k generally, some thought was given to making the rules mandatory for qualifying firms. in theory, a mandatory rule would eliminate the cost to taxpayers of determining whether and how to elect the rules and would promote greater use of the simplified spbf system. in reality, however, a mandatory rule may not achieve either objective. even without an explicit election, well-advised taxpayers may nevertheless attempt to determine whether the simplified system is more favorable to them than the default operating rule system. to avoid the spbf rules, a taxpayer need only fail one or more of the eligibility conditions for an spbf. in that sense, the spbf rules are elective one way or the other, and there seems to be no good reason to force taxpayers to utilize transactional devices to avoid them. hence, the proposal provides for an explicit election. because some taxpayers, including certain smaller, unsophisticated firms for which the spbf rules are specifically designed, may not be aware of the existence of an election or may fail to comply with whatever procedure is established for executing it, the proposal provides only for a permissible election by any spbf out of the simplified conduit version. a failure to elect automatically means the spbf is taxed under the simplified system.' the subchapter s election under current law is different from the above. eligible corporations must affirmatively elect into subchapter s and all shareholders must consent to the election. 74 failure to make the s election means the corporation is taxed as a separate entity under subchapter c. presumably, congress wanted to avoid surprising shareholders regarding the effect of the conduit election of subchapter s, with the accompanying counterintuitive obligation on their part to report their share of undistributed items in the current year."7s hence, it makes sense to require an affirmative s election under current law. this article recommends, however, that all private business firms shall be taxed as conduits. if that recommendation is 173. both the installment sales and entity classification elections operate in this fashion. see irc § 453(d); regs. § 301.7701-3(b)(1). despite this feature, this article still refers to the non-spbf conduit system as the "default system." 174. see irc § 1362(a). 175. see james s. eustice, subchapter s corporations and partnerships: a search for the pass through paradigm (some preliminary proposals), 39 tax l. rev. 345, 369 (1984). [vol 4:3 the future taxation of private business firms adopted, then the norm will be for all owners of private firms to report currently their share of passthrough items, including undistributed items, and the consequences of the simplified conduit version should therefore not be a surprise. finally, the elective nature of the spbf rules emphasizes again the importance of achieving the proper balance in the substantive outcomes under the spbf and default operating rule systems. 2. passthrough scheme; allocations of tax items and debt of the firm a. in general.-the proposal adopts the basic passthrough structure common to partnerships and s corporations under current law. all tax items of an spbf are allocated among the owners of the firm who must include such items in determining their income tax liabilities. the character of each item is determined at the firm level, with that character then passed through and reported by the owners. owners must take into account their share of the firm's tax items in their taxable years in which the firm's tax year ends. because no limitation is placed on the nature of an spbf's income or activities, the tax items to be passed through to the owners should be the same as those listed in section 702(a) of the code. if some simplified passthrough scheme can be devised where fewer categories of items need to be separately stated and passed through, that simplified rule would apply to an spbf as well. like an s corporation, an spbf is generally not permitted to make special allocations. to accomplish that objective, the spbf proposals limit the firm to having only one class of residual ownership interests and generally require all tax items to be allocated in accordance with the percentage interests of the residual interest holders. the obvious model is the "one class of stock" rules in subchapter s. there is difficulty, however, in defining exactly what a "one class of stock" rule means in the context of a partnership, llc, or other unincorporated venture. corporate stock generally provides the holder with both a profits and capital interest in the firm. moreover, each share of stock in the same class ordinarily has identical rights with respect to distributions and liquidation proceeds. finally, changes in the percentage interest in a given class of shares arise in connection with a contribution, redemption, or purchase and sale transaction, all of which may be taxable events and have, in any event, only prospective effect.'76 176. the permissible allocation of all tax items in a pro rata manner to each day of the taxable year of an s corporation creates the possibility of a change in interest having some retroactive effect. see irc § 1377(a)(1). 19991 florida tax review in contrast, it is possible to create partnership or llc interests which are "profits only" interests.'77 ownership interests may not entail any set formula for distribution and liquidation rights. and changes in percentage interests may be made by private agreement, ordinarily without tax consequences and potentially with retroactive effect. the check-the-box regulations will require the treasury to specify what an unincorporated venture will need to do to satisfy the "one class of stock" rule in subchapter s. under those regulations, an unincorporated firm may elect to be taxed as a corporation and, if the s eligibility requirements are satisfied, elect to be taxed as an s corporation. 7 s (an unincorporated firm might wish to do so, for example, to facilitate a future tax-free reorganization with a subchapter c corporation.) to date, however, no guidance has been issued. 79 in the absence of such guidance, the spbf proposals dictate restrictions on the terms of the ownership interests of an unincorporated firm to follow closely the normal consequences in the corporate context. thus, an spbf may have only a single class of residual ownership interests and each such interest must provide the holder with identical rights with respect to the income, loss, distributions, and liquidation proceeds of the spbf. all tax items (other than income allocated to preferred interest holders, described shortly) must be allocated in a "straight-up" manner in accordance with the per-day, percentage share of the owner in the residual class of interests. a change in interest may occur only upon a contribution, a partial or complete redemption of an owner's interest, or the purchase and sale of interests by the owners. finally, changes in interests may have prospective effect only. obviously, these limitations may be too restrictive, and may unnecessarily undermine the appeal of the spbf option. for example, they might seem to preclude the common "money-and-brains" venture where one or more persons supply all of the capital needs of the firm and other persons provide services in exchange for a profits only interest. in fact, it may be possible to accommodate that arrangement and others in the spbf system (as 177. the term "profits only" interest merely signifies the absence of a capital interest in the firm. a "profits only" partner may or may not share in the losses of the firm. 178. see regs. § 301.7701-3(a); staff of the joint comm. on tax'n, 105th cong., review of selected entity classification and partnership tax issues, 24 n.48 (comm. print 1997). 179. priv. ltr. rul. 96-36-007 (may 30, 1996) involved the transfer of all of the assets and liabilities of an s corporation to an llc classified as a corporation for tax purposes under the prior version of the classification regulations. the service held that if the transaction qualifies as an "f' reorganization and ff the llc meets the requirements of an s corporation, the transaction would not terminate the transferor's s election and such election would apply to the surviving entity. the ruling did not specify what the llc would need to do in order to meet the requirements of an s corporation. [vol 4:3 the future taxation of private business firms they are accommodated in subchapter s) through the use of salary payments, deferred compensation,"' options,"' restricted stock,"8 straight debt, 183 and preferred interests (described below). to provide flexibility beyond these forms would seem to result in the undesirable introduction of complexity into the spbf system, such as a required maintenance of capital accounts.184 b. preferred interests.-the proposal, however, does allow an spbf to issue limited classes of preferred interests. in effect, this permits a narrow form of special allocation-a preferred allocation of income to one or more classes of owners. permissible preferred interests provide income preferences only which are fixed and limited to the earnings of the firm, are not convertible into any other interest of the firm, and do not provide for redemption or liquidation rights in excess of the issue price of the interest. a preferred interest generally lies on the border between an equity interest and debt. for the most part, in an spbf, the need to distinguish between equity and debt is not great, particularly when the holder of the interest is viewed as an owner of the enterprise in any event. the preferred interest simply allocates part of the income of the firm to one class of owner, thereby allocating it away from other owners. ultimately, all the income of the firm is taken into account by its owners. whether a preferred interest of an spbf is thought of as a form of debt or equity makes a difference, though. strictly, holders of equity interests in a business taxable as a conduit should be allocated income whose character is determined at the entity level. however, if that rule were applied to preferred interests, clever planning could convert the preferred interest into a special item allocation. one preferred class could receive the first $100,000 of capital gain income that happened to arise in that year, another class could receive the first $100,000 of foreign income arising in a different year, etc. therefore, the proposal allows for a preferred interest which will receive only an allocation of ordinary income, with the firm being entitled to the equivalent of an ordinary deduction. thus, the allocation of income 180. see regs. § 1.1361-1(b)(4). 181. see regs. § l.1361-1()(4)(iii)(b)(2). 182. see regs. § 1.1361-1(b)(3). 183. see irc § 1361(c)(5). 184. it is unclear whether capital accounts might, in theory, already be required for subchapter s corporations. the regulations provide that the one class of stock requirement is met so long as the governing provisions provide for identical distribution and liquidation rights, even though the actual timing of the distributions is not uniform. see regs. § 1.13611)(2)(i), -l/2)(v), ex. 2. if the timing of distributions varies, some account may be necessary to keep track of the rights of the shareholders during the interim. 1999] florida tax review pursuant to a preferred interest would be analogous to the payment of interest by the firm to the holder. the proposal contemplates more than one class of preferred interests in an spbf. the different classes are to be distinguished solely on the basis of their priority: the most senior class would have allocated to it a certain amount of the firm's income; when that amount has been allocated, the next senior class would have allocated to it a certain additional amount of the firm's income; and so forth down to the residual class of interests which would have the most junior claim to income. the classes are not to be distinguished based on the nature of the income earned. thus, there cannot be one class that receives the first $10,000 of foreign income, another class that receives the first $10,000 of capital gain income, etc. income allocations to preferred interest holders are permissible only when the firm has earned the money needed to make the allocation, that is, under circumstances analogous to situations in which a dividend could be paid by a corporation. because an spbf has no equivalent of accumulated earnings and profits (all income from prior years is effectively "distributed" for tax purposes through the allocation process), income is allocable only if the firm has net income for the year in that amount. at the same time, if the firm has enough income to support the preference, the income is allocable even though there is no distribution. if no distribution is ever made of previously allocated amounts, the firm will have ordinary debt forgiveness income. such income should cancel out the effect to the residual owners of the prior income allocation. allocations must be made based on the period the preferred interest is held and the extent of the holder's interest. for example, suppose on december 1, a taxpayer purchases a preferred interest in the first $12,000 of a calendar-year firm's annual income and holds that interest until the end of the calendar year. the taxpayer may not be allocated more than $1,000 of the firm's income for the year. although allowing preferred interests increases the flexibility of owners of spbfs, it should not override the general prohibition against special allocations. thus, suppose the taxpayer in the above example attempts to purchase on december 31 a preferred interest in the first $3,650,000 of the firm's income. the allocation rule described above would allow $10,000 of the firm's income to be allocated to the taxpayer. however, the interest would have to be issued for value. the value of an interest worth $3,650,000 annually should be quite high. unless the preferred interest was issued for its true value, general tax doctrines relating to sham transactions should be applicable to prevent the allocation of $10,000 to the taxpayer. c. losses.-as described above, losses of an spbf may only be allocated to the residual interest owners of the firm. consistent with [vol 4:3 the future taxation of private business firns sections 704(d) and 1366(d), the passthrough of spbf losses or deductions is limited to such owner's basis in residual or preferred interests in the firm as of the end of the year in which the loss is incurred. any losses passed through to an owner would reduce his or her outside basis in the same order as in current subchapter s-first to the owner's basis in residual interests, if any, and then to the basis of any preferred interests.'8 any losses disallowed by reason of the basis limitation shall be treated as incurred by the firm in the succeeding taxable year with respect to the owner involved.' d. spbfliabilities.--one major difference between the rules of subchapter k and the rules of subchapter s is that partners but not s corporation shareholders include both recourse and nonrecourse debts of the entity in their outside bases.' inclusion of debt in outside basis provides partners with several potential tax benefits. because distributions from both a partnership and an s corporation are taxable to the extent money distributed exceeds outside basis, the partnership rule reduces the likelihood of a partner being taxed in such a transaction.' 8 for a similar reason, contributions of property encumbered by liabilities in excess of the transferor's basis in the property are more likely to be taxable transactions in the world of subchapter s than subchapter k. 89 but the major consequence of including debt in basis is that it increases the likelihood that the owner can deduct losses incurred by the entity. this outcome results from the rule for both s corporations and partnerships which generally limits an owner's deduction of losses to the amount of his or her outside basis.'90 as just described, such a rule is included in the spbf system. the decision of whether to include entity debt in the basis of owners of an spbf is a difficult one. as a theoretical matter, some might argue that the paradigmatic case justifying inclusion of debt in outside basis is the general partnership whose partners are jointly and severally liable for all of the firm's debts. under those circumstances, it makes sense to provide the partners with tax basis for their share of the firm's liabilities. adherents to this view might point to the absence of a comparable provision in subchapter 185. cf. irc §§ 1366(d)(1), 1367(b)(2). 186. cf. irc § 1366(d)(2). 187. see irc § 752. 188. see irc §§ 731(a)(1), 1368(b). 189. see irc § 357(c). partners are generally taxed only if the net amount of liability relief (after taking into account the partner's share of the resulting partnership liability) exceeds the partner's basis in the property transferred. see regs. § 1.752-1 (0; irc § 731 (a)(1). 190. see irc §§ 704(d), 1366(d). 19991 florida tax review s, perhaps because of the limited liability protection offered the shareholders of an s corporation. thus, it could be argued that entity debt should be included in the outside basis of an owner only in circumstances where the owner is personally liable for repayment of the debt. such a rule would draw a sharp distinction between taxpayers based on their choice of organizational form-proprietors, co-owners, and general partners, for example, would obtain basis for their business debts, but owners of other firms, such as limited partnerships, limited liability companies or corporations, would not. it might discourage the use of the latter forms of business organization. it would also be at cross purposes with the current law entity classification rules which generally disregard limited liability and other organizational characteristics for income tax purposes. moreover, current law allows taxpayers to receive tax basis for indebtedness even though the taxpayer is protected from personal liability on the debt because it is nonrecourse.191 that tax principle would seem to reduce the force of a distinction based on the presence or absence of limited liability protection for the owners of the firm. in addition, as a practical matter, many smaller businesses, regardless of their organizational form, are able to borrow money only if their owners are held accountable for the borrowing, for example as guarantors. if entity debt were included in an owner's outside basis only if the owner were liable for the debt, would an owner guarantee affect basis?"9 if not, owners may simply be forced to structure their borrowing in certain ways-for example, borrowing directly and then contributing the proceeds to the firm-rather than using other, more natural and more easily attainable ways. as is true in subchapter s, there would be a premium on proper tax planning. other complicated rules may also be needed to relieve the absence of rules like section 752, such as the provisions in subchapter s enabling losses to be deducted up to debt basis.' 93 191. see crane v. commissioner, 331 u.s. 1 (1947). 192. in subchapter s, the answer generally is "no." see, e.g., estate of leavitt v. commissioner, 90 t.c. 206 (1988), aff'd, 875 f.2d 420 (4th cir. 1989), cert. denied, 493 u.s. 958 (1989); harris v. united states, 902 f.2d 439 (5th cir. 1990). in both subchapter k and in determining whether the guarantor is "at risk" with respect to the liability, the answer may be "yes," generally depending upon the nature of the primary obligor's obligation and the reimbursement rights of the guarantor. see regs. § 1.752-2(b)(3)(i), (5), and (6); prop. regs. § 1.465-6(d) (guarantee does not increase at risk amount); brand v. commissioner, 81 t.c. 821 (1983) (guarantee does not increase at risk amount because of guarantor's right of indemnification against the partnership); peters v. commissioner, 89 t.c. 423 (1987) (same); abramson v. commissioner, 86 t.c. 360 (1986) (guarantee increased at risk amount because there was no primary obligor and no right of reimbursement from anyone). 193. see irc § 1366(d)(1)(b). [vol 4:3 the future taxation of private business firms finally, the basic case against inclusion of entity debt in outside basis is not limited to the taxation of an spbf; the argument applies with equal force to non-spbf private business firms. in other words, the argument would question the presence of section 752 in the default version of conduit taxation, i.e., subchapter k, and not just in the spbf system. this follows from the fact that the spbf classification line is not based on the limited liability protection offered to the owners of the firm. indeed, for several reasons, a much stronger case could be made to exclude section 752 from the default conduit version than to exclude it from the spbf system. for one thing, inclusion of debt in basis increases the amount of losses of the firm currently available to owners. it therefore places greater pressure on the proper allocation of those losses. but unlike the default version of conduit taxation, which may be vulnerable to potential misallocations of tax items, the spbf system mandates a straightforward allocation scheme designed to preclude manipulative possibilities. in particular, all losses of an spbf are allocable only to residual interest holders in accordance with their percentage interest in that class of ownership. hence, the inclusion of debt in basis is much less likely to result in an abusive outcome in the spbf system than in the default system. second, the allocation of debt of the firm among the owners is considerably more difficult for the default conduit system than in the spbf system. in subchapter k, for example, the regulations under section 752 generally attempt to allocate partnership debt among the partners in accordance with the manner in which they share the economic risk of loss relating to the liability.194 yet to determine that share, the regulations require one to fantasize a completely improbable scenario--a constructive liquidation of the partnership under the worst possible circumstances.' this process is a complicated one and leaves serious doubt whether the allocation of liabilities authorized by the regulations is appropriate.'9 further, the basic economic risk of loss analysis does not apply in determining the allocation of nonrecourse liabilities of a firm, or of any liabilities of a firm, all of whose owners are provided with limited liability protection."' these problems are virtually eliminated in an spbf where all 194. see regs. § 1.752-2(a). 195. see regs. § 1.752-2(b)(1). 196. see berger, supra note 63, at 123 ("at best, the § 752 technique for measuring a partner's 'economic risk of loss' offers a crude surrogate for quantifying a partner's actual risk, which is indeterminate; inevitably, the § 752 calculation exaggerates the partner's exposure."). 197. see id. at 137 ("[a]llocations rooted in nonrecourse debt cannot have economic reality, or any reality, whatsoever, except in the ingenious, magical and mechanical world of the § 704(b) regulations."). 1999] florida tax review liabilities, recourse and nonrecourse, as well as the losses of the firm may be allocated straight up to the owners in accordance with their residual ownership interests. finally, the "at risk" (section 465) and passive activity loss (section 469) rules provide another layer of protection against the improper deduction of losses by taxpayers, and that protection is particularly effective in the spbf context. this is because the principal taxpayers exempt from those rules are nonclosely-held c corporations. 98 but as previously described, a public c corporation may not be an owner of an spbf. thus, in contrast to the owners of firms taxed under the default conduit system, all owners of an spbf would be subject to the at risk and passive activity loss restrictions. indeed, the broad applicability of the at risk rules in an spbf setting seems to make unnecessary a rule restricting the passthrough of spbf debt only to owners personally liable for repayment of the debt. such a rule in fact was enacted in 1976'9' but was repealed just two years later as "redundant" in view of an expansion of the at risk rules." since that time, the at risk rules have been expanded even more20' and, as noted, they would provide virtually full coverage to participants in an spbf venture. thus, limited partners, members of an llc, and other owners with limited liability protection are generally not treated as being "at risk" with respect to their firm's debts, recourse or nonrecourse.2 "2 they therefore may be unable to deduct their share of losses attributable to those debts even if their outside bases were sufficient to permit the deduction.2"3 to be sure, certain nonrecourse real estate financing falls outside of the at risk rules.2 4 thus, one might argue that those rules provide an inadequate shield against the claiming of uneconomic passthrough losses. whatever the merits of the real estate exception, however, one cannot expect the issue to disappear in a debate regarding whether to include a firm's 198. see irc §§ 465(a)(1)(b), 469(a)(2)(b). a c corporation is subject to the at risk rules if five or fewer individuals own more than 50% of the corporation. see irc § 542(a)(2). 199. see tax reform act of 1976, pub. l. no. 94-455, § 213(e), 90 stat. 1520, 1548 (1976) (amending § 704(d)). 200. see revenue act of 1978, pub. l. no. 95-600, § 201(b)(1), 92 stat. 2763, 2816 (1978); staff of the joint comm. on tax'n, 96th cong., 1st sess., general explanation of the revenue act of 1978 130 (comm. print 1979). 201. see tax reform act of 1986, pub. l. no. 99-514, § 503(a), 100 stat. 2085, 2243 (1986) (repealing blanket exclusion from at risk rules of real property activities). 202. see s. rep. no. 938, 94th cong., 2d sess. 49 n.3 (1976), reprinted in 1976 u.s.c.c.a.n. 3439, 3485; mckee, nelson & whitmire, federal taxation of partnerships and partners 10-171 (3d ed. 1997). 203. see irc § 465(a)(1). see eustice, supra note 175, at 399 (would let at risk rules rather than outside basis dictate significance of owners' personal liability for entity debt). 204. see irc § 465(b)(6). [vol 4:3 the future taxation of private business finns nonrecourse financing in an owner's outside basis. presumably, the same interests which have successfully exempted certain real estate financing from the at risk rules would push for inclusion of the same financing in outside basis. thus, the basic issue concerns the merit of the real estate exception; it is unreasonable to assume that the issue will somehow be circumvented by shifting the controversy to section 752. and for that reason, there is no basis to decide the section 752 question because of concern about the real estate exception. in conclusion, including entity debt in the outside basis of spbf owners would help to eliminate tax distinctions based on organizational form and characteristics and permit businesses to finance their activities as they wish, without regard to tax considerations and tax planning. further, the restrictive allocation rules of an spbf and the broad applicability of the at risk and passive activity loss rules to spbf owners would protect against the potential misuse of resulting passthrough losses. finally, as an administrative matter, the allocation of the debt to spbf owners could be done in a straightforward manner based on the owners' shares of the residual interests of the firm. although certain of these reasons are inapplicable to the default version of conduit taxation-and, therefore, additional thought must be given to whether section 752 principles should be available in that world-these reasons seem more than adequate to justify inclusion of those principles in the spbf system.205 3. contributions and distributions a. contributions-present la.-almost any contribution to a partnership in exchange for a partnership interest is tax-free. the major exception is the contribution of services in exchange for an interest in the capital of the partnership. 'z in general, the irs treats the receipt for services of a mere partnership profits interest as being tax-free. 7 in contrast, contributions to an s corporation are governed by the same rules that apply to all corporations.' accordingly, a transfer of property to an s corporation in exchange for its stock is tax-free only if the transferor, either alone or with a group of transferors, owns at least 80% control of the corporation following the transfer.20 furthermore, any stock 205. inclusion of § 752 principles in the spbf system, but not the default system, would have the side benefit of increasing the appeal of the simplified system to taxpayers. 206. see united states v. frazell, 335 f.2d 487, 489 (5th cir. 1964). cert. denied, 380 u.s. 961 (1965). 207. rev. proc. 93-27, 1993-2 c.b. 343. 208. see irc § 1371(a)(1). 209. see irc § 351. 1999] florida tax review of an s corporation received in exchange for services is taxable to the recipient."' although this rule is different from the partnership rule, it results from the fact that an s corporation has only one class of stock. thus, stock in an s corporation must inevitably carry with it an interest in the capital of the corporation. as noted, when services are contributed in exchange for partnership capital, the transaction is taxable. the tax authorities early on accepted the proposition that a contribution of property to a partnership in exchange for a partnership interest is not a taxable event. 21' the 1920 solicitor's opinion which first makes this point quotes united states v. coulby,21 2 for the proposition that "[u]nlike a corporation, a partnership has no legal existence aside from the members who compose it." the solicitor's opinion goes on to say: it thus appears, both from the decision of the federal court and from the ruling of this department, that, for income tax purposes, the common law doctrine of the nature of a partnership must be adhered to, and that the more modem doctrine, prevailing in some states, which recognizes a partnership for many purposes as an entity not greatly differing from the corporation, must be ignored. a 1932 general counsel memorandum emphasizes that this rule is a function of nonrealization, not nonrecognition, since the statute did not provide any special rule in this area.2" 3 the general counsel memorandum extracts from this analysis the rule now embodied in section 704(c). that is, if a contribution of appreciated property to a partnership is not considered a realization event yet the contributing partner is given economic credit for the full value of the property, then it follows that the gain inherent at the time of the contribution must be allocated to such partner." 4 a partner recognizes gain, and a shareholder of an s corporation recognizes gain or loss, upon a transfer of property to a firm qualifying as an "investment company. 2 5 the 1997 act broadened the definition of investment company to stem the reappearance of "swap funds," i.e., firms 210. see irc § 351(d)(1). 211. sol. op. 42, 3 c.b. 61 (1920). 212. 251 f. 982 (6th cir. 1918). 213. gen. couns. mer. 10,092, xi-1 c.b. 114 (1932), revoked on another issue, gen. couns. men. 26,379, 1950-1 c.b. 58. 214. the courts did not accept this position of the commissioner, and the result ultimately had to be achieved by statute. see eaton v. commissioner, 37 b.t.a. 715 (1938); see also helvering v. walbridge, 70 f.2d 683 (2d cir. 1934) and helvering v. archbald, 70 f.2d 720 (2d cir. 1934). 215. see irc §§ 351(e)(1), 721(b). [vol 4:3 the future taxation of private business firms permitting investors to obtain tax-free diversification of their investment assets. 216 b. distributions-present lav.-in contrast to the roughly comparable provisions for contributions, the rules dictating the tax consequences of distributions from a partnership or s corporation are much different. a partnership is never taxed on a distribution to a partner as such.2 17 in some cases, as discussed subsequently, complicated rules may cause the partnership distribution to be recharacterized as something else, but there is no tax absent such recharacterization. in contrast, distributions from an s corporation are governed by the anti-general utilities rules of sections 311 and 336, which cause gain inherent in the distributed property, and loss inherent in property distributed in liquidation, to be recognized by the corporation (and passed through to the shareholders) as if the property had been sold. the taxation of the distributee is also much different. the partnership rules minimize the amount of gain or loss that must be recognized in a distribution. in doing so, they rely on a partner's outside basis as the final determinant of how much basis will be available to the partner following the distribution and how much gain or loss must be recognized in the transaction. indeed, it is generally only where money distributed exceeds outside basis that gain must be recognized, because the basis of money cannot be reduced below its face value.18 and it is generally only where a partner's outside basis would otherwise be lost forever, as in the case of a liquidating distribution of money less than the distributee's outside basis, that loss may be recognized. 219 the nonrecognition objective and the policy decision to rely upon outside basis result in certain complications where outside basis and the aggregate inside bases of the properties distributed are different from one another.y the s corporation rules are different in an ordinary distribution, a distributee must recognize gain to the extent the money and value of property distributed exceed the distributee's stock basis."' a similar rule applies in 216. see staff of the joint comm. on tax'n, 105th cong., ist sess., general explanation of tax legislation enacted in 1997, 183 (comm. print 1997). 217. see irc § 731(b). this discussion assumes that a liquidating distribution is taxed as a distribution under § 736(b)(1) rather than as a distributive share or guaranteed payment under § 736(a). 218. see irc § 731(a)(1). section 731(c) is an exception to this rule discussed later. 219. see irc § 731(a)(2)(a). loss is also recognized to prevent the distributee's excess outside basis from being allocated to ordinary income items distributed. see irc § 731(a)(2)(b). 220. see irc § 732. 221. see irc § 1368(b). 1999] florida tax review a liquidating distribution except that the shareholder may recognize loss as well.m finally, gain or loss is recognized in a partial liquidation of a shareholder's interest except that the shareholder's outside basis must be allocated to the shares redeemed.' thus, in combination with the tax treatment of the corporation, all gains and most losses are recognized in a distribution by an s corporation. the shareholders therefore receive a freshstart fair market value basis in any property distributed.224 c. additional partnership rules to prevent income shifting, income character changes, and timing distortions.-as just described, the partnership tax rules are more liberal than the s corporation rules in permitting property to be transferred into and out of the firm without the recognition of gain or loss. the generally unimpeded nature of partnership transfers has necessitated basis preservation and allocation rules as well as a series of additional rules designed to prevent income shifting, income character changes, and timing distortions. as a conceptual matter, because property more frequently changes ownership in the partnership world without the recognition of gain or loss, there is greater pressure to develop and maintain links between the property transferred and the original owner to make sure the eventual recognition of income or loss is of the right amount, to the right person, of the right character, and at the right time. the following is just a sample of the provisions that have been developed to achieve those ends: i. section 704(c)(1)(a).-we have already seen the irs's early recognition of the need for a rule to prevent the shifting of gains or losses from the contributor of built-in gain or loss property to some other partner. as an important exception to the rule that all allocations must have economic effect, section 704(c)(1)(a) requires a special allocation of such gains or losses back to the contributor. a common problem occurs under section 704(c)(1)(a) where the subsequent tax items arising from the partnership's ownership of the contributed property are less than the amount of built-in gain or loss at the time of the contribution.' for example, land contributed with built-in gain 222. see irc §§ 331(a), 302(a). 223. see irc § 302(a). the term "partial liquidation" refers to a transaction in which a distribution redeems some, but not all, of the distributee's interest in the firm. it should not be confused with the use of the term in §§ 302(b)(4) and (e), dealing with liquidating events occurring at the entity level. 224. see irc §§ 301(d), 334(a). 225. one commentator states that ceiling-limited situations constitute a "pervasive obstacle to satisfying the objectives of § 704(c)" and speculates that they arise in over one-half of all possible cases. see john p. steines, jr., partnership allocations of built-in gain or loss, 45 tax l. rev. 615, 647 (1990). [vol 4:3 the future taxation of private business firms of $7,000 might be subsequently sold by the partnership for a $6,000 gain. economically, this transaction could be broken into a $7,000 gain to be allocated to the contributor plus a $1,000 loss to be shared by all of the partners. the so-called "ceiling rule," however, generally does not permit that outcome.226 apparently, the concern of the treasury has been the extension of partnership "flexibility" into a world of make-believe, i.e., a world in which a $7,000 gain and a $1,000 loss are being allocated to the partners when, in fact, neither tax result actually occurred. this concern is warranted because the propriety of both the "$7,000 gain" and the "$1,000 loss" depends upon the accurate valuation of the property initially, a questionable assumption in certain cases. thus, the ceiling rule permits a special allocation of at most $6,000 in this example, the amount of tax gain actually recognized by the partnership from the sale of the property. the current regulations offer three ways of dealing with the problem of ceiling-limited transactions. one possibility is to ignore the problem, which permits a certain amount of income shifting to occur.m to protect the fisc, however, and to further complicate matters, taxpayers may not choose to ignore the problem if they entered into the ceiling-limited transaction "with a view" towards gaining that tax advantage.' another possibility is to make so-called "curative allocations" of tax items unrelated to the contributed property in order to make up for the shortfall.' curative allocations are allocations of tax items only and thus also violate the economic effect test. in a general effort to conform the cure to the problem, various restrictions are imposed on the amount, character, and timing of the tax item subject to the curative allocation" and curative allocations are impermissible in certain cases where the taxpayer has the wrong subjective purpose." a final option is to make "remedial allocations," which are similar to curative allocations except that they are entirely make-believe. ' rather than repealing the ceiling rule altogether, the irs has prescribed remedial allocations as the one permissible method for creating fictitious allocations in order to avoid the undesirable effects of the ceiling rule.233 226. see regs. § 1.704-3(b)(1). 227. see regs. § 1.704-3(a)(1), -3(b)(1). 228. regs. § 1.704-3(a)(10), -3(b)(2), ex. (2)(ii). 229. regs. § 1.704-3(c)(1). 230. see regs. § 1.704-3(c)(3). 231. see regs. § 1.704-3(c)(4), ex. (3). for the view that these subjective overrides should have only a limited reach, see laura e. cunningham, use and abuse of section 704(c). 3 fla. tax rev. 93, 115 (1996). 232. see regs. § 1.704-3(d)(1) (authorizing the creation of remedial items by the partnership). 233. see regs. § 1.704-3(d)(5)(i). 19991 florida tax review ii. reverse section 704(c) allocations.-the need for a reverse section 704(c) allocation arises whenever there is some change in the ownership of a partnership and one or more partnership assets contains a built-in gain or loss at that time. thus, if new partner c joins existing partners a and b at a time when partnership ab has certain assets with builtin gains, those gains must be specially allocated to a and b and away from c in order to prevent income shifting among them. of course, certain of those gains might already be subject to an existing, "regular" section 704(c) special allocation if the asset was contributed by a or b with a built-in gain or loss, so matters can get complicated fairly quickly.2" the regulations deal with reverse section 704(c) allocations in the same manner as regular section 704(c) allocations. 5 under the regulations, however, just to make sure everyone stays alert, partnerships are not required to use the same allocation method for both regular and reverse section 704(c) adjustments even if such adjustments relate to the same property at the same time.236 iii. section 704(c)(1)(b).-assuming that one can keep track of all of the required and prohibited special allocations, they would nevertheless not be wholly effective at preventing the potential income shifting from built-in gains and losses. one reason is that special allocations under section 704(c)(1)(a) only apply to tax items of the partnership; therefore, if property subject to a special allocation somehow escapes the partnership in a nonrecognition transaction, such as through a distribution to a partner other than the contributing partner, then the mandated special allocation is rendered impotent. section 704(c)(1)(b) generally deals with that problem by providing that a distribution of built-in gain or loss property within seven years of its contribution to the partnership triggers gain or loss to the contributing partner equal to the amount that would have been specially allocated to such partner had the partnership sold the property. 3" iv. section 737.-another reason a mandated special allocation might prove to be ineffective is if the partner to whom the built-in amount is to be allocated ceases to be a partner prior to such allocation. special allocations only serve to shift tax items among partners of the 234. regular special allocations of the gains and other tax items from the property may also be permitted or prohibited depending upon compliance with the substantial economic effect test and one or more subjective purpose standards. 235. see regs. § 1.704-1(b)(4)(i) and -1(b)(5), exs. (14)(i) (iv), (18)(ii) (xiii). 236. see regs. § 1.704-3(a)(6)(i). nor are partnerships required to use the same allocation method in coping with a series of reverse § 704(c) adjustments. see id. 237. query whether the rule should also apply to built-in gains or losses arising not just from a contribution but also in a reverse § 704(c) situation. [vol 4.3 the future taxation of private business firms partnership; thus, to do the job right, one must monitor potential tax-free disappearances of partners by means of, for example, a liquidation of the partnership interest. indeed, in certain cases, tax advantage may be gained even if the contributing partner does not completely disappear from the scene, but is only the recipient of a tax-free distribution. congress took its first step down this road by enacting section 737 which generally treats as a gain recognition event a distribution of property to a partner who contributed builtin gain property to the partnership within the previous seven years. v. section 707(a)(2)(b).-in addition to incomeshifting concerns, the liberal manner in which property can enter and leave a partnership without the recognition of gain or loss raises the question whether the contribution and distribution are in reality a taxable sale. section 707(a)(2)(b) attempts to make this nebulous determination based upon whether the two transfers "are properly characterized as a sale or exchange of property." the regulations interpret this unhelpful statutory standard by creating a two-year rule of thumb as well as a series of additional rules. there is a rebuttable presumption that transfers occurring within two years of one another constitute a sale or exchange and that those outside that time frame are not"23 vi. section 731(c).-a related concern is addressed by section 731(c), enacted in late 1994. recall that cash distributions from a partnership are generally taxable to the extent the cash exceeds the distributee's basis in the partnership, but property distributions are generally taxfree. in a remarkably convoluted rule, section 731(c) treats a portion of "marketable securities" as cash for purposes of the distribution rule. thus, a distribution of marketable securities may result in gain recognition to the distributee. according to the legislative history, the transaction is the "economic equivalent of a sale of a partner's share of the partnership's [other] assets" for an increased share of the partnership's marketable securities." this characterization of the transaction bears resemblance to section 751(b), described next. vii. sections 724, 735, and 751(b).-liberal nonrecognition rules on property transfers breed a greater need for income character tracing rules to prevent a character shift when the tax consequences from the property are ultimately recognized. section 724 traces the character 238. see regs. § 1.707-3(c)(1), -3(d). 239. h.r. rep. no. 826, 103d cong., 2d sess. 187 (1994), reprinted in 1994 u.s.c.c.an. 3959. 1999] florida tax review of contributed property and section 735 serves the same purpose for distributed property. in addition, section 751(b) recharacterizes a distribution as a taxable exchange by the partners if, as a result of the distribution, there is a change in the partners' share of the ordinary income items of the partnership. because its operative impact is to create an exchange among the partners, section 751(b) also has an important effect on the timing of the recognition event. in a partnership distribution, the provision can, with great surprise, result in the taxation of a partner who is not a distributee on gains inherent in property which is not distributed.24 as noted, one partnership tax expert has asserted that there is a mere 2-1/2% compliance rate with section 751(b)241 and another has characterized it as "the achilles heel of subchapter k. 242 viii. subjective purpose.-finally, the general "antiabuse" regulation in the partnership area overlays all of the foregoing rules and may operate to reverse the tax consequences of any one of them.243 as previously noted, the rule may even override the taxpayer's compliance with some other, more specific, anti-abuse rule, such as the disguised sale provision in section 707.2' d. analysis of current law.-as we have seen, the partnership tax rules are more liberal than the s corporation rules in providing nonrecognition of gains and losses upon property transfers to and from the firm and, as a result, a veritable array of highly complex, anti-abuse rules, some mechanical in application and some based on subjective standards, have also developed in the partnership area.245 although certain of the same concerns in the partnership area are present for taxpayers in a subchapter s setting, the s rules are remarkably free of the same complications.246 in 240. see, e.g., regs. § 1.751-1(g), ex. (3). 241. hearings, supra note 63 (statement of joel rabinovitz). 242. see eustice, supra note 175, at 383. 243. see regs. § 1.701-2(b). 244. see supra note 70. 245. for criticism of these anti-abuse protections, see mark p. gergen, reforming subchapter k: contributions and distributions, 47 tax l. rev. 173, 181-98 (1991). see also terence floyd cuff, the section 704(c)(1)(b) proposed regulations, 73 taxes 283, 284 (1995) ("the intricate web of anti-abuse rules [affecting contributions and distributions of partnership property] challenge the most talented partnership tax practitioner .... a partnership may undertake a seemingly innocent transaction and discover itself tangled in a web of anti-abuse provisions. these provisions complicate even routine partnership transactions."). 246. subchapter s is not, however, completely free of such complications. for example, s corporations are subject to the collapsible corporation rules, which are similar in [vol 4:3 the future taxation of private business finns part, this phenomenon is attributable to the more restrictive nature of subchapter s; for example, a section 704(c)(1)(a)-type solution cannot easily be prescribed where special allocations are not permitted. in part, it may be a consequence of a policy judgment to maintain a modicum of simplicity for the s rules. but in important part, it results from the fact that fewer transfers to and from an s corporation are tax-free. moreover, despite this complicated web of rules, partnership distributions still provide ample opportunity for manipulation by taxpayers. manipulation may result from a misallocation or mistiming of income or other partnership tax items as a result of the distribution, or a conversion of ordinary income into capital gains.247 to illustrate one conversion possibility, consider the following simplified example:"48 example 1. a and b form ab, an equal partnership. a contributes unimproved land worth $10,000 with a basis of $10,000, and $20,000 cash. b contributes a depreciable asset worth $20,000 and with a basis of $20,000, and $10,000 cash. the depreciable asset increases in value to $30,000. ab then liquidates, with a receiving the depreciable asset and $5,000, and b receiving the land and $25,000. in the liquidation, neither the partnership nor either of the partners recognizes any gain or loss. a preserves his or her $30,000 outside basis by getting $5,000 cash and taking the depreciable asset with a $25,000 basis. b does likewise by getting $25,000 cash and taking the land with a $5,000 basis. although the total amount of potential gain in the partnership before the liquidation ($10,000) is still preserved in the partners' hands afterwards ($5,000 of lurking gain for each partner) the ability to shift basis around from one asset to another provides potential tax advantages. in effect, the value of the dollars of basis available to the parties has been increased as a result of the liquidation, since the basis of the depreciable asset will be used to reduce ordinary income currently through depreciation deductions while the basis of the land, which won't be used until the land is sold, may ultimately affect only the amount of a capital gain recognized in the future.249 in theory, this objective and complexity to § 751. in addition, to the extent the partnership anti-abuse rule is simply articulating a common-law "substance over form" standard generally applicable to all of tax law, the subchapter s provisions are of course subject to that standard. 247. for some examples, see andrews, supra note 67; ali 1984 subchapter k proposals, supra note 60, at 195-200; 1997 jct partnership tax study, supra note 67, at 2738; regs. § 1.701-2(d), exs. (8)-(11). 248. this example disregards the possible application of the general anti-abuse rule in the partnership area. 249. if the depreciable asset is a § 1231 asset, then increasing its basis may also provide the taxpayer with an ordinary loss upon sale of the asset. see irc § 1231(a)(2). 1999] florida tax review rule is symmetric; if the land and not the depreciable asset had increased in value, basis would have been shifted to the land (and away from the depreciable asset) on liquidation. however, if that had been the case, the partnership need not have liquidated. the manipulation possibilities illustrated by example 1 are even greater as a result of the 1997 tax act. this is because the partnership tax law, in trying to preserve character due to the nonrecognition consequences of most partnership distributions, merely segregates certain ordinary income assets from other assets; it unjustifiably treats all of those other assets alike." as shown by example 1, this procedure is obviously incorrect to the extent it lumps depreciable and nondepreciable property together. but it is even more incorrect under post-1997 act law because of the additional new categories of assets created by that act. depending upon the tax bracket of the taxpayer, the nature of the asset involved, and its holding period, gains on the sale of assets may be taxed at a series of possible tax rates ranging from 8% to ordinary income rates.5" in addition, the taxation of gains from real estate will vary, depending upon whether the gain is attributable to the recapture element of depreciation, the nonrecapture element, or appreciation in value. and the tax treatment of losses from assets and the use of assets will continue to be different. in short, current law's treatment of all assets other than ordinary income assets as essentially fungible items for tax purposes is now dramatically incorrect, thanks to the changes of the 1997 act. to illustrate another potentially erroneous outcome involving the mistiming and possible exemption of income under the partnership rules, consider the following example:252 example 2. d, e, and f form a partnership to start a computer software business. d and e agree to bankroll the know-how of partner f. f initially takes a profits only interest in the firm. if the partnership were liquidated the day after formation, d and e would split all the money and f would get nothing. 250. see, e.g., irc § 732(c)(1). 251. see irc § 1(h), as amended by the 1997 act. in addition to the difference in tax rates, the amount of gain subject to tax may also vary, depending upon the asset. see, e.g., irc § 1202(a) (50% exclusion from gain on sale of certain qualified small business stock) and irc § 121, as amended by the 1997 act ($250,000/$500,000 exemption from sale of principal residence). 252. cf. mark p. gergen, reforming subchapter k: compensating service partners, 48 tax l. rev. 69, 99-100 (1992). again, this example disregards the potential application of the general partnership anti-abuse rule. [vol. 4:3 the future taxation of private business finns during the early years, f is compensated through a modest guaranteed payment, with d and e splitting all losses of the venture. business begins to look promising for the product being produced by the firm. at that point, the partners have a falling out and decide to split up. the partners book up their capital accounts to reflect the current value of the firm's product and the firm then liquidates f's interest, which is now worth $500,000. the partnership purchases and distributes to f a $500,000 collectible desired by f, which f continues to hold after the liquidation. alternatively, the firm purchases and distributes residential property desired by f worth $500,000 which f lives in for a couple of years and then sells for cash. do any of these events, other than the income from the guaranteed payment, generate any tax consequences to f? true, if f is untaxed, f may end up with a zero basis in the collectible or the residential property following the distribution, but f may be willing to hold onto them for some time, maybe until f's death. 3 and f may sell the residence after living in it for a minimum period of time and avoid paying any tax whatsoever on most or all of the gain from the sale.' " in summary, the enormous complexity of the partnership contribution and distribution rules and their continued ineffectiveness, which might foreshadow further change in the rules and even more complication, provide powerful support for more restrictive rules, such as those in subchapter s, for the spbf system. the following sections consider some possible counterarguments: i. entity versus aggregate theory of the firm.-it might be argued that the s corporation rules are consistent with an entity theory of the firm whereas the partnership rules favor the aggregate or conduit theory. because the spbf system involves a simplified version of conduit taxation, the partnership and not the s corporation rules should therefore be the appropriate starting model. in fact, however, neither the s corporation nor the partnership rules are supported by either an aggregate or an entity theory of the firm. an entity theory would suggest that property transfers between the owners and the firm are generally taxable ones with perhaps some relaxation of that result where the firm is a mere alter ego of the owner so that the transfer effects a mere change in form in the owner's investment. 5 but certainly the "alter ego" 253. see irc § 732(b). 254. see irc § 121(a). 255. this is the common explanation for § 351. see portland oil co. v. commissioner, 109 f.2d 479, 488 (1st cir. 1940), cert. denied, 310 u.s. 650 (1940). 19991 florida tax review exception would not support the general rules in the partnership area, which permit virtually any transfer of property between a partnership and partner to be tax-free. nor would an alter ego or mere change in form exception support the s corporation rule on contributions. although one might quibble with whether 80% is the appropriate standard for measuring a mere change in form, the s rule permits a tax-free result even though an unrelated group of persons is necessary to achieve the 80% controlling interest in the corporation. certainly, any one person in that group may not have effected a mere change in form in that person's investment, yet that person gets tax-free treatment under current law.756 in addition, the s corporation rule taxes property leaving the corporation even though the recipient is an alter ego of the corporation, such as a sole shareholder. an aggregate theory of the firm would suggest that transfers between an owner and the firm constitute in substance transfers among the owners. thus, if a contributor of property is the sole owner, or nearly so, of the firm, one might excuse the existence of a taxable event because the contributor is merely transferring the property to himself or herself. even that nontaxable outcome is not without some doubt, however, because an important rationale under current law for not taxing unrealized gains or imputed income is the absence of a market transaction to measure accurately those gains and income. if there is at least a semblance of a market transaction, which would be the case in any contribution or distribution other than, perhaps, one occurring in a setting involving a sole owner, then the policy against taxing the transaction is not nearly as compelling. in any event, under an aggregate theory, one would certainly not extend tax-free treatment to the lengths provided by either the partnership or s corporation rules. 7 under the aggregate theory, a group of investors who join together to pool their respective capital have made a substantial change in their property rights as a result of the pooling and, under normal income tax principles, ought to be taxed.28 as we have seen, the historical explanation for the partnership rule was based on the common law understanding of a partnership, unlike a corporation, having no legal existence aside from its partners. but as just noted, pure aggregate principles do not support a completely tax-free result in virtually all transfers between the firm and its owners. moreover, state law 256. see boris i. bittker & james s. eustice, federal income taxation of corporations and shareholders 3.01, at 3-6 (6th ed. 1994); ronald h. jensen, of form and substance: tax-free incorporations and other transactions under section 351, 11 va. tax rev. 349, 377 (1991). 257. one would also not tax all distributions from s corporations. 258. this is the theory of the recent expansion of the investment company rules. see supra note 216 and accompanying text. [vol 4:3 the future taxation of private business firms views have continued to evolve away from an aggregate interpretation of the partnership. 9 finally, as discussed in part ii of this article, tax policy considerations rather than "aggregate" or "entity" characterizations of a firm for state law purposes should dictate how the transaction should be taxed. ii. tax policy considerations.-from a tax policy perspective, common justifications for a nonrecognition result like the partnership treatment of contributions and distributions are liquidity and valuation concerns and the potential lock-in effect of an income recognition rule.' ° the absence of a liquid means to pay any tax resulting from a transfer to or from a business is a superficially appealing argument in favor of nonrecognition. the reality, however, is that there is no general liquidity exception to the recognition of income, and there are many instances where the tax system taxes illiquid gains. if the lack of liquidity is considered an overriding concern, the proper course of action would be to require the immediate recognition of gains but to permit the payment of tax to be deferred with interest.26' valuation concerns are a little more worrisome. it is true that, except perhaps where property is transferred between an owner and a wholly-owned firm, valuation of any property transferred is very likely to have occurred. moreover, in those unusual cases where valuation has not, in fact occurred, the income and character tracing rules such as section 704(c)(1)(a) all carry with them the requirement of immediate valuation.m hence, one could hardly justify a nonrecognition rule based on valuation difficulties if one 259. under both the upa and the rupa, a partner has no interest in specific partnership property, with the partner's interest in the partnership being classified as personalty, regardless of the nature of the underlying assets. unif. partnership act § 26, 6 u.l.a. 730 (1995); unif. partnership act § 502 (amended 1994), 6 u.l.a. 67 (1995). thus, a partner who transfers real property to a partnership in exchange for an interest in the partnership has exchanged realty for personalty, which is not even a nonrecognition event under § 1031. see regs. § 1.1031(a)-1(b). 260. see karen c. burke, disguised sales between partners and partnerships: section 707 and the forthcoming regulations, 63 ind. lj. 489, 524-26 (1988); david r. keyser, a theory of nonrecognition under an income tax: the case of partnership formation, 5 am. j. tax pol. 269, 288-94 (1986); philip f. postlewaite et al., a critique of the ali's federal income tax project-subchapter k. proposals on the taxation of partners, 75 geo. lj. 423, 471-73 (1986); cf. maijorie e. korahauser, section 1031: ve don't need another hero, 60 s. cal. l. rev. 397, 407-11 (1987). 261. cf. irc § 453a(c). 262. the capital account rules in the partnership area also require knowledge of the value of property contributed to a partnership. see regs. § 1.704-1(b)(2)(iv)(b)(2) and (5). similarly, the partnership basis allocation rules enacted in 1997 require valuations. see irc § 732(c). 1999] florida tax review intends to comply with all of the additional rules accompanying an initial nonrecognition result. nevertheless, there will be certain instances where the parties have agreed to valuations only in gross terms and not on a property-by-property basis. in those cases, a rule requiring the recognition of gains and losses will cause some difficulty and will inevitably lead to the shaving of income amounts in the taxpayer's favor. a nonrecognition rule relying solely on basis amounts avoids these problems. although valuation concerns are not significant enough to justify a nonrecognition rule in this instance, they cannot be dismissed out of hand. lock-in-the potential deterrent effect a recognition rule would have on the movement of capital into and out of businesses-might initially seem to be a false worry. after all, the cause of the lock-in is the earlier failure to tax gains as they economically accrued. thus, one could argue that a nonrecognition rule improperly channels capital only in certain directions favored by the rule-for example, the rule encourages the transfer of property to and from a firm instead of the sale of such property to a third party-and extends and increases the lock-in effect for the future. by contrast, a recognition rule terminates the lock-in effect; because it is the realization principle that creates the distortion in the first place, the best solution to minimize distortion is to require the realization and recognition of gains at the earliest feasible moment.263 a transfer of property to or from a business is a transaction, and often a market transaction, and therefore qualifies as a feasible opportunity to trigger tax consequences. any concern about the overtaxation of capital generally should be dealt with on a more global scale, such as through the adoption of a consumption tax, rather than in an ad hoc manner through the proliferation of selective nonrecognition rules. but perhaps that argument is too facile. given the existence of the realization principle, one might well worry that a general recognition rule would unduly deter transfers of capital to or from businesses. the failure to tax unrealized gains inherent in property retained by the taxpayer, and not transferred, could operate as a powerful disincentive against making the transfer. the potential importance of the lock-in effect requires judgment regarding the sensitivity or elasticity of the transfer to the resulting tax consequences. to make that judgment, it is necessary to consider the nontax reasons for the transfer. for a transfer of capital to a firm, there would seem to be at least two reasons: the benefits offered by state law features of the 263. see keyser, supra note 260, at 285; daniel n. shaviro, an efficiency analysis of realization and recognition rules under the federal income tax, 48 tax l. rev. 1, 28 (1992). [vol 4:3 the future taxation of private business firns firm (limited liability, for example)' and the economic benefits of pooling the property with the capital and services of other investors. in theory, the greater the nontax benefits obtained, the higher the permissible tax cost of the transaction without creating an undesirable disincentive to the movement of capital." at one time, the nontax benefits obtained from a transfer to an s corporation might have been considered greater than those from a transfer to a partnership. both transfers offered the pooling advantage,' but the s contribution transfer also achieved the important benefits of incorporation. hence, the partnership area perhaps needed a somewhat more liberal nonrecognition rule to be sufficiently responsive to lock-in concerns. in contrast, because of its greater nontax benefits, contributions to an s corporation could face a higher tax barrier. this is not to suggest that this difference between s corporations and partnerships was the basis for the development of their two different rules, but it is a possible way to rationalize their existence. 67 with the blurring of state law characteristics among the various business forms, however, the advantages of incorporation may no longer be significant. put another way, transfers to a partnership, an llc, or another, not yet authorized, unincorporated business form may gradually provide the same nontax benefits as transfers to an s corporation. this transformation at the state level, combined with the failure to distinguish private firms for tax purposes based on their organizational characteristics, suggests that the same tax rule should apply to property contributions to private business firms, whether they are taxed under the spbf system or the default version of conduit taxation. moreover, if the s corporation rule has been adequately responsive to lock-in concerns, it may be an acceptable rule for the spbf system. at minimum, concerns about lock-in do not provide any compelling case for adoption of the more liberal partnership contribution rule. 264. cf. note, losing control: toward a new understanding of the taxation of post-incorporation stock sales, 108 harv. l. rev. 1661, 1662 n.7 (1995). by transferring capital to a firm providing limited liability protection, the transferor potentially protects untransferred assets from tort and other liabilities arising from the firm's business operations. 265. see shaviro, supra note 263, at 32-34. 266. we ignore transfers to wholly-owned s corporations because they are tax-free under current § 351. thus, the only case where the restrictive nature of the s corporation rule (in contrast to the partnership rule) on property contributions might come into play is in cases where there is more than one shareholder. 267. one commentator has suggested that the 80o control requirement in § 351 was inserted solely to prevent corporations with marketable securities from using their stock to buy property, thus shielding their vendors from immediate tax (and possibly transforming ordinary income into capital gain). because partnership interests are generally not marketable, and certainly were not when the partnership rule was established, the more liberal nonrecognition rule was appropriate for transfers to partnerships. see jensen, supra note 256, at 397. 1999] florida tax review a similar analysis applies to distributions. the principal nontax benefit of a distribution would seem to be the withdrawal of money or property from the common pool and the resulting ability of the distributee to make investment or consumption decisions directly. both partnership and s corporation distributions provide this same benefit. on the other hand, at least traditionally, there has been a difference between the nontax consequences of a liquidating distribution by an s corporation and a partnership: only the former has entailed the nontax disadvantage of loss of limited liability and other benefits of state law incorporation.268 despite this nontax difference, as we have seen, the tax cost of a distribution by an s corporation is higher than that of a distribution by a partnership. thus, from a lock-in standpoint, the partnership and s corporation tax rules would seem to be exactly the opposite of what they should be. the s rule, mindful of the somewhat smaller nontax benefits of an s distribution, should impose a smaller tax burden than the partnership rule to avoid an undesirable trapping of cash and property within the firm. the fact that the s rule does not do so of course does not justify it as the correct rule for the spbf system. but it does suggest that lock-in concerns may not be that significant in fashioning the proper rule in this area. and it also offers no compelling justification for adoption of the partnership distribution rule. a final observation: although the s distribution rules are more restrictive than the partnership rules, the difference between the two should not be overstated. for pro rata cash distributions, the rules are essentially identical.269 moreover, if section 751(b) were scrupulously followed by taxpayers-admittedly a highly questionable assumption-many non-pro rata property or cash distributions by a partnership may well be caught within its reaches, thereby triggering potential tax consequences to nondistributees as well as distributees relating to gains and losses inherent in undistributed as well as distributed property. in other words, the partnership tax consequences might be more onerous than the s corporation consequences in many of those transactions. when one further adds the recent bells and whistles of provisions such as sections 731(c), 704(c)(1)(b) and 737, it is evident that many partnership distributions are not nonrecognition events. this observation bolsters the notion that the choice between the two sets of rules should not make a significant difference from the standpoint of preventing lock-in. e. summary and proposals.-income recognition rules for contributions and distributions are strongly supported by simplification 268. "liquidating" distributions refer to distributions which completely liquidate the distributee's interest in the firm, whether or not the firm itself liquidates in the process. 269. see irc §§ 731(a)(1), 1368(b). [vol 4:3 the future taxation of private business firms objectives, a principal concern of the spbf system. furthermore, such rules are less vulnerable to taxpayer manipulation than nonrecognition rules such as the partnership rules. in contrast, widespread nonrecognition rules are not supported by either aggregate or entity principles and entail the highest transaction costs. tax policy considerations also do not dictate strongly in their favor. therefore, the spbf system should adopt the following contribution and distribution rules: i. contributions.--contributions to an spbf should follow the s corporation rules with two modifications. first, the 80% control standard should be significantly reduced. whatever its historical explanation, the standard is too high if the purpose of the rule is to distinguish between real economic exchanges and mere changes in form of ownership of the property contributed. lowering the 80% standard will also help to mitigate concerns about valuation difficulties and lock-in. at the same time, the "control group" rule in section 351 should not be adopted for the spbf system. as previously discussed, the control group rule permits transferors who clearly are achieving a substantial change in their property interests in joining a firm to obtain a nonrecognition result, so long as they join together with others who have a controlling interest in the firm. this result is not justified by either entity or aggregate principles. not including the control group rule also eliminates the need to define what the group is and avoids the potential surprise to members of the group when one of them is subsequently disqualified." dropping the control group rule may also be a necessary step, as a practical matter, if one is serious about requiring the recognition of gains and losses on contributions to an spbf constituting a real economic change. consider a minority owner whose contribution of property to an spbf would ordinarily be taxable due to an insufficient ownership interest in the firm. if there were a control group rule, that taxable result could easily be avoided by having the other owners accommodate the minority owner and make contemporaneous contributions of cash to the firm. under the proposed rule for spbf distributions (described next) as well as the current law applicable to partnerships and s corporations, pro rata cash distributions from an spbf are tax-free to the extent of the distributee's outside basis. thus, existing owners with enough outside basis might simply receive tax-free cash distributions and then recontribute the proceeds to accommodate the minority owner. this 270. cf. james v. commissioner, 53 t.c. 63 (1969) (disqualification of one transferor caused other transferors to be taxed). 1999] florida tax review maneuver seems to be possible under existing subchapter s and would also exist in the spbf system if the control group rule were retained.27' ii. no section 704(c)(1)(a) rule.-for several reasons, no section 704(c)(1)(a) rule is proposed for the spbf system. first, the rule is needed only where a property contribution to a firm is a nonrecognition event, something that will occur less frequently in the spbf system than under current partnership tax law. second, from the treasury's perspective, the principal purpose of the rule is to prevent the temporary misallocation of tax liabilities among the owners. eventually, the proper amounts of gain or loss will be allocated to the proper parties. but the spbf ownership restrictions are designed to limit the advantage of temporary shifts of that nature. thus, the fisc should be adequately protected even though section 704(c)(1)(a) is not mandated in the taxation of spbfs. third, inclusion of such a rule would introduce administrative complexities inconsistent with the goals of the spbf system. it would require property valuations on a property-by-property basis in exactly the types of situations---contributions by transferors who own a significant percentage of the firm-where precise valuations may not have been made. it would also be particularly difficult to implement in a tax regime which does not generally permit special allocations. moreover, to be wholly effective, any such rule would also need to overcome the ceiling rule problem and to apply to reverse section 704(c) situations, both of which would introduce even more complication. finally, although the issue arises under current subchapter s, we take some comfort in the fact that the treasury has managed to survive without importing section 704(c)(1)(a) principles into that area. some thought was given to returning to pre-1984 law for spbfs and to allowing the section 704(c)(1)(a) adjustment to be an option for the taxpayers. the reason is that the adjustment may be a desirable one for owners who fail to take into account in their economic dealing the difference in the tax quality of their respective contributions.272 thus, for such owners, a section 704(c)(1)(a) election could relieve a hardship. but elections are inconsistent with a goal of keeping the system simple. what may be relief for some may turn out to be an attractive nuisance for many others. in addition, it was unclear how common the hardship situation actually arises. at least for 271. it may be appropriate to fashion a tax-free exception for certain contributions to firms for which capital is not a material income-producing factor. this rule would allow, for example, a service partner who combines his or her firm with an existing service partnership to avoid being taxed on the contribution of goodwill even though the transferor does not end up with a sufficient ownership interest in the combined firm to qualify for taxfree treatment under the general rule. 272. see berger, supra note 63, at 143-46. [vol 4:-3 the future taxation of private business firms regular section 704(c)(1)(a) cases, the issue only comes up when there is a noncash contribution to a firm, which necessarily requires the parties to make some determination of the value of the property contributed. because value determinations are much more difficult than basis determinations, if the parties can satisfactorily reach agreement regarding value, it may be reasonable to expect that they will take into account basis information in their economic deal as well. this might be particularly true under the proposed spbf rule for contributions, which permits a nonrecognition result only where the contributor has some significant interest in the firm following the contribution. iii. distributions.-deciding on distribution rules for the spbf system that properly balance all of the competing considerations has been difficult. the foregoing discussion supports spbf rules more restrictive than the partnership rules, but it does not indicate how restrictive they should be. this article proposes that distributions by an spbf generally follow the subchapter s rules but again with certain modifications. first, like current partnership law and unlike current subchapter s, the taxation of distributees should be determined by just two categories of distributions, liquidating and nonliquidating. no special rule shall be provided for partial liquidations.m in a nonliquidating distribution, a distributee shall recognize gain only to the extent the amount of the distribution exceeds the distributee's outside basis. no loss shall be recognized. in a liquidating distribution, a distributee shall recognize gain or loss in the same manner as a sale or exchange of the ownership interest. as under current law, in determining the tax consequences of the distribution to the distributee, the distributee's outside basis should first be adjusted for any gain or loss recognized by the spbf in the distribution and passed through to the distributee. ' 4 in general, distributees shall obtain fresh start fair market value bases in any property distributed. failure to include a partial liquidation rule might seem to create a tax disparity between such a transaction and a sale by the owner of a portion of his or her ownership interests to a third party. in the former transaction, there would not be any required allocation of basis in computing gain whereas in the latter, there would be. but the two transactions may not be exactly alike because only the distribution results in a withdrawal of funds from the firm. in addition, the rules differentiating ordinary distributions from partial liquidations under current law are generally designed to prevent the former 273. compare irc § 302(a). again, the term "partial liquidation" is used here to refer to a distribution which effects a partial redemption of the distributee's interest. see supra note 223. 274. see irc § 1368(d). 19991 florida tax review from being disguised as the latter.27 5 in contrast, in the spbf system as in existing subchapter s, tax advantage would be gained from the opposite strategy, which the existing rules are ineffective at stopping.276 thus, as a practical matter, preservation of a partial liquidation rule may serve little purpose. 2 77 the other modification to the s distribution rules involves a nonrecognition exception in the spbf system for distributions constituting a mere change in form of ownership of the property distributed. this exception turns on the percentage ownership of the distributee in the spbf immediately prior to the distribution, and the percentage may or may not be the same as for the nonrecognition rule in the case of spbf contributions. 278 where the exception applies, the spbf does not recognize any gain or loss. the distributee also does not recognize any loss but must recognize gain to the extent money plus the basis of any property distributed exceeds the distributee's basis in the spbf prior to the distribution. this rule is necessary to prevent the distributee from obtaining basis without the recognition of a commensurate amount of income. the distributee inherits the spbf's basis in any property distributed, and the distributee's outside basis must be reduced by the money and the basis of any property distributed. example 3. immediately prior to a nonliquidating distribution, a owns 90% of the residual interests of an spbf with an outside basis of $100. assume the percentage interest is high enough to qualify for the nonrecognition exception. in the distribution, a receives property worth $150 and with a basis to the spbf of $30. under the exception, neither the spbf nor a recognizes any gain or loss in the transaction. a takes a $30 basis in the property distributed and reduces outside basis to $70. example 4. same facts as in example 3 except that the spbf had a $130 basis in the property distributed to a. under the nonrecognition exception, the spbf still does not recognize any gain or loss. a, however, must recognize $30 of gain, the excess of the spbf's basis 275. see irc § 302. 276. for example, the distributee might retain an option to acquire the necessary percentage of ownership interests to prevent a distribution from satisfying the numerical standard for a disproportionate redemption. cf. irc §§ 302(b)(2) and (c)(1), 318(a)(4). 277. professor eustice has recommended elimination of the partial liquidation rule for s corporations. see eustice, supra note 175, at 406. 278. different percentages might be justified if, for example, it were considered more problematic to discourage property contributions to an spbf than distributions from such firms. [vol 4:3 the future taxation of private business firms in the property distributed ($130) over a's pre-distribution outside basis ($100). a takes a $130 basis in the property distributed and a's outside basis is reduced to zero. an spbf may elect to have the foregoing exception not apply. an election is needed because there is one case in which the exception would produce an unfavorable result for taxpayers. in a liquidating distribution where the distributee's basis in the spbf is greater than the money and basis of property distributed, the exception causes the distributee to lose basis. this case is illustrated by the following: example 5. same facts as in example 3 except that the distribution liquidates a's interest in the firm. also, assume that a's outside basis in the spbf just prior to the distribution is $150. under the nonrecognition exception, no gain or loss is recognized to either a or the firm and a inherits the firm's basis of $30 in the property distributed. $120 of a's pre-distribution outside basis has disappeared. some thought was given to permitting a to receive a $120 capital loss in this situation. this would be the mirror image of the rule where the distributee's pre-distribution outside basis is less than the money plus the basis of any property distributed. as noted, in that case, the distributee is required to recognize gain equal to the excess. recognition of a capital loss to a might, however, create certain tax avoidance opportunities. step back a moment and assume that b previously owned the property distributed in example 5, with value of $150 and basis of $30, and was prepared to sell it to a for $150. assume the property qualified as a capital asset to b so that a straight sale of the asset would have resulted in $120 of capital gain to b and a $150 cost basis in the asset to a. instead, b contributes the asset tax-free to an spbf in exchange for 90% of the residual interests, and then sells the 90% interest to a for $150. on the sale, b recognizes the same $120 capital gain. if the subsequent liquidating distribution of the property to a allowed a to claim a capital loss, then a would receive a $120 capital loss and a basis in the asset of $30. in contrast to the results of the straight sale, a has basically deducted immediately $120 of the investment. true, the deduction is only a capital loss but if a has capital gains which need sheltering, this might be an attractive deal. consideration was also given to providing a with an exchanged basis in the asset distributed rather than a transferred basis whenever the exception applies. for example, in example 5, a would not recognize any gain or loss and would simply receive a $150 basis in the property distributed.. current 19991 florida tax review partnership tax law generally follows this approach279 but it raises many difficult questions. for instance, should there be any tax consequences to the spbf, either in terms of income recognition or reduction in basis of other assets, to reflect the increase in the asset's basis from $30 to $150?80 if the spbf were required to recognize income, how should its character be determined? if inside basis were reduced, how should the decreases be allocated?2"' and if more than one asset were distributed, or some combination of money and assets, how should the distributee's outside basis be allocated among the properties received? 282 it seemed unlikely that these and other questions could be satisfactorily resolved without a degree of complication inconsistent with the goals of the spbf system. in contrast, application of the proposed general rule for distributions would seem to provide the taxpayer with a perfectly acceptable result: example 6. same facts as example 5, except that the spbf elects out of the special exception. under the general rule for distributions, the spbf must recognize $120 in capital gain on the liquidating distribution and such gain is passed through to a, increasing outside basis to $270. thus, a would also recognize a $120 capital loss on the distribution, which would offset the $120 passthrough gain. a would receive a fair market value basis of $150 in the asset distributed. this result is exactly the same as the one that would have been obtained by a had the transaction involved the straight purchase and sale of the asset with b. although an election introduces its own complexities, it would seem to be the simplest solution in this case. the "mere change in form" exception is intended as a relief provision and where it produces an undesirable result, taxpayers should be provided with a way out of it. failure to provide an explicit election would simply give advantage to the well-advised who would "elect" out in a transactional manner. because in most cases, however, the exception would be advantageous to taxpayers, the proposal provides that taxpayers must affirmatively elect out of the exception. 279. see irc § 732(b). 280. under partnership law, if a § 754 election is in effect, the partnership would have to reduce its basis in other assets by the $120. see irc § 734(b)(2)(b). 281. under partnership law, basis reductions must generally be allocated to partnership property of "like character" to the property distributed, although there are anomalies in the allocation process. see irc § 755. 282. the partnership law rules are provided by § 732(c), as amended in 1997. [vol 4:3 the future taxation of private business firms iv. other rules not included.-in view of the proposed rules for spbf contributions and distributions, sections 704(c)(1)(b), 737, and 731(c) are unnecessary and not included in the spbf system. although section 751(b) is not made completely superfluous by the proposals-for example, a non-pro rata cash distribution might trigger tax consequences under that provision but not under existing subchapter s-it is also not included in the spbf system. discussion of section 751(b), however, as well as whether sections 724 and 735 and the collapsible corporation rules should be included in the spbf system, is included in a following section. certain highly publicized transactions continue to justify the need for effective disguised sale rules. 3 in addition, at a much less publicized level, there appears to be widespread noncompliance in that area. in a recent poll, a cross-section of accountants were asked to identify their prime targets for irs audit if they were to receive compensation equal to a percentage of any additional tax discovered. somewhat astonishingly, the "use of partnerships to defer taxation of disguised sales" was among the top five targets identified, along with such common areas of noncompliance as nanny tax situations and disguised dividends.' the need for disguised sale rules is much reduced in the spbf system. to the extent the transaction involves a property transfer to or distribution from an spbf which is taxable under the proposed rules for contributions and distributions, a disguised sale transaction obviously does not work. another common technique is to use special allocations to effect the disguised exchange of economic interests but the spbf rules specifically restrict the availability of special allocations.' but the need for anti-disguised sale rules in the spbf system is not completely eliminated. for example, a contribution of appreciated property to an spbf by an owner with a sufficient interest in the firm might be followed by a cash distribution to the transferor not exceeding the transferor's basis in the property contributed. if respected, both transactions would be taxfree under the spbf rules (as well as under existing subchapter s) even though they may together constitute the economic equivalent of a partial sale of the property contributed. another possible disguised sale opportunity under the proposals is where both a contribution and distribution of property are 283. see lee a. sheppard, using llcs for disguised dividends, 76 tax notes 1524 (sept. 22, 1997) (describing attempted tax-free sale of hundreds of millions of dollars worth of times mirror stock through use of disguised sale technique with an llc). 284. see burgess j.w. raby & william l. raby, tax 20 forum: an audit "hit list," 75 tax notes 105 (apr. 7, 1997). 285. the proposal does allow an spbf to have preferred interests. however, preferred returns are less likely to cause concern under the disguised sale rules. see regs. § 1.707-4(a)(2). 19991 florida tax review tax-free due to the transferor and the distributee having a sufficient ownership interest in the spbf. on balance, the reduced need for disguised sale rules in the spbf system does not justify retention of such complicated provisions, and they are not included in the spbf system. in the two cases just described, normal step transaction and other substance over form principles should adequately protect the interest of the fisc. for example, a cash distribution linked to a prior contribution of appreciated property should be considered boot received in the initial transaction which will cause the recognition of gains.28 6 although there is no doubt that some disguised sales will escape recharacterization under substance over form principles, it would appear that, as described above, the more elaborate partnership rules have also not been wholly effective. finally, we again take some solace in the fact that subchapter s has managed to function without any such rules. v. relation to default conduit system.-finally, the proposed income recognition rules for contributions and distributions within the spbf system must be compared to the taxation of comparable transactions under the default conduit version. for example, if the default version were to include the partnership nonrecognition provisions on contributions and distributions, taxpayers might be discouraged from using the spbf system. the various factors described above concerning the proper contribution and distribution rules are applicable to the default system as well as the spbf system. although simplification may be a higher priority for the spbf system, it is certainly an important consideration for the default system as well. further, no system benefits from a rule structure which can be easily manipulated by the taxpayer. and the default system is particularly vulnerable to potential manipulation because of the absence of any ownership restrictions and limitations on special allocations. in short, perhaps the easiest way to reconcile the two systems in this area would be to adopt the same basic rules in each system for contributions and distributions. the need for additional rules may then vary depending upon the peculiar features of each system. 4. treatment of ordinary income assets of an spbf a. sections 751 and 341 not included in the spbf rules.-the partnership provisions contain elaborate rules to insure that a partner's interest in potential ordinary income of the partnership is reflected 286. cf. irc § 351(b). see berger, supra note 63, at 151-52 (suggesting that the step transaction doctrine would prevent the transaction from succeeding). [vol. 4:3 the future taxation of private business firms in the character of the gain the partner recognizes in disposing of an interest in the partnership.' these rules also try to prevent character shifting among the partners as a result of a distribution.' on the other hand, if the correct proportion of ordinary income and other assets (determined by value of the assets) is distributed, no attempt is made to be sure that the assets distributed have the same mix of unrealized ordinary income or loss as the underlying assets of the partnership.' these "collapsible partnership" rules governing the treatment of ordinary income assets held by a partnership are among the most complicated in the code. moreover, unlike rules such as subpart f in the foreign tax area or the consolidated return regulations, these rules apply to many taxpayers with very simple business arrangements and relatively unsophisticated advisors. the result, not surprisingly, is a common assumption that these rules are often honored in the breach. the collapsible partnership rules apply to transfers of partnership interests and to distributions from partnerships. the rules governing transfers are in some ways easier to understand than the rules governing distributions. they essentially insure that the transfer of a partnership interest be viewed as a transfer of the underlying assets in order to preserve the character of gain or loss inherent in the transfer. but the rules governing distributions are of equal importance in preventing the use of the partnership structure to avoid the proper characterization of income at the partner level. it would not be possible to adopt the rules for transfers without some rules for distributions. as previously described, a distribution of property by an spbf would be taxable in more instances than a comparable distribution by a partnership. this change reduces but does not eliminate the theoretical need for a collapsible partnership rule in a distribution. for example, a non-pro rata distribution of cash by an spbf with ordinary income assets would generally not be taxable under the spbf proposal yet it may shift some of the potential ordinary income tax liability from one owner to another. some of the complexity of the collapsible partnership rules derives from the broad definition of assets that are covered by the rule. although the statute speaks of unrealized receivables and either inventory (in the case of transfers of partnership interests29 ) or substantially appreciated inventory (in the case of distributions29 ), the provisions apply to portions of assets and to expectancies in a way that only a well-advised firm could possibly be expected to follow. 287. see irc § 751(a). 288. see irc § 751(b). 289. see mckee, nelson & whitmire, supra note 202, 21.01[2] at 21-6 21-7. 290. see irc § 751(a)(2). 291. see irc § 751(b)(1)(a)cii). 1999] florida tax review but the complexity of the provisions goes beyond those details because they require taxpayers to trace through the consequences of complicated transactions that are created by the statute alone. it is hard to imagine such a structure being applied correctly by any but the most welladvised taxpayers. s corporations are not subject to the collapsible partnership rules. on the other hand, they are subject to the infamous "collapsible corporation" rules (section 341), which the american law institute has previously described as "characterized by a pathological degree of complexity, vagueness and uncertainty." '292 where it applies, section 341 treats as ordinary income any capital gain from the sale of an s corporation's stock or from a distribution treated as a sale or exchange. 93 the provision is a close brethren of the collapsible partnership rules, both in terms of purpose and complexity. it therefore seems inevitable that neither of these rules will be included in any simple regime such as the spbf system. the question is whether it is necessary to preserve some part of them in order to avoid abuse of the spbf structure. consider the following example: example 7. taxpayer g owns an asset with a significant amount of unrealized ordinary income. g transfers the asset to an spbf in exchange for an ownership interest in the firm. g subsequently sells the interest to h, recognizing capital gain on the sale. one small way the proposed spbf rules would prevent this transaction is by restricting the instances in which g could transfer the asset tax-free to the firm. a more important protection, however, is the ownership limitations of an spbf. to the extent the owners of an spbf are in roughly the same tax position, concerns that one taxpayer may avoid some tax at the expense of another owner may be minimized. in other words, as long as the issue is the proper allocation of income character among the owners, the spbf ownership rules may provide adequate protection without the need for a special set of rules. thus, example 7 should not lead to major tax avoidance if h (and any other owners of the firm) can be expected to pay tax at roughly the same rate g would have been subject to.294 so long as the unrealized ordinary 292. american law institute, proposals of the american law institute on the income taxation of corporate acquisitions and dispositions, a.l.i. federal income tax project, subchapter c 111 (1982). 293. see irc § 341(a). 294. if h were not a permissible owner of an spbf, then eligibility for the simplified system would end with the sale. we have not worked out all of the consequences of a transition from the spbf system to the default conduit system, but presumably one [not 4:3 the future taxation of private business firms income remains in the spbf following the sale, some future owner will have to pay tax on it. as described in the next section, no inside basis adjustment is authorized upon sale of an spbf ownership interest. thus, any unrealized income of the spbf should ordinarily remain inside the firm following such a sale. indeed, under those circumstances, one might even expect h's purchase price for the ownership interest to reflect to some extent the lurking ordinary income tax liability inside the firm. a similar analysis applies to distributions. if a non-pro rata distribution of cash to one owner leaves behind a disproportionate amount of the firm's ordinary income tax liability for another owner, one might presume that the fisc will come out about the same if the two owners are in roughly the same tax position. in a rough way, congress has shown acceptance of this theory through enactment of section 341(f). in general, that provision allows a shareholder to recognize capital gain upon the sale of stock of a collapsible corporation on condition that the corporation recognize any unrealized ordinary income at some future point in time. in other words, as long as someone pays tax on the ordinary income--either the remaining shareholders of an s corporation or the corporation itself in the case of a c corporation--the concern of the collapsible corporation rules is satisfied. moreover, unlike the protection offered by the spbf ownership rules, the section 341(0 election is not conditioned on whether the ultimate taxpayer is in the same tax position as the shareholder who sold the stock.' to be sure, this pollyannish approach to taxing spbfs will not be justified in every case. but even the full panoply of current subchapter k does not prevent taxpayers from structuring transactions that fulfill the requirements of the code and yet appear to be inconsistent with the intent of this subchapter.29 furthermore, rules are only as effective as their voluntary, correct observance by taxpayers or their proper enforcement by the irs, both of which being matters of serious doubt when it comes to provisions such as the collapsible partnership and corporation rules. although some abuses will no doubt remain in the spbf system, the goal of the consequence would be the application of the normal default system rules to the terminating transaction. thus, if § 751(a) were part of the default system, it would potentially recharacterize g's gain on the sale from capital gain to ordinary income. 295. the rule may, nevertheless, have that general effect. c corporations with taxable income of $75,000 or more are taxed near the highest individual rates. and s corporations have approximately the same ownership restrictions as an spbf. of course, the § 341(f) election is nonsensical in today's world with the repeal of general utiities. the taxpayer gets a benefit by having the corporation agree to do something--recognize corporatelevel income--which is already required by law. 296. see n.y.s.b.a. tax section report, supra note 67. see also regs. § 1.7012(d), exs. 7, 8; ti). 8588, 1995-1 c.b. 109 (preamble to original version of regs. § 1.701-2). 19991 florida tax review structure is to balance the needs of the fisc with the desire to have a system that can be applied by the taxpayers who elect to use it. omitting the collapsible partnership and corporation rules from the spbf structure may lead to the shifting of some ordinary income and capital gain among owners of an spbf, but should not lead to widespread tax avoidance. accordingly, sections 751 and 341 are not included in the spbf system. b. character continuation rules.-a different issue altogether arises if a transaction permits the conversion of ordinary income into capital gain, rather than the mere misallocation of such items. the spbf ownership restrictions provide no protection against this advantage. conversion opportunities arise because, under the normal rule for conduit taxation, the character of income is determined by the firm and then passed through to the owners.2" thus, an owner with an asset containing unrealized ordinary income might contribute the asset to an spbf in a taxfree manner and then have the firm recognize the income. if the firm's income were properly characterized as capital gain, the ordinary income tax liability would be lost forever. similarly, an spbf holding an asset with unrealized ordinary income might distribute the asset to an owner in a taxfree manner. again, if the distributee's recognition of the income were capital gain, the ordinary income tax liability would be lost forever. the proposed contribution and distribution rules for an spbf narrow the instances of this problem by restricting how often such transactions will be nonrecognition events. but under the proposals, certain contributions and distributions will still be tax-free. when they are, the ordinary income character of an asset in the hands of the spbf and the distributee following a contribution and distribution, respectively, will be preserved. these rules are embodied in current sections 724 and 735 applicable to partnerships. for the spbf system, those two rules are adopted but simplified by limiting their application to traditional ordinary income items (e.g., inventory items and accounts receivables) and ordinary income recapture items. 5. inside basis adjustments a. in general.-if a partnership makes an election under section 754 of the code, any transfer of an interest in the partnership results in a set of adjustments for the transferee with respect to the bases of assets held by the partnership; the adjustments will generally bring the bases of 297. see irc §§ 702(b), 1366(b). the spbf proposals follow this rule. see supra part iv.c.2.a. [vol. 4:3 77t future taxation of private business firms those assets attributable to the transferee closer to their fair market values.298 similarly, if a section 754 election is in effect at the time of a partnership distribution, adjustments are made under section 734(b) to the bases of the assets of the partnership to take account of any discrepancies between the pre-distribution basis of any distributed asset in the hands of the partnership and the post-distribution basis of such asset in the hands of the distributee.29 the rules of subchapter s have no provision comparable to section 754. b. adjustments made on distributions of property.-in the case of distributions of property, the adjustments made under section 734(b) that are based on discrepancies between the pre-distribution inside basis of property distributed and the post-distribution basis of such property in the hands of the distributee are not necessary as a result of the proposed spbf treatment of distributions. under that proposal, a distribution results either in the recognition of gain or loss by the spbf, with accompanying fair market value basis to the distributee in the property distributed, or a pure transferred basis to the distributee equal to the firm's pre-distribution basis. section 734(b), however, also applies when the distributee recognizes gain or loss on a distribution and this situation could arise in the spbf system: example 8. a, b and c contribute $10,000 each to an spbf and take back equal shares of the firm. the firm purchases for $18,000 an asset which increases in value to $24,000. at that time, the spbf distributes $12,000 to a in liquidation of a's interest. under the spbf distribution proposal, a must recognize a $2,000 gain. if a section 754 election were available and in effect, the basis of the firm's asset would be increased by the $2,000 gain recognized by a. thus, if the asset is subsequently sold by the spbf for $24,000, there would be only $4,000 gain recognized, allocated $2,000 each to b and c. without that basis adjustment, the firm's gain on the sale would be $6,000, allocated $3,000 each to b and c. the failure to adjust basis if there were no section 754 election available or in effect does not create a permanent mismeasurement of the amount of gain or loss to be recognized by the remaining owners. in the example above, absent a section 754 election, the $6,000 gain passed through to b and c increases their outside bases by $3,000 apiece. if the spbf were 298. see irc §§ 743(b), 755. 299. see irc §§ 734(b), 755. 1999] florida tax review liquidated at that time and each of them received a distribution of $12,000, each would recognize a $1,000 loss. thus, when there is no section 754 election made, the effect is on the timing of income. although there is no equivalent of section 751 in the spbf rules, the absence of a section 754 election will not affect the character of the income recognized to the owners as a group. in the example above, if the asset owned by the spbf would generate ordinary income, a would nevertheless recognize a $2,000 capital gain on the liquidation of the spbf interest (assuming it is a capital asset in a's hands). this is a consequence of the absence of section 751. however, because there is no section 754 available, the firm will recognize the full $6,000 gain as ordinary gain, and c, as well as b, will have $3,000 of ordinary income as a result. presumably, the parties can take this into account in fixing a price necessary to liquidate a's interest. of course, if the asset had decreased in value, resulting in a distribution of less than $10,000 to a, the effect would have been an acceleration of capital loss (but no ordinary loss) to a, while b and c would have received an allocation of more ordinary loss than they would strictly "deserve." section 754 elections make the conduit rules operate more precisely. however, they do so in a way that involves substantial complexity for those who must comply with the tax provisions. it seems likely that many spbfs would not rigorously apply the rules of sections 754 and 734(b) even if the opportunity were available to them. furthermore, the proposed distribution rules for the spbf system makes the election less necessary in the case of an spbf distribution than under subchapter k. in order to make the spbf system more manageable for those who elect it, no section 754 election is provided for in a distribution. c. adjustments made on the sale of ownership interests.-when a section 754 election is in effect, upon a sale of a partnership interest, the transferee receives special basis adjustments with respect to the partnership assets attributable to the transferred interest.3" as a result, the transferee is not required to pay tax on unrealized gain that the transferee has, in effect, already paid for. as with the adjustment on distributions, omitting the adjustment on a sale changes the timing of the recognition of income: example 9. same facts as in example 8, except that instead of liquidating a's interest, a sells it to buyer d for $12,000, its fair market value. a recognizes a $2,000 gain on the sale. if a section 754 election were available and in effect, d would receive a special 300. see irc §§ 743(b), 755. [vol. 4.3 the future taxation of private business firms $2,000 upward basis adjustment with respect to the firm's appreciated asset (one-third of the $24,000 fair market value less one-third of the $18,000 basis). thus, if the asset is sold by the firm for $24,000, d's $2,000 share of the firm's $6,000 gain would be completely offset by d's special $2,000 basis adjustment. in example 9, when no section 754 election is in effect, d's $2,000 share of the gain on the sale of the asset results in a larger outside basis in the firm. thus, when d sells the interest in the firm, d will have less income than had a section 754 election been in effect. the increased income at the time the asset is sold is matched by decreased income when the spbf interest is sold. despite the benefits that the precision of section 754 affords in the case of a transfer of ownership interests, the cost in terms of complexity is quite great. unlike the adjustments on a distribution which can be made to the general basis of the firm, the basis adjustments on a sale are unique to particular owners. in example 9, the $2,000 basis adjustment belongs to d only; b and c would be taxed incorrectly if the general basis of the firm in the asset were increased by $2,000 and the three owners subsequently split equally the resulting $4,000 gain upon sale of the asset.~" in addition, if the firm has many assets, the total basis adjustment must be allocated among those assets. if there are multiple sales, it will have to keep track of separate sets of such adjustments for different owners. moreover, it will have to remember to apply all of the adjustments correctly in calculating and allocating gains and losses of the firm on future sales. the timing problems that arise when no section 754 election is permitted have been tolerated in the subchapter s context. because of the proposed spbf distribution rules, there should be no permanent effect on the amount of income recognized. not allowing a section 754 election can give individual owners tax consequences that are not precise. however, those consequences can to some 301. but see prop. regs. § 1.743-2(a) allowing a special basis adjustment with respect to only one partner to be taken into account as a general partnership basis adjustment when partnership assets are deemed contributed to a corporation pursuant to an elective conversion from partnership to association tax status. (under prop. regs. § 301.7701-3(g)(l)(i), if a partnership elects to be classified as an association for tax purposes, the partnership is deemed to contribute all of its assets and liabilities to the association in exchange for stock in the association, followed by an immediate liquidation of the partnership and distribution of such stock to the former partners.) in the deemed contribution of assets to a corporation, the corporation's basis in the assets contributed generally takes into account any special basis adjustments belonging to individual partners. prop. regs. § 1.743-2(a). the individual partners also preserve their special basis adjustments in determining their basis in the corporate stock received in the exchange. prop. regs. § 1.743-2(c) (2d sentence). 19991 florida tax review extent be predicted at the time of a purchase, and, at least in theory, adjustments can be made to the purchase price to accommodate those consequences. in any event, the benefits of the simplicity of the spbf system should prove attractive enough to make taxpayers willing to adopt the spbf structure despite this imprecision. the absence of the section 754 election also permits manipulation by the owners of some of their tax consequences. but because section 754 is elective under current law, that possibility already exists.2' true, the absence of section 751 in the spbf structure makes this manipulation potentially more serious. yet the manipulation is primarily a problem to the fisc to the extent taxpayers with significantly different tax profiles are willing and able to join together in an spbf. if the spbf qualification rules are sufficiently stringent generally to prevent that phenomenon, the benefits of the simplicity of the spbf system outweigh the cost of an occasional abuse. in summary, the spbf system does not provide for inside basis adjustments in the case of transfers of spbf interests or distributions by an spbf. 6. conversions/reorganizations of firms from one system to another.-the proposals described in this article would tax general business firms in three ways. private firms qualifying as spbfs would be taxed at their election under either the spbf system or the default conduit system. all other private firms would be subject to the default conduit system. finally, public firms would continue to be taxed under subchapter c. this section sketches out some preliminary considerations in ascertaining the tax consequences of a firm moving from one system to another. the movement may occur as a result of an elective conversion (for example, an spbf electing to leave the spbf system and to be taxed under the default conduit system) or a reorganization of some sort (for example, a public firm acquiring a private firm in a transaction qualifying as a reorganization under current law). a. private firm (either spbf or default system) to public finn (subchapter c).-the movement from one of the private firm tax 302. see regs. § 1.701-2(d), ex. (8) and (9) (describing manipulative possibilities under current subchapter k if no § 754 election is in effect). the acm partnership transaction also would not have worked had there been a § 754 election in effect. see supra note 88. strategic planning may help to prolong the benefit. cf. louis s. freeman & thomas m. stephens, using a partnership when a corporation won't do: the strategic use and effects of partnerships to conduct joint ventures and other major corporate business activities, 68 taxes 962, 995 (1990). finally, imprecision in the § 755 basis allocation rules creates planning opportunities. see andrews, supra note 67, at 25-37. [vol 4:3 the future taxation of private business firms systems to subchapter c involves a change from a conduit tax system to a double tax system. as such, this type of transaction would seem to be a good candidate for liberal tax-free treatment. current law generally achieves this result. for example, there are no tax consequences if a private c or s corporation goes public; in the latter case, the corporation simply loses its s eligibility and is thereafter taxed under subchapter c. in addition, both a private c and s corporation may be acquired by a public corporation in a taxfree reorganization. finns taxed under subchapter k cannot convert to public c status quite as easily as private corporations, and cannot reorganize directly with public c corporations, but they can accomplish the same general results with adequate advance planning. for example, the irs generally respects the form chosen by the taxpayer for incorporating a partnership, with tax-free treatment being the general consequence, although the specific tax results vary slightly among the techniques.0 3 once incorporated, the firm may go public or, with sufficient delay, the former partnership may then participate in a tax-free reorganization with a subchapter c corporation. certain publicly traded partnerships are also automatically treated as corporations for tax purposes and taxed under subchapter c.30 4 while the substantive outcomes of firms moving from private c, subchapter k, or subchapter s status to public c status are therefore alike, the manner of achieving those results under current law are different. there does not seem to be any good policy reason for preserving these differences, with their accompanying increase in planning and transaction costs. hence, this article proposes generally to allow movement of a firm from the spbf or default conduit system to subchapter c to be accomplished in a tax-free manner, whether the transaction is carried out as a conversion or reorganization. thus, for example, if an spbf converts to public c status or is acquired by a public c corporation in a transaction qualifying as a reorganization, and in the process, the spbf liquidates, no gain or loss should be recognized by the spbf or its owners in the liquidation. 303. under rev. rul. 84-111, 1984-2 c.b. 88, if the partnership transfers its assets, subject to its liabilities, to a new corporation and then liquidates, the transfer to the corporation is governed by § 351 and the liquidation of the partnership is governed by § 731 and § 732 (taking into account the effects of § 752). if it liquidates, and then its partners transfer the assets and liabilities to a new corporation, the liquidation is governed by § 731 and § 732 (taking into account the effects of § 752), and the transfer to the corporation is governed by § 351. if the partners transfer their partnership interests to a new corporation. which causes the partnership to terminate as a matter of law, the transfer is governed by § 351 (taking into account the effects of § 752), and the liquidation is governed by § 731 and § 732. 304. see irc § 7704(a). 19991 florida tax review b. public firm (subchapter c) to private firm (either spbf or default system).-in contrast to a private-to-public transaction, a public-toprivate transaction places the integrity of the double tax system in jeopardy because all private firms are taxed under the proposal as conduits. when the situation arises under current law, the double tax obligations are generally either triggered in the transaction or preserved. for example, conversion of a corporation into a partnership for tax purposes is treated as a taxable liquidation of the former. 5 conversion of a c corporation into an s corporation gives rise to the potential applicability of the built-in gains and passive investment income taxes under subchapter s.3"6 in general, those two provisions authorize the subsequent taxation of the firm's accumulated subchapter c earnings and profits and built-in subchapter c gains in certain circumstances. the built-in gains and passive investment income provisions, however, offer incomplete protection for the double tax system. for example, the built-in gains tax applies only when there is a net built-in gain in the assets of the corporation at the time of the conversion. no attention is paid to the likelihood of any built-in gains or losses being recognized in the future, or to the character of such gains and losses. and exposure to the tax is limited to a ten-year period. the passive investment income provision merely attempts in a very rough way to limit the ability of a firm to delay the shareholder tax on subchapter c distributions. in addition to being incomplete, both provisions also introduce undesirable complexity into the rule structure. a public-to-private transaction may be relatively infrequent but when it occurs, it generally represents a fundamental change in the nature of the firm. currently, the tax system treats far less significant changes as taxable events.307 it therefore seems appropriate to treat a public-to-private transaction as a taxable event, thereby protecting better the integrity of the double tax system and avoiding the complexity of provisions such as those found in subchapter s. this rule would be similar to current proposals to treat 305. proposed amendments to the check-the-box regulations adopt this approach if the change in the tax status of the firm is made by election. see prop. regs. § 301.77013(g)(1)(ii). liquidation treatment occurs even though the corporation is a private c or subchapter s firm. 306. see irc §§ 1374, 1375. the s corporation is also more vulnerable to loss of its subchapter s eligibility if the firm has a subchapter c history. see irc § 1362(d)(3). these rules apply regardless of whether the subchapter c corporation was public or private. 307. see, e.g., regs. § 1.1001-3 (rules for determining whether a modification of the terms of a debt instrument receives exchange treatment under irc § 1001). [vol. 4:3 the future taxation of private business firms conversions of large c corporations into s corporations as complete liquidations for tax purposes.3°s one public-to-private transaction under current law--a public c corporation going private but remaining under subchapter c-is not a taxable event. further, if the public-to-private change results merely from an inadvertent crossing of the public/private line, the change may not even be a very significant one for the firm.' the proposals do not provide a comparable way to address this hardship case because they do not permit private firms to be taxed under subchapter c. one narrow solution to this problem is to allow any public firm which unintentionally becomes a private firm to continue to be taxed under subchapter c for a period of time. during that period, the firm could either regain public status, and thereby continue under subchapter c, or make permanent its private status. in the latter case, the normal consequences of a public-to-private change would then arise at the end of the period. c. changing tax systems of private firms (spbf to default system or vice-versa).-under current law, the taxation of private firms which change tax systems is not very coherent. for example, an s corporation which converts to a partnership is treated as a taxable liquidation of the firm. on the other hand, a partnership can generally incorporate and elect to be taxed under subchapter s in a tax-free manner. change from private subchapter c status to one of the other tax systems implicates the double tax features of subchapter c. under the proposal, all private firms are taxed as conduits, pursuant to either the spbf or default systems. thus, changing from one system to another, either by way of conversion or reorganization, could potentially be a tax-free transaction. that conclusion, however, must be tempered by the desire to protect the integrity of the rules of each system. for example, the default conduit tax system, modeled after existing subchapter k, will likely have a number of structures in them that are intended to prevent abuse of that form. the spbf structure does not include those provisions in order to keep its operational rules relatively simple and easy to work with. thus, as previously described, the rules involving "hot assets" and special allocations are not included in the spbf system. if a non308. see staff of the joint committee on tax'n, 105th cong., description and analysis of certain revenue-raising provisions contained in the president's fiscal year 1998 budget proposal 43 (comm. print 1977). the same proposal is included in the president's f'y 1999 budget submission. president's budget proposals, fy 1999, 352 table 8-6 (effect of proposals on receipts). 309. the public/private line under current law is set forth in § 7704(b) and the regulations thereunder. 1999] florida tax review spbf private firm could be transformed into an spbf with no tax consequences, it seems likely that the anti-abuse rules for the non-spbf form could be avoided. similarly, consider the taxation of a firm changing from the spbf system to the default conduit system. at first blush, this might seem to be the most benign of possible transactions because the firm is leaving a system with relatively few anti-abuse protections and entering one with many more. on the other hand, the default conduit system will likely contain various desirable tax features unavailable in the spbf system. for example, the default system will likely permit inside basis adjustments not allowed by the spbf system. a change from the spbf to the non-spbf system should not allow a firm to gain one of these tax advantages without being subject to an appropriate anti-abuse protection. example 10. a and b own an spbf whose principal asset would generate ordinary income if sold. there is a sale of ownership interests from b to c. in the sale, b recognizes capital gain because the spbf rules do not have a section 751-type rule. this result makes sense if c has more-or-less the same tax profile as b and steps into b's shoes vis-a-vis the unrealized ordinary income of the firm. c, however, is a nonresident alien and the sale therefore causes the firm to lose its spbf status and to be taxed under the default conduit system. under the default system, the firm makes a section 754 election which provides c with a special basis adjustment in the ordinary income asset of the firm to reflect the gain recognized by b on the sale. as a result, b's ordinary income liability is lost forever; it is not recognized by b on the sale nor will it be recognized by c in the future. the precise tax consequences of private firms changing tax systems under the proposal are somewhat up in the air as long as all of the details of the spbf and default conduit systems remain unsettled. however, the result under example 10 should not be permitted. in general, firms would be entitled to the benefits of the default system only if they are fully subject to the antiabuse protections of that system. 7. transitional considerations.-this section will briefly discuss some transitional considerations to bridge the gap between current law and the proposals presented in this article. to help explain the development of the concepts, this article has generally described the spbf and default version of conduit taxation as brand-new operating rule systems. in fact, however, the spbf system is very similar to existing subchapter s and the default system should be similar to [vol 4:3 the future taxation of private business firns existing subchapter k. thus, existing firms subject to either subchapter k or s should have little difficulty making the transition to the world presented by these proposals. upon adoption of these proposals, the firms will simply be taxed under slightly amended versions of those subchapters. private firms currently taxed under subchapter c, however, face a significant transitional problem because that subchapter would no longer be available to such firms once the proposals are adopted. moreover, the normal consequence of the conversion of a subchapter c firm to one taxed under a conduit tax system is a taxable liquidation of the former. it seems unlikely that forcing all existing private c corporations to liquidate in a taxable manner upon adoption of the proposals would either be appropriate from a policy standpoint or feasible politically. the transitional alternatives to an immediate taxable liquidation of private c corporations run the gamut from (1) a permanent grandfather of all existing private c corporations; (2) a temporary grandfather period during which a liquidation must take place; (3) an immediate or deferred liquidation with resulting tax liabilities to be paid over an extended period of time, or with some reduction in the tax liability owed;3 0 (4) a tax-free conversion to one of the conduit systems combined with rules such as sections 1374 and 1375 to preserve subchapter c gains; and (5) a tax-free conversion with no preservation of subchapter c gains. a number of factors, including political considerations, will help to decide which if any of these alternatives should be implemented. v. summ ary and conclusion as a result of recent federal and state law developments, the taxation of private business firms is no longer rational. existing law is built upon the premise that business organizational form and characteristics are significant for tax purposes. the recent developments, however, contradict that premise. consequently, the entire scheme of taxing private businesses, including the current choices of subchapters c, k, and s for many private business firms, must be rethought. this article suggests that in the future, all private firms should be taxed as conduits. under conduit taxation, the firm is not taxed but the owners of the firm are. although conduit taxation is flawed in important respects and is extremely complicated to implement, the alternative of taxing the firm and not the owners may not be any better. further, an entity tax 310. for example, any resulting gains might be taxable at a special low rate of tax, or some portion of the gains might be exempted from tax altogether. this option might be justified on the basis that most private c firms do not ever incur a full double tax on their income. 1999] 248 florida tax review [vol. 4:3 scheme would present greater transitional problems than widespread adoption of conduit taxation. because conduit taxation is so difficult, this article further suggests that it should be implemented in two versions. one version-a reformed subchapter k-should concentrate on providing as precisely correct conduit tax results as possible, even at the cost, if necessary, of some additional complication. the other version-a liberalized subchapter s-should focus on providing as administrable a set of conduit rules as possible with some concession, if necessary, to not achieving the correct outcome in all cases. because the simplified conduit version would be elective to qualifying firms, careful consideration of the substantive tax outcomes under the two versions must be given to insure the continuing appeal of the simplified version. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 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for horizontal equity ("he") without a vertical equity ("ve") rule, as i argued, is at best to be seen as a protection against arbitrary discrimination, a goal which could also be met by random taxation.' i stayed with that view' until louis kaplow's support of a similar position4 made me return to the issue. perhaps a bit wiser if less clever, i then came to conclude that there was a case, after all, for recognizing he as a distinct norm.5 kaplow, responding in this review, rejected my case as assuming what is to be proven.6 i am not persuaded and hence this further note. as i suggested in my paper, a distinction need be drawn between viewing the problem in a first best setting where taxes can be arranged so as to fully comply with equity norms and situations where, due to political or other constraints, the choice is among second best solutions. the same distinction is again drawn here. * h.h. burbank professor of political economy, emeritus, harvard university and adjunct professor, university of california at santa cruz. 1. richard a. musgrave, the theory of public finance: a study in public economy 160 (1959). 2. id. 3. see richard a. musgrave & peggy b. musgrave, public finance in theory and practice 216 (2d ed. 1976). 4. louis kaplow, horizontal equity: measures in search of a principle, 42 nat'l. tax j. 139 (1990). 5. richard a. musgrave, horizontal equity, once more, 43 nat'l. tax j., 113 (1990). 6. louis kaplow, a note on horizontal equity, 1 fla. tax rev. 191 (1992). horizonial equity": a further note hi. first best setting applied to the first best world, i grant for purposes of this commentary a setting where arrangements which satisfy ve also satisfy he.' this then permits me to focus on situations of conflict which arise from political and practical constraints. assuming first that there are no such constraints, let l, and l, have similar low and h, and h., similar high incomes. then if ve calls for the h group to pay twice as much as the l group, it also follows that l, and l, each will pay the same, as will h, and h,. meeting the ve rule also meets the he rule. this much follows, but the story does not end here. while satisfying ve implies also satisfying he, it does not follow that he is a mere derivative of ve. i again begin with the observation that almost everyone agrees with the he rule, which calls for equal treatment of people in equal positions.' the general principle of he is almost universally accepted. at the same time views on ve, the desirable pattern of differentiation among unequals, differ widely. x, who sees distributive justice in lockean terms of entitlement to earnings, will view justice in taxation in benefit terms: people who value public services equally should pay a similar tax price. y and z, who take a utilitarian approach, will view as just that distribution of the tax burden which minimizes the aggregate welfare loss, but the shape of their subjective welfare functions will differ. others may choose yet different criteria of fairness, such as a burden distribution which imposes a proportional loss. given perfect implementation, all these rules involve equal treatment of equals, but the outcomes will differ. my conclusion to be drawn from this observation is not that he is redundant and a mere derivative of ve. rather, the pervasiveness of the he rule in the varying ve contexts suggests that he is a primary principle, reflecting a basic premise of social mores-as stated in the biblical golden rule or the kantian imperative-with which all just people will (must) agree. but having complied therewith, just individuals are then free to disagree on 7. departing from the well-behaved setting, conflicts may arise even with identical tastes if the feasible set is non-convex (see a.b. atkinson and joseph e. stiglitz. lectures in public economics, 354 (mcgraw-hill) (1990)) and more generally where tastes differ (see martin s. feldstein, on the theory of tax reform. j. pub. econ. ( 1976) 6. 1. at 83). see also infra note 9. 8. this is not to deny that there may be a debate over the appropriate index of equality, e.g. equal income or consumption, appropriate definition of the taxable unit and so forth. these are important issues in tax practice, but a more or less satisfactory solution may be agreed upon. see richard a. musgrave, the nature of horizontal equity and the principle of broad-based taxation: a friendly critique, (john c. hind ed. 1983). taxation issues of the 1980s, australian tax research foundation, reproduced in i richard a. musgrave, public finance in a democratic society 301 (new york univ. press) t 1986). 19931 florida tax review the desirable pattern of ve. they are free to defend their positions when participating in the formation of a social consensus regarding ve policy. the universally accepted he rule and the agreed upon pattern of ve differentiation are then both encompassed in the final norm, but the inputs differ. the "practical" man or woman might argue that the decomposition of the final equity norm into its he and ve components is of no practical concern, since both components will anyhow be encompassed in the final solution. perhaps so from that person's perspective, but the more careful observer of social mores will find it of interest and importance to understand the distinct inputs which enter into equitable solutions. moreover, that understanding becomes crucial when proceeding to an imperfect setting which meets the actuality of tax reform. iii. second best settings as kaplow sees it, my concern with he in that setting undermines my very case for recognizing he as a distinct norm. he, he argues, is achieved as a by-product of distributive theories because such theories are usually derived in a first best world. to make my case for an independent he rule, he holds, i must offer an example where an he violation would, under any "relevant" (meaning, i take it, first best and widely accepted) distributive theory, count as decisive against an otherwise desirable policy. he then posits a situation where redistribution from the rich to the poor would yield substantial welfare gains, even though one among many rich cannot be tagged. he concludes that under any "relevant distributive theory," including the usual utilitarian model, such an he defect would not be permitted to reject the policy. this of course follows if the relevant norm is defined in ve terms so as to permit only the usual welfare losses to count. my contention is precisely that such a formulation is insufficient and that a more complex "meta set" (to use stiglitz's term) is needed which allows for he considerations.9 to avoid misunderstanding, note that this does not mean "decomposition" of ve into two components, but the addition of an he component to the ve norm. once that further dimension is allowed for, kaplow's 9. see joseph e. stiglitz, utilitarianism and horizontal equity: the case for random taxation, j. pub. econ. (1982) 18 at 28, where the need for a meta principle, which transcends the welfare maximization rule, is recognized to deal with such situations. for a similar finding in the context of differences in ability and preferences, see feldstein supra note 7, at 97, where it becomes necessary to balance "the desire for horizontal equity against the utilitarian principle of optimal taxation." whereas these conflicts pertained to tax design without political constraints but caused by an "ill-mannered" setting, my concern is with those less lofty situations where for political or other reasons it is impossible to implement what might otherwise be optimal solutions. nevertheless, the need for what stiglitz calls a meta principle or what feldstein calls a tradeoff need arises in both cases. [vol. 1:6 horizontal equitv: a further note illustration (large ve gain, small he loss) stacks the deck and can easily be matched by a counter illustration with opposite weights. in order to illustrate situations where he and ve considerations may conflict and a tradeoff is called for, i attempted in my earlier paper to construct indices, designed to measure the degree of he and ve, and then to apply them in ranking a set of hypothetical and simplified policy choices. ranking of second best solutions initial i ii ill iv income tax net tax net tax net tax net 1. l, 5 0 5 1 4 0.4 4.6 0 5 2. l, 5 0 5 1 4 1.3 3.7 0 5 3. h, 10 4 6 3 7 2.5 7.5 3 7 4. h, 10 4 6 3 7 3.8 6.2 5 5 5. total 30 8 22 8 22 8.0 22.0 8 22 indices 6. ve -0 6.4 6.4 1.6 7. he:l -0 0 2.3 0 8. e:h-0 0 3.5 1.1 9. he:total -0 0 2.3 1.6 the above table repeats that illustration. it covers two low income and two high income individuals and compares four ways of raising the same revenue from them. line 6 shows the resulting index of vertical equity, where the loss is measured as the ratio of excess loss to actual loss, and excess loss equals actual loss minus the lowest feasible loss." loss is computed on the assumption of marginal utility of income equal to ten for the first dollar of income and declining by ten percent for each additional dollar. to simplify, deadweight losses are disregarded. lines 7 and 8 show the he index for the two lowand two high-income individuals respectively, defined as the excess of the combined welfare loss over that which would result had he been met.1' line 9 finally gives the combined index for both groups as a 10. the ve index for each column is defined as e -wca dwcml / e'vcal 100, where x--vca is total actual welfare cost for all four taxpayers and -wcnm is the lowest achievable level. 11. the he index for each group of equals is given as i '\vca ewcel i -vca} 100, where --vca is the actual welfare cost for the group and !-ivce is the cost which obtains with equal burden distribution among equals. the combined he index for the column is obtained as i [ e\wca lvce] / -wca) 100. where ewca is the actual welfare cost for all four taxpayers and envce is their cost obtained with equal treatment of equals within each group. 19931 florida tax review weighted average for both. comparing arrangements iii and iv shows iv to win on both grounds and is thus to be preferred. comparing ii and iii, both come out equal on ve grounds, but ii is superior on he grounds. thus outcome ii is to be preferred. the situation becomes more difficult, however, when comparing ii and iv, with ii superior on he and iv superior on ve grounds. thus a scale is needed by which the two can be weighed against each other. kaplow raises no serious objection to this ve index, reflecting as it does the standard concept of equity, based on minimizing total welfare loss as arrived at by impartial choice from behind a veil. 12 but he offers two critiques of my he measure. first, he suggests that by basing the he measure on differential welfare losses, it becomes part of the welfare-based ve measure. i disagree. measuring the burden of he in terms of excess welfare loss need not lead to the conclusion that ve has to be defined in the usual welfare terms. the proposed he measure may also be combined with a benefit view of ve. but kaplow's second critique makes an important and valid point. even if it were agreed that my he index is reasonable when applied to a simplified illustration which allows for two income levels only, a reformulation is needed once many income levels are included. it then becomes unreasonable to limit considerations of departure from he to individuals with identical incomes only, while disregarding the relative treatment of individuals with more or less similar incomes. this is a good point, but it does not follow that this critique of my simplified he measure goes to "the very essence" of my he concept. allowance for a wider income range, to be sure, greatly complicates the task of measurement, but that does not void the distinction between the he and ve qualities of policy outcomes. a problem does not cease to exist if there is no simple solution. nor does it follow that allowance for he effects over a wider income range is already reflected in ve. 13 finally, there remains the further question (distinct from that of how to measure departures from he) of how to develop a "meta principle" or tradeoff scale by which the ve and he qualities of any particular reform may 12. my preceding paper added an alternative ve index which measured the welfare cost of various cases on the assumption that the actual amounts raised among equals were distributed equally. musgrave, supra note 5 at 119. kaplow objects to what looks like "decomposition" of the ve index and i am also somewhat uncomfortable with that version. my argument is better made without it and i therefore omit that version in reproducing the above table. 13. i do not claim that the he measure proposed here is the only possible or necessarily the best one. other indices have been suggested such as measures of dispersion in after tax positions of pretax equals or effects of tax changes on rank orders, but similar problems again arise when applying the measure over a range of more or less equal settings. see feldstein, supra note 7, at 82-83. [val 1:6 horizontal equity: a further note be weighed against each other. to insist on the need for such a scale or meta rule, moreover, does not require me to define its shape. setting that shape is a matter for the political process to decide, based on the public's sense of equity, including both he, ve and their value relation. this process is similar to that by which the shape of a mutually agreed upon social welfare function (needed for implementation of ve) is arrived at. in short, i accept kaplow's critique of my oversimplified he index but this, i maintain, does not invalidate my basic thesis, that he has merit as a distinct norm, especially when it comes to ranking second best settings. such is the case, notwithstanding the difficulties of formulating a wholly satisfactory measure of he, or the discomfort caused by trading the determinateness of "relevant" if one-dimensional distributive theory against the complexities of a meta function. iv. the relevance of reality first best theory is fun, but the second best reality of real world tax reforms is not irrelevant. it is thus well to conclude with a reference to application, where the distinction between he and ve does play a major role. the tax reform of 1986 was praised for its broadening of base while holding the overall pattern of effective rate progression unchanged. agreement on the latter was what permitted the former. the gain from base broadening, to be sure, was not only in the improvement of horizontal equity, especially over the upper end of the scale, but also in the reduction of deadweight loss ensuing from lower marginal bracket rates. nevertheless, changes such as the more equal treatment of capital gains (now about to be largely lost) were seen as removing a source of horizontal inequity, and they were welcomed on those grounds. was all this a matter of conceptual confusion? 19931 login | florida tax review main navigation main content sidebar current archives search subscribe toggle 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to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 18 2015 number 4 all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 1 1993 number 6 neutral international tax rules allocating costs: successful formula for u.s. research and development karen b. brown" i. introduction the decline of u.s. research and development efforts in recent years dominates political, scientific and academic discourse.' it is attributed, in part, to military research cutbacks after the end of the cold war and, in part, to the u.s. economic recession.2 many fear that the research and development slowdown portends the demise of the united states as a significant factor in the global market for goods and services.' others believe the decline is only one of many indicators of the diminished competitive position of the united states in the global economy.4 in a pre-elecion proposal to stimulate technological growth and to strengthen industry for anticipated "international trade wars of the 1990's and beyond," president clinton advocated a shift of at least thirty billion dollars from military research activities to the private sector over a four year period.5 the clinton proposal envisioned cost sharing technology joint ventures between the federal government and private industry.6 increased government spending is one way to stimulate research and * ©1993 karen b. brown. professor of law, brooklyn law school. this article is dedicated with every morsel of love to my husband, blair c. dickerson. thanks for the grand tetons! i also thank brooklyn law school for its generous financial support for summer research and my assistant, pamela fanning, for her very valuable research support. 1. spending by the federal government, private industry and educational institutions slowed in the mid-1980s and has declined since the end of that decade. william j. broad. research spending is declining in u.s. as it rises abroad, n.y. times. feb. 21. 1992. at al. 2. id. 3. see id. the national science board reported that the u.s. share of the global market for high technology goods fell from 40% in 1980 to 37% in 1988. id. at a16. 4. g. hufbauer, u.s. taxation of international income, blueprint for reform 2-4 (1992). 5. william j. broad, clinton to promote high technology, with gore in charge, n.y. times, nov. 10, 1992, at cl. 6. see id. at c14. florida tax review development activity. international tax policy also may provide research incentives. one example of important tax rules for u.s. businesses is the rules governing the allocation and apportionment of research and development expenses to domestic or foreign source income. research cost allocation is a crucial determinant of the allowable foreign tax credit for multinational businesses." designed to mitigate the double taxation hazard to u.s. businesses that operate in other countries, the foreign tax credit permits a taxpayer to offset against its u.s. tax liability certain income taxes paid to foreign countries. because the credit against u.s. tax liability is limited to a tax computed at u.s. rates on foreign source taxable income,8 the internal revenue code rewards the allocation of research expenses to domestic source income, which results in a corresponding increase in foreign source taxable income as a proportionate part of worldwide taxable income.9 in the past, congress has employed international tax policy to stimulate u.s.-based research by enacting rules that favor u.s.-based research. those rules were promulgated in response to complaints by the u.s. business community that the 1977 regulations resulted in an inappropriate allocation of research expenses to foreign source income, which resulted in an inability to obtain full credit against u.s. tax liability for taxes paid abroad.'0 president clinton's most recent initiative, which is part of his new economic plan, proposes allocation of all u.s.-based research costs to domestic source income." this article contends that tax rules should not provide an incentive 7. see interaction between u.s. tax policy and domestic research and development: hearing before the subcomm. on taxation and debt management of the senate committee on finance, 100th cong., 1st sess. 20 (1987) [hereinafter 1987 r&d hearing]. 8. irc § 904(a). the appropriate rate is the taxpayer's effective u.s. rate. 9. see 1987 r&d hearing, supra note 7, at 18. 10. the revised rules accommodated the demands of u.s. business. the problem was created by foreign income tax rules that denied a deduction for research conducted in the united states. the denial of the deduction resulted in a higher foreign income tax liability. the failure of the u.s. rules to apportion all of the research cost deduction to domestic source income resulted in lower foreign source taxable income for u.s. purposes (because more of the research deduction was allocated to foreign source income) and a lower foreign tax credit for u.s. income tax purposes. see research and experimental source allocation rules: hearings before the subcomm. on oversight of the house comm. on ways and means, 98th cong., 1st sess. 191-94 (1983) [hereinafter 1983 hearings]. 11. § 231 l(a), treasury department's legislative language for president clinton's revenue proposals, released april 30, 1993, daily tax rep., special supplement, rep. no. 83 (bna) (may 3, 1993); see u.s. treas. dep't, summary of the administration's revenue proposals 58 (feb. 25, 1993) [hereinafter administration's revenue proposals]. in h.r. 2141, the omnibus budget reconciliation act of 1993, recently passed by the house, only 50% of u.s.-based research costs would be allocated to domestic source income. comparison of president clinton's revenue proposals with reconciliation bill, 59 tax notes 994, 995 (may 24, 1993) [hereinafter comparison]. [vol 1:6 neutral intenational tar rules allocating costs for u.s.-based research. accordingly, this article supports neutral tax rules that apportion research costs on the basis of income expected to be derived from those activities. ii. origin of current research and development allocation rules section 174(a) of the code permits a deduction for research or experimental expenditures made in connection with a trade or business. 2 research or experimental expenditures are those "incurred in connection with a trade or business which represent research and development costs in the experimental or laboratory sense."' 3 u.s. multinational businesses must determine the proper method for allocating and apportioning those expenses to domestic or foreign source income in order to compute foreign tax credit' 4 because of the foreign tax credit limitation, u.s. taxpayers prefer to allocate most research costs to domestic source income. allocation of expenses to domestic source income will result in higher foreign source taxable income and increase the credit for foreign income taxes paid.'" 12. in the absence of the rule expressed in section 174(a). a taxpayer would capitalize research and development expenditures either as start-up costs or as the cost of acquiring a resulting product or service. 1987 r&d hearing. supra note 7. at 3. in lieu of the annual deduction permitted by section 174(a), a taxpayer would recover the expenses either as an offset against proceeds received upon sale of the product or service or over a fixed period of time if special amortization rules applied. 13. regs. § 1.174-2(a)(1). the term "research or experimental expenditures" includes "costs incident to development of an experimental or pilot model, a plant process. a product, or formula, an invention, or similar property...." id. stankevich v. commissioner, 64 t.c.m. (cch) 460, t.c.m. (ria) 192,458. at 92-2467 (1992): natbony. infra note 61, at 362. the term does not include expenditures for the acquisition or improvement of land or property subject to an allowance for depreciation or depletion even if the property is used in connection with research or experimentation; however, depreciation or depletion allowances for property used in connection with research or experimentation are deductible under section 174. regs. § 1.174-2(b)(1). 14. the term "allocation and apportionment" of deductions is a term of art defined in regulations sections 1.861-8(a)(2). (b). (c) and 1.861-8t(c)( 1). the regulations provide rules for many types of deductions including interest, charitable contributions, taxes, legal and accounting fees, and losses, as well as research expenses. a deduction must be allocated to a class of gross income to which it is definitely related and then apportioned within the class to foreign or domestic source income on the basis of factual relationship. 2 j. isenbergh. u.s. taxation of foreign taxpayers and foreign income 195-201 (1990). for purposes of this article, the terms "allocation" and "apportionment" are used interchangeably. 15. see 1987 r&d hearing, supra note 7. at 17. "[a) statutory formula limits the foreign tax credit so that the credit will offset only the u.s. tax on the taxpayer's foreign income." id. foreign source taxable income grows higher as more of the research deduction is allocated to domestic source income. consequently. allocation of a larger portion of the 19931 florida tax review the current research allocation and apportionment rules derive from regulations 6 promulgated by the treasury department in 1977."7 the regulations treat research and development expenditures as related to all classes of gross income "reasonably connected" to specified product categories. 8 classes of gross income include interest, royalties, business income, and compensation for services. 9 under an exception, research expenses undertaken solely to meet legal requirements imposed by a political entity are allocated only to the geographic source in which the taxpayer anticipates substantially all of the gross income resulting from that research will be generated (the "government requirements rule").2 c viewing research and development as most valuable in the country in which it is performed, the regulations require apportionment of all research or experimental expenditures, not subject to the government requirements rule, on the basis of a fixed formula and on the location of research activities.2 ' thirty percent 22 of the deduction for research expenses is apportioned to the grouping of gross income arising from the geographic source where research activities accounting for more than half of the amount of the deduction were performed.23 the balance of the deduction is apportioned to the statutory (foreign source) and residual (domestic source) research deduction to u.s. income permits a taxpayer to maximize its foreign tax credit. 16. regs. § 1.861-8(e)(3). 17. t.d. 7456, 1977-1 c.b. 200. the regulations were first adopted in 1957. t.d. 6258, 1957-2 c.b. 368. 18. regs. § 1.861-8(e)(3)(i)(a). 19. regs. § 1.861-8(a)(3). 20. regs. § 1.861-8(e)(3)(i)(b). the regulations apply the exception by example. if, for instance, the taxpayer performs tests on a product under a u.s. food and drug administration requirement, the costs of testing are allocated solely to u.s. source gross income if the test results "cannot reasonably be expected to generate amounts of gross income (beyond de minimis amounts) outside the united states." id. 21. the regulations offer two reasons for the conclusion that research is most valuable in the country in which performed. first, research benefits a broad product category consisting of products likely to be sold in the nearest (domestic) market. second, results of research are utilized in the nearest market before they are utilized in foreign markets. consequently, the regulations conclude that research has a lower value per unit of sales when used in foreign markets. regs. § 1.861-8(e)(3)(ii)(a). the regulations presume that only some products benefiting from a taxpayer's research activities will be sold in foreign markets because they do not require that the taxpayer demonstrate minimal foreign sales in order to rely upon the fixed percentage apportionment rule. if, however, the taxpayer wishes to establish entitlement to a greater fixed percentage, it must establish that the research and development is reasonably expected to have very limited or long delayed application outside the geographic source where it was performed. 22. the fixed percentage was 40% for taxable years beginning in 1978 and 50% in 1977. regs. § 1.861-8(e)(3)(ii)(a). 23. id. [1/61. 1:6 neutral international tar rules allocating costs groupings of gross income in proportion to each grouping's share of total amount of sales from the relevant product category (the "primary method").24 an optional method permits apportionment of research deductions (not allocated under the government requirements rule) in one of two ways.' the first optional method allows a taxpayer to apportion research expenses to the statutory and residual groupings on the basis of each grouping's share of total gross income. ' this method applies only if the amount of research expense so apportioned is at least fifty percent of the amounts that would be apportioned to both the statutory and the residual groupings, respectively, under the primary method.-7 consequently, the taxpayer has limited ability to shift research deductions to foreign source income because the first optional method is available only if it results in apportionment to foreign source income of at least fifty percent of the amount apportioned under the sales method.2 the second optional method permits apportionment to the statutory grouping of fifty percent of the amount so apportioned under the primary method and the balance to the residual grouping if the first optional method is not available because the amount apportioned to the statutory grouping fails the fifty percent test described above. the second optional method also permits apportionment to the residual grouping of fifty percent of the amount so apportioned under the primary method and the balance to the statutory grouping if the first optional method is not available because the amount apportioned to the residual method fails the fifty percent test described above.'9 in 1981, congress enacted a two-year moratorium on the research 24. sales from the same product category by unrelated ("uncontrolled") parties who can be expected to benefit from the taxpayer's research are included in apportioning the research deduction. the covered sales are those involving intangible property licensed or sold by the taxpayer to the unrelated party. regs. § 1.861-8(e)t3iiltc). sales by related ("controlled") parties are also considered in the apportionment if those parties can be expected to benefit from the taxpayer's research expense. regs. § i.861-8(e)t3)6iiud). a controlled party is a party that bears a relationship specified in section 267(b) to the taxpayer or is a member of a controlled group of corporations to which the taxpayer belongs under section 993(a)(3) of the code. regs. § 1.861-8(e)(3)(ii)(c. 25. the optional method does not permit automatic allocation of 30% of research expenses to the geographic source where activities accounting for more than 50% of the deductions were performed. regs. § 1.861-8(e)(3)(iii). 26. the optional method does not permit apportionment on the basis of product categories. regs. § 1.861-8(e)(3)(iii). 27. regs. § 1.861-8(e)(3)(iii)(a). 28. house ways and means comm. rep. on h.r. 3545, h.r. rep. no. 391 (parts 1 and 2), 100th cong., 1st sess. 1572 (1987) (hereinafter -1987 house report". 29. regs. § 1.861-8(e)(3)(iii)(b). 19931 florida tax review allocation regulations.3" the moratorium derived from congress' concern that the regulations provided a disincentive for multinational businesses to conduct research and development in the united states. this resulted because the regulations caused a portion of research and development expenses conducted in the united states to be allocated to foreign source income. in some cases, a foreign country in which the business operated did not permit deduction of research expenses conducted in the united states. the unavailability of a deduction for research activities against foreign income (presumably earned as a result of u.s.-based research) increased the amount of foreign income taxes due. however, the u.s. tax rules denied full credit for the foreign taxes to be applied against u.s. tax liability because foreign source taxable income, which determines the limitation on the foreign tax credit, was reduced by a portion of expenses from u.s. research activities. consequently, congress was concerned that businesses would locate research activities outside of the united states in countries that permitted deduction of research expenses only for activities conducted within their borders.3 the moratorium, enacted by the economic recovery tax act of 1981, substituted for the regulations a rule requiring that expenses from u.s.based research activities be allocated or apportioned solely to u.s. source income. the remaining research expenses (from foreign-based research activities) were apportioned on the basis of sales or gross income, as described above.32 deduction of the expenses solely against u.s. source income resulted in an increase of foreign source taxable income, which increased the foreign tax credit. after a 1983 treasury report indicating that a reduction in u.s.based research and development could adversely affect the competitive position of the united states, the moratorium was extended for two additional years.33 in 1985, congress again extended the moratorium, that time for one year.34 the moratorium expired with the enactment of the tax reform act 30. section 223 of the economic recovery act of 1981, pub. l. no. 97-34, 95 stat. 249 (1981). the moratorium covered the first two taxable years beginning after august 13, 1981. for calendar year taxpayers, the period included the 1982 and 1983 taxable years. see also staff of joint comm. on taxation, 100th cong., 1st sess., description of proposals relating to research and development incentive act of 1987 (s. 58) and allocation of r&d expenses to u.s. and foreign income (s. 716) 29 (comm. print 1987). 31. 1987 house report, supra note 28, at 1573. 32. 1987 r&d hearing, supra note 7, at 30. 33. section 126 of the tax reform act of 1984, pub. l. no. 98-369, 98 stat. 648 (1984). the extension governed taxable years beginning after august 13, 1983 and on or before august 1, 1985. 34. the consolidated omnibus budget reconciliation act of 1985, pub. l. no. 99272, 100 stat. 82, 324 (1985). the extension covered taxable years beginning after august 1, 1985 and on or before august 1, 1986. [vol 1:6 neutral intenzational tar rules allocating costs of 1986. the 1986 rules, effective for taxable years beginning after august 1, 1986 and on or before august 1, 1987, retained the government requirements rule of the regulations, but made three modifications to other provisions. first, it permitted allocation of fifty percent of u.s.-based research expenses to u.s. source income. second, it permitted use of the fifty percent allocation rule even by taxpayers electing the optional gross income method. third, it suspended the rule requiring users of the optional gross income method to apportion to foreign source income at least fifty percent of the amounts apportioned under the sales method.'5 in 1988, congress enacted new research expense allocation rules. ' the new rules retained the former government requirements rule of the regulations, which in general required allocation of research expenses to the geographical location of the political entity imposing legal requirements that necessitate the conduct of research.37 for all other research expenses, the rules allocated sixty-four percent of expenditures for research conducted in the united states to u.s. source income and sixty-four percent of expenditures for research conducted outside the united states to foreign source income.38 the remainder was apportioned at the taxpayer's election on the basis of either gross sales or gross income." special provisions governed expenditures attributable to activities conducted in space and activities of affiliated groups.4 the rules were a stop-gap measure that applied for only four months of the taxable year beginning after august 1, 1987.4 the 1977 regulations applied to the balance of the year. in 1989, congress enacted code section 864(f) to deal with the allocation question and to eliminate the necessity for periodic modifications of the 1977 regulations. the provisions contained in the new code section were identical to those enacted in 1988. the rules adopted were not 35. tax reform act of 1986, pub. l. no. 99-514, § 1216, 100 stat. 2085. 2549 (1986); joint comm. on taxation, 99th cong., 2d sess., general explanation of the tax reform act of 1986 960-961 (joint comm. print 1987). 36. technical and miscellaneous revenue act of 1988, pub. l. no. 100-647, § 4009, 102 stat. 3342, 3653 (1988). congress had proposed research allocation rules in 1987 that were not enacted. 37. regs. § 1.861-8(e)(3)(i)(b). 38. technical and miscellaneous revenue act of 1988, pub. l. no. 100-647. § 4009(a)(2), 102 stat. 3342, 3654 (1988). 39. id. § 4009(a)(3) (requiring taxpayer electing apportionment on the basis of gross income to apportion to foreign source income at least 30% of the amount apportioned to foreign source income on the basis of gross sales). 40. id. § 4009(c), (d). 41. id. § 4009(e). the rules applied only to a prorated amount of research expenses for the year determined by applying a fraction for which the numerator was four months and the denominator was the total number of months for the year. 19931 florida tax review permanent, however, as they were effective only for taxable years beginning after august 1, 1989 and before august 2, 1990.42 they did not apply to all taxpayers because they did not affect the apportionment method of foreign taxpayers for all purposes.43 the rules applied only for nine months of the affected taxable years. 44 congress extended section 864(f) in 1990 and again in 1991,4' but failed to extend the provision in 1992. consequently, those rules expired on june 30, 1992 for calendar year taxpayers.46 commentators concluded that on expiration of section 864(f) the 1977 regulations regained control over the allocation of research deductions by u.s. businesses.47 in july, 1992, however, the service issued revenue procedure 92-56,48 which permitted u.s. taxpayers49 to elect to apply rules substantially similar to those contained in section 864(f) rules for eighteen months.50 eventually these 42. irc § 864(f) (1989). in addition, the rules applied only to the portion of research expenses treated as having been incurred in the first nine months of the year for which the rules were effective. id. 43. although section 4009 of the 1988 act and section 864(f) are identical, the 1989 house ways and means committee report states that the rules do not apply to foreign taxpayers for purposes of computing taxable income effectively connected with conduct of a u.s. trade or business. because section 864(f) did not apply, the 1977 regulations governed foreign taxpayers for those purposes. 44. omnibus reconciliation act of 1989, pub. l. no. 101-239, § 7111, 103 stat. 2106, 2326 (codified as amended at 26 u.s.c. § 864(f)(5) (1989)). 45. omnibus reconciliation act of 1990, pub. l. no. 10 1-508, § 11401(a), 104 stat. 1388-472; tax extension act of 1991, pub. l. no. 102-227, § 101(a), 105 stat. 1686. 46. § 101(a), 105 stat. at 1686 (providing that section 864(f) is effective for the first six months of the taxable year beginning after august 1, 1991). 47. see, e.g., turro, infra note 54, at 1140. 48. 1992-28 i.r.b. 7. 49. as section 864(f) applied only to u.s. taxpayers, it appears that revenue procedure 92-56 applies only to u.s. taxpayers. 50. the rules are effective for the last six months of a taxpayer's first taxable year beginning after august 1, 1991, and for the subsequent taxable year. 1992-28 i.r.b. 7. unlike section 864(0), apportionment on the basis of gross sales must take into account sales of controlled and uncontrolled parties as required in regulations section 1.861-8(e)(3)(ii)(c), (d). revenue procedure 92-56 was modified by revenue procedure 92-69, 1992-36 i.r.b. 18 which provided guidance for section 936 corporations, certain corporations doing business in u.s. possessions. some commentators believe that interim guidance issued by the treasury department may be invalid. turro, infra note 54, at 1141. after expiration of section 864() and in the absence of legislative or administrative action, regulations section 1.861-8(e)(3) regained effect for u.s. taxpayers. it has also been asserted that the treasury department has the authority to provide interim guidance modifying the regulations. see john b. jones, sr., et al., ibm urges modification of r&d allocation regs., (may 6, 1992) (lexis, fedtax library, tni file, elec. cite 92-tni 19-24, at 19); edmund t. pratt, jr., pfizer seeks modification of r&d rules, (apr. 29, 1992) (lexis, fedtax library, tni file, elec. cite 92tni 18-36, at 9 (suggesting that in the absence of a contrary code provision, "treasury has [vol. 1:6 neutral international tar rules allocating costs rules will be replaced by permanent rules promulgated by the treasury department or enacted by congress. a recent proposal by the clinton administration, which is part of the president's comprehensive economic plan, offers two permanent proposals that affect research cost allocation rules. first, all expenses for u.s.-based research would be directly allocated to domestic source income,' and all expenses for foreign-based research would be allocated on the basis of gross sales. 2 second, the tax credit for increases in qualified research expenditures for u.s.-based activities would be extended.53 the next section urges rejection of the clinton proposal in favor of a neutral rule that would not accord a preference to u.s.-based research. iii. u.s. tax rules should not favor u.s.-based research as described above, in recent years, foregoing appraisal of rational tax policy, congress has enacted a series of temporary stop-gap research cost allocation measures that never became permanent. the international tax legal community has expressed concern about the absence of rules concerning the allocation of research and development expenses." this article addresses this concern by proposing new permanent rules that would eliminate the weaknesses of the expired rules. in general, one must distinguish between the rules set forth in the regulations that applied before the effective date of section 864(f), the premoratorium regulations, and the rules set forth in new code section 864(f), the post-moratorium rules. the pre-moratorium regulations provided a complex allocation and apportionment formula to be used by domestic and the authority to-and should-[modify] the regulation[s]."). 51. summary of administration's revenue proposals. supra note 11. at 57-59. 52. this part of the proposal was added by section 2311 (a) of the revenue reconciliation bill of 1993, the administration's proposal submitted to congress on april 30. 1993. section 2311(b) authorizes regulations regarding the determination of whether activities are conducted in or outside the united states and the provision of adjustments for cost-sharing arrangements and contract research. the rules would be effective for taxable )cars beginning after december 31, 1993. 53. summary of administration's revenue proposals. supra note 11. at 9-10. a third proposal, not directly relevant to the issues discussed in this article, combines the research cost allocation rules with a proposal to treat all foreign source royalty income as passive separate limitation income in order to reduce a preference for licensing intangible property to foreign persons for use abroad. see infra text accompanying notes 87-89. objections to the royalty income proposal apparently led to its rejection by the ways and means committee. see comparison, supra note 11, at 995; covington & burling. foreign royalty income: response to treasury briefing paper, 59 tax notes 829 (may 10. 1993). 54. see, e.g., john turro, the u.s. r&d allocation deal: is this any way to run a country?, 5 tax notes int'l 1139 (nov. 30. 1992). 19931 florida tax review foreign multinational businesses. a fixed portion (thirty percent) of research and development costs was apportioned to income derived from the location of research activities. under the post-moratorium rules of section 864(f), sixty-four percent of research costs was allocated to income derived from the location of research activities.: the post-moratorium rules were arbitrary and inconsistent. they were primarily based upon a factor, location of research activities, that bears no apparent relationship to the benefits and burdens of research on business. furthermore, they did not apply to foreign businesses with operations similar to those of domestic companies. the pre-moratorium rules were complex and also applied an arbitrary allocation formula based, in part, upon the location of research activities. both sets of rules were inadequate because they were founded upon chauvinistic goals and lack of familiarity with modem operations of international businesses. research and development is a valuable business activity.5 6 government action to encourage that activity-by direct subsidy of research ventures-is appropriate and increasingly necessary in the competitive international business arena. favorable tax rules allocating research costs also may influence research strategies for multinational businesses. the enactment of such rules, however, is not a valid means of stimulating research and development. 7 the development of sound tax policy is informed by three important goals-maximization of revenue, fairness and efficiency.58 these goals have been neglected by congress and the executive branch in the formulation of research and development tax rules. these goals are not and cannot be served by tax rules that encourage u.s.-based research. this article advocates adoption of neutral research expense allocation rules that address these three goals. the expired rules described above failed because they resulted in an unnecessary loss of u.s. revenue, treated foreign and domestic taxpayers differently, did not respond to the needs of multinational businesses and ignored recent trends in the global marketplace. the expired rules allocated a fixed portion of costs to domestic source income on the basis of location of research activities. as noted above, allocation of costs to domestic source income reduces domestic taxable 55, a 1982 study prepared for the commerce department found that the most reliable apportionment figure would be 56%. the 64% rule adopted in section 864(0) approximates that figure. see jones, supra note 50, at 15 (discussing a. benvignati, impact of american tax policy on the level and location of industrial research and development 3 (mar., 1982)). 56. hufbauer, supra note 4, at 9. 57. not all tax subsidies are objectionable. however, the subsidy provided by the research allocation rules is misguided because, as is discussed in part iv below, it does not achieve its stated goal. 58. j. stiglitz, economics of the public sector 390 (2d ed. 1988). [vol 1:6 neutral international tar rules allocating costs income and increases foreign taxable income, which increases the portion of foreign income taxes that serve as a credit to offset u.s. tax liability." while, arguably, the rules provided an incentive for the performance of research in the united states by lowering the overall tax cost of u.s.-based research, they also had two negative effects. first, they created a tax subsidy and caused a loss of u.s. tax revenue.60 that revenue loss was not matched by a discernible corresponding benefit to the government, except a possible unquantifiable benefit in the mere proliferation of research in the united states.6 second, the incentive was not available to foreign businesses conducting research activities in the united states for purposes of determining a taxable income effectively connected with a u.s. trade or business. for those purposes they were required to allocate research expenses largely on the basis of gross sales or gross income.62 denial of a tax subsidy to foreign businesses without demonstration of a detriment or lack of benefit to the u.s. government cannot be supported. the expired rules also were not successful because they did not allocate research costs to the u.s. and non-u.s. revenue generated by the enterprise. arbitrary allocation as demonstrated by the formulary approach adopted by those rules forecloses any measure of the appropriate amount of income to be taxed. that approach encourages inefficient allocation of resources by u.s. businesses because it focuses solely on the location of research. a tax policy that encourages the conduct of research activities in the united states represents mere chauvinism. such a policy is misplaced because it ignores the growing trend of internationalization of industrial research and development. u.s. tax policy should permit u.s. businesses to secure the most efficient research and development opportunities whether they are in or outside of the united states. it should also support collaboration among u.s. and foreign businesses and academic institutions. indeed, in one of its own major research activities, the superconducting supercollider, the u.s. government has sought international collaboration.6" the government's 59. see supra note 10. 60. see infra note 81. 61. but see william natbony. the tax incentives for research and development: an analysis and a proposal, 76 geo. l. j. 347, 348 (1987) ("[tlhe present system of current deduction and incremental credit provides a significant subsidy, but a very questionable incentive, for research and development activity."). 62. see regs. § 1.861-8(e)(3). even under the regulations. 30% of rcsearch costs are apportioned automatically to income arising from the source where research activities accounting for more than 50% of the deduction were performed. regs. § 1.861-8(cu311iila). 63. under construction near waxahachie, texas, the supercollider is the world's largest proton accelerator. when completed, at an estimated cost of s8.4 to si0 billion, it is expected to "move science a giant step closer to understanding why the universe contains the 19931 florida tax review unwillingness to consider the policy advantages in international collaboration in research and development is inconsistent and wrong. tax rules that favor u.s.-based research derive, in part, from an inaccurate idea that such activities will produce products that will wipe out the burgeoning u.s. trade deficit. 4 however, despite the enactment since 1981 of a series of tax rules encouraging research in the united states, domestic research has declined 6 ' and international research ventures have proliferated.66 moreover, since 1981, the u.s. trade imbalance has steadily accelerated. the government has demonstrated no connection between exports of u.s. products and the location of research activities (united states versus foreign locations) by u.s. taxpayers.67 finally, there is no nexus between the measurement of income appropriately taxed and the expired u.s. tax rules that set up a preference for location of the activities in the united states. consequently, failure to encourage international collaboration places the united states in the unfortunate position of exalting a weak national interest (pride in u.s. ingenuity) over stronger international (efficiency and collaboration) and national (revenue and rational tax rules) interests. the organization of economic cooperation and development ("oecd") has reported the increase in cooperative research and development ventures among companies in oecd countries, including the united states, in their home countries as well as abroad.68 collaboration offers a number of advantages. it permits distribution of costs around the world, utilization of kind of matter it does, and why matter has familiar but unexplained properties, particularly mass." malcolm w. browne, roy f. schwitters, scientist at work: building a behemoth against great odds, n.y. times, mar. 23, 1993, at cl. the supercollider began under the reagan administration, but the push to "internationalize" the project began when the bush administration grew to fear that rising costs would doom it and other "big science projects." david e. sanger, bush in japan, in setback for administration, japan gives no aid on supercollider, n.y. times, jan. 9, 1992, at a9. a key target, the japanese government, has not committed itself to the u.s. project, citing consideration of various alternative approaches. recently, taiwan voted against joining the project. malcolm w. browne, clinton backs funds for science projects, n.y. times, feb. 23, 1993, at c2. 64. the u.s. trade deficit widens, n.y. times, mar. 19, 1993, at d2. 65. broad, supra note 1; hufbauer, supra note 4, at 11. 66. see infra note 68. 67. the united states taxes the worldwide income of its citizens and residents, including that of domestic corporations that operate internationally. foreign based research would generate products to be sold that are nonetheless subject to u.s. tax unless the technology is sold or licensed to a foreign subsidiary. the code contains special provisions designed to curb possible abuses in the transfer of technology abroad. see infra text accompanying notes 85-89; 1987 r&d hearing, supra note 7, at 41. 68. robert brainard, internationalizing r&d, oecd observer, feb.-mar. 1992, at 7, 8; see also hufbauer, supra note 4, at 8 ("to be sure r&d has become more international, but this is largely the result of cross-border alliance between firms to share firm-specific expertise rather than a global spread of r&d facilities."). [vol. 1:6 neutral international tar rules allocating costs the expertise of local and foreign personnel and the combination of technological strengths in strategic ways.9 in addition, companies may derive cost benefits from pooling resources, but they may continue competitive advantages in the application and marketing of technology." the increasing involvement of u.s. companies in international research and development agreements suggests that the u.s. government's chauvinistic tax policy ignores the reality of current business practices and may impede development. 7' in creating new rules, congress must acknowledge that the interest of the united states lies in encouragement of international research and development collaborations and, hence, in elimination of location-based research allocation rules.12 consequently, congress should reject the recent proposal by the clinton administration to allocate research costs to the place of performance. the proposal, which is part of president clinton's comprehensive economic plan, is designed to encourage the conduct of research in 69. brainard, supra note 68. at 8. recent examples of potential savings from international collaborations abound. for example, the race for a worldwide standard in a highdefinition television system would have been less costly if the united states. europe and japan had cooperated in the development of the new digital technology currently under examination by the federal communications commission. instead, the european community recently announced a decision to abandon its own efforts to develop "conventional analog, or wave. broadcasting systems" because the u.s.-developed technology is certain to become the worldwide standard. the move enabled the european community to avoid wasting another $600 million on the european technology. two european companies. one dutch and one french, participated in the u.s. research effort as members of a consortium. richard w. stevenson, europeans giving up advanced-tv project. n.y. times. feb. 20. 1993. at a46. 70. brainard, supra note 68, at 9. 71. id. the oecd staff has proposed that oecd countries reject nationalistic policies: the science and technology policies of oecd countries at present tend to have an intrinsic insular bias. to offset it, priority should be given to developing international collaboration in pre-commercial r&d and to promoting technological activities that combine resources and complementary technical capabilities, with particular emphasis on 'generic technologies.' id. at 10. 72. as the oecd staff noted: to formulate policies for exploiting the potential technological and economic gains of internationalization, governments have to determine where 'national interest' lies in an era of transnational integration of industrial and economic activities. it is significant that there is an apparent divergence between the global strategies of companies and the national policies of governments; indeed, they frequently seem to be at crosspurposes. yet the respective objectives of the nation-state and multinational industry can be reconciled. 19931 florida tax review the united states. the plan is commendable for its goal of simplifying complex rules and thereby promoting compliance.73 for the reasons discussed above, however, it is misguided in its goal of encouraging the location of research in the united states. the current state of the u.s. economy, the need for rational tax rules and the needs of u.s. multinational businesses and the international community demand a different tactic. congress should adopt a neutral rule, discussed more fully below in section iv, that connects research costs to projected benefits. the rule would completely eliminate allocation on the basis of location of research activities. instead, research costs would be allocated on the basis of gross sales or gross income expected to be derived from the activity or on the basis of the asset method of apportionment similar to that provided in the interest allocation rules. in addition, an alternative method would permit the taxpayer to establish any other reasonable method of allocation and apportionment consistent with other business practices.74 while this article contends that u.s. tax rules should not provide an incentive for u.s.-based research, it acknowledges that suitable methods of encouraging research by u.s. businesses do exist. the most appropriate method is a direct appropriation to u.s. business, such as president clinton's pre-election proposal to shift military funding to private industry research and the related recent announcement of the president's technology initiative.75 direct appropriation would renew opportunities for research and development by u.s. businesses without frustrating the tax policy and international community goals discussed above. another possible measure is extension of the research credit for all activities of u.s. taxpayers. an incremental credit, such as the credit for increases in certain qualified research expenses provided by section 41, may increase research activity by u.s. taxpayers.7 6 president clinton's proposal calls for extension of the credit for u.s.-based activities only. however, such a limited credit presents the same problem found in the research cost allocation proposal, that of providing a preference for u.s.-based activities with no significant benefit to the government. moreover, it frustrates the other important national and international goals discussed above. consequently, if no revenue concerns existed, then a better solution would be to extend the credit for qualified expenditures wherever conducted. however, the joint 73. administration's revenue proposals, supra note 11, at 58. 74. cf. regs. § 1.863-3(b)(2) ex. 3 (describing procedure to obtain permission for alternative method of allocating sales receipts to u.s.-source income and foreign-source income). 75. john markoff, clinton proposes changes in policy to aid technology, n.y. times, feb. 23, 1993, at al; see also broad, supra note 5. 76. but see natbony, supra note 61. [val 1:6 neutral hiternational tax rules allocating costs committee on taxation estimated that extension of the research credit to u.s.-based expenditures alone would result in a revenue loss of $6.2 billion over a four year period.77 because extension of the credit to all expenditures would create an unsupportable revenue loss, extension of the credit is rejected. the next section of this article discusses the failure of the u.s. rules to account for modem international business practices and current concerns of the international community. it also details the proposal for the new tax rules described above. 1v. research allocation rules should be neutral congress failed to extend section 864(f) or to provide permanent allocation rules because it believed that the executive branch should adopt acceptable rules that appropriately balance concerns of both government and business. some believe that congress abdicated its responsibility to legislate when representative rostenkowski, chair of the house ways and means committee, indicated that the 1992 revenue bill would not contain a research allocation proposal to extend expiring section 864(f).8 mr. rostenkowski stated his committee's belief that "the treasury department should now resolve [the research expense allocation] controversy." 9 he also advocated that the revised regulations reflect three goals, two of which were announced by president bush in his fiscal year 1993 budget and the third of which had not been previously explored. the two goals announced by president bush were to provide incentives to increase the overall performance of research and development activity by u.s. taxpayers and incentives to encourage the location of research within the united states. the third goal, which seemingly reflected the committee's awareness of the increasing internationalization of research activities, was that the regulations should not penalize taxpayers who "are required for business purposes to conduct significant amounts of r&d at foreign sites. ' one may speculate whether congress's failure to provide research 77. joint comm. on taxation, 102d cong., 1st sess.. description of provisions expiring in 1991 and 1992, app. ix (joint comm. print 1991). 78. see turro, supra note 54, at 1139. 79. joint comm. on taxation, chairman's mark of revenue-related provisions (enterprise zones, extension of certain expiring tax provisions. tax simplification. intangible assets, real estate, luxury excise tax. taxpayer bill of rights, technical corrections, and certain revenue-raising provisions) and subcommittee proposals 23 (joint comm. print 1992) [hereinafter chairman's mark]. 80. id. 1993] florida tax review expense allocation rules resulted from its concern about the revenue impact" or its genuine belief that such rules are more appropriately promulgated by the treasury department, which is charged with the responsibility to investigate and propose a solution in this area.82 congressional inaction in 1992, provides an opportunity to examine the failure of any branch of the federal government to develop effective tax policy. examination suggests two needs: promulgation of permanent research cost allocation and apportionment rules that fairly link research costs to the sources of income generated and elimination of arbitrary location-based allocation provisions. a fair measurement of income derived by multinational businesses that conduct substantial research and development requires the apportionment of research costs to gross income, gross sales or assets of the enterprise. expired section 864(f) (sixty-four percent allocation of u.s.-based research costs to domestic source income), the clinton administration's proposal (one hundred percent allocation of such costs to domestic source income) and, to a lesser extent, the 1977 regulations (thirty percent allocation of such expenses) are not based upon income measurement, but rather upon a desire to maximize the foreign tax credit for u.s. businesses. a rational tax system would allocate and apportion deductions on the basis of fair measurement of income and would reject as the determining factor maximization of the foreign tax credit. furthermore, the approaches taken in expired section 864(f) and the new proposal by the clinton administration must also be rejected because they do not meet their objective of encouraging research activity in the united states. the most recent comprehensive treasury report concerning tax research incentives, published in 1983, indicated that the moratorium on the 1977 regulations (one hundred percent allocation of u.s.-based costs to domestic source income as under the clinton plan) failed to meet that objective.8 3 it concluded that for a number of reasons the moratorium was an ineffective and haphazard method of increasing domestic research and 81. the joint committee on taxation estimated that extension of the research allocation rules of sections 861(b), 862(b), 863(b), and 864(0 for fiscal years 1992-1996 would cause a total revenue loss of $3.9 billion. description of provisions expiring in 1991 and 1992, supra note 77. 82. h.r. conf. rep. no. 841, 99th cong., 2d sess., at 11-608. in the chairman's mark, the ways and means committee suggested deference to treasury's regulatory authority: the internal revenue code generally articulates only the broad principles of how expenses reduce u.s. and foreign source gross income, leaving the treasury department to provide detailed rules for the task of allocating and apportioning expenses. chairman's mark, supra note 79, at 22. 83. u.s. treasury dep't, the impact of the section 861-8 regulation on u.s. research and development 28-32 (june 1983). mio. 1:6 neutral inter ational tax rules allocating costs development. the treasury study found that while the moratorium resulted in a reduction of u.s. tax liability, taxes were not of primary importance to u.s. taxpayers in determining the location of research and development investment. in addition, there was little evidence that the 1977 regulations resulted in a large shift of research and development offshore. moreover, it projected that foregone tax revenues could exceed the dollar value of any increase in research activity.' another defect in the logic of the clinton proposal and the similar approach under expired section 864(f) is that they fail to support and encourage research and development by start-up companies. the 1983 treasury report indicated that because the moratorium only reduced the u.s. tax liability of firms with excess foreign tax credits, it had its most significant effect on large, mature multinationals. it found no benefit for the young "high technology" companies. as the administration's proposal is identical to the moratorium rule, one must conclude that the administration's proposal also will not favor the intended beneficiaries. a serious threat to the competitive position of the united states is the transfer of technology or know-how offshore by u.s. companies to foreign subsidiaries at "below market" prices.8'5 that practice worsens the u.s. trade deficit, which reflects badly on the u.s. role in the world economy." recent regulations under section 482 (according treasury the authority to allocate income and deductions among related domestic and foreign parties in order to prevent manipulation of u.s. income) directly attack this problem.' the clinton administration's proposal to treat all foreign source royalty income as passive separate limitation income for foreign tax credit purposes is another excellent weapon against wholesale transfers of u.s.-created technology abroad.8 8 if adopted, the proposal would counteract a current preference for licensing technology abroad by eliminating the effect of 84. the report contrasted direct government funding of a research project, resulting in a one dollar increase in research for each dollar of authorized funding. w ith the described result under the allocation rules. see 1987 r&d hearing. supra note 7, at 42. 85. see, e.g., westreco v. united states. t.c. memo (cch) 1992-561 t 1992); regs. §§ 1.482-la, -2a. 86. hufbauer, supra note 4. at 8-9. 87. regs. §§ 1.482-la, -2a. prop. regs. § 1.482-2(g). a different approach to the same problem was taken by the proponents of the foreign income tax rationalization and simplification bill of 1992. section 304 of the bill would have added new section 482(b) of the code to require reporting of a minimum amount of taxable income (75% of the product of gross profits and an industry-wide profit percentage) by 25% owned foreign corporations. see joint comm. on taxation, explanation of h.r. 5720 (foreign income tax rationalization and simplification bill of 1992) 48-55 (joint comm. print 1992) [hereinafter -1992 bill"]. 88. cf. foreign royalty income: response to treasury briefing paper. supra note 19931 florida tax review placing royalty income derived from the trade or business of a u.s. corporation in the same basket for foreign tax credit separate limitation purposes as other business income. under the current rules, lower-taxed royalty income offsets higher-taxed business income and correspondingly increases the foreign tax credit available for all income in the overall business income basket.89 the research cost allocation rules proposed by the clinton administration are not effective weapons against offshore technology transfers because they relate only to the location of research activities of u.s. taxpayers. consequently, those rules should not be adopted to deal with a problem they cannot solve. another flaw in president clinton's research cost allocation proposal and the expired section 864(f) rules is that they fail to provide similar treatment to similarly situated domestic and foreign taxpayers.90 although foreign corporations with u.s. tax liabilities derived from the conduct of a u.s. trade or business could benefit from the favorable research cost allocation rules, those rules are not applicable.9 discrimination against foreign taxpayers, however, is unwarranted and irrational for several reasons.92 first, a rule that purports to measure taxable business income, such as the rules governing allocation and apportionment of deductions, should be applied consistently to all income derived, whether by domestic or foreign persons.93 second, if the research cost allocation rules are intended to encourage u.s.-based research, there is no rational reason to deny the 89. irc § 904(d). 90. expired section 864(f) did not apply to foreign taxpayers for purposes of determining income subject to u.s. tax. see supra note 43. president clinton's proposal does not specify whether it covers foreign taxpayers with u.s. tax liabilities that may be offset by the foreign tax credit. see 1992 bill, supra note 87. see also stiglitz, supra note 58 at 399 ("[a] tax system is said to be horizontally equitable if individuals who are the same in all relevant respects are treated equally. the principle of horizontal equity is so important that it is, in effect, enshrined in the constitution as the fourteenth amendment...."). 91. see irc §§ 864(c), 882. 92. most u.s. bilateral treaties contain a nondiscrimination clause under which a national and resident of a treaty partner may not be subjected to taxation more burdensome than that imposed on a national or resident of the united states. isenbergh, supra note 14, at 440-441. foreign corporations that conduct business in the united states are subject to u.s. income tax on all income effectively connected with the business and are entitled to research expense deductions that reduce ultimate u.s. tax liability. failure to permit foreign corporations to use the same research allocation rules as u.s. corporations might violate a treaty's nondiscrimination clause. see sanford h. goldberg & peter a. glicklich, treaty-based nondiscrimination: now you see it now you don't, i fla. tax rev. 51, 86-88 (1992). since the 1988 technical and miscellaneous revenue act, however, congress has the authority to override such a treaty provision. isenbergh, supra note 14, at 448-450. 93. 1983 hearings, supra note 10, at 219-220 (statement of prof. richard l. kaplan and prof. hugh j. ault). [vol. 1:6 neutral intenzational tar rules allocating costs incentive for foreign businesses. indeed, if the national identity of the taxpayer controls and the u.s. rules are intended to encourage development by u.s. taxpayers, then the premise for the clinton proposal and section 864(f)-that only u.s.-based research, and not all research wherever performed, by u.s. taxpayers is to be encouraged-is incongruous with a purported goal of encouraging development by u.s. taxpayers. given their premise, those rules must be rejected because they do not achieve their goal of encouraging all research, including foreign-based research. third, the government can point to no disadvantage in providing an incentive for u.s.based research by foreign taxpayers other than the frustration of a national pride interest. as discussed above, the government's interest in supporting u.s. ingenuity is outweighed by other important national and international interests. the failure of the clinton proposal to anticipate the growing importance of international goals in the development of technology also undermines its viability for the future. as noted in a recent carnegie commission report, the administration should seek ways to promote international cooperation in research and development and should reject a temptation to isolate u.s. activities: overall, u.s. international relations have suffered from the absence of a long-term, balanced strategy for issues at the intersection of science and technology with foreign affairs as the united states faces problems similar to those of other countries-say, in energy-collaboration will help to find better solutions. as the world's scientific community pursues common aspirations on the great research frontiers-in physics and genetics, for example-improved communications will spur mobility and exchanges involving u.s participants as well as joint financing and planning of nextgeneration projects. as american openness and the tradition of an international process in science and engineering combine in u.s. global initiatives, the health of the american research and development enterprise itself will be strengthened. the private sector has often learned these lessons of interdependence more quickly than has the government.' the carnegie commission also noted that the relatively large amounts of money spent by the u.s. government and the private sector compared to 94. carnegie commission on science, technology, and government. science and technology in u.s. international affairs 10-11 (jan. 1992). 19931 florida tax review other countries will not guarantee technological leadership without international cooperation.95 just as government spending must acknowledge the importance of cooperation, tax policy also must anticipate that u.s. taxpayers, who are players in the world arena, possess business reasons to develop international relationships that may call for research activity outside u.s. borders. tax policy should not sanction rules that penalize such taxpayers for conducting activities out of the united states. considering the disadvantages of the research allocation rules found in the clinton proposal and the expired section 864(f) rules, this article proposes a different approach. the proposal is that the rules eliminate allocation and apportionment of research costs based on the location of research activities. the allocation provisions should attempt to measure income of all multinational businesses, whether domestic or foreign, by attributing research expenses to gross income or gross sales of the business. unlike the 1977 regulations, the proposal would permit allocation on the basis of gross sales or gross income without limitation.96 an alternative basis for allocation suggested by the treasury department in its recent report on international tax reform,9 7 would be the asset method employed under the current rules in which a taxpayer allocates interest expense to the source of income derived from the location of its assets (determined on the basis of asset or book value).98 that method of allocation is based upon a belief that research expense is fungible-attributable to all activities and property regardless of location. the treasury department supports the asset method of allocation, termed a "worldwide fungibility" approach, because "it could 95. the commission noted: developed countries must seek exchanges about (and deals with) each other's r&d. u.s. firms must seek alliances with foreign firms, while u.s. universities must make contacts with leading investigators around the world. much of this focuses on the excellent work in europe and japan, and the commerce department has been active, for example, in stimulating private sector liaison for these most industrialized regions. id. at 26 (footnote omitted). 96. see supra text accompanying notes 25-29. 97. u.s. treasury department, international tax reform: an interim report (jan. 15, 1993) (lexis, fedtax library, tni file, elec. cite 93-tni 15-12, at 40) [hereinafter interim report]. 98. regs. § 1.861-9t, -10, -10t. the asset method of allocating interest expense is available only for u.s. taxpayers and foreign individuals. separate and more complicated rules apply to foreign corporations. see regs. § 1.882-5; prop. regs. § 1.882-5. regulations section 1.861-9t is based upon the principle that all money is fungible and that interest is attributable to all activities and property regardless of any specific purpose for incurring an obligation on which interest is paid. consequently, interest deductions are considered related to all income producing activities and assets of the taxpayer. interest expense of affiliated group members is allocated under the separate rules of regulations section 1.861-1 it. [vol. 1:6 neutral intentational tax rules allocating costs better reflect the factual relationship of [research and development] expense to gross income." 99 the last alternative under the proposal would permit the taxpayer to establish any other reasonable method of allocation and apportionment consistent with other business practices. similar rules have been employed in the regulations governing apportionment of costs of taxpayers that manufacture within the united states and sell outside of the united states or vice versa.'0° a significant benefit of this approach is that it provides the taxpayer with an opportunity to establish a business justification for allocation and apportionment. adopting the theory that similarly situated foreign and u.s. taxpayers should be treated similarly, the proposal would apply to all taxpayers for all purposes. consistent application of the rules would avoid unjustified discrimination against foreign taxpayers and would accommodate the interest of multinational enterprises in locating research activities where they are most economically feasible. the proposal rejects special rules for u.s.-based research by u.s. taxpayers because the aims sought by such rules, proliferation of research in the united states and bolstering of the u.s. reputation for technological leadership, are anachronistic in today's global economy. this article's proposal accommodates the more important international interests in efficiency, cooperation and technological development. as discussed above, the relatively weak interest of the u.s. government in promoting pride in united states creativity cannot be accomplished by the research allocation rules. promulgation of the rules proposed by the clinton administration would undermine more significant national interests in revenue maximization, fair income measurement and strengthened connections in the international community. v. conclusion current u.s. tax rules allocating research costs of multinational businesses are ineffective and outdated because they fail to fairly measure income, to support the business needs of international operations and to support the current trend of collaboration in the international community. for these reasons those rules should be rejected. the rules proposed by this article should be adopted because they provide neutral allocation rules that do not depend upon location of research activities or the national identity of the taxpayer and they do not impede collaborative research efforts of multinational businesses. 99. interim report, supra note 97. at 40. 100. see supra note 74. 19931 florida tax review volume 2 1995 number 9 treaty override by administrative regulation: the multiparty financing regulations richard l doernberg" 1. overview of section 7701(l) regulations ......... 522 ]1. history of multiparty financing regulations and relationship of conduit rules to treaty interpretation ............................... 524 a. defining undefined treaty terms; applying domestic antiabuse rules ................... 524 b. do the multiparty financing regulations override treaties? ........................ 527 1. regulations not intended as override ..... 528 2. regulations intended as override ........ 530 m. establishing authority to override .............. 533 a. statutory authority to override ................ 533 b. delegation of override authority to treasury ...... 534 1. explicit delegation ................... 535 2. implicit delegation ................... 541 3. regulatory override without delegation ... 543 iv. appropriate date for later-in-time purposes ..... 544 a. legislative regulations alone are not laws in constitutional sense ....................... 546 b. statutes cannot override prospectively .......... 548 v. conclusion .................................. 550 * k.h. gyr professor of law, emory university school of law (b.a. 1970, yale university; j.d. 1976, university of connecticut; ll.m. (taxation) 1980. new york university). the author wishes to thank lewis j. kweit and mark b. perla for their research assistance. copyright (c) 1995 by richard l. doemberg. florida tax review i. overview of section 7701(1) regulations section 7701(), enacted as part of the omnibus budget reconciliation act of 1993, provides: "the secretary of the treasury may prescribe regulations recharacterizing any multiparty financing transaction as a transaction directly among any 2 or more of such parties where the secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by this title."' the provision originated out of a concern "that taxpayers were inappropriately avoiding u.s. tax by intricately structuring financial transactions which utilize multiple entities, where one or more of those entities serve as a conduit.",2 the treasury issued regulations in response to this legislation in july of 1995.3 under the regulations, various financing arrangements are recharacterized for u.s. tax purposes to disregard a conduit entity or entities. for example, suppose that if a, a foreign financing entity, made a loan to c, a u.s.-financed entity, interest paid by c to a would be subject to a 30% withholding tax in the united states.4 but suppose that pursuant to a financing arrangement, a instead makes a loan to b, a foreign intermediate entity,5 which in turn makes a loan to c, and suppose further that if the form of the transactions is respected, the interest paid by c to b will not be subject to a 30% u.s. tax, but rather will be subject to a reduced or zero rate of u.s. tax because of an exemption under u.s. law, such as the portfolio interest exemption of section 881(c), or as a result of the application of a tax treaty.6 the regulations set out circumstances under which such a financing arrangement may be recharacterized for u.s. tax purposes to disregard the intermediate entity, b, as a conduit and treat the interest as paid directly by c to a, thereby resulting in a 30% u.s. withholding tax. this article does not discuss the regulations' implementation of the authorizing statute, although the regulations, as proposed, were the subject of 1. omnibus budget reconciliation act of 1993, pub. l. no. 103-66, § 13238, 107 stat. 312, 508. 2. h.r. rep. no. 111, 103d cong., ist sess. 729 (1993), reprinted in 1993 u.s.c.c.a.n. 378, 960. 3. t.d. 8611, 60 fed. reg. 40,997 (1995). the regulations were proposed in oct. of 1994. intl-64-93, 59 fed. reg. 52,110 (1994). 4. irc §§ 881(a)(1), 1442(a). 5. see regs. § 1.881-3(a)(2)(i) (defining "financing arrangement"). 6. see, e.g., convention between the united states of america and the kingdom of the netherlands for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, dec. 18, 1992, u.s.-neth., art. 12 k.a.v. 3507 [hereinafter u.s.-neth. treaty]. [vol 2:9 treaty override by administrative regulation substantial criticism.7 instead, the focus is on the relationship of the regulations to u.s. treaty commitments. according to the regulations: where the participation of a conduit entity in a conduit financing arrangement is disregarded pursuant to this section, it is disregarded for all purposes of section 881, including for purposes of applying any relevant income tax treaties. accordingly, the conduit entity may not claim the benefits of a tax treaty between its country of residence and the united states to reduce the amount of tax due under section 881 with respect to payments made pursuant to the conduit financing arrangement. the financing entity may, however, claim the benefits of any income tax treaty under which it is entitled to benefits in order to reduce the rate of tax on payments made pursuant to the conduit financing arrangement that are recharacterized.... 8 in the example, if b is a resident of a country with which the united states has an income tax treaty and the treaty exempts interest paid to that country's residents from u.s. tax, the regulations require that the treaty be ignored in determining the u.s. tax on the interest payment from c to b. treaty benefits may be claimed only under a treaty between the united states and a's country of residence. for purposes of discussion, this article focuses on the treaty between the united states and the netherlands.9 the regulations thus may override u.s. treaty obligations. many u.s. treaties contain limitations on benefits provisions that deny certain treaty benefits, usually including reduced withholding rates on interest payments." where the regulations merely duplicate the effects of a limitation on benefits provision, there is no override problem. however, as discussed below, the regulations' scope goes beyond that of some limitations on benefits provisions, and many income tax treaties do not have such provisions. the united states is no stranger to treaty overrides. on several occasions, congress has passed legislation with the intent of overriding tax 7. see, e.g., jeffrey m. o'donnell, et al., attorneys suggest modifications to conduit financing regs, 10 tax notes int'l 134 (jan. 9, 1995) (arguing that the regulations abandon traditional common law elements of conduit theory in favor of an unauthorized test); see also john j. coneys, price waterhouse finds conduit regs negative in tone and overbroad in scope, 10 tax notes int'l 134 (jan. 9, 1995). 8. regs. § 1.881-3(a)(3)(ii)(c). 9. see u.s.-neth. treaty, supra note 6. 10. see e.g., id., art. 26. 19951 florida tax review treaties." what makes the conduit financing regulations different from previous overrides is that congress has not explicitly authorized a treaty override, and the override results instead from actions of an administrative agency-the treasury. this article focuses on whether the treasury is authorized by the constitution and by congress to override u.s. treaty commitments. the article also analyzes the effect of an administrative override, if permissible, under treaties ratified after the enactment of section 7701(l). ii. history of multiparty financing regulations and relationship of conduit rules to treaty interpretation a. defining undefined treaty terms; applying domestic antiabuse rules it is important to distinguish the use of domestic law to override treaties-a clear violation of international law-from the lawful use of domestic law to define terms left undefined by treaty. under article 3(2) of the 1994 oecd model treaty, any term not defined in a treaty takes the meaning that it has under the law of the state applying the treaty unless the context otherwise requires. 2 some version of article 3(2) appears in every u.s. income tax treaty. accordingly, in the back-to-back loan example discussed above, the united states must determine whether the interest article of the u.s.-country b treaty applies to the interest paid from c to b. while treaties typically define some terms in the interest article, including "interest,"' 3 other terms in the article may be undefined, and domestic law of the state applying the treaty can be consulted to define the undefined terms. in aiken industries, inc. v. commissioner, 4 a bahamian company that had loaned money to its u.s. subsidiary assigned the obligation to a honduran subsidiary in exchange for the latter's note, which had the same 11. see, e.g., richard l. doemberg, overriding tax treaties: the u.s. perspective, 9 emory int'l l. rev. 71 (1995); richard l. doemberg, hi ho silver! congress rides, or rather overrides, again: the proposed tax on capital gains of foreign shareholders, 2 tax notes int'l 464 (1990); richard l. doemberg, legislative overrides of income tax treaties: the branch profits tax and congressional arrogation of authority, 42 tax law. 173 (1989). 12. see committee on fiscal affairs, organization for economic co-operation and development model tax convention on income and on capital, art. 3, para. 2 (1994) [hereinafter 1994 oecd model]; john avery jones, article 3(2) of the oecd model convention and the commentary to it: treaty interpretation, 33 european taxation 252 (1993); klaus vogel, double tax treaties and their interpretation, 4 int'l tax & bus. law. 1, 62 (1986). 13. 1994 oecd model, supra note 12, art. 11, para. 3. 14. 56 t.c. 925 (1971), acq., 1972-2 c.b. i. [vol. 2:9 treaty override by administrative regulation interest rate and payment schedule as the obligation from the u.s. subsidiary. the honduran subsidiary realized no profit from the transaction because the interest it received from the u.s. corporation was immediately payable to the bahamian corporation. the u.s. subsidiary claimed that no withholding was required on interest payments to the honduran company under a treaty that then existed between the united states and honduras. the tax court denied the use of the treaty, even though it found that the honduran corporation was not a sham. the court ruled that the honduran corporation never "received" the interest as required by the treaty because the receipt of the interest and the obligation to transmit to the bahamian corporation were inseparable. as stated by the court: [we interpret the terms "received by" to mean interest received by a corporation of either of the contracting states as its own and not with the obligation to transmit it to another. the words "received by" refer not merely to the obtaining of physical possession on a temporary basis, .. .. but contemplate complete dominion and control over the funds.' 5 two related revenue rulings, both citing aiken, deny treaty benefits where interest is not "derived by" treaty country residents within the meaning of that treaty term. in revenue ruling 84-152,6 a swiss corporation (p) owned two subsidiaries-s, a netherlands antilles corporation, and r, a u.s. manufacturing corporation. when r required an increase in working capital, p loaned the funds to s, which reloaned the funds to r. r made timely interest payments at 11% to s, which made timely interest payments to p at 10%. 17 in revenue ruling 84-153,8 a u.s. holding corporation (p) had a wholly-owned netherlands antilles subsidiary (s) and a wholly-owned u.s. subsidiary (r). in order to raise funds for r, s issued bonds to foreign persons outside the united states and loaned the bond proceeds to r at an interest rate 1% higher than the rate payable on the bonds.' 9 in these two rulings, which were issued in tandem, the irs held that interest payments made by the u.s. subsidiary (of a foreign corporation in revenue ruling 84-152 and of a u.s. corporation in revenue ruling 84-153) 15. id. at 933. 16. 1984-2 c.b. 381, obsoleted by rev. rul. 95-56, 1995-36 i.r.b. 20 (sept. 5). 17. without further explanation, the irs noted that neither r nor s were thinly capitalized, but that s was not sufficiently liquid to make the loans to r out of its own funds. 18. 1984-2 c.b. 383, obsoleted by rev. rul. 95-56, 1995-36 i.r.b. 20 (sept. 5). 19. the interest payments by r did not qualify for the portfolio exemption because the bonds did not meet the requirements of § 163(f)(2)(b). 19951 florida tax review to a related netherlands antilles corporation did not qualify for the interest exemption under the then-existing treaty between the united states and the netherlands antilles ("antilles treaty"). 20 the rulings hold that for purposes of the interest article of the antilles treaty, the interest could not be said to have been "derived by" the antilles subsidiaries merely because they possessed the interest temporarily. 2' although the subsidiaries had corporate substance and were not shams, they never had dominion and control over the interest payments. the primary purpose of using the subsidiaries was to obtain the benefits of the antilles treaty exemption and thus avoid u.s. taxation. even if the transactions may have served some business purpose, there was not "sufficient business or economic purpose to overcome the conduit nature of the transaction. 22 beyond the use of domestic law to define terms left undefined by treaties, contracting states are generally recognized to have authority to apply antiabuse principles of domestic law, including rules that elevate substance over form. this consensus is reflected in the oecd commentary, which states: the large majority of oecd member countries consider that such measures [e.g., substance-over-form rules] are part of the basic domestic rules set by national tax law for determining which facts give rise to a tax liability. these rules are not addressed in tax treaties and are therefore not affected by them.... a dissenting view, on the other hand, holds that such rules are subject to the general provisions of tax treaties against double taxation, especially where the treaty itself 20. the antilles treaty, which was partially terminated as of january 1, 1988, was an extension of the former united states-netherlands treaty. convention between the united states of america and the kingdom of the netherlands with respect to taxes on income and certain other taxes, apr. 29, 1948, u.s.-neth. art. viii, para. 1, t.i.a.s. 1855. 21. the irs cited aiken indus., inc. v. commissioner, supra notes 14-15 and accompanying text, for this proposition. 22. rev. rul. 84-152, 1984-2 c.b. 381, obsoleted by rev. rul. 95-56, 1995-36 i.r.b. 20 (sept. 5); rev. rul. 84-153, 1984-2 c.b. 383, obsoleted by rev. rul. 95-56, 1995-36 i.r.b. 20 (sept. 5). the irs cited gregory v. helvering, 293 u.s. 465 (1935) and aiken on this point. in priv. let. rul. 8722009 (feb. 12, 1987), the irs ruled that interest payments from a u.s. corporation to a netherlands corporation were not exempt from u.s. taxation under article viii of the 1948 united states-netherlands treaty. in the ruling, third-country investors, who had made loans to the u.s. corporation directly, restructured the loans through a recently purchased, inactive netherlands corporation, whose debt-equity ratio was 89:1. the irs' conclusion was based on both the thin capitalization of the netherlands corporation and the fact that interest checks received by the netherlands corporation were deposited in the foreign investors' bank accounts. [vol 2:9 treaty override by administrative regulation contains provisions aimed at counteracting its improper use. 23 the united states certainly holds the majority view. although aiken and the two revenue rulings discussed above rely in large part on domestic law to define undefined treaty terms, they also convey a flavor that domestic substance-over-form (or anti-conduit) rules should apply to transactions that formally come within the reach of treaties. this view is confirmed by revenue ruling 87-89,21 which did not use domestic law to define an undefined treaty term but instead relied on a domestic substance-over-form argument to deny the use of a treaty. in this ruling, fp, a foreign corporation organized in a state having no treaty with the united states, had a domestic subsidiary (ds) that required funds for its business. fp deposited funds in a demand deposit with bk, a publicly-held bank in a state that had a treaty with the united states exempting interest from source-state taxation. bk thereafter loaned most of the deposited money to ds for use in its business. the difference between the interest paid by bk to fp on the demand deposit and interest charged by bk on the loan to ds was less than 1%. absent the deposit by fp, bk would have charged a higher interest rate. the ruling states that the treaty exemption could apply only if the deposit and loan were "independent transactions such that the loan from bk would be made or maintained on the same terms irrespective of the deposit." 5 because bk would have charged more interest to ds in the absence of the deposit by fp, the irs found this independence lacking and denied bk the benefits of the treaty. in such deposit/loan situations, any contractual or statutory right of bk to an offset against the deposit in the event of a default by the borrower is presumptive evidence that bk would not have maintained the loan on the same terms without the deposit. b. do the multiparty financing regulations override treaties? in the preamble to the proposed regulations, the treasury explains its view of the relationship of the regulations to u.s. treaty commitments: these regulations are intended to provide anti-abuse rules that supplement, but do not conflict with, the limitation on 23. 1994 oecd model, supra note 12, commentary on art. 1, para. 23. the united states is a member of the organization for economic cooperation and development (oecd). 24. 1987-2 c.b. 195, obsoleted by rev. rul. 95-56, 1995-36 i.r.b. 20 (sept. 5). 25. id. at 196. 19951 florida tax review benefits articles in u.s. income tax treaties .... it has been recognized that contracting states may supplement these rules by transactionally-based domestic anti-abuse rules, including rules under which a particular transaction may be recast, in accordance with the substance of the transaction. these regulations, which reflect common law substance over form principles as applied to conduit financing arrangements, complement the limitation on benefits provisions of income tax treaties and are not precluded by the inclusion of such provisions... 26 from this statement, it seems clear that the treasury does not view the regulations as a treaty override but merely as treaty supplementation. but, is that claim credible? 1. regulations not intended as override-suppose we take the treasury at its word that the regulations are not intended to override treaties. indeed, there is much to support this conclusion. it is unquestioned doctrine that wherever possible, "a united states statute is to be construed so as not to conflict with ... an international agreement of the united states.27 moreover, congress stated no intention that the regulations under section 7701() override conflicting treaties.28 if no treaty override is intended, the regulations must be interpreted in a manner that does not nullify any treaty provision.29 perhaps this can be done with little problem where a potentially applicable treaty does not contain a provision dealing with conduit entities. the international community seemingly agrees, as the oecd commentary suggests, that the united states has the right to apply domestic substance-over-form principles to deny treaty benefits where the treaty is silent on the issue. for example, the application of the regulations to deny the benefits of the u.s.-switzerland treaty may not be a problem.30 26. 59 fed. reg. 52110, 52112-13 (1994) (to be codified at 26 c.f.r. pt. 1) (proposed oct. 14, 1994). 27. restatement (third) of foreign relations law of the united states § 114 & note 2 (1986) (citing cook v. united states, 288 u.s. 102 (1933)) [hereinafter restatement]. 28. see trans world airlines, inc. v. franklin mint corp., 466 u.s. 243, 252 (1984). 29. cook v. united states, 288 u.s. 102, 120 (1933). 30. 1994 oecd model, supra note 12, commentary on art. 1, paras. 25-26. however, some argue that even in this situation, the regulations go beyond the common law principles contemplated by the oecd commentary. see o'donnell, et al., supra note 7, at 134. [vol 2:9 treaty override by administrative regulation there may also be no override problem if a treaty contains a limitation on benefits provision that does not specifically address multiparty financing issues. for example, under the limitation on benefits provision of the u.s.-australian treaty," treaty benefits are available to an australian corporation if more than 75% of the beneficial interests in the corporation are owned by individuals residing in australia.3 suppose b, an australian corporation wholly-owned by individual residents of australia, makes a loan to c, a u.s. borrower. under the treaty, interest paid by c to b may be eligible for reduced u.s. withholding, even if much or all of the interest received by the australian corporation is paid out to a, a nontreaty lender.3 that is, the treaty contains no base erosion provision that denies treaty benefits if the treaty resident's income is reduced through deductible payments to recipients outside the treaty country. in this situation, the regulations, in treating b as a conduit ineligible for treaty benefits, arguably supplement rather than override the treaty. the situation is more complicated under a treaty with a base erosion test. for example, the u.s.-netherlands treaty contains a very elaborate limitation on benefit provision,34 under which a dutch corporation (b) that satisfies an ownership test is entitled to treaty benefits only if it also satisfies a base reduction test.35 b meets the base erosion test if less than 50% of its income is used to make deductible payments' in the current taxable year to persons other than qualified persons (e.g., nonresidents).3 7 for example, suppose that a, a treaty nonresident, makes an interest-free demand loan to b, a dutch corporation wholly owned by individual residents of the netherlands, and b makes an interest-bearing loan to c, a u.s. borrower. since none 31. convention between the government of the united states of america and the government of australia for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, aug. 6, 1982, u.s.-austl. art. 16. paras. l(a)(iii), 3, t.i.a.s. 10773 [hereinafter u.s.-austl. treaty]. 32. there are other ways to qualify for treaty benefits as well. see u.s.-austl. treaty, supra note 31, art. 16, para. l(a)-(c). 33. u.s.-austl. treaty, supra note 31, art. 11. 34. u.s.-neth. treaty, supra note 6, art. 26. see also philip d. morrisson & mary c. bennett, the new u.s.-netherlands treaty: part i-limitation on benefits and related issues, 6 tax notes int'l 331 (feb. 8, 1993); eric m. overman. note, the u.s.-netherlands tax treaty: important changes, practitioners' response, and primary effects. 48 tax law. 207, 214-25 (1994). 35. u.s.-neth. treaty, supra note 6, art. 26, para. l(d)(i) (ownership test), l(d)(ii) (base reduction test). 36. see id. art. 26, para. 5(c) (defining "deductible payment"). 37. id. art. 26, para. 5. an alternative base reduction test permits up to 70% of b's gross income to be used for deductible payments to nonqualified persons if less than 30% of the gross income is used to make deductible payments to persons who are not residents of member states of the european union. 1995] florida tax review of b's income (interest from c) is used to made deductible payments to nonresidents, b satisfies the ownership and base reduction tests, and the treaty limitation on benefits does not deny b the benefits of the interest article, which, in this case, gives exclusive taxing authority to the netherlands.38 if the regulations apply, c's interest payment to b might not qualify for treaty benefits if one of the principal purposes for b's participation is to obtain the withholding exemption under the u.s.-netherlands treaty.39 if the treasury truly did not intend the regulations to override treaty commitments, the regulations should not be applied to disallow treaty benefits that are clearly permitted by the treaty. the united states and the netherlands (or at least the united states) clearly perceived that multiparty financing arrangements were being used to obtain treaty benefits inappropriately, but they negotiated a detailed response to the perceived problem.4" the regulations cannot be considered supplementary to a treaty with a 50% base erosion test if they deny treaty benefits in some circumstances where there is no base erosion. nothing in the u.s.-netherlands treaty suggests that domestic law can alter the bargain struck by the two contracting states. in sum, the regulations, if not intended to override treaties, cannot be applied in direct conflict with a limitation of benefits provision that includes a detailed base erosion test.4' the treasury should clarify that the regulations do not apply where detailed treaty base erosion tests reach a conflicting result. 2. regulations intended as override-if the regulations are intended to apply in direct conflict with treaty provisions that address the conduit issue in detail, they must be regarded as a treaty override or an attempted override, notwithstanding the treasury's contrary claim. the regulations state that a "conduit entity may not claim the benefits of a tax treaty between its country of residence and the united states to reduce the amount of tax due under 38. id. art. 12. it is assumed that this transaction is the only relevant transaction for the year. 39. see regs. § 1.881-3(e) ex. 11. 40. in addition to the base reduction test, the u.s.-netherlands treaty contains a conduit company test that applies to companies in a treaty state that are owned by certain publicly-traded corporations. u.s.-neth. treaty, supra note 6, art. 26, para. l(c)(ii)(b). 41. another example of a conflict between the u.s.-netherlands treaty and the regulations: if b is an unrelated netherlands bank with which a regularly deposits cash held as working capital, b is likely entitled to treaty benefits under the active business test of article 26, paragraph 2. however, if a deposits funds substantially in excess of its working capital needs and b has a right of offset against a's deposits to satisfy a loan by b to c, the regulations may deny treaty benefits notwithstanding the treaty. see regs. § 1.881-3(e) ex. 20. [vol. 2:9 treaty override by administrative regulation section 881 with respect to payments made pursuant to the conduit financing arrangement."42 there is no doubt that properly enacted domestic law that overrides a treaty provision will be upheld in a u.s. court of law,43 even though the override is a clear violation of international law.4 a taxpayer cannot successfully assert breach of a treaty commitment as a defense against the application of u.s. domestic law.45 a tax convention is a treaty under the u.s. constitution.' the supremacy clause of the constitution provides in part: "this constitution, and the laws of the united states which shall be made in pursuance thereof, and all treaties made, or which shall be made, under the authority of the united states, shall be the supreme law of the land."' in a series of early cases, the supreme court ruled that under the supremacy clause, statutes and treaties have equal status.' as a consequence, the court reasoned, a treaty "may supersede a prior act of congress, and an act of congress may supersede a prior treaty."49 the idea that treaties and the laws of the united states are of equal dignity has been challenged." indeed, although no one would contend that the constitution is on equal footing with a statute, they are enumerated together in the supremacy clause. nevertheless, the doctrine of equal status is firmly entrenched.5' in the internal revenue code, the doctrine of equal status is codified in section 7852(d)(1), which provides: 42. regs. § 1.881-3(a)(3)(ii)(c). 43. see, e.g., the cherokee tobacco, 78 u.s. 616, 621 (1870); see also chinese exclusion case, 130 u.s. 581, 600 (1889); whitney v. robertson, 124 u.s. 190, 195 (1888); head money cases, 112 u.s. 580, 599 (1884). 44. while a statute may supersede a prior treaty as a matter of u.s. domestic law, as a matter of international law, the united states is obligated to fulfill its treaty obligations. see vienna convention of the law of treaties, may 23, 1969, art. 26, 8 i.lm. 679, 690; restatement, supra note 27, § 321 cmt. a. this principle is embodied in the doctrine of pacta sunt servanda-agreements of the parties must be observed. the international obligation survives any subsequent restrictions in domestic law. the fact that an override violates international law has obviously not completely deterred the united states from enacting and enforcing overriding legislation. 45. diggs v. shultz, 470 f.2d 461, 464-67 (d.c. cir. 1972), cert. denied. 411 u.s. 931 (1973). 46. samann v. commissioner, 313 f.2d 461, 463 (4th cir. 1963); american trust co. v. smyth, 247 f.2d 149, 153 (9th cir. 1957). 47. u.s. const. art. vi, cl. 2. 48. see supra note 43. 49. the cherokee tobacco, 78 u.s. at 621. 50. committee on u.s. activities of foreign taxpayers and foreign activities of u.s. taxpayers of the new york state bar association section of taxation. legislative overrides of tax treaties, 37 tax notes 931, 932-33 (nov. 30. 1987); louis henkin, foreign affairs and the constitution 163-64 (1972). 51. see restatement, supra note 27, § 115(1)(a) note 1. 19951 florida tax review "for purposes of determining the relationship between a provision of a treaty and any law of the united states affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law." in cook v. united states,52 the supreme court found that the mere re-enactment of a statute authorizing the boarding of vessels suspected of smuggling liquor into the united states did not supersede a treaty with the united kingdom that limited such boarding. generally, it takes a clear expression of congressional intent-either in the statutory language or in the legislative history-before a court will interpret a statute to override a preexisting treaty.53 however, even if there is not a clear expression of congressional intent to override, courts may infer the intent if a statute directly takes away a treaty right. in the cherokee tobacco,54 a divided supreme court ruled that a statute imposing an excise tax on tobacco applied in cherokee territory even though a preexisting treaty guaranteed to every cherokee resident the right to sell tax free any products from farming or manufacturing. under the u.s. jurisprudence on the relationship of treaties to domestic legislation, at least two requirements must be satisfied in order for a domestic regulation to have the effect of overriding a treaty commitment. first, since the supremacy clause refers to "laws of the united states" and treaties, a treaty-overriding regulation must be a law of the united states. a regulation only has authority as law insofar as it is authorized by statute.55 there is no independent authority for a regulation to override a treaty provision. if the multiparty financing regulations are to override conflicting treaty provisions, such as article 26 of the u.s.-netherlands treaty, the override must be pursuant to congressional authority. second, even if congressional intent to override conflicting treaty provisions can be discerned, the supremacy clause merely treats the overriding provision as equal in force to the treaty so that the later-in-time rule applies. some important conceptual issues relating to the later-in-time rule must be explored in determining whether, as a matter of u.s. domestic law, the regulations override the u.s.-netherlands treaty and other treaties that enter into force after the enactment of section 7701(l). 52. 288 u.s. 102 (1993). 53. see trans world airlines, inc. v. franklin mint corp., 466 u.s. 243,252 (1984) (citing cook v. united states, 288 u.s. 102, 120 (1933)); see also rev. rul. 80-223, 1980-2 c.b. 217. 54. 78 u.s. 616 (1870). 55. chrysler corp. v. brown, 441 u.s. 281, 304 (1978). [vol 2:9 treaty override by administrative regulation iii. establishing authority to override a. statutory authority to override section 7701(t) does not directly express a congressional intent to authorize an override. the provision does nothing more than grant authority to promulgate regulations necessary to prevent the avoidance of tax through conduit arrangements. therefore, if section 7701(t) is to be interpreted as authorizing the treasury to override treaties with these regulations, that intent must be found somewhere other than the statutory language. congress has sometimes shown its intent to override treaties in the legislative history to a statute.56 in this situation, there is no direct language in the legislative history showing an intent to override treaties. the legislative history accompanying section 7701(1) describes the problem with which congress was concerned in enacting this legislation. the various committee reports refer to the aiken case as an example of the problem. because treaty benefits were denied in aiken, a quick reading might suggest that congress was authorizing regulations that would also deny treaty benefits. however, as discussed above, aiken was a case where domestic law was used to interpret undefined terms in a treaty and did not involve a treaty override.57 the regulations seem to go far beyond the interpretation of undefined treaty terms.58 however, the legislative history contains no ex56. see, e.g., h.r. rep. no. 658, 94th cong., 1st sess. 226 (1975). reprinted in 1976 u.s.c.c.a.n. 2897, 3121-22; s. rep. no. 938, 94th cong. 2d sess. 237 (1976). reprinted in 1976 u.s.c.c.a.n. 3439, 3667-68 (stating that changes to foreign tax credit are intended to apply notwithstanding inconsistent treaty provisions). 57. see supra text accompanying notes 14-15. 58. see mary c. bennett, et al., the proposed anti-conduit regulations under section 7701(l), 24 tax mgmt. int'l j. 3, 3 (1995). a technical advice memorandum cited in the legislative history portends an increasingly aggressive posture by the irs against perceived treaty shopping. in the memorandum, a u.s. subsidiary paid interest to its shareholder, a foreign financing intermediary that distributed a dividend of the same amount to its foreign parent in the same year. the irs determined that the interest should be treated as paid to the foreign parent and that the treaty between the united states and the financing intermediary's state could not be applied to reduce the withholding rate. the intermediary was regarded as a conduit, and the interest was deemed to be "paid to" the foreign parent. i.r.s. t.a.m. 9133004 (may 3, 1991). the legislative history to § 7701(/) also suggests that the regulations might go beyond the back-to-back loan situation to cover "multiple-party transactions involving debt guarantees or equity investments." senate finance committee, report on revenue provisions of omnibus budget reconciliation act of 1993-foreign tax provisions, 103d cong., 1st sess. (1993), 93 tni 120-24 (june 23, 1993) (lexis, fedtax library. tni file). see generally peter c. canellos, report of the tax section of the new york state bar association, 8 tax notes int'l 367 (feb. 7, 1994). the legislative history also discusses two revenue 19951 florida tax review plicit statement that section 7701(/) is intended to override treaty commitments. even without an explicit statement, the requisite intent could be inferred if section 7701() had no purpose other than to override treaty commitments.5 9 however, regulations under section 7701() could apply in situations that would not require treaty overrides-in particular, where there is no applicable treaty or an applicable treaty contains no detailed limitation of benefits provision. assume a foreign corporation (a) with a u.s. subsidiary (c) makes a loan to an unrelated foreign corporation (b), which reloans the proceeds on similar terms to c. interest payments from c to b might be literally within the statutory portfolio interest exemption of section 881(c),6' but the regulations would deny the exemption by requiring that b be ignored as a conduit. this denial of a tax benefit otherwise available does not involve the denial of treaty benefits. in sum, neither section 7701() nor its legislative history explicitly overrides any treaty commitment, and because section 7701() can operate successfully in situations where no override is involved, there is no implicit override of treaties. b. delegation of override authority to treasury assuming arguendo that congress expressed an intention to authorize regulations under 7701() that override treaties, can the authority to override be delegated to treasury? delegation of override authority may assume two forms. first, congress could explicitly delegate the authority to the treasury to override treaties. second, congress could be silent on the issue of override authority and merely delegate authority to promulgate legislative regulations, which might include override authority if it was found not to be beyond the scope of the enabling act. in either case, an administrative agency's power to promulgate legislative regulations is limited to the authority delegated by congress.6" rulings dealing with the "beneficial ownership concept." see rev. rul. 84-152, 1984-2 c.b. 381, obsoleted by rev. rul. 95-56, 1995-36 i.r.b. 20; rev. rul. 84-153, 1984-2 c.b. 383, obsoleted by rev. rul. 95-6, 1995-36 i.r.b. 20; see discussion supra text accompanying notes 16-22. 59. see the cherokee tobacco, 78 u.s. 616 (1870) (finding that the statute flatly took away a right granted by treaty and holding that the statute overrode the treaty). 60. even in the absence of the regulations, the irs might deny the portfolio interest exemption on the authority of aiken and revenue ruling 84-152, 1984-2 c.b. 381, obsoleted by rev. rul. 95-56, 1995-36 i.r.b. 20; see discussion supra text accompanying notes 14-17. 61. bowen v. georgetown univ. hosp., 488 u.s. 204, 208 (1988); see american standard, inc. v. united states, 602 f.2d 256 (ct. cl. 1979) (holding a legislative regulation invalid because it was inconsistent with the enabling statute). [vol 2:9 treaty override by administrative regulation in chevron u.s.a. inc. v. natural resources defense council, inc.' the supreme court addressed epa promulgated standards implementing the clean air act amendments of 1977. the epa had defined "stationary source" in a manner that was not directly specified in the legislation or the legislative history. the court upheld the epa's decision, finding that although congress expressed no intention regarding the specific concept used by epa, the concept was an appropriate policy for the epa to adopt. with regard to section 7701(1), it is not clear that congress would not have wanted the regulations to override treaties, especially since cases dealing with treaties were mentioned in the legislative history and congress did not say that the regulations were not intended to override treaties. as stated by the court in chevron: if congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation. such legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute. sometimes the legislative delegation to an agency on a particular question is implicit rather than explicit. in such a case, a court may not substitute its own construction of a statutory provision for a reasonable interpretation made by the administrator of an agency.63 1. explicit delegation.-treasury regulations fall into two categories: legislative regulations and interpretative regulations. a legislative regulation is authorized by statute to establish operative rules. interpretative regulations explain the treasury's interpretation of the code, and are issued under section 7805(a), which grants the treasury power to "prescribe all needful rules and regulations." as between these two types, legislative regulations are entitled to greater weight and deference.' 4 a legislative regulation, if valid, has the effect of law.' the regulation is valid if it is consistent with the statute that authorized it, adopted pursuant to proper procedure, and reasonable. in chrysler corp. v. brown, chrysler sought to enjoin public disclosure of documents it was required to submit to the government. chrysler argued that the trade secrets act 62. 467 u.s. 837 (1984). 63. id. at 843-44 (citations omitted). 64. rowan cos., inc., v. united states, 452 u.s. 247, 253 (1981); see also tate & lyle, inc. v. commissioner, 103 t.c. 656, 666 (1994). 65. chrysler corp. v. brown, 441 u.s. 281, 304 (1979). 19951 florida tax review prohibited the government from disclosing the information.6 the court of appeals held that the government was "authorized by law" to disclose the information-that regulations promulgated by the department of labor's office of federal contract compliance programs provided the law necessary to authorize the disclosure of the documents, in effect overriding the trade secrets act.67 the supreme court disagreed. although it recognized that a regulation can have the force and effect of law if "rooted in a grant of such power by the congress and subject to limitations which that body imposes, 68 the court held that the enabling statute did not provide authority for overriding the trade secrets act.69 therefore the regulation could not provide the "authorization by law" that was required by the trade secrets act. because legislative regulations have the effect of law to the extent that they are consistent with the enabling act, the question arises as to what powers congress may delegate to an agency to aid in carrying out the necessary functions of government.70 the constitution of the united states provides that "[a]ll legislative powers herein granted shall be vested in a congress of the united states."' as explained by the supreme court in field v. clark, "[t]hat congress cannot delegate legislative power to the president is a principle universally recognized as vital to the integrity and maintenance of the system of government ordained by the constitution.'"" 66. the act provides: whoever, being an officer or employee of the united states or of any department or agency thereof, publishes, divulges, discloses, or makes known in any manner or to any extent not authorized by law any information coming to him in the course of his employment or official duties... shall be fined ... or imprisoned... and shall be removed from office or employment. 18 u.s.c. § 1905 (1988 & supp. v 1994). 67. the regulations were authorized by 5 u.s.c. § 301 (1994), which provides: the head of an executive department or military department may prescribe regulations for the government of his department, the conduct of its employees, the distribution and performance of its business, and the custody, use, and preservation of its records, papers, and property. this section does not authorize withholding information from the public or limiting the availability of records to the public. 68. chrysler corp., 441 u.s. at 302. 69. id. at 312. 70. generally, congress cannot delegate its legislative power to one of the other branches of government. see field v. clark, 143 u.s. 649, 692 (1892). 71. u.s. const. art. 1, § 1. 72. 143 u.s. 649, 692 (1892). [vol 2:9 treaty override by administrative regulation however, for the first 150 years of u.s. history, the supreme court uniformly held that challenged statutes did not unconstitutionally delegate legislative power.73 the classic exposition of the governing test was offered by chief justice taft: so long as congress "lay[s] down by legislative act an intelligible principle to which the person or body authorized to [exercise delegated authority] is directed to conform, such legislative action is not a forbidden delegation of legislative power."'74 in 1935, the supreme court relied on the delegation doctrine to invalidate portions of the national industrial recovery act of 1933. in panama refining co. v. ryan, the court held that "congress manifestly is not permitted to abdicate, or to transfer to others, the essential legislative functions with which it is thus vested."75 these essential legislative functions apparently consist primarily of the formulation of legislative policy to guide the executive and judicial branches. as long as the policy is determined by the congress, it seems that the power to make regulations to enforce that policy may be delegated to the agency of congress' choice. 6 as stated in panama refining: the constitution has never been regarded as denying to the congress the necessary resources of flexibility and practicality, which will enable it to perform its function in laying down policies and establishing standards, while leaving to selected instrumentalities the making of subordinate rules within prescribed limits and the determination of facts to which the policy as declared by the legislature is to apply!' in panama refining, the court held that a congressional delegation authorizing the president to interdict interstate transportation of petroleum produced in excess of amounts permitted by state authority was invalid because "congress has declared no policy, has established no standard, has laid down no rule" to guide the president's discretion. 8 the court found that, because the statute was devoid of criterion governing the president in his actions and contained no limits to the president's actions, congress had given 73. see synar v. united states, 626 f. supp. 1374, 1383 (d.d.c. 1986). aff'd sub noma. bowsher v. synar, 478 u.s. 714 (1986). 74. j.w. hampton, jr., & co. v. united states, 276 u.s. 394, 409 (1928). 75. 293 u.s. 388, 421 (1935). 76. if congress is permitted to delegate power to the president then there appears to be no restriction on granting that same power to an agency in the executive branch. id. at 420. 77. id. at 421. 78. panama refining co. v. ryan, 293 u.s. 388, 430 (1935). 19951 florida tax review the president unlimited authority to declare a policy of his own.79 the court was unable to find any criterion that would restrict the president and thus determined that the president was acting more like a "legislature rather than ... an executive or administrative officer executing a declared legislative policy.""0 thus, in order to find a permissible delegation of power, the delegation must provide a policy and standards by which that policy must be implemented. these limits apply whether the delegation of power is express or implied. as the court stated in panama refining: "there are limits of delegation which there is no constitutional authority to transcend."'" in the same year as panama refining, the court struck down another delegation of authority in a.l.a. schechter poultry corp. v. united states.82 in schechter, the court found that a provision of the national industrial recovery act delegating to the president the power to approve "codes of fair competition" lacked sufficient standards to guide the president's discretion.83 these codes were to be approved upon application of a trade or industrial association meeting certain requirements, but if no such code were approved, the president had authority to prescribe a code, the violation of which was punishable as a misdemeanor. the purpose of these codes was to "effect the policies of title i of the national industrial recovery act. "' panama refining and a.la. schechter are the only two cases in which the supreme court has invalidated an act as violating the nondelegation doctrine.8 5 the following year, the court considered the delegation issue in the context of foreign affairs in united states v. curtiss-wright export corp.86 congress, in a joint resolution, had delegated to the president the power to prohibit sales of arms or munitions to countries engaged in armed conflict. before making such a prohibition, the president was to determine if this action might have the effect of bringing about peace. the extent of the prohibition, and its duration, were within the president's discretion. violation of the prohibition was punishable as a crime. in curtiss-wright, the court considered whether this delegation was valid. 7 citing the long history of 79. id. at 415. "the congress left the matter to the president without standard or rule, to be dealt with as he pleased." id. at 418. 80. id. at 418-19. 81. id. at 430. 82. 295 u.s. 495 (1935). 83. id. at 541-42. 84. id. at 523. 85. see mistretta v. united states, 488 u.s. 361, 373-74 (1989) (citing cases in which the court has since upheld various delegations of power). 86. 299 u.s. 304 (1936). 87. id. at 315. [vol. 2:9 treaty override by administrative regulation cases allowing broad discretion to be delegated to the president in matters of foreign affairs, the court found that the delegation was not invalid, despite the breadth of discretion left to the president.m since 1935, the supreme court has repeatedly refused to invalidate statutes under the nondelegation doctrine.89 however, regulations have been struck down where the court has determined that they did not reflect congressional intent. in industrial union department v. american petroleum institute, 9° the court struck down a rule issued by the occupational safety and health administration (osha) that banned workplace exposure to benzene. the court determined that osha was required to take costs into account in carrying out its delegated responsibility to "assure" a "safe and healthful" workplace. the court applied a "clear statement rule," requiring that congress issue a clear statement before a regulatory agency would be able to assume power to legislate.9' the current standards are detailed in a well-reasoned district court case decided by now-justice scalia, synar v. united states.' the court found that although a grant of authority to the comptroller general under the gramm-rudman-hollings act93 was unconstitutional due to a separation of powers issue, the power was one that could lawfully be delegated. the delegated power authorized the comptroller general, if the deficit exceeded a certain amount, to issue a report to the president and to congress containing deficit estimates and budget reduction calculations. after receiving this report, the president was required to issue a sequestration order containing the budget reductions specified by the comptroller general. in essence, congress delegated power to make budget cuts if the deficit exceeded a specified amount. in synar, the court was faced with two questions: first, did the legislature delegate legislative power that may not be delegated under any circumstance; and second, can the legislative authority be given to the comptroller general, who is an officer removable by congress? the court rejected the notion that some powers were inherently nondelegable and held that the true measure of what could be delegated was to be found in how precise the standards governing the delegation were. in doing so, the court rejected the 88. id. at 322-29. 89. see cases cited in synar v. united states, 626 f. supp. 1374. 1383-84 n.9 (d.d.c. 1986). 90. 448 u.s. 607 (1980). 91. id. at 645. 92. 626 f. supp. 1374 (d.d.c. 1986) (per curiam with scalia, j., sitting as one of the three judges), affd sub nom. bowsher v. synar, 478 u.s. 714 (1986) (affirming the district court on the separation of powers issue). 93. balanced budget and emergency deficit control act of 1985, pub. l no. 99177, § 200, 99 stat. 1038 (1985). 1995] florida tax review notion that there were core legislative functions that could not be delegated under any circumstances.94 the court stated: [t]he ultimate judgment regarding the constitutionality of a delegation must be made not on the basis of the scope of the power alone, but on the basis of its scope plus the specificity of the standards governing its exercise. when the scope increases to immense proportions (as in schechter) the standards must be correspondingly more precise.95 the court went on to explain what is needed for a permissible delegation. in order to permissibly delegate authority, congress must provide "adequate standards to restrict administrative discretion. 96 citing an earlier supreme court case, the court found that "[t]he essential inquiry is whether the specified guidance 'sufficiently marks the field within which the administrator is to act so that it may be known whether he has kept within it in compliance with the legislative will.' ,97 this standard is also reflected in mistretta v. united states,98 where the supreme court considered congress' delegation to the united states sentencing commission, by the sentencing reform act of 1984, of the power to fix penalties for violations of federal criminal statutes. in the act, congress provided goals and purposes to be met by the commission in promulgating sentencing guidelines. the court found that the delegation was constitutional. it stated that "[s]o long as congress 'shall lay down by legislative act an intelligible principle to which the person or body authorized to [exercise the delegated authority] is directed to conform, such legislative action is not a forbidden delegation of legislative power. "99 although the delegated discretion was broad, the court found that congress had provided adequate standards to guide the commission in the implementation of its discretion.1° a delegation is not invalid, according to the court, simply because the agency is required to use its own judgment in exercising the delegated authority. so long as a delegation of power is accompanied by adequate 94. the court noted that the supreme court has never held a legislative power to be nondelegable due to being a core function. synar, 626 f. supp. at 1385. 95. id. at 1386. 96. id. at 1387. 97. id. at 1387 (quoting yakus v. united states, 321 u.s. 414, 425 (1944)). 98. 488 u.s. 361 (1989). the court in mistretta cited synar with approval. id. at 373. 99. id. at 372 (quoting j.w. hampton, jr., & co. v. united states, 276 u.s. 394, 409 (1928)). 100. mistretta, 488 u.s. at 377. [vol 2:9 treaty override by administrative regulation standards to guide the person or agency to which power is delegated, it is not unconstitutional. under the foregoing authorities, it seems likely that the power to override treaties can be delegated. however, to make a valid delegation of this power, congress must issue a clear statement and provide adequate standards. no clear statement and no standards of any sort can be found in section 7701() or its legislative history.'0' 2. implicit delegation.-the lack of an explicit delegation raises the question of whether congress might constitutionally be able to delegate override authority implicitly. override authority might be implied from legislative history citing cases and rulings involving treaty overrides or perhaps from a statute that could only be applied in an override context." in weinberger v. rossi,"0 3 the supreme court confronted a situation where ambiguous statutory language arguably overrode thirteen international agreements. the statute before the court prohibited discrimination against u.s. citizens on overseas military bases in employment decisions.'"' an exception provided that the statute would not apply if this type of discrimination was permitted by a "treaty." the issue before the court was whether the term "treaty" was limited to its meaning under article ii, section 2, clause 2 of the u.s. constitution or had some broader meaning. if the term was construed narrowly, the thirteen international agreements, not rising to the constitutional meaning of treaty, would be overridden. however, the court construed the term more broadly to encompass all international agreements, thereby permitting the thirteen international agreements to control. the court quoted schooner charming betsy'05 for the proposition that "an act of congress ought never to be construed to violate the law of nations, if any other possible construction remains. . . ." the court stated that "some affirmative expression of congressional intent to abrogate the united states' international obligations is required" before the court could adopt an interpretation that would have 101. see supra text accompanying notes 57-60. 102. see the cherokee tobacco, 78 u.s. 616 (1870). 103. 456 u.s. 25 (1982). 104. military selective service act of 1967, sec. 106, 85 stat. 348, 355 (1971). 105. murray v. schooner charming betsy, 6 u.s. 64, 118 (1804). 106. the court cited mcculloch v. sociedad nacional de marineros de honduras, 372 u.s. 10, 20-21 (1963), as a case applying this principle. in that case, the court found that without a clearly expressed intention to violate the law of nations, it would not find that congress intended for the national labor relations board to have jurisdiction over seamen on ships flying the flag of a foreign nation, even though the ships were owned. through a series of corporations, by a u.s. parent corporation and ultimately by u.s. shareholders. 19951 florida tax review the effect of overriding thirteen international agreements. 7 in weinberger, the court showed a reluctance to find an override of an international agreement, even one not rising to the level of a treaty within the constitutional sense. if congress cannot implicitly override u.s. treaty commitments, an administrative agency surely cannot override a treaty based on implicit congressional authority. in trans world airlines v. franklin mint corp.,"0 8 the court was faced with regulations that arguably overrode parts of the warsaw convention. the regulations were promulgated by the civil aeronautics board (cab) pursuant to authority granted by congress in accordance with the warsaw convention. the regulations, designed to limit the liability of international air carriers, were originally based on the par value modification act (pvma). when the united states went off the gold standard, the pvma was repealed, but the cab continued to use the last official price of gold as a conversion factor. the regulations were challenged on the ground that repeal of the pvma rendered the convention unenforceable in the united states. in rejecting this contention, the court recognized "a firm and obviously sound canon of construction against finding implicit repeal of a treaty in ambiguous congressional action," and stated that "[legislative silence is not sufficient to abrogate a treaty."'" the regulations were legislative regulations, promulgated pursuant to an executive branch determination of the appropriate conversion factor, and the court was "bound to uphold that determination unless [it found] it to be contrary to law established by domestic legislation or by the convention itself.""0 further, "[wie may overrule the cab's action only if we conclude that it is inconsistent with the purposes of the convention or with domestic law.""' by finding that the regulations must comply with both domestic law and the convention, the court recognized that the regulations themselves had no independent authority to override the convention. the court determined that the authority to make the conversion factors was properly delegated by congress to the executive branch, but it nevertheless required the delegation to be exercised in a manner not "inconsistent with domestic or international law."'"12 thus, even with properly delegated administrative authority, the regulations could not override a u.s. treaty commitment. 107. weinberger, 456 u.s. at 32. 108. 466 u.s. 243 (1984). 109. id. at 252. 110. id. at 254. 111. id. at 255 n.26. 112. id. at 261. [vol. 2:9 treaty override by administrative regulation 3. regulatory override without delegation.-certainly, if congress cannot implicitly delegate authority to promulgate regulations overriding treaties, the judiciary will not uphold a regulatory override in the absence of any delegation. the treasury cannot on its own initiative override treaty commitments. legislative regulations only have the effect of law to the extent they are within a congressional grant of authority. ' 3 indeed, courts will go to great lengths to prevent regulations from limiting a treaty commitment, even indirectly. in tate & lyle, inc. v. commissioner," 4 the court was faced with regulations that indirectly, but significantly limited the benefits of an income tax treaty with the united kingdom. the treaty provides that interest payable to a resident of the united kingdom is not taxable by the united states."15 the regulations are legislative regulations promulgated under section 267(a)(3), which authorizes regulations applying the matching principle of section 267(a)(2) to payments to related foreign persons." 6 in tate & lyle, the effect of the regulations was to prevent the domestic subsidiaries of a united kingdom parent from deducting interest owed to the parent until the interest was paid, even though the subsidiaries used the accrual method of accounting. the matching principle of section 267(a)(2) only requires that an item payable to a related person not be deducted before the recipient is required under its method of accounting to report it as gross income. in contrast, the regulations require all interest payable to related foreign persons to be deducted on a cash basis if it is not effectively connected with a u.s. business of the recipient, whether or not the recipient is subject to u.s. tax on receipt of the income."17 in tate & lyle, the regulations did not directly affect the treaty exemption, but they indirectly impaired its value by deferring the payor-subsidiaries' deductions for the interest beyond the time when it would normally be deductible under the subsidiaries' accrual methods of accounting. the court held that the regulations went beyond the authority granted by the statute. in the court's view, the u.k. parent corporation had not taken the interest into u.s. gross income because of the treaty, which exempted it 113. chrysler corp. v. brown, 441 u.s. 281, 304; american std., inc. v. united states, 602 f.2d 256, 261 (ct. cl. 1979) ("though legislative regulations are law, they are good law only if enacted in accordance with the authority vested in the treasury by the enabling act"). 114. 103 t.c. no. 37 (1994). 115. convention between the government of the united states and the united kingdom of great britain and northern ireland for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, dec. 31, 1975, u.s.-u.k., art. 11, para. 1. 116. regs. § 1.267(a)-3. 117. regs. § 1.267(a)-3(b). 19951 florida tax review from u.s. tax, and not because of the parent's method of accounting. by finding that the regulations went beyond the authority granted by the statute, the court avoided the issue of whether the regulations could override or limit treaty benefits. a similar conclusion-that the regulations go beyond the authority granted in by statute-is warranted in the section 7701(/) context. iv. appropriate date for later-in-time purposes from the foregoing, it appears that u.s. domestic law does not support regulations under section 7701(l) that override treaty commitments. however, for purposes of this section, it is assumed that (1) congress may delegate authority to override a treaty to the treasury and adequately expressed an intention to do so in section 7701() and (2) the treasury intends the regulations to override treaties. even with these assumptions, the regulations will not, under the later-in-time rule, override any treaty made after the regulations are promulgated. it is less clear how the later-in-time rule should apply in case of a conflict between the regulations and a treaty ratified after the enactment of section 7701 (1) but before the promulgation of the final regulations. 8 for example, section 7701(l) was enacted on august 10, 1993, the u.s.-netherlands treaty became effective on january 1, 1994, and the regulations were proposed on october 14, 1994"' and were issued in final form on august 10, 1995.120 which is later in time? section 7701(l) and its accompanying regulations will not override the u.s.-netherlands treaty if the relevant date for later-in-time purposes is the date of enactment of section 7701(1). however, if the relevant date is the date on which the final regulations are promulgated, the regulations are later-in-time and therefore override the u.s.-netherlands treaty. the later-in-time rule is not constitutionally mandated.'12 it arose out of taylor v. morton, 22 one of the first cases to recognize that acts of congress and treaties had equal status under the supremacy clause. in that case, justice curtis, in resolving a conflict between an earlier-ratified treaty and a later-enacted statute, commented almost offhandedly that "the act of 118. see bennett, et al., supra note 58, at 22 n.98. 119. intl-64-93, 59 fed. reg. 52,110 (1994). 120. the regulations were filed on august 10, 1995 and were published in the federal register on aug. 11, 1995. t.d. 8611, 60 fed. reg. 40,997 (1995). the regulations are generally effective for payments made by financed entities after september 10, 1995. regs. § 1.881-3(0. 121. the cherokee tobacco, 78 u.s. 616, 621 (1870) ("the effect of treaties and acts of congress, when in conflict, is not settled by the constitution."). 122. 23 f. cas. 784 (c.c.d. mass. 1855) (no. 13,799). [vol. 2:9 treaty override by administrative regulation congress, because it is the later law, must prescribe the rule by which this case is to be determined... ."'23 taylor v. morton was cited with approval in a series of supreme court cases firmly establishing the later-in-time rule.' 24 every application of the rule focuses on the enactment date of "an act of congress ' 25 or "an act of legislation."'6 no reference is made to the date of enactment of a regulation. the judicially developed later-in-time rule is codified in section 7852(d)(1), as follows: "for purposes of determining the relationship between a provision of a treaty and any law of the united states affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law." the legislative history of this provision states in part: in adopting this rule the committee intends to permanently codify (with respect to tax-related provisions) present law to the effect that canons of construction applied by the courts to the interaction of two statutes enacted at different times apply also in construing the interactions of revenue statutes and treaties enacted and entered into at different times. the committee does not intend this codification to alter the initial presumption of harmony between, for example, earlier treaties and later statutes.'27 the history of another provision perhaps offers some insight into a changed mood in congress. prior to amendment in 1988, section 894(a) provided in part: "income of any kind, to the extent required by any treaty obligation of the united states, shall not be included in gross income and shall be exempt from taxation under this subtitle." this language seems innocuous enough, but congress became concerned that it proclaimed that tax treaties were superior to domestic legislation. as amended in 1988, section 894(a) now reads: "the provisions of this title shall be applied to any taxpayer with due regard to any treaty obligation of the united states which applies to such taxpayer." the change serves as a congressional warning that treaty obligations must give way to later-enacted legislation. 123. id. at 785 (emphasis added). 124. chinese exclusion case, 130 u.s. 581, 602 (1889); whitney v. robertson, 124 u.s. 190, 194-95 (1888); head money cases, 112 u.s. 580, 585 (1884); the cherokee tobacco, 78 u.s. 616, 621 n.9 (1870). 125. chinese exclusion case, 130 u.s. at 602; head money cases. 112 u.s. at 599; the cherokee tobacco, 78 u.s. at 621; taylor v. morton, 23 f. cas. at 785. 126. whitney v. robertson, 124 u.s. at 194. 127. s. rep. no. 445, 100th cong., 2d sess. 321 (1988). reprinted in 1988 u.s.c.c.a.n. 4515, 4833. 19951 florida tax review however, neither section 7852(d)(1) nor section 894(a) answers the question of whether the date of the regulation or the date of the authorizing statute should govern for later-in-time purposes. a. legislative regulations alone are not laws in constitutional sense although the supreme court has never directly addressed this question, it has made clear that a regulation is given the effect of law only because it is authorized by statute. in chrysler corp. v. brown, 2 8 the court stated that a regulation can have the "force and effect of law," but further noted: "the legislative power of the united states is vested in the congress, and the exercise of quasi-legislative authority by governmental departments and agencies must be rooted in a grant of such power by the congress and subject to limitations which that body imposes."'2 9 in manhattan general equipment co. v. commissioner, 30 the court considered whether a treasury regulation could apply to a transaction consummated after the enactment of the authorizing statute but before the regulation was promulgated. the court held that it could, rejecting the contention that this resulted in the regulation being applied retroactively. "the statute defines the rights of the taxpayer and fixes a standard by which such rights are to be measured. the regulation constitutes only a step in the administrative process. it does not, and could not, alter the statute."13' in city of new york v. fcc,32 the supreme court, in the course of deciding whether a federal regulation could preempt a state statute, discussed the role of regulations under the supremacy clause. focusing on the phrase "laws of the united states" in the supremacy clause, the court concluded: "the phrase 'laws of the united states' encompasses both federal statutes themselves and federal regulations that are properly adopted in accordance with statutory authorization."' 133 when congress authorizes an agency to promulgate regulations it is not delegating power to make law; rather, the agency is given power to carry into effect the will of congress as expressed by the statute. 34 if a nexus is not established between the regulation and the congressional delegation, the 128. 441 u.s. 281 (1979). 129. id. at 302. 130. 297 u.s. 129 (1936). 131. id. at 135. 132. 486 u.s. 57 (1988). 133. id. at 63. 134. manhattan general equip. co. v. commissioner, 297 u.s. 129, 134 (1936); see also dixon v. united states, 381 u.s. 68, 74-75 (1965). [vol. 2:9 treaty override by administrative regulation regulation does not have the effect of law.' 35 these principles lead to the conclusion that because it is the enabling statute that is the law, the enabling statute's effective date should be controlling for later-in-time purposes. this conclusion draws additional support from the supreme court's decision in immigration and naturalization service v. chadha6 to invalidate section 244(c)(2) of the immigration and nationality act, which authorized "one house of congress, by resolution, to invalidate the decision of the executive branch ... to allow a particular deportable alien to remain in the united states."' 37 the house of representatives had vetoed the attorney general's decision to allow chadha to remain in the united states after his visa expired. the court held the house's action to be legislative in nature and therefore subject to the presentment clause of the constitution, which states that "every bill which shall have passed the house of representatives and the senate, shall, before it becomes a law, be presented to the president of the united states."' 31 since the one-house veto process did not follow this procedure, the court found it invalid. the court's emphasis on observing the substance and formalities of legislative power lends support to the conclusion that the date of enabling legislation should control for later-in-time purposes. according to the chadha court, "the prescription for legislative action in art. i, §§ 1, 7, represents the framers' decision that the legislative power of the federal government be exercised in accord with a single, finely wrought and exhaustively considered, procedure."' 39 noting the irony that its insistence on the solemnity of legislative acts resulted in upholding an administrative decision of the attorney general in the face of legislative objections, the court explained the constitutional effect of an administrative action. to be sure, some administrative agency action-rulemaking, for example-may resemble "lawmaking." this court has referred to agency activity as being "quasi-legislative" in character. clearly, however, "[in] the framework of our constitution, the president's power to see that the laws are faithfully executed refutes the idea that he is to be a lawmaker." youngstown sheet & tube co. v. sawyer, 343 u.s. 579, 587 (1952). when the attorney general performs his duties 135. chrysler corp. v. brown, 441 u.s. 281, 302 (1979). 136. 462 u.s. 919 (1983). 137. id. at 923. 138. u.s. const. art. i, § 7, cl. 2. 139. immigration and naturalization ser. v. chadha, 462 u.s. at 951. 19951 florida tax review pursuant to § 244, he does not exercise "legislative" power. 1 40 likewise, when the treasury exercises its authority to promulgate regulations, it does not exercise legislative power. it does not pass a "law of the united states" within the meaning of the supremacy clause, and it therefore does not establish a date for resolving conflicts arising out of the supremacy clause under the later-in-time rule. the later-in-time rule is intended to resolve a conflict between two acts of the sovereign-a treaty and congressional authorization to override that treaty. the rule is rooted in the common sense notion that the last act of the sovereign is likely to represent its present intentions. suppose that the united states through an act of congress enacts a provision which purports to override treaty commitments and subsequently makes a treaty providing that it is to apply notwithstanding the earlier legislation. this later act of the sovereign must prevail because it occurred with full knowledge of the earlier act. this should be so even if subsequent to the effective date of the treaty, the treasury promulgates regulations carrying out the earlier legislation. in sum, if congress wants to override the u.s.-netherlands treaty, it can do so only by the enactment of a post-treaty law clearly stating that intent. b. statutes cannot override prospectively an additional issue that needs to be explored is whether congress can pass a statute that overrides subsequent treaties. 4 ' more specifically, can congress delegate to the treasury power to promulgate regulations that will override future treaties? if congress has this power, section 7701(1) may provide statutory authority to override the u.s.-netherlands treaty. by the later-in-time rule, the supreme court has construed the supremacy clause to empower congress to override prior treaties by passing a statute in direct conflict with them, but there is no suggestion in the 140. id. at 953 n.16 (some citations omitted). 141. congress purported to do this in the tax reform act of 1986, pub. l. no. 99514, § 1810(a)(4), 100 stat. 2085, 2822-23, which provides: section 904(g) of the internal revenue code of 1954 shall apply notwithstanding any treaty obligation of the united states to the contrary (whether entered into on, before, or after the date of the enactment of this act) unless (in the case of a treaty entered into after the date of the enactment of this act) such treaty by specific reference to such section 904(g) clearly expresses the intent to override the provisions of such section. [vol 2:9 treaty override by administrative regulation supremacy clause that a prospective override would be effective. conversely, nothing in the supremacy clause recognizes the ability of treaty partners to agree that a treaty will apply notwithstanding future acts of congress. in either case, serious constitutional issues arise. in addition to ignoring the later-in-time rule, a statute that purports to override subsequent treaties raises a constitutional question as to whether the treaty process has been violated. 2 the constitution provides that the president "shall have power, by and with the advice and consent of the senate, to make treaties, provided two thirds of the senators present concur."'4 if valid, a statute purporting to override later treaties limits the president's treaty making powers, and the house of representatives is included in the process by being a part of the enactment of the statute. ' conversely, a treaty purporting to deprive congress of the right to enact future legislation overriding the treaty would arguably usurp the house of representatives' role in legislation. 4' statutes are interpreted, to the extent possible, to avoid troubling constitutional issues. for example, in national labor relations board v. catholic bishop of chicago,"4 the nlrb received petitions seeking union representation for lay teachers at catholic schools that offered traditional secular education, similar to that in public secondary schools, in addition to religious instruction. the nlrb accepted jurisdiction over the petitions and ordered elections because the schools were not completely religious.4 7 the schools refused to recognize the unions, arguing that the nlrb had no jurisdiction over religious schools. the supreme court, in rejecting nlrb jurisdiction, analyzed the legislative history of the national labor relations act of 1935 to determine whether congress intended the nlrb to have jurisdiction over religious schools. it made this analysis because a construction of the act that allowed nlrb jurisdiction over these schools would force the court to determine 142. committee on u.s. activities of foreign taxpayers and foreign activities of u.s. taxpayers of the new york state bar ass'n sec. tax'n, legislative overrides of tax treaties, 37 tax notes 931, 933-34 (nov. 30, 1987) [hereinafter committee on u.s. activities of foreign taxpayers]. 143. u.s. const. art. h, § 2, cl. 2. 144. committee on u.s. activities of foreign taxpayers, supra note 142, at 933-34. also, such a statute can make treaty negotiations more difficult by inhibiting the negotiators' freedom. id. 145. u.s. const. art i, § 1. 146. 440 u.s. 490, 500 (1979). 147. the nlrb's "policy was to decline jurisdiction over religiously sponsored organizations 'only when they are completely religious, not just religiously associated.'" nlrb v. catholic bishop of chicago, 440 u.s. at 493 (quoting roman catholic archdiocese of baltimore, 216 nlrb 249, 250 (1979)). 19951 florida tax review whether this jurisdiction violates the religion clauses of the first amendment.' because the court could not find congress' clear intent to grant jurisdiction to the nlrb over church-operated schools, the court interpreted the act in a way that avoided the constitutional issue.'49 similarly, in murray v. schooner charming betsy,"5° chief justice marshall stated that "an act of congress [is] never to be construed to violate the law of nations if any other possible construction remains...." thus, a statute that arguably has the effect of overriding subsequent treaties should be interpreted in a way that does not raise the constitutional issues mentioned above. with respect to section 7701(/), it is possible to interpret the statute in a way that does not violate the treaty process. because congress has not expressed a clear intent to override subsequent treaties, the statute might be read to override treaties already in existence when section 7701() was enacted but not any subsequent treaties.' 5' v. conclusion whenever congress overrides a treaty, it violates international law-an act that should not be undertaken lightly. in the absence of a direct conflict, every effort should be made to interpret the act of congress and the treaty in a nonconflicting manner. congress can override a treaty only by signaling its intent clearly. if it chooses to delegate the actual operation of the override to the treasury by regulations, the delegation must be clear and must include some guidance on the exercise of the delegated authority. finally, if congress has explicitly delegated the authority to override and has provided the constitutionally required guidance, then, once the treasury has carried out its authority, all treaties whose effective dates precede the legislative act must give way to that act. by the same token, all treaties made after the legislative act must prevail over the legislation to the extent of any conflict. as applied to section 7701() and the subsequent u.s.-netherlands treaty, these principles yield the following results: section 7701() does not on its face or in its legislative history explicitly state an intent to override any treaty. the provision can have a wide range of application even if it does not override conflicting treaty provisions. notwithstanding the absence of legislative intent to override, the regulations under section 7701() appear to 148. the first amendment provides that "congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof..... u.s. const. amend. i. 149. nlrb v. catholic bishop of chicago, 440 u.s. at 507. 150. 6 u.s. (2 cranch) 64,118 (1804). 151. however, as noted in part ili.b, an intent to override preexisting treaties is neither explicit nor implicit in § 7701(/). [vol 2:9 treaty override by administrative regulation apply in an overriding manner, although the treasury denies that this is the intent or effect. the regulations deny treaty benefits (e.g., exemption of interest payments from u.s. withholding tax) that would otherwise be available. this denial occurs even where the treaty partners confronted the problem addressed by the regulations and responded with a lengthy and detailed limitation on benefits provision. finally, even if the requisite intent to override were present in the legislation and carried out by treasury pursuant to articulated standards, any conflict between the treaty and section 7701([) must be resolved by comparing the date of the treaty with the date of enactment of the statute. accordingly, a post-statute treaty, such as the important treaty between the united states and the netherlands, must preval even though the overriding regulations were promulgated after the treaty was made. the constitutional authority for congress to override international agreements is not easily understood or embraced by other countries. while the supreme court has recognized this authority on numerous occasions, it has tempered the authority with the admonishment that it will recognize legislation as overriding preexisting treaties only if congress clearly expresses an intent to override and the domestic legislation presents an insurmountable conflict with the treaties. section 7701(1) does not clearly express an intent to authorize treaty-overriding regulations and conflict with preexisting treaties is not insurmountable. as a policy matter, congress rather than its delegatee should be the one to violate international law when that is necessary, and any such violation should be clear and explicit. 19951 florida tax review volume 1 december 1992 number 3 tufts and the evolution of debt-discharge theory deborah a. geier** i. introduction ii. the historical development of the dichotomy a. the tufts decision 1. the tufts facts atnd the nvo tufts issues. 2. the court's resolution of the first issue. 3. the court's deference to the collapsed approach with respect to the second issue. b. the tufts briefs c. the regulations mi. does the dichotomy make sense? a. the "functional-relation" argument in tufts b. footnote 11 of tufts 1. the outinoded theo'. 2. the outmoded case. c. real-world consequences of the dichotomy d. asserted justifications for the dichotomy iv. personal-use property: providing the answer v. conclusion * copyright 1992 deborah a. geier. ** assistant professor of law, cleveland-marshall college of law, cleveland state university. j.d., 1986, case western reserve school of law: a.b.. 1983. baldwin-wallace college. i am grateful for the helpful comments of marjorie komhauser on an earlier draft of this article as well as for her moral support throughout my young academic career. tulane's gain is most surely cleveland-marshall's loss. i would also like to thank charlotte crane. a member of the editorial board of the florida tax review, for her helpful comments on the submitted draft. florida tax review i. introduction consider poor debtor, who purchased a personal residence for $130,000 several years ago with a hefty mortgage and today, like many others caught between the scylla of the economic recession and the charybdis of collapsing real estate values,' finds himself losing his home. perhaps he loses his home because he can no longer continue to meet the mortgage payments. perhaps he simply stops making mortgage payments because he appreciates the economic reality that it would not be wise to continue to make payments on the $122,000 remaining mortgage when the fair market value of the home has plunged to $100,000. this approach would be particularly appealing if debtor knew that the creditor would not, or could not, enforce any deficiency against debtor's other assets. what are the tax consequences upon transfer of the home to the mortgagee infull satisfaction of the debt? upon researching the law, debtor's tax advisor learns that, because the debt discharged ($122,000) exceeds the fair market value of the property transferred in satisfaction of the debt ($100,000), the tax consequences will vary dramatically depending on whether the debt is styled "recourse" or "nonrecourse." these are the facts of a 1991 technical advice memorandum, 2 which memorandum demonstrates most clearly both the irrationality and the growing acceptance as settled doctrine of the irreconcilable conceptual approaches taken by the government (including both the internal revenue service in rulings and cases and the treasury department in regulations) regarding the discharge or cancellation3 of recourse and nonrecourse debt in the course of a transfer of property. if the debt is "recourse, 4 the government bifurcates the transaction (the "bifurcated approach"): the property disposition is analyzed under section 1001 of the code, and the discharge of indebtedness is analyzed under sections 61(a)(12) and 108. under this approach, the asset is considered sold for its fair market value (resulting in the realization of gain or loss on i. i did not originally think the reference to scylla and charybdis called for a footnote, but upon recently reading another reference to these unfortunate creatures accompanied by an explanatory footnote, i decided to cite that helpful footnote for any reader in need of clarification. see kenneth lasson, feminism awry: excesses in the pursuit of rights and trifles, 42 j. legal educ. 1, 23 n.94 (1992). 2. i.r.s. t.a.m. 9130005 (march 29, 1991); see infra notes 174-98 and accompanying text. 3. a debt is cancelled or discharged, rather than satisfied, when it is not repaid in full, as when property transferred in payment of the debt has a value less than the outstanding indebtedness. 4. by "recourse debt" i generally mean a debt for which the debtor is personally liable for the amount of the debt. [vol 1:3 tufts and the evolution of debt-discharge theory the property disposition under section 1001), and the sale proceeds are then considered used to settle the outstanding indebtedness (resulting in the realization of income from the discharge of indebtedness under section 61(a)(12)). the authority cited for the bifurcated approach is a regulation which provides: "the amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under section 61(a)(12)." the accompanying example states: in 1980, f transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which f is personally liable. the amount realized on the disposition of the asset is its fair market value ($6,000). in addition, f has income from the discharge of indebtedness of $1,500 ($7,500-$6,000).6 thus, with a recourse mortgage our debtor would realize a $30,000 nondeductible personal loss on the property disposition" and $22,000 of ordinary income resulting from the discharge of indebtedness.' 5. regs. § 1.1001-2(a)(2). 6. regs. § 1.1001-2(c), ex. 8. if property is sold in foreclosure for less than the full amount of an outstanding recourse liability and the creditor does not abandon its rights to collect the deficiency, the debtor's amount realized for purposes of calculating gain or loss under section 1001(a) equals the proceeds received in the sale. if the creditor eventually abandons its claims regarding the deficiency, the debtor will be charged with cancellation-ofindebtedness income ("cod income") at that time. if the debtor pays the deficiency in full, cod income is avoided. see aizawa v. commissioner, 99 t.c. no. 10 at 48.401 (cch), 9,910 (p-h) (aug. 6, 1992). this separation of the tax consequences of the sale from the tax consequences of the debt is consistent with the bifurcated approach. 7. the difference between the fair market value of the residence (s100,000) and the taxpayer's cost basis ($130,000) produces a $30,000 realized capital loss under sections 1001 and 1221. because the loss arises on the disposition of a personal-use asset, the loss is nondeductible. irc § 165(a) and (c). 8. the difference between the fair market value of the asset transferred in payment of the debt ($100,000) and the amount of the debt discharged on the transfer ($122,000) produces $22,000 of ordinary income under section 61(a)(12) which must be recognized immediately unless, in general, the debtor has filed bankruptcy under title ii of the united states code or is insolvent. see irc § 108(a)(1). in the event of either bankruptcy or insolvency, the debtor pays the tax due on the cod income more slowly over time (presumably when the taxpayer is in a better financial condition) through reduction of favorable tax attributes or of basis of depreciable property owned by the debtor. see irc §§ 108(b), 1017. of course, deferral by itself results in partial forgiveness because of the time value of money. see charlotte crane, more theory about debt discharge income. 8 am. j. tax pol'y 107, 109-11 (1989) (describing the value of tax deferral on the reduction of property basis in lieu of immediate recognition of cod income). the only instance in which the exclusion provided in section 108(a) was intended by congress to result in complete 19921 florida tax review forgiveness is that rare one in which the taxpayer has none of the tax attributes listed and owns no property the basis of which could be reduced. the general intent of the statute is not to forgive the tax but rather merely to defer it. see s. rep. no. 1035, 96th cong., 2d sess. 10 (1980) (law was intended "to carry out the congressional intent of deferring, but eventually collecting within a reasonable period, tax on ordinary income realized from debt discharge"). the insolvency exclusion provided in section 108(a) differs dramatically from the common-law insolvency exclusion that it replaced which was developed by the courts prior to adoption of current section 108 as part of the bankruptcy tax act of 1980, pub. l. no. 96-589, 94 stat. 3389 (1980). the common-law insolvency exclusion was a complete forgiveness provision which rested on the cryptic rationale given by justice holmes in united states v. kirby lumber co., 284 u.s. 1 (1931), the case that established the general rule that the discharge of indebtedness produces gross income. justice holmes reasoned that when the taxpayer bought its bonds on the market for nearly $138,000 less than their face amount, "it made available $137,521.30 assets previously offset by the obligation of bonds now extinct." id. at 3. later courts reasoned that if no assets were freed from liabilities as a result of the discharge, as in the case of an insolvent taxpayer who is not made solvent by the discharge, then no income is even realized. by 1980, the freeing-up-of-assets rationale had gone by the wayside; most commentators argued that the rationale underlying the general rule that income is realized on the forgiveness of debt is simple symmetry. see infra notes 81-117 and accompanying text (discussing current rationale in more detail). because the loan amount is excluded on receipt on the theory that there is no "accession[] to wealth" over which the taxpayer has "complete dominion," commissioner v. glenshaw glass co., 348 u.s. 426, 431 (1955), in light of the obligation to repay with after-tax dollars, an extinguishment of that obligation to repay takes away the authority for the initial exclusion. under that theory, solvency becomes irrelevant; cod income is realized even by insolvent debtors. (and rightly so. after all, wages earned by a taxpayer with a negative net worth are not exempt from tax merely because the debtor is insolvent and is not made solvent by the increase in assets.) see boris i. bittker & lawrence lokken, federal taxation of income, estates and gifts, 6.4.1, at 6-31 to 6-32 (2d ed. 1989). recognizing the financial straits of bankrupt and insolvent debtors who realize cod income, however, congress permitted those debtors to defer recognition of that realized income to some point in the future through the mechanism contained in section 108(b). see generally estate of newman v. commissioner, 934 f.2d 426, 430-32 (2d cir. 1991) (containing an excellent, succinct history of the developing theory of the insolvency exclusion). the only instance in which no cod income is considered as even being realized (and thus by definition will never be recognized in the future through the mechanism in section 108(b)) arises when a solvent debtor outside bankruptcy negotiates a debt reduction with the seller of property who also financed the purchase of the property with the cancelled debt. because the seller wears two hats-seller of property and lender of dollars to finance the purchase-until 1980 numerous factual controversies arose in the case of a reduction of a purchase-money mortgage. the surrounding facts had to be examined carefully to determine whether the seller-creditor had his seller's hat on (in which case the reduced debt reflected a renegotiated purchase price) or his creditor's hat on (in which case the reduced debt reflected cancelled debt). the former resulted in no income but a lowered cost basis, while the latter resulted in no alteration in the purchased property's basis but also resulted in the realization of cod income. after 1980, even when the surrounding facts clearly indicate an intention by the seller-creditor to cancel debt rather than renegotiate the purchase price, the debt reduction is "treated as a purchase price adjustment" by fiat under section 108(e)(5). in essence, the now-repealed option to reduce basis instead of recognizing cod income (see infra notes 38-40 [vol 1:3 tufts and the evolution of debt-discharge theorn if the debt is "nonrecourse,"9 the government collapses the two component parts into the property disposition under section 1001 by including the entire debt in the amount realized (the "collapsed approach"). no cancellation-of-indebtedness income ("cod income") is deemed realized. this approach was approved by the supreme court in commissioner v. tufts,'0 discussed more fully below, and can now be found in the following subsections of the same treasury regulation containing the rule for recourse debt discussed above. except as provided in paragraph (a)(2) [pertaining to recourse debt]..., the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition." the fair market value of the security at the time of sale or disposition is not relevant for purposes of determining under paragraph (a) of this section the amount of liabilities from which the taxpayer is discharged or treated as discharged. thus, the fact that the fair market value of the property is less than the amount of the liabilities it secures does not prevent the full amount of those liabilities from and accompanying text) remains in this very narrowly defined context but is mandatory. the provision applies whether the debt involved is recourse or nonrecourse and whether the property is used in a trade or business, is investment property, or is personal-use property. because section 108(e)(5) by definition applies only to amounts that would otherwise be cod income, facts that indicate a post-purchase renegotiation of purchase price of debt-financed items, instead of debt reduction, ought still to be treated as resulting in a nontaxable price reduction and not cod income even if the item purchased with the debt constitutes services instead of "property" within the meaning of section i08e)(5). cf. infra note 217 (discussing the zarin case). for an exhaustive article examining all the tax permutations of discharge-ofindebtedness doctrine, see fred t. witt, jr. & william h. lyons, an examination of the tax consequences of discharge of indebtedness, 10 va. tax rev. 1 (1990). 9. "although the term 'nonrecourse' is used in a number of provisions, it is nowhere defined in the code. similarly, the regulations do not provide a general definition of what constitutes nonrecourse indebtedness." frederick h. robinson. nonrecourse indebtedness, ii va. tax rev. 1, 3 (1991). by "nonrecourse debt," i generally mean a debt for which the debtor is not personally liable. the lender is barred from action against the borrower's other assets if the security value is insufficient to satisfy the loan. for a helpful description of the origins and use of nonrecourse debt for both nontax and tax reasons, see daniel n. shaviro, risk and accrual: the tax treatment of nonrecourse debt. 44 tax l rev. 401. 421-27 (1989). 10. 461 u.s. 300 (1983). 11. regs. § 1.1001-2(a)(l) (emphasis added). 19921 florida tax review being treated as money received from the sale or other disposition of the property. however, see paragraph (a)(2) of this section for a rule relating to certain income from discharge of indebtedness.1 2 thus, our debtor would be considered to be disposing of his property for $122,000 under this approach, producing an $8,000 nondeductible personal loss. 13 no cod income would be considered realized. 14 does the dichotomy in treatment of recourse and nonrecourse debt make conceptual sense? if not, how did it come about and why does it remain? what are the practical consequences of the dichotomy? these are the questions with which this article deals. and while the questions seem to be fairly narrow in scope, their resolutions require a broad consideration of fundamental principles of income taxation, including the treatment of gains and losses attributable to personal-use property. part ii of this article delves into the historical development of the dichotomy, exploring the decision and briefs in tufts and the promulgation of the regulations formalizing the tufts approach for nonrecourse debt and containing the bifurcated rule for recourse debt. a thoughtful parsing of both the tufts decision and the supporting briefs reveals that the court was not likely aware that the bifurcated approach controlled in the case of recourse debt and was not likely aware that it was cementing different approaches in the tufts situation depending on whether the debt involved in the transaction is recourse or nonrecourse. part iii examines whether the dichotomy makes sense in light of both the historical development and the more recent development of doctrine in this area and its effects in the tax world. even if the collapsed approach for nonrecourse debt were defensible at the time tufts was considered, its continued defensibility at this point in the evolution of debt-discharge theory is questionable. nonrecourse indebtedness, once considered an inseparable part of the ownership interest in the securing property, has been increasingly recognized as a separate tax attribute requiring independent tax analysis in 12. regs. § 1.1001-2(b) (emphasis added). 13. the difference between the debtor's $130,000 cost basis and the $122,000 amount realized produces the $8,000 realized capital loss under sections 1001(a) and 1221, which loss is a nondeductible personal loss under section 165(a) and (c). 14. in the more distant past, neither the government nor the courts consistently applied the bifurcated approach in the case of recourse debt, oftentimes applying the collapsed approach instead. see alice cunningham, payment of debt with property-the two-step analysis after commissioner v. tufts, 38 tax law. 575, 599-605 (1985) [hereinafter cunningham i]. however, the bifurcated approach has clearly controlled in recent years in the case of recourse debt. see infra note 72 and accompanying text (discussing a recent case and ruling consciously affirming the bifurcated approach for recourse debt). [vol 1:3 tufts and the evolution of debt-discharge theory contexts prior to a transfer of the securing property. the theory underlying the collapsed approach, that nonrecourse indebtedness is considered too intimately tied to the property ownership to be analyzed as a separate tax attribute on disposition of the property itself, is fast becoming a conceptual relic in this evolution. moreover, the perceptiveness of tax professionals who appreciate the radical difference in tax consequences on disposition of the securing property depending on whether the debt is recourse or nonrecourse, as well as the radical difference in tax consequences on the discharge of nonrecourse debt itself depending on whether the securing property is retained or transferred, has resulted in the structuring of transactions that exploit these discontinuities. of course, that in itself is not troublesome if the differing treatments are warranted for sound conceptual reasons, but an examination of the reasons fashioned for the collapsed approach finds them wanting. because all good things come to those who wait, the heart of the critique of the collapsed approach is reserved for part iv. part iv considers the indefensible effects of the collapsed approach on the disposition of personal-use property and the lessons learned in that context. the collapsed approach allows, in effect, a backdoor deduction of what is considered taxable personal consumption in that context. examining the consequences of the collapsed approach in those circumstances (circumstances which may be rare in the real world) demonstrates the fatal flaw of the collapsed approach in all contexts: it links the accession to wealth that arises on failure to repay loan proceeds to the ownership interest in the securing property when the accession to wealth should be attributed solely to the liability relief. the article ultimately suggests the adoption of the bifurcated approach for both nonrecourse and recourse debt when debt is discharged upon the transfer of property worth less than the outstanding debt. ii. the historical development of the dichotomy a. the tufts decision 1. the tufts facts and the two tufts issues.-in the simplified facts of commissioner v. tufts,' 5 tufts transferred property with a fair market value of $1,400,000 to a buyer who agreed to reimburse sale expenses and to take the property subject to the nonrecourse mortgage. tufts had financed 15. 461 u.s. 300 (1983). the taxpayer incurring the nonrecourse debt was actually a partnership in which tufts was a partner. the property disposed of was actually each partner's interest in the partnership. these subtleties, however, did not affect the outcome of the case, and the holding applies to all dispositions of property subject to nonrecourse debt, whether or not within the context of a partnership. 19921 florida tax review the property's construction entirely with a $1,850,000 nonrecourse mortgage, and thus the property's initial basis was $1,850,000 under the rule in crane v. commissioner.'6 because of $400,000 of depreciation deductions taken while tufts owned the property, its adjusted basis was $1,450,000 at the time of the sale. 7 tufts had not made any principal payments on the $1,850,000 loan before selling the property. tufts claimed a $50,000 loss on the disposition under section 1001, implicitly accepting that the transaction was governed entirely by section 1001 but arguing that the amount realized under that section was equal to the amount of debt of which he was relieved but limited to the fair market value of the property transferred. tufts lost in the tax court' 8 but won a reversal in the fifth circuit court of appeals. 9 the supreme court granted the government's petition for certiorari. justice blackmun's opinion for the court began: over 35 years ago, in crane v. commissioner, 331 u.s. 1 (1947), this court ruled that a taxpayer, who sold property encumbered by a nonrecourse mortgage (the amount of the mortgage being less than the property's value), must include the unpaid balance of the mortgage in the computation of the amount the taxpayer realized on the sale. the case 16. 331 u.s. 1 (1947). under crane, the amount of purchase debt is included in cost basis, whether the debt is recourse or nonrecourse. on the death of her husband, mrs. crane received an apartment building subject to nonrecourse debt of $225,000 plus $7,000 in overdue interest. for estate tax purposes, the land and building were valued at $262,000-precisely the amount of the principal and overdue interest-so her equity in the land and building was zero. she took depreciation deductions totalling $25,500 over her seven years of ownership. she collected rent and paid expenses and taxes, but the remaining net cash flow was not sufficient to service the debt. at the end of seven years, the $225,000 principal remained and the interest arrearage actually increased. the mortgagee threatened foreclosure, so mrs. crane sold the property for $3,000 in cash (less $500 in selling expenses). the mortgagee also took the property subject to the nonrecourse mortgage. she reported $2,500 gain, arguing that the amount realized was $2,500 and her adjusted basis was zero because "property" within the meaning of the predecessor of section 1014 (pertaining to the basis of property acquired from a decedent) referred to "equity" in the land and the building, not the land and building themselves. the supreme court held that "property" referred to the land and building themselves, not merely her equity, and thus her original unadjusted basis on receipt of the land and building was not zero but rather $262,000. id. at 11. once the court determined that her basis included the nonrecourse debt, it concluded that the amount realized on sale similarly included the debt. id at 13, while crane itself dealt only with the basis of property acquired from a decedent, its holding that acquisition debt is included in basis was immediately extended to cost basis as well. 17. basis is reduced by allowable depreciation deductions under section 1016(a)(2). 18. tufts v. commissioner, 70 t.c. 756 (1978). 19. tufts v. commissioner, 651 f.2d 1058 (5th cir. 1981). [vol 1-:3 tufts and the evolution of debt-discharge theor" now before us presents the question whether the same rule applies when the unpaid amount of the nonrecourse mortgage exceeds the fair market value of the property sold.' thus, from its first sentence, the court did not identify and treat as separate issues what were really two independent questions that needed to be resolved in order to determine the tax consequences to tufts on the disposition.2' the first issue was whether relief from nonrecourse debt in excess of the fair market value of the property transferred could properly be considered an accession to wealth. that was the question with which the government was most concerned and the question on which it spent all of its efforts. if the answer to the first question were in the affirmative, as the government argued and as the court held, then the second question concerned an issue not presented by the facts of crane-the proper conceptual approach to that debt relief. with respect to this issue, the government argued, more implicitly than explicitly, that the transaction should not be bifurcated into its component parts-discharge of debt and property disposition-but rather that the collapsed approach, under which debt relief is collapsed into the analysis of the property disposition under section 1001, was proper. the debt cancellation simply becomes part of the amount realized in that computation. this second issue never arose in crane because no debt was cancelled as part of the transaction; mrs. crane satisfied the debt in full. the inclusion of the nonrecourse debt in amount realized was the only means available to take account of the accession to wealth simply because the value of the property was deemed to equal or exceed the amount of the debt encumbering the property. thus, there was no possible competition between section 61(a)(12) and section 1001. with the guidance given it, the court failed to appreciate this distinction between crane and tufts and thus failed to give adequate attention to the second issue presented by tufts which was not an issue in crane. the court indicated that tufts was really no different in character from crane: "in crane i. commissioner, ... this court took the first and controlling step toward the resolution of this issue."' 2. the court's resolution of the first issue.-the court dedicated almost the entirety of its majority opinion to the first issue, concluding correctly that the relief from the entire indebtedness, including that portion of nonrecourse indebtedness exceeding the fair market value of the property 20. tufts, 461 u.s. at 301-02. 21. for the tax consequences to the buyer, see erik m. jensen. the unanswered question in tufts: what was the purchaser's basis?, 10 va. tax rev. 455 (1991) [hereinafter jensen i.]. 22. tufts, 461 u.s. at 304. 19921 florida tax review transferred, produced an accession to wealth. to do so, the court had to abandon the intimation made earlier in crane that the rationale for this conclusion was due to the "economic benefit" realized by the taxpayer on being relieved of the debt. under the economic-benefit rationale, the crane court argued that a mortgagor receives an economic benefit when he transfers property subject to a mortgage, even if the mortgage is nonrecourse to the taxpayer, because he will treat the loan as if he were personally liable in order to protect the equity he has in the property. 3 tufts picked up on the crane court's intimation in footnote 37 of the case that if the securing property is worth less than the mortgage debt, the taxpayer who is not personally liable on the debt has no economic reason to satisfy the debt in full and thus receives no economic benefit when another assumes that obligation.24 in ruling against tufts, justice blackmun stated: crane ultimately does not rest on its limited theory of economic benefit; instead, we read crane to have approved the commissioner's decision to treat a nonrecourse mortgage in this context as a true loan. this approval underlies crane's holdings that the amount of the nonrecourse liability is to be included in calculating both the basis and the amount realized on disposition. that the amount of the loan exceeds the fair market value of the property thus becomes irrelevant.2 justice blackmun's "true loan" rationale reflects the fact that the taxpayer did not include in income any of the nonrecourse loan proceeds on receipt on the 23. see crane v. commissioner, 331 u.s. 1, 13-14 (1947). 24. footnote 37 in crane stated: obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot. that is not this case. id. at 14 n.37. 25. tufts, 461 u.s. at 307 (emphasis added). the language here regarding the appropriateness of including the entire debt relief in amount realized illustrates the failure of the court to tease out what are really two separate issues. the fact that the full amount of the loan can properly be taken into consideration in determining the tax consequences does not determine whether those consequences should arise solely under section 1001 or whether the consequences of the debt relief should be analyzed under the provisions governing cod income. [vol 1:3 tufts and the evohtion of debt-discharge theory theory that there was no "accession to wealth"' 6 because of the obligation to repay with after-tax dollars. indeed, the taxpayer's inclusion of the full amount of debt in basis (upon which depreciation is calculated) evidenced the taxpayer's acknowledgment that these loan proceeds were received and excluded on that theory. when the obligation to repay disappeared so did the justification for the original exclusion from income. this rationale is the same used by modem commentators to justify the inclusion in gross income of cod income.27 3. the court's deference to the collapsed approach with respect to the second issue.-the conclusion that relief from nonrecourse indebtedness in excess of the fair market value of the property transferred in the transaction constitutes an accession to wealth for which the tax law can account fails to answer the question regarding how the tax law should account for such relief. as noted above, the majority opinion gave short shrift to this issue, simply stating that the collapsed approach adopted by the commissioner was not unreasonable. 28 the court indicated in a footnote that the bifurcated approach described in an amicus brief ' "indeed could be a justifiable mode of analysis" '30 but that the proper role of the court was not to decide which method was best. rather, its job was to decide only whether the method chosen by the commissioner was a reasonable one. because the government, as developed more fully below, neither fully alerted the court that the bifurcated method was used for recourse debt nor, consequently, defended using different approaches for different types of debt, the court's conclusion that the collapsed approach was "reasonable" was itself unsurprising. thus, the court affirmed that tufts's disposition generated $400,000 of gain under section 1001: the difference between tufts's $1,450,000 basis and the $1,850,000 debt of which he was relieved. justice o'connor, in her concurring opinion, agreed with the majority regarding the proper role of the court but went on record as strongly endorsing the bifurcated approach, advocated in an amicus brief submitted by 26. commissioner v. glenshaw glass co., 348 u.s. 426, 431 (19551 (defining income as "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion"). 27. see supra note 8 and infra notes 81-117 and accompanying text (describing current debt-discharge theory). 28. see tufts, 461 u.s. at 310. indeed, had it not been for professor barnett's amicus brief (see infra notes 31-35 and accompanying text), the court would probably not have been aware of the possibility of using the bifurcated approach. 29. see infra notes 31-35 and accompanying text (discussing the amicus brief). 30. tufts, 461 u.s. at 310 n.l 1 (indicating that the court might also affirm that approach if the commissioner changed his position). 19921 florida tax review professor wayne g. barnett of her alma mater,3' as the more conceptually correct approach.32 the bifurcated approach described is in its essentials the bifurcated approach actually adopted in the regulations for recourse debt when property worth less than the debt is transferred in complete discharge of the debt.33 under that approach,34 tufts's asset would be considered sold 31. brief for amicus curiae, commissioner v. tufts, 461 u.s. 300 (1983) (no. 811536). professor barnett was professor of law at stanford law school from 1966-1986. he has been professor emeritus at stanford since 1986. see ass'n of am. law schools, the aals directory of law teachers 1991-1992, at 163 [hereinafter the directory]. stanford was justice o'connor's alma mater. because justice o'connor graduated from stanford in 1952, however, she could not have been professor bamett's student. 32. tufts, 461 u.s. at 317 (o'connor, j., concurring). 33. professor barnett's approach is actually a bit broader than the bifurcated approach taken in the regulations for recourse debt. barnett's bifurcated approach, under which the tax consequences of the liability are analyzed separately from the tax consequences of the property transfer, would apply in all cases, even in cases unlike tufts in which the fair market value of the property transferred exceeds the extinguished liability. the bifurcated approach for recourse debt described in the regulations, in contrast, applies only in those cases in which the fair market value of the property transferred is less than the extinguished debt, for only in those cases is there a tension between cod income under section 61(a)(12) and gain under section 1001. professor cunningham describes the broader approach with the following example. assume, for example, that the unpaid balance of the debt is $100 and that the property transferred in payment of the debt has a fair market value and an adjusted basis of $110. under the tufts analysis, the transaction would produce asset loss of $10 (the $110 adjusted basis of the transferred property less the $100 amount realized from the discharged debt). that loss would be taxable under the gain-from-sale rules and thus might be subject to the capital loss limitations. similarly, the two-step analysis also would produce a net loss of $10: (1) a liability loss of $10 (the $100 debt discharged less the $110 paid therefor) and (2) an asset gain of 0 (the $110 value of the transferred property less the $110 adjusted basis of such property). however, the $10 liability loss would be taxable under the debtrelief rules and hence would be deductible in full against ordinary income as a premium paid in discharge of the debt. cunningham i, supra note 14, at 585-86 (footnote omitted). she notes that this scenario might occur when foreign-currency-denominated debt is repaid with foreign currency that has appreciated against the dollar. at the time she wrote the article, the code was silent regarding the proper taxation of such transactions. the tax reform act of 1986 enacted section 988 of the code, entitled "treatment of certain foreign currency transactions," which essentially accomplishes the result she describes in her example. outside of foreign-currency transactions (now addressed by statute), the facts of professor cunningham's example (a transfer of property with a fair market value exceeding the debt settled on the transfer) would not seem to be very common. most taxpayers would, it seems, sell the property first, settle the debt in cash, and keep the excess cash. the tension that exists between the creation of cod income under section 61(a)(12) and the creation of gain under section 1001 because the discharged debt exceeds the fair market value of the property transferred is the more significant one in the real world. while adoption of the [vol 1:3 tufts and the evolution of debt-discharge theory for its $1,400,000 fair market value. that sale would produce a loss of $50,000 under section 1001 for tufts. the sale proceeds would then be considered used to extinguish tufts's liability with respect to the indebtedness. because a $1,850,000 debt would be considered extinguished for $1,400,000, tufts would realize $450,000 of cod income. while the net amount of income happens to be the same on these particular facts under the bifurcated approach as under the collapsed approach-$400,000 net positive amount-the character of the income may well be different, and that was the point stressed by professor barnett. -5 cod income is ordinary and potentially deferrable under section 108 while gain from the sale of an asset is most likely capital, at least in part,3' and not deferrable. in view of the limitation on the deductibility of capital losses' and the historical preference given net capital gain at that time, why did the service argue for $400,000 gain instead of $450,000 ordinary income coupled with a $50,000 capital loss? would not the latter bring in more dollars to the bifurcated approach in all transfer cases (i.e., even to recourse debt cases to which it does not apply now, cases in which the fair market value of the property transferred is greater than the discharged debt), would be the more conceptually pure approach. the extension of the bifurcated approach to nonrecourse debt in the single context in which it now applies to recourse debt (i.e., when the fair market value of the property transferred is less than the discharged debt) would alleviate the vast majority of incongruous results arising under current law. thus, this article makes that more modest proposal. if the proposal advocated in this article is adopted, a transfer of property with an adjusted basis and value of si 10 in satisfaction of a $100 debt would continue to produce a $10 loss under section 1001, whether the debt is recourse or nonrecourse. 34. see supra notes 4-8 and accompanying text (describing the bifurcated approach). 35. in his brief professor barnett stated: [c]ontrary to the parties' assumptions, the resolution of the "amount realized" question the government presents will in fact have no effect whatever on the total amount of the gain that ... [tuftsl must be held to have realized. all that it will determine, to the contrary, is the character of the gain: how much is to be treated as an asset gain (and hence as a capital gain) and how much as a liability gain (and hence as ordinary income potentially deferrable under § 108). brief for amicus curiae, supra note 31. at 14; see cunningham i. supra note 14, at 585 ("in actuality, the difference between the one-step and the two-step analyses lies not in the amount of income or loss, but in its character."). see infra notes 191-98 and accompanying text (arguing that the more significant difference between the two methods is the intolerable inconsistency in the amount of income taken into account when personal-use property is transferred in satisfaction of the debt). 36. this conclusion assumes that the asset is either a capital asset or a section 1231 asset. some or all of tufts's gain under the majority's analysis would have constituted ordinary income in any event under the depreciation recapture provisions. see irc §§ 1245. 1250. 37. see irc §§ 1211, 1212. 19921 florida tax review treasury? at the time the case was decided, the answer was "not necessarily." prior to the tax reform act of 1986,38 section 108 allowed deferral of cod income arising on the discharge of "qualified business indebtedness" even by solvent taxpayers39 by a timely election to reduce the basis of depreciable property.4° with that incentive to use the collapsed approach now history, why doesn't the treasury issue a revised regulation conforming its approach for nonrecourse debt relief to that of recourse debt relief?4 as this article argues that it must do just that-that using different approaches depending on the status of the debt is not reasonable and, further, that the collapsed approach itself is flawed-the medicine should not be too difficult to swallow.42 b. the tufts briefs the court's easy affirmation of the collapsed approach is understandable in view of the posture of the case, the information provided it, and the 38. pub. l. no. 99-514, § 822(a), 100 stat. 2373 (1986). 39. see supra note 8 (discussing the section 108(a) exclusion for insolvent and bankrupt taxpayers). 40. see william d. popkin, introduction to federal income taxation 529 (1987) ("the commissioner probably preferred sales proceeds treatment because discharge of indebtedness income usually resulted in tax deferral, by allowing the taxpayer to reduce basis."). 41. "to my mind, the court left little doubt about how the government could, if it wished, adopt the barnett view. had that analysis been codified in regulations, the court strongly hinted that it would have deferred to the revised treasury position." erik m. jensen, nonrecourse liabilities and real costs: a reply to professor johnson, 11 va. tax rev. 643, 650 (1992) [hereinafter jensen ii]. see also kimberly s. blanchard, discharge of nonrecourse debt: a reexamination of the distinction between recourse and nonrecourse debt and related issues, special report, 50 tax notes 773, 779 (feb. 18, 1991) (arguing that the treasury department has the power to unilaterally change the collapsed approach affirmed in tufts because the only reason that the tufts court affirmed the collapsed approach rather than the bifurcated approach was deference to the commissioner). the current supreme court has recognized that deference under chevron u.s.a., inc. v. natural resources defense council, inc., 467 u.s. 837 (1984), to an administrative agency's permissible construction of a statute is warranted, even if it blatantly reverses a longstanding construction, so that the agency may take account of changes in policy, theory, the state of technology, or other changes over time. see, e.g., rust v. sullivan, 111 s. ct. 1759, 1769 (1991); see also antonin scalia, judicial deference to administrative interpretations of law, 1989 duke l.j. 511, 518 ("[ihe capacity of the chevron approach to accept changes in agency interpretation ungrudgingly seems to me one of the strongest indications that the chevron approach is correct."). 42. on the other hand, the insolvency and bankruptcy exclusions under section 108(a), which are not available to shelter gain realized under section 1001, may be used by many more taxpayers today than one might at first imagine. with net capital gain taxed at or near the rates applied to ordinary income (see irc § l(h)), the government's best revenue interests might yet be in preserving the collapsed approach. [vol 1:3 tufts and the evolution of debt-discharge theory government's own apparent misunderstanding of how a tufts transfer would be taxed in the case of recourse debt under its regulations.'first, tufts's attorneys had no incentive to argue that use of the bifurcated approach was necessary because that approach would likely have produced a larger tax bill for tufts.44 tufts did not make a timely election at the time of the sale to reduce the basis in other property held in lieu of recognizing the cod income under the "qualified business indebtedness" provision. thus, the $450,000 in cod income would have been immediately taxable under section 61(a)(12) (unless tufts was insolvent or in bankruptcy court),4 5 and the $50,000 capital loss would have been subject to the capital-loss-limitation rules contained in sections 1211 and 1212. it follows that tufts was better off, if he lost the issue concerning whether any accession to wealth occurs in view of the debt exceeding the fair market value of the property transferred, accepting the collapsed approach in analyzing that accession to wealth. as noted, he recognized $400,000 of gain under section 1001, some of which would be ordinary, under that approach. second, the government's briefs, which are quoted extensively below to give an accurate picture of the cumulative effect of the government's statements, also failed to help the court appreciate the second issue in tufts. in fact, the briefs illustrate that the government did not appreciate how its own regulations operated in the case of a tufts transfer involving recourse debt. from the petition for writ of certiorari onward, the government characterized the case as presenting only a single issue, thus allowing the court to conclude easily that if relief from nonrecourse debt in excess of the fair market value of the property transferred was properly considered an 43. "[the quality of a court's thinking is often limited by the quality of arguments presented to it." jensen ii, supra note 41, at 648. 44. the thrust of tufts's supreme court brief was that the statutory definition of amount realized cannot be judicially expanded to include the recapture of earlier tax benefits. brief for the respondents, commissioner v. tufts, 461 u.s. 300 (1983) (no. 81-1536). perhaps recognizing that if the court agreed with that proposition it might conclude that tufts nevertheless realized cod income, the brief also argued that, "this case involves only 'amount realized' upon the 'sale or disposition' of ... [propertyl and not cancellation of indebtedness income." id. at 10. in support of this proposition. the brief conceded that although cod income would be realized if the debt had been recourse (id. at 13-14). no cod income can be realized with respect to nonrecourse debt because "non-recourse debt is not truly debt.... economically, non-recourse obligations are not true debt at all. no one owes the debt or has promised to repay it." id. at 16-17. the brief recognized that a loophole existed if the debt relief neither created amount realized nor created cod income but that it was congress's job to close it. "petitioner contends that this court should close the non-recourse loophole by expanding section 1001(b) because congress has not seen fit to do so. respondents contend to the contrary, for exactly the same reason." id. at 17. 45. see supra note 8 (discussing the section 108 exclusion for insolvent and bankrupt taxpayers). 1992] florida tax review accession to wealth, the sole method to ensure its taxation was to include it in the amount realized on the property disposition. the single question presented by the government in its petition was: whether a person who owns property subject to mortgage indebtedness for which he assumes no personal liability (nonrecourse debt), where such indebtedness is properly includable in his tax basis of the property for depreciation and other purposes, must likewise include the full measure of the indebtedness as an "amount realized" when he disposes of the property subject to the mortgage, whatever the fair market value of the property at the time of the disposition.46 the government's principal brief rephrased the question a little which, if anything, served to stress the computation of gain or loss under section 1001. whether, for purposes of computing gain or loss for tax purposes, a person who owns property subject to mortgage indebtedness for which he assumes no personal liability (nonrecourse debt) and who properly includes the funds borrowed under the mortgage in his cost basis of the property for depreciation and other purposes, must likewise include the full measure of the unrepaid indebtedness as an "amount realized" when he disposes of the property subject to the mortgage, whatever the fair market value of the property at the time of the disposition.47 the brief toys a little with the notion of cod income but does so only to support the argument that relief from the nonrecourse indebtedness in excess of the property's fair market value constitutes an accession to wealth.4 ' the brief then immediately goes on to characterize that accession to wealth not as cod income (because related to the failure to repay the full principal amount of the debt) but as amount realized.49 if the theoretical basis for excluding the proceeds of a loan from the gross income of the borrower is the existence 46. petition for writ of certiorari to the united states court of appeals for the fifth circuit at (i), commissioner v. tufts, 461 u.s. 300 (1983) (no. 81-1536). 47. brief for the petitioner at (i), tufts, (no. 81-1536). 48. see id. at 11-13. 49. see id. at 15-16. [vol 1:3 tufts and the evolution of debt-dischar'ge theory of an offsetting liability to repay the loan, then the termination of that liability with the repayment in cash of less than the amount received should normally give rise to taxable income. the classic illustration of that principle is this court's decision in united states v. kirby lumber co., 284 u.s. 1 (1931). there, the court held that where a corporation purchased and retired some of its own bonds for less than their par value (which it had received for them when issued), the difference was taxable income. the taxable receipt arose upon the cancellation or discharge of the indebtedness when the corporation purchased its bonds for less than the liability they represented. the proposition that relief from a liability can be treated as consideration received on the disposition of property-i.e., part of the "amount realized"-is squarely supported by crane v. commissioner, 331 u.s. 1 (1947), the decision that is the focus of this case. there, the court concluded that relief from the obligation of a nonrecourse mortgage was part of the amount realized by the mortgagor upon the sale of the encumbered property for cash plus the buyer's taking subject to the mortgage. upon such a transfer, "the benefit to him is as real and substantial as if the mortgage were discharged, or as if a personal debt in an equal amount had been assumed by another." id. at 14.' most troubling were the errors in omission as well as commission in dealing with the disparate treatment of recourse and nonrecourse debt in the tufts situation. the briefs not only failed to alert the court to the disparate treatment provided in the regulations (and thus failed to argue further that such disparate treatment was justifiable), they actively misled the court to the belief that the government treats nonrecourse debt and recourse debt alike on the disposition of property in full satisfaction of a debt exceeding the fair market value of the property. thus, the court was led to believe that a holding for the government would confonn the tax consequences of tufts's transaction to an identical transaction involving recourse debt. the court's belief that its holding was doing away with the distinction between recourse and nonrecourse debt in a tufts situation is plainly evident. 50. id. (footnote omitted). not only does this excerpt use cod-income theory in justifying the argument that an accession to wealth occurred, while reverting to the collapsed approach in taxing that accession, it also fails to acknowledge that crane could not have involved cod income. the debt relief in crane could only have been included in amount realized as no debt was cancelled; the property's value covered the debt. 19921 florida tax review although a different approach might have been taken with respect to a nonrecourse mortgage loan, the commissioner has chosen to accord it the same treatment he gives to a recourse mortgage loan. ... because no difference between recourse and nonrecourse obligations is recognized in calculating basis, crane teaches that the commissioner may ignore the nonrecourse nature of the obligation in determining the amount realized upon disposition of the encumbered property. he thus may include in the amount realized the amount of the nonrecourse mortgage assumed by the purchaser. the rationale for this treatment is that the original inclusion of the amount of the mortgage in basis rested on the assumption that the mortgagor incurred an obligation to repay. moreover, this treatment balances the fact that the mortgagor originally received the proceeds of the nonrecourse loan tax-free on the same assumption. unless the outstanding amount of the mortgage is deemed to be realized, the mortgagor effectively will have received untaxed income at the time the loan was extended and will have received an unwarranted increase in the basis of his property. the commissioner's interpretation of § 1001(b) in this fashion cannot be said to be unreasonable. respondents received a mortgage loan with the concomitant obligation to repay by the year 2012. the only difference between that mortgage and one on which the borrower is personally liable is that the mortgagee's remedy is limited to foreclosing on the securing property. this difference does not alter the nature of the obligation; its only effect is to shift from the borrower to the lender any potential loss caused by devaluation of the property.5' commentators characterizing the effect of tufts have similarly assumed that the court believed that what it was doing was conforming the treatment of nonrecourse and recourse debt in a tufts transaction. in his student treatise, professor marvin a. chirelstein comments that the tufts court held that "[iln effect, borrowing with personal liability and borrowing without personal liability are to be treated alike for ... [purposes of section 1001].1:52 51. tufts, 461 u.s. at 308-12 (emphasis added) (footnotes omitted). 52. marvin a. chirelstein, federal income taxation: a law student's guide to the leading cases and concepts 270 (6th ed. 1991); see also william j. rohrbach, jr., the [vol. 1:3 tufts and the evolution of debt-discharge theory the government's briefs repeatedly reinforce this incorrect notion. in its principal brief, the government repeats a statement it made in its petition for writ of certiorari (and repetition brings with it emphasis): moreover, a taxpayer's basis does not turn on whether he is personally liable on the indebtedness encumbering the property, or whether the debt is nonrecourse in nature. in either event, the debt is includable in his cost basis and any antount remaining unpaid is includable in the amount realized upon disposition to a person taking the property' subject to the mortgage.53 the italicized statement is simply not true if the property is worth less than the debt, the precise facts before the court in tufts. the recourse debt relief in excess of the property's value creates cod income, not amount realized.54 compounding the incorrect insinuation is the hypothetical immediately preceding the text quoted above in both the principal brief and the petition for writ of certiorari. the hypothetical describes a transfer in which no debt is cancelled because the debt is less than the value of the property transferred. [i]f a purchases property for $25,000 in cash and obtains a $75,000 mortgage loan, his basis in the property is s 100,000. if he later sells it for $35,000 plus the [buyer's] agreement to assume the unamortized mortgage balance of $75,000, the amount realized is $110,000 ($35,000 plus $75,000), resulting in a $10,000 gain. while that is a true statement of the law, it has nothing to do with whether the accession to wealth in the very different tufts situation should be analyzed as cod income or amount realized. there is no potential cod income in the hypothetical. indeed, because the debt discharged was worth disposition of properties secured by recourse and nonrecourse debt. 41 baylor l rev. 231. 237-38 (1989) ("by edict from the high nine on the potomac. nonrecourse and recourse indebtedness will be treated similarly upon the sale or disposition. and gain or loss will be then easily determined under section 1001 of the code."). 53. brief for the petitioner at 11. tufts (no. 81-1536) (emphasis added). see also petition for a writ of certiorari to the united states court of appeals for the fifth circuit at 8, tufts (no. 81-1536). 54. see supra notes 4-8 and accompanying text (describing bifurcated approachi. 55. brief for the petitioner at 10-11. tufts (no. 81-1536); see also petition for a writ of certiorari to the united states court of appeals for the fifth circuit at 8, tufts (no. 811536). 1992] florida tax review less than the property transferred in the hypothetical, the buyer had to kick in some cash to boot. the hypothetical is simply another version of the crane situation, in which the issue of potential cod income does not exist. thus, while true, the statement misleads one to believe that, in the ttufts situation as well, the sole candidate for the honor of controlling the accession to wealth is the "amount realized" portion of section 1001.56 again and again, the brief implies, if only by omission of any mention of the potential application of section 61(a)(12), that if the court should rule that the accession to wealth cannot be included in amount realized under the section 1001 analysis, it will escape taxation altogether.5" again 56. the same hypothetical is repeated yet a third time later in the brief, by which time the justices could probably recite it in their sleep: if a purchases property for $100,000 by putting up $25,000 and obtaining a $75,000 fully recourse mortgage loan for which he is personally liable, his basis in the property is $100,000. the $100,000 is his cost, on the assumption that he will pay off the $75,000 loan in accordance with his undertaking. if he later sells the property for $35,000 cash plus the buyer's agreement to assume the unamortized mortgage balance of $75,000, the amount realized is $110,000 ($35,000 plus $75,000). in these circumstances, $100,000 turns out not to have been a's actual cost because, instead of repaying the loan, he has sold the property subject to the mortgage. we do not, however, reach back and adjust his basis downward in such a case, but rather account for his nonpayment of the loan by charging him with $75,000 of consideration received from the purchaser. moreover, as the lower courts and the treasury have interpreted it, crane established that the same results generally obtain even if the debt is nonrecourse in nature so that the property owner has no obligation to satisfy the debt other than out of the property. in such a case, the borrowed funds are includable both in the borrower's cost basis and in the amount realized upon disposition. brief for the petitioner at 19-20, tufts (no. 81-1536). in one fell swoop, the brief manages to imply once again that (1) a holding for the government would treat nonrecourse and recourse debt alike in the tufts situation; (2) the rationality of the hypothetical, which does not involve debt cancellation because the property is not worth less than the debt, supports the government's position in the tufts situation; and (3) the accession to wealth identified inevitably has to be analyzed as additional amount realized rather than cod income. 57. beginning at page 19, for example, the brief states: just as the exclusion of borrowing from the debtor's gross income is premised upon the existence of a corresponding obligation to repay the debt, the inclusion of borrowed funds in the cost basis of debt-financed property likewise proceeds upon the identical assumption that the owner of the property will pay off the debt encumbering the property. if that assumption proves false because the owner of the property disposes of it subject to the mortgage, the elimination of indebtedness rule likewise fixes the day of reckoning upon which the taxpayer is required to close out the transaction and account for any potential income represented by his release from the unrepaid mortgage indebtedness. if this day of reckoning does not occur, the property owner will escape taxation forever on the amount of [ vol 1:3 tufts and the evolution of debt-discharge theory and again, the brief implies, if only by omission, that the collapsed approach applies in the case of recourse debt as well as nonrecourse debt when the property transferred is worth less than the debt. 58 professor barnett did mention, perhaps too briefly, in his amicus brief that the government required the bifurcated approach for recourse debt in the tufts situation. the impennissibilit, of the distinction drawn between recourse and nonrecourse liabilities.-although the government's brief is less than clear on the point, the regulations are explicit that their rules for asset-for-relief exchanges involving nonrecourse liabilities are quite different from the the unrepaid loan proceeds. the taxpayer will have received fimds whose tax-free receipt was predicated only on the assumption that the loan would befully repaid. nothing in the code calls for such a bizarre result. indeed. the fundamental teaching of this court in crane rejects it. as we have shown, the inclusion of borrowed funds in basis-where the receipt of such borrowing was not taxable-requires the quid pro quo of including the full amount of the unpaid debt in amount realized to insure that all potential for income is ultimately accounted for upon the sale or disposition of the property. if such were not the case, the taxpayer would have the best of both worlds-basis inflated by nonrecourse indebtedness. on the assunption that the debt will be paid by hint. and the exclusion of the amount of the unpaid debt upon disposition, even though we then know with certainty that the taxpayer will not pay the debt because it has been transferred with the property. a rational tar systen cannot simultaneously comprehend the adoption of such contradictory assumptions. logic, and the statute's directive to tax all income "from whatever source derived," demand that if nonrecourse borrowed funds received tax free can purchase basis and the resultant tax deductions, then the unrepaid amount of such indebtedness must be included in amount realized upon the disposition of the property subject to the mortgage. id. at 19-20 (emphasis added). 58. at page 18, for example, the brief states: where property is used to discharge a debt. the amount of the debt discharged may be greater than the value of the property transferred. where the proceeds of the loan represented by the debt are received tax free, and the creditor accepts the property in full satisfaction of the remaining debt, the debtor's taxable gain or loss on the property transferred is measured by including the full amount of the debt discharged as the consideration received. this situation occurs where, as here, property subject to a nonrecourse mortgage is transferred subject to the mortgage and the amount of the outstanding mortgage exceeds the value of the property. id. at 18. there is no disclaimer to the effect that "this situation" specifically does not include a tufts situation where the debt is recourse. 19921 florida tax review rules that are to be applied when the taxpayer is personally liable on the note. if the taxpayer is personally liable, the regulations prescribe, there is to be a separate reckoning for the gain or loss derived from the liability transaction as such, and for that purpose-i.e., to separate the asset gain and the liability gain-the amount deemed received by the taxpayer for the asset and expended by him for the liability relief is to be fixed by the value of the exchanged items. it is only when the liability is without recourse that there is to be no separate accounting for the liability gain; only then that the amount deemed received for the asset is to be fixed by the basis of the liability; and only then that the entire gain is to be treated as an asset gain.59 in responding to the amicus brief, the government's reply brief never acknowledges its own regulations regarding recourse debt save in a footnote, and it misstates the law as to that! it is the most telling evidence that the government itself was not aware of the dichotomy it was cementing with its arguments. finally, we reject the amicus barnett's thesis ... that the gain in this case is ordinary income from the cancellation of indebtedness under section 61(a)(12).... if one were writing on a clean slate in this area and considering the question as an original matter, one might construct a theory that would assign "basis" to liabilities, attribute significance to the value of nonrecourse liability securing property at the time of its cancellation, and break down a disposition of property subject to a nonrecourse mortgage into its component parts. in these circumstances, one could well conclude that ordinary income treatment for respondents' relief from indebtedness would be appropriate. indeed, if respondents are correct in urging that their amount realized is limited to the $1.4 million value of the property, then the gain that respondents unquestionably realized must be accounted for as ordinary income from the cancellation of indebtedness. but the tax law has not traveled down that path and no one in this litigation or in any of the previous cases has urged that the gain realized in such circumstances is taxable as ordinary income. indeed, apart from the anomaly of the 59. brief for amicus curiae at 23-24, tufts (no. 81-1536) (footnote omitted). [vol, 1:3 tufts and the evolution of debt-discharge thteor decision below, the entire history of the tax treatment of mortgage indebtedness at least since crane evidences a consistent judicial treatment requiring the inclusion of the full amount of the nonrecourse mortgage debt in the amount realized for the property, regardless of the value of the property upon disposition.' ... given this well-established line of authority, it is simply too late in the day to expand the scope of the question presented in this case so as to recast these transactions involving mortgage debt and recharacterize the nature of the gain. the commissioner's longstanding position to permit such gain to be attributed to the transfer of the property subject to the mortgage debt is a reasonable and permissible interpretation of the statutory definition of "amount realized" in section 1001(b). requiring an unraveling of the various components of assets and obligations conveyed in the sale of property subject to a mortgage, and an individualized computation and characterization of the income or loss realized upon each of these components, would introduce complexities of enormous dimensions into the taxation of any sale of property subject to a purchase money obligation. ' of course, if property is transferred in exchange for the discharge of an unrelated recourse debt, the transaction may produce ordinary income from the discharge of indebtedness under section 61(a)(12) of the code. see treasury regulations on income tax (1954 code), sections 1.1001-2(a)(3) and 1.1001-2(c), example (8). see also united states v. davis, 370 u.s. 65, 72 (1962). 60 the brief fails to indicate that the bifurcated approach applies to all tufts dispositions involving recourse debt. the footnote's statement that the bifurcated approach applies only in cases of the discharge of "unrelated recourse debt" is simply wrong. the regulation's words are not so limited," and the government has not restricted its application to cases of "unrelated recourse debt." indeed, both the technical advice memorandum alluded to in part i and discussed more fully in part iv and recent cases consciously apply the bifurcated approach to recourse debt that relates solely to the property transferred.62 moreover, the bifurcated approach, which the brief implies to 60. reply brief for the petitioner at 7-9. tufts (no. 81-1536) (citations omitted). 61. see supra notes 5-6 and accompanying text (quoting the regulationi. 62. see supra note 2 and accompanying text. infra notes 72 and 174-90 and 19921 florida tax review be too cumbersome to apply to the transfer context and thus should not be forced unwillingly on the government, is the precise approach willingly adopted by the government if the debt is recourse. the brief fails to explain why such an approach is too cumbersome to apply in the nonrecourse context while at the same time is not too cumbersome to apply in the recourse context, and more important, the brief fails to offer any conceptual justification for using different approaches, which leads to the anomalies described below in part iii. c. finally, in its principal brief, the government selectively quoted from regulations section 1.1001-2, acknowledging only the tufts rule memorialized there and quoting a consistent example involving nonrecourse debt. the government failed to quote or mention the portion of the regulation mandating the bifurcated approach for recourse debt; in fact, the government affirmatively misstated yet again that "amount realized" always includes relief from debt, whether recourse or nonrecourse and whether or not the debt exceeds the value of the property transferred. section 1.1001-2 of the treasury regulations on income tax (1954 code) (26 c.f.r.), promulgated on december 12, 1980 ... explicitly provides that the fair market value of property transferred subject to nonrecourse indebtedness "is not relevant" in determining the amount realized on the transfer.... example (7) of that regulation is particularly relevant, for it describes a factual situation presenting the same issues as the case at bar.... although section 1.1001-2 of the treasury regulations was promulgated while this case was pending in the court of appeals, that regulation did not announce a new policy with respect to the tax treatment of nonrecourse indebtedness. to the contrary, treasury regulations in force since 1926 have consistently taken the position that the amount realized on the sale of mortgaged property includes the amount of the mortgage, whether the debt is recourse or nonrecourse in nature.63 again, we know that that last statement is simply untrue in the tufts situation involving recourse debt. these extensive quotations serve to illustrate why the court so easily affirmed the government's position. accompanying text. 63. brief for the petitioner at 43-45, tufts (no. 81-1536) (emphasis added) (footnote omitted) (citations omitted). [ vol 1:3 tufts and the evolution of debt-discharge theory c. the regulations regulations section 1.1001-2, containing the bifurcated approach for recourse debt and the collapsed approach for nonrecourse debt, was promulgated while the tufts case was before the fifth circuit. the terse preamble neither detailed the differing approaches nor discussed the underlying rationale for using different approaches for recourse and nonrecourse debt.' the bifurcated rule for recourse debt was not contained in the original set of proposed regulations.65 with respect to its addition to the final regulations, the preamble to the final regulations simply stated: a number of comments suggested that amounts treated as income from discharge of indebtedness under existing regulations might be treated as amounts realized on the sale or other disposition of property under the proposed regulations. therefore, the treasury decision makes it clear that the amount realized on the sale or other disposition of property that secures a recourse liability does not include amounts that are income from the discharge of indebtedness. 66 the supreme court noted the timing of release of regulations section 1.1001-2 in the middle of the tufts litigation but also noted that the regulation "merely formalized the commissioner's prior interpretation...." as discussed, the court gave no evidence that it was aware that the regulations contained disparate analysis in the tufts situation depending upon whether the debt discharged on the transfer is recourse or nonrecourse. although regulations section 1.1001-2 was appended in its entirety to the brief for petitioners,68 it is unlikely that the court appreciated on its own the disparate treatments provided in the regulations for recourse and nonrecourse debt, particularly in light of the misleading comments made in the government's reply brief regarding the recourse-debt provision.' regulations section 1.1001-2 is not well drafted (to put it kindly). nowhere does it clearly state that the bifurcated approach controls in the case of recourse debt while the collapsed approach applies in the case of nonrecourse debt. one must link up the different subsections and two examples in 64. see t.d. 7741, 1981-1 c.b. 430. 65. see prop. regs. § 1.1001-2. 44 fed. reg. 76,815 (1979). 66. t.d. 7741, 1981-1 c.b. 430. 67. tufts, 461 u.s. at 310 n.9. 68. see brief for the petitioner app. at la-6a, tufts (no. 81-1536). 69. see supra notes 60-62 and accompanying text. 19921 florida tax review order to arrive at the conclusion that its effect, when taken in total, is to use the bifurcated approach with recourse debt and the collapsed approach with nonrecourse debt. ° the regulation certainly does not announce those results clearly, 7' and nowhere has the government justified using different approaches for the two types of debt. in any event, other courts since made fully aware of the dichotomy have demonstrated unquestioning acceptance of it.72 70. see supra notes 4-14 and accompanying text (quoting and discussing the various provisions of regulations section 1.1001-2 which, taken together, require the collapsed approach for nonrecourse debt and the bifurcated approach for recourse debt). adding to the confusion of the already-quoted provisions of regulations section 1.1001-2 are subsections (a)(4)(i) and (ii): (i) the sale or other disposition of property that secures a nonrecourse liability discharges the transferor from the liability; (ii) the sale or other disposition of property that secures a recourse liability discharges the transferor from the liability if another person agrees to pay the liability (whether or not the transferor is in fact released from liability).... taken together, these two statements seem to imply once again that recourse debt and nonrecourse debt are treated alike in all situations, even the tufts scenario where the debt exceeds the fair market value of the property transferred. 71. the cryptic drafting may have been responsible for the fact that the government's own attorneys in the tufts case misapprehended the regulation's operation. see supra notes 60-62 and accompanying text. 72. see, e.g., bressi v. commissioner, 62 t.c.m. (cch) 1668, t.c.m. (p-h) 1 91,651 (1991). the taxpayer in bressi transferred property with a fair market value of $3,010,000 and an adjusted basis of $1,807,352 in lieu of foreclosure to a creditor in satisfaction of a $3,510,251.62 debt secured by the property. the tax court accepted without comment the regulation's rules requiring application of the bifurcated approach if the debt is recourse and the collapsed approach if the debt is nonrecourse. contrary to the intimation in the government's brief in tufts (see supra notes 60-62 and accompanying text), the tax court did not limit application of the bifurcated approach to disposition of property in satisfaction of unrelated recourse debt. the property transferred was constructed with the proceeds of the recourse loans cancelled on the transfer. the government argued, and the tax court found, that the debt was recourse, so the bifurcated approach controlled, resulting in $500,251.62 of cod income and $1,202,648 of gain under section 1001. the tax court rejected the taxpayer's argument that the debt was nonrecourse, which would have resulted in no cod income and increased gain under section 1001, taxed as capital gain to the taxpayer. the tax court defined "nonrecourse" as meaning "that the lienor may look only to the property that is subject to his lien to satisfy his debt and cannot look to the debtor personally for payment." bressi, 62 t.c.m. (cch) 1668, 1672, t.c.m. (p-h) 91,651 at 3227 (1991). rejecting the taxpayer's argument that a performance bond essentially transformed the debt into nonrecourse debt, the court observed that nothing in the loan documents themselves limited the personal liability of the taxpayer. the internal revenue service, too, has reaffirmed its position that the bifurcated approach controls in the case of recourse debt. in revenue ruling 90-16, 1990-1 c.b. 12, the debtor transferred property with an adjusted basis of $8,000 and fair market value of $10,000 to a creditor in complete satisfaction of a $12,000 recourse debt. the ruling focused on regulations section 1.1001-2(c), example 8 (see supra text accompanying notes 4-5), and [ vol 1:3 tufts and the evolution qf debt-discharge theory of course, pointing out that the supreme court was likely unaware of the dichotomous treatment it was cementing with its opinion in tufts does not necessarily mean that such dichotomous treatment is in fact nonsensical or, if it is nonsensical, does not tell us which approach should be adopted for both situations. it simply means that these issues cannot be considered as having been finally decided by the supreme court in tufts. the issues must be examined on their own merits, which brings us to parts iii and iv of this article. mh. does the dichotomy iiake sense? because the court was never truly given the opportunity to decide the case as suggested in this article, its reasoning should not be seen as precluding adoption of the bifurcated approach for both nonrecourse and recourse debt. but because the government still tends to rely on some of the tufts arguments, parts a and b below examine more closely those portions of the court's opinion often cited as justifying, as a theoretical matter, rejection of the bifurcated approach for nonrecourse debt. that discussion leads to parts c and d, which examine the practical consequences of the dichotomy and the asserted justifications for the dichotomy other than those based on tufts. a. the "functional-relation" argument hi tufts the tufts court seemed to extend easily the argument first made in crane that amount realized bears a "functional relation"' to basis that concluded that the taxpayer realized $2,000 of cod income under section 61(a1l12) as well as $2,000 of gain under section 1001. because the taxpayer was insolvent. the cod income could be deferred under the mechanism provided in section 108(b), but the realized gain could not be similarly deferred. neither the ruling nor its underlying general counsel memorandum (see g.c.m. 39814 (mar. 30, 1990)) discusses the defensibility of the bifurcated approach for recourse debt in light of tufts or the defensibility of using a different approach than the collapsed approach used for nonrecourse debt. 73. thus, i fundamentally disagree with mr. robinson. who has written that "iln light of the tufts case and its emphasis on the discretion of the commissioner in this area. the validity of these regulations is beyond question." robinson. supra note 9. at 22. that statement assumes knowledge on the part of the supreme court of the dichotomy it was cementing as well as conscious affirmation of it as a reasonable dichotomy. as demonstrated in the text above, the court's rhetoric in both crane and tufts indicated that it thought it was conforming the treatment of nonrecourse debt to recourse debt when the securing property is transferred. including cases in which the fair market value of the property transferred is less than the extinguished debt. 74. in crane, "the court recognized the 'functional relation' in the statute between basis and amount realized." brief for the petitioner at 11. tufts (no. 81-1536). 19921 florida tax review requires any debt included in basis to be included in amount realized on disposition of the property. the court extended the reasoning by holding that the same is true when nonrecourse debt exceeds the fair market value of the property transferred. the government has continued to use this functionalrelation argument in other contexts.75 the functional-relation argument proves too much if it is interpreted as requiring section 1001 amount realized to take precedence over section 61(a)(12) cod income. indeed, recourse debt is not fully included in amount realized in the tufts situation even though it is included in the basis of the property transferred; rather, the unsatisfied recourse debt creates cod income. the usefulness of the functional-relation argument is limited to the inquiry whether any accession to wealth at all should be considered as occurring on the disposition of property, the basis of which includes untaxed loan proceeds. as implicitly used by the government in tufts, the argument implies, for example, the opposite notion that after-acquired mortgages which do not affect basis cannot be included in amount realized on disposition of property subject to the debt. that notion is untrue.76 assume, for example, that taxpayer acquires blackacre solely with $100,000 in cash. blackacre's adjusted basis would be its $100,000 cost under section 1012. assume further that when the fair market value of the property appreciates to $500,000, taxpayer borrows $400,000 on a nonrecourse basis using blackacre as security. the basis of blackacre does not include the debt, as it would under crane if the debt had been purchase debt, because the $400,000 cash has its own basis (or the property purchased with the $400,000 cash has its own cost basis). now assume taxpayer disposes of blackacre for $100,000 in cash plus assumption of the $400,000 liability when the property is still worth $500,000 (i.e., there is no debt cancellation). the $400,000 is included in amount realized under section 1001 even though the $400,000 liability was not included in basis. taxpayer thus has realized $400,000 of gain under section 1001. 7 7 75. see discussion infra note 100 (discussing this argument as it was made in the allan case). 76. the regulations do, however, specifically provide that purchase debt that is not included in basis cannot be included in amount realized. see regs. § 1.1001-2(a)(3) ("in the case of a liability incurred by reason of the acquisition of the property, this section does not apply to the extent that such liability was not taken into account in determining the transferor's basis for such property."). this scenario arises, for example, in the case of acquisition nonrecourse debt that is so inflated that it is not considered a true liability, in whole or in part, and is thus ignored and not included in basis. see generally jensen 1, supra note 21 (discussing the purchaser's cost basis in tufts). 77. see woodsam associates, inc. v. commissioner, 198 f.2d 357 (2d cir. 1952) (holding that after-acquired debt is not included in basis but is included in amount realized upon disposition of the property securing the debt). [vol 1:3 tufts and rhe erohtion of debt-discharge theory just as failure to include debt in basis does not necessarily mean that relief from indebtedness need not be included in amount realized (as demonstrated in the hypothetical), inclusion of the debt in basis of the property does not by that very fact require that relief from the debt in excess of the property's value be included in amount realized as opposed to being analyzed as cod income. inclusion of the debt in basis (coupled with excluding the loan proceeds from gross income in the year the loan was incurred) is excellent evidence that what the taxpayer received in the year the loan proceeds were received was not an undeniable accession to wealth over which the taxpayer had complete dominion but rather a "true loan" that would be repaid in full and thus should not be taxed on receipt.71 when that obligation to repay in full disappears, there is a taxable accession to wealth.7" whether that taxable accession to wealth should be analyzed as amount realized or cod income is not answered by discussing any "functional relation" between basis and amount realized in cases in which debt is discharged on a transfer of property worth less than the debt. b. footnote 11 of tufts the tufts court, in footnote i1, expressed other misgivings about characterizing the debt relief in excess of the property's value as cod income. we are not presented with and do not decide the contours of the cancellation-of-indebtedness doctrine. we note only that our approach does not fall within certain prior interpretations of that doctrine. in one view, the doctrine rests on the same initial premise as our analysis here-an obligation to re78. if property is personal-use property on which no depreciation deductions are allowable under section 167(a), inclusion of the debt in basis will not provide immediate tax benefits to the taxpayer. but the taking of depreciation deductions is not a prerequisite to the symmetry argument for rationalizing the taxation of cod income. the exclusion of the proceeds of the acquisition indebtedness from gross income is alone evidence enough of the receipt of the tax-free loan proceeds. absent the debt, the personal-use asset would have been purchased with after-tax dollars. cancellation of the debt without taxation, even absent tax benefits such as depreciation deductions based on basis, is nevertheless inconsistent with the prior exclusion from gross income. the loan was never repaid with after-tax dollars; thus, the tax-free consumption of the personal-use asset purchased with the debt is inconsistent with the prior exclusion. it results in personal consumption with before-tax dollars. see chirelstein, supra note 52, at 55-56. the mechanism for taxing that consumption should be section 61(a)(12). see infra notes 191-98 and accompanying text (discussing in more detail the intersection of personal-use property with the dichotomy that is the subject of this article). 79. see discussion supra note 8 and infra notes 80-117 and accompanying text (discussing in more detail the rationale underlying the taxation of cod income). 19921 florida tax review pay-but the doctrine relies on a freeing-of-assets theory to attribute ordinary income to the debtor upon cancellation. according to that view, when nonrecourse debt is forgiven, the debtor's basis in the securing property is reduced by the amount of debt canceled, and realization of income is deferred until the sale of the property. see fulton gold corp. v. commissioner, 31 b.t.a. 519, 520 (1934).... [i]f the nonrecourse indebtedness exceeds the value of the securing property, the taxpayer never realizes the full amount of the obligation canceled because the tax law has not recognized negative basis. although the economic benefit prong of crane also relies on a freeing-of-assets theory, that theory is irrelevant to our broader approach. in the context of a sale or disposition of property under § 1001, the extinguishment of the obligation to repay is not ordinary income; instead, the amount of the canceled debt is included in the amount realized, and enters into the computation of gain or loss on the disposition of the property. according to crane, this treatment is no different when the obligation is nonrecourse: the basis is not reduced as in the cancellation-of-indebtedness context, and the full value of the outstanding liability is included in the amount realized. thus, the problem of negative basis is avoided.8" these misgivings are premised both on outmoded theory and an outmoded case and thus should not be viewed as theoretical constraints against discarding the collapsed approach. 1. the outmoded theory.-the outmoded theory is the freeing-up-ofassets rationale enunciated by justice holmes in united states v. kirby lumber8l as the rationale justifying the realization of cod income. as discussed previously,82 that rationale no longer holds sway. if it did, insolvent debtors not made solvent by the debt discharge would realize no income as none of their assets would be freed from offsetting liabilities. 80. tufts, 461 u.s. at 310-12 n. 11 (citations omitted). the two penultimate sentences quoted demonstrate yet again the court's belief that relief from recourse debt is simply included in amount realized and does not create cod income. see supra notes 50-63 and accompanying text (describing other evidence showing the court believed that it was conforming the treatment of recourse and nonrecourse debt in the situation before it when in fact the court cemented dichotomous approaches with its decision). 81. 284 u.s. 1, 3 (1931). 82. see discussion supra note 8. [vol 1:3 tufts and the evolution of debt-discharge theory current law abandons the freeing-up-of-assets approach by holding that insolvent debtors do indeed realize cod income, though congress decided that for policy reasons insolvent debtors may defer recognition of cod income until some point in the future when, presumably, they are in a better financial condition to pay the tax due.83 rather, today's commentators argue that the symmetry rationale adopted by justice blackmun in recognizing the accession to wealth in tufts itself justifies the inclusion in income of cancelled debt. under the symmetry rationale, solvency is irrelevant and taxing insolvent debtors (even though the tax is deferred to some future time) is conceptually defensible. exclusion from gross income on receipt of the loan proceeds (evidenced by inclusion in the basis of property if purchase debt or simply failure to declare it as income in the case of other debt) is premised on the obligation to repay with after-tax dollars. when that obligation disappears, so does the justification for the initial exclusion.8s in this sense, the theory underlying cod income smacks of the broad articulation of the tax-benefit theory" enunciated by the supreme court in hillsboro national bank v. commissioner,'6 in which the court required inclusion in gross income of gain realized on an otherwise tax-free liquidation 83. see discussion supra note 8; lee a. sheppard, debt assumptions without buildings, news analysis, 55 tax notes 155, 156 (april 13, 1992): the pernicious notion that a borrower should recognize no cod income unless assets were somehow "freed" by the discharge has been used to justify everything from the insolvency exception to ill-advised real estate lending. despite occasional endorsement in respectable circles, the freeing-of-assets notion is outdated, impractical, and, as the decisions relying on this notion show, wildly unpredictable in its application. the transactional approach has prevailed, as it should. 84. see discussion supra note 8; crane, supra note s. at 117 ("the loan proceeds theory is the most useful way to think about debt discharge income. under this theory, income results on debt discharge because the loan represented the receipt of funds without the payment of tax, and on discharge this tax must be paid."). 85. the narrowly articulated tax-benefit rule requires that recovery of an item previously deducted must be included in gross income to the extent the prior deduction reduced positive taxable income (i.e., to the extent the deduction produced a tax benefit in the prior year). for general discussions of the tax-benefit rule, see borris 1. bittker & stephen b. kanner, the tax benefit rule, 26 ucla l. rev. 265 (1978); louis a. del cotto & kenneth f. joyce, double benefits and transactional consistency under the tax benefit rule, 39 tax l. rev. 473 (1984); alice w. cunningham, characterization of income recovered under the tax benefit doctrine, 7 va. tax rev. 121 (1987) [hereinafter cunningham ill; and steven j. willis, the tax benefit rule: a different view and a unified theory of error correction, 42 fla. l. rev. 575 (1990) [hereinafter willis i]. 86. 460 u.s. 370 (1983). the facts recounted in the text are those of united states v. bliss dairy inc., no. 81-930 (7th cir. 1983), the companion case to hillsboro national bank. 19921 florida tax review on the transfer of expensed cattle feed that was not in fact used in the course of a dairy business. the later liquidation was "fundamentally inconsistent"'87 with the premise on which the earlier deduction (proper when taken) was based, namely, that the cattle feed would be consumed in the course of the taxpayer's business. not including in gross income loan proceeds no longer subject to a repayment obligation with after-tax dollars would be fundamentally inconsistent with the tax benefit (proper when taken) obtained in the earlier year (i.e., the exclusion from gross income premised on the obligation to repay with after-tax dollars).88 in short, the taxation of loan proceeds is, at its simplest, a matter of timing. loan proceeds must be taxed at some point in time. current law chooses to place the tax event at the point of repayment of the principal by excluding the loan proceeds from gross income on receipt but taxing the income used to repay the principal amount.8 9 "in other words, the difference between the borrower and the taxpayer who saves or consumes out of his own funds is that the borrower can defer tax until repayment."9 if loan proceeds were taxed as ordinary income on receipt, then the amounts used to pay off the principal amount would not be taxed (i.e., would be deductible).9' coupling an up-front exclusion of the loan proceeds with a back-end, 87. id. at 383. 88. see joseph m. dodge, the logic of tax 180 (1989); louis a. del cotto, debt discharge income: kirby lumber revisited under the "transactional equity" rule of hillsboro, special report, 50 tax notes 761, 764 (feb. 18, 1991) (both noting that cod income analysis can be explained under the broad articulation of the tax-benefit theory). 89. the fact that tax-exempt proceeds may be used to repay the principal of a loan, such as gift proceeds under section 102 or interest received on certain state or local bonds under section 103, does not undercut the generalization. congress decided that these and certain other accessions to wealth should be free of tax, and the exemption should not be lost through the back door by taxing them when used to repay the principal of a loan. the point is that the wealth used to repay the loan entered into the tax calculus, resulting in tax in most cases and exemption in a few. when no wealth is used to repay a loan, the prior exclusion of loan proceeds is no longer defensible. 90. popkin, supra note 40, at 118; see william d. popkin, the taxation of borrowing, 56 ind. l.j. 43 (1980). 91. see boris i. bittker & barton h. thompson, jr., income from the discharge of indebtedness: the progeny of united states v. kirby lumber co., 66 cal. l. rev. 1159, 1165-66 (1978): were we blessed with perfect foresight, it would be preferable to exclude borrowed funds from gross income only to the extent that they ultimately will be repaid and to tax at the outset the amount that eventually will be discharged. in the absence of such prevision, however, another solution is required. one alternative would be to tax the entire amount borrowed when received and to allow deductions only as the debt is paid back. but since most loans are in fact repaid in full and taxing the receipt would impose a heavy front-end burden on debt financing, a better alternative is the existing system of excluding the borrowed funds from gross income [vol 1:3 tufts and the evolttion of debt-discharge theory tax-free repayment of the principal amount would allow an accession to wealth to escape taxation. failure to repay the loan with after-tax dollars at the back end (which occurs on debt discharge) requires, in essence, retroactive taxation at the front end. the tax bill, however, will arise in the year of cancellation; the prior year's return will not be reopened. this analysis is analogous to the treatment of depreciation recapture under sections 1245 and 1250 and the repayment of previously taxed income under section 1341, each of which, like section 61(a)(12) itself, are statutory provisions that smack of the error-correction approach apparent in the broad articulation of the tax-benefit concept. in each instance, the tax treatment in prior years is "correct" when made in the sense that it is based on certain assumptions about what will happen in future years. the exclusion of loan proceeds is correct based on the assumption that the loan will be repaid with after-tax dollars in the future; the ordinary depreciation deductions are correct based on the assumption that the deductions reflect the cost of producing ordinary business income and the asset will be consumed in the business; and gross income received in the expectation that the recipient has the right to retain the income is correctly taxed on receipt under the rates in effect for that year. but in each case the earlier tax treatment turns out to be "incorrect" in the sense that the assumptions on which it was based do not hold true in later years. the money is not paid back; the property is not used up in producing ordinary income but rather is sold, producing gain; and the income taxed in the year of receipt must be repaid in a year in which an offsetting deduction under lower rates will not make the taxpayer whole. the corrective mechanism does not open up the prior year's return and change the tax treatment in the earlier year but rather accounts for the change in the prior assumptions all in the year in which the changed facts occur. as justice o'connor phrased it, "the basic purpose of the tax benefit rule is to achieve rough transactional parity in tax, and to protect the government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous." 92 courts that have understood this relationship between the initial exclusion of debt proceeds and the potential realization of cod income on discharge have found that no cod income arises when a debt is cancelled if no tax-free loan proceeds were received in the first instance." the first when received and requiring the taxpayer to account for any subsequent gain from settling the debt for less than the amount originally received. 92. hillsboro nat'l batik, 460 u.s. at 383 (emphasis added) (citation omitted). 93. professor bittker unearthed an interesting footnote to the kirby lumber ease which may have made it an inopportune vehicle in which to enunciate the principle that the 19921 florida tax review step-the receipt of tax-free dollars that represent real value in the marketplace-is critical, for without it the discharge of the obligation to pay dollars does not result in an accession to wealth. without it there would be no prior exclusion in need of correction on the discharge. for example, the second circuit held in commissioner v. rail joint co.94 that no cod income arose on repurchase of corporate bonds at a discount when the bonds were previously issued as a nondeductible dividend. 95 "the second circuit's decision was correct because the corporation had not received any property or cash upon the issuance of the bonds. therefore, the rail joint company realized no accession to wealth when it repurchased its obligations at a discount."" similarly, a taxpayer whose pledge of money to a charity is forgiven realizes no cod income. notwithstanding that upon discharge assets previously subject to the liability of the pledge are freed from that liability in the sense of kirby lumber, "the taxpayer did not receive any potentially taxable gain when he incurred the debt (where is the gain when a taxpayer pledges money discharge of debt produces gross income. it appears that the bonds that were repurchased at a discount in kirby lumber were originally issued in exchange for the taxpayer's preferred stock and in cancellation of dividend arrearages on that stock. the amount originally received by the corporation for the stock is unclear. see boris i. bittker, income from the cancellation of indebtedness: a historical footnote to the kirby lumber case, 4 j. corp. tax'n 124 (1977). 94. 61 f.2d 751 (2d cir. 1932). 95. the second circuit was prescient in its view of cod income. the case predated by many years the current thinking recounted in the text. but see del cotto, supra note 88, at 768 n.54 (criticizing rail joint by arguing that the corporation did receive value in the form of "corporate satisfaction and gratification" upon the distribution of the dividend notes). rail joint has been relied upon as recently as 1988. in united states steel corp. v. united states, 848 f.2d 1232 (fed. cir. 1988), u.s. steel repurchased its debt instruments for cash. the debt had originally been issued in exchange for preferred stock which in turn had originally been issued for cash. in determining whether any cod income arose on the debt repurchase, the federal circuit, relying in part on rail joint, required a comparison between the repurchase price and the amount of cash originally received by u.s. steel on issuance of the preferred stock, not the value of that stock at the time of the stock-for-debt exchange. the court held that u.s steel realized no cod income as the cash originally received was less than the amount paid to repurchase the bonds. for an interesting colloquy between professors gunn and shakow surrounding this case, see alan gunn, reconciling united states steel and kirby lumber, special report, 42 tax notes 851 (feb. 13, 1989); david j. shakow, united states steel and kirby lumber: another view, special report, 42 tax notes 1371 (march 13, 1989); alan gunn, united states steel and the functional approach to legal problems, special report, 43 tax notes 213 (april 10, 1989); david j. shakow, a short retort on united states steel, letter to the editor, 43 tax notes 1173 (may 29, 1989); alan gunn, gunn's reply, letter to the editor, 43 tax notes 1174 (may 29, 1989). see also elliot pisem, more on united states steel corporation, letter to the editor, 43 tax notes 1414 (june 12, 1989). 96. witt & lyons, supra note 8, at 8 (footnotes omitted). [vol 1:3 tufts and the evolution of debt-discharge theory to a charity?). 97 the government and the courts have begun to focus more openly on the tax-benefit underpinnings of debt-discharge theory, but they have not always gotten the focus right. in allan v. commissioner,9 ' the government and the tax court considered the tax-benefit theory in a tufts situation but did not make the connections illustrated in this article. the debtor partnership in that case was unable to pay either real estate taxes due on the collateral securing nonrecourse debt or interest on the debt itself. the creditor paid the real estate taxes and added the amount paid on the debtor's behalf to the outstanding principal balance of the mortgage. the creditor similarly added interest arrearages to the outstanding principal amount. the debtor deducted 97. popkin, supra note 40, at 130. because the payment would have ben deductible, the hypothetical is problematic. see irc § 108(e)(2) ("no income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction."); del cotto, supra note 88, at 768 (criticizing a similar hypothetical used by the rail joint court). the problem can be cured by simply changing the hypothetical to delete the charitable status of the promisee. as recently as 1991, however, at least one commentator continued to argue under the freeing-up-of-assets rationale that a discharged debt could produce gross income even if no cash or other value was originally received in exchange for the promise to pay. the balance sheet improvement in the year of the discharge, rather than the prior exclusion (which would be absent if no loan proceeds were originally received on the promise to pay), could justify the income inclusion. professor del cotto stated: certainly a forcible argument can be made that a balance sheet increase in net worth, by itself and without regard to other factors or transactions, as justice holmes expressed it in kirby lumber, is "'... an accession to income, if we take words in their plain popular meaning. as they should be taken here, burnett v. sanford & brooks co., is such a rule fair to the taxpayer? arguably, yes. because the rule makes economic and tax sense. relief from debt without asset depletion makes available to the taxpayer assets previously burdened by-i.e., dedicated to paying-the debt. if this increase in net worth is not. to paraphrase mr. justice holmes. in plain words an accession to wealth. what is it? the fact that ... no cash or other asset was received for the debt ... is sinply irrelevant to the economic and tax fact that the debt discharge increases wealth at no cost to the taxpayer. del cotto, supra note 88, at 763-64 (emphasis added) (footnote omitted). under this approach. any promisor who promises to make a future payment for no consideration and is discharged from that obligation would realize gross income. the tax-benefit approach to debt-discharge theory more appropriately focuses on clear accessions to wealth in the form of cash or equivalent value which is received at the time the promise to pay is made and which is excluded from gross income solely because of that promise. the balance sheet improvement in the year of the discharge bncause of liability relief is descriptive but a mere happenstance; the taxing event is the failure to repay with after-tax dollars the identifiable value previously received free of tax on the assumption that it would in fact be repaid. cf. sheppard, supra note 83. 98. 86 t.c. 655 (1986). aff'd, 856 f.2d 1169 (8th cir. 1988). 19921 florida tax review the interest and taxes under the usual rule that deductions are not delayed until repayments are made on debt incurred to finance deductible outlays.99 the collateral was eventually transferred to the creditor in lieu of foreclosure at a time when the outstanding principal amount of the debt exceeded the fair market value of the property, i.e., a tufts transfer occurred except that the transfer was made to the creditor instead of to a third party. the tax court held (and the eighth circuit affirmed) that the excess debt was simply included in amount realized under section 1001, creating capital gain. relying on tufts, the tax court rejected the government's chief contention that the tax-benefit rule required that the excess debt should be recovered by the debtor as ordinary income instead of capital gain, albeit only to the extent of the prior deductions for taxes and interest.'00 the government's invocation of the tax-benefit rule to require recognition of ordinary income on the transfer to the extent of the prior ordinary income deductions taken with use of the loan proceeds was on the right track but headed in the wrong direction. in invoking tax-benefit theory, the government looked forward from the time the loan was incurred to the use to which the loan proceeds were put-spent on items producing ordinary deductions-rather than back to the exclusion from gross income when the loan proceeds were first deemed received.'0 ' the use to which the loan proceeds were put should not have been the critical element in determining whether the accession to wealth arising on failure to fully repay the loan resulted in additional amount realized under section 1001. what "scandalized" the government, as professor willis put it, "was the apparent inconsistency of a taxpayer using borrowed funds to generate an ordinary deduction ... but 99. for example, assume arterio ("art"), who has no medical insurance, incurs huge medical bills for open heart surgery. he must borrow money from a bank in order to pay his medical bills. art may deduct the allowable amount under section 213 in the year the medical bills are paid. the deduction is not delayed until the bank loan is repaid. 100. the government also argued in part that it would be inappropriate to include the portion of the mortgage reflecting the real estate taxes and interest arrearages in amount realized because those amounts were not included in basis and depreciated; they were currently expensed. see allan, 86 t.c. at 660-61. this linkage of basis to amount realized as justifying the application of the collapsed approach (or, as the government argued here, preventing its application because of the absence of the link) has already been debunked. see supra notes 74-79 and accompanying text. 101. while i agree with professor willis when he criticizes the artificial distinction between recourse and nonrecourse debt (see infra notes 172 and 188-90 and accompanying text), i disagree with him that in this situation the use to which loan proceeds are put is the critical inquiry in determining the existence of gross income, as opposed to amount realized, on discharge. see steven j. willis, the option aspect of nonrecourse loans, 54 tax notes 441, 449 (jan. 27, 1992) [hereinafter willis ii] ("ultimately this is an issue of the tax benefit rule and not discharge of indebtedness income"). [vol 1:3 tufts and the evolution of debt-discharge theory then recognizing capital gain on the discharge of the loan."' 2 as willis also noted, however, there is no general bar to using tax-favored income to pay ordinary expenses.' 03 what should have scandalized the government, in this as well as all nonrecourse tufts transactions, is that the exclusion of ordinary income on receipt of the original loan proceeds is in effect reversed in a transaction which might, depending on the character of the property transferred, produce capital gain.' what the government needed to do was to recognize once and for all the tax-benefit underpinnings of cod-income theory itself and reject the collapsed approach affirmed in tufts. had the loan proceeds been taxable on receipt, they would have been taxed as ordinary income, as all gross income is ordinary unless it consists of gain realized on the disposition by sale or exchange of a capital asset under sections 1001, 1221, and 1222 of the code. the debtor receives cash, either actually or constructively, when he borrows; he does not sell a capital asset at that time.' ' "had the initial assumption erroneously giving rise to the ... [exclusion] in year 1 not been made, the income realized in year 1 would have retained not only its status as an element of taxable income but its character as capital gain or ordinary income."'0 6 the correction that arises in the later year produces ordinary income under cod-income theory, which is itself premised on the broad articulation of tax-benefit theory, because the exclusion provided in the year the loan proceeds were received was an ordinary-income exclusion." 7 102. willis ii, supra note 101, at 450. 103. id. there are some statutory bars, however. see. e.g., section 265 (disallowing certain deductions paid with tax-favored funds). 104. even more damning than the character problems is the potential backdoor deduction of nondeductible personal consumption. see infra notes 191-98 and accompanying text (describing the effects of the collapsed approach in connection with personal-use property). 105. professor cunningham, however, seems to disagree by arguing that the acquisition of the put option she describes as implicit in all nonrecourse debt would transform at least an unspecified portion of such taxable loan proceeds into capital gain if taxed on original receipt. she has stated: the question is what benefit the taxpayer received in the tax system when the debt was incurred. when the benefit originally received was gain from the sale of property, as where the borrower acquires a right to "put" the property to a lender in rchange for the amount of the nonrecourse debt, then the correct treatment on discharge of the obligation to repay is to recapture the income as gain from sale. cunningham ii, supra note 85, at 147-48 (emphasis added) (footnoted omitted). for reasons described below (see infra notes 157-73 and accompanying text, this article rejects the deemed-put-option analysis in governing the tax consequences of nonrecourse debt on a tufts transfer. 106. cunningham ii, supra note 85, at 128 (footnote omitted). 107. bittker and thompson have argued that "kirby ltmber is broader than the tax 1992] florida tax review the government's argument in allan, taken to its logical extreme, demonstrates that tufts was wrongly decided because the loan proceeds in tufts created ordinary depreciation deductions. the narrow exception to tufts that the government requested in allan was fundamentally inconsistent with tufts itself. thus, the tax court's opinion, premised on tufts, was not surprising. the government's insistence on using the narrowly articulated taxbenefit rule to require the ordinary income inclusion in allan is simply inconsistent with the tax-benefit underpinnings of debt-discharge theory, and it could come back to haunt the government. if the government had won allan, or if another court in another case is persuaded by the same argument made by the government in allan, the amount taxed as ordinary income rather than capital gain under the collapsed approach would be constrained by the inquiry into how the loan proceeds were spent. only to the extent the loan proceeds were expended in a fashion producing ordinary tax deductions would the gain be characterized as ordinary; the excess would retain its character as capital under the collapsed approach. such an approach not only requires complex inquiries and calculations, it is unnecessarily constrained. 0 8 the entire amount of the discharged debt (i.e., the amount by which benefit rule, for it applies even if the taxpayer does not receive a tax benefit from the borrowing transaction (e.g., if the borrowed funds are expended for items of a personal nature)." bittker & thompson, supra note 91, at 1180 n.74. this formulation ignores the clear tax benefit received in the year the proceeds were received-exclusion of the dollars received in hand from gross income-regardless of how the proceeds were spent. if spent on consumption, the consumption was purchased with before-tax dollars, contrary to the haig-simons premise that the tax base consists of consumption plus savings. the taxation of the consumption is deferred until the debt is repaid. 108. in approximate numbers, the fair market value of the property in allan was $540,000, its basis was $650,000, the total debt was $1,500,000, and the portion of the debt attributable to the advances for interest and taxes was $560,000 (meaning that $940,000 represented the original debt). the tax court confirmed that allan realized $850,000 of gain under section 1001 (the difference between the basis of $650,000 and the debt of $1,500,000), $100,000 of which was conceded to be ordinary income under the depreciation recapture provisions. the remaining $750,000 was characterized as capital gain. see allan, 86 t.c. 655, 659, 668; cunningham ii, supra note 85, at 122 & n.13; alice w. cunningham, reprise: characterization of income recovered under the tax benefit doctrine, 43 tax law. 121, 122 (1989) [hereinafter cunningham ihi]. if the government had won, allan would have realized $560,000 of ordinary income in addition to the $100,000 conceded to be ordinary income as depreciation recapture under the government's tax-benefit rule (which presumably would not have been cod income eligible for deferral under section 108 if allan had been insolvent or in bankruptcy court) and only $190,000 of capital gain. professor cunningham advocates this result as the correct one. see cunningham ii, supra note 85, at 133-35. she notes that the analysis would have been more difficult if the property's fair market value ($540,000) had exceeded the portion of the outstanding mortgage balance not attributable to the advances for deductible interest and taxes [ vol 1:3 tufts and the evolution of debt-discharge theory the debt exceeded the fair market value of the property transferred to satisfy it) should result in ordinary cod income-just as would be the case if the debt had been recourse debt-not merely the amount of such debt representing the nonrecourse loan proceeds used to pay deductible expenses. a recent tax court case illustrates more bluntly the close relationship between the broad articulation of tax-benefit theory and cod-income theory in general. at the same time, however, the case demonstrates the ill-advised continued insistence by both the government and the courts that the two theories be recognized as independent grounds for generating ordinary income in the debt-discharge situation. (though the case did not involve a tufts transfer and thus in that sense is a bit of a diversion from the main point of this article, it is worth talking about in connection with this section, which discusses the outmoded debt-discharge theory discussed in footnote 11 of tufts and the current tax-benefit theory.) in schlifke v. commissioner,°9 the taxpayers borrowed $225,000 secured by a second mortgage on their home. the terms of the loan required sixty monthly payments of interest and a balloon payment of the principal at the end of the five-year period. for nearly three years, the taxpayers paid ($940,000). she provides: for example, assume a mortgage liability of $100 (including $20 of unpaid interest) discharged by the transfer of property worth $95. as only s5 of the mortgage liability would remain unpaid, the discharge could not undermine the full s20 deduction. whether the portion of the liability unpaid should be attributed in tot to the prior interest deduction (yielding a tax benefit recovery of s5) or whether the transferred property should be regarded as having contributed proportionally to both the deductible and to the nondeductible portions of the debt (yielding a tax benefit recovery of 5% of s20) remains unclear. cunningham ii, supra note 85, at 128-29 n.50; see also cunningham ill, supra. at 142. under the bifurcated approach advocated in this article. allan would have realized a capital loss of $110,000 (the difference between the property's fair market value and basis) and cod income of s960,000 (the difference between the debt and the fair market value of the property transferred in complete settlement of it). because the ordinary income arises under debt-discharge theory by linking the failure to satisfy with after-tax dollars the entire debt originally excluded, the extent to which the proceeds were used for deductible purposes becomes irrelevant, and the difficulty noted above disappears. in the example posited by professor cunningham, the transfer would produce $5 of cod income, just as in the case of recourse debt. this would be true regardless of how much, if any, of the principal amount of the loan was used to pay deductible expenses such as taxes and interest. the use to which the loan proceeds were put is simply irrelevant in analyzing the taxability of cod income when debt is cancelled. (moreover, tracing the use of fungible loan proceeds is a dubious enterprise at best. see infra note 203 (discussing the futility of tracing the use of loan proceeds in order to determine whether discharge of a debt produces cod income under the kerbaugh-empire rule that no cod income arises if the loan proceeds were expended in an unprofitable transaction).) 109. 61 t.c.m. (cch) 1697, t.c.m. (p-h) 1 91.019 (1991). 19921 florida tax review deductible interest and finance charges of approximately $140,000, which did reduce the positive taxable income of the taxpayers in the years deducted. pursuant to the loan agreement, no principal payments were made. the taxpayers were then informed that the lender failed to comply with the requirements of the truth in lending act, giving the taxpayers the right to rescind the loan if they wished by repaying the principal amount of the loan "less any payments made by them.' '" ° the taxpayers effected the rescission by paying the creditor $85,000. the taxpayers, in effect, were permitted to charge the prior interest payments they had made against the $225,000 principal in determining the outstanding principal that needed to be repaid to accomplish the rescission. in effect, the loan was converted into an interestfree loan for the nearly three-year period it was outstanding."' the commissioner argued that the taxpayers realized $140,000 gross income in the year of the rescission under alternative theories: (1) the discharge of the $225,000 loan on the payment of $85,000 produced $140,000 of cod income; and (2) the crediting of the interest payments deducted in prior years against the principal of the loan was an event "fundamentally inconsistent '"" 2 with the premise of the prior deductions (that the payments were interest, not principal), producing $140,000 of gross income under the narrow articulation of the tax-benefit rule."3 the tax court chose to hold for the commissioner on the second ground, citing its aversion to grappling with the nuances of debt-discharge theory. the issue of income from discharge of an indebtedness for less than its face amount is, to say the least, controversial. see zarin v. commissioner. since we conclude that respondent's determination should be sustained under the tax benefit rule, we find it unnecessary to cut our way through the thicket of sub-issues which inhere in that controversy, such as the presence of a liquidated, as distinguished from an unliquidated, indebtedness, and the enforceability of the underlying obligation, i.e., whether it is void or voidable and the impact of the element of rescission thereon.' 110. t.c.m. (cch) 1697, t.c.m. (p-h) 91,019 at 78. 111. code section 7872, which imputes interest to certain below-market loans, was not yet enacted at the time of this transaction. thus, characterizing the loan for tax purposes as an interest-free loan generated no further tax consequences. 112. see supra notes 86-87 and accompanying text (discussing hillsboro national bank v. commissioner, 460 u.s. 370 (1983), which uses such language in describing when the inclusionary aspect of the tax-benefit rule operates). 113. see supra note 85 (describing the narrowly articulated version of the tax-benefit rule). 114. 61 t.c.m. (cch) 1697, 1698, t.c.m. (p-h) 91,019 at 79 (citation omitted). [vol 1:3 tufts and the evolution of debt-discharge theory the court's troublesome language implies that absent the availability of the alternative tax-benefit argument in the case because of the happenstance that the interest was deducted and then was allowed to be credited against principal, debt-discharge theory alone might not have prevailed to require taxation. the inclusion in gross income under debt-discharge theory should not be constrained by any consideration of the "liquidity" of the loan or the "enforceability of the underlying obligation" for nontax purposes-the perceived difficulties quoted above which the tax court felt attached to any analysis of cod income--once the tax-benefit underpinnings of debtdischarge theory are recognized. the debt is not "discharged," the argument goes, if it could not be enforced. but the lack of enforceability simply is the impetus for the failure of the debtor to repay fully the originally excluded loan proceeds which creates the accession to wealth in the first place. not only should the tax law avoid placing a favorable premium on entering into loan agreements that are unenforceable (as compared to enforceable loan agreements that are not enforced in fact), it is a catch-22 to argue that the very unenforceability which created the debt cancellation (because it prevented the creditor from collecting the debt in full) saves it from taxation. the debt in tufts was, in fact, unenforceable to the extent that it exceeded the fair market value of the collateral, and yet the court confirmed that an accession to wealth occurred on the failure to repay that debt, even though it analyzed that accession to wealth as gain under section 1001. that accession to wealth should not escape taxation outside the transfer context, as it would if the unenforceability of debt prevented taxation of cod income when the debt is not repaid in full; the same accession to wealth occurs in both the transfer context and the nontransfer context. such nonissues as unenforceability cloud the fundamental tax point confirmed in tufts that the prior loan proceeds were received free of tax on assumptions that prove to be unwarranted when the loan proceeds are not in fact fully repaid with after-tax dollars-for whatever reason. the prior receipt coupled with the failure to repay in full should be the beginning and end of the inquiry under debt-discharge theory)".5 see infra notes 206-17 and accompanying text (discussing the cited zarin case). 115. reliance on the dictionary definition of "'discharge" presents a nonissue that beclouds thinking in this area because it loses sight of the underlying structural rationale for taxing cod income in the first place. the disagreement is really one about statutory interpretation: to what extent should the dictionary definition of words control, severed from context? see lawrence zelenak, thinking about nonliteral interpretations of the internal revenue code, 64 n.c. l. rev. 623 (1986). this debate has gained a remarkable renascence since the elevation of antonin scalia to the supreme court in view of his strict adherence to textualism. see william n. eskridge, jr., the new textualism, 37 ucla l rev. 621 (1990). of course, textualism purports to take account of the larger statutory structure in interpreting words, but in practice it all too often ignores the larger structure and falls back on the 19921 florida tax review as in allan, the deductibility of the interest payments made on the loan should not have controlled the inquiry, though once again the broad taxbenefit idea encapsulated in cod income justifies taxation here. if the interest paid on the loan had been nondeductible personal interest rather than deductible "qualified residence interest"' 6 so that the narrowly articulated version of the tax-benefit rule could not have applied, the commissioner should nevertheless have won on its first argument. if the prior payments are respected as interest because paid "as the amount one has contracted to pay for the use of borrowed money, and as compensation paid for the use or forbearance of money' '1 7 (even though nondeductible), the $225,000 loan was in fact discharged for a principal payment of $85,000, producing $140,000 of cod income. the deductibility or nondeductibility of the interest has no relevancy to the accession to wealth obtained because of the prior exclusion from gross income on the receipt of $225,000 viewed together with the failure to repay $140,000 of that principal amount with after-tax dollars. 2. the outmoded case.-like the outmoded cod-income theory described by the tufts court in footnote 11, the fulton gold case,"' also cited in tufts,"9 has been relegated to a footnote in history. in that case, the taxpayer purchased property in 1920 subject to a nonrecourse mortgage which the taxpayer did not assume. 2° the taxpayer subsequently satisfied the nonrecourse debt in 1922 for less than its face amount. on disposition of the property in 1929-the transaction before the board of tax appeals-the board held that the property's basis equalled the cash initially paid for it plus the amount subsequently paid in satisfaction of the nonrecourse debt.' 2' basis did not include, as the taxpayer contended it should, the portion of the debt that was cancelled. the opinion does not make it clear whether the taxpayer included in gross income the cod income realized in 1922, though dictionary definition of words as they are "commonly understood." for example, justice scalia, writing for the majority this past term, disparagingly stated, "the dissent believes petitioner's position on this point to be supported by the history and structure of the ada ... sources it deems 'more illuminating' than a 'narrow focus' on the ada's language . morales v, trans world airlines, inc., 60 u.s.l.w. 4444,4446 n.2 (u.s. june 1, 1992) (emphasis added). 116. the interest on loan proceeds traced to personal uses is nondeductible unless the interest is "qualified residence interest" within the meaning of section 163(h)(3). see irc § 163(h)(1). see generally temp. regs. §§ 1.163-8t through 10t. 117. rev. rul. 69-188, 1969-1 c.b. 54 (defining the term "interest" for tax purposes by citing old colony railroad co. v. commissioner, 284 u.s. 552 (1932) and deputy v. dupont, 308 u.s. 488 (1940)). 118. fulton gold corp. v. commissioner, 31 b.t.a. 519 (1934). 119. see supra text accompanying note 80. 120. see fulton gold corp., 31 b.t.a. at 520. 121. see id. at 521. [vol 1:3 tufts and the evolution of debt-discharge theory the taxpayer cited kirby lunber in arguing that it should get basis credit for the cod income." the board reasoned, in essence, that kirby lumber applied only to recourse debt, that nonrecourse debt was not really "debt" but only an "encumbrance on property." here the petitioner, instead of assuming the mortgage, bought the property subject to it, and by making the purchase on such terms incurred no personal liability for the debt. accordingly, payment of the mortgage did not result in the liquidation of a personal debt. by it the petitioner merely satisfied an encumbrance on property in which it had an equity and there was no release of assets "previously offset by the obligation" of the notes or bonds evidencing the debt secured by the mortgage.'rightly or wrongly, fulton gold came to stand for the more general proposition that a cancellation of nonrecourse debt not related to a disposition of the property under section 1001 results not in cod income but rather results only in a decrease in basis. this interpretation of fulton gold has been roundly criticized 24 and, based as it was on the freeing-up-of-assets rationale which, as noted above, has been itself abandoned as the rationale underlying cod income, was finally interred by both the tax court and the internal revenue service. in gershkowitz i. comnissioner,"'the very much simplified facts boil down to the discharge of two nonrecourse loans: one a simple cancellation without surrender of the securing property and the other a cancellation upon surrendering the securing property, which, as in tufts, had a fair market value that was less than the extinguished debt. in a reviewed decision with no dissents or separate concurrences,'26 the tax court held that the cancellation of a $250,000 nonrecourse debt without surrender of the securing property worth $2,500 and with a basis of $50,000 produced cod income under section 61(a)(12) to the extent of the cancelled debt.'z in so holding, 122. see id. at 520. professor cunningham assumes that the taxpayer did not include any cod income in gross income in the earlier year. "'when the taxpayer subsequently discharged the mortgage for less than the unpaid balance, the debtor was not charged with cancellation-of-indebtedness income." cunningham l, supra note 14, at 607. 123. 31 b.t.a. at 521 (citation omitted). 124. see, e.g, blanchard, supra note 41 (criticizing both tufts and fulton gold). 125. 88 t.c. 984 (1987). 126. see id. at 1019. 127. see id. at 1004-14. because the cod income was realized by a partnership, most of the analysis dealt with whether the insolvency exception to the recognition of realized 19921 florida tax review the court quoted the portion of footnote 11 of tufts quoted above, 2 ' containing the reference to fulton gold, and rejected an argument that the amount of cod income must be limited to the $2,500 value of the collateral under a freeing-up-of-assets rationale. while not very clearly written, the opinion also seemed to reject any extrapolation from fulton gold that cod income could be recognized only to the extent of the basis in the securing property because of the anathema of a negative basis. the opinion has to be read more broadly as rejecting the dubious rule attributed to fulton gold in the first instance that cancellation of nonrecourse debt without a transfer of the securing property automatically results in a decrease in basis (to the extent thereof) and no cod income. the actual result in the case is simply incompatible with the approach attributed to fulton gold'29 when nonrecourse debt is cancelled without the surrender of the securing property. 3 cod income should be applied at the partnership or partner level. the tax court concluded that the insolvency exception applied at the partner level, a result now codified in section 108(d)(6). although the court refers at some points to the amount taken into account as "gain" (see id. at 1014) and refers to the amount of debt discharged as "amount realized" (see id. at 1012), cod income is not "gain" under section 1001 but rather is ordinary income, and there is no "amount realized" on debt cancellation. "gain" and "amount realized" are words of art under section 1001, dealing with property dispositions. in the end, however, the opinion has to be read as holding that cod income was realized on the transaction and that no transaction under section 1001 occurred as the court stated: "having concluded that each partner must recognize ordinary income from the discharge of indebtedness as a result of the prentice-hall transaction, we must now consider the amount of that income." id. at 1010. 128. see id. at 1011-12. 129. "although the tax court has not actually overruled fulton gold, the court has severely limited its application." witt & lyons, supra note 8, at 64 n.280. 130. the tax court quite rightly saw the potential for abuse if it were to limit the amount of cod income to either the $2,500 value of the retained collateral based on the freeing-up-of-assets rationale or the $50,000 basis of the collateral based on an extrapolation from fulton gold. see 88 t.c. at 1014. if the taxpayer had transferred the collateral in foreclosure without the payment of a cent, it would have realized gain under tufts and section 1001 to the extent of the excess of the $250,000 nonrecourse debt over the taxpayer's $50,000 basis in the collateral. in an attempt to avoid this result, the taxpayer actually paid 80% of the collateral's basis-40,000 in cash-to the creditor in exchange for extinguishment of the debt, apparently banking on being able to use the insolvency exception to immediate recognition of the cod income created. see id. at 1013. the government was the party that actually argued that the cod income was limited to the $2,500 value of the collateral, and it did so because of the increase in the outside basis of the partners in their partnership interests under section 705(a)(1)(a) that accompanied the realization of the larger amount of cod income by the partnership. see id. at 1009. the inflated outside basis permitted flow through of large losses to each partner under section 704(a) and (d). if the tax court had accepted the government's position that cod income was limited to either the value or basis of the collateral when nonrecourse debt is forgiven without surrender of the collateral, it no doubt would have come back to haunt the government. the advantages of structuring such transactions outside the partnership context by avoiding the [vol 1:3 tufts mid the evolution of debt-discharge theory with respect to the nonrecourse loan extinguished on transfer of the securing property to the creditor, the gershkowiitz court applied tufts and ruled that the entire indebtedness, including that portion in excess of the fair market value of the collateral transferred, was included in amount realized in the calculation of gain under section 1001. no cod income was deemed realized, so the insolvency exception was irrelevant.' the internal revenue service certainly has read gershkowitz as an abandonment of fulton gold. in revenue ruling 91-31,'2 the internal revenue service cited gershkowitz in ruling that "[t]he reduction of the principal amount of an undersecured nonrecourse debt by the holder of a debt who was not the seller of the property securing the debt results in the realization of discharge of indebtedness income...."' the facts of the ruling concerned a debtor who borrowed $1,000,000 from a creditor on a nonrecourse basis in 1988 in order to purchase an office building from a seller for $1,000,000. the debt was secured by the office building, and the creditor was not the seller of the building."u when the value of the disposition of the collateral are obvious: both gain under section 1001 and substantial cod income could be avoided on the debt discharge. the tax court, however, was not very clear regarding precisely how it reached its result analytically. the tax court should have simply rejected outright the rule attributed to fulton gold as inconsistent with the development of theory since tufts (even if fulton gold could be considered correct when decided), then rejected the freeing-up-of-assets rationale as an historical footnote in view of the symmetry rationale now accepted as the premise underlying the realization of cod income, and finally held that under that symmetry rationale the taxpayer realized cod income to the extent of the cancelled debt. 131. see gershkowitz, 88 t.c. at 1016; see infra notes 141-52 (discussing inability to defer under section 108(a) gain realized under section 1001 in the tufts situation, even though the accession to wealth arises because of the failure to repay debt). 132. 1991-1 c.b. 19. 133. id. at 20. 134. id. at 19. if the debt had been a purchase-money mortgage, forgiveness of the debt would have been treated for tax purposes as a renegotiation of the purchase price under section 108(e)(5), even if the surrounding facts clearly indicated an intention to forgive debt rather than lower the purchase price. the statutory rule was enacted in order to eliminate such factual inquiries when the creditor and seller are the same person. see discussion supra note 8. no cod income would have been created, but the cost basis of the property under section 1012 would have been reduced, accordingly. while the approach taken by the statutory purchase-money-mortgage rule is similar to that of fulton gold, its application is both narrower and broader. it is narrower in the sense that it applies to reduce basis rather than create cod income only in the case of a purchasemoney mortgage. see irc § 108(e)(5). the forgiveness of indebtedness by a third-party creditor who is not the seller of the property purchased with the debt results in the realization of cod income, the recognition of which can be deferred only by bankrupt or insolvent debtors and certain farmers under section 108(a). the deferral mechanism in those instances might in fact be the lowering of basis of property owned by the taxpayer, including property purchased with the debt proceeds. see id. §§ 108(a), (b)(2)(d). (b)15), 1017: regs. § 1.101719921 florida tax review building fell to $800,000 in 1989, the creditor agreed to a modification of the debt to reduce the outstanding principal amount from $1,000,000 to $800,000.11 the ruling determined that the debtor realized $200,000 of cod income. after describing tufts, gershkowitz, and fulton gold, the ruling concludes: the tufts and gershkowitz decisions implicitly reject any interpretation of fulton gold that a reduction in the amount of a nonrecourse liability by the holder of the debt who was not the seller of the property securing the liability results in a reduction of the basis in that property, rather than discharge of indebtedness income for the year of the reduction. fulton gold, interpreted in this manner, is inconsistent with tufts and gershkowitz. therefore, that interpretation is rejected and will not be followed. 36 the internal revenue service and the courts have thus laid to rest any putative dichotomy between the treatment of discharged recourse and nonrecourse debt that may have once reigned, at least in theory, when the debt discharge does not arise by reason of transfer of the securing property. whether recourse or nonrecourse, the discharged debt creates cod income. the conceptual approach evident in the rejection of fulton gold is the view that the tax consequences of the debt, whether recourse or nonrecourse, should be considered separately from the tax consequences of the ownership of the securing property. the rule attributed to fulton gold, under which discharge of nonrecourse debt resulted in a reduction of the securing property's basis, did not view nonrecourse debt as a tax incident separate from the taxpayer's ownership interest in the securing property. the nonrecourse debt was considered so intimately bound with the ownership interest in the securing property that a cancellation of all or part of the debt simply reduced the property's basis. (it is ironic that both the service and the tax court cited tufts, the case which cemented the dichotomous approaches to recourse and nonrecourse debt contained in the regulations on the transfer of property resulting in the cancellation of debt, as requiring an abandonment l(a)(1). it is broader in the sense that it applies to both recourse and nonrecourse debt whereas fulton gold applied only in the case of nonrecourse debt. cf. rev. rul. 92-99, 1992-46 i.r.b. 5 (reduction of nonrecourse purchase debt held by third-party lender results in cod income, not a basis reduction under section 108(e)(5), because the debt was not of the purchaser "to the seller"). 135. rev. rul. 91-31, 1991-1 c.b. at 19. 136. id. at 20. [vol 1:3 tufts md the evolution of debt-discharge themy of such dichotomous approaches when the securing property is not transferred. tufts, after all, is the quintessential case treating nonrecourse debt as part and parcel of ownership of the property rather than as an independent tax attribute.) in short, discharged nonrecourse debt is now analyzed separately from the ownership of the underlying property securing the debt when the securing property is retained. 137 this evolution in thinking is critical to considering the continued defensibility of using different approaches to recourse debt and nonrecourse debt when the debt discharge occurs upon transfer of the securing property because the debt is satisfied with property worth less than the debt and the lender either chooses not to collect or is precluded from collecting the deficiency. in view of the conforming conceptual approach regarding recourse and nonrecourse debt in the context in which the collateral is retained, the question regarding the disparate treatment when the collateral is transferred becomes all the more pointed. the bifurcated approach in the transfer context analyzes the debt discharge separately from ownership of the underlying property, but that approach currently applies only in the case of recourse debt. in the case of nonrecourse debt, the approach inherent in revenue ruling 91-31-i.e., similarly treating the nonrecourse debt discharge separately from ownership of the securing property-is rejected when the debt discharge arises by reason of transfer of the property. thus, in the transfer context alone does the view that nonrecourse debt and ownership of the securing property are a single, inseparable construct (which requires the collapsed approach under section 1001) continue to hold sway. the only distinguishing feature between the situation in which relief from nonrecourse debt arises without a transfer of the securing property and the situation in which relief from nonrecourse debt arises by reason of a transfer of the securing property is, of course, the transfer itself. yet, in the first situation the nonrecourse debt is, as a conceptual matter, considered separately from the property ownership (resulting in cod income rather than a reduced basis in the securing property under the cost basis rule of section 1012) while in the second situation the nonrecourse debt is, as a conceptual matter, viewed as inseparable from the property ownership (entering into the calculation of "gain from dealings in property" under sections 1001 and 137. the only exception arises in the case of purchase-money debt. w here the statute itself treats the transaction as a renegotiation of the purchase price by the seller rather than as debt discharge. see supra notes 8. 134 (discussing section 108ielt5)). because of the competing factual characterization vying for attention in the context of a purchase-money mortgage (see discussion supra note 8). that statutory rule does not shed light on the proper conceptual approach to take in the absence of a competing factual interpretation of the transaction. 1992] florida tax review 61 (a)(3) rather than resulting in cod income). thus, the act of transfer itself must somehow hold the key to the justification for viewing the nonrecourse debt in fundamentally different ways as a conceptual matter at different times in the ownership period. does it? subsection d considers two possible arguments. identifying the conceptual argument, if any, that justifies these disparate approaches becomes critical when one considers the consequences, even manipulation (described next in subsection c), that can occur because of the disparate approaches. what appear to be improper consequences, after all, are not improper if there truly is a conceptual, substantive basis justifying these incongruous results. c. real-world consequences of the dichotomy most of the real-world consequences described below no doubt ran through the reader's mind upon considering the composite result of the section 108 rules, the dichotomous approaches used on the transfer of property depending on whether debt is recourse or nonrecourse, the gershkowitz case, and revenue ruling 91-31. the results described below are the product of the intersection of three sets of rules: (1) section 108 allows deferral of cod income realized under section 61(a)(12) by financially strapped debtors but not deferral of gain realized from property under sections 1001 and 61(a)(3) that results because of debt discharge;'38 (2) the cancellation of recourse debt is treated differently from nonrecourse debt when the securing property is transferred in satisfaction of a debt exceeding the property's value;' 39 and (3) the cancellation of nonrecourse debt itself is treated differently depending upon whether the securing property is transferred or retained upon discharge of the debt. 4 ° as described below, these results could all be conformed if the bifurcated approach were adopted for nonrecourse debt in the transfer context. congress has decided as a policy matter (whether wise or unwise) that financially strapped debtors ought to be able to defer the recognition of realized income arising from the discharge of indebtedness and pay tax on it 138. see discussion supra note 8 (describing deferral under section 108(a)). cf. timothy m. larason, is gain on transfer of property to creditor by insolvent taxpayer subject to income tax?, special report, 49 tax notes 1135 (dec. 3, 1990) (arguing that congress may have intended gain realized under section 1001 on the transfer of property in discharge of a nonrecourse debt to be excludable under section 108(a) by insolvent debtors). 139. see supra notes 4-14 and accompanying text (describing the bifurcated and collapsed approaches). 140. see supra notes 9-14 and accompanying text (describing the collapsed approach in the transfer context) and notes 132-37 and accompanying text (describing revenue ruling 91-31, 1991-1 c.b. 19, in the retained-collateral context). [val 1:3 tufts and rite evolution of debt-discharge theorv slowly over time (presumably when they are in a healthier financial condition) by reducing favorable tax attributes, including the depreciable basis of property.4 such debtors cannot defer tufts gain arising under section 1001 because of the discharge of previously untaxed loan proceeds, notwithstanding that the justification for taxing both cod income and the gain arising under the collapsed approach is the same: the release from the obligation to repay previously received untaxed loan proceeds with after-tax dollars. 42 thus, an insolvent or bankrupt debtor who transfers property in foreclosure to a creditor in satisfaction of a nonrecourse debt exceeding the value of the property transferred cannot defer the portion of the gain realized under the collapsed approach that would have been cod income under the bifurcated approach. in estate of delnan v. conmnissioner,14-' for example, an insolvent taxpayer transferred property with a fair market value of $400,000 and adjusted basis of $500,000 to a creditor in foreclosure of a $1,200,000 nonrecourse debt.'" under the collapsed approach used for nonrecourse debt, the tax court confirmed that the transfer produced a gain of $700,000 under section 1001. such gain could not be deferred under section 108(a) by reducing the basis of property held by the taxpayer under section 108(b) (as the taxpayer argued) because the "gain" arising under section 1001 is by definition not cod income. had the debt been recourse, the bifurcated approach would have controlled, producing $800,000 of deferrable cod income and a $100,000 deductible loss. 45 just as in tufts, the net anount taken into account for tax purposes would have been the same whether the collapsed approach or bifurcated approach controlled.' 6 however, because only the bifurcated approach creates cod income, the nature of the debt as recourse or nonrecourse determined whether the taxpayer was entitled to deferral of the tax bill on that amount. although the tax court correctly applied tufts in the delman case, 141. see supra note 8 (describing deferral under section 108(a1). 142. see supra notes 81-117 and accompanying text (discussing the overlap of justice blackmun's rationale in tufts with cod-income theory). 143. 73 t.c. 15 (1979). 144. the numbers are rounded for ease of discussion. 145. the s1,200,000 debt would be considered satisfied with the property valued at $400,000, producing $800,000 of cod income. the difference between the value of the property and its adjusted basis would produce a deductible loss under sections 1001 and 165, as the property was held for investment. 146. see supra notes 35-36 and accompanying text. just as in tufts, however, the character of the gain might have been different. see supra notes 35-36 and accompanying text. even the amount would have been different if the taxpayer had insufficient tax attributes and depreciable property to cover the amount of realized cod income. see supra note 8. 19921 florida tax review the case illustrates one of the incongruities produced by tufts. in the delman situation, the taxpayer is insolvent whether the debt is recourse or nonrecourse; the accession to wealth arises by reason of debt cancellation whether the debt is recourse or nonrecourse; but if the debt is recourse, the tax bill is deferred, while if the debt is nonrecourse, the bill is not deferred. it seems that horizontal equity" 7 is violated for no justifiable reason unless there is a satisfactory conceptual justification for viewing nonrecourse debt at the point of transfer as part of the ownership interest in the underlying property, while at the same time viewing recourse debt at the point of transfer as separate from the underlying property, as well as viewing nonrecourse debt at all times prior to the point of transfer as separate from the underlying property.1 48 the difference in treatment encourages the structuring of transactions that differ in form but not substance' 49-a boon perhaps to tax lawyers advising their clients but at the least unsettling to those who believe that disparate treatment should be soundly based in theory. witt and lyons advise that [i]f the nonrecourse debt is to be discharged in full as a result of the transfer of the collateral back to the lender, then an insolvent taxpayer might consider (1) converting a nonrecourse debt into a recourse debt prior to the disposition of the collateral; (2) selling the collateral with the lender's consent and cooperation and using the proceeds to satisfy the nonrecourse debt; or (3) discharging a portion of the debt by making a cash payment on the debt and then transferring the property to the original lender. the third alternative should prevent classification of the transaction as a sale of the collateral because the taxpayer has not satisfied the nonrecourse debt according to its terms. thus, the justification ... for treating the transfer of collateral to the lender in satisfaction of nonrecourse debt as a sale of the collateral does not 147. "horizontal equity" refers to the maxim that similarly situated taxpayers ought to be taxed similarly. 148. see supra notes 137-38 and accompanying text (discussing the differing conceptual approaches apparent in the collapsed approach on the one hand and both the bifurcated approach and the approach of revenue ruling 91-31, 1991-1 c.b. 19, on the other). 149. witt and lyons have (euphemistically?) referred to the ability to structure a transaction to suit these disparate tax results as a "planning opportunity." see witt & lyons, supra note 8, at 61. professor shaviro labels as "tax overhead costs" or "deadweight costs" the increased resources devoted to tax planning, compliance, and administration stemming from tax rules that may not be soundly based. see shaviro, supra note 9, at 437. [vol 1:3 tufts and the evolution of debt-discharge theory exist 50 the first of these "planning opportunities"'"' described by witt and lyons arises because of the dichotomous approaches to nonrecourse debt and recourse debt in the transfer context. whether the debt is considered recourse or nonrecourse in this context proves to be crucial, as in the delman case.152 if the bifurcated approach were applied to nonrecourse debt as well 150. witt & lyons, supra note 8, at 61. witt and lyons exemplify the benefits of these alternatives with the following example. donald debtor purchases a building, giving the seller a nonrecourse note for $20,000. in 1990, the note remains unpaid and the building has a fair market value of $15,000 and an adjusted basis to debtor of s16,000. if debtor transfers the building back to the original seller, the service would treat the transfer as a sale of the building and debtor would realize and recognize $4,000 of gain ..., none of which would be eligible for exclusion under section 108. to avoid this result. debtor should consider the following alternatives: (1) convert the nonrecourse debt to recourse debt. then transfer the building to the original seller in satisfaction of the debt. under the regulations, debtor would have to bifurcate the transaction, recognizing a $1,000 loss on the transfer ... and $5,000 of discharge of indebtedness income.... if debtor is insolvent or the subject of a title ii proceeding.... he could take advantage of the benefits of section 108. (2) with the consent and cooperation of the nonrecourse lender, sell the building to a third party for $15,000 and use the proceeds to satisfy the nonrecourse debt. debtor would have the same tax results as in alternative (1). (3) make a partial payment of, for example, si.000 on the $20,000 nonrecourse debt, then transfer the building to the original seller in satisfaction of the remaining debt. although the service would treat a discharge accomplished solely by the transfer of the building back to the original seller as a sale of the building, the cash payment should change that result. debtor would have $4,000 of discharge income ... and would realize a loss of $1,000.... witt & lyons, supra note 8, at 62-63 (footnote omitted). 151. see supra note 149. 152. in bressi v. commissioner, 62 t.c.m. (cch) 1668. t.c.m. (p-h) 1 91,651 (1991), discussed supra note 72, the taxpayer argued that the debt discharged on a transfer of property in lieu of foreclosure was nonrecourse. requiring the collapsed approach to control. (apparently the solvent taxpayer preferred gain under section 1001 to cod income under section 61(a)(12) because at least part of the gain would have been taxed as capital gain.) the tax court concluded that the debt was recourse, applied the bifurcated approach, and held that the taxpayer realized cod income instead of gain. the bottom line was that the taxpayer paid a premium for failing to consult a sage tax advisor prior to transferring the property back to the creditor in lieu of foreclosure. as the creditor received nothing but the property anyway, the creditor might have been willing to convert the nominally recourse loan into a nonrecourse loan prior to the transfer. see also lee a. sheppard. forgiveness of nonrecourse debt and other problems, news analysis, 54 tax notes 784 (feb. 17. 1992) (considering, among other 19921 florida tax review as recourse debt in the transfer context, this difference would disappear. there would be no need to convert the debt to the desired status in order to choose a desired treatment or avoid an undesired treatment. cod income would be created on the relief from debt-whether recourse or nonrecourse-not additional gain under section 1001, and the chips would fall where they would. insolvent and bankrupt debtors would be able to defer the income, which seems to be consistent with congress's desire with respect to debt relief, and solvent debtors would pay tax immediately on the accession to wealth at ordinary income tax rates. the second and third "planning opportunities" described by witt and lyons arise because of the disparate treatments accorded a discharge of nonrecourse debt itself depending upon whether the discharge occurs because of a transfer of the collateral or a transfer of cash. the facts of gershkowitz, described earlier,'53 exemplify this disparate treatment most dramatically. the structure used in gershkowitz was prompted by the fact that the cancellation of nonrecourse debt without a transfer of the securing property produces cod income while the cancellation of nonrecourse debt by reason of a transfer of the securing property produces property gain. recall that in gershkowitz the collateral securing a $250,000 nonrecourse debt had an adjusted basis of $50,000 and a fair market value of only $2,500 at the time of the transaction at issue. 54 under the collapsed approach, the taxpayer, a partnership, would have realized and recognized $200,000 of gain under sections 1001 and 61(a)(3) if it simply transferred the property back to the creditor. the partnership was insolvent at the time and so negotiated with the creditor a discharge of the nonrecourse debt for a payment of $40,000-an amount far in excess of the value of the collateral the creditor would have received on foreclosure-in the hope of creating deferrable cod income instead of gain. because the collateral was retained, there was no realization event under section 1001, and so the court held that the taxpayer realized $210,000 of cod income. 55 things, whether parties can ensure cod income rather than gain under section 1001 by converting nonrecourse debt into recourse debt shortly before a forced sale). 153. see supra notes 125-31 and accompanying text (discussing gershkowitz). 154. see supra notes 125-31 and accompanying text (discussing gershkowitz). 155. gershkowitz v. commissioner, 88 t.c. 984, 1009 (1987). on the particular facts of the case, the partners' hopes of deferral were dashed in any event. the partners themselves were all solvent, and the court held that the insolvency exception of section 108(a) should be applied at the partner, not the partnership, level. this result is now codified at section 108(d)(6). other taxpayers outside the partnership context, however, learned of a wonderful "planning opportunity" (see discussion supra note 149) upon reading the case. as witt and lyons put it: gershkowitz is significant for a number of reasons. principally, it illustrates the differing tax consequences that will result depending upon [vol 1:3 tufts and the evolution of debt-discharge theory in so doing, the court, at least implicitly, rejected the fulton gold approach to the discharge of nonrecourse debt in the retained-collateral context. that case, as discussed above, 56 came to stand for the proposition that a discharge of nonrecourse debt without a transfer of the securing property does not result in cod income but rather results in a decrease in basis to the extent thereof. the implicit conceptual underpinning of the fulton gold approach is that the debt should not be considered a tax attribute separate from the underlying property securing the debt. that is the approach inherent in the collapsed approach to nonrecourse debt in the transfer context and the approach rejected in the bifurcated approach to recourse debt in the transfer context. the fulton gold approach would have produced either a negative basis or income that escapes taxation and so its rejection in gershkowitz might be easily defended. but its rejection is an implicit rejection of its conceptual basis as well, which collapsed the nonrecourse debt into the property ownership, the conceptual basis which continues to control the very same debt in the transfer context. if the bifurcated approach were extended to nonrecourse debt in the transfer context, this "planning opportunity," too, would disappear. whether the discharge of the nonrecourse debt in gershkowitz resulted because of a transfer of collateral worth $2,500 or a transfer of $2,500 in cash, the discharge would produce cod income, and the chips would fall where they would. insolvent or bankrupt taxpayers could defer the income; others could not. once again, there would be no need to make sure the correct item is transferred in connection with the debt cancellation in order to produce the desired tax results or avoid undesired tax results. for these "planning opportunities" to be justified, the dichotomous approaches to recourse and nonrecourse debt in the transfer context must be justifiable as a conceptual matter. d. asserted justifications for the dichotomy the collapsed approach is certainly not without its supporters. since tufts, many commentators, including eminent professors such as douglas a. the form in which taxpayers structure a debt cancellation transaction. in the context of a nonrecourse debt, the case confirms that a taxpayer can realize discharge of indebtedness income by paying cash in satisfaction of the debt. on the other hand, if capital gain or loss is desirable, then the taxpayer can produce a section 1001 sale or exchange by transferring the property securing the debt or property with no relation to the initial borrowing transaction to the lender in satisfaction of the debt. witt & lyons, supra note 8, at 80. the service confirmed these results regarding cod income in revenue ruling 91-31, 1991-1 c.b. 19. see supra notes 132-36 and accompanying text. 156. see supra notes 118-24 and accompanying text (discussing fulton gold). 19921 florida tax review kahn, 57 have defended the use of the collapsed approach for nonrecourse debt while maintaining the use of the bifurcated approach for recourse debt for reasons independent of the stated reasoning of the tufts court majority. they defend the collapsed approach, under which the debt relief is deemed tied too intimately to the property disposition to be treated independently, by arguing that there is, in fact, no debt discharge. some simply argue that the debt is satisfied in full according to the terms of the debt obligation by the transfer of the property and thus there is no income from the "discharge" of indebtedness within the meaning of section 61(a)(12) by definition.' some take the analysis a step further by viewing nonrecourse debt as encompassing an option component to put'59 the property back to the creditor if the fair market value of the property falls 157. professor kahn is the paul g. kauper professor of law at the university of michigan. see the directory, supra note 31, at 501. see also infra notes 162-73 and accompanying text (discussing professor kahn's position). 158. see, for example, the following quotation from fred t. witt and william h. lyons: [t]he distinction drawn by the regulations between recourse and nonrecourse debt is necessary because treasury and the service have adopted the position, accepted by the supreme court in commissioner v. tufts, that nonrecourse debt is true debt. under this position, a transfer of collateral to the lender in satisfaction of a nonrecourse debt will not give rise to discharge of indebtedness income because the debt has been satisfied according to its terms. that is, the lender's only recourse in the event of a default on the debt instrument is repossession of the collateral. witt & lyons, supra note 8, at 59 (emphasis added) (footnotes omitted). 159. a "put" is an option entitling the holder to sell property for a specified price to the other party to the option. a more far-reaching analysis of nonrecourse debt is to view the lender as the true owner of the property with the debtor as the holder of a "call" option, an option entitling the holder to purchase property for a specified price from the other party to the option, which the debtor would exercise by paying off the purported "principal amount" if the fair market value of the property continues to exceed the amount of the purported debt. see robinson, supra note 9, at 42-43 (discussing this approach in extreme cases). this analysis was suggested by the tax court in estate of franklin v. commissioner, 64 t.c. 752 (1975), aff'd, 544 f.2d 1045 (9th cir. 1976), in which the amount of nonrecourse debt exceeded the fair market value of the property ostensibly purchased with the debt by such an exorbitant amount that the tax court concluded that all the buyers had done in effect was to purchase a call option for the property with the purported "down payment." 64 t.c. at 762 & n.7; 544 f.2d at 1047 n.3. in such cases, foreclosure would not result in a property disposition under section 1001 for the debtor, as the debtor is never considered as owning the property for tax purposes. the debt is not respected as bona fide debt. in less extreme cases, in those run-of-the-mill situations in which the nonrecourse purchase debt is not so inflated that no purchase is deemed to occur in the first instance, the debtor is considered as the owner of the property for tax purposes, which raises the question of the debtor's proper treatment on disposition. it is to that more common situation that the put-option analysis is argued to apply. [val. 1:3 tufts and the evolution of debt-discharge theory below the principal amount of the indebtedness. 16 the agreed strike price of the put is whatever the amount of the outstanding indebtedness happens to be at the time of transfer. the accession to wealth is so intimately tied to the property disposition, arising as it does because of an imputed contract right to sell the property to the creditor (in effect), that the accession to wealth is properly analyzed under section 1001 rather than section 61(a)(12). the more simplistic version of the argument-that the debt is satisfied in full according to its terms and thus cannot by definition give rise to cod income-is beguiling but is a red herring. it attaches too much significance to the raw terminology in section 61(a)(12), on the literal meaning of the word "satisfied" as well as the literal meaning of the word "discharged," while losing sight of the structural reason why the accession to wealth which that section labels "income from the discharge of indebtedness" is included in gross income in the first place. 6' such a reliance on the dictionary definition of words focuses on nonissues that arise because of an excessive solicitude to the perceived exactitude of the meaning of words severed from their structural context as part of the internal revenue code. the point is not that congress should have chosen better words than "discharge of indebtedness" to describe the accession to wealth-the words are as clear as they probably can be-but rather that those words must be given meaning by taking account of the larger structural context in which they are used. the salient inquiry is not whether the debt is "'satisfied" according to its terms for commercial law purposes, as surely it is in such situations, but rather how the accession to wealth that arises on the transfer, because of the prior tax exclusion of the full amount of the loan proceeds that are in fact not fully repaid, should be taken into account for tax purposes. making the semantic argument that the debt is "satisfied" (or "unenforceable") for commercial law purposes does not help answer that tar question. the fact remains that there is an accession to wealth that must be accounted for, it arises solely because of the prior exclusion of loan proceeds, and thus it is intimately tied to the failure to repay that full amount of previously excluded dollars with after-tax dollars. that relationship between the prior exclusion and failure to repay with after-tax dollars is the conceptual underpinning for taxing cod income, 160. see, e.g., yishai beer, nonrecourse loans: do not forget to tax the option. special report, 53 tax notes 837 (nov. 18. 1991); cunningham 1, supra note 14, at 593; alvin d. lurie, new ghosts for old-crane footnote 37 is dead (or is it?). 2 am. j. tax pol'y 89, 96 n.15 (1983); willis ii, supra note 101; willis i, supra note 85. at 634-35. 161. similarly, unenforceability of a debt is thought by some to be a significant factor to consider in the debt-discharge area because of the terminology used. a debt is not "discharged," the argument goes, if it could not be enforced. see discussion supra notes 114-15 and accompanying text; discussion infra notes 167. 217. 19921 florida tax review not property gain. after all, the amount of gain inherent in property is related to the yet-untaxed appreciation in value since purchase owing to the rule of administrative convenience embodied in the realization requirement (that such gain will be deferred during ownership in order to avoid annual valuations). property gain (or loss) is thus intimately tied to value, not to the excess debt encumbering it. the collapsed approach distorts the gain component of the transaction, transforming a mere deferral rule (the realization requirement) into a rule that alters the amount of gain. analyzing whether a debt is literally "discharged" for commercial law purposes and, since it is not, then relying on the fallback provisions of the gain-realization provisions (in order to ensure that the accession to wealth that indisputably occurs on the transaction does not escape taxation altogether) loses sight of the underlying conceptual rationale for taxing the accession to wealth that arises in these situations in the first place. the failure to repay debt is the only fact that is relevant. the more sophisticated version of the argument (which seems to be at the root of even the more simplistic version)-that nonrecourse debt should be considered as encompassing a put option that is exercised on transfer which requires the accession to wealth to be controlled by the provisions pertaining to property dispositions-is more beguiling still because of its technicality. without using the term "option," professor kahn, in his student treatise, states the argument in the following way in defending the disparate treatment between recourse and nonrecourse debt in the tufts situation. if a loan is made to a taxpayer on a nonrecourse basis, the lender implicitly agrees to accept the encumbered property as full payment for the outstanding balance of the debt if the debtor does not satisfy the debt in cash or other property. in effect, the parties agree at arms' length that the property will be treated by them as never having a value that is less than the amount of the outstanding debt. so, if the property is acquired by the creditor as the final payment on the debt, there is reason to treat the property as having been valued by the creditor and the debtor at a figure that is equal to the outstanding debt. the treatment of the entire debt as consideration for the transferred property in such cases is warranted by the usual rule that a value set at an arms' length bargain will not be disturbed by the tax authorities. on the other hand, when the debt is a recourse debt, the creditor has not consented at the time of the loan to treat the underlying property as never having a value that is less than the outstanding debt. to the contrary, the creditor has retained the right to collect from the debtor any deficiency in the payment received that results from an inadequacy in the [vol 1:3 tufts and the evoluion of debt-discharge theorn value of the encumbered property. so, if the creditor agrees to forego his right to collect the deficiency from the debtor, that constitutes a forgiveness by the creditor of that portion of the debt. the regulation reflects the reality that the creditor does forgive a portion of the debt when he chooses not to enforce his right to require the debtor to make-up [sic] the unpaid portion of the debt. 62 the quoted analysis turns on one misplaced assumption and two items that should have no relevance in determining the proper tax consequences of the accession to wealth that arises in these transfer situations. the assertion that the arm's-length agreement between creditor and debtor (that the value of the property should always be deemed to equal the outstanding principal at any point in time) should be respected for tax purposes is not convincing. even ann's-length agreements are suspect if the parties' tax positions are not adverse or if they do not report the arm's-length allocation consistently, and the fact is that, notwithstanding the implicit agreement described above, the lender will not treat the value of the property on foreclosure as equal to the outstanding loan amount for tax purposes. rather, the lender will value it at fair market value and take a deduction for the resulting "bad debt" under section 166.16moreover, requiring the lender to honor the implicit agreement by disallowing a bad debt deduction, if that is the alternative suggestion to the one advanced in this article, fails to account for the other weaknesses of this analysis. two items accorded persuasive force in the recourse context by professor kahn but that should be irrelevant in determining the proper tax consequences of the accession to wealth in the transfer situation are (1) the timzing of the agreement that a deficiency in repayment will not be pursued and (2) the unilateral versus bilateral nature of the agreement not to pursue a deficiency. professor kahn notes that the feature distinguishing a recourse debt from a nonrecourse debt is that in the former "the creditor has not consented at the time of the loan to treat the underlying property as never having a value that is less than the outstanding debt"'" and "that the creditor does forgive a portion of the debt when he chooses not to enforce his right ' 1 to collect any deficiency remaining upon transfer of the property. after stating these assertions, he fails to explain why they are relevant. 162. douglas a. kahn, federal income tax: a student's guide to the internal revenue code 492-93 (2d ed. 1992). 163. see cunningham i, supra note 14. at 595 (discussing authority confirming this result). 164. kahn, supra note 162, at 493 (emphasis added). 165. id. (emphasis added). 19921 florida tax review why should the timing of the agreement not to pursue a deficiency matter in determining the proper tax consequences of the debtor's accession to wealth that occurs only at the time the deficiency is not, in fact, pursued? in the nonrecourse situation, much seems to be made of the fact that the creditor foregoes collection of the deficiency before any deficiency arises whereas in the recourse situation the creditor does not forego collection of the deficiency until such time as the deficiency arises. why should that timing difference affect the tax analysis of the conceded accession to wealth that arises in both situations solely because the creditor will not, in fact, collect the entire loan amount previously advanced to the debtor and previously excluded from gross income for tax purposes? moreover, why should the voluntariness or involuntariness of the creditor's actions in foregoing collection of the deficiency affect the tax analysis of the conceded accession to wealth that arises in both situations solely because the creditor will not, in fact, collect the entire loan amount previously excluded from gross income for tax purposes? professor kahn implies that if the creditor voluntarily chooses to "forgive" a loan, the debtor realizes cod income but that if the creditor does not voluntarily choose to "forgive" a loan but rather fails to collect because of a bilateral agreement with the debtor, the debtor does not realize cod income, so the accession to wealth is properly analyzed as amount realized.'66 this reasoning ignores the conceptual underpinnings for taxing debtors when they fail to repay the full amount of previously excluded loan proceeds. while some do loosely refer to income arising under section 61 (a)(12) as "debt-forgiveness income," the conceptual underpinnings justifying the inclusion in gross income under section 61(a)(12) of recourse debt that is not fully repaid has nothing to do with the subjective state of mind of the creditor in failing to collect the entire amount of previously advanced (and untaxed as ordinary income) loan proceeds. the reason the debtor is taxed under section 61(a)(12) is simply because of the failure to repay with after-tax dollars the amount previously received from the lender and excluded from gross income solely on the assumption that the full principal amount would, in fact, be repaid with after-tax dollars. the proper perspective for the analysis is from the taxpayer-debtor's point of view. thus, the absence of that subjective state of mind on the part of the creditor to "forgive" voluntarily the debt in the nonrecourse context does not justify the conclusion that the accession to wealth that arises in the nonrecourse context should not be analyzed as cod income under section 61(a)(12). indeed, a bilateral agree166. the very evidence professor kahn seems to require to create cod income could result in its nontaxability. if the "forgiveness" arises out of "detached and disinterested generosity," commissioner v. duberstein, 363 u.s. 278 (1960), the realized cod income could be excluded from gross income as a gift under section 102. [vol 1:3 tufts and the evohtion of debt-discharge theory ment entered into between the debtor and lender to reduce nonrecourse debt after the initial loan is incurred will result in cod income if the collateral is retained t67 nonrecourse debt simply limits the creditor's ability to pursue full collection under commercial law of the amount previously received untaxed by the debtor-no more. as justice blackmun emphasized in tufts itself: the only difference between [a nonrecoursel mortgage and one on which the borrower is personally liable is that the mortgagee's remedy is limited to foreclosing on the securing property. this difference does not alter the nature of the obligation; its only effect is to shift from the borrower to the lender any potential loss caused by devaluation of the property. if the fair market value of the property falls below the amount of the outstanding obligation, the mortgagee's ability to protect its interests is impaired, for the mortgagor is free to abandon the property to the mortgagee and be relieved of his obligation. this, however, does not erase the fact that the mortgagor received the loan proceeds tax-free and included them in his basis on the understanding that he had an obligation to repay the full amount. when the obligation is canceled, the mortgagor is relieved of his responsibility to repay the sum he originally received and thus realizes value to that extent .... 68 there is no getting around the fact that the accession to wealth for tax purposes arises solely because of that previous exclusion of loan proceeds-the very heart of cod-income theory-whether or not the loan proceeds were advanced on terms giving the lender recourse beyond the value of the collateral and whether or not the occasion for failure to pay the entire nonrecourse indebtedness is a transfer of the collateral (which produces gain under current law) or a bilateral modification of the loan agreement (which 167. see supra notes 132-36 and accompanying text discussing revenue ruling 91-31, 1991-1 c.b. 19. professor kahn's implicit argument-that in order for a debtor to realize cod income the creditor must "forgive" the debt by "choos[ingl not to enforce his right" to collect the debt in full--suffers from the same weakness of looking to the enforceability of the debt that is found in the zarin and schlifke cases. see supra notes 114-15 and accompanying text; supra note 162 and accompanying text. discussion infra note 217. the implicit message is that only debt that is enforceable but that is not in fact enforced by the creditor can result in cod income when not collected in full. that reasoning simply loses sight of the conceptual basis for taxing cod income in the first place. 168. tufts v. commissioner. 461 u.s. 300. 311-12 (1983) (citations omitted). 19921 florida tax review produces cod income under current law). the reason the lender fails to collect does not affect the debtor's accession to wealth for tax purposes, and the transfer of the collateral is simply the event that identifies that the remaining indebtedness will never be repaid, thus triggering the realization of ordinary income previously deferred on the assumption the loan proceeds previously received would be repaid in full. the most fundamental problem with the put-option justification for the collapsed approach, however, is that it is inconsistent with treating nonrecourse debt as "true debt" in full as does current law except in the most abusive of situations.'69 the put option that is deemed embedded in all nonrecourse debt under this approach is never taxed as an option during the ownership of the property. for example, the premium deemed paid for the put is never treated as a premium paid for a put; it is treated as additional interest.17° it is inconsistent to argue on the one hand that a put should be deemed to be a part of all nonrecourse debt at the time the property is transferred in satisfaction of a debt exceeding the property's value (justifying the collapsed approach) but to ignore the put on the other hand at all other times during the property ownership. 7' that conclusion, however, does not mean 169. see supra text accompanying note 25 (quoting justice blackmun as characterizing the nonrecourse debt in tufts as a "true loan" for tax purposes). while not addressing in particular the dichotomy between the bifurcated and collapsed approaches in the tufts situation, professor shaviro argues that "the existing nonrecourse debt rules involve an absurd and unnecessary level of contradiction and complexity. the rules should be consolidated and changed to treat nonrecourse debt somewhat more like personal liability debt." shaviro, supra note 9, at 405. "[o]nly the overstatement of purchase price argument provides a convincing ground for treating nonrecourse debt differently than personal liability debt." id. at 432. professor shaviro is referring to the issue left unanswered in the tufts case itself: what was the purchaser's basis? see jensen i, supra note 21. because acquisition nonrecourse liability is included in basis, the potential for abuse in overstating the amount of acquisition nonrecourse indebtedness can be a problem. this potential is greatest in the case of sellerprovided nonrecourse financing (as opposed to the acquisition of property subject to preexisting nonrecourse indebtedness). see generally jensen ii, supra note 41, at 645-46 (discussing these different abuse potentials); discussion supra note 159 (discussing the estate of franklin case); discussion supra note 76 (citing and discussing the pertinent regulation). however, once the purchaser's appropriate cost basis is determined under the analysis set forth in professor jensen's article (i.e., once it is determined whether to respect the debt as "true debt"), the tax consequences on disposition of the property should not differ depending on whether that debt is labelled recourse or nonrecourse. 170. see generally beer, supra note 160; willis ii, supra note 101 (both describing what the authors conclude should be the appropriate tax consequences under the option rules if the put option is recognized and given effect during the ownership period). 171. the put-option argument is less extreme than some other views of nonrecourse debt because it recognizes the debt as true debt to a great extent. it simply adds the put option to the deal. other arguments that are also far from absurd can be made that nonrecourse debt should not be treated as debt to any extent. one can argue that nonrecourse debt is nothing more than an opportunity to purchase the property securing the debt. see discussion supra note [vol 1:3 tufts and tire evolution of debt-discharge theory that a put option should, in fact, be given credence during the owner-ship period as well. as professor willis has persuasively illustrated, the put option some deem embedded in all nonrecourse debt is really nothing more than a risk premium-a premium paid to the lender for agreeing to shoulder the downside risk that the collateral will lose value-and risk premiums are not similarly segregated from recourse debt and treated as a put option, requiring application of the collapsed approach on transfer of the collateral." while clearly not absurd if viewed in isolation of other rules considered in this article,'73 the put-option justification for the collapsed approach does not have such strong conceptual force that the discontinuities described above in subsection c (which arise solely because of the collapsed approach) should be tolerated with an easy mind. the mind becomes more uneasy yet when the collapsed approach is considered in the context of personal-use property, discussed in part iv. iv. personal-use property: providing the answer it is time to return to the facts of the technical advice memorandum 159 (discussing the call-option approach in the estate of franklin casel. alternatively, one can view nonrecourse debt as co-ownership of the securing property by the debtor and creditor or as some other form of shared equity investment. see tufts. 461 u.s. at 308 n.5 (considering this alternative). as robinson notes, however, these alternative conceptions of nonrcourse debt have as their common denominator the view that a nonrecourse loan is something other than true debt. robinson, supra note 9, at 41. thus, these differing conceptions carry with them "far different tax treatment[s]" (robinson, supra note 9, at 41) than arise under current law. for example, such conceptions would alter the availability of depreciation deductions to the debtor who takes them in full under the current approach. except in abusive cases, the code-as well as the supreme court-rejects these more radical approaches to nonrecourse debt. viewing nonrecourse debt as true debt. see supra text accompanying note 168 (quoting tufts): discussion supra note 44 (describing the unsuccessful argument made in tufts's brief that nonrecourse debt is "not truly debt"). the evaluation of the collapsed approach has to be made with this fundamental structural decision to respect typical nonrecourse debt as "true debt" in mind. 172. professor willis illustrates this phenomenon with the hypothetical described infra text accompanying notes 188-90. see willis ii. supra note 101. at 447. shortly before this article went to press, beer published his views that even recourse debt should be considered to encompass a put option, and taxed accordingly, to the extent the creditor shoulders a risk of default in the particular facts and circumstances. see yishai beer, the taxation of the risk component in a loan: an option analysis, special report, 57 tax notes 525 (oct. 26. 19912). beer's approach argues for the adoption of the collapsed approach for both recourse and nonrecourse debt, a result which would, at the least, continue the disparate results that occur between the transfer and nontransfer contexts and which would continue to present problems in the context of personal-use property. see infra part iv. 173. see supra text accompanying notes 138-40 (describing the intersection of the collapsed approach with related rules). 19921 florida tax review with which this article began.174 in that memorandum, the creditor foreclosed on a personal residence in a nonjudicial foreclosure proceeding. the debtor had purchased the residence for $130,000; the residence had a fair market value of $100,000 at the time of foreclosure; and the outstanding indebtedness at that time was $122,000. although the loan documents themselves apparently did not limit the creditor's recourse rights, the creditor was barred from pursuing the deficiency in debt satisfaction under a state (alaska) antideficiency statute.'75 how was the debtor's accession to wealth upon failure to pay the remaining $22,000 of principal originally borrowed and excluded from gross income treated for tax purposes? one could easily argue that the effect of the state statute preventing the creditor from pursuing the deficiency against the debtor's other assets was to transform the nominally recourse loan into a nonrecourse loan. under the collapsed approach for nonrecourse debt, no cod income would be considered realized. 176 the debtor would be considered as transferring his property with a basis of $130,000 for an amount realized that included the remaining $122,000 indebtedness, producing an $8,000 nondeductible personal loss.'77 without even considering the effect of the state antideficiency statute on the debt's status as "recourse" or "nonrecourse," however, the ruling simply cited the bifurcated rule that applies in the case of recourse debt found in treasury regulation section 1.1001-2(c), example 8, and ruled that the debtor realized $22,000 in cod income.'78 under the bifurcated approach, the debtor also realized a $30,000 nondeductible personal loss.' 79 the issue actually considered in the ruling was whether the value of the residence should be considered in determining whether the debtor was "insolvent" within the meaning of section 108(d)(3) i's and thus entitled to 174. i.r.s. t.a.m. 9130005 (march 29, 1991). see supra text accompanying note 2. 175. the ruling fails to cite the alaska statute, but apparently the statute prevented creditors from pursuing deficiencies arising on foreclosure of personal residences or purchasemoney mortgages pertaining to real estate. see i.r.s. t.a.m. 9130005 (march 29, 1991). cf. infra note 186 (quoting california antideficiency statute). 176. see supra notes 9-14 and accompanying text (describing collapsed approach for nonrecourse debt). 177. see discussion supra note 13. 178. i.r.s. t.a.m. 9130005 (march 29, 1991). 179. see discussion supra note 7. 180. that subsection defines insolvency as "the excess of liabilities over the fair market value of assets. with respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer's assets and liabilities immediately before the discharge." on the liability side, the service recently ruled that "[t]he amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt is taken into account in determining whether, and to what extent, a taxpayer is insolvent within the meaning of section 108(d)(3) of the code, but [vol 1:3 tufts atu the evolution of debt-discharge theory use the deferral mechanism in sections 108(a) and (b) (which could result in complete forgiveness if the taxpayer had no tax attributes that could be reduced in lieu of immediate recognition of the cod income)."' if the residence were considered an "asset" for this purpose, the debtor would not be considered insolvent, but if the residence were not considered an "+asset" for this purpose, the debtor would be considered insolvent. the ruling concluded that the residence should not be considered an "asset" for purposes of testing insolvency by relying on the discredited freeing-up-of-assets rationale for the taxation of cod income in the first instance. "because the rationale for the insolvency exception is that where no assets are freed from claims of creditors no income is realized, only assets that are subject to claims of a taxpayer's creditors should be used to determine insolvency."'12 because the asset was exempt from the claims of creditors under the antideficiency statute that created the cod income in the first instance (obviously a bit circular), the ruling reasoned it should not be considered in determining insolvency. 3 the taxpayer could thus take advantage of the insolvency exclusion. there is much to consider here beyond the wiseness of the conclusion that assets exempt from creditors under state statutes should not be considered in determining solvency for purposes of the insolvency exclusion of federal tax law.1 4 first, why did the antideficiency statute not make the debt nononly to the extent that the excess nonrecourse debt is discharged." rev. rul. 92-53, 1992-27 i.r.b. 1. the service added that nonrecourse debt should also be treated as a liability in determining insolvency to the extent of the fair market value of the property securing the debt. id. 181. see discussion supra note 8 (describing the deferral mechanism under section 108(a)). 182. i.r.s. t.a.m. 9130005 (march 29. 1991). 183. the ruling is consistent with other rulings and cases similarly holding that assets exempt from the claims of creditors in whatever state in which the debtor happens to be residing should not be considered an "asset" in determining insolvency under section 108(d)(3). see, e.g., marcus estate v. commissioner, 34 t.c.m. (cch) 38. 41. t.c.m. (p-h) 75,009 at 43 (1975); davis v. commissioner, 69 t.c. 814 (1978); hunt v. commissioner, 57 t.c.m. (cch) 919, 946, t.c.m. (p-h) 1 89,335 at 1700 (1989). priv. let. rul. 9125010 (march 19, 1991) (all discussed in sheppard, supra note 152, at 787). 184. relying as it does on the outdated freeing-up-of-assets rationale underlying cod-income theory, the ruling's position has been criticized and is purportedly under reconsideration. see sheppard, supra note 152, at 787 (reporting that mary harmon. special assistant to the internal revenue service chief counsel, "stated that the chief counsel's office is re-examining the letter rulings in light of the demise of the freeing-of-assets theory"). the rationale for the insolvency exclusion now rests on a don't-kick-them-when-they-are-down rationale. see discussion supra note 8. cod income is undoubtedly realized by insolvent debtors on the discharge of indebtedness under the symmetry or tax-benefit rationale, but deferral of the tax bill until some point in the future is thought to allow some debtors to stay afloat. the mechanism is, admittedly, imperfect. it fails to ever tax cod income of insolvent 19921 florida tax review recourse, which (under the collapsed approach) would not produce cod income? what is nonrecourse debt but debt that deprives the creditor of recourse to assets beyond the securing collateral for satisfaction of the debt? should the loan papers alone determine whether debt is "nonrecourse" or "recourse" when so much is at stake for tax purposes depending on which label applies? in freeland v. commissioner,185 the debtor bought unimproved california real estate for $50,000 by paying $9,000 in cash and giving a purchase-money mortgage for the remaining $41,000. the debtor eventually transferred the property back to the vendor-creditor by quitclaim deed prior to the institution of foreclosure proceedings at a time when the property's value had fallen to $27,000 and the indebtedness remained at $41,000. a california antideficiency statute prevented the vendor-creditor from pursuing the deficiency. 86 the opinion states, "it is conceded that by application of ... [the antideficiency statute], the note in the instant case was secured only by the property and not by the personal liability of petitioner."'8 7 the opinion considered only whether the conveyance by the debtor to the vendordebtors who happen not to have any of the tax attributes that could preserve the income recognition for some future point. moreover, by failing to include an interest component similar to that found in section 453a pertaining to income deferred under the installment method, it fails to take account of the substantial tax savings that arise solely because of the income deferral. perhaps one could defend the ruling's position (halfheartedly at least) even under the don't-kick-them-when-they-are-down rationale for the insolvency exclusion. the exclusion, premised on an inability to pay, may be warranted if the assets protected by state statutes are the bare necessities needed for life, such as personal belongings and modest residences. perhaps the tax law ought not require immediate payment of the tax bill, allow deferral until some point in the future when the debtor is presumably in better financial health, if immediate payment would require sale of such personal assets. when one considers the opulence of some personal residences, however, the argument is not terribly persuasive. if this rationale carries the day, however, a further change in the implementation of it is nevertheless warranted. there are obvious horizontal equity problems-the possibility of treating similarly situated taxpayers differently-in relying on 50 different state exemption statutes in determining the definition of "insolvency" for federal tax purposes. just as a uniform definition of "alimony" was created for federal tax purposes that surely differs from many state statutes (see irc § 71), perhaps the code or regulations should spell out the extent to which personal assets should not be considered in determining insolvency for federal tax purposes. 185. 74 t.c. 970 (1980). 186. the case quotes the language of the statute as follows: "no deficiency judgment shall lie in any event after any sale of real property for failure of the purchaser to complete his contract of sale, or under a deed of trust, or mortgage, given to the vendor to secure payment of the balance of the purchase price...." id. at 971. thus, the california statute apparently applies to both personal-use and other real property but applies only to sellerfinanced mortgages. 187. id. at 971-72. [vol 1:3 tufts and the evolution qf debt-discharge theor" creditor constituted a "sale" (producing capital loss under the collapsed approach for nonrecourse debt) or an "abandonment" (producing an ordinary loss for failure to satisfy the "sale or exchange" requirement of section 1222 of the code). the court concluded that the conveyance constituted a "sale." should whether a state antideficiency statute transforms a debt into a nonrecourse debt depend on the concessions of the taxpayer and internal revenue service as in freeland? if we look beyond the loan documents themselves to state statutes in determining the status of a creditor's recourse rights, should we also look to the economic reality surrounding the creditor's nominal recourse rights? let us return to an example posited by professor willis." s joe wealthy and joe penniless are considering identical transactions and decide to go to the same bank for financing. on a recourse basis, the bank offers a rate of 8% to wealthy and 15% to penniless. the bank also offers a rate of 15% to wealthy on a nonrecourse basis. the difference in rates quoted to wealthy with respect to the recourse and nonrecourse loans reflects the risk assumed by the bank in the case of the nonrecourse loan that is absent in the case of the recourse loan. that same risk premium is also very apparent, however, in the 15% recourse loan offered to penniless. "penniless ... pays a large risk premium because the encumbered property is all he has. he and the bank do not label the loan nonrecourse, but the realist banker knows it really is. and penniless knows it, too."' 89 because penniless's loan is essentially nonrecourse when penniless's finances are considered, should that mean that the debt should be considered nonrecourse for tax purposes, resulting in application of the collapsed approach on disposition of the property for less than the outstanding indebtedness? economically, wealthy's nonrecourse loan and penniless's recourse loan are identical. "surely the 'labels' are insufficient grounds for disparate [tax] results."'190 a second-and more important-point to ponder in connection with the facts of the technical advice memorandum is that it illustrates the 188. see willis ii, supra note 101, at 447. 189. id. 190. id. in discussing the disparate tax results arising between recourse and nonrecourse debt on foreclosure in the partnership context. ms. sheppard writes: this article necessarily assumes that nonrecoursc liabilities can be distinguished from recourse liabilities for tax purposes. "i don't know what a nonrecourse liability is," one practitioner complains, noting that the term recourse can be confusing when the borrower is an entity [or a person such as penniless?] with limited liability. should a so-called -exculpatory" liability that is recourse to a partnership but nonrecourse to its partners be considered a recourse liability for tax purposes? ... in the case of a singleasset partnership, there may be no practical difference between a nonrecourse liability and an exculpatory liability. sheppard, supra note 152, at 785. 19921 florida tax review deficiency of the collapsed approach itself. if the antideficiency statute had resulted in transforming the indebtedness into nonrecourse debt (or if there had been no antideficiency statute but the loan itself had been styled "nonrecourse"), the collapsed approach would have produced an $8,000 nondeductible capital loss and no cod income instead of $22,000 of cod income coupled with a $30,000 nondeductible capital loss. that, for reasons developed below, is the wrong conceptual result. many have stated that the difference between the collapsed and bifurcated approaches is really one only of character191-itself an ambiguous concept 92 and thus perhaps not really particularly important (the availability of the section 108(a) exclusions aside). recall that in tufts the majority held that tufts realized $400,000 of gain under the collapsed approach while justice o'connor's concurring opinion preferred the bifurcated approach, under which tufts would have realized $450,000 of cod income and $50,000 of loss. the net amount taken into account on the tax return would have been $400,000 under either approach. in fact, in all business and investment contexts, the net amount taken into account for tax purposes will always be the same, whether the collapsed approach is applied or whether the bifurcated approach is applied, because both sides of the equation-the loss as well as the gain or income-will be cognizable for tax purposes. only the character-potentially deferable and ordinary cod income versus nondeferable capital gain or reduced capital loss-differs. the memorandum, because it deals with personal-use property, demonstrates the fallacy of the assumption that the net amount taken into account will always be the same, that the difference here is really one only of character. because the loss attributable to the property transaction under section 1001 will not be cognizable for tax purposes in view of the personal use of the property, the decision whether to apply the collapsed approach or bifurcated approach is critical in determining the actual amount that the taxpayer must take into account for tax purposes. the collapsed approach allows the taxpayer who finances personaluse property with nonrecourse debt, or debt considered to be nonrecourse, to escape taxation of the accession to wealth arising from failure to repay with 191. see supra note 35 and accompanying text. 192. see willis ii, supra note 101, at 446: unfortunately, tax law ... has ... distorting principles, not known to accounting. not the least of these is the bizarre notion of character. whoever originated this idea surely was not thinking as an accountant. from my standpoint, income is income. no principle of natural law makes gains-from an option or otherwise-capital and thus favored. only politicians hoping to control the economy do. [vol 1:3 tufts and the evolution of debt-discharge theory after-tax dollars loan proceeds used in personal consumption.' extrapolating from the facts of the memorandum, we can compare little bucks, who purchases a personal residence for $130,000 entirely with nonrecourse debt, with big bucks, a taxpayer who purchases an identical residence with $130,000 in cash. the difference between little bucks and big bucks is that little bucks can defer tax until repayment of the principal amount of the loan received free of tax while big bucks already paid tax on the entire $130,000 used to purchase the residence.' 94 both residences decrease in value to $100,000. the residence owned by little bucks is transferred to the creditor at a time when the outstanding indebtedness is $122,000; the residence owned by big bucks is sold for its fair market value of $100,000. big bucks realizes a $30,000 nondeductible personal loss, as her loss is considered one arising out of personal consumption rather than investment.195 little bucks, on the other hand, is considered as realizing only an $8,000 nondeductible personal loss under the collapsed approach. he realizes no cod income. by allowing little bucks to attribute the accession to wealth 193. the fact that the debtor described in the memorandum may not have recognized any income under the bifurcated approach is inapposite. (nonrecognition could occur because of the insolvency exclusion under section 108(a) coupled with the lack of tax attributes or depreciable property listed in section 108(b)). the policy reasons ostensibly supporting the insolvency exclusion can change and are independent from the conceptual rationale producing the realized income in the first instance. 194. see supra notes 89-91 and accompanying text (discussing this principle). 195. of course we all know that the decrease in value may have been due to market forces and not to wear and tear on the house arising out of its use for shelter. nevertheless, the loss on a house used as a personal residence is considered at the present time, for tax purposes, to arise from personal consumption and thus is nondeductible. regs. § 1.165-9(a). the only exception to this rule is in the case of substantial casualty losses, see section 165(c)(3) and (h), which are allowed to be deducted on ability-to-pay grounds (i.e.. verticalequity grounds). the ability of a taxpayer with substantial personal casualty losses to pay taxes is considered diminished. thus, to the extent losses exceed a threshold below which ability to pay is not considered substantially diminished, the loss is deductible. this is the same rationale underlying the deduction for medical expenses, a deduction for personal consumption which also includes a threshold. but see louis kaplow, the income tax as insurance: the casualty loss and medical expense deductions and the exclusion of medical insurance premiums, 79 cal. l. rev. 1485 (1991) (arguing that the casualty loss and medical expense deductions are premised on insurance principles rather than vertical-equity principles). see generally richard a. epstein, the consumption and loss of personal use property under the internal revenue code, 23 stan. l. rev. 454 (1971) (arguing that the current system mistaxes losses arising in connection with personal-use property). while we may challenge the wisdom of that underlying assumption-that losses on personal residences reflect personal consumption rather than investment losses-our analysis of the situation described in the technical advice memorandum has to take notice of the current decision and the disparate treatment under it between those who finance with recourse debt (see infra note 197), those who have the opportunity to finance with nonrecourse debt. and those who pay cash. 19921 florida tax review that arises upon failure to repay $22,000 of the loan proceeds previously received free of tax to a decrease in his nondeductible loss, we have mistaxed little bucks. both big bucks and little bucks consume the same $30,000 of value in their personal residences, yet big bucks is disallowed a deduction for the entire $30,000 while little bucks is allowed, in effect, a deduction of $22,000 of that loss. if little bucks had paid tax on the income used to purchase the residence (either before purchase by not borrowing money for the purchase or on the transfer by charging him with $22,000 of cod income), he would have been similarly disallowed a deduction for the entire $30,000 loss as personal consumption instead of only for $8,000. allowing little bucks to escape taxation on the dollars used to purchase the residence gives him a backdoor deduction for that personal consumption; it allows personal consumption on a before-tax basis. the hypothetical involving nonrecourse debt secured by personal-use property-even if not very common or realistic in the real world-illustrates the inappropriateness of attributing the accession to wealth that arises on the failure to repay debt secured only by property to the taxpayer's ownership interest in the property itself. the accession to wealth is attributable to the debt or, more accurately, to the failure to repay loan proceeds previously received free of tax on the assumption that they would be repaid in full with after-tax dollars. thus, the accession to wealth in the tufts situation should produce cod income-not additional gain or decreased loss on the property disposition-just as it would if the property were retained rather than transferred and just as it would if the debt were recourse.' 96 big bucks and little bucks both realize $30,000 in nondeductible personal consumption. little bucks also realizes $22,000 in cod income because of the failure to repay with after-tax dollars $22,000 of the original $130,000 before-tax dollars used to purchase the residence.'97 this analysis does not mean that we should have a special rule applying the bifurcated approach to tufts transfers involving nonrecourse debt in the case of personal-use property while maintaining the collapsed approach for business and investment property. moreover, because the hypothetical demonstrates why the collapsed approach itself is flawed conceptually, it also 196. see supra notes 132-36 and accompanying text (discussing revenue ruling 9131, 1991-1 c.b. 19, in the retained collateral context) and notes 4-8 and accompanying text (describing the bifurcated approach in the transfer context for recourse debt). 197. the same incongruous results would occur if big bucks had not purchased her residence with cash but rather incurred a recourse loan for the entire $130,000 purchase price and, just as little bucks, then transferred the residence to the creditor at a time when the residence was worth only $100,000 but the outstanding debt (which the creditor does not pursue) is $122,000. under the bifurcated approach applied to recourse debt, big bucks would still realize a $30,000 nondeductible personal loss. under this scenario, however, big bucks would also realize $22,000 of cod income. so should little bucks. [vol 1:3 tufts and the evolution of debt-discharge theory demonstrates that our problems would not be solved by adopting the collapsed approach for both recourse and nonrecourse debt. while the manipulation described in part im. c. would be reduced if the collapsed approach were applied to all debt, the conceptual flaw inherent in the collapsed approach itself would remain. (moreover, such an approach would continue the disparate results that occur between the transfer and nontransfer contexts.) as has been noted elsewhere, one way to test the rationality of a theory is to apply it in other factual situations.'98 considering the collapsed approach in the context of personal-use property simply reveals more starkly the conceptual flaw in the collapsed approach itself: the inappropriate linking of the accession to wealth on the debt discharge to the tax consequences of the property disposition rather than to the debt itself. the collapsed approach should be abandoned once and for all. a niggling footnote must be considered in advocating that solution, however: the supreme court's decision in bowers v. kerbaugh-empire co. 199 the taxpayer in that case borrowed german marks before world war i, converted the borrowed funds into dollars, lost them in a business transaction, and finally repaid the post-war devalued marks with dollars that cost about $685,000 less than the borrowed marks were worth when received and originally converted into dollars. in effect, the taxpayer borrowed more than it repaid even though the transaction as a whole, considering the use to which the loan proceeds were put, resulted in a loss for the taxpayer. the court held that the difference between the value of the marks when received and when repaid was not income2° because the "the whole transaction was a loss"'" and "the mere diminution of loss is not gain, profit or income."20 2 in effect, the court applied the collapsed approach in considering the net effect of the borrowing transaction coupled with the transaction in which the proceeds were spent. though very poorly reasoned,20 ' kerbaugh-enzpire was not over198. deborah a. geier, the tax court, article ill, and the proposal advanced by the federal courts study committee: a study in applied constitutional theory. 76 cornell l. rev. 985, 988-89 (1991) (citing erik m. jensen, monroe g. mckay and american indian law: in honor of judge mckay's tenth anniversary on the federal bench. 1987 b.y.u. l rev. 1103, 1130). sorry, i was unable to work in this citation within the first five footnotes. see david a. golden, note, humor, the law, and judge kozinski's greatest hits, 1992 b.y.u. l. rev. 507, 507 n.* ("while this citation [of my own work] appears self-serving, good form seems to require an author to cite his or her most recent publication within the first five footnotes of a nev article."). 199. 271 u.s. 170 (1926). 200. such difference would clearly constitute income today. see irc § 988. 201. 271 u.s. at 175. 202. id. 203. taken literally, the kerbaugh-enpire rule would require tracing of all loan proceeds to evaluate whether a debt discharge produces cod income. no cod income would 19921 florida tax review ruled in kirby lumber;2° it was distinguished,"°5 thus giving some more contemporary judges reason to believe it might continue to have vitality in considering debt-discharge income. if it does, one could reasonably argue that little bucks ought not to be charged with income on the discharge of his $122,000 indebtedness for $100,000 when his house lost value-whether the debt is recourse or nonrecourse for that matter-because the "whole transaction was a loss," in the words of kerbaugh-empire. for example, one dissenting opinion in the tax court in zarin v. commissioner °6 discussed kerbaugh-empire as follows in arguing that a compulsive gambler who borrowed $3,400,000 from a casino, lost it all, and settled resulting debt-collection litigation for a payment of $500,000 does not realize $2,900,000 in cod income. i find it unnecessary to rely in kerbaugh-empire and therefore need not embrace or reject the approach of that case. i am constrained to note, however, that it does not follow from the "freeing of asset" approach adopted by the supreme court in commissioner v. glenshaw glass co., 348 u.s. 426 (1955), that kerbaugh-empire is moribund for all be deemed realized under this approach if the proceeds were used in an unprofitable transaction. "it is usually impossible to make this latter determination, however, since the borrowed funds are ordinarily absorbed into the business so completely that tracing the travels of interchangeable dollars lacks even the surface plausibility that it could claim in kerbaughempire." bittker & thompson, supra note 91, at 1162. in addition to that practical criticism, there is a more fundamental conceptual criticism to the court's approach. the business transaction in which the proceeds are lost would itself produce a deduction in most instances, thus producing the effect of a double deduction if the related cod income is not taken into account. see id. at 1163-64. 204. united states v. kirby lumber co., 284 u.s. 1 (1931). see supra note 8 (discussing kirby lumber). 205. kirby lumber dismissed kerbaugh-empire as follows: in bowers v. kerbaugh-empire co ... , [the taxpayer] owned the stock of another company that had borrowed money repayable in marks or their equivalent for an enterprise that failed. at the time of payment the marks had fallen in value, which so far as it went was a gain for the defendant in error, and it was contended by the plaintiff in error that the gain was taxable income. but the transaction as a whole was a loss, and the contention was denied. here there was no shrinkage of assets and the taxpayer made a clear gain. as a result of its dealings it made available $137,521.30 assets previously offset by the obligation of bonds now extinct.... the defendant in error has realized within the year an accession to income, if we take words in their plain popular meaning, as they should be taken here. 284 u.s. at 3. 206. 92 t.c. 1084 (1989), rev'd, 916 f.2d 110 (3d cir. 1990). [vol 1:3 tufts and the evoluion of debt-discharge theory purposes. nor does such moribundity flow from united states v. kirby lumber co., 284 u.s. 1 (1931), or commnissioner v. tufts, 461 u.s. 300 (1983). see colonial savings association v. conunissioner, 85 t.c. 855, 862 n.l 1 (1985), affd. 854 f.2d 1001 (7th cir. 1988). " the concept that petitioner received his money's worth from the enjoyment of using the chips (thus equating the pleasure of gambling with increase in wealth) produces the incongruous result that the more a gambler loses, the greater his pleasure and the larger the increase in his wealth.207 the majority opinion in the tax court, which held that zarin realized $2,900,000 in cod income, rejected kerbautgh-empire as implicitly overruled by later supreme court opinions, quoting at length a ninth circuit opinion concluding the same.2es one such later supreme court opinion predictably discussed is tufts, in which the taxpayer used the loan proceeds in an unprofitable transaction (depreciation deductions aside) and yet was held to have realized an accession to wealth on the failure to repay nonrecourse debt in excess of the value of property transferred in satisfaction of it. one opinion not mentioned,? however, seems to have dealt with the language of the kerbaugh-empire argument obliquely and to have rejected it. one of the arguments made by mrs. crane1 in support of her position that the relief from nonrecourse indebtedness not in excess of the fair market value of the property transferred in satisfaction of it is not income within the meaning of the sixteenth amendment was that "the entire transaction was thought to have been 'by all dictates of common sense ... a ruinous disaster,' as it was termed in her brief.. ,,.,i1 the court did not accept this argument. she was entitled to depreciation deductions for a period of nearly seven years, and she actually took them in almost the allowable amount. the crux of this case, really, is whether the law permits her to exclude allowable deductions from consideration in computing gain. we have already showed 207. id. at 1101 (tannenwald, i., dissenting). 208. id. at 1093-94 (quoting the opinion in vukasovich, inc. v. commissioner. 790 f.2d 1409, 1414-15 (9th cir. 1986)). the service itself recently recognized that kerbaughempire is no longer good law. "[s]ubsequent supreme court decisions and other court cases. when viewed together, have discredited kerbaugh-empire." rev. rul. 92-99, 1992.46 i.r.b. 5. 209. crane v. commissioner, 331 u.s. i (1947). 210. see supra note 16 (describing crane). 211. 331 u.s. at 15. 1992] florida tax review that, if it does, the taxpayer can enjoy a double deduction, in effect, on the same loss of assets. the sixteenth amendment does not require that result any more than does the act itself. 212 even without deductions produced by the use of loan proceeds (e.g., in the case of a purchase of a personal residence), the exclusion of the proceeds on receipt produces an unwarranted tax benefit if not fully repaid with after-tax dollars. if the loan proceeds are dissipated in a business or investment, the loan proceeds will be deductible (e.g., crane's and tufts's depreciation deductions, and allan's interest and real estate tax deductions, as well as recognizable losses on disposition). if the loan proceeds are dissipated in personal consumption, there is no deduction but there is not intended to be any deduction (e.g., zarin's net gambling ioss 2 13 and little bucks's loss). if the failure to repay the loan proceeds with after-tax dollars is itself not taxed, there will result, in effect, a double deduction in the case of loan proceeds dissipated in business or investment (as occurred in kerbaughempire2 14) or an inappropriate deduction for personal consumption in the case of loan proceeds used for personal consumption (as occurred in the hypothetical of little bucks and at least arguably in the zarin case2 l"). the third circuit reversed the majority holding in zarin, agreeing with the dissents' 216 conclusion that zarin realized no income, but expressly stated, "we do not pass on the question whether or not bowers [v. kerbaughempire] is good law., 2 17 kerbaugh-empire, notwithstanding judge tannen212. id. at 15-16 (footnote omitted). 213. see infra note 217 (discussing the nondeductibility of net gambling losses). 214. see supra note 203 (discussing the double-deduction effect). 215. see infra note 217 (discussing whether zarin should properly be viewed as a nonstatutory purchase-price-adjustment case, resulting in no taxation, or as a cod-income case, resulting in taxation in order to avoid the backdoor deduction of personal consumption). 216. zarin v. commissioner, 916 f.2d 110 (3d cir. 1990). there were three tax court dissenting opinions in zarin. in addition to the opinion penned by judge tannenwald, joined by judge wells (see supra note 207 and accompanying text), judge jacobs wrote a dissent, as did judge ruwe, joined by judges chabot, swift, williams, and whalen. 92 t.c. at 1105-1107, 1107-16. 217. 916 f.2d at 116 n. 11. the third circuit majority reasoned that because the debt was unenforceable under state law, the amount of indebtedness was in dispute. thus, the court applied the usual rule that no cod income arises on settlement of a debt, the amount of which is in dispute. the third circuit's reasoning is described in more detail-and lambasted-in daniel shaviro, the man who lost too much: zarin v. commissioner and the measurement of taxable consumption, 45 tax l. rev. 215, 252-58 (1990). professor shaviro disagrees not with the result that no income is realized but with the poor reasoning of the third circuit in reaching that result. perhaps because the facts are interesting and unusual (a definite plus when pondering tax cases), the case has generated an unusual amount of interest. see commentary collected in babette b. barton, legal and tax incidents of compulsive behavior: lessons [ vol 1:3 tufts and the evolution of debt-discharge theory from zarin, 45 tax law. 749 (1992). the argument that the unenforceability of the debt rendered the amount of the debt uncertain is off the mark. the reason that no cod income is realized on the settlement of a debt, the amount of which is in dispute, is because the realization of cod income depends entirely on the prior value received untaxed at the time the loan was incurred. see supra notes 93-97 and accompanying text (discussing rail joint and related material). if that amount is uncertain, so is the conclusion that cod income arises on the settlement. there was no uncertainty regarding the dollar amount of the debt in zarinonly its enforceability was at issue. the unenforceability of the debt was indeed a "red herring." as termed by ms. sheppard. see lee a. sheppard, a gambling exception to cancellation of indebtedness income?. news analysis, 49 tax notes 1516 (dec. 31, 1990). the nonrecourse debt in tufts was unenforceable to the extent it exceeded the value of the property transferred in satisfaction of it, yet the total amount of the debt, including the unenforceable amount, produced an accession to wealth for tax purposes. the rule should be no different in the nontransfer context. debt discharge analysis should not turn on such nonissues as liquidity or enforceability. the unenforceability of a debt, i.e., the inability of the creditor to force repayment in full, simply creates the cod income in the first place. see supra notes 114-15 and accompanying text (describing tax court's hesitancy to decide the schlifke case under cod-income theory because of such nonissues); supra note 161 and accompanying text (discussing how terminology used in section 61(a)(12) leads to consideration of such nonissues); and supra note 167 (discussing the irrelevancy of the voluntariness or involuntariness with which the creditor foregoes collection of the debt in analyzing whether debtor realizes cod income on failure to repay debt in full). debt discharge analysis should focus on the amount previously received free of tax by the taxpayer on the assumption that the amount would be repaid with after-tax dollars. whether someone has the right to enforce repayment does not change the character of the accession to wealth that occurs on failure to repay. enforceability simply is not relevant when the matter is viewed from the taxpayer-debtor's perspective, as it must be. the fact that the loan proceeds were lost gambling is also a nonissue, notwithstanding judge tannenwald's concern that the more one gambled and lost on credit, the more income with which one would be charged if the loan is eventually discharged rather than paid. if loan proceeds are lost in a business or investment activity, the losses are deductible. if loan proceeds are lost in personal consumption, they are not, and are not intended to be. the more money spent on personal consumption and saving, the higher the tax bill. failure to charge a taxpayer with income on the discharge of debt used in personal consumption allows a backdoor deduction for personal consumption. see supra notes 193-97 and accompanying text (discussing the personal consumption losses of big bucks and little bucks). while gambling can constitute a "trade or business" on the right facts (see groetzinger v. commissioner, 771 f.2d 269 (7th cir. 1985), aff'd, 480 u.s. 23 (1987)), resulting in above-the-line deduction of professional gambling expenses under section 62(a)(1). net gambling losses (the excess of gross losses over gambling receipts) are rendered nondeductible personal consumption by statutory fiat. see irc § 165(d). if zarin had borrowed the $3,400,000 in cash from a third-party creditor (instead of from the casino itself) and then lost it gambling, there should be no doubt that zarin would have realized $2,900,000 in cod income upon settlement of the debt with the third-party creditor for $500,000. the previous s3,400,000 in cash was received free of tax on the assumption that it would be repaid with after-tax dollars. when that assumption proves unwarranted by $2,900,000, the debtor's accession to wealth is apparent. while it is true that consumption and savings define the tax base and that -[clash is a plausible initial proxy for income solely because of its uses, consumption and saving, and not because it has any innate, 1992] florida tax review wald's zarin opinion and the noncommittal stance taken by the third circuit, should be considered dead. it was bad law when decided, and its conceptual uniquely income-like quality" (shaviro, supra, at 223), cash received in kind from a third party and used directly in consumption should be includable in full. it is difficult to value the consumption as anything less than the face amount of the cash actually used for consumption in that case. the crux of the zarin case, then, fell on the happenstance that the creditor wore two hats: lender as well as vendor of the services purchased with the credit. zarin's debt was, in a broad sense, a purchase-money mortgage but, instead of purchasing property as in the more typical conception of that term, he purchased services. (one of the other nonissues in the case was whether zarin had in fact purchased "property" on purchasing the gambling chips so that the rule in section 108(e)(5) could apply. suffice it to say that zarin did not spend $3,400,000 on little pieces of plastic; he spent the money on the activity of gambling which he purchased from the lender's establishment. it is not inherently bizarre to characterize gambling as services or other entertainment. see erik m. jensen, economic performance and progressive jackpots: a better analysis, letter to the editor, 45 tax notes 635 (oct. 30, 1989).) the fact that the loan was financed by the vendor might have rendered the amount loaned, though a precise number was attached, more nebulous in fact for the same reason that the amount of "true debt" may be artificially inflated in the case of more typical, sellerprovided nonrecourse financing. see supra note 169. in such a case, some of that precisely delineated $3,900,000 amount might be "funny money" and should not enter into the first step in calculating the amount of cod income realized: the amount of prior value received and excluded from income. if the entire $3,900,000 is respected as "true debt," there is yet another possible avenue providing for nontaxation. in cases involving the more typical purchase-money mortgage of property, factual disputes arose on the reduction of debt revolving around whether the debt was actually discharged or whether the purchase price of the property was actually renegotiated downward. in order to avoid these factual disputes, congress enacted section 108(e)(5) (see supra notes 8 and 134), which makes an actual factual inquiry in such cases unnecessary. even when the facts clearly show an intent to reduce debt rather than reduce the purchase price, the statute by fiat provides that the reduction will be "treated as a purchase price adjustment." thus, no cod income is deemed realized; the purchaser is considered to have received a post-purchase, nontaxable discount in price. thus, one question presented by zarin is whether there ought to be a similar rule regarding purchase-money mortgages of services, i.e., mortgages in which the lender is also the vendor of the purchased services, in order to obviate just the kind of dispute involved in zarin. that is, should such transactions result in no taxation on the theory that the purchaser of services on credit should be deemed to have received a purchase-price adjustment-a postpurchase, nontaxable discount in price-rather than to have realized cod income in order to avoid a factual inquiry into the nature of the settlement with the vendor-creditor for less than the full amount originally borrowed? if such a rule is wise as a policy matter, then the other question is whether judges should be the ones to craft it. does the presence of section 108(e)(5), pertaining to purchase-money mortgages of property only, carry the negative implication that all other purchase-money mortgages (as broadly defined here) fall outside the rule? or should the presence of section 108(e)(5) invite judges to extend by analogy its rule to situations not contemplated by the congress who enacted it? because section 108(e)(5) requires the presence of cod income in the first place, true purchase-price adjustments ought still to result in no taxation under section 61 itself. such is the stuff of statutory interpretation. see popkin, supra note 40, at 157. [vol 1:3 tufts and the evolution of debt-discharge theon and practical weaknesses are even more glaring today. v. conclusion the taxpayer in tufts was held to have realized $400,000 of gain under section 1001 under the collapsed approach to analyzing the relief from nonrecourse debt upon the transfer of property worth less than the debt. if the debt in tufts had been recourse, the bifurcated approach provided in the government's own regulations would have created a $50,000 loss and $450,000 of cod income. the supreme court rejected use of the bifurcated approach in tufts apparently without fully appreciating that it would have controlled the transaction if recourse debt had been used. the supreme court, thinking (with the guidance that it was given) that it was conjbrming the tax consequences of nonrecourse debt and recourse debt by recognizing the former as "true debt," in fact unwittingly memorialized their difference when property worth less than the debt is transferred in satisfaction of the debt. it is not at all certain that the supreme court would knowingly condone the disparate treatments of what it considers "true debt" for tax purposes in the absence of sound reasons justifying the different approaches. the disparate treatment of relief from recourse and nonrecourse debt when property worth less than the debt is transferred in satisfaction of the debt has no persuasive conceptual rationale. neither the regulations themselves nor the preamble to them give any reason for the disparate treatment, and none can be fashioned. it leads to manipulation and, even worse, to treating similarly situated taxpayers in quite different manners without sound justification. and more than merely the character of income or gain is at stake. the most telling situation revealing the weakness of the collapsed approach is that involving personal-use property. its application in that context is untenable as it results in sheltering from the tax base taxable personal consumption. its application in that context reveals the real weakness of the approach for all contexts, including business and investment contexts: it links the accession to wealth to the property ownership when the accession to wealth relates solely to the liability discharge. the holding in tufts that the taxpayer realizes an accession to wealth when nonrecourse debt remains unsatisfied upon a transfer of the securing property was necessary, and the court is to be lauded for it, but the method of accounting for that accession to wealth should not be tied to the ownership interest in the underlying property. nor should it be tied to the uses to which the loan proceeds are put-whether deductible or nondeductible. the accession to wealth arises solely because of the failure to repay loan proceeds previously received free of tax on the assumption that they would be repaid with after-tax dollars. when that fails to transpire, the debtor realizes ordinary 19921 florida tax review cod income, notwithstanding the fact that the event undermining the prior assumption that the loan proceeds would be repaid in full with after-tax dollars happens to be a transfer of the securing property. the evolution of debt-discharge theory has increasingly recognized its tax-benefit underpinnings and has increasingly recognized that the liability should be analyzed for tax purposes separately from the ownership interest in the securing property. thus, a reduction of nonrecourse indebtedness without transfer of the collateral is now considered to result in cod income, not in a basis reduction as under earlier views of nonrecourse debt. it is time to take the last step. it is time, in the continuing evolution of debt-discharge theory, to recognize that the collapsed approach is not defensible. it is time to discard tufts.218 218. will it happen? i would not bet the ranch. as professor shaviro commented with respect to other outdated ideas pertaining to nonrecourse debt: "man may be mortal, but legal doctrine endures." shaviro, supra note 9, at 457. [vol 1:3 * copyright © 2001 by j. clifton fleming, jr., robert j. peroni & stephen e. shay. all rights reserved. we thank alice abreu, karen brown, terrence chorvat, deborah geier, michael graetz, charles gustafson, martin mcmahon, jr., ronald pearlman, julie roin, brett scharffs, reed shuldiner, michael wachter, alvin warren, jr ., george yin and participants in the faculty research colloquia at the brigham young university law school and the university of pennsylvania law school and in the ernst & young tax policy seminar at georgetown university law center for their helpful comments on earlier drafts of this article. ** associate dean and ernest l. wilkinson professor of law, brigham young university. *** robert kramer research professor of law, the george washington university. **** partner with ropes & gray, boston, massachusetts. 299 florida tax review volume 5 2001 number 4 fairness in international taxation: the ability-to-pay case for taxing worldwide income* j. clifton fleming, jr.,** robert j. peroni*** and stephen e. shay**** i. introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301 ii. ability-to-pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 a. the deference accorded to ability-to-pay . . . . . . . . . . 306 b. whose abili ty-to-pay? . . . . . . . . . . . . . . . . . . . . . . . . . 309 c. ability-to-pay and source of income . . . . . . . . . . . . . . 311 d. compared to whom? . . . . . . . . . . . . . . . . . . . . . . . . . . 314 iii. what if everybody can do it? . . . . . . . . . . . . . . . . . . . . . 315 a. a self-inflicted wound? . . . . . . . . . . . . . . . . . . . . . . . . 315 b. portfolio investment as a possible answer . . . . . . . . . . 316 c. implicit taxes as a possible answer . . . . . . . . . . . . . . . 317 iv. u.s. c corporations and ability-to-pay . . . . . . . . . . . . . 318 a. the need for an anti-deferral device . . . . . . . . . . . . . 318 b. the overbreadth of the corporate income tax . . . . . . . 321 c. searching for the lesser evil . . . . . . . . . . . . . . . . . . . . 322 d. defining corporate residence and pursuing runaway corporations and shareholders . . . . . . . . . . . . . . . . . . 324 v. the foreign tax credit and ability-to-pay . . . . . . . . . 328 a. the exemption effect of the foreign tax credit . . . . . . 328 b. the foreign tax credit limitation . . . . . . . . . . . . . . . . 332 vi. attempting to overcome ability-to-pay by revising the benefits theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333 a. the collapse of the original benefits theory . . . . . . . . 333 b. the revised benefits theory . . . . . . . . . . . . . . . . . . . . . 334 300 florida tax review [vol.5:4 c. the revised benefits theory as a partial exemption system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 d. fairness and partial exemption . . . . . . . . . . . . . . . . . . 336 e. double taxation and partial exemption . . . . . . . . . . . . 338 vii. ability-to-pay and the deferral privilege . . . . . . . . . 339 a. exemption through the back door . . . . . . . . . . . . . . . . 339 b. creeping towards taxing consumption . . . . . . . . . . . . 341 viii. tax competition and exemption . . . . . . . . . . . . . . . . . . . 341 a. tax competition and the incentive to invest abroad . . . 342 b. assistance to poor countries . . . . . . . . . . . . . . . . . . . . 344 ix. enforcement of worldwide taxation . . . . . . . . . . . . . . 349 x. concluding observations: weighing the factors . . . 350 a. why not do as others do? . . . . . . . . . . . . . . . . . . . . . 350 b. ending deferral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 c. the preferred alternative . . . . . . . . . . . . . . . . . . . . . . . 354 2001] fairness in international taxation 301 1. the meaning of ability-to-pay can be controversial at the margins. for example, commentators often refine the ability-to-pay fairness concept by subdividing it into a horizontal equity component (taxpayers with equal incomes should pay equal amounts of tax) and a vertical equity component (taxpayers with unequal incomes should pay amounts of tax which are sufficiently unequal to fai rly reflect the differences in their incomes). see david f. bradford, untangling the income tax 150-53 (1986); joseph m. dodge, the logic of tax 88 (1989); michael j. graetz & deborah h. schenk, federal income taxation: principles and policies 31 (3d ed. 1995); william a. klein, policy analysis of the federal income tax 7 (1976); joel slemrod & jon bakija, taxing ourselves, 49-50, 52-54, 73-74 (1996); eric m. zolt, the uneasy case for uniform taxation, 16 va. tax rev. 39, 86-98 (1996). other commentators have criticized these refinements by asserting that horizontal equity has no significance as a tax policy norm separate from vertical equity or that neither horizontal nor vertical equity has any content that is independent of more general notions regarding fundamental fairness. see generally paul r. mcdaniel & james r. repetti, horizontal and vertical equity: the musgrave/kaplow exchange, 1 fla. tax rev. 607 (1993); louis kaplow, a note on horizontal equity, 1 fla. tax rev. 191 (1992); richard a. musgrave, horizontal equity: a further note, 1 fla. tax rev. 354 (1993); louis kaplow, horizontal equity: measures in search of a principle, 42 nat’l tax j. 139 (1989); richard a. musgrave, horizontal equity, once more, 43 nat’l tax j. 113 (1990). there has also been disagreement regarding nuances of the ab ility-to-pay concept, such as the proper handling of psychic income, leisure and underachievement. see staff of joint comm. on taxation, impact on individuals and families of replacing the federal income tax (jcs-8-97), at § iv.b.3 (comm. print 1997); zolt, supra, at 89-101; see also barbara h. fried, the puzzling case for proportionate taxation, 2 chapman l. rev. 157, 182-83 (1999). nevertheless, administrability considerations have led to a u.s. tax policy consensus that presumptive fairness within an income tax regime requires taxpayers with larger net incomes in a given year to generally pay more tax than those who have smaller net incomes in the same year. this consensus also holds that when comparing net incomes for ability-to-pay purposes, items that cannot be feasibly measured (e.g., leisure and forgone opportunities) are omitted. see u.s. treas. dep’t, blueprints for basic tax reform 3, 159-62 (1977) [hereinafter u.s. treas. dep’t , bluepr ints]; 1 u.s. treas. dep’t, tax reform for fairness, simplicity, and economic growth, 14-15, 37-42 (1984) [hereinafter u.s. treas. dep’t, tax reform]; walter j. blum & harry kalven, jr., the uneasy case for progress ive taxation 64 (1953); bradford, supra, at 16-19, 155-56; graetz & schenk, supra, at 31; william a. klein, joseph bankman & daniel shaviro, federal income taxation 7-9 (12th ed. 2000); vada waters lindsey, the widening gap under the internal revenue code: the need for renewed progressivity, 5 fla. tax rev. 1, 3, 7-8, 39-40 (2001); herbert a. ste in, what’s wrong with the federal tax system, in 1 house comm. on ways and means, tax revision compendium 107, 110-14 (comm. print 1959) [hereinafter house comm. compendium]. we have made the theoretical disagreements over vertical equity, horizontal equity and other refinements and nuances of the ability-to-pay concept irrelevant to this article by adopting the preceding consensus ability-to-pay concept. our analytical approach also uncouples the ability-to-pay concept from the i ssues of whether the federal income t ax shou ld employ progressive rates and if so, how progressive they should be. see infra note 27. i. introduction the ability-to-pay fairness concept1 is a key factor underlying the historic u.s. policy of relying principally on the income tax to finance federal 302 florida tax review [vol. 5:4 2. as stated by one commentator: in the united states, consumption taxes account for only about 17 percent of total federal, state and local revenues–compared to an average of 30 percent for oecd member countries–and the u.s. federal government’s share of that is quite small. less than 5 percent of federal revenues come from excise taxes on specific kinds of consumption, and the federal government has no broad-based tax on consumption. michael j. graetz, the u.s. income tax: what it is, how it got that way, and where we go from here 201 (1999); see also u.s. dep’t of commerce, statistical abstract of the united states 847 (1999); slemrod & bakija, supra note 1, at 19-21. 3. see staff of joint comm. on taxat ion, 100th cong., 1st sess., general exp lanation of the tax reform act of 1986, at 6-7 (comm. print 1987); u.s. treas. dep’t, blueprints, supra note 1, at 1, 24; joseph m. dodge, j. cl ifton fleming, jr. & deborah a. geier, federal income tax: doctrine, structure and policy 19, 21-22 (2d ed. 1999); graetz & schenk, supra note 1, at 43; peter andrew harris, corporate/shareholder income taxation and allocating taxing rights between countries 452-53 (1996); slemrod & bakija, supra note 1, at 135-36; lindsey, supra note 1, at 34-40. 4. professor michael graetz recently challenged “[t]he focus in the international income tax literature on economic e fficiency to the exclusion of a ll other values” as a cr iter ion for u.s. international tax policy and asserted that “deciding to tax income reflect s a decision to place issues of fairness at the heart of tax policy debates. that commitment cannot be ignored simply because income traverses national borders.” michael j. graetz, taxing international income: inadequate principles, outdated concept s and unsat isfactory policies, 54 tax l. rev. 261, 294, 307 (2001). for an article that focuses on fairness considerations in international taxation, see nancy h. kaufman, fairness and the taxation of international income, 29 law & pol’y int’l bus. 145 (1998). 5. see infra part iv. 6. moreover, since the 1990s, cross-border u.s. portfolio investment has exceeded u.s. multinationals’ cross-border direct inve stment in volume. see national foreign trade council, international tax policy for the 21st century: a reconsideration of subpart f 5-6 to 5–7 (1999); graetz, supra note 4, at 263-67. in the decade just past, cross-border direct investment increasingly was engaged in by private equity partnerships that amassed $1 bi llion or more from individuals and tax-exempt institutional investors. government expenditures.2 indeed a major justification for this reliance, as opposed to significant dependence on consumption levies, is that the income tax is a system for spreading the costs of government in a way that advances fairness by giving substantial deference to comparative ability-to-pay.3 consequently, one would expect tax policy analysts to routinely examine the equity implications of international income tax rules by applying the fairness criterion with the same rigor as in the domestic context. but surprisingly, there has been relatively little discussion in the literature regarding the role of the ability-to-pay concept in analyzing international tax policy issues.4 this may be because the composition of international investment histor ically has been dominated by the direct foreign investments of multinational corporations, which pose perplexing issues in evaluating fairness concerns.5 even if true, however, this is an inadequate reason to forego analysis of fairness considerations when scrutinizing the important international dimension of a modern income tax.6 in 2001] fairness in international taxation 303 7. see u.s. treas. dep’t, the deferral of income earned through u.s. controlled foreign corporations 2 (2000) [hereinafter u.s. treas. dep’t, deferral]; harris, supra note 3, at 295-96; sol picciotto, international business taxation 12-13 (1992); michael j. graetz & michael m. o’hear, the “original intent” of u.s. international taxation, 46 duke l.j. 1021, 1041-47 (1997). the decision of the united states to grant its residents a foreign tax credit is consistent with the international norm which assigns to residence countries the primary obliga tion of mitigating international double taxation. see charles h. gustafson, robert j. peroni & richard crawford pugh, taxation of international transactions 18-19 (2d ed. 2001); harris, supra note 3, at 313; robin woellner, stephen barkoczy & shirley murphy, 2000 australian taxation law 1303-04, 1336 (1999). 8. see herman b. bouma, further support for territorial taxation, letters to the editor, 87 tax notes 580 (2000). the decision to treat expatriate citizens as quasi-u.s. residents for this purpose is more controversial. see infra note 18. 9. see national foreign trade council, supra note 6, at 6-29; herman b. bouma, the tax code and reality: improving the connection, 85 tax notes 811, 813 (1999); ter rence r. chorvat, ending the taxation of foreign business income, 42 ariz. l. rev. 835 (2000); grae tz, supra note 4, at 330-31; klaus vogel, world-wide vs . source taxation of income–a review and reevaluation of arguments, in influence of tax differentials on international competitiveness 117 (1990); transcript from the symposium: globalization and the taxat ion of foreign investments, 21 tax notes int’l 1268, 1272-73 (2000); see also daniel j. mitchell, oecd tax competition proposal: higher taxes and less privacy, 89 tax notes 801, 821 (2000). this article, we examine the role that fairness concerns, embedded in the abilityto-pay concept, play in justifying the u.s. policy of taxing u.s. residents on their worldwide incomes. from almost the commencement of the modern income tax, the united states has taxed the worldwide income (i.e., both foreign-source and domesticsource income) of its residents and ameliorated international double taxation resulting from this approach by allowing a u.s. income tax credit for foreign tax imposed on foreign-source income.7 thus, if the foreign tax is less than the u.s. tax on a resident’s foreign-source income, the united states receives a residual tax equal to the difference. although there has been relatively little disagreement with worldwide taxation of the income of u.s. resident individuals,8 many in the u.s. multinational business community, and some academic commentators, argue that considerations of fairness, simplification, competitiveness and/or efficiency support abandonment of the residual u.s. tax on the foreign-source active business income of u.s. resident corporations. they would favor adopting a territorial, or exemption, system under which such foreign-source income is excluded from the gross income of corporate residents.9 we have previously questioned the efficiency claims in favor of an exemption system and argued that taxation of foreign-source income at the time it is earned is necessary to avoid creating an inefficient and unjustified tax 304 florida tax review [vol. 5:4 10. see robert j. peroni, j. clifton fleming, jr. & stephen e. shay, getting serious about curtailing deferral of u.s. tax on foreign source income, 52 smu l. rev. 455 (1999); j. clifton fleming, jr., robert j. peroni & stephen e. shay, deferral: consider ending it instead of expanding it, 86 tax notes 837 (2000). there seems to be general recognition that an exempt ion system provides an incentive for u.s. residents to invest their directly-owned funds in low-tax foreign countries instead of at home or in other countries with effective tax rates equal to or greater than the u.s. resident’s u.s. tax on the same category of foreign income. see, e.g., staff of joint comm. on taxation, 106th cong., 1st sess., description and analysis of present-law rules relating to international taxation, at 75 (comm. print 1999) [hereinafter joint comm., description]; peggy brewer richman, taxation of foreign investment income: an economic analysis 51 (1963). there is also recognition of the fact that an exemption system encourages res idents of high tax/high government benefit countries to engage in the strategic behavior of enjoying the costly perquisites of their residence country while earning their income in low tax/low government benefit countries. see ju lie roin, competi tion and evas ion: another perspective on international tax competition, 89 geo. l.j. 543, 588-89, 591 (2001). a degree of confusion has existed, however, regarding the incentive effect produced by the present u.s. system’s deferred taxation of foreign-source income earned in low-tax countr ies by foreign subsidiar ies of u.s. corporations. this confusion has its roots in an article by economist david g. hartman. the article asserts that two seemingly contradictory propositions are both true. the first proposition holds that because u.s. tax on the foreign-source income of a foreign subsidiary is deferred until the subsidiary pays dividends to its u.s. parent, the u.s. tax on the dividends is irrelevant in deciding whether a “mature” fore ign subsidiary (i.e ., one that does not require additional capital from its parent) will reinvest its earnings in its low-taxed foreign operations or pay dividends to its u.s. parent. the second hartman proposition holds that because u.s. tax on the foreignsource income of a foreign subsidiary is deferred until the subsidiary pays dividends to its u.s. parent, a u.s. parent is encouraged to have the foreign subsidiary retain and reinvest its earnings instead of transferring them to the parent as dividends. see david g. hartman, tax policy and foreign direct investment, 26 j. pub. econ. 107, 110-11, 116, 119 (1985). hartman’s explanat ion of why these apparently conflicting assertions are, in fact, harmonious relies heavily on algebraic equations that may bewilder many lawyers. see id. at 112-113, 116-117. other writers have attempted verbal explanations with mixed success. see rosanne altshuler, recent developments in the debate on deferral, 20 tax notes int’l 1579, 1590 (2000); reuven s. aviyonah, globalization, tax competition, and the fiscal crisis of the welfare state, 113 harv. l. rev. 1573, 1593 n.70 (2000); chorvat, supra note 9, at 843-44; harry grubert & john mutti, taxing international business income: dividend exemption versus the current system 8 (the aei press 2001) [he reinafte r grubert & mutti, dividend exemption]. we now try our hands at clarifying the matter by analyzing the following example: usco, a u.s. resident c corporation, owns 100% of the shares of forco, a foreign c corporation resident in, and doing business exclusively in, country x, which imposes a 15% corporate income tax and no dividend withholding tax. usco is subject to a 35% u.s. tax on its worldwide income. in yea r 1, forco earns $117 .65, pays a 15% x country tax ($17.65) and has $100 left. if forco pays the $100 to usco at the close of year 1 as a dividend, usco’s calculation of year 1 u.s. tax on the dividend will be: ($117.65 (see irc § 78) x .35) $17.65 foreign tax credit = $23.53 u.s. tax incentive for u.s. residents to invest abroad in low-tax countries.10 we now 2001] fairness in international taxation 305 if usco then invests $76.47 ($100 $23.53) at 10% for one year, receives $7.65 of earnings at the end of year 2 and pays a $2.68 tax thereon, usco will finish with $81.44 ($76.47 + [$7.65 $2.68]) at the end of year 2. if, however, forco defers the u.s. dividend tax by retaining its $100 of year 1 after-tax earnings and if forco also invests this sum for one year at 10%, forco will have $10 of investment earnings at the end of year 2 on which it will pay a 15% country x tax ($1.50), leaving $8.50. assuming that forco immediately distributes $108.50 ($100 + $8.50) to usco, the year 2 u.s . dividend t ax calculat ion for usco will be: ([$117.65 + $10 (see § 78)] x .35) ($17.65 + $1.50) foreign tax credit = $25.53 u.s. tax at the end of year 2. assuming that the correct discount rate is the 8.5% after-tax rate of return that forco earned in country x (.10 x [1 .15] = .085), the $127.65 grossed-up dividend amount used in the second scenario u.s. tax calculation ($117.65 + $10 = $127.65) has a year 1 present value of $117.65 ($127.65 ÷ 1.085 = $117.65), which equals the grossed-up dividend amount used in the year 1 u.s. tax calculation of the first scenario. consequently, there is no surprise in discovering that the $25.53 u.s. tax which usco pays on the forco dividend at the end of year 2 in the second scenario has a present value at the end of year 1 of $23.53 ($25.53 ÷ 1.085), which is the same as the $23.53 u.s. tax that usco incurred at the end of year 1 on the forco dividend in the first scenario. thus, the u.s. tax on the forco dividend has the same present value ($23.53) in both the first scenario (immediate repatriation) and the second scenario (reinvestment by forco for one year). in that limited sense, the u.s. tax on dividends received by usco from forco does not affect the decis ion of whether to have forco accumulate or distribute its earnings. this is apparently what hartman meant by his first proposition. but note that usco finishes the second scenario with $108.50 (year 2 dividend from forco) $25.53 (u.s. tax on forco dividend) = $82.97 at end of year 2. this is $1.53 more than the $81.44 usco had at the end of year 2 in the first scenario. this inequality results from the facts that in the second scenario, deferral gives forco $23.53 more to invest during year 2 than usco has in the first scenario ($100 $76.47 = $23.53) and that the after-tax rate of return available to forco on its investments is no worse than usco’s after-tax rate of return. in other words, in spite of the truth of hartman’s first proposition, deferral encourages usco to cause forco to reinvest its earnings in its low-tax homeland instead of repatriating them for investment by usco in the united states. with respect to empir ical evidence regarding the effect of low foreign tax rates on the investment location decisions of u.s. multinational corporations under the present u.s. system, which approximates an exemption system for active business income, see avi-yonah, supra, at 1588-91; james bandler & mark maremont, how a xerox plan to reduce taxes and boost profit backfired, wall st. j., apr. 17, 2001, at c1; harry grubert & john mutti, do taxes influence where u.s. corporations invest?, 53 nat’l tax j. 825 (2000) [hereinafter grubert & mutti, where u.s. corporations invest] (suggesting that almost one out of every five dollars invested abroad by u.s. corporations is drawn to its investment location because of low host country taxes); donald j. roussl ang, deferra l and optimal taxation of international investment income, 53 nat’l tax j. 589, 596 (2000). regarding taxpayer response to the partial u.s. exemption regime contained in the foreign sales corporation (fsc) provisions, see congress ional research service, the foreign sales corporation (fsc) tax benefit for exporting and the wto (rs20571, sept. 22, 2000); stephen a. cohen, will the wto’s fsc ruling be the demise of the guam foreign sales 306 florida tax review [vol. 5:4 corporation? 20 tax notes int’l 1627 (2000); jose oyola, foreign sales corporations beneficiar ies: a profile, 88 tax notes 933 (2000); jose oyola, news analysis: a fresh look at fsc beneficiaries, 23 tax notes int’l 71 (2001); ma rjor ie rawls roberts, wto’s fsc ruling could prove detrimental to the usvi’s economy, 20 tax notes int’l 1626 (2000). the fsc provisions have been replaced by irc §§ 114, 941-43, which were contained in the fsc repeal and extraterritorial income exclusion act of 2000, pub. l. no. 106-519, and were generally effective october 1, 2000. it remains to be seen whether this new regime wil l survive the challenge brought by the european union in the world trade organization’s dispute resolution body. see chuck gnaed inger & robert goulder, wto finds successor to fsc regime also violates trade rules, 92 tax notes 15 (2001); richard a. westin & stephen vasek, the extraterritorial income exclusion: where do matters stand following the wto panel report?, 23 tax notes int’l 337 (2001). 11. see u.s. treas. dep’t, distributional analysis methodology, ota paper no. 85, § 1 (1999) [hereinafter u.s. treas. dep’t, distributional analysis]; bradford, supra note 1, at 133-34, 148-49; slemrod & bakija, supra note 1, at 62-69; george k. yin, the future taxa tion of private business firms, 4 fla. tax rev. 141, 153-54 (1999). 12. there is currently a sharp debate over whether economic well-being should be measured by reference to income that is both saved and consumed or only by reference to consumption. see, e.g., u.s. treas. dep’t, blueprints, supra note 1, at 38-42; u.s. treas. dep’t, tax reform, supra note 1, at 199-200; dodge, fleming & geier, supra note 3, at 472-81; william d. andrews, a consumption-type or cash flow personal income tax, 87 harv. l. rev. 1113 (1974); joseph bankman & barbara h. fried, winners and loser s in the shift to a consumption tax, 86 geo. l.j. 539 (1998); bruce bartlett, the end of tax expenditures as we know them?, 92 tax notes 413, 420-22 (2001); john k. mcnulty, flat tax, consumption tax, consumption-type income tax proposa ls in the uni ted states : a tax policy discussion of fundamental tax reform, 88 cal. l. rev. 2095 (2000); alvin c. warren, jr., would a consumption tax be fairer than an income tax?, 89 yale l.j. 1081 (1980). moreover, the consider whether fairness considerations embedded in the ability-to-pay concept, as well as concerns regarding efficiency, favor worldwide taxation over an exemption system (or a deferral regime that functions as an exemption system). as we will discuss at greater length below, there are limits on our ability to apply the fairness criterion in the taxing of international (and domestic) income, such as the problems presented by our classical system of taxing corporate earnings. nonetheless, we submit that fairness considerations are at the heart of the u.s. policy to tax the worldwide income of u.s. residents. ii. ability-to-pay a. the deference accorded to ability-to-pay ultimately, taxes that support the u.s. government and its direct expenditure programs are borne by individuals.11 in that regard, the u.s. socioeconomic consensus recognizes that one of the most important criteria for spreading the income tax burden among individual taxpayers is the proposit ion that this onus should be allocated on the basis of comparative economic wellbeing,12 often referred to as ability-to-pay.13 there are, of course, many occasions 2001] fairness in international taxation 307 present income tax is generally recognized as being a hybrid system that is substantially based on both of these approaches. see, e.g., u.s. treas. dep’t, blueprints, supra note 1, at 33-35; bradford, supra note 1, at 8, 28-29; edward j. mccaffery, tax policy under a hybrid incomeconsumption tax, 70 tex. l. rev. 1145, 1152-55 (1992). the current hybrid nature of the income tax does not, however, affect the analysis in this ar ticle because the u.s . income tax has important features that involve the taxation of both income that is consumed and income that is saved and the analysis herein is consistent with such a tax. this article is premised on the assumption that the united states will not in the foreseeable future adopt a value added-type consumption tax or otherwise rely principally on consumption taxes for federal revenue. 13. see report on double taxation, league of nations doc. e.f.s. 73.f.19, at 18 (1923), in 4 staff of joint comm. on taxation, legislative history of united states tax conventions 4003, 4022 (1962); u.s. treas. dep’t, blueprints, supra note 1, at 1, 24; graetz & schenk, supra note 1, at 31, 38-43; klein, bankman & shaviro, supra note 1, at 7-9; richard a. musgrave & peggy b. musgrave, public finance in theory and practice 232-240 (4th ed. 1984); slemrod & bakija, supra note 1, at 49-55, 59-62, 73-74; stephen g. utz, tax policy 3132, 41 (1993) ; graetz, supra note 4, at 295; robert a. green, the future of source-based taxat ion of the income of multinational enterprises, 79 cornell l. rev. 18, 29 (1993); lindsey, supra note 1, at 3, 8, 34-40; martin j. mcmahon, jr. & alice g. abreu, winner-take-all markets: easing the case for progressive taxa tion, 4 fla. tax rev. 1, 66-71 (1998); robert l. palmer, toward unilateral coherence in determining jurisdiction to tax income, 30 harv. int’l l.j. 1, 9-10 (1989); joseph t. sneed, the criter ia of federal income tax policy, 17 stan. l. rev. 567, 574-80 (1965); see also u.s. treas. dep’t, distributional analysis, supra note 11, at § 5. for a discussion of the use of fa irness considerations in defining income, see victor thuronyi, the concept of income, 46 tax l. rev. 45 (1990). indeed, the familiar schanz-haig-simons definition of income, see henry simons, personal income taxation 50 (1938), is principally based on the ability-to-pay concept. see u.s. treas. dep’t, blueprints, supra note 1, at 31; u.s. treas. dep’t, distributional analysis, supra note 11, at § 5.1; dodge, fleming, & geier, supra note 3, at 31-32; see also joseph m. dodge, what’s wrong with carryover basis under h.r.8, 91 tax notes 961, 971 (2001) (suggesting that the assignment of income doctrine, a core principle in the u.s. federal income tax, may be based on the ability-to-pay concept). ability-to-pay is a foundational principl e in the income tax systems of many countries in addition to the united states. see woellner, bar koczy & murphy, supra note 7, at 43-45; frans vanistendael, legal framework for taxation, in 1 tax law design and drafting 15, 2223 (victor thuronyi ed., 1996). the ability-to-pay principle has even been made a constitutional limitation on the power to tax income in italy, spain and germany. see vanistendael, supra. for a discussion of the practical difficul ty of trans lating the gene ral concept of ab ilityto-pay into a specific rate structure, see dodge, fleming & geier, supra note 3, at 24-25, 265-71. an important exception to ability-to-pay taxation is the u.s. tax regime that applies to the u.s.-source income of nonresidents. see irc §§ 871, 881, 882. many other countries also impose similar source-based taxes. because such a regime usually reaches less than the taxpayer’s entire net income, it cannot be grounded on ability-to-pay. instead, it is often rationalized as a benefit-based charge imposed by the source country. see american law institute, proposals on united states taxation of foreign persons and of the foreign income of united states persons 18-19, 29, 34, 37-38 (1987); harris, supra note 3, at 483, 485; graetz, supra note 4, at 298; lawrence lokken, the sources of income from international uses and dispositions of intell ectual property, 36 tax l. rev. 235, 239-40 (1981). the gross-basis, source-based tax on foreign persons is also often justified on administrative grounds because it would be difficult, if not impossible, to impose any other type of tax on foreign persons who are beyond the practica l reach of the internal revenue service (irs). see, e.g., gustafson, peroni 308 florida tax review [vol. 5:4 & pugh, supra note 7, at 196; julie roin, rethinking tax treaties in a strategic world with disparate tax systems, 81 va. l. rev. 1753, 1762 n.28 (1995). but see avi-yonah, supra note 10, at 1649-50 (suggesting that the prevailing practice of giving priority to source-based taxes on international income, so that residence countries are limited to a residual tax, arose partly out of a recognition that source countries were generally poorer than residence countries in the 1920s when the current structure of internat ional taxation was created); hugh j. ault & david f. bradford, taxing international income: an analysis of the u.s. system and its economic premises, in taxation in the global economy 11, 31-32 (assaf razin & joel slemrod eds., 1990) (suggesting that source-based taxes are imposed because source governments have the power to get away with it); green, supra, at 31 (same); roin, supra note 10, at 581-84 (suggesting that foreign persons are overtaxed by source countries, in relationship to benefits received, because they are generally unable to defend themselves through participation in the source country political process). 14. see 1 house comm. compendium, supra note 1, at ix; zolt, supra note 1, at 99101. these other considerations include economic efficiency, simplicity and administrabi lity. see u.s. treas. dep’t, blueprints, supra note 1, at 1-2; u.s. treas. dep’t, international tax reform: an interim report, ch i, §§ a, b (1993); 1 u.s. treas. dep’t, tax reform, supra note 1, at 13-20; sneed, supra note 13, at 567. at present, there is considerable conflict at both the theoretical and empirical levels regarding whether a system of worldwide taxation is, or is not, more economically efficient than an exemption system. indeed, the staff of the joint committee on taxation of the u.s. congress recently stated that “[t]he literature on the theory of international taxation provides no clear direction” with respect to this dispute. staff of joint comm. on taxation, 106th cong., 1st sess., overview of present-law rules and economic issues in international taxat ion, at § iv.d. (comm. print 1999) [hereinafter joint comm., overview]; see also altshuler, supra note 10; james r. hines, jr ., the case against defer ral : a deferential reconsideration, 52 nat’l tax j. 385 (1999); rousslang, supra note 10, at 595-96. by contrast, an earli er joint commit tee staff publication took a considerably more certain position by stating that “[e]conomic analysis can demonstrate that for any capital import–neutral [i .e., exempt ion system] policy, there is almost always a superior revenue–neutral capital export–neut ral [i.e., worldwide system] policy.” staff of joint comm. on taxation, 102d cong., 1st sess., factors affecting international competitiveness of the united states, at 5 (comm. print 1991) [hereinafter joint comm., international competitiveness]. for similar conclusions regarding the endorsement of capitalexport neutrality by the economics literature, see u.s. treas. dep’t, deferral, supra note 7, at 97; avi-yonah, supra note 10, at 1604-11; alvin c. warren, jr ., income tax discriminat ion against international commerce, 54 tax l. rev. 131, 136, 159-60, 162-63 (2001). this cont roversy, however, centers primarily on the issue of which of the two approaches–an exemption system or a system of worldwide taxation–will maximize aggregate worldwide income. see generally altshuler, supra; graetz, supra note 4, at 282-94; rousslang, supra. thus, it has little relevance to the subject matter of this article, which is an inquiry into how fairness considerations affect the selection of a method for taxing foreign-source income. with respect to whether there would be a substantial simplification gain from the united states replacing its current worldwide taxation system with an exemption system, see graetz, supra note 4, at 330-31; charles i. kingson, the foreign tax credit and its critics, 9 am. j. tax pol’y 1, 52-55 (1991); peter r. merrill, international tax and competitiveness aspects of fundamental tax reform, in borderline case 87, 103 (james m. poterba ed., 1997); david r. tillinghast, international tax simplification, 8 am. j. tax pol’y 187, 209-12 (1990). when ability-to-pay must yield to other considerations,14 but it is usually given 2001] fairness in international taxation 309 15. see, e.g., 1 u.s. treas. dep’t, tax reform, supra note 1, at 25-26; sneed, supra note 13, at 579-80, 601-02; see also mcmahon & abreu, supra note 13, at 65-71. 16. see generally staff of joint comm. on taxation, 98th cong., 2d sess., general explanation of the revenue provisions of the deficit reduction act of 1984, at 463-65 (comm. print 1984); report on double taxation, league of nations doc. e.f.s. 73.f.19, at 18-20 (1923), in 4 staff of joint comm. on taxation, legislative history of united states tax conventions 4003, 4022-24 (1962); brian j. arnold & michael j. mcintyre, international tax primer 21 (1995); hugh j. ault, comparative income taxation: a structural analysis 368 (1997); harris, supra note 3, at 11-12, 478. 17. see irc § 7701(a)(4), (b). 18. for example, one can entertain good faith doubts about whether an individual who is present in the united states for 183 days in one year, but is never in the united states during any other year and has no ongoing u.s. ties, is properly treated by irc § 7701(b)(3) as a u.s. tax resident for the single year during which she was physically present in the united states. objections can also be raised to treating u.s. citizens as residents when they have not recently lived in the united states. see pamela b. gann, the concept of an independent treaty foreign tax credit, 38 tax l. rev. 1, 58-69 (1982); see also harris, supra note 3, at 478. the right of return to the united states that inheres in a long-term expatriate’s retained u.s. citizenship is, however, a valuable privilege, see, e.g., cook v. tait, 265 u.s. 45, 56 (1924), and an expatriate’s decis ion not to renounce u.s. citizenship can be seen as evidence that the benefits of citizenship are worth facing an annual u.s. tax on worldwide income. see generally alice g. abreu, taxing exits, 29 u.c. davis l. rev. 1087 (1996) (arguing against proposals for mark-togreat weight in the domestic tax policy process.15 there is no reason why it should not receive equal deference when international tax provisions are being scrutinized. one may, of course, dissent from this consensus and contend that the tax burden should be allocated on some basis other than ability-to-pay. nevertheless, since ability-to-pay is the prevailing fairness dogma under our current income tax system, its implications regarding the issue of worldwide versus territorial taxation should be analyzed even if one might prefer a different doctrinal approach. b. whose abili ty-to-pay? but whose ability-to-pay is relevant in an international context? which individuals should be included in the group that bears the portion of government cost funded by the individual income tax? certainly, individuals should be taken into account if their connection with u.s. society is so substantial that fundamental fairness requires their net incomes to be compared with the net incomes of other u.s. residents for purposes of making an equitable allocation of the tax burden under an ability-to-pay system.16 those who continuously live year-round in the united states easily satisfy this standard but there is less clarity when the connection with the united states is less extensive. congress has drawn lines to deal with this issue17 and one can debate whether the lines have been properly positioned.18 that dispute, 310 florida tax review [vol. 5:4 market taxation of those who renounce u.s. citizenship on fairness, economic rationality and complexity grounds as well as on considerations of personal autonomy and the fact that citizenship does matter); alice g. abreu, the difference between expatriates and mrs. gregory: citizenship can matter, 67 tax notes 692, 695 (1995). but see jeffrey m. colon, changing u.s. tax jurisdiction: expatriates, immigrants, and the need for a coherent tax policy, 34 san diego l. rev. 1 (1996) (arguing that a mark-to-market taxing regime for persons and property that enter or leave u.s. residence taxation or u.s. trade or business taxation would better reflect the ability-to-pay norm because it includes all changes in a citizen’s net wealth in the income tax base). such questions of whether the u.s. residency rules are overly aggressive at the margins should not, however, obscure the fact that most individual taxpayers who are treated as u.s. tax residents have sufficient u.s. connections so that the u.s. tax treatment of their total incomes must be compared to that of other u.s. residents for purposes of applying the ability-to-pay concept. with respect to the residence of corporations, see joseph l. andrus, determini ng the source of income in a changing world, 75 taxes 839, 848 (1997) and infra part iv.d. 19. fairness considerations arguably are satisfied by allowance of a deduction, as opposed to a credit, for foreign taxes. see kaufman, supra note 4, at 177-78 (arguing that both the foreign tax credit and exemption approaches to mit igating international double taxation should be viewed as tax expenditures that are inconsistent with the ability-to-pay principle); see also david gliksberg, the effect of the statist-political approach to international jurisdict ion of the income tax regime-the israeli case, 15 mich. j. int’l l. 459, 469 (1994). nonetheless, as discussed further in part v below, we believe that the efficiency and diplomatic gains that result from allowance of a foreign tax credit to mitigate double taxation properly supercede application of the fairness criterion in addressing the double taxation issue. to the extent that the u.s. resident’s foreign taxes exceed the u.s. foreign tax credit limitation, the excess is disregarded in calculating the u.s. resident’s net u.s. income tax liability so as to prevent the foreign tax credit from offsetting u.s. tax liability on u.s.-source income. (the foreign taxes in excess of the applicable l imitation are not deductible but are carried back to the two pr ior years and carried forward to the five subsequent years under irc § 904(c).) in such a case of excess foreign tax credits, the need to protect the u.s. income tax base from erosion by high foreign taxes is a considerat ion that outweighs the ability-to-pay criterion. see infra part v.b. if a u.s. r esident elects to deduct, rather than credit, foreign taxes the resident’s foreign tax payments do reduce net income and such reduct ion is , of course, consistent with the abi lity-topay principle. however, is outside the scope of this art icle and it leaves unaffected the basic principle that individuals substantially connected to the united states should have their net incomes taken into account in determining how the income tax will allocate the fiscal burden of the u.s. government. and, if an individual has such a connection, it seems clear that her entire net income19 must be considered regardless of whether it is derived from u.s. or foreign sources. 2001] fairness in international taxation 311 20. see u.s. treas. dep’t, blueprints, supra note 1, at 98-99; arnold & mcintyre, supra note 16, at 5-6; bradford, supra note 1, at 16; ault & bradford, supra note 13, at 11, 27, 31, 41; roy blough, taxation of income from foreign sources, in 3 house comm. compendium, supra note 1, at 2145; walter j. blum, tax policy and preferential provisions in the income tax base, in 1 house comm. compendium, supra note 1, at 83-84; gliksberg, supra note 4, at 468-69, 473; green, supra note 13, at 29; lokken, supra note 13, at 239; peggy b. musgrave, consumption tax proposals in an international setting, 54 tax l. rev. 77, 80 (2000) [hereinafter musgrave, consumption tax proposals]; peggy b. musgrave, “substituting consumption-based direct taxation for income taxes as the international norm”: a comment, 45 nat’l tax j. 179, 181-82 (1992); robert j. peroni, back to the future: a path to progressive reform of the u.s. international income tax rules, 51 u. miami l. rev. 975, 981-82 (1997); see also harris , supra note 3, at 318, 461. for a view that an ability-to-pay “comprehensive income tax base is, at least theoretically, susceptible to division by source,” see kaufman, supra note 4, at 174-75. one commentator, klaus vogel, offers a dissenting view on this point. see vogel, supra note 9, at 157. he argues that foreign-source income should not be taxed by a residence country until it is remitted thereto because before then, it is not enjoyed in the residence country and it remains subject to investment risks in the foreign country. this argument overlooks three critical facts. first, foreign-source income reinvested offshore has an immediate wealth increase effect that enhances the taxpayer’s ability-to-pay out of residence country resources. second, where signi ficant currency control s or other foreign law restrictions prevent the all-events test from being sati sfied with respect to foreign-source income of accrual method taxpayers, or prevent the receipt requirement from being satis fied with respect to foreign-source income of cash method taxpayers, the taxpayers will be relieved from recognizing the affected income by the ordinary operation of the u.s. tax system. see, e.g., regs. § 1.451-1(a). if this is not regarded as an adequate remedy for the problem of foreign legal barriers to income repatriation, considerat ion could be given to a nar rowly focused provision that defers inclusion of the income for as long as it is subject to such restrictions. see irc § 964(b). third, the investment risk object ion is relevant to ability-t o-pay only if the risk resolves adversely and a loss actually occurs. if this happens, the proper response by the tax system is to allow the taxpayer a deduction when the loss is sustained, provided that the loss represents income that was previously included in gross income under the taxpayer’s accounting method. the exercise of taxing jurisdiction over the foreign-source income of residents is clearly acceptable under international norms. see, e.g., american law institute, proposals on united states taxation of foreign persons and of the foreign income of united states persons 4-6 (1986); restatement (third) of foreign relations law of the united states § 412(1)(a) (1987); ault, supra note 16, at 367; gustafson, peroni & pugh, supra note 7, at 14. 21. see peroni, supra note 20, at 981-82. the u.s. view is expressed in irc § 61(a), which defines gross income as “all income from whatever source derived.” c. ability-to-pay and source of income the source of net income is simply irrelevant to ability-to-pay.20 the u.s. system of taxing the worldwide income of resident individuals is consistent with this conclusion;21 an exemption or territorial system, under which foreignsource income is excluded from the tax base, is fundamentally inconsistent. to illustrate this point, consider hypothetical individuals a and b who live year-round in the united states. a always earns $8,000 of u.s.-source net income per year as a full-time convenience store clerk while b wholly owns a 312 florida tax review [vol. 5:4 22. a might also receive government transfer payments, includ ing an earned income tax credit, that should be taken into account for purposes of determining whether the alloca tion of the tax burden between a and b properly reflects their comparative abilities-to-pay. see u.s. treas. dep’t, distributional analysis, supra note 11, at § 5.1; harris, supra note 3, at 16; j. clifton fleming, jr., renewing progressive taxation by relying more on spending, letters to the editor, 60 tax notes 802 (1993); fried, supra note 1, at 182-83. transfer payments would, however, have little effect on the differences between a’s and b’s ability-to-pay and they are left out of the analysis to simplify it. 23. see gustafson, peroni & pugh, supra note 7, at 18; see also palmer, supra note 13, at 15 (“a home country’s exemption of income earned through a foreign economic relationship presents greater problems in effectuating the fairness doctrine than does a properly designed foreign tax credit regime”). 24. because b’s income is vastly larger than a’s, the consensus-ability-to-pay fairness concept (see supra text accompanying note 1) clearly would be violated by a u.s. territorial system that imposed identical tax liabilities on a and b. this conclusion is sufficient for our purposes; there is no need to analyze the a-b example in terms of vertical and horizont al equ ity. see supra text accompanying note 1. however, if other observers would prefer to describe equal taxation of a and b in this example as a violation of the principle of verti cal equity, we have no quarrel with their doing so. see, e.g, avi-yonah, supra note 10, at 1616. 25. see authorities cited in supra note 20. although this conclusion is sometimes justified as necessary to prevent avoidance of the individual income tax’s progressive rate structure, see u.s. treas. dep’t, blueprints, supra note 1, at 99; vito tanzi, taxation in an integrating world 77-78 (1995); reuven s. avi-yonah, the structure of international taxation: a proposal for simplificat ion, 74 tex. l. rev. 1301, 1311-12 (1996); lee burns & richard krever, individual income tax, in 2 tax law design and drafting 495, 496-97 (victor thuronyi ed., 1998); graetz, supra note 4, at 333; green, supra note 13, at 29; roin, supra note 13, at 1761; introduction, in 2 tax law design and drafting xxi, xxii-xxiii (victor thuronyi ed., 1998), the conclusion is fully applicable to a single-rate income tax, see blum & kalven, supra note 1, at xvii; see also infra note 27. many of those who prefer to subdivide the ability-to-pay concept into horizontal and vertical equity components would argue that including b’s foreignsource income in the tax base is necessary to satisfy both components irrespective of concerns about progressivi ty. u.s. limited liability company (in a jurisdiction permitting single-member llcs) which always earns $8,000 per year of u.s.-source net income and $10 million per year of net income sourced to active branch operations in low-tax country x.22 under a pure territorial system, only a’s and b’s $8,000 of u.s.-source income would be taken into account for income tax purposes.23 stated differently, a terr itorial system would allocate the fiscal burden of the u.s. government between a and b as if they had equal abilities-to-pay and both would remit the same amount of tax. this is clearly the wrong answer.24 there is nothing about foreign-source income that excuses it from being taken into account in allocating the tax burden between a and b under a tax system based on the ability-to-pay concept. a’s and b’s comparative abilities to pay can be properly measured only by including b’s foreign-source net income in the calculus.25 current law accomplishes this result 2001] fairness in international taxation 313 26. see regs. § 301.7701-3(a), (b)(1)(ii). there are narrow exceptions to this general approach of imposing worldwide taxation on u.s. residents. see, e.g., irc §§ 911 (exclusion of a limited amount of foreign earned income and certain qualified housing amounts); 114, 94143 (new exclusion for narrowly defined extraterritorial income). 27. see generally irc § 1. the current internal revenue code imposes progress ive ra tes on the incomes of individuals (and on corporations as well, see irc § 11). although we are supporters of this approach (at least with respect to individuals) we have chosen to defer our advocacy in behalf of progression. thus, in this article when we assert that b’s $10 million of foreign-source net income should be included in her u.s. taxable income and that she should pay a larger tax than a, we are saying nothing about what the rate of tax should be on a’s $8,000 of net income or whether any part of b’s income should be taxed at a rate higher than the rate applicable to a’s net income. stated differently, in this article, we do not, and need not, enter the debate over whether tax rates are too low or too high, or the debate regarding whether the income tax should be progressive and if so, how progressive. instead, we limit ourselves to arguing that because b’s income is 1,251 times larger than a’s, b should pay a tax that is at least 1,251 times larger than the amount paid by a. we seem to have general support for this position from per sons who are not usually counted as friends of rigorous income taxation. for example, even former president ronald reagan said: proportionate taxation we should gladly accept on the theory that those better able to pay should remove some of the burden from those least able to pay. the bible explains this in its instruction on tithing. we are told that we should give the lord one tenth and if the lord prospers us ten times as much, we should give ten times as much. ronald reagan , encroaching control: keep government poor and remain free, 27 vital speeches of the day 677 (1961), quoted in marvin a. chirels tein, federal income taxat ion 5-6 n.4 (rev. 8th ed. 1999). also, wi lliam safir e, the conservative new york times political commentator, has stated: “most of us accept as ‘fa ir’ this principle: the poor should pay nothing, the middle rs something, the rich the highest percentage.” william safire, the 25% solution, n.y. times, apr. 20, 1995, at a23, quoted in graetz, the u.s. income tax, supra note 2, at 11. indeed, most observers would readily concede that in the a-b example, b has a much greater ability-to-pay than a, and should pay a much greater tax, regardless of where these observers stand on the issue of progressive income taxation. that consensus is suffici ent for purposes of this article. for a sampling of the rich lit erature on the progressive taxat ion controversy, see blum & kalven, supra note 1; fr iedrich a. hayek, the constitution of liberty (1960); klein, supra note 1, at 12-45; arthur m. okun, equality and efficiency: the big tradeoff (1975); randolph e. paul, taxation in the united states 714-64 (1954); john f. witte, the politics and development of the federal income tax (1985); fried, supra note 1; lindsey, supra note 1; michael a. livingston, blum and kalven at 50: progressive taxation, “globalization,” and the new millennium, 4 fla. tax rev. 731 (2000); mcmahon & abreu, supra note 13; joel b. slemrod, the economics of taxing the rich, in does atlas shrug?–the economic consequences of taxing the rich 1 (joel b. slemrod ed., 2000); lawrence zelenak & kemper moreland, can the graduated income tax survive optimal tax analysi s? 53 tax l. rev. 51 (1999). for a dissenting view arguing that government should be financed by a modified regressive head tax, see jeffrey a. schoenblum, tax fairness or unfai rness? a consideration by ignoring the llc for tax purposes, treating the llc’s entire net income as taxable to b26 and imposing a much larger tax on b than on a.27 314 florida tax review [vol. 5:4 of the philosophical bases for unequal taxation of individuals, 12 am. j. tax pol’y 221 (1995). for a response, see donna m. byrne, locke, property and progressive taxes, 78 neb. l. rev. 700 (1999). the merits and deficiencies of a head tax need not be included in this discussion because such a t ax is not within the range of plausible poli cy alternatives. see blum & kalven, supra note 1, at 3; graetz & schenk, supra note 1, at 38-39; slemrod & bakija, supra note 1, at 136; fried, supra note 1, at 161-62, 194. 28. see generally klaus vogel, the search for compatible tax systems, in tax policy in the twenty-first century 76, 85 (herbert stein ed., 1988); vogel, supra note 9, at 156-57. 29. see restatement (third) of foreign relations law of the united states §§ 411-413 (1987); commission of the european communities, tax policy in the european union–priorities for the years ahead 9, 25 (may 23, 2001); woellner, barkoczy & murphy, supra note 7, at 1303; avi-yonah, supra note 10, at 1629; graetz, supra note 4, at 277-282; roin, supra note 10, at 597; stanley s. surrey, current issues in the taxation of corporate foreign investment, 56 colum. l. rev. 815, 824 (1956); alvin c. warren, jr., alternatives for international corporate tax reform, 49 tax l. rev. 599, 612 (1994); see also harris, supra note 3, at 443-44, 474; dan r. mastromarco, department of treasury exercises good judgment on oecd initiative, news, commentary and analysis, 91 tax notes 1623, 1624 (2001); mitchell, supra note 9, at 814-15; u.s. treasury secretary statement on oecd tax havens, official announcements, notices and news releases, 22 tax notes int’l 2617 (2001); letter from congressman dick armey to secretary of the treasury lawrence summers (sept.7, 2000), reprinted in 88 tax notes 1539, 1540 (2000). 30. see mitchell, supra note 9, at 803-06, 814-15, 821-22; surrey, supra note 29, at 825 (“when a ll of the recommendations of these organizations for e liminating double taxation are added up, the basic juri sdict ional rule they suggest i s not that of the count ry of citizenship d. compared to whom? one could argue that if individual c is an x country resident who also earns $10,000,000 of x country-source business income and pays the low x country rate thereon, fairness requires the a-b comparison to be replaced with a b-c comparison and requires that b’s $10,000,000 x country-source income be exempted from the u.s. tax base so that this income bears only the low x country tax paid by c.28 if, however, the u.s. congress decides to tax u.s. residents’ entire taxable incomes at a high rate (with a credit for foreign taxes) and country x decides to impose tax at a low rate on its residents and on income sourced within its borders, there is no fairness-based reason why the level of x country source-based taxation should dictate the u.s. conception of fairness with respect to u.s. residents. each country has the right to decide the notions of tax fairness that will prevail with respect to members of its society. 29 moreover, if x country’s tax rate on b’s and c’s country x-source income were higher than the u.s. rate on b’s country x-source income, it would be difficult to find advocates for the view that the b-c comparison compels the united states to raise its rate on b’s country x income up to the country x rate (so that b would not have any x country tax in excess of the u.s. credit that could be cross-credited against low foreign taxes on other income or carried back to prior years or forward to future years).30 2001] fairness in international taxation 315 and not that of the country of source, but rather that of the country with the lowest tax rate.”). 31. boris i. bittker, equity, efficiency, and income tax theory: do misallocations drive out inequities?, 16 san diego l. rev. 735, 739 (1979). 32. see ault & bradford, supra note 13, at 29-30; zolt, supra note 1, at 91-92. 33. see authorities cited in supra note 1. iii. what if everybody can do it? a. a self-inflicted wound? assume that the united states has adopted an exemption system and that u.s. residents e and f each has sufficient capital to invest in a business that will produce before-tax net income of $10 million per year. assume further that all u.s. residents have ready access to foreign investment opportunities. e chooses to acquire a business in low-tax country x. therefore, he pays no u.s. tax on his $10 million of country x-source income. f could do the same as e but, instead, she acquires a u.s. business. as a result, she pays u.s. tax on her $10 million of u.s.-source income. some analysts would argue that this disparate treatment of e and f does not contravene the ability-to-pay principle. this is because we are assuming that f had an equal opportunity to make a country x investment annually yielding $10 million of foreign-source net income. under this assumption, the fact that the united states imposes a heavier tax on f’s income of $10 million than on e’s income of the same amount is due entirely to f’s affirmative choice to earn u.s.-source income instead of exempt country xsource income. thus, some commentators would argue that although this hypothetical exemption system is a poorly-designed tax expenditure that improperly encouraged e to make a foreign investment, f is the victim of a “selfinflicted wound”31 and is not suffering from a violation of the ability-to-pay norm. 32 we disagree with this argument because it is impractical to measure ability-to-pay in terms of forgone opportunities. the only feasible way of comparing the abilities-to-pay of separate taxpayers is by looking at their actual incomes from all sources. thus, the predominant approach to measur ing abilityto-pay would regard the disparate u.s. taxation of e’s and f’s incomes as violating the ability-to-pay concept.33 a more fundamental problem with this “self-inflicted wound” analysis, however, arises from its critical assumption that opportunities to earn foreignsource business income are freely and equally available to all u.s. residents. this is plainly not correct. there are barriers of distance, language, custom and unfamiliar and complex legal regimes that exclude numerous u.s. residents from the opportunity to earn foreign-source business income with anything approaching the foreign income earning facility of other u.s. residents. consequently, the fact that f pays a heavier u.s. tax on her income in the 316 florida tax review [vol. 5:4 34. for 1998, aggregate u.s. income receipts on non-government u.s. assets owned abroad were $252,247,000,000, while employee compensation earned abroad by americans was $1,857,000,000. see u.s. dep’t of commerce, supra note 2, at 790; see also avi-yonah, supra note 10, at 1617-18; green, supra note 13, at 60. 35. see ault & bradford, supra note 13, at 29-30. preceding example than does e cannot necessarily be dismissed as the result of f’s bad judgment. this lack-of-equal-access point becomes many times larger when we return to our example of a, the u.s. resident convenience store clerk who earns $8,000 of u.s.-source net income per year and b, the u.s. resident who owns a u.s. llc that produces $8,000 per year of u.s.-source net income and $10 million per year of active business net income in low-tax country x. if one argues that the hypothetical u.s. exemption system does not violate the abilityto-pay principle in the case of e and f, above, one would seemingly be forced to also argue that since a “chose” to earn his $8,000 of wage income in the united states instead of achieving exemption from u.s. taxation by working at a country x convenience store, the ability-to-pay principle is not violated by the fact that a u.s. exemption system would levy identical u.s. income taxes on a’s and b’s vastly different incomes. but the stipulation that country x is a low-tax jurisdiction means that it is not contiguous to the united states. thus, u.s. resident a cannot freely elect to work in a country x convenience store. this illustrates a larger point: the wage income that dominates the earnings of a and most other individual taxpayers is far less mobile than other business income. indeed, most of the international income earned by u.s. residents is from capital–either direct or portfolio investments of capital.34 thus, the key premise of the preceding discussion, equal opportunity to earn foreign-source business income, does not really exist so long as there are disparit ies in wealth among taxpayers that result in some u.s. residents being able to earn foreign-source income from investing mobile capital while many more u.s. residents are effectively limited to earning relatively immobile wage income from u.s. sources. b. portfolio investment as a possible answer some would point out at this juncture that a lthough a and f might not have a ready oppor tunity to earn foreign-source business income from foreign direct investment, there are abundant opportunities for u.s. residents to earn foreign-source portfolio income by purchasing shares in foreign companies and by investing in mutual funds that buy foreign securities.35 this point is not responsive, however, because the advocates of a u.s. exemption system do not ordinarily contemplate that the system would cover foreign-source passive 2001] fairness in international taxation 317 36. see national foreign trade council, supra note 6, at 6-29; grubert & mutti, dividend exemption, supra note 10, at 2; merrill, supra note 14, at 103; h. david rosenbloom, from the bottom up: taxing the income of foreign controlled corporations, 26 brook. j. int’l l. 1525, 1549 (2001); joel slemrod, the taxat ion of foreign direct investment: operational and policy perspect ives, in borderline case 11, 34 (james m. poterba ed., 1997). indeed, countries that have adopted exemption systems have typically excluded foreign-source portfolio income from their exemption regimes. see ault, supra note 16, at 402-06. 37. see dodge, fleming & geier, supra note 3, at 472-78; stephen e. shay & victoria p. summers , select ed international aspects of fundamental tax reform proposals, 51 u. miami l. rev. 1029, 1032-33 (1997). 38. of course, many types of modern business income are also quite mobile and that is one key reason why an exemption for foreign business income would likely lead to tax motivated business investment in low-tax foreign countries. see u.s. treas. dep’t, deferral, supra note 7, at 44-45, 182-84, 197-209. 39. for explanations of implicit taxes, see u.s. treas. dep’t, blueprints, supra note 1, at 152-53; george cooper, the taming of the shrewd: identifying and controlling income tax avoidance, 85 colum. l. rev. 657, 698-99 (1985); harvey galper & dennis zimmerman, preferential taxation and portfolio choice: some empirical evidence, 30 nat’l tax j. 387, 388 (1977); calvin h. johnson, inefficiency does not drive out inequity: market equilibrium & tax shelters, 71 tax notes 377, 381-82 (1996); stanley s. surrey & paul r. mcdaniel, the tax expenditure concept and the budget reform act of 1974, 17 b.c. indus. & com. l. rev. 679, 702-06 (1976); edward yor io, equity, efficiency, and the tax reform act of 1986, 55 fordham l. rev. 395, 397-400 (1987). on these facts, of course , the exemption system produces an inefficient result in the sense that it induces u.s. residents to over-invest in country x. see altshuler, supra note 10, at 1581; avi-yonah, supra note 10, at 1604-05; zolt, supra note 1, at 92. income.36 this reticence is probably due to the fact that a generally available zero u.s. rate for offshore passive income would be seen as inconsistent with a fundamental feature of an income tax, as opposed to a consumption tax, namely, that income from capital should be taxed.37 moreover, the exemption of foreign portfolio investment income from u.s. taxation would likely encourage u.s. residents to effect a large shift of passive investments from the united states to lowor zero-tax rate foreign jurisdictions.38 c. implicit taxes as a possible answer but suppose the exemption system adopted by the united states causes internationally sophisticated u.s. residents to engage in so much direct investment in country x that the before-tax rate of return on b’s active business investments in country x is driven down to a point where b’s after-tax return on those investments equals the after-tax rate of return available to a on u.s. investments. exemption system advocates could argue that the ability-to-pay objection to the hypothetical u.s. exemption system has been eliminated because b is now paying an implicit tax39 on her country x income, in the form of a 318 florida tax review [vol. 5:4 40. moreover, it is doubtful that the flow of direct investment capital into low-tax foreign countries would be sufficient to result in a convergence of after-tax rates of return. see national foreign trade council, supra note 6, at 6-16. with respect to the failure of after-tax rates of return on tax exempt municipal bonds and taxable bonds to converge, see johnson, supra note 39, at 377. 41. for the sake of simplicity, we assume throughout the remainder of this article that all shareholders are individuals unless otherwise stated. thus, we reserve for a future article a discussion of the extent to which look-through rules are appropriate where stock is owned by juridical entities. 42. see bouma, supra note 8; graetz, supra note 4, at 325-31, 333-35. decreased before-tax rate of return, that results in her greater income bearing a larger aggregate tax than a’s smaller income. the problem with this line of argument is that implicit taxes are not collected by governments. thus, the implicit tax paid by b, in the form of a lower before-tax rate of return on her country x investment, does not go to the u.s. treasury and, therefore, it does nothing to increase the portion of the cost of the u.s. government borne by b vis-a-vis a. stated differently, the implicit tax borne by b fails to correct the misallocation of the u.s. tax burden that exists between a and b if a pays the same amount of u.s. tax as b. nor does the implicit tax go to the country x treasury where it would support a claim by b against the united states for double tax relief.40 in short, the implicit tax suffered by b does not solve the ability-to-pay objection to the hypothetical u.s. exemption system. thus, there seem to be no market dynamics undermining the critical observation that the ability-to-pay principle requires b’s larger income to bear a greater u.s. tax than a’s smaller income and that an exemption system produces a contrary result. iv. u.s. c corporations and ability-to-pay 41 a. the need for an anti-deferral device some commentators apparently concede that the preceding analysis establishes a persuasive case for worldwide taxation of u.s. resident individuals but, nevertheless, they are attracted to u.s. exemption treatment for the foreignsource income of u.s. resident c corporations.42 this raises the question of whether the preceding ability-to-pay analysis is applicable to income earned through c corporations. a useful way to pursue an answer is to revisit the preceding example in which u.s. resident individual b owns a u.s. llc earning $8,000 per year of u.s.-source net income and $10 million per year of active business net income in low-tax country x. now assume that b converts her wholly owned llc into a u.s. c corporation named usco. b then sells half of her new usco stock in 2001] fairness in international taxation 319 43. see irc §§ 702(a), 1366(a); jeffrey l. kwall, the uncertain case against the double taxation of corporate income, 68 n.c. l. rev. 613, 629 (1990). for a descript ion of such an integrat ion scheme, see u.s. treas. dep’t, blueprints, supra note 1, at 69-73, 98-100. some of the most prominent recent integration proposals have, however, regarded this approach to integration as unfeasible and have advocated schemes that rely on a corporate-level tax. see u.s. treas. dep’t, integration of the individual and corporate tax systems 39-49 (1992) [hereinafter u.s. treas. dep’t, integration]; american law institute, integration of the individual and corporate income taxes 92-94 (1993) [hereinafter american law institute, integration]. 44. in the example in the text, the number of shareholders and the nonresident alien status of 10,000 of them will prevent taxpayer b from using a subchapter s election to get her corpora tion out of c status. see irc § 1361(b)(1). moreover, if b had forgone conversion of her llc to a c corporation and had, instead, sold half her interest in profits and capital to 10,000 investors, the probable public trading in the ownership interests of taxpayer b’s llc would prevent the llc owners from avoiding c status by failing to formally incorporate the llc. see irc § 7704 and assume that irc § 7704(c) is inapplicable. 45. see irc §§ 11, 61(a)(3), (7). the shareholder-level tax is not reduced by credits reflecting corporate-level tax. thus, the corporate-level and shareholder-level income taxes function as independent, cumulative levies. this article assumes that this classical double taxation of c corporation income will continue as the general pattern under the internal revenue code for the foreseeable future even though we believe that integration of the corporate and shareholder income taxes would be a desirable policy move. double taxation is avoided in the cases of domestic c corporations reporting their income with a parent corporat ion on a consolidated return, see irc §§ 1501-1504, and certain wholly owned domestic subsidiaries of s corporations, see irc § 1361(b)(3). 46. see irc § 11(a), (b)(1); m. slade kendrick, corporate income tax rate structure, in 3 house comm. compendium, supra note 1, at 2289, 2297; yin, supra note 11, at 152. because the corporate-level tax is generally regarded as borne by living taxpayers and not the a public offering to 10,000 residents of country x and donates the stock sales proceeds to her favorite law school as an endowment for a tax law chair. thereafter, the shares of usco are traded on an established securities market. on these facts, b’s amounts of u.s.-source and foreign-source income are reduced by half to $4,000 and $5 million respectively (she owns only 50% of the usco stock), but both amounts should be taken into account for u.s. income tax purposes in measuring b’s ability to pay vis-a-vis low-income a. this result would be achieved directly if c corporation income were taxed to shareholders under a pass-through integration regime based on the principles of subchapter k or s.43 this is not, however, the way that the united states generally taxes c corporations. the income of a u.s. c corporation44 is typically subjected to both a corporate-level tax as it is earned by the corporation and also to a shareholderlevel tax at the, perhaps distant, time when the shareholders receive the income from the corporation or sell their shares.45 this taxation scheme cannot be explained on ability-to-pay grounds because liability under the corporate-level tax is calibrated to the taxable income of the corporation and bears no necessary relationship to the respective abilities to pay of any individuals.46 thus, several rationales other than ability-to-pay 320 florida tax review [vol. 5:4 entity itself, the question of a c corporation’s ability-to-pay is commonly viewed as irrelevant. see u.s. treas. dep’t, blueprints, supra note 1, at 4; harris, supra note 3, at 104; graetz, supra note 4, at 301-02; see also katherine pratt, the debt-equity distinction in a second-best world, 53 vand. l. rev. 1055, 1113-14 (2000). 47. see american law institute, integration, supra note 43, at 44-46; american law institute, taxation of private business enterprises 51-55, 59-63 (1999); bradford, supra note 1, at 103; jeffrey a. maine, linking limited liability and entity taxation: a critique of the ali report ers’ study on the taxation of private business enterprises, 62 u. pitt. l. rev. 223, 241-44, 253-57 (2000); pratt, supra note 46, at 1100-03, 1109-10. with respect to the historical origins of the corporate-level tax, see majorie e. kornhauser, corporate regulation and the origins of the corporate income tax, 66 ind. l.j. 53 (1990). 48. see graeme s. cooper & richard k. gordon, taxat ion of enterprises and their owners, in 2 tax law design and drafting 811, 817 (victor thuronyi ed., 1998); pratt, supra note 46, at 1112-13; george k. yin, corporate tax integration and the search for the pragmatic ideal, 47 tax l. rev. 431, 434 (1992); see also u.s. treas. dep’t, integration, supra note 43, at 27-35. among other things, large numbers of shareholders imply frequent trading in a corporation’s stock which creates difficulties in allocating income and losses to the shareholders. for contrary views asserting that a pass -through system can be constructed for corporations with large numbers of shareholders, see u.s. treas. dep’t, blueprints, supra note 1, at 69-74; yin, supra note 11, at 195-96. 49. see u.s. treas. dep’t, integration, supra note 43, at 189 n.1; 1 u.s. treas. dep’t, tax reform, supra note 1, at 118-21 ; howard e. abrams & richard l. doenberg, federal corporate taxat ion 8 (4 th ed. 1998); j.d.r. adams & j. whalley, the international taxat ion of multinational enterprises in developed countries 8 (1977); american law institute, integration, supra note 43, at 94; bradford, supra note 1, at 55; harris, supra note 3, at 102-04; joseph a. pechman, federal tax policy 136 (5th ed. 1987); slemrod & bakija, supra note 1, at 235-36; ault & bradford, supra note 13, at 37; cooper & gordon, supra note 48, at 812-13; malcolm gammie, the taxation of inward direct investment in north america following the free trade agreement, 49 tax l. rev. 615, 628-29 (1994); graetz, supra note 4, at 302; kwall, supra note 43, at 629-30 ; see a lso u.s. treas. dep’t , deferral , supra note 7, at 4; jeffrey l. kwall, the federal income taxation of corporations, partnerships, limited liability companies, and their owners 6-8 (2d ed. 2000); utz, supra note 13, at 177-78; pratt, supra note 46, at 1115; rebecca s. rudnick, who should pay the corporate tax in a flat tax world, 39 case w. res. l. rev. 965, 1066-69 (1988-89); joseph a. snoe, the entity tax and corporate integrat ion: an agency cost analysis and a call for a deferred distribution tax, 48 have been proposed as justifications for the corporate-level tax and there is disagreement regarding which of these is the “best” and, indeed, whether the basic concept of a separate, unintegrated corporate income tax is defensible at all.47 the merits of this controversy are outside the scope of this article. more importantly, in spite of this dispute over the theoretical justification for a separate, unintegrated tax on corporate income, there is broad agreement that because pass-through treatment cannot be pract ically imposed on corporations with large numbers of shareholders48 and because congress is quite unlikely, in the near term, to adopt other means of currently taxing shareholders on corporate income through integration of the corporate and individual income taxes, the present corporate-level tax must be maintained as a crude, second-best antideferral device.49 otherwise, c corporation shareholders would be able to 2001] fairness in international taxation 321 u. miami l. rev. 1, 43 (1993). of course, if the corporate-level tax were integrated with the shareholder-level tax, the corporate-level tax could continue to serve its anti-deferral function without imposing the double tax result that characterizes the present approach to taxing c corporations. there is, however, no near-t erm likelihood of such an integration scheme being adopted and this article assumes continuation of the current regime of c corporation taxation, no matter how ill-advised that may be from a tax policy standpoint. 50. generally speaking, only closely held businesses can qua lify for the subchapter k or s regimes. see irc § 1361(b)(1)(a) regarding subchapter s and irc § 7704 regarding subchapter k. there are also many closely held c corporations left over from the era preceding the rise of the llc and the check-the-box, entity classification regulations. but the current structure of the income tax creates an incent ive for new closely held enterprises to operate under subchapter k or s pass-through taxation. see u.s. treas. dep’t, taxes and corpora te choice of organizational form, ota paper no. 73 (1997). but see john w. lee, a populist political perspective of the business tax entities universe: “hey the stars might lie but the numbers never do,” 78 tex. l. rev. 885 (2000) (pointing out that despite the conventional wisdom that the choice of entity for new, closely held ventures is an llc, in all but one state, new formations of corporations (either c corporations or s corporations) outnumbered new llc formations, usually by a 2-to-1 or greater margin, in the 1995-1998 period). 51. see u.s. treas. dep’t, blueprints, supra note 1, at 4-5; u.s. treas. dept., distributional analysis, supra note 11, at § 6.4; u.s. treas. dep’t, integration, supra note 43, at 146-47; bradford, supra note 1, at 136-39; slemrod & bakija, supra note 1, at 66-67; william a. klein, the incidence of the corporation income tax: a lawyer’s view of a problem in economics, 1965 wisc. l. rev. 576; pratt, supra note 46, at 1108; roin, supra note 10, at 57677. 52. see kwall, supra note 43, at 635 n.115. completely defer taxation until they withdrew the corporations’s earnings (or sold their shares), thus achieving a deferral of u.s. tax that is not available to the owners of closely held businesses50 taxed under the subchapter k or s passthrough regimes. indeed, we believe that the anti-deferral effect of the present u.s. corporate income tax is the only persuasive reason for a large, unintegrated levy on corporate earnings. b. the overbreadth of the corporate income tax the corporate-level income tax, however, is indeed a crude anti-deferral instrument for three reasons. first, its rates (15% to 35%) bear no direct relationship to the length of time that shareholder-level tax is deferred. thus, the corporate-level tax is usually either greater than, or less than, the amount necessary to offset the economic benefit gained from deferring the shareholderlevel tax. second, the corporate-level tax in the preceding example may be partially shifted to investors in the noncorporate sector and to usco’s customers and suppliers of materials and labor,51 none of whom are engaged in deferring shareholder-level tax on shares of usco’s income.52 finally, usco may satisfy the 80% active foreign business requirement of sections 871(i)(2)(b) and 881(d) 322 florida tax review [vol. 5:4 53. see irc §§ 861(c), 871(i), 881(d). 54. see irc §§ 871, 881; regs. § 1.1441-5(b)(2) (i); rev. proc. 89-31, 1989-1 c.b. 895. 55. see also u.s. treas. dep’t, deferral, supra note 7, at 35; avi-yonah, supra note 10, at 1609. 56. for a description of such an integration regime, see u.s. treas. dep’t, blueprints, supra note 1, at 69-73, 98-100. so that the part of the dividends received by usco’s foreign shareholders that is proportionate to the corporation’s foreign-source gross income would be exempt from u.s. tax.53 to that extent, the foreign shareholders are not engaging in deferral of investor-level tax with respect to usco’s income and they are not proper targets of the corporate-level anti-deferral regime. moreover, a passthrough tax regime modeled on subchapter k would relieve the foreign shareholders from paying tax on the $5 million of usco’s foreign-source net income that is a ttr ibutable to them.54 therefore, it is inappropriate to apply a corporate-level anti-deferral tax to that income even if usco does not satisfy the 80% foreign business requirement. nevertheless, under current law the foreign shareholders’ entire portion of usco’s income bears u.s. corporate-level tax to the extent that the tax burden is not shifted to others. we should note, however, that the first two of these cr iticisms (the lack of relationship between the corporate-level tax rates and the deferral period and the partial shifting of the corporate-level tax) apply even if a c corporation’s income is entirely from u.s. sources. only the third criticism (that the corporatelevel tax reaches foreign stockholders’ shares of foreign-source corporate income) is directly relevant to the issue of whether a u.s. corporation’s foreignsource income is properly subject to the corporate-level tax. moreover, the cure for this third criticism (as well as the first two) lies in the united states adopting a responsive integration system. thus, the imprecision of the corporate-level tax does not present a case for exempting the foreign-source income of u.s. c corporations.55 instead it presents a case for a corporate integration regime that would (1) relieve foreign shareholders of u.s. tax on their portion of corporate foreign-source income, but (2) also uphold the ability-to-pay principle by imposing current u.s. tax on all corporate income (foreign-source as well as u.s.-source) attributable to u.s. resident shareholders.56 c. searching for the lesser evil unfortunately, the united states has not adopted the necessary integration scheme and is unlikely to do so in the near future. thus, the federal income tax system continues to require a corporate-level tax that functions as a second-best anti-deferral device. this means that although exempting foreignsource income of u.s. c corporations from the corporate-level tax would cure 2001] fairness in international taxation 323 57. see authorities cited in infra note 101. neither the u.s. domestic nor international anti-deferral regimes are serious threats to this tax planning approach. see generally boris i. bittker & james s . eustice, federal income taxat ion of corporations and shareholders ch. 7 (7th ed. 2000); 1 joel d. kuntz & robert j. peroni, u.s. international taxation chs. b2, b3 (1992); peroni, fleming & shay, supra note 10, at 460-64. moreover, as discussed recently by the u.s . treasury department , exempting a c corporation’s foreign-source income from u.s. tax while maintaining an entity-level tax on u.s.-source income would distort investment behavior by corporations: [r]educing only the tax on foreign investment income would cause domestic corporate investors to favor a foreign investmen t over a domest ic alt ernative that has a higher pretax return. the tax bias against corporate investment [because of the u.s. double tax regime], by itself, does not provide a compelling reason to favor foreign or domestic corporate investments if the overall goal is to minimize distortions in investment decisions. u.s. treas. dept, deferral, supra note 7, at 35. in other words, the appropriate solution to the overbreadth problem of the u.s. corporate tax is not lowering or eliminating the tax on only foreign-source income. 58. see supra par t iv.b. 59. this issue was presented in 1876 to the exchequer court under the british regime which taxed the worldwide income of british resident corporat ions . in upholding the imposition of this tax on the foreign-source income of a briti sh resident corporation whose shares were owned primarily by nonresidents, chief baron kelly stated, “that if a foreigner residing abroad the overbreadth of that tax with respect to foreign-source income attributable to foreign shareholders, it would do so at the cost of allowing u.s. stockholders to substantially remove their shares of corporate foreign-source income from the u.s. tax base by causing u.s. c corporations to defer distributions until the present value of the shareholder-level tax shrinks to insignificance.57 this would effectively defeat the ability-to-pay principle, which requires that both u.s.source and foreign-source income be included in determining a u.s. resident’s appropriate share of the expense of government. stated more broadly, granting exemption from the corporate-level tax for all foreign-source income of u.s. c corporations would allow u.s. resident individuals to escape the inclusionary requirement of the ability-to-pay principle by interposing a u.s. c corporation between themselves and their foreign-source income. by contrast, maintaining an unintegrated corporate-level tax on the worldwide income of u.s. c corporations would uphold the ability-to-pay principle with respect to u.s. shareholders but, as explained above,58 would incorrectly tax the portion of the foreign-source income of u.s. c corporations that is attributable to foreign shareholders. this difficult dilemma should be resolved in favor of sustaining the ability-to-pay principle with respect to u.s. shareholders by imposing u.s. corporate-level tax on the foreign-source income of u.s. corporations regardless of the presence of foreign shareholders. this is burdensome to the foreign shareholders but not unfair because the corporate-level tax is a clearly disclosed element of the u.s. tax system and nonresidents purchase the shares of u.s. corporations with their eyes wide open.59 324 florida tax review [vol. 5:4 . . . thinks fit to come and invest his money in this country, and so to obt ain the broad shi eld of protection of the law to his property, he must take it with the burdens belonging to it.” calcutta jute mills co. v. nicholson and cesena sulphur co. v. nicholson, 1 reports of tax cases 83, 88, 102 (1876). 60. irc §§ 11, 7701(a)(4), (5). 61. see herman b. bouma, two arguments against an alternative view of deferral, 20 tax notes int’l 875 (2000); h. david rosenbloom, the david r. tillinghast lecture: international tax arbitrage and the “international tax system,” 53 tax l. rev. 137, 139 (2000). 62. see slemrod, supra note 36, at 31. for example, towards the end of the boom in technology stocks, israeli technology start-up companies were routinely formed as u.s. corporations in anticipation of issuing nasdaq-traded stock. d. defining corporate residence and pursuing runaway corporations and shareholders in the preceding discussion, we have referred to corporations taxed by the united states on their worldwide incomes as “u.s. corporations” and “u.s. c corporations” without further explanation. we recognize that in taking this approach, we have oversimplified matters by acting as if the identification of such corporations were an obvious, non-controversial matter. we did so because this is, in fact, a difficult and complex issue and a thorough analysis would substantially detract from our focus on the international implications of the ability-to-pay principle. nevertheless, the problem of identifying the corporations that should be subjected to u.s. taxation of their worldwide incomes has important implications regarding the ability-to-pay principle and a brief discussion is appropriate at this point. a corporation is treated as a u.s. resident, taxed by the united states on its worldwide income, if it satisfies the internal revenue code’s definition of a “domestic corporation”–i.e., if it is incorporated under the laws of the united states, one of the 50 states or the district of columbia.60 commentators have argued that when this place-of-incorporation rule is coupled with the u.s. worldwide taxation system, it creates the indefensible possibility of a corporation with no u.s. shareholders, no u.s. assets and no u.s.-source income incurring u.s. tax on its foreign-source income merely because it was incorporated in a u.s. jurisdiction. 61 we recognize that when u.s. resident status is bestowed on a corporation owned exclusively by foreign shareholders and earning its income entirely outside the united states, the result is overtaxation of the foreign shareholders by the united states. we do not view this as a significant practical problem, however, because the universe of domestic corporations with no u.s. shareholders, no u.s. assets and no u.s.-source income is surely very small and nearly always the result of informed planning.62 2001] fairness in international taxation 325 63. see bouma, supra note 9, at 813; ryan j. donmoyer, multinationals beg finance to simplify international laws, 82 tax notes 1539 (1999); roin, supra note 10, at 589 n.151, 590; see also avi-yonah, supra note 10, at 1594, 1665-66, 1670; graetz, supra note 4, at 32829. 64. the australian definition of resident corporation generally follows the shareholder residence approach. see income tax assessment act 1936, § 6(1). 65. for a proposal to do so, see peroni, fleming & shay, supra note 10, at 507-16. 66. michael j. grae tz, taxing international income: inadequate principles, outdated concepts and unsatisfactory policies, 54 tax l. rev. 261, 320 (2001). a related suggestion has been made that the combination of the u.s. approach to defining corporate residency and the u.s. system of worldwide taxation will drive u.s. resident corporations to incorporate their new ventures (say intel’s development of its next-generation processor) in low-tax offshore jurisdictions.63 the new corporations would then be foreign residents that escape current u.s. taxation of their foreign-source income. however, if runaway corporations are truly a threat to the u.s. income tax base, the problem can be properly addressed by expanding the definition of “domestic corporation.” to be specific, if u.s. resident corporations incorporate their new product developments offshore, the united states could counter that tax-avoidance strategy by enlarging the definition of “domestic corporation” to include entities whose stock is held in significant percentages by u.s. residents.64 even better, the united states could totally end deferral of u.s. tax on income earned by u.s. shareholders through foreign corporations by applying a pass-through regime to such income.65 more importantly, the concept of corporate residence is critical to a system of worldwide taxation because only residents are taxed by their residence country on their worldwide incomes. recently, professor michael graetz has cast doubt on whether any definition of corporate residence, including the stock ownership approach suggested immediately above, is defensible or practical. his specific statements are: [i]n the case of corporations, the idea of residence is largely an effort to put flesh into fiction, to find economic and political substance in a world occupied with legal niceties . . . .66 . . . . it is precarious to turn significant u.s. tax consequences on the status of a corporation as a resident or nonresident, given the difficulty of assessing the “true” residence of corporations, except in the case of closely-held companies where the residence of the owners easily can be determined. linking corporate residence to the residence of its 326 florida tax review [vol. 5:4 67. id. at 323. 68. see id. at 331. 69. see supra par t iv.c. 70. see supra par t iv.c. 71. see ault, supra note 16, at 371-72. 72. see supra par t iv.c. owners simply does not seem practical in the context of multitiered multinationals. on the other hand, insisting that a corporation’s residence is the same as that of its managers or officers seems difficult to justify.67 professor graetz uses these assertions regarding the difficulty of formulating a defensible and feasible definition of corporate residence as an element in constructing a case for seriously considering exemption treatment of corporate foreign-source income by the united states.68 we agree that any definition of corporate residence is inevitably art ificial because corporations themselves are artificial beings. but as previously noted, failure by the united states to tax u.s. corporations on their worldwide incomes would allow u.s. resident individuals to materially avoid u.s. taxation through interposing a corporation between themselves and their foreign-source income.69 this would significantly undermine the ability-to-pay principle. the united states should not go down this road unless it is clear ly established that there is no feasible and defensible definition of u.s. corporate residence. we do not believe that this is the case. as explained above, a principal purpose of the u.s. tax on corporate income is to serve as an anti-deferral device that preserves the efficacy of the shareholder-level tax on the worldwide incomes of u.s. shareholders.70 this suggests that a definition of corporate resident is defensible if it is constructed to reach corporations with substantial numbers of u.s. resident shareholders. a definition grounded on place of incorporation (the present u.s. approach) or place of management (an approach commonly used in british commonwealth countries71) might satisfy this requirement because it seems quite possible that most corporations that are incorporated or managed in the united states are substantially owned by u.s. residents. this is, unfortunately, an empirical question for which we do not have the definitive answer but which could be usefully investigated with empirical research techniques. it is clear, however, that defining corporate residence in terms of the level of share ownership by u.s. residents would be consistent with the role of the u.s. corporate income tax as a device to protect the shareholder-level tax. granted, if the required level of u.s. ownership were set at any point less than 100%, foreign shareholders would be overtaxed on their portion of the u.s. corporation’s foreign-source income. but for the reasons stated above,72 this is an acceptable result in a decidedly second-best world. moreover, the imperfection 2001] fairness in international taxation 327 73. graetz, supra note 4, at 323. 74. see, e.g., irc §§ 902 (indirect credit for domesti c corpora tions owning 10% or more of a foreign corporation’s voting stock), 904(d)(3) (look-through rules for foreign tax credit limitation purposes for “united states shareholders” of controlled foreign corporations), 904(d)(4) (look-through rules for foreign tax credit limitation purposes for domestic corporations owning 10% or more of a foreign corporation’s voting stock), 960 (indirect credit for “united states shareholders” of controlled foreign corporations owning 10% or more of the corporation’s voting stock). one commentator has suggested that using a shareholder residence test for defining corporate residence is unworkable in the case of corporations whose shares are publicly traded, particularly where the trading occurs in more than one country. see avi-yonah, supra note 10, at 1666, 1670. nevertheless, it would seem that if the u.s. ownership threshold were set at a substantial level, say more than 50% of the vote or value of the stock, public trading would rarely create a si tuat ion in which a corporation drifted into or out of residency qualification. cf., e.g., irc § 884(e)(4) (“qualified resident” includes more than 50% ownership by residents of a country, with a special rule for publicly traded corporations that looks to regular trading on an established securities market in that country). the problem of foreign corporations that refuse to provide information concerning the u.s. res idency of their shareholders could be addressed by a presumption that each foreign corporation that solicited u.s. investors, either by registering shares for sale to u.s. persons with the securities and exchange commission (sec) or by offering shares to u.s. persons under a private placement exemption from sec registration, is a u.s. resident under the shareholder residence test unless the corporation proves otherwise. 75. see national foreign trade council, supra note 6, at 6-23 to 6-24. 76. for a proposal to do so, see peroni, fleming & shay, supra note 10, at 507-16. of this second-best answer makes out a case for integration, not exemption. in this second-best context, defining a u.s. resident corporation as one in which u.s. residents own some considerable percentage of the stock of the corporation, e.g., more than 50% of the vote or value of the stock, strikes us as about right. as noted above, professor graetz has argued that such an approach “simply does not seem practical in the context of multitiered multinationals.”73 we respectfully disagree. it strikes us that we already use look-through rules in a number of contexts in the international tax provisions, which penetrate layers of entity shareholders and reach the ultimate individual owners.74 the suggestion has also been made that taxing u.s. resident corporations on their worldwide incomes is rendered indefensible by the fact that u.s. resident individuals can obtain the benefits of exemption treatment of corporate income simply by purchasing portfolio investments in the shares of corporations located in exemption system countries.75 however, this runaway shareholder problem could be addressed by adopting a system of currently taxing u.s. resident stockholders on their shares of foreign corporate income regardless of how small their percentage of stock ownership might be.76 in summary, we conclude that the challenges of constructing a defensible and feasible definition of corporate residence, or of dealing with u.s. residents who become portfolio investors in foreign corporations, do not rise to a level that 328 florida tax review [vol. 5:4 77. see gustafson, peroni & pugh, supra note 7, at 18-20; green, supra note 13, at 2324; see also joint comm., description, supra note 10, at 26; u.s. treas. dep’t, deferral, supra note 7, at 25-42. but see richard l. doernberg, electronic commerce: changing income tax treaty principles a bit?, 21 tax notes int’l 2417, 2423 (2000) (suggesting that international double taxation is not objectionable where the sum of the two taxing countries’ marginal tax rates does not exceed 10%). the need for remedial action by the united states as the residence country is so wellsettled, and so powerfully driven by the capaci ty of source countries to effectively claim priority for their income taxes vis-a-vis the income taxes of residence countries, that we accept it as given that the united states must act unilaterally (in the absence of an applicable income tax treaty) to mitigate international double taxation when the united states is in the residence country role. justifies compromising the ability-to-pay principle by adopting an exemption regime on the foreign-source income of u.s. corporations. v. the foreign tax credit and ability-to-pay a. the exemption effect of the foreign tax credit preceding portions of this article have argued that the ability-to-pay principle requires foreign-source income of u.s. residents to be included in the u.s. tax base to the same extent as u.s.-source income. is this argument undermined by the u.s. policy of employing a foreign tax credit to mitigate international double taxation of u.s. residents’ foreign-source income? to illustrate this issue, assume that if usco, a u.s. resident corporation, builds its next plant in the united states, it will earn a 10% before-tax rate of return on the invested capital but that if the plant is built in country d, the before-tax rate of return will be 15%. clearly, the country d investment is economically superior. now assume that country d taxes income earned therein at 35%, that the united states applies the same rate to its residents’ worldwide incomes and that there is no united states-country d income tax treaty. if double taxation is not ameliorated, the u.s. plant will produce a 6.5% rate of return after the 35% u.s. tax (.10 x [1 .35]) but the country d plant will yield a only a 4.5% rate of return (.15 x [1 .70]) after the combined 70% u.s. and country d taxes. in these circumstances, the tax system will push usco to choose the economically inferior u.s. investment. there is broad agreement that this is an inappropriate result and that because the united states is the residence country and there is no tax convention in force that remedies the problem, the united states should act unilatera lly to relieve usco’s double taxation.77 if fairness were the only consideration, we would advocate that the united states handle usco’s tax payments to country d like any other business expense–i.e., as allowable deductions in calculating net income. under this 2001] fairness in international taxation 329 78. “congress enacted the foreign tax credit in 1918 to prevent u.s. taxpayers from being taxed twice on their foreign-source income.” joint comm., description, supra note 10, at 26. we use the term “residual tax” in its conventional sense–i.e., the residence country tax liability remaining after allowance of a credit for source country tax that was levied at a lower rate than the residence country tax. deferral of residual tax refers to the feature of many residence country tax systems approach, u.s. taxpayers would pay the same rate of u.s. tax on their aggregate u.s.and foreign-source income. although allowing only a deduction for foreign taxes would satisfy the ability-to-pay criterion, it would, however, leave usco with a substantial tax disincentive to pursue the superior country d investment. to illustrate this fact, assume that in the preceding example, usco is deciding between investing $1,000 in a u.s. plant (with a 10% before-tax rate of return) and $1,000 in a country d facility (with a 15% before-tax rate of return) and that the united states treats country d tax payments as a deductible business expense. the $1,000 country d investment would produce $150 of before-tax net income for country d tax purposes ($1,000 x .15) and a $52.50 tax ($150 x .35) would be paid to country d. for u.s. tax purposes, however, before-tax net income in this case would be $150 $52.50 = $97.50 and $34.13 would be payable to the u.s. treasury ($97.50 x .35). thus, after payment of both taxes, usco would have $63.37 of its $150 left. by contrast, investment of the $1,000 in a u.s. plant would produce $100 of before-tax net income ($1,000 x .10) and $65 after the 35% u.s. tax ($100 x [1 .35]). all other factors being neutral, usco would invest in the economically inferior u.s. plant because of its higher after-tax return. in other words, the u.s. decision to treat the country d tax payment as a business expense deduction in this case would not overcome the double-tax barrier to usco’s making the superior country d investment and would not remedy the double-tax problem in a wide range of other cases. thus, the united states has been faced with a choice between (1) pursuing a tax system that is totally faithful to fairness concerns (i.e., that treats foreign tax payments as income tax deductions) but that leaves international double-taxation substantially in place as a barrier to its residents’ foreign business and investment activit ies, or (2) finding a way to ameliorate the doubletax barrier while preserving the ability-to-pay tax base to the greatest extent possible. the first alternative has been judged unacceptable and it is difficult to quarrel with this outcome. the issue then is which of the generally accepted methods to ameliorate double taxation is super ior from a fairness perspective. we submit that adopting a foreign tax credit system while prohibiting deferral of any residual u.s. tax remaining after allowance of the foreign tax credit is the preferred way to achieve fairness and efficiency objectives.78 330 florida tax review [vol. 5:4 that generally al lows payment of residual tax on income earned through a foreign corporat ion to be postponed until residents receive dividends or sell their stock. deferral reduces the present value of residual tax and allows residents who defer for lengthy periods to achieve the approximate result of an exemption system. for further discussion of deferral, see text accompanying infra notes 100-101. for a discussion of why a deduction is sufficient to achieve fairness objectives, see kaufman, supra note 4, at 177-78. 79. see also supra note 19. it has been sugges ted that a credi t for foreign income tax payments also may be analyzed as the economic equivalent of having usco pay the 35% u.s. tax to the u.s. government and having the u.s. government in turn pay usco’s tax owed to country d. see kaufman, supra note 4, at 179. treating the foreign tax as a u.s. tax for this purpose, however, links payment of the deemed u.s. tax with use of the tax proceeds as a grant to the foreign government a t the behest of the taxpayer. this k ind of directed benefit is inconsistent with the redistributive objective for the u.s. tax. under a credit system without deferral, if usco built the plant in country d, usco’s 35% foreign tax liability would eliminate its 35% u.s. tax liability, so that the country d investment would bear only the country d tax (i.e., the u.s. residual tax would be zero). thus, the country d investments’ after-tax rate of return would be 9.75% (.15 x [1 .35]), which would make it superior to the 6.5% after-tax return on the u.s. investment (.10 x [1 .35]). double taxation of usco’s country d profits would be remedied and the tax system would not pose a barrier to pursuing the superior country d investment. the foreign tax credit approach means, however, that whenever the foreign income tax rate is greater than zero, the foreign-source income of u.s. residents will bear a lower u.s. tax rate than domestic-source income. indeed, in the preceding example, allowing usco to claim a credit for the country d tax will result in usco’s foreign-source income bearing a zero u.s. tax while its u.s.-source income is taxed at 35% even though both types of income contribute equally to a taxpayer’s ability-to-pay. speaking more broadly, mitigating international double-taxation by allowing a credit for foreign income tax payments is the economic equivalent of exempting foreign-source income in proportion to the amount of u.s. income tax that is offset by the credit. thus, on the facts of the preceding usco example, the foreign tax credit will fully offset the u.s. tax on country d-source income and effectively exclude that income from the u.s. tax base. to restate the issue, do the preceding consequences which flow from the decision of the united states to ameliorate international double taxation by employing a foreign tax credit invalidate the ability-to-pay principle with respect to u.s. residents’ foreign-source income that bears a foreign income tax? the answer to this question is no. this is simply a situation in which policy makers have required an important value (fairness, as expressed in the ability-to-pay principle) to give ground to another important, but conflicting, value (ameliorating international double taxation).79 the compromise is a reasonable 2001] fairness in international taxation 331 we recognize that in many situations involving a u.s. resident’s foreign-source passive nonbusiness income (such as nonbusiness interest income) that is subject only to a gross basis foreign withholding tax, a strong argument could be made that no double taxation problem exists that would distort economic behavior because the u.s. resident-creditor does not bear the economic burden of the foreign tax (which instead is borne by the foreign debtor who pays the u.s. creditor an amount of interest income that was agreed to be net of foreign taxes). see deborah a. geier, some thoughts on the incidence of foreign taxes, 87 tax notes 541 (2000). in such situa tions, both effici ency and ability-to-pay considerations support allowing the u.s. resident only a deduction (rather than a credit) for foreign taxes. one and it in no way invalidates the proposition that an income tax system that gives great weight to the ability-to-pay principle should generally include foreignsource income in the tax base. note, however, that on the facts of the usco example above (35% tax rate in both the united states and country d), the foreign tax credit creates the same result as an exemption system—a zero u.s. tax on income earned in country d. the same will be true whenever the source-country tax rate equals or exceeds the u.s. rate. this raises the issue of why, when choosing a method to ameliorate international double taxation, the united states should choose the foreign tax credit approach instead of an exemption system. one response is that under the foreign tax credit approach, if the foreign country’s income tax rate is below the u.s. rate, the u.s. collects a current residual tax on foreign-source income, assuming no deferral of residual tax. stated differently, where the foreign tax rate is less than the u.s. rate, a foreign tax credit system (without deferral) effectively includes foreign-source income in the u.s. tax base, and gives effect to the ability-to-pay principle, in proport ion to the amount of u.s. tax that remains after allowing the foreign tax credit. thus, the foreign tax credit recognizes that ameliorating double taxation indeed involves a compromise with the ability-to-pay principle. by contrast, an exemption system would leave foreign-source income out of the u.s. tax base in all cases regardless of the relationship of the foreign tax rate to the u.s. ra te. this would amount to a blanket renunciation of the ability-to-pay principle instead of a compromise between ability-to-pay and mitigation of international double taxation. moreover, when we move away from cases where the foreign tax rate is equal to, or greater than, the u.s. tax rate, an exemption system (and the current u.s. deferral system) introduces a highly distortive element into the income tax that is not presented by the foreign tax credit. to illustrate this point in a worst case scenario, return to the example above involving usco and assume that its choice is between building the plant in the united states, where it will produce a 10% return, before u.s. income taxation, and building it in country e, where it will produce an 8% return, before u.s. income taxation. assume further that the united states will tax usco at a flat 35% rate and that country e will impose a zero rate under an investment incentive regime. if the united states had 332 florida tax review [vol. 5:4 80. see irc § 904. 81. see joint comm., description, supra note 10, at 28 (“permitting the foreign tax credit to reduce u.s. tax on u.s. income would in effect cede to foreign countries the primary right to tax income earned from u.s. sources.”); graetz, supra note 4, at 324 (“no one urges an unlimited foreign tax credit, because it would both undermine the ability of the united states to collect taxes on u.s. source income and invite other nations to impose high taxes on u.s. a real worldwide system (no deferral of residual tax), usco would face a 35% tax rate if it located the new business in the united states and a 35% cumulative tax rate (zero foreign tax plus 35% u.s. residual tax) if it established the new business in country e. consequently the after-tax rates of return would be 6.5% for the u.s. location (.10 x [1 .35]) and 5.2% for the foreign location (.08 x [1 .35]). thus, the u.s. location’s comparative before-tax superiority (.10 ÷ .08 = 1.25) would continue to exist after-tax (.065 ÷ .052 = 1.25) and usco’s location decision would be unaffected by the u.s. tax system. by contrast, if usco can avoid paying u.s. tax on the foreign profits (either because usco engages in deferral planning under the current u.s. system or because the united states adopts an exemption system), usco will be choosing between after-tax returns of 6.5% (.10 x [1 3.5]) in the u.s. location and 8% (.08 x [1 0]) in the country e location. thus, the effect of the current u.s. system, and of an exemption regime, is to create a strong incentive for usco to make the economically inferior foreign investment. in summary, a foreign tax credit system (without deferral) is superior to an exemption system as a double-tax mitigation approach because it avoids international double taxation, minimizes the effect of tax considerat ions on investment choice and achieves fairness objectives. stated differently, a foreign tax credit system (without deferral) achieves a compromise between the abilityto-pay principle and elimination of double taxation, instead of abandoning ability-to-pay, and does so without the distortions of economic behavior resulting from an exemption system. b. the foreign tax credit limitation one might raise an objection, however, to the u.s. foreign tax credit limitation that restricts the credit to the amount of u.s. tax on foreign income in a particular foreign tax credit limitation category.80 where this limitation prevents the current utilization of excess foreign tax credits, the foreign income effectively bears a greater aggregate tax burden than domestic-source income and the ability-to-pay cr iterion arguably is violated in those cases where the result is substantially disparate treatment of u.s. residents with similar amounts of total income. this is, however, another instance in which a countervailing concern (the possibility of high foreign taxes eroding or eliminating the u.s. tax on u.s.source income) outweighs the ability-to-pay criterion.81 2001] fairness in international taxation 333 companies as a way to shift revenues from our treasury to theirs.”). 82. see harris, supra note 3, at 313, 443; musgrave, consumption tax proposals, supra note 20, at 80; lee a. sheppard, rethinking subpart f, 90 tax notes 149, 150 (2001). to illustrate this point, if the country d and u.s. tax rates in the initial example above were 45% and 35%, respectively, and a u.s. resident earned country d-source and u.s.-source income, an unlimited u.s. foreign tax credit would require the united states to forgo its full 35¢ of tax on each dollar earned by the u.s. resident in country d plus an additional 10¢ of revenue on a dollar of the resident’s u.s.-source income. the united states is understandably unwilling to allow country d to finance its governmental operations by effectively appropriating u.s. taxes on u.s.-source income. the u.s. foreign tax credit, with its limitation, addresses the issue of how the united states will respond to the fact that other governments also have legitimate claims to a portion of its tax base.82 a resolution of that problem does not necessitate abandonment of the ability-to-pay principle for purposes of defining the tax base. instead, it requires an intergovernmental compromise regarding a sharing of that base. the united states has responded to the need for compromise by granting a credit for foreign income tax, limiting u.s. tax collection to a residual tax on foreign-source income of u.s. residents and declining to surrender u.s. tax on u.s.-source income. the prudentia l policy of limiting the credit in a way that preserves u.s. tax on u.s.-source income in no way invalidates the command of the ability-to-pay principle to include foreignsource income in the tax base. moreover, an exemption system does not have a superior fairness claim in circumstances where the foreign tax credit limitation would come into play. if a foreign country’s effective tax rate on foreign-source income of a u.s. person equals or exceeds the u.s. tax on the same income, a foreign tax credit system subject to a limitation as described above and an exemption system yield equivalent results. in both cases, the residence country would neither collect any residual tax on the foreign income nor allow the foreign tax to reduce the taxpayer’s u.s. tax on u.s.-source income. vi. attempting to overcome ability-to-pay by revising the benefits theory a. the collapse of the original benefits theory tax theorists once argued that fairness required the tax burden to be apportioned among taxpayers in relation to the government benefits received by 334 florida tax review [vol. 5:4 83. see report on double taxation, league of nations doc. e.f.s. 73.f.19, at 18 (1923), in 4 staff of joint comm. on taxation, legislative history of united states tax conventions 4003, 4022 (1962); fried, supra note 1, at 159-60. 84. see blum & kalven, supra note 1, at 36; dodge , fleming & geier, supra note 3, at 24; harris, supra note 3, at 13-14; palmer, supra note 13, at 25-26; see also roin, supra note 10, at 555 (“the nature of the tax base makes the correspondence between any particular taxpayers’ tax costs and tax benefits loose at best.”). 85. see dodge, supra note 1, at 90-91; graetz & schenk, supra note 1, at 39; slemrod & bakija, supra note 1, at 52-54. 86. see harris, supra note 3, at 14-15; utz, supra note 13, at 42. 87. see authorities cited in supra note 13. 88. the most fully developed statement of the revised benefits theory is in harris, supra note 3, at ch. 7. three other statements are roin, supra note 10, at 588-94; jeffer son vanderwolk, the deferral debate and the benefits theory, 20 tax notes int’l 1469, 1469-71 (2000), and vogel, supra note 9, at 152-66. (professor vogel presents the revised benefits theory as an alternative to his preferred approach of an exemption system.) 89. harris, supra note 3, at 445-49, 457-59, 462; roin, supra note 10, at 588-94; vanderwolk, supra note 88, at 1470; vogel, supra note 9, at 155-56; see also warren, supra note 14, at 134. each individual.83 tax payments would then be calibrated to the value of the goods and services provided to each person by government. this approach proved unworkable because it was impossible to formulate accurate allocations of important, but generalized, benefits (e.g. , national defense, the corrections system, a legal system that protects property rights, and environmental protection) to particular individuals and because much of modern governmental expenditure is for redistributive assistance provided to recipients precisely because they are too poor to pay.84 thus, the notion of financing government by levying taxes on separate individuals in amounts that reflect government benefits received by each of those individuals is a historical curiosity except for charges that can be feasibly traced to one’s use of a discrete government good or service (e.g., bridge and highway tolls, municipal water use charges and postage stamps).85 instead, as discussed above, the ability-to-pay principle, which makes no attempt to account for benefits received by taxpayers,86 is now the prevailing u.s. norm for effecting a fair allocation of the income tax burden.87 b. the revised benefits theory recently, however, a few commentators have sought to displace the ability-to-pay norm with a revised benefits theory.88 their objective is to create a fairness justification for at least partia lly exempting international income. these commentators begin by effectively dividing income into three classes: (1) income earned within the taxing country by its residents, (2) income earned outside the taxing country by its residents and (3) income earned within the taxing country by nonresidents.89 class (1) is pure single-nation income and 2001] fairness in international taxation 335 90. see harris, supra note 3, at 446-50, 458-62, 468-70, 478-89; roin, supra note 10, at 555, 588-89, 591-93; vanderwolk, supra note 88, at 1470; vogel, supra note 9, at 155-66; see also warren, supra note 14, at 134 (discussing several possible methods for allocating the tax base). 91. see harris, supra note 3, at 449, 458-59, 462, 468-70, 486; roin, supra note 10, at 588-89, 591-93; vanderwolk, supra note 88, at 1470; vogel, supra note 9, at 156. 92. see harris, supra note 3, at 446-47, 477, 489; vogel, supra note 9, at 155-56. classes (2) and (3) embrace all the categories of international income because they cover all situations in which residents of one country earn income in another. moreover, both classes (2) and (3) always involve a pair of countries with potentially competing tax claims–the country in which the income earner resides (residence country) and the country where the income is earned (source country). the advocates of the revised benefits theory assert that the fair way to tax these three income groups is to apply separately to each class a rate, or set of rates, calculated to produce an aggregate tax yield from each class that compensates each government for the cost of benefits provided to assist in the earning and enjoyment of the total income in each class.90 moreover, residence and source country governments should set the rates on classes (2) and (3) at levels lower than the “normal” rates applicable to class (1) (single-nation income) because governments provide more services for the earning and enjoyment of class (1) income than they provide for the earning and enjoyment of income classes (2) and (3).91 this approach to levying taxes in relationship to benefits received by taxpayers is supposed to avoid the infirmity of the original benefits theory because the new version directs the allocation of total benefits to only three classes of aggregate income and does not require that particular benefits be traced to numerous specific taxpayers.92 c. the revised benefits theory as a partial exemption system the consequence of residence countr ies and source countries imposing lower than normal tax rates on international income (classes (2) and (3)), is that each group of countries effectively operates a par tial exemption system. for example, if the united states imposes 20% of normal class (1) tax on business income earned by its residents in mexico, and mexico imposes a tax on this income equal to 80% of its normal business income tax, the result is mathematically indistinguishable from the united states charging its regular rate but exempting 80% of its residents’ mexican-source income and mexico charging its regular rate but exempting 20% of the mexican-source income of u.s. residents. to illustrate this point, assume that under the 20%/80% system described above, both the united states and mexico charge a 35% normal rate and that a hypothetical u.s. resident earns $100 of income in mexico. the 336 florida tax review [vol. 5:4 united states will charge a tax of .20 x .35 x $100 = $7, which is mathematically indistinguishable from the united states exempting $80 of the mexican-source income and applying the 35% normal tax to the $20 remainder (.35 x $20 = $7). conversely, mexico will charge a tax of .80 x .35 x $100 = $28, which is mathematically indistinguishable from mexico exempting $20 of the mexicansource income and applying the 35% normal tax to the $80 remainder (.35 x $80 = $28). the result for the united states in this hypothetical case (collection of a $7 tax) is actually better than under the current u.s. worldwide system, which would allow the united states to collect no tax because the $35 tentative u.s. tax would be offset by a $35 credit for the mexican tax, assuming that the taxpayer is not in an excess credit position. if, however, the source country rate were significantly less than the u.s. tax rate, this hypothetical part ial exemption system would cause the united states to lose revenue in comparison to the residual tax that it would collect under the present worldwide system. a useful framework for evaluating this partial exemption system that emerges from the revised benefits theory is to adopt the analytical approach applied in the preceding section regarding the relationship between ability-to-pay and the foreign tax credit. in other words, this partia l exemption system can be effectively examined first by scrutinizing it in terms of a proper formulation of the income tax base and second by evaluating it as a mechanism for mitigating international double taxation when nations find that their tax bases overlap. d. fairness and partial exemption as explained above, the revised benefits theory effectively argues for partially exempting international income from both the source country’s and the residence country’s tax base on the premise that international income (classes (2) and (3)) receives fewer benefits from either the residence country or the source country than does class (1) income, which merits a full normal tax. accordingly, the revised benefits theory requires the extent of the respective exemptions for class (2) and class (3) income to be determined by comparing the costs of services provided by each taxing country for the earning and enjoyment of that income with the services provided by that country for the earning and enjoyment of class (1) income. the problem with this approach, however, is that the approximate cost of government benefits allocable to each of these three classes of income is no more measurable than the cost of government benefits allocable to each of a multitude of individuals under the original benefits theory. this point is illustrated by the disarray among the advocates of the revised benefits theory. one of them effectively argues for the residence and source countries to each 2001] fairness in international taxation 337 93. see vanderwolk, supra note 88, at 1470. 94. see vogel, supra note 9, at 156. 95. see harris, supra note 3, at 479, 489; roin, supra note 10, at 588-94. 96. see vogel, supra note 9, at 155-56, 159-61, 165-66. 97. see supra text accompanying note 13. 98. see harris, supra note 3, at 11, 446-49, 488-89; vanderwolk, supra note 88, at 1470. (professor roin seems to regard the cost of welfare assistance as part of the benefit charge that should be apportioned to class (1) and class (2) income, but not to class (3) income, and gives no guidance as to how the apportionment should be made. see roin, supra note 10, at 589, 591.) when these analysts fully address the issue of apportioning the burden of welfare assistance, they may decide that this component of each country’s annua l budget should be allocated in some way among all residents with incomes above the threshold required for inclusion in the tax rolls. such an approach, however, abandons any attempt at a benefitsreceived allocation for this major portion of the cost of modern government. exempt 50% of international income.93 a second suggests that the source country might exempt 25% and the residence country 75%. but the residence country is then directed to reduce the 25% retained in its tax base to reflect any indirect taxes imposed on residents.94 other analysts assert that the correct answer is for each residence and source country to make its own independent determination of how much international income to retain in the tax base and how much to exempt, but no practical guidance is given regarding these decisions.95 the revised benefits theory also suffers from a lack of clarity regarding a crucial point that bedeviled the original benefits theory–the reality that a huge portion of the budgets of the united states and many other countries provides redistributive benefits to lower income people who cannot pay a quid pro quo in taxes. to be specific, one of the advocates of the revised benefits theory seems to argue that no part of a taxing country’s welfare budget should be borne by income earned inside the taxing country by nonresidents (class (3) income) or by the foreign-source income of residents (class (2) income).96 this position is partially plausible with respect to class (3) income because the tax thereon is usually regarded as a benefits-based levy;97 but even so, welfare benefits contribute to a stable social order that fosters the earning of class (3) income. furthermore, it is completely implausible to argue that the ability-to-pay of residents can be called on to fund welfare benefits if that ability-to-pay is based on income earned in the residence country (class (1)) but not if it is based on foreign-source income (class (2)). other advocates of the revised benefits theory seem unaware of the difficulty of accounting for the cost of welfare assistance under a scheme that attempts to allocate the tax burden in relationship to the distribution of government benefits. accordingly, they do not explain how this problem should be resolved.98 in short, the revised benefits theory fails as a fairness guide largely for the same reasons that the original theory failed–the benefit allocations required 338 florida tax review [vol. 5:4 99. “as far as the next 25 years are concerned, most important in any consideration of u.s. national security is the extent to which the global economic system will continue its path toward integration . . . . continued integration promises greater wealth for most countries, including the united states . . . .” united s tates commission on national security/21st century, new world coming: american security in the 21st century, phase i report, supporting research and analysis 21 (1999). by the theory are not feasible and it is not clear how the theory would cope with the large portion of the national budget that funds benefits for the poor. thus, this new iterat ion for the benefits theory cannot displace ability-to-pay from its position as the benchmark for determining fairness in the u.s. income tax system. indeed, one can persuasively argue that the only relevance of the benefits theory to the issue of whether a country should tax its residents on their foreignsource income is as a supplement to the affirmative answer provided by the ability-to-pay principle. specifically in the case of the united states, federal expenditures for trade promotion, economic development of foreign customer countries, a generally stable commercial world order,99 u.s. diplomatic assistance abroad and u.s. military readiness to protect foreign business employees and assets all combine to create enormous benefits for the foreign income activities of u.s. residents and these benefits constitute a secondary ground, in addition to ability-to-pay, for taxing their foreign-source income. e. double taxation and partial exemption thus, the revised benefits theory fails to establish a fairness case in favor of a partial exemption system. but does the revised benefits theory nevertheless point to a cure for the double tax burden that arises when both residence and source countries assert taxing jurisdiction over the same income? would the problem of international double taxation be better handled by fractionally apportioning international income between the source and residence countr ies instead of applying the current u.s. approach under which the source country imposes the amount of tax it deems appropr iate and then the residence country collects any residual tax that remains after it allows a credit for the source country tax? mitigation of double taxation by fractionally apportioning international income between residence and source countries would be feasible where pairs of countries are able to reach bilateral apportionment agreements. of course, for reasons explained above, the countries would have to abandon any pretense of objectively basing the allocation fractions on the cost of governmental services provided with respect to the earning and enjoyment of international income. instead, each pair of negotiating countries would have to agree on allocation fractions for the source and residence countr ies that were purely the product of 2001] fairness in international taxation 339 100. see peroni, fleming, & shay, supra note 10, at 459-64, 501-05; fleming, peroni & shay, supra note 10, at 839-43. national self-interest and relative bargaining power. this process would probably yield tax treaties that are workable, but not demonstrably superior to the current u.s. system in which the source country takes the priority position in taxing international income and the residence country collects any residence country tax that remains after allowing a credit for source country tax. (multilateral agreements would not improve on theses outcomes significantly.) moreover, the united states does not have bilateral tax treaties with most of the world’s nations. thus, the united states must adopt a unilateral measure to mitigate double taxation of its residents’ international income when a treaty does not apply. a fractional allocation system would be highly problematic as a unilateral measure because it would reach the correct result only in situations where the other country had unilaterally adopted a fractional allocation scheme that was perfectly complementary to the u.s. system. in all other cases, which could well be most cases, double taxation would be overor under-mitigated. to illustrate this point, assume a u.s. policy decision that the proper unilateral double tax mitigation approach is to exempt half the foreign-source income of u.s. residents. if a u.s. resident then earns income in a source country that has unilaterally determined to exempt 75% of the local income of nonresidents, one quarter of the u.s. resident’s foreign-source income will be free of both u.s. tax and source country tax. this goes far beyond what is required to ameliorate international double taxation and provides a distortionary incentive for u.s. residents to earn income in the source country. by contrast, if the source country unilaterally decides to exempt only 25% of the local income of nonresidents, one quarter of the u.s. resident’s foreign-source income will be subject to double taxation and the economic harm of double taxation will persist to that extent. for these reasons, the fractional apportionment system has little attraction as a measure for ameliorating international double taxation. vii. ability-to-pay and the deferral privilege a. exemption through the back door the “deferral privilege,” which is among the most prominent features of the u.s. system for taxing international income, is broadly available to u.s. residents that conduct overseas business operations through controlled foreign corporations.100 this privilege generally allows such residents to defer paying u.s. tax on a controlled foreign corporation’s foreign-source business earnings until those earnings are repatriated through distributions to u.s. resident 340 florida tax review [vol. 5:4 101. for example, assuming a 7% after-tax interest rate, $1.00 of u.s. income tax has a present value of only about 13¢ if payment of the tax is deferred, interest free, for 30 years. consistent with this phenomenon, a recent study found that there were virtually no repatriations of controlled foreign corporation income in the first 15 years after such a corporation had been incorporated in a low-tax, foreign count ry. see grubert & mutti, dividend exemption, supra note 10, at 13. moreover , the effecti ve u.s. tax rate on active foreign-source income has been calculated in a range from 2.7% to negative 2.6%. see altshuler, supra note 10, at 1589; see also rosanne altshuler & t. scott newlon, the effects of u.s. tax policy on the income repat riat ion patterns of u.s. multinational corporations, in studies in international taxation 77, 109 (alberto giovannini, r. glenn hubbard & joel slemrod eds., 1993) (“[u.s. corporations] . . . are able to take advant age of defer ral and the overall limitation on the foreign tax credit to avoid paying much u.s. tax on their foreign income.”); hines, supra note 14, at 401 (“[e]ach year u.s. taxes are deferred on roughly half of the income earned by the foreign subsidiaries of american multinational corporations.”); sheppard, supra note 82, at 151 (“[t]he privilege of deferral under the present swiss–cheese subpart f is so great that all the whining amounts to nothing more than just whining.”). of course, the cross-crediting of foreign taxes in the irc § 904(d)(1)(i) “basket” also plays a substantial role in producing this low effective tax rate on foreign-source income . in fact , the combina tion of deferral, poorly designed source rules (e.g., the titl e-passage test for sales of inventory), defective deduction-allocation rules and a foreign tax credit system that allows liberal cross-credit ing of high and low-taxed fore ign-source business income imposes lower effective u.s. income tax than would a properly designed exemption system. see u.s. treas. dep’t, deferral, supra note 7, at 46, 193-95; altshuler, supra note 10, at 1588-90, 1593; robert j. peroni, the proper approach for taxing the income of foreign controlled corporations, 26 brook. j. int’l l. 1579, 1586 (2001); rosenbloom, supra note 36; grubert & mutti, dividend exemption, supra note 10, at 6, 8-24. 102. see chorvat, supra note 9, at 841-45; hartman, supra note 10, at 116; rosenbloom, supra note 36. 103. for evidence that the distortion is substantial, see u.s. treas. dep’t, deferral, supra note 7, at 44-45; grubert & mutti, where u.s. corporations invest, supra note 10, at 835; jacqueline manasterli, offshore financial centers and harmful tax regimes trigger flurry of international developments, 21 tax notes int’l 2541 (2000); martin a. sullivan, u.s. firms invest heavily in low-tax countries, 89 tax notes 1349, 1349-52 (2000). 104. see peroni, fleming & shay, supra note 10, at 464-70; fleming, peroni & shay, supra note 10, at 841-46. shareholders or through shareholder sa les of controlled foreign corporation stock at a price which reflects accumulated income. if the deferral period is sufficiently long, the present value of the deferred u.s. tax will fall to such a low level that deferral virtually equals exemption of the foreign-source income from u.s. tax.101 thus, deferral can be regarded as an indirect, elective method for well-advised u.s. residents to achieve an exemption-like treatment for their foreign-source income.102 this means that in addition to being faulted for distort ing decision making103 by encouraging u.s. residents to locate business operations in low-tax foreign countries,104 deferral should also be criticized–just like an explicit exemption system–as being a substantial departure from the ability-to-pay norm. stated differently, the deferral privilege is fundamentally inconsistent with the 2001] fairness in international taxation 341 105. see u.s. treas. dep’t , blueprints, supra note 1, at 133; 1 u.s. treas. dep’t, tax reform, supra note 1, at 208. 106. see congress ional budget office, the economic effects of comprehensive tax reform ch. 2 (1997); staff of joint comm. on taxation, description and analysis of proposals to replace the federal income tax 51-55 (comm. print 1995). 107. for a more detailed examination of the parallels between a consumption tax regime and deferral of u.s. tax on income earned through a controlled foreign corporation, see peroni, fleming & shay, supra note 10, at 466-68. ability-to-pay principle and, therefore, fundamentally inconsistent with an income tax system based on the ability-to-pay norm. b. creeping towards taxing consumption consumption tax devotees might object to this conclusion. this is because corporate income is not taxed under a theoretically pure cash-flow consumption tax105 and although corporations appear to be taxpayers under a value added tax or a retail sales tax, those levies are actually borne by consumers with corporations serving as mere collection agents for the government.106 thus, consumption tax advocates might see the near-zero u.s. corporate tax that can be achieved through deferral of u.s. tax on controlled foreign corporation income as a welcome incremental step towards a comprehensive consumption tax regime.107 we submit, however, that granting consumption tax treatment to income earned through a controlled foreign corporation (as well as to other items such as ira contributions), while generally maintaining an income tax regime with respect to domestic income-producing activities, creates unacceptable distortions in taxpayer investment decisions. if a consumption tax regime is the right approach for providing most of the federal government’s revenues (we believe that it is not), then congress should adopt a comprehensive consumption tax instead of including ad hoc, distortive consumption tax features in the income tax. in making this argument, however, we recognize that administrability concerns may require consumption tax treatment of certain items (e.g., unrealized appreciation) with the result that the federal income tax likely will continue to be a hybrid income-consumption tax regime. nevertheless, the distortion and unfairness that result from deferral of controlled foreign corporation income persuasively argue against including the feature of deferral in the u.s. income tax regime. viii. tax competition and exemption many countries offer low general income tax rates or specific income tax incentives, such as tax holidays for set periods, to at tract investments within their 342 florida tax review [vol. 5:4 108. see avi-yonah, supra note 10, at 1575-76. in 1998, the council of ministers of the oecd adopted a report identifying certain practices as harmful tax competition. see oecd, harmful tax competition: an emerging global issue (1998). in this report, the oecd made a number of recommendations, including that countr ies enact controll ed foreign corporation and passive foreign investment company regimes in order to combat harmful tax competition. see id.; see also gustafson, peroni & pugh, supra note 7, at 564. 109. see gustafson, peroni, & pugh, supra note 7, at 348-49; alan r. rado, united states taxation of foreign investment: the new approach 51 (1963); avi-yonah, supra note 10, at 1642; william w. park, fiscal jurisdiction and accrual basis taxation: lifting the corporate ve il to tax fore ign company profi ts, 78 colum. l. rev. 1609, 1637 (1978); roin, supra note 10, at 547. the term “tax competition” previously was associated principally with competi tion among sub-national political jurisdictions. within the united states, constitutional restrictions on burdens on intersta te commerce limit the ability of states to combat t ax reduction incentives of other states other than by matching the tax reduction. as discussed in the text, in an international context it is permissible for a residence country to counteract source country income tax incentives by imposing tax on the same income. 110. see peroni, fleming & shay, supra note 10 , at 464-66; sur rey, supra note 29, at 823; authorities cited in supra note 101. 111. see generally mastromarco, supra note 29; mitchell, supra note 9, at 814; letter from congressman dick armey to treasury secretary paul o’neill (march 16, 2001); center for freedom and prosperity praises u.s. administration’s policy towards oecd’s harmful tax initiative, 22 tax notes int’l 2621, 2622 (2001). 112. see mitchell, supra note 9, at 805. borders by foreigners. this approach to international economic development has recently become identified as “tax competition.”108 a. tax competition and the incentive to invest abroad in an international context, the tax competition strategy is negated to the extent that capital exporting residence countries maintain systems of worldwide taxation without deferral. this is because such a residence country collects a current residual tax equal to the excess of its regular tax over the low taxes paid by its residents to tax competitors. thus the investment inducing effect of low source taxes is negated by the residual tax.109 however, the deferral of u.s. tax on foreign-source income that is permitted under the present u.s. system substantially reduces the impact of the u.s. residual tax and permits u.s. residents to capture a significant part, if not all, of the benefit from low tax rates offered by countries as investment incentives.110 if the united states adopted an exemption system with an explicit zero tax rate on the foreign-source income of u.s. residents, the enjoyment of low foreign tax rates by u.s. residents who invest in countries offering these tax incentives would be accomplished more directly. thus, a defense of tax competition can be seen as an integral part of building the case in favor of deferral and exemption.111 advocates of tax competition argue that it promotes capital formation by creating worldwide pressure for lower taxes112 and that it causes governments 2001] fairness in international taxation 343 113. see mitchell, supra note 9, at 806. 114. see roin, supra note 10, at 554-61. 115. see avi-yonah, supra note 10, at 1575-79. 116. see roin, supra note 10, at 549. 117. see john e. anderson & robert w. wassmer, bidding for business, the efficacy of local development incentives in a metropolitan area (2000); avi-yonah, supra note 10; mitchell, supra note 9; beverly i. moran, economic development: taxes, sovereignty, and the global economy, in taxing america 197 (karen b. brown & mary louise fellows eds., 1996); roin, supra note 10; vito tanzi & howell h. zee, tax policy for emerging markets: developing countries, 53 nat’l tax j. 299, 315-19 (2000); edwin van der bruggen, momentum builds in asia to end tax holidays, news, commentary and analysis, 21 tax notes int’l 2565 (2000). 118. see authorities cited in supra notes 10 and 103. 119. see roin, supra note 10, at 588-89, 591-93. 120. see supra text accompanying notes 88-92. 121. see supra text accompanying notes 92-98. to be less wasteful.113 they further argue that tax competition enhances worldwide economic efficiency by encouraging the nations of the world to arrange themselves into a menu of countries with varying mixes of tax burdens and government service levels from which investors can choose the combinations that most appeal to them.114 by contrast, the critics of tax competition argue that it forces countries to shift their taxes from wealthy owners of mobile capital to relatively immobile and less wealthy workers, and to reduce taxes and to cut back services and benefits so that the unfortunate members of society receive less protection from a meaner globalized world. 115 the popular description of this phenomenon is the “race to the bottom.”116 both the claimed benefits and asserted harms of tax competition must be regarded as significantly speculative at present.117 what is clear, however, is that the combination of tax competition and the current u.s. system of worldwide taxation with deferral distorts the decision making of u.s. residents by encouraging them to locate their income earning activities in low-tax countries instead of in the united states.118 adoption of a generally applicable exemption system would only worsen this situation. indeed, one tax competit ion advocate119 has recognized this weakness in an exemption system and suggested mitigating the problem with a partial exemption system along the lines described above.120 for the reasons previously given,121 however, this is not a workable solut ion. in addition, we believe that proponents of tax competition fail to articulate the full implications of their position vis-a-vis the united states as a tax competitor in the global economy. there are two tax policy options available to the united states to compete with other countries’ tax incentives. one is to tax worldwide income and, as discussed above, cause the benefit of the foreign tax incentive to accrue to the u.s. treasury and cause the decisions of u.s. persons regarding whether to invest within or without the united states to be unaffected 344 florida tax review [vol. 5:4 122. see robert goulder, heritage foundation crit icizes oecd war against tax havens, 21 tax notes int’l 1628, 1630 (2000); mitchell, supra note 9, at 810, 814-15; roin, supra note 10, at 559, 585; letter from congressman major r. owens to treasury secretary paul h. o’neill (february 7, 2001); letter from congressman charles rangel and 25 others to treasury secretary paul h. o’neill (march 14, 2001). 123. see supra text accompanying note 109. 124. see roin, supra note 10, at 586; surrey, supra note 29, at 823-24. 125. see authorities cited in supra note 29. by foreign tax incentives. the proponents of so-called tax competition, however, seek to deny this policy alternative to the united states. instead, they would limit the united states to the only other policy option available to retain u.s. investment in the united states, which is to reduce tax rates on domestic investment. since this is impractical, the proponents of so-called tax competition in essence prefer no competition (by the united states) so that the benefits of foreign tax incentives accrue to the private u.s. investor for investment outside the united states. finally, it is also clear that deferral and exemption violate the ability-topay norm. the use of the mantra of tax competition to bring about back-door pressure for reductions in u.s. tax rates does not provide sufficient justification for the united states to either continue deferral or explicitly exempt foreignsource income from the income tax base. b. assistance to poor countries if the foregoing were the sum and substance of the tax competition debate, this article’s discussion of the subject would be concluded. however, tax competition advocates advance another important argument for their position. they contend that in a world where direct aid from prosperous countries to impoverished nations is small in relationship to needs, the only practical way for desperately poor countries to get essential economic development funds is to engage in tax competition that attracts investments of privately held capital from corporate and individual residents of comparatively high-tax countries.122 for the reasons explained above,123 the immediate residual tax resulting from a worldwide taxation system without deferral would be deadly to the tax competition strategy of poor nations. this suggests the argument that the united states should maintain deferral as an accommodation to impecunious countries and that, even better, the united states should facilitate the tax competition efforts of poor nations by moving to an across-the-board exemption system. 124 of course, the sovereign status of the united states means that it is free to tax its residents without regard to the impact of the u.s. revenue regime on the development strategies of impoverished countries.125 thus, to argue that the united states should assist developing countries through deferral or exemption 2001] fairness in international taxation 345 126. in a classic ar ticle , professor bittker argued that the tax expenditure concept is a deficient policy guide because it assumes agreement on a normative tax base, departures from which are tax expenditures. but in reality, professor bittker demonstrated, there are many points of disagreement regarding the content of a normative tax base. see boris i. bittker, accounting for federal “tax subsidies” in the national budget, 22 nat’l tax j. 244 (1969); see also bartlett, supra note 12, at 415-17. professor bit tker’s argument , although val id on numerous points, is not applicable to our use here of the tax expenditure concept. this is because current taxation of realized worldwide income is clearly a feature of a normative income tax base (a consumption tax base is somewhat more nuanced on this point) and both deferral and exemption of realized foreign-source income are clearly departures from the norm. see supra part ii; fleming, peroni & shay, supra note 10, at 841-43. moreover, even if the entire tax expenditure concept were abandoned, an argument for employing deferral or exemption to assist the economic development of indigent nations is, nevertheless, an argument for a particular form of foreign aid that must be evaluat ed in the light of other approaches for providing such assistance. that is the focus of this portion of our article. 127. see cordia scott, fatf releases new money-laundering blacklist, 23 tax notes int’l 8 (july 2, 2001). is to argue that the united states should provide discretionary foreign aid, and that it should do so through a tax expenditure program126 instead of a direct appropriation scheme. the wisdom of maintaining deferral, or of adopting a general exemption system, to provide assistance to foreign countries that engage in tax competition can be usefully tested by assuming that the universe of tax competitors consists of the following four nations: celtica – an economically developed country with per capita gross domestic product in the top third of all nations but which, nevertheless, maintains a general corporate tax ra te of 12% to at tract investment from other countries. hostilia – a poor country that is unfriendly to the united states and its allies, that provides bases for terrorist groups and that is using its limited resources to develop weapons of mass destruction. incorrectia – a poor country that is ruled by a corrupt dictator and a small group of cronies. incorrectia oppresses women and racial and religious minorities and generally circumscribes civil liberties. it has a general tax rate for resident corporations of 30% but it attracts foreign investment with a zero corporate tax rate for 5 years and a 5% rate thereafter. incorrectia also trumpets its minimal environmental and worker safety rules and the availability of child labor as further reasons for foreign multinationals to operate on its soil. additionally, it is on the financial action task force’s list of countries that have failed to take adequate steps to prevent money-laundering.127 freelandia – a poor democratic country with full civil liberties and equality for all residents, environmentally friendly policies and progressive worker safety and child labor rules. freelandia applies a 5% 346 florida tax review [vol. 5:4 128. we do not wish to quarrel in this article with readers who might disagree as to part or all of these specific conclusions. see, e.g., steven e. landsburg, the imperialism of compassion, wall st. j., july 23, 2001, at a14. being poor means making hard choices. . . . third worlders are making pretty much the same choices that americans and other westerners made back in the 19th century when we were poor: they’re not worrying a whole lot about the quality of thei r environment, and they’re not spending a lot of quality time with their families. instead, they’re working long, hard, dirty hours to earn enough to eat. and they’re putting their children to work, just as poor people have always done. we only wish to illustrate the larger point that a direct economic aid program will always make distinctions, hopefully rational ones, among countries that are potential aid recipients. 129. see gene rally karen b. brown, transforming the unilateralist into the internationalist, in taxing america, supra note 117, at 214, 217-18, 230; graetz, supra note 4, at 309. 130. the organization for economic co-operation and development (oecd) has issued a report on tax sparing, which seeks to develop among the oecd countries “a more coherent posit ion on the granting and design of tax sparing provis ions.” oecd, tax sparing: a reconsideration 3 (1998). the oecd report states: “[t]his report does not suggest that oecd and other countries which have traditionally granted tax sparing should necessarily cease to do so.” id. at 42. the oecd report, however, did ident ify “ a number of concerns that put into question the usefulness of the granting of tax sparing re lief, ” including (1) the vulnerabili ty of tax sparing to taxpayer abuse; (2) the effectiveness of tax sparing as a method for providing foreign aid and promoting economic development; and (3) “general concerns with the way in which tax sparing may encourage countries to use tax incentives.” id. at 41; see also gustafson, peroni & pugh, supra note 7, at 350. for a sampling of the commentary on tax sparing, see ti mo viherkentta, tax incentives in developing countries and international taxation (1991); mary bennett, tax rate to both foreign and domestic corporations. one of its major political parties, however, has begun to argue that freelandia should cut back on enforcement of environmental, child labor and worker safety rules so that it can afford to offer a five-year tax holiday like incorrectia’s. if the united states were considering a program of direct economic development foreign aid to these four countries, a plausible outcome is that no assistance would be provided to the first three and that freelandia would receive aid only if it gave assurances that it would not significantly degrade enforcement of its environmental, child labor and worker safety regulations.128 therefore, a tax expenditure scheme should not be substituted for the direct aid program unless the tax expenditure plan allows the kinds of nuanced distinctions between candidate countries that would be features of a direct aid program.129 neither a general exemption system nor a broad deferral system satisfies this criterion because both approaches would confer assistance on all four of these countries indiscriminately. the logical response to the preceding concerns is to engage in negotiated tax sparing.130 if a foreign country offers a concessionary tax rate to foreign 2001] fairness in international taxation 347 reflections on current u.s. policy for developing country tax treaties, 2 tax notes int’l 698 (1990); b. anthony billings & gary a. mcgill, tax sparing on u.s. multinationals, 48 tax notes 615 (1990); richard d. kuhn, united states tax policy with respect to less developed countries, 32 geo. wash. l. rev. 261 (1963); damian laurey, note, reexamining u.s. tax sparing policy with developing countries: the merits of falling in line with international norms, 20 va. tax rev. 467 (2000); jeffrey owens & torsten fensby, is there a need to reevaluate tax sparing? 16 tax notes int’l 1447 (1998); richard c. pugh, the deferral principle and u.s. investment in developing countries, in u.s. taxation of developing countries, at 267, 270-71 (robert hellawell ed. 1980). 131. this is the usual situation in which the tax sparing issue arises. see gustafson, peroni & pugh, supra note 7, at 348-50; roin, supra note 10, at 547 n.17. 132. the question of whether to grant tax sparing does not usually arise in this situation because countries usually engage in tax competition through narrowly-targeted tax incentives rather than by adopting a low general rate. however, one of the objections to tax sparing is that it abets the distortion that results when a foreign country creates exceptions to its generally applicable tax rate by conferring concessionary rates on a narrow class or classes of activities. see joint comm., description, supra note 10, at 87. thus, if a developing country responds to this objection by choosing to attract foreign investment through lowering its generally applicable tax rate instead of creat ing narrow tax concessions, its candidacy for tax sparing should be regarded as enhanced. 133. see irc §§ 901(j), 999. 134. of course, the united states does not presently have income tax treaties with many low-tax developing countries. our recommendation would require a change on this point. one of the traditional u.s. objections to tax sparing through bilateral treaties has been that tax sparing amounts to giving the affected foreign-source income a lower tax burden than domestic-source income and that this ought not to be accomplished through the treaty process. see joint comm., international competitiveness, supra note 14, at § ii.h.1. the logic of this posit ion is not convincing, assuming that the united states decides that tax sparing is a desirable way to assist low-tax developing countries. 135. see richman, supra note 10, at 70. investors that is below the country’s normal rate, the tax spar ing concept would have the united states give a foreign tax credit equal to the amount of the country’s generally applicable tax.131 where the selected country employs a low general tax rate without special concessions for foreigners, the tax sparing concept would require a u.s. foreign tax credit that combines both the foreign tax paid and at least part of the difference between the low foreign rate and the u.s. rate.132 this system could be established by congressional enactment of a list of approved low-tax countries or a set of criteria that defines countr ies eligible for tax sparing.133 this approach, however, would inevitably prove awkward in dealing with the diverse array of developing countries and with changes in their tax systems. a better method would be for the united states to negotiate tax sparing provisions in bilateral tax treaties with low-tax countries.134 this latter method would allow appropriate distinctions to be made among nations and would assist the united states in negotiating appropriate reciprocal tax concessions for its residents.135 it also would allow a sunset feature to be included in the tax sparing 348 florida tax review [vol. 5:4 136. see richmond, supra note 10, at 70. however, one of us has previously cautioned that use of tax penalty or “negative tax expenditure” provisions as a means of achieving nontax policy objectives should undergo a cost-benefit analysis. see, e.g., peroni, supra note 20, at 1010. this author would also apply the same caution to use of tax sparing provisions as a means of achieving child protection, worker safety, or environmental protection goals. 137. see gustafson, peroni & pugh, supra note 7, at 349-50; brown, supra note 129, at 224-25. 138. see joint comm., description, supra note 10, at 87; surrey, supra note 29, at 823. 139. see supra part i; peroni, fleming & shay, supra note 10. 140. see joint comm., description, supra note 10, at 87. 141. see small business job protection act of 1996, pub. l. no. 104-188, § 1601, 110 stat. 1755, 1827. the 1996 legislation terminated the § 936 credit for new claimants and phased the credit out over a 10-year period for existing claimants. 142. see united states general accounting office, pharmaceutical industry tax benefits of operating in puerto rico, reprin ted in 138 cong. rec. 11376, 11377 (may 14, 1992). for critiques of the cost effectiveness of § 936 as a tax subsidy device, see thomas r. barker, note, ending “welfare as we know it” (corporate welfare, that is): international taxat ion and the troubled history of internal revenue code section 936, 21 suffolk transnat’l l. rev. 57 (1997); nancy h. kaufman, puerto rico’s possessions corporations: do the tefra amendments go too far?, 1984 wis. l. rev. 531; camilla e. watson, machiavelli and the polit ics of wel fare, national health , and old age: a comparat ive perspective of the policies of the united states and canada, 1993 utah l. rev. 1337, 1402. article of the freelandia treaty so that the article could be revisited periodically and changed if freelandia “cheats” on the deal by significantly compromising its concern for children, the environment and the safety of its workers.136 the united states has historically resisted tax spar ing.137 one of the principal reasons for doing so is the view that granting tax spar ing to avoid the effect of the u.s. residual tax on low-taxed foreign income is unnecessary because deferral already allows u.s. residents to substantially eliminate the u.s. residual tax.138 this objection would disappear, however, if the united states adopted our recommendation to abolish deferral and reject exemption.139 the united states has also feared that granting tax sparing would encourage poor countries to engage in tax competition by lowering their rates and sacrificing needed revenues.140 in addition, the cost effectiveness of this form of foreign aid is highly questionable. the u.s. domestic experience with section 936 is instructive. income tax incentives in the form of reduced tax rates favor the highest profit margin industries, such as pharmaceuticals and electronics. in puerto rico, the u.s. general accounting office found that before the amendments to severely restrict section 936 in 1996,141 the tax subsidy for an electing section 936 corporation in the pharmaceutical industry was $70,788 per worker, which was 267% of the average wages paid to pharmaceutical workers.142 this experience suggests that, to be cost effective, there would have to be a close monitoring of the effects of the subsidy. our purpose, however, is not to provide a full analysis of tax sparing in this article. instead, the larger point to be drawn from this discussion is that if a 2001] fairness in international taxation 349 143. see avi-yonah, supra note 10, at 1583-86, 1593-98; roin, supra note 10, at 594. 144. see avi-yonah, supra note 10, at 1583-86, 1593-98; graetz, supra note 4, at 313. this problem is likel y confined to individuals and closely held businesses . the pressure on publicly traded corporations to support their stock prices by showing as much income as possible on their financial s tatements probably prevents these corporations from hiding foreign-source income from the internal revenue service. see roin, supra note 10, at 602 n.194. 145. see supra par ts i, ii and iv. 146. see graetz, supra note 4, at 314. there have been assert ions that exchange of information between countries is unacceptable where the purpose is to enforce residence country taxation of foreign-source income. see letter from congressman dick armey to treasury secretary paul o’nei ll (mar. 16, 2001); dan mitchell , cent er for freedom and prosperity strategic memorandum (june 11, 2001); mastromarco, supra note 29, at 1625. this view full consideration of costs and benefits establishes that the united states should assist poor countries by accommodating tax competition, bilateral tax sparing agreements are a better approach for doing so than deferra l or exemption. stated differently, the tax competit ion strategies of impoverished countries do not establish a case for compromising the ability-to-pay principle by maintaining the current deferral system or by adopting a generally applicable exemption system for foreign-source income of u.s. residents. ix. enforcement of worldwide taxation it has been suggested that u.s. residence taxation, i.e., taxation of u.s. residents on their worldwide incomes, has become significantly unenforceable with respect to foreign-source income.143 this suggestion is based on the realities that the united states cannot practically withhold tax on foreign-source income, that u.s. residents have abundant opportunities to invest in low-tax countries with which the united states has no effective information exchange arrangements and that in this environment, many u.s. residents do, and will continue to, underreport their foreign-source income.144 from these premises, one might argue that the united states should explicitly exempt foreign-source income instead of turning u.s. residents into tax felons by clinging to a worldwide system that is unenforceable with respect to numerous taxpayers. we disagree with this argument. the data with respect to noncompliance by u.s. residents with respect to u.s. tax on foreign-source income under current law is limited and highly speculative. moreover, for the reasons given above,145 the importance of maintaining fidelity to the ability-to-pay principle and avoiding an exemption system’s perverse incentives strongly suggests that before surrendering to an exemption approach out of concerns regarding taxpayer noncompliance, the united states should continue initiatives to enforce taxation of the foreign-source income of u.s. residents. the united states should also continue to widen its network of information exchange agreements with source countries.146 350 florida tax review [vol. 5:4 assumes that worldwide income taxation is improper. by now, it is abundantly clear that we respectfully and strongly disagree. 147. an interview with peter l. faber, news, commentary and analysis, 87 tax notes 349 (2000). 148. see supra text accompanying notes 100-104. 149. see national foreign trade council, supra note 6, at 6-28 to 6-29. 150. see authorities cited in supra note 3. 151. see chorvat, supra note 9, at 850-53. x. concluding observations: weighing the factors a. why not do as others do? with respect to deferral, a leading tax lawyer has recently stated that “[w]e often hear tax reformers scream about the evils of deferring taxes on foreign earnings, but if other countries do the same with their companies it is hard to see why we should treat our companies less favorably.”147 as the analysis in part vii has indicated, deferral is a device that effectively allows taxpayers to elect out of the u.s. worldwide taxation system and into the close economic equivalent of an exemption system. 148 thus, exemption system advocates are inclined to broaden the preceding quotation and ask why, if some other countries directly confer the advantages of an exemption system on their residents, should the united states treat its residents less favorably by holding to a worldwide system?149 the answer is that we might choose to treat our companies less favorably than companies resident in exemption-system countries because we give a higher priority to fairness in the design of our income tax rules than is implied by the choice of an exemption system. to be specific, the u.s. income tax is heavily grounded on a fairness notion–that taxpayers should contribute to the cost of government in relationship to their comparative economic well being or ability-to-pay.150 it is clear, however, that in constructing or reforming an income tax, the goals of simplicity, economic neutrality/efficiency and economic growth must also be taken into account and may require that fairness concerns be somewhat circumscribed. with respect to simplification, exemption system proponents argue that an exemption regime would advance the goal of reducing complexity in the tax system.151 after all, what could be simpler than not taxing foreign-source income at all? adoption of an exemption regime might, indeed, simplify the u.s. system for taxing its residents’ foreign-source income, but the amount of simplification to be gained by the switch from a worldwide approach is uncertain and may not be great. this is largely due to the fact that adoption of a regime that provides an explicit zero rate of tax for foreign-source income will heighten the importance of those elements of the system dealing with the distinction 2001] fairness in international taxation 351 152. see generally michael j. mcintyre, thoughts on the irs’s apa report and more territorial taxation, 87 tax notes 445, 446 (2000); merrill, supra note 14, at 103; peroni, supra note 20, at 985; tillinghast, supra note 14, at 211-12; see also grubert & mutti, dividend exemption, supra note 10, at 7. 153. see ault, supra note 16, at 402-06, 411-12; woellner, barkoczy & murphy, supra note 7, at 1336-37, 1340-64; chorvat, supra note 9, at 855-59; graetz, supra note 4, at 324, 329; see also rosenbloom, supra note 36, at 1549-50; tillinghast, supra note 14, at 209-10. 154. see kingson, supra note 14, at 53-54; peroni , supra note 20, at 986. although australia generally employs an exemption regime for foreign-source income, it taxes certain foreign-source income under a worldwide system that features an anti-deferral r egime described as “probably the most complex tax legislation which this country has seen.” see woellner, barkoczy & murphy, supra note 7, at 1347. 155. see ault, supra note 16, at 402; roin, supra note 13, at 1761-62 n.27. between u.s.-source and foreign-source net income. thus, the sourcing rules, transfer pricing rules and expense-allocation rules will inevitably assume a greater role under an exemption regime than under the present worldwide system. we should expect that these rules would all be tightened in the exemption context, thereby becoming more complex and more productive of controversy between taxpayers and the irs.152 moreover, to mitigate fairness and economic efficiency/neutrality concerns, some countries exclude both passive income and low-taxed foreignsource business income from their exemption systems (indeed, most countries exclude passive income from their exemption systems) and employ a worldwide system (with a foreign tax credit) for this excluded income.153 if the united states went down this road and preserved its worldwide system (with its complex foreign tax credit) for passive and low-taxed foreign-source income, the simplification gains from an exemption system could be slim indeed.154 in addition, some exemption countries have determined that although a resident’s foreign-source income should be excluded from the tax base, it should, nevertheless, be taken into account for purposes of determining the progressive tax rate that applies to the resident’s domestic-source income. this principle is generally referred to as exemption-with-progression.155 if the united states were to adopt this approach, the issue of whether or not to recognize unrepatriated controlled foreign corporation income when implementing exemption-withprogression would be critically important and might well result in the preservation of the subpart f and the passive foreign investment company regimes for this purpose. if so, the simplification gains from converting to an exemption system would be significantly reduced. an exemption system is also a highly distortionary departure from the goal of economic neutrality. at its worst, an exemption system can cause an investment in a low-tax foreign country to be preferred to a u.s. investment even though the u.s. investment has a higher before-tax rate of return and is, 352 florida tax review [vol. 5:4 156. see supra text accompanying notes 79-80; avi-yonah, supra note 10, at 1604 n.132; see also jane g. gravelle, foreign tax provisions of the american jobs act of 1996, 72 tax notes 1165, 1166 (1996); grubert & mutti, where u.s. corporations invest, supra note 10, at 835; mitchell, supra note 9, at 804; peroni, supra note 20, at 983; robert j. peroni, deferral of u.s. income tax on international income: end it, don’t mend it–why should we be stuck in the middle with subpart f?, 79 tex. l. rev. 1609, 1613-14 (2001). 157. see, e.g., gary clyde hufbauer, u.s. taxation of international income: blueprint for reform 57-59 (1992). 158. see, e.g., joint comm., overview, supra note 14, at § iv.d; u.s. treas. dep’t, deferral, supra note 7, at 25-54; altshuler, supra note 10, at 1585; hines, supra note 14, at 40102; rousslang, supra note 10, at 595-97. 159. see u.s. treas. dep’t, deferral, supra note 7, at 56. 160. see u.s. treas. dep’t, deferral, supra note 7, at 56-57, 61. 161. see supra text accompanying notes 108-146. therefore, economically superior.156 it is difficult to see how the economic wellbeing of the united states is furthered by distorting taxpayer decisions in this manner. with respect to economic growth, exemption advocates contend that exemption systems create greater worldwide economic well-being than do worldwide taxation systems.157 the empirical and theoretical support for this proposit ion is, however, so mixed and debatable that the claimed economic growth virtues of the exemption approach must be regarded as speculative at best.158 likewise, the claims that adoption of an exemption system by the united states is necessary to keep american businesses on a competitive footing in foreign markets are rendered dubious, at best, by the extensive overseas success of american businesses.159 advocates of the competitiveness view have failed to provide convincing empirical evidence for their claims that worldwide taxation undermines the ability of u.s. individuals and corporations to compete in the global marketplace.160 in addition to the preceding points, parts viii and ix have discussed ways to overcome objections to worldwide taxation that are based on a desire to accommodate the tax competit ion strategies of poor countries and a concern for the enforceability of residence taxation.161 thus, it is quite rational for americans to conclude that when the significance of the ability-to-pay fairness principle is weighed against an exemption system’s distortionary effects, uncertain simplification benefits and speculat ive economic growth consequences, and against the strong competitive performance of american businesses abroad, worldwide taxation is the preferred option. this holds true regardless of the fact that other countries, with other ideas 2001] fairness in international taxation 353 162. see reuven s. avi-yonah, tax, trade, and harmful tax competition: reflections on the fsc controversy, 21 tax notes int’l 2841, 2843 (2000) (arguing that an exemption system, as typically constructed, is a prohibited export subsidy under the general agreement on tariffs and trade). for a more cautious view on this point, see westin & vasek, supra note 10, at 341-44. 163. see supra part vii. 164. see u.s. treas. dep’t, deferral, supra note 7, at 46; altshuler, supra note 10, at 1588-93; grubert & mutti, dividend exemption, supra note 10, at 4. 165. see peroni, fleming & shay, supra note 10, at 458-59, 501-04. 166. if the united states cannot summon the political will to circumscribe the deferral loophole in its worldwide taxation regime, the second-best alternative may be to abandon worldwide taxation cum deferral and adopt an explicit exemption system. as suggested above, however, in order to prevent the exemption system from eroding u.s. taxing jurisdiction over u.s.-source income, an explicit exemption system would require enhanced transfer pricing, source-of-income and expense-allocation rules. moreover, to restrain the exemption system from providing a strong incent ive for u.s. taxpayers to shi ft highly mobile passive income to low-tax foreign countr ies, a prope rly des igned exemption system would exclude passive income from the exemption regime and handle it under a worldwide sys tem with a for eign tax credit. finally, concerns about fairness and economic efficiency would probably dictate that low-taxed foreignsource business income be excluded from the exemption system and taxed under a worldwide system. when an exemption regime having all of these characteristics is present ed in fullydeveloped form, much of the attractiveness that exemption possesses as an abstract concept may disappear. certainly, much of an exemption system’s simplification potential is lost if significant amounts of foreign-source income remain subject to a worldwide system, unless a “rough justice” approach is adopted under which international double taxation is mitigated by regarding the relative importance of fairness, countenance generous deferral of foreign-source income or employ exemption systems.162 b. ending deferral as indicated previously, however, the feeble u.s. anti-deferral provisions allow u.s. residents to effectively elect out of the u.s. worldwide system and into the close equivalent of an exemption system by taking advantage of generous opportunities to defer recognition of foreign-source income.163 the deferral privilege allows u.s. residents to achieve the approximate tax results of an exemption system164 but only if these residents engage in economically wasteful business arrangements.165 thus, the deferral privilege is a poorly designed quasiexemption system that is available only to well-advised taxpayers. for the same reasons set out above in relation to an exemption system, we believe that the ability-to-pay criterion supports ending deferral of u.s. tax on foreign income earned through a foreign corporation. the current system of deferral distorts investment decisions, is unbearably complex and has not been shown to improve u.s. economic growth. when the ability-to-pay fairness principle is taken into account, it furnishes yet another basis on which to prefer current taxation of worldwide income with no deferral pr ivilege.166 354 florida tax review [vol. 5:4 allowing only a deduction for foreign taxes borne by passive income or low-taxed business income remaining in the worldwide system. see rosenbloom, supra note 36, at 1549-50. (because the source country rate of tax on passive income would usually be low, there is little or no double taxation problem and, consequent ly, much to be said for confining u.s. taxpayers to a deduction, instead of a credit, for foreign taxes on foreign-source passive income. this approach would avoid many of the complexities of a foreign tax credit. see graetz, supra note 4, at 332-34; rosenbloom, supra note 36, at 1549-50.) in other words, the simplificati on potential of an exemption system depends heavily on achieving substantial repeal of the foreign tax credit provisions, including the complex basket limitation rules. see irc § 904(d). conversely, the simplification goal is defeated to the extent that concerns about perverse incentives and fairness lead to the adoption of a system that is a hybrid of the exemption and credit approaches. we intend to explore these matters in a future article. it seems useful at this juncture to emphasize that a repeal of deferral could be accompanied by a counterbalancing cut in the corporate, or individual, tax rates so that the repeal would be revenue neutral. indeed, our advocacy for repealing deferral is based on concerns regarding fairness and distort ion, not on the hope that federal revenues will be increased. thus, we would urge the elimination of deferral regardless of whether congress used any resulting revenue increase to enlarge government spending or pay for a general tax cut. c. the preferred alternative although the application of the ability-to-pay fairness principle to international income taxation is complicated by the presence of foreign taxpayers, by income earned through c corporations and by the claims of other governments to tax cross-border income, it is nonetheless possible, and indeed important, to analyze international tax policy in terms of fairness. as the foregoing discussion demonstrates, we believe that the fairness criterion supports the conclusion that taxing worldwide income and ending the deferral privilege provides a tax regime that is superior to either the current system or the adoption of an exemption system. florida tax review volume 2 1995 number 10 demystifying lifo: towards simplification of inflation-adjusted inventory valuation edward a. morse* 1. introduction ................................ 561 ii. overview of lifo concept ...................... 562 a. cost flow methodologies .................... 562 b. measures of business income under fifo and lifo-a simplified example ................. 563 ii. capital maintenance as a framework for measuring economic income .................... 565 a. income vs. capital ........................ 566 b. financial capital maintenance ................ 566 c. physical capital maintenance ................. 567 iii. using lifo to implement the physical capital maintenance concept ........................... 572 a. specific goods lifo ....................... 572 b. dollar-value lifo ........................ 580 1. historical development ............... 580 2. index methods ...................... 584 a. double-extension method ........ 584 b. index method ................. 586 c. link-chain method ............. 587 d. scope of an item ............... 590 e. cost components as "items" ....... 605 f. conclusion ................... 611 * assistant professor of law, creighton university school of law. j.d., 1988, university of michigan; b.s.b.a., 1985, drake university. the author wishes to thank heidi guttau-fox (creighton class of 1997) for her assistance in the preparation of this article. copyright © 1996 by edward a. morse. 560 florida tax review [vol. 2:10 iv. lifo simplification efforts ................... 612 a. legislative background of simplified lifo provisions .............................. 612 b. inventory price index computation (ipic) method .. 615 1. categorizing inventory ................ 615 2. assigning indexes ................... 616 3. computing a composite index ........... 618 a. 80% limitation ................ 618 b. cost adjustment ............... 620 4. conclusions on ipic method ............ 623 c. simplified dollar-value lifo method for certain small businesses-irc section 474 ............. 625 d. alternative lifo method for automobile dealers ... 626 v. conclusion .................................. 628 demystifing lifo i. introduction the last in, first out (lifo) method of inventory accounting has been available to taxpayers for more than 50 years.' the basic concept of lifo is relatively simple: it reverses the normal assumed flow of costs (first-in, first-out or fifo) by matching the costs of the latest purchases or production against current-year sales. during periods of rising costs, lifo generally results in lower taxable income than the fifo method because current-year increases in inventory costs are charged to cost of goods sold, rather than accumulated in ending inventory. thus, lifo provides protection from the effects on taxable income of rising inventory costs (hereinafter "inflation"). like many other aspects of federal income tax law, the practical implementation of lifo has often proved to be a complex task. particularly difficult issues have arisen over the fundamental concept of measuring costs on a comparable basis over time for inventory affected by stylistic, technological, or other changes. the tax law currently lacks objective, determinate standards for ascertaining the proper lifo cost of inventory items that change. current standards rely on concepts of similarity, involving fine distinctions that are difficult to apply consistently and resulting in costly and burdensome controversies, with little promise of more determinate results. moreover, efforts to simplify lifo have not freed taxpayers from mystifying complexity in this area, as the available simplified methods are far from simple and are not viable alternatives for many taxpayers. this article analyzes the complexities of measuring inflation in an environment of changing inventory composition. it argues that administrative feasibility, rather than precision, should be the guiding principle for reform in this area. externally generated indexes of inflation, such as those currently produced by the bureau of labor statistics (bls), hold the greatest promise for meaningful simplification of lifo while continuing to protect taxpayers from inflationary effects on income. such indexes are readily available and they offer consistent, objective solutions to problems of changing inventory items that otherwise cause administrative uncertainty for taxpayers and the government. part i provides an overview of lifo in the context of inventory accounting. part ii analyzes capital maintenance as a conceptual framework for measuring economic income in an inflationary environment, and places lifo within that framework. part iii analyzes two basic approaches to implementing lifo-specific goods and dollar-value-and explores sources 1. see revenue act of 1938, pub. l. no. 554, ch. 289, § 22(d). 52 star. 447. 459 (allowing lifo to certain industries only); cf. irc § 22(d) (1939) (removing industry specific restrictions and making lifo available to all taxpayers). the principal code provisions authorizing the use of lifo are presently in § 472. 19951 florida tax review of controversy within each approach caused by changes in inventory content. part iv discusses efforts to simplify lifo, and suggests further reforms to reduce administrative and compliance burdens while fulfilling the general purpose of the method. part v provides a concluding perspective on the roles of simplification and precision in this context. ii. overview of lifo concept lifo is perhaps best understood by first placing it within the broader context of inventory costing. taxpayers required to maintain inventories2 face several practical questions in computing taxable income: (1) what costs must be capitalized into inventories; (2) how should inventoriable costs be allocated among items purchased or produced during the year; and (3) how should such costs be allocated between the items purchased or produced during the year and items remaining on hand at year-end (ending inventory).3 answers to the first two questions are generally found in section 263a, which is (mercifully) beyond the scope of this discussion. the answer to the third question-the value of ending inventory-depends upon the cost flow assumption adopted by the taxpayer. as discussed below, several cost flow methodologies are available, and each reflects a different approach to measuring income in an environment of changing inventory costs. a. cost flow methodologies taxpayers may choose from three cost flow methodologies: (1) specific identification; (2) first-in, first-out (fifo); and (3) last-in, first-out (lfo).' lifo and fifo are often referred to as cost flow assumptions, as they do not necessarily track the actual movement of particular costs into and out of inventory. as a practical matter, specific identification is either impossible or undesirable for many taxpayers.5 the regulations seem to 2. in general, inventories are required "in every case in which the production, purchase, or sale of merchandise is an income-producing factor." regs. § 1.471-1. 3. see generally stephen f. gertzman, federal tax accounting %t 6.06-.08 (2d ed. 1993). 4. see regs. § 1.471-2(d). a fourth methodology-average costs-is also used in many industries, although it is neither expressly prescribed nor expressly prohibited by the code or regulations. see gertzman, supra note 3, t 6.08[3]; 1 leslie j. schneider, federal income taxation of inventories § 2.02[1], [4] (1981). some commentators have suggested that regs. § 1.471-8 indirectly supports an average costing approach by allowing valuation based on average costs if the average is based on costs incurred during the taxable year. see gertzman, supra, i 6.08[3][a] & n.359, at 6-88 to 6-89, 6-91. however, the status of average costing is not without controversy, particularly where the so-called "moving average" method is used. see id. t 6.08[3]; schneider, supra, § 2.02[4]. 5. the root of this impracticality or undesirability lies in the difficulty of tracking specific inventory items. as one financial accounting text explains: [vol 2:10 demystif'ing lifo recognize this practical reality, as they presume a fifo cost flow where goods have been "so intermingled that they cannot be identified with specific invoices."6 the vast majority of taxpayers with inventories use fifo and lifo. 7 under fifo, the "[g]oods taken in the inventory ... will be deemed to be the goods most recently purchased or produced, and the cost thereof will be the actual cost of the goods purchased or produced during the period in which the quantity of goods in the inventory has been acquired."' thus, the first goods purchased or produced during the year are deemed to be the first goods sold, and the ending inventory is composed of the last goods purchased or produced during the current taxable year. lifo reverses the fifo assumption. inventory on hand at the close of the taxable year is comprised first of those items on hand in the beginning inventory and then, to the extent of any excess, items acquired during the taxable year.9 lifo thus may result in a stratified inventory, composed of several annual inventory layers valued according to costs incurred during the period of acquisition. b. measures of business income under fifo and lifo-a simplified example fifo and lifo reflect fundamentally different approaches to the it may be practical in a few situations in which units are costly and can be easily distinguished (for example. an automobile dealership), but in many complex manufacturing and retailing situations it is impossible to apply the specific identification method because the cost of each individual unit is not identifiable, and it is not known which specific units are sold. in addition, as volume increases, so does the cost of record keeping, and the method may become too expensive to use. loren a. nikolai & john d. bazley, intermediate accounting 351 (4th ed. 1988). 6. regs. § 1.471-2(d). even where the taxpayer has the ability to track specific invoices, the service has generally not required taxpayers to use a specific identification method instead of fifo. schneider, supra note 4, § 2.02[3]. however, query the extent to which the increased use of bar coding and other electronic identification devices may increase the ability to track specific inventory items and thus affect the service's decision to respect taxpayer choice of fifo over specific identification. 7. in a survey of annual reports of 600 selected industrial and merchandising companies, the american institute of certified public accountants [aicpa] reported that it was not unusual for a company to utilize more than one inventory method to determine total inventory cost. in 1991, 60% of the surveyed companies used lifo and 70% used fifo. about 33% used the average cost method and only 8.317 used another method, which was defined to include "specific identification, accumulated costs for contracts in process, and 'current cost" see american inst. certified pub. accountants, accounting trends and techniques 142 & tbls. 2.8, 2.9 (jack shohet & richard rickert eds., 46th ed. 1992). 8. regs. § 1.471-2(d). 9. see irc § 472(b). 19951 florida tax review measurement of business income during periods of changing inventory costs. in particular, they differ as to the time at which changes in the replacement costs of inventory-which during a period of rising costs is herein referred to generally as "inflation"-should be taken into account. under fifo, inflationary gains (the excess of current replacement costs over historical acquisition costs) are taken into income entirely in the current taxable year, whereas lifo generally defers recognition of those gains until the inventory is deemed to be liquidated. the following highly simplified example provides a useful starting point to explore the differences between lifo and fifo.10 assume that a firm begins the year with 100 widgets costing $1 each. during the year, the firm sells 100 widgets for $2 each. at year-end, the firm purchases 100 more widgets for $2 each. assume further that the widget price increased because of inputs unique to widgets, so that this price increase has no measurable effect on the general price level within the economy as a whole. gross profit computations for year one under lifo and fifo cost flow assumptions are shown below: fifo lifo sales $200 $200 cost of goods sold: beginning inventory $100 $100 add: purchases 200 200 cost of goods available for sale $300 $300 less: ending inventory 200 100 cost of goods sold $100 $200 gross profit on sales $100 $ 0 under the fifo method, the change in the cost of replacement goods during the period between purchase and resale is treated as realized gain for the current taxable year. the cost to replace the inventory sold during the taxable year is capitalized in the ending inventory account. thus, the fifo method produces net income of $100, which represents gross profit realized from effectively liquidating the beginning inventory during the taxable year." 10. the example does not take into account such factors as changes in the general price level, changes in the quantity or nature of the inventory, and variations in methods of computing the lifo value of the inventory. these complexities are addressed throughout the remainder of this article. 11. see henry j. aaron, inflation and the income tax: an introduction, in inflation and the income tax 13 (henry j. aaron ed., 1976) (analogizing fifo to a tax on the increased liquidation value of the firm). [vol 2:10 demysrifying lifo on the other hand, lifo shifts the increased cost of replacement inventory to cost of goods sold, which in these circumstances results in no gross profit for the taxable year. lifo thus defers recognition of gain from the initial inventory amount until that inventory is ultimately liquidated and not replaced. to illustrate the deferral until liquidation, suppose that the taxpayer in the example goes out of business in year two and liquidates the 100 widgets in ending inventory by selling them for $2 each. the gross profit computations for year two are as follows: fifo lifo sales $200 $200 cost of goods sold: beginning inventory $200 $100 add: purchases 0 0 cost of goods available for sale $200 $100 less: ending inventory 0 0 cost of goods sold $200 $100 gross profit on sales $ 0 $100 total gross profit on sales years i and 2 $100 $100 the final line in the table shows that the firm is ultimately subject to the same measure of taxable income over its life whether fifo or lifo is used. lifo merely defers, but does not eliminate, the recognition of income (and ultimately, the imposition of income tax) caused by increases in the cost of items held in ending inventory. in this sense, lifo differs from other proposals that would permanently exempt inflationary profits from taxation.'2 m. capital maintenance as a framework for measuring economic income ultimately, the tax law reflects political choices, which do not necessarily fit within any particular theoretical framework for measuring income. 3 practical difficulties in implementing economic measures of income sometimes call for concessions against theoretical accuracy. neverthe12. for discussion of such proposals, see, e.g., michael c. durst. inflation and the tax code: guidelines for policymaking, 73 minn. l. rev. 1217 (1989); david h. safavian, indexing tax attributes for inflation: dispelling the myths and advocating change, 1995 det. c.l. rev. 109. 13. see michael d. rose & john c. chommie, federal income taxation 17 (3d ed. 1988). ("[alt the legislative level, the tax law-making process is a political process. which assures that, at best, pure theory will be recognized only in dim outline in the code itself.'); see also hellerman v. commissioner, 77 t.c. 1361, 1366 (1981) ("[nleither the constitution nor tax laws 'embody perfect economic theory.' ") (citing weiss v. weiner, 279 u.s. 333, 335 (1929)). 19951 florida tax review less, the distinction between income and capital has played an important role in shaping the contours of taxable income.' 4 a brief look at economic concepts of income may help to understand the measures of income under lifo and fifo. a. income vs. capital as commentators have noted, the sixteenth amendment's provision of the power to "lay and collect taxes on incomes ... [b]y necessary implication ... excludes the power to tax capital receipts.' 5 "capital must be maintained before income can be measured."' 6 the distinction between income and capital has been described as follows: capital is perceived as a stock of wealth at an instant of time, while income is considered the flow of wealth in excess of that necessary to maintain a constant capital. stated differently, capital represents the "tree," which should remain intact; income, the "fruit" on the tree, which can be consumed. we can also view capital as "the amount in the reservoir at any one time, and [income] as the amount flowing out of the reservoir during a period of time."' 7 although capital maintenance is a benchmark for income measurement, the measure of income ultimately adopted is still subject to debate, in part because the nature of capital to be maintained is subject to different interpretations. two general approaches may be applied to measure capital in an economic or accounting sense: one focuses on "financial capital" and the other focuses on "physical capital."' 8 b. financial capital maintenance financial capital maintenance focuses on sustaining an equivalent value of investment in the firm over time." when this value is expressed 14. see rose & chommie, supra note 13, at 17 ("arguably ... the distinctions drawn historically between income and capital in more general economic theory and in trust law have contributed as much as anything to the development of the income concept for federal tax purposes."). 15. id. at 21. 16. robert bloom & araya debessay, inflation accounting 89 (1984). 17. id. at 90 (footnotes omitted) (quoting e.s. hendriksen, accounting theory 142 (4th ed. 1982)). 18. see id. at 90-91; financial accounting standards board, statement of financial accounting concepts no. 5: recognition and measurement in financial statements of business enterprises 46-48 (1984). 19. bloom & debessay, supra note 16, at 92. [vol. 2:10 denystifying lfo in terms of stable monetary units, this approach could be viewed as maintaining the same "economic power" of the enterprise, a concept that focuses on the change in the real market value of the firm before distributions to shareholders, eliminating nominal gains and losses resulting from changes in the general price level.' in the example above, which assumes (perhaps unrealistically) that the price of replacement widgets changes discretely without affecting the general purchasing power of the dollar, the firm may be considered better off at the end of year one by $100. the firm's only asset-inventory-is worth $100 more than at the beginning of the year. since the general purchasing power of the dollar is unchanged, the firm's financial capital (and economic power) increased since the beginning of the year, reflecting economic income. 2' critics of this financial capital or economic power approach argue that the "profit" in this situation is not real economic income because it cannot be distributed to the owners of the firm without impairing the firm's current level of operations.' unless the firm could obtain outside financing, a $100 distribution to its owners (or to the government in the form of taxes) would leave only $100 to reinvest in replacement inventory, enough to replace only 50 widgets. thus, unless the firm could increase its efficiency so that it could continue the same level of operations with less inventory on hand, the firm's business operations would effectively be cut in half. to avoid this result, critics argue that income should be measured based on the concept of physical capital maintenance, in which capital is viewed in a physical sense as the capacity to produce goods and services.2c. physical capital maintenance the rationale for a physical capital maintenance approach can be stated as follows: 20. see joseph a. pechman, federal tax policy 177 (5th ed. 1987). 21. although the fifo method measures income accurately under the economic power measure in the example, it would not do so if general price level change had occurred during the year, in which case the increase in nominal value would not represent an increase in purchasing power. an adjustment for changes in the general price level would be necessary to reflect the same economic power of the firm. so-called indexed fifo approaches have been proposed from time to time to adjust for the effects of inflation on inventory costs. see. e.g., the president's tax proposals to the congress for fairness, growth, and simplicity 174-78 (1985); accounting: further irs guidance likely next year on "indopco," irs official says, daily tax rep. (bna) no. 218, at d-i i (nov. 10. 1992) (discussing 1992 proposal by bush administration to index fifo inventory values by consumer price index). 22. see bloom & debessay, supra note 16, at 94. 23. id. 19951 florida tax review firms produce certain goods or services. to ensure a firm's ability to produce such goods and services, at least at its present operating levels, it is necessary for the firm to maintain its prevailing physical operating capacity. this implies that the income should represent the maximum dividend that could be paid without impairing the productive capacity of the firm.' the physical capital maintenance concept thus seeks to preserve the business enterprise by measuring income during the firm's operational period as the amounts that could be distributed on a sustainable basis.z5 taxation before liquidation of income resulting from increases in the value of inventory may be perceived as a tax on capital, rather than a tax on income.2 6 the assumption that distributions must not impair current operations is consistent with the financial accounting assumption of the going concern.27 in the example, the physical capital maintenance concept of income leads to the conclusion that the firm has no income in year one. it possesses the same asset-an inventory of 100 widgets-at both the beginning and end of the year. 8 all of the revenue from selling inventory was reinvested in replacement widgets, thus allowing the firm to continue operating at the same level. none of the revenue can be distributed to the owners without disrupting the firm's operations. imposing an income tax on holding gains reflected on a fifo basis in ending inventory would require that the firm either reduce its inventory or incur debt to pay the tax, thus inhibiting the formation of capital needed to continue its business.2 9 24. id. (footnote omitted). 25. see id. the distributable income is sometimes described as "sustainable income" since the firm is able to maintain its productive assets intact while making distributions of income to its owners. see id. 26. see pechman, supra note 20, at 174 (discussing the analogous problem of historical cost depreciation). 27. bloom & debessay, supra note 16, at 95; see h. t. mcanly, recognizing current price levels in the profit and loss statement and in the balance sheet, in dollar value lifo-cost accounting concepts-managements services 111, 120 (n.d.) ("[a] company cannot liquidate its inventory and stay in business. a working amount of inventory is as essential to the conduct of business as are other items of working capital and physical facilities.") 28. as discussed below, changes in items held in ending inventory can complicate this conclusion. 29. lifo's contribution to the formation of business capital has been cited as a basis for expanding its availability. see generally house comm. on small business, inventory accounting as a burden on the capital formation process, h.r. rep. no. 1448, 96th cong., 2d sess. 5-13 (1980). [vol. 2:10 denysti'ing lifo the example shows that lifo tracks the general contours of the physical capital maintenance theory in the context of inventory investment. 0 literature relating to the early development of lifo reflects similar concern for physical capital maintenance. for example, h.t. mcanly, an early proponent of lifo, viewed fifo as deficient because it created "artificial profits" that were essentially part of the capital investment in the firm: the use of the first-in, first-out basis may serve to deceive the investors through creating a false profit to the extent that a portion of the profit represents a revaluation of a continuing monetary investment in inventory. therefore, it is rightfully claimed that the portion of the net income which represents the increase or decrease in profit brought about through the revaluation of a continuing investment in inventory under this first-in, first-out method is not income which has been earned and therefore available for distribution." in contrast, mcanly viewed lifo as promoting a more realistic measure of income: "with lifo everyone can speak of earnings and profits as meaningful positive enrichment rather than imaginary, theoretical or transient profits, resulting from mere fluctuations in the value of things we own."' 2 courts discussing lifo also point to its basic purpose in terms of eliminating artificial profits created by inflation. as the tax court often repeats: "the theory behind lifo is that income may be more accurately determined by matching current costs against current revenues, thereby eliminating from earnings any artificial profits resulting from inflationary increases in inventory costs."33 other courts have explained inflation-induced 30. full analysis of the physical capital maintenance concept requires that assets other than inventory, including plant and equipment, also be taken into account. see bloom & debessay, supra note 16, at 94. this analysis focuses solely on inventory as a discrete component of physical capital. 31. h.t. mcanly, curbing the effect of our erratic dollar in pricing inventories and providing for depreciation, in selected writings on accounting and related subjects 60, 65 (n.d.). 32. h.t. mcanly, a need for agreement on a uniform basis of inventory valuation, in selected writings on accounting and related subjects 87, 101 (n.d.). 33. amity leather prods. co. v. commissioner, 82 t.c. 726,732 (1984) (citing fox chevrolet, inc. v. commissioner, 76 t.c. 708, 723 (1981), acq. 1984-2 c.b. 1); see shasta indus. v. commissioner, 52 t.c. memo (cch) 190, 195-96, t.c. memo (p-h) 1 86.377 (1986) ("the theory of the lifo method is generally that the determination of income may be more accurate if current costs are matched with current revenues, thereby eliminating any inflation-induced profit."); see also hamilton indus., inc. v. commissioner, 97 t.c. 120, 130 (1991) ("by matching the cost of the most recently purchased goods with current sales revenue, the lifo convention removes from current earnings any artificial profits attributable 1995] florida tax review profit in terms of the inability to distribute such profits, which are needed to replace inventory that was sold.34 unfortunately, the practical realities of measuring economic income under a physical capital maintenance approach are much more complex than the simplified example suggests. the principal difficulty in applying the approach to inventory involves the criteria for measuring productive capacity-here, the inventory as a measure of that capacity-consistently over time. commentators have suggested at least three different interpretations of physical productive capacity: 1. maintaining identical or similar physical assets that the firm presently owns 2. maintaining the capacity to produce the same volume of goods and services 3. maintaining the capacity to produce the same value of goods and services.35 to inflationary increases in inventory costs."); oak knoll cellar v. commissioner, 68 t.c. memo (cch) 412, 420, t.c. memo (ria) 94,396 (1994) (using similar language). 34. for example, a district court judge stated: under the fifo method the earliest historical costs are matched against current revenues and, to the extent that current costs exceed such historical costs, gross profit is overstated and distorted. rather than being available totally for the payment of operating expenses, the repayment of debt, new investment, distribution to owners and the like, a portion of such 'profit' must be used merely to replace the inventory which was sold. it is this distortion of profit which may be substantially mitigated by the use of lifo. the objective of the lifo method is to match relatively current costs against current revenues in order to produce a more realistic gross profit. william powell co. v. united states, 524 f. supp. 841, 844-45 (s.d. ohio 1981) (quoting stephen f. gertzman, lifo: current problems and needed changes, 34 n.y.u. inst. on fed. tax. 234, 240 (1976)). another statement of the idea: if the taxpayer were to use the first in, first out (fifo) method, it would realize greater income earlier because lower priced goods are the first sold. however, that greater income would not account for the cost of replacing goods in inventory. under lifo, the higher income from the sale of lower cost, earlier-produced or purchased goods is deferred until the business depletes its prior-year inventory. lifo allows the taxpayer to match current costs with current revenues more accurately, but usually it results in lower taxes. this is acceptable because the lower taxes on lower income is attributable to inventory inflation. kohler co. v. united states, 95-2 u.s. tax cas. 50,600 (ct. cl. 1995). 35. bloom & debessay, supra note 16, at 94. these three alternatives are derived from a report submitted to the british parliament in 1975 by a committee chaired by f.e.p. sandilands, esq. inflation accounting committee, inflation accounting 117, at 35 (1975) [hereinafter sandilands report]. [vol 2:10 demystif6.ing lifo for the inventory component of physical capital, the first two of these interpretations are most relevant.36 the first approach-maintaining identical or similar physical assets-presents definitional questions that inhibit its practical implementation. similarity is a matter of degree. 7 how many characteristics must be the same in order for the inventory assets to be similar? stated differently, at what point should a change in the composition of inventory justify treating the firm as having liquidated its former inventory and entered into a new productive activity, requiring that taxes be imposed on deferred gains? a requirement of physical similarity presents the potential for liquidations-and hence recognition of deferred holding gains-resulting from changes in the composition of inventory. if physical identity or similarity were required, inventory composition changes caused by such factors as variation in quality or stylistic or technological innovation could require frequent inclusions of holding gains in income. " that result is inconsistent with the underlying realities of a going concern-if a firm is to continue its operations, it must adapt its inventory to a changing environment. the firm's shift to different inventory items arguably does not put the firm in a position to make sustainable distributions to owners (or to the government in the form of taxes). the second approach-maintaining the same volume of inventory without requiring physical similarity (or perhaps by applying a very general standard of similarity)-has the potential to avoid the effects of frequent liquidations imposed by the first alternative.39 however, measuring volume 36. the third alternative, which focuses on maintaining capacity to produce the same value of goods, takes into account changes in the selling prices of goods. bloom & debessay, supra note 16, at 95. according to the sandilands report. this alternative "attempts ... to take account of the fact that because of price changes the value of the company's products may be increasing while its physical inventory of productive assets may be static or decreasing." sandilands report, supra note 35, 1 118, at 35. the report conceded that this approach, as well as the second approach focusing on volume, were "difficult to apply in practice." id. since our income tax system permits only a cost basis for lifo inventories, this approach focusing on value is not discussed here. see irc § 472(b)(2). 37. similar is defined as "having characteristics in common: very much alike" or "alike in substance or essentials." webster's third new international dictionary 2120 (1993). 38. for fungible commodities, units such as gallons, pounds, bushels, barrels, and the like may be easily compared over time. however, other items are not so easily quantified and compared. the time period over which inventory changes are measured could also affect the frequency of such liquidations. for example, if comparisons are made on a year-to-year basis only, subtle changes in composition might go unnoticed. however, over longer periods of time, the cumulative effects of these changes might be significant. 39. see bloom & debessay, supra note 16, at 95 (noting that this approach "accommodates technological improvements and in this respect is superior to the [interpretation requiring maintaining identical or similar physical assets)"). 19951 florida tax review on a comparable basis over time without resorting to physical units can be a formidable task.40 assume that in year one, a firm holds 100 widgets costing $1 each, but in year two, the firm shifts its inventory investment by replacing 50 widgets with 25 gidgets, which cost $2 each. if gidgets existed in year one and if the costs of widgets and gidgets have remained stable between years one and two, we could focus on the volume of inventory in dollars and conclude that the volume has not changed. however, if prices have changed, dollars from each year are not comparable measures of physical capital. some adjustment to the dollar value is required to ensure comparability between periods. as discussed below, the dollar-value lifo method makes such an adjustment possible, albeit with considerable complexity. iv. using lifo to implement the physical capital maintenance concept the tax law recognizes two principal bases for lifo inventory computations: specific goods lifo and dollar-value lifo.4 these methods implement, with varying degrees of effectiveness, the two interpretations of physical capital maintenance discussed above in part ii. specific goods lifo is derived from the first interpretation, which measures changes in inventory investment by focusing on similar inventory items. dollar-value lifo flows from the second interpretation, which measures changes in inventory investment by converting physical inventory measurements to dollars that are comparable between measurement periods. both methods depart from a precise application of the physical capital maintenance concept due to the practical realities of implementing them in an environment of changing inventory content. a. specific goods lifo the earliest lifo methods focused on specific goods or raw material units as the basis for comparing inventory quantities over time. 2 the 40. see sandilands report, supra note 35, 118, at 35 (noting difficulty of applying this concept). 41. gertzman, supra note 3, 7.04[1]; schneider, supra note 4, § 12.01. 42. see gertzman, supra note 3, 7.0412] ("the specific goods method is the simplest and oldest of lifo systems"). the lifo method is thought to have originated in the mid-1930's as a financial accounting concept developed by the petroleum industry. see raymond a. hoffman & henry gunders, inventories 184 (2d ed. 1970) (noting that "[ulse of the phrase 'last-in, first-out' appears to have started with committees representing the petroleum industry"). however, the concepts inherent in the lifo method may have originated earlier; lifo is similar to the so-called base stock method, which used before that time. see id.; schneider, supra note 4, § 9.01 ("the lifo concept is not a recent innovation; in differing forms, it probably dates back to the origins of the income tax law and to the initial reporting [vol 2:10 demystifying lifo revenue act of 1938, which first authorized the use of lifo for tax purposes, 43 restricted lifo to raw materials inventories in the leather tanning and nonferrous metals industries.' in 1939, congress removed the industry-specific restrictions so that, in theory, any taxpayer with inventories could use lifo.45 although the first statutes did not prescribe a detailed system for implementing llfo, 46 the treasury issued regulations indicating of inventories. the lifo concept owes its development to another method of inventory valuation [the base stock method] that was used by some taxpayers in reporting their inventories under the earliest income tax statutes."); 51 harv. l. rev. 1430, 1432 (1938) (characterizing 1938 legislation permitting lifo in some industries as adopting the base stock principle). the base stock method has been described as follows: under the base stock inventory method the minimum quantity of raw materials or other goods without which management considers the operation cannot be continued, except for limited periods, is treated as being a fixed asset subject to constant renewal. the base quantity is carried forward at the cost of the original stock. hoffman & gunders, supra, at 169. schneider notes that the principal difference between the base stock method and lifo is that "under the lifo method, a normal or base quantity concept was discarded and the flow of all goods was simply reversed from first-in, first-out to last-in, first-out" schneider, supra note 4, § 9.01. the base stock method thus seemed to be a crude attempt to implement the physical capital maintenance concept. see 51 harv. l. rev., at 1432 ("the advocates of the base stock principle do not challenge the soundness of reflecting inventory 'gains or losses' in income determination; they merely assert that insofar as a certain quantity of inventory is absolutely essential to the carrying on of a business, the reflection in the income account of changes in the value of that amount of inventory, even though the separate units have been sold and replaced, is as fallacious as including changes in the value of real estate or machinery."): see also gertzman, supra note 3, 9i 7.02[2] (referring to the "base stock" and "reserve" methods as the "so-called normal stock methods" based on the premise that "a certain 'normal' quantity of inventory was generally required throughout the life of a business and thus should be valued as a fixed asset rather than on the basis of changing prices over the course of a business cycle"). however, the treasury and ultimately the supreme court in lucas v. kansas city structural steel co., 281 u.s. 264 (1930), held that the base stock method was not acceptable for tax purposes. see generally gertzman, supra note 3. 1 7.0212] schneider, supra note 4. § 9.01; 51 harv. l. rev. at 1436-37. 43. see revenue act of 1938, pub. l. no. 554, ch. 289. § 22(d), 52 stat. 447, 459 (current version at irc § 472). 44. ironically, the petroleum industry, which was thought to have originated the "last-in, first-out" concept, was not included in the select group of taxpayers initially allowed to use lifo. one commentator suggested that the narrow authorization of lifo in the 1938 bill was the result of the treasury's concern that "drafting adequate safeguarding regulations" would be impossible if lifo was "allowed indiscriminately to a wide group of taxpayers." 51 harv. l. rev. 1430, 1431 (1938). 45. see irc §22(d) (1939). 46. section 22(d)(2) of the 1938 act required that ending inventory consist of "[f]irst, those [items] included in the inventory as of the beginning of the taxable year (in the order of acquisition) to the extent thereof, and second, those acquired in the taxable year. in 19951 florida tax review that lifo was feasible only for inventories that could be measured in common physical measuring units, such as tons, gallons, or yards.47 this approach is now known as specific goods lifo.4 8 under specific goods lifo, the comparison of the total inventory investment from year to year is generally based on the physical similarity of "goods" in inventory.49 the classification or grouping of similar goods is significant because each classification is effectively treated as a separate inventory.5" as a result, shifts in the inventory composition can result in liquidations of some classifications or incremental increases in others.5 ' in these circumstances, the deferral of inventory profit required by the physical capital maintenance concept may terminate despite the need for continued inventory investment. specific goods lifo thus reflects a more restrictive form of capital maintenance theory, providing only limited deferral of holding gains for the order of acquisition." a similar statutory formula has continued throughout the history of the lifo statute. see irc § 472(b)(1). 47. see schneider, supra note 4, § 9.03. 48. id. 49. section 472 and the regulations thereunder use the term "goods" to describe the inventory content. for example, § 472(a) and (b) both refer to use of the lifo method for inventorying "goods." similarly, regs. § 1.472-1(a), (c) refers to "goods remaining on hand" and to a "class of goods." the term "goods" may not be intended as a technical limitation on the availability of the lifo method. the regulations allow lifo to be applied to raw material content of work in process and finished goods, regs. § 1.472-1(c), and the service has ruled that lifo may be applied to intangibles, such as securities, rev. rul. 60-321, 1960-2 c.b. 166. nevertheless, the irs national office has taken the position in that an "item" must be a "good." see i.r.s. t.a.m. 9405005 (oct. 15, 1993). in the discussion below, the terms "goods," "items," and "costs" are used interchangeably. for a summary of the arguments favoring a definition of "item" that is not limited to "goods," see gertzman, supra note 3, 7.04[3][e]. 50. gertzman refers to classifications or groupings of specific goods as "pools." gertzman, supra note 3, 7.04[2]. occasionally, the service also uses this term to describe groupings of similar goods, see, e.g., rev. rul. 62-77, 1962-1 c.b. 80 (discussing change from specific goods to dollar-value lifo using the same "pools"), as does the tax court, see oak knoll cellar v. commissioner, 68 t.c. memo (cch) 412, t.c. memo (ria) 94,396 (1994). however, the regulations appear to use the term "pooling" only in the dollar-value lifo context. compare regs. § 1.472-1(d), (f) (referring to raw materials, groups, or classifications) with regs. § 1.472-8(b) (referring to dollar-value lifo pools). in any event, a specific goods "pool" is much narrower than a dollar-value "pool." see generally schneider, supra note 4, § 13.01[2] (discussing the two pooling methods). 51. as noted above, an incremental increase in inventory quantity is effectively treated as a new investment, which is reflected at an amount approximating current cost. the regulations provide three principal alternatives for valuing increments, which focus on the costs of earliest acquisitions, latest acquisitions, or an average of acquisitions. see regs. § 1.4722(d)(1)(i)(a)-(c). other methods may also be used if the taxpayer satisfies the irs that they clearly reflect income. regs. § 1.472-2(d)(1)(i)(d). [vol. 2:10 demystifing ljfo taxpayers affected by shifting inventory compositions. moreover, it can be particularly difficult to administer for taxpayers with complex inventories or changing inventory compositions, due in part to the practical difficulties and uncertainties in properly grouping similar goods.52 the regulations provide only limited guidance as to the grouping of similar goods,53 much of which is found in the context of defining similar raw materials in connection with a specific goods lifo election for raw materials or raw material content. first, the regulations provide the following general guidance: for the purposes of this section, raw material in the opening inventory must be compared with similar raw material in the closing inventory. there may be several types of raw materials, depending upon the character, quality, or price, and each type of raw material in the opening inventory must be compared with a similar type in the closing inventory.' significantly, the regulations adopt a standard of similarity, not identity. moreover, the absence of detailed rules suggests that some flexibility is allowed in applying these standards of "character, quality, or price." the regulations contain further examples illustrating that raw materials with different characteristics may sometimes be treated as a single classification: 52. see, e.g., oak knoll cellar v. commissioner, 68 t.c. memo (cch) 412, 420, t.c. memo (ria) 94,396 (1994) ("because the specific-goods lifo method requires the matching of physical units, practically speaking, it is only used as a method for valuing inventories in those industries with inventories which contain a limited number of items with quantities that are easily measured in units.") (quoting wendle ford sales. inc. v. commissioner, 72 t.c. 447, 452 (1979)). however, schneider, while noting the impracticality of applying specific goods lifo to complex inventories, states that he is aware of taxpayers in a diverse range of industries who have successfully used the specific goods method for finished goods produced in complex manufacturing businesses. in these cases, the taxpayer typically has reduced its finished goods to some common denominator of fungibility and has maintained only a few separate specific goods categories. schneider, supra note 4, § 12.02[4]. however, schneider also notes that these taxpayers are "vulnerable to challenge from the service because the multiplicity of different finished products requires numerous separate specific groupings." id. n.57. 53. see oak knoll cellar v. commissioner, 68 t.c. memo (cch) at 420. 54. regs. § 1.472-1(d). by comparison, the dollar-value lifo regulations on raw material content focus on whether raw materials are "substantially similar" in determining how raw materials should be pooled. see regs. § !.472-8(b)(3)(ii). the concept of pooling in dollar-value lifo is discussed briefly infra part iv.b. 19951 florida tax review in the cotton textile industry there may be different raw materials depending upon marked differences in length of staple, in color or grade of the cotton. but where different staple lengths or grades of cotton are being used at different times in the same mill to produce the same class of goods, such differences would not necessarily require the classification into different raw materials." however, the parameters for similarity seem elusive. on one hand, "marked differences" (whatever that means) in some physical characteristics "may" require separate classification. on the other hand, materials with different characteristics do not "necessarily" require separate classification if the materials are incorporated into a common output. additional factors of "price and use" are illustrated in an example from the pork packing industry: as to the pork packing industry a live hog is considered as being composed of various raw materials, different cuts of a hog varying markedly in price and use. generally a hog is processed into approximately 10 primal cuts and several miscellaneous articles. however, due to similarity in price and use, these may be grouped into fewer classifications, each group being classed as one raw material.56 again, the standards for similarity of price and use are somewhat unclear, but they arguably recognize some latitude in grouping specific goods to implement lifo in a dynamic product environment. 57 case law and published rulings add little clarity to the interpretation and interrelationships of these factors.58 in one case, the service required 55. regs. § 1.472-1(e) (emphasis added). 56. regs. § 1.472-1(f). here, "price" apparently refers to a market price for particular cuts, as presumably the cost to the packer is, in most cases, measured by the cost of the whole animal. the intended meaning of "use" is not clear, but it may refer to use by the packer in further processing, such as in wieners or sausage. 57. one commentator has observed: "it is noteworthy that meatpackers process hogs and cows into more finite products, such as individual steaks and other meat cuts. the example in the regulations seems to imply that the meatpacker need not treat these detailed products as its specific goods groupings." schneider, supra note 4, § 12.04[2]. 58. see id. § 14.01[2][a] n.12 ("unfortunately, most of [the] experience [in the determination of similar physical goods] is as a result of audits and is not officially recognized or published."). in a recent tax court decision involving specific goods lifo, the court observed: "the parties have not cited, and the court has not found, any published opinion which directly addresses the appropriateness of a taxpayer's grouping of items under the specific-goods lifo method." oak knoll cellar v. commissioner, 68 t.c. memo (cch) 412, 421, t.c. memo (ria) 94,396 (1994). [vol 2:10 demysti.ing lifo materials with relatively wide variances in grade and costs to be treated as the same materials for specific goods lifo purposes.59 in another ruling, the service allowed refined petroleum products-defined as including "gasoline and various types of fuel oil"-to be in the same specific goods grouping.' however, it is difficult to extract principles from these decisions. if a particular type of goods varies by grade and price, but the mix in grades and their corresponding prices stay relatively fixed over time, the grouping of goods with some differences in physical characteristics does no violence to the purpose of lfo. such groupings reduce the burden of separate computations for each narrow type of good and alleviate the impact of temporary liquidations caused by variations in the quantities on hand of each type. however, groupings of goods with varying physical characteristics, such as different quality grades, coupled with corresponding variations in cost creates the potential for inaccurate measures of the level of inventory investment over time. such inaccuracy could either benefit the taxpayer (if the mix tends toward including more higher cost goods) or the government (if the mix tends toward including more lower cost goods). in addition to the regulations' standards for physical similarity, the service has interpreted costing rules for determining the value of ending inventory 6' to require separate groupings for otherwise similar goods based on the nature of the taxpayer's business activities. in revenue ruling 79290,62 the service concluded that a taxpayer who discontinued its manufacturing and processing operations and, instead, purchased and distributed similar products could not continue to use the same specific goods groupings. 59. john l. denning & co. v. commissioner, 7 t.c. memo (cch) 980. t.c. memo (p-h) 48,277 (1948), remanded on other grounds, 180 f.2d 288 (10th cir. 1950). where an inventory of broomcom comprised of different grades, ranging in cost from s91.50 to s145.52 per 1,000 pounds, was treated as a single raw material classification. the taxpayer had purchased relatively greater quantities of the cheaper broomcom grades during the taxable year, which resulted in an increment in the quantity of broomcorn on hand at year-end. the taxpayer sought to value this increment based on the acquisition cost of the cheaper grades, rather than the average cost of all purchases, which had been used to value increments in previous years. the service required the taxpayer to continue its former method, which resulted in a valuation that was less advantageous to the taxpayer. on one hand, since the service could have taken the position that the higher quality broomcorn had been liquidated, this case could stand for the proposition that broad ranges are acceptable. on the other hand, the principle that methods of accounting generally cannot be changed unilaterally could also explain the result. see schneider, supra note 4, § 12.03141 (citing denning for the proposition that increment valuation methods must be applied consistently). 60. rev. rul. 79-290, 1979-2 c.b. 221. as discussed below, this ruling also introduced a separate criterion for specific goods groupings based on the business activity of the taxpayer. see infra notes 61-63 and accompanying text. 61. regs. § 1a72-2(d). 62. 1979-2 c.b. 221. 1995] florida tax review the service pointed out that the regulations have separate costing rules for manufacturers and for wholesalers or retailers. apparently, the service reasoned that this difference implied that manufacturing is a separate business activity from wholesaling or retailing, thereby justifying separate groupings.63 in effect, the ruling finds that a change from manufacturing to wholesaling is sufficiently significant to treat the taxpayer as having liquidated its former inventory investment, thereby justifying the recognition of previously deferred holding gains. the ruling concludes that the taxpayer's income would be "distorted" if such holding gains were not recognized. 6 although determination that a taxpayer has liquidated one business and started another may provide economic justification for ending the deferral of inventory holding gains, the legal basis for this conclusion does not readily appear in the lifo statute or regulations. the taxpayer in the ruling closed a manufacturing and processing plant, but continued its selling activities. 65 it is difficult to articulate a sound basis for treating the inventory investment necessary for its selling activities as fundamentally different merely because the taxpayer changed its source of supply by discontinuing processing activities and purchasing similar products from others.' the investment in plant and equipment may have changed, but the inventory investment appears to be consistent. these uncertainties in the standards for defining similar goods (and, if revenue ruling 79-270 is accepted, for defining similar business activities) presents a potential for substantial variation in the lifo benefits obtained by taxpayers who elect specific goods lifo. one commentator has observed: [t]axpayers' practices and the service's attitude toward grouping raw 63. the ruling also appears to be based on the fact that the dollar-value lifo regulations require separate pools for wholesaling and retailing operations. these regulations provide in part: "where a manufacturer or processor is also engaged in the wholesaling or retailing of goods purchased from others, the wholesaling or retailing operations with respect to such purchased goods shall not be considered a part of any manufacturing or processing unit." regs. § 1.472-8(b)(2)(i). 64. rev. rul. 79-209, 1972-2 c.b. 221. 65. the ruling does not specify whether the taxpayer engaged in retailing activities before discontinuing its processing activities. however, even if it was only engaged in wholesaling, nothing in the regulations suggests that otherwise similar goods in a wholesaling operation must be grouped separately from those in a retailing operation. see regs. § 1.4722(d)(1)(i) (retail grocer, druggist, and miner selling ore without smelting or refining are all subject to same rules). 66. this ruling has been criticized as being inconsistent with the specific goods lifo concept, which focuses on comparing goods, not business activities. see schneider, supra note 4, § 12.04[2]. schneider also takes the position that the specific goods regulations do not address the question of whether a purchased product and an identical produced product should be considered part of the same class of goods. [vol. 2:10 demystify.ing lifo materials vary widely. in some areas of the country and in some industries, grouping of raw materials on a fairly broad basis appears to have been permitted by the service, whereas in other areas of the country and in other industries, narrower groupings of raw materials have been required.67 this variation may also create unequal treatment of taxpayers and is likely to increase tax administration costs for both taxpayers and the government. a recent case, oak knoll cellar v. commissioner," illustrates the potential burdens of satisfying the indeterminate standards of the regulations. in oak knoll cellar, the commissioner had proposed an adjustment rejecting a taxpayer's use of a single specific goods grouping for all wine costs and requiring a separate grouping for each varietal wine.69 the commissioner maintained this position in preparing for trial, even though representatives of the irs district office did not agree that separate poolings for each varietal wine were appropriate,7" and a settlement proposal based on only two groupings (one for red wines and one for white wines) was made to an unrelated taxpayer that had also used a single pool for wine costs.7 two weeks before trial, and nearly three years after the audit began, the commissioner conceded the issue.72 although the taxpayer was a "prevailing party" and satisfied the exhaustion of administrative remedies requirement of code section 7430, the court denied recovery of litigation costs to the taxpayer because it could not show that the commissioner was unjustified in challenging its specific goods grouping.7 3 the court found that "the appropriate scope of a specific-goods grouping is a complex question depending on the facts and circumstances of the particular taxpayer."'74 the court further noted that "[ilt may be reasonable for the commissioner to pursue litigation that may tend to clarify the law, even though such litigation will be burdensome and expensive for the taxpayer, and even though the commissioner's chances of success may be marginal. ' '75 moreover, the court found that the commissioner's discretion to ensure that the taxpayer's method clearly reflects income was itself an 67. schneider, supra note 4. § 12.04[31. 68. 68 t.c. memo (cch) 412, t.c. memo (ria) 1 94,396 (1994). 69. id. at 415. varietal wines are based on the varieties of grapes from which they are made, such as chardonnay, cabernet franc, cabernet sauvignon, or merlot. id. at 413. 70. id. at 415. 71. such a proposal was later made to the taxpayer in this case. who was represented by the same counsel as the unrelated taxpayer. 72. id. at 416. 73. id. at 420-21. 74. id. at 420. 75. id. at 421. 19951 florida tax review adequate basis for such a challenge to its specific goods groupings, even though the taxpayer alleged that it had applied its method consistently and that the method was consistent with practices in the wine industry and with gaap. in these circumstances, the commissioner's decision "to concede the cases rather than to litigate such a complex issue" was not unreasonable.7 6 oak knoll cellar illustrates the potential for both taxpayers and the government to expend considerable resources in deciding similarity issues that ultimately depend on particular facts and circumstances. even if the case had been litigated to a decision, a principled basis for deciding this issue is not apparent, given the limited guidance in the regulations on tolerances for variation among specific goods. moreover, the possibility that such a decision might resolve conflicts in other industries, or even within the same industry, is small, given variation among taxpayers and their practices. the grouping process seems to be further removed from any objective standard by the court's position that a taxpayer's conformance with grouping methods used in the wine industry and with gaap is not sufficient to bar an adjustment by the service. ultimately, any departure from a standard of identity leaves a taxpayer vulnerable to challenge on audit, with uncertain results. b. dollarvalue lifo the dollar-value lifo method alleviates many of the conceptual and administrative problems of the focus on specific physical goods. however, dollar-value lifo presents its own administrative problems, many of which also involve comparing the characteristics of inventory or business activities from year to year. 1. historical development.-as the tax court has explained, dollarvalue lifo arose as a means to resolve practical difficulties of measuring quantities based on physical units under the specific goods method: under the specific-goods method, the physical quantity of homogeneous items of inventory at the end of the taxable year is compared with the quantity of like items in the beginning inventory to determine whether there has been an increase or decrease during the year. because the specificgoods method requires the matching of physical units, practically speaking, it is only used as a method of valuing inventories in those industries with inventories which contain a limited number of items with quantities that are easily measured in units. in contrast to the specific goods method, the dollar-value method measures increases or decreases in 76. id. at 423. [vol. 2:10 denzvstifying lifo inventory quantities, not in terms of physical units, but in terms of total dollars. thus, to determine whether there has been an increase or decrease in the inventory during the year, the ending inventory is valued in terms of total dollars that are equivalent in value to the dollars used to value the beginning inventory. because it is not predicated upon the matching of specific items, use of the dollar-value method permits the application of the lifo principle in those industries with complex inventories containing a vast number of items." the dollar-value method's origins are generally traced to h.t. mcanly, who devised the method to expand access to lifo.78 mcanly explained: to attempt to apply the principle of last-in, first-out to quantities of specific items in a company producing many different and rapidly changing items from many types of materials involving numerous fabricating operations, or engaged in jobbing or retailing many items of merchandise, not only would be a wholly impracticable procedure, but would not accomplish its underlying purpose of excluding fluctuations in value covering that portion of the aggregate inventory which is considered as a continuing investment therein. yet companies with a wide variety of products are required to maintain continuing investments in inventories, and it would seem that they should be permitted to keep from increasing the aggregate valuation of their inventories in a period of rising markets through the use of the last-in, first-out principle, by reflecting only the increase over the beginning inventory (if such exists) at prices and costs occurring within the fiscal period.7" according to mcanly, specific goods lifo presents two main problems: first, the difficulty of comparing similar physical items due to product changes from year to year; and second, when a "new" item enters the inventory (i.e., an item dissimilar to those on hand in prior years), the resulting liquidations in "old" inventory items and increments in "new" 77. wendle ford sales, inc. v. commissioner. 72 t.c. 447, 452 (1979). acq. 1980-2 c.b. 2 (citations omitted). 78. see gertzman, supra note 3, 7.04131; schneider, supra note 4. § 9.05[l 1. 79. h.t. mcanly, origin of the dollar value lifo method. in selected writings on accounting and related subjects 17. 18 (n.d.). 19951 florida tax review replacement inventory items do not fully effectuate the concept of physical capital maintenance.80 in effect, mcanly recognized that the adapting of inventory content to changing technology, styles, tastes, or demands is not a replacement of old inventory with different inventory items-that is, is not a new investment that should trigger realization of deferred inventory gains. instead, mcanly argued that a broader interpretation of lifo was necessary to implement the physical capital maintenance concept in a dynamic inventory environment: regardless of whether or not the same quantities of specific items or the same items are in existence at the close of the year as were on hand at the beginning of the year, the last-in, first-out principle should be one of determining an aggregate valuation of an investment in inventory of related products on a basis that prevents the increasing of operating profits through writing up the valuation of the portion of the ending inventory investment which represents a continuing investment, as evidenced by the fact that it was in existence at the inception of the fiscal period. it appears only reasonable to explore the possibilities of its application's being broadly interpreted so as to cover the cost elements which are common to all products, and not literally interpreted as being confined to the movement of specific products whose costs are determined from these basic cost factors: material prices, occupational wage scales, and burden or expense rates.8' the dollar-value lifo method proposed by mcanly has three key elements. first, inventory items are combined into "general related product groupings," instead of treating each specific type of item as a separate grouping. 2 second, the dollar value of each such grouping is determined by pricing each item within the grouping at the price level at the beginning of the first year for which lifo was elected (the "base year") or, if the items 80. see id. at 20-21 ("if the term 'units' [in the specific goods lifo regulations] is construed to mean units of specific product design, its application will be extremely limited not only because of the mechanics of its application but because the resultant valuation derived from its use on a specific product quantity basis may not reflect an equitable picture of earnings .... ); h.t. mcanly, curbing the effect of our erratic dollar in pricing inventories and providing for depreciation, in dollar value lifo-cost accounting concepts-management services 60, 66 (n.d.) (if lifo is applied to specific items instead of a group of related products, "income will not be clearly or correctly reflected"). 81. h.t. mcanly, origin of the dollar value lifo method, in selected writings on accounting and related subjects 17, 20 (n.d.). 82. id. at 23-24. these groupings were later referred to as "pools." see regs. § 1.472-8(b). [vol. 2:10 demysti fing lifo did not exist at that time, at a cost constructed for the price level at that time.83 third, to the extent the base-year cost of inventory exceeds the baseyear cost of the inventory for the prior year, an increment occurs, which is priced at current-year costs.' decrements, on the other hand, are removed from sequential layers of increment in reverse chronological order. the dollar-value regulations have adopted these same concepts, albeit in greater detail.8 ' by referring to the "so-called 'dollar-value' method, '' 6 the regulations appear to have incorporated the method developed by mcanly, which was being used by taxpayers when the regulations were adopted.' although the dollar-value method eliminates the comparison of physical quantities of similar inventory items from year to year, the physical composition of inventory items is not ignored. first, characteristics of inventory items, and, in some cases, of business activities in connection with such items, are relevant in grouping items in pools.ss although a detailed discussion of pooling is beyond the scope of this article, dividing inventory into dollar-value lifo pools is another source of complexity in lifo for 83. h.t. mcanly, origin of the dollar value lifo method, in selected writings on accounting and related subjects 17, 23 (n.d.). although mcanly refers to the beginning of the year, the example to which he refers involves the first year for adopting lifo. the regulations generally refer to the first year for adopting lifo as the "base year." see regs. § 1.472-8(a). as discussed below, the regulations also authorize different methods of determining the lifo value, some of which are based on pricing inventory items as of the beginning of the taxable year, while others are based on pricing as of the base year. see regs. § 1.472-8(e). 84. h.t. mcanly, origin of the dollar value lifo method, in selected writings on accounting and related subjects 17, 23 (n.d.). 85. see regs. § 1.472-8. 86. see regs. § 1.472-1(1). 87. that tax provisions are often based on current business and accounting practices was apparently no surprise to mcanly, who observed: "normally and naturally, the interpretation of legislative provisions follow, but rarely precede, business practice." h. t. mcanly, a practical method of keeping inflation out of inventory valuations, in dollar value lifo-cost accounting concepts-management services 39 (n.d.); see beneficial corp. v. united states, 814 f.2d 1570, 1573 (fed. cir. 1987) ("it would be unreasonable to presume that congress had adopted a statutory term, whose sole meaning was well established in the [accounting] field, in a manner contrary to that established meaning without explicit indication to that effect"). 88. see regs. § 1.472-8(b), (c). for example, manufacturers and processors must form inventory pools based either on "natural business unit" or "multiple pool" approaches. regs. § 1.472-8(b)(1). a natural business unit "ordinarily consists of the entire productive activity of the enterprise within one product line or within two or more related product lines." regs. § 1.472-8(b)(2)(i). multiple pools "ordinarily consist of inventory items which are substantially similar." regs. § 1.472-8(b)(3)(i). for wholesalers and retailers, pools are generally determined by "major lines, types, or classes of goods." regs. § 1.472-8(c). 19951 florida tax review which only cryptic guidance is given in the regulations.89 because separate pools create a potential for increments and liquidations based on shifting content, it is questionable whether a requirement of more than one pool per taxpayer is consistent with the physical capital maintenance concept. 90 second, in order to compare inventory quantities in terms of dollars, the ending inventory must be translated into dollar values equivalent to those of the base year. this translation into base-year dollars is typically made by applying a taxpayer-developed index of cost changes affecting its inventory-' the computation of this index requires careful analysis of the characteristics of each inventory item to ensure a valid comparison between currentyear and base-year costs. as discussed below, the degree of similarity allowed or required when comparing items to compute a lifo index is controversial. 2. index methods.-the regulations authorize three principal methods for computing an internally developed index: "double-extension," "index," and "link-chain., 92 the problem of "new items"-items with different characteristics than those existing in a prior period-is common to each of these methods, although the extent of this problem may vary depending on the number of items and the time period involved in the computation. a. double-extension method.-the principal method for computing an internally developed price index is the "double-extension method. 93 under this method, the taxpayer prices all items in inventory at current-year and base-year costs, and computes the ratio (index) of the current-year cost to the base-year cost of all the items in ending inventory. the determination of the base-year cost of each item requires the taxpayer to 89. for example, with regard to multiple pooling, the regulations state in part: "in determining whether such similarity exists, consideration shall be given to all the facts and circumstances. the formulation of detailed rules for selection of pools applicable to all taxpayers is not feasible." regs. § 1.472-8(b)(3)(i). the scope of a "product line" for purposes of natural business unit pooling or of "lines, types, or classes" of goods is also not defined. 90. if more than one pool is required, each pool is effectively treated as a separate investment, since increments (representing new investments) and decrements (representing a liquidation of prior investments) are measured separately for each pool. as discussed above in connection with specific goods groupings, shifts in inventory composition are a questionable basis for discontinuing the deferred taxation of inventory holding gains. a single pool for each taxpayer would provide the greatest relief from the adverse effects of these shifts. 91. as discussed below, an index may also be developed from external sources. 92. see regs. § 1.472-8(e)(1). a fourth method is the retail method, which requires externally generated indexes. 93. see id. ("a taxpayer may ordinarily use only the so-called 'double-extension' method for computing the base-year and current-year cost of a dollar-value inventory pool."). [vol 2:10 demystifying lifo answer a practical question: what would the item in ending inventory have cost if it had been acquired in the base year? pricing each inventory item at the base-year cost presents a formidable task for a taxpayer with many different inventory items. as products or other inventory items change over time, the base-year cost may become increasingly difficult to determine. thus, comparing similar items still presents a practical problem, albeit in determining prices instead of comparing physical quantities as under the specific goods method. the regulations provide no explicit guidance for determining when a "new item" enters an inventory. as is discussed below, courts have taken different positions as to the scope of an item and the parameters for a "new item." however, if a new item exists, the regulations prescribe the following procedures for determining the item's base cost: [t]he base-year unit cost of the entering item shall be the current-year cost of that item unless the taxpayer is able to reconstruct or otherwise establish a different cost. if the entering item is a product or raw material not in existence on the base date, its cost may be reconstructed, that is, the taxpayer using reasonable means may determine what the cost of the item would have been had it been in existence in the base year. if the item was in existence on the base date but not stocked by the taxpayer, he may establish, by using available data or records, what the cost of the item would have been to the taxpayer had he stocked the item. if the base-year unit cost of the entering item is either reconstructed or otherwise established to the satisfaction of the commissioner, such cost may be used as the base-year unit cost in applying the double-extension method. if the taxpayer does not reconstruct or establish to the satisfaction of the commissioner a base-year unit cost, but does reconstruct or establish to the satisfaction of the commissioner the cost of the item at some year subsequent to the base year, he may use the earliest cost which he does reconstruct or establish as the base-year unit cost.94 for a new item that existed on the base date, but was not then carried in the taxpayer's inventory, other sources for base-year price data may be available, such as price lists from suppliers." determining base year costs 94. regs. § ia72-8(e)(2)(iii). 95. see schneider, supra note 4. § 14.0115]. 19951 florida tax review for such items might be time consuming, but not too difficult. for a new item that did not exist on the base date, guidance from the regulations is limited to allowing "reasonable means" to determine a hypothetical base-year cost. the scope of "reasonable means" has not been tested in the courts. some commentators have suggested that published price indexes, such as those compiled by the bureau of labor statistics, could be used for this purpose.96 engineering and cost estimates might also be used to break down a product into its cost components, and the costs of these components could be compared to similar costs in the base year.' 7 substituting the index for a similar item or items in the same pool has also been suggested.98 for a taxpayer with many new items, the reconstruction process could prove daunting. the regulations suggest that reconstruction of base cost for new items is optional," but the failure to reconstruct, in most cases, leads to a disadvantage because using the current-year cost as the base-year cost effectively treats the new item as having no inflation from the base year. 00 thus, new items can effectively limit the benefits of lifo. to the extent "reasonable means" is interpreted restrictively to require precision, it is likely to generate further controversies at the audit level. moreover, since objective standards have not been provided for measuring reasonableness, and the taxpayer bears the burden of proving reasonableness, controversies are inevitable.' 0 ' b. index method.-the "index" method allows qualifying taxpayers to depart from the complete double-extension approach by doublepricing only a portion of the inventory. the regulations state: where the use of the double-extension method is impractical, because of technological changes, the extensive variety of 96. see gertzman, supra note 3, 7.04[3][b]; schneider, supra note 4, § 14.01[5]. 97. schneider, supra note 4, § 14.01[5]. however, as discussed below, the service has challenged this approach to index computation. see id. (citing i.r.s. t.a.m. 9405005 (oct. 15, 1993)). 98. schneider, supra note 4, § 14.01[5]. 99. the regulations phrase reconstruction in terms of whether the taxpayer is "able" to reconstruct. regs. § 1.472-8(e)(2)(iii). further, in the case of a new item not in existence in the base year, the regulations provide that the taxpayer "may" reconstruct the base cost, which suggests that reconstruction is voluntary. id. some commentators suggest that the voluntary nature of reconstruction should be used to the taxpayer's advantage for an item that may have cost more in the base year. see schneider, supra note 4, § 14.01[5]. 100. schneider, supra note 4, § 14.01[5]. 101. schneider, supra note 4, § 14.0115] ("revenue agents are finding it easy to assert a large deficiency in such [new item] cases by treating all new items as having a baseyear cost equal to their current cost"). [vol. 2:10 denystifying lifo items, or extreme fluctuations in the variety of the items, in a dollar-value pool, the taxpayer may use an index method for computing all or part of the lifo value of the pool. an index may be computed by double-extending a representative portion of the inventory in a pool or by the use of other sound and consistent statistical methods. the index used must be appropriate to the inventory pool to which it is to be applied. the appropriateness of the method of computing the index and the accuracy, reliability, and suitability of the use of such index must be demonstrated to the satisfaction of the district director in connection with the examination of the taxpayer's returns. 2 the index method provides only limited relief from the burdens of doublepricing items because costs for sampled items must still be determined as of the base year. this can be difficult if the sampled items include "new items." moreover, the service has never established clear parameters for the "appropriateness" of the method or the "accuracy, reliability, and suitability" of the index. the potential for controversy clearly exists. as one practitioner has observed, "the propriety of a taxpayer's sample has come to be one of the leading audit issues. nevertheless, official guidelines continue to be lacking."' 0t 3 c. link-chain method.-a third method of constructing an internal price index-the "link-chain method"-differs from the doubleextension method by focusing on annual changes in the cost of inventory items, rather than changes occurring between the current year and the base year. under the link-chain method, an annual index is computed from the ratio of current-year cost to prior-year cost of the items in inventory, and this index is "linked" or multiplied by the indexes computed annually from the base year to compute a cumulative index, which represents the inflation in the ending inventory. 4 the link-chain method can also be combined with the sampling aspect of the index method, so that the annual index computation 102. regs. § 1.472-8(e)(i). 103. schneider, supra note 4, § 14.02121[al. 104. according to the regulations, the "so-called 'link-chain' method" may be used only if "the taxpayer can demonstrate to the satisfaction of the district director that the use of either an index method or the double-extension method would be impractical or unsuitable in view of the nature of the pool." regs. § 1.472-8(e)( 1). by referring to the "so-called" method. the regulations apparently authorize approaches previously used by taxpayers. the service has not provided a computational example of the method. for descriptions and illustrations of linkchain computation approaches, see generally gertzman, supra note 3, 1 7.04131[blliii]; schneider, supra note 4, § 14.02131. 1995] florida tax review involves only a statistical sample or other representative portion of the inventory items. °" by focusing on costs for the immediately preceding year, instead of base-year costs, the link-chain method may partially alleviate the difficulty of reconstructing costs of new items.' 6 finding the same item, or a similar item, for purposes of determining a prior period cost is more likely when successive years are involved. further, to the extent that the same or a similar item cannot be found and the taxpayer is forced to use the current-year cost as the prior-year cost,'0 7 the taxpayer effectively loses the benefit of only one year's inflation. as one commentator has explained, "in effect, the assumption is made that the inflation inherent in the new item from the base date to the end of the prior year is equal to the inflation inherent in the taxpayer's ever changing inventory of other items throughout that same period.' 08 this feature of the link-chain method, which attributes the cumulative inflation of the prior year to the items in ending inventory regardless of the actual inflation, can result in an overall measure of inflation that is not precise. to illustrate, assume that a taxpayer has an inventory of two items (a and b) that have a base-year cost of $1. in the first two years of applying the lifo method, the cost of item a increases by $1 per year, while the cost of item b remains $1. in the third year, the taxpayer discontinues item a and substitutes an extra item b, which still costs $1 per unit. the link-chain computations are as follows: ° 105. see gertzman, supra note 3, 7.04[3][b][iii]; schneider, supra note 4, § 14.0213]. schneider also quotes from a nonpublic letter consenting to an accounting method change in which the service recognized the use of sampling in conjunction with link-chain if sampling "can be shown to be satisfactory." schneider, supra note 4, § 14.01[5]. the tax court also permitted a link-chain approach based on sampling in richardson invs., inc. v. commissioner, 76 t.c. 736 (1981). for a discussion of statistical sampling in connection with the lifo method, see generally darshan l. wadhwa & william horst, development of a lifo index with the use of statistical analysis, 42 oil & gas q. 565 (1994). 106. gertzman, supra note 3, 7.04[3][b][iii]. 107. see regs. § 1.472-8(e)(2), which provides guidance for reconstructing base cost. although this guidance involves the double-extension method, it has been interpreted as applying to link-chain computations as well. see gertzman, supra note 3, 7.04[3][b][iv]. 108. gertzman, supra note 3, 7.04[3][b][iii]. if a link-chain taxpayer can use the current-cost as the prior-year cost of a new item and thereby treat the item as having the cumulative inflation from the base year to the end of the prior year, a double-extension taxpayer arguably should be entitled to at least the same benefit in reconstructing the base cost of a new item that did not exist in the base year. however, according to schneider, revenue agents often reject an approach which effectively gives the same inflation to new items as to other inventory items. schneider, supra note 4, § 14.01[5]. 109. in each year, the annual index is the ratio of the current-year quantity and cost of items a and b to the same quantity at the prior-year cost. the cumulative index is the [vol 2:10 denvs4fing lifo current annual cumulative base year quantities cost index index cost base i a $1 1b $1 $2 ---1.000 s2.000 19x1 1 a $2 1b $1 $3 1.500 1.500 s2.000 19x2 i a $3 1b $1 $4 1.333 2.000 $2.000 19x3 0 a 2b $2 $2 1.000 2.000 si.000 as long as the mix of items a and b remains the same, as happens through year 19x2, the link-chain method produces the same result as the doubleextension method. in each case, the base cost of one item a and one item b totals $2. however, when a change in mix occurs in 19x3, the link-chain method produces a different result. under the double-extension method, two item b's have a total base cost of $2 (two units at $1 per unit), which is the same as the current-year cost. thus, a double extension approach produces an index of 1.00, reflecting no inflation since the base year. however, the link-chain method attributes the cumulative inflation from the prior year to the items in ending inventory, resulting in an index of 2.00, a total base cost of $1, and a partial liquidation of the taxpayer's investment in inventory. the example is simplified and extreme. most taxpayers do not experience such a dramatic change in mix in one year. although the change in mix in this example favors the taxpayer, it could just as easily go against the taxpayer. a shift in inventory composition to include more inventory with a higher level of inflation (i.e., more item a's instead of more item b's) would cause the cumulative link-chain index to understate the total inflation in the pool. nevertheless, the example further demonstrates the important point that the dollar-value lifo regulations already reflect concessions to precision in order to accommodate the practical application of lifo. the example also assumes perfect knowledge of the composition and cost of inventory throughout the taxpayer's existence. as a practical matter, determining actual base-year costs for a taxpayer with a complex inventory including many new items is either technically impossible or unreasonably product of the annual index and the cumulative index from the prior year. the base cost is the current cost divided by the cumulative index. 19951 florida tax review expensive. indeed, the taxpayer presumably cannot adopt the link-chain method without demonstrating that the double-extension and index methods are impracticable. "0 thus, in many cases any lack of precision resulting from the link-chain method is not discoverable. even if information is available to compute the result under a doubleextension method, a taxpayer arguably should not be required to recompute its inventory value under the more precise approach. the link-chain method is a method of accounting, which may be changed only with the service's consent."' moreover, the regulations state, "any taxpayer may elect to determine the cost of his lifo inventories under the so-called 'dollar-value' lifo method, provided such method is used consistently and clearly reflects the income of the taxpayer in accordance with the rules of this section.' '1 2 if the taxpayer obtained approval for the link-chain method, such an approach should be treated as clearly reflecting income regardless of any hypothetical differences in result as compared with the double-extension method." 3 d. scope of an "item. "-as discussed above, the index and link-chain methods may alleviate, but do not fully resolve, the practical problems of applying lifo to inventories with new items. however, even the most liberal index computation approach-the link-chain method combined with a sampling approach-could prove administratively difficult if new items emerge on a frequent basis. the scope of an "item"-and the parameters for a "new item"-therefore merit careful attention. a lower tolerance for differences in items results in more accurate cost comparisons, leading to a more accurate measure of inflation. however, a narrow definition of "item" may impose significant administrative costs or otherwise limit the effectiveness of lifo, just as a narrow definition of goods creates difficulties in the specific goods lifo context. on the other hand, although a broader definition of "item" may ease administrative burdens for 110. regs. § 1.472-8(e)(1); see also schneider, supra note 4, § 14.02[3][a] (discussing criteria used to justify use of link-chain method). 111. see irc § 446(e); see also schneider, supra note 4, § 14.02[31[a] (discussing method changes from double-extension to link-chain methods). 112. regs. § 1.472-8(a). 113. however, recent decisions of the tax court cast doubt on whether compliance with the regulations is sufficient to satisfy the clear reflection of income standard. see, e.g., ford motor co. v. commissioner, 102 t.c. 87 (1994), aff'd, no. 94-1956, 1995 wl 710913 (6th cir., dec. 5, 1995); oak knoll cellar v. commissioner, 68 t.c.m. (cch) 412, t.c. memo (ria) 94,396 (1994). see generally w. eugene seago, when may the commissioner reject an accounting method specifically authorized by regulations? 64 tax notes 109 (july 4, 1994). such decisions are troubling, as they appear to allow the commissioner to measure clear reflection of income by reference to the method that most favors the government's position, even though the regulations provide a choice among methods. [vol 2:10 demysti.'ing lifo some taxpayers, it could lead to inaccuracies in comparing costs between periods. finding an acceptable compromise between these two positions has proved difficult. as noted above, the regulations give no clear guidance as to the scope of an item." 4 few cases have squarely addressed this issue, and, not surprisingly, the courts have not developed a consistent approach to resolving it. in wendle ford sales, inc. v. commissioner,"' the tax court considered the scope of an item in the inventory of an automobile dealer. at issue in the case was whether a 1975 ford vehicle was a different item from a 1974 ford vehicle, when the 1975 vehicle contained a catalytic converter and a solidstate ignition system not found on the 1974 model." 6 the court phrased the issue as follows: "in more general terms, we must decide whether minor modifications in the composition of a product by a manufacturer require the retailer of that product to make yearly adjustments to the base-year cost of its dollar-value inventory."'' 7 as a preliminary matter, the court determined that in the case of a retailer of goods, the term "item" in section 1.472-8(e)(2)(iii) of the regulations refers to a finished product, and not to the individual parts of the product." 8 if the case had involved a catalytic converter and a solid state ignition entering an inventory of automobile parts, they "would constitute new 'items' entering the pool for the first time . . . ."19 however, the court framed the item issue as involving vehicles, not their component parts. the court's analysis relies heavily on the historical development of the dollar-value lifo method as a practical means of implementing the lifo concept for all taxpayers. 20 in light of this history, the court concluded that requiring an adjustment for "minor" product changes would be inconsistent with the fundamental nature of the dollar-value method: [d]ollar-value lifo affords the only practicable way of applying the last-in, first-out principle to inventories containing a wide variety of items. by eliminating the need to match 114. the service has opened a regulations project (ia-reg-014-93) to provide guidance on the definition of "item," but the project remains incomplete. see report by office of chief counsel, internal revenue service, on regulations projects status and disposition as of february 28, 1995, daily tax rep. (bna), special supplement rep. no. 52, mar. 17, 1995. 115. 72 t.c. 447 (1979). 116. id. at 456. 117. id. 118. id. at 455. as discussed below, the court's rationale does not settle whether an "item" can be defined in terms of a cost component. see id. at 455-56. 119. id. at 456 n.9. 120. id. at 456-58. 19951 florida tax review specific goods in opening and closing inventories, and focusing instead on the total dollars invested in inventory, dollarvalue lifo necessarily ignores minor changes in the design of a product from year to year. this freedom from having to take into account minor technological changes in a product represents a major objective of the dollar-value approach.' noting that modifications to improve the quality and style of goods were a common feature of commercial life, the court recognized the practical impossibility of requiring a taxpayer to make "minor" adjustments in the cost of goods whenever such modifications occurred: where... the modifications in a product are relatively minor in nature, it would be unreasonable to have, and, in most instances, virtually impossible to comply with, a requirement that the retailer or wholesaler annually adjust its base-year cost to reflect these modifications. indeed, this attention to detail is precisely the type of accounting for inventories that the dollar-value method was designed to eliminate.'22 the court recognized that at some point, product changes are sufficient to create a new item, thereby requiring an adjustment. it rejected the taxpayer's argument that "a car is a car is a car,"'2 and agreed with the commissioner that a car of the 1970's was a different item from a car of the 1930's.124 however, just where the "new item" line would be crossed is not altogether clear. according to the court, the determination is to be made on a "case-by-case basis from an examination of all the relevant facts.' 25 in wendle ford, the burden on the taxpayer of implementing a narrower definition of an item was apparently an important factor, but the court also noted two other points in support of its conclusion. first, apart from reducing hydrocarbon and carbon monoxide emissions and improving the starting performance of the vehicle, neither part "had any appreciable effect on [the vehicles].' 26 second, "the cost of a converter and a solid121. id. at 458. 122. id. at 459 (footnote omitted). 123. id. at 460. 124. id. 125. id. at 459. 126. id. at 459-60. the court found that "[nleither the converter nor the solid-state ignition appreciably affected the operating performance, efficiency, or value of the 1975 model vehicle when compared with the 1974 model vehicle." id. at 450. [vol. 2:10 denzystifyizg lifo state ignition together represent only an insignificant percentage of the total cost of the parts of an unassembled automobile."127 wendle ford thus rejects a narrow view of an item for dollar-value lifo purposes, and willingly sacrifices theoretical precision in favor of practical realities of implementing lifo. this case also shows that facts needed to support a precise answer are not always available, making precision an illusory standard. even if the court had concluded that the 1975 vehicle was a new item as compared to the 1974 vehicle, the amount of the correct adjustment is far from clear. moreover, that this case involved the taxpayer's first year of applying the double-extension method is also potentially significant. in the first year, the double-extension method reflects the same methodology as the link-chain method.12s the court accepted the possibility that sufficient changes over time could create a new item under the double-extension method. however, year-to-year changes in the inventory of a taxpayer using the link-chain method could produce cumulative differences of the same magnitude as the double-extension method, but presumably with no adjustment.' no authority suggests that an item should be defined more narrowly if the linkchain method is elected. in short, wendle ford shows that lifo indexes based on finished products are necessarily imprecise. 127. id. at 460. the commissioner had adjusted the base cost of inventory by s80 per unit for catalytic converters and by $50 per unit for ignitions, which was the average cost to the taxpayer's parts department. id. at 451. the taxpayer had no other records indicating the change in cost of the vehicle attributable to these features. as the court pointed out. "it is even doubtful ford motor co. could have isolated the particular additional cost, if any, of pollution control devices on the 1975 model vehicles." id. at 450, n.2. if the cost of a car were considered to be the sum of its parts, excluding assembly costs, the record shows that a car would cost "approximately $25,000[, which is] 4 or 5 times that of the dealer cost including labor costs for the same vehicle from the factory." id. at 451. the taxpayer objected to the amount of the adjustment, as the cost on a part-by-part basis overstates the effect on base cost. id. at 460 n.15. in deference to the taxpayer's position. the court apparently compared the proposed adjustment to the hypothetical cost of an unassembled vehicle. assuming a total adjustment of $130 compared to a factory cost of s5,000, the variation is about 2.6%. when compared to an unassembled vehicle cost of $25,000, the difference is about 0.52%. 128. as discussed above, the principal difference between index computation under the link-chain and double-extension methods is that the link-chain method involves doublepricing to the immediately preceding year, whereas the double-extension method involves double-pricing to the base year. in the first year, the base year and the preceding year are the same. 129. to illustrate, assume that the service correctly identified the cost of the converter and ignition to be $130 per vehicle, with an average vehicle cost of $5,000. if an average of 2.6% of the vehicle cost were erroneously treated as inflation each year. the cumulative effect would be to understate ending inventory (and taxable income) by more than 29% over a 10 year period ((1.026)'"=1.2926). 19951 florida tax review as noted above, wendle ford dealt with the scope of an item in the inventory of a retailer. the application of this concept to a manufacturer was addressed in amity leather products company v. commissioner,130 which involved a manufacturer of leather goods using a double-extension, dollarvalue lifo method.' 3' the taxpayer carried on its manufacturing operations primarily in wisconsin and new mexico, and through subsidiaries, it had also done manufacturing in puerto rico.' however, in 1975, it dissolved a puerto rican subsidiary and operated there as a division, pooling the division's inventory of billfolds manufactured in puerto rico with billfolds manufactured in the united states. 133 the puerto rican billfolds cost much less to produce, 34 but they were otherwise identical to those originating in the united states.'35 the taxpayer sought to treat the puerto rican billfolds as new items and to reconstruct their base cost. 136 in these circumstances, treating a lower cost billfold as a new item benefited the taxpayer, as the reconstructed base cost for the puerto rican billfolds resulted in a lower lifo inventory value than reflected by the domestic billfolds. the commissioner rejected this approach, arguing in part that the physical similarity should preclude any adjustment for new items. 137 the tax court recognized that this case presented the novel question of defining "item" for a manufacturer. 3 1 in analyzing this issue, the court made the following observations about "items" in a dollar-value pool: the nature of "items" in a pool must be similar enough to allow a comparison between ending inventory and base-year 130. 82 t.c. 726 (1984). 131. id. at 731. 132. id. at 728-30. 133. id. at 730. 134. id. at 730, 739. 135. id. at 739. 136. id. 137. id. at 739. the commissioner argued that: (1) the billfolds produced by alpco division [in puerto rico] were indistinguishable from those produced in the united states and those produced by the puerto rican affiliates, (2) changes in cost to produce or acquire an item do not create a new item, and (3) petitioner had already selected as one item all men's billfolds, whether produced in the united states or in puerto rico. id. at 739. the latter point relates to an argument that the taxpayer's change of base-year cost for the putative new items was an unauthorized change in method of accounting. 138. id. at 739-40. as discussed below, this position is significant because it also suggests that an item need not always be a finished product, as wendle ford had required in the case of a wholesaler or retailer. [vol. 2:10 demystifying lifo inventory. because the change in the price of an item determines the price index and the index affects the computation of increments or decrements in the lifo inventory, the definition and scope of an item are extremely important to the clear reflection of income. if factors other than inflation enter into the cost of inventory items, a reliable index cannot be computed. for example, if a taxpayer's inventory experiences mix changes that result in the substitution of less expensive goods for more expensive goods, the treatment of those goods as a single item increases taxable income. this occurs because any inflation in the cost of an item is offset by the reduction in cost resulting from the shift to less expensive goods. conversely, if changes in mix of the inventory result in the substitution of more expensive goods for less expensive goods, the treatment of those goods as a single item decreases taxable income because the increase in inventory costs is eliminated from the lifo cost of the goods as if such cost increase represented inflation. a narrower definition of an item within a pool will generally lead to a more accurate measure of inflation (i.e. price index) and thereby lead to a clearer reflection of income. at the same time, the method of inventory accounting must be adhzinistratively feasible and not unduly burdensome from the standpoint of each of the parties. within limits of reasonableness, regulations governing lifo inventory accounting have to be applicable across the board. whether they achieve the best result in a particular fact situation is not controlling. 139 the court's analysis of the item question adopts a balancing approach, which measures the benefits of greater accuracy in measuring price changes with the administrative burdens of a restrictive definition of "item." this approach recognizes that a precise computation of a price index is an unrealistic expectation outside of a static inventory environment.'" for example, as in wendle ford, taxpayers are allowed to ignore minor changes in products from period to period in order to make lifo more feasible. narrower and narrower definitions of "item" would ensure more accurate comparisons of costs between periods, assuming all items existed in the taxpayer's inventory. however, if new items arise, administrative feasibility 139. id. at 733-34 (emphasis added). 140. cf. david f. bradford, untangling the income tax 53 (noting that lifo "provides a fair approximation to income, as long as inventories do not change much"). 19951 florida tax review must be taken into account. a balancing is required, but clear standards for the weight of each competing value are difficult to ascertain. the court's choice of example to illustrate its concern about accuracy-the substitution of "more expensive goods for less expensive goods"-is somewhat confusing. on one hand, to the extent the substitution of "more expensive goods" refers to a situation such as that in wendle ford, where additional features were added to a product which made it more valuable, the example is consistent with the common understanding of inflation. for example, product changes are factored out of external price indexes computed based on wholesale or retail prices, but mere changes in price are not.'' on the other hand, to the extent the substitution of "more expensive goods" refers solely to changes in cost, independent of any physical changes in the products, this raises some troubling prospects that may increase the indeterminacy of the lifo method. as illustrated above, the lifo method typically charges cost increases to cost of goods sold without any need to differentiate between items based on interperiod changes in costs. if items were differentiated solely on the basis of interperiod changes in their total cost, every item would effectively be a "new item." such an interpretation-which would require a reconstructed base cost for every item affected by a price change-appears absurd. if the only data available to a taxpayer concerning an item is the total cost of that item, the reconstructed base cost for the new item is presumably the same as the base cost for the former item. thus, whether the new item is differentiated or not makes no difference. 42 however, to the extent that other data is available to distinguish the item, such as the source of purchase (in the case of a wholesaler or retailer) or the components of production costs (in the case of a manufacturer), a reconstructed base cost might be different than the base cost of the former item.1 141. see bureau of labor statistics, u.s. dept. of labor, bulletin 2414, bls handbook of methods 141-42 (1992) [hereinafter bls handbook] (discussing price index computation and impact of physical product changes and quality adjustments). 142. the reconstruction process is designed to answer the question of what the cost would have been had the new item been in existence in the base year. if cost is the only available information to differentiate the item from the physically identical item in the prior year, the taxpayer should use the same base cost as the physically identical product in the prior year. 143. for example, if base costs are determined from a supplier's price list, and products are differentiated by supplier because of different costs, the base cost from supplier x's price list might differ from the base cost from supplier y's list. commentators have expressed doubt about whether a mere change in source of supply should create a new item. see schneider, supra note 4, § 14.01[41 n.146 ("[i]f the cost of a raw material varies because it was acquired from different sources, this cost difference alone should not normally be regarded as the cause of separate items being maintained.") however, schneider notes that the [vol. 2:10 demysti.'ing lifo the items in amity leather were physically identical, but their costs differed during the same time period because of differences in the manufacturing costs in the locations in which they were produced." the taxpayer maintained records identifying the origins of its inventory items. in these circumstances, the court permitted the taxpayer to treat the otherwise identical products as different items. it contrasted the approaches of the commissioner and the taxpayer as follows: [commissioner] would require petitioner to treat both the billfolds manufactured by it in puerto rico and those manufactured in the united states as the same item. this method, however, would lead to an inaccurate measure of any inflation or deflation. the puerto rican billfolds cost substantially less than the domestic billfolds to manufacture. [commissioner's] method would result in the assumed or "constructive" substitution of less expensive goods for more expensive goods in the cost of goods sold computation, and any inflation in the cost of the domestic billfolds would be at least partially offset by the shift to the puerto rican billfolds in the lifo valuation of the inventory. further, because the ratio of billfolds manufactured in the united states in relation to billfolds manufactured in puerto rico in petitioner's inventory pool may change, and because it is likely that the rate of inflation in puerto rico may vary from the rate of inflation in the united states, [commissioner's] method would continue to lead to an inaccurate measure of inflation in future years. [taxpayer's] method, on the other hand, of treating the [puerto rican] billfolds as a separate item from domestic billfolds is obviously a more narrow definition of the term "item." under this approach, the impact of inflation on petitioner's inventory is more accurately eliminated, and its income is more clearly reflected.'45 the taxpayer was in the enviable position of arguing that a narrower definition of "item," reflecting different manufacturing cost characteristics of service has suggested in private rulings that "new items are created when the cost structure of products is materially altered by technological changes." id. 144. the opinion does not set forth the basis for the cost differences costs between the united states and in puerto rico. however, differences in geographical location and local market conditions could create differences in virtually every element of cost. 145. amity leather, 82 t.c. at 740. 19951 florida tax review the puerto rican and domestic billfolds, was administratively feasible and resulted in lower taxable income. unlike the taxpayer in wendle ford, which the court found should not be burdened by the process of ascertaining the cost effects of minor product changes, the taxpayer in amity leather had such cost data and utilized the data in its computations. by letting the taxpayer define "item" more narrowly than otherwise would be required under wendle ford, the court in amity leather arguably reached the right result. the definition of an item is a method of accounting, which cannot be changed without the service's consent, 46 but the taxpayer adopted this treatment for a new item, which is not subject to the restrictions of a former method of accounting. 47 although the taxpayer happened to benefit from treating the puerto rican billfolds as separate items, future benefits from this method were not guaranteed. the taxpayer's method is consistent with the regulations and should be respected. 48 as in other tax planning contexts, the taxpayer is under no obligation to structure its affairs to pay the highest amount of tax or, as in this case, to get the lowest lifo benefit. 149 although amity leather reached a defensible result, the court's analysis creates unresolved questions about the circumstances in which a new item may arise, and whether a taxpayer must treat a change in cost as creating a new item. the tax court's subsequent decision in hamilton industries v. commissioner, 50 raises similar questions, and creates further uncertainty about the scope of an item. hamilton industries involved the question of whether inventory purchased at a bargain price in the acquisition of a manufacturing business could be treated as the same item as inventory subsequently manufactured by that business. 5' the purchase price allocated 146. hamilton indus., inc. v. commissioner, 97 t.c. 120 (1991). 147. the accounting method analysis of a new item could be tautological, as the failure to apply the existing method of accounting is premised on the determination that the item is "new." 148. but see supra note 113. 149. see helvering v. gregory, 69 f.2d 809, 810 (2d cir. 1934), aff'd sub. nom., gregory v. helvering, 293 u.s. 465 (1935) ("any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose the pattern which will best pay the treasury; there is not even a patriotic duty to increase one's taxes."). 150. 97 t.c. 120 (1991). 151. the taxpayer-hamilton industries, inc.-was the successor in interest to mayline company, inc., and acquisitions of both companies were at issue. id. at 120. mayline acquired the assets of a manufacturer of drafting equipment and related furniture and accessories on april 29, 1975, and thereafter continued to operate the business. id. at 122. mayline elected lifo for its taxable year ended april 30, 1975, when its inventory consisted only of the items acquired from the former manufacturer. id. hamilton acquired the assets of a manufacturer of laboratory and hospital case goods and furniture on june 28, 1982, and thereafter continued to operate the business. id. at 123. hamilton elected lifo for its taxable [vol 2:10 demystifing lifo to the inventories was considerably below the fifo value in the hands of the seller, reflecting discounts of 60 to 96 percent. 52 the taxpayer elected lifo, using a double-extension method and a single pool, and treated the price allocated to the acquired inventory as the base cost.' in subsequent years, the taxpayer's inventory records did not distinguish between the products produced after the acquisition and those purchased from the former manufacturer." the taxpayer treated the purchased and produced products as the same items, and double-extended them at base costs which reflected the large discounts from the then-current costs at the time of the acquisition. as a result, as long as the taxpayer maintained the same or a greater inventory volume, the basis of this bargain purchase would be carried over to future years under the lifo method, thereby deferring substantial profits on the bargain-purchased inventory. the commissioner challenged this practice, arguing that either (1) the subsequently produced inventory should not be included in the same pool as the inventory purchased from the former manufacturer or (2) even if they were pooled together, the difference in cost should require the purchased items to be distinct from the subsequently produced items.' 5 either position effectively denied deferral of gain under the lifo method. if they were pooled separately, the purchased item pool would liquidate and the produced item pool would reflect a new base layer valued at current-year costs. if they were pooled together but treated as different items, and only produced items existed at year-end, the base cost of the produced items would have to be reconstructed. reconstructing base costs using costs of production during the year would also cause the taxpayer to lose all (or substantially all) of the benefit of deferring the bargain element of the purchase, as the costs of production were considerably higher than the bargain purchase costs. the court rejected the commissioner's pooling argument, allowing the taxpayer to retain a single pool for both purchased and produced items. although the regulations require a manufacturer with wholesaling or retailing operations to maintain separate pools for its manufacturing and reselling year ended june 30, 1982, when its inventory "primarily" consisted of the items acquired from the former manufacturer. id. 152. for mayline, the fifo value of the inventory in the hands of the seller was $2,034,680.48, while mayline allocated only $79,028.32 of the purchase price to that inventory. id. at 122. for hamilton, the fifo value of the inventory in the hands of the seller was $16,566,320, while hamilton allocated only $6,550,262 of the purchase price to that inventory. id. at 123. 153. id. at 122-24. 154. id. at 122-23. with regard to the mayline inventory, the court specifically found that the products subsequently produced were identical to those purchased from the former manufacturer. id. at 122. 155. id. at 127. 19951 florida tax review activities, 56 the court had previously rejected an attempt to apply these regulations to inventory purchased in connection with a business acquisition and used to carry on a manufacturing business.'57 although the bargain purchase issue was not raised in the earlier case, the court nevertheless found the situations indistinguishable, and therefore held for the taxpayer. 58 the taxpayer's victory on the pooling issue was pyrrhic, however, as the court agreed with the commissioner that the purchased and produced inventory should be treated as separate items. in analyzing the item issue, the court first reiterated some principles about the item concept from wendle ford and amity leather. in [wendle ford], we held that the concept of an item was flexible enough to include minor technical and stylistic changes made in a product over time. furthermore, we have held [in amity leather] that the definition of the term must not be so narrow as to impose unreasonable administrative burdens upon taxpayers, thus rendering impractical the taxpayer's use of the double-extension method of dollar value lifo inventory valuation. 59 in hamilton, these principles seem to support the taxpayer's position, as the taxpayer did not maintain records that segregated purchased and produced items, and they were physically identical. however, the court dismissed the taxpayer's argument that separate accounting would be too burdensome, noting that "the difficulty petitioner faces is largely of its own making."'' the court stated that the inventory purchased in connection with these business acquisitions "could have been tracked as it was liquidated by sales in the course of [taxpayer's] business."' 6'1 in other words, the court suggested that the taxpayer should have applied a specific identification method to its inventory, even though the regulations recognize that this is generally not possible. 62 by failing to track these costs specifically, the taxpayer was forced to accept the commissioner's assumption that the purchased goods were sold first and that all remaining inventory was 156. see regs. § 1.472-8(b), (c); see also amity leather products co. v. commissioner, 82 t.c. 726, 734-36 (1984). 157. ufe, inc. v. commissioner, 92 t.c. 1314, 1320, 1322 (1989). some commentators have also questioned a literal interpretation of the requirement for separate wholesale/retail pools when a manufacturer purchases parts and uses them to effect incidental sales for replacement or warranty purposes. see raymond a. hoffman, inventories 233 (1962). 158. hamilton indus., 97 t.c. at 134-35. 159. id. at 135. 160. id. at 139. 161. id. 162. see supra text accompanying note 5. [vol 2:10 demnystifting lifo comprised of new items. 63 however, the assumption that the first items in inventory were sold first is contrary to the lifo cost flow assumption. the court looked to its previous decision in amity leather to justify distinguishing the purchased and produced inventory based on the differences in cost. according to the court, hamilton presents the converse of the situation in amity leather in the sense that "more expensive" goods are substituted for "less expensive" goods, but the two situations are otherwise analogous."6 first, the court asserted that the cost increases were something other than inflation: the difference between petitioner's base year inventory cost and inventory cost incurred after the acquisitions is not attributable to inflation, but rather to the artificially low value assigned base year inventory as compared to the cost of subsequently purchasing or producing such inventory at prevailing market prices. the consequence of permitting such replacement is an increase in the cost of goods sold, resulting in an understatement of petitioner's income. 6 ' the basis for this determination is highly questionable, as the taxpayer's practice appears inconsistent with the court's own definition of inflation: by matching the cost of the most recently purchased goods with current sales revenue, the lifo convention removes from current earnings any artificial profits attributable to inflationary increases in inventory costs. the subject inflation is the rise in the taxpayer's own inventory cost, not the overall increase of prices in the economy." the cost increases affected by the lifo method are the taxpayer's own cost increases, not a measure of general changes in the price level. the lifo method as applied by the taxpayer in hamilton treated the "bargain" cost as its initial investment in inventory, and deferred recognition of any profit on that investment until that inventory was liquidated. this result is entirely consistent with the lifo method and the physical capital maintenance approach to income measurement. nevertheless, the court viewed the taxpayer's approach as failing to reflect income clearly. as the court correctly observed, 163. hamilton indus., 97 t.c. at 140. 164. id. at 136-37 (quoting amity leather products co. v. commissioner. 82 t.c. 726, 733-34 (1984)). 165. id. at 137. 166. id. at 130 (citation omitted). 19951 florida tax review if petitioner were permitted to combine the bargain cost inventory with goods carried at higher cost, representing the current costs of production, petitioner could postpone recognition of the gain realized on disposal of the bargain cost inventory until such time as it decided to permit a liquidation of inventory, thus allowing such bargain cost to flow into cost of goods sold.167 but, this is precisely the treatment that is allowed to taxpayers under the lifo method. 68 apparently, the court was most concerned with matching the bargain cost to the sales revenue from the goods in the year they were presumably sold: in order to clearly reflect income, petitioner should be required to recognize the gain inherent in the bargain cost inventory at the time such gain is realized, rather than at a later time of petitioner's choosing. such a requirement is in harmony with the matching principle which is at the heart of the inventory accounting rules. to hold otherwise would permit petitioner to include the cost increases attributable to the replacement of bargain cost inventory with inventory produced at prevailing market prices in the cost of goods sold as though such cost increases were attributable to inflation. the lifo method was not intended to permit taxpayers to include in cost of goods sold cost increases attributable to the replacement of goods with low cost characteristics with goods possessing higher cost characteristics.' 69 the matching principle applied by the court, which the court identified as "at the heart of the inventory accounting rules," is not the matching principle associated with the lifo method. lifo is intended to match current costs with current revenues, which in these circumstances is accomplished by the taxpayer's approach. 7 ' 167. id. at 138. 168. curiously, the court analogizes the taxpayer's method to the "base stock" method, which it points out "is not a permissible method of tax accounting because it 'obscures the true gain or loss of the year and, thus, misrepresents the facts."' hamilton indus., 97 t.c. at 138 n.5 (quoting lucas v. kansas city structural steel co., 281 u.s. 264, 269 (1930)). lifo has conceptual origins in the base-stock method, but the rejection of the basestock method is hardly relevant to the validity of the taxpayer's lifo method, which was authorized by statute long after the base stock method was disallowed. see supra note 42. 169. hamilton indus., 97 t.c. at 138 (citing amity leather, 82 t.c. at 733-34). 170. see, e.g., hamilton indus., 97 t.c. at 130 ("by matching the cost of the most recently purchased goods with current sales revenue, the lifo convention removes from current earnings any artificial profits attributable to inflationary increases in inventory costs"). [vol. 2:10 demystifying lifo further, the court's interpretation of amity leather as authority for disrupting the normal application of the lifo method in these circumstances is troubling. in amity leather, the taxpayer chose to adopt a narrower definition of an item that was supported by its inventory records; in hamilton, in contrast, the commissioner forced a narrower definition on the taxpayer when no such records were available. amity leather should be restricted to allowing taxpayers to adopt narrower definitions of an item than otherwise required by the physical characteristics of goods. otherwise, no principled basis exists for treating the changes in cost reflected in the taxpayer's inventory as anything other than inflation. this is evident from the hamilton court's attempt to limit the extension of its decision to contexts other than a bargain purchase involving the entire base inventory: we do not mean to suggest that every bargain purchase of inventoriable property will require the creation of new items within the dollar value lifo pool, as occasional purchases concluded on advantageous terms are to be expected in the course of normal business activities. moreover, where a taxpayer uses lifo, the gain realized upon sale of such goods probably will be recognized within a short time, unless an increase in closing inventory prevents such bargain cost from flowing into cost of goods sold. consequently, an isolated bargain purchase in the course of an ongoing business differs materially from the case where a taxpayer attempts to value its entire base-year inventory at bargain cost. creation of a new item for tax accounting purposes on the basis of differences in cost characteristics is required only where necessary to clearly reflect income, and the issue is to be resolved on a case-by-case basis.17 1 hamilton has been roundly criticized by commentators,'" and it confirms taxpayers' worst fears about the indeterminacy of the item concept. however, the court of federal claims recently followed hamilton in connection with a bulk purchase of inventory costing approximately 50% less 171. id. at 139 n.6 (citations omitted). 172. see, e.g., marc d. levy, et al., hamilton industries: abusing the clear reflection standard, 54 tax notes 741 (feb. 10, 1992); larry maples & mark a. turner, bargain purchases of inventory and dollar value lifo: hamilton should be overturned! 54 tax notes 1533 (mar. 23, 1992); william l. raby, tax court decision on acquisition inventory sets tax time bomb ticking for thousands of businesses, 52 tax notes 1393 (sept. 16, 1991). 1995] florida tax review than otherwise identical manufactured items.' the court upheld the government's treatment of the bargain purchased inventory as an item separate from the manufactured inventory, based on the commissioner's authority to ensure that the taxpayer's method of accounting clearly reflects income." the standards for determining clear reflection in this context are amorphous as is reflected in the court's summary of the government's position: defendant concedes that a taxpayer frequently buying goods at a discount could treat those goods as the same items even though they may have different cost characteristics. the test, according to defendant's expert, should be whether the discount purchase occurs in the taxpayer's normal course of business. cf. hamilton industries, 97 t.c. at 139 n.6 (suggesting that an occasional discount purchase "in the course of normal business activities" might not necessitate different item treatment). a taxpayer which buys discount goods once during the course of its business may not have to treat the items differently, depending on the quantity and the timing of the discount purchase. however, defendant maintains that goods obtained in a nonrecurring transaction of significant magnitude-a bulk purchase at a large discount-should be treated as different items from those subsequently manufactured or purchased. the outcome would depend on the circumstances of each taxpayer and transaction. 75 in these circumstances, the court agreed with the government that the taxpayer's application of the lifo method, which would otherwise have deferred recognition of income from the sale of the bargain-purchased items until the lifo inventory was liquidated, did not clearly reflect income: "while deferral of higher income is an acceptable result of the lifo method of accounting, we cannot find that the method was intended to defer the flow of lower costs that are not the result of inflation."'7 however, neither the court nor the government explained why the bargain purchased items could not be used to measure inflation, while such items may be used for that purpose in other contexts. variation in the amount of discount should not alter the characterization of "inflation" for purposes of the dollar-value lifo method because the lifo index is based on a change in the costs incurred 173. kohler co. v. united states, 95-2 u.s. tax cas. 50,600 (ct. ci. 1995). 174. id. 175. id. 176. id. [vol. 2:10 demystifying lfo by the particular taxpayer, not changes in the general price level or average changes for a commodity or industry."v unfortunately, even if the ambiguous language in amity leather concerning the substitution of "more expensive goods" for "less expensive goods" is appropriately limited (i.e., by respecting a taxpayer's decision to adopt a narrower definition of an item than otherwise compelled by the physical characteristics of the inventory) and the facts and circumstances oriented approach in hamilton is ultimately rejected, indeterminacy would still exist in connection with differences in physical characteristics of items. one further attempt to reduce complexity in determining the scope of an item must be briefly discussed: the use of cost components (raw material, labor, and overhead) as "items." despite the effectiveness of this method in reducing the inherent complexity of the lifo method for some taxpayers, the service has raised questions about its validity and its future is uncertain. e. cost components as "items. "-as discussed above, inventories of complex goods subject to frequent changes in style, quality, or content present a new item problem. to draw on a familiar example, consider the automobiles in wendle ford. vehicles in each model year are affected by design or engineering changes, which change the composition of finished products. moreover, individual vehicle content varies considerably, depending on body styles, options, and accessories, so that vehicle costs can vary widely, even within the same model. furthermore, a significant portion of a manufacturer's inventory may be work-in-process composed of different types of materials and conversion costs at different stages of completion. alternatively, consider a manufacturer producing goods on special orders from its customers. the finished products may be unique to each customer, but may involve similar materials and conversion costs. in recognition of the practical difficulties inherent in computing a price index based on a product-oriented definition of "item," early formulations of the dollar-value lifo method contemplated that a manufacturer could treat an item as including cost components, i.e., materials, labor, and overhead. for example, mcanly's original discussion of the origins of the dollar-value lifo method contemplated that items could include cost components: in place of visualizing the in-process and finishedproduct inventory of a manufacturing company as being comprised of quantities of product units varied in design, 177. see infra part v, discussing simplified dollar-value lifo methods that use externally generated indexes instead of indexes generated from the taxpayer's own cost experiences. 19951 florida tax review style, size, etc., let us consider this inventory as representing quantities of basic elements of cost-namely, various materials (regardless of their status or the type of the product in which they are contained) which have specific cost prices, and hours of manufacturing time that can be valued at various occupational wage rates, and burden or expense rates. 78 in other writings, it is clear that mcanly viewed cost components as essential to implementing dollar-value lifo: in as much as we are dealing with a means of valuing the total inventory investment so as not to affect profits with fluctuations in a fixed inventory investment (defined as the beginning-inventory investment to the extent that it is in existence in the closing inventory) it seems reasonable to suggest that the mechanics of application of this last-in, firstout principle to an inventory of a manufacturing concern should cover units of cost elements (materials and manufacturing time) with their attendant value factors (materials price levels, wage scales, etc.) if its underlying purpose is to be effectuated in the evaluation of any inventory. let us consider a broad interpretation of the last-in, first-out principle as applied to the cost elements representing the factors which are valued in the determination of individual product costs and through which the total inventory valuation is determined.'79 mcanly continued to advocate this concept of dollar-value lifo throughout his career. in 1963, he wrote: "by using a basic dollar value as the common denominator, we can, therefore, easily apply the last-in, first-out principle, regardless of the complexity of the inventory. the objective is to express the ending inventory at the beginning-of-year price levels of materials, labor and overhead."' 80 apparently, mcanly believed that the 178. h.t. mcanly, origin of the dollar value lifo method, in selected writings on accounting and related subjects 17, 19 (n.d.). 179. id. at 22-23. 180. h.t. mcanly, lifo-broad application, in selected writings on accounting and related subjects 180, 183 (n.d.). mcanly notes that "[i]n some cases, it is practicable to extend the quantities on hand at the end of the year-of each raw material, production in process and finished product-at the beginning-of-the-year price levels." id. thus, according to mcanly, the method was intended to accommodate the practical needs of the taxpayer. this is consistent with the broad goal of the 1939 act of making lifo available to all taxpayers. see generally schneider, supra note 4, § 9.03 (discussing effect of 1939 act). [vol 2:10 demystifying lifo dollar-value lifo regulations, promulgated in 196 1,' allowed the method. numerous other commentators have shared this view, as the cost components approach enjoyed widespread use by taxpayers, approval by commentators, and apparent acceptance by the service both before and after detailed dollarvalue lifo regulations were promulgated." 181. t.d. 6539, 1961-1 c.b. 167. these regulations have continued in nearly identical form, with the only modifications being the addition of provisions to allow the expanded use of bls indexes. see t.d. 7814, 1982-1 c.b. 84. 182. extensive discussion of arguments supporting the component costing method are found in gertzman, supra note 3, 1 7.0413][e]; schneider, supra note 4. § 14.01[21[b]. for examples of the acceptance of component costing throughout the history of dollar-value lifo, see montgomery's federal taxes 2-30 (philip bardes et al., eds.. 37th ed. 1958) ("many exponents of lifo maintain that [the cost components method] will provide the most accurate results, and there appears to be a strong argument in support of such a position."); montgomery's federal taxes 2-35 to 2-36 (philip bardes et al.. eds., 38th ed. 1961) (same); montgomery's federal taxes 2-34 to 2-35 (philip bardes et al., eds., 39th ed. 1964) (same): raymond a. hoffman, inventories 225-31 (1962) (discussing example involving pooling by cost components, which reflects component costing), raymond a. hoffman & henry gunders, inventories 275-82 (2d ed. 1970); c. richard cox & carl l. glassberg, lifo: "the deflator"-a current review and analysis, 1 tax adviser 738. 746 (1970) (stating that pooling by cost components is a "commonly used technique for manufacturers which has received irs acceptance in practice"); william r. sutherland. lifo-an analysis of some computational procedures, 9 tax adviser 4, 9-10 (1978) (stating that regulations contemplate either component or product costing; "component cost theory frequently has been used by taxpayers and has been accepted on audit by the irs"); c. paul jannis, et al., managing and accounting for inventories 216 (3rd ed. 1980) ("labor is purchased in a manufacturing business in terms of hours, just as steel is purchased in terms of tons, and the inventory analysis may disclose that at the beginning of a period there was on hand the product of 1,500 direct labor hours and at the end of the period the inventory represents the fruits of 1,800 direct labor hours. the number of hours will, in many situations, be a better measure of the 'form utility' element of the goods on hand than the number of units of particular articles.-). however, some accounting theorists were critical of component costing because of the possibility for increased production efficiency to result in a lower lifo inventory value for the same quantity of finished goods in ending inventory. see edward j. blakely & peter h. knutson, l.i.f.o. or l.o.f.i.-which? 38 acct. rev. 75 (1963). nevertheless, these authors accepted the validity of component costing for both tax and financial accounting purposes: "although the technique of computing lifo inventories on the basis of units of cost component appears well grounded in accounting theory and tax law, it may be considered fallacious by independent theorists." id. at 82. blakely reiterated his concern about component costing in a 1969 article. see edward j. blakely & howard e. thompson, technological change and its effects on dollar-value lifo, mgmt. acct., august 1969, at 33. once again, however, that it was noted that component costing was "approved by both the american institute of certified public accountants and the internal revenue code." id. further. the authors make clear that this article merely presents an academic commentary by independent theorists, and not the judgment of the profession as a whole: "the reader should be aware that this article in no way suggests how or what changes should be made in the application of the dollar-value lifo inventory method. we ourselves believe, however, that in many instances the dollar-value lifo method, as presently applied, is bad accounting." id. at 36. 19951 florida tax review in spite of the use and acceptance of component costing, as further evidenced by the service's 1976 training manual, 8 3 the service apparently began to reassess component costing in 1979, when it issued a technical advice memorandum and then a general counsel memorandum critical of component costing.' 8 although the general counsel memorandum proposed a revenue ruling disallowing the use of component costing, 8 5 such a ruling was never issued. component costing is still embroiled in controversy, however, with the service's most recent pronouncement on the issue taking a similar position, requiring the taxpayer to change to a product cost method or otherwise adjust its method so that it does not "distort income."18 6 the crux of the service's criticism of component costing lies in potential differences between component costing and product costing in an environment of technological change.'87 to illustrate, consider a widget that requires $3 to manufacture in the base year, consisting of one pound of raw material at $1/pound, and two hours of labor at $1/hour. 8 8 for simplicity, assume that no overhead costs are incurred. in the next year, assume labor has become more efficient, so that only one hour of labor is required to make the widget. if one widget remains on hand at year-end, the base-year cost under component costing is only $2 (one pound of raw material at $1/pound plus one hour of labor at $1/hour). by comparison, either of two answers is defensible under a product costing approach. first, if the widget is the same item, the base-year cost under product costing is $3. this result may be appropriate under wendle ford, as the change in the item may be viewed as minor, requiring no adjustment. alternatively, if the widget is a new item because of a difference in the structure of manufacturing costs, as suggested by amity leather, the base year cost could be reconstructed. 183. see gertzman, supra note 3, 7.04[3][e] ("the use of component costing remained widespread after 1961 and was routinely reviewed by the irs on audit and accepted by it. indeed, the irs training manual on lifo, which was issued in 1976, made it clear that a manufacturer's election to use lifo could be implemented in any of several ways, including the use of component costing."). 184. i.r.s. t.a.m. 7920008 (feb. 12, 1979); g.c.m. 38478 (aug. 25, 1980). 185. g.c.m. 38478 (aug. 25, 1980). 186. see i.r.s. t.a.m. 9405005 (oct. 15, 1993); see also carol conjura, irs continues challenge of the components-of-cost lifo method, 25 tax adviser 356 (1994) (discussing t.a.m. 9405005). 187. see generally w. eugene seago, the components-of-cost approach to dollarvalue lifo inventory valuation, 57 tax notes 117-18 (oct. 5, 1992). 188. for purposes of this example, it is assumed that overhead or burden is assigned to inventory based on labor hours. however, other methods are available, such as labor dollars or machine hours. see regs. §§ 1.471-1 1(d)(2)(ii), 1.263a-l(f)(3)(i). [vol 2:10 demystifying ufo the question of how to reconstruct the base-year cost appears to be a very important point of debate about component costing." essentially, the task of reconstruction involves determining what the item would have cost if it had existed in the base year (or in the prior year under a link-chain method).' 90 on one hand, a physically identical widget was produced in the base year at a cost of $3. relying on technology of the base year (including labor efficiency), the base-year cost is $3. however, this approach essentially ignores the difference that is deemed to create a new item in the first place; if the item is truly new, arguably the labor efficiency that created it should be treated as though it also occurred in the base year. under this approach, the base-year cost is only $2 (1 pound of raw material at $1/pound and 1 hour of labor at $1/hour), which is the same result as component costing. commentators have disagreed over whether the technology of the current-year or of the base period should be used in reconstructing the base costs of new items. on one hand, proponents of the base-year technology approach argue that the purpose of the lifo method is frustrated by using the current-year technology, as it allows the taxpayer to deduct through cost of goods sold more than the replacement cost of current goods.t"' on the other hand, proponents of using the current-year technology focus on the fact that, if technological changes are the cause of the new item, such changes should be treated as existing in the reconstruction period: after all, using the old technology to reconstruct the baseyear cost of the new item is tantamount to assigning to the new item the base-year cost of the old item. it makes no sense to compare the current-year cost of the new item with the base-year cost of the old item." 189. see i.rls. t.a.m. 9405005 (ocl 15, 1993) ("itlhe issue of whether technological change creates a new product requiring a reconstructed base-year cost is not the real point of contention. assuming arguendo that even minor technological change creates a new item, the issue is not whether there should be a reconstructed base-year cost for the new item, but rather what that cost should be-and here is the crux of our disagreement with taxpayer."); schneider, supra note 4, § 14.01[5]. 190. see regs. § 1.472-8(e)(2)(iii). 191. see seago, supra note 187, at 119-20. seago uses an example in which a taxpayer requires 10 hours to produce a quantity of goods in the base year, but because of government requirements, must use 15 hours to produce the same quantity in the following year. focusing solely on labor costs at $10 per hour in each year, seago shows that current costs of $150 could not be deducted against current revenues if the current-year conditions are used to reconstruct base cost. conversely, seago shows that if the hour requirements are reversed, the taxpayer would be allowed to deduct $150, which is more than the $100 incurred to replace the goods. 192. schneider, supra note 4, § 14.01[5], at 14-60. schneider suggests that perhaps the former technology should be used if new technology did not exist in the prior year. 19951 florida tax review any evaluation of component costing based on hypothetical results under product costing must be put into proper perspective, however, because such comparisons must be made in the real world. an index computed under the product costing method is subject to considerable variation in results, depending on such factors as (1) whether product differences create new items, (2) the methodology for reconstructing base costs, and (3) whether changes in mix have affected results under the link-chain method. this potential for variation should be taken into account, and similar variation should be accepted under other approaches. another problem with using a product costing approach as a benchmark is that the necessary computational data may not be readily available to a taxpayer using component costing. where taxpayers have developed accounting systems in reliance on component costing and component costing is the only practicable means of implementing the lifo method, it may well be the best solution available to the problem of new items in the dollar-value lifo context.'9 3 component costing faces an uncertain future. legislation proposed in 1994 would have disallowed it, but the proposal was not enacted. 9 4 even if component costing is generally accepted, the tug of war between taxpayers and the government over the scope of an item will probably continue. for example, some commentators have raised questions as to whether average labor hours under the component costing method are truly comparable when differences in labor composition occur from year to year. 19' overhead costs present additional complexities within the components of cost method, as changes in overhead composition from year to year could be deemed to create new items, raising complex questions as to whether and how costs should be reconstructed for prior periods. 96 however, focusing on whether the same technology exists in a prior year raises potentially vexing questions, as technological advances are often made by combining existing technology in new ways. 193. for example, although seago criticizes component costing because he believes it does not properly deal with technological changes, he concludes that component costing should be available to taxpayers when product costing is impractical. see seago, supra note 187, at 120-21. but see gertzman, supra note 3, 7.04[3][e], at 7-55 (component costing properly takes into account technological changes); schneider, supra note 4, § 14.01[5], at 14-60. 194. see schneider, supra note 4, § 14.041]. 195. see seago, supra note 187, at 120. 196. id. at 120. the simultaneous effects of changing the total labor hours because of labor efficiency or inefficiency, while also impacting the allocation base for overhead costs, present additional complexity in this area. to illustrate, assume a taxpayer incurs $2 of overhead costs to manufacture one product, and that product requires two hours of labor to produce. if overhead is assigned based on labor rates, the overhead rate is $1/hour. however, if labor becomes more efficient so that only one hour of labor is required, with the same amount of overhead, then the overhead rate will increase to $2/hour. in reality, changes this [vol. 2:10 denystifying lifo f. conclusion.-through the controversies over the scope of an item, the only constant theme has been the government's changing positions in response to variations in taxpayers' accounting systems. understandably, each party has argued for either more detailed or more general definitions of an item when it has best served its position. wendle ford's guidance-to allow "minor" differences from year to year to ensure administrative feasibility of the lifo method-is inherently unpredictable to implement. in amity leather, the government argued for a broader definition of an item and lost, where the taxpayer had maintained detailed information that allowed it to use a narrower definition. in hamilton industries, the government argued for a narrower definition of an item and won, despite the fact that the taxpayer did not maintain its inventory records on that basis. more recently, the taxpayer subject to tam 9405004 argued for a narrow definition of an item by suggesting that new items could be created by any changes in the costs to produce the item, but the service rejected this position, relying on wendle ford. thus, from the taxpayer's perspective, the question of whether to apply a narrow or broad definition of an item seems to depend in significant part on the effects on tax liability. like the determination of the scope of similar goods under specific goods lifo, the scope of items in the dollar-value lfo method presents intractable problems. from the perspective of the service, varying approaches create understandable concerns about whether changes in costs are being accurately measured. given the large amounts invested in inventories,197 even small percentage differences in lifo computations can generate large dollar adjustments, creating considerable incentives for revenue agents to invest audit resources and to propose adjustments. the uncertainty of standards leaves taxpayers vulnerable to long and costly challenges from revenue agents, with threats of potentially large deficiencies. moreover, variation in the application of these uncertain standards could lead to questions about the fairness of the system to particular taxpayers or to particular industries. 198 dramatic are unlikely to occur. to the extent only minor changes occur each year. wendle ford would suggest ignoring them to make computations practical for taxpayers. see supra text accompanying notes 117-129. however, such an indeterminate answer is not likely to reduce controversy in this area. 197. see david f. bradford, untangling the income tax 54 (1986) ("few seem to appreciate that inventories constitute nearly one-fourth of the reproducible assets of nonfinancial corporations in the united states" (quoting board of governors of the federal reserve system, april 1984)). 198. for example, special procedures are available for applying lifo to the inventory of an automobile dealer which are not allowed for taxpayers in other industries. see rev. proc. 92-79, 1992-2 c.b. 457. 19951 florida tax review a more objective approach, one that avoids detailed comparison of inventory items, could reduce controversy and compliance burdens. more simplified, objective approaches to lifo computations have been attempted. however, those efforts have achieved only limited success, in part because their availability is limited to certain groups of taxpayers, or they have attempted refinements that make them effectively unworkable. simplification efforts are discussed below. v. lifo simplification efforts congress and the service have taken several steps toward simplifying dollar-value lifo. in 1981, congress directed the development of a lifo method based on externally generated indexes, 99 which is now prescribed in the regulations.2° in 1986, congress revisited the issue of simplification, providing a simplified method for small businesses under section 474 of the code.2"' the service attempted further simplification for automobile dealers in 1992,202 and other simplification legislation has been proposed from time to time. unfortunately, the simplified methods are still too complex, reflecting an ideal of precision which is generally unworkable. a. legislative background of simplified lifo provisions the house committee on small business began a series of hearings in 1980 to "help simplify the tax law on accounting for inventories," which was viewed "as a way of easing the regulatory and inflationary burdens placed on small business."2 3 focusing specifically on inventories, the committee found that the tax laws on lifo were "vastly too complex for the small business person.",204 the process of internally developing a lifo index was considered "[o]ne of the primary reasons for the complexity of lifo." 205 199. economic recovery tax act of 1981, pub. l. no. 97-34, § 235, 95 stat. 172, 252 (enacting § 472(f)) [hereinafter erta 1981]. 200. regs. § 1.472-8(e)(3). 201. tax reform act of 1986, pub. l. no. 99-514, § 802, 100 stat. 2085, 2348. 202. rev. proc. 92-79, 1992-2 c.b. 457. 203. inventory accounting as a burden on the capital formation process, 1980: report of the committee on small business, 96th cong., 2d sess. 4 (1980) [hereinafter report on inventory accounting]. 204. id. at 8. 205. id. at 10. other reasons included difficulty in applying the pooling rules for wholesalers and retailers, which require pooling by major lines, types, or classes of goods, and the requirement that market writedowns be restored to income entirely in the year lifo is adopted. see id. at 8-9. [vol 2:10 denysti 'ing lifo externally generated indexes could eliminate the accounting burden of double-pricing inventory and the controversies over the scope of an item by shifting the index computation task to the government agency generating the index.m6 however, under the then-applicable law, only department stores using the retail method were generally permitted to use retail price indexes prepared by the bureau of labor statistics (bls). -' other taxpayers, such as specialty stores, could use bls indexes only if they could demonstrate the "accuracy, reliability, and suitability of such indexes.' 'zes the service's restrictive position on the use of bls indexes was based on concerns over their statistical accuracy.29 the committee pointed out that many commentators were critical of this quest for statistical accuracy, and some had even suggested using change in the general price level to alleviate the problems associated with detailed indexes."' in early 1981, the service responded by issuing proposed regulations "to simplify the use of the dollar-value lifo method so that the lifo method could be used by more taxpayers and would be easier to use by taxpayers currently using the method.",2" these proposed rules expanded the availability of bls indexes, which had formerly been limited to a special series of indexes developed for department stores ("department store inventory price indexes"), to include the indexes published in the "cpi detailed report" or "producer prices and price indexes."2 2 congress responded approvingly by enacting section 472(f) of the code, which directed the treasury to "prescribe regulations permitting the use of suitable published governmental indexes in such manner and circumstances as determined by the 206. however, the agency generating the indexes must address the questions relating to the scope of an item and the effects of changes in item composition. see bls handbook. supra note 141, at 142-43 (discussing agency efforts to take into account changes in products and technology). centralizing the responsibility for these issues should create a more consistent approach for affected taxpayers. 207. report on inventory accounting, supra note 203, at 11. see regs. § 1.4728(e)(1) ("a taxpayer entitled to use the retail method of pricing lifo inventories authorized by paragraph (k) of § 1.472-1 may use retail price indexes prepared by the united states bureau of labor statistics"). 208. report on inventory accounting, supra note 203, at 11. see rev. rul. 75-181. 1975-1 c.b. 150. 209. report on inventory accounting, supra note 203. at 11-12. an irs representative explained: "the mix of goods as well as the inventory weights assigned to the various classifications of goods may vary significantly from one type of taxpayer to another. we must resolve this problem before permitting any such extension [of bls indexes to taxpayers other than retailers]." id. at 11. 210. id. at 12. 211. 46 fed. reg. 3912 (1981). 212. see id. at 757. 1995] florida tax review secretary" for the purposes of implementing the lifo method.213 final regulations were issued under this provision on march 1, 1982.214 in addition to enacting section 472(f), congress responded to two other concerns raised in the 1980 report. it added section 472(d) to the code, which permits market writedowns restored to income as a result of electing the lifo method to be spread over three years.215 in addition, it added section 474, which allowed some small businesses to use a single lifo pool, instead of multiple pools as may otherwise be required under the regulations.216 in 1986, congress attempted more comprehensive relief for small businesses by effectively repealing old section 474 and adding a new section 474, entitled "simplified dollar-value lifo method for certain small businesses. '217 as indicated by the joint committee staff, past simplification efforts for small businesses were inadequate: the congress believed ... that the complexity and greater costs of compliance associated with the lifo method, including the dollar-value lifo method, discouraged some smaller taxpayers from using the lifo method in accounting for their inventories. the congress believed that the lifo method should be simplified for smaller taxpayers so that the use of the method will be practical for all taxpayers.218 as discussed below, although the simplified method in current section 474 may have alleviated complexities of lifo for some small taxpayers, many taxpayers ineligible to adopt that method still have no meaningful alternative to internally generated indexes. 213. erta 1981, supra note 199, § 235, 95 stat. at 252. 214. t.d. 7814 1982-1 c.b. 84. 215. previously, taxpayers that had taken market writedowns had to restore the writedowns entirely in the year they elected lifo. report on inventory accounting, supra note 203, at 15. this was thought to create an initial penalty that inhibited the election of lifo. id. at 23. 216. see erta 1981, supra note 199, § 237, 95 stat. at 252-53. as to the pooling rules, see generally regs. § 1.472-8(b). the senate version of this bill would also have allowed taxpayers to elect to use the link-chain or indexing method "without showing that any other method of computing dollar-value lifo inventory is unsuitable or impractical." however, this provision was not included in the legislation as enacted. see h.r. conf. rep. no. 215, 97th cong., 1st sess. 226-27 (1981), reprinted in 1981 u.s.c.c.a.n. at 315-16. 217. tax reform act of 1986, pub. l. no. 99-514, § 802, 100 stat. 2085, 2348. 218. staff of joint committee on taxation, 100th cong., ist sess., general explanation of the tax reform act of 1986, at 482 (1987). [vol 2:10 demvstifing lifo b. inventory price index computation (ipic) method the regulations now have rules designed to allow computation of lifo indexes based on consumer or producer price indexes developed by the bureau of labor statistics (bls). a taxpayer applying this method, which is called the "inventory price index computation method" (ipic method),1 9 must follow several steps to compute its lifo index. in general, these steps involve (1) categorizing inventory, (2) assigning indexes, and (3) computing a composite index for each pool, which may involve two further adjustments: (a) applying a so-called "80% limitation" and (b) adjusting indexes to a cost price basis. each of these steps is discussed below. 1. categorizing inventory.-the taxpayer must classify its inventory according to detailed listings in the "cpi detailed report" or in "producer prices and price indexes," which are published index series developed by bls. manufacturers, processors, wholesalers, jobbers, and distributors must classify their inventory according to categories in the "producer prices and price indexes" series ("ppi indexes"),2' which covers the output of the goods-producing sectors of the domestic economy.2' retailers using the retail method generally classify their inventory according to categories in the "cpi detailed report" series ("cpi indexes"), -m which covers consumer goods and services.' the taxpayer must choose "the most detailed index category which includes that specific inventory item."' ' 4 again, the regulations refer to an "item" without defining it. as a practical matter, taxpayers must classify their 219. regs. § 1.472-8(e)(3)(i). 220. see regs. § 1.472-8(e)(3)(iii)(b), (c). 221. see bls handbook, supra note 141, at 141. the ppi index series was formerly known as the "wholesale price index," reflecting its orientation toward commodities traded in markets other than retail markets, which are measured in the cpi index series. see id. at 176. 222. regs. § 1.472-8(e)(3)(iii)(b), (c). retailers using the retail method may select from the producer price index categories only if an appropriate index is not available in the consumer price index categories. regs. § 1 .472-8(e)(3)(iii)(c). 223. see bls handbook, supra note 141, at 176 ("the consumer price index (cpi) is a measure of the average change in the prices paid by urban consumers for a fixed market basket of goods and services"). "the eleven categories [of consumer goods] are food and beverages, housing maintenance and repair commodities, fuels (other than gasoline), house furnishings and housekeeping supplies, apparel commodities, private transportation (including gasoline), medical care commodities, entertainment commodities, tobacco products, toilet goods and personal care appliances, and school books and supplies." see regs. § 1.4728(e)(3)(iv). 224. regs. § 1.472-8(e)(3)(iii)(b)(l). presumably, this process reflects deference to the classifications of inventory in the taxpayer's own inventory accounting system. 19951 florida tax review inventory based on products, since the cpi and ppi index categories are oriented primarily toward products. however, the term "item" may mean something other than finished products if it includes raw materials and workin-process, which are also subject to this method. unfortunately, the regulations do not explain how work-in-process inventories are to be treated in this categorization process. commentators have suggested that the best approach is to categorize work-in-process according to the finished product that will ultimately be produced.' however, such treatment may not be accurate for products in various stages of completion, which have different material, labor, and burden content. work-in-process could perhaps be broken down into its cost components, 6 but this approach adds complexity.227 legislation proposed in 1994 would have allowed taxpayers to apply bls indexes based solely on finished goods composition. 228 this approach would have eased the computation burden, but it raises practical questions. for example, some taxpayers have virtually no finished goods inventories because their products are sold upon completion. for these taxpayers, estimating inventory composition based on sales might be appropriate, although such a measure is potentially imprecise because different inventory turnover rates could affect the actual inventory mix. 2. assigning indexes.-once the inventory items are categorized, the taxpayer must assign the appropriate bls indexes to the inventory. bls indexes are structured to include detailed categories that may be aggregated into more general categories. ppi categories are assigned commodity codes ranging from the most general (2-digit) to the most detailed categories (8digit). to illustrate, consider the following ppi categories from table 6 of the april 1995 producer prices and price indexes report: 225. schneider, supra note 4, § 14.04[3]. where different finished products can be made from work-in-process inventory, the treatment of work-in-process is even less clear. possible treatments might include allocations based on production or inventory quantities of the applicable finished goods. 226. schneider states that "categorization of the item based on its status as an inprocess item might be permissible." id. however, it is unclear whether this suggests an explosion technique. schneider suggests that exploding a finished product into component parts for purposes of assigning specific index categories, as discussed below in the second step, is inappropriate. see id. 227. bls indexes might be applied to components of costs. for example, bls collects data on wage rates, but the indexes are not part of the series referenced in the regulations. see bls handbook, supra note 141, at 42-50 (discussing wage rate surveys). bls indexes may also be available for components of overhead, such as indirect labor, electricity, fuel, and various supplies. however, such an approach would not take into account changes in production volumes that ultimately affect the total cost of finished products. 228. see schneider, supra note 4, § 14.04[3], n.201. [vot. 2:10 demystifying lifo code description 12 furniture and durables 121 household furniture 1212 wood household furniture 121201 living room furniture 12120101 tables the most detailed category, "tables," is included along with other items such as desks and chairs in the 6-digit category for "living room furniture," which in turn is included in the more general 4-digit category of "wood household furniture," and so on until indexes are aggregated at the two digit level. the cpi index categories are structured similarly, although they do not use numbered product codes. 9 bls determines indexes from price data collected for products at the most detailed category level and aggregates that data to compute indexes for more general categories based on weights determined for each category.' for example, the weights for the ppi indexes, currently found in table 12 of the annual supplement to producer prices and price indexes,"' reflect the percentage weight of each commodity in a composite ppi for "all commodities," which is used as a measure of inflation in the economy as a whole.?2 a taxpayer uses these bls indexes and bls weights to assign indexes to inventory. any category with 10% or more of the value of inventory in a lifo pool is assigned that category's index. -3 however, categories with less than 10% of the value of a pool must be aggregated until they reach the 10% level, or else they are combined in a miscellaneous category.' indexes for such aggregated or miscellaneous categories must be determined though a weighting process which utilizes the weights from bls, rather than the values of the inventory in that category. -5 229. see, e.g., bureau of labor statistics, united states department of labor, cpi detailed report 11-15 (december 1994) (showing detailed expenditure categories under each general expenditure category). 230. see bls handbook, supra note 141, at 140. 231. see schneider, supra note 4, § 14.0413], at 14-130 to 14-131. 232. ppi weights are based on the value of shipments derived from information provided by the bureau of census and certain other sources. see bls handbook, supra note 141, at 146-47 (1992). cpi weights are based on estimates from a "consumer expenditure survey," which provides data on consumer purchases over time. see id. at 178. 233. regs. § 1.472-8(e)(3)(iii)(b)(l), (4); see schneider, supra note 4. § 14.04[3), at 14-129. 234. regs. § 1.472-8(e)(3)(iii)(b)(3); see schneider, supra note 4. § 14.04[31, at 14129. 235. see regs. § 1.472-8(e)(3)(iii)(b)(3), (5). to illustrate, assume a taxpayer had wooden household tables and desks in inventory, each of which comprises 5% of the dollar value of a lifo pool. according to table 12 in the producer price index. the bls weight for 19951 florida tax review using bls weights instead of the taxpayer's actual inventory data effectively injects an element of arbitrariness, 236 which has been criticized by commentators.237 neither the proposed nor final regulations explain why this approach was adopted. if the purpose was simplification, it is doubtful any simplification was accomplished. legislation proposed in 1994 would have eliminated the use of bls weights, but it was not enacted.238 3. computing a composite index.-after the indexes are assigned and weighted composite indexes are computed for any aggregated categories, the taxpayer must compute a composite index for the pool based on its actual inventory quantities for each applicable category. thus, the index for those categories meeting the 10% threshold without aggregation are weighted by the value in that category; the composite index for any aggregated categories (computed by using bls weights) is weighted by the total actual value of those categories to compute a composite index for the pool. 23 9 two additional adjustments further complicate this composite index computation: an adjustment to reflect only 80% of the inflation in the applicable bls indexes ("80% limitation"), and an adjustment to restate bls indexes on a "cost" basis ("cost adjustment"). a. 80% limitation.-the 80% limitation is rooted in concerns about protecting the public fisc from taxpayers who select the ipic method only when more advantageous than their current method. the preamble to the final regulations explains the rationale for this limitation: taxpayers experiencing a rate of inventory price inflation tables (commodity code 12120101) is .026 and the weight for desks (commodity code 12120103) is .007. bureau of labor statistics, u.s. department of labor, producer price indexes 354 (1994). converting these bls weights to a percentage, the bls weight for tables will be 78.2% (.026/.033), and the bls weight for desks will be 21.8% (.007/.033). these percentages will be multiplied by the inflation in the applicable indexes to determine the composite index for this portion of the inventory pool. 236. for example, in the computations in note 235 above, the tables and desks were assigned respective bls weights of 78.2% and 21.8% when the items should have been weighted equally (50%), since both comprise half of the goods that must be aggregated at the 10% level. 237. see gertzman, supra note 3, 7.04[5][a][i], at 7-67 ("by using [bls] weights, rather than the relative weights of the actual items in the taxpayer's inventory, a potentially distorting and arbitrary result may occur."); schneider, supra note 4, § 14.04[3], at 14-131 ("the requirements for weighting indexes based on bls weights, rather than the taxpayer's own mix, is potentially a complex and burdensome requirement."); c2 william sutherland, inventories 903.03 (cch tax transactions library 1988) ("the averaging process using bls weights is complicated and the results are sometimes illogical in relation to the taxpayer's own weights"). 238. see schneider, supra note 4, § 14.0413], at 14-129 n.201. 239. see regs. § 1.472-8(e)(3)(iii)(b)(5). [vol 2:10 dermystiffing lifo lower than the published rate [i.e., the bls index rate] would tend to choose the use of the published consumer and producer price indexes. taxpayers experiencing a rate of inventory price inflation higher than the published rate would tend to choose to use a price index based on their own inventory price inflation experience. it was decided that the use of the consumer and producer price indexes prepared by the bureau of labor statistics should not depend on whether a taxpayer's actual rate of inventory price inflation was relatively high or low. however, it was also decided that the use of overstated inflation rates to value lifo inventory pools should be reduced to the extent possible consistent with the purposes of simplifying the use of the dollar-value lifo method.... the 80 percent limitation is intended to be an alternative to computing an inventory price index based on the taxpayer's own inflation rate and is intended to be an appropriately conservative estimate that the taxpayer can use without regard to the inflation rate actually experienced by the taxpayer. however, since small businesses, as a practical matter, are unable to compute their own inflation experience and therefore do not have the opportunity to choose to use their own inflation experience, the treasury decision modifies the 80 percent limitation and allows an eligible small business, as defined by section 474(b) of the code, to use 100% of the percent change in the applicable indexes. all other taxpayers would be limited to 80 percent of the percent change in the applicable indexes.2' because the bls indexes are based on average price movements, some taxpayers are necessarily above or below average. however, given the complexity of the ipic method computations, it is questionable whether a business with complex inventories could accurately predict whether the ipic method would be advantageous. the burden of making computations under the ipic method and under its own internal index computation method would tend to limit the degree of adverse selection of the ipic method against the interest of the government.24 furthermore, past inflationary trends of 240. t.d. 7814, 1982-1 c.b. 84. 241. general comparisons or estimates may be possible. see schneider, supra note 4, § 14.04[4] (advising taxpayers to compare their indexes with bls indexes, but suggesting that the 80% limitation "will probably render the simplified lifo method financially undesirable, except in unusual cases"). however, the full complexity of the method, including the "cost adjustment" discussed below, requires more extensive efforts for an accurate comparison. 19951 florida tax review particular taxpayers may not always be a valid predictor of whether the ipic method would be advantageous in future years. once elected, the ipic method is a method of accounting, which can generally be changed only with the consent of the commissioner, thus ensuring long term benefits of consistency for the government.242 proposed legislation in 1994 would have substituted a 95% limitation in lieu of the 80% limitation imposed under present law.243 while a 95% limitation is less restrictive, it is no more rational than the 80% limitation. if a percentage limitation is retained, its scope merits some attention. currently, the 80% limitation applies to a taxpayer other than an "eligible small business, as defined by section 474(b) of the code." 2' when these regulations were promulgated, section 474(b) defined an "eligible small business" as a taxpayer with average annual gross receipts not exceeding $2 million during a three-year period ending with the current taxable year.24 5 however, a 1986 amendment to section 474 raised the average gross receipts standard for an eligible small business to $5 million.246 the applicable definition should be clarified to avoid uncertainty.247 further, the scope of a small business should be reevaluated in the current economic and technological climate.2' a second issue involving a percentage limitation involves the timing of the adjustment in relation to any "cost" adjustment that is required for taxpayers not on the retail method. different results can be obtained depending on whether the 80% adjustment precedes or follows the "cost" adjustment, but the regulations provide no clear guidance on this point. the "cost" adjustment is discussed below. b. "cost" adjustment.-the regulations contain only cryptic references to the "cost" adjustment: "if a retailer not using the retail inventory method selects an index from the cpi detailed report, the selected index must be converted into a cost price index. manufacturers, processors, whole242. irc § 446; regs. § 1.472-8(e)(3)(v). 243. schneider, supra note 4, § 14.04[1]. 244. regs. § 1.472-8(e)(3)(ii). 245. irc § 474(b) (1986) (current version at § 474(c)). 246. see irc § 474(c). 247. see schneider, supra note 4, § 14.04[4] ("it is unclear whether this restriction will be coordinated with the new definition of a small business in irc section 474(c) ... "). 248. it is not entirely clear that size should be the determining factor for whether a business deserves special treatment for lifo purposes. for example, a small business with relatively few items might be able to compute a lifo value much more easily than a larger business with many items. moreover, to the extent that information technology such as bar coding becomes more widely available, some small businesses may have the same or even greater lifo computation abilities as compared with their larger counterparts. [vol 2:10 densi ifng lifo salers, jobbers and distributors, must convert selected indexes into cost price indexes."249 the rationale for this conversion is that the ppi and cpi indexes are based on selling prices, whereas the lifo method should measure changes in inventory costs.? in effect, the regulations assume that the taxpayer's selling prices will reflect the changes experienced in the market as a whole as measured by the bls index, but that its costs may not reflect the same changes as in the market. to illustrate, assume a taxpayer in year one has one widget that costs $1 and sells for $2. assume further that in year two, the widget costs $1.50 to make (an increase of 50%), but the selling price is $2.20 (an increase of only 10%). a bls index measuring changes in selling prices will report inflation of only 10%. however, the taxpayer's costs increased by 50%. unless an adjustment is made, the bls index would understate the taxpayer's inflation in costs for this year. conversely, if the selling price rose faster than the taxpayer's costs, the bls index based on selling price would overstate the taxpayer's inflation. neither the regulations nor revenue procedure 84-57, " which was intended to provide guidance in implementing the ipic method, addresses the specifics of making this adjustment. revenue procedure 84-57 provides an example in which the applicable cpi index for each year is multiplied by the complement of the taxpayer's gross profit percentage 25in order to take into account varying profit margins for each year, and the adjusted indexes are determined by dividing the result for each year by the result from a base period.23 however, the example does not explain how the gross profit percentage is to be determined, or how the computations are to be applied for a taxpayer with multiple bls index categories.' 249. regs. § 1.472-8(e)(3)(iii)(c). conversely, the regulations provide that "[i]f a retailer using the retail inventory method selects a price index from producer prices and price indexes, the selected index must be converted into a retail price index." id. 250. see schneider, supra note 4. § 14.0412], at 14-127 n.406. 251. 1984-2 c.b. 496. 252. for example, if a gross profit percentage is 41.2%. the complement is one minus 41.2%, or 58.8%. see id. § 3.03. 253. using the data from the widget in the example above, the computation looks like this: year i year 2 bls index 100.0 110.0 gross profit % ((sales-cost)/s ales) 50% 31.82% cost % (1-gross profit %) 50% 68.18% adjusted price index (step 1 *step 3) 50.0 75.0 cost price index (step 4/50.0) 100.0 150.0 254. the example in rev. proc. 84-57 states that the gross profit percentage is "[t]o be determined by the taxpayer for each index category on the basis of its own average for the tax year." 1984-2 c.b. 496, § 3.03. this could be interpreted as referring to the taxpayer's own overall average, or to the taxpayer's own average for a particular index category. 19951 florida tax review commentators have differed in their interpretation of how this computation should be made. some have taken a very restrictive approach, requiring the cost price adjustment to be done separately for each index category of goods, thereby implying separate gross profit computations for each item in inventory.255 others have taken a more flexible approach, allowing the cost price adjustment to be done based on available data.256 since the regulations were intended to provide a simplified method of implementing the lifo method, it is difficult to justify a requirement that taxpayers determine gross profit margins for each index category. for many taxpayers, cost and sales data cannot be easily determined for each item in inventory. for example, an integrated manufacturer cannot easily determine the gross profit from particular parts which are incorporated into a finished product without making extensive assumptions about costs and transfer prices among its units. 7 an analogous problem exists in state taxation of multistate businesses, where separate accounting for the income attributed to operations in particular states has generally been rejected as impractical and unreliable.5 8 separate computation of gross profit and cost price indexes elsewhere, in discussing application of the cost price adjustment to a retailer, rev. proc. 84-57 suggests that it is appropriate to compute gross profit ratios on a departmental basis, which is potentially broader than an individual index category. see id. § 3.03(1). 255. schneider, supra note 4, § 14.04[2], at 14-127. 256. gertzman states: although it is generally recognized that the conversion [to a cost price index] would occur by reducing the published price index by the taxpayer's gross profit margin, the determination of this gross profit margin for this purpose is unstated. possible alternatives include the use of a single gross profit percentage developed for the taxpayer as a whole, use of a single gross profit percentage attributable to each pool, and, assuming the data is readily available, use of a separate gross profit percentage for each category of goods in ending inventory. gertzman, supra note 3, 7.04[5][a](i], at 7-67. 257. for example, in wendle ford, the court suggested that not even ford motor company could know the cost of a catalytic converter added to a finished vehicle. wendle ford v. commissioner, 72 t.c. 447, 450 n.2 (1979). 258. see generally i jerome r. hellerstein & walter hellerstein, state taxation 8.03 (2d ed. 1993), which discusses three inherent defects in separate accounting. first, it is "fearfully expensive, since adequate underlying data cannot be furnished without maintaining the books of account in a manner that will show the details of the taxpayer's business operations, and transactions, broken down on a state-by-state basis." id. at 8-29 to 8-30. second, constructing imputed prices for goods transferred between branches or subsidiaries of the enterprise, or imputing a "reasonable profit" to such transfers, is difficult because of a lack of comparable data. id. at 8-30. third: [separate accounting] operates in a universe of pretense; as in alice in wonderland, it turns reality into fancy, and then pretends that it's in the real world. for the essence of the separate accounting technique of [vol 2:10 demysif'ing lifo for each index category should also be rejected in this context unless data is readily available. in addition to the question of the scope of the cost price adjustment, a further issue not addressed in the regulations involves the standard for determining the sales and cost elements which go into the computation of gross profit. for example, should costs include all inventoriable costs required by section 263a of the code? or should costs determined for financial accounting purposes be sufficient? again, a quest for further details here is possible, leading to further administrative burdens for taxpayers. as one commentator has observed: in determining the level of detail required for purposes of making the cost conversion, taxpayers and tax practitioners should assume that agents will review the computations carefully, but agents should apply reason, common sense, and understanding in determining the acceptability of the cost conversion process. to the extent too much detail is required, the benefits of applying the simplified indexing method will be greatly reduced.2 9 it is important to keep a proper perspective on the cost price adjustment. at best, it takes into account a rough approximation of the effects of changing costs on the measure of inflation for particular taxpayers. however, since the method assumes that the taxpayer's selling prices are adequately reflected in the bls index, its focus only on variation in costs is questionable. much of the potential controversy over the mechanics of the cost adjustment could be avoided if the adjustment were eliminated entirely. legislation proposed in 1994 would have eliminated the cost adjustment in connection with a simplified indexing method, but the proposal was not enacted.26° 4. conclusions on ipic method.-from the above discussion, it is evident that the ipic method is neither simple, nor practical, nor entirely logical. elimination of the bls weighting component and cost price dividing the income of a unitary business is to ignore the interdependence and integration of the business operations conducted in the various states. and treat them, instead, as if they were separate. independent, and nonintegrated. id. at 8-31 to 8-32. similar or perhaps even stronger criticisms could be applied to requiring separate accounting of the gross profit generated from each item in inventory under a bls indexing approach. 259. gertzman, supra note 3. 1 7.0415][allil. at 7-67. 260. see schneider, supra note 4. § 14.0412]. at 14-127 n.405. 19951 florida tax review adjustments, as proposed in 1994, would reduce its complexity. moreover, increasing the measure of inflation closer to the actual levels measured by bls inflation would further remove economic incentives to its application and possibly increase the number of taxpayers using the method. however, taxpayers would still face the practical problem of assigning inventory to detailed bls categories. several approaches might simplify assigning inventories to bls categories. first, all taxpayers might be allowed to use broader categories, such as the general categories from ppi or cpi indexes, as small businesses may do under section 474 of the code: the fewer required categories, the easier the assignment task. second, taxpayers might be allowed to estimate the composition of inventory in the applicable product categories. for example, instead of evaluating inventory content each year, taxpayers might assign all inventory categories based on finished goods inventories, or perhaps even based on sales of finished goods. this would eliminate controversies over the treatment of work-in-process and raw materials, and could potentially reduce the need for detailed categorization efforts every year. to the extent estimates based on sales data might be inaccurate due to varying turnover rates, periodic evaluation of actual inventory content could limit the impact of any imprecision. to the extent that taxpayers must choose a method and follow it consistently, the possibility of manipulation and abuse should be limited. third, the present system of ppi and cpi categories for products could be replaced by other index series designed to reflect the inflation for particular industries. for example, bls currently computes indexes based on the output of various industries, which might be adopted for particular taxpayers based on their industry classifications.26' industry-specific figures may not reflect the actual inflation of particular taxpayers due to variation in inventory composition, but these types of indexes may provide an acceptable compromise between detailed categories and an adjustment only for general price level changes. if more than one industry classification applies to a taxpayer, then methods of allocating inventories between such classifications would have to be developed, but these problems should not be insurmountable. in any event, for bls indexes to provide an effective alternative to internally-generated indexes, the service and taxpayers must be willing to trade perceived accuracy (obtained by focusing on greater and greater detail) for more generalized approaches. generalized approaches still perform the function of removing inflationary profits, but should be easier to administer 261. see bls handbook, supra note 141, at 146-47 (discussing indexes based on industry output defined by reference to standard industrial classifications). [vol 2:10 demystifying lifo for both taxpayers and the government. in addition, a bls indexing approach would presumably make a double-extension method possible, thus avoiding inaccuracies due to changes in inventory mix under the link-chain method.262 granted, the results under an approach using bls indexes will not be precise for every taxpayer, but as discussed above, precision is an illusory goal. as courts have recognized in other tax contexts, "[t]he tax law and generally accepted principles of accounting recognize that substantial accuracy is the objective to be achieved and that in many situations exact determinations are neither practicable nor necessary.2 3 c. simplified dollar-value lifo method for certain small businesses-irc section 474 the impracticality of applying the ipic method was confirmed by the amendment of section 474 of the code, which provided another simplified dollar-value lifo method specifically for small businesses.' section 474 resolves the difficulty of assigning inventory to detailed bls indexes by allowing taxpayers to apply very general index categories: for retailers using the retail method, any of the eleven general expenditure categories of the cpi, and for other taxpayers, any of the 2-digit classifications in the ppi.2" as noted above, this method is available only to an "eligible small business," which is satisfied if the taxpayer's "average annual gross receipts... for the [three] preceding taxable years do not exceed $5,000,000."' special rules apply to prevent controlled groups from circumventing the $5 million limitation.267 allowing general index categories eases administration of lifo. however, detailed rules for applying the method under section 474 have not been promulgated, 2 ' and there are practical questions that need to be addressed. for example, work-in-process inventories could be classified in more than one general category, and it is unclear whether raw materials are 262. see discussion supra part iv.b.2.c. 263. e.w. bliss co. v. united states. 224 f. supp. 374, 377 (n.d. ohio 1963). aff'd, 351 f.2d 449 (6th cir. 1965). 264. see tax reform act of 1986, pub. l. no. 99-514, § 802, 100 stat. 2085, 2348-50, (amending irc § 474). 265. see irc § 474(b)(1)(a), (2). 266. irc § 474(c). 267. see irc § 474(d)(i). 268. see report by office of chief counsel, internal revenue service, on regulations projects status and disposition as of february 28, 1995, daily tax rep. (bna). special supplement rep. no. 52, at 5-16 (mar. 17, 1995) (noting two open regulations projects under § 474: ia-reg-030-87 and ia-reg-031-87). 19951 florida tax review to be classified separately.269 currently, section 474 also requires taxpayers to adopt separate pools for each corresponding ppi or cpi general classification,27 rather than the single pool allowed under the former version of section 474. the legislative history indicates that multiple pools were adopted "in order to avoid the construction of a weighted index specific to the taxpayer., 27 1 however, the use of relatively few general categories significantly reduces the weighting complexity. moreover, given separate pooling requirements, inventory values for each category must be determined in any event. thus, simplification is not achieved. the requirement for multiple pooling increases the opportunity for temporary liquidations of lifo inventories, with a corresponding loss of the lifo benefits. a single pool would provide much greater benefits to small businesses and increase simplicity. d. alternative lifo method for automobile dealers further evidence of the inadequacy of reforms in both the ipic method and simplified lifo under section 474 is found in revenue procedure 92-79,272 which creates a third "alternative lifo method" solely for taxpayers "engaged in the trade or business of retail sales of new automobiles or new light-duty trucks."273 by way of background, controversies over the scope of an item for automobile dealers continued after wendle ford, with the service taking the position that options and accessories should be treated differently from the base vehicle.274 many automobile dealers were audited, and industry groups and the service cooperated to resolve the item issues by promulgating the so-called "alternative lifo method. 275 the stated purpose of the alternative lifo method is simplifica269. to illustrate further, consider a manufacturer who purchases vans and customizes them by installing tables, luxury upholstery, electronic goods, and the like. the taxpayer's inventory might include leather, metal products, rubber and plastic products, and motor vehicles, all of which could be classified in separate bls categories. should this manufacturer be required to have separate pools for each category of materials? or might that manufacturer be allowed to have a single pool for "transportation equipment," which is its end product sold to customers? 270. see irc § 474(b)(1)(a). 271. staff of joint comm. on taxation, 99th cong., 2d sess., general explanation of the tax reform act of 1986, at 483 (joint comm. print 1987). 272. 1992-2 c.b. 457. 273. id. § 1; see id. § 3.03 (referring to alternative lifo method as "[n]ew alternative method" in addition to ipic, simplified lifo under section 474, and general dollarvalue lifo methods). 274. see generally schneider, supra note 4, § 14.0113], at 14-38 to 14-39. 275. id. § 14.03[1], at 14-40. [vol 2:10 demystfying lifo tion.276 this simplification is accomplished by defining the item used to compute an internal index by reference to the "manufacturer's base model code number," which is "almost always" part of the vehicle identification number on each dealer invoice.2' the "base vehicle cost" of the vehicles in ending inventory is used to compute the lifo index using a link-chain approach without adjustment for any "options, accessories, or other costs" that may differ from year to year.278 the applicable index from comparing the base vehicle costs is also applied to the options, accessories, and other costs in the pool.279 thus, the method assumes that other costs in the lifo pool have the same inflation as the base vehicle. to the extent that manufacturers include more options and accessories as part of the base vehicle, this method allows dealers to treat the increased cost as inflation, a potential benefit. however, the treatment of "new items" is less advantageous to taxpayers, and appears to compensate for any potential benefits.' "new items" are created whenever the manufacturer changes the base model code, or effects a "change to the platform (i.e., the piece of metal at the bottom of the chassis that determines the length and width of the vehicle and the structural set-up of the vehicle) that results in a change in track width or wheel base."' if the "new item" existed in the prior year, but was not stocked by the dealer, the prior-year cost may be based on a manufacturer's price list.28 2 however, if the "new item" did not exist in the prior year, the dealer must treat the current-cost as the prior-year cost,"3 which effectively attributes no inflation to that item. according to revenue procedure 92-79, new models have a lifespan of five to seven years. "accordingly, the treatment of new items could result in dealers losing from 14-20% of the inflation that would otherwise result if they were permitted to reconstruct the base cost.25 276. rev. proc. 92-79, 1992-2 c.b. 457, § 4.01 ("the comprehensive alternative lifo method is designed to simplify the dollar-value computations of automobile dealers."). 277. id. § 4.02(3). for conversion vans, the definition of an item also includes "the most detailed conversion package designation." id. according to one commentator, "the ford taurus two-door, four-door, station wagon, and sho are each separate items." schneider, supra note 4, § 14.01[3], at 14-40. 278. rev. proc. 92-79, 1992-2 c.b. 457, § 4.02(4). 279. id. 280. see id. § 4.01 (describing new item treatment as "compensating sub-methodsl). 281. id. § 4.02(5). 282. id. § 4.02(7). 283. id. § 4.02(6). 284. id. § 4.01. 285. assuming ratable inflation during a seven year period, one year would encompass approximately 14% (1/7) of the total inflation. similarly, during a five year period, one year would encompass approximately 20% (1/5) of the total inflation. 19951 florida tax review the index computation approach under the alternative lifo method is appealing to the extent that it produces an objective definition of an item, which is easier to administer and produces more consistent results than are otherwise available under the dollar-value lifo method. through this approach, taxpayers avoid burdensome computational requirements that might otherwise be imposed.286 the results are not precise, but they appear generally to achieve the purposes of the lifo method by dealing with inventory cost increases. however, the feasibility of this approach appears limited to retailers with relatively high-value items identified by model numbers. the alternative lifo method does not solve all problems even for automobile dealers, as used vehicles and replacement parts are not covered by the method.2 87 moreover, to the extent that manufacturers are in control of the definition of an item, adequate measures to prevent abuse may be needed.288 a method relying on bls indexes is not subject to these limitations and concerns. vi. conclusion the current approach to lifo suffers from a common problem in the tax law, which is the "enormous complexity" of attempting precision.289 precision can increase equity among taxpayers, and thereby enhance the perceived fairness of the tax law. 29 ' however, precision can also impose heavy burdens on taxpayers seeking to comply with the law and on government efforts to monitor that compliance.29' precision is an illusory goal in the lifo context. first, a theoretical benchmark for precision is difficult to define. while physical capital maintenance might appear to provide such a benchmark, its usefulness is 286. see schneider, supra note 4, § 14.01[3], at 14-40 (noting that taxpayers who do not adopt the alternative lifo method will be held to restrictive standards requiring adjustments for differences in equipment between otherwise similar models). 287. see rev. proc. 92-79, 1992-2 c.b. 457, § 5.01(2) (requiring a different method for parts & used vehicles). 288. it is interesting to note that some dealers have complained that "manufacturers sometimes change the model codes indiscriminately, thereby reducing the benefit of the alm." schneider, supra note 4, § 14.0113] at 14-41 n.127. other factors, such as marketing and consumer demands, may thus affect the assignment of model numbers more than the tax designs of the dealers. 289. see hal gann & roy strowd, the enormous complexity of being fair, 95 tax notes int'l 52-12 (mar. 17, 1995) ("[t]he principal cause of complexity [in the tax law] is the desire to measure taxpayers' liabilities with ever-greater precision."). 290. id. these authors also suggest that precision can raise revenue without raising tax rates. however, this suggestion assumes that precision unilaterally favors the government, which is often not the case. 291. see id. [vol 2:10 denystifying lifo limited by the complexity of formulating a measure of changing physical capital that is truly comparable from period to period. second, even if a theoretically precise method could be identified, the lifo method relies heavily on the accounting information available to the taxpayer, which must accommodate practical needs. as one accounting theorist has observed, accounting practices are the accountant's instruments for measurement and communication. some practices attain general acceptance because they enhance the accuracy of measurement or reduce equivocation in the information presented. others are dictated by the structure of particular environments. all may reflect, to some extent, the demands of practicality, expediency, technical and economic necessity, compromise, and diverse other influences.' as this theorist pointed out, "[t]he [lifo] measurement, accomplished by any technique, approaches only imperfectly a successful matching of current inventory cost expirations against revenue." 93 neither the code nor the regulations establish a particular method as a benchmark, which should counsel hesitation in determining that any method fails to clearly reflect income based on differences in results between methods. external indexes have the potential to demystify lifo by avoiding the indeterminacy inherent in an internal index computation. an external indexing method shifts the resolution of difficult issues created by changing technology and item content to the government agency generating the indexes, which should increase consistency in the measure of inflation applied in lifo computations. if policymakers are able to avoid the tendency toward precision, which manifests itself in the multiplicity of indexes and complex cost adjustments, such a method should also reduce tax administration burdens for taxpayers and the government, providing meaningful simplification in an exceedingly complex area of law. 292. peter a. firmin, dollar-value lifo: legitimate or not? 38 acct. rev. 270, 270 (1963). 293. id. at 276-77. 19951 volume 18 2016 number 5 florida tax review article provisions denying a deduction for illegal expenses and expenses of an illegal business should be repealed douglas a. kahn howard bromberg florida tax review volume 18 2016 number 5 i article provisions denying a deduction for illegal expenses and expenses of an illegal business should be repealed douglas a. kahn howard bromberg 207 florida tax review volume 18 2016 number 5 ii the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. each volume consists of ten issues. the subscription rate, payable in advance, is $125.00 per volume in the united states, plus sales tax where applicable and $145.00 per volume elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. subscriptions and changes of address should be sent to: florida tax review, university of florida levin college of law, post office box 117634, gainesville, florida 32611-7627. requests for back issues should be sent to: william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. if you have any questions regarding a subscription, you may call customer service at (352)273-0904 or email ftr@law.ufl.edu. copyright © 2016 by the university of florida florida tax review volume 18 2016 number 5 iii editor-in-chief martin j. mcmahon, jr. james j. freeland eminent scholar in taxation university of florida associate editors university of florida yariv brauner professor of law karen burke richard b. stephens eminent scholar in taxation dennis a. calfee professor of law michael k. friel professor of law david m. hudson professor of law emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar in taxation charlene luke professor of law grayson mccouch professor of law adam smith visiting assistant professor samuel c. ullman adjunct professor of law board of advisors hugh j. ault boston college bradley t. borden brooklyn law school j. martin burke university of montana charlotte crane northwestern university jasper l. cummings, jr. alston & bird, llp raleigh, north carolina deborah a. geier cleveland state university stephen a. lind university of california hastings college of law gregg d. polsky university of north carolina kerry a. ryan st. louis university graduate editors alisa french paul hankin john hodnette laura michael hughes m. blair james young hei jo michael schwartz mark westenberger executive assistant keyosha r. monroe florida tax review volume 18 2016 number 5 iv information for contributors the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the review publishes several types of manuscripts: “articles,” “commentaries,” and “book reviews.” the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law, with the assistance of a number of graduate tax students who assist the faculty editorial board. the florida tax review prefers electronic submissions in microsoft word either by e-mail to ftr@law.ufl.edu or through expresso. if a hard copy submission is necessary, please mail your article to: editor, florida tax review, university of florida levin college of law, p.o. box 117634, gainesville, fl 32611-7634. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a preference for submissions that are 30,000 words or less, including text and footnotes. the florida tax review will consider manuscripts at any time. all citations should follow a uniform system of citation (19th ed.); however, some modifications will be made by our editors to conform with the florida tax review styles manual. for submissions made directly to the florida tax review, the board of editors will endeavor to decide within three weeks whether to publish a manuscript. after the decision has been made to publish, the review is committed to expediting publication. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the review. florida tax review volume 18 2016 number 5 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations under the internal revenue code of 1986, as amended, unless otherwise indicated. florida tax review volume 3 1996 number 7 unfair business competition and the tax on income destined for charity: forty-six years later donald l sharpe* i. introduction ................................ 369 ii. justifying tax exemption for the charitable actiities of non-profit organizations .................... 374 m. the problem of unfair competition and its resolution: tax the income destined for charity or distribute the tax with the income? . . . . . . . . . . . . . . . . . . . . . . . 380 a. bath houses, noodles and piston rings in the service of charity ......................... 380 b. the revenue act of 1950 .................... 383 c. unfair competition: the rationale for the tax on unrelated business income ................ 385 1. unfair competition for market share ...... 385 2. capital market competition at the investor level ............................ 389 3. loss of federal tax revenue ........... 392 4. the sale-leaseback problem ............ 396 d. the tax reform act of 1969 .................. 398 e. variations on the theme of section 512(b)(15) ..... 402 f. is the elective credit sound tax policy? ......... 405 iv. the courts search for statutory meaning: forty-six years wandering in the desert ........ 412 a. "trade or business": in pursuit of a definition .... 412 1. the 1958 regulations ................. 414 2. the 1967 regulations ................. 415 * associate professor, fordham university school of law. b.a. 1956, oberlin college; m.a. 1960, harvard university; j.d. 1962, boston college; ll.m. 1966, new york university. special thanks go to joseph perillo and linda sugin for helpful comments relating to this article. i also would like to thank my research assistants dave rifkin and charles wilk. i am grateful to mary whelan and claudette parker for helping with the manuscript. florida tax review a. the reference to section 162 ...... 415 b. "[t]he term 'trade or business'... generally includes any activity carried on for the production of income from the sale of goods or performance of services .................... 416 c. a trade or business "is not limited to integrated aggregates of assets, activities and good will which comprise businesses for the purposes of certain other provisions of the internal revenue code.".. ............... 418 3. the tax reform act of 1969 ............ 419 4. decisions in the 1980s ................ 421 5. is profit motive the correct standard? ..... 424 6. reformulation of the standard ........... 426 b. trade or business: substantially related or unrelated? .............................. 427 1. the 1958 regulations ................. 428 2. the 1967 regulations ................. 428 3. profit and profit motive ............... 432 4. competitive, commercial manner ........ 437 5. identifying unrelated businesses by the activities of taxable entities ............ 439 6. identifying unrelated businesses by the potential for competition with taxable entities ........................... 441 c. is a finding of unfair competition a prerequisite to imposition of the tax ..................... 443 v. metastasis of the unfair competition rationale and a regime for containment .................. 450 a. the challenge from the small business community .............................. 450 1. competition between related businesses and taxable enterprises ............... 450 2. the statutory standard revisited ......... 457 b. compliance and beyond ..................... 460 vi. conclusion .................................. 462 appendix a ....................................... [vol. 3:7 • 465 unfair business competition i. introduction two sectors in american society, private enterprise and the federal government, are widely recognized as playing indispensable institutional roles, and both are in obvious need of revenue to accomplish their respective goals. the importance of a third sector-those institutions broadly subsumed under the classification of private, nonprofit charitable organizations-should not be undervalued relative to the other two, nor should its equally pressing need for revenue be underestimated. beginning early in american history, private institutions have played a major role in attending to social needs. in contrast to other countries where major institutions attending to social needs are financed and operated by the government, many of the universities, schools, scientific research organizations, hospitals, libraries, museums, symphony orchestras, and social welfare agencies in the united states are voluntarily supported and operated by private citizens.' from the very beginning, tax law in the united states has recognized the unique role played by private, nonprofit charitable organizations by affording them exemption from tax.2 section 501(c)(3) of the internal revenue code exempts from income tax organizations organized and operated exclusively3 for religious, charitable,4 scientific, literary, or 1. see commission on private philanthropy and public needs, giving in america: toward a stronger voluntary sector 9 (1975); note, criticized uses of federal tax exemption privileges by charitable foundations and educational institutions, 98 u. pa. l rev. 696, 69697 (1950). 2. the tariff act of 1894, sec. 32, exempted from tax "corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes .... " tariff act of 1894, ch. 349, sec. 32, 28 stat. 509. 556. the language was carried over to the tariff act of 1913, ch. 16, sec. ii(g)(a), 38 stat. 114. 172. for a history of the charitable exemption, see generally john d. colombo, why is harvard tax-exempt? (and other mysteries of tax exemption for private educational institutions), 35 ariz. l rev. 841, 844-45 (1993); kenneth liles & cynthia blum, development of the federal tax treatment of charities, law & contemp. probs., autumn 1975, at 6. 3. regulations § 1.501(c)(3)-1(c)(i) (as amended in 1990) relaxes the "operated exclusively" test by providing that an organization must engage primarily in activities which accomplish one or more exempt purposes specified in irc § 501(c)(3). for a critical analysis of the treasury regulations, see colombo, supra note 2. at 845-47. 4. regs. § 1.501(c)(3)-1(d)(2) provides in part: the term "charitable" is used in section 501 (c)(3) in its generally accepted legal sense and is, therefore, not to be construed as limited by the separate enumeration in section 501(c)(3) of other tax-exempt purposes which may fall within the broad outlines of "charity" as developed by judicial decisions. such terms include: relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of government; and promotion of social 1996] florida tax review educational purposes, testing for public safety, or for the prevention of cruelty to children or animals.5 no part of the net earnings of such organizations may inure to the benefit of any private shareholder or individual.6 exemption from tax, nevertheless, has historically proved inadequate as the sole means to generate sufficient revenue to enable the charitable sector to make ends meet. in their never-ending quest for revenue, 501(3)(c) organizations7 in the early decades of the twentieth century began to turn to the commercial world in search of profitable ventures to support their exempt activities, operating the ventures either directly or through wholly-owned "feeder" corporations. relying on a series of cases which held that the test of tax exemption is the charitable destination of the income generated by those ventures and not their commercial source, exempt organizations, most especially universities, marched into the private enterprise sector with increasing acceleration in the years following world war u. one of their favorite ventures was the acquisition of real estate with borrowed funds, lease of the property back to the vendor under a long-term lease, and amortization of the loan with tax-free rental income received from the property. following hearings before the house committee on ways and means in 1942 and 1947 and hearings before both the house and senate committees in 1950 investigating the perceived growing abuse of the tax exemption,8 and on president truman's urging to curb the abuse,9 congress reacted by welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency. 5. irc § 501(c)(3). 6. additionally, no substantial part of the organization's activities can be carrying on propaganda or otherwise attempting to influence legislation, and the organization cannot participate in, or interfere in (including the publishing or distributing of statements), any political campaign on behalf of any candidate for public office. irc § 501(c)(3). 7. for purposes of this article, the term "501(c)(3) organization" means an organization described in § 501(c)(3) that has as its primary function the conduct of an activity in furtherance of its exempt purposes. the term does not include churches and other religious organizations. the claim to exemption for these organizations rests on somewhat different grounds. 8. revenue revisions of 1950: hearings before the senate comm. on finance on h.r. 8920, 81st cong., 2d sess. (1950) [hereinafter senate hearings of 1950]; revenue revision of 1950: hearings before the house comm. on ways and means, 81st cong., 2d sess., pt. 1 (1950) [hereinafter house hearings of 1950]; hearings before the house comm. on ways and means on a bill to reduce individual income tax payments, 80th cong., 1st sess. 1895 (1947) [hereinafter hearings of 1947]; revenue revision of 1942: hearings before the house comm. on ways and means on revenue revision of 1942, 77th cong., 2d sess. 89 (1942) (statement of randolph paul, tax adviser to the secretary of the treasury). 9. 96 cong. rec. 769 (1950) (message from the president of the united states). [vol 3:7 unfair business competition including in the revenue act of 1950'0 several solutions. these measures abolished the tax exemption of feeder corporations, imposed an income tax on the taxable income of unrelated businesses conducted directly by certain exempt organizations primarily to raise revenue for their exempt purposes, and taxed specified rents received in connection with the leveraged sale and leaseback of real estate." forty-six years after the enactment of the revenue act of 1950, a number of issues remain to be resolved. this article explores the following central questions: should an income tax exemption be retained for "related" businesses directly furthering the charitable purposes of 501(c)(3) organizations in the face of charges from the small business community of unfair competition? can 501(c)(3) organizations receive tax-free income from their feeders and "unrelated" businesses without affording such businesses the opportunity to compete unfairly with their taxable counterparts? have the treasury department and the courts applied appropriate criteria to differentiate "related" from "unrelated" businesses conducted by 501(c)(3) organizations? is the "substantially related" standard administerable? are there additional measures that can be taken to promote the integrity and financial viability of the private, nonprofit charitable sector? central to the thesis of the article is the view, explored in part ii, that the private, nonprofit charitable organization represents generically a better model than the for-profit enterprise to provide the socially essential or important activities enumerated in section 501(c)(3). the tax exemption afforded to the charitable activities of nonprofit organizations is justified as a means of subsidizing and encouraging an institutional system that has historically fostered pluralism, diversity, and democratic decentralization in american society. part iii of the article describes the concurrent entry of 501(c)(3) organizations into the private enterprise sector and explores the judicial evolution of the "destination of income" theory which protects from tax the income generated by commercial ventures used to support the organization's exempt activities. there follows a broad description of the provisions included in the revenue act of 1950 to curb the perceived abuses of the exemption and subsequent amendments added by the tax reform act of 1969. although several commentators challenge the claim that untaxed feeders and unrelated businesses enjoyed an advantage over their for-profit taxpaying competition, this article assumes arguendo the validity of the unfair competition rationale as justification for imposition of the new taxes. 10. revenue act of 1950, pub. l. no. 81-814, §§ 301, 331, 64 stat. 906, 947-52 (1950). 11. irc §§ 502, 511-14 (formerly irc §§ 101, 421-423). 19961 florida tax review two questions underlie the discussion in part li. first, as an alternative to paying the taxes imposed by the revenue act of 1950, and assuming that appropriate limitations and safeguards are built into the statutory system, could not the problem of unfair competition also be resolved 1) by requiring the feeder or unrelated business to charge competitive rates, and 2) by granting the feeder or unrelated business the option to distribute a combined amount equal to its tax liability plus an assumed adequate return on investment to the 501(c)(3) organization to be used exclusively in financing its charitable activities? second, if such a statutory system were put into effect, would the loss of federal tax revenue be justified by the social benefits anticipated from the additional distribution to the 501(c)(3) organization? both questions are answered in the affimative. congress unwittingly created the framework for its own affirmative response to the first question when it inserted into the tax reform act of 1969 a piece of special interest legislation designed for the exclusive benefit of radio station wwl, operated by loyola university. the proposed amendment to the statute, outlined in appendix a of this article, is an attempt to expand on the innovative motif of this special interest legislation. the amendment does so by granting a feeder or unrelated business maintaining competitive pricing a limited elective credit against tax for certain distributions to its 501(c)(3) owner to cover its current operating losses from the conduct of activities related to the furtherance of its exempt purposes. assuming that the elective credit is as effective in eliminating the potential for unfair competition as is payment of the tax to the government, adoption of the credit can be viewed as a measure to replace diminished revenue from public contributions and federal grants with a revenue source that is within the control of the 501(c)(3) organization's wholly-owned business benefactors. adoption of the credit as a provision of universal application, however, can be justified on the condition that the charitable sector concomitantly addresses certain operational weaknesses in its various subsectors by establishing the type of self-regulatory bodies responsible for planning and oversight more fully described in part v of the article. alternatively, the elective credit can be more narrowly employed to enable and to encourage the charitable sector to meet specific social goals such as the delivery of essential goods and services to the needier segments of the public. the focus in part iv of the article shifts from an analysis of the solutions offered by the 1950 and 1969 tax legislation regarding the problem of unfair competition to an exploration of the legislative, regulatory, and judicial evolution of two defining elements of the statute itself. first, for purposes of the tax imposed by section 511 on the taxable income of an unrelated trade or business conducted by a 501 (c)(3) organization, what is a trade or business? second, what is an unrelated trade or business? [vol. 3:7 unfair business competition inasmuch as a trade or business substantially related to the performance of the organization's exempt purposes should not have as its primary purpose the making of profit, subpart a of part iv concludes that the definition of the phrase "trade or business" as it evolved for the purpose of allowing the deduction of business expenses under section 162, viz., an activity conducted with an intent, or primary intent, to earn profit, is an inappropriate standard for purposes of the tax imposed by section 511. defining trade or business more accurately as the sale of goods or the performance of services at market value from which gross income is derived encompasses activities whether designed principally to further the exempt purposes of the organization or to earn profit. accordingly, the reference to section 162 in both the legislative history of the tax on unrelated business and in treasury regulations interpreting the statutory meaning of essential terms have misled the courts into applying the "for profit" test in their attempt to distinguish trade or business activity from other types of endeavors such as fund raising conducted by section 501(c)(3) organizations. subpart b of part iv explores both the primary motive test of the 1958 treasury regulations and the "substantial causal relationship" tests of the 1967 regulations in their attempt to sort out whether or not a trade or business is related or unrelated to the charitable purposes of the exempt organization. subpart b concludes that many courts slip back into applying the 1958 subjective standard even after having recited the 1967 objective standard as the one to apply. subpart b further concludes that the error in applying the "for profit" test to identify trade or business has misled a number of courts into resolving the "related versus unrelated" issue by focusing more on the existence of profit itself than on the causal connection between the activity in question and the accomplishment of the organization's exempt purposes. additionally, courts have relied on other inaccurate assumptions to conclude that an activity is an unrelated rather than related trade or business. subpart c of part iv explores the issue of whether a specific finding of unfair competition with a taxable entity engaged in a similar activity should be a prerequisite to imposing the section 511 tax on an unrelated trade or business. in june of 1987 the subcommittee on oversight of the house committee on ways and means held hearings to review the incomeproducing activities of organizations exempt from income tax, to determine whether the "substantially related" test was the appropriate one to determine which income-producing activities should be taxed, and to ascertain the degree of compliance with the law. the small business community used the occasion to mount a vigorous attack, challenging the tax exemption afforded to business activities related to the charitable purposes of 501 (c)(3) organizations and to question the effectiveness of the "substantially related" test in differentiating related from unrelated business. part v of the article addresses 19961 florida tax review the two primary issues presented by the 1987 house hearings: is the "substantially related" test an appropriate expression of tax policy and is it a workable standard in differentiating exempt from taxable activities? again, both questions are answered in the affirmative. the lesson to be learned from the 1987 house hearings is that tax exemption for "related" activities is no longer sacrosanct. the article concludes with the proposal that the various subgroups of 501(c)(3) organizations establish their own self-regulatory associations for the purpose of formulating planning strategies, operational guidelines, and periodic review procedures to monitor compliance with the law and the degree to which member organizations are efficiently providing social benefits to the public. it is virtually imperative that the charitable sector seize the initiative to demonstrate accountability to the public, to promote understanding of its unique role in american society, and to restore public confidence in the tax exemption it enjoys. i. justifying tax exemption for the charitable activities of non-profit organizations apparently acting on the assumption that the legitimacy of the tax exemption afforded to private, nonprofit charitable organizations is selfevident, congress has through the years reenacted the provision with little explanation for its justification.' 2 although commentators have offered several rationales to support the exemption, none is fully satisfactory. one view, most fully developed by boris bittker and george rahdert, is that the exemption requires no affirmative justification as a special privilege in the tax system.' 3 rather, nonprofit organizations engaged in charitable, educational, scientific, and social welfare activities are exempt from income tax because the principles used in our tax system to compute gross income less business expenses "rest on the premise that the organization seeks to maximize its profit, and hence are not a satisfactory way of measuring the success of organizations that reject this basic premise."' 4 in this view, such organizations do not derive taxable income as presently defined in the tax system. moreover, according to bittker and rahdert, even if charitable organizations realized taxable income, there is no easy method to determine the appropriate tax rate on such income because "the economic burden of the tax will fall on 12. see colombo, supra note 2, at 845. 13. boris i. bittker & george k. rahdert, the exemption of nonprofit organizations from federal income taxation, 85 yale l.j. 299, 304 (1976). 14. bittker & rahdert, supra note 13, at 307. [vol. 3:7 unfair business competition the organization's ultimate beneficiaries"' 5 who are generally unknown at the time the income is received by the organization. 6 alternative rationales for the tax exemption afforded to 501(c)(3) organizations view the exemption as an indirect governmental subsidy and a concomitant loss of federal revenue that requires affirmative justification. 7 15. id. at 315; see william a. klein, income taxation and legal entities, 20 ucla l. rev. 13, 56 (1972) ("in my view, on the other hand, if one focuses (as one should) on the effects achieved by imposing taxes on the income of charitable foundations, it is taxation rather than nontaxation that appears to be unnatural and in need of special justification."). 16. colombo, citing henry hansmann, criticizes this theory on the ground that it is no more difficult to measure the income derived by a nonprofit organization from the sale of goods and services than it is for any other business. see colombo, supra note 2, at 859. maintaining that tuition and sales revenue received by educational institutions "fall squarely within the definition of § 61," colombo states: "in addition, aside from the profit motive issue, the expenses of most educational institutions (teacher salaries, maintenance and the like) are classic examples of deductible business expenses under i.r.c. § 162." id. at 860. the profit motive issue was precisely bittker and rahdert's point. it may be possible to come up with a number that looks like "taxable income" derived by a nonprofit organization from the sale of goods or services. the problem is that "taxable income" normally measures the results of an enterprise seeking to maximize profits. bittker & rahdert, supra note 13, at 307. hansmann argues that the most satisfactory explanation is to view the exemption as a subsidy in recognition of the fact that nonprofit organizations (a) have difficulty raising capital and (b) supply goods and services that would be undersupplied, or less efficiently supplied, by the private market. henry hansmann, the rationale for exempting nonprofit organizations from corporate income taxation, 91 yale lj. 54, 55 (1981). colombo is also critical of hansmann's capital subsidy theory. see colombo, supra note 2, at 868-71. colombo states: "if nonprofit firms face capital formation problems sufficient to warrant government intervention, a far more precise mechanism would be direct government construction grants, government-assisted loans or tax incentives targeted at capital formation." id. at 870. those who fear overdomination by the federal government and the entrapment of the nonprofit, charitable sector into dependence on the prevailing political view in washington may prefer to stay with a stable income tax exemption than to rely on government subsidies. see also rob atkinson, altruism in nonprofit organizations, 31 b.c. l. rev. 501 (1990); colombo. supra note 2, at 871-73 (criticizing atkinson's altruism theory). 17. the governmental subsidy resulting from tax exemption is not obvious unless the 501(c)(3) organization realizes the equivalent of "taxable income." for example, assume that a 501(c)(3) organization receives $50x from donations, ss0x interest and dividends from investments, and s300x gross receipts from the operation of related activities for the taxable year, and incurs $400x of "deductible" expenses in the operation of such activities. in this case, the entire financial support is ostensibly received from the public and previously received gifts and none from tax exemption. alternatively, assume the same facts, except that the "deductible" operating expense are $300x and the applicable tax rate is 35%. the equivalent of taxable income is $100x and the tax savings resulting from exemption is s35x. thus, s365x financial support is received from the public and previously received gifts and s35x from the federal subsidy. compared to a taxable entity with s100x taxable income, the subsidy resulting from the tax exemption allows the 501(c)(3) organization to lower prices by s35x or to accumulate that amount. in either case, it is clear that exemption from tax as a governmental subsidy works very imprecisely. see colombo, supra note 2, at 863-64. 19961 florida tax review in a rare congressional pronouncement on the matter the house committee on ways and means, in 1938, observed that "the government is compensated for the loss of revenue by its relief from financial burden which would otherwise have to be met by appropriations from public funds, and by the benefits resulting from the promotion of the general welfare."' 8 in other words, the private, nonprofit charitable sector merits the tax savings afforded by the exemption because the money foregone by the government would have to have been appropriated by congress to meet the very same public needs being met by the charitable sector. 9 one of the difficulties with this quidpro-quo rationale for the exemption is its failure to address the alternative possibility that the government could revoke the exemption, collect the otherwise foregone tax, and use the revenue to meet the public needs now being met by the 501(c)(3) sector.20 obviously, the government would have 18. h.r. rep. no. 1860, 75th cong., 3d sess. 19 (1938). 19. "[u]nder this law, in view of the fact that bequests for public purposes operate in aid of good government and perform by private means what ultimately would fall upon the public, exemption from taxation is not so much a matter of grace or favor as rather an act of public justice." maurice finkelstein, freedom from uncertainty in income tax exemptions, 48 mich. l. rev. 449, 451 (1950) (quoting harrison v. barker annuity fund, 90 f.2d 286, 288 (7th cir. 1937)). 20. some commentators view the revenue loss resulting from a tax incentive designed to further a social goal (e.g., exemption from tax) as economically equivalent to the government collecting the tax and allocating the revenue as a direct expenditure through grants, loans, and guarantee of loans. these commentators look upon tax incentives with disfavor because the foregone revenue is not explicitly accounted for in the federal budget and there is consequently no public and legislative review of what is essentially a concealed federal subsidy. see stanley s. surrey, tax incentives as a device for implementing government policy: a comparison with direct government expenditures, 83 harv. l. rev. 705 (1970); comment, tax incentives as state action, 122 u. pa. l. rev. 414 (1973). professors bittker, surrey, and hellmuth have vigorously debated the issue. see boris i. bittker, accounting for federal "tax subsidies" in the national budget, 22 nat'l tax j. 244 (1969); stanley s. surrey & william f. hellmuth, the tax expenditure budget-response to professor bittker, 22 nat'l tax j. 528 (1969); boris i. bittker, the tax expenditure budget-a reply to professors surrey & hellmuth, 22 nat'l tax j. 538 (1969). this article views the § 501(c)(3) exemption from tax as a federal subsidy, imprecise as it is, granted to broad classifications of socially essential or important activities conducted by charitable, nonprofit organizations in part as an affirmation of the principle of decentralization of institutionalized power in america. a shift in power from the charity to the federal government implicit in the repeal of the exemption (i.e., the right to decide how to spend the tax collected or whether even to spend it on 501(c)(3) type activities) contravenes this principle. see liles & blum, supra note 2, at 56 ("having come this far and having achieved so much under a tax system which encourages private philanthropy, it would be a disaster if we were at this late date to decide to junk the present system in favor of some untried scheme of direct government subsidy or operation of all charity."); see also james t.y. yang, collaboration between nonprofit universities and commercial enterprises: the rationale for exempting nonprofit universities from federal income taxation, 95 yale l.j. 1857, 1874 [vol 3:7 unfair business competition to expend amounts far in excess of the foregone tax to meet the same public need now being met by a tax exempt nonprofit charity."' the most appealing rationale for the exemption, but one admittedly resting on value judgments and assumptions that are difficult to test, justifies the tax savings afforded by the exemption as the result of two fundamental hypotheses: (1) profit motivated enterprise cannot be relied upon to meet the essential or important public needs enumerated in section 501(c)(3) that have been historically addressed by the private, nonprofit charitable sector, and (2) any shift in revenue and decision-making power from the charitable sector to the federal government implicit in the repeal of exemption could not be accomplished without endangering the decentralized form of democracy as it has developed in the united states. with respect to the first hypothesis, this view assumes that if a for-profit business undertook to meet a social need traditionally addressed by a 501(c)(3) organization, the primary goal of the endeavor would be profit and the fulfillment of the social need would be but the means to this end. if meeting the public need did not appear to be profitable prospectively, or if it turned out to be unprofitable, the for-profit business would not embark upon the endeavor or would later abandon it. moreover, in an effort to maximize the bottom line, the for-profit business may be tempted to sacrifice the quality of the goods and services offered to meet the public need. this point appears to cut against the classic principle that only the best quality of goods and services serving a particular market survive in a competitively free marketplace. the "free marketplace" (1986) (arguing that universities are a better alternative to conduct basic scientific research than the government because of the relative independence, freedom from sluggish and expensive bureaucracy, encouragement of private philanthropy, and link to training). the 501(c)(3) exemption from tax does not imply that congress endorse the policies of any given nonprofit, charitable organization. comment, supra. at 463. "indeed, to characterize every grant of tax-exempt status as an approval of each underlying activity would be to render the government's § 501(c)(3) approval policies nonsensical since the government would often be endorsing various activities that work at complete cross purposes from one another." comment, the revocation of tax exemptions and tax deductions for donations to 501(c)(3) organizations on statutory and constitutional grounds, 30 ucla l rev. 156, 184 (1982). for example, both planned parenthood and "pro-life" organizations qualify under § 501(c)(3). id. at 184 n.174. 21. see bittker & rahdert. supra note 13, at 332; colombo, supra note 2, at 862-64. colombo states that "[t]he establishment and maintenance of institutions of higher education is certainly not the responsibility of the federal government." colombo. supra note 2 at 863, quoting chauncey belknap, the federal income tax exemption of charitable organizations: its history and underlying policy, in research papers sponsored by the commission on private philanthropy and public needs 2025, 2033 (u. s. dep't of the treasury ed., 1977). colombo correctly points out that the scope of activities historically exempt from tax as "educational" extends beyond what could be argued as being within the perimeters of governmental responsibility. id. at 864. 19961 florida tax review principle nevertheless may not work to encourage private enterprise to offer the best quality of goods and services of the type now offered by 501(c)(3) organizations when consumers have difficulty forming an educated judgment as to what they or society is receiving. 22 how, for example, would a forprofit university's consumers judge the quality of the university's contribution to literary scholarship or to pure scientific research? by contrast, the raison d'8tre of private, nonprofit charitable organizations described in section 501(c)(3) is to address a category of public needs designated by congress as essential or important, and not to earn profit for the benefit of its owners or other individuals. a 501(c)(3) organization is less likely to abandon its activities for lack of profit, and there is far less temptation to sacrifice quality for the bottom line.' further, the amount of public financial support received by a 501(c)(3) organization, an indication of its relevant success in addressing a public need, extends beyond the revenue received from the consumers of its goods and services to include gifts from private citizens, corporations, and foundations and the income derived from the investment of previously received donations. in this view of the exemption there is an essential democratic decentralization implicit in the opportunity afforded to private citizens of diverse religious, ethnic, and racial backgrounds and with different economic, political, and social agendas to contribute their time and money to the 22. hansmann calls this "contract failure." see hansmann, supra note 16, at 69; dennis zimmerman, nonprofit organizations, social benefits, and tax policy, 44 nat'l tax j. 341, 342 (1991): here the problem is one of an essentially private good about which the seller possesses much more information than the buyer, leading to a possibility that the buyer will be taken advantage of by the profitmotivated seller .... nursing homes and mental treatment facilities are thought to be good examples of services that fit this profile. in such instances, the nondistribution constraint on nonprofit organizations (the prohibition against surplus or profit being distributed to board members or managers) supposedly reduces the incentive for the service provider to take advantage of the consumer's informational disadvantage. additionally, some commentators argue that private enterprise cannot supply a sufficient quantity of its goods or services in cases where they are consumed collectively by the public. see id. at 341-42. 23. for a contrary view, see colombo, supra note 2, at 866 n.149 ("one can argue, in fact, that for-prcfit institutions are likely to be more responsive to community needs, since for-profits rely on customer patronage for financial success, and customer patronage requires selling a product the customer wants."). colombo argues that "the existence of for-profit private schools also would increase parental choice, educational opportunity and promote diversity." colombo, id. at 866. the primary problem presented by the private enterprise sector, however, is not lack of diversity, but lack of reliability if the enterprise turned out to be unprofitable. [vol 3:7 unfair business competition privately controlled nonprofit charitable organization of their choice in an effort to meet public needs and to promote controversial causes. it is precisely this pluralism, diversity, and opportunity for private philanthropy and public service extending beyond the power structure of the federal government that not only allows for creativity and innovation in the resolution of social issues, but also serves as a counterweight to the power and wealth of both the government and for-profit enterprise. 24 in this view, one that is accepted by this article, as a general principle the subsidization, encouragement, and preservation of the private, nonprofit charitable sector as an essential institutional provider of public goods and services justifies the loss of revenue by the federal government resulting from the exemption from tax afforded 501(c)(3) organizations.' this view of the exemption does not mean to 24. for an eloquent expression of this view, see lawrence m. stone, federal tax support of charities and other exempt organizations: the need for a national policy, 1968 u.s. cal. tax inst. 27, 39-40; see also yang, supra note 20. 25. building on hansmann's theory that nonprofit organizations spring up when the private market fails to function properly, colombo proposes his donative theory to explain the exemption. see colombo, supra note 2, at 873-87. under this theory, tax exemption is deserved only when there is both private market failure and governmental failure to provide the desired goods and services at an optimal level. id. at 874. government failure occurs because the majority of the legislators will not vote for certain goods and services desired by a minority bloc; however, the majority will permit a partial subsidy of such goods and services in the form of a tax exemption in the expectation that they will receive like treatment for their own special interests. id. at 874-75. the best evidence of this twin failure, according to colombo, is "donations by more than a de minimis number of individuals to a given entity. where neither the private markets nor the government supplies a good or service at an optimum level of production, high-demanders have no choice but to donate to the supplying entity to encourage more production." id. at 876. exemption is deserved only when donations constitute a prescribed minimum percentage of the nonprofit organization's total support, e.g., 10 to 33% in the case of educational institutions. the donative theory, according to colombo, is "the key to an objective, administrable standard for granting exemption." id. at 873-74. colombo's theory raises several questions. why is not the public's purchase of nonprofit organizations' "related" goods and services also an indication of this twin failure? what would happen to the required minimum charitable donation percentage if a flat tax eliminating a deduction for charitable contributions were adopted? will the minimum required charitable deduction percentage cause charitable organizations to allocate an undue percentage of their budget to fundraising? colombo asks: "would harvard really go out of business if it were not tax exempt?" id. at 867. why not ask the same question in cases where donations constitute 33% of a university's total support, indicating, in colombo's view, that the university deserves exemption? more fundamentally, colombo is compelled to quantify the standard for exemption because he erroneously tests what he calls the "community benefit theory" against specific nonprofit charitable organizations rather than against the nonprofit, charitable sector as a whole. see id. at 864-68. the "community benefit theory" justifies the exemption as the result of two assumptions: (1) private enterprise cannot be relied upon to meet the public needs enumerated in § 501(c)(3); and (2) the shift in revenue and power from the charitable sector 19961 florida tax review suggest that the federal government should not concomitantly devote its financial resources to the meeting of public needs and the resolution of essential social issues. iii. the problem of unfair competition and its resolution: tax the income destined for charity or distribute the tax with the income? a. bath houses, noodles and piston rings in the service of charity in the year 1913, the income of the legal representative of an ancient religious order located in the philippines consisted primarily of rents from its real estate holdings, dividends from stocks, interest on loans, and negligibly of proceeds from the sale of wine, chocolate, and other articles.26 stipulating that the legal representative was an exempt charitable organization organized and operated under the predecessor of section 501(c)(3) and that its income was used exclusively to carry out its religious, charitable, and educational work, the tax collector argued nonetheless that the organization was operated to the federal government implicit in the repeal of the exemption would be an undesirable encroachment upon the form of decentralized power as it developed in the united states. thus, the "special qualities" or "special ethic" that colombo seeks can be found in the private, nonprofit, charitable sector as a whole rather than in any particular organization. as an initial matter, a particular nonprofit organization "deserve[s]" the exemption if it is organized and operated primarily to further one or more of the activities enumerated in § 501(c)(3) and complies with the section's additional requirements. id. at 865. whether a particular organization is in fact being operated primarily to further its stated purposes, or is in violation of a prohibited rule, is quite another matter that needs to be addressed by compliance procedures. it is also another matter whether treasury regulations are sufficiently precise (or an appropriate expression of social policy) in their attempt to delimit the scope of activities that fall within the broad classifications enumerated in § 501(c)(3). it can also be questioned whether the treasury department should be the agency issuing the regulations, or whether the internal revenue service should be the agency interpreting the regulations and enforcing compliance. rather than audit a particular exempt organization to determine whether it is being operated primarily to further its stated purposes, or is in violation of a prohibited rule, colombo prefers, and attempts to formulate, a quantitative test for granting and maintaining the exemption to be applied on an entity-by-entity basis. see colombo, supra note 2, at 87387. but see richard steinberg, "unfair" competition by nonprofits and tax policy, 44 nat'l tax j. 351, 361-62 (1991): the burden of proof should not fall upon each individual [nonprofit] to justify its exemption. [nonprofit]s innovate and experiment, and not every experiment is a success. successful innovations (such as day care, hospitals, drug-addiction therapy, and universities) have often been picked up by government or for-profits after [nonprofits] have demonstrated their viability; "inefficient" subsidies may be the price we have to pay for the next breakthrough. 26. see trinidad v. sagrada orden, 263 u.s. 578, 579-80 (1924). [vol 3:7 unfair business competition also for business purposes and that it should pay tax on the income from its commercial activities.27 the tax collector lost in both the trial and appellate courts.' the supreme court affirmed in trinidad v. sagrada orden.29 the case is notable for its governing principle, one that would prevail for the next twenty-four years: the destination, not the source, of the income of a corporation organized and operated exclusively for religious, charitable, scientific or educational purposes is the ultimate test of exemption." charitable activities, the court observed, cannot be carried on without money:3 "evidently," said the court, "the exemption is made in recognition of the benefit which the public derives from corporate activities of the class named, and is intended to aid them when not conducted for private gain."32 if trinidad left any doubt as to whether the destination of income principle applied to a full-blown business operated for the benefit of a charitable organization, the confusion was dispelled by the second circuit in roche's beach, inc. v. cormnissioner.3 roche's beach, inc. was a feeder corporation organized to operate a bathing beach business and to turn over its profits to a tax-exempt charitable foundation for the relief of destitute women and children. 4 the business, operated by 34 employees during the summer, consisted of 3000 bath houses to be rented to transient bathers, plus suit and towel rentals, restaurant and refreshment concessions, and other property rentals.35 citing trinidad, the court held that a feeder corporation was exempt from income tax even though it conducted business activities for profit and did not itself engage in charitable endeavors.' in 1947, a new york university school of law alumni group orchestrated the purchase of c.f. mueller company, one of the country's leading noodle manufacturers, for the benefit of the school of law." the group organized a delaware corporation for the "charitable" purpose of operating the noodle business and distributing its dividends to the university for the benefit of the school of law, a tax-exempt educational institution.3" the delaware corporation borrowed $3,550,000 under a 15-year loan from the prudential insurance company, purchased all of the outstanding stock of the 27. id. at 580-8 1. 28. id. at 579. 29. id. at 578. 30. id. at 581. 31. id. 32. id. for an analysis of the case, see finkelstein, supra note 19, at 453-57. 33. 96 f.2d 776 (2d cir. 1938). 34. id. at 776-77. 35. id. at 777. 36. id. at 779. for an analysis of the case. see finkelstein, supra note 19, at 457-59. 37. c.f. mueller co. v. commissioner, 190 f.2d 120, 120-21 (3d cir. 1951). 38. id. 19961 florida tax review existing taxable new jersey company for $3,495,057.60 and then merged the delaware corporation into itself.39 the internal revenue bureau challenged the tax exemption of the feeder corporation; but the third circuit reversed the tax court, which had found for the commissioner, because the court of appeals could not distinguish the case from roche's beach.40 although it was by no means the largest of the acquisitions of taxable businesses for the benefit of a tax-exempt charitable organization, the purchase of a well-known noodle company engineered by benefactors of the n.y.u. school of law was perhaps the most notorious. furthermore, it served as an alarming example for those who were becoming concerned with the rapidity with which taxexempt organizations, especially colleges and universities, were entering the world of commercial enterprise. in point of fact, the purchase of c.f. mueller company was but one of four acquisitions on behalf of new york university over a relatively few years. the other three were howes leather company, valued at $35,000,000; american limoges china, inc., valued at $3,300,000; and the ramsey corporation, manufacturer of piston rings, valued at $3,000,000.4 1 on december 13, 1948, the new york times ran a story entitled "university dollars yielding tax-free business profits," in which it was reported that other types of businesses had been acquired for the benefit of various educational institutions across the country, including a cattle ranch, an english walnut grove, filling stations, a street car company, a citrus grove, and an airport.41 by far the most widespread practice that had developed during the post-world war ii era, however, was the acquisition of commercial real estate by colleges and universities, hundreds of millions of dollars worth of 39. c.f. mueller co. v. commissioner, 14 t.c. 922, 923-24 (1950), rev'd, 190 f.2d 120 (3d cir. 1951). 40. c.f. mueller, 190 f.2d at 121-23, rev'g 14 t.c. 922 (1950); cf. willingham v. home oil mill, 181 f.2d 9 (5th cir.), cert. denied, 340 u.s. 852 (1950) (corporation originally organized as for-profit entity and later reorganized as not-for-profit held to be tax-exempt); but cf. universal oil prods. co. v. campbell, 181 f.2d 451, 465 (7th cir.) (for-profit corporation reorganized into "research fund" trust held to be not tax-exempt), cert. denied, 340 u.s. 850 (1950). 41. see house hearings of 1950, supra note 8, at 780, 799 (statement of solomon barkin). 42. benjamin fine, university dollars yielding tax-free business profits, n.y. times, dec. 13, 1948, at al, a29. the times article was one of a number of articles publicizing the perceived abuse of the tax exemption. two years later, both the house committee on ways and means and the senate committee on finance held hearings. house hearings of 1950, supra note 8; senate hearings of 1950, supra note 8; see also comment, colleges, charities, and the revenue act of 1950, 60 yale l.j. 851, 851 (1951) ("[congress, however,] lacked precise information ... regarding the extent to which exempt organizations are operating commercial enterprises."); note, supra note 1, at 698-700 (providing examples of "criticized activities of educational institutions"). [vol 3:7 unfair business competition properties that included the real estate of the country's largest department store chain, warehouses, shopping centers, office buildings, and apartment houses.43 most often, the purchased property was leased back to the seller under a long-term lease. in many cases the educational organization borrowed the entire purchase price for the property and amortized the loan with the taxfree rental income received from the vendor-lessee.' in its report accompanying the bill to enact the revenue act of 1950, the house committee on ways and means commented: "the purchase and lease-back arrangement apparently is of recent origin. nevertheless, it has already become big business and a recent writer has characterized it as 'the most noteworthy, financial device of the present century."' 4 b. the revenue act of 1950 in his message to congress in 1950, president truman noted that "[s]ome tax loopholes" had emerged "through the abuse of the tax exemption accorded educational and charitable organizations." '46 it was not his purpose, said president truman, to change the policy supporting the exemption. rather, his concern was that "an exemption intended to protect educational activities [had] been misused in a few instances to gain competitive advantage over private enterprise through the conduct of business and industrial operations entirely unrelated to educational activities.4 7 president truman urged congress to close the tax loopholes as part of his plan "to improve the fairness of the tax system, to bring in some additional revenue, and to strengthen [the] economy."' ' congress responded by including three measures in the revenue act of 1950, designed to curb the perceived abuse of the tax exemption. effective for taxable years beginning after december 31, 1950, the predecessors to code sections 511-513 imposed the regular corporate income tax on the taxable income (gross income less directly connected deductions) of any trade or business regularly carried on"0 by certain tax-exempt organizations, "the conduct of which is not substantially related (aside from the need of such organization[s] for income or funds or the use [they make] of the profits derived) to the exercise or performance by such organization[s] of [their] 43. fine, supra note 42, at a29. 44. see h.r. rep. no. 2319, 81st cong., 2d sess. 38 (1950). 45. id. 46. 96 cong. rec. 769, 771 (1950) (message from the president to the united states). 47. id. 48. id. at 769. 49. see irc § 511(a)(1). the individual income tax rate was imposed on the unrelated business income of certain tax-exempt trusts. see irc § 511 (b)(1). 50. see infra note 124 and accompanying text. 19961 florida tax review charitable, educational, or other purpose or function constituting the basis for [their] exemption."'" included among the organizations subject to the new tax were religious, charitable, scientific, literary, and educational organizations, and organizations established for the prevention of cruelty to children or animals; but excluded were churches, their integrated auxiliaries, and conventions or associations of churches.52 also excluded from the reach of the tax on unrelated trade or business was "passive" investment income received by section 501(c)(3) organizations, i.e., all dividends, interest, annuities, royalties (including overriding royalties) whether measured by production or by gross or taxable income, rents from real property (including personal property leased with real property), except certain rents on property acquired with borrowed funds, and gains or losses from the disposition of property other than inventory or property held primarily for sale to customers in the ordinary course of the trade or business.53 a 5% (of unrelated business net income) charitable contribution deduction was allowed in computing the taxable income of the unrelated trade or business, provided the contribution was not made to the organization operating the unrelated business. 4 a $1,000 specific deduction was allowed in order to eliminate de minimis cases involving excessive costs of collection and payment.55 under the second measure included in the revenue act of 1950, the predecessor to code section 502, a feeder organization operated for the primary purpose of conducting a trade or business for profit was no longer 51. irc § 513(a) (formerly irc §§ 421, 422). 52. see irc §§ 511(a)(2) (formerly § 421(b)), 501(a), (c)(3), 508(c)(1)(a). also subject to the tax were certain other categories of exempt organizations, including labor, agricultural, and horticultural organizations and business and trade associations. see id. § 501(c)(5)-(6). for a more detailed discussion of the judicial and regulatory developments prior to 1950, and the legislative history of the 1950 act, see comment, supra note 42. see also john h. myers, taxing the colleges, 38 cornell l. rev. 368 (1953); kenneth c. eliasberg, charity and commerce: section 501(c)(3)-how much unrelated business activity?, 21 tax l. rev. 53 (1965); liles & blum, supra note 2, at 41-48. 53. see irc § 512(b)(l)-(5) (formerly § 422(a)). irc § 512(b)(7)-(9) excludes all income derived from research: for the united states or any of its agencies or instrumentalities, or any state or political subdivision; performed by a college, university, or hospital; or performed by an organization operated primarily for the purpose of carrying on "fundamental" research benefitting the general public. see id. § 512(b)(7)-(9) (formerly § 422(a)(7)-(8)(b)). for a discussion of the exclusion for research, see myers, supra note 52, at 381-84. 54. see irc § 512(b)(10) (formerly § 422(a)(9)(a)). the charitable contribution deduction currently allowed is 10%. id. the requirement that the contribution be made to another charity can be traced to the house and senate reports of the revenue act of 1950. see h.r. rep. no. 2319, supra note 44, at 111; s. rep. no. 2375, 81st cong., 2d sess. 109 (1950), reprinted in 1950 u.s.c.c.s. 3053. 55. see irc § 512(b)(12) (formerly § 421(c)). [vol. 3:7 unfair business competition exempt from income tax on the ground that all of its profits were payable to one or more tax-exempt organizations.5 6 under the third measure, the predecessor to code section 514, designed to combat the "lease-back problem," rental income received by a 501(c)(3) organization from the lease of real property for more than five years (including options to extend) was subject to the new tax if, at the close of the lessor's taxable year, there existed unpaid debt incurred by the lessor in acquiring or improving the leased property.' the amount of such rent included in the gross income of the tax-exempt organization was the same proportion of the total rent received during the taxable year as the amount of the borrowed funds at the end of the year bore to the adjusted basis of the property at the end of the year.5" a proportionate amount of real property taxes paid during the taxable year with respect to the leased property, interest paid on the debt, and depreciation were allowed in computing the net income from the lease.59 the tax applied whether or not the vendor of the property to the exempt organization and the lessee were the same person. c. unfair competition: the rationale for the tax on unrelated business income 1. unfair competition for market share.-as explained by the house committee on ways and means, the problem that had developed which necessitated the imposition of the tax on unrelated business income of certain otherwise exempt organizations, as well as the elimination of the exemption of feeder organizations, was primarily one of unfair competition; i.e., such businesses were in direct competition with their taxable counterparts: "the tax-free status of these [501(c)(3)] organizations enables them to use their profits tax-free to expand operations, while their competitors can 56. see irc § 502 (formerly § 101). educators testifying before congress did not resist this measure, but vigorously opposed taxing unrelated businesses operated directly by educational institutions. see comment, supra note 42, at 876-77 n.1 12; myers. supra note 52, at 375. at the same time, the consensus of educators was that their institutions should refrain from engaging in commercial enterprises. see comment, supra note 42, at 877 n. 112. 57. see irc § 514 (formerly § 423). 58. see irc § 514(a)(1). assume, for example, that an educational institution purchased property for $500,000 and leased it for a period of 20 years, and the adjusted basis of such property at the close of the first taxable year was also s500.000. if the institution borrowed $200,000 to acquire the property, because this is two-fifths of the adjusted basis, two-fifths of the rental income received from the leased property would enter into the computation of unrelated business net income. if, in a subsequent year, the indebtedness were reduced to $100,000, assuming the adjusted basis were still $500,000, one-fifth of the rental income would be included as an item of gross income in computing the unrelated business net income. id. 59. see id. § 514(a)(2), (3) (formerly § 423(d)(3)). 19961 florida tax review expand only with the profits remaining after taxes."' in confining the scope of the new tax to unrelated business income, congress chose to leave the basic exemption of the 501(c)(3) organization intact and did not restrict such organizations' rights to acquire and operate businesses unrelated to their charitable purposes. only if operating a business for profit became an organization's primary activity would there be a danger of losing the underlying exemption.61 the problem thus stated by the house committee on ways and means underplayed the extent of the concern making its way through the congress of 1950. to illustrate the extent of the perceived problem, assume that a well-recognized university invests one million dollars of its endowment fund by purchasing all of the stock of an ice cream manufacturing corporation. the corporation merges into a new corporation designed to turn over all of its profits to the university, and the new corporation is exempt from corporate income tax under the trinidad "destination of income" test. assume for purposes of this discussion that taxable income equals cash profit and that both the corporate and individual income tax rates are 35%. if both the feeder organization and a taxable corporate competitor owned by taxable shareholders earn $100x profit for the taxable year from the sale of ice cream of comparable quality, the feeder obviously has the ability to retain $35x more than its taxable competitor after the latter's payment of the corporate income tax. if both the feeder and the competitor are passthrough entities or unincorporated businesses, the feeder still has the ability to retain $35x additional profit because its university owner is tax-exempt, whereas the competitor presumably will be required to distribute $35x to the taxable investors to cover their tax on the passed-through income. 60. h.r. rep. no. 2319, supra note 44, at 36. the rationale for exempting § 501(c)(3) organizations from tax also served to justify the continued exemption of related businesses, even though they might compete with taxable entities. see note, the macaroni monopoly: the developing concept of unrelated business income of exempt organizations, 81 harv. l. rev. 1280, 1284 (1968) [hereinafter the macaroni monopoly]. 61. regs. § 1.501(c)(3)-i(e)(1) states: an organization may meet the requirements of section 501 (c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513. for discussion of the potential threat business activity poses to the § 501(c)(3) exemption itself, see eliasberg, supra note 52; norman a. sugarman & harlan pomeroy, business income of exempt organizations, 46 va. l. rev. 424 (1960); comment, preventing the operation of untaxed business by tax-exempt organizations, 32 u. chi. l. rev. 581 (1965); note, profitable related business activities and charitable exemption under section 501(c)(3), 44 geo. wash. l. rev. 270 (1976). [vol 3:7 unfair business competition the feeder has several options with respect to its $35x additional profit. it can temporarily reduce or eliminate the additional profit by selling at a lower price the same quality ice cream as sold by the taxable competitor. 2 it can maintain its price and allocate the $35x to research and development, invent a better ice cream, and sell the improved product at the same price as the taxable competitor's product. it can retain the $35x to tide it over in difficult times. or it can spend the additional $35x to modernize production facilities, expand marketing efforts, or improve distribution systems. accordingly, there is the potential that the exempt feeder will be able to eat into the profits of its taxable competitor, or drive the competitor out of business altogether. the feeder, in fact, may be able to increase market share enough to eat into the profits of several taxable competitors, and perhaps even comer the ice cream manufacturing market by driving all of its tax-paying competitors out of business. if one tax-exempt unrelated business of one university has the potential to accomplish this economic feat, think of what hundreds of tax exempt unrelated businesses of hundreds of universities could do to their taxable competitors. the free enterprise system would move to the top of the list of endangered species.63 62. commentators disagree as to whether income tax has an impact on the price of a product. see comment, supra note 42, at 876 (noting that the exempt organization's advantage declines proportionately as prices are cut lower and lower), comment. supra note 61, at 591 ("yet under competitive conditions all firms in an industry produce until the cost of another unit of output equals the additional revenue it will bring. because an income tax is levied only on profits, it will not be relevant in determining when that equalzation point is reached."); the macaroni monopoly, supra note 60, at 1281 (describing how an exempt organization might win a price war by driving taxable competitors' return on investment so low that investors would restrict their investments to fields in which there were no tax-exempt players; however, a number of factors make such a price war unlikely). klein. supra note 15, at 64-65 (arguing that it is unlikely that feeders will lower prices to drive out competition); richard l. kaplan, intercollegiate athletics and the unrelated business income tax. 80 colum. l. rev. 1430, 1465-66 (1980) (§ 501(c)(3) organizations, typically pressed for current income, are unlikely to cut prices to drive out competition). but see finkelstein, supra note 19, at 460: profit itself, we are told, enters into the determination to undertake enterprises and is an element in the determination of prices; and if such be the case, it is obvious that a tax levy on profits would be an important element in the consideration of the price structure, and the exemption from the income tax would be a substantial benefit to a competitor. see susan rose-ackerman, unfair competition and corporate income taxation. 34 stan. l rev. 1017, 1023 (1982) (in either a competitive market or an oligopolistic industry the presence of nonprofits could lower prices). 63. some commentators find this scenario overly simplistic. see rose-ackerman, supra note 62, at 1022-38 (maintaining that tax-exempts may or may not have an unfair advantage over their taxpaying competition, depending on such factors as the efficiency of capital markets, excessive entry of nonprofits into an industry, the degree to which the business 19961 florida tax review the basic premise of this scenario is that the exempt feeder will retain all or a part of the additional $35x profit and reinvest it in business operations or lower prices to the detriment of its taxable competitor. the commissioner stipulated in roche's beach, however, that any excess of income over expenses earned by the feeder in that case was in fact turned over to the foundation for its charitable purposes.' assume that the feeder in the above example distributes its $100x profit to the university rather than reinvesting any part of it in business operations and the university uses the distributed amount to conduct its educational activities, i.e., does not directly or indirectly reinvest an equivalent amount of cash or property back into the feeder. having distributed its additional $35x profit to its university owner, the feeder is no longer in a position to compete unfairly with its taxable competitor for market share. if the feeder were required to distribute its entire profit to the university for its educational purposes, the taxable competitor would now in fact be in a position to compete unfairly with the feeder, i.e., the taxable competitor would have available $65x more than the feeder to reinvest in business operations. alternatively, assume that the feeder is required to distribute to the university for its educational purposes only an amount equal to the tax liability of its taxable competitor ("tax equivalent amount"), i.e., $35x. although neither business appears at first glance to have retained a competitive advantage over the other, subsequent dynamics could swing the advantage back to the feeder. the feeder, for instance, would regain an advantage if the taxable competitor was impelled to distribute a dividend to its shareholders, e.g., $15x. in that case the feeder would have available $65x retained income for business operations compared to the taxable competitor's activities of nonprofits are diffused, the exit costs faced by taxable businesses from an industry, the foreseeability of nonprofit competition at the time the taxable entity entered the industry, and the degree to which taxable oligopolists are already earning super competitive profits in an industry). the author concludes that the tax on unrelated businesses of nonprofits caused their profitable activities to be concentrated into areas deemed related, which concentration allowed them to inflict losses on their taxpaying competition. id. at 1038. but, why is this undesirable? presumably, congress sanctioned the competitive advantage related businesses enjoyed with respect to their taxpaying competition in recognition of the unique role played by the private, nonprofit charitable sector in american society. see the macaroni monopoly, supra note 60, at 1282 ("even in an industry with inelastic demand the untaxed business will be able to invest in improvements at a faster rate than its competitors."); klein, supra note 15, at 61-64 (congress "responded to a paranoid delusion" when it bought the unfair competition argument because (a) allowing a feeder to go untaxed will not affect the economic behavior of either the feeder or its taxable competition, (b) investors in a taxable competitor will not shift investments to the feeder because they would have to give their assets to charity to do so, and (c) the feeder will not be induced to expand because the taxable competitor's supply to the market will not decline.). 64. roche's beach, inc. v. commissioner, 96 f.2d 776, 777 (1938). [vol. 3:7 unfair business competition $50x (after payment of a $35x tax to the government and a s15x distribution to shareholders). in order to eliminate its potential competitive advantage, the feeder would have to distribute to the university not only a tax equivalent amount, but also an additional amount approximating an adequate return on investment to the shareholders of the taxable competitor. assume that the feeder is required to distribute to the university both a tax equivalent amount plus an amount representing an adequate return on investment. the university would be in a position to regain its competitive advantage by directly or indirectly reinvesting the tax equivalent amount back into the feeder as a capital contribution or loan. a statutory provision would have to be devised to prevent such a reinvestment. further, with the university receiving a greater return on investment than the shareholders of the taxable competitor (equal to the tax equivalent amount), the feeder would be in the position to lower its prices and still have the ability to distribute to the university a greater return on investment than could its taxable competition. a further statutory provision, therefore, would have to be devised to insure that the feeder maintained competitive prices. 2. capital market competition at the investor level.-apart from the fear of the 1950 congress that unrelated businesses operated by 501 (c)(3) organizations had the potential to compete unfairly with their taxable competitors for market share, was there concern as well with the potential that such tax-exempt organizations were in a position to compete unfairly as investors in the capital markets even if competition for market share at the operational level were made fair? as explained by the house committee on ways and means, dividends, interest, royalties, rents (other than on property acquired with borrowed funds), and gains on sales were not subject to the tax on unrelated business income because investments producing such "passive" income used for exempt purposes had "long been recognized as proper for educational and charitable organizations.""5 furthermore, explained the senate committee on finance, because such types of income are passive in character they "are not likely to result in serious competition for taxable businesses having similar income."6 65. h.r. rep. no. 2319, supra note 44, at 38. 66. s. rep. no. 2375, supra note 54, at 30-3 1. reprinted in 1950 u.s.c.c.s. at 3083. for cases dealing with the "active" versus "passive" income issue, see disabled am. veterans v. comnmissioner, 942 f.2d 309 (6th cir. 1991), rev'g 94 t.c. 60 (1990); fraternal order of police, illinois state troopers v. commissioner, 833 f.2d 717 (7th cir. 1987). aff g 87 t.c. 747 (1986); disabled am. veterans v. united states, 650 f.2d 1178 (ct. cl. 1981); national collegiate athletic ass'n v. commissioner, 92 t.c. 456 (1989). rev'd on other grounds. 914 f.2d 1417 (10th cir. 1990); national water well ass'n v. commissioner, 92 t.c. 75 (1989); see also rev. rul. 81-178, 1981-2 c.b. 135. 19961 florida tax review two conclusions can be drawn from the committee explanations. first, by creating an artificial distinction between active and passive investments and by categorizing rent received from the lease of real property as passive, the 1950 congress presumably was unconcerned that an exempt organization's tax free rental income could put it in a position to compete unfairly in the rental market by lowering the rent, improving the property, or paying a higher purchase price for additional real property than could be offered by a taxable investor. nor was there apparent concern that the combination of tax-free current income and freedom from capital gains tax on an eventual sale of the real property could put the exempt organization in a position to accept a lower sales price.67 the second conclusion is that the 1950 congress was unconcerned that a 501(c)(3) organization's exempt dividends, interest, and capital gains could put it in a position to compete unfairly as an investor in the capital markets by either driving the rate of return down or by outbidding taxable investors for the investment. 8 67. see thomas j. gallagher, iii, the taxation of investments by pension funds and other tax-exempt entities, 67 taxes 981, 990 (1989) ("in rev. rul. 69-574 and later in rev. rul. 78-88, the irs supported an 'active' versus 'passive' analysis for determining whether a given level of activity constituted a trade or business for purposes of calculating an entity's ubti."); see bittker & rahdert, supra note 13, at 319 ("moreover, the labels 'active' and 'passive' were accepted as though they denoted self-defining and clear-cut compartments, although in fact the spectrum of profit-oriented activity is not readily bisected."). 68. see bittker & rahdert, supra note 13, at 319. equally mysterious was the unarticulated but widely accepted assumption that charities would compete unfairly with their taxable rivals in "active" manufacturing and mercantile pursuits, but not in "passive" investment areas. no one suggested, for example, that charities would lend their endowment funds or rent their real estate for less than the going rate, and thus drive private investors in these areas out of business .... nor was there any discussion of the possibility that, if charities increased their ownership of active business enterprises, they would correspondingly reduce their ownership of marketable securities and other passive investments and, hence, compete less vigorously with taxable investors for these assets. bittker & rahdert, supra note 13, at 319. for the view that there was no clear rationale for exempting "passive" income, see kaplan, supra note 62, at 1466 ("thus, the unrelated business income tax lacks a consistent economic underpinning. rather, it is a political compromise that keeps certain customary sources of income-interests, dividends, rents, and the like-tax-free and eliminates the perceived tax advantages of actively conducting 'unrelated' commercial operations."). see also note, supra note 1, at 705-706; gallagher, supra note 67, at 989-92 (mentioning several alternative theories to support the full or partial exemption of investment income received by § 501(c)(3) organizations: (1) inasmuch as contributions to such organizations are deductible and thus excluded from the tax base, the investment earnings from the contributions should be excluded as well; (2) if a portion of a contribution is not deductible, the same proportion [vol 3:7 unfair business competition thus, although both an incorporated feeder and its incorporated competitor are required to pay corporate income tax subsequent to the revenue act of 1950, the 501(c)(3) organization, unlike the taxable shareholders of the competitor, is in a position to receive dividends from the feeder tax-free and to sell its shares of stock in the feeder free of capital gains tax. similarly, although the section 511 tax imposed by congress on the income of an unincorporated, unrelated business conducted by a 501(c)(3) organization, or by a wholly-owned pass-through entity, prevented the 501(c)(3) organization from receiving larger distributions of tax-free current income from the business for nonbusiness use than could be received by a taxable investor, the charity was still in a position to realize a higher total return on the investment by eventually selling the noninventory assets of the unrelated business free of capital gains tax. assume that the 1950 congress had elected to level the playing field for market share competition by requiring the feeder to maintain competitive prices and by affording the feeder an option to distribute a tax equivalent amount plus an amount representing an adequate return on investment to the 501(c)(3) organization for its exempt purposes as an alternative to the imposition of the corporate tax. if the feeder in the previous example receives $100x taxable income from the sale of ice cream and distributes to the university for its educational purposes a tax equivalent amount of $35x plus an additional $15x representing an adequate return on investment, the university would receive the entire $50x undiminished by tax. on the other hand, the taxable shareholders of the competitor who receive an equivalent $15x return on investment in the form of a dividend would, in the assumed 35% tax bracket, retain only $9.75x. had the feeder been required to pay federal income tax and had both the feeder and its taxable competitor declared a $15x dividend, the exempt university would have retained $15x of the dividend and the taxable shareholders of the competitor would have retained $9.75x. alternatively, assume that in lieu of the section 511 tax, an unrelated business wholly-owned by a 501(c)(3) organization or conducted through a of investment earnings therefrom should not be excluded; (3) citing george break & joseph a. pechman, relationship between the corporation and individual income taxes, 28 nat'l tax j. 341,344 (1975), a moderate tax on investment income would "reduce their ability to finance activities not directly supported by the public"; (4) citing hansmann, supra note 16, the exemption promotes efficiency in areas underserved by the private sector and compensates for nonprofits' lack of access to equity capital). "the contrary argument, that the earnings should be exempt because they are used in furtherance of the entity's exempt purpose recalls the destination of income test rejected in the 1950s legislation." gallagher, supra note 67, at 991. it is the position of this article that congress should have been able to live with the destination of income test had the problem of unfair competition been resolved through distribution of the tax on feeders and unrelated businesses to the § 501(c)(3) organization for its exempt purposes. 19961 florida tax review wholly-owned pass-through entity is afforded the same option to maintain competitive prices, and to distribute a tax equivalent amount plus an amount representing an adequate return on investment to the exempt organization for its charitable purposes. if both the unrelated business and the competitor owned by taxable investors earn $100x taxable income for the taxable year from a sale of ice cream of comparable quality and both distribute $50x to their respective owners, the university will retain the entire $50x undiminished by tax and the taxable investors of the competitor will retain $15x after payment of a $35x tax. had the section 511 tax been imposed on the university with respect to its unrelated business taxable income, both investors would have retained $15x. thus, whether the ice cream business is operated through an incorporated feeder or as a directly owned unrelated business, allowing the university to retain a tax equivalent amount as an alternative to a tax payment to the government increases its return on investment in the above example by $35x over what it could receive under the current statute. while the 1950 congress may have been unconcerned that a 501(c)(3) organization's traditional portfolio income consisting of dividends, interest, and capital gains could put the organization in a position to compete unfairly as an investor in the capital markets, clearly an increased disparity in current return on investment equal to the tax equivalent amount was not factored into the equation. little, in fact, would be accomplished by removing the potential for unfair competition for market share at the operational level only to discover an enhanced potential for unfair competition has turned up at the investment level. an additional statutory provision would have to be devised, therefore, to insure that the tax equivalent amount, optionally distributed by the unrelated business to the university as part of a plan to eliminate the business's potential for unfair competition for market share, was used to fund the university's exempt activities rather than used to augment its portfolio of investments. if such additional yield were in fact used to operate the organization's exempt activities, rather than to reinvest back into the unrelated business or add to the endowment fund, the exempt organization's substantially higher return on its investment should be viewed as no more unfair than the organization's underlying tax exemption itself. 3. loss of federal tax revenue.-the house committee on ways and means intended the revenue bill of 1950 to reduce substantially war excise taxes that had been in effect since world war ii. it was anticipated that the new tax on feeder organizations and on the unincorporated unrelated businesses conducted by certain 501(c)(3) organizations would partially compensate for the loss of revenue. by the time the bill reached the senate, the breakout of war in korea converted this tax legislation into one to raise [vol. 3:7 unfair business competition revenue to meet an increased defense budget.69 thirty years later courts were still debating the importance of the revenue raising aspect of the new tax, relative to the goal of preventing unfair competition. the framers of the revenue act of 1950 predicted that the tax on unrelated business would generate annual revenues of $100 million.7' in its first year of operation the tax raised thirty seven dollars. 2 by 1985 tax collections had risen to $39 million;73 by 1990, to $128 million;' and for the government's fiscal year ending september 30, 1995, to $294,336,706.7 1 this last figure consists only of tax collections with respect to unrelated businesses reporting on irs form 990-t. the figure does not include tax collections with respect to separately incorporated feeders reporting on the regular corporate income tax return, form 1120, or with respect to "unrelated" joint ventures reporting on the partnership return, form 1065. the figure, therefore, is an understated amount. the figure may not reflect taxable income derived from unrelated businesses on a composite basis for the additional reason of poor compliance. whatever immediate additional revenue was anticipated through imposition of the new tax, of graver concern to the 1950 congress was the potential future erosion of the tax base if the feared expansion of operations by feeders and unrelated businesses through unfair competition was not put in check.76 no congressional study was published, however, to determine 69. s. rep. no. 2375, supra note 54, at 1, reprinted in 1950 u.s.c.c.s. at 3053. 70. see infra p. 444. 71. see george cooper, trends in the taxation of unrelated business activity, 29 n.y.u. inst. on fed. tax'n 1999, 2019 (1971). 72. id. 73. steinberg, supra note 25, at 352. 74. id. 75. telephone interview with peggy reilly, office of taxpayer services, internal revenue service (may 21, 1996). 76. h.r. rep. no. 2319, supra note 44, at 39: see also house hearings of 1950, supra note 8, at 580 (testimony of rep. dingell) ("eventually all the noodles produced in this country will be produced by corporations held or created by universities ... and there will be no revenue to the federal treasury from this industry."). when the 1950 legislation was proposed, there was some fear that the acquisition of taxable business enterprises by tax-free feeder corporations would narrow the federal tax base, but this danger seems, in retrospect. overstated if not wholly erroneous. this is because the sellers of the business would presumably reinvest the proceeds of the sale in new enterprises, marketable securities, rental real estate, etc., which would produce a taxable yield to restore the status quo ante. the charitable organization purchasing the enterprise, for its part, would shift its investment from assets producing tax-free dividends, interest, and rent to equally tax-free business profits. bittker & rahdert, supra note 13, at 320. 19961 florida tax review whether and to what extent feeders and unrelated businesses were in fact reinvesting their profits back into the business as opposed to distributing them to the owner 501(c)(3) organizations for their charitable purposes." nor was there any study published to compare the loss of tax revenue resulting from the exemption afforded to feeders and unrelated businesses under the destination of income test (reduced by the potential cost of collecting such revenue) with the cost of the social benefits that were being financed by such exempt business profits.78 suppose feeders and unrelated businesses were offered the option to maintain competitive prices and to distribute a tax equivalent amount plus an amount representing an adequate return on investment to their owner 501(c)(3) organizations to be used exclusively to operate their charitable activities as an alternative to payment of the tax to the government. would the loss of tax revenue be justified by the social benefits anticipated from the additional distribution to the 501(c)(3) organization? assuming that statutory safeguards are built into the system to prevent the 501(c)(3) organization from directly or indirectly reinvesting the tax equivalent amount back into the business, the distributing business would no longer be in a position to erode the tax base by expanding with tax dollars that are not available to its competition. although unfair competition for market share would be beyond reach, there is always the possibility that a feeder or unincorporated unrelated business would still be able to expand with dollars earned through fair competition and/or the effects of inflation, even after having distributed each 77. bittker & rahdert, supra note 13, at 319. 78. several reasons additional to unfair competition and loss of tax revenue were offered to justify taxing feeder corporations and unrelated businesses. commenting on the "destination of income" test as applied to the commercial activities of colleges and other institutions, secretary of the treasury john snyder, in his testimony before the committee on ways and means, stated: "the correction of present abuses, which shift additional burdens to the rest of the population, becomes essential for reasons of equity." house hearings of 1950, supra note 8, at 19. the comment fails to address the degree to which the untaxed income was being used for charitable purposes. there was also concern that preoccupation of 501(c)(3) organizations with commercial ventures would detract from their exempt purposes. see the macaroni monopoly, supra note 60, at 1283; but see unrelated business income tax: hearings before the subcomm. on oversight of the house comm. on ways and means, 100th cong., 1 st sess. 208 (1987) (statement of the independent sector) [hereinafter ubit hearings] ("the traditional argument that running unrelated businesses diverts attention from charity is a bit threadbare-it is not clear why it is any better to have the board worry about fundraising or portfolio management than an unrelated business."). there should be added to the list of reasons justifying the new taxes: (a) the undue risk § 501 (c)(3) organizations might be willing to take with respect to their endowment funds by shifting investment funds to more speculative ventures in the hope of obtaining a higher yield; and (b) the concentration of economic power in colleges and universities. see hearings of 1947, supra note 8, at 3528. [val. 3:7 unfair business competition year a tax equivalent amount to its 501(c)(3) owner. such an expansion would result in an increasing amount of tax dollars going to the charity rather than to the government. the c.f. mueller company, for example, purchased in august 1947 for $3,495,407 for the benefit of the school of law of new york university, was sold in 1976 for $115 million cash, notwithstanding the fact that it was subject to tax on its taxable income in 26 of those 30 years. 79 through the sale of the stock of the noodle company, the university was able to add $47.5 million to its unrestricted endowment, an increase of 200%, and $67.5 million to its endowment for the benefit of the law school."0 the ability of any given 501(c)(3) organization to enjoy the benefits of such spectacular growth due to the business acumen or luck of its feeder benefactor operating in the free enterprise world is the result of the very freedom the system affords to charitable organizations. the 1950 congress did not require exempt organizations to dispose of their unrelated businesses or to pay capital gains tax on their eventual disposition, but merely to pay the same tax on operating income as their profit-motivated competition."1 it is only due to hit-or-miss fortune that the famous noodle company was acquired for the benefit of a well-recognized law school of a large private university rather than for the benefit of a 501(c)(3) organization that did not already derive support in the marketplace from public contributions, endowment funds resulting from such contributions, or income from the sale of goods or services related to its charitable purpose. c.f. mueller company's taxable income increased from $962,366.75 for 19462 to $6.1 million for 1975.3 had c.f. mueller company been afforded the option to pay its tax obligation to new york university for the operating budget of its law school rather than to the government, the increasing loss of tax revenue would have to be weighed against the benefit derived from such revenue's support of educational and legal services delivered by the school, e.g., in the form of more money for need-based scholarships, lower tuition, better research facilities, legal services to the disadvantaged, etc., or simply to meet increasing costs or to offset a decline in contributions (perhaps caused by a change in the tax laws) or diminished investment 79. see c.f. mueller co. v. commissioner, 14 t.c. 912, 923 (1950). rev'd, 190 f.2d 120 (1951); william j. ruane, nyu to sell mueller's for s 115 million. law school, university to share profit, wash. square news, sept. 29, 1976, at 1. 80. ruane, supra note 79, at 1. 81. see united states v. american college of physicians, 475 u.s. 834, 838 (1986) ("[iwn the 1950 act [congress] struck a balance between its two objectives of encouraging benevolent enterprise and restraining unfair competition by imposing a tax on the 'unrelated business taxable income' of tax-exempt organizations."). 82. c.f. mueller co., 14 t.c. at 925. 83. foremost agrees to buy for cash c.f. mueller co., wall st. j., sept. 29. 1976, at aio. 19961 florida tax review income due to market conditions. for instance, new york university itself incurred an operating deficit of $4.4 million for the taxable year ending august 31, 1975 and a deficit of $2-$3 million in the subsequent year.' assuming feeders and unrelated businesses were afforded the option to maintain competitive prices and to distribute a tax equivalent amount plus an amount representing an adequate return on investment to their owner 501(c)(3) organizations to be used exclusively to operate charitable activities, a number of safeguards in addition to those already mentioned would need to be incorporated into the statutory system. first, although it might be argued that any organization qualifying under section 170(b)(1)(a)85 as a "50% type" charity by definition receives most of its financial support from the public and therefore demonstrates its responsiveness to social need, in order to justify the loss of tax revenue to the government, the tax equivalent amount the organization may receive from feeders and unrelated businesses should not exceed a limit based on an acceptable ratio of unrelated business gross receipts to gross receipts generated by public financial support. second, both to safeguard the federal revenue and to discourage the 501(c)(3) organization from subjecting more than a certain percentage of its investment portfolio to undue risk by investing in, or accepting as contributions, unrelated businesses or feeders, there would need to be a limit imposed on the tax equivalent amount the 501(c)(3) organization may receive from feeders and unrelated businesses, determined by an acceptable ratio of the organization's basis for its assets used in feeders and unrelated businesses to the tax basis of the total investment portfolio. third, in order to discourage the 501 (c)(3) organization from diverting its attention and energies away from its charitable purposes, there would need to be a prohibition against employees of a 501(c)(3) organization receiving compensation from the feeder or unrelated business. 4. the sale-leaseback problem.-although a 501(c)(3) organization anticipating tax-free rental income from the sale and leaseback of real property appears to be in a position to outbid a taxable competitor for the purchase of the rental building or to charge lower rent on the lease of the property back to the vendor, the 1950 congress did not act to prevent this potential for unfair rental market or investment competition. of particular concern to congress was the practice that had developed among certain 84. id. 85. irc § 170(b)(1)(a) includes: (i) churches, (ii) educational organizations, (iii) medical, hospital care, medical education, medical research organizations, (iv) college or university related organizations, (v) governmental units, (vi) a governmentally or publicly supported § 170(c)(2) organization, (vii) a private foundation described in § 170(b)(l)(e), or (viii) a § 509(a)(2) or (3) organization. [vol 3:7 unfair business competition exempt organizations of borrowing all or a portion of the purchase price and amortizing the loan with its tax-free rental income from the purchased building. through this practice the exempt organization was in a position to exploit its competitive advantage over and over again without the use of its own funds. the potential for acquisition was thus unlimited by the size of the exempt organization's existing endowment fund. the practice was attractive to the taxable seller/lessee because of the potential for disposing of fully depreciated property at an inflated price and leasing it back for a low, deductible rent. as explained by the house committee on ways and means, there were three principal objections to the leveraged lease-back transaction. "first, the tax-exempt organization is not merely trying to find a means of investing its own funds at an adequate rate of return but is obviously trading on its exemption, since the only contribution it makes to the sale and lease is its tax exemption."86 the second objection stated: [i]t is altogether conceivable that if its use is not checked, exempt organizations in the not-too-distant future may own the great bulk of the commercial and industrial real estate in the country. this, of course, would lower drastically the rental income included in the corporate and individual income tax bases .... such acquisitions are not in any way limited by the funds available for investment on the part of the exempt institution. this explains why particular attention should be given to lease-backs which involve the use of borrowed funds. where an exempt organization uses its own funds, expansion of its property holdings through the leaseback device must necessarily proceed at a much slower pace.' the third objection offered was in fact a reformulation of the first one, i.e., "the exempt organization has in effect sold part of its exemption" by purchasing the property at a higher price than a taxable competitor could pay or by agreeing to lower rent on the leaseback.m a fourth objection, not mentioned in the house report, might have been the use of the leveraged sale-leaseback transaction to enable an exempt organization to accumulate real estate wealth not measured in any way by such organization's responsiveness to social needs. 86. h.r. rep. no. 2319, supra note 44, at 38-40. 87. id. at 39. 88. id. 19961 florida tax review had the 1950 act afforded the 501(c)(3) organization entering into a leveraged leaseback transaction the option to use a tax equivalent amount to finance activities related to its charitable purpose, with some appropriate mechanism to prevent the use of an equivalent amount to pay principal on the acquisition loan, and with the safeguards previously suggested incorporated into the statutory system, the exempt organization would have lost its advantage over a taxable competitor entering into a similar transaction. with the 501(c)(3) organization paying its tax liability by using an equivalent amount to fund its charitable activities, both the exempt organization and its taxable competitor would enter a sale-leaseback transaction with the prospect of an equal amount of after-tax dollars. d. the tax reform act of 1969 in february of 1953 the shareholders of clay brown & company, a corporation engaged in the sawmill and lumber business, sold all of their stock to the california institute for cancer research for a $1.3 million dollar noninterest bearing note.89 the institute agreed to make a $5,000 downpayment from the assets of the company and to pay the balance of the purchase price over a ten-year period exclusively out of the income generated by the business.90 it was agreed that the company would be liquidated immediately after closing and that the institute would lease the business assets under a five-year lease to a new corporation, fortuna sawmills, inc., owned by the attorneys for the sellers. 9' fortuna was to pay 80% of its operating profit before depreciation or taxes to the institute as rent for the assets and the institute would pay 90% of its rent as payments on the $1.3 million dollar note.92 fortuna operated the sawmill and lumber business by taking over clay brown & company's situs and virtually all of its personnel.93 the selling shareholders reported the amounts received on the note as capital gain.94 in a 1965 decision, commissioner v. clay brown,95 the supreme court, affirming the tax court and the ninth circuit, agreed that payments on the note were capital gain and not taxable as ordinary income as claimed by the commissioner. 96 the clay brown decision and a tax court case reaching a similar result, university hill foundation v. commis89. commissioner v. clay brown, 380 u.s. 563, 567 (1965). 90. id. 91. id. 92. id. 93. id. at 568. 94. id. 95. 380 u.s. 563 (1965). 96. id. [vol. 3:7 unfair business competition sioner,97 spawned no less than three separate measures included in the tax reform act of 1969 to curb the new abuse of the tax exemption as perceived by congress. fortuna was able to avoid payment of income tax on 80% of its taxable income generated by the lumber business by deducting the rent it paid to the institute for the lease of its operating assets.98 however, the very requirement to pay out a substantial portion of its taxable income to the institute and the opportunity to retain only 20% of it for working capital left fortuna in no position to compete unfairly with its taxpaying competition in the lumber market-9 rather, by converting operating income received by fortuna into "passive" rental income received tax-free by the institute, the clay brown lease enabled what was essentially unrelated business taxable income to escape tax at any level. a comparable amount of income received by a competitor pass-through entity would have been taxed once at the investor level. even with the almost 100% financing afforded the institute by the sellers of the stock, the institute's rental income escaped the reach of section 514, the sale-leaseback provision of the 1950 act, because of that section's limited purpose to tax only rent received from the lease of real property acquired or improved with debt. the clay brown transaction presented congress in 1969 with virtually the identical problem presented by the sale and leaseback of real property financed with debt nineteen years earlier. by financing the purchase of business assets with tax-free earnings generated by those assets, the exempt organization was placed in a unique position to pay a higher price than a taxable investor could afford with after-tax dollars." not using its own funds to make the purchase and not being limited by the size of its own endowment, the exempt organization could practice this form of unfair investor competition without limitation and without any "relation to public approval of the activities or purposes of the organization."'' once again, the exempt organization's only contribution to the transaction was in effect the sale of its exemption and once again there was concern that, if unchecked, the clay brown transaction could result in substantial loss of tax revenue in 97. 51 t.c. 548 (1969), rev'd, 446 f.2d 701 (9th cir. 1971), cert. denied, 405 u.s. 965 (1972). the clay brown provisions of the tax reform act of 1969 were adopted prior to the irs's 1971 victory in the united states court of appeals for the ninth circuit. 98. id. at 567. 99. id. 100. s. rep. no. 552, 91st cong., ist sess. 62-63 (1969). reprinted in 1969 u.s.c.c.a.n. 2027, 2091. 101. hearings before the house comm. on ways and means on the subject of tax reform, 91st cong., ist sess. 5359 (1969) (general explanation of treasury tax reform proposals). 19961 florida tax review the future.' 2 what especially rankled the 1969 congress was the seller's use of the exemption to obtain an inflated purchase price for their business. the seller's ability to convert ordinary income generated by operating assets into capital gain upon receipt of the very same income as installments of the purchase price for the stock only added insult to what was already considered to be an injury to the federal tax structure. 0 3 curiously, the clay brown case itself was not the best illustration of the multiple potential evils congress feared could flow from a clay brown transaction. the tax court, for instance, found the purchase price of the stock to be "within a reasonable range in light of the earnings history of the corporation and the adjusted net worth of the corporate assets, '' "° not above market value and presumably not significantly higher than a taxable competitor would pay. moreover, fortuna closed its doors after only four years of operations because of a lack of demand for lumber, and the institute was forced to sell the business for only $300,000. allowed to retain a meager 10% of the sales proceeds, the institute was able to add $30,000 to its net worth, nowhere near the $1.3 million that had been contemplated. nonetheless, congress did not stray from its purpose to discourage clay brown transactions "by eliminating the incentive for owners desiring to sell a business to exploit the tax exemption of nonprofit organizations."'0 5 effective for taxable years beginning after december 31, 1969, section 514 was amended to tax income received by any exempt organization0 6 in any form (e.g., dividends, royalties, rent) from any type of property (e.g., rental real estate, tangible personal property, corporate stock) unrelated to its 102. h.r. rep. no. 413, 91st cong., 1st sess., pt. 1, at 46 (1969), reprinted in 1970 u.s.c.c.a.n. 1645, 1691. 103. s. rep. no. 552, supra note 100, at 62-63, reprinted in 1969 u.s.c.c.a.n. at 2091. 104. clay brown v. commissioner, 37 t.c. 461, 486 (1961), aff'd, 325 f.2d 313 (9th cir. 1963), affd, 380 u.s. 563 (1965). 105. h.r. rep. no. 413, supra note 102, at 46, reprinted in 1969 u.s.c.c.a.n. at 1691. for a discussion of developments to and including the tax reform act of 1969, see cooper, supra note 71. 106. tax reform act of 1969, pub. l. no. 91-172, 83 stat. 487 (1969) (extending the unrelated business income tax to all exempt organizations except united states instrumentalities because many of such organizations had begun to engage in substantial commercial activity). some churches are engaged in operating publishing houses, hotels, factories, radio and tv stations, parking lots, newspapers, bakeries, restaurants, etc. furthermore, it is difficult to justify taxing a university or hospital which runs a public restaurant or hotel or other business and not tax a country club or lodge engaged in similar activity [sic]. s. rep. no. 552, supra note 100, at 67, reprinted in 1969 u.s.c.c.a.n. at 2096. [vol. 3:7 unfair business competition charitable functions acquired or improved with debt." under a formula essentially similar to the one enacted in 1950, the same percentage of total income received by the exempt organization was includable in gross income as the average debt for the taxable year with respect to the property bore to the average adjusted basis of such property."es the same percentage of capital gains was taxed on the sale of the property." 9 assume that taxable investors had entered into a transaction identical in terms to the facts in clay brown, liquidating the acquired lumber company and leasing the business assets to operating company. assume further that both fortuna sawmills and operating company earn $125x profit before depreciation and taxes for the taxable year and distribute, and deduct, 80% as rent, i.e., $100x, under the terms of the lease. after payment of $35x tax on the rent received, the taxable investors have available $65x, 90% of which, i.e., $58.5x, is required to amortize the acquisition note. assume that the california institute for cancer research incurred a $50x operating loss for the taxable year in the conduct of its 501(c)(3) activities after taking into account unrestricted current contributions and 107. irc § 514. under another amendment added by the tax reform act of 1969, a tax-exempt "controlling organization" is taxable on interest, annuities, royalties, and rents derived from either a taxable or tax-exempt "controlled organization." irc § 512(b)(13)(a)(b). 108. for example, "[i]f a business or investment property is acquired subject to an 80 percent mortgage, 80 percent of the income and 80 percent of the deductions are to be taken into account for tax purposes. as the mortgage is paid off, the percentage taken into account diminishes." s. rep. no. 552, supra note 100, at 63-64, reprinted in 1969 u.s.c.c.a.n. at 2092. two additional weaknesses of the 1950 legislation were addressed: (1) rental income from the lease of property is taxable under amended § 514 regardless of whether the term of the lease exceeds five years, and (2) to eliminate front-loading depreciation deductions in the early years of the debt-financed transaction when a higher percentage of income generated by the property is taxable, only straight-line depreciation is allowed. section 514(b)(3)(a) exempts from the definition of "debt-financed property" real property acquired by an exempt organization if (1) the principal purpose of the acquisition is substantially related to the exercise or performance of the organization's purposes, (2) the real property is in the neighborhood of other property owned by the organization, and (3) the property is used for such purpose within 10 years of the acquisition. section 514(c)(2)(b) excludes from acquisition indebtedness a mortgage on real property when such real property was acquired by an exempt organization by bequest or devise, so long as the organization did not agree to assume the mortgage in order to acquire the property. the period during which such mortgage will not be considered acquisition indebtedness may not exceed 10 years from the date of acquisition. 109. irc § 514(a)(1); regs. § 1.514(a)-i(a)(l)(v). for a critical view of§ 514, see bittker & rahdert, supra note 13, at 322-25. for the view that there is lacking "a systematic tax policy analysis supporting the rules regarding the taxation of debt-financed income of exempt organizations," see gallagher, supra note 67, at 991. "[o]ne must seriously question whether the approach of section 514 is correct in a non-bootstrap acquisition scenario." id. at 992; see also id., at 993-96. 1996] florida tax review income from its portfolio of stocks and bonds. had fortuna been required to maintain competitive prices and had the institute been afforded the option of either paying to the government the $35x tax imposed by section 514 or using an equivalent amount plus an additional $6.5x as a return on investment to reduce the operating deficit incurred in the conduct of its related activities, but not to make payments on debt incurred to acquire or improve assets used in activities unrelated to its charitable purposes, both the institute and the taxable investors would have had available the same $58.5x with which to make payments on the notes issued to acquire the stock of the respective lumber companies. e. variations on the theme of section 512(b)(15) it appears from the inclusion of another measure in the tax reform act of 1969 that congress stumbled upon an alternative solution to counter the threat of unfair competition other than to tax feeder corporations or unrelated businesses conducted directly by 501(c)(3) organizations. in a remarkable bit of special interest legislation designed for the benefit of the religious order operating loyola university's radio station wwl," ' the 1969 congress enacted what is now section 512(b)(15). the measure provides in substance that the income and all directly connected deductions of a federally licensed unrelated service business carried on by a religious order (or by an educational organization maintained by the order), in operation before may 27, 1959, is not subject to the tax on unrelated business income if 1) less than 10% of each year's net income from the business was used for activities which were not related to the religious order's exemption and 2) it was established to the satisfaction of the secretary that the rates or other charges for such services were competitive with those charged for similar services by persons subject to tax. according to the senate committee on finance, which introduced the measure, "in such a case there are no competitive advantages obtained by the business from the exemption, and where the exempt organization has for a long time depended on this income, to make it forego approximately half of it would constitute a serious hardship."' " not surprisingly, no explanation was offered by the senate finance committee as to why this alternative solution to the threat of unfair competition, i.e., the maintenance of competitive prices and the mandatory distribution of more than 90% of the net income of an unrelated business to the exempt organization for its charitable purposes, would not work as well for the cancer research conducted 110. see cooper, supra note 71, at 2009. 111. s. rep. no. 552, supra note 100, at 70, reprinted in 1969 u.s.c.c.a.n. at 2099. [vol 3:7 unfair business competition by the california institute in clay brown and for other worthy 501(c)(3) organizations as it would for the religious order that was the exclusive beneficiary of section 512(b)(15). admittedly a piece of special interest legislation designed to benefit one radio station operated by a particular university owned by a religious order, section 512(b)(15) carries a message more significant than the 1969 congress realized. by predicating the radio station's exemption from tax on the distribution of more than 90% of its net income to be used for activities related to the religious order's charitable purposes, section 512(b)(15) resurrected the "destination of income" principle formulated by the supreme court forty-five years earlier and abandoned the tax reforms adopted by the revenue act of 1950. the charitable destination of income, not its commercial source, is the ultimate test of exemption, the supreme court held in 1924.'12 by requiring the radio station to charge competitive rates as well as to distribute the bulk of its net income to the religious order, section 512(b)(15) was unique in its attempt to preserve the station's tax-free revenue stream for the benefit of the 501(c)(3) organization without affording the "unrelated" source of that revenue the opportunity to compete unfairly with its taxable competition." 3 112. trinidad v. sagrada orden, 263 u.s. 578, 581 (1924). 113. section 512(b)(15) was not the first attempt to resolve the unfair competition issue by mandating a distribution of income to the charity. john gardes. an attorney instrumental in new york university's acquisition of the c.f. mueller company, was quoted as suggesting: mhat if tax exemption placed a corporation so organized in an advantageous competitive position, a practical remedy would be to amend the federal tax laws to provide that tax-exempt institutions deriving profit from businesses be compelled to use currently for educational purposes a sum equivalent to the amount which a business concern having the same profits would be compelled to pay in the form of taxes. n.y.u. denies it is misusing tax exemption, herald trib., jan. 25, 1950, (in author's files). in a provision included in h.r. 2976, 81st cong., 1st sess. (1949), which was not enacted. feeder organizations were mandated to distribute 75% of their net income (other than capital gains) each year to the charity, unless the commissioner approved a plan to accumulate more. see comment, supra note 42, at 876 n. 111. other solutions to the unfair competition problem had also been suggested, "such as rigid antitrust law enforcement, direct limits on expansion of tax-exempt business, or limits on capital accumulation." the macaroni monopoly, supra note 60, at 1282 n. 13. in crosby valve & gage company, a separately incorporated feeder made a distribution to its parent, a charitable organization, and claimed a deduction under § 170 for a charitable contribution. the united states court of appeals for the first circuit observed that an unrelated business operated directly by a charity is allowed to deduct up to 5% of its taxable income for a charitable contribution to another charity. the court refused to allow the feeder to deduct the "charitable contribution" made to its own parent because, quoting legislative history, "[i]t is difficult to see why a difference in tax treatment should be allowed 19961 florida tax review section 512(b)(15) nevertheless lacks the statutory safeguards and refinements to merit wholesale expansion of its scope to include feeders and unrelated businesses of all 501 (c)(3) organizations. the proposed amendment to the tax on feeders and unrelated businesses more fully developed in appendix a to the article is an attempt to construct a statutory provision based upon the section 512(b)(15) motif, but adding sufficient safeguards to make the provision useful as a fiscal option of broad application. the amendment draws upon the analysis of the effect of distributions on the potential for unfair competition discussed above. the amendment preserves the existing tax, but grants the feeder or unrelated business an elective credit against its income tax liability for distributions made or deemed made during the taxable year to its 501(c)(3) owner on the basis of $1 credit for a combined distribution of $1 plus an additional amount (e.g., $.35) assumed to equal an adequate return on investment that a for-profit competitor would be expected to distribute to its owners. the goal is to leave the feeder or unrelated business in approximately the same "after-tax/distributions to owners" position as its for-profit competition, rather than leaving the feeder or unrelated business at a competitive disadvantage which would be the result if it were required to distribute more than 90% of its net income for the taxable year to its 501(c)(3) owner. the amendment requires the feeder or unrelated business to establish the competitiveness of its rates or charges, but supplements the facts-andcircumstances approach of section 512(b)(15) by incorporating a set of safe harbor guidelines. the goal is to establish an objective standard to prove competitive pricing without imposing a case-by-case fact-finding burden on the internal revenue service. the amount of the elective credit is subject to a number of additional limitations. in order to assure that the distributed amounts are used by the 501(c)(3) owner to fund its related activities rather than (1) reinvested back into the feeder or unrelated business as a capital contribution, loan, or collateral for a loan; (2) used to augment the 501 (c)(3) owner's investment portfolio; or (3) used to amortize debt incurred to acquire merely because in one case the income is earned directly by an educational or charitable organization, while in the other it is earned by a subsidiary of such an organization." crosby valve & gage co. v. commissioner, 380 f.2d 146, 148 (1st cir. 1967), cert. denied, 389 u.s. 976 (1967). comparing the bottom-line results to the feeder with the results to a "competing business corporation not owned by a charity," the court correctly observed that the tax savings resulting from allowing the feeder to deduct up to 5% of its taxable income for a distribution to its own parent would leave the feeder with an increased after-tax net profit with which to "finance competition in services, etc." or which would allow the charity to receive a greater return on its investment. id. at 149 at n.3. as a third option, the feeder could cut prices to a level such that its after-tax net profit would still equal its competitor's. id. in the court's view, this is precisely the unfair competition the 1950 act attempted to prevent. see also c.f. mueller co. v. commissioner, 55 t.c. 275, 297-98 (1970), aff'd, 479 f.2d 678 (3d cir. 1973). [vol 3:7 unfair business competition or improve assets used in activities unrelated to its exempt purposes, the elective credit for a taxable year available to a 501(c)(3) owner's feeders and unrelated businesses is limited on a combined basis to an amount equal to the net operating loss incurred by the 501(c)(3) owner for the same taxable year in the conduct of all of its related activities divided by 1.35 (assuming $1.00 credit for $1.35 distribution). for this purpose, the net operating loss is determined by adding net investment income and unrestricted gifts received during the taxable year to related activity gross income, excluding noncash items as deductions, but deducting capital expenditures for the acquisition of assets substantially used to further related activities. in order to cap the potential loss of tax revenue to the federal government, and to discourage the 501(c)(3) owner from subjecting more than 25% of its total investment portfolio to the risks inherent in business ventures, the amount of the elective credit available to each of a 501(c)(3) owner's feeders and unrelated businesses is reduced by four percentage points for each percentage point in excess of 25% that the value of the 501(c)(3) owner's total investment portfolio at the time of acquisition (not including assets substantially used in related activities) consists of investments in feeders and assets used in unrelated businesses. further, in order to reduce the danger that a 501(c)(3) owner could use the distributed amounts to fund activities unresponsive to social needs, the amount of the elective credit available to each of a 501(c)(3) owner's feeders and unrelated businesses is reduced by four percentage points for each percentage point in excess of 25% that the 501(c)(3) owner's gross receipts for the taxable year from all sources is derived from feeders and unrelated businesses. finally, in order to discourage a 501(c)(3) owner from diverting energy away from its charitable purposes, as a condition to electing the credit, employees and directors of the 501(c)(3) owner are prohibited from being employed by, or serving as a director of, any of such owner's feeders or unrelated businesses. f. is the elective credit sound tax policy? essentially, the elective credit against tax described in appendix a grants a feeder or unrelated business maintaining competitive pricing the option to pay regular tax to the government or to distribute a tax equivalent amount (plus an assumed adequate return on investment) to its 501(c)(3) owner to cover its current operating loss from related activities. assuming that the elective credit is as effective to eliminate the potential for unfair competition as is payment of the tax to the government, the question remains whether the social benefits anticipated from the additional distribution to the 1996] florida tax review 501(c)(3) organization justify the foregone tax." 4 that the amount of the foregone tax cannot be readily determined significantly complicates the answer. 15 assuming that the total amount of the tax lost to the government through exercise of the elective credit proves to be more than minimal, can one persuasively argue pluralism as the rationale for granting feeders and unrelated businesses the option to distribute a tax equivalent amount to their 501(c)(3) owners in lieu of paying the tax to the government? commentators who justify the exemption afforded related activities directly furthering the charitable purposes of the organization on the grounds of democratic decentralization may be reluctant to extend the same rationale for the benefit of feeders and unrelated businesses indirectly furthering the same purposes. collection of the tax otherwise lost through exercise of the credit may be justified not only for the reason that the federal government needs revenue, but also in support of the principle that congress has the duty to allocate the tax dollars collected in accordance with national priorities determined through public debate. the public debate must, nevertheless, reckon with the fact that two sources of revenue historically relied upon by the nonprofit, charitable sector for financial survival--contributions from the public and grants from the 114. see bittker & rahdert, supra note 13, at 325-26 (commenting on the taxation of unrelated business income). by reducing the amount that the exempt organization can apply to its charitable or other purposes, the tax necessarily burdens the beneficiaries of these activities, and their ability to pay ought to be considered in deciding whether and to what extent to impose the tax. yet it was evidently never suggested during the 1950 and 1969 debates that the tax on the unrelated business income of charitable organizations reflected the ability to pay of those affected by it. almost certainly, we believe, it did not, and thus made the income tax more regressive. id. the incidence of the ubit is also of importance for policy analysis.... perhaps some portion of the tax would fall on donors or grantmakers or charitable-service recipients, not just on paying consumers, owners, or suppliers of capital and labor. this subject has, to my knowledge, received no attention in the literature. steinberg, supra note 25, at 354. 115. current data applicable to 501(c)(3) organizations is insufficient to determine what the tax liability of feeders and unrelated businesses would be on a composite basis if the maximum 25% of investment assets were invested in feeders and unrelated businesses. moreover, current data is insufficient to determine on a composite basis (i) the ratio of distributions received from feeders and unrelated businesses to gross receipts received by 501(c)(3) organizations from all sources, and (ii) net operating losses (as defined in appendix a) incurred by 501(c)(3) organizations in the conduct of their related activities. cf. statistics of income bulletin, internal revenue service, spring 1995 and spring 1996. [vol 3:7 unfair business competition federal government-have in recent years diminished as a percentage of total revenue and threaten to shrink even more significantly in the future. charitable contributions to 501(c)(3) organizations dipped from 36% of total revenue from all sources in 1946 to 18% in 1982. '16 although the cause is not certain, studies indicate that federal taxes, in particular the charitable contribution deduction available to itemizers, the interplay of this deduction with the standard deduction, and, to some extent, marginal tax rates, affect the size of charitable gifts and the type of recipient. taxpayers in the highest tax brackets are most affected by a decline in marginal rates. the top marginal income tax bracket decreased from 91% in 1946 to 50% in 1982. for taxable years beginning in 1988 the top marginal income tax bracket decreased even further to 28%, with each decrease representing a tax disincentive for a high bracket taxpayer to contribute to a 501(c)(3) organization because of the diminished tax savings generated by the charitable contribution deduction. proposals to eliminate the charitable contribution deduction altogether through the enactment of a flat tax (without replacing the deduction with a credit) seriously threaten the revenue stream from public and corporate gifts historically relied upon by the charitable, nonprofit sector for financial viability."17 as private donations as a percent of total revenue have diminished, federal government support of activities conducted by 501(c)(3) organizations continues to be dictated by the prevailing political philosophy in congress and the nation and therefore remains an unreliable source for funding as well. as a case in point, "between 1982 and 1984, federal spending for activities supported by human service nonprofits declined an estimated $42 billion."' 18 finally, although the size of the average endowment fund of colleges and universities may have increased over the years, there is evidence that such funds have actually decreased in purchasing power based on the consumer price index.' 19 501(c)(3) organizations have thus been confronted with the task of meeting increasing operating expenses with diminished and unreliable revenue streams from traditional sources. if it was true in 1953, for example, that 116. ubit hearings, supra note 78, at 139 (statement of jennie s. stathis, associate director, general government division, u.s. general accounting office). 117. see charles t. clotfelter, federal tax policy and charitable giving 277 (1995). on the other hand, a decrease in the marginal tax rates increases "the after-tax income from which taxpayers can make contributions." id. at 274. see also, fred stokeld, charities fear loss of deduction under flat tax proposals, 70 tax notes 935 (feb. 19, 1996). 118. ubit hearings, supra note 78, at 239 (testimony of the national assembly of national voluntary health & social welfare organizations); see also id. at 158 (statement of marion r. fremont-smith, board member, independent sector) (discussing the decline in government participation). 119. see id. at 369 (statement of the american council on education). 19961 florida tax review "[t]he present financial plight of american colleges and universities is not an acute non-recurring illness but the aggravation of a chronic condition of many years standing,"' 2 then forty-three years later financial suffocation threatens to render the patient terminal absent the discovery of life-saving procedures. adoption of the elective credit can be justified as a measure to replace diminished revenue for the benefit of 501(c)(3) organizations with sources that are at least within the control of the organization's wholly-owned business benefactors. this is not to suggest that the elective credit should be viewed as a panacean replacement for other possible forms of direct and indirect federal government subsidization of the activities of 501(c)(3) organizations. what is more essential than the specific form of the tax subsidy and/or direct expenditure designed to benefit charitable nonprofits and their beneficiaries are the guiding principles employed in the selection. first, of necessity, the financial support afforded the charitable sector in the form of the underlying exemption from tax must remain an indirect federal tax subsidy as opposed to an annually reviewed direct government expenditure as an expression of its purpose to preserve the political independence and continuity of the sector. second, tax and social policy planners need to come to terms with the fact that the combination of exemption from tax afforded "related" activities and the itemized deduction for private gifts to charitable organizations has historically proved inadequate as measures to ensure sufficient revenue to enable the charitable sector to make ends meet. additional federal subsidization of the sector is therefore required. third, the form of the additional federal subsidy must be designed to preserve the charitable sector's political and financial independence. fourth, in an attempt to ensure that the additional federal subsidy is utilized to fund activities responsive to social needs, the subsidy should either track the nonprofit organization's revenues derived from "related" activities and/or gifts from the public, e.g., a federal direct grant program matching gifts received by the organization from private sources (over and above the indirect tax subsidy afforded the charitable contribution), or the subsidy should be targeted for a specific purpose, e.g., a need-based scholarship or loan program, a tax credit for college tuition payments, or a grant program to provide essential services to the poor. from this perspective, it is not necessary to view the elective credit solely as a life-saving provision of universal application designed to enable the nonprofit, charitable sector as a whole to assume some measure of control over its financial destiny. the credit can be more narrowly utilized as a means to enable and to encourage the charitable sector to meet specific social goals. the utilization of the credit for this purpose is suggested partly in 120. myers, supra note 52, at 368. [vol 3:7 unfair business competition recognition of several operational weaknesses, albeit correctable ones, in several of the nonprofit subsectors as the provider of public goods and services. first, a number of nonprofit subsectors providing essential public services, such as health care and higher education, lack a self-regulatory body responsible for overall planning and oversight with authority to enforce compliance with its regulations. lack of self-regulation allows for inefficiency, waste, violation of the constraint against private inurement, and ad hoc expansion of capacity and subsequent downsizing in reaction to changes in the demand for services.'2 1 second, if consumers of public goods and services are willing to pay too high a price to a for-profit enterprise as a result of their inability to judge the quality of what they or society are receiving in exchange, they are willing to pay the same high price to a nonprofit organization as well. in the case of the for-profit enterprise, the effort to maximize price and minimize cost is driven by the purpose to earn profit, a purpose that constitutes an intrinsic defect in the for-profit model as the provider of essential public goods and services. in the case of the nonprofit organization, the effort to maximize price may be driven by the necessity to meet an operating budget inflated by lack of planning, inefficiency, excessive compensation, excessive marketing for consumers of its products and services, and fund raising for a diminished pool of contribution dollars.'2 these operational failures, while serious, do 121. see robert c. degaudenzi, tax-exempt public charities: increasing accountability and compliance, 36 cath. lawyer 203 (1995) (tracing recent incidents of self-dealing and other abusive practices involving public charities and the scrutiny they have invited. id. at 204-09). see also zimmerman, supra note 22, at 341-43. zimmerman discusses two additional sources of voluntary sector failure, viz., (1) "philanthropic paternalism," the definition of community needs determined by the wealthy, who have the means to contribute to charity and thereby to influence the voluntary sector's agenda to serve themselves rather than serve the poor, and (2) "asymmetric information failure," nonprofits providing goods and services with complex characteristics, such as health care, to a wealthy group of clientele, to suggest that the nonprofit is not really delivering a social benefit. zimmerman admits that "[e]mpirical evidence on voluntary sector failure is somewhat anecdotal." id. at 343. zimmerman summarizes several studies leading to the conclusion that there are incidences of voluntary sector failure, e.g. herzlinger and krasker in 1987: "they found that the nonprofit hospitals were spending much of their tax benefits on behalf of the professional staff of the hospitals '... without providing better, cheaper, or more accessible health care in return."' id. at 344. "[s]uspicion abounds that some tax revenues are being wasted without commensurate provision of social benefits." id. at 345. 122. public perception of this type of nonprofit failure among institutions of higher education has been enhanced by negative coverage in the media. the philadelphia inquirer ran a five-part series from march 31 to april 4, 1996, maintaining that college tuition has almost tripled between 1981 and 1996, more than twice the rate of inflation, not because of a rise in demand, but because of a "chivas regal" effect-the more expensive, the better. see karen heller & lily eng, higher education: how high the price, phila. inquirer, mar. 31. 1996, at al. with the last of the "baby boomers" reaching college age in the early 1980s. 19961 florida tax review not constitute intrinsic defects in the nonprofit model as the provider of essential public goods and services. nevertheless, establishment of a series of self-regulatory bodies responsible for planning and oversight in the various nonprofit subsectors, further described in part v of the article, should be viewed as the necessary companion piece of legislation to adoption of the elective credit in the form of universal application described in appendix a.'2' demand, in fact, went down. see id. with no outside monitoring and no incentive to cut spending, increasing tuition revenues have supported an explosion in inefficiency and waste rather than an increase in the quality and accessibility of higher education-more administrators, more assistant administrators, more faculty assistants, more fundraisers, more marketers, more student amenities, more building programs. see id. as a case in point, between 1980 and 1996, the number of full-time students registered at the university of pennsylvania increased by 29; the number of administrators and nonteaching staff members increased by 1820. see id. with colleges and universities competing against each other for a diminished pool of applicants, a high percentage of their inflated operating budgets have been allocated to marketers and recruiters for students and to other budget lines thought to increase the prestige of the institution, such as fundraising and faculty whose primary strength is published research rather than teaching. see id. at a25. college presidents and deans have been chosen not based on how well they govern, but on how well they fundraise. see id. moreover, a high percentage of the gifts and grants received have been allocated to the endowment fund and an insufficient amount into the current operating budget. see id. at a24. saddled with more administrators, faculty, programs, and buildings than are needed to accommodate present demand, colleges and universities are finding downsizing extremely difficult. see id. at a24. the philadelphia inquirer series of articles made its point, but overstated the case. certainly, some percentage of the tuition increase that occurred between 1981 and 1996 was returned to students in the form of necessary increases in faculty salaries and benefits, enhanced counseling and placement services, upgrading of laboratories, libraries, and physical plant, and installation of computer systems and new technology. additionally, colleges and universities are compelled to comply with a myriad and burgeoning amount of federal regulations. further, although the authors of this series are correct to point out that some percentage of the tuition increase had occurred because of an increasing budget line for student financial aid, with more student aid being required because of the higher tuition, a spiraling effect squeezing the middle class out of the opportunity to go to college, the phenomenon is the result of lack of social planning that implicates the federal government as much as it does institutions of higher education. 123. there have been legislative proposals to deny tax exemption to a nonprofit entity unless the organization can satisfy a quantifiable test proving the delivery of adequate social benefits. see zimmerman, supra note 22, at 346-48. for the view that a certain degree of nonprofit inefficiency is an expected price to pay for nonprofit innovation, see steinberg, supra note 25, at 361-62. if the delivery of adequate benefits to low-income beneficiaries is implicitly the sole test to be applied to each and every nonprofit organization in order to retain tax exemption, the test reflects a constricted view of the role of nonprofits in american society. the performance of many essential public services by nonprofits, e.g., the conduct of basic and applied research by a university, indirectly benefit all income groups. further, it is not always easy to determine which income groups benefit from the activities of nonprofits, let alone to quantify the benefit. see charles t. clotfelter, who benefits from the nonprofit sector?, the univ. of chi. press (1992). additionally, if it is determined that a nonprofit [vol 3:7 unfair business competition this is not to infer that there do not already exist vast numbers of 501(c)(3) organizations efficiently delivering reasonably priced high quality goods and services to the public. nor is it to infer that measures to correct whatever operational deficiencies now exist in certain subsectors of the nonprofit, charitable sector will additionally eliminate their pressing need to acquire a revenue source to replace traditional sources threatening to shrink significantly in the future. it is only to suggest that from the point of view of tax policy efficient utilization of financial resources, planning, and oversight are the necessary companions to a broad-based federal subsidization of the activities of nonprofit charitable organizations. it is also to suggest that the elective credit can be utilized for purposes other than to address in broad terms the financial crisis confronting the entire charitable sector. the credit can be more narrowly utilized to fund a nonprofit organization's sub-budget specifically targeted to meet social needs that are being inadequately addressed at the present time (in a somewhat modified form from that described in appendix a). the credit could be made available, for instance, on condition that the required distributions by the feeder or unrelated business to its 501 (c)(3) owner be used exclusively to fund need-based college scholarships, with all administrative and overhead expenses necessary to conduct the scholarship program coming from the organization's general budget. or, revenues generated by the credit could be used in similar fashion to fund sub-budgets exclusively targeted to deliver any number of goods and services to the disadvantaged, such as healthcare, nursing home care, day care centers, legal representation, a trip to a major art museum, or seats at a symphony orchestra concert, with a general budget again supplying the required administrative and overhead support. subsector is devoting a low percentage of its resources to the needs of the poor, as lester m. salamon has determined with respect to the social services, then the question to ask is, "'why is this the case?" see clotfelter, id. at 171. salamon provides the answer. in order to cope with their dependancy on external revenue sources over which they have little control, nonprofit human service agencies have had to broaden their sights "well beyond the needs of the poor..... ic "the one truly effective countervailing force in the system has been the availability of government funding targeted to the poor. based on our statistical analysis, it has been the availability of such funding that has allowed or encouraged the nonprofit sector to focus on the poor to the limited extent it has." id. if, then, the government cuts back its financial support granted to a nonprofit organization targeted to aid the poor, is the solution to deny tax exemption to the nonprofit entity, or is it to seek a revenue source to enable the entity to aid the poor, including reinstatement of government funding? similarly, if it is found that "the bulk of the benefits of the activities of nonprofit arts and cultural organizations are realized by people in the upper half of the income distribution .. .", as dick netzer has so found (id. at 202), is the solution to add to the financial pressures already confronting symphony orchestras and museums by denying them tax exemption, or is it to attempt to find a method to increase access to, and interest in, their benefits for people in the lower half of the income distribution? 19961 florida tax review it is doubtful that the present resources of federal agencies are up to the task of administering and enforcing the use of the elective credit in this fashion, let alone administering and enforcing the tax on unrelated business income as it currently exists. the vital subject of compliance is explored in part v of the article. iv. the courts search for statutory meaning: forty-six years wandering in the desert a. "trade or business": in pursuit of a definition unless one of the specific exceptions is applicable, gross income of a 501(c)(3) organization is "includible in the computation of unrelated business taxable income if (1) it is income from trade or business, (2) such trade or business is regularly carried on by the organization,"24 and (3) the 124. regs. § 1.513-1(a) (as amended in 1983). for a discussion of "regularly carried on," see regs. § 1.513-1(c); national collegiate athletic ass'n v. commissioner, 914 f.2d 1417 (10th cir. 1990) (holding that ncaa's share of net revenues from the sale of programs and advertising space therein for the men's division i basketball championship was not derived from a business "regularly carried on."). in 1991 the internal revenue service announced that it would not follow the tenth circuit ncaa decision. i.r.s. t.a.m. 91-47-007 (aug. 16, 1991) ("the tam"). see james r. hasselback and rodney l. clark, colleges, commerciality, and the unrelated business income tax, 74 taxes 335, at 339 (may, 1996). on the other hand, proposed regulations issued in january, 1993 take the position that revenue received from a corporate sponsor by a 501(c)(3) organization conducting a bowl game, where the organization "acknowledges the sponsorship payment by adding the corporation's name to the title of the event," does not constitute advertising "because it does not promote the sponsor's service, facility or product." prop. regs. § 1.512(a)-l(e), ex. 2(i). the proposed regulations additionally confirm that the sale to commercial broadcasters of the right to broadcast the bowl game on television and radio, as well as admission fees, are not taxable to the 501 (c)(3) organization. id. see mary e. monahan, unfair competition or fundraising? a proposal to modify the regularly carried on test of the unrelated business income tax, 10 am. j. of tax pol'y 73 (1992) (proposing a two-part test to be substituted for the "regularly carried on" test. '"the test will first examine whether the purchaser of the goods or services derives more than an insignificant commercial benefit from the purchase. if the commercial benefit is insignificant, the activity would not be commercial and would not be subject to ubit. if the commercial benefit to the purchaser is significant, the test would then examine whether the activity was intended and operated as a fundraiser with full disclosure of profit and the approval of the membership of the organization. if the activity lacks one of the factors of the second part of the test, it would be a business subject to ubit." id. at 73-74.). it is indisputable that intercollegiate athletics has become "big business. in 1988 alone, the 104 division i-a college football teams made over $500 million through gate, television, and licensing receipts and $52 million in bowl game revenues. in 1995, with the so-called 'bowl allicance' between the tostitos fiesta bowl, the federal express orange bowl, and the nokia sugar bowl, the average payout per team per bowl game was over $8 million." hasselback and clark, at 340. observing that a loss in a late-season game could send a team to a far less lucrative bowl encounter than a win, malcolm moran, writing in the new [vol. 3:7 unfair business competition conduct of such trade or business is not substantially related (other than through the production of funds) to the organization's performance of its exempt functions."' the revenue act of 1950 provided no definition of the phrase "trade or business" for purposes of the new tax.126 the senate report accompanying the 1950 revenue bill offered the assurance, however, that the term had the same meaning for purposes of the tax on unrelated trade or business as it had elsewhere in the code, citing as a specific reference the predecessor of section 162127 which allows as a deduction ordinary and necessary expenses incurred in carrying on a trade or business." the difficulty with this clarification is that neither the code nor the treasury regulations at the time of the enactment of the 1950 legislation or ever after has supplied an all-purpose definition. nor can much be gleaned from judicial interpretation of the predecessor of section 162 preceding the senate report.' by the time of the enactment of the 1950 legislation the supreme court had decided two major cases dealing with the meaning of the phrase "trade or business" as used in the predecessor of section 162: deputy v. du pont" and higgins v. commissioner.32 faced with the question of whether a corporate shareholder was engaged in a trade or business when he sold some of his stock short in order to preserve the value of his investment, the majority of the court in du pont in effect sidestepped the issue, disallowing the short sale expenses on the grounds that they were neither york times, commented: "[n]o college player should have to live with the consequences of a missed extra point that cost his school more than s7 million." malcolm moran, bowl alliance raises the stakes too high, the n.y. times, dec. 2, 1996, at c3. 125. section 513(a) excludes from the reach of the tax any trade or business: (1) in which substantially all the work. . . is performed for the organization without compensation; or (2) which is carried on ... by the [charitable] organization primarily for the convenience of its members, students, patients, officers, or employees . . .; or (3) which is the selling of merchandise, substantially all of which has been received by the organization as gifts or contributions. irc § 513(a) (formerly irc § 422(b) (1939)). an example of the first exception is an "exempt orphanage running a second-hand clothing store" where "substantially all the work is performed by volunteers without compensation." s. rep. no. 2375, supra note 54, at 108. reprinted in 1950 u.s.c.c.a.n. at 3166. an example of the second exception "would be a laundry operated by a college for the purpose of laundering dormitory linens and the clothing of students." id. an example of the third exception is a thrift shop. see regs. § 1.513-1(e). 126. see irc § 513(a) (formerly irc § 422(b) (1939)). 127. irc § 162(a) (formerly irc § 23(a) (1939)). 128. s. rep. no. 2375, supra note 54 at 106. reprinted in 1950 u.s.c.c.s. at 3165. 129. see commissioner v. groetzinger, 480 u.s. 23. 27 (1987). 130. id. the supreme court has provided a brief judicial history of the phrase "trade or business." id. 131. deputy v. du pont, 308 u.s. 488 (1940). 132. higgins v. commissioner, 312 u.s. 212 (1941). 19961 florida tax review ordinary nor necessary. in higgins, however, the court squarely addressed the issue, holding that an investor who incurred salaries and other expenses in managing his portfolio of stocks and bonds was never engaged in a business no matter how regular and continuous the investor's activity. inasmuch as the 1950 congress had already determined that gross income, less related expenses, derived from most investment activity engaged in by a 501(c)(3) organization was to be excluded from unrelated business taxable income,' 33 neither supreme court decision illuminated the trade or business landscape painted by the 1950 legislation. more prophetic was justice frankfurter's attempt at a definition in his concurring opinion in du pont: "'carrying on any trade or business,' within the contemplation of § 23(a), involves holding one's self out to others as engaged in the selling of goods or services. this the taxpayer did not do."'" 1. the 1958 regulations.-in the summer of 1958 the treasury department adopted a set of regulations interpreting the code provisions imposing the tax on unrelated businesses.' 35 echoing the senate report's earlier reference to section 23(a), the 1958 regulations provided that "the term 'trade or business' has the same meaning as it has in section 162."' 136 in the eight years that had elapsed between the issuance of the senate report and the 1958 regulations, however, little had developed on the judicial horizon to shed further light on the definition as it related to the deduction for business expenses. what is more significant is the inference that can be drawn from both the senate report and the 1958 regulations as to the scope of the term in the context of the tax on unrelated businesses. it is clear that both congress and the treasury contemplated that a trade or business conducted by a 501(c)(3) organization could be substantially related to the organization's performance of its exempt purpose as well as substantially unrelated. the senate report offered as examples of related businesses "a wheat farm operated by an exempt agricultural college as part of its educational program" and athletic activities conducted by an educational organization.'37 the 1958 regulations added to the list of substantially related businesses "a university radio station or press ... operated primarily as an integral pait of the educational program of the university" and the sale of articles made by handicapped persons as 133. irc § 512(b)(1)-(5) (formerly irc § 422(a)(i)-(5) (1939)). 134. du pont, 308 u.s. at 499. 135. t.d. 6301, 1958-2 c.b. 197. the 1958 regulations adopted under the 1954 code were for the most part a readoption of the 1952 regulations adopted under the 1939 code. see t.d. 5928, 1952-2 c.b. 181. 136. regs. § 1.513-1(a)(1) (as amended by t.d. 6301, 1958-2 c.b. 197). 137. s. rep. no. 2375, supra note 54 at 107, reprinted in 1950 u.s.c.c.s. at 3165. [vol. 3:7 unfair business competition part of their rehabilitation training. 3' it appears, therefore, that whatever meaning the term "trade or business" held in the context of the 1950 legislation should apply equally to describe those businesses substantially related to the exempt purposes of the organization as well as to those substantially unrelated. 2. the 1967 regulations.-in december of 1967 the treasury department amended the 1958 regulations in an attempt to bring into sharper focus the meaning of the term "trade or business" in the context of the tax on unrelated businesses. 3 9 the 1967 regulations contained the following salient provisions relating to the meaning of the term: (1) "for purposes of section 513 the term 'trade or business' has the same meaning it has in section 162";"4 (2)a trade or business "generally includes any activity carried on for the production of income from the sale of goods or performance of services"; 4' (3) a trade or business for purposes of the tax on unrelated businesses is not limited to integrated aggregates of assets, activities and good will which comprise businesses for the purposes of certain other provisions of the internal revenue code. activities of producing or distributing goods or performing services from which a particular amount of gross income is derived do not lose identity as trade or business merely because they are carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization; 142 and (4) trade or businesses can be related to the purposes for which exemption is granted as well as unrelated to such purposes. 43 a. the reference to section 162.-although it appears at first glance that the 1967 regulations merely repeated earlier references to section 162 without further significance, two circuit court opinions handed 138. regs. § 1.513-1(a)(4) (as amended by t.d. 6301, 1958-2 c.b. 197). 139. proposed regulations were announced in technical information release 899 (april 14, 1967). final regulations were set out on december 11, 1967. effective for taxable years beginning after december 12, 1967. t.d. 6939, 1968-1 c.b. 274. 140. regs. § 1.513-1(b) (as amended by t.d. 6939, 1968-1 c.b. 274). 141. id. 142. id. 143. see id.; regs. § 1.513-1(d)(2) (as amended by t.d. 6939, 1968-1 c.b. 274). "trade or business is 'related' to exempt purposes, in the relevant sense, only where the conduct of the business activities has causal relationship to the achievement of exempt purposes...." id. 19961 florida tax review down subsequent to the 1958 regulations infused new meaning into the 1967 pronouncement that the phrase "trade or business" has for purpose of section 513 the same meaning it has for purposes of the deduction for business expenses. in hirsch v. commissioner,"4 the ninth circuit held that an activity cannot be a business for purposes of the deduction unless the basic and dominant intent behind the activity is ultimately to make a profit, "i.e., taxable income."1 45 the court refused to allow business expenses claimed by an officer and director of corporation because there was no understanding that the officer/director would be compensated for his activities. 146 similarly, in lamont v. commissioner,4 7 the second circuit found that the taxpayer's activities as a writer, publisher, and lecturer did not constitute a trade or business because the most important criterion, genuine profit motive, was lacking. although earlier cases suggested that profit motive was an essential element for the allowance of the business expense deduction, the ninth and second circuit opinions brought this requirement into sharp focus just several years preceding the issuance of the 1967 regulations.1 4 1 one can only conject whether the 1967 regulations meant to imply by the reference to section 162 that an activity conducted by a 501(c)(3) organization is not trade or business, related or unrelated, unless the dominant or "genuine" intent behind the activity is to make a profit. the regulations do not use the words "dominant intent" and "profit" in defining the term. describing a related trade or business as one that contributes importantly to the accomplishment of the organization's exempt purposes, 49 could the 1967 regulations have possibly meant that the intent behind related business activity is primarily a desire for profit? b. "[t]he term 'trade or business'. . . generally includes any activity carried on for the production of income from the sale of goods or performance of services. "pl--critical to the meaning of this provision is whether the word "income" means gross income or profit. in other words, is the phrase "activity carried on for the production of income" meant to paraphrase the profit motive test of hirsch and lamont? read in their entirety, the 1967 regulations offered a number of indications that the word "income" meant gross income and not profit. in 144. hirsch v. commissioner, 315 f.2d 731 (9th cir. 1963). 145. id. at 736. 146. id. 147. lamont v. commissioner, 339 f.2d 377 (2d cir. 1964). 148. cf. white v. commissioner, 227 f.2d 779 (6th cir. 1955), (disallowing expense deductions because transaction not entered into for profit), cert. denied, 351 u.s. 939 (1956). 149. regs. § 1.513-1(d)(2) (as amended by t.d. 6939, 1968-1 c.b. 274). 150. id. § 1.513-1(b) (as amended by t.d. 6939, 1968-1 c.b. 274). [vol 3:7 unfair business competition illustrating the meaning of the phrase "trade or business," the regulations repeatedly refer to activities of producing or distributing goods or performing services from which "gross income" is derived.'' moreover, the words "gross income" and "income" are used interchangeably.5 2 additionally, having used the word "profit" a scant two times in the text of the regulations, the drafters in no instance explained the phrase "trade or business" as any activity carried on to derive profit from the sale of goods or the performance of services. 5 3 the regulations made it clear that trade or business substantially related to the exempt purposes of the organization can receive "gross income," not just businesses substantially unrelated." assuming the phrase "activity carried on for the production of income" implies a motive to produce gross income, can it be said that an organization conducting a related trade or business has such a motive? presumably, a 501(c)(3) organization such as a university that charges tuition in order for students to attend classes, thereby deriving gross income, intended to generate gross income from the performance of services. but this intention does not imply a further intention 151. e.g., id. ("activities of producing or distributing goods or performing services from which a particular amount of gross income is derived .. "). regs. § 1.513-1(d(l) provides: "gross income derives from 'unrelated trade or business,' within the meaning of [irc] section 513(a), if the conduct of the trade or business which produces the income is not substantially related ... to the purposes for which exemption is granted." id. regs. § 1.513-1(d)(2) refers to "the conduct of trade or business from which a particular amount of gross income is derived" and states further. "whether activities productive of gross income contribute importantly to the accomplishment of any purpose for which an organization is granted exemption depends in each case upon the facts and circumstances involved." 152. e.g., id. § 1.513-1(d)(1) (as amended by t.d. 6939, 1968-1 c.b. 274) ("gross income derives from 'unrelated trade or business,' within the meaning of [irci section 513(a), if the conduct of the trade or business which produces the income is not substantially related . .. to the purposes for which exemption is granted."); see also id. § 1.513-1(d)(4)(iv) (as amended by t.d. 6939, 1968-1 c.b. 274) (example six of the regulation states: "therefore, notwithstanding the fact that the production of income from advertising utilizes the circulation developed and maintained in performance of exempt functions, such income is gross income from unrelated trade or business."). 153. e.g., id. § 1.513-1(b) (as amended by t.d. 6939, 1968-1 c.b. 274). this regulation uses the word "profit" as follows: "however, where an activity carried on for the production of income constitutes an unrelated trade or business, no part of such trade or business shall be excluded from such classification merely because it does not result in profit." id. does the sentence indicate that the drafters are using "income" to mean gross income and "profit" to mean an excess of gross income over expenses, or are the two words being used interchangeably? compare to the last sentence of irc § 513(c) added by the tax reform act of 1969. see irc § 513(c). 154. e.g., regs. § 1.513-1(d)(4)(i) (as amended by t.d. 6939, 1968-1 c.b. 274) ("gross income derived from charges for the performance of exempt functions does not constitute gross income from the conduct of unrelated trade or business."). 19961 florida tax review to derive profit from the classroom, as the gross income may be needed to match expenses. inasmuch as the regulation did not require a dominant intent to produce gross income as the driving force of the activity, a motive to produce gross income can be consistent with a dominant intent to further the exempt purposes of the organization. moreover, the regulations did not illustrate the phrase "activity carried on for the production of income" in terms of motive. rather, the phrase is recast-"the production or distribution of the goods or the performance of the services from which the gross income is derived"' 55 -emphasizing the nature of the activity that generates the gross income rather than the motive behind the activity. c. a trade or business ". . . is not limited to integrated aggregates of assets, activities and good will which comprise businesses for the purposes of certain other provisions of the internal revenue code. " 6-one of the treasury department's reasons for issuing the 1967 regulations, if not the primary reason, was to lay the foundation for the taxation of advertising revenue received by an exempt organization even though the advertising is published in a journal that editorially furthers the exempt purposes of the organization.5 7 to this end, the regulations fragmentized what would otherwise be considered an integrated business, e.g., the publication of the journal, into its component parts, e.g., the advertising, circulation and editorial components, in order to be able to treat the advertising component as a separate business. hence, the regulations determined the related versus unrelated issue with respect to each activity conducted by an exempt organization rather than with respect to each integrated business.15' 155. id. § 1.513-1(d)(2) (as amended by t.d. 6939, 1968-1 c.b. 274). 156. id. § 1.513-1(b) (as amended by t.d. 6939, 1968-1 c.b. 274). 157. see william j. lehrfeld, the unfairness doctrine: commercial advertising profits as unrelated business income, 23 tax lawyer 349 (1970). 158. regs. § 1.513-1(b) provides: thus, for example, the regular sale of pharmaceutical supplies to the general public by a hospital pharmacy does not lose identity as trade or business merely because the pharmacy also furnishes supplies to the hospital and patients of the hospital in accordance with its exempt purposes.... similarly, activities of soliciting, selling, and publishing commercial advertising do not lose identity as [sic] trade or business even though the advertising is published in an exempt organization periodical which contains editorial matter related to the exempt purposes of the organization. id.; see id. § 1.513-1(d)(4)(iv) (as amended by t.d. 6939, 1968-1 c.b. 274) (ex. 6, 7). the publisher of the new england journal of medicine challenged the validity of the 1967 fragmentation regulation as contravening congressional intent. see massachusetts medical soc'y v. united states, 514 f.2d 153 (1st cir. 1975). the first circuit agreed with the taxpayer. id. the case was decided after the 1969 congress codified the fragmentation regulations by enacting irc § 513(c), the decision, therefore, applied only to taxable years beginning before the 1969 amendment. id. regs. § 1.512-1(d)(2), the first circuit observed, [vol 3:7 unfair business competition 3. the tax refonn act of 1969.-noting the controversy swirling around the issue as to whether the 1950 congress had intended a scalpel to be applied to an integrated business so that it might be dissected into its component parts, and with the avowed purpose of codifying the scalpel invented by the 1967 regulations,5 9 the 1969 congress added the regulations' fragmentation language to the code as subsection 513(c): for purposes of this section, the term "trade or business" includes any activity which is carried on for the production of income from the sale of goods or the performance of services. for purposes of the preceding sentence, an activity does not lose identity as a trade or allows the excess of expenses attributable to the editorial content of the magazine over income derived therefrom, i.e., a loss produced solely by the exempt related business component of the magazine, to offset advertising taxable income, i.e., the unrelated business component. observed the court: "it is doubtful that congress would have approved such an anomalous result." massachusetts medical soc'y, 514 f.2d. id. at 156. in american medical ass'n v. united states, 887 f.2d 760 (7th cir. 1989). the ama challenged the validity of regs. § 1.512-1(a)-(f) governing the allocation of revenue and expenses between a journal's exempt editorial activities and its taxable advertising activities. for a discussion and generally critical view of the fragmentation regulations, see thomas r. moore, current problems of exempt organizations, 24 tax l. rev. 469, 472, 474-76 (1969); liles & blum, supra note 2, at 50-54; john m. donahue, unrelated business income of tax exempt organizations, 37 n.y.u. inst. on fed. tax'n § 27.0611] (1979); the macaroni monopoly, supra note 60, at 1291. the author of the macaroni monopoly acknowledges that if a university radio station whose programs further educational purposes is taxed on its advertising income, the "exemption for the radio station itself is meaningless" because advertising income is usually a radio station's only income. id. additionally, although exempt publications "compete for advertising, their income from this source is necessarily limited by the size and quality of their readership. when a publication like the national geographic magazine expands, the expansion would presumably serve the purpose for which the geographic society was granted its tax exemption." id. at 1291-92. nevertheless. the author finds the fragmentation provisions of the 1967 regulations acceptable because the tax will only apply to publications whose total subscription and advertising income exceed expenses. id. at 1292. 159. in 1968 the senate approved a measure to exempt advertising revenue in exempt journals, but the conference committee eliminated it. the senate also voted down a measure to delay application of the new regulations for a period of one year. s. rep. no. 1497, 90th cong., 2d sess. 11 (1968). in referring to the 1967 regulations. the house committee on ways and means considering the 1969 tax reform act commented: in general, [your committee] is in agreement with the purpose of the regulations. your committee believes that a business competing with taxpaying organizations should not be granted an unfair competitive advantage by operating tax free unless the business contributes importantly to the exempt function. it has concluded that by this standard, advertising in a journal published by an exempt organization is not related to the organization's exempt functions, and therefore it believes that this income should be taxed. h.r. rep. no. 413, supra note 102, at 50, reprinted in u.s.c.c.a.n. at 1695. 19961 florida tax review business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization. where an activity carried on for profit constitutes an unrelated trade or business, no part of such trade or business shall be excluded from such classification merely because it does not result in profit. 160 although the supreme court in united states v. american bar endowment 6' refers to the first sentence of subsection 513(c) as defining a trade or business, 16 the language is presumably not intended as an allencompassing definition for purposes of a tax on unrelated trade or business. the word "includes" in the first sentence, as originally appearing in the 1967 regulations, most likely is directed at including a component part of an integrated business, i.e., an activity, within the grasp of the tax as well as a whole business. keen on wheeling integrated businesses into the operating room for obligatory surgery, the 1969 congress unfortunately codified the ambiguity of the word "income" in the first sentence as well. does the use of the word "profit" in the third sentence indicate that congress knew the difference between "income" and "profit" and deliberately chose not to use "profit" in the first sentence? is the word "profit" associated only with an unrelated trade or business, whereas "income" is associated with any trade or business, related or unrelated? or, is subsection 513(c) simply using the two words "income" and "profit" interchangeably?'63 160. irc § 513(c). section 513(c) was added by the tax reform act of 1969. see tax reform act of 1969, pub. l. no. 91-172, § 502(c), 83 stat. 487, 576. the supreme court, in united states v. american college of physicians, 475 u.s. 834 (1986), did not challenge the validity of the fragmentation rationale embodied in § 513(c). 161. 477 u.s. 105 (1986). 162. id. at 110. 163. the senate committee on finance drafted § 513(c) in narrower terms, to be limited to advertising in otherwise exempt journals, a sale by a hospital pharmacy of drugs to persons other than hospital patients, and the operation of a race track by an exempt organization. s. rep. no. 552, supra note 100, at 76, reprinted in 1969 u.s.c.c.a.n. at 2104. the senate committee interpreted "an activity carried on for the production of income" to mean "net income." the senate committee further stated: under both the house and committee versions of the bill, an organization which publishes more than one magazine, periodical, etc., may treat any of these on a consolidated basis in determining its unrelated trade or business income so long as each such periodical, etc., is 'carried on for the production of income.' the organization, however, would not be permitted to consolidate the losses of a publication not carried on for the production of income with the profits of other publications which are carried on for profit. [vol 3:7 unfair business competiion 4. decisions in the 1980s.-stepping into the middle of this fugue of statutory interpretation written contrapuntally by congressional tax committees and the treasury during the previous three decades, courts in the 1980s were confronted with the meaning of the phrase "trade or business" for purposes of the tax on unrelated businesses with little more than ambiguity to guide them. faced with the issue in louisiana credit union league v. united states"6 of whether a business league exempt under section 501(c)(6) was engaged in a trade or business through the activities of endorsement and promotion of insurance, data processing, and debt collection service, the fifth circuit held that the proper test is whether the organization "is engaged in extensive activity over a substantial period of time with the intent to earn a profit."'65 noting that section 513(c)---"any activity which is carried on for the production of income" "-first raises the issue of motive, the court allowed itself to be guided by the regulations to the "familiar jurisprudence of section 162" and in turn to the conclusion that the statutory standard must be a motive for profit.' 67 implicit in the standard formulated by the fifth circuit is the requirement that the profit be earned from the sale of goods or the performance of services. under this standard, the court found that the league was engaged in a trade or business.16s finding the "carried on for the production of income" language of subsection 513(c) "quite clear," the fourth circuit in carolinas farm & id. the conference committee followed the house bill, but in the third sentence of § 513(c) substituted the word "profit" for "income," i.e., "where an activity carried on for profit" rather than 'vhere an activity carried on for income." see conf. rep. no. 782. 91st cong., ist sess. (1969), reprinted in 1969 u.s.c.c.a.n. 2392, 2406. presumably, the purpose of the third sentence of § 513(c) is to allow the consolidation of the losses of one periodical published by an exempt organization with the profits of another periodical published by the same organization when the advertising in both is profit-motivated. see cooper, supra note 71. at 2010; see also kaplan, supra note 62, at 1438 (applying § 513(c) to support author's position that a university's intercollegiate athletic program can be a trade or business separate from its physical education program). as to whether broadcast revenues can be treated as a trade or business separate from the intercollegiate athletic program, see kaplan, supra note 62, at 1436 n.35. 164. louisiana credit union league v. united states, 693 f.2d 525 (5th cir. 1982). although organizations exempt from income taxation under categories other than § 501 (c)(3) are not the focus of this article, the principles developed in cases dealing with the tax on unrelated business applicable to such organizations can be, and have been, applied to the activities of § 501(c)(3) organizations. see united states v. american bar endowment, 477 u.s. 105, at 110 n. 1 (1986) (citing several appellate court decisions dealing with organizations exempt under § 501(c)(6) with respect to the definition of a trade or business in applying the term to the activities of a § 501(c)(3) organization). 165. id. at 532. 166. id. at 531. 167. id. at 532. 168. id. at 534. 19961 florida tax review power equipment dealers ass'n v. united states'69 also equated that language with the profit motive test to hold a trade association taxable on insurance premium rebates received from a commercial carrier. the court said: "[d]efining an activity as a trade or business on the basis of the taxpayer's motive for conducting it arguably effectuates congress's intent since an activity conducted with a profit motive and not substantially related to a charitable end 'presents sufficient likelihood of unfair competition to be within the policy of the tax.' 26 c.f.r. 1.513-1(b)."'"7 once again, the inference can be drawn that an exempt organization's primary motive, or at least one motive, for conducting a trade or business substantially related to its charitable purpose is by definition a desire for profit. in a 1984 decision, professional insurance agents of michigan v. commissioner,17 1 the sixth circuit explicitly followed the logic of louisiana credit union league in holding another business league taxable on its income received from splitting insurance premiums with a commercial carrier in exchange for the organization's promotion of the insurance product among its membership. 72 similarly, the tax court has either explicitly or implicitly assumed that the word "income" in the first sentence of section 513(c) means "profit" or has extracted that conclusion from the reference to section 162 and the hirsch rationale. 7 3 accordingly, the tax court has consistently determined that the proper test to determine the presence of a trade or business is whether the organization is conducting the activity with a predominant motive, or at least a motive, for profit. 74 it was in this judicial setting that the supreme court decided united states v. american bar endowment'm in 1986. american bar endowment 169. 699 f.2d 167, 170 (4th cir. 1983). 170. id. at 170 (quoting regs. § 1.513-1(b)). 171. 726 f.2d 1097 (6th cir. 1984). 172. id. at 1103-04. 173. see veterans of foreign wars, mich. v. commissioner, 89 t.c. 7, 20 (1987) ("if an activity is carried on for the production of income from the sale goods or the performance of services, then it is a 'trade or business' within the meaning of § 513(c).... in determining whether petitioner carried on the christmas card program for the production of income, our inquiry is directed at petitioner's intent in carrying on the activity. we must determine whether petitioner carried on the christmas card program with the intent of producing income, or stated another way, whether petitioner had a profit motive."). see also national water well ass'n v. commissioner, 92 t.c. 75, 84 (1989). 174. see national water well ass'n v. commissioner, 92 t.c. 75, 84-85 (1989); veterans of foreign wars, mich. v. commissioner, 89 t.c. 7, 20 (1987); st. joseph farms v. commissioner, 85 t.c. 9, 20 (1985); professional ins. agents v. commissioner, 78 t.c. 246, 259 (1982), aff'd, 726 f.2d 1097 (6th cir. 1984); see also kaplan, supra note 62, at 1438 (equating the word "income" in § 513(c) with "profit," and concluding that an activity is a trade or business if at least one of the motives for operating it is the desire for profit). 175. 477 u.s. 105 (1986). [vol. 3:7 unfair business competition (abe) is a 501(c)(3) organization devoted to advancing legal research and to promoting the administration of justice. abe has automatically as its membership all members of the american bar association. during the taxable years in question abe provided group life, health, accident and disability insurance to its members. in return for choosing the insurer, negotiating premium rates, soliciting its members, collecting the premiums, and screening claims for benefits, abe received all dividends (refund of excess premiums) declared by the insurance carriers. as a condition to participation in an insurance program, members were required to agree to allow abe to keep the dividends rather than distribute them to the membership. 176 after reciting section 513(c)'s definition of a trade or business as "any activity which is carried on for the production of income from the sale of goods or the performance of services" and noting in footnote 1 that "it]he standard test for the existence of a trade or business for purposes of § 162 is whether the activity 'was entered into with the dominant hope and intent of realizing a profit,' ,.n the supreme court determined that abe's insurance program "falls within the literal language of these definitions."'7 in order to assure itself that abe's activities constituted both the sale of goods and the performance of services, and possessed the general characteristics of a trade or business, the court compared the organization's insurance programs to activities that potentially could be, or in fact are, carried out by taxable entities: "certainly the assembling of a group of better-than-average insurance risks, negotiating on their behalf with insurance companies, and administering a group policy are activities that can be-and are-provided by private commercial entities in order to make a profit."'79 because the claims court' 80 and court of appeals for the federal circuit 8 ' had determined that abe lacked a motive for profit in operating its insurance program, much of justice marshall's opinion is devoted to dispelling the notion that the dividends received by abe are voluntary contributions from the membership and therefore can not constitute profits."176. id. at 107-08. 177. id. at 110 & n.1 (quoting brannen v. commissioner, 722 f.2d 695. 704 ( 1th cir. 1984)). 178. id. at 110. 179. id. at 111. 180. american bar endowment v. united states, 4 ci. ct. 404 (1984). afrd in part and rev'd in part, 761 f.2d 1573 (fed. cir. 1985), rev'd, 477 u.s. 105 (1986). 181. american bar endowment v. united states, 761 f.2d 1573 (fed. cir. 1985). rev'd, 477 u.s. 105 (1986). 182. id. at 111-16. 19961 florida tax review 5. is profit motive the correct standard?.-if profit in a nontax sense is the excess of revenues generated by an activity over allocable expenses, three of the types of activities conceivably conducted by 501(c)(3) organizations-fund raising, investing, and unrelated trade or business-typically are driven by a desire for profit to enable the organization to carry on its exempt purposes. inasmuch as each of these activities can be conducted with regularity as well, defining the phrase "trade or business" as "extensive activity over a substantial period of time with the intent to earn a profit"'83 or as an activity "entered into with the dominant hope and intent of realizing a profit '"' does not serve as a useful guidepost to distinguish business activity from the other two types of endeavors. conversely, as the fifth circuit observed in louisiana credit union league, the fourth type of activity potentially conducted by 501(c)(3) organizations, substantially related trade or business, cannot by the definition within section 513(a) have as its primary function the potential to raise revenue to support the organization's exempt function.'85 thus, the fifth circuit appears to have concluded that the touchstone of trade or business is profit motive and that a related trade or business by definition can not have a motive primarily to earn profit. similarly, in united states v. american college of physicians,186 another 1986 supreme court decision involving the tax on the unrelated business income of a section 501(c)(3) organization, the court appears to confirm the position that a trade or business is not substantially related to the exempt purposes of the organization if the exempt function it furthers is incidental to its purpose to raise revenue.'87 in this respect the two supreme court cases decided in 1986 interpreting the section 511 tax, american college of physicians and american bar endowment, appear to be inconsistent. to exclude from the category "substantially related trade or business" any activity primarily driven by a desire for profit (american college of physicians) and to adopt the view that a trade or business is an activity involving the sale of goods or performance of service with the dominant intent of realizing profit (american bar endowment) is to fail to define the phrase "trade or business" as an activity that can be either related or unrelated to the accomplishment of the exempt purposes of the organization. 183. louisiana credit union league v. united states, 693 f.2d 525, 532 (5th cir. 1982). 184. brannen v. commissioner, 722 f.2d 695, 704 (11 th cir. 1984). 185. louisiana credit union league, 693 f.2d at 530. 186. united states v. american college of physicians, 475 u.s. 834 (1986). 187. id. at 848-49. the court, in affirming the claims court and reversing the court of appeals, quotes with favor the claims court: "[a]ny educational function [the advertising] may have served was incidental to its purpose of raising revenue." id. at 848. [vol 3:7 unfair business competition what both related and unrelated trade or business activities have in common with trade or businesses conducted by taxable organizations, and is not characteristic of either investing or fund raising, is the receipt of gross income from the sale of goods or the performance of services at market value. to add an additional ingredient to the definition in the context of the tax imposed by section 51 1--that the activity be driven by a motive, or primary motive for profit-is to restrict the scope of the definition to include unrelated, but not related, trade or business. from this perspective the reference to section 162, both in legislative history and the regulations, has misled the courts into infusing the hirsch and lamont profit motive gloss into the meaning of the phrase "trade or business" for purposes of the tax on unrelated business income. requiring profit motive to be the touchstone of trade or business activity makes sense if the task is to differentiate an individual taxpayer's business expenses deductible under section 162 from his hobby or other expenditures nondeductible under section 262.'" the "for profit" criterion may be the proper one as well to determine whether the expenses of a trade or business are deductible under subsection 512(a)(1) to determine unrelated business taxable income. the "for profit" test is misapplied when the task is to differentiate trade or business activity from other types of endeavors conducted by 501(c)(3) organizations."s 188. see irc § 262(a) (disallowing deductions for personal, living, or family expenses). 189. the united states court of appeals for the district of columbia circuit and the united states court of appeals for the seventh circuit both cite the supreme court's decision in american bar endowment as establishing profit motive as the proper test to determine the presence of trade or business. see american postal workers union v. united states, 925 f.2d 480, 481 (d.c. cir. 1991); illinois ass'n of professional ins. agents v. commissioner, 801 f.2d 987, 990-91 (7th cir. 1986). the united states court of appeals for the federal circuit also applied the profit motive test in national ass'n of postal supervisors v. united states, 944 f.2d 859, 861 (fed. cir. 1991). in concluding that a full-time gambler was engaged in a trade or business within the meaning of § 162, the supreme court held that "while the offering of goods and services usually would qualify the activity as a trade of business, this factor, it seems to us, is not an absolute prerequisite." commissioner v. groetzinger, 480 u.s. 23, 34 (1987). further, the court stated: we accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. a sporadic activity, a hobby, or an amusement diversion does not qualify. id. at 35. but the court refused to supply an all-purpose definition: but the difficulty rests in the code's wide utilization in various contexts of the term 'trade or business,' in the absence of an all-purpose definition by statute or regulation, and in our concern that an attempt judicially to 19961 florida tax review arguably, the majority of courts erroneously applying the "for profit" criterion have nonetheless reached the correct conclusion in their attempt to identify trade or business activity for purposes of the section 511 tax. there is, however, a compelling reason to encourage courts to apply a more accurate definitional test beyond the need to be logical. the "for profit" test is relevant to differentiate unrelated from related trade or business, but not to distinguish trade or business from other types of endeavors such as fund raising. as discussed in subpart b, infra, by injecting the element of profit motive in the attempt to identify trade or business, many courts in effect have resolved the related versus unrelated question before even turning to consider that issue. 6. reformulation of the standard.-regulations section 1.513-1(b) should be amended in part to provide that for purposes of section 513 the phrase "trade or business" generally includes any activity (1) involving the sale of goods or the performance of services at market value from which gross income is derived; and (2) which otherwise possesses the characteristics required to constitute trade or business within the meaning of section 162, but without regard to whether or not the activity is engaged in with a motive, or primary motive, to derive profit. had the proposed standard been applied to the facts in american bar endowment, the supreme court could have found abe to be engaged in a trade or business from the basic conclusion that the excess premiums received by abe from the insurance carriers more likely constituted gross income from the sale of goods and the performance of services at market value than they did charitable contributions from the membership resulting from the members voluntarily paying the higher than necessary premiums abe negotiated with the carriers. unfortunately, the court interjected the element of motive into the inquiry when it identified abe's insurance as a trade or business by comparing the activity to similar endeavors actually or potentially carried on by taxable organizations for profit. one can assume that desire for profit is the driving force behind all sales and service activity conducted by taxable organizations and is a necessary component to find such activity to be a trade or business in the hands of an individual. one cannot make the same assumption with respect to all sales and service activity conducted by 501(c)(3) organizations. 9 ' fomulate and impose a test for all situations would be counterproductive, unhelpful, and even somewhat precarious for the overall integrity of the code. id. at 36. 190. in american bar endowment, the united states claims court applied its own test to identify trade or business, viz., whether the activity was conducted in a competitive, [vol 3:7 unfair business competition b. trade or business: substantially related or unrelated? the statutory definition of the term "unrelated trade or business" has remained unchanged since the revenue act of 1950. section 513(a) defines the term as "any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption... ,,' the senate report accompanying the 1950 revenue bill attempted to illuminate this "substantially related" standard by way of example and not by way of explication. examples offered of substantially related business were a wheat farm operated by an exempt agricultural college as part of its educational program; commercial manner. 4 cl. ct. 404, 411-12 (1984). this test was developed by the united states court of claims in disabled am. veterans v. united states, 227 cl cl. 474 (1981), wherein a charitable organization sent out books, maps, charts and other premiums in connection with the solicitation of contributions. the government asserted that the activity was engaged in for profit and therefore constituted a trade or business. id. at 486. the court responded: "[i]t is clear that not all activity engaged in with the expectation of gain constitutes a 'trade or business' as that term is utilized with respect to ubti." id. the court pointed out that both s. rep. no. 552, 91st cong., 1st sess. (1969) and subsequently amended regs. § 1.513-1(b) contain statements to the effect that the sending out of low cost articles incidental to the solicitation of charitable contributions was not to be considered a trade or business. disabled am. vets., 227 ct. cl. at 486-87. it is clear that the court of claims viewed an activity as being conducted in a competitive, commercial manner when the exempt organization offered the premium items only in exchange for prior contributions in amounts that approached the retail value of the item. on the other hand, a "competitive situation would not be present" when the contribution required for the premium item was greatly in excess of the retail value of the premium. id. at 488-89. utilized in this way, the "competitive, commercial manner" test employed to identify trade or business is the same criterion proposed in this article, viz., trade or business is the sale of goods or the performance of services at market value from which gross income is derived. fundraising would include the supply of goods or the performance of services to the extent that the amount voluntarily paid for the goods or services exceeded their market value. if the article sent out is "low cost:* the entire amount remitted to the charitable organization can be considered a contribution. see irc § 513(h) (added by pub. l. no. 99-514, 100 stat. 2766 (tax reform act of 1986)) (providing that in the case of a charitable organization, the term "unrelated trade or business" does not include activities relating to the distribution of low cost articles incidental to the solicitation of charitable contributions). in american bar endowment, the claims court again applied the "competitive, commercial manner" test to conclude that the abe membership was voluntarily supporting a fundraising effort because "the amount of money abe is permitted to retain far exceeds the value of any service it may be providing through the operation of the insurance programs. it is quite obvious, then, that this money was not earned from the sale of goods or the performance of services... but for some other reasons." american bar endowment. 4 ct. cl. at 411-12. 191. irc § 513(a) (formerly irc § 422(b)). 19961 florida tax review income of an educational organization from charges for admissions to football games; a nonprofit hospital's income from patients; and income from the sale of articles made by handicapped persons derived by an exempt organization engaged in their rehabilitation." 2 not surprisingly, the manufacture and sale of automobile tires by a college was offered as an example of a business ordinarily considered unrelated to the exempt purposes of the school. 3 1. the 1958 regulations.-although the statute focuses on the relatedness of the conduct of business activity to the performance of the organization's exempt purpose, the test under the 1958 regulations was the underlying principal purpose driving the activity. under the 1958 regulations, a trade or business is ordinarily "substantially related to the activities for which an organization is granted exemption if the principal purpose of such trade or business is to further (other than through the production of income) the purpose for which the organization is granted exemption."'94 two important guideposts were offered to determine an activity's principal purpose: (a) the nature and size of the activity in question compared with the scale of the organization's exempt activity, and (b) the manner in which the activity in question was conducted. 5 expanding upon an example in the senate report accompanying the 1950 revenue bill, the 1958 regulations observed that a wheat farm may not be substantially related to the educational program of an agricultural college if it is "operated on a scale disproportionately large" when compared with the exempt activity.' according to the regulations: similarly, a university radio station or press is considered a related trade or business if operated primarily as an integral part of the educational program of the university, but is considered an unrelated trade or business if operated in substantially the same manner as a commercial radio station or publishing house.' 2. the 1967 regulations.-as noted above, the 1967 regulations are remembered for their announcement to the charitable sector that the treasury 192. s. rep. no. 2375, supra note 54, at 107-08, reprinted in 1951 u.s.c.c.s. at 3165-66. 193. id. see also the macaroni monopoly, supra note 60, at 1291 (suggesting that the criterion used in the house and senate reports to distinguish related from unrelated business was more that between "normal" and "unusual" than a determination of how substantially the activity furthered the organization's exempt purposes). 194. regs. § 1.513-2(a)(4) (as amended in 1975). 195. id. 196. id. 197. id. [vol. 3:7 unfair business competition department had honed a new surgical skill-an ability to dissect an integrated business into its component parts, each of which was to be tested as a separate trade or business to determine that particular component's relatedness or unrelatedness to the exempt purposes of the organization. thus, under the 1967 regulations, the activities of soliciting, selling, and publishing commercial advertising in an exempt organization periodical was a trade or business separate from the activity of publishing the editorial matter. similarly, the regular sale of pharmaceutical supplies to the general public by a hospital pharmacy was a business separate from the furnishing of supplies to hospital patients. t9 creating less controversy at the time was the 1967 regulations' reformulation of the standard governing whether a trade or business, fragmented or unfragmented, was related to the exempt purposes of the organization. under the 1967 regulations, which are still in effect, a business is substantially related if the conduct of the business has a substantial causal relationship to the achievement of the organization's exempt purposes.' 9 as the 1967 regulations rephrase it, "the production or distribution of the goods or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of' the exempt purposes of the organization. 200 in each case the test is one of facts and circumstances. to determine the issue of substantial relatedness, both the 1958 and the 1967 regulations direct one's focus to the size and extent of the activities in question compared to the nature and extent of the organization's exempt activity.20' under the 1958 regulations, however, objective factors such as the manner in which the activity is conducted are a means to determine the subjective primary purpose of the activity,22 i.e., did the organization intend the activity to contribute importantly to the fulfillment of its exempt purposes? under the 1967 regulations objective factors are a means to determine whether or not the activity in fact contributes importantly to the accomplishment of the exempt goals. -0 3 did the treasury department intend a substantive change by adopting in the 1967 regulations a reformulated standard governing the substantial relatedness issue? perhaps the treasury department came to realize that the 198. id. regs. § 1.513-1(b) (as amended in 1983). 199. id. regs. § 1.513-1(d)(2). 200. id. 201. see id. regs. § 1.513-1(d)(3) (1967 regulations); regs. § 1.513-2(a)(41 (1958 regulations) (as amended in 1969). 202. see regs. § 1.513-2(a)(4) (as amended in 1969). 203. see regs. § 1.513-1(d). one possible difference is that an activity too large relative to the exempt purposes it served was totally taxable under the 1958 regulations and only partially taxable under the 1967 regulations. see moore, supra note 158, at 473-74. 19961 florida tax review 1958 regulations were out of step with the statute by requiring a determination of an exempt organization's subjective primary motive in operating a business activity. section 513 requires only a determination of whether the conduct of the business is substantially related to the performance of the exempt function, rather than discovery of the principal motive driving the activity. noticeably absent from the 1967 regulations are references to principal purpose or motive. did the 1967 regulations mean to imply that an activity could meet the "contribute importantly" test and fail the "principal purpose" test?"° perhaps the 1967 regulations reflected the treasury department's intention to withdraw the principal purpose test of the 1958 regulations, focusing rather on more objective criteria, as a necessary consequence of that regulation's fragmentation of an integrated business into its component parts each of which itself is regarded as a trade or business. although a business as an integrated whole is likely to be driven by a discernible primary motive, the exempt organization may have failed to formulate a motive, at least on a conscious level, for each of the business's component parts. whatever the reason for the reformulation of the standard, it is probable that a court faced with the related versus unrelated issue will come to the same conclusion whether the standard applied is the principal purpose test of the 1958 regulations or the causal relationship test of the 1967 regulations. both standards require an examination of the same objective facts and circumstances to resolve the issue. moreover, it can be assumed in the usual case that if the manner in which an activity is conducted contributes importantly to the exempt purposes of the organization, the activity mirrors the principal motive to further those purposes. nonetheless, the case of a 501(c)(3) organization falling to conduct a business activity in a manner that contributes importantly to its exempt purpose despite its principal purpose to do so is not beyond imagination. less likely is the case in which the activity contributes importantly to the accomplishment of the organization's exempt purposes notwithstanding a principal purpose to earn profit.05 is it significant that section 513(c), added by the tax reform act of 1969, codified those portions of the 1967 regulations fragmenting an integrated business into its component parts, but failed to codify those portions dealing with the issue of whether the activity, fragmented or unfragmented, was substantially related to the exempt purposes of the organization? 204. professor kaplan assumes this to be the case: 'thus, an activity is 'substantially related' if it 'contributes importantly' to the university's educational mission, even if the activity's principal purpose is financial or is otherwise unrelated to education." kaplan, supra note 62, at 1451. what luck if a university sets out primarily to make money from an activity and the activity also contributes importantly to the university's educational mission! 205. see infra note 222 and accompanying text. [vol 3:7 unfair business competition unfortunately, the last sentence of subsection 513(c) casts a lingering doubt as to whether the 1969 congress intended subjective motive to play a role: "where an activity carried on for profit constitutes an unrelated trade or business, no part of such trade or business shall be excluded from such classification merely because it does not result in profil" 2 6 whether or not the 1967 regulations were intended to divert attention away from subjective motive, very few courts applying the "contribute importantly" standard to resolve the related versus unrelated issue have been able to avoid sliding back into the principal purpose test of the 1958 regulations, even after having recited the "contribute importantly" standard as the appropriate one. for instance, in american college of physicians,2 involving facts almost identical to example (7) of section 1.513-1(d)(4)(iv) of the 1967 regulations, the supreme court was faced with the issue of whether the business of selling advertisements containing information about the use of medical products published in the annals of internal medicine was substantially related to the educational purpose of the college. reciting the regulation's direction to examine the importance of the business activity's contribution to the organization's exempt purpose, the supreme court agreed with the claims court that the manner in which the college selected the advertisements did not establish the necessary causal relationship between the activity and the exemption [e.g., those willing to pay for space got it and there was lacking a comprehensive or systematic presentation of the goods or services advertised],.08 but the claims court itself slipped into the principal purpose standard of the 1958 regulations when it concluded that any educational function that may have been served by the advertisements was incidental to the college's purpose of raising revenue. -09 the supreme court pursued this theme with the following comment: "this is not to say that the college could not control its publication of advertisements in such a way as to reflect an intention to contribute importantly to its educational functions."21 doubtless example (7) of the regulation itself with its reference to both "governing objective" and "method" contributed to the 206. irc § 513(c). 207. 475 u.s. 834 (1986). 208. id. at 849. 209. american college of physicians v. united states, 3 cl. c. 531. 535 (1983). rev'd, 743 f.2d 1570 (fed. cir. 1984), rev'd, 475 u.s. 834 (1986). 210. american college of physicians, 475 u.s. at 849 (emphasis added). for an analysis of the case, see note, "substantially related"--the magic words for nonprofit organizations: united states v. american college of physicians, 21 u.s.f. l rev. 795 (1987). 19961 florida tax review court's attention to the motive of the college as well as to the manner in which the advertisements were selected. 2" in california thoroughbred breeders association v. commissioner,212 the tax court, citing american college of physicians, understood the supreme court to hold that "it would examine the conduct and intent of the organization,, 21 3 that the supreme court "found that the taxpayer did not use or intend to use the advertising for the purpose of contributing to the educational value of the journal" 214 and that the supreme court "found that any educational function that the advertisements might serve was only incidental to its purpose of raising revenue. 2 5 it would appear, therefore, that the principal purpose standard of the 1958 regulations remains in vigorously good health to this day. 3. profit and profit motive.-the 1958 regulations did not explicitly provide that if the principal purpose of a trade or business is not to further the exempt purpose of the organization, a fortiori, the principal purpose must be to earn profit (ultimately to be used to further the organization's exempt purpose).2 6 nor do the 1967 regulations explicitly state that if a business is found not to contribute importantly to the accomplishment of the organization's exempt purpose, the only alternative is to conclude that it is primarily 211. regs. § 1.513-1(d)(4)(iv) ex. 7. example 7 provides in pertinent part: although continuing education of its members in matters pertaining to their profession is one of the purposes for which z is granted exemption, the publication of advertising designed and selected in the manner of ordinary commercial advertising is not an educational activity of the kind contemplated by the exemption statute; it differs fundamentally from such an activity both in its governing objective and in its method. id. 212. 57 t.c. memo (cch) 962, t.c. memo (ria) 89,342 (1989). 213. id. at 967; 58 t.c. memo (ria) at 89-1722 (emphasis in original). 214. id. (emphasis added). 215. id. (emphasis added). see note, insurance trade association held subject to unrelated business income tax: independent insurance agents of huntsville, inc. v. commissioner, 47 tax law. 815 (1994) (interpreting the supreme court in american college of physicians to hold that "to contribute importantly (and hence to be substantially related), an activity need only reflect an intention to contribute importantly and not actually do so." id. at 818. the unstated inference is that the principal purpose standard of the 1958 regulations lies at the heart of the 1967 regulations, notwithstanding the fact that the 1967 regulations focus on the casual relationship between the conduct of an activity and achievement of the organization's exempt purposes. the note observes that a number of appellate court decisions handed down subsequent to american college of physicians, notably huntsville, focused more on the outcome of the activity in question rather than on the organization's intent as evinced by how the activity was conducted. id. at 823. 216. see regs. § 1.513-2(a) (as amended in 1969). [vol 3:7 unfair business competition a revenue raiser." 7 nonetheless, the inference in both regulations that a business activity must serve one master or the other is unmistakable and the vast majority of courts have assumed this to be the case. in iowa state university of science & technology v. united states, 8 one of the few cases decided under standards set out during the brief nine-year reign of the 1958 regulations, the court of claims was faced with the question of whether the operation of a college television station was related or unrelated to the educational purposes of the university. repeating the example in the regulation that a university radio station is unrelated if operated in substantially the same manner as a commercial station, the court observed that the primary purpose of a typical commercial facility is profit.2 9 the court examined the programming policy of the television station, i.e., the selection of popular entertainment programs to attract the largest number of viewers, as well as the secondary importance of public affairs and educational programs, to support the conclusion that the station was being operated in a manner to maximize revenue.' finding that the primary goal of iowa state's woi-tv was revenue maximization, the court held the university's television business not to be substantially related to the school's exempt purposes."" typically, the issue is framed in the manner in which the seventh circuit put it in illinois association of professional insurance agents, inc. v. commissioner. we must ask: do iapia's activities in promoting errors and omissions insurance coverage among independent insurance agents evince an intention to use that promotion of e & 0 coverage for the purpose of contributing importantly to the improvement of conditions in a particular line of business, or do its activities in promoting coverage indicate that any exempt function which is served is incidental to its purpose of raising revenue?' 217. see regs. § 1.513-1(d). 218. 500 f.2d 508 (ct. cl. 1974). 219. id. at 517. 220. id. at 518-20. 221. id. at 520. 222. illinois ass'n of professional ins. agents v. commissioner, 801 f.2d 987, 994 (7th cir. 1986); see also independent ins. agents, inc. v. commissioner, 998 f.2d 898. 902 (lth cir. 1993) ("iiah's conduct does not evince an intention to use its public insurance activities to contribute importantly to the improvement of conditions in the insurance business or to further its exempt purposes. instead, its conduct indicates that raising revenue was its primary concern."). 19961 florida tax review if the parties have stipulated that the activity in question constitutes a trade or business, courts generally approach the related versus unrelated issue by first identifying the exempt purposes of the organization and then by deciding whether the manner in which the activity in question is conducted contributes importantly (or in terms of the 1958 regulations, evidences an intention to contribute importantly) to the accomplishment of those purposes. if the court finds lacking the necessary causal relationship between the conduct of the business and the accomplishment of the exempt purposes, only then is the conclusion reached that the activity is being operated in a manner primarily to raise revenue and therefore the principal underlying motive is profit. the finding of a primary profit motive is the final step in the analysis.2 23 there is a certain logic to the proposition that an activity's principal purpose must either be to further directly the organization's exempt purposes, in which case it constitutes a related business, or the primary motive is profit, in which case the activity is unrelated. one would have thought that it follows from this proposition that every unrelated trade or business is primarily motivated by profit. apparently there is an exception to every proposition. in west virginia state medical ass'n v. commissioner, 882 f.2d 123 (4th cir. 1989), a medical association incurred an excess of direct advertising costs over advertising revenue for 21 consecutive years in connection with its monthly medical journal. id. at 125. it was not disputed that the advertising activity was not substantially related to the association's exempt purpose. id. at 124. since the court concluded that the advertising activity losses evidenced a lack of profit motive, the losses could not offset the income from another unrelated activity. id. at 125. why, then, did the medical association continue to sell advertising space? perhaps the association thought that the advertising directly furthered its exempt purposes or that the readership of the journal would diminish without advertising, i.e., that it was related activity. perhaps hope springs eternal and the association thought that the advertising might eventually make a profit. or perhaps the association never gave the matter much thought one way or the other. conversely, one would have thought that it follows from the main proposition that an activity primarily motivated by profit cannot be a related trade or business. professor kaplan suggests that this may not be the case. see kaplan, supra note 62, at 1451. he speculates that iowa state university of services and technology might have been decided in favor of the taxpayer if the 1967 regulations had been applicable, i.e., the university tv station contributed importantly to the educational purposes of the university notwithstanding its primary purpose to make profit. kaplan, supra note 62, at 1451-52. with the supreme court, in american college of physicians, continuing to interject motive into the resolution of the related versus unrelated issue, it appears unlikely that a court would conclude that an activity was primarily motivated by profit, yet contributed importantly to the organization's exempt purposes. see the macaroni monopoly, supra note 60, at 1289 ("an activity operated primarily for profit not only is likely to vitiate concern with exempt purposes, but also will probably be more competitive than an activity which only incidentally produces income."); see also louisiana credit union league v. united states, 693 f.2d 525, 537 (5th cir. 1982) ("because the league's insurance endorsement is basically a fundraising activity, it is by definition unrelated business activity under section 513(a)."). 223. see united states v. american college of physicians, 475 u.s. 834 (1986); texas apartment ass'n v. united states, 869 f.2d 884 (5th cir. 1989); hi-plains hosp. v. united states, 670 f.2d 528 (5th cir. 1982); minnesota holstein-friesian breeders ass'n v. [vol. 3:7 unfair business competition unfortunately, as previously noted, a number of courts faced with both the issue of whether an activity falls within the definition of a trade or business and, if it does, whether the activity is related or unrelated to the organization's exempt purpose, find profit to be the primary motive underlying the activity through a resolution of the former issue rather than the latter. assuming trade or business for purpose of the section 511 tax to be an activity motivated primarily by profit, these courts often find such a motive by applying the axiom that profit itself constitutes strong evidence of a primary intent to earn it. thus, by interjecting profit motive into the trade or business issue, these courts have in effect resolved the related versus unrelated issue before even turning to it.?4 for instance, prior to examining whether or not a business league's insurance activities contributed importantly to the exempt purposes of the organization, the fourth circuit in carolinas farm & power equipment concluded that the activities were carried on primarily to earn a profit as evidenced by the consistently profitable result of the operations and the proportion of insurance income to total income.22 observed the court: "[w]e think that there is no better objective measure of an organization's motive for conducting an activity than the end it achieves. ' z6 similarly, in american postal workers, the court of appeals for the district of columbia circuit discounted testimony on behalf of the union to the effect that the commissioner, 64 t.c. memo (cch) 1319, t.c. memo (ria) 92,663 (1992): california thoroughbred breeders ass'n v. commissioner, 57 t.c. memo (cch) 962, t.c. memo (ria) 89,342 (1989). 224. the following decisions (i) apply the profit motive test to determine whether an activity constitutes a trade or business for purposes of the tax on unrelated business income; (2) then infer profit motive wholly or partly from the fact that the activity was profitable; and (3) then turn to the related versus unrelated issue: illinois ass'n of professional ins. agents v. commissioner, 801 f.2d 987 (7th cir. 1986) (in effect applying the profit motive test twice, first to determine whether the activity constitutes a trade or business and second to determine whether the trade or business is related or unrelated to the exempt purposes of the organization); carolinas farm & power equip. dealers ass'n v. united states, 699 f.2d 167 (4th cir. 1983); louisiana credit union league v. united states, 693 f.2d 525 (5th cir. 1982); texas farm bureau v. united states, 822 f. supp. 371 (w.d. tex. 1993). rev'd in part, 53 f.3d 120 (5th cir. 1995); national water well ass'n v. commissioner, 92 t.c. 75 (1989); veterans of foreign wars, mich. v. commissioner, 89 t.c. 7 (1987); and professional ins. agents v. commissioner, 78 t.c. 246 (1982), aff'd. 726 f.2d 1097 (6th cir. 1984). in national ass'n of postal supervisors v. united states, 944 f.2d 859, 862 (fed. cir. 1991), the court of appeals for the federal circuit inferred a primary profit motive from profit, but did not have the related versus unrelated issue before it. in american postal workers union, v. united states, 925 f.2d 480, 483-85 (d.c. cir. 1991), the court of appeals for the district of columbia circuit decided that the activity in question was an unrelated trade or business before deciding that it was a trade or business. 225. carolinas farm & power, 699 f.2d at 170-71. 226. id. at 170. 19961 florida tax review prospect of earning profit had not occurred to anyone even in the face of evidence of substantial net profit.227 commented the court: "apparently, we are invited to believe that the profit received was, as has been said of the british empire, merely picked up in moments of absentmindedness. 228 while it is obvious that recurrent profit, especially large profit, may indicate a principal motive to earn it, the presence of profit is not conclusive with respect to the issue of motive. assume, for example, that ten years ago a tax exempt school received $20 million gross income from student tuition, that both tuition and deductible expenses have increased 6% per annum, and that taxable income has averaged 1% of gross income, i.e., the school has consistently derived taxable income in the range of $200,000 to $340,000. assume further that the performance of the services from which the gross income is derived contributes importantly to the accomplishment of the school's educational purpose and that the school has acted in a manner to indicate that fulfillment of its educational mission is its principal purpose. can it be said that substantial and recurrent profit necessarily contradicts this principal purpose? if the market place has afforded the school a recurrent 1% profit, the statute does not require, nor should it require, the school to lower tuition to eliminate the profit by attempting to match more perfectly deductible expenses, a feat which in itself may be difficult to accomplish. while not the driving force underlying a related business activity, profit may legitimately occur and may be needed to tide the school over a period of anticipated decline in enrollment, to cope with inflation, to expand services, to improve staff, to add to the endowment fund, or to finance fund raising efforts or needed capital improvements. in iowa state university of science & technology, the court of claims observed that, "a profitable 227. american postal workers, 925 f.2d at 484-85. 228. id. similarly, professor kaplan looks to the presence of profit as evidence of profit motive in order to demonstrate that intercollegiate athletics is a trade or business. kaplan, supra note 62, at 1439-40. finding many university intercollegiate athletic programs to be profitable, professor kaplan observes that universities dropping their intercollegiate football programs because they were losing money shows that such programs were undertaken to make money in the first place. id. at 1444-45. could not one also conclude that the football program was undertaken to further the university's educational goals, but the university simply could not afford to keep it going? it is, however, essentially the "problematic" connection between intercollegiate athletics and education, and the mania for winning, that leads professor kaplan to the plausible conclusion that in many cases intercollegiate athletic programs are not substantially related to the educational goals of the university. id. at 1459-60. winning means greater revenue from broadcasting, larger gate admissions, and the opportunity to play in bowl games. the inference is that the focus on winning demonstrates a primary goal to derive profit. are there not, rare as they may be, intercollegiate athletic programs with a tradition of winning that can nevertheless demonstrate a primary purpose to promote educational values by emphasizing cooperation, perseverance, excellence, living up to potential, pride in accomplishment, and playing by the rules, and not simply winning at all costs? [vol. 3:7 unfair business competition operation may be justified by factors which, on balance, show that the conduct of the business was substantially related to the exempt purpose of the institution."229 4. competitive, commercial manner.-the notion that a business activity operated by an exempt organization is unrelated if conducted in a manner similar to the operation of a taxable enterprise has its origins in the 1958 regulations, which, as noted supra, provided: "similarly, a university radio station or press is considered a related trade or business if operated primarily as an integral part of the educational program of the university, but is considered an unrelated trade or business if operated in substantially the same manner as a commercial radio station or publishing house."' the inference underlying the 1958 regulations is that the manner in which an activity is conducted reflects the exempt organization's principal motive to conduct it, e.g., if the business in question is operated like a taxable business is operated, the likely motive is profit. the court of claims misapplied the "commercial manner" test in disabled american veterans to determine whether an activity was a trade or business rather than to resolve the issue of whether the trade or business was related or unrelated to the exempt purposes of the organization."3 another court, applying the test to resolve the related versus unrelated issue, observed that the lack of advertising and solicitation "substantiate the essentially non-commercial operation" of the activity.' one taxpayer even argued that its farming operation was so inefficient that 229. iowa state univ. of science & technology v. united states, 500 f.2d 508,518 (cl cl. 1974). one commentator has questioned why a related business activity ever needs to make a profit see cooper, supra note 71, at 2020. setting a fee to earn a profit curtails the "widest possible distribution of the goods or services being provided by the exempt organization." id. at 2021. according to cooper the only excuse for charging profitable prices is to earn money for support of other activities of the organization. while this is a laudable goal, it is precisely the justification which was advanced for selling advertising space in exempt organization publications. the exempt publishers were merely being alert to the fact that there was profit potential as a by-product of their related publishing businesses. if congress was willing to bar this form of skimming profits out of a related business, it is not a great step to saying that any business which earns a profit should be taxed. id. at 2021. 230. regs. § 1.513-2(a)(4) (as amended in 1969). 231. see supra note 190. 232. st. luke's hosp. v. united states, 494 f. supp. 85, 91 (w.d. mo. 1980): see also hi-plains hosp. v. united states, 670 f.2d 528, 532 (5th cir. 1982) ("[the hospital pharmacy] has not sought to expand its market or the type of products it sells. it does not advertise nor does it use display areas to attract customers. in short, it lacks the indicia of a modem commercial drug store ... "). 19961 florida tax review it could not possibly be compared to a for-profit enterprise. 3' unfortunately, courts attempting to apply the "manner reflects motive" inference underlying the 1958 regulations often fail to differentiate between an activity simply utilizing modem business practices to achieve its exempt goals and one conducted in a manner to maximize profit. clearly, the distinction between unrelated and related business is not that the former is operated in an efficient, business-like manner and the latter is not. evidence that a business activity operated by an exempt organization advertises, markets, or promotes its goods or services, prices its goods or services in accordance with what the market will bear, attempts to keep costs down, operates efficiently, makes capital improvements, or engages in other behavior similar to the manner in which a taxable organization behaves is not inconsistent with either a principal purpose to further the organization's exempt purpose or a finding that the activity contributes importantly to the achievement of that purpose. exempt organizations offering goods or services to the public often find it imperative to engage in such "commercial" activity with respect to their obviously related businesses in order to survive in a world in which competition for the dollar is fierce and a dollar earned buys less. evidence of such "commercial" activity does not ipso facto answer the question of whether the manner of operation in its totality indicates a substantial causal connection to the accomplishment of the organization's exempt purposes or indicates that the activity is essentially a revenue raiser. in califonia thoroughbred breeders association v. commissioner,34 the tax court was called upon to determine whether an exempt agricultural organization's auctions of thoroughbred horses was related or unrelated to its exempt purpose. although the association's auctions in many respects resembled those conducted by commercial auction houses, the taxpayer's expert witness observed, "in summary the ctba has not acted like a profit maximizer, commercial auction company.'235 233. st. joseph farms v. commissioner, 85 t.c. 9, 20 (1985), nonacq., 1986-2 c.b. i ("in support of its contention that the farm is not operated primarily for profit, petitioner cites various operational practices (such as delayed replacement of equipment; failure to use maximum automation; the failure to expand the farm or to borrow money; and loans of equipment, facilities, and the brothers' time to neighboring farms) and petitioner's accounting practices (failure to use accelerated depreciation or to claim investment tax credits) as inconsistent with maximizing profits."). the tax court responded that the mere fact that a trade or business may not be run as efficiently as possible does not negate a primary motive for profit. id. at 20-21. 234. 57 t.c. memo (cch) 962, t.c. memo (ria) 89,342 (1989). 235. id. at 969; see sugarman & pomeroy, supra note 61, at 432-33 n.42 ("if applied literally, [the regulations] would deny exempt treatment to a university station or press operated in a business-like manner. presumably the statement is directed more to the subject or content of programs or publications than to method of conduct of operations."). [vol 3:7 unfair business competition 5. identifying unrelated businesses by the activities of taxable entities.-confronted with whether the activities of a business league exempt under section 501(c)(6) were related to the purposes of the organization, the fourth circuit in carolinas farm & power equipment dealers association,236 citing regulations section 1.501(c)(6)-1,' concluded that the association's insurance activities operated to benefit individual members and not the industry as a whole because "the fees charged members for participation in the insurance program are in direct proportion to the benefits received."'2 8 observed the court: "the service provided by the association is one commonly provided by for-profit entities.... where a service is available in the marketplace, a trade association need not provide it to accomplish an exempt purpose."239 more recently, a federal district court in texas expanded the generalization, presumably to apply to all tax exempt entities and not just trade associations or agricultural organizations exempt under section 501(c)(5), with the comment that "[a]n activity is less likely to be substantially related if it is one commonly provided by for-profit entities.,24 the tax court repeated this proposition in florida trucking ass'n v. commissioner.24' faced with the issue of whether advertisements appearing in the association's journal, florida truck news, furthered the tax exempt purposes of another trade association, the court observed that the sale 236. carolinas farm & power equip. dealer's assoc. v. united states, 699 f.2d 167 (4th cir. 1983). 237. "a business league is an association of persons having some common business interest, the purpose of which is to promote such common interest and not to engage in a regular business of a kind ordinarily carried on for profit. ... thus, its activities should be directed to the improvement of business conditions of one or more lines of business as distinguished from the performance of particular services for individual persons." regs. § 1.501(c)(6)-1 (as amended in 1990). 238. carolinas farm & power, 699 f.2d at 171 (citations omitted). 239. id. at 171-72. but see united states v. american bar endowment, 477 u.s. 105, 111 (1986) (comparing abe's insurance activities to the type of businesses conducted by taxable entities in support of the court's conclusion that the activity was a trade or business, not to demonstrate that the activity was an unrelated trade or business). the seventh circuit compared iapia's insurance activities to the type of business conducted by for-profit entities both to demonstrate that the activity was a trade or business and to demonstrate that the activity was an unrelated trade or business. see illinois ass'n of professional ins. agents v. commissioner, 801 f.2d 987, 992, 994 (7th cir. 1986) ("finally, the services performed by iapia, and the insurance sold through its efforts are the kind of services performed, and insurance sold, by private commercial entities in order to make a profit .... where services and goods are available in the marketplace, 'a trade association need not provide it to accomplish an exempt purpose."' (citing carolinas farm & power, 699 f.2d at 172)). 240. texas farm bureau v. united states. 822 f. supp. 371, 377 (,v.d. tex. 1993), rev'd on other grounds, 53 f.3d 120 (5th cir. 1995). 241. 87 t.c. 1039 (1986). 19961 florida tax review of advertising ordinarily is conducted by for-profit entities and therefore a trade association need not provide it to accomplish an exempt purpose.2 42 the generalization as applied in florida trucking ass'n begins to weaken even as applied to business leagues tax exempt under section 501(c)(6). what the tax court meant was that "[t]he entities that paid for advertisements in florida truck news presumably could have and did pay for similar or identical advertisements in other magazines or newspapers that were taxpaying entities. 243 as the court itself acknowledged, had florida truck news selected advertisements to appear in its publication on the basis of coordinating the advertising and editorial content of the issue, or selected only advertisements to reflect new developments in the industry, the magazine's business of selling advertising space may well have furthered the exempt purpose of the organization to enhance the interests of the trucking industry.2' this thought was suggested by the supreme court in american college of physicians with respect to the annals of internal medicine. presumably, a for-profit entity would not select advertisements for tires, engines, and trailers with a view to promoting the common business interests of the trucking industry, but rather with an eye primarily on their revenue producing potential. the axiom that a trade or business is more likely to be unrelated if it is one provided by a taxable entity becomes even less tenable when applied to the activities of a 501(c)(3) organization. the committee reports accompanying the 1950 revenue bill and both the 1958 and 1967 regulations recognized that a related business activity may be of the type conducted by both tax-exempt and taxable entities.245 the related versus unrelated issue is not determined by the qualitative nature of the activity; rather, it is decided by whether or not the exempt organization conducts the activity in a manner to further its exempt purposes. 246 as noted, the position of the 1958 regulations is that a university radio station or press is a related or unrelated trade or business depending upon the manner in which it is operated.247 similarly, in st. luke's hospital 242. id. at 1044-45. 243. id. 244. id. at 1045. 245. e.g., s. rep. no. 2375, supra note 54, reprinted in 1951 u.s.c.c.s. at 3165 (offering as examples of potentially related businesses a wheat farm and a football game), regs. § 1.513-1(d)(4) (as amended in 1983) (adds to the list a trade show, the sale of milk and cream, and the sale of advertising in a newspaper). 246. early revenue rulings addressing the related versus unrelated issue often decided the issue by finding that the activity in question is normally conducted by taxable entities. for a criticism of this approach, see the macaroni monopoly, supra note 60, at 1286. 247. regs. § 1.513-2(a)(4) (as amended in 1969). [vol 3:7 unfair business competition v. united states,248 a missouri federal district court found the hospital's pathology department to be conducting a related business when it performed diagnostic tests for nonhospital patients of staff physicians because the tests contributed to the teaching functions of the hospital.?9 observed the court, "there can never be too many tests, because the more there are the richer the available instructional material is and the better the teaching program is." -o likewise, the fifth circuit in hi-plains hospital found the hospital's pharmacy sales to private patients of the staff doctors contributed importantly to the hospital's exempt purposes because one of the purposes of the establishment of a medical center in hale center, texas, a small town of about 2,250 people, was to induce doctors to practice there. the pharmacy sales in question, said the court, facilitated the practice of medicine in the town and thus furthered the goal of making medical services available there. 251 the fact that taxable entities operate radio stations, newspapers, medical diagnostic testing laboratories, and pharmacies was irrelevant to the issue of whether the same activity in the hands of a section 501(c)(3) organization was related to the organization's exempt purposes. as the fifth circuit noted in hi plains hospital 2 and as the supreme court held in american college of physicians, congress in considering the tax reform act of 1969 rejected a version of section 513(c) that would have made sales by a hospital pharmacy to nonhospital patients and sales of advertising space by tax-exempt professional journals per se unrelated. 3 it may be that certain activities like pharmacy sales to nonhospital patients, the sale of advertising space in journals, and the farming activities in st. joseph farms are frequently conducted by taxable entities and are not traditionally considered charitable work, but there is no avoiding "... the explicit case-by-case requirement articulated in treas. reg. 1.513-1(d)(2)... 6. identifying unrelated businesses by the potential for competition with taxable entities.-in national water well ass'n v. commissioner,255 the tax court stated: 248. 494 f. supp. 85 (wv.d. mo. 1980). 249. id. at 93. 250. id. at 90. 251. hi-plains hosp. v. united states, 670 f.2d 528. 531 (5th cir. 1989). 252. id. at 532. 253. united states v. american college of physicians, 475 u.s. 834, 84547 (1986); hi-plains, 670 f.2d at 532. 254. american college, 475 u.s. at 844. 255. national water well ass'n v. commissioner, 92 t.c. 75 (1989). 19961 florida tax review in its trade or business determination, the supreme court also pointed out that the income from the insurance program constituted ubti [unrelated business taxable income-ed.] because the taxpayer unfairly competed with other insurance companies. united states v. american bar endowment, supra, 477 u.s. 114.... the supreme court held that the facts in the case represented 'precisely the sort of unfair competition that congress intended to prevent' since private commercial entities could have provided the same services for the insurance program that were provided by the taxpayer. 477 u.s. at 114.256 the difficulty with the tax court observation is that the supreme court in american bar endowment (abe) did not have before it the issue of whether a trade or business was related or unrelated to the accomplishment of the exempt purposes of abe. the parties in the case stipulated that the activity was unrelated. rather, the issue before the court was whether the activity was a business or a fund-raiser. the insurance program's potential for unfair competition with taxable entities led the supreme court to the conclusion that the activity was a trade or business and thus, being unrelated by stipulation, was "precisely the sort of unfair competition that congress intended to prevent. '' 257 the supreme court did not conclude that the insurance program was unrelated as opposed to related because of the potential for competition. the supreme court, in fact, overstated the case with its observation that "[t]he undisputed purpose of the unrelated business income tax was to prevent tax-exempt organizations from competing unfairly with businesses whose earnings were taxed." 8 while the adoption of the tax and unrelated businesses of exempt organizations clearly expressed a congressional concern about the potential for unfair competition between an unrelated business and its taxable counterpart, congress never intended the potential for competition to serve as a guidepost to differentiate unrelated from related trade or business. a business activity furthering the exempt purposes of the organization is still able to compete, fairly or unfairly, with its taxable counterparts without itself paying tax. as noted by the court in midwest research institute v. united states, "tax-exempt organizations do enjoy a competitive advantage when providing the same goods and services as ordinary businesses .... nonetheless, the drafters chose to tax only income from businesses 256. id. at 90, 91. 257. id. at 91. 258. american bar endowment, 477 u.s. at 114. [vol. 3:7 unfair business competition that were not 'substantially related' to the exempt purpose of the organization, not all income from activities that competed with private industry."' 9 c. is a finding of unfair competition a prerequisite to imposition of the tax? tax-exempt organizations resisting the government's efforts to collect the section 511 tax on unrelated businesses on occasion have argued that an activity cannot be a trade or business unless the court finds that the activity competes unfairly with a taxpaying entity.' the taxpayer in louisiana credit union league v. united states6' framed the issue more accurately. assuming that the activity in question is a trade or business and is unrelated to the fulfillment of the organization's exempt purpose, is a specific finding of unfair competition with a taxable entity engaged in a similar activity nevertheless a prerequisite to imposition of the tax? 2in all cases the taxpayer's argument against taxation under section 511 has been based on an expression of congressional intent that one of the purposes of the tax is to prevent such unfair competition. notable among the decisions in which the taxpayer lost the "no competition/no tax" argument are clarence labelle post no. 217, veterans of foreign wars v. united states263 and louisiana credit union league. in clarence labelle post, the eighth circuit held that a 501(c)(4) organization could be taxed on revenues received from the operation of bingo games 259. midwest research inst. v. united states. 554 f. supp. 1379, 1383-84 (w.d. mo. 1983) (citation omitted), affd, 744 f.2d 635 (8th cir. 1984); see also the macaroni monopoly, supra note 60, at 1287; h.r. rep. no. 413, supra note 102, reprinted in 1969 u.s.c.c.a.n. at 1695 ("your committee believes that a business competing with taxpaying organizations should not be granted an unfair competitive advantage by operating tax free unless the business contributes importantly to the exempt function."). in the case of trade associations, tax exempt under irc § 501(c)(6) their activities further a common business interest rather than the members in their individual capacities; the government has argued that the fact that the activity competes with those of taxable entities demonstrates that the activity is not unique to the organization's exempt purpose and therefore does not contribute importantly to it. see texas apartment ass'n v. united states, 869 f.2d 884. 887-89 (5th cir. 1989) (in which the government lost this argument because the court found the taxpayer's materials to be "unique"). 260. see fraternal order of police, ill. state troopers, lodge no. 41 v. commissioner, 833 f.2d 717, 722 (7th cir. 1987); greene county medical soc'y found. v. united states, 345 f. supp. 900, 901 (w.d. mo. 1972). 261. 693 f.2d 525 (5th cir. 1982). 262. id. at 539. 263. 580 f.2d 270 (8th cir.), cert. dismissed, 439 u.s. 1040 (1978) [hereinafter clarence labelle post]. 19961 florida tax review even though the games did not compete with taxable organizations. 2" similarly, in louisiana credit union league the fifth circuit concluded that the presence or absence of actual competition between a taxable business and an unrelated trade or business is irrelevant to the issue of whether the section 511 tax is to be imposed.26 on the other side of the ledger, the seventh circuit in hope school v. united states' declined to tax a 501(c)(3) educational organization on revenues generated by its greeting cards mail-out program to prospective donors because there was no evidence that the school's solicitation campaign competed unfairly with taxable greeting card businesses.26 likewise, judge schatz, dissenting in clarence labelle post, vigorously supported the taxpayer's argument that its bingo games could not be taxed because of lack of competition with taxable businesses.268 both sides of the controversy argued that legislative history supported its position. in louisiana credit union league, the fifth circuit conceded that the prevention of unfair competition was a goal of the 1950 legislation, but maintained that congress was equally concerned with two other problems, viz., the loss of revenue resulting from the ownership of unrelated businesses by tax-exempt organizations and the inequity of allowing such ownership at no tax cost.269 similarly, the eighth circuit in clarence labelle post concluded that the goal of eliminating unfair competition "existed only as part of a larger goal of raising revenue. 270 as a rejoinder, judge schatz, dissenting in clarence labelle post, cited table 1 of the senate report accompanying the revenue act of 1950 to make the point that most of the additional revenue to be raised by the act was projected to come from higher corporate and individual income tax rates.27' in fact, as judge schatz points out, the senate bill compared to the house bill substantially decreased the projected additional revenue to be generated by the amendments affecting tax-exempt entities. thus, in the opinion of the judge, while congress desired to raise revenue as an overall objective of the 1950 legislation, the specific goal of the new tax on unrelated businesses was to eliminate unfair competition.272 judge schatz's view is 264. id. at 274. 265. louisiana credit union league, 693 f.2d at 541-42. 266. 612 f.2d 298 (7th cir. 1980). 267. id. at 304. 268. clarence labelle post, 580 f.2d at 279-81 (schatz, j., dissenting). 269. louisiana credit union league, 693 f.2d at 540. 270. clarence labelle post, 580 f.2d at 272. 271. id. at 277 (schatz, j., dissenting). 272. id. [vol. 3:7 unfair business competition shared by the supreme court in united states v. american bar endowment273 and is supported by treasury regulations.274 while judge schatz, as well as the seventh circuit in hope school, accurately interpreted the legislative history of the section 511 tax, there is little either can glean from the statutory language itself to support the position that a specific finding of unfair competition is a prerequisite to imposition of the section 511 tax. section 513 defines the term "unrelated trade or business" as any trade or business not substantially related to the exempt purpose of the organization.275 as the fifth circuit stated in louisiana credit union league: although the legislative history speaks of competition, those who actually drafted the statute avoided the word as if it were the plague. the statute nowhere requires or even suggests that the presence or absence of competition is a factor to be considered in connection with the unrelated business income tax.2'6 carefully avoiding reference to the statute itself, the seventh circuit in hope school turned rather to other sources in search of ammunition to support its "no competition/no tax" position, including a 1975 amendment to the treasury regulations.2' the 1975 amendment provides that the tax on unrelated businesses does not apply when low cost articles are sent out incidental to the solicitation of a contribution because "the organization is not in competition with taxable organizations."27 the seventh circuit failed to quote, however, another sentence of the same regulation that appears to establish a conclusive presumption that an unrelated trade or business conducted by a tax-exempt entity competes unfairly: however, in general, any activity of a section 511 organization which is carried on for the production of income and which otherwise possesses the characteristics required to constitute "trade or business" 273. 477 u.s. 105 (1986). "the undisputed purpose of the unrelated business income tax was to prevent tax-exempt organizations from competing unfairly with businesses whose earnings were taxed." id. at 114. 274. see regs. § 1.513-1(b) ("the primary objective of adoption of the unrelated business income tax was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete."). 275. irc § 513(a). 276. louisiana credit union league, 693 f.2d at 541. 277. hope sciool, 612 f.2d at 301. 278. regs. § 1.513-1(b). 19961 florida tax review within the meaning of section 162-and which, in addition, is not substantially related to the performance of exempt functions-presents sufficient likelihood of unfair competition to be within the policy of the tax.279 aware of this last quoted sentence of the regulation, judge schatz, dissenting in clarence labelle post, held steadfast in his opinion that the sentence is subservient to the primary purpose of the section 511 tax to eliminate unfair competition, a purpose confirmed by the first sentence of the same regulation.80 judge schatz, however, did not, and could not, cite any provision in either the code or the regulations that explicitly imposes a finding of competition as a condition to taxation under section 511. as a parting sally the taxpayer in clarence labelle post argued that by enacting section 513(d) 281 in 1976, congress provided additional evidence that it intended to exclude from the section 511 tax unrelated businesses that do not actually compete with taxpaying entities. the senate report accompanying the 1976 legislation indeed indicated that section 513(d) was adopted as a reaction to internal revenue service rulings-involving horse racing at an exempt county fair association and renting display space at a convention trade show-in which the service held that the tax applies even though the activity does not compete with commercial endeavors.282 similarly, the seventh circuit in hope school found support for the "no competition/no tax" position with the adoption of section 513(f) in 1978.283 in specifically overruling the holding in clarence labelle post, subsection 513(f) excludes from the term "unrelated trade or business" the conduct of bingo games where such activity is not ordinarily carried out on a commercial basis in the state in which the exempt organization operates.2" as the house report accompanying section 513(f) explained, 279. id.; see louisiana credit union league, 693 f.2d at 542. 280. clarence labelle post, 580 f.2d at 278 (referring to the first sentence of regs. § 1.513-1(b): "the primary objective of adoption of the unrelated business income tax was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the non-exempt business endeavors with which they compete."). 281. irc § 513(d) (providing that qualified public entertainment activities or qualified convention and trade show activities are not unrelated trade or businesses). 282. s. rep. no. 938, 94th cong., 2d sess. 602 (1976), reprinted in 1976 u.s.c.c.a.n. at 3439 (indicating that (1) the committee thought that the activities in question were related to the exempt purposes of the organizations that conduct them, and that (2) in any event, there was little opportunity for the activities to compete with those conducted by taxpaying entities). 283. hope school, 612 f.2d at 304. 284. irc § 513(f). [vol 3:7 unfair business competition the basic rationale of the section 511 tax does not apply where taxable organizations are not carrying on the same activity. -8 unconvinced by the taxpayer's argument, the eighth circuit in clarence labelle post reasoned that the adoption of section 513(d) provided evidence to support precisely the opposite conclusion. rather than requiring a finding of competition between the unrelated trade or business and a taxable entity as an across-the-board general rule, argued the court, congress, in enacting section 513(d), chose to carve out only two specific exceptions for horse racing at an exempt county fair and renting display space at trade shows. 6 the eighth circuit's reasoning applies to the adoption of section 513(f) as well, the very provision that subsequently overruled its decision in clarence labelle post. section 513(f) confines its focus narrowly to bingo games, bypassing the opportunity to exclude from the tax all unrelated trade or business in situations where taxable organizations are not carrying on the same endeavor. as the fifth circuit stated in louisiana credit union league: "for over thirty years, congress has had the opportunity to create a requirement of competition with taxable entities as a prerequisite for taxation on unrelated business income. it has declined to do so."' one would have thought that the supreme court put the competition matter to rest with its 1986 decision, united states v. american bar endowment.28 in determining that abe's insurance program "presents an example of precisely the sort of unfair competition that congress intended to prevent,"289 the court was untroubled by the fact that "abe prices its policies competitively with other insurance policies offered to the public and to abe members" 290 nor by the failure of the claims court to find any taxable entities that compete with abe. without subjecting earnings from its insurance program to tax, the court speculated, abe was in a position to earn less profit, presumably by lowering prices and still earn the same return on investment as taxable organizations offering group insurance policies to its members. furthermore, speculated the court, it was likely that abe members were also members of such taxable organizations."' as the 285. h.r. rep. no. 1608, 95th cong., 2d sess., 6 (1978). reprinted in 1978 u.s.c.c.a.n. 3716, 3718. 286. clarence labelle post, 580 f.2d at 273. 287. louisiana credit union league, 693 f.2d at 541 (footnote omitted); see also carolinas farm & power equip. dealers ass'n v. united states, 699 f.2d 167, 170 (4th cir. 1983). 288. united states v. american bar endowment, 477 u.s. 105 (1986). 289. id. at 114. 290. id. at 108. 291. id. at 114-15. the court also stated: "if abe's members may deduct part of their premium payments as a charitable contribution, the effective cost of abe's insurance will be lower than the cost of competing policies that do not offer tax benefits." id. at 114. the 19961 florida tax review seventh circuit subsequently noted in its 1987 decision, fraternal order of police, illinois state troopers, lodge no. 41 v. commissioner, 292 "in concluding that the american bar endowment's insurance program did unfairly compete, the [supreme] court relied on hypothetical possibilities, rather than on an actual finding of unfair competition." 293 given the present statutory framework, the question remains whether congress should now adopt a general rule requiring a specific finding of unfair competition as a prerequisite to imposing the tax on unrelated business. assume that congress adopts such a rule and places the burden of proof on the government. the internal revenue service subsequently attempts to collect the tax from a very successful ice cream manufacturer operated by a university tax-exempt under section 501(c)(3). the government is able to establish both the parameters of the market place in which the feeder currently operates and the identity of a taxable competitor attempting to sell ice cream of comparable quality within the same territory. having demonstrated actual competition, the government should not have the additional burden to prove the competition to be unfair. the competition is potentially unfair even if the feeder does not currently take advantage of its newly enacted exemption. whatever amount the taxable manufacturer is required to pay as income tax, the feeder has available an equivalent amount to add to any budget line it chooses, whether it be sales, marketing, management, production, inventory, capital improvement, investment, training or research, or it can simply lower its prices. further, if the feeder distributes 100% of its profit to its 501(c)(3) owner, there is nothing in the present statute to prevent the exempt organization from recontributing an equal amount back to the feeder at a later time. once the fact of competition has been established, the unfairness of the competition should be presumed. should the government even have the burden to prove the existence of an actual competitor doing business in the same marketplace as the feeder? united states v. american bar endowment illustrates the difficulties that can court then proceeded to eliminate this potential for unfair competition by holding that no portion of the premium payments constituted charitable contributions. id. at 119. for an analysis of the case, see charitable donations or unrelated business income?: united states v. american bar endowment, 21 u.s.f. l. rev. 817 (1987). 292. 833 f.2d 717 (7th cir. 1987). 293. id. at 722 (citations omitted). see donald c. haley, the taxation of the unrelated business activities of exempt organizations: where do we stand? where do we seem to be headed?, 7 akron tax j. 61 (1990) ("[t]he controversy over the relevance of the presence or absence of competition with taxable entities continues." id. at 78. some of the cases cited by haley to support this statement focused upon the potential for competition with taxable entities, or the lack of it, to determine whether the activity in question was "unrelated" or "related." id. at 79.). [vol 3:7 unfair business competition be encountered in the attempt. by assuming that the abe membership as a group constituted the marketplace, the claims court unsurprisingly was unable to identify any taxable entity competing with abe for the business of the group as a whole. by contrast, the supreme court, realizing that the potential market consisted of abe's members as individuals rather than as a group, speculated that it was likely that such individuals were eligible to participate in other group insurance programs offered by various taxable entities of which they were also a member. furthermore, although it cannot be denied that group insurance programs traditionally offers lower rates than individual policies, the argument can be made that every licensed insurance broker residing in the same community as an abe member potentially competed with abe's insurance program for premium dollars. given that the abe membership is dispersed throughout the country, should not a court be empowered to take judicial notice of the fact that insurance brokerage exists as a trade or business throughout the united states? or, is it necessary that the government specifically identify at least one group insurance program sponsored by a taxable organization available to each abe member, or alternatively at least one insurance agency doing business in his or her community? assume that the feeder is able to establish affirmatively that there are no taxable businesses competing in the same territory with its goods or services, e.g., the feeder's brand of ice cream is the only one sold in its comer of the marketplace. given that ice cream is sold elsewhere, there is the possibility that the taxable ice cream manufacturers have been unable to crack the feeder's market due to the advantages afforded the latter by its exemption from tax. failure to find an actual taxable competitor, therefore, may be just as indicative of unfair competition as a finding of actual competition in the same marketplace. nor would it matter significantly if the feeder conducted a business not found anywhere else. it has to be assumed that if a section 501(c)(3) organization finds an unrelated trade or business potentially profitable enough to conduct, it is probable that a taxable entity would regard operating a competing business with equal interest. inasmuch as any unrelated trade or business invites its own potential taxable competition, one must in all cases reckon with the potential anti-competitive effect of the exemption from tax, whether actual competition is found or not. in rejecting the "no finding of competition/no tax" rule, one is led full circle back to the presumption of unfair competition found in regulations section 1.513-1(b): any unrelated trade or business "presents sufficient likelihood of unfair competition to be within the policy of the tax."' 294. regs. § 1.513-1(b). 1996/ florida tax review v. metastasis of the unfair competition rationale and a regimen for containment a. the challenge from the small business community 1. competition between related businesses and taxable enterprises.-in june of 1987, the subcommittee on oversight of the committee on ways and means held hearings in furtherance of its mandate to reexamine "the policy considerations underlying the appropriate tax treatment of incomeproducing activities of tax-exempt organizations,"'295 in particular to determine how the tax on unrelated business income impacted both taxexempt organizations and for-profit businesses. although the witnesses before the subcommittee representing the nonprofit sector and the small business community, respectively, could agree on very little, both camps were confronted with the irrefutable fact that the number of nonprofit organizations had increased dramatically over the years. between 1967 and 1987, the irs 295. ubit hearings, supra note 78, at 3. 0. donaldson chapoton, deputy assistant secretary (tax policy), department of the treasury, was the first witness and, de facto, set the agenda for the hearings. mr. chapoton commented on the following items: the "substantially related" standard, which the treasury department believes has "conceptual merit as the basis for granting exemption from tax," id. at 24, although there was concern that its "inherent generality is a source of administrative difficulty," id. at 39; the need for an expanded form 990, i.e., more detailed reporting to improve enforcement and compliance; the need to reexamine the "volunteer" exception to the definition of unrelated business provided by § 513(a)(1); the need to reexamine the "convenience" exception to the definition of unrelated business provided by § 513(a)(2) for an activity carried on primarily for the convenience of the organization's members, students, patients, officers, or employees; the justification for the "donated property" exception provided by § 513(a)(3); the need for legislation to override rensselaer polytechnic institute v. commissioner, 732 f.2d 1058 (2d cir. 1984), which allocated fixed costs of the institute's field house between related and unrelated uses on the basis of its total hours of use rather than on the basis of comparing the hours used for the unrelated business to the total hours available for use (as contended by the irs); the suggestion to increase the $1,000 specific deduction provided by § 512(b)(12) to $5,000; the necessity of maintaining the "fragmentation rule" provided by § 513(c); the need to broaden the "controlled subsidiary" test provided by § 512(b)(13) to include subsidiaries more than 50% owned, by voting power or value, by the parent exempt organization, using attribution rules; the desirability of including the unrelated business activities of subsidiaries to determine whether the primary purpose of the parent organization is the carrying on of an unrelated business; the desirability of maintaining the exclusion for "passive" income (dividends, interest, annuities, royalties, and rents provided by § 512(b)(l)-(3)); the need to reexamine the definition of "royalty" to make amounts measured by net profits taxable; the need to develop appropriate standards to differentiate exempt from taxable research activities; the need for additional restrictions to prevent improper allocation of partnership deductions between partners who are tax-exempt and taxable; and the need to reexamine the issue of whether a 501 (c)(3) organization acting as a general partner in a limited partnership is "incompatible with the prohibition against distribution of earnings to private interests and whether they create a conflict of interest for the exempt organization." ubit hearings, supra note 78, at 23-54. [vol 3:7 unfair business competition master file for active tax-exempt organizations had increased from approximately 400,000 to in excess of 850,000.296 further, although there was insufficient data to draw quantifiable conclusions, it appeared that 501(c)(3) organizations were becoming increasingly reliant on income-producing activities, in particular, revenues from the sale of goods and services, as a source of funding and less reliant on government grants and private donations.297 irs master file data show that, in 1946, organizations exempt under section 501(c)(3) obtained 59% of their support from business receipts, interest, dividends, rents, royalties, sales of assets and miscellaneous sources other than government grants, private contributions, dues and assessments; 71 percent from such sources in 1975; and 78% in 1983.298 views clashed sharply, however, as to the nature of the incomeproducing activities upon which 501(c)(3) organizations were presumably becoming more reliant and the significance of the meager data that was available. some members of the small business community were of the opinion that unfair competition between tax-exempt organizations and taxable businesses had intensified primarily due to the former's expansion into areas beyond the traditional role of the non-profit sector-in part due to increased demand for services and excess capacity. 299 at least one witness on behalf 296. see ubit hearings, supra note 78, at 12 (containing statements of 0. donaldson chapoton, deputy assistant secretary (tax policy), u.s. department of the treasury). in 1987, there were "nearly 390,000 religious (other than churches), educational, charitable and scientific organizations exempt under section 501(c)(3) . i.." id. at 26. in 1985, operating expenditures of nonprofits totaled s239 billion, or 6% of gnp, according to an estimate of the bureau of economic analysis. id. "in 1984, 47 percent of current operating expenditures of nonprofits were accounted for by health service organizations, and 22 percent by educational and research organizations." id. at 27. 297. see id. at 97 (testimony of frank s. swain, chief counsel for advocacy, u.s. small business administration); id. at 129-39 (containing statements of jennie s. stathis, associate director, general governmental division, u.s. general accounting office); id. at 134, 139 (statement of jennie s. stathis, associate director, general governmental division, u.s. general accounting office); id. at 158, 183 (statement of marion r. fremont-smith, board member, independent sector); see also id. at 160 (statement of marion r. fremontsmith, board member, independent sector) (discussing how private payments, primarily fees for service, for social services increased in 1984 while governmental payments decreased). 298. id. at 27 (statement of 0. donaldson chapoton, deputy assistant secretary (tax policy), u.s. department of the treasury). 299. see id. at 134 (statement of jennie s. stathis, associate director, general governmental division, u.s. general accounting office) ("[s]ome business people told us that this apparent increase in income-producing activities [by tax-exempt organizations] is a source 19961 florida tax review of the business community was prepared to admit, however, that increased competition between the two sectors had resulted as much from taxable businesses seeking a foothold in a certain traditionally nonprofit markets such as health care as it had from nonprofits expanding into the domain of taxable business.3" witnesses on behalf of 501(c)(3) organizations emphasized that third-party and government funding for social services had made it profitable for taxable businesses to enter fields traditionally reserved for nonprofits such as "hospitals, day-care centers, alcoholism treatment centers, homes for the aged, health research, continuing education and even cemeteries." '' other members of the tax-exempt community viewed the data indicating increased reliance on income-producing activities as simply reflective of the fact that 501(c)(3) organizations as a group were more reliant on charging fees for related goods and services in furtherance of their exempt purposes than on contributions from the public or government funding.302 of unfair competition."); id. at 218 (statement of joseph o'neil, chairman, business coalition for fair competition) (discussing increased demand and excess capacity). of particular concern to the small business community was the entry of nonprofits into the following businesses: paging, answering, cleaning, and laundry services; retail pharmaceuticals; hearing aids; medical equipment; and prosthetics. id. at 100 (statement of frank s. swain, chief counsel for advocacy, u.s. small business administration). other businesses included: "interior decorating, computerized billing for doctors, catering, health and fitness clubs, travel agencies, marketing of frozen foods for the elderly, data processing, day-care centers, and medical hotels for patients who no longer need hospital care but are not ready to return home." id. (quoting james j. mcgovern, restructured nonprofit hospitals, 35 tax notes 405, 406 (apr. 27, 1987)). mr. o'neil also listed the following businesses which compete with nonprofits: areas in which businesses go head to head with nonprofits include food service, testing laboratories, retail sales of books and computers, travel, recreation, nurseries, day care, hearing aids, veterinarians, blood banks, consulting engineers, medical equipment suppliers, pencil makers, specialty advertisers, hotels, bus operators, printing, construction, laundries, janitorial services, waste hauling, electrical, plumbing, and heating contracting to name a few. id. at 218. there was, however, no attempt to identify which of these endeavors were: (1) claimed by the nonprofit to be a "related" activity; (2) claimed by the nonprofit to be nontaxable under the "convenience" exception; (3) reported as an "unrelated" activity; or (4) not reported as an "unrelated" activity. 300. see id. at 218 (statement of joseph o'neil, chairman, business coalition for fair competition). 301. cf. id. at 155 (statement of marion r. fremont-smith, board member, independent sector). 302. see id. at 134 (statement of jennie s. stathis, associate director, general governmental division, u.s. general accounting office); id. at 241 (testimony of the national assembly of national voluntary health & social welfare organizations) ("some [nonprofit) organizations do rely heavily on fee income."). see generally walter b. slocombe, exempt organizations: business and other activities in an uncertain world, 70 taxes 974 (1992) (discussing a number of issues confronting 501(c)(3) organizations). [vol 3:7 unfair business competition conceding that some percentage of the perceived increased competition confronting for-profits may have found its source in activities directly related to furthering the charitable purposes of the conducting organization, the small business community took the position before the subcommittee on oversight that such related activity should nonetheless be taxed."0 3 the logic of the argument proceeded as follows: if exemption from tax afforded 501(c)(3) organizations is based on the rationale that such organizations provide the citizenry with governmental type goods and services otherwise unavailable in the marketplace, then there is no justification for the exemption with respect to those goods and services sold by both for-profits and taxexempts in the same market.3 4 further, nonprofits are not necessarily more on the other hand, the proscription against nonprofit organizations raising equity capital and their inability to borrow at favorable rates had impelled 501(c)(3) organizations to seek capital for their related activities through collaborative joint ventures with for-profit entities. typically, the charity would act as the general partner in a limited partnership and the for-profit investors would participate as limited partners. such collaborative enterprises raise a number of issues of their own. should the 501(c)(3) organization's tax-exempt status be threatened because it operates such a joint venture with a substantial non-exempt purpose, i.e., to further the private interests of the profit-motivated investors? does the fiduciary duty of the charity acting as general partner to the limited partners create a conflict of interest? does a distribution to the limited partners violate the prohibition against a charity's earnings inuring to private individuals? is there unwarranted shifting of tax benefits to taxable partners? is the charity engaging in unfair competition for invested capital? see id. at 51-54 (statement of 0. donaldson chapoton, deputy assistant secretary (tax policy), u.s. department of the treasury); id. at 416-17, 420-21 (statement of jeff carr, vice chancellor for university relations and general counsel, vanderbilt university); michael h. schill. the participation of charities in limited partnerships, 93 yale l.j. 1355 (1984). we realized that vanderbilt had the land and the professional faculty talent to support an additional facility, but not the capital.... a collaborative effort with hospital corporation of america (hca) was developed under which an 88-bed child and adolescent psychiatric hospital would be built on vanderbilt land, professionally staffed with vanderbilt faculty, financed by hca capital, and managed by hca.... of particular importance is the point that this child and adolescent psychiatric hospital would not and could not have been built and operated without the unique contributions of both vanderbilt and hca. ubit hearings, supra note 78, at 420-21 (statement of jeff carr. vice chancellor for university relations and general counsel, vanderbilt university). 303. ubit hearings, supra note 78, at 90 (containing statements of frank s. swain, chief counsel for advocacy, u.s. small business administration) (suggesting the tightening of the current relatedness test); id. at 103-04 (statement of frank s. swain, chief counsel for advocacy, u.s. small business administration). 304. see id. at 103-04 (statement of frank s. swain, chief counsel for advocacy, u.s. small business administration); id. at 219 (statement of joseph o'neil, chairman, business coalition for fair competition). 19961 florida tax review efficient, more regulated, or more moral than for-profits.3 5 moreover, the relationship between volunteerism and nonprofit status, desirable as it is, is not dependent on tax exemption, but on the volunteer's knowledge that his efforts will promote the public good and not private gain." thus, the expansion of for-profits and tax-exempts into each other's markets has "blurred [their] separate identities" 3°7 and reduced the primary distinction between them to one of taxation for the former and an exemption for the latter. this distinction offers tax-exempts an unfair competitive advantage which should be eliminated.0 s 305. see id. at 220 (statement of joseph o'neil, chairman, business coalition for fair competition). 306. see id. at 219-20. 307. id. at 97 (statement of frank s. swain, chief counsel for advocacy, u.s. small business administration). 308. see id. at 90 (containing statements of frank s. swain, chief counsel for advocacy, u.s. small business administration); id. at 98 (testimony of frank s. swain, chief counsel for advocacy, u.s. small business administration). the small business community complained that nonprofits enjoyed competitive advantages in addition to federal tax exemption, including federally subsidized mail rates; numerous state and local tax exemptions; special treatment under various federal laws, including those relating to social security, unemployment insurance, and minimum wage; and a goodwill advantage in marketing their goods and services-referred to as the "halo effect." id. at 98-99. additionally, there were complaints that feeders were purchasing supplies at the taxexempt parent's lower rates; using the parent's personnel and property; and availing themselves of the parent's ability to accumulate tax-free capital. see id. at 835 (views of paul simmons, president, health industry distributors association) (discussing recommendations of the u.s. department of the treasury). "even when an activity is considered unrelated and, therefore, taxable, the exempt organization gains a significant advantage because it is able to use untaxed income from other sources, such as dues, contributions of related activity, to fund unrelated commercial activity." id. at 104 (statement of frank s. swain, chief counsel for advocacy, u.s. small business administration). in addition to their ability to accumulate tax-free internal capital to fund feeders and unrelated businesses, 501(c)(3) organizations, unlike for-profit investors, can also raise investment capital through gifts, grants, and donations. these advantages, however, may be offset by the inability of 501(c)(3) organizations to raise equity capital or to borrow money as easily as can for-profit investors. see steinberg, supra note 25, at 355. further, under the present statute: [w]hen a [nonprofit] invests in active production, it forgoes the opportunity to earn the pre-corporate-tax rate of return from alternative passive investments. in contrast, when a [for-profit] invests in active commercial production, it forgoes the post-corporate-tax rate of return. thus, [nonprofits] face a higher opportunity cost of active production, and would prefer passive investment unless the active commercial output strongly and directly helps them accomplish the exempt purpose. id. steinberg also raises a number of nontax issues when a for-profit entity alleges that a nonprofit organization is unfairly competing with it, viz., the degree of the for-profit entity's [vol. 3:7 unfair business competition the difficulty with this argument begins with its premise, viz, activities directly furthering the charitable purposes of nonprofit organizations should be exempt from tax only when the public goods and services they offer are otherwise unavailable in the marketplace. comparing the nonprofit and for-profit models, it is the intrinsic defect in the for-profit model, i.e., its focus on the bottom line rather than on continuity and quality, that justifies the exemption subsidy afforded nonprofits in cases where similar essential public goods and services are offered by both nonprofits and for-profits in the same market. comparing the nonprofit model with the federal government, it is the principles of pluralism and democratic decentralization that add further weight to the legitimacy of the exemption subsidy in cases where similar essential public goods and services are offered by both. the importance of the nonprofit charitable sector to society does not arise only when there is a void left to fill by the twin failures of for-profit enterprise and the federal government. a nonprofit entity organized and operated primarily to further one or more of the activities enumerated in section 501(c)(3), and in compliance with the section's additional requirements, merits exemption as representing generically an essential provider of the type of public goods and services it offers, and not simply as a third-string player. the problem with the position taken by the small business community is illustrated by one of the case studies of "unfair" competition submitted to the subcommittee on oversight by the national federation of independent businesses. in "non-profit case-no. 7" the president of a business consulting firm complained that the "[1]ocal university, the north carolina department of industrial engineering[,] publishes a listing of course offerings and seminars in direct competition with local consultants and other private businesses with expertise in the same areas."" clearly, the for-profit business consulting firm does not through its own course offerings or consultations bring to the marketplace the same efficiency; whether the nonprofit entity is benefiting from a cost advantage; whether the forprofit entity suffers "from competition only in circumstances where... [its) profits would otherwise be exorbitant"; and whether there is a random element to "[nonprofit] successes and corresponding [for-profit] failures .... to the extent that success and failure occur for random reasons, [for-profits] are just as likely to succeed and [nonprofits] to fail as vice versa. however, only the former would be reported anecdotally. leaving a biased picture." id. at 352. additionally, "[i]f [nonprofits] enjoy greater success at the expense of [for-profitsl. which of the many tax and regulatory differences in treatment of the two sectors are responsible? elimination of some differences might not help [for-profits] very much, and the different taxes have varying impacts on the broader economy." id. steinberg concludes that "[w]e do not yet know the impact of tax and regulatory differentials on the behavior and performance of competing [for-profit] and [nonprofit] firms." id. at 361. 309. ubit hearings, supra note 78, at 291 (statement of john j. motley, ii and abraham schneier, national federation of independent business). 19961 florida tax review character and quality of services brought by the university. the continuing or adult education programs of the university must be viewed as an integral component of the larger institution. the sole purpose of the university is to promote the general welfare, viz, to meet society's "intellectual, cultural, social, economic and technological needs" ' through teaching, research, and public service to the local community in which it exists. the primary purpose of the private consulting firm is to make a profit. as a nonprofit organization, the university is forbidden from distributing profits, if it should earn any, to or for the benefit of private persons. the purpose of the private consulting firm is to make such a distribution to its owners. the university is required to make its services available to a broad segment of the community. the private consulting firm has no such mandate. the university as an american institution has existed in excess of 300 years as a preserve of "the legacies of our past through a succession of cultural fads, political changes, and ideological movements";312 it has the capacity to conduct its activities without consideration of short-term market demands, and it can continue to serve the community around it through continuing education and assistance programs in depressed economic times on a break-even basis.3"3 the private consulting firm, guided primarily by market forces, will disappear if the profit opportunity evaporates. as the united states economy in the past decades has gradually shifted from one based on manufacturing to one based on technology, the central and vital role of the american university in the conduct of basic and applied research, in the transfer of the resultant technological innovation to the business community, and in the transmission of technological information to the public, has grown in importance.314 it is not surprising, therefore, that congress has made a decision to encourage the "related" activities of the university, including continuing education programs, through exemption from income tax and not similarly to subsidize the activities of the private consulting firm that happens to operate in the same community. thus, there may be competition between the "related" activities of the 501(c)(3) organization directly furthering the purposes of its mandate and similar activities conducted by a taxable enterprise, but the tax exemption 310. id. at 363 (statement of the american council on education). 311. see id. at 367 ("pursuant to ... legislative mandates ... colleges and universities provide public services that range from continuing education and adult education programs to technical assistance to low-income health clinics."). 312. id. at 364. 313. see id. at 373 (noting that the farming community needs to know that critical services provided by colleges and universities will be around in both good and bad economic times, whether or not the services are profitable to perform). 314. see id. at 365, 372. [vol 3:7 unfair business competition afforded the former does not render the competition unfair. rather, the exemption from tax and any competitive advantage that may be the result is an expression of a national policy to encourage and preserve the 501(c)(3) organizations' historic social mission. 2. the statutory standard revisited.-from this perspective, the statutory exemption from tax afforded business activities substantially related ("contributing importantly") to the fulfillment of the organization's charitable purpose is an appropriate standard in furtherance of this national policy. proposals offered by the small business community to tax an activity conducted by a 501(c)(3) organization based on the activity's "commercial" nature rather than its purpose 1 5 contravenes this policy. these proposals include taxing any commercial activity conducted by a nonprofit;3" 6 taxing a nonprofit if its commercial activity exceeds a specified minimum; 317 taxing any activity that competes with the for-profit sector,3t or imposing a rebuttable presumption of taxability if an activity both earns a profit and competes with a for-profit entity in the same market.31 1 as a fallback position, some advocates on behalf of the small business community urged tightening of the "substantially related" test in part to reverse the statutory expansion of the definition that had occurred since enactment of the original statute in 1950. the chief counsel for advocacy for the u.s. small business administration observed that "[the definition] has been held to encompass the sale of broadcasting rights, the operation of grocery stores, and horse racing tracks, the exchange of mailing lists, and the sale of milled lumber and greeting cards, to name just a few activities."' it is true that a number of legislative amendments to the original statute have removed certain activities from the reach of the tax. for example, the tax 315. see id. at 223 (statement of joseph o'neil, chairman, business coalition for fair competition). 316. see id. at 822 (statement of the american clinical laboratory association). 317. see id.; see also id. at 90 (containing statements of frank s. swain, chief counsel for advocacy, u.s. small business association) (suggesting applying an overall cap on the amount of commercial activity a nonprofit organization can conduct). 318. see id. at 104 (testimony of frank s. swain, chief counsel for advocacy. u.s. small business administration). 319. see id. at 223-24 (statement of joseph o'neil, chairman, business coalition for fair competition). the deputy assistant secretary (tax policy). department of the treasury, took the position that the "substantially related" test had "conceptual merit." see id. at 24 (statement of 0. donaldson chapoton, deputy assistant secretary (tax policy). u.s. department of the treasury). also, internal revenue commissioner gibbs said that the irs couldn't determine whether competition was unfair. see id. at 69 (testimony of lawrence b. gibbs, commissioner of internal revenue). 320. id. at 105 (statement of frank s. swain. chief counsel for advocacy, u.s. small business administration). 19961 florida tax review reform act of 1976 exempted specified entertainment activities traditionally conducted at agricultural affairs or educational expositions, as well as activities traditionally conducted at trade shows;32 1978 legislation exempted bingo games when such games were not ordinarily conducted on a commercial basis;322 and the tax reform act of 1986 exempted activities relating to distribution of low cost articles incidental to the solicitation of charitable contributions, as well as the exchange or rental of mailing lists among charitable organizations. 3 on the other hand, the most important amendment to the original statute, the tax reform act of 1969, extended the tax on unrelated business income to include all exempt organizations other than united states instrumentalities, 324 adopted the fragmentation rule allowing each component of an integrated business to be tested against the relatedness standard, 32 expanded the scope of the tax with respect to acquisitions financed with debt,326 extended the tax to cover income received from a controlled corporation 327 and narrowed the exclusion of rents received from the lease of personal property in combination with real property.328 the record of statutory amendments taken in its entirety does not support the generalization that congress has been chipping away at the reach of the tax on unrelated business. frank swain, chief counsel for advocacy, u.s. small business administration, additionally complained that the existing "substantially related" test left "the boundaries between related and unrelated activities... so unclearly drawn that the test has proven difficult for the service to administer and enforce," it has promoted inconsistency in its application, and has allowed "somewhat related" activities to go untaxed.329 mr. swain, appearing before the subcommittee on oversight, pointed to hi-plains hospital v. united states, 330 the 1985 fifth circuit decision, as an example of "[h]air-splitting court cases illustrative of the fact that 'substantially 321. see tax reform act of 1976, pub. l. no. 94-455, § 1305(a), 90 stat. 1716 (adding irc § 513(d)). 322. see pub. l. no. 95-502, § 301(a), 92 stat. 1702 (adding irc § 513(f)). 323. see tax reform act of 1986, pub. l. no. 99-514, § 1601(a), 100 stat. 2766 (adding irc § 513(h)). 324. see supra note 106. 325. see irc § 513(c). 326. see supra note 107; see also irc § 514. 327. see irc § 512(b)(13). 328. see irc § 512(b)(3). 329. ubit hearings, supra note 78, at 104 (testimony of frank s. swain, chief counsel for advocacy, u.s. small business administration). 330. 670 f.2d 528 (5th cir. 1982). [vol 3:7 unfair business competition related' requires subjective decisionmaking,"33' and, since hi-plains hospital was one of several decisions holding for the taxpayer on the issue, presumably illustrative of the fact that some courts are willing to apply the standard loosely in favor of the charitable organization.3 2 in his testimony before the subcommittee, the commissioner of the internal revenue service, laurence gibbs, offered further illustration of the difficulty in enforcing the "substantially related" standard due to its facts-andcircumstance nature by comparing one irs ruling holding the sale of a teddy bear to be a substantially related activity "where it was identified as a model of the stuffed toy named after theodore roosevelt, and because it introduced children to american history and president roosevelt," '333 with another ruling in which the sale of blazer buttons adapted from a medal commemorating george washington's first inauguration was held to be an unrelated activity because of the utilitarian purpose of the buttons ... [but] if the blazer buttons were sold with descriptive literature explaining their connection with the original medal, the sales might then be considered related activity. 3 the two rulings can better serve to illustrate just how minuscule the focus of the irs had become in its efforts to enforce a statute adopted in reaction to fear that major ventures owned by tax-exempt organizations were threatening to drive all their taxable competition out of business. 335 unfortunately, subjective decisionmaking appears to be endemic to the application of a legal standard, such as "substantially related", to facts and circumstances. the treasury department for its part has attempted to offer guidance as to the meaning of "substantially related" by including numerous examples in the 1967 regulations illustrating when and when not, in its view, an activity contributes importantly to the accomplishment of the organiza331. ubit hearings, supra note 78, at 104 (testimony of frank s. swain, chief counsel for advocacy, u.s. small business administration) (footnote omitted). 332. see id. (noting the decision in hi-plains hospitao; see also ubit hearings, supra note 78, at 38 (statement of 0. donaldson chapoton, deputy assistant secretary (tax policy), u.s. department of the treasury) ("ithere are indications [that the standard] has been applied in an overly generous manner."). 333. id. at 67-68 (testimony of lawrence b. gibbs, commissioner of internal revenue). 334. id. at 68. 335. see also rev. rul. 73-105, 1973-1 c.b. 264 (holding that sales in a museum shop of souvenirs related to the city in which the museum is located constitute an unrelated activity). 19961 florida tax review tion's exempt purpose.336 any inference that the courts have interpreted the "substantially related" test liberally in favor of exempt organizations is controverted by the government's victories with respect to this issue in the supreme court,337 in the fourth,33 fifth,339 seventh (twice)," ° eleventh,34' federal3 2 and district of columbia circuits, ' 3 several times in the claims court,' and numerous times in the tax courty5 b. compliance and beyond apart from their differences with respect to the appropriateness of the "substantially related" standard as an expression of tax policy or as a guide to enforcement of that policy, all witnesses before the subcommittee agreed that what was needed was more detailed reporting requirements by taxexempt organizations in order to improve data collection, compliance, and 336. see supra text accompanying notes 198-215. 337. see united states v. american college of physicians, 475 u.s. 834 (1986). 338. see carolinas farm & power equip. dealers ass'n v. united states, 699 f.2d 167 (4th cir. 1983). 339. see louisiana credit union league v. united states, 693 f.2d 525 (5th cir. 1982). 340. see illinois ass'n of professional ins. agents v. commissioner, 801 f.2d 987 (7th cir, 1986); carle found. v. united states, 611 f.2d 1192 (7th cir. 1979), cert. denied, 449 u.s. 824 (1980). 341. see independent ins. agents of huntsville, inc. v. commissioner, 998 f.2d 898 ( lith cir. 1993). 342. see national ass'n of postal supervisors v. united states, 944 f.2d 859 (fed. cir. 1991). 343. see american postal workers union v. united states, 925 f.2d 480 (d.c. cir. 1991). 344. see national ass'n of postal supervisors v. united states, 21 cl. ct. 310 (1990), aff'd, 944 f.2d 859 (fed. cir. 1991); disabled am. veterans v. united states, 650 f.2d 1178 (ct. cl. 1981); iowa state univ. of science & technology v. united states, 500 f.2d 508 (ct. cl. 1974). 345. see national water well ass'n v. commissioner, 92 t.c. 75 (1989); veterans of foreign wars, dept. of mich. v. commissioner, 89 t.c. 7 (1987); shiloh youth revival ctrs. v. commissioner, 88 t.c. 565 (1987); florida trucking ass'n v. commissioner, 87 t.c. 1039 (1986); st. joseph farms v. commissioner, 85 t.c. 9 (1985), nonacq., 1986-2 c.b. 1; professional ins. agents v. commissioner, 78 t.c. 246 (1982), aff'd, 726 f.2d 1097 (6th cir. 1984). subsequent to the conclusion of the ubit hearings, on june 23, 1988, the chairman of the subcommittee on oversight, j.j. pickle, released a draft report to the other members of the subcommittee containing proposals for legislative reforms, including taxing mail order, gift shop and book store sales, fitness and exercise activities, travel services, veterinary services, and advertising sales under a per se rule; repealing the "convenience exception" provided by § 513(a)(2); and reducing the 80% "controlled subsidiary" test to a "more than 50%" test. see haley, note 293, supra, at 82-3. [vol. 3:7 unfair business competition enforcement.' commissioner gibbs testified that of the approximately 900,000 exempt organizations on the master file, about 500,000 were not required to file form 990, the annual information return, either because they were churches or received $25,000 or less in gross receipts, and of the remaining 400,000, only 27,000 on average filed form 990-t, which requires reporting of unrelated business gross receipts in excess of $1,000.11 7 unquestionably, present resources of federal administrative agencies are inadequate to supervise the efficient delivery of social benefits by 501(c)(3) organizations, and the inadequacy will markedly increase if the elective credit described in appendix a to the article is enacted into law. at the same time, commentators have observed that the internal revenue service, an agency devoted primarily to raising revenue and not "to make certain that revenue dollars foregone are wisely spent,"' is ill-suited to supervise the spectrum of nonprofit organizations concerned with such diverse issues as higher education, health care, research and public policy, wildlife and the environment, housing and employment, youth and the family, disaster relief, and arts, culture, and humanities. in 1967 professor lawrence stone offered the suggestion that a separate division be created within the treasury department to supervise exempt organizations, perhaps emulating in legal structure and function the securities and exchange commission, chaired by a new commissioner of charities, a presidential appointee.3 9 in addition to being required to file an annual report, each exempt organization would be required to register with the commission and to re-register every three to five years to assure periodic review.3'0 the commission would have "equity powers, including the power, with court approval, to remove derelict trustees, add trustees, force the merger of charities whose original purposes have ceased to exist into active charities, and require the restoration to charity of property improperly taken 346. see ubit hearings, supra note 78, at 24, 27-28, 39 (statement of 0. donaldson chapoton, deputy assistant secretary (tax policy), u.s. department of the treasury); id. at 69 (testimony of lawrence b. gibbs, commissioner of internal revenue). the chief counsel for advocacy, u.s. small business administration, admitted that there was insufficient data to prove anything. see id. at 127 (containing statements of frank s. swain, chief counsel for advocacy, u.s. small business administration). 347. see id. at 70 (containing statements of lawrence b. gibbs. commissioner of internal revenue). see also degaudenzi, supra note 121, at 214-31 (discussing more recent proposals to improve disclosure and to impose sanctions as a means to increase compliance among public charities). 348. zimmerman, supra note 22, at 347. 349. stone, supra note 24, at 63-67. 350. id. at 64. 19961 florida tax review from it."'35' professor stone's suggestion made sense in 1967. it makes even more sense today. professor stone went on to suggest that the commissioner of charities have the power to "delegate regulatory authority to states or to private self-regulatory associations," '352 the latter "operating with quasigovernmental powers and subject to some supervision by government. ' in the wake of the challenge from the small business community to tax exemption afforded to related activities of 501 (c)(3) organizations, and public perception of operational weaknesses within the charitable sector, private selfregulatory associations of the various subgroups of charitable nonprofits are virtually an imperative. such self-regulatory associations could formulate codes of behavior for their members; devise planning strategies, such as to avoid overcapacity or undercapacity within a subsector; issue policy directives, such as to determine what percent of gifts and contributions should be allocated to the current budget rather than to the endowment fund; and construct general operational guidelines. they could periodically review a 501(c)(3) organization member to assess its success in fulfilling its social mission; its compliance with the prohibition against private inurement and compensation unreasonable in amount; its degree of inefficiency, waste, and excessive budgeting for fund-raising and marketing for consumers; its maintenance of an arms-length relationship with its feeders and unrelated businesses; its avoidance of abusing the "convenience" exception to the tax on unrelated activities; and its thoroughness in reporting unrelated activities. they could investigate allegations of misconduct or lack of compliance. in the event the elective credit outlined in appendix a is enacted into law, such selfregulatory associations could enforce compliance with its various conditions, such as the competitiveness of the rates charged by a 501 (c)(3) organization's feeders and unrelated businesses, the computation of the related activity net operating loss limitation, and the computation of the percentage limitations with respect to total gross receipts and the investment portfolio. vi. conclusion in 1950 congress enacted legislation to tax the income generated by feeders and unrelated businesses destined for charity primarily to protect private enterprise from the threat of unfair competition. assuming arguendo the validity of the rationale supporting the 1950 legislation, the statutory 351. id. at 65. 352. id. at 66 353. id. at 67. [vol. 3:7 unfair business competition solution to retain tax exemption for related businesses and to tax only feeders and unrelated businesses was a commendable attempt to balance the interests of private enterprise and of the nonprofit sector. retention of tax exemption for activities substantially related to the furtherance of the 501(c)(3) organization's stated purposes was also an appropriate expression of a policy to preserve the unique social mission of such organizations in the pursuit of their charitable endeavors. notwithstanding administrative and judicial difficulties in accurately defining the statutory phrase "trade or business" and in applying appropriate criteria to differentiate related and unrelated activities, the "substantially related" test, properly applied, is an administrable standard. with the accuracy of vision that hindsight affords it is clear that the 1950 congress, while attempting to balance the interests of private enterprise and of the nonprofit sector, failed to appreciate the inadequacy of mere tax exemption as a means to meet the pressing and legitimate need of charitable organizations for revenue. this congressional failure in perception may not have been simply a case of nearsightedness. the federal government apparently does not view the fiscal soundness of the private, nonprofit charitable sector to be within the ambit of its legitimate concerns. yet, federal government action has directly and indirectly played a key role in shaping the financial destiny of the charitable sector in the ensuing years. decreases in federal research grants and health care reimbursements have profoundly impacted the fiscal well-being of universities and nonprofit hospitals. charitable contributions to 501(c)(3) organizations as a percent of total support have diminished, perhaps in part due to changes in the tax laws affecting the economic result of contributions to donors. as revenue sources have decreased, compliance with a burgeoning quantity of federal legislation and regulations has caused expenses to mount. navigating in a society that espouses laissez faire, but in fact profoundly affected by the actions of the federal government, the charitable sector has attempted to make ends meet by playing in the "free market" competition game without a compass or a map. in some instances the competition to squeeze revenue out of a shrinking pool of available consumer dollars and contribution funds has led 501(c)(3) organizations to overburden their operating budgets with undue allocations to marketing and fundraising. in other cases the pressure for revenue has led charitable nonprofits to push the "convenience exception" to unrelated business activity beyond its intended limits. at the same time, for-profit enterprises have added to the competitive pressure by finding certain traditionally nonprofit activities to be profitable, at least for the moment. as a result, forty-six years after the effective date of the 1950 legislation, it is the private, nonprofit charitable sector that now threatens to move to the top of the list of endangered species. it is the position of this article that the species is worth saving as representing an essential ingredient 1996] florida tax review in the mix of american pluralistic society. clearly, a plan to secure an adequate and reliable source of revenue to fund the charitable activities of 501(c)(3) organizations will require a collaborative effort on the part of the organizations and the federal government; one that, hopefully, respects the charitable sector's needs for financial and political independence. this article suggests that the charitable sector's need to replace diminished revenue from traditional sources may, to some measure, be achieved through enactment of the elective credit outlined in appendix a. the elective credit offers the advantage of a revenue source that is at least within the control of the 501(c)(3) organization's wholly-owned business benefactors without compromising the ability of for-profit enterprises to compete fairly with those benefactors. finally, the article maintains that the creation of private selfregulatory associations of the various subgroups of charitable nonprofits is virtually an imperative. such self-regulatory associations, working in tandem with a new commission of charities, could go a long way toward promoting the efficient delivery of social benefits by 501(c)(3) organizations, enforcing their accountability to the public, increasing understanding of the unique role played by charitable nonprofits in american society, and thereby restoring public confidence in the tax system as it applies to the charitable sector. [vol. 3:7 unfair business competition appendix a 1. subject to the limitations described below, a feeder or unrelated business wholly owned by a 501(c)(3) organization (other than a private foundation as defined in section 509) shall be allowed an elective credit against its income tax for the taxable year an amount equal to distributions made or deemed made during such taxable year to its 501(c)(3) owner on the basis of $1 credit for (for purposes of illustration) $1.35 of distributions. example 1: assume that taxable income equals pre-tax cash profit and that the income tax rate is a flat 35%. feeder, inc., wholly-owned by university, earns $1 ox taxable income for the taxable year on which there is a $35x tax before application of the elective credit. feeder, inc. distributes $47.25x to university during the taxable year ($35x tax times 1.35) and elects to claim a $35x credit against its $35x tax liability. thus, feeder, inc. may elect to reduce its income tax liability to zero on condition that it distributes the sum of a tax equivalent amount ($35x) plus an additional amount, in this case $12.25x (12.25% of taxable income), to university. rationale: the assumption is that feeder, inc.'s for-profit competitor earning $100x taxable income and paying $35x tax will be expected to distribute 12.25% of taxable income to its shareholders as an adequate return on investment. the goal is to leave the feeder with the same "after tax/distributions to owners" dollars as its for-profit competition ($100x taxable income minus [$35x plus $12.25x] equals $52.75x remaining for each). 2. as a condition to electing the credit, the feeder or unrelated business shall be required to establish the competitiveness of the prices it charges for the sale of its goods or services. compliance with "safe harbor" guidelines shall be deemed compliance with this condition, e.g., the five-year average of the taxpayer's gross profit margin (or return on equity capital) within an acceptable deviation does not exceed, or is not less than, the industry standard for gross profit margin (or return on equity capital). rationale: absent this condition, feeder, inc. in example 1 could lower its prices by, e.g. 20%, in which case feeder, inc.'s taxable income would be $80x on which there would be a $28x tax before the elective credit. feeder, inc. could elect to reduce the tax to zero 19961 florida tax review by distributing $37.8x to university. although feeder, inc.'s "after tax/distritutions to owners" dollars would be $42.2x ($80x taxable income minus $37.8x distributions) compared to its for-profit competitors $52.75x ($100x taxable income minus the sum of $35x tax and $12.25x distributions to its shareholders), university's return on investment ($37.8x) would still be 3.086 times more than that received by the shareholders of the for-profit competitor pre-tax ($12.25x). 3. the elective credit allowable on a combined basis to a 501(c)(3) owner's feeders and unrelated businesses shall not exceed an amount equal to the net operating loss incurred by the 501(c)(3) owner for the same taxable year in the conduct of all of its related activities divided by 1.35 (corresponding to a $1 credit for a $1.35 of distributions). the amount of the elective credit allowable under this limitation allocable to a particular feeder or unrelated business is hereinafter referred to as limitation a. for this purpose, net operating loss is determined by: a. adding the sum of the following items received by the 501(c)(3) owner during the taxable year: (a) net investment income other than from feeders and unrelated businesses; (b) gifts, grants, contributions, and membership fees, excluding any of such items restricted by the donor to a special purpose, to the endowment fund, or to a capital campaign; (c) gross income from the conduct of all related activities; and b. subtracting from the total of the items in 1, above, the total of the following items paid out by the 501(c)(3) owner during the taxable year: (a) expenses allocable to all related activities, and (b) capital expenditures for the acquisition of assets substantially used to further related activities for which there are no other specially allocated purchase funds. example 2: same as example 1. feeder, inc. is the only feeder or unrelated business owned by university. university incurs a $47.25x net operating loss for the taxable year. the amount of limitation a is $35x ($47.25x divided by 1.35). feeder, inc. may elect to take a credit against $35x tax by having distributed $47.25x to university. [vol. 3:7 unfair business competition example 3: same as example 2, except that university incurs a $40.5x net operating loss for the taxable year. the amount of limitation a is $30x ($40.5x divided by 1.35). the maximum credit allowable to feeder, inc. is $30x. rationale: the purpose of limitation a is to assure that the equalizing distributions of amounts equal to tax and return on investment are used by the 501(c)(3) owner to fund its related activities rather than (i) reinvested back into the feeder or unrelated business as a capital contribution, loan, or collateral for a loan; (ii) used to augment the 501(c)(3) owner's investment portfolio; or (iii) used to amortize debt incurred to acquire or improve assets used in activities unrelated to its charitable purposes. 4. the elective credit otherwise allowable to each of the 501(c)(3) owner's feeders and unrelated businesses before application of any limitation hereunder shall be reduced by four percentage points for each percentage point (or fraction thereof) the limitation b percent exceeds 25%. for this purpose the limitation b percent is basis to 501(c)(3) owner, or fair market value at time of gift, of investments in feeders and assets used in unrelated businesses x 100 basis to 501(c)(3) owner, or fair market value at time of gift, of all assets (other than assets substantially used in connection with related activities) the values of the numerator and the denominator of the fraction shall be determined at the beginning of the taxable year. example 4: same as example 3. university's bases for all of its assets at the beginning of the taxable year (not including assets substantially used in connection with related businesses) is $900x of which $225x is allocable to feeders and unrelated businesses. the limitation b percent equals $225x divided by $900x, or 25%. since no more than 25% of university's total investment assets consist of investments in feeders and unrelated businesses, the elective credit is not limited by limitation b. the maximum credit allowable to feeder, inc. is $30x under limitation a. 19961 florida tax review example 5: same as example 3. university's bases for all of its assets (not including assets substantially used in connection with related businesses) is $900x of which $270x is allocable to feeders and unrelated businesses. the limitation b percent equals $270x divided by $900x, or 30%. since the limitation b percent exceeds 25% by 5 percentage points, the elective credit otherwise allowable to feeder, inc. is reduced by 20 percentage points to 80%. 80% times $35x credit otherwise allowable before application of any limitation equals $28x. the maximum credit allowable to feeder, inc. under limitation b is $28x. example 6: same as example 5, except that one half of university's investment assets are allocable to feeders and unrelated busineses. the limitation b percent is 50%. since the limitation b percent exceeds 25% by 25 percentage points, the elective credit otherwise allowable to feeder, inc., is reduced by 100 percentage points to zero. the maximum credit allowable to feeder, inc. under limitation b is zero. rationale: the purpose of limitation b is (a) to discourage the 501(c)(3) owner from subjecting more than 25% of its total investment portfolio to the risks inherent in wholly-owned business ventures, and (b) to cap the potential loss of tax revenue to the federal government. 5. the elective credit otherwise allowable to each of the 501(c)(3) owner's feeders and unrelated businesses before application of any limitation hereunder shall be reduced by 4 percentage points for each percentage point (or fraction thereof) the limitation c percent exceeds 25%. for this purpose the limitation c percent is gross receipts received by the 501(c)(3) owner during the taxable year from feeders and unrelated businesses x 100 gross receipts received by the 501(c)(3) owner during the taxable year from all sources for this purpose, gross receipts received from unrelated businesses means distributions received from unrelated businesses to be used by the 501(c)(3) owner in the conduct of its charitable activities. [vol. 3:7 unfair business competition example 7: same as example 5. university's gross receipts received during the taxable year from all sources is s 89x of which $47.25x is received from feeder. inc. the limitation c percent is $47.25x divided by $189x, or 25%. since no more than 25% of university's gross receipts received during the taxable year is derived from feeders and unrelated businesses, the elective credit is not limited by limitation c. the maximum credit allowable to feeder, inc. under limitation b is $28x. example 8: same as example 5. university's gross receipts received during the taxable year from all sources is $135x of which $47.25x is received from feeder, inc. the limitation c percent is $47.25x divided by $135x, or 35%. since the limitation c percent exceeds 25% by 10 percentage points, the elective credit otherwise allowable to feeder, inc. is reduced by 40 percentage points to 60%. 60% times $35x credit otherwise allowable before application of any limitation equals $21x. the maximum credit allowable to feeder, inc. under limitation c is $21x. rationale: the purpose of limitation c is to restrict the ability of the 501(c)(3) owner to use equalizing distributions of amounts equal to tax and return on investment distributed from feeders or unrelated businesses to fund related activities where the organization does not receive at least 75% of its financial support during the taxable year from (i) gifts, grants, contributions, and membership fees; (ii) investments, other than feeders and unrelated businesses; and (iii) related businesses. otherwise, the danger exists that any given 501(c)(3) organization could use tax equivalent dollars and equalizing distributions of return on investment to fund activities unresponsive to social needs as reflected by the excessive ratio of gross receipts received from feeders and unrelated businesses to financial support received from the public. 6. as a condition to electing the credit, officers, directors, and employees of the 501(c)(3) owner shall be prohibited from receiving compensation from a feeder or unrelated business. rationale: the purpose is to discourage the 501(c)(3) owner from diverting energy and attention away from its charitable purposes. 1996] login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 6 2004 special issue recent developments in federal income taxation* the year 2003 ira b. shepard" martin j. mcmahon, jr.*** i. accounting ....................................... 449 a. accounting methods ............................ 449 b. inventories ................................... 451 c. installment method ............................. 451 d. year of receipt or deduction ..................... 451 h. business income and deductions .................... 454 a . income ...................................... 454 b. deductible expenses versus capitalization .......... 457 c. reasonable compensation ....................... 462 d. miscellaneous expenses ......................... 463 e. depreciation and amortization ................... 466 f. credits ...................................... 470 g. natural resources deductions & credits ........... 474 h. loss transactions, bad debts and nols ............ 479 i. at-risk and passive activity losses ................ 480 * this outline is based on prior current developments outlines presented by the authors at numerous continuing legal education conferences over the past year. among the conferences at which one or both of the authors presented current developments based on this outline during the year 2003: aba tax section midyear meeting, american institute on federal taxation, american petroleum institute, denver tax institute, houston bar association tax section, kentucky institute on federal taxation, state bar of new mexico tax symposium, university of north carolina tax institute, southern federal tax institute, state bar of texas tax section, tax executives institute, tennessee tax institute, texas society of cpas (austin chapter) institute, university of texas annual taxation conference, university of virginia conference on federal taxation, wednesday tax forum (houston), william & mary tax conference. ** professor of law, university of houston law center. *** clarence teselle professor of law, university of florida fredric g. levin college of law. florida tax review iii. investment gain ................................... 480 a. capital gain and loss .......................... 480 b. section 121 ................................... 482 c. section 1031 .................................. 482 d. section 1035 .................................. 483 e. section 1041 .................................. 483 iv. compensation issues ............................... 484 a. fringe benefits .............................. 484 b. qualified deferred compensation plans ............ 488 c. nonqualified deferred compensation, section 83, and stock options .................... 489 d. individual retirement accounts ................... 490 v. personal income and deductions ................... 490 a . rates ........................................ 490 b miscellaneous income .......................... 494 c. profit-seeking individual deductions .............. 495 d. hobby losses and § 280a home office and vacation homes ............................... 499 e. deductions and credits for personal expenses ....... 499 f. education: helping pay college tuition (or is it helping colleges increase tuition?) ................. 502 vi. corporations ..................................... 502 a. entity and formation ........................... 502 b. distributions and redemptions ................... 504 c. liquidations .................................. 505 d. s corporations ................................ 505 e. affiliated corporations ......................... 506 f. reorganizations ............................... 511 g. corporate divisions ............................ 515 h. personal holding companies and accumulated earnings tax ................................. 518 i. miscellaneous corporate issues .................. 519 vii. partnerships ...................................... 520 a. formation and taxable years .................... 520 b. allocations of distributive share partnership debt, and outside basis .............................. 520 c. distributions and transactions between the partnership and partners ........................ 524 d. sales of partnership interests, liquidations and m erges ................................... 526 e. inside basis adjustments ........................ 526 f. partnership audit rules ......................... 527 g. m iscellaneous ................................. 528 [voi.6:si 2004] recent developments in federal income taxation 447 v i. tax shelters ...................................... 528 a. tax shelter cases .............................. 528 b. identified "tax avoidance transactions" . ........... 536 c. disclosure and settlement ....................... 539 d. individual tax shelters ......................... 544 ix. exempt organizations and charitable giving ....... 546 a. exempt organizations .......................... 546 b. charitable giving ............................. 547 x. tax procedure .................................... 548 a. interest, penalties and prosecutions ............... 548 b. discovery: summonses and foia ................. 549 c. litigation costs ............................... 557 d. statutory notice ............................... 558 e. statue of limitations ........................... 558 f. liens and collections ........................... 560 g. innocent spouse ............................... 562 h. m iscellaneous ................................. 567 xi. witholding and excise taxes ....................... 572 a. employment taxes ............................. 572 b. self-employment ............................... 573 c. excise taxes .................................. 573 xii. tax legislation ................................... 574 a . enacted ..................................... 574 florida tax review recent developments in federal income taxation: the year 2003 by martin j. mcmahon, jr. ira b. shepard this recent developments outline discusses, and provides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the most recent twelve months and sometimes a little farther back in time if we find the item particularly humorous or outrageous. most treasury regulations, however, are so complex that they cannot be discussed in detail and, anyway, only a devout masochist would read them all the way through; just the basic topic and fundamental principles are highlighted. amendments to the internal revenue code generally are not discussed except to the extent that (1) they are of major significance, (2) they have led to administrative rulings and regulations, (3) they have affected previously issued rulings and regulations otherwise covered by the outline, or (4) they provide many the opportunity mock our elected representatives. the outline focuses primarily on topics of broad general interest [to the two of us, at least] income tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, and generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. please read this outline at your own risk; we take no responsibility for any misinformation in it, whether occasioned by our advancing ages or our increasing indifference as to whether we get any particular item right. [vol.6:sl recent developments in federal income taxation i. accounting a. accounting methods 1. really kind taxpayer-favorable § 481 adjustments. rev. proc. 2002-19, 2002-13 i.r.b. 696 (4/1/02). this revenue procedure modifies rev. proc. 97-27, 1997-1 c.b. 680, and rev. proc. 2002-9, 2002-3 i.r.b. 327 (1/22/02). it revises the revised rules for obtaining the irs's consent to changes in accounting methods. the most significant changes to rev. proc. 97-27 and rev. proc. 2002-9 are: (1) allowing a taxpayer to change its method of accounting prospectively, without audit protection, when the method to be changed is an issue pending for a taxable year under examination or an issue under consideration by either an appeals office or a federal court; and (2) taking negative, i.e., taxpayer-favorable, § 481 (a) adjustments into account entirely in the year of change. this revenue procedure was amplified and clarified by rev. proc. 2002-54, 2002-35 i.r.b. 432 (8/14/02). a. and just a little more for taxpayers in the name of simplicity. reg-142605-02, administration simplification of section 481(a) adjustment periods in various regulations, 68 f.r. 25310 (5/12/03). proposed amendments to regulations under §§ 263a and 448 would allow taxpayers changing a method of accounting to take any § 481(a) adjustments over the same number of taxable years that is provided in the general guidance provided under rev. proc. 92-27, 1997-1 c.b. 680 (as modified and amplified by rev. proc. 2002-19, 2002-13 i.r.b. 696, and modified by rev. proc. 2002-54, 200235 i.r.b. 432) for accounting method changes (four years for positive adjustments and one year for negative adjustments]. 2. is it an accounting method or is it not? a. taxpayer's change in its cost recovery period is not a change of accounting method. brookshire brothers holding, inc. v. commissioner, 320 f.3d 507, 91 a.f.t.r.2d 2003-629, 2003-1 u.s.t.c. 50,214 (5th cir. 1/29/03), affig t.c. memo. 2001-150 (6/22/01). the taxpayer filed amended returns changing its cost recovery period for convenience stores from 31.5 and 39 years to 15 years, as permitted by a specialized program coordinated issue paper. the irs asserted that the change required consent under § 446(e). the fifth circuit affirmed the tax court's (judge nims) holding that treas. reg. § 1.446-1 (e)(2)(ii)(b) [providing that a change of useful life is not an accounting method change] applied to changing the § 168 acrs cost recovery period. although it did not need to do so to decide the case, the court of appeals went a step further and reasoned that even if the switch in cost recovery periods was a change in accounting methods, for the commissioner to have challenged the switch in cost recovery periods, he would have had to do so for the first year in which the switch had been made, before the statute of limitations had expired on that year. b. another case holding that a reclassification of macrs property is not a change of accounting method. green forest manufacturing inc. v. commissioner, t.c. memo. 2003-75 (3/14/03). the tax 20041 florida tax review court (judge nims) followed brookshire brothers holding, inc. v. commissioner, 320 f.3d 507, 91 a.f.t.r.2d 2003-629, 2003-1 u.s.t.c. 50,214 (5th cir. 1/29/03), affg t.c. memo. 2001-150 (6/22/01), in holding that reclassification of macrs property used outside the u.s., which resulted in a changed recovery period and method, was not a change of accounting method. the court declined to follow rev. proc. 96-31, §2.01, 1996-1 c.b. 714, providing that a change from not allowing depreciation to allowing depreciation is a change of accounting method, because the guidance did not contain any reasoning and thus was not entitled to deference under united states v. mead corp., 533 u.s. 218 (2001). s note that the relief provided by rev. proc. 96-31, updated by rev. proc. 2002-9, rev. proc. 2002-19, and rev. proc. 2004-11, infra, permits a deduction for all prior allowable depreciation that was erroneously not taken by the taxpayer with respect to an asset owned by the taxpayer. this relief is available to taxpayers who file a form 3115 for a change of accounting method with their income tax return for the year of sale, or, preferably, at an earlier date. c. however, new regulations provide that a change in depreciation will generally constitute a change in accounting method. t.d. 9105, changes in computing depreciation, 69 f.r. 5 (1/2/04); reg-12645903, 69 f.r. 42 (1/2/04). these final, temporary and proposed regulations provide that changes in depreciation or amortization generally are changes in accounting method under reg. § 1.446-1 (e). additionally, these regulations (1) amend reg. § 1.167(e)-1 to provide that certain changes in depreciation method for property for which depreciation is determined only under § 167 are not changes in accounting method, and (2) amend reg. § 1.1016-3 to provide that § 1016(a)(2) does not permanently affect a taxpayer's lifetime income for purposes of determining whether a change in depreciation or amortization is a change in method of accounting. * the useful life exception to the general rule [that a change in depreciation method is a change in accounting] applies only to property for which depreciation is determined under § 167. however, a change to or from a useful life (or recovery period or amortization period) that is specifically assigned by the code, the regulations, or other guidance published in the internal revenue bulletin is a change in method of accounting. * other exceptions include (1) a change in computing depreciation allowances made in the year in which the use of property changes in the hands of the same taxpayer, (2) the making of a late depreciation election or the revocation of a timely valid depreciation election, and (3) a change in the placed-in-service date of an asset. (1) automatic consent procedure to make a change in method of accounting for depreciable or amortizable property after its disposition. rev. proc. 2004-11, 2004-3 i.r.b. 311 (12/31/03). this revenue procedure provides an automatic consent procedure allowing a taxpayer to make a change in method of accounting under § 446(e) for depreciable or amortizable property disposed of in the year of change. this revenue procedure modifies rev. proc. 2002-9 (as modified by rev. proc. 200254, rev. proc. 2002-19, rev. proc. 2002-33, and as modified and clarified by [vol6:sl recent developments in federal income taxation announcement 2002-17), and other revenue procedures to conform to temp. reg. § 1.446-1 t(e)(2)(ii)(d), and waives the application of the two-year rule set forth in rev. rul. 90-38, 1990-1 c.b. 57, for certain changes in depreciation or amortization. 0 extensive portions of the appendix of rev. proc. 2002-9 are deleted and replaced with new language in the appendix to rev. proc. 2004-11. b. inventories 1. rev. proc. 2003-51, 2003-29 i.r.b. 121 (6/25/03). this revenue procedure provides three basic methods for valuing inventory items acquired when a taxpayer purchases the assets of a business for a lump sum or a corporation acquires the stock of another corporation and makes a § 338 election: (1) the replacement cost method, (2) the comparative sales method, and (3) the income method. however,"[v]aluing inventory is an inherently factual determination... [and] the three valuation methods outlined above serve only as guidelines for determining the fair market value of inventories." c. installment method there were no significant developments regarding this topic during 2003. d. year of receipt or deduction 1. another taxpayer friendly accounting method ruling. rev. rul. 2003-3, 2003-2 i.r.b. 252 (1/13/03). a state or local income or franchise tax refund resulting from nol carrybacks is includible by an accrual method taxpayer in the earlier of the year in which the taxpayer receives payment or notice that the refund claim has been approved. rev. ruls. 65-190, 1965-2 c.b. 150, and 69-372, 1969-2 c.b. 104, which held that the refund is accrued in the year of the loss, are revoked. the irs reasoned that review and approval of the refund claims by state authorities is not merely ministerial, but substantive. [this follows the holding in doyle, dane, bernbach, inc. v. commissioner, 79 t.c. 101 (1982), nonacq., 1988-2 c.b. 1, acq., 2003-2 i.r.b. 251 (1/12/03).] automatic change of accounting method is available. 2. this year or next year? only the irs knew, and now they are telling us. rev. rul. 2003-10, 2003-3 i.r.b. 288 (1/21/03). this ruling addresses the accrual under the all events test of § 451 of income from goods sold when an accrual method taxpayer's customer disputes its liability under certain circumstances: (1) if the taxpayer overbills a customer due to a clerical mistake in an invoice and the customer discovers the error and, in the following taxable year, disputes its liability for the overbilled amount, then the taxpayer accrues gross income in the taxable year of sale for the correct amount; (2) a taxpayer does not accrue gross income in the taxable year of sale if, during the taxable year of sale, the customer disputes its liability to the taxpayer because the taxpayer shipped incorrect goods; (3) a taxpayer accrues gross income in 20041 florida tax review the taxable year of sale if the taxpayer ships excess quantities of goods and in the next year the customer agrees to pay for the excess quantities of goods. 0 the irs has requested comments on the application of § 451 to a situation in which a taxpayer ships defective products to a customer that discovers the defect in the next taxable year and disputes its liability: (1) does the taxpayer have a fixed right to income under § 451 in the taxable year of sale? (compare hallmark cards, inc. v. commissioner, 90 t.c. 26 (1988), with celluloid co. v. commissioner, 9 b.t.a. 989 (1927), acq. vii-1 c.b. 6); (2) does the taxable year concept require the taxpayer to accrue income in the taxable year of sale because the dispute did not arise until the next taxable year? 3. taxpayer got the deduction, but not § 1341 relief. cinergy corp. v. united states, 55 fed. cl. 489, 91 a.f.t.r.2d 2003-1229, 2003-1 u.s.t.c. 150,302 (3/10/03). the court of claims held that § 1341 did not apply to repayments to customers of utility charges [additional charges to cover deferred taxes] that were determined by regulatory authorities in subsequent years to have been excessive. the court accepted the irs's view [see rev. rul. 58-226, 1958-1 c.b. 318; rev. rul. 67-48, 1967-1 c.b. 50] that when the taxpayer's right to an income item was absolute in the year of inclusion but was undermined by subsequently arising facts, § 1341 does not apply. section 1341 applies only when the taxpayer had merely an "apparent" right to the income item. thus, although the repayments were deductible, no rate arbitrage relief was available. 4. even if the economic performance rules don't get ya, the nonqualified deferred compensation rules might. weaver v. commissioner, 121 t.c. no. 14 (10/8/03). the taxpayer controlled two corporations, an accrual method calendar year s corporation (cl) and a cash method july 31 fiscal year c corporation (j). j rendered services to cl and cl deducted the amounts owed to j even though it had not paid the amounts until more than two and one-half months after the close of its taxable year (i.e., by march 15) the tax court (judge laro) held that the amounts were not deductible in the year the services were rendered because the economic performance requirement of § 461 (h) had not been met. reg. § 1.461 -1 (a)(2)(iii)(d) and § 404(d) required deferral of the deduction amounts owed to a cash method taxpayer for services until its taxable year the last day of which is within two and one-half months of the day on which the amount is includable in the service provider's gross income if there was a plan or arrangement for the deferral of the payment. judge laro emphasized the holding rested on the conclusion that there was such a plan or arrangement between the two entities. 5. regulations on nonaccrual-experience method applied. hospital corp. of america v. commissioner, 348 f.3d 136, 92 a.f.t.r.2d 2003-6705, 2003-2 u.s.t.c. 50,702 (6th cir. 10/30/03), affg 107 t.c. 116 (9/17/96). the taxpayer-hospitals were entitled to elect the § 448 nonaccrualexperience method for years 1987 and 1988 for calculating their uncollectible amounts because they do not "sell" medical supplies to their patients, but they are furnished to patients as part of the hospitals furnishing medical services. the sixth circuit upheld the tax court's (judge wells) decision that the taxpayers [vol6:si recent developments in federal income taxation were required to use the amended temp. reg. § 1.448-2t(e)(2) to compute the excluded amount, as opposed to the original temporary regulation; under the amended temporary regulation, the "uncollectible amount" is equal to the yearend receivables multiplied by a fraction equal to (1) total bad debts sustained during the current and 5 preceding years divided by (2) total accounts receivable earned throughout the same 6-year period, not merely (1) total bad debts divided by (2) total year-end accounts receivable (which would have been the result under the traditional former § 166(c) bad debt reserve computed under the black motorv. commissioner, 41 b.t.a. 300 (1940), af'd on another issue, 125 f.2d 977 (6th cir. 1942) formula). like the tax court, the court of appeals concluded that § 448(d)(5) was an ambiguous statute and legislative history left a gap that was properly filled by the amended temporary regulation, following chevron u.s.a., inc. v. national resources defense council, inc., 467 u.s. 837 (1984). we must ... not substitute our own construction of the tax law where the regulation at issue is reasonable. . . . several permissible constructions may be reasonable, and where congress has left gaps, agencies may fill the gaps with necessary rules that are reasonable. . . . [w]e 'should not interfere with this process,' .. ., which is what would happen were we to decide whether a method is the better of two possibilities. we need only determine if the one chosen by the treasury is reasonable. in reviewing the legislative history of the statute and the treasury decisions promulgating the regulation, we conclude that the treasury did not act arbitrarily but selected a reasonable method to measure accounts that should not be accrued from experience. 0 the taxpayer also argued that under united states v. mead corp., 533 u.s. 218 (2001), the temporary regulation was not entitled to chevron deference because it was issued without following the notice and comment process that was involved in chevron, but the court of appeals rejected this application of mead: the court made clear, however, that while most of the supreme court cases applying chevron involved notice-andcomment rulemaking or formal adjudication, "the want of such procedure.., does not decide the case, for we have sometimes found reasons for chevron deference even when no such administrative formality was required and none was afforded." 533 u.s. at 231.... the temporary regulations involved in this case were arrived at centrally by the treasury department, after careful consideration. they were issued pursuant to statutory authority to "prescribe" needful rules and regulations. see i.r.c. § 7805(a). the regulation was "interpretive" in the same sense that the regulation in chevron was interpretive it gave content to ambiguous statutory terms. congress clearly intended that the treasury department do so, and chevron deference is therefore appropriate. 20041 florida tax review 6. section 461(1) deductions for transfers related to contested liabilities. t.d. 9095, transfers to provide for satisfaction of contested liabilities, 68 f.r. 65634 (11/21/03); reg-136890-02, 68 f.r. 65645 (11/21/03). the treasury has promulgated temporary regulations and published identical proposed regulations clarifying issues under § 461(f) and coordinating § 461(f) and § 461(h) [the economic performance requirement]. temp. reg. § 1.461-2t(c)(1) and prop. reg. § 1.461-2(c)(1) provide that the transfer to a trust of the transferor's debt instrument or stock, or the stock or indebtedness of a related person or corporation, does not give rise to a deduction under § 461(f) with respect to a contested liability. temp. reg. § 1.461-2t(e) and prop. reg. § 1.461-2(e) provide that a payment to a trust to provide for satisfaction of a contested claim with respect to which the economic performance rules of § 461(h) require payment to the claimant e.g., tort and workers compensation claims, rebates, prizes and jackpots, warranty claims, etc. will not result in a deduction under § 46 1(f). a. fudging around with § 461(f), especially when combined with economic performance requirements, makes for a "listed transaction." notice 2003-77, 2003-49 i.r.b. 1182 (11/19/03). certain contested liability trusts used improperly to attempt to accelerate deductions under § 461(f) are identified as "listed transactions." these transactions include those involving: (1) retention of powers over the trust assets by the taxpayer; (2) transfers of promissory notes to a trust under circumstances indicating the underlying liability is not genuine; (3 and 4) transfers to trusts for contested tort, workers compensation and similar, liabilities for which economic performance requires payment to the claimant, except where the trust is the person to which the liability is owed or payment to the trust discharges the taxpayer's liability to the claimant; and (5) transfers of stock of the taxpayer, or indebtedness or stock issued by a party related to the taxpayer, that are made on or after 11/19/03 to a trust purported to be established under § 461(f). 7. prepayments for funerals are deposits because they are refundable, albeit rarely refunded. perry funeral home, inc. v. commissioner, t.c. memo. 2003-340 (12/16/03). applying the principles of indianapolis power & light co. v. commissioner, 493 u.s. 203 (1990), judge wherry held that refundable prepayments for funerals were excludable deposits even though refunds were rarely requested. the customers, rather than the taxpayer, controlled whether funds would be retained by taxpayer or refunded. h. business income and deductions a. income 1. maybe the raiders would have won the super bowl if it had been played in the ninth circuit's courtroom. milenbach v. commissioner, 318 f.3d 924, 91 a.f.t.r.2d 2003-818, 2003-1 u.s.t.c. 50,229 (9th cir. 2/6/03), rev'g in part and aff'g in part 106 t.c. 184 (1996). the taxpayer was a partner in the oakland/los angeles/ oakland raiders. the partnership received a $6.7 million nonrecourse loan from the los angeles coliseum commission as part of a package of inducements to move the raiders from [vol6:si recent developments in federal income taxation oakland to los angeles. the loan was repayable only out of net rents received by the raiders from leases by the raiders of luxury skyboxes in the los angeles coliseum during the years 1982 through 1986 and was secured only by the suites to be constructed. at the time the loan was made, there were no such skyboxes in the coliseum. the raiders partnership was required by the agreement to construct the skyboxes "as soon as practicable as determined by the partnership in its reasonable discretion, having in mind considerations deemed important or significant to the partnership." in fact, the skyboxes were never constructed, and the tax court found that there was no evidence that the coliseum commission intended to enforce the requirement that they be constructed. reasoning that this standard for determining when the skyboxes were to be constructed "gave the raiders great latitude in timing the construction," which amounted to "unlimited discretion," the tax court found that the obligation to construct the skyboxes to be illusory. thus, because the raiders' obligation to repay the loan was conditional, the raiders were required to include the funds in gross income upon receipt. on another related issue, the tax court held that $10 million received by the partnership as the first disbursement on a $115 million nonrecourse loan from the city of irwindale, made as a part of a package to lure the raiders to move from the los angeles coliseum, was a true loan even though the loan agreement relieved the raiders from any obligation to repay the $10 million if the city of irwindale failed to advance the remaining funds or to perform certain other acts toward construction of a stadium as required by the loan agreement. at the time the funds were received, they were not under the raiders' complete dominion and control. the raiders' obligation to repay was not conditional on their own actions, but could be cancelled by a condition subsequent that was within the lender's control. when the obligation was cancelled in the following year, however, the raiders realized $10 million of discharge of indebtedness income. * with respect to the l.a. coliseum commission loan, the ninth circuit (judge tashima) reversed, finding that "the raider's broad discretion in the timing of the construction of the suites did not make the contract illusory. under california law, an obligation under a contract is not illusory if the obligated party's discretion must be exercised with reasonableness or good faith .... here the raiders were required to exercise their discretion reasonably and nothing in the [agreement] indicates that construction of the suites was optional." * the taxpayer's victory mightjust be one of timing. the ninth circuit's opinion points out that when the los angles coliseum obligation was extinguished [in 1990] the partnership realized cod income. [we wonder, did the commissioner ask for a waiver of the statute of limitations on that year?] * as far as the irwindale loan was concerned, the ninth circuit reversed the holding that cod income was realized by the raiders in 1988 as "clearly erroneous," because the tax court had relied solely on the grounds that a state statute passed in 1988 prevented performance by the city under the plan as proposed. the court of appeals reasoned that under california law the debt might not have been discharged until a subsequent year and remanded the case for a "practical assessment of the facts and circumstances relating to the likelihood of payment." according to the ninth circuit, the debt was 20041 florida tax review not discharged until "when, as a practical matter, it became clear that irwindale would not be able to fund the entire loan and that the stadium would not be built." 0 the commissioner did receive a consolation prize from the ninth circuit when the court of appeals affirmed the tax court's decision that damages received by the partnership in a suit against the city of oakland for inverse condemnation of the raiders team were taxable as damages in lieu of lost profits; although settlement agreement stated that its purpose was to resolve a claim involving "restoration of lost franchise value," the taxpayer's damages study indicated that claim was based on lost profits. 2. fuel cost over-recoveries are not includible in income. cinergv corp. v. united states, 55 fed. cl. 489, 91 a.f.t.r.2d 2003-1229, 2003-1 u.s.t.c. 50,302 (3/10/03). fuel cost over-recoveries (and interest earned thereon) received by a public utility company under a fixed fuel factor scheme instituted by state regulatory authorities [for the benefit of customers, by avoiding large fluctuations in monthly bills] were not includible in gross income under the claim of right doctrine because taxpayer did not have complete dominion, but was obligated to repay or credit the customers accounts. the court followed houston industries, inc. v. united states, 125 f.3d 1442 (fed. cir. 1997), which also involved fuel surcharges, and distinguished iowa southern utilities co. v. united states, 841 f.2d 1108 (fed. cir. 1988), involving a construction surcharge, on the grounds that in that case as opposed to this case there was no "unequivocal contractual, statutory, or regulatory duty to repay." 3. tax-free subsidies for environmentalist landowners. rev. rul. 2003-59, 2003-24 i.r.b. 1014 (6/16/03). all or a portion of cost sharing payments received under the conservation reserve programa usda program under which landowners receive 50 percent of the cost of establishing certain practices for soil and water conservation, wetland establishment and restoration, and reforestation are eligible for exclusion under § 126. 4. congress might have changed one of the holdings of gitlitz,' but the treasury put another one in the regulations. t.d. 9080, reduction of tax attributes due to discharge of indebtedness, 68 f.r. 42590 (7/18/03). the treasury has promulgated temp. reg. §§ 1.108-7t and 1.1017-it(b)(4), dealing with reduction in tax attributes under §§ 108(b) and 1017 when cod income is excluded from income under § 108(a)(1)(a)-(c). examples (and the preamble) indicate that the tax liability for the year of discharge first must be determined without any reduction in attributes in order to identify the amounts, if any, of the tax attributes that will be reduced. "this ordering rule affords the taxpayer the use of certain of its tax attributes described in section 108(b)(2), including any losses carried forward to the taxable year of discharge, for purposes of determining its tax for the taxable year of discharge, before subjecting those attributes to reduction." basis reductions under § 1017 occur at the beginning of the taxable year following the year in which the discharge occurred. if a § 381 transaction ends a taxable year 1. gitlitz v. commissioner, 531 u.s. 206 (2001). see, job creation and worker assistance act of 2002, which reverses the result of gitlitz by providing that excluded cancellation of indebtedness income of s corporations does not result a § 1366 adjustment to the basis of stock owned by the shareholders. [volt:si recent developments in federal income taxation in which the distributing or transferor corporation excluded cod income under § 108(a), the basis of the property acquired by the acquiring corporation reflects the reduction under § 1017. 5. united states v. brown, 348 f.3d 1200,92 a.f.t.r.2d 2003-6826 (10th cir. 11/4/03). the court of appeals upheld the regulations under § 468b. a receiver's estate may be a qualified settlement fund under § 468b(g) and reg. § 1.468b-1 if it is established to "resolve" claims -even if the establishment of the fund and the transfer of assets to it does not extinguish claims against the alleged tortfeasor. the creation of a qualified settlement fund is not dependent on the deductibility of amounts transferred to it. as a qsf, the receiver's estate was liable for income taxes. b. deductible expenses versus capitalization indopco aftermath: "... deductions are exceptions to the norm of capitalization .... " indopco, inc. v. commissioner, 503 u.s. 79, 84 (1992) (blackmun, j.) 1. kudos from taxpayers; pans from professors. treasury abandons the future benefits test of indopco long live the separate and distinct asset test. or, do the final regulations go beyond the separate and distinct asset test and interpret indopco in a more efficient way? t.d. 9107, guidance regarding deduction and capitalization of expenditures, 69 f.r. 436 (1/5/04), proposed in reg-125638-01, 67 f.r. 77701 (12/19/02). the treasury department has promulgated regs. § 1.263(a)-4 and § 1.263(a)-5, which deal comprehensively with the capitalization of expenditures that relate to intangible assets and "future benefits." these regulations are commonly referred to as the indopco regulations, because they are intended to provide bright-line rules to make the standards based approach to capitalization articulated by the supreme court in indopco more administrable, however, the regulations more aptly might be called the anti-indopco regulations, because they reverse the principle, if not the specific holding of indopco. 0 the supreme court in indopco v. commissioner, 503 u.s. 79 (1992), unequivocally rejected the view that capitalization was not required unless the expenditure resulted in the creation or improvement of a "separate and distinct asset," but also clearly announced that "the notion that deductions are exceptions to the norm of capitalization" is embodied in various aspects of the code and is supported by a long line of supreme court precedents. the regulations turn on their head these interpretations of §§ 162, 261, and 263 by the supreme court. a. capitalization is an exception to the norm of deductibility. under reg. § 1.263(a)-4(b)(1), the only expenditures that must be capitalized are those incurred (1) to acquire, create, or enhance an intangible, (2) to facilitate in the acquisition, creation, or enhancement of an intangible or (3) that are otherwise identified by the irs in prospectively effective published guidance. the term "separate and distinct intangible" is limited by reg. § 1.263(a)-4(b)(3) to "a property interest of ascertainable and measurable value in money's worth that is subject to protection under applicable state or federal law and the possession and 20041 florida tax review control of which is intrinsically capable of being sold, transferred, or pledged (ignoring any restrictions imposed on assignability) separate and apart from a trade or business." the last phrase of this definition presumably excludes business goodwill for the definition of intangible.2 the regulations provide extensive lists of the intangibles to which they apply, including, for example, ownership interests in corporations or partnerships, debt instruments, financial interests, options, patents, copyrights, trademarks, franchises, customer lists, covenants not to compete, certain contract rights, government licenses, assembled workforce, and goodwill. see reg. § 1.263(a)-4(c)(1) and (d). in addition, the regulations specifically provide that any fund or account that may revert to the taxpayer is a separate and distinct intangible. reg. § 1.263(a)4(b)(3)(i). on the other hand, expenditures to induce another person to enter into a contract are not required to be capitalized unless the expenditures are listed as expenditures that give rise to a separate and distinct intangible. reg. § 1.263(a)4(b)(3)(i). thus, for example, a signing bonus to induce an employee enter into an employment relationship is not required to be capitalized if the employee is free to leave and go to work for a competitor at any time. reg. § 1.263(a)4(d)(6)(vii), ex. 8. 9 in the preamble to the proposed regulations, the treasury department explained that "the separate and distinct asset standard has not historically yielded the same level of controversy as the significant future benefit standard," and that "the separate and distinct asset test is a workable principle in practice." the preambles to both the proposed and final regulations also explained that the irs and treasury department might in the future identify expenditures that are not listed in the regulations, but for which capitalization is nonetheless appropriate. capitalization of non-listed expenditures will be required, however, only if (and after) they have been identified in published guidance. unless an expenditure relating to an intangible asset is listed in the regulations or in such subsequently published guidance, however, capitalization will not be required and a current deduction will be allowed. thus, under the regulations, capitalization become an exception to the norm of deducting business expenditures 0 the only expenses not related to a separate and distinct asset that must be capitalized under the proposed regulations are costs to "facilitate... a restructuring or reorganization of a business entity or a transaction involving the acquisition of capital, including a stock issuance, borrowing, or recapitalization." reg. § 1.263(a)-5 separately requires capitalization of any these expenditures, as well as any expenditures to facilitate acquisition of controlling ownership of another trade or business, regardless of whether the acquisition is an acquisition of the assets constituting the business or of the stock of the corporation conducting the business. this category includes only fact patterns analogous to the narrow fact pattern in indopco and a number of cases involving similar issues that followed indopco. thus, the future benefits test of indopco has been largely abandoned. see, e.g., reg. § 1.263(a)-4(d)(4) (expenses for certification of products, services or business processes are not subject to capitalization). * the regulations provide two very important exceptions to the rule requiring capitalization of transaction costs. first, 2. see baker v. commissioner, 338 f.3d 789 (7th cir. 2003) (business goodwill cannot exist and be sold separately from business assets to which it could attach). [vol6:si recent developments in federal income taxation under a "simplifying convention" that is in fact a major substantive rule, reg. § 1.263(a)-4(e)(4)(ii) provides that compensation paid to employees (including certain independent contractors who perform employee-like work) and the employer's associated overhead are never capitalized. reg. § 1.263(a)-5(d)(2) provides a similar rule with respect to transaction costs involving business acquisitions and restructurings. these provisions reject case law to the contrary and go far beyond the principle of those cases that in certain circumstances have allowed a current deduction for employee compensation that facilitates the acquisition of an intangible asset.3 moreover, they adopt a rule for dealing with intangible assets that is diametrically opposed to the treatment of transaction costs with respect to tangible assets, which always must be capitalized under either or both of §§ 263(a) or 263a. 0 second, reg. § 1.263(a)-4(e)(4)(iii) provides an exception that permits de minimis transaction costs defined as costs that do not exceed $5,000 per transaction (not payee) to be deducted currently.4 in applying this de minimis rule, the taxpayer may use an elective pooling method in which the transaction costs of all similar transactions are averaged and all for the costs are deductible as long as the average does not exceed $5,000. thus for example, the taxpayer could average fifty $4,750 expenditures with fifty $5,250 expenditures and deduct them all because the average of the one hundred expenditures was only $5,000. to prevent substantial manipulation that would result in current deductions for very significant transaction costs, this pooling method must be elected prospectively, must include all similar transactions, and is available only if the taxpayer reasonably expects to include at least twenty-five transactions. furthermore, expenditures that are reasonably expected to differ significantly from the average cannot be included. see reg. § 1.263(a)-4(h). for example, a single $401,000 expenditure could not be averaged with 99 different $1,000 expenditures to permit a deduction of the $401,000 expenditure even though the average of the 100 expenditures is only $5,000 (([99 x $1,000] + $401,000) + 100). b. the"whether and which" test shall too pass. reg. § 1.263(a)-5 significantly changes the scope of § 195 with respect to transaction costs involving business investigation and expansion expenditures (but not start-up costs). the regulations replaced rev. rul. 99-23's "whether and which" standard for determining the point at which expenditures are inherently capital costs of the acquisition of the business with a bright-line rule. under the regulations, expenses incurred in the process of pursuing an acquisition of a trade or business whether the acquisition is structured as an acquisition of stock or of assets (and whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) must be capitalized only if (1) they are "inherently facilitative" of the acquisition or (2) they relate to activities performed on or after the earlier of (a) the date on which a letter 3. see norwest corp. v. commissioner, 112 t.c. 89 (1999) (disallowing deduction), rev'd sub nom., wells fargo & co. v. commissioner, 224 f.3d 874 (8th cir. 2000); pnc bancorp, inc. v. commissioner, 110 t.c. 349 (1998) (disallowing deduction), rev'd, 212 f.3d 822 (3d cir. 2000); lychuk v. commissioner, 116 t.c. 374 (2001) (disallowing deduction). 4. reg. § 1.263(a)-5(d)(3) provides a similar rule with respect to transaction costs involving business acquisitions and restructurings. 2004] florida tax review of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by representatives of the acquirer and the target, or (b) the date on which the material terms of the transaction are authorized or approved by the taxpayer's board of directors (or committee of the board of directors) or, if taxpayer is not a corporation, the date on which the material terms of the transaction are authorized or approved by the taxpayer's appropriate governing officials. expenditures that are "inherently facilitative" include amounts expended to determine the value of the target, drafting transactional documents, or conveying property between the parties. however, a taxpayer is not required to capitalize any portion of its own employee compensation attributable to these activities, and the regulations also provide a de minimis rule similar to that applicable to intangibles generally. reg. § 1.263(a)-5(d)(2) and (3). the preamble indicates that expenses which escape capitalization under reg § 1.263(a)-5 nevertheless are not deductible if they are start-up expenses subject to § 195. c. depreciation on intangibles with unascertainable useful lives. reg. § 1.167(a)-3(b) provides a fifteen-year "safe-harbor" amortization period for any capitalized expenses relating to a self-created intangible for which another amortization period is not prescribed by the code or regulations and for which amortization is not proscribed. d. the 12-month rule for prepaid expenses. reg. § 1.263(a)-4(d)(3) requires that prepaid expenses generally be capitalized. however, reg. § 1.263(a)-4(f) adopts the holding of the court of appeals in u.s. freightways v. commissioner, 270 f.3d 1137 (7th cir. 2001), and provides that an expenditure to create or enhance intangible rights or benefits that do not extend for more than twelve months after the expenditure is incurred is not required to be capitalized.' furthermore, the deduction will not be deferred under the "clear reflection of income" standard of § 446(b). amounts paid to create rights or benefits that extend beyond twelve months must be capitalized in full and deducted ratably over the period benefited. this arbitrary line produces some strange results. suppose that in march 2004, taxpayer a pays an insurance premium of $130,000 for the period from april 1, 2004 through april 30,2005. taxpayer b, on the other hand, in december 2004, pays an insurance premium of $120,000 for the period from december 1, 2004 through november 30, 2005. for 2004, taxpayer a's deduction is $90,000. taxpayer b's deduction for 2004, however, is $120,000, even though taxpayer b's prepayment extends further into 2005 than does taxpayer a's prepayment. 2. irs identifies issues to be addressed in forthcoming proposed regulations on tangible property costs. notice 2004-6, 2004-3 i.r.b. 308 (12/23/03). these issues include [using the numbering from the notice]: (1) what general principles of capitalization should be applied? (2) what is the appropriate "unit of property"? (3) what is the starting point for determining whether property value is increased or useful life is prolonged? (11) should the regulations provide "repair allowance" type rules? (12) should the regulations provide a de minimis rule? (13) when should the "plan of rehabilitation" doctrine be applied? (15) are 5. a taxpayer may elect to capitalize and amortize prepaid expenses that cover a period of twelve months or less. reg. § 1.263(a)-4(f)(7). [vol.6:si recent developments in federal income taxation there circumstances where tax treatment should follow financial or regulatory accounting treatment? 3. go ahead and deduct the cost of asbestos removal at least as long as you don't change the building's use. cinergv corp. v. united states, 55 fed. cl. 489, 91 a.f.t.r.2d 2003-1229, 2003-1 u.s.t.c. 50,302 (3/10/03). the court of federal claims allowed a § 162 deduction for the cost of removing and encapsulating deteriorating fireproofing material that contained asbestos fibers. the fireproofing material did not create a problem for years, but as it deteriorated the danger of the asbestos circulating in the offices increased. the work prevented the asbestos from crumbling or circulating. in allowing the deduction, the court applied the test applied by the sixth circuit in united dairy farmers, inc. v. united states, 267 f.3d 510 (6th cir.2001), and found all of the elements to be met. [t]hree elements must be satisfied for a valid deduction under § 162 for environmental cleanup costs: first, the taxpayer contaminated the property in its ordinary course of business; second, the taxpayer cleaned up the contamination to restore the property to its pre-contamination state; third, the cleanup did not allow the taxpayer to put the property to a new use. the court distinguished united dairy farmers, inc., in which the taxpayer acquired the property after it had been contaminated, and dominion resources, inc. v. unites states, 219 f.3d 359 (4th cir. 2000), in which the environmental remediation adapted the property for a different use. 0 note, however, the possibility of deductibility of cleanup costs under § 198 if the site is certified by the state and the expiration date of § 198 is extended beyond the end of 2003. 4. would you like to fly on a jet without its engines? fedex corporation v. united states, 91 a.f.t.r.2d 2003-1940,2003-1 u.s.t.c. 50,405 (w.d. tenn. 4/7/03). the district court denied the taxpayer's motion for summary judgment that expenditures for its off-wing engine maintenance program were deductible repairs under reg. § 1.162-4. the court found that there was a genuine issue of fact regarding whether the appropriate unit of property for measuring whether the expenditures added value or materially prolonged life was (1) the entire aircraft, as argued by fedex, or (2) the jet engines and auxiliary power units, as argued by the government. the court concluded that there is no 'entire vehicle' rule of law requiring that repairs be measured against the entire vehicle rather than against components. a. you don't have to, at least in memphis. fedex corp. v. united states, 291 f.supp.2d 699,92 a.f.t.r.2d 2003-5986,2003-2 u.s.t.c. 50, 697 (w.d. tenn. 8/27/03). taxpayer was permitted to deduct the costs of engine shop visits for jet aircraft engine inspection, heavy maintenance and repair because the relevant unit of property was held to be the entire aircraft, not the engine. 2004] florida tax review 5. judge laro draws the line between deductible expenses and capital expenditures. d'angelo v. commissioner, t.c. memo. 2003-295 (10/23/03). in this otherwise unremarkable case, in the context of determining whether certain legal fees were currently deductible or were capital expenditures, judge laro articulated the following standards for drawing the line between deductible expenses and capital expenditures:6 just because a particular expense fits within the literal language of section 162, it does not automatically become deductible. this is because other sections, such as section 261, except certain payments from the current deductibility provisions. indopco, inc. v. commissioner, [503 u.s. 79 (1992)]. section 261 states that "no deduction shall in any case be allowed in respect of the items specified in this part", e.g., part ix, items not deductible. section 263(a)(1), which is contained in part ix, generally provides that a deduction is not allowed for "any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." as we recently noted in lychuk v. commissioner, [116 t.c. 374 (201)], the supreme court's mandate as to capitalization requires that an expenditure be capitalized when it (1) creates a separate and distinct asset, (2) produces a significant future benefit, or (3) is incurred "in connection with" the acquisition of a capital asset. see also commissioner v. idaho power co., 418 u.s. 1, 13 (1974); woodward v. commissioner, 397 u.s. 572, 575-576 (1970). if any of the three conditions is met, an expense may not be deducted and must be capitalized c. reasonable compensation 1. the commissioner at least has to give it the "good old college try" if he expects to win. devine brothers, inc. v. commissioner, t.c. memo. 2003-15 (1/16/03). judge cohen upheld the taxpayer corporation's compensation deduction in full. the taxpayer made a prima facia case for reasonableness. the salary was within the range paid to similarly situated executives. the commissioner provided no evidence to the contrary and failed to explain how he calculated the disallowed portion. under either a traditional multi-factor test or the exacto spring [196 f.3d 833 (7th cir. 1999)] hypothetical investor test, the result was the same. 2. haffner's service stations inc. v. commissioner, 326 f.3d 1, 91 a.f.t.r.2d 2003-1461, 2003-1 u.s.t.c. 50,333 (1st cir. 3/31/03). a corporation's payments to two officers [treasurer and assistant treasurer, who were also wife and husband] were not reasonable compensation. the corporation was founded by the treasurer's parents and was run by one of their five children. judge boudin selected a multifactor test over the exacto spring corp. v. commissioner, 6. compare t.d. 9108, guidance regarding deduction and capitalization of expenditures, 69 f.r. 436 (1/5/04). [vol.-s recent developments in federal income taxation 196 f.3d 833 (7th cir. 1999), single factor independent investor test based on the facts and circumstances of this case: return on equity, while high, was declining in recent years, and the roles played by the two officers was relatively modest. 3. an old-fashioned multi-factor reasonable comp analysis. brewer quality homes, inc. v. commissioner, t.c. memo. 2003-200 (7/10/03). in an case appealable to the fifth circuit, the tax court (judge chabot) applied a traditional multi-factor analysis, based on the factors enumerated in ownesby & kritikos, inc. v. commissioner, 819 f.2d 1315 (5th cir. 1987), to determine the portion of bonus payments to the president of a corporation, all of the stock of which was owned by the president and his wife, that was reasonable compensation. judge chabot observed that the "independent investor test" is a "lens through which the entire analysis should be viewed," citing dexsil corp. v. commissioner, 147 f.3d 96, 100-101 (2d cir. 1998), and that "[d]iscerning the intent behind the payments also presents a factual question to be resolved within the bounds of the individual case." 4. t.d. 9083, golden parachute payments, 68 f.r. 45745 (8/14/03). the treasury department has promulgated final regulations under § 280g, relating to payments contingent on ownership changes. the effective date is 8/4/03 for payments contingent on ownership changes occurring after 12/31/03. see also, rev. proc. 2003-68, 2003-34 i.r.b. 856 (8/1/03) for modified stock option valuation guidance for golden parachute rules. d. miscellaneous expenses 1. without a debt, there's no interest. indeck energy services, inc. v. commissioner, t.c. memo. 2003-101 (4/11/03). indeck energy services, inc. ("indeck") fired polsky in 1990 and in january 1991 an arbitrator ordered indeck to pay polsky $15,030,000 to repurchase his shares of indeck stock. indeck appealed, and the case was settled in 1994 pursuant to the following agreement indeck... agrees to purchase.., the thirty (30) shares of... stock.., for a price computed as follows ("purchase price"): (i) ... $501,000 per share, for a total of... $15,030,000; plus (ii) an amount determined by ten percent (10%) per annum on the amount in (i) from january 31, 1991 through april 13, 1994 for a total of... $4,809,600; plus (iii) an amount determined by interest on the amount in (i) at ... [the federal funds rate] between april 14, 1994 and may 9, 1994, for a total of... $47,321.85. the total purchase price of... $19,886,921.85 shall be paid... at the closing. polsky treated the full $19,886,921.85 as the amount realized on the stock. indeck treated $15,030,000 as the price of the stock and deducted the remaining $4,856,922 as interest. the tax court (judge gale) held that no portion of the $19,886,921 constituted interest on two alternative grounds: first, the evidence, including indeck's failure to issue polsky a form 1099 for interest, indicated that the parties intended the entire amount to be the stock purchase price. second, until the settlement agreement was signed, there was no indebtedness within the 20041 florida tax review meaning of § 163(a) on which interest could accrue -" it was not paid with respect to an existing, legally enforceable obligation for the payment of a principal sum, nor was the amount of the obligation fixed as of the date the purported interest began to accrue." the court distinguished halle v. commissioner, 83 f.3d 649 (4th cir. 1996), rev'g on other grounds kingstowne v. commissioner, t.c. memo. 1994630, and dunlap v. commissioner, 74 t.c. 1377 (1980), rev'd on other grounds, 670 f.2d 785 (8th cir.1982), on the ground that in both of those cases, "there was agreement between the purported debtor and creditor as to the amount of the obligation and its due date, as of the time the purported interest began to accrue." in contrast, "indeck's obligation and its due date were disputed during the period that the bulk of the claimed interest purportedly accrued." 2. every buck counts even if not spent on a springmaid sheet.' t.d. 9064, substantiation of incidental expenses, 68 f.r. 39011 (7/1/03). reg. § 1.274-5 0)(3) authorizes the commissioner to permit taxpayers traveling away from home to use a specified amount for incidental expenses in lieu of substantiating (under § 274(d)) the actual cost of incidental expenses. applicable to expenses paid or incurred after 9/30/02. 3. issuers of so-called "feline prides" investment units may deduct interest on the debt component. rev. rul. 2003-97,2003-34 i.r.b. 380 (8/25/03). this ruling deals with whether, under very detailed facts, a corporation that issues units, each consisting of instruments in the form of a 5-year note and a 3-year forward contract to purchase a quantity of the corporation's common stock, may deduct the "interest" accruing on the note under § 163(a), or whether the deduction is disallowed by 163(). the ruling held that the instrument was a debt instrument, even though the components were severable when issued. the instrument was not a disqualified debt instrument under § 163(l)(2) [indebtedness of a corporation that is payable in equity of the issuer or a related party], because absent specific evidence of bad faith with respect to the debtor's performance of its obligations the transaction was not reasonably expected to give the debtor an option to pay the notes in, or convert them into, its stock. accordingly, the interest was deductible. the ruling will not be applied adversely to any unit issued on or before 8/22/03 if certain circumstances are met. 4. fishing trip costs deductible because taxpayer had a business purpose for them, as well as an expectation of future benefits from them. townsend industries inc. v. united states, 342 f.3d 890, 92 a.f.t.r.2d 20036096, 2003-2 u.s.t.c. 50,666 (8th cir. 9/15/03). the taxpayer manufactured 't51 printing press attachments," consisting of approximately 800 parts that give users the ability to print multiple color documents in a single pass through a printing press. annually for 40 years, it gathered its in-house sales personnel, its outside independent contractor sales people and its engineers and factory workers 7. this refers to one of the most famous advertisements of the last century. its author was elliott white springs, who, after assuming control of his family textile firm, wrote a series of risqu6 magazine advertisements, including one showing a smiling young native american woman departing from a hammock [made, of course, from a springmaid sheet] that was occupied by an exhausted native american man, captioned "a buck well spent on a springmaid sheet." [vol.6:si recent developments in federal income taxation for an annual two-day meeting at corporate headquarters, followed by a four-day expense-paid fishing trip. the two-day meeting was often used to introduce new products. judge bowman held that the costs of the fishing trip were deductible based upon taxpayer's "realistic expectation to gain concrete future benefits from the trip based on its knowledge of its own small company, its knowledge of the utility of interpersonal interactions that probably would not occur but for the trip, and its knowledge of its own past experience," and the trip qualified as a § 132(d) working condition fringe benefit for the employees who attended. 5. the irs never seems able to catch up with the movements in the price of gasoline, and more tinkering is in store for 2004. rev. proc. 200376, 2003-43 i.r.b. 924 (10/27/03), superseding rev. proc. 2002-61, 2 c.b. 616. the optional standard mileage rate for business use of automobiles will increase on 1/1/04 from 36 cents per mile to 37.5 cents per mile; the mileage rate for medical and moving will increase from 12 cents per mile to 14 cents per mile; and the mileage rate for giving services to a charitable organization will remain at 14 cents per mile. the procedure also revises the limitation on simultaneous use of multiple automobiles to allow a taxpayer using up to four vehicles simultaneously to use the standard mileage rate. 6. change your globes antigua and barbuda are now part of north america! rev. rul. 2003-109, 2003-42 i.r.b. 839 (10/20/23). this revenue ruling supersedes rev. rul. 94-56, 1994-2 c.b. 37, and lists all of the geographical areas included in the north american area for purposes of § 274(h), which generally denies any deduction for the cost of attending a "convention, seminar, or similar meeting held outside the 'north american area."' 7. florida progress corp. v. commissioner, 348 f.3d 954, 92 a.f.t.r.2d 2003-6583 (11th cir. 10/21/03) (per curiam), affig 114 t.c. 587 (2000). section 1341 does not apply to rate reductions by a public utility to indirectly compensate customers for prior charges that retrospectively were determined to have over-recovered costs and, therefore, to have been excessive. section 1341 does not independently authorize a deduction, but operates only when a deduction is allowed under some other code section. the tax court's finding that rate reductions were income reductions, not deductible expenses, was not erroneous. 8. electronic employee expense reimbursement arrangement is ok, except for non-itemized hotel bills. rev. rul. 2003-106,2003-44 i.r.b. 936 (11/03/03). this revenue ruling explains when an employer's expense reimbursement arrangement for deductible travel and entertainment expenses that uses electronic receipts and expense reports is an accountable plan under § 62(a)(2)(a) and (c) and the regulations thereunder. under the plan, the credit card company provides the employer with an electronic receipt for all expenses billed to an employee's business credit card. the electronic receipt contains the date of the charge, the amount of the charge, the merchant's name, the merchant's location, and, if available, an itemization from the merchant of each expense included in the charge. employees access the database to create an electronic expense report to accompany the electronic receipts associated with their travel and entertainment expenses, and the employees must provide all relevant information 20041 florida tax review to substantiate the deduction under § 274(d) and the regulations. employees must be required to submit paper expense reports and receipts for: (1) any expense over $75 where the nature of the expense is not clear on the face of the electronic receipt; (2) all lodging invoices for which the credit card company does not provide the merchant's electronic itemization of each expense; and (3) any expenses paid for by the employee without using the business credit card; paper receipts and expense reports must contain all required information. 9. schedule c deficiency interest is nondeductible in the fifth circuit. alfaro v. commissioner, 349 f.3d 225,92 a.f.t.r.2d 2003-6914, 20032 u.s.t.c. 50,715 (5th cir. 11/6/03). the fifth circuit held that interest on taxpayers' individual income tax liability that arose from a sole proprietorship belonging to husband is nondeductible personal interest under § 163(h), joining five other circuits in this result. judge weiner followed robinson v. commissioner, 119 t.c. 44 (2002), and all of the other courts that have decided the issue, and upheld the validity of temp. reg. § 1.163-9t(b)(2)(i)(a), disallowing a deduction for interest on an individual income tax deficiency, as applied to interest on a deficiency arising from income attributable to a trade or business. he decided that the regulation is a reasonable interpretation of the statute, that it is consistent with the blue book, and that congress has not acted to overturn it in the intervening years since it was promulgated. e. depreciation & amortization 1. the job creation and worker assistance act of 2002, pub. l. 107-47, 115 stat. 260, provides for additional first-year depreciation of 30 percent for certain property that was acquired after 9/10/01 (and before 9/11/04) and placed in service before 1/1/05. qualifying property consists of (1) § 168 property with a recovery period of 20 years or less, (2) computer software other than computer software covered by § 197, (3) water utility property, and (4) leasehold improvement property. for passenger automobiles, the § 280f(a)(1)(a)(i) limitation is to be increased by $4,600. this provision also applies to improvements to used property. 0 depreciation claimed pursuant to this provision may be used for alternative minimum tax purposes even though the 200 percent declining balance depreciation tables are used for the basis remaining after the additional first-year depreciation is taken. a. rev. proc. 2002-33,2002-20 i.r.b. 963 (5/20/02). this revenue procedure provides procedures for claiming the additional 30 percent firstyear depreciation provided by § 168(k) [and § 1400l(b)]. it also explains how a taxpayer may elect not to deduct the additional first-year depreciation for qualified property. b. fifty-percent bonus depreciation. section 168(k)(4), added by the 2003 act, allows a deduction of fifty percent of the adjusted basis of qualified property (in lieu of the prior 30 percent) placed in service after 5/5/03 and before 1/1/05. [vol6:si recent developments in federal income taxation * section 168(k)(2)(f) provides that the 50 percent (and 30 percent) first year allowance is also allowable as a deduction for purposes of the alternative minimum tax. 0 bonus depreciation is extended to passenger automobiles by increasing the § 280f(a)(1)(a)(i) limit by $4,600 for passenger automobiles that are qualified property placed that are in service after 9/10/01 and before 5/6/03, and by $7,650 for passenger automobiles that are qualified property placed that are in service after 5/5/03 and before 1/1/05. c. regulations on bonus depreciation. t.d. 9091, special depreciation allowance, 68 f.r. 52986 (9/8/03); reg-157164, special depreciation allowance, 68 f.r. 53008 (9/8/03). the treasury has promulgated temporary regulations [temp. reg. § 1.167(a)-14t (dealing with qualified intangible property); temp. reg. § 1.168(k)-it (dealing with tangible property)] and published identical proposed regulations (prop. reg. § 1.167(a)14; prop. reg. § 1.168(k)-it] dealing with first year bonus depreciation under § 168(k). 2. increased § 179 expensing for small business with an increased phase-out amount. the 2003 act increased the amountdeductible under § 179 to $100,000 for property placed in service in taxable years beginning in 2003, 2004, and 2005. in addition, for those years, the dollar-for-dollar phaseout of the amount begins when the cost of property placed in service exceeds $400,000 (adjusted for inflation in 2004 and 2005). the 2003 act also amended § 179(d) to treat off-the-shelf computer software placed in service in taxable years beginning in 2003 through 2005 as qualifying property. 0 the 2003 act amended § 179(c)(2) to allow elections to expense assets under § 179 with respect to taxable years beginning in 2003 through 2005 to be revoked (by an amended return) without the consent of the commissioner. 3. the service agrees that the rotable spare parts pool used in a maintenance service business is depreciable property, not inventory. rev. rul. 2003-37, 2003-15 i.r.b. 717 (4/14/03). the service will follow hewlett packard, inc. v. united states, 71 f.3d 398 (fed. cir. 1995), and honeywell, inc. v. commissioner, t. c. memo. 1992-453, afffd, 27 f.3d 571 (8th cir. 1994), and will treat rotable spare parts as depreciable assets provided they are used in the taxpayer's maintenance service business and are not held for sale. the ruling seeks comments on the maximum amount of rotable spare parts sales that should be permitted from a rotable spare parts pool that is treated as a depreciable asset. 4. the "exhaustion, wear and tear" prerequisite for depredation is an undemanding standard. and, cost recovery periods are not accounting methods. o'shaughnessy v. commissioner, 332 f.3d 1125,91 a.f.t.r.2d 20032559,2003-1 u.s.t.c. 50,522 (8th cir. 6/13/03), affg 89 a.f.t.r.2d 2002-658, 2002-1 u.s.t.c. 50,235 (d. minn. 9/29/2001). the s corporation in which the taxpayer was a shareholder manufactured glass using a "float process" that involved the use of a molten tin "bath " that lost volume and purity in the manufacturing process, requiring periodic replenishment. the amount of tin added each year equaled the amount of tin consumed in glass production during the year. the corporation deducted the cost of adding tin to the bath and depreciated the cost 20041 florida tax review of the original volume of tin. applying rev. rul. 75-491, 1975-2 c.b. 19, which was directly on point, the irs disallowed the depreciation. the court of appeals affirmed the district court's refusal to apply the revenue ruling, because it was not binding and because it predated the acrs depreciation system, and held that the original volume of tin was depreciable because over time it would have been completely exhausted by volume and purity losses. on another issue, the court of appeals reversed the district court and held that reallocation of certain plant assets from one asset category to another for the purposes of macrs depreciation did not constitute a change in accounting method, following brookshire brothers holding, inc. v. commissioner, 320 f.3d 507, 91 a.f.t.r.2d 2003-629, 2003-1 u.s.t.c. 50,214 (5th cir. 1/29/03). but see, t.d. 9105, at i.a. 2.c. 5. more tangible personal property that the local zoning board and building inspector think is real estate. cost segregation studies to take advantage of this phenomenon. rev. rul 2003-54,2003-23 i.r.b. 982 (6/9/03). this ruling provides guidance on how the common gasoline pump canopies and their supporting concrete footings used by 90 percent of gasoline stations are to be classified for depreciation purposes. gasoline pump canopies are not inherently permanent structures; for depreciation purposes they are classified as tangible personal property includible in asset class 57.0 of rev. proc. 87-56, 19872 c.b. 674. the supporting concrete footings are inherently permanent structures classified as land improvements includible in asset class 57.1 of rev. proc. 87-56. 0 no fooling! note the recent trend of obtaining a "cost segregation study" to determine the amount and nature of tangible personal property in either an existing or a newly-constructed building. these studies are based on the holding in hospital corporation of america v. commissioner, 109 t.c. 21 (1997), affd on another issue, 348 f.3d 136, 92 a.f.t.r.2d 2003-6705, 2003-2 u.s.t.c. 50,702 (6th cir. 10/30/03). see also, ilm 199921045 (4/1/99) [sic], which held that this determination must be based on facts and circumstances. this is different from component depreciation, which involved separate useful lives for different parts of the real estate. these studies determine whether there is tangible personal property that is part of the building, for purposes of depreciating this tangible personal property separately from the real estate. 6. section 197 amortization applies to noncompete agreements ancillary to stock redemptions. frontier chevrolet co. v. commissioner, 116 t.c. 289 (5/14/01), affd, 329 f.3d 1131, 91 a.f.t.r.2d 2003-2338, 2003-1 u.s.t.c. 50,490 (9th cir. 5/28/03). * the tax court (judge ruwe) held that § 197 applied to a covenant not to compete entered into when a corporation redeemed the stock of its 75-percent owner. the covenant not to compete had to be amortized over 15 years under § 197, even through it was for only a 5-year term because the redemption constituted the acquisition of an interest in a trade or business. [the holding is consistent with reg. § 1.197-2(b)(9), which was not applicable because the case arose prior to its effective date.] 0 the ninth circuit (judge trott) agreed with the tax court that taxpayer's redemption was an indirect acquisition of an interest in a trade or business because "the substance of the transaction was to [vol.6:si recent developments in federal income taxation effect a change of controlling corporate stock ownership," so taxpayer had to amortize the covenant under § 197. 0 query whether the redemption of less than a controlling amount of stock would result in the acquisition of an interest in a trade or business? 7. notice 2003-45, 2003-29 i.r.b. 86 (7/21/03). this notice provides for an automatic extension of time until 12/31/03 to amend returns to use the mid-year convention as opposed to the mid-quarter convention for property placed in service during 2001 for entities whose third and fourth quarters included 9/11/01 (as permitted by notice 2001-70, 2001-2 c.b. 437, and notice 2001-74, 2001-2 c.b. 551). the treasury and irs intend to amend the regulations under § 168 to incorporate the guidance provided in this notice, which may be relied upon meanwhile. a. similarly, rev. proc. 2003-50, 2003-29 i:r.b. 119 (7/21/03), provides an extension until 12/31/03 for taxpayers to claim (or not claim) the additional 30-percent first-year depreciation under § 168(k) or change their selection of § 179 property for the taxable year that included 9/11/01. 8. changes in use change macrs depreciation. reg-138499-02, changes in use under section 168(i)(5), 68 f.r. 43047 (7/21/03). the treasury has published comprehensive proposed regulations to provide rules for determining macrs depreciation under § 168 when the taxpayer changes the use of the property. changes in use include: (1) a conversion of personal use property to a business or income-producing use, (2) conversion from business or incomeproducing to personal use, or (3) a change in use that results in a different recovery period, depreciation method, or both. the regulations will be effective when finalized. any reasonable method will be acceptable for changes after 12/31/86 and before final regulations are published. however, current reg. § 1.167(g)-i limits the depreciable basis of property converted from personal to business use to its fair market value at the time of the conversion. 9. ia 80 group, inc. v. united states, 347 f.3d 1067,92 a.f.t.r.2d 2003-6714, 2003-1 u.s.t.c. 50,703 (8th cir. 10/30/03). section 168(e)(3)(e) provides a 15-year class life to "retail motor fuels outlets," whether or not food or other items are sold there. a building of more than 1,400 square feet qualifies only if: (1) 50 percent or more of the gross revenues from the property are generated from petroleum sales, or (2) 50 percent or more of the floor space in the property is devoted to petroleum marketing sales. the court of appeals (judge smith) held that § 168(e)(3)(e)(iii) applies on a building-by-building basis with respect to a multi-building truck stop that consisted of fuel center buildings, and separate restaurants, stores, and other facilities. some of the buildings, such as the restaurants, were not 15-year property, even though the gross revenue test was meet with respect to the aggregate gross receipts for all the buildings, because neither the gross receipts test nor the floor space test was met with respect to those buildings. 10. the cost of removing and replacing roof-covering material is deductible. campbell v. commissioner, t.c. summary opinion 2002-117 2004] florida tax review (9/6/02) (nonprecedential pursuant to § 7463(b)). special trial judge pajak held the $8,000 expenditure for roofing work done on taxpayer's rent house was a deductible repair, and need not be capitalized. as set forth in the opinion, "the contractors removed the existing top layers of the roof and recovered it with fiberglass sheets and hot asphalt. they made no structural changes to the roof... .there was no replacement or substitution of the roof. petitioner's only purpose in having the work done to the roof was to prevent the leakage and keep her rental house in operating condition and not to prolong the life of the property, increase its value, or make it adaptable to another use." a. same result for costs of spraying roof with foam to prevent future leaks because there was "no replacement or substitution of the roof." northen v. commissioner, t.c. summary opinion 2003-113 (8/13/03) (nonprecedential pursuant to § 7463(b)). special trial judge pajak held that, with respect to. the roof of a commercial building, the replacement of 28 sheets of plywood, the removal of all tar and gravel and the spraying of a primer topped with a spray polyurethane foam coating constituted a deductible repair expense. the court followed oberman mfg. co. v. commissioner, 47 t.c. 471 (1967), in finding that roof work done to prevent leakage and not to prolong the life of the property, increase its value, or make it adaptable to another use was deductible because there was no replacement or substitution of the roof. f. credits 1. leveraging the new markets credit. rev. rul. 2003-20, 20037 i.r.b. 465 (2/18/03). for purposes of determining the § 45d new markets tax credit (39% of the investment over seven years), the amount of the qualified equity investment made by a partnership [llc] includes cash from a nonrecourse loan to the partnership that the partnership invests as equity in a qualified community development entity. 2. big brother may be watching your mouth, but he won't give your dentist a tax credit for it. fan v. commissioner, 117 t.c. 32 (7/24/01). dr. fan, who had some hearing-impaired patients, purchased an intraoral camera system [consisting of a camera and monitor, video presentations and educational materials] for use in his dental practice [which was an eligible small business as defined in § 44(b)]. the system was useful with respect to all of his patients, but because dr. fan considered the system to be a more effective and efficient way to communicate with hearing-impaired patients, he claimed the § 44 disabled access credit for the cost of the system. the tax court upheld the commissioner's disallowance of the credit on the grounds that the system was not an "eligible access expenditure" as defined in § 44(c). dr fan was already ada compliant; and the system was not marketed, acquired, or used specifically as an auxiliary aid or service to ensure effective communication to comply with the applicable requirements of the ada. a. but he will give your optometrist a tax credit if he purchases an automatic refractor to accommodate disabled patients. hubbard v. commissioner, t.c. memo. 2003-245 (8/14/03). the tax court allowed taxpayer a $5,000 tax credit under § 44 because his optometry practice is an [vol6:si recent developments in federal income taxation eligible small business that falls within the definition of a public accommodation, and he must make reasonable modifications to provide services to disabled individuals. the court noted that in the year before taxpayer purchased the automatic refractor, he had to refer about 30 disabled patients to other optometrists. judge swift distinguished fan on the ground that in that case taxpayer was already in compliance with ada. he also noted that it was irrelevant that taxpayer used the refractor to treat nondisabled patients. 3. nothing in the statutory structure of the amt warrants a de novo calculation of taxable income. ventas. inc. v. united states, 57 fed. cl. 411, 92 a.f.t.r.2d 2003-5711, 2003-1 u.s.t.c. 50,513 (fed. cl. 7/30/03). section 280c requires that § 162 deductions be reduced by the amount of the § 51 targeted jobs credit [now work opportunity credit] claimed in computing regular income tax. for the year in question, the taxpayer was subject to the amt and did not reduce the wage deduction in computing amti, because the credit is not allowed against the amt. the court (judge wiese) held that in computing amti and tentative amt for purposes of § 38(c), any reduction in the amount of deductions required by § 280c by virtue of a credit having been claimed with respect to the otherwise deductible expenditure must be taken into account. judge wiese rejected the taxpayer's argument that the amt was a separate tax system, and that since the targeted jobs credit was not allowable under the amt, the expense deduction should not be disallowed. "taxable income," which is the starting point for computing amti under § 55, is taxable income under the regular income tax. nothing in the statutory structure provided the adjustment sought by the taxpayer or warranted a de novo calculation of taxable income. 0 the tax court reached the same decision regarding the statutory structure in allen v. commissioner, 118 t.c. 1 (2002), although in that case the taxpayer was not subject to the amt and the issue was the application of the limitation of the general business credit in § 38(c). • this case has implications beyond the work opportunity credit because the same statutory structures apply to welfare to work credit, orphan drug credit, and increased research activities credit. 4. a little assistance in identifying new employees that qualify for the work opportunity credit. rev. rul. 2003-112, 2003-45 i.r.b. 1007 (11/10/03). an individual whose family receives tanf8 assistance for the requisite period meets the requirements to be certified as a qualified iv-a recipient under § 51(d)(2)(a) if the individual is included on the grant and receives assistance for some portion of the specified period. 5. the final research credit regulations that weren't. in t.d. 8930, credit for increasing research activities, 66 f.r. 280 (1/3/01), the irs promulgated final regulations relating to the computation of the credit under § 41(c) and the definition of qualified research under § 41 (d). the final regulations immediately came under withering criticism from the business sector, and, in an unusual move, in notice 2001-19, 2001-10 i.r.b. 784, the treasury (secretary o'neill, himself, actually) announced that it will review the "final" regulations by 8. temporaty assistance for neady families (tanf), replaced aid for families with dependent children (afdc). 2004] florida tax review reconsidering the comments submitted and requesting additional comments on the regulations to be received by 4/2/01. any additional changes to the regulations will be made in proposed form. the regulations, including any future changes, will not be effective until the review is complete, except for the retroactive effective date [12/31/85] of the taxpayer-friendly changes to internal-use computer software rules. taxpayers may rely on the final rules pending new regulations. 0 what the suspended final regulations said. the final regulations cover the requirements to qualify for the credit, rules for computing the credit, and rules for electing and revoking the election of the alternative incremental credit, and take into account the legislative history of the tax relief and extension act of 1999. 0 the final regulations do not change the definition of gross receipts from that in the proposed regulations. reg-10517097, 63 f.r. 66503 (12/2/98). * the final regulations retain the requirement in the proposed regulations that a taxpayer seek to discover information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering.9 but, in response to comments regarding the discovery requirement, the final regulations make a number of changes. * in order to satisfy the discovery requirement, research must be undertaken for the purpose of discovering information that is beyond the knowledge that should be known to skilled professionals had they performed a reasonable investigation of the existing level of knowledge in the particular field of science or engineering [instead of technology or science], but there is no requirement that a taxpayer actually conduct such an investigation in order to claim the credit. the regulations also state, by example, that trade secrets generally are not within the common knowledge of skilled professionals (because they are not reasonably available to skilled professionals not employed, hired, or licensed by the owner of such trade secrets). underlying principles of science or engineering used in the research need not be novel. obtaining a patent [other than a design patent] raises a conclusive taxpayer favorable presumption. * the prescribed four-step process in the definition of experimentation in prop. reg. § 1.41-4(a)(5) has been eliminated. 0 the requirement of experimental record keeping in prop. reg. § 1.41-4(a)(5) has been eliminated. 0 the shrinking-back rule has been modified in response to comments. reg. § 1.41-4(b). * the exclusion of most activities after commercial production has commenced has been retained. theperse exclusion list retains debugging, but not correction of flaws. * research with respect to internal-use software that satisfies both the general conditions for credit eligibility and the three-part test is eligible for the credit. the final regulations retain the definition of 9. a discovery requirement was applied in united stationers, inc. v. united states, 163 f.3d 440 (7th cir. 1998), cert. denied, 527 u.s. 1023 (1999), norwest corp. v. commissioner, 110 t.c. 454 (1998), and wico-or, inc. v. united states, 116 f. supp. 2d 1028 (e.d. wis. 2000), aff'd, 263 f.3d 659 (7th cir. 2001). [vol.6:si recent developments in federal income taxation internal-use software and the additional qualifying test in the proposed regulations, but provide a new exception (pursuant to § 41(d)(4)(e)) under which certain internal-use software used to deliver noncomputer services to customers with features that are not yet offered by a taxpayer's competitors is not subject to the additional tests. following the conference report to the 1999 act, the final regulations clarify that software that is intended to be used to provide noncomputer services to customers is internal-use software, while software that is to be used to provide computer services is not developed primarily for internal use. 0 the final regulations clarify (1) that the three-part test in the proposed regulations is the high threshold of innovation test, and not a separate requirement, and (2) how the three-part part high threshold of innovation test supplements the discovery requirement. research with respect to internal-use software is credit eligible only if it is intended to exceed, expand, or refine the common knowledge of skilled professionals (as defined in reg. § 1.414(a)(3)(ii)) to a degree that is substantial and economically significant. a. the new research credit proposed regulations that are. reg112991-01, 66 f.r. 66362 (12/26/01). new proposed regulations under § 41 expand the definition of qualified research by eliminating the "discovery test" included in the 1/3/01 regulations. 0 treasury and irs have eliminated in these proposed regulations the requirement that qualified research must be undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering. rather, treasury and the irs believe that the requirement that qualified research be "undertaken for the purpose of discovering information which is technological in nature" is intended to distinguish technological research, which may qualify for the research credit, from non-technological research, which does not. 0 the proposed regulations repeat the requirement from reg. § 1.174-2(a)(1) by stating that research is undertaken for the purpose of discovering information if it is intended to eliminate uncertainty concerning the development or improvement of a business component. uncertainty, for purposes of this requirement, exists if the information available to the taxpayer does not establish the capability or method of developing or improving the business component, or the appropriate design of the business component. 0 the proposed regulations revise the shrinking-back rule to conform it to the rule in the legislative history to the 1986 act. these proposed regulations also reiterate that the shrinking-back rule may not itself be applied as a reason to exclude research activities from credit eligibility. * no separate research credit-specific documentation requirement is included in these proposed regulations. * the preamble notes that the service will not generally challenge return positions that are consistent with the proposed regulations. b. new final research credit regulations retain the requirement that experimentation "must be an evaluative process ... capable of evaluating more than one alternative." they validate the old joke: 'how's your wife?' "compared with whom?"' t.d. 9104, credit for increasing 20041 florida tax review research activities, 69 f.r. 22 (1/2/04). the final research credit regulations generally retain the provisions of the december 2001 proposed regulations. the rules for internal-use software are not included in these regulations, but are the subject of an advanced notice of proposed rulemaking. 0 they require a process of experimentation directed at resolving uncertainty regarding the taxpayer's development or improvement of a business component that fundamentally relies on the principles of the physical or biological sciences, engineering, or computer science. one or more alternatives intended to eliminate that uncertainty must be identified, and a process of evaluating the alternatives must also be identified. the process may involve, e.g., modeling, simulation, or a systematic trial-and-error methodology. c. anprm on internal-use software. reg-153656-03, credit for increasing research activities, 69 f.r. 43 (1/2/04). the treasury department has published an advance notice of proposed rulemaking under § 41(d)(4)(e), seeking comments on the definition of intemal-use software for research credit purposes. g. natural resources deductions & credits 1. to "produce" or to "transport" gas, that is the question. saginaw bay pipeline co. v. united states, 338 f.3d 600, 92 a.f.t.r.2d 20035613,2003-2 u.s.t.c. 50,592 (6th cir. 7/30/03), rev'g 88 a.f.t.r.2d 2001-6019, 2001-2 u.s.t.c 50,642 (e.d.mich. 8/23/01) 0 the district court (judge o'meara) held that the natural gas gathering systems were used to transport gas [class 46.0] not in production [asset class 13.2] and thus are depreciable over 15 years rather than seven years because the taxpayer was engaged in the transportation of natural gas, not in the production or processing of natural gas. the district court described duke energy natural gas corp. v. commissioner, 172 f.3d 1255 (10th cir. 1999), as "wrongly decided." 0 the sixth circuit (judge krupansky) found the duke energy reasoning persuasive and reversed the district court. the court held that the period of depreciation of natural gas gathering systems should depend upon the use to which they were being put, and not upon the producer or nonproducer status of the owner of the pipeline. inasmuch as the pipelines in question were used to transport impure "raw" or "wet' natural gas from the field wellheads to a cleansing and processing facility, they qualify as "gathering pipelines" under asset class 13.2 or rev proc. 87-56, 1987-2 c.b. 674. natural gas gathering systems are depreciable over seven years rather than the 15 years for pipelines used to transport gas under asset class 46.0. a. non-producer must use 15-year recovery period. clajon gas co. l.p.v. commissioner, 119 t.c. 197 (10/25/02) (reviewed, 10-5). the tax court in a decision by judge halpern upheld the government's notices of final partnership administrative adjustment in determining that the recovery period for gathering pipeline systems owned and operated by a non-producer were transportation property with a 15-year recovery period, and not natural gas production property with a 7-year recovery period. the court adhered to its [vol.6:si recent developments in federal income taxation decision in duke energy natural gas corp. v. commissioner, 109 t.c. 416 (1997), rev'd, 172 f.3d 1255 (10th cir. 1999), and refused to follow the tenth circuit's reversal. the majority held that clajon's use of the pipeline system was relevant, and inasmuch as clajon was not a producer, the pipeline system could not have been part of the production system. 0 judge wells' dissent was based upon the tenth circuit's plain language analysis in duke energy of rev. proc. 87-56, 19872 c.b. 674, which only requires that the assets be "used" by natural gas producers to qualify for 7-year depreciation. the tax court majority requires that the asset be both owned and used by a natural gas producer. judge wells notes that the tax court held in rauenhorst v. commissioner, 119 t.c. 157 (10/7/02), that "the commissioner may not choose to litigate against an official position the commissioner has published without first revising or revoking that position." * judge foley's dissent was based upon similar grounds, that the asset meets the regulatory requirement even though claj on was not a producer. b. tax court holding reversed by the eighth circuit: 7year recovery period for gathering pipelines. clajon gas. co., lp v. commissioner, 354 f.3d 786,93 a.f.t.r.2d 2004-396,2004-1 u.s.t.c. 50,123 (8th cir. 1/12/04). the court followed the eighth circuit's duke energy case and the sixth circuit's saganaw bay pipeline case. 2. the exxon saga: after an initial setback in the tax court, exxon has been meeting with success in the federal circuit on the issue of taking percentage depletion on fixed contract natural gas on representative market or field prices that are greatly in excess of the actual sale price for the gas. a. tax court: taxpayer not permitted to follow the literal language of the regulations. exxon corp. v. commissioner, 102 t.c. 721 (6/6/94). taxpayer was not permitted to follow the literal language of reg. § 1.6133(a) and use "representative market or field prices" (rmfp) in determining "gross income from the property" for purposes of computing percentage depletion under §613a(b)(1)(b) ["fixed contract" exception]. even though the regulation states that "the gross income from the property shall be assumed to be equivalent to rmfp" with respect to natural gas transported from the premises prior to sale, the purpose of that provision was to prevent integrated producers from taking depletion deductions on transportation, refiing, etc. and not to permit a taxpayer to take depletion based upon a rmfp price five times the actual sales price of the natural gas to an exxon affiliate. the actual contract sales price was therefore reduced by royalties and transportation expenses to determine "gross income from the property." b. same issue in court of federal claims. exxon corp. v. united states, 33 fed. cl. 250, 75 a.f.t.r.2d 95-1733, 95-1 u.s.t.c. 50,245 (fed. cl. 4/11/95). on the same issue, the court held, that while the amount upon which depletion can be taken is not necessarily limited by actual gross income [21 cents], the rmfp calculated by exxon [41 cents] was not a reasonable basis upon which depletion may be taken and [based upon the burden of proof] the complaint was dismissed. but reversed .... 20041 florida tax review c. federal circuit holds that rmifp which exceeds actual gross receipts is not precluded, nor is it per se "unreasonable." exxon cor. v. united states, 88 f.3d 968, 77 a.f.t.r.2d 96-2521, 96-2 u.s.t.c. 50,324 (fed. cir. 6/20/96), cert. denied 520 u.s. 1119 (3/17/97), rev'g and remanding 33 fed. cl. 250,95-1 u.s.t.c. 50,245 (fed. cl. 1995). the court held that the taxpayer was entitled to calculate its depletion deduction based upon an rmfp of 39 cents based upon the wellhead price that would be realized by nonintegrated producers. the court further held that the court of federal claims should not have limited the price by making an independent assessment of the reasonableness of the price because the §611 (a) language "reasonable allowance . . . in each case" refers to the different types of depletable resource, not to individual taxpayers. d. and you thought you couldn't deplete more than your gross income. of course you can, silly boy. exxon corp. v. united states, 45 fed. cl. 581, 84 a.f.t.r.2d 7235, 2000-1 u.s.t.c. 50,116 (fed. cl. 12/2/99). exxon sought a $172.6 million refund based on percentage depletion for 1975, under §613a(b)(1)(b), allowing §613 percentage depletion for natural gas sold under a fixed contract. the long-term contracts in issue were with houston lighting & power co. (hl&p) and with southwestern electric and power co. (swepco), the irs assessed a deficiency for 1975 on the grounds that exxon was not entitled to use the rmfp under reg. §1.6133(a) to compute percentage depletion because the fixed-contract exception in §613a(b)(1)(b) did not permit use of the rmfp. exxon filed suit, and the court of claims initially denied the government's motion for summary judgment, in which the government argued that reg. §1.613-3(a) did not apply to post-1974 depletion allowed under the fixed contract exception. 0 on the government's motion for summary judgment, the court (senior judge gibson) held that: (1) reg. § 1.6133(a), absent evidence that the regulation systematically causes a material distortion of the "gross income from the property," was not facially invalid as applied to percentage depletion deduction pursuant to the post-1974 fixed contract exception [even if the rmfp exceeded the actual sales price, which it can under exxon, corp. v. united states, 88 f.3d 968 (fed. cir. 1996)], and (2) evidence raised genuine issues of material fact that the regulation produced a result that was arbitrary, capricious, or manifestly contrary to the post-1974 statutory percentage depletion scheme. 40 fed. cl. 73 (1998). after trial, the court held: * first: not all of the natural gas was eligible under reg. § 1.613a-7(c)(5) and (d). exxon failed to prove that its contract with hl&p qualified as a "fixed contract." the hl&p excess royalty reimbursement and additional gas contract terms permitted exxon, in part, to raise prices after feb. 1, 1975, by amounts tied to the market price for natural gas [which would allow it to recover through price increases increased tax liabilities arising from the repeal of percentage depletion], and the sales prices did in fact increase. exxon did not prove by "clear and convincing evidence" that the price increase did not "to any extent" permit it to recoup tax increases attributable to the repeal of percentage depletion. the contract with swepco, however, was qualified. although the contract had a price adjustment clause under which exxon "could potentially have recovered a portion of its increased income tax liabilities," the [vol.6:s1 recent developments in federal income taxation contract qualified as a "fixed contract" because the contract price did not in fact increase after february 1, 1975. 0 second: for calculating exxon's 1975 percentage depletion allowance, the rmfp is $0.6831 per thousand cubic feet (mcf) of natural gas that is eligible for percentage depletion. (1) the texas gulf coast/east texas region, rather than the entire state, constituted a "market area that was geographically 'representative"' of exxon's 1975 production from the properties at issue. (2) in determining whether that region was the relevant market area, judge gibson found that exxon's 1975 "gas well gas production" comprising 90.24 percent of the gas in issue was comparable or superior to gas produced and sold generally through the region; only 9.74 percent [casinghead gas] was not comparable and must be excluded from the computation of exxon's allowance. (3) after determining the appropriate rmfp transaction sample and adjusting for the pre-sale costs of compression and dehydration, the court held that the rmfp for purposes of reg. §1.613-3(a) was $0.6831 per mcf. 0 exxon had argued that every sale of raw gas at a delivery point anywhere on the producer's leased property was a transaction in which the sale price was untainted by transportation before the sale. the court held that exxon failed to support that position, and that it was not feasible to cure tainted transactions by subtracting the transportation cost from the gas sale price. e. affirmed in part, reversed in part. literalism triumphs in the federal circuit. taxpayer celebrates a little bit more. exxon mobil corp. v. united states, 244 f.3d 1341, 87 a.f.t.r.2d 1508, 2001-1 u.s.t.c. 50,348 (fed. cir. 4/3/01). the federal circuit affirmed the court of federal claims holding that percentage depletion should be calculated with respect to a rmfp that exceed the taxpayer's actual sale price. judge michel rejected the government's argument that reg. § 1.613-3(a) here would lead to "absurd results," and would "thwart the obvious purpose" of the 1975 act by noting that treasury considered, but declined to fix, the "perceived anomaly." he so held because "it is not the province of this court to remedy anomalies in the tax laws that congress and the [treasury] have refrained from correcting." the 1975 addition of §613a "may have changed pre-1975 law by redefining what kinds of gas are eligible for percentage depletion, nothing in the regulation changes . . . the method of computing the amount of percentage depletion or eligible gas." (emphasis in original) * he also affirmed the trial court's holding that casinghead gas [gas that was dissolved in oil at reservoir conditions but becomes gaseous at atmospheric pressure at the top or "casinghead of an oil well] should be excluded from the computation of the rmfp because it was not comparable to its gas well gas. finally, the court of appeals reversed the trial court's holding that the hl&p contract was not a "fixed price contract," holding as a matter of law that it was a fixed price contract, thereby entitling exxon to percentage depletion on the gas sold pursuant to that contract. under the contract, exxon could not raise the price of gas unless hl&p exercised its rights under the additional gas clause. that did not alter the fact that the price for the original quantity of gas was fixed from exxon's perspective. hl&p controlled whether the additional gas clause, and thus the price increase, would be invoked. 20041 florida tax review f. the district court for the northern district of texas permits percentage depletion based on the rmfp, but not for the hl&p and swepco contracts. exxon mobil conp. v. united states, 253 f.supp.2d 915, 2003-2 u.s.t.c. 50,260 (n.d.tex. 3/10/03). in this refund action for the 1976 year, the court found that natural gas sold under 18 fixed price, long-term contracts was eligible for percentage depletion based upon the representative market or field price ("rmfp"). the court, however, found that two additional contracts [with hl&p and swepco] were not "fixed contracts" because taxpayer failed to meet its burden of proving by clear and convincing evidence that the prices thereunder were not subject to adjustment to reflect the increase in liabilities of exxon for federal income tax after 1974 by reason of the [1975 act] repeal of percentage depletion. 3. a § 29 credit no-ruling issue. rev. proc. 2000-47, 200046 i.r.b. 482 (11/13/00). rev. proc. 2000-3, §5, 2000-1 i.r.b. 103, was amplified by adding to the list of issues on which the irs will not issue advance rulings the question of whether a solid fuel other than coke or a fuel produced from waste coal is a qualified fuel under §29(c)(1)(c). waste coal for this purpose is limited to waste coal fines from normal mining and crushing operations and does not include fines produced (for example, by crushing run-of-mine coal) for the purpose of claiming the credit. a. rulings will again be available. but treasury didn't revert to pre-suspension ruling standards. rev. proc. 2001-30, 2001-19 i.r.b. 1163 (4/23/0 1), modified by rev. proc. 2001-34. 2001-22 i.r.b. 1293 (5/8/01). the ruling provides the circumstances under which the service will issue private letter rulings regarding whether a solid fuel produced from coal is a qualified fuel under § 29(c)(1)(c). the circumstances necessary for the service to issue a private letter ruling include the presence of coal feedstock particles no larger than a specific size, and the performance of specific activities in processing the feedstock in order to effectuate a significant chemical change. the chief requirement is that the fuel be "synthetic." to be synthetic "a fuel must differ significantly in chemical composition, as opposed to physical composition, from the substance used to produce it." examples of "favorable processes" set forth in the revenue procedure include "gasification [sic] and liquefaction [sic] and production of solvent refined coal that result[s] in substantial chemical changes to the entire coal feedstock rather than changes that affect only the surface of the coal." b. eleven days later, the treasury reverted to presuspension ruling standards. rev. proc. 2001-34 modifies rev. proc. 2001-30 to expand the range of sizes of coal feedstock and to eliminate one particular activity as a necessary part of a process that results in a qualified fuel. c. irs looks again at coal-based synfuels or, is it sinfuels? announcement 2003-46, 2003-30 i.r.b. 222 (7/28/03). irs suspends issuance of letter rulings related to the § 29 tax credit for the production of solid synthetic fuels produced from coal pending review of tests that purportedly show that the processes resulted in significant chemical change. [vol6:si recent developments in federal income taxation d. someone holds the "kies" to irs continuation of rulings in this area at least for the time being. announcement 2003-70, 200346 i.r.b. 1090 (10/29/03). in so doing, the announcement states: the service has finished the review started with announcement 2003-46. as a result of this review, the service has determined that the test procedures and results used by taxpayers are scientifically valid if the procedures are applied in a consistent and unbiased manner. the service believes, however, that the processes approved under its long standing ruling practice and as set forth in rev. proc. 2001-30 do not produce the level of chemical change required by § 29(c)(1)(c) and rev. rul. 86-100. nevertheless, the service continues to recognize that many taxpayers and their investors have relied on its longstanding ruling practice to make investments. therefore, the service will continue to issue rulings on significant chemical change but only under the guidelines set forth in rev. proc. 2001-30 as modified by rev. proc. 2001-34. although the service will resume its ruling practice, the service has continuing concerns regarding the sampling and data/record retention practices prevalent in the synthetic fuels industry. accordingly, in order to receive future rulings, taxpayers will be required to (i) maintain sampling and quality control procedures that conform to astm or other appropriate industry guidelines at their synthetic fuel production facilities, (ii) obtain regular reports from independent laboratories that have analyzed the synthetic fuel produced in such facilities to verify that the coal used to produce the fuel undergoes a significant chemical change, consistent with prior ruling practice, and (iii) maintain records and data underlying the reports that taxpayers obtain from independent laboratories including raw ftir data, and processed ftir data sufficient to document the selection of absorption peaks and integration points. the service also plans to issue guidance extending these requirements to taxpayers already holding rulings on the issue of significant chemical change. in addition to these requirements, the service is considering whether to impose certain requirements on laboratories used by taxpayers to demonstrate significant chemical change, consistent with prior ruling practice, such as requiring that the laboratories be accredited by the nist national voluntary laboratory accreditation program. h. loss transactions, bad debts and nols there were no significant developments regarding this topic during 2003. 20041 florida tax review i. at-risk and passive activity losses 1. whose "participation" counts if the taxpayer isn't a natural person? the mattie k. carter trust v. united states, 256 f.supp.2d 536, 91 a.f.t.r.2d 2003-1946,2003-1 u.s.t.c. 50,418 (n.d. tex. 4/11/03). the district court (judge mcbryde) held that in determining whether a trust "materially participated" in an activity [in this case a ranching operation] the activities of all of the trust's fiduciaries, employees, and agents should be considered, as urged by the taxpayer, and not just the activities of the trustee, as argued by the government. 2. soon (or eventually), no amounts borrowed from your partner will increase your at-risk amount. reg-209377-89, at-risk limitations; interest other than that of a creditor, 68 f.r. 40583 (7/8/03). section 465(b)(3) provides that amounts borrowed for use in an activity do not increase the borrower's amount at risk in an activity listed in § 465(c)(1) [(1) motion-picture films or videotapes; (2) farming; (3) leasing § 1245 property; (4) oil and gas resources and geothermal deposits] if the lender has an interest other than that of a creditor in the activity or if the lender is related to a person (other than the borrower) who has a disqualifying interest in the activity. section 465(c)(3)(d) provides that § 465(b)(3) applies to activities to which § 465 is extended by § 453(c)(3)(a) all other business and profit seeking activities only to the extent provided in regulations; alexander v. commissioner, 95 t.c. 467 (1990), affd by order sub nom. stell v. commissioner, 999 f.2d 544 (9th cir. 1993), held that until regulations were issued, §465(b)(3) does not apply to activities other than those described in § 465(c)(1). the revisions to prop. reg. § 1.465-8 and 1.465-20 would apply § 465(b)(3) to the activities described in § 465(c)(3)(a). the regulation will be effective when finalized. il. investment gain a. capital gain and loss 1. this collar just plain clean works. rev. rul. 2003-7, 2003-5 i.r.b. 363 (1/16/03). the irs ruled that a shareholder has neither sold stock currently nor caused a constructive sale of stock under § 1259 where he (1) receives a fixed amount of cash, (2) simultaneously enters into an agreement to deliver on a future date a number of shares of common stock that varies significantly depending on the value of the shares on the delivery date [but which does provide a "collar" on the number of shares of stock to be delivered, in effect providing a "collar" on the ultimate sale price], (3) pledges the maximum number of shares for which delivery could be required, (4) has the unrestricted right to deliver the pledged shares or to substitute cash or other shares on the delivery date, and (5) is not economically compelled to deliver the pledged shares. 0 there was not a sale of the pledged shares because the shareholder was not required to relinquish the pledged shares but had an unrestricted right to reacquire them by delivering cash or other shares. there was not a constructive sale under § 1259(c)(1)(c) because due to the variation in the number of shares that might be delivered, the agreement was not a contract to deliver a substantially fixed amount of property for purposes of § 1259(d)(1). [vol.6:si recent developments in federal income taxation 2. a little help for bears. rev. rul. 2003-31, 2003-13 i.r.b. 643 (3/31/03). this revenue ruling dealt with two issues regarding short sales in margin accounts. first, changes to the terms of a margin account through which a short sale was effectuated do not result in the short sale being consummated for purposes of reg. § 1.1233-1 (a)(4). second, if a taxpayer's pre-6/9/97 appreciated financial position and short-against-the-box transactions are not taken into account for purposes of applying § 1259 of the internal revenue code to post-6/8/97 transactions, as provided by the transition rule in § 1001(d)(2) of the taxpayer relief act of 1997, changes to the terms of the margin account through which the short sale was effectuated will not result in transition rule ceasing to apply. 3. capital gains rates reduced to 15 percent. generally speaking, under the 2003 act, gains from the sale of capital assets held for more than one year realized by taxpayers otherwise subject to income tax rates of greater than 15 percent (formerly taxed at a 20-percent rate) are taxed at a rate of 15 percent. for taxpayers otherwise subject to income tax rates of 10 or 15 percent, capital gains (formerly taxed at an 8or 10-percent rate) are taxed at 5 percent (with a special zero percent rate capital gains rate for 10and 15-percent bracket taxpayers in 2008). * the 25and 28-percent capital gains rates remain. some or all of any capital gains realized on the sale of depreciable real estate, however, may be taxed at a maximum rate of 25 percent if realized by a taxpayer (otherwise in a tax bracket greater than 15 percent), and gains on the sale of collectibles, e.g., art work, precious gems, gold bullion, antiques, etc., are subject to a maximum rate of 28 percent. 0 for taxable years that include 5/6/03, the rate on net long-term capital gains is bifurcated pursuant to § 301(c) of the 2003 act. for gains taken into account prior to 5/6/03, net long-term capital gains are taxed under former law. gains taken into account after 5/5/03 will be taxed at the new rates. 4. you have to transfer some other business asset before you can sell goodwill. baker v. commissioner, 338 f.3d 789, 92 a.f.t.r.2d 2003-5640, 2003-2 u.s.t.c. 50,604 (7th cir. 8/4/03), affg 118 t.c. 452 (5/29/02). the taxpayer was a state farm insurance agent, who sold policies exclusively for state farm as an independent contractor, operating his own agency, developing clients, hiring employees, and paying expenses. upon retirement, the taxpayer returned all of state farm's property to it, but transferred no identifiable assets of his own, and he received a "termination payment" the insurance policies he had written were assigned to a successor agent. the seventh circuit (judge bauer) affirmed the tax court (judge panuthos) decision denying the taxpayer capital gain treatment with respect to the termination payment. he transferred no assets that owned; the telephone number and at-will employment relationships were not assets. he could not transfer goodwill, because he transferred nothing to which goodwill could attach because (contractually) the customer list belonged to the insurance company. the entire termination payment was ordinary income without regard to the potion of it allocable to a covenant not to compete. as the court stated: 20041 florida tax review fundamentally, in order to have the ability to sell something, one must own it. because warren baker did not own any property related to the policies, he could not sell anything. 5. welter v. commissioner, t.c. memo. 2003-299 (10/29/03). grain commodity trading by the shareholder of a corporation engaged in the grain farming business were not hedging transactions under the predecessor of reg. § 1.1221-2 because they were effected through the shareholder's personal brokerage account. the gains and losses (net losses) were capital. 0 the same result would occur under current reg. § 1.1221-2. b. section 121 1. peripatetic taxpayers sold the wrong house. guinan v. united states, 91 a.f.t.r.2d 2003-2174,2003-1 u.s.t.c. 50,475 (d. ariz. 4/9/03). reg. § 1.121-1 (b)(2) provides that the property used by the taxpayer for a majority of the time during the year will be treated as the taxpayer's principal residence. the taxpayers in guinan owned three residences a residence in wisconsin, which they sold, a residence in georgia, and a residence in arizona. during the five year period prior to selling the wisconsin residence, the taxpayers spent more time in the aggregate in the wisconsin residence (847 days) than in either of the other two residences (563 days in the georgia residence and 375 days in the arizona residence), but their combined use of the georgia and arizona residences exceeded their use of the wisconsin residence. the taxpayers spent the majority of their time in the wisconsin residence only in the first year of the five-year period. the other factors listed in treas. reg. § 1.121-1 (b)(2) did not support treating the wisconsin residence as the taxpayers' principal residence at various times the taxpayers had registered to vote in wisconsin, georgia, and arizona, they had arizona and georgia driver's licenses, but not wisconsin licenses, and they filed arizona and georgia state income tax returns, but not wisconsin returns. thus, the wisconsin residence was not the taxpayers' principal residence, and the § 121 exclusion was not available. c. section 1031 1. safe-harbor deferred like in-kind exchanges for car rental companies. rev. proc. 2003-39, 2003-22 i.r.b. 971 (6/2/03). this revenue procedure provides safe harbor rules allowing under § 1031 with respect to programs involving ongoing exchanges of tangible personal property using a single intermediary ("lke programs"). [for background information on this revenue procedure, see attorneys request guidance for like-kind exchange programs, 2002 tnt 78-22 (4/1/02).] [vol6:si recent developments in federal income taxation d. section 1035 1. rev. rul. 2003-76, 2003-33 i.r.b. 355 (8/18/03). an exchange of a portion of an annuity contract into a new annuity contract effected by the owner assigning a portion of the cash surrender value (60 percent) to a different insurance company was a tax-free exchange under § 1035. the investment in the contract and basis are allocated according to the cash value immediately prior to the exchange using the rules of § § 72 and 1031. thus, the basis in the new contract equals 60 percent of the basis in the contract immediately before the exchange. after the transaction, the basis in the old contract equals 40 percent its original basis. e. section 1041 1. a welcome regulation is made final! subchapter c principles govern which spouse will be taxed on stock redemptions incident to a divorce at least unless the spouses mutually elect otherwise. t.d. 9035, constructive transfers and transfers of property to a third party on behalf of a spouse, 68 f.r. 1534 (1/13/03). because of the inconsistent standards applied by the courts in dealing with redemptions of stock incident to a divorce, in reg-107151-00, constructive transfers and transfers of property to a third party on behalf of a spouse, 66 f.r. 40659 (8/3/01), the treasury proposed regulations [prop. reg. § 1.1041-2] to provide greater certainty in determining which spouse will be taxed on stock redemptions occurring during marriage or incident to divorce. reg. § 1.1041-2 has been finalized and reg. § 1.1041 -it(c) q&a-9 no longer controls redemptions of stock incident to a divorce. reg. § 1.1041-2 applies only where the nonredeemed spouse owns stock of the redeeming corporation either immediately before or immediately after the stock redemption. if a corporation redeems stock of one spouse, and that redemption is treated as a constructive distribution to the other spouse under subchapter c principles the primary and unconditional obligation standard [wall v. united states, 164 f.2d 462 (4th cir. 1947); sullivan v. united states, 363 f.2d 724 (8th cir. 1966)] the redemption is treated as a distribution to the spouse who continues as a shareholder. section 1041 applies to the deemed transfer of the stock by the redeemed spouse to the continuing shareholder spouse. section 1041 does not apply to the deemed transfer of stock from the nontransferor spouse to the redeeming corporation. any property actually received by the redeemed spouse from corporation is treated as flowing through the continuing shareholder-spouse, and § 1041 applies to that transfer. in all other cases, the form of the stock redemption will be respected; the redeemed spouse will be taxed on the redemption and the continuing spouse has not tax consequences. the preamble to the proposed regulations specifically state: [i]f the rules of the proposed regulations had applied in the ames case,"l0 because the husband did not have a primary and unconditional obligation to purchase the wife's stock, the redemption would have been taxed in accordance with its form 10. ames v. united states, 981 f.2d 456 (9th cir. 1992), not applied by tax court, ames v. commissioner, 102 t.c. 522 (1994) (reviewed, 7 judges dissenting). 20041 florida tax review with the result that the wife would have incurred the tax consequences of the redemption. a a special rule applies if an effective divorce or separation instrument, or a written agreement between the spouses [executed before the due dates of their returns], requires the spouses to file their federal income tax returns in a consistent manner that treats the stock as being redeemed from the continuing shareholder spouse rather than from the spouse from whom it was actually redeemed. in such a case spouses and former spouses will treat a redemption that otherwise would be taxed according to its form as a redemption from the continuing shareholder spouse involving (1) a deemed § 1041 transfer of the stock by the redeemed spouse to the continuing shareholder spouse, and (2) a deemed § 1041 transfer by the continuing shareholder spouse to the redeemed spouse of the redemption proceeds. * the final regulations add a provision dealing with situations in which the redemption results in a constructive dividend distribution to the nontransferor spouse under subchapter c principles, but the spouses nevertheless would like to agree that the redemption will be treated as a redemption distribution to the transferor spouse. reg. § 1.1041-2(c) allows' the spouses to agree in the divorce or separation instrument, or other valid written agreement, that the redemption will be taxable to the transferor spouse notwithstanding that the redemption might otherwise result in a constructive dividend distribution to the nontransferor spouse. example 2 in § 1.1041-2(d) illustrates the application of this special rule. * under the final regulations, the spouses can elect the special rule by expressly providing, in a divorce or separation instrument or other valid written agreement, that expressly supersedes any other instrument or agreement concerning the purchase, sale, redemption, or other disposition of the stock that is the subject of the redemption, their mutual intent concerning [which spouse should receive redemption treatment]. * these regulations are applicable to redemptions of stock on or after january 13, 2003 that are pursuant to instruments in effect after january 13, 2003. these regulations are also applicable to redemptions before january 13, 2003 or that are pursuant to instruments in effect before january 13, 2003 if the spouses or former spouses execute a written agreement on or after august 3, 2001, that satisfies the requirements of § 1.1041 2(c)(1) or (2). iv. compensation issues a. fringe benefits 1. irs revokes notice 2001-10 and for future arrangements will require taxation under one of two mutually exclusive regimes. notice 2002-8, 2002-4 i.r.b. 398 (1/28/02), revoking notice 2001-10, 2001-5 i.r.b. 459. when the treasury and service publish proposed regulations providing comprehensive guidance regarding the tax treatment of split-dollar life insurance arrangements, the regulations will provide the following in employment-related arrangements: * if the employer is formally designated as owner of the life insurance contract, then the employer will be treated as [vol6:si recent developments in federal income taxation providing current life insurance protection and other economic benefits to the employee. a transfer of the life insurance contract to the employee would be taxed under § 83, but an employer would not be treated as having made a transfer of the cash surrender value for purposes of § 83 "solely because the interest or other earnings credited to the cash surrender value of the contract cause the cash surrender value to exceed the portion thereof payable to the employer." this has the effect of leaving that issue unresolved, and would change the position in notice 2001-10 that the employee would be taxed under § 83 on the transfer of a beneficial interest in the cash surrender value. 0 if the employee is formally designated as owner, the premiums paid by the employer would be treated as a series of loans by the employer to the employee if the employee is required to repay the employer out of insurance proceeds or otherwise. the loans are subject to taxation under the §§ 1271-1275 od provisions and the § 7872 compensation-related below-market loan provision. if the employee is not required to repay the employer, then the premiums paid would be treated as compensation income to the employee when paid. 0 the above rules will be effective for arrangements entered into after the date of publication of final regulations. p.s. 58 rates may be used for provisions valuing current life insurance protection entered into before 1/28/02 and for arrangements entered into before the date of publication of final regulations. a. notice 2002-8 is carried into proposed regulations. reg-164754-01, split-dollar life insurance arrangements, 67 f.r. 45414 (7/9/02). these proposed regulations provide guidance on the income, employment and gift taxation of split-dollar life insurance arrangements and carry out the concepts of notice 2002-8. these proposed regulations will be effective for splitdollar life insurance arrangements entered after the date of publication of final regulations in the federal register. b. crackdown on split-dollar life insurance arrangements that are designed to understate the value of benefits for income or gift tax purposes. notice 2002-59, 2002-36 i.r.b. 481 (9/9/02). the irs held that neither the premium rates in table 2001 nor the insurer's lower published premium rates may be relied on to value the insured's current life insurance protection for the "purpose of establishing the value of policy benefits to which another party may be entitled." under reverse split-dollar arrangements, one party with a right to current life insurance protection may use various techniques to confer policy benefits other than current life insurance protection on another party, but using such techniques to understate the value of other policy benefits "distorts the income, employment, or gift tax consequences of the arrangement." 0 according to tax notes today, 2002 tnt 161-4 (8/20/02), this notice was issued after treasury officials read a 7/28/02 story in the new york times, which stated that jonathan blattmachr had developed this technique based upon a 1996 private letter ruling [identified as ltr 9636033]. c. equity split-dollar proposed regulations. reg-16475401, split-dollar life insurance arrangements, 68 f.r. 24898 (5/8/03). supplement 2004] florida tax review the 2002 proposed regulations to provide guidance on the valuation of economic benefits under an equity split-dollar life insurance arrangement. under an equity split-dollar arrangement, the payments by the owner of the policy establish a pool of assets in which the non-owner has rights of withdrawal, borrowing, surrender, assignment or the like; in addition, this pool of assets may be also placed beyond the reach of the owner's creditors. the proposed regulations provide that the nonowner "has current access to any portion of the policy cash that is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner's general creditors." "access" is thus to be broadly construed. 0 thus, the non-owner is to be taxed on the value of curr.ent term life insurance protection plus the amount of policy cash value to which he has "current access." there is also a third component: "the value of any economic benefits ... provided to the non-owner." d. final split-dollar regulations are effective on 9/17/03. t.d. 9092, split-dollar life insurance arrangements, 68 f.r. 54336 (9/17/03). the treasury department has promulgated comprehensive final regulations [reg. §§ 1.61-22, 1.83-3(e), 1.83-6(a)(5), 1.301-1(q), and reg. § 1.7872-15] regarding the federal income, gift, and employment taxation of split-dollar life insurance arrangements (as defined in § 1.61-22(b)(1) or (2)). they adopt the proposed regulations with only minor changes. the effective date of the final regulations is 9/17/03, the date of publication in the federal register, i.e., the regulations apply to any split-dollar life insurance arrangement that is entered into after 9/17/03 and to any split-dollar life insurance arrangement entered into on or before that date that is materially modified after that date. (1) rev. rul. 2003-105, 2003-40 i.r.b. 696 (9/12/03). this revenue ruling renders prior guidance in this area obsolete. in the case of any split-dollar life insurance arrangement entered into on or before 9/17/03, taxpayers may continue to rely on prior revenue rulings to the extent described in notice 2002-8, but only if the arrangement is not materially modified after that date. 2. a tax court loss for an airline pilot on taxation of disability benefits, the premiums on which were employer-paid. tuka v. commissioner, 120 t.c. 1 (1/06/03). the taxpayer claimed that disability payments, based on age, years of service, and salary, received from an employer sponsored plan were tax exempt under § 104(a)(3). judge ruwe held that the exclusion of disability benefits under § 104(a)(3) is available only if the contributions to the accident and health plan were includible in the employee's gross income. even if the plan had been funded by wage savings to the employer resulting from collective bargaining with the union it would not have been an employee contribution plan. 3. amounts received from employer may be excluded as § 139 qualified disaster relief; amounts received from a state agency are excluded as gifts. rev. rul. 2003-12, 2003-3 i.r.b. 283 (1/21/03). amounts received by an individual from an employer to reimburse the individual for necessary medical, temporary housing, or transportation expenses incurred as a result of a flood are not excludable as a gift under § 102, but are excluded from gross income as qualified disaster relief under § 139 if the flood was a presidentially declared disaster. [vol.6:si recent developments in federal income taxation similar amounts received from a state agency are excludable under the administrative general welfare exclusion; and similar amounts received from a charity are excluded under § 102. 4. health fsas and hras with point of service electronic payment. rev. rul. 2003-43, 2003-21 i.r.b. 935 (5/27/03). an employersponsored health fsa [§ 125] or hra [notice 2002-45, 2002-28 i.r.b. 93] qualifies under § 105 where the plan provides electronic reimbursement of medical expenses through the use of a debit card or stored-value card, or payment by a credit card, issued to the employee and charged to the employer's account if: (1) use of the card is limited to the maximum dollar amount of coverage available in the cardholder's health fsa or hra, (2) the card is effective only at authorized physicians, pharmacies, dentists, vision care offices, hospitals, and other medical care providers, (3) the employee certifies that any expense paid with the card has not been reimbursed and that the employee will not seek reimbursement under any other plan, (4) the employee agrees to acquire and retain sufficient documentation, including invoices and receipts, for expenses paid with the card, and (5) the employer maintains comprehensive procedures for substantiating claimed medical expenses after the use of the card. but where the employer does not comprehensively substantiate that the expenses paid with the card qualify as medical expenses for example, only statistically samples expenditures to verify that the expenditure was not for cosmetic procedures the plan does not qualify. a. you don't need a prescription to be reimbursed by a health fsa for over-the-counter drugs. rev. rul. 2003-102,2003-38 i.r.b. 559 (9/22/03). the test for reimbursement by a health fsa under § 105(b) for drugs simply requires that they be obtained for .'medical care' as defined in section 213(d)," and does not require that they satisfy they requirement of § 213(b) which permits an amount paid for a medicine or drug to be taken into account for purposes of the § 213 deduction "only if the medicine or drug is a prescribed drug or insulin." b. contrast reimbursement plans with deductibility under § 213. under § 213 a prescription is required for medicines and drugs to be deductible. rev. rul. 2003-58, 2003-22 i.r.b. 959 (6/2/03). amounts paid by an individual for medicines that may be purchased without a prescription of a physician, e.g., aspirin, are not deductible under § 213 of the code, even when the taxpayer's physician instructs the taxpayer to take the medication to alleviate a medical problem. see v.e., below. 5. guidance on health savings accounts. notice 2004-2,2004-2 i.r.b. 269 (1/12/04). the irs has issued guidance in q&a form on health savings accounts under new § 223 (added by § 1201 of the medicare prescription drug, improvement, and modernization act of 2003, pub. l. 108173, 117 stat. 2066). this guidance provides basic information about hsas. this new provision offers health-spending accounts without the "use it or lose it" requirement of health fsas. 20041 florida tax review b. qualified deferred compensation plans 1. epcrs updated again. rev. proc. 2003-44, 2003-25 i.r.b. 1051 (6/23/03), updating and superseding rev, proc. 2002-47, 2002-29 i.r.b. 133. this iteration of the employee plans compliance resolution system will be generally effective 10/1/03. 2. cash balance plan proposed regulations provide a green light for adoptions of cash balance plans favoring younger employees, including permission to require quasi-geriatrics to spin their [retirement accrual] wheels during "wear-away" periods. reg-209500-86 and reg-164464-02, reductions of accruals and allocations because of the attainment of any age; application of nondiscrimination cross-testing rules to cash balance plans, 67 f.r. 76123 (12/11/02). these proposed regulations provide guidance on age discrimination requirements under §§ 41 l(b)(1)(h) and 41 1(b)(2), including the allocation of these requirements to cash balance pension plans. * a cash balance plan is a defined benefit plan under which an employee has a hypothetical individual account that provides a benefit upon retirement based upon pay credits and interest credits a concept that closely resembles a defined contribution plan. section 411 (b)(1)(h) provides that a defined benefit plan fails to comply with the age discrimination rules of § 411 (b) if benefit accrual is ceased or reduced on the attainment of any age, and § 411 (b)(2) provides that a defined contribution plan similarly fails to comply unless the rate at which amounts are allocated to an employee's account is not similarly ceased or reduced because of age. 0 a cash balance qualifies, inter alia, only if "the participant accrues the right to future interest credits (without regard to future service) at a reasonable rate of interest that does not decrease because of the attainment of any age." 0 the rules for conversion of traditional defined benefit plans to cash balance plans require that either (1) the converted plan defines the benefit as the sum of the benefits under the traditional defined benefit plan and the cash balance account, or (2) the converted plan must establish each participant's opening account balance as an amount not less than the actuarial present value of the participant's prior accrued benefit. the second alternative would permit a "wear-away" period during which the participant will not accrue net benefits for some period after the conversion. a. treasury and irs withdraw the proposed cashbalance plan nondiscrimination regulations. announcement 2003-22,2003-17 i.r.b. 846 (4/7/03). the proposed nondiscrimination regulations under § 401 (a)(4) that would have required a modified form of cross-testing, which were proposed at the same time as the proposed cash balance regulations, are withdrawn because (as proposed) they would make it difficult "for plan sponsors converting longstanding traditional pension plans to cash balance plans to provide different types of transitional relief to plan participants." the withdrawn proposed regulations will be re-proposed. b. courts find that xerox and ibm cash balance plans violate erisa. berger v. xerox corporation retirement income guarantee plan, [vol6:si recent developments in federal income taxation 338 f.3d 755, 2003-2 u.s.t.c. 50,597 (7th cir. 8/1/03) (plan violates erisa because method of determining an ex-employee's benefit if a lump sum under $25,000 is chosen on leaving before retirement); cooper v. ibm personal pension plan, 274 f.supp.2d 1010, 2003-2 u.s.t.c. 50,576 (s.d. 111. 8/1/03) (plan violates erisa § 240(b)(1)(g) [reduction of accrued benefit solely on increases in age or service] and 240(b)(1)(h) [rate of benefit accrual decreases once a certain age is attained]). 3. here's how to deduct a redemption. boise cascade corp. v. united states, 329 f.3d 751,91 a.f.t.r.2d 2003-2280,2003-1 u.s.t.c. 50,472 (9th cir. 4/10/03). boise cascade's esop held over 6.7 million shares of boise cascade convertible preferred stock. to fund distributions to employees who had terminated their employment when they had vested account balances, boise cascade redeemed a relatively small number of shares of the convertible preferred stock held by its esop. the court of appeals upheld boise cascade's claim that the redemption failed all of the tests of § 302(b), and thus was a dividend under § 301, and, as such, was deductible pursuant to § 404(k). furthermore, § 162(k) did not apply to bar the deduction. responding to what appears to have been a groundless argument by the government, the court held that § 318 did not treat the plan beneficiaries as owners [because the esop was a § 401(a) trust]. the court held that the esop was not a grantor trust of which the beneficiaries were the owners. c. nonqualified deferred compensation, section 83, and stock options 1. just exactly what does "included" mean? robinson v. united states, 52 fed. cl. 725, 90 a.f.t.r.2d. 2002-5003, 2002-2 u.s.t.c. 50,524 (6/24/02). the court of federal claims followed venture funding, ltd. v. commissioner, 110 t.c. 236 (1998), affd per curiam, 198 f.3d 248 (6th cir. 1999), cert. denied, 530 u.s. 1205 (2000), to hold that §83(h) allows a deduction for the value of a compensatory transfer of restricted stock to an employee only when the amount of the discount is actually "included" by the employee, not when the amount is "includable" but not reported as income by the employee. since the employee was appealing from an unfavorable audit with respect to the income item attributable to the year of the transfer [in which the employee-coo had made a § 83(b) election and reported the bargain element as zero, giving notice to himself as a representative of the corporation, even though the taxpayers owned all of the remaining stock of the s corporation90 percent], the fact of inclusion was not yet established and the refund claim was not ripe. taxpayers claimed that employee received restricted stock worth $28 million for $2 million and made the § 83(b) zero election without advising them or anyone else at the corporation at the time; taxpayers did not find out about the § 83(b) election until negotiating the coo's termination three years later (when they sent the coo an amended form w-2). a. reversed and reg. § 1.83-6(a) invalidated. "included" means included under law, not included in fact. robinson v. united states, 335 f.3d 1365, 92 a.f.t.r.2d 2003-5349, 2003-2 u.s.t.c. 50,590 (fed. cir. 7/15/03). the federal circuit (judge bryson) reversed. the court reasoned that since a deduction under § 162 for compensation paid is allowed whether or not the employee actually includes the amount in income, the word "included" in § 83(h) 20041 florida tax review refers only to whether the amount was properly includable by the employee under § 61. in support of this proposition, the court quoted the legislative history of § 83(h): "the allowable deduction is the amount which the employee is required to recognize as income. the deduction is to be allowed in the employer's accounting period which includes the close of the taxable year in which the employee recognizes the income." s. rep. no. 91-522, 91st cong., 1st sess. 123 (1969) [emphasis added], focusing on the italicized language. the court also cited the bluebook for support. 0 furthermore, the court refused to apply reg. § 1.83-6(a), as revised in 1995, which was the controlling regulation and which supported the commissioner's position, because, the court reasoned, the regulation was contrary to the plain meaning of the statute [even though that plain meaning was not apparent to the tax court or the sixth circuit in venture funding, ltd. v. commissioner, with which the federal circuit noted it disagreed] and flunked the first half of the chevron analysis. 2. rev. rul. 2003-98, 2003-34 i.r.b. 378 (8/25/03). this revenue ruling deals with the corporation entitled to claim the deduction under § 83(h) when a nonstatutory stock option with no ascertainable value granted to an employee of t is exercised or settled after t has been acquired by p. in three situations, after the acquisition of the t stock, t survives as a subsidiary [for which there was no § 338 election made]. in all three cases, t was entitled to the deduction without regard to whether the employee received cash from t to settle the option or the employee exchanged the t option for a p option that was later exercised. in the fourth situation, t merged into p and the employee exchanged the t option for a p option that was later exercised; in that case p was entitled to the deduction. d. individual retirement accounts 1. guidance for waivers of the 60-day rollover period. rev. proc. 2003-16,2003-4 i.r.b. 359 (1/27/03). the irs has provided guidance in applying for a waiver of the 60-day rollover period for iras and pension plan distributions, including when automatic waivers will be granted. 2. t.d. 9056, earnings calculation for returned or recharacterized ira contributions, 68 f.r. 23586 (5/5/03). final regulations provide a new method to be used for calculating the net income attributable to ira contributions that are distributed as a returned contribution under § 408(d)(4) or recharacterized under § 408a(d)(6). the regulations are applicable to ira contributions made on or after 1/1/04. v. personal income and deductions a. rates 1. dividends received are to be taxed at capital gains rates. the 2003 act added § 1 (h)( 11), which provides that dividends received by taxpayers other than corporations generally will be taxed at the same rate as long-term capital gains, i.e., 15 percent for taxpayers otherwise taxable at a rate greater than 15 [vol6:si recent developments in federal income taxation percent; and five percent for taxpayers otherwise at 10 or 15 percent (with a special zero percent rate for 10and 15-percent bracket taxpayers in 2008). this rate applies to dividends received from domestic and qualified foreign corporations for purposes of both the regular tax and the alternative minimum tax. a dividend is treated as investment income for purposes of determining the amount of deductible investment interest under § 163(d) only if the taxpayer elects to treat the dividend as not eligible for the reduced rates. the provision is effective for taxable years beginning after 12/31/02, and beginning before 1/1/09. 0 note that § 1 (h)( 11) treats dividends as "adjusted net capital gain" under § 1(h)(3), even though the dividend itself (in contrast to the stock) is not a capital asset as defined in § 1221, and dividends are not taken into account in the calculation of "net capital gain" under § 1222. the principal effect of this statutory construction is to extend the 5-percent and 15percent maximum rates under § 1 (h) to dividends received by taxpayers, without permitting capital losses to be deducted against dividend income (except to the extent allowed by §§ 1211 and 1212). a. which dividends are taxed at capital gains rates? the 2003 act added § 1(h)(1 1), which provides that dividends received by taxpayers other than corporations generally will be taxed at the same rate as long-term capital gains, i.e., 15 percent for taxpayers otherwise taxable at a rate greater than 15 percent; and five percent for taxpayers otherwise at 10 or 15 percent (with a special zero percent rate for 10and 15-percent bracket taxpayers in 2008). the conference report states: under [§ 1(h)(11)], dividends received by an individual shareholder from domestic [and qualified foreign" ] corporations are taxed at the same rates that apply to net capital gain. this treatment applies for purposes of both the regular tax and the alternative minimum tax. thus, under the provision, dividends will be taxed at rates of five and 15 percent. if a shareholder does not hold a share of stock for more than [60] days during the [120]-day period beginning [60] days before the ex-dividend date (as measured under section 246(c)), dividends received on the stock are not eligible for the reduced rates. also, the reduced rates are not available for dividends to the extent that the taxpayer is obligated to make related payments with respect to positions in substantially similar or related property. if an individual receives an extraordinary dividend (within the meaning of section 1059(c)) eligible for the reduced rates with respect to any share of stock, any loss on the sale of the stock is treated as a long-term capital loss to the extent of the dividend. 11. qualified foreign corporations include those "eligible for the benefits of a comprehensive income tax treaty [other than the barbados treaty]" and those paid "with respect to stock that is readily tradable on an established securities market in the united states [including those whose stock is traded in the form of american depository receipts]." 20041 florida tax review * the 15and 25-percent rates under § 11 on corporate taxable income of $75,000 or less make it advantageous to pay dividends out of corporate earnings, as opposed to paying "zeroing out" the corporation with shareholder/employee compensation. this strategy does not work for professional services corporations, the income of which is taxed at a flat rate of 35 percent. * note that the 60-day holding period cannot be satisfied by stock that is acquired one day before the ex-dividend date. this anomaly is to be retroactively corrected in the tax technical corrections bill (h.r. 3654), which was introduced by ways & means committee chair thomas and ranking minority member rangel. 2003 tnt 236-1. b. investment income § 163(d) limitations may lead to a taxpayer election to have dividends taxed at regular rates. the existence of a preferential rate for dividends gives rise to tax arbitrage possibilities similar to those that arise when an interest deduction is allowed with respect investments that produce only tax-favored capital gains, for which § 163(d) historically has limited interest deductions. accordingly, the 2003 act amended § 163(d)(4) to exclude from the definition of net investment income any dividends that are taxed at preferential rates under § 1(h). however, §§ 1(h)(1 1)(d)(i) and 163(d)(4)(b) allow taxpayers to elect to forgo the preferential rates for dividends and to treat the dividends as investment income for purposes of § 163(d). if a taxpayer does not have other investment income against which investment interest may be deducted under § 163(d), it may be to the taxpayer's advantage to elect not to have the preferential rates under § 1(h) apply to an amount of dividend income equal to the amount of investment interest that otherwise would be nondeductible by virtue of § 163(d). c. payments in lieu of dividends are not eligible for the exclusion. see § 6042(a) and 6045(d), relating to statements required to be furnished by brokers regarding these payments. notice 2003-67, 2003-40 i.r.b. 752 (9/16/03). this notice provides guidance for brokers and individuals regarding payments in lieu of dividends (sometimes called "substitute payments"). brokers are essentially given a pass for 2003 reporting as to whether a payment is a dividend [on form 1099-div] or a payment in lieu of a dividend [in box 8 of form 1099-misc], but must adopt proper procedures by 2004, brokers will be permitted to treat shares as loaned first by tax-indifferent customers, then by other customers using the random lottery method provided in existing reg. § 1.60452(f)(2)(ii)(b). d. qualified foreign corporations include those "eligible for the benefits of a comprehensive income tax treaty [other than the barbados treaty]." notice 2003-69, 200342 i.r.b. 851 (10/20/23). this notice provides a list of u.s. income tax treaties meeting the requirements of § 1 (h)( 1)(c)(i)(ll), which results in treating foreign corporations as a "qualified foreign corporation" dividends from which are eligible for the 5 / 15 percent maximum rates. e. stock that is readily tradable on an established securities market in the united states [including stock that is traded in the [vol.6:s! recent developments in federal income taxation form of american depository receipts]. notice 2003-71, 2003-43 i.r.b. 922 (10/27/03). this notice defines what it means 'to be readily tradable on an established securities market in the united states for purposes of determining whether dividends on stock of a foreign corporation are eligible for the 5 / 15 percent preferential rates. f. simplified 2003 reporting procedures for qfcs. notice 2003-79, 2003-50 i.r.b. 1206 (12/15/03). this notice provides guidance regarding simplified 2003 reporting procedures for dividends paid by "qualified foreign corporations" and corporations whose stock is readily tradable on an established u.s. securities market. g. t.d. 9103, information statements for certain substitute payments, 68 f.r. 74847 (12/29/03). the treasury department has promulgated final regulations on information reporting under § 6045(d) for payments in lieu of dividends made to individuals on or after 1/1/03. these regulations provide that, pending issuance of further amendments to reg. § 1.6045-2, brokers may rely on notice 2003-67 to comply with information reporting requirements under § 6045(d). 2. income tax rate reductions accelerated. in the 2003 act, congress accelerated the rate reduction by putting the 25 percent, 28 percent, 33 percent, and 35 percent brackets previously scheduled to take effect in 2006 into effect for all years after 2002. 3. marriage penalty relief for the upper limit of the 15-percent bracket accelerated. the 15-percent bracket rate was not reduced, but the 2003 act increased the size of the upper limit of the 15-percent regular income tax rate bracket for married taxpayers filing joint returns to twice the width of the 15percent regular income tax rate bracket for single returns for taxable years beginning in 2003 and 2004. * for taxable years beginning after 2004, the upper limit of the 15 percent rate bracket for married taxpayers filing joint returns reverts to the amount provided in § 1 (a) and (f). 4. increased width of the 10-percent rate bracket. the 2003 act also temporarily accelerated an increase in the taxable income ceiling of the 10percent rate bracket from $6,000 to $7,000, and for married taxpayers filing joint returns from $12,000 to $14,000 (indexed for inflation in 2004), previously scheduled to take effect in 2008, to be effective in 2003 and 2004. 0 starting in 2005, the taxable income ceiling for the 10-percent rate bracket reverts to the levels provided under the 2001 act (which are not adjusted for inflation). see § l(i). 5. increased amt exemption amount. the 2001 act and the 2003 act combined to increase the alternative minimum tax exemption amount for 2001 and 2002 to $35,750 for single taxpayers and $49,000 for married taxpayers filing joint returns, and for 2003 and 2004 to $40,250 for unmarried taxpayers and to $58,000 for married taxpayers filing joint returns. 20041 florida tax review 6. a fraudulently obtained annulment leaves you married for filing status purposes. rinehart v. commissioner, t.c. memo. 2003-109 (4/18/03). judge vasquez held that the taxpayers proper filing status was as married, as asserted by the commissioner, notwithstanding that they had their marriage judicially annulled, because, on the unusual facts, the tax court found that annulment had been obtained by a fraud on the texas court. b. miscellaneous income 1. you have to prove that the damages were received for a physical personal injury. prasil v. commissioner, t.c. memo. 2003-100 (4/9/03). the taxpayer received $7,650 to settle a sex discrimination claim against her employer. the court held that § 104(a)(2) did not exclude the payment. the record was devoid of any evidence to corroborate the taxpayer's "own self-serving testimony... that [the employer's] sex discrimination caused a physical injury to or the physical sickness of mrs. prasil." furthermore, the settlement agreement referred only to the sex discrimination claim and "did not specifically carve out any portion of the settlement payment as a settlement on account of personal physical injury or physical sickness, let alone make reference to a physical injury or a physical sickness .... 2. forste v. commissioner, t.c. memo. 2003-103 (4/16/03). when deloitte, haskins & sells informed the taxpayer that he was being terminated because of his refusal to fly to meetings, he negotiated a settlement for retirement payments and "other amounts." in negotiating the settlement, the taxpayer asserted numerous tort and contract causes of action. the settlement agreement described $25,130 of the payments as "[i]n settlement of all claims for workmen's compensation arising from my employment or termination with dh & s, and without dh & s admitting any liability, and expressly denying any liability for any and all claims which may be or are claimed to result from my employment or termination with dh & s . . . ." additional amounts, equal to the difference between $25,130 and the taxpayer's salary, were described as paid to settle other claims. nevertheless, the taxpayer excluded the full payments [which dh&s reported on w-2s], claiming that § 104(a)(2) [as in effect before 11/13/95] applied. the tax court (judge ruwe) held that the taxpayer produced credible evidence that $25,130 of the $45,615 received by the taxpayer was paid and received on account of tort or tort type personal injuries, that under § 7491 the burden of proof shifted to the commissioner with respect to that amount of $25,130, and that the commissioner had failed to satisfy the burden. the court concluded that the workers' compensation language was based on advice from the taxpayer's accountant and was intended to indicate that the payment was to settle tort-type claims, for which workers' compensation is a substitute. thus, $25,130 was excludable. the taxpayer, who bore the burden of proof regarding the amount in excess of $25,130, failed to prove that the excess was excludable; as it was paid to settle the contract claims. 12. see tam 200041022 (7/17/00) for some indication as to what the irs might consider a physical injury. [vol.6:s! recent developments in federal income taxation 3. how not to behave when dealing with an issue for which there is no precedent. roco v. commissioner, 121 t.c. 160 (9/11/03). qui tam payments are includable in gross income, and taxpayer is penalized for not doing so despite the absence of any precedent in large part because the taxpayer sought a private letter ruling and withdrew his request after being advised that the service would rule adversely. 4. dennis rodman is a supporting actor in what might be a farreaching tax court case; only walter matthau and jack lemmon can do justice to this script. rodman's nickname might change from "the worm" to "the squirrel." amos v. commissioner, t.c. memo. 2003-329 (12/1/03). the taxpayer was a television cameraman who was kicked in the groin and injured by dennis rodman after rodman ran out of bounds and tripped, landing on the taxpayer i.e., the kick took extra effort by rodman. the taxpayer settled any claims he had against rodman for $200,000. the settlement agreement expressly provided that rodman paid the taxpayer a portion of the settlement amount at issue in return for his agreement not to: (1) defame rodman, (2) disclose the existence or the terms of the settlement agreement, (3) publicize facts relating to the incident, or (4) assist in any criminal prosecution against rodman with respect to the incident. the tax court (judge chiechi) characterized these provisions collectively as "the nonphysical injury provisions," and found that $80,000 of the settlement was attributable to these provisions and that only $120,000 of the settlement was "on account of" personal physical injury and therefore excludable. c. profit-seeking individual deductions 1. the alternative minimum tax ("amt") trap for attorneys' fees on large recoveries. a. cases decided in past years by the first, fourth, seventh, eighth, ninth, tenth and federal circuits sprang the amt trap. attorney's fees incurred by an individual in a nonbusiness profit-seeking transaction are [§ 212] miscellaneous itemized deductions [§67] and may not be deducted for amt purposes. to avoid this result, taxpayers in a number of cases in recent years have argued the portion of a taxable damage award retained by the taxpayer-plaintiff's attorney as a contingent fee is excluded from the taxpayerplaintiff s income and treated as income earned directly by the attorney. the tax court and most courts of appeals have reached conflicting results on this question. generally, the tax court holds that attorney's fee awards paid directly to a plaintiffs attorney [or the portion of a damage award that is the attorney's contingent fee that is so paid] are nevertheless includable in the litigant's gross income, and that the taxpayer then may claim a deduction, subject to any applicable limitations, including disallowance of the deduction for amt purposes if it is a § 212 deduction. bagley v. commissioner, 105 t.c. 396 (1995), affd 121 f.3d 393 (8th cir. 1997). accord baylin v. united states, 43 f.3d 1451 (fed. cir. 1995), affig 30 fed. cl. 248 (1993);alexanderv. irs, 72 f.3d 938,96-1 u.s.t.c. 50,011 (1st cir. 1995), aff'g t.c. memo. 1995-51; coady v. commissioner, 213 f.3d 1187, 2000-1 u.s.t.c. 50,528 (9th cir. 2000), affg t.c. memo. 1998-291; benci-woodward v. commissioner, 219 f.3d 941, 2000-2 u.s.t.c. 50,595 (9th cir. 2000), aff'g t.c. memo. 1998-395, cert. denied, 531 u.s. 1112 (2001); 20041 florida tax review kenseth v. commissioner, 259 f.3d 881, 88 a.f.t.r.2d 2001-5378, 2001-2 u.s.t.c. 50,570 (7th cir. 8/l/01), affg 114 t.c. 399 (5/24/00) (reviewed, 8-5); young v. commissioner, 240 f.3d 369,87 a.f.t.r.2d 2001-889,2001-1 u.s.t.c. 50,244 (4th cir. 2/16/01), affig, 113 t.c. 152 (8/20/99); hukkanen-campbell v. commissioner, 274 f.3d 1312, 88 a.f.t.r.2d 2001-7983, 2002-1 u.s.t.c. 50,351 (10th cir. 12/19/01), aff'g t.c. memo. 2000-180 (6/12/01), cert. denied, 535 u.s. 1056 (5/13/02). b. but the fifth and sixth circuits see things differently. (1) in cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959), however, the fifth circuit held that attorney's fees so paid directly to a plaintiff's attorney are not includable by the litigant. the court of appeals reasoned that under the alabama attorney's lien law, the ownership of the portion of the award representing attorney's fees vested in the attorney ab initio. subsequently, in srivastava v. commissioner, 220 f.3d 353,86 a.f.t.r.2d 20005410,2000-2 u.s.t.c. 50,597 (5th cir. 2000) (2-1), rev'g t.c. memo. 1998-362, a majority decision of a fifth circuit panel held that cotnam applied to attorneys' fees under texas law because there is no difference in the "economic reality facing the taxpayer-plaintiff' between alabama and texas attorney's liens and any distinction between them does not affect the analysis required by the anticipatory assignment of income doctrine. a dissent by judge dennis distinguished cotnam on the ground that alabama law gives the holders of attorney's liens greater power than does texas law. (2) estate of clarks v. united states, 202 f.3d 854, 85 a.f.t.r.2d 2000-405, 2000-1 u.s.t.c. 50,158 (6th cir. 1/13/00). the sixth circuit held that the taxpayer was not required to include the portion of the taxable interest attached to a damage award excluded under §104(a)(2) that was paid directly to the taxpayer's attorney. the court discussed the particularities of the attorney's fee statutory lien law in cotnam, found the michigan attorney's fees common law lien law to be similar to the alabama law involved in cotnam, and stated that it was following cotnam. but the court also provided a broader explanation for its decision, concluding that the opinions representing the weight of authority, e.g., baylin v. united states, 43 f.3d 1451 (fed. cir. 1995), inappropriately relied on the assignment of income doctrine cases, e.g., lucas v. earl, 281 u.s. 111 (1930) and helvering v. horst, 311 u.s. 112 (1940), which, while relevant in family transactions, were not relevant in a arm's length transaction. c. in the eleventh circuit (as derived from pre-split fifth circuit precedents1 3), under the golsen rule, attorney's fees are not included in the income of an alabama taxpayer who received a large punitive damages award. davis v. commissioner, 210 f.3d 1346, 85 a.f.t.r.2d 20001567,2000-1 u.s.t.c. 150,431 (4/27/00) (per curiam), affg t.c. memo. 1998-248 13. under bonner v. city of prichard, alabama, 661 f.2d 1206 (11 th cir. 1981), fifth circuit decisions rendered before the eleventh circuit was created are binding precedent in the eleventh circuit. [vol6:si recent developments in federal income taxation (7/7/98). the eleventh circuit panel held that, with respect to alabama taxpayers, it was bound by cotnam. (1) in foster v. united states, 249 f.3d 1275, 1278, 87 a.f.t.r.2d 2001-2011,2001-1 u.s.t.c. 50,392 (1 lth cir.2001), the eleventh circuit followed davis in a subsequent case involving another alabama taxpayer. d. there is no amt trap in vermont! will the second circuit get a chance to opine? raymond v. united states, 247 f. supp. 2d 548, 91 a.f.t.r.2d 2003-535,2003-1 u.s.t.c. 50,196 (d. vt. 12/17/02). the district court (chief judge sessions) followed cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959), to exclude contingent attorney's fees in a wrongful discharge cases attorney's fees because under state law the plaintiff taxpayer never personally owed the contingent fee and attorney's lien gave him an equitable interest in the plaintiff s claim. he concluded that the taxpayer transferred an interest in income producing property before the income was realized, rejecting the reasoning of all of the cases to the contrary, e.g., kenseth v. commissioner, 259 f.3d 881 (7th cir. 2001), affg 114 t.c. 399 (2000), that refused to treat state law as controlling and applying the assignment of income doctrine of old colony trust co., 279 u.s. 716 (1929). notably, judge sessions also chose not to rely on srivastava v. commissioner, 220 f.3d 353 (5th cir. 2000), in which the fifth circuit abandoned reliance on state law in holding that successful plaintiffs are not required to include and deduct contingent attorney's fees but may simply exclude them. (1) yes, it is now up to the second circuit because in connecticut the client must include contingent attorney's fee in gross income. parmanand v. capewell components, llc, 289 f.supp.2d 35, 92 a.f.t.r.2d 2003-6594 (d. conn. 9/10/03). in a-suit for taxable damages in which the plaintiff prevailed, in the context of ruling the on motions regarding information return reporting requirements, the district court (judge dorsey) held that the portion of the award paid to the plaintiffs attorney was includable in the plaintiffs gross income because under connecticut law the attorney had no equitable ownership in the judgment. (2) raymond reversed by the second circuit, which follows the majority rule. raymond v. united states, 355 f.3d 107, 93 a.f.t.r.2d 2004-416, 2004-1 u.s.t.c. 50,124 (2d cir. 1/13/04). taxpayerplaintiff was required to include the gross recovery in gross income because he received "money's worth" for the fee diverted to attorney. state attorney's fee lien law was analyzed but was not solely determinative. the taxpayer had sufficient control of the source of funds to require full inclusion in gross income. e. now we discover that in the ninth circuit it all depends on which state's attorney's lien law controls. banaitis v. commissioner, 340 f.3d 1074 (9th cir. 8/27/03), rev'g t.c. memo. 2002-5, cert. granted, 124 s. ct. 1713 (3/29/04). in a case involving attorney's fees subject to oregon attorney's fee lien law, the ninth circuit (judge thomas) held the portion of a taxable damage award (for wrongful discharge from employment) retained by the attorney as a contingent fee was not includable in the taxpayer-plaintiff s gross income. judge thomas found that the nature of the attorney's fee lien was determinative. examining relevant state law, he concluded that under oregon law, the attorney's 20041 florida tax review claim to the fee was even stronger than under alabama law. therefore he applied the fifth circuit's decision in cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959), holding that contingent attorney's fees paid directly to an attorney were not includable in the client's gross income because alabama attorney's fee lien law vested title in the attorney ab initio. judge thomas declined to apply the ninth circuit's precedents in benci-woodward v. commissioner, 219 f.3d 941, (9th cir.2000), cert. denied, 531 u.s. 1112 (2001), and coady v. commissioner, 213 f.3d 1187 (9th cir.2000), on the grounds that oregon attorney's fee lien law was significantly different than that of california and alaska, which were relevant in those cases. * in his opinion, judge thomas described the fifth circuit as having "reached a similar conclusion about the operation of texas law" in srivastava v. commissioner, 220 f.3d 353 (5th cir.2000), and the eleventh circuit as "extending cotnam's alabama-lawbased holding into the law of the entire eleventh circuit" in foster v. united states, 249 f.3d 1275, 1278 (11 th cir. 2001), notwithstanding that in srivastava the fifth circuit actually reached its conclusion wholly apart from the niceties of texas attorney's lien law and in foster the eleventh circuit was dealing with a case that arose in alabama, for which there was no doubt that cotnam was the controlling precedent. [the eleventh circuit has not yet decided an attorney's fees amt trap case arising in florida or georgia.]. f. now we know how to exclude california contingent attorney's fees move to the sixth circuit in before petitioning the tax court! banks v. commissioner, 345 f.3d 373, 92 a.f.t.r.2d 2003-6298, 2003-3 u.s.t.c. [50,675 (6th cir. 9/30/03), cert. granted, 124 s. ct. 1712 (3/29/04). the sixth circuit followed the fifth circuit's decision in srivastava v. commissioner, 220 f.3d 353 (5th cir. 2000), and reaffirmed that the sixth circuit's holding in estate of clarks v. commissioner, 202 f.3d 854 (6th cir. 2000), was based on a broader principle than the ground that state attorney's fee lien law determines whether the taxpayer-plaintiff can exclude attorney's fees. the taxpayer, who lived in michigan when he filed his tax court petition, but who had previously been employed in california and had settled a wrongful termination suit brought in california for taxable tort damages under california law, was allowed to exclude the contingent attorney's fees, even though they were governed by california law and the ninth circuit would have reached a contrary conclusion under benciwoodward v. commissioner, 219 f.3d 941 (9th cir. 2000). g. the expense of suing your former employer might be "attributable" to the trade or business of being an employee, but it's not "incurred by the employee in connection with the performance of services as an employee of the employer." biehl v. commissioner, 118 t.c. 467 (5/30/02). the taxpayer successfully sued his former employer for wrongful termination and, in addition to damages, pursuant to his employment contract, the employer was required to pay his attorney's fees. the taxpayer [who lived in the ninth circuit, which has already ruled that successful plaintiffs cannot exclude attorney's fees, see, e.g., sinyard v. commissioner, 268 f.3d 756 (9th cir. 2001)] attempted to avoid the amt trap on miscellaneous itemized deductions by arguing that the attorney's fees were employer reimbursement of a § 162 employee business plan excludable under an accountable plan pursuant to § 62(c) and reg. § 1.62-2(c) and [vol.6:si recent developments in federal income taxation (d). judge beghe held that that even though the expenses were § 162 employee business expenses because they were "attributable" to his trade or business of being an employee, the expenses did not meet the requirement of reg. § 1.62-2(d) that the expenses be "paid or incurred by the employee in connection with the performance of services as an employee of the employer." this latter requirement is met only if the expenses were incurred on the employer's behalf, which clearly was not true in this case. furthermore, it cannot be met if the expenses are incurred after the employment relationship has been terminated, which was true in this case. (1) and the ninth circuit agrees. biehl v. commissioner, 351 f.3d 982, 92 a.f.t.r.2d 2003-7280, 2004-1 u.s.t.c. 50,109 (9th cir. 12/12/03). the ninth circuit (judge trott) affirmed following essentially the same reasoning as judge beghe in the tax court. in contrast to § 62(a)(1), which requires only that an expense be "attributable to a trade or business," § 62(a)(2)(a) applies only to reimbursement of expenses incurred in performing duties for or on behalf of the taxpayer's employer. the legislative history supports treas. reg. § 1.62-2(d). 2. a nondeductible estate administration expense. schwan v. united states, 264 f.supp.2d 887, 91 a.f.t.r.2d 2003-1658, 2003-1 u.s.t.c. 50,362 (d. s.d. 3/16/03). interest, required by a state statute, on a specific legacy payable from an estate to the legatee when the legacy is not paid within a statutorily specified period, is not deductible under either § 163 or § 212. d. hobby losses and § 280a home office and vacation homes 1. section 183 sent the claimed loss deduction to davy jones's locker. magassy v. commissioner, t.c. memo. 2004-4 (1/5/04). judge foley applied § 183 to disallowing a claimed § 1231 loss on the sale of a yacht. e. deductions and credits for personal expenses 1. another court imposes second-class citizen status on a trust's § 212 deductions for investment advisory fees. the fourth circuit follows the federal circuit's mellon case, but not the sixth circuit's o'neill trust case, in deciding that a trust's investment advisor fees are subject to the § 67(a) two-percent floor for miscellaneous itemized deductions. scott v. united states, 328 f.3d 132, 91 a.f.t.r.2d 2003-2100, 2003-1 u.s.t.c 50,428 (4th cir. 5/1/03), affg 186 f. supp. 2d 664,89 a.f.t.r.2d 1314,2002-1 u.s.t.c. 50,364 (e.d. va. 2/28/02). the court used dictionary definitions to affirm the district court's grant of summary judgment to the government, and rejected the taxpayers' contention that the fees were fully deductible under § 67(e) (which allows full deduction if the fees "would not have been incurred if the property were not held in trust"). the court concluded that the requirement of the second clause of § 67(e)(1), excepting from the floor costs that would not have been incurred if the property were not held by a trust or estate did not apply because "investmentadvice fees are commonly incurred outside the context of trust administration." that "'the investment advisory fees were necessary to the continued growth of the trust and were caused by the fiduciary duties of the co-trustees"' was irrelevant. "[t]he second requirement of § 67(e)(1) does not ask whether costs are commonly 2004] florida tax review incurred in the administration of trusts. instead, it asks whether costs are commonly incurred outside the administration of trusts." the fourth circuit followed mellon bank, n.a. v. united states, 265 f.3d 1275 (fed. cir. 2001), and declined to follow william j. o'neill revocable trust v. commissioner, 994 f.2d 302 (6th cir. 1993), rev'g 98 t.c. 227 (1992). judge king noted that "investment advice fees are commonly incurred outside the administration of trusts." 0 the fourth circuit did not reach the virginia state law issue on which the district court decided the case. 2. boltinghouse v. commissioner, t.c. memo. 2003-134 (5/13/03). a declaration that the custodial spouse will not claim the child as a dependent is valid pursuant to § 152(e)(2) even though it was executed prior to the divorce decree and was not incorporated into the divorce decree. 3. grandma's big teeth may not be whitened with tax-deductible dollars, but the costs of breast reconstruction surgery and vision correction surgery are deductible. rev. rul. 2003-57, 2003-22 i.r.b. 959 (6/2/03). costs for breast reconstruction surgery following a mastectomy for cancer and for vision correction surgery are deductible medical care expenses under § 213. costs to whiten teeth discolored as a result of age are not medical care expenses under § 213(d) and are not deductible. a. sometimes you need a prescription, sometime you don't. rev. rul. 2003-58, 2003-22 i.r.b. 959 (6/2/03). amounts paid by an individual for medicines that may be purchased without a prescription of a physician, e.g., aspirin, are not deductible under § 213 of the code, even when the taxpayer's physician instructs the taxpayer to take the medication to alleviate a medical problem. amounts paid by an individual for equipment, supplies [e.g., crutches for a taxpayer with a broken leg] or diagnostic devices [e.g., a blood sugar monitoring kit for a taxpayer with diabetes] that may be purchased without a physician's prescription may be deductible under § 213. 4. marriage penalty relief for the standard deduction amount. the combined effect of the 2001 act and the 2003 act has been to set the basic standard deduction amount for married taxpayers filing a joint return at twice the basic standard deduction amount for single individuals on a temporary basis for 2003 and 2004. * for 2005 the basic standard deduction amount for married taxpayers filing a joint return is 174 percent of the basic standard deduction for single individuals, increasing in steps over the following four years, with the result that in 2009 and thereafter the amount of the basic standard deduction for married taxpayers filing a joint return again will be twice the basic standard deduction for single individuals. however, these changes sunset on 12/31/10. 5. acceleration of increase in the § 24 child credit. in the 2001 act, the amount of the § 24 child credit was increased to $600 for taxable years 2001 and 2002. the 2003 act increases the amount to $1,000 for 2003 and 2004. * in 2005, the credit is reduced to $700, but then increases in steps to $1,000 for 2010. see § 24 (a)(2). however, these [vol6:si recent developments in federal income taxation changes sunset on 12/31/10. thus, absent further congressional action the amount of the credit reverts to $500 in 2011. 6. advance refund of the increased amount of 2003 child credit. the 2003 act adds new § 6429, which provides an advance cash refund of $400 per child who was allowed a § 24 credit for the 2002 year and who has not attained the age 17 (as of 12/31/03). the cash refund is to be made before 10/1/03. the amount of the cash refund will reduce the 2003 child credit, but not below zero. 0 this provision may be expanded to include more children of lower-income (non)taxpayers. 7. "happy birthday to you, happy birthday to you .... how old are you now?" under what circumstances will the irs will use the birthday rule, as opposed to the common law rule. rev. rul. 2003-72,2003-33 i.r.b. 346 (8/18/03). a child attains an age on his or her birthday for purposes of § § 21 (child and dependent care credit), 23 (adoption credit), 24 (child tax credit), 32 (earned income credit), 129 (excludable dependent care benefits), 131 (excludable foster care benefits), 137 (excludable adoption assistance benefits), and 151 (dependency exemptions). * under the common law rule, a person attains an age on the day before his or her birthday. in her 2003 report, the national taxpayer advocate recommends legislation to add a new subsection to § 7701 adopting the birthday rule. 2004 tnt 12-122. 8. the dependency exemption may be released by the custodial parent in favor of the child's father to whom she was never married. king v. commissioner, 121 t.c. no. 12 (9/26/03). the support tests of § 152(e) apply to the unmarried parents of a minor child. this is because § 152(e)(1)(a)(iii) provides that § 152(e) applies to "parents... who live apart at all times during the last 6 months of the calendar year." inasmuch as the custodial parent released her claim to exemption on form 8332 for 1987 and "future years," judge goeke held that the non-custodial parent was entitled to the exemption deduction for the child. 0 note that the current version of form 8332 contains instructions that the form should not be used by parents who never married each other. a. the service will change form 8332 in accordance with the king decision. on 11/13/03, the irs announced a change to the internal revenue manual that form 8332 for 2003 is being revised by deleting all references to the requirement that the custodial and non-custodial parents must be or have been married to each other before the special support tests apply. 9. is the kid like a car with respect to recordkeeping? 'he do the entries in different inks."4 mccullar v. commissioner, t.c. memo. 2003-272 (9/17/03). if parents are divorced, §152(e) provides that custodial parent is ordinarily entitled to claim the children as dependents. in a 'split-custody' case, the father proved that he had physical custody of a child for more than one-half of the 14. cf., charles dickens, our mutual friend ("he do the police in different voices."). this was the working title of t.s. eliot's, "the waste land." 20041 florida tax review year through a detailed logbook with entries written in different ink and typed in different fonts covering the times the child was in his custody. judge halpern stated, "petitioner' s log gives detailed descriptions about the time he spent with and without his daughter each day of 1998, written in different ink and typed in different fonts. respondent argues that the log contains errors. given the testimony of both petitioner and his ex-wife, we have determined that petitioner is a credible witness and that his log is valid and not fabricated." f. education: helping pay college tuition (or is it helping colleges increase tuition?) 1. is there any hope that the educational credit rules ever will be understandable to anyone in the income range eligible to use them like the earned income tax credit rules? t.d. 9034, education tax credit, 67 f.r. 78687 (12/26/02). the treasury department has promulgated final regulations regarding the hope scholarship credit and the lifetime learning credit under § 25a. 2. notice 2003-53, 2003-33 i.r.b. (7/31/03). this notice provides guidance for reporting requirements and transitional rules applicable to coverdell education savings accounts ("cesas") under § 530. vi. corporations a. entity and formation 1. back to back § 351 transfers are ok. rev. rul. 2003-51,200321 i.r.b. 938 (5/5/03). w corporation and x corporation (unrelated to w) both engaged in the same line of business. w's business was worth $40x; x's business, conducted through its subsidiary, y corporation, was worth $30x. pursuant to a prearranged binding agreement w and x consolidated their business operations in a new corporation with a holding company structure. w formed z corporation by transferring the business assets to z in exchange for all of z's stock. w immediately contributed the z stock to y in exchange for y stock of y and x simultaneously contributed $30x to y (to meet the capital needs of the business) in exchange for additional stock of y. w and x owned 40 percent and 60 percent, respectively, of the y stock. y, in turn, transferred all of its assets to z. viewed separately, each of the first transfer, the combined second and third transfers, and fourth transfer qualifies as a transfer described in § 351. the irs ruled that the second transfer w's transfer of its z stock to y did not cause the first transfer w's transfer of assets to z to fail the control requirement of § 351, even though both transfers were undertaken pursuant to a prearranged binding agreement. citing rev. rul. 84-111, 1984-2 c.b. 88 (situation 1), the irs concluded that treating a transfer of property that is followed by a nontaxable disposition of the stock received as a § 351 transaction is "not necessarily inconsistent with the purposes of § 351." the irs distinguished rev. rul. 70-140, 1970-1 c.b. 73, in which a transfer of assets of a proprietorship to a controlled corporation, followed by an exchange of the subsidiary's stock for stock of an unrelated, widely held corporation was treated as a direct transfer of assets to the other corporation in a taxable transaction. in rev. rul. 70-140 no alternative form of transaction could [vol6:si recent developments in federal income taxation have qualified for nonrecognition. in the instant case, however, w's transfer of the business assets to z was not necessary for w and x to combine their businesses in a holding company structure that would have qualified under § 351. if in exchange for y stock, w had transferred the assets to y and x had transferred $30x to y, and y had transferred the business to z in exchange for all of the z stock, the transfers would have would have qualified under § 351. [see rev. rul. 83-34; rev. rul. 77449.] 2. an anprm announcing that the treasury intends to amend the code via regulations and this time it might actually have the statutory authority to do so. reg100818-01, liabilities assumed in certain transactions, 68 f.r. 23931 (5/6/03). the irs and treasury are concerned that §§ 357(d) and 362(d) [providing rules for determining the amount of liability treated as assumed for purposes of §§ 357, 358(d), 358(h), 362(d), 368(a)(1)(c), and 368(a)(2)(b)], enacted as part of the miscellaneous trade and technical corrections act of 1999, public law 106-36, 113 stat. 127, do not always produce appropriate results and that it might be desirable to modify certain rules by regulation, as permitted by § 357(d)(3). this notice explains the issues and the rules the irs and treasury are considering proposing. the major proposals are as follows: 0 (1) to modify § 357(d)(1)(b) to provide that if the transferor and the transferee have no agreement regarding the satisfaction of a nonrecourse liability, the transferee will not be treated as assuming the entire amount of the nonrecourse liability; if one or more of the assets that secure a nonrecourse liability are transferred to a transferee, the transferee would be treated as assuming a pro rata amount of the nonrecourse liability, based on relative fair market values of the transferred assets securing the liability and the fair market value of all of the assets securing the liability that are retained by the transferor. • (2) to treat a transferee's express assumption of a nonrecourse debt of the transferor as a debt assumption even if no assets secured by the debt have been transferred if the transferee is expected to satisfy the nonrecourse liability. * (3) to modify § 357(d)(2) to reduce the amount of the nonrecourse liability a transferee is treated as assuming to reflect the amount another person has agreed, and is expected, to satisfy, even if such amount is in excess of the fair market value of the assets subject to such liability that the other person owns after the transfer. 0 (4) to apply standards similar to those used to determine whether a transferee has assumed a recourse liability to determine whether a transferee has assumed a nonrecourse liability, if the transferee agrees to satisfy all or a portion of the liability. in such a case should the amount of liability assumed by a subsequent transferee be determined with reference to the rules pertaining to assumptions of nonrecourse liabilities or with reference to the rules pertaining to assumptions of recourse liabilities? * (5) to respect an agreement that the transferee will satisfy only a portion of a nonrecourse debt secured by transferred property with a value greater than the agreed upon portion where the transferor does not agree to indemnify the transferee against a loss in excess of the agreed upon debt assumption. 20041 florida tax review * (6) to provide that if a transferee has agreed to satisfy an amount of a liability that is greater than the amount that it is expected to satisfy, the transferee will be treated as having agreed to satisfy only the amount of the liability that it is expected to satisfy [only if the transferor, the transferee, and each person related to the transferor and transferee within the meaning of § § 267(b) and 707(b) treat the transferee as having agreed to satisfy the amount of the liability that it is expected to satisfy]. * (7) to provide that a debt assumed by a transferee will no longer be treated as a debt of the transferor for any purposes, including a subsequent application of § 357(d). 0 (8) to extend the rules of § 357 to §§ 304 and 336. b. distributions and redemptions 1. the tax court is bearish on merrill lynch. merrill lynch & co., inc. v. commissioner, 120 t.c. 12 (1/15/03). in 1986 and 1987 merrill lynch structured several transactions to sell certain assets of first-tier and second-tier subsidiaries and not only eliminate any tax on the gains, but to create losses. to take advantage of the interaction of the consolidated return regulations and § 304 [before the promulgation of reg. § 1.1502-80(b), rendering § 304 inoperative in consolidated returns], merrill lynch caused the subsidiaries holding the assets to drop the assets to be retained into new lower level subsidiaries [in § 351 transactions], following which the new subsidiaries were sold cross chain to other merrill lynch subsidiaries. the sales proceeds were then distributed to its parent by the subsidiary to be sold, and that subsidiary was then sold. the plan was that the cross chain sale would be recharacterized as a dividend under § 304, which would result in a basis increase under reg. §§ 1.1502-32 and -33 [as then in effect] in the stock of the subsidiaries to be sold. the irs did not contest that § 304 applied, but responded that the "distributions" coupled with the sales of the subsidiaries outside the group were part of a firm and fixed plan by the subsidiaries that were sold outside the group to dispose of the stock of the lower tier subsidiaries that had been sold cross chain. therefore, even after applying § 304 the distributions were treated as amounts received in a redemption under §302(b)(3) [applying zenz v. quinlivan, 213 f.2d 914 (6th cir. 1954)]. the tax court (judge marvel) held that under the principles of niedermeyer v. commissioner, 62 t.c. 280 (1974), a firm and fixed plan existed with respect to every such sale and held for the irs. the record establishes that on the dates of the cross-chain sales, petitioner had agreed upon, and had begun to implement, a firm and fixed plan to completely terminate the target corporations' ownership interests in the issuing corporations (the subsidiaries whose stock was sold cross-chain). the plan was carefully structured to achieve very favorable tax basis adjustments resulting from the interplay of section 304 and the consolidated return regulations, and the steps of the plan were described in detail in written summaries prepared for meetings of merrill parent's board of directors. as described in those written summaries, the cross-chain sales of the issuing corporations' [vol.6:si recent developments in federal income taxation stock and the sales of the target corporations were part of the same seamless web of corporate activity intended by petitioner to culminate in the sale of the target corporations outside the consolidated group. 2. nothing succeeds like the sweet smell of success. delta plastics, inc. v. commissioner, t.c. memo. 2003-54 (2/28/03). shareholder loans to a startup corporation were respected as such, and an interest deduction allowed, even thought the corporation's debt-equity ratio was 26:1. the corporation was capitalized with $183,500. it incurred $2,322,838 of secured startup loans $2,169,013 from three unrelated creditors and $153,825 from a 47 percent shareholder. the corporation borrowed another $1,337,500 from a group of individuals consisting of six of its seven shareholders and the father of the one shareholder who did not make a loan to the corporation. the shareholder loans were roughly proportional to stock holdings, but they had all of the formal indicia of debt. they were evidenced by debenture notes, bore reasonable interest, and had a 10-year repayment schedule. payments were not dependent upon profits or losses. although the notes were unsecured and subordinated to secured creditors, and the debenture holders could enforce payment on the debenture notes only if the holders of more than 50 percent of the value of all the outstanding debenture notes joined in a proceeding to enforce payment, the corporation made all scheduled payments due. in just over 3 years, as a result of successful operations, the taxpayer's debt-equity ratio (treating the notes as debt and not as equity) was reduced from approximately 26:1 to approximately 4: 1. however, the corporation paid no dividends. after examining those debt-equity analysis factors that it found relevant, the court concluded, "credible trial testimony was offered that a debtorcreditor relationship was intended between petitioner and the debenture holders with regard to the debenture funds." 3. which dividends are taxed at capital gains rates? see v.a. l.a., above. c. liquidations 1. rev. rul. 2003-125, 2003-52 i.r.b. 1243 (12/29/03). this revenue ruling holds that when an election is made to change the classification of an entity from a corporation to a disregarded entity, the shareholder of such entity is allowed a worthless security deduction under § 165(g)(3) if the fair market value of the assets of the entity (including intangible assets such as goodwill and going concern value) does not exceed the entity's liabilities. in that case, in the deemed liquidation of the entity the shareholder receives no distribution on its stock. d. s corporations 1. excusing late elections is now simpler. rev. proc. 2003-43, 2003-23 i.r.b. 998 (6/9/03). this revenue procedure provides a simplified method for taxpayers to request relief for late s corporation elections, esbt elections, qsst elections and qsub elections. generally, relief is provided if the request for relief is filed within 24 months of the due date of the election. 20041 florida tax review 2. when your s corporation goes into bankruptcy, watch out! mourad v. commissioner, 121 t.c. 1 (7/2/03). the filing of a bankruptcy petition by taxpayer's wholly-owned s corporation for a chapter 11 plan of reorganization (in which an independent trustee was appointed by the bankruptcy court) neither terminates an s election nor creates a separate taxable entity. judge ruwe held that the taxpayer is liable for the tax on the sale by the s corporation of its principal assets. * query: how could taxpayer have planned this better? 3. stacking qualified subpart e or testamentary trust status and a qsst or esbt election. t.d. 9078, qualified subchapter s trust election for testamentary trusts, 68 f.r. 42251 (7/17/03). the treasury has promulgated amendments to reg. § 1.1361-1 relating to the two-year period for which former qualified subpart e trusts and testamentary trusts continue as qualified shareholders of s corporations and qsst elections for testamentary trusts at the termination of that period. the final regulations provide that a testamentary trust includes a trust that receives s corporation stock from a § 645 electing trust. the regulations also clarify that an esbt election may be made for a former qualified subpart e trust or a testamentary trust that qualifies as an esbt. subject to certain exceptions, the regulations are effective 7/18/03. 4. t.d. 9081; reg129709-03, prohibited allocations of securities in an s corporation, 68 f.r. 42970 (7/21/03). the treasury department has promulgated temporary regulations and published identical proposed regulations under § 409(p) concerning requirements for esops holding stock of s corporations. the regulations prohibit allocations or accruals to the esop for any year that "meaningful benefits" are not provided to rank-and-file employees. the temporary and proposed regulations provide rules defining terms, such as "synthetic equity" and "disqualified persons." 5. four-year spread for short-year income occasioned by a change in the annual accounting period to the calendar year during a transition period. rev. proc. 2003-79,2003-45 i.r.b. 1036 (11/10/03). rev. proc. 2002-38, 2002-1 c.b. 1037, and rev. proc. 2002-39, 2002-1 c.b. 1046, provide procedures for an corporation to change its annual accounting period if its current taxable year no longer qualifies as a natural business year (or, for certain s corporations, an ownership taxable year). this new revenue procedure provides procedures under which a shareholder of such an s corporation may elect to take into account ratably over four taxable years the shareholder's income from the s corporation that is attributable to the short taxable year ending on or after may 10, 2002, but before june 1, 2004. e. affiliated corporations 1. suspended loss rules to be promulgated. notice 2002-18,200212 i.r.b. 644 (3/25/02). the service announced that it and the treasury intend to issue regulations that will prevent a consolidated group from obtaining a tax benefit from both the utilization of a loss [vol.6:si recent developments in federal income taxation from the disposition of stock (or another asset that reflects the basis of stock) and the utilization of a loss or deduction with respect to another asset that reflects the same economic loss. for example, where a member of a group contributes built-in loss assets to another member of the group in exchange for stock of such member in a transaction in which the basis of such stock is. determined, directly or indirectly, in whole or in part, by reference to the basis of such assets and the transferor member sells such stock without causing the deconsolidation of the transferee, the group may benefit from the built-in loss in the contributed assets more than once. it is expected that the regulations will defer or otherwise limit utilization of the loss on the stock in such transactions and other transactions that facilitate the group's utilization of a single loss more than once. a. the proposed suspended loss regulations are here. reg131478-02, guidance under section 1502; suspension of losses on certain stockdispositions, 67 f.r. 65060(10/23/02). temp. reg. § 1.337(d)-2t (3/7/02), which generally allows a loss on the disposition of subsidiary member stock only to the extent that a taxpayer can establish that the stock loss is not attributable to the recognition of built-in gain, does not disallow stock loss that reflects loss carryforwards, deferred deductions, or built-in asset losses of the subsidiary member. b. final regulations on suspended losses. t.d. 9048, guidance under section 1502; suspension of losses on certain stock dispositions, 68 f.r. 12287 (3/14/03); reg131478-02,68 f.r. 12324 (3/14/03)."s the treasury departmenthas promulgated temp. § 1. 1502-35t, amendedvarious provisions, and published identical proposed regulations that: (1) require a consolidated group to redetermine the basis in subsidiary stock it owns immediately before certain transactions involving the subsidiary; and (2) suspend certain losses that the group recognizes on the disposition of subsidiary stock. these regulations implement notice 2002-18, 2002-12 i.r.b. 644. 0 basis redetermination: if a group member transfers subsidiary stock with a basis exceeding its value ("loss shares") but the subsidiary remains a member of the group, the basis of the subsidiary's stock held by members of the group immediately before the transfer must be redetermined as follows: (1) all members of the group aggregate their bases in all shares of the subsidiary; and (2) that basis is allocated, (a) first to the shares of the subsidiary's preferred stock owned by the members of the group in proportion to, but not in excess of, their value on the date of the transfer, then (b) second, among all common shares of the subsidiary held by members of the group in proportion to their value on the date of the transfer. 0 if a group member owns loss shares in a subsidiary before the subsidiary deconsolidates, the basis of the subsidiary's stock held by members of the group immediately before the deconsolidation must be redetermined as follows: (1) the group's basis in subsidiary loss shares is reduced 15. we are indebted to prof. don leatherman, university of tennessee college of law, for assistance with this description. any errors that remain are our own. 20041 florida tax review by the "reallocable basis amount;" and (2) the "reallocable basis amount" is allocated (a) to increase the basis of all preferred shares of the subsidiary held by members of the group after the transfer to increase the basis of each share to its value immediately before the transfer, and then (b) to increase the group's basis in common shares in the subsidiary so that to the extent possible each share has the same ratio of basis to value the "reallocable basis amount" is the lesser of (1) the aggregate loss in the group's subsidiary loss shares immediately before the deconsolidation, or (2) the subsidiary's items of deduction and loss that the group took into account in computing its basis adjustments for any subsidiary shares that were not loss shares. the basis redetermination rule does not apply if, among other things, the group disposes of all of its subsidiary stock to nonmembers in a single taxable year in one or more fully taxable transactions, or is allowed a worthless stock deduction with respect to all of its subsidiary stock (other than any transferred stock). 0 suspended losses: if, after applying the basis redetermination rule, a member of the consolidated group recognizes a loss on the disposition of stock of a subsidiary that remains a member of the group, the loss is suspended to the extent of the "duplicated loss" with respect to that stock. the aggregate amount of duplicated loss for a subsidiary is the excess of (1) the sum of (a) the aggregate basis of the subsidiary's assets (excluding stock in other subsidiaries), (b) the subsidiary's losses that are carried to its first taxable year after the disposition, and (c) the subsidiary's deductions that have been recognized but deferred under another provision, over (2) the sum of (a) the value of stock of the subsidiary and (b) the subsidiary's liabilities that have been taken into account for tax purposes. the group must allocate that aggregate amount among all subsidiary shares, including the transferred shares. the suspended loss is limited to the duplicated loss for the transferred shares. the suspended loss is thereafter reduced, i.e., disallowed, as the subsidiary's deductions and losses are taken into account (i.e., absorbed) in determining the group's consolidated taxable income (or loss). but the loss reduction loss is limited to the excess of (1) the amount of the subsidiary's losses and deductions, over (2) the amount of those items the group takes into account in basis adjustments under the investment adjustment rules. an item of income or deduction is not taken into account to the extent the group can establish that the item was not reflected in the computation of the subsidiary's duplicated loss. any suspended stock loss remaining at the time the subsidiary leaves the group is allowed (to the extent otherwise allowable). the regulations also provide that the loss suspension rule will not to be applied in a manner that permanently disallows an otherwise allowable deduction for an economic loss. • worthlessness, etc.: if a member treats subsidiary stock as worthless under § 165(g) and § 1.1502-80(c) or if a member disposes of subsidiary member stock and on the following day the subsidiary is not a member of the group and does not have a separate return year, e.g., a liquidation or worthless stock deduction, the unabsorbed losses of the subsidiary are treated as expired at the beginning of the group's next consolidated return year. however, the deemed expiration does not result in a negative basis adjustment to any member's stock under reg. § 1.1502-32. * all of the rules are subject to various exceptions and tiering rules. the regulations are generally effective after march 7, 2002, but only if the return is due after march 14, 2003. [vol.6:si recent developments in federal income taxation 2. so just when will this suspended loss be allowed? textron. inc. v. commissioner, 115 t.c. 104 (8/7/00). in 1967, when avco acquired paul revere (pr) and pr became part of the avco group, pr owned 4 million shares of avco. in 1977, avco redeemed its shares owned by pr, and pursuant to former reg. § 1.150214(b)(1), pr did not recognize its loss, but pursuant to former reg. § 1.1502-31(b)(2)(ii) pr's basis in the stock was reallocated to the note. in 1987, after textron acquired avco, avco redeemed the note held by pr, on which pr realized a $15,000,000 loss, following which pr was liquidated into avco in a § 332 liquidation. judge laro agreed with the commissioner that former reg. § 1.1504-14(d)(4)(i) "deferred" pr's loss in 1987 [because the note was received in exchange for property, i.e., avco stock, in an exchanged basis transaction and the note was never held by a nonmember]. judge laro held that the determination of whether a note has been held by a nonmember under former reg. § 1.1502-14(d)(4)(i)(c) looks to whether the holder of the note is a nonmember at the time of the redemption, not to whether the holder of a note was a nonmember when the note was received when the holder becomes a member before the redemption. finally, under former reg. § 1.1502-14(d)(4)(ii) and (e)(2), the liquidation of pr in a § 332 liquidation did free up the suspended loss because avco inherited pr's tax characteristics. 0 the analytical methodology of the textron opinion is at odds with tax court judge wells's opinions in csi hydrostatic testers v. commissioner, 103 t.c. 398 (1994) and intermet corp. v. commissioner, 111 t.c. 294 (12/8/98), rev 'd, 209 f.3d 901 (6th cir. 4/20/00).6 those cases strictly construed the consolidated return regulations even though the results were difficult to support theoretically. in contrast, in textron, judge laro interpreted reg. § 1. 1502-14(d)(4)(i) in a manner that is difficult to justify under the literal language, but which reached a sensible theoretical result [under the single-entity theory of consolidated returns. he concluded that reg. § 1.150214(d)(4)(i) required pr to defer its loss on the redemption of the obligation it received for its avco stock even though one of the conditions for that section to apply is that the obligation "never have been held by a nonmember." since pr acquired the obligation before it became a member of the textron group that redeemed the obligation, judge laro's conclusion that membership status was determined at the time that the obligation was redeemed effectively read out of the rule the word. he could have more effectively reached the same result by looking to former reg. § 1.1502-13(f)(2) to note that the avco group was a predecessor group to the textron, so that paul revere should not have been considered ever to have been a nonmember. * note that if the redemption by avco of its stock held by pr had occurred after july 12, 1995, the loss would have been permanently disallowed under reg. § 1.1502-13(f)(6), which disallows any loss to a member on the sale or exchange of stock of the common parent corporation of a consolidated group. under current regulations, if avco and pr both had been subsidiary members of the same consolidated group and the redemption was described in § 302(a) which would be unlikely reg. § 1.1502-20(a) would disallow the loss, although a portion of it might be allowed under reg. § 1.150220(c). section 267(f) would not defer the loss because reg. § 1.267(f)-1(c)(1) 16. we are indebted to prof. don leatherman, university of tennessee college of law, for insightful suggestions regarding the analysis of the textron case. 20041 florida tax review adopts the acceleration rule of reg. § 1.1502-13(d). the loss might, however, be subject to the anti-avoidance rules of both reg. § 1.267(01(h) and § 1.1502-13(h). a. exactly when the taxpayer wanted it to, says the court of appeals. "plain meaning" carries the day. reversed. textron v. united states, 336 f.3d 26, 92 a.f.t.r.2d 2003-5373, 2003-2 u.s.t.c. 50,571 (1st cir. 7/16/03). the court of appeals (judge porfilio) applied gitliz style "plain meaning" analysis to interpreting the regulations and allowed the loss deduction. since former reg. § 1.1504-14(d)(4)(i)(c) required that the note never have been held by a nonmenber, and pr was a nonmember when it acquired the note, the condition in the regulation for deferring the loss had not been satisfied. 3. t.d. 9084, dual consolidated return computation, 68 f.r. 44616 (7/30/03). final regulations providing that certain events will not trigger recapture of a dual consolidated loss or payment of the associated interest charge. 4. schizophrenic temporary regulations for consolidated group discharge of indebtedness income and reduction of attributes. t.d. 9089, guidance under section 1502; application of section 108 to members of a consolidated group, 68 f.r. 52487 (9/4/03). the treasury department has promulgated temporary regulations under § 1502, amending temp. reg. § 1.150219t(b) and (h), temp. reg. § 1.1502-21t(b), and temp. reg. § 1.1502-32t, and adding temp. reg. § 1.1502-28t, governing the application of § 108 when a member of a consolidated group realizes discharge of indebtedness income. the regulations provide that the amount of discharge of indebtedness income excluded from gross income in the case in which the debtor-corporation is insolvent is determined based on the assets and liabilities of only the member with discharge of indebtedness income. however, applying an interpretation of dominion industries, inc. v. united states, 532 u.s. 822 (2001), the regulations provide that the group's consolidated attributes in their entirety are subject to reduction under § 108(b), but the attributes attributable to the debtor member are the first attributes reduced. the regulations also adopt a look-through rule that applies if the debtor member's attribute that is reduced is the basis of stock of another group member. in this case, corresponding adjustments are made to the attributes attributable to the lower-tier member. identical proposed regulations have been published. 68 f.r. 52542 (9/4/03). a. temporary regulations are amended. t.d. 9098, guidance under section 1502; application of section 108 to members of a consolidated group, 68 f.r. 69024 (12/11/03). temp. reg. § 1.1502-28t(a)(4) provides that when a member of a consolidated group realizes cod income excluded under § 108(a), after the reduction of the tax attributes attributable to the debtor member under § 108(b), tax attributes attributable to other members other than the debtor member (other than asset basis) that arose in a separate return year or that arose (or are treated as arising) in a separate return limitation year to the extent that no srly limitation applies to the use of such attributes by the group are subject to reduction. the regulations are generally effective as of 8/29/03. 5. sixth circuit holds itc recapture is proper despite seeminglycontradictory consolidated returns regulations. aeroquip-vickers. inc. v. [vol.6:sl recent developments in federal income taxation commissioner, 347 f.3d 173,92 a.f.t.r.2d 2003-6555,2003-2 u.s.t.c. 50,693 (6th cir. 10/20/03) (2-1), rev'g trinova corp. v. commissioner, 108 t.c. 68 (2/27/97). taxpayer transferred all of its assets relating to a glass manufacturing business, including property for which it had previously claimed investment tax credits, into a wholly-owned subsidiary, and then transferred the stock of the subsidiary outside the consolidated group. 0 the tax court determined that taxpayer was not liable for itc recapture because pursuant to reg. § 1.1502-3(f)(2)(i) "a transfer of section 38 property from one member of the group to another.member of such group during a consolidated return year shall not be treated as a disposition or cessation within the meaning of section 47(a)(1)." it also followed example (5) of that regulation, which permitted the sale of all the stock of the subsidiary to a third party in a subsequent year without 1tc recapture. it refused to follow rev. rul. 82-20, 1982-1 c.b. 6, which held the contrary where the spin-off of the subsidiary "immediately" follows the asset transfer. * the sixth circuit followed the second and ninth circuits in finding that rev. rul 82-20 is entitled to receive "some deference," and under the "end-result test" variation of the step transaction doctrine, the transaction "must be treated as a single unit." therefore, inasmuch as taxpayer entered into the transaction to move the section 38 property out of the consolidated group, itc recapture is appropriate. f. reorganizations 1. merging tax somethings into tax nothings is ok, but not the opposite! t.d. 9038, statutory mergers and consolidations, 68 f.r. 3384 (1/24/03), and reg-126485-01, statutory mergers and consolidations, 68 f.r. 3477 (1/24/03). in reg-126485-01, statutory mergers and consolidations, 66 f.r. 57400 (11/15/01), the treasury withdrew the proposed regulations [reg-10618698, certain corporate reorganizations involving disregarded entities, 65 f.r. 31115 (5/16/00)] that would have provided that neither the merger of a disregarded entity into a corporation nor the merger of a target corporation into a disregarded entity was a statutory merger qualifying as a reorganization under § 368(a)(1)(a), and proposed more liberal regulations [prop. reg. § 1.368-2(b)(1)]. under the 2001 proposed regulations, a merger of a corporation into a disregarded entity that is wholly owned by another corporation could qualify as a type (a) merger. the treasury department has now promulgated the 2001 proposed regulations, with some modifications, as temp. reg. § 1.368-2t(b) and. simultaneously published new identical proposed regulations. 0 the main point of the regulations is that the merger of a target corporation into an llc wholly owned by another corporation (thereby rendering the llc a disregarded entity) can qualify as a type (a) reorganization and under more complex structures as a triangular reorganization; that the merger of a corporation into a q-sub [also a disregarded entity] can qualify as a type (a) reorganization; and that a merger into a qualified reit subsidiary can qualify as a type (a) reorganization. 0 nevertheless, the new regulations introduce significant definitional jargon. the term "disregarded entity" means a business entity (as defined in reg. § 301.7701-2(a)) that is disregarded as an entity separate from its owner for federal tax purposes, including single member 20041 florida tax review corporate-owned llcs, qualified reit subsidiaries, and q-subs. "combining entity" means a corporation [as defined in reg. § 301.7701-2(b)] that is not a disregarded entity. "combining unit" means a combining entity and all disregarded entities, if any, the assets of which are treated as owned by such combining entity for federal tax purposes. under the proposed regulations, a statutory merger or consolidation under § 368(a)(1)(a) must be effected pursuant to the laws of the united states, a state or the district of columbia. [foreign statutory mergers still do not qualify, but the domestic statute no longer needs to be a "corporate" law.] all of the following events must occur simultaneously: (1) all of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of one other combining unit (the transferee unit); and (2) the combining entity of each transferor unit ceases its separate legal existence [although its formal existence can continue under state law for certain limited purposes that are not inconsistent with the "all of the assets" requirement.]. the examples provide all of the details of the rules: divisive mergers [see rev. rul. 2000-5, 2000-1 c.b. 436] cannot qualify (ex. 1); forward triangular mergers (into a disregarded entity owned by a subsidiary) are allowed (ex. 2 & 4); the merger of a target s corporation that owns a q-sub into a disregarded entity owned by a c corporation qualifies as to both the target s corporation and its q-sub (ex. 3); the owner of the disregarded entity must be a corporation (ex. 5); mergers of disregarded entities into corporations do not qualify (ex. 6); none of the consideration received by the target shareholders may be interests in the disregarded entity (ex. 7); and the target can be tailored by selling assets and distributing proceeds, as long as all of the remaining assets are transferred to the disregarded entity in the merger (ex. 8). 0 these regulations became effective on january 24, 2003. 2. caligula xxi had cobe. payne v. commissioner, t.c. memo. 2003-90 (3/27/03). the transfer from one corporation to another corporation wholly owned by the same shareholder of the substantially all assets associated with operation of a houston strip club [caligula xxi] in a transaction that met all of the statutory requirements of § 368(a)(1)(d) was a taxfree reorganization, even though at the time of the transfer the shareholder contemplated selling strip club and three months later the transferee corporation did sell all of its assets. judge halpern held that the continuity of business enterprise requirement of reg. § 1.368-1(d) was met: [t]here is no direct evidence that jkp's actual sale of its assets was part of an overall plan existing at the time of the transfer of the club's operation from 2618 to jkp; and we do not infer the existence of such a plan by reason of the proximity in time of the two transactions. the mere fact that petitioner may have contemplated selling the club at the time of its transfer from 2618 to jkp does not require a finding that such transfer lacked cobe. [vol.6-si recent developments in federal income taxation [in lewis v. commissioner, 176 f.2d 646 (1st cir. 1984, the taxpayer's] plan contemplated that the new company would carry on the... business, and this was done. although petitioners' intention was to dispose of the... [business] eventually, the fact that a going business was transferred and operated left the new company and petitioners, its shareholders, in a position where they stood to gain or lose from operations just as before the transfer; if business conditions warranted it, the business could have been continued indefinitely. we hold that the reasoning of the first circuit court of appeals in lewis v. commissioner, supra, applies to this case and that the transfer of the club from 2618 to jkp possessed cobe. 3. rev. proc. 2003-33,2003-16 i.r.b. 803 (4/21/03). this procedure provides guidance to taxpayers in obtaining an extension of time under reg. § 301.9100-3 to file § 338 elections [form 8023]. 4. mutual-to-stock f reorganization followed by a second reorganization is ok (part i). rev. rul. 2003-19, 2003-7 i.r.b. 468 (2/18/03). * situation 1 involved the conversion of a mutual insurance company to a stock insurance company. the mutual amended its articles of incorporation to authorize the issuance of stock and changed its name. members of the mutual exchanged theirinterests for all the stock company's voting common stock, but persons holding mutual membership interests under contracts covered by § 403(b) or § 408(b) received policy credits in exchange for those interests. the irs ruled that the conversion was either a § 368(a)(1)(e) recapitalization or a § 368(a)(1)(f) reorganization. * situation 2 involved the conversion of a mutual insurance company to a stock insurance company and the creation of a holding company structure. mutual incorporated a mutual holding company, which incorporated a stock holding company. mutual amended its articles of incorporation to authorize the issuance of stock and changed its name. mutual's members received mutual holding company membership interests in exchange for their mutual membership interests. stock company issued all of its stock directly to mutual holding company; and mutual holding company transferred all of its stock company stock to stock holding company in exchange for voting stock of stock holding company. the irs ruled that the conversion was a reorganization under either § 368(a)(1)(e) or § 368(a)(1)(f). furthermore, the result was not altered by the subsequent change in the direct ownership of the converted company, citing reg. § 1.368-1(e)(1); rev. rul. 96-29, 1996-1 c.b. 50; and rev. rul. 77-415, 1977-2 c.b. 311. in addition, the acquisition by stock holding company of stock company qualified as reorganization under § 368(a)(1)(b), as well as a § 351 transfer. * in situation 3 mutual holding company owned all of the stock of stock holding company, which owned all of the stock of stock company 1, a stock insurance company. mutual company amended its 20041 florida tax review articles to authorize the issuance of stock and changed its name to stock company 2; mutual company's members received mutual holding company interests in exchange for their mutual company interests; stock company 2 issued all of its stock directly to mutual holding company; and mutual holding company transferred all of its stock company 2 stock to stock holding company in exchange for voting stock of stock holding company. the conversion from mutual company to stock company 2 qualified as a reorganization under both § 368(a)(1)(e) and § 368(a)(1)(f). in addition, mutual holding companys acquisition of either an interest equivalent to the stock of stock company 2 or the actual stock of stock company 2 qualified as a § 368(a)(1)(b) reorganization. mutual holding company's transfer of its stock company 2 stock to stock holding company qualified as both a § 368(a)(1)(b) reorganization and as a § 351 transfer. 5. mutual-to-stock f reorganization followed by a second reorganization is ok (part i). rev. rul. 2003-48,2003-19 i.r.b. 863 (5/12/03). the revenue ruling applied the principles developed in rev. rul. 2003-19,2003-7 i.r.b. 468 (2/18/03), to the conversion of mutual savings banks to stock banks, as well as the adoption of holding company structures. the initial conversion and creation of a holding company qualified under § 351 and under § 368(a)(1)(e) and (f). * but in situation 1, which involved a reverse triangular merger of the stock bank, into which the mutual bank had been converted, into a transitory subsidiary of the mutual holding company [to invert the parent-subsidiary relationship of the converted mutual and the mutual holding company] followed by a prearranged drop of the stock savings bank to a stock holding company [more than 50 percent, but less than 80 percent of the stock of which was owned by the mutual holding company], the merger was not a reorganization under § 368(a)(1)(b) or § 368(a)(2)(e) because mutual holding did not control stock holding. however, because pursuant to the integrated plan the stock holding company had issued more than 20 percent but less than 50 percent of its common stock to the public in a qualified underwriting transaction [as defined in reg. § 1.35 1-1 (a)(3)], the merger transfer was entitled to nonrecognition under § 351. * in situation 2, not more than 20 percent of the stock of stock holding company was issued to the public. in that situation, the merger qualified under both § 368(a)(1)(b) and § 368(a)(2)(e). 6. turning off the step transaction doctrine when the acquirer so chooses. t.d. 9071, effect of elections in certain multi-step transactions, 68 f.r. 40766 (7/9/03). temp. reg. § 1.338(h)(10)-1ot(c)(2) provides that the step transaction doctrine will not be applied if a taxpayer makes a valid § 338(h)(10) election with respect to a stock acquisition that, standing alone, is a qualified stock purchase, even if the transaction is part of a multi-step transaction that would otherwise qualify as a reorganization. the effective date of these temporary regulations is 7/9/03. see also, reg-143679-02, for proposed regulations that mirror the temporary regulations. the principles underlying rev. rul. 2001-46, 2001-2 c.b. 321, are reflected in these regulations. [vol.6:si recent developments in federal income taxation g. corporate divisions 1. does this ruling apply when the geo dealer buys a mercedes dealership? rev. rul. 2003-18,2003-7 i.r.b. 467 (1/22/03). this rulinglheld that the taxable acquisition of a franchise to sell and service brand y automobiles and the assets to operate the franchise by a corporation that had a five-year history of being a dealer of brand x automobiles constituted an expansion of the brand x business rather than the acquisition of a new or different business under reg. §1.355-3(b)(3)(ii). the facts of the ruling state that the brand x and brand y dealership businesses were conducted on adjacentleaseholds, but the analysis does not pursue this fact. the analysis states: [b]ecause (i) the product of the brand x automobile dealership is similar to the product of the brand y automobile dealership, (ii) the business activities associated with the operation of the brand x automobile dealership (i.e., sales and service) are the same as the business activities associated with the operation of the brand y automobile dealership, and (iii) the operation of the brand y automobile dealership involves the use of the experience and know-how that d developed in the operation of the brand x automobile dealership, the brand y automobile dealership is in the same line of business as the brand x dealership and its acquisition does not constitute the acquisition of a new or different business .... 0 rev. rul. 57-190,1957-1 c.b. 121 was obsoleted. 0 althoughthe quoted language mightbe read as a factual conclusion that the specific cars involved were similar, e.g., toyotas and hondas, irs chief counsel's office views it as a conclusion of law, e.g., geos are the same as mercedes. 2. bricks to clicks business expansion passes the smoake test.' rev. rul. 2003-38, 2003-17 i.r.b. 811 (4/28/03). corporation d operated a retail shoe store business in shopping malls and other locations, under the name "d" for more than five years. d's business enjoyed favorable name recognition, customer loyalty, and goodwill in the retail shoe market. d created an internet web site and began selling shoes at retail through the internt. to take advantage of d's name recognition, customer loyalty, and established goodwill, and to enhance the web site's chances for success, the web site was named "d.com," to a significant extent, the operation of the web site drew upon d's experience and know-how. two years later, d transferred the web site based business's assets and liabilities to c, a newly formed controlled subsidiary, and spun-off c pro rata. the irs ruled that under reg. § 1.3553(b)(3)(ii), the internet sales operation was an expansion of the retail store business, not a new business. thus, each of d and c was engaged in the active conduct of a five-year trade or business. see rev. rul. 2003-18 and § 1.355-3(c), examples (7) and (8). the products and the principal business activities of the retail shoe store business and the internet-based business were the 17. shared (1) subject matter; (2) operational activities; and (3) knowledge and experience. 20041 florida tax review same. although selling shoes on the internet required some know-how different from operating a retail store (different marketing approaches, distribution chains, and technical operations issues), the web site's operation drew significantly on d's existing experience and know-how, and its success would depend largely on d's pre-existing goodwill. 0 the analytical model used by the revenue ruling to determine that the clicks business was an expansion of the bricks business was based on analyzing the extent that the two shared (1) subject matter; (2) operational activities; and (3) knowledge and experience. [the smoake test?] the first two were met and the third was not, but the deficiency was cured by the overlapping goodwill. 3. beef for the boy and grass for the girl equals business purpose. rev. rul. 2003-52, 2003-22 i.r.b. 960 (6/2/03). the irs ruled that the business purpose requirement of reg. § 1.355-2(b) was satisfied in the following circumstances. x corporation was engaged in the farming business, consisting of breeding and raising livestock and growing grain, for more than five years. the stock of x was owned equally by father, age 68, mother, age 67, son, and daughter. father and mother participated in some major management decisions, but son and daughter performed most of the management. son and daughter generally cooperated and operated the farm without disruption, but they disagreed about the appropriate future direction of the farming business. son wanted to expand the livestock business, while daughter wanted to sell the livestock business and concentrate on the grain business. the disagreement prevented them from developing, as they saw fit, the business in which each of them was most interested. father and mother were neutral regarding the disagreement, but because of the disagreement, they wanted to bequeath separate interests in the farm business to the children. for reasons unrelated to the farm, son and daughter's husband dislike each other. although this did not impair the farm's operation, father and mother believed that requiring son and daughter to run a single business together was eventually likely to cause family discord. to enable son and daughter each to devote his or her undivided attention to, and apply a consistent business strategy to, the farming business in which he or she is most interested, to further the estate planning goals of father and mother, and to promote family harmony, x transfers the livestock business to a newly formed wholly owned subsidiary, y corporation, and x distributed 50 percent of the y stock to son in exchange for all of his x stock. the remaining y stock was distributed equally to father and mother in exchange for half of their x stock. thereafter, father and mother (who each owned 25 percent of the outstanding stock of x and y) continued to participate in some major management decisions related to the business of each corporation. daughter, who had no interest in the livestock corporation, managed and operated x, and son managed and operated y and had no interest in x. father and mother amended their wills to devise their y stock to son and their x stock to daughter. the irs reasoned that the distribution eliminated a disagreement that prevented the development of the business and "allowed each sibling to devote his or her undivided attention to, and apply a consistent business strategy to, the farming business in which he or she is most interested, with the expectation that each business would benefit. therefore, although the distribution is intended, in part, to further the personal estate planning of father and mother and to promote family [vol6:si recent developments in federal income taxation harmony, it is motivated in substantial part by a real and substantial non-federal tax purpose that is germane to the business of x." 4. you only have to be pure of mind at the time of the distribution. rev. rul. 2003-55, 2003-22 i.r.b. 961 (6/2/03). the irs ruled that the business purpose requirement of reg. § 1.355-2(b) is satisfied if the distribution of the stock of a controlled corporation is, at the time of the distribution, motivated, in whole or substantial part, by a corporate business purpose, but that purpose cannot be achieved as the result of an unexpected change in circumstances following the distribution. "the regulations do not require that the corporation in fact succeed in meeting its corporate business purpose, as long as, at the time of the distribution, such a purpose exists and motivates, in whole or substantial part, the distribution." the specific facts were as follows. d, a publicly traded corporation conducted two businesses directly and a third business through its wholly owned subsidiary, c. to invest in plant and equipment and to make acquisitions, c had to raise a substantial amount of capital. d's investment banker advised d that the best way to raise this capital was by a public offering of c stock after c was separated from d. d distributed the c stock to its shareholders, and c prepared to offer its stock to the public, with a target date approximately six months after the distribution. following the distribution and before the offering could be undertaken, market conditions unexpectedly deteriorated to such an extent that the public offering was postponed. one year after the distribution, conditions still had not improved sufficiently to permit the offering to go forward and c funded its capital needs through the sale of debentures. 5. management focus is a business purpose. rev. rul. 2003-74, 2003-29 i.r.b. 77 (7/21/03). distributing is a publicly traded corporation that conducts a software technology business. controlled is a wholly-owned subsidiary of distributing and conducts a paper products business. management of each corporation would prefer to concentrate its efforts solely on the business conducted by that corporation, but the ownership of controlled by distributing prevents distributing's management from concentrating solely on the software business. held, the distribution of the stock of a controlled corporation by a distributing corporation to enable the management of each corporation to concentrate on its own business satisfies the business purpose requirement of reg. § 1.355-2(b). 6. competing for investors and lenders is a business purpose. rev. rul. 2003-75, 2003-29 i.r.b. 79 (7/21/03). distributing is a publicly traded corporation that conducts a pharmaceuticals business. controlled is a whollyowned subsidiary of distributing and conducts a cosmetics business. these businesses compete for capital from borrowing and internal cash flows. the distribution of the stock of a controlled corporation to resolve a capital allocation problem between the two corporations satisfies the business purpose requirement of reg. § 1.355-2(b). 7. private letter rulings under § 355 will be harder to come by after august 8th. rev. proc. 2003-48, 2003-29 i.r.b. 86 (7/21/03). this revenue procedure notes that in the past the irs has not adhered to its policy of not giving "comfort rulings" in the § 355 area. it sets up a one-year pilot program for rulings postmarked after 8/8/03 of not ruling on three issues with respect to corporate 20041 florida tax review divisions. the national office will not determine (1) whether a proposed or completed distribution of the stock of a controlled corporation is being carried out for one or more corporate business purposes, (2) whether the transaction is used principally as a device, or (3) whether the distribution and an acquisition are part of a plan under § 355(e). 8. "nephew of morris trust" transaction is blessed. rev. rul. 2003-79, 2003-29 i.r.b. 80 (7/21/03). a spin-off of one of two business of equal size by means of a transfer of the assets of one of the businesses to a controlled corporation, followed by the acquisition of substantially all the assets of the controlled corporation by an unrelated corporation in the same business, meets all the requirements of §§ 368(a)(1)(d), 355(a), and 368(a)(1)(c) even though an acquisition of the same properties from the distributing corporation would have failed this requirement if the transfer of those properties had not been made to the controlled corporation. 9. pesticides and baby food? a statement of facts that only a tax professor could have invented! rev. rul. 2003-110, 2003-46 i.r.b. 1083 (11/17/03). a publicly traded corporation that conducted a pesticide business spunoff its controlled subsidiary that conducted a baby food business to deal with "public perception problems" that caused potential baby food buyers from dealing with the subsidiary as long as it was affiliated with a pesticide producer. in determining whether the distribution of the stock of the controlled corporation satisfied the business purpose requirement in reg. § 1.355-2(b), which requires that the distribution be motivated, in whole or substantial part, by one or more corporate business purposes, the fact that § 355 permits the distributing corporation to distribute the stock of a controlled corporation without recognition of gain otherwise required under § 311 (b) does not present a potential for the avoidance of federal taxes. h. personal holding companies and accumulated earnings tax 1. personal holding company tax rate reduced to 15 percent. because the 2003 act reduced the maximum tax rate on dividends to 15 percent, § 541 was amended to reduce the personal holding company tax rate to 15 percent. 2. accumulated earnings tax rate reduced to 15 percent. because the 2003 act reduced the maximum tax rate on dividends to 15 percent, § 531 was amended to reduce the accumulated earnings tax rate to 15 percent. 3. debt aversion avoids aet. otto candies, llc v. united states, 288 f.supp.2d 730,91 a.f.t.r.2d 2003-2520,2003-1 u.s.t.c. 50,516 (e.d. la. 5/28/03). the taxpayer [an llc taxed as an s corporation that was a successor to a c corporation], a family corporation with three shareholders that was "one of the leading providers of marine transportation in the gulf of mexico," was held not to be liable for the § 531 accumulated earnings tax. the corporation, which had accumulated reserves of between $15 and $21 million during the years in question, was engaged in a volatile business and the dominant shareholder was conservative and avoided debt. accumulations were required to fund necessary periodic fleet replacement, including newer vessels with modem technology meeting customer [vol6:si recent developments in federal income taxation demands, new ventures into related businesses, and to internally fund future redemptions [under a contract] upon the death of a shareholder. 4. advanced delivery and chemical systems of nevada, inc. v. commissioner, t.c. memo. 2003-250 (8/20/03). the taxpayer-holding company was not liable for accumulated earnings tax. under reg. § 1.537-3(b), the business activities of its subsidiaries and partnerships in which it was a partner were attributed to the taxpayer. in light of the rapid growth of the affiliates' businesses, the accumulations did not exceed the taxpayer's reasonable needs for expansion of the affiliates, and on the particular facts [including a reorganization to reduce state taxes], even if the accumulations did exceed the taxpayer's reasonable needs, there was not tax avoidance purpose. i. miscellaneous corporate issues 1. repeal of collapsible corporation rules. with dividends and long-term capital gains taxed at the same rate, the tax avoidance issues at which § 341 was directed no longer exist. accordingly, § 341 was repealed in the 2003 act. 2. the tax court continues on its capitalization spree. illinois tool works inc. v. commissioner, 117 t.c. 39 (7/31/01). the taxpayer acquired the assets of another corporation [for approximately $126 million] in a taxable transaction in which the taxpayer assumed the target's liabilities, including a contingent liability for a patent infringement claim, [lemelson v. champion spark plug co., 975 f.2d 869 (1992)], for which it established a reserve of $350,000. subsequently, the taxpayer, as the target's successor was held liable for damages, interest, and court costs [totaling over $17 million], which it paid. the tax court (judge cohen) upheld the commissioner's treatment requiring capitalization of the payments as a cost of acquiring the assets rather than a deductible expense, even though the parties had not adjusted the purchase price to reflect the contingent liability. the liability was known, was considered in setting the price, and was expressly assumed. that the taxpayer considered it highly unlikely that it would be called upon to pay was not relevant. 0 the commissioner conceded the deductibility of the judgment in two respects: (1) pre-judgment interest accruing after the acquisition date was deductible; and (2) to the extent that the additional purchase price was allocable to assets the taxpayer had disposed of, the judgment was deductible. 0 note that in many, if not most, cases, the disposition of a portion of target's assets will not affect the characterization of the payments because, under § 1060 and reg. § 1.1060-1, the capitalized contingent liability will be allocated to class vi and vii amortizable intangibles for which no loss is allowed until the complete disposition of all such intangibles acquired from the target. see § 197(f)(1). the grounds for the commissioner's concession were not clearly articulated in the opinion. a. affirmed. 355 f.3d 997,93 a.f.t.r.2d 2004-548,20041 u.s.t.c. 50,130 (7th cir. 1/21/04). the seventh circuit held that the contingent liability was one that taxpayer was aware of when it acquired the assets of the devilbiss co., and taxpayer's payment of the liability was a cost of acquiring the 20041 florida tax review business assets and had to be capitalized. the court followed david r. webb co. v. commissioner, 708 f.2d 1254 (7th cir. 1983), aff'g 77 t.c. 1134 (1981), noting that webb stood for the proposition that, "generally, the payment of a liability of a preceding owner of property by the person acquiring such property, whether or not such liability was fixed or contingent at the time such property was acquired, is not an ordinary and necessary business expense." (emphasis in original) 0 judge kanne, in footnote 4 of the opinion, defends tax court judge cohen against taxpayer's attack that she failed "to engage in the appropriate open-minded, fact-based inquiry advocated [by the 7th circuit in a.e. staley mfg. co. v. commissioner, 119 f.3d 482 (1997)]." we find it curious that itw would choose to attack judge cohen for failing to engage in the appropriate open-minded, fact-based inquiry advocated in staley. judge cohen, who served as trial judge in the staley case, as well as here, dissented from the tax court opinion from which the staley appeal was taken.a.e. staley mfg. co. v. commissioner, 105 t.c. 166,210 (1995) (cohen, j., dissenting). it was her dissent that this court cited favorably in its ruling reversing the tax court. see staley, 119 f.3d at 491 n.8. and, in her closing instructions to the parties about their posttrial briefs in the present matter, she discusses staley and its possible implications, describing her involvement in that case. (tr. at 21415.) vii. partnerships a. formation and taxable years there were no significant developments regarding this topic during 2003. b. allocations of distributive share, partnership debt, and outside basis 1. no more "inappropriate" increases or decreases in the adjusted basis of a corporate partner's interest in a partnership. t.d. 8986, determination of basis of partner's interest; special rules, 67 f.r. 15112 (3/29/02). the treasury has finalized reg. § 1.705-2 [proposed in reg-10670200, determination of basis of partner's interest; special rules, 66 f.r. 315 (1/3/01)] which is intended to prevent what the irs has determined to be "inappropriate" increases or decreases in the adjusted basis of a corporate partner's interest in a partnership [consistent with notice 99-57, 1999-2 c.b. 692] resulting from the partnership's disposition of the corporate partner's stock [under the general principles of rev. rul. 99-57, 1999-2 c.b. 678] when: (1) a corporation acquires an interest in a partnership that holds stock in the corporation, (2) the partnership does not have a § 754 election in effect for the year in which the corporation acquires the interest, and (3) the partnership later sells or exchanges the stock. the increase or decrease in the corporation's adjusted basis in its partnership interest resulting from the sale or exchange of the stock equals the amount of gain or loss that the corporate partner would have recognized (absent the application of § 1032) if, for the tax year in which the corporation acquired the interest, a § 754 election had been in effect. the final regulations require appropriate adjustments [vol6:si recent developments in federal income taxation to the basis of tiered partnerships to prevent evasion of their purpose where a corporation acquires an indirect interest in its own stock though a chain of partnerships and gain or loss from the sale of stock is subsequently allocated to the corporation. the regulation is effective retroactively to gain or loss allocated on sales or exchanges of stock occurring after 12/6/99. a. proposed amendments before the ink is dry. reg167648-01, amendments to rules for determination of basis of partner's interest; special rules, 67 f.r. 15132 (3/29/02). the treasury has proposed amendments to reg. § 1.705-2, which was finalized on the same day the proposed amendments were published, "to address remaining issues that [were] considered during the development of the final regulations. the proposed amendments would extend the rules of reg. § 1.705-2 to situations in which a corporation owns a direct or indirect interest in a partnership that owns stock in that corporation, the partnership distributes money or other property to another partner and that partner recognizes gain on the distribution during a year in which the partnership does not have a § 754 election in effect, and the partnership subsequently sells or exchanges the stock. the proposed amendments also clarify that "stock" of a corporate partner includes any position with respect to stock of a corporate partner. the proposed amendments would be effective retroactively to gain or loss allocated on sales or exchanges of stock occurring after 3/29/02. b. finalized. t.d. 9049, amendments to rules for determination of basis of partner's interest; special rules, 68 f.r. 12815 (3/18/03). the proposed amendments to reg. § 1.705-2 have been finalized with a generally effective date of after 12/6/99. the final regulations extend the rules of the proposed regulations to situations in which a corporation owns a direct or indirect interest in a partnership that owns stock in that corporation, the partnership distributes money or other property to another partner and that partner recognizes loss on the distribution or the basis of the property distributed to that partner is adjusted during a year in which the partnership does not have an election under § 754 in effect, and the partnership subsequently sells or exchanges the stock. 2. what happens when § 752 meets a deferred like-kind exchange that straddles year-end? rev. rul. 2003-56, 2003-23 i.r.b. 985 (5/9/03). the ruling deals with the treatment of partnership liabilities under § 752 when a partnership enters into a deferred § 1031 like kind exchange in which property subject to a liability is transferred in one taxable year and replacement property subject to a liability is received in the following taxable year. the irs ruled that the liabilities are netted for purposes of § 752. a net decrease in a partner's share of partnership liability is treated as a distribution under § 752(b) in the year the surrendered property was transferred; and under reg. § 1.7311(a)(1)(ii) and rev. rul. 94-4, 1994-1 c.b. 196, it is treated as an advance or draw of money to the extent of each partner's distributive share of income for that year, with the result that basis increases for partnership income for the year are taken into accounting for the deemed distribution. the gain recognized under § 1031 attributable to the boot that results from net debt relief is treated as recognized in the year in which the relinquished property has been transferred; thus the gain from the § 1031 transaction is taken into account in determining whether the § 752(b) deemed distribution exceeds the partner's basis in the partnership interest under § 20041 florida tax review 731. [if the relinquished liability and the replacement liability are nonrecourse, under reg. § 1.704-2(d), the partnership minimum gain on the last day of the first taxable year of the partnership is computed by using the replacement property and its tax basis as determined under § 1031(d) and the replacement nonrecourse liability (but only to the extent of the relinquished nonrecourse liability).] a net increase in a partner's share of partnership liability is taken into account under § 752(a) in the year in which the partnership receives the replacement property. 3. fighting duplication and acceleration of losses through partnerships before june 24,2003. t.d. 9062, assumption of partner liabilities, 68 f.r. 37414 (6/24/03). temp. reg. § 1.752-6t provides rules, similar to the rules applicable to corporations in § 358(h), to prevent the duplication and acceleration of loss through the assumption by a partnership of a liability of a partner in. a nonrecognition transaction. under the temporary regulations, if a partnership assumes a liability, as defined in § 358(h)(3), of a partner (other than a liability to which § 752(a) and (b) apply) in a § 721 transaction, after application of §§ 752(a) and (b), the partner's basis in the partnership is reduced (but not below the adjusted value of such interest) by the amount of the liability. for this purpose, the term "liability" includes any fixed or contingent obligation to make payment, without regard to whether the obligation is otherwise taken into account for federal tax purposes. reduction of a partner's basis generally is not required if: (1) the trade or business with which the liability is associated is transferred to the partnership, or (2) substantially all of the assets with which the liability is associated are contributed to the partnership. however, the exception for contributions of substantially all of the assets does not apply to a transaction described in notice 2000-44, 2000-2 c.b. 255 (or a substantially similar transaction). 0 the temporary regulations are effective for transactions occurring after 10/18/99 and before 6/24/03. 4. defining the term "liability" in § 752 and fighting duplication and acceleration of losses through partnerships after june 24, 2003. reg106736-00, assumption of partner liabilities, 68 f.r. 37434 (6/24/03). the treasury has proposed extraordinarily complex, verging on incomprehensible, regulations: (1) defining liabilities under § 752; (2) dealing with a partnership's assumption of certain fixed and contingent obligations in exchange for a partnership interest [prop. reg. § 1.752-7]; and (3) providing rules under § 358(h) for assumptions of liabilities by corporations from partners and partnerships [prop. reg. § 1.358-7]. reg. § 1.752-1(a)(1)(i) would be amended to include the principles of rev. rul. 88-77, 1988-2 c.b. 128; an obligation is a liability to the extent that incurring the obligation: (1) creates or increases the basis of any of the obligor's assets (including cash); (2) gives rise to an immediate deduction; or (3) gives rise to an expense that is not deductible in computing taxable income and is not properly chargeable to capital. prop. reg. § 1.752-7 deals with the assumption by a partnership of a partner's fixed or contingent obligation to make payment that is not one of the three types described in reg. § 1.752-1 (a)(1)(i) [including accrual method liabilities the deduction for which was deferred under § 453(h)]. unlike temp. reg. § 1.752-6t, the proposed regulations do not reduce the partner's outside basis when the partnership assumes a § 1.752-7 liability. if the partnership satisfies the liability while the partner remains in the partnership, the deduction with respect to the built-in loss associated with the § 1.752-7 liability is allocated [vol.6:s! recent developments in federal income taxation to the partner, reducing that partner's outside basis. alternatively, if one of three events occurs that separate the partner from the liability, then the partner's outside basis is reduced immediately before the occurrence of the event. the events are: (1) a disposition (or partial disposition) of the partnership interest by the partner, (2) a liquidation of the partner's partnership interest, and (3) the assumption (orpartial assumption) of the liability by another partner. the basis reduction generally is the lesser of (1) the excess of the partner's basis in the partnership interest over the adjusted value of the interest, or (2) the remaining built-in loss associated with the liability. (in the event of a partial disposition, the reduction is pro rated.) thereafter, to the extent of the remaining built-in loss associated with the liability, the partnership (or the assuming partner) is not entitled to any deduction or capital expense upon satisfaction (or economic performance) of the liability, but if the partnership notifies the partner, the partner is entitled to a loss or deduction. if another partner assumed the liability, the partnership must immediately reduce the basis of its assets by the built-in loss, and upon satisfaction, the assuming partner must make certain basis adjustments to his partnership interest. there are exceptions for (1) transfer of the trade or business with which the liability is associated is transferred to the partnership, and (2) de minimis transactions (liabilities less that 10 percent of the partnership's assets or $1,000,000). unlike under the temporary regulations, there is no exception for transactions in which substantially all of the assets with which the liability is associated are contributed to the partnership. when finalized, the regulations will be effective for transactions occurring after 6/24/03. 5. "[olne brother got the... income without paying all of the tax, while the other brother paid the tax without getting any of the income." estate of ballantyne v. commissioner, 341 f.3d 802, 92 a.f.t.r. 2d 2003-5694, 2004-1 u.s.t.c. 50,120 (8th cir. 8/7/03), affg t.c. memo. 2002-160 (6/24/02). the decedent taxpayer (melvin) and his brother (russell) for many years operated a partnership that engaged in the oil and gas business, run by the decedent, and the farming business, run by the decedent's brother. the partnership was an oral partnership, and the brothers consistently reported as equal partners, even though the decedent consistently withdrew the profits from the oil and gas business and decedent's brother consistently withdrew the profits from the fanning business. after the decedent's death, the estate took the position that all of the income from the farming activity was reportable as the decedent's brother's distributive share. because the partnership did not maintain capital accounts, the allocation lacked economic substance, and the partners' interests in the partnership were determined under the facts and circumstances test of reg. § 1.704-1(b)(3). based on the evidence, the estate could not overcome the presumption that the partners were equal partners. there was no record of capital contributions; the amount of profits of each activity varied from year to year, as did withdrawals but the partners' economic interests and interests in cash flow could not be determined because the partnership books and records were inadequate. however, the "facts" mostly the witnesses' "beliefs" that the brothers were 50/50 partners indicated that they were to share liquidating distributions equally. that factor, combined with the brothers long-time consistent reporting as equal partners and the absence of any evidence that the brothers' reporting position involved tax avoidance, was sufficient to convince judge ruwe that they were equal partners. 20041 florida tax review 0 the court of appeals (judge beam) affirmed. first, the claimed allocation did not have economic effect because the partnership failed to comply with the capital account rules in the § 704(b) regulations. second, the tax court correctly applied the regulations to determine the partners' distributive shares based upon their interests in the partnership based on all the facts and circumstances. the court rejected the estate's argument that it was clear that the brothers had agreed that russell would get farming profits and melvin the oil profits, because it was also "clear that the brothers had evenly split some of the burdens, i.e., the tax consequences of the combined profits and losses." finally, the brothers' interests in cash flow and liquidating distributions supported the tax court's conclusion. actual operating distributions were not based on the clear-cut delineation claimed by the taxpayer to some extent the brothers shared the profits from the two businesses. 6. reg-160330-02, section 704(c), installment obligations and contributed contracts, 68 f.r. 65864 (11/24/03). the treasury has published proposed amendments to reg. § 1.704-3(a)(8) clarifying that if a partnership disposes of § 704(c) property in exchange for an installment obligation the installment obligation is § 704(c) property; likewise if a partner contributes a contract that is § 704(c) property and pursuant to the contract the partnership obtains property in a transaction in which less than all of the gain or loss is recognized, the property is § 704(c) property. proposed amendments to reg. § 1.704-4(d)(1) provide that an installment obligation received by a partnership and property acquired pursuant to a contributed contract are treated as § 704(c) property for purposes of § 704(c)(1)(b) to the extent that the installment obligation or the acquired property is § 704(c) property under reg. § 1.704-3(a)(8). the regulations are effective as of 11/24/03. c. distributions and transactions between the partnership and partners 1. partnership capital shifts resulting from option exercises won't be taxable. reg-103580-02, noncompensatory partnership options, 68 f.r. 2930 (1/22/03). the treasury department has published proposed regulations dealing with noncompensatory partnership options, including convertible debt and convertible equity interests. the proposed regulations do not address compensatory options, and the preamble states that no inferences regarding the treatment of compensatory options should be drawn. under the proposed regulations, neither the grant nor the exercise of an option generally results in the recognition of gain or loss to either the partnership or the option holder. prop. reg. § 1.721-2. the issuance of an option is not governed by § 721, but rather (under general tax principles) is an open transaction for the issuer and an investment (capital expenditure) by the holder. if the holder uses appreciated or depreciated property to acquire the option, the holder recognizes gain or loss. * upon exercise, the option holder is treated as contributing property in the form of the premium, the exercise price, and the option privilege to the partnership in exchange for the partnership interest, and § 721 applies, even if the conversion results in a shift of capital from the old partners to the option holder. the conversion right in convertible debt or convertible equity is taken into account for tax purposes as part of the underlying instrument. (the proposed regulations do not deal with the consequences of a right [vol.6:sl recent developments in federal income taxation to convert partnership debt into an interest in the issuing partnership to the extent of any accrued but unpaid interest on the debt.) an amendment to reg. § 1.12711 (e) would treat partnership interests as stock for purposes of the special oid rules for convertible debt instruments. section 721 does not apply to the lapse of an option; the lapse of an option results in recognition of income by the partnership and the recognition of loss by the former option holder. 0 the proposed regulations amend the §704 regulations to deal with the fact that the option holder generally receives a partnership interest with a value that is greater or less than the sum of the option premium and exercise price, i.e., there is a capital shift. the option holder's initial capital account equals the consideration paid to the partnership for the option plus the fair market value of any property (other than the option itself) contributed to the partnership upon exercise. to meet the substantial economic effect test of reg. § 1.704-1 (b), the partnership must revalue its property following the exercise of the option, and must allocate the unrealized income, gain, loss, and deduction from the revaluation, first, to the option holder to reflect the holder's right to partnership capital, and, then, to the historic partners. to the extent that unrealized appreciation or depreciation in the partnership's assets has been allocated to the option holder's capital account, under § 704(c) principles the holder will recognize any income or loss attributable to that appreciation or depreciation as the underlying assets are sold, depreciated, or amortized. if after all of the unrealized appreciation or depreciation in the partnership's assets has been allocated to the option holder, the option holder's capital account still does not equal the amount of partnership capital to which the option holder is entitled, the partnership must adjust the capital accounts of the historic partners by the amounts necessary to provide the option holder with a capital account equal to the holder's rights to partnership capital under the agreement. starting with the year the option is exercised, the partnership must make corrective allocations of tax items that differ from the partnership's allocations of book items of gross income or loss to the partners to reflect any shift in the partners' capital accounts occurring as a result of the exercise of an option. 0 the proposed regulations also provide rules for revaluing the partners' capital accounts under reg. § 1.704-1(b)(2)(iv)(j) while an option is outstanding. the aggregate value of partnership property is reduced by the amount by which the value of the option exceeds it price or is increased by the amount by which price of the option exceeds its value. * an option holder will be recharacterized as a partner if (1) under a facts and circumstances test, the option holder's rights are substantially similar to the rights afforded to a partner and (2) as of the date that the noncompensatory option is issued, transferred, or modified, there is a strong likelihood that the failure to treat the option holder as a partner would result in a substantial reduction in the present value of the partners' and the option holder's aggregate tax liabilities. prop. reg. § 1.761-3. if an option is reasonably certain to be exercised, the first half of this test is generally met. if the option holder is treated as a partner under the proposed regulations, then the holder's distributive share of the partnerships income, gain, loss, deduction, or credit must be determined in accordance with such partner's interest in the partnership under reg. § 1.7041 (b)(3). for this purpose, the option holder's share of partnership items should reflect the lesser amount of capital investment if appropriate; the option holder's 20041 florida tax review distributive share of partnership losses and deductions may be limited by § § 704(b) and (d) to the amount paid for the option. 0 the proposed regulations do not apply to options issued by single member llcs. 0 the regulations will apply to noncompensatory options issued on or after the date final regulations are published. 2. permitting a partnership book-up when you can't make the regs work if you don't do it. reg-139796-02, section 704(b) and capital account revaluations, 68 f.r. 39498 (7/2/03). proposed amendments to the § 704(b) regulations would expressly allow partnerships to increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property on the partnership's books in connection with the grant of an interest in the partnership (other than a de minimis interest) in consideration of services to the partnership by an existing partner acting in a partner capacity or by a new partner acting in a partner capacity or in anticipation of being a partner. the regulation will be effective when finalized. 3. if you want § 707(a) treatment, document the transaction as such. bitker v. commissioner, t.c. memo. 2003-209 (7/15/03). the taxpayers owned farmland that they allowed a family partnership engaged in the farming business to use in that business without any express rental agreement. the partnership made payments of principal and interest on the taxpayer's mortgage debt secured by on the land, and the taxpayers claimed that the payments should be deductible by the partnership as rental expenses and includable by them as passive activity rental income. although this type of transaction could be so characterized under § 707(a), the taxpayer's offered no evidence that partnership actually made the payments as rent for such use or the payments represented fair rental value. accordingly, the taxpayers' shares of partnership income were not reduced for rent, their income from their rental real estate activity was not increased for such rent, and the payments were treated as partnership distributions (which, on the facts, were not in excess of basis). d. sales of partnership interests, liquidations and mergers there were no significant developments regarding this topic during 2003. e. inside basis adjustments 1. partnership inside basis adjustments fully coordinated with §§ 197 and 1060. t.d. 9059, coordination of sections 755 and 1060; allocation of basis among partnership assets and application of the residual method to certain partnership transactions, 68 f.r. 34293 (6/9/03). the treasury has promulgated final regulations [proposed in reg-107872-99, 65 f.r. 17829 (4/5/00) to replace temp. reg. § 1.755-2t] relating to the allocation of basis adjustments among partnership assets under § 755 to implement § 1060(d) [which applies the residual method to partnership transactions in connection with determining the value of § 197 intangibles]. [vol6:si recent developments in federal income taxation 0 the new rules are amendments to reg. § 1.755-1. as amended, reg. § 1.775-1 applies the residual method to all allocations for § 743(b) and § 734(d) inside basis adjustments under § 755. reg. § 1.755-1(a) uses the residual method to value all § 197 intangibles [not just goodwill and going concern value, as would have been the rule under the proposed regulations]. values are assigned to assets as follows. first, the partnership determines the values of its assets other than § 197 intangibles [taking into account § 7701(g)]. second, the partnership determines the "partnership gross value." third, the partnership determines the value of its § 197 intangibles under the residual method [partnership gross value minus value of assets other than § 197 intangibles]. if the aggregate value of partnership property other than § 197 intangibles is equal to or greater than the partnership gross value, all § 197 intangibles are treated has having zero value. if there is any value assigned to the § 197 intangibles, that value is allocated among § 197 intangibles other than goodwill and going concern value before any value is assigned to goodwill and going concern value. in allocating values and basis to § 197 intangibles, value is assigned first to those § 197 intangibles (other than goodwill and going concern value) that would produce § 751(c) flush language unrealized receivables [i.e., previously amortized or depreciated] to the extent of basis and the unrealized receivable amount; then among all § 197 intangibles (other than goodwill and going concern value) relative to fair market value. for most § 743(b) basis adjustments, the benchmark for determining the gross partnership value is the amount paid for a transferred partnership interest. partnership gross value is the amount that, if assigned to all partnership property, would result in a liquidating distribution to the transferee partner equal to that partner's basis (reduced by the amount, if any, of such basis that is attributable to partnership liabilities) in the transferred partnership interest immediately following the relevant transfer. in cases involving § 734(b) basis adjustments [and § 743(b) basis adjustments resulting from substituted basis transactions], partnership gross value is the value of the entire partnership as a going concern, increased by the amount of partnership liabilities. f. partnership audit rules 1. even the irs doesn't know when it has to have a partnership level audit in order to send a valid deficiency notice to a partner. katz v. commissioner, 335 f.3d 1121, 92 a.f.t.r.2d 2003-5153, 2003-2 u.s.t.c. 50,557 (10th cir. 77/03), rev'g 116 t.c. 5 (2001). the commissioner disallowed the taxpayer's losses claimed as a distributive share of partnership income in 1990, the year he filed a bankruptcy petition, on the grounds that the distributive share for the entire partnership taxable year was reportable by bankruptcy estate. 0 the tax court (judge vasquez) denied the taxpayer's motion to dismiss for lack of jurisdiction, in which the taxpayer argued that the deficiency notice was invalid because there had not been any fpaa under the partnership audit provisions. judge vasquez held that the allocation of the distributive share of partnership loses between the bankrupt partner and his bankruptcy estate was not a partnership item that would require a partnership-level proceeding, because the bankrupt partner and his bankruptcy estate were a single partner as far as the partnership-level audit rules were concerned. on the merits, he 20041 florida tax review held that the entire distributive share of partnership losses was properly reportableby the bankruptcy estate. b the court of appeals (judge hartz) reversed. first, the court held that reg. § 301.6231 (c)-7t(a), which converts items that otherwise would be partnership items into nonpartnership items if they arose in a taxable year "ending on or before the last day of the latest taxable year of the partner with respect to which the united states could file a claim for income tax due in the bankruptcy proceeding," was not controlling because 1989 was the latest taxable year for which the united states could file a claim in the bankruptcy proceeding. second, the court held that the partner's share of partnership losses was a partnership item that could not be determined without a partnership-level proceeding even though the allocation of the distributive share of losses between the bankrupt partner and his bankruptcy estate did not affect other partners. the holding was grounded on the idea that regardless of whether the items were properly the bankrupt partner's or the bankruptcy estate's, the partnership return was required to show the allocation and the allocation is a partnership item that can be challenged only in a partnership-level proceeding, even if there might be "sound policy reasons for not requiring a full-blown partnership-level proceeding when an alleged error in one partner's return affects only one other taxpayer rather than all the partners." g. miscellaneous 1. four-year spread for short-year income occasioned by a change in the annual accounting period to the calendar year during a transition period. rev. proc. 2003-79,2003-45 i.r.b. 1036 (11/10/03). rev. proc. 2002-38, 2002-1 c.b. 1037, and rev. proc. 2002-39, 2002-1 c.b. 1046, provide procedures for a partnership to change its annual accounting period if its current taxable year no longer qualifies as a natural business year. this new revenue procedure provides procedures under which a partner in such a partnership may elect to take into account ratably over four taxable years the partner's share of income from the partnership that is attributable to the short taxable year ending on or after may 10, 2002, but before june 1, 2004. viii. tax shelters a. tax shelter cases 1. tax shelter benefits from § 453 contingent sale partnership tax shelter not allowed because the tax shelter is a sham and "serves no economic purpose other than tax savings." merrill lynch's persistence overcomes initial doubts of tax department. acm partnership v. commissioner, t.c. memo. 1997-115 (3/5/97) affid in part, rev'd in part, 157 f.3d 231, 82 a.f.t.r.2d98-6682, 98-2 u.s.t.c. 50,790 (3d cir. 10/13/98) (2-1), cert. denied, 526 u.s. 1017 (3/22/99). judge laro found a § 453 contingent sale partnership tax shelter to be a prearranged sham, "tax-driven and devoid of economic purpose," and "serv[ing] no economic purpose other than tax savings," following goldstein v. commissioner, 364 f.2d 734 (2d cir. 1966), cert. denied, 385 u.s. 1005 (1967). under the scheme to shelter colgate's $105 million 1988 capital gain, a partnership was formed in 1989; its three partners were affiliates of (a) a foreign bank (about [vol6:sl recent developments in federal income taxation 90%), (b) colgate (about 9%), and (c) merrill lynch (about 1%). a bank note was purchased by the partnership and immediately sold for a large immediate payment and much smaller future contingent payments. under the contingent payment sale provisions of the temporary regulations [§ 15a.453-1(c)] the partnership's basis was to be allocated ratably over the several years in which contingent payments could be made, resulting in a large 1989 installment sale gain to the partnership. the lion's share of that installment sale gain was allocated to the foreign bank (which was not taxable on u.s. source capital gain), followed by the redemption of the foreign bank's partnership interest. this left colgate as the 90 percent partner. in 1991, the installment sale obligation was sold by the partnership, triggering about $100 million of capital losses, which colgate attempted to use to shelter its 1988 capital gain. 0 the third circuit affirmed the tax court's application of the "economic substance" doctrine, which eliminated the capital gains and losses attributable to acm's application of the ratable basis recovery rule of the contingent installment sale provisions. the third circuit held, however, that out-of-pocket amounts were deductible. 2. judge foley finds another merrill lynch § 453 partnership plan does not work because, under the facts, there was no partnership. asa investerings partnership v. commissioner, t.c. memo. 1998-305 (8/20/98). in another merrill lynch § 453 partnership plan to create capital losses to shelter earlier capital gains, alliedsignal lost when judge foley held that the parties to the partnership agreement did not join together for a common purpose of investing in interest-bearing instruments, and they did not share profits and losses. a. affirmed, asa investerings partnership v. commissioner, 201 f.3d 505,85 a.f.t.r.2d 2000-675,2000-1 u.s.t.c. 50,185 (d.c. cir. 2/1/00), cert. denied, 531 u.s. 871 (10/2/00). the d.c. circuit's opinion noted that it disagreed with the tax court's statements that persons with "divergent business goals" are precluded from having the requisite intent to form a partnership; however, this view was not essential to the tax court's conclusion that the parties did not intend to join together as partners to conduct business activities for a purpose other than tax avoidance. the court held that there was a single business purpose rule. 3. saba partnership v. commissioner, t.c. memo. 1999-359 (10/27/99). brunswick's (the taxpayer's) transactions, which were identical to acm's, were found to lack economic substance. judge nims held that the transactions lacked nontax business purposes and that congress did not intend to favor such transactions "regardless of their economic substance." he held that fees paid for the organization of the partnership were deductible subject to the limitations of § 709(b) [60-month amortization], but that the fees paid with respect to the sham transactions were not deductible. a. d.c. circuit remands saba for reconsideration in light of its opinion in asa investerings. saba partnership v. commissioner, 273 f.3d 1135, 88 a.f.t.r.2d 2001-7318, 2002-1 u.s.t.c. 50,145 (d.c. cir. 12/21/01), remanding for reconsideration in light ofasa investerings t.c. memo. 1999-359 (10/27/99), on remand to t.c. memo. 2003-31 (2/11/03). the court felt 2004] florida tax review this case was indistinguishable from asa investerings, which was decided on a sham partnership theory, as opposed to judge nims' decision in the tax court, which was grounded on a sham transaction theory. the court of appeals refused to simplyaffirm the tax court's decision on the alternative ground that the partnerships were shams. even the government conceded that the sham transaction and sham partnership approaches yield different results; the adjustments under the sham transaction theory would be different from those under the sham partnership theory [although the government apparently conceded at oral argument that under either approach, brunswick could deduct actual losses from the transactions]. the government argued that the court of appeals should applyasa investerings to hold that the partnerships were shams, and remand the case to the tax court for the limited purpose of determining the amount of any necessary adjustments. but the court of appeals accepted the taxpayer's argument that the "question of whether 'an entity should be regarded as a partnership for federal tax purposes is inherently factual,"' and remanded to allow the taxpayer to address the question to the trial court, even though it doubted that the tax court's "findings are inadequate because of 'significant differences' alleged by the taxpayer "between the actions of brunswick in this case and those of [the taxpayer] in asa." indeed, the court of appeals opinion said: "as far as we can tell, the only difference between this case and asa is that brunswick and abn did not meet in bermuda." in remanding, judge tatel foreshadowed what he expected to be the result on remand: in any case, asa makes clear that "the absence of a nontax business purpose is fatal" to the argument that the commissioner should respect an entity for federal tax purposes. ... here, the tax court specifically found "overwhelming evidence in the record that saba and otrabanda were organized solely to generate tax benefits for brunswick." . . . arguably, this broader finding subsumes any factual differences that might exist between this case and asa. [citations omitted]. ... although the present record might strongly suggest that saba and otrabanda were sham partnerships organized for the sole purpose of generating paper tax losses for brunswick, fairness dictates that we ought not affirm on this ground. in particular, in presenting its case in the tax court, brunswick may have acted on the mistaken belief that the supreme court's decision in moline properties, inc. v. commissioner, 319 u.s. 436, 87 l. ed. 1499, 63 s. ct. 1132 (1943), established a two-part test under which saba and otrabanda must be respected simply because they engaged in some business activity, an interpretation thatasa squarely rejected .... 0 note the effect of this opinion on the boca investerings case, below. b. on remand, the same result, following the court of appeals' instructions. t.c. memo. 2003-31 (2/11/03). on remand judge nims again denied the deductions. he found the case indistinguishable from asa inversterings. the partnerships were not recognized for tax purposes because they had no business purpose other than tax avoidance. the minimal business activity [vol6:si recent developments in federal income taxation of the partnership with respect to commercial paper did not amount to a nontax purpose. 4. same arrangement as earlier failed shelters, different trial court judge it's a business deal, not a shelter. boca investerings partnership v. united states, 167 f. supp. 2d 298, 88 a.f.t.r.2d 2001-6252, 2001-2 u.s.t.c. 50,690 (d. d.c. 10/5/01). american home products [now wyeth] entered into a merrill lynch marketed tax shelter virtually identical to those in acm partnership v. commissioner, 157 f.3d 231, 82 a.f.t.r.2d 98-6682, 98-2 u.s.t.c. 50,790 (3d cir. 10/13/98), affig t.c. memo. 1997-115 (3/5/97), cert. denied, 526 u.s. 1017 (1999), asa investerings partnership v. commissioner, 201 f.3d 505,2000-1 u.s.t.c. 50,185 (d.c. cir. 2/1/00), affgt.c. memo. 1998-305 (8/20/98), and saba partnership v. commissioner, t.c. memo. 1999-359 (10/27/99), judgment vacated by 273 f.3d 1135 (d.c. cir. 2001), on remand to t.c. memo. 2003-31. the losses from the transaction sheltered the gain on the sale of a corporate subsidiary. judge friedman held that a valid partnership existed and that the losses were allowable because he found that the taxpayer had both a business purpose and an objective profit potential in entering into the transaction. a. reversed: asa investerings is followed. boca investerings partnership v. united states, 314 f.3d 625, 91 a.f.t.r.2d 2003-444, 2003-1 u.s.t.c. 50,181 (1/10/03). the d.c. circuit held that the district court "erred as a matter of law when it did not properly apply the holding of asa investerings, requiring that a legitimate non-tax business necessity exist for the creation of the otherwise sham entity inserted into the partnership for tax avoidance reasons in order to meet the intent test of commissioner v. culbertson, 337 u.s. 733 (1949), as applied to this type of partnership transaction." judge sentelle quoted asa to make clear that "the absence of a nontax business purpose" is fatal to an argument that the commissioner should respect an entity for federal tax purposes. 5. lease-strip transaction by pseudo-black box intermediary fails in the tax court; affirmed by second circuit. nicole rose cor. v. commissioner, 117 t.c. 328 (12/28/01), affd by summary order, 320 f.3d 282, 90 a.f.t.r.2d 2002-7702, 2003-1 u.s.t.c. 50,137 (2d cir. 12/13/02) (per curiam), publication status changed by the court from unpublished to published, (2d cir. 2/24/03). the taxpayer corporation's stock was sold to an intermediary [which then merged downstream], following which its assets were sold to the prearranged ultimate purchaser. to offset the gains realized on the asset sale, the taxpayer acquired by a § 351 transaction interests in certain equipment leaseback transactions [secured by trusts that resulted in a circular cash flow] that had no foreseeable value, which it immediately transferred to a dutch bank, the sole consideration for which was assumption of taxpayer's obligations [of which there were in reality none]. taxpayer claimed a $22 million ordinary business expense deduction as a result of the transfer of the leaseback interests. the deduction was denied because the transactions lacked business purpose and economic substance under "any version" of the tests. judge swift held that the transaction lacked business purpose and economic substance even as measured against the eleventh circuit's broad articulation of the test in ups of america, inc. v. commissioner, 254 f.3d 1014 (1 1th cir. 2001), that "a transaction has a 'business purpose' when 20041 florida tax review we are talking about a going concern.... as long as it figures in a bona fide, profitseeking business." 6. the tax court hammers another shelter, and in the process tells us the "purpose" of the legislative plan." andantech l.l.c. v. commissioner, t.c. memo. 2002-97 (4/9/02), aff'd and remanded, 331 f.3d 972, 91 a.f.t.r.2d 2003-2623,2003-1 u.s.t.c. 50,530 (d.c. cir. 6/17/03). norwest, through its equipment-leasing subsidiary, engaged in a complex [seven powerpoint slides worth] purchase and leaseback tax shelter transaction involving 40 ibm mainframe computers already under lease to end-users. the promoter [comdisco] sold the computers for cash and notes to an llc owned by two nonresident aliens, which leased them back to the promoter, who retained all responsibilities to the end-users; the llc sold the stream of rental payment to be received for net present value, thereby accelerating income realization, and applied the proceeds to the balance due on the note. less than three months later, one of the nonresident aliens [indirectly] transferred his 2 percent llc interest to a trust established by promoter, and norwest, thorough a subsidiary, acquired the remaining 98 percent interest in the llc [thereby closing the taxable year in which the income had been realized] for an amount roughly equal to one half of one percent of the approximately $122 million basis of the computers. norwest subsequently reported its distributive share of depreciation deductions, but was allocated no income. after three years, the computers were reconveyed to the promoter, pursuant to an "early termination option," which the court found the "economics of the transaction ... mandate[d]," and the llc was liquidated. s the tax court (judge jacobs) struck down the shelter. he concluded that neither the original llc, with the foreign partners, nor the subsequent llc of which norwest' s subsidiary was a member, was a valid partnership to be recognized for federal tax purposes; in neither case did the purported partners intend to join together as partners for the purpose of carrying on a business, i.e., they did not join together to share in the profits or losses from an equipment leasing activity. alternatively, judge jacobs would have disregarded the participation of the foreign llc members in the transactions under the step transaction doctrine [applying either the end result or mutual interdependence test]. furthermore, the llc's sale-leaseback transaction with the promoter was a sham because it (a) was not a true multiple-party transaction, (b) lacked economic substance, (c) was not compelled or encouraged by business realities, and (d) was shaped solely by tax-avoidance features. as far as norwest and its subsidiary were concerned, the transaction was not respected because it lacked both business purpose and economic substance. the llc, and norwest's subsidiary, had no reasonable possibility of making an economic profit, but the tax benefits were more than sufficient to cover any potential losses. the norwest subsidiary never acquired the benefits and burdens of ownership of the depreciable equipment, and thus was not entitled to depreciation deductions. in addition, the llc's debts were not bonafide and no interest deductions were allowable. * finally, judge jacobs concluded by looking back to early supreme court jurisprudence: in higgins v. smith, 308 u.s. [473] at 476-477 [19401, the supreme court stated: [vol6:si recent developments in federal income taxation there is no illusion about the payment of a tax exaction. each tax, according to a legislative plan, raises funds to carry on government. the purpose here is to tax earnings and profits less expenses and losses. if one or the other factor in any calculation is unreal, it distorts the liability of the particular taxpayer to the detriment or advantage of the entire tax-paying group.... the sale-leaseback transaction was designed by comdisco to create just such a distortion. it is axiomatic that taxpayers may structure transactions to take advantage of tax benefits. but "after a certain point, . . . , the transaction ceases to have any economic substance and becomes no more than a sale of tax profits." hines v. united states, 912 f.2d 736, 741 (4th cir.1990). here, the evidence in the record clearly indicates that the investment scheme devised and orchestrated by comdisco "reached the point where the tax tail began to wag the dog." id. a. the sixth circuit (judge sentelle) concluded that the partnership should be disregarded and remanded to the tax court for a determination as to how the reported income and losses should be allocated. the court followed asa investerings and determined that the purported partners "did not intend to join together in order to share any profit or loss from the business activity of andantech [partnership,] namely the sale and leaseback of computer equipment," and "'the absence of a nontax business purpose' is fatal to the validity of a partnership." 7. third circuit comes down hard on coli, with lots of language the government will love. internal revenue service v. cm holdings inc. (in re cm holdings inc.), 301 f.3d 96, 90 a.f.t.r2d 2002-5850, 2002-2 u.s.t.c. 50,596 (3d cir. 8/16/02), affg 254 b.r. 578,86 a.f.t.r.2d 2000-6470, 2000-2 u.s.t.c. 50,791 (d. del. 10/16/00). in cmi's bankruptcy, the irs filed proofs of claim for taxes based on the disallowance of interest deductions that cmi claimed for its coli plan (involving policies on 1400 employees). e the district court held no interest deduction was allowable under § 163(a) because the entire transaction was a "sham in substance" that lacked subjective business purpose. apart from tax savings from the interest deduction, cmi could not reasonably expect a positive cash flow from the coli plan in any year and could not expect to benefit from the inside cash value build-up [which continuously remained at zero throughout the plan] or profit from the death benefits on covered employees. interest deductions were disallowed, and § 6662 substantial understatement penalties were imposed because the transaction lacked economic substance. the transaction was entered into without a reasonable expectation of profit in the absence of the interest deductions over the life of the 40-year transaction from either the inside build-up or mortality components of the plan. * the third circuit court of appeals (judge ambro) affirmed on the ground that the "coli policies lacked economic substance and therefore were economic shams." [the court did not reach the issue 20041 florida tax review of whether the transactions were factual shams.] the court dismissed out of hand the need to examine the "intersection of... statutory details." [plursuant to gregory v. helvering, 293 u.s. 465 (1935), and knetsch v. united states, 364 u.s. 361 (1960), courts have looked beyond taxpayers' formal compliance with the code and analyzed the fundamental substance of transactions. economic substance is a prerequisite to the application of any code provision allowing deductions.... it is the government's trump card; even if a transaction complies precisely with all requirements for obtaining a deduction, if it lacks economic substance it "simply is not recognized for federal taxation purposes, for better or for worse." in holding for the government, the court rejected the taxpayer's argument that [based on gregory, knetsch, acm partnership and other cases] the application of the economic shams doctrine properly hinges on the "'fleeting and inconsequential' nature" of the transaction under scrutiny. rather, the court concluded that "[d]uration alone cannot sanctify a transaction that lacks economic substance. the appropriate examination is of the net financial effect to the taxpayer, be it short or long term. the point of our analysis in acm partnership is that the transactions 'offset one another with no net effect on acm's financial position."' in any event, the court found the coli transactions bore "striking similarities" to knetsch. the court further rejected the argument that for analytical purposes the pre-tax profit should have been "grossed-up" by the anticipated tax benefits because, [t]he point of the analysis is to remove from consideration the challenged tax deduction, and evaluate the transaction on its merits, to see if it makes sense economically or is mere tax arbitrage. courts use "pre-tax" as shorthand for this, but they do not imply that the court must imagine a world without taxes, and evaluate the transaction accordingly. instead they focus on the abuse of the deductions claimed: "[w]here a transaction has no substance other than to create deductions, the transaction is disregarded for tax purposes." [citation omitted] choosing a taxfavored investment vehicle is fine, but engaging in an empty transaction that shuffles payments for the sole purpose of generating a deduction is not. 0 finally, the court rejected the taxpayer's argument that because "the transaction had objective non-tax economic effects.. . the court must not look further," and that the district court improperly applied a subjective analysis. rather, the court of appeals read gregory to permit an inquiry into motive. "if congress intends to encourage an activity, and to use taxpayers' desire to avoid taxes as a means to do it, then a subjective motive of tax avoidance is permissible. but to engage in an activity solely for the purpose of avoiding taxes where that is not the statute's goal is to conduct an economic sham." because the court found that nothing in statute to indicate that congress intended to encourage leveraged coli investments, the inquiry into motive was proper. in this regard, it was significant that "the plan was marketed as a tax-driven investment." because [vol6:si recent developments in federal income taxation the coli "plan had no net effect on camelot's economic position,. . . it fails the objective prong of the economic sham analysis." because there was no "legitimate business purpose behind the plan, ... it fails the subjective prong as well." penalties were also upheld. a. but a district court finds for the taxpayer in an incredible opinion. dow chemical co. v. united states, 250 f. supp. 2d 748, 91 a.f.t.r.2d 2003-1489, 2003-1 u.s.t.c. 50,346 (e.d. mich. 3/31/03). in a carefully detailed opinion, judge lawson found that dow did correctly almost everything that camelot and aep did incorrectly. the interest rate on policy loans was not unreasonably high, and a positive pre-tax cash flow was expected. the court found that there was a business purpose for the coli arrangements, i.e., to provide retiree benefits. the premiums for the first three years were payable with policy loans and the premiums for years four through seven were payable 90% with partial [cash] withdrawals (from policies whose cash value had been previously borrowed) and 10% with cash from the taxpayer. judge lawson found that the partial withdrawals were "shams in fact" because there was no cash value left in the policies to borrow, but that the § 264(c)(1) test was met because of the payments of 10% of the premiums by taxpayer with its own cash in years four through seven. the court found that the § 264(c)(1) safe harbor did not require level premiums over the first seven years and that the "premium" for each of years four to seven was the 10% paid in cash. judge lawson found that reg. § 1.2644(c)(1)(ii) (which required level premiums) was invalid, and he rejected the holding in both cm holdings and aep that the four-out-of-seven test required level premiums. 0 in finding that taxpayer expected a positive pre-tax cash flow, judge lawson refused to admit into evidence a statement in taxpayer's protest that could have led to a contrary conclusion on the ground that rule 408 of the federal rules of evidence provides that statements made during settlement negotiations are inadmissible at trial. b. there's no harm in asking? not from asking judge lawson! dow chemical co. v. united states, 278 f.supp.2d 844,92 a.f.t.r.2d 2003-6418, 2003-2 u.s.t.c. 50,681 (e.d. mich. 8/12/03). the government's motion to amend the court's judgment was granted in part and denied in part, but left intact the same judgment and basic result. ironically, since the motion opened up all findings of fact, judge lawson reversed his earlier finding that the partial withdrawals in years four through seven were "shams in fact," thus making moot the government's argument relating to the logical consequences of this earlier finding, i.e., that taxpayer did not meet the four-of-seven test because it did not pay the entire premium in each of years four through seven from its own funds. c. the circuit to which dow is appealable (sixth circuit) holds for the government in a coli case. american electric power co. v. united states, 326 f.3d 737,91 a.f.t.r.2d 2003-2060,2003-1 u.s.t.c. 50,416 (6th cir. 4/28/03). the sixth circuit court of appeals affirmed a the district court finding that taxpayer's coli plan was an economic sham because it would lose a substantial amount of money absent the policy-loan interest deductions. the court declined to decide whether the dividends in years 4-7, generated by circular cashless netting transactions, were factual shams. 20041 florida tax review d. one of the costs of coli in texas is that the employer does not have an insurable interest in ordinary employees. mayo v. hartford life insurance co., 354 f.3d 400 (5th cir. 1/5/04). wal-mart employee's estate sued wal-mart on the claim that the life insurance policy on the employee's life was void on the ground that it violated the texas insurable interest doctrine. in such a case, texas law applies the equitable remedy of constructive trust to enable recovery by the lawful beneficiary of the proceeds unlawfully procured by a named beneficiary that lacks an insurable interest. the district court concluded that the policy was void because wal-mart lacked a sufficient financial interest in the lives of its rank-and-file employees. b. identified "tax avoidance transactions." 1. notice 2003-22, 2003-18 i.r.b. 851 (4/4/03). this notice addresses an abusive arrangement designed to evade income and employment taxes on compensation income through the use of unrelated conduit domestic and foreign employee leasing companies. the arrangements are "listed transactions." see viii.d., below for a more complete description. 2. temporary and proposed son-of-boss regulations. t.d. 9062, assumption of partner liabilities, 68 f.r. 37414 (6/24/03); reg-106736-00, assumption of partner liabilities, 68 f.r. 37434 (6/24/03). the treasury department has promulgated temporary regulations and published proposed regulations regarding a partnership's assumption of a partner's liabilities in a transaction substantially similar to the son-of-boss transactions described in notice 2000-44. these regulations prevent taxpayers from relying on the exceptions in § 358(h)(2)(b) [for transfers of the trade or business with which the liability is associated is, or substantially all of the assets with which the liability is associated are, transferred to the partnership assuming the liability], which were intended to exclude ordinary business transactions from the application of § 358(h), and were not intended to allow taxpayers to engage in transactions that create noneconomic tax losses. 3. lease strips are made a listed transaction. notice 2003-55, 2003-34 i.r.b. 395 (7/21/03), superseding notice 95-53, 1995-2 c.b. 354. the irs has concluded based upon its victories in andantech ll.c. v. commissioner, 331 f.3d 972 (d.c. cir. 2003), and nicole rose corp. v. commissioner, 320 f.3d 282 (2d cir. 2002) that lease strips improperly separate income from related deductions. the notice also states that the irs may challenge lease strips on other grounds, including (1) assignments or accelerations of future payments as fmancings, (2) lack of a valid partnership, and (3) judicial doctrines such as lack of business purpose, step transaction, sham, etc. a. but not on § 482 grounds. rev. rul. 2003-96, 2003-34 i.r.b. 386 (7/21/03). the irs has concluded the inapplicability of the § 482 rationale of notice 95-53 because an agreement between unrelated parties to arbitrarily shift income or deductions "does not by itself evidence the type of control necessary to satisfy [§ 482]." [vol.6:si recent developments in federal income taxation 4. restates and updates the list of 24 transactions determined by the irs to be "listed transactions." notice 2003-76, 2003-49 i.r.b. 1181 (11/7/03), supplementing and superseding notice 2001-51, 2001-34 i.r.b. 190 (8/3/0 1). the irs has identified 24 listed transactions for purposes of reg. §§ 1.6011-4(b)(2) and 301.6111-2(b)(2). as restated andupdated, thelist includes: (1) rev. rul. 90-105, 1990-2 c.b. 69, transactions (deductions for contributions to certain pension plans attributable to future year's compensation); (2) notice 95-34, 1995-1 c.b. 309, certain trust arrangements (purported multiple employer welfare benefit funds); (3) notice 98-5, 1998-1 c.b. 334, transactions in which the expected economic profit is insubstantial in comparison to the value of the expected ftcs; (4) asa investerings-type and acm-type transactions; (5) prop. reg. § 1.643(a)-8 transactions involving distributions from charitable remainder trusts; (6) notice 99-59, 1999-2 c.b. 761, transactions involvingthe distribution of encumbered property in which taxpayers claim tax losses for capital outlays that they have in fact recovered (the pwc so-called boss tax shelter); (7) reg. § 1.7701(1)-3 fast-pay arrangements; (8) rev. rul. 2000-12, 2000-11 i.r.b. 744, certain transactions involving the acquisition of two debt instruments the values of which are expected to change significantly at about the same time in opposite directions; (9) notice 2000-44, 2000-36 i.r.b. 255, transactions generatinglosses resulting from artificially inflatingthe basis ofpartnership interests (the kpmg socalled blips' tax shelter); (10) notice 2000-60,2000-49 i.r.b. 568, transactions involving the purchase of a parent corporation's stock by a subsidiary, a subsequent transfer of the purchased parent stock from the subsidiary to the parent's employees, and the eventual liquidation or sale of the subsidiary; (11) notice 200061, 2000-49 i.r.b. 569, transactions purporting to apply § 935 to guamanian trusts; (12) notice 2001-16, 2001-9 i.r.b. 730, intermediary sales transactions; (13) notice 2001-17, 2001-9 i.r.b. 730, contingent liability § 351 transfer transactions; (14) notice 2001-45, 2001-33 i.r.b. 129, certain redemptions of stock in transactions not subject to u.s. tax in which the basis of the redeemed stockpurports to shift to a u.s. taxpayer; (15) notice 2002-21, 2002-1 c.b. 730, transactions involving the use of a loan assumption agreement to inflate basis in assets acquired from another party in order to claim losses; (16) notice 2002-35, 2002-1 c.b. 992, transactions involving the use of a notional principal contract to claim current deductions for periodic payments made by a taxpayer while disregarding the accrual of a right to receive offsetting future payments; (17) notice 2002-50, 2002-2 c.b. 98, transactions involving the use of a straddle, a tiered partnership structure, a transitory partner and the absence of a § 754 election to claim a permanent non-economic loss, and similar transactions identified in notice 2002-65,2002-2 c.b. 690, andnotice 2003-54,2003-33 i.r.b. 363; (18) rev. ru12002-69,2002-2 c.b. 760, modifying and superseding rev. rul. 99-14, 1999-1 c.b. 835, lease-in/lease-out [lilo] transactions); (19) notice 2002-70, 2002-2 c.b. 765, transactions involving reinsurance. arrangements between a taxpayer and the taxpayer's own reinsurance company; (20) rev. rul. 2003-6, 2003-3 i.r.b. 286, arrangements involving the transfer of esops that hold stock in an s corporation for the purpose of claiming eligibility for the delayed effective date of § 409(p); (21) notice 2003-22,2003-18 i.r.b. 851, arrangements involving foreign leasing companies used to evade or avoid federal income and employment taxes; (22) notice 2003-24, 2003-18 i.r.b. 853, arrangements that purportedly 18. see 2003 tnt 112-12. 2004] florida tax review qualify as collectively bargained welfare benefit funds excepted from the account limits of §§ 419 and 419a; (23) notice 2003-47, 2003-30 i.r.b. 132, transactions involving compensatory stock options and related persons to avoid or evade federal income and employment taxes; and (24) notice 2003-55, 2003-34 i.r.b. 395, modifying and superseding notice 95-53, 1995-2 c.b. 334, transactions in which one participant claims to realize rental income and another participant claims the deductions related to that income (often referred to as "lease strips"). 5. in less than a month after notice 2003-76, here's another one! notice 2003-77, 2003-49 i.r.b. 1182 (11/19/03), clarified (12/1/03). certain contested liability trusts used improperly to attempt to accelerate deductions under § 461(f) are identified as "listed transactions." see i.d., above, for contested liability trusts used for an attempted acceleration of deductions under § 461(f). 6. and, yet one more! notice 2003-81, 2003-51 i.r.b. 1123 (12/4/03). this transaction involves the purchase by the taxpayer of offsetting options on foreign currency (which are § 1256 contracts) [the "purchased options"] and the receipt of premiums by the taxpayer for writing offsetting options on a different foreign currency that has a very high positive correlation with the first currency, but which is not traded through regulated futures contracts (which are not § 1256 contracts) [the "written options"]. the taxpayer assigns to a charity both (1) the purchased option that has a loss (which is marked to market when it is assigned to the charity and recognized by the taxpayer) and (2) the offsetting written option that has a gain (which is limited to the premium received for the option, and which the taxpayer does not recognize). 7. s corporation stock owned by esops that fail to provide benefits to rank-and-t'de employees. rev. rul. 2003-4, 2004-6 i.r.b. 414 (1/23/04). ownership structures of s corporations designed to allow taxpayers to take advantage of the tax-exempt status of the s corporation that results from the ownership of its outstanding stock by the esop but which result in the esop not providing benefits to rank-and-file employees will cause the s corporation income to be taxed to the person who earned it. transactions that are the same or substantially similar to the following transaction are identified as "listed transactions." these are transactions in which (i) at least 50 percent of the outstanding shares of an s corporation are employer securities held by an esop, (ii) the profits of the s corporation generated by the business activities of a specific individual are accumulated and held for the benefit of that individual in a qsub or similar entity, (iii) these profits are not paid to the individual as compensation within 2-1/2 months after the end of the year in which earned, and (iv) the individual has rights to acquire shares of stock of the qsub or similar entity representing 50 percent or more of the fair market value of the stock of such qsub or similar entity. 8. abusive roth ira transactions are listed transactions. notice 2004-8, 2004-4 i.r.b. 333 (12/31/03). in these transactions a taxpayer who owns a pre-existing business sells property from the business, such as accounts receivable, for less than fair market value to a corporation owned by taxpayer's roth ira. the notice applies to any arrangement between the roth ira and the taxpayer that has the effect of transferring value to the corporation owned by the [vol6:si recent developments in federal income taxation roth ira that is comparable to a contribution to the roth ira that exceeds the statutory limits on such contributions contained in § 408a. 9. silo transactions. interestingly enough, sale-in, lease-out (silo) deals [under which a tax-exempt or foreign entity sells property to the taxpayer and leases it back, with the lessee depositing collateral in defeasance of its obligation] were not made "listed transactions," although president bush's budget proposal seeks a legislative remedy for this widespread perceived abuse. 2004 tnt 19-3. 10. see i.d., above, for a "listed transaction" relating to contested liability trusts and vii.d., below, for additional "listed transactions" aimed at individuals. c. disclosure and settlement 1. june 2002 temporary and proposed regulations. t.d. 9000, modification of tax shelter rules 111, 67 f.r. 41324 and reg-1 10311-92,67 f.r. 41324 and 41362 (6/18/02). these temporary and proposed regulations modify the disclosure, registration and list maintenance rules under § § 6011 (a), 6111 (d) and 6112 with respect to tax shelters. * the new regulations extend the requirement to disclose listed and other reportable transactions under reg. § 1.6011-4t to individuals, trusts, partnerships, and s corporations that participate, directly or indirectly, in listed transactions. further, they clarify indirect participation in a reportable transaction. a taxpayer indirectly participates in a reportable transaction if the taxpayer knows or has reason to know that the tax benefits claimed from the transaction are derived from a reportable transaction. * the irs notes that some taxpayers and promoters have applied the "substantially similar" standard in reg. §§ 1.6011-4t and 301.6111-2t in an overly narrow manner to avoid disclosure, and the regulations to clarify that the term "substantially similar" includes any transaction that is expected to obtain the same or similar types of tax benefits and that is either factually similar or based on the same or similar tax strategy. further, the term "substantially similar" must be broadly construed in favor of disclosure. a. additional guidance in october 2002. t.d. 9017, tax shelter disclosure statements, 67 f.r. 64799, and reg-103735-00, tax shelter disclosure statements, 67 f.r. 64840 (10/22/02). the irs has promulgated temporary and proposed regulations to provide additional guidance needed to comply with the § 6011(a) disclosure rules. the regulations cover tax shelter transactions involving income, estate, gift, employment, or exempt organizations excise taxes. they revise the categories of transactions that must be disclosed on returns: (1) listed transactions; (2) confidential transactions; (3) transactions with contractual protection; (4) loss transactions above stated thresholds; (5) transactions with a significant book-tax difference; and (6) transactions involving a less-than45-day holding period that result in a tax credit exceeding $250,000. these temporary regulations are effective 1/1/03. 2004] florida tax review (1) t.d. 9018 and reg-103736-00, requirement to maintain a list of investors in potentially abusive tax shelters, 67 f.r. 64807 and 64842 (10/22/02). the irs has promulgated conforming temporary and proposed regulations, which modify the list maintenance requirements under § 6112. 2. february 2003 final regulations. t.d. 9046, tax shelter regulations, 68 f.r. 10161 (2/28/03). this treasury decision modifies and finalizes the rules relating to tax shelter disclosure statements to be filed with tax returns under § 6011(a), as well as the rules relating to the registration of confidential corporate tax shelters under § 6111(d) and the resulting list maintenance requirements under § 6112. the amendments retain the six disclosure categories contained in the october 2002 temporary regulations, see l.a., above, with the following modifications: (1) they delete the clarification that a claim of privilege does not cause a transaction to be confidential because a privilege does not restrict the taxpayer's ability to disclose the tax treatment or tax structure of the transaction; (2) they change the focus to provide that this refers to refunds of fees to be received back from a person who stated what the tax consequences of the transaction would be, or from the person on whose behalf the statement was made; (3) a list of the loss which need not be taken into account for reporting is contained in rev. proc. 2003-24, 2003-11 i.r.b. 599 (3/17/03); (4) a list of the transactions with significant book-tax difference which need not be taken into account for reporting is contained in rev. proc. 2003-25, 2003-11 i.r.b. 601 (3/17/03). 0 reg. § 1.6011-4(b)(3)(iii) contains a presumption relating to whether a transaction is confidential: presumption. unless the facts and circumstances indicate otherwise, a transaction is not considered offered to a taxpayer under conditions of confidentiality if every person who makes or provides a statement, oral or written, to the taxpayer (or for whose benefit a statement is made or provided to the taxpayer) as to the potential tax consequences that may result from the transaction, provides express written authorization to the taxpayer in substantially the following form: "the taxpayer (and each employee, representative, or other agent of the taxpayer) may disclose to any and all persons, without limitation of any kind, the tax treatment and tax structure of the transaction and all materials of any kind (including opinions or other tax analyses) that are provided to the taxpayer relating to such tax treatment and tax structure." except as provided in paragraph (b)(3)(ii) of this section, this presumption is available only in cases in which each written authorization permits the taxpayer to disclose the tax treatment and tax structure of the transaction immediately upon commencement of discussions with the person providing the authorization and each written authorization is given no later than 30 days from the day the person providing the written authorization first makes or provides a statement to the taxpayer regarding the tax consequences of the transaction. a transaction that is claimed to be exclusive or proprietary to any party other than the taxpayer will not be considered a confidential transaction [vol.6:si recent developments in federal income taxation under this paragraph (b)(3) if written authorization to disclose is provided to the taxpayer in accordance with this paragraph (b)(3)(iii) and the transaction is not otherwise confidential. 0 these regulations are effective for transactions entered into on or after 2/28/03, except that taxpayers may elect to apply them for transactions entered into on or after 1/1/03. a. rules on disclosure of confidential transactions are clarified. t.d. 9108, confidential transactions, 68 f.r. 75128 (12/30/03). reg. § 1.6011-4(b)(3) provides that certain confidential transactions are reportable transactions that are subject to the disclosure rules under § 1.6011-4 and the list maintenance rules under § 301.6112-1. under the february 2003 regulations, a confidential transaction is a transaction that is offered under conditions of confidentiality. (the february 2003 regulations also provided that there was a presumption of non-confidentiality if the taxpayer receives written authorization to disclose the tax treatment and tax structure of the transaction.) * under these amended final regulations, the confidentiality filter is limited to situations in which an advisor is paid a large fee and imposes a limitation on disclosure that protects the confidentiality of the advisor's tax strategies. * transactions in which confidentiality is imposed by a party to the transaction acting in such capacity will no longer be reportable. further, the exceptions and presumption language have been removed because they no longer are necessary under this narrower rule. * effective 12/29/03. 3. warm-up the photocopier for those tax accrual workpapers. announcement 2002-63, 2002-27 i.r.b. 72 (7/8/02). in auditing returns filed after 7/1/02 that claim any tax benefits from a "listed transaction," see notice 2001-51, 2001-34 i.r.b. 190, the irs may request tax accrual workpapers. listed transactions will be determined "at the time of the request." neither the attorney client privilege nor the § 7525 tax practitioner privilege protects the confidentiality of the workpapers. a. specific procedures regarding requests for tax accrual workpapers. chief counsel notice cc-2003-012 (4/9/03). procedures to be used regarding requests for tax accrual and other financial audit workpapers. 4. "the irs and treasury believe that taxpayers have improperly relied on opinions or advice issued by tax advisors to establish reasonable cause and good faith as a basis for avoiding the accuracy-related penalty." reg-126016-01, establishing defenses to the imposition of the accuracy-related penalty, 67 f.r. 79894 (12/31/02). the treasury department has published proposed amendments to the regulations under §§ 6662 and 6664 [regs. §§ 1.6662-3; 1.6664-4] to limit the available defenses to an accuracy-related penalty when a taxpayer (1) fails to disclose a reportable transaction or (2) fails to disclose that it has taken a position on a return based upon a regulation being invalid. under the proposed amendments, a taxpayer who takes a position that a regulation is invalid cannot rely on an opinion or advice to satisfy the reasonable cause and good faith exception under § 6664(c) with respect to that position unless 20041 florida tax review the position was disclosed on a return (including disclosing the position that the regulation in question is invalid). a taxpayer who engages in a reportable transaction [see temp. reg. § 1.6011-4t] cannot rely on an opinion or advice to satisfy the reasonable cause and good faith exception under § 6664(c) with respect to the transaction unless the transaction was disclosed pursuant to the § 6011 regulations. finally, a taxpayer who engages in a reportable transaction cannot rely on the realistic possibility standard under § 6662 to avoid the accuracy-related penalty for negligence or disregard of rules or regulations if the position regarding the reportable transaction is contrary to a revenue ruling or notice. when finalized, the amendments will apply to returns filed after 12/30/02, with respect to transactions entered into after 12/31/02. 0 but be careful about over-reliance on effective dates. the preamble states: the irs, however, cautions taxpayers and tax practitioners that it will rigorously apply the existing facts and circumstances standard under § 1.6664-4(c) regarding a taxpayer's reasonable reliance in good faith on advice from a tax professional, as well as the other provisions of the regulations under sections 6662 and 6664, including § 1.6664-4(c) relating to special rules for the substantial understatement penalty attributable to tax shelter items of a corporation. in addition to the modifications contained in these proposed regulations, and regardless of when a transaction was entered into, the irs, in appropriate circumstances, may consider a taxpayer's failure to disclose a reportable transaction or failure to disclose a position that a regulation is invalid as a factor in determining whether the taxpayer has satisfied the reasonable cause and good faith exception under section 6664(c) to the accuracy-related penalty. a. regulations are now final. t.d. 9109, establishing defenses to the imposition of the accuracy-related penalty, 68 f.r. 75126 (12/30/03). the key provision is as follows: § 1.6664-4 -reasonable cause and good faith exception to section 6662 penalties. • .c) reliance on opinion or advice -(1) facts and circumstances; minimum requirements. all facts and circumstances must be taken into account in determining whether a taxpayer has reasonably relied in good faith on advice (including the opinion of a professional tax advisor) as to the treatment of the taxpayer (or any entity, plan, or arrangement) under federal tax law. for example, the taxpayer's education, sophistication and business experience will be relevant in determining whether the taxpayer's reliance on tax advice was reasonable and made in good faith. in no event will a taxpayer be considered to have reasonably relied in good faith on advice (including an opinion) unless the requirements of this paragraph (c)(1) are satisfied. the fact that these requirements are satisfied, [vol.6:si recent developments in federal income taxation however, will not necessarily establish that the taxpayer reasonably relied on the advice (including the opinion of a tax advisor) in good faith. for example, reliance may not be reasonable or in good faith if the taxpayer knew, or reasonably should have known, that the advisor lacked knowledge in the relevant aspects of federal tax law. . . in addition, the requirements of this paragraph (c)(1) are not satisfied if the taxpayer fails to disclose a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item. (iii) reliance on the invalidity of a regulation. a taxpayer may not rely on an opinion or advice that a regulation is invalid to establish that the taxpayer acted with reasonable cause and good faith unless the taxpayer adequately disclosed, in accordance with § 1.6662-3(c)(2), the position that the regulation in question is invalid. b. penalty policy statement issued by commissioner mark w. everson goes beyond the regulations to provide that taxpayers may not rely on the advice of a "conflicted" tax advisor. penalty policy statement issued by commissioner mark w. everson to the lmsb and sb/se commissioners, 2003 tnt 249-9 (12/30/03). this document instructs irs employees that taxpayers may not rely on the advice of a tax advisor who has a financial arrangement or referral agreement with a tax shelter promoter because his independent judgment is compromised. moreover, the irs will question the reasonableness and good faith of taxpayers who know or have reason to know that the tax advisor is not independent, and will not accept taxpayer reliance on an opinion from a non-independent tax advisor as proof of "reasonable cause and good faith." see, § 6664(c). 5. proposed revisions to circular 230 related to tax shelters require disclosures in tax shelter opinions of relationship between practitioner and promoter, etc. reg-122379-02, regulations governing practice before the internal revenue service, 68 f.r. 75186 (12/30/03). new proposed amendments to circular 230 differ from the 1/12/01 proposed amendments in several ways: (1) § 10.33 prescribes best practices for all tax advisors; (2) § 10.35 combines and modifies the standards applicable to "marketed" and "more likely than not" tax shelter opinions from former §§ 10.33 and 10.35; (3) § 10.36 contains the revised procedures for ensuring compliance with §§ 10.33 and 10.35; and (4) new § 10.37 contains provisions relating to advisory committees to the office of professional responsibility. 0 under § 10.33 "best practices" include: (1) communicating clearly with the client regarding the terms of the engagement and the form and scope of the advice or assistance to be rendered; (2) establishing the relevant facts, including evaluating the reasonableness of any assumptions or representations; (3) relating applicable law, including potentially applicablejudicial doctrines, to the relevant facts; (4) arriving at a conclusion supported by the law and the facts; (5) advising the client regarding the import of the conclusions reached; and (6) acting fairly and with integrity in practice before the irs. 20041 florida tax review 0 tax shelter opinions covered by § 10.35 are more-likely-than-not and marketed tax shelter opinions; they, however, do not include preliminary advice provided pursuant to an engagement in which the practitioner is expected subsequently to provide an opinion that satisfies § 10.35. the definition of "tax shelter," tracking the one found in § 6662 which was contained in the 2001 proposed regulations, remains the same. the requirements for tax shelter opinions include: (1) identifying and considering all relevant facts and not relying on any unreasonable factual assumptions or representations; (2) relating the applicable law to the relevant facts in a reasonable manner; (3) considering all material federal tax issues and reaching a conclusion supported by the facts and the law with respect to each issue; and (4) providing an overall conclusion as to the federal tax treatment of each tax shelter item, and the reasons for that conclusion and providing an overall conclusion as to the federal tax treatment of each tax shelter item and the reasons for that conclusion. * under § 10.35(d), a practitioner must disclose any compensation arrangement he may have with any person (other than the client for whom the opinion is prepared) with respect to the tax shelter discussed in the opinion, as well as any other referral arrangement relating thereto. the practitioner must also disclose that a marketed opinion may not be sufficient for a taxpayer to use for the purpose of avoiding penalties under § 6662(d), and must also state that taxpayers should seek advice from their own tax advisors. a limited scope opinion must also disclose that additional issues may exist and that the opinion cannot be used for penalty-avoidance purposes. * under § 10.36 procedures to ensure compliance are required to be followed by tax advisors with responsibility for overseeing a firm's practice before the irs. these include ensuring that the firm has adequate procedures in effect for purposes of complying with § 10.35. * under § 10.37 the director of the office of professional responsibility is authorized to establish advisory committees to review and make recommendations regarding professional standards or best practices for tax advisors. they may also, more particularly, advise the director whether a practitioner may have violated §§ 10.35 or 10.36. a. here comes cono! treasury and irs announced the appointment of caplin & drysdale partner cono r. namorato as director of the irs's office of professional responsibility on 12/29/03. 2003 tnt 249-1. d. individual tax shelters 1. government misconduct amounting to fraud does not require a showing of prejudice to justify relief. tax shelter investors entitled to the same deal received by the taxpayers who cooperated with the government. dixon v. commissioner, 316 f.3d 1041, 91 a.f.t.r.2d 2003-569, 2003-1 u.s.t.c. 50,194 (9th cir. 1/17/03), remanding t.c. memo. 2000-116 and t.c. memo. 1999-101. the ninth circuit reversed the tax court finding that misconduct by irs attorneys during the trial of test cases [secretly allowing the deduction of attorney's fees in exchange for taxpayer cooperation] constituted harmless error. the tax shelter was one designed and administered by honolulu businessman henry kersting, in which participants purchased stock with loans from entities financed by two layers of promissory notes, resulting in their claiming [vol.6:si recent developments in federal income taxation interest deductions on their individual returns. judge hawkins held that the taxpayers demonstrated fraud by the irs attorneys and that a demonstration of prejudice was unnecessary. the tax court was directed to enter judgment in favor of taxpayers on terms equivalent to the secret settlement agreements entered into with the test case taxpayers who cooperated with the government. a. chief counsel notice cc-2003-008 (2/3/03). this notice reminds chief counsel attorneys of their obligation to adhere to the highest ethical standards in all aspects of their responsibilities, including representation of the commissioner before the tax court. aba model rules 3.3 [candor to tribunals], 3.4 [fairness to opposing party and counsel], 4.1 [truthfulness in statements to third persons], and 8.4 [misconduct] were discussed in the notice. 2. faux foreign. notice 2003-22,2003-18 i.r.b. 851 (4/4/03). this notice addresses an abusive arrangement designed to evade income and employment taxes on compensation income through the use of unrelated conduit domestic and foreign employee leasing companies. the taxpayer purports to terminate his employment relationship with his employer, to enter unto an employment relationship with a foreign employee leasing corporation, which leases the employee to a domestic employee leasing corporation, which it turn leases the employee to his original employer. domestic leasing pays taxpayer substantially less than the original employer and remits the balance (less a fee) to the foreign company, which (1) claims treaty benefits resulting in no us tax because it has no effectively connected income, and (2) effectively sets-aside the funds for the taxpayer's benefit. the irs will challenge these (and similar) arrangements on a variety of theories, and will impose penalties. the arrangements are "listed transactions." 3. sale of nonqualified stock option to related person is a listed transaction. arrangements heavily promoted to executives to defer the tax on the option gain by selling the option to a related person for a long-term unsecured note, and claiming that the option gain is not taxable until payments are made on the note. a. the irs attacks the e&y, inter alia, nonstatutory stock option deferral shelter, act i. notice 2003-47,2003-30 i.r.b. 132 (7/1/03). transactions involving the transfer of nonstatutory stock options to a related person in exchange for a long-term, unsecured deferred payment obligation are not arm's length transactions for purposes of reg. § 1.83-7. the receipt of the deferred payment obligation will not result in a deferral of the recognition of income arising from the transfer. "[t]he irs will argue that the option recipient recognizes income to the extent that the amount of the deferred payment obligation transferred to the option recipient, plus any cash or other property received by the individual, exceeds the amount, if any, the option recipient paid for the option." the transactions (and any substantially similar transactions) are "listed transactions" for purposes of reg. §§ 1.6011-4(b)(2), 301.6111-2(b)(2), and 301.6112-1(b)(2). b. act h: the irs hammers the nonstatutory stock option deferral shelter. t.d. 9067, transfers of compensatory options, 68 f.r. 39453 (7/2/03). temp. reg. § 1.83-7t provides that a sale or other disposition of 20041 florida tax review a nonstatutory stock option to a related person will not be treated as a transaction that closes the application of § 83 with respect to the option. a person is related to the service provider if: (1) the person and the service provider bear a relationship to each other that is specified in § 267(b) or § 707(b)(1), modified to replace "50 percent" with "20 percent" and to treat the spouse of any family member as a family member for purposes of constructive stock ownership under § 267(c)(4), or (2) the service provider and the person are engaged in trades or businesses under common control (as defined in § 52(a) and (b)), excepting the service recipient with respect to the option or the grantor of the option. the effective date is 7/2/03. ix. exempt organizations and charitable giving a. exempt organizations 1. hmos are not tax exempt. ihc health plans, inc. v. commissioner, 325 f.3d 1188, 91 a.f.t.r.2d 2003-1767, 2003-1 u.s.t.c. 50,368 (10th cir. 4/9/03), affg t.c. memo. 2001-246. the commissioner denied the hmos' requests for tax exemption under § 501(c)(3), and this decision was affirmed by the tax court and by the tenth circuit on appeal. judge tacha held that the hmos did not operate primarily for the purpose of promoting health for the benefit of the community even though they covered fifty percent of utah's total medicaid population and twenty percent of utah's total population because providing health care services to all in the community in exchange for a fee is not sufficient for charitable tax exemption. the organization must provide some additional "plus," such as (1) providing free or below-cost services, (2) maintaining an emergency room open to all regardless of ability to pay, or (3) devoting surpluses to research, education and medical training. in the absence of any "positive externalities," or "public goods," or "additional community or public benefits" however this "plus" is denominated the hmos do not provide a community benefit in order to be charitable organizations exempt from taxation under § 501(c)(3). * additionally, the hmos do not qualify for exemption as an "integral part" of ihc health services, inc., a related § 501 (c)(3) organization that operates hospitals and provides charitable care, because "separately incorporated entities must qualify for tax exemption on their own merits," following and quoting geisinger health plan v. commissioner, 30 f.3d 494,498 (3d cir. 1994). 2. joint venture did not result in loss of tax exemption for charity hospital despite its failure to meet the criteria of revenue ruling 9815. st. david's health care system v. united states, 89 a.f.t.r.2d 2002-2998, 2002-1 u.s.t.c. 50,452 (w.d. tex. 617/02). summary judgment was granted to a community-owned, not-for-profit hospital on its tax-exempt status. the hospital's entering into a limited partnership with hca, inc. [a for-profit health care company], in which it had general and limited partnership interests of 49.5 percent and in which the for-profit partner was the managing partner, did not result in forfeiture of hospital's § 501(c)(3) exemption. the court held that the community benefit standard did not absolutely require a community board, and that st. david's satisfied this standard even though it appointed only half the board members where the chairman's seat was reserved for a st. david's appointee. there was language [vol.6:si recent developments in federal income taxation in the partnership agreement requiring all the partnership's hospitals to operate in accordance with the community benefit standard outline in rev. rul. 69-45, 1969-2 c.b. 117, and st. david's could unilaterally dissolve the partnership if they failed to do so. * query whether rev. rul. 98-15, 1998-1 c.b. 718, which provides an example of an acceptable joint venture in which the nonprofit partner has numerical control of the board, will still be considered valid. see also, redlands surgical services v. commissioner, 113 t.c. 47 (1999), affid per curiam, 242 f.3d 904, 87 aftr2d 2001-642,2001-1 u.s.t.c. 50,271 (9th cir. 2001). a. litigation costs were ordered. st. david's health care system v. united states, 90 a.f.t.r.2d 2002-6878, 2002-2 u.s.t.c. 50,745 (w.d. tex. 9/20/02). the district court ordered the united states to pay $951,000 in litigation costs under § 7430 to st. david's. judge nowlin held that novelty of the issues did not necessarily mean that any position that the government took was reasonable, concluding, finally, the united states argues that, since this case involved novel issues, it is more likely that its position was substantially justified. while it is true that some of the specific issues had a hint of novelty to them, that does not mean that any position taken on those issues is reasonable. to the extent that there were novel issues in this case, settled law clearly applied and disposed of those issues. b. fifth circuit vacates the district court's summary judgment ruling and its award of attorney's fees, and remands for trial. exempt organization must have control of joint venture. st. david's health care system v. united states, 349 f.3d 232, 92 a.f.t.r.2d 2003-6865, 2003-2 u.s.t.c. 50, 713 (5th cir. 11/7/03). in vacating the district court decision, judge garza's opinion relied upon rev. rul. 98-15 and found that the central issue was not whether the partnership between st. david's and columbia/hca healthcare corporation provided some charitable services, but rather whether the activities substantially further the profits-seeking interests of the for-profit partner. the opinion further analyzed facts that showed it was likely that st. david's had, as a practical matter, ceded control over the partnership to hca particularly with respect to a noncompete provision in the partnership dissolution rights, which would have prevented either party from competing in the austin area for two years and would have been inconvenient for hca but disastrous for st. david's. b. charitable giving 1. professor donates his patent to the university, but . . . contributions of partial interests in patents aren't deductible. rev. rul. 200328, 2003-11 i.r.b. 594 (2/26/03). no deduction is allowed under § 170 for a charitable contribution of (1) a license to use a patent, if the taxpayer retains any substantial right in the patent [e.g., a right to license to others], or (2) a patent subject to a conditional reversion [e.g., a contribution of a patent to a university subject to a reversion if a particular faculty member ceases to be a member of the 20041 florida tax review faculty within 15 years], unless the likelihood of the reversion is so remote as to be negligible. both of these transfers are transfers of partial interests, a deduction for which is disallowed by § 170(f)(3). a § 170 deduction is allowable for a charitable contribution of a patent subject to a license or transfer restriction generally [e.g., a restriction of transfer or licensing for 3 years], but the restriction reduces what would otherwise be the value of the patent. x. tax procedure a. interest, penalties and prosecutions 1. this false w-2 resulted in a felony rather than a misdemeanor. united states v. gambone, 314 f.3d 163,91 a.f.t.r.2d 2003-330, 2003-1 u.s.t.c. 50,162 (3d cir. 1/3/03). an employer who files fraudulent w-2s for the purpose of evading employment taxes and income tax withholding, and who encourages employees to file fraudulent returns consistent with the w-2s, can be convicted of a felony under § 7206(2). the exclusivity of § 7204, which makes filing a false or fraudulent w-2 a misdemeanor in lieu of any other crime is limited to instances in which the only action taken is "merely furnish[ing] false w-2s." conduct involving the furnishing of false w-2s, but not limited to filing false w2s, such as encouraging employees to file false returns, can be prosecuted under § 7206(2). 2. irs announces an amnesty for offshore credit-card abusers who clear up their tax liabilities by april 15th 2003. irs news release ir2003-5,2003 tnt 10-11 (1/14/03). an offshore voluntary compliance initiative provides that "eligible taxpayers," who used offshore payment cards or other offshore financial arrangements to hide their income, may avoid civil fraud and information return penalties [but not failure to pay tax or accuracy-related penalties] if they come forward and pay up by 4/15/03 and provide full details on those who promoted or solicited the offshore scheme. promoters and solicitors are not eligible. the information release contains the following example: for example, a taxpayer who understated his income to avoid $ 100,000 in taxes in 1999 would wind up paying $ 149,319 to the government. this includes the tax liability plus $ 29,319 in interest and an additional accuracy-related penalty of $ 20,000. a. rev. proc. 2003-11, 2003-4 i.r.b. 311 (1/14/03). this revenue procedure contains detailed procedures for the offshore voluntary compliance initiative, including as an exhibit the "specific matters closing agreement" to be executed by the taxpayer. 3. rev. rul. 2003-23, 2003-8 i.r.b. 511 (2/24/03). an individual who files a late return for the preceding taxable year and pays as required the installments properly based upon the tax shown on that return, will not be liable for the § 6654(a) addition to tax for an underpayment of estimated tax for the current taxable year. the § 6654(d)(1)(b)(ii) safe harbor does not require a timely return. [vol6:sl recent developments in federal income taxation 4. the irs foot-faulted on preparing a tax protestor's substitute return and lost the failure to pay penalty, but salvages a frivolous position penalty. cabirac v. commissioner, 120 t.c. 163 (4/22/03). the taxpayer filed income tax return forms with zeros on the relevant lines for computing tax liability. the irs prepared unsubscribed substitute returns showing zeros, and sent a deficiency notice based on a calculation of taxable income and tax shown in a revenue agent's report, which had not been attached to the substitute returns. the tax court (judge ruwe) held that the taxpayer was liable for the § 6651 (a)(1) failure to file penalty, but not for the § 6651 (a)(2) failure to pay penalty. the unsubscribed substitute returns showing zero taxes did not meet the requirements for a § 6020(b) return, and the subsequently prepared notice of proposed adjustments and the revenue agent's report, which were not attached to the unsubscribed substitutes for return, whether viewed separately or in conjunction with the substitute return, were not an adequate § 6020(b) return. however, a $2,000 § 6673(a)(1) frivolous position penalty was assessed. 5. the tax court just says "no" to impermissible stacking of penalties. said v. commissioner, t.c. memo. 2003-148 (5/22/03). where one spouse is liable for the civil fraud penalty on the entire underpayment relating to a joint return, the § 6662 accuracy related penalty cannot be assessed against the other spouse with respect to any part of the understatement. 6. hot dog! no hot interest here. med james, inc. v. commissioner, 121 t.c. 147 (9/9/03). section 6621(c) increases the interest on corporate deficiencies to 5 percent above the short-term federal rate [instead of the normal 3 percent] if the deficiency exceeds $100,000. the tax court (judge goeke) held that the increased ["hot"] interest under § 6621(c) does not apply where an nol that arose in a year before the deficiency notice was sent is carried back to reduce the deficiency, which otherwise would have exceeded $100,000, to less than $100,000. 7. mendes v. commissioner, 121 t.c. 308 (12/11/03) (reviewed, 3 dissents). in an opinion by judge halpern, the majority held that a late return filed after a deficiency notice has been issued is not taken into account in determining whether the addition to tax for underpayment of estimated taxes is avoided under § 6654(d)(1)(b) even if the return shows that the tax due for the year was zero. the penalty can be collected pursuant to deficiency notice on underlying tax liability. judge foley (joined by judges laro and marvel) dissented on the grounds that the literal requirements of § 6654(d)(1)(b) had been met by the late filed return, and that the proper question was whether the late filed return was indeed a valid return, i.e., was it merely an attempt to avoid the penalty without an honest and reasonable attempt to comply with the requirements for a return. b. discovery: summonses and foia 1. the pwc deal. ir-2002-82 (6/27/02). the irs announced in a news release that it cut a deal with pricewaterhousecoopers (pwc) to resolve tax shelter registration and list maintenance issues. the irs news release, which is similar to one issued last august regarding merrill lynch, says that "without admitting or denying liability, pwc has agreed to make a 'substantial payment' to 2004] florida tax review the irs to resolve issues in connection with advice rendered to clients dating back to 1995." under the agreement, pwc will provide to the irs certain client information in response to summonses. according to the release, pwc also will"work with the irs to develop processes to ensure ongoing compliance with [the shelter registration and investor list maintenance requirements]." a. the ey deal. ir-2003-84 (7/2/03). theirs announced in a news release that it has settled ernst & young's potential liability under the tax shelter registration and list maintenance penalty provisions for a nondeductible payment of $15 million. b. the kpmg deal. rumored, but not here yet.19 2. does the crime/fraud exceptionto the attorney client privilege defeat privilege claim? united states v. bdo seidman, 225 f.supp.2d 918, 90 a.f.t.r. 2d 2002-6810,2002-2 u.s.t.c. 50,763 (n.d. ill. 10/10/02). documents for which accounting firm claimed § 7525 privilege were ordered to be produced for magistrate's in camera review. in his opinion, judge shadur noted, one last point has occurred to this court something that has not been addressed by either of the parties. suppose that some of the documents for which bdo claims privilege could otherwise fit within the standards governing the attorney-client privilege (and hence the equivalent statutory accountant-client privilege), but that they relate to the types of "abusive tax shelters" that have triggered the congressional enactment at issue here. in that event, would the utilization of such an "abusive tax shelter" by a taxpayer to whom bdo has given advice as to its use create the potential of criminal as well as civil liability on the taxpayer's part? and if so, would that trigger the application of the crimefraud exception to the privilege? a. decision on whether proposed intervenors could claim "identity" privilege under § 7525. united states v. bdo seidman. 91 a.f.t.r12d 2003-1651, 2003-1 u.s.t.c. 50,255 (n.d. ill. 2/4/03). judge holderman decided that there are four criteria as to whether client identity is privileged on a document-by-document basis: (1) whether the purpose of the representation was to provide tax advice? [must be "yes" to be privileged]; (2) whether revealing identity would reveal client's motives for seeking tax advice [must be "yes"]; (3) whether the irs could determine that clients participated in the transactions without obtaining their names from bdo [must be "no']; and (4) whether the document was generated for the purpose of preparing tax returns [must be "no"]. findings for each in camera document followed. b. affirmed. seventh circuit say tax shelter disclosure rules virtually preclude assertions of identity privilege by tax shelter investors. united states v. bdo seidman. 337 f.3d 802,92 a.f.t.r.2d 2003-5443,2003-2 u. s.t. c. 50,582 (7th cir. 7/23/03). the court ofappeals (judge ripple) affirmed 19. as of february 22, 2004. [vol6:si recent developments in federal income taxation the district court's determination that the investors failed to establish that a confidential communication would be disclosed if their identities were revealed. disclosure of their identities would disclose to the irs only that they had participated in one of the tax shelters described in the summonses, but no confidential communication could be inferred from that information alone. the court distinguished in re grand jury proceeding (cherney), 898 f.2d 565 (7th cir. 1990); tillotson v. boughner, 350 f.2d 663 (7th cir. 1965), as cases in which "the government already knew much about the substance of the communications between the attorney and his unidentified client," from this case, where "the irs knows relatively little about the interactions between bdo and the [the investors], the nature of their relationship, or the substance of their conversations." furthermore, none of the summonsed documents were subject to any other independent claim of privilege beyond identity. then, in sweeping language, the court concluded that the tax shelter disclosure rules virtually preclude assertions of identity privilege by tax shelter investors. more fundamentally, the does' participation in potentially abusive tax shelters is information ordinarily subject to full disclosure under the federal tax law .... congress has determined that tax shelters are subject to special scrutiny, and anyone who organizes or sells an interest in tax shelters is required, pursuant to i.r.c. § 6112, to maintain a list identifying each person to whom such an interest was sold. this list-keeping provision precludes the does from establishing an expectation of confidentiality in their communications with bdo, an essential element of the attorney-client privilege and, by extension, the § 7525 privilege.... at the time that the does communicated their interest in participating in tax shelters that bdo organized or sold, the does should have known that bdo was obligated to disclose the identity of clients engaging in such financial transactions. because the does cannot credibly argue that they expected that their participation in such transactions would not be disclosed, they cannot now establish that the documents responsive to the summonses, which do not contain any tax advice, reveal a confidential communication.... bdo's affirmative duty to disclose its clients' participation in potentially abusive tax shelters renders the does' situation easily distinguishable from the limited circumstances in which we have determined that a client's identity was information subject to the attorney-client privilege.... c. you don't have to be a criminal to claim identity privilege in chicago. united states v. arthur andersen. llp, 273 f.supp.2d 955, 92 a.f.t.r.2d 2003-5207, 2003-2 u.s.t.c. 50553 (n.d. ill. 7/2/03). investors in tax shelters promoted by arthur andersen successfully intervened anonymously and asserted identity privilege under § 7525 when the irs sought to enforce an administrative summons to obtain the lists of investors. the court (judge castillio) rejected the government's argument [based on in re grand jury proceeding 2004] florida tax review (cherney), 898 f.2d 565 (7th cir.1990); tillotson v. boughner, 350 f.2d 663 (7th cir. 1965)] that identity privilege can exist only where the client has engaged in past criminal conduct, and applied the four part test of united states v. bdo seidman, 91 a.f.t.r.2d 2003-1016, 20031 u.s.t.c. 50,255 (n.d. ill. 2/4/03). (n.d. ill. 2003) [united states v. bdo seidman, 92 a.f.t.r.2d 2003-5443 (7th cir. 7/2/03)]. judge castillio concluded that "revealing the clients' identities would reveal their motives for seeking tax advice [because] [t]he irs is seeking information, including the identities... in an effort to determine whether or not andersen was complying with the irs regulations governing potentially abusive tax shelters.... under these circumstances, it is difficult to see how revealing the identities of the poes and the does could amount to anything less than a revelation of their motivations in seeking andersen's tax advice-to invest in potentially abusive tax shelters. this motivation, the "very substantive reason that the client sought.., advice in the first place," is confidential and therefore privileged under § 7525. judge castilio held further that reg. § 301.6112-it q & a-1 7(b) provides that the § 7525 privilege trumps the requirements of § 6112. finally, he rejected the government's argument that the crime-fraud exception to privilege applied because there was no prima facia showing of a crime. 0 it would appear that the seventh circuit's subsequent opinion in bdo seidman, see above, overrules judge castillio's opinion in arthur andersen, llp. d. and indeed it does! united states v. arthur andersen llp, 92 a.f.t.r.2d 2003-5800, 2003-2 u.s.t.c. 50,624 (n.d. m. 8/15/03). judge castillo characterizes bdo as providing that "it appears that the seventh circuit intended in bdo to pronounce a generally applicable prohibition on the assertion of the identity privilege in irs summons enforcement actions that does not seem altered by differing factual scenarios," and reluctantly holds that the intervenors may not assert a § 7525 privilege in their identities. 3. now here's a legitimate case of identity privilege. united states v. braun, 92 a.f.t.r.2d 2003-5406 (n.d. cal. 6/17/03). the irs was investigating the civil tax liability of w at the same time that w and c were under investigation by a local police force for grand theft. c was charged by the u.s. government with structuring transactions to avoid reporting under 31 u.s.c. § 5324(a)(3). c was represented in the criminal matter by attorney a. c waived attorney client privilege and the irs obtained documents from attorney a that identified attorney b as the source of payments of c's legal fees. the district court refused to enforce an irs summons against attorney b seeking the identity of his client who had sought legal representation for c, because, based on information in the attorney's sealed affidavit, the court found that the client had disclosed confidential information to the attorney that would necessarily be revealed if the client's identity were known. 4. are you practicing law or practicing tax when you write that opinion letter? united states v. kpmg llp, 237 f.supp.2d 35, 91 a.f.t.r.2d 2003-317, 2003-1 u.s.t.c 50,174 (d. d.c. 12/20/02). the irs served administrative summonses on kpmg in connection with investigating kpmg's promotion and participation in tax shelters and sought judicial enforcement when it determined that kpmg had not complied. kpmg withheld documents that [vol.6:si recent developments in federal income taxation would have been responsive to the summonses on grounds that the documents were privileged, and kpmg provided the irs with a privilege log of the withheld documents. citing united states v. lawless, 709 f.2d 485 (7th cir. 1983), for the principle that the attorney-client privilege does not extend to communications between a taxpayer and his attorney simply for the purpose of preparing a tax return, the court held that the § 7525 privilege does not extend to communications between a taxpayer and tax practitioner simply for the purpose of preparing a tax return. the court then went on to hold that kpmg's tax opinion letters to its clients were not privileged because they were prepared in connection with the preparation of tax returns. furthermore, memoranda of kpmg's employees' discussions with clients' lawyers were not privileged because the communications were in connection with tax return preparation. somewhat contradictorily, however, the court held that opinion letters prepared by law firms in connection with preparation of tax returns were privileged if the taxpayer, rather than the accounting firm, retained the lawyer. 0 the court also held that § 7525 did not protect accountant work product. with respect to attorney work product, the court articulated the following standard: "the burden of showing that the materials prepared were in anticipation of litigation is on the party asserting the privilege," and "this burden entails a showing that the documents were prepared for the purpose of assisting an attorney in preparing for litigation, and not for some other reason." after an in camera review and comparison of a random sample of thirty allegedly privileged documents and the corresponding entries in the privilege log prepared in response to the summons, the court found that only four of the privilege log entries were completely supportable; accordingly it referred the matter to a special master to conduct an examination of the withheld documents, evaluate the asserted privileges, and submit a report and recommendation. a. a subsequent kpmg magistrate's opinion. united states v. kpmg llp, 92 a.f.t.r.2d 2003-6498, 2003-2 u.s.t.c. 50,691 (d. d.c. 10/8/03). kpmg's documents were reviewed by a special master, who found some of them protected by attorney-client privilege and some by § 7525. 5. district court finds subject-matter waiver of privilege in all communications between two corporations and their outside tax counsel by reason of the assertion of a "reasonable cause" defense. in re: g-i holdings inc., 218, f.r. 428, 92 a.f.t.r.2d 2003-6451, 2004-1 ustc 50,154 (d. n.j. 7/18/03). the court (judge bassler) refused to bifurcate discovery and trial on the issue of penalties pending resolution of the substantive tax issues because the debtors waived any attorney-client privilege with respect to their outside tax counsel [bill mckee and will nelson] by asserting a "reasonable cause" defense that placed attorney-client communications at issue. the court further found that the debtors' communications with michael baldasaro [an accountant then with arthur andersen] are not privileged under united states v. kovel, 296 f.2d 918 (2d cir. 1961), because he was hired as a consultant his expertise in partnership transactions taxation was too great to consider him as a "translator or facilitator." 6. magistrate denies government's motion to compel discovery of 63 documents, including some between taxpayer's in-house attorneys and deloitte & touche. the black & decker corp. v. untied states, 219 f.r. 87, 92 20041 florida tax review a.f.t.r.2d 2003-6426,2003-2 u.s.t.c. 1 50,659 (d. md. 9/15/03). in the course of the taxpayer's refund suit arising from a series of transactions involving special purpose entities formed to manage employee health care benefits, the government sought discovery of numerous documents prepared by deloitte & touche, which taxpayer had retained to give advice regarding the transaction. first, certain communications to taxpayer's in house counsel were not subject to attorney-client privilege under the kovel doctrine, because the accounting firm's advice was not necessary to facilitate communications between the taxpayer's attorney and its nonattorney officers. the evidence that many of the communications in question were directed to non-attorney employees of the taxpayer supported this conclusion. furthermore, the documents were not "'translation' services' but were hybrid... tax and business advice." 0 taxpayer, with the assistance of deloitte & touche, created special purpose entities to manage its employee and retiree health care benefits and claimed a large capital loss, as well as a total federal tax refund of about $57 million for the years 1995 through 2000. the taxpayer did provide a "short opinion" from d&t, and subsequently offered to provide a "long opinion" from d&y on the transaction and refused to produce 63 other documents. (the production of the "long opinion" was conditioned on an agreement that the government would not assert that such disclosure does not constitute a subject matter waiver, a condition the government refused.) after reviewing the documents in camera, the magistrate held that the attorney-client privilege [in its derivative form under united states v. kovel, 296 f.2d 918 (2d cir. 1961] was inapplicable because d&t was not primarily providing "translation" services to assist the inhouse attorneys in rendering legal advice to the taxpayer, but was instead providing tax and business advice to the taxpayer. however, the work product doctrine was held to apply to the documents [53 of which were opinion work product and 10 of which were fact work product], and there was no waiver of this protection by the provision of the "short" opinion letter to the government. * nevertheless, the documents were protected under the work product doctrine. the government conceded that the documents had been prepared in anticipation of litigation, but argued that the "privilege" for work product had been waived. the court held that the work product doctrine can be waived where the party puts the work "in issue," but that the work in question had not been put in issue. that the documents may have related to an opinion letter on which the taxpayer was going to rely in an effort to avoid penalties and with respect to which the taxpayer thus waived privilege did not result in waiving the work product doctrine, which is "broader and more robust than the attorney-client privilege." however, the court did not explain, however, how an accounting firm's work became "attorney work product." this is significant because the § 7525 privilege [which was not expressly raised in the case] does not have a "work product" variant. 0 the opinion discusses four factors relevant to the applicability of the derivative privilege: (1) whether the advice was provided to the counsel or the client; (2) whether the in-house counsel also acts as a corporate officer; (3) whether the accountant is regularly employed as the client's auditor or advisor; and (4) which parties initiated or received the communications. 7. long-term capital holdings rulings. long-term capital holdings v. united states, 90 a.f.t.r.2d 2002-7446, 2003-1 u.s.t.c. 50,105 [vol.6:si recent developments in federal income taxation (d. conn. 10/30/02), modified by, 91 a.f.t.r.2d 2003-1139, 2003-1 u.s.t.c. 50,304 (d. conn. 2/14/03). in connection with a transaction, the taxpayer obtained opinions from sherman & sterling and king & spalding relating to different aspects of the transaction. without specifically disclosing the k&s opinion letter itself, the taxpayer revealed to its tax accountant that it had a "more likely than not" opinion with respect to the allowability of the deduction. the s&s opinions, in contrast, were voluntarily disclosed in the course of the audit. the magistrate held that disclosure of existence of the k&s opinion and that it was a more likely than not opinion with respect to allowance of the deduction disclosed the gist of the opinion and thus was an express subject matter waiver even though the disclosure was extra-judicial. in addition, the magistrate alternatively reasoned that voluntary disclosure of the s&s opinions, while asserting privilege as to k&s opinion regarding a different aspect of the same transaction, was an attempt to use the "privileged communications as both a shield and a sword." the magistrate found implied waiver as to the k&s opinion. the alternative holding is confusing, however, because the magistrate also factored in the express waiver resulting from the disclosure of the existence of the k&s opinion to its tax accountant. nevertheless, the magistrate ultimately concluded that the k&s opinion could constitute work product under second circuit's application of the doctrine to documents prepared "in anticipation of litigation," in united states v. adiman, 134 f.3d 1194 (2d cir. 1998). accordingly, the magistrate required submission of documents for an in camera inspection. 0 on reconsideration, the magistrate found that the s&s opinion was not privileged because it was prepared for the purpose of ascertaining the basis of a partnership interest and thus was a record that had to be made available to the irs under reg. § 1.6001-1(a). since the s&s opinion was not privileged to begin with, its disclosure was not a subject matter waiver. furthermore, after considering additional facts the k&s opinion was found not to deal with the same issues as the s&s opinion, and thus the disclosure of the s&s opinion was not a waiver with respect to the k&s opinion. however, the magistrate reaffirmed that the disclosure of existence of the k&s opinion and that it was a more likely than not opinion with respect to the allowance of the deduction disclosed the gist of opinion and thus was an express waiver, but rather than being a subject matter waiver as originally held the waiver was only of those portions of the opinion letter reflecting the matter actually disclosed. finally, the magistrate held that the k&s opinion was opinion attorney work product that was not discoverable by the irs. 8. attorney-client privilege and work product doctrine can shield documents from the irs, but you've got to have a privilege log. toler v. united states, 91 a.f.t.r.2d 2003-2262,2003-1 u.s.t.c. 50,476 (s.d. ohio 4/29/03). in connection with a criminal investigation [prior to a referral to the justice department], the irs issued a summons seeking the taxpayer's documents, including all records used or resulting from preparation of the taxpayer's tax returns, to kiesling, an accountant-attorney, who had advised the taxpayer on various tax matters in his capacity as an attorney. kiesling represented the taxpayer in the criminal matter until august 2000, when the taxpayer retained another law firn, "szd," which in turn retained kiesling. because prior to august 2000, kiesling did not possess any of the documents in question, the summons was quashed in that regard. however, if kiesling possessed any documents or obtained 20041 florida tax review any information described in the summons that were created or obtained after the taxpayer retained szd a fact that was not admitted the documents and information were protected by the attorney-client privilege to the extent that they "serve[d] to disclose confidential legal communications between [taxpayer] and szd," since kiesling was szd's agent. furthermore, to the extent any relevant documents were prepared or created to assist in defending against the possible criminal charges, they were protected by the work product doctrine, regardless of whether kiesling was acting as an attorney or accountant after being retained by szd. however, because the taxpayer failed to provide a privilege log, the motion to quash was denied, without prejudice to renew following preparation of a disclosure log. finally, the pre-existing documents that were gathered after august 2000 were not protected by the fifth amendment because the "fact that the contents of such documents, to the extent they exist, may be incriminating does not render the production of those documents incriminating." 9. a lawyer's description and opinion regarding a prepackaged tax shelter transaction is not privileged. doe #1 v. wachovia corporation, 268 f.supp.2d 627,92 a.f.t.r.2d 2003-5125, 2003-2 u.s.t.c. 50,558 (w.d. n.c. 6/24/03). the irs served an administrative summons on wachovia seeking investor lists, documents, and other information relating to potentially abusive tax shelters under reg. § 301.6112-it. investors argued that disclosure of their names would "be tantamount to disclosure of privileged information" provided by them to kpmg [§ 7525 privilege] and to jenkens & gilchrist [attorney-client privilege], and that other confidential privileged information would be disclosed by compliance with the summons. the court found that there was no attorney-client relationship between the investors and jenkens & gilchrist. rather, jenkens & gilchrist "appear[ed] to have merely sold a package to them which contained a description of the transaction and a memorandum as to the potential tax consequences stemming from the transaction." there was no evidence that any investor "ever had so much as a conversation with an attorney at j & g," and there was nothing uniquely tied to the individual investors' financial situation. the package contained no confidential information, was sent to all investors without any individual tailoring, and was delivered by wachovia, not jenkens & gilchrist. [i]n this case there is no evidence that j & g was (1) retained by the client, as opposed to by wachovia; (2) contacted by the client, except through wachovia; (3) providing legal advice based on individual financial information, as opposed to selling a tax advantaged structure; and (4) by the terms of its own agreement, acting as an attorney for the "client." 0 similarly, the § 7525 privilege did not apply with respect to kpmg. first, the privilege only applies in cases by or against the government and before the irs. this was a suit by investors seeking an injunction against wachovia, not a proceeding in which the united states appeared, and the issuance of an administrative summons to a bank is not a "tax proceeding" before the irs. second, the privilege does not apply "to any written communication between a federally authorized tax practitioner and a director, shareholder, officer, or employee, agent, or representative of a corporation in [vol.6:si recent developments in federal income taxation connection with the promotion of the direct or indirect participation of such corporation in any tax shelter," which exactly described this cases. third, kpmg did not provide any advice other than in the context of return preparation, which is not privileged. o on 6/26/03, the investors filed a potice of intent to appeal. 10. there's no client identity privilege when it's the lawyer's tax return being audited. naii ar v. united states, 91 a.f.t.r.2d 2003-2166, 2003-1 u.s.t.c. 50,470 (s.d. ind. 4/11/03). the irs issued a summons to the taxpayerlawyer's bank seeking documents relating to the taxpayer's account designated as an interest on lawyers' trust account (iolta). the court rejected the taxpayer's argument that the requested documents were protected by attorney client-privilege. banking transactions are not confidential communications between an attorney and client; they are commercial transactions that disclose the identity of the parties to the transaction to the third party banking institution. the requested documents were relevant because "the clients themselves may be instrumental in identifying and verifying non-income and income items in the attorney's trust account." 11. a § 7602 summons solely for a criminal investigation is ok! scotty' s contracting and stone, inc. v. united states, 326 f.3d 785, 91 a.f.t.r.2d 2003-2047, 2003-1 u.s.t.c. 50,413 (6th cir. 4/24/03). the irs issued summonses to accountants for scotty's contracting and its owner, scott, "to determine whether... has unreported federal income tax liabilities .. ., and whether... scott has committed any offense under the internal revenue laws." the court of appeals (judge gibbons) rejected the government's argument that scotty's contracting lacked standing to challenge the summonses because they were issued for the sole purpose of a criminal investigation of scott, not scotty's. however, the court held that under § 7602, as amended in 1982, the irs may validly issue a summons pursuant for the sole purpose of a criminal investigation, as long as the case has not yet been referred to the justice department. accord: united states v. millman, 822 f.2d 305,308 (2d cir. 1987); pickel v. united states, 746 f.2d 176, 183-84 (3d cir. 1984); united states v. g & g adver. co., 762 f.2d 632 (8" cir. 1985); united states v. schmidt, 816 f.2d 1477 (10th cir.1987); la mura v. united states, 765 f.2d 974 (11th cir. 1985). 12. chief counsel sets forth the rules for playing hardball by keeping secret certain chief counsel advice. chief counsel notice cc-2003022, 2003 tnt 129-3 (7/1/03), modifying and supplementing chief counsel notice cc-2002-026 (5/16/02). this notice apprises chief counsel employees of the procedures for processing taxpayer specific chief counsel advice when it is determined that no portion of a particular cca need be disclosed to the public under the provision of § 6110. c. litigation costs 1. frivolous arguments are painful to lawyers' pocketbooks. takaba v. commissioner, 119 t.c. 285 (12/16/02). judge halpern sua sponte awarded the government excess attorneys costs of $10,500, payable by taxpayer's counsel, under § 6673(a)(2), where counsel continued to press a 20041 florida tax review frivolous "§ 861 argument" [that only income earned from possessions, corporations, or the federal government is subject to tax] originally advanced by the taxpayer acting pro se. 2. it will warm your heart to know that the sword to push the irs to settle has a keen edge. gladden v. commissioner, 120 t.c. 446 (6/27/03). the taxpayer made a "qualified offer" under § 7430(c)(4)(e), and after a judicial decision relating to issues pertinent to the substantive tax adjustment the parties finally settled the substantive tax adjustment for less than the offer. temp. reg. § 1.7430-7t(a) provides that "[t]he provisions of the qualified offer rule do not apply if the taxpayer's liability under thejudgment... is determined exclusively pursuant to a settlement... ." because legal arguments and issues relating to the substantive issues were litigated and decided by a court, the judgment was not regarded as merely pursuant to a settlement. thus the taxpayer's qualified offer was not limited by the settlement limitation on qualified offers in section § 7430(c)(4)(e)(ii)(i). accordingly, the taxpayers qualified as a prevailing party under § 7430(c)(4) by reason of section 7430(c)(4)(e). 3. florida country clubs, inc. v. commissioner, 122 t.c. no. 3 (2/3/04). even though § 7430(c)(2) provides that reasonable administrative cost include costs incurred after the irs sends a 30-day letter, attorney's fees are not available with respect to a case in which the irs has issued a 30-day letter but which has been settled without either an deficiency notice or appeals decision having been issued. although the definition of "reasonable administrative costs" includes costs incurred from the date of the 30-day letter, the government still has not "taken a position" for purposes of § 7430(c)(7) until a deficiency notice or appeals decision has been issued, and thus the taxpayer cannot be a "prevailing party" as defined in § 7430(c)(4). d. statutory notice 1. the irs does not have to comply with at least one section of the irs restructuring and reform act of 1998. elings v. commissioner, 324 f.3d 1110, 91 a.f.t.r.2d 2003-1648,2003-1 u.s.t.c. 150,357 (9th cir. 4/8/03). the ninth circuit held that the failure to comply with § 3463(a) of the irs restructuring and reform act of 1998, an uncodified provision, stating that the irs "shall include on each notice of deficiency.., the date determined by [the irs] as the last day on which the taxpayer may file a petition in the tax court," does not invalidate the deficiency notice. accord rochelle v. commissioner, 116 t.c. 356 (2001), aft'd, 293 f.3d 740 (5th cir. 2002); smith v. commissioner, 275 f.3d 912 (10th cir. 2001). e. statute of limitations 1. the eighth circuit rejects a thirty-year-old revenue ruling. kaffenberger v. united states, 314 f.3d 944, 91 a.f.t.r.2d 2003-374, 2003-1 u.s.t.c. 50,164 (8th cir. 1/3/03). section 6532(a) allows the irs to agree to an extension of time [beyond the normal two year period of limitations] for filing a refund suit. in rev. rul. 71-57, 1971-1 c.b. 405, the irs ruled that such an agreement was valid only if the agreement is executed before the statutory time [vol.6:si recent developments in federal income taxation expired. the court of appeals held that rev. rul. 71-57 misconstrues § 6532(a)(2), and that an agreement to extend the statute of limitations executed by the irs after it had expired was valid. the court reasoned that § 6501, the provision limiting the period for the irs's to assess taxes allows the period to be extended "by subsequent agreements in writing made before the expiration of the period previously agreed upon," but that § 6532(a)(2) contains no such language; and the inference therefore is that the agreement need not be entered into before the period expires, because to "do so renders the above quoted portion of § 6501 'insignificant, if not wholly superfluous."' 2. brosi v. commissioner, 120 t.c. 5 (1/13/03). tolling of the statute of limitation under § 6511(h) is not available to a taxpayer who serves as a "care-giver" to a relative; it applies only in the case of a serious mental or physical disability of the individual taxpayer seeking relief. 3. the government end-runs the statute of limitations via a setoff. pacific gas & electric co. v. united states, 55 fed. cl. 271, 91 a.f.t.r.2d 2003-1035, 2003-1 u.s.t.c. 50,267 (2/20/03). without any particular statutory authority, the government may setoff an erroneous refund against other refunds due to the taxpayer. if the other refund relates to the same taxpayer, tax, and tax year, the government can setoff the prior erroneous refund even if the statute of limitations on bringing suit for the erroneous refund has expired. in this case, an erroneous overpayment of interest on overpayment of income tax was setoff against a subsequent refund claim. the irs did allow the taxpayer a deduction for the amount of the setoff in the year of the setoff. 4. counting the days on the calendar. rev. rul. 2003-41,2003-17 i.r.b. 814 (4/28/03). if pursuant to § 7503 [providing that, if the last day for filing a return falls on a saturday, sunday, or legal holiday, the return will be considered timely if filed on the next succeeding day that is not a saturday, sunday, or legal holiday], a taxpayer files a timely return after april 15, e.g., on april 17, then the § 6511 statute of limitations for filing a refund claim expires three years after the extended filing date, e.g. april 17. but if the taxpayer had filed a timely return before april 15, when the due date was extended by § 7503 to a later date, a refund claim filed after april 15 three years later is not timely, because §6513(b)(1) treats wage withholding as paid on april 15, and § 7503 does not affect § 6513(b)(1). 5. regulations on the statute of limitations suspension when enforcement is sought with respect to a designated summons issued to a corporation. reg-208199-91, suspension of limitations period, 68 f.r. 44905 (7/31/03). proposed regulations under § 6503(j), relating to the suspension of the statute of limitations when a case is brought with respect to a "designated" or "related" summons issued to a corporation. 6. no mulligan for the tax court and the irs. carroll v. united states, 339 f.3d 61, 92 a.f.t.r.2d 2003-5650,2003-2 u.s.t.c. 50,608 (2d cir. 8/5/03). for purposes of suspending the statute of limitations for deficiencies pending a tax court order in a docketed case, the order is entered under § 7459 when it is signed, docketed, and served, even if the document itself is undated due to a clerical error. the tax court's order vacating its earlier undated order and 2004] florida tax review reentering the original order did not restart the statute of limitations either because the tax court had no jurisdiction to vacate its first order or because the second order was a "non-substantive housekeeping document" and the assessment was untimely. 7. when does a taxpayer become subject to the "duty of consistency" rule? banks v. commissioner, 345 f.3d 373, 92 a.f.t.r.2d 20036298,2003-2 u.s.t.c. 50,705 (6th cir. 9/30/03), rev'g t.c. memo. 2001-48. the sixth circuit held that the duty of consistency rule does not apply when the taxpayer merely makes a mistake of law that the commissioner does not challenge (a "mutual mistake of law"), rather than an affirmative misrepresentation; in such a case the taxpayer subsequently may claim the deduction in the proper year, even though the year of the erroneous deduction is closed. the taxpayer originally claimed an alimony deduction in 1993, when an amount escrowed with the state court was paid to his ex-wife; in a subsequent tax court proceeding with respect to 1990, the taxpayer claimed the deduction properly should have been allowed under § 461(f) in 1990 when the amount was paid over to the state court. the case was remanded for a finding on whether the taxpayer made a misrepresentation or there was merely a mutual mistake of law [and whether the payment actually was alimony]. 8. martin v. commissioner, t.c. memo. 2003-288 (10/8/03). an unauthorized tax court petition filed by the taxpayer's former wife's attorney with respect to a statutory notice relating to a year for which they filed ajoint return, and which was dismissed with respect to the taxpayer on his motion, nevertheless [pursuant to § 6503(a)(1)] suspended the statute of limitations on assessment. 9. the statute of limitations remains suspended until the irs acknowledges the withdrawal of an offer in compromise. united states v. donovan, 92 a.f.t.r.2d 2003-6762 (6th cir. 10/31/03). form 656, on which an offer in compromise is submitted provides that the statute of limitations is suspended "while the offer is pending (see (m) above).., and for one additional year beyond each of the time periods identified in this paragraph." paragraph (m) provides: "the offer is pending starting with the date an authorized irs official signs this form and accepts my/our waiver of the statutory periods of limitation. the offer remains pending until an authorized irs official accepts, rejects or acknowledges withdrawal of the offer in writing." the court of appeals (judge boggs) held that when the taxpayer withdrew his offer on april 18, 2000, the statute of limitations continued to be suspended until the irs acknowledged the withdrawal on april 28, 2000. as a result, the statute of limitations expired the day after the suit for collection was filed, not nine days earlier. f. liens and collections 1. a qdro creates an interest in a pension fund that trumps a later federal tax lien. united states v. taylor, 338 f.3d 947,92 a.f.t.r.2d 20035606,2003-2 u.s.t.c. 50,636 (8th cir. 7/31/03). when the irs attempted to levy on a delinquent taxpayer's pension fund, his ex-wife, who had an interest in the fund under a valid qdro, intervened. the court (judge riley) held that as a result of the qdro, the ex-wife was a "judgment lien creditor" with a perfected interest, [vol.6:sl recent developments in federal income taxation regardless of whether she had satisfied state law perfection requirements. furthermore, a modification of the qdro related back to the date of the original qdro. accordingly, her claim had priority over a subsequent federal tax lien. 2. the taxpayer won the procedural battle but lost the substantive war. washington v. commissioner, 120 t.c. 114 (3/6/03). in a reviewed opinion by judge chiechi, the tax court held (majority of 8, with 7 judges concurring) that in a § 6330 due process hearing, the tax court has jurisdiction to determine whether the u.s. bankruptcy court previously had discharged the taxpayers from unpaid income tax liabilities for the years in question. [the bankruptcy court order simply provided "the debtor is released from all dischargeable debts."] ps the taxpayer lost on the merits. 3. it can be expensive to seek judicial review of a §§ 6320/6330 due process hearing primarily for purposes of delay. roberts v. commissioner, 329 f.3d 1224, 91 a.f.t.r.2d 2003-1673, 2003-1 u.s.t.c. 50,359 (11th cir. 3/13/03), affg 118 t.c. 365 (5/3/02). in reviewing the appeals officer's decision in a §§ 6320/6330 due process hearing that collection of a tax shown on the return but not paid was warranted, judge chiechi held that a computer generated record of assessment on form racs 006 complied with the requirements of reg. § 301.6203-1; a signed assessment certificate, form 23c, is not required. a $10,000 penalty under § 6673(a)(1) was imposed on the taxpayer for petitioning for review of the §§ 6320/6330 due process hearing primarily for purposes of delay. the court of appeals affirmed, finding the taxpayer's due process claims without merit and that the tax court did not abuse its discretion in imposing sanctions. 4. administrative levy on property held as tenants by the entirety for one spouse's tax liability is ok. hatchett v. united states, 330 f.3d 875, 91 a.f.t.r.2d 2003-2457, 2003-1 u.s.t.c. 50,504 (6th cir. 6/4/03). the sixth circuit held that pursuant to craft v. united states, 535 u.s. 274 (2002) [holding that under § 6321 a tax lien for one spouse's tax liability attached to that spouse's interest in real property held with his wife an tenants by the entirely], the irs had to power under § 6331 to levy on the taxpayer-husband's interest in real property held as tenants by the entirety by seizing and selling the entire property and accounting to the wife for her interest. 5. timeliness counts. herrick v. commissioner, t.c. memo. 2003167 (6/9/03). special trial judge armen held that where the taxpayer fails to file a timely request for a collection due process hearing, the tax court lacks jurisdiction to review a the irs's decision in a "decision letter" following an "equivalent hearing." it was irrelevant that the irs had erroneously advised the taxpayer that he had been granted an extension of time to request the due process hearing, because kennedy v. commissioner, 116 t.c. 255 (2001), held that the commissioner is not authorized to waive the time period requirements in § 6330. 6. you have a right to make an oral recording of the frivolous arguments you make in a due process hearing, even if you can't do so in an ordinary appeals conference. keene v. commissioner, 121 t.c. 8 (7/8/03). in a reviewed opinion (judge dawson) adopting the opinion of special trial judge armen, the tax court held that § 7521(a)(1) provides taxpayers the right to audio 20041 florida tax review record a § 6330 due process hearing. several concurrences pointed out that the holding did not invalidate any other irs procedures or regulations regarding the ordinary appeals process. * judge chiechi (joined by judge cohen and swift) dissented on the grounds that § 7521 was intended to apply only to the in-person audit interviews and the in-person collection interviews that existed in 1988, when § 7521 was enacted, and did not intend the provision to apply to voluntary conferences initiated by taxpayers "conducted in an informal setting in order to review and consider actions taken by the examination division or the collection division of the irs and to discuss the facts and the law relating to such actions for the purpose of settling or resolving those matters without resort to litigation." * judge swift dissented on the grounds that the taxpayer had raised only frivolous argument and should not be permitted to complain about procedural questions to further delay the proceedings. 7. sometimes it's a return, sometimes it isn't. swanson v. commissioner, 121 t.c. 111 (8/28/03). a substitute for a return prepared by the irs pursuant to § 6020 is not a return for purposes of § 523(a)(1)(b) of the bankruptcy act. because the taxpayer had not filed any returns for the year in issue, he was not discharged from his income tax liabilities by the discharge in bankruptcy. 8. procedures for submitting an offer in compromise. rev. proc. 2003-71, 2003-36 i.r.b. 517 (9/8/03). this revenue procedure explains the procedures for submitting an offer in compromise, and the procedures followed by the irs in processing the offer. it is effective as of 8/21/03, except the fee provisions, which are effective 11/1/03. 9. rev. rul. 2003-108,2003-44 i.r.b. 963 (11/3/03). for purposes of § 6323(a), a purchaser, holder of a security interest, mechanic's lienor or judgment lien creditor is protected against a statutory tax lien for which a notice of federal tax lien has not been filed notwithstanding actual knowledge of the statutory tax lien. 10. montgomery v. commissioner, 122 t.c. no. 1 (1/22/04). because no deficiency notice is issued when the irs attempts to collect unpaid taxes shown as due on the return filed by the taxpayer, at a § 6330 collection due process hearing the taxpayer may challenge the existence or amount of the tax liability reported on the original tax return. the taxpayer's did not have any other opportunity to "contest" the liability. g. innocent spouse 1. a limitation on claiming the assessment is barred by the statute of limitations. block v. commissioner, 120 t.c. 62 (1/23/03). judge ruwe held that he tax court's jurisdiction under § 6015(e) to review the commissioner's denial of innocent spouse relief pursuant to a stand alone petition does not permit the taxpayer seeking innocent spouse relief to raise other substantive or procedural claims (e.g., the statute of limitations on assessments). [vol6:si recent developments in federal income taxation 2. appeal rights for taxpayers seeking relief under § 66. rev. proc. 2003-19, 2003-5 i.r.b. 371 (2/3/03). this revenue procedure provides guidance regarding administrative appeal rights of a taxpayer seeking relief from tax liability under § 66(c). [section 66(c) provides relief for a spouse who does not file a joint return, and does not know of or include in income certain items of community income attributable to the other spouse, if it would be "inequitable" to include the items in the innocent spouse's gross income.] 3. sorry kathryn, the tax court is indeed a court of limited jurisdiction. bernal v. commissioner, 120 t.c. 102 (2/20/03). the taxpayer, a resident of a community property state, sought relief under § 66(c) from tax liability for community income earned by her spouse, from whom she lived apart and was in the process of divorcing and with whom she did not file a joint return. the commissioner denied the relief. and the taxpayer filed a stand-alone petition for review of the commissioner's decision. the tax court dismissed the petition because § 66(c) does not contain a provision parallel to § 6015(e) providing for review by the tax court of the commissioner's decision not to grant innocent spouse relief: 'there is nothing in the statute or legislative history from which we could conclude that congress intended to provide independent ("stand alone") review by the tax court of the denial of a claim for relief under section 66." 4. innocent spouse relief for the dead. rev. rul. 2003-36,2003-18 i.r.b. 849 (5/5/03). an executor may pursue an existing § 6015 request for innocent spouse relief made during decedent's lifetime, and he has authority under § 6903 to file a request for innocent spouse relief under § 6015 "as long as the decedent had satisfied any applicable requirements while alive." 5. "[s]ince refunds are included in the relief provided under section 6015,... a request for relief under section 6015 encompasses a request for a refund of tax to the extent permitted under section 6015." washington v. commissioner, 120 t.c. 137 (4/21/03). the taxpayer and her then husband filed a joint return for 1989, reflecting her salary income and his self-employment income, that showed tax owed, but did not pay the tax, beyond the wage withholding on the taxpayer's salary. the irs garnished the taxpayer's wages and applied overpayments of her tax from 1992 and 1994-98 to the unpaid 1989 tax liability. the irs denied the taxpayer's request for § 6015 equitable relief. judge jacobs held that the irs had abused its discretion because it had not taken into account the extent of the economic hardship that the taxpayer would suffer if relief were not granted and the facts established that the unpaid tax was attributable to the taxpayer's former husband's income and she had no knowledge of reason to believe at the time the returns was signed that he would not pay it. no factors in rev. proc. 2000-15, 2000-1 c.b. 447 or reg. § 301.6343-1 weighed against granting relief. the court also rejected the irs's argument that even if the taxpayer was entitled to relief under § 6015(f), the provision did not apply to the portion of the tax liability that was paid on or before july 22, 1998 [the date of enactment of internal revenue service restructuring and reform act of 1998], for which she was seeking a refund. section 6015 applies to the full amount of any preexisting tax liability for a particular taxable year, if any of that liability remained unpaid as of july 28, 1998, and not just to the portion of tax liability that remained unpaid thereafter [following flores v. united states, 51 fed. cl. 49 (2001)]. however, 20041 florida tax review pursuant to § 6015(g)(1) the taxpayer's right to a refund was limited to amounts for which claims were filed within the periods in § 6511 in this case amounts paid within two years prior to filing the refund claim. taxpayer's letters to a revenue officer seeking to have her account placed on "uncollectible status" and requesting abatement of interest and penalties on the grounds that her husband owned the taxes constituted a sufficient informal refund request. 6. the tax court is the chancellor under § 6015(f). wiest v. commissioner, t.c. memo. 2003-91 (3/27/03). the commissioner's denial of § 6015(f) equitable innocent spouse relief was arbitrary where only $900 of a $4,162 underpayment (after wage withholding) was attributable to the requesting spouse's income, and the nonrequesting spouse had handled the preparation and filing of the return. in light of the nonrequesting spouse's "pattern of deception," the taxpayer had no reason to know that she would not pay the tax shown on the return, and the irs erred in treating signing the return as knowledge or reason to know that the tax would not be paid. furthermore, the irs's calculation of the taxpayer's share of the unpaid tax was arbitrary. 7. you might be able to wriggle out of a closing agreement under the power of § 6015. hopkins v. commissioner, 120 t.c. 451 (6/30/03). the taxpayer-wife (yvonne) filed a request for innocent spouse relief under § 6015 with respect to 1982 and 1983. the taxpayers had reported losses from a partnership for those years; in 1988 they signed a closing agreement under § 7121 with respect to adjustments relating to the deductions. in a subsequent bankruptcy the taxpayer-wife sought innocent spouse relief under former § 6013(e), but the bankruptcy court, in a decision that was affirmed [in re hopkins, 146 f.3d 729 (9th cir. 1998)], held that the closing agreement precluded innocent spouse relief. in the instant case the commissioner argued that the closing agreement precluded a claim for relief under § 6015, and also argued that resjudicata and collateral estoppel precluded the taxpayer's claim. judge ruwe held that a closing agreement entered into prior to the effective date of § 6015 does not preclude the taxpayer from seeking § 6015 innocent spouse relief, which may be available for any tax that remained unpaid as of 6/22/98. nor did resjudicata or collateral estoppel preclude the claim. 8. when they both have income and erroneous deductions, how do you apportion liability? hopkins v. commissioner, 121 t.c. 73 (7/29/03). mr. and mrs. hopkins filed a joint return on which he claimed erroneous deductions passed-through from a partnership and she claimed erroneous nol deductions. mrs. hopkins (marianne) was denied innocent spouse relief under § 6015(b), but was granted some apportioned liability relief under § 6015(c). she was granted relief from tax liability attributable to mr. hopkins' erroneous partnership deductions except for the portion, if any, that offset her income. she was liable for any deficiencies attributable to her erroneous nol deductions to the extent they offset her income, but she was relieved of liability for any remaining portion of the deficiencies attributable to the nol that offsets his income. decision was entered under rule 155. 9. but you can't wriggle out of a priorjudgment in a stand alone innocent spouse petition. just one bite at the innocent spouse apple. thurner [vol6:si recent developments in federal income taxation v. commissioner, 121 t.c. 43 (7/11/03). judge cohen held that a taxpayer who had failed to raise a innocent spouse claim in a prior district court proceeding instituted by the irs to reduce an assessment to judgment was barred by res judicata from raising the claim in a stand alone petition if the taxpayer participated meaningfully in the prior action. because mr. thurner had meaningfully participated, his claim was barred; whether mrs. thurner had materially participated could not be determined on a motion for summary judgment. on another issue, the court held that § 6015 relief is not available for tax liabilities that had been paid prior to 6/22/98. 10. community property income on separate returns. t.d. 9074, treatment of community income for certain individuals not filing joint returns, 68 f.r. 41067 (7/10/03). the treasury has promulgated final regulations under § 66, relating to the treatment of married individuals in community property states who do not file joint income tax returns. the regulations deal primarily with issues under § 66(c) [relief from community property rules]. the regulations apply only to community income, and provide that the law of the state in which the taxpayer is domiciled determines whether income is community property. the regulations apply an item-by-item approach to § 66(c) relief, and provide that knowledge of the source of community income or the income-producing activity, without knowledge of the specific amount of income, is sufficient knowledge to preclude relief. 11. "equitable relief" revenue procedure. rev. proc. 2003-61, 2003-32 i.r.b. 296 (7/24/03). rules for spouses requesting equitable relied from income tax liability under § 6015(f) or its community-property equivalent, § 66(c). 12. zoglman v. commissioner, t.c. memo. 2003-268 (9/12/03). the tax court denied § 6015(c) apportioned innocent spouse relief with respect to an understatement attributable to the taxpayer's spouse's omitted social security benefits because the taxpayer had actual knowledge of the amount of spouse's social security benefits. 13. principal purpose of separation was to transfer assets under the guise of state family law. ohrman v. commissioner, t.c. memo. 2003-301 (10/29/03). section 6015(c)(4) provides that an allocated liability election under § 6015(c) is ineffective to the extent of the value of property transferred from the spouse to whom an erroneous item is attributable to the spouse making the election, if the principal purpose of the transfer was tax avoidance. any transfer occurring after the date one year before the taxpayer receives a thirty-day letter proposing a deficiency is presumed to have the proscribed purpose regardless of its actual motivation, unless the transfer was pursuant to a divorce or separation and the taxpayer proves that it did not have the proscribed purpose. judge cohen held that a transfer of assets pursuant to legal separation within one year before taxpayers received a thirty-day letter, after which the spouses continued to reside together, was subject to the § 5015(c)(4) exception to apportioned liability because the principal purpose for the legal separation was to transfer assets under the guise of state family law. 20041 florida tax review 14. election not made within two years of first collection activity. campbell v. commissioner, 121 t.c. 290 (11/24/03). pursuant to §§ 6015(b)(1)(e) and (c)(3)(b) [and rev. proc. 2000-15, § 5, 2001-1 c.b. 447], an innocent spouse election must be made within two years of the irs's first collection activity against the individual making the election. in this case, judge foley held that an offset of an overpayment for one year as credit against an unpaid tax liability for another year, pursuant to § 6402(a), is a collection activity. as a result, the taxpayer's election was not timely. 15. ewing v. commissioner, 122 t.c. no. 2 (1/28/04). in a reviewed opinion by judge colvin, the tax court held that even though the standard for reviewing the commissioner's failure to grant equitable relief under § 6015(f) is abuse of discretion, the tax court's review is not necessarily limited to the facts that were in the administrative record. judges halpem, holmes, chiechi, and foley dissented. 16. they're literally dying to try to get § 6015(c) relief. jonson's estate v. commissioner, 118 t.c. 106 (2/8/02). in an innocent spouse case involving tax shelter deductions that was appealable to the tenth circuit, the tax court applied the ninth circuit's liberal standard from price v. commissioner, 887 f.2d 959 (9th cir. 1989), requiring only that a spouse seeking relief "establish that she did not know and had no reason to know that the deduction would give rise to a substantial understatement," on the basis of a favorable citation to price in an unpublished tenth circuit opinion. however, the tax court denied § 6015(b) relief because the spouse was well educated, active in her husband's financial affairs, had full knowledge of the facts of the investment, and benefited from the understatement. the deceased wife's personal representative [her husband] made a § 6015(c) apportioned liability election more than 12 months after her death [and the commissioner did not challenge the representative's procedural right to make the election], but § 6015(c) relief was denied. the personal representative "stepped into the shoes" of the deceased spouse, and she did not qualify for § 6015(c) relief because at the time of her death she and her husband were not divorced or separated and were members of the same household. although h. rept. no. 105559 at page 252, n.16 states that a taxpayer is no longer married if he or she is widowed, congress did not intend § 6015(c) to apply to the estate of a spouse who was "happily married" at the time of death. equitable relief under § 6015(f) also was denied. a. affirmed, but possibly on different grounds. 353 f.3d 1181,93 a.f.t.r.2d 2004-323,2004-1 u.s.t.c. 50,122 (10th cir. 12/30/03). the tenth circuit (judge hartz) affirmed, but the reasoning might [or might not be] slightly different. the court of appeals concluded that although the estate could perform the act of filing request for relief, it could not satisfy the condition that the "individual" seeking relief was "no longer married to" or "not a member of the same household as" the other the spouse. only an "individual" can meet that condition and an "individual" is a living being, not a decedent's estate. thus, there was no individual eligible for relief. [vol.6:si recent developments in federal income taxation h. miscellaneous 1. published guidance will be followed by the courts. rauenhorst v. commissioner, 119 t.c. 157 (10/7/02). taxpayers transferred warrants to four charities, which the charities sold shortly thereafter. at the time of the transfer, the taxpayers knew of a contemplated acquisition of the corporation. judge ruwe held that the taxpayers were not subject to tax on the charities' sale of warrants, under the anticipatory assignment of income doctrine, because rev. rul. 78-197, 1978-1 c.b. 83, holds that the anticipatory assignment of income doctrine is inapplicable to donated property where the charitable donees are not legally obligated, nor can they be compelled, to sell the contributed property. a. chief counsel reminds irs lawyers. chief counsel notice cc-2002-043 (10/17/02). the irs reminds chief counsel attorneys of the requirement to follow published guidance in papers filed in the tax court or in defense or suit letters sent to the department of justice. b. and again, this time with more specificity. chief counsel notice cc-2003-014 (5/8/03). clarifies the guidance of cc-2002-043 to provide specific rules regarding the requirement to follow published guidance. * rule 1: chief counsel attorneys may not argue contrary to final guidance; they should generally follow final or temporary regulations in force even if the service has subsequently issued proposed regulations which might yield a different result; 0 rule 2: proposed regulations have no legal effect unless and until they are adopted; proposed regulations should not be the subject of plrs and tams; 0 rule 3: if there are no final or temporary regulations, chief counsel attorneys may not take a position that is inconsistent with proposed regulations; * rule 4: perceived conflict between proposed regulations and final guidance (or between two or more pieces of nonregulatory final guidance) should be coordinated; 0 rule 5: case law invalidating or disagreeing with the service's published guidance does not alter rule 1 or 3; and 0 rule 6: the government's authority to resolve cases through settlement or other dispute resolution mechanisms remains unchanged, so long as the rules set forth above are not violated. 2. just how detailed a fimding on the burden of proof issue does the eighth circuit want the tax court to make? griffin v. commissioner, 315 f.3d 1017,91 a.f.t.r.2d 2003-486,2003-1 u.s.t.c. 150,186 (8th cir. 1/14/03), rev'g t.c. memo. 2002-6 (1/8/02). reversing the tax court, the eighth circuit, in a per curiam opinion, held that the taxpayer had introduced credible evidence that payments of real estate taxes on property owned by an s corporation in which he was a shareholder were made in his capacity as a proprietor of a business, not in his capacity as a shareholder. (if the payments had been made in his capacity as a proprietor they could have been deductible.) the court accepted the commissioner's definition of "credible evidence": "'the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision 20041 florida tax review on the issue if no contrary evidence were submitted (without regard to the judicial presumption of irs correctness)"', and found this standard satisfied by the testimony of the taxpayer and his accountant. the commissioner had cross examined the taxpayer's witnesses, but had not introduced any evidence. the case was remanded to the tax court for further proceedings to determine if the commissioner met the burden of proof, even though the tax court opinion, in a footnote, stated that its decision would have been the same if the commissioner had borne the burden of proof. perhaps tipping its hand that it wanted the taxpayer to win, the court of appeals admonished the tax court that "[i]f the same conclusion is reached by the tax court without a new hearing, an explanation is warranted as to how the existing record justifies the conclusion that the commissioner has met his burden of proof." 0 according to the tax court, the taxpayers did "not contend that the real property taxes in question were imposed upon them, that they owned the real property against which the taxes were assessed, or that they owned any equitable or beneficial interest in the real property that might entitle them to a deduction under section 164.... the only evidence regarding the nature of [taxpayers'] business activities consists of [one taxpayer's] summary and uncorroborated testimony. he testified, with little elaboration, that he has been a building contractor and land developer for about 30 years, during which time he has developed about one project a year. on cross-examination, he testified that his construction and real-estate development businesses are not separate businesses, but are 'all tied together. they're all any business i have is if i if they are oftentimes i incorporate, because of the liability aspect. they are subchapter s if they are.' . . . [t]here is no credible evidence that the tax payments were made with respect to such activities. to the contrary, [taxpayer's] accountant testified that the tax payments were reported on schedule e because they were attributable to [his] s corporations.... [taxpayers] failed to introduce credible evidence to establish that [taxpayer's] failure to make the tax payments would have caused direct and proximate adverse consequences to any businesses conducted in [taxpayers'] individual capacities. [one taxpayer] testified that he made the tax payments 'in order to preserve my integrity and my standing with the bank, and my good name, my goodwill.' there is no evidence to indicate, however, to what extent [the taxpayer's] failure to make the tax payments would have resulted in any damage to his reputation or creditworthiness. [taxpayers] have introduced no credible evidence to show that petitioner made the tax payments to protect the reputation of any business operation conducted in [their] individual capacities. on the basis of [taxpayer's] testimony, we are unable to conclude that the tax payments would have represented ordinary expenses to advance any business carried on in [taxpayers'] individual capacities, as opposed to capital outlays to establish or purchase goodwill or business standing...." 3. burton kanter in trouble again. investment research associates, ltd. v. commissioner, t.c. memo. 1999-407 (12/15/99). in a 600-page opinion burton kanter was held liable for the §6653 fraud penalty by reason of his being "the architect who planned and executed the elaborate scheme with respect to the kickback income payments .... in our view, what we have here, purely and simply, is a concerted effort by an experienced tax lawyer [kanter] and two corporate executives [claude ballard and robert lisle] to defeat and evade the payments of taxes and to cover up their illegal acts so that the corporations [vol.6:sl recent developments in federal income taxation [employing the two corporate executives] and the federal government would be unable to discover them." a. so far, he is unable to wriggle out, the way he did 25 years ago when he was acquitted by a jury.0 the taxpayers subsequentlymoved to have access to the special trial judge's "reports, draft opinions, or similar documents" prepared under tax court rule 183(b). they based their motion on conversations with two unnamed2' tax courtjudges that the original draft opinion from the special trial judge was changed by judge dawson before he adopted it, they were turned down because the tax court held that the documents were related to its internal deliberative processes. see, tax court order denyingmotion, 2001 tnt 23-31 (4/26/00) and (on reconsideration) 2001 tnt 23-30 (8/30/00). taxpayers sought mandamus from the fifth, seventh and eleventh circuits, but were unsuccessful. b. and the tax court's procedures are vindicated and taxpayer ballard loses on appeal on the fraud issue in the eleventh circuit. ballardv. commissioner 321 f.3d 1037,2003-1 u.s.t.c. 50,246,91 a.f.t.r.2d 2003-928 (11 th cir. 2/13/03), affg t.c. memo. 1999-407. the eleventh circuit affirmed the tax court decision and rejected the taxpayers' argument that changes allegedly made by the tax court special trial judge were improper. judge fay stated: even assuming dick's [taxpayers' lawyer's] affidavit to be true and affording petitioners-appellants all reasonable inferences, the process utilized in this case does not give rise to due process concern. while the procedures used in the tax court may be unique to that court, there is nothing unusual about judges conferring with one another about cases assigned to them. these conferences are an essential part of the judicial process when, by statute, more than one judge is charged with the responsibility of deciding the case. and, as a result of such conferences, judges sometimes change their original position or thoughts. whether special trial judge couvillion prepared drafts of his report or subsequently changed his opinion entirely is without import insofar as our analysis of the alleged due process violation pertaining to the application of [tax court] rule 183 is concerned. despite the invitation, this court will simply not interfere with another court's deliberative process. the record reveals, and we accept as true, that the underlying report adopted by the tax court is special trial judge couvillion's. petitioners-appellants have not demonstrated that 20. iis partner (and son-in-law) was convicted and imprisoned. see united states v. baskes, 649 f.2d 471 (7th cir. 1980), cert. denied, 450 u.s. 1000 (1981). 21. kanter's attorney revealed the names of the two judges when asked at oral argument to the seventh circuit as tax court judge julian jacobs and chief special trial judge peter j. panuthos. see the text at footnote 1 of judge cudahy's dissent in the seventh circuit kanter estate opinion, below. 20041 florida tax review the order of august 30, 2000 is inaccurate or suspect in any manner. therefore, we conclude that the application of rule 183 in this case did not violate petitioners-appellants' due process rights. accordingly, we deny the request for relief and save for another day the more troubling question of what would have occurred had special trial judge couvillion not indicated that the report adopted by the tax court accurately reflected his findings and opinion. c. and the tax court's procedures are vindicated and taxpayer kanter's estate2' loses on appeal on the fraud issue in the eleventh circuit estate of kanter v. commissioner, 337 f.3d 833, 92 a.f.t.r.2d 20035459,2003-2 u.s.t.c. 150,605 (7th cir. 7/24/03) (per curiam) (2-1), affg inpart and rev'g in part t.c. memo. 1999-407. the court found the nondisclosure of the special trial judge's original report to be proper, following the eleventh circuit's ballard opinion. it affirmed the findings on deficiencies, fraud and penalties, but reversed on the issue of the deductibility of kanter' s expenses for his involvement in the aborted sale of a purported john trumball painting of george washington because "kanter has shown a distinct proclivity to seek income and profit through activities similar to the failed sale of the painting." (1) the supremes will sing on kanter's grave. certiorari was granted. 124 s.ct. 2066 (4/26/04). d. and the tax court's procedures are vindicated but taxpayer lisle's estate wins on appeal on the fraud issue in the fifth circuit. estate of lisle v. commissioner, 341 f.3d 364,92 a.f.t.r.2d 2003-5566,2003-2 u.s.t.c. 50,606 (5th cir. 7/30/03), affg in part and rev'g in part t.c. memo. 1999-407. the fifth circuit (judge higginbotham) followed the eleventh and seventh circuits on the nondisclosure of the special trial judge' s original report by the tax court. it affirmed the findings of deficiencies, except for the deficiency in a closed year because the government's proof of lisle's fraud did not rise to the level of "clear and convincing evidence." 4. alleged settlement based upon appeals officer's mistake in computation is unenforceable. estate of halder v. commissioner, t.c. memo. 2003-84 (3/25/03). the tax court (judge vasquez) declined to enter decision on a settlement that was reached after an appeals officer faxed the estate's accountant a valuation that mistakenly listed the proposed value of a partnership interest as $1 million [its 1987 value], as opposed to $1,124,410 [its value as of the 1997 date of death]. the tax court ruled that the appeals officer's offer was based upon a mistake, so that there was no meeting of the minds between the parties. in a footnote, judge vasquez also noted: even if we held there was a meeting of the minds, we would deny the estate's motion because the "settlement" was never signed or approved by, or even submitted to, any irs official 21. burton kanter died on october 31, 2001. [vol.si recent developments in federal income taxation authorized to approve it. gardnerv. commissioner, 75 t.c. 475, 479 (1980). 0 the accountant advised the estate's lawyers and beneficiary of the mistake and was advised by them not to inform the appeals officer, but instead to accept the $1 million offer. 5. the regulations say i have to file this document at an irs office that no longer exists. notice 2003-19,2003-14 i.r.b. 703 (3/19/03). this notice provides guidance on the proper locations for filing elections, statements and the like following the irs reorganization. the notice provides that, pending issuance of revised regulations, if a taxpayer files a document as directed in existing regulations, the service will forward it to its proper filing location. 6. strong v. commissioner, t.c. memo. 2003-87 (3/25/03). in response to an irs reconstruction of the taxpayer's income using the bank deposit method, the taxpayer claimed that he had held a $165,000 cash hoard at the beginning of the period under examination, even though he had asserted in a bankruptcy petition that he had no such cash at that time. the commissioner moved for summary judgment on the issue of the existence of the cash hoard on the grounds that the taxpayer was estopped from claiming its existence, but the court (judge panuthos) denied summary judgment on the grounds that there were genuine material issues of fact regarding the reason for the omission of the cash hoard from the bankruptcy petition that might affect the application of estoppel. 7. the tefra notice wasn't an unauthorized disclosure even if some of the recipients turned out not to be partners. abelein v. united states, 323 f.3d 1210, 91 a.f.t.r.2d 2003-1476, 2003-1 u.s.t.c. 50,331 (9th cir. 3/27/03). the taxpayer, an investor in a tax shelter partnership of which the irs was conducting a tefra audit, claimed the mailing of final partnership administrative adjustment (fpaa) forms to all persons who the irs believed might have been partners entitled to notice improperly disclosed confidential tax return information because some notices went to people who were not partners. there was no doubt that return information had been disclosed, but the irs argued that the § 6103(h)(4) exception for disclosure in administrative proceedings applied. the court of appeals (judge fernandez) held that the administrative proceeding exception applied because (1) the taxpayers were parties to the administrative proceeding, and (2) under § 6231 the irs must notify all persons who the irs believes to be partners in the partnership undergoing the tefra audit. 8. sign the form 870 and sue for a refund. smith v. united states, 328 f.3d 760, 91 a.f.t.r.2d 2003-1919, 2003-1 u.s.t.c. 50,396 (5th cir. 4/16/03), rev'g 2002-1 u.s.t.c 50,409 (s.d. tex. 4/1/02), corrected by 2003-1 u.s.t.c 50,176 (s.d. tex. 11/22/02). the taxpayer, whose deficiency was determined in a partnership level proceeding, could seek refund of penalties after executing form 870 with phrase "settlement position" at top. although the taxpayer clearly waived right to file a tax court petition, neither form 870, nor accompanying "penalty report," which taxpayer also signed, clearly indicated that the taxpayer was his waiving right to contest the penalties through a refund claim. 20041 florida tax review 9. the aclu unsuccessfully tries to protect irwin schiff's right to pander fraudulent tax-scams. united states v. schiff, 269 f.supp.2d 1262,92 a.f.t.r.2d 2003-5047, 2003-2 u.s.t.c. 50,551 (d. nev. 6/16/03). the united states obtained an injunction against irwin schiff, an infamous fraudulent tax-scam promoter. schiff falsely stated that income earned by individuals is not subject to federal income taxes, advised customers to file zero-income tax returns, assisted them in submitting false w-4 forms to stop withholding taxes from wages, helped them prepare other fraudulent tax documents, and urged customers to inundate the irs, federal courts and department of justice with frivolous lawsuits and hearings. the first amendment did not prevent an injunction against the promotion of the tax scam though publication and sale of schiff s book, the federal mafia, even though the nevada aclu vigorously argued that schiff should not be censored. the irs identified nearly 5,000 zero-income federal income tax returns filed by approximately 3,100 of schiff's customers during the past three years using a twopage attachment referenced in the federal mafia. 10. you have a choice of forum for review of the commissioner's refusal to abate interest. beall v. united states, 336 f.3d 419, 92 a.f.t.r.2d 2003-5001, 2003-2 u.s.t.c. 50,551 (5th cir. 6/27/03). the fifth circuit (judge garwood) held that a district court has jurisdiction in a refund suit to review for abuse of discretion the commissioner's refusal to abate interest. judge garwood reasoned that the grant of jurisdiction to the tax court in § 6404(h) was not exclusive. xi. withholding and excise taxes a. employment taxes 1. is there a circular 230 issue lurking here? veterinary surgical consultants, p.c. v. commissioner, t.c. memo. 2003-48 (2/26/03). an s corporation failed to treat its sole shareholder/president/sole employee as an employee for employment tax purposes. the tax court (judge cohen) denied § 530 relief because the corporation had no reasonable basis for disregarding the explicit rules of § 3112(d)(1) and reg. §§ 31.3121(d)-1(b) and 31.3306(i)-1(e), treating corporate officers as employees. for the same result for earlier years, see veterinary surgical consultants, p.c. v. commissioner, 117 t.c. 141 (2001). * the taxpayer was a client of joseph m grey, a tax practitioner who suffered a similar fate with respect to his own s corporation in joseph m. grey public accountant, p.c. v. commissioner, 119 t.c. 121 (2002). 0 on the same day the tax court handed down five almost identical cases involving other clients of joseph m grey: mike graham trucking, inc. v. commissioner, t.c. memo. 2003-49 (2/26/03); superior proside, inc. v. commissioner, t.c. memo. 2003-50 (2/26/03); specialty transport & deivery services, inc. v. commissioner, t.c. memo. 2003-51 (2/26/03); nulook design, inc. v. commissioner, t.c. memo. 2003-52 (2/26/03); water-pure systems, inc. v. commissioner, t.c. memo. 2003-53 (2/26/03). 2. "nothing in the language or legislative history of section 530 leads us to the conclusion that denial of section 530 relief was meant to be an [vol6:si recent developments in federal income taxation additional penalty for the failure to timely rile information returns .... " medical emergency care associates, s.c. v. commissioner, 120 t.c. no. 15 (5/19/03). the taxpayer provided hospitals with emergency room physicians and treated those physicians as independent contractors. the taxpayer did not treat the physicians as employees for any period, filed all tax returns treating the physicians as independent contractors, and had a reasonable basis for not treating the physicians as employees. for the year in question however, the taxpayer filed the information returns after the due date (but before the audit). the commissioner denied § 530 relief because the taxpayer failed to timely file forms 1096 and 1099. rev. proc. 85-18, 1985-1 c.b. 518 states that the irs will not grant § 530 relief unless all forms 1099 have been timely filed. judge nims refused to follow rev. proc. 85-18 and granted relief, holding that the late filing of information returns did not preclude the taxpayer from obtaining relief. "nothing in the language or legislative history of section 530 leads us to the conclusion that denial of section 530 relief was meant to be an additional penalty for the failure to timely file information returns, particularly under the circumstances in this case." because the court was "unable to ascertain the thoroughness of the agency's consideration or the validity of its reasoning' it would not "defer to its requirement of timely filing as a prerequisite to section 530 relief ...... 3. both the taxpayer and the commissioner argued against tax court jurisdiction, but they were both wrong. charlotte's office boutique v. commissioner, 121 t.c. 89 (8/4/03). the commissioner asserted a deficiency for unreported employment taxes and additions to tax for 1995 through 1998, and the taxpayer petitioned the tax court under § 7436(a) for a determination of employment status. thereafter, the taxpayer conceded that the person whose status was in question for 1996 through 1998 was an employee, and the parties agreed that the tax court lacked jurisdiction over those years because the taxpayer did not dispute the employment status during those years. the commissioner argued that the tax court's jurisdiction under § 7436(a) extends only to cases in which a taxpayer asserts that an individual performing services for the taxpayer is a nonemployee and the commissioner has determined that the individual is an employee. the tax court (judge laro) held that the agreement of the parties as to jurisdiction is not dispositive. section 7436(a) confers not only jurisdiction to determine whether an individual providing services is an employee, but also whether an employer is entitled to relief under § 530 of the revenue act of 1978, and the correct amounts of employment taxes. the court went on to find that purported royalties were wages, that § 530 relief was not available, and that penalties were warranted. b. self-employment there were no significant developments regarding this topic during 2003. c. excise taxes there were no significant developments regarding this topic during 2003. 20041 florida tax review xh. tax legislation a. enacted 1. the jobs and growth tax relief reconciliation act of 2003 ("jgtrra" or the "2003 act"), pub. l. 108-27, 117 stat. 752 was signed by president bush on 5/28/03. 0 the 2003 act accelerated the effective dates of a number of the income tax provisions enacted in the economic growth and tax reconciliation act of 2001 (the "2001 act"), most significantly, the reduction of the upper level income tax rates. the 2003 act also decreased corporate and other business taxes through preferential depreciation deductions, and significantly reduced the tax rate on long-term capital gains. finally, and most dramatically, the 2003 act significantly reduced the tax rate on dividends received on corporate stock, taxing such dividends at the same preferential low rates that apply to long-term capital gains. many of the changes in the 2003 act are scheduled to sunset after three or four years, and those that are not scheduled for an earlier sunset, will sunset on 12/31/10, like all of the changes in the 2001 act. 2. the military family tax relief act of 2003, pub. l. 108-121, 117 stat 1335, was signed by president bush on 11/10/03. 3. the medicare prescription drug, improvement, and modernization act of 2003, pub. l. 108-173, 117 stat. 2066 was signed by president bush on 12/8/03. [vol6:si florida tax review volume 2 1996 number 12 assumption of contingent liabilities on sale of a business daniel halperin* i. introduction ....................... ......... 675 ii. outline of issues ............................... 676 iii. fixed liabilrrles-deferred compensation ......... 678 a. creation of liability ....................... 678 b. transfer of the liability ..................... 681 c. sale of the business ........................ 683 1. the facts ......................... 683 2. treatment of s ...................... 683 3. treatment of p ...................... 684 d. differences in tax and interest rates ........... 686 1. business not sold ................... 686 2. sale of the business .................. 688 iv. contingent liabilities included in basis .......... 688 a. determining whether a liability has been assumed . 689 b. amount of basis adjustment .................. 691 c. price adjustment for expected value ............ 693 d. price adjustment for amounts paid ............. 697 v. ignoring contingent liabilities .... a. the proposal ................ b. treatment of seller ............ c. treatment of buyer ............ * professor of law, georgetown university law center. i thank professor charlotte crane and michael schler for their comments on an earlier draft of this article. i am also indebted to my colleagues professors stephen cohen and martin d. ginsburg and to the participants at a seminar on current research in taxation sponsored by the harvard law school fund for tax and fiscal research, particularly professor alvin c. warren, for their suggestions. i further thank my research assistants, particularly steven clemens and jessica chun, for their help. florida tax review 1. equivalent of expensing ............... 702 2. carryover basis ..................... 703 d. when does it apply? ....................... 703 vi. evaluation and conclusion ..................... 706 a. the alternative of expensing by the buyer ........ 706 b. including assumed liabilities in basis ........... 707 1. estimated liabilities .................. 707 2. deferred basis adjustment ............. 708 c. resolving the issue ........................ 710 1. the seller ......................... 710 2. the buyer ......................... 711 d. a last word ............................. 711 appendix i ........................................ 712 append ix ii ........................................ 715 a. the employer ............................ 715 b. the employee ............................ 716 [vol 2:12 assumption of contingent liabilities on sale of a business i. introduction this article discusses the federal income tax consequences of a buyer's assumption of contingent liabilities in a taxable sale of the assets of a trade or business.' although judicial precedent remains scarce, several articles written over the past few years have considered this issue.2 nevertheless, the matter remains unsettled both as to the theoretically correct result and, perhaps, more importantly, as to what is required to achieve a workable solution. since the treasury apparently considers the treatment of contingent liabilities to be ripe for a regulation project,3 my hope here is to clarify the issues and to present the options in a comprehensive and orderly manner so as to facilitate a decision. although i do not describe current law in detail, i indicate where the possible approaches might differ from existing precedent and, therefore, to what extent it might be necessary to seek legislation a solution is made more difficult, in some circumstances, by the reintroduction of a substantial difference between the rates applicable to ordinary income and capital gains. an appreciation of the issue's ramifications requires a sophisticated understanding of the impact of what has been referred to as the "time value 1. the term "taxable sale" includes a deemed transfer of assets following a sale of stock under a § 338 election. under present law, taxpayers rarely make § 338 elections, and c corporations usually prefer tax-free reorganizations or stock sales to asset sales. see martin d. ginsburg & jack s. levin, mergers, acquisitions, and buyouts § 107.2, at 33 (1995). thus. the issues discussed here may arise mostly in connection with asset sales by sole proprietorships, partnerships, and s corporations. 2. see, e.g., kevin m. keyes, the treatment of liabilities in taxable asset acquisitions, 2 n.y.u. inst. on fed. tax'n ch. 21 (1992); charlotte crane, accounting for assumed liabilities not yet accrued by the seller is a buyer's deduction really costless? 48 tax notes 225 (july 9, 1990); committee on alternative minimum tax. n.y. state bar ass'n, report on the federal income tax treatment of contingent liabilities in taxable asset acquisition transactions, 49 tax notes 883 (nov. 19, 1990) [hereinafter nysba]; michael l. schler, sales of assets after tax reform: section 1060, section 338(h)( 10). and more, 43 tax l. rev. 605 (1988); robert r. wootton, mrs. logan's ghost: the open transaction doctrine today, 71 taxes 725 (1993); alfred d. youngwood, the tax treatment of contingent liabilities in taxable asset acquisitions, 44 tax law. 765 (1991). 3. see robert j. wells, officials discuss corporate inversions guidance, 67 tax notes 1419 (june 12, 1995). 4. contrast the conflicting views of alfred d. youngwood and the nysba as to their similar proposals. youngwood suggests legislation is necessary, while the nysba declares it is not. nysba, supra note 2, at 885; youngwood, supra note 2, at 782. the nysba, however, would modify its proposal in those few situations where there is clear judicial precedent to the contrary. nysba, supra note 2, at 884. 19961 florida tax review of money, ''5 including the role of "matching" of income and deductions (to compensate for an error in the treatment of one of the parties) and the fact that changing the timing of income inclusions or deductions need not affect the value of the item if interest and tax rates do not change.6 i hope to show that the approach of ignoring contingent liabilities, which is advanced by some and is described in part v, is more generous than its supporters might appreciate and that the difficulties and potential for abuse inherent in taking account of contingent liabilities, while significant, are not as great as some might fear. these conclusions derive from my belief that the present value of contingent liabilities is appropriately measured by discounting the expected payments at an after-tax rate of interest. a main goal of this article is to convince readers that this is correct. ii. outline of issues if a buyer assumes liabilities on the acquisition of a business, the amounts of cash and other consideration is reduced accordingly. instead of the assumption, the buyer could pay more cash, and the seller could use a portion of the cash to pay its debts. the buyer could raise the extra cash by borrowing to replace the liabilities paid by the seller. an assumption should produce tax results that are reasonably consistent with those of an all-cash purchase. it is helpful to divide liabilities into two categories. the first is where the seller obtains a tax attribute upon incurring the liability. in most situations, a taxpayer borrowing funds or incurring a liability either is allowed a deduction or an increase in the basis for its assets or obtains cash which can be used to pay a deductible expense or purchase an asset. payment of the liability has no tax consequences, aside from the deduction for interest.7 borrowing from a bank is used in this article as an example of this type of liability. 5. see generally daniel i. halperin, interest in disguise: taxing the "time value of money," 95 yale l.j. 506 (1986). 6. for a general description of this recurring phenomenon, see alvin c. warren, jr., the timing of taxes, 39 nat'l tax j. 499 (1986). 7. the treatment of these liabilities is straight forward, except where the face amount of the liability (more accurately, its adjusted issue price) differs from its fair market value. this occurs if the applicable interest rate has changed since the debt arose. see generally keyes, supra note 2, § 21.03[2][c]; alvin h. shrago, the uncertain tax treatment of liabilities in corporate acquisitions, 2 n.y.u. inst. on fed. tax'n ch. 19 (1994); schler, supra note 2, at 648-51. a question may also arise when there is an assumption of nonrecourse liabilities which, when added to the other consideration paid, exceed the value of the assets transferred. discussion of these issues is generally beyond the scope of this article, but there is a brief synopsis in appendix i. [vol 2:12 assumption of contingent liabilities on sale of a business second, a seller may have a liability that has accrued economically, in the sense that the value of the business is diminished, without obtaining either a deduction or an addition to basis.8 this may occur because the liability is too contingent to be recognized for tax purposes,9 because of matching rules that require payment before a deduction may be taken,"0 because of the economic performance rules," or because the seller is on the cash basis. in this second situation, a future event, perhaps payment, may, in the absence of the buyer's assumption, have resulted in a deduction or basis addition for the seller. in this article, a deferred compensation arrangement is used to illustrate a liability of this kind. deductions are sometimes deferred in order to facilitate more accurate measurement. for example, where there is a long delay until payment, it may be desirable to delay the deduction to avoid the problem of "discounting.' ' as discussed below, deferral is also often intended to over-tax the payor to compensate for a deferral of the intended payee's recognition of income. in the latter situation, if the payor's sale of the business has the effect of causing its income to be accurately measured, the seller is no longer over taxed, and it may be appropriate to transfer this burden (the equivalence of a delayed deduction) to the purchaser. ideally, in order to achieve consistency with an all-cash transaction, the amount of the liabilities assumed in a taxable sale of a business should, in all circumstances, be added at the time of the sale to both the amount realized by the seller and the purchase price. payment of the liability should have no tax consequences. with respect to the first category of liabilities (the bank loan), but not the second (the deferred compensation arrangement), a buyer should be entitled to a deduction for interest accrued after the sale. in the second situation, if the seller, in the absence of the sale, would have been entitled to a deduction upon payment of the liability (or another future event), it should be granted a deduction at the time of the sale. these conclusions are described and discussed in part iv. some have recommended that for practical reasons, an assumed contingent liability should not be included in either the selling price or the 8. see keyes, supra note 2, § 21.02[1]. 9. under the all events test, contingent liabilities are not deductible because all of the events that determine the fact of liability have not occurred. regs. § 1.461-1(a)(2)(ii). 10. for example, under § 404(a)(5). deferred compensation that is not part of a qualified plan cannot be deducted until it is included in the employee's gross incomegenerally when paid. see also irc § 267(a)(2) (denying a deduction for liability to a related party until the "amount is includible in the gross income of the person to whom the payment is made"). 11. under § 461(h), enacted in 1984, no deduction may be taken for an accrued liability before "economic performance," often payment, has occurred. 12. see ford motor co. v. commissioner, 102 t.c. 87. 100-01 (1994). 19961 florida tax review buyer's basis for the assets and that the buyer should instead step into the seller's shoes, being allowed a deduction at the time and in the amount that the seller would have been entitled to had the sale not taken place. this proposal is discussed in part v. the main thrust of this article is to consider the appropriateness of this proposal as compared to treating contingent and fixed liabilities in the same way. my conclusions are summarized in part vi. i begin in part iii with a discussion of the appropriate treatment of fixed liabilities in the second category. ih. fixed liabilities-deferred compensation a. creation of liability initially, it is assumed that the parties can always earn 10% interest and are always subject to a 40% tax rate. complexities caused by differences in or changes to the interest rate or the tax rate are introduced at a later point. assume edwards (e), an employee of standard corp. (s), is entitled to salary of $100 on the last day of year 1. if e is paid currently and deposits her after-tax earnings with bank b, she will, if tax on the interest is paid from the account, have a balance of $63.60 on the last day of year 2. wages $100.00 tax at 40% 40.00 net wages 60.00 interest at 10% 6.00 tax at 40% 2.40 net interest 3.60 balance $ 63.60 suppose s and e agree to defer her salary for one year, until the last day of year 2. if e uses the cash method (as is almost invariably the case for employees), she is taxed on the salary, and s can deduct it, only when payment is made and received.' 3 if s is willing to pay the same rate of interest as bank b, e will have $66 after tax. wages year 1 $100.00 plus 10% interest 10.00 deferred wages 110.00 tax at 40% 44.00 net $ 66.00 13. for e's recognition of income, see reg. § 1.451-1(a); rev. rul. 60-31, 1960-1 c.b. 174, modified, rev. rul. 64-279, 1964-2 c.b. 121 and rev. rul. 70-435, 1970-2 c.b. 100. for s's deduction, see irc § 404(a)(5). employees of tax-exempt organizations and governments might not be able to achieve deferral. irc § 457. [vol 2:12 assumption of contingent liabilities on sale of a business however, does the deferral of s's deduction until payment affect the interest it might be willing to pay? if s pays $100 to e immediately, it can deduct the payment for a tax savings of $40. if it invests this amount for one year, at its 6% after-tax return, this amount accumulates to $42.40 at the end of the year, as is shown in column i of table i. alternatively, if s sets aside $100 and earns 6% after-tax, it will have $106 after one year, and on payment and deduction of this amount, the tax savings will be $42.40, as shown in column ul. this suggests that s should be indifferent between immediate and deferred payment only if, in the deferral case, its liability increases by the after-tax rate of return (6%), rather than the 10% pretax rate. a year 2 payment of $106 also places e in the same position she would have had if she were paid in year 1. deferred wages $106.00 tax at 40% 42.40 net $ 63.60 thus, if the parties desire to maintain their economic positions, a deferred obligation should, in this context, bear interest at an after-tax rate. as i have argued elsewhere, this occurs because the deferral of the deduction is equivalent to an immediate deduction for the compensation and the denial of any deduction for the interest. 4 it may appear that the $106 deduction for the deferred compensation effectively includes $6 of deduction for interest. however, $106 in year 2 is equivalent in value to $100 in year 1 because the 6% after-tax interest rate merely compensates for the delay in the deduction. thus, s can be said to fully deduct the compensation, as if there were no delay, but be denied a deduction for interest. compare column ill where, even though payment is deferred, s is granted an immediate tax deduction of $100, saving $40. if no further deduction is allowed for interest, column el shows that despite the immediate deduction, s continues to be indifferent between an immediate distribution of $100 and a deferred distribution only if the liability increases by the 6% after-tax rate of return.' 5 14. see halperin, supra note 5, at 511, 522-23. this observation is the converse of the familiar point that an acceleration of a deduction is equivalent to a deduction at the appropriate time, coupled with a tax exemption for the income generated by the deducted item from the time of the accelerated deduction until the appropriate time for deduction. 15. for a detailed discussion of why the tax law may choose to defer the deduction in such a situation, see halperin, supra note 5, at 531-34. for one thing, if the agreement merely calls for a payment of a particular amount at a future time, determining the present value of that liability requires a determination of the appropriate interest rate. 19961 florida tax review table i i ii iii year i year 2 year 2 payment payment payment deferred immediate deduction deduction a. transfer to e or set aside 100 100 100 b. tax benefit from 40 40 deduction (40% of a) c. amount retained by s 40 100 140 d. pretax earnings (10% of 4 10 14 c) e. tax (40% of d) 1.60 4 5.60 f. net earnings (d-e) 2.40 6 8.40 g. available to s (c+f) 42.40 106 148.40 h. distribution to e -106 106i. tax benefit from year 2 no 42.40 no deduction payment deduction j. retained by s (g-h+i) 42.40 42.40 42.40 in sum, in the case of deferred compensation, the employer's deduction is deferred to compensate for (or match) the corresponding deferral of income by the employee. because of the deferral, the amount of the deferred payment is likely less than it would have been if the employer's tax, like the bank's, were accurately computed-that is, if in addition to an immediate deduction of $100 for compensation, s were allowed to deduct the interest accrued on its obligation. if s cannot deduct interest, it can be expected to compensate by accruing interest on the obligation to e at an after-tax rate. if e only earns interest at an after-tax rate, this offsets the tax advantage achieved by the employee through deferral. since, deferral of taxation is equivalent to tax exemption of investment income, if e earns an after-tax rate of return, she is in the same position as if she earned a pretax rate and investment income were taxable. [vol. 2:12 assumption of contingent liabilities on sale of a business nevertheless, many deferred compensation arrangements appear to provide pretax rates of interest to employees.' 6 this might occur because the employer is not currently subject to tax (e.g. as a result of a net operating loss deduction) or because the employer earns a much higher pretax rate of return than the employee. in the latter case, what appears to be a pretax rate of return from the employee's perspective accurately reflects the employer's after-tax earnings. this is discussed further below when i consider differences in interest and tax rates either over time or as between the parties. if the parties are subject to the same rates of interest and tax, an employer who credits interest at 10%, in lieu of 6%, is assuming a larger burden than if it paid $100 in current compensation. if, in line h in column ii of table i, s pays $110 to e and receives a tax benefit of $44, s's retention, at the end of one year, is $40 ($106-$110+$44), as compared to $42.40. the reduction of $2.40 is the after-tax cost of its additional payment of $4. thus, in these circumstances, s effectively continues to credit interest at 6% and has increased e's compensation to $103.77.' possibly the employer does not grasp the cost of providing a pretax return. more likely, it has a reason to increase compensation if the employee accepts deferral.'" b. transfer of the liability suppose on the last day of year 1, s, in connection with a sale of its business or otherwise, wishes to pay production corp. (p) to assume its obligation to pay e $106 on the last day of year 2. how much would s have to pay? the answer to this question would be reasonably clear if the obligation were an ordinary borrowing. assume s, on the last day of year 1, borrows $96.36 from bank b, agreeing to repay $106, including interest at 10%, in one year. if s pays p $96.36 to assume the debt to b, p can, by investing this amount at a pretax return of 10%, accumulate the $106 needed to pay b, provided that the interest paid to the bank is deductible, offsetting the interest income. 16. deborah rankin, the case for deferred compensation. n.y. times, jan. 25, 1987, § 3, at 11. 17. if $103.77 were paid as current compensation, the tax savings would be $41.51, which, if invested to earn 6% after-tax, would accumulate to $44 at the end of one year. put another way, $103.77 is the present value of sl10 in one year at 6%. 18. see daniel i. halperin, special tax treatment for employer-based retirement programs: is it "still" viable as a means of increasing retirement income? should it continue? 49 tax l. rev. 1, 8-10 (1993). 1996] florida tax review received from s interest income total $ 96.36 9.64 $106.00'9 taxable income interest income interest expense taxable income returning to the original case, if p could similarly deduct the interest on its payment to e, it would also agree to assume s's obligation to e for a payment of $96.36. but recall that e, in return for $106 of deferred compensation, agreed to defer wages of $100. s would have a windfall if it could relieve itself of this obligation by paying p only $96.36, at least if this payment is deductible as $100 of current wages would be. to put s in the same position as if it had paid current compensation, it would have to make a $100 deductible payment to p. however, p would have a windfall if it would not taxable be on the receipt of $100 from s and could deduct the interest owed to e. amount received interest at 10% total available payment to e taxes net to p $100.00 10.00 $110.00 $106.00 1.60 $ 2.40 interest income interest expense taxable income tax at 40% the key to preventing any advantage from the transfer of the liability lies in the fact that the postponing of s's deduction until payment is equivalent to an immediate deduction of $100 (which s gets if it can deduct the payment to p), with no additional deduction for interest. thus, in the simple world of uniform interest and tax rates, s can be allowed a deduction for the $100 payment to p (and p need not be taxable), as long as p is allowed no deduction for the payment of the additional $6 to e. it is, as noted above, the denial of the interest deduction, not the deferral, that is important. payment from s interest 10% amount available payment to e tax total payments $100.00 10.00 110.00 106.00 4.00 $110.00 taxable income interest deduction net taxable tax $9.64 9.64 -0$10.00 6.00 $ 4.00 $ 1.60 $10.00 -0$10.00 $ 4.00 19. arguably, p is taxable on the money received from s. if so, p would accept $96.36 as payment for its assumption of the liability only if it could claim an immediate offsetting deduction for its obligation to bank b and an additional deduction of $9.64 to reflect the increase in its obligation after one year. [vol. 2:12 assumption of contingent liabilities on sale of a business even if the interest deduction is denied, s might reap a net tax savings by transferring the liability to a tax-exempt p or to a p subject to a lower marginal rate of tax. denying p an interest deduction to compensate for the deferral of income by e is to no avail if p is tax-exempl therefore, s should generally not be allowed to accelerate its deduction by paying p to assume its liability.' however, as discussed below, in the context of a sale of a business, allowing s a deduction should be acceptable. c. sale of the business 1. the facts.--consider the following example, which again assumes the parties always earn 10% before tax and are always subject to tax at 40%. production corp. (p) plans to acquire the assets of standard corp. (s) on the last day of year 1. the assets have a basis of $200 and are worth $500. s has two liabilities: a. a $100 loan from bank b, which is due, together with 10% interest, in one year (the last day of year 2).2' b. deferred compensation of $106 due to edwards (e) on the last day of year 2. if s retains the liabilities to b and e, p will pay $500 for the business and s will pay b $110 and e $106 in one year. if p assumes the liabilities, s should receive only $300. the difference of $200 is, as described below, the present value of the liabilities-the amount s or p would have to expend to extinguish the debts at the time of the sale. whether it transfers $500 to s or reduces the payment to $300 to reflect the assumption of the liabilities, p effectively pays $500 for the assets. this should be its basis. similarly, in either event, s receives $500 (perhaps in part through liability relief), and its gain should be $300 ($500, less basis of $200). 2. treatment of s.-as just stated, if s sells for cash, part of which is used to pay its liabilities, it will have a $300 gain. nothing should change if p holds back part of the cash and assumes the debt. also, in both cases, s 20. if s can shift assets to a tax-exempt entity for more than one year, merely delaying s's deduction until p pays does not eliminate the advantage of avoiding tax on investment income. the investment income must be imputed to s despite the claimed transfer. 21. to make the example easier to follow, i have chosen here to hold the present value of the two obligations equal, at $100, with different amounts due in one year. in the previous section, to make the point, it was helpful for the amounts due in one year to be equal, which led to a difference in present value. 19961 florida tax review bears the economic burden of the payment to e, for which it has not yet obtained a deduction. either it receives $500 and pays $106 to e in year 2, or it suffers an equivalent $100 reduction in the purchase price.22 it should get a deduction that reflects its burden. if s retains the liability to e, there is no problem. it merely deducts $106 when it pays, just as it would if the business had not been sold. if p assumes the liability, s effectively pays $100 at the time of sale because the liability reduces the cash received for the business. s should get a deduction for this expenditure (or an addition to basis if the salary is capital rather than an ordinary business expense). while this accelerates the deduction as compared to the situation where the business is not transferred or s retains the obligation, the present value of the deduction is unchanged. a deduction of $100 at the time of the sale is mathematically and economically equivalent to a deduction of $106 one year later.23 as shown in the first column of table i, the $100 deduction produces a tax savings of $40, which if invested for one year at 10%, will accumulate to $42.40 after tax, the same amount that would be derived from a tax deduction of $106 for year 2. in the case of an expressly-assumed liability, the regulations, in accord with much of the case law, 24 allow a seller this deduction in some circumstances.2 the regulations provide that if a deduction would have been allowed but for the economic performance requirement, economic performance occurs as the seller takes account of the amount realized. unfortunately, because sections 404(a)(5) and 267 require inclusion of income by the payee as a condition for a deduction, when either of these sections applies, the irs may not be able to allow a deduction at the time of the sale without a change in the law.26 in addition, the economic performance regulations do not deal with contingent liabilities. 3. treatment of p.-if the assets are worth $500, p should pay $300 in cash if it assumes the liabilities to b and e. the liability assumption 22. if s receives $500, it should put $100 aside in order to meet its obligation to e, leaving it in the same position as if it received only $400. if s earns 10% interest and pays tax at a 40% rate, $106 will be accumulated at the end of one year. 23. see generally staff of joint comm. on tax'n, general explanation of the revenue provisions of the deficit reduction act of 1984, at 261 (1984) [hereinafter 1984 bluebook]; halperin, supra note 5, at 521-23, 531-34. compare irc § 468a. 24. keyes, supra note 2, §§ 21.03[l][a], 21.04[2][a][iii]; nysba, supra note 2, at 885-87 (discussion of support for this position); youngwood, supra note 2, at 772. 25. regs. § 1.461-4(d)(5), (g)(1)(ii)(c). 26. see priv. let. rul. 8939002 (june 15, 1989); irs technical advice memorandums, 45 tax notes 189-90 (oct. 9, 1989); keyes, supra note 2, § 21.04[2][a][iii]. 27. see regs. § 1.461-40) ("contingent liabilities. [reserved]"). [vol 2:12 assumption of contingent liabilities on sale of a business should be reflected in p's basis for the assets, which should be $500. 28 upon payment of the loan to b, p can deduct interest of $10. should p get a $6 interest deduction when it pays $106 to e?. as current law appears to require,' the answer should be no. because s' deduction for the deferred salary would, in the absence of a sale, have been delayed until payment, we have assumed that interest on the deferred amount effectively accrues at an after-tax rate of return (6%). denial of a deduction for the interest element is consistent with this assumption. if p reduces the amount it pays for the business by $100 to reflect its assumption of the liability to e, sets aside $100, earns 10% on this amount, and is subject to tax at 40%, it will, without any further deduction, accumulate the $106 needed to pay e.' if p could deduct the $6, it could fund the payment by setting aside less than $100,"' which results in a windfall. thus, p's payment to e should give rise to no further deduction even though p will pay $106, not $100.32 if the $6 is not deductible, the buyer's cash payment is reduced by $100 for each of the two liabilities, even though in one case p's payment one year later is $110 and in the other it is $106. both have the same present 28. it has been suggested that the rules deferring s's deduction until payment also require that the basis addition on account of the assumption be delayed until payment to e. see webb v. commissioner, 77 t.c. 1134, 1138-39 (1981). aft'd, 708 f.2d 1254. 1256 (7th cir. 1983); f&d rentals inc. v. commissioner, 44 t.c. 335. 349 (1965), aft'd, 365 f.2d 34, 41 (7th cir. 1966), cert. denied, 385 u.s. 1004 (1967); wootton, supra note 2, at 740. however, if s' deduction would have been delayed solely because of § 404(a)(5), it is arguable that since p is not claiming a deduction for compensation, this section should not apply. also, as discussed below in the text at note 70, a delay in the deduction need not be harmful to taxpayers if the basis addition is increased, here to s106 (s506 in total). 29. schler, supra note 2, at 671; wootton, supra note 2. at 740. 30. it is assumed that p is not taxed on the effective receipt of s200 (by way of a purchase price reduction) for its agreement to assume s's obligations to b and e. see commissioner v. oxford paper co. 194 f.2d 190 (2d cir. 1952): rev. rul. 55-675, 1955-2 c.b. 567. as discussed below in note 63, if p is taxed on the s100 related to the obligation to e, it should be allowed an offsetting deduction for its payment of s106. in present value. these two amount are equivalent. see also supra note 19 as to the loan to bank b. 31. if the deduction was denied to s solely because it is on the cash basis, the deferral of the deduction is not necessarily intended to compensate for a tax advantage to the payee, and conceivably the obligation bears an inherent pretax rate of return. thus, a buyer's interest deduction need not be denied if the sole reason for the delay is that the seller is on the cash basis. such a liability could be treated like the loan to bank b as far as the buyer is concerned. 32. if the buyer is in a lower tax bracket than the seller, there is an advantage, despite the denial of the deduction, because the lower tax rate reduces the detriment from the effective denial of the interest deduction. however, if the liability assumption is part of a sale of a business, we probably should not worry about a difference in tax bracket. see wootton, supra note 2, at 739; regs. § 1.461-4(d)(5)(iii). preamble at 57 fed. reg. 12,411 (1992). 19961 florida tax review value ($100), despite the difference in the payments, because they bear different rates of interest. the obligation to b bears a 10% rate of interest because the interest of $10 paid to b will be deductible by s or p. thus, if p holds back $100, earns $10 interest, and pays $110 to b, no tax will be due because the $10 of interest income will be offset by $10 of interest deduction, leaving the entire $110 available to pay the bank. in contrast, since the interest paid to e will not be deductible, p (like s) will pay e $106, not $110, because it must pay tax on the $10 it will earn on its investment. if p's expected liability to e were $110 rather than $106, it would hold back $103.77, not $100. d. differences in tax and interest rates 1. business not sold.-the discussion so far has been based on the unrealistic assumption of uniform interest and tax rates that never change. in reality, the parties may face different interest or tax rates, and these rates may change over time. if each party is taxed on its own economic income, the tax law need not concern itself with varying interest rates because whatever interest is earned or paid is taken into account in measuring income and taxed at the appropriate rate. but, in the situations discussed here, taxable income departs from economic income in two ways, and we need to consider whether this raises additional problems if interest or tax rates differ or change. first, effectively, interest income is not taxed to one party (e) and to compensate, the other party (s) is denied an interest deduction. this results in the correct amount of tax only if the parties pay tax at the same rate. it protects the revenue only if the payor is subject to tax at a rate at least as high as the payee. conversely, the transaction is over taxed if the payor is taxed at a higher rate. while the parties can avoid this situation, it is a cause for concern if it leads them to forego economically sensible transactions for which there is no easily available alternative. thus, this substitute or surrogate taxation of the employer in order to collect the employee's tax should be avoided unless there is no alternative.33 secondly, the tax rules achieve the impact on interest through the indirect means of deferral of deduction and income inclusion. the example in table i shows that if tax and interest rates are uniform and do not change, the deferral is equivalent to accounting currently for compensation and ignoring interest. this is true because the amount taken into account in the year of payment is equivalent in present value, at a uniform, unchanging interest rate, to the original compensation. thus, taxing and deducting the deferred amount is equivalent to taxing and deducting the compensation when 33. see halperin, supra note 5, at 544-50 (suggesting an alternative). [vol. 2:12 assumption of contingent liabilities on sale of a business earned. what remains to be considered is the extent to which this remains true when the assumptions of uniformity and permanence are relaxed. the compensation is taxed and deducted at the tax rate prevailing at the time of deduction and inclusion, rather than the rate when it was earned. 4 assume first that overall tax rates do not change, but the employer's or employee's marginal rate is nevertheless different because individual circumstances have changed. for an employee whose income drops significantly after retirement, this might be viewed as a form of lifetime income averaging, mitigating the impact of progressive rates. for the employer, something similar to averaging, the extension of the carryover period for net operating losses, may sometimes be said to occur. assume the employer has a net operating loss deduction for the year in which the compensation is earned and, but for the deduction for the deferred compensation, would have been taxed at a higher tax for the year of payment. in this case, the result of the deferred deduction is the same as if the deduction had been allowed in the earlier year and carried forward. it is not obvious that these results are inappropriate. if tax rates increase or decrease overall, matching may play a role. for example, concern over avoidance of high wartime rates through deferral of compensation may be mitigated by the fact that the employer must defer its deduction. if interest rates vary, either from party to party or over time, a party's after-tax rate of return may differ from the rate inherent in the arrangement. this could result from a change in interest or tax rates, or it could be an intended consequence of the original agreement. on the other hand, if the employer agrees to pay the amount it earns (after-tax) from a specified investment and it actually makes the investment, there is an identity between the employer's rate of return and the amount paid to the employee, even if rates change. appendix ii compares the effects of the immediate and deferred deductions when interest rates change. in sum, it appears that in the absence of a sale of the business, the potential of changes in interest rates or a difference between the interest rates of the employer or the employee and the rate inherent in the agreement is not a substantial cause for concern. however, the opportunity to exploit a difference between a higher tax rate applicable to the employee and a lower rate paid by the employer is a major weakness in this approach. 34. if the deferred compensation were immediately deductible and includible and the interest element were explicitly neither taxed nor deducted, the compensation would be properly accounted for at the appropriate tax rate. in addition, while the profitably of the transaction might be affected by an unanticipated change in the rate of return, the rate of return would, in the absence of a sale of the business, be irrelevant for tax purposes because, under this approach, interest is explicitly not taken into account. 19961 florida tax review 2. sale of the business.-if a sale results in a deduction for the seller without a corresponding income inclusion by the payee, the matching of income and deduction is violated. the foregoing discussion suggests that if the deduction is properly calculated and no deduction is allowed for subsequently accruing interest on the deferred liability, matching is primarily important as a check on the parties' ability to select a low tax year for the employee and a high tax year for the employer. if the seller can accelerate its deduction only in connection with a sale of a business, this may not be a serious concern. symmetry in the treatment of interest income and interest expense can be maintained through the buyer. in the earlier discussion, it is assumed that the interest rate available for the buyer's investments is the same as the rate inherent in the deferred compensation agreement and that the present value of the obligation is known. in that case, to continue to match the treatment of the employee, the buyer should get basis equal to the present value of the assumed liability and should not get a deduction for any additional amount paid. how should this be affected if the buyer can earn a higher (or lower) rate of return than is inherent in the obligation? if present value is determined with an interest rate that is higher than the rate under the agreement, the amount of liabilities assumed, and hence the purchase price, is overstated. for the seller, the amount realized on sale is overstated as is the offsetting deduction for compensation, but this is not a problem unless capital gains are specially treated. for the buyer, however, the purchase price-the buyer's basis-is inflated at no cost because the overstatement of the liability means there is a corresponding understatement of nondeductible interest. thus, establishing the correct interest rate is more important here than it is with respect to liabilities for which the seller has obtained tax attributes.35 however, under current practice, a change in interest rate from that reflected in the agreement is presumably not taken into account. iv. contingent liabilities included in basis all contingent liabilities fall into the second of the two categories described in part fl-typified by the deferred compensation arrangementbecause the seller is allowed no deduction, basis, or other tax attribute until 35. for example, with respect to the liability to bank b, a discount rate lower than the interest rate on the loan causes an overstatement of the purchase price and an understatement of deductible interest. see text accompanying infra note 123. the same thing happens here, but the shift is more serious since it is from nondeductible interest to amortizable purchase price. [vol 2:12 assumption of contingent liabilities on sale of a business the contingency is resolved. 36 thus, i believe that the treatment of contingent liabilities should in principle be the same as that applied to the liability to e, including denying an interest deduction to p. the difficulty of this approach might depend upon how two ancillary issues are resolved. first, must the basis adjustment be made at the time of purchase, or can it await actual payment (or if the contingency is the only reason for the delay, the liability becoming "fixed")? under present law, no amount is added to basis until the liability is determined, and, apparently, none of the payment is treated as interest to compensate for the deferral.' second, what is the appropriate treatment when it is determined that the obligation was assumed but the amount turns out to be much larger or smaller than the parties anticipated? in that case, does the basis adjustment still reflect the expected amount of assumed liabilities? i turn to the latter question after first considering the circumstances under which a liability should be considered to be assumed. a. determining whether a liability has been assumed the law is unclear about how to distinguish between assumed liabilities and post-sale liabilities incurred by the buyer. several tests have been suggested that appear logical if the goal is to determine the expected value of the assumed liabilities. this goal is most clear if the decision turns on whether the liabilities were reflected in the purchase price."' but, it can also be what the courts have in mind when they ask whether the liability was expressly assumed39 or whether the buyer was aware of the liability.' 36. under the all events test, a deduction is not allowed until the "fact" of the liability is determined and the amount can be determined with "reasonable accuracy." regs. § 1.461-1(a)(2)(1). in these circumstances, deferral may be required to prevent the seller from overstating the amount of the liability. 37. temp. regs. § 1.338(b)-3(c); keyes, supra note 2, § 21.04121[b][11; schler, supra note 2, at 616, 622. some have suggested that if the seller retains the liability and the buyer agrees to make additional payments to the seller equal to the payments that the seller eventually makes to discharge the liability, the buyer could treat part of the deferred payment as deductible interest. schler, supra note 2, at 671; wootton, supra note 2, at 737-38. the buyer might prefer this approach since it allows some of the payment to be deducted immediately, rather than being capitalized as basis. however, it may convert part of the seller's capital gain into interest income, and it may also increase the gain reported for the year of the sale because part of the seller's basis would be used against the deferred selling price. thus, it is not clear whether the overall tax burden would be reduced or not. it seems to me to be senseless to give the parties this alternative when, under the terms of the deal, the risks have not changed; the buyer is assuming the risk as to the amount of the liability just as it would if the seller were out of the picture. 38. keyes, supra note 2, § 21.04[ll[e]. 39. id. § 21.04[l][f]. 19961 florida tax review other standards seem more appropriate if the goal is to determine whether a particular liability, rather than a particular amount, was assumed. one possibility is to consider whether the event giving rise to the liability (e.g., the manufacture of a defective product or the release of toxic wastes) took place before the sale.4' another is to determine when the legal liability arose (e.g., customer injury from defective product or a new environmental statute).4" however, the existence of legal liability does not necessarily reduce the value of a business. for example, a liability to pay rent under a long term lease or wages under an employment contract does not diminish value if the rent or salary is consistent with the benefit to be received. just as the presence of legal liability at the time of sale is not inconsistent with future value, the absence of such liability does not necessarily indicate that the item did not affect the purchase price. consider costs incurred by the buyer to pare back the seller's workforce (severance pay) or facilities (payments to a landlord to cancel a lease). liability may not arise until the buyer discharges employees or terminates the lease, but if the buyer expects to take this course, it is reflected in the amount it is willing to pay. also, the future costs of providing medical benefits for retirees may reduce the value of the business, even if legal liability does not exist at the time of the sale because some employees have not satisfied the conditions for vesting or the employer has a unilateral right to amend or terminate the plan. on the other hand, the buyer might believe that the cost of a retiree medical program, or other fringe benefits based upon past service, might be recoverable out of future income. since the existence of the plan might enable the employer to spend less on wages, total future compensation costs might not exceed the value of future services. if this is true, liability under the plan does not reduce the value of the business.4 3 this might explain the belief that contributions to qualified pension plans, even if on account of service prior to the transfer of the business, should not be considered an assumed liability. 44 these examples suggest that the appropriate distinction is whether the potential liability relates to past or future income. if so, potential product liability or warranty claims with respect to goods sold before the sale of the 40. id. § 21.04[1][cl. however, in pacific transp. v. commissioner, 483 f.2d 209, 213 (9th cir. 1973), rev'g per curiam, 29 t.c. memo (cch) 133, t.c. memo (p-h) 70,041 (1970), cert. denied, 415 u.s. 948 (1974), the court stated that if the buyer was aware of the potential claim, it did not matter that the liability proved to be far greater than anticipated. 41. keyes, supra note 2, § 21.04[1][b. 42. id. § 21.04[i][d]. 43. see nysba, supra note 2, at 892-93, 896. 44. keyes, supra note 2, § 21.04[1][f]; youngwood, supra note 2, at 769. see also g.c.m. 39274 (apr. 23, 1984). [vol 2:12 assumption of contingent liabilities on sale of a business business should be treated as acquisition costs, even if no injury has yet occurred.4' but, if the goods have not been sold when the business is sold, any resulting liability should be deemed to be incurred by the buyer. " suppose that inventory can be sold for $100, the buyer expects to incur future costs of $20 ($15 for storage and selling expense and $5 for product liability), and wants to have a profit of $10. in these circumstance, the buyer should be willing to pay $70 for the inventory. if the future costs become part of the basis for the inventory, perhaps very little would turn on whether or not these are considered assumed liabilities.47 however, it seems to me that they are not. basis for the inventory should be $70, and the costs should be deducted by the buyer, even if the defect relates to manufacturing done by the seller.' in any event it seems that present law is unclear, not only in application but also as to the underlying principle. i consider next whether the treatment of errors in estimating assumed liabilities sheds any light on this matter. b. amount of basis adjustment the discussion thus far, which suggests a distinction between costs related to past profits and those related to future income, seems to apply to fixed as well as contingent costs. it does not answer the question of what to do if amount of the liability is estimated incorrectly. for example, if instead of paying $106 to e, p actually pays $120, is the appropriate addition to basis still $100? suppose the production of previously sold goods resulted in environmental damage, or these goods contain a carcinogen; either the parties were unaware of the problem, or the law that created the liability was not anticipated.49 if the seller had retained the business, it's profits from these sales 45. professor charlotte crane has suggested to me that a seller may make good on warranties in order to enhance its reputation, thereby enabling it to charge a premium in future sales and show an adequate profit, even taking the warranty cost into account. this is analogous to past service pension liabilities being considered a current cost because they enable the employer to pay lower wages. 46. see rev. rul. 76-520, 1976-2 c.b. 42 (disallowing deductions for costs to fill prepaid subscriptions the income from which is taxable to the seller but allowing deductions for costs relating to post transaction newsstand sales). see also keyes, supra note 2, § 21.04[l][a]; youngwood, supra note 2, at 770. 47. it would matter, however, if the buyer uses a lifo inventory method. 48. youngwood seems ambivalent, supporting this result as to warranty costs but suggesting, or perhaps fearing, that it would not apply to product liability expense. see youngwood, supra note 2, at 780. 49. see youngwood, supra note 2, at 778. youngwood suggests that if the liability derives from a post acquisition statute, it cannot be an assumed liability. but, the parties' ignorance of the carcinogen's existence would not preclude this liability from being treated as 19961 florida tax review would have been less than it originally believed. the sale of the business preserves the seller's expected profits and shifts the liability to the buyer. since these costs relate to past income of the seller and not future income of the buyer, are they assumed liabilities, even if not anticipated? in the case of a purchase price that is contingent upon the performance of the acquired assets, it is clear that the amount actually paid is the purchase price. but this amount is, at least in some sense, the true value of the business ex post, even if it is not the value expected at the time of the sale. in contrast, when contingent liabilities exceed the amounts estimated at the time of the sale, this does not indicate that the purchased assets are worth more than anticipated. i do not believe that we would adjust the selling price to give the seller additional capital gain and ordinary deductions to reflect an unexpected increase in liabilities,5" and it seems to me, therefore, that the increase should not affect the purchase price either. it may not be meaningful to ask whether the buyer has paid more for the business than it expected or just suffered an unanticipated additional cost of future operations. however, it is certain that even if it is an additional cost of the acquisition, it does not enhance the value of the business, and at least an unrealized loss has occurred. it seems sensible to recognize this loss by allowing the buyer a deduction for liabilities not reflected in the purchase price. conversely, if the buyer pays less than anticipated, it should have current income, reflecting the bargain purchase, and not just a reduced purchase price, resulting in less in the way of cost recovery. in sum, in these circumstances, expected liabilities seem clearly to be a better indicator of value. since the amount expected to be paid on the liabilities is what is reflected in the purchase price and the amount of cash transferred, it provides the right answer, at least in principle, to the question of what has been assumed. thus, i believe that the correct price adjustment is the expected value of the liabilities.5 while the section 338 regulations assumed. see david r. webb co. v. commissioner, 708 f.2d 1254, 1256 (7th cir. 1983) (stating that it is not relevant whether liability is known). 50. wootton, supra note 2, at 739-40. a look back to the "seller" may make sense in the context of a § 338 election since buyer and seller are one economic entity. however, this is not true in the case of a § 338(h)(10) election, where the impact falls on the original seller. 51. in the example, this amount is $100 if basis is determined at the time of purchase. if, as discussed below, the basis adjustment is deferred until payment, the basis addition should be $106 (the estimated present value ($100), increased by the expected rate of return). if p pays, say, $120 to e, and payment of this expense would normally be immediately deductible, the buyer should be entitled upon payment to a deduction of $14. if the buyer only pays $80, the purchase price adjustment should remain at $106, requiring the buyer to report $26 of ordinary income. [vol 2:12 assumption of contingent liabilities on sale of a business suggest that the price is adjusted as the amount of contingent liabilities is fixed, the irs could probably modify its position, despite some case law to the contrary.52 however, it should be considered whether this approach, which requires an estimate of contingent liabilities, can be administered; that is, is it substantially more difficult than looking to the amount ultimately paid on account of the assumed liabilities? the next two sections consider this matter in more detail. c. price adjustment for expected value if expected value is relevant, the liabilities must be valued at the time of the transaction. it is claimed that the amounts of the contingent liabilities intended to have been assumed is not usually apparent from the negotiations.53 while i have not had enough transactional experience to be sure, it seems to me that the parties must have some amount in mind that cannot be completely hidden. for example, some evidence might be provided from accounting records or the agreement of sale. to implement the approach suggested here, the buyer's basis for the purchased business should include, from the outset, an amount equal to the present value of the expected payments on the contingent liabilities. this amount can be computed as a specified series of expected future payments, discounted at the after-tax rate of return.' as is true of fixed liabilities, payments of assumed contingent liabilities should not be deductible. in the case of fixed liabilities nondeductibility extends to the interest portion. is the denial of interest correct in the case of contingent liabilities? as discussed above, in the case of deferred compensation, the employer is required to defer the deduction until payment, even if the amount is known, in order to compensate for the delay in the employee's recognition of income. this effectively denies the employer a deduction for interest, just as deferral effectively relieves the employee from tax on investment income. i argue above that unless the buyer is similarly denied an interest deduction, the effort to compensate for the advantage to the employee is thwarted. the 52. several authors have supported this approach. james m. lynch, transferring assets subject to contingent liabilities in business restructuring transactions. 67 taxes 1061, 1070 n.61 (1989); gregory j. soukop, accounting for assumed liabilities not yet accrued by the seller. a response, 48 tax notes 637 (july 30, 1990); wootton. supra note 2, at 740. another suggested it as an alternative. keyes, supra note 2, § 21.04121[a][i. 53. thomas h. yancey, emerging doctrines in the tax treatment of environmental cleanup costs, 70 taxes 948, 968 (1992). see nysba, supra note 2. at 898 (suggesting that the parties may have different values in mind). but see c. ellen macneil, glenn r. carrington & ross s. friedman, dealing with contingent liabilities in taxable asset acquisitions, 83 j. tax'n 208, 209 (1995). 54. see crane, supra note 2. at 226 (suggesting a need to know the discount rate). 19961 florida tax review question remains whether this treatment of the buyer should extend to contingent liabilities. the potential payees of some contingent liabilities may not be deferring tax on the corresponding income. without an income deferral, the payor could possibly be allowed the equivalent of an interest deduction.55 however, if, in the absence of the sale of the business, the seller's deduction for the item would have been delayed until payment,56 it effectively does not get an interest deduction in connection with the payment of contingent liabilities. if this treatment is considered unwarranted, it should be corrected whether or not a sale takes place. i see no reason for a different result merely because the business has been sold. thus, if the seller would not get an interest deduction, neither should the buyer. the entire payment should be nondeductible. the expected payments on a contingent liability, unlike those under fixed liabilities, may never occur. however, under the approach advocated here, the amount deemed assumed (and included in the purchase price of the business) is based on the expectation at the time of the acquisition, not actual events. if the contingent payments are less than expected, the purchase price is not reduced, but the buyer instead recognizes as income the amounts of expected payments that are not actually made. if the contingent payments are made as expected, they are nondeductible under this approach. in many instances, it may not be easy to determine which payments by the buyer are made in satisfaction of assumed contingent liabilities. this difficulty argues for modifying the suggested approach to avoid the need to match particular payments with particular liabilities. therefore, on the dates projected for the expected payments, the buyer could be required to forgo deductions equal to the anticipated payments, or to include an equivalent amount in income, regardless of whether actual events are consistent with the estimate. if the expected contingent payments are made in a later year than expected, the results would be an inclusion of income in the year the payment was expected with a corresponding deduction, equivalent in present value, in a later year. if tax rates change or there are cash flow problems, the taxpayer may be disadvantaged as compared to a disallowance of the deduction in the year of payment. perhaps, a taxpayer who can establish that the contingent liability will be paid later than expected could be allowed to follow the latter approach. it is extremely important to recognize that under the suggested 55. see halperin, supra note 5, at 529-30. 56. if the seller would have been allowed an interest deduction, the buyer should be as well. for example, interest on an assumed liability for corporate income taxes should be deductible. see youngwood, supra note 2, at 781. [vol. 2:12 assumption of contingent liabilities on sale of a business approach, a taxpayer could not profit from deliberately overestimating the amount of contingent liabilities, as long as the disallowance of the deduction, or equivalent inclusion, leads to an actual tax payment. the additional basis given to reflect the liability equals the present value of the nondeductible payments of the liability. in effect, for every dollar added to basis, the taxpayer forgoes a future deduction (or is burdened with an income inclusion) whose present value is one dollar at the time of the acquisition. trading a deduction for a basis adjustment of equal value cannot benefit the taxpayer unless a change in tax rates is anticipated.' there may, however, be some concern that the taxpayer will dissipate assets before the offsetting future tax is due or, perhaps, that a failure to report the correct amount of income will not be easily detected on audit. the suggested approach thus entails a form of credit risk for the irs. another problem is that the results might be distorted by an erroneous discount rate. under this approach, the taxpayer will effectively be allowed excessive deductions if the present value of the expected payments on the assumed liabilities is determined with a discount rate that is lower than the taxpayer's expected after-tax rate of return. this is almost certain to occur if the after-tax discount rate is computed by converting the rate paid by the united statess8 into an after-tax rate. 9 when the estimated interest rate is too low, either too much basis is given to reflect the assumed liability, or if the basis amount is considered correct, the estimate of the nondeductible future payments is too low. either way, future deductions are excessive, either in the form of too much depreciation or other basis recovery or too much deduction for future payments. one of the two amounts, which are equal in present value,' is unwarranted. 57. the treasury objects to a buyer adding to basis the estimated present value of a contingent purchase price. see infra note 66. but in those circumstances, an overestimate would not correct itself as easily as it can when an after-tax interest rate is appropriate. 58. see irc § 1274(d) (establishing the "applicable federal rate" (afr)). 59. arguably, a pretax rate can be used, even if an after-tax rate is more accurate, as a means of offsetting the fact that the rate (e.g., the afr) is likely to be low. see halperin, supra note 5, at 530. there is precedent for doing this. for example § 468, in adjusting for errors in estimating the cost of mine reclamation or solid waste disposal, assumes earnings at the short-term federal rate, § 468(a)(2)(b), although an after-tax rate may be more appropriate. see halperin, supra, at 530-31. also, in allowing deferral for payments received for dealer warranties, provided that the income inclusions for subsequent years are increased to be equal in present value to the deferred amounts, the irs uses a pretax afr for calculating the economically equivalent income inclusion. rev. proc. 92-98, 1992-2 c.b. 512, § 5.01. 60. assume the future payment is estimated to be $106 payable in one year, and the present value (basis adjustment) is computed, using a 6% rate of return, as $100. if the taxpayer is able to earn 7% after tax, it can accumulate $107 from a s100 set-aside. if $100 of basis is correct, the estimated future payments should be $107. if the estimated payment of $106 is correct, the basis should be $99.07 (the present value of $106 in one year at 7%). 19961 florida tax review the credit risk and discount rate problems could be mitigated by requiring that an amount equal to the assumed liabilities be segregated in a separate fund, which would grow at the actual after-tax rate of return and would be used to pay the liabilities as they became due.6 payments from the fund would not be deductible, but once the fund ran out, the buyer could deduct all further payments. any excess in the fund, after the assumed liabilities are paid, would be included in income, and the fund would be a source for collecting the tax on this income. since the fund would continue to grow at the after-tax rate of return, there would be minimal advantage to delaying recognition of an excessive set aside.62 another approach would be to require the buyer to include in income, at the time of the acquisition, an amount equal to the basis adjustment for the contingent liabilities and to allow the buyer deductions for all payments on the liabilities.63 since the basis amount equals the present value at the time either the taxpayer has taken 93 cents too much basis, or has underestimated the future payment by $1. at the taxpayer's 7% discount rate, the present value of $1 to be paid in one year is 93 cents. 61. see irc § 468a (using a similar approach). the § 468a fund is restricted in its investment choices in order to curb self-dealing that might reduce the fund's income. irc §§ 468a(e)(5), 4951. see also halperin, supra note 5, at 532. for a similar proposal, see treasury dep't, tax reform for fairness, simplicity and economic growth ch. 12.10 (1984) [hereinafter treasury i] (proposing reserve account for property and casualty companies). 62. in our continuing example, the fund would grow from $100 to $106 after one year. if no payment on the liabilities is ultimately required, the amount in the fund would be included in income. assuming constant tax rates, there is no difference between including $100 in income in year one and $106 in income in year two. still, there should be some cutoff, perhaps when the buyer cannot establish any remaining contingencies or, in any event, after the passage of a specified number of years. 63. this approach was used in rev. rul. 71-450, 1971-2 c.b. 78. see crane, supra note 2, at 228 n.9. for the treatment of the seller in the situation involved in the ruling, see james m. pierce v. commissioner, 326 f.2d 67 (8th cir. 1964). the approach in the ruling has been defended on the grounds that the buyer has in effect received a payment from the seller for agreeing to assume liabilities (in the form of a purchase price reduction) and that this payment should be taxable, just like an insurance premium would be. the buyer, like an insurer, can then deduct the costs of carrying out its agreement. however, the approach has been criticized as not reflecting economic reality. see lynch, supra note 52, at 1068-69; nysba, supra note 2, at 897. i offer it more in the way of a mathematical offset. since the payments that the buyer should not be able to deduct cannot easily be distinguished from other payments, the buyer would be allowed to deduct everything but be subject to an extra tax equal to the tax savings from the unwarranted deductions. for example, a deduction of $106, one year after the sale, produces tax savings of $42.40. if cash flow is not a problem, the deduction compensates the buyer for the extra tax of $40 paid one year earlier as a result of the inclusion in income of the estimated amount of assumed liabilities ($100). if the buyer borrowed $40 at 10% interest, it would owe $44 and would obtain $1.60 in tax savings from the interest deduction. [vol. 2:12 assumption of contingent liabilities on sale of a business of the sale of the expected future payments on the assumed contingent liabilities, including this amount in income at that time is the equivalent of disallowing deductions for the expected future payments.64 thus, the buyer can be allowed to deduct all payments of liabilities that would have been deductible by the seller, without regard to whether they have been assumed. however, neither of these alternatives may be well enough understood to be feasible, particularly since both of them would probably require legislation. thus, the assumption of a credit risk by the irs and the potential for taxpayer advantage from understating the rate of interest may not be avoidable.6 d. price adjustment for amounts paid we could, as the irs suggests, adopt a wait and see approach, delaying the buyer's addition to basis until the amount of the liability is fixed and thereby making it unnecessary to measure the expected value of contingent liabilities.' the major challenge in the implementation of this proposal may be to counter pressure from the irs to treat liabilities as assumed when they should be considered the buyer's liabilities. thus, as 64. since the income inclusion effectively takes away the benefit of the future deductions at the time of sale, regardless of the interest rate, it obviates the need for making an interest rate assumption to determine the amount of future deductions to be disallowed. 65. to determine whether, given the interest rate problem, this approach is preferable to the alternative of ignoring contingent liabilities, we need to compare the potential doubling of basis and expensing for part of the purchase price under this approach with the expensing of everything, which is the result of the alternative proposal. if the result of a toolow interest rate is seen as being excessive basis, as would be true in the case of fixcd liabilities (in the example in note 60, basis should have been only s99.07, not sloo as claimed), the matter can be analyzed by estimating the present value equivalent of the cost recovery allowed for a typical purchase price and determining by how much the estimated purchase price would have to exceed the actual price in order for the present value of cost recovery of this excess to be better than expensing, or 100%. whether the latter is likely to happen depends upon the period involved and the amount by which the actual return exceeds the assumed rate. if the basis is considered correct, the taxpayer obtains an unwarranted expense deduction. (in the example in note 60, $107 should be disallowed, not s106.) by how much again depends upon the period involved and the interest error. quantifying the potential taxpayer advantage involves a comparison of this extra deduction to the typical difference between expensing and the present value of cost recovery. the estimated advantage to the taxpayer would be greater under this second approach. (the present value at the time of the sale of an extra $1 deduction one year later is 93¢. an additional deduction of 93c is more beneficial than the same amount added to basis.) 66. this corresponds to the treatment of a contingent purchase price under the § 338 regulations and the proposed regulations on contingent payment obligations. see prop. regs. § 1.1275-4(c)(4)(iii)(b)(6) ex. l(iv). the option of expensing does not apply in that situation. 19961 florida tax review discussed above, we would need to develop a standard to determine whether particular payments satisfy assumed liabilities, which should be added to basis, or are expenses of the buyer, which can be deducted. while the basis adjustment is deferred, its value could be kept constant. in the example we have been using, ideally, p should take a $500 basis at the time of the purchase from s, including $100 for the assumption of the liability to e, and no part of the payment of $106 should be deductible. however, equivalent results can be obtained by stating p's basis as $400 initially and increasing it by $106 at the time of payment to e if, as described below, the allocation of the purchase price and the timing of depreciation are properly determined. in neither case does the buyer get a deduction for interest. if it gets basis of $100 at the time of purchase and no deduction for the payment of $106, it is explicitly denied tax credit for the additional $6 in the nature of interest. if it adds $106 to basis one year later, it appears to take account of the interest element, but $106 is merely the future value of $100, increased by the after-tax rate of interest to compensate for the delay.67 thus, the $6 effectively remains nondeductible. whether purchasers would be disadvantaged by the deferred basis alternative might depend upon how often basis adjustments are made and upon the allocation of the basis additions among various assets. under the regulations, the noncontingent purchase price is first allocated to cash and marketable securities in an amount equal to market value.68 the remainder of the purchase price is allocated to "class iii" assets-all other assets, except goodwill and going concern value-in proportion to their values but not in an amount exceeding fair market value. any remaining cost is allocated to goodwill and going concern value. it is assumed that with the enactment of section 197, the regulations will be amended to redefine the residual category to include all assets subject to section 197.69 if the purchase price, without regard to contingent payments, exceeds the fair market value of assets other than goodwill and other property subject to section 197, then any subsequent adjustment will be to the basis of intangible assets, which have a uniform amortization period of 15 years. in these circumstances, adjusting basis at the time of payment may not be particularly troublesome, even if, as discussed below, a new 15-year period begins each time there is a basis addition. 67. see supra text accompanying note 14. 68. temp. regs. § 1.338(b)-2. see youngwood, supra note 2, at 772 (describing method of allocation). 69. h.r. rep. no. 111, 103d cong., 1st sess. 776 (1993), reprinted in 1993 u.s.c.c.a.n. 378, 1007. [vol. 2:12 assumption of contingent liabilities on sale of a business the adjustment is more difficult if the noncontingent consideration allocated to class iii assets is less than fair market value, for at least two reasons. first, if this occurs, there will be basis adjustments, perhaps recurring basis adjustments, potentially to numerous class i assets, including inventory, accounts receivable, and depreciable property. second, merely allocating an amount to bring the basis of these assets up to their fair market value at the time of sale, and depreciating this amount over the original recovery period, does not produce the correct result. both fair market value and the recovery period must be adjusted. in the example, the deferred basis approach provides the buyer with basis of $106 one year after the sale, in lieu of $100 at the time of the sale. as noted, these two amounts are equivalent in present value. assume that if added to basis at the time of the purchase, the $100 would have been allocated to a depreciable asset that has a five year recovery period and is worth $100 at that time. if the basis adjustment is deferred, p will have depreciation deductions of equivalent value only if $106 is added to the basis of this asset one year later and is recovered over five years from the time of payment, not from the acquisition date.7° to permit this to occur, fair market value at the time of the sale ($100) must be adjusted by an assumed after-tax rate of return (e.g., 6%) to determine the equivalent value at the time of payment ($106). these suggestions for an increase in the fair market value (which probably helps taxpayers) and a new recovery period for each basis addition (which clearly harms taxpayers) might appear odd and not consistent with present practice.71 it is probably even odder when cost recovery occurs on the asset's disposition. in that case, if the basis arises one year after purchase, the larger basis offset should be allowed one year after sale.' perhaps, an 70. each amount claimed as depreciation would be one year later and 6% larger than if $100 were added to basis at the time of sale. see halperin, supra note 5, at 537. as shown in the case of the deduction for deferred compensation, the increase compensates for the delay. alternatively, $106 could be discounted back to the point of sale to create a retroactive $100 increase in basis at that time, but this approach would require reopening earlier returns every time a basis adjustment occurs. 71. the irs suggests that cost recovery should occur over the original period, with the amounts allocable to years prior to the year of the basis adjustment being spread over the remaining period. prop. regs. § 1.168-2(d)(3). see temp. regs. § 1.338(b)-3(d). h.r. rep. no. 111, 103d cong., 1st sess. 772 (1993), reprinted in 1993 u.s.c.c.a.n. 378. 1003; schler, supra note 2, at 611. there is no indication that the irs would adjust the fair market value. 72. halperin, supra note 5, at 537 n.118. in this case, since it would not affect past years, it would be simpler to discount the amount to be added to basis back to an equivalent value at the time of the business acquisition. adding this lower amount to basis would allow the basis offset to be taken into account at the time of sale. however, it would be to the taxpayer's advantage to understate interest in order to increase the addition to basis. 19961 florida tax review acceptable compromise is to forgo both adjustments, making the deferred basis adjustment for only the original fair market value and writing it off over the remainder of the original amortization period. generally, the results of this compromise would be to allocate too much basis to goodwill and to write off the added basis over too short a recovery period. v. ignoring contingent liabilities a. the proposal because of the difficulty in valuing assumed liabilities and the apparent complexity of the approach discussed in part iv, some commentators propose ignoring the assumption of contingent liabilities in determining both the amount realized by the seller and the buyer's basis." those advocating this approach would place the buyer in the seller's shoes and allow the buyer a deduction at the time and in the amount to which the seller would have been entitled had the business not been sold. thus, if the liability to e were contingent, the transaction described in the example would be analyzed as through p purchased assets from s for $400, rather than their fair market value of $500. s' gain on sale would be $200, and p's basis would be $400. s would be allowed no deduction for the obligation to e, but payment by p would be deductible, just as if the payment were of a liability incurred in p's business. therefore, it would not be necessary to determine whether the payment related to an assumed liability. one author makes this proposal because of his fear that the parties would otherwise have an incentive to inflate the amount of the assumed liabilities.74 another proponent of the proposal, a committee of the new york state bar association, worried that the irs would otherwise inflate the amount of assumed liabilities to deny the buyer deductions for costs arising after the purchase, claiming that particular payments relate to assumed liabilities and are therefore part of the purchase price that should be added to basis. 75 this explains the committee's proposal that in no case should a contingent liability be deemed to have been assumed by the buyer. 73. nysba, supra note 2, at 891-92; nysba, supra note 2, at 891-92; youngwood, supra note 2, at 784-85. others suggest that in practice, taxpayers may often follow this course. e.g., crane, supra note 2, at 226. 74. youngwood, supra note 2, at 784. as to the buyer, this concern was expressed in the context of a proposal to allow the buyer to increase basis at the time of the acquisition by the amount of contingent liabilities claimed to have been assumed. it was stated that any subsequent correction when the actual amount of the assumed liabilities was determined would not compensate for the time value advantage of the earlier inflated deductions. youngwood, supra note 2, at 784. but see supra text accompanying note 57. 75. nysba, supra note 2, at 891-92. those who had this concern apparently assumed that basis would not arise until the liability is paid. [vol 2:12 assumption of contingent liabilities on sale of a business b. treatment of seller in the case of the seller, relatively little may turn on the total amount of liabilities assumed. s, which sells assets with a basis of $200 for $500, should have gain of $300, and it should also be entitled to a $100 deduction for the liability. under the alternative proposal, no deduction would be allowed, but only $200 would be reported as gain. the understatement of the gain may have the same effect as a $100 deduction for the seller.76 in the relatively rare circumstance where payment of the liability would never be deductible (e.g., a fine77 or a federal income tax liability), the proponents modify their proposal to add these liabilities to the amount realized.7 thus, at least if capital gain is not differentiated from ordinary income, s is in the same position as if the assumption of the liability were taken into account in measuring the selling price and s were allowed an offsetting deduction for the deferred compensation. if capital gain is more favorably treated 79 and liabilities were taken into account, the seller would have an incentive to overstate the amount of assumed liabilities, increasing both capital gain and ordinary deductions; since the gross sales price and offsetting liabilities would be equally inflated, the cash received would not be affected, but the tax picture would be improved. c. treatment of buyer in the case of the buyer, the amount of the liabilities claimed to be assumed, and the tax treatment afforded them is nearly always important. the proposed treatment, which ignores contingent liabilities on the sale of a business, would be more favorable than the treatment of fixed liabilities or of contingent liabilities assumed other than in connection with the purchase 76. this approach makes it unnecessary to determine whether the deduction should be allowed at the time of the sale or at some other time. for example, if contingent liabilities are taken into account and the transaction is not reported as an installment sale, the seller's gain is recognized at the point of sale, but the deduction could be deferred, perhaps until the contingency is resolved (although it has been settled as far as the seller's exposure is concerned) or due to the application of § 404(a)(5). 77. see irc § 162(f). 78. nysba, supra note 2, at 891 n.87; youngwood, supra note 2. at 784. 79. capital gains may be taxed at a lower rate. see irc § 1(h) (applicable only to individuals). also, capital gains may effectively be untaxed because they can be offset by capital losses that might otherwise be wasted. ignoring liabilities may result in an unusable capital loss, while taking them into account might have the effect of reducing or eliminating the capital loss and creating ordinary deductions. if capital losses on the sale of a business were allowable without limit, which seems sensible, this would not be a concern. 19961 florida tax review of a business. this treatment could be viewed as the equivalent of either partial tax-free treatment of an otherwise taxable sale or expensing of the amount of the liability at the time of the purchase. this should be compared with the treatment of fixed liabilities, the assumption of which creates additional basis, which, under the rules for allocating the purchase price, may be allocated to goodwill and amortized over 15 years.80 1. equivalent of expensing.-at first glance, it might appear that reducing the purchase price from $500 to $400 and allowing a deduction for the payment of the assumed liability could make the purchaser better or worse off, depending upon the relative timing of the payment and the amortization of asset basis. if the asset is land, the purchaser is obviously better off under this proposal, but the purchaser might appear to be worse off if, on average, it could amortize its purchase price before it could deduct the payment. this would be true if the proposal applied to p's assumption of s' liability on the loan obtained from bank b. if this liability was ignored in determining p's basis and p was allowed to deduct its principal payment to bank b, p would be better or worse off than with its treatment under present law (inclusion of the liability in basis and no deduction for the payment), depending upon whether the recovery of basis would on average be later or earlier than the time of the loan payment. in either case, accrued interest would be deductible. however, the liability to e differs from the bank loan because, as explained above,8' interest on this obligation is effectively nondeductible. p's assumption of the liability should increase the purchase price and its basis by $100, as in the case of the bank loan, but, unlike that case, it should get no interest deduction when it pays $106 to e. the proposed alternative treatment is that in lieu of a $100 addition to basis and no further deduction for interest, p should be allowed to deduct the payment to e of $106,82 just as s would have been allowed to do had the sale not taken place. thus, we are not comparing an addition to basis of $100 with a delayed deduction of $100. rather, the delayed deduction of $106 is economically equivalent to an immediate deduction of $100. as described above, allowing s to deduct $100 80. see supra text accompanying note 68. 81. see supra text accompanying notes 14-15, 37, 67. 82. suppose the contingent liability is for an environmental cleanup cost, the payment of which the irs would require to be capitalized and for which the amortization period is unclear. in this case, if the buyer steps into the seller's shoes, the basis resulting from the payment should be allocated to this item, leaving the buyer in more or less the same situation under the alternative proposal as it would be if contingent liabilities were taken into account at the time of the purchase. [vol 2:12 asswnption of contingent liabilities on sale of a business at the time of sale is equivalent in present value to the s 106 deduction it would have had one year later if the sale had not taken place.8 ' when there is no sale, the deduction, although deferred, is increased by the after-tax rate of interest, which compensates for the delay. similarly, if the purchaser is allowed to deduct $106 one year after the purchase, its position is the same as if it were allowed a deduction of $100 at the time of purchase. thus, $100 of additional basis is less valuable than a deduction of the $106 payment in one year, even if the basis would be recovered by depreciation or amortization before payment occurs. because the basis adjustment approach would deny interest, the purchaser would always be better off under the alternative proposal unless the entire purchase price is immediately deductible, in which case it is indifferent between the two approaches. 2. carryover basis.-it is argued, however, that despite this advantage, the proposed treatment would not create an incentive to sell the business since the tax results would be approximately the same as if the business had not been sold.8' this assertion is correct because the proposal is equivalent to a partial carryover basis transaction; in return for the buyer accepting a basis below fair market value, the seller is allowed to avoid part of the gain. how can this be explained? under the proposal, the deduction for contingent liabilities is deferred until the time it would have been allowed had no sale taken place. if buyer and seller are taxed at the same marginal rates, the value of the deduction is not changed by the sale. the proposal reduces the selling price and hence the seller's gain,'5 but the purchaser's basis is reduced by the amount of the unrecognized gain. the latter results are equivalent to a partial carryover basis. as in a tax-free reorganization with a complete carryover of basis, there is no effect on revenues and no tax-created incentive to sell if buyer and seller are taxed at the same rate. d. when does it apply? since this approach does not accurately measure income, its application would presumably have to be restricted to transfers of entire 83. see supra note 22 and accompanying text. 84. nysba, supra note 2, at 895; youngwood, supra note 2. at 785. 85. since the deduction for the payment of the liability is allowed to the buyer, not the seller, the reduction of the gain to s200 can be viewed as a partial exemption, not an offsetting deduction. assuming identical rates, it is also equivalent to the seller recognizing an additional $100 of gain and the buyer obtaining an immediate write-off for the same amount, which is how the transaction is analyzed in the immediately preceding section. 19961 florida tax review businesses in order to prevent abuse.8 6 this restriction would make it necessary to distinguish that event from a more casual sale of assets.87 also, because fixed liabilities would be less favorably treated than contingent liabilities, it would be important whether a liability is fixed or contingent at the time of an acquisition. under the all events test of existing law, a liability is fixed when all events have occurred that establish the fact of liability and the amount can be determined with reasonable accuracy.88 however, the line between fixed and contingently liabilities is anything but clear,89 particularly in light of two recent supreme court decisions. the court held that an obligation to make a specified payout to unknown future players of a slot machine was fixed, even though the casino could avoid liability by terminating its business before the winning combination was played.90 a year later, the court held that liability under a self-insured medical plan was contingent until employees filed claims.9' because of various deduction-deferring rules, including the requirement of economic performance,92 it is often not necessary under existing law to determine whether the all events test is satisfied. in particular, it is generally not relevant whether deferred compensation is contingent because, under section 404(a)(5), such amounts, even if fixed, cannot be deducted until paid. 86. for example, consider a taxpayer that owns vacant land with a basis equal to its value of $1 million and also has contingent liabilities with an expected value of $750,000, the payment of which by the taxpayer would be deductible. assume the land is sold for $250,000 in cash and an assumption of the liabilities. if the liabilities are ignored, the buyer has a basis of $250,000 for the land and can deduct the liabilities when paid. the effect may be to allow the buyer to deduct most of the cost of nondepreciable land while the buyer continues to own the land. the treatment of the seller may not be clear. would the seller have a capital loss on the sale of $750,000 (amount realized of $250,000, less adjusted basis of $1 million)? or, would the seller have no gain or loss on the sale and a deduction for the liabilities when paid? the former treatment, which converts the seller's deduction from ordinary to capital but accelerates it, might add to the tax advantages flowing from the transaction, particularly if the seller is a corporation (enjoying no rate preference for capital gains). 87. for the meaning of the term "trade or business," see regs. § 1.461-4(d)(5)(ii); schler, supra note 2, at 611-13. 88. irc § 461(h)(4); regs. § 1.461-1(a)(2). 89. see generally accounting methods: general principles, 302 tax mgmt. (bna) at a98-ai 13 [hereinafter accounting methods]; lee g. knight & ray a. knight, the deductibility of expenses for accrual-basis taxpayers: continued controversy under the allevents test, 15 j. corp. tax'n 245 (1988). 90. united states v. hughes property, inc. 476 u.s. 593, 601 (1986) (finding the all events test to be satisfied). 91. united states v. general dynamics, 481 u.s. 239, 244 (1987) (finding the allevents test not satisfied). 92. for the requirement of economic performance, see § 461(h). [vol 2:12 assumption of contingent liabilities on sale of a business if this issue must be faced for the purpose of deciding the treatment of the buyer, it could raise some difficult questions. for example, is liability under a deferred compensation arrangement contingent if it is based upon the return from a hypothetical investment? while the payout is uncertain, the deferred compensation is sometimes set aside and invested in the measuring asset. in these circumstances, the employer's obligation is fixed at the amount set aside. would the line depend upon whether there was a set aside, and if so, how closely it tracked the measuring asset, or would the liability in all these circumstances be fixed because the amount can be determined with "reasonable accuracy"? further, although an obligation to pay a retired employee or her beneficiary $50,000 per year for 10 years is certainly fixed, suppose the payment continues for the life of the employee or the employee and her spouse. would this be considered contingent because the amount could not be definitely determined?93 at least if the employer has a large number of these arrangements, a fairly accurate measurement is possible. in general, even if the total amount to be paid to a group can be measured with reasonable accuracy, the "fact" of the liability is not established until particular individuals have "vested" rights. 94 for example, one court denied a deduction for a projected tort liability, even though it was agreed that the taxpayer's exposure clearly exceeded the limit on its selfinsurance.95 although the total amount was known, it was still necessary to establish which claimants would eventually be paid and how much. similarly, an obligation to provide vacation pay to all employees at the end of year one who remain employed until june 30 of year two might be considered contingent since it cannot be established which employees vill become entitled to vacation pay.96 it seems odd, however, to treat these obligations very differently from fixed liabilities because the buyer has a pretty good fix on the amount it will have to pay for both tort liability and vacation pay. 93. the irs appears to believe that a liability based on life expectancy is contingent. see isp coordinated issue paper, 92 tax notes 113-43 (june 1. 1992). there is, however, contrary authority. see accounting methods, supra note 89. at a-107-8. 94. see, e.g., brown v. helvering, 291 u.s. 193, 201 (1934); accounting methods, supra note 89, at a-100-01, 108. but in hughes. a liability was accrued even though the identity of the eventual lucky gambler was not known. hughes, 476 u.s. at 601. the court apparently relied on the fact that the state enforced the casino's obligation to make the payment. id. at 593. 95. supermarkets general v. united states, 537 f. supp. 759 (d.nj. 1982) 96. see accounting methods, supra note 89, at a-101. 19961 florida tax review vi. evaluation and conclusion a. the alternative of expensing by the buyer ignoring the assumption of contingent liabilities would make it unnecessary to determine the amount of assumed liabilities or whether a particular payment is in satisfaction of an assumed liability or one that arose after the transaction. this method would also eliminate subsequent basis adjustments each time a contingency is resolved. on the other hand, this approach requires distinguishing between the sale of a business and other asset transfers, which may not always be easy. it also treats fixed and contingent liabilities differently, even though the factual distinction between them may be slight. moreover, because the difference is narrow, it probably can be affected by the actions of the parties,7 which may lead to economic distortion and possibly manipulation as the parties seek to cloak liabilities as contingent. for example, suppose the parties, desiring to keep the risk of contingent liabilities on the seller, provide that if the buyer's payments on assumed contingent liabilities exceed a certain amount, the cash payable by the seller is reduced dollar for dollar.9" since less cash changes hands between buyer and seller as more is paid by the buyer on the assumed liabilities, the purchase price is unaffected by the amount of the liabilities. 9 for purposes of the proposal to ignore only contingent liabilities, the liabilities should be considered fixed in this case. however, treating the liabilities as fixed in these circumstances would create a tax incentive to shift the risk to the buyer to take advantage of the more favorable treatment of contingent liabilities. finally, this proposal most likely understates income. a sale of appreciated assets is an occasion to recognize that appreciation, and the recognition of gain produces net revenue to the fisc if the buyer's cost recovery is deferred. '° ignoring contingent liabilities is equivalent to a carryover basis approach. while this approach mitigates the tax bias against sales, "under an income tax with realization, the fact of a sale is supposed to 97. wootton, supra note 2, at 741; youngwood, supra note 2, at 785 (suggesting that the line is not clear and stating that if a liability is contingent only as to time of payment, it should be regarded as fixed). 98. unless the seller is entitled to additional cash if the liabilities are less than the specified amount, the buyer's obligation is contingent up to the specified amount. 99. as this occurs, the seller should have an offsetting deduction. 100. this assumes that the seller is immediately taxed at ordinary rates. if the seller's gain is not taxable or can be deferred or taxed at lower capital gain rates, a sale can cause a net loss in tax revenue, particularly if the buyer gets a rapid write-off of asset basis. [vol 2:12 assumption of contingent liabilities on sale of a business make a difference."'01 the ultimate question is whether the difficulty involved in taking account of contingent liabilities justifies a departure from the realization principle through converting a taxable transaction into one that is partially tax free. b. including assumed liabilities in basis i have discussed two methods of taking account of contingent liabilities-an estimate of the amount assumed at the time of sale or deferring the adjustment until liabilities are fixed. 1. estimated liabilities.-this approach has been opposed because of the difficulty of measurement. however, as explained earlier,"tu taxpayers would have little incentive to exaggerate these liabilities since any overestimation would cost an equivalent amount in deductions. the parties may attempt to underestimate the amount assumed because, as shown above, 3 the omission of a contingent liability from basis, coupled with the eventual deduction for payment of the liability, has the effect of an immediate deduction for the omitted amount. however, this possibility does not seem to be a serious problem, given that the alternative is to omit all contingent liabilities from basis and allow deductions for all payments on these liabilities. the estimated liabilities should be the amount that is actually taken into account by the parties in measuring the purchase price. this provides a principled distinction between liabilities deemed assumed and post-acquisition liabilities incurred by the buyer. while payment of the assumed liabilities would not be deductible, it is not essential that particular future outlays be matched with the liabilities deemed assumed. finally, creating basis equal to the expected amount of assumed contingent liabilities is consistent with the likely treatment of fixed liabilities," and should alleviate the need to distinguish between fixed and contingent debt. taxpayers could game the system by underestimating their true discount rate or by overestimating liabilities and defaulting on the tax due on 101. crane, supra note 2, at 227. the nysba response to crane's comment evidences a misunderstanding of the effects of their proposal. see nysba, supra note 2, at 894-95. to the extent a seller has an alternative to gain recognition (e.g.. a sale of stock in the case of a c corporation), one might be more tolerant of carryover basis. 102. see supra text accompanying note 57. 103. see supra text accompanying notes 81-83. 104. but see supra note 28 (discussing whether a delayed basis adjustment would be required in some circumstances). 19961 florida tax review the correction of the overestimate."' these problems could be alleviated by either segregating assets equal to the expected amount of liabilities assumed or immediately including this amount in income, although these two methods probably would both require legislation, which may be difficult to obtain. 2. deferred basis adjustment.-taking account of the actual liabilities as they are paid, rather than the expected liabilities at the time of the acquisition, appears simpler since no estimate is required. further, a delay in the addition to basis need not affect value if current practice is changed in two ways-by adjusting the fair market value limit on basis allocation to account for the delay in creating basis (which probably helps taxpayers) and by beginning a new amortization period each time a basis addition is made (which clearly hurts taxpayers)."t 6 while it is probably within the irs' power to make these changes, they might not easily gain acceptance. perhaps, making these adjustments elective would be an acceptable compromise, 1 7 even if it allows all taxpayers to choose the most favorable approach at the cost of having to compute the benefits of both alternatives. any advantage to taxpayers who don't elect is at least not as favorable as full expensing. some commentators are troubled that deferring the basis adjustment would cause excessive gain to be reported if inventory is sold or accounts receivable are collected before the adjustment occurs. but, a similar result would occur under the proposal to ignore contingent liabilities. s08 in that proposal, the amounts paid on the liabilities would be deductible, perhaps after the inventory is sold or the receivables are collected, but similar results would occur under the deferred basis approach to the extent the basis adjustment is allocated to inventory or accounts receivable. in addition, if fair market value is adjusted as suggested above, the delay would be offset by a larger basis at a later point."° 105. see supra text accompanying notes 58-64. 106. see supra text accompanying notes 66-72. 107. alternatively, if the taxpayer can be prevented from understating its rate of return, the taxpayer could be allowed to discount the basis adjustment back to the point of sale and file amended returns. see supra note 70. 108. this leads to the suggestion that the seller retain accounts receivable or inventory. lynch, supra note 52, at 68; see youngwood, supra note 2, at 784-85. 109. assume that if the contingent liability was taken into account at the point of sale $200 would be allocated to the basis of inventory, but because the basis reflecting contingent liabilities is deferred, the inventory initially takes a basis of $100. the inventory is quickly sold for $220, yielding a profit of $120, which is overstated by $100. when the contingent liabilities are determined, an additional amount will be added to the basis of inventory (and immediately deducted if the inventory has been sold). if this occurs one year later, under our interest rate assumption, the maximum additional basis will be increased to $106. a $106 deduction in year 2 exactly offsets $ 100 of income in year 1. if the taxpayer borrowed [vol 2:12 assumption of contingent liabilities on sale of a business on the other hand, this approach depends upon a workable distinction between fixed and contingent liabilities if the former, as seems likely, are taken into account at purchase."0 moreover, and most importantly, to avoid excessive additions to basis of amounts that should be expensed by the buyer, this approach requires an administrable distinction between the buyer's own liabilities and those it has assumed. as suggested above,"' the starting point in determining whether a liability has been assumed could be whether the income to which the expense relates is earned before or after the sale. this could be subject to some rules of thumb, particularly for employee compensation, in order to ease administrative difficulties. for example, liability for wages and fringe benefits might be considered not to have been assumed unless the expense clearly relates exclusively to pretransaction events, such as bonuses based on an earlier year's performance, 2 individual deferred compensation arrangements for previously retired or deceased employees (or where it is clear that amounts have been set aside out of the covered employee's wages)," 3 costs related to a prior plant closing or a funding deficiency with respect to a qualified plan." 4 in addition, consistent with my belief that the purchase price should reflect only anticipated liabilities, if the event that gave rise to the liability was wholly unknown and unanticipated at the time of sale, the resulting liabilities should not be considered to have been assumed. $40 to pay the tax (40% rate), at the assumed rate of return (10%). it will owe s44 in one year. the interest deduction for $4 will save s1.60 in tax, for a net cost of $42.40. a tax deduction for $106 generates $42.40. to this extent, the result is no different than if the alternative proposal were adopted and the payment of contingent liabilities was directly deducted. in accordance with the earlier discussion of depreciation (text accompanying notes 70-71) if the payment is one year after the acquisition, the inventory adjustment should take place one year after the inventory is sold. for this purpose, it is probably reasonable to assume that sales of inventory and collection of receivables occur at the point of sale. since income is measured over a taxable year and not on a daily basis, these adjustments cannot be perfect. see victor thuronyi, the concept of income, 46 tax l. rev. 45, 65-68 (1990); daniel i. halperin, commentary, in life insurance company taxation: the mutual vs. stock differential 5-2, (m. graetz ed., 1986). 110. see supra note 28. 111. supra text accompanying notes 38-46. 112. youngwood, supra note 2, at 778-79. 113. david r. webb co. v. commissioner, 77 t.c. 1134 (1981), aft'd, 708 f.2d 1254 (7th cir. 1983). cf. m. buten & sons, inc. v. commissioner, 31 t.c. memo (cch) 178, t.c. memo (p-h) 72,044 (1972) (allowing deduction for payments to beneficiary of deceased employee where death occurred after the acquisition). even payments to previously retired employees could be intended to impart a sense of security to the current work force and, thus, provide future value. 114. youngwood, supra note 2, at 770. 19961 florida tax review c. resolving the issue 1. the seller.-if the seller would have been allowed a deduction for its payment of a liability, the buyer's assumption of the liability should have no net tax impact for the seller because any inclusion of the liability in the amount realized should be offset by a deduction for the amount so included. some commentators have suggested that sellers often ignore contingent liabilities despite the absence of any law allowing them to do so."5 also, to the extent that sellers must, or actually do, include assumed contingent liabilities in the amount realized, it is not clear that they are allowed offsetting deductions. while the regulations waive the economic performance requirement in these circumstances, 6 the irs has not taken a position with respect to contingent liabilities and has enforced specific statutory rules deferring the deduction until receipt by the payee (e.g., section 404(a)(5). it does not seem sensible to keep the seller in the picture after the sale, leaving its amount realized from the sale and, perhaps, deductible expenses to be determined by future events over which it has no control and about which it may have no information." 7 thus, if contingent liabilities are to be taken into account, they should be accounted for by estimate at the point of sale for the purpose of determining both the selling price and the deductible expense. if the seller would have been allowed a deduction for its payment of an assumed liability, the only difference between ignoring and accounting for the liability is the possible trade off between ordinary deductions and capital gain. it seems best to avoid that quagmire whenever possible. thus, as to the seller, i believe the best treatment is to ignore at least those liabilities that cannot be definitely valued. in order to avoid distinguishing between fixed and contingent liabilities, this treatment might be extended to those fixed liabilities that will lead to future deductions. since this would deprive the seller of a capital gain advantage, it may require legislation." 8 115. nysba, supra note 2, at 893; youngwood, supra note 2, at 782. 116. regs. § 1.461-4(d)(5). 117. see macneil, carrington & friedman, supra note 53, at 211. 118. arguably, allowing the seller to take liabilities into account would create a tension between seller and buyer that might lead them to agree on more accurate measurements of assumed contingent liabilities. the seller would try to inflate the amounts of these liabilities so as to maximize ordinary deductions, at the cost of additional capital gain, while the buyer, as discussed in the text below, would want to minimize the amounts. it seems more likely, however, that the parties would resolve this tension in a way that minimizes tax overall. that is, if the seller gains more from reporting capital gains and claiming ordinary deductions than the buyer loses from adding to basis in lieu of expensing, the parties would maximize assumed liabilities. conversely, if the cost to the buyer is greater than the seller's gain, the liabilities would be minimized. i see no point in creating tension if the likely result is reduced tax revenues. [vol 2:12 assumption of contingent liabilities on sale of a business even with this legislation, however, the seller could retain the opportunity for capital gains by continuing to be responsible for the debt. 2. the buyer.-the irs suggests that when assumed contingent liabilities become fixed, the buyer must adjust basis by the actual obligation, with no provision for interest, and that the new basis is amortized over the remainder of the period beginning at the point of acquisition for assets of that category. 9 this may also be the result with respect to fixed liabilities where statutory rules prohibit deduction until payment. but, basis is adjusted at the time of the acquisition for other fixed liabilities. while this approach does not require estimates of the amounts of assumed contingent liabilities, it does distinguish between assumed liabilities and those incurred by the buyer. the almost total absence of litigation over this very difficult issue suggests that taxpayers have engaged in self-help and ignored contingent liabilities or, at least, that the irs has not been active in this area."2 an alternative would be to require an immediate basis adjustment for fixed liabilities and for contingent liabilities whose amounts can be determined with reasonable accuracy. in other circumstances, taxpayers could be allowed to defer the basis adjustments until payment. taxpayers fearing that the irs would insist on excessive basis adjustments could be allowed to elect the expected liability alternative, which i prefer, perhaps conditioned on protecting tax revenues by either a segregation of assets equal to the liabilities deemed assumed or an immediate recognition of income in this amount. d. a last word my stated goal in this article is to set out the issues surrounding the assumption of contingent liabilities so that policy makers can make informed choices that appropriately balance administrative feasibility and consistent application of income tax principles. this requires increased understanding of the impact of the time value of money. i have shown that ignoring contingent liabilities is equivalent to partial tax-free treatment of an otherwise taxable transaction and can also be described as immediate expensing of a portion of the purchase price. such generosity to taxpayers needs stronger justification than has been offered. 119. see supra note 66 and accompanying text. 120. because of fear that irs activism may lead to basis additions far beyond the amount of liabilities assumed, it has been urged that the practice of ignoring contingent liabilities should be confirmed and legitimatized. see part v. it seems to me that the latter approach is more generous than its supporters have recognized and is not required by valuation difficulties. 1996] florida tax review on the other hand, recognition of contingent liabilities as part of the purchase price is not as problematic as may be believed. deferral of a basis adjustment until payment need not affect its value, although it does require that assumed liabilities be distinguished from the buyer's liabilities, which is difficult both in principle and in application. this problem, however, is avoided if assumed liabilities are estimated at the point of sale. taxpayers have much less to gain by exaggerating this amount than is probably believed. underestimation remains a concern, but this concern cannot make this approach less desirable than the alternative, which would ignore contingent liabilities and effectively value them as zero. none of the approaches discussed is easy; no approach can be simple as long as we have a realization-based income tax. this has led some to advocate a move to a consumption tax. while a pure consumption tax would be simpler than a pure income tax for businesses (although not necessarily for individuals), i believe that because of issues relating to fairness and transition, a consumption tax in any form is highly unlikely to be adopted. certainly, a simple consumption tax that treats all forms of investment income alike will never happen. for me, the road to reform is improvement in the income tax, primarily efforts to extend the application of mark to market.. or other mean of currently accounting for investment income and loss, so as to minimize the importance of realization. appendix i liabilities for which tax attributes exist it is generally thought that liabilities assumed in the sale of a business are taken into account at face, rather than market value.' however, the failure to account for the difference between the face amount and value of a liability could understate or overstate interest income and deductions. for the seller, this error is offset by an equal error in the measurement of the selling price and thus is relevant only if there is a difference in treatment between capital gain and ordinary income. for the buyer, it affects the relative amounts allocated to interest expense as opposed to the basis of the assets purchased, and is relevant whenever the timing of interest on the liability differs from the timing of basis recovery. this appendix discusses this issue for liabilities whose tax attributes are recognized before the sale (e.g., ordinary borrowings and liabilities deducted on accrual before the sale). 121. see, e.g., joseph bankman, a market-value based corporate income tax, 68 tax notes 1347 (sept. 11, 1995). 122. for a more detailed discussion of this issue, which is outside the main thrust of this article, see shrago, supra note 7, § 19.05 at 19-11. [vol 2:12 assumption of contingent liabilities on sale of a business if interest rates have risen since the liability was incurred, the seller could possibly discharge the liability at a discount, and the buyer could not borrow the face amount at the stated interest rate. in these circumstances, the reduction in the cash price to reflect the assumption is likely less than the face amount of the liability. if this fact is not recognized and the selling price is considered to be the sum of the cash transferred and the face amount of the liability, the seller's amount realized is overstated, and the seller avoids income from the discharge of indebtedness. these amounts are offsetting unless the seller enjoys more favorable treatment of capital gains. for the buyer, the purchase price (basis) is exaggerated, but interest expense is understated by the difference between the amount really borrowed and the larger amount to be repaid. whether this is an advantage depends upon the length of the loan term as compared to the period for cost recovery of the asset to which the additional purchase price is allocated and upon the cost recovery devices used for the loan and assets. the excess purchase price may be allocated to goodwill or another intangible asset subject to section 197.12 some suggest, however, that it could be attributed to "favorable financing," and written off over the life of the loan (essentially as additional interest expense). 2 ' if interest rates have fallen, the seller would have to pay a premium to prepay the debt, and the buyer could borrow more than the face amount of the debt at the stated interest rate. in this case, treating the purchase price as the sum of the cash transferred and the face amount of the liability understates the seller's amount realized, but deprives the seller of an equal deduction for the premium. in the absence of a capital gain advantage or capital loss disadvantage, these amounts offset. the buyer's basis is understated, and the buyer has excessive interest deductions because of the failure to take account of the bond premium, the amortization of which would effectively reduce its interest cost to markel'5 in sum, if interest rates have risen, the buyer understates interest and overstates the purchase price, while the seller is understating ordinary income and overstating gain, which could be capital gain. if interest rates have fallen, the buyer overstates its interest deductions and understates the purchase price, while the seller could be understating capital gain and overstating ordinary income. however, even in the absence of an assumption of liabilities, the parties may have a similar opportunity to misstate interest income and 123. id. § 19.04 at 19-9. 124. id. § 19.04 at 19-7 to 19-8. 125. the buyer can accelerate the deduction for this interest by paying off the debt. see shrago, supra note 7, § 19.04 at 19-10. 19961 florida tax review expense.'26 in the case of a deferred payment of the purchase price, interest need not be provided at a rate higher than the applicable federal rate (afr), 27 which is likely to be less than the market rate faced by the buyer. 28 if the afr is used, the buyer probably understates interest expense and overstates the purchase price, while the seller understates interest income and overstates gain, which could be capital gain. since there is no statutory rule fixing a maximum rate,129 the parties might also have an opportunity to overstate interest and understate the purchase price. apparently, because of the difficulty of a subjective determination of the true interest rate implicit in each transaction, a decision has been made to live with this distortion. given this determination, it generally seems unnecessary to try to achieve an accurate interest rate in the case of an assumption. however, it seems sensible to adjust the interest rate on an assumed liability if it is less than the afr. one additional issue involves the treatment of nonrecourse liabilities, which, by statute, must be included in the selling price at face. 3 1 when interest rates have risen, the sum of the other consideration and the face amount of the debt exceeds the fair market value of the property. 3' for the seller, this could again be said to result in overstatement of the amount realized and understatement of discharge of indebtedness income. 32 in the buyer's case, although there is authority to include the liability in basis to bring basis up to fair market value, normally when the sum of other consideration and the face amount of contingent liability exceed the value of the property acquired, basis does not include the amount of the liability.133 if the basis is effectively limited to the cash outlay, the purchase price is understated. this does not appear appropriate in these circumstances since the buyer still has an economic incentive to pay the liability, which it is valuing at fair market value."3 126. keyes, supra note 2, § 21.03[2] at 21-10. 127. irc §§ 483, 1274. 128. irc § 1274(d) (basing the afr on the average yield on treasury obligations of comparable length). 129. the irs has the power to reduce above-market interest in the case of a "potentially abusive transaction." irc § 1274(b)(3); prop. regs. § 1.1274-1(d). see schler, supra note 2, at 645. 130. irc § 7701(g). 131. see shrago, supra note 7, § 19.05[2] at 19-16. 132. tufts v. commissioner, 461 u.s. 300, 319 (1983) (o'connor, j., concurring). 133. see shrago, supra note 7, § 19.05[2] at 19-16. 134. id. [vol 2:12 assumption of contingent liabilities on sale of a business appendix h impact of difference between discount rate & rate inherent in agreement in order to focus on differences between the assumed discount rate and that faced by the parties, the discussion in the following paragraphs assumes that the tax rate at the time of payment is the same as when the liability arose. a. the employer if the employer were granted a deduction for the deferred compensation when it was earned, it could invest the tax savings at its after tax rate of interest. when the deduction is deferred, the tax savings increase by the rate of return inherent in the arrangement, which might not be the employer's after-tax rate. the deferred deduction is worth more than an immediate deduction for an employer who credits the employee with more than it actually earns and is less valuable for an employer who increases the employee's benefit by less than its after-tax rate of return. if the original intent was to credit the employee at the rate earned, there is no reason to expect actual results to be biased in either direction. moreover, the deduction could be viewed as correct if the employer's investment return is said to have increased or decreased the compensation, as the case may be. an employer who originally intends to pay the employee at a rate less than it expects to earn would (all other things being equal) be worse off with the deferred deduction than if it paid cash compensation and borrowed or otherwise obtained equivalent funds from the employee or other sources. by borrowing elsewhere, it would benefit from the spread in rates without reducing the value of its tax deduction for compensation. one reason not to be concerned about the effect of a deferred compensation arrangement in these circumstances is that the spread in rates could occur because the employer is not currently taxable and it retains the benefit of the tax exemption by offering the employee the equivalent of an after-tax rate of return.135 this opportunity would not arise if it borrowed in a way in which the interest would be taxable. 135. one might expect the interest rate to be somewhere in between the normal cost to the employer and the normal expectation of the employee, depending upon the bargaining power of the parties. on the other hand, in the case of deferred compensation arrangements for senior executives, one might expect the rate to be set at the employer's after-tax return with the entire differential being captured by the employees. 1996] florida tax review an employer who sets out to pay the employee more than its expected rate of return benefits from the deferral of the deduction because the tax savings from the deduction increases at the higher rate reflected in the agreement. it seems, however, that such an arrangement cannot really exist. an employer who purports to do so seems to be effectively increasing the amount of compensation and providing interest in line with its own expected earnings, in which case there is no additional advantage from deferral. b. the employee in order to compare the employee's status to the position she would have held if she paid the tax up front and then received a tax-free return at the rate provided by the arrangement with the employer, we need to consider whether the employee would have paid the tax out of her savings or by borrowing. if she would have paid out of savings, we need to know the rate of return she earns on her savings. if she would have borrowed, we need to know the rate of interest she would have had to pay. an employee who would have paid the tax from savings is better off doing so, in lieu of deferral, if her after-tax rate of return is less than what she obtains from the employer. in that case, when tax is postponed, her retained savings are insufficient to pay the deferred tax. she comes out ahead with a deferred tax only if she earns more than is provided through the deferred compensation. an employee who would have borrowed gains from the deferral if the interest rate she would have had to pay exceeds the rate provided by the employer. in that case, the amount that she would have owed on the loan (including interest) at the time the deferred compensation is paid exceeds the tax on the deferred compensation. since the employee may not have funds to pay the tax and may likely have to borrow at more than she will earn from the arrangement, the benefit of deferred compensation for the employee may exceed that which would be achieved merely by accounting for compensation when earned and ignoring investment income and the interest paid. this would not be true, however, if the employer distributed enough to pay the tax. it would have to be recognized, moreover, that the latter approach has its own difficulties. it would require that the present value of the compensation be determined, which is always difficult, and perhaps not possible, with respect to contingent liabilities. further, the employee could abuse that approach by setting the interest rate unrealistically high, thereby understating the true compensation. thus, on balance, the prospect of a difference in discount rates should not cause the deferred deduction approach to be considered more problematic unless there is a transfer of the business. [vol 2:12 login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe florida tax review volume 5 2001 number 2 recent developments in federal income taxation: the year 2000 ira b. shepard martin j. mcmahon, jr.** 1. accounting ....................................... 111 a. accounting methods ............................ 111 b. inventories ................................... 117 c. installment method ............................. 117 d. year ofreceipt or deduction ..................... 119 ii. business income and deductions .................... 121 a . income ...................................... 121 b. deductible expenses versus capitalization .......... 123 c. reasonable compensation ....................... 134 d. miscellaneous expenses ......................... 135 e. depreciation &amortization ..................... 138 f. credits ...................................... 139 g. natural resources deductions & credits ........... 140 h. loss transactions, bad debts and nols ............ 146 i. at-risk and passive activity losses ................ 147 m . investment gain ................................... 151 a. capital gain and loss .......................... 151 b. interest ...................................... 156 c. section 1031 like kind exchanges ................ 157 d. section 1041 .................................. 161 e. section 1042 .................................. 165 iv. compensation issues ............................... 165 a. employee compensation and plans ................ 165 b. individual retirement accounts ................... 168 v. personal income and deductions ................... 170 a. miscellaneous income .......................... 170 b. deductions and credits ......................... 172 vi. corporations ..................................... 181 a. entity and formation ........................... 181 b. distributions and redemptions ................... 182 c. liquidations .................................. 185 d. s corporations ................................ 187 * professor of law, university of houston law center. ** clarence . teselle professor of law, university of florida fredric g. levin college of law. 109 110 florida tax review [vol. 5:2 e. affiliated corporations ........................ 192 f. section 482 ................................... 196 g. reorganizations and corporate divisions ........... 196 h. personal holding companies .................... 203 vii. partnerships ........................................ 203 a. partnership audit rules ......................... 203 b. m iscellaneous ................................. 205 viii. tax shelters ..................................... 211 a. corporate tax shelters ......................... 211 b. individual tax shelters ......................... 223 ix. exempt organizations and charitable giving ....... 225 a. exempt organizations .......................... 225 b. charitable giving ............................. 226 x. tax procedure .................................... 229 a. penalties and prosecutions ...................... 229 b. discovery: summonses and foia ................. 231 c. statutory notice ............................... 233 d. statute of limitations ........................... 233 e. liens and collections ........................... 234 f. innocent spouse ............................... 236 g. m iscellaneous ................................. 240 xi. withholding and excise taxes ..................... 243 a. employment taxes ............................. 243 recent developments in federal income taxation this current developments outline discusses, andprovides context to understand the significance of, the most important judicial decisions and administrative rulings and regulations promulgated by the internal revenue service and treasury department during the year 2000.1 most treasury regulations, however, are so complex that they cannot be discussed in detail; only the basic topic andfundamental principles are highlighted. amendments to the internal revenue code generally are not discussed except to the extent that they have either led to administrative rulings and regulations or have affected previously issued rulings and regulations otherwise covered by the outline. the outline focuses primarily on topics of broad general interest -income tax accounting rules, determination of gross income, allowable deductions, treatment ofcapital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. it deals summarily with qualified pension and profit sharing plans, but generally does not deal with international taxation or specialized industries, such as banking, insurance, and financial services. i. accounting a. accounting methods 1. pharmaceuticals administered by physicians are not merchandise; they're supplies used in connection with the rendering of services. osteopathic medical oncology and hematology, p.c. v. commissioner, 113 t.c. 376 (1999) (11-6 decision). chemotherapy drugs administered by a cash-method professional medical corporation were not merchandise under reg. § 1.471-1, so inventory accounting and a hybrid method [accrual method for the chemotherapy drugs and cash method for the balance of taxpayer's business] were not required. generally, goods sold by a service provider ancillary to the provision of services must be inventoried and accounted for under the accrual method. see wilkinson-beane, inc. v. commissioner, t. c. memo. 1969-79, aff'd, 420 f.2d 352 (1st cir. 1970) (undertaker's supply of caskets); rev. rul. 74-279, 1974-1 c.b. 110 1. this outline is based on prior current developments outlines presented by the authors at numerous continuing legal education conferences over the past year. among the conferences at which one or both of the authors presented current developments based on this outline during the year 2000: aba tax section midyear meeting, american institute on federal taxation, american petroleum institute, denver tax institute, houston bar association tax section, university ofmontana tax institute, university ofnorth carolina tax institute, southern federal tax institute, southwestern legal foundation institute on oil and gas law and taxation, state bar of texas tax section, tax executives institute, tennessee tax institute, texas society of cpas (austin chapter) institute, university of texas annual taxation conference, tulane tax institute, university of virginia conference on federal taxation, wednesday tax forum (houston), william & mary tax conference. 2001] florida tax review (optometrist's supply of glasses and frames). but "giv[ing] significance to the uniqueness of the industry... in relation to other service industries," the tax court, in a reviewed opinion by judge laro, has carved out a special exception for pharmaceuticals in this case, medicines administered in the course of chemotherapy cancer treatments furnished by a physician (or hospital) provided as "an integral, indispensable, and inseparable part of the rendering of medical services." the tax court, has held that such a transaction is not a "sale of 'merchandise,"' even if the items involved are very expensive [charges for the drugs constituted 26% of taxpayer's gross receipts and were separately invoiced] and thus represent a significant portion of the transactions. accordingly, such pharmaceuticals need not be inventoried and accounted for (with the taxpayer required to shift to the accrual method), but are supplies that can be expensed under § 162.2 the commissioner abused his discretion in requiring the medicines to be treated as inventory subject to the accrual method when the taxpayer otherwise used the cash method. a critical factor in this result, however, was that the pharmaceuticals could not have been purchased from the taxpayer separately from the associated medical services. the court also noted that the taxpayer kept only a two-week supply. * a dissent by judge halpern criticized the majority opinion for, among other things, overturning the commissioner's discretion in an accounting methods case in which the taxpayer failed to demonstrate that its accounting method clearly reflected income [an issue which judge halpern correctly notes was not addressed in the majority opinion]. the dissent further asserted that reg. § 1.162-3 mandates that the deduction for supplies on hand should be made only as "they are actually consumed and used in operation during the taxable year," as opposed to "incidental materials or supplies on hand, for which no record of consumption is kept," which may be currently deducted. judge halpern relies on wilkinson-beane inc. v. commissioner, 420 f.2d 352 (1st cir. 1970), aft'g, t. c. memo. 1969-79 (funeral home in service business has merchandise when it derives a substantial part of income from the regular purchase and sale of tangible personal property). a. play it again. mid-del therapeutic center, inc. v. commissioner, t. c. memo 2000-383. on facts essentially the same as those in osteopathic medical oncology and hematology, p. c., the court reached the same result. b. and the irs acquiesces in the result. a.o.d. 2000-05 (4/27/00). the irs acquiesces in the result in osteopathic medical oncology 2. in hospital corp. of america v. commissioner, 107 t.c. 116 (1996), the tax court held that a cash method hospital was not required to use accrual method to account for medical supplies dispensed to patients in course of hospital stay, but did not reach the inventory question. [vol 5:2 recent developments in federal income taxation and hematology, p.c., and agrees that under circumstances comparable to this case, prescription drugs or similar items administered by healthcare providers are not merchandise under reg. § 1.471-1. the a.o.d. notes, however, that. reg. § 1.162-3 may require a similarly situated health care provider to treat the cost of prescription drugs or similar items as deferred expenses that are deductible only in the year they are used or consumed. 2. nor is ready-mixed concrete merchandise held for sale by a contractor. racmp enterprises, inc. v. commissioner, 114 t.c. 211 (2000). the taxpayer was a construction contracting company that constructed concrete foundations, driveways, and walkways. the tax court (in a 10-6 reviewed opinion by judge parr) rejected the commissioner's attempt to compel the taxpayer to switch from the cash method to the accrual method and permitted the taxpayer to use the cash method to account for its income and expenses for the cost of ready-mix liquid concrete and other materials. the materials were used up before they were paid for and before the taxpayer reported their expense. like the road contractor in galedrige construction, inc. v. commissioner, t. c. memo 1997-240, who was permitted to use the cash method for purchases and sales of emulsified asphalt in connection with road building contracts, racmip was in the business of providing services, not of selling merchandise, and the ready-mix concrete material was an indispensable and inseparable part of the provision of that service. fill sand, drain rock, and hardware were not as "ephemeral" as the liquid concrete, but also were indispensable to and inseparable from the services provided by racmp, even though a de minimis amount often remained on hand at the end of a contract. reg. § 1.471-1 does not provide that any materials that are an income producing factor are ipso facto merchandise, citing osteopathic medical oncology and hematology, p.c. in the course of the opinion, the court stated: [w]here a taxpayer is a "small" corporation permitted to use the cash method under § 448(b)(3), is not required to maintain an inventory, consistently used the cash method of accounting since its incorporation, and has made no attempt to unreasonablyprepay expenses or purchase supplies in advance, the taxpayer is not required to show a substantial identity of results between the taxpayer's method of accounting and the method selected by the commissioner. 0 judge gerber vigorously dissented on numerous grounds: (1) taxpayer did not meet the heavier-than-normal burden of showing an abuse of the commissioner's discretion; (2) the majority's conclusion that the materials involved were merely an inseparable part of petitioner's performance of a service was not supported by the record; (3) the majority's holding and approach may result in unintended preferential tax treatment for a particular industry and/or taxpayers dealing in so-called "ephemeral" products or materials; (4) the holding in galedrige construction, 200o1 florida tax review inc. was erroneous and the majority's reliance upon it thus unfounded; and (5) the racmp case was factually distinguishable from osteopathic medical oncology & hematology, p. c. 0 the essence of judge halpern's dissent is captured in the following: restaurants do not sell tobacco products anymore, and liquor may give them pause, but can fancy french restaurants (or large food service operations) now argue that they need not inventory their comestibles since they are inherently a service business, with peas, carrots, truffles, and boeuf being integral to that service? what about the proliferation of dot.corn businesses, whose added value is generally some service, such as the ability to shop at home for merchandise, such as books or music, that used to require a trip to the store? i fear that our new rule may be misunderstood. 3. but not this time. von euw & l.j. nunes trucking, inc. v. commissioner, t. c. memo 2000-114. the commissioner did not abuse his discretion in requiring a sand and gravel trucking company that purchased and resold sand and gravel to switch from the cash to the accrual method because the taxpayer primarily sold sand and only incidentally transported it. racmp industries, inc. was distinguishable. 4. yet another construction company is allowed to use the cash method. jim turin & sons, inc. v. commissioner, 219 f.3d 1103 (9th cir. 2000). the court of appeals affirmed a tax court decision that commissioner abused his discretion in requiring paving company to change from the cash method to the accrual method, reasoning asphalt is not susceptible to being inventoried. the case follows galedridge construction inc., and racmp enterprises, inc. and distinguishes von euw & nunes trucking, inc. 5. is the irs is aiming for a split in the circuits after the dust settles on the first round of appeals? vandra bros. construction co., inc. v. commissioner, t. c. memo 2000-233. racmp enterprises was followed on "indistinguishable" facts. 6. this one really "floor" us. yesterday, emulsified asphalt was not inventory, today carpets are not inventory, tomorrow ... . smith v. commissioner, t. c. memo 2000-353. a flooring contractor who installed custom ordered, and often custom designed, flooring was not required to maintain inventories or use the accrual method. judge wells found that smith carpets was a service provider because all floor coverings were specially ordered from the manufacturer to the customer's specifications and, even though the taxpayer maintained a warehouse [to store the flooring pending [vol 5:2 recent developments in federal income taxation installation], it did not maintain a stock of goods to sell to the public merchandise within the meaning of reg. § 1.471-1 [although it did maintain a stock of supplies, e.g., padding, glue, etc.]. racmp enterprises, inc. was held to be controlling. 7. irs ends the small-dollar aspect of its crusade against the cash method, but continues the crusade against "small" taxpayers with gross receipts between $1million and $5 million. rev. proc. 2000-22, 2000-20 i.r.b. 1008. the commissioner will exercise his discretion to except a "qualifying taxpayer," i.e., one with average annual gross receipts of $1 million or less [as determined under reg. § 1.448-1t(f)(2)(iv), from the requirements of accounting for inventories and using an accrual method of accounting for purchases and sales of merchandise. a business that adopts the cash method under this revenue procedure will treat inventory items as materials and supplies that are not incidental under reg. § 1.162-3. this means that the taxpayer must capitalize the cost of actual purchases of goods or materials to be resold or incorporated into manufactured products and offset the capitalized amounts against the amount realized when the goods are resold, but the taxpayer may deduct currently all other manufacturing and handling costs (including labor, warehousing, and other direct and indirect costs that normally must be capitalized under § 263a). to qualify, the business may not use any method other than the cash method for its books and records and other reports. an automatic change in accounting method to the cash method under rev. proc. 2000-22 is effective for tax years ending after 12/16/99. a. modified and superseded, with some changes. rev. proc. 2001-10, 2001-2 i.r.b. 287, modifies and supersedes rev. proc. 2000-22 to clarify that the revenue procedure does not apply to tax shelters. it also clarifies the proper time to take into account the cost of inventoriable items that are treated as supplies that aren't incidental under reg. § 1.162-3. further, it clarifies the computation of the adjustment required under § 481(a) in connection with the automatic changes in method of accounting under rev. proc. 2001-10. also, the conformity requirement of § 5.07 has been removed, and § 6.02 has been modified to provide that small businesses using an accrual method of accounting that are not required under § 471 to account for inventories may use the automatic consent provisions to change to the cash method. 8. and you thought there were only two fundamental accounting methods. well, think again. tutor-saliba corp. v. commissioner, 115 t.c. 1 (2000). the tax court upheld reg. § 1.460-6(c)(2)(vi), which provides that under the percentage of completion method, the "estimated contract price" includes amounts related to contingent rights (i.e., incentive fees or amounts in dispute) and liabilities that have a "reasonable expectancy" of occurring 20011 florida tax review whether or not the all events test has been met because the regulation "harmonizes with the plain language, origin, and purpose of § 460." the taxpayer argued that the all events test is a fundamental tax principle that cannot be ignored without an express mandate from congress, but judge gerber rejected the argument because "the § 460 version of the percentage of completion method is a self-contained, statutorily created form of accounting method which varies substantially from prior accrual accounting methodology 9. final word on that other-worldly accounting method. t.d. 8929, accounting for long-term contracts, 66 f.r. 2219 (1/10/0 1). the treasury has promulgated final regulations, reg. §§ 1.460-1 through 1.460-6, under § 460. the final regulations generally follow the proposed regulations [reg-20815691, 64 f.r. 24096 (5/5/99)] with a number of modifications. costs are allocated to long-term contracts under a single standard linked to the uniform capitalization rules of § 263a. subcontracted costs are either direct material or direct labor costs that must be allocated. the look-back rule is modified to apply first in the year in which the long-term contract is completed and accepted. hybrid contracts involving both the manufacture of personal property and the construction of real property can electively be reported under the percentage of completion method. if the customer breaches before completion, previously reported gross income is reversed and the adjusted basis of the retained property equals previously deducted costs. 10. section 446(b) denies taxpayers the "license to change freely from one characterization to another when hindsight shows that it is financially advantageous," or, as spanky said to alfalfa, "first thing ya say always counts". fpl group, inc. v. commissioner, 115 t.c. 554 (2000). fpl, a major public utility, followed accounting and regulatory [ferc uniform system of accounts] rules and capitalized expenditures for the addition or replacement of "retirement unit" components, as expanded by fpl under permissible elections, of its plant and equipment. except for using the percentage repair allowance (pra) provided in reg. § 1.167(a)-11 (d)(2), and a reserve for storm -hurricane, as in andrew, that is-damage, fpl characterized expenditures as capital for tax purposes using the same method it used for accounting purposes. fpl first claimed additional repair deductions in its petition in response to a deficiency notice on other issues, but never filed a form 3115. the commissioner argued that under § 446(e) fpl was impermissibly attempting to materially change an accounting method because fpl had not requested consent and the change was not a "mere correction." on summary judgment, the tax court (judge ruwe) upheld the commissioner's position. fpl's schedule m-1 adjustments for the pra and storm damage did not establish that regulatory and financial accounting treatment were not the basic accounting method it followed to determine the character of expenditures [vol. 5:2 recent developments in federal income taxation [repair vs. capital], as modified by the pra. the irs's failure to object to similar changes for other years did not constitute implied consent. b. inventories 1. new § 1221(a)(8), enacted in 1999, excludes from capital asset treatment supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer. see iii.a., infra. 2. reg-107644-98, dollar-value lifo regulations; inventory price index computation method, 65 f. r. 31841 (5/19/2000). the treasury department released proposed amendments to reg. § 1.472-8 relating to changes in the inventory price index computation of lifo dollar-value inventory pools. c. installment method 1. the tax relief extension act of 1999 amended § 453 by adding new § 453(a)(2) denying accrual method taxpayers the privilege of installment reporting on any sales of property whatsoever. even though the taxpayer uses the accrual method, however, § 453(a)(2) does not disallow the installment reporting under § 453(1) for dispositions of property used or produced in the trade or business of farming or dispositions of residential lots or time-share condominium units. 0 the legislative history explains the purpose of this change by stating that: the installment method is inconsistent with the use of the accrual method of accounting and should not be allowed in situations where the disposition ofpropertywould otherwise be reported using the accrual method. the committee is concerned that the continued use of the installment method in such situations would allow a deferral of gain that is inconsistent with the requirement of the accrual method that income be reported in the period it is earned, rather than the period it is received. although this language may sound like congress had installment sales of goods in the ordinary course of business in mind in enacting the provision, the legislative history specifically notes that under pre-1999 § 453 "[s]ales to customers in the ordinary course of business" were not eligible for the installment method. thus, it is reasonably clear that the sales congress had in mind were asset sales other than in the ordinary course of business. accordingly, the installment method under § 453 is no longer 2001] florida tax review available to report the disposition of § 1231 property or capital assets used in the trade or business of an accrual method taxpayer. 0 for example, if a hardware store business, consisting of inventory, accounts receivable, equipment, land and building, and goodwill is sold "lock, stock, and barrel" for a lump sum payment due in five years, the entire gain on all of the assets (which must be computed separately on each asset) must be reported in the year of the sale, even though under prior law the sales of the equipment (except to the extent of § 1245 recapture), land, building, and goodwill (except to the extent of § 1245 recapture if the goodwill was a § 197 amortizable intangible) could have been reported on the installment method. a. guidance on application of denial of installment method to accrual method taxpayers. notice 2000-26,2000-17 i.r.b. 954. this notice provides guidance in a q&a format regarding the application of § 453(a)(2). o cash method shareholders of an accrual method corporation may report sales of stock under the installment method, regardless of whether the purchaser makes a § 338(g) election. 0 cash method shareholders of an accrual method s corporation may not report under the installment method if a joint § 338(h)(10) election has been made. 0 cash method partners of an accrual method partnership may report the sale of a partnership interest on the installment method [subject to the limitations of § 453(i)(2) and rev. rul. 89-108, 1989-2 c.b. 100]. 0 even if an installment obligation provides for contingent payments, an accrual method taxpayer generally may not use the open transaction method of burnet v. logan, 283 u.s. 404 (1931) to report the gain. open transaction reporting is available only in those rare and extraordinary cases in which the fair market value of the obligation cannot reasonably be ascertained. see reg. §§ 1.1001-1(a) and (g); 1.483-4 and 1.1275-4 [for rules concerning the taxpayer's treatment of the installment obligation]. b. the installment tax correction act of 2000, signed 12/28/00, retroactively repealed 1999 addition of § 453(a)(2) and restored the availability of § 453 installment reporting to accrual method taxpayers on the same basis that it was available before the 1999 legislation. 2. the tax relief extension act of 1999 also amended § 453a(d) to apply the "pledge as recognition" rule whenever a taxpayer holding an installment obligation has the right to satisfy all or any portion of his own debt to any creditor by transferring the installment obligation. unless one of the various special exceptions applies, both the seller and buyer report the oid on [vol 5:2 recent developments in federal income taxation the accrual method. any gain on the sale of the property itself is reported by an accrual method taxpayer in its entirety in the year of the sale and by a cash method taxpayer either currently or using the installment method under § 453 if the sale is eligible for installment reporting under that code provision. this provision was not repealed in 2000. d. year of receipt or deduction 1. boylston market3 still reigns. usfreightways corp. v. commissioner, 113 t.c. 329 (1999). an accrual method trucking company was required to capitalize expenditures for licenses and insurance which had an effective period extending beyond the tax year. judge nims held that taxpayer's argument whether or not the argument is well-taken that the expenditures should be currently deductible if their benefit extends "less than 12 months into the subsequent tax period" is inapplicable to an accrual method taxpayer. 2. schlumberger technology corp. v. united states, 195 f.3d 216 (5th cir. 1999). the taxpayer was not required to accrue a swiss arbitral award until the period for appeal had expired. under swiss law, an arbitral award required judicial confirmation before becoming enforceable and the unappealed award was not judicially confirmed until the period for appeal had lapsed. 3. exxon mobil corp. v. commissioner, 114 t.c. 293 (2000). taxpayer's 22% share of estimated dismantlement, removal, and restoration costs of $928 million related to prudhoe bay oil field production equipment and facilities were not sufficiently fixed and definite to be accruable under the reg. § 1.46 1-1(a)(2) all-events test. judge swift further held that taxpayer's share of $111 million in estimated drr costs relating specifically to oil wells and to well drilling sites were sufficiently fixed under the all-events test. however, the costs were not accruable as a capital cost because that would constitute an accounting method change for which taxpayer had not received permission, nor were they accruable as a current expense because this would cause a distortion in taxpayer's income. 4. clinton tax increase claims another casualty. thomas v. united states, 213 f.3d 927 (6th cir. 2000). the court of appeals affirmed a district court summary judgment that a "cash option" lottery winner had income in the later year when prize was verified (1993), not [under the "economic benefit" doctrine] in the earlier year in which the ticket was drawn and taxpayer claimed the prize (1992). it took approximately six weeks to process taxpayer's claim. the court found that taxpayer did not have irrevocable rights in any specific fund in 1992 that were greater than general creditors of the fund. 3. 131 f.2d 966 (1st cir. 1942). 2001] florida tax review 5. american express co. v. united states, 47 fed. cl. 127 (2000). before 1987, taxpayer included annual credit card fees in income when the fees were billed. in 1987 taxpayer changed its method of accounting on the basis of fasb 91 to include the fees ratably over the 12-month period for which they were billed and sought the commissioner's approval for the change in accordance with rev. proc. 71-21, 1971-2 c.b. 549. the court held the commissioner's denial of the request to be within his discretion on the ground that rev. proc. 71-21 and gen. couns. mem. 39,434 (oct. 25, 1985) provide an adequate basis for the determination that the fees were not for services. the gcm viewed card fees as payments for credit, not as payments for "contingent services." the court held that barnett banks of florida v. commissioner, 106 t.c. 103 (1996) (allowing ratable inclusion of refundable credit card fees) was decided on its own facts [which are, in fact, difficult to distinguish] and did not as a matter of law require overturning the commissioner's discretion in this case. the court further noted that the barnett banks court did not "fully address the question of whether there was an adequate basis for the commissioner's exercise of discretion under rev. proc. 71-21" and that the court of federal claims will not make close factual judgments where there is no abuse of discretion. 6. midamerican energy co. v. commissioner, 114 t.c. 570 (2000). section 1341 does not apply to rate reductions by public utility to indirectly compensate customers for prior charges that retrospectively were determined to have over-recovered costs and therefor to have been excessive; rate reductions were income reductions, not deductible expenses, and amounts and benefitted customers depended on current consumption, not consumption in year of overcharges. accord florida progress corp. v. commissioner, 114 t.c. 587 (2000). 7. you might not be able to have your cake and eat it too, but you can take your accrual deduction and hold back payment of the cash. newhouse broadcasting corp. v. commissioner, t. c. memo 2000-244. taxpayer's random house subsidiary was contractually obligated to pay book authors royalties on all books sold and not returned, even if payment was never received. random house accrued deductions for royalties on all books sold in the year. it did not pay authors royalties on all books sold but set up a "reserve" against returns and held back payment for the portion of the royalties attributable to books expected to be returned. the tax court (judge halpern) rejected the commissioner's argument that this practice negated satisfaction of the all events test with respect to the amount of royalties equal to the additions to the reserve and not paid. the royalties were legally "owed" to the authors until the books were returned, which was a subsequent event, even if they were not yet payable and might never be payable due to those subsequent events. [vol. 5:2 recent developments in federal income taxation 8. taxes now, cash received later the worst of all possible worlds. keith v. commissioner, 115 t.c. 605 (2000). the taxpayer [through a partnership] sold residential real property through contracts for deed, under which the buyers obtained possession, assumed responsibility for taxes, insurance, and maintenance, and agreed to make monthly payments, with interest, of the purchase price. a warranty deed would be delivered to the buyers only upon full payment; any default by the buyers voided the contracts; the seller could retain, as liquidated damages, all amounts previously received, and the buyer was not liable for the remaining balance. the partnership, whose return indicated it was on the accrual method, did not report any gain attributable to the contracts until the year in which full payment was received and title transferred. interest payments were included over the term of the contracts. the partnership also depreciated the subject properties during the term of each contract. in a reviewed decision (13-2), the tax court held that because under state law the benefits and burdens of ownership passed to the buyers, there was completed sale for tax purposes in the year the contracts were executed. because the sales were dealer dispositions to which § 453 did not apply, the gain from the dispositions was recognized and reportable in that taxable year. the tax court reconsidered, and no longer will follow, its opinion in baertschi v. commissioner, 49 t.c. 289 (1967), rev'd, 412 f.2d 494 (6th cir. 1969), in which the tax court held that the "nonrecourse" nature of the buyer's obligation precluded passage of the benefits and burdens of ownership. i. business income and deductions a. income 1. the beginning of a long story. estate of smith v. commissioner, 110 t.c. 12 (1998). algerine smith, frankie allen and jessamine allen owned oil royalty interests. when jessamine died in 1979, algerine smith inherited jessamine's interest; when frankie died in 1989, algerine smith inherited a portion of frankie's interest. in 1988, exxon sued algerine (and others) to recover a portion of royalties paid to algerine smith, frankie and jessamine allen (and others) from 1975 through 1980. after algerine died in 1990, algerine's estate settled the claims against algerine, frankie, and jessamine. the estate claimed the benefit of§ 1341 with respect to the repayment. the tax court held that the estate could apply § 1341 only to the repayment of the claims against algerine. section 1341 does not apply to repayments of amounts received by and taxed to the taxpayer's predecessor in interest. repayments by a beneficiary of an estate of amounts received by and taxed to the decedent and inherited by the beneficiary are not subject to § 1341. 2001] florida tax review a. affirmed and reversed. estate of smith v. commissioner, 198 f.3d 515 (5th cir. 1999). the value of a reimbursement claim against an estate should not have been limited to a post-death settlement, but should have been determined as of the date of the decedent's death. judge weiner further held that the income tax benefit the estate derived under § 1341 for its settlement payment was not a separate estate asset, and that the estate did not have cod income by settling the claim for less than the amount deducted under § 2053. b. the irs has non-acquiesced in fifth circuit smith decision on the estate tax issue, 2000-19 i.r.b. 962. c. assessment and collection while tax court litigation is pending on remand? you betcha, if you don't file an appeal bond. estate of smith v. commissioner, 115 t.c. 342 (2000). in an earlier proceeding, the tax court [108 t.c. 412 (1997), supplemented 110 t.c. 12 (1998)] had determined a deficiency. the taxpayer appealed, but did not file an appeal bond, and the irs proceeded to assess and collect the taxes. the court of appeals [198 f.3d 515 (5th cir. 1999)] reversed and remanded the earlier tax court decision for further proceedings without indicating any particular amount of the deficiency that clearly could not be assessed. normally, if the tax court is reversed, a portion of the deficiency disallowed, and the case remanded even though the litigation is not terminated under § 7486 the taxpayer may obtain a refund of the "provisionally" collected taxes. in the instant case, the irs had entered the assessment but had stayed collection pending appeal. notwithstanding the reversal on appeal, the tax court (judge ruwe) held that the reversal and remand did not indicate any particular amount of the deficiency that clearly could not be assessed. accordingly, the assessment was not abated, a refund of the portion paid was not ordered refunded, and collection was not restrained pending the decision on remand. 2. final regulations on curbing the whipsaw potential of § 110 also make clear that people like us tax professionals are retailers and that backoffice and storage spaces are included. t.d. 8901, qualified lessee construction allowances for short-term leases, 65 f. r. 53584 (8/29/00). the treasury department has promulgated final regulations under § 110 [added in 1997] relating to the exclusion for gross income for qualified lease construction payments provided by a lessor to a lessee for the purpose of constructing longlived improvements pursuant to a short-lived lease. reg. § 1.110-1. the regulations provide a safe harbor that allows a lessee in a short-term lease of retail apace to exclude from income construction allowances it uses to construct qualified long-term property. the safe harbor defines "qualified long-term real property" as nonresidential real property which is part of the rental space and which reverts to the lessor at the termination of the lease. it defines "short-term [vol 5:2 recent developments in federal income taxation lease" as a lease for retail space for 15 years or less. "retail space" is defined as real property used by a lessee in its trade or business of selling tangible personal property or services to the general public. the regulations impose information reporting requirements on both the lessor and lessee. they also clarify the definition of "retail space" to include offices for hair stylists, insurance agents, stock brokers, bankers, doctors, lawyers, and other professionals. they further clarify that back office spaces are included, as well as the selling floor. 3. rev. proc. 2000-33,2000-36 i.r.b. 257. the acquisition of corporate debt by a beneficiary of a decedent creditor's estate or by a beneficiary of a revocable trust that became irrevocable upon the creditor's death where the beneficiary of the estate is related to the corporate debtor, the decedent creditor was also related to the corporate debtor, but the estate or trust is not related to the corporate debtor, is not an indirect acquisition of the debt by the corporation under reg. § 1.198-2(b) triggering cod income to the corporation under § 108(e)(4). b. deductible expenses versus capitalization indopco aftermath: "deductions are exceptions to the norm of capitalization." (blackmun, j.) 1. is rev. rul. 94-38 all it's cracked up to be?4 dominion resources, inc. v. united states, 48 f. supp. 2d. 527 (e.d. va. 1999). the taxpayer incurred environmental remediation expenses to remove asbestos and other contaminants from a site previously used as a power generating station for the purpose of preparing the site of the retired power plant for use as an office building site or for sale. rev. rul. 94-38, 1994-1 c.b. 35, generally allows a deduction for environmental remediation costs to remedy the taxpayer's own 4. a definitive, but less-than-comprehensive, post-lvdopco revenue ruling. rev. rul. 94-38, 1994-1 c.b. 35. this ruling addresses soil remediation and groundwater treatment costs attributable to pollution caused by the taxpayer, and does not apply to costs attributable to pre-ownership contamination or to costs other than soil remediation and groundwater treatment. it relies upon plainfield-union water co. v. commissioner, 39 t.c. 333 (1962), which held that costs incurred to restore taxpayer's property to essentially the same condition that existed prior to the contamination were deductible under § 162. the ruling holds that environmental cleanup costs incurred to clean up land and to treat groundwater that a taxpayer contaminated with hazardous waste from its business (other than costs attributable to the construction of groundwater treatment facilities) are deductible under § 162 as ordinary and necessary business expenses. the cost of constructing groundwater treatment facilities must be capitalized under §§ 263 and 263a. this ruling applies whether the taxpayer plans to continue its manufacturing operations that discharge the hazardous waste or to discontinue those manufacturing operations and hold the land in an idle state, but it does not apply to costs incurred in anticipation of sale of the land. this ruling supersedes tech. adv. mem. 93-15-004 (dec. 17, 1992), which required capitalization of cleanup costs for land contaminated with pcbs. 20011 florida tax review prior pollution. notwithstanding the revenue ruling, the taxpayer was required to capitalize the expenditures because they did not merely maintain the property, but increased the appraised value of the property from approximately $1.5 million to approximately $9 million and prepared it for a new or different use. rev. rul. 94-38 was inapplicable because the site was no longer used as a power generating station, nor was such use in the future contemplated by taxpayer. a. dominion resources affirmed. dominion resources, inc. v. united states, 219 f.3d 359 (4th cir. 2000). the cleanup costs permitted the property to be utilized in a different way so the improvement is considered a capital expenditure as opposed to an improvement that only restores value to the property that existed prior to the deterioration [or prior to a discrete event that damaged the property], which is treated as a deductible repair expense. the cleanup altered the character of the property, enabling the property to be put to "a wide range of new uses," as opposed to keeping the property in its ordinary efficient condition. b. irs rules contra to dominion resources; cleaning up after yourself is currently deductible. tech. adv. mem. 1-05979-99 (aug. 28, 1999) can be found in priv. ltr. rul. 1999-52-075 (aug. 28, 1999). restoration costs allocable to contamination that occurred during taxpayer's ownership and operation of a manufactured gas plant are currently deductible under § 162 and reg. § 1.162-4 because these costs merely restored the site to the condition that existed at the time taxpayer acquired the property. the ruling also stated that the plan of rehabilitation doctrine did not apply because of taxpayer's construction of a new building on the site because "these remediation costs merely are restorative in nature, [and] they do not adapt the property to a new or different use.... [they] were not directly related to the construction of the building [but] "to the restoration of the land, an asset separate and apart from the new building." c. uniteddairy farmers, inc. v. united states, 107 f. supp. 2d. 937 (s.d. oh. 2000). taxpayer incurred environmental remediation expenses to clean up pollution caused by prior owners who operated gas stations on the site of a convenience store. even though the taxpayer was unaware of the pollution at the time of the purchase and thus "overpaid" for the property, the expenses were required to be capitalized because they "increased the value of the property." rev. rul. 94-38 did not apply. 2. extending expensing of certain environmental remediation costs. as originally enacted in 1997, § 198 provides for "expensing of environmental remediation costs ... which [are] paid or incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site [vol 5:2 recent developments in federal income taxation "applied only to expenditures paid or incurred between 8/5/97, and 12/31/00. in 1999, congress extended the provision's sunset date to 12/31/01. 3. iso costs ok. rev. rul. 2000-4, 2000-4 i.r.b. 331. cost incurred by a taxpayer to obtain, maintain, and renew iso 9000 [a series of international standards for quality management systems developed by the international organization for standardization (iso) comprised of several specific requirements that are intended to ensure a quality process in providing services or products to an organization's customers] certification are deductible as ordinary and necessary business expenses under § 162 except to the extent they result in the creation or acquisition of an asset having a useful life substantially beyond the taxable year (e.g., a quality manual). indopco does not require capitalization of all such expenses because iso 9000 certification is neither a separate and distinct asset nor does it result in future benefits that are more than incidental. the benefits are akin to those from training and advertising. moreover, the mere fact that the certification facilitates expansion of the existing business does not require capitalization. 0 note that the ruling compares as different types of situations, the expenditures in briarcliff candy corp. v. commissioner, 475 f.2d 775 (2d cir. 1973), which it notes were deductible, and those in fm)r corp. v. commissioner, 110 t. c. 402 (1998), which it notes were not deductible, apparently citing briarcliff candy with approval, notwithstanding the tax court's holding innorwestv. commissioner, 112 t.c. 89 (1999), rev'd sub nom. wells fargo & co. v. commissioner, 224 f.3d 874 (8th cir. 2000), that indopco had sub silentio overruled briarcliff candy. 4. and the irs never mentioned indopco in this pro-taxpayer ruling. rev. rul. 2000-7, 2000-9 i.r.b. 712. the irs allowed a current deduction for the cost or removing old telephone poles as part of a project to replace the poles supporting a line with new poles. the removal costs related to the retired assets, not to installation or construction of the new assets, and neither §§ 263 nor 263a applied. nor did § 280b apply [because the telephone poles were not "buildings"]. the ruling cautions: the analysis in this ruling does not apply to the removal of a component of a depreciable asset, the costs of which are either deductible or capitalizable based on whether replacement of the component constitutes a repair or an improvement. see § 1.162-4 and § 1.263(a)-l(b). 5. he who lives by the [financial accounting] sword will die by the [tax] sword. pnc bancorp, inc. v. commissioner, 110 t.c. 349 (1998). a bank's loan origination expenditures were incurred in the creation of loans, which were separate and distinct assets that generated revenue over a period beyond the current taxable year. judge ruwe held the expenditure must be 20011 florida tax review capitalized. taxpayer had argued that they were recurring expenses, so deductible. however, these costs were capitalized for financial accounting purposes, and amortized over the life of the loans, in accordance with sfas 91 [relating to deferral of loan origination (1) "incremental direct costs" and (2) certain costs related to specified activities of the lender]. a. pnc bancorp reversed. consumer and commercial loans. are not "separate and distinct assets," because loan revenue was the bank's largest revenue source and costs of originating loans were normal costs of doing business. pnc bancorp, inc. v. commissioner, 212 f.3d 822 (3d cir. 2000), rev'g 110 t.c. 349 (1998). the court of appeals for the third circuit reversed the tax court's decision in pnc bancorp and allowed a current deduction. judge rendell reasoned that the loans in question were not "separate and distinct assets" because loan revenue was the bank's largest revenue source. origination costs thus were merely the normal and routine costs of doing business that did need to be capitalized. the opinion distinguished commissioner v. lincoln savings & loan association, 403 u.s. 345 (1971), on the grounds that the "secondary reserve fund," to which lincoln savings made the payments and which was the separate asset in that case, existed wholly apart from lincoln savings' business and that pnc's origination activities did not "create" the loans in the way lincoln savings' payments created the secondary reserve fund because pnc's payments did not become part of the balance of the loan. the court relied on the bank credit card cases [colorado springs nat'l bankv. united states, 505 f.2d 1185, 1190 (10th cir. 1974); iowa-des moines nat'l bank v. cir, 592 f.2d 433 (8th cir. 1979)], which allowed a current deduction for the expenses incurred by banks to initiate bank credit card lending activities, which the court of appeals concluded continue to have vitality after indopco. the court then went on to find that indopco itself was not controlling to require capitalization because the future benefit test was not intended by the supreme court to be talismanic in all cases. although the loans themselves may have had lives of several years, the information obtained by the bank as a result of the original fees had a relatively short life it was not a "permanent betterment or improvement" in the statutory language of § 263(a). and there was no concern regarding distortion of income because of the recurring nature of the expenses. 0 while there might be some merit to the third circuit's points that consumer and commercial loan origination is the ordinary everyday activity of a bank and that the regularity of the expenses somewhat limits the potential for distortion, it is equally true that manufacturing cars, the cost of which must be capitalized, is the ordinary everyday activity of general motors. likewise, while the third circuit may be correct that the credit check and other information gathered in the loan origination process has a life that lasts only until it is used, and thus the expenses to obtain that benefit might be said to have limited future benefit, the same might be said of the expenses [vol 5:2 recent developments in federal income taxation incurred in a title search of real estate to be purchased, and those expenses clearly must be capitalized. finally, looking through the prism of commissioner v. idaho power co., 418 u.s. 1 (1974), would indicate that to focus on the life of the information obtained as a result of the loan origination expenditures is myopic. that information, which itself might have had a short life, was a cost of producing the loans, just as the depreciation on the relatively short-lived construction equipment in idaho power was a cost of the long-lived power plant. 6. the eighth circuit uses symbolic [illogic to divine the true meaning of indopco, but allows a deduction to target for friendly takeover expenses. wells fargo & co. v. commissioner, 224 f.3d 874 (8th cir. 2000), rev'gnorwest corp. v commissioner, 112 t.c. 89 (1999). a. the tax court (judge laro) held that a takeover target's expenses for investment banking, legal and accounting fees for investigating whether to accede to the takeover were required to be capitalized because all these costs "were sufficiently related to an event that produced a significant long-term benefit," citing 1ndopco, inc. v. commissioner, 503 u.s. 79 (1992), and a.e. staley mfg. co. v. commissioner, 105 t.c. 166 (1995), rev'd and remanded, 119 f.3d 482 (7th cir. 1997), victory markets, inc. v. commissioner, 99 t.c. 648 (1992). even though these costs were not incurred as "direct costs of facilitating the event that produced the long-term benefit" which would have been required by the 7th circuit's staley holding "the costs were essential to the achievement of that benefit." included among the costs capitalized was a $150,000 allocation from the salaries paid to nine executives and 73 other officers of the target, attributable to their services on various aspects of the takeover transaction. the taxpayer argued that the salaries were deductible because they would have been incurred anyway. alternatively, the taxpayer argued that the "business expansion" doctrine was implicitly codified by the enactment of § 195 and that the salaries were deductible under that doctrine (an argument that was a tough row to hoe because taxpayer had conceded that under indopco the direct costs were capital expenditures). expanding the holding in fm]? corp. v. commissioner, 110 t.c. 402 (1998), judge laro flatly stated that indopco had effectively overruled the line of cases, starting with briarcliff candy corp. v. commissioner, 475 f.2d 775 (2d cir. 1973), that allowed a current deduction for "business expansion" costs, in contrast to start-up costs. judge laro added that the enactment of § 195 did not implicitly endorse the deductibility of all business expansion costs. b. the court of appeals for the eighth circuit reversed stating that the tax court had illogically read indopco. the court of appeals (district judge hand sitting by designation) analyzed the precedents and the facts using symbolic logic to conclude that 1ndopco did not require 20011 florida tax review capitalization of expenditures that produced intangible long-term benefits unless the expenditures were "directly" rather than "indirectly" related to the creation of the benefits. the court stated: the tax court went on to hold: 'in accordance with indopco, [all] the costs must be capitalized because they are connected to an event (namely, the transaction) that produced a significant long-term benefit. (citation omitted).' this is a misinterpretation of indopco.... therefore, we conclude it was error for the tax court to require capitalization of the expenses at issue simply because they were incidentally connected with a future benefit. instead, the tax court should have performed an independent and appropriate legal analysis to determine whether each of the expenditures at issue were "ordinary."... the tax court erred when it so easily dismissed a major distinction between the instant case and indopco. the indopco case addressed costs which were directly related to the acquisition, while the instant case involves costs which were only indirectly related to the acquisition. (citation omitted).... [w]e certainly agree that payments made by an employer are deductible when they are made to employees, are compensatory in nature, and are directly related to the employment relationship (and only indirectly related to the capital transaction, which provides the long term benefit). likewise, it is true that, a deductible expense is not converted into a capital expenditure solely because the expense is incurred as part of the terms of a corporate reorganization. rather, the important consideration in determining the nature of an expenditure for tax purposes is the origin and character of the claim for which the expenditure is incurred. (citations omitted).... in 1ndopco, the expenses in question were directly related to the transaction which produced the long term benefit. accordingly, the expenses had to be capitalized. (citation omitted). we conclude that if the expense is directly related to the capital transaction (and therefor, the long term benefit), then it should be capitalized. (citation omitted). in this case, there is only an indirect relation between the salaries (which originate from the employment relationship) and the acquisition (which provides the long term benefit).5 5. wells fargo co., 224 f.3d at 885-87. [vol. 5:2 recent developments in federal income taxation the eighth circuit's website provides the following diagram to explain its logic [or lack thereof]. b or-b no easy answer. apply facts and circumstances of each case to determine whether there is such a direct relationship (r) between the expense and b, that capitalization required. or is the expense more directly related to something more ordinary, and only so indirectly related (r) to b that deduction is appropriate? legend a = physical capital asset created or enhanced; -a = no physical capital asset created or enhanced; b = benefit beyond the taxable year, -b = no benefit beyond the taxable year, r = the expense is directly related to b; -r = the expense is indirectly related to b; c = captialize; d = deduct. 2001] florida tax review as far as the legal fees were concerned, on appeal the commissioner conceded, applying the reasoning of rev. rul. 99-23, 1999-1 c.b. 998, that by analogy any fees incurred during the "investigatory stage" were deductible.6 "without adopting all of the conclusions in rev. rul. 99-23," but thereafter referring to it, the court agreed with the commissioner, however, that any legal fees incurred by the target corporation after the "final decision" had been made to go forward with the acquisition were subject to capitalization. on the facts, the court held that this decision was made on the date the parties entered into the "agreement and plan of reorganization," but the court stated that this holding was based on the facts and circumstances of the case and was not intended to provide a "bright line rule for determining when a 'final decision' has been made."7 it was small victory for the commissioner. only $27,820 of the target corporation's legal expenses were capitalized; the remaining $83,450, which were incurred prior to the "final decision" were deductible. o under the court of appeals analysis, an expense (1) that is recurring, i.e., ordinary, (2) that neither directly not indirectly creates a separate and distinct asset and (3) that is only "incidentally" [indirectly] related to producing a future benefit is not a capital expense. o rev. rul. 73-580, 1973-2 c.b. 86, which was not discussed or cited by the wells fargo court, requires that the salary of corporate employees who spend a "substantial" amount of time on acquisition work, e.g., legal accounting and other such activities in connection with acquisitions be capitalized. nor did the eighth circuit cite or discuss commissioner v. idaho power co., 418 u.s. 1 (1974), in which the supreme court held that an electric utility company that owned trucks and other equipment used in part for ordinary maintenance and in part to construct a power plant had to capitalize into the basis of the power plant the portion of depreciation allocable to the use of the equipment in the construction. in reaching its decision, the court, in part, reasoned: there can be little question that other constructionrelated expense items, such as tools, materials, and wages paid construction workers, are to be treated as part of the cost of acquisition of a capital asset. the taxpayer does not dispute this. of course, reasonable wages paid in the carrying on of a trade or business qualify as a deduction from gross income. § 162(a)(1) of the 1954 code, 26 u.s.c. § 162(a)(1). (citation omitted). but when wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized and are then entitled to be amortized over the life of the capital asset so acquired. (citations omitted).... 6. wells fargo & co., 224 f.3d 888. 7. id. at 889. ['vot 5:2 recent developments in federal income taxation an additional pertinent factor is that capitalization of construction-related depreciation by the taxpayer who does its own construction work maintains tax parity with the taxpayer who has its construction work done by an independent contractor. the depreciation on the contractor's equipment incurred during the performance of the job will be an element of cost charged by the contractor for his construction services, and the entire cost, of course, must be capitalized by the taxpayer having the construction work performed. the court of appeals' holding would lead to disparate treatment among taxpayers because it would allow the firm with sufficient resources to construct its own facilities and to obtain a current deduction, whereas another firm without such resources would be required to capitalize its entire cost including depreciation charged to it by the contractor. idaho power, 418 u.s. at 2225. 0 in ignoring idaho power, the eighth circuit in wells fargo is either wrong or has created [whether or not is was trying to do so] a distinction in the treatment of indirect costs of assets and indirect costs of long-term benefits. there is also some indication that the court of appeals confused the tax court's terminology in norwest (which referred to the expenses as "incidental" in the sense of indirect) and the supreme court's acknowledgment that "incidental" long-term benefit does not require capitalization. the adjective is the same but the noun is different. the commissioner's concession, applying the reasoning of rev. rul. 99-23, by analogy, that any legal fees incurred during the "investigatory" stage were deductible appears to be a broader concession that jndopco did not sub silentio completely overrule the business expansion doctrine as expounded in the briarcliff candy line of cases. 7. antitrust suit legal fees had to be capitalized.american stores co. v. commissioner, 114 t.c. 27 (2000). legal fees incurred in defending against the state of california's federal antitrust suit challenging taxpayer's proposed acquisition of lucky stores were required to be capitalized under indopco because they were paid in connection with an acquisition. the federal trade commission had approved the acquisition under hart-scott-rodino [15 u.s.c. § 18a] in 1998 and lucky stores was acquired by taxpayer in that year, i.e., title was acquired but lucky stores continued to be separately operated; the california attorney general continued to litigate until the matter was settled in 1990. judge ruwe held that the "principal difference between a deduction and an item that must be capitalized and amortized is the timing of the recovery of the expenditure," and that the long-term benefits of the acquisition were not 2001u available until 1990 when the lucky's stores acquired could be integrated into taxpayer's existing operations. 8. keeping them happy down on the farm. t.d. 8897, rules for property produced in a farming business, 65 f. r. 50638 (8/21/00). corrected regulations issued, t.d. 8897, 65 f. r. 61091 (10/16/2000). these final regulations prove special rules for applying [limiting the application of] § 263a to farming. 9. deductions float down old man river. ingram indus. inc. v. commissioner, t. c. memo. 2000-323. expenses for periodic maintenance of inland barge towboat engines were deductible under § 162 and reg. § 1.162-4 as repairs rather than being capital expenses. the taxpayer operated over 60 towboats, most of which were purchased used for $2.2 $2.3 million. the towboats, including the engines if properly maintained, had an expected useful life of 40 years. maintenance was performed every three or four years, depending on the number of hours of operation, but while the engines were still serviceable, at a cost of approximately $100,000 per boat. replacement used engines would have cost approximately $600,000 per boat, and new engines $1,500,000 per boat. the work was performed mostly by the crews, took about 10-12 days, and did not necessitate dry-docking the boats. the work was not the equivalent of rebuilding or overhauling the engines. for financial reporting purposes, the taxpayer accrued the estimated costs of these repairs as expenses for the periods of usage prior to the performance of the maintenance; for federal income tax purposes, the taxpayer deducted the costs in the year incurred. the commissioner determined the costs had to be capitalized and depreciated over the 10-year period beginning with the date the costs were incurred. the court (judge gerber) rejected the commissioner's argument that the engines should be treated as separate property from the boats themselves. the evidence did not support findings that, within the industry, engines ordinarily were replaced within the 40-year life of the boats or engines were evaluated separately from the remainder of the boats in pricing. there was no way to measure any increment in value of a boat resulting from the maintenance. applying the standards of plainfield-union water co. v. commissioner, 39 t.c. 333 (1962), the expenses were deductible. the tax court held that indopco was irrelevant. 10. fly the repaired skies of .... rev. rul. 2001-4,2001-3 i.r.b. 295. the irs provided significant guidance regarding the dividing line between repair costs deductible under § 162 and replacement and rehabilitation costs that must be capitalized. the ruling dealt with costs incurred by an airline with respect to work on aircraft airframes as part of a heavy maintenance visit [performed approximately every eight years] in three specific situations involving fully depreciated aircraft [aircraft have a 7-year cost recovery period]. [vol. 5:2florida tax review recent developments in federal income taxation at the time the aircraft were placed in service, it was anticipated that, if maintained, they would be useful for up to 25 years. the irs ruled that heavy maintenance expenses generally are deductible § 162. but costs incurred in conjunction with a heavy maintenance visit must be capitalized to the extent they materially add to the value of, substantially prolong the useful life of, or adapt the airframe to a new or different use. costs incurred as part of a plan of rehabilitation, modernization, or improvement also must be capitalized. 0 in the first situation, a heavy maintenance, taking 45 days, was performed for the purpose of preventing deterioration of the inherent safety and reliability levels of the airframe. the aircraft was substantially disassembled, inspected, repaired, and reassembled, after which it was tested, and returned to service. although numerous parts were replaced, the maintenance visit did not extend the useful life of the airframe beyond the originally anticipated 25 year useful life, but merely kept it in an efficient operating condition. it was used for the same purposes and in the same manner as prior to the maintenance. the expenses were fully deductible. * in the second situation, significant wear and corrosion of fuselage skins necessitated replacement of a significant portion of all of the skin panels of the aircraft, and the work performed materially added to the value of the airframe. while the aircraft was disassembled for the heavy maintenance, it was upgraded by the addition of a cabin smoke and fire detection and suppression system, a ground proximity warning system, and an air phone system to enable passengers to send and receive voice calls, faxes, and other electronic data while in flight. the expenses incurred with respect to this aircraft had to be allocated between the deductible heavy maintenance and the skin replacement and electrical upgrades, which had to be capitalized. 0 in the third situation, the aircraft, which was 22 years old and nearing the end of its anticipated useful life, was substantially improved to increase its reliability and extend its useful life. all of the expenses, including what otherwise would have been deductible routine heavy maintenance expenses, on the third aircraft had to be capitalized as part of a plan of general rehabilitation and modernization that materially increased the value and life of the aircraft. in addition, because the work was considered the production of property, under § 263a, allocable indirect costs as well as direct costs had to be capitalized. 11. potentially pyrrhic victory for the commissioner? ashley v. commissioner, t. c. memo. 2000-376. the taxpayer purchased a single family rental property and renovated it. when he sold the property nine years later he claimed a § 1231 loss by including in basis various operating expenditures such as insurance, refinancing interest, and real estate taxes paid during the renovation period, on the grounds that § 263a required such capitalization because he was in the trade or business of purchasing and restoring homes for resale. on the record, the court (judge vasquez) upheld the commissioner's 200o1 argument and found that the taxpayer was not engaged in business but was merely an "investor" not subject to § 263a. on the consequently lower basis, the taxpayer realized a gain on the sale. c. reasonable compensation 1. throw out all the reasonable comp factors. judge posner tells us there's a single inquiry that answers the question in every case. the tax court's use of a "multi-factor" test was improper. exacto spring corp. v. commissioner, 196 f.3d 833 (7th cir. 1999), rev'gheitzv. commissioner, t.c. memo. 1998-220 (gerber, j.). going a step further than the second circuit in dexsil corp. v. commissioner, 147 f.3d 96 (2d cir. 1998), a step that appears to be in the opposite direction in some ways than leonardpipeline contractors, ltd. v. commissioner 142 f.3d 1133 (9th cir. 1998), judge posner, writing for the court of appeals for the seventh circuit, castigated the tax court for its reliance on "factors" in resolving "reasonable compensation" cases and held that the only relevant inquiry is whether a hypothetical investor would be satisfied with the return on the investment that resulted from the employee/shareholder's management activities. according to judge posner, if the hypothetical investor would have been satisfied with the return, then the compensation, whatever it might have been, is reasonable. judge posner concluded that this limited test was sufficient to implement what he perceived to be the sole purpose of § 162(a)(2), to prevent the distribution of dividends (or gifts) in the guise of deductible compensation. accordingly, a salary of$1,300,000 and $1,000,000 in successive years was held to be reasonable on the sole grounds that the irs expert testified that a hypothetical investor would be satisfied with a 13% return and the corporation's return on invested capital was 20%. judge posner was not content to set forth a test for the tax court to apply on remand. he reversed the judgment "with directions to enter judgment for the taxpayer." * judge posner's opinion infers that, if the rate of return on invested capital is sufficiently above the "market" rate of return (adjusted for risk) and is due to the exertions of the employee/shareholder, there is no limit on the amount payable and deductible as compensation. it does not clearly explain why a hypothetical investor would be happy to see an unrelated manager appropriate the lion's share of economic rents earned by a firm even though his test appears to allow the lion's share of economic rents to be distributed as deductible compensation as long as a sufficient portion of the excess profits are retained or paid out as dividends to result in an above-market rate of return to invested capital. this problem may be partially addressed by the court's acknowledgment that for the payment to be deductible it must have been intended as compensation, rather than a dividend [as held in o.s.c. & associates, inc. v. commissioner, 187 f.3d 1116 (9th cir. 1999), which was not cited by judge posner], a requirement that judge posner found to have been florida tax review [vol. 5:2 recent developments in federal income taxation satisfied in the instant case through the approval by other shareholders of the salary in question. 2. but multi-factor reasonable compensation tests are alive and well out on the coast, i.e., in the ninth circuit. labelgraphics, inc. v. commissioner, 221 f.3d 1091 (9th cir. 2000), aff'g t. c. memo. 1998-343. the ninth circuit (judge mckeown) affirmed the tax court's decision that only $406,000 out of $878,913 paid as compensation to the sole shareholder of a corporation in which he was the "heart of the company" was deductible as reasonable compensation. in doing so, the court of appeals found that the tax court had correctly applied all of the "five broad factors" set forth in elliotts, inc. v. commissioner, 716 f.2d 1241 (9th cir. 1983). in elliotts, we set out five broad factors that are relevant to the reasonableness inquiry: (1) the employee's role in the company; (2) a comparison of the employee's salary with those paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) evidence of an internal inconsistency in a company's treatment of payments to employees. (citation omitted). no single factor is decisive. (citation omitted). when conducting the reasonableness inquiry, 'it is helpful to consider the matter from the perspective of a hypothetical independent investor. a relevant inquiry is whether an inactive, independent investor would be willing to compensate the employee as he was compensated.' (citation omitted.).... 3. normandie metal fabricators, inc. v. commissioner, t. c. memo. 2000-102. in determining whether a hypothetical investor would be satisfied with the corporation's return to capital, it is misleading to compute a return based on the shareholder/employee's nominal initial contribution to capital [$119 in this case]. d. miscellaneous expenses 1. notice of proposed rulemaking, qualified transportation fringe benefits, reg-1 13572-99,65 f.r. 4388 (1/27/00), corrections issued in 65 f.r. 16545 (3/29/00). proposed reg. § 1.132-9 provides in q&a format extraordinarily detailed rules regarding scope of excludable qualified transportation fringe benefits under § 132(f), including rules regarding elections under § 132(f)(4) between taxable cash and tax-free qualified parking outside of the cafeteria plan rules. 2001] florida tax review 2. the deduction was more than the includable compensationand itwas legal! sutherlandlumber-southwest, inc. v. commissioner, 114 t.c. 197 (2000). pursuant to reg. § 1.162-25t, an employer-corporation that provided private nonbusiness flights on a company-owned airplane to employees was permitted to deduct the cost of providing the flights because the fair market value of the flights was included in the employees' reported compensation under reg. § 1.61-21(b). accordingly, pursuant to § 274(e)(2), the limitations of § 274 did not apply even though the airplane otherwise could be considered to be an entertainment facility. furthermore the employer's deduction was not limited to the lesser amount includable by the employees under special fringe benefit valuation rules [reg. § 1.61-21(g)]. 3. aleda v. commissioner, t. c. memo. 2000-136. if the taxpayer has no regular place of business in the metropolitan area in which the taxpayer resides, even transportation expenses to travel to temporary job sites in other metropolitan areas are nondeductible commuting costs. 4. jorgensen v. commissioner, t. c. memo. 2000-138. a public high school english teacher, who taught in a predominantly asian-american school, incurred expenses to enroll in and attend university of california extension courses in southeast asia religious traditions and greek legends that were offered in southeast asia and greece, respectively. the courses of study included lectures, assigned readings, and visits to historical sights. although credit was available for the courses if the students wrote a topical paper, the taxpayer did not do so and did not seek credit. the expenses of course enrollment and travel were deductible educational expenses under reg. § 1.1625 and were not disallowed under § 274(m)(2). 5. home is where the hearth is, well, where the ac is, since home was in florida. johnson v. commissioner, 115 t.c. 210 (2000). the taxpayer was the captain of a merchant ship that sailed worldwide carrying equipment of the u.s. military. he received lodging and meals while on-board the vessel, but paid for his other incidental travel expenses. based on predecessors of rev. proc. 2000-9, 2000-2 i.r.b. 280, which provides that in lieu of substantiating actual travel expenses an employee may use the federal per diem rates for meal and incidental expense (m & ie) to deduct meal and incidental expenses incurred while away from home, the taxpayer claimed miscellaneous itemized deductions based on the full m & ie rates. (he had no receipts.) the tax court (judge laro) rejected that commissioner's argument that johnson was an itinerant with no tax home from which to be away, and held that his permanent residence, where he resided with his wife and their daughter, was his tax home. he had a legitimate reason for maintaining his personal residence while traveling throughout the world in the course of employment. that the employer [vol 5:2 recent developments in federal income taxation provided meals and lodging excludable under § 119 does not change this result. the court stated: according to respondent, an employee such as petitioner can never have a tax home because he continually travels to different cities during his employment. we disagree that such continual travel, in and of itself, serves to disqualify a taxpayer from having a tax home for purposes of § 162(a). regardless of where a taxpayer performs most of his or her work, the fact that he or she maintains financially a fixed personal residence generally means that he or she has a tax home someplace. (citation omitted). although the taxpayer's testimony, by itself, supported a finding that he paid incidental travel expenses while away from his tax home, he was denied the use of the full m & ie rates. the deduction is limited to the amounts attributable to incidental expense, which was only $2 per day in the continental us and between $1 and $53 per day in other locations. 6. only half the cost of mint juleps & country ham with beaten biscuits is deductible. churchilldowns v. commissioner, 115 t.c. 279 (2000). the tax court (judge laro) held that § 274(n) limited to 50% of the cost churchill downs' deduction for the expenses of entertainment [the kentucky derby sport of kings gala, press receptions, hospitality tents, winners parties, etc.] in connection with the kentucky derby, the breeders' cup, and other major horse races. although churchill downs was in the "entertainment business" the expenses for the functions were not part of its entertainment product, which was horse racing. nor were the costs deductible as entertainment available to the public [§ 274(n)(2), (e)(7) exception] or sold to customers [§ 274(n)(2), (e)(8) exception] because the functions were by invitation only and not open to the public. 7. badell v. commissioner, t. c. memo. 2000-303. advances by a law firm to its clients to pay for costs were nondeductible loans in the year the advances were made because the amounts were unconditionally repayable. that some clients might have been so destitute that actual collection was "doubtful" did not affect the result. judge colvin distinguished boccardo v. commissioner, 56 f.3d 1016 (9th cir. 1995), which held that litigation expenses paid by a law firm on behalf of its client-tort plaintiffs, which the law firm would recover only if client prevailed were deductible business expenses, not loans to the client. in boccardo the client had no personal obligation to repay advances and firm received only a "gross fee" of one third of the gross recovery. 20011 florida tax review e. depreciation & amortization 1. t.d. 8865, amortization of intangible property, 65 f. r. 38200 (1/25/2000). the treasury has promulgated final regulations § 1.167(a)-14 [dealing with depreciation of intangibles not subject to § 197] and § 1.197-2 [dealing with rules for amortization under § 197]. the regulations apply to property acquired after 1/25/00. some highlights: o for purposes of § 197 a group of assets constitutes a trade or business if (1) their use would constitute a trade or business under § 1060 [if goodwill or going concern value could, under any circumstances, attach to the assets], or (2) they include any franchise, trademark, or trade name [unlike the proposed regulations, which applied this per se rule to any customer based intangibles]. 0 purchased computer software is amortizable over 15 years if§ 197 applies but over 36 months if the software is not a § 197 intangible. section 197 (rather than reg. § 1.162-11) applies to costs to acquire a § 197 intangible that is a limited interest in software. computer software costs bundled in the cost of the computer hardware are capitalized and depreciated as part of the computer hardware. 0 amortization begins no earlier than the first day of the month in which the active trade or business or the activity described in § 212 begins. o a partnership generally may make curative or remedial allocations to its noncontributing partners of amortization relating to an asset that was amortizable (or a zero-basis intangible that otherwise would have been amortizable) in the hands of the contributor. a a § 743(b) basis step up in § 197 intangibles generally may be amortized. 0 if a right to use a § 197 intangible is obtained under a license entered into as part of a purchase of a trade or business, amounts paid for the right are chargeable to capital account. an exception [not in the proposed regulations] applies to licenses of technology, know-how, and other similar items (including most types of information base). royalty payments under a contract for the use of § 197 intangibles unconnected with the purchase of a trade or business are not required to be capitalized. 2. the irs is soft on software development. choose the treatment you prefer. rev. proc. 2000-50, 2000-52 i.r.b. 601. the irs will not disturb the consistent treatment of the cost of developing computer software, either for the taxpayer's own use or for sale or licensing to others, under one of the following methods. the taxpayer may (1) deduct the expenses under rules similar to those in § 174; or (2) capitalize the expenses and recover them either (a) over 60 months under rules similar to § 174(b), or (b) over 36 months after the software is placed in service under § 167(f)(1). purchased software that is [-vol. 5:2 recent developments in federal income taxation bundled into the nonseparately stated price of hardware can be treated as hardware. automatic change of accounting method procedures are available. 3. how to capitalize $107,748,925 as the cost basis of a $13,865,000 asset. union carbide foreign sales corp. v. commissioner, 115 t.c. 423 (2000). the taxpayer was the lessee of a seagoing vessel built to its specifications. when the lease became onerous, pursuant to the lease terms, taxpayer purchased the vessel for $107,748,925, rather than paying approximately 20% more simply to terminate the lease. at the time of the purchase, the vessel (apart from the lease) was worth $13,865,000. the taxpayer capitalized $13,865,000 as the cost of the vessel and deducted the remaining $93,883,295 as lease termination expenses. the commissioner disallowed the deduction on the grounds that § 167(c)(2) required capitalization of the entire purchase price, and the tax court (judge gerber) upheld the commissioner's position. the court noted that whether it was more or less costly to acquire the vessel or to simply terminate the lease was not relevant to the conclusion. in so holding, the court rejected the taxpayer's argument that § 167(c)(2) applies only to property acquired subject to a lease that continues in the future, accepting, instead, the commissioner's argument that § 167(c)(2) applies whenever property is acquired at a time that it was subject to a lease. accordingly, a lessee of an asset who purchases that asset for the purpose of terminating the lease is subject to § 167(c)(2). the court held alternatively that the same result would be reached wholly apart from § 167(c)(2), rejecting the taxpayer's argument [based on clevelandallerton hotel, inc. v. commissioner, 166 f.2d 805 (6th cir. 1948)] that the transaction could be bifurcated into two transactions, the termination of the onerous lease and the purchase of the vessel. the court held that in millinery center building corp. v. commissioner, 350 u.s. 456 (1956), affg 221 f.2d 322 (2nd cir. 1955), the supreme court had implicitly rejected the holding of cleveland allerton hotel, and that in any event in millinery center building corp, the second circuit, to which appeal of this case would lie, had expressly rejected clevelandallerton hotel. f. credits 1. the tax relief extension act of 1999,26 u.s.c. § 41, extended the increased investment expenditures credit through 6/30/04. the 1999 act also extended the credit to expenditures incurred in puerto rico and united states possessions (subject to limitations in § 280c(c)(1) disallowing expenditures taken into account in determining the § 41 credit from being taken into account in computing certain other credits). special rules in § 41(d) limit (1) the availability of the credit generated by activities incurred between 7/1/99 and 9/30/00 to offset tax payments due before 10/1/00, and (2) the availability of the credit generated by activities incurred between 10/1/00 and 9/30/01 to offset tax 20011 florida tax review payments due before 10/1/01. this limitation pushes the credits into the following federal fiscal year to defer their impact on the surplus. 2. the irs explains how to cope with a politically motivated deferral of extended credits that pushed the credits into the following federal fiscal year to defer their impact on the "surplus." notice 2001-2, 2001-2 i.r.b. 265. the tax relief extension act of 1999 extended the § 41 increased investment expenditures credit through 6/30/04. special rules in § 41(d) limit (1) the availability of the credit generated by activities incurred between 7/1/99 and 9/30/00 to offset tax payments due before 10/1/00, and (2) the availability of the credit generated by activities incurred between 10/1/00 and 9/30/01 to offset tax payments due before 10/1/01. the notice provides guidance for computing § 41 credit for years that include the suspension period. 3. the tax relief extension act of 1999,26 u.s.c. § 45, extended the § 45 "electricity produced from renewable resources" credit to any facility originally placed in service by the taxpayer before 1/1/02. the credit also has been extended to electricity produced from poultry waste [the cs subcredit?] at a facility originally placed in service after 12/31/99 and before 1/1/02. 4. "world headquarters" requires international operations.payless cashways inc. v. commissioner, 114 t.c. 72 (2000). the itc under the tra 1986 § 204(a)(7) rifleshot provision was denied for the costs of equipping and furnishing a corporation's "world headquarters" because taxpayer lacked substantial international operations. judge ruwe held that this necessitated having either employees stationed outside the united states or exports or foreign source income or liability for foreign taxes or a foreign permanent establishment or foreign subsidiaries or foreign joint ventures. g. natural resources deductions & credits 1. s/v drilling partners v. commissioner, 114 t.c. 83 (2000) (reviewed, 13-2). the partnership produced and sold 15,483 barrel equivalents of gas from a tight formation and 16,927 barrel equivalents from a tight formation that was also devonian shale. it claimed a § 29 credit not indexed for inflation for the 15,483 barrel equivalents from the tight formation and a double credit ($3 + $3 indexed for inflation) for each barrel equivalent produced from the tight formation that was also devonian shale. in a reviewed opinion by judge colvin (with two differing dissents), the tax court held that § 29 does not provide a double credit for gas produced from a tight formation that is devonian shale. only one credit, based on production from devonian shale, which is indexed for inflation, is allowed. but the court rejected the commissioner's argument that taxpayer's credit was limited to the greater of (1) [vol 5:2 recent developments in federal income taxation $3 unindexed on the full 32,410 barrel equivalents from a tight formation or (2) $3 indexed on the 16,927 barrel equivalents from devonian shale. 0 judge foley dissented on the double credit issue and judge vasquez dissented on the indexing issue. 2. the exxon saga: after an initial setback in the tax court, exxon has been meeting with success in the federal circuit on the issue of taking percentage depletion on fixed contract natural gas on representative market or field prices that are greatly in excess of the actual sale price for the gas. a. tax court: taxpayer not permitted to follow the literal language of the regulations. exxon corp. v. commissioner, 102 t. c. 721 (6/6/94). exxon was not permitted to follow the literal language of reg. § 1.613-3(a) and use "representative market or field prices" (rmfp) in determining "gross income from the property" for purposes of computing percentage depletion under § 613a(b)(1)(b) ["fixed contract" exception]. even though the regulation states that "the gross income from the property shall be assumed to be equivalent to rmfp" with respect to natural gas transported from the premises prior to sale, the purpose of that provision was to prevent integrated producers from taking depletion deductions on transportation, refining, etc. and not to permit taxpayer to take depletion based upon a rmfp price five times the actual sales price of the natural gas to an exxon affiliate. the actual contract sales price was therefore reduced by royalties and transportation expenses to determine "gross income from the property." b. same issue in court of federal claims. exxon corp. v. united states, 33 fed. cl. 250 (4/11/95). on the same issue, the court of federal claims held that while the amount upon which depletion can be taken is not necessarily limited by actual gross income [21 cents], the rmep calculated by exxon [41 cents] was not a reasonable basis upon which depletion may be taken and [based upon the burden of proof] the complaint was dismissed. but reversed .... c. federal circuit holds that rmfp which exceeds actual gross receipts is not precluded, nor is it per se "unreasonable." exxon corp. v. united states, 88 f.3d 968 (fed. cir. 6/20/96), cert. denied, 520 u.s. 1119 (3/17/97), rev'g and remanding 33 fed. cl. 250, (1995). the court found that exxon was entitled to calculate its depletion deduction based upon an rmfp of 39 cents based upon the wellhead price that would be realized by nonintegrated producers. the court further held that the court of federal claims should not have limited the price by making an independent assessment of the reasonableness of the price because the § 611(a) language "reasonable allowance.., in each case" refers to the different types of depletable resource, not to individual taxpayers. 20011 florida tax review d. and you thought you couldn't deplete more than your gross income. of course you can, silly boy. exxon corp. v. united states, 45 fed. cl. 581 (12/2/99). exxon sought a $172.6 million refund based on percentage depletion for 1975, under § 613a(b)(1)(b), allowing § 613 percentage depletion for natural gas sold under a fixed contract. the long-term contracts in issue were with houston lighting & power co. (hl&p) and with southwestern electric and power co. (swepco). the irs assessed a deficiency for 1975 on the grounds that exxon wasn't entitled to use the rmfp under reg. § 1.613-3(a) to compute percentage depletion because the fixedcontract exception in § 613a(b)(1)(b) did not permit use of the rmfp. exxon filed suit, and the court of claims initially denied the government's motion for summary judgement, in which the government argued that reg. § 613-3(a) did not apply to post-1974 depletion allowed under the fixed-contract exception. * on the government's motion for summary judgement, the court (senior judge gibson) held that: (1) absent evidence that the regulation systematically causes a material distortion of the "gross income from the property," reg. § 1.613-3(a) was not facially invalid as applied to percentage depletion deduction pursuant to post-1974 fixed contract exception [even if the rmfp exceeded the actual sales price, which it can under exxon corp. v. united states, 88 f.3d 968 (fed. cir. 1996)], and (2) evidence raised, genuine issues of material fact the regulation produced a result that was arbitrary, capricious, or manifestly contrary to post-1974 statutory percentage depletion scheme. 40 fed. cl. 73 (1998). after trial, the court held: 0 first: not all of the natural gas was eligible under reg. § 1.613a-7(c)(5) and (d). exxon failed to prove that its contract with hl&p qualified as a "fixed contract." the hl&p excess royalty reimbursement and additional gas contract terms permitted exxon, in part, to raise prices after feb. 1, 1975 by amounts tied to the market price for natural gas [which would allow it to recover through price increases increased tax liabilities arising from the repeal of percentage depletion], and the sales prices did in fact increase. exxon did not prove by "clear and convincing evidence"that the price increase did not "to any extent" permit it to recoup tax increases attributable to the repeal of percentage depletion. the contract with swepco, however, was qualified. although the contract had a price adjustment clause under which exxon "could potentially have recovered a portion of its increased income tax liabilities," the contract qualified as a "fixed-contract" because the contract price did not in fact increase after february 1, 1975. o second: for calculating exxon's 1975 percentage depletion allowance, the rmfp is $0.6831 per thousand cubic feet (mcf) of natural gas that is eligible for percentage depletion. (1) the texas gulf coast/east texas region, rather than the entire state, constituted a "market area that was geographically 'representative"' of exxon's 1975 production from the properties at issue. (2) in determining whether that region was the relevant [vol. 5:2 recent developments in federal income taxation market area, judge gibson found the exxon's 1975 "gas well gas production" comprising 90.24% of the gas in issue was comparable or superior to gas produced and sold generally through the region; only 9.74% [casinghead gas] was not comparable and must be excluded from the computation of exxon's allowance. (3) after determining the appropriate rmfp transaction sample and adjusting for the pre-sale costs of compression and dehydration, the court held that the rmfp for purposes ofreg. § 1.613-3(a) was $0.6831 per mcf. * exxon had argued that every sale of raw gas at a delivery point anywhere on the producer' lease property was a transaction in which the sale price was untainted by transportation before the sale. the court held that exxon failed to support that position, and that it was not feasible to cure tainted transactions by subtracting the transportation cost from the gas sale price. e. affirmed in part, reversed in part. literalism triumphs in the federal circuit. taxpayer celebrates a little bit more. exxon mobil' corp. v. united states, 244 f.3d 1341 (fed. cir. 4/3/01). the federal circuit affirmed the court of federal claims holding that percentage depletion should be calculated with respect to a rmfp that exceed the taxpayer's actual sale price. judge michel rejected the government argument that applying reg. § 1.613-3(a) would lead to "absurd results," and would "thwart the obvious purpose" of the 1975 act by noting that treasury considered, but declined to fix, the "perceived anomaly." he so held because "it is not the province of this court to remedy anomalies in the tax laws that congress and the [treasury} have refrained from correcting." the 1975 addition of § 613a "may have changed pre-1975 law by redefining what kinds of gas are eligible for percentage depletion, nothing in the regulation changes ... the method of computing the amount of percentage depletion or eligible gas." (emphasis in original) he also affirmed the trial court's holding that casinghead gas [gas that was dissolved in oil at reservoir conditions but becomes gaseous at atmospheric pressure at the top or "casinghead" of an oil well] should be excluded from the computation of the rmfp because it was not comparable to its gas well gas. finally, the court of appeals reversed the trial court's holding that the hl&p contract was not a "fixed-price contract," holding as a matter of law that it was a fixed-price contract, thereby entitling exxon to percentage depletion on the gas sold pursuant to that contract. under the contract, exxon could not raise the price of gas unless hl&p exercised its rights under the additional gas clause. that did not alter the fact that the price for the original quantity of gas was fixed from exxon's perspective. hl&p controlled whether the additional gas clause, and thus the price increase, would be invoked. 8. this word is silent when the name of the taxpayer is pronounced. 2001] florida tax review 3. delay rentals meet the uniform capitalization rules. notice of proposed rulemaking, depletion; treatment of delay rentals, reg10388299, 65 f. r. 6090 (2/8/00). the service has released proposed reg. § 1.6123(c)(2), which would conform the regulations on delay rentals to the requirements of § 263a. current reg. § 1.612-3(c)(2) allows a payor to elect to deduct a delay rental as an expense or charge it to depletable capital account under § 266. in contrast, § 263a, which was enacted after current reg. § 1.6123(c)(2) was finalized, requires a delay rental to be capitalized in some circumstances. [the uniform capitalization rules of § 263a generally require the capitalization of all direct costs and certain indirect costs properly allocable to property produced by the taxpayer.] the proposed regulations would provide that the payor of a delay rental may elect to currently expense the delay rental or charge it to depletable capital account under § 266 to the extent that § 263a does not require capitalization. capitalization may be required even though production (development) has not yet begun. reg. § 1.263a-2(a)(3)(ii). a. industry specialization paper for the petroleum industry (9/19/97). the service concluded that delay rentals under oil and gas leases held for development, that are incurred in tax years beginning after 12/31/93, are required to be capitalized and added to the depletable basis of the property to which they relate. b. tech. adv. mem. 9602002 (1995). delay rentals paid by the taxpayer are pre-production costs subject to capitalization under § 263a as costs of producing oil and gas property. 4. marginal production depletion rates. notice 2000-50, 2000-38 i.r.b. 291. percentage depletion [15%] remains available to independent producers and royalty owners under § 613a(c). section 613a(c)(6) increases the percentage depletion rate on oil or gas that is "marginal production," by one percentage point, to a maximum rate of 25%, for each dollar by which the "reference price" for crude oil generally speaking, average wellhead price per barrel for domestic crude oil b for the preceding calendar year falls below $20. the applicable percentage for purposes of determining percentage depletion for oil and gas produced from marginal properties in 2000 is 19% [down from 24% for 1999]. 5. section 43 inflation adjustment. notice 2000-51, 2000-38 i.r.b. 291. the § 43 credit for domestic "enhanced oil recovery costs" equals 15% of qualified costs for the taxable year. the credit is subject to phase-out for any taxable year in which the reference price of crude oil (determined under § 29(d)(2)(c)) for the prior year exceeds $28 (adjusted for inflation); the credit is wholly phased out if the reference price of oil equals or exceeds $34, adjusted [vol. 5:2 recent developments in federal income taxation for inflation. the enhanced oil recovery credit for taxable years beginning in 2000 is determined without reference to the phase-out. 6. shellpetroleum, inc. v. united states, 46 fed. cl. 719 (2000). shell claimed a refund for the § 29 credit for oil produced from tar sands. by interrogatory, shell sought disclosure from the irs of (1) other taxpayers' § 43(c)(2)(b) certificates, on the grounds that information in the certificates was "directly related" to its rebuttal of the government's contention that shell's wells produced "crude oil" rather than "oil from tar sands [as defined in fea 1976-49]" and (2) information in other taxpayers' certificates concerning production methods that "directly related" to shell's claim that it produced oil with technology that was not "widely available." [shell also contested the government's claim of the scope of production techniques that qualified.] the government claimed that disclosure was prohibited by § 6103. the court denied the first disclosure on the grounds that information from other taxpayers about other wells could not help shell rebut the government's contention, but with respect to the second request, § 6103(h)(4)(b) [permitting disclosure of return information "directly related" to resolution of an issue in the proceeding] arguably permitted disclosure and shell was entitled to in camera review of the certificates to determine whether the certificates contained such information in sufficient detail. to determine whether shell used technology that was not "widely available" requires an analysis of the technology used by other companies, including shell's competitors. production method information could be separated from the remainder of the § 43 certificate information, thereby allowing the government to produce the information without violating § 6103. a. further proceedings. 47 fed. cl. 812 (2000). the court denied motions by the government and berry petroleum, as an intervener, for reconsideration of its order compelling the production of the certificates for in camera inspection. judge damich found that there was no manifest error. the court found that the inspection and disclosure would not violate the purposes of § 6103, which "must be understood within the context of a post-watergate backlash against the use of information contained in tax returns for purposes of political advantage and intimidation." further, § 6103(h)(4)(b) does not require that the taxpayer requesting discovery be "directly related" to the taxpayer whose returns are being sought, and that the standard for "directly related" was similar to, but not exactly the same as, the standard for admissible evidence under the federal rules of evidence, not a higher standard. any information in 9. fea 1976-4 states that "tar sands" are: "the several rock types that contain an extremely viscous hydrocarbon which is not recoverable in its natural state by conventional oil well production methods including currently used enhanced recovery techniques. the hydrocarbon-bearing rocks are variously known as bitumen-rocks, oil impregnated rocks, oil sands and rock asphalt." 20011 florida tax review the certificates that was not directly related to shell's claims would be redacted by the court. the opinion noted that the court was sympathetic to berry's concerns about revealing trade secrets, but found that issue premature because the earlier order required an in camera inspection by the court, but not disclosure to shell. 7. a § 29 credit no-ruling issue. rev. proc. 2000-47, 2000-46 i.r.b. 482. rev. proc. 2000-3, § 5, 2000-1 i.r.b. 103, is amplified by adding to the list of issues on which the irs will not issue advance rulings the question of whether a solid fuel other than coke or a fuel produced from waste coal is a qualified fuel under § 29(c)(1)(c). waste coal for this purpose is limited to waste coal fines from normal mining and crushing operations and does not include fines produced (for example, by crushing run-of-mine coal) for the purpose of claiming the credit. a. rulings will now be given. rev. proc. 201-30, 2001-19 i.r.b. (4/23/01), modified by rev. proc. 2001-34, 2001-22 i.r.b. (5/4/01). these revenue procedures provide the circumstances under which the service will issue private letter rulings regarding whether a solid fuel produced from coal is a qualified fuel under § 29(c)(1)(c). the circumstances necessary for the service to issue a private letter ruling include the presence of coal feedstock particles no larger than a specific size, and the performance of specific activities in processing the feedstock in order to effectuate a significant chemical change. the chief requirement is that the fuel be "synthetic." to be synthetic "a fuel must differ significantly in chemical composition, as opposed to physical composition, from the substance used to produce it." examples of "favorable processes" set forth in the revenue procedure include "gasification [sic] and liquefaction [sic] and production of solvent refined coal that result[s] in substantial chemical changes to the entire coal feedstock rather than changes that affect only the surface of the coal." o rev. proc. 2001-34 modifies rev. proc. 200 130 to expand the range of sizes of coal feedstock and to eliminate one particular activity as a necessary part of a process that results in a qualified fuel. h. loss transactions, bad debts and nols 1. behold the mighty powers of the bankruptcy trustee. he avoids irrevocable elections in a single bound. united states v. sims (in re feiler), 218 f.3d 948 (9th cir. 2000), aff'g 230 b.r. 164 (9th cir. bap. 1999). a prepetition election to waive a net operating loss carryback -allegedly "irrevocable" under § 172may nevertheless be avoided by the bankruptcy trustee as a fraudulent transfer pursuant to 11 u.s.c. § 548(a)(2). under § 1398, the bankruptcy estate succeeds to tax attributes of the debtor, including the "net [l. 5:2 recent developments in federal income taxation operating loss carryovers determined under § 172." the court followed in re russell, 927 f.2d 413 (8th cir. 1991). although the election to waive an nol carryback under § 172(b)(3)(c) is irrevocable, if it was made within one year prior to the taxpayer's bankruptcy, § 1398(g)(1), providing that the bankruptcy estate succeeds to the debtor-taxpayer's nols, does not displace § 548(a)(2) of the bankruptcy act. the tax refund the nol carryback could have produced is property and the united states is a transferee by virtue of not having paid the refund that otherwise would have been paid and available to creditors. 2. culley v. united states, 222 f.3d 1331 (fed. cir. 2000). the taxpayer orchestrated a bribery and kickback scheme under which his corporation overcharged customers for products. subsequently he sold the business for a price that was based in part on the artificially inflated earnings. when the scheme fell apart, as part of a combined settlement of the criminal charges and civil suits, the taxpayer agreed to make restitution to the customers and the purchaser of the business. he was allowed a § 165 loss deduction, but not the benefits of § 1341. section 1341 applies only if it appeared to the taxpayer himself at the time of receipt that he had an unrestricted right to the funds subsequently repaid. thus, a deduction for restitution of funds obtained by fraud is not subject to § 1341, even though it may have appeared to the defrauded parties at the time that they paid him that the taxpayer had an unrestricted right to the funds. i. at-risk and passive activity losses 1. connorv. commissioner, 218 f.3d 733 (7th cir. 2000). the seventh circuit upheld the commissioner's interpretation of the 1992 versions of proposed reg. §§ 1.469-4(a), -4(c)(2) and -2(f)(6) (1992) to recharacterize as nonpassive income rental income received from a c corporation in which the taxpayers materially participated. [this result is clearly mandated by the final regulations section, see fransen v. united states, 191 f.3d 599 (5th cir. 1999).] the "written binding contract" exception in reg. § 1.469-1 l(c)(1)(ii) did not apply on the facts because the lease was unenforceable under state law. 2. retroactive application of changed passive activity loss regs upheld again sidell v. commissioner, 225 f.3d 103 (1st cir. 2000), affg t. c. memo. 1999-301. sidell was the sole shareholder of kgr, a c corporation in a manufacturing business in whiclh sidell materially participated. through a grantor trust, sidell purchased an historic property that was refurbished and leased to kgr. he claimed § 47 rehabilitation credits to offset rental income received from kgr. the tax court upheld the irs's application of the self-rental rule of reg. § 1.469-2(f)(6) and the attribution rule of reg. § 1.4694(a) [treating a taxpayer's activities as including those conducted through c corporations that are subject to § 469, s corporations, and partnerships] to 2001] florida tax review recharacterize the rental income from the property from passive to nonpassive income. because the taxpayer had no other passive income the rehabilitation credit, which remained passive under § 469(d)(2) and temporary reg. § 1.4693t [in force for the years in question], was unusable. the first circuit (judge selya) affirmed. reg. § 1.469-2(f)(6) is a legislative regulation [under § 469(/)], which under chevron u.s.a. inc. v. natural resources defense council, inc., 467 u.s. 837, 844 (1984), is entitled to "controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute."'' the court upheld the retroactive application of reg. § 1.469-4(a), adopted in october 1994, to 1993 and all of 1994. even though the precise rules in the final regulations differed substantially from those in the proposed regulations (particularly in reg. § 1.469-4(a)), the proposed regulations "put all concerned parties on clear notice that a sea change was in the wind." 3. kosonen v. commissioner, t. c. memo. 2000-107. the aggregation of losses from seven rental real estate properties on schedule e [as active losses under § 469(c)(7)] did not constitute an election to treat the activities, which were recharacterized by the irs and tax court as passive activities because the taxpayer did not materially participate, as a single activity. an election must clearly notify the irs that the election is being made. that the irs had not yet published guidance regarding how to make the election did not affect the decision. 4. the statute was self-executing; the taxpayer doesn't have to wait for regs. hillman v. commissioner, 114 t.c. 103 (2000). the taxpayer's s corporation performed management services for real estate partnerships in which the taxpayer directly or indirectly was a partner. the taxpayer received passthrough nonpassive income from the s corporation and passthrough passive deductions from the partnerships. based on § 469(l)(2) and its legislative history, under circumstances analogous to those in proposed reg. § 1.469-7 [56 f. r. 14034 (4/5/91)] permitting the offsetting of "self-charged" interest incurred in lending transactions, the taxpayer offset passive management fee deductions against the corresponding nonpassive management fee income. section 469(l)(2) provides that the irs "shall" promulgate regulations "which provide that certain items of gross income will not be taken into account in determining income or loss from any activity (and the treatment of expenses allocable to such income)." proposed reg. § 1.469-7 permits offsetting of "selfcharged" interest incurred in lending transactions, but the irs did not issue any regulation for self-charged items other than interest. under the proposed regulations, a taxpayer who was both the payor and recipient of interest was allowed, to some extent, to offset passive interest deductions against nonpassive 10. accord fransen v. united states, 191 f.3d 599 (5th cir. 1999); krtkowski v. commissioner, 114 t.c. no. 366 (2000); schwalbach v. commissioner, 111 t.c. 215 (1998). [vol. 5:2 recent developments in federal income taxation interest income. the commissioner argued that the taxpayer could not set off the deductions and income because the irs had not issued regulations for self-charged items other than interest and had thereby limited the offset. the court (judge gerber) held that the substantive set-off rule was self-executing and the taxpayer was entitled to offset the passive management deductions against the nonpassive management income. such self-charged treatment was congressionally intended not only for interest, but also for other appropriate items, and the commissioner did not argue that there was any distinction of substance between interest and management fees within the self-charged regime. a. well, now, not for this taxpayer and not in the fourth circuit. what "plain meaning" giveth in gitlitz,11 it taketh away in hillman. reversed, 250 f.3d 228 (4th cir. 2001). the court of appeals (judge hamilton) reversed, finding "nothing in the plain language of irc section 469 suggests that an exception to irc section 469(a)'s general prohibition against a taxpayer's deducting passive activity losses from nonpassive activity gains exists where, as in the present case, the taxpayer essentially paid a management fee to himself." the court reasoned that hillmans' argument for ignoring the plain language of the statute could prevail only if one of "two extremely narrow exceptions to the plain meaning rule" applied: (1) "when literal application of the statutory language at issue produces an outcome that is demonstrably at odds with clearly expressed congressional intent to the contrary" or (2) "when literal application of the statutory language at issue 'results in an outcome that can truly be characterized as absurd, i.e., that is so gross as to shock the general moral or common sense."' in the eyes of the court, neither of those situations was present. 5. an s corporation and 116 partnerships are a single activity. glick v. united states, 96 f. supp. 2d. 850 (s.d. ind. 2000). in 1992 and 1993, the taxpayer was a partner in 116 limited partnerships that owned rental real estate. in 79 of the partnerships, the taxpayer held a "controlling" general partnership interest and in 33 of them, the taxpayer held a 1% general partnership interest. the court agreed with the taxpayer that under reg. § 1.469-2(d) the partnerships could be aggregated with an s corporation, in which the taxpayer owned 93.6% of the stock, and in which taxpayer materially participated, which permitted the taxpayer to claim the losses from the partnerships against nonpassive income. the s corporation was formed specifically for the purpose of managing the limited partnership's rental properties and did so. thus, the partnerships and the s corporation were "an "appropriate economic unit" under the regulations. the entities were "so substantially intertwined that to separate their income for tax purposes would unfairly deny them the benefits of § 469's limitations." in 11. 121 s. ct. 701 (2001), discussed infra vi.d.2. 20011 addition, the s corporation's trade or business activities, i.e., managing the real estate, were "insubstantial" relative to the partnership's rental activities because the s corporation's gross income was less than 11% of that of the partnerships and the fair market value of the s corporation's assets was approximately 3% of that of the partnerships'. that the s corporation's activities were "essential" to the partnerships did not as a matter of law render the s corporation's activities not relatively insubstantial. [note that after 1993, § 497(c)(7) might moot this issue for a taxpayer who is engaged in the real estate business.] 6. both a co-owner and borrower from your co-owner be ye not. van wyk v. commissioner, 113 t.c. 440 (1999). the taxpayer and another person each owned 50% of the stock of an s corporation engaged in the farming business. taxpayer and his wife borrowed funds from the other shareholder and his wife and relent them to the corporation, after which taxpayer attempted to claim passed-through losses against the debt basis under § 1366(d)(1)(b). the tax court (judge wells) held that pursuant to § 465(b)(3), the taxpayer shareholder was not at risk for amounts lent to the corporation because he borrowed the funds from another shareholder (and that shareholder's spouse, from whom borrowing is treated in the same manner as borrowing from the husband under § 465(b)(3)(c)) to re-lend them to the corporation. the taxpayer was thus denied a current deduction for losses passed through under § 1366. money that is borrowed from a third party by the taxpayer on his own credit and then invested or contributed by the taxpayer to an activity is not governed by § 465(b)(1)(a), but rather is treated as borrowing with respect to the activity and will be considered to be at risk only if the borrowing transaction passes muster under the several other subsections of § 465 dealing with the treatment of borrowed funds. the negligence penalty was not upheld because "the complexity of § 465 and the lack of express guidance in the regulations, led [taxpayers] to an honest mistake." 7. a double loss. more v. commissioner, 115 t.c. 125 (2000). the taxpayer was an individual lloyds of london underwriter who pledged stock to secure a letter of credit posted to show he could cover claims. when he incurred losses on claims paid, the issuer of the letter of credit sold the stock. because the stock had been acquired before underwriting activity began, the gain was portfolio income under § 469(e)(1)(a) and reg. § 1.4692t(c)(3)(i)(c), which could not be offset by the passive activity losses from the insurance claims. the stock was not property used in the trade or business of insurance underwriting, and the gain was not derived in the ordinary course of business. the court noted, however, that income generated in the ordinary course by the investment component of a reinsurance business is not portfolio income. thus if the stock had been purchased with premiums from the insurance business and acquired and held for the purpose of "showing means" to cover potential losses, gain might have been passive. florida tax review [vol. 5:2 recent developments in federal income taxation 8. tarakci v. commissioner, t. c. memo. 2000-358. temporary reg. § 1.469-1t(e)(3)(ii)(d) and (vi)(c) applied to except from the passive activity loss rules equipment rental activity in which the taxpayer materially participated because it was rented to a partnership in which the lessor was a 50% partner and which conduced a trade or business. the rental was incidental to a nonrental activity of the taxpayer [conducted through the partnership] and the use and de minimis gross rental tests were met. iii. investment gain a. capital gain and loss 1. a safe harbor for debt modifications; the debt substitute election is now permanent. rev. proc. 2000-29, 2000-28 i.r.b. 113 (2000). this revenue procedure eliminates the 6/30/00 sunset date and makes the debt substitution election of rev. proc. 99-18 permanent. under this election a taxpayer can treat a substitution of debt instruments as a realization event for federal income tax purposes even though there is no "significant modification" under reg. § 1.1001-3; the taxpayer would not recognize any realized gain or loss immediately, but would take gain or loss into account over the term of the new debt instrument. it applies to substitutions after 3/1/99. a. rev. proc. 99-18, 1999-1 c.b. 736. this revenue procedure provides for an election to treat a substitution of publicly-traded debt instruments as a realization event for federal income tax purposes, even though it does not result in a significant modification under reg. § 1.1001-3 (and is, therefore, not an exchange). the election is made by a written agreement between the issuer and the holders of the debt instruments. under this election, taxpayers do not recognize any realized gain or loss on the date of the substitution, but instead take the gain or loss into account over the term of the new debt instruments. the issuer treats the new instrument as an oid instrument or as an instrument with bond premium. the holder takes a substituted basis and treats new instrument as market discount bond if the redemption price exceeds the substituted basis. the rules are applicable to substitutions that occur between 3/1/99 and 6/30/00. 2. restructured section 1221. the exceptions listed in § 1221(a)(1) through (8) are exclusive, so common-law exceptions are no longer available. corn products exception codified in § 1221(a)(7). the tax relief extension act of 1999 restructured § 1221 to create a subsection (a) in which the categories of property that are not capital assets are listed and a subsection (b) providing certain definitions relating to the some of the categories of assets 2001u florida tax review in § 1221(a). the 1999 act also added three additional categories of assets, listed in § 122 1(a)(6)-(8) that are excluded from the definition of "capital asset." • new § 122 1(a)(6) excludes any "commodities derivative financial instrument" held by a commodities derivatives dealer, unless (1) it is established to the satisfaction of commissioner that the particular instrument in question had no connection to the activities of the dealer as a dealer, and (2) the instrument was clearly identified in the dealer's records as having no connection to the dealer activities before the close of the day on which it was acquired, originated, or entered into. 0 section 1221(b)(1) defines a "commodities derivatives dealer" as any person that regularly offers to enter into, assume, offset, assign or terminate positions in commodities derivative financial instruments with customers in the ordinary course of a trade or business. a "commodities derivative financial instrument" is defined in § 1221(b)(2) as any contract or financial instrument with respect to commodities, the value or settlement price of which is calculated by reference to any combination of a fixed rate, price, or amount, or a variable rate, price, or amount, which is based on current, objectively determinable financial or economic information. this definition includes instruments such as swaps, caps, floors, options, futures contracts, forward contracts, and similar financial instruments with respect to commodities, but it does not include shares of stock in a corporation; a beneficial interest in a partnership or trust; a note, bond, debenture, or other evidence of indebtedness; or a contract to which § 1256 applies. o new § 1221(a)(7) excludes any hedging transaction that has been clearly identified as such before the close of the day on which it was acquired, originated, or entered into. this provision in effect largely codifies previously promulgated regulations [reg. § 1.1221-2], but changes the definition of a hedging transaction somewhat from that provided in the regulations. presumably the negative inference is that if a hedging transaction has not been so identified, it will be a capital asset. o section 1221(b)(2) codifies the definition of"a hedging transaction" in generally the same manner as reg. § 1.1221-2, but broadens the scope by abandoning the "risk reduction" standard of the regulations to one of "risk management" with respect to ordinary property held (or to be held) or certain liabilities incurred (or to be incurred) by the taxpayer. in addition, § 1221(b)(2)(a)(iii) permits the irs to expand by regulations the definition to include transactions entered into primarily to manage other risks. congress did not intend that the "risk management" based definition of a hedging transaction extend to "speculative transactions or other transactions not entered into in the normal course of a taxpayer's trade or business." 0 section 1221(b)(2)(b), requires the treasury to issue regulations requiring proper characterization of (1) transactions that are in fact hedging transactions but which have not been properly identified, and (2) transactions that have been identified by the [vol. 5:2 recent developments in federal income taxation taxpayer as hedging transactions but which in fact are not hedging transactions. thus, the identification or non-identification of an asset as a hedging transaction presumably will only create a presumption one way or the other. because the accompanying committee reports express congressional concern that taxpayers may seek to "whipsaw" the treasury, the identification rule is highlighted as important. thus, the recharacterization pursuant to regulations issued under § 1221(b)(2)(b) very well may turn out be a sword only for the treasury, with the taxpayer's identification (or non-identification) being only a partial shield. 0 new § 1221(a)(8) excludes supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer. this subsection is more closely related to § 1221(a)(1) (as § 1221(1) was renumbered in 1999), which excludes inventory, stock in trade, and property held primarily for sale to customers in the ordinary course of business, but which does not expressly exclude stocks of previously expensed supplies used in the course of providing services. this new provision eliminates any question in this regard, relegating supplies to ordinary asset characterization. this assures that hedging transactions with respect to such supplies, for example, jet fuel for an airline, would be ordinary transactions. in a number of cases, supplies consumed by the taxpayer or the taxpayer's customer in the course of providing services have been held not to be inventory for purposes of accounting method rules, and these cases raise the question of whether such supplies, which have been expensed upon purchase, are capital assets. section 1221(a)(1) does not expressly exclude stocks of previously expensed supplies used in the course of providing services, and neither does § 1221(a)(2). 3. new section 1260. in 1999 congress enacted new § 1260 in response to its concerns with the use of derivative contracts-forward contracts, notional principal contracts, and other similar arrangements with respect to property that provides the investor with the same or similar economic benefits as owning the property directly-by taxpayers in arrangements designed primarily to convert what otherwise would be ordinary income and short-term capital gain into long-term capital gain. * congress was particularly concerned with derivative contracts with respect to partnerships and other pass-thru entities that might have resulted in the taxpayer being taxed more favorably than if he actually had acquired an ownership interest in the entity. these transactions escaped the ambit of § 1258, which only applies to transactions in which the taxpayer's expected return is attributable solely to the time value of his net investment. • one example of a conversion transaction involving a derivative contract is when a taxpayer enters into an arrangement with a securities dealer whereby the dealer agrees to pay the taxpayer any appreciation with respect to a notional investment in a hedge fund. in return, the 2001.1 florida tax review taxpayer agrees to pay the securities dealer any depreciation in the value of the notional investment. the arrangement lasts for more than one year. the taxpayer is substantially in the same economic position as if he or she owned the interest in the hedge fund. however, the taxpayer may treat any appreciation resulting from the contractual arrangement as long-term capital gain. moreover, any tax attributable to such gain is deferred until the arrangement is terminated. 0 section 1260 presents a double-barreled attack on such transactions. first, § 1260(a)(1) limits the amount of gain with respect to any "constructive ownership transaction with respect to any financial asset" that may be characterized as long-term capital gain. the amount of gain that may be characterized as long-term capital gain is limited to the "net underlying long-term capital gain," essentially the amount of gain that would have been long-term capital gain if, during the term of the derivative contract, the taxpayer had held the underlying assets directly. any gain in excess of this amount is ordinary income. second, § 1260(b) imposes an interest charge with respect to deferral effected during years the transaction remained open on any gain treated as ordinary income, as opposed to capital gain, under § 1260(a)(1). 4. capital gains rules on sales of interests in passthrough entities are final, with some modifications. t.d. 8902, capital gains, partnership, subchapter s, and trust provisions, 65 f.r. 57092 (9/21/00). the treasury has promulgated final regulations on capital gain on sale of passthrough entities. the look-through provisions will not apply to the redemption of a partnership interest. the allocation of a divided holding period [where a partner acquired portions of an interest at different times] continues to be the rule, but exceptions are provided (1) to permit a partner to reduce cash contributions made during the year before the sale by cash distributions received during the same period on a lifo basis, and (2) to permit the irs to provide additional exceptions in published guidance for other cash contributions. the final regulations also provide that deemed contributions and distributions of cash under § 752(a) and (b) are not to be taken into account. a. don't you just love dealing with the nuances of multiple capital gains rates? reg-106527-98, capital gains, partnership, subchapter s, and trust provisions, 64 f. r. 43117 (8/9/99). [effective for transactions on or after the date the final regulations are published.] (1) proposed reg. § 1(h)-i, deals with rates applicable to sales of interests in entities that own property subject to different capital gains rates under § 1(h) for taxable years ending after 5/6/97. 0 pursuant to § l(h)(6)(b), any gain from the sale of an interest in a partnership, an s corporation, or a trust that has been held for more than one year (or more than 18 months for relevant periods in 1997) that is attributable to unrealized appreciation in the value of collectibles held by [vol. 5:2 recent developments in federal income taxation the entity is treated as gain from the sale or exchange of a collectible [applying rules similar to § 751(a) to determine the amount of that gain]. the amount of collectibles gain equals the collectibles gain that would be allocated to the selling partner, shareholder, or beneficiary [with respect to the portion of the transferred interest that is subject to long-term capital gain] if the entity had sold all of its collectibles in a taxable transaction immediately before the transfer of the interest. if the partner, s corporation shareholder, or trust beneficiary recognizes less than all of the gain upon the sale of its interest, a proportionate part of the gain is treated as collectibles gain. ° under § 1 (h)(7)(a), the amount of long-term capital gain (not otherwise treated as ordinary income under § 751 (a)) that would be treated as if§ 1250 applied to all depreciation is unrecaptured § 1250 [capital] gain, subject to a maximum rate of 25%. the proposed regulations follow h. rep. no. 105-356, 105th cong. 1st sess. (1997), at 16, fa. 11; s. rep. no. 105-174, 105th cong. 2d sess. (1998), at 149, fti. 65, and provide that upon the sale of a partnership interest held for more than one year, the amount of the gain that would have been ordinary income under § 75 1(a) if the partnership's unrecaptured § 1250 gain had been ordinary income is treated as unrecaptured § 1250 gain by the selling partner. the amount of the overall gain that is unrecaptured § 1250 gain equals the amount that would have been the partner's share of unrecaptured § 1250 gain if the partnership had sold all of its § 1250 property in a taxable transaction immediately before the transfer of the partnership interest. if the partner recognizes less than all of the gain upon the sale of the interest, a proportionate part of the gain is treated as unrecaptured § 1250 gain. however, for purposes of applying § 1(h)(7)(b) [which limits unrecaptured § 1250 gain to the taxpayer's net § 1231 gain] a selling partner's gain from the sale of a partnership interest that results in § 1250 capital gain is not treated as § 1231 gain even if § 1231 would apply to a disposition of the underlying partnership property. the treasury believes that although § 1(h)(7) requires a "look-thru rule" for determining the capital gain rate applicable to the sale of a partnership interest while no "look-thru rule" applies for applying § 1231, "[a]nomalous results would follow if § 1250 capital gain derived from the sale of a partnership interest were treated as § 1231 gain for purposes of applying the limitation in § 1 (h)(7)(b) but not for purposes of actually applying § 1231." (2) proposed reg. § 1.1223-3, deals with the holding periods of partnership interests acquired at different times in multiple transactions. a partner has a single basis in a partnership interest [rev. rul. 8453, 1984-1 c.b. 159], even if the partner acquired portions of the interest at different times or acquired the interest in a single transaction that gave rise to different holding periods under § 1223 partnership. if a partner sells the entire partnership interest any capital gain or loss is divided between long-term and short-term capital gain or loss in the same proportions as the holding period of 20011 florida tax review the interest in the partnership is divided between the portion of the interest held for more than one year and the portion of the interest held for one year or less. the portion of a partnership interest to which a holding period relates is a percentage that equals the fair market value of the portion of the partnership interest received in the transaction to which the holding period relates divided by the fair market value of the entire partnership interest (determined immediately after that transaction). a selling partner may use the actual holding period of the portion of a partnership interest sold if the partnership is a "publicly traded partnership" [see § 7704(b)], the partnership interest is divided into identifiable units with ascertainable holding periods, and the selling partner can identify the portion of the interest transferred. otherwise, the holding periods of the transferred interest must be divided in the same ratio as the holding periods of the partner's entire partnership interest. the preamble notes that irs may apply judicial doctrines, e.g., substance over form or step transaction, or reg. § 1.701-2 to attack abusive transactions designed to shift gain from the portion of a partnership interest with a short-term holding period to the portion with a long-term holding period. b. interest 1. rev. proc. 99-43, 1999-47 i.r.b. 579. the service has issued modified guidance regarding the application of § 6621(d) with respect to interest accruing before 12/1/98. a. rev. proc. 2000-26, 2000-24 i.r.b. 1257. the service has published procedures for applying the zero net interest rate under § 6621(d) for interest accruing on or after 10/1/99. 2. rev. rul. 99-40, 1999-40 i.r.b. 443, modifying and superseding rev. rul. 84-58 and rev. rul. 88-98. when a taxpayer reports an overpayment on its income tax return, interest will be assessed on that portion of a subsequently determined deficiency for the overpayment return year that is less than or equal to the overpayment as of: (1) the date on which the service refunds the overpayment without interest; or (2) the date on which the overpayment is applied to the succeeding year's estimated taxes; interest will be assessed on any remaining portion of the deficiency from the original due date of the tax for the overpayment return year. 3. t.d. 8886, use of actuarial tables in valuing annuities, interests for life or terms of years, and remainder or reversionary interests, 65 f.r. 36908 (1/12/00), corrected, 65 f.r. 58222 (9/28/00). the treasury has promulgated final regulations under § 7520 revising the actuarial tables to be used in valuing annuities, interests for life or terms of years, and remainder or reversionary interests. the regulations apply to interests created after 4/30/00. [vol. 5:2 recent developments in federal income taxation the revision was necessary because § 7520(c)(3) requires the tables to be revised not less frequently than once each 10 years. 4. security state bank v. commissioner, 214 f.3d 1254 (10th cir. 2000), aff g 111 t.c. 210 (1998). section 1281, imposing the oid rules on certain short-term debt instruments, applies only to investment type debt instruments, not to undiscounted "loans" with stated interest that have been "made" in the ordinary course of a cash method lender's business. 5. equity kicker to lender creates old. custom chrome, inc. v. commissioner, 217 f.3d 1117 (9th cir. 2000), aff'g in part and vacating and remanding in part t.c. memo 1998-317. warrants to purchase stock granted by a corporate borrower to lender to provide additional compensation to lender for making a risky loan resulted in the "price paid" by the lender for the borrower's note [under § 1273(b)] being less than the stated principal amount of the note. thus, the obligation was an oid instrument. the warrants, even though not publicly traded, properly were valued at the time of issuance, not the time of exercise, because § 83 and reg. § 1.83-7 apply only to warrants issued in exchange for services. but the tax court erred in finding that because the warrants were "at the money" at the time of issuance and the lender carried them on its books at only $1,000, they had no value thus disallowing the taxpayer any deduction for accrued oid [which the taxpayer first sought in the tax court proceeding]. under any well established financial method for valuing options, the warrants had value. remanded. c. section 1031 like-kind exchanges 1. depreciation for macrs property acquired in a § 1031 exchange of macrs property, or acquired in replacement of involuntarily converted macrs property to which § 1033 applies. notice 2000-4,2000-3 i.r.b. 313. to the extent the taxpayer's basis in the acquired macrs property does not exceed the taxpayer's adjusted basis in the exchanged or involuntarily converted macrs property, the acquired property is depreciated over the remaining recovery period of, and using the same depreciation method and convention as that of, the exchanged or involuntarily converted property. any additional basis in the acquired property is treated as newly purchased macrs property. [this is the same method as provided for acrs property in proposed reg. § 1.168-5(f) (1984).] effective for acquired macrs property placed in service on or after 1/3/00 in a like-kind exchange of macrs property under § 1031 or as a result of an involuntary conversion of macrs property under § 1033. for property acquired before 1/3/00, taxpayers who treated the entire basis as new macrs property may continue to do so, or may change accounting methods to conform. 2001] 158 florida tax review [vol. 5:2 2. tech. adv. mem. 200035005 (may 5, 2000). the exchange of fcc radio licenses for an fcc television license is a like-kind exchange under § 1031. the revenue agent had contended that the exchange of fcc licenses also involve an exchange of all the station's radio or tc property [including programming content, advertising contracts, etc.], while the taxpayer argued that the underlying property to which the licenses related was the tangible personal property consisting of transmitters, towers and antenna [described in the same product classes 3663 and 3441 as in the sic manual]. 3. look ma, "i'm an eat in a qeaa!" a safe harbor for reverse exchanges is created by the irs. rev. proc. 2000-37,2000-40 i.r.b. 308. the irs has provided safe-harbor guidance blessing § 1031 treatment for reverse starker exchanges, i.e., when the replacement property is received by an "exchange accommodation titleholder" ("eat") before the taxpayer transfers the property to be disposed of in the exchange [a situation not covered in reg. § 1.1031(k)-1], if the required conditions have been met. 2001] recent developments in federal income taxation 159 step 1 i7 j i replacement property step 2 relinquished property florida tax review * an "exchange accommodation titleholder" ("eat") may be, but need not be, a qualified intermediary [as defined in reg. § 1.1031(k)-l(g)(4)], but may not be a disqualified party [as defined in reg. § 1.1031(k)-l(k)] and must be either subject to tax or a partnership or s corporation more than 90% owned by persons subject to tax. under the revenue procedure the exchange accommodation titleholder will be treated as the owner of the property if the property is held in a "qualified exchange accommodation arrangement." the eat must hold legal or beneficial title to the property, i.e., "qualified indicia of ownership." o the qeaa must be entered into in writing within five days of the eat acquiring qualified indicia of ownership, the relinquished property must be identified [consistently with the principles of reg. § 1.1031(k)-l(g)(4)] within 45 days of the exchange accommodation titleholder acquiring qualified indicia of ownership, and the exchange must be completed within 180 days of the intermediary acquiring qualified indicia of ownership. o the taxpayer (or a disqualified party) can guarantee the accommodation party's debt, advance funds to the accommodation party to pay the purchase price, lease the property from the accommodation party, supervise the property or construction, and provide certain arrangements to protect the accommodation party against risk of loss from fluctuations in value. o a transaction can qualify under both the revenue procedure and the regulations if the accommodation party is a qualified intermediary who holds both properties simultaneously for a period not in excess of 180 days. 0 no inference is to be drawn regarding the treatment of a transaction not covered by the safe harbor. effective 9/15/00. a. outside the safe harbor, it's a rainforest. decleene v. commissioner, 115 t.c. 457 (2000). in a purported reverse like-kind exchange, the buyer acquired the replacement property from taxpayer (who not only located it, but also purchased it), held it while a new building was constructed on it (financed by taxpayer), and then exchanged it for the relinquished property. the transaction taxpayer and buyer tried to implement was a "reverse exchange" directly without the participation of any third-party facilitator. judge beghe held that there was a taxable sale of property, not a like-kind exchange, because the buyer never acquired the benefits and burdens of ownership of the replacement property in that there was an agreement between taxpayer and buyer that the relinquished property and the replacement property were of equal value. bloomington coca-cola bottling co. v. commissioner, 189 f.2d 14 (7th cir. 1951) (no § 1031 exchange occurs when taxpayer constructs a building on property he already owns) was held to be indistinguishable. the court held that [vol. 5:2 recent developments in federal income taxation the deferred exchange regulations under § 103 1(a)(3) do not apply to reverse exchanges, and that rev. proc. 2000-37 is prospective only. 4. no rulings that syndicated fractional interests in real estate are real estate rather than partnership interests. rev. proc. 2000-46, 2000-44 i.r.b. 438. the irs will not give advance rulings on whether an undivided fractional interest in real estate is [or is not] an interest in a partnership that is not eligible for like-kind exchange treatment under § 1031. [rev. proc. 2000-3, § 5.10, 2000-1 i.r.b. 103 amplified]. the irs is concerned that taxpayers are treating as undivided interests in real estate, eligible for § 1031 like-kind exchange treatment, interests in arrangements involving real property that properly should be treated as partnership interests. it intends to study the facts and circumstances relevant to the determination of whether such arrangements are separate entities for federal tax purposes. the irs requests comments regarding the relevance of the following factors in determining whether arrangements involving undivided fractional interests in real property constitute separate entities for federal tax purposes: (1) leasing or management agreements with respect to the property and the relationships between the parties to such agreements and the promoter or organizer of the arrangement; (2) agreements between the promoter or organizer of the arrangement and the holders of the fractional interests or among the holders of the fractional interests, including any contractual restrictions to which the fractional interests are subject, such as waivers of the right to partition, rights of first refusal, and options to put and/or call the fractional interests; and (3) the overall economics of the arrangements, including the sharing of profits and losses from operating the property and appreciation and depreciation in the property's value. 5. the erosion of the glass-steagall act changes the face of likekind exchanges. reg-107175-00, definition of disqualified person, 66 f.r. 3924 (1/17/01). proposed amendments to reg. § 1.1031(k)-1(k)(4) would generally provide that a bank that is a member of a controlled group that includes an investment banking or brokerage firm as a member will not be a disqualified person [with respect to deferred like-kind exchanges through an intermediary] merely because the investment banking or brokerage firm has provided services to an exchange customer within a two-year period ending on the date of transfer of the relinquished property by that customer. proposed effective date: 1/17/01. d. section 1041 1. 'tis doubly blessed to get redeemed in divorce than in marital bliss. ready. commissioner, 114 t.c. 14 (2000). mr. and mrs. read (h &w) owned substantially all of the stock of mulberry motor parts, inc. (mmp). when they divorced, the final judgment ordered (1) that w sell to h, or at h's 2001u florida tax review election to mmvp or mmp's esop plan, all of her imp stock, and (2) that h, or at h's election mmp or mmp's esop plan, pay $838,724 to w ($200,000 down and the balance by interest-bearing note). h elected to cause mmp to purchase and pay for w's stock, and the transaction was so structured. w argued that she was entitled to nonrecognition under § 1041(a) and reg. § 1.1041-it(c), q&a-9, which treats certain transfers to third parties as a transfer of property by the transferring spouse directly to the nontransferring spouse that qualifies for nonrecognition treatment under § 1041 followed by an immediate transfer of the property by the nontransferring spouse to the third party in a transaction that is not subject to § 1041 i.e., h would have a redemption treated as a dividend. h argued that § 1041(a) and reg. § 1.10411t(c), q&a-9 were inapplicable because he never had an unconditional obligation to purchase w's mmp stock, and that accordingly he recognized no income and w recognized gain on the redemption of her stock. the commissioner took the position that he was a mere stakeholder and had issued deficiency notices to both taxpayers in the joined cases to avoid a whipsaw, but the commissioner argued that w "has the better argument." 0 the tax court in a reviewed opinion (8-7) by judge chiechi, agreed with the commissioner and w. the court held that in cases involving corporate redemptions in a divorce setting, the primary-andunconditional-obligation standard that generally applies in "bootstrapacquisitions" [see rev. rul. 69-608, 1969-2 c.b. 42] is not the appropriate standard to apply to determine whether the transfer of property by the transferring spouse to a third party is on behalf of the nontransferring spouse within the meaning of reg. § 1.1041-it(c), q&a-9. applying the common, ordinary meaning of the phrase "on behalf of' in q&a-9, w's transfer of her stock to mvip was a transfer of property by w to a third party on behalf of h within the meaning of the regulation. thus, under § 1041(a), no gain was recognized by w and h recognized a dividend. the majority reasoned that hayes v. commissioner, 101 t.c. 593 (1993), did not limit the treatment of a redemption of one divorcing spouse's stock as a § 1041 transfer by that spouse and a dividend to the nonredeeming spouse. it distinguished blatt v. commissioner, 102 t.c. 77 (1994), because in that case the record did not establish that corporation acted on behalf of husband in redeeming wife's stock; and the majority attempted to distinguish the tax court's prior opinion in arnes v. commissioner, 102 t.c. 522 (1994), as involving an instance in which the husband did not have an unconditional obligation to acquire the wife's stock. 0 dissents by judges ruwe, halpern, and beghe, all argued in one way or another that the primary-and-unconditionalobligation standard that generally applies in bootstrap-acquisitions was the appropriate standard to apply, nothing in reg. § 1.1041 -1t(c), q&a-9 indicated otherwise, and that on the facts h did not have a primary and unconditional obligation to purchase w's stock. [-vol. 5:2 recent developments in federal income taxation 0 a joint dissent by judges laro and marvel argued that reg. § 1.1041-1t(c), q&a-9, never should apply to redemptions like those in any of these cases. 2. the wrong answer again, via judge hall of the ninth circuit, who here defers to the tax court as has been so seldom her wont. remember, it all began with the ninth circuit's ames decision that gave the temporary(?) regulations under § 1041 such a convoluted interpretation. 2 craven v. united states, 215 f.3d 1201 (1lth cir. 2000) a stock redemption for $4.8 million in future cash, incident to a 1989 divorce, was governed by § 1041. thus, the redeeming spouse did not recognize gain nor (because § 1041 applies) did she have imputed interest during the period before receiving cash. the stock redemption agreement between the redeeming spouse 12. ninth circuit applies § 1041 to exclude gain on wife's stock redemption. ames v. united states, 981 f.2d 456 (9th cir. 1992). the ninth circuit (judge hall) affirmed a district court's grant of summary judgment to taxpayer, holding that the divorce-settlement redemption of taxpayer's stock (in a mcdonald's franchise corporation she owned equally with her former husband) qualified for exemption under § 1041. the former husband was held to have been relieved of an obligation by the corporate redemption, so a-9 of temp. reg. § 1.1041-it would treat taxpayer's stock as having been transferred to her former husband, and then retransferred to the corporation (the "third party") in a non-§ 1041 transaction. the $450,000 cash is to be treated as paid to taxpayer by the corporation on behalf of her former husband (and presumably constituting a taxable distribution to her former husband). see temp. reg. § 1.1041-1t, a-2, example (3). but tax court holds § 1041 does not apply to tax her husband on the redemption, so neither is taxed. ames v. commissioner, 102 t.c. 822 (1994) (reviewed, 7 judges dissenting). redemption of wife's stock [in corporation owned 50-50 by husband and wife] was not a constrictive dividend to husband because he did not have a primary and unconditional obligation to purchase wife's stock, relying on rev. rul 69-608, 1969-2 c.b. 42. dissents on ground that the ninth circuit has passed on the legal issue, citing golsen v. commissioner, 54 t.c. 742 (1970) aftd, 455 f.2d 985 (10th cir. 1971), and on the untenable result that neither stockholder will incur tax consequences as a result of the $450,000 stock redemption. tax court had held for wife when husband had been obligated to purchase her stock. hayes v. commissioner, 101 t.c. 593 (1993). the existence of a provision in their separation agreement obligating husband to purchase wife's stock in their wholly-owned [mcdonald's franchise] corporation results in a constructive dividend to husband when the corporation redeemed wife's shares and results in tax-free § 1041 treatment to wife under temp. reg. § 1041-lt(c), q&a 9. the tax court disagrees with the ninth circuit'sarnes decision, and judge beghe has the correct answer. blatt v. commissioner, 102 t.c. 77 (1994) (reviewed, 3 judges dissenting). wife's redemption (pursuant to a divorce decree) of all her stock in a corporation she owned entirely with her husband was not governed by § 1041, and was taxable to her. the court refused to follow the reg. § 1.1041-it, q&a 9 theory that the redemption was a transfer to the corporation on behalf of her husband, as held in ames v. united states, 981 f.2d 456 (9th cir. 1993), in which the court refused to follow. judge beghe's concurring opinion stated that the proper interpretation of that regulation should be that no redemption should be considered to be "on behalf of' the remaining spouse unless it discharges that spouse's primary and unconditional obligation to purchase the redeemed stock, as set forth in the examples of rev. rul. 69-608, 1969-1 c.b. 42. 2001] and the corporation provided that the payments were to be made without stated interest and that the corporation would send the wife forms 1099-int stating the amounts of interest imputed to her under § 1272. senior judge cynthia hall (of the 9th circuit) followed read, supra, to find the redemption was governed by § 1041 pursuant to temporary reg. § 1.1041-it(c), q&a-9. * it appears that the intention of the parties in 1989 was to have the redemption treated as a taxable redemption by the redeeming spouse, and to have the wife taxed on the gain. the stock redemption agreement provided that since the payments under the note were without stated interest the corporation would send the redeemed wife forms 1099-int stating the amounts of interest imputed to her under § 1272, which the corporation did. the parties did not contemplate a § 1041 transfer because under reg. § 1.12741 (b)(iii) the original issue discount rules do not apply to transaction covered by § 1041. a. the nuances of §§ 301 and 302 elude yet another court when § 1041 is pulled over the judge's eyes. craven v. united states, 70 f. supp. 2d. 1323 (n.d. ga. 1999). the court followed the ninth circuit's decision in ames v. united states, 981 f.2d 456 (9th cir. 1992), to apply § 1041 to provide nonrecognition on redemption pursuant to divorce decree of wife's 47% of stock of a corporation controlled by husband. the court reasoned that the purpose of the redemption was to effect a division of marital property and thus § 1041 applied to the wife. the opinion states that the proper treatment of the husband, i.e., whether the husband had a constructive dividend by reason of the redemption, was not before the court and, in any event, was not relevant to the proper treatment of the wife's redemption. the court did get right that § 1041 did apply to the oid component of the promissory note that the wife received in exchange for the redeemed stock. 3. another "income item" exception to § 1041? field service advice 200005006 (11/1/99). the irs concludes that united states v. davis, 370 u.s. 65 (1962), is still alive when it comes to transactions not involving property and that this is just an assignment of (compensation) income. when an ex-husband transfers stock options to his ex-wife incident to a divorce, he has § 83 ordinary income on their fmv at that time, and she gets a carryover basis under § 1041(b). (if the options originally were incentive options, they automatically become nonqualified upon transfer.) neither spouse will be taxed when the options are exercised, but she will recognize capital gain on the sale of the stock. her basis is the sum of her carryover basis and the exercise price. the fsa analogizes the result from the transfer of savings bonds with accrued interest. rev. rul. 87-112, 1987-2 c.b. 207. 0 when ex-wife later exercised the options, employer issued a form 1099 to the ex-husband. he included the gain on his tax return and filed a refund claim. under united states v. davis, 370 u.s. 65 florida tax review [vol. 5:2 recent developments in federal income taxation (1962), the stock options were exchanged for the release of other marital rights or property. therefore, the transfer was at arm's length and subject to the § 83 rule that stock options are taxable on transfer. when the ex-wife exercised the options, it was not a taxable event. instead, the service said, when the stock received is sold she will realize gain on the difference between the stock's selling price and her basis, which is the sum of her carryover basis from the husband's taxable transfer and the exercise price. anticipating an argument that § 1041 shields the husband from tax, the service remarked that the options were compensation. section 1041 only deals with the nonrecognition of gain or loss in an interspousal transfer, not with excluding income. the service also noted that the assignment of income doctrine overrides § 1041. the fsa reasons that under united states v. davis, which was overruled with respect to transfers of property by the enactment of § 1041, the stock options were exchanged for the release of other marital rights or property; thus they were an income item, not "property," so the transfer was taxable to the husband. the are two internal inconsistencies in the reasoning of the fsa. first, under pre-§ 1041 law, the transferee spouse took a fmv basis, not a carryover basis. rev. rul. 67-221, 1967-2 c.b. 63. second, under berger v. commissioner, t.c. memo. 1996-076, under the § 1041 regime, if the transferor spouse recognizes gain on the transfer of an income item, the transferee spouse is entitled to a stepped-up basis. e. section 1042 1. rev. rul. 2000-18, 2000-14 i.r.b. 847. if a taxpayer who has sold stock to an esop or cooperative and has elected to defer the recognition of gain under § 1042(a) subsequently transfers qualified replacement property to a partnership in exchange for a partnership interest, the transfer to the partnership is a disposition of the qualified replacement property resulting in recapture of the deferred gain under § 1042(e). iv. compensation issues a. employee compensation and plans 1. reg-109101-98, special rules regarding optional froms ofbenefit under qualified retirement plans, 65 f.r. 16546 (3/29/00). the treasury issued proposed regulations under § 411(d)(6), permitting.qualified plants to eliminate some alternative forms of benefits. a. t.d. 8900, special rules regarding optional forms of benefit under qualified retirement plans, 65 f.r. 54100 (8/31/00). the treasury promulgated final regulations that permit qualified defined 2001] florida tax review contribution plans to be amended to eliminate some alternative forms of benefit and to permit transfers between defined contribution plans that were not permitted under prior final regulations. 2. t.d. 8880, relief from disqualification for plans accepting rollovers, 65 f.r. 21312 (4/21/00). the treasury promulgated final regulations under § 401(a)(31) to provide specific rules that grant relief from disqualification to an eligible retirement plan that inadvertently accepts an invalid rollover contribution. the regulations clarify that it is not necessary for a distributing plan to have a favorable irs determination letter in order for a plan administrator of a receiving plan to reach a reasonable conclusion that a contribution is a valid rollover contribution. 3. t.d. 8878, tax treatment of cafeteria plans, 65 f. r. 15548, 200015 i.r.b. 857 (3/23/00). final reg. § 1.125-4 permits mid-year cafeteria plan elections with respect to medical and group term life insurance by an employee who has a change of status, such as change in marital status or number of dependents, employment, work site, etc., during the year. [employees generally are permitted to make elections between cash or qualified tax free benefits only at the beginning of the plan year.] a. reg-l 17162-99, notice of proposed rulemaking, tax treatment of cafeteria plans, 65 f.r. 11587 (3/23/00). the treasury issued proposed amendments to various subsections of reg. §§ 1.125-1,-2, and -4 that would extend to dependent care assistance and adoption assistance the availability of mid-year cafeteria plan elections based on a change of status, under the same terms that apply to mid-year elections with respect to medical and group term life insurance under reg. § 1.125-4. b. t.d. 8921, tax treatment of cafeteria plans, 66 f.r. 1837 (1/10/01). the march 2000 final regulations have been modified to permit employees to elect to increase or decrease group-term life insurance or disability coverage in response to a change-of-status event, including birth, adoption, or death. 4. same desk rule limited by treasury, but it will take congress to eliminate the rule completely. rev. rul. 2000-27, i.r.b. 1016. an employer's sale of less than 85% of the assets in a trade or business does not constitute a sale of substantially all the assets within the meaning of§ 401 (k)(10)(a)(ii), so the prohibition of distributions on the ground of separation from service under the "same-desk" rule will not be applied under those circumstances. 5. notice 2000-32, 2000-26 i.r.b. 1274. this notice provides permanent relief and guidance relating to the exception to the definition of [vol. 5:2 recent developments in federal income taxation "eligible rollover distribution" for hardship distributions. the exception was added in 1998 to §§ 402(c)(4) and 403(b)(8)(b). 6. rev. proc. 2000-27, 2000-26 i.r.b. 1272. this revenue procedure opens the irs determination process for individually designed pension plans for amendments incorporating legislative changes from 1994 to 1998. it extends the remedial amendment period for one more year, i.e., to the last day of the first plan year beginning after 12/31/00. (the deadline for master and prototype plans is not extended beyond the 12/31/00 deadline set forth in rev. proc. 200020.) 7. t.d. 8891, increase in cash-out limit under sections 411(a)(7), 411(a)(11), and 417(e)(1) for qualified retirement plans, 65 f.r. 44679 (7/19/00). the treasury has promulgated final regulations relating to the increased cash-out limit. the regulations increase from $3,500 to $5,000 the limit on distributions from qualified retirement plans that can be made without participant or spousal consent. 8. t.d. 8894, loans from a qualified employer plan to plan participants or beneficiaries, 65 f.r. 46588 (7/31/00). the treasury promulgated final regulations in q&a form under § 72(p) relating to plan loans. a. reg-1 16495-99, proposed rules, loans from a qualified employer plan to plan participants or beneficiaries, 65 f.r. 46677 (7/31/00). the treasury has issued proposed modifications of t.d. 8894 relating to suspended loan repayments during a participant's military service, to unrepaid loans treated as distributions, and to multiple plan loan arrangements. 9. reg-1 14697-00, proposed rules, nondiscrimination requirements for certain defined contribution retirement plans, 65 f.r. 59774 (10/6/00). proposed regulations would prescribe conditions under which "new comparability" defined contribution plans will be permitted to satisfy nondiscrimination requirements based on proposed plan benefits, rather than on actual plan contributions. 10. a little more help for rabbi trusts. notice 2000-56, 2000-43 i.r.b. 393. this notice deals with the application of reg. § 1.1032-3 if a parent corporation contributes its stock to a rabbi trust established by a subsidiary to provide deferred compensation to the subsidiary's employees. the parent corporation will be considered the grantor and the owner of the parent's stock held in the trust if the parent's stock (1) is subject to the claims of the creditors of the parent corporation, and (2) reverts to the parent on termination of the trust to the extent it is not transferred to an employee. this result obtains even if the parent stock in the trust is also subject to the claims of the subsidiary's creditors. 20011 the parent stock will not be considered transferred to the subsidiary used to satisfy the subsidiary's deferred compensation obligation (or when a claim is made against the trust by a creditor of the subsidiary). as a result the immediate transfer requirement of reg. § 1.1032-3(c)(2) is satisfied with respect to the parent stock. model language in rev. proc. 92-64, 1992-2 c.b. 422, may be modified to take this change into account and an advance ruling may be obtained. 11. estate of ashman v. commissioner, 231 f.3d 541 (9th cir. 2000), affg, t.c. memo. 1998-145. in 1990, the taxpayer received a distribution from a qualified plan that she reported as a tax-free rollover from one qualified retirement plan to another [pursuant to § 402(c)]. in fact, the rollover did not comply because the contribution to the new account was not made within the 60 days required by § 402(c)(3). in 1993, when the taxpayer withdrew funds from the new account, she did not report receipt of the distribution. she claimed a basis offset on the grounds that the 1990 transaction did not qualify for taxfree rollover. because 1993 was a closed year, the commissioner denied the basis offset on the grounds that the taxpayer was estopped from claiming that the 1990 transaction was a qualified rollover. the ninth circuit affirmed the tax court's application of the "duty of consistency" to disallow the basis offset and require inclusion of the full distribution. 12. fundamental changes in the treatment of split-dollar life insurance. notice 2001-10, 2001-5 i.r.b. 459. this notice provides interim guidance on split-dollar life insurance contracts. it notes that the p.s. 58 rates no longer reflect current fair market value of insurance protection. the notice requires that employer payments be consistently treated as: (1) interest-free loans under § 7872, (2) investments by the employer in the contract, or (3) payments of compensation. the service had long rejected interest-free loan treatment of the employer investment in the cash value of split-dollar life insurance, but the enactment of § 7872 in 1984 enables interest-free loan treatment to be used as a valid model. the alternative is to have the true cost of insurance protection reflected in the employee's income; insurance companies will be required to provide rates at which comparable term policies will be available to the general public (instead of the low-ball rates that had been provided in the past). b. individual retirement accounts 1. was this bunney dumb? bunney v. commissioner, 114 t.c. 259 (2000). while he was married, the taxpayer established an ira using community property. when he was divorced, the decree required him to pay over to former spouse one-half of the balance of the ira. the one-half of community funds paid to the former spouse were not taxable to the former florida tax review [vol 5:2 recent developments in federal income taxation spouse on distribution of the funds to the husband followed by his transfer of them to the wife pursuant to the court judgment that ordered the funds "to be divided equally between the parties." the taxpayer-participant was taxed on the entire distribution. judge laro held that recognition of community property interests for federal income tax purposes would conflict with the application of § 408, which defines an ira as a trust created or organized "for the exclusive benefit of an individual or his beneficiaries." the court held, additionally, that the qdro-like provisions of § 408(d)(6) were inapplicable because there was no transfer of the ira participant's "interest" in the ira to his spouse. 2. notice 2000-30, 2000-25 i.r.b. 1266. this notice specifies a new consistent method to be used by ira trustees for reporting ira recharacterizations [trustee-to-trustee transfers] and reconversions [a conversion is the transfer, by rollover or other means, of an amount in a nonroth ira to a roth ira (which is treated as a distribution from the nonroth ira); a reconversion is a conversion from a nonroth ira to a roth ira of an amount that had previously been recharacterized as a contribution to the nonroth ira after having been earlier converted to a roth ira] occurring after 2000. reporting of distributions on form 1099-r, and reporting of contributions on form 5498. 3. notice 2000-39, 2000-30 i.r.b. 132. this notice provides guidance permitting a new method for calculating the net income attributable to post1999 ira contributions that are distributed as a returned contribution or recharacterized as a contribution to a different-type ira. 4. they're taking all the fun out of calculating minimum required distributions from plans and iras. reg-130477-00 and; reg-130481-00, required distributions from retirement plans, 65 f.r. 3928 (1/17/01). proposed regulations under § 401(a)(9), etc. would substantially simplify the calculation of minimum required distributions (mrd) from qualified plans, iras, and other related retirement savings vehicles. the changes in the proposed regulations are based on the concept of a uniform lifetime distribution period. the regulations provide a single table that any recipient can use to calculate their yearly mrd amount by plugging in their age and the prior yearend balance of their retirement account or ira. the table eliminates the need to elect recalculation of life expectancy, determine a designated beneficiary by the required beginning date, or satisfy a separate incidental death benefit rule. the proposed regulations will result in reducing mrds for the vast majority of employees and ira holders. although mrds will be calculated without regard to the beneficiary's age, the regulations will continue to permit a longer payout period if the beneficiary is a spouse more than 10 years younger than the employee. 2001u florida tax review v. personal income and deductions a. miscellaneous income 1. nielsen v. commissioner, 114 t.c. 159 (2000). the taxpayer'sresidence was condemned by the state of south dakota for purposes of a federally aided highway construction project. a a result of the condemnation, the taxpayer received $65,000 [for a year not governed by current § 121]. subsequently, the taxpayer received an additional $100,000 of supplemental relocation assistance payments under the uniform relocation assistance and real property acquisition policies act of 1970, pub. l. no. 91646, 84 stat. 1894. the taxpayer claimed that not only was the $100,000 excludable under the provisions of the relocation act exempting payments thereunder from income [42 u.s.c. § 301], but that the $65,000 received for her home in the condemnation proceeding was likewise exempt, and she reported no capital gain on the disposition of her home. the tax court upheld that commissioner's determination that the $65,000 was not exempt and that the taxpayer recognized a gain to the extent that the payment exceeded her basis in her residence. 2. warren v. commissioner, 114 t.c. 343 (2000) (reviewed, 14-3). if a parsonage allowance is paid to a minister, under § 107(2) it is excludable up to the amount of eligible expenses actually paid out of the allowance, even though the amount of the allowance exceeds the "fair rental value" of the parsonage, which can occur when the allowance covers mortgage payments in full, as well as real estate taxes, maintenance, utilities, and funishinrs for a home owned by the minister. the court rejected the commissioner's argument that the exclusion under § 107(2) was limited to the $58,000 rental value of the minister's home where between $76,000 and $80,000 of total compensation of $77,000 to $99,000 designated as an annual parsonage allowance over three taxable years was expended on qualifying expenditures. the excess of the designated allowance over actual housing expenditures was taxable. 3. additional amount of severance payments treated as recovery for wrongful discharge. greer v. united states, 207 f.3d 322 (6th cir. 2000). the court held that the additional amount of severance payments [in excess of the amount taxpayer would have been ordinarily entitled to$331,968 as compared to $51,000] was received in settlement of taxpayer's tort claim for wrongful discharge. taxpayer was transferred from the position of ashland oil's environmental compliance director after completing many negative environmental compliance audits of his employer's petroleum operations; he was discharged because "he did not fit in." [vol. 5:2 recent developments in federal income taxation 4. making the world safe for toasters. the "kinder and gentler" irs that emerged from the internal revenue service restructuring and reform act of 1998 says that free toasters at least really cheap free toasters from your bank aren't income. rev. proc. 2000-30, 2000-28 i.r.b. 113. on the grounds of "administrative convenience," the irs will not require a bank depositor who receives a de minimis premium to include the value of the premium in gross income. nor will the depositor be required to reduce the basis in the account by the de minimis premium. [a basis reduction would have rendered the account an oi) instrument.] the financial institution that provides a de minimis premium is not required to report it as interest under § 6049. for these purposes, a "de minimis premium" is a non-cash inducement, provided by a financial institution to a depositor to open or add to an account, that does not have a cost to the financial institution in excess of $10 for a deposit of less than $5,000 or $20 for a deposit of $5,000 or more. 5. new regs clarify 1954 provision that many didn't realize was so ambiguous. t.d. 8890, definition of a grantor, 65 f.r. 41332 (7/5/00). the treasury has promulgated reg. § 1.671-2(e), dealing with the identification of the grantor of a trust for purposes of the grantor trust rules. the term "grantor" includes any person that directly or indirectly makes a gratuitous transfer of cash or property to a trust, whether or not the person created the trust. if a person creates or funds a trust on behalf of another person, both of them are treated as grantors of the trust, unless the person who created a trust made no gratuitous transfers to it. a gratuitous transfer is any transfer other than a transfer for fair market value. a transfer is for fair market value only to the extent of the value of property received from the trust, services rendered by the trust, or the right to use property of the trust. an interest in the trust is not property received from the trust. * "grantor" includes any person who acquires an interest in a trust from a grantor of the trust if the interest acquired is an interest in investment trusts described in reg. § 301.7701-4(c), liquidating trusts described in reg. § 301.7701-4(d), or environmental remediation trusts described in reg. § 301.7701-4(e). • if a partnership or corporation makes a gratuitous transfer to a trust for a business purpose of the partnership or corporation, the partnership or corporation will generally be treated as the grantor of the trust. 6. a man's (woman's) home is his (her) tax-free castle. reg105235-99, exclusion of gain from sale or exchange of a principal residence, 65 f.r. 60136 (10/10/00). proposed regs. §§ 1.121-1 through 1.121-4 and 1.1398-3 provide guidance regarding the application of the $250,000/$500,000 exclusion for gain on the sale of the taxpayer's principal residence. there are no real surprises. 2001] 7. praise the lord and pass the form 1040. fullman v. commissioner, t.c. memo. 2000-340. fullman received slightly over $11,000, which he did not report, for playing the organ during services at two different churches. he claimed that he was a "'minister of music' and play[s] the organ for the glory of god. *** god does not want his church affiliated with the state." he lost. b. deductions and credits 1. the individual amt originally was intended to apply primarily to taxpayers with significant economic income who because of tax shelter investments were paying little or no income taxes. because of numerous amendments to the amt and the regular income tax provisions over the years, mostly provisions specifically limiting tax-shelter deductions and credits, the individual amt currently does not significantly affect investors or businesses. instead it increasingly affects middle-class wage earners taxpayers not engaged in tax-shelter or deferral strategies. for 1997 five items that are "personal" in nature and not the result of tax planning strategies personal exemptions, standard deductions, state and local tax deductions, medical expense deductions, and miscellaneous itemized deductions collectively comprised 73.4% of individual amt preferences and adjustments. studies indicate that, by 2007, almost 95% of the revenue from amt preferences and adjustments will be derived from the personal exemption, the standard deduction, state and local taxes, and miscellaneous itemized deductions. see harvey & tempalski, the individualamt: why it matters, 50 nat. tax j. 468 (1997); tax simplification recommendations from aba, aicpa, and tel, lexis, tax ana, 202000 tnt 39-82 (feb. 28,2000). because the individual amt so widely misses its original mark while adding inordinate complexity to the tax system for middle-class wage earners due to its interaction with limitations on the various personal credits, there is growing sentiment for its repeal, even among tax "reformers" who originally supported the enactment of the individual amt. a. the alternative minimum tax ("amt") trap for attorneys' fees on large recoveries. alexander v. irs, 72 f.3d 938 (1st cir. 1995), affig, t.c. memo. 1995-51. attorney's fees are miscellaneous itemized deductions, and may not be deducted for amt purposes. the entire recovery of $250,000, of which $245,000 was retained by taxpayer's lawyer as legal fees, was required to be included in gross income. the attorney's fees were allowable only as a miscellaneous itemized deduction. b. attorney's fees not included in the income of taxpayer who received a large punitive damages award, at least in the fifth and eleventh circuits (as derived from pre-split fifth circuit precedents), florida tax review [vol. 5:2 recent developments in federal income taxation under the golsen rule. davis v. commissioner, t.c. memo. 1998-248. willie mae barlow davis recovered $152,000 of compensatory damages and $6 million of punitive damages against two companies that made loans to homeowners in alabama. her share of the recovery after legal fees and expenses was $3,039,191. generally, the tax court holds that attorney's fee awards paid directly to a plaintiff's attorney [or the portion of a damage award that is the attorney's contingent fee that is so paid] are nevertheless includable in the litigant's gross income, and that the taxpayer then may claim a deduction, subject to any applicable limitations, including disallowance of the deduction for amt purposes if it is a § 212 deduction. bagley v. commissioner, 105 t.c. 396 (1995), affd, 121 f.3d 393 (8thcir. 1997).accordbaylin v. united states, 43 f.3d 1451 (fed. cir. 1993). in cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959), however, the fifth circuit held that attorney's fees so paid directly to a plaintiffs attorney are not includable by the litigant. in davis, which was appealable to the eleventh circuit, the tax court followed cotnam under the golsen rule because under bonner v. city ofprichard, alabama, 661 f.2d 1206 (1 lth cir. 1981), fifth circuit decisions rendered before the eleventh circuit was created are binding precedent in the eleventh circuit. c. the eleventh circuit affirms davis. davis v. commissioner, 210 f.3d 1346 (2000) (per curiam). the eleventh circuit court of appeals held that it was bound by cotnam. the irs argued in the alternative that taxpayer made a taxable disposition of her property in [time-barred] 1989, and that the burnet v. logan open transaction doctrine applied. the court held that burnet v. logan applies only when both the asset exchanged and the asset received have an unascertainable value, and "the irs provided no proof that the values of either the cause of action or the attorneys' services were unascertainable." 0 the problem is that those values are unascertainable at the time taxpayer entered into a contingent fee agreement with her counsel. does § 83 apply to the agreement? yes, as to the lawyer; and yes, as to the taxpayer's deduction. would a § 83(b) election made at the time of the contingent fee agreement help? no, it would cap taxpayer's deduction, and it is questionable whether it would cap the amount realized on the exchange. see gregg d. polsky, "taxing contingent attorneys' fees: many courts are getting it wrong," 89 tax notes 917 (nov. 13, 2000). d. but, not so fast. tax court says case involving attorney's fees paid under texas common law is not bound by cotnam, which involved alabama law which by statute gives attorneys a substantive right to fees based on their lien. srivastava v. commissioner, t.c. memo. 1998-362. the taxpayers were not entitled to exclude the 40% of their settlement proceeds from a personal injury lawsuit that they assigned to their attorneys. under the texas common law on attorneys' liens, no ownership interest was transferred to the 200o1 florida tax review attorneys. judge parr held that cotnam v. commissioner, supra, was inapplicable to this case under the golsen rule because the texas common law [giving no ownership rights to the attorneys] differed from the alabama statutory law ["the same right and power over said suits, judgments and decrees, to enforce their liens, as their clients had or may have for the amount due thereon to them."]. the attorneys' fees are deductible for regular income tax only as a miscellaneous itemized deduction governed by § 67, and not deductible at all for alternative minimum tax ("amt") purposes. on the issue of allocating the settlement that was entered into after the damage award by the trial court, the commissioner proposed a method of allocation, suggesting that "it is presumed that actual damages would be paid before prejudgment interest, postjudgment interest, or punitive damages, and that prejudgment interest would be paid before punitive damages." 0 to the same effect under arizona common law attorneys' liens is sinyard v. commissioner, t.c. memo. 1998-364 (swift, j.). e. fifth circuit: tekas common law lien not subject to amt trap. srivastava reversed in split decision based upon cotnam. srivastava v. commissioner, 220 f.3d 353 (5th cir. 2000) (2-1). as a matter of original impression, the majority (judge jerry smith) would have included contingent fees in taxpayer's gross income under the anticipatory assignment of income doctrine, just as non-contingent attorney's fees included in a damage award are includable in gross income. however, judge smith held that cotnam cannot be distinguished because there is no difference in the "economic reality facing the taxpayer-plaintiff' between alabama and texas attorney's liens and any distinction between them does not affect the analysis required by the anticipatory assignment of income doctrine. o a dissent by judge dennis distinguished cotnam on the ground that alabama law gives the holders of attorney's liens greater power than does texas law. f. the sixth circuit creates a split in the circuits on the amt trap for attorney's fees. estate ofclarks v. commissioner, 202 f.3d 854 (6th cir. 2000). the sixth circuit applied cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959) to hold that the taxpayer was not required to include the portion of the taxable interest attached to a damage award excluded under § 104(a)(2) that was paid directly to the taxpayer's attorney. the sixth circuit discussed the particularities of the attorney's fee statutory lien law in cotnam, found the michigan attorney's fees common law lien law to be similar to the alabama law involved in cotnam and stated that it was following cotnam. the court then went on, however, to provide an arguably broader explanation for its decision, concluding that the opinions representing the weight of authority, e.g., baylin v. commissioner, 43 f.3d 1451 (fed. cir. 1995), inappropriately relied [vol. 5:2 recent developments in federal income taxation on the assignment of income doctrine cases, e.g., lucas v. earl, 281 u.s. 111 (1930) and helvering v. horst, 311 u.s. 112 (1940), which, while relevant in family transactions, were not relevant in an arm's length transaction. the court stated: the present transaction under scrutiny is more like a division of property than an assignment of income. here the client as assignor has transferred some of the trees in his orchard, not merely the fruit from the trees. the lawyer has become a tenant in common of the orchard owner and must cultivate and care for and harvest the fruit of the entire tract. here the lawyer's income is the result of his own personal skill and judgment, not the skill or largess of a family member who wants to split his income to avoid taxation. the income should be charged to the one who earned it and received it, not as under the government's theory of the case, to one who neither received it nor earned it. the situation is no different from the transfer of a one-third interest in real estate that is thereafter leased to a tenant. g. tax court: wisconsin attorney's fees subject to the amt trap because of assignment of income doctrine. tax court majority holds that it was congress's doing; dissents state that courts can cure the problem. kenseth v. commissioner, 114 t.c. 399 (2000) (reviewed, 8-5). the tax court adheres to its holdings that contingent attorney's fees paid in an age discrimination settlement are includable in taxpayer's gross income. judge ruwe specifically declined to follow the sixth circuit's estate of clarks case, and held that taxpayer had income which he could not assign. judge chabot dissented on the ground that the assignment of income doctrine was court-made, so the court could grant relief. judge beghe (who tried the case) dissented on the ground that taxpayer lacked control over the attorney's share, so it would not be reasonable to include it in his income. h. ninth circuit: alaska statutory lien law requires entire recovery to be included in taxpayer's gross income. coady v. commissioner, (9th cir. 2000). attorneys' fees awarded on a wrongful termination suit under alaska law do not reduce the amount includable in taxpayer's income. instead, the attorneys' fees are deductible as miscellaneous itemized deductions. the court refused to follow cotnam v. commissioner, 263 f.2d 119 (5th cir. 1959), and clarks v. united states, 202 f.3d 854 (6th cir. 2000), but chose instead to follow baylin v. united states, 43 f.3d 1451 (fed. cir. 1995), and'alexander v. irs, 72 f.3d 938 (1st cir. 1995). alaska's statutory attorney's lien provisions do not create a superior lien or ownership interest in the cause of action as they do in alabama and michigan but specifically subordinate the lien to "the rights existing between the parties to the action or proceeding." 2001u florida tax review * accord benci-woodward v. commissioner, 219 f.3d 941 (9th cir. 2000). the portion of a taxable damage award retained by the taxpayer's attorney as a contingent fee under california attorney's fee lien law was includable in taxpayer's income, following coady. the sixth circuit decision in estate of clarks was distinguished on the grounds of the different attorney's fee lien law involved there and the inherent conflict with estate of clarks was ignored. i. but cotnam doesn't apply to all alabama attorney's fees. wait a minute, yes it does. foster v. united states, 106 f. supp. 2d. 1234 (n.d. ala. 2000), affd in part, rev'd in part, 249 f.3d 1275 (1 lth cir. 2001). taxpayer received a favorable jury verdict that included $1,000,000 of [taxable] punitive damages. under an alabama statute, the trial judge reduced the punitive damage award to $250,000. taxpayer had agreed to pay her attorney a contingent fee of 50% for the trial. for the appeal, the contingent fee arrangement was amended to treat all post-judgment interest collected as an additional contingent fee. the district court held that under cotnam the taxpayer could treat the originally agreed upon contingent fee as excluded from gross income and received directly by the attorney, but the postjudgment interest paid as the additional contingent fee was includable in gross income and deductible under § 212. at the point that contingent fee arrangement was negotiated, the taxpayer's claim, which had been upheld by the jury, had value and the "uncertainties" of the appellate process were not sufficient to displace the applicability of the assignment of income principles. the court of appeals affirmed the district court except with respect to the post judgement interest paid as the additional contingent fee. the court of appeals held that the post-judgment agreement was analogous to a pretrial contingency fee agreement, and thus, because the case arose in alabama, under cotnam the interest retained by the attorney as the fee was not includable in the taxpayer's gross income. the taxpayer was entitled to her litigation costs because the irs was not substantially justified in litigating the issue on the basis of attempting to overturn cotnam as wrongly decided. j. whether a profit-seeking expense is deductible under § 162 or, on the other hand, under § 212, and thereby subject to the myriad of more restrictive ancillary rules, turns on the "origin and character of the claim for which the expense was incurred and whether the claim bears a sufficient nexus to the taxpayer's business." guill v. commissioner, 112 t.c. 325 (1999). taxpayer was a sole proprietor/independent contractor insurance agent who after having been fired by an insurance company sued the insurance company and collected compensatory damages for breach of contract and conversion of business profits, together with punitive damages. the taxpayer deducted his legal fees on schedule c, but the irs took the position that the taxpayer's attorney's fees were deductible under § 212 as itemized deductions [vol. 5:2 recent developments in federal income taxation [subject to the myriad of limitations on deductibility of miscellaneous itemized deduction]. the tax court (judge laro), in what was described as a case of first impression, held that under a variation of the ubiquitous "origin of the claim" test, the attorney's fees were deductible above the line under § 162. 0 one wonders how this was a case of first impression since in srivastava v. commissioner, t.c. memo. 1998-362, the tax court held that plaintiff's attorney's fees incurred in a defamation suit were § 212 expenses, not § 162 expenses even though the defamation related to the taxpayer's conduct of his medicalpractice, obviously a trade or business. the court reasoned that whether the defamatory attack was on the personal reputation or the professional reputation, the defamation is personal in nature even though it may have derivative consequences for the business, relying on roemer v. commissioner, 716 f.2d 693 (9th cir. 1983) and threlkeld v. commissioner, 87 t.c. 1294 (1986), affd, 848 f.2d 81 (6th cir. 1988). but, in fabry v. commissioner, 111 t.c. 305 (1998), the tax court held that "injury to business reputation" [which in that case resulted from the effect on the taxpayer's products of defective products purchased from a supplier] is not as a matter of law a "personal injury." one further wonders how this aspect of srivastava can be reconciled with guill and fabry other that as an idiosyncratic anomaly attributable to the torturous history of the interpretation of§ 104(a)(2). 2. noons v. commissioner, t.c. memo. 2000-106. legal fees to defend criminal charges arising out of the allegedly fraudulent acquisition by a fslic employee of an underperforming promissory note from the original lender, which had been placed in receivership by fslic, were deductible as a miscellaneous itemized deduction, not as a § 162 trade or business deduction, because the taxpayer was not in the trade or business of acquiring and selling promissory notes. the deduction was disallowed under the amt. 3. ttrea '98 § 2001 amends § 26(a) to allow nonrefundable personal credits fully against regular tax liability during 1998, and amends § 24(d)(2) to provide that the additional [$400] child tax credit is not reduced by amt during 1998. a. 1999 act. for taxable years beginning in 2000 and 2001 the child and education credits may offset the excess of regular tax liability over amt. for years after 2001, the rule reverts to the pre-1998 rule, under which the credits may offset only the excess of regular tax liability over amt liability. 4. it's just business nothing personal (even though he also went to burlesque shows just to listen to the band). at least gladstone did not try to deduct expenses incurred in his quest to save prostitutes. vitale v. commissioner, t.c. memo. 1999-13 1, affd by order, 217 f.3d 843 (4th cir. 2000). a treasury department budget analyst engaged in a part-time activity 200o1 florida tax review writing a book about legalized prostitution, titled "searchlight nevada," which was published and marketed and in researching and writing a sequel entitled "nevada nights, san joaquin dawn." judge fay found that taxpayer was engaged in the activity for profit and that he was allowed to deduct most of his expenses (including expenses in excess of income from the activity), even though not all were documented; the cohan rule was applied. amounts paid to prostitutes for "interviews," however, were nondeductible as inherently personal expenses, even to the extent documented by a journal and credit card receipts. 5. all he needed was a little cooperation from his ex wonder why he didn't get it. miller v. commissioner, 114 t.c. 184 (2000). under § 152(e)(2) the actual signature of the custodial spouse on the declaration [form 8332] is crucial to shifting the dependency exemption to the noncustodial spouse. even though a state court order, which had been signed by the custodial former spouse's attorney, allocated the dependency exemptions to the noncustodial father, the noncustodial father was not entitled to claim the dependency exemptions with respect to his children, even though he attached a copy of the court order to his return, because his former wife had not personally signed a waiver of her right to claim the exemptions. 6. maybe if he'd trampled down some of their shrubs in making good his escape. chamales v. commissioner, t.c. memo. 2000-33. o.j. simpson's neighbors in the brentwood section of los angeles could not deduct as a casualty loss the diminution in value of their home that they attributed to the murder ofnichole brown simpson and ronald goldman and the subsequent focus on o.j. simpson as a suspect. 7. strange v. commissioner, 114 t.c. 206 (2000). the taxpayer paid nonresident state income taxes to nine states on net royalty income derived from interests in oil and gas wells located within those states. in calculating total net royalty income, and thus agi, the taxpayer deducted the state income taxes they paid. the tax court (judge parr) held that the revision of § 164 by the revenue act of 1964 did not alter the pre-existing law under which state income taxes were deductible only as itemized deductions. state nonresident income taxes [unlike property taxes] are not "attributable" to property held for the production of royalties and, therefore, are not deductible under § 62(a)(4) in computing agi. 8. rev. rul. 2000-24, 2000-19 i.r.b. 963 expenses (registration and transportation) incurred to attend a medical conference relating to the chronic disease of the taxpayer's dependent are deductible medical expenses if the costs are primarily for and essential to the medical care of the dependent. the cost of meals and lodging while attending the conference is not deductible because [vol. 5:2 recent developments in federal income taxation neither the taxpayer nor the taxpayer's dependent is receiving medical treatment. 9. did the bible foresee the internal revenue code? miller v. commissioner, 114 t.c. 511 (2000). the taxpayers held a religious belief that a social security number was the "mark of the beast" warned against in the bible at revelations 13:16-17 and consequently refused to obtain social security numbers for their children. their religious beliefs, which did not meet the requirements of § 1402(g) to excuse them from participation in the social security system, however, did not excuse them from complying with the § 151(e) requirement to provide an ssn as a condition for claiming the dependency exemption for their children. the requirement that taxpayers provide an ssn for children claimed as dependents, rather than a tin, which the taxpayers were willing to obtain but which the irs would not issue because children were eligible for an ssn, did not violate the religious freedom restoration act because the government has a compelling interest in preventing improper claims of dependency exemptions and administering the system in a uniform and fair manner. davis v. commissioner, t.c. memo. 2000-210, reached the same result. 10. who says it's a "net" income tax? what happened to those § 212 deductions? mellon bank, n.a. v. united states, 47 fed. cl. 186 (2000). investment advisor's fees incurred by a trust are excluded from the § 67 haircut on miscellaneous itemized deductions only if the expenses "would not have been incurred if the property were not held in such trust." the court of federal claims (judge andewelt) reached a conclusion similar to that of the tax court and contrary to the sixth circuit in william j o'neill revocable trust v. commissioner, 98 t.c. 227 (1992) (investment adviser fees paid by irrevocable trust are not "administration fees" excluded from § 67 disallowance rules by § 67(e)), rev'd, 994 f.2d 302 (6th cir. 1993) (investment adviser's fees that would not have been incurred if property had not been held in trust are not subject to 2% floor pursuant to § 67(e)). nevertheless the court of federal claims declined to grant summary judgment for government because it would not take judicial notice of fact that individuals often pay investment advisory fees. a. and the taxpayer concedes. 86 a.f.t.r.2d 6432, 2001-1 u.s.t.c. 50,153 (fed. cl. 9/18/00). on further proceedings after remand, summary judgment was granted to government because mellon bank stipulated that its evidence would not meet the requisite legal standard [determined in the federal circuit's opinion] to prevail. 11. no carrots for mr. ed helps taxpayer prove that horse breeding is a business, not a hobby. jordan v. commissioner, t.c. memo. 2000-206. 2001u a thoroughbred horse breeding activity conducted by taxpayers who did not have "any affectionate attachment to any of their race horses in particular, or to horses in general" and did not use their horses for farm or recreational purposes was conducted with a profit-seeking motive. it was not improbable that taxpayers' cumulative losses could be recovered by a single successful foal, and the court could "see no other reason why [taxpayers] would have engaged in the activity and incurred the resulting expenses unless for profit." 12. listen to your parents and always tell the truth. novak v. commissioner, t.c. memo. 2000-234. the taxpayer was a physician whose arabian horse breeding activity losses were disallowed despite the fact that he was an expert in horse breeding and hired many experts. among other things, he did not have a business plan and admitted that he would never be able to recoup the losses more than $1.2 million over 12 years, without a single profitable year. he also admitted that he became a doctor instead of a school teacher because while he was in college he father advised him "if you ever want to have horses you can't be a school teacher, you've got to find a job where you can make some money, be a doctor or a dentist." 13. it doesn't have to be fun to be a hobby. dirkse v. commissioner, t.c. memo. 2000-356. taxpayers' [public school teacher and nurse] apiary and tree-farming activities that were conducted in an unbusinesslike manner and consistently produced losses were not conducted for profit even though taxpayer derived no personal pleasure or recreation from the activities. 14. no, you can't report your w-2 income on schedule c to beat the § 67 haircut on deducting employee business expenses. d'acquisto v. commissioner, t.c. memo. 2000-239. a tv commercial voice-over actor was an employee of numerous employers, not an independent contractor, because he did not control how the scripts were performed. his right to pick and choose which jobs to accept did not render him an independent contractor. and he received numerous w-2s without protesting to the issuing employers. 15. the sound and the fury. ilm 200038059 (9/22/00), modifying ilm 200034029 (7/25/00). the first legal memorandum determined that the parents of a kidnapped child may take a dependency exemption for the year of the kidnapping, but not thereafter because they may not meet the § 152(a) support test for the child. the second legal memorandum determines that where the child was kidnapped by a stranger, i.e., where no individual other than the parents has legal custody of the child or would be entitled to claim a dependency exemption, "it should ordinarily be presumed that the parents have incurred sufficient expenses for the support of the child to satisfy the support requirement of § 152(a)." florida tax review [vol 5:2 recent developments in federal income taxation a. who would oppose this bill just before election day? on 9/26/00, the house unanimously passed h.r. 5117 to permit the parents to continue to claim the dependency exemption, the child credit, the earned income credit, and their filing status for later years [during the child's minority] in which the child remains missing after being kidnapped by a non-family member. b. the provision was enacted as part of the community renewal act of 2000. 16. is the eitc welfare or is it a tax refund? it matters in bankruptcy. williamson v. jones, 224 f.3d 1193 (10th cir. 2000), affg in re montgomery, 219 b.r. 913 (bap 10th cir. 1998). as result of the advance availability of the eitc under § 3507, even if a taxpayer does not claim advance credits under that provision, a refund attributable to the taxpayer's eitc upon filing a tax return can become part of the taxpayer's bankruptcy estate for the portion of the year to which the eitc relates that was prior to the date the taxpayer filed for bankruptcy. 17. not so smarty after all. geary v. commissioner, 235 f.3d 1207 (9th cir. 2000). this case dealt with expenses incurred by a san francisco police officer to put an initiative on the local ballot that would allow him to patrol his beat in north beach using a ventriloquist's dummy to assist in breaking down language/cultural barriers in the neighborhood. the dummy's name was "puppet officer brendan o'smarty." apparently gearys supervisors ordered him to stop using the puppet "because it makes the department look stupid." geary took the issue directly to san francisco voters and won. the expenses of his public referendum were disallowed under § 162(e)(1)(c) as nondeductible lobbying expenses (i.e., this provision disallows business deductions for expenses incurred "in connection with any attempt to influence the general public, or segments thereof, with respect to elections, legislative matters, or referendums"). vi. corporations a. entity and formation 1. no more double-counting § 357(c) gains in basis. pub. l. no. 10636, the miscellaneous trade and technical corrections act of 1999, amended § 357(c) and added new § 357(d) to limit basis increases attributable to assumption of liabilities not to exceed the fair market value of the property transferred. abuses had resulted where properties subject to liabilities were transferred to different corporations, with the result that both corporations 20011 florida tax review increased basis by the same liabilities. the provision is applicable to transfers made after 10/18/98. b. distributions and redemptions 1. t.d. 8924, liabilities assumed in certain corporate transactions, 66 f. r. 723 (1/3/00), corrected, 66 f. r. 10190 (2/14/01). temporary reg. § 1.301-it(g) applies rules similar to those of § 357(d) [for determining when a liability is assumed] for purposes of determining when the amount of a distribution will be reduced under § 301(b). [identical proposed regulations in reg-106791-00 (1/3/01).] a recourse debt has been assumed only if, based on all the facts and circumstances, the transferee has agreed to pay the debt regardless of whether or not the transferor has been relieved of liability vis-a-vis the creditor. a transferee is treated as assuming any nonrecourse debt encumbering property it receives, but the amount of the debt assumed is reduced by the lesser of(1) the amount of the debt secured by assets not transferred that another person or corporation has agreed (and is expected to) satisfy, or (2) the fair market value of the other assets secured by the debt. 2. sharewell, inc. v. commissioner, t.c. memo. 1999-413. one of taxpayer's shareholder-employees retired and his stock was redeemed pursuant to a contract calling for the retiring shareholder to be paid $1.3 million, of which $300,000 was deferred and represented by an assignment of certain accounts receivable. twelve days after the agreement was signed, the taxpayer and the retiring shareholder executed a letter agreement denominated "noncompete agreement," whereby the retiring shareholder agreed not to compete for three years in consideration of the $300,000 of accounts receivable referred to in the shareholder agreement. the court held that even though the retiring shareholder reported the entire $1.3 million as amount realized on redemption of his stock, because there was (1) evidence of mutual mistake, (2) the noncompete agreement was subsequent to, not prior to, the purchase agreement, and (3) together the two written documents created an ambiguity, the danielson [378 f.2d 771 (3d cir. 1967)] rule, which had been adopted by the circuit to which the case was appealable, did not apply. on the facts, the parties had agreed to allocate $300,000 to the non-compete agreement, and because they had no tax adverse interests, i.e., the amount allocated to the non-compete would be deferred but the stock purchase price would not be deferred, the allocation would be respected and taxpayer allowed an amortization deduction. 3. doctors are still pathologically addicted to tax shelters doomed to failure. failed veba life insurance-based tax shelter results in constructive dividends. neonatology associates, p.a. v. commissioner, 115 t.c. 43 (2000). in these consolidated cases, several employer/participants [doctors and medical professional associations] made contributions to separate [vol. 5:2 recent developments in federal income taxation plans formed under two purported [§ 419a(f)(6) ten-or-more-employer] vebas "crafted by ... insurance salesmen ... and marketed to professional small business owners as a viable tax planning device." each plan provided that a covered employee [usually a shareholder of the corporate employer] would receive term life insurance benefits. but the premiums on the underlying insurance policies substantially exceeded the cost of term life insurance because they funded not only the purchase of term insurance, but also "credits" that, together with interest on the account in which the excess amounts were set aside, would be applied to convert, at the employee-beneficiary's option, the term insurance into individual universal life policies with cash value, for each of the individual insureds. the conversion credits were earned over 120 months, but substantially vested only in the fifth year. as a result, after five years, a policyholder could withdraw any earned amount or borrow against it with no out-of-pocket expense. judge laro found that the plans were "marketed to professional, small business owners as a viable tax planning device [and] [t]he veba scheme was subscribed to by varied small businesses whose employee/owners sought primarily the advertised tax benefits and tax-free asset accumulation. the subject vebas were not designed, marketed, purchased, or sold as a means for an employer to provide welfare benefits to its employees." the court disallowed all of the § 162 deductions for contributions to the plan in excess of the cost of group term life insurance [which was allowable under reg. § 1.162-10(a)]. the remainder of the contributions constituted distributions of "excess cash for the benefit of the employee/owners." as far as the corporate employers and their shareholder/employees who were plan beneficiaries were concerned, the excess contributions were constructive dividends in the year that the amounts were contributed to the plan. judge laro found no evidence that there was any intent that the excess amounts were compensation and found that the evidence positively supported the finding that the purpose and operations of the plans was to surreptitiously provide a tax-free savings device to the shareholder employees. that there was some possibility of forfeiture of the conversion credits [by failure to convert] and that they did not augment death benefits under the term life insurance part of the plan did not alter this conclusion. the forfeitability concepts of § 83 do not apply to distributions [in contrast to compensation] from a corporation a to shareholder-employee. * section 6662(a) and (b)(1) penalties for negligence and intentional disregard of the rules and regulations were upheld. "reliance" on the advice of the life insurance salesman (who was not a tax professional) regarding the tax consequences of the plan was not "reasonable." nor does the preparation of returns by a cpa necessarily constitute "reliance" on the advice of a competent professional. the mere preparation of a return by a cpa does not mean that he has "opined" on any or all of the items reported in the return. but, judge laro declined to impose $25,000 penalties under § 6673(a)(1)(b) for frivolous and groundless litigation because taxpayers did reasonably rely on the advice of trial counsel that their positions had merit. 2001] florida tax review 4. not enough business purpose for a corporate expenditure and too much personal benefit for the shareholder = constructive dividend. tax court finds a constructive dividend by reason of the corporation's payment that conferred an economic benefit on the shareholder. hood v. commissioner, 115 t.c. 172 (2000) (reviewed, no dissents). a corporation's payment of legal fees for the defense of its sole shareholder against a tax evasion charge from income unreported from the predecessor sole proprietorship was held to be a constructive dividend to the shareholder and therefore not deductible by the corporation. from 1978 through 1988 hood had operated a sole proprietorship that was incorporated as hif in 1988. hood was sole shareholder and president. he was an indispensable employee of the corporation. there was no express agreement by hif to assume the proprietorship's debts, but hif paid the accounts receivable in the ordinary course. after hif was incorporated, hood was indicted and tried, but acquitted, for criminal tax evasion [§ 7201] and false declaration [§ 7206(1)] arising from the alleged failure to report income from the sole proprietorship. hif paid hood's legal fees in connection with the criminal charges. the tax court (judge gale) held that the payment of legal fees was a constructive dividend because it primarily benefitted the sole shareholder. the legal fees were hood's obligation and hif was not protecting its own interests it had not been indicted. therefore, the corporation could not deduct the expenses. even though hood was indispensable to the corporation's business, the payment of his legal fees was not necessary because he had adequate personal assets. the court followed the fifth circuit's decision in jack's maintenance contractors, inc. v. commissioner, 703 f.2d 154 (5th cir. 1983), rev'gper curiam t. c. memo. 1981-349, and to the extent it was inconsistent overruled its own prior opinion. judge gale held that the earlier tax court decision should not be followed because there was insufficient consideration given to the possibility of a constructive dividend in that case. 0 the tax court opinion in jack's maintenance found the legal fees to be deductible because the criminal charge had its origin in a business (rather than personal) situation; query whether tax evasion by a sole proprietor is a business-related matter. therefore, the tax court in the earlier case permitted the legal fees to be deducted by the corporation because the shareholder was "essential" to the corporation's operation. in the current case, the tax court found that the payment was made primarily for the benefit of the shareholder. 5. more on constructive dividends. and a possible concession that fees to defend criminal tax fraud cases are deductible by sole proprietors. midwest stainless, inc. v. commissioner, t.c. memo. 2000-314. the owner of a sole proprietorship incorporated the business but continued to directly receive payments for jobs in progress at the time the business was incorporated. the corporation treated the receipts as its own for book and tax purposes and entered [vol. 5:2 recent developments in federal income taxation a receivable from the shareholder on its books [which the parties stipulated was a valid debt]. the shareholder was indicted for failing to report income of the sole proprietorship on his pre-incorporation personal income tax returns and paid his own legal fees. however, the corporation claimed a deduction for the amount of the legal fees and correspondingly reduced the receivable from the shareholder. the parties agreed that the corporation was not entitled to deduct the legal defense fees and that shareholder was entitled to deduct them on his personal returns as schedule c expenses. the tax court (judge beghe) held that the reduction of the receivable on the corporation's books was a constructive dividend to the shareholder because it increased his net worth. the court rejected the taxpayer's legal argument that a constructive dividend cannot arise without a corporate outlay, as well as the taxpayer's factual argument that the book entry made by the corporation's accountant reducing the debt was equivocal. 6. not only did the corporation not get a bad debt deduction, but the controlling shareholder had dividend income. purported loans between sibling corporations were really constructive dividends. shed v. commissioner, t.c. memo. 2000-292. mr. & mrs. shed each owned 50% of the stock of j&j and mr. shed owned 100% of the stock of tlc, both of which were engaged in the freight-forwarding business. j&j advanced over $100,000 to tlc, which never repaid the advances. the tax court (judge gerber) not only denied j&j a bad debt deduction because the advances served no corporate business purpose, but also treated the transaction as a constructive dividend to shed and a contribution by him to tlc. c. liquidations 1. new § 1060/§ 338 rules. now there's seven classes of assets, instead of five. reg107069-97, purchase price allocations in deemed actual asset acquisitions, 64 f.r. 43461 (8/10/99). the treasury issued proposed amendments to the regulations under §§ 338 and 1060. under the proposed regulations, there will be a total of seven classes of assets possible in an acquisition. proposed reg. § 1.338-1 through -10, § 1.338(h)(10)-(1) and § 1.1060-1 are intended to clarify the treatment of, and provide consistent rules (where possible) for, both deemed and actual asset acquisitions under §§ 338 and 1060. the irs identified three major deficiencies in the current regulations: (1) their statement of tax accounting rules and their relationship to tax accounting rules for asset purchases outside of § 338; (2) the effects of the allocation rules; and (3) their lack of a complete model for the deemed asset sale (and, in the case of § 33 8(h)(1 0) elections, the deemed liquidation) from which tax consequences not specifically set forth in the regulations can be determined. the proposed regulations also take into account amendments to the code enacted since the different portions of the current regulations were promulgated. 20011 the proposed regulations have four major aspects: (1) reorganization of the regulations; (2) clarification and modification of the accounting rules applicable to deemed and actual asset acquisitions; (3) modifications to the residual method mandated for allocating consideration and basis, increasing the number of classes to seven; and (4) miscellaneous revisions to the current regulations. old target and new target (and any other affected parties, for example, when a § 338(h)(10) election is made) must determine their tax consequences as if they actually had engaged in the sale and purchase transactions deemed to have occurred under § 338. the consistency rules are unchanged. * the seven asset classes are: class i cash and cash equivalents; class ii cds, securities, foreign currency; class ill accounts receivable, mortgages, credit card receivables; class iv inventory; class v all assets not included in the other classes; class vi § 197 assets other than goodwill and going concern value; class vii § 197 goodwill and going concern value. the change relates to the addition of two new classes of "fast pay" assets, which must receive basis up to fair market value before there is any basis allocated to tangible property. a. purchase price allocations in deemed and actual asset acquisitions are promulgated as temporary regulations. t.d. 8858, purchase price allocations in deemed and actual asset acquisitions, 65 f. r. 1236 (1/7/00). the proposed regulations were promulgated as temporary regulations pending further review of comments on the proposed regulations and promulgation of final regulations. effective 1/6/00. 2. good news, bad news. robson v. commissioner, t.c. memo. 2000201. if a corporation cancels a debt of a shareholder to the corporation in connection with the complete liquidation of the corporation, the transaction is not treated as cancellation of indebtedness income under § 61 (a)(12) subject to § 108. rather, the amount of the canceled debt is treated as an amount realized in exchange for the stock pursuant to the liquidation under § 331, which results in capital gain treatment. 3. reg-1 10659-00, proposed regulations, amendment, checkthe box regulations, 66 f.r. 3959 (1/17/01). proposed reg. § 301.7701-3(g)(2)(ii) would provide that if an unincorporated entity that previously had elected to be taxed as a corporation elects to convert to a partnership, it is treated as distributing all of its assets to its shareholders in a taxable liquidation, followed by the contribution of all the assets to a newly formed partnership. if the entity elects to convert from a corporation to a disregarded entity, it is deemed to have distributed its assets to its owner. sections 332 and 337 can apply if the owner is a corporation. to facilitate application of § 332, the proposed regulations provide that a plan of liquidation is deemed to have been adopted immediately before the deemed liquidation resulting from the election to change entity florida tax review [vol. 5:2 recent developments in federal income taxation classification, unless a formal plan of liquidation that contemplates the filing of the elective change was adopted at an earlier date. d. s corporations 1. final passthrough and basis adjustment regulations. t.d. 8852, passthrough of items of an s corporation to its shareholders, 64 f.r. 71641 (12/22/99) [proposed in reg-209446-82, 63 f. r. 44181 (8/18/98)]. amended regs. §§ 1.1366-1 through 1.1366-5, 1.1367-1(e), (f), (g), (h) and (j), 1.1366-3, 1.1368-1(d), (e), 1.1368-2, 1.1368-3, and 1.1368-4, deal comprehensively with the passthrough of subehapter s corporation income and basis adjustments. the final regulations adopt the proposed regulations with a few modifications. the final regulations clarify that the allocation of any tax under § 1375 is based on the total net passive investment income for the taxable year. the final regulations make clear that when a net negative adjustment occurs, the aaa is adjusted to take into account distributions before the aaa is adjusted to take into account any net negative adjustment. reg. § 1.1366-1(a)(2)(viii), as amended, provides that cod income excluded at the corporate level under § 108 is not "tax exempt" income for purposes of §§ 1366 and 1367. 2. cancellation of indebtedness income of insolvent s corporations. a. "because the code's plain language permits the taxpayers here to receive these benefits, we need not address this policy concern ["that, if shareholders were permitted to pass through the discharge of indebtedness income before reducing any tax attributes, the shareholders would wrongly experience a 'double windfall"']." gitlitz v. commissioner, 121 s.ct. 701, (2001). gitlitz and winn each owned 50% of the stock of an s corporation that realized $2,021,096 of cod income. at that time the corporation was insolvent to the extent of $2,181,748. thus all of the cod income was excluded under § 108(a)(1)(b). both shareholders had carried losses that had been suspended under § 1366(d)(1) as well as operating losses that would be further suspended unless the excluded cod income increased their bases in their stock under § 1367(a)(1). b. the tax court followed its reviewed decision in nelson v. commissioner, 110 t.c. 114 (1998), aff'd, 182 f.3d 1152 (10th cir. 1999), which held that a shareholder of an insolvent s corporation may not increase his stock basis under §§ 1367(a)(1)(a) and 1366(a)(1)(a) bythe amount of his pro rata share of the corporation's [excluded under § 108(a)] discharge of indebtedness income on the theory that the cod income was passed-through exempt income. the tax court agreed with the irs that § 108(d)(7)(a) requires that the exclusion of income apply at the s corporation level, so that the reduction of tax attributes applied by § 108(b) also applies at the corporate level 2001] florida tax review and the discharge of indebtedness income never passes through to the shareholder. section 108, through the attribute reduction rules, is generally intended to defer the recognition of income, not to exempt it totally from income. e. affirmed. 182 f.3d 1143 (10th cir. 1999). the court of appeals for the tenth circuit affirmed, but on different reasoning. it assumed that the cod income was "tax exempt income" under § 1366(a)(1)(a), which potentially could pass through to the shareholders and increase basis. the court agreed with the commissioner and the tax court, however, that § 108(d)(7)(a) requires that the exclusion of income apply at the s corporation level, so that the reduction of tax attributes applied by § 108(b) also applies at the corporate level and the discharge of indebtedness income never passes through to the shareholder. the court further concluded that § 108(d)(4)(a) merely requires that attribute reduction is the last step in the calculations, it does not necessarily defer the attribute reduction until the year following the year in which the excluded cod income is realized. thus, there was no corporate level income to pass through to the shareholders and to increase their bases. furthermore, the reduction in tax attributes under § 108(b) absorbed the shareholders' losses carried over from prior years under § 1366(d)(1). d. reversed-a total victory for the taxpayers. the supreme court, in a 8-1 decision by justice thomas, held that the statute's plain language establishes that cod income realized by an insolvent s corporation that is excluded under § 108(a) is an item of tax-exempt income that passes through to shareholders under § 1366(a)(1)(a) and increases their bases in the s corporation's stock under § 1367. furthermore, the pass through occurs before the reduction of the s corporation's tax attributes under § 108(b), and thus the shareholders' carried-over losses [which § 108(d)(7)(b) treats as a corporate nol for purposes of § 108(b)] to the year in which the cod occurs may be deducted against the basis increase without reduction in that year. any suspended losses remaining then will be treated as the s corporation's net operating loss and reduced by the discharged debt amount. * justice breyer, in dissent, would have held that § 108(d)(7)(a) [applying § 108(a), (b), (c), and (g) at the corporate level], precludes any pass through of cod income realized by an insolvent s corporation. in response to the majority's last paragraph, he stated, "it is .. difficult to see why, given the fact that the 'plain language' admits either interpretation, we should ignore the policy consequences .... the arguments from plain text on both sides here produce ambiguity, not certainty. and other things being equal, we should read ambiguous statutes as closing, not maintaining, tax loopholes. such is an appropriate understanding of congress' likely intent." [vol. 5:2 recent developments in federal income taxation 0 and the reasoning of the opinion might partially invalidate reg. § 1.1366-1(a)(2)(viii). as part of its effort to deal with this issue, in t.d. 8852, supra, the treasury amended reg. § 1.1366l(a)(2)(viii) to provide that cod income excluded at the corporate level under § 108 is not "tax exempt" income for purposes of §§ 1366 and 1367. although the gitlitz opinion is not a model of clarity, the last sentence states that "the codes' plain text permits the taxpayers here to receive these benefits." this would indicate that the treasury has no power to alter the result by regulation. but at another point, integral to the analysis the opinion states: "this section [§ 1366] expressly includes 'tax-exempt' income, but this inclusion does not mean that the statute must therefore exclude 'tax-deferred' income. the section is worded broadly enough to include any item of income, even tax-deferred income, that 'could affect the liability for tax of any shareholder."' this language is not nearly so definitive as to the clarity of the statutory language and leaves open the possibility that the courts might not invalidate the regulation. but we doubt it. 3. no surprise here. ding v. commissioner, 200 f.3d 587 (9th cir. 1999). for purposes of computing self employment tax, a shareholder/employee of an s corporation cannot deduct passed through s corporation losses against schedule c income from a sole proprietorship. rev. rul. 59-221, 1959-1 c.b. 225, followed. 4. grojean v. commissioner, t.c. memo 1999-425. an s corporation shareholder who acquired a loan participation interest in a loan from a bank to his wholly-owned s corporation, as required by the lender, by borrowing from the bank was a mere guarantor. the shareholder's note and the corporation's note had identical terms and the bank automatically credited payments on the corporation's note against the shareholder's note. no cash passed hands between the shareholder and bank in the circular transaction, and shareholder made no economic outlay. the shareholder acquired no additional basis to support passed through losses. 5. proposed regulations regarding the qsub election have been finalized. t.d. 8869, subchapter s subsidiaries, 65 f. r. 3843 (1/25/00) [proposed in reg-251698-96, 63 f. r. 19864]. a qualified subchapter s subsidiary (qsub) is any domestic corporation that (1) is not an ineligible corporation, (2) is wholly owned by an s corporation, and (3) for which the parent s corporation elects to treat as a qsub. section 1361(b)(3)(b). election procedures are describedinreg. § 1.1361-3(a). a corporation for which a qsub election is made is not treated as a separate corporation. transactions between the s corporation parent and the qualified s corporation subsidiary are not taken into account for tax purposes. all assets, liabilities, and items of income, deduction, and credit of the qsub are treated as assets, liabilities, and items of 200o1 florida tax review income, deduction, and credit of the parent s corporation. reg. § 1.13614(a)(1). the existence of the stock of a qsub is ignored for tax purposes. reg. § 1.1361-4(a)(4). if a qsub election is made for a newly formed subsidiary, the subsidiary is treated as a qsub from its inception-the parent and subsidiary both are treated as if the subsidiary never had been formed. in the case of a preexisting subsidiary, as a result of a qsub election the subsidiary is deemed to have liquidated under §§ 332 and 337 immediately before the election is effective. reg. § 1.1361-4(a)(2), (b). 0 reg. § 1.1361-3(a)(4) allows the effective date of a qsub election to be any specified date within two months and 15 days prior to, or not more than 12 months after, the date the election is made. unlike an s election, a qsub election does not have to be made within two months and 15 days of the beginning of a taxable year. 0 a qsub election may be revoked as of any specified date within two months and 15 days prior to, or not more than 12 months after, the date of the revocation. reg. § 1.1361-3(b)(2). a qsub that ceases to qualify under § 1361(b)(3)(b) or whose election has been revoked is treated as a new corporation that has acquired all of its assets and assumed all of its liabilities from its s corporation parent in exchange for the subsidiary's stock immediately before the cessation of qsub status. section 1361 (b)(3)(c); reg. § 1.1361-5(b)(1). this hypothetical transaction is governed by general income tax principles, including § 351 and its associated sections. for purposes of determining control under § 351, equity instruments that are not treated as a second class of stock under § 1361(b)(2)(d) are disregarded. the regulations also provide that the step transaction doctrine is applicable. thus a disposition of the stock of the former qsub will affect application of § 351. reg. § 1.13615(b)(3), ex. (1). a qsub whose election has terminated may not have a qsub election made with respect to it (or, if its stock is acquired by eligible shareholders, make an s election itself) before its fifth taxable year that begins after the first taxable year for which the termination is effective without the service's consent. section 1361(b)(3)(d); reg. § 1.1361-5(c). if a qsub election is terminated by reason of the disposition of the stock of the subsidiary by the parent, the new owners may make an immediate s election, without the consent of the irs, provided that there has been no intervening period in which the corporation was a c corporation. reg. § 1.1361-5(c)(2). 6. s corporations aren't always corporations. rev. rul. 2000-43, 2000-41 i.r.b. 333. an accrual-method s corporation may not elect under § 170(a)(2) to treat a charitable contribution as paid in the year authorized by the s corporation's board of directors if the contribution is paid by the s corporation after the close of the taxable year. section 1363(b) requires s corporations to compute taxable income in the same manner as individuals [to whom § 170(a)(2) does not apply]. [vol 5:2 recent developments in federal income taxation 7. when subchapter s and subchapter k collided, the aggregate theory of partnership taxation was applied. coggin automotive corp. v. commissioner, 115 t.c. no. 28 (2000). taxpayer originally was a holding company that had a number of controlled subsidiaries engaged in the retail sale of motor vehicles. the subsidiaries maintained their inventories under the lifo method, and all of the corporations filed a consolidated return. in 1993, the taxpayer restructured to make an s election. six new s corporations were formed to become the general partners in six limited partnerships. each subsidiary contributed its dealership assets to a limited partnership in exchange for a limited partnership interest, following which the subsidiaries were liquidated and the taxpayer became the limited partner in each. the commissioner asserted that the taxpayer's conversion to an s corporation triggered the inclusion of the affiliated group's pre-s-election lifo reserves (approximately $5 million) under § 1363(d). the commissioner argued alternatively (1) that the restructuring should be disregarded because it had no purpose independent of tax consequences, and (2) that under the aggregate approach to partnerships, a pro rata share of the pre-s-election lifo reserves (approximately $4.8 million) was attributable to the taxpayer as a partner. the tax court (judge jacobs) rejected the commissioner's first argument, holding that the restructuring was a genuine multiple-party transaction with economic substance, compelled by business realities and imbued with tax-independent considerations. but judge jacobs accepted the commissioner's second argument, holding that application of the aggregate approach [rather than the entity approach] to partnership taxation furthered the purpose of § 1363(d). thus, the taxpayer was treated as owning a pro rata share of the partnerships' inventories and as a result of its election it was required to include $4.8 million of lifo recapture. 0 in reaching its decision regarding subchapter k, the tax court followed casel v. commissioner, 79 t.c. 424 (1982), applying the aggregate approach to apply § 267 to disallow losses between related parties; holiday village shopping center v. un ited states, 773 f.2d 276 (fed. cir. 1985), applying the aggregate approach for purposes of determining depreciation recapture when a corporation distributed a partnership interest to its shareholders; and unger v. commissioner, 936 f.2d 1316 (d.c. cir. 1991), in determining permanent establishment. it distinguished as inapposite the entity approach applied inp.d.b. sports, ltd. v. commissioner, 109 t.c. 423 (1997), for purposes of applying § 1056; madison gas & elec. co. v. commissioner, 72 t.c. 521,564 (1979), affd, 633 f.2d 512 (7th cir. 1980), applying the entity approach in determining whether expenditures were deductible under § 162 or were nondeductible start-up expenditures; and the eighth circuit's decision in brown group. inc.& subs. v. commissioner, 77 f.3d 217 (8th cir. 1996), revg, 104 t.c. 105 (1995), concluding that the entity approach, rather than the aggregate approach, should be used in characterizing income (subpart f income) earned by a partnership. the differences, the court found, were based on 2001] determining the relevant congressional intent in enacting the non-subchapter k provision involved in each case. e. affiliated corporations 1. reg-106219-98, acquisition of an s corporation by a member of a consolidated group, 63 f.r. 69581 (12/17/98). the treasury has issued proposed regulations amending reg. § 1.1502-76 on consolidated group acquisition of 80% or more of an s corporation's stock. the proposed regulations provide that the s corporation becomes a member of the group at the beginning of the day of its acquisition and its tax year ends at the end of the previous day. a. t.d. 8842, acquisition of an s corporation by a member of a consolidate group, 64 f.r. 61205 (11/10/99). final consolidated return regulations, amending reg. § 1.1502-76, provide specific rules that apply to the acquisition of the stock of an s corporation by a member of the consolidated group. 2. losses suffered by a profitable corporation were not part of a group's consolidated net operating loss. intermet corp. v. commissioner, 111 t.c. 294 (1998). for 1992, the taxpayer's consolidated group reported a consolidated net operating loss of nearly $26 million. three of the members of the group reported positive taxable income but reported deductions of $1,226,000 that arguably were specified liability loss deduction items within the meaning of § 172(f)(1). [the items were state and local taxes and interest on federal taxes relating to a year more than three years before 1992.] judge wells held that under reg. §§ 1.1502-12 and 1.1502-21a, the group's specified liability losses did not include the deductions in question because members of the group that reported positive separate taxable income did not contribute to the group's consolidated nol. accordingly, the 10-year carryback period of § 172(b)(1)(c) did not apply with respect to a portion of the consolidated nol equal to the items in question. [the court did not reach the question of whether the items were specified liability losses under § 172(f)(1), as in effect for 1992, in the first place.] a. but on appeal the taxpayer wins. 209 f.3d 901 (6th cir. 2000). the court of appeals assumed that the losses in question were specified liability losses [because the tax court did not reach the issue], and allowed them to be carried back. the court reasoned that the subsidiary's specified liability loss deduction items reduced the subsidiary's separate taxable income dollar-for-dollar and thus contributed to the consolidated nol. an individual component member's taxable income has no independent significance; it is merely a step in computing the consolidated nol. there was no basis in reg. [vol 5:2florida tax review recent developments in federal income taxation § 1.1502-21a for treating a specified liability loss as constituting part of the consolidated nol when the member that incurred the deduction had negative taxable income but not when that member had positive separate taxable income [as long as a srly year is not involved]. 3. on the same issue, the fourth circuit reversed a district court decision and found in favor of the government. uniteddominion industries, inc. v. united states, 208 f.3d 452 (4th cir. 2000). a consolidated group may not carry back separate return product liability expenses, i.e., product liability expenditures by profitable corporations, because these do not enter into the consolidated net operating loss, and the statute speaks of specified liability losses not specified liability expenses. instead, only that portion of a member's separate net operating loss attributable to specified liability losses may enter into the computation of the portion of the consolidated nol attributable to specified liability losses. 4. and the supreme court appears to have developed a taste for corporate tax cases. certiorari was granted to the fourth circuit in united dominion industries, inc., 121 s. ct. 562 (2000). 5. consolidated return duplicated loss disallowance regs are valid. rite aid corp. v. united states, 46 fed. cl. 500 (2000). reg. § 1.1502-20, which, subject to certain exceptions, disallows any loss realized by a member of a consolidated group upon the disposition of the stock of a subsidiary, is valid and is not in derogation of § 165. under reg. § 1.1502-20, the amount of loss that is disallowed is limited to the sum of(1) income or gain resulting from "extraordinary gains dispositions," which are defined as dispositions of capital assets, depreciable property used in the trade or business, certain bulk asset dispositions, and discharge of indebtedness income, (2) positive investment adjustments (other than those attributable to extraordinary gain dispositions), and (3) "duplicated loss," which is the aggregate of the subsidiary's asset bases and loss carryovers over the value of the subsidiary's assets. any losses in excess of these amounts are deductible. reg. § 1.1502-20 is designed to prevent "duplicated losses" the deduction by both the parent and subsidiary of the same economic loss. rite aid sold a subsidiary (encore) and realized a taxable loss of $33 million and an "economic loss" of $22 million, which it claimed should be deductible. the court held that because encore's built-in loss of $28 million [as calculated by rite-aid] exceeded rite-aids' economic loss, no loss deduction was allowed. the court pointed out that rite aid could have avoided reg. § 1.1502-20 by finding a buyer who would agree to a § 338(h)(10) election. 6. zero basis no more. t.d. 8883, guidance under section 1032 relating to the treatment of a disposition by one corporation of the stock of 20011 florida tax review another corporation in a taxable transaction, 65 f. r. 31073 (5/16/00). the treasury has promulgated final regulations under § 1032 on use of parent's stock by subsidiary to acquire property or services. if an acquiring corporation receives its parent corporation's stock in a § 362(a) transaction and "immediately" transfers the stock for money or other property in a purchasetype transaction, the transaction is treated as if the acquiring corporation had purchased the issuing [parent] corporation's stock at fmv with cash contributed by the issuing corporation immediately before the transaction. 7. so just when will this suspended loss be allowed? textron, inc. v. commissioner, 115 t.c. 104 (2000). in 1967, when avco acquired paul revere (pr) and pr became part of the avco group, pr owned four million shares of avco. in 1977, avco redeemed its shares owned by pr, and pursuant to former reg. § 1.1502-14(b)(1), pr did not recognize its loss, but pursuant to former reg. § 1.1502-31(b)(2)(ii) pr's basis in the stock was reallocated to the note. in 1987, after avco had been acquired by textron, avco redeemed the note held by pr, on which pr realized a $15,000,000 loss, following which pr was liquidated into avco in a § 332 liquidation. judge laro agreed with the commissioner that former reg. § 1.1504-14(d)(4)(i) "deferred" pr's loss in 1987 [because the note was received in exchange for property, i.e., avco stock, in an exchanged basis transaction and the note was never held by a nonmember]. judge laro held that the determination of whether a note has been held by a nonmember under former reg. § 1. 1502-14(d)(4)(i)(c) looks to whether the holder of the note is a nonmember at the time of the redemption, not to whether the holder of a note was a nonmember when the note was received when the holder becomes a member before the redemption. finally, under former reg. § 1.1502-14(d)(4)(ii) and (e)(2), the liquidation of pr in a § 332 liquidation did free-up the suspended loss because avco inherited pr's tax characteristics. * the analytical methodology of the textron opinion is at odds with tax court judge wells's opinions in csihydrostatic testers v. commissioner, 103 t.c. 398 (1994) and intermet corp. v. commissioner, 111 t.c. 294 (1998), rev'd, 209 f.3d 901(6th cir. 2000)." those cases strictly construed the consolidated return regulations even though the results were difficult to support theoretically. in contrast, in textron, judge laro interpreted reg. § 1.1502-14(d)(4)(i) in a manner that is difficult to justify under the literal language, but which reached a sensible theoretical result [under the single-entity theory of consolidated returns]. he concluded that reg. § 1.1502-14(d)(4)(i) required pr to defer its loss on the redemption of the obligation it received for its avco stock even though one of the conditions for that section to apply is that the obligation "never have been held by a 13. we are indebted to prof. don leatherman, university of tennessee college of law, for insightful suggestions regarding the analysis of the textron case. [vol 5:2 recent developments in federal income taxation nonmember." since pr acquired the obligation before it became a member of the textron group that redeemed the obligation, judge laro's conclusion that membership status was determined at the time that the obligation was redeemed effectively read out of the rule the word "nonmember". he could have more effectively reached the same result by looking to former reg. § 1.1502-13 (f)(2) to note that the avco group was a predecessor group to the textron, so that pr should not have been considered ever to have been a nonmember. 0 note that if the redemption by avco of its stock held by pr had occurred after 7/12/95, the loss would have been permanently disallowed under reg. § 1.1502-13(f)(6), which disallows any loss to a member on the sale or exchange of stock of the common parent corporation of a consolidated group. under current regulations, if avco and pr both had been subsidiary members of the same consolidated group and the redemption were described in § 302(a) which would be unlikely reg. § 1.1502-20(a) would disallow the loss, although a portion of it might be allowed under reg. § 1.1502-20(c). section 267(f) would not defer the loss because reg. § 1.267(f)l(c)(1) adopts the acceleration rule of reg. § 1.1502-13(d). the loss might, however, be subject to the anti-avoidance rules of both reg. §§ 1.267(f)-1(h) and 1.1502-13(h). 8. notice 2000-53, 2000-38 i.r.b. 293. the irs will promulgate regulations providing elective transitional relief from retroactive repeal of the srly rules when §§ 382 or 383 applies, as provided in t.d. 8823, consolidated returns-limitations on the use of certain losses and deductions, 64 f.r. 36092 (7/2/99), amending reg. §§ 1.1502-15, -21, and -22. 9. reg-103805-99, agent for consolidated group, 65 f.r. 57755 (9/26/00). proposed reg. §§ 1.1502-77 and -78 would clarify and supplement the rules concerning the agent for a consolidated group and the designation of a new agent for the group. under the proposed regulations the common parent remains the agent as long as it continues to exist as a corporation, even if it ceases to be the common parent. the common parent also is the agent for any corporation improperly included in the consolidated return. the proposed regulations continue the current rule that if the common parent ceases to exist it may designate another member of the group as its successor agent. if no such designation is made, the irs may designate the successor agent. the current rule permitting the remaining members to designate the successor agent will be removed. effective upon publication of final regulations. the proposed regulations would deal with the interlake corp. [112 t.c. 103 (1999)] problem by providing that a refund resulting from a carryback of a nol under § 172 should be paid to the common parent or agent for the carryback year. 2001] florida tax review f. section 482 1. the tax relief extension act of 1999 amended § 6103(b)(2) to include within the definition of "return information" an advance pricing agreement (apa) under § 482 as well the application and any background information submitted in connection with the application for the apa. g. reorganizations and corporate divisions 1. what, a little theoretical consistency across types of reorganizations what will they think of next? reg-1 15086-98, the solely for voting stock requirement in certain corporate reorganizations, 64 f. r. 31770 (6/14/99), proposed reg. § 1.368-2(d)(4)(i)-(iii) would vitiate the application of the bausch & lomb doctrine in § 368(a)(1)(c) stock-for-asset reorganizations. the new rules will be effective upon publication of final regulations, subject to the usual grandfathering of transactions pursuant to a binding agreement at that time. 0 bausch &lomb optical co. v. commissioner, 30 t.c. 602 (1958), aff'd, 267 f.2d 75 (2d cir.), cert. denied, 361 u.s. 835 (1959), upheld the irs's position in rev. rul. 54-396, 1954-2 c.b. 147, that the acquisition of assets of a partially controlled subsidiary cannot not qualify as a tax-free reorganization under § 368(a)(1)(c). the rationale of the bausch & lomb doctrine is that the acquisition violates the solely for voting stock requirement, because the parent corporation acquires only part of the subsidiary's assets in exchange for its voting stock, with the remaining portion of the subsidiary's assets being acquired in a liquidating distribution in exchange for previously held stock of the subsidiary. 0 the bausch & lomb doctrine has been criticized because (1) a transaction in which a parent corporation converts an indirect ownership interest in a subsidiary's assets to a direct interest does not resemble a sale, and (2) the taxable treatment of the "upstream" type c reorganization under the bausch & lomb doctrine is inconsistent with the taxfree treatment of the "upstream" type a reorganization. o under the proposed regulations, preexisting ownership of a portion of a target corporation's stock by an acquiring corporation generally will not negate satisfaction of the solely for voting stock requirement in a c reorganization. if in connection with a potential c reorganization the acquiring corporation acquires any target corporation's stock for consideration other than its own voting stock (or its parent's voting stock if the parent's stock is used in attempted c reorganization), whether from a shareholder of the target corporation or from the target corporation itself, such consideration will be treated as money or other property exchanged by the acquiring corporation for the target corporation's assets for purposes of applying the boot limitation in § 368(a)(2)(b). whether there has been an [vol 5:2 recent developments in federal income taxation acquisition in connection with a potential c reorganization of a target corporation's stock for consideration other than voting stock will be made on the basis of all of the facts and circumstances. a. notice 2000-1, 2000-2 i.r.b. 288. the effective date of the proposed regulations was changed to transactions occurring after 12/31/99. taxpayers may also obtain letter rulings permitting them to apply the proposed regulations to transfers taking place on or after 6/11/99. b. regulations are made final. t.d. 8885, the solely for voting stock requirement in certain corporate reorganizations, 65 f.r. 31805 (5/19/00). thebausch &lomb repeal regulations on creeping c reorganizations were finalized. 2. divisive transactions fail to qualify as a reorganizations despite being accomplished under a state [texas] "merger" statute. rev. rul. 20005, 2000-5 i.r.b. 436. transactions in which (1) a target corporation "merges" under state law with and into an acquiring corporation [but does not go out of existence], or (2) a target corporation "merges" under state law with and into two or more acquiring corporations [and goes out of existence], do not qualify as mergers under § 368(a)(1)(a). a. definition of "merger" revised in new proposed regulation. reg-106186-98, certain corporate reorganizations involving disregarded entities, 65 f.r. 31115 (5/16/00). proposed reg. § 1.368-2(b)(1) would be revised to require that by operation of state, etc. merger law "the transaction must result in one corporation acquiring the assets of the merging corporation and the merging corporation ceasing to exist" [with similar requirements for consolidations]. mergers involving disregarded entities are not a reorganizations. they may qualify as type c reorganizations if the requirements are met. these proposed regulations would encompass the matters ruled upon in rev. rul. 2000-5, relating to the texas "merger" statute. 3. what continuity of interest? rev. rul. 99-58, 1999-2 c.b. 701. the open market purchase of its shares by a publicly traded corporation following a tax-free reorganization in which the shareholders of the target corporation received 50% cash and 50% stock does not violate the continuity of interest requirement under reg. § 1.368-1(e), even though the acquiring corporation's intent to repurchase shares [to prevent dilution] had been announced prior to the reorganization, because the repurchase was not negotiated with the target or its shareholders and there was no "understanding" between the acquiring corporation and the target shareholders that their ownership would be transitory. 200o1 florida tax review 4. guidance under § 356 relating to the treatment of nonqualified preferred stock and other preferred stock in certain exchanges and distributions. t.d. 8904, treatment of nonqualified preferred stock and other preferred stock in certain exchanges and distributions, 65 f.r. 58650 (10/2/00) [proposed in reg-105089-99, 65 f. r. 4203 (1/26/00)]. the taxpayer relief act of 1997 amended §§ 351, 354, 355, 356, and 1036 to provide that nonqualified preferred stock (as defined in § 351(g)(2)) (nqps) received in an exchange or distribution will not be treated as stock or securities but, instead, will be treated as "other property" or "boot." under §§ 354(a)(2)(c), 355(a)(3)(d), and 356(e)(2), nqps is treated as stock, and inot other property, in cases where the nqps is received in exchange for, or in a distribution with respect to, nqps. as a result, the receipt ofnqps in exchange for nqps will not result in gain or loss recognition. nqps (as defined in § 351(g)(2)) received in an exchange will not be treated as stock or securities but, instead, will be treated as "other property" or "boot." as a result, the receipt of nqps stock will result in recognition of gain under § 356 unless a specified exception applies. sections 354(a)(2)(c), 355(a)(3)(d), and 356(e)(2) provide that nqps is treated as stock rather than as other property in cases where the nqps is received in exchange for, or as a distribution on, other nqps. as a result, the receipt of nqps in such an exchange will not result in recognition of gain or loss under §§ 355 or 356. regulations §§ 1.354-1(f), 1.355-1(d), and 1.356-7(c) provide additional rules to deal with various aspects of exchanges of nqps in reorganizations. under the general rule in the regulations, the nonrecognition rule applies only if nqps is received with respect to "substantially similar" nqps. stock is substantially identical if two conditions are met: (1) the stock received does not contain any terms which, in relation to the terms of the stock previously held, decrease the period in which a redemption or purchase right will be exercised, increase the likelihood that such a right will be exercised, or accelerate the timing of the returns from the stock instrument (including the receipt of dividends or other distributions); (2) as a result of the receipt of the stock, the exercise of the right or obligation does not become more likely than not to occur within a 20-year period beginning on the issue date of the stock previously held. stock described in § 35 l(g)(2) is nqps for these purposes regardless of the date on which the stock is issued. 5. a cozy change in the cosi regulations. t.d. 8898, continuity of interest, 65 f. r. 52909 (8/31/00). final amendments to the cosi regulations, reg. § 1.368-1 (e)(1)(ii) and (e)(6), ex.9, [generally effective 8/30/00] deal with the effect of pre-reorganization redemptions on the continuity of shareholder interest requirement in corporate reorganizations. the proposed and temporary regulations had provided that, for purposes of determining whether the shareholder continuity of interest requirement had been satisfied in connection with a potential reorganization, a shareholder's proprietary interest in the target corporation (t) would not be treated as preserved if prior to and in connection [vol. 5:2 recent developments in federal income taxation with the acquisition the shareholder's stock was redeemed or to the extent that an extraordinary distribution is made with respect to the stock. in essence, the temporary and proposed regulations treated preacquisition redemptions and distributions as if they were cash boot payments by the acquiring corporation. 0 in response to critical comments [including some emphasizing the practice of withdrawing as much of the aaa as possible before the acquisition of an s corporation by a c corporation], the final regulations are substantially different. final regs. § 1.368-1(e)(1)(ii) provides that in the event of a preacquisition redemption of its stock or extraordinary distribution by the target corporation (other than one held by the acquirer (p)) the shareholder's proprietary interest is not preserved only to the extent that consideration received prior to the potential reorganization is treated as boot received from p (or a related party) in exchange for t stock for purposes of § 356 (or would be so treated if the t shareholder also had received p stock in exchange for t stock owned by the shareholder [thus dealing with preacquisition complete redemptions of one or more shareholders]). all of the facts and circumstances, as well as other sections of the regulations and general principles of tax law, are taken into account in making this determination. 6. backing into control within 5 years of the spin-off backed them right out of § 355. mclaulin v. commissioner, 115 t.c. 255 (2000). the taxpayers were shareholders of rpi, an s corporation. until 1993, rpi owned 50% of the stock of sunbelt (a c corporation); the other 50% was owned by hutto. in 1993, after protracted negotiations regarding whether rpi should purchase hutto's stock in sunbelt or hutto should purchase rpi's sunbelt stock, sunbelt redeemed all of hutto's stock for cash [$828,943], which was borrowed from rpi, and property [$101,000], leaving rpi as sunbelt's sole shareholder. later on the same day as the redemption, rpi distributed all of the stock of sunbelt to rpi's three equal shareholders the taxpayers in a transaction intended to qualify as a tax-free spinoff under § 355. the stated purposes of the distribution were to relieve rpi from any potential liabilities arising from sunbelt's operations, to prepare sunbelt to go public, and to preserve rpi's s election [the controlling version of § 1361(b) for the year in question prohibited the parent of an affiliated group from being an s corporation]. • the tax court (judge halpem) held that because rpi's distribution of the stock of sunbelt occurred less than five years after rpi acquired control of sunbelt in a transaction in which gain or loss was recognized [i.e., the redemption of hutto's stock], the distribution failed to satisfy the active business requirement of § 355(a)(1)(c) and (b)(2)(d)(ii). judge halpern rejected the taxpayer's "blanket assertion" that a redemption of stock of the other shareholder's stock, thereby backing the parent into control of the subsidiary, never could be treated as the acquisition of control within five years in a taxable transaction. he likewise declined to follow the 2001] commissioner's argument directly to apply rev. rul. 57-144, 1957-1c.b. 123, which would treat any instance in which a redemption resulted in the acquisition of control within five years as a disqualifying acquisition. rather, he emphasized the negotiations leading up to the transaction and the fact that the cash for the redemption came from rpi to conclude that in this case there was no difference between the transaction as it occurred and a direct purchase by rpi. accordingly, § 335(c)(1) did not apply to provide nonrecognition at the corporate level; under § 31 (b), rpi recognized gain on the distribution of the sunbelt stock, and the gain passed through to the rpi shareholders under § 1366(a). [the court did not address the commissioner's argument that the shareholders failed to prove that the distribution was designed to achieve a corporate business purpose as required by reg. § 1.355-2(b).] 7. no cobe, not even close. honbarrier v. commissioner, 115 t.c. 300 (2000). the taxpayer was the sole shareholder of t corp., which for many years prior to 1988 was in the freight trucking business. between 1988 and 1990, t corp. liquidated its freight business and invested the proceeds from the sale of its operating assets in tax-exempt bonds and a municipal bond fund. [t corp. had been an s corporation until 1992; starting in 1993 t was a c corporation.] on 12/31/93, t corp. was merged into a corp., a trucking company in which the taxpayer owned the majority of the stock [his wife and children owning the remainder], in a transaction in which the taxpayer received solely a corp. stock. a corp. was an s corporation. two months before the merger, t corp. held approximately $7.35 million of tax-exempt bonds and bond funds and a small amount of cash. on the day of the merger, t liquidated one of its tax-exempt bond funds and its municipal bond fund, and its assets consisted of $2,415,321 in cash, $4,849,146 in tax-exempt bonds, $37,800 in interest and dividends receivable, $18,926 in money funds, and an icc operating authority. before the merger, a corp. did not hold any tax-exempt bonds; it held cash balances in short-term investments, such as cds. immediately following the merger, a corp. distributed $7 million to its shareholders, which they treated as a tax-free distribution from t's aaa [which exceeded $10 million] under § 1368(c)(1). the distribution consisted of $2,450,854 in cash and tax-exempt bonds worth $4,549,146 that had been acquired from t corp. within four months, a corp. disposed of the remaining tax-exempt bonds that it acquired from t corp. the taxpayer and the corporations treated the transaction as a tax-free reorganization under § 368(a)(1)(a). 0 the tax court (judge ruwe) upheld the commissioner's assertion that the merger was not a tax-free reorganization because the cobe requirement of reg. § 1.368-1(d) had not been satisfied. t corp. had abandoned its trucking business long before the merger and had entered into the business of holding tax-exempt bonds and bond funds. this investment business was t corp.'s historic business at the time of the merger. florida tax review [vol. 5:2 recent developments in federal income taxation a corp. neither continued the t corp.'s historic business nor used a significant portion of t corp.'s historic business assets in a business conducted by a corp. therefore, the taxpayer recognized all of the gain realized gain with respect to the t stock disposed of in the merger. t corp. did not realize any gain in merger because the basis of its assets equaled their fair market value. 8. the wrath of general utilities repeal rewritten. reg-1075-66-o, notice of proposed regulations, guidance under § 355(e): recognition of gain on certain distributions of stock or securities in connections with an acquisition, 66 f.r. 66 (1/2/01). revised prop. regs. §§ 1.355-7 and withdrawing proposed regulations issued in reg-1 16733-98, 64 f. r. 46155 (8/24/99). the new proposed regulations provide that whether a distribution and an acquisition are part of a plan is determined based on all the facts and circumstances. they include nonexclusive lists of facts and circumstances to be considered in making the determination and six safe harbors. * if an acquisition follows a distribution, the distribution and acquisition are considered part of a plan if the distributing corporation (d), the controlled corporation (c), or any of their controlling shareholders, intended on the date of the distribution that the acquisition or a similar acquisition occur in connection with the distribution. if an acquisition precedes a distribution, the distribution and acquisition are considered part of a plan if d, c, or any of their controlling shareholders intended on the date of the acquisition that a distribution occur in connection with the acquisition. all acquisitions of stock of a corporation that are pursuant to a plan are aggregated to determine whether the 50% threshold of § 355(e)(2)(a)(ii) is met. 0 facts and circumstances. there are two nonexclusive lists of factors to consider, one list tends to demonstrate that a distribution and an acquisition are part of a plan and the other list tends to demonstrate that a distribution and an acquisition are not part of a plan. the weight of the factors varies and the determination does not depend on merely counting factors. • factors indicating a plan: six factors [three with respect to pre-acquisition distributions and three with respect to postacquisition distributions] focus on whether d, c, or their respective controlling shareholders discussed the second transaction of the pair with outside parties before the first transaction occurred. a seventh factor considers whether the distribution was motivated by a purpose to facilitate the acquisition or a similar acquisition of d or c; evidence of such a purpose exists if there was a reasonable certainty that within six months after the distribution an acquisition would occur, an agreement, understanding, or arrangement would exist, or substantial negotiations would occur regarding an acquisition. elaborate "operating rules" describe the impact of numerous scenarios. an eighth factor considers whether an acquisition and a distribution occurred within six months of each other, or whether there was an agreement, understanding, arrangement, 2001] florida tax review or substantial negotiations regarding the second transaction (or, if an acquisition is the second transaction, a similar acquisition) within six months after the first transaction. the ninth considers whether the debt allocation between d and c made an acquisition of d or c likely in order to service the debt. 0 factors indicating the absence ofaplan: five factors [three with respect to pre-acquisition distributions and two with respect to post-acquisition distributions] focus on the absence of any discussions between d, c, or their respective controlling shareholders, with outside parties regarding the second transaction of the pair before the first transaction occurred. one of the factors in each category is that there was an identifiable, unexpected change in market or business conditions after the first transactions that resulted in the second, unexpected transaction. the sixth nonplan factor is the existence of a real and substantial corporate business purpose, other than a purpose to facilitate the acquisition or a similar acquisition, for the distribution [using principles similar to reg. § 1.355-2(b)(1)]. the seventh factor is that the distribution would have occurred at approximately the same time and in similar form regardless of the acquisition or a previously proposed similar acquisition. 0 safe harbors: a distribution and an acquisition are not part of a plan if they are described in one of the safe harbors. (1) an acquisition more than six months after a distribution if there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition before a date that is six months after the distribution and the distribution was motivated in whole or substantial part by a corporate business purpose other than a business purpose to facilitate an acquisition. this safe harbor applies if the distribution was motivated in whole or substantial part by a nonacquisition business purpose. (2) an acquisition more than six months after a distribution for which there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition before a date that is six months after the distribution. this safe harbor applies where the distribution was motivated in whole or substantial part by a business purpose to facilitate an acquisition of no more than 33% of the stock of either d or c, and no more than 20% of the stock of the corporation whose stock was acquired in the acquisition that motivated the distribution was either acquired or the subject of an agreement, understanding, arrangement, or substantial negotiations before a date that is six months after the distribution. (3) an acquisition more than two years after a distribution if there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition at the time of the distribution or within six months thereafter. (4) an acquisition more than two years before a distribution if there was no agreement, understanding, arrangement, or substantial negotiations concerning the distribution at the time of the acquisition or within six months thereafter. [vol 5:2 recent developments in federal income taxation (5) if d or c is listed on an established market, an acquisition if the stock is transferred between shareholders of d or c who are not 5% shareholders (subject to certain exceptions). (6) an acquisition of stock by an employee or director in connection with the performance of services, including an acquisition resulting from the exercise of certain compensatory stock options, is not part of a plan. for all purposes, depending on all relevant facts and circumstances, parties can have an agreement, understanding, or arrangement even though they have not reached agreement on all terms. under certain circumstances, such as in public offerings or auctions of d or c stock, an agreement, understanding, arrangement, or substantial negotiations can exist regarding an acquisition even if the acquirer has not been specifically identified. special rules deal with options. proposed to be effective upon publication of final regulations. h. personal holding companies 1. a phc in 1996 and 1997? what was this guy thinking? calypso music, inc. v. commissioner, t.c. memo. 2000-293. the taxpayercorporation's sole shareholder was a highly regarded motion picture music editor. in 1996 and 1997, 74% and 76% of the taxpayer's income was derived from contracts to perform movie music editing that specifically required the work to be performed by the shareholder-employee. the § 542 personal holding company tax applied to the corporation's undistributed earnings. but the § 6662 accuracy related penalties were not upheld because taxpayer reasonably relied on its cpa to prepare the returns which did not self assess the phc tax. vii. partnerships a. partnership audit rules 1. gaf corp. v. commissioner, 114 t.c. 519 (2000) (reviewed, 10-3). the question was whether the transfer of property to the partnership was to be treated as a sale or as a contribution to capital an $80 million question. the irs issued both a statutory notice to gaf corp. and an fpaa to the partnership. judge ruwe, for the majority, decided that a deficiency notice based on "affected items" issued prior to completion of the related partnershiplevel proceedings is invalid, so the tax court proceeding based on the deficiency notice must be dismissed for lack of jurisdiction. 0 judge halpern, in dissent, would have overruled the maxwellv. commissioner, 87 t.c. 783 (1986), line of cases to the extent they hold that the tax court lacks subject matter jurisdiction to redetermine a deficiency attributable to an "affected item" until the related 2001] florida tax review partnership proceeding is completed. the minority would not have dismissed the case, but only would have deferred proceeding until consideration of the affected items was appropriate. 0 the related case of rhone-poulenc surfactants & specialties, l.p. v. commissioner, 114 t.c. 533 (2000) (reviewed, 8-6), dealt with a partner's motion for summary judgment based upon the running of the statute of limitations, which was denied. the majority did not see dismissal of the partner-level case as mooting the partnership-level case. 2. joint return doesn't make one spouse's income the other's. when items become nonpartnership items for the partner spouse, they necessarily become so with respect to the nonpartner spouse. callaway v. commissioner, 231 f.3d 106 (2d cir. 2000), rev'g t. c. memo. 1998-99. taxpayer's late husband owned a partnership interest as separate property but his distributive share of income was reported on a joint return. after the husband died, his estate filed a request for prompt assessment, and, as a result [under § 6231(b)(1)(d), (c)(1), and reg. § 301.6231(c)-8t], his share of the partnership's items became nonpartnership items [a point not contested by the commissioner]. in a case of first impression in the courts of appeals, the issue was whether the conversion of the husband's partnership items into nonpartnership items also applies for purposes of assessing against the wife deficiencies attributable to the partnership items. the court held that where only one spouse owned an interest in partnership items, the conversion of those partnership items into nonpartnership items necessarily converts into nonpartnership items with respect to the other spouse as well all the items taken into account on the joint return by reason of the partnership interest. as a consequence: (1) pursuant to § 6230(a)(2)(a)(ii) the regular deficiency notice procedures applied, and (2) under § 6229(f) the statute of limitations expired one year after the items became nonpartnership items. on the facts "precautionary" assessments, later computational adjustments, and a later affected items deficiency notice, all issued after the fpaa and more than one year after the items became nonpartnership items, were time barred, with respect to the taxpayer as well as with respect to her deceased spouse's estate. 3. reg-104867-00, taxable years of partner and partnership; foreign partners, 66 f.r. 3920 (1/17/01). proposed reg. § 1.706-4 would generally disregard foreign partners who are not subject to u.s taxation on a net basis, i.e., foreign partners who are not allocated any effectively connected income or, if claiming treaty benefits, that do not have a permanent establishment, for purposes of applying § 706(b) to determine the partnership's permitted year. these rules do not apply if the partnership year would be determined with reference to domestic partners no one of which holds at least a 10% interest and which in the aggregate hold less that 20% of the interests. [vol. 5:2 recent developments in federal income taxation b. miscellaneous 1. partnership § 179 passthrough is limited to the taxable income of the partnership. hayden v. commissioner, 204 f.3d 772 (7th cir. 2000), aff'g, 112 t.c. 115 (1999). the court upheld the validity of reg. § 1.1792(c)(2), which limits the § 179 deduction passed through to partners to the taxable income of the partnership. the result was dictated by §§ 179(b)(3)(a) and 179(d)(8) themselves. 2. notice of proposed rulemaking, allocation of partnership debt. reg-103831-99, allocation of partnership debt, 65 f. r. 2081 (1/13/00). proposed reg. § 1.752-3(b) would solve problems that have arisen in determining how to determine the amount of§ 704(c) minimum gain under reg. § 1.752-3(a)(2) when a partnership holds multiple properties subject to a single nonrecourse liability. this problem typically occurs when a partnership that holds several properties subject to individual mortgages refinances the individual liabilities with a single nonrecourse mortgage. under the proposed regulations a partnership that holds multiple properties subject to a single liability may allocate the liability among the properties using any reasonable method. a method is not reasonable if it allocates to any property an amount that exceeds the fair market value of the property. thus, for example, the liability may be allocated to the properties based on the relative fair market value of each property. the portion of the nonrecourse liability allocated to each item of partnership property is then treated as a separate liability under reg. § 1.752-3(a)(2). once a liability is allocated among the properties, a partnership may not change the method for allocating the liability. if, however, one of the properties ceases to be subject to the liability, the portion of the liability originally allocated to that property must be reallocated to the properties still subject to the liability. a. finalized. t.d. 8906, allocation of partnership debt, 65 f.r. 64888 (10/31/00). the treasury has promulgated final regulations under § 752 relating to the allocation of nonrecourse liabilities by a partnership. the regulation revises and clarifies the rules under tier three of the three-tiered allocation structure. regs. § 1.752-3(a)(3) also provides that an excess nonrecourse liability may be allocated under the third tier in accordance with excess reverse § 704(c) gain as well as with respect to § 704(c) gain. the final regulations also provide that the rules in reg. § 1.752-3(a)(3) do not apply to disguised sales under reg. § 1.707-5(a)(2)(ii). 3. notice of proposed rulemaking, applying § 197 to partnerships. reg-100163-00, applying section 197 to partnerships, 65 f.r. 3903 (1/25/00). the treasury issued prop. regs. § 1.197-2(h)(12)(ii) regarding when the 2001] florida tax review § 197(f)(9) anti-churning rules will be applied to basis increases for § 197 amortizable intangibles under § 732(b) or § 734(b). a. t.d. 8907, application of the anti-churning rules for amortization of intangibles in partnerships, 65 f. r. 69667 (11/20/00). the treasury has promulgated final regulations on the application of the antichurning rules for § 197 intangible property to partnership transactions involving §§ 732(b) and 734(b). the final regulations change the fraction used to determine a continuing partner's share of a § 734(b) basis adjustment. the fraction now compares a continuing partner's post-distribution capital account as determined under § 704(b) and reg. § 1.704-1(b)(2)(iv) to the aggregate of all of the continuing partners' post-distribution capital accounts. if the partnership doesn't maintain capital accounts in accordance with reg. § 1.7041(b)(3), the fraction is determined by reference to the partner's overall interest in the partnership under reg. § 1.704-1(b)(3). t.d. 8907 is effective 11/20/00. 4. reg-107872-99, coordination of sections 755 and 1060 relating to allocation of basis adjustments among partnership assets, 65 f.r. 17829 (4/5/00). the treasury has promulgated proposed regulations relating to the allocation of basis adjustments among partnership assets under § 755, which implement § 1060(d) [which applies the residual method to partnership transactions in connection with determining the value of § 197 intangibles]. 0 proposed reg. § 1.755-2 [to replace temporary reg. § 1.755-2t] implements § 1060(d), by applying the residual basis allocation method to all allocations of § 743(b) [and § 734(d)] inside basis adjustments under § 755. these proposed regulations determine the value of the partnership's individual assets, which value is in turn used to determine the allocation under reg. § 1.755-1 of the inside basis adjustment. under the proposed regulations, the amount paid for the transferred partnership interest is the benchmark for valuing all of the partnership's assets. the partnership's assets are valued in five tiers: (1) cash and general deposit accounts (including savings and checking accounts) other than certificates of deposit held in banks, savings and loan associations, and other depository institutions; (2) partnership assets other than cash equivalents, capital assets, § 123 1(b) property, and § 197 intangibles (i.e., ordinary income property other than § 1245 recapture and other items treated as unrealized receivables under the flush language of § 751 (c)); (3) capital assets and § 1231(b) property other than § 197 intangibles; (4) § 197 intangibles other than goodwill and going concern value; (5) goodwill and going concern value. 5. gulley v. commissioner, t.c. memo. 2000-190. even though under the relevant state law [texas], a general partner of a limited partnership ceased to be a partner in a partnership upon the partner's bankruptcy, the bankruptcy of the sole general partner of a limited partnership did not terminate the [vol 5:2 recent developments in federal income taxation partnership under § 708(b)(1)(a) because the partnership did not wind up its affairs until a later year. the succession of the chapter 7 bankruptcy estate to the bankrupt partner's 66.67% partnership interest under § 1398 was not a "transfer" resulting in a termination of the partnership under § 708(b)(1)(b). the bankrupt partner's partnership year did not close under § 706(c)(2)(a). section 706(d) did not apply either. thus, the passed-through partnership loss for the entire year was allocated to the bankruptcy estate. 6. penny-wise and pound foolish. how to vaporize depreciation deductions. jeyapalan v. commissioner, t.c. memo. 2000-207. the taxpayers formed a partnership to purchase and operate an apartment building. the acquisition was substantially debt financed. subsequently, to obtain limited tort liability, the partners formed an s corporation and began conducting the rental activity through the corporation. although title to the building never was transferred to the corporation [because the lender demanded a $10,000 fee to transfer the liability], the partnership filed a final tax return and the taxpayers held out the corporation as the owner and operator of the building. only the taxpayer's cash contributions to the s corporation were taken into account in determining the basis limitation on passed-through losses under § 1366(d), and most of the operating losses were disallowed at the shareholder level. [note that if the partnership had been liquidated and the apartment transferred to the corporation, the shareholders' initial § 358 basis in their stock would have indirectly included the amount of the purchase-money debt on the building]. 7. is § 381 an alter ego talisman? rev. rul. 2000-44,2000-41 i.r.b. 336. if a corporation tfiat acquires assets of another corporation in a tax-free transaction described in § 381(a) [e.g., a parent that acquires its subsidiary's assets in a § 332 liquidation or the acquirer in a statutory merger type a reorganization] succeeds to liquidated corporation's status for purposes of applying the exception for reimbursements of pre-formation expenditures and determining whether a liability is a qualified liability under the § 707(a)(2)(b) disguised sale regulations [regs. §§ 1.707-4(d),-5(a)(6)]. 8. reg-106702-00, determination of basis of partner's interest; special rules, 66 f. r. 315 (1/3/01). prop. reg. § 1.705-2 would prevent what the irs has determined to be "inappropriate" increases or decreases in the adjusted basis of a corporate partner's interest in a partnership [consistent with notice 99-57, 1999-2 c.b. 692] resulting from the partnership's disposition of the corporate partner's stock [under the general principles of rev. rul. 99-57, 1999-2 c.b. 678], when: (1) a corporation acquires an interest in a partnership that holds stock in the corporation, (2) the partnership doesn't have a § 754 election in effect for the year in which the corporation acquires the interest, and (3) the partnership later sells or exchanges the stock, then the increase or decrease in the corporation's adjusted basis in its partnership interest resulting 2001] from the sale or exchange of the stock equals the amount of gain or loss that the corporate partner would have recognized (absent the application of § 1032) if, for the tax year in which the corporation acquired the interest, a § 754 election had been in effect. the rule would be effective retroactively to gain or loss allocated on sales or exchanges of stock occurring after 12/06/99. 9. form controls partnership mergers and divisions. t.d. 8925, partnership mergers and divisions, 66 f.r. 715 (1/4/01). the treasury has promulgated final reg. §§ 1.708-1(c) and amendments to § 1.752-1(f) and (g). the tax consequences of mergers of partnerships depend on the form followed under the laws of the applicable jurisdiction, either the "assets-over form" or the "assets-up form" [even if none of the merged partnerships are treated as continuing for federal income tax purposes]. generally, [and if no particular form is chosen] the assets-over form applies. (this approach is consistent with the treatment of partnership to corporation elective conversions under the check-the-box regulations and technical terminations under § 708(b)(1)(b).) but, if as part of the merger, the partnership titles the assets in the partners' names, the assets-up form applies. if partnerships use the interest-over form to accomplish the result of a merger, the partnerships will be treated as following the assets-over form for federal income tax purposes. * under the assets-up form, partners recognize gain under §§ 704(c)(1)(b) and 737 (and incur state or local transfer taxes) when the terminating partnership distributes the assets to the partners. however, under the assets-over form, gain under §§ 704(c)(1)(b) and 737 is not triggered. see §§ 1.704-4(c)(4) and 1.737-2(b). because the adjusted basis of the assets contributed to the resulting partnership is determined first by reference to § 732 (as a result of the liquidation) and then § 723 (by virtue of the contribution, the adjusted basis of the assets contributed may not be the same as the adjusted basis of the assets in the terminating partnership if the partners' aggregate adjusted basis of their interests in the terminating partnership does not equal the terminating partnership's adjusted basis in its assets. under the assets-over form, because the resulting partnership's adjusted basis in the assets it receives is determined solely under § 723, the adjusted basis of the assets in the resulting partnership is the same as the adjusted basis of the assets in the terminating partnership. 0 when two or more partnerships merge under the assets-over form, increases or decreases in partnership liabilities associated with the merger are netted by the partners in the terminating partnership and the resulting partnership to determine the effect of the merger under § 752. a partner in the terminating partnership will recognize gain on the contribution under § 731 only if the net § 752 deemed distribution exceeds that partner's adjusted basis of its interest in the resulting partnership florida tax review [vol 5:2 recent developments in federal income taxation * if the merger agreement (or some other contemporaneous agreement) specifies that the resulting partnership is purchasing an exiting partner's interest in the terminating partnership and the amount paid for the interest, the transaction will be treated as a sale of the exiting partner's interest to the resulting partnership * form also will be followed, and the resulting differing tax consequences respected with regard to corporate divisions if the partnership undertakes the steps of either the assets-over form or the assets-up form. gain under §§ 704(c)(1)(b) and 737 often may be triggered when § 704(c) property or substituted § 704(c) property is distributed to certain partners in the context of partnership divisions. if a partnership divides, the transfer to one new partnership can follow the assets-over form while the transfer to the other follows the assets-up form. all resulting partnerships are bound by the original partnership's elections. * the new rules are generally effective as of 1/4/01, with an elective effective date of 1/11/00. 10. the form was all the substance that was necessary. estate of strangi v. commissioner, 115 t.c. 478 (2000) (reviewed, 9-5). the decedent established a family limited partnership two months before he died, transferring cash, securities, life insurance policies, annuities, real estate, and partnership interests; cash and securities were 75% of the value. decedent held a 99% interest as a limited partner and a corporation owned 47% by decedent and 53% by his wife, as trustee, held a 1% general partnership interest. the partnership distributed a substantial portion of its assets soon after the decedent's death. the irs rejected the estate's discounted valuation based on the position that under the economic substance and business purpose doctrines the existence of the partnership should be ignored. the flp was held to be valid for estate tax purposes, § 2703 did not apply to the agreement, and the transfer to the partnership was not a gift, and discounts [33% for lack of marketability and lack of control] were acceptable. * in a reviewed opinion by judge cohen, the tax court rejected the estate's claims that the partnership was formed to protect the assets from claims or will contests, as well as the estate's argument that the partnership was a joint investment vehicle. she also found that the management of the assets was not the purpose for the formation of the partnership. no active business was conducted by the partnership. nevertheless, the existence of the partnership was respected. sflp [the partnership] was validly formed under state law. the formalities were followed, and the proverbial "i's were dotted" and "t's were crossed." the partnership, as a legal matter, changed the relationships between decedent and his heirs and decedent and actual and potential creditors. regardless of subjective intentions, the partnership had 20011 sufficient substance to be recognized for tax purposes. its existence would not be disregarded by potential purchasers of decedent's assets, and we do not disregard it in this case. 0 however, once past this issue [and other structural estate tax issues] the court accepted the commissioner's lesser discount rather than the large one claimed by the estate. o judge laro, concurring, foreseeing the mischief the majority opinion could cause in income tax cases, would have limited the holding that the partnership had enough substance to be recognized to estate and gift tax purposes. o judge ruwe, in dissent, would have found a taxable gift under 2512(b) in the amount of any diminution in value of the assets, because that value was transferred to other family members by the overall arrangement. o judge parr's dissent described the transactions as "a mere paper arrangement" that did not limit the decedent's control over the assets. 0 judge beghe's dissenting opinion would have applied the end result version of the step transaction doctrine to include the partnership assets directly in the decedent's estate. judge beghe wrote: [u]nder the end-result test, the formally separate steps of the transaction (the creation and funding of the partnership within 2 months of mr. strangi's death, the substantial outright distributions to the estate and to the children, and the carving up of the merrill lynch account) that were employed to achieve mr. strangi's testamentary objectives should be collapsed and viewed as a single integrated transaction: the transfer at mr. strangi's death of the underlying assets. under judge beghe's analysis, there is no valuation issue. 11. knight v. commissioner, 115 t.c. 506 (2000) (reviewed, 12-1). in another family limited partnership valuation case, involving gift tax valuation, the tax court, in a reviewed opinion, by judge colvin upheld the validity of the limited partnership's existence solely on the ground that it was a valid partnership under state [texas] law. the opinion distinguishedasa investerings partnership and a cm partnership without explaining the particular basis for the distinction. florida tax review [vol. 5:2 recent developments in federal income taxation viii. tax shelters a. corporate tax shelters 1. tax shelter benefits from § 453 contingent sale partnership tax shelter not allowed because the tax shelter is a sham and "serves no economic purpose other than tax savings." merrill lynch's persistence overcomes initial doubts of tax department. acm partnership v. commissioner, t.c. memo. 1997-115. judge laro found a § 453 contingent sale partnership tax shelter to be a prearranged sham, "tax-driven and devoid of economic purpose," "serv[ing] no economic purpose other than tax savings," following goldstein v. commissioner, 364 f.2d 734 (2d cir. 1966). under the scheme to shelter colgate's $105 million 1988 capital gain, a partnership was formed in 1989; its three partners were affiliates of (a) a foreign bank (about 90%), (b) colgate (about 9%), and (c) merrill lynch (about 1%). a bank note was purchased by the partnership and immediately sold for a large immediate payment and much smaller future contingent payments. under the contingent payment sale provisions of the temporary regulations [§ 15a.453-1(c)] the partnership's basis was to be allocated ratably over the several years over which contingent payments could be made, resulting in a large 1989 installment sale gain to the partnership. the lion's share of that installment sale gain was allocated to the foreign bank (which was not taxable on u.s. source capital gain), followed by the redemption of the foreign bank's partnership interest. this left colgate as the 90% partner. in 1991, the installment sale obligation was sold by the partnership, triggering about $100 million of capital losses, which colgate attempted to use to shelter its 1988 capital gain. a. acm affirmed by third circuit, except for determination that out-of-pocket amounts are deductible.acmpartnership v. commissioner, 157 f.3d 231 (3d cir. 1998) (2-1), affg and rev'g t. c. memo. 1997-115. the third circuit affirmed the tax court on its application of the "economic substance" doctrine, which eliminated the capital gains and losses attributable to acm's application of the ratable basis recovery rule of the contingent installment sale provisions. 2. judge foley finds another merrill lynch § 453 partnership plan does not work because, under the facts, there was no partnership. asa investerings partnership v. commissioner, t.c. memo. 1998-305. in another merrill lynch § 453 partnership plan to create capital losses to shelter earlier capital gains, alliedsignal lost when judge foley held that the parties to the partnership agreement did not join together for a common purpose of investing in interest-bearing instruments, and they did not share profits and losses. 200o1 a. affirmed. asa investerings partnership v. commissioner, 201 f.3d 505 (d.c. cir. 2000). the d.c. circuit's opinion noted that it disagreed with the tax court's statements that persons with "divergent business goals" are precluded from having the requisite intent to form a partnership. however, this view was not essential to the tax court's conclusion that the parties did not intend to join together as partners to conduct business activity for a purpose other than tax avoidance. the court held that there was a single business purpose rule. 3. judge nims follows acm to deny benefits to brunswick. saba partnership v. commissioner, t.c. memo. 1999-359. brunswick's transactions identical to acm's were found to lack economic substance. judge nims held that the transactions lacked nontax business purposes and that congress did not intend to favor such transactions "regardless of their economic substance." he held that fees paid for the organization of the partnership were deductible subject to the limitations of § 709(b) [60-month amortization], but that the fees paid with respect to the sham transactions were not deductible. 4. step-down preferred [fast-pay stock] to be recharacterized. reg104072-97, recharacterizing financing arrangements involving fast-pay stock, 64 f. r. 805 (1/6/99). proposed regulations that recharacterize for tax purposes financing arrangements involving fast-pay stock. economically, fastpay stock is self-amortizing because distributions are in part a return on investment and in part a return of the investment, which understates the taxable income on the benefitted stock during the initial period. the proposed regulations follow notice 97-21, 1997-1 c.b. 407, except for using a different model that treats the benefitted shareholders as first issuing the financing instruments in exchange for cash equal to the fast-pay stock's fair market value, and then as contributing the cash to the corporation (which increases their basis in the benefitted stock). grandfather that limits taxable income to that provided in notice 97-21 until these regulations become final. a. finalized. t.d. 8853, recharacterizing financing arrangements involving fast-pay stock, 65 f.r. 1310 (1/10/00). the final regulations simplify the definition of "fast-pay arrangement" to any arrangement by which a corporation has fast-pay stock outstanding for any part of its taxable year. they change the rule in the proposed regulations that any redemption that results in dividend treatment results in fast-pay stock. stock is not fast-pay stock solely because a redemption results in dividend treatment exists unless there is a principal purpose to achieve the effect of fast-pay stock. effective date, 2/27/97 (with some transition relief). 5. springstein isn't the only boss; tax avoidance using distributions of encumbered property. notice 99-59, 1999-52 i.r.b. 761, florida tax review [vol. 5:2 recent developments in federal income taxation advises taxpayers that losses from "boss" product transactions are not properly deductible. the notice describes the boss product as follows: in one typical arrangement, taxpayers act through a partnership to contribute cash to a foreign corporation, which has been formed for the purpose of carrying out the transaction, in exchange for the common stock of that corporation. another party contributes additional capital to the corporation in exchange for the preferred stock of that corporation. the foreign corporation then acquires additional capital by borrowing from a bank and grants the bank a security interest in securities acquired by the foreign corporation that have a value equal to the amount of the borrowing. thereafter, the foreign corporation makes a distribution of the encumbered securities to the partnership that holds its common stock. the effect of the distribution, combined with fees and other transaction costs incurred at the corporate level, is to reduce the remaining value of the foreign corporation's common stock to zero or a minimal amount. although the distributed securities are encumbered by the bank debt (and the taxpayers or their partnership may be secondarily liable for the debt as guarantors), the foreign corporation has sufficient other assets to repay the debt, and it is the understanding of all parties that the foreign corporation will repay the debt with such other assets. for example, if the taxpayers' partnership had contributed $100x for the common stock of the foreign corporation, the partnership might receive a distribution of securities with a fair market value of approximately $100x, and that distribution would have the economic effect of reducing the remaining value of the foreign corporation's common stock to zero. nonetheless, because the distribution to the partnership is subject to the bank debt, the parties take the position, pursuant to § 301(b)(2), that the amount of the distribution is zero for purposes of§ 301. on that theory, no part of the distribution is treated either as a dividend or as a reduction of stock basis under § 301(c). the partnership is treated as having subsequently disposed of the stock of the foreign corporation, giving rise to a tax loss equal to the excess of the partnership's original basis in the stock ($100x in the example) over the fair market value of the common stock alter the distribution of securities (zero). the deemed disposition of the stock may be based upon an election under reg. § 301.7701-3(c) to change the federal income tax classification of the foreign corporation from a corporation to 200ou a partnership, giving rise to a deemed liquidation of the foreign corporation, or by treating the partnership as a trader in securities which elects under § 475(f) to treat the securities that it holds, including the stock of the foreign corporation, as having been sold for their fair market value on the last business day of the taxable year. thereafter, typically in a later taxable year, the bank debt is repaid out of other assets held by the foreign corporation. although the parties previously treated the debt as reducing the amount of the earlier distribution from the foreign corporation, promoters advise taxpayers to take the position that the foreign corporation's repayment of the debt is not treated as a distribution on its common stock. 0 the pricewaterhousecoopers description of the boss product was published at 1999 tnt 233-58 (12/6/99). 6. aba tax section recommendation to amend circular 230, to provide new minimum standards for practitioners who provide "more likely than not" opinions used in the offering materials for corporate tax shelters (11/1/99). the recommended language would require the practitioner "to evaluate and take account of all relevant facts; to relate the applicable law to those facts; to consider, to the extent relevant and appropriate, both the substance and the purpose of the plan or arrangement; to identify and discuss all material tax issues; to identify and discuss the relevance and persuasiveness of the legal authority pertinent to the facts and material tax issues; and to contain a reasoned analysis of whether applicable authority supports the position taken by the taxpayer." the recommendation further provides that "it would be unreasonable for a practitioner merely to assume the existence of a business purpose for a transaction if business purpose is a material fact." 7. modifications of circular 230 are proposed, including the standards for providing advice regarding tax shelters; firms will be required to have procedures to ensure compliance. reg-111835-99, regulations governing practice before the internal revenue service, 66 f. r. 3276 (1/12/01). changes proposed to circular 230 include: o amended § 10.21 would require practitioners to advise a client who had not complied with revenue laws of the manner in which the error or omission may be corrected and the possible consequences of not taking such corrective action. 0 amended § 10.24 would limit the dissociation from a disbarred or suspended person only to matters constituting practice before the irs. 0 new § 10.35 would prescribe new standards florida tax review [vol. 5:2 recent developments in federal income taxation for tax shelter opinions at the more-likely-than-not (or higher) level of confidence. these would include a requirement to make inquiry as to all relevant facts, and be satisfied that the material facts are accurately and completely described in the opinion. the regulations under §§ 6662 and 6664 will be modified to provide that only opinions that satisfy the standards of circular 230 may be relied upon. • amended § 10.33 would apply to all tax shelter opinions not governed by new § 10.35, and would also provide a series of requirements for compliance. 8. corporate tax shelter disclosure and registration requirements. announcement 2000-12, 2000-12 i.r.b. 835 announcement of three sets of temporary and proposed regulations relating to disclosure and registration requirements for corporate tax shelters, as well as a notice of listed transactions. a. lists. t.d. 8875, requirements to maintain list of investors in potentially abusive tax shelters, 65 f. r. 11211 (3/2/00), modified by t.d. 8896, modification of tax shelter rules, 65 f. r. 49909 (8/16/00) (modifications effective (8/11/00), and notice 2000-11, i.r.b. 761, and reg103736-00, requirement to maintain lists of inventors in potentially abusive tax shelters, correction, 65 f.r. 17617 (4/4/00), and notice 2000-11, i.r.b. 768. the treasury has promulgated temporary and proposed regulations under § 6112 amends temporary reg. § 301-6112-1t, [in q&a form] to require promoters to maintain a list of investors in "potentially abusive tax shelters." it relies on the temporary reg. § 301.6111-2t definitions. * under the august 2000 amendments, only promoters that are classified as organizers under § 6111(e)(1) are required to register tax shelters. * the august 2000 amendments to reg. § 301.6111-2t limit the definition of a tax shelter promoter to persons who participate in the organization, management or sale of a tax shelter under § 6111(e)(1) and reg. § 301.6111-1t (q&a-26 through q&a-33), or are related to such person under §§ 267 or 707(b). 0 under the august 2000 amendments, an organizer or seller of an interest in a shelter is not required to (but may) list any investor in a tax shelter that (1) is not required to be registered under § 6111, (2) is not a listed transaction described in reg. § 301.6111-2t(b)(2), and (3) is not a projected income investment described in reg. § 301.6111-1t a-57a, if(a) the total consideration paid to all organizers and sellers with respect to such investor's acquisition of the interest is less than $25,000, or (2) the organizer reasonably believes that (a) such investor's acquisition of the interest will not result in a reduction of tax liability of any corporation (or corporations) that exceeds (i) $1 million in any single taxable year or (ii) a total of $2 million for any combination of taxable years and (b) will not result in a reduction of the 20011 florida tax review income tax liability of any noncorporate taxpayer (or taxpayers) that exceeds (i) $250,000 in any single taxable year or (ii) a total of $500,000 for any combination of taxable years. b. registration. t.d. 8876, corporate tax shelter registration, 65 f. r. 11215 (3/2/00), and reg-110311-98, corporate tax shelter registration, 65 f.r. 11272 (3/2/00). the treasury has promulgated temporary and proposed regulations under § 6111(d) on registration of "confidential corporate tax shelters". modified by t.d. 8896, modification of tax shelter rules, 65 f. r. 49909 (8/16/00), effective 8/11/00. 0 temporary reg. § 301.6111-2t defines "confidential corporate tax shelters" as "any transaction" [including "all the factual elements necessary to support the tax benefits that are expected to be claimed with respect to any entity, plan, or arrangement"]: (i) a significant purpose of which is the avoidance or evasion of federal income tax; (ii) that is offered to any potential participant under conditions of confidentiality; and (iii) for which the tax shelter promoters may receive aggregate fees in excess of $100,000. registration is to be on form 8264, "application for registration of a tax shelter." * avoidance or evasion transactions include (1) "listed transactions" [see, e.g., notice 2000-15, infra]; (2) transactions lacking economic substance if the expected pre-tax profit (after foreign taxes and transaction costs) is insignificant relative to the present value of the expected net federal income tax savings; or (3) if the transaction has been structured to produce federal income tax benefits that constitute an important part of the intended results of the transaction and the promoter expects it to be presented in substantially similar form to more than one potential participant (unless the participant is expected to participate in the ordinary course of its business in a form consistent with customary commercial practice and there is a "longstanding and generally accepted understanding" that the federal income tax benefits are allowable). registration will not be required for "excepted transactions," which are those for which "there is no reasonable basis under federal tax law for denial of any significant portion of the expected federal income tax benefits," or those transactions which the irs has determined are not subject to registration requirements. a ruling request procedure is provided. o "conditions of confidentiality" is a facts and circumstances determination, with an exception for written agreements expressly authorizing disclosure. under the august 2000 modifications, restrictions on disclosure of the structure or tax aspects of the transaction reasonably necessary to comply with securities laws are not considered to be a confidentiality agreement. [vol 5:2 recent developments in federal income taxation 0 under the august 2000 modifications, an exclusivity agreement (i.e., an agreement requiring the offeree to pay a fee to a promoter if the offeree engages in the transaction, whether or not the offeree uses the promoter's services) is a condition of confidentiality. but an exclusivity arrangement ordinarily will not result in an offer being treated as made under conditions of confidentiality if it provides express written authorization for disclosure. limitations on disclosure or use constitute a condition of confidentiality only if the limitations relate to the structure or tax aspects of the transaction and the limitations are for the benefit of any person other than the offeree. • registration is to be made not later than the day on which the first offering for sale is made, with extensions generally until 8/26/00. c. red flagging returns. t.d. 8877, tax shelter disclosure statements, 65 f. r. 11205 (3/2/00), and reg-103735-00, modification of tax shelter rules, 65 f.r. 11269 (3/2/00). temporary and proposed regulations under § 6011 requiring corporations to attach statements to their federal corporate income tax returns that disclose tax shelters. modified by t.d. 8896, modification of tax shelter rules, 65 f. r. 49909, (8/16/00), effective 8/11/00. 0 temporary reg. § 1.6011-4t was issued under §§ 6001 [required records provision] and 6011(a) [general requirement of return or statement]. it requires that, for "reportable transactions," corporations must both attach a disclosure statement to their tax returns [separately mailing a copy to the irs large & mid-size business division] and retain all related documents until the expiration of the statute of limitations. related documents include all marketing materials, all written analyses, all correspondence, etc. under the august 2000 modifications, the required records include all documents and other records related to a transaction subject to disclosure under the regulations that are material to an understanding of the facts of the transaction, the expected tax treatment of the transaction, or the corporation's decision to participate in the transaction. • a "reportable transaction" is either: (1) a "listed transaction" [see, e.g., notice 2000-15, 2000-12 i.r.b. 826], or (2) another reportable transaction if it possesses at least two of six of the following characteristics: (a) confidentiality; (b) protection against the possibility that intended tax benefits will not be sustained (including rescission rights, refund of fees, insurance protection, indemnities other than customary non-promoter indemnities); (c) promoter fees in excess of $100,000; (d) expected tax treatment expected to differ by more than $5 million from book treatment; (e) the participation of a tax indifferent person; and (f) the expected characterization for u.s. income tax purposes differs from that for foreign taxes. 20011 florida tax review * four exceptions are provided: (1) transactions in the ordinary course of business in a form consistent with customary commercial practice if the taxpayer "reasonably determines" that it would have participated irrespective of the expected federal income tax benefits; (2) transactions in [ordinary course and customary commercial practice] if the taxpayer "reasonably determines" that there is a long-standing and generally accepted understanding that the expected federal income tax benefits are allowable for substantially similar transactions; (3) transactions for which the taxpayer "reasonably determines" that there is "no reasonable basis under federal tax law for denial of any significant portion of the expected federal income tax benefits"; (4) transactions identified in published guidance as being exempt from disclosure. d. identified "tax avoidance transactions." notice 2000-15, 2000-12 i.r.b. 826. the irs has published a list of tax transactions that it has determined to be tax avoidance transactions. ten transactions are on the list, including "lease strips," certain notice 98-5 transactions, acm-type transactions, certain charitable remainder trust distributions, lease-in/lease-out transactions, notice 99-59 encumbered property distributions, fast-pay stock arrangements, and rev. rul. 2000-12, 2000-11 i.r.b. 774, debt straddle transactions. 9. rev. rul. 2000-12,2000-11 i.r.b. 744. loss on sale of debt straddle tax shelter [also called a "bull-bear bond" transaction] cannot be claimed. the shelter involves the taxpayer corporation purchasing two private placement debt instruments structured using reset provisions that will cause the value of the notes to move in opposite directions. 10. baby boss is a fraud too! notice 2000-44, 2000-36 i.r.b. 255. "artificial" capital losses generated by baby boss transactions will not be allowed. 0 scheme #1: the taxpayer purports to borrow at a premium interest rate. for example. a lender gives the taxpayer $3,000 and the parties treat the stated principal amount of the loan as only $2,000, with the remaining $1,000 that must be repaid representing interest. the taxpayer contributes the loan proceeds into a partnership, which assumes the liability, and uses the proceeds to purchase an investment asset worth $3,000. the taxpayer/partner takes the position under § § 705(a)(2), 722, and 752(b) his basis in his partnership interest is $1,000 [the $3,000 cash contribution minus the $2,000 assumed liability], even though the value of the partnership interest is zero. the taxpayer then sells the partnership interest for a nominal amount, claiming a $1,000 capital loss. [everyone apparently ignores the $1,000 discrepancy between the cash proceeds of the loan and the $2,000 "principal amount," which has to produce income to someone sometime.] [vol 5:2 recent developments in federal income taxation 0 scheme #2: the taxpayer simultaneously purchases a call option and writes an offsetting call option, both of which are then contributed to a partnership. the taxpayer takes the position that the basis of the partnership interest equals the basis of the purchased call option, unreduced by the liability associated with the written call option, i.e., that the partnership did not assume a liability when it took responsibility for the written call option. the taxpayer then uses this artificially high basis to claim a capital loss on the sale of his partnership interest. [compare rev. rul. 95-26, 1995-1 c.b. 131, holding that a partnership's short sale of securities creates a liability.] 0 notice 2000-44 disallows the losses [under §§ 165(a) and (c)] produced by both of these baby boss transactions as artificial, citing, in the case of individuals, fox v. commissioner, 82 t.c. 1001 (1984), holding that § 165(c)(2) requires a primary profit motive for a loss from a particular transaction is to be deductible. the notice also cites reg. § 1.702-2 [the partnership anti-abuse rules]. the government also is reexamining the partnership basis rules. * compound indicia of criminal tax fraud? the government believes that the baby boss transactions were not being individually reported on schedule d, but instead have been buried in grantor trusts. for example, an individual taxpayer with an unrealized capital gain contributes both the appreciated assets and the baby boss partnership interest into a grantor trust, which sells both, and the individual reports only the net gain or loss from the grantor trust's transactions on his return, rather than breaking out gains and losses separately, as is required [by reg. § 1.671-2]. treasury department officials suggest that criminal penalties might apply to this kind of reporting, which willfully conceals the facts. * changes coming to tax shelter disclosure rules. the recently proposed corporate tax shelter disclosure rules will be changed by dropping of the requirement that a shelter be marketed to a corporation to trigger the requirement that a promoter maintain a customer list. under the amended regulations, a customer list would have to be maintained for a shelter that is exclusively peddled to individuals, provided threshold amounts of fees and tax savings are met. 11. notice 2000-60, 2000-49 i.r.b. 568. the irs has identified and "listed" another tax shelter involving a parent, a subsidiary and an unrelated company. parent and unrelated transfer cash to the subsidiary, reducing parent's ownership in the subsidiary to less than 89%. the subsidiary then uses cash to purchase parent stock from parent shareholders and then transfers parent stock to parent employees to cover parent's stock-based compensation obligations. the subsidiary then liquidates. parent claims a capital loss in the stock of the subsidiary because the value of the subsidiary has been reduced by the transfers to parent's employees. subsidiary claims a capital loss on the sale of its remaining parent stock because it treats transfers to parent employees as 20011 florida tax review contributions of capital to the parent under reg. § 1.83-6(d). the irs held that the transfers to parent's employees are properly characterized as distributions by the subsidiary to the parent, followed by compensatory transfers by the parent to its employees. alternatively, the irs says it can disregard the steps in the transaction and treat it as a redemption by the parent. 12. corporate owned life insurance ("colr"). a. tax court denies "pre-amendment" benefits "retroactively." the tax court determined that pre-1996 hipaa leveraged corporate-owned life insurance program lacked economic substance and business purpose, and thus was a sham for tax purposes. deductions for interest on policy loans were denied. winn-dixie stores inc. v. commissioner, 113 t.c. 254 (1999). in 1993, taxpayer entered into a broadbased leveraged corporate-owned life insurance ("coli") group plan covering approximately 36,000 of its employees. the decision to shift from its existing "key-person" coli program of individual policies [covering 615 managers] was made pursuant to a proposal that emphasized the "tax arbitrage created when deductible policy loan interest is paid to finance non-taxable policy gains." the proposal indicated that taxpayer would have pre-tax loss totaling $755 million for its 1993-2052 years, but would have total after-tax earnings of more than $2.2 billion for the same period (as the result of total projected income tax savings of more than $3 billion). the coli policies were terminated in 1997, following 1996 legislation that impacted the plan. judge ruwe held that the coli program lacked substance and business purpose, and thus was a sham. 0 judge ruwe rejected taxpayer's argument that the policies could conceivably produce pre-tax benefits if some catastrophe were to occur that would produce large, unexpected death benefits. "we are convinced that this was so improbable as to be unrealistic and therefore had no economic significance." the court further found that the possible use of projected after-tax earnings to fund employee benefit plans would not cause the coli plan to have economic substance, noting that, if so, "every sham taxshelter device might succeed." in light of the $3,000 per year premium paid to insure each employee or former employee, it was irrelevant that there was a relatively small death benefit of $5,000 paid with respect to each dead employee or former employee. judge ruwe rejected taxpayer's position that the § 264 safe-harbor test protected its interest deductions. he noted that the right to an interest deduction is governed by § 163 [and not § 264], citing knetsch v. united states, 364 u.s. 361 (1960). he further quoted, "but we do not agree with [taxpayer's] assertion that the legislative history should be turned into an open-ended license applicable without regard to the substance of the transaction. ... knetsch ... involved transactions without substance. congress in enacting section 264(a)(3), struck at transactions with substance. it is a reductio ad [vol. 5:2 recent developments in federal income taxation absurdum to reason, as [taxpayer] does, that congress simultaneously struck down a warm body and breathed life into [taxpayer's] cadaver." (1) bye-bye to leveraged company-wide coli. the health insurance portability and accountability act of 1996, § 501 amended § 264 to deny the deduction for interest on loans with respect to companyowned life insurance. there is an exception for key person insurance. there are phase-in future effective dates and interest rates. (2) the tax and trade relief extension act of 1998, § 4003(i), further amended § 264 to expand the definition of "unborrowed [insurance] policy cash value" to include "inside buildup," for purposes of the coli pro rata interest disallowance rules. b.lrs v. cmholdings inc. (in re cmholdings, inc.), 254 b.r. 578,2000-2 u.s.t.c. 50,791, 86 a.f.t.r.2d 2000-6470 (d. del.). in ci's bankruptcy, the irs filed proofs of claim for taxes based on the disallowance of interest deductions cmi claimed for its coli plan. the court held that no interest deduction was allowable under § 163(a) because the entire transaction was a "sham in substance" that lacked subjective business purpose. apart from tax savings from the interest deduction, cmi could not reasonably expect a positive cash flow from the coli plan in any year and could not expect to benefit from the inside cash value build-up [which continuously remained at zero throughout the plan] or profit from the death benefits on covered employees. interest deductions were disallowed and § 6662 substantial understatement penalties were imposed because the transaction lacked economic substance. the transaction was entered into without a reasonable expectation of profit in the absence of the interest deductions over the life of the 40-year transaction from either the inside build-up or mortality components of the plan. # notably the court specifically rejected the irs's argument that it should apply the "generic tax shelter test" of rose v. commissioner, 88 t.c. 386 (1987), aff'd, 868 f.2d 851 (6th cir. 1989), to disallow the deductions, and questioned whether the tax court would continue to apply that test. rather, the court exhaustively analyzed the facts. ° in addition, the § 264(c)(1) "four-out-ofseven" safe harbor test was not met because the premiums in years four through seven were paid through so-called "loading dividends." pursuant to its coli plan cmi purchased individual, whole life insurance policies, of which it was the owner and beneficiary, on 1,400 employees. in the first three policy years, 1991-1993, cmi paid premiums largely through nonrecourse policy loans. in the fourth through seventh policy years, cmi "paid" the annual premiums largely through a combination of partial withdrawals and loading dividends [premium rebates to cmi]. the irs determined that cmi's coli plan was a "no pay" plan under which premiums and interest were funded by policy loans out in connection with life insurance policies. the court (judge schwartz) found that the loans for the first three years were real, but that the loading dividends 20011 were factual shams that were created by circular accounting treatment, and that there thus was a substantial shortfall in the payment of annual premiums due in years four through seven. accordingly, § 264(a) applied to disallow the deductions because the premiums were financed by systematic borrowing on the policies. the § 264 (c)(1) exception "if no part of 4 of the annual premiums due during the 7-year period (beginning with the date the first premium... was paid) is paid under such plan by means of indebtedness" did not apply. the court accepted the irs' argument that "'annual premiums due' means the nominal annual premiums due less the 'loading dividends' that were offset against the contract premiums," rather than cmi's argument that annual premiums due meant the "contract-specified premiums." these were circular netting transactions for the sole purpose of reducing the annual cash premiums paid in those years, and were factual shams. 13. a goldman sachs shelter bites the dust. salina partnership, lp, fpl group, inc. v. commissioner, t.c. memo. 2000-352. fpl group, inc., incurred a large capital loss on the sale of a subsidiary. a partnership [salina] formed by two affiliates of abn [dutch bank, acting on behalf of goldman sachs] for the benefit of fpl took a short position in u.s. treasury bills and fpl purchased a 98% limited partnership interest. fpl claimed that through a constructive liquidation under § 708(b)(1)(b) and pre-1987 reg. § 1.708-1 it had a special § 732(b) downward basis adjustment to reflect a basis equal to its cash purchase price. salina then closed its short position and claimed it realized stcg of $344 million [$337 million of which was allocated to fpl and used by fpl against its capital loss]. salina was then liquidated after pursuing a sophisticated investment strategy, with fpl claiming large ordinary losses that were usable because of its $337 million outside basis by reason of the stcg allocated to it. because the partnership continued for two years after the transactions described above, during which period it managed a variety of financial assets producing for fpl an economic profits apart from tax benefits, judge jacobs held that the partnership was not a sham. however, judge jacobs upheld the commissioner's position [applying rev. rul. 95-26, 1995-1995-1 c.b. 31] that the partnership's obligation to return the treasury bills that it sold short was a partnership liability under § 752, contrary to its treatment otherwise by fpl in calculating its basis in its partnership interest. accordingly, fpl was denied the § 732(d) negative basis adjustment and the capital loss was disallowed. 14. intermediary transactions tax shelters will be targeted. sellers of stock and buyers of assets will now have to care about what is in the black box between them. notice 2001-16, 2001-9 i.r.b. 730. the service has announced that it intends to challenge the purported tax results of intermediary transactions tax shelters. the transactions generally involve a shareholder who desires to sell stock of a target corporation, an intermediary corporation, and a florida tax review [vol. 5:2 recent developments in federal income taxation buyer who desires to purchase the assets, but not the stock, of the target. the shareholder purports to sell the stock of the target to the intermediary. the target then purports to sell some or all of its assets to the buyer. the buyer claims a basis in the target assets equal to its purchase price. under one version of this transaction, the target is included as a member of the affiliated group that includes the intermediary, which files a consolidated return, and the group reports losses (or credits) to offset the gain (or tax) resulting from the targets sale of assets. in another form of the transaction, the intermediary may be an entity that is not subject to tax and that liquidates the target with no reported gain on the sale of the target's assets. further, transactions that are the same as or similar to the one described in the notice are "listed transactions" temporary reg. §§ 1.6011-4t(b)(2) and 301.6111-2t(b)(2). 15. contingent liability tax shelters will be targeted. notice 2001-17, 2001-9 i.r.b. 730. the irs intends to disallow losses generated by contingent liability tax shelters. the shelter transactions involve the transfer of a high basis asset to a corporation in exchange for stock of the transferee corporation, and the transferee corporation's assumption of a liability that the transferor has not yet taken into account for federal income tax purposes. the transferor typically remains liable on the underlying obligation. the basis and fair market value of the transferred asset, which may be a security of another member of the same affiliated group of corporations, are generally only marginally greater than the present value of the assumed liability. therefore, the value of the stock of the transferee received by the transferor is minimal relative to the basis and fair market value of the asset transferred to the transferee corporation. 16. "customary" leasing transactions need not be registered as tax shelters. notice 2001-18, 2001-9 i.r.b. 731. this notice provides an exception from the registration requirements of § 6111(d) and the list maintenance requirement of § 6112 for certain customary leasing transactions. the exception applies to a leasing transaction that (1) is a lease or sale leaseback between an owner-lessor of tangible personal property and a lessee who is the user of the property; (2) contains terms that are consistent with customary commercial practice for the leasing of similar items of property; (3) qualifies as a lease for federal income tax purposes under rev. proc. 75-21, 1975-1 c.b. 715, or under case law; (4) is not the same as or substantially similar to a listed transaction under reg. § 301.6111-2t(b)(2), including a lease strip or lease in/lease out transaction; and (5) has a lessor and lessee who agree to consistently report the transaction as a lease. b. individual tax shelters 1. united states v. estate preservation services, 202 f.3d 1093 (9th cir. 2000) (sneed, j.). the ninth circuit affirmed preliminary injunctions under 20011 florida tax review § 6700 ordered by the district court against the promoter, attorney, and cpa who were involved in the marketing and sale of abusive tax shelters, i.e., asset protection trusts. promotional materials advised that assets transferred tax-free into such trusts took a fair market value basis. "the apt manual represented that taxpayers could transfer equipment into an apt at no cost to the trust, and thereby give the trust a higher basis in the equipment than it had in the hands of the taxpayer. the district court did not commit clear error in holding these statements to be fraudulent." 2. lawyer/tax shelter partners were negligent because they did not reasonably rely on nyu tax professor guy maxfield. addington v. commissioner, 205 f.3d 54 (2d cir. 2000). three partners of nyc law firm sann & howe did not reasonably rely on maxfield, who was "of counsel" to the firm, for their investment in the "plastic recycling" programs [transactions involving the sale and leaseback of sentinal recyclers]. although they learned of the programs from maxfield and allegedly relied on his investigation, maxfield had disclaimed knowledge of the plastics industry and questioned whether the offering materials correctly valued the recycling machines. judge sotomayor held that the taxpayers particularly in light of their own sophistication-should have recognized the necessity of performing their own investigations and that their reliance on maxfield was objectively unreasonable. maxfield testified that he viewed his role as a "conveyor of information and ... impressions," and that he had "made it very clear" to the taxpayers that the investment was "their business decision," and not his. the court further held that taxpayers could not justifiably rely on john taggart, who had been retained to draft the offering memoranda and tax opinions for the partnerships in the programs and owned a 6.66% interest in one of the partnerships, because it should have been clear to the taxpayers that taggart could not advise them because of a conflict of interest. 3. notice 2000-61, 2000-49 i.r.b. 569. the irs has moved to shut down the guam resident trust tax shelter by ruling that the single filing rule contained in § 935 applies solely to individuals with guam connections, and not to trusts. the scheme under which a trust seeks to avoid both u.s. and guamanian tax liability was identified as a listed transaction for purposes of temporary reg. §§ 1.6011-4t(b)(2) and 301.6111-2t(b)(2). the government of guam was complicit in this tax scheme by issuing certificates entitling holders to a rebate of all income taxes paid to guam provided that half of the rebated taxes are kept on deposit in guam for five years. [vol. 5:2 recent developments in federal income taxation ix. exempt organizations and charitable giving a. exempt organizations 1. t.d. 8874, travel and tour activities of tax-exempt organization, 65 f. r. 5771 (2/7/00). final regulations under § 513 clarifywhen the travel and tour activities of tax-exempt organizations are substantially related to the purposes for which exemption was granted and provides needed guidance for taxexempt organizations concerning when travel tour activities may be subject to tax as an unrelated trade or business. the final regulations do not impose additional record-keeping requirements. however, examples in the final regulations illustrate that contemporaneous documentation showing how an organization develops, promotes and operates the travel tour, is relevant to the facts and circumstances analysis. 2. reg-209601-92, taxation of tax-exempt organizations' income from corporate sponsorship, 65 f. r. 11012 (3/2/00). the treasury has published proposed regulations relating to the unrelated business income tax treatment of sponsorship payments received by exempt organizations. the 1997 act added code § 513(i), which provided that unrelated trade or business does not include the activity of soliciting and receiving qualified sponsorship payments. being an "exclusive sponsor" is ok, but being an "exclusive provider" is not. admission parties and pro-am playing spots are not ok. advertising [e.g., the address and phone number of a sponsor that included the statement "for your music needs give them a call today at 555-1234"] on a noncommercial broadcasting station is not ok. 3. all the charm and subtlety of john rocker. branch ministries v. commissioner, 211 f.3d 137 (d.c. cir. 2000). the irs did not abuse its discretion in revoking a church's tax-exempt status on the ground that the church took out an anti-clinton ad a few days before the 1992 presidential election. judge buckley noted that the church could have created a related § 501(c)(4) organization to do the same thing, but could not have used its taxfee dollars for that purpose. an equal protection clause argument on selective prosecution was rejected because "widespread and widelyreported involvement by other churches in political campaigns" was held not comparable to placing advertisements in newspapers with nationwide circulation opposing a candidate and soliciting tax deductible contributions to defray the cost of the advertisements. 4. quality auditing co. v. commissioner, 114 t.c. 498 (2000). a nonprofit corporation organized to audit structural steel fabricators pursuant to a quality certification program administered by the [§ 501(c)(6)] american institute of steel construction is not a § 501(c)(3) organization because it does 2001] florida tax review not lessen the burdens of government nor confer benefits to the general public, but furthers the private interests of the steel fabricators. judge nims held that "the presence of a single nonexempt purpose, if substantial in nature, precludes exempt status, regardless of the number or importance of truly exempt purposes." 5. priv. ltr. rul. 200037053. the irs issued a private letter ruling that concluded that contributions to a donor advised fund qualified as "public support" under § 509(a)(1) to help the charity attain public charity status and to avoid private foundation status. the ruling was not issued to a community foundation but to a charity whose principal charitable purpose is to maintain a comprehensive web site where visitors can obtain information about charitable organizations. 6. intermediate sanctions regulations are out; break out the supply of 1099s. reg246256-96, excise taxes on excess benefit transactions, 66 f.r. 2173 (1/10/01); t.d. 8920, excise taxes on excess benefit transactions, 66 f. r. 2144 (1/10/01). the treasury has issued proposed and temporary regulations under § 4958, which permits the irs to impose excise taxes against disqualified persons who participate in excess benefit transactions with § 501(c)(3) and 501(c)(4) organizations. these rules reflect the spirit under which § 4958 was enacted, which was to tax "excess" benefits provided by charities to insiders (including board members); these "excess" benefits also include benefits provided to insiders that are not reported as compensation. 7. president clinton signed (on 7/1/00) h.r. res. 4762, 106 pub. l. 230, 114 stat. 477, adding new § 527(j), which requires reporting and disclosure by "section 527" political organizations of expenditures and contributions. naturally, § 501(c)(5) labor unions' political expenditures are not covered by legislation. " a. ir-2000-50. form 8871 is prescribed for filings by § 527 political organizations. b. charitable giving 1. the irs goes after charitable split-dollar life insurance arrangements with all guns blazing. notice 99-36, 1999-1 c.b. 1284. the irs "advises" taxpayers and § 170(c) organizations (including § 501(c)(3) charities) that certain charitable split-dollar insurance transactions that purport to produce charitable contribution deductions under § 170 or § 2522 will not produce the tax benefits advertised by their promoters and may lead to penalties. the targeted transactions generally involve transfers of funds to a charity, with the understanding that the charity will use the funds to pay premiums on a cash [vol. 5:2 recent developments in federal income taxation value life insurance policy that benefits both the charity and the taxpayer's family. in a related transaction, the charity enters into a split-dollar agreement (usually with a trust) that specifies the portion of the insurance policy premiums to be paid by parties related to the donor and the portion to be paid by the charity and the extent to which each party can exercise standard policyholder rights. commonly the noncharitable beneficiaries enjoy disproportionately high percentages of the cash-surrender value and death benefits relative to the percentage of premiums paid. although there is no express obligation that the taxpayer will transfer funds to the charity to cover premium payments, or requiring the charity to use funds transferred by the taxpayer for that purpose, both parties understand that this will occur. a. this result was codified by the enactment of code § 170(f)(10) in the tax relief extension act of 1999. the legislative history explains that congress was concerned about an abusive scheme referred to as charitable split-dollar life insurance, and the provision is designed to stop "the spread of this scheme," and goes on to state that "the provision restates present law." section 170(f)(10) expressly denies a charitable contribution deduction for any transfer to a charity if(1) either (a) the charity directly or indirectly pays or paid any premium on a life insurance, annuity or endowment contract in connection with the transfer or (b) there is an understanding or expectation that any person will directly or indirectly pay any premium on any such contract, and (2) any direct or indirect beneficiary under the contract is the transferor, any member of the transferor's family (broadly defined in § 170(f)(10)(h) to include all lineal descendants of the taxpayer's or the taxpayer's spouse's grandparents and the spouses of all such descendants), or any other person (other than another charitable organization) chosen by the transferor. section 170(f)(10)(d) provides an exception in certain cases in which a charitable organization purchases an annuity contract to fund an obligation to pay a charitable gift annuity. section 170(f)(10)(e) provides an exception for transfers to certain charitable remainder trusts that possess all of the incidents of ownership of the contracts in question and are entitled to receive all payments under the contracts. congress capped off its attack on these abusive schemes by imposing a punitive excise tax on the charities that participated in them; § 170(f)(10)(f) imposes on a charitable organization an excise tax equal to 100% of the amount of the premiums paid by the organization on any life insurance, annuity, or endowment contract, if the premiums are paid in connection with a transfer for which a deduction is disallowed under § 170(f)(10)(a). this excise tax applies regardless of when the transfer to the charitable organization was made. b. notice 2000-24, 2000-17 i.r.b. 952. this notice provides guidance to help charitable organizations comply with the information reporting requirements imposed in connection with § 170(f)(10). the reporting requirements apply to charitable organizations that pay premiums after 2/8/99, 2001] in connection with subject split-dollar life insurance, annuity, and endowment contracts. c. announcement 2000-82,2000-42 i.r.b. 385. organizations that pay premiums on § 170(f)(10) "personal benefit contracts" must report on form 8870. for taxable years prior to 2000, form 8879 must be filed within 90 days of 10/16/00. 2. abusive charitable remainder trusts curtailed. reg-1 16125-99, prevention of abuse of charitable remainder trusts, 64 f. r. 56718 (10/21/1999). the treasury has issued proposed regulations under §§ 643 and 664 to combat abuses in the use of charitable remainder trusts that occur when distributions in excess of income are made to non-charitable beneficiaries where the trustee borrows money or enters into a forward sale of the trust assets. the trust would be treated as having sold a pro rata portion of its assets to the extent that the distribution (1) is not characterized as income under § 664(b), and (2) is made from amount received by the trust that is neither (a) a return of basis nor (b) attributable to a deductible charitable contribution made in cash. a. regulations now final. t.d. 8926, prevention of abuse of charitable remainder trusts, 66 f. r. 1034 (1/5/01). the treasury has finalized the regulations under § 664 relating to the elimination of abusive transactions involving charitable remainder trusts. 3. ghoul trusts rejected. reg-100291-00, lifetime charitable lead trusts, 65 f. r. 17835 (4/5/00). the treasury has issued proposed amendments to reg. § 25.2522(c)-3, relating to the definitions of a guaranteed annuity interest and a unitrust interest for purposes of the income, gift, and estate tax charitable deductions. the proposed regulation restricts the permissible terms for charitable lead trusts in order to eliminate the potential for abuse [e.g., artificially inflating the charitable deduction by using as a measuring life the life of an unrelated individual who is seriously ill but not "terminally ill" under the § 7520 regulations; thus the charitable interest is valued based on the actuarial tables. the proposed regulations limit the permissible term for guaranteed annuity interests and unitrust interests to either (1) a specified term of years, or (2) the life of one or more of the following individuals living at the date of the transfer: (a) the donor, (b) the donor's spouse, or (c) a lineal ancestor of all the remainder beneficiaries. the limitation on permissible measuring lives does not apply to a charitable guaranteed annuity interest or unitrust interest payable under a charitable remainder trust described in § 664. an interest for a specified term of years can qualify even if subject to a "savings clause" intended to ensure compliance with a rule against perpetuities, as long as the savings clause uses a period for vesting of 21 years after the deaths of measuring lives who are florida tax review ['vol 5:2 recent developments in federal income taxation selected to maximize, rather than limit, the term of the trust. when finalized the rules will be effective as of 4/4/00. 4. taxpayers should have sued irs officials like the scientologists did. sklar v. commissioner, t.c. memo. 2000-118. the court relied on hernandez v. commissioner, 490 u.s. 680 (1989), and found that the church of scientology settlement was irrelevant because the "auditing" involved there was "not identical [to the general, including religious, education involved in the case at hand] in their organization, structure or purpose." x. tax procedure a. penalties and prosecutions 1. vinick v. united states, 205 f.3d 1 (1st cir. 2000). a district court determination that the taxpayer was a responsible person under § 6672 was reversed because it applied an improper legal standard. the court of appeals held that the responsible person penalty applies only to persons who exercise daily management of the decisions regarding the payment of debts. although the taxpayer was a shareholder, director, held the title of treasurer, had the authority to write checks and to hire and fire employees, and, as the corporation's accountant, filed its employment tax returns, during the quarters in question, he did not exercise decision-making control over payment of the corporation's debts [even though he did exercise such control during subsequent quarters]. 2. burton kanter in trouble again. investment research associates, ltd. v. commissioner, t.c. memo. 1999-407. in a 600-page opinion burton kanter was held liable for the § 6653 fraud penalty by reason of his being "the architect who planned and executed the elaborate scheme with respect to the kickback income payments .... in our view, what we have here, purely and simply, is a concerted effort by an experienced tax lawyer and two corporate executives to defeat and evade the payments of taxes and to cover up their illegal acts so that the corporations [employing the two corporate executives] and the federal government would be unable to discover them." a. so far, he is unable to wriggle out, the way he did 25 years ago when he was acquitted by a jury.14 the taxpayers subsequently moved to have access to the special trial judge's "reports, draft opinions, or similar documents" prepared under tax court rule 183(b). they based their 14. his partner was convicted and imprisoned. see united states v. baskes, 649 f.2d 471 (7th cir. 1980), cert. denied, 450 u.s. 1000 (1981). 20011 motion on conversations with two unnamed tax court judges that the original draft opinion from the special trial judge was changed by judge dawson before he adopted it. they were turned down because the tax court held that the documents related to its internal deliberative processes. tax court order denying motion, 2001 tnt 23-31 (4/26/00) and (on reconsideration) 2001 tnt 23-30 (8/30/00). taxpayers are seeking mandamus from three circuits, but have so far been unsuccessful. 3. remington v. united states, 210 f.3d 281 (5th cir. 2000). a partner who was not subject to liability under § 6672 was nevertheless liable for law firm's delinquent payroll taxes because § 6672 does not preempt the state law under which general partners are liable for partnership debts. 4. united states v. tenzer, 127 f.3d 222 (2d cir. 1997). the dismissal of failure-to-file indictment of an experienced long island tax attorney was reversed. judge miner held that defendant was not entitled to the benefit of the irs "voluntary disclosure" policy because he had not paid his taxes or made "bona fide arrangements to pay." moral: don't be too cute because that can adversely impact a voluntary disclosure; that policy requires taxpayer to be currently compliant and to have made a reasonable offer as to past unsatisfied taxes. a. on subsequent appeal after sentencing on remand. united states v. tenzer, 213 f.3d 34 (2d cir. 2000). the conviction was upheld. new evidence that tenzer's offer in compromise proposal had been "returned as unprocessable" rather than "rejected" was not material to prior holding that no agreement to pay had been made. but the sentence was vacated and the case remanded for reconsideration of whether sentence should be reduced below guidelines based on mitigating circumstances of tenzer's offer to settle with irs, negotiations to pay, and "good intentions" and the irs' decision to terminate negotiations with respect to tenzer's offer. 5. one set of books is required, two is pretty strong evidence of fraud, as well as a big help to the irs in reconstructing income. karcho v. commissioner, t.c. memo. 2000-213. taxpayer operated a video arcade business. the gross receipts deposited in his bank account matched the aggregate amounts shown on his "daily income reports" provided to his accountant and reported for tax purposes. a second set of "daily income reports," which reflected substantially higher income, matched the total cash shown on the "meter reading sheets" for the video games, and even reconciled the differences between the disparate gross receipts. taxpayer pleaded guilty to criminal tax fraud. the civil case was a slam-dunk for the irs. florida tax review [vol 5:2 recent developments in federal income taxation 6. a warning shot across the bow. section 6673 sanctions will be applied to frivolous § 6330 [and § 6320] petitions. pierson v. commissioner, 115 t.c. 576 (2000). taxpayer's petition to review irs's decision to levy, alleging no liability, was dismissed for failure to respond to earlier deficiency notice, following goza v. commissioner, 114 t.c. 176 (2000). because taxpayer made only tax protestor type arguments, the court (judge wells) raised the issue of § 6673 sanctions for a frivolous petition. because its jurisdiction over § 6330 actions is so new, sanctions were not imposed. however, the court strongly warned that it would do so in the future. 7. be careful not to over-empathize with your client. nis family trust v. commissioner, 115 t.c. 523 (2000). after filing a tax court petition, taxpayers, who were represented by counsel, abandoned their return positions and relied on a strategy of noncooperation and delay, undertaken behind a smokescreen of frivolous tax-protester arguments. the taxpayers' attorney [according to the tax court] in bad faith aided in that strategy by making additional meritless tax-protester arguments, making meritless motions and responses to motions, and abusing the court's subpoena power. furthermore, pursuant to upholding § 6662 accuracy related penalties, the tax court imposed a $25,000 penalty under § 6673(a)(1) for instituting and maintaining these proceedings primarily for delay and taking frivolous and groundless positions. in addition, pursuant to § 6673(a)(2) taxpayers' counsel was ordered to personally pay $10,643.75 for the commissioner's excess attorney's fees reasonably incurred as a result of her course of conduct. 8. maybe if she'd been able to delay the trial until after mel carnahan was elected to the senate. luce v. luce, 119 f. supp. 2d. 779 (s.d. ohio 2000). the sole officer and majority shareholder of a corporation was a responsible person under § 6672 even though she testified that her deceased husband made all the business decisions and she could not question those decisions. b. discovery: summonses and foia 1. the 1998 act, § 3417, adds new code § 7602(c), which requires the irs to give "reasonable notice in advance to the taxpayer that contacts with persons other than the taxpayer may be made," and to require that the irs provide a record of such contacts periodically or on request. a. the irs can mess up if it makes third-party contacts without notifying taxpayers in advance; it can also mess up when it sends a prophylactic letter to an unnecessarily large number of taxpayers about possible third-party contacts. tr-1999-19. the service will revise a letter for taxpayers to "more clearly spell out the circumstances surrounding third-party 2001] contacts about liability." beginning 1/18/99, letters began going out to taxpayers stating that the irs "may need to contact third parties [which] may include, but are not limited to, neighbors, employers, employees and banks." commissioner rossotti stated that the letter "mistakenly raised taxpayer concerns about privacy issues." b. the 15-point solution? ir-2000-08. the irs will release 15 different clearer, specialized versions of letters and notices alerting taxpayers that third parties might be contacted as part of the collection or examination process. letters 3164 a through m and notices 1219a and 1219b are the designations. 2. tax analysts v. irs, 99-2 u.s.t.c. t 50,794, 84 a.f.t.r.2d 99-5457 (d.d.c. 1999), affirmed in part, vacated in part, and remanded, 214 f.3d 179 (d.c. cir. 2000). the closing agreement between christian broadcasting network and the irs relating to termination of tax liability in connection with cbn's application for restoration of tax exempt status was return information that was not disclosable under foia. 3. a little privacy remains. a taxpayer who is not under investigation and who has no legal relationship to any other taxpayer under investigation is entitled to notice of a third-party summons issued by the irs to the taxpayer's bank with respect to an irs investigation of another taxpayer. 'p v. united states, 205 f.3d 1168 (9th cir. 2000). ip's fianc6 was a jewelry agent for diamond trade ltd. (dtl). ip was not an employee, owner, or officer of dtl. the irs assessed a tax liability against dtl and issued thirdparty summonses to two banks requesting information relating to dtl and its agents. believing that ip deposited dtl sales proceeds into her bank accounts on dtl's behalf, the irs also summoned ip's bank records. ip filed a petition to quash the summonses on the grounds of improper service and lack of notice. 0 the district court dismissed the petition, concluding that ip was not entitled to notice under § 4609(c)(2)(d) [then § 4609(c)(2)(b)] because the summonses were issued "in aid of the collection" of dtl's tax liability. o the court of appeals (judge aldisert) reversed, holding that ip was entitled to notice under § 7609(a) because she had no legal relationship to dtl. the court rejected the irs's argument that the literal language of § 7609(c)(2)(d)(i) dispenses with the notice requirement any time a third-party summons is issued "in aid of the collection" of any assessed tax liability. rather, the court held that the notice exception applies only when the assessed taxpayer "has a recognizable [legal] interest" in the summoned records. accepting the irs's interpretation would render meaningless the express language of § 7609(c)(2)(b)(ii) which dispenses with notice when a summons is "in aid of the collection of 'the liability.., of any transferee or florida tax review [vol 5:2 recent developments in federal income taxation fiduciary of any person... in clause (i)."' the appeals court distinguished the instant case from barmes v. united states, 199 f.3d 386 (7th cir. 1999), on which the irs relied. unlike in barmes, there was no fiduciary relationship between ip and dtl, nor did dtl have any recognizable legal interest in ip's bank account. c. statutory notice 1. going postal? reg-104939-99, definition of last known address, 64 f. r. 63768 (11/22/99). the treasury has issued proposed regulations defining "last known address" in relation to the mailing of notices of deficiency and other notices, statements and documents. under these proposed regulations, the service would annually update its address records from the u.s. postal service's national change of address database. a. rev. proc. 2001-18, 2001-8 i.r.b. 708. the irs has provided guidance explaining how to inform it of a change of address. 2. should taxpayer's lawyer have ignored the undated 90-day letter and let the statute of limitations expire? smith v. commissioner, 114 t.c. 489 (2000). a deficiency notice that failed to include a date in the section entitled "last day to file a petition with the united states tax court" is valid where the taxpayers received the notice prior to the expiration of the § 6501 limitations period and filed a timely tax court petition. judge foley held that congress failed to prescribe what the consequences of irs failure to follow the requirement of § 3463(a) of the irs restructuring and reform act of 1998, pub. l. no. 105-206, 112 stat. 685, 767, that "the secretary... shall include on each notice of deficiency.., the date determined by [the irs] as the last day on which the taxpayer may file a petition with the tax court." d. statute of limitations 1. estimated tax payments are tax "payments" on the due date of the return and the statute of limitations stop watch on refunds starts ticking. baral v. united states, 120 s. ct. 1006 (2000). under § 6513(b) estimated tax payments are deemed to have been "paid" on the due date (including extensions) for the taxpayer's return, not on the later date on which a delinquent return is filed. thus, a refund of overpayments of estimated taxes was time barred by § 6511 (b)(2)(a) because the taxpayer's return seeking the refund was delinquent by more than three years (after taking into account the automatic extension period). 2. a refund claim made on a delinquent return by definition has been filed within three years of filing the return. weisbart v. united states, 20011 florida tax review 222 f.3d 83 (2d cir. 2000). the second circuit held that a return filed more than three years after its due date and which sought a refund of overwithholding was a timely refund claim under § 6511 (a), a position that even the government conceded was correct [following rev. rul. 76-511, 1976-2 c.b. 428]. the refund claim remains limited, however, by the look-back rule of § 6511(b), which limits the amount of the refund to taxes paid within a period equal to three years, plus any period for which the filing date was extended, prior to filing the claim. thus, because the taxpayer had been granted a four month automatic extension of the time to file and had filed his return exactly three years and four months after the unextended due date, the § 6511 (b) limitation did not apply. in determining when the refund claim/return was filed, the court interpreted reg. § 301.6402-3(a)(5) and § 301.7502-1 to apply the timely mailed/timely filed mailbox rule to a refund claim in the form of a delinquent return. contra miller v. united states, 38 f.3d 473 (9th cir. 1994), holding that if a return is not filed within two years of the due date, a refund claim for withheld taxes made in the delinquent return is time barred under § 6511 (a). a. irs acquiesces and announces that it will no longer argue that § 7502(a) does not apply under facts such as those in weisbart. a.o.d. 2000-09 (11/13/00). "accordingly, the service will apply the timely mailing/timely filing rule of § 7502(a) in such cases and treat claims for refund included on delinquent original returns as filed on the date of mailing for purposes of § 6511 (b)(2)(a)." 3. final regulations under § 7502 relating to the treatment of a timely mailing as a timely filing. t.d. 8932, timely mailing treated as timely filing/electronic postmark, 66 f.r. 2257 (1/11/01). under amended reg. § 301.7502-1, in certain situations, a claim for credit or refund made on a late filed original income tax return will be treated as timely filed on the postmark date for purposes of § 6511(b)(2)(a) [consistent with weisbart v. united states, 222 f.3d 93 (2d cir. 2000)]. the same rule will apply to claims for credit or refund made on late filed original tax returns other than income tax returns, including form 720, quarterly federal excise tax return, and form 706, u.s. estate tax return. late filed original tax returns also will be treated as filed on the postmark date. e. liens and collections 1. federal law, not state law, determines extent of tax lien. pletz v. united states, 221 f.3d 1114 (9th cir. 2000). a tax lien against one spouse who owns property with the other spouse, against whom there is no deficiency, as tenant by the entirety is a lien against the taxpayer's present interest. the tax lien is not limited to the debtor/taxpayer's survivorship interest to which a state [vol. 5:2 recent developments in federal income taxation law creditor's judgment lien would have been limited. the lien can be foreclosed by sale of the entire property as long as the other spouse is compensated. 2. section 6330 doesn't give the taxpayer two bites at the underlying tax liability. goza v. commissioner, 114 t.c. 176 (2000). the tax court has jurisdiction to review the commissioner's determination not to accord a hearing under § 6230 in response to taxpayer's claims that a previously assessed deficiency was unconstitutional. pursuant to § 6330(c)(2)(b), the taxpayer was not entitled to contest the underlying tax liability in a § 6330 proceeding because the taxpayer had received a valid deficiency notice for the year in question and did not petition the tax court for a redetermination. 3. offiler v. commissioner, 114 t.c. 492 (2000). the taxpayer's failure to request a § 6330 review by appeals within 30 days of receipt of notice of intent to levy by the irs bars the taxpayer from subsequently seeking review by tax court; under § 6330(d), the tax court's jurisdiction to review irs levies is limited to review of determinations by appeals. 4. nor can the taxpayer say "i'll take mine later." sego v. commissioner, 114 t.c. 603 (2000). the tax court lacked jurisdiction to review a notice of intent to levy under § 6330 because the taxpayer had consciously refused delivery of the notice of deficiency. 5. section 6330 hearings before appeals are informal. davis v. commissioner, 115 t.c. 35 (2000). a taxpayer's right to a pre-levy hearing before an appeals office under § 6330 does not include the right to subpoena and (cross)examine witnesses as part of the hearing. when it enacted § 6330, congress was aware of the informal nature of appeals hearings. in the absence of any showing by the taxpayer of irregularity in the assessments, the appeals officer may rely on form 4340 to verify the proper assessment of tax. 6. this guy needs a lawyer-or, at least, a calendar. mccone v. commissioner, 115 t.c. 114 (2000). section 6330(d)(1) extends the period for appealing an adverse decision in an appeals hearing before levy under § 6330 for an additional 30 days after a determination of another court, e.g., a district court, that an appeal filed in that court was filed in the wrong court, i.e., because the appeal related to unpaid income tax and the district court had no jurisdiction. if the appeal to the wrong court is untimely as well, the additional 30 day extension to appeal to the tax court does not apply. [mccone's pro se tax court petition was also filed more than 30 days after the district court dismissed.] 2001u florida tax review 7. van es v. commissioner, 115 t.c. 324(2000). section 6330(d) does not confer on the tax court jurisdiction to review an appeals decision not to stay a levy pursuant to an assessed § 6702 frivolous return penalty. section 6330(d) does not expand the tax court's jurisdiction to types of taxes over which the tax court does not ordinarily have jurisdiction. 8.katzv. commissioner, 115 t.c. 329 (2000). section 6320(d) confers on the tax court jurisdiction to review appeals decision not to abate interest in connection with an appeal under § 6320 of a filing of a lien. the commissioner's refusal to abate interest under § 6404 is appealable to tax court under § § 6404(i) and 7481(c). relitigation of the underlying deficiency stipulated in prior decision was barred by resjudicata. 9. sections 6220/6230 judicial review has a bite as well as a bark. mesa oil, inc. v. united states, 86 a.f.t.r.2d 7312 (d. colo. 2000). the district court (judge babcok) held that the irs appeals officer had abused her discretion in failing to grant relief from a proposed levy [for unpaid employment taxes] pursuant to a §§ 6220/6230 hearing because the requirement of § 6330(c)(3) that the government's collection concerns be balanced against the intrusiveness of the collection had not been satisfied. the appeals officer's decision was based on the fact that the irs had followed proper procedures but it did not take into account the impact the levy would have on mesa's continued operation as a going business. f. innocent spouse 1. you still can't get innocent spouse relief if you had reason to know of the understatement and enjoyed the benefit of the unreported income. butler v. commissioner, 114 t.c. 276 (2000). the taxpayer, who was the wife of a physician who owned an s corporation that conducted a gardening business, petitioned for innocent spouse relief with respect to unreported income that should have been passed-through from her husband's s corporation. the petition was filed under § 6013(e), but was treated as an election under § 6015(b)(1) because the case was still pending on effective date of § 6015(b)(1). relief was denied because the wife, who had a college education and owned and operated her own s corporation, was responsible for family finances, including tax return preparation, enjoyed a high standard of living, and since the husband concealed no financial information from her and she had actual knowledge of the transaction giving rise to the unreported income, had reason to know of the understatement. the court also held that as part of a deficiency proceeding in which the taxpayer has affirmatively raised the innocent spouse defense, the tax court has jurisdiction to review the commissioner's denial of equitable relief under § 6015(f). section 6015(e) does not limit review to denial of relief under § 6015(b) or (c). the court will apply [vol 5:2 recent developments in federal income taxation an "abuse of discretion" standard. for the same reason that relief was denied under § 6015(b)(1), the court found that the commissioner had not abused his discretion under § 6015(f). 2. fernandez v. commissioner, 114 t.c. 324 (2000). section § 6015(e)(1)(a) confers jurisdiction to review the commissioner's denial of equitable relief in a "stand alone" petition, apart from any deficiency determination, even though the taxpayer could not qualify for relief under § 6015(b) or (c) because of failure to file a proper election. a. a.o.d. 2000-06, 2000 tnt 190-14 (9/29/00). the irs acquiesces in fernandez, and now agrees that it will no longer contest the tax court's jurisdiction to review claims for equitable relief under § 6015(f) if the requirements of § 6015(e) are met. 3. charlton v. commissioner, 114 t.c. 333 (2000). a husband who prepared a joint tax return on which income from his [now former] wife's sole proprietorship was understated was not entitled to innocent spouse relief under § 6015(b) because even though he relied on wife's inaccurate summary he had access to the business' books and therefore had reason to know of the understatement, citing case law under former § 6013(e)(1)(c) as support. however, apportioned liability under § 6015(c) and (d) was available because the husband did not have actual knowledge of understatement because other conditions prerequisite had been met and request for apportioned liability was timely. the court also held that it had jurisdiction to review the commissioner's denial of § 6015(f) relief for the wife. a. and the service throws in the towel. the irs has announced that it will no longer challenge the tax court's jurisdiction [as it did in butler, fernandez, and charlton] to review denials of claims for innocent spouse relief under § 6015(f), regardless of whether an election was made under § 6015(b) or (c). 2000 tnt 111-8 (6/8/00). 4. corson v. commissioner, 114 t.c. 354 (2000). where one spouse elects innocent spouse status and the commissioner grants such relief in a stipulated settlement of a case docketed in the tax court, the non-electing spouse should be afforded an opportunity to litigate the commissioner's decision to grant relief from joint and several liability to the electing spouse. judge nims held that § 6015(e)(4) grants the non-electing spouse some "participatory entitlement." in a docketed tax court case, the non-electing spouse has the "opportunity to become a party" in order that he may have his day in court, particularly in a stipulated settlement, which is "subject to the court's discretionary review and may be rejected in the interests of justice." 20011 5. more self-executing statutes in the form of directives to promulgate rules. king v. commissioner, 115 t.c. 118 (2000). mr. & mrs. king received separate deficiency notices after they were divorced. mr. king did not contest the deficiency, but mrs. king filed a free-standing § 6015(e) petition in the tax court that sought innocent spouse relief but did not contest the deficiency. section 6015(e)(4) directs the tax court to establish rules under which a spouse who joined in the joint return but is not seeking innocent spouse relief receives notice and an opportunity to intervene as a party to petition filed by the other spouse seeking innocent spouse relief. interim rules 324(a) and 325(b) deal with notice and intervention, respectively, but are not yet complete. the tax court has interpreted § 6015(e) to be self-operative to require the commissioner to notify the other spouse (or former spouse) of his or her right to intervene to contest the claim for relief "whenever in the course of any proceeding before the court, a taxpayer raises a claim for relief from joint liability under § 6015 and the other spouse or former spouse is not a party." a. a.o.d. 2000-07, 2000 tnt 190-13 (9/29/00). the irs has acquiesced in king, and stated that it would apply the notice and intervention rules to all cases in which an innocent spouse issue is raised. 6. when the legislative history is ambiguous, read the statute. tax court majority holds that the test for knowledge under the § 6015(c)(3)(c) separate liability election is the same as that under former § 6013(e)(1)(c), which is that knowledge of an item of omitted income is sufficient to deny relief even if the spouse has no reason to believe that the way the item was reported on the return was correct. cheshire v. commissioner, 115 t.c. 183 (2000) (reviewed, 11-4). a spouse who has actual knowledge of the transaction giving rise to omitted income has "reason to know" of the understatement and is not entitled to innocent spouse relief under § 6015(b). the taxpayer's proposed standard based on a prudent taxpayer being expected to know of the understatement was rejected as providing too broad an escape hatch from liability. more importantly, the tax court (judge jacobs) held that for the spouse to be denied apportioned liability relief, § 6015(c)(3)(c) does not require actual knowledge of whether the entry on the return is or is not correct. the applicable knowledge standard under § 6015(c)(3)(c) is "an actual and clear awareness (as opposed to reason to know) of the existence of an item which gives rise to the deficiency (or portion thereof)." thus because when the spouse seeking apportioned liability in cheshire signed the joint return, she was aware of the amount, the source, and the date of receipt of a retirement distribution received by her then husband, she was denied apportioned liability, even though at that time she misunderstood how much of the retirement distribution properly was taxable and thus did not know that the amount of income was understated. wife was told by her husband that their accountant had advised him that amounts used to pay off mortgage could be excluded from income the same way florida tax review [vol 5:2 recent developments in federal income taxation that the portion of the distribution that was "rolled over" was treated. the majority held that wife does not need to have knowledge of the tax consequences of the item or that the entry on the return is incorrect. the court relied on former § 6013 cases, such as wiksellv. commissioner, 215 f.3d 1335 (9th cir. 2000), affg without published opinion t.c. memo. 1999-32, and bokum v. commissioner, 94 t.c. 126 (1990), aff'd, 992 f.2d 1132 (1lth cir. 1993), to the effect that knowledge of the legal consequences of an item may be presumed if the spouse has knowledge of the item. the court declined to follow a statement in h. conf. rept. 105-599, at 253 (1998) that "if the irs proves that the electing spouse had actual knowledge that an item on a return is incorrect, the election will not apply to the extent any deficiency is attributable to such item." the court did however, find commissioner abused his discretion in failing to grant equitable relief from penalties under § 6015(f), even though the failure to grant equitable relief on the underlying deficiency was not an abuse of discretion. the taxpayer relied on her husband's description of the tax consequences of the transaction and his representations that he hadbeen advised by a cpa and had no reason to doubt him. 0 the dissenting opinions (judges parr, colvin, marvel, and gale), based on the legislative history, would limit denial of relief under § 6015(c)(3)(c) to cases in which the spouse actually knew of the understatement of the item). judge colvin's dissent is based upon the conclusion that § 6015(c) was enacted to make clear that the spouse must have had "actual knowledge that the treatment of the item on the tax return was incorrect" in order to be denied innocent spouse treatment. 7. but a little ray of mercy shines through. martin v. commissioner, t.c. memo. 2000-346 (2000). section 6015(c) relief was granted to a wife who had only superficial incomplete knowledge of a complex transaction in which her husband disposed of stock in a purported § 351 transaction, which was designed to fraudulently deceive state insurance regulators, without the actual receipt of any cash or property by either spouse. 8. reg-106446-98, relief from joint and several liability, 66 f.r. 3888 (1/17/01). proposed regulations under § 6015 relating to innocent spouse relief. the proposed regulations reflect changes in the law made by the irs restructuring and reform act of 1998, which repealed § 6013(e) and replaced it with § 6015. they clarify that case law interpreting the language under former § 6013(e) will be used to interpret that same language under § 6015. also, "knowledge or reason to know" of an understatement exists only when either the requesting spouse actually knew of the erroneous item giving rise to the understatement, or a reasonable person in similar circumstances would have known of the item. knowledge of an item under the proposed regulations would be knowledge of the receipt or expenditure. the proposed regulations would further amend reg. § 1.6013-4 to clarify that if a spouse asserts and establishes 20011 florida tax review that he or she signed a joint return under duress, then the return is not a joint return, and he or she is not jointly and severally liable. relief must be requested within two years from the first collection activity, but not before the taxpayer receives a notification of an audit or notice that there might be outstanding liability. finally, the proposed regulations would provide that the nonrequesting spouse must be given notice that the requesting spouse has filed a claim for relief and be given an opportunity to participate in the proceedings. at the request of one spouse, the irs would omit from shared documents information that would reasonably identify that spouse's location. g. miscellaneous 1. the quality of mercy is not strained .... little v. commissioner, 113 t.c. 474 (1999). the taxpayer was the administrator of an estate. during administration of the estate, he received information indicating possible income tax liabilities of the estate, which he provided to the estate's lawyer, who erroneously and repeatedly advised taxpayer that the estate had no tax liabilities and advised him to make disbursements and distributions. acting in good faith, taxpayer followed this advice and eventually closed the estate without paying the estate's income tax liabilities. the irs sought to impose the unpaid income tax liabilities on the administrator under 31 u.s.c. § 3713(b) [which imposes personal liability on a fiduciary who pays others before paying claims of the united states]. noting that a long line of cases has limited liability under 31 u.s.c. § 3713(b) to situations in which a fiduciary knowingly disregards debts due to the united states, the tax court (judge ruwe) declined to hold the taxpayer liable. in this case the taxpayer-fiduciary reasonably and in good faith relied on an attorney's advice there were no debts due to the united states before paying other claims, and he thus did not knowingly disregarded debts due to the united states. 2. checkbox initiative to begin with the 2001 filing season. ir2000-23, 2000 i.r.b. lexis 132 (4/13/00). paid preparers, with their clients' permission, would be allowed to work directly with the irs to resolve tax return processing issues. a checkbox would permit taxpayers to designate their paid individual preparer to resolve such issues. 3. notice 2000-12, 2000-9 i.r.b. 727. the irs has announced a pilot program for pre-filing agreements (pfas), under which large businesses may request examination and resolution of specific issues relating to tax returns expected to be filed between september and december 2000. these pfas would be treated as closing agreements, and would be confidential return information under § 6103(b)(2)(a). [vol 5:2 recent developments in federal income taxation 4. corporation suspended for failure to pay state income taxes lacked the capacity to file a petition to the tax court. daviddungle, m.d., inc. v. commissioner, 114 t.c. 268 (2000). a corporation the state charter of which had been suspended for nonpayment of state taxes lacked capacity to file a petition in the tax court because under state law it lacked the capacity to bring suit. the reinstatement of its charter after the 90 day period for filing a tax court petition did not validate the petition filed during suspension and did not toll the 90 day period for filing the petition. 5. notice 2000-35, 2000-29 i.r.b. 118. the procedures for issuing letter rulings, determination letters, and information letters, as well as for furnishing technical advice, continue to apply despite the reorganization of the office of chief counsel. 6. take those tax court requests for admissions seriously, or forever hold your peace. unitedstates v. boyce, 2000-1 u.s.t.c. 50,341, 85 a.f.t.r.2d 1938 (s. d. cal. 2000). res judicata attaches to a tax court judgment based on the taxpayer's failure to answer requests for admission, which, as a result of the taxpayer's failure to answer, under the tax court rules were deemed to be true. summary judgment to reduce assessment to ajudgment was granted. 7. bye-bye bivens. shreiber v. mastrogiovanni, 214 f.3d 148 (3d cir. 2000). a bivens action does not lie against an irs agent for alleged violations of a taxpayer's constitutional rights in the course of making an assessment because congress has created an extensive scheme [e.g., § 7433] providing remedies to a taxpayer complaining of the conduct of government officials in connection with tax assessments and collections. 8. no ex parte communications between exam and appeals. rev. proc. 2000-43, 2000-43 i.r.b. 404. twenty-nine q&as that address situations frequently encountered by appeals officers during the course of an administrative appeal provide guidance on the prohibition of ex parte communications between irs appeals officers and other irs employees. this was issued pursuant to the directive in § 1001(a)(4) of the the internal revenue service restructuring and reform act of 1998 to develop a plan to prohibit such communications that appear to compromise the independence of appeals officers. appeals officers may speak to lawyers in office of chief counsel, but the appeals officers are to "remain responsible for independent evaluation of the strengths and weaknesses of specific issues or positions in the case, or of the case as a whole, and for making independent judgments concerning the hazards of litigation." the prohibition has no impact on the procedures relating to the appeals process for cases docketed in the tax court. 0 appeals retains procedures for (a) returning 20011 florida tax review cases that are not ready for appeals consideration, (b) raising certain new issues, and (c) seeking review and comments from the originating irs function with respect to new information or evidence furnished by the taxpayer or representative. o appeals continues to be able to obtain legal advice from the office of chief counsel, subject to limitations designed to ensure that the advice to appeals is not provided by the same field attorneys who previously gave advice on the same issue to the irs officials who made the determination appeals is reviewing. 0 irs counsel who previously provided advice to exam will be treated as part of exam for this purpose. 0 commissioner and others responsible for overall irs operations (including appeals) may continue to communicate ex parte with appeals in order to fulfill their responsibilities. * effective for communications between appeals officers and other internal revenue service employees that place after 10/23/00. 9. reg-246249-96, information reporting requirements for certain payments made on behalf of another person, payments to joint payees, and payments of gross proceeds from sales involving investment advisers, 65 f. r. 61292, (10/16/00). proposed amendments to reg. §§ 1.6041-1, -3; 1.6045-1, -2; 1.6049-4; 31.3406(a)-2, and other correlative sections would (1) clarify who is the payee for information reporting purposes if a check or other instrument is made payable to joint payees; (2) provide information reporting requirements for escrow agents and other persons making payments on behalf of another person; and (3) clarify that the amount to be reported paid is the gross amount of the payment. proposed regulations under § 6045 would remove investment advisers from the list of exempt recipients. 10. irs cca 200046037 (10/15/00) sets forth in detail the calculation method for injured spouse relief in a community property state (form 8379). injured spouses are joint filers whose joint refunds have been seized to pay certain of their spouses' nontax debts, such as past-due child or spousal support or a federal loan. 11. nis family trust v. commissioner, 115 t.c. 523 (2000). as a general rule, where there are no material issues of fact and resolution of the case turns on solely on legal issues, the burden of proof rule of § 7491 is irrelevant. thus, § 7491 did not affect the commissioner's burden on motion for judgment on the pleadings, which can be granted only if there are no material issues of fact. ['vol. 5:2 recent developments in federal income taxation 12. shwarz v. united states, 234 f.3d 428(9th cir. 2000). section 7433 provides the exclusive remedy, and § 7431 does not apply, if an unauthorized disclosure of tax return information occurs in connection with collection activities. 13. extended time for use of the revised form w-9. announcement 2001-15, 2001-8 i.r.b. 715. this announcement advises persons required to file information returns of the availability and required use of form w-9, request for taxpayer identification number and certification (rev. dec. 2000). in response to payor concerns about implementing the new certification requirements, the use of revised form w-9 is optional until 7/1/01. the major change to the form is that under part ii, certification, a payee must now certify that he or she is a u.s. person (including a u.s. resident alien). payors must use the revised form w-9 for all new solicitations after 6/30/01. a foreign person may not use form w-9 to furnish his or her taxpayer identification number to the payor after 12/31/00. instead, foreign payees must use the appropriate form w-8. xi. withholding and excise taxes a. employment taxes 1. court defers to reasonable irs interpretation. morrison restaurants, inc. v. united states, 118 f.3d 1526 (11th cir. 1997). under § 3111 (a) & (b) and 3121(q), the irs could validly assess employer's share of fica with respect to restaurant employees' unreported tips on the basis of an aggregate computation, without determining individual employees' shares. a. fior d'italia inc. v. united states, 21 f.. supp. 2d. 1097, (n.d. cal. 1998), holds that the irs lacks authority to assess employer's share of fica without determining the tip income of individual employees. b. bubble room inc. v. united states, 159 f.3d 553 (fed. cir. 1998). the irs has statutory authority to assess fica taxes against an employer without determining the tip income of individual employees and awarding wage credits to the employees. c. is the northern district of florida still in the eleventh circuit? quietwater entertainment, inc. v. united states, 80 f. supp. 2d. 1323 (n.d. fla. 1999). the irs determined a deficiency in the employer's share of fica taxes for tips to employees in its restaurant. in doing so, the irs used a modified mcquatters formula [t. c. memo. 1973-240], on an aggregate basis, a methodology approved by the eleventh circuit in morrison restaurants v. 20011 florida tax review united states, 118 f.3d 1526 (1 lthcir. 1997), and presumed a 12% tip rate for cash bills and a 16% rate for credit card bills. district court judge vinson held that the 1 1th circuit got it wrong in morrison restaurants and that § 6053(c), which requires withholding by the employer of the employee's share of fica based on a presumed 8% tip rate implicitly caps the assessment of the employer's share at 8% as well and prescribes the only available allocation methods, implicitly proscribing aggregate assessments of the employer's share. d. the answer is yes! quietwater reversed per curiam. quietwater entertainment, inc. v. united states, 220 f.3d 592 2000-2 u.s.t.c. $ 50,540, 85 a.f.t.r.2d 2195 (11th cir. 2000) (unpublished). the court of appeals held that morrison controlled this case and reversed with directions to enter summary judgment for the government. e. how will this affect service in cocco pazzo? 330 west hubbardrestaurant corp. v united states, 203 f.3d 990 (7th cir. 2000). under §§ 3111(a) & (b) and 3121(q), irs could validly assess employer's share of fica with respect to restaurant employees' unreported tips on the basis of an aggregate computation, without determining individual employees' shares. deferring to both the federal and eleventh circuits, held that the irs is authorized to collect an employer's fica taxes without first assessing individual employees and crediting their social securities earnings records. judge coffey also deferred to the irs interpretation of § 3121(q). 2. american airlines inc. v. united states, 204 f.3d 1103 (fed. cir. 2000), rev g and remanding in part and affg in part, 40 fed. cl. 712 (1998). on summary judgment, the court of claims held that as an employer american airlines was liable for withholding and fica taxes on per diem payments provided to employees under collective bargaining agreements; exclusion was limited to $14 per day (as allowed by reg. § 1.274-5 as then in effect) because the per diem payments were not excludable as working condition fringe benefits as amounts reasonably expected to be incurred on an overnight trip; other per diem allowances were not excludable as working condition fringe benefits because they were paid in connection with turnaround trips that did not require "sleep or rest." it also held that credit card vouchers [of $100 per employee] did not constitute de minimis fringe benefits because the employer could have easily accounted for them, a result confirmed by the subsequently-issued reg. § 1.1326t(c). on the first issue, the federal circuit reversed and remanded, holding that the court of claims erred in holding that there was not a factual dispute regarding whether american reasonably believed its per diem was less than or equal to the employee's expenses. but it affirmed the holding that the per diem allowances, for which substantiation was not required, could not be working condition fringe benefits. on the second [turn-around per diem] and third [amex vouchers] issues, the federal circuit affirmed. [vol 5:2 recent developments in federal income taxation 3. wuebker v. commissioner, 205 f.3d 897 (6th cir. 2000), rev'g 110 t.c. 431 (1998). the taxpayer was a farmer who received payments for enrolling land in the conservation reserve program ("crp") under the food security act of 1995, removing the land from production and establishing a vegetative cover. • 1 the tax court held that the payments were rents from real estate, even though related to farming to farming activities, and pursuant to reg. § 1.1402(a)-4(d) were not subject to self employment tax. frederick wuebker and his wife owned 258 acres of land, of which 214 acres was tillable; the rest of the land was highly erodible. after years of farming the property, the wuebkers agreed to enroll their tillable land into the crp in 1991. in exchange for annual payments, the wuebkers established and maintained vegetative cover; disallowed grazing, harvesting, and other commercial use of the ground cover; and controlled weeds, insects, and pests. under the crp agreement, the wuebkers were required to turn the soil and plant seed in 1992; the wuebkers used their existing farming equipment to accomplish these tasks. thereafter, the upkeep was minimal. the wuebkers received $18,000 per year in crp payments in 1992 and 1993, which they reported as farm rental income that was not subject to self-employment tax. the irs determined that the amounts received under the crp plan constituted income from the trade or business of farming that was subject to self-employment tax under § 1401. the tax court held that the payments were rental payments excludable from selfemployment income under § 1402. the irs appealed. • the sixth circuit reversed. judge gilman held that the crp payments constituted self-employment income, concluding that the income was derived from the wuebkers' trade or business of farming. contrary to the tax court's conclusion, the appeals court found that there was a sufficient nexus between the crp payments and the wuebkers' farming operations, noting that the couple was actively engaged in the farming business both before and during the term of their crp agreement. the agreement, judge gilman pointed out, merely required the wuebkers to perform ongoing tasks with respect to the land placed in the crp. thus, the crp payments were "'in connection with' and had a 'direct nexus to' [the wuebkers'] ongoing trade or business," the court concluded. rejecting the wuebkers' argument to the contrary, judge gilman concluded that the crp payments were not "rent" because they were not made in exchange for the "use or occupancy of property." the appeals court disagreed with the notion that the restrictions the agriculture department imposed on the wuebkers' use of their land constituted "use" by the agency, pointing out that the couple continued to maintain control over and free access to their land. judge gilman also disagreed with the tax court's determination that the wuebkers' service-performance obligations under the crp agreement were insignificant and merely incidental to the contract's primary purpose. the essence of the crp, the court explained, was to prevent participants from farming the enrolled property and to require them to perform 20011 various activities in connection with the land continuously throughout the life of the contract. thus, judge gilman reasoned, the wuebkers' maintenance obligations were significant and the payments were compensation for their labor. 0 dissenting, circuit judge nathaniel r. jones found that the substantial and wide-ranging limitations the crp imposed on the wuebkers' use of their land constituted "use" by the agriculture department as contemplated by the ordinary definition of "rent." 4. a reverse reasonable comp case; salaries paid to s corporation shareholder-employees must not be too low! joly v. commissioner, 211 f.3d 1269 (6th cir. 2000), aff'g t. c. memo. 1998-361. the taxpayers were shareholders of an s corporation who performed services for the corporation but drew no salaries. a portion of the shareholders' profit shares was recharacterized as salary, giving rise to employment tax liability. the assessment of accuracy related penalties was upheld. 5. neely v. commissioner, 115 t.c. 287 (2000). the tax court (judge vasquez) decided that it has jurisdiction under its new § 7436 "worker classification"jurisdiction to decide (in the context of the case) whether the irs is barred by the § 6501 statute of limitations from assessing a deficiency based upon worker classification because the statute of limitations is an affirmative defense. 6. not all includable employee compensation is "wages" subject to withholding. hb&r, inc. v. united states, 229 f.3d 688 (8th cir. 2000). travel expenses between the continental us and alaska paid by an employer on behalf of alaskan north slope oil worker employees were excluded from "wages" subject to withholding and fica under code § 3401 and reg. § 31.3401(a)l(b), and code § 3121(a), respectively, even if the oil workers could not exclude travel expenses as a working condition fringe benefit under § 132(a)(3) because the travel was "commuting". [reg. § 31.3401(a)-i(b)(2) provides that "[a]mounts paid specifically-either as advances or reimbursements-for traveling or other bona fide ordinary and necessary expenses incurred or reasonably expected to be incurred in the business of the employer are not wages and are not subject to withholding."] the court held that the withholding regulations applied to exclude the airfares from "wages" because the regulations "do not expressly distinguish between commuting from home to work, and other employee traveling, so long as the expense is ordinary and necessary to the business of the employer... [v]iewed from the perspective of hb&r... the employee airfare expenses were incurred regularly and necessarily in [its] business .... " florida tax review [vol 5:2 2001] recent developments in federal income taxation 247 7. the scheme worked until a labor dispute arose. united states v. kontny, 238 f.3d 815 (7th cir. 2001). judge posner upheld a criminal conviction and sentencing for fraudulent nonpayment of payroll taxes. kontny thought he could beat both the fair labor standards act and the irc by not paying time-and-a-half for overtime but just not reporting or withholding on straight-time pay for overtime hours. login | florida tax review main navigation main content sidebar current archives search subscribe toggle search register login search toggle navigation home login subscription or article purchase required to access item. to verify subscription, access previous purchase, or purchase article, log in to journal. username password forgot your password? keep me logged in login register sidebar-links about overview editorial board publication ethics contact contributors author guidelines submit an article subscribers subscribe/renew recommend to your librarian news sign-upnews sign-up issn: 1066-3487 eissn: 2476-1699   main office: 2046 ne waldo road suite 2100 gainesville, fl 32609 phone: 352-392-1351 email: journals@upress.ufl.edu navigation home search current archives subscribe found property as gross income: realization revisited florida tax review volume 4 2000 number 10 accessions to wealth, realization of gross income, and dominion and control: applying the “claim of right doctrine” to found objects, including record-setting baseballs joseph m. dodge* i. introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687 ii. windfall vs. nonwindfall in-kind receipts.. . . . . . . . . . 689 a. is “income” equatable with “cash”?. . . . . . . . . . . . . . . . 689 1. in-kind receipts under the regulations.. . . . . . . . 689 2. “income” refers to changes in wealth, not cash.. 690 3. accessions to wealth are not “imputed” income.. . 691 b. distinguishing in-kind windfalls from unrealized appreciation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 694 1. commercial bargain purchases.. . . . . . . . . . . . . . . 694 2. sought-after property.. . . . . . . . . . . . . . . . . . . . . . . 696 a. self-obtained inventory.. . . . . . . . . . . . 697 b. self-obtained personal-use property... 699 3. true windfalls.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 705 iii. realization of in-kind income.. . . . . . . . . . . . . . . . . . . . . . 706 a. realization of income through the eisner v. macomber period.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 706 b. lessee improvements.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 707 c. employee compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . 709 1. employee stock options.. . . . . . . . . . . . . . . . . . . . . 709 2. vested v. nonvested in-kind compensation.. . . . . . 711 v. a “borrowing” model for receipts involving doubtful title.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 713 v. can james be applied to w indfall found objects?. . . . 715 a. property-law status of found items.. . . . . . . . . . . . . . . . . 715 b. applying regulations section 1.61-14 to windfall found objects.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 717 c. forfeitable property outside of internal revenue code section 83.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 717 d. home-run baseballs.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 724 * joseph m. dodge is the william h. francis, jr., professor of law at the university of texas school of law. professor dodge has a b.a. from harvard (1963), an ll.b. from harvard law school (1967), and an ll.m. (in taxation) from new york university school of law (1973). professor dodge is the author of texts, casebooks, monographs, and articles on taxation, and is active in professional organizations and e-mail bulletin boards. 685 686 florida tax review [vol.4:10 e. should the regulations be changed as to windfall found objects?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 725 f. let congress do it.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 728 vi. conclusion.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 728 2000] applying the “claim of right doctrine” to found objects 687 i. introduction1 this article explores the tax treatment of certain in-kind receipts of property, namely, windfall found objects. the basic and unremarkable thesis is that in-kind property windfalls (commonly referred to as “found objects”) are gross income when received. however, there is more than meets the eye here: the finder of a found object often does not obtain clear legal title, so there exists a possibility that the item might have to be returned to its rightful owner. this possibility of having to return the item raises two issues seriatim. the first is that the income represented by the found object may not be immediately realized due to the forfeiture condition and attendant valuation problems. this approach is explored but rejected. at this point the solution appears to be including the item in gross income upon receipt and claiming a deduction if and when the item is returned. this approach is commonly referred to as the “claim of right doctrine,” although, after james v. united states, its operation no2 3 longer is conditioned on the taxpayer’s having a “claim of right.” in any event, the application of this doctrine to in-kind property (as opposed to cash) is somewhat problematic, but i argue in favor of this approach. the conclusion is that the object should be included upon receipt, but that the idea of “receipt” can here be rendered in a flexible fashion so as to allow for a disclaimer or its functional equivalent. the endeavor might be vulnerable to the charge of being “much ado about nothing” were it not for a recent piece by professors lawrence zelenak and martin mcmahon arguing that found objects, such as record-setting home run baseballs, are not “residual” gross income upon acquisition. zelenak and4 mcmahon justify their thesis by analogy first to imputed income and then to self-created assets, which are not taxed until (and if) they are sold or exchanged. moreover, zelenak and mcmahon suggest that regulations section 1.61-14(a), which cites “treasure trove” as being an example of in-kind gross income, is probably invalid or, if it is not, should be withdrawn.5 1 . this article was worked up while i was a visiting professor at the florida state university college of law. i would like to thank prof. steven bank of that institution for commenting on an earlier draft. various portions of this piece express ideas found in the joseph dodge, j. clifton fleming, jr., and deborah geier, teacher’s manual to federal income taxation: doctrine structure and policy 27-66 (2d ed. 1999). i am greatly indebted to my coauthors of said teacher’s manual. 2 . the “claim of right” phrase appeared in north american oil consolidated v. burnet, 286 u. s. 417, 424 (1932) (damages award subject to refund if taxpayer were to lose appeal). 3 . 366 u.s. 213 (1961) (embezzled funds are income despite absence of lawful claim and existence of possibility of forfeiture). 4 . the term “residual gross income” means gross income that does not fall into any of the enumerated categories of gross income listed in irc § 61(a), such as “compensation,” “gross income derived from business,” “gains derived from dealings in property,” “interest,” “rents,” and so on. these categories do not exhaust “gross income.” 5 . lawrence a. zelenak and martin mcmahon, jr., taxing baseballs and other found property, 84 tax notes 1299, 1308 (aug. 30, 1999) (hereinafter “zelenak & mcmahon”). 688 florida tax review [vol. 4:10 according to glenshaw glass, residual gross income requires an6 “accession to wealth,” “realization,” and taxpayer “dominion and control.” i argue narrowly that found objects are not imputed income, that they represent accessions to wealth, and that the so-called treasure-trove regulation is valid without question. so much is relatively easy. the “realization of gross income” issue, as distinct from the “realization of gain” issue, has received little recent scholarly attention. the realization-of-income concept would pose the issue of whether an in-kind receipt of property is includable in gross income at the time received, or at some later time such as: (1) the time of use or obtaining economic benefits from the property, (2) the time all adverse property claims lapse or are settled, or (3) the time of disposition. in the case of self-created property, income is not realized until the selfcreated objects are sold. however, found property is not analogous to selfcreated property. rather, there is a meaningful distinction between true windfall gains, where something is received for nothing, and nonwindfall gains resulting from the investment of capital and services. the category of nonwindfall gains7 includes not only gains from self-created property, but also property that is found or taken from nature in the pursuit of a venture involving the investment of the taxpayer’s labor and/or capital. nonwindfall gains are, and, under the present realization-based income tax, should be, taxed (if at all) only when realized, i.e., upon sale. windfall gains should be taxed upon acquisition,8 subject to the possibility of meaningful disclaimer. the realization-of-income area is an obscure and perhaps somewhat messy backwater of income tax doctrine, but it has potential application to windfall found objects due to the fact that the “finder” rarely obtains instant title. i argue that courts should restrict the “realization of income” doctrine to cases where current enjoyment rights (as opposed to “legal title”) in property received in-kind are significantly “contingent.” lack of dominion and control translates into “nonrealization.” mere nonliquidity, difficulty of valuation, or a possibility of forfeiture should not be a bar to current realization. at worst, a significant possibility of forfeiture would reduce the value of a found object, but that would rarely be the case in the found-object situation. institutionally, immediate realization should be the judicial norm, barring extreme circumstances, and exceptions should be left to congress. it is argued that absence of title does not render a “finding” into an excludible “borrowing.” the claim of right doctrine holds that a forfeitable item should be included in gross income when possession is obtained, and a deduction may be available when the item is returned. i argue that this approach 6 . commissioner v. glenshaw glass co., 348 u.s. 426, 431 (1955). 7 . in general, a “true windfall gain” is distinguishable from other self-obtained property situations because of the taxpayer’s amateur status, a zero or negligible actual cost, a minimal expenditure of labor, and perhaps a negligible opportunity cost. 8 . whether the gratuitous transfer of an asset or the transfer of an asset incident to a divorce or separation should be a deemed realization event is an issue that transcends the tax treatment of found or self-created assets, and is therefore beyond the scope of this article. 2000] applying the “claim of right doctrine” to found objects 689 is economically correct and should be extended to property (as well as cash),9 and that an appropriate deduction should be available as a matter of right. part i advances the propositions that windfall in-kind property receipts are not imputed income but are true accessions to wealth. the category of nonwindfall self-obtained property is distinguished. part ii explores the realization of income concept. part iii sets out the claim of right approach, namely, initial inclusion followed by a later deduction if and when property is returned. part iv sorts out the various problems in applying that approach to inkind property receipts in general and found objects in particular. the solution to the problem of record-setting home-run baseballs is, to mix sports metaphors, a “slam dunk.” ii. windfall vs. nonwindfall in-kind receipts this part affirms that windfall in-kind property receipts are gross income (as opposed to being untaxed imputed income), and distinguishes selfobtained property resulting from the investment of capital and/or labor. a. is “income” equatable with “cash”? contrary to the “trial balloon” floated by zelenak and mcmahon, gross income is not prima facie equatable with cash. 1. in-kind receipts under the regulations.—initially, zelenak and mcmahon mischaracterize the role of the so-called “treasure trove regulation,” regulations section 1.61-14. that regulation does not establish the principle that in-kind receipts are gross income. that honor belongs to section 1.61-1(a), which broadly and unambiguously states: gross income includes income realized in any form, whether in money, property, or services. income can be realized, therefore, in the form of services, meals, accommodations, stock, or other property, as well as cash. section 1.61-14, which is captioned “miscellaneous items of gross income,” actually offers a concession with respect to treasure trove: in addition to the items enumerated in section 61(a), there are many other kinds of gross income. [the regulation then cites punitive damages, a third-party payment of the taxpayer’s income taxes, and illegal income.] treasure trove, to the extent of its value in united 9 . irc § 83(a) adopts the reverse approach for forfeitable property received as compensation for services, but i argue, see in the text accompanying notes 148-80 that this deferral approach should not be extended beyond the bounds of section 83. 690 florida tax review [vol. 4:10 states currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession. [emphasis added.]10 thus, with regard to “treasure trove” (which is not defined), section 1.61-14(a) states that it is includable in the year that it is reduced to undisputed possession. since section 1.61-1(a) refers to “income realized in any form” (emphasis added), the clear implication is that treasure trove, as with any inkind receipt, is gross income, but it is not “realized” until the year it is “reduced to undisputed possession” – which phrase is (also) undefined. thus, section 1.61-14(a), insofar as it applies to treasure trove, is not principally an inclusionary rule. in that respect it is redundant to section 1.61-1(a). insofar as section 1.61-14(a) “adds anything,” it is to recognize the possibility of deferral of gross income. that is, it indicates that income with respect to treasure trove (and perhaps other found objects) may conceivably be deferred until realized, but the circumstances in which such deferral might be proper are not stated or even hinted at. in addition, since the purpose of section 1.61-14(a) is merely to point out the existence of the category of “residual” gross income and to list some examples of it, the concept of “treasure trove” has no special significance, and can be taken to refer to any found object, or collection thereof, having more than de minimis market value. 2. “income” refers to changes in wealth, not cash.—at a higher level of abstraction, zelenak and mcmahon suggest the income tax is “all about” the receipt of cash, with in-kind receipts being taxed only out of expediency, namely, to prevent wholesale erosion of the cash tax base. although it is11 undoubtedly true that taxing in-kind receipts in many cases does prevent the erosion of the tax base, it does not follow that “income” is equatable with “cash.” indeed, the notion that “income” is basically “cash” is incoherent. the “income tax” idea is keyed to changes in wealth (including property). since zelenak and mcmahon do not suggest that non-consumption12 cash outlays (savings and investments) are to be deducted when made, it can be assumed that they are not arguing for a cash-flow consumption tax. but once13 one posits an “income tax” – a tax in which capital expenditures are nondeductible (with the resulting creation of basis) – one has to concede that14 10 . this sentence is almost identical to rev. rul. 53-61, 1953-1 c.b. 17. that ruling consists of a single sentence. in both the ruling and the regulation there is no definition of “treasure trove” and no explanation of “reduced to undisputed possession.” regs. § 1.61-14 was adopted in 1960, t.d. 6500, 25 fr11402 (nov. 26, 1960). 11 . see zelenak & mcmahon, supra note 5, at 1304-05. 12 . see, e.g., united states treas. dept., blueprints for basic tax reform 25-32 (1977) (hereinafter blueprints) (explaining that the difference between an income tax and a cashflow consumption tax lies in the fact that an income tax accounts for changes in wealth). 13 . in a cash-flow consumption tax, non-consumption capital expenditures are deducted. see id. at 30. 14 . a capital expenditure is a cash outlay that changes the form of wealth, as opposed to being a complete loss of such wealth to the taxpayer during the taxable year. see irc §§ 263 2000] applying the “claim of right doctrine” to found objects 691 the dominant paradigm is “changes in wealth.” the basis for nondeductability of capital expenditures is precisely that what matters is wealth, not cash. in addition, the neutrality (efficiency) norm, as well as the ability-to-15 pay fairness norm, are justifications for including in-kind receipts (and16 unrealized appreciation) in the tax base. arguments for a “cash” view of income would elevate convenience over all other policy norms, but even convenience argues against a “cash” view of income in the case of enterprises that use gaap accounting.17 contrary to the thesis advanced by zelenak and mcmahon, there is not even a coherent or persuasive normative basis for an across-the-board exclusion for unrealized appreciation. such “convenience” factors as difficulty of valuation and nonliquidity are matters of degree, not inherent quality, and in many cases these factors are not significantly present. 18 3. accessions to wealth are not “imputed” income.—zelenak and mcmahon also argue that the failure to tax imputed income shows that income basically refers to cash receipts. the term “imputed income” as used in the tax literature is not entirely without ambiguity. the principal meanings, which overlap somewhat, appear to be: (1) the flow of satisfactions obtained by a taxpayer (which would include not only the value of satisfactions derived from owning and spending but also the value of leisure, sleep, a happy marriage, (no deduction for capital expenditures) and 1012 (basis is dollars “in” investment that were previously subject to tax because of being nondeductible capital expenditures). 15 . the neutrality norm stipulates that the tax system should not discriminate among various categories of investments. if found objects are not “after tax” (by reason of being excludible upon receipt), whereas other assets are “after tax” (resulting from nondeductible capital expenditures), then the former would be favored by the tax-system. however, neutrality is not an important norm in this case, since found objects (properly defined) occur by chance. nevertheless, taxing found objects upon receipt would encourage the highest and best use of such assets: the finder, who has a low subjective preference for the object, would either disclaim it or sell it in the market. 16 . the concept of “ability to pay” is a term of art in the tax literature referring to the tax base, not the medium for paying the tax. as applied to the tax base, it means wealth, as opposed to cash, and is commonly deployed as a justification for an “income tax” (or perhaps a wealth tax) over a “consumption tax.” see blueprints, supra note 12, at 31. (the competing norm is “personal consumption” or perhaps “standard of living.”) 17 . taxpayers following “generally accepted accounting principles” (gaap), as well as other taxpayers subject to the mandate of irc §§ 447(a) and 448(a), are required to follow the accrual method of accounting, which basically looks, on the income side, to the acquisition of rights to future cash rather than to the receipt of cash itself. see regs. § 1.451-1(a). 18 . see david a. weisbach, line drawing, doctrine, and efficiency in the tax law, 84 corn. l. rev. 1627, 1633-37 (1999) (finding the existing line between realization and nonrealization to be incoherent). in my view, it would make more sense from both administrative and policy perspectives to draw the line between liquid and nonliquid assets than between “income” and “appreciation”, investors can move more easily between income and appreciation assets than they can between liquid and nonliquid assets. 692 florida tax review [vol. 4:10 etc.), and (2) the market-price equivalents of non-market economic activity19 (such as the value of self-grown crops and the rental value of self-owned assets, and possibly the value of self-performed services). the flow-of-satisfactions20 definition is either so all-encompassing as to be worthless, or else it simply re-21 states the distinction between intangible benefits (utility) and tangible benefits (such as accessions to wealth). the second definition is more useful because it focuses on a particular kind of “economic benefit,” namely, the hypothetical, cash income that would be obtained if the person, contrary to fact, entered the market and sold or rented her services, self-created goods, or self-owned assets.22 it might be objected that “income” is something that is objectively determined in terms of market values gleaned from actual market transactions,23 and that a found object doesn’t fit the usual concept of “market transaction,” at least if that term is conceived narrowly in terms of a bargained-for quid pro quo. however, the market-transaction concept should not be so rigidly conceived, and in any event it is distinct from that of imputed income. the function of the market-transaction idea is (partly) to provide a common denominator for the 19 . see marsh, the taxation of imputed income, 58 pol.sci.q. 514 (1943), excerpted in paul r. mcdaniel, hugh j. ault, martin j. mcmahon, jr. & daniel l. simmons, federal income taxation, cases and materials 83-85 (4 ed. 1998). robert haig stated that “income”th is “fundamentally” a flow of satisfactions (utility). see robert m. haig, the concept of income – economic and legal aspects (1921), in r. musgrave and c. shoup (eds.), readings in the economics of taxation 54, 55 (1938). an economics perspective is necessarily concerned with the fact that the inevitable exclusion of some satisfactions from the tax base regrettably tends to distort economic behavior and leads to deadweight loss. it does not follow that income in the legal sense equates (or should equate) with “flow of satisfactions.” thus, even the utilitarian tax tradition generally concedes that (1) consumption is measured by market value (not subjective value), and (2) only satisfactions obtained in market transactions are to be counted. see daniel n. shaviro, an efficiency analysis of realization and recognition rules under the federal income tax, 48 tax l. rev. 1, 7-10 (1992). the ability-to-pay norm would not include imputed income in the tax base because satisfactions are not “wealth.” see chancellor thomas, imputed income and the ideal income tax, 67 or. l. rev. 519 (1988) (arguing that the tax base should not be defined with reference to utility). of course, one might view ability-to-pay in terms of income-producing capacity rather than in terms of actual wealth outcomes. but this approach, which would (inter alia) tax the acquisition of human capital, is considered too extreme in its imposition of economic norms on human conduct. 20 . henry simons, in noting the difficulty in ascertaining what might be an “economic” gain, compared self-grown crops, a self-grown flower garden, and self-provided services. see h. simons, personal income taxation 51-52 (1938). 21 . see id. at 50-56 (rejecting a “flow of satisfactions” approach to income but acknowledging the problems in defining “income” in terms of “economic” gain). 22 . see chancellor, supra note 19, at 567-69. for example, the so-called “imputed interest” on below-market loans subject to irc § 7872 is not imputed (hypothetical). rather, it represents real gain on the investment component of the loan. a below-market loan consists of (1) a “transfer” (or “expense”) component (excess of loan over present value of repayment obligation) and (2) an “investment” (capital expenditure) component (equal to the present value of the repayment obligation). the excess of the repayment amount over the present value thereof is economic gain that is “realized” (as original issue discount) with the passage of time. 23 . see supra note 19. 2000] applying the “claim of right doctrine” to found objects 693 exclusions for intangible (psychic) benefits and hypothetical (imputed) income. although excluded psychic benefits and imputed income can be characterized as “non-market” benefits, it does not logically follow that all non-market benefits are per se exempt from tax. the market-transaction concept does not preclude evaluating tax issues on their merits. obtaining a windfall found object is distinguishable from psychic income and imputed income in being a tangible accession to wealth.24 income does not cease to be “income” just because the transferor or payor of cash or wealth cannot be identified. positive law, whether the code,25 the regulations, or the supreme court in glenshaw glass, rejects the idea26 27 that an idiosyncratic source negates the existence of gross income. in sum, zelenak and mcmahon have not made a case for equating income with cash. from the policy angle, tax issues are not properly resolved simply by invoking such broad concepts as “imputed income” and “market transaction.” that the income tax base has been, and perhaps should be, modified to take into account practical concerns such as difficulty or impossibility of valuation and nonliquidity is commonplace. but practical28 concerns do not automatically trump other norms. nevertheless, insofar as zelenak and mcmahon are arguing that practical concerns should be taken seriously, i would not only concur but advance the point a step further: accommodation to practical considerations should not be viewed as a “retreat” from “principle,” but rather as a “shift” to a different kind of principle, namely, a “legal” (as opposed to “economic” or “fairness”) principle. legal issues that are relevant to the present discussion include: (1) whether or not rules that can rarely be enforced, or which are enforced at the whim of officials, are “rules” worth having, and (2) whether various distinctions among tax categories are coherent and intelligible. admitting legal norms into tax policy debates should29 not be a cause for embarrassment. 24 . see h. simons, supra note 20, at 51 (income is “gain” measured according to objective market standards). 25 . see irc § 61(a) (defining gross income as “all income from whatever source derived”). 26 . regs. § 1.61-1(a)(1) (repeating code language). 27 . glenshaw glass, supra note 6, involved a non-bargained-for gain in the form of statutory damages. 28 . see, e.g., richard goode, the individual income tax 26-35 (rev. ed. 1978) (citing compliance and administration); joseph sneed, the criteria of federal income tax policy, 17 stan. law rev. 567, 572-74 (1967) (citing “practicality”); william andrews, a consumptiontype or cash-flow personal income tax, 87 harv. l. rev. 1113, 1141-43, 1148-65 (1974) (citing practical advantages of cash-flow consumption tax relative to an accretion-type or a partial-accretion-type income tax). 29 . in taxes, legal norms obviously relate to compliance and administration. there is a growing literature that evaluates the distinctions made in tax law to economic efficiency concerns. see weisbach, supra note 18; jeff strnad, taxing new financial products: a conceptual framework, 46 stan. l. rev. 569 (1994). it is not necessary here, however, to draw the line between economics and law. 694 florida tax review [vol. 4:10 b. distinguishing in-kind windfalls from unrealized appreciation tax law generally does not include unrealized gains in income until the sale or other disposition of the property. it follows that gain is not realized30 upon the purchase of property for cash, even where the value of the property significantly exceeds the “cost” thereof. the prime example is the “commercial bargain purchase,” discussed immediately below. a similar situation is presented by self-created property and property (natural resources) obtained as the result of a venture that aims to obtain such property. examples cited by zelenak and mcmahon include gold found by prospectors and fish and game caught by fishers and hunters, whether amateur or professional. but these31 situations do not undermine the case for including windfall found objects in gross income when received, because they all involve unrealized appreciation, that is, the acquisition of property in which value exceeds cost. in contrast, inkind windfall gains are not purchased. they involve “something for nothing,” and therefore produce an immediate “accession to wealth” that can be treated as current gross income. 1. commercial bargain purchases.—in the case of property already owned by the taxpayer, the meaning of realization is usually straightforward: there must be a sale or disposition of the property or, in the case of losses, some event must occur such that the loss can be said to be “sustained,” that is, “fixed” or “final.” 32 the “exclusion” with respect to commercial bargain purchases of property (the proverbial purchase of a rembrandt oil painting at a flea market for $100) appears to be viewed as an extension of the unrealized-appreciation concept to its outer limit: appreciation is viewed as any excess of value over cost, even if such excess exists at the moment of purchase. this approach has33 30 . see irc § 1001(a) (gain realized only upon “sale or other disposition” of property). 31 . i am somewhat confused about the references in zelenak and mcmahon to “big game hunting.” a similar problem arises with game fishing. the people who organize safaris, hunts, and fishing expeditions are basically providing a service to amateurs who enjoy the activity and, if successful, kill game (or catch fish) that can be preserved and displayed as trophies. occasionally, an individual might organize his or her own hunt (etc.) with an aim, inter alia, of obtaining trophies. hunting and fishing trophies can be viewed either as “self-created” assets or as “self-taken” assets, i.e., as the “products” of business or hobby activities, but in either case they are not included in gross income. (conventional “awarded” trophies are not discussed in this article, but i hope to discuss them in a future article, where i shall argue that in-kind consumption should sometimes be excluded from gross income and that most awarded trophies should be viewed as in-kind consumption, rather than as accessions to wealth.) of course, enterprises do exist that collect live fish and game as inventory, and those that collect dead animal and fish parts or by-products, such as elephant tusks, cuttlefish bones, hides, horns, manure, and so on, and sell (or convert) the same as inventory. enterprises that treat animals and fish (or their parts and byproducts) as inventory are not essentially different from farming enterprises. 32 . irc § 1001(a); regs. § 1.165-1(b). 33 . pellar v. commissioner 25 t.c. 299 (1955)(acq.); 1956-2 c.b. 7, 1956-1 c.b. 5. this rule assumes that the parties are not related in such a way that the transaction can be viewed 2000] applying the “claim of right doctrine” to found objects 695 practical virtues, since true commercial bargain purchases among unrelated parties are rare, and it would be even rarer for the irs to find out about them. moreover, “true” commercial bargain purchases are limited to collectibles and other non-publicly-traded business and investment property. business and investment property can be taxed upon disposition. 34 the commercial-bargain-purchase exclusion also has a principled basis, namely, that the appreciation element in a commercial bargain purchase can be said to occur “after” the purchase, because the true value of a collectible can only be objectively revealed through appraisals or testing the market. stated more abstractly, for tax purposes the value at the time of purchase is deemed to equal cost, because (objective) value is synonymous with market price. thus,35 the commercial bargain purchase situation is essentially the same as that of purchasing a speculative investment that turns out to be a bonanza, such as raw land that yields valuable minerals. in both cases the (high) value is “there” upon purchase but is only “revealed” later. on the other hand, this exclusion (deferral rule) can be criticized on the ground that, if we view the finding of a rembrandt in an attic to be gross income, it is hard to distinguish the case where the rembrandt is purchased for a small amount of cash. however, the distinction between an in-kind windfall receipt and unrealized appreciation is clear in principle: in the first, one receives something for nothing, and in the second, one has invested in valuable property. of course, there may be borderline cases that raise the issue of whether there has been an investment in the valuable property. to count as “investment in the property,” the cost should have been purposefully incurred in an activity or venture to obtain valuable property. thus, the cost of some personal activity, such as a vacation to belize, that fortuitously results in the finding of gold coins on the beach should not be viewed as “investment in the property.”36 as a deliberate attempt by the seller to transfer wealth to the purchaser. compare irc § 83(a) (compensation for services). thus, the commercial-bargain-purchase exclusion posits ignorance by the seller of the property’s true value. 34 . personal-use property (that depreciates in value) would escape tax entirely if not taxed in full upon receipt. fortunately, depreciating personal-use property will not be the subject of a true bargain purchase. that distinction is pretty much reserved for art works, collectibles, raw land containing natural resources, and perhaps other items whose true quality can escape the scrutiny of merchants. these items fall in the “investment” category for purposes of this discussion because they do not lose value by reason of obsolescence, being displayed, or perhaps even by normal use. 35 . thus, simply getting a “good deal” in the marketplace (such as a big discount on a car purchase) is not properly viewed as raising a serious gross income issue, since market transactions are reckoned by the income tax on the basis of “cost” rather than value received. for the great mass of arms-length transactions, cost is the best (most objective and easy to ascertain) criterion of value. see daniel n. shaviro, the man who lost too much: zarin v. commissioner and the measurement of taxable consumption, 45 tax l. rev. 215, 222-29 (1990). 36 . cf. cesarini v. united states, 296 f.supp. 3 (n.d.ohio 1969), aff’d per curiam, 428 f.2d 812 (6 cir.1970) (cash found in a piano is gross income). the result should be theth same if diamonds are found in the piano. a harder case would be where a person purchased a 696 florida tax review [vol. 4:10 another argument might be that the commercial-bargain-purchase exclusion confounds the neutrality norm that all investment be after-tax. 37 however, here the violation of neutrality is trivial, since transactions of this type are rare, the seller is certainly unaware of the true value of the item, and the buyer may also be unaware of the true value at the time of purchase. also, the bargain-purchase exclusionary rule avoids valuation disputes between the taxpayer and the irs. 2. sought-after property.—the point of discussing the “commercial bargain purchase” situation is to show that, doctrinally, the concept of “unrealized appreciation” is, for better or worse, taken seriously. that being the case, it is easy to understand the principle that property that is produced or obtained by a taxpayer’s efforts also does not yield income until the property is sold or disposed of in a realization event. thus, contrary to the zelenak and mcmahon thesis, the category of “found objects” does not, as a matter of positive law, encompass each and every asset obtained in-kind by a taxpayer. rather, found objects (in tax talk) are thought of as acquired at random and without special effort (i.e., by persons in an “amateur” capacity), i.e., as “windfalls.” objects (including those that can38 be sold in more or less their natural state, such as gold, gems, treasure, oil, fish, and game) that are sought after and obtained as the result of a venture, activity, or enterprise (that requires planning, financing, and implementation) are not usually referred to as “found.” for want of a better term, i will use the word “taken” to refer to in-kind property appropriated as the result of a commercial venture or personal hobby, so as to connote the “active” posture of the taxpayer relative to the “passive” posture of a taxpayer appropriating a windfall found object. there is no meaningful distinction between “taken” and “self-created” objects. (a “self-created” item is property produced by the taxpayer’s own personal efforts, as opposed to the labor of others or with significant capital investment.) both taken property and self-created property will be referred to as “self-obtained” property. both categories of self-obtained property are excluded from income when acquired, but the rationale for exclusion might differ somewhat as between self-obtained business inventory and self-obtained personal-use items.39 locked safe at an auction that contained diamonds: the buyer could well be speculating that the safe would have valuable contents. these were roughly the facts in the non-tax case of city of everett v. estate of sumstad, 614 p.2d 1294 (wash.ct.app. 1980), at 1505-06, which (dubiously) held that the seller could get the contents of the safe back. 37 . see calvin h. johnson, soft money investing under the income tax, 1989 u. of ill. l. rev. 1019 (1989). 38 . see comment, taxation of found property and other windfalls, 20 u. chi. l. rev. 748, 748 (1953). 39 . it is hard to conceive of “taken” property as being of an “investment” type or as property to be “used” in a trade or business. the situations cited by zelenak and mcmahon (gold 2000] applying the “claim of right doctrine” to found objects 697 a. self-obtained inventory.—in the context of a commercial venture, the “taking” of business inventory, such as fish, game, gold nuggets, manganese nodules, native copper, diamonds, truffles, and the raising of sunken treasure from the sea, as well as the “creating” of inventory, such as art or craft works, are similar to the conventional manufacturing of inventory or the raising of crops by a farmer, as far as investment of capital and labor is concerned. self-obtained property entails some investment of capital, whether it be in raw materials, supplies and equipment, the labor of others, or transportation.40 investment does not give rise to income until gain is realized. even the pure performing of services for wages or fees does not give rise to realized income until the wages are received or accrued. the high labor component of selfcreated inventory (perhaps) results in a higher accounting profit, but the ratio of profit to accounting cost has nothing to do with when profit is realized. that inventory may be produced in stages (as in manufactured or self-created inventory), purchased intact, or “harvested” intact (as in “taken” inventory) sets out distinctions without a tax difference. looking at the venture as a whole, the actual obtaining of the inventory, by whatever techniques, is not an “end” but rather a “means” (or opportunity) to earn a profit. the sale of the inventory, not the obtaining of it, is the realization event. once again, the correct distinction is not between “found” and “selfcreated” objects but between windfall property and property obtained in the course of a profit-seeking activity. this distinction is embedded in tax doctrine. where property (as opposed to cash) is acquired by windfall (without significant effort), it is taxed when realized, which usually means immediately.41 a windfall, by definition, is the receipt of something for nothing (or virtually nothing). where property is acquired through investment of labor or capital, it is not really a windfall gain, even if the outcome is extremely profitable relative to the investment. 42 realization of inventory gain is the culmination of the inventory accounting cycle. section 263a (subject to various exceptions) requires43 capitalization with respect to property that is either “produced” or “acquired for prospecting, fish and game, salvaging sunken treasure, etc.) all result in the obtaining of property that would (or at least could) be inventory if obtained in the course of a commercial venture. about the only exception i can think of is the capture of wildlife for breeding purposes, but it seems likely that capturing enterprises are carried on by different entrepreneurs than breeders. 40 . labor costs in the production or acquisition of inventory are capitalized. irc § 263a(a); regs. § 1.263a-1(e)(2)(i)(b) &(e)(3)(ii)(a). from the economic efficiency angle, there is no reason to treat enterprises with paid-for labor differently from those with self-provided labor. 41 . regs. §§ 1.61-1(a) and 1.61-14. 42 . see eric kades, windfalls, 108 yale l. j. 1489, 1504-20 (1999) (economic analysis and legal doctrine should view commercial ventures ex ante and not treat large profits as windfalls simply by looking at ex post results). 43 . see irc § 61(a)(2) (inventory) and (a)(3) (other property); regs. § 1.61-4(a) and (c) (self-grown crops generate income only when sold, exchanged, etc.); rev. rul. 56-496, 19562 c.b. 17 (self-grown crops fed to one’s own animals are not a taxable disposition). 698 florida tax review [vol. 4:10 resale.” the term “produced” includes “develop,” “create,” “raise,” or44 “grow,” and the term “acquire” is broad enough to encompass “find,”45 “discover,” “take,” “harvest,” and the like. similarly, the taxation of natural resources assumes that gross income is realized when the minerals are sold or royalties are received, not when the minerals are acquired or extracted. the46 issue of whether or not to capitalize various kinds of acquisition costs assumes that the income or gain with respect to the inventory or other property will be realized upon ultimate sale or disposition. treating self-obtained inventory uniquely as gross income at the time of acquisition would be the equivalent of a one-time marking of such property to market, in contrast to wage income or gains from property created or acquired as the result of investment of capital and/or labor. but, if “selfobtaining” should be a realization event, why would not the acquisition of the right to produce or acquire such property (in the form of a license, lease, contract right, mineral claim, salvage permit, etc.) also be a realization event? but neither approach makes sense, unless there is a good reason to single out self-obtained inventory for more burdensome taxation than “conventional” purchased or manufactured inventory. the distinction between windfall gains and inventory profits is not only imbedded in doctrine but also makes sense from an economics perspective: taxes on business or investment activity influence behavior and create deadweight loss, whereas taxes on true windfalls do not. thus, economic efficiency dictates that true windfalls be taxed more heavily than economic returns, and this can be accomplished by taxing windfalls upon acquisition47 rather than when disposed of. a possible argument for taxing a particular type of business more heavily than others is that the type of business obtains a “windfall equivalent” in the form of “unearned rents” such as might result from monopoly, unequal bargaining power, government action, or unforeseen events. however, there48 is no reason to think that self-obtained inventory reaps a windfall equivalent simply by being taken or self-created. the fact that the value of the taken or self-created items might have a value far in excess of any investment of effort or capital does not suggest otherwise. 44 . irc § 263a(b). 45 . regs. § 1.263a-2(a)(1)(i). 46 . see irc §§ 263(c) (expensing of idcs), 612 (basis for cost depletion), 613(a) & (c)(1) (percentage depletion keyed to net gross income from mining), 616 & 617 (cost recovery), and 636 (status of production payments). irc § 631(a), allowing a taxpayer to treat the cutting of timber as a sale or exchange, presupposes that the general rule would be that timber gains are realized upon sale. 47 . see, e.g., richard a. musgrave & peggy b. musgrave, public finance in theory and practice 277-96 (1989); saul levmore, the case for retroactive taxation, 22 j. legal stud. 265, 273 (1993). 48 . see kades, supra note 42, at 1505. 2000] applying the “claim of right doctrine” to found objects 699 enterprises that offer the hope of a payoff far in excess of investment are generally considered to be “risky investments.” for every successful venture, there are numerous failures. in this respect, there is no real difference between a treasure-hunting venture and the development of, say, a patent or copyright (or corpus of artwork) whose commercial success is unknown in advance. high-risk investments are generally not singled out for49 discriminatory tax burdens. 50 it might be argued that the realization principle is wrong, misconceived, or draws lines in the wrong places. true, if all property were marked-to-51 market, then there would be no reason to exempt self-obtained objects. but if only some property were marked-to-market, self-obtained inventory would not be a prime candidate. the case for marking inventory to market is weaker than, say, marking publicly-traded investments to market: the latter are easier to value and more liquid, and the possibility of tax avoidance by long deferral of realization is much stronger. at least some categories of self-obtained52 inventory would be harder to value and be less liquid than conventional purchased or manufactured inventory. in any event, the point here is not to question the realization principle at the policy level, but simply to show that there is an established and principled doctrinal basis for distinguishing selfobtained inventory from windfall gains. self-constructed business-use property, such as a building or equipment, is unlike inventory in that it will not be held for immediate sale. hence, realization of income attributable to such property will be factored into the ultimate sale of inventory and services. this delayed realization of income in a business context raises significant neutrality concerns that are absent in the case of self-created inventory, and will not be discussed here as they have been dealt with elsewhere.53 b. self-obtained personal-use property.—amateurs, as well as professionals, can discover or harvest wealth in a saleable form, just as both amateurs and professionals can create wealth by their own personal efforts, although their goals differ: a professional (in his or her capacity as such) intends 49 . see gary kinder, ship of gold in the deep blue sea (1998)(describing investment of capital and labor in treasure-seeking venture). 50 . see generally, michael livingston, risky business: economics, culture, and the taxation of high-risk activities, 48 tax l. rev. 163 (1993). cf. noel b. cunningham, the taxation of capital income and the choice of tax base, 52 tax l. rev. 17, 29-43 (1996) (arguing that risky investments are systematically favored under an income tax). 51 . compare david j. shakow, taxation without realization: a proposal for accrual taxation, 134 u. pa. l. rev. 1111 (1986), with david a. weisbach, a partial mark-to-market tax system, 53 tax l. rev. 95 (1999). 52 . inventory is denied capital gains treatment, irc § 1221(2), precisely because the producer or purchaser of it will sell it (as opposed to hoarding it) without any special tax inducement. 53 . self-constructed business-use property is discussed in noel b. cunningham & deborah h. schenk, how to tax the house that jack built, 43 tax l. rev. 447 (1988). 700 florida tax review [vol. 4:10 to sell, whereas an amateur (in his or her capacity as such) contemplates use and enjoyment (although eventual sale is conceivable). in short, in the non-business context, a person may find property, create property, or “take” it, all in the course of a hobby activity (such as fishing and hunting). self-created property of an individual in an amateur capacity is almost certain to be non-liquid, and it will likely be held for the creator’s or finder’s54 personal use. for this reason, unless such property is included in gross income55 upon completion, it likely will not be taxed at all. the argument for inclusion56 of self-created personal-use property is simple enough: a completed self-created personal-use asset constitutes an accession to wealth or, if you will, enhanced ability to pay. the argument contra is that, unless and until the item is sold,57 any economic benefits derived from the item are untaxed “imputed” income. resolving this issue entails moving beyond labels. an argument can be made that in-kind consumption should generally not be viewed as gross income (unless there is a good reason to tax it, as in the case of employee fringe benefits). although this argument is basically beyond58 the scope of this article, it can be sketched briefly here. one foundation for the argument is the ability-to-pay “tax justice” norm, which posits that the aggregate tax burden should be apportioned among the population on the basis 54 . it is hard to imagine self-created property with a high degree of liquidity. alchemy is an illusion, and the creation of currency or bearer bonds is an illegal high-risk activity such that a purchaser would demand a significant discount. even these examples imply some degree of professionalism. most self-created property would be in the nature of arts, crafts, utilitarian objects, self-grown crops, and self-raised animals, most of which would initially be intended for personal use. insofar as they are intended for sale, the taxpayer is operating in a business capacity. an autograph (or autographed item) may be liquid, but since it has no value to the author, it is analogous to business inventory (if sold) or to good-will advertising (if given free of charge). 55 . irc § 263a(c)(1) exempts self-created personal-use property from the general capitalization rule. given that such costs are just as much “capital” as in the case of business or investment property, this exception is presumably based on the premise that there is no point in maintaining a basis account for such property, since it cannot be depreciated and probably won’t be sold. 56 . the value will decline to zero in the hands of the acquiring taxpayer or any donee. property that happens to appreciate in value will escape tax under irc §§ 102 and 1014. 57 . doctrinally, a self-created non-inventory asset (not used in the taxpayer’s trade or business) is a “capital asset,” unless excepted under irc § 1221(3), notwithstanding its derivation from the taxpayer’s personal services. cf., e.g., wodehouse v. commissioner, 177 f.2d 881 (2d cir.1949); lewis v. rothensies, 61 f.supp. 862 (e.d.pa.1944), aff’d per curiam, 150 f.2d 959 (3d cir.1945) (both cases holding that such an asset is “property” for purposes of assignment-ofincome doctrine). however, the capital asset issue is conceptually distinguishable from the inclusion-upon-completion issue. the capital asset issue comes into play only when such property is realized upon by sale or exchange. in that context, it is hard to sort out the “appreciation” and “services” components of the gain, and hence an all-or-nothing rule serves a useful purpose. 58 . in the case of employee fringe benefits, the “good reasons” include avoiding significant erosion of the tax base and economic neutrality. henry simons appears to take the utility-based position that in-kind consumption should be taxed unless there is good reason not to tax it. see h. simons, supra note 20 at 51-55 and 110-24. 2000] applying the “claim of right doctrine” to found objects 701 of material wealth (as opposed to a flow of satisfactions or utility). the other59 foundation acknowledges utility as the basis of taxation but concludes that, for mostly practical reasons, the “consumption” component of the tax base should be figured with reference to amounts spent by a taxpayer on personal consumption, as opposed to benefits received. either way, the “consumption”60 component of an income tax base is reached mainly by disallowing deductions rather than by including in-kind benefits. there are various situations where positive law does not tax in-kind consumption benefits. this exclusionary61 principle is not rigid. in-kind consumption should be included in gross income where there is good policy reason to do so and such inclusion is not impractical.62 insofar as in-kind consumption would be deemed excludable, then there would be the issue of distinguishing in-kind “wealth” from in-kind “consumption.” applying this distinction to self-created property would result in the inclusion of non-personal-use assets, but it would arguably result in the exclusion of assets that can be expected to be consumed by the taxpayer. of63 course, self-created assets that would be expected to hold their value in the long term, such as residences, and possibly arts and crafts, might be viewed as falling on the “wealth” side of the line. but consumable items, such as self-grown crops and utilitarian objects, could reasonably be viewed as in-kind (excludable) consumption, rather than as wealth. (of course, even under an inclusionary rule the cost of materials, etc., would not be deducted, so that any “investment” component of a self-created personal-use item would be “after tax.”) 59 . see 3 report of royal commission on taxation 3-8 (1966) (canada) (role of ability-to-pay principle); alan gunn, the case for an income tax, 46 u.chi.l.rev.370, 378-88 (1979) (discussing content of ability-to-pay principle). 60 . see shaviro, supra note 35. shaviro does not discuss in-kind consumption as such, but would presumably treat it as income when: (1) inclusion is enforceable, and (2) the value of the consumption can be objectively determined. 61 . examples include imputed income and other benefits received in non-market transactions, in-kind support received by a dependent, in-kind benefits received from the government, working-condition fringe benefits (irc § 132(a)), other fringe benefits that have been excluded under the “convenience of the employer” doctrine and its statutory successors (the history is described in commissioner v. kowalski, 434 u.s. 77 (1977)), and “incidental benefits” (such as receiving business entertainment, recruiting trips, and promotions), see united states v. gotcher, 401 f.2d 118 (5 cir.1968).th 62 . generally, in-kind consumption should be included in gross income where it is judged to be the equivalent of the receipt of cash followed by a free, or lightly constrained, spending choice. such a situation would likely arise where the parties are quasi-related and inkind consumption can be transferred in satisfaction of a liability or obligation or in exchange for goods and services. 63 . an example is free samples, which are not included in gross income unless treated as “wealth.” see haverly v. united states, 513 f.2d 224 (7 cir. 1975), (free sample includedth where deduction claimed for donating it to charity); g.c.m. 36,639 (march 22, 1976) (suggesting that unsolicited books are gross income when placed in one’s library). compare g.c.m. 36,865 (sept. 29, 1976) (books that employee requested from employer and then donated to charity were gross income when received). 702 florida tax review [vol. 4:10 it is one thing to argue that self-created personal assets “could” be treated as excludible in-kind consumption, and it is quite another to argue that it “should” be so treated. a conceptual approach to justification would start with the proposition that the value of self-performed services is non-income (a form of excluded “imputed income”). self-created personal-use property simply is a particular embodiment of the excludible value of self-provided services that happens to produce a flow of satisfactions over a period of time, rather than all at once. another theory is that self-provided services (including the creation of personal-use assets) is a substitute for leisure, which is not included. 64 yet again, the justification for excluding the value of self-created personal-use assets is that they are not obtained in a “market transaction.” 65 this approach bases the exclusion on one or more of the following: (1) an inclusionary rule would be unenforceable, (2) an exclusionary rule would tend to impinge upon personal autonomy by directing all human activity to the market, and (3) a self-created asset would not entail the “withdrawal” of66 anything from “society.”67 finally, taxing self-provided services (and self-created personal use assets) would tend to be regressive, because these activities are more likely to be engaged in by low-income groups.68 some of these arguments seem somewhat akin to the argument that pain-and-suffering damages should be excluded from gross income because they are a “substitute for” some untaxed good, such as the capacity to enjoy a normal life. unlike others, i am skeptical of this kind of argument: converting69 a non-taxed item to cash is analogous to performing personal services for wages. thus, i don’t happen to buy the “substitute for leisure” argument. but70 64 . see h. simons, supra note 20, at 110-11. 65 . see supra text accompanying note 23. 66 . see alvin warren, would a consumption tax be fairer than an income tax?, 89 yale l.j. 1081, 1114-1117 (1980); gunn, supra note 59, at 382 (all arguing against taxing accessions to human capital and in favor of deferring services income until realization). 67 . henry simons appears to base the market-transaction principle on all of these theories. see h. simons, supra note 20, at 51 and 110. the last theory may be circular, or redundant with the second theory, since the item is not “in” society because it has not been offered in the market. however, simons appears to have adopted the market-transaction principle somewhat reluctantly and to have emphasized its value as a principle of measuring income in terms of market prices rather than subjective utility. 68 . henry simons ultimately favored excluding the value of self-provided services while including imputed income from homes but largely on equity (progressivity) grounds. see id. at 110-22. accord, michael j. mcintyre, “what should be redistributed in a redistributed income tax? retrospective comments on the carter commission report,” in w. neil brooks (ed.), the quest for tax reform: the royal commission on taxation twenty years later (1988). simons did not appear to address the issue of self-created personal-use assets. 69 . see sol. op. 132, i-1 c.b. 92 (1922) (damages for alienation of affection); jennifer j.s. brooks, developing a theory of damage recovery taxation, 14 wm. mitchell l. rev. 759 (1988). 70 . see joseph m. dodge, taxes and torts, 77 cornell l. rev. 143, 152-53 (1992). 2000] applying the “claim of right doctrine” to found objects 703 the situations are somewhat dissimilar. pain-and-suffering damages occur in a market transaction (broadly defined) and are payable in cash, and therefore are akin to wages. self-created personal-use property, on the other hand, has a dual capacity: it is an asset, but the asset provides consumption benefits in kind, and these benefits derive partly from the non-deductible costs of raw materials and equipment and partly from the value of self-provided services. even conceding a self-created personal-use asset to be “wealth,” there would still be the problem of “realization.” self-created personal-use property entails more than de minimis investment, so that any “accession to wealth”71 resulting from the creative process can be viewed as unrealized appreciation and/or unrealized labor income. in other words, self-created personal-use property, as in the case of self-created inventory, would not give rise to any income until (if ever) such income is realized by a sale or exchange.72 at the level of economic theory, taxing self-created personal-use property upon completion could have three possible effects: (1) forcing taxpayers into market activity (selling their services or products), (2) forcing taxpayers into nontaxed activity (self-provided services or leisure), or (3) having little effect on taxpayer behavior. this is ultimately an empirical question, but the second possibility intuitively seems most likely if one assumes that the tax on self-created items were enforced. in that case, nothing useful would be accomplished by taxing self-created personal-use property. the third possibility (inelasticity) is the most plausible, because an inclusionary rule could not realistically be enforced. thus, only the first, and least likely scenario, advances the efficiency argument for taxing self-created personal-use assets. the position that self-created personal-use property is not income (unless and until realized) finds doctrinal support in the authority holding that self-grown crops are not income if consumed by the taxpayer. 73 similar considerations apply to “taken” personal-use property. here the analogy to imputed income from self-provided services is less compelling, but there is still investment of capital and labor by the taxpayer. that such property is obtained by an investment that is below the property’s fair market value is no reason to tax the gain prior to realization. the borderline between commercial ventures and casual or hobby activities is not always clear, but this distinction should not be relevant to the realization issue. if the self-obtained property has a value in excess of “cost” (broadly conceived), it looks like a gain-seeking venture, discussed above, such that the gain should be taxed only when realized. indeed, even non-profitable 71 . even self-grown crops require seeds, fertilizer, water, plows, and so on. 72 . in helvering v. horst, 311 u.s. 112, 115-17 (1940), there is language that can be construed to equate “realization” with “enjoyment.” however, that case was about income attribution, and the ultimate rationale appears to be that income is taxed to the person who controls the enjoyment of the income, rather than the person who actually enjoys the income. indeed, the realization event in horst was the taxpayer’s disposition of an income right. thus, the word “enjoyment” as used in horst cannot be equated with “utility” derived from ownership. 73 . see morris v. commissioner, 9 b.t.a. 1273 (1928). 704 florida tax review [vol. 4:10 speculative activities (with or without an obvious personal-pleasure flavor), such as small-scale prospecting and salvage operations, would normally be treated as for-profit ventures.74 in the typical pleasureable hobby activity involving saleable selfobtained property, it is likely that the costs of pursuing the activity will exceed the value of the product or harvest. hobbies like hunting, fishing, photography, casual production of arts and crafts, rock hounding, butterfly collecting, etc., entail significant costs that in most cases would exceed the net market value of the harvest. the excess of hobby-activity deductions over realized hobbyactivity gross income is currently disallowed under internal revenue code section 183(a). where the self-obtained property is never sold, there would be no need to account for disallowed costs. however, a deemed-realization rule would require taxpayers to account for costs at the time of completion. but, if proper accounting showed a loss (which would usually be the case), the exercise would be pointless. in short, a deemed-realization rule would impose burdensome and unnecessary administrative costs. 75 it is true that optimal taxation theory suggests that activities undertaken for personal motives (true hobby activities) can be taxed more heavily than gain-seeking activities, since the former are more inelastic than the latter. but, of course, the borderline between hobby and for-profit activities is often difficult to draw. speculative ventures may fall on the for-profit side of the76 line despite repeated failures, as do activities that actually produce a profit. 77 78 mark-to-market taxation of profitable outcomes from marginal activities would be inferior, because of difficulties in enforcement, to permanently disallowing not only the net losses from such activities, as is currently the case under section 183(a), but also disallowing the deductions that are currently allowed by section 183(b)(2). in conclusion, there are reasonable arguments for the position that, in a realization system, self-created (and taken) objects should not be treated as giving rise to gross income until sale, etc. that is certainly the rule of positive law. 74 . see regs. § 1.183-2(a) (“small chance of making a large profit” is consistent with objective of making a profit). 75 . cf. irc § 263a(h) (waiving capitalization rules for free-lance authors, artists, and photographers). in addition, in some of these situations, such as amateur art and crafts, the value would be very low since there would be no established market for the items. 76 . see regs. § 1.183-2. the case outcomes under irc § 183(c) show no consistent pattern. compare nickerson v. commissioner, 700 f.2d 402 (7 cir. 1983) (weekend farmer heldth to be in for-profit activity); golanty v. commissioner, 72 t.c. 411 (1979), aff’d 647 f.2d 170 (9 cir. 1981) (opposite result); hawkins v. commissioner, 38 t.c. memo (cch) 469 (1979),th aff’d without opinion, 652 f.2d 62 (9 cir.1981) (legal secretary writing a book of verse held toth be in not-for-profit activity). 77 . see supra note 74. 78 . see irc § 183(d) & (e); regs. § 1.183-2(b)(6). 2000] applying the “claim of right doctrine” to found objects 705 3. true windfalls the term “windfall gains” is somewhat redundant: since obtaining a windfall (by definition) entails no significant investment or effort, the result must be an “instant” in-kind gain that suffers no doctrinal impediment to being treated as gross income. that is, the windfall gain is not (nor analogous to)79 unrealized appreciation. nor are windfall accessions to wealth “imputed income” as that term is usually used, i.e., in the sense of income from self-provided services or selfowned personal-use assets. indeed, imputed income, whether meaning a “flow80 of satisfactions” or as “hypothetical market income” is distinct from material wealth. there is no categorical doctrinal exclusion for “nonmarket transactions.” at the level of theory, the “market transaction” idea does not81 rule out taxing clear accessions to wealth, regardless of source. unlike psychic82 benefits and imputed income, in-kind windfalls do not pose any unique valuation problem. moreover, the concept of “market transaction” is ambivalent as it applies to found or discovered property. many found objects exist in nature; many others were “left there” by another party. it is settled that obtaining cash or property by theft or embezzlement is gross income notwithstanding the lack of a market transaction in the conventional sense. 83 there is no apparent distinction between found property that was lost, misplaced, hidden, or abandoned, on the one hand, and stolen property, on the other, as far as the person obtaining the item is concerned. indeed, the distinction between “finding” and “stealing” is doctrinally meaningless and, in some instances, factually nonexistent (as where a tourist loots a legallyprotected archaeological site). in addition, it would be unseemly to have a rule excluding found objects when the most common category of in-kind windfalls, namely, prizes and awards, is clearly includable. the only possible distinction between the84 two cases is that of enforceability. but it would be odd indeed if nonenforceability with respect to windfall found objects were alone sufficient 79 . the term “windfall” is not limited to found objects (and prizes and awards), but may include windfall gains arising out of transactions (such as the commercial bargain purchase or unearned rents). see kades, supra note 42, at 1504. however, since i am not proposing any surtax on windfalls over and above any applicable normal tax, it is not necessary for tax purposes to formulate an economically sophisticated definition of “windfall.” 80 . see supra note 19. see also helvering v. independent life ins. co., 292 u.s. 371 (1934) (dictum). 81 . see regs. §§ 1.61-1 and –14. 82 . see supra text accompanying notes 23 and 24. 83 . james v. united states 366 u.s. 213 (1961) (cash); collins v. commissioner, 3 f.3d 625 (2d cir.1993) (off-track betting tickets). 84 . see irc § 74(a). 706 florida tax review [vol. 4:10 to give rise to a rule that windfall found objects are excludable. whether a85 clear inclusionary rule that is difficult to enforce should be publicly abandoned or allowed to lie fallow is dealt with in part iv.e. iii. realization of in-kind income the line between windfall gains, which give rise to current taxation, and gains produced by commercial ventures, taxation of which is deferred until realization, is principled and relatively easy to apply. arguing that the realization principle is unjustified in theory, and therefore that it should be86 construed as narrowly as possible (so as to tax commercial bargain purchases and self-obtained property), is too facile a move, since it obscures the merits of particular issues and of the consequences of redrawing established lines of distinction. a person might argue the alternative position that the same reasons87 that underlie the exclusion of unrealized appreciation can be extended to in-kind windfalls. the doctrinal theory for this position would be that not only “gain” but also “gross income” must be “realized.” that gross income must be “realized” is stipulated in the well-known glenshaw glass case, as well as in88 regulations section 1.61-1(a). neither authority sheds any light on what “realization” means. this part raises the issue of whether, or when, the realization principle might actually be deployed so as to defer the recognition of in-kind windfall gains. a. realization of income through the eisner v. macomber period in the very early 1913-1921 period of the modern income tax, many important doctrinal issues were unresolved. at this time there was a strong89 85 . one might avoid the obvious horizontal equity problem by excluding all in-kind windfalls, including prizes, awards, and raffle winnings, but that would truly be a case of the tail wagging the dog. 86 . i have advocated in print mark-to-market taxation of publicly traded securities, see joseph m. dodge, a combined mark-to-market and pass-through corporate-shareholder integration proposal, 50 tax l. rev. 265 (1995), and would probably favor a mark-to-market approach to derivatives. i also favor treating gratuitous transfers of nonliquid property as deemed realization events. see joseph m. dodge, further thoughts on realizing gains and losses at death, 47 vand. l. rev. 1827 (1994), excerpts reprinted in p.caron et al., federal wealth transfer tax anthology 373 (1997). 87 . for a discussion of the lines drawn by current realization (and recognition) doctrine, see daniel n. shaviro, an efficiency analysis of realization and nonrecognition rules under the federal income tax, 48 tax l. rev. 1 (1992); weisbach, supra note 18. see generally, david m. schizer, realization as subsidy, 73 n.y.u. l. rev. 1549 (1998). 88 . supra note 6. 89 . the unresolved issues included virtually everything having to do with basis, whether casual capital gains were income, the amount of the charitable contribution deduction with respect to property, whether exchanges of property were realization events, and the status of recoveries for personal injuries. all of the issues were dealt with by regulation prior to being dealt with by statute. see revenue act of 1918, § 202(a), 40 stat. 1057 (first appearance of rules 2000] applying the “claim of right doctrine” to found objects 707 constituency for the proposition that “realization” required conversion to cash, but there was also support for the “accretion” ideal. with the passage of time, a “compromise” position evolved with respect to the notion of “realization of gain,” so that “cash” was diluted first to “property that is the equivalent of cash,” and then to “property having an ascertainable fair market value.” in the90 case of realization of gain upon the disposition of property, this movement away from a strict cash requirement was limited by eventual acceptance of the opentransaction doctrine, derived from the early case of burnet v. logan, which91 applies to sales for contingent-payment consideration. 92 in the “realization of income” situation (not involving a disposition of property), the seminal case is, of course, the 1920 case of eisner v. macomber,93 which held that a pro-rata stock dividend was beyond the power of congress to tax, because: (1) “income” necessarily implied realization; (2) “realization” required severance of the “fruit” from the “tree” (the underlying investment); and (3) a pro-rata stock dividend wasn’t “fruit” (income) in the first place, but rather a reconstituted portion of the tree. the first two of these holdings, and perhaps the third, were overturned by the 1940 case of helvering v. bruun,94 and in any event the third holding is irrelevant to the case of found property, since it cannot be said to be “part” of any underlying investment. the macomber case, significantly, did not hold that “realization” required the receipt of “cash” or “cash equivalent.” eventually, the stock-dividend issue was settled by the enactment of internal revenue code section 305. b. lessee improvements the next realization-of-income case of general interest is the 1938 case of m.e. blatt co. v. united states, where the government attempted to tax a95 landlord on building improvements erected by the lessee in the year the purporting to define basis and amount realized); taft v. bowers, 278 u.s. 470 (1929) (discussing evolution of basis rules for gratuitous transfers); marjorie e. kornhauser, the origins of capital gains taxation: what’s law got to do with it?, 39 sw.l.j. 869 (1985); marjorie e. kornhauser, section 1031: we don’t need another hero, 60 so.cal.l.rev. 397, 400-407 (1987) (realization and recognition). 90 . see kornhauser, supra note 89, 60 so. cal. l. rev. at 401-02. 91 . 283 u.s. 404 (1931). see also helvering v. tex-penn oil co., 300 u.s. 481 (1937) (corporate reorganization). section 202(e) of the revenue act of 1921, pub. l. no. 67-98, 42 stat. 227, codified (until the revenue act of 1924) the idea that the amount realized was the “readily ascertainable fair market value” of property received. 92 . there is no need here to consider the line of cases dealing with the issue of when an “exchange” might not be a realization event on the theory that the property received is essentially the “same” as the property given up. see cottage savings ass’n v. commissioner, 499 u.s. 554 (1991) (adopting an expansive concept of realization in exchanges), and cases discussed therein. 93 . 252 u.s. 189 (1920). 94 . 309 u.s. 461 (1940), see infra text and note 97. 95 . 305 u.s. 267 (1938). 708 florida tax review [vol. 4:10 improvements were completed. the court held that the improvements were96 neither rental income (because not stipulated to be rent) nor “residual” gross income. on the latter issue, the court made the following holdings: (1) the improvements (painting, certain fixtures, ventilation system, and architect’s fee) would have no value if detached from the building; (2) insofar as the improvements increased the value of the building, the result was unrealized appreciation; (3) insofar as the improvements would have no value at the end of the lease term, they could not be income prior to the end of the lease term; and (4) that insofar as the improvements would possess value as of the termination of the lease, there was no realization of income or gain prior to such time because the lessor could neither use nor dispose of the improvements until the lease terminated. two years later, in 1940, the supreme court in the bruun case held,97 inter alia, that the receipt of a building by a lessor upon the expiration of a lease gave rise to residual income equal to the then value of the building, even98 though property of this sort is hard (if not impossible) to value, and is quite illiquid insofar as it is “attached” to the land. on the merits, nonliquidity should not be a basis for a court deciding that an in-kind accession to wealth is not income. the concept of “nonliquidity” is indeterminate: the concept of illiquid property ranges from property that is marketable but where valuation is imprecise (such as real estate, the sale of which also entails significant transaction costs) to property that has no market but conceivably might be sold as the result of direct solicitation (such as a closely held business interest). moreover, the causes of nonliquidity are varied, and include imperfect market information, lack of a market mechanism, and legal inhibitions on alienation. any attempt by courts to draw lines according to “degree” of nonliquidity (or difficulty of valuation) would only create uncertainty. bruun clearly overrules two of the holdings of the blatt case. after bruun, it is clear that there is income when another party directly adds to the taxpayer’s physical capital. also, it is irrelevant whether the addition can be99 detached or severed from the taxpayer’s original investment. and, as mentioned above, difficulty of valuation and relative illiquidity were no bar to inclusion in 96 . the government’s theory of the case was faulty: the amount includable, according to the government, was the lessee’s cost reduced by the accounting depreciation that would have accumulated as of the end of the lease term. such includable amount was to be pro-rated in gross income over the remaining lease term. the correct valuation approach would have been the present discounted value, as of the completion of the improvements, of the estimated fair market value of the improvements at the end of the lease term. 97 . helvering v. bruun, 309 u.s. 461 (1940). 98 . in a somewhat confusing passage, the court seemed to hold that the stipulated gain was income if it represented either the value of the building (whether or not such building was readily removable from the land) or the enhancement in value of the property attributable to the building, in each case as of the date the lease was cancelled. see 309 u.s. at 467-68. 99 . if another person indirectly adds value to the taxpayer’s investment (such as where the state builds a freeway interchange near the taxpayer’s land), the resulting enhancement in value to the taxpayer’s investment is treated as unrealized appreciation. 2000] applying the “claim of right doctrine” to found objects 709 bruun. what remains are two factors. the first is that in blatt the lessee, not the lessor, had current possession and use of the item. possession by another party would seem to indicate “lack of dominion and control,” but perhaps lack of current dominion and control is one form of “nonrealization.” the second relevant factor is that the improvements may or may not have been expected to survive the lease term. in other words, there was a condition precedent to future dominion and control. since blatt involved a future interest following a possessory interest in another that was contingent both as to coming into possession and value, it is not clear if any of: (1) futurity, (2) contingency as to possession, or (3) uncertain future value are alone sufficient to defeat current realization, or whether all must be present. 100 an analogous line of authority to blatt holds that a debtor does not realize income when a third party guarantees a debt, but only when the third party makes good on the guarantee. this situation involves a contingent101 future right, but there is no third-party possession as such. however, a bare contract right might be viewed as a weaker case for current realization than a contingent interest in property.102 in any event, the specific outcome of bruun was reversed by the enactment of internal revenue code sections 109 and 1019. c. employee compensation the issues of valuation, liquidity, and contingency were also played out in cases in the area of employee compensation prior to the enactment of section 83 in 1969. there are basically two lines of cases, one involving stock options, and the other involving restricted property. 1. employee stock options.—in the stock option situation, the two leading supreme court cases upheld the government’s attempt to tax the 100 . see also united states v. frazell, 335 f.2d 487 (5 cir.1964), cert. denied, 380th u.s. 961 (1965) (compensatory right to acquire interest in speculative oil properties upon the occurrence of a future contingency stipulated to be includable when interest became possessory). 101 . maher v. commissioner, 469 f.2d 225 (8th cir.1972), acq. rev. rul. 77-360, 1977-2 c.b. 86. 102 . an aberration in the realization doctrine occurs in the case of cash received in put and call options: the cash is not included in gross income when received despite the fact that there is no repayment contingency; rather, the transaction is held “open” until it is closed either by the lapse of the option or the transfer of the underlying property. see rev. rul. 71-521, 19712 c.b. 313. critical commentary on this approach is given in bruce kayle, realization without taxation? the not-so-clear reflection of income from an option to acquire property, 48 tax l. rev. 233 (1993); noel b. cunningham & deborah h. schenk, taxation without realization: a “revolutionary” approach to ownership, 47 tax l. rev. 725 (1992); calvin h. johnson, taxing the income from writing options, 73 tax notes 203 (1996). this aberration derives from being unable to determine the character of the income until the transaction is closed. in any event, it has more to do with “realization of gain” than with “realization of [in-kind] income.” 710 florida tax review [vol. 4:10 “spread” between the option price and the fair market value of the stock at the exercise date. in the 1945 smith case, there was no spread on the date the103 options were issued, and hence there could have been no compensation income at that time. nevertheless, the court held that the spread on the exercise date was “compensation” because the employer, upon issuing the options, contemplated the possibility of a future spread. also, the treasury had issued regulations holding that a bargain purchase of employer property by an employee was income if it was in the nature of compensation. 104 in the 1956 lobue case, the court rejected the taxpayer’s attempt to105 invoke the commercial-bargain-purchase exclusion on the ground that the compensation situation is not an arms-length purchase in commerce. the taxpayer’s principal contention in lobue was that the compensation, if any, occurred when the options were issued, not when they were exercised. the court said that this was a theoretical possibility, but not for this taxpayer, since the options in question were nontransferable, lacked a “readily ascertainable” fair market value, and were subject to conditions precedent and subsequent. the court endorsed the treasury’s practice since 1923 of deferring taxation until the exercise date unless the options possessed a readily ascertainable fair market value when granted. this line of cases might be construed to support the view, contrary to bruun, that the receipt of in-kind property does not give rise to realized income if the property is not transferable or if it is hard to value. however, this deferral of realization rule was promoted by the treasury, not taxpayers, and for strategic reasons: such factors as nontransferability and the existence of contingencies would drastically reduce the value of an option, and the absence of a current spread might eliminate value entirely, resulting in a zero or small106 inclusion of compensation income, with all subsequent appreciation being capital gain. the “readily ascertainable fair market value” test has now been107 codified, and the regulations, emphasizing “readily ascertainable,” construe108 103 . commissioner v. smith, 324 u.s. 177, reh’g denied, 324 u.s. 695 (1945). 104 . regs. § 101, art. 22(a)(1). 105 . commissioner v. lobue, 352 u.s. 859 (1956). 106 . the “old” view was that an option could have no (or negligible) current value if there was no current “spread” between the option price and the current fair market value of the underlying property. this view is now obsolete. see fischer black & myron scholes, the pricing of options and corporate liabilities, 81 j. pol. econ. 637 (1973), and the valuation of option contracts and a test of market efficiency, 27 j. fin. 399 (1972). 107 . the assumption has always been that there can only be one “compensation” event, subsequent to which the employee has converted to “investor” status. the logic of this position escapes me. it would seem that any transfer of value from an employer to an employee can be treated as compensation. nevertheless, the only-one-compensation-event approach was codified in irc § 83(e)(3) and (4). 108 . irc § 3(e)(3). 2000] applying the “claim of right doctrine” to found objects 711 the test so narrowly as to render deferral of compensation the usual result except where the option is actively traded on an established market.109 in short, the stock option cases may stand for the proposition that difficulty of valuation is alone sufficient to defer realization. on the other hand, these cases may be sui generis, being based on acquiescence in the treasury’s willingness to concede deferral except in cases of maximum liquidity. moreover, the deferral of realization is only until the option is exercised (or allowed to lapse), as opposed to when the stock obtained by such exercise is sold. 2. vested vs. nonvested in-kind compensation.—in the case of property other than stock options, doctrinal development more closely conforms to an early-realization model. in the 1947 ward case, it was held that an employee110 receiving a future interest (an annuity contract) had current income, since the annuity contract was both vested and assignable. “dominion and control” was not an issue: the taxpayer acquired a property right, and no third party had a current possessory interest. the 1950 drescher case took matters a long step111 further in holding that a vested future interest (again an annuity contract) was current income even though it was not assignable. the drescher result accords with the “economic benefit” doctrine sanctioned in the 1951 sproull case. the economic-benefit doctrine covers112 the situation where: (1) cash is placed in a trust or escrow for future distribution to the taxpayer, (2) the taxpayer’s rights in the trust or escrow are fully vested, and (3) (debatably) the cash is to be invested. there is no requirement that the113 taxpayer’s interest be alienable. these cases establish seemingly in contrast to the stock option cases that even total illiquidity, along with attendant difficulties of valuation, is not, standing alone, a bar to current realization of in-kind gross income. it might114 be argued that these authorities are confined to the “compensation” situation, since the latter is an enumerated category of gross income that is to be broadly 109 . see regs. § 1.83-7. an option (not actively traded on an established market) might not have a readily ascertainable fair market value even if the option is transferable, not subject to contingencies, and is exercisable immediately, because an option can possess value over and above the date of grant spread due to the “option privilege.” see supra note 106. under regs. § 1.83-7(b)(3), the option cannot possess a readily ascertainable fair market value unless the value of this option privilege “can be measured with reasonable accuracy.” 110 . ward v. commissioner, 159 f.2d 502 (2d cir.1947). 111 . united states v. drescher, 179 f.2d 863 (2d cir.1950). 112 . sproull v. commissioner, 16 t.c. 244 (1951). 113 . see reed v. commissioner, 723 f.2d 138 (1 cir.1983). imposition of anst investment requirement seems incorrect, since the absence of a duty to invest the cash simply reduces the current value of the taxpayer’s interest, just as the lack of transferability reduced the value of the taxpayer’s annuity in drescher. 114 . in drescher, the annuity had to be reduced to present value and then was to be further discounted on account of nonliquidity. 712 florida tax review [vol. 4:10 construed. it is true that “compensation” is broadly construed, but it must be115 noted that the “economic benefit” doctrine exists outside of the employee compensation area. therefore, the drescher holding should likewise extend116 beyond the compensation area. it might be argued that the economic-benefit doctrine is distinguishable because that doctrine “belongs” in the realm of cash-method accounting, rather than in that of “realization.” but the cash method can be viewed as a statutory resolution of the “realization” issue limited to cases where rights to future cash are acquired. the cash method has never been viewed as allowing deferral117 with respect to in-kind property income. the economic-benefit doctrine can118 be viewed as a determination that a funded right to future cash is “property” rather than the sort of right to future cash that yields deferred realization under the cash method. only unfunded rights to future cash entail deferred taxation119 under the cash-method doctrine. it is hard to imagine one “finding” an120 unfunded right to future cash. a bearer bond, or gold bullion, would be viewed as in-kind property. to continue the discussion of compensation received in the form of property, the 1952 kuchman case held that an employee did not have gross income on the receipt of property that was subject to a substantial risk of forfeiture, on the theory that such property would have no fair market value. 121 presumably, no rational person would purchase such property where the forfeiture condition “follows the property” and where the occurrence of the forfeiture condition is under the control of one or more third parties. any value assigned to such an interest would be pure guesswork, and any such investment would be a gamble. 115 . see regs. § 1.61-2(d). 116 . see kuehner v. commissioner, 214 f.2d 437 (1954) (stock sale proceeds); reed, supra note 113 (real estate escrow); pulsifer v. commissioner, 64 t.c. 245 (1975) (lottery winnings). the economic benefit doctrine has been codified in the deferred compensation area. irc § 402(b)(1). 117 . the cash method is authorized by irc § 446(c)(1). 118 . see regs. § 1.446-1(c)(1)(i). 119 . application of the economic benefit doctrine would not necessarily require inclusion of a (nongratuitous receipt of a) remainder interest in trust. a vested remainder in trust implies a current possessory interest in another party, a factor which is not present in the compensation situation. the fact of a possessory interest in another party might preclude realization on the theory that the taxpayer lacks “dominion and control.” however, if the remainder is vested, the remainder interest should be sufficiently noncontingent and capable of valuation to satisfy the test of “realization.” compare rev.proc. 92-64, 1992-2 c.b. 422 (economic benefit doctrine defeated where, in deferred compensation “rabbi trust,” the employer’s creditors, and vicariously the employer, have a contingent interest in the trust, the exercise of which would defeat the employee’s rights). 120 . see regs. § 1.83-3(e) (employee compensation). 121 . kuchman v. commissioner, 18 t.c. 154 (1952) (reviewed) (acq.). 2000] applying the “claim of right doctrine” to found objects 713 other cases have reached a similar result where the compensation took the form of a contingent right (unrelated to forfeiture conditions), such as a pure profits interest in speculative property.122 this deferred-realization approach for contingent property has been codified in the compensation area by internal revenue code section 83(a).123 the section 83 approach can be critiqued, or at least viewed as being idiosyncratic. the restricted property situation is properly characterized as “current ownership and possession subject to a condition of divestiture,” whereas the blatt (lease) situation involved a non-possessory interest subject to a condition precedent. the problem of valuation could be finessed by124 including the value of the restricted property without regard to forfeiture conditions, and then allowing a deduction for the basis thereof if and when the property is subsequently returned. this approach is followed in the case of the receipt of forfeitable cash outside of the compensation area, as is explained in part iii, as well as where an employee makes an election under section 83(b) to currently include the forfeitable property in gross income. the question of125 whether that approach should be extended to (noncompensatory) in-kind property receipts in general and to found objects in particular is dealt with in part iv. iv. a “borrowing” model for receipts involving doubtful title insofar as generalizations can be made across transactional categories, it is reasonable to claim that “nonrealization” is limited to cases where the taxpayer lacks current enjoyment, dominion, and/or control over the property and/or where ultimate enjoyment of in-kind property is significantly contingent on future events. on the other hand, neither mere difficulty of valuation nor a 122 . see vestal v. united states, 498 f.2d 487 (8 cir.1974).th 123 . irc § 83(a) also makes clear that the lapse of such forfeiture conditions is a realization event. compare lehman v. commissioner, 17 t.c. 652 (1951) (reviewed) (contrary result under prior law). in lehman, the tax court held that the lapse of a forfeiture condition could not give rise to income that could be called “compensation” because the then value of the stock might bear no relation to the value of the services rendered; otherwise, the increase in value to the date of lapse was simply unrealized appreciation. lehman seems contrary to the spirit, if not the letter, of smith and the later lobue case. cf. also boston consol. gas co. v. commissioner, 128 f.2d 473 (1 cir.1942) (unclaimed deposits became gross income whenst statute of limitations for their refund expired). in addition, if the reason for deferral of income is impossibility of valuation, and if the lapse of a forfeiture condition removes such difficulty, then such lapse should mark the realization of income. the treasury subsequently issued regulations to reverse the lehman result. regs. § 1.421-6, t.d. 6416, 1952-2 c.b. 126. these regulations were confirmed (and superseded) by the enactment of irc § 83(a) in 1969. 124 . an analogous situation to blatt would be a promise to make a future transfer property to the taxpayer if certain conditions precedent were satisfied. in that case, deferral of income would arguably be proper. 125 . irc § 83(a)(1) (amount includable computed with regard to fair market value unreduced by forfeiture conditions). 714 florida tax review [vol. 4:10 prohibition on alienation preclude realization upon initial receipt. all of this is consistent with doctrine in the “realized gain” area.126 the crucial issue here is whether, outside of section 83, the forfeitability of property is the kind of contingency that would preclude current realization when the taxpayer first obtains the property. the leading noncompensation case involving the forfeitability of cash is north american oil consolidated v. burnet, decided in 1932, which held that the receipt of a cash127 damages award was current income notwithstanding the possibility that the cash might have to be refunded if the taxpayer lost on appeal. the “claim-of-right” idea was so literally followed by the supreme court in the 1946 wilcox case as to produce an exclusion for embezzled cash. the 1952 rutkin case limited128 wilcox to “void title” cases. in rutkin, an extortionist was held to have129 obtained gross income notwithstanding having “voidable” title. the wilcoxrutkin distinction was swept aside by the 1961 james case, which held that,130 legal subtleties notwithstanding, a person has gross income when receiving cash unless there is a consensual obligation to repay. the james approach is normally treated as delimiting the “borrowing exclusion,” as opposed to dealing with “realization.” but there really is no131 essential distinction between the two doctrines. thus, one can describe a conventional borrowing as a “nonrealization of income” event on account of the absolute obligation to repay; “realization of income” occurs if, when, and to the extent that the repayment obligation is subsequently cancelled. 132 regulations section 1.61-14, which was promulgated in 1957, prior to the supreme court decision in james, states that treasure trove is gross income in the year that it is “reduced to undisputed possession.” this approach seems to echo wilcox, which was undermined by rutkin and overruled by james. the irs did not withdraw its acquiescence in wilcox until 1962. 133 the approach set out in james seems to be suitable for found cash as well as stolen cash, since the two situations present near-identical scenarios. applying james to in-kind cash windfalls results in a finder’s having income 126 . see warren jones co. v. commissioner, 524 f.2d 788 (9 cir.1975) (cash-th method taxpayer must treat in-kind property as “amount realized” at its fair market value even if property is not “cash equivalent”); regs. § 15a.453-1(d)(2)(ii)(a) (open-transaction reporting allowed only for contingent payment obligations whose value cannot be readily ascertained). a special case is the “pool of capital” (nonrecognition) doctrine in the oil and gas area. see walter schwidetzky, the pool of capital doctrine: a peace proposal, 61 tul. l. rev. 519 (1987). 127 . 286 u.s. 417 (1932). 128 . commissioner v. wilcox, 327 u.s. 404 (1946). 129 . rutkin v. united states, 343 u.s. 130 (1952). 130 . see james v. united states, 366 u.s. 213 (1961) (embezzled party had right to recoup funds embezzled by taxpayer). 131 . the possibility of having to refund the item to its true owner does not really raise a “lack of dominion and control” issue, despite gratuitous statements apparently to the contrary made in commissioner v. indianapolis power & light co., 493 u.s. 203 (1990). 132 . see irc § 61(a)(12). 133 . rev. rul. 61-185, 1961-2 c.b. 9, revoking g.c.m. 24945, 1946-2 c.b. 27. 2000] applying the “claim of right doctrine” to found objects 715 upon taking possession of the cash, notwithstanding a possibility that the cash might have to be turned over to another, unless the finder immediately agreed to turn over the cash to a claimant (or possibly into an escrow pending ultimate disposition of the claim).134 v. can james be applied to windfall found objects? despite james, the “reduced to undisputed possession” language in section 1.61-14 would appear to control in the case of found cash and property, or at least of “treasure trove.” to discern a proper construction of “reduced135 to undisputed possession,” it is desirable to look first at the relevant law of personal property, before trying to settle the issue of tax doctrine. a. property-law status of found items herein is a brief description of personal property law as it applies to found items. the law turns out to be quite complex and unclear in application. generally speaking, “finder’s keepers” is not the prevailing rule. “finder’s keepers” is the prevailing rule only for abandoned items, as well as for fish and game. however, the finder’s title may be superseded by that of the private landowner or of the state, due to trespass or a violation of law or regulations. abandoned property would not be a significant income tax136 137 category in any event, since abandoned property is likely to have little intrinsic or net salvage value (or else it would have been sold by the original owner). as to “lost” (as opposed to abandoned) items, a finder who takes possession has good title against all persons except the owner. but a finder’s right to possession is inferior to the landowner’s if the finder is a trespasser, as may also be the case if the finder is an invitee or licensee.138 134 . my research has failed to uncover any dispute in which a taxpayer attempted to exclude, or defer realization of, income with respect to a windfall found object pursuant to the “reduced to undisputed possession” language of regs. § 1.61-14. 135 . see commissioner v. estate of hubert, 117 s.ct. 1124 (1997) (tax treatment of certain estate administration expenses governed by treasury regulation, as construed by the supreme court, in absence of clear resolution under the code). 136 . see r. brown, the law of personal property (3d ed. w. rauschenbush) (1975) §§ 1.6, 2.1, 2.2, and 2.4 (hereinafter referred to as brown). 137 . to be “abandoned,” there must be an intent to abandon, which might be shown by facts indicating that the owner made no attempt to recover an item. there is probably no such thing as “abandoned” cash. 138 . see id. at §§ 3.1 and 3.3. 716 florida tax review [vol. 4:10 next, as to “misplaced” items, the finder’s title is inferior not only to139 that of the owner but also to that of the owner of the premises where the item was misplaced. 140 a fourth category is “treasure trove,” meaning “gold or silver in coin, plate, or bullion [that] is found concealed in a house or in the earth or other private place, the owner thereof being unknown.” note that “treasure trove”141 refers only to cash and cash-like property. in england treasure trove escheats to the state, but in the united states it is usually treated as abandoned, lost, or misplaced, as the case may be. it is worth noting the treasure-trove category142 is quite narrow. it does not include treasure recovered from the sea, the shore, or other public place. finally, the ownership of found (or stolen) items may be the subject of statute and, especially in the case of cultural property, international143 agreement. 144 in sum, except for abandoned objects and objects that have no owner, the finder’s “title” is subordinate to that of the true owner (or possibly the state), and his or her right to possession may be inferior to the owner of the property where the item was found. thus, in general, the finder has the duties of a gratuitous bailee, and can be forced to return the item to the true owner in good condition. if the finder sells the item to a third party, the purchaser may (or145 may not) acquire valid title as a bona fide purchaser without notice, but the146 finder-seller would be liable (civilly and criminally) for conversion. despite the foregoing, the finder may obtain title against the owner after the running of the 139 . a “misplaced” item is an item set aside by the owner, who then forgets to pick it up. thus, a diamond ring left on a dressing table in a hotel would be misplaced, whereas a diamond ring that washed down the shower drain would (presumably) be lost. 140 . see brown, supra note 136, at § 3.4. 141 . see brown, at § 3.3. 142 . see id. 143 . these statutes, often of pre-civil war vintage, exist in about one-third of the states. typically, they provide that the finder of any object over a de minimis value post local notice of the finding; after the running of a period of time, and assuming that the owner does not appear, the finder can keep a portion of the value and the rest escheats to the state. apparently, these statutes are so rarely used as to be virtually a dead letter. see david riesman, jr., possession and the law of finders, 52 harv. l. rev. 1105, 1123-24 (1939). (the author, then a professor at what is now s.u.n.y. buffalo law school, is the same david riesman of the lonely crowd fame.) 144 . see unidroit convention on stolen or illegally exported cultural objects, june 24, 1995, art. 3(1), 34 i.l.m. 1322, 1331 [hereinafter unidroit convention] discussed in lyndel v. pratt, commentary on the unidroit convention (1997). see generally, lyndel v. prott & p.j. o’keefe, law and the cultural heritage (3 volumes, 1989) (describing state, national, and international law as it pertains to the excavation, theft, sale, etc., of art objects and other objects classed as “cultural heritage”). 145 . a bailee has a duty of care over the property, as well as the duty to return the property to the bailor. see brown, supra note 136, at §§ 11.1 and 11.7. 146 . under the unidroit convention, supra note 144, art. 3(1), the bona fide purchaser rule is abrogated, so that persons who possess objects covered by the convention have an unqualified obligation to return the item. 2000] applying the “claim of right doctrine” to found objects 717 statute of limitations (usually six years) if the finder’s possession is adverse to the owner. of course, the concept of “adverse” possession is highly factdriven.147 b. applying regulations section 1.61-14 to windfall found objects stated narrowly, the issue to be faced at this point is how to “construe” the language of regulations section 1.61-14 as to found items. my conclusions are: (1) courts should view the regulation as being ambiguous, (2) the regulation should be construed in light of james, and, (3) the james principle can and should be applied to property (as well as to cash). the meaning of the phrase “reduced to undisputed possession” is inherently ambiguous: in virtually all cases, possession (a physical fact) is held by one party. it is “title” (a legal fact) that would normally be “disputed.” in the context of the law of personal property, a “right to possession” is inferior to ownership but superior to possessory claims of other claimants. thus, a finder and the owner of the premises on which the property is found (or the state) might dispute possession, but whichever party prevails has inferior title to the owner. for that very reason, it is likely that disputes over possession would rarely be litigated in the courts. whether all of this learning is intended to have been encompassed by the phrase “reduced to undisputed possession” is somewhat speculative, since that phrase is not elaborated upon in either section 1.61-14 or the rulings that preceded it. indeed, it is doubtful that the regulation was drafted on the basis of a sophisticated understanding of personal property law, since the regulation refers to a category (“treasure trove”) that is not generally recognized by american law. also, as previously mentioned, the regulation was issued in the confused environment of wilcox and rutkin, prior to the clarification imported by james. thus, “undisputed possession” may have been a way of stating the now obsolete claim of right idea. whether one views the language in section 1.61-14 as being borne out of confusion as to both tax and personal-property-law doctrine, it should be construed, in light of james, in a literal fashion, i.e., to mean “possession (as opposed to title), except where possession (or title) is actually being disputed” (as opposed to being merely “disputable” in the abstract). c. forfeitable property outside of internal revenue code section 83 given the ambiguity of the regulation, it is pertinent to ask whether or not the james principle should apply to receipts of found (or stolen) property 147 . see brown, supra note 136, at §§ 4.1 and 4.2. for items covered by the unidroit convention, art. 3(3), the statute of limitations runs at the earlier to occur of (1) 50 years from the theft (etc.) or (2) three years from the owner’s discovery of the item’s location. 718 florida tax review [vol. 4:10 (as well as of cash), or whether such property should be treated as non-realized income until such time as the forfeiture conditions imposed by law lapse. 148 an advocate of deferred realization might argue on the basis of precedent, namely, the kuchman case, discussed earlier, involving forfeitable149 property received as compensation. one reply is that kuchman was superseded first by regulation and then by the enactment of internal revenue code section 83(a). more generally, there is a good reason to confine kuchman to the domain of employee compensation. in the employment area, it can be said that risks of forfeiture tied to employment render the income from the property as being “compensation” (income from human capital) until the forfeiture conditions lapse; thereafter, the employee converts from “employee” status to “investor” status with respect to the property. this particular status-shifting idea has no150 application to in-kind windfall receipts. another reason to distinguish (returnable) found objects from restricted property subject to deferred realization under section 83 is that, in the section 83 situation, the value of the restricted property would be unascertainable because potential assignees would be “on notice” of the forfeiture conditions.151 the same could not be assumed to be the norm in the case of found (or stolen) property. even in the case of found or stolen objects to which the bona-fidepurchaser rule would not apply, the possibility of forfeiture could be expected152 to be an element of risk that would reduce value rather than destroy it completely.153 thus, in-kind property income must be included, when realized, at its then fair market value. difficulty of valuation (that does not wholly destroy value) is not sufficient to cause deferred realization. the amount currently includable should be the “normal” market value of the property, as reduced by the possibility of forfeiture (which would be factored into market value). in the case of forfeitable property received as compensation, the conditions of forfeiture may be of a nature and significance as to render the property 148 . see comment, supra note 38, at 756 (posing issue of whether found object is included when found, when claimed (as of “right”), or when the statute of limitations has run against the loser.) 149 . see supra note 121 and accompanying text. 150 . see mark p. gergen, pooling or exchange: the taxation of joint ventures between labor and capital, 44 tax l. rev. 519, 544-50 (1989) (also arguing that difficulties of valuation are overrated and should not generally be a bar to realization of income or gain). 151 . see irc § 83(c)(2) (property is transferable only if transferee is free of forfeiture conditions). 152 . see supra note 146. illegal drugs are subject to seizure and forfeiture. see priv.ltr.rul. 92-07-004 (oct. 21, 1991) (illegal drugs included in gross estate at full value, despite possibility of forfeiture). 153 . cf. erickson v. commissioner, t.c. memo (p-h) ¶ 89, 552, aff’d, 937 f.2d 1548 (10 cir. 1991) (value of seized drugs lays basis for inference that taxpayer had unreportedth income with which to purchase same). presumably, the cost incurred by a drug dealer in obtaining illegal drugs contains a possibility-of-forfeiture discount. 2000] applying the “claim of right doctrine” to found objects 719 incapable of valuation in the employee’s hands, so that even the government154 might be better off under a deferred-realization rule. what scant authority exists correctly holds that the james principle extends to (stolen) property as well as to cash.155 the same analysis applies to the case of windfall found objects. if the finder fails to “disclaim” the item, or is not approached by the owner, within a reasonable (short) period of time, the finder should be treated as having “undisputed possession.” at this point, it seems unlikely that forfeiture will occur as a practical matter. the true owner is not likely to learn about the156 finding and the identity of the finder, and the finder is not (at that point) likely to seek out the owner. in short, the finder has possession and command over the found object. moreover, the circumstances may be such to indicate that the157 owner is long dead or far away. indeed, in a great many cases it can be presumed that the (negative) value of the forfeiture condition is unascertainable, and, therefore, zero. alternatively (as in the case of art works without provenance), the market would simply factor the defect in title into the market value. in sum, the possibility of forfeiture would, at most, rise to the level of158 a valuation consideration, and would not be so overwhelming as to justify deferral. at the level of financial theory, a compelling argument can be made that, once a taxpayer appropriates possession of a found (or stolen) object, it is never appropriate to treat it as having been “borrowed,” since even an159 acknowledged “restoration” obligation has no “interest” (rent) component. the best rationale for the borrowing “exclusion” derives from financial analysis: 160 154 . the chances that an employee may be fired are significant. moreover, an employee may decide that it is in her best interests to seek another position, despite triggering the forfeiture condition. 155 . see collins v. commissioner, 3 f.3d 625 (applying james to stolen pari-mutual tickets); vasta v. commissioner, t.c. memo (p-h) ¶ 89, 531 (applying james to seized cocaine); rev. rul. 71-528, 1971-2 c.b. 219 (securities received as advance commissions). cf. delaney v. commissioner, t.c. memo (p-h) ¶ 82, 666 (taxpayer received gold coins from swiss source; held: value of coins is includable, since taxpayer could not prove that they were purchased); melsa v. commissioner, t.c. memo (p-h) ¶ 77, 415 (value of groceries taken from whollyowned corporation). 156 . see riesman, supra note 143. 157 . see corliss v. bowers, 281 u.s. 376 (1930) (stating, in context of revocable transfer, that income taxation is keyed to beneficial enjoyment and command, rather than technical ownership). 158 . an art object or cultural artifact subject to the unidroit convention is subject to a serious risk of forfeiture if discovered. however, the unidroit convention has not been ratified by the united states. moreover, it (arts. 1, 2, and 3(1) & (2)) is limited to transnational instances resulting from the theft, illegal export, or illegal excavation, of certain categories of valuable objects, and would be more of a concern to individuals and institutions who have purchased such items. 159 . see stahl v. united states, 441 f.2d 999 (d.c.cir.1970) (bailment not a loan, resulting in inability of bailor to take bad debt deduction). 160 . the financial justification is contrasted with the “traditional” reliance on business accounting doctrine, which justifies the exclusion on the basis of a “liability” to repay principal 720 florida tax review [vol. 4:10 in an arms-length borrowing, the amount borrowed is equal to the present value of the obligation to pay both principal and interest. if there is no obligation161 to pay interest or rent, as is the case with a bailee, the borrower has an accession to wealth on account of not having to pay interest or rent, and the only issue162 is “when” (and how much) such accession to wealth occurs (and how it is to be measured). if the borrowing is for a term, the borrower’s accession to wealth can be reduced to present value. if the borrowing is “on the lender’s demand,” the borrower has gain for each taxable period that interest (or rent) is not paid. 163 since the date, if any, when a found object might have to be returned cannot be known in advance, the found-object scenario is closer to a demand borrowing than to a term borrowing. a close proxy for including imputed interest (or rent) in income is to include the value of the cash (or property) in income when received (unreduced by the “value” of the restoration obligation) and then to give the taxpayer a deduction (or tax credit) if and when the cash is repaid (or the property is returned). for example, assume cash or property worth $100,000 is received with an annual discount rate or rental value of 6%. one year later, the item is returned. if the imputed interest or rent were included in gross income, the taxpayer would incur an annual tax liability of $2,400 (assuming a 40% tax rate). alternatively, assume that the taxpayer includes $100,000 in year one, resulting in a $40,000 year one tax, and deducts $100,000 in year two, resulting in a tax savings of $40,000. this pair of events is the equivalent of a one-year interest-free loan of $40,000 to the government, which (at a discount rate of 6%) is worth $2,400 to the government.164 that “offsets” the incremental “asset” (the borrowed cash or property). this accounting treatment ignores the obligation, if any, to pay interest or rent. the absence of such an obligation means that the value of the repayment obligation is less than the borrowed amount. the excess of the borrowed amount over the value of the repayment obligation indicates that the borrower’s wealth is increased because of the borrowing-repayment series of events. the accounting treatment of borrowing ignores this increase in wealth; the financial treatment does not. 161 . this analysis assumes a “market” interest rate. 162 . see brown, supra note 136, at § 11.9 (right of gratuitous bailee to use property is implicit compensation for bailee’s services). 163 . see irc § 7872 (imputing interest on certain below-market-interest loans, and distinguishing between term loans and demand loans). 164 . this analysis raises the issue of whether or not the precisely correct result is to confer a credit equal to the increase in tax attributable to the year one exclusion, as opposed to a deduction. the credit approach has initial theoretical appeal, but it produces the wrong result where the property was held by the finder for personal use and decreased in value during the period between the find and the return. see infra notes 168-173 and accompanying text infra. in any event, irc § 1341 allows a choice between a credit and a deduction in certain circumstances, but it is not clear if that section would apply in the windfall found object situation, because irc § 1341(a)(1) requires that “it appeared that the taxpayer had an unrestricted right to such item.” although this language prevents thieves and embezzlers from using irc § 1341, it is not clear how one would apply “unrestricted right” to a finder lacking clear title (and perhaps even a right to possession), and how one construes “appeared” in the context of the niceties of personal property law. (there appears to be no case dealing with this issue.) one might prefer either a deduction approach or a credit approach in principle, but there is no justification for giving the 2000] applying the “claim of right doctrine” to found objects 721 this result can be obtained under the james doctrine without statutory enactment. however, contrary (perhaps) to prevailing case law, the deduction165 should be granted as a matter of right. a doctrinal basis for granting the166 deduction would be that the property, even if of the personal use variety, did involve a “transaction entered into for profit” under internal revenue code section 165(c)(2) insofar as the taxpayer acquired the property for nothing, rather than having purchased it. this approach also supports the proposition167 that the deduction should be the lesser of the taxpayer’s basis (earlier amount included) or its value at the time of restoration.168 reinforcing the conclusion that a james-type analysis should apply is the observation that, like james, bailment-type obligations are imposed by state law, rather than by the consent of the parties. as a practical matter it is quite unlikely that finders would report found objects as gross income when the possibility of forfeiture lapses, since: (1) finders are unlikely to know when this occurs (unless there is an actual settlement or proceeding to determine title); (2) taxpayers generally do not think of having gross income when a forfeiture condition (such as the running of a state law statute of limitations) lapses; and (3) there is no reporting obligation on the part of any third party, or any public event, that would put the irs on notice of the lapse of forfeiture conditions. taxpayer a choice. also, irc § 1341 has generated substantial litigation costs that probably outweigh any dubious gain in “equity.” therefore, irc § 1341 should be repealed. 165 . although the repayment deduction (or, where available, the irc § 1341 credit) is often allowed, see rev. rul. 76-374, 1976-2 c.b. 19 (repayment by embezzler is deductible as a “loss” under irc § 165), it is not allowed as a matter of right, and, even where allowed, it might be an “itemized deduction” or even a “miscellaneous itemized deduction” under § 67. some cases take the position that the repayment must either satisfy the requirements of irc § 1341 or be independently deductible as an expense under irc § 162 or § 212. see pahl v. commissioner, 67 t.c. 286 (1976). however, the better view is that § 1341 can apply only if a deduction would be allowed by some other code section. see irc § 1341(a)(2); united states v. skelly oil co., 394 u.s. 678, 683 (1969); wood v. united states, 863 f.2d 417 (5 cir.1989). th conversely, failure to satisfy the requirements of irc § 1341(a) should not bar a deduction under other code provisions. (in the case of property, the deduction should be allowed under irc § 165(c)(2).) nevertheless, the deduction has been disallowed in various situations. see murphree v. united states, 867 f.2d 883 (5 cir.1989) (repayment of embezzled amount deductible as lossth only if “involuntary”); wood, supra (drug dealer’s loss deduction resulting from forfeiture to government disallowed on public policy grounds). the public policy doctrine would not apply to the restoration of a found object, and neither should voluntariness be a bar to deductibility so long as the original owner has a colorable claim to title. see barrett v. commissioner, 96 t.c. 713 (1991) (nonacq.). see also pike v. commissioner, 44 t.c. 787 (1965) (acq.) (voluntariness only a bar to using irc § 1341, but not a bar to deductibility). 166 . accord, harold dubroff, the claim of right doctrine, 40 tax l. rev. 729, 74849 (1985). my research has not uncovered any case involving personal-use property that has considered this issue. 167 . cf. rev. rul. 82-74, 1982-1 c.b. 110 (restitution of insurance proceeds obtained as a result of committing arson to one’s own property; deduction allowed, but only to the extent of the gain earlier recognized by reason of having received the insurance proceeds). 168 . that portion of the property represented by the decline in value attributable to personal use was not acquired for profit. 722 florida tax review [vol. 4:10 as in james, there is a rather obvious doctrinal “hook” for distinguishing current-realization from deferred-realization cases involving found objects. in james, the hook was the taxpayer-centered test of “consensual obligation to repay.” in the found-object situation, the doctrinal equivalent would be “meaningful efforts to find the true owner.” a person who is seriously trying to return the object to the true owner is not exercising “dominion and control” over the object, and therefore is not currently “realizing” the income, at least until such efforts cease or become moot. this approach fits within the phrase “reduced to undisputed possession” in regulations section 1.61-14, which would be viewed from the finder’s position, not that of the owner. finally, applying james would also serve the aims of the underlying property law, which is to provide incentives for finders to return objects to their true owners.169 interesting and perplexing issues would seem to be posed on account of the likelihood that the value of the object at the date returned will be greater (or less) than the value when acquired. what is the amount of the finder’s deduction, and does the return of the object constitute a realization event to the finder and/or the original owner? if these issues cannot be resolved, then the case for applying james to windfall property receipts would be weakened. i believe that these issues can be coherently resolved on the basis of the principle that, if the item is eventually returned, any appreciation or depreciation during the finder’s period of possession should be allocated to the original owner, who ultimately reaps the benefit of any appreciation or the burden of any depreciation (that does not represent personal consumption of the finder).170 thus, the finder, according to james, would include the property in gross income, and acquire a basis in the property in an amount equal to its value upon the acquisition of possession. upon returning the item, the finder should not be viewed as realizing gain or loss on the difference between such basis and the value at the date returned, because the return of the property to the original owner does not “pay for” any benefit received either from the property or the original owner, other than the initial accession (which has already been taxed171 to the finder). the return of the item to the original owner would entail a deductible loss to the finder, since the finder became the “tax owner” by reason of the earlier inclusion in gross income. if the item had not been held for172 personal use, the deduction would be the finder’s adjusted basis. if the property 169 . see kades, supra note 42, at 1522; riesman, supra note 143, at 1124. 170 . this approach is consistent with the authorities cited in infra note 176, which would apply to the owner’s side of the transaction. 171 . compare diedrich v. commissioner, 457 u.s. 191 (1982) (discharge of gift tax liability); united states v. davis, 370 u.s. 65 (1962), reh’g denied, 371 u.s. 854 (settlement of support obligation running to ex-wife); international freighting corp. v. commissioner, 135 f.2d 310 (2d cir.1943) (payment of compensation); kenan v. commissioner, 114 f.2d 217 (2d cir.1940) (loan repayment). 172 . the finder would acquire basis only by actually reporting the item as gross income. see infra note 185. 2000] applying the “claim of right doctrine” to found objects 723 had been held by the finder for personal use, the loss deduction should be the lesser of the finder’s adjusted basis or the value of the item at the time the item is returned.173 the original owner’s tax treatment should hinge on whether such owner took a deduction upon the loss of the item. if such a deduction had been taken, the recovery of the item would trigger the tax benefit rule: an amount equal to the original deduction would be included in gross income to the extent that it reduced taxable income. the original owner’s original basis would then be174 restored. alternatively, if no deduction had earlier been taken, the original175 owner’s basis would still be available. because the original owner retained an interest in the property (the right of recovery), the re-acquisition should not be treated as a realization event. in this fashion, the original owner’s tax176 treatment will be the same as if the item had never been lost. the foregoing analysis answers any possible objection to the effect that the james approach should be limited to receipts of cash (given that u.s. cash can have no value apart from its face amount). in conclusion, the “reduced to undisputed possession” language in section 1.61-14 should be strictly construed against deferred realization. the key is the use of the word “undisputed,” as opposed to “undisputable.” it is reasonable to confine deferred realization to situations where an actual dispute is joined at (or shortly after) the finder’s appropriation of the item, as opposed to the indeterminate realm of situations where a dispute (sooner or later) is conceivable. possession should be viewed as being disputed only if the finder: (1) turns the item over to a third party or the state, or (2) segregates the item177 173 . thus, if the item is worth $100x when found, is held by the finder for personal use, and is worth $85x when returned, the finder would deduct $85x as an ordinary loss upon return, but the loss of $15x would not be allowed on the ground that it represented personal consumption obtained by the finder. cf. regs. § 1.165-7(b)(1). if the item is held for investment, there would be an ordinary loss of $100x. if the item appreciated to $127 when returned, there would be also be an ordinary loss deduction of $100x. 174 . see irc § 111. 175 . the basis would presumably be fully restored even if all or a part of the original deduction had been disallowed, for example, by irc § 165(h). see dobson v. commissioner, 320 u.s. 489 (1943), reh’g denied, 321 u.s. 231 (1944) (basis in property is not lost where loss deduction failed to produce a tax benefit). 176 . cases applying the tax benefit rule to recoveries of property that were deducted under irc § 170 support this approach. in that context, the taxpayer includes the lesser of the property’s fair market value when returned or the amount, if any, of the prior deduction, with no recognition of gain (or loss). see rosen v. commissioner, 611 f.2d 942 (1 cir.1980); alicest phelan sullivan corp. v. united states, 381 f.2d 399 (ct.cl.1967); 885 investment corp. v. commissioner, 95 t.c. 156 (1990). 177 . cf. united states v. merrill, 211 f.2d 297 (9 cir.1954) (after discoveringth mistake, taxpayer agreed to repay funds and thereby avoided inclusion in gross income). but cf. quinn v. commissioner, 524 f.2d 617 (7 cir. 1975) (rejecting merrill). merrill is limited toth “mistake” cases, and does not apply to embezzlement and other misappropriation cases. see, e.g., buff v. commissioner, 496 f.2d 847 (2d cir.1974). 724 florida tax review [vol. 4:10 (as in a lost-and-found department). short-term or half-hearted action, such178 as posting notices on electric poles or advertising in the newspaper, should not be sufficient to negate or defer “undisputed possession,” unless such action179 results in the prompt return of the item to the original owner. at a more abstract level, the foregoing analysis suggests that “lack of dominion and control,” as when an object is disclaimed or returned, can directly indicate non-income, or it can indicate lack of current “realization,” i.e., where the circumstances denoting lack of dominion and control may be only “temporary.” since the realization-of-income principle potentially applies to all (inkind) gross income items, and since the realization-of-income principle is180 (inartistically) acknowledged in the “reduced to undisputed possession” language of section 1.61-14, there is every reason to view section 1.61-14 as illustrative only. indeed, section 1.61-14 by its terms only purports to be illustrative. therefore, no particular weight should be placed upon the term “treasure trove.” d. home-run baseballs to apply the foregoing analysis to record-setting baseballs chased down by fans results in the conclusion that the baseballs would be current gross income, as it appears that no person or entity (other than the finder) has a legal claim to the balls that would preclude current realization under the section 1.6114 or general tax principles. the item should be deemed realized unless it is disclaimed within a reasonably short period of time. the concept of disclaimer can be applied flexibly in this context to allow the ball to be “returned” to the home team, the league, an organization affiliated with the league (such as the baseball hall of fame), and (more debatably) the player hitting the ball. 181 an argument for “nonrealization” unique to the home-run-baseball situation might be that the value of any record-setting object cannot be 178 . cf. miele v. commissioner, 72 t.c. 284 (1979) (segregation of prepaid fees into restricted account). 179 . generally, the case law takes a very hard line against attempts by embezzlers and thiefs to avoid james-type income (by, for example, agreements to return the item or actually returning the item during the same taxable year). e.g., buff v. united states, 496 f.2d 847 (2nd cir.1974) (confession of judgment); estate of sympson v. commissioner. 1994 ria t.c. memo ¶ 94,002 (renouncing claim to item), aff’d 95-1 t.c. ¶ 50,276 (unpublished opinion, 10th cir.1995); taylor v. commissioner, 1997 ria t.c. memo ¶ 97, 513. compare gilbert v. commissioner, 552 f.2d 478 (2d cir.1977) (contemporaneous intent to repay avoids james); united states v. merrill, 211 f.2d 297 (9 cir. 1954) (good faith mistake); gaddy v.th commissioner, 38 t.c. 943 (1962) (immediate agreement to restore excessive rent). 180 . see regs. § 1.61(a)(1); commissioner v. glenshaw glass, supra note 6. 181 . the irs took precisely this position in ir news release 98-56, 16 stand. fed. tax rep. (cch) ¶ 46,532. see comment, the tax implications of catching mark mcgwire’s 62 home run ball, 52 tax law. 871 (1999) (arguing that the taxpayer, by directing the ball tond mcgwire, rather than to major league baseball, exercised dominion and control rather than making a true disclaimer). 2000] applying the “claim of right doctrine” to found objects 725 determined at the moment it is acquired, because such value can be diminished by subsequent record-setting items. but, insofar as the object could lose value due to future events, the current market value would be significantly discounted. from such discounted amount the value might well increase, since the possibility of subsequent record-setting items may disappear (due to the end of a season or of a slugger’s career). the contingencies that affect future value are closer in kind to those that produce unrealized appreciation and depreciation than those that can be called conditions of forfeiture: a record-setting item does not lose all significant value just because the record might be (and eventually is) surpassed. thus, the argument that value uncertainty precludes realization is not persuasive. another possible argument is that obtaining a record-setting baseball is closer to a commercial venture, or to a commercial bargain purchase, than to a found object, because the taxpayer “invested” in a ticket to attend the game. however, the price of the ticket is exhausted by the entertainment value of the game. the cost of the ticket is a personal consumption expense. there is no separate basis in the remote opportunity to obtain the record-setting baseball. 182 e. should the regulations be changed as to windfall found objects? in light of the foregoing, there is no basis for concluding that found objects, including record-setting baseballs, are not gross income when obtained (assuming the item is “accepted”). there is also no basis for the notion that section 1.61-14, which only makes concessions to taxpayers, is invalid as to treasure trove or to any other category of found object. at this point, zelenak and mcmahon appear to argue that, since the irs does not enforce the inclusion of found objects in gross income, the treasury should withdraw the sentence in section 1.61-14 referring to treasure trove. as a preliminary matter, the evidence cited by zelenak and mcmahon (absence of cases and private letter rulings) does not establish that the irs ignores the principle that in-kind windfall receipts are gross income. the absence of cases and rulings involving found objects suggests that taxpayers and their advisors have no doubt that found property is gross income when received, except perhaps pending an actual and bona fide dispute over ownership. (as previously mentioned, the fact that the irs does not advance the treasure trove regulation in the case of commercial ventures involving fishing, big game, and treasure hunting is justified and natural: these situations involve produced inventory, not found objects.) the other possibility is that taxpayers systematically cheat on this issue, notwithstanding potential liability for fault and no-fault penalties for not 182 . a similar situation was presented in cesarini, where the taxpayer purchased a piano that happened to contain concealed cash. the entire purchase price was allocated to the piano. the cash was held to be wholly taxable. 726 florida tax review [vol. 4:10 reporting significant items of gross income. such cheating would hardly be183 the fault of the irs, however, which has no independent access to knowledge of in-kind windfalls except from what might appear in newspapers. but it is hard to imagine revenue agents scouring newspapers just to learn about in-kind windfalls of significant value, which are rare in any event. that the irs cannot reasonably be expected to enforce a rule that found objects are generally gross income might be a cause for concern to one who thinks that all law should be enforced to the letter. the principal problem with a law that is rarely enforced is that of arbitrary exercise of discretion by government officials, and possibly that of undue intrusions into privacy. these concerns would not seem to be especially present in the case of in-kind windfall gains, since the irs would simply maintain its posture of ignorance unless tipped off by publicity or possibly an informer. since found objects of significant value are fairly rare, the irs would not find it worthwhile to launch invasive “fishing expeditions.” there is no reason to think that the irs would abuse “prosecutorial discretion” in this area, nor is there anything inherently “private” or “personal” about in-kind windfall gains. another possible concern with a rule that is mostly unenforceable is that it will breed disrespect for the law. however, in the case of in-kind windfall gains, unenforceability does not imply that the rule itself is misconceived. a184 parallel situation is posed by state laws imposing fines on littering. in both cases the rule embodied in the law establishes, and to some degree publicizes, a norm governing conduct, but in both cases widespread enforcement is impossible. this is especially the case with a tax rule that cannot be enforced by imposing a reporting obligation on the transferor, given that tax is basically a selfenforcement regime. windfall found objects are (generally) small fish indeed relative to market transactions. the aggregate amount of found currency and other objects is probably very small compared to the aggregate amount of unreported wages, for example. the irs is not required to devote its very scarce resources to trivia. despite an assumed low level of enforcement effort, the regulations bearing on windfall receipts of cash or property serve a purpose in the very rare case where large amounts of cash or high-value assets are found. these events are subject to publicity, so that enforcement is a possibility. also, as mentioned earlier, an inclusionary tax rule provides taxpayers with an incentive to take meaningful steps to return the property to the true owner. if non-cash liquid items are not treated as gross income when received, the government faces the possibility that the taxpayer will claim: (1) a basis equal to fair market value upon receipt notwithstanding the fact that the income was not reported, or (2) capital gains treatment equal to the full amount realized on sale. although the 183 . see irc § 6662. 184 . for example, the fact that criminal laws relating to sodomy and drug use are largely unenforceable calls attention to the fact that zealous enforcement would cause governmental intrusions into privacy. 2000] applying the “claim of right doctrine” to found objects 727 taxpayer will probably be stuck with a zero basis, he or she may well obtain185 capital gains treatment, although that seems wrong as a matter of principle. 186 187 it is worth repeating the fact that the inclusionary rule is not found in the treasure trove regulation, regulations section 1.61-14, but rather in section 185 . basis should be zero for in-kind income that is not in fact included in gross income, since the function of basis is to prevent double taxation of previously-taxed dollars (or tax-exempt dollars). however, at one time it appeared that failure to report an in-kind income item did not preclude acquiring a basis. see bennet v. helvering , 137 f.2d 537 (2d cir.1943) (taxpayer not estopped, by erroneous exclusion, from claiming basis equal to value when property acquired). cf. helvering v. salvage, 297 u.s. 106 (1936) (assumed that government’s only remedy in this type of case was doctrine of estoppel, which was not available on the facts presented). fortunately, the weight of authority now appears to favor a zero-basis rule, without regard to estoppel. see charley v. commissioner, 91 f.3d 72 (9 cir.1996) (conversion ofth employer-paid frequent-flyer credits to cash; the credits were not included as earned); continental oil co. v. jones, 177 f.2d 508 (10 cir.1949) (no basis from erroneous exclusion, even thoughth elements of estoppel not present); timken v. commissioner, 141 f.2d 625 (6 cir.1944) (no basisth for unreported in-kind dividend). cf. detroit edison co. v. commissioner, 319 u.s. 98 (1943) (no basis for property purchased with excluded non-shareholder contributions to capital); helvering v. gowran, 302 u.s. 238 (1937) (zero basis for non-taxed stock dividend); robbins v. united states, 21 f.supp. 403 (ct.cl.1937) (taxpayer, who erroneously excluded prior item, estopped from claiming refund on theory that basis was value upon receipt). an erroneous exclusion might also give the irs a remedy under irc §§ 1311(a) and 1312(7) (consisting of inclusion in the earlier year, despite the statute of limitations, plus interest), but only if: (1) the taxpayer maintained “inconsistent positions,” see irc § 1311(b)(1)(b), (2) there is a current determination that basis equals fair market value on receipt, and (3) there was a prior (erroneous) “determination” (tax court decision or closing agreement) in the taxpayer’s favor, see irc § 1313(a). irc §§ 1311-1314 should not be viewed as the exclusive remedy for the irs in erroneous-exclusion situations, since it is based on assumptions about underlying “tax common law” that are no longer valid. 186 . it is not clear whether a zero basis (or lack of investment) precludes capital asset treatment. cases allowing capital asset characterization include metropolitan bldg. co. v. commissioner, 282 f.2d 592 (9 cir. 1960) (surrender of lease), and ofria v. commissioner, 77th t.c. 524 (1981) (sale of self-developed know-how). in these cases, the taxpayer can be said to have made an investment that did not happen to be capitalized. other cases have denied capital asset treatment: commissioner v. gillette motor transp., inc., 364 u.s. 130 (1960) (no separate basis in “temporal slice” of an asset owned by the taxpayer); hort v. commissioner, 313 u.s. 28 (1941) (same); norton v. united states, 551 f.2d 821 (ct.cl.1977), cert. denied, 434 u.s. 831 (franchise right in which taxpayer had no investment); vestal v. united states, 498 f.2d 487 (8th cir.1974) (contingent right not previously included in income); foote v. commissioner, 81 t.c. 930 (1983) (surrender of tenure). 187 . the weight of commentary is that significant investment by a taxpayer should be a prerequisite for capital asset treatment. see jay a. soled, the sale of donors’ eggs: a case study of why congress must modify the capital asset definition, 32 u.c. davis l. rev. 919, 960-62(1999); william popkin, the deep structure of capital gains, 33 case w. res. l. rev. 153, 197-198 (1983); calvin johnson, seventeen culls from capital gains, 48 tax notes 1285, 1288 (sept. 3, 1990). assuming a zero basis that results either from not reporting the in-kind receipt as income or from a deferred-realization-of-gross-income rule, the gain (at least to the extent of market value when received) does not reflect unrealized appreciation and therefore should not obtain capital gains treatment. cf., united states v. skelly oil co., 394 u.s. 678, 683 (1969) (refund of partially excluded income is deductible only to extent of earlier inclusion); haverly v. united states, 513 f.2d 224 (7 cir. 1975) (free samples donated to charity wereth included in gross income at their acquisition-date value). 728 florida tax review [vol. 4:10 1.61-1(a), which states that in-kind receipts are income when realized. the treasury is hardly going to withdraw that regulation. nor should it. the treasury has to maintain the position that a rule is a rule, and that taxpayers cheat at their own risk. 188 f. let congress do it in the end, the issue of the taxation of record-setting home run balls is the perfect setting for congressional intervention. congress could fulfill its role of “waving the flag” over symbolic issues (the american pastime) and, in the process, finessing valuation difficulties, in an extremely narrow area without doing any serious damage to the tax system. indeed, the legislation might189 perform a service by expressly denying both basis and capital gain treatment to windfall property not included in gross income upon receipt. perhaps the legislation could give the taxpayer an election to include the item at market value, so that subsequent appreciation would be capital gain. in all seriousness, a principal lesson to be derived from the history of realization doctrine is that virtually every contested realization issue has been settled by ad hoc legislation or government concession. courts are best190 equipped to elaborate rules based on clear and coherent categories, but “difficulty of valuation” and “nonliquidity” are matters of degree, and courts are ill-equipped to sort out cases of this type. in contrast, in-kind property subject to contingencies that render such property inalienable, incapable of current enjoyment, or without any readily ascertainable fair market value can be said to fall into a separate and distinct category of nonrealized income. home-run baseballs are not contingent property, but congress, not the courts, can legitimately create a separate deferral rule for home-run balls apart from the current-inclusion rule for (noncontingent) in-kind windfalls generally. vi. conclusion so what’s new? it may be somewhat of a surprise to find that the socalled treasure-trove regulation, in the course of citing a certain kind of windfall found object as being an example of “residual” gross income, actually hints at the possibility of deferred realization. moreover, deferred realization is not wholly implausible, since the finder usually does not acquire clear title, so that there is at least a theoretical possibility of having to return the item to a superior claimant. moreover, there is a body of “realization of gross income” doctrine that potentially opens the door to income deferral. 188 . nothing written in the pages of this journal will convince a person who thinks that winning a lottery (or obtaining a windfall) entails avoiding tax as well. 189 . accord, comment, supra note 181, at 879. 190 . see irc §§ 83 (restricted property and compensatory stock options), 109 (lessee improvements), 305 (stock dividends); regs. § 1.61-14 (treasure trove whose title is disputed). 2000] applying the “claim of right doctrine” to found objects 729 however, upon further inquiry it is concluded that deferred realization is limited to rare and unusual circumstances. although exactly what combination of circumstances (including perhaps lack of possession, or “dominion and control”) might justify deferral may be hard to state with exactitude, it is clear enough that windfall found objects should not be held to be within any such deferred-realization rule. a better approach is to treat the item as gross income when acquired, taking into account any discount due to uncertainty over title, and then to allow, as a matter of right, a deduction in the appropriate amount if and when the item is returned. the return would not be191 a realization event to the original owner, but any prior loss deduction would have to be reversed according to the tax benefit rule. there are also lessons here about the appropriate roles of congress, the treasury, the courts, and the irs on the income tax stage. 191 . see supra text accompanying notes 171-73. e. should the regulations be changed as to windfall found objects? florida tax review volume 20 2017 number 4 i article accretion-based progressive wealth taxation david hasen uf law 2017 fl tax review 20-4 r2.pdf 1 4/19/17 5:50 pm florida tax review volume 20 2017 number 4 ii information for subscribers the florida tax review is a publication of the graduate tax program of the university of florida levin college of law. for volume 20, the subscription rate is $125.00 in the united states and $145.00 elsewhere. if a subscription is to be discontinued at expiration, notice to that effect should be sent; otherwise, it will be automatically renewed. for volume 20, subscriptions and changes of address should be sent to florida tax review, university of florida levin college of law, post office box 117627, gainesville, florida 32611. requests for back issues should be sent to william s. hein & co., inc., 1285 main street, buffalo, ny 14209. please notify florida tax review of your changes of address one month in advance. beginning with volume 21, the florida tax review will be published by the university of florida press on behalf of the graduate tax program of the university of florida levin college of law. for subscription information and queries relating to volume 21 and subsequent volumes, please contact the johns hopkins university press, p.o. box 19966, baltimore, md 21211; phone 1-800-548-1784; jrnlcirc@press.jhu.edu. all correspondence of a business nature, including advertising, should be addressed to the university of florida press, 15 nw 15th st., gainesville, fl 32603; phone 352-392-1351; http://upress.ufl.edu. copyright © 2017 by the university of florida uf law 2017 fl tax review 20-4 r2.pdf 2 4/19/17 5:50 pm florida tax review volume 20 2017 number 4 iii editor-in-chief charlene luke professor of law university of florida associate editors university of florida yariv brauner hugh culverhouse eminent scholar karen burke richard b. stephens eminent scholar dennis a. calfee professor of law patricia e. dilley professor emeritus michael k. friel professor emeritus david m. hudson professor emeritus lawrence a. lokken emeritus hugh culverhouse eminent scholar grayson mccouch gerald sohn professor of law martin j. mcmahon, jr. james j. freeland eminent scholar adam smith visiting assistant professor lee-ford tritt professor of law samuel c. ullman adjunct professor of law steven j. willis professor of law board of advisors jennifer bird-pollan university of kentucky bradley t. borden brooklyn law school deborah a. geier cleveland state university leandra lederman indiana university– bloomington omri marion university of california, irvine gregg d. polsky university of georgia james r. repetti boston college kerry a. ryan st. louis university reed shuldiner university of pennsylvania graduate student editors emily snider carvalho brandon c. gardner devon goldberg jessica e. griffin william carroll mcdonald philip nodhturft, iii benjamin m. parnell kathleen duggan pfahlert executive assistant jessica e. joseph uf law 2017 fl tax review 20-4 r2.pdf 3 4/19/17 5:50 pm florida tax review volume 20 2017 number 4 iv information for contributors the florida tax review is a faculty-edited law review published by the graduate tax program of the university of florida levin college of law. the florida tax review invites the submission of manuscripts addressing issues of tax law and policy. the florida tax review prefers electronic submissions sent via expresso (https://www.bepress.com/products /expresso/); articles may also be e-mailed to ftr@law.ufl.edu as a microsoft word document. if a hard copy submission is necessary, please mail your article to editor-in-chief, florida tax review, university of florida levin college of law, 309 village drive, gainesville, fl 32611. although the florida tax review has no minimum or maximum page requirements for submissions, it does have a strong preference for submissions that are 30,000 words or less, including text and footnotes. all citations should follow the bluebook uniform system of citation (20th ed.); some modifications will, however, be made by our editors to conform to the florida tax review style manual. all tax law and policy positions presented are solely those of the authors. the editors and the university of florida levin college of law do not approve of or adopt such positions merely through the act of publishing the manuscripts in the florida tax review. uf law 2017 fl tax review 20-4 r2.pdf 4 4/19/17 5:50 pm florida tax review volume 20 2017 number 4 v all references and citations to sections in this issue are to sections of the internal revenue code of 1986, as amended, unless otherwise indicated. all references and citations to regulations are to treasury regulations promulgated under the internal revenue code of 1986, as amended, unless otherwise indicated. uf law 2017 fl tax review 20-4 r2.pdf 5 4/19/17 5:50 pm uf law 2017 fl tax review 20-4 r2.pdf 6 4/19/17 5:50 pm